4 Revenue and Expenses
Income Statement Fundamentals
Jacqueline Gagnon
Closing Entries
Moving Balances from Income Statement Accounts to Retained Earnings
The Retained Earnings account will keep its opening balance and remain completely unchanged during the period until… we make closing entriesClosing Entry:
There are two closing entries. The first closes income statement accounts to retained earnings, the effect is that income statement accounts are set to zero and retained earnings is adjusted for net income (loss). The second entry closes dividends declared to retained earnings (DR retained earnings; CR dividends declared).. In effect, closing entries move Net Income to Retained Earnings. But each and every income statement account has to be zeroed–outZero-Out an Account:
Entering a journal entry to deliberately set the balance of an account to zero. For example, closing entries zero-out income statement accounts to retained earnings at the end of a period. See also: Closing entries.: their balances reduced to zero.
How do we make income accounts zero? Income accounts like Sales Revenue, Interest Income, and Gains have a credit balance, so they are zeroed out with a debit. Expense accounts like COGS, Operating Expenses, and Losses are the opposite; they have a debit balance, so they are zeroed out with a credit. Here’s a handy reference journal entry to get the idea:
| DR | Sales Revenue | |||
| CR | Cost of Goods Sold | |||
| CR | Bad Debt Expense | |||
| CR | Depreciation Expense | |||
| CR | Freight & Shipping Expense | |||
| CR | Office Expense | |||
| CR | Salaries Expense | |||
| CR | Telephone Expense | |||
| CR | Utilities Expense | |||
| DR | Interest Income | |||
| DR | Gain on Sale of PPE | |||
| CR | Interest Expense | |||
| CR | Loss on Sale of PPE | |||
| CR | Income Tax Expense | |||
| CR | Retained Earnings |
In this entry, we are closing out income and expense accounts to the Retained Earnings account. Notice that all the accounts seem to be on the wrong side: income accounts are on the left, and expenses are on the right. You’re right, when we record events during the year, income transactions are recorded as credits and expense as debits. But let’s remember what we’re trying to do here. The entity has set up income and expenses during the year, and now we are trying to make the balance of these accounts zero. If Sales revenue has a balance of $100,000 credit, for example, we’ll need an equal debit transaction to zero out this account. The balance will be transferred to Retained Earnings. T-account workings may look like this, where the opening balance of Retained Earnings is unknown (note: JE is short for journal entry):
| Sales Revenue | |||
|---|---|---|---|
| DR | CR | ||
| — | o/b | ||
| 100,000 | Revenue earned during the year | ||
| Closing JE | 100,000 | ||
| — | |||
The pre-closing balance of Sales revenue was $100,000, and the closed-out balance is zero. Perfect! Also, Retained Earnings is $100,000 higher. Does this make sense? I think so. Retained Earnings is an equity account that increases with credits, as is the case here. Does sales revenue increase shareholder equity? Indeed, it does!
How do we calculate that credit to Retained Earnings? We will add up the debit column, and then subtract the credits. It is helpful to write down the total debits and total credits on this closing entry. It makes it easier to calculate Retained Earnings and helps us catch our mistakes.