Closing entries: what they are and how to record them

Every accounting year ends the same way. Revenue and expense accounts that have been growing for twelve months are reset to zero, and the year's profit or loss moves into retained earnings. The journal entries that do this are called closing entries.

They're one of the oldest routines in accounting, and one of the most misunderstood. This guide explains what they are, which accounts they touch, how to record them, and how they differ from adjusting entries.

What are closing entries?

Closing entries are journal entries made at the end of an accounting period to transfer the balances of temporary accounts into retained earnings. Once they're posted, revenue, expense and dividend accounts start the new period at zero, so next year's profit and loss measures next year only. Balance sheet accounts carry forward unchanged.

Temporary and permanent accounts

The difference comes down to what an account measures:

• Temporary accounts measure activity over a period: revenue, cost of sales, operating expenses, and dividends or owner draws. They are closed at the end of every year.
• Permanent accounts measure what the business owns and owes at a point in time: cash, receivables, equipment, payables and equity. They are never closed.

Take the illustrative purchase used across this site. Six laptops are bought for €9,000, and bill #A-311 is booked at $9,720 to computer equipment, an asset. When it's paid, a $45 realized FX loss and a $15 payment fee are recorded as expenses. At year-end, the $45 and the $15 close with every other expense. The $9,720 of equipment stays on the balance sheet, and the supplier's balance, already cleared to zero, carries forward as it is.

How to record closing entries in four steps

The traditional method uses a temporary account called income summary:

1. 1Close revenue. Debit each revenue account for its balance and credit income summary.
2. 2Close expenses. Credit each expense account for its balance and debit income summary.
3. 3Close income summary. Move its remaining balance, which equals net income, to retained earnings. A profit is a credit to retained earnings; a loss is a debit.
4. 4Close dividends or draws. Credit the dividends or draws account and debit retained earnings.

Many teams skip income summary and close revenue and expenses directly to retained earnings in one entry. The result is the same.

A closing entry example

In the illustrative year below, revenue is $1,240,000, cost of sales is $512,000 and operating expenses are $398,000, so net income is $330,000. One entry closes all three to retained earnings:

Debits equal credits, every temporary account is now zero, and retained earnings has grown by exactly the year's net income. The same $330,000 appears as net income on the profit and loss statement and as the increase in retained earnings on the balance sheet. If those two numbers don't agree, something was posted after the statements were produced.

After closing, run a post-closing trial balance. It should list only permanent accounts, and debits should still equal credits.

Closing entries vs. adjusting entries

The two are easy to confuse, but they do different jobs and happen in a fixed order.

• Adjusting entries come first. They correct the books before the period ends: accruing expenses incurred but not yet billed, releasing prepaid expenses, recording depreciation and recognizing earned revenue.
• Closing entries come last. They don't change profit at all. They move the period's final, adjusted profit into retained earnings and reset the temporary accounts.

If an adjusting entry is posted after closing, the year's profit and retained earnings will both be wrong. That's why the period is locked once closing entries are posted.

Common mistakes

• Closing a permanent account, such as cash or accounts payable, by mistake.
• Posting adjustments after the period has been closed.
• Forgetting to close dividends or owner draws.
• Closing before every subledger has been reconciled, which locks errors in.

What changes on one system

Closing entries are only as reliable as the balances they move. When purchasing, bills, payments and the ledger run as one system, exchange differences and fees are posted as payments settle, payables and receivables agree with the ledger because they are the same records, and the statements come from those records too. Closing becomes the last, quiet step of a year that already reconciles. See how it works on the Accounting page.