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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.