The closing process and Income Summary account

December 22, 2013

“Closing the books” is an important process in the life cycle of any company. It is necessary for both reporting and tax purposes and helps management assess the health and well-being of the business. In this article, we will look at why the process is necessary and discuss the role played by the Income Summary account at the end of a fiscal year.

1. What is the Income Summary account?

One of the first things learned by accounting students is the accounting equation:

Assets = Liabilities + Equity

We can expand this equation to include revenues earned and expenses incurred:

Assets = Liabilities + Equity + Revenues - Expenses

At the end of the year, closing entries are used to combine revenues and expenses with the Retained Earnings equity account. The Income Summary account is only used during the year-end closing process -- it facilitates the transfer of balances away from the temporary accounts and into the permanent accounts.

2. How is the Income Summary account related to the year-end closing process?

Throughout the year, revenue accounts are credited and expense accounts are debited as the company goes about its usual course of business. These accounts are usually named based on the source of the revenue or expense -- examples include interest expense, cost of goods sold, supplies expense, sales revenue, and investment income. One way to clear these accounts at year end is to debit each revenue account and credit retained earnings while crediting each expense account and debiting retained earnings. For a simplified example, let’s assume that Company X’s records for its first year of operations show $1,000 in interest expense, $10,000 in cost of goods sold, $50,000 in sales revenue, and $5,000 in investment income. Recall that revenue accounts normally have credit balances while expense accounts normally have debit balances. To close the accounts, Company X could make individual entries for all accounts as follows:

Account Titles

Debit

Credit

Retained Earnings

1,000

 

          Interest Expense

 

1,000

     

Retained Earnings

10,000

 

          Cost of Goods Sold

 

10,000

     

Sales Revenue

50,000

 

          Retained Earnings

 

50,000

     

Investment Income

5,000

 

          Retained Earnings

 

5,000

As you can see, this method would be cumbersome for large corporations with 50 or 60 different expense and revenue accounts. In addition, separate entries do not allow for the simple determination of net income (loss) for the year. Instead, Company X can utilize the Income Summary account to simplify the closing process. First, we need to move all revenue and expense account balances to the Income Summary account:

Account Titles

Debit

Credit

Sales Revenue

50,000

 

Investment Income

5,000

 

          Income Summary

 

55,000

     

Income Summary

11,000

 

          Interest Expense

 

1,000

          Cost of Goods Sold

 

10,000

All revenue accounts are closed together in a single entry, while all expense accounts are closed in the second entry. All expense and revenue accounts now show a zero balance, and the income summary has a credit balance of $44,000. We can now move that balance over to Retained Earnings. In addition, the income summary closing entry tells us the company’s profit for the year.

Account Titles

Debit

Credit

Income Summary

44,000

 

          Retained Earnings

 

44,000

If the Income Summary account instead shows a debit balance after closing all revenue and expense accounts, the final closing entry will show the company’s loss for the year. Let’s assume that Company X’s income summary has a $2,000 debit balance after closing revenue and expense accounts. The final closing entry would be as follows:

Account Titles

Debit

Credit

Retained Earnings

2,000

 

          Income Summary

 

2,000

3. Why is it important to close certain accounts at the end of the year?

A company must be able to account for net income for financial reporting, taxation, and internal decision making purposes. Let’s extend the example of Company X, which had a $44,000 profit in its first year of operations. Let’s now assume that, in its second year of operations, the company incurs $2,000 of interest expense and $15,000 of cost of goods sold expense while gaining $55,000 in sales revenue and $6,000 in investment income.

If Company X had not closed its revenue and expense accounts after year one, the Sales Revenue account would show a $105,000 balance (i.e., $50,000 + $55,000), while the Interest Expense account would show a $3,000 balance (i.e., $1,000 + $2,000) at the end of the second year. Company X could determine amounts for the second year by subtracting amounts from the first year, but that method would become more and more difficult after 10, 20, or perhaps 100 years. Closing temporary accounts allows Company X to easily track costs and income on a yearly basis.

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