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Interest on Capital

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Interest allowed on the proprietor’s, partners capital is some times treated as a business expense.If the amount of capital were invested outside the business it would have earned a normal rate of interest.Therefore allowance is sometimes made for this interest  before the actual net profit of the business is ascertained.

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.

Comments (3)

  • if interest on capital is not a balance sheet item then what is the need to add to capital. if you add it to capital then the nature is credit.

    Reply
    • Normally Interest on capital is calculated at the end of the financial year and make a provision to make it payable to the contributor.Since the capital is the owners money, it is added to his money and business owes that money to him. He can withdraw that money in the next financial year. I am talking about usual procedure if you have provision to issue interest on capital monthly you can do it making a payment entry and no need mix up with balance sheet.

      Reply
  • interest on capital is Expenses, then why added in capital? interest on capital have two entry 1. Expenses Side 2. other one in reduce from capital this is correct entry.

    Reply

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