5.1 Describe and Prepare Closing Entries for a Business

Closing Entries and Retained Earnings

Closing entries are the final journalizing step in the accounting cycle. They reset all temporary accounts to zero so the next period starts with a clean slate, and they transfer the period's net income or loss into Retained Earnings, a permanent equity account.

Closing Entries for Revenue and Expenses

Every revenue and expense account is a temporary (nominal) account, meaning it only tracks activity for one period. At period-end, you empty each of these accounts through the Income Summary account, which acts as a temporary holding place.

Here's the four-step closing sequence:

1. Close revenue accounts to Income Summary. Debit each revenue account for its full balance; credit Income Summary for the same total. This zeroes out all revenue accounts.

2. Close expense accounts to Income Summary. Credit each expense account for its full balance; debit Income Summary for the same total. This zeroes out all expense accounts.

3. Close Income Summary to Retained Earnings. After steps 1 and 2, Income Summary's balance equals net income (credit balance) or net loss (debit balance). Transfer that balance to Retained Earnings:

   • Net income: Debit Income Summary, credit Retained Earnings.
   • Net loss: Debit Retained Earnings, credit Income Summary.

4. Close the Dividends account to Retained Earnings. Debit Retained Earnings and credit Dividends for the account's balance. Dividends reduce equity, so this entry decreases Retained Earnings.

After all four entries are posted, every temporary account has a zero balance, and Retained Earnings reflects the cumulative effect of the period's activity.

Purpose of Closing Temporary Accounts

Temporary accounts (revenues, expenses, dividends, and Income Summary) exist only to measure one period's performance. If you didn't close them, the next period's income statement would include old balances mixed with new activity, making the financial statements unreliable.

Real (permanent) accounts like assets, liabilities, and equity carry their balances forward from period to period and are not closed. The post-closing trial balance should contain only these real accounts with their correct balances.

Calculation of Final Retained Earnings

The closing process feeds directly into the Retained Earnings balance. You can verify the result with this formula:

$\text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income (or} - \text{Net Loss)} - \text{Dividends}$

Example:

• Beginning Retained Earnings: $100,000
• Net income for the period: $50,000
• Dividends declared: $20,000

$\text{Ending Retained Earnings} = \$100{,}000 + \$50{,}000 - \$20{,}000 = \$130{,}000$

This $130,000 is the balance you'll see in Retained Earnings on the post-closing trial balance and on the balance sheet.

The Accounting Cycle and Post-Closing Procedures

Closing entries are step 9 (of 10) in the full accounting cycle, coming right after the financial statements are prepared. Two things happen after closing entries are posted:

• Post-closing trial balance. This verifies that debits still equal credits and that only real accounts (assets, liabilities, equity) remain with non-zero balances. If a temporary account still shows a balance, a closing entry was missed or posted incorrectly.
• Reversing entries (optional). Some companies record reversing entries on the first day of the new period. These reverse certain adjusting entries (like accrued expenses) to simplify recording the related cash transaction when it occurs later. Not every company uses them, and not every adjusting entry needs one.