If you have been in business long enough, you have heard the term closing your books. What does this mean? Closing your books means zeroing out the income statement and dividend accounts at the end of the year so you start fresh in the next year.
Why are profit and loss accounts closed?
Closing the profit and loss account is comparable to your personal annual wages you earn on the job. You do not get a w2 at the end of the year with the cumulative income how much you have earned since you started working. That information will not be very useful to you. What will be more useful to you is receiving a w2 that stated your income for just that year. In the same way, you want to know how much you make in your business each year. It is the job of the profit and loss statement to give you information for the current year.
On the other hand, the balance sheet provides a way for you to know what you have accumulated in your business. All profit and loss statement accounts gets closed to the balance sheet accounts: this gives you a good picture of how your business has done over time. At the end of the accounting period (which is a calendar year for most businesses), whatever balance is in the profit and loss and dividend accounts is netted with retained earnings account. The retained earnings account is the accumulation of all net income less dividends. In other words, the retained earnings account is what you have kept in your business over time.
The accounting cycle
When you open a business, there are a lot of activities that goes on. You write checks, invoices, sales receipts, etc. The combined process of recording and reporting the accounting events of a business is called the accounting cycle. The series of steps that make up the accounting cycle starts with an event and ends with its presence in the financial statement.
The steps of the accounting cycle are as follows:
- Record transactions
- Adjust accounts
- Prepare statements
- Close temporary accounts
Record Transactions
This is what you do every day in your business. If you use an accounting software, you write checks, create invoices, enter bills, receive cash, etc.
Adjust accounts
At the end of the year, you need to go through your balance sheet account and correct the amounts that are no longer accurate. For example, let us say you prepaid your insurance bill, the right way to classify that transaction initially is prepaid expense. At the end of the accounting period, you have to compute what portion of the insurance has expired, and then enter that amount as an expense on your profit and loss statement. Another example is accruing wages that was earned in the current accounting year but not paid.
Prepare financial statements
Once all entries and adjustments have been made. The financial statements are prepared. There are 4 main financial statements that should be prepared:
- The profit and loss statement
- The balance sheet statement
- The statement of cash flow
- Statement of changes in equity
Closing Temporary accounts
Temporary accounts are accounts that close into the retained earnings at the end of an accounting period: The revenue, dividend and expense accounts are netted with the retained earnings account. This is called the closing process. The effect of this is to zero out all revenue and expense account so a new accounting period starts with a fresh slate. If you use a financial software this is done automatically (phew!).