(Accounting for possible unexpected warranty costs, LO 8) Nouvelle Ltd.

(Nouvelle) is a privately owned industrial-products manufacturer located in Sherbrooke, Québec. The president of Nouvelle owns 25% of the shares of the company and three investors who are not active in managing the company own the remaining 75% of the shares. The company has a large demand loan outstanding at the bank. The terms of the loan require that Nouvelle maintain a current ratio of 1.5 and a debt-to-equity ratio of 1.25 to 1. Nouvelle’s senior executives have an employment contract that entitles them to share a bonus pool equal to 10% of the company’s net income. The financial statements are also used for tax purposes.

On December 21, 2006 Nouvelle’s quality control engineer presented a report to the president where she expressed concern about problems with a new line of the company’s products. The engineer believes that these new products were rushed into production and as a result there are some technical flaws that have not been corrected in products that have been sold to customers. The engineer has reported that there has been an increase of about 20% in service calls required on the new products, as compared with other company products, but she believes that repairs will increase dramatically once the products have been used by customers for more than 2,500 hours. The engineer estimates that she expects to see a sharp increase in repairs on these products from 12 to 18 months from the date of purchase and that the cost of repairing these products will be $3,000,000 higher than the amount originally budgeted. To date, repair costs on the new product line are about

$250,000 higher than budgeted. The engineer bases her concerns on extensive tests she has carried out in the quality control laboratory.

Nouvelle’s product design engineer, who was responsible for development of the products, has stated flatly that there are no technical flaws and that the increase in service calls is reasonable for a new product line.

On December 15, 2006 Nouvelle’s vice-president of finance provided the president with the following estimates of the December 31, 2006 financial statements:

Net income $ 2,540,000 Current assets 22,300,000 Current liabilities 18,200,000 Non-current liabilities 57,500,000 Shareholders’ equity 62,800,000 Required:

Prepare a report to Nouvelle’s president discussing the accounting and financial reporting issues regarding treatment of the concerns raised by the quality control engineer. Your report should identify alternative ways that the possible future costs could be treated and explain the implications of the alternatives. The president would also like your supported recommendations on what should be done.