What it means
Imagine running a marathon and resetting your stopwatch at every mile marker. That is essentially what temporary accounts do for your business finances.
They track activity for a specific timeframe, usually one financial year, allowing you to measure performance over that exact period. These accounts include all revenue categories, expense categories, and the owner's drawings.
At the end of the financial year, these temporary balances must be cleared out. This process is known as closing the books.
Accountants transfer the net profit or loss from these temporary accounts into retained earnings, which lives on the balance sheet. By zeroing out the temporary accounts, the business prepares to measure performance accurately for the upcoming year without mixing past results with new ones.
Why does this matter for non-finance managers? Because it ensures that your profit and loss statement reflects only what happened during the current period.
If temporary accounts were not reset, your sales and costs would accumulate indefinitely, making it impossible to tell if your business is growing, shrinking, or holding steady this year compared to last year. In day-to-day operations, you interact with temporary accounts every time you record a sale, pay an electricity bill, or buy office supplies.
While your balance sheet items like cash and loans roll over continuously, your income statement items rely entirely on these temporary setups to keep score for the current financial cycle. Temporary accounts are like the daily trip odometer in a car.
You reset it to zero before a specific journey to track that single trip, while the main odometer keeps running up the total lifetime mileage.
In practice
Real-world examples
Example 1
A freelance graphic designer earns $4,000 in client fees and spends $500 on software in December. On 31 December, these income and software expense totals are cleared to zero.
Example 2
A local cafe records $15,000 in coffee sales and $11,000 in ingredient costs for the month. At month-end, these temporary totals are processed, leaving a clean slate for the next month.
Example 3
A small consultancy firm tracks $8,000 in staff travel costs over the summer. When the financial year ends in September, this travel cost account is reset to zero for the new fiscal year.
Think of it
Temporary accounts are like the daily trip odometer in a car. You reset it to zero before a specific journey to track that single trip, while the main odometer keeps running up the total lifetime mileage.
Formula
Calculation
Net Income = Total Revenues - Total Expenses
Worked example: total revenues are $50,000 and total expenses are $35,000, so net income is $50,000 - $35,000 = $15,000.
The closing process moves this $15,000 in three steps. First, debit Revenue $50,000 and credit Income Summary $50,000, which zeroes the revenue account. Second, debit Income Summary $35,000 and credit Expenses $35,000, which zeroes the expense accounts. Third, debit Income Summary $15,000 and credit Retained Earnings $15,000, which moves the profit onto the balance sheet.
If the owner also took $4,000 in drawings during the year, that account is closed too: debit Retained Earnings $4,000 and credit Drawings $4,000. Retained earnings then rise by $15,000 - $4,000 = $11,000 in total for the year.Case study
Seen in the real world
This is a fictional, illustrative scenario. Bright Spark Lighting, a small retail shop, reached the end of its financial year on 31 March. Throughout the year, the manager carefully tracked sales and costs using temporary accounts. The books showed total sales revenue of $120,000 and operating expenses of $85,000, leaving a net profit of $35,000.
To prepare for the new financial year starting on 1 April, the accountant performed the year-end closing process. The accountant debited all revenue accounts and credited all expense accounts until their balances hit zero. The net difference of $35,000 was moved into the company's retained earnings account on the balance sheet. When the team arrived at work on 1 April, all sales and expense tracking started fresh from zero.
This allowed Bright Spark Lighting to measure its new performance accurately without interference from the previous year's figures. The reset also made the next year's comparison simple. When the following year closed with $132,000 in revenue and $91,000 in expenses, the manager could see at once that net profit had risen from $35,000 to $41,000, an increase of about 17%, without untangling any carried-over balances.
Watch out
Common mistakes
- Failing to reset temporary accounts at the end of the accounting period, which distorts the next period's results.
- Confusing temporary accounts with permanent accounts like bank balances or long-term loans.
- Forgetting to transfer the final net balance into the permanent equity or retained earnings section.
Questions
People also ask
What happens if I forget to close temporary accounts?
Your next year's income statement will include revenues and expenses from the previous year, making your financial reports inaccurate.
Are asset accounts temporary?
No. Assets, liabilities, and equity accounts are permanent accounts because their balances roll over into the next financial period.
Do temporary accounts only reset annually?
While usually reset annually, some businesses choose to close their temporary accounts monthly or quarterly for internal reporting.