Closing Entries for a Merchandising Company: A Worked Example
Closing entries for a merchandising company are end-of-period journal entries that bring every temporary account to zero. Close sales and other revenues to Income Summary, then close sales discounts, sales returns and allowances, cost of goods sold, and other expenses. Transfer Income Summary’s balance (net income or loss) to Retained Earnings, then close Dividends to Retained Earnings.
The distinctive challenge is contra revenue. Sales discounts and returns reduce revenue, but their normal balances are debits. Close them with credits, just as you close debit-balance expenses. The example assumes the balances have been adjusted and the financial statements prepared.
Watch: Closing Entries Explained Step by Step
Closing Entries Simplified Using Example & Journal Entries
This Farhat lecture reviews the general four-step process. Apply that foundation to the merchandising accounts in the original example below.
Which merchandising accounts close?
Temporary accounts measure activity for one period. Permanent accounts carry financial position into the next period. Closing entries are bookkeeping only. They do not involve cash, collect receivables, or pay suppliers.
| Account | Normal balance in this example | Closing treatment |
|---|---|---|
| Sales revenue; interest revenue | Credit | Debit to bring to zero |
| Sales discounts; sales returns and allowances | Debit | Credit to bring to zero |
| Cost of goods sold and other expenses | Debit | Credit to bring to zero |
| Dividends | Debit | Credit; debit Retained Earnings |
| Inventory, receivables, equipment, liabilities, common stock | Permanent balances | Carry forward; do not close |
Income Summary is a temporary clearing account used in this teaching method. Its balance after revenues and expenses have been closed equals the period’s net income or loss. The OpenStax explanation of closing entries provides the general framework. For the foundation, see our general closing entries guide.
Original example: Harbor Retail’s adjusted balances
Hypothetical example. Harbor Retail Inc. has the following temporary account balances at December 31, 20X7. Beginning Retained Earnings is $22,000. These are the same facts used in the companion merchandising company financial statements example. All amounts are dollars; no additional accounts or adjustments are assumed.
| Temporary account | Debit balance | Credit balance |
|---|---|---|
| Sales revenue | — | $250,000 |
| Interest revenue | — | 1,000 |
| Sales discounts | $4,000 | — |
| Sales returns and allowances | 6,000 | — |
| Cost of goods sold | 150,000 | — |
| Selling expenses — combined for this example | 30,000 | — |
| Administrative expenses — combined for this example | 40,000 | — |
| Interest expense | 3,000 | — |
| Income tax expense | 4,500 | — |
| Dividends | 3,500 | — |
The selling and administrative rows represent combined expense balances to keep the entry readable. In an actual ledger, credit each separate expense account for its own adjusted balance. Dividends are listed because they close, but they are not included in the profit calculation.
Record closing entries for a merchandising company
1. Close revenue accounts
Sales Revenue and Interest Revenue have credit balances. Debit each for its full balance and credit Income Summary for the total, $251,000.
| Account — December 31, 20X7 | Debit | Credit |
|---|---|---|
| Sales Revenue | $250,000 | — |
| Interest Revenue | 1,000 | — |
| Income Summary | — | $251,000 |
After posting, both revenue accounts are zero. Income Summary has a $251,000 credit balance. Do not substitute net sales for Sales Revenue here: the ledger contains a $250,000 sales account and separate contra revenue accounts.
2. Close contra revenue and expense accounts
Credit the debit-balance accounts to eliminate their balances. The offset is a debit to Income Summary. The total is $4,000 + $6,000 + $150,000 + $30,000 + $40,000 + $3,000 + $4,500 = $237,500.
| Account | Debit | Credit |
|---|---|---|
| Income Summary | $237,500 | — |
| Sales Discounts | — | $4,000 |
| Sales Returns and Allowances | — | 6,000 |
| Cost of Goods Sold | — | 150,000 |
| Selling Expenses — combined | — | 30,000 |
| Administrative Expenses — combined | — | 40,000 |
| Interest Expense | — | 3,000 |
| Income Tax Expense | — | 4,500 |
Contra revenue is not an operating expense. Combining these debit-balance accounts in one closing entry is a journalizing convenience; the income statement still deducts discounts and returns from sales before calculating gross profit. For transaction-level detail, see our sales discounts guide and sales returns and allowances guide.
Exam tip: when Sales Discounts has its normal debit balance, credit it to close. In that case, eliminate any option that debits Sales Discounts in the closing entry.
3. Close Income Summary to Retained Earnings
Income Summary now has a $13,500 credit balance: $251,000 − $237,500. That matches net income. Eliminate it with a debit and increase Retained Earnings with a credit.
| Account | Debit | Credit |
|---|---|---|
| Income Summary | $13,500 | — |
| Retained Earnings | — | $13,500 |
If expenses and contra revenue had exceeded revenue, Income Summary would instead have a debit balance. For a $2,000 net loss, debit Retained Earnings $2,000 and credit Income Summary $2,000. The loss decreases accumulated earnings.
