Interest on capital

Interest on capital is interest payable to the owner/partners for providing a firm with the required capital to commence the business. It’s a fixed return that a business owner is eligible to receive.

When the business firm faces a loss, the interest on capital will not be provided. It is permitted only when the business earns a profit. Such payment of interest is generally observed in partnership firms. It is provided before the division of profits among the partners in a partnership firm.

If an owner or partner introduces additional capital to the business, it is also taken into account for providing interest on capital.

Sample journal entry

Interest on capital is an expense for business, thus, debited as per the golden rules of accounting, debit the increase in expense, and the owner/partner’s capital a/c is credited as per the rule, credit all incomes and gain.

As per the modern rules of accounting, we debit the increase in expenditure and credit the increase in capital.

As we know, as per the business entity concept, business and owner are two different entities and a business is a separate living entity. Therefore, the capital introduced by the owner/partners is the amount on which they’re eligible to receive a return.

Example:

Tom is the business owner of the firm XYZ Ltd. He has contributed ₹ 10,00,000 to the business with 10% interest provided to Tom at the end of the year.

Solution:

Here interest on capital will be calculated as,

Interest on capital = Amount invested × Rate of interest × Number of Months/12

= 10,00,000 × 10% × 12/12

= ₹ 1,00,000