Drawings refer to transactions where the owner or owners withdraw funds from the business in cash or other assets. Accounting for drawings is vital to ensure you correctly account for owners capital and apply the proper tax treatments.
Withdrawal of Capital From a Business
Drawings relate to an owner taking funds from a business that they have already put in, i.e. they are drawing down what they have built up in the business in the form of capital. It is important to mention here the four ways that an owner can withdraw funds from a business. These withdrawals can be in the form of dividends, loans, reimbursement of expenses or drawings.
We are not worrying about the other forms of taking funds from a business; they are in other articles as part of our accounting tutorial series.
Accounting for Drawings Theory
The drawings account is a capital contra account and, therefore, a debit account by nature. A contra account is an account allocated the opposite debit or credit of the type of accounts associated with. Another word that may explain it is to say it is an off-setting account.
The thing to remember for the moment is that it is a capital account used to record the owner’s drawings through a year but is a debit account in nature. This provides a neater way of tracking the owner’s capital in the business rather than running all of these transactions through the main capital account. Let’s look at an example of the accounting entries involved.
The Accounting Equation
The use of the accounting equation in these explanations can be beneficial. It sets out how the inflows and outflows must balance and how the double-entry system records the movement of economic benefits.
So let’s look at an example with ABC Ltd again, this time with one of the owners, Brian Smith. Brian wishes to withdraw $10,000 in cash from the firm. Looking at the accounting equation ABC Ltd has to record a reduction of the bank by $10,000 and an increase in drawings for Brian of $10,000. You will see with the table below the equation stays in balance as there is a decrease and increase on the same side:
Journal Entries Accounting for Drawings
Now we have looked at the theory of drawings, and how it impacts the accounting equation, it’s time to work through some examples. Below we have several examples with journal entries to explain the accounts involved in different types of drawings.
We work through five different common examples of how owners withdraw capital from the business. The first one we’ll look at is the drawdown of initial capital placed in the business. This transaction will use a different owner’s account, the capital account. Let’s have a quick look at their differences before getting stuck into the examples.
Capital and Current Accounts
Many businesses will often use two accounts for owners, a capital account and a current account. In particular, you will see this in partnership accounting. The purpose of the capital account is to record ownership positions of the business. For example, the owner adds the initial funds, or a new owner buys into the business.
We use current accounts to record capital movements due to owner salaries, drawings, dividends, profit shares, bonuses, and the other items we will cover below. As you can see, the current is a record of regular changes in what an owner is drawing out of or building up in the business. In contrast, the capital account is a permanent record of changes in the ownership mix.
Example One – Changing Ownership Mix
In our first example, we wanted to quickly look at the owners capital account before getting into the more common current account drawings that we will see below. This example is first because the drawings account is typically not used to record the movement of funds. Let me explain. Brian, along with three other people, put in $100,000 to ABC Ltd some years ago. We’ll keep the example simple by not worrying about the change in Brian’s share over the years, but let’s say Brian wants to draw down $50,000 worth of his capital now. In this case, we would prepare the following journal entry:
|15 July||Owner’s Captial Account||$50,000|
Now we have that example out of the way; we’ll move onto examples using the drawings account.
Example Two – Cash Drawings
According to the scenario we described above, Brian is drawing down $10,000 cash from the business. To account for this transaction, you would prepare the following journal:
The debit side of the entry increases the drawings account, while the credit to the bank account reduces its balance. In terms of the accounting equation, and to check it all remains in balance, you would see the following changes to ABC’s equation:
Example Three – Fixed Asset Drawings
Now, instead of cash, Brian took one of the older diggers at an agreed market value. ABC Ltd would need to re-record an increase in drawings, but this time a reduction in the machinery asset account. As the table below shows, bank and machinery are both asset accounts, and therefore the accounting equation entry looks the same:
The journal entry to bring this entry into ABC’s accounts would look something like this:
But let us make this example a little more realistic and have the situation where we would have to deal with accumulated depreciation and any loss or profit on disposal.
