Accounting for product recalls

Plush toys, baby sleeping bags, raw pet food and Thai green chicken curry. These are just a few of the products that were recalled during August 2019, according to the Chartered Trading Standards Institute.

Companies that manufacture products can never completely rule out the possibility of shipping a defective product. But the discovery of a foreign body or a fault can reduce consumer confidence, leading to a decline in customer loyalty and, potentially, damage to the brand. If not handled appropriately, a product recall could also attract the wrong kind of attention in the marketplace.

History shows that even the biggest companies fail to get it right. A case in point is Mattel, number one toymaker in the US. In 2007, it had to recall around 20 million products because of loose batteries posing a swallowing hazard to children, and unusually high levels of lead.

The manufacturer was heavily criticised, originally blaming the recalls on a Chinese subcontractor, but later apologised and admitted that a design flaw and its own weak safety controls were at fault. Mattel had to save face because at the time the country produced around 65% of all its toys and it couldn’t run the risk of the relationship breaking down.

This shows that big brands are not immune from the damage that can be caused by product recalls. Even when handled correctly, recalls can affect shareholder confidence and drive down share prices, as Toyota can attest to.

Between 2009 and 2011, the Japanese car manufacturer experienced its biggest ever recall, affecting several million vehicles. At one point, share prices fell 23% over a three-week period. According to YouGov’s BrandIndex data, Toyota’s brand perception dropped dramatically in the UK, Germany and the US.

While studies show that the bigger the brand the more the damage that can be done to a company’s reputation, bigger brands are likely to have more financial and legal muscle to deal with any claims or fines. And, ultimately, to regain the trust and confidence of consumers.

For small to medium-sized businesses, however, knowing what to do can be a challenge.

When a leading UK food supplier discovered that the rice it had been supplied had been contaminated with tiny fragments of metal, it led to a product recall that cost the business somewhere in the region of £250,000.

“We were supplying to a couple of major retailers for use in their own-brand products. The foreign object was discovered through our metal detector,” says Karen Green, the then commercial director, whose job it was to make the process of navigating the recall less painful.

“We stopped production immediately and reassured our customers that everything was under control,” she adds. “The losses came from written-off stock, fines from retailers and sales lost while we worked on resolving the issue. The whole situation meant we didn’t get back into full production for a whole five days.”

Reflecting on the experience, Green, who now advises SMEs, says that employing a good crisis management PR firm can help to minimise some of the impact. But it’s also essential to have recall insurance.

Many businesses will overlook recall insurance by focusing only on the cost to retrieve products, which in reality can end up being a fraction of the total costs.

Andrew Manderfield, a partner at top 40 accountancy firm Streets Chartered Accountants, says: “More often, expense is burned through thanks to the miscalculation of the impact and cost of the remedy.”

Businesses may also wrongly assume that costs can be recovered under another policy, such as product liability insurance. But that only provides coverage in the event of a product causing bodily harm or damage to property.

The best recall insurance policies will cover the cleaning of equipment of buildings, product replacement and redistribution, and ancillary costs, including the transportation and disposal of damaged or faulty goods. Some will also cover the cost of advertising and promotional activity in the weeks following a recall event.

Given the range of products available, it can be difficult to know what protection you actually need and what you can go without, says Green. But by understanding your risk profile, you can give your insurance broker more information to find the right product that works for the business.

A pharmaceutical company has had to suspend operations due to quality issues with batches, recalling a number of products. The company also uses a significant amount of inventory in the manufacturing of the products.

Under International Accounting Standard 2, inventories are measured at the lower of cost and net realisable value. Generally, a company should not carry assets in excess of amounts expected to be realised from their sale or use.

However, if the company’s inventory has been impaired then it might not be possible to recover the value of the raw material. In this situation, it’s imperative that the company quickly determines the reason for the recall, whether the quality issue can be resolved and whether there’s an opportunity to use the raw material in another manufacturing process, so as not to lose its value entirely.

