Home / Part 1 / Chapter 4 / P2

Closing Process & Post-Closing Trial Balance

🎯 Learning Objectives

  • Understand the purpose and importance of the closing process in the accounting cycle
  • Identify temporary versus permanent accounts and understand why they are treated differently
  • Apply the REID sequence (Revenues, Expenses, Income Summary, Dividends) for closing entries
  • Prepare formal closing journal entries and understand their effect on account balances
  • Prepare and verify a post-closing trial balance
  • Explain how closing entries affect the accounting equation and prepare the company for the next period

📚 Background & Principles

The closing process is the final step in the accounting cycle where accountants prepare the books for the next accounting period. Think of it as resetting the game board—keeping the permanent pieces (assets, liabilities, equity) in place while gathering up all the temporary scores (revenues, expenses, dividends) to update the player's total.

Core Principle: The closing process transfers the balances of temporary accounts (revenues, expenses, dividends) to permanent equity accounts, specifically Retained Earnings, thereby resetting temporary accounts to zero for the next period.
💡 Key Insight: The closing process is like the inning break in a baseball game. You tally up all the runs scored (revenues) and subtract the costs incurred (expenses) to see if the team is ahead or behind (net income/loss), then reset for the next inning while keeping the running total.

Why Is the Closing Process Necessary?

Reset Temporary Accounts

Revenue and expense accounts must start at zero each period to correctly measure income for that specific period only.

Update Retained Earnings

Net income (or loss) and dividends must flow to Retained Earnings to track cumulative company profits over time.

Error Detection

The post-closing trial balance verifies that debits still equal credits after all closing entries are posted.

Fresh Start

Each accounting period begins with a clean slate for revenues and expenses while permanent accounts carry forward.

📋 Closing Process Flow
1
📊
Adjusted
Trial Balance
Start with all account balances after adjustments have been posted.
2
📤
Close
Revenues
Transfer all revenue balances to Income Summary.
3
💸
Close
Expenses
Transfer all expense balances to Income Summary.
4
📈
Close Income
Summary
Transfer net income/loss to Retained Earnings.
5
💰
Close
Dividends
Transfer dividends to Retained Earnings.
6
✅
Post-Closing
Trial Balance
Verify debits equal credits with permanent accounts only.

🔑 Key Concepts

Temporary Accounts

Revenue, expense, and dividend accounts that are closed to zero at the end of each period. Their balances do not carry forward to the next accounting period.

Permanent Accounts

Asset, liability, and equity accounts (including Retained Earnings) that are NOT closed. Their balances carry forward to the next accounting period.

Closing Entries

Journal entries that transfer the balances of temporary accounts to permanent accounts, specifically Income Summary and Retained Earnings.

Income Summary

A temporary account used only during the closing process. It accumulates all revenues and expenses to determine net income (or loss) before transferring to Retained Earnings.

Retained Earnings

A permanent equity account that tracks cumulative net income less dividends declared since the company's inception.

Post-Closing Trial Balance

A trial balance prepared after closing entries are posted, containing ONLY permanent accounts to verify that debits equal credits.

🔍 Deep Dive

Explore the closing process at different levels of depth:

🟢 Foundational Level

Understanding the basic concept of closing temporary accounts.

The Simple Analogy: Sports Season

Analogy: Basketball Season

Imagine tracking a basketball team's performance. Each game, you record points scored (revenues) and expenses like player salaries, travel costs, equipment. At the end of the season, you tally everything up. The team's overall standing is like Retained Earnings—it accumulates all the wins and losses over time.

Step 1: Identify What Gets "Reset"

Points scored in each game, expenses for each game—these are temporary. They get tallied up but don't carry to next season individually.

Step 2: Identify What Gets "Kept"

The team's overall record, its championship wins, and its cash reserves—these are permanent and carry to next season.

