Principles of Financial Accounting: The Accounting Cycle - Closing Entries, Closing Temporary Accounts to Retained Earnings

What It Is

Closing entries are the final step in the accounting cycle, where temporary accounts are closed to retained earnings. This process ensures that the financial statements accurately reflect the company's financial position and performance. For example, if a company has a net income of $50,000 and wants to close its temporary accounts, it will debit the temporary accounts (e.g., Sales, Cost of Goods Sold) and credit Retained Earnings for $50,000.

Key Concepts & Formulas

• Temporary Account: An account that is closed to retained earnings at the end of each accounting period. Example: Sales, Cost of Goods Sold.
• Permanent Account: An account that is not closed to retained earnings, such as assets, liabilities, and equity accounts. Example: Cash, Accounts Payable.
• Closing Entry: A journal entry that closes temporary accounts to retained earnings. Example: Debit Sales $50,000, Credit Retained Earnings $50,000.
• Retained Earnings: The portion of net income that is retained in the business and not distributed to shareholders. Formula: Retained Earnings = Beginning Retained Earnings + Net Income - Dividends.
• Net Income: The profit earned by a business during an accounting period. Formula: Net Income = Sales - Cost of Goods Sold - Operating Expenses.
• Dividend: A distribution of net income to shareholders. Example: A company pays a dividend of $10,000 to its shareholders.
• Closing Process: The process of closing temporary accounts to retained earnings. Example: Closing the Sales account by debiting it and crediting Retained Earnings.
• T-Account: A format used to display account balances and prepare closing entries. Example: Dr. Sales $50,000 Cr. Retained Earnings $50,000
• Debit: An entry that increases an asset account or decreases a liability account. Example: Debit Cash $10,000.
• Credit: An entry that decreases an asset account or increases a liability account. Example: Credit Accounts Payable $5,000.

Journal Entry Examples

1. Closing the Sales account: Dr. Sales $50,000 Cr. Retained Earnings $50,000 Explanation: The Sales account is debited to close it, and Retained Earnings is credited to increase its balance.
2. Closing the Cost of Goods Sold account: Dr. Cost of Goods Sold $30,000 Cr. Retained Earnings $30,000 Explanation: The Cost of Goods Sold account is debited to close it, and Retained Earnings is credited to increase its balance.
3. Closing the Net Income account: Dr. Net Income $20,000 Cr. Retained Earnings $20,000 Explanation: The Net Income account is debited to close it, and Retained Earnings is credited to increase its balance.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Expense accounts are debited, and revenue accounts are credited. Use the "DEBIT What? CREDIT What?" rule.
2. Mistake: Forgetting to close temporary accounts. Correction: Close temporary accounts to retained earnings at the end of each accounting period.
3. Mistake: Incorrectly calculating net income. Correction: Net income = Sales - Cost of Goods Sold - Operating Expenses.

Exam Tips

1. Tip: Remember that dividends are not an expense, but rather a distribution of net income to shareholders.
2. Tip: Be careful when reversing normal balances, as this can lead to incorrect journal entries.
3. Tip: Use the "DEBIT What? CREDIT What?" rule to determine the correct debit or credit for expense and revenue accounts.

Quick Practice

1. What is the adjusting entry for accrued salaries of $5,000? Answer: Debit Salaries Expense $5,000, Credit Salaries Payable $5,000. Explanation: The Salaries Expense account is debited to increase its balance, and the Salaries Payable account is credited to increase its balance.
2. What is the closing entry for the Sales account if it has a balance of $50,000? Answer: Debit Sales $50,000, Credit Retained Earnings $50,000. Explanation: The Sales account is debited to close it, and Retained Earnings is credited to increase its balance.
3. What is the net income if Sales are $100,000 and Cost of Goods Sold is $60,000? Answer: Net Income = $100,000 - $60,000 = $40,000. Explanation: Net income is calculated by subtracting Cost of Goods Sold from Sales.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Temporary accounts are closed to retained earnings at the end of each accounting period.
3. Permanent accounts are not closed to retained earnings.
4. Net income = Sales - Cost of Goods Sold - Operating Expenses.
5. Retained Earnings = Beginning Retained Earnings + Net Income - Dividends.
6. Debit What? CREDIT What? (Expense accounts are debited, and revenue accounts are credited).
7. Do not forget to close temporary accounts.
8. T-Accounts are used to display account balances and prepare closing entries.
9. Debit increases assets and decreases liabilities.
10. Credit decreases assets and increases liabilities.