Definition
Closing entries reset temporary accounts to zero. Revenue and expense accounts are closed to Income Summary, the Income Summary balance, which equals net income or loss, is closed to retained earnings, and dividends are closed directly to retained earnings. Permanent accounts for assets, liabilities and equity are not closed. A post-closing trial balance should then contain only permanent accounts. Accounting software usually performs the close automatically when the year is rolled forward.
Why it matters in an audit or review
The retained earnings rollforward depends on the close, so the auditor agrees opening retained earnings to the prior audited balance and checks that net income carried to equity matches the income statement. Entries posted after the close, such as audit adjustments, require reopening the period or posting to the next year, which affects comparatives.
Example
Illustrative: revenue of $840,000, expenses of $700,000 and dividends of $30,000. Dr Revenue $840,000 and Cr Income Summary $840,000. Dr Income Summary $700,000 and Cr expenses $700,000. Dr Income Summary $140,000 and Cr Retained earnings $140,000. Dr Retained earnings $30,000 and Cr Dividends $30,000. Retained earnings rises by $110,000.
Common mistakes
- Closing dividends through Income Summary.
- Posting audit adjustments to a locked prior period without reversing the close.
Sources
- OpenStax, Principles of Accounting, Volume 1: Financial Accounting, 5.1 Describe and Prepare Closing Entries for a Business (openstax.org/books/principles-financial-accounting/pages/5-1-describe-and-prepare-closing-entries-for-a-business)
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error