Closing Entries: 4 Simple Steps with Journal Entries

Closing entries are journal entries recorded at the end of an accounting period to reset temporary accounts (revenues, expenses, and dividends) to zero and move the period’s results into retained earnings. Using the four-step method, you close revenues and expenses to Income Summary, close Income Summary to retained earnings, then close dividends directly to retained earnings.

The purpose is to separate one period’s activity from the next. Closing does not pay bills, collect receivables, or erase transaction history. This tutorial continues the original Cedar Studio example from preparing financial statements.

Watch Professor Farhat explain

Watch the related Farhat lesson on YouTube. Selected segment: 4:43–17:30.

This segment of Professor Farhat’s closing process lesson runs about 13 minutes. Watch it first, then work through the Cedar Studio entries below at your own pace.

Which accounts do closing entries affect?

Don’t go by the account name alone. Unearned service revenue is a liability, so it is permanent. Accumulated depreciation is a contra asset, so it also remains. Depreciation expense is temporary.

Retained earnings is permanent even though closing entries change its balance. “Permanent” means the account is not reset to zero at every period-end. This distinction prevents a common error: closing every equity-related account just because dividends are closed.

Start with the adjusted balances

Hypothetical example. Cedar Studio Inc. closes its books on December 31, 20X7 after preparing its statements. Its adjusted balances include service revenue of $40,000; salaries expense of $16,000; rent expense of $6,000; insurance expense of $1,000; supplies expense of $2,000; and depreciation expense of $1,000. Dividends have a $2,000 debit balance. Beginning retained earnings is $8,000.

Total expenses are $26,000 and net income is $14,000. Use the actual adjusted balance of each account. A closing entry must be recorded on the opposite side of that balance to bring the account to zero.

What are the four closing entries?

Step 1: Close revenue to Income Summary

Service revenue has a normal credit balance. Debit it for $40,000 and credit Income Summary for the same amount. The revenue account becomes zero; Income Summary temporarily holds a $40,000 credit.

Step 2: Close expenses to Income Summary

Expenses have debit balances in this example. Credit each expense for its full adjusted balance and debit Income Summary for their combined amount.

Income Summary now contains a $40,000 credit and a $26,000 debit, leaving a $14,000 credit balance. This equals net income on Cedar’s income statement. If the amounts disagree, investigate before continuing.

Step 3: Close net income to Retained Earnings

The debit clears Income Summary. The credit increases retained earnings from $8,000 to $22,000 before considering dividends. Income Summary is a temporary clearing account used during closing, not a financial statement.

Step 4: Close Dividends directly to Retained Earnings

Dividends reduce retained earnings to $20,000. They bypass Income Summary because they are distributions to shareholders, not expenses. Closing the Dividends account does not pay anyone. The dividend was already recorded when the board declared it, and any unpaid amount still sits in Dividends Payable.

Post the entries and check the ending balances

Journalizing writes the entries in the journal, just like any other transaction. Posting transfers each debit and credit to its ledger account. Both steps are necessary: an unposted closing entry leaves the ledger balances unchanged.

Exam tip: If a question only asks for ending retained earnings, you don’t need to journalize anything. Use beginning retained earnings plus net income minus dividends. For Cedar Studio, that is $8,000 + $14,000 − $2,000 = $20,000.

Now prepare the post-closing trial balance from the updated ledger. Cash, receivables, equipment, and liabilities are carried forward. A check of temporary accounts should reveal no remaining balance.

What changes when there is a net loss?

In a separate hypothetical case, suppose revenue is $18,000 and expenses are $23,000. After the first two closing entries, Income Summary has a $5,000 debit balance. Clear it with a $5,000 credit and debit Retained Earnings for $5,000. A loss reduces accumulated earnings.

The dividend entry still debits Retained Earnings and credits Dividends. Do not mechanically repeat the net-income entry when Income Summary has a debit balance. Check the balance before choosing the direction.

How do closing entries work for sole proprietorships and partnerships?

The steps are the same, but the equity account changes. A corporation closes Income Summary to Retained Earnings. A sole proprietorship closes it to the owner’s capital account, and a partnership splits it among the partners’ capital accounts based on their partnership agreement.

The owner’s drawing account (also called withdrawals) takes the place of Dividends. It is closed directly to capital, just like Dividends is closed directly to Retained Earnings.

