Closing the books transfers the balances of temporary accounts (revenues, expenses, dividends/draws) into retained earnings, resetting them to zero for the next period. This is the final step in the accounting cycle before the post-closing trial balance.
Steps:
- Close revenue accounts. Debit each revenue account for its balance, credit Income Summary.
- Close expense accounts. Credit each expense account for its balance, debit Income Summary.
- Close Income Summary. If Income Summary has a credit balance (net income), debit Income Summary and credit Retained Earnings. If it has a debit balance (net loss), credit Income Summary and debit Retained Earnings.
- Close dividends/draws. Debit Retained Earnings, credit Dividends.
- Prepare a post-closing trial balance. Only permanent accounts (assets, liabilities, equity) should remain. All temporary accounts should show zero.
Worked example: Service Revenue has a 12,000 debit balance. Rent Expense has a 2,000 debit balance.
| Account | Debit | Credit |
|---|---|---|
| Service Revenue | $20,000 | |
| Income Summary | $20,000 |
| Account | Debit | Credit |
|---|---|---|
| Income Summary | $15,000 | |
| Wages Expense | $12,000 | |
| Rent Expense | $3,000 |
Income Summary now has a $5,000 credit balance (net income).
| Account | Debit | Credit |
|---|---|---|
| Income Summary | $5,000 | |
| Retained Earnings | $5,000 |
| Account | Debit | Credit |
|---|---|---|
| Retained Earnings | $2,000 | |
| Dividends | $2,000 |
After closing, all temporary accounts are zero and Retained Earnings increased by 5,000 income minus $2,000 dividends).
Why this matters: Without closing entries, revenue and expense balances would accumulate across periods, making the income statement meaningless — it would show all-time totals instead of the current period.