Accountancy · Ch 3 — Accounts of Partnership Firms – Fundamentals
Interest on Drawings — Methods of Calculation
Interest on Drawings — Methods of Calculation
A partner is entitled to withdraw money from the firm for personal use during the year — these withdrawals are drawings. When a partner draws money out early in the year rather than at the year's end, the firm effectively loses the use of that capital for the remaining part of the year, exactly the way a bank loses interest income on money a borrower repays early. To compensate the firm for this, the partnership deed may provide that interest on drawings be charged to each partner, at an agreed rate, calculated for the period the money was actually out of the firm. Interest on drawings is (unlike interest on capital) a gain to the firm and an expense to the partner personally — it is credited in the Profit and Loss Appropriation Account and debited to the partner's Capital or Current Account.
How interest on drawings is actually worked out depends entirely on the pattern of withdrawal:
1. A single, lump-sum drawing on a known date. This is the simplest case — interest is calculated using the ordinary simple-interest formula for the exact period the amount remained withdrawn until the books close:
Interest on Drawings = Amount Drawn × Rate/100 × (Period Outstanding in Months ÷ 12)
2. Equal amounts drawn regularly (monthly or quarterly) throughout the year. Working out the exact number of days or months for every single instalment separately would be needlessly tedious when the amount and the interval are both constant, so accountants use the Product Method (also called the Average Period Method) instead. Two mathematically equivalent ways of applying it:
- Product Method: multiply each instalment by the number of months it remains outstanding until the year-end, add up all these "products," and apply the rate to the total for one month (i.e. total product × rate/100 × 1/12).
- Average Period (shortcut) Method: because the instalments and interval are both equal, the average period for which the money was outstanding can be worked out just once, and applied to the total amount drawn during the year:
Interest = Total Drawings × Rate/100 × (Average Period in Months ÷ 12).
The average period itself follows a small set of standard, memorable results for a full accounting year, all of which can also be derived from first principles using the product method if a student prefers to check rather than memorise:
| Pattern of equal drawings over a full year | Average period outstanding |
|---|---|
| At the beginning of every month (12 instalments) | 6.5 months |
| At the end of every month (12 instalments) | 5.5 months |
| In the middle of every month (12 instalments) | 6 months |
| At the beginning of every quarter (4 instalments) | 7.5 months |
| At the end of every quarter (4 instalments) | 4.5 months |
Interest charged to a partner, at the rate fixed by the partnership deed, on the amounts he withdraws from the firm during the year for personal use — compensating the firm for the loss of use of that money for the period it remained withdrawn. It is a gain to the firm (credited in the P&L Appropria …
A method of calculating interest on drawings for a series of instalments by multiplying each instalment by the number of months it remains outstanding until the year-end, totalling these products across all instalments, and then applying the rate of interest to that total f …
A faster equivalent of the Product Method, usable only when equal instalments are drawn at equal, regular intervals throughout the year. A single average period of outstanding (e.g. 6.5 months for equal monthly drawings at the start of each month) is applied to the total amount drawn for the whole year, inste …