Why Revenue and Expense Accounts Are Closed
An income statement reports activity over a defined period, while retained earnings is part of the company’s accumulated equity. At the end of a period, the revenue and expense balances must be transferred so that the next period’s income measurement starts afresh. The closing process accomplishes this transfer through journal entries; it does not erase the period’s result from equity.
Revenue accounts normally have credit balances, and expense accounts normally have debit balances. Closing entries reverse those balances to bring each account to zero. Income Summary collects the period’s revenues and expenses; its remaining balance is then transferred to retained earnings. If revenues exceed expenses, the period has net income. If expenses exceed revenues, it has a net loss.
The closing entries are bookkeeping transfers, not new revenue, expenses, cash flows, or asset purchases. They move the accumulated result from temporary accounts into equity. The adjusted balances used below are assumed to include all required period-end adjustments.
The Closing Sequence
Use the adjusted revenue and expense balances. The entries are dated at the end of the reporting period and are posted to the ledger in sequence. The usual sequence is to close revenues to Income Summary, close expenses to Income Summary, and then close Income Summary to retained earnings.
Debit each revenue account for its credit balance and credit Income Summary for the total revenues. This reduces the revenue balances to zero.
Debit Income Summary for total expenses and credit each expense account for its debit balance. This reduces the expense balances to zero.
If Income Summary has a credit balance, debit it and credit retained earnings. If it has a debit balance, credit it and debit retained earnings.
The account balances explain the directions of the entries. Closing revenues removes credit balances with debits; closing expenses removes debit balances with credits. After the first two steps, the balance in Income Summary equals revenues minus expenses. Its balance determines whether the final transfer increases or decreases retained earnings.
Why the Transfer Equals Net Income or Net Loss
Let \(R\) be total revenue for the period and \(E\) be total expenses. After the revenue-closing entry, Income Summary has a credit balance of \(R\). After the expense-closing entry, it has received debits of \(E\). Therefore its remaining balance is:
This is the period’s net income when \(R>E\), or the negative of the net loss when \(E>R\). The final entry clears that balance. For net income, debiting Income Summary removes its credit balance, and crediting retained earnings transfers the increase in equity. For a net loss, crediting Income Summary removes its debit balance, and debiting retained earnings transfers the decrease.
This follows the accounting equation: revenues increase equity through income, while expenses reduce equity through income. Closing the accounts changes where the period’s result is recorded, not the total equity created or reduced by the period’s operations. After the entries, the revenue accounts, expense accounts, and Income Summary have zero balances. They can then accumulate only the next period’s activity.
Worked Example: Closing Accounts With Net Income
A hypothetical design firm has the following adjusted balances at December 31: design revenue, $84,600 credit; rent expense, $18,000 debit; wages expense, $31,200 debit; supplies expense, $4,400 debit; depreciation expense, $2,000 debit; and insurance expense, $1,000 debit. Prepare the closing entries and verify the result.
Method: total the adjusted balances, then close each class of account. Total expenses are:
Revenue exceeds expenses by \(84{,}600-56{,}600=28{,}000\), so the firm has net income of $28,000.
Entry 1: close revenue. Debit design revenue $84,600 and credit Income Summary $84,600. Design revenue is now zero, and Income Summary has a credit balance of $84,600.
Entry 2: close expenses. Debit Income Summary $56,600. Credit rent expense $18,000, wages expense $31,200, supplies expense $4,400, depreciation expense $2,000, and insurance expense $1,000. The credits total $56,600, so the entry balances. Each expense account is now zero, and Income Summary has a credit balance of \(84{,}600-56{,}600=28{,}000\).
Entry 3: close Income Summary. Debit Income Summary $28,000 and credit retained earnings $28,000. Income Summary is now zero. The credit to retained earnings records the period’s net income in equity.
Check. The closing credits and debits balance within each entry. Each revenue and expense account has been cleared, and the $28,000 credit transferred to retained earnings equals the independently calculated net income. The common mistake avoided is crediting Income Summary for expenses instead of debiting it.
Worked Example: Closing Accounts With a Net Loss
A hypothetical repair shop reports adjusted service revenue of $52,000 credit. Its adjusted expenses are wages, $35,000 debit; rent, $12,000 debit; utilities, $5,500 debit; and depreciation, $9,000 debit. Prepare the closing entries.
Method: compare total expenses with total revenue before deciding the final entry’s direction. Total expenses are:
Expenses exceed revenue by \(61{,}500-52{,}000=9{,}500\). The period therefore has a net loss of $9,500.
Entry 1: close revenue. Debit service revenue $52,000 and credit Income Summary $52,000.
Entry 2: close expenses. Debit Income Summary $61,500; credit wages expense $35,000, rent expense $12,000, utilities expense $5,500, and depreciation expense $9,000. The credits total $61,500.
Income Summary now has a debit balance of \(61{,}500-52{,}000=9{,}500\). Entry 3: close the loss. Credit Income Summary $9,500 and debit retained earnings $9,500. The debit clears Income Summary; the debit to retained earnings records the decrease from the net loss.