Step 3: The REID Sequence

Close Revenues → Close Expenses → Close Income Summary → Close Dividends

R
Revenues
→
E
Expenses
→
I
Income Summary
→
D
Dividends
💡 Memory Hook: Think of "REID" like "Read" to remember the closing sequence: Revenues, Expenses, Income Summary, Dividends.
1
Temporary
Accounts
→
2
Income
Summary
→
3
Retained
Earnings
→
4
Permanent
Accounts
💡 Professional Tip: After closing entries, only permanent accounts (Assets, Liabilities, Common Stock, Retained Earnings) should have balances. If you see revenue, expense, or dividend balances, you've missed a closing step!

🟡 Standard Level

Understanding the four closing entries and how to prepare them.

The Four Closing Entries

Each closing entry serves a specific purpose in transferring temporary account balances:

Entry 1: Close Revenues to Income Summary

Journal Entry:

Dr Consulting Revenue $7,990

Dr Service Revenue $500

Cr Income Summary $8,490

All revenue debits, Income Summary credit = Total Revenue

Entry 2: Close Expenses to Income Summary

Journal Entry:

Dr Income Summary $4,000

Cr Rent Expense $1,000

Cr Salaries Expense $1,050

Cr Supplies Expense $1,200

Cr Insurance Expense $300

Cr Depreciation Expense $450

Income Summary debit = Total Expenses

Entry 3: Close Income Summary to Retained Earnings

Journal Entry (Net Income):

Dr Income Summary $4,490

Cr Retained Earnings $4,490

Net Income = Revenue $8,490 - Expenses $4,000 = $4,490

Entry 4: Close Dividends to Retained Earnings

Journal Entry:

Dr Retained Earnings $200

Cr Dividends $200

Reduces retained earnings by dividends declared

Step-by-Step Closing Process for FastForward Company

Let's prepare closing entries based on the Adjusted Trial Balance from P1.

Step 1: Review Adjusted Trial Balance

Identify which accounts are temporary (will be closed) and which are permanent (will carry forward).

Treatment
Assets - PERMANENT (Keep Balance)
Liabilities - PERMANENT (Keep Balance)
Equity - PERMANENT (Keep Balance)
Revenues - TEMPORARY (Close to $0)
Expenses - TEMPORARY (Close to $0)
Dividends - TEMPORARY (Close to $0)
Step 2: Prepare Closing Entry #1 - Close Revenues
Dec 31
8,490
7,990
500
Step 3: Prepare Closing Entry #2 - Close Expenses
Dec 31
4,000
1,000
1,050
1,200
300
450
Step 4: Prepare Closing Entry #3 - Close Income Summary

Net Income Calculation: Income Summary Credit $8,490 - Income Summary Debit $4,000 = $4,490 Credit Balance (Net Income)

Dec 31
4,490
4,490
Step 5: Prepare Closing Entry #4 - Close Dividends
Dec 31
200
200

🔴 Advanced Level

Understanding the post-closing trial balance, reversing entries, and the complete accounting cycle.

The Post-Closing Trial Balance

After all closing entries are posted, only permanent accounts should have balances. The post-closing trial balance verifies this.

Debit
Credit
$5,800
2,100
8,400
2,100
26,000
$450
6,200
350
1,950
30,000
9,580
$44,400
$44,400
✓ Verification: The post-closing trial balance balances! Total debits ($44,400) equal total credits ($44,400). Notice that all temporary accounts (revenues, expenses, dividends) have zero balances—they were closed in the closing entries.

Reversing Entries (Optional but Common)

Some accountants prepare reversing entries at the beginning of the next period for accrued revenues and accrued expenses. This simplifies subsequent recording.

Why Use Reversing Entries?

Accrued revenues recorded at period end (Dr Accounts Receivable, Cr Revenue) would normally be recorded again when cash is received. A reversing entry simplifies this by allowing the subsequent cash receipt to be recorded normally (Dr Cash, Cr Revenue) without double-counting.

