You may have heard the term "closing the books" or "month-end close." This is the final step of the accounting cycle. If you've been working your way through the cycle, then you've identified and analyzed your transactions, recorded journal entries, posted them to the general ledger, prepared your unadjusted and adjusted trial balance, created your financial statements, and now it's time to close your books.
What Does it Mean to “Close the Books?”
Closing your books means returning the balance of your temporary accounts back to zero. To do this, you need to make journal entries to transfer the balance, known as closing journal entries. These are made at the end of the accounting period, typically monthly, quarterly, and annually. Closing the books allow for a fresh start in the next period.
Permanent vs. Temporary Accounts
Permanent Accounts
Permanent accounts consist of those on the balance sheet, such as assets, liabilities, and equity. The balance of these accounts will roll over into the next period, so they don’t need to be closed. The ending balance for these accounts will be the same as the beginning balance for the next period.
Temporary accounts
Temporary accounts include revenue, expense, and withdrawal/dividend accounts. They are temporary because they are closed at the end of each period. That means that they need to have a balance of zero before you move into the next period. This is done by transferring the balance of temporary accounts into permanent accounts.
How to Prepare Closing Entries
There are four steps to preparing closing entries:
Close Revenue accounts to Income Summary
Close Expense accounts to Income Summary
Close the Income Summary account to Equity/Retained Earnings
Close Withdrawal/Dividends accounts to Equity/Retained Earnings
In order to bring balances to zero, it’s important to understand which accounts need to be debited and which accounts need to be credited.
Closing Revenue Accounts
Revenue accounts include sales revenue and service revenue. By looking at the chart above, you can see that in order to decrease revenue accounts, you must debit them. To close these accounts, you debit revenue to zero and credit the Income Summary for the total revenue.
Closing Expense Accounts
Expense accounts may include rent, salary, utilities, and advertising. You decrease expense accounts by crediting them and debiting Income Summary for the total of your expenses.
Closing Income Summary account
Income Summary is a temporary closing account used to store the closing balance of revenue and expenses. After transferring the balance of revenue and expense accounts to the Income Summary account, you must subtract revenue from expenses and close the Income Summary to equity/retained earnings.
The Income Summary should equal the net profit or loss on the income statement. If you have a profit, debit Income Summary, and credit Equity/Retained Earnings. If you have a loss, credit Income Summary and debit Equity/Retained Earnings.
Closing Withdrawal/Dividends account
Depending on the structure of your business, you may have a withdrawal or dividend account. Sole Proprietorships and Partnerships have drawing accounts to record withdrawals made by the owner or partners. To close the drawing account, you must credit drawing and debit capital.
If you pay out dividends at the end of the year, take the net income or net loss on the statement of retained earnings and subtract any dividends. To close the dividends account, you want to credit for the total amount of dividends to bring the balance to zero, and debit retained earnings for the total of the dividends.
The End
Closing entries may be performed monthly or annually. At the end of the period, the balance for revenue, expense, and withdrawal/dividends should all be zero, with the balances being rolled over to equity or retained earnings. A post-closing trial balance will then be created, showing the balance of all asset, liability, and equity accounts.
If you need help closing your books, our bookkeepers are happy and ready to help. Contact us or give us a call at (360) 756-5020!