[Nicole90]

I am confused about the process that one goes through to close accounts. What happens with the Income Summary and the Capital? I am trying to wrap my brain around this topic. Any help would be appreciatied.

[manik chand dey]

Balance sheet shows the snapshot view about assets and capital & liabilities, that business has, as on a particular date, while income statement summarises various expenses incurred and incomes earned, that has a net effect on the capital contributed by owners.
The fundamental accounting identity is, asset= equity(capital)+ liability

As expenses* and incomes (nominal accounts) relates to a particular year, those have to be closed to know the net result(that is net profit or net loss) for the year.

*An expense by the definition is an item which decreases the asset or increase the liability, ultimately reduces the capital.

[Criado]

Income Summary is a nominal account (temporary) and needs to be closed. Capital account is a permanent account, so, it does not need closing. Income Summary should be closed against the Capital Account.

[morgaine300]

*An expense by the definition is an item which decreases the asset or increase the liability, ultimately reduces the capital.

An expense by definition is not an item which increases a liability. They are used together often, but that isn't all-inclusive. Liabilities can be increased by various things -- it merely means the company owes more or has more obligation, but not necessarily where the obligation came from. And while the using up of or consuming of an asset turns into an expense, a mere decrease in an asset (which can happen for other reasons) does not automatically mean you have an expense.

Expenses are generally when someone provides a service to the company, and the consuming of an asset (not just decrease for whatever reason). Students often mistakenly think exactly what you just wrote, and it needed clarified.

Once someone is to the closing process, all the expenses would already be recorded anyway.

[morgaine300]

Closing the accounts is taking temporary accounts (revenues, expenses and drawing) and netted them back out to zero so that you can start a new year with zeros. Also, all of these accounts actually belong in capital. (I'm assuming you're doing sole proprietorships since you used the account name Capital.) Revenues increase capital, expenses & drawing decrease it. And you have to get those numbers into Capital before ending the year.

The process:
1) Close revenues. You do the opposite of the balance in order to get the account closed and net it to zero. Since revenues are credits, you debit them to net to zero, for whatever balance is in there. i.e. Sales has $100,000 credit balance, so you debit $100,000, which wipes it out. The other side of this entry (the credit) is Income Summary. Income Summary is a temporary "holding account" so to speak. (A student of mine called it that the other day and oddly I'd never thought of that. But that's a good description for it.)
2) Close expenses. Process is the same. You're still trying to get rid of the balances in these accounts, so you have to do the opposite of the balance to net them to zero. Except since expenses are debits, you credit them. The other part of that entry (the debit) is also Income Summary.

At this point, you now have your revenues and expenses all in Income Summary. Since the difference between revenue and expense is net income, that's what you have as a balance in Income Summary now: net income. But that too is a temporary account. (i.e. what "happens" to it is that numbers go in and come right back out and you'll never use it any other time.)

3) Close Income Summary. Hopefully this balance is a credit (it will be a debit if there's a net loss cause those debit expenses are bigger). Same rule: to get rid of that balance you must do the opposite and get it back to zero. Assuming it's a credit balance, that means debiting it. Now, at this point we need to start getting stuff into Capital. Because that is where these revenues & expenses really belong. So the other side of this entry is Capital. If we debited Income Summary, we credit Capital. And think about: net income will increase Capital. This entry right here is why most companies are in business. :-)

4) Close Drawing. Drawing is a contra account and a debit balance. Again, we want to get rid of it, so we credit that balance to get it to zero. The other side of this entry is also Capital. It not does go through Income Summary because it's got nothing to do with income. It goes directly into capital. So you'd debit capital. And think about that too: drawing is the owner taking money out, so it reduces capital. That's what that debit to Capital is going to do.

Ultimately, you have taken all your temporary accounts and netted them to zero, and have transferred revenues, expenses and drawing to Capital so that it is updated.