← Prepare financial information

Closing entries and why they work

Every closing entry in this paper follows the same underlying logic: reset temporary accounts to zero so the next period starts clean.

The two destinations every closing entry has

  • REVENUE and EXPENSE accounts close to the PROFIT AND LOSS SUMMARY — this is what actually calculates profit for the year, gathering every revenue and expense into one place.
  • DRAWINGS closes DIRECTLY to CAPITAL — it never touches the Profit and Loss Summary, because drawings are not an expense of earning profit, they are the owner withdrawing already-earned equity.
  • After both sets of closing entries, every temporary account (revenue, expense, drawings) sits at zero, ready for the next reporting period.
Worked example Closing a depreciation expense at year end Depreciation on computers for the year is
,200. Record the closing entry, and explain what it achieves. Depreciation on computers is an EXPENSE account, so it closes to the Profit and Loss Summary. Journal entry: Debit Profit and Loss Summary 1,200, Credit Depreciation on Computers 1,200. This removes the
,200 expense from its own account (resetting it to zero for next year) and gathers it into the Profit and Loss Summary, where it will reduce this year's calculated profit. ✓ The Depreciation on Computers account starts the next reporting period at zero, while the
,200 has already done its job of reducing this year's profit through the Profit and Loss Summary. ✕

Closing drawings to the Profit and Loss Summary instead of Capital

Drawings represent the owner taking out value they already own — it is not a cost of running the business, so it must NEVER pass through the Profit and Loss Summary or reduce reported profit. The closing entry for drawings is always Debit Capital, Credit Drawings, moving directly between two equity accounts with no detour through profit calculation. ℹ

The Profit and Loss Summary account itself is also closed

After every revenue and expense account has closed INTO the Profit and Loss Summary, that account's own balance (which now represents the year's profit or loss) is itself closed to Capital — Debit Profit and Loss Summary, Credit Capital for a profit (or the reverse for a loss). This final step is what actually moves the year's profit into the owner's equity, completing the cycle from individual transaction through to the Statement of Financial Position.

Practise just this