What are Temporary Accounts?
How do temporary accounts work?
What are the essential elements you should know!
In this article, I will break down the definition of Temporary Accounts so you know all there is to know about it!
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Let me explain to you what are temporary accounts and why they are important!
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Table of Contents
What Are Temporary Accounts
Temporary accounts have a zero balance at the beginning of every accounting year and where its balance is transferred to another account at the end of the accounting year.
In essence, temporary accounts in accounting are used to accumulate transactions for a given period of time allowing companies and analysts to extract reports and financial data for various purposes.
At the end of an accounting period, temporary account balances are closed so that the transactions recorded in one accounting period do not get mixed up with transactions in the next accounting period.
The main objective of having temporary accounts is to show the profits (or losses) that were generated during an accounting period.
Typically, accounting temporary accounts have a balance that increases over time instead of decreasing and its balances are used by companies to prepare their financial statements.
When temporary accounts are closed at the end of the accounting year, their balances are generally transferred to the retained earnings account.
Temporary Accounts Definition
How do you define temporary accounts?
According to the Corporate Finance Institute, temporary accounts are defined as follows:
A temporary account is an account that is closed at the end of every accounting period and starts a new period with a zero balance.
As you can see from this definition, temporary accounts have the following characteristics:
- They are used for accounting purposes
- They have a zero balance at the start of an accounting period
- They are closed at the end of an accounting period
Temporary Accounts vs Permanent Accounts
What is the difference between temporary accounts vs permanent accounts?
Temporary accounts are accounts that start an accounting period with a zero balance and end the period with a certain balance.
At the end of the accounting period, the entire balance of the temporary accounts is transferred to the retained earnings account leading bringing back the account balance to zero for the start of the next period.
On the other hand, permanent accounts are those that retain their transactions all the time.
In other words, a permanent account does not start with a zero balance at the beginning of a period nor is its balance shifted to another account at the end of the period.
In most cases, permanent accounts are used to account for assets, liabilities, and equity.
The main difference between permanent vs temporary accounts is that:
- A temporary account balance is “closed” at the end of the accounting period whereas the permanent account does not
- Temporary account balances do not carry over to the next financial period whereas permanent accounts do
In general, permanent accounts are used to account for equity, liabilities, and assets (collectively referred to as real accounts).
Permanent accounts include:
- Accounts receivable
- Accounts payable
- Loans payable
- Retained earnings
- Owner’s equity
Temporary Accounts Examples
What are some examples of temporary accounts so we can better understand the concept?
Here are some examples of temporary accounts:
- Revenue accounts
- Expense accounts
- Gain and loss accounts
- Income summary account
Let’s look at a few of these accounts in more detail.
For example, imagine that Company ABC can have a temporary account to record its revenues.
If in the first accounting period the company generates $1,000,000 in revenues, the second period it generates $2,000,000 in revenues, and third period $3,000,000 in revenues, then the company will have the following temporary accounts:
- Accounting Period 1: $1,000,000
- Accounting Period 2: $2,000,000
- Accounting Period 3: $3,000,000
This way, the company can see that it is doing better and better every accounting period.
On the other hand, if the company did not record its revenues in a temporary account but rather in a permanent account, then it would have a total balance of $6,000,000 at the end of the third accounting period.
In this case, the company may appear to be very profitable but that is not the case as $6,000,000 represents the accumulated revenues over the course of three accounting periods (not just one).
Revenue accounts can include:
- Service revenue
- Interest income
- Rent income
- Royalty income
- Dividend income
- Gain on sale of equipment
Temporary expense accounts are accounts where a company or business will record its ongoing expenses.
During a specific accounting period, all the company’s expenses will get recorded in the relevant expense account (such as cost of goods sold account or compensation expense account etc).
Then, at the end of the accounting year, the total expense balance gets transferred to the income summary.
The expense account gets credited with an amount equal to its ending balance and the income summary account gets debited with the equivalent amount.
Expense accounts can include:
- Cost of sales
- Salaries expenses
- Rent expenses
- Interest expenses
- Delivery expenses
- Utility expenses
Income Summary Account
The income summary account, as its name suggests, is an account where the company’s income is summarized.
In other words, all the revenue accounts and expenses accounts are closed at the end of a financial period where their balances are transferred to the income summary account.
The income summary account will then reflect the company’s net income.
For example, if a company had a total of $1,000,000 in its revenue accounts and $700,000 in its expense accounts, then these balances will get reflected on the income summary account showing a net profit of $300,000.
Temporary Accounts FAQ
Let’s look at a few commonly asked questions regarding temporary accounts.
What are the 4 temporary accounts
The four temporary accounts are revenue accounts, expense accounts, income summary account, and drawing account.
Although many consider a drawing account to be a temporary account, in fact, it’s actually a capital account.
The reason that is the case is that at the end of an accounting period, the balance of the drawing account does not go to the income summary account.
Also, when you debit or credit the drawing account, the corresponding credit or debit will be applied to a capital account.
What are temporary and permanent accounts
Temporary accounts, also called nominal accounts, are accounts that start an accounting period with a zero balance and, at the end of the same period, the account balance is “closed”.
Permanent accounts are accounts whose balance carries over from one accounting period to another.
Which is not a temporary account
A drawing account, also known as a corporation’s dividend account, is an account used to distribute dividends to company owners.
Technically, this is not a temporary account as its account balance is not transferred to the income summary account.
Rather, a drawing account is a capital account as when you debit a drawing account, the corresponding credit goes to a capital account.
How to close a temporary account
Closing a temporary account is pretty simple.
For example, if you have a revenue account with a balance of $1,000,000 in a given accounting period, here is how you would close your temporary revenue account:
- Debit the revenue account by $1,000,000 at the end of the period
- Credit the income summary account by $1,000,000
To close an expense account, you do the same thing.
Here is an example to close an expense account if you had $600,000 in expenses:
- Debit the income summary account by $600,000 at the end of the period
- Credit the expense account by $600,000
Finally, you close your income summary account as follows (if you had a $400,000 balance):
- Debit the income summary account by $400,000
- Credit the retained earnings account by $400,000
Temporary Accounts Meaning Takeaways
So there you have it folks!
What is the meaning of temporary accounts?
How do they work?
What are some examples of temporary accounts?
In short, temporary accounts are general ledger accounts that start a given accounting period with a zero balance, and its account balance is fully transferred to another account at the end of the same accounting period.
In essence, all of the income statement accounts used by a company are tracked using temporary accounts.
The reason why companies use temporary accounts to record and classify transactions in a given accounting year is to make their financial reporting easier.
Some examples of temporary accounts include:
- Earned interest
- Sales discount
- Sales returns
- Cost of goods sold
- Compensation expenses
- And more
Temporary accounts are important for companies to assess their profitability, understand their gains and losses, and be able to report on them.
Now that you know what are temporary accounts, how they work, and why they are important, good luck with your research and investigation!
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