Let’s talk about why do we close the books. The best analogy is one that I read years back in a textbook it was a sports analogy and I’m going to paraphrase that to help us understand this closing process a little better. Let’s assume that the Yankees and the Orioles two baseball professional teams are playing each other.
Usually when two professional baseball teams play each other, they’ll play three games in a series. Let’s assume that game one ended yesterday with the Orioles winning with a score of ten and the Yankees with a score of three, that’s my fantasy that Orioles win against the Yankees occasionally.
So again game one ended yesterday, now today this evening game two will be played. And I ask you a question, I said at this point on the eve of game two what is the score for game two? Now you might look perplexed for a second and then you’re going to say of course the score is zero zero. And you’re absolutely right, the score at this point for game two is zero zero, so I’m going to follow up with a question again and say well what happened to last night’s score and you’re gonna say well last night’s game is over. This is a new game today.
And you’re right again, so in other words we have closed the books for game one, and game one score does not seep into game two, it does not affect game two. However the statistics involving game one that information does affect the players will stay on permanently and will affect those players averages lifetime averages etc. But yet the important point here is that each games score stands on its own merits.
So is it with closing when we close the books what we’re doing is we are isolating information from one period to another in terms of the revenues and expenses specifically.
So if hypothetically we were to close out the books every month then what that helps us do is produce an income statement that only reflects that month’s revenues and that month’s expenses. And if we do this monthly, each month we can produce an income statement with one month of revenues and one month of expenses and in turn we can show the net income or net loss for that one month.
So closing out cells again isolate information from one period to another period. How often should we be closing? There’s no hard and fast rules but midsize and larger companies should be closing monthly because when you close monthly then you can prepare monthly financial statements.
Smaller companies don’t need to close monthly, they can close more infrequently like quarterly or even semi-annually, if the company is pretty small. Having said that, let’s get into the mechanics of how do we achive the closing of the books.
Well we start off with a series of closing entries that I’ve outlined below, so here is this example we have the closing journal entries for Ellie dance company for the year ending December 31st 2011.
Now to close out there are several steps that we need to follow. So here in this example I’ve outlined four steps. Step one is where you close out your revenues, step two you close our expenses, step three you close out income summary and step four you close out your drawing if you have a proprietorship if you have a corporation you do not have a drawing account so there will be no need for step four in that case.
Let’s go back now to step one and look at the specific closing journal entry for step one. Step one again was to close out your revenue. In my example for Ellie dance company we just have one revenue account called service revenue.
So prior to closing entry, let’s go back and look at the general ledger and on this side here I have oultlined an informal representation of the general ledger in the form of T accounts.
So you can see that prior to the closing entry, for the service revenue account we have a normal credit balance of $20,000. Service revenue is a revenue account normal balance is a credit 20,000. Our task is to close out this service revenue account.
What do we mean by the words closing out? Closing out means you’re bringing to a zero balance your revenue account. So how do you go about bringing to a zero balance a revenue account that currently has a credit balalnce of 20,000.
You are going to accomplish this task by creating closing entry where you debit the service revenue account which is what we do in entry number one. We debit the service revenue accouint and the offsetting credit will go to this new temporary account called income summary.
So we debit service revenue 20,000 credit income summary for 20,000. Now once you make that entry and then it back to your general ledger and you can see here l’ve just shown the posting against the service revenue account only. That 20,000 debit creates a zero balance and that’s how you close out a service revenue account that has a normal credit balance.
Next we go to step two, step two we have to close our expense. In this example in the interest of remedy I’ve only shown you three expense accounts. But of course in a regular company you’re going to have many many expense accounts and that’s fine we’ll still follow same logic in the same process.
So here with the expense account prior to making this closing entry, let’s look at the general ledger account here for just one of them which is advertising expense.
Advertising expense prior to this closing entry had a $3,500 normal debit balance, so our job is to take this account for the $3,500 debit balance and bringing to a zero balance.
how do we do that, we do that by creating a closing entry that credit your advertising account and the offsetting debit will go for that same income summary account that we use in step one. And when you have more than one expense account, you’ll use same logic and credit each of these expense accounts. Again the interest of brevity I’ve only outline one expense account here in the genaral ledger.
Once you make this closing entry, but debit income summary and credit the respective expense account and you post that to your general ledger in this case I’m illustrating again the advertising expense only, you will find that your closing entry when it gets posted as a credit will bring your adverrtising expense to zero balance. Remember it had normal debit balance before then your closing entry was a credit to the advertising expense and that gives you a zero balance and as I said you repeat the process again with as many expense accounts as you have.
Step three, step three is to close out your income summary account. However close out your income summary account we first need to calculate the balance of income summary, because remember prior to the closing process your income summary accout had a zero balance, however based on entry no1 and entry no2, in step one and step two respectively your income summary account has some activity right now.
So let’s look at income summary account here, and you can see that from entry number one from this income summary credit when this gets posted this got posted as a credit here to your income summary general ledger account and then from entry number two, entry number two you had a debit to income summary of 9,860, and that got posted as a debit to income summary general ledger account.
This creates a balance of 10,140 credit. Your job in step three is to take this credit balance of 10,140 and bringing it to a zero balance.
How do you that? You do that by creating another closing entry in step three which will debit the income summary for 10,140. And the offsetting account will go to your capital account, if it’s a proprietorship or to retained earnings if it’s a corporation.
And when you make this entry, entry number three with a debit income summary and you post that to your general ledger income summary account, here at the debit you can see the cross reference, here is a debit 10,140 and you see the cross reference that says closing that will give you a zero balance.
Now what is important to remember with entry number three is when you credit your capital account or retained earning account that amount represent your net income in this case.
So your net income basicallay is getting shifted into your capital account or into your retain earning accout increasing it. Step four is your drawing account and again this is only if you have a proprietorship.
So if you have proprietorsihp then you use this closing entry and drawing is when the owner takes out money from the company for business purposes and it had it’s a contract equity account that has a normal debit balance just to close it out we are going to credit drawing and again the offset will be to the capital account reducing your capital. so in essense drawing reduces your capital.
Now remember that will not here but that the entry number three is when you’re using your retain earning or capital, you’re not closing out the account you are merely increasing your capital or retain earnings acccount through that entry number three.
So this is an orverview of the closing out process again we go to the different entries I’ve given the rationale and I hope this will help you further in your studies.