Lesson 8 of 9
Turning a year into a balance
Revenue and expenses are emptied into retained earnings and start again at zero. Why some accounts reset and others never do, and what that boundary means.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Revenue and expense accounts are temporary. They measure a period, so they are emptied at the end of it and start the next year at zero.
- Assets, liabilities and equity accounts are permanent. They measure a position, so their balances carry forward unchanged.
- Closing is how a year's profit becomes retained earnings, which is the only place profit ever lands.
At the end of a year, the revenue account holds $150,000 and the wages account holds $45,000. Next year those figures have to start again at nothing, or the second year's income statement would contain the first year's sales.
Closing is the mechanism. It empties every temporary account into one place and leaves the permanent ones alone.
Which accounts reset and which carry forward
Temporary: closed to zero
- Revenue, $150,000.
- Cost of sales, $26,000.
- Wages, rent, depreciation and interest, $62,400 together.
Permanent: carried forward
- Cash, receivables, materials, prepaid rent, equipment.
- Payables, deferred revenue, interest payable, the loan.
- Share capital and retained earnings.
A period account is emptied at the year end. A position account is not, because a position does not stop at midnight on 31 December.
The closing entries
Check the arithmetic: $150,000 less $88,400 is $61,600, and $88,400 is $26,000 plus $45,000 plus $9,000 plus $6,000 plus $2,400.
Why equity is the destination
Profit belongs to the owners, so it has to end up in the part of the balance sheet that records their claim. Every expense reduces that claim and every sale increases it, which is exactly the rule from lesson three about why revenue carries a credit balance and expenses carry debits.
Retained earnings therefore has one meaning and it is precise: the running total of every profit the business has ever made, less every dividend it has ever paid. Fen Street Bindery paid no dividend, so its retained earnings at the end of year one is the whole of its first-year profit.
Had it paid a dividend of $20,000, the entry would have been a debit to retained earnings and a credit to cash, and the year-end balance would have been $41,600. A dividend is not an expense and never touches the income statement, because paying the owners is not a cost of earning the profit.
The boundary this draws
The closing process is where the two halves of accounting meet, and the boundary is worth stating once plainly.
An income statement covers a stretch of time and is emptied when that stretch ends. A balance sheet describes one instant and continues. That is why a published income statement always names a period, "for the year ended", and a balance sheet always names a day, "as at".
It is also why comparing a period figure with a position figure needs care. A year of profit divided by a balance sheet total is mixing a flow with a stock, which is why ratios like return on equity are usually computed against the average of the opening and closing balance rather than one of them.
What closing does not do
It does not check anything. A set of books with a wrong estimate in it closes exactly as cleanly as a correct one, and the profit that lands in retained earnings is whatever the adjusted accounts said.
In modern systems closing is often notional: the software keeps the running balances and reports a period by date range rather than by emptying accounts. The concept survives even where the mechanical step does not, because a period figure and a position figure are still different things.
Check yourself
Why are revenue and expense accounts closed at the year end?
- To correct errors found during the year
- Because they measure a period, so the next period must start from zero
- Because regulators require the accounts to be emptied
Show the answer
Answer: B.
Leaving last year's revenue in the account would put it into this year's income statement. Position accounts carry forward for the opposite reason: a balance does not stop at a year end.A company pays a $20,000 dividend. Where does it appear?
- As an expense on the income statement
- As a debit to retained earnings, reducing equity, with no effect on profit
- As a liability that never clears
Show the answer
Answer: B.
A dividend is a distribution of profit already earned, not a cost of earning it. It reduces the owners' accumulated claim without passing through the income statement.What does retained earnings represent?
- Cash the company has set aside
- Every profit ever made, less every dividend ever paid
- This year's profit only
Show the answer
Answer: B.
It is cumulative and it is a claim rather than a fund. The money it corresponds to was spent long ago on whatever assets the business now holds.Sources
- This lesson is taught from first principles. No external source is cited, because no claim here depends on one.
What this leaves out
- Fen Street Bindery and every figure are invented, chosen so the closing arithmetic can be checked by hand.
- The income summary account is a teaching convention. Many systems close the temporary accounts straight to retained earnings and never create it.
- Real equity also moves for share issues, buybacks, share-based pay and other comprehensive income, none of which appear in this simple example.
- Nothing here is advice about any security.