Closing Entries - Online Tutor, Practice Problems & Exam Prep

Closing entries are essential for zeroing out temporary accounts, which include revenues, expenses, and dividends, after preparing financial statements. Revenues are debited to the Income Summary, while expenses are credited to bring their balances to zero. Dividends, treated as a reduction in retained earnings, are also closed. Finally, the net income from the Income Summary is transferred to retained earnings, reflecting the company's profit for the period. This process ensures accurate financial reporting and prepares accounts for the new fiscal year.

Introduction to Closing Entries:Temporary and Permanent Accounts

All right, so after we've adjusted our books, made our adjusted trial balance, created our financial statements, well then, we're ready to close the books for the year. Let's check it out. So we're going to make some closing entries after we've put out our financial statements, right? And these closing entries are used to zero out what we call temporary account balances. Let me go back to red. Temporary account balances and this is after the financial statements have been created. Right? So let's talk about what these temporary accounts are. Temporary accounts are accounts related to a certain time period. Okay? So they're temporary because they're only related to that time period, and those are generally going to be our income statement accounts for the most part. And I'm gonna say income statement and dividends because that is the other one, right? So we've got our revenues, our expenses and dividends are the temporary accounts. Okay? So remember that dividends is not an expense. Right? We've said it all in unison together. Dividends are not an expense. Dividends are not an expense, but they are a temporary account because they only hold the value from this year's dividends then we want to start over next year. Alright, so those are temporary accounts being our income statement accounts plus dividends that are permanent accounts. Well, these are accounts that hold balances from period to period. These are gonna be our balance sheet accounts. Okay. Balance sheet accounts, you could think there's some cash balance last year, but we're not gonna zero out the cash. Right? We still have that cash, and the next year we're gonna have a different amount of cash or sometimes the same amount of cash. Whatever it might be, that account is never gonna be closed. There's always gonna be some balance in the cash account and we're going to leave it year over year. Alright? So those asset, liability, and equity accounts, those are going to be our permanent accounts. I want to introduce you to one more account, the Income Summary account, and this is a temporary account used during the closing process. Okay? So it only comes up now while we do the closing entries. And then we don't use it throughout the year. It just helps us close the books. Okay? So let's pause here and then we'll go through each of the closing entries using our example from the adjusted trial balance. So grab your adjusted trial balance from the previous lessons and we're gonna use that to close out the books of that company. Alright? So let's do that now.

Closing Journal Entries

Alright. Let's go through these closing entries now. We're going to be using the adjusted trial balance from the previous lesson. Okay? So let's go ahead and start with the revenues. Just so you know what I'm talking about, I'm going up here to the adjusted trial balance. And when I talk about service revenue, I'm talking about closing this revenue account using this balance, using our adjusted trial balance. Okay? So let's go back to this first entry. The first entry says debit each revenue account for its full balance and credit income summary. So if you think about it, revenue accounts have a credit balance, right? They generally have a credit balance, and now we're going to debit it to get it down to 0. So there's some balance in the account. We're going to debit it by that amount to zero it out. So it's zero, and it's ready for the next year. So our revenue was 7,500 from our adjusted trial balance. So we're going to debit our revenue account 7,500. That brings the revenue down to 0. And the income summary account, we're going to credit for the 7,500. Okay? So now, if you think about it, all of our revenues have been taken off the books and have been put into the income summary account. The income summary account is sitting with a 7,500 credit balance, right? There's a 7,500 credit balance in the income summary account after that entry.

Now let's move on to the second entry. We've closed our revenue accounts, right? There was a revenue account with a balance in it; we just negated that balance down to 0. So we want to do the same thing with expenses. But remember, expenses generally have a debit balance. So to get rid of the expenses with debit balances, we're going to need to credit all those expenses. I'm pulling all these expenses from that adjusted trial balance, and it's just going to go down the line. We had rent expense was a thousand. So we're going to credit rent expense a 1,000. Salary expense, 1,800. Supplies expense was 300, depreciation 400, utilities 500, and income tax 600. These were all the expenses from the adjusted trial balance and now they've been zeroed out, right? Because they had a debit balance, we credited them the same amount, so that negates it down to 0. So the last thing to do in this step is to find out what's going to be the debit to the income summary, right? Because we have all of these credits in this entry, so we need to total them up to find the amount of the debit. So I'm just going to go ahead and do it on my phone. We've got 1,000, 1,800, 300, 400, 500 plus 600, and we get a total of 4,600. So now we're debiting the income summary 4,600. But now, we're going to subtract 4,600, right? Because there was this debit entry. And if you haven't seen this before, CR, I think it means credit record, Dr for debit record. I think that's the terminology there. So sometimes, you'll just see credit or debit. So we're taking this 7,500 credit balance and subtracting 4,600 from it, right? And those were the expenses. So that makes sense. This kind of going to summarize our income into one account in the income summary account. So 7,500-4,600, that's a 2,900 credit balance, right? It's important to note if the income summary is going to have a debit or a credit balance so that we know what's going to happen at the end. Okay? So right now, we have a credit balance of 2,900 in the income summary account.

