Closing Entries
Resetting temporary accounts for the new period
Why This Matters
At the end of the year, you've earned $100,000 in revenue and spent $60,000 in expenses. That gives you $40,000 in profit.
Now it's January 1st of the next year. You look at your ledger. Your Service Revenue account still shows $100,000. Your Salary Expense still shows $60,000.
Here's the problem: You can't measure next year's performance if last year's accounts are still open. How will you know if January is good or bad? You won't—because the accounts are polluted with prior-year data.
Closing entries are the reset button that makes period-by-period comparison possible.
What Are Closing Entries?
Closing entries are journal entries made at the end of an accounting period to zero out temporary accounts (revenue, expenses, dividends) and transfer their balances to retained earnings or owner's equity.
Temporary Accounts
Measure performance for ONE period only
Permanent Accounts
Carry forward to measure cumulative position
Think of it like sports stats:
Temporary vs. Permanent Accounts
Temporary Accounts (Closed)
Revenue Accounts
Closes- Sales Revenue
- Service Revenue
- Rental Income
- Any income account
Revenue measures ONE period. Next year's revenue is new and different.
Expense Accounts
Closes- Salary Expense
- Rent Expense
- Utilities Expense
- Any expense account
Expenses measure ONE period. Next year's expenses are separate.
Dividends / Drawings
Closes- Owner's Drawings
- Dividends
- Money taken out by owner
Separate from salary—tracks owner withdrawals for ONE period.
Permanent Accounts (NOT Closed)
Assets
Permanent- Cash
- Accounts Receivable
- Equipment
- Any asset
Dec 31 balance becomes Jan 1 balance. Equipment doesn't disappear.
Liabilities
Permanent- Accounts Payable
- Notes Payable
- Any liability
Dec 31 balance becomes Jan 1 balance. Debt doesn't disappear.
Equity
Permanent- Owner's Capital
- Retained Earnings
- Any equity account
Cumulative over time. Increased by profits, decreased by withdrawals.
The Closing Process
Closing entries typically happen in three steps (some use four, but three is most common):
Revenue needs to be zeroed so next year shows only new revenue.
(To close all revenue accounts)
Effect on Ledger:
Real-World Example: ABC Consulting
Let's close the books for ABC Consulting at December 31, 2026.
Adjusted Trial Balance (Before Closing)
ADJUSTED TRIAL BALANCE
ABC Consulting - December 31, 2026
| Account | Debit | Credit |
|---|---|---|
| Cash | $20,000.00 | |
| Accounts Receivable | $18,000.00 | |
| Prepaid Insurance | $1,100.00 | |
| Equipment | $50,000.00 | |
| Accumulated Depreciation | $5,416.67 | |
| Accounts Payable | $8,000.00 | |
| Unearned Revenue | $11,000.00 | |
| Salaries Payable | $2,000.00 | |
| Owner's Equity | $49,200.00 | |
| Owner's Drawings(Temporary) | $5,000.00 | |
| Service Revenue(Temporary) | $39,000.00 | |
| Salary Expense(Temporary) | $14,000.00 | |
| Rent Expense(Temporary) | $6,000.00 | |
| Insurance Expense(Temporary) | $100.00 | |
| Depreciation Expense(Temporary) | $416.67 | |
| Totals | $114,616.67 | $114,616.67 |
The Four Closing Entries
#1 Close Revenue
Service Revenue $39,000
Income Summary $39,000
Service Revenue: $39,000 → $0
#2 Close Expenses
Income Summary $20,516.67
Salary Expense $14,000
Rent Expense $6,000
Insurance Exp $100
Depreciation Exp $416.67
All expenses → $0
#3 Close Income Summary
Income Summary $18,483.33
Owner's Equity $18,483.33
Net income transferred to equity
#4 Close Drawings
Owner's Equity $5,000
Owner's Drawings $5,000
Drawings: $5,000 → $0
Post-Closing Trial Balance
POST-CLOSING TRIAL BALANCE
ABC Consulting - December 31, 2026
| Account | Debit | Credit |
|---|---|---|
| Cash | $20,000.00 | |
| Accounts Receivable | $18,000.00 | |
| Prepaid Insurance | $1,100.00 | |
| Equipment | $50,000.00 | |
| Accumulated Depreciation | $5,416.67 | |
| Accounts Payable | $8,000.00 | |
| Unearned Revenue | $11,000.00 | |
| Salaries Payable | $2,000.00 | |
| Owner's Equity | $62,683.33 | |
| Totals | $89,100.00 | $89,100.00 |
Notice:
- Only balance sheet accounts remain
- All revenue, expense, and dividend accounts are gone
- Trial balance still balances
- Owner's Equity: Starting $49,200 + Net Income $18,483.33 - Drawings $5,000 = $62,683.33
Why This Matters: The Comparison Problem
Without Closing Entries
Year 1 Ledger (Dec 31):
Service Revenue: $100,000
Salary Expense: $60,000
Year 2 (January):
New service recorded: +$5,000
Service Revenue now shows: $105,000
Jan 31 Report: "Revenue this month: $105,000???"
