Closing Entry in Accounting: Definition, Example, and Best Practices

Introduction

Closing entries are a fundamental part of accounting, essential for resetting temporary accounts and ensuring accurate financial records for the next period. This process highlights a company’s financial performance and position. In this guide, we delve into what closing entries are, including examples, the process of journalizing and posting them, and their significance in financial management.

The Accounting Cycle

The accounting cycle involves several steps to manage and report financial data, starting with recording transactions and ending with preparing financial statements. Closing entries are made at the end of this cycle. These entries transfer balances from temporary accounts—such as revenues, expenses, and dividends—into permanent accounts like retained earnings. 

For example, closing an income summary involves transferring its balance to retained earnings. This crucial step ensures that financial records are accurate and up-to-date for the next period, making it easier to track the company’s performance over time.

What Is a Closing Entry?

A closing entry is a journal entry made at the end of an accounting period to transfer the balances of temporary accounts (like revenues, expenses, and dividends) to the permanent accounts (like retained earnings). It helps prepare the books for the next accounting period.

Purpose of closing entries

Closing entries serve two primary purposes: 

1. To transfer temporary account balances to permanent accounts
2. To reset temporary accounts to zero for the new period

What are Temporary and Permanent Accounts?

Permanent accounts:

Permanent accounts have the following attributes: 

• Assets, liabilities, and equity are permanent accounts.
• They reside in the general ledger, and their closing balances at the end of an accounting period carry forward to the next accounting period.
• Permanent accounts reflect the ongoing financial position of a business.

Temporary accounts:

Temporary accounts have the following attributes:

• Revenues, expenses, and dividends are temporary accounts.
• They also reside in the general ledger but are specific to a particular accounting period. At the end of the period, their closing balances need to be reset to zero.
• This resetting process is accomplished using closing entries.

In summary, permanent accounts hold balances that persist from one period to another. In contrast, temporary accounts capture transactions and activities for a specific period and require resetting to zero with closing entries.

Closing Entry Example

Let’s investigate an example of how closing journal entries impact a trial balance. Imagine you own a bakery business, and you’re starting a new financial year on March 1st.

The trial balance is like a snapshot of your business’s financial health at a specific moment. It lists the current balances in all your general ledger accounts. In this case, we can see the snapshot of the opening trial balance below.

Analyzing the opening trial balance:

Permanent accounts in the opening balance comprises of: 

• Assets: Cash, accounts receivables, accrued revenue, property and equipment
• Liabilities: Accounts payable, salaries payable, accrued expenses, deferred revenue, long-term loans
• Equity: Share capital, retained earnings

These permanent accounts form the foundation of your business’s balance sheet. They carry over their balances from the previous year. However, you might wonder, where are the revenue, expense, and dividend accounts? Trial balances often filter out accounts with zero balances. These accounts were reset to zero at the end of the previous year to start afresh. On expanding the view of the opening trial balance snapshot, we can view them as temporary accounts, as can be seen in the snapshot below.

Here we can see that revenue, dividends, and expenses (cost of service, overhead expense, interest expense and tax expense) are temporary accounts that have been reset to zero

Once we have obtained the opening trial balance, the next step is to identify errors if any, make adjusting entries, and generate an adjusted trial balance. 

The adjusted trial balance snapshot:

Once we have made the adjusting entries for the entire accounting year, we have obtained the adjusted trial balance, which reflects an accurate and fair view of the bakery’s financial position. It encompasses an entire year’s worth of transactions.

Once all the adjusting entries are made the temporary accounts reflect the correct entries for revenue, expenses, and dividends for the accounting year. We can also see that the debit equals credit; hence, it adheres to the accounting principle of double-entry accounting. .

Now, all the temporary accounts have their respective figures allocated, showcasing the revenue the bakery has generated, the expenses it has incurred, and the dividends declared throughout the past year.

How to post closing entries?

To smoothly transfer temporary account balances to permanent accounts, we can use either the long or short-form method to post closing entries. Let’s focus on the long-form method and break it down into manageable steps:

Long-form method:

This process ensures that your temporary accounts are properly closed out sequentially, and the relevant balances are transferred to the income summary and ultimately to the retained earnings account.

