Closing entries are the entries used to transfer the balances of the temporary accounts to permanent accounts. The temporary accounts in accounting are revenue, expenses, and dividend accounts. In a normal accounting process, the balances of these accounts or the income statement accounts will start with zero from the new accounting period.
How is closing entries made?
At the end of the reporting period, the credit accounts or revenue accounts are closed by making a debit entry for the balance. For all the debit accounts or expense accounts a credit entry is made for the balance in the general ledger.
While making a closing entry a new temporary account known as income summary is created. So all the outstanding revenues and expenses balances are transferred to this income summary account.
Finally all the balances have to be in a permanent account. So after the closing entries have been made about the temporary account balances in the income summary, it will be closed in the Retained Earnings. Since the balance in the income summary account is the difference between sales and expenses in turn its owner's equity.
So by making the closing entries, rough idea about the profit and losses can be got. To know the details about the profit and losses the balance sheet has to be referred. In small firms the closing entries decide the profits or revenues earned by a company.