TUTORIAL 19.

2 (30 marks; 36 minutes)

Pets Choice (Pty) Ltd (“Pets Choice”) produces dog food that is sold to the retail market across the country. The
company imports one of its raw materials that are used in the production process, called corn gluten, from
China. The company was forced to recall some of its dog food from shop shelves after it was found that the corn
gluten was contaminated with a poisonous industrial chemical, called melamine. The directors became aware of
the contaminated dog food when they were contacted by a vet in December 2012, but as they did not want to
create a panic at that stage, they made no announcement about the incident and instead started with their own
investigation. Soon after, the information about the contaminated food was leaked to the press and the
directors were forced to take action by recalling more of its unsold products from the retailers.

The directors are currently finalising the financial statements for the year ended 28 February 2013 and have
contacted you for assistance with regards to the accounting treatment of the following issues:

Contaminated products:

1. Dog food (finished products) recalled from the shop shelves during January and February 2013
amounted to R2 600 000 (selling price). These products are currently being checked for contamination
and the directors expect that all of these products will no longer be suitable for sale and as a result will
have to be destroyed. The company issued credit notes to the retail customers from whom these
products were recalled.
2. In addition, dog food (finished products) still on hand at 28 February 2013 was tested for any traces of
melamine. Finished products on hand amounting to R5 580 000 were identified as contaminated and
clearly marked ‘not for sale, to be destroyed’.
3. Detailed testing of the corn gluten (raw materials) on hand at 28 February 2013 revealed that corn
gluten to the value of R2 100 000 tested positive for melamine and was therefore clearly labelled ‘not
for use, to be destroyed’.
4. The directors have estimated that it will cost R450 000 to safely destroy all the contaminated food and
raw materials. The products will only be destroyed later in 2013 after all the tests have been
completed.

Legal action resulting from sale of contaminated products:

5. By 28 February 2013, the directors were aware of dogs that had died after eating the Pets Choice
products, and the company had been informed by the lawyers of some of these pet owners that they
plan to take legal action against the company.
6. The directors instructed their own lawyers on 12 March 2013 to investigate the situation. The lawyers
were of the opinion that it was highly probable that these pet owners would be successful in their
claims, and also envisaged that most of the other pet owners that had had the same experience would
probably soon do the same. As a result the lawyers suggested that the company offer an out-of-court
settlement to these pet owners to prevent any further bad publicity.
7. Following the advice from their lawyers, the directors concluded at their board meeting held on
28 March 2013 to offer each pet owner who claimed that they had lost a pet as a result of eating the
contaminated dog food, a full settlement amount of R20 000 per pet. At the time of the board meeting,
the company had identified 18 pet owners to whom a settlement would be made.
8. On 31 March 2013 the company received an invoice amounting to R240 000 from their lawyers for their
investigations so far and paid it on 15 April 2013.
TUTORIAL 19.2 Continued

Anticipated legal action against the supplier of the corn gluten (raw materials) in China:

9. The directors appointed an international legal firm in early February 2013 to investigate the legal action
options available against the Chinese supplier that sold the contaminated corn gluten and whether they
will be able to claim for any compensation. This is expected to be a lengthy process and the only
feedback that has been received so far from this legal firm is that “it is possible that you may be able to
recover some costs from the Chinese supplier”.

Note: The financial statements were authorised for issue on 10 April 2013.

YOU ARE REQUIRED TO:

Discuss, with reference to applicable IFRS, how the following issues should be recognised and/or disclosed in the
financial statements of Pets Choice (Pty) Ltd for the year ended 28 February 2013:

1. The contaminated dog food (finished products) and corn gluten (raw materials) (4 marks)

2. The estimated cost to destroy the contaminated products. (5 marks)

3. The out-of-court settlements offered to the owners of pets that have died after eating the dog food.
(7 marks)
4. The lawyers’ invoice relating to their investigations so far. (7 marks)
5. The anticipated legal action against the Chinese supplier. (7 marks)
TUTORIAL 19.2 - SUGGESTED SOLUTION

Discussion of the following issues:

1. The contaminated dog food (finished products) and corn gluten (raw materials)

The inventory should be recognised at the lower of cost and net realisable value. (1)

The net realisable value of the contaminated dog food and corn gluten is zero as these products (on
hand at the reporting date) can no longer be sold; they are clearly identified and will be destroyed later
in the year. (1)

All these items should be recognised at no value i.e. should no longer be included as inventory in the
statement of financial position at 28 February 2013. (1)

The cost of the contaminated food and raw materials should be written off to cost of sales in the
statement of financial position. (1)

The amounts of the write downs of inventory to net realisable value should be disclosed in the notes to
the statement of financial position. (1)

Note: Further the returned dog food (finished products) would be recorded as a reversal of sales and so
revenue needs to be reduced by R2.6m and a corresponding reduction of trade receivables and/ or
recognition of some provision for credit notes. The cost of the dog food returned also needs to be
removed from Cost of Sales for the YE 28 February 2013 and an expense for inventory written off
debited.