WRONG! Only $5,000 was this month. The rest was last year.
WITH Closing Entries
Year 1 (Dec 31):
Service Revenue: $100,000 → CLOSED → $0
Salary Expense: $60,000 → CLOSED → $0
Year 2 (January):
New service recorded: +$5,000
Service Revenue shows: $5,000
Jan 31 Report: "Revenue this month: $5,000" ✓
CORRECT! Clean comparison to prior months.
Closing entries make period-by-period comparison meaningful.
The Closing Process Flow
ADJUSTED TRIAL BALANCE
(With Revenue & Expenses)
Step 1: CLOSE REVENUE
All Revenue → $0 → Income Summary
Step 2: CLOSE EXPENSES
All Expenses → $0 → Income Summary
Step 3: CLOSE INCOME SUMMARY
Net Income → $0 → Owner's Equity
Step 4: CLOSE DIVIDENDS
Dividends → $0 → Owner's Equity
POST-CLOSING TRIAL BALANCE
(Only Balance Sheet Accounts)
The Three Accounts That Make It Work
Income Summary
Temporary holding area during closing. Collects all revenues and expenses to calculate net income.
Balance:
After closing revenue: +$X
After closing expenses: Net income
After closing to equity: $0
Retained Earnings
For corporations—holds accumulated profits from all years.
Balance:
Beginning: Prior years' retained
Plus: Current year net income
Minus: Current year dividends
Owner's Drawings
For sole proprietors—distinguishes owner withdrawals from salary/expenses.
Balance:
During year: Withdrawals recorded
At close: Transferred to equity
After close: $0
Common Closing Entry Errors
Error #1: Forgetting to Close a Revenue or Expense
Service Revenue: $100,000 (not closed!)
Other Revenue: $5,000 (closed)
Next year shows $105,000 when only new activity happened
Service Revenue: $100,000 → $0
Other Revenue: $5,000 → $0
All revenue accounts closed
Fix: Close EVERY revenue and expense account without exception.
Error #2: Closing Balance Sheet Accounts
Cash $20,000
Income Summary $20,000
(Don't do this! Cash is permanent)
Cash stays at $20,000
Permanent accounts are NOT closed
Fix: Only close revenue, expenses, and dividends. Never close assets, liabilities, or equity.
Error #3: Wrong Direction of Entry
Salary Expense $14,000
Income Summary $14,000
(This increases expense!)
Income Summary $14,000
Salary Expense $14,000
(This zeros out the expense)
Fix: To close an account, debit/credit the OPPOSITE of its normal balance.
Modern Software & Closing Entries
In Most Accounting Software (QuickBooks, Xero, Sage)
What you do:
- Click "Close Period" or "Year-End Close"
- Software does closing entries automatically
- Software generates post-closing trial balance
What you must understand:
- Why closing happens
- What accounts close vs. don't close
- How to verify the process worked
You rarely manually write closing entries in modern systems, but you must understand what's happening.
Key Takeaway
Closing entries are the mechanism that resets temporary accounts (revenue, expenses, dividends) to zero at the end of each period, while preserving permanent accounts (assets, liabilities, equity). This allows meaningful period-by-period comparison and ensures that next year measures only new activity. Without closing entries, every year's financial statements would be polluted with prior-year data and useless for comparison.
Test Your Understanding
Which type of account is CLOSED at the end of the period?
Why do we close revenue accounts?
What is the purpose of the Income Summary account?
Which account INCREASES when you close net income?
True or False: Cash account balances should be closed at the end of the period.
Ready to Practice?
You now understand why closing entries are necessary and how to execute them. The Practice Lab is where you'll prepare adjusted trial balances, write closing entries, and verify post-closing trial balances—completing the full accounting cycle.
Try the Practice Lab