PROBLEMS & SOLUTIONS

Problem 1:

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 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 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 vineyard’s 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.

ANSWER:No, the leased building should not be accounted as an asset

because the lease would be considered as an operating lease, on which the expense would be accrued day by day as the asset (building) is used. To determine this is in fact an operating lease, the life of the lease should be less than 75% of the useful life of the asset being leased. For instance, this is a ten-year lease, which is less than the economic life of a 30-year asset. The rental payments would be expensed as incurred and offset by the asset used to make the rental payments (i.e. cash), the lessor would still hold the benefit of the ownership.

In addition, there are no stipulations to support that ownership will be transferred to Mike. And then there is no bargain purchase option nor the lease term is for the major part of the economic life of the asset even if title is not transferred.

Yes, the agreement to pay lease rentals should be recorded as a liability because the building rent qualifies as finance lease. Therefore, the asset should be recorded as a liability.

Building $30,722.85Lease Liability $30,722.85

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 loan’s principal.

ANSWER:Issuance of debt/loan

Cash $180,000Notes Payable $180,000

Year OneRepayment of Loan

Notes Payable $10,000 Cash $10,000

Year Two Repayment of Loan

Notes Payable $10,000Cash $10,000

Year Three Repayment of Loan

Notes Payable $160,000Cash $160,000

To record the interest payments on existing loan/monthly 10% interest rateInterest Expense $1,500

Interest Payable $1,500

To record interest payment annuallyInterest Payable $18,000

Cash $18,000(Principal: $180,000*10%=$18,000)

Present Value of Minimum Lease Payment= (1-(1/(1+(.10)10)/.10)= (1-(1/(1*.10)10)/.10)= 6.14457 x $5,000= $30,722.85, which is the 96% of the estimated cost of the

building ($32,000)

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.

ANSWER:All expenditures should be assigned to cost centers like

fermentation, aging, and the like. Mike should treat the expenditures for the vines, vine planting, fertilizing, and water as part of the cost of producing wines since these are directly related in producing wines.

The costs associated with manufacturing/producing the wine should be capitalized until the vine is sold, the costs should be expensed (COGS) when selling transaction happens. For example, the special grapevines brought from Australia at $50,000.00 ($10,000.00 x5 acres) should be capitalized over the time that is taking the vine to be ready for production ($50,000.00/5yrs= $10,000.00).

Labor, which is a direct inventoriable cost (the extra help hired to plant the vines at $2,000.00 per acre x5= $10,000.00) should be capitalized over 5 years.

Land should be capitalized over the useful life of the asset. Fertilizer and water should be expensed as they are incurred.

Following the accrual accounting concepts: Conversation, Realization, and Matching, Mike should treat the expenditures as follows:

Item

No.

Item Description Treatment Over Time

Rationale

1 Building Lease $5,000/year

Expense, be amortized by $5,000/year

Mike cannot control the property as the lease contract did not mention about Mike might assume ownership of the leased building.

2 Purchase of land $250,000

Asset, be depreciated according to its lease term year

Mike owns the land after purchase.

3 Bank loan $180,000 for land purchase

Loan payable in liability

It is a source for the land.

4 Interest for land purchase

Be capitalized as part of land asset

It is an amount related to borrowing made to finance the land and it is identifiable.

5 Vines $10,000*5=$50,000

Asset - inventory

It is a kind of equipment producing grapes.            

6 Vines Transportation cost $2,500

It is an asset - inventory and could be computed into vines asset

It is cost that is necessary to make the vines ready for its intended use.

7 Vine planting $2,000*5=$10,000

It is an asset - inventory computed into vines. When vines are brewed and sold, it becomes as cost of goods sold

Same as above, it is necessary to make the vine ready for its use.  

8 Fertilizing and water fee: $1,000*5=$5,000

Outright expense, part of operating expense of the

These works are to keep the asset (land and vine) in good operating conditions and they did

company not add capitalized cost of the asset (land and vine).

9 Labor directly related in producing wine (the extra help hired to plant the vines at $2,000.00 per acre x5= $10,000.00)

Asset Labor is needed to produce wine.

When the benefits of assets are used up or consumed, the expenditures are eventually transformed into expenses.

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

Mike’s greatest concern is that his vines will contract Phylloxera disease, “Black Goo” syndrome, or Pierce’s 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.

ANSWER:When vines have not been diagnosed with any of the disease such

as Phylloxera disease, ‘Black Goo’ syndrome, or Pierce’s disease, it is in good conditions and still keeps its value. It could be keep as asset with no change. However, the incidents of Black Goo and Pierce disease have been increasing over the last several years and are the most dangerous to vines younger than three years old. Based on conservatism concept, recognize the expenses of vine lost as soon as they are reasonably possible. It is better to use declining depreciation method for the possible vine loss due to the diseases in the first three years.

If vines are diagnosed with one of the diseases and it will lose half of its annual value until they die 10 years after contracting the condition. Thereafter their service life will be shortened and the residual value could be written off as obsolete expense in 10 years.

5. How should Mike account for the oak barrels? ANSWER:

Oak barrels are equipments containing wines and therefore it is an asset. It has 15 years of service life. Its book value will be depreciated

over its service life using straight-line depreciation method. The depreciation will be accumulated as a contra-asset account for the oak barrels.

