When the end of the accounting period arrives, closing entries are recorded where accounting information in temporary accounts is summarized and transferred over to permanent accounts. Most closing entries involve revenue and expense accounts. At the end of the accounting 12-month period, also known as year end, closing entries are part of the preparation process to create the annual financial statements of the entity.
Revenue accounts contain the cumulative amount of revenue sales transactions recorded throughout the accounting period. Examples of revenue accounts include sales revenue or service revenue. The credit balance in this account is debited, and a corresponding credit is recorded to income summary. These closing entries zero out the revenue balances of the ending year’s transactions and prepare the account for the next fiscal year.
Expense accounts contain the cumulative amount of expenses recorded throughout the accounting period. Examples of expenses include salary expense, insurance expense and advertising expense. The debit balances in these accounts are credited and a corresponding debit is recorded to income summary. These closing entries zero out the expense balances of the ending year’s transactions and prepare the accounts for the new fiscal year that is set to begin.
After all the revenue and expense accounts have been closed, the income summary account is closed to the retained earnings account (for corporations) or owner’s equity accounts (for noncorporate entities). All the debits and credits recorded to income summary from the closing entries will result in a net debit balance (equal to the period’s net loss) or a net credit balance (the period’s net income). The income summary’s net debit or credit balance is credited/debited and a corresponding debit/credit is recorded to retained earnings or owner’s equity. This is the closing entry that zeros out the income summary account.
Any capital withdrawals made throughout the period relate to dividends for corporate entities or owner’s drawings for noncorporate entities. In a corporate environment, capital withdrawals are represented by dividends paid; this account is closed to retained earnings by recording a credit for the account balance with a corresponding debit to retained earnings. In a noncorporate environment, capital withdrawals are recorded through a capital drawing account; this account is closed by crediting its balance and debiting the owner’s capital account for the same amount.