4. Close Dividends directly to Retained Earnings
Dividends distribute earnings to shareholders. They bypass Income Summary because they are not expenses and do not affect net income.
| Account | Debit | Credit |
|---|---|---|
| Retained Earnings | $3,500 | — |
| Dividends | — | $3,500 |
Check retained earnings and the remaining balances
Ending Retained Earnings is $22,000 + $13,500 − $3,500 = $32,000. This must agree with the retained earnings statement and the equity section of the balance sheet. The SEC financial statements guide explains how earnings and shareholder distributions relate to equity.
Verify that Sales Revenue, both contra revenue accounts, COGS, other expenses, Dividends, and Income Summary are all zero. Inventory and other permanent accounts remain. For Harbor, inventory stays at $35,000; closing COGS does not remove that unsold merchandise. A post-closing trial balance lists the remaining permanent balances.
Adjusting entries versus closing entries: what changes?
Adjusting entries measure the correct revenues, expenses, assets, and liabilities before financial statements are prepared. Closing entries for a merchandising company come afterward: they transfer the completed period’s results to Retained Earnings and reset temporary accounts for the next period. The distinction matters because an adjustment can change net income, whereas the closing process transfers the net income already calculated.
For example, if December wages have been earned but not recorded, the company first debits Wages Expense and credits Wages Payable. That adjustment increases expenses and liabilities. When the expense accounts are later closed, Wages Expense returns to zero, but Wages Payable remains outstanding. Closing does not pay the employees or remove the liability. The same distinction applies to an unpaid interest expense recorded before year-end.
Inventory requires a separate timing check. In the perpetual example above, Harbor’s adjusted Cost of Goods Sold balance is already $150,000 and its ending Inventory is $35,000. Use those adjusted balances when closing. Under the periodic approach shown below, the beginning inventory, purchase accounts, and ending inventory are incorporated into the closing entries. Do not combine the two methods by recording the same inventory change twice.
Before preparing closing entries for a merchandising company, label each balance as temporary or permanent and confirm whether it is a debit or a credit. Then ask what the entry accomplishes: does it update a balance for an unrecorded economic event, or does it transfer an already measured result? This question helps distinguish an adjusting entry from a closing entry without relying only on the account names.
Finally, compare the statements and ledger at the correct point in the cycle. The adjusted trial balance supports the financial statements. The post-closing trial balance confirms the permanent balances carried forward. A zero expense balance after closing does not mean that the business incurred no expenses; the period’s expenses remain reported on its completed income statement.
How Do Closing Entries Differ Under the Periodic Inventory System?
Everything above assumes a perpetual inventory system, where Cost of Goods Sold is updated with every sale. Under a periodic system, inventory is counted at the end of the accounting period instead of being tracked continuously, so there is no running Cost of Goods Sold account. Instead, the ledger holds Purchases, Purchase Discounts, Purchase Returns and Allowances, and Freight-In, plus the beginning inventory balance.
One common textbook approach updates inventory inside the closing entries. Assume Harbor used a periodic system with these balances: beginning inventory $30,000, Purchases $160,000, Purchase Discounts $3,000, Purchase Returns and Allowances $5,000, Freight-In $3,000, and an ending inventory count of $35,000. Every other account matches the example above. Cost of goods sold still works out to $150,000: $30,000 + $160,000 − $3,000 − $5,000 + $3,000 − $35,000.
Entry 1: Close credit-balance accounts and record ending inventory
| Account | Debit | Credit |
|---|---|---|
| Sales Revenue | $250,000 | — |
| Interest Revenue | 1,000 | — |
| Merchandise Inventory (ending) | 35,000 | — |
| Purchase Discounts | 3,000 | — |
| Purchase Returns and Allowances | 5,000 | — |
| Income Summary | — | $294,000 |
Entry 2: Close debit-balance accounts and remove beginning inventory
| Account | Debit | Credit |
|---|---|---|
| Income Summary | $280,500 | — |
| Merchandise Inventory (beginning) | — | $30,000 |
| Sales Discounts | — | 4,000 |
| Sales Returns and Allowances | — | 6,000 |
| Purchases | — | 160,000 |
| Freight-In | — | 3,000 |
| Selling Expenses (combined) | — | 30,000 |
| Administrative Expenses (combined) | — | 40,000 |
| Interest Expense | — | 3,000 |
| Income Tax Expense | — | 4,500 |
Income Summary now has a credit balance of $294,000 − $280,500 = $13,500, the same net income as before. Steps 3 and 4 are identical to the perpetual example. Inventory ends at $35,000 because the $30,000 beginning balance was removed and the $35,000 count was recorded.
