Temporary and permanent accounts
Income and expense accounts are temporary. They measure a period, so they reset each year. Assets, liabilities and equity are permanent and carry their balances forward.
If expenses were never reset, next year's profit would include this year's. The reset makes each year stand alone.
How the closing works
Traditionally, an accountant makes closing entries: income accounts are debited to zero, expense accounts are credited to zero, and the difference goes to retained earnings. If the business made a profit, retained earnings increases. A loss reduces it.
Accounting software does this automatically. On the first day of the new year the profit and loss shows zero and the previous year's profit appears in retained earnings.
What retained earnings means
It is the cumulative profit kept in the business after owner draws or dividends. For sole proprietors and partnerships, equity may be shown differently, with draws closing directly into owner equity. For corporations, dividends reduce retained earnings.
A negative retained earnings balance means total losses and distributions exceed past profits. That can be fine for a young company, but it is a point lenders note.
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Locking the year
After your tax preparer finishes, set a closing date in the software. Changes to the prior year can alter retained earnings and break agreement with filed returns. If a correction is genuinely needed, discuss with your preparer first and make a dated entry.
Late adjustments, like a missed depreciation entry, change the previous year's profit, and so change retained earnings. Track them carefully.
Common problems
Retained earnings that differ from the prior year's ending equity may point to edits in a closed period, an incorrect opening balance after converting software, or an equity account that was used as a catch-all. Compare the prior year's balance sheet with the start of the current year.
If you changed software or accountants, ask for a reconciliation of opening equity to the final tax return, so you know the numbers tie.
A short example
Suppose a business ends the year with income of one amount and expenses of a smaller amount. After closing, the profit lands in retained earnings and the profit and loss starts the new year at zero. If the owner had also taken draws, those reduce equity separately. When you open the balance sheet in January, retained earnings equals the prior balance plus last year's profit, and any difference from the tax return should be explained before you start a new year of entries.
Keep both the final tax return and the closing balance sheet together in a year folder. Matching the two each year is an easy way to catch edits that should not have happened.
Worked example with numbers
A business has income of $120,000 and expenses of $97,000 for the year, so net income is $23,000. Retained earnings started the year at $15,000. After closing, retained earnings is $15,000 + $23,000 = $38,000, or $38,000 minus any distributions that close through it. If the owner took $10,000 of distributions through retained earnings, it ends at $28,000. The new year's profit and loss starts at zero.
If your balance sheet shows a different ending retained earnings than the prior-year tax return workpapers, look for edits in a closed year.
Check your work
Compare opening retained earnings to last year's ending figure every January, and lock the closed year.
Common questions
Do I make closing entries manually?
Not in most software. It rolls profit forward automatically.
Why did retained earnings change after year end?
Because someone edited a prior-year transaction. Review the activity log.
Is retained earnings cash?
No. It is an accounting balance. Cash may have been spent on assets or draws.
This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.
