Every company is formed after the proprietor or the owner of the company has infused capital into the company and since the company has taken capital from the owner it pays the interest on capital following the business entity concept of accountancy. In the books of accounts also there will be adjustment entry for interest on capital, let’s look at the journal entry for interest on capital –
Interest on capital account Dr
To Capital account
In the above entry since interest on capital is an expense as far as the company is concerned and that is the reason why it is debited and capital account of the owner is credited so as to reflect an increase in capital of the owner. After this entry, another journal entry is passed while preparing final accounts and that is
Profit and loss account Dr
To Interest on capital
By passing the above entry the company has transferred the interest on capital to the profit and loss account which results in a decrease in the profits of the company and another effect of this adjustment will be on the balance sheet as in the balance sheet the capital account of the owner will increase due to addition of interest on capital amount.
The reason behind giving interest on capital to the owner is that if the owner has not invested the money in the business than he or she could have put that money at some other place and taking into account the opportunity cost of capital and business entity concept this adjustment of interest on capital is done in the books of accounts of the company.