Question

Michael Metals Limited (MML) has been a private company since it was incorporated under federal legislation over 40 years ago. At the present time (September, Year 5), ownership is divided among four cousins, each of whom holds 25% of the 100 outstanding common shares of MML. Each shareholder obtained the shares from his or her parents, who formed and operated the company for many years.
The owners have decided to offer the business for sale over a period of years. Laser Investments Limited (LIL), a public company holding shares of companies in a number of other businesses, has been given the opportunity to acquire 46.67% of MML immediately, and the balance over the next five years. The proposal is to purchase 70 shares now as follows:
The other 80 shares would be acquired at a rate of four per year from each cousin for five years. The purchase price of the 80 shares would be tied to MML's profitability as measured by accounting standards for private enterprises (ASPE).
The board of directors of LIL is interested in pursuing the investment in MML. The proposed purchase price of the initial 70 shares is to be partially based on the financial statements for fiscal Year 5 and for future years. The board of directors of LIL has asked its advisors, Bouchard and Co., Chartered Accountants, to assist it in evaluating the proposed purchase. Jules Bouchard, the partner in charge of the engagement, has asked you, the CA, to prepare a memo discussing (1) all relevant business considerations pertaining to the purchase so that he can discuss the issues with the board of directors and (2) how LIL should report its investment in MML if it were to proceed with the purchase of 70 shares.
MML has always been a scrap-metal dealer, primarily of iron and copper. In recent years, it has also dealt in lead, brass, aluminum, and other metals. Scrap iron is acquired from a variety of sources (e.g., old automobiles, appliances, and spoil age during manufacturing processes) and is sorted, compacted, and sold to steel mills. Much of the scrap copper is coated electrical wiring, which has to be stripped of the insulation coating and then chopped into pieces. The copper wire pieces are stored in barrels, which are about one meter high. In summary, a limited amount of processing is needed to convert the purchased scrap into saleable products.
Most of the scrap arrives at MML's storage yards on trucks, which are weighed both loaded and empty in order to determine the physical quantities of scrap on the truck. Some of the scrap is kept indoors, but most is kept outdoors in several large piles in different yard locations. MML's property is protected by tall wire fences and monitored by security cameras 24 hours a day.
To be successful in this industry, a scrap dealer has to buy at low prices and store the processed or unprocessed scrap until metal prices are high. Sometimes, quantities of some grades of metal have to be stored for several years. When sell ing prices are stable, the purchase price has to be sufficiently low that a profit can be made after processing costs have been incurred.
MML tends to operate at its maximum bank line of credit, as it is generally short of cash. MML's maximum line of credit is 70% of its receivables and 50% of its inventory.
Your client arranged for you to have access to all of MML's accounting records and the auditors' working papers. MML's fiscal year-end is June 30. From the accounting records and auditors' working papers, you and your staff have assembled the information provided in Exhibit IV.
Required:
Prepare the memo.
EXHIBIT IV
INFORMATION GATHERED BY CA FROM MML’S ACCOUNTING RECORDS AND AUDITORS’ WORKING PAPERS
1. From audit working paper reviews:
a. Most of the processing equipment and the buildings are old and almost fully depreciated. The company's land was purchased many years ago. As a result, inventory often represents two-thirds of the balance sheet assets, and receivables are close to one-fifth of assets in most years. Total assets vary between $25 and $32 million from year to year. Accounts receivable turnover can be anywhere between 1.5 and 4 times per year.
b. Perpetual records are limited to estimates of quantity because the quality of the scrap, the amount of insulation on wires, and a variety of other factors affect how much saleable metal will result from a bulk purchase of scrap.
c. A seller of scrap seldom knows how much it weighs. MML usually quotes a price per unit, but does not inform the seller of the weight until the delivery truck has been weighed at MML's yard. MML's auditors are suspicious that MML reduces weights before calculating the amount payable.
d. The auditors visit MML's yard and offices three times per year to conduct an interim audit, to attend the physical inventory count, and to carry out year-end substantive audit procedures.
2. MML owns 40% of a joint venture, Green Environmental Limited (GEL), a waste disposal company. The other 60% is owned by the spouses of the four cousins who own MML. All of MML's waste is handled by GEL, and MML purchases scrap iron and wire from GEL.
3. MML deals with a Japanese trading company that allows lengthy credit terms and uses letters of credit stating that MML does not have to pay for five or six months.
A substantial amount of MML's metal purchases are from various sites that are owned by the Japanese company.
4. The truck weigh scales produce weigh tickets that can be attached to receivable and payable invoices. However, no numerical ticket sequence exists to account for all tickets that have been printed. Receiving records are handwritten in a loose-leaf book.
5. Approximately 15% of sales invoices have to be adjusted for weight discrepancies between what was shipped and what the customer claims to have received. On average, the reductions are approximately 20% of the invoice amount.
6. The perpetual inventory weight records appear to have been adjusted each year to whatever the physical inventory count indicated.
7. In recent years, the after-tax profits of MML have ranged between $1.2 and $3 million, after management bonuses.
8. MML maintains two vacation homes, one in Florida and one in Barbados. These homes are usually occupied by suppliers and customers of MML, free of charge.
9. Accounts receivable and inventory are pledged as security to MML's bank. In addition, the bank has a general security agreement against all other assets, and has limited personal guarantees from the shareholders.
10. Revenue is usually recognized on shipment of the metal. Adjustments for weight discrepancies are made as they become known to MML.
11. MML's management has been considering expansion because one competitor is nearing retirement and wants to sell his company. In recent years, MML has purchased from, and sold to, this competitor. MML has also borrowed inventory from and loaned inventory to this competitor.
12. Some purchases of scrap are acquired on a conditional basis. MML pays the supplier only after it has determined the quality of metal that the scrap yielded when processed.


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  • CreatedJune 08, 2015
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