By posting adjusting entries to respective accounts, you prepare adjusted trial balance to derive income statement and balance sheet of the company. After preparing these reports, you need to post closing entries to zero out all temporary accounts and transfer their balances to permanent accounts. This entire process is known as closing of the books.
In the closing process, you will reset the opening balance of all the temporary accounts to zero to begin the new accounting year. Closing entries takes place at the end of the financial year.
Temporary accounts are revenues, expenses and dividend since the balance in these accounts is to be reset to zero each year. These revenues and expenses accounts are closed every year by transferring the year end balances to income summary account and then to retained earning account.
Balance sheet accounts such as Assets, liabilities and owner’s capital account are not closed as these are known as permanent account since their balances carry over from year to year.
Steps followed for closing entries in financial accounting system
In preparation of new accounting period, accountant has to close the revenue and expenses account in earlier period by transferring it to income summary account.
After taking it to income summary account, the resulting figure known as retained earning is transferred to owner’s capital. In this way, earlier year’s expenses, revenue and income summary account is closed.
Income summary account is only used during the closing process. You are required to transfer closing balances of all the revenues and expenses to income summary A/c to close those accounts.
Here are the steps followed in the closing process:
- You will see credit balances in the revenue accounts of the company. Those balances are to be set to zero as it has already taken to the income statement. To return them to zero, you need to pass a closing entry by debiting each revenue A/c with the credit balance and debiting income summary account. In this way revenue balance will be taken to the income summary A/c.
- Similarly, go to the expenses account. You will see debit balance in all expenses A/c. To return the expenses A/c to zero, you need to post a credit entry in each of these expenses A/c by debiting income summary account. After preparing the financial statements, these closing entries takes all the income and expenses account balances to income summary account and makes their balance zero.
- Now you have all debit balance of expenses and credit balance of revenues in income summary account. The net result in income summary A/c will give you net profit or loss. This means if total of credit balances is higher than total of debit balance, then it will result in profit or else loss. This net profit or loss has to be taken to retained earnings A/c. To do this, perform a journal entry by debiting income summary A/c and by crediting retained earning A/c.
- In the last step, you need to close the dividend A/c by crediting dividend account and debiting retained earnings account.
- The resulting figure in retained earnings gets added to the opening balance of retained earnings to show in balance sheet the closing figure of retained earnings as part of share capital value.
Instead of using income summary account, you can use retained earnings account to transfer all debit and credit balances of revenue and expenses accounts. But in large companies they keep both separate.
Closing in retained earning account is presented on the balance sheet as part of owner’s capital or shareholder’s equity.
Here are some of the closing entries passed during the closing of books;
To transfer balance from revenue A/c:
To Income Summary
To transfer balance from expenses A/c:
To Travel and conveyance
To office expenses
To transfer balance from income summary to retained earnings
To Retained earnings
To transfer dividend to retained earnings
After all these closing entries, you will only be left with balance in assets, liabilities and capital A/c. These balances are to be carried forwarded to the next year for preparation of new year’s trial balance.
Accounting software or ERP will automate the entire process once you have closed the accounting period or opened a new accounting period. However, while implementing the accounting system in ERP or accounting software, you need to give special attention to these processes so that system can automate it to get the end result. System does not require any manual intervention for the closing process if you have customized it properly.