Daniel Dobbins Distillery, Inc. In early August 1988, David Dobbins, president and chief operating officer (COO) of Daniel Dobbins Distillery, Inc., of Oakwoods, Tennessee, sat in his ofce pondering the results of the previous day's meeting of the board of directors and wondering whether he should submit the 1988 financial statements (Exhibits 1 and 2) to the Ridgeview National Bank of Nashville, Tennessee in support of a recent loan request for $3 million, or whether he should wait until after next month's board meeting to clarify some of the preceding day's discussion. A great deal of controversy had arisen over the 1988 reported loss of $814,000 and how this result should be reported to the bank. The controversy revolved principally around the accounting treatment of various expenses reported in the "other costs" section of the operating statement. Mr. Dobbins knew that a decision had to be reached on these matters quickly, because the company had reached a point where additional working capital was needed immediately if it was to remain solvent. Company History Daniel Dobbins began distilling whiskey in 1880. Daniel had come to Oakwoods, Tennessee from Scotland the preceding year and had decided to carry on in the family tradition of beverage manufacture. He purchased a tract of land on a high knoll adjacent to a small stream fed by a limestone spring and began to distill bourbon whiskey in an old barn behind his home. His business grew from a trickling in 1880 to a million-dollar rm by 1911. He attributed this growth to the high-quality, distinctive bourbon whiskey that he produced. The quality of "Old Trailridge," Dobbins's only brand of whiskey, was claimed to be the result of the unusual iron-free spring water used in the distillation process and the specially prepared re-charred white oak barrels used in the aging process. From 1911 to 1933, the years of prohibition in Tennessee, the distilling equipment lay dormant, and it was not until late in 1934 that the company began to operate once again in a newly constructed building. Sales rose from $500,000 in 1935 to nearly $5 million in 1941, when the plant was converted to US. defense production of commercial alcohol. In 1973, David Dobbins, great-grandson of Daniel, took over as COO of the company and nearly doubled sales revenue during the next 10 years. Mr. Dobbins felt that the company had grown because of the stress it placed on marketing a distinctive, high-quality, high-price product and because of its continued concentration on only one brand of fine bourbon whiskeyOld Trailridge. The company's advertising stressed the uniqueness of the cool, bubbling spring water used in the distillation of Old Trailridge and pointed to its use of "specially prepared and cured re-charred white oak barrels." This promotion had been very effective in establishing a brand image of Old Trailridge in the consumer's mind that connoted full-bodied mellowness, camaraderie, and old-fashioned backwoods quality. In 1987, the company produced just over 1% of the whiskey distilled in the United States and thus was one of the smaller distillers in the industry. Since the mid-19805, the company's production had been stable; the financial statements for 1987 (Exhibits 1 and 2) were typical of the results of the preceding several years. After a surge in demand in the 1970s, no special effort had been made to gain a larger share of the market, but at a board meeting in December 1987, a decision had been made to expand production to try to capture a larger than proportionate share of the increase in whiskey consumption that Mr. Dobbins had forecasted, based on an industry research report. This report showed that the consumption of straight bourbon whiskey was increasing as the baby boom generation matured. Based on this report and other industry forecasts, Mr. Dobbins had forecasted a doubling of straight whiskey consumption from 1987 to 1995. In view of this assumption, and because bourbon whiskey had to be aged for at least four years, the board had decided to increase the production of whiskey in 1988 by 50% of the 1987 volume (see Exhibit 2) in order to meet the anticipated increase in consumer demand for straight bourbon whiskey from 1991 through 1995. The Manufacturing Process 01d Trailridge was a straight bourbon whiskey and thus, by law, had to be made from a mixture of grains containing at least 51% corn and be aged in new (not reused) charred white oak barrels. The process began when the ground corn was mixed with pure limestone spring water in a large vat. To this mixture was added a certain amount of ground barley malt and rye. It was then heated slowly until the starches were converted to sugars, thus completing the "mashing" process. This mash was then pumped into a cypress fermenting vat where yeast and certain other ingredients were added. This mixture was allowed to ferment for several days until the yeast had converted the sugars into alcohol, at which time the fermenting process was complete and the mash was pumped into a distillation tower (or still) where the alcohol was separated from the "slurry," or spent mash, through a series of distillation tanks and condensers. The distilled liquor was then mixed with limestone spring water to obtain the desired proof (percent of alcohol by volume where one degree of proof equals .5% alcohol). At this point the whiskey was a clear liquid with a sharp, biting taste and had to be mellowed before consumption. For this process, it was pumped into 50gallon barrels and moved to an aging warehouse. The cost accumulated in the product prior to its entry into barrels, including all direct and indirect materials and labor consumed in the production process, was approximately $1 per gallon (see Exhibit 2). The volume of production had been the same for each of the years 1984 to 1987, and all