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What are Closing Entries in Accounting?
Closing Entries is a set of journal entries made at the end of the accounting period to move balances from temporary ledger accounts like revenue, expense and withdrawal/dividends to permanent ledger accounts.
- It is like resetting the balances of temporary accounts to zero to make it clean to be used in the next accounting period, meanwhile hitting the balance sheet accounts with their balances. It is also known as closing the books and the frequency of closing can vary as per the size of a company.
- A large or mid-size firm usually opts for monthly closing to prepare monthly financial statements and gauge the performance and operational efficiency, however, a small firm can go for quarterly, semi-annually or even annual closing.
Steps for Posting Closing Entries Journal
- Closing Revenue & Expense: It involves transferring the balances of the whole accounting period from revenue account and expense account to the income summary account
- Closing Income Summary: Moving the net income or net loss from income summary account to the retained earnings account of the balance sheet
- Closing Dividends: If there has been a dividend pay-out then transferring the balance from Dividends account to the retained earnings account
Example of Closing Entries in Accounting
To look at it more practically let’s take closing entries journal example of a small manufacturing company ABC Ltd which is going for an annual closing of books:
Let’s assume ABC Ltd. earned ₹ 1,00,00,000 from sales revenue over the year 2018 so the revenue account has been credited throughout the year. Now at the end of the year, it needs to be zeroed out by debiting it and crediting the Income summary account.
Let’s also assume that ABC Ltd incurred expenses of ₹ 45,00,000 in terms of raw material purchase, machinery purchase, salary paid to its employees, etc over the accounting year 2018.
All these examples of closing entries journals have been debited in the expense account. Now at the end of the accounting year 2018, the expense account needs to be credited to clear its balances and Income summary account should be debited.
So for posting the closing entries in the general ledger, the balances from revenue and expense account will be moved to the income summary account. Income summary account is also a temporary account which is just used at the end of the accounting period to pass the closing entries journal. It is not reported anywhere.
The net balance of the income summary account would be the net profit or net loss incurred during the period.
In the above case, there is a net credit of ₹ 55,00,000 or profit which will then finally be moved to the retained earnings account by debiting the Income summary account. The accounting assumption here is that any profit earned during the period needs to be retained for use in future investments of the company.
Something noteworthy here is that the above closing entry can be passed even without using the income summary account. i.e., moving the balances directly from revenue and expense account to retained earnings account. But using the income summary account used to give a clear view of the performance of the company when there was only manual accounting. Usually, where the accounting is automated or done using software, this intermediate income summary account is not used and the balances are directly transferred to the retained earnings account. In either of the ways, the temporary accounts need to be zero at the end of an accounting period.
Coming back to our initial example let’s suppose that ABC Ltd also paid out dividends worth ₹ 5,00,000 to its shareholders during the accounting year 2018, i.e. the dividend account has a debit balance of ₹ 5,00,000 which needs to be credited and then directly debiting the retained earnings account. Since dividends account is not an income statement account, it is directly moved to the retained earnings account.
Eventually, after having followed the above steps the temporary account balance will be emptied while taking the effect into the balance sheet accounts.
Below are the types of Closing Entries segregation into Temporary and Permanent accounts:
#1 – Temporary accounts
Temporary Accounts closing entries are only used to record and accumulate the accounting or financial transactions over the accounting year and they do not reflect the financial performance of the company. So it is essential to clear the balances of temporary account so that, for example, revenues and expenses for ABC Ltd. for the accounting year 2018 should be isolated and not be mixed with revenues and expenses of the year 2019.
#2 – Permanent accounts
Permanent Account closing entries shows the long-standing financial position of a company. It is necessary to transfer the balances to this account because it takes into account the appropriate consideration of assets or liabilities for future utilization for e.g. Let’s suppose ABC Ltd. incurred an expense to buy a machinery to be used for manufacturing, it is going to be utilized in the future years and not just in the accounting year in which it was recorded, so it needs to be moved to the balance sheet account from the temporary account.
So, if the closing entries journal is not posted then there will be incorrect reporting of financial statements. And not having an accurate depiction of change in retained earnings might mislead the investors about the financial position of a company.
Hence there are strong accounting regulations and policies which restrict the public listed companies to abuse certain loopholes while producing their financial reports. Apart from the guidelines, there are strict auditing rules to protect and ensure the integrity of the numbers being reported for any accounting period. Having an intermediate income summary account proves helpful to the accountant here as it provides a trail of accounting closing entries for each financial transaction.
This has been a guide to what is Closing Entries in Accounting. Here we discussed types of Closing Entries Journal along with practical examples. You can learn more about accounting with the following articles –