What Are Closing Entries in Accounting and How to Make Them?

Every company needs an accounting "reset", typically at the end of the month or at least at the end of year. "Resetting" helps businesses clearly assess their financial performance for a current period. This is where closing entries come in: they ensure that financial reports accurately reflect a company's performance and prevent confusion between different time periods.

What Are Closing Entries?

Closing entries are accounting entries made at the end of an accounting period to reset temporary account balances to zero. Historically, these accounting entries were manually recorded by accountants. Nowadays most of the online accounting software automates this process for the end of the year. However, the automatic closing entries are not always accurate and may require manual adjustments (we will talk about it in details later). Monthly closing entries are still performed in big companies manually by corporate accountants.

What Are Temporary Accounts?  

Temporary accounts (another term for them is nominal accounts) are associated with financial activity of the company for the given period of time. Here’s an example of temporary accounts:

1. Revenue Accounts: These accounts record income generated from sales of goods or services (e.g., Sales Revenue, Service Revenue).

   
   

2. Expense Accounts: These accounts capture costs incurred during a specific period (e.g., Rent Expense, Utilities Expense, Salaries Expense).

   
   

3. Gain and Loss Accounts: These accounts reflect gains or losses from transactions outside the company's primary operations (e.g., Gain on Sale of Assets, Loss on Investments).

   
   

Where can you see temporary accounts on your books? Well, they are all reflected on the company’s Profit and Loss statement. See the image below:

Now, once we figured out what temporary accounts are, we need to know where they are being moved to. Surprisingly, as logic suggests, temporary accounts are moved to permanent accounts.

 What are Permanent Accounts?

Permanent accounts maintain their balances from one accounting period to the next, representing the company’s financial position over time. (In contrast, temporary accounts show actual financial activity for a given period).  The acronym ALE helps recall the three main types of permanent accounts. Here is a break down of permanent accounts:

1. Assets: Cars, office space, cash in bank.

2. Liabilities: Loans, unpaid bills.

3. Equity: Owner's value in the company, for small businesses it is usually either Retained earnings or Capital accounts.

   
   

 Where can you see permanent accounts on your books? Well, they are reflected on the company’s Balance Sheet. See the image below:

Among all the permanent accounts, the only one that usually gets affected is Retained Earnings (or Capital Accounts in partnerships). Other permanent accounts, such as assets, liabilities, and common stock, are not directly affected by closing entries but remain open and carry their balances into the next accounting period.

Posting Closing Entries

So, now we know that closing entries move temporary accounts to permanent accounts (usually Retained Earnings). But what is the process? How do you record those entries on your books? Here are two main methods:

Method 1: Step-by-Step Process (aka the proper way)

1. Reset Revenue Accounts:

   • Debit: revenue accounts for total revenue earned during the period.

   • Credit: the income summary account.

   Example: If revenue is $20 million:

   • Debit: Revenue Account ($20 million)

   • Credit: the income Summary Account ($20 million)

     
     

2. Reset Expense Accounts:

   • Credit: expense accounts for their total amount.

   • Debit: the income summary account.

   Example: If expenses are $16 million:

   • Debit: The income Summary Account ($16 million)

   • Credit: Expenses Account ($16 million)

     
     

3. Move everything out of the Income Summary Account:

   
   

If the income summary account has a credit balance (net income), debit it and credit retained earnings. If there’s a net loss, do the opposite.

   Example: If the income summary has a credit balance of $4 million:

• Debit: The income Summary Account ($4 million)

• Credit: Retained Earnings ($4 million)

  
  

Why do we need this income summary account in the first place, you ask me?  Well, the income summary account is important for several reasons. First, it simplifies financial reporting by bringing together revenues and expenses, making it easy to calculate net income or loss. Second, it ensures that debits and credits balance correctly by keeping entries separate. Finally, it acts as a transition point, helping to keep a records trail for zeroing out temporary accounts.

Method 2: One-Step Closing Entry (aka the easy way)

In this method, revenue accounts are debited for total revenue, while expense accounts are credited. The difference is transferred directly to retained earnings, representing net income or loss. There is no income summary account

   Example: If revenue is $20 million and expenses are $16 million

• Debit: Revenue Account ($20 millions)

• Credit: Expense Accounts ($16 millions)

• Credit: Retained Earnings ($4 millions, the difference)

  
  

This easy method for closing entries is an effective approach that resets all temporary accounts to zero while updating the retained earnings account to reflect the company’s net income or loss for the period. This method is beneficial for several reasons: it is faster and more efficient, as it combines all closing entries into one step, saving time and reducing errors. Additionally, it works perfectly with automated systems, as many accounting software programs automatically utilize the short method, making digital tools easier to use. Moreover, accountants can minimize manual work by spending less time on individual entries for revenues, expenses, and dividends. However, this one step method has some drawbacks. It provides less detailed information than the long method, which can be a disadvantage for those seeking a more in-depth view of their accounts. It also offers limited control, as the long method may be better for manual accounting systems or complex adjustments. Finally, if adjustments are needed after closing, it can be more challenging to identify which accounts were incorrect when using the short method.

The Post-Closing Trial Balance

After closing entries are done, we prepare a post-closing trial balance to show the company's financial position with all temporary accounts reset to zero. In most cases the accounting software creates this balance for us automatically. This balance includes only permanent accounts:

• Assets: Cash, accounts receivable, inventory, property.

  
  

• Liabilities: Loans, accounts payable, deferred revenue.

  
  

• Equity:  retained earnings or capital accounts if we talk about partnerships.

  
  

Temporary accounts are excluded since their balances are now zero.

Where can you a trial balance in your accounting software? Well, you would need to pull a report for it and it looks like this:

Next Year's Opening Balance

Did you notice that the date on this trial balance is January 1st? The post-closing trial balance serves as the starting point for the next accounting period. The balances in permanent accounts will carry forward to become the opening balances for the new period.

For example, if a company ends the current period with $500,000 in cash, $1 million in liabilities, and $2 million in retained earnings, these amounts will be the opening balances for the next period.

Conclusion

Closing entries are a very important part of accounting. They help you start each new accounting period afresh. Businesses keep their financial records accurate and up-to-date by moving temporary accounts (like income, expenses, and dividends) to permanent accounts (like retained earnings).

Sometimes, especially in the case of smaller businesses that use online accounting software, closing entries are done automatically. In larger companies, these entries are still done manually, following a step-by-step process.

Regardless of whether you use automated software or not, it is important to understand the logic behind closing entries. By understanding this logic, you will understand the entire accounting process of your company. And if you ever need help, please reach out. We've helped numerous business owners with their accounting problems.