Closing entries are used to close out (or bring the balance to $0) temporary accounts (nominal accounts) to Retained Earnings. Basically, closing entries are journal entries to transfer the nominal accounts to the real accounts. For the accounting period being closed, temporary accounts are: revenue, expense, income summary and dividends paid/declared accounts.
For easier understanding and more clearly figure, here is an “Income Statement” example:
Revenues reported on the income statement are closed to the income summary account. Since Revenues are posted to the General Ledger as a credit, debiting the Revenue accounts for the total balance will zero them out. The entry to close Revenues to the Income Summary account is as follows:
[Debit]. Revenues = $4,960
[Credit]. Income Summary = 4,960
Expenses reported on the income statement are closed to the income summary account. Since Expenses are posted to the General Ledger as a debit, crediting the Expense accounts for the total balance will zero them out. The entry to close Expenses to the Income Summary account is as follows:
[Debit]. Income Summary = $4,423
[Credit]. Expenses = 4,423
Closing Income Summary
The income summary account is used as a check figure because the balance in the account, after Revenues and Expenses are closed out, should be equal to Net Income or Net Loss for the period being closed. A Net Income for an accounting period creates a credit balance in the income summary account, and a Net Loss creates a debit balance. Now close the Income Summary account to Retained Earnings (debiting or crediting the account depending on the ending balance):
[Debit]. Income Summary = $537
[Credit]. Retained Earnings = 537
If Dividends were paid or declared during the accounting period in questions, the account will need to be closed out to Retained Earnings. Since Dividends have a debit balance, and reduce Retained Earnings, the account will be credited in order to close it out:
[Debit]. Retained Earnings XXXo
[Credit]. Dividends XXX
Finally, the balance in the Retained Earnings account will be the ending retained earnings for the accounting period in question and go on the balance sheet in its proper place.
Note: As with other journal entries, closing entries are posted to the right general ledger.