5.1 Describe and Prepare Closing Entries for a Business

What are Closing Entries?

Closing entries are journal entries made at the end of an accounting period to transfer balances from temporary accounts (revenues and expenses) to permanent accounts (equity/retained earnings).

Purpose of Closing Entries

Why Close Accounts?

1. Reset Temporary Accounts: Revenue and expense accounts are reset to zero for the next period
2. Update Retained Earnings: Net income or loss is transferred to retained earnings
3. Prepare for Next Period: Accounts are ready to accumulate new period's transactions
4. Complete the Accounting Cycle: Closing is the final step before starting a new period

Temporary vs. Permanent Accounts

Temporary Accounts (Closed at Period End):

• Revenue Accounts (Class 7): Reset to zero
• Expense Accounts (Class 6): Reset to zero
• Income Summary (temporary account used in closing process)

Permanent Accounts (Not Closed):

• Asset Accounts (Classes 2, 3, 4, 5): Balances carry forward
• Liability Accounts (Classes 1, 4): Balances carry forward
• Equity Accounts (Class 1): Updated but not reset

The Closing Process

The closing process involves four steps:

1. Close Revenue Accounts → Income Summary
2. Close Expense Accounts → Income Summary
3. Close Income Summary → Retained Earnings
4. Close Withdrawals/Distributions → Retained Earnings (if applicable)

Step 1: Close Revenue Accounts

Purpose: Transfer all revenue account balances to Income Summary

Process:

• Debit each revenue account for its balance
• Credit Income Summary for total revenues

Example:

From adjusted trial balance:

• Service Revenue (701000): €13,000 credit balance
• Sales Revenue (700000): €2,000 credit balance

Closing Entry:

Date: 2024-11-30

701000 Service Revenue              €13,000
700000 Sales Revenue                 2,000
350000 Income Summary                           €15,000
To close revenue accounts to Income Summary

PCN Note: Income Summary is typically account 350000 or a temporary account. Some businesses use a direct closing method.

After Closing:

• Service Revenue: €0
• Sales Revenue: €0
• Income Summary: €15,000 credit balance

Step 2: Close Expense Accounts

Purpose: Transfer all expense account balances to Income Summary

Process:

• Credit each expense account for its balance
• Debit Income Summary for total expenses

Example:

From adjusted trial balance:

• Salaries Expense (620000): €9,500 debit balance
• Rent Expense (612000): €2,400 debit balance
• Utilities Expense (615000): €1,500 debit balance
• Insurance Expense (613000): €100 debit balance
• Depreciation Expense (640000): €500 debit balance
• Interest Expense (660000): €100 debit balance
• Supplies Expense (619000): €1,000 debit balance

Total Expenses: €15,100

Closing Entry:

Date: 2024-11-30

350000 Income Summary               €15,100
620000 Salaries Expense                         €9,500
612000 Rent Expense                             2,400
615000 Utilities Expense                        1,500
619000 Supplies Expense                         1,000
613000 Insurance Expense                          100
640000 Depreciation Expense                       500
660000 Interest Expense                           100
To close expense accounts to Income Summary

After Closing:

• All expense accounts: €0
• Income Summary: €15,100 debit, €15,000 credit = €100 debit balance (Net Loss)

Step 3: Close Income Summary

Purpose: Transfer net income or net loss to Retained Earnings

Process:

• If Net Income: Debit Income Summary, Credit Retained Earnings
• If Net Loss: Credit Income Summary, Debit Retained Earnings

Example (Net Loss):

Income Summary has €100 debit balance (Net Loss)

Closing Entry:

Date: 2024-11-30

104000 Retained Earnings            €100
350000 Income Summary                           €100
To close Income Summary (net loss) to Retained Earnings

After Closing:

• Income Summary: €0
• Retained Earnings: Decreased by €100 (net loss)

If Net Income (Alternative Example):

If Income Summary had €2,000 credit balance (Net Income):

Closing Entry:

Date: 2024-11-30

350000 Income Summary               €2,000
104000 Retained Earnings                        €2,000
To close Income Summary (net income) to Retained Earnings

Step 4: Close Withdrawals/Distributions (If Applicable)

Purpose: Transfer owner withdrawals or distributions to Retained Earnings

Note: This step applies if the business has a withdrawals account (common in sole proprietorships) or makes distributions (in corporations).

Example (Withdrawals):

If owner withdrew €500 during the period:

Closing Entry:

Date: 2024-11-30

104000 Retained Earnings            €500
301000 Owner's Withdrawals                      €500
To close withdrawals to Retained Earnings

PCN Note: Withdrawals are typically in Class 3 or handled through equity accounts, depending on entity type.

Alternative: Direct Closing Method

Some businesses close directly to Retained Earnings without using Income Summary:

Step 1: Close Revenues

701000 Service Revenue              €13,000
700000 Sales Revenue                 2,000
104000 Retained Earnings                        €15,000

Step 2: Close Expenses

104000 Retained Earnings            €15,100
620000 Salaries Expense                         €9,500
612000 Rent Expense                             2,400
[Other expenses...]

Result: Same as using Income Summary, but fewer entries.

Complete Closing Example

Let's close the books for Le Petit Bistro using the Income Summary method:

From Adjusted Trial Balance:

• Service Revenue: €13,000 credit
• Total Expenses: €15,100 debit
• Net Loss: €100

Closing Entries:

Entry 1: Close Revenues

701000 Service Revenue              €13,000
350000 Income Summary                           €13,000
To close revenue accounts

Entry 2: Close Expenses

350000 Income Summary               €15,100
620000 Salaries Expense                         €9,500
612000 Rent Expense                             2,400
615000 Utilities Expense                        1,500
619000 Supplies Expense                         1,000
613000 Insurance Expense                          100
640000 Depreciation Expense                       500
660000 Interest Expense                           100
To close expense accounts

Entry 3: Close Income Summary

104000 Retained Earnings            €100
350000 Income Summary                           €100
To close Income Summary (net loss) to Retained Earnings

Posting Closing Entries to T-Accounts

Service Revenue:

Service Revenue (701000)
─────────────────────────────
Nov 30  Close    €13,000 │  Nov 01-30  Revenue  €13,000
─────────────────────────────
Balance  €0

Income Summary:

Income Summary (350000)
─────────────────────────────
Nov 30  Expenses  €15,100 │  Nov 30  Revenues   €13,000
Nov 30  Close      €100   │
─────────────────────────────
Balance  €0

Retained Earnings:

Retained Earnings (104000)
─────────────────────────────
Nov 30  Net Loss   €100   │  Nov 01  Balance    €5,000
─────────────────────────────
        │  Balance  €4,900

Luxembourg Compliance Note

In Luxembourg, closing entries must:

• Be made at period end (monthly, quarterly, or annually)
• Use proper PCN account classifications
• Be documented and retained for 10 years
• Be completed before filing financial statements
• Follow PCN standards for account treatment

Think It Through

Why is it important to close revenue and expense accounts at the end of each period? What would happen if these accounts weren't closed?

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