costs during this period had been substantially the same as the 1987 costs shown in Exhibit 2. In order to mellow the whiskey, improve its taste, and give it a rich amber color, the new bourbon whiskey had to be matured or aged for a period of time of not less than four years under controlled temperature and humidity conditions. The new whiskey reacted with the charred oak and assimilated some of the avor and color of the fire-charred oak during the period of aging. Since the quality of the aging barrel was an important factor in determining the ultimate taste and character of the final product, Dobbins had his 50-gallon barrels manufactured under a unique patented process at a cost of more than $60 per barrel. The barrels could not be reused for aging future batches of bourbon whiskey but could be sold to used barrel dealers for $1 each at the end of the aging period. The filled barrels were next placed in open "ricks" in an aging warehouse rented by Dobbins or in that half of the factory building converted into warehousing space. The increased production in 1988 necessitated the leasing of an additional warehouse at an annual rental cost of $200,000. The temperature and humidity of the warehouse space had to be controlled, since the quality of the whiskey could be ruined by its aging too fast or too slowly, a process determined by temperature and humidity conditions. Every six months, the barrels had to be rotated from a high rick to a lower rick or vice versa (because of uneven temperatures at different locations in the warehouse) and sampled for quality and character up to that point in the aging process. A small amount of liquid was removed from representative barrels at this time and sent to the sampling laboratory for quality inspection (usually performed by skilled tasters). If the quality of the whiskey was not up to standard, certain measures were taken, such as adjusting the aging process, to bring it up to standard. At this time, each barrel was also checked for leaks or seepage, and the required repairs were made. At the end of the four-year aging period, the barrels were removed from the ricks and dumped into regauging tanks where the charred oak residue was ltered out and volume was measured. On the average, the volume of liquid in a barrel declined by 30% during the aging period because of evaporation and leakage. Thus, a barrel originally lled with 50 gallons of new bourbon would, on the whole, produce only 35 gallons of aged bourbon. The regauging operation was supervised by a government liquor tax agent, since it was at this point that federal excise tax of $21 per gallon was levied on the whiskey removed from the warehouse. Once the bourbon had been removed from the aging warehouse, it was bottled and shipped to wholesalers with the greatest speed possible because of the large amount of cash tied up in taxes on the finished product. During both 1987 and 1988, the company sold 30,000 regauged barrels of whiskey, equivalent to about 43,000 barrels of original production. Excerpts from Board of Directors' MeetingAugust 3. 1988 David Dobbins: I'm quite concerned over the prospect of obtaining the $3 million loan we need in light of our 1988 loss of $814,000. We have shown annual profits since 1974, and our net sales of $42 million this year are the same as last year, and yet we incurred a net loss for the year. I think I understand the reason for this, but I'm afraid that the loan officers at the Ridgeview National Bank will hesitate in granting us a loan on the basis of our most recent performance. It appears that we are becoming less efficient in our production operation. James Bond (Production Manager): That's not quite so David. You know as well as I do that we increased production by 50% this year, and with this increased production our costs are bound to increase. You can't produce something for nothing. Darlene Thompson (Controller): Well, that's not quite so, Jim. Granted that our production costs must rise when production increases, but our inventory account takes care of the increased costs of deferring these product costs until a future period when the product is actually sold. As you can see by looking at our 1988 profit and loss (P&L) statement, our cost of goods sold did not increase in 1988, since the volume of sales was the same in 1988 as in 1987. The largest share of the increase in production costs has been deferred until future periods, as you can see by looking at the increase in our inventory account of more than $1 million. I believe that the real reason for our loss this year was the large increase in other costs, composed chiey of warehousing costs. The "Occupancy Costs" category in our P&L is really the summation of a group of expense accounts, including building depreciation or rent, heat, light, power, building maintenance, labor and supplies, real estate taxes, and insurance. In addition, warehouse labor cost also rose substantially in 1988. Even administrative and general expenses went up, due primarily to higher interest expense on the additional money needed to finance our increase in inventory. David Dobbins: Well, what's our explanation for the large increase in warehousing costs, Jim? James Bond: As I said before, Dave, we increased production, and this also means an increase in warehousing costs, since the increased production has to be aged for several years. You just can't age 50% more whiskey for the same amount of money. David Dobbins: But I thought Darlene said that increased production costs were taken care of in the inventory account. Isn't that so, Darlene? Darlene Thompson: Well, yes and no, David. The inventory account can only be charged with those costs associated with the direct production of whiskey, and our warehousing costs are handling or carrying costs, certainly not production costs. James Bond: Now just