It is necessary to 'Close the Accounts' in order to calculate Profit on a periodical basis and transfer it to Owners Equity.
(Remember Profit belongs to the Owners).
This is the process of the 'matching of revenue and expenses'.
Profit = Revenue -Expenses
We have previously prepared a Profit and Loss Statement by listing the balances in the various Revenue and Expense accounts.
We prepared a Profit and Loss Statement outside the ledger that is no changes were made to the accounts themselves.
However, at the end of the accounting period we close down the Accounts by making entries in the accounts and creating two new accounts known as the
Profit Determining accounts
For a trading business, profit determination is calculated in two stages, giving Gross profit and Net profit.
The Profit Determining accounts are
the Trading account, used to calculate Gross profit and
the Profit and Loss account, used to calculate Net Profit.
At the end of the accounting period the balances of the Revenue and Expense accounts are transferred to the these Profit Determining accounts.
They are ordinary accounts contained within the ledger.
The Asset, Liability, and Owners Equity accounts remain open as their balances form the basis for drawing up a Balance Sheet.
These balances are the only ones carried into the new accounting period.