Closing Entries: Temporary vs Permanent Accounts and Income Summary

Overview

• Focus: closing entries in accounting to reset temporary accounts and update the permanent accounts for a new period.

• Key idea: Incoming revenues and expenses are for a specific period. To start the next period clean, we zero out temporary accounts.

• Temporary accounts include: revenues, expenses, dividends, and income summary (a temporary clearing account used only for closing).

• Permanent accounts are the balance sheet accounts and are not closed at period end.

• The closing process ensures the ending Retained Earnings reflects the period's net income and any dividends paid.

• The post-closing trial balance should only include permanent accounts (temporary accounts should have zero balances).

Key concepts and terminology

• Income statement accounts = revenues and expenses (temporary)

• Statement of retained earnings = updates retained earnings (temporary for the period, then closed)

• Income Summary = a temporary account used to accumulate net result of revenues minus expenses during closing

• Normal balances concept (for exams):

• Assets, Expenses, and Dividends typically have debit balances

• Liabilities, Equity (including Revenues) typically have credit balances

• Net income (NI) for the period = $NI = ext{Total Revenues} - ext{Total Expenses}$

• Ending Retained Earnings (RE_end) is updated only after closing entries; it carries forward into the next period.

The closing process: four steps (in order commonly used)

• Step 1: Close revenue accounts to Income Summary

• Rationale: revenues have credit balances and need to be zeroed for the new period

• Journal entry (example with total revenues = $1{,}000{,}000$):

  • Debit Revenues for $1{,}000{,}000$

  • Credit Income Summary for $1{,}000{,}000$

• This transfers the revenue balance to Income Summary.

• Step 2: Close expense accounts to Income Summary

• Rationale: expenses have debit balances and need to be zeroed for the new period

• Journal entry (example with total expenses = $E$):

  • Debit Income Summary for $E$

  • Credit each Expense account for its individual balances totaling $E$

• After this step, Income Summary holds the net result: credit balance equals total revenues minus total expenses.

• Step 3: Close Income Summary to Retained Earnings

• Rationale: transfer the period’s net income (or net loss) to Retained Earnings

• If NI > 0 (net income):

  • Debit Income Summary for $NI$

  • Credit Retained Earnings for $NI$

• If NI < 0 (net loss):

  • Debit Retained Earnings for $-NI$

  • Credit Income Summary for $-NI$

• Net effect: Retained Earnings increases by net income (or decreases by net loss).

• Net income example (if Revenues = $1{,}000{,}000$ and Expenses = $X$):

  • $NI = 1{,}000{,}000 - X$

  • Entry moves $NI$ into Retained Earnings as above.

• Step 4: Close Dividends (or Owner’s Draw) to Retained Earnings

• Rationale: dividends reduce retained earnings

• Journal entry:

  • Debit Retained Earnings for $D$ (dividends total)

  • Credit Dividends for $D$

• Outcome: Retained Earnings is reduced by the amount of dividends paid during the period.

Special notes and tips mentioned in the transcript

• You can choose the order of Step 1 and Step 2 (revenues vs expenses) depending on your chart of accounts; the instructor uses a specific sequence for ease but the order can be flexible.

• The income statement and the statement of retained earnings are for a period (year/month).

• The “income summary” account is opened only as long as it takes to close the accounts; it should be closed in Step 3 to Retained Earnings.

• You should be mindful of normal balances when preparing for exams; the normal balance concept may shift in future chapters, but remains a fundamental check for the current exam.

• After closing entries are posted, you should prepare a post-closing trial balance to ensure columns balance; if the post-closing trial balance does not balance, you must review the closing entries.

• The ending Retained Earnings balance reflects the net income and dividends for the period; it does not update until the closing entries are completed.

Worked example from the transcript (conceptual)

• Revenues for 2021 totaled $1{,}000{,}000$.

• Suppose ending balances before closing would roll into 2022 if not closed; closing resets temporary accounts to zero for the new period.

• Example calculation of a fraction used in a problem:$rac{2}{3} imes 15{,}000 = 10{,}000$

• Use this type of calculation to verify journal entry amounts or to allocate portions of revenue/expense allocations when reviewing problems.

Formulas and key equations (LaTeX)

• Net income for the period:
  $NI = ext{Total Revenues} - ext{Total Expenses}$

• Closing entries (summary form):

• Close Revenues to Income Summary:
  $ext{Debit: Revenues} \ ext{Credit: Income Summary} \ ext{Total: } ext{Revenues}$

• Close Expenses to Income Summary:
  $ext{Debit: Income Summary} \ ext{Credit: Expenses} \ ext{Total: } ext{Expenses}$

• Close Income Summary to Retained Earnings (net income case):
  $ext{Debit: Income Summary} \ ext{Credit: Retained Earnings} \ ext{Amount: } NI$

• Close Dividends to Retained Earnings:
  $ext{Debit: Retained Earnings} \ ext{Credit: Dividends} \ ext{Amount: } D$

• Ending Retained Earnings relationship (for the period):
  $RE<em>{end} = RE</em>{begin} + NI - D$

• Net assets check after closing: post-closing trial balance should include only permanent accounts (no temporary accounts).

Quick recap of the practical workflow

• Identify temporary vs permanent accounts

• Sum Revenues and Expenses to determine NI

• Move Revenues to Income Summary (close)

• Move Expenses to Income Summary (close)

• Close Income Summary to Retained Earnings (net income or net loss)

• Close Dividends to Retained Earnings

• Update and verify the post-closing trial balance

• Prepare next period with all temporary accounts reset to zero