A business owner may regard their capital as an investment on which they 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 a form of income for the owner. Interest on capital has the following two effects on final accounts:
- It is an expense of the business, so it will be recorded on the debit side of the profit and loss account
- It is a form of income for the owner, so it will be added to the capital account in the balance sheet
Interest on capital is an expense to business. To record it, make the following adjusting entry:
Mr. White’s capital balance was $50,000 on 1 January 2016. Interest is allowed on capital at the rate of 10%.
Required: Make adjusting entries for 31 December 2016.
On 31 December 2016, the following adjusting entry will be made to record interest on Mr. White’s capital:
Note: Interest on capital amounts to $50,000 × 0.1 = $5,000.