Closing Entries: Temporary vs Permanent Accounts Step by Step
A complete walkthrough of the closing entry process — the four-step closing sequence, how temporary accounts (revenues, expenses, dividends) feed retained earnings, and worked examples for both sole proprietorships and corporations.
A complete walkthrough of the closing entry process — the four-step closing sequence, how temporary accounts (revenues, expenses, dividends) feed retained earnings, and worked examples for both sole proprietorships and corporations.
Learning Objectives
- ✓Distinguish temporary (nominal) from permanent (real) accounts.
- ✓Apply the four-step closing sequence using the Income Summary account.
- ✓Recognize the differences between sole proprietorship and corporation closing entries.
1. Direct Answer: What Closing Entries Do
Closing entries zero out temporary accounts (revenues, expenses, dividends/withdrawals) at the end of an accounting period and transfer their balances to retained earnings (or owner's capital for sole proprietorships). Permanent accounts (assets, liabilities, equity) carry their balances forward into the next period and are not closed. The process uses an intermediate clearing account called Income Summary that briefly holds the net income or loss before it is transferred to retained earnings. After closing entries, every temporary account has a zero balance and the books are ready for the new period. The post-closing trial balance contains only permanent accounts and should equal the ending balance sheet.
Key Points
- •Temporary accounts (revenues, expenses, dividends) get zeroed each period.
- •Permanent accounts (assets, liabilities, equity) carry forward.
- •Income Summary is the clearing account; it is also temporary.
- •Post-closing trial balance contains only permanent accounts.
2. The Four-Step Closing Sequence
Step 1: Close revenue accounts to Income Summary. Debit each revenue account for its balance, credit Income Summary for the total. Step 2: Close expense accounts to Income Summary. Debit Income Summary for the total expense, credit each expense account for its balance. After steps 1 and 2, Income Summary holds the net income (credit balance) or net loss (debit balance). Step 3: Close Income Summary to Retained Earnings (corporation) or Owner's Capital (sole proprietorship). For net income: Debit Income Summary, Credit Retained Earnings. For net loss: Debit Retained Earnings, Credit Income Summary. Step 4: Close Dividends (corporation) or Owner's Drawings (sole proprietorship) directly to Retained Earnings (NOT through Income Summary). Debit Retained Earnings, Credit Dividends/Drawings. After all four steps, every temporary account is zero.
Key Points
- •Step 1: Revenues → Income Summary (debit revenues, credit IS).
- •Step 2: Expenses → Income Summary (debit IS, credit expenses).
- •Step 3: Income Summary → Retained Earnings (direction depends on net income vs loss).
- •Step 4: Dividends/Drawings → Retained Earnings (bypasses IS).
3. Worked Example: Corporation with Net Income
Year-end balances: Service Revenue $200,000; Interest Revenue $5,000; Salaries Expense $80,000; Rent Expense $24,000; Utilities Expense $6,000; Depreciation Expense $15,000; Dividends $20,000; Retained Earnings $50,000 (beginning balance). Step 1: Dr Service Revenue 200,000, Dr Interest Revenue 5,000, Cr Income Summary 205,000. Step 2: Dr Income Summary 125,000, Cr Salaries Expense 80,000, Cr Rent Expense 24,000, Cr Utilities Expense 6,000, Cr Depreciation Expense 15,000. Income Summary now has a credit balance of $205,000 - $125,000 = $80,000 (net income). Step 3: Dr Income Summary 80,000, Cr Retained Earnings 80,000. Step 4: Dr Retained Earnings 20,000, Cr Dividends 20,000. Final Retained Earnings = $50,000 + $80,000 - $20,000 = $110,000. All temporary accounts now have zero balances.
Key Points
- •Revenues close first (debit them) to credit Income Summary.
- •Expenses close next (credit them) to debit Income Summary.
- •Income Summary then goes to Retained Earnings.
- •Dividends close directly to Retained Earnings, bypassing IS.
4. Worked Example: Corporation with Net Loss
Year-end: Service Revenue $90,000; Salaries Expense $70,000; Rent Expense $40,000; Dividends $5,000; Retained Earnings beginning $30,000. Step 1: Dr Service Revenue 90,000, Cr Income Summary 90,000. Step 2: Dr Income Summary 110,000, Cr Salaries Expense 70,000, Cr Rent Expense 40,000. Income Summary has a debit balance of $20,000 (net loss). Step 3 (net loss case): Dr Retained Earnings 20,000, Cr Income Summary 20,000. Step 4: Dr Retained Earnings 5,000, Cr Dividends 5,000. Ending Retained Earnings = $30,000 - $20,000 - $5,000 = $5,000. Important: a corporation should think carefully before paying dividends in a loss year — most states have a "legal capital" restriction that prohibits dividends if retained earnings would go negative.
Key Points
- •In a loss year, Step 3 reverses direction: Dr RE, Cr IS.
- •Loss reduces retained earnings; dividends reduce it further.
- •State law often restricts dividends if retained earnings would go negative.
