An interest on Capital Journal Entry is similar to an entry relating to an interest expenditure incurred by the entity for its loans or borrowings. So, Interest on Capital is also an expense to the business.
Let me explain how this guide flows. First, I will explain the reason for charging interest on capital, followed by the entry, FAQs, and the Summary at the end.
Table of contents
Is the Interest on the Capital GL Account debit or credit to the journal entry?
Interest on Capital, being an expense GL, is a Nominal Account. Per Nominal A/c Golden rules of accounting, “Debit all Expenses and Loss, and Credit all Incomes and Gains”. Therefore, we must debit the Interest on Capital in the journal entry.
What does Capital mean?
Capital is the initial sum that owners bring into the business. Capital is a liability to the company because its general practice is to consider the business separate from its owner.
Partners bring in Capital either through Cash/Bank or in the form of assets.
For example, partners may introduce a personal car or bring cash into the business. These are nothing but capital contributions.
If the Partner brings Capital in the form of assets, then the equivalent value of such assets will be the Capital investment recorded in the books of accounts.
What’s the reason for charging interest on Capital investment?
The owner invests his/her hard-earned money in a business with the expectation of earning some profits or receiving an inflow of cashback. Therefore, partners hope to get some return on the investments.
We arrive at Profits after reducing all the expenses from the income. So, there isn’t a guarantee that there will always be a positive surplus from the business operations.
Therefore, Interest is introduced. It’s a mandatory charge against the current year’s income.
Summary of the reasoning:
Profits are the residual amounts remaining after deducting expenses. However, interest is charged against income. Therefore, interest expense is always a priority payment to the owner compared to profits.
Interest on Capital Journal Entry
The two GL accounts are the Interest on Capital Account and the Capital Account. Interest is an expense account, and capital is a liability account for the business.
Let’s record the journal entry based on the modern rules of accounting.
Per the Modern rules of accounting,
Liability Rules:
- Debit the Liability to decrease
- Credit the Liability to increase
Expenses Rules:
- Debit the Expenses to Increase
- Credit the expenses to decrease
Note: All business owner transactions need to involve the capital account.
Journal Entry:
Now that we understand the framework for recording the journal entry, let’s move into the main section.
1) Interest on Capital Journal Entry.
2) Entry to pay the interest amount to the owner
FAQs relating to Interest on Capital Journal Entry:
How is the interest percentage calculated?
The Interest Percentage is determined based on the terms decided upon by the partners, which are mentioned in the partnership deed.
Why is Capital credited in a journal entry?
The capital account represents the amount owed to the owner by the business. This is in line with the Business entity concept. So, we must consider the owner and the business as two different persons.
The general practice is to hit the capital account for any transaction relating to the owners. The transaction can be either an expense or an income to the entity. Capital accounts act as the residual GL to record the transaction.
If we consider the accounting rules,
Increase the Capital account to record the amount payable to the Owner (Interest on Capital). Therefore, it results in crediting the Capital account as a liability.
Let’s consider a different scenario of interest on drawings. This Interest is an income to the entity and an expense to the owner. So, the journal entry in the books of the entity is
Debit the Capital Account to reduce the Liability because of interest receivable by the entity from its owner. Interest on drawings being income GL will be on the credit side of the journal entry.
Where would you record Interest on Capital Journal Entries when Capital is fixed?
Record the Interest on Capital in the Partner’s Current account when the capital accounts are fixed. The current account here means the GL account to record transactions other than relating to the Capital in and out transactions.
Therefore, the current account will record all routine transactions, such as Interest on Capital, Interest on drawings, and remuneration payments to the partners.
What is the journal entry for the drawing?
Interest on drawings, which are income, will be credited with a corresponding debit to the capital account. Refer to the article Interest on Drawings JE.
Conclusion:
Interest on Capital is an expenditure for the business. That’s a receipt to the owner for using the Capital brought in for business operations. Debit the Interest on Capital GL and Credit the Capital GL to record the journal entry for this transaction. The Partnership deed provides the details of the percentage of Interest.
