Closing the Books Section 7 Accounting 11

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1 Closing the Books At the end of a fiscal year once all the transactions for the entity have been recorded, the revenue and expense accounts must be closed out to a zero balance. These accounts have been accumulating balances over the period and they need to be set back to zero so that the next period s amounts can be accumulated. The standard practice in business is to not let these accounts accumulate balances for more than one year. Aside from closing the books at the fiscal year-end, many entities choose to close their accounts every month or quarter. The accounts that have accumulated balances are called temporary accounts. Also called nominal accounts, they include all revenue and expense accounts. Permanent accounts are those that have a continuing balance from one period to the next. All of the balance sheet accounts are permanent, or real, accounts. This means that asset, liability, and equity accounts are permanent but there is another permanent account called Retained Earnings that we have not yet introduced. Retained Earnings Retained Earnings represent the net income of an entity that has been kept in the business. The Retained Earnings account is an equity account that reflects the amount of income that is either reinvested in the company or not paid out to the owners through drawings or dividend: the income that is retained within the company. Remember net income is the link between the income statement and balance sheet but as net income is accumulated over subsequent periods, there needs to be an account to gather the amounts. In order to determine what the accumulated amount is, a Statement of Retained Earnings is prepared at the end of each period. Essentially any net income (or loss) is added to (subtracted from) the retained earnings from the previous period. When we talked about net income as the link between the balance sheet and income statement, we showed the following sample statements with the net income being directly transferred to the balance sheet: Page 1 of 8

2 Statement Examples: ABC Accounting Services Income Statement For the month ended July 31, 20XX Revenue Service Revenue $6,000 Expenses Rent $ 700 Salaries 3,000 Supplies 500 Travel 500 Total Expenses 4,700 Net Income $1,300 ABC Accounting Services Balance Sheet As at July 31, 20XX Assets Liabilities Cash $5,000 Bank Loan $3,000 A/R 1,000 A/P 1,750 Equip. 2,500 Total Liabilities $4,750 Equity Common Stock $2,450 Net Income 1,300 Total Equity 3,750 Total Liabilities Total Assets $8,500 and Equity $8,500 Net income is not typically placed on the balance sheet as an account; rather the Retained Earnings account balance is shown. The Statement of Retained Earnings shows how the balance is determined. If we assume that the example company, ABC Accounting Services, began operations on July 1 and the owner did not withdraw any money then this is what the Statement of Retained Earnings and the equity section of the Balance Sheet would look like at month end: ABC Accounting Services Statement of Retained Earnings For the month ended July 31, 20XX Balance, July 1 $ 0 Add: Net Income 1,300 Less: Withdrawals 0 Balance, July 31 $1,300 ABC Accounting Services Balance Sheet As at July 31, 20XX Equity Common Stock $2,450 Retained Earnings 1,300 Total Equity 3,750 The following month, the Statement of Retained Earnings will show a beginning balance of $1,300 and the net income for August will be added to it to determine the balance in the retained earnings account. Page 2 of 8

3 Closing the Temporary Accounts In order to close the temporary accounts an intermediary account is used called Income Summary. The income summary account is used to do just that: summarize the net income by holding all the revenue and expense account balances for the period. The balance of the income summary account is then transferred to the retained earnings account and the books are considered closed. In addition, the Owner s Drawings account must be closed in a similar way (it is also a temporary account that must return to a zero balance). There are four steps in the closing procedure: 1. Close Revenue Accounts With one compound closing journal entry, the balances of the revenue accounts are transferred to the Income Summary account. Since revenue accounts have a credit balance, the balances are debited to the Income Summary account. This sets the revenue account balances to zero and the Income Summary account holds the transferred balances Repair Revenue 42,000 Service Earned 12,000 Income Summary 54,000 To close the revenue accounts 2. Close Expense Accounts Again, with one compound closing journal entry, the balances of the expense accounts are transferred to the Income Summary account. Since expense accounts have a debit balance, the balances are credited to the Income Summary account. Income Summary 30,250 Rent Expense 9,000 Truck Expense 1,400 Utilities Expense 1,800 Supplies Expense 1,650 Salaries and Wages 7,200 Insurance Expense 650 Depreciation Expense 1,450 Income Tax Expense 7,100 To close the expense accounts Page 3 of 8

