Definition: Temporary accounts or nominal accounts are closed at the end of every year. This means the account balances are zeroed out and the moved to the retained earnings account. That is why these accounts are called temporary accounts. They don’t perpetually have a balance. Every year they are zeroed out and closed. Temporary accounts consist of revenue, expense, and distribution/dividend accounts. These are all accounts that appear on the income statement.
What Does Temporary Account Mean?
Asset, liability, and retained earnings accounts track a company’s history forever. These accounts take a picture of what the financial position of the company looked like at that moment in time. These accounts are called permanent accounts and they are never closed. They just keep building on the prior years’ balances. Not all accounts are permanent accounts, however. Some account in a chart of account close at the end of every year. These accounts are called temporary accounts.
Think about it like this. Companies want to keep track of their annual revenue and expenses. That way they can present an annual income statement to show how much profit they made for the year. If income statement accounts never closed, these accounts would have multiple years worth of balances in them. There would be no way to separate the current year income from past years income.
By closing or zeroing out these temporary accounts, the balances are transferred to the retained earnings account and the next year’s income statement starts fresh. The next year’s balance sheet, however; carries the balances of these accounts in the retained earnings account. This makes sense because the retained earnings account holds the company’s profits that were not distributed to owner. In other words, it holds the company’s retained earnings.