Which is not a temporary account? Often I have found many people confused between temporary and permanent accounts and hence prepared this detailed guide about accounts that are not considered permanent.
When it comes to managing your finances, one of the most important decisions you can make is which type of account to open. There are various types of accounts available which all offer different benefits and security levels. Amongst these is the temporary account which should not be confused with non-temporary or permanent accounts.
So,
What a is Temporary Account?
A temporary account is an account that begins each fiscal year with a zero balance. At the end of the year, its ending balance is shifted to another account. Temporary accounts are interim accounts that track a company’s financial activity during a specified time period.
These accounts are closed at the end of each accounting period and their balances are not carried forward into the next period.
Examples of temporary accounts include revenue, expense, dividend accounts, cost of goods sold, income tax expense, unearned revenue, payroll tax expense, and interest income. I will explain each of these in detail below.
Which is not a Temporary Account?
Permanent accounts like asset, liability, and equity are not considered temporary accounts.
Unlike a temporary account, a permanent account does not get closed at the end of each accounting period. Instead, its balance is carried forward from one period to the next until the account is closed when the business ceases operations.
Permanent accounts provide information on a business’s long-term financial position, as opposed to temporary accounts that report on short-term financial activity.
Types of Temporary Accounts: Explained in Detail
Understanding the different types of temporary accounts can help ensure that they are correctly recorded and closed at the end of each accounting period.
There are three types of temporary accounts, which are –
1. Revenue Accounts
Revenue accounts are the accounts that record the income earned by a business from its operations during a specific period. These accounts include sales, service revenue, rent income, commission earned, and interest earned.
Revenue accounts have a credit balance.
2. Expense Accounts
Expense accounts are the accounts that record the costs incurred by a business to carry out its operations during a specific period. These accounts include salaries and wages, rent expense, utilities, advertising, and interest expense.
Expense accounts have a debit balance.
3. Dividend or Drawing Accounts
Dividend or drawing accounts are the accounts that record the money withdrawn by the owners or shareholders from the business for personal use.
These accounts have a debit balance.
In brief, temporary accounts are essential for accounting because they help in tracking the financial performance of a business. They are also useful in preparing financial statements and tax returns.
How do Temporary Accounts Work?
As per my understanding so far, I can explain how temporary accounts work in the context of financial accounting.
Temporary accounts are accounts that capture financial transactions and are used to report financial activity during a specific period, usually one fiscal year. The balances of these accounts are then transferred, or “closed,” to a permanent account at the end of the period.
Temporary accounts are important for measuring a company’s income and expenses over a period of time. Income accounts, such as revenue and gains, and expense accounts, such as salaries and rent, are temporary accounts because they are closed at the end of the period. Any remaining balance in these accounts are transferred to retained earnings, a permanent account on the balance sheet.
Similarly, dividend accounts, which record the distribution of profits to shareholders, are also temporary accounts. At the end of the period, the balance in the dividend account is also transferred to retained earnings.
The main advantage of temporary accounts is that they provide a snapshot of a company’s financial performance over a period of time. They are crucial for financial reporting and help investors, creditors, and other stakeholders understand a company’s financial performance.
How to Open a Temporary Account?
To open a temporary account, you need to consider below things –
Determine the type of account: You must first determine what type of temporary account you need (e.g. revenue, expense, or dividend) depending on the financial activity you are tracking.
Choose a unique account name: Give your new account a name that accurately describes its purpose, such as “Sales Revenue,” “Rent Expense,” or “Dividend Expense.”
Select an accounting system: Choose an accounting system, such as a spreadsheet, accounting software, or a physical ledger, to track your financial activity.
Define the financial period: Determine the specific fiscal year or period for which you want to open the temporary account.
Record transactions: Record all relevant transactions in the temporary account as they occur during your selected financial period.
Close the account at the end of the period: At the end of the designated financial period, close the temporary account and transfer its balance to a permanent account like retained earnings.
Benefits of Temporary Accounts
Temporary accounts have several benefits. Here are some of the advantages of using temporary accounts:
Accurate Financial Reporting
Temporary accounts help businesses to accurately report their financial transactions in a specific financial period, usually a fiscal year. This helps businesses to produce accurate financial statements that are critical for decision-making processes.
