As a business owner, you are likely familiar with certain accounting accounts, like your assets or expense accounts. But did you know that each account can also be labeled as a permanent or temporary account?
Read on to learn the difference between temporary vs. permanent accounts, examples of each, and how they impact your small business.
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Temporary vs. permanent accounts
Before you can learn more about temporary accounts vs. permanent accounts, brush up on the types of accounts in accounting.
As a brief recap, the five core types of accounts are the following:
- Assets
- Expenses
- Liabilities
- Equity
- Income or revenue
Your accounts help you sort and track your business transactions. Each time you make a purchase or sale, you need to record the transaction using the correct account. Then, you can look at your accounts to get a snapshot of your company’s financial health.
You might also use sub-accounts to record transactions. A few examples of sub-accounts include petty cash, cost of goods sold, accounts payable, and owner’s equity.
Businesses typically list their accounts using a chart of accounts, or COA. Your COA allows you to easily organize your different accounts and track down financial or transaction information.
So, where do permanent and temporary accounts come into play in accounting?
Temporary accounts
What are temporary accounts? Temporary accounts in accounting refer to accounts you close at the end of each period. Temporary accounts are general ledger accounts. All income statement accounts are considered temporary accounts.
You must close temporary accounts to prevent mixing up balances between accounting periods. When you close a temporary account at the end of a period, you start with a zero balance in the next period. And, you transfer any remaining funds to the appropriate permanent account.
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Temporary accounts include revenue, expense, and gain and loss accounts. If you have a sole proprietorship or partnership, you might also have a temporary withdrawal or drawing account. Examples of temporary accounts include:
- Earned interest
- Sales discounts
- Sales returns
- Utilities
- Rent
- Other expenses
Unlike permanent accounts, temporary accounts are reset from period to period. The closing process resets the balances for your temporary accounts and prepares them for a new period. Closing temporary accounts at the end of the period lets you see:
- Generated revenues
- Incurred expenses
- Earned net income
How long you maintain a temporary account is up to you. You might decide to close a temporary account at year-end. Or, you might choose to close accounts every quarter. Either way, you must make sure your temporary accounts track funds over the same period of time.
Permanent accounts
What are permanent accounts? Permanent accounts are accounts that you don’t close at the end of your accounting period. Instead of closing entries, you carry over your permanent account balances from period to period. Basically, permanent accounts will maintain a cumulative balance that will carry over each period.
Because you don’t close permanent accounts at the end of a period, permanent account balances transfer over to the following period or year. For example, your year-end inventory balance carries over into the new year and becomes your beginning inventory balance.
Report permanent accounts on your balance sheet. Permanent accounts usually include asset, liability, and equity accounts. Here are a few examples of permanent accounts:
- Accounts receivable
- Inventory
- Accounts payable
- Loans payable
- Retained earnings
- Owner’s equity
Unlike temporary accounts, you do not need to worry about closing out permanent accounts at the end of the period. Instead, your permanent accounts will track funds for multiple fiscal periods from year to year.
Typically, permanent accounts have no ending period unless you close or sell your business or reorganize your accounts.
Examples of temporary and permanent accounts
Now that you know more about temporary vs. permanent accounts, let’s take a look at an example of each.
Temporary account example
Say you close your temporary accounts at the end of each fiscal year. Your company, XYZ Bakery, made $50,000 in sales in 2021. You forget to close the temporary account at the end of 2021, so the balance of $50,000 carries over into 2022.
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In 2022, your business makes $70,000. Because you did not close your balance at the end of 2021, your sales at the end of 2022 would appear to be $120,000 instead of $70,000 for 2022.
To avoid the above scenario, you must reset your temporary account balances at the beginning of the year to zero and transfer any remaining balances to a permanent account. That way, you can accurately measure your 2021 and 2022 sales.
Permanent account example
Let’s say you have a cash account balance of $30,000 at the end of 2021. Because it’s a permanent account, you must carry over your cash account balance of $30,000 to 2022. Your beginning cash account balance for 2022 will be $30,000.
In 2022, you add an additional $25,000 in your cash account. Your year-end balance would then be $55,000 and will carry into 2023 as your beginning balance. This permanent account process will continue year after year until you don’t need the permanent accounts anymore (e.g., when you close your business).
Temporary vs. permanent accounts recap
Temporary vs. permanent accounts can be a lot to digest. To help you further understand each type of account, review the recap of temporary and permanent accounts below.
Temporary accounts:
- Include revenue, expense, and gain and loss accounts
- Are closed at the end of each period
- Reset to a balance of zero at the beginning of a period
- Might include drawing or withdrawal accounts (e.g., partnerships)
- Help you track funds from period to period
Permanent accounts:
- Include asset, liability, and equity accounts
- Don’t close at the end of an accounting period
- Are reported on the balance sheet
- Maintain a cumulative balance
- Track account balances from year to year
Looking for a simple way to track your temporary and permanent account balances? Patriot’s accounting software has you covered. Easily record income and expenses, then get back to your business. What are you waiting for? Start your free trial today!
This article is updated from its original publication date of November 12, 2019.
This is not intended as legal advice; for more information, please click here.
Source: https://t-tees.com
Category: WHICH
