ZeePedia

INTEREST ON CAPITAL AND DRAWINGS

<< Financial Statements of Partnership firms
DISADVANTAGES OF A PARTNERSHIP FIRM >>
img
Financial Accounting (Mgt-101)
VU
Lesson-35
INTEREST ON CAPITAL AND DRAWINGS
The partnership agreement may include one or both of the following clauses:
o
o  Partners are charged interest on drawings (this may be on the total amount of the current
account balance or on the amount exceeding a specific limit, depending upon the terms of
agreement).
o  Partners are given interest on their capital (again this can be on the total amount of the
capital or the amount exceeding a specific figure).
REASONS FOR INTEREST ON CAPITAL
The profit/loss sharing ratio may not be equal despite the fact that partners have contributed equal
o
capital, depending upon the partnership agreement.
Take the following example:
o
o  Two partners start a business and contribute equal capital and decide to share equal profits.
o  But they also realize that in future the business may need further capital and at that time
both partners may not be able to contribute equally.
o  So, instead of revising the contract every time, they include a clause in the agreement,
whereby, the partners are allowed an interest on the capital contributed.
o  This interest can be on the whole amount of both partners or only of one partner on the
amount contributed in excess of the other partner.
o  This way a partner, who provides capital in excess of his profit sharing ratio, can be
compensated.
o  One may say that the same results can be achieved by saying that profit and loss sharing will
be proportionate to the amount of capital invested.
o  But, as we have said that in partnership everything depends on the Partnership Agreement.
REASONS FOR INTEREST ON DRAWINGS
Drawings are opposite to capital invested i.e. these are the funds drawn by partners from the
o
business.
Therefore, in order to keep the distribution of profit fair, a clause may be inserted in the agreement,
o
where an interest is charged on the drawings of the partners.
Again, this can be on the total amount or on an amount exceeding a specific limit.
o
Both of the above things depend upon the agreement between partners.
o
ACCOUNTING TREATMENT
One may think that as Interest on Capital is paid to the partners, so it should be treated as business
o
expense and Interest on Drawings is charged from the partners, therefore, it should be treated as
income.
But this is not the case.
o
Just like partners salaries, both these items will be included in the Profit and Loss Appropriation
o
Account.
Partners' salaries, interests etc. are never treated as expense or income of the business. They are a
o
part of DISTRIBUTION OF PROFIT.
EXCEPTIONS
235
img
Financial Accounting (Mgt-101)
VU
Rent paid to partner for use of his premises, purchase of stocks, assets or other items for use in
o
business, Markup on loan from partner are the exceptions. All these expenses are charged to
profit & loss account of the partnership firm.
ACCOUNTING ENTRIES
Interest on Capital
o
Debit:
Profit and Loss Appropriation Account
Credit:
Partner A's Current Account
Credit:
Partner B's Current Account
Credit:
Partner C's Current Account
Interest on Drawings
o
Debit:
Partner A's Current Account
Debit:
Partner B's Current Account
Debit:
Partner C's Current Account
Credit:
Profit and Loss Appropriation Account
Example # 1
Mr. Abid is a partner in a partnership firm. His capital on July 1, 2001 was Rs. 200,000. He invested further
capital of Rs. 100,000 on March 1, 2002.
You are required to calculate his mark up. Mark up rate is 5%. The financial year is from July to June.
SOLUTION
Rs. 200,000 was invested in the beginning of the year and extra capital was invested on 1st March. So, from
March onward, the capital is Rs. 300,000 (200,000 + 100,000). We will calculate mark up on Rs. 200,000 for
12 months, i.e., from July to June. Mark up on 100,000 will be for 4 months, i.e., from March to June.
Mark up is calculated as follows:
200,000 x 5% = 10,000
=
10,000.00
100,000 x 5% = 15,000 x 4/12 =
1666.67
Total Mark Up
11,666.67
236
img
Financial Accounting (Mgt-101)
VU
Example # 2
Mr. Naeem is a partner in a partnership firm. He drew following amount during the financial year:
Rs.
September 1
3,000
November 1
5,000
January 1
4,000
March 1
5,000
June 1
2,000
You are required to calculate Mark up on his drawings, if the rate of mark up is 5%. The financial year is
from July to June,
SOLUTION
3,000 x 5% = 150 x 10/12 = 125.00
5,000 x 5% = 250 x 8/12 = 166.67
4,000 x 5% = 200 x 6/12 = 100.00
5,000 x 5% = 250 x 4/12 = 83.33
2,000 x 5% = 100 x 1/12 =  8.33
Total Mark Up
483.33
EXAMPLE # 3
Atif, Babar and Dawar are three partners sharing profits equally.
You are required to prepare profit and loss appropriation account and extract from balance sheet, showing
partners capital and current accounts from the following information:
�
Net profit for the year Rs. 558,000
�
Opening balance of Capital accounts Atif Rs. 500,000, Babar Rs. 600,000, Dawar Rs. 400,000
�
Opening balance of Current Account Atif Rs. 55,800, Babar Rs. 63,820, Dawar Rs. 20,555.
�
Salaries to be paid to Babar Rs. 10,000, Dawar Rs. 12,000.
�
Drawings during the year Atif Rs. 180,000, Babar Rs. 220,000 Dawar Rs. 151,000
�
Mark up on Capital @ 5% and Mark up on drawings are: Atif Rs. 9,000, Babar Rs. 11,000 and
Dawar Rs. 7,550.