Example: Accrued Service Revenue

Adjusting Entry (Dec 31):

Dr Accounts Receivable $100

Cr Service Revenue $100

Reversing Entry (Jan 1):

Dr Service Revenue $100

Cr Accounts Receivable $100

Collection Entry (Jan 15):

Dr Cash $100

Cr Service Revenue $100

Example: Accrued Wages

Adjusting Entry (Dec 31):

Dr Wages Expense $140

Cr Wages Payable $140

Reversing Entry (Jan 1):

Dr Wages Payable $140

Cr Wages Expense $140

Payment Entry (Jan 15):

Dr Wages Expense $800

Cr Cash $800

💡 Professional Tip: Reversing entries are optional and often used by larger organizations with sophisticated accounting systems. Small businesses may skip them. They primarily benefit accrual-type transactions where cash flow occurs after the accrual.

🎨 Interactive: Closing Entries Simulator

Practice preparing closing entries and see how balances flow to Retained Earnings. Enter values and watch the closing process unfold.

📊 FastForward Company - Closing Process Simulator

Enter account balances and prepare closing entries

📈
Consulting Revenue Total revenue earned this period
$
$7,990
💸
Total Expenses Sum of all expense accounts
$
$4,000
💰
Dividends Distributions to shareholders
$
$200
📊
Beginning Retained Earnings RE balance from prior period
$
$5,290
📈
Net Income $3,990
💼
Ending Retained Earnings $9,080

📝 Closing Entries Summary

Entry 1: Close Revenues to Income Summary
Dr Consulting Revenue $7,990 Cr Income Summary $7,990
Entry 2: Close Expenses to Income Summary
Dr Income Summary $4,000 Cr Expenses $4,000
Entry 3: Close Income Summary to RE
Dr Income Summary $3,990 Cr Retained Earnings $3,990
Entry 4: Close Dividends to RE
Dr Retained Earnings $200 Cr Dividends $200
💡 Try It: Change the values above. Notice how:
  • Net Income = Revenue - Expenses
  • Ending RE = Beginning RE + Net Income - Dividends
  • Each closing entry balances (Dr = Cr)
  • Income Summary always ends at $0 after all entries

📊 Visual: How Closing Entries Flow

Watch how closing entries transfer balances through the accounts:

Red entries = Closing entries
Ending balance shown at bottom
RE carries forward, Temp accounts zero
💡 Key Pattern: Observe the flow:
  • Revenues decrease (Dr) and flow INTO Income Summary (Cr)
  • Expenses decrease (Cr) as they flow OUT of Income Summary (Dr)
  • Net Income flows from Income Summary to Retained Earnings
  • Dividends flow directly from Dividends to Retained Earnings
  • Income Summary always ends at $0 (temporary account)

🚫 Common Misconceptions & Professional Tips

❌ Misconception 1: "Closing entries are the same as adjusting entries."

✅ Reality: Adjusting entries update accounts for the current period's transactions (accruals, deferrals). Closing entries reset temporary accounts to zero and transfer their balances to Retained Earnings. They serve completely different purposes and occur at different times in the accounting cycle.
❌ Misconception 2: "Dividends are an expense and should appear on the Income Statement."

✅ Reality: Dividends are NOT an expense. They are a distribution of earnings to shareholders. They appear on the Statement of Retained Earnings and the Balance Sheet (reducing equity), but never on the Income Statement.
❌ Misconception 3: "The Income Summary account appears on the financial statements."

✅ Reality: The Income Summary is a temporary "holding" account used ONLY during the closing process. It does NOT appear on any formal financial statement. Its purpose is simply to accumulate revenues and expenses before transferring the net result to Retained Earnings.
❌ Misconception 4: "Retained Earnings represents cash available for dividends."

