How Do Temporary Accounts Differ From Permanent Accounts?

Introduction

In accounting, there are primarily five types of accounts: assets, liabilities, equity, revenue, and expenses. These are further categorized as temporary and permanent accounts. It is important to understand the difference between these accounts to keep your records accurate and maintain the credibility of your financial reports. 

Temporary accounts, such as revenue and expenses, are closed at the end of each period, so they start fresh in the next one. In contrast, permanent accounts, such as assets, liabilities, and equity, carry forward their balances from one period to the next. Efficient management of these accounts helps prevent errors and makes financial reporting easier. Further, automation tools can enhance this process, ensuring sound financial management.

In this blog, we’ll explore the key differences between temporary and permanent accounts and understand the key role they play in ensuring accurate financial reporting. 

What are Temporary Accounts?

Temporary accounts are financial accounts used to record specific transactions for a fixed period. These accounts are set to zero at the start of each accounting period and are closed at its end period to maintain an accurate record of accounting activity for that period.

At the end of an accounting period, the balance in a temporary account is not carried forward. Instead, a closing entry is made to reset the balance to zero. Any remaining balance is then transferred to a permanent account, which typically involves the retained earnings on the balance sheet. This resets the temporary account balance to zero at the beginning of the next fiscal period.

Examples of Temporary Accounts

Here are some common examples of temporary accounts: 

• Revenue accounts

  
  

These accounts record the income earned from selling goods or providing services during a specific accounting period. For instance, sales revenue tracks income from product sales, while service revenue captures earnings from services. At the end of the period, balances from these accounts are transferred to the income summary account.

• Expense accounts

  
  

These accounts track all costs incurred by the business to maintain operations within an accounting period. Examples include rent expense, which records costs related to office or retail space, and salary expense, which captures employee wages. These accounts are closed at period end and their balances are transferred to the income summary account.

• Income summary accounts

  
  

This account serves as a temporary placeholder to compile and summarize all revenues and expenses at the end of an accounting period. After compiling the totals from revenue and expense accounts, the net income or loss is transferred to retained earnings, and the income summary account is closed.

• Drawing or dividend accounts

  
  

In sole proprietorships and partnerships, drawing accounts track withdrawals taken by owners for personal use. In corporations, dividend accounts record the profits distributed to shareholders. At the end of the period, the balances in these accounts are closed and transferred to retained earnings or capital.

What are Permanent Accounts?

Permanent accounts are balance sheet accounts that are not closed at the end of an accounting period. The balances of these accounts are not reset to zero at the end of each accounting period but instead, carry forward continuously to subsequent accounting periods.

Also known as real or general ledger accounts, the accountants record the closing balance of the permanent account at the end of the accounting period. However, they are not closed, and the accounts remain active throughout the life of the business. As a result, when the new accounting period begins, the account maintains the closing balance from the preceding period.

Examples of Permanent Accounts

Here are some common examples of permanent accounts: 

• Asset accounts

  
  

These accounts track the resources owned by a business that provide future economic benefits. Examples include cash, accounts receivable, and equipment. Unlike temporary accounts, asset balances carry over from one accounting period to the next and reflect the company’s financial position over time.

• Liability accounts

  
  

These accounts record what the business owes to others, representing obligations to be settled in the future. Examples include accounts payable, loans payable, and accrued expenses. Liability accounts carry their balances forward and provide insight into the company’s debt and financial obligations.

• Equity accounts

  
  

These accounts track the owner’s residual interest in the company after liabilities are deducted from assets. Examples include common stock and retained earnings. Equity accounts accumulate over time, reflecting the long-term financial health and ownership structure of the business.

Permanent Vs Temporary Accounts: Key Differences

While temporary accounts track financial activity within a specific period and reset their balances afterward, permanent accounts maintain ongoing records of a business’s financial position, carrying balances forward across fiscal periods. Let’s look into the six key differences that set them apart. 

Permanent Accounts	Temporary Accounts
Includes asset, liability, and equity accounts	Includes revenue, expense, and profit and loss accounts
Balances are carried over to the next period	Balances are reset to zero at the end of each period
Records long-term financial transactions	Records only short-term financial transactions
Track ongoing financial position	Measure financial performance for a specific period
Examples include: assets (cash, accounts receivable), liabilities (accounts payable, loans payable), equity (common stock, retained earnings)	Examples include: revenue (sales revenue, service revenue), expenses (rent expense, utilities expense), income summary, drawing, or dividend accounts

Common Challenges in Managing Temporary and Permanent Accounts

Managing temporary and permanent accounts can be challenging, especially for businesses with complex financial transactions. Understanding the challenges is critical for effective financial management and accurate financial reporting. Here are some of the common challenges businesses face when managing these accounts: 

• Inaccurate recording

  
  

One of the most significant challenges businesses face when managing temporary and permanent accounts is ensuring they are accurately recorded. Any errors in recording can lead to inaccurate financial statements, which can have severe consequences. Accurate recording is essential for businesses to make informed financial decisions and maintain credibility.

