Why is closing temporary accounts important

Both the revenues and expenses are recorded in the same period as defined by the matching principle because, otherwise, your closing income statement would contain anomalies. Ask your vendors to provide you with work in progress figures so that you can include them in the income statement.

All accounts will be closed at the end of the accounting period, giving them the name temporary accounts. Knowing how much money you spent to make what you earned will help you make strategic decisions in the future. You will quickly know if you need to cut the costs to lower the expenses or increase the price to bulk up revenue. Whatever the case may be, closing temporary accounts is critical for your business operations.

Permanent accounts need to be managed actively throughout the accounting period. It is important so the current capacity of the business can always be determined correctly.

No balance in the account will go away unless it is written off. We may receive compensation from some partners and advertisers whose products appear here. Compensation may impact where products are placed on our site, but editorial opinions, scores, and reviews are independent from the advertising side of The Blueprint and our objectivity is an integral part of who we are. Our commitment to you is complete honesty: we will never allow advertisers to influence our opinion of products that appear on this site.

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Permanent accounts are those that are not bound by a set time frame. They include things like retained earnings and equity accounts.

They are also commonly referred to as balance sheet accounts. Unlike the income statement , the balance sheet is not a reflection of performance. Permanent accounts, like the balance sheet that they feed, show the cumulative total of past efforts. So when you close out a temporary account, you add or subtract from the totals shown in the permanent accounts.

Making closing entries means creating a zero balance in all temporary accounts by carrying those balances over to permanent accounts. This prepares the books for the next accounting period to start. When the time comes to make closing entries, an accountant will transfer all the balances in the temporary accounts to the Income Summary Account.

This account works as a holding account for these balances so that the accountant can then make fewer entries to transfer the balance to the permanent accounts. After all account balances for temporary accounts have been transferred and a zero balance remains in each , the income summary account should mirror your net income.

The eighth step in the accounting cycle is preparing closing entries, which includes journalizing and posting the entries to the ledger. Four entries occur during the closing process. The first entry closes revenue accounts to the Income Summary account. The second entry closes expense accounts to the Income Summary account. The third entry closes the Income Summary account to Retained Earnings.

The fourth entry closes the Dividends account to Retained Earnings. The information needed to prepare closing entries comes from the adjusted trial balance. The Printing Plus adjusted trial balance for January 31, , is presented in Figure. The first entry requires revenue accounts close to the Income Summary account.

To get a zero balance in a revenue account, the entry will show a debit to revenues and a credit to Income Summary. The closing entry will debit both interest revenue and service revenue, and credit Income Summary.

Notice that the balances in interest revenue and service revenue are now zero and are ready to accumulate revenues in the next period. The second entry requires expense accounts close to the Income Summary account.

To get a zero balance in an expense account, the entry will show a credit to expenses and a debit to Income Summary. Notice that the balances in the expense accounts are now zero and are ready to accumulate expenses in the next period.

Why are these two figures the same? The income statement summarizes your income, as does income summary. If both summarize your income in the same period, then they must be equal.

If they do not match, then you have an error. The third entry requires Income Summary to close to the Retained Earnings account. To get a zero balance in the Income Summary account, there are guidelines to consider. Remember that net income will increase retained earnings, and a net loss will decrease retained earnings. The Retained Earnings account increases on the credit side and decreases on the debit side. Notice that the Income Summary account is now zero and is ready for use in the next period.

The fourth entry requires Dividends to close to the Retained Earnings account. Remember from your past studies that dividends are not expenses, such as salaries paid to your employees or staff. Instead, declaring and paying dividends is a method utilized by corporations to return part of the profits generated by the company to the owners of the company—in this case, its shareholders. If dividends were not declared, closing entries would cease at this point.

If dividends are declared, to get a zero balance in the Dividends account, the entry will show a credit to Dividends and a debit to Retained Earnings. As you will learn in Corporation Accounting , there are three components to the declaration and payment of dividends. The first part is the date of declaration, which creates the obligation or liability to pay the dividend. The second part is the date of record that determines who receives the dividends, and the third part is the date of payment, which is the date that payments are made.

The closing entry will credit Dividends and debit Retained Earnings. Why was income summary not used in the dividends closing entry? Dividends are not an income statement account.

Only income statement accounts help us summarize income, so only income statement accounts should go into income summary. It is contra to retained earnings. If we pay out dividends, it means retained earnings decreases. Retained earnings decreases on the debit side. This is the same figure found on the statement of retained earnings.

The statement of retained earnings shows the period-ending retained earnings after the closing entries have been posted. When you compare the retained earnings ledger T-account to the statement of retained earnings, the figures must match. It is important to understand retained earnings is not closed out, it is only updated. Retained Earnings is the only account that appears in the closing entries that does not close.

You should recall from your previous material that retained earnings are the earnings retained by the company over time—not cash flow but earnings. The T-account summary for Printing Plus after closing entries are journalized is presented in Figure.

Notice that revenues, expenses, dividends, and income summary all have zero balances.