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Closing Entries: Process, Major Steps, Purpose & Objectives

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  • 0:02 What is Closing?
  • 0:44 What Accounts Are Involved?
  • 2:14 The Closing Entries
  • 6:15 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

The accounting cycle is a multi-step process. In this lesson, you will learn about part of that process: making closing entries. You will learn what closing entries are, what accounts are affected, and how they are made.

What Is Closing?

I can't tell you how many times over the years that I've heard someone say, 'When one door closes, another one opens.' Now, most of the time when I hear that, I think about life in general. But I got to thinking recently and realized that in all honesty, that statement could be one of the basic rules of accounting. I bet you wonder why.

Well, because for every accounting period that opens, a previous period had to close. So, what do I mean when I say that a previous period had to close? In accounting, closing a period means that all the balances that are in temporary accounts are transferred to permanent accounts. This zeroes out the temporary accounts so that they can be used in the next accounting period.

What Accounts Are Involved?

Now, let's stop right here and look at a few key words that I just mentioned. Temporary accounts are accounts that are only used for a specific time period, usually one accounting period. They are not part of the chart of accounts of a company.

Revenue, expense, and dividend accounts are excellent examples of temporary accounts. Revenue accounts are accounts where income that has come into a company is recorded. Expense accounts are accounts where expenses that a company has incurred are recorded. Dividend accounts are accounts where the dividends, or distribution of a portion of a company's income to its stockholders, are recorded.

Another important account that is created as a temporary account and used in the closing process is the income summary account. The income summary account contains all the revenue and expense information and is used to calculate the dollar amount that retained earnings will change during each accounting period. The income summary account will never be found on any financial statement because it's solely used in the closing process.

Permanent accounts are accounts that once opened will always be a part of the chart of accounts that a company has. Permanent accounts have balances that accrue over time, and they are not closed at the end of an accounting period. It's to permanent accounts that the temporary account balances are transferred. Cash, accounts receivable, accounts payable, and liability accounts are all examples of permanent accounts.

The Closing Entries

All the account information that you'll need for the closing entries can be found on the company's trial balance. The trial balance is a listing of all the company's accounts and their balances. The easiest way to remember what accounts need to be closed and the manner in which they're closed is to remember the acronym REID. REID stands for Revenue, Expense, Income summary, and Dividend.

The first closing entry, according to REID, is for revenue accounts. Revenue accounts have credit balances. So, in order to make these accounts have a zero balance, the closing entry that's made will be a debit to the revenue account and a credit to the income summary account. Let's look at an example:

Hill's Lawnmower Sales and Repair has the following revenue accounts that appear on their income statement:

Sales Revenue - $268,000
Service Revenue - $42,000

Now using this information, we can create the following journal entry:

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You see that the revenue accounts have received a debit entry for their balance amounts. This entry results in the revenue accounts being zeroed out and preparing them to be used in the next accounting period.

The second entry that's made is similar to the first. This time, however, the focus is not on the revenue that has come in this period, but on the expenses that the company incurred to make that revenue. The expense accounts normally have a debit balance. So since that is the case, they will be credited in the closing entry, and the income summary account will be debited. Let's take a look at an example:

Hill's Lawnmower Sales and Repair has the following expense accounts appear on their quarterly income statement:

Supplies Expense - $18,279
Inventory Expense - $97,000
Payroll Expense - $10,500
Utilities Expense - $3,000
Insurance Expense - $1,800
Rent Expense - $15,000

Now, the closing entry to close out the expense account should look like this:

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The third entry that needs to be made, according to REID, involves the income summary account. This account will need to be closed to the company's permanent retained earnings account. Now in order to make this entry, the balance in the income summary account must be calculated.

From closing entry number one, we can see that the credit balance in the income summary account is $310,000. The second closing entry resulted in a debit being made to the income summary account in the amount of $146,029. The balance in the income summary account is a credit balance of $163,721.

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