What it means
The income statement measures performance over a single period, so revenue and expenses must start at zero each time. If last year's sales stayed in the revenue account, this year's total would be a confusing mixture of two periods.
Closing entries solve that by sweeping the temporary balances into permanent equity. The profit or loss for the year ends up in retained earnings, which then appears on the balance sheet.
There are four standard steps. Revenue accounts are closed to an income summary account, expense accounts are closed to the same account, the income summary balance is moved to retained earnings, and finally the dividends account is closed to retained earnings.
The income summary account is just a holding account used for convenience during the process. Many accounting systems skip it and close directly to retained earnings, and modern software performs the whole routine automatically at year end.
Before closing, the accountant prepares an adjusted trial balance to confirm that debits equal credits. After closing, a post-closing trial balance should show only permanent accounts, which is a useful check that nothing was left behind.
Understanding closing entries helps non-accountants read the statement of retained earnings. The movement in that statement is the net income for the year less dividends, exactly the figure the closing process produces.
In practice
Real-world examples
Example 1
A consulting firm finishes its financial year on 30 June. The accountant posts closing entries that clear $1,200,000 of fees and $1,050,000 of costs, leaving a $150,000 profit in retained earnings. She then prints the post-closing trial balance for the file. The partners also use the printed figures to compare profit with the budget.
Example 2
A small shop uses cloud accounting software that closes the year automatically. The owner sees the profit move into the equity section of the balance sheet and notices that sales and expense accounts start the new year at zero. The only items that remain are the permanent balances such as cash and loans.
Example 3
A club treasurer closes the books after the annual event. Donations of $18,000 and costs of $14,500 are cleared, and the surplus of $3,500 is added to the club's accumulated funds. The committee reports the balance at the next annual meeting. Members see the same figure in the treasurer's report.
Think of it
Closing entries are like emptying your pockets at the end of each day and putting everything in your savings account. You start the next day with empty pockets.
Formula
Calculation
Change in retained earnings = Net income - Dividends
A company has revenue of $500,000, expenses of $430,000 and dividends of $20,000 for the year. The closing entries are:
Debit Revenue $500,000, credit Income Summary $500,000
Debit Income Summary $430,000, credit Expenses $430,000
Income Summary now has a credit balance of $500,000 - $430,000 = $70,000, so debit Income Summary $70,000, credit Retained Earnings $70,000
Debit Retained Earnings $20,000, credit Dividends $20,000
Net change in retained earnings = $70,000 - $20,000 = $50,000.Case study
Seen in the real world
Kestrel Components is an illustrative, fictional manufacturer whose new accountant joined just before the year end. She found that the old process involved copying figures into a spreadsheet by hand and that last year's revenue accounts had never been properly cleared.
As a result, the first-quarter sales report included a few late invoices from the previous year, and the profit and loss account showed $45,000 more revenue than the business had really earned in the period.
She formalised a year-end checklist that included adjusting entries, closing entries and a post-closing trial balance. In this illustrative case the next year's figures began cleanly at zero, and the auditors commented that the opening balances agreed exactly to the prior year closing position. She also trained a junior colleague so the process no longer depended on one person. The checklist is stored where the whole finance team can see it, and each step is signed off with a date and initials.
Watch out
Common mistakes
- Closing the books before posting adjusting entries such as depreciation and accruals.
- Forgetting to close the dividends account, which leaves the drawings looking like an expense.
- Trying to close permanent accounts such as cash or loans, which should always carry forward.
Questions
People also ask
Do closing entries change profit?
No, they only move the profit already calculated into retained earnings and reset the temporary accounts. The reported profit does not change, and the balance sheet still balances afterwards.
Do I need to do closing entries if I use software?
The software usually does it automatically, but you should still review the trial balance before and after to make sure the process worked.
Are closing entries needed every month?
Most businesses close formally only at the year end, though they may produce monthly reports without clearing the accounts. Monthly reports use year-to-date balances and do not need the accounts to be cleared.
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