Under IFRS and IAS 12, withdrawals made by a natural person from a business they operate as a sole proprietorship (which lacks separate legal personality) should not be recorded as expenses in the financial statements. Here’s an analysis of the accounting issue, how tax authorities might view it, and the recommended resolution approach, along with an example.
- Misclassification of Withdrawals as Expenses: Since a sole proprietorship does not have a separate legal entity from the owner, any amount the owner withdraws for personal use represents a drawing, not a business expense. Recording personal withdrawals as expenses would reduce the reported net income of the business, which is inaccurate and does not align with IFRS requirements.
- Impact on Financial Reporting and Taxable Income: Personal withdrawals should be shown as deductions from equity or retained earnings, not as deductions from revenue. Misclassifying these withdrawals as expenses results in an understatement of profit, affecting both financial reporting and tax calculations.
2. Tax Authority Perspective:
- Non-Deductibility of Personal Withdrawals: Tax authorities do not permit personal withdrawals to be treated as deductible expenses for tax purposes, as they do not represent costs incurred in generating business income. If a business reports personal withdrawals as expenses, tax authorities will likely adjust taxable income by adding back the withdrawn amount, potentially resulting in additional taxes, penalties, or interest.
- Focus on Accurate Representation of Business Income: Tax authorities expect businesses to present accurate financial information, particularly when it involves sole proprietorships where personal and business funds may intertwine. Misclassification of personal withdrawals as business expenses may trigger scrutiny and compliance checks.
- Reclassify Withdrawals as Drawings: The business should reclassify any personal withdrawals from the income statement (where they may have been mistakenly recorded as expenses) to the equity section of the balance sheet, as drawings or reductions in owner’s equity.
- Adjust for Tax Purposes: For the tax return, ensure that any amount withdrawn by the owner is not deducted as an expense. Instead, the withdrawal should be added back to the taxable income, preserving the integrity of the reported business expenses.
- Clear Documentation: Document these adjustments thoroughly to ensure clarity in financial statements and tax filings, providing an audit trail that separates personal drawings from legitimate business expenses.
Suppose a sole proprietor withdraws AED 102,000 from the business for personal use and mistakenly records it as an expense.
- Adjustment in Financial Statements: Reverse the AED 102,000 expense entry in the income statement. Record the AED 102,000 as a deduction from equity (drawings) in the balance sheet.
- Tax Adjustment: For tax purposes, add back AED 102,000 to the business’s taxable income, as personal withdrawals are not deductible.
- Result: The adjusted financial statements accurately represent the business income, with no understatement due to personal withdrawals. The tax return reflects the correct taxable income, ensuring compliance and reducing the risk of penalties or adjustments from tax authorities.
By reclassifying personal withdrawals and documenting them separately, the business complies with IFRS, aligns with IAS 12, and presents an accurate depiction of its financial performance, meeting tax authority expectations.