An Introduction to Interest on Capital
Interest on capital is the fixed return amount that the business owner is eligible to receive from their investment. It is the interest on share capital paid to the investor for the amount they agree to start their business. The partner is eligible to receive the interest for the amount exceeding the total amount employed by them. It generally occurs in partnership business. However, the company does not pay interest on capital in cash but increases the partner’s capital. Interest on capital is deducted from the profit and loss statement of the business and is recorded as an expense on the debit side and added to the partner’s capital account.
What is Interest on Capital?
Interest on capital is the interest allowed on capital allocated by the partners. Generally, if the partner’s capital is unequal to the profit-sharing ratio, then the partners may agree to allow interest on capital. It will compensate the partners who have invested a high amount towards the capital. The rate of interest on capital is generally agreed upon by the partners of the business firm and is always mentioned in the partnership deed. It is permitted only when the business earns a profit and it is provided before the division of profits among the partners. No interest is permitted on the capitals of partners if it is not specifically mentioned in the partnership deed.
When the business firm faces loss, the interest on capital will not be provided. If there is insufficient profit, that is, the net profit is less than the amount of interest on capital, interest on capital will not be given, but the profit among the partners of the business firm will be distributed in their capital ratio.
What is the Journal Entry for Interest on Capital?
For Providing Interest On Capital
For closing Interest on Capital Account
Interest on Capital Example
Rahul is the business owner of the firm ABC solution. He has contributed ₹ 20,00,000 to the business with 10% interest provided to Rahul at the end of the year.
Solution:
Here, interest on capital is calculated as
Interest on capital Formula: Amount Invested * Rate of Interest * 12
Therefore, IOC = 20,0000 * 10100 * 12
= 20,000
The journal entry for the same will be:
Interest on Capital A/C 10,000
To Rahul’s Capital A/C 10,000
What Does Capital Interest Mean?
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 a 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 one percent over the AA Bond rate. This is calculated with the amount which is being reported to the financial press during the initial purchase.
What is Interest in Borrowed Capital?
Interest on capital that is borrowed is deductible, only if the conditions given below are satisfied —
The assessee must have borrowed the money.
The borrowed money is used for business purposes.
The interest is paid or payable on the amount that is borrowed.
Interest in respect of the capital that is borrowed for business or profession is a type of permissible deduction. Interest in your capital is not deductible. In other words, it means that interest will be paid to another person. Interest paid by one unit of the assessee to another unit is not allowed to be deducted.
The following propositions should also be considered:
The deduction of interest on capital that is borrowed cannot be ignored only because the borrowed capital obtains nontaxable income.
The assured interest paid to shareholders of the company on paid-up capital is not deductible.
Interest that is paid to wife and daughters on money given to them on the partition, is deductible.
As per the provision of section 40 (b) i.e.@ 12% per annum simple interest, Interest paid by a firm to partners is deductible. However, the interest that is authorized to be paid by an association of persons to its members is not deductible.
Interest on Borrowed Capital for Acquiring Capital Interest
Interest liability refers to the period initiating from the date on which capital is borrowed by an existing concern for the purchase of an asset till the date. When such an asset is first put to use, it should be capitalized and it cannot be declared as deduction according to section 36. Only interest on capital that is borrowed to purchase a capital asset for business use concerning the period after the asset is put to use, is withdrawn every year according to section 36.
What is Capitalized Interest?
Capitalized interest is the financing cost used to finance the construction of a long-term asset that an entity builds for itself. The capitalization of interest is needed under the accrual basis of accounting and increases the total amount of fixed assets that are shown on the balance sheet. An example of such a situation is when an enterprise constructs its corporate headquarters, by using a construction loan to do so.
Accounting Equation on Capitalized Interest
The capitalized interest is included in the cost of the long-term asset so that the interest is not identified as an interest expense in the current period. Rather, it is represented as a fixed asset and is included in the depreciation cost of the long-term asset. Hence, it first appears in the balance sheet and is charged to expense over the useful life of the asset. Therefore, the expenditure appears as depreciation expense on the income statement, rather than interest expense.
FAQs on Interest on Capital: Meaning and Calculation
1. Is interest on capital 12%?
Interest on capital does not have a fixed rate like 12% universally; the rate is usually decided by business agreement or organizational policy. In partnerships, for example, the interest rate can range between 6% and 12%, but it depends on what is mutually agreed in the partnership deed. Interest on capital is the compensation paid to partners for investing their funds in the business, and its rate is not set by law but by internal arrangements. To summarize, 12% is just an example and not a standard or mandatory rate for interest on capital; always check the specific agreement for the applicable rate.
2. What is journal entry for interest on capital?
To record interest on capital in the accounting books, a journal entry is made that reflects the interest provided to the owner or partner. The typical entry involves debiting the Interest on Capital Account and crediting the Capital Account of the respective owner or partner. This entry shows the business expense and increases the capital balance. The standard journal entry format is: Debit – Interest on Capital Account, Credit – Partner's Capital Account. This ensures the interest expense is recognized, and the partner's contribution is increased by the same amount in the accounts.
3. Is interest on capital a debit or credit?
Interest on capital is treated as both a debit and a credit in accounting, depending on the perspective. In the books of the business, it is recorded as an expense (debit) because it is a payment made to the owner or partner for using their capital. At the same time, it is credited to the respective partner’s capital account, increasing their total investment or claim on the business. To clarify, interest on capital is debited to the Interest on Capital Account and credited to the Capital Account. This dual effect properly reflects both the cost to the business and the benefit to the partner.
4. How is interest on capital treated in balance sheet?
Interest on capital is not shown separately in the balance sheet but affects the capital account balances of the owners or partners. When interest on capital is allowed, it is added to the respective partner’s capital. This means the closing balance in each partner’s capital account will include both their initial investment and any interest credited during the year. On the liabilities side of the balance sheet, the increased capital amount appears under the heading “Capital.” Thus, interest on capital is included as part of the total capital shown in the balance sheet at year-end.
5. Why is interest on capital allowed in partnerships?
Interest on capital is allowed in partnerships to fairly compensate partners for their investment in the business. Since partners may contribute different amounts of capital, offering interest on capital ensures those who invest more receive a fair return, even if the profit-sharing ratio differs. This method helps avoid disputes and encourages higher investments. By allowing interest on capital, partnerships can balance the returns for both contribution and effort, making the financial arrangement more equitable for all partners.
6. How is interest on capital calculated?
Interest on capital is calculated based on the amount of capital invested and the agreed interest rate, usually for the period it remains invested. The general formula is: Interest on Capital = Capital Amount × Interest Rate × Time (for a year, Time = 1). If capital is introduced or withdrawn during the year, only the appropriate time period is considered. This calculation helps ensure that each partner or owner receives interest proportional to their investment and the length of time their capital was used in the business.
7. Is interest on capital an expense or appropriation?
Interest on capital is considered an appropriation of profit, not a business expense. In partnership firms, it is paid only when there is profit and after allocating net profit among partners. Unlike wages or rent, which are business expenses, interest on capital is a way to divide profits fairly among partners based on their investments. As a result, it appears in the Profit and Loss Appropriation Account, not the main Profit and Loss Account, separating it from actual operational expenses.
8. What is the impact of interest on capital on partners' profit sharing?
Interest on capital affects profit sharing by reducing the amount of profit available for distribution to partners. First, interest is credited to partners who have invested capital, which is deducted from the net profit before the remaining profit is shared according to the agreed ratio. This ensures fair compensation for capital contribution and may result in partners with higher capital receiving more total benefit. Overall, crediting interest on capital helps create a more balanced profit distribution system in partnerships.
