Question

Love Your Pet, Inc. (LPI) is a pet food company located in rural Quebec. LPI has been operating for years as a distributor of pet food but in the last year has begun to manufacture raw dog food. In the current year, LPI has been certified by the Canadian Association of Raw Pet Food Manufacturers, (CARPFM). This organization believes that companion animals benefit greatly from a diet more closely related to their hereditary and biological makeup. Certification was completed in the third quarter. Sales of raw dog food literally doubled in the fourth quarter.

Prices have been on the rise for raw meat used in production. Dog food is primarily made from the organs of cattle, lamb, duck, or, in some cases, bison. LPI purchases its raw materials only from other companies that have received CARPFM certification. Accordingly, there are a limited number of suppliers that can provide raw materials as needed. Raw materials for manufacturing either raw dog food or dry dog food are turned over quickly to reduce spoilage. Raw foods are freeze dried immediately once produced. Dry dog food is immediately packaged. Both freeze dried and packaged raw food has a shelf life of one year if the product is unopened.

To meet CARPFM standards, LPI has made a significant investment in equipment, financed in part through an increased term loan plus a line of credit from its bank. The bank has tied the maximum line of credit amounts to 50% of inventory and 70% of accounts receivable.

You have been hired as the new controller for LPI. Your boss, Stuart Mack, needs guidance on proper treatment of several accounting issues, since the new arrangements with the bank will now necessitate an audit. LPI has not needed assurance on its financial statements in the past, and simply had a Notice to Reader prepared to assist with tax return preparation. LPI will be preparing its statements in accordance with IFRS.

Facts to note:
• Under specific identification, periodic and perpetual always give the same result because the cost of each specific item sold is identified. Therefore, the same inventory amount is shown for both.

• Average cost yields different results under the periodic and perpetual methods because the numbers of items and their costs are averaged together differently under a moving average (perpetual) than under a historical tabulation of purchases (periodic).

• FIFO always yields the same result under both periodic and perpetual methods.

1. LPI sells bags of dry dog and cat food in its retail stores throughout Canada. Customers can collect stamps on an LPI frequent buyer card, and for every 10 similar bags purchased, LPI will provide an 11th bag for free. The price of a bag of dog food ranges between $15.00 and $70.00, depending on the size of the bag. This program has been in operation for the past two years. LPI has been tracking the extent of redemptions, and to date the program has attracted roughly 60% of customers who buy packaged dry food. This program is ignored in the accounting system the product “given out for free” is simply expensed in the period it is distributed as part of cost of goods sold.
2. LPI has an agreement with a large farm in Quebec that gives LPI a rebate of 10% on purchases of raw meat as long as volume reaches a certain level. Volumes have been met, and in fact are increasing in every quarter since the agreement was signed. This rebate is paid to LPI in the quarter following purchases. LPI has always recorded this discount as a credit to cost of goods sold in the quarter received.

3. With the exception of direct materials and direct labour, all costs of operating the manufacturing operation are expensed in the period incurred.

4. LPI is a distributor of dry food for other suppliers. Recently, a manufacturer in the United States began a recall of several significant batches of its dry pet food products due to possible contamination with salmonella. There have been U.S. reports of some older small breed dogs dying after allegedly consuming this brand of dog food. The manufacturer has since gone out of business. Unfortunately, this product line had previously made up 20% of LPI’s dry dog food sales. LPI had four months of inventory on hand, only some of which were from the recalled batches. However, all products from this supplier have been removed from the shelves and are essentially unsaleable because of concerns over pet health.

5. LPI has always used FIFO for all types of inventory, but Stuart is wondering if LPI should switch to the average cost method. A number of competitors use this method and he has asked you what the impact might be on gross margin and the current ratio as a result of the switch. 

6. One of Stuart’s friends, Carly Jetson, the owner of a local boutique holistic health store, has started a holistic line of rabbit food. LPI does not currently manufacture or sell rabbit food so Stuart has allowed Carly to have free shelf space for her product. Stuart pays Carly 80% of the retail price when the food sells.

 

Required:

Prepare a memo to Stuart in which you identify and analyze the accounting implications of each of these issues. Include a clear conclusion for the accounting treatment that should be adopted.

Answer 1

Overview

 

LPI is preparing IFRS-compliant financial statements for the first time, and will be audited for the first time. The company has a line of credit that is limited to 70% of accounts receivable and 50% of inventory, and thus accounts receivable and inventory balances are important. Then company uses its financial statements for tax purposes, and tax minimization might be a reporting objective. 

 

Issues

 

1. Loyalty program

2. Rebates

3. Manufacturing costs

4. Recall

5. FIFO versus average cost

6. Consignment goods

 

Analysis and recommendations

 

1. 

