Closing Entries in Accounting

What are Closing Entries in Accounting?

Closing Entries in Accounting are the different entries made at the end of any accounting year for the purpose of nullifying the balances of all the temporary accounts created during the accounting period and transferring 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, also called the Second Book of Entry, is a book that summarizes all the journal entries in the form of debits & credits to use for future reference & create financial statements. read more like revenue, expense, and withdrawal/dividends to permanent ledger accounts.

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Steps for Posting Closing Entries Journal

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:

Let’s assume 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.read more 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.

AccountDebitCredit
Revenue₹ 1,00,00,000
Income Summary₹ 1,00,00,000

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 the Income summary account should be debited.

AccountDebitCredit
Expense₹ 45,00,000
Income Summary₹ 45,00,000

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, 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 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.read more here is that any profit earned during the period needs to be retained for use in future investments of the company.

AccountDebitCredit
Income Summary₹ 55,00,000
Retained Earnings₹ 55,00,000

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.read more. 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.read more 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 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.read more 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 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.read more 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.

AccountDebitCredit
Dividend₹ 5,00,000
Retained Earnings₹ 5,00,000

Eventually, after having followed the above steps, the temporary account balance will be emptied while taking the effect into the balance sheet accounts.

Types

Below are the types of Closing Entries segregation into Temporary and Permanent accounts:

Types of Closing Entries in Accounting

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#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 financial performance of the company. 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.read more 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.read more 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 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.read more. 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 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 –

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