A business is regarded as an economic unit distinct from the owner/owners and the amount invested by the owner/owners is regarded as liability of the business (business has borrowed this money from the owner). The money borrowed by a business from its owner / owners is known as capital: When a business borrows money from a bank or from a private individual, it pays interest on the borrowed money and this interest is considered as an expense of the business and is charged to profit and loss A/c. In the same way, the profit of the business is only justified, if interest on capital (interest on money borrowed from the owner) is also regarded as an expense of the business and is charged to profit and loss A/c along with other expenses. Moreover, interest on capital is regarded as an expense of the business because if the owner would invest, elsewhere an amount equal to the amount of capital invested in the business, he would have obviously earned some income i.e. investment in the Government securities or certificates etc. This is known as normal income or normal profit. The interest on capital (at normal rate) is charged to Profit and Loss A/c in order to see whether the business is earning extra profit over and above the normal profit. The owner will have to earn extra profit over and above the normal profit in order to cover un-certainties and risks involved in business. The more the risk, the more should be the amount of extra profit. This extra profit is, regarded as true profit of the business. Similarly, owner’s salary is also regarded as an expense of the business and is charged to Profit and Loss A/c.
INTEREST ON DRAWINGS:
The interest on drawings is exactly opposite of interest on capital when interest is allowed on capital and is regarded as an expense of the business, then it is very much logical that business should also charge the owner with interest on his drawings. This interest on drawings is revenue to the business and is credited to profit and loss A/c.
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