Accounting Treatment for Partners’ Interest on Capitals
As it is a business, the partners seek to generate a profit. It is good practice to set out the terms agreed by the partners in a partnership agreement. Interest on capital is allowable only if there are enough profits to cover it up otherwise not as well as it should be cleared to all that partners shall not be entitled any interest on capital unless specifically given or written in the partnership agreement. Paying interest on capital is a means of rewarding partners for investing funds in the partnership as opposed to alternative investments. In a partnership firm, the partners invest the amount as the capital as per partnership deed.
Partnership accounts do not present much difficulty unless there is an admission, retirement, death or dissolution. Interest in capital introduced by the partners is calculated on the basis of time of contribution and it should also be considered the introduction of fresh capital by any partner as well as drawings made by the partners. As such, it reduces the amount of profit available for sharing in the profit and loss sharing ratio.
It is important to note here that, the interest on capital provided to a partner is a compensation given to him for his/her investment in the firm foregoing the alternative risk-free/risky investment available with an even higher return. Interest in the capital is necessary to partners because they always not share the profit on the basis of capital contribution ratio rather sometimes equally even though the capital contribution is unequal. For this purpose, the calculation of interest is of some importance. Interest should always be calculated with reference to time. So, it equalizes the weight to maintain a parity the interest on capital plays a vital role among partners.
The interest on capital is an appropriation of profits, so, it is charged to profit and loss appropriation account and credited to respective partners’ capital account or current account. Profit and Loss Account is prepared in the usual way and the Balance Sheet is also made out in the usual manner.
Interest on capital………………….Dr.
To partners’ capital A/C
Profit and loss appropriation A/C ……………Dr.
To Interest on capital A/C.