Check. The final $9,500 debit to retained earnings equals expenses less revenue, and Income Summary is zero. A frequent error is to credit retained earnings for a loss, using the net-income direction even though Income Summary has a debit balance. The loss requires the opposite direction.
Multiple Revenue and Expense Accounts
A company may have several revenue accounts as well as several expense accounts. Each account must be included at its adjusted balance. The Income Summary credit after the first entry is total revenue, not the balance of just the largest revenue account. Similarly, the debit in the second entry is total expenses. Careful totals are essential when the account list is long.
Worked Example: Closing Several Accounts and Checking the Equity Transfer
A hypothetical analytics firm has adjusted credit balances of $120,000 in consulting revenue and $3,000 in interest revenue. Adjusted debit balances are $64,000 in salaries expense, $18,000 in rent expense, $7,000 in depreciation expense, $2,000 in bad debt expense, and $4,000 in interest expense. Retained earnings before closing is $47,000. Prepare the closing entries and determine retained earnings after this closing process.
Method: aggregate by account type, then close the net result. Total revenue is \(120{,}000+3{,}000=123{,}000\). Total expenses are:
Net income is \(123{,}000-95{,}000=28{,}000\).
Entry 1: close both revenues. Debit consulting revenue $120,000 and interest revenue $3,000; credit Income Summary $123,000. The debits and credit both total $123,000.
Entry 2: close all five expenses. Debit Income Summary $95,000. Credit salaries expense $64,000, rent expense $18,000, depreciation expense $7,000, bad debt expense $2,000, and interest expense $4,000. The credits total \(64{,}000+18{,}000+7{,}000+2{,}000+4{,}000=95{,}000\). Income Summary is left with a $28,000 credit balance.
Entry 3: transfer net income. Debit Income Summary $28,000 and credit retained earnings $28,000. Retained earnings after this closing process is \(47{,}000+28{,}000=75{,}000\).
Check. Every listed revenue and expense balance is cleared, and the Income Summary balance is zero. The increase in retained earnings equals net income. The $75,000 result reflects only the specified opening balance and this income transfer; other equity transactions are outside this calculation.
Common Traps and Practical Checks
The direction of a closing entry follows the balance being removed, not the account’s name alone. Revenue has a normal credit balance, so it takes a debit to close it. Expense has a normal debit balance, so it takes a credit to close it. Income Summary’s direction in the final entry depends on whether it has a credit or debit balance after the first two steps.
For example, suppose total expenses are $56,600. An incorrect expense-closing entry would debit each expense and credit Income Summary for $56,600. That would increase the debit balances in the expense accounts rather than clear them. The correction is to debit Income Summary $56,600 and credit each expense account for its own debit balance. The credits must add to $56,600.
Use these checks before finishing:
- Use adjusted balances, not unadjusted amounts that omit period-end adjustments.
- Confirm that the total debits equal total credits in every entry.
- Confirm that each revenue and expense account ends at zero.
- Calculate \(R-E\) independently and make sure the Income Summary transfer has the matching amount and direction.
Closing transfers the current period’s operating result into retained earnings while clearing the temporary operating accounts. Because those temporary accounts begin the next period at zero, the next income statement measures that period’s activity rather than mixing it with the prior period’s totals.
Check Your Understanding
For each problem, determine the closing result and verify the direction of the Income Summary transfer.
- A hypothetical media studio has advertising revenue of $44,000 and adjusted expenses of $12,000 for wages, $9,000 for rent, and $5,000 for software. State net income and the final closing entry. (Answer: Net income is $18,000; debit Income Summary $18,000 and credit retained earnings $18,000.)
- A hypothetical laboratory has testing revenue of $73,500 and adjusted expenses of $28,600 for salaries, $19,400 for supplies, $8,500 for rent, and $2,000 for depreciation. Give the total expense closing entry amount and the net income transfer. (Answer: Expenses total $58,500; net income is $15,000; debit Income Summary and credit retained earnings for $15,000 in the final entry.)
- A hypothetical distributor has product revenue of $96,000 and service revenue of $14,000. Its expenses are $42,000 for wages, $27,000 for inventory-related expense, $12,000 for rent, $6,000 for delivery, and $3,000 for depreciation. What balance remains in Income Summary after the first two closing entries, and how is it closed? (Answer: Total revenue is $110,000 and total expenses are $90,000, leaving a $20,000 credit balance; debit Income Summary and credit retained earnings $20,000.)
- A hypothetical clinic has revenue of $76,500 and expenses of $47,500 for wages, $16,000 for rent, $3,800 for utilities, and $12,700 for depreciation. Calculate the loss and give the final entry. (Answer: Expenses total $80,000, so the net loss is $3,500; credit Income Summary and debit retained earnings $3,500.)
- A hypothetical engineering firm has revenue of $105,000. Its adjusted expenses are $39,000 for salaries, $24,000 for rent, $18,000 for project costs, $11,000 for depreciation, and $6,000 for insurance. If Income Summary has already been credited for all revenue and debited for all expenses, what balance remains and what final entry clears it? (Answer: Expenses total $98,000, leaving a $7,000 credit balance; debit Income Summary and credit retained earnings $7,000.)