Interest on Capital – Interest is generally allowed on capitals of the partner Interest on capital of partners is calculated for the relevant period for which the amount of capital has been used in the business. Normally, it is charged for full year on the balance of capital at the beginning of the year unless some fresh capital is introduced during the year. On the additional capital introduced, interest for the relevant period of utilisation is calculated
A partner is not entitled to interest on his capital as a matter of right. But if there is an agreement, that partner would receive interest on his capital it is paid at the agreed rate only out of profits. Interest on capital is generally calculated on the opening balance and allowance is made for any additions of capital or withdrawals there from during the accounting period.
- The amount of interest is debited to interest on capital accounts and credited to the capital accounts, if capitals are fluctuating and current accounts, if capitals are fixed. Interest on capital account is then closed by transfer to profit and loss appropriation account.
- Alternatively, credit the capital (or current) account of the partner concerned and debit the profit and loss appropriation account.
Interest on Capital
In More Simple Worlds -The interest will be payable only out of profits. As a general rule, interest on capital subscribed by partners is not allowed unless there is an agreement or usage to that effect. The principle underlying this provision of law is that regards the capital brought by a partner in the business, he is not a creditor of the firm but an adventure.
In case of fixed capital accounts, interest is calculated on the balance of capital accounts only and no interest is payable / chargeable on the balance of current accounts.
Subject to contract between the partners, interest-on capitals is to be provided out of profits only. Thus in case of loss, no interest is provided. But in case of insufficient profits( i.e., net profit less than the amount of interest-on capital), the amount of profit is distributed in the ratio of capital as partners get profit by way of interest-on capital only
For example, before charging interest on-capital a business earned for one year a net profit of 4000 and the capital at the beginning of the year was 10000. If the trader had invested this amount in government securities he would have earned (say) 8% interest per year. That is 800. As such the real business profit that is, the profit after charging normal interest on capital would be 3200.
Journal entry for Interest on capital
To allow interest on capital
interest on Capital – Debit 800
Capital Account – Credit 800
Closing Entry to transfer Interest on-capital to P& L Account.
The interest on capital will be shown on the debit or expense side of the profit and loss account.
Profit & Loss A/c—- Debit 800
To Interest on capital —Credit 800
Interest on capital on balance sheet.
Interest on-capital is not a balance sheet item, but the interest is added to the capital of the partners or proprietor. Hence the total of capital increased with the amount of interest. as per our example capital would become 10800. and shown on the liability side of balance sheet.