Although it may lead to confusion, try not to confuse when an account is not temporary and when it is temporary. Basically, an account is not temporary when it is permanent. However, there are some issues that you should be aware of in order to sharpen this definition.
If we had to understand quickly how the temporary account works, we would say that these are accounts that can be closed at the end of an accounting period. They start in the next accounting period with a zero balance.
This case does not apply to all accounts, hence the difference. Let’s try to understand these issues a bit more.
What is a temporary account?
A temporary account is an account that will be closed after a while. Generally, it will correspond to the accounting period.
When the temporary account is closed, it has as a measurement element the transactions that will be significant during the accounting cycle they represent. In other words, they will not be used or relevant either for the previous accounting cycle or for the next one.
Thus, these are accounts recognized in the income statement and are allocated to the computation of expenses and income within companies.
There are exceptions: the giro account is closed after each accounting period. That is an account that is not to be integrated into the income statement and is not considered a temporary account. In this case, it would be a profit and loss account.
Some examples of temporary accounts may include:
- Income account
- Expenditure account
- Profit and loss account
It is also possible to have a withdrawal account in the case of sole proprietorships or partnerships. Within a temporary account, you can usually find items such as:
- Returns on sales
- Discounts on purchases
- Rent payments
- Business expenses
One of the reasons why use temporary accounts is to adjust the results of each accounting period to the reality of a company.
An example commonly used to demonstrate this is the following: imagine that a company makes a net profit in the first year of $160,000, the second year of $90,000, and the third year of $50,000. If this has not been reported in separate accounting periods on temporary accounts, the average income might be around $100,000 per year in profit. However, the reality does not reflect the decreasing profit trend.
Types of temporary accounts
There is no single type of temporary account. In fact, in some cases, they can even be configured in a particular way and combine different concepts. However, these are the three common types that accept as characteristics:
These are the accounts reflecting the income earned from the enterprise activity. How it is a temporary account, this income will only show during specific accounting periods.
At the end of each accounting period, this account is closed. When opening again, the balance will be zero.
Sometimes these accounts may be associated with a receivable (or credit account). When this happens, closing the revenue account, a debit entry is necessarily applied. A credit entry in the income statement will be necessary.
The expense accounts, as the name suggests, represent the total expenditure of the enterprise. It should noted that the day-to-day (daily) operations in the enterprise, are usually recorded as separate expenses.
It is important to know that not all expense accounts are the same. Depending on the type of business, the account reflects different movements or expenses incurred. Some of the common ones are:
- Income Summary Account
The account would be to which the result aplies at the close of the income and expense accounts.
This type of account tries to calculate the net profit or loss. It is by crossing the income and expenses that the summary is obtained, which is eventually allocated to this account. Subsequently, it can derive to other types of incomes, such as the profit and loss accounts.
It is important to appreciate that in the income statement account, a negative credit balance can also be generated in case the company has lost money. In this situation it is common to use the capital or profit account, or, in the worst case, to access financing to cover the negative result.
How to close these accounts
The closure of temporary accounts must coincide with the end of the accounting period to which they relate. This is not exactly a closure, as the account continues to exist. What is do is to bring the balances to record the corresponding changes, and in the case of income and expense accounts to zero.
The mechanisms are relatively simple:
- Close the income account. Transfer the money from the income account to the Income Summary account. The balances are transferred
- Close the expense account. That is the same as above, but, in this case,the debits are transferred. In other words, the costs incurred during the accounting year are reflected.
The permanent accounts
We have already looked at non-permanent accounts, but what do permanent accounts look like? It is not difficult to explain.
They are accounts that will maintain their balances over time regardless of the passage of any accounting period.
Generally, a permanent account is associated with transactions on the assets, liabilities, and equity of companies. They are, therefore, accounting tools that could be added to the balance sheet.
In fact, these types of accounts will use to represent the enterprises the real value. Balances may change depending on daily transactions, but these accounts are not closed and do not transfer balances to the owners’ capital accounts.
Therefore, the fundamental difference is that permanent accounts will not be closed at the end of the accounting period and are composed of equity, assets, and liabilities. There are different types of permanent accounts, the most common being:
- Of assets
Another noteworthy aspect is that these accounts will not have an expiry date. The expiry date may be caused by the sale of the business, the reorganization of the accounts, or a change in accounting system in the company.