Closing entries and post-closing trial balance

After preparation of financial statements, last step of accounting cycle is the closure of books of account for an accounting period. This involves posting closing entries and preparing a post-closing trial balance to ensure that all temporary accounts have been closed appropriately.

Temporary accounts include all the income statement accounts and dividend/drawings account. As these accounts are related to information that is for a particular period and which is presented in the previous step of accounting cycle in the form of financial statements, purpose of these temporary accounts is fulfilled. Net balance of income statement accounts, which is either net profit or net loss for  the period is transferred to equity account. Dividend/drawings balance is also transferred to equity account. By doing so, balance of these accounts will become zero so that no information is carried forward to next accounting period. In the next accounting period, these accounts will show only the information related to that accounting period.

Let’s separately discuss both steps involved in closure of books of account for an accounting period.

Closing entries

Closing entries are the journal entries which are posted at the end of an accounting period to close all the temporary accounts. Temporary accounts include the following:

  • all the income statement accounts
  • dividend account (in case of a corporation)
  • drawings account (in case of sole proprietorship)

Balance sheet accounts are considered permanent accounts as the balances of these accounts are carried forward from one accounting period to the next. Although dividend/drawings account is also a balance sheet account, but its nature is temporary and is used to report information for a particular accounting period. Therefore, dividend/drawings account is also closed at the end of the accounting cycle.

Temporary accounts are closed by transferring their balances to following equity accounts, which are permanent accounts and whose balances are carried forward to the next accounting period:

  • Retained earnings/accumulated loss account (in case of a corporation)
  • Owner’s capital account (in case of sole proprietorship)

For closing the income statement accounts, a temporary account called “income summary account” is often used by accountants. Balances of all the income statement accounts, which include income, gains, expenses, and losses are initially transferred to income summary account. After that, the net balance of income summary account is transferred to retained earnings/owner’s capital account.

Let’s take the adjusted trial balance of Ricardo Garments Inc. used in the example of previous chapter and record closing entries for better understanding.

Example – Closing entries

Date Accounts Debit Credit
31 Dec Cash sales 80,000  
  Credits sales 20,000  
  Services fee income 12,500  
  Training fee income 2,000  
  Income summary account   114,500
  (Transferring the balance of all income accounts to income summary account)    
31 Dec Income summary account 90,358  
  Material cost   30,000
  Selling and administrative expenses   5,500
  Salaries and wages   26,000
  Utilities   9,608
  Depreciation expense   18,000
  Insurance expense   750
  Provision for doubtful debts expense   500
  (Transferring the balance of all expense accounts to income summary account)    
31 Dec Income summary account 24,142  
  Retained earnings   24,142
  (Transferring the net balance (114,500 – 90,358) of income summary account to retained earnings)    

* In this example, there are no drawings or dividends, therefore closing entry is not required for dividends or drawings.

Post-closing trial balance

It is a trial balance which is prepared or extracted from the accounting system after posting the closing entries in relevant ledger accounts. It is a summary report listing all the ledger accounts and their balances at the end of an accounting period. Purpose of preparing post-closing trial balance is to ensure that books of account have been closed appropriately. Post-closing trial balance helps to identify any errors made while posting closing entries. Accountants usually check the following two characteristics of post-closing trial balance before jumping on to the next accounting period:

  • the sum of debits should be equal to sum of credits.
  • there should be no temporary accounts in the post-closing trial balance, as balances of all temporary accounts are nullified after posting closing entries.

This is the last step of accounting cycle. Furthermore, post-closing trial balance provides the opening balances of permanent ledger accounts for the next accounting period.

Let’s take a look at the post-closing trial balance of Ricardo Garments Inc.

Ricardo Garments Inc.
Post-closing trial balance
For the year ended 31 December 20xx