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Temporary Accounts

What Are Temporary Accounts?

Temporary accounts are created in a business’s accounting ledger to identify and define financial activity for a specific reporting period. They are closed, and their balances reduced to zero, at the close of the reporting period to avoid having their balances mixed with the same activity for the next reporting period or with permanent accounts that maintain continuous records.

In contrast, a permanent account is not closed after the reporting period ends. Its balances carry over from one reporting period to the next and are cumulative, meaning that they add up over time.

Temporary accounts, also referred to as nominal accounts, are intended to illustrate specific financial activity, such as revenue and expenses, for a defined period of time. Recording this financial activity in a temporary account enables accountants and financial managers to accurately reflect how that activity is impacting the business.

What Are the Four Kinds of Temporary Accounts?

Temporary accounts typically fall into one of four categories.

  1. A revenue account records all of the income earned by the business for the reporting period. Revenue can come from a variety of sources. Multiple accounts may be used to record this income, such as sales revenue, rental income, fees, dividends, and professional services or commissions. These will vary depending on the nature of the business and the manner in which revenue is generated. A business may record some, one, or all of these types of revenue transactions.

  2. Revenue is offset by expenses. A temporary expense account will record expenses incurred by the business for all of its operations during the reporting period. This can include such expense activity as advertising, supplies, rent, utilities, fees, repairs, maintenance, salaries, and wages.

  3. Expenses are subtracted from revenue to determine net income for the reporting period. A third temporary account known as the income summary will record this calculation. At the end of the reporting period when the temporary revenue and expense accounts are closed, their ending balances are recorded in the income summary to calculate its balance. It too is a temporary account, so its balance will also be canceled out to zero and transferred to a permanent account.  

  4. A fourth temporary account, known as a drawing account, is used to record money withdrawn from the business by its owners. Draws can be made in the form of cash or other assets, and they reflect the owner(s) taking out a portion of their equity of the business.

What Is a Permanent Account?

In contrast to a temporary account, the balances of permanent accounts, also known as real accounts, carry over from one reporting period to the next. The cumulative impact of ongoing transactions on these accounts causes their balances to fluctuate over time, by increasing, decreasing, or canceling out to zero. But they are never closed like temporary accounts.

The activity in permanent accounts feeds the basic accounting equation of Assets = Liabilities + Equity.

Unlike temporary accounts, which “start over” at a zero balance in each new reporting period, permanent accounts will have a balance that carries over from one reporting period to the next. The ending balance of the previous reporting period will be the starting balance of the next reporting period.

How Are Transactions Recorded in Temporary Accounts?

Because they only record balances for a defined reporting period, temporary accounts will cancel out to zero before they are closed. For example, if a temporary revenue account records revenues earned of $10,000 for the period, a debit entry will be made for the same amount at the end of the reporting period to bring the total balance to zero.

In accordance with the double entry system of accounting, every journal entry is recorded in at least two different places and they cancel each other out. In the case of the temporary revenue account, the same closing entry of $10,000 will be recorded as a credit in the income summary.

At the same time, the temporary expense account must also be closed out. If, for example, the account records expenses of $5,000 for the period, a credit for the same amount will be recorded as a closing entry bringing the ending balance to zero. The same amount will be debited to the same income summary.

In the next step, the net income is calculated by subtracting the expenses ($5,000) from the revenue ($10,000). The result ($5,000) reflects the net income for the reporting period. Since the income summary is also a temporary account, that ending balance also must be closed out. This is done by making a debit entry of $5,000 in the income summary, bringing that balance also to zero.

Finally, a corresponding credit entry of $5,000 will be entered into the retained earnings account (a permanent account), which shows the net income of the business for that particular point in time.

FAQ

Why Are Temporary Accounts Important?

Temporary accounts are an important accounting tool that allows financial managers to properly assess the profit or loss of a business over a particular period of time, often one year.

Some accounting information reflects the business’s ongoing financial affairs, such as assets, liabilities, and equity. These are properly recorded in permanent accounts.

Temporary accounts allow financial managers to separately record, calculate, and analyze transactions that reflect on the business’s performance for a particular, defined period of time. Temporary accounts allow for greater accuracy in reporting this activity and feeding it into financial statements.