How Does the Owner Withdrawing Cash From the Business Affect the Accounting Equation?
The accounting equation is a formula for calculating the value of business assets relative to the amounts that its owners have earned, spent and invested in business equity. When a business owner withdraws cash from a company account, the value of company assets decreases because some capital reserves have been transferred from business to personal use. Although an owner draw affects the value of a company's assets, it is essentially unrelated to the part of the equation that calculates how much the business has earned through its sales and operations.
The assets portion of the accounting equation represents the total amount that your business owns. Business assets include money in the bank, equipment, inventory, accounts receivable and other sums that are owed to your company. When a business owner withdraws cash from his business, the portion of the company's assets made up of cash on hand decreases. This withdrawal adds an extra step to the accounting equation, which involves subtracting the amount of the owner's draw from the accumulated assets to calculate an adjusted amount.
The liabilities section of the accounting equation represents the amount your business owes in either loan principals or outstanding balances on invoices for inventory or services rendered. When an owner withdraws cash from a company, this transaction has no effect of the liabilities section of the accounting equation. The cash withdrawal comes out of the company's assets, which are calculated using the sum of its liabilities as one of the earlier variables in the equation.
The owner's capital is the part of the accounting equation that represents the liquid cash that the company has earned, which it has on hand for daily operations as well as capital investments. When a business owner withdraws cash for personal use, these funds come out this capital account. The larger the sum the owner withdraws, the smaller the sum that remains in the business as operating capital.
In a sense, the actual change in a sole proprietorship's accounting equation that occurs when the owner withdraws cash from the business is merely semantic. When a sole proprietor sells her company, she sells the systems and physical assets, such as the equipment and inventory. She does not sell the bank balance that the business has accumulated, whether that money is in a bank account under her name or under the name of her business. That money belongs to her, regardless of the bank account where it is held, and regardless of whether it appears on her own or on the company's balance sheet.