Four steps through Income Summary; dividends straight to retained earnings

Why some accounts restart at zero

Revenue, expense and dividend accounts measure a period. Service Revenue of 214,000 means 214,000 this year; on 1 January it must read zero so that next year's figure is next year's. These are the temporary accounts. Assets, liabilities and equity accounts measure a position — cash on hand, a loan owed, shares issued — and carry forward: the permanent accounts. Closing empties the temporary accounts into Retained Earnings, which is where a year's income and dividends belong once the year is over.

Worked example — Harrowgate Landscaping Ltd., 31 December

Adjusted balances: Service Revenue 214,000; Interest Revenue 600; Salaries Expense 98,500; Rent Expense 24,000; Supplies Expense 11,300; Amortization Expense 17,200; Insurance Expense 4,800; Interest Expense 3,900; Dividends 12,000; Retained Earnings (opening) 41,700.

Step 1 — close the revenues. Revenues have credit balances; debit each to zero and credit the total to a clearing account, Income Summary:

Dec 31  Service Revenue                 214,000
        Interest Revenue                    600
            Income Summary                         214,600

Step 2 — close the expenses. Expenses have debit balances; credit each to zero and debit Income Summary with the total, $98,500+24,000+11,300+17,200+4,800+3,900=159,700$:

Dec 31  Income Summary                  159,700
            Salaries Expense                        98,500
            Rent Expense                            24,000
            Supplies Expense                        11,300
            Amortization Expense                    17,200
            Insurance Expense                        4,800
            Interest Expense                         3,900

Income Summary now holds a credit of $214,600-159,700=54,900$ — and that is net income. If it is not, an entry upstream is wrong: a revenue or expense was missed or miscopied. Income Summary is a check, not a statement account; it exists for a few minutes on the last day of the year.

Step 3 — close Income Summary to Retained Earnings. Dr Income Summary 54,900 / Cr Retained Earnings 54,900. (A net loss would run the other way: Dr Retained Earnings / Cr Income Summary.)

Step 4 — close Dividends to Retained Earnings. Dr Retained Earnings 12,000 / Cr Dividends 12,000. Dividends are not an expense and never touch Income Summary — routing them through it would make the Income Summary balance disagree with net income, which is exactly the check step 2 relies on.

Retained Earnings after closing: $41,700+54,900-12,000=84,600$ — the same figure the statement of retained earnings computed. Closing is how the ledger catches up with the statement.

The post-closing trial balance

After the four entries, every temporary account is zero and a trial balance is taken again. It lists permanent accounts only — Cash, receivables, prepaids, Equipment and its Accumulated Amortization, the payables, Common Shares, and Retained Earnings at its closing figure of 84,600. No revenue, no expense, no Dividends, no Income Summary. Accumulated Amortization is on it: a contra asset is a permanent account and is never closed — its balance is the wear to date, which is a position, not a period.

The order of the year end

Adjust → adjusted trial balance → statements → close → post-closing trial balance. Closing comes after the statements because the statements need the temporary balances; close first and there is nothing left to report.