CLOSING ENTRIES: Everything You Need To Know

Summary

In this educational video, James teaches viewers how to post closing entries in accounting, detailing both a long and a short method. He explains the purpose of closing entries in resetting temporary accounts to zero and transferring balances to retained earnings. The video uses the example of a ride-sharing app, Unter, to illustrate the process step-by-step, from adjusting trial balances to creating financial statements, and finally posting closing entries to prepare for the next accounting period.

Takeaways

• 🔢 Closing entries are an essential part of the accounting cycle, occurring as the final step after financial statements are prepared.
• 🔄 They reset temporary accounts like revenue, expenses, and dividends to zero and transfer these balances to the retained earnings account.
• 📚 The acronym 'DEALER' helps remember which accounts are debit or credit, with 'RED ALE' (Revenue, Expenses, Dividends) being temporary accounts.
• 📈 Retained earnings, a permanent account, accumulates a company's profits for future use and is found on the balance sheet.
• 📋 A trial balance shows the current balances in every general ledger account and can be filtered to show only accounts with activity.
• 🚀 The video provides a detailed example using a fictional ride-sharing app company called 'Unter' to illustrate the process.
• 📉 The adjusted trial balance reflects a true and fair view of a company's financial position after all transactions for the year have been posted and adjusted.
• 💼 The long method of posting closing entries involves four steps, including transferring balances to an income summary account before moving to retained earnings.
• 🏁 The short method simplifies the process by clearing all temporary accounts directly to retained earnings in a single entry.
• 💡 Modern accounting software often automates the short method, making the process more efficient and less prone to errors.
• 🔄 The post-closing trial balance, which shows the state of accounts after closing entries are posted, serves as the opening trial balance for the next accounting period.

Q & A

What are closing entries in accounting?

Closing entries are journal entries that reset temporary accounts to zero and transfer their balances into retained earnings, which is a permanent account held in a balance sheet.

Why are closing entries important?

Closing entries are important because they help prepare the financial statements for the next accounting period by resetting temporary accounts and ensuring that the retained earnings account reflects the current period's profits or losses.

What is the accounting cycle and where do closing entries fit in?

The accounting cycle consists of eight steps, with closing entries being the last step (step 8). They are posted at the end of each accounting period after financial statements have been created.

What is the difference between temporary and permanent accounts?

Temporary accounts, such as revenue, expenses, and dividends, are reset to zero at the end of each accounting period. Permanent accounts, like assets, liabilities, and equity, carry their balances forward from one period to the next.

What does the acronym DEALER stand for and how does it help in accounting?

DEALER stands for Dividends, Expenses, Assets, Liabilities, Equity, and Revenue. It helps in remembering which accounts are normally debit (DEAL) and which are normally credit (ER).

What is the RED ALE trick mentioned in the script?

The RED ALE trick is a mnemonic to remember which accounts are temporary: Revenue, Expenses, and Dividends are temporary accounts, while Assets, Liabilities, and Equity are permanent accounts.

Can you explain the process of posting closing entries using the 'long way' as described in the script?

The 'long way' involves four steps: 1) Clear revenue to the income summary account, 2) Clear expenses to the income summary account, 3) Transfer the balance in the income summary account to retained earnings, and 4) Clear the current year dividends straight to retained earnings.

How does the 'short way' of posting closing entries differ from the 'long way'?

The 'short way' involves a single closing entry that clears all temporary accounts (revenue, expenses, and dividends) directly to retained earnings, instead of using the income summary account as an intermediary.

What is an income summary account and why is it used?

An income summary account is a temporary account used during the closing process to accumulate the balances of revenue and expense accounts before transferring the net balance to retained earnings.

What is a trial balance and how does it change after posting closing entries?

A trial balance is an accounting report showing the current balances in every general ledger account. After posting closing entries, the trial balance will show all temporary accounts reset to zero and their balances transferred to retained earnings.

How does the process of posting closing entries affect the balance sheet and income statement?

Posting closing entries affects the balance sheet by updating the retained earnings account with the net income or loss of the period. The income statement summarizes the performance over the period, showing revenue, expenses, and the resulting profit or loss.

