Sometimes the owner of the business regards his capital as an investment on which he should receive interest. Interest at a normal rate is calculated on owner’s capital and is charged to the income statement (or profit and loss account) for the purpose of ascertaining what extra income is derived from the business over and above the usual rate of interest on capital employed. The capital invested in the business is treated as a loan granted to the business.
The amount of interest charged on capital is an indirect expense of the business and on the other hand, it is an income of the owner. Interest on Capital has the following two effects on final accounts:
- It is an expense of the business, therefore; it will be recorded on the debit side of Profit and Loss Account.
- On the other hand, it is an income of the owner, therefore; it will be added in the Capital Account in Balance Sheet.
The interest on capital is an expense to business and the following adjusting entry would be made to record it:
Mr. White had a capital balance of $50,000 on January 1, 2016. Interest is allowed on capital at the rate of 10%. Make adjusting entries on December 31, 2016.
At December 31, 2016, the following adjusting entry will be made to record interest on White’s capital:
Interest on capital: $50,000 × 0.1 = $5,000