Closing Entry

What is a Closing Entry?

A process where all temporary accounts opened in the fiscal year are transferred and closed to a permanent arrangement. Doing so will give zero balance to the brief history to use for the next fiscal year.

Closing Entries is simple, as you must follow only a few steps. However, the hard part of Closing Entries is remembering and knowing which accounts to close and how you complete them. 

Fortunately, there is an abbreviation that would help you to remember what to close, which will be shown further down.

In Accounting, Closing Entries are the same in every accounting standard worldwide except for some minor details. Countries may have extra steps or fewer steps when closing their entries, but generally, it is all the same where Temporary Accounts are closed and the balances are transferred.

As stated in the name, Temporary accounts are temporary and will last until the end of the fiscal period. They are created to hold the accumulated balances from entries/transactions in the general ledger. They are used and generally seen in the Income Statement. 

The income Statement, also known as the Profit or Loss statement, is one of the 3 Main Financial Statements that every accountant and company globally uses. It shows the Revenue, Expenses, and, most importantly, the Net Income the company generated during the fiscal year.   

Examples of Temporary Accounts:

• Revenue
• Expense
• Sales Discounts
• Sales Return
• Utilities
• Dividends

As you can tell by the examples of Temporary Accounts, they all belong to 3 types of accounts. The Revenue, Expense, and Dividends accounts. When closing entries, those three types of accounts are the only ones closed.

What Are Permanent Accounts?

Permanent Accounts are the opposite of Temporary Accounts as they are not closed at the end of the fiscal year, and their balances are carried over to the next fiscal year. 

Permanent Accounts can be found in every Financial Statement; some examples of Permanent Accounts would be:

• Cash
• Account Receivable
• Account Payable
• Equipment
• Supplies

As mentioned above, Temporary Accounts are closed, and their balances are transferred into a Permanent Account. During the process of closing accounts, there are multiple steps and information that you must remember. If not followed precisely, it would cause a misreport of a very important Account.

Before starting the Closing Entry Process, you must ensure that all the information and balances are correctly entered in the general ledger and financial statements, as one mistake could affect the whole process, which would lead to a bunch of different problems in the future for the Closing Entry Process and others.

To begin the process, you must have prepared three crucial pieces of information. First, it would help if you found the total balances of all the Revenue, Expense, and Dividends. After that, you can begin Closing Entry. 

It contains four steps, and an abbreviation was created to help accountants and students remember the four steps. To reflect the four steps, you must remember the four-letter abbreviation REID.

Closing Entries and REID

The abbreviation REID makes it simple to recall which accounts need to be closed and how they are completed. Revenue, Expense, Income Summary, and Dividend are referred to as REID.

R: Revenue

The First Step of Closing Entries is closing the Revenue account. To complete the Revenue account, you must debit the revenue account and credit an Income Summary Account account. The income Summary account is a temporary account where you would transfer the balance from the Revenue and Expense account.

Revenue Accounts

A revenue account is a financial account that records the monetary balances that the business has generated through its sales/services during the fiscal year without considering expenses, taxes, and deductions.

E: Expense

The Second Step of Closing Entries is closing the Expense Account. To complete the Expense account, you must credit all the Accounts and debit the Income Summary account once again. Doing this would bring the balances of the Expenses Account to zero.

Expense Accounts

Accounting Expense is a contra account that displays the balance of the assets and liabilities spent to generate Revenue in the business. 

I: Income Summary

The Third Step of Closing Entries is closing the Income Summary Account. Now, if you realize from steps 1 & 2, the balance of the Income Summary is also the same amount as the Net Income. As stated before, Income Summary is a temporary account and would also be closed.

The income Summary Account would be Credited, and Retained Earnings would be debited. Retained Earning is the company's profit after paying all costs, taxes, and dividends. 

D: Dividends

The Final Step of Closing Entries is closing the Dividends account. Then, making sure Dividends is paid to shareholders at the end of the fiscal year, the Dividends account would be credited, and Retained Earnings would be debited.

Dividends

Dividends are payments by corporations to the shareholders using the extra profits they have generated during the fiscal year. Each year the dividends could be different as the number of profits the business generates could differ depending on how the industry did.

Where Can You Find The Closing Entry Information?

