What Is Drawing Accounts?
A drawing account is an equity account used in sole proprietorships and partnerships to record withdrawals of cash or other assets by the owner(s) for personal use. It is a contra-equity account, meaning it reduces the owner's equity in the business. Drawing accounts fall under the broader financial category of accounting and are a crucial element in maintaining accurate financial records for non-corporate business structures. Unlike a salary, which is a regular payment for services, withdrawals from a drawing account are not considered a business expense for tax purposes but rather a return of capital or profit to the owner22.
History and Origin
The concept of tracking owner withdrawals is intrinsically linked to the evolution of double-entry bookkeeping, a system that became widely adopted in Europe by the end of the 15th century. Luca Pacioli, often credited as the "father of accounting," codified this system in his 1494 mathematics textbook, Summa de arithmetica, geometria, proportioni et proportionalità. While Pacioli did not invent the system, his detailed description allowed for its widespread study and use.20, 21 The principles of double-entry bookkeeping require that every financial transaction has a corresponding and opposite entry in at least two different accounts to maintain balance within the accounting equation. This foundational principle necessitates a mechanism, like the drawing account, to accurately reflect reductions in owner's equity due to personal withdrawals, ensuring the balance sheet remains in equilibrium. Early mercantile businesses, particularly those operating as sole proprietorships or partnerships, would have needed clear methods to distinguish business assets from personal assets, making the systematic tracking of owner withdrawals essential for financial transparency.
Key Takeaways
- A drawing account records the owner's personal withdrawals from a business.
- It is a contra-equity account, reducing the owner's capital.
- Drawing accounts are typically used by sole proprietorships and partnerships.
- Withdrawals from a drawing account are not considered a business expense.
- Owners are responsible for personal income taxes on these withdrawals.
Formula and Calculation
A drawing account does not have a specific formula in the same way that a financial ratio might. Instead, it represents a direct reduction in the owner's capital account. The general effect on owner's equity can be expressed as:
In this context, "Owner's Drawings" directly refers to the cumulative amount recorded in the drawing account during an accounting period. Each time an owner takes a withdrawal, the drawing account is debited, and the cash account or other asset account is credited.
Interpreting the Drawing Account
The drawing account provides a clear picture of how much capital an owner has withdrawn from the business for personal reasons. A high balance in the drawing account could indicate that the owner is heavily relying on the business for personal income, which might impact the business's ability to retain earnings for reinvestment or growth. Conversely, a low or zero balance might suggest that the owner is leaving profits within the business, potentially strengthening its working capital or allowing for greater expansion. Interpreting the drawing account balance requires considering the overall financial health of the business, its profitability, and the owner's personal financial needs. It is also important to consider the business structure, as only certain types of entities utilize drawing accounts.
Hypothetical Example
Consider "Sarah's Art Studio," a sole proprietorship. Sarah starts the year with an owner's equity of $20,000. During the first quarter, her studio earns a net income of $5,000. Sarah decides to take $1,500 for personal expenses, such as rent and groceries. This withdrawal is recorded in her drawing account.
Here's how the journal entry would appear:
| Date | Account | Debit | Credit |
|---|---|---|---|
| Mar 31 | Sarah, Drawing | $1,500 | |
| Cash | $1,500 | ||
| To record owner's withdrawal |
At the end of the quarter, to calculate her new owner's equity:
Beginning Owner's Equity: $20,000
Add: Net Income: $5,000
Less: Owner's Drawing: $1,500
Ending Owner's Equity: $23,500
This demonstrates how the drawing account directly reduces the owner's stake in the business.
Practical Applications
Drawing accounts are a fundamental aspect of financial management for unincorporated businesses. For sole proprietors and partners, understanding and correctly managing drawing accounts is crucial for accurate financial reporting and tax compliance. These accounts help in tracking the flow of funds between the business and its owners, which is distinct from employee salaries or other operational expenses.
