What is a Temporary Account?
A temporary account is an account that is closed at the end of every accounting period to start a new period with a zero balance. It is done in order to avoid a mix-up of the balances between two or more accounting periods. The objective is to see the profits or revenues, as well as 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 account must be closed, and a new record is 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.
From the name itself, it refers to the total amount of money earned by a company that needs to be closed at the end of the accounting year. The revenue type of temporary account, when closed, requires the accountant to create a debit entry for the revenues. For example, the total revenue recorded was $20,000, then, a debit of the same amount should be written in the revenue account that will create a zero balance again.
Then, in the income summary account, a corresponding credit of $20,000 is recorded in order to maintain the balance of the entries. After the credit entry is done, the revenue account is closed and then transferred to another temporary account, which is the income summary account.
Expenses are an important part of any business because these keep the company going. The expenses account is a temporary account that shows everything that the company spent on its operations, including advertising and supplies, among others.
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 it onto that account, consequently zeroing the balance on the expenses account. Accordingly, the $5,000 worth of expenses is also recorded as debit to the expenses 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 summary by making a debit of the same amount from the income summary and making a credit of it to the capital account.
What is the Drawings Account?
Drawings account is otherwise known as a corporation’s dividends, 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 acquired by 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.
- The account includes equity, liabilities, and assets accounts and is also called a real account.
- 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. It 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.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: