Interest on capital

Interest on capital is actually a compensation to partners due to some inherent extra contribution by one over the other partner so that all their returns from firm business remain fair in comparison to each other.

Why do the question of interest arises

Following two situations may force partners to consider Interest on capitals in the business: –

  • when the partners contribute unequal amounts of capitals but share profits equally,
  • where the capital contribution is same but profit sharing is unequal.

 

When is interest allowed on Capital

Interest on capital is allowed 

  • If it is expressly agreed among the partners.
  • When the Deed specifically provides for it, interest on capital is credited to the partners
  • The rate is the agreed rate with reference to the time period for which the capital remained in business during a financial year.
  • Due allowance is given for addition or withdrawals of capital during the accounting period

 

 Which Capital Amount to consider while computing interest

When there are both addition and withdrawal of capital by the partners during a financial year, the interest on capital is calculated as follows:

(i) On the opening balance of the capital accounts of partners, interest is calculated for the whole year;

(ii) 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.

(iii) In case of withdrawal of capital, interest on capital will be calculated as:

On opening capital from the beginning of the year till date of capital withdrawn and then on the reduced capital for the remaining time period.

 

Alternatively, it can be calculated with respect of amount remained in business for the relevant period.

 

 

 

Example: –

 A, B, C are partners with 1:1:1 ratio

Accounting Year Jan – Dec

Rate of interest is    5% P.A

Capitals: –

Partner01 Jan CapAddition on01 AugWithdrawal on 01 Aug
A25,000NilNil
B35,00015,000Nil
C70,000Nil2,000

 

 

First Approach: – Balance change Approach

A – 25000 x 5/100 = 1,250

B – 35000 x (5/100) x (7/12) = 1020.83

(35000+15000) x (5/100) x (5/12) = 1041.67

Interest = 1020.83 +1041.67= 2,062.5

C – 70000x (5/100) x (7/12) = 2041.67

(70000-2000) x (5/100) x (5/12) = 1416.67

Interest = 2041.67 +1416.67 = 3,458.34

 

Alternative Approach: – Amount remains in business approach

A – 25000 x 5/100 = 1,250              (Jan to Dec )

B- 35000 x (5/100) = 1,750             (Jan to Dec)

15000 x (5/100) x(5/12) =312.50   (Aug to Dec)

1750+312.50= 2062.50

C – (70000-2000) x (5/100)  = 3400 (Jan to Dec)

2000 x(5/100) (7/12)     =    58.33 ( Jan to July )

3400+58.33 = 3458.33