In the food industry in particular, over half (56%) of manufacturers are spending more on insurance so they can meet contractual demands from retailers, according to the Lockton Food & Beverage Report. Research from the world’s largest privately-owned independent insurance broker found that retailers are pushing responsibility further down the supply chain. Some manufacturers are even being priced out of contracts as a result.

Green says regardless of where you sit in a supply chain, it’s essential that you negotiate the right deal with your own customers to minimise potential losses. Ideally, you wouldn’t agree loss of profit claims but these tend to be woven into supply agreements anyway.

When selling and dealing with consumers directly, what matters most is how you are able to identify and reach them, argues Manderfield: “For example, do you have records in place? Do you have a direct relationship with your customers? Are there third-party distributors involved or do you need to broadcast recall notices?”

By taking steps to identify and reach consumers that might look to put in a claim, you can deal with any problems quickly and efficiently. “Preparations need to be made to fund replacements, to rectify mistakes and refund those demanding them. Not being prepared in this way is what can lead to brand or reputation damage,” adds Manderfield. “It’s best to have some sort of crisis action plan in place far in advance of anything happening. The more you can pre-empt any potential snags like this, the better.”

Another thing you need to consider, says Green, is negotiating the right deal with suppliers. This includes carrying out financial and corporate due diligence and checking that the suppliers themselves have adequate insurance.

Manderfield adds that if faulty parts or contaminated materials can be attributed to a supplier, then another thing you need to factor in when accounting for recalls is the time spent communicating with suppliers, as well as the associated legal and administrative costs.

“The journey and cost of finding alternative suppliers can be equally arduous. This can impact on cash flow, so you need to rethink forecasts and your ability to weather what could be a protracted period of instability,” says Manderfield. “It benefits to be constantly engaged with your supply chain. This can ensure that additional materials can be procured and supplied in the event of an emergency.”

A product recall can be an expensive and logistical problem, but what happens if a business is a small player with a short supply chain and can’t afford the premiums for any kind of product recall insurance?

You have to ensure that there is absolutely no reason why the product should be recalled once it leaves your premises, says Julian Abel, managing director of a Lancashire-based artisan manufacturer that sells to a high-end supermarket chain in northern England.

“Even the most basic recall premiums start at about £7,000. And with fines starting at about £2,000 per stock-keeping unit, the costs are beyond the means of most small producers and manufacturers,” he explains.

The only recalls his company has experienced have been minor ones related to incorrect labelling as a result of raw material suppliers making mistakes.

Abel believes that, while you can’t ever rule out products being recalled, carrying out stringent quality assurance procedures and ensuring products meet current legislation is the best way to self-insure against any recalls. Even if you find yourself under pressure from stakeholders to lower the price of products, cheaper ingredients shouldn’t be procured at the expense of quality.

Nevertheless, businesses should always be prepared to absorb or carry the cost of recalls, says Manderfield. “If adequate plans have been put in place, then this shouldn’t be too much of an issue,” he adds. “Financial departments should have the ability to withstand a storm of sorts.”

An electrical goods company has put out a recall notice to its customers, who have a legal right to return goods that are faulty or unfit for purpose.

When customers receive a different product or full or partial refund, International Financial Reporting Standard 15 – effective as of January 2018 – now requires sales revenues to be reduced to reflect the anticipated value of items that will be returned. Instead, a refund liability is recognised and the inventory cost of items is excluded from cost of sales.

However, while the electrical goods company anticipated a certain level of returns, it did not expect recalls to affect thousands of items. In this situation, the list of sales made between the dates affected by the recall needs to be reviewed and sales removed from revenue and then the inventory included. If the refunds haven’t been paid before the year-end, the financial statement needs to be reviewed to confirm that the refunds due are included in current liabilities.

Failing to take the necessary measures could result in the company overstating its revenue, understating liabilities and misstating inventory.

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• Accounting for product recalls
  Business & Management Magazine, Issue 278, October 2019

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