When preparing an income statement or cash flow statement, journal entries of temporary accounts are used to record financial activity because they measure activity over a period of time. Company accounts such as 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.
Definition
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 a company’s financial stability and well-being.
Examples
Looking at the income statement provides a variety of temporary account examples. Revenue totals and expense accounts are all temporary and illustrate the trajectory of a business.
Examples of temporary accounts:
-Sales
-Sales Discounts
–Cost of Goods Sold
-Rent
-Salaries Expense
-Advertising
-Utility Expense
–Interest Expense
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 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 financial statements’ accuracy, especially when transitioning over to the next period. Accountants and bookkeepers must understand temporary accounts to perform their jobs effectively.
What Is The Difference Between A Temporary Account And a Permanent Account?
During the month-end-close process, permanent accounts are not closed like temporary accounts are. Additionally, balances on permanent accounts roll forward to future accounting periods. Permanent accounts are listed as the company’s balance sheet accounts like asset accounts, liability, and owner’s equity accounts. Temporary account balances, also known as nominal accounts, are closed out with closing entries. At the beginning of a new year or financial reporting period, the account balance is reduced to a zero balance. Temporary accounts are income statement accounts such as revenue accounts, expenses, gains, dividend accounts, and loss accounts. Income summary accounts and the withdrawals or withdrawal accounts in a sole proprietorship or proprietor’s drawing account are also classified as temporary accounts. The drawing account balance is transferred over to the owner’s capital account. After revenues and total expenses are zeroed out, the balance represents net income. While the distinction may not matter when viewing the financial statements, it matters for the bookkeeping process to flow smoothly at the end of every accounting period and into the next accounting period.
Temporary accounts play a critical role in measuring financial activity that’s ultimately reflected on the income statement accounts and statement of cash flows. It’s important to measure financial performance over time to get a feel for a business’s profitability and trajectory.
Resources:
https://www.sba.gov/sites/default/files/accounting_worksheet.pdf
https://accessdl.state.al.us/AventaCourses/access_courses/accounting_ua_v15/2_unit/02-03_intro.htm
