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Before learning about Interest on Drawings Journal Entry, let’s learn about what is Interest on Drawings and whats is purpose of Interest on Drawings.
What is Interest on drawings ?
Interest on drawings refers to the concept of charging interest on the amount withdrawn by a business owner or partner from the business for personal use.
It is a way to compensate the business for the opportunity cost and financial impact of the funds being utilized by the owner instead of being retained in the business.
When a business owner or partner withdraws funds from the business for personal use, it is considered a withdrawal or drawing.
Interest on drawings is calculated based on the amount withdrawn and the agreed-upon interest rate.
The interest charged is typically a percentage of the drawing amount and is often calculated on an annual basis.
What is purpose of Interest on drawings ?
The purpose of charging interest on drawings is to align the financial arrangements between the business and the owner/partner. It helps ensure that the owner recognizes the cost of utilizing business funds for personal purposes and prevents the business from suffering any financial loss due to the withdrawal.
Interest on Drawings Journal Entry
When charging interest on drawings, the journal entry is typically made at the end of the accounting period to record the interest expense and its impact on the owner’s equity. Here’s an example of the Interest on Drawings Journal Entry:
| Date | Particular | Debit | Credit |
|---|---|---|---|
| 31/03/20XX | Interest on Drawings [Expense account] | XXXX | |
| To Owner’s Drawings [Owner’s Equity account] | XXXX |
Example of Interest on Drawings
Let’s say a business owner withdraws $10,000 from the business for personal use during the accounting period. The agreed-upon interest rate on drawings is 5% per annum. The business charges interest on the drawings at the end of the accounting period.
To calculate the interest on drawings, we multiply the drawing amount by the interest rate:
Interest on Drawings = Drawing Amount * Interest Rate
Interest on Drawings = $10,000 * 5% = $500
The journal entry to record the interest on drawings would be:
| Date | Particular | Debit | Credit |
|---|---|---|---|
| 31/03/20XX | Interest on Drawings [Expense account] | $500 | |
| To Owner’s Drawings [Owner’s Equity account] | $500 |
In this entry, the Interest on Drawings expense account is debited to recognize the expense incurred by the business. The Owner’s Drawings account, which reduces the owner’s equity, is credited to reflect the impact of the drawings and interest on the owner’s capital.
Charging interest on drawings helps maintain the financial integrity of the business and ensures that the owner recognizes the cost of utilizing business funds for personal purposes. It is an accounting practice used to fairly compensate the business for the opportunity cost of the withdrawn funds.
Thank you reading till last. Keep Learning.
| Date | Particular | Debit | Credit |
|---|---|---|---|
| 31/03/20XX | Interest on Drawings [Expense account] | XXXX | |
| To Owner’s Drawings [Owner’s Equity account] | XXXX |
Income Statement: Drawings do not directly affect the income statement since they are not considered business expenses. Therefore, they are not included in the calculation of revenues or expenses.
Owner’s Equity: Drawings reduce the owner’s equity or capital in the business. The amount withdrawn is deducted from the owner’s capital account to reflect the reduction in the owner’s investment in the business. This reduction in equity is shown in the balance sheet.Balance Sheet: Drawings are reported as a deduction from the owner’s capital in the balance sheet. The balance sheet shows the owner’s equity, which is calculated by subtracting the total drawings from the initial owner’s capital. It provides a snapshot of the owner’s investment in the business after considering any withdrawals made.
