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 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.
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 $30,722.85
Lease 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 loans principal.
ANSWER:
Issuance of debt/loan
Cash $180,000
Notes Payable $180,000

Year One
Repayment of Loan


Notes Payable $10,000
Cash $10,000

Year Two
Repayment of Loan
Notes Payable $10,000
Cash $10,000

Year Three
Repayment of Loan
Notes Payable $160,000
Cash $160,000

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

To record interest payment annually
Interest 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
company
These works are to keep
the asset (land and vine)
in good operating
conditions and they did
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:
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.
ANSWER:
When vines have not been diagnosed with any of the disease such
as Phylloxera disease, Black Goo syndrome, or Pierces 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
winerys 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 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
ANSWER:
The table below shows the placement of the enumerations above in
the IASBs proposed Statement of Financial Performance.
Normal Other Comprehensive
Income
To be reported
separately
1. Depreciation
2. 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. Extraordin
ary items
infrequent
and
unusual
items



liability
5. Provisions (Initial
recognition,
subsequent interest
costs)
value change
5. Foreign exchange
gains and losses
6. 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 IASBs Statement?
ANSWER:
The IASBs 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 FASBs and IASBs 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 projects goals?
ANSWER:
Yes. FASB projects 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 projects 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 entitys 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.