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 the types of Temporary account:
#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 account, 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 of time. Thus, accounts like Cost of sales account, Salaries expense account, interest expense account, Delivery expense account, Purchase account etc are the type of temporary accounts getting covered under Losses and Gains
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#3 – Drawing Account or Income Summary Account
At the end of the year, the summary of the Income statement is transferred to the capital account 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 dividend. 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
Below are the examples of Temporary account
Example #1
- 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 statements. If the temporary account was not closed, the total revenues seen would be $1800,000.
- The company can be visible as profitable due to total turnover, however that can not hold good always because three years-worth of revenues cannot be clubbed to measure the solvency of the business. 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.
Example #2
- Let’s take the example of retained earnings. Retained earnings show the accumulated gains or losses earned by the company over a period of time. Every year, at the end of the year, the balances of income and expense accounts are transferred to the income statement 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 surplus 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
| Points | Temporary Account | Permanent Account | ||
| Closure of account | It is getting closed at the end of every year. | These accounts are never getting closed. | ||
| Income statement Vs Balance sheet | All the income statement accounts are temporary accounts. | All the balance sheet accounts are Permanent accounts. | ||
| Carry forward of balances | The balances of these accounts are not carried forward. | Balances of Permanent accounts are carried forward to next year. | ||
| Brought forward of balances | As no carried forward of balances, a temporary account will have never brought forward of balances. | The permanent account may or may not have brought forward balances. | ||
| Also known as | They are also known Nominal accounts. | They are also known as Permanent Account. | ||
| Post-closing trial balance existence | After the preparation of the trial balance, the balance of all the temporary accounts will be zero. | Post-closing trial balance, there will be only a permanent account as it will be having balances to be carried forward. | ||
| Example | Temporary Account Examples include Sales Account, Purchase Account, expense account , income account etc. | Asset account, liability account, capital account, etc. |
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 the Temporary accounts
- Revenue and Gains Account – Step one is to square off the revenue and gains account. It includes transferring the amount of the revenue account 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 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.
Conclusion
Thes are prepared to avoid a mix-up of the balances between two or more accounting periods. 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 as a temporary account then, it will erode the asset base of the entity.
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