At the end of a business's fiscal year, all temporary accounts are closed to the balance sheet. These closing journal entries allow a company to review its financial position at the end of the year and prepare the company books to begin the new fiscal year. Temporary accounts include income accounts, expense accounts and the temporary equity accounts, such as distributions to owners and dividends paid. Most accounting software performs these closing journal entries automatically, but it's important to understand the process.
Set up a temporary income summary account. The balance in this account will be used to close the net income to the company's equity account. In a corporation, the equity account is called retained earnings; in a limited-liability company, it is called members' equity; in a partnership, it is partners' equity. Like other temporary income and expense accounts, the income summary account will have a zero balance once all the closing journal entries are made.
Close all income accounts to the income summary by debiting them with an amount equal to their credit balances and crediting the income summary account with an equal amount. For example, if an income account has a credit balance of $200,000, the closing entry will be a debit to the income account for $200,000 and a credit to the income summary account or $200,000. If there is more than one income account, you can make a compound closing entry. For example, if the bicycle sales account has a credit balance of $50,000, the tricycle sales account has a credit balance of $25,000 and the unicycle sales account has a credit balance of $15,000, the closing entry would be: a $50,000 debit to bicycle sales, a $25,000 debit to tricycle sales, a $15,000 debit to unicycle sales and a $90,000 credit to the income summary account.
Make closing journal entries for each of the expense accounts. Expense accounts normally have a debit balance, so the closing journal entry will be a credit to the expense account and debit to the income summary account. For example, if the office expense account has a debit balance of $1,475, the closing journal entry would be a credit of $1,475 to office expense and a debit of $1,475 to the income summary account. Once all the income and expense accounts are closed to the income summary account, the balance in the income summary account will be the company's net income for the fiscal year.
Create a closing journal entry to transfer the balance from the income summary account to the company's equity account. For example, if a corporation's net income for the year is $45,000, the closing entry will be a debit of $45,000 to the income summary account and a credit of $45,000 to retained earnings. At the end of this process, the balances in all temporary income accounts, expense accounts and the income summary account should be zero.
Close any temporary equity accounts directly to the permanent equity accounts. For example, if the company is a partnership with two equal partners and each of the partners took a distribution of $15,000, the temporary equity account called partners distributions will have a debit balance of $30,000 at the end of the year. The closing journal entry will be a credit to partner distributions of $30,000, a debit to partner A's partnership equity account of $15,000, and a debit to partner B's partnership equity account of $15,000. All temporary equity accounts should have zero balances when closing entries are completed.