What it means
Accounts fall into two groups. Permanent accounts (assets, liabilities and equity) accumulate over the life of the business; a bank balance or a loan carries forward from year to year.
Temporary accounts (revenue and expenses) measure activity within a single period; sales for this year should not run on into next year's total. Closing entries are how the books enforce that distinction.
Once the income statement for the year has been prepared, the balances in every revenue and expense account are transferred out, leaving them at zero, and the net result, the year's profit or loss, is added to retained earnings. The traditional method uses an income summary account as a clearing step.
First, each revenue account is debited for its balance and the total credited to income summary. Second, income summary is debited and each expense account credited for its balance.
Income summary now holds the net profit (a credit) or loss (a debit). Third, income summary is closed to retained earnings.
Fourth, dividends or drawings, which are not expenses but reduce equity, are closed directly to retained earnings. After these four entries, a post-closing trial balance is prepared containing only permanent accounts, and the new period begins.
Modern accounting software performs the close automatically when a period is locked; the user never sees the entries. But the logic still applies, and understanding it explains several things: why retained earnings equals the sum of all past profits less all distributions, why an income statement always covers a period while a balance sheet is at a date, and why reopening a closed period to post a late entry changes both that period's profit and the opening retained earnings of the next.
Closing entries should not be confused with adjusting entries, which come before the statements are prepared and bring balances up to date, or with reversing entries, which are optional entries at the start of the next period that undo certain accruals to simplify later bookkeeping.
In practice
Real-world examples.
Example
A sole trader's bookkeeper closes the year's sales and expense accounts to the profit and loss summary, then transfers the profit to the owner's capital account and closes drawings against it.
Example
A company's accounting system locks December once the auditors sign off, automatically rolling the year's profit into retained earnings and opening January with zero revenue and expenses.
Example
A controller discovers a $20,000 supplier invoice for the prior year after the close, and reopens the period to post it, reducing prior-year profit and opening retained earnings by $20,000.
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
Closing Retained Earnings = Opening Retained Earnings + Net Profit for the period minus Dividends (or Drawings)
Worked example. A consultancy's adjusted trial balance at 31 December shows:
- Consulting revenue: $620,000 (credit)
- Salaries expense: $380,000 (debit)
- Rent expense: $48,000 (debit)
- Other expenses: $72,000 (debit)
- Depreciation expense: $15,000 (debit)
- Dividends paid: $40,000 (debit)
- Retained earnings at 1 January: $210,000 (credit)
Closing entries:
1. Debit consulting revenue $620,000; credit income summary $620,000
2. Debit income summary $515,000; credit salaries $380,000, rent $48,000, other expenses $72,000, depreciation $15,000
3. Income summary now has a credit balance of $105,000 (net profit). Debit income summary $105,000; credit retained earnings $105,000
4. Debit retained earnings $40,000; credit dividends $40,000
Closing retained earnings = $210,000 + $105,000 minus $40,000 = $275,000
On 1 January the revenue, expense and dividend accounts all stand at zero, retained earnings stands at $275,000, and the post-closing trial balance contains only assets, liabilities and equity.Case study
Seen in the real world.
A growing e-commerce company used a spreadsheet-based ledger for its first three years and never formally closed a period. Revenue and expense accounts simply kept accumulating, and the owner produced "annual" figures by subtracting last year's running totals from this year's. It worked until an error in the subtraction went unnoticed and the tax return overstated profit by $60,000.
When the company moved to proper accounting software, the implementation consultant had to reconstruct three years of closing entries to establish an opening retained earnings figure that agreed with the tax filings and the bank's records. The exercise took six weeks and uncovered $14,000 of drawings that had been posted as expenses. The company now closes monthly, locks each period after review, and the owner receives an income statement that starts from zero every month.
Watch out
Common mistakes.
- Closing balance sheet accounts. Only revenue, expense, gain, loss and dividend accounts are closed; assets, liabilities and equity carry forward.
- Treating dividends as an expense. They are a distribution of profit and are closed directly to retained earnings, not through income summary.
- Posting entries into a closed period without reopening it properly, which breaks the link between last year's closing and this year's opening balances.
Questions
People also ask.
What is the difference between adjusting and closing entries?
Adjusting entries update balances before the statements are prepared. Closing entries reset temporary accounts after the statements are prepared.
Why is retained earnings not closed?
It is a permanent equity account that accumulates the business's undistributed profits over its whole life.
Do closing entries affect the balance sheet?
Only through retained earnings, which absorbs the period's profit or loss and any dividends. Total assets and liabilities are unchanged.
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