When preparing an income statement or cash flow statement, temporary accounts are used to record financial activity, because they measure activity over a period of time. Temporary accounts are closed during the month-end process, or when a company decides to publish financial statements. Without temporary accounts, it would be difficult to track operating performance and trends.
Temporary accounts are not continuous in nature. Rather, they are used to record activity for a set period of time, such as a calendar or fiscal year. They are used in the bookkeeping process and must be closed, before preparing financial statements. These accounts allow businesses to measure financial performance and profitability, providing insight into the financial stability and well-being of a company.
Looking at the income statement provides a variety of temporary account examples. Revenue and expense accounts are all temporary and illustrate the trajectory of a business.
How to Close Temporary accounts?
During the closing process, a trial balance is created that includes all permanent and temporary accounts. When performing a manual closing, the temporary accounts ultimately net to the total income or loss for the period. An entry is prepared that reduces the temporary accounts to zero, moving their balances to the income summary and retained earnings accounts.
Closing is mostly an automated process given that electronic general ledger systems are in common use. However, manually adjusting a post closing trial balance to reduce the temporary accounts to zero and produce financials still happens in small businesses. The manual process is normally performed in Excel and comprises a workbook with formulated worksheets. Knowing how software closes temporary accounts is important for validating the accuracy of financial statements. Accountants and bookkeepers must understand temporary accounts to perform their jobs effectively.
What is the Difference Between a Temporary Account and Permanent Account?
During the month-end-close process, permanent accounts are not closed like temporary account are. Additionally, balances on permanent accounts roll forward to future accounting periods. Temporary accounts are closed out, and at the beginning of a new year or financial reporting period, the account balance is reduced to zero. While the distinction may not matter when viewing the financial statements, it matters for the bookkeeping process to flow smoothly.
Temporary accounts play a critical role in measuring financial activity that’s ultimately reflected on the income statement and statement of cash flows. It’s important to measure financial performance over time to get a feel for the profitability and trajectory of a business.