• Misclassification

  
  

Another common challenge is the misclassification of accounts. For example, classifying a long-term asset as a short-term expense can lead to inaccurate financial reporting. Misclassification can also lead to over- or under-reporting of revenues and expenses, negatively impacting the business’s bottom line.

• Inadequate documentation

  
  

Insufficient documentation is another challenge businesses face when managing temporary and permanent accounts. Without proper documentation, it can be challenging to track financial transactions accurately. Adequate documentation is necessary to ensure accurate financial reporting and ensure compliance with regulatory requirements.

• Inconsistent accounting practices

  
  

Inconsistent accounting practices can also lead to challenges in managing temporary and permanent accounts. It’s crucial to establish and maintain consistent accounting practices to ensure accurate financial reporting. Consistency in accounting practices helps businesses to track financial transactions accurately, identify discrepancies, and make informed decisions.

• Lack of communication

  
  

Lack of communication between different teams involved in financial management can lead to challenges in managing temporary and permanent accounts. It’s essential to establish clear lines of communication to ensure everyone is aligned. Effective communication helps businesses to avoid accounting errors and enables effective decision-making.

How Can Automation Enhance the Management of Temporary and Permanent Accounts?

Automation offers significant benefits for managing both temporary and permanent accounts, improving accuracy and efficiency in financial processes. By integrating automated systems, businesses can streamline account management, reduce manual errors, and enhance overall financial oversight. Here’s how automation can transform the management of these accounts:

• Accuracy and consistency

  
  

Automation minimizes human error by ensuring that transactions are recorded accurately in both temporary and permanent accounts. Automated systems use predefined rules and algorithms to handle data, reducing discrepancies and improving the consistency of financial records.

• Efficiency in closing periods

  
  

For temporary accounts, automation simplifies the process of closing and resetting balances at the end of each accounting period. Automated systems can generate and post closing entries, transfer balances to permanent accounts, and prepare the necessary financial reports with minimal manual intervention.

• Real-time data updates

  
  

Automation provides real-time updates to permanent accounts, ensuring that financial data is always current. This allows businesses to track their financial position and performance continuously, rather than relying on periodic updates or manual entries.

• Enhanced reporting

  
  

Automated systems can generate detailed financial reports and summaries, helping businesses better understand their performance. For temporary accounts, this includes income statements and expense reports, while for permanent accounts, it includes balance sheets and equity statements.

• Error detection and correction

  
  

Automation tools often include features for detecting and correcting errors in real-time. For both temporary and permanent accounts, this means that any discrepancies or anomalies can be identified and addressed quickly, reducing the risk of inaccurate financial reporting.

• Streamlined reconciliation

  
  

Automation simplifies the reconciliation process for both temporary and permanent accounts. Automated reconciliation tools compare account balances against external statements or records, ensuring that discrepancies are identified and resolved efficiently.

How Can HighRadius Enhance the Management of Temporary and Permanent Accounts?

HighRadius’ Record to Report Solution significantly enhances the management of both temporary and permanent accounts by automating key processes and ensuring real-time accuracy. It streamlines the closing process for temporary accounts, accelerates financial reporting with real-time updates, and reduces manual errors through automated data entry and reconciliation. 

On a border note, HighRadius offers a cloud-based solution that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.

Our Financial Close Software is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%.The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it. 

Our Account Reconciliation Software provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close. Our solution has the ability to prepare and post journal entries, which will be automatically posted into the ERP, automating 70% of your account reconciliation process. 

Our AI-powered Anomaly Management Software helps accounting professionals identify and rectify potential ‘Errors and Omissions’ throughout the financial period so that teams can avoid the month-end rush. The AI algorithm continuously learns through a feedback loop which, in turn, reduces false anomalies. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.

FAQs

1. Which 4 accounts are considered temporary accounts?

Temporary accounts include revenue accounts (sales revenue), expense accounts (rent expense and utility expense), income summary accounts used at period-end, and drawing or dividend accounts (owner’s draw or dividends paid). These accounts are closed at the end of each period to reset their balances and prepare for the next accounting period.

2. How do I know if an account is permanent or temporary?

To determine if an account is permanent or temporary, check if it carries its balance over to the next period. Permanent accounts like assets, liabilities, and equity maintain balances across periods, while temporary accounts like revenue and expenses reset to zero at period-end.

3. What is the main difference between temporary and permanent accounts?

The difference between temporary and permanent accounts is that temporary accounts, like revenue and expenses, are reset to zero at the end of each period, reflecting performance for that timeframe. Permanent accounts, such as assets and liabilities, carry their balances forward, showing the ongoing financial status of the business.