5. Sole Proprietorship and Partnership Adjustment
For a sole proprietorship, the closing process is identical except: (a) Step 3 closes Income Summary to Owner's Capital (not Retained Earnings); (b) Step 4 closes Owner's Withdrawals/Drawings (not Dividends) to Owner's Capital. Same arithmetic; different account names. Partnerships do the same with each partner's capital account, with the net income or loss allocated to each partner per the partnership agreement before closing. Service Revenue $200K, Expenses $125K, Drawings $20K, Capital beginning $50K → Capital ending = $50K + $80K - $20K = $110K.
Key Points
- •Sole proprietorships use Owner's Capital and Owner's Drawings.
- •Partnerships allocate net income to each partner's capital account.
- •Mechanics are identical; only the equity account names differ.
6. Why Closing Entries Matter (Beyond Bookkeeping)
Closing entries enforce the period concept — each accounting period stands on its own and starts fresh. Without closing entries, a company would not be able to tell which year's revenue and expense produced which year's net income. Closing also produces the post-closing trial balance, which validates that debits equal credits after the closing process and that the books are ready for the next period. From an audit perspective, the post-closing trial balance is the bridge between the income statement (closed accounts) and the ending balance sheet (carried-forward accounts). A common student error is forgetting to close Dividends/Drawings, which leaves an open temporary account in the next period and corrupts the period concept.
Key Points
- •Closing enforces the period concept — each year stands alone.
- •Post-closing trial balance is the bridge from IS to BS.
- •Forgetting to close Dividends is a common error.
7. Connection to Adjusting Entries and Financial Statements
Closing entries come AFTER adjusting entries and AFTER the financial statements are prepared from the adjusted trial balance. The sequence: unadjusted trial balance → adjusting entries → adjusted trial balance → financial statements → closing entries → post-closing trial balance → reversing entries (optional) → new period. The closing process zeros temporary accounts but does not affect the financial statements that were already prepared from the adjusted trial balance. This sequence is the spine of the accounting cycle covered in the financial statements complete guide and the adjusting entries complete guide pillars.
Key Points
- •Closing happens AFTER adjusting and AFTER financials are prepared.
- •Financial statements are based on the adjusted trial balance, not the closing entries.
- •Reversing entries (next period) optionally simplify the new period's accruals.
8. Using AccountingIQ for Closing Entry Problems
Snap a photo of an adjusted trial balance and AccountingIQ identifies temporary vs permanent accounts, walks through the four-step closing sequence with running Income Summary balance, generates each journal entry, and produces the post-closing trial balance. The app handles corporate, sole proprietorship, and partnership variations automatically based on the equity account structure.
Key Points
- •Automatic temporary vs permanent classification.
- •Four-step closing sequence with running Income Summary.
- •Handles corporation, sole proprietorship, and partnership variations.
High-Yield Facts
- ★Temporary accounts: revenues, expenses, dividends/drawings, Income Summary.
- ★Permanent accounts: assets, liabilities, capital/retained earnings.
- ★Four-step closing: revenues → IS, expenses → IS, IS → RE, dividends → RE.
- ★Net income: Dr IS, Cr RE. Net loss: Dr RE, Cr IS.
- ★Dividends bypass Income Summary and close directly to Retained Earnings.
Practice Questions
1. Revenues $300,000; Expenses $230,000; Dividends $15,000. Show the four closing entries.
2. After all closing entries, what should the Income Summary balance be?
3. A company has a $50,000 net loss and pays $10,000 dividends. Ending retained earnings beginning at $80,000. Compute ending balance.
FAQs
Common questions about this topic
Income Summary is a clearing account that simplifies the closing process. Without it, you would close each revenue and each expense individually to Retained Earnings, which generates many separate entries to the equity account and makes the period's net income harder to see at a glance. Income Summary collects all revenues and expenses in one place, where the resulting balance equals net income or loss, before that single number is transferred to Retained Earnings. Some software automates closing without an explicit Income Summary; the result is identical.
No. Reversing entries are OPTIONAL entries made at the START of the next period that reverse certain adjusting entries (typically accruals like accrued wages or accrued interest) to simplify the next period's recording. Closing entries are MANDATORY entries at the END of the period that zero out temporary accounts. Reversing entries do not affect any temporary account because temporary accounts are already zero post-closing.
Because dividends are not an income statement item — they are a distribution of equity, not an expense. Income Summary collects revenues and expenses to compute net income, so adding dividends to IS would misstate net income. Dividends reduce retained earnings directly because they reduce the equity available to shareholders, not the period's profit.
The forgotten temporary account carries its balance into the next period, where it will be combined with that period's activity. For example, forgetting to close last year's Salaries Expense of $50,000 would make this year's Salaries Expense look $50,000 higher than it should, understating this year's net income and overstating cumulative retained earnings through last year. Auditors test the post-closing trial balance specifically to catch this.
Yes, with adjusted vocabulary. Nonprofits close revenues and expenses to net assets (unrestricted, temporarily restricted, permanently restricted). Government entities close to fund balance with classifications under GASB 54 (restricted, committed, assigned, unassigned). The mechanics are similar but the equity categorization is more elaborate to reflect the different stewardship requirements.
Snap a photo of an adjusted trial balance and AccountingIQ walks through the four-step closing sequence with running Income Summary balance and generates each journal entry with full debits and credits. The app handles corporate, sole proprietorship, and partnership variations based on the equity accounts present, and produces the post-closing trial balance to verify the closing.