One of the most confusing aspects of the accounting process is understanding the difference between temporary and permanent accounts. Someone may ask, why is knowing this important? It is important because, if you must do a proper booking keep then this knowledge of what a temporary account is will come in handy.
In this article, we have tried as much as we can to provide concise information about temporary and permanent accounts as we know that this information will help you know which is not a temporary account including the characteristics of a temporary account.
What is a Temporary Account?
An account is considered to be a temporary account if it is designed to track financial activities over a stipulated period of time. This is a type of account that should be closed after the stipulated period of financial activities has elapsed.
Since it is a type of account that is used to track financial activities over a period of time, it Immortal that after the stipulated time has elapsed the account should be closed so that no financial activity carried out in the current period would be charged to the next period.
The main types of accounts taught in Accounting 101 are Assets, Liabilities, Expenses, Income/revenue and Equity.
All accounting transactions are recorded in these accounts at a different level, whether you account for a small business or a Fortune 500 company. For example, when you pay $1,500 a month in rent, you directly affect the asset and expense accounts.
When you are paid $150 by a customer, the process affects the asset and income accounts. With this process in mind, it’s easier to understand what temporary accounts are for and why they’re important.
Examples of Temporary Accounts
Basically, there are three types of temporary accounts namely Income, Expenditure and Income Summary.
#1. Income/Revenue Account
In a company account, the total money earned by that company is called the revenue. This type of account in a company needs to be closed by the end of the year so that it will not be carried over to the next year.
For a company to close this account, the accountant will need to create a debit entry for the entire income balance. If the total recorded revenue is, for example, $25,000, the revenue account to be debited of the same amount, i.e. the debit entry of$25,000 should be written in the revenue account.
A corresponding credit of $25,000 is then posted to the revenue summary account to maintain the entry balance.
#2. Expense Account
You cannot remove expenses from a running business as it is an important aspect of any company. The only way to keep a business moving is through expenses. This is a type of account that tracks the expenses made by a company or business over a period of time. These expenses are always made toward the running of the business including supplies, advertisement, etc.
For example, $7,000 is spent by a company in running its business over a year – at the end of the accounting year, the amount is transferred to the income summary by crediting the expense account, in which case the balance is reset and the corresponding amount is debited from the income summary.
#3. Income Summary Account
An income Summary Account is one of the most important types of temporary account – this is where the revenues and expenses made by a company over a period of time is transferred as the revenue and expense account has been closed, the account now shows the net income of the company.
In the example above, a gross income of $25,000 less gross expenses of $7,000 results in net income of $18,000, which appears on the income summary.
You should also remember that the income summary is a type of temporary account, it should be transferred to the capital account. This can be done by making a debit entry to the income summary account and making a credit entry to the capital account.
Also Read: 9 States With No Income Tax
Where do Temporary Accounts Come from?
We stated the importance of a temporary account to a business, be it small or big. Temporary accounts are tools that help for the smooth running of a business daily. These accounts keep records of income, expenses and net income over a period of time. It is through these accounts that financial statements are created.
If we want to know where the use of these methods of accounting started, then we need to look as far back as centuries ago when merchants use them to keep their transactions and assets on track.
Today, companies use software like Quickbooks to create these accounts which makes for the easy tracking of resources and cash flow. With a computer, manual entry is no longer necessary and the accounting process is much easier.
With help of technology, the accounting process is now much easier – the process of keeping temporary accounts is now automated and computerised.
Non-Temporary Account Definition – What is a Permanent Account?
Permanent accounts are non-temporary financial accounts that cannot be closed easily like temporary accounts. They are a type of account that require prior notice before they are closed. This means that the account will remain open even if you are inactive.
Permanent accounts are a type of account that require debit and credit cards to be associated with them. Savings and Checking accounts are types of permanent accounts.
These accounts often have a wide range of features and services associated with them and they include access to online banking, bill payment options, overdraft protection, direct deposit and more. With a permanent account, individuals can enjoy the convenience of having all their financial products in one place.
In addition, they offer more security than other temporary or short-term financial products. However, another important thing you should know about a permanent account is the fact that you may have to pay more fees in managing them than you will do in a temporary account.
What’s the Difference between Temporary and Permanent Accounts?
Temporary accounts refer to accounts whose balance has not been transferred at the end of the accounting period. Instead, the balances of these accounts are transferred to the corresponding permanent accounts at the end of the period.
