Sunshine Mines Ltd. (SML) is a small public company in the process of developing a gold mine in the Canadian North. It has already staked a claim on a highly promising find and has conducted all the preliminary exploratory drilling. SML is now looking for funds to finance the approximately three years of preproduction mine devel¬ opment costs. SML had originally planned to raise these additional funds through the usual combination of long¬ term debt and short-term bank loans. However, a private investment house has approached the company with an offer of a "gold loan" to finance a portion of SML's requirements.

The investment house has a large inventory of gold that it is holding on its own account. The investment house expects gold to rise significantly in value over the next decade, so it does not want to sell its gold inventory and invest the proceeds. However, as long as the gold is held in commodity form, it earns no interest. Accordingly, the investment house is proposing to lend 100,000 ounces of gold to SML. The "interest rate" on the loan would be lower than the rate on a cash loan: about two-thirds of the cash interest rate. How¬ ever, the interest would be payable in additional ounces of gold — not in currency — once SML reaches the production stage. SML's gold mining claims would be held as security for the loan. In this manner, the investment house would earn "interest" while still maintaining a gold investment, and SML would obtain some of the funds it needs for development simply by selling the original 100,000 ounces of gold.

Because of the unique nature of the proposed loan and the risks involved, the investment house is especially concerned about the possibility of SML defaulting on its payments. If SML's gold reserves are much smaller than projected, then production may never be sufficient to repay the loan. Accordingly, the investment house has asked your firm, Rousseau & Locke, Public Accountants, SML's auditors, to provide it with a special report or some kind of "gold flow" forecast to evaluate SML's ability to repay its loan. The partner assigned to the SML engagement has asked you to write a memo to him, recommending a reporting alternative that will satisfy the investment house and discussing issues that may arise in preparing the report.

Furthermore, the vice-president of finance is also concerned about the audit implications for the coming year's audit.

Required Prepare the memo requested by the partner, and address the concerns of the vice-president of finance.

(CICA adapted)