Outlines

00:00

📊 Understanding Closing Entries

In this introductory paragraph, James explains the purpose of the video, which is to demonstrate how to post closing entries in accounting using two methods: a long way and a short way. He emphasizes the importance of closing entries in the accounting cycle, specifically at step 8, where temporary accounts are reset to zero and their balances are transferred to retained earnings. James introduces key concepts such as journal entries, temporary accounts, and permanent accounts, using the acronym 'DEALER' to differentiate between them. He also mentions the 'RED ALE' trick to remember which accounts are temporary and which are permanent.

05:04

📈 Trial Balance and Financial Statements

This paragraph discusses the trial balance for a business named Unter, highlighting its significance as an accounting report that shows current balances in all general ledger accounts. James explains that Unter's trial balance is an opening one, dated January 1st, marking the start of the new financial year. He differentiates between permanent accounts (assets, liabilities, equity) and temporary accounts (revenue, expenses, dividends), noting that the latter are reset to zero at the end of the accounting period. The paragraph sets the stage for understanding how these accounts interact in the financial statements, specifically the income statement, which summarizes Unter's performance over the year.

10:11

🔄 Steps to Post Closing Entries

In this section, James outlines the four steps involved in posting closing entries using the long method. He begins by resetting Unter's revenue account to zero, transferring its balance to the income summary account, which is a temporary account used solely for this purpose. He emphasizes the importance of identifying the correct revenue account, as there are multiple accounts with 'revenue' in their names. Following this, he discusses resetting all expense accounts to zero, detailing how to post equal and opposite entries to clear their balances. The paragraph concludes with the process of transferring the balance from the income summary account to retained earnings, illustrating how this reflects the company's profit for the year.

📉 Finalizing Closing Entries

This paragraph continues the closing entry process with step four, where James explains the need to reset current year dividends to zero and transfer that balance to retained earnings. He clarifies that dividends represent profits distributed to shareholders, which reduces retained earnings. James details the closing entry required to reset the dividends account and its impact on retained earnings. He then introduces the post-closing trial balance, which shows the remaining balances in Unter's accounts after all temporary accounts have been reset to zero. This section emphasizes the completion of the closing process and sets up for a quicker method.

⚡ The Short Way to Closing Entries

In this concluding paragraph, James introduces a quicker method for posting closing entries, which involves clearing all temporary accounts (revenue, expenses, and dividends) to retained earnings in a single entry. He revisits the adjusted trial balance to illustrate how this can be done efficiently. By debiting the revenue account and crediting the dividends and expenses accounts, all temporary accounts are reset to zero with one closing entry. James summarizes the long and short methods of posting closing entries, highlighting the advantages of modern accounting software that often automates this process. He encourages viewers to support his channel and mentions the availability of cheat sheets for further learning.

Keywords

💡Closing Entries

Closing entries are journal entries used in accounting to transfer the balances of temporary accounts to retained earnings at the end of an accounting period. These entries reset temporary accounts to zero and are a crucial step in the accounting cycle. In the video, James demonstrates how to post these entries both in a detailed 'long way' and a quicker 'short way', emphasizing their importance in preparing financial statements and resetting the accounting system for the next period.

💡Accounting Cycle

The accounting cycle is a sequence of steps that accountants follow to summarize, analyze, and report financial transactions. It includes everything from recording transactions to preparing financial statements. The video script mentions that closing entries are the last step in this cycle, highlighting the cyclical nature of accounting processes.

💡Temporary Accounts

Temporary accounts, also known as nominal accounts, are used to record revenues, expenses, and dividends for a specific accounting period. They are reset to zero at the end of each period. The script uses the acronym 'RED' (Revenue, Expenses, Dividends) to help remember these accounts, which are central to understanding how closing entries work.

💡Permanent Accounts

Permanent accounts, in contrast to temporary ones, retain their balances across accounting periods. They include assets, liabilities, and equity. The video script introduces the acronym 'ALE' (Assets, Liabilities, Equity) to differentiate these from temporary accounts and emphasizes their role in the balance sheet.