✅ Reality: Retained Earnings is an equity account tracking cumulative net income less dividends. It has NO relationship to cash. A company can have high retained earnings but no cash (if profits are tied up in receivables or inventory), or have cash but low retained earnings (if it has historical losses).
💡 Professional Tip #1: Always close revenues FIRST, then expenses. This ensures that when you calculate net income in the Income Summary, you've captured all revenues and expenses.
💡 Professional Tip #2: After posting closing entries, verify that all temporary accounts (revenues, expenses, dividends) have zero balances. If any have non-zero balances, you've missed a closing step.
💡 Professional Tip #3: Use the post-closing trial balance as your final check. If it balances and contains only permanent accounts, your closing process is complete and correct.
💡 Professional Tip #4: In practice, closing entries are often automated in accounting software. However, understanding the manual process helps you audit and troubleshoot when issues arise.

🧠 Memory Aids & Quick Reference

⚡ Quick Recall: The REID Sequence

Revenues → Expenses → Income Summary → Dividends

Close in this order to transfer balances correctly to Retained Earnings.

⚡ Quick Recall: What Gets Closed?

TEMPORARY (Close to $0): Revenues, Expenses, Dividends

PERMANENT (Keep Balance): Assets, Liabilities, Common Stock, Retained Earnings

📋 The Four Closing Entries

Entry 1: Dr Revenues, Cr Income Summary

Entry 2: Dr Income Summary, Cr Expenses

Entry 3: Dr Income Summary, Cr Retained Earnings (net income)

Entry 4: Dr Retained Earnings, Cr Dividends

📊 Income Summary Logic

Credit Balance (Revenues > Expenses) = Net Income

Debit Balance (Expenses > Revenues) = Net Loss

Always closes to zero after Entry 3

⚖️ Post-Closing TB Verification

Only permanent accounts should have balances

Total Debits must equal Total Credits

No revenue, expense, or dividend balances should remain

🎯 Retained Earnings Formula

Beginning RE + Net Income - Dividends = Ending RE

Ending RE = $5,290 + $4,490 - $200 = $9,580

📖 Glossary

Closing Entries

Journal entries made at the end of an accounting period to transfer the balances of temporary accounts (revenues, expenses, dividends) to permanent equity accounts.

Temporary Accounts

Revenue, expense, and dividend accounts that are closed to zero at the end of each period. Their balances do not carry forward to the next accounting period.

Permanent Accounts

Asset, liability, and equity accounts (including Retained Earnings) that are NOT closed. Their balances carry forward to the next accounting period.

Income Summary

A temporary account used only during the closing process. It accumulates all revenues and expenses to determine net income (or loss) before transferring to Retained Earnings.

Retained Earnings

A permanent equity account that tracks cumulative net income less dividends declared since the company's inception.

Post-Closing Trial Balance

A trial balance prepared after closing entries are posted, containing ONLY permanent accounts to verify that debits equal credits.

Reversing Entries

Optional journal entries made at the beginning of the next period that reverse the effect of certain adjusting entries, simplifying subsequent transaction recording.

Dividends

Distributions of a company's earnings to its shareholders. Recorded in a temporary account that is closed to Retained Earnings at period end.

Net Income

Total revenues minus total expenses for a period. If positive, transferred to Retained Earnings; if negative, deducted from Retained Earnings.

Accounting Cycle

The sequence of steps followed to record, classify, and summarize financial information: Transactions → Journal → Ledger → TB → Adjustments → Adj TB → Statements → Closing → Post-Closing TB

🎯 Final Knowledge Check

Test your understanding of the Closing Process and Post-Closing Trial Balance:

Question 1: Which of the following accounts should be closed at the end of the accounting period?





Question 2: What is the correct order for closing entries (REID)?





Question 3: A company has $50,000 in total revenues and $35,000 in total expenses. What is the journal entry to close Income Summary (assuming a net income)?





Question 4: Which of the following accounts will appear on the post-closing trial balance?





Question 5: Dividends are closed with which entry?





Question 6: Why is the Income Summary account used in the closing process?





Question 7: After closing entries are posted, what should be the balance of the Service Revenue account?





Question 8: Which statement about reversing entries is TRUE?