Closing entries in Accounting Cycle

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Financial Statement Analysis-FIN621

Lesson-9

ACCOUNTING CYCLE/PROCESS

(Continued)

Other steps in the Accounting Cycle after the preparation of Financial Statements are:-

h) Closing entries in Accounting Cycle.

As previously stated, revenues increase owner's equity, and expenses and withdrawals by the

owner decrease owner's equity. If the only financial statement that we needed was a balance sheet, these

changes in owner's equity could be recorded directly in the owner's capital account. However, owners,

managers, investors, and others need to know amount of specific revenues and expenses, and the

amount of net income earned in the period. Therefore we maintain separate ledger account to measure

each type of revenue and expense, and other owner's drawings.

The revenue, expense, and drawing accounts are called temporary accounts, are nominal

accounts, because they accumulate the transactions of only one accounting period. At the end of this

accounting period the changes in owner's equity accumulated in these temporary accounts are

transferred into the owner's capital account. This process serves two purposes. First it updates the

balance of the owner's capital account for changes in owner's equity account for changes in owner's

equity occurring during the accounting period. Second, it returns the balances of the temporary accounts

to zero, so that they are ready for measuring the revenue, expenses, and drawings of the next accounting

period.

The owner's capital account and other balance sheets are called permanent or real

accounts, because their balances continue to exist beyond the current accounting period. The process of

transferring the balances of the temporary account into the owner's capital account is called closing the

accounts. The journal entries made for the purpose of closing the temporary accounts are called closing

entries.

Revenue and expense accounts are closed at the end of each accounting period by

transferring their balances to a summary account called income summary. When the credit balance of

the revenue accounts and the debit balances of expense accounts have been transferred into one

summary account, the balance of this income summary will be the net income or net loss for the period.

If the revenue (credit balances) exceeds the expenses (debit balances), the income summary account will

have a credit balance representing net income. Conversely, if expenses exceed revenue, the Income

Summary will have a debit balance representing net loss. This is consistent with the rule that increases

in owner's equity are recorded by credits and decreases are recorded by debits.

Closing Entries for Revenue Accounts

Revenue accounts have credit balances. Therefore, closing a revenue account means

transferring its credit balance to the Income Summary account. This transfer is accomplished by a

journal entry debiting the revenue account an amount equal to its credit balance, with an offsetting

credit to the Income Summary account. The debit portion of this closing entry returns the balance of the

revenue account to zero; the credit portion transfers the former balance of the revenue account into the

Income Summary account.

Closing Entries foe Expense Accounts

Expense accounts have debit balances. Closing an expense account means transferring

its debit balance to the Income Summary account. The journal entry to close an expense account,

therefore, consists of a credit to the expense account in an amount equal to its debit balance, with an

offsetting debit to the Income Summary account.

Financial Statement Analysis-FIN621

Closing the Income Summary Account

Due to increase in net income owner's equity increases. The credit balance of Income

Summary account is, therefore transferred to the owner's equity account. Conversely if the expenses of

a business are larger than its revenue, the Income Summary account will have a debit balance,

representing a net loss for the accounting period .In this case, the closing of the Income Summary

account requires a debit to the owner's capital account and an offsetting credit to the Income Summary

account. The owner's equity will, of course, be reduced by the amount of the loss debited to the capital

account.

Note that the Income Summary account is used only at the end of the period when the accounts are

being closed. The Income Summary account has no entries and no balance except during the process of

closing the accounts at the end of accounting period.

Closing the Owner's Drawing Account

Withdrawals of cash or other assets by the owner are not considered an expense of the

business and, therefore, are not a factor in determining the net income for the period. Since drawings by

the owner do not constitute an expense, the owner's drawing account is closed not into the Income

Summary account but directly to the owner's capital account.

Revenue, Expense and Drawing (by owner) change owner's equity. These are temporary capital

accounts. To make these Accounts ready for recording events of next accounting periods, we take the

following steps:-

Close (transfer) Revenue Accounts to Income Summary Account.

Close (transfer) Expense Accounts to Income Summary Account.

Close (transfer) Income Summary Account to Owner's Equity Account or Capital Account.

Close Drawing Account directly to Capital Account.

Debit and credit entries of course are involved in journal and ledger.

Prepare after-closing trial balance. In many cases, another trial balance is prepared

after closing entries have been recorded in journal and posted in ledger.

Summary

Steps in Accounting Cycle:

The accounting procedures in the accounting cycle may be summarized as follows

Journalize Transactions

Post to Ledger Accounts

Prepare A Trial Balance

End of Period Adjustments

Prepare an Adjusted Trial Balance

Prepare Financial statements

Journalize and Post Closing Entries

Prepare an After Closing Trial Balance

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