The Owner's Draw That Wasn't a Draw
Mira runs a small ceramics business as a sole trader. She keeps a separate business bank account but frequently pays personal expenses from it because it is convenient, intending to 'fix it up later'. In the March quarter she paid her home electricity bill of $340 from the business account, withdrew $900 cash for a family holiday, and paid $1,200 to a supplier for clay that she also used for personal hobby pieces (roughly one-quarter of that clay was for personal use). Her bookkeeper recorded all three payments as business expenses. The business bank balance is now lower than the profit figure shown in the draft income statement, and Mira is confused why she cannot 'see the profit in the bank'.
1. Classify each of the three payments for accounting purposes and explain the effect of the bookkeeper's treatment on the reported profit and on equity.
Read the worked answer
The $340 electricity and the $900 cash withdrawal are personal outlays with no business substance, so they are drawings (reductions in equity), not expenses. Recording them as expenses understates profit and understates drawings; equity is reduced either way, but the two components are misstated, which distorts any assessment of business performance. The $1,200 clay payment is a mixed transaction: $900 (three-quarters) is a legitimate cost of goods or supplies, and $300 is personal consumption, so $300 must be reclassified as drawings. Net effect of the corrections: profit increases by $340 + $900 + $300 = $1,540, and drawings increase by the same $1,540. The owner's equity total is unchanged, which is exactly why the bank balance never matched profit - profit is a measure of performance, not of cash, and drawings plus asset purchases explain the gap.
2. Explain to Mira why the bank balance differs from profit even after the corrections, using the figures given.
Read the worked answer
Profit and the bank balance measure different things. Profit records revenue earned and expenses incurred regardless of cash timing, while the bank balance records only cash movements. Here, the corrected profit is higher than the reported figure by $1,540, but the bank balance is unaffected by the reclassification because the cash had already left the account. The gap Mira sees is explained by drawings ($340 + $900 + $300 = $1,540 of personal use) plus any timing differences such as amounts owed by customers or owing to suppliers. A useful reconciliation statement - opening bank balance, plus cash received from customers, less cash paid to suppliers and for expenses, less drawings - shows the closing bank balance, while the income statement shows profit. Mira should be advised to keep personal and business transactions strictly separate, since commingling creates an audit trail problem and makes both profit and drawings unreliable.