Interest on Capital, Journal entry for Interest on capital (All Details)

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

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.