11. The Closing Process

Let's talk about the closing process. So in accounting, there are permanent accounts, and there are temporary accounts. And the closing process happens at the end of the accounting period where you take the temporary accounts and you close them out to permanent accounts. And so the difference between these two, the temporary and the permanent accounts, is the permanent accounts stay open and the temporary accounts do not. The temporary accounts get closed, the permanent accounts stay open from year to year. So for example, on the permanent side, let's take cash. If at the end of Year 1, we have $1,000 in cash, at the beginning of Year 2, we're gonna have $1,000 in cash.

That makes enough sense, right? End of Year 1 becomes beginning of Year 2. And the cash didn't go away just because we went from December 31 to January 1. So cash would be considered a permanent account because it stays open. The year passed, the year turned over to the new year, and you didn't just zero out that account. But let's talk about revenue. So at the end of Year 1, you may have $10,000 in revenue. But at the beginning of Year 2, you have zero in revenue, right? It's Year 2, and you haven't earned any revenue yet. In all of Year 1, you earned $10,000, but then the new year started, and you haven't earned any.

So that's why we call revenue a temporary account because as the new period, and it's typically a year, as the new year starts, it goes back to zero. But the question is, how did we get from $10,000 to zero? Where did we put this $10,000? And that's what we're gonna look at in the closing process here. And I know that you're gonna think I'm crazy, but the closing process is actually kind of fun. It's kind of a big puzzle. So let me show you how it's done. We've got revenue, expenses and dividends.

And so let's just say we've got $10,000 in revenue, $4,000 in expenses, and we'll say $1,000 in dividends. We know, because we've gone over it a hundred times by now, that revenues minus expenses equals net income, right? So now we're actually gonna look at the process by which we derive this net income account. So we're gonna make one more temporary account. We're just gonna make this account up out of nowhere. And this is called income summary.

And this is the first step of the closing process. You create this income summary account. And so what we wanna do is we wanna close revenue, and we wanna close expenses, and where we close them to is we close them into this income summary. So let's start by closing revenue. So what we're gonna do is we're gonna put whatever the total amount is, in this case it's $10,000, we're gonna put it on the opposite side so that we effectively zero it out. Right? Now you can see it's zero. So what we just did in the form of a journal entry is we took revenue and we debited it $10,000.

And we know that every journal entry has to balance, so we're gonna put a credit on income summary of $10,000. See how that's not really hard? It's just kind of a puzzle. So all we did was we said, "How much is on the right side? Let's put it on the left side." Well, you can't just have an entry that only has a debit, so let's put a credit over here also. And you do the same thing with expenses. So we zero out expenses. Now, that looks like you put $4,000 on the credit side.

And so we're missing a debit here, and you guessed it, that becomes income summary. So we put $4,000 on the debit side here. So now if you look, we're doing basically revenues minus expenses. We end up with $6,000 on the credit side. So without even really trying, you just closed out revenue and expenses, and you closed them out to the income summary. And like I said, it's not hard. It's just a matter of left, right, left, right, left, right. You just make sure that all of them balance. So now we've got $6,000 in income summary. Well, we need to close this account out also, and we haven't even touched dividends yet.

So this is effectively our net income, isn't it? Because we said revenues minus expenses is net income. Now, can you think of a formula that involves net income and dividends? What about beginning retained earnings plus net income minus dividends equals ending retained earnings? Well, we have net income and we have dividends, so maybe we should try to use this formula. So let's open up the retained earnings account. And you may already have some amount in there, so let's say we just have $10,000, and this would just be your beginning balance. Just like here, we start with beginning retained earnings. So the problem may tell you you have, you know, $12,000 in, uh, retained earnings.

That's what you put there. Okay, so now we've got the retained earnings account to deal with. So let's go ahead and close out. Get rid of all this mess. We can close out this income summary account in the same way that we closed out revenues and expenses. So income summary has $6,000 on the right. To close it, we put $6,000 on the left.

So we've just done income summary, and we did a $6,000 debit. So we need to put a $6,000 credit somewhere, and that place is retained earnings. So we're gonna put a $6,000 credit in retained earnings so that these two balance out. And you see what we did was this right here, we took beginning retained earnings, we added in net income, that's our net income that came from the income summary. So now we need to take out dividends. So dividends, to close out dividends, you do the opposite of whatever's there. So we put $1,000 on the right side.

So half of the journal entry looks like that, $1,000 on the right, and the other half is gonna be income summary, $1,000 on the left. So we end up with $1,000 on the left. And if you'll notice, exactly, we just took out dividends. So we have turned this formula into an actual T-account here, the retained earnings T-account. So we took beginning retained earnings, we put the opening balance in there, $10,000. Add in your net income, $6,000. Take out your dividends, and that was done by putting them right here, closing out the dividends account and then moving it over to here.

And then that gives you your ending retained earnings, 10 plus 6 minus 1 is $15,000. So what we did was we just shuffled all of our temporary accounts into this permanent account of retained earnings because all balance sheet accounts are permanent. Anything that goes on the balance sheet is permanent. The income statement is temporary, so we moved revenues, expenses, and then we moved dividends also into this permanent account so that when the year rolls over, revenues equals zero, expenses equals zero, and dividends equals zero. But we didn't just get rid of them, we moved them into this retained earnings account because we know that beginning retained earnings plus net income minus dividends gives you ending retained earnings.

And the closing process is the process by which we're doing this right here. So this formula really, this formula is the closing process. And there's really not a whole lot to remember because you've got revenues, you've got expenses, and you've got dividends. Right? Now, they all have balances in them already.

You don't have to really know much of anything. To close revenues, you put $10,000 on the left. Right? Then in this income summary, you just do the opposite. So you started with $10,000 on the right, you put it on the left, then put it back on the right so that the left and the right balance because you have revenue, 10,000; income summary, 10,000. So all you're trying to do is make it balance. So you're not really even doing any thinking. Expenses, $4,000 left, $4,000 right, $4,000 left. Right? It's just left, right, left, right, left, right. So then you have expenses, 4,000; income summary, 4,000.

That comes out to 6,000. You've got retained earnings. Well, let's close this out. 6,000 left, 6,000 right. 1,000 right, 1,000 left. If you had a $10,000 opening balance, you'd end up with $15,000 at the end. It's not thinking. You're not having to think at all. All you're doing is taking beginning plus net income, and net income happens to be revenues minus expenses, and this right here is this income summary, minus dividends gives you ending. So this is this. The closing process is actually just the statement of retained earnings.