237
img
Financial Accounting (Mgt-101)
VU
SOLUTION
PROFIT & LOSS APPROPRIATION ACCOUNT
Atif, Babar, Dawar & Co
Profit Distribution Account
Particulars
Note
Amount Rs. Amount Rs.
Net Profit
558,000
Less: Partner's Salary ­ Babar
10,000
Dawar
12,000
(22,000)
Less: Interest on capital ­ Atif (5% of 500,000)
25,000
Babar (5% of 600,000)
30,000
Dawar(5% of 400,000)
20,000
(75,000)
Add: Interest on Drawings ­ Atif
9,000
Babar
11,000
Dawar
7,550
27,550
Distributable Profit
488,550
Less: Partner's Share in Profit
Atif (1/3of 488,550)
162,850
162,850
Amir (1/3 of 488,550)
Babar (1/3 of 488,550)
162,850
(488,550)
0
Atif's Current Account
Account Code --------
Particulars
Amount
Particulars
Amount
Dr. (Rs.)
Cr. (Rs.)
Drawings
180,000 Opening Balance
55,800
Interest on Drawings
9,000 Interest on Capital
25,000
Profit for the year
162,850
Balance c/d
54,650
Total
243,650 Total
243,650
Babar's Current Account
Account Code --------
Particulars
Amount
Particulars
Amount
Dr. (Rs.)
Cr. (Rs.)
Drawings
220,000 Opening Balance
63,820
Interest on Drawings
11,000 Salary
10,000
Interest on Capital
30,000
Profit for the year
162,850
Balance c/d
35,670
Total
266,670 Total
266,670
238
img
Financial Accounting (Mgt-101)
VU
Dawar's Current Account
Account Code --------
Particulars
Amount
Particulars
Amount
Dr. (Rs.)
Cr. (Rs.)
Drawings
151,000 Opening Balance
20,555
Interest on Drawings
7,550 Salary
12,000
Interest on Capital
20,000
Profit for the year
162,850
Balance c/d
56,855
Total
215,405 Total
215,405
ADMISSION OF A PARTNER
When a new partner join the business, old agreement of partnership is modified or a new agreement is
prepared. This new agreement contains new ratios in which partners share profit and loss in new set up. At
the admission of a new partner, all the assets and liabilities of the old business are revalued in order to know
the exact worth of the business. Goodwill of the business is also revalued. The value (in monetary terms) of
the reputation of the business is called GOODWILL. It is an intangible asset.
DISSOLUTION OF A FIRM
When a partnership is dissolved, all the liabilities of the firm are paid, out of the assets of the firm, available
at the time of dissolution. The remaining amount after paying all the liabilities, if available, will be distributed
among the partners in their profit loss sharing ratios. If assets of the firm are not sufficient to pay all the
liabilities of the firm, the partners will contribute the balance amount in their profit/loss sharing ratios to
meet the liabilities of the firm.
239
Table of Contents:
  1. Introduction to Financial Accounting
  2. Basic Concepts of Business: capital, profit, budget
  3. Cash Accounting and Accrual Accounting
  4. Business entity, Single and double entry book-keeping, Debit and Credit
  5. Rules of Debit and Credit for Assets, Liabilities, Income and Expenses
  6. flow of transactions, books of accounts, General Ledger balance
  7. Cash book and bank book, Accounting Period, Trial Balance and its limitations
  8. Profit & Loss account from trial balance, Receipt & Payment, Income & Expenditure and Profit & Loss account
  9. Assets and Liabilities, Balance Sheet from trial balance
  10. Sample Transactions of a Company
  11. Sample Accounts of a Company
  12. THE ACCOUNTING EQUATION
  13. types of vouchers, Carrying forward the balance of an account
  14. ILLUSTRATIONS: Ccarrying Forward of Balances
  15. Opening Stock, Closing Stock
  16. COST OF GOODS SOLD STATEMENT
  17. DEPRECIATION
  18. GROUPINGS OF FIXED ASSETS
  19. CAPITAL WORK IN PROGRESS 1
  20. CAPITAL WORK IN PROGRESS 2
  21. REVALUATION OF FIXED ASSETS
  22. Banking transactions, Bank reconciliation statements
  23. RECAP
  24. Accounting Examples with Solutions
  25. RECORDING OF PROVISION FOR BAD DEBTS
  26. SUBSIDIARY BOOKS
  27. A PERSON IS BOTH DEBTOR AND CREDITOR
  28. RECTIFICATION OF ERROR
  29. STANDARD FORMAT OF PROFIT & LOSS ACCOUNT
  30. STANDARD FORMAT OF BALANCE SHEET
  31. DIFFERENT BUSINESS ENTITIES: Commercial, Non-commercial organizations
  32. SOLE PROPRIETORSHIP
  33. Financial Statements Of Manufacturing Concern
  34. Financial Statements of Partnership firms
  35. INTEREST ON CAPITAL AND DRAWINGS
  36. DISADVANTAGES OF A PARTNERSHIP FIRM
  37. SHARE CAPITAL
  38. STATEMENT OF CHANGES IN EQUITY
  39. Financial Statements of Limited Companies
  40. Financial Statements of Limited Companies
  41. CASH FLOW STATEMENT 1
  42. CASH FLOW STATEMENT 2
  43. FINANCIAL STATEMENTS OF LISTED, QUOTED COMPANIES
  44. FINANCIAL STATEMENTS OF LISTED COMPANIES
  45. FINANCIAL STATEMENTS OF LISTED COMPANIES