Welcome to Accounting 101 episode 16 closing the books at the end of the period the closing process. If you recall from our episode on the accounting cycle after we prepare our adjusted trial balance and prepare our financial statements. We have to reset all of the temporary accounts to zero for the next accounting period the temporary accounts that we are going to reset to zero or every revenue account every expense account as well as the contribution and distribution accounts with the inequity. If you recall from L re we have a hyphen between our balance sheet accounts. And our income statement accounts today, we are mostly going to be focused on the income statement because this process is how the income statement is reset to zero each year. So every single account on the income statement will be zero when we are done. This process also affects owners distribution and contribution accounts. You may see these accounts called different things based on the type of entity, but I'm trying to be as generic as possible right now because the concept is the same regardless of what the title of the account is owners distribution and contribution accounts are accounts with inequity that track money received from or given to owners as distributions or contributions side note and I don't Get to off topic here, but I do want you to understand that the owners of a company can get money into or out of a company in a variety of different ways. So they can make loans to or from the company. They can take money out in the form of a salary. They can take money out as a management fee Etc. We are talking specifically just about contributions and distributions. The closing process however is more involved with the revenue and expense accounts because there are a lot more of them. To Briefly summarize the closing process. We will Zero out each revenue account each expense account and each owners distribution or contribution accounts by making whatever debit or credit we need to for the ending account balance to be 0 and that debit or credit we make in each revenue account and each expense account will have a corresponding debit or credit for the same amount. To an account called income summary you may see this called income summary clearing account revenue and expense summary profit and loss summary or income and expense summary. It's all the same thing. It doesn't matter what we call it. I'm just going to generically call it the income summary account for Simplicity the corresponding debit or credit for the owners distribution and contribution accounts will be made directly to the capital. Out the income summary account itself is temporary. It will have no balance before we start and it will have no balance by the time we're done the income summary account helps us transfer the net income or net loss from our income statement to the balance sheet. As we discussed in an earlier episode Equity is the transfer point between the income statement and the balance sheet and this income summary account is the mechanism used to actually make the debits and credits to transfer the temporary account balances to equity. So let's do a pretty simple example. Let's say for this period you have a sole proprietorship and you had revenue of $100,000 wage expense of $40,000 and computer expense of $30,000. Let's also assume that you as the sole owner contributed $10,000 to the company this year. Again, and feel free to roll your eyes. Every time I say this now this process like almost every other concept I've went over with you is entirely about using the L re method and understanding of the debits and credits as you will see if we look at our income statement. We will see that we have 100,000 dollars of Revenue and seventy thousand dollars of expenses. So the net income for the company is $30,000 stated another way on our income statement. We have $100,000 of credits and $70,000 of debits. So the net amount from our income statement is $30,000 of credits, which represents $30,000 of positive income. We know we must reset our income statement at the end of the period. So we need to transfer this $30,000 of credits from the income statement which represents the $30,000 of positive income to in equity account on the balance sheet. And we also know that Equity has a normal credit balance. So we 30 thousand dollar credit transferred from the income statement to equity will increase equity. That makes sense because if you make 30,000 in income for your business, you would expect that your Equity would increase by 30,000 pause here to absorb this if you need to this is an important concept to understand. The opposite is true, too. If we had 100,000 dollars of expenses and only 70,000 of Revenue. Everything would be reversed. We would have a debit balance on our income statement. And if we were to transfer a debit balance from our income statement to equity on the balance sheet Equity would be reduced by 30 thousand dollars back to our example after we prepare the financial statements and are ready to close out the books. We will make the following entries. Free to follow along with t-accounts and journal entries for our revenue account. We will assume that it is just one account for Simplicity. But you need to do this for each revenue account. So our revenue account that is currently sitting with a 100 thousand dollar credit balance. We make the following entry debit Revenue 100,000 Credit Income summary, 100,000 the effect of this transaction is that Revenue will nail have a Zero balance and we will now have a 100,000 credit balance in the income summary account. We transferred the credit balance from revenue to the income summary account. We do the same thing for our to expense accounts. We will credit wage expense for 40,000 and debit income summary for 40,000. This will reduce our wage