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5/24/2018 Acctg Prob

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Accounting at MacCloud Winery

Mike MacCloud had worked in the operations side of a winery for several years.Having built a strong knowledge of the art of making wine, he had decided to create hisown wine label (i.e., brand). For his label, he planned to grow all of his own grapes. He

had identified an ideal plot of five acres of land in northern California that had mostrecently been used to grow soybeans. His initial plans were to lease a nearby building touse as a winery (i.e., a place for processing grapes and fermenting and aging his wine).However, Mike hoped someday to build his own winery and thus would only plant onfour acres of land. Mike agreed to lease the building for 10 years at $5,000 per year. Itwas estimated that the building was worth $32,000 and had a 30-year economic life. Thelease contract Mike signed did not mention any bargain purchase option or that Mikemight assume ownership of the leased building. The interest rate Mike received on hispersonal bank account was 5%. When Mike started the business, he opened a checkingand savings account for MacCloud Wines Inc. that paid 6% annual interest. The annualinterest rate the bank charged was 10%.

Mike purchased the five acres of land for $250,000. To finance the transaction,Mike borrowed $180,000 from the bank to be repaid $10,000 annually and a lump sum atthe end of three years. In addition, Mike bought from Australia special grapevines at acost of $10,000 per acre. The transportation costs totaled $2,500. Once Mike had thegrapevines, he hired extra help to plant the vines at a cost of $2,000 per acre.

While vines might produce a limited amount of grapes during the first fivegrowing seasons, the young vine grapes could not be used for wine (or any other

commercial purpose). Although Mike would not use these grapes, he would need tospend $1,000 per acre per each of the five years to fertilize and water the vines. If this

were not done, the vines would not produce high-quality grapes in the future.

Beginning in the sixth growing season the vines would bear a full crop of high-quality grapes. Some vines continued to produce at this level until their 100thgrowingseason. However, generally production began to decline after the 75th growing season.Once production declined, the land would be replanted with a new set of vines.Interestingly, many experts believed that grapes from old growth vines (for the type ofvines Mike was planting, a vine was old growth after it had been planted 50 or more

growing seasons) made a higher-quality wine. Once the vines began to produce high-quality grapes, Mike would need to spend $1,500 per acre per year for fertilizing andwater. If he did not provide these nutrients, the grapes produced that year would not be of

high enough quality to produce wine. However, this would not affect the ability of thevines to produce high- quality grapes in the future.

Beginning with the first harvest, Mike planned to mature his wine in expensiveoak barrels imported from France, which he believed were required for the production ofabove-average quality wine. Each barrel would be used for a period of up to five years tomature the better-quality wine. Thereafter, the barrel would be used on a one-year-cyclebasis to mature the vineyards lower-quality wines. At the end of 15 years, the barrel


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would be sold as raw material to a manufacturer of charcoal chips for outdoor grills.Cheaper locally procured barrels with an average expected useful life of 10 years wouldbe used to mature lower-quality wines. At the end of their useful life these barrels wouldalso be sold to a charcoal-chip manufacturer.

Questions with Answers:1. Should the leased building be accounted for as an asset? Should the agreement topay lease rentals be recorded as a liability? Justify your answers. Do not refer toany FASB rules on this issue.

2. Record the journal entries to account for the bank loan for all three years. Assumethe loan was made at the beginning of year one and repaid at the end of year three.Assume all interest payments are made on an annual basis. The $10,000 per yearpayment is to reduce the loans principal.

3. Applying the principles of accrual accounting, how should Mike treat theexpenditures for the land, vines, vine planting, fertilizing, and water? Be specificregarding the treatment over time, including amounts, and the rationale for thetreatments.

4. Without changing your answers to the above questions, consider the followingfacts:

Mikes greatest concern is that his vines will contract Phylloxera disease,

Black Goo syndrome, or Pierces disease. While these conditions do not kill thevines immediately, they reduce production of quality grapes by approximately50%. Further, the vines generally die approximately 10 years after contracting thecondition. While Mike will probably be able to avoid Phylloxera by planting

genetically treated vines, incidents of Black Goo and Pierce disease have beenincreasing over the last several years and are most dangerous to vines that are lessthan three years old.

How should the potential for vine disease be reflected in the financialstatements if the vines have not been diagnosed with any of the diseases? Doesthis change if the vines are diagnosed with one of the diseases? Be specificregarding any amounts and the rationale for these treatments.

5. How should Mike account for the oak barrels?6. How would the transactions in Question 3 and the bank loan be recorded in the

winerys indirect statement of cash flows?

