Closing entries are one of the most widely used financial record-keeping techniques. It helps organizations keep temporary accounts and transfer financial entries to permanent ledgers and balance sheets at the end of a given accounting period. Studying closing entries will help you keep more accurate financial accounts as a corporate accountant or bookkeeper.
We will talk about a closing entry in this article, provide you with a step-by-step guide on how to prepare one, and explore the benefits of using closing entries in corporate accounting.
Introduction
When preparing the accounts of any organization for any year, there will be some opening and closing entries that must be included in the balance sheet. Without the inclusion of opening and closing entries, accounts would not reflect a true and fair view of the financial position of the entity.
Closing entries are an essential part of accounting. They help reset temporary accounts so that financial records for the next period are accurate. This process brings out a company’s financial performance and position.
What is Closing Entry?
The Closing entry is a journal entry that is done at the end of an accounting period. It transfers balances in temporary accounts such as revenues, expenses, and dividends to permanent accounts like retained earnings. This entry ensures the books are prepared for the next accounting period.
All the nominal expenses and incomes or revenues connected to nominal accounts must be closed at the end of an accounting year. Closing is possible only by transferring these nominal accounts to either Trading A/c or Profit and Loss A/c. Journal entries that have to be passed in the process of transferring these are known as a ‘closing entry’.
Purpose of Closing Entries
The Closing entries serve two primary purposes:
- Transfer of temporary accounts balance to permanent accounts
- To zero out temporary accounts for the new period
A temporary account is used in tracking business transactions for a short period, whereas a permanent account is a balance sheet account that tracks business transactions for more than one accounting period. Closing entries involve resetting the balances of temporary accounts to zero and transferring those corresponding transactions into permanent accounts appearing on the balance sheet.
Recording a Closing Entry
Accounting software automatically maintains closing accounting entries for you. But if you do not own accounting software, then you must write closing entries manually for each accounting span.
You can close an account with a closing entry by closing your income and expenditure accounts and transferring the credits into an “income summary account.” Furthermore, the income summary account is used only in closing cycle accounting online. The income summary account is the amount of your earnings minus expenditures. After transferring the amount into the owned earnings account, which is a permanent account, you will close the earnings summary account.
An established sequence of journal entries forms the entire closing process:
- All revenue accounts are posted to the income summary. The accounts are transferred through a journal entry, debiting the revenue accounts and crediting income summary.
- Same procedure is carried for expenses. All the expenses are closed by transferring amount to income summary from the expense accounts.
- The Income summary account is closed and transferred to retained earnings.
- If it is a dividend payout then the balance is transferred to the retained earnings from the account of the dividend.
Importance of Closing Entries in Accounting
The closing of earnings and expenses accounts helps to compare a company’s earnings and its costs. Without these accounts, the sum would be amassed, making it difficult to compare terms. Closing entries reduce the value of the temporary accounts to zero and prevent future accounting periods from credited earnings or expenditure accounts.
Similarly, transferring funds between transient and permanent accounts amends the company’s earnings account. Retained revenues can be presented in the income statement or balance sheet but cannot be transferred to accounts because failure to do so would record incorrect financial records.
The following are some benefits of using closing entries:
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Accurate calculation of taxes
The closing entries help you maintain accurate records of the monthly, quarterly, or annual financial activities of a business. You will find this useful while calculating the goods and service taxes (GST) for the company and income tax. Usually, the computation of taxes requires financial data for the last fiscal year. By using closing entries, you maintain different sets of financial records for different years, making it easier to calculate taxes.
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Monitor shorter accounting periods
Using closing entries and the temporary accounts helps simplify account processing. This makes accounting easier for businesses to report revenue, expenses, as well as profit and loss for shorter periods.
Therefore, if you are observing the costs incurred for the project, you can refer to the monthly records. You keep the calculations smaller and understand the monthly profit and loss by calculating at the end of each month the monthly revenue and expenses, therefore closing the temporary accounts using closing entries.
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Clearance of specific accounts
The use of the same accounts for recording revenue and expenses in more than one accounting period makes you confused and overwhelmed. Closing entries clear specific accounts at the end of the accounting period, so you start a new accounting period with a zero balance. It’s a great accounting practice for beginners; it is easy to apply and simple to prepare.
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Monitor financial trends
The use of closing entries along with temporary accounts is a valuable method for monitoring, measuring, and analyzing the variation in the finances of any organization from one accounting period to another. It gives you the ability to compare financial trends and point to areas that need improvement by optimizing the cost efficiency of the business.
For example, monthly accounting will enable easy comparison of revenues and costs for each month, enabling easy budgeting for cost control purposes.
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Keep accurate long-term records
These closing entries help businesses utilize temporary accounts for accounting purposes for the specific accounting period without degrading the accuracy of the permanent records. The balance that is taken from these temporary accounts and transferred to the permanent record at the end of the accounting period will keep the long-term records accurate without causing any temporary accounting mistakes that eventually affect the long-term finances.
It also enhances more precise financial planning and helps the organization keep up with accounting rules and regulations.
Conclusion
In summary, closing entries are essential entries done at the end of an accounting course, which transfers transient account credits into a permanent account. The purpose of closing entries is to combine your accounts so you can choose your own revenues. Retained returns represent the shares your business owns after paying expenditures and dividends for a particular time period.
Closing entries is a critical component of keeping your books and records in order; hence, maintaining your bookkeeping ensures that you are continually updated. You would constantly know the financial state of your business, among other information that is constantly fed into your system.
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