How do temporary accounts differ from permanent accounts? Name three temporary accounts. Is retained earnings a temporary or a permanent account?
The correct answer and explanation is:
Temporary accounts and permanent accounts are two key categories in accounting that differ in terms of their role and how they are managed during the accounting period.
- Temporary accounts: These are accounts that are used to accumulate financial information for a specific period (typically a fiscal year). They are closed at the end of each accounting period, and their balances are transferred to permanent accounts. These accounts track transactions that will reset at the start of the next period. The primary goal of temporary accounts is to measure the performance of a company over a specific period.
- Permanent accounts: Unlike temporary accounts, permanent accounts track financial information over multiple periods and their balances are carried forward to the next accounting period. These accounts are never closed and reflect the company’s ongoing financial position.
Three examples of temporary accounts include:
- Revenue accounts: These accounts track income generated from the sale of goods or services during a specific period (e.g., sales revenue).
- Expense accounts: These accounts track the costs incurred by the company to generate revenue (e.g., rent expense, utilities expense).
- Drawing accounts: These accounts track withdrawals made by the owner of the business (e.g., owner’s drawings).
Retained earnings is a permanent account. It reflects the cumulative amount of net income that a company has retained over time, after distributing dividends. Retained earnings are updated at the end of each period when the net income (or loss) is transferred from the income summary temporary account. Because retained earnings carry forward from one period to the next and are not closed at the end of the period, they are considered a permanent account.
In summary, the main difference is that temporary accounts reset to zero after each period, whereas permanent accounts carry their balances forward indefinitely, reflecting the ongoing financial position of the company.