Closing entries are journalized and posted

Closing the Books

LEARNING OBJECTIVE 2 Explain the process of closing the books.

At the end of the accounting period, the company makes the accounts ready for the next period. This is called closing the books. In closing the books, the company distinguishes between temporary and permanent accounts. Temporary accounts relate only to a given accounting period. They include all income statement accounts and the Dividends account. The company closes all temporary accounts at the end of the period.

Alternative Terminology Temporary accounts are sometimes called nominal accounts, and permanent accounts are sometimes called real accounts.

In contrast, permanent accounts relate to one or more future accounting periods. They consist of all balance sheet accounts, including stockholders' equity accounts. Permanent accounts are not closed from period to period. Instead, the company carries forward the balances of permanent accounts into the next accounting period. Illustration 4-5 identifies the accounts in each category.

Illustration 4-5 Temporary versus permanent accounts

Helpful Hint A contra-asset account, such as accumulated depreciation, is a permanent account also.

Preparing Closing Entries At the end of the accounting period, the company transfers temporary account balances to the permanent stockholders' equity account, Retained Earnings, by means of closing entries. Closing entries formally recognize in the ledger the transfer of net income (or net loss) and Dividends to Retained Earnings. The retained earnings statement shows the results of these entries. Closing entries also produce a zero balance in each temporary account. The temporary accounts are then ready to accumulate data in the next accounting period separate from the data of prior periods. Permanent accounts are not closed. Journalizing and posting closing entries is a required step in the accounting cycle. (See Illustration 4-12.) The company performs this step after it has prepared financial statements. In contrast to the steps in the cycle that you have already studied, companies generally journalize and post closing entries only at the end of the annual accounting period. Thus, all temporary accounts will contain data for the entire year. In preparing closing entries, companies could close each income statement account directly to Retained Earnings. However, to do so would result in excessive detail in the permanent Retained Earnings account. Instead, companies close the revenue and expense

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accounts to another temporary account, Income Summary, and they transfer the resulting net income or net loss from this account to Retained Earnings. Companies record closing entries in the general journal. A center caption, Closing Entries, inserted in the journal between the last adjusting entry and the first closing entry, identifies these entries. Then the company posts the closing entries to the ledger accounts. Companies generally prepare closing entries directly from the adjusted balances in the ledger. They could prepare separate closing entries for each nominal account, but the following four entries accomplish the desired result more efficiently:

1. Debit each revenue account for its balance, and credit Income Summary for total revenues. 2. Debit Income Summary for total expenses, and credit each expense account for its balance. 3. Debit Income Summary and credit Retained Earnings for the amount of net income. 4. Debit Retained Earnings for the balance in the Dividends account, and credit Dividends for the same amount.

Helpful Hint Dividends is closed directly to retained earnings and not to income summary because dividends is not an expense.

Illustration 4-6 presents a diagram of the closing process. In it, the boxed numbers refer to the four entries required in the closing process.

Illustration 4-6 Diagram of closing process—proprietorship

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If there were a net loss (because expenses exceeded revenues), entry 3 in Illustration 4-6 would be reversed: there would be a credit to Income Summary and a debit to Retained Earnings.

CLOSING ENTRIES ILLUSTRATED In practice, companies generally prepare closing entries only at the end of the annual accounting period. However, to illustrate the journalizing and posting of closing entries, we will assume that Pioneer Advertising Agency Inc. closes its books monthly. Illustration 4-7 shows the closing entries at October 31. (The numbers in parentheses before each entry correspond to the four entries diagrammed in Illustration 4-6.)

Illustration 4-7 Closing entries journalized

Note that the amounts for Income Summary in entries (1) and (2) are the totals of the income statement credit and debit columns, respectively, in the worksheet. A couple of cautions in preparing closing entries: (1) Avoid unintentionally doubling the revenue and expense balances rather than zeroing them. (2) Do not close Dividends through the Income Summary account. Dividends are not an expense, and they are not a factor in determining net income.

