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 his
own 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 most
recently been used to grow soybeans. His initial plans were to lease a nearby building to
use 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 on
four acres of land. Mike agreed to lease the building for 10 years at $5,000 per year. It
was estimated that the building was worth $32,000 and had a 30-year economic life. The
lease contract Mike signed did not mention any bargain purchase option or that Mike
might assume ownership of the leased building. The interest rate Mike received on his
personal bank account was 5%. When Mike started the business, he opened a checking
and savings account for MacCloud Wines Inc. that paid 6% annual interest. The annual
interest 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 at
the end of three years. In addition, Mike bought from Australia special grapevines at a
cost of $10,000 per acre. The transportation costs totaled $2,500. Once Mike had the
grapevines, 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 five
growing 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 to
spend $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 100
th
growing
season. However, generally production began to decline after the 75
th
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 of
vines 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 and
water. 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 the
vines to produce high- quality grapes in the future.

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

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 would
be used to mature lower-quality wines. At the end of their useful life these barrels would
also be sold to a charcoal-chip manufacturer.

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

2. Record the journal entries to account for the bank loan for all three years. Assume
the 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 year
payment is to reduce the loans principal.

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

4. Without changing your answers to the above questions, consider the following
facts:
Mikes greatest concern is that his vines will contract Phylloxera disease,
Black Goo syndrome, or Pierces disease. While these conditions do not kill the
vines immediately, they reduce production of quality grapes by approximately
50%. Further, the vines generally die approximately 10 years after contracting the
condition. While Mike will probably be able to avoid Phylloxera by planting
genetically treated vines, incidents of Black Goo and Pierce disease have been
increasing over the last several years and are most dangerous to vines that are less
than three years old.
How should the potential for vine disease be reflected in the financial
statements if the vines have not been diagnosed with any of the diseases? Does
this change if the vines are diagnosed with one of the diseases? Be specific
regarding 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 Performance
Reporting by Business Enterprises project may change the form and content,

classifications and aggregations, and display of specified items and summarized amounts
on the face of all basic financial statements. An important result of this project may be
that net income would be eliminated as an income statement item. It would be replaced
by comprehensive income. Currently, comprehensive income plays little, if any, role in
equity valuations.

The projects goal is to
Improve the quality of information displayed in financial statements so that
statement users can better evaluate an enterprises performance.
Ensure that sufficient information is contained in financial statements to permit
calculation of key financial measures used by investors and creditors.
In the interest of global convergence of accounting principles, the FASB is
working closely on this project with the International Accounting Standards
Board (IASB), which has a similar project underway with the United Kingdoms
Accounting Standards Board. The FASB and IASB have tentatively decided on a
similar 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 includes
all changes in equity during a period except those resulting from investments by owners
and distributions to owners.

The FASB in SFAS 130, Comprehensive Income, required companies to
display in their financial statements total comprehensive income and its components in
either 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.




SFAS 130s operational definition of comprehensive income is net income plus
other comprehensive income. Other comprehensive income consists of those accounting
items that are direct debits or credits to owners equity that do not involve transactions
with owners, such as foreign currency translation gains and losses and unrealized gains or
losses on marketable securities classified as available-for-sale.

IASB


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

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

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

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

Principle 4 A performance statement should identify gains and losses where the
change 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 proscribed
subtotals, 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 reporting
comprehensive income is shown in Table C. It is based on Principle 3.
To illustrate further the IASBs approach and Principle 3, the components of financial
performance relating to pension costs would be reported using the Table C format as
follows:
(i) Operating, Column 1service cost
(ii) Operating, Column 2actuarial gains and losses relating to changes in
assumptions about future cash outflows
(iii) Financing, Column 1interest cost, expected return on assets
(iv) Financing, Column 2actuarial gains and losses relating to return on assets
and changes in discount rate assumptions




Other Possible Approaches

The FASB is studying the IASBs tentative comprehensive income statement
format for possible adoption. In addition to the separation by functional classification, the
FASB has directed its staff to explore the possibility of further separating the information
in the statement of comprehensive income. Several possible approaches for separation
being explored are:
a. Separating transactions with third parties from all other transactions and
events.
b. Separating cash measurements, accrual measurements, and fair-value
measurements.
c. Separating transactions and events driven by historical cost principles from
transactions and events driven by fair value or remeasurement principles.
d. Separating income and expenses resulting from the remeasurement of an
asset or liability from all other income and expenses (the current IASB
approach).
e. Some other approach.

Timetable
The FASBs objective is to issue in 2003 an Exposure Draft relating to the
reporting of items of revenue, expense, gains, and losses in a statement of comprehensive
income.



Questions with Answers:
1. Where in the IASBs proposed Statement of Financial Performance would you
display the following?
o Tangible fixed assetsdepreciation, impairments, gains or losses on
disposal and revaluations (permitted under International Financial
Reporting Standards)
o Investment propertiesrent and revaluations
o Goodwillimpairments
o Inventorysales and impairments
o Investments in equity securitiestotal value change
o Financial assets and liabilities held for tradingtotal value changes
o Foreign exchangegains and losses
o Nonequity financial assets and liabilitiesinterest income and expenses
o Provisionsinitial recognition, subsequent interest costs, remeasurements
due to changes in the original estimates
o 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?