Reference no: EM132987179

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 100th 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.

Problem 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.

Problem 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.

Problem 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.

Problem 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.

Problem 5. How should Mike account for the oak barrels?

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