To close retained earnings at the end of an accounting period, you post four journal entries in order: close every revenue account into Income Summary, close every expense account into Income Summary, transfer the net balance in Income Summary to Retained Earnings, and close the Dividends account against Retained Earnings. When all four entries have posted, your temporary accounts sit at zero and Retained Earnings reflects the company’s updated cumulative profit ready to carry into the new year.
Before You Post Anything
Two things need to be in place first.
The adjusted trial balance is your starting point. This is the list of every account balance after adjusting entries for depreciation, prepaid expenses, and accrued liabilities, but before any closing entries. If it doesn’t balance, or if an adjustment is missing, every closing entry built on it will be wrong. Verify it before you touch anything else.
You’ll also use an account called Income Summary. It never appears on a financial statement. It exists only during closing as a holding area: revenue and expenses flow in, and the net result flows out to Retained Earnings. If your chart of accounts doesn’t already have one, add it before you begin.
The distinction driving the whole exercise is temporary versus permanent accounts. Revenue, expenses, and dividends are temporary — they track a single period’s activity. Assets, liabilities, and equity (including Retained Earnings) are permanent and carry forward indefinitely. Closing entries empty the temporary accounts into the permanent ones so the next period starts clean.
Step 1: Close Revenue Accounts to Income Summary
Revenue accounts carry credit balances during the year. To zero them out, debit each revenue account for its full ending balance and post a single offsetting credit to Income Summary.
If your company earned $200,000 in service revenue and $5,000 in interest revenue, the entry is:
- Debit Service Revenue $200,000
- Debit Interest Revenue $5,000
- Credit Income Summary $205,000
After the entry posts, every revenue account reads zero, and Income Summary holds the year’s total revenue as a credit balance.
Step 2: Close Expense and Contra-Revenue Accounts to Income Summary
Expense accounts carry debit balances, so this entry mirrors Step 1. Credit each expense account for its full balance and debit Income Summary for the total.
If expenses totaled $150,000 across salaries, rent, utilities, and depreciation, you credit each of those accounts to zero and debit Income Summary for $150,000.
Contra-revenue accounts like Sales Returns and Allowances also carry debit balances, and they close the same way expenses do. Credit the contra-revenue account to zero and include it in your debit to Income Summary. Some accountants net contra-revenue against revenue in Step 1, but closing it here keeps each account’s entry explicit.
After this step, Income Summary holds the net of revenue minus expenses. Using the running example, it now carries a $55,000 credit balance ($205,000 minus $150,000), representing net income. If expenses had exceeded revenue, Income Summary would show a debit balance instead, representing a net loss.
Step 3: Close Income Summary to Retained Earnings
This is the entry that actually changes equity.
If Income Summary has a credit balance (net income), debit Income Summary for the full amount and credit Retained Earnings. In the example, you debit Income Summary $55,000 and credit Retained Earnings $55,000. Equity goes up.
If the company had a net loss, the direction reverses. Credit Income Summary to zero it out and debit Retained Earnings to reduce equity. A loss year shrinks the cumulative Retained Earnings balance, which is what the balance sheet should reflect.
After this entry, Income Summary carries a zero balance and stays dormant until next year’s close.
Step 4: Close the Dividends Account to Retained Earnings
Cash dividends paid to shareholders during the year sit in a separate Dividends account with a debit balance. To close it, credit Dividends for the full amount of distributions and debit Retained Earnings. This reduces equity to reflect the cash that left the business.
Retained Earnings now shows the updated cumulative total: the prior balance, plus this year’s net income (or minus this year’s loss), minus dividends paid. That single number on the balance sheet represents everything the company has earned and kept since it was formed.
Verify With a Post-Closing Trial Balance
Once all four entries have posted, run a post-closing trial balance. It lists only permanent accounts: assets, liabilities, and equity. Every temporary account should be zero and either not appear or appear as zero. If total debits don’t equal total credits, something went wrong in one of the four entries, and you trace it back to the adjusted trial balance.
This is the last checkpoint of the accounting cycle. Skip it and you risk carrying a hidden imbalance into the new year, where finding it becomes much harder.
If You Declared Stock Dividends Instead of Cash
Cash dividends reduce Retained Earnings dollar for dollar. Stock dividends are different because they distribute additional shares rather than cash, and the accounting depends on the size of the distribution.
A small stock dividend, generally less than 20 to 25 percent of outstanding shares, requires the company to transfer an amount equal to the fair market value of the new shares out of Retained Earnings and into paid-in capital. Issue 1,000 shares trading at $30 each and Retained Earnings drops by $30,000, even though no cash moved.
A large stock dividend, above that threshold, functions more like a stock split. Only the par value of the new shares gets reclassified out of Retained Earnings, which is usually a much smaller number. If your company declared stock dividends during the year, the type and size determine how much of the reduction you’ll see after closing.
If You’re Not a Corporation
Retained Earnings is a corporate concept. If you run a sole proprietorship, your equity section uses a single Owner’s Capital account. The closing process is mechanically identical: close revenue and expenses into Income Summary, then close Income Summary into Owner’s Capital instead of Retained Earnings. The Draws account (owner withdrawals) closes against Owner’s Capital the same way Dividends closes against Retained Earnings.
Partnerships follow the same pattern but use a separate Capital account for each partner. Net income gets allocated among partner capital accounts according to the partnership agreement, and each partner’s withdrawals close against their individual capital account. If you’re looking for how to close retained earnings and you don’t have a corporation, these are the accounts you’re actually closing to.
If You Discover an Error From a Prior Year
A material error from a previous year doesn’t get fixed in the current period’s income statement. Under GAAP, material prior-period errors require a restatement. The correction hits the opening balance of Retained Earnings for the earliest period presented in your comparative financial statements, and you adjust all affected line items retroactively. You’ll also need to disclose the nature of the error, the amount of the correction, and its effect on previously reported figures.
The reason for touching Retained Earnings directly is that current-year income shouldn’t be distorted by a mistake belonging to a prior year. Immaterial errors can be corrected in the current period without restating anything. The line between material and immaterial is a judgment call, but an error large enough to change a lender’s or investor’s view of the company is almost certainly material.
A Note on Software
Most modern accounting software posts the closing sequence automatically at year-end, generating the debits and credits to Income Summary and Retained Earnings without manual journal entries. Understanding the four steps still matters. When the software-generated post-closing trial balance shows a balance you didn’t expect, you need to know which of the four steps went sideways and how to trace it back to the adjusted trial balance where the process started.
The IRS expects businesses to keep records sufficient to prepare accurate financial statements and to support every item reported on a return. Records must be available for inspection at all times, and a complete set speeds up any examination.1Internal Revenue Service. Publication 583, Starting a Business and Keeping Records Clean closing entries are the foundation of that record.