Lesson Objectives:- Definition of permanent and temporary accounts
- Difference in the two types of accounts
- Examples of the account types and how they are recorded
Before we take a look at the final step in the accounting cycle of performing closing entries, you must understand the fundamental difference between permanent and temporary accounts. The most important rule related to this concept is the fact that in financial accounting, we will only close the account balances of temporary accounts.
Temporary does not mean the accounts themselves are getting removed, it simply means that the balances will be closed out in the final step of closing entries. Temporary accounts are often referred to as nominal accounts.
Permanent accounts retain their balances at the end of the year and are not used in closing entries. Permanent accounts are known as real accounts.
Now let's compare the different accounts that fall within each category and how they are recorded.
Temporary accounts are the accounts that show up on the income statement, with the exception of dividend accounts, which are shown on the retained earnings statements. Remember the temporary accounts by using RED acronym, which stands for revenues, expenses and dividend accounts, which are also referred to as owner's drawings account.
At the end of the accounting cycle, the balance of temporary accounts is transferred to a permanent account and reset to zero.
Permanent accounts involve the assets, liabilities and equity accounts. When you think of permanent accounts, think of the accounts that are listed on the balance sheet.
They are the polar opposite of temporary accounts as they are not reset to zero, the account balance is compounded each year. The reason for doing this is to be able to track the RED account balances for each year instead of the years cumulatively.
The graphic above gives you a side by side comparison of the account types and how they are recorded.
Let's take a look at a few real world examples of temporary and permanent accounts.
For the first type of temporary account, an example would be if a company earns $30,000 revenue at the beginning of the year. At the end of the year, the revenue account value of $30,000 is transferred to retained earnings. The next year we would start rerecording the revenue values before they are closed out for the end of the accounting period.
An example of a permanent account would be when the property assets are equated to $5 million at the end of the year. This figure would carry over to the beginning of the next year, instead of being zeroed out and transferred to a closing balance. Say the company purchases another $1 million worth of property in the second year; the new balance of $6 million would then carry over into the next year.
Now that you have a basic understanding of the two types of accounts, let's move onto the next lesson on how to prepare closing entries.