What are Closing Entries in Accounting?
Closing Entries in Accounting are the different entries made at the end of any accounting year to nullify the balances of all the temporary accounts created during the accounting period and transfer their balance into the respective permanent account.
In simple words, Closing entries are a set of journal entries made at the end of the accounting period to move balances from temporary ledger accountsLedger AccountsLedger in accounting records and processes a firm’s financial data, taken from journal entries. This becomes an important financial record for future reference. It is used for creating financial statements. It is also known as the second book of entry. 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. and gauge the performance and operational efficiency. However, a small firm can go quarterly, semi-annually, or even annual closing.
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Steps for Posting Closing Entries Journal
- Closing Revenue & Expense: It involves transferring the balances of the whole accounting period from the revenue account and expense account to the income summary account.
- Closing Income Summary: Moving the net income or net lossNet Income Or Net LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet. from the income summary account to the retained earnings account of the balance sheet.
- Closing Dividends: If there has been a dividend pay-outDividend Pay-outThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Income then transferring the balance from Dividends account to the retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. account
Example of Closing Journal Entries
To look at it more practically, let’s take closing entries journal example of a small manufacturing company ABC Ltd which is going for the annual closing of books:
ABC Ltd. earned ₹ 1,00,00,000 from sales revenue over the year 2018 so the revenue accountThe Year 2018 So The Revenue AccountRevenue accounts are those that report the business's income and thus have credit balances. Revenue from sales, revenue from rental income, revenue from interest income, are it's common examples. has been credited throughout the year. 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 the raw material purchase, machinery purchase, salary paid to its employees, etc., over the accounting year 2018.
All these examples of closing entries in journals have been debited in the expense account. At the end of the accounting year 2018, the expense account needs to be credited to clear its balances, and the 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 that 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, a net credit of ₹ 55,00,000 or profit will finally be moved to the retained earnings account by debiting the Income summary account. The accounting assumptionThe Accounting AssumptionAccounting assumptions are a set of rules that ensures an organization's business operations are conducted efficiently and as per the standards defined by the FASB (Financial Accounting Standards Board), which ultimately helps lay the groundwork for consistent, reliable and valuable information. here is that any profit earned during the period needs to be retained for use in future company investments.
Something noteworthy here is that the above closing entry can be passed even without using the income summary accountIncome Summary AccountAn income summary is a transitory account created to transfer all the expenses and revenue accounts at the end of the accounting period. An increase in credit side balance exhibits profit, while a higher debit side balance shows a loss.. i.e., moving the balances directly from revenue and expense accountExpense AccountExpense accounting is the accounting of business costs incurred to generate revenue. Accounting is done against the vouchers created at the time the expenses are incurred. to the retained earnings account. But using the income summary account was used to give a clear view of the company’s performance when there was only manual accounting. Usually, where the accounting is automated or done using software, this intermediate income summaryIncome SummaryAn income summary is a transitory account created to transfer all the expenses and revenue accounts at the end of the accounting period. An increase in credit side balance exhibits profit, while a higher debit side balance shows a loss. account is not used, and the balances are directly transferred to the retained earnings account. 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 balanceA Debit BalanceIn a General Ledger, when the total credit entries are less than the total number of debit entries, it refers to a debit balance. A debit balance is a net amount often calculated as debit minus credit in the General Ledger after recording every transaction. of ₹ 5,00,000, which needs to be credited and then directly debiting the retained earnings account. Since the dividends account is not an income statement account, it is directly moved to the retained earnings account.
Eventually, after following the above steps, the temporary account balance will be emptied into the balance sheet accounts.
Below are the types of Closing Entries segregated into Temporary and Permanent accounts:
#1 – Temporary accounts
Temporary Accounts entries are only used to record and accumulate the accounting or financial transactions over the accounting year, and they do not reflect the company’s financial performance. So it is essential to clear the balances of temporary accountTemporary AccountTemporary accounts are nominal accounts that start with zero balance at the beginning of the financial year. The balance is visible in the income statement at the year-end and then transferred to the permanent as reserves and surplus. 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 entries show 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, e.g., Let’s suppose ABC Ltd. incurred an expense to buy 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 accountBalance Sheet AccountA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. from the temporary account.
So, if the closing entries journal is not posted, there will be incorrect reporting of financial statements. And not having an accurate depiction of change in retained earnings might mislead the investors about a company’s financial position.
Hence, strong accounting regulations and policies restrict the public listed companies from abusing 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 periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.. 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 article has been a guide to what Closing Entries in Accounting are. Here we discussed types of Closing Entries Journal along with practical examples. You can learn more about accounting with the following articles –