Your textbook may record ending inventory and cost of goods sold with an adjusting entry before closing instead. Follow the method your instructor uses. Net income and ending retained earnings come out the same either way.
Common mistakes to avoid
- Debiting sales discounts again: its debit balance needs a credit to close.
- Closing only net sales: clear each actual ledger account, including separate contra revenue accounts.
- Closing dividends in step 2: dividends are not an expense. If Harbor included its $3,500 of dividends in step 2, Income Summary would show $10,000 instead of the $13,500 net income. Close them separately in step 4.
- Closing permanent contra assets: accumulated depreciation and the receivables allowance carry forward.
- Skipping the reconciliation: Income Summary’s balance before step 3 should match the income statement.
Closing Entries for a Merchandising Company: Key Takeaways
- Close every temporary account: revenues, contra revenues, cost of goods sold, other expenses, and Dividends.
- Sales discounts and sales returns and allowances have debit balances, so you credit them to close.
- Before step 3, Income Summary’s balance equals net income ($13,500 for Harbor).
- Dividends skip Income Summary and close directly to Retained Earnings.
- Inventory is permanent. Closing cost of goods sold does not touch the $35,000 still on hand.
- Check your work: beginning retained earnings + net income − dividends = ending retained earnings ($22,000 + $13,500 − $3,500 = $32,000).
Closing Entries for a Merchandising Company: Interactive Exercise
Practice closing entries, contra revenue, Income Summary, and Retained Earnings with six multiple-choice questions. Check your understanding of the closing process, review the explanations, then apply the rules in the three numerical practice questions below.
Choose the correct answer
Select one answer per question, then select “Check answers.”
Answer key and explanations
- Merchandise Inventory. It is a permanent asset, so it carries forward. Sales Discounts and Cost of Goods Sold are temporary and close to zero.
- Debit Income Summary $6,000; credit Sales Returns and Allowances $6,000. The credit removes the debit balance, and contra revenue accounts need their own closing entry.
- Debit Retained Earnings $6,000; credit Income Summary $6,000. Contra revenue plus expenses exceed revenues by $6,000, so Income Summary has a debit balance (a net loss) that reduces Retained Earnings.
- Dividends are distributions to owners, not expenses, so they never affect net income. That is why they close directly to Retained Earnings.
- Net income or net loss. If Income Summary does not match the income statement before step 3, find the error before you close it.
- $47,000. $40,000 + $12,000 − $5,000 = $47,000.
Three practice questions with explained answers
1. Sales Discounts has a $900 debit balance. How is it closed?
Answer: Debit Income Summary $900; credit Sales Discounts $900. The credit eliminates its existing debit balance.
2. Revenue totals $120,000; contra revenue and expenses total $112,000. What is step 3?
Answer: Debit Income Summary $8,000 and credit Retained Earnings $8,000. The $8,000 difference is net income.
3. Beginning retained earnings is $14,000, net loss is $2,000, and dividends are $1,000. What remains after closing?
Answer: Retained Earnings is $11,000. Both the loss and dividends reduce equity: $14,000 − $2,000 − $1,000.
Frequently asked questions
Does inventory close at year-end?
No. Merchandise Inventory is a permanent asset, so its balance carries into the next period. Under the perpetual system it never appears in a closing entry. Under the periodic system, some textbooks use the closing entries to remove beginning inventory and record ending inventory, but the account itself is not closed to zero. See the periodic section above for a worked example.
Are sales returns expenses?
No. Sales Returns and Allowances is contra revenue. Its debit balance closes in the same direction as an expense, but its income statement classification differs.
Do closing entries change net income?
No. They transfer the period’s net income or loss, which is already determined, to Retained Earnings and reset the temporary accounts. Correct closing entries do not create another sale or another expense.
Do You Have to Use an Income Summary Account?
No. Income Summary is a teaching and checking tool. Many companies close revenues and expenses directly to Retained Earnings, and most accounting software rolls net income into Retained Earnings automatically at year-end. The ending Retained Earnings balance is the same either way. Use Income Summary when your course or exam question does.
Is Cost of Goods Sold Closed?
Yes. Cost of Goods Sold is a temporary expense account with a debit balance, so you credit it to close. Merchandise Inventory, the asset, is not closed and carries forward to the next period.
How Are Merchandising Closing Entries Different From a Service Company’s?
A merchandising company has extra temporary accounts to close: Cost of Goods Sold and contra revenue accounts such as Sales Discounts and Sales Returns and Allowances. Under the periodic system it also closes purchase accounts such as Purchases and Freight-In. The four steps are the same.
About the author: Mansour Farhat, CPA, CIA, DBA, creates the courses and YouTube lessons at Farhat Lectures, where he teaches accounting along with CPA, CMA, and EA exam topics.
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