Closing Entries

After financial statements are prepared, you are ready to get your books ready for the next accounting period by clearing out the income and expense accounts in the general ledger and transferring the net income (or loss) to your owner's equity account. This is done by preparing closing entries in the general journal.

Note the distinction between adjusting entries and closing entries. Adjusting entries are required to update certain accounts in your general ledger at the end of an accounting period. They must be done before you can prepare your financial statements and income tax return. Closing entries are needed to clear out your revenue and expense accounts as you start the beginning of a new accounting period.

Preparing your closing entries is a very simple, mechanical process. Follow these steps:

1. Close the revenue accounts. Prepare one journal entry that debits all the revenue accounts. (These accounts will have a credit balance in the general ledger prior to the closing entry.) Credit an account called "income summary" for the total.
2. Close the expense accounts. Prepare one journal entry that credits all the expense accounts. (These accounts will have a debit balance in the general ledger prior to the closing entry.) Debit the income summary account for the total.
3. Transfer the income summary balance to a capital account. Prepare a journal entry that clears out the income summary account. This entry effectively transfers the net income (or loss) of the business to the owner's equity account.
4. Close the drawing account. If your business is a sole proprietorship or partnership, close the drawing accounts (if any) by preparing a journal entry that credits the drawing account and debits the owner's equity account.

As an example, assume that you have finalized your general ledger and prepared a balance sheet and income statement for the year ended December 31, 2011. You want to get your books ready for next year. You prepare the four closing entries as follows:

	Debit	Credit
Sales	462,452
Income summary		462,452
To close the revenue account on 12/31/2011

	Debit	Credit
Income summary	399,871
Purchases		230,934
Advertising		1,850
Depreciation		13,250
Insurance		5,400
Payroll taxes		8,200
Rent		9,600
Repairs and maintenance		13,984
Utilities		17,801
Wages		98,852
To close the expense accounts on 12/31/2011

	Debit	Credit
Income summary	62,581
Tom Beta, capital		62,581
To transfer 12/31/2011 net income to the capital account

	Debit	Credit
Tom Beta, capital	12,000
Tom Beta, drawing		12,000
To close drawing account for year ended 12/31/2011

After all closing entries are made, post the entry totals to the general ledger. Foot the general ledger accounts to arrive at the beginning amounts for the new accounting period. All revenue and expense accounts should have a zero balance.