💡Journal Entry

A journal entry is a record of financial transactions, which is used to update accounts in the general ledger. The video explains that closing entries are a type of journal entry, necessary for transferring balances from temporary to permanent accounts, such as from revenue and expenses to retained earnings.

💡Retained Earnings

Retained earnings represent the cumulative profits of a business that are not distributed as dividends but are reinvested or held for future use. In the script, retained earnings are described as a permanent account where the net income (after expenses and revenues are accounted for) is transferred to at the end of the accounting period.

💡Income Summary Account

The income summary account is a temporary account used during the closing process to accumulate the balances of revenue and expense accounts before transferring them to retained earnings. The video script illustrates its use in the 'long way' of posting closing entries, showing how it acts as an intermediary before the final transfer to retained earnings.

💡Trial Balance

A trial balance is an accounting report that lists all general ledger accounts and their balances at a given point in time. The video script mentions an 'opening trial balance' at the start of the financial year and an 'adjusted trial balance' at the end, showing how accounts change throughout the accounting cycle.

💡Debit and Credit

Debits and credits are the fundamental actions used in double-entry bookkeeping to record financial transactions. The video script explains how to use debits and credits to post closing entries, emphasizing the need for equal and opposite entries to maintain the balance of the general ledger.

💡General Ledger

The general ledger is the central repository of financial information for a business, containing all its accounts. The video script discusses how both temporary and permanent accounts are recorded in the general ledger and how their balances are carried forward or reset at the end of the accounting period.

💡Balance Sheet

The balance sheet is a financial statement that presents a company's financial position by listing its assets, liabilities, and equity at a specific point in time. The video script explains that permanent accounts such as assets, liabilities, and equity are part of the balance sheet, and how the closing entries affect these figures.

Highlights

Introduction to posting closing entries in two different methods: long and short ways

Explanation of the accounting cycle and the role of closing entries

Definition of closing entries as journal entries that reset temporary accounts to zero

Description of retained earnings as a permanent account on the balance sheet

Introduction to the DEALER acronym for remembering debit and credit accounts

Differentiation between temporary and permanent accounts using the RED ALE trick

Explanation of the trial balance and its significance in accounting

Example of a trial balance for a ride-sharing app business called Unter

Description of how temporary and permanent accounts change throughout the accounting cycle

Process of creating an adjusted trial balance after a year of transactions

Explanation of how revenue and expenses are reflected in the income statement

Details on how the balance sheet includes permanent and temporary accounts

Step-by-step guide to posting closing entries the long way

Explanation of the income summary account and its temporary nature

Process of transferring balances from temporary accounts to the income summary account

Clearing the income summary account balance to retained earnings

Final step of resetting current year dividends and their impact on retained earnings

Introduction to the quicker method of posting closing entries using one entry

Recap of the steps involved in posting closing entries both long and short ways

Discussion on the practicality of the two methods for manual and software-based accounting systems

Encouragement for viewers to support the channel and access additional resources

Transcripts

Hey guys my name is James and in this quick video  i'm going to show you how to post closing entries  

in two different ways

a long way and a short way  a lot of you have been asking for this one so thanks for all your requests

and an extra special thanks to my channel members

your contributions helped me make this so without further ado

let's begin

this is the accounting cycle it shows  us how financial accounting works in eight steps

closing entries are tucked away at the very  end of the cycle in step 8

we post them at the end of each accounting period after  we're done creating financial statements

but what are they exactly?

closing entries are journal entries that reset temporary accounts to zero

they transfer their balances into retained  earnings which is a permanent account held in a balance sheet

remember a journal entry is a record  of a financial transaction

and retained earnings are a businesses profits held for future use  but what are temporary and permanent accounts?

let me show you

if you've watched my videos  before then you're probably familiar with dealer

but if you're new here dealer is a  handy little acronym that can help us remember debit and credit accounts

it stands for dividends, expenses, assets, liabilities, equity and revenue

dividends, expenses and assets are normal debit  accounts

whereas liabilities, equity and revenue are normal credit accounts

but here's the thing some of these are temporary accounts

and some are permanent

any idea which is which? hmm... i'll grab a drink while we think about it

Got it?

