At the end of a financial period, the accounting department of a company or a certified public accountant records adjusting and closing entries and prepares several trial balances. Initially, the accountant prepares a trial balance without adjusting entries, then subtracts or adds adjusting entry totals and creates an adjusted trial balance. Finally, he closes all income and expense accounts to retained earnings and prepares a final, post-closing trial balance. Each entry causes a difference between the adjusted and post-closing trial balances.
At the end of each accounting cycle an accountant prepares adjusting entries, an income statement and closing entries to the general ledger. The total income and expense for the period is transferred to the income summary account and the balances are returned to zero. The income summary is then used to create an income statement. Closing entries do not affect the trial balance directly; they are necessary to create an income statement, which removes the income and expenses for the period from the post-closing trial balance.
The adjusted trial balance includes income from the current period. Closing entries reduce the income account to zero and transfer the balance to the income summary account. Each income account listed in the income summary balance contributes to total revenue for the period. When income is recognized on the income statement, the total credit balance of all adjusted trial balance entries is reduced. When the post-closing trial balance is prepared, the income accounts are not listed because they all equal zero.
The adjusted trial balance also includes expenses for the current period, which are transferred to the income summary account and income statement. Expenses for the period are included in the adjusted trial balance before being transferred to the income statement. Closing entries to the general ledger reduce the balance of each expense to zero; the accounts are not included in the post-closing trial balance.
Once the income statement accounts have been closed, net income is determined and dividends for the period are subtracted from net income. The resulting amount is considered retained earnings, or the amount of funds still on hand after paying for all expenses. A company can choose to keep those funds for future use, pay back investors or pay towards the principal of notes or accounts payable. The retained earnings reported on the adjusted trial balance is the amount left over from the previous period, whereas the amount reported on the post-closing trial balance includes the previous amount plus the retained earnings for the current period.