Problem 7 - Accounting

Question

Ben Bowman and Savannah Mapes formed a limited liability company with an operating agreement that provided a salary allowance of \(\$ 75,000\) and \(\$ 60,000\) to each member, respectively. In addition, the operating agreement specified an income-sharing ratio of 3:2. The two members withdrew amounts equal to their salary allowances. a. Determine the division of \(\$ 188,000\) net income for the year. b. Provide journal entries to close the (1) income summary and (2) drawing accounts for the two members.

Step-by-Step Solution

Answer

Ben: \( \$106,800 \); Savannah: \( \$81,200 \). Total net income is closed proportionately via journal entries.

Step 1: Calculate Salary Allowances

First, we identify the salary allowances for both Ben Bowman and Savannah Mapes as specified in their operating agreement. Ben's salary allowance is \( \\(75,000 \), and Savannah's is \( \\)60,000 \). Therefore, no further adjustments are needed for their salaries as they have withdrawn exactly these amounts.

Step 2: Calculate Remaining Net Income

Subtract the total salary allowances from the net income to find the remaining income to be shared. The total salary allowance is \( \\(75,000 + \\)60,000 = \\(135,000 \). Subtracting this from the net income: \( \\)188,000 - \\(135,000 = \\)53,000 \). This \( \$53,000 \) will be divided according to the agreed income-sharing ratio of 3:2.

Step 3: Divide Remaining Net Income According to Ratio

The remaining income \( \\(53,000 \) is divided between Ben and Savannah. According to the 3:2 ratio, Ben receives \( \left( \frac{3}{5} \right) \times \\)53,000 = \\(31,800 \) and Savannah receives \( \left( \frac{2}{5} \right) \times \\)53,000 = \$21,200 \).

Step 4: Total Income for Each Member

Add each member's share of the remaining income to their respective salary allowances. Ben’s total share is \( \\(75,000 + \\)31,800 = \\(106,800 \), and Savannah’s total share is \( \\)60,000 + \\(21,200 = \\)81,200 \).

Step 5: Journal Entry for Closing Income Summary

To close the income summary: Dr. Income Summary \( \\(188,000 \) Cr. Ben Bowman's Capital \( \\)106,800 \) Cr. Savannah Mapes' Capital \( \$81,200 \) This entry closes the income summary to each member's capital account.

Step 6: Journal Entries for Closing Drawing Accounts

Since both members withdrew amounts equal to their salary allowances, their drawing accounts will be closed with these amounts: 1. Close Ben's Drawing: Dr. Ben Bowman's Capital \( \\(75,000 \) Cr. Ben Bowman's Drawing \( \\)75,000 \)2. Close Savannah's Drawing: Dr. Savannah Mapes' Capital \( \\(60,000 \) Cr. Savannah Mapes' Drawing \( \\)60,000 \)

Key Concepts

Income Allocation

In a Limited Liability Company (LLC), income allocation refers to distributing the business income among the members. This is often done according to specific terms in the operating agreement.

For Ben Bowman and Savannah Mapes' LLC, the income allocation begins with salary allowances. These allowances, clearly defined in their operating agreement, provide Ben with a salary of \(75,000\) and Savannah with \(60,000\). These amounts have already been withdrawn by them.

After accounting for the salary allowances, any remaining net income is shared according to the agreed ratio, which in this case is 3:2. It ensures that the income distribution remains fair and aligns with their initial agreements.

Operating Agreement

An operating agreement is a crucial document for any LLC. It sets out the financial, organizational, and operational guidelines for the company. Think of it as the rulebook or constitution of the LLC.

For Ben and Savannah, their operating agreement specifies both salary allowances and the income-sharing ratio. These aspects dictate how income is allocated and ensure transparency in financial decisions. Such agreements can prevent conflicts by providing a clear understanding of each member's entitlement and responsibilities.

Without an operating agreement, disputes can arise, especially concerning income distribution and management roles. Therefore, having a well-crafted operating agreement is essential for smooth business operations.

Journal Entries

Journal entries are the backbone of accounting records. They systematically record all financial transactions of a business, ensuring accuracy and accountability. When closing the books for an LLC, several journal entries are necessary.

In our exercise, two key types of journal entries are made: closing the income summary and drawing accounts. Closing the income summary involves transferring the net income to each member's capital account. This balances the company's books at the end of the fiscal year.

For Ben and Savannah, this entry was:

• Dr. Income Summary \(188,000\)
• Cr. Ben Bowman's Capital \(106,800\)
• Cr. Savannah Mapes' Capital \(81,200\)

This entry effectively moves the net income into their respective capital accounts, reflecting their earnings from the year.

Net Income Distribution

Net income distribution is the process of dividing the business's profits among its members after meeting specific conditions. For the LLC of Ben and Savannah, the net income was \(188,000\).

The first step in distributing this income was subtracting the combined salary allowances, which totaled \(135,000\). This left \(53,000\) to be distributed according to their income-sharing ratio of 3:2.

Calculation of this distribution involved simple arithmetic based on their agreed ratio, giving Ben a larger share due to his higher allocation ratio. Ben received \(31,800\), and Savannah received \(21,200\).

This meticulous step ensures each member receives their fair share, maintaining equity and respect for the operating agreement.