What is an income summary account?

The income summary account is a temporary account solely for posting entries during the closing process. It is a holding account for revenues and expenses before they are transferred to the retained earnings account.

Step 1: Clear revenue to the income summary account

1. Within the adjusted trial balance, locate the revenue account that needs to be reset to zero.
2. Ensure you’re adjusting the revenue under the temporary accounts tab, not the accrued or deferred revenue found under assets and liabilities, respectively, as these are permanent accounts.

Adjust the revenue account:

1. Your business has earned $20 million this year, reflecting a credit balance in the revenue “T” account (right-hand-side).
2. Post a closing journal entry to reset this temporary account to zero.
3. Debit the revenue account by $20 million and credit the income summary account with the same amount.

Analyze the resulting balances:

1. The closing entry transfers the balance from the revenue account to the income summary account.
2. As a result, the revenue account now shows a balance of zero dollars, while the income summary account reflects $20 million.

Step 2: Clear expenses to the income summary account

1. Locate the expense accounts in the adjusted trial balance that need to reset to zero.
2. There are four expense accounts: cost of services, overhead expenses, interest, and tax.
3. Ignore accrued expenses, as it is a permanent liability account.

Adjust the expense accounts:

1. 1. Post a closing entry similar to reset the expense accounts to zero.
   2. Expenses reflect a debit balance in the revenue “T” account (left-hand-side)

1. Post equal and opposite credits to each account to reset them to nil.
2. The total balance is $16,050,000, which will be debited to the income summary account.

Balance the journal entry:

1. The debit column’s total must match the credit column in every journal.
2. Credit the right-hand side of each expense account to reset them to zero.
3. Debit the left-hand side of the income summary account, giving it a new balance of $3,950,000, a net credit on the right-hand side.

Step 3: Clear the balance in the income summary account to retained earnings

Clear out the Income summary account:

1. Look at the income summary account in your trial balance, which has a credit balance of $3,950,000.
2. The income summary account represents the combination of your business’s revenues and expenses for the year.
3. To clear this balance, you must debit the income summary account by the same amount and credit the balance to retained earnings.

Post the closing entry:

1. The closing entry for this step is straightforward. Debit the income summary account by $3,950,000.
2. Then, credit the same amount to retained earnings.
3. By posting this entry, your business’s retained earnings, or profits held for future use, will increase to $13,950,000.

Step 4: Clear the dividends straight to retained earnings

Reset dividends and adjusting retained earnings:

1. Reset the current year’s dividends to zero and clear the balance to retained earnings.
2. Your business declared dividends of $500,000 this year, which represents profits distributed to owners and shareholders.
3. Since retained earnings reflect profits held for future use, issuing dividends reduces the balance in retained earnings.

Closing entry for dividends:

1. The dividends account is a debit account, so we will credit the dividend account by $500,000 in the closing entry.
2. Simultaneously, debit retained earnings by the same amount.
3. By posting this closing entry, your business’s dividends will be reset to zero, and its retained earnings will decrease to $13,450,000.

Post closing trial balance snapshot:

All the temporary accounts, including revenue, expense, and dividends, have now been reset to zero. The balances from these temporary accounts have been transferred to the permanent account, retained earnings.

Short-form method:

In short, we can clear all temporary accounts to retained earnings with a single closing entry. By debiting the revenue account and crediting the dividend and expense accounts, the balance of $3,450,000 is credited to retained earnings. 

Note: In double-entry accounting, every transaction has at least two equal and opposite sides. When we post this closing entry, all temporary accounts are reset to zero.

With the use of modern accounting software, this process often takes place automatically.

Closing Entries Best Practices

At HighRadius, we recently surveyed seasoned accountants across industries to gather their expertise on closing entries. Based on their insights, here are the five biggest practical takeaways to follow:

1. Maintain consistency:
   Perform closing entries steps consistently at the end of each accounting period, whether monthly, quarterly, or annually, to minimize errors and maintain accurate financial records.
2. Streamline intercompany transactions:
   Scrutinize transactions between related entities or departments, eliminating or appropriately consolidating intercompany revenues and expenses for consolidated financial statements.
3. Adjust for timing differences:
   Account for timing differences in revenue and expenses, ensuring all relevant transactions from the accounting period are included to prevent misstatements.
4. Conduct comparative analysis:
   Compare current financial statements with prior periods to detect significant variances or anomalies. Analyze differences and investigate unexpected fluctuations for accurate and consistent financial reporting.
5. Leverage accounting software:
   Streamline the closing entry process by utilizing modern and dependable accounting software features that automate calculations, generate reports, and ensure accurate execution.