a minute, Darlene, I think that some of those costs are just as valid production costs as are direct labor and materials going into the distillation of the new bourbon. The manufacturing process doesn't stop with the newly produced bourbon; why it isn't even marketable in that form. Aging is an absolutely essential part of the manufacturing process, and I think the cost of barrels and part of the warehouse labor should be treated as direct costs of the product. David Dobbins: Great, Jim! I agree with you that warehousing and aging costs are an absolutely essential ingredient of our nal product. We certamly couldn't market the bourbon before it had been aged. I think that all the costs associated with aging the product should be charged to the inventory account. I think that most of the "other costs" should be considered a cost of the product. Don't you agree, Darlene? Darlene Thompson: Sure, Dave! Let's capitalize depreciation, interest expenses, your salary, the shareholders' dividends, our advertising costs, your secretary's salarywhy, let's capitalize all our costs! That way we can show a huge inventory balance and small expenses! I'm sure Ridgeview and the Internal Revenue boys would be happy to cooperate with us on it! Why, we'll revolutionize the accounting profession! David Dobbins: I think you're being facetious, Darlene. Be reasonable about this. I'm afraid I really don't see why we couldn't charge all of those costs you mentioned to the inventory account, since it seems to me that they are all necessary ingredients in producing our nal product. What distinction do you draw between these so-called "direct" costs you mentioned and the aging costs? Darlene Thompson: By direct costs, I mean those costs that are necessary to convert raw materials into the whiskey that goes into the aging barrels. This is our cost of approximately $1 per ga]lon and includes the cost of raw materials going into the product such as grain, yeast, and malt; the direct labor necessary to convert these materials into whiskey; and the cost of any other overhead items that are needed to permit the workers to convert grain into whiskey. [don't see how aging costs can be included under the generally accepted accounting denition of the inventory cost of the product. David Dobbins: I think we'd better defer further discussion of this entire subject until our meeting next month. In the meantime, I am going to try to get this thing squared away in my own mind. I have never really thought that nancial statements had much meaning, but now I am not at all sure that they aren't truly misleading documents! 1 89-065 -6- Exhibit 1 Daniel Dobbins Distillery, Inc., Balance Sheet as of June 30, 1987 and 1988 ($ thousands) Current Assets 1987 Cash $ 2,548 Accounts receivabletrade (less allowance for doubtful accounts of approximately $330,00m 2,354 Inventories: Bulk whiskey in barrels at average production cost (no excise tax includew 9,013 Bottled and cased whiskey, 175,000 gallons in each year at an average cost of $22.50 per gallon (including excise tax) 3,938 Inventory in process 202 Raw materials and supplies 800 Prepaid expenses 1 Total current assets $20,236 Accumulated Fixed Assets Cost Depreciation Net 1987 1988 1987 1988 1987 1988 Cash surrender value of officers' life insurance $ 64 $ 70 Land $ 60 $ 60 60 60 Building3 3,820 4,220 $1,600 $1,706 2,220 2,514 Factory equipment 144 144 52 76 92 68 Warehouse equipment 70 128 48 68 22 60 Trademarks and brands 16 16 _16 _16 Total assets 2,474 $22,710 Current Liabilities Notes payable: Short-term to banks $ 2,200 Current maturities of long-term debt 460 Accounts payable 1,720 Accrued liabilities 398 Federal excise taxes payable 820 Total current liabilities $ 5,598 Noncurrent Liabilities Notes payable (9 1/2w secured by deed of trust on warehouse property (less current maturities of $460,000 for 1987 and $966,000 for 198% 7,000 Stockholders' Equity Common stock held principally by members of the Dobbins family 3,600 Earnings retained in the business 6,512 Total liabilities and capital gggllg 1988 $ 632 3,662 10,061 3,938 202 472 777 $19,744 2,788 $22,532 $ 3,000 966 838 230 $ 5,034 8,200 3,600 5,698 $22,532 n June 1988, payment was made for work that had been performed during the year in adding to and improving the warehousing space in the building owned by Dobbins Distillers. Exhibit 2 Daniel Dobbins Distillery, Inc., Statement of Income for the Years Ended June 30, 1987 and 1988 ($ thousands) Net sales: Sale of whiskey to wholesalers Cost of goods sold: Federal excise taxeson barrels sold Cost of product charged to sales: Bulk whiskey inventory July 1, of each year472,000 barrels Plus: Cost of whiskey produced to inventory (43,000 barrels in 1987 and 63,000 barrels in 1988 at an average cost of $52.40/50 gallon barrel in both years Less: Bulk whiskey inventory June 30 of respective year. (172,000 and 192,000 barrels, at average production cosn Cased goods and in process July 1, of respective year Cased goods and in process June 30, of respective year Other costs charged to Cost of Goods Sold: Cost of barrels used during year at $63.00 per barrel Occupancy costs: factory building rented building Warehouse labor and warehouse supervisor Labor and supplies expense of chemical laboratory Depreciation: factory equipment warehouse equipment Cost of government supervision and bonding facilities Cost of bottling liquor (labor, glass, and miscellaneous supplies) Total cost of goods sold Gross profit from operations Less: Selling and advertising expenses Administrative and general expense Net profit (loss) 1987 9,013 2,253 11,266 9,013 4,140 4,140 2,709 265 272 188 136 24 12 458 1,568 31,605 2,253 $33,858 4,070 37 2 $ 4,072 1988 31,605 9,013 3,301 12,314 10,061 2,253 4,140 4,140 $33,858 3,969 297 572 334 166 24 20 14 458 5,854 $39,712 $ 2,288 1,874 1,223 3,102 1141