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Closing journal entries are made at year-end to prepare temporary accounts for the next accounting period. Temporary or nominal accounts, (also called income statement accounts), are measured periodically. The amounts in one accounting period should be closed or brought to zero so that they won't be mixed with those of the next period. Temporary accounts consist of all revenue and expense accounts, and also withdrawal accounts of owner/s in the case of sole proprietorships and partnerships. Take note that closing entries are prepared only for temporary accounts. Permanent accounts are never closed. Four Steps in Preparing Closing Entries 1. Close all income accounts to Income Summary 2. Close all expense accounts to Income Summary 3. Close Income Summary to the appropriate capital account 4. Close withdrawals to the capital account/s (this step is for sole proprietorship and partnership only) Closing Entries: Example Prepare the closing entries using the following information: Gray Electronic Repair Services Adjusted Trial Balance December 31, 2016 Account Title Debit Credit Cash $ 7,480.00 Accounts Receivable 3,700.00 Service Supplies 600.00 Furniture and Fixtures 3,000.00 Service Equipment 16,000.00 Accumulated Depreciation $ 720.00 Accounts Payable 9,000.00 Utilities Payable 1,800.00 Loans Payable 12,000.00 Mr. Gray, Capital 13,200.00 Mr. Gray, Drawing 7,000.00 Service Revenue 9,850.00 Rent Expense 1,500.00 Salaries Expense 3,500.00 Taxes and Licenses 370.00 Utilities Expense 1,800.00 Service Supplies Expense 900.00 Depreciation Expense 720.00 Totals $ 46,570.00 $ 46,570.00 Step 1: Close all income accounts to Income Summary Date 2016 Particulars Debit Credit Dec 31 Service Revenue 9,850.00 Income Summary 9,850.00 In the given data, there is only 1 income account, i.e. Service Revenue. It has a credit balance of $9,850. To close that, we debit Service Revenue for the full amount and credit Income Summary for the same. The Income Summary account is temporary. It is used to close income and expenses. As you will see later, Income Summary is eventually closed to capital. Step 2: Close all expense accounts to Income Summary 31 Income Summary 8,790.00 Rent Expense 1,500.00 Salaries Expense 3,500.00 Taxes and Licenses 370.00 Utilities Expense 1,800.00 Service Supplies Expense 900.00 Depreciation Expense 720.00 To close expenses, we credit the expense accounts and debit Income Summary. Now for the next step, we need to get the balance of the Income Summary account. In step 1, we credited it for $9,850 and debited it in step 2 for $8,790. It would then have a credit balance of $1,060. Notice that the balance of the Income Summary account is actually the net income for the period. Remember that net income is equal to all income minus all expenses. Step 3: Close Income Summary to the appropriate capital account The Income Summary balance is ultimately closed to the capital account. 31 Income Summary 1,060.00 Mr. Gray, Capital 1,060.00 Step 4: Close withdrawals to the capital account Note: This step is applicable only to sole proprietorships and partnerships. In a sole proprietorship, a drawing account is maintained to record all withdrawals made by the owner. In a partnership, a drawing account is maintained for each partner. Drawing accounts are closed to capital at the end of the accounting period. Our example is a sole proprietorship business. Mr. Gray's withdrawals are recorded in Mr. Gray, Drawing. To close the drawing account to the capital account, we credit the drawing account and debit the capital account. Notice that drawings decrease capital. 31 Mr. Gray, Capital 7,000.00 Mr. Gray, Drawing 7,000.00 Conclusion The purpose of closing entries is to prepare the temporary accounts for the next accounting period. In other words, the income and expense accounts are "restarted". After preparing the closing entries above, Service Revenue will now be zero. The expense accounts and withdrawal accounts will now also be zero. The balances of these accounts have been absorbed by the capital account – Mr. Gray, Capital, which now has a balance of $7,260 ($13,200 beginning balance + $1,060 in step #3 - $7,000 in step #4). The last step in the accounting cycle is to prepare a post-closing trial balance. A post-closing trial balanceis prepared after closing entries are made and posted to the ledger. It is the third (and last) trial balance prepared in the accounting cycle. For a recap, we have three types of trial balance. They all have the same purpose (i.e. to test the equality between debits and credits) although they are prepared at different stages in the accounting cycle. 1. Unadjusted trial balance - This is prepared after journalizing transactions and posting them to the ledger. Its purpose is to test the equality between debits and credits after the recording phase. 2. Adjusted trial balance - This is prepared after adjusting entries are made and posted. Its purpose is to test the equality between debits and credits after adjusting entries are prepared. It is also the basis in preparing the financial statements. An adjusted trial balance contains nominal and real accounts. Nominal accounts are those that are found in the income statement, and withdrawals. Real accounts are those found in the balance sheet. 