Financial Performance Reporting

The Financial Accounting Standards Boards (FASB) Financial PerformanceReporting by Business Enterprises project may change the form and content,


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classifications and aggregations, and display of specified items and summarized amountson the face of all basic financial statements. An important result of this project may bethat net income would be eliminated as an income statement item. It would be replacedby comprehensive income. Currently, comprehensive income plays little, if any, role inequity valuations.

The projects goal is to

Improve the quality of information displayed in financial statements so thatstatement users can better evaluate an enterprises performance.

Ensure that sufficient information is contained in financial statements to permitcalculation of key financial measures used by investors and creditors.In the interest of global convergence of accounting principles, the FASB isworking closely on this project with the International Accounting StandardsBoard (IASB), which has a similar project underway with the United KingdomsAccounting Standards Board. The FASB and IASB have tentatively decided on asimilar objective for the new statementto enhance the predictive feedback value

of the information that is presented in a statement of comprehensive income.

Comprehensive Income

The FASBs Concept Statement No. 6 defines comprehensive income. It states:Comprehensive income is the change in equity of a business enterprise during a period

from transactions and other events and circumstances from nonowner sources. It includesall changes in equity during a period except those resulting from investments by ownersand distributions to owners.

The FASB in SFAS 130, Comprehensive Income, required companies to

display in their financial statements total comprehensive income and its components ineither an income statement-type format (Table A) or in a changes-in-equity format(Table B). Most companies have elected to use the changes in equity format.


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SFAS 130s operational definition of comprehensive income is net income plus

other comprehensive income. Other comprehensive income consists of those accountingitems that are direct debits or credits to owners equity that do not involve transactionswith owners, such as foreign currency translation gains and losses and unrealized gains orlosses on marketable securities classified as available-for-sale.

IASB


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The IASB is ahead of the FASB in its financial performance reporting project. Toguide its deliberations, the IASB has tentatively agreed on the following five principles:

Principle 1 A performance statement should be able to distinguish the return ontotal capital employed from the return on equity.

Principle 2 Components of gains and losses should be reported gross unless theygive little information with respect to future income.

Principle 3 Income and expenses resulting from the remeasurement of an asset orliability should be reported separately. (Remeasurement refers to gains and expensesarising from the revision of estimates embedded in the carrying values of assets andliabilities.)

Principle 4 A performance statement should identify gains and losses where thechange in economic value does not arise in the period in which it is reported.

Principle 5 Within the prescribed format and without the use of proscribedsubtotals, the performance statement should allow reporting in the form of:

i. Information on the entity as a whole, analyzed by nature or function;ii. The activities in (i) disaggregated by business segments (geographic or

product- based);iii. Additional distinctions according to managerial discretion.

The IASBs proposed format for the financial performance statement reportingcomprehensive income is shown in Table C. It is based on Principle 3.

To illustrate further the IASBs approach and Principle 3, the components of financialperformance relating to pension costs would be reported using the Table C format asfollows:

(i) Operating, Column 1service cost(ii) Operating, Column 2actuarial gains and losses relating to changes inassumptions about future cash outflows(iii) Financing, Column 1interest cost, expected return on assets(iv) Financing, Column 2actuarial gains and losses relating to return on assetsand changes in discount rate assumptions


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Other Possible Approaches

The FASB is studying the IASBs tentative comprehensive income statementformat for possible adoption. In addition to the separation by functional classification, theFASB has directed its staff to explore the possibility of further separating the information

in the statement of comprehensive income. Several possible approaches for separationbeing explored are:

a. Separating transactions with third parties from all other transactions andevents.

b. Separating cash measurements, accrual measurements, and fair-valuemeasurements.

c. Separating transactions and events driven by historical cost principles fromtransactions and events driven by fair value or remeasurement principles.

d. Separating income and expenses resulting from the remeasurement of anasset or liability from all other income and expenses (the current IASBapproach).

e. Some other approach.Timetable

The FASBs objective is to issue in 2003 an Exposure Draft relating to thereporting of items of revenue, expense, gains, and losses in a statement of comprehensiveincome.


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Questions with Answers:

1. Where in the IASBs proposed Statement of Financial Performance would youdisplay the following?

o Tangible fixed assetsdepreciation, impairments, gains or losses ondisposal and revaluations (permitted under International Financial

Reporting Standards)o Investment propertiesrent and revaluationso Goodwillimpairmentso Inventorysales and impairmentso Investments in equity securitiestotal value changeo Financial assets and liabilities held for tradingtotal value changeso Foreign exchangegains and losseso Nonequity financial assets and liabilitiesinterest income and expenseso Provisionsinitial recognition, subsequent interest costs, remeasurements

due to changes in the original estimateso Extraordinary itemsinfrequent and unusual items

2. What is your appraisal of the IASBs Statement?3. Does the Statement satisfy the FASB projects goals?4. How might equity investors use this Statement?5. What changes to the Statement would you propose?

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