Study: Closing Entries: Identify Temporary Accounts
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Slides 1-3 (1m:33s)
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Slide 1
Welcome to Introduction to Accounting Preparing for a User’s Perspective
Closing Entries: Identify temporary accounts
Slide 2
I hope you are getting excited because we are almost done with the full accounting cycle. We’ve gone through the process of recording original transaction entries, and preparing the pre-adjusted trial balance, recording adjusting entries and preparing the adjusted trial balance, and we’ve just finished preparing the financial statements which means we need to prepare the accounts to start a brand-new year.
What that means is any accounts that only relate to the prior year, such as revenues, expenses and dividends, need to be closed. Those accounts are called temporary [i.e. nominal] accounts; therefore, we need to identify those temporary accounts, revenues, expenses and dividends, analyze how to close them, record the closing entries, which will close them down to zero, and transfer their balances into a permanent account called retained earnings. We’ll have to post those entries into their respective ledger accounts so all temporary accounts are zero and the retained earnings account has been updated for the transfer of those temporary accounts and we will prepare a post-closing trial balance.
The only accounts with balances that should appear on the post-closing trial balance are balance sheet accounts, assets, liabilities and equity. All revenues, expenses and dividends should be zero and will not appear on the post-closing trial balance.
Slide 3
And now, here in Round 3 we are going to do the closing entries. This video is all about identifying those temporary accounts that need to be closed.
Slide 4 (1m:50s)
Links to an external site.Slide 4
If you recall, this is the adjusted trial balance that we used to prepare the financial statements. One key thing you should see is that we still have all revenues, expenses, and dividends on this adjusted trial balance, and our retained earnings account, for this brand-new company didn’t even appear because it was a zero balance on the adjusted trial balance. What that means is that all these temporary accounts need to be closed into retained earnings. So one key thing you need to be able to do is identify which accounts are balance sheet accounts and therefore are permanent carrying their balances forward from period to period and which ones are temporary.
Take a moment and see if you can identify all permanent accounts.
Hopefully you are able to do that.
Here is your answer.
All these [current assets, noncurrent assets, contra assets, current liability, noncurrent liability and balance sheet equity accounts] are accounts that will appear on the balance sheet and therefore are permanent. Therefore, at the end of one accounting period, for example December 31st, whatever the balance is in these accounts, that will be the beginning balance for 1/1/X2.
Now these other accounts, are not permanent accounts. These are temporary accounts.
Stop the video and see if you can identify which of these temporary accounts are income statement accounts.
Hopefully, you are able to do that.
The income statement accounts are all revenues and expenses. Other income statement accounts are gain on sale of long-term assets, or loss on sale of long-term assets, as well as contra revenues, which we haven’t really discussed much in the course yet.
Now another temporary account which does not appear on the income statement, because it is not a revenue or an expense, is the dividends account. This account only appears on the statement of retained earnings, but once again, it influences how much of the company’s earnings the company retains.
So net income increases the amount of earnings the company can retain, and dividends reduce the amount that they did retain.
Slide 5 (0m:59s)
Links to an external site.Slide 5
This is the statement of retained earnings that we prepared in the prior video on preparing the financial statements. You should see that we have net income, which are all the revenues minus all the expenses, and we have the dividends.
Because this was a brand-new company, we started with zero retained earnings. We added net income and deducted dividends to arrive at the ending retained earnings balance. These accounts here, between the beginning and ending retained earnings balance, are all temporary accounts.
These temporary accounts need to be zeroed out and their balances transferred into retained earnings. The key point you need to pay attention to though is that this is just the financial statement. We actually have not recorded the closing of these accounts into the retained earnings account in the actual ledger accounts. That’s an important point to remember. We will actually need to record closing entries that we will then post to the ledger accounts to close these temporary accounts into the retained earnings ledger account.
Slide 6 (1m:09s)
Links to an external site.Slide 6
The reason we do this [i.e. the closing process] is because of the periodicity concept. Economic transactions and events are to be accounted for in the accounting period and in the financial statements to which they relate.
With the balance sheet, the balance sheet is reported as of a given point in time, beginning of the year, end of the year.
All balance sheet accounts carry their ledger account balances forward each year; therefore, all balance sheet accounts are permanent accounts. So, assets, liabilities and equity are permanent [i.e. real] accounts.
Whatever the ending balance is at the end of one year, will become the beginning balance at the beginning of the next year. It’s like when you go to bed at night if there is a soda pop in the refrigerator, December 31st, when you wake up the next day the soda pop is still there. It’s balance carries forward and the end of X2 will be the beginning of X3.
Now a key cause of change between the beginning and ending balance sheet accounts are all the temporary accounts. All income statement and dividend accounts are closed each year into retained earnings which is a permanent account, which can be carried forward on the balance sheet. Therefore, all income statement and dividend accounts are temporary accounts.
Slide 7 (1m:12s)
Links to an external site.Slide 7
This is another way of looking at which accounts are permanent and which accounts are temporary. See if you can take a moment and identify which of all these accounts in the expanded accounting equation are permanent accounts.
Hopefully you got that.
It’s all of these above the line here [in the blue box]. Every one of these accounts will appear on the balance sheet. By default then, if an account is not a permanent account, it must be a temporary account, also known as nominal accounts. Temporary accounts must be closed into retained earnings.
We’re going to close revenues, expenses and contra revenues into this account which we will call income summary, and then that account will be closed into retained earnings and then the dividends account will be closed into retained earnings.
One way to remember which accounts are temporary and need to be closed each year is the acronym REID.
- R: standing for revenues and gains. Gains work just like revenues [debits decrease them and credits increase them].
- E: expenses and losses and contra revenues. Losses work just like expenses [debits increase them and credits decrease them].
- I: income summary, that’s this account right here which we will call income summary when we are recording closing entries.
- D: dividends, this account here.
All these accounts [in the red box] flow into and get closed into retained earnings.
Slides 8-10 (0m:51s)
Links to an external site.Slide 8
Just as a review, you absolutely need to be able to classify all the accounts in this list as permanent or temporary accounts. The permanent accounts appear on the balance sheet, the temporary accounts appear either on the income statement or on the statement of retained earnings. All revenues, expenses and dividends will impact the retained earnings account when they are closed into it.
Slide 9
Another way of seeing that is to just go back to the statement of retained earnings and anything that is between the beginning balance and the ending balance [of retained earnings] represents a temporary account that needs to be closed.
Slide 10
I hope this helped you understand what a temporary account is. The main thing is that it is an account that only relates to a given accounting period and therefore must be closed out to zero so a new accounting period can be started fresh.
Good luck on the quiz.