What are Drawings in Accounting?
Tracking the flow of money to and from your business is crucial to its financial health. To easily track the flow of money, accounting uses specialised language to refer to the different ways money moves in a business
22nd September 2022
Tracking the flow of money to and from your business is crucial to its financial health. To easily track the flow of money, accounting uses specialised language to refer to the different ways money moves in a business. One such technical term is “drawing.”
What exactly are drawings in accounting, and how does it affect business accounts? Here we will answer these questions and more.
What Are Drawings In Accounting?
Drawings are withdrawals of funds or assets from a business for personal use, rather than for business use. A drawing occurs when a business owner withdraws cash from a business account for any personal use, whether it is something as huge as buying a personal car or as small as paying for a meal.
Drawings are not always cash. Drawings also occur when a business owner withdraws business assets, such as a product, for personal use.
Such drawings are made to compensate the owners or partners for their personal living expenses. The amount of drawings usually cannot exceed the amount of profits earned by the business. Thus, when a business owner or partner withdraws money from the business for personal use, it is important to document it as a drawing to keep accurate financial records.
Drawings can be made either in cash or by check and should be properly documented in the company’s books. If drawings are not documented, it can create problems when trying to determine the business’ taxable income. Therefore, documenting all drawings is an important part of good accounting practices.
How to Manage Drawings in Business Accounts
Drawings represent withdrawals from the company over the course of the year for personal use.
So that your books are not disrupted, you need to keep a drawing account to record these transactions. The drawing account is opened at the beginning of the financial year and closed at the end of the financial year.
Drawings reduce capital from the total equity of the business. So, when there is a drawing, the typical accounting entry is a debit to the “drawing account.” The corresponding credit entry is in the account cash (for cash drawings) or the account of the specific asset withdrawn (for withdrawals of goods).
In the balance sheet, a drawing is shown as a reduction on the equity side, representing a decrease in the owner’s equity.
Who Uses Drawing Accounts?
Drawing accounts are used by unincorporated businesses like sole traders and partnerships.
The reason is that in unincorporated businesses, the owner and the business are not separate entities. Therefore, the businesses feature a high degree of direct owner participation that can easily confuse how owners use the money and assets of the business.
Thus, unincorporated businesses need a solution to clearly separate the usage of a business’ money and assets into business use and personal use. The drawing account does this.
However, in incorporated businesses, the owners and the business are separate entities. So, there is no need for a drawing account to separate the usage of the business’ money or asset.
Characteristics of a Drawing Account
A drawing account has the following features:
· It tracks business capital withdrawn for personal use
· It is not an expense account
· It is not a continuing account
1. Tracks Business Capital Withdrawn for Personal Use
By separating the usage of a business’ money and assets into personal use and business use, a drawing account essentially tracks the total amount of capital that owners withdraw from a business for personal use.
Thus, a drawing account helps put a check on the withdrawals of the owners of unincorporated businesses (partnerships and sole traders), thereby helping to maintain the company’s overall capital balance.
2. It Is Not an Expense Account
The drawing account is a debit account and reduces the business capital. However, a drawing is not an expense, so the drawing account is not an expense account.
Expenses are necessary costs that a business incurs in order to operate, such as inventory, salary, rent, repairs and maintenance, etc. Business expenses are recorded in the profit and loss (P&L) account.
On the other hand, when business owners make drawings, the money or asset withdrawn leaves the business but does not help it in any way. So, drawing is simply a reduction of money available in a business and, therefore, not an expense.
Thus, while expenses are recorded in the P&L account, drawings are recorded in the balance sheet as a reduction in owner’s equity.
3. It Is Not a Continuing/Permanent Account
In accounting, a permanent account is an account that you do not close at the end of the accounting period. Instead, its balances carry over to the next accounting period. Examples of permanent accounts include inventory, accounts receivable, accounts payable, etc.
For example, because inventory is a continuing/permanent account, you transfer your year-end inventory balance over to the New Year as your beginning inventory balance.
However, the drawing account is not a permanent account but a temporary one that you open at the beginning of the financial year and close at the end of the financial year. To close the drawing account, you apply for credit in the ledger and transfer the balance to the owner’s equity side of the balance sheet by means of a debit.
When running as a sole trader or partnership, there’ll come a time when you need to withdraw money from the business for personal use. Without a means to track such withdrawals, the money available in your business may reduce uncontrollably and ground your business.
Drawings represent money or goods withdrawn from a business for personal use. So, a drawing account helps you keep business and personal finance separate and organised.
When you withdraw a business’ money for personal use, debit the drawing account and credit the cash account, and close the drawing account at the end of the accounting period.
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