Accounting for Vineyards and Wineries (#255)
/In this podcast episode, we discuss the accounting for vineyards and wineries. Key points made are noted below.
The Basis of Accounting
In the United States, a farm is nearly always allowed to use the cash basis of accounting, no matter how big it is, and a vineyard is classified as a farm – so, vineyards usually use the cash basis of accounting. Doing so allows them to somewhat defer the recognition of income, so they can delay paying income taxes. A winery is not classified as a farm, since it’s more of a production operation, so wineries usually use the accrual basis of accounting. This difference means that a vineyard and a winery are set up as two separate entities, with the vineyard using the cash basis and the winery using the accrual basis. So, the accountant for a combined operation needs to be conversant with both approaches, and will need to maintain two sets of books.
Expenditure Capitalization
Even though a vineyard is on the cash basis, it needs to capitalize quite a lot of its initial expenditures. The problem is that it can easily be a half-decade – usually longer – before it begins to produce grapes in commercial quantities. That’s because it takes time for a site survey to figure out how to configure the vineyard, and decide on what types of vines to plant, and then extract rocks, and grade the land, and possibly fumigate the soil, and add fertilizer, and drill wells, and lay down an irrigation system – and that’s before planting any vines. And then there’s vine planting, and setting up windbreaks, and installing a trellis system, and training the vines to grow on the trellis system – and so on. The up-front investment is pretty incredible, which is why mostly rich folks own vineyards. At any rate, most of these expenditures are capitalized, up to the point when commercial production begins.
Winery Operations
Which brings us to the winery. So, a winery has four main operations. There’s the crush phase, where the grapes are crushed. Then there’s the cellar operation, where the juice is kept in tanks to let the sediment drop out, followed by fermentation, and then bulk aging in oak barrels or stainless steel tanks. The next step is bottling, which involves filling the bottles and adding labels and a cork or a screw-top cap. And finally, the bottles are left in storage for a period of months for further aging. Of these four steps, the crush and bottling phases are quite short, while the other two can be very long.
Cost Accounting Issues
This makes for an interesting cost accounting situation, since the various products spend differing amounts of time in the cellar or bottle storage. For example, a white wine or a red wine with lower production values could spend far less time in the process than a high-grade red wine. So, logically, a high-grade red wine should accumulate a lot more indirect costs than a product that spends less time in the winery.
And there are a lot of indirect costs. There’s the depreciation on the production facility and equipment, and the labor by the winemaster and the rest of the staff, and utilities, and production supplies, and testing expenses, and so on. So, the wineries have come up with a variation on activity-based costing, where they assign expenses to each of the functional areas in the winery, and then allocate the costs of these functional areas to what they call gallon/months of each wine product. So, for example, if 1,000 gallons of Merlot are aged in barrels for six months, then that is 6,000 gallon/months of Merlot. And, if the cellar operation accumulates a half million dollars of costs in a year, that cost is assigned to the Merlot based on its proportion of the total gallon/months of wine kept in the cellar. The same approach works when allocating the cost of bottle storage.
So this can get a little complicated. And it gets worse, for several reasons. First, wines could be kept in storage for more than one year, so you have to allocate costs not just to several types of wine, but also to several vintages of each varietal. And on top of that, the winemaster might decide to engage in blending activities somewhere in the production process, which mixes wines together, and, of course, complicates the cost accounting. And, there can be wine shrinkage, where the wine evaporates while it’s aging in the oak barrels. And furthermore, the winery may choose to sell off some wine in bulk before it reaches the bottling process, so that a good chunk of the wine volume never makes it to the end of the process.
Now, you might ask if this cost accounting is a little excessive. No, it’s not. For two reasons. First, most wine sales go through distributors, who demand some really aggressive pricing deals, to the point where a winery will probably only make a 20% gross profit on its distributor sales. This is opposed to the much smaller sales volume a winery generates through its tasting room or wine clubs, where the gross margins can be in the 70% range. So, because of the crappy profits on distributor sales, the winery really needs to know how much its products cost.
And the second reason for a good cost accounting system is that the Internal Revenue Service demands it. The IRS wants to see the profit levels for each product sold, and proof for the calculations. And on top of that, the IRS wants wineries to allocate interest costs to wine when the production process takes at least two years, so there’s another cost accounting step.
And if you think that’s enough cost accounting for one day, no – not even close. The wineries prefer to use last in, first out costing to value their ending inventory, since it matches their latest costs against revenue, which should lower their taxable income. The trouble is that calculating LIFO is kind of tough on a per-unit basis. So, what they do is use the dollar-value LIFO system, where the ending inventory valuation is based on a conversion price index. This index is based on a comparison of the base year cost of the inventory and the current year cost, which is then converted into a percentage and used to value the ending inventory.
This is a fairly complicated calculation, so the wineries want to limit it to just two types of inventory, which are bulk wine and cased goods. The IRS doesn’t think that’s good enough, so they want to see separate calculations that are broken down into more groups, such as by the type of wine, the source of the grapes, the length of the aging process, and even the size of the storage containers being used. This can result in a small war with the IRS if a winery gets audited.
Sales Tax Exemptions
Of course, there are other accounting issues that are specific to vineyards and wineries. For example, there are sales tax exemptions for oak barrels, and for wine labels and fertilizer, since these items are all involved in either the grape growing or production processes. The assumption is that the final consumer will pay for the sales tax on these items, not the winery.
Charitable Donations
Here’s another issue – charitable donations. Wineries are always being asked to contribute their wine to charity auctions. The simplest way to account for these donations is not to do anything at all. The donated bottled are just not in stock at the next physical inventory count, so they’re charged to the cost of goods sold at the end of the month.
Depletion Allowance
And a final topic is the depletion allowance. Wineries sometimes offer a discount of a certain amount for each case that their distributors sell through to retailers. This is a depletion of a distributor’s inventory, which is where the name comes from.
The problem is that the distributors have to report the amount of cases sold back to the winery, usually in the form of a bill-back, so the winery ends up paying the distributor. This is an issue at month-end, when the winery is closing its books, since distributors may not report back about the number of cases sold for several weeks. And if you’re trying to close the books, this means that the amount of the depletion allowance has to be accrued, and it’s pretty much a guess. And if you’re wrong on the accrual, then the adjustment falls into the next month. Which introduces some inaccuracy into the financial statements.