The Closing Process
In the previous article, we discussed how the economic life of a business can be divided into periods (monthly, quarterly or yearly), known as the accounting period concept. When a period ends, it has to be "closed". This is where certain accounts are zeroed out in order to prepare for the start of the next period. The act of zeroing out these accounts is called Closing.
After the adjusting entries have been posted in the ledger, the ledger will agree with the financial statements. The accounts on the balance sheet are carried over into the next accounting period. These are called real accounts. Accounts on the income statement are not carried over into the next accounting period. Also, the dividends (reported on the earnings statement) is not carried forward. These accounts that are only reported for one period are called temporary or nominal accounts.
Temporary accounts are zeroed out by transferring them to an account called the Income Summary. This is sometimes called Revenue and Expense Summary, Profit and Loss Summary, Income and Expense summary, and Clearing Account. The balance of the Income Summary is then transferred to the retained earnings account. The entries that transfer these accounts are called closing entries, and the process is called the closing process.
There are four closing entries that are required at the end of an accounting period. The closing entries are detailed below:
- Debit each revenue account for the amount of its balance, and credit Income Summary for the total revenues. The Fees Earned, Rent Revenue and other accounts in the revenue side are normally recorded as credits. By debiting them, this will zero out their accounts, summarizing the total of them in the credit section of the Income Summary.
- Credit each expense account for the amount of its balance, and debit income Summary for the total expenses. Expenses are recorded as debits in their accounts. By crediting them, this will zero out their accounts, summarizing the total of them in the debit section of the Income Summary. Note that you do not credit the dividend account at this time.
- Debit or Credit Income Summary for the amount of its balance, and debit/credit retained earnings for the same amount. If there is a Net Income, the credit side of Income Summary will be larger than the debit side. In this case, you would add an additional debit to Income Summary to make the total of this account zero. This amount would then be credited to Retained Earnings. If there is a Net Loss, the debit side of Income Summary will be larger than the credit side. In this case, you would add an additional credit to Income Summary to make the total of this account zero. This amount would then be debited to Retained Earnings.
- Credit Dividends account for the amount of its balance, and debit Retained Earnings for the dividends amount. Dividends are recorded in the debit section. By crediting the dividend account, this will zero it out, and move it to Retained Earnings as a debit.
After the closing entries have been processed, another trial balance is prepared. The post-closing trial balance is created to make sure that the ledger is in balance at the beginning of the next period. The accounts and amounts listed on the post-closing trial balance should agree exactly with the accounts and amounts listed on the balance sheet at the end of the period.
The annual accounting period adopted by a business is known as its fiscal year. Most business use the standard calendar year for their fiscal year. Others may have their fiscal year begin and end at other times of the year. Fiscal year begin with the first day of the month selected and end with the last day of the following twelfth month. Some business choose to have their fiscal year end at the lowest point of their annual operating cycle. This type of fiscal year is called the natural business year.