What are Temporary Accounts? An In-Depth Look
What Are Temporary Accounts?
Temporary accounts, also known as nominal accounts, are those where the balance goes to zero before starting the next accounting period. The most common accounting period for small businesses is the fiscal year.
By zeroing out these accounts, companies ensure funds earned in one fiscal year do not carry over into a new fiscal year. This provides a clear picture of profit or loss for the year.
The measurement of net income is the scoreboard of the business world. (Plus, deep down, we accountants all love the idea of using temporary accounts. Making numbers disappear is the Harry Potter-like moment we wait 365 days to deploy.)
We will help you understand how temporary accounts work, why we must close them at the end of the year, and where the money in them goes.
Definition of Temporary Accounts
The use of temporary accounts is the best way for accountants to measure profitability for a business. You can use these temporary accounts for any accounting period, such as a quarter. However, most of the time, a fiscal year is most common.
Most temporary accounts are on the income statement. But a few show up on the balance sheet.
Over a fiscal year, the temporary account starts with a zero balance on January 1. Through your bookkeeping, you record your company’s transactions during the year. And before the start of the new year, the temporary accounts must return to a zero balance.
That happens when you move the temporary account balances at the end of the year into a permanent account.
These are called closing entries, and they reset the balances and close the temporary accounts for the year to prepare them for the new accounting cycle.
With the accurate measurement of income in an accounting period, you can compare the business’ performance over time. Without using temporary accounts, making these comparisons would be far more challenging.
What Are the 4 Temporary Accounts?
You may use as many as four general types of temporary accounts to prepare financial statements. Each type of account has its own function.
- Revenue: The revenue accounts measure the cash or receivables the company earns through selling its goods and services to customers. It contributes a positive amount to the profit and loss calculation and has a credit balance on the trial balance.
- Expense: The expense accounts measure money the company spends on the performance of its operation. The account balance increases each time the company spends funds, creating a negative amount that offsets revenue in the profit and loss calculation.
- Income summary: The income summary is also known as net income on the income statement. It’s a running total of all your revenue and expenses. The income summary account is also a temporary account. Eventually, your accounting software will move this amount into the permanent earnings account on the balance sheet.
- Drawings or dividends: Business owners use a drawing account to withdraw money for personal use. This is a distribution of company profits to the business owner. Businesses with sole proprietorships, partnerships, or S-Corps often use a drawing account. In contrast, C-Corporations will return shareholder capital and company profits through dividends. Your software will move its balance into the owner’s equity or capital account at the end of an accounting period.
What Is the Difference Between a Temporary and a Permanent Account?
When trying to determine when to use a temporary account versus a permanent account (also called a real account), it helps to understand that the two types of accounts have quite a few similarities. They track financial transactions and are necessary for the accounting process to generate accurate financial statements.
The primary difference between the two is that you will zero out your temporary accounts before starting a new period. The permanent accounts will never zero out, remain open, and roll forward to future periods.
Permanent accounts are asset accounts, liabilities, and equity accounts you’ll see on the balance sheet.
How to Close Temporary Accounts
The closing process for your temporary accounts is not complicated. You may already be familiar with it during your month-end or year-end closing procedures.
The process starts by having your accounting software transfer the balances of the income statement temporary accounts to net income.
This profit or loss is then transferred to the retained earnings account on the balance sheet. This resets the income statement accounts and net income back to zero.
If you use a drawing account, you should also have the software zero it out and move it to the owner’s capital account.
It is important to consistently close the temporary accounts for the same period for consistency and accurate comparisons. For most businesses, this will be once a year. A few companies may reset the temporary accounts every quarter.
Examples of Temporary Accounts
Some examples of temporary accounts you’ll find in a chart of accounts include:
- Cost of goods sold
- Gains on sale of assets
- Loss accounts
- Interest expense
- Owner draws
To understand why you should use temporary accounts, consider this example.
In 2019, your new company showed a profit of $250,000.
But in 2020, the company lost $10,000 before losing $120,000 in 2021.
If you reset the temporary accounts after each fiscal year, it becomes clear the company is struggling because the results are trending in the wrong direction.
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But if you don’t use temporary accounts, it would appear that the company’s earnings sit at $120,000 (calculating the revenues and expenses of the three years together).
In a situation like this, it may appear as though the company is in solid shape rather than struggling with significant losses and possible cash flow issues over the past two fiscal years.
Accounting for Temporary Accounts
Ultimately, the beauty of temporary accounts is their ability to give you a clear picture of revenues generated, expenses incurred, and the profit or loss of the business over a fiscal year.
They don’t require any extra work on your part to track revenues and expenses in them, either. They work like any other account. You’ll record debits and credits and post journal entries to your general ledger for temporary accounts as you would permanent ones.
They have an expiration date like that salad dressing bottle that’s been in the back of your fridge for a couple of years.
As long as you remember to zero out the temporary accounts at the end of the year, they’re a great tool to measure business performance.