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 2016, 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 2017 and have contacted you for assistance with regards to the accounting treatment of the following issues:

Contaminated products:

Dog food (finished products) recalled from the shop shelves during January and February 2017 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.

In addition, dog food (finished products) still on hand at 28 February 2017 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.

Detailed testing of the corn gluten (raw materials) on hand at 28 February 2017 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.

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 2017 after all the tests have been completed.

Legal action resulting from sale of contaminated products:

By 28 February 2017, 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.

The directors instructed their own lawyers on 12 March 2017 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.

Following the advice from their lawyers, the directors concluded at their board meeting held on 28 March 2017 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.

On 31 March 2017 the company received an invoice amounting to R240 000 from their lawyers for their investigations so far and paid it on 15 April 2017.

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 2017 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 2017.

YOU ARE REQUIRED TO:

Discuss, with reference to applicable section of IFRS for SMEs, 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 2017:

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

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