Financial statements reflect profitability as well as financial position of a business and accounting is the key function on the basis of which these statements are prepared. Accounting process includes passing journal entries, posting them in ledger accounts, preparation of trial balance and then drawing up the financial statements. Journal entries (sometime referred to as accounting entries) are thus the basis on which the entity’s financial statements are ultimately prepared. They are passed continuously throughout the accounting period and up to the ultimate finalization of the books of accounts.
On the basis of various grounds, journal entries can be classified into different types. The article “adjusting entries vs closing entries” looks at meaning of and difference between two types of these entries based on their timing and purpose – adjusting entries and closing entries.
Definitions and meanings
Adjusting entries are those accounting entries which are passed at the end of the accounting period. These entries are made to align the books of accounts to the matching concept and accrual principles laid down by accounting standards. These entries are passed to ensure that the books present a more accurate picture of how the entity has performed during the period in terms of profits and cash flows and what is its current financial position.
Adjusting entries are primarily of the following types:
1. Entries required for accrual of expenses incurred but not accounted for during the accounting period
Example: The accounting year ends on 31st December; however, electricity bill is received on the 10th of each month. Thus, pro-rata electricity expense (on average basis) incurred till 31st December will have to be provided for through an adjusting entry.
2. Entries required for recognition of income earned but not recognized during the accounting period
Example: A loan has been given on 1st December, interest of which is receivable on a quarterly basis. Thus, interest income which has accrued by 31st December (i.e., for one month) although not yet received is accounted for by an adjusting entry.
[Debit] Income receivable
[Credit] Interest income
3. Entries required for deferment of expenses and incomes accounted for but pertaining to subsequent accounting periods
Example: Annual maintenance expenses are paid for in advance at the inception of the contract. As on 31st December, say there are 3 months left on the contract. An adjusting entry to account for prepaid expenses needs to be passed.
[Debit] Prepaid expenses
[Credit] Maintenance expenses
Adjusting entries are typically passed after compilation of the trial balance but before finalization of financial statements.
Closing entries are accounting entries passed to transfer balances of individual temporary ledger accounts to relevant permanent accounts. Temporary accounts are income and expense accounts that are created during the accounting period and closed at the end. At the start of entity’s next accounting period, they are opened again but start with a zero balance. Permanent accounts are balance sheet accounts whose balances are carried forward to the subsequent accounting period. Examples of these permanent accounts include all asset and liability accounts.
Closing entries typically follow the following pattern
1. Entry required to close the temporary income accounts to income summary account
All income accounts in the ledger such as sales, interest income, rental income, other income etc. are closed and their credit balances are transferred to the income summary account.
[Credit] Income summary
2. Entry required to close the temporary expenses accounts to income summary account
All expense accounts in the ledger such as materials, wages, electricity, rent etc. are closed and their debit balances are transferred to the income summary.
[Debit] Income summary
3. Entry required to close the temporary income summary account to permanent retained earnings account
The income summary account is also a temporary account which is opened and used just to empty the balances of various income and expense accounts in the ledger. Its balance is further transferred to a permanent balance sheet account known as retained earnings account. The income summary account is thus closed to retained earnings account.
In case of credit balance or profit:
[Debit] Income summary
[Credit] Retained earnings
In case of debit balance or loss:
[Debit] Retained earnings
[Credit] Income summary
4. Entry required to close dividends account
Dividends in a company are equal to drawings in a sole proprietorship form of business. Since they represent withdrawal and not expense, the balance shown by dividends account is directly transferred to retained earnings account by making the following closing entry:
[Debit] Retained earnings account
The above entries close entity’s all temporary accounts to retained earnings account which is a permanent account and appears in balance sheet.
Difference between adjusting entries and closing entries
Some main points of difference between adjusting entries and closing entries has been listed below:
- Adjusting entries are entries made to ensure that accrual concept has been followed in recording incomes and expenses.
- Closing entries are entries made to close temporary ledger accounts and ultimately transfer their balances to permanent accounts.
- At the close of the accounting period, adjusting entries are passed first so that the expenses and incomes can be appropriately reflected.
- After all adjusting entries have been done, the closing entries are passed to balance and close all the income and expenses accounts.
3. Effort involved
- Adjusting entries require analysis of all incomes and expenses to determine whether accrual system has been followed and identify what adjustments are required to be made. Hence the effort involved is considerable.
- Closing entries are more mechanical and simpler as they only involve arithmetical calculation and transferring of year end balance.
- As adjusting entries require application of accounting principles, human intervention may be required in an automated accounting system.
- Closing entries most often can be passed automatically by the automated accounting system without the need for much human involvement.
- The purpose of adjusting entries is to ensure adherence to the accrual concept of accounting.
- The purpose of closing entries is to assist in drawing up of financial statements.
6. Impact on profitability
- Adjusting entries have an impact on profitability as they increase or decreases income and/or expenses.
- Closing entries do not impact profitability as these entries are merely for consolidating account balances of several individual ledger accounts.
- Examples of adjusting entries are extensive including:
-: accounting for accrued expenses but not actually paid,
-: accounting for earned revenue but not actually received,
-: accounting for prepaid expenses for expenses paid but not accrued,
-: creating deferred revenue for income received but not earned.
- Examples of closing entries are only limited to a few entries discussed above.
Conclusion – adjusting entries vs closing entries:
As accounting entries form the basis of many mandatory financial statements like income statement and balance sheet, the entity must pay a proper attention to record them correctly. Once accountants complete the passing of all adjusting and closing entries, they go for drawing up the financial statements. Auditors then proceed to evaluate the books including the correctness of these entries and may also recommend changes in case they have not been correctly recorded. All in all, the ultimate goal of all these entries is that the financial statements should reflect a true and fair view of the entity’s financial position.