Question

A and B contribute ₹ 4,00,000 and ₹ 3,00,000, respectively, as their capitals. They decide to allow interest on capital @ 8% p.a. Their respective share of profit is 3 : 2 and the profit for the year is ₹ 42,000 before allowing for interest on capital. Show the distribution of profits:

1. Where there is no agreement except for interest on capital and
2. Where there is a clear agreement that the interest on capital will be allowed even if it involves the firm in loss.

Answer 1

I. The available profit is ₹ 42,000, whereas the interest due on capitals is ₹ 56,000 (32,000 + 24,000). Since the profit is less than the interest, the available profit will be distributed in the ratio of interest, i.e., 32,000 : 24,000 or 4 : 3.

Dr.	Profit and Loss Appropriation Account				Cr.
Particulars	Amount (₹)	Amount (₹)	Particulars	Amount (₹)	Amount (₹)
To Interest on Capital:		42,000	By Profit and Loss A/c (Profit for the year)		42,000
A	24,000
B	18,000
		42,000			42,000

II. Interest on capital will be allowed even if the firm incurs a loss. It means interest on capital is a charge against profit. As such, it would be debited to profit and loss and not to the profit and loss appropriation account.

Dr.	Profit and Loss Account				Cr.
Particulars	Amount (₹)	Amount (₹)	Particulars	Amount (₹)	Amount (₹)
To Interest on Capital		56,000	By Balance b/d (Profit for the year)		42,000
A	32,000		By loss transferred to:		14,000
B	24,000		A’s Capital A/c `(3/5)`	8,400
			B’s Capital A/c `(2/5)`	5,600
		56,000			56,000