expense balance to zero. We will credit computer expense for 30,000 and debit income summary for 30,000 as well. This will reduce our computer expense balance to zero if you're keeping score at home. Now, all of our revenue and expense accounts are at zero and we have $70,000 of debits and 100,000 of credits on the income summary account. This means that our income summary account has a credit balance of $30,000. So all we Done so far is transfer our thirty thousand dollar credit balance from our income statement to the income summary account. The next step is to transfer the balance from the income summary account to your capital account, which is an equity account on the balance sheet. We will debit income summary for $30,000 and credit your capital account for $30,000 the effect of this transaction is that the income summary account now has a zero balance. We're done with it. And your Capital account was increased by thirty thousand dollars, which represents the net income for the year from the income statement. Now, we must also consider the cash contribution of ten thousand dollars that you made during the year when the contribution was made assuming it was one transaction. We would have made the following entry debit cash $10,000 because the company received cash and credit your owners contribution account for $10,000. Owners contribution is an equity account. But as we discussed earlier contribution and distribution accounts are temporary for each accounting period so we need to reset that amount to zero and transfer the balance to your capital account. Unlike when we transferred our income this transaction will be Equity neutral because both accounts are within equity on the balance sheet. We already increased Equity when we booked that first journal entry, and I'm Wing it a capital account in this example because we are using a sole proprietorship the actual name of the account will vary based on the type of the entity. This could be a capital account. It could be a retained earnings account. The debits and credits are the same. However, so we have a ten thousand dollar credit balance sitting in contributions. We need to debit contributions for $10,000 and credit your Capital account for $10,000. The effect of this transaction is that it zeros out the contribution account and your Capital account was just increased by ten thousand dollars. So again, the company's Equity was instantly increased when you contributed the $10,000 but since the contribution and distribution accounts need to be wiped out at the end of the accounting period we make this entry 2. Transfer it from the contribution or distribution accounts to the capital account. So in total your Capital account was increased by forty thousand four that year 30,000 from the net income and 10,000 from the contribution. But keep in mind that although the capital account was increased by forty thousand during the closing process Equity itself was only increased by thirty thousand during the closing process because what we just discussed If This Were A Loss or if it were a distribution rather than a contribution it would be the same thing except it would be debit balances being transferred rather than credit balances The next step after the closing process is to prepare a post-closing trial balance, but you may or may not actually do that in practice often. That's just a theoretical step but the books are now ready for the next year our Revenue accounts and our expense accounts all show zero balances and our contribution and distribution accounts all showed zero balances because each revenue and expense account shows a zero balance. That means that the income statement has nothing on it. Blank, if you are using an accounting software program, there's a good chance that the computer is closing the books for you automatically, but it's important for your Mastery of accounting that you understand how this process works at the debit credit level. That's all I have on closing the books. I hope that makes as much sense to you as it does to me, please tell your classmates roommates and friends about the show. I really think that anyone who listens to the show can pass accounting one with no problem and this knowledge will help prepare. Are you for more advanced accounting Concepts? Please also spend a moment to rate and review the show. I appreciate those of you who have already done. So and for the kind words, I am very happy that I am able to help some of you. Hopefully all of you understand accounting at a higher level. Thanks for joining me. I'll speak to you next time.
Example: You own a sole proprietorship. For this period, you had revenue of $100,000, wage expense of $40,000, and computer expense of $30,000 (net income of $30,000). You also contributed $10,000 to the business this period. Step 1 – Transfer Revenue and Expense items to Income Summary                                                              Debit           Credit Revenue                                        $100,000             Income Summary                                  $100,000 Income Summary                       $40,000            Wage Expense                                           $40,000 Income Summary                       $30,000            Computer Expense                                  $30,000 Step 2 – Transfer Income Summary to Equity (capital account)                                                                   Debit           Credit Income Summary                            $30,000            Capital Account – YOUR NAME                 $30,000 Step 3 – Transfer contribution/distribution accounts to capital account                                                             Debit          Credit   Contributions – YOUR NAME     $10,000           Capital Account – YOUR NAME           $10,000 