Definition
A drawing account is a type of account used in a sole proprietorship or a partnership business structure where the owner or partner can withdraw funds for personal use. It’s essentially an account that tracks money withdrawn from the business by its owners. Any withdrawals noted in the drawing account are not considered to be business expenses.
Key Takeaways
- The first main takeaway about the finance term “Drawing Account” is that it is an account which is used by a business owner or partners to withdraw profits from their own company. This is not considered as their salary or income, but rather it is a portion of profits that they have decided to re-invest into their personal assets.
- Secondly, these withdrawals are usually tracked in the Drawing Account. This allows visibility on how much a business owner is personally taking from the business earnings. This account is typically cleared out (zeroed) at the end of each year, as these drawings are subtracted from the owner’s equity.
- Finally, any amount withdrawn from the Drawing Account is subject to taxes. This will affect the business owner’s tax return where it will appear as personal income. It’s important for businesses to manage this account well to avoid potential tax implications.
Importance
The finance term “Drawing Account” holds significant importance because it represents the amount of money or other assets that a business owner withdraws from the company for their personal use.
This account functions primarily in partnerships and sole proprietorship businesses, providing a clear record of the owner’s withdrawals, which could be for living expenses or personal investments.
Discerning these transactions is crucial in assessing the financial health of the company because frequent or large withdrawals could indicate potential cash flow problems or financial instability.
Therefore, having a well-managed drawing account is integral in ensuring accurate financial statements, which aids in the establishment of business credibility and transparency.
Explanation
Drawing accounts serve a critical purpose in tracking the amount of money that a company’s partners or owners withdraw for their personal use. Businesses find it crucial in keeping an accurate account of the withdrawal transactions that are removed from the overall profit of the business.
The use of a drawing account offers a clear and organized record of funds withdrawn from the company that separates the personal transactions from corporate expenses. Consequently, it aids in clear financial analysis, forecasting, and avoiding any confusion or misuse.
The drawing account is used for recording the distribution of the owner’s share from the company’s profits, whether it be for personal or professional utilization. In partnerships or sole proprietorship businesses, it helps in calculating the profit or loss at the end of the fiscal year by deducting the drawings from the capital account.
By maintaining an accurate record of the business owners’ withdrawals, it ensures proper allocation and control of funds, maintains the transparency of a company’s financial status, and promotes the company’s financial integrity.
Examples of Drawing Account
Small Business Owner: A sole proprietor has a drawing account for his small bakery business. Whenever he needs funds for personal expenses, he withdraws money from this drawing account, reducing the overall equity in his business. At the end of the year, the balance of this account would be subtracted from the business’s equity section to reflect actual owner’s equity.
Consulting Firm Partnership: In a management consulting partnership, each partner may have a drawing account. Depending on their agreement, partners may periodically draw for personal use a certain amount from the partnership profits. This money withdrawal would be recorded in their individual drawing accounts.
Independent Online Retailer: An eBay seller who sells vintage clothes has a drawing account where she records the money she takes from her business for personal use, such as rent or bills. Even though she doesn’t have a physical shop, the drawing account clearly helps differentiate between her business and personal finances.
Drawing Account FAQ
What is a Drawing Account?
A drawing account is a type of account used in a sole proprietorship, a type of business where one person owns all of the company’s assets. The owner, known as the entrepreneur, records a decrease in business capital for his/her personal use through the drawing account.
Is a drawing account an expense?
No, a drawing account is not an expense. Instead, it represents a reduction in owners’ equity. So, it is not reported on an income statement, but it’s reported as a decrease in owner’s equity on a statement of changes in equity.
What happens to the drawing account at the end of the year?
At the end of the fiscal year, the drawing account is closed—it’s deducted from the owner’s equity. Any funds the owner withdrew during the fiscal year for personal use are accounted for and subtracted from the initial equity amount.
Can I invest in a drawing account?
No, a drawing account is simply a record keeping track of funds withdrawn by the owner from the business for personal use. It is an internal arrangement and cannot be used for investments.
What is the purpose of a drawing account?
The primary purpose of a drawing account is to measure the amount of funds taken by the owner or owners for personal use. These draws are not part of the business’s expenses and are not listed on the income statement. Instead, they’re transactions that reduce the owner’s equity in the business.
Related Entrepreneurship Terms
- Equity Capital
- Owner’s Draw
- Partnership Distribution
- Personal Income
- Capital Withdrawal
Sources for More Information
- Investopedia: This website provides general finance and investing information, including a detailed explanation of drawing accounts.
- AccountingTools: A comprehensive resource for accounting and finance information.
- Debits and Credits: A website dedicated to helping understand the basics of accounting including details on drawing accounts.
- Corporate Finance Institute: An educational platform with resources including definitions, examples, and detailed analysis of financial terms including drawing accounts.
