Definition
A Temporary Account, in finance, refers to an account that resets to zero at the end of each accounting period. These accounts are primarily revenue, expense, and withdrawal accounts used to track transactions for a specific period. At the end of this period, the accounts are closed out to summarize the financial activity, then reset to start the new accounting cycle.
Key Takeaways
- Temporary accounts refer to accounts in a company’s general ledger that are closed at the end of each accounting year, like revenue, expense, and dividend accounts. This is done to prepare the accounts for the next fiscal year and creates a record of transactions for the given year.
- The closing process at year’s end results in the net income or net loss of the company being added to the retained earnings, a permanent account. This portrays the cumulative earnings of the company less any dividend payments.
- Understanding and analyzing temporary accounts is crucial for assessing a company’s financial health and making future decisions. They provide insights on a company’s income, expenses, and dividends, reflecting on the firm’s profitability and wealth distribution.
Importance
Temporary accounts are fundamental in financial accounting because they help track the income, expenses, and withdrawals for a specific period. This is crucial in providing a clear picture of an organization’s financial performance.
At the end of each accounting period, these accounts are reset to zero through a process called closing. This allows the company to start fresh in the next period without any prior period’s influences.
The breakdown of revenues and expenses in temporary accounts also supports the decision-making process by providing detailed insight into the company’s earnings and spending patterns. Without temporary accounts, it would be challenging to accurately track changes and trends in a company’s financial health.
Explanation
Temporary accounts, also known as nominal accounts, serve an important purpose in the finance and accounting systems of a company. Essentially, these records are used to track financial data over a specified period of time, usually one year.
This information is largely related to revenue, expenses, withdrawals, and income summary. By tracking these aspects of finance, temporary accounts help businesses understand their financial situation, allowing them to make informed decisions on their future economic activities.
They also provide a picture of a company’s profitability during the accounting period, by showing income and expenses incurred. At the end of the accounting period, these temporary accounts are reset to zero through an action known as “closing the books”. This process involves shifting the balances from temporary accounts to permanent ones, thereby readying the temporary accounts for the next accounting cycle.
This is important for accurate record keeping and reporting as it separates the transactions of one total accounting period from those of the next. Consequently, temporary accounts play a key role in tracking and managing a company’s financial data, contributing to the overall financial management and growth strategy.
Examples of Temporary Account
Revenue Account: This temporary account includes all income a business generates during a specific period, which can include revenue from product sales, interest income, and other business operations. At the end of the accounting period, the total revenue is transferred to the permanent balance sheet and income statement accounts.
Expense Account: This is another example of a temporary account where businesses record all their expenses like salaries, rent, supplies, and utilities for a specific period. Once the accounting period concludes, the total expenses are also closed and transferred into the final accounts to determine the net income or loss.
Dividends Account: Businesses use this temporary account to track any profit distributions to its shareholders during a particular period. Unlike revenue or expense accounts, the dividends account is closed directly to the retained earnings account, not the income summary account. This balance does not get carried over to the next financial period.
FAQs for Temporary Accounts
1. What is a temporary account?
A temporary account is an account that companies close at the end of every accounting period. They include all income statement accounts, the income summary account, and the drawing account.
2. What happens to a temporary account at the end of an accounting period?
All temporary accounts are closed at the end of an accounting period. The net balance is then transferred into the owner’s capital account or the corporation’s retained earnings account. This process is known as closing the books.
3. Are all accounts temporary?
No, not all accounts are temporary. Only income statement accounts, the income summary account, and the drawing account are considered temporary. Other accounts, like assets, liabilities, and owner’s capital, are permanent accounts that continue to accumulate balances over the lifetime of the business.
4. How are temporary accounts used in financial reporting?
Temporary accounts provide valuable information about a company’s operations during a specific accounting period. They help generate the income statement of a business, which is one of the financial statements that companies use to report their financial performance.
5. What is the purpose of resetting temporary accounts?
Resetting temporary accounts at the end of each accounting period helps to accurately report a company’s revenue, expenses, and withdrawals for each new period. This ensures that the income statement for each period only reports the transactions that occurred during that specific period.
Related Entrepreneurship Terms
- Closing Entries
- Revenue Account
- Expense Account
- Income Summary Account
- Retained Earnings Account
Sources for More Information
- Investopedia: A comprehensive financial education website providing articles, dictionaries, videos, tutorials, and more on topics of finance and investing, including temporary accounts.
- AccountingCoach: A website providing free and premium accounting courses and resources that can explain the concept of temporary accounts in more detail.
- Khan Academy: A well-known educational organization, offering practice exercises, instructional videos, and a personalized learning dashboard that address various topics including finance and capital markets.
- Corporate Finance Institute (CFI): An established provider of online financial analyst certification programs, providing a glossary of terms that includes temporary accounts.
