|Closing entries made in the accounting cycle bring the income statement accounts to zero so that the new reporting period will start with zero balances.|
Since we are reporting sales and expenses for January, for example, February sales and expenses should start with a zero balance to properly report sales, expenses, and net income only for the month of February. Accountants can close accounts for any reporting period (e.g. monthly, quarterly, and yearly).
Nominal Accounts and Real Accounts
The adjusted trial balance lists income statement accounts, or temporary accounts, highlighted below.
At the end of the reporting period, the credit accounts (i.e. sales accounts) are closed by making a debit entry for the balance, and the debit accounts (i.e. expense accounts) are closed by making a credit entry for the balance in the general ledger.
During this closing process, a new temporary account, called income summary, is created to transfer the income and expense account balances. The balance in the income summary account equals the difference between sales and expenses, which is then transferred to owner’s equity.
For example, Sunny Sunglasses Shop closed January sales and expense accounts in the general journal as follows:
Since sales and revenue accounts have a credit balance, these accounts are closed by debiting the sales and revenue accounts, and crediting the income summary account. Similarly, closing entries are made to the expense accounts by crediting each expense account, and debiting the income summary account.
The difference between sales and expenses, or net income, was transferred to the income summary account.
Calculating Net Income
|Sales||+ Repair Revenue||– Expenses||= Net Income|
|$11,680||+ $20||– $11,452||= $248|
The $248 equals net income and the balance in the income summary account after the sales and expense accounts are closed. In the final step, Sunny transferred the balance in the income summary account to retained earnings. Net income directly increases retained earnings and owner’s equity, or the value of the business as discussed in accounting formulas and net income.
The $248 transferred to retained earnings appears on the balance sheet template for January.
After the above entries are posted to the general ledger accounts, the general ledger sales and expense accounts show a zero balance. For example, the sales account and the wage expense account appear as follows in the general ledger after the closing entries are posted from the accounting journal to the accounting ledger.
Because the sales account has a credit balance, the closing entry is made on the debit side to bring the account balance to zero. Similarly, because expense accounts have debit balances, the closing entry is made on the credit side to bring the expense account balances to zero.
GJ-2 simply means these entries were made on the second page of the general journal and posted to the general ledger above. Similarly, the accounts listed on the general journal under the “Reference” column indicate the accounting entries were posted to the respective general ledger accounts to close the accounts for January.
Closing Entries Summary
|Recording Closing Entries is a Three Step Process:
After the income statement accounts are closed, the company prepares a final trial balance.