Small businesses, which form a significant part of the U.S. economy, often rely on owner withdrawals for owner compensation. According to the Federal Reserve's Small Business Credit Survey, small businesses account for a vast majority of U.S. firms and nearly half of private-sector employment, highlighting the prevalence of structures that might utilize drawing accounts.19 The Federal Reserve System regularly conducts research and surveys to understand the financial conditions and needs of small businesses, including their financing needs and experiences.17, 18 Properly maintaining drawing accounts contributes to the overall clarity of a small business's financial statements and assists in assessing the business's capacity for growth and investment, separate from the owner's personal financial activities.
Limitations and Criticisms
While drawing accounts serve a vital function for certain business structures, they come with specific limitations and potential drawbacks. A primary criticism is that withdrawals from drawing accounts are not subject to standard payroll tax withholdings, such as Social Security and Medicare taxes, at the time of withdrawal.16 This means that sole proprietors and partners must proactively manage their personal tax obligations, often through estimated tax payments throughout the year, to avoid a large tax liability at year-end or potential penalties.
Furthermore, excessive or inconsistent withdrawals from a drawing account can negatively impact a business's liquidity and financial stability. If an owner draws too heavily on the business's profits without considering its operational needs or future investments, it can leave the company with insufficient cash flow to cover expenses, pay suppliers, or pursue growth opportunities. Unlike corporations where owner compensation in the form of dividends is typically based on retained earnings and profit distribution policies, drawing accounts offer more flexibility, which can lead to poor financial discipline if not managed carefully. The IRS code, specifically Section 402, primarily addresses the taxability of distributions from qualified retirement plans, which is a different context than owner draws from a business.11, 12, 13, 14, 15 This distinction underscores the unique tax responsibilities associated with drawing accounts for business owners.
Drawing Accounts vs. Salary
The distinction between drawing accounts and a salary is crucial for business owners, largely dictated by the legal structure of the business and its tax implications.
| Feature | Drawing Account | Salary |
|---|---|---|
| Business Type | Sole proprietorships, partnerships, LLCs (taxed as SP/Partnership) 10 | Corporations (S-Corp, C-Corp) 9 |
| Tax Withholding | No automatic tax withholding; owner responsible for estimated taxes 8 | Automatic payroll tax withholding (e.g., federal, state, FICA) 7 |
| Business Expense | Not considered a business expense | Is considered a deductible business expense |
| Consistency | Flexible; can be irregular and vary based on need 6 | Fixed and recurring payments at set intervals 5 |
| Impact on Equity | Directly reduces owner's equity 4 | Does not directly reduce owner's equity in the same way; impacts retained earnings |
Owners of sole proprietorships and partnerships typically use drawing accounts, as the business's profits are "passed through" directly to their personal income. This means all business income is taxed at the owner's individual income tax rate, and they are responsible for self-employment taxes (Social Security and Medicare) on the entire profit, regardless of how much they draw.3 In contrast, owners of corporations (like S-Corporations) are often paid a salary, which is a fixed payment subject to payroll taxes and can be a deductible business expense. S-Corp owners might also take distributions (similar to draws) in addition to a reasonable salary, which can offer tax advantages regarding self-employment taxes.2
FAQs
What type of businesses use drawing accounts?
Drawing accounts are primarily used by sole proprietorships and partnerships. Limited Liability Companies (LLCs) that elect to be taxed as a sole proprietorship or partnership also utilize drawing accounts.
Are withdrawals from a drawing account taxable?
Yes, withdrawals from a drawing account are taxable as personal income to the owner. The business's profits are "passed through" to the owner's personal income, and the owner is responsible for paying income tax and self-employment taxes (Social Security and Medicare) on these profits.1
How do drawing accounts affect owner's equity?
Drawing accounts are contra-equity accounts, meaning they reduce the owner's equity in the business. When an owner takes a draw, it decreases the overall capital invested in the business. This is reflected in the owner's equity statement.
Can a drawing account have a debit or credit balance?
A drawing account typically has a debit balance, as withdrawals decrease equity, and decreases to equity accounts are recorded as debits. At the end of an accounting period, the balance of the drawing account is usually closed out to the owner's capital account, effectively reducing it.
What is the difference between a drawing account and retained earnings?
A drawing account is used by unincorporated businesses (sole proprietorships, partnerships) to record owner withdrawals. Retained earnings, on the other hand, are an equity account found in corporations, representing the accumulated profits that have not been distributed to shareholders as dividends.