A drawing account serves as a temporary equity account within the double-entry bookkeeping system, primarily used by sole proprietorships and partnerships to record withdrawals of cash or other assets by the owner(s) for personal use. These withdrawals reduce the owner's Capital or Equity in the business, reflecting a decrease in the owner's investment rather than a business Expense. The drawing account is an essential tool in Accounting for maintaining a clear distinction between personal and business finances.
History and Origin
The concept of a drawing account is deeply rooted in the historical evolution of small business structures, particularly the Sole proprietorship and Partnership. In these unincorporated business forms, the owner and the business are not considered separate legal entities for tax and financial reporting purposes. Early accounting practices, which focused on tracking the personal wealth invested in a business, naturally developed mechanisms to account for personal funds taken out. As businesses grew more complex, the need for systematic Bookkeeping to track these owner withdrawals became apparent. The drawing account became a standard way to segregate these personal transactions from the business's operational Revenue and expenses, ensuring that the true financial performance of the business could be assessed. The Internal Revenue Service (IRS) outlines the characteristics and tax implications of sole proprietorships, emphasizing the unified nature of the owner and business from a legal standpoint, which underpins the use of a drawing account for personal withdrawals.9
Key Takeaways
- A drawing account is an equity account used by sole proprietorships and partnerships to record owner withdrawals for personal use.
- It reduces the owner's equity in the business.
- The drawing account has a normal Debit balance, as it decreases equity.
- At the end of an accounting period, the balance in the drawing account is closed to the owner's capital account.
- Unlike salaries in corporations, owner's draws are generally not considered business expenses for tax purposes.
Formula and Calculation
The drawing account itself doesn't have a complex formula but rather functions as a direct reduction of owner's equity. When an owner withdraws funds, the transaction is recorded with a debit to the drawing account and a Credit to the cash account (or other Assets withdrawn).
At the end of the accounting period, the balance in the drawing account is transferred to the owner's capital account. This process is known as closing the drawing account.
The general impact on the accounting equation is:
When drawings occur, the specific accounts affected are:
- Cash (an asset) decreases.
- Drawing account (an equity contra-account) increases with a debit.
The closing entry at the end of the period typically looks like this in the General ledger:
This entry effectively reduces the owner's capital balance by the total amount of drawings made during the period.
Interpreting the Drawing Account
The drawing account provides a clear record of how much capital an owner has removed from the business for personal needs over an accounting period. A high balance in the drawing account indicates significant owner withdrawals, which can impact the business's liquidity and its ability to reinvest profits or expand. For a sole proprietor or partner, understanding the drawing account balance is crucial for managing personal finances alongside business finances. It directly affects the owner's equity shown on the Balance sheet at the end of the period, demonstrating the net investment remaining in the business after accounting for profits, losses, and withdrawals. A healthy business allows for consistent owner draws without impairing its operations or long-term growth.
Hypothetical Example
Consider "Sarah's Sweets," a small bakery operated as a sole proprietorship. Sarah is the owner and needs to withdraw cash from the business for her personal rent payment.
- Initial Situation: Sarah's Sweets has $10,000 in its business checking account.
- Withdrawal: On March 15th, Sarah withdraws $1,500 from the business checking account for her personal rent.
- Journal Entry: In the business's Bookkeeping records, the accountant would make the following entry in the General ledger:
- Debit: Sarah, Drawing Account - $1,500
- Credit: Cash - $1,500
This entry reflects the decrease in the business's cash and the increase in the owner's personal withdrawals.
- Impact: The business checking account balance is now $8,500 ($10,000 - $1,500). The Drawing Account shows a balance of $1,500.
- End of Period (e.g., December 31st): Assuming Sarah's total drawings for the year were $15,000, and her initial capital was $50,000, and the business had a net income of $30,000 for the year. The closing entry would be:
- Debit: Sarah, Capital Account - $15,000
- Credit: Sarah, Drawing Account - $15,000
After closing, the drawing account balance becomes zero, and Sarah's capital account would be updated to reflect the initial capital plus net income minus drawings ($50,000 + $30,000 - $15,000 = $65,000).
