A temporary account provides an accumulated balance of a specific account type for one accounting period only. It starts and ends with a zero balance for each accounting period.
Let us discuss what is a temporary account, its different types, and its key differences from a permanent account.
What is a Temporary Account?
A temporary account is a type of account that is closed at the end of each accounting period. Hence, the account balance in a temporary account is temporary and reflects only the current accounting period balance.
The title of a temporary account remains the same for the next accounting period. However, its ending balance is carried forward to permanent accounts on the balance sheet at the end of each accounting cycle.
Therefore, the closing and opening balance of a temporary account should be zero at the end and beginning of an accounting cycle respectively.
Temporary accounts belong to the income statement of an entity. The bottom line of the income statement is then shifted to the retained earnings or capital account on the balance sheet depending on the type of entity.
Common examples of temporary accounts include:
- Sales revenue
- Interest income
- Proceeds from investing activities
- Rent, utilities, and administrative expenses
- Gains or losses from financing activities
- Income tax
- Net income
How Does a Temporary Account Work?
Temporary accounts reflect the summary balances from ledger accounts for their respective categories.
A business records every accounting transaction on its general ledger first. These accounts are then reconciled and adjusted for accuracy.
The adjusted balances are then carried forward to either temporary accounts on the income statement or permanent accounts on the balance sheet.
Temporary accounts belong to the income statement. The bottom line of these accounts is net profit (or loss) at the end of each accounting period. Once this amount is carried forward to the balance sheet, the ending balances of all temporary accounts become nil.
Therefore, each temporary account will show a zero balance at the end. The running balance will start from zero for the next period and keep changing during the period.
Unlike permanent accounts, temporary accounts do not show accumulated balances but running balances for a specific accounting period. This accounting period can be a day, month, quarter, or year.
Types of Temporary Account
Temporary accounts are income statement accounts. We can summarize these accounts into three main categories.
This section contains the income and revenue accounts of an entity. Revenue accounts include sales, interest revenue, service revenue, etc.
The sum of all revenue accounts is moved to the income summary account at the end of each accounting cycle. So, the balance of revenue accounts will be zero at the beginning and ending date of the accounting period.
Expense accounts represent the money spent by a business to generate revenue and maintain its operations. Common expense accounts include the cost of goods sold, administrative, marketing, taxes, and depreciation accounts.
Like revenue accounts, the ending balances of expense accounts are also transferred to the income summary account through the income statement.
Income Summary/Retained Earnings
The income summary account shows the net profit or loss of an entity at the end of an accounting period. It shows the net effect of profit and losses incurred by an entity.
Then, the ending balance is shifted to the retained earnings account on the balance sheet. Some businesses use the direct method and transfer the net income amount from the income statement to the retained earnings or capital account on the balance sheet.
Temporary Account – Example
Suppose a company ABC makes sales of $ 1,500,000 for the year 2020. It deducts operating and administrative expenses from the gross revenue amount.
The company reports a net income of $ 300,000 for the year 2020. As both these accounts are temporary, ABC will move the ending balances to the income statement.
Then, the net profit amount of $300,000 will be transferred to the retained earnings account. So, at the beginning of the year 2021, ABC company will start with $0 sales and $0 income for the year again.
If the company prepares temporary accounts for quarterly or monthly periods, it will transfer revenue and expense account balances accordingly. The purpose is to transfer all temporary account balances to the permanent accounts in the balance sheet.
Key Features of a Temporary Account
Temporary accounts represent the summary of income/loss of a business at any time. These accounts differ from permanent accounts in nature.
Here are a few key features of these accounts.
Temporary accounts follow the accounting cycle. Each temporary account begins with a zero balance and the ending balance is transferred to the balance sheet.
Unlike permanent accounts, these accounts do not accumulate balances over the life of a business. The account titles remain the same for the next period and their running balances show for the current accounting period only.
Zero Ending Balance
As mentioned above, temporary accounts show zero ending balances at the end of each accounting period. It means these accounts begin with zero account balances as well.
The primary purpose of temporary accounts is to provide useful information to different stakeholders. However, the temporary accounts represent the balances for a specified accounting period only.
Temporary accounts can be used to track the income and expenses generated during the accounting period. It can also help a business to compare the performance of a business against previous periods.
Temporary accounts represent several income and expense sub-accounts from the income statement.
Common examples of temporary accounts include sales, COGS, marketing expenses, rent, salaries, taxes, and so on.
How to Close Temporary Accounts?
All temporary accounts go through the closing process at the end of each accounting period. A business records all transactions on the general ledger as and when they happen.
Then, the ledger balances are adjusted for corrections and reconciled. The adjusted trial balances are then moved to the income statement temporary accounts. Then, the temporary accounts are closed for the accounting period.
Here are a few key steps to follow in the closing process.
- The first step is to transfer the revenue account balance from the income statement to the income summary account.
- The second step is to transfer the expense and losses account balances from the income statement to the income summary account.
- Then, the revenue and expense account balances brought to the income summary account are transferred to the capital account.
- Finally, the drawing account balance is transferred to the capital or retained earnings account.
The closing of income statement temporary accounts is similar for all categories. Once reconciled, the ending balances are shifted from the income statement to the balance sheet simply.
How to Treat Drawings Account?
A drawing or dividend account is not a temporary account. However, its ending balance is transferred to the capital account at the end of each accounting cycle as well.
A drawings or dividends account shows the cumulative amount withdrawn by the owner of a business during the accounting period.
Therefore, it should also be closed at the end of the accounting period like any other revenue or expense account.
The drawings account is debited and the capital account is credited for the same account to transfer the balance.
Temporary Accounts Vs Permanent Accounts
Temporary and permanent accounts provide useful information to stakeholders and can be used to evaluate the performance of an entity over specified accounting periods.
Temporary accounts represent the performance of an entity for a specific accounting period; a day, month, or year. Permanent accounts represent the performance of an entity for the life of an entity.
Temporary accounts are closed at the end of each accounting period and they begin with zero balances for the next period. Permanent accounts carry forward their ending balances to the next accounting period and do not get closed.
Temporary accounts include income statement sub-accounts including revenue, expenses, gains, and losses. Permanent accounts include the balance sheet accounts like assets, liabilities, and equity.
Both types of accounts serve different purposes for a business. They are both essential parts of the financial statements of a business. The main difference between both types of accounts remains the way the ending balance is maintained at the end of an accounting period.