A temporary account is an account that is closed at the end of every accounting period and starts a new period with a zero balance. The accounts are closed to prevent their balances from being mixed with the balances of the next accounting period. The objective is to show the profits that were generated and the accounting activity of individual periods.
For example, Company ZE recorded revenues of $300,000 in 2016 alone. Then, another $200,000 worth of revenues was seen in 2017, as well as $400,000 in 2018. If the temporary account was not closed, the total revenues seen would be $900,000.
The company may look like a very profitable business, but that isn’t really true because three years-worth of revenues were combined. In order to properly compute for the year’s total profits, as well as the total expenses, the temporary accounts must be closed, and a new balance created at the beginning of a new accounting period.
Examples of Temporary Accounts
There are basically three types of temporary accounts, namely revenues, expenses, and income summary.
Revenue refers to the total amount of money earned by a company, and the account needs to be closed out at the end of the accounting year. To close the revenue account, the accountant creates a debit entry for the entire revenue balance. For example, if the total revenue recorded was $20,000, then a debit entry of the same amount should be written in the revenue account.
Then, in the income summary account, a corresponding credit of $20,000 is recorded in order to maintain a balance of the entries.
Expenses are an important part of any business because they keep the company going. The expense accounts are temporary accounts that show everything that the company spent on its operations, including advertising and supplies, among other expenses.
For example, at the end of the accounting year, a total expense amount of $5,000 was recorded. The amount is transferred to the income summary by crediting the expense account, consequently zeroing the balance, and an equal amount is recorded as a debit to the income summary account.
3. Income Summary
The income summary is a temporary account of the company where the revenues and expenses were transferred to. After the other two accounts are closed, the net income is reflected. Taking the example above, total revenues of $20,000 minus total expenses of $5,000 gives a net income of $15,000 as reflected in the income summary.
Since the income summary is a temporary account, it needs to be transferred to the capital account by making a debit entry of 15,000 from the income summary and making a credit entry to the capital account.
What is the Drawings Account?
A drawings account is otherwise known as a corporation’s dividend account, the amount of money to be distributed to its owners. It is not a temporary account, so it is not transferred to the income summary but to the capital account by making a credit of the amount in the latter.
For example, the drawings account contains $5,000. The accountant then needs to make a debit of $5,000 from the drawings account and a credit of the same amount to the capital account.
Temporary Account vs. Permanent Account
A temporary account, as mentioned above, is an account that needs to be closed at the end of an accounting period. It aims to show the exact revenues and expenses for a company for a specific period.
A permanent account, on the other hand, possesses the following characteristics:
It is not closed at the end of every accounting period and may stay open throughout the life of the company.
Such types of accounts include equity, liabilities, and assets accounts and are also referred to as real accounts.
A permanent account’s balances are continued in the next accounting period, which means the end of the previous period is the beginning of the next one.
How to Close a Temporary Account
Basically, to close a temporary account is to close all accounts under the category.
Close the revenue account. This involves transferring the amount in the revenue account to the income summary.
Close the expenses account. The same thing is done wherein the amount in the expenses account is transferred to the income summary.
Close the income summary. The amount in the income summary, which is the expenses and revenue, is transferred to the capital account.
Close the drawings account. The amount in the drawings account is transferred to the capital account or the retained earnings account.
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