Temporary account
Accounts are used in the accounting system of the company to collect the recorded data from all financial transactions. There are individual accounts for every asset, liability, revenue, expense and stockholders’ equity. Accounts can be categorized as permanent or temporary accounts[1].
The temporary account starts each accounting period with zero balance, accumulates new information, and then at the end of the fiscal year, its balance is cleared through closing entries. Therefore, temporary accounts are used to gather information for a particular accounting period and balances of these accounts are not included in the next fiscal period[2].
Temporary vs. Permanent account
Main differences between temporary and permanent accounts are shown in the table below[3]:
| Accounts | End-of-period balances | |
|---|---|---|
| Temporary account (or nominal account) |
|
The account is closed. Balance is transferred to the income summary account.
New accounting period starts with zero balance. |
| Permanent account (or real account) |
|
Carried to the next accounting period. |
Closing process
Closing entries are journal entries which prepare temporary accounts for the new accounting period. At the end of the fiscal period, temporary accounts must be closed, and a new accounting period must be opened with zero balances to accumulate new information. Closing entries of revenue and expense accounts are first transferred to the income summary account. The income summary account is also a temporary account where the net income or net loss is recorded. This account does not have a normal balance. It depends on amounts posted to the account at the end of the accounting period (e.g. revenue is higher than incurred expenses,the income summary account has a credit balance)[4].
Closing the temporary account includes three steps[5]:
- Balances of expenses and revenue accounts must be transferred to the income summary.
- Balance of the income summary ought to be transferred to the owner's Capital.
- Balance of Withdrawals account must be transferred to the owner's capital account.
Examples of Temporary account
- Sales: Sales is an account used to record the revenue generated from selling products or services to customers. It is a temporary account, since the revenue is only realized when the goods or services are sold.
- Cost of Goods Sold: Cost of Goods Sold (COGS) is a temporary account that records the cost of the goods sold during a period. This cost includes the cost of raw materials, labor, and other direct expenses that are necessary for producing the goods.
- Advertising Expense: Advertising Expense is another temporary account which records the costs associated with advertising activities, such as the costs of advertising materials, advertising campaigns, and other marketing expenses.
- Wages Expense: Wages Expense is a temporary account that records the wages and salaries paid to employees for the services rendered during a period. It also includes associated payroll taxes and benefits paid to employees.
Advantages of Temporary account
A temporary account is a type of accounting record that is used to track the financial activity of a business over a particular period of time. Temporary accounts provide businesses with the ability to track their financial activity in a specific period, allowing them to make more informed decisions. The following are some of the advantages of using temporary accounts:
- Temporary accounts allow businesses to track their financial activity in a specific period. This enables businesses to gain a better understanding of their financial performance and make more informed decisions.
- Temporary accounts also allow businesses to compare their financial performance to that of their competitors. This helps businesses identify areas where they can improve their financial standing and make better decisions.
- Temporary accounts can also help businesses identify trends in their financial activity. This can help businesses identify areas where they can increase their profitability or reduce their expenses.
- Finally, temporary accounts help businesses create financial reports that are more accurate and reliable. This helps businesses make better decisions and improve their overall financial performance.
Limitations of Temporary account
Temporary accounts are not ideal for long-term financial records and analysis due to the following limitations:
- Temporary accounts lack the ability to provide an overall summary of a company’s financial situation over a long period of time. The data in these accounts are only updated at the end of the reporting period, making it difficult to track progress and compare year-over-year results.
- They are only used to record short-term transactions and do not provide comprehensive information on the financial performance of a business.
- Temporary accounts are not suitable for external reporting because the data is not reliable enough to provide an accurate picture of the business’s financial position.
- They are not typically used for decision making because the data is not complete enough to provide an accurate picture of the business’s financial position.
- Temporary accounts are not suitable for tax reporting because the information is only applicable to the reporting period and not the entire financial year.
- They are not suitable for audit purposes since the data is not reliable enough to provide an accurate picture of the business’s financial position.
One approach to managing temporary accounts is to track the impacts of transactions on accounts and the account balances over time. This approach can be used to record the initial transaction and then the impacts of subsequent transactions. Some of the other approaches related to temporary accounts are:
- Accrual accounting: This approach allows companies to record transactions in the period in which they occur, not necessarily when cash is exchanged. This allows fluctuations in accounts to be tracked more accurately.
- Deferral accounting: This approach allows companies to record transactions in the period in which they occur, but recognize the affects of the transactions in the following period. This allows companies to smooth out cash flow and better manage their accounts.
- Matching principle: This approach requires companies to match the costs of an asset to the revenue that is generated by the asset. This allows companies to better manage their accounts and ensure that their assets are generating the expected returns.
In summary, there are several approaches that can be used to manage temporary accounts, such as accrual accounting, deferral accounting, and matching principle. These approaches can be used to track the impacts of transactions on accounts and account balances over time.
| Temporary account — recommended articles |
| Nominal account — Matching principle — Exceptional Item — Income summary — Income summary account — Revenue expenditure — Cost principle — Time period concept — Account Analysis |
References
- Bienias Gilbertson C., W. Lehman M., Gentene D. (2013) Century 21 Accounting: Multicolumn Journal, Introductory Course, Chapters 1-17, Cengage Learning, 10
- Boyd K. W.(2014) CPA Exam For Dummies, John Wiley & Sons
- Epstein L., Myers S. (2008) Wiley Pathways Small Business Accounting Small Business Resource Center, John Wiley & Sons
- Needles B., Powers M. (2006) Financial Accounting, Cengage Learning, 9
- Nikolai L. A., Bazley J. D., Jones J.P. (2009) Intermediate Accounting (Book Only), Cengage Learning, 11
Footnotes
Author: Anna Woroń
