What is a 'Closing Entry'
A closing entry is a journal entry made at the end of the accounting period in which data is moved into the permanent accounts on the balance sheet from temporary accounts on the income statement. The purpose of the closing entry is to bring the temporary account balances to zero on the general ledger, including revenue, expense and dividend accounts. All income statement balances are eventually transferred to retained earnings.
BREAKING DOWN 'Closing Entry'Most closing entries involve the use of the account income summary. Income summary is a holding account used to aggregate all income accounts except for dividends expense. Income summary is not reported on any financial statements because it is only used during the closing process, and at the end of the closing process, the account balance is $0. Income summary effectively collects net income for the period and distributes the amount to be retained into retained earnings.
Sequence of Closing Entries
There is an established sequence of journal entries that encompass the entire closing procedure. First, all revenue accounts are transferred to income summary. This is done through a journal entry debiting all revenue accounts and crediting income summary. Next, the same process is performed for expenses. All expenses are closed out by crediting the expense accounts and debiting income summary.
Third, the income summary account is closed. If a company’s revenues were greater than its expenses, the closing entry entails debiting income summary and crediting retained earnings. In the event of a loss for the period, the income summary account needs to be credited and retained earnings are reduced through a debit. Finally, dividends are closed directly to retained earnings. The retained earnings account is reduced by the amount paid out in dividends through a debit, and the dividends expense is credited.
The closing entries have a few purposes for financial reporting. First, all revenue and expense accounts at the end of all closing entries have a $0 balance. This is because revenue is reported in defined periods and does not carry over into future periods. For example, $100 in revenue this year does not count as $100 of revenue for next year, even if the company retained the funds for use in the next year. This is contrasted with balance sheet accounts, in which $75 of cash held today is still valued at $75 on the balance sheet next year if it is not spent.
Second, the next income earned by the company is moved into retained earnings. The assumption is made that all income from the company in one year is held onto for future use. Any funds that are not held onto incur an expense that reduces net income. One such expense that is determined at the end of the year is dividends. The last closing entry reduces the amount retained by the amount paid out to investors.