Posting Closing Entries Illustration 4-8 shows the posting of the closing entries and the underlining (ruling) of the accounts. Note that all temporary accounts have zero balances after posting the closing entries. In addition, you should realize that the balance in Retained Earnings represents the accumulated undistributed earnings of the corporation at the end of the accounting period. This balance is shown on the balance sheet and is the ending amount reported on the retained earnings statement, as shown in Illustration 4-4. Pioneer uses the Income Summary account only in closing. It does not journalize and post entries to this account during the year.

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Illustration 4-8 Posting of closing entries

Helpful Hint The balance in income Summary before it is closed must equal the net income or net loss for the period.

As part of the closing process, Pioneer totals, balances, and double-underlines its temporary accounts—revenues, expenses, and Dividends, as shown in T-account form in Illustration 4-8. It does not close its permanent accounts—assets, liabilities, and stockholders' equity (Common Stock and Retained Earnings). Instead, Pioneer draws a single underline beneath the current-period entries for the permanent accounts. The account balance is then entered below the single rule and is carried forward to the next period. (For example, see Retained Earnings.)

DO IT! Closing Entries The worksheet for Hancock Company shows the following in the financial statement columns:

Dividends $15,000 Common stock $42,000 Net income $18,000

Prepare the closing entries at December 31 that affect stockholders' equity.

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Action Plan ✓ Close Income Summary to Retained Earnings. ✓ Close Dividends to Retained Earnings.

Solution

Dec. 31 Income Summary 18,000

Retained Earnings 18,000

(To close net income to retained earnings)

31 Retained Earnings 15,000

Dividends 15,000

(To close dividends to retained earnings)

Related exercise material: BE4-4, BE4-5, BE4-6, E4-4, E4-7, E4-8, E4-10, E4-11, and 4-2.

ACCOUNTING ACROSS THE ORGANIZATION

Cisco Performs the Virtual Close

Alex Slobodkin/iStockphoto.

Technology has dramatically shortened the closing process. Recent surveys have reported that the average company now takes only six to seven days to close, rather than 20 days. But a few companies do much better. Cisco Systems can perform a “virtual close”—closing within 24 hours on any day in the quarter. The same is true at Lockheed Martin Corp., which improved its closing time by 85% in just the last few years. Not very long ago it took 14 to 16 days. Managers at these companies emphasize that this increased speed has not reduced the accuracy and completeness of the data. This is not just showing off. Knowing exactly where you are financially all of the time allows the company to respond faster than competitors. It also means that the hundreds of people who used to spend 10 to 20 days a quarter tracking transactions can now be more usefully employed on things such as mining data for business intelligence to find new business opportunities.

Who else benefits from a shorter closing process? Answer:

Investors benefit from a shorter closing process. The shorter the closing, the sooner the company can report its financial results. This means that the financial information is more timely and therefore more relevant to investors.

Source: “Reporting Practices: Few Do It All,” Financial Executive (November 2003), p. 11.

Preparing a Post-Closing Trial Balance

LEARNING OBJECTIVE 3 Describe the content and purpose of a post-closing trial balance.

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After Pioneer has journalized and posted all closing entries, it prepares another trial balance, called a post-closing trial balance, from the ledger. The post-closing trial balance lists permanent accounts and their balances after journalizing and posting of closing entries. The purpose of the post-closing trial balance is to prove the equality of the permanent account balances carried forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent—balance sheet—accounts. Illustration 4-9 shows the post-closing trial balance for Pioneer Advertising Agency Inc.

Illustration 4-9 Post-closing trial balance

Pioneer prepares the post-closing trial balance from the permanent accounts in the ledger. Illustration 4-10 shows the permanent accounts in Pioneer's general ledger.

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Illustration 4-10 General ledger, permanent accounts

A post-closing trial balance provides evidence that the company has properly journalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period. However, like the trial balance, it does not prove that Pioneer has recorded all transactions or that the ledger is correct. For example, the post-closing trial balance still will balance even if a transaction is not journalized and posted or if a transaction is journalized and posted twice. The remaining accounts in the general ledger are temporary accounts, shown in Illustration 4-11. After Pioneer correctly posts the closing entries, each temporary account has a zero balance. These accounts are double-underlined to finalize the closing process.

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Illustration 4-11 General ledger, temporary accounts

Copyright © 2012 John Wiley & Sons, Inc. All rights reserved.

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