After financial statements are prepared, you are ready to get your books ready for the next accounting period by clearing out the income and expense accounts in the general ledger and transferring the net income (or loss) to your owner’s equity account. This is done by preparing closing entries in the general journal.
Note the distinction between adjusting entries and closing entries. Adjusting entries are required to update certain accounts in your general ledger at the end of an accounting period. They must be done before you can prepare your financial statements and income tax return. Closing entries are needed to clear out your revenue and expense accounts as you start the beginning of a new accounting period.
Preparing your closing entries is a very simple, mechanical process. Follow these steps:
Close the revenue accounts. Prepare one journal entry that debits all the revenue accounts. (These accounts will have a credit balance in the general ledger prior to the closing entry.) Credit an account called “income summary” for the total.
Close the expense accounts. Prepare one journal entry that credits all the expense accounts. (These accounts will have a debit balance in the general ledger prior to the closing entry.) Debit the income summary account for the total.
Transfer the income summary balance to a capital account. Prepare a journal entry that clears out the income summary account. This entry effectively transfers the net income (or loss) of the business to the owner’s equity account.
Close the drawing account. If your business is a sole proprietorship or partnership, close the drawing accounts (if any) by preparing a journal entry that credits the drawing account and debits the owner’s equity account.