Types of Accounts

Remember the income statement is like a moving picture of a business, reporting revenues and expenses for a period of time (usually a year). We want income statements to start every year from zero, but for accounts like equipment, debt, and cash accounts—reported on the balance sheet—we want to keep a running balance from the beginning of the business. We call those permanent accounts.

• Permanent accounts: balance sheet accounts including assets, liabilities, and equity accounts (except for withdrawals). These account balances roll over into the next period. The ending balance of this period will be the beginning balance for next period.
• Temporary accounts: revenues, expenses, and withdrawals accounts. These account balances do not roll over into the next period after closing. The closing process reduces revenue, expense, and withdrawals account balances (temporary accounts) to zero so they are ready to accumulate data for the next accounting period.

Now you know a bit about permanent and temporary accounts. Let’s move on to learn about how to record closing those temporary accounts.

Preparing a Closing Entry

As we previously discussed, some computerized accounting systems, such as QuickBooks™ don’t actually create or post closing entries, but within the system, when you run a report, the software treats the accounts as if they were closed at the end of all the prior periods. Other accounting software, such as Oracle’s PeopleSoft™, post closing entries to a special accounting period that keeps them separate from all of the other entries. So, even though the process today is slightly (or completely) different than it was in the days of manual paper systems, the basic process is still important to understand.

We won’t be using NeatNiks as an example of closing entries for two reasons:

1. It’s not the end of the year for NeatNiks, just the end of a month, and
2. NeatNiks is probably going to switch to a computerized system before the end of the year anyway, such as Quickbooks, and that particular system (which is representative of most of the others) doesn’t actually post closing entries.

We’ll use a company called MacroAuto that creates and installs specialized exhaust systems for race cars. Here are MacroAuto’s accounting records simplified, using positive numbers for increases and negative numbers for decreases instead of debits and credits in order to save room and to get a higher-level view. Also, there are only a handful of transactions each year.

Notice that in the beginning, everything is zero. Then our business owner makes a deposit and things get rolling. By the end of 2019, there is only one asset, which is the $14,800 in our checking account that includes $5,000 in debt to the bank, so equity is $9,800 ([latex]\text{A}-\text{L}=\text{E}[/latex]). Revenues for the year were $10,500 and expenses were $500, so net income was $10,000. The owner put in $1,000 at the beginning of the year and took out $1,200 on December 31, leaving equity of $9,800.

In accounting, we often refer to the process of closing as closing the books. The four basic steps in the closing process are:

1. Closing the revenue accounts: transferring the credit balances in the revenue accounts to a clearing account called Income Summary.
2. Closing the expense accounts: transferring the debit balances in the expense accounts to a clearing account called Income Summary.
3. Closing the Income Summary account: transferring the balance of the Income Summary account to the owner’s capital account.
4. Closing the withdrawal account: transferring the debit balance of the owner withdrawal account to the capital account.

Let’s look at this process for MacroAuto’s 2020 information using T accounts that will stand in for the full ledgers. Notice that the 2019 ending balances carry forward to become 2020 beginning balances and that we start fresh in the revenue, expense, and withdrawal accounts (because we closed the books on 12/31/2019):

MacroAuto

General Ledger (represented by T accounts)

As of 12/31/2020

Permanent Accounts                                                                           Temporary Accounts

Before we do closing entries, let’s run an adjusted trial balance:

From this trial balance, as we learned in the prior section, you make your financial statements. After the financial statements are finalized and you are 100 percent sure that all the adjustments are posted and everything is in balance, you create and post the closing entries. The closing entries are the last journal entries that get posted to the ledger.

Below are the T accounts with the journal entries already posted.

Permanent Accounts                                                                           Temporary Accounts

Let’s go through these closing entries step by step.

Step 1: Close Revenue accounts

To close an account means to make the balance zero. We see from the adjusted trial balance that our revenue account has a credit balance. To make the balance zero, debit the revenue account and credit the Income Summary account. We’ll call this closing entry A, just to keep track of it.

Step 2: Close Expense accounts

The expense accounts have debit balances. To get rid of their balances, we will do the opposite or credit the accounts. Just as in step one, we will use Income Summary as the offset account, but this time we will debit income summary. The total debit to income summary should match total expenses from the income statement. In this case, we just have one expense account. We’ll label this “closing entry B.”

Step 3: Close Income Summary account

At this point, you have closed the revenue and expense accounts into income summary. The balance in the income summary account would now be an $8,400 credit ($13,100 debit minus $4,700 credit) and income summary should now match net income from the income statement. We want to remove this credit balance by debiting income summary. What did we do with net income on the statement of owner’s equity? We added it to the capital account. We’re now making a journal entry to do this in the books. We’ll call this “closing entry C.”

If expenses were greater than revenue, we would have net loss. A net loss would decrease owner’s capital, so we would do the opposite in this journal entry by debiting the capital account and crediting Income Summary.

Step 4: Close withdrawals account

After we move the balances in the revenue and expense accounts (net income or loss) to owner’s equity, we close the withdrawal account as well (closing entry D):

Now that the journal entries are prepared and posted, you are almost ready to start next year. Remember, modern computerized accounting systems go through this process in preparing financial statements, but the system does not actually create or post journal entries.

Here’s a summary of this section:

You can view the transcript for “How to Prepare Closing Entries (Financial Accounting Tutorial #27)” here (opens in new window).

The next and final step in the accounting cycle is to prepare one last post-closing trial balance. But first, check your understanding of this process.