Revenue increases retained earnings and expenses and dividends decrease it. Revenues, expenses and dividends are called nominal or temporary accounts, because they accumulate the transactions of only one accounting period. In this connection it is to be noted that the retained earnings and other balance sheet accounts are called real or permanent account, because their balances continue to exist beyond the current accounting period. At the end of an accounting period the change in retained earnings as accumulated through temporary i.e. nominal accounts needs to be transferred to Retained earning statement. This process of transfer is called closing the accounts and the journal entries made in this regard are called closing entries. At year end, for the purpose of preparing financial statement revenues and expenses are transferred to an account called Income Summary or Income Statement. When through such transfer the credit balance of revenue account and debit balance of expenses account are transferred to the summary account, the balance of that account will be net income or net loss. This is consistent with the rule that the increase in owners’ equity is recorded by credits and decrease is recorded by debits.
Rules for Closing Temporary Accounts
Following steps necessary for closing entries:
- Close the revenue accounts by transferring their balances into the income summary accounts.
- Close the expenses accounts by transferring their balances into the income summary accounts.
- Close the income summary account by transferring its balance into the retained earning account.
- Close the dividend account by transferring the balance into retained earning account.