Closing Entries

Periodically, usually at the end of the accounting period, all revenue and expense account balances are transferred to an account called income summary or profit and loss account and are then said to be closed. (a detailed discussion on profit and loss account can be had in a subsequent lesson).

The balance in the profit and loss account, which is the net income or net loss for the period, is then transferred to the capital account and thus the profit and loss account is also closed. In the case of corporation the net income or net loss is transferred to retained earnings account which is a part of owners’ equity. The entries which are passed for transferring these accounts are called as closing entries. Because of this periodic closing of revenue and expense accounts, they are called as temporary or nominal accounts. On the other hand, the assets, liabilities and owners’ equity accounts, the balances of which are shown on the balance sheet and are carried forward from year to year are called as permanent or real accounts

The principle of framing a closing entry is very simple. If an account is having a debit balance, then it is credited and the profit and loss account is debited. Similarly if a particular account is having a credit balance, it is closed by debiting it and crediting the profit and loss account. In our example sales account and interest account are revenues, and purchases account and salaries account are expenses. Purchases account is an expense because the entire goods have been sold out in the accounting period itself and hence they become cost of goods sold out. This aspect would become more clear when the reader proceeds to the lessons on profit and loss account. The closing entries would appear as follows:

Now profit and loss a/c, retained earnings a/c and balance sheet can be prepared which would appear as follows: