- 1 Definition of Owners Drawings – What Are They?
- 2 Business Structures and Owners Drawings
- 3 Examples of Owners Drawings
- 4 Conclusion
We have written a few articles on owners drawings, in particular dealing with interest charges and tax. In this article we wanted to go into some more detail, providing a more complete article on what drawings are, how to account for them and show some examples of the typical transactions that are made in business.
Definition of Owners Drawings – What Are They?
As we noted in our earlier articles, drawings are transactions withdrawing equity an owner has either previously put into the business or otherwise built-up over time.
Of course what often causes people confusion is …. so what is the difference between making drawings from a business compared to say shareholder salary or dividends?
So lets look at each of the main business structures first, just so the differences are clear.
Business Structures and Owners Drawings
This is the simplest and the most common structure used for small business. In a legal and tax sense there is no difference between the business and the business owner, they are not separate legal or tax entities. So this does make the accounting easier, in particular when it comes to the income tax side of things.
In the sole trader example there are no dividends or salary transactions to be concerned about. There are no dividends as these solely relate to companies. And there are no salaries as one cannot claim an expense for a payment to yourself (as you and the business are one and the same). Of course you can pay salaries to an employee, but that is a separate tax entity to the business, ie you.
And so under all the tax jurisdictions I have worked, profits from a sole trader are taxed at the owners effective marginal rate.
Now, you may wish to operate a drawings account in a sole trader set of books, in particular if you are using a separate bank etc (as you should). A drawings account would enable you to more easily see what funds are being “built-up” in the business as it grows. It may also provide an effective tool for you later if you were to convert the business into a company structure and/or were to sell it to a third party. The payments to you would then be much more easily identified.
A sole trader may also operate a capital and current account too. This again would provide a very clean means of tracking the capital flows within the business, even with a sole trader structure. Please see below for a further explanation of capital and current accounts.
Like limited liability companies (below) and unlike sole traders discussed above, partnerships are normally governed by legislation. For example in the UK these structures are covered the Partnership Act of 1890, which defines a partnership as being:
“… the relation which subsists between persons carrying on a business in common with a view of profit” (s.1.1).
Because we are now generally dealing with a more complex business structure and perhaps volume of transactions, partnerships will generally operate two different owner accounts, a capital account and a current account.
The purpose of the capital account is to provide a more permanent record of the pure capital flow of the business in respective of what each partner has introduced and withdrawn. This account would normally remain fixed with changes only being made as formal capital introductions or withdrawals are made – often relating to overall changes in the capital structure of the business; for example a partner joins or leaves the business.
Although not required, but often used, there are also current accounts. Where as the capital account is more “fixed” in nature, a current account enables the grouping of transactions such as interest charged or paid on capital, drawings of goods for own use, salaries or commissions paid to partners etc. So this is where we will expect to see owners drawings being recorded rather than through the capital account.
One can think of it as similar to using accumulated depreciation accounts (contra asset accounts) in dealing with depreciation of fixed assets. You could run the depreciation figures through the asset account each year, but it is cleaner to do this in a separate accumulated depreciation account.
In the example section below we’ll run through the different types of normal current account transactions to show you their impact upon a business and the journal entries involved.
Limited Liability Companies
We are usually dealing with closely held companies, ie those with only a few or often one shareholder. Many jurisdictions around the world use the threshold of five or fewer shareholders controlling 50 per cent or more of the common stock of a company as their definition of these types of companies.
Similar to partnerships, often two separate accounts will be operated with a shareholders or directors (very different roles, but often one and the same in small companies) capital and current accounts. The capital account provides a more fixed position of the capital brought in and taken out of the business by a shareholder. While the current account provides a more flexible record of other shareholder transactions taking place.
Examples of Owners Drawings
Now that we have worked through the most comment ownership structures it’s time to look at the most common drawings that are made by owners in these businesses. As drawings would normally be put through an owners current account, that is the one will be using today.
We turn to ABC Ltd our trusty example company used in our accounting tutorial series. As the debits and credits are very similar in what we are dealing with, we’ll stick to just using a company structure in the example. From this you can easily apply the same entries to sole trader or partnership accounting.
Listed below are the typical transactions you normally find running through current accounts. We will use Kevin as our shareholder example, one of five shareholders that owns ABC Ltd (as an aside, this of course means in most jurisdictions ABC Ltd is a closely held company). The details we will be using are:
- the company has declared and paid a dividend of $100,000;
- Kevin also works at ABC Ltd and earns a management salary of $50,000;
- Kevin has a capital account balance of $150,000 and earns 5 per cent on this from the company (the company has paid-up capital of $1,000,000, being 1,000,000 $1 ordinary shares);
- Kevin’s current account was in debit (overdrawn) for part of the year, and for this the company charges 5 per cent per annum; and
- Kevin incurred approved business travel costs of $2,000 for which he was not reimbursed for.
Dividends Awarded and Paid
The payment of dividends has two parts to it. The first is the dividends need to be declared, ie they are approved by the board of directors for payment. And second, the dividends are then paid to shareholders. We’ll look at both of these for ABC Ltd.
As we listed above, the Board has approved a dividend of $100,000 to be paid across the five shareholders (based on their share ownership). Kevin has 150,000 $1 shares in the company. This makes his ownership 15 percent of the total 1,000,000 shares. So Kevin is entitled to receive $15,000 of the $100,000 dividend.
|March 31||Dividends Declared||$100,000|
The debit to dividends declared is a temporary capital contra account (as opposed to say accumulated depreciation, which is a permanent asset contra account) that is put through retained earnings. While the credit to dividends payable raises the obligation (liability) the company now has.
|March 31||Dividends Payable||$100,000|
|Shareholder Current Account – Kevin||$15,000|
|Shareholder Current Accounts – Other||$85,000|
Our next journal entry moves the dividends payable liability to the shareholders respective current accounts. Each current account would be credited separately (as we have for Kevin), but we have just grouped the other shareholders under “other” for simplicity.
|April 15||Shareholder Current Account – Kevin||$15,000|
|Shareholder Current Accounts – Other||$85,000|
And the last entry for dividends is the payment transaction. This is a debit to current accounts and a credit to bank. Remember the dividend could also be in the form of more shares and so the credit would be to issued share capital rather than bank. You will also notice that the declaration and payment are generally not on the same date.
Salary and Commissions Earned
Kevin is earning $50,000 per annum at ABC Ltd as a management salary. Kevin is paid a monthly amount of $4,167 (0 dp) and we will assume a flat income tax rate of 20 per cent, under a withholding income system.
Withholding tax for ABC to deduct from Kevin’s monthly salary is:
($50,000 x 20%) / 12 = $833 (0 dp)
Therefore Kevin’s net salary for the month of July is $3,334 ($4,167 – $833).
|July 28||Management Salary||$4,167|
|Wages and Salaries Income Tax Withheld||$833|
|Shareholder Current Account – Kevin||$3,334|
The debit of $4,167 is to the management salary expense account. While the credit of $833 is to the withholding tax payable (liability) that ABC is due to pay to the local tax authority on Kevin’s behalf. And finally the net $3,334 is the net salary that is credited to Kevin’s current account.
In our case Kevin has agreed with ABC that he will draw down his whole salary for July. If Kevin doesn’t get paid out his full salary in a month that credit remains in his current account to be used for later or perhaps to earn interest on. However for July the journal entry would be:
|July 28||Shareholder Current Account – Kevin||$3,334|
The debit reduces the current account balance (ie what is owed to Kevin), while the credit to bank reflects the payment of cash to Kevin by ABC Ltd.
Interest Earned on Capital Accounts
Each of the five shareholders earns 5 per cent interest on their capital account balances, compounded daily and credited annually. This interest is not credited to the capital accounts, but rather added to the respective shareholder current accounts.
In Kevin’s case he had a steady balance of $150,000 invested in ABC Ltd over the financial reporting year. The calculations for his earnings would be:
(opening balance x (1 + interest rate / 365) ^ 365) – opening balance
($150,000 x (1 + 5% / 365) ^ 365) – $150,000 = $7,690
And for the total capital account balances held by the shareholders the figure would be:
($1,000,000 x (1 + 5% / 365) ^ 365) – $1,000,000 = $51,267
|March 31||Interest Expense||$51,267|
|Shareholder Current Account – Kevin||$7,690|
|Shareholder Current Accounts – Others||$43,577|
The debit is to the interest expense account for the ABC Ltd, while the credit increases the current account balances to Kevin and the other four shareholders.
Interest Charged on Current Accounts
As we mentioned above Kevin had a debit balance of $12,000 in his current account for part of the year (a total of 73 days). On any debit balances (ie overdrawn current accounts) ABC Ltd charges the shareholder 5 per cent compounded daily, debited annually. For Kevin the calculation would be:
($12,000 x (1 + 5% / 365) ^ 73) – $12,000 = $121 (0 dp)
|March 31||Shareholder Current Account – Kevin||$121|
Kevin’s current account is reduced by $121 by the debit, while the interest being charged is income to the company and this is reflected by the credit entry.
Expenses Incurred on Behalf of
The last owners drawings entry we want to cover today is for expenses incurred on behalf of the company by a shareholder. In Kevin’s case he incurred some business travel costs that the company didn’t reimburse him for (but had agreed he could incur) and so this is credited to his current account. The journal for this would be:
|Sept 15||Business Travel Expenses||$2,000|
|Shareholder Current Account – Kevin||$2,000|
As these were company related business expenses for which ABC agreed to cover, a debit of $2,000 is created so as to reflect this expense in their accounts (for financial reporting and tax purposes). While the credit increases Kevin’s current account balance. This example may arise where the company may not be able to cover the cash flow at the time of expenses and asks the employee to cover them. Or it could be Kevin knew his current account was going to be overdrawn and so perhaps agreed with company he would cover these costs. This would enable Kevin to say put the expenses on his personal credit (and earn his much loved frequent flyer miles), while “paying” the company back for his overdrawn current account.
We trust you have found this explanation of owners drawings helpful. We covered quite a lot of material, looking at the three common business structures, capital and current accounts and finally examples of the different types of drawings that can be made. We always welcome readers’ feedback, so please comment below, get in touch through the contact us page or raise a question through the ask a question section.