no worries if not

here's a little trick  to help you remember

red ale

revenue, expenses and dividends are temporary accounts

and assets, liabilities and equity are permanent accounts

well i don't know about you but i'll cheers to that  actually it's a bit early... yeah we'll put that away...

you can find dealer and red ale on my closing entries cheat sheet

which i'll leave a link to down in the description just for you...

so permanent accounts

assets, liabilities and equity

these guys live in the general ledger and their balances are  always carried forwards from one accounting period into the next

on the other hand

revenue, expenses and dividends are temporary accounts

these also belong in the general ledger but  they only correspond to one accounting period  

once that period's over they need to be reset  to zero and we do that using closing entries

if none of this is making sense don't sweat it i  think this example might help clear things up

Happy new year!

this is a trial balance for a business called Unter

a late comer to the world of ride sharing apps

a trial balance is an accounting report showing the current balances in every general ledger account

and this is an opening trial balance because the date is January 1st

the start of Unter's new financial year

if we flick back to the accounting cycle we find ourselves right here

at the very beginning

now let's see how Unter's temporary and permanent accounts change as we move around this

at the moment they have some assets, some liabilities and some equity

A-L-E which means that all of these are permanent accounts making up Unter's balance sheet

but hang on where's revenue, where's expenses and dividends?

trial balances often have filters applied so that  they only show accounts with numbers in them

if we expand this out then we find the usual  suspects

revenue, expenses and dividends R-E-D

these are Unter's temporary accounts which were  reset to zero at the end of last year

okay great now let's skip through steps one  to six and get onto the good stuff  

the adjusted trial balance

Unter drivers have been diligently moving customers from a to b for a whole year now

and we find ourselves at December 31st

here's Unter's adjusted trial balance

a whole year's worth of transactions have been  posted and adjusted so that this represents a true and fair view of their business

as you can see all of the temporary R-E-D accounts have got numbers in them now these show us the revenue that Unter has earned

the expenses that it's incurred and the dividends that it's declared during the past year

now Unter can create some financial statements

revenue and expenses are temporary accounts  that make up Unter's income statement

this summarizes Unter's performance over a one year period

we can see that they've made a tidy profit of three million nine hundred and fifty thousand dollars

but while the income statement only looks at revenues and expenses Unter's balance sheet is made up of everything

all of Unter's permanent and temporary accounts  belong in here

assets, liabilities and equity are permanent accounts whereas current year dividends is a temporary account

and current year profit feeds directly through to here from  the income statement

which as we saw is made up of temporary revenue and expense accounts

Unter has earned three million nine hundred and fifty thousand dollars in profit and they've declared half a million dollars in dividends  

step eight

time to post the closing entries

i'm going to show you two ways to do this

the long way and the short way

the long way involves four steps and we'll move through these one by one

in step one we're going to reset Unter's revenue  account to zero by transferring the balance  

to the income summary account

what is an income summary account?

it's a very special, very temporary account that only exists while we're posting closing entries

and it works a bit like this

if we go back to the adjusted trial balance we're going  to reset revenue to zero

but be careful with this because i can see three accounts with revenue in their descriptions

accrued revenue, deferred revenue and revenue revenue

accrued revenue is an asset and deferred revenue is a liability

they are both permanent accounts that we use  for adjusting entries so we can leave them alone for this example

we're only interested in this temporary revenue account

so let's take a closer look at it

Unter earned 20 million dollars this year

this sits on the right hand side of their revenue t account

because revenue is a normal credit account

think dealer

we want to reset this temporary account to zero

so we need to post a closing journal entry on December 31st

we'll debit revenue by 20 million dollars and credit the income summary account by the same amount

as you can see this transfers the balance from  the revenue account to the income summary account

so we're left with zero dollars in revenue and  20 million dollars in the income summary account  

step two

now we need to do the same thing again  but this time with all of the expense accounts

