Interest on Capital

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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

Interest On Capital A/C

Debit

To Partner’s Capital A/C

Credit


For closing Interest on Capital Account

Profit And Loss Appropriation A/C

Debit

    To Interest On Capital A/C

Credit


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:

  1. The deduction of interest on capital that is borrowed cannot be ignored only because the borrowed capital obtains nontaxable income.

  2. The assured interest paid to shareholders of the company on paid-up capital is not deductible.

  3. Interest that is paid to wife and daughters on money given to them on the partition, is deductible.

  4. 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.

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FAQs (Frequently Asked Questions)

1. What is the effect of interest on capital in a financial statement?

The Interest in the capital has two effects on a financial statement. It is a business expense, so it will be recorded on the debit side of the profit and loss account. It is the form of income for the business owner, so it will be added to the capital account in the balance sheet.

2. How interest on capital will be calculated if there is any capital added or withdrawn during that period?

Interest on capital is calculated at the beginning of the period. If there is any additional capital included or withdrawn during the particular period, it will cause a change in the capital amount and interest is to be calculated proportionately on the change in capital for the relevant period.

3. How to calculate the opening capital amount in case of fluctuating capital?

If the opening capital is not given in the questions, then it will be calculated as  Opening Capital: 


Closing Capital - Profit Earned - Interest on Capital - Salary + Interest on Drawings + Drawings

4. Why is Interest Charged on Capital?

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.

5. What is meant by ‘Partnership is Dissolved’?

The dissolution of a partnership happens when the business relationship between the partner's 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.

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

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 * Rate of interest per annum * 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.

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