Interest on Capital in Partnership

What is Interest on Capital

Meaning - Interest on Capital is an appropriation of profits in case of partnership. It is a way to compensate more the partners who have contributed more capital compared to other partners. Since it is an appropriation so it is neither a profit nor loss for the firm.

The key principle of calculating any kind of interest is that it is always paid for the period for which the money is used.

Charge vs Appropriation - Interest on Capital is an appropriation of profits and is taken to profit and Loss Appropriation A/c. However if the question says that it is charge then we have to treat it as a charge against profits.

Whether to pay Interest on Capital -

flowchart TD style A fill:#f9f,stroke:#333,stroke-width:2px; style B fill:#f9f,stroke:#333,stroke-width:2px; style H fill:#ff0000,stroke:#333,stroke-width:2px; style G fill:#00ff00,stroke:#333,stroke-width:2px; style I fill:#00ff00,stroke:#333,stroke-width:2px; A(Treated as Appropriation) B(Treated as Charge) C(Firm Earned Profits) D(Firm Incurred Loss) E(Firm Earned Profits) F(Firm Incurred Loss) G(Interest Paid) H(Interest not Paid) I(Interest Paid) A-->C A-->D B-->E B-->F C-->G D-->H E-->I F-->I

Interest Rate - The interest rate is as agreed in the partnership deed. In the absence of partnership deed or no agreement as to interest on capital no interest is paid on interest on capital.

When Interest on Capital Paid - Interest on capital is usually paid at the end of the accounting year at the time of preparation of profit and loss appropriation A/c for distribution of profits

Calculation of Interest on Capital

Normal Case

It is calculated using interest rate on the opening capital. Suppose A and B are partners. They have opening capital as on 01-Apr-20XX of Rs 2L and 3L respectively. Rate of Interest on Capital agreed is 6% per annum.

A's Interest on Capital = (200000*6/100) . Note - Interest is paid from beginning of the year till end of the year for 12 months normally

B's Interest on Capital = (300000*6/100) . Note - Interest is paid from beginning of the year till end of the year for 12 months normally

What is Opening Capital - It means the capital of the partner at the beginning of the accounting year (ex. 01-Apr-20XX). In contrast closing capital means the capital of the partner at the end of the accounting year (ex. 31-Mar-20XX)

Additional Capital introduced during the year

Interest on Capital is calculated for the proportionate period in such cases

Suppose in the above example during the year on 01-Jul-20XX, A introduced additional capital of Rs 50K and b introduced additional Capital of Rs 1L on 01-Dec-20XX.

A's Interest on Capital = (200000*6/100*3/12) + (250000*6/100*9/12). Note that A's Capital remained Rs 2L for 3 months (April, May and June) and Rs 2.5L for 9 months (July 20XX to March 20XX)

B's Interest on Capital = (300000*6/100*3/12) + (400000*6/100*4/12). Note that B's Capital remained Rs 3L for 8 months (April to Nov) and Rs 4L for 4 months (Dec 20XX to March 20XX)

Capital Withdrawn during the year

Interest on Capital is calculated for the proportionate period in such cases also

Suppose in the above example A also withdrew Rs 1L on 01-Feb-20XX. His interest on capital will be (200000*6/100*3/12) + (250000*6/100*7/12) + (150000*6/100*2/12). Note capital changed again on 01-Feb-20XX

When closing capital of partners is given in question

In such cases first we have to find the opening capital of the partners by making adjustments for transactions entered during the year in partner capital account.

The transactions entered in partner capital A/c will be different depending upon whether firm follows fixed capital method or fluctuating capital method

flowchart TD style A fill:#f9f,stroke:#333,stroke-width:2px; style D fill:#90EE90,stroke:#333,stroke-width:2px; A(Interest on Capital) B(Opening Capital is Given) C(Closing Capital is Given) D(Calculate Interest) E(Find Opening Capital) subgraph F[Find Opening Capital] G(Start with <br>Closing Capital) H(Add items on Dr <br>side of capital A/c) I(Subtract items on Cr<br> side of capital A/c) J(Items Different for fixed <br> and fluctuating method) end A-->B A-->C B-->D C-->E E-->D E--->F F-->G G-->H G-->I H-->J I-->J

Whether interest paid on balance in Current A/c

If the firm is maintaining fixed capital method then firm will maintain both capital A/c and current A/c for each partner. In such cases interest is paid only on the balances in capital A/c. No Interest is paid on balances in current A/c

Journal Entries

  • Profit and Loss Appropriation A/c Dr..
    • To Interest on Capital A/c
  • Interest on Capital A/c Dr..
    • To Partners Capital A/c

We can combine the above two entries and pass a single entry as below

  • Profit and Loss Appropriation A/c Dr..
    • To Partners Capital A/c

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