Lesson Objectives:- What closing entries are used for.
- The closing process
- Performing closing entries for the RED accounts.
We have finally reached the last step in the accounting cycle; we are now ready to perform the closing entries. This step can also be referred to as closing the general ledger accounts.
As we talked about in the previous lesson, the only accounts that will be closed out are temporary accounts. The accounts that fall into this category are known as the RED accounts.
Closing entries are the accounting journal entries that are used to zero out the account balances of temporary accounts and carrying them over to the permanent accounts.
At this point, you may be wondering: how are we going to bring the account balances to zero?
We will need to perform either a credit or debit to clear out the account balance and transfer it to the permanent account. Let's take a look at how this process flows.
The sequence of closing entries starts with revenues, then expenses, and finally dividends.
Here are the four steps involved in this process:
1. Revenue accounts are closed to the income summary account.
2. Expense Accounts are closed to the income summary.
3. The income summary is closed and transferred to retained earnings.
4. Dividends are closed to the retained earnings account.
In order to see how these closing entry steps are applied in the accounting cycle, let's see how each entry in the income statement is closed out.
We will go in order starting with closing the revenue account. I have listed a sample income statement above, and we will use those balances to perform our closing entries. Also, for the purpose of this lesson we will say dividends are $2,000.
The company has earned $30,000 worth of revenue for the year. As you recall, revenues and expenses are listed under Stockholders' Equity, which has a normal credit balance. You reduce expenses by crediting them, and reduce revenues by debiting them. The balance at the end of the year would be $30,000, so in order to bring the balance to zero, we would need to debit the account by $30,000. The balance would be transferred as a credit to income summary, which accounts for the net income figure.
The expense entries are naturally debit balances, so in order to zero out the balances, we would need to credit each type of expense. The expenses in this example are salaries expense, rent expense, utilities expense and amortization expense. Each account will need a credit entry with the total of $7,600 being transferred to the income summary account as a debit.
Now, that we've closed out the revenues and expenses, before we move onto closing the dividends entries, we will need to transfer the net income amount to the retained earnings figure.
When there is a positive net income figure, the company would see their retained earnings increasing, therefore the entry would be a credit to the retained earnings account. In contrast, if the company is dealing with a net loss situation, the entry to the retained earnings account would be a debit and the income summary account would be a credit.
Since the net income is a positive figure in this example, we could credit the retained earnings for $22,400 and debit the income summary account for $22,400, leaving it with a zero balance.
Finally, dividends will need to be transferred to retained earnings and reset to zero in order to complete the close process. As we mentioned in the beginning of the lesson, the dividends figure for this example is $2,000, which means the retained earnings figure would be decreasing. Remember that dividends are listed under Stockholders' Equity with a normal debit balance. The closing entry would be a debit to retained earnings for $2,000 and a credit to dividends for $2,000.
The closing entries are the final step in the accounting cycle. They allow the company to close out the balances of temporary accounts and start preparing their financial records for the next year.