The accounting equation is a formula for calculating the value of business assets relative to the amounts that its owners have earned, spent and invested in business equity. When a business owner withdraws cash from a company account, the value of company assets decreases because some capital reserves have been transferred from business to personal use. Although an owner draw affects the value of a company's assets, it is essentially unrelated to the part of the equation that calculates how much the business has earned through its sales and operations.
Assets
The assets portion of the accounting equation represents the total amount that your business owns. Business assets include money in the bank, equipment, inventory, accounts receivable and other sums that are owed to your company. When a business owner withdraws cash from his business, the portion of the company's assets made up of cash on hand decreases. This withdrawal adds an extra step to the accounting equation, which involves subtracting the amount of the owner's draw from the accumulated assets to calculate an adjusted amount.
Liabilities
The liabilities section of the accounting equation represents the amount your business owes in either loan principals or outstanding balances on invoices for inventory or services rendered. When an owner withdraws cash from a company, this transaction has no effect of the liabilities section of the accounting equation. The cash withdrawal comes out of the company's assets, which are calculated using the sum of its liabilities as one of the earlier variables in the equation.
Owner's Capital
The owner's capital is the part of the accounting equation that represents the liquid cash that the company has earned, which it has on hand for daily operations as well as capital investments. When a business owner withdraws cash for personal use, these funds come out this capital account. The larger the sum the owner withdraws, the smaller the sum that remains in the business as operating capital.
Relevance
In a sense, the actual change in a sole proprietorship's accounting equation that occurs when the owner withdraws cash from the business is merely semantic. When a sole proprietor sells her company, she sells the systems and physical assets, such as the equipment and inventory. She does not sell the bank balance that the business has accumulated, whether that money is in a bank account under her name or under the name of her business. That money belongs to her, regardless of the bank account where it is held, and regardless of whether it appears on her own or on the company's balance sheet.
References
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Devra Gartenstein is an omnivore who has published several vegan cookbooks. She has owned and run small food businesses for 30 years.
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What Is a Drawing Account?
A drawing account is an accounting record maintained to track money and other assets withdrawn from a business by its owners. A drawing account is used primarily for businesses that are taxed as sole proprietorships or partnerships. Owner withdrawals from businesses that are taxed as separate entities must be accounted for generally as either compensation or dividends.
Key Takeaways
- A drawing account is a ledger that tracks money and other assets withdrawn from a business, usually a sole proprietorship or a partnership, by its owner(s).
- A drawing account acts as a contra account to the business owner’s equity; an entry that debits the drawing account will have an offsetting credit to the cash account in the same amount.
- Drawing accounts work year to year: An account is closed out at the end of each year, with the balance transferred to the owner’s equity account, and then reestablished in the new year.
How a Drawing Account Works
An owner’s draw occurs when the owner of an unincorporated business such as a sole proprietorship, partnership,
or limited liability company (LLC) takes an asset such as money from their business for their own personal use. Owners of such businesses are free to take money from
their business bank accounts and deposit it in their personal accounts to pay personal expenses as and when they choose—provided, of course, that they play by the rules.
A drawing account covers all assets, not just cash. For example, this means that equipment withdrawn from the business for the owner’s personal use would also count as a drawing.
A drawing account is a contra account to the owner’s equity. The drawing account’s debit balance is contrary to the expected credit balance of an owner’s equity account because owner withdrawals represent a reduction of the owner’s equity in a business.
In keeping with double entry bookkeeping, every journal entry requires both a debit and a credit. Because a cash withdrawal requires a credit to the cash account, an entry that debits the drawing account will have an offsetting credit to the cash account for the same amount.
Since the drawing account tracks distributions to owners in a given year, it must be closed out at the end of the year with a credit (representing the total withdrawn), and the balance is transferred to the main owner’s equity account with a debit. The drawing account is then reopened and used again the following year for tracking distributions.
Because taxes on withdrawals are paid by the individual partners, there is no tax impact to the business associated with the withdrawn funds.
Creating a schedule from the drawing account shows the details for and summary of distributions made to each business partner. The appropriate final distributions may be made at year-end, ensuring that each partner receives the correct share of the company’s earnings, according to the partnership agreement.
Since the drawing account is not an expense, it does not show up on the income statement of the business.
Recording Transactions in the Drawing Account
A journal entry to the drawing account consists of a debit to the drawing account and a credit to the cash account. A journal entry closing the drawing account of a sole proprietorship includes a debit to the owner’s capital account and a credit to the drawing account.
For example, at the end of an accounting year, Eve Smith’s drawing account has accumulated a debit balance of $24,000. Eve withdrew $2,000 per month for personal use, recording each transaction as a debit to her drawing account and a credit to her cash account. The journal entry closing the drawing account requires a credit to Eve’s drawing account for $24,000 and a debit of $24,000 to her capital account.
What is the entry of a drawings account?
The accounting entry typically would be a debit to the drawing account and a credit to the cash account—or whatever asset is withdrawn.
Is a drawing account an asset?
The drawing account represents a reduction of the business’ assets, as the assets in question are withdrawn and transferred to the owner for personal use.
Are owner draws an expense?
No. Owner draws are for personal use and do not constitute a business expense. This means, among other things, that they are not tax deductible.
The Bottom Line
Small business owners should be aware of the rules before withdrawing cash or other assets from their business. Owner draws can be helpful and function as a method for a business owner to pay themselves. However, it’s important to remember that they are not considered business expenses, must be recorded in the correct way, and can weaken the company financially if made excessively.