Interest on Capital Journal Entry is similar to entry relating to an interest expenditure incurred for the entity’s loans/borrowings. So, this Interest on Capital is also an expense to the business.
Let me explain how this guide flows. The reason for charging interest on capital will be explained first, followed by the entry, FAQs, and the Summary at the end.
Table of contents
- Is the Interest on Capital GL Account debit or credit to journal entry?
- What does Capital mean?
- What’s the reason for charging interest on Capital investment?
- Interest on Capital Journal Entry
- FAQs relating to Interest on Capital Journal Entry:
- Recommended Articles:
Is the Interest on Capital GL Account debit or credit to 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 need to debit the Interest on Capital in the journal entry.
What does Capital mean?
Capital is the initial sum which owners bring into the business. Capital is a liability to the company. That’s 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 Introduce Personal Car or bring Cash into the business. These are nothing but capital contribution.
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 an expectation of earning some profits/inflow of cashback. Therefore, partners hope to get some return in the form of interest on the investments.
We arrive at Profits after reducing all the expenses from the income. So, there isn’t a guarantee that there will be always a positive surplus from the business operations.
Therefore, the concept of Interest comes to picture. It’s a mandatory charge against the current year income.
Summary for the reasoning:
Profits are the residual amounts remaining after deducting the expenses. But Interest is a charge against the income. Therefore, the interest expense is always a priority payment to the owner compared to profits.
Interest on Capital Journal Entry
The Two GL accounts involved here are Interest on Capital Account and Capital Accounts. Interest is an Expenses account, and Capital is a Liability Account to the business.
Lets record the journal entry based on the modern rules of accounting.
Per the Modern rules of accounting,
- Debit the Liability to decrease
- Credit the Liability to increase
- Debit the Expenses to Increase
- Credit the expenses to decrease
Note: All the owner transactions of the business need to involve the Capital account.
Now, we understood the framework of recording the journal entry. Let’s move into the main section of recording the journal entry.
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?
Interest Percentage is determined based on the terms decided upon by the partners, and these terms will be 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 need to consider the owner and 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 expense or income to the entity. Capital accounts act as the residual GL to record the transaction.
If we consider the accounting rules,
To record the amount payable to the Owner (Interest on Capital), increase the Capital account . Therefore, it results in crediting the Capital account as its 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 Entry when Capital is fixed?
Record the Interest on Capital in the Partners Current account when the capital accounts are fixed. The current account here means the GL account to record the transactions other than relating to the Capital in and out transactions.
Therefore, Current account will have the record of all the routine transactions such as Interest on Capital, Interest on drawings and remuneration payments to the partners.
What is the journal entry of drawing?
Interest on drawings being income will be credited with corresponding debit to the capital account. Refer to the article Interest on Drawings JE.
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 percentage of Interest.