Closing Process

The closing process zeros out the balances in all temporary accounts (revenue, expense, and dividend accounts), in order to prepare the recording and posting of transactions for the new accounting period. For example, Amazon.com would need to close the revenue and expenses on the income statement each year so that when a new year starts, the new revenue and the new expenses for the new year can start to be accumulated. Balances in these temporary accounts are transferred to a clearing account titled income summary. The sole purpose of this income summary account is to facilitate the closing process of the temporary accounts.

Only revenue and expense accounts are "closed out" to income summary while dividends are closed directly to retained earnings. The income summary account, as the name suggests, shows us our net income or loss and will be exactly the same as the net income/loss on the income statement, which also does not include dividends. The balance in the income summary account is also closed out directly to retained earnings.

Let's look at how to prepare closing entries.

Closing Entries

Closing Entries
Transaction Number	Date	Account	Ref.	Debit	Credit
1	20XX	Revenue	331	$20,000	-
-	Dec.31	Income Summary	350	-	$20,000

The first step in the closing process is to close all revenues. Revenues increase owner's equity, so they would have a credit balance. To get rid of them or taken down to zero then, we would debit them. So we would debit revenues and credit income summary. In our example, we only have one revenue account. So we will debit revenue $20,000 and credit income summary for $20,000 as well.

Closing Entries

Closing Entries
Transaction Number	Date	Account	Ref.	Debit	Credit
2	20XX	Income Summary	350	$16,467	-
-	Dec.31	Utilities Expense	345	-	$500
-	-	Supplies Expense	343	-	800
-	-	Insurance Expense	342	-	400
-	-	Interest Expense	346	-	166.67
		Depreciation Expense, Equipment	347		9,600
		Depreciation Expense, Truck	348		5,000

The second step in the process is to close all expenses. Expenses decrease owner's equity, so they would have a typical debit balance. So to get rid of them or take them to zero, we would credit them. So we will debit income summary, leave that blank for now, and credit all the expenses. Once we get a total of all the expenses, that's what we will debit to income summary.

So in our example, we have six expenses, utilities expense of $500, supplies expense of $800, insurance expense of $400, interest expense of $166.67, depreciation expense (equipment) for $9,600 and depreciation expense (truck) of $5,000. So if we total them then, it comes to $16,467. And that's what we will debit to income summary.

Closing Entries

Closing Entries
Transaction Number	Date	Account	Ref.	Debit	Credit
3	20XX	Income Summary	350	$3,533	-
-	Dec.31	Retained Earnings	313	-	$3,533

The third step in the process is the only step that doesn't have a specific rule. We do know that the third step will always contain income summary and retained earnings. Which one is debited and which one is credited, however, can change. In this case, we debited income summary for the expenses of $16,467 and credited it for the revenues of $20,000. So we have a credit balance of $3,533.

To get rid of that then, we would debit income summary for that amount and credit retained earnings for that same amount. Had we lost money or had more expenses and revenues, this transaction would be reversed. We would debit retained earnings and credit income summary.