Scenario One – Book Value Equals Agreed Price
In this first scenario, we have the following additional information: the cost price of the digger was $40,000, and the accumulated depreciation was $30,000. As before, the agreed sale price is $10,000. Now that we have to deal with accumulated depreciation and potential gains or losses on disposal (coming up next), we will need to use an asset realisation account. You could also call it an asset disposal account. The name doesn’t matter too much, as long as it’s clear for the auditors!
|15 July||Accumulated Depreciation||$30,000|
Our first journal entry closes off the accumulated depreciation associated with the digger by debiting the account, moving it across to the asset disposal account.
|15 July||Asset Disposal||$40,000|
The second journal does the same thing, this time with the digger’s fixed asset account. The fixed asset account carries the digger’s gross cost, so we apply a credit entry to this asset account, with the corresponding debit to the asset disposal account.
And the final entry for scenario one is the clearing of the asset disposal account with a credit, reflecting the net book value of $10,000 balance. The matching $10,000 debit to the drawings account reflects the agreed sale price of the asset transfer. Although the two figures are the same, they reflect two very different parts of the transaction – this will be clearer in the next couple of examples.
Scenario Two – Book Value is Greater than Agreed Sale Price
Let us take scenario one information, change the sale price from $10,000 to $8,000 and leave all the other variables the same. All of the journal entries we used in scenario one remain the same, except for the last one. In our new scenario, we would make the following journal entry:
|Loss on Asset Disposal||$2,000|
The first line of the journal is the $8,000 agreed sale price to Brian. The credit line is the closing of the disposal account, being the net book value of $10,000 ($40,000 – $30,000). And we achieve this with the $2,000 debit to the Loss on Asset Disposal account. You would disclose this amount in the statement of financial performance (profit and loss statement).
Scenario Three – Book Value is Less than Agreed Sale Price
As in scenario two, we’ll keep all of the variables the same except the sale price. In scenario three, the sale price will be $15,000. We now have a $5,000 profit on the sale to deal with, which we would with the following journal entry:
|Profit on Asset Disposal||$5,000|
We see a drawings debit of $15,000, being the sale price of the digger to Brian. We then have the two credits, $5,000 Profit on Asset Disposal and $10,000, to clear the net book value from the Asset Disposal account.
Example Four – Expenses Paid on Behalf
The fourth example for drawings is where the business pays expenses on behalf of the owner. These types of situations do tend to have fringe benefit tax implications. Still, we’ll ignore these as those will have to be for another article and are very much tax jurisdiction-specific. In our case, Brian has his professional Directors membership fees paid ABC Ltd. These don’t form part of his remuneration, and so he treats it as drawings each year. The $2,500 annual expense journal entries would be:
We make the debit to drawings as ABC is not incurring membership fees as part of its operations. But instead, it is, in effect, just being a payment agent for someone else. Instead of applying the debit directly to drawings, some might argue that they would debit the membership fees first and make two journal entries. For completeness, let’s have a look at that quickly:
|15 July||Directors Membership Fees||$2,500|
|Directors Membership Fees||$2,500|
However, in accounting, we don’t typically offset transactions in expense and revenue accounts like this. This approach adds another journal entry that is not required, and I wouldn’t recommend recording it this way. Instead, use the one journal entry as initially shown.
Example Five – Loan Repayment
We are now at the final example, the repayment of a loan. In this case, it is a loan that Brian has with ABC, rather than to say a third party (like the expense situation we looked at in example four). In this example, Brian owes BAC $5,000 for an advance he took three months ago. Instead of paying the cashback to ABC Ltd, Brian and ABC agree it will treat the repayment as drawings.
As there was no interest involved, the journal entry would be:
|Loan to Brian||$5,000|
The debit increases Brian’s drawings for the year by $5,000, while the credit to the Loan account, an asset to ABC Ltd, is closed by the $5,000 credit.
We trust the explanations and examples have helped. Remember, drawings are not subject to income tax. Either because tax has already been paid or it is capital in nature, and no income tax is payable. We welcome your feedback, so please use the comments section below or our contact us page. You can also raise any questions in the ask a question section.