we'll reset them to zero and clear  their balances to the income summary  

account Unter has four different expense accounts

cost of services, overhead expenses

interest and tax

we can ignore accrued expenses  because it's a permanent liability account

we need to post another closing entry  and repeat what we did back in step one

expenses are normal debit accounts so their  balances are on the left of these t accounts  

if we want to reset them to nil then we need to  post equal and opposite credits to each account  

for cost of services, overhead expenses, interest  and tax and that leaves us with a total balancing  

amount of 16 million fifty thousand dollars which  we'll debit to the income summary account

in every journal the total in the debit column has to match  the total in the credit column

when we post this one we credit the right hand side of each expense  account resetting all of them to zero

and we debit the left hand side of the income summary account  now it's got a new balance of

three million nine hundred and fifty thousand dollars which is  a net credit sitting on the right hand side  

sound familiar?

it should do because this number is exactly the same as Unter's profit for the year which we saw in their income statement

step three  it's time for us to clear out that balance in the income summary account and put it where it belongs

retained earnings which is a permanent equity account in Unter's balance sheet

back to our trial balance here's our income summary account and it has a three million nine hundred and fifty thousand dollar credit balance  

which is a combination of Unter's revenues  and expenses for the year

the closing entry for this one is nice and simple we have a three million nine hundred and fifty thousand dollar  

credit balance in the income summary account so  we need to debit it by the same amount and credit  

the balance to retained earnings

when we post this  Unter's retained earnings or their profits held for future use

increases to $13,950,000

and... bye bye income summary account

sorry this just isn't working out between us you know you're going  to make a lucky accountant really happy someday

so job done right?

not quite

step four

we need to reset current year dividends to zero and clear the balance to retained earnings

Unter declared half a million dollars of dividends this year

these are the businesses profits that they've  chosen to distribute to the owners of the business

it's shareholders and we know retained earnings  are a businesses profits held for future use

so if Unter issues dividends then it's not holding on  to these profits anymore

so its retained earnings are going to go down

as you'll see right now

Unter has five hundred thousand dollars of dividends which is a normal debit account so in this closing entry we're going to credit the dividend account

by five hundred thousand dollars  and debit retained earnings by the same amount

when we post this closing entry Unter's dividends  are reset to nil and its retained earnings  

decrease to $13,450,000

just as we predicted

now can i get a drumroll please...

this is Unter's post closing trial balance it  shows us what's left in each of Unter's accounts  

after posting their closing entries you can  see that all of their temporary accounts  

have been reset to zero and their balances  have been transferred to retained earnings  

gee... that took a while didn't it?

thankfully there's a quicker way

the short way

this time we're going to take all of Unter's temporary accounts its revenue, expenses and dividends and clear their balances to retained earnings

using one closing entry so let's rewind and go back to the adjusted trial balance

here are Unter's temporary accounts  we have revenue in the credit column and we have dividends and expenses in the debit column

we can reset all of these to zero using one closing entry

by debiting the revenue account and  crediting the dividend and expense accounts

the balance of three million four hundred and fifty  thousand dollars is credited to retained earnings

because in double entry accounting there are  at least two equal and opposite sides to every  

transaction when we post this closing entry all of  the temporary accounts are reset to zero

fantastic!

we covered a lot there didn't we?

so here's a quick recap

when we post closing entries the long way there are four steps

first we clear revenue to the income summary account

then we clear expenses to the income summary account

then we clear the balance in the income summary account to retained earnings

and finally we clear the dividends  straight to retained earnings

this might seem like a bit of a faff but if you're using a manual  accounting system then the income summary account

can help you methodically work your way through  this closing process

with the short way we clear all of these temporary accounts to retained earnings in one go often this happens automatically if you're using modern accounting software

but whichever method you're using we get to the same post-closing trial balance which usually looks like this

filtered to hide accounts with zero balances the post closing trial balance for this  year becomes next year's opening trial balance

if you're enjoying these videos and you'd  like to help support the channel well  

thank you one way you can do that is by  clicking on the join button below and  

another way is by buying one of my cheat sheets  there's one for closing entries which covers  

yeah everything we just went through thanks  for watching and i'll see you again soon!