8. Closing the books: permanent and temporary accounts

At the end of an accounting period, all accounts are prepared for the next period. In this regard, it is important to distinguish between permanent and temporary accounts. Balance sheet accounts (i.e., assets, liabilities, and equity) have a continual nature; therefore, they are not closed after each period. That's why they are called permanent accounts.

Permanent accounts are balance sheet accounts. They are not closed after each period. Their balances are carried forward into the next period. Permanent accounts are also called real accounts.

In contrast, revenue, expense, and distribution accounts are used to collect information about a single accounting period. At the end of a period, amounts in revenue, expense, and distribution accounts are transferred to the Retained Earnings account. Accordingly, the revenue, expense, and distribution accounts must have zero balances after closing the books at the end of one accounting period and at the beginning of the next period.

Temporary accounts are closed at the end of each period. These are mostly income statement accounts, except for a distribution account that is an equity statement account. Temporary accounts are also called nominal accounts.

The process of transferring the balances from the temporary accounts to the permanent account (i.e., the Retained Earnings account), is referred to as closing the accounts or closing the books.

9. Financial statements description

Using the five transactions described above, we can now prepare the company financial statements for the period. Recall that there are four general-purpose financial statements:

• Income Statement
• Statement of Changes in Equity
• Balance Sheet
• Statement of Cash Flows

9.1. Presentation of the income statement

An income statement is presented below. (We will not go into detail on the preparation of financial statements process in this tutorial. That topic will be covered in future tutorials. The financial statements below are presented to give you an idea of what an income statement looks like.)

Illustration 9: Income statement for Friends Company

The income statement measures the change in net assets or the difference between asset increases and asset decreases from operating activities. The asset increases from the operating activities are labeled revenues. The asset decreases from the operating activities are called expenses. The difference between revenues and expenses is called net income if revenue is greater than expenses or a net loss if vice versa.

Note: At this point we don't consider liabilities in the determination of revenues and expenses. Liabilities and how they impact revenues and expenses are covered in other tutorials.

Net income is the excess of revenues over expenses for an accounting period.

Net loss is the opposite of net income. Net loss results from the excess of expenses over revenues for an accounting period.

9.2. Presentation of the statement of changes in equity

The statement of changes in equity has the following format:

Illustration 10: Statement of changes in equity for Friends Company

The statement of changes in equity explains the effects of transactions on owner's equity during an accounting period. The statement includes the beginning and ending balances of contributed capital and reflects any new capital acquisitions made during the accounting period in the contributed capital section. The statement also shows the portion of net earnings retained in the business in the retained earnings section.

Not a member?

See why people join our
online accounting course: