Temporary Accounts

Temporary accounts, also called nominal accounts, are accounts in the general ledger whose balances relate to one accounting period only. At the end of each period, normally the financial year, their balances are transferred to an equity account through closing entries, leaving them at zero. They then start accumulating again for the new period.

They contrast with permanent accounts, also called real accounts, which are the balance sheet accounts for assets, liabilities and equity. Permanent account balances carry forward from one period to the next; cash at 31 December is the opening cash on 1 January. Temporary accounts exist so that the income statement can measure performance for a defined period, rather than mixing this year's revenue with last year's.

• Revenue accounts, such as sales, service revenue and interest revenue.
• Expense accounts, such as cost of goods sold, wages, rent, depreciation and income tax expense.
• Gains and losses, such as a gain on sale of equipment.
• Contra-revenue accounts, such as sales returns and allowances and sales discounts.
• Dividends declared in a corporation, recorded in a dividends declared account, or owner withdrawals in a sole proprietorship or partnership, recorded in a drawing account.
• Under a periodic inventory system, purchases and its related accounts, such as freight-in and purchase discounts.
• The income summary account, a clearing account that exists only during the closing process.

Closing entries are usually made in four steps:

1. Debit each revenue and gain account for its balance and credit income summary for the total.
2. Credit each expense and loss account for its balance and debit income summary for the total.
3. Close income summary, whose balance now equals net income or net loss, to retained earnings or owner's capital.
4. Close the dividends or drawing account directly to retained earnings or capital.

After closing, a post-closing trial balance is prepared. It lists only permanent accounts, confirming that all temporary accounts are at zero.

At year end, a small consulting firm organized as a corporation has these temporary account balances: service revenue $380,000, interest revenue $2,000, salaries expense $210,000, rent expense $36,000, utilities expense $8,000, depreciation expense $12,000, income tax expense $24,000 and dividends declared $50,000.

The first entry debits service revenue $380,000 and interest revenue $2,000 and credits income summary $382,000. The second debits income summary $290,000 and credits the five expense accounts. Income summary now has a credit balance of $92,000, which is net income:

Here total revenues are $382,000 and total expenses $290,000. The third entry debits income summary $92,000 and credits retained earnings $92,000. The fourth debits retained earnings $50,000 and credits dividends declared $50,000. Retained earnings increase by a net $42,000, and every temporary account starts the new year at zero.

Closing temporary accounts is what lets the income statement report one period's revenue and expenses, and it moves the period's result into equity, keeping the balance sheet in balance. Forgetting to close an account would carry this year's activity into next year's income statement and leave retained earnings understated or overstated. Modern accounting software usually performs the closing automatically when a year is locked, often without a visible income summary account, but the effect is identical. Understanding temporary accounts is a basic part of the accounting cycle and of reading trial balances during the year, when revenues and expenses show cumulative year-to-date totals.