The free bags should be treated as a separate performance obligation in the sales transaction at the time of the initial sale (IFRS 15). LPI does not account for the free bags until the time of customer redemption. Instead, the fair value of the consideration in respect of the initial sale must be allocated between the award credits and the other components of the sale. LPI will need to apportion the sales revenue on each bag so that 10% of the sales amount is deferred and recorded as unearned revenue until the customer claims the “free” 11^th bag. No deferral is required for the 40% of sales that have not been drawn to the program. LPI has been tracking redemptions, so the percentage of bags actually redeemed by the customers who take part in the program should be verifiable. 

 

This is a change in accounting policy, to be accounted for retrospectively (IAS 8). 

 

This change in accounting policy not have any impact on accounts receivable or inventory for purposes of the line of credit calculation, but it will reduce earnings because sales are being deferred.

 

2. 

Rebates for inventory must be deducted in determining the cost of purchase (IAS 2). LPI’s current policy is to defer recognition until the subsequent quarter when the amount of the rebate is known and received. Volumes have historically been met and purchases are increasing with sales continuing to grow in recent months. It is very likely that the minimum volumes will continue to be met, so the purchase discount should be recorded based on the estimated rebate expected, resulting in a 10% decrease in inventory and accounts payable at the time of purchase. 

 

Again, this is a change in accounting policy, to be accounted for retrospectively (IAS 8). 

 

The new policy will have the impact of decreasing inventory for purposes of calculating the maximum line of credit available. Earnings will increase, because of the growing volumes; larger discounts are being accrued earlier.

 

3. 

LPI has been expensing all manufacturing costs related to production other than direct labour and direct materials. The costs of conversion of inventories include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods (IAS 2). Accordingly, all costs of manufacturing operations should not be expensed during the period, as is presently the case. 

 

Any costs of conversion that are presently expensed need to be allocated to units produced based on the normal capacity of the production facilities. Any units held in ending inventory should have a fixed manufacturing overhead component that is part of the total cost of these units. 

 

This is a change in accounting policy to comply with the GAAP requirement for absorption costing and must be applied retrospectively. 

 

If production is higher than sales in a given year this method, this will result in a higher amount in ending inventory for purposes of calculating the line of credit, as compared to expensing all costs during the period other than direct labour and direct materials. 

 

 

4. 

The recall of the dry dog food brings two issues into question. The first issue is one of inventory valuation. LPI has chosen to remove all products from the supplier from its shelves due to health concerns, rendering them unsaleable, and therefore having no net realizable value. Given that the supplier has gone out of business, it is unlikely that there is any avenue for LPI to recover costs on this product. The carrying amount of these products must be removed from inventory completely and recorded as a loss in the current period; this is an impairment (IAS 2). If there is any subsequent reversal of any write-down of the inventory because amounts become recoverable, this is recognized in the reversal year. It seems unlikely there will be a reversal in this situation. 

 

The impairment will result in lower inventory in the current period for purposes of calculating the available line of credit amount. Earnings will also decrease. 

 

The second issue is the potential for contingent liabilities arising if customers file suit against LPI in their role as a distributor for the contaminated food. The batches held by LPI included some that were suspected of contamination. Presently, no action has been launched against LPI and there are no Canadian incidents. Lacking a loss incident, no accrual or note disclosure is required in the financial statements. This may be an issue for consideration in future periods. 

 

5. 

This is a voluntary change in accounting policy, from FIFO to average cost. A voluntary change in accounting policy should be made if it results in information that is more relevant and reliable to the users of the financial statements (IAS 8). In this instance, a change from FIFO to the average cost method would arguably make LPI’s statements more comparable to competitors in the industry, making financial statements more relevant to users. 

 

Once more, this is a change in accounting policy, to be accounted for retrospectively (IAS 8). 

 

Given that prices are rising, a switch to average cost would result in higher cost of goods sold expense and lower ending inventory as compared to FIFO where the newer, higher costs would be averaged in cost of goods sold and not deferred in ending inventory. This would lower the gross margin in the current period and decrease the current ratio, decreasing the maximum borrowing amount based on the line of credit agreement. Earnings would decrease.

 

6. 

LPI does not pay for the rabbit food product until it is sold, giving Carly 80% of the retail price at that time. The inventory held at LPI locations has not actually been purchased, and therefore is not an asset to be recorded by LPI. This is consignment inventory and should not be recorded in LPI’s records. As an agent, the company will record only their sales commission as revenue, not the amount charged to the customer in-store. Because the rabbit food is not recorded as inventory, it will not be included for purposes of calculating the maximum line of credit available. 

 

Conclusion

 

Many of the issues above affect income and inventory. If tax minimization is important, the overall impact will have cash flow implications, increasing or decreasing the tax paid. Inventory is significant with respect to the operating line of credit. 

 

The company’s cash flow requirements over the coming year should be determined, using a cash budget. If the line of credit is close to its limits, the bank should be consulted in advance.

The company’s cash flow requirements over the coming year should be determined, using a cash budget. If the line of credit is close to its limits, the bank should be consulted in advance.