An important purpose of closing entries is to
a. adjust the accounts in the ledger
b. set nominal account balances to zero at the start of the next period.
c. set real account balances to zero at the start of the next period.
d. help in preparing financial statements.
The correct answer and explanation is :
The correct answer is:
b. set nominal account balances to zero at the start of the next period.
Explanation:
Closing entries are an essential step in the accounting cycle, performed at the end of an accounting period. Their primary purpose is to reset the balances of nominal (temporary) accounts to zero, ensuring that revenue and expense accounts start fresh for the new accounting period.
Understanding Nominal and Real Accounts
- Nominal Accounts: These accounts are temporary and include revenues, expenses, income summary, and dividends (or withdrawals in the case of sole proprietorships). Since these accounts accumulate transactions for a specific period, their balances should not carry over to the next period.
- Real Accounts: These are permanent accounts, such as assets, liabilities, and equity accounts, which continue from one period to another and are not closed.
Why Closing Entries Are Necessary?
- Prevent Carryover of Old Balances: By resetting nominal accounts to zero, closing entries ensure that revenue and expense recognition starts anew in the next period, preventing incorrect financial reporting.
- Summarize Performance for the Period: Closing entries transfer the net income (or loss) to the owner’s equity (or retained earnings) account, reflecting the company’s performance over the period.
- Prepare for New Transactions: A fresh start for revenue and expense accounts allows accurate tracking of financial performance in the next period.
- Facilitate Financial Statement Accuracy: The process ensures that the income statement and retained earnings statement reflect only the relevant data for the current period.
Thus, closing entries help maintain proper accounting records and financial reporting by ensuring that only real account balances carry forward while nominal accounts are reset.