The next step is to close our dividends account. So remember, dividends are not an expense. They do not show up on the income statement; they get taken straight out of retained earnings. Retained earnings are all the income that we've made in previous years; it's all sitting in retained earnings. So if we want to pay out to our stockholders, we take a bit of that retained earnings and pay it out to them. Okay? So in this case, our dividends were $3,200 in the example. So we have to decrease our retained earnings with a debit of $3,200 and then $3,200 as a credit to the dividends. The dividends were originally sitting with a debit balance. So just so you know when we declared the dividends, so the company said, hey, we're paying a dividend of $3,200. They would have made an entry that looks like this. Debit dividends for 3,200, credit cash 3,200, something like that. Okay? It could get more complicated later on, but we don't need to deal with that right now, okay? So, that's the idea. This dividends, debit balance, right? There was this debit to dividends when we declared them, well, that was sitting in the equity account. Remember, equity accounts are generally credit balances, right? Credit is a good thing for equity. So this debit was decreasing the equity balance, and now we're finally getting it off the books, right? So there was a previous debit of 3,200 to dividends. Now we're crediting it 3,200 to get rid of it, right? And it's finally coming out of retained earnings. So our income summary balance after this transaction, well, it's still 2,900, right? We didn't touch the income summary in that in that entry. Okay? So our income summary is still at 2,900, and now it's time to close out the income summary, right? So notice, dividends got closed to retained earnings, and now we're closing the income summary to retained earnings, right? So remember, all of our net income, as I've said before, the net income goes to retained earnings, right? Every year we get some net income, it goes to retained earnings. Well, this is it finally going to retained earnings, alright? So throughout the year, we earned all these revenues, we paid all these expenses, and now we're finally putting those numbers into retained earnings. So in the case that revenues were greater than expenses, like in the case that we have here, we made a profit, right? There was more revenues than there were expenses. And in this case, the income summary is going to have a credit balance. And that makes sense, right? Because the revenues were credits, so those credits were bigger than the expenses, those debits. So we end up with a net credit balance in the income summary. So since it has a credit balance, we need to use a debit to get rid of the income summary, and the opposite would be true. If we had a loss, we would be closing the income summary with a credit. In this case, we have a profit, so the income summary has a credit balance. So just like we have here, 2,900 credit balance, to get rid of that, we need to debit the income summary 2,900, and our credit is going to be to retained earnings. So notice we're crediting retained earnings in this case. This increases the value of retained earnings, right? Because retained earnings goes up with credit balances. So this profit that we made, we made $2,900 profit in net income this year, that is being closed to retained earnings, and it's increasing the value of retained earnings just like we would expect. Cool? So now the income summary balance, well, it was 2,900. We just debited it 2,900, so it is now closed. There's nothing left in the income summary. All of our revenue accounts are closed. All our expense accounts are closed. Dividends are closed. We're done. We're fresh and ready for the new year. Cool? So let's pause here and then move on to the next video.

Here’s what students ask on this topic:

What are closing entries in accounting?

Closing entries are journal entries made at the end of an accounting period to zero out temporary accounts, such as revenues, expenses, and dividends. This process transfers the balances of these accounts to permanent accounts, specifically retained earnings. By doing so, it ensures that the temporary accounts start with a zero balance in the new accounting period, allowing for accurate tracking of financial performance year over year.

Why are closing entries necessary?

Closing entries are necessary to reset the balances of temporary accounts to zero at the end of an accounting period. This process ensures that revenues, expenses, and dividends are accurately reported for the specific period they pertain to. Additionally, closing entries help in transferring the net income or loss to retained earnings, which is a permanent account. This prepares the accounts for the new fiscal year and ensures accurate financial reporting.

How do you close revenue accounts?

To close revenue accounts, you need to debit each revenue account for its full balance and credit the Income Summary account. Revenue accounts typically have a credit balance, so debiting them will bring their balance to zero. For example, if the Service Revenue account has a balance of $7,500, you would debit Service Revenue for $7,500 and credit Income Summary for $7,500. This transfers the revenue to the Income Summary account, preparing the revenue account for the new period.

What is the Income Summary account used for?

The Income Summary account is a temporary account used during the closing process to summarize revenues and expenses. It helps in transferring the net income or loss to retained earnings. After closing revenue accounts to the Income Summary, expenses are also closed to this account. The resulting balance in the Income Summary, which represents the net income or loss, is then transferred to retained earnings. This account is only used during the closing process and does not appear in financial statements.

How do you close expense accounts?

To close expense accounts, you need to credit each expense account for its full balance and debit the Income Summary account. Expense accounts typically have a debit balance, so crediting them will bring their balance to zero. For example, if Rent Expense has a balance of $1,000, you would credit Rent Expense for $1,000 and debit Income Summary for $1,000. This transfers the expenses to the Income Summary account, preparing the expense accounts for the new period.