What is the Closing Process?

The Closing Process is a step in the accounting cycle that occurs at the end of the accounting period, after the financial statements are completed. This serves to get everything ready for the next year. 

In order to understand this, you need to know the difference between permanent and temporary accounts. 

What is a Permanent Account? 

Permanent accounts, also known as balance sheet accounts, are the accounts that report on activities related to one or more future accounting periods - such as cash. At the end of the accounting period it doesn't involuntarily go down to zero (by itself). The ending balance carries over to the next year. They are accounts that pertain to either assets, liabilities, or owner's equity.  Another example would be a payables account. 

What is a Temporary Account?

Temporary accounts, also known as income statement accounts, are the accounts related to one accounting period. These are accounts that close out at the end of the accounting period. They do not carry over to the next year. These accounts tend to have a specific or special purpose. Once the purpose for the account is served, they are erased. For example, an account to accrue commission payments to sales people may be closed once the commission are paid. Erasing the account means that we won't claim them for more than one period. They are assets that pertain to revenues, expenses, and dividends ("r-e-d accounts").

Temporary accounts are opened at the beginning of the period and used to record transactions and events for that period. Then they're closed at the end of the period. Where are they closed to? 

How does a Closing Entry Work? 

Oftentimes, a closing entry is done manually, however, there are accounting methods, with the aid of technological advancement that supports a computerized way of shifting balances from temporary accounts into permanent ones. A closing entry entails resetting the balances of temporary accounts and permanent accounts, in which the balance of temporary accounts is zero and the balance of the permanent accounts increase. The income summary is important in a closing entry, this is the summary used in the aggregation of all income accounts. It is, however, important to note that the account income summary does not appear on financial statements, rather, it is a summary used in the closing process/entry.

Closing Entry Sequences

There are specific sequences used for the closing entry procedure, the sequences are;

• The transfer of all revenue accounts into the income summary- this entails a debit on revenue accounts and a credit on the income summary.
• Closing of all expenses by crediting the expense accounts and debiting income summary.
• Closing of the income account.
• Transfer of all income statement balances to retained earnings, this means that all dividends are closed or transferred to retained earnings.

End Result

There are certain roles played by the closing entries in a financial report, the specific ones are;

• The amounts on the temporary accounts on the income statement are moved into the permanent accounts on the balance sheet.
• Revenue accounts and expense accounts have zero balance at the end of closing entries.
• All revenue, income or dividends that a company earns are transferred into retained earnings.

Related Topics

• What is the Accounting Cycle? – Financial Accounting
• Accrual vs Cash Basis Accounting – Financial Accounting
• What are Accounting Adjustments? – Financial Accounting
• What is an Adjusted Trial Balance – Financial Accounting
• Completing the Accounting Cycle - Creating Financial Statements
• What is the Trial Balance Closing Process – Financial Accounting
• Example of the Closing Process