Interest on Partners’ Capital - Class 12 Partnership Accounts Fundamental

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 Interest on Partners’ Capital

  • Interest on capital is allowed to compensate a partner for contributing capital to the firm in excess of the profit sharing ratio.
  • No interest is allowed on partners’ capitals if partnership deed is silent.
  • When the Deed specifically provides for it, interest on capital is credited to the partners at the agreed rate.
  • Interest on capital is accounted as an appropriation of profit and it is allowed only when there is profit.
  • Interest is paid with reference to the time period for which the capital remained in business during a financial year.

Why Partners ask for interest on capital?

Interest on capital is generally provided for because of two situations:

  1. When the partners contribute unequal amounts of capitals but share profits equally, and
  2. Where the capital contribution is same but profit sharing is unequal.

How interest on capital is calculated?

  1. On the opening balance of the capital, interest is calculated for the whole year;
  2. On the additional capital brought in by any partner during the year, interest is calculated from the date of introduction of additional capital to the last day of the financial year.
  3. On the amount of capital withdrawn (drawings against capital) Interest is allowed on the Opening Capital up to the date of withdrawal and on the Balance Capital (Opening Capital – Capital Withdrawn) from the date capital is withdrawn.
  4. Drawings against Capital means capital withdrawn by the partner from the firm.

Accounting Treatment:

Interest on capital when Profit available for Appropriation is inadequate
  • Interest on capital is allowed to the extent of available profit only, since interest on capital is an appropriation of profit.
  • In such a case total amount of appropriation (salary, commission etc.)  for each partner is determined and profit is distributed in the ratio of appropriation.
  • In case, interest on capital is a charge on profit, it will be allowed irrespective of profit.

Illustration 1

Rajesh and Ramesh are partners with profit sharing ratio of 3:2. Their capital are Rs. 5,00,000 and Rs. 3,00,000 respectively. Interest to be allowed @ 10 p.a. Profit before allowing interest is Rs. 40,000. Prepare Profit and Loss Appropriation Account to distribute Profit.

Answer

The interest on Rajesh’s Capital and Manish’s capital is respectively 50,000 & 30,000, total interest on capital is 80,000.Profit before interest is Rs. 40,000.

Ratio of their appropriation is 5:3, so interest on capital will be allowed as follows
Rajesh’s Interest = 40,000 x 5/8 = 25,000
Manish’s Interest = 40,000 x 3/8 = 15,000

Illustration 2

Rajesh and Ramesh are partners with profit sharing ratio of 3:2. Their capital are Rs. 5, 00,000 and Rs. 3,00,000 respectively. Interest to be allowed @ 10 p.a. Profit before allowing interest is Rs. 1,40, 000. Prepare Profit and Loss Appropriation Account to distribute Profit.

Click for Calculation for Opening Capital

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