4 3. Close Income Summary Account The Income Summary account now holds the same balance as the net income (Revenue Expenses) so its balance is closed to the Retained Earnings account. Income Summary Debit Credit _ 30,250 54,000 23,750 (credit balance) In order to get that balance out of the Income Summary account and transfer it to Retained Earnings, the balance must be zeroed. Retained Earnings is an equity account and so by debiting Income Summary, the amount of net income is credited and Equity increases accordingly. Income Summary 23,750 Retained Earnings 23,750 To close the Income Summary account 4. Closing Owner s Drawing Account Throughout the accounting period an equity account called Owner s Drawings (or a similar name) has been debited every time the owner has removed an asset from the company. The following journal entry would be made: Owner s Drawing 10,000 Cash/Bank 10,000 Withdrawal of $10,000 by the owner during the accounting period. This account is a contra-equity account it has a debit balance and serves to reduce the Owner s Equity. This is understandable because it represents withdrawals from the company the exact opposite of contributing capital. When the final financial statements are created, this account is transferred into Retained Earnings. Don t forget that Retained Earnings is the permanent account that contains all the income a company has made LESS WITHDRAWLS BY THE OWNER(S). Page 4 of 8

5 If an owner has withdrawn $10,000 during the year, the balance in the Owner s Drawings account will have a $10,000 debit balance. To bring the balance in the account to zero, the following general journal entry is required: Retained Earnings 10,000 Owner s Drawing 10,000 Closing Owner s Drawing account. The balance in the Owner s Drawing account will now be zero. Once the closing entries are finished, a Post Closing Trial Balance is prepared and used to prepare the financial statements for the period. Page 5 of 8

6 Student Worksheet Closing the Books 1. All of the balance sheets accounts are referred to as accounts. 2. A account is one that is closed at the end of the accounting period. 3. The balance in the account before it is closed is equal to the amount of net income for the period. 4. The equity that is not reinvested or paid out to owners is shown in the account on the balance sheet. 5. Which of the following is true? a. To close a revenue account, you debit the revenue account and credit the Income Summary account. b. To close an expense account, you debit the revenue account and credit the Income Summary account. c. To close a revenue account you debit the Income Summary account and credit the Retained Earnings account. d. To close an expense account you credit the Income Summary account and debit the Retained Earnings account 6. and accounts are closed to the account. 7. By closing a revenue or expense account, the account balance is brought to account. 8. True or False: The temporary accounts have no effect on the equity in the company. They are ultimately closed to the retained earnings account, which affects equity. Page 6 of 8

7 9. At the end of its fiscal year (December 31, 2009) Wally s Wallpapering had revenues totalling $32,000 and expenses totalling $18,000 and owner withdrawals of $5,000. Prepare the closing entries required. Date Account Debit Credit 10. If Rolly Inc. suffers a loss of $10,000 in one period (and no owner s withdrawals) what is the entry to close the Income Summary account (period ending December 31, 2009)? Date Account Debit Credit Page 7 of 8

8 Answer Key Closing the Books Section 7 Accounting permanent 2. temporary 3. Income Summary 4. Retained Earnings 5. a 6. revenue, expense, Income Summary 7. zero 8. False 9. Journal Entries: DR Revenue $32,000 CR Income Summary $32,000 To close the revenue account DR Income Summary $18,000 CR Expense accounts $18,000 To close the expense accounts DR Income Summary $14,000 CR Retained Earnings $14,000 To close the Income Summary account DR Retained Earnings $5,000 CR Owner s Drawing $5,000 To close the Owner s Drawing account 10. Journal Entry: DR Retained Earnings $10,000 CR Income Summary $10,000 To close the Income Summary account Page 8 of 8

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