[max 4]

2. The estimated cost of R450 000 to destroy the contaminated products

The issue is whether the company should recognise a liability at the reporting date for the cost to
destroy the contaminated inventory. (1)

The products will only be destroyed once all the tests have been completed, which is anticipated to
happen later in 2013, after the 28 February 2012 year end. (1)

The company has identified the contaminated inventory, and expect to destroy the inventory as it is no
longer suitable for sale. However, the company has no present obligation to destroy the contaminated
inventory, but they will probably do it in the interest of safety. (1)

The past event is when the contaminated inventory is destroyed, and as this has not happened at the
reporting date and can still be avoided by the company if they so choose, there is no past event. (1)

Thus, there is no liability at 28 February 2013 relating to the cost to destroy the contaminated products.
(1)

The company therefore also does not have a contingent liability at the reporting date either, as there is
no liability. (1)

However, as this action is considered important information (material), the fact that the directors plan
to destroy the contaminated inventory and the estimated cost involved should be disclosed as a note in
the financial statements. (bonus mark)
 TUTORIAL 19.2 SUGGESTED SOLUTION CONTINUED

[5]

3. The out-of-court settlements offered to the owners of pets that have died after eating the dog food

The issue is whether the company should recognise a liability (or provision) at the reporting date for the
anticipated settlement cost offered to the owners of the pets that have died after eating the dog food.
(1)

The directors’ decision to offer settlement payments to pet owners is an event after the reporting date.
It provides further evidence of conditions that existed at year end (the past event and obligation as
discussed below) and so is an adjusting event. (1)

The directors have a present obligation to settle with those pet owners who have lost a pet, the
obligation stems from the fact that evidence existed that these dogs died after eating the food, and that
the directors have decided to make such offers. (1)

The past event is the fact that the company has sold contaminated dog food to the owners of these pet,
which resulted in their deaths. The past event creating the obligation occurred before year end (the
conditions existed at year end) when the contaminated dog food was sold. (1) [NOTE: The company was
guilty of selling contaminated goods, their guilt arose on the date the goods were sold, and it was
therefore this event that created an obligation].

The outflow of economic benefits is the settlements offered to the owners. (1)

The settlement amounts can not be reliably measured, but it can be estimated based on the number of
claims received to date, which is 18 owners x R20 000 per pet owner = R360 000. (1)

[It will not be appropriate for the company to make a general provision for more claims if they are not
aware of any further claims]

The outflow of future economic benefits is probable; it is more likely than not that the company will
settle those pet owners who have lost a pet. (1)

But as there are uncertainty about the timing of the payments, and the amounts to be settled, the
company should recognise a provision at the reporting date, based on the best estimate of the amount
payable relating to such claims. (1)

When making this estimate, the company should consider all evidence that is available up to the date
when the financial statements are finalised, i.e. any information regarding adjusting events after the
reporting date that is obtained after the reporting date. (bonus mark)

4. The lawyers invoice relating to their investigations so far

The issue is whether the company should recognise a liability at the reporting date for the invoice
received from its lawyers relating to the services rendered. (1)

The directors have appointed the lawyers and as a result have a present obligation to pay them for the
services rendered. (1)
 TUTORIAL 19.2 SUGGESTED SOLUTION CONTINUED

However, their appointment was only made on 12 March 2013, i.e. after the reporting date, and their
investigations were also done after the reporting date. (1)

Thus, there was no past event resulting in this obligation at the reporting date – i.e. this is a non-
adjusting event after the reporting date. (1)

No liability existed at the reporting date relating to the work performed by the lawyers, and no liability
should be recognised. (1)

The instructions to the lawyers and their subsequent investigations are a non-adjusting event resulting
from the contaminated dog food. (1)

As all these issues are related and their effect is material, it is advisable to disclose details of the
subsequent investigation and related costs in the notes to the financial statements. (1)

5. The anticipated legal action against the Chinese supplier.

The issue is whether the company should recognise an asset (or contingent asset) for amounts
recoverable from the Chinese supplier. (1)

Thus, should any probable recourse1 receivable from the Chinese supplier be disclosed as a contingent
asset at the reporting date? (1)

The past event is the fact that the directors have investigated the legal action against the Chinese
supplier during February 2013, which is before the reporting date. (1)

At this stage there is very little evidence that any legal action against the Chinese supplier will be
successful, therefore there only exists a possible resource at this date. (1)

Furthermore, the lawyers have indicated that it is only possible that the company will receive any
compensation from them and therefore that future economic benefits flowing into the company are
only possible. (1)

There is also no indication of the measurement of any amount of compensation. (1)

As the lawyers indicated that it is only possible that the company’s claim will be successful and not
probable or virtually certain, no disclosure of the claim should be included in the financial statements.
(1)

The outcome of the legal action is dependent on the result of a court case to claim compensation, and
this has not been initiated yet.

Should the directors decide to include this fact as part of the note disclosure relating to the whole issue
of contaminated dog food (as it is considered material information for the users of the financial
statements), the directors should be careful not to create any expectation of any possibility of receiving
compensation from the Chinese suppliers. (bonus mark)

1
Recourse: The right to demand payment or seek aid/ damages in court from a party (entity) to a contract when that
party fails to perform as required
 TUTORIAL 19.2 SUGGESTED SOLUTION CONTINUED

Overall disclosure:

The reputation risks and other possible future actions against the company as a result of the
contaminated dog food, and the effect there-of on future profits, is considered material (i.e. it is
information that the user of the financial statements should be made aware of to make an informed
decision about the future prospects of the company) and disclosure of full details of the facts known to
the directors at the time of publishing the financial statements are recommended. (bonus mark)