Better Decision-making
By capturing financial activity in a specific period, temporary accounts help businesses to make informed decisions about their operations, investments, and expenditures.
Easier Tracking of Expenses and Revenues
Temporary accounts allow businesses to track and analyze their expenses and revenues for a specific period, enabling them to make better financial decisions based on accurate data.
Improved Tax Filings
Temporary accounts make it easier to calculate taxes owed for a specific period, which helps businesses to meet tax obligations and avoid penalties.
Clearer Understanding of Business Performance
By using temporary accounts to track financial activity, businesses can better understand their financial health and make adjustments as needed to improve performance.
Efficient Audit and Inspection Processes
Temporary accounts make it easier for businesses to be audited or inspected since all financial activity can be traced back to a specific period.
Temporary Account vs. Permanent Account
People are often confused between temporary and permanent accounts. Hence, have classified key differences between these two account types so that you can decide which account you need to open and when –
Temporary Accounts:
- Purpose: Temporary accounts are used to record financial activity for a specific period, usually a fiscal year. They are closed out at the end of that period and their balances are transferred to a permanent account.
- Examples: Some examples of temporary accounts include revenue accounts, expense accounts, and dividend accounts.
- Balance: The balance in temporary accounts starts at zero at the beginning of each fiscal year and ends at zero at the end of that fiscal year.
- Capitalization: Generally, temporary accounts are not capitalized accounts.
- Reporting: Temporary accounts are used to report a company’s financial performance for a specific period and are used to calculate a business’s net income.
Permanent Accounts:
- Purpose: Permanent accounts are accounts that remain open from one fiscal year to the next and their balances are carried forward. They provide information about a business’s long-term financial position.
- Examples: Some examples of permanent accounts include asset accounts (such as cash, inventory, and property), liability accounts (such as loans and accounts payable), and equity accounts (such as retained earnings).
- Balance: The balance in permanent accounts carries forward from one fiscal year to the next.
- Capitalization: Permanent accounts may be capitalized accounts, which are accounts used to represent a business’s investments in long-term assets like buildings and equipment.
- Reporting: Permanent accounts are used to report a company’s long-term financial position and are critical for making key business decisions.
How to Close a Temporary Account?
Closing a temporary account involves reviewing the account transactions, entering any adjusting entries, closing the temporary account by transferring its balance to a permanent account, and resetting the account to zero.
Let me explain each step in detail –
- Identify the temporary account: Determine which temporary account you need to close. For example, revenue, expense, or dividend accounts.
- Review the account transactions: Review the transactions recorded in the temporary account for the fiscal year. Check that the account balance accurately reflects the financial activity recorded.
- Enter any adjusting entries: Enter any adjusting entries needed to bring the temporary account up to date. These entries should reflect any financial activity that was not previously recorded in the account to ensure that the account balance is accurate.
- Close the account: At the end of the fiscal year, close the temporary account and transfer its balance to a permanent account, such as retained earnings. This is usually done by creating a closing entry that debits the temporary account and credits the permanent account by the same amount.
- Reset the account: Once the balance of the temporary account has been transferred, reset the account to zero so that it is ready to capture financial activity for the next fiscal year.
What is the Drawings Account?
The Drawings Account is a temporary account in the company’s general ledger that is used to track the amount of money taken out of a business for personal use by its owners or employees. This account is commonly used by sole proprietors, partners and corporations.
The balance in this account starts at zero at the beginning of each year or period and ends with a credit balance when the total withdrawals are subtracted from it at the end of that year or period.
The purpose of this account is to keep track of all monies taken out and ensure that they are properly accounted for.
The Drawings Account can be used to record not only withdrawals made by the owner or employee, but also capital contributions made to the business, direct labor costs, per diem expenses, employee benefits, etc. When the year or period ends, these entries should be transferred to a permanent account such as Retained Earnings.
Also Read – Which Account does not Appear on the Balance Sheet?
Wrapping it up…
In conclusion, understanding different types of accounts is key for any business owner who wants to track their finances accurately and make informed decisions based on accurate data.
Hope this detailed guide has helped you to understand temporary accounts properly.
