Closing entries in accounting

Introduction

This tutorial will guide you through the process of preparing closing entries in accounting. Closing entries are essential for resetting temporary accounts to zero at the end of an accounting period, allowing you to start fresh for the new period. Understanding this process is crucial for accurate financial reporting and maintaining organized records.

Step 1: Understand Debits and Credits

Before you create closing entries, it's important to grasp the concept of debits and credits.

• Debits increase asset and expense accounts, and decrease liability and equity accounts.
• Credits decrease asset and expense accounts, and increase liability and equity accounts.

Practical Tip

Remember the mnemonic DC ADE LER:

• Debits = Credits
• Assets, Dividends, Expenses (debit balance)
• Liabilities, Equity, Revenue (credit balance)

Step 2: Classify Accounts

Differentiate between permanent and temporary accounts:

• Permanent Accounts: Assets, Liabilities, and Equity

  • These accounts carry their balances over to the next accounting period.

• Temporary Accounts: Revenues, Expenses, and Dividends

  • These accounts will be reset to zero during the closing process.

Common Pitfall

Neglecting to classify accounts correctly may lead to errors in your financial statements.

Step 3: Prepare the Trial Balance After Corrections

Ensure all adjustments have been made and the trial balance reflects accurate account balances.

• Review all journal entries for accuracy.
• Confirm that all adjustments for accruals and prepaids are completed.

Step 4: Create Closing Entries for Temporary Accounts

To close temporary accounts, follow these steps:

1. Close Revenue Accounts

   • Debit each revenue account to reset to zero.
   • Credit the Income Summary account with the total revenue.

2. Close Expense Accounts

   • Credit each expense account to reset to zero.
   • Debit the Income Summary account with the total expenses.

3. Transfer Net Income to Retained Earnings

   • Calculate net income (Total Revenue - Total Expenses).
   • If net income is positive, debit the Income Summary account and credit Retained Earnings.
   • If there is a net loss, the entries will be reversed.

Example Entries

# Closing Revenue
Debit: Revenue Account
Credit: Income Summary

# Closing Expenses
Credit: Expense Account
Debit: Income Summary

# Transferring to Retained Earnings
Debit: Income Summary
Credit: Retained Earnings

Step 5: Close Dividend Accounts

If dividends were declared during the accounting period, close the dividend account by:

• Debiting the Retained Earnings account.
• Crediting the Dividends account, resetting it to zero.

Practical Tip

Always ensure that the dividend account is closed to reflect the earnings distribution accurately.

Step 6: Prepare the Post-Close Trial Balance

After closing entries are made, create a post-close trial balance:

• Verify that all temporary accounts have been reset to zero.
• Ensure that the balances of permanent accounts are carried forward accurately.

Conclusion

Closing entries are a vital part of the accounting cycle, ensuring that temporary accounts are reset for the new period. By understanding how to classify accounts, prepare closing entries, and create a post-close trial balance, you can maintain accurate financial records. As you move forward, practice these steps consistently to enhance your accounting skills and prepare for the next accounting period with confidence.