What is the purpose of closing entries?
Closing entries serve the purpose of transferring the temporary account balances to the permanent accounts in the accounting system. The temporary accounts, such as revenue, expense, and dividend accounts, are only used to accumulate data for a specific accounting period, usually a month or a year. At the end of the accounting period, closing entries are made to reset these temporary accounts to zero and close them out.
There are a few steps involved in the process of closing entries:
1. Identify the temporary accounts: Temporary accounts are usually listed on an income statement, such as revenue and expense accounts. Dividend or withdrawal accounts may also be included.
2. Determine the net income or net loss: Calculate the difference between total revenues and total expenses. If the revenues exceed the expenses, it's considered net income. If the expenses exceed the revenues, it's net loss.
3. Debit or credit the revenue and expense accounts: If there is net income, you would credit revenue accounts and debit expense accounts. If there is a net loss, you would debit revenue accounts and credit expense accounts.
4. Transfer the net income or net loss to the retained earnings account: The retained earnings account is a permanent account that shows the accumulated earnings or losses over time. If there is net income, you would debit the retained earnings account. If there is a net loss, you would credit the retained earnings account.
5. Close dividend or withdrawal accounts: If there are any dividend or withdrawal accounts, you need to close them by debiting the retained earnings account and crediting the dividend account.
6. Prepare a post-closing trial balance: After completing the closing entries, you should prepare a post-closing trial balance to ensure that the accounting equation remains in balance. This trial balance includes only permanent accounts.
By following these steps, closing entries ensure that the temporary accounts are reset to zero and the financial statements accurately reflect the financial position of the company for the next accounting period.