Closing Entries

A closing entry is a journal entry made at the end of a reporting period that cancels or "zeroes out" a transaction. This is part of a larger process to reset the account in question and prepare it for the next reporting period. Closing entries will be done in so-called temporary or nominal accounts and involve shifting data from temporary accounts to permanent accounts.

In business accounting, some transactions have a short-term, or one-time, impact on the financial affairs of the operation. They affect the profit and loss of the business only within a specified reporting period, which is usually a month, quarter, or year. For this reason, they are reported on the income statement for that accounting period.

Other transactions have a more long-term and sustained effect on the business. Their impact carries over to, and is reported in, subsequent accounting periods. These financial activities do not affect the profit or loss of the business during a specific reporting period, but they do reflect on the overall financial well-being or status of the business. For this reason, they will appear on the balance sheet.

Closing entries are made in temporary accounts to calculate the short-term impact of the transactions that are recorded there, and to clear the account for a new set of transactions that will be recorded in the next reporting period.

Temporary accounts include such transactions as revenue, expenses, and dividends, all of which affect the profitability of a business only in the period in which they are reported. They will be zeroed out, and the accounts closed, at the end of the period.

For example, $100,000 in sales revenue impacts the profitability of a business, but only in the reporting period in which it is received. It does not impact the business in the following period or any others because it does not occur then (other, new sales revenue will be received in those periods). Therefore, it is recorded in a temporary account during the period when it was received.

In contrast, permanent accounts include a variety of long-term assets, liabilities and equities, such as accounts receivable, loans, and stocks. These do not affect the profit or loss of the business during a reporting period, but they do have a sustained impact on the business. They will be reported in permanent accounts that carry over from one cycle to the next to ensure that they always factor into the relevant, broader calculations about the business.

For example, real estate property does not directly impact profitability, but it impacts the overall financial picture of the business. Throughout the time that it is owned by the business, it will be reported as a long-term asset, and it will carry over from one reporting period to the next.

According to the double-entry system of accounting, transactions are always recorded in at least two places, and those entries will cancel each other out, one as a debit and the other as a credit.

The same principle applies to closing entries, which are made by recording two transactions that cancel each other out or add up to zero. One of these transactions will be recorded in a temporary account, and the other will be recorded in a permanent account.

Depending on the value and the nature of the transaction, the entry will be made in the temporary account as either a debit or a credit. This transaction will cancel the value in the temporary account and bring its ending value to zero, allowing the account to be closed out for the period. An opposite entry will be made in a permanent account to allow for an overall assessment of the business's financial status.

For example, revenue accounts are closed out by making a journal entry in the form of a debit for the period. Similarly, expense accounts are closed out by recording a journal entry that credits expenses.

Revenue is then credited to the income statement, and expenses are debited there. The income account is also closed out by calculating the net sum of the difference between revenue and expenses and making a corresponding journal entry there. A profit is canceled out with a debit, and a loss is canceled out with a credit.

Finally, the data is carried over to the balance sheet and the income summary is closed out. If the business earned a profit, this will be recorded as a credit to the retained earnings account. A loss is recorded as a debit.

In the example above, a business earned $100,000 in sales revenue for one reporting period. If this was earned for the first quarter of the year, a closing entry would be made at the end of March.

The first step in this instance would be to close out the revenue account where the transaction was recorded. A debit of $100,000 would be entered there to close out the account. A corresponding credit of $100,000 would then be recorded in the income account.

To calculate profit or loss, expenses will also have to be accounted for. In the same example, if the business incurred $45,000 of expenses related to its sales, the expense account would be closed out with a closing entry credit for that amount. A corresponding debit of $45,000 would also be entered into the income account.

To calculate net profit, the business would subtract the value of the expenses from the value of total sales revenue. The net sum of $100,000 minus $45,000 leaves the business with a profit of $55,000.

A debit for this amount would be entered as income and the account would be closed. A credit of the same amount would be made in the retained earnings account, and the value of $55,000 would be reported on the balance sheet for the business.