Quick example: Lina’s design business, a sole proprietorship, has net income of $10,000 and owner withdrawals of $3,000.

Entry 3: Debit Income Summary $10,000; credit Lina, Capital $10,000.

Entry 4: Debit Lina, Capital $3,000; credit Lina, Drawing $3,000.

Lina’s capital increases by a net $7,000.

Closing entries vs. adjusting entries: what’s the difference?

Students mix these up because both happen at the end of the period. Here is the short version.

In the accounting cycle, the order is: adjusting entries, adjusted trial balance, financial statements, closing entries, and then the post-closing trial balance.

What are the most common closing entry mistakes?

Doubling a balance: crediting a revenue account that already has a credit balance makes it bigger instead of clearing it. Close each account on the side opposite its balance. Revenues usually need a debit and expenses usually need a credit. Watch for contra-revenue accounts, which are accounts that reduce revenue, such as Sales Returns and Allowances and Sales Discounts. They normally carry debit balances, so they are closed with a credit, usually in the same entry that closes expenses. Cost of Goods Sold is an expense, so it closes with the other expenses.

Closing permanent accounts: accounts payable and accumulated depreciation remain open even though related expenses close.

Confusing adjusting and closing: adjusting entries update recognition and measurement before statements; closing entries reset temporary accounts afterward. Reversing entries, when used, are optional entries at the beginning of the next period that reverse selected adjustments. They are a separate procedure.

For an independent educational reference on the bookkeeping mechanics, see OpenStax’s explanation of closing entries. The SEC’s Beginners’ Guide to Financial Statements explains how net income and shareholders’ equity fit together. Both sources describe dividends as a distribution of earnings to owners.

Three practice questions with explained answers

1. A revenue account has a $7,500 credit balance. How is it closed?

Answer: Debit Revenue $7,500; credit Income Summary $7,500. The debit offsets the existing credit balance.

2. Income Summary has a $2,400 debit balance after revenue and expenses are closed. What is the next entry?

Answer: Debit Retained Earnings $2,400; credit Income Summary $2,400. The debit balance represents a loss.

3. Should $900 of dividends be closed through Income Summary?

Answer: No. Debit Retained Earnings $900 and credit Dividends $900. Dividends reduce equity without reducing net income.

Want more practice like this? The Farhat Lectures Free Sample Course lets you try lessons before you commit to a full course.

Key takeaways

• Closing entries reset revenues, expenses, and dividends to zero at the end of the period.
• After revenues and expenses are closed, Income Summary equals net income or net loss. After that balance is transferred to Retained Earnings, Income Summary equals zero.
• Net income is closed with a credit to Retained Earnings; a net loss is closed with a debit.
• Dividends close directly to Retained Earnings and never pass through Income Summary.
• Permanent accounts, including Retained Earnings, are never closed.

Frequently asked questions

Must every company use Income Summary?

No. Some systems close revenues and expenses directly to retained earnings. The four-step method makes the net-income check visible and is the approach used here.

Are books closed every month?

A textbook may use monthly closing to illustrate the process. Many companies prepare monthly reports while formally closing temporary accounts annually; procedures depend on the accounting system.

Does closing erase the past year’s transactions?

No. The journal and ledger history remain available. Closing brings the temporary account balances to zero for the next period while preserving the records.

When are closing entries recorded?

At the end of the accounting period, after the adjusting entries are posted and the financial statements are prepared. The post-closing trial balance comes next.

Which accounts are not closed?

Permanent accounts: assets, liabilities, and equity accounts such as Common Stock and Retained Earnings. Their balances carry into the next period. Contra assets like Accumulated Depreciation are not closed either.

Can closing entries be reversed?

Not as a normal step. Reversing entries are a separate, optional procedure that undoes selected adjusting entries at the start of the next period. If a closing entry contains an error, record a correcting entry.

Does accounting software make closing entries automatically?

Many accounting software packages handle year-end closing automatically by rolling net income into retained earnings, so you may never type these entries yourself. Knowing them still matters for exams and for checking the results.

About the author

Mansour Farhat, CPA, CIA, DBA, is the instructor behind Farhat Lectures. He teaches accounting and CPA exam topics through online courses and the Farhat Lectures YouTube channel.