The value of residual value for 10 years could be based on the purchase price for cheaper local procured barrels that used to mature lower-quality life. The revenue of recycling is only recognized when it is sold to make charcoal chips after 15 years.

Thus, the oak barrel should be accounted as part of the property, plant, and equipment (fixed assets) basing from IAS 16.

6. How would the transactions in Question 3 and the bank loan be recorded in the winery’s indirect statement of cash flows?

ANSWER:The outflows paid as ‘interest on loan’ are considered part of the

operating activities. The issuance of the $180,000 loan would be an inflow of cash used to purchase land. Therefore, it is a financing activity. The repayment of the loan (principal only) is considered an outflow of cash in the financing section of the statements of cash flows. The land is an outflow of cash on the investing activities section of the statement of cash flows. The purchase of the vine is an outflow of cash on the operating activities. Vine planting is an outflow of cash and therefore recorded as operating activities. Water & fertilizer is an outflow of cash on accounts payable, which is also part of the operating activities.

Problem 2:

Financial Performance Reporting

The Financial Accounting Standards Board’s (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 project’s goal is to Improve the quality of information displayed in financial statements so that

statement users can better evaluate an enterprise’s 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 Kingdom’s Accounting Standards Board. The FASB and IASB have tentatively decided on a

similar objective for the new statement—to enhance the predictive feedback value of the information that is presented in a statement of comprehensive income.

Comprehensive Income

The FASB’s 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 130’s 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 IASB’s 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 IASB’s 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 1—service cost (ii) Operating, Column 2—actuarial gains and losses relating to changes in assumptions about future cash outflows (iii) Financing, Column 1—interest cost, expected return on assets (iv) Financing, Column 2—actuarial gains and losses relating to return on assets and changes in discount rate assumptions

Other Possible Approaches

The FASB is studying the IASB’s 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 FASB’s 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 IASB’s proposed Statement of Financial Performance would you

display the following? o Tangible fixed assets—depreciation, impairments, gains or losses on

disposal and revaluations (permitted under International Financial Reporting Standards)

o Investment properties—rent and revaluations o Goodwill—impairments o Inventory—sales and impairments o Investments in equity securities—total value change o Financial assets and liabilities held for trading—total value changes o Foreign exchange—gains and losses o Nonequity financial assets and liabilities—interest income and expenses o Provisions—initial recognition, subsequent interest costs, remeasurements

due to changes in the original estimates o Extraordinary items—infrequent and unusual items

ANSWER:The table below shows the placement of the enumerations above in

the IASB’s proposed Statement of Financial Performance.Normal Other Comprehensive

IncomeTo be reported

separately1. Depreciation2. Gains and losses

on disposal – Investing

3. Investment properties – rent – investing

4. Nonequity financial assets and

1. Revaluation (Tangible fixed assets)

2. Goodwill – impairment

3. Investment revaluation

4. Investment in equity securities – total

1. Extraordinary items – infrequent and unusual items

liability5. Provisions (Initial

recognition, subsequent interest costs)

value change5. Foreign exchange –

gains and losses6. Provisions -

remeasurements*These activities pertain to cash flows only. Therefore, there are

activities wherein cash is not involved like depreciation.

2. What is your appraisal of the IASB’s Statement? ANSWER:

The IASB’s statement presents the comprehensive income by separating the information according to activities (i.e. operating, financing, tax). It also presents the income flows along side by its valuation adjustments, which is aligned with FASB’s and IASB’s objective for the new statement – to enhance the predictive feedback value of the information. With this regard, faithful representation is being observed. However, the principle on uniformity may be compromised as valuation adjustments were included as part of the statement. Therefore, it may not be observing the principle of comparability. Moreover, the statement is structured combining the normal composition of net income plus the income and expense not found in the normal income statement. It can also be seen that the discontinued operations account is reported as part of the operating activity. This is incorrect since discontinued operation is not part of the regular operation of a business. It must be reported separately in the income statement.

3. Does the Statement satisfy the FASB project’s goals? ANSWER:

Yes. FASB project’s goals are to improve the quality of information in the financial statements that will eventually lead to better evaluation of its performance; and to permit calculations of key financial measures used by investors and creditors. By doing so, ‘Statement’ satisfies the FASB project’s goals.

In the IASB statement it can be implied that the information pertaining to different entities were consolidated into one statement. In line with this, it would misrepresent the actual performance of each entity.

4. How might equity investors use this Statement? ANSWER:

Investors (whether potential or existing) use this ‘Statement’ to aid them in making economic decisions and for assessing the effectiveness of the entity’s management easier or lighter. They are concerned with the risk inherent in, and return provided by, their investments. They need information to help them determine whether they should buy, hold, or sell.

Using the information stated in the financial performance report, investors should be able to gauge whether or not management is using funds wisely and primarily how profitable is the company.

5. What changes to the Statement would you propose? ANSWER:

Separating the normal income from the other comprehensive income that is not recognized in the traditional profit or loss statement may be presented in the ‘Statement.’ This way, the information supplied will be more relevant to common users. The purpose of presenting the statement of performance is to give internal and external users awareness on how the company executed its plan for the year and whether or not they have achieved their goals set at the beginning of the year. In addition, information material to the company (i.e. associates, discontinued operations) must be reported separately in order to observe prudence and comparability.