Accounting: The Language of Business - Vol. 2 (Intermediate: Part 34)

For a hot-shot CEO taking over a troubled company, mass firings are the ultimate quick fix, the accounting equivalent of crack: cheap, easy to score, instantly gratifying, and highly addictive.

Arianna Huffington

A Review of the Accounting Cycle (Part K)

by

Charles Lamson

Step 8: Close Temporary Accounts

The next step in the accounting cycle (continued from part part 33) requires closing all temporary accounts, which are all income statement accounts and dividends that must be reduced to a zero balance in order to report net income (or net loss) and dividends for the next accounting period. The temporary accounts begin the next period with a zero balance to ensure that prior period revenues and expenses are not included in the computation of the next year's net income or loss. Closing is the process of bringing all temporary accounts to a zero balance.

In contrast to the income statement temporary accounts, the balance sheet consists of permanent accounts, which are accounts with cumulative balances carried forward period after period. Permanent accounts are not closed at the end of the period.

Closing each revenue and expense temporary account to retained earnings would involve a significant amount of detail flowing through the retained earnings account. To avoid the excessive detail and retained earnings, companies use another temporary account, income summary, to accumulate revenues and expenses and transfer the net value of the income summary to retained earnings in a single journal entry.

Four closing entries are required to close the temporary accounts.

1. Close out revenue and gain accounts: Debit all revenue and gain accounts and credit income summary for the total of the accounts debited.

2. Close out expense and loss accounts: Debit income summary for total expenses and losses and credit each expense and loss account for its balance.

3. Close out income summary account: Debit income summary and credit earnings for the amount of net income; conversely, credit income summary and debit retained earnings in the event of a loss.

4. Close out the dividends account: Debit retained earnings and credit the dividends account for the year. 

EXAMPLE 4.12 Closing Entries

PROBLEM: Consider Plush Service Corporation from the prior examples in the preceding parts of this volume. Prepare the closing entries for Plush Service Corporation.

SOLUTION: We record each of the four closing entries. First, we debit the service revenue account and credit income summary. Second, we credit each of the expense accounts and debit the total amount to income summary. At this point, income summary will have a credit balance because revenues are greater than expenses and represent net income for the period. Third, we debit income summary for its balance (which, in this case, is net income as opposed to net loss) and credit retained earnings. Finally, we credit the dividends account for its balance and debit retained earnings. The closing entries on December 31 are presented here: 

*GORDON,RAEDY,SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 117-118*

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