Closing Entries

After financial statements are prepared, you are ready to get your books ready for the next accounting period by clearing out the income and expense accounts in the general ledger and transferring the net income (or loss) to your owner's equity account. This is done by preparing closing entries in the general journal.

Note the distinction between adjusting entries and closing entries. Adjusting entries are required to update certain accounts in your general ledger at the end of an accounting period. They must be done before you can prepare your financial statements and income tax return. Closing entries are needed to clear out your revenue and expense accounts as you start the beginning of a new accounting period.

Preparing your closing entries is a very simple, mechanical process. Follow these steps:

  1. Close the revenue accounts. Prepare one journal entry that debits all the revenue accounts. (These accounts will have a credit balance in the general ledger prior to the closing entry.) Credit an account called "income summary" for the total.
  2. Close the expense accounts. Prepare one journal entry that credits all the expense accounts. (These accounts will have a debit balance in the general ledger prior to the closing entry.) Debit the income summary account for the total.
  3. Transfer the income summary balance to a capital account. Prepare a journal entry that clears out the income summary account. This entry effectively transfers the net income (or loss) of the business to the owner's equity account.
  4. Close the drawing account. If your business is a sole proprietorship or partnership, close the drawing accounts (if any) by preparing a journal entry that credits the drawing account and debits the owner's equity account.

 
Example

As an example, assume that you have finalized your general ledger and prepared a balance sheet and income statement for the year ended December 31, 2001. You want to get your books ready for next year. You prepare the four closing entries as follows:

 

Debit Credit
Sales 462,452
Income summary
462,452
To close the revenue account on 12/31/2001

 

Debit Credit
Income summary 399,871
Purchases
230,934
Advertising
1,850
Depreciation
13,250
Insurance
5,400
Payroll taxes
8,200
Rent
9,600
Repairs and maintenance
13,984
Utilities
17,801
Wages
98,852
To close the expense accounts on 12/31/2001

 

Debit Credit
Income summary 62,581
Tom Beta, capital
62,581
To transfer 12/31/2001 net income to the capital account

 

Debit Credit
Tom Beta, capital 12,000
Tom Beta, drawing
12,000
To close drawing account for year ended 12/31/2001

After all closing entries are made, post the entry totals to the general ledger. Foot the general ledger accounts to arrive at the beginning amounts for the new accounting period. All revenue and expense accounts should have a zero balance.