How does interest on drawings work?

You’ve probably heard of interest on your bank account, but what about interest on drawings? So, what is interest on drawings? Read on to understand more about this very common, very important term that sole proprietors and partners in a limited partnership must be aware of. 

Drawings are funds taken from the firm for personal use by partners. Such withdrawals are treated as loans from the business to the owner; therefore, they will be subject to interest, just like any other loan. So the answer to the “what is interest on drawings?” question is as follows: 

Interest on drawings is the interest that is charged on drawings taken from the business by an owner for their personal use. 

Interest on withdrawals is not usually paid in cash right away. The capital account must be involved, and the settlement takes place once a year. For capital account transactions, this is the standard procedure.

Another option is to include the interest receivable in your journal. Interest on drawings is a source of revenue for the company; thus, it will be recorded on the credit side of the ledger. The Capital account will be debited as a result of the debit.

Why is interest payable on drawings?

The capital account is considered a liability for the business. The partner is owed money for interest on drawings. As a result, the capital liability and the interest receivable asset will be offset. As a result, the journal item should debit the capital account. 

The partnership firm earns money via interest on withdrawals. As a result, the profits and gains must be credited according to the golden standards of accounting. 

To put it another way, modern accounting standards allow an income account to be expanded by crediting it. If the payment is made immediately, the equivalent debit will be the Capital account, which will be reduced to the extent of the interest payable by the partner or the Bank account.

The interest paid on the business’s capital drawings is offset by the interest charged on the drawings. Lenders such as banks and financial institutions may need to be contacted to obtain the amount of funds removed from the firm. Interest is accrued on such borrowings. 

How does Interest on Drawings work?

Let’s take a look at how to account for interest on drawings. According to the accounting principles, the business owner and his business are separate entities. The partnership or sole proprietorship agreement will contain specific terms that mention the rate of interest chargeable on drawings. It may also include provisions as to the maximum amount that can be withdrawn by one or more partners for personal use. 

For example, if a partner withdraws $10,000 from his business for personal purposes, then it is considered a $10,000 loan given to them by the business. The interest will be charged on their drawings from the date on which the amount was drawn and until the date on which the amount is repaid.  

Hopefully, this post has provided some clarity on the entire concept of what interest on drawings is.