Interest on Capital

What Do You Mean By Interest in Capital?

Interest on capital is required to be explained as the amount which is being received by an owner of the capital, adding to the principal for investing in a particular investment or in an opportunity. The interest on capital is also to be looked at from the angle of compensation to the owner of capital for taking an investment decision.

Interest on Capital is paid for a certain reason that the proprietor who has invested funds in the business, that business is using the funds to sustain. Accordingly, this interest on capital is paid on the balance in the partner's capital account.

Capital Interest For the Firm 

A capital interest is a hypothetical interest that a shareholder receives if the company was to be liquidated and the partnership was dissolved. A capital interest is actually the financial interest for a company. A capital interest holder shares both the profits and losses of the partnership. A capital interest is often determined by:

  • A member's first contribution to the capital of the business.

  • The total amount of all the financial contributions to the business.

The capital interest rate is defined as the AA Bond rate. This is calculated with the amount which is being reported to the financial press during the initial purchase.

Interest on Partner’s Capital 

The Interest on Partner's Capital is an amount that is to be agreed at a rate of interest that is credited to a partner by the amount of capital that is being contributed by him or her. The Interest on the partner's capital is actually an expense for the firm and thus it is debited to the profit and loss appropriation A/c.

Interest on Borrowed Capital

Interest on capital that is borrowed is allowed as a deduction, only if the following conditions are satisfied —

The assessee must have borrowed the money.

The money that is borrowed is used for the purpose of business.

The interest is paid or payable on such borrowing.

Interest in respect of the capital that is borrowed for the purpose of business or profession is a type of permissible deduction. Interest on your own capital is not deductible. In other words, interest will be paid to another person. Interest paid by one unit of the assessee to another unit is not thereby deducted.

Capital Gain Deposit Scheme 

The government, in order to encourage reinvestment of the capital gains made on the sale of capital assets by the seller, has provided relief from capital gains tax if such capital gain is re-invested in certain specified assets within a specified time limit.

Interest on Capital Accounting Equation

Interest on capital is another expense for a firm that is debited to the profit and loss appropriation account. Interest is thereby payable to the partners, for this the partner's capital account is credited with the amount of interest. In case of loss, no interest is to be served on capital.

Capitalizing Interest 

Capitalized interest is the cost of borrowing which is required to acquire or construct a long-term asset. While, an interest expense that is incurred for any other purpose, like capitalized interest is not expensed immediately on the income statement of a company's financial statements. While firms capitalize it.

Interest on Capital in Final Accounts

Interest on Capital has two effects on the final accounts which is an expense of the business, which is to be recorded on the debit side of the Profit and Loss Account. This is an income of the owner, that is to be added to the Capital Account of the Balance Sheet.

The owner of the business with regard to capital is an investment on which the business should receive interest. The interest at a normal rate is to be calculated on the owner’s capital and to be charged in the income statement or in the profit and loss statement for the purpose of ascertaining the income which is extra. This is derived from the business over and above at the usual rate of interest on the capital employed. The capital invested in the business is treated as a loan that is being granted to the business.

Accounting Treatment

The amount of interest that is charged on the capital is an indirect expense of the business. While it is the income of the owner. The Interest on Capital has the following two effects on the final accounts:

This is an expense of the business, which will be recorded on the debit side of the Profit and Loss Account.

Also, it is the income of the owner, which will be added to the Capital Account in the Balance Sheet.

FAQs (Frequently Asked Questions)

1. How is the Interest on Capital Calculated in a Business?

Ans. Interest on capital is particularly an expense for the business which is added to the owner's capital, this increases the overall capital of the owner in the business. Two accounts that are involved in the accounting for the interest on capital is the Capital A/c and the Interest on Capital A/c.

Interest on capital = Amount of capital x Rate of interest per annum x Period of interest.

The amount of interest that is charged on capital is an indirect expense of the business. This is the income of the owner. Interest on Capital affects the final accounts, as this is an expense of the business and thus recorded on the debit side.

2. What is Meant By ‘Partnership is Dissolved’?

Ans. The dissolution of a partnership happens when the business relationship between the partners’ changes, the dissolution of a firm means dissolving the firm along with the relation of the partners. Here all the assets and liabilities are settled and appropriately disposed of in such dissolution.

A dissolution generally occurs when one of the partners ceases to be a partner in a firm. Other causes of dissolution are the BANKRUPTCY or death of a partner, then the agreement of all partners is dissolved, this might also happen when an event makes the partnership business illegal.

3. Why is Interest Charged on Capital?

Ans. Interest on Capital is paid for the reason that the proprietor has invested his funds in the business and the business is using the funds to sustain the competition. 

Accordingly, this interest on capital is paid on the balance in the partner's capital account.