Preparing for Closing Entry is simple and quick, as all the required information can be easily found. Closing Entries are designed after Financial Statements for the fiscal periods are created, which means all the needed information is already there; you need to find it.

To find the Revenue, you need to look for the Revenue section in the Income Statement. Once you find the Revenue section, you must find the total amount displayed there.

To find the Expenses, just like for Revenue, you would also find it in the Income Statement. The expenses would be listed in the expense section, so you would need to find the total costs. Depending on the company, there could be many different expenses.

If there isn't a total expense, then add up all the costs listed on the income statement. For Example

1. Cost of Goods Sold

The cost of goods sold is an account that displays the balance of the total cost amount that the company used to produce the products sold. In other words, it means the cost of making a sale. 

For Example: If a company generates 10000 for selling 10 Machines and each machine costs $500 to make, then the Cost of Good Sold would be $5000. In General Ledger, It would be written like this.

2. Operating Expense

Operating expenses include employee salaries and office supplies incurred by a firm to maintain it. The cost of goods sold (materials, direct labor, manufacturing overhead) and capital expenditures are not included in operating expenses (larger expenses such as buildings or machines).

a. Utility Expense

The cost of the company's usage of water, heat, electricity, gas, etc.

b. Maintenance Expense

The cost of maintaining a company's assets.

c. Rent Expense

Rent Expense is the cost of renting/inhabiting a building or land that the company has not purchased and owned.

d. Accounting & Legal Fee

Legal fees are the cost of any legal fees paid during the year. An example would be if the company were to get sued, then a lawyer would be hired, and that fee would need to be paid.

e. Wages/Salaries Expense

Wages/Salaries Expense is self-explanatory as the amount paid to workers.

f. Prepaid Expense

Prepaid Expense is where the Expense is paid in advance before the expense transaction even happens; since it is paid beforehand, the account is viewed as an asset account.

g. Non-Operating Expense

Costs not primarily connected to ongoing business activities are non-operating expenses. For example, interest on debt, restructuring charges, inventory write-offs, and payments to settle lawsuits are a few examples of non-operating costs. 

Stakeholders can have a clearer picture of the company's performance by documenting non-operating expenses separately from operating expenses.

h. Accrued Expenses

Accrued Expenses are expenses from the previous fiscal year that still need to be paid. 

i. Financial Expense

Financial expenses are expenses from lenders/borrowers and other economic activities.

The Income summary cannot be found as it is a temporary account created during the Closing Entry process to hold the balances of both the Revenue and Expenses before transferring the total amount into Retained earnings.

For Dividends, It can be easily found in the Statement of Cash flow. The Statement of Cash Flow shows Cash's business transaction, whether its inflow or outflow. Dividends are paid by Cash, so the transaction balance of paid tips would be demonstrated under Financial Activities.

Example of Where Closing Entries Are

The following Income Statement is a BASIC version, as Financial Statements from actual companies are more detailed and complicated.

The following Statement of Cash is a BASIC version, as Financial Statements from actual companies are more detailed and complicated.

After Closing Entries in the accounting cycle, a Post-Closing Trial Balance would be created. Just like a normal Trial Balance, it will contain and display all accounts that have non-zero balances and see if the debits and credits will balance.

The Post-Closing Trial Balance is prepared to check whether or not the accountant has successfully finished the Closing Entry Process and that all the Temporary accounts (Revenue, Expense, and Dividends Accounts) are properly closed and transferred into a Permanent account.

If the Post-Closing Trial Balance is not balanced and the Pre-Closing Trial Balance is balanced, then there were errors in the Closing Entry Process. The following would be an example of a trial balance; you can see that there are no temporary accounts and that all accounts have a natural number balance.

Conclusion

Closing Entry is an important aspect of Accounting as it immensely affects the company's financial records if done wrong. Closing Entry makes it look like a simple process but contains many different tasks in which one slip-up would change the entire results.

Knowing where to find all the required information to start the Closing Entry Process, how to create the Closing Entry Process, and what to do are all important things that you must remember and master as an Accountant.

After reading this article, you should better understand what Closing Entry is, and it's up to you to master it. To further learn about Accounting, other types of accounts, or even the 3 Financial statements and Financial models, you can enroll in the Accounting Foundation course below.

Researched & Authored by Edward Q

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