Closing Entries Accounting with Automation

Automation transforms the process of closing entries in accounting, making it more efficient and accurate. By leveraging automated systems, businesses can ensure that all tasks related to closing entries are handled seamlessly, reducing manual effort and minimizing errors. 

Here are the key benefits of automation in closing entries accounting:

1. Precision and accuracy: Executes journalizing and posting closing entries with high precision, minimizing errors.
2. Efficiency: Automates closing entries for dividends, expenses, and income summary accounts, saving time.
3. Post-closing trial balances: Quickly generates accurate post-closing trial balances.
4. Timely insights: Provides timely financial performance insights, enhancing decision-making.
5. Streamlined operations: Reduces manual workload, simplifying operations.
6. Compliance and integrity: Enhances compliance and maintains financial integrity, making the closing process seamless and reliable.

How Highradius Can Help You Streamline Your Accounting Management

Closing entries are crucial for maintaining accurate financial records. HighRadius has a comprehensive Record to Report suite that revolutionizes your accounting processes, making them more efficient and accurate. At the core of this suite is the Financial Close Management solution, which simplifies and accelerates financial close activities, ensuring compliance and reducing errors.

LiveCube Task Automation is designed to automate repetitive tasks, improve efficiency, and facilitate real-time collaboration across teams. By leveraging advanced workflow management, the no-code platform, LiveCube ensures that all closing tasks are completed on time and accurately, reducing the manual effort and the risk of errors. Organizations can achieve a 40% increase in close productivity, resulting in a more streamlined financial close process and allowing your team to focus on more strategic activities.

Another essential component of the Highradius suite is the Journal Entry Management module. This module automates the creation and management of journal entries, ensuring consistency and accuracy in your financial statements. Organizations can achieve up to 95% journal posting automation with a pre-filled template, reducing errors and discrepancies and providing a reliable view of financial data.

FAQs

1) How are closing entries posted in the general ledger?

Closing entries are posted in the general ledger by transferring all revenue and expense account balances to the income summary account. Then, transfer the balance of the income summary account to the retained earnings account. Finally, transfer any dividends to the retained earnings account.

2) In which journal are closing entries typically recorded?

Closing entries are typically recorded in the general journal. This journal is used to document the final entries that transfer balances from temporary accounts (such as revenue and expenses) to permanent accounts (like retained earnings), ensuring the accounts are reset for the next accounting period.

3) Which types of accounts do not require closing entries?

Permanent accounts, also known as real accounts, do not require closing entries. These include asset, liability, and equity accounts. Examples are cash, accounts receivable, accounts payable, and retained earnings. These accounts carry their ending balances into the next accounting period and are not reset to zero.

4) Should closing entries be performed before or after adjusting entries?

Closing entries are performed after adjusting entries in the accounting cycle. Adjusting entries ensures that revenues and expenses are appropriately recognized in the correct accounting period. Once adjusting entries have been made, closing entries are used to reset temporary accounts.

5) Which accounts remain unaffected by closing entries?

Permanent accounts, such as asset, liability, and equity accounts, remain unaffected by closing entries. These accounts, including examples like cash, accounts receivable, accounts payable, and retained earnings, carry their ending balances into the next accounting period and are not reset to zero, unlike temporary accounts.

6) How to close revenue accounts?

To close revenue accounts, you first transfer their balances to the income summary account. Start by debiting each revenue account for its total balance, effectively reducing the balance to zero. Then, credit the income summary account with the total revenue amount from all revenue accounts.

7) How to close an income summary account?

To close an income summary account, transfer the net income or net loss to the retained earnings account. First, debit the income summary account for its total balance (net income) or credit it (net loss). Then, credit retained earnings for the net income amount or debit it for the net loss amount.