How to show interest on capital in profit and loss account?

Interest on capital is the interest provided on the capital invested in the business. It is calculated as a percentage on the capital invested. Interest on capital is provided if there is any rule established by the owner of the capital. Otherwise, it is not provided.

We generally encounter ‘Interest on capital’ in partnership accounting but a sole proprietorship can also provide interest on capital.

Interest on capital is charged or appropriated from the profits of the firm. Hence, it appears on the debit side of the profit and loss account.

The journal entry is as follows:

The partners, in case the firm makes profit, are provided interest on their capital balance apart from their share of profit if provision of interest on capital is mentioned in the partnership deed.

Hence, interest on capital is an appropriation of profit in partnership accounting. The journal in case of partnership account is as follows:

The Interest on capital is credited to the capital/ partners’ capital account thereby increasing the capital balance.  The journal is as follows:

In the balance sheet it is shown as an addition to the capital account.

Numerical example

P, Q and R are partners. Their firm reported a net profit of ₹ 20,000. Their capitals are ₹30,000, ₹45,000 and ₹60,000. It is in their partnership deed to provide the partners 4% interest on capital and a salary of ₹5,000 per annum for Q. Calculate the interest on capital.

Solution:

Interest on capital to be provided to the partners:

P – ₹30,000 x 6% = ₹1,800

Q – ₹45,000 x 6% = ₹2,700

R – ₹60,000 x 6% = ₹3,600

This interest will be credited to the partners’ capital. The journals are as follows: