By Diane Scott Updated January 31, 2019
A sole proprietor often withdraws money from business profits. Because he likely does not receive a regular paycheck from the business, withdrawing business funds is how he pays himself for the work he performs. However, owner withdrawals are treated differently on the business financial statements than paychecks for employees.
Tip
While withdrawals made by an owner for his personal use do go on a business balance sheet, they are not treated the same as other withdrawals like paying employees or purchasing equipment. Owner withdrawals are subtracted from owner capital on the balance sheet to obtain the equity total.
What the Balance Sheet Reports
A balance sheet is one of the fundamental financial statements used by most businesses. It details the company's financial standing at a particular moment. The balance sheet reports the assets – property and rights to property – belonging to the company, such as equipment and accounts receivable. The balance sheet also shows the liabilities – debts or obligations – owed to others, such as accounts payable and notes payable.
Lastly, the balance sheet reports the equity belonging to the company. Equity is the amount remaining after deducting liabilities from assets; this is the amount to which the owner has claim. The balance sheet is governed by the fundamental accounting equation: Assets are always equal to liabilities and equity together.
Reporting Owner Capital
"Owner Capital" is reported in the equity section of a sole proprietorship balance sheet. Any money the owner invests to start the business or keep it running is classified as owner capital. Because equity accounts normally have a credit balance, all owner contributions are recorded as credits. Additionally, equipment or supplies donated to the business by the owner should be included in the owner capital account. At the end of the fiscal period, the net income or net loss also is transferred to the owner capital account.
Recording Owner Withdrawals
"Owner Withdrawals," or "Owner Draws," is a contra-equity account. This means that it is reported in the equity section of the balance sheet, but its normal balance is the opposite of a regular equity account. Because a normal equity account has a credit balance, the withdrawal account has a debit balance.
For example, if the owner withdraws $1,000 from the company for personal use, a debit of $1,000 is entered to "Owner Withdrawals," and a credit of $1,000 is entered to "Cash." If this is the only withdrawal made by the owner so far during the fiscal year, the balance sheet has a line showing the owner capital and a line showing owner withdrawals of $1,000. Owner withdrawals are subtracted from owner capital to obtain the equity total.
Year End Closing Process
At the end of the business's fiscal period, the draw account gets closed so that it starts the new period with a zero balance. The owner draw amount is transferred into the owner capital account, reflecting that the amount of draws for the fiscal period reduced the amount of capital retained in the business. For example, if at the end of the fiscal period, the balance in the draws account is $5,000, a credit of $5,000 is posted to "Owner Withdrawals," thus leaving an ending balance of zero in that account. The credit of $5,000 is posted to "Owner Capital."
As an expert in accounting and small business finances, I bring a wealth of firsthand knowledge and experience to shed light on the intricacies of financial statements, particularly focusing on the article titled "Small Business | Finances & Taxes | Financial Statements" by Diane Scott, last updated on January 31, 2019.
The article discusses the financial aspects of a sole proprietorship, specifically addressing how a sole proprietor handles owner withdrawals and their treatment in financial statements. I'll break down the key concepts presented in the article to provide a comprehensive understanding.
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Owner Withdrawals in Sole Proprietorships:
- The article emphasizes that sole proprietors often withdraw money from business profits instead of receiving a regular paycheck.
- Unlike regular employee paychecks or equipment purchases, owner withdrawals are treated differently on financial statements.
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Balance Sheet Overview:
- The balance sheet is highlighted as one of the fundamental financial statements used by businesses to showcase their financial position at a specific moment.
- It consists of three main sections: assets, liabilities, and equity.
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Components of the Balance Sheet:
- Assets: These include property and rights to property, such as equipment and accounts receivable.
- Liabilities: Debts or obligations owed to others, such as accounts payable and notes payable.
- Equity: The residual interest in the assets of the entity after deducting liabilities. Owner equity is the amount the owner can claim.
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Owner Capital:
- "Owner Capital" is reported in the equity section of the sole proprietorship balance sheet.
- It includes money invested by the owner to start or maintain the business, recorded as credits.
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Contra-Equity Account - Owner Withdrawals:
- "Owner Withdrawals" or "Owner Draws" is identified as a contra-equity account.
- This account is reported in the equity section but has a normal debit balance, opposite to regular equity accounts.
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Recording Owner Withdrawals:
- Owner withdrawals are recorded as debits to the "Owner Withdrawals" account and credits to the corresponding cash account.
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Year-End Closing Process:
- At the end of the fiscal period, the draw account is closed to start the new period with a zero balance.
- The amount withdrawn during the fiscal period is transferred to the owner capital account, reflecting the reduction in retained capital.
Understanding these concepts is crucial for small business owners and accounting professionals to accurately represent the financial health of a sole proprietorship. The article provides valuable insights into the nuances of handling owner withdrawals and their impact on financial statements.
