The second part is the date of record that determines who
receives the dividends, and the third part is the date of payment,
which is the date that payments are made. Printing Plus has $100 of
dividends with a debit balance on the adjusted trial balance. The
closing entry will credit Dividends and debit Retained
Earnings. To further clarify this concept, balances are closed to assure
all revenues and expenses are recorded in the proper period and
then start over the following period. The revenue and expense
accounts should start at zero each period, because we are measuring
how much revenue is earned and expenses incurred during the period.
If your business is a corporation, you will not have a drawing account, but if you paid stockholders, you will have a dividends account. If you paid dividends for the month, you will need to close that account as well. This is the adjusted trial balance that will be used to make your closing entries. While these accounts remain on the books, their balance is reset to zero each month, which is done using closing entries.
All income statement balances are eventually shifted to retained earnings, which is a permanent account on the balance sheet. A business will use closing entries in order to reset the balance of temporary accounts to zero. The remaining balance in Retained Earnings is $4,565 (Figure 5.6). This is the same figure found on the statement of retained earnings. Closing entries transfer the balances from the temporary accounts to a permanent or real account at the end of the accounting year. Failing to make a closing entry, or avoiding the closing process altogether, can cause a misreporting of the current period’s retained earnings.
It also helps the company keep
thorough records of account balances affecting retained earnings. Revenue, expense, and dividend accounts affect retained earnings
and are closed so they can accumulate new balances in the next
period, which is an application of the time period assumption. There may be a scenario where a business’s revenues are greater than its expenses. This means that the closing entry will entail debiting income summary and crediting retained earnings. But if the business has recorded a loss for the accounting period, then the income summary needs to be credited. The first entry requires revenue accounts close to the Income Summary account.
Guide to Understanding Accounts Receivable Days (A/R Days)
Instead, declaring and paying dividends is a method utilized by
corporations to return part of the profits generated by the company
to the owners of the company—in this case, its shareholders. Since the income summary account is only a transitional account, it is also acceptable to close directly to the retained earnings account and bypass the income summary account entirely. The net result of these activities is to move the net profit or net loss for the period into the retained earnings account, which appears in the stockholders’ equity section of the balance sheet.
Printing Plus has $100 of supplies expense, $75 of depreciation expense–equipment, $5,100 of salaries expense, and $300 of utility expense, each with a debit balance on the adjusted trial balance. The closing entry will credit Supplies Expense, Depreciation Expense–Equipment, Salaries Expense, and Utility Expense, and debit Income Summary. You might be asking yourself, “is the Income Summary account even currency translation adjustments necessary? ” Could we just close out revenues and expenses directly into retained earnings and not have this extra temporary account? We could do this, but by having the Income Summary account, you get a balance for net income a second time. This gives you the balance to compare to the income statement, and allows you to double check that all income statement accounts are closed and have correct amounts.
- The goal is to zero out your Income and Expense accounts, then add your fiscal year’s net income to Retained Earnings.
- Income summary is a holding account used to aggregate all income accounts except for dividend expenses.
- For this reason, these types of accounts are called temporary or nominal accounts.
- For smaller businesses, it might make sense to bypass the income summary account and instead close temporary entries directly to the retained earnings account.
However, the cash balances, as well as the other balance sheet
accounts, are carried over from the end of a current period to the
beginning of the next period. In some cases, accounting software might automatically handle the transfer of balances to an income summary account, once the user closes the accounting period. The entries take place “behind the scenes,” often with no income summary account showing in the chart of accounts or other transaction records.
These journal entries are made after the financial statements have been prepared at the end of the accounting year. A closing entry also transfers the owner’s drawing account (a temporary balance sheet account) balance to the owner’s capital account. The closing entries will mean that the temporary accounts (income statement accounts and drawing account) will start the new accounting year with zero balances. To update the balance in the owner’s capital account, accountants close revenue, expense, and drawing accounts at the end of each fiscal year or, occasionally, at the end of each accounting period.
The Purpose of Closing Entries
The income statement
summarizes your income, as does income summary. If both summarize
your income in the same period, then they must be equal. However, if the company also wanted to keep year-to-date
information from month to month, a separate set of records could be
kept as the company progresses through the remaining months in the
year. For our purposes, assume that we are closing the books at the
end of each month unless otherwise noted.
Company
Once the books are closed, you aren’t supposed to enter any entry for that fiscal year. Some programs prohibit you from making any entry even if that entry corrects or makes your books more accurate. Let’s move on to learn about how to record closing those temporary accounts. Companies are required to close their books at the end of each
fiscal year so that they can prepare their annual financial
statements and tax returns. The
business has been operating for several years but does not have the
resources for accounting software.
Step #4: Close Dividends
The Retained Earnings account balance
is currently a credit of $4,665. Printing Plus has a $4,665 credit balance in its Income Summary
account before closing, so it will debit Income Summary and credit
Retained Earnings. Let’s explore each entry in more detail using Printing Plus’s
information from
Analyzing and Recording Transactions and
The Adjustment Process as our example. The Printing Plus
adjusted trial balance for January 31, 2019, is presented in
Figure 5.4. It is the end of the year,
December 31, 2018, and you are reviewing your financials for the
entire year.
If a corporation has more than one class of stock and uses dividend accounts to record dividend payments to investors, it usually uses a separate dividend account for each class. If this is the case, the corporation’s accounting department makes a compound entry to close each dividend account to the retained earnings account. The income summary account is an intermediary between revenues and expenses, and the Retained Earnings account. It stores all of the closing information for revenues and expenses, resulting in a “summary” of income or loss for the period. The balance in the Income Summary account equals the net income or loss for the period.
Adjusting entries are used to modify accounts so that they’re in compliance with the accrual concept of recording income and expenses. We at Deskera offer the best accounting software for small businesses today. Our program is specifically developed for you to easily set up your closing process and initiate book closing within seconds – no prior technical knowledge necessary. Do you want to learn more about debit, credit entries, and how to record your journal entries properly? Then, head over to our guide on journalizing transactions, with definitions and examples for business.
Step 4: Close withdrawals to the capital account
Here you will focus on debiting all of your business’s revenue accounts. If your business is a sole proprietorship or a partnership, your next step will be to close your income summary account. You can do this by debiting the income summary account and crediting your capital account in the amount of $250. This reflects your net income for the month, and increases your capital account by $250. After this closing entry has been posted, each of these revenue accounts has a zero balance, whereas the Income Summary has a credit balance of $7,400. Clear the balance of the expense accounts by debiting income summary and crediting the corresponding expenses.
What is the current book value of
your electronics, car, and furniture? Are the value of your assets and
liabilities now zero because of the start of a new year? Your car,
electronics, and furniture did not suddenly lose all their value,
and unfortunately, you still have outstanding debt. Therefore,
these accounts still have a balance in the new year, because they
are not closed, and the balances are carried forward from December
31 to January 1 to start the new annual accounting period. Temporary accounts, as mentioned above, including revenues, expenses, dividends or (withdrawal) accounts.
The retained earnings account is reduced by the amount paid out in dividends through a debit, and the dividends expense is credited. In essence, we are updating the capital balance and resetting all temporary account balances. Income and expenses are closed to a temporary clearing account, usually Income Summary.
Temporary accounts include all revenue and expense accounts, and also withdrawal accounts of owner/s in the case of sole proprietorships and partnerships (dividends for corporations). The next and final step in the accounting cycle is to prepare one last post-closing trial balance. Now that the journal entries are prepared and posted, you are almost ready to start next year.