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What is a Temporary Account?
A temporary account is the general ledger account that is closed after each accounting period. At the start of a new period, it resets to zero. The process makes it such that revenues and expenses are accounted for and reported at a particular time, a factor that helps in knowing profits and performance in that span of time.
Consider, as an example, that Company X had revenues of $100,000 in 2022 and another $150,000 in 2023. Without the reset of temporary accounts, the revenue account would reflect $250,000 rather than just $150,000 in 2023. Upon closing temporary accounts at the year-end, an accountant will provide correct information concerning the financial position about each particular year, resulting in the financial statements.
Why Do Temporary Accounts Matter?
Temporary accounts are very critical in attaining a clean separation of accounting periods. They benefit a corporation:
- Measure accurately the net income or net loss.
- Be able to separate the period results of the current period from the cumulative performance.
- Ease of handling the financial reporting experience by eliminating carryover of balances.
Temporary Account Examples
Temporary accounts are broadly classified into three categories: revenues, expenses, and income summary. Here is a closer look at either one.
1. Revenues
The Revenue accounts are the accounts of the total amount of money a business makes as a result of its operations, whether it is made from sales, fees earned, or service revenue. At the close of an accounting period, revenue balances are settled.
As an example, a store with $30,000 in sales revenue for the year will have a debit entry of $30,000 in the revenue account to close the revenue account. Concurrently, a credit of $30,000 is recorded in the income summary.
2. Expenses
Expense is a report on all the expenses incurred in the business on rent, salaries, utility, depreciation, and advertisement. Expenses are a factor relating to the action taken over a given period, and as such, they ought to be reset again at the end of each period.
Consider a business that has a cumulative amount of expenses of $12,000. The accountant credits each expense account to a figure of zero and, at the same time, debits the income summary an amount of $12,000 to clear up these accounts.
3. Income Summary
An income summary is a special form of temporary account that is only utilized during the closings. It acts as a medium in which amounts of revenue and expense books are crossed.
To take an example we used above:
- Revenues of $30,000 are credited to the income summary.
- The expenses of $12,000 are charged to the income summary.
Permanent Accounts vs. Temporary Accounts
There is a need to draw a line between temporary accounts and permanent accounts:
Temporary Accounts
- Include revenues, expenses, and income summary.
- Begin with a zero-balance period by period.
- The year-end was closed to provide proper period reporting.
Permanent Accounts
- Include liabilities, assets, and equity.
- Forward carry-overs automatically happen.
- Not closed- balances of the accounts have a carryover to the next period.
How to Close Temporary Accounts
It is a systematic procedure to eliminate temporary accounts:
- Close Revenues -Transfers balances to the income summary.
- Close Expenses -Transfer balances to income summary.
- Close Income Summary-Carry the net of the result (profit or loss) to the capital account or retained earnings.
- Drawings- The withdrawals are transferred directly to the capital account.
Conclusion
Temporary accounts ensure that every accounting period presents an accurate representation of the business’s performance within the period. Businesses maintain clear, precise, and consistent financial reporting by resetting balances and re-transferring the results to permanent accounts.