3. Post-closing trial balance - This is prepared after closing entries are made. Its purpose is to test the equality between debits and credits after closing entries are prepared and posted. The post-closing trial balance contains real accounts only since all nominal accounts have already been closed at this stage. Example To illustrate, here is a sample adjusted trial balance: Gray Electronic Repair Services Adjusted Trial Balance December 31, 2016 Account Title Debit Credit Cash $ 7,480.00 Accounts Receivable 3,700.00 Service Supplies 600.00 Furniture and Fixtures 3,000.00 Service Equipment 16,000.00 Accumulated Depreciation $ 720.00 Accounts Payable 9,000.00 Utilities Payable 1,800.00 Loans Payable 12,000.00 Mr. Gray, Capital 13,200.00 Mr. Gray, Drawing 7,000.00 Service Revenue 9,850.00 Rent Expense 1,500.00 Salaries Expense 3,500.00 Taxes and Licenses 370.00 Utilities Expense 1,800.00 Service Supplies Expense 900.00 Depreciation Expense 720.00 Totals $ 46,570.00 $ 46,570.00 At the end of the period, the following closing entries were made: Dec 31 Service Revenue 9,850.00 Income Summary 9,850.00 31 Income Summary 8,790.00 Rent Expense 1,500.00 Salaries Expense 3,500.00 Taxes and Licenses 370.00 Utilities Expense 1,800.00 Service Supplies Expense 900.00 Depreciation Expense 720.00 31 Income Summary 1,060.00 Mr. Gray, Capital 1,060.00 31 Mr. Gray, Capital 7,000.00 Mr. Gray, Drawing 7,000.00 After posting the above entries, all the nominal accounts would zero-out, hence the term "closing entries". Let's take a look. In the first closing entry, Service Revenue was debited. Before that, it had a credit balance of 9,850 as seen in the adjusted trial balance above. Now its balance would be zero. Second entry. All expenses were credited. Before that, they had debit balances for the same amounts. They would now have zero balances. In the first and second closing entries, the balances of Service Revenue and the various expense accounts were actually transferred to Income Summary, which is a temporary account. The Income Summary account would have a credit balance of 1,060 (9,850 credit in the first entry and 8,790 debit in the second). Income Summary is then closed to the capital account as shown in the third closing entry. And finally, in the fourth entry the drawing account is closed to the capital account. At this point, the balance of the capital account would be 7,260 (13,200 credit balance, plus 1,060 credited in the third closing entry, and minus 7,000 debited in the fourth entry). Post-Closing Trial Balance Example After incorporating the closing entries above, the post-closing trial balance would look like this: Gray Electronic Repair Services Post-Closing Trial Balance December 31, 2016 Account Title Debit Credit Cash $ 7,480.00 Accounts Receivable 3,700.00 Service Supplies 600.00 Furniture and Fixtures 3,000.00 Service Equipment 16,000.00 Accumulated Depreciation $ 720.00 Accounts Payable 9,000.00 Utilities Payable 1,800.00 Loans Payable 12,000.00 Mr. Gray, Capital 7,260.00 Totals $ 30,780.00 $ 30,780.00 The balances of the nominal accounts (income, expense, and withdrawal accounts) have been absorbed by the capital account – Mr. Gray, Capital. Hence, you will not see any nominal account in the post-closing trial balance. And just like any other trial balance, total debits and total credits should be equal. Reversing entries are made at the beginning of the new accounting period to enable a smoother accounting process. This step is optional and is especially useful to companies that use the cash basis method. In this step, adjusting entries made at the end of the previous accounting period are simply reversed, hence the term "reversing entries". However, not all adjusting entries qualify for this step. The following are the only types that can be reversed: 1. Adjusting entry for accrued income, 2. Adjusting entry for accrued expense, 3. Adjusting entry for unearned revenue using the income method, and 4. Adjusting entry for prepaid expense using the expense method. Adjusting entries for unearned revenue under the liability method and for prepaid expense under the asset method are never reversed. Adjusting entries for depreciation, bad debts and other allowances are also never reversed. Let us illustrate each of the above types. Reversing Entry for Accrued Income Example: ABC Company is to receive $3,000 interest income at the end of February 2017. It covers 3 months starting December 1, 2016. At the end of 2016, the accountant properly makes an adjusting entry for one month's worth of accrued income. Date 2016 Particulars Debit Credit Dec 31 Interest Receivable 1,000.00 Interest Income 1,000.00 At the beginning of 2017, the accountant can prepare this reversing entry: Date 2017 Particulars Debit Credit Jan 1 Interest Income 1,000.00 Interest Receivable 1,000.00 The adjusting entry is simply reversed. Debit what was credited and credit what was debited. When the ABC Company receives the interest income at the end of February, the accountant will then prepare this journal entry: Feb 