Practical Applications
Drawing accounts are a fundamental component of financial management for unincorporated businesses, enabling owners to take funds from the business for personal needs while maintaining proper accounting records. For Sole proprietorships and Partnerships, owner's draws are distinct from employee salaries. The Small Business Administration (SBA) provides guidance on how small business owners can pay themselves, including through owner's draws, highlighting the flexibility this method offers compared to a fixed salary.8 These withdrawals are typically not deductible business expenses for income tax purposes, and the owner is responsible for paying self-employment taxes on the business's net profits, regardless of the amount withdrawn.76 This is a key difference from corporate structures, where owner-employees receive a salary subject to payroll taxes. Owners often use drawing accounts to manage cash flow for personal expenses, such as household bills, mortgage payments, or personal investments. The ability to take flexible draws allows owners to adapt to varying business profitability and personal financial needs, though it requires careful self-discipline to ensure the business retains sufficient operating Capital. The IRS provides specific guidelines for sole proprietorships, emphasizing that the business and owner are generally treated as one for tax purposes, making the drawing account a method for personal fund access rather than a tax deduction.5
Limitations and Criticisms
While useful for sole proprietorships and partnerships, the drawing account concept has limitations. It is not applicable to corporations, where owners (shareholders) typically receive compensation through salaries (if they are also employees) and dividends, which are recorded differently and have distinct tax implications. Using a drawing account can sometimes blur the lines between personal and business finances if not managed rigorously, potentially leading to inadequate cash reserves for the business's operational needs or growth. Small business owners must carefully manage their personal withdrawals to avoid negatively impacting the business's financial health. The New York Times highlights the importance of separating personal and business finances for small businesses to ensure clear financial management and avoid potential pitfalls.4 Furthermore, large or inconsistent draws can make it challenging to assess the business's true profitability and financial stability, especially for external stakeholders like potential lenders, who prefer to see consistent, predictable financial patterns. An academic perspective from the St. Louis Federal Reserve notes the complexities of how owners are compensated in small businesses, and how funds can flow to owners in ways that are not always transparent or tied directly to wages, impacting broader economic analyses.32 Without a formal salary structure, owner's draws might not provide a clear income history that is often required for personal loan applications, such as mortgages.
Drawing account vs. Owner's Equity
The terms "drawing account" and "Owner's equity" are closely related but represent distinct concepts in accounting. Owner's equity, also known as owner's capital, represents the owner's total investment in the business, including initial contributions, accumulated profits, and retained earnings, less any losses or withdrawals. It signifies the residual claim on the business's Assets after Liabilities are satisfied. The owner's equity account is a permanent account on the Balance sheet.
In contrast, a drawing account is a temporary contra-equity account. Its sole purpose is to record the withdrawals made by the owner(s) for personal use during a specific accounting period. It reduces the overall owner's equity, but it does not represent the total investment itself. At the end of each accounting period, the balance from the drawing account is transferred to the owner's equity (capital) account, effectively netting out the withdrawals against the owner's total investment or accumulated profits. This distinction helps in tracking personal withdrawals separately before they are officially closed out to the main equity account.
FAQs
What types of businesses use a drawing account?
Drawing accounts are primarily used by unincorporated businesses, specifically Sole proprietorships and Partnerships. These business structures do not have a separate legal identity from their owners, making the drawing account an appropriate tool for recording personal withdrawals.
Is a drawing account an expense?
No, a drawing account is not considered a business Expense. It is an equity account that reduces the owner's investment in the business. Expenses are costs incurred to generate Revenue for the business, such as rent, utilities, or salaries paid to employees, and appear on the Income statement. Owner's draws, however, reflect a reduction in the owner's claim on the business's assets.
How does a drawing account affect financial statements?
The drawing account directly impacts the owner's equity section of the Balance sheet. While it is a separate account during the accounting period, its balance is eventually closed into the owner's capital account at the end of the period, thereby reducing the total owner's equity. It does not appear on the Income statement or the Statement of cash flows as an operating activity.
Can an owner take more from a drawing account than the business earns?
While technically possible for an owner to withdraw more from a drawing account than the business earns in a period, doing so can deplete the business's Capital and negatively impact its financial stability. Consistent withdrawals exceeding profits can lead to cash flow problems or require additional owner contributions or external financing to sustain operations. The Small Business Administration advises that owners should manage their compensation to align with their business's profitability and cash flow.1