Question

What is the closing process, and why is it necessary prior to preparing financial statements? Include temporary and permanent accounts in your discussion. Consider using an example of a real company to discuss why the closing process is a necessary step in the accounting cycle.

Answer 1

The Purpose of closing entries:

A term often used for closing entries is "reconciling" the company's accounts. Accountants perform closing entries to return the revenue, expense, and drawing temporary account balances to zero in preparation for the new accounting period.

The closing entries are also recorded so that the company's retained earnings account shows any actual increase in revenues from the prior year and also shows any decreases from dividend payments and expenses.

Retained earnings are those earnings not distributed to shareholders as dividends, but retained for further investment, often in advertising, sales, production, and equipment.

The Income summary account:

The income summary account serves as a temporary account used only during the closing process.

It contains all the company's revenues and expenses for the current accounting time period.

In other words, it contains net income or the earnings figure that remains after subtracting all business expenses, depreciation, debt service expense, and taxes.

The income summary account doesn't factor in when preparing financial statements because its only purpose is to be used during the closing process.

Four steps to complete closing entries:

1. Locate the revenue accounts in the trial balance, which lists all of the revenue and capital accounts in the company's ledger. You will see that they have a credit balance. To return them to zero, you must perform a debit entry for each revenue account to move the balance to the income summary account.
   
2. Locate the expense accounts in the trial balance. You will see that they have a debit balance. Perform a credit entry for each expense account to the income summary account, to return the expense account totals to zero.
   
3. If the income summary account has a credit balance after completing the entries, or the credit entry amounts exceeded the debits, the company has a net income. If the debit balance exceeds the credits the company has a net loss. Now, the income summary must be closed to the retained earnings account. Perform a journal entry to debit the income summary account and credit the retained earnings account.
   
4. The last step involves closing the dividend account to retained earnings. The dividend account has a normal debit balance. Credit the dividend account and debit the retained earnings account. Retained earnings now reflect the appropriate amount of net income that was allocated to it.

For most companies, this completes the accounting cycle for the current time period.

Software Handling:

For smaller businesses, it might take sense to bypass the income summary account and instead close temporary entries directly to retained earnings account.

In some cases, accounting sotware might automatically handle the transfer of balances to an income summary account, once the user closes the accounting year. The entries takes place behind the scenes often with no income summary account.

Example:

At the end of each year, the revenue and expense account balances are transfered to income summary account. This way all the revenue and expense account have a zero balance at the end of the year and will start the next year fresh with no prior activity.

The income summary account balance is then transferred to the retained earnings or capital accounts depending on what type of entity the business is.

After the closing entries have been made and all of the temporary accounts have been closed, a post closing trial balance is prepared. This is a listing of all the accounts with balances that will carry forward to the next accounting period. Since the income statement accounts don’t have balances anymore, you can think of this as the opening balance sheet for the next accounting period.