28 Cash 3,000.00 Interest Income 3,000.00 Notice that Interest Income is credited for 3,000. Now you might be asking this: Under the concept of accrual, the interest income to be recognized in 2017 should be $2,000. Then why credit $3,000 Interest Income? Very good. Well, in the reversing entry at the beginning of the period, Interest Income was already debited for $1,000. So if we combine them ($1,000 debit and 3,000 credit), then we'll end up with $2,000 Interest Income which is the correct amount to be recognized in 2017. We said that reversing entries are optional. If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon collection of the income. Feb 28 Cash 3,000.00 Interest Receivable 1,000.00 Interest Income 2,000.00 Note: Actually, if you combine the reversing entry and journal entry for collection. You'll come up with the journal entry above. Reversing Entry for Accrued Expense Example: Suppose that ABC Company and its lessor agrees that ABC will pay rent at the end of January 2017, covering a 3-month period starting November 1, 2016. The entire amount is $6,000. At the end of December 2016, the accountant properly prepares this adjusting entry for two months worth of rent expense (Nov 1 to Dec 31): Date 2016 Particulars Debit Credit Dec 31 Rent Expense 4,000.00 Rent Payable 4,000.00 At the beginning of 2017, the accountant can prepare this reversing entry: Date 2017 Particulars Debit Credit Jan 1 Rent Payable 4,000.00 Rent Expense 4,000.00 Again, notice that the adjusting entry is simply reversed. When the company pays the entire rent, the accountant will then prepare this journal entry: Jan 31 Rent Expense 6,000.00 Cash 6,000.00 In effect, Rent Expense for 2017 is $2,000 even if the accountant debits $6,000 upon payment. This is because of the reversing entry which includes a credit to Rent Expense for $4,000. If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon payment of the rent. Jan 31 Rent Payable 4,000.00 Rent Expense 2,000.00 Cash 6,000.00 There you have the first two types of adjusting entries that can be reversed. If you are having trouble understanding the process, don't worry. It requires some time and a little effort for the concepts to sink in. In part 2, we'll take a look at the other two types. Part 2: Reversing Entries for Unearned Income and Prepaid Expense In part 1, we had an introduction to reversing entries and discussed examples for accrued income and accrued expense. In this part, we will cover the two other types of entries that can be reversed – unearned income and prepaid expense. Reversing Entry for Unearned Income If the income method is used in recording unearned income, reversing entries can be prepared. Take note that adjusting entries for unearned income recorded using the liability method are never reversed. Example: ABC Company recorded customer advances amounting to $5,000 in December 1, 2016. The company uses the income method in recording unearned income. Date 2016 Particulars Debit Credit Dec 1 Cash 5,000.00 Service Revenue 5,000.00 At the end of 2016, the company rendered $2,000 worth of services. We need to set-up the unearned income of $3,000 and bring Service Revenue to its correct balance ($2,000). The adjusting entry would be: Dec 1 Service Revenue 3,000.00 Unearned Revenue 3,000.00 At the beginning of 2017, the following reversing entry can be prepared: Date 2017 Particulars Debit Credit Jan 1 Unearned Revenue 3,000.00 Service Revenue 3,000.00 Notice that the adjusting entry is simple reversed. At the end of 2017, Service Revenue will again be checked to see if there is any unearned portion and if an adjusting entry is necessary. Reversing Entry for Prepaid Expense If the expense method is used in recording prepaid expense, reversing entries can be prepared. Adjusting entries for prepaid expense under the asset method are not reversed. Example: On December 1, 2016, ABC Company paid $7,500 of rent for 3 months starting December 1. The expense method was used in recording this transaction. Date 2016 Particulars Debit Credit Dec 1 Rent Expense 7,500.00 Cash 7,500.00 At the end of 2016, 1 month worth of rent has already expired. Prepaid Rent should be set-up for the remaining 2 months. The adjusting entry would be: Dec 31 Prepaid Rent 5,000.00 Rent Expense 5,000.00 At the beginning of 2017, the following reversing entry can be prepared: Date 2017 Particulars Debit Credit Jan 1 Rent Expense 5,000.00 Prepaid Rent 5,000.00 Again, notice that the adjusting entry is simple reversed. At the end of February, the entire rent paid has already expired. We do not need to make an entry here since we already prepared a reversing entry. Nonetheless, Rent Expense will be reviewed at the end of the year. Rent Expense and all other expenses will be checked to see if there are any unexpired portions which will require adjusting entries. Author's Notes And there you have the four types of adjusting entries that can be reversed. We've covered all of them and provided examples to guide you. Again, if you are having a hard time understanding the process, don't worry. It requires some time and a little effort for the concepts to sink in. After all, the process will always be the same.