What is a Temporary Account?
Temporary accounts are nominal accounts that start with zero balance at the beginning of all the financial year, at the end of the year balance of the same are visible in the income statement and then the balance will be transferred to the permanent account in the form of reserves and surplus. Thus, accounts that are part of the Income statement are temporary accounts and are periodically closed.
Types of Temporary Account
Following are its types –
#1 – Revenues and Gains
Revenue and gains earned by the entity need to be closed at the end of every year. Thus, account like Sales account, Service Revenue account, Interest Income account, dividend income account, Profit on sale of an asset accountAn Asset AccountAsset Accounts are one of the categories in the General Ledger Accounts holding all the credit & debit details of a Company’s assets. The examples include Short-Term Investments, Prepaid Expenses, Supplies, Land, equipment, furniture & fixtures etc. , discount income account, etc. are the type of temporary accounts getting covered under Revenue and Gains
#2 – Losses and Expenses
Expenses are at the core of all businesses. Hence, as discussed in revenue, expenses also need to be clear at the end of the year to verify the net outflow of the cash for the given period. Thus, accounts like Cost of sales accountCost Of Sales AccountThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales., Salaries expense account, interest expense account, Delivery expense account, Purchase account, etc. are the type of temporary accounts getting covered under Losses and Gains
#3 – Drawing Account or Income Summary Account
At the end of the year, the summary of the Income statement is transferred to the capital accountThe Capital AccountThe capital account refers to the general ledger that records the transactions related to owners funds, i.e. their contributions earnings earned by the business till date after reduction of any distributions such as dividends. It is reported in the balance sheet under the equity side as “shareholders’ equity.” in sole proprietorship and in partnership. While in corporate, the income statement summary is getting credited to Reserves and Surplus in the form of a corporate dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.. Without these entries, books cannot be closed. Hence, entries with the nature of such adjustments are considered as closing entries, and they are passed in the temporary accounts.
Temporary Account Examples
- ABC Limited recorded revenues of $600,000 for the financial year 2017. Then, $400,000 worth of revenues were recorded in 2018, as well as $800,000 in 2019.
- The company will use here a temporary account to represent the revenue annually to display in 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.. If the account was not closed, then the total revenues would be $1800,000.
- The company can be visible as profitable due to total turnover. However, that can not be good always because three years-worth of revenues cannot be clubbed to measure the solvency of the businessSolvency Of The BusinessSolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.. For the proper computation of any year’s profit, as well as the expenses, the temporary account must be created and closed adequately at the end of the year.
- Let’s take the example of retained earningsExample Of Retained 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.. Retained earnings show the accumulated gains or losses earned by the company over some time. Every year, at the end of the year, the balances of income and expense accounts are transferred to the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. and then squared off against the income summary account, bypassing the closing entries.
- Once the process of accounting completed, books are closed by transferring the surplus/losses to retained earning account. Ledger Reserves and surplusReserves And SurplusReserves and Surplus is the amount kept aside from the profits that are to be used either for the business or for the shareholders to pay out dividends. Reserves and surplus is reflected under shareholders funds in the balance sheet. will not be closed at the end of a period as the nature of the same is permanent. Rather, it contains a balance and carries it forward to the next year and discloses the company’s past period income and losses.
Difference Between Temporary Account and Permanent Account
How to Close the Temporary Account?
It is always mandatory to close all temporary accounts and record the net change to the Owner’s capital account. This can be achieved by passing the journal entries and posting the same to respective ledgers, balancing the same, and then passing closing entries for all temporary accounts. An Income Summary account prepared to show the summary of revenue and expense accounts and discloses the profits and losses of the entity for the given period.
Below are the steps to be followed to close these accounts
- Revenue and Gains Account – Step one is to square off the revenue and gains account. It includes transferring the amount of the revenue accountRevenue 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. to the income summary account on the debit side.
- Expenses and Losses Account – Step two is to square off the expenses and losses account. It includes transferring the amount of the cost account to the income summary account on the credit side.
- Income Summary Account – Step three is to square off the income summary. The amount of the income summary, which is nothing but the expenses and revenue, is transferred to the capital account.
- Drawings Account – The last step is to square off the drawings account. The amount in the drawings account is transferred to the capital account or the retained earnings account.
These are prepared to avoid a mix-up of the balances between two or more accounting periodsAccounting PeriodsAccounting 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.. The main objective here is to see the profits or gains, as well as the accounting activity of individual periods. It is very much important to classify any account under a temporary account diligently because if any asset account is wrongly considered then, it will erode the asset base of the entity.
This article has been a guide to What is a Temporary Account and it’s Definition. Here we discuss temporary account examples along with types and how these accounts can be closed. You can learn more about accounting from the following articles –