Before we can talk about overdrawn current accounts, first we need to talk about Shareholder current accounts.
If you have ran a company or done accounting in NZ for a while, you will have come across something known as a ‘Shareholder’s current account’. The first time I started working on NZ company accounts, I was perplexed by it.
It’s a current account – is it the same as a current asset?
No, it isn’t.
But it’s a Shareholder’s account – does that mean it is a form of Equity?
Apparently not either!
So what is a Shareholder Current Account (shortened to SCA to save time typing) then?
In short, an SCA is recognised as a liability on the company’s balance sheet as it records the amount of money the company owes to the shareholder(s). An SCA is generally made up of funds introduced by the shareholders and any drawings made by the shareholders. Now, you could argue that the SCA sounds very much like equity, but it is different in one key respect that if the shareholders owe the company money, they need to ‘pay’ an interest to the company on the amount owed (more on this later).
TL;DR? (Too Long; Didn’t Read – millenial shorthand for not reading lengthy walls of text)
Basically an SCA is an account which keeps track of the money put in and taken out of the business by the shareholders.
Let’s take an example:
Gaurav runs a furniture business called Good Chairs Ltd. During the year 2020 he introduces money worth $20,000 to the business. Throughout the year he also takes out drawings of $10,000 from the business. This means that his SCA has a credit balance of $10,000 at the end of the year. A credit balance means that Good Chairs Ltd owes Gaurav $10,000.
Now, while it sounds like Good Chairs Ltd owes Gaurav money. As the owner, Gaurav isn’t going to demand that his company pay him back. Like most business owners, Gaurav would prefer to keep that money in this company for use for business purposes.
So far so good?
Ok, because it starts to get tricky from here.
First of all, let’s talk about shareholder salaries. Shareholder salaries are accounting adjustments made at the end of the financial year. Typically your accountant will do this for you. What they do is really simple: They take whatever profit your company has earned during the year – and then provided it is of a reasonable amount (generally around $70,000 or so) they will expense it off as a ‘Shareholder Salary’ paid out to the shareholders.
Now, it is VERY important to note that as a shareholder, you don’t get any actual physical cash from a shareholder salary. Your accountant is doing this because in most cases, it is cheaper to pay tax as an individual on a scale rate than it is to pay 28% tax at a flat rate as a company, so they take out profit from the company and pay it out to you as a ‘shareholder salary’. The shareholder salary is supposed to ‘represent’ the drawings you have taken out of the company and any other non-monetary benefit you have derived from operating the company.
Another important thing to remember is that shareholder salaries are not taxed on PAYE, because, duh, they get recorded only at the end of the year. If you are already on a PAYE salary with your company, this does not count as a ‘Shareholder salary’ either – it is known as a Shareholder PAYE salary. They sound the same, but are very different from each other. The biggest difference being that you actually EARN cash from the PAYE salary, but get nothing from Shareholder Salary.
Now, a Shareholder Salary gets recorded as a credit entry in your SCA because it is treated like funds introduced because it represents the time and effort you have put in service of your business.
Paying a shareholder salary is also useful from an accounting perspective because that means that us accountants don’t have to worry about…
Overdrawn current accounts!
Which is the main focus of our topic today!
Unfortunately, they are a very real and very tedious part of accounting.
Right, so in most cases, your SCA would have a credit balance. Your company would owe money to you, you’re happy to keep your money in the company, everyone’s happy right? So let’s keep it that way!
But no, some business owners take MORE money out of their company (through drawings) than they put back in! Generally us accountants try to balance out the SCA by paying off shareholder salaries because they tend to bring the SCA back into a credit balance (see Shareholder Salaries above) which makes everything right again!
But sometimes, this isn’t possible. Sometimes the company has made too little profit or is running at a loss. Sometimes the tax situation is such that there might be more overall tax to pay if a shareholder salary is paid out (as can be the case with some super-wealthy individuals). Sometimes the owners have taken TOO MUCH from the company that even paying out Shareholder Salaries won’t fix it! When this happens, the SCA will have a debit balance because it is overdrawn (due to over drawing – obviously). This is what we accountants like to call an ‘overdrawn current account’.
An overdrawn current account means that instead of the company owing you money, YOU owe the company money! This means that the SCA has a debit balance and is recorded as an asset on the company’s balance sheet. And when that happens, you have to pay ‘Shareholder’s Interest’ to the company.
Now don’t worry just yet. Much like the ‘Shareholder Salary’ you don’t actually pay anything for ‘Shareholder Interest’. However, your accountant will need to calculate an interest on the balance that you owe your company and record this as income to your company – income which will get taxed.
There’s a whole lot of math and spreadsheets that go into this process – so I won’t bore you with the details.
All you need to know is that if you owe the company money, your accountant will record interest income for the company which you have ‘paid’ (but not really) to the company in exchange for the money you have borrowed from the company.
Phewh!
Now why is it important to understand the SCA?
Mainly because if you choose to wind up the business – whatever value left in the SCA will be paid out to you, as a shareholder, provided that it is a credit balance.
HOWEVER
If there is a debit balance left in the SCA, then YOU OWE the company money! If the company winds up, you will have to pay the liquidators the amount you owe the company in the SCA.
Can you imagine having to fork out more money just to wind up your company because you owe yourself money? Bizarre, but true.
TL; still DR?
To keep it simple:
It is always easier to keep the SCA in a credit balance. It makes your life easier and it makes your accountant’s life easier. Everyone is happy. Sometimes your accountant will record a shareholder’s salary for you (which gets recognised as your personal income for income tax purposes) and you pay taxes on that – easy.
Don’t take too much money out of your company – that will send your SCA into a debit balance and make everyone unhappy. Like seriously, your company is not your personal ATM. Need a reminder on how to be responsible about taking drawings? – Read up on it over here.
Remember: A credit balance SCA is a happy SCA!!