At the end of the fiscal period, accountants “close” certain accounts in order to prepare the financial statements. To do so, they transfer the balances on the income statement (the revenue, expense and dividend accounts) to the statement of retained earnings, and reset the numbers on the income statement to zero. This way, the accounts on the income statement are ready to start tracking economic activity for the next fiscal period. Because the income statement accounts only hold the financial information for a single fiscal period, they are known as temporary accounts.
Note that the balance sheet accounts (the assets, liabilities, and shareholders’ equity accounts) are not temporary—they accumulate data over time, from the company’s very first fiscal period onward, and are never reset to zero. They are known as permanent accounts.
Why close accounts?
The reason for the transfer of the temporary accounts to the retained earnings account is to ensure that all revenues, expenses and dividends continue to be reflected on the balance sheet and consequently that the fundamental accounting equation remains in balance. As the income statement starts anew with each fiscal period, its data must move (else be lost) to a permanent account (in this case, the retained earnings account which is part of the shareholders’ equity account). The net result of this transfer is that the statement of retained earnings is an ongoing reflection of past revenues, expenses and dividends and it changes accordingly as these accounts increase or decrease.
Markle, K. (2004, August). Introduction to Accounting. Presentation delivered at Schulich School of Business, York University, Toronto, Canada.
Pratt, Jamie. (2003). Financial Accounting in an Economic Context. New York: John Wiley & Sons.