How to Use Temporary T-accounts
Using the accounting equation for keeping the books for an actual business has one main drawback, which is that it is cumbersome to infer what caused equity to change, as only the level (the value at a point in time) of equity is available. In other words: revenues and expenses are not separately recorded.
Using temporary T-accounts overcomes this drawback. Instead of changing the T-account ‘retained earnings’ as a result of revenues or expenses, additional T-accounts are used (such as ‘sales’, ‘wages expense’, ‘interest expense’, etc.). These T-accounts are called temporary T-accounts, as at the end of the accounting period their balances are booked into retained earnings. This way, the next period’s income statement starts with all zeros, while at the same time getting the balance sheet back into balance (as net income needs to be added to retained earnings). The balance sheet T-accounts are called permanent, because they are not cleared at year’s end.
Permanent T-accounts will show the amount or ‘stock’ at some point in time:
Value = Beginning value + increases – decreases = Ending value
Temporary T-accounts will show the change, or ‘flow’, since the beginning balance is set to zero for these T-accounts:
Value = 0 + increases – decreases = Change
The debit and credit rules for temporary T-accounts follow those of equity. That means that if equity increases because of revenue, a temporary T-account is credited. If equity is reduced because of an expense, a temporary T-account is debited.
Temporary Account Example
Using the same examples as above to illustrate the use of temporary T-accounts.
Jan 15: ABCD Inc receives 3,000 cash for services delivered in January.
Cash (an asset) increases by 3,000 and retained earnings (equity) increases by 3,000. Instead of crediting retained earnings, another (temporary) T-account sales is used.
Jan 26: ABCD joins the Association of Landscapers, and receives an invoice of 400 to be payable in February.
Instead of debiting retained earnings, another (temporary) T-account operating expenses is used.
Temporary and Permanent Accounts Explained
– T-accounts for the balance sheet are called permanent T-accounts; the end of year balance is carried over to the next year
– T-accounts that record changes in retained earnings are called temporary T-accounts
– the end of year balance for all temporary T-accounts is carried over to ‘Retained earnings’ so that the next period’s opening balance for each temporary T-account is zero