Non-temporary (permanent) accounts, on the other hand, recycle balances every accounting period.
Examples of permanent accounts are Assets, liabilities, and equity and they can be found on your balance sheet, while revenue and expense accounts are temporary accounts on your summary statement that must be closed each fiscal year.
Remember to close the Temporary Account
Using a temporary account can help you keep a close eye on your account balance. However, closing temporary accounts is just as important as using them.
Tracking and closing temporary accounts is a time-consuming process when using manual accounting systems or spreadsheets, and creating accurate accounts such as income summaries or balance sheets is more difficult. Why not automate the entire process with accounting software?
How to close a Temporary Account
Basically, closing a temporary account means closing all accounts belonging to that category.
Close your revenue account
While we were defining the types of temporary accounts we talked about how you will need to transfer the amount in your revenue account to your summary account – which means that you have closed the account.
This explains how to close this type of account. All you need to do is to perform a debit entry on the revenue account and perform a credit entry of the same amount on the income summary account.
Close the Expense Account
You follow the same process when closing the expense account. All you need to do is to transfer the amount on the expense amount to the income summary which can be done by performing a debit entry on the expense account and performing a credit entry of the same amount on the income summary.
Close the Income Summary
This is an account that helps to close the Revenue and Expense Account. This is the third type of temporary account. To close this account, you need to transfer the amount in this account to the capital account.
You need to perform a debit entry on the income summary and perform a credit entry of the same amount on the capital account.
Close the drawings account
The last part of closing temporary accounts is to close the drawings account. This is done by transferring the amount in the drawing account to the capital account or the retained earnings account
Learn about the Benefits of Permanent and Temporary Accounts
There are certain financial benefits that can accrue from knowing the difference between temporary and permanent accounts. We have discussed some of them below:
Accurate and timely financial reporting
When you have a good understanding of which account is permanent and the one that is temporary it will help you to report financial activities in a timely and more accurate manner.
Permanent accounts record the activities of a business for as long as necessary such as customer cash flow, business loans, inventory purchases, etc. on the other hand temporary accounts provide an overview of income and expenses over a stipulated period of time.
Improve your budget
Knowing how to classify accounts correctly allows companies to better allocate resources to achieve their goals. When the accounts associated with a company can be differentiated, i.e. when the temporary and permanent accounts are known, it will help the company to know their current financial state and as such be able to make budgets that will suit them at any point in time.
Better decision making
By understanding permanent and temporary accounts, businesses will be able to make more progressive decision that relates to their finances. For example, if a company believes that an investment will generate income in the future, it can use long-term financing instead of short-term financing.
Optimize cash flow
By knowing which accounts are permanent and which are temporary it will be possible for businesses to maximise cash flow.
Small businesses will benefit the most from this as it will come in handy when they want to make huge investments or large purchases that will aid the scaling and growth of the business. This can help any business stay up to date and become more valuable to the public.
Increase financial understanding
When you know the difference between permanent and temporary accounts you will have a better understanding of your company’s financial performance, this will definitely give you an edge when making informed business decisions.
This financial literacy will help your business make smarter financial choices that will bring about growth and maximisation of your investments.
Increased confidence in forecasts
The knowledge of accounts which are permanent and the ones that are temporary will businesses make decisions that will be beneficial in the future. This helps them develop long-term strategies that depend on facts and not probabilities. This, in turn, allows companies to plan for success with greater certainty.
Strengthen internal control
Since permanent and temporary accounts are different, their correct classification can help companies deal with their financing of these accounts in a proper way. This will allow the company to stay away from errors due to misappropriations and wrong data entries.
Improve investor relations
Investors can better decide whether to invest in a company by looking at accurate and timely financial statements. When a company can its temporary accounts from its permanent ones, they will look good in front of potential investors. This will increase their level of credibility and attract more investors
Enhanced management capabilities
By knowing how to properly categorize accounts, business owners can better understand how they work. This way they can identify areas where they need to put more effort – they will also be able to strategies in a bid to increase efficiency and profitability. Ultimately, this helps to manage a business or a company better
More reliable audits
When the permanent and temporary accounts in a business are known and classified according, auditors will find it very easy to go through the financial record and process of that business with less effort.
This will help any business to have a reliable audit. And we know that a reliable audit helps a business relate well with creditors, stakeholders and investors.
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