Drawing account is an accounting record that keeps track of the amount of money withdrawn from a business and given to its owner(s). A drawing account is only used for companies that have a sole proprietorship or partnership.
Although similar, the drawing account is still slightly different from dividends found in the corporate environment—more on this later. Additionally, fund withdrawal through a drawing account doesn’t incur a tax obligation for the company, the proprietor(s) is the one being taxed on it. This is also the case for dividend receivers.
- The Impact of a Drawing Account
- Journal Entry of Drawing Account
- Schedule of Drawing Account
- Example of Drawing Account
- Differences Between a Drawing Account and Other Types of Income Distribution
The Impact of a Drawing Account
When an owner draws money from their business, it results in equity or asset reduction to the company. An owner takes away money or product from the business. Keep in mind that the owner’s equity account, which represents the proprietor ownership, is the one being reduced. In other words, the owner isn’t arbitrarily taking money out of the company they possess.
Still, a drawing account affects the business’s total equity. In short, a drawing account is a contra account — or an account that records loss instead of gain (in this case loss) and vice versa — to the owner’s equity account.
Journal Entry of Drawing Account
Every time the owner executes a fund withdrawal, the amount is debited to the drawing account and credited to the cash account. A cash account is used since the owner is taking money from the company. These two entries happen to adhere to record-keeping 101: every transaction requires both a debit and a credit (adduction and reduction).
A drawing account is a temporary account, meaning that a bookkeeper clears out the amount reported on the balance sheet at the end of each period, i.e., the account balance is always zero at the start of every fiscal year.
When they close the journal, the drawing account has a credit equal to the total amount of money withdrawn throughout the year. At the same time, the owner’s equity account is debited with the same amount. A debit to the owner’s equity account goes against the common practice of credit balance entry. This is usually done during the closing period. The debit entry is the representation of equity reduction.
While it’s true that a drawing account is closely related to business equity reduction, it’s not treated as an expense. Income distributions do not affect the bottom line or net profit of a company. As a result, the drawing account does not appear under the income statement but is still reported on the balance sheet.
Schedule of Drawing Account
The scheduling of a drawing account is vitally important, especially if there is more than one business owner. A schedule ensures that each owner receives the appropriate amount of money agreed upon in the partnership agreement. Furthermore, it also mitigates the risk of disputes over the amount of money withdrawal.
A decent schedule should show the correct detail and summary for each drawing account transaction. It also needs to be as transparent as possible to minimize any potential conflict.
Example of Drawing Account
First, let’s refresh our memory. Each owner’s withdrawal triggers the accountant to make a debit entry to the drawing account and a credit entry to the cash account. When the journal is about to be closed, the sum of money withdrawn by the owner is credited to the drawing account and debited to the owner’s equity account, representing total equity reduction. Additionally, the drawing account should be equal to zero for the next fiscal period due to the credit entry mentioned above.
Let’s take a look at the following.
James is the sole proprietor of his business. Every month, he withdraws $6,000 in cash from his company, effectively placing a debit entry to the drawing account and credit entry to the cash account. The journal recording the transaction is closed and reopened every 12 months. Can you determine what kind of impact these transactions have on the journal entry at the end of the year?
We know that the drawing account is credited, and the owner’s equity account is debited when the journal is ending. As for the amount, it should be equal to the sum of money withdrawn by James throughout the year. Therefore, the closing journal entry would be $72,000 worth of drawing account credit and $72,000 for the owner’s equity account debit.
Differences Between a Drawing Account and Other Types of Income Distribution
Drawing account, dividend, wage, salary, and share repurchase are some examples of income distribution that involve a company paying a certain amount of money to people related to its operation. To get a better understanding of the drawing account, observe its difference against the other terms.
Drawing Account vs. Dividend
Both a drawing account and dividends have a lot of similarities. These two types of revenue distributions require a company to put away funds to its owner(s). However, there are still distinctions.
Dividends are payments made to investors (third parties) by corporations. On the other hand, a drawing account is a portion of revenue distributed to the owner(s) who own and run the business. The tax charges for both dividend and drawing accounts are imposed on the recipients.
Drawing Account vs. Share Repurchase
Corporations may execute a share repurchase plan for a couple of reasons. The most common one would be to boost the value of an undervalued stock. Buying back their shares can potentially increase the demand and price of the companies’ shares.
Another reason is shareholders’ compensation. Apart from stock’s value improvement, buying back shares will also give money to shareholders. With that said, this means that the ownership percentage of these shareholders is decreased. To alleviate any issue, share repurchase is often done through equal proportions so that the relative ownership status quo won’t change.
Drawing Account vs. Wage & Salary
This one might be obvious. Drawing account, wage, and salary are usually paid to the respective recipients on a periodical basis. However, a drawing account is paid to the owner of the business. A business pays wage and salary to employees who are considered an asset or liability. Wages and salaries are often called remuneration—the payment for service or employment. Remuneration includes the base pay as well as additional bonuses, commonly referred to as compensation.
Another thing to note is that the money paid through a drawing account and salary (excluding bonuses/compensation) is usually fixed. In contrast, wage payment tends to vary depending on work hours or per unit basis.
A drawing account is one of the more straightforward concepts in accounting to understand. The biggest thing to keep in mind when you see the term is that an owner is taking cash from the company. Whether it’s to pay themselves or fund their fifth vacation for the year is up to business terms and, hopefully, the owner’s good judgment.