When individuals create a business venture, they introduce capital into it. This capital helps them grow and fund their operations. The business may either make a profit or a loss. Usually, once it goes through several accounting periods, it will accumulate some earnings. Some businesses use these earnings to invest in new operations. Others, however, may repay their owners.
In most businesses, repaying the owners occur through drawings. It refers to the amount owners withdraw from the earnings. In the case of companies, it occurs through the distribution of dividends.
Either way, it represents a decrease in the equity reported on the balance sheet. Before understanding how to account for owner withdrawal, it is crucial to discuss some other terms.
What is Equity?
Equity represents the residual amount after deducting a business’ assets from its liabilities. Assets include any resources owned or controlled by an entity that results in future inflows of economic benefits. Liabilities are obligations with probable future economic benefits outflows. In general, equity refers to the owners’ interest in a business.
Equity usually includes several balances. Of these, the most common include capital (or share accounts), retained earnings and reserves. The accounting treatment for each of these will differ based on the type of entity.
Similarly, the rights for each of these balances will also vary on how the business operates. For most owners, the reserves and capital accounts may be out of bounds.
Equity usually represents credit balances. All the accounts listed above include positive balances, making them all credit accounts. In some cases, however, the retained earnings account may contain negative balances, which will make it a credit account. In the trial balance, equity balances also usually appear on the credit side.
Similarly, the above balances appear in the equity (or shareholders’ equity) portion of the balance sheet. As long as the balance is positive, it will represent a credit balance. In case it is negative, the opposite will apply. Overall, equity represents the total stake an entity’s owners have in its operations. However, the type of entity will dictate the balances and the rights within it.
What is Owner Withdrawal?
Owner withdrawal also referred to as drawings, is when an entity’s owner withdraws assets from it. Usually, owners have the right to do so due to their ownership of the entity’s balance. However, there may be some limitations on these withdrawals based on the type of entity. Furthermore, some entities may not allow such drawings to occur at all.
Usually, drawings are relevant to a business like sole proprietorships, partnerships or other similar structures. In these structures, owners invest capital, which becomes a part of the entity’s equity.
The entity then operates and generates profits using this finance. For these business structures, both the capital and profits are available for withdrawal. In partnerships, there may be some limitations.
For companies, the primary owners include the shareholders. However, shareholders are external stakeholders and cannot decide on withdrawals. In general, no company allows shareholders to extract assets directly from its operations.
Therefore, owner withdrawals are not relevant to companies. While shareholders get dividends that are similar, these are not owner withdrawals.
In most cases, owner withdrawals include owners withdrawing cash from an entity. However, it may also contain other assets.
Under the double-entry accounting concept, the type of withdrawal does not matter. As long as owners withdraw an asset from the entity’s operations, it will fall under owner withdrawal. Therefore, companies must treat it accordingly.
What is the accounting treatment for Owner Withdrawal?
The accounting treatment for owner withdrawal is straightforward. As mentioned, the process usually involves the removal of an asset from an entity’s operations.
However, entities must account for these in two accounts under the double-entry bookkeeping concept. Owner withdrawals also impact an entity’s capital or equity balances.
As mentioned, equity represents an entity’s owners’ claim to its assets after paying off liabilities. Owner withdrawals are a decrease in an entity’s assets. It also results in a decline in the owners’ claim to the entity’s equity.
Therefore, owner withdrawal affects an entity’s equity balance adversely. In short, the transaction impacts both assets and equity negatively.
Usually, people confuse owner withdrawal with expenses due to similar accounting treatment. Since both transactions result in a decrease in inequity, they can be confusing. However, expenses represent the outflow of economic benefits during an accounting period. Instead, owner withdrawals are a decrease in the owners’ claim to the entity’s assets.
Due to the above accounting treatment, owner withdrawals do not appear on the income statement. Instead, they are a part of the balance sheet as a deduction in the retained earnings or capital accounts. Owner withdrawal is also not the same as the distribution of profits. However, both will have the same treatment. It is a type of contra equity account, which offsets an entity’s equity balances.
Is Owner Withdrawal a debit or a credit?
Equity balances are usually credited on the balance sheet and trial balance. However, owner withdrawal is not a part of equity.
In contrast, it is a contra equity account, which is the opposite of equity accounts. Therefore, owner withdrawal is a debit. As mentioned, this treatment makes it similar to expenses. However, it is not the same due to its treatment on the financial statements.
When a business owner invests in it, it represents capital. The journal entries for investment through capital will be as follows.
The type of asset will differ based on the transaction. Usually, owners invest cash into their businesses. However, it may also include other assets, such as buildings, land, vehicles, stock, etc. Owners may also withdraw the same assets back. Therefore, journal entries for owner withdrawal will also involve crediting the asset account, as follows.
Assuming an entity makes profits, it will accumulate a balance in the retained earnings account. This account will also be a credit balance.
However, owners can also directly withdraw their profits. In some cases, this withdrawal will be considered a distribution of profits. In others, it may fall under owner withdrawal. However, both of these will have the same accounting treatment but with different disclosures.
After every accounting period, entities must remove the balance from the drawings account and net it against equity.
Similarly, if an entity has retained earnings balance, the drawings account will first decrease that amount. After that, it will affect the capital balance. In case no retained earnings exist, owner withdrawal will directly relate to capital.
Mr. ABC starts his sole proprietorship, ABC Biz, with a cash injection of $10,000. Being the only employee for the business, Mr. ABC holds the rights to its equity. Finally, the owner records the initial investment in ABC Biz as follows.
After a year, ABC Biz makes a profit of $5,000. Therefore, the business’ total equity is $15,000 with the initial investment. Mr. ABC withdraws $7,000 cash from ABC Biz. The journal entries for the withdrawal will be as follows.
After this transaction, ABC Biz will only have a capital of $8,000. Of the above $7,000 withdrawn, $5,000 will offset the profits made from the business. The rest will net off against the existing capital balance.
Equity represents a business owner’s claim to its assets after subtracting its liabilities. It usually includes capital, retained earnings and reserves.
Owner withdrawal is when an owner withdraws assets from a business. It also represents a decrease in equity. Owner withdrawal is a debit in the accounts and falls under a contra equity account.