Closing and reversing entries

Learning goals

• Distinguish temporary and permanent accounts.
• Close revenues, expenses, and dividends to retained earnings.
• Prepare and interpret a post-closing trial balance.
• Use optional reversing entries without double-counting revenue or expense.

Prerequisite check

Which accounts should start a new fiscal year at zero? Revenues, expenses, and dividends are temporary. Assets, liabilities, share capital, and retained earnings carry forward because they describe continuing resources, obligations, and equity.

Vocabulary

• Closing entry: transfers a temporary account balance into equity.
• Income Summary: optional temporary clearing account used during closing.
• Post-closing trial balance: list of permanent-account balances after closing.
• Reversing entry: optional first-day entry that reverses selected accruals or deferrals.
• Fiscal year: the entity's annual reporting period.

Core idea

Closing separates one period's performance from the next. Reversing is different: it simplifies later routine cash entries for certain adjustments. It does not undo the prior year's statements because it is dated in the new period.

Why this treatment makes sense

Users need both lifetime equity and one-period performance. Retained Earnings accumulates profit and dividends across years, while revenue and expense accounts reset so next year's income statement measures only next year's activity. Reversals reduce the chance that a January payment repeats a December accrual.

A repeatable method

1. Confirm statements and adjusted trial balance are complete.
2. Close all credit-balance revenues to Income Summary.
3. Close all debit-balance expenses to Income Summary.
4. Transfer Income Summary's net balance to Retained Earnings.
5. Close Dividends directly to Retained Earnings.
6. Prepare the post-closing trial balance using permanent accounts only.
7. On day one, reverse eligible accrued revenues/expenses if the system's policy uses reversals.

Worked example

At year-end, Aurora Analytics Inc. has Service Revenue $94,000, total expenses $71,500, and Dividends $6,000. Profit is $22,500.

Table: Aurora Analytics closing entries

Net increase in Retained Earnings is $16,500. If opening Retained Earnings was $38,000, closing Retained Earnings is $54,500.

Suppose December's adjustment debited Wages Expense and credited Wages Payable $2,400. A January 1 reversal debits Wages Payable and credits Wages Expense $2,400. When the $2,400 is paid January 5, the routine entry debits Wages Expense and credits Cash; the two January expense entries net to zero.

Journal, ledger, and statement connection

Closing posts zero balances to every revenue, expense, and dividend ledger. The post-closing trial balance includes Cash, receivables, assets, accumulated depreciation, liabilities, share capital, and the updated Retained Earnings. Closing changes ledger organization but does not change the already-issued profit.

Common mistakes

• Closing assets or liabilities.
• Closing dividends through Income Summary and treating them as an expense.
• Reversing depreciation; routine reversals normally target accruals and selected deferrals.
• Dating a reversal December 31, which would undo the adjustment before reporting.
• Assuming software means closing can be skipped; the software may perform it automatically.

Guided practice

Revenue is $62,000, expenses are $49,300, dividends are $3,500, and opening Retained Earnings is $21,000. Profit is $12,700; ending Retained Earnings is $21,000 + $12,700 − $3,500 = $30,200. The closing transfer credits Retained Earnings $12,700; closing dividends debits it $3,500.

Independent practice

1. State whether each belongs on a post-closing trial balance: Accounts Payable, Sales Revenue, Accumulated Depreciation, Dividends, Retained Earnings.
2. Record a January 1 reversal for $1,850 interest accrued at December 31.
3. If revenue is $110,000, expenses $96,000, and dividends $4,000, by how much does closing change Retained Earnings?

Self-check and solutions

1. Include Accounts Payable, Accumulated Depreciation, and Retained Earnings. Exclude the closed temporary accounts Sales Revenue and Dividends.
2. Debit Interest Payable $1,850; credit Interest Expense $1,850.
3. Profit is $14,000 and dividends are $4,000, so Retained Earnings increases $10,000.

Retrieval practice

1. Why is Dividends not an expense?
2. When is a reversing entry dated?
3. What does a post-closing trial balance fail to prove?

Answers: it is a distribution to owners, not a cost of earning revenue; the first day of the new period; it cannot prove correct classification, timing, or amounts.

Exam-style application

A student closes Accounts Receivable $9,000 to Income Summary and leaves Consulting Revenue $41,000 open. Explain two resulting problems.

Solution: Accounts Receivable is a permanent asset and would incorrectly begin the new year at zero. Consulting Revenue is temporary and would carry prior-year revenue into the next income statement. Reverse the mistaken receivable closing and close Consulting Revenue to Income Summary.

Lesson summary

Closing resets performance accounts and updates continuing equity. Reversing is an optional new-period convenience for selected adjustments, never a way to erase valid year-end reporting.