In business accounting, some transactions have a short-term, or one-time, impact on the financial affairs of the operation, while the effect of other transactions is more long-term and sustained. To help separate these two types of activities, businesses record them in either temporary or permanent accounts.
The difference between temporary and permanent accounts reflects the way accountants track and measure the financial performance of a business through reporting cycles. Temporary accounts are used to record transactions that impact the profit and loss of the business within a reporting period. Permanent accounts record cumulative financial activity that is carried over from one cycle to the next.
Some financial activity only impacts the business over a relatively short-term, or more specifically, within one business or accounting cycle, such as one year. These transactions must be recorded and processed within the larger context of the general ledger of the business. However, after the cycle is closed, these transactions will be canceled out to zero. They will not carry over or otherwise appear in the accounting for the business because they no longer have an impact on its financial status or health.
These types of transactions are recorded in temporary accounts (also called nominal accounts). These feed into, and help the business report, its actual earnings, or net profit, for the accounting period in question. How a business performs from one period to the next is not reflected by the transactions in the preceding periods, which is why temporary account transactions will not be reported again.
For example, the sales for a business in year one have no bearing on the sales in year two. For this reason, sales will be reported in a temporary account and zeroed out at the end of each year.
Some financial activity has a long-term impact on the financial well-being of the business, and it carries over to, or is reported in, subsequent accounting periods. These financial activities do not impact the profit or loss of the business during the reporting period in question, but they do reflect on its overall financial well-being or status and will appear on the balance sheet for the business.
These long-term journal entries are recorded in so-called permanent accounts, which carry over from one cycle to the next. They are not zeroed out when a particular cycle is closed.
For example, long-term assets, such as buildings or equipment, do not impact profit and loss during a given reporting period. As long as the business owns these assets, they will have an impact on its overall financial status. They will be reported in permanent accounts that carry over from one cycle to the next to ensure that they always factor into the relevant, broader calculations about the business.
There are four types of temporary accounts:
Revenue accounts record all revenue coming into the business for the accounting period. Examples of revenue accounts include sales, service fees, interest income, dividend income, prepaid expenses, rental revenue, discount income, and returns.
Expense accounts record all money paid by the business to cover operating costs. These include salaries and benefits, advertising, purchasing, utilities, rent, and travel reimbursements.
The income summary is the account where all closing entries from the revenue and expenses accounts may be transferred, itemized, and tallied. This closes out the other temporary accounts, and it allows accountants to make a calculation of the profit or loss incurred by the business for the accounting period.
A drawing account is used to record money withdrawn from the business by its owners. Draws can be made in the form of cash or other assets, and they reflect the owner(s) taking out a portion of their equity in the business.
Permanent accounts may be closed out at the end of an accounting period, but they will not be zeroed out. The balance in these accounts will carry over from one accounting period to the next.
Permanent accounts fall into one of three categories:
Asset accounts refer to any resource owned by the business that has monetary value. Examples include accounts receivable, cash on hand, patents and intellectual property, logos, investments, inventory, machinery, equipment, vehicles, furniture, and property or real estate.
Liability accounts record all the business's financial obligations, or money owed to another individual or business. This includes accounts payable, loans and mortgages, wages, unearned revenue, taxes, and payable interest and dividends.
Equity accounts measure the value of ownership in the business. Examples of equity accounts include stocks, bonds, retained earnings, contributed surplus (money paid by investors for stock in excess of its market value), owner's distribution, and owner's capital.
Virtually all business accounting conforms to the double-entry system. Under this system, all transactions are recorded as journal entries which will be recorded as either a debit or a credit. According to this system, every entry has at least one other corresponding journal entry recorded in another account and the two will cancel out.
Temporary and permanent accounts use the same system of journal entries. However, there is one significant difference. In the case of temporary accounts, the account will be zeroed out at the end of the reporting period. This is typically done by making a corresponding entry in the income summary.
Let's look at an example. All revenue is recorded as credits in the revenue account. If a business has received $50,000 in revenue for the year, the revenue account will show this total in credits.
At the end of the reporting period, the business will make a debit entry for the same amount, which will bring that account to zero.
At the same time, the business will make a credit entry of $50,000 in the income summary. After expenses are also accounted for (and the expense account is also zeroed out), a similar process will be conducted in the income summary account. A debit entry will be made for the net total. A corresponding credit entry will be made in the capital account, and the income summary account will also be zeroed out for the period.
Temporary and permanent accounts serve important and distinct functions in business accounting. Temporary accounts allow a business to make an accurate accounting of its performance for a specific reporting period. Permanent accounts enable the business to calculate and report on the financial status of the business over time from one period to the next and over multiple periods.