What is the purpose of closing entries and why are they necessary in accounting cycles?

• A. To transfer temporary accounts to retained earnings and reset them for the next period.
• B. To record all asset purchases.
• C. To adjust for tax liabilities.
• D. To reduce cash.

Answer: (A)

Closing entries reset the books so the new period starts fresh and the period’s results are captured in equity. Temporary accounts—like revenues, expenses, and dividends (withdrawals) for many entities—accumulate activity during the period. At the cycle’s end, these accounts are closed: revenues and expenses are moved to a summary account, and then that net result is transferred to Retained Earnings. This plus closing any dividends to Retained Earnings updates equity to reflect the period’s profit or loss. After closing, the temporary accounts have zero balances, ready to record the next period’s activity, while Retained Earnings shows the cumulative effect of past periods. This is why closing entries are necessary: they separate financial results by period and keep the balance sheet and income statement clean and accurate for the next cycle.