Drawings are the withdrawal of capital from a business by an owner. In this article, we will look at a simple example and the journal entry required to account for interest charged on drawings. The two accounts we are going to deal with in this situation are the drawings account and the interest account.
We do not treat drawings as income for owners, unlike, say, dividends and wages. Therefore, they are not subject to income tax. Instead, we recognise drawings in accounting and tax systems as withdrawals of capital funds from the business. However, in circumstances where an owner may charge the business interest for capital funds held, the business may charge the owner interest on funds withdrawn.
The drawings account is a contra capital or owners equity account and therefore is a natural debit account. To increase the balance of this type of account, a debit entry is used, which we will be using today. And, of course, to reduce the account, a credit entry is required.
Interest Revenue Account
There usually are two types of interest accounts used in business, an interest expense account and an interest revenue account. Today we will be dealing with interest revenue, which is a credit account. A credit entry is required to increase the balance, and of course, a debit is applied to reduce it. Worth noting that debit or off-setting entries are generally not put through revenue accounts – but that is for another day.
Example and Journal Entries
ABC Ltd, our trusty example business, has had a request from one of its owners, Brian Smith, to withdraw $10,000 from the business. You may remember Brian from our article dealing with the debits and credits associated with drawings transactions.
So a quick recap of the initial journal entry for Brian’s drawings:
The debit of $10,000 increases Brian’s drawings account. The credit of $10,000 to the Bank reduces ABC’s bank balance.
The owners of ABC have an agreement in place; as it’s a closely held firm, ABC will pay owners interest for their funds introduced above their paid-up capital; in effect, these are loans from the owners. However, offset against this will be any drawings made on the business. This agreement is to ensure all owners are treated fairly while at the same time providing them flexibility in putting monies into and taking monies out of the business.
The owners are charged 1% per month, simple compounding, on their drawings account. At the end of July, the month-end management accounts are prepared, and the interest calculation and journal entry for Brian’s drawings are prepared.
The calculation we need to make is to work out how much interest to charge Brian for the 16 days of the month he has taken the $10,000 for:
16 days / 31 days in July x 1% x $10,000 = $51.61
The journal entry would therefore be:
|Interest on Drawings||51.61|
And so, the interest calculation would be made at the end of each month, reflecting a growing drawings balance for Brian and an increasing interest in drawings revenue for ABC.
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