Nouvelle Ltd. (Nouvelle) is a privately owned industrial-products manufacturer located in Sherbrooke, Qubec. The president of Nouvelle
Question:
Nouvelle Ltd. (Nouvelle)
is a privately owned industrial-products manufacturer located in Sherbrooke, Québec.
The president of Nouvelle owns 25 percent of the shares of the company and three investors who aren’t active in managing the company own the rest. The company has a large demand loan outstanding. The terms of the loan require that Nouvelle maintain a current ratio of greater than 1.5 and a debt-to-equity ratio of 1.25 to 1 or less.
Nouvelle’s senior executives have an employment contract that entitles them to share a bonus pool equal to 10 percent of the company’s net income. The financial statements are also used for tax purposes.
On December 21, 2014, Nouvelle’s quality control engineer presented a report to the president where she expressed concern about problems with a new product line.
The engineer believes these new products were rushed into production with some technical flaws that haven’t been corrected. The engineer says service calls required on the new products are about 20 percent higher than other company products and she expects repairs will increase dramatically once the products have been used by customers for more than 2,500 hours, which should occur 12 to 18 months from the date of purchase. She estimates that the cost of repairing these products will be \($1,500,000\) higher than the amount originally budgeted. To date, repair costs on the new product line are about \($125,000\) 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 developing 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, 2014, Nouvelle’s vice-president of finance provided the president with the following estimates of the December 31, 2014 financial statements:
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 to treat the possible future costs and explain the implications of the alternatives. The president would also like your supported recommendations on what should be done.
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