What is Closing Entries?
Closing entries are journal entries made at the end of an accounting period to reset temporary accounts and transfer profits to retained earnings.
What Are Closing Entries?
Closing entries are the journal entries made at the end of an accounting period to: 1. Reset all temporary (revenue and expense) accounts to zero 2. Transfer the net income or loss to the owner's equity or retained earnings account Think of closing entries as the accounting system's "reset" button — at the end of every period, you close the books on that period so the next period starts with a clean slate. The Accounting Cycle: The full accounting cycle ends with closing entries. The sequence: source documents → journal entries → ledger → trial balance → financial statements → closing entries → new period. Modern accounting software automates most of this, but understanding it helps you understand your year-end financials.
Temporary vs. Permanent Accounts
Temporary Accounts (Closed Each Period) - Revenue accounts — Track income for the current period - Expense accounts — Track costs for the current period - Owner's Draw/Dividends — Track distributions to owners These accounts start at zero each period, accumulate activity during the period, and are closed to zero at period end. Permanent Accounts (Not Closed) - Asset accounts — Cash, accounts receivable, equipment, etc. - Liability accounts — Accounts payable, loans payable, etc. - Equity/Retained Earnings — Cumulative profits retained in the business These carry their balances forward indefinitely.
The Four-Step Closing Process
Step 1: Close Revenue Accounts to Income Summary `` Debit: Revenue (each revenue account) Credit: Income Summary ` This reduces all revenue account balances to zero and transfers the total to the Income Summary account. Step 2: Close Expense Accounts to Income Summary ` Debit: Income Summary Credit: Each expense account ` This reduces all expense account balances to zero and transfers the total to Income Summary. Step 3: Close Income Summary to Owner's Equity If there's a profit (revenue > expenses): ` Debit: Income Summary Credit: Owner's Capital / Retained Earnings ` If there's a loss (expenses > revenue): ` Debit: Owner's Capital / Retained Earnings Credit: Income Summary ` This transfers the net income (or loss) to equity. Step 4: Close Owner's Draw to Owner's Capital ` Debit: Owner's Capital Credit: Owner's Draw `` For sole proprietors, any owner draws are closed to the owner's capital account.
The Result: A Clean Start
After closing entries, your financial statements show: - Income Statement — Zero balances (ready for the new year) - Balance Sheet — Retained Earnings or Owner's Capital updated with the year's profit (or loss)
What This Means for Freelancers
Year-End Closing At year-end, your accountant or accounting software closes your books for tax filing. This is why your year-end P&L shows zero for all income and expense accounts — they're closed, not deleted. Retained Earnings The profit from your P&L flows to the balance sheet's retained earnings (LLC/corporation) or owner's capital (sole proprietor). This increases your business equity — the business "kept" the profit rather than distributing it. Balance Sheet Equation After Closing Assets = Liabilities + (Beginning Capital + Net Income − Owner Draws) The closing entries ensure the balance sheet equation stays in balance.
Modern Accounting Software Handles This Automatically
If you use QuickBooks, Xero, Wave, or FreshBooks, closing entries are generated automatically when you run your year-end reports or file your taxes. You don't need to make these entries manually. However, understanding closing entries helps you understand: - Why your P&L resets to zero at year-end - Why retained earnings accumulates over time - What actually happens to your profit from an accounting perspective
The Post-Closing Trial Balance
After all closing entries are made, accountants prepare a post-closing trial balance — a trial balance showing only permanent accounts. This confirms that the accounting equation (debits = credits) is in balance after closing.
Bottom Line
Closing entries are the accounting machinery that allows each accounting period to start fresh while preserving the cumulative history of your business on the balance sheet. For freelancers, you won't make closing entries manually — your software handles it — but understanding what they are and why they're made gives you deeper insight into how your financial statements come together at year-end.