Background Metal Masters Limited (MML) is a producer of highly specialised sheet-metal products that include furnace duct work, sheet-metal roofing, and custom sheet-metal designs for industrial and residential use. The custom designs and the metal forming machines are all proprietary items (that is, patented and owned by the company) and are franchised to various heating and metalworking contractors in the country. The company provides the instructions and training for the designs and machines for all franchisees/contractors, who have to sign a secrecy clause prohibiting them to sell or distribute any designs or equipment to anyone. The company also provides warranty protection to the customers on behalf of the contractors and maintains complete inspection rights on all jobs to ensure acceptable quality. Personnel Ken Smart and Bob Horn, the current CEO, formed a partnership in the 1990s. Five years later, it was incorporated with each partner acquiring a 50 percent ownership of the shares. At that time, a buy/sell agreement was set up stating that on the death of either owner, a third-party arbitrator, by mutual agreement between the parties concerned, would be used to value the deceased owners share of the business to activate the agreement. It had been agreed within the Smart family that the company would acquire Ken Smarts shares on his death from his widow, if she was still alive. Otherwise the shares would go to his son, Peter. Peter, Kens son, joined the company in 2009 after graduating with an engineering degree and an M.B.A. He is in charge of the production and finance of the business. Trained as a materials engineer, he has helped to develop some of the new products that the company has incorporated into its product line. He has also excelled himself in settling the warranty problems. At a recent engineering conference, Peter was introduced to the total quality management concept and he is keen to learn more about it so that it could be implemented in the company. Janet Brown joined the company in 2015 as Director of Marketing. A graduate in engineering, she had extensive background in metal products acquired at a major steel manufacturer. She also had very good marketing skills. At the time when Janet joined the company, many marketing staff refused to work for a woman. Janet was able to manage the situation over the years. Such prejudice is now rare in the company as her knowledge and work ethic have earned her the respect of both senior staff and staff working on the production lines. A number of employees had been with the company from the beginning, for example, the shop supervisor, Jim Jones, and several others who have been there for over 10 years. Both Ken and Bob had complete trust in their judgement. Senior management listen to staff grievances and treat them fairly. Compensation and benefits are well above the normal levels for the industry. An unforeseeable event At the untimely death of Ken in 2019, the business valuator valued his shares at $1.1 million, and the company had to decide how to finance the purchase from the widow. The remaining owner, Bob Horn, also had to decide, along with the rest of the management, namely, Peter Smart and Janet Brown, who should then acquire the shares and in what proportions. The result was that both Peter and Janet bought some of the shares, and Bob sold some of his shares so that the final ownership proportions were as follows: Bob 45%, Janet 30%, and Peter 25%. 110.303 Assignment 2 (Semester 2, 2020) 4 Both Janet and Peter mortgaged their houses to purchase their shares; the balance of their required financing was supplied by the company as Loans for Share Purchases ($900,000), at reasonable interest rates with a 10-year repayment period. Bob had agreed to reduce his ownership percentage so that at least two owners of the three would have to vote together to obtain the majority. He believed that consensus was the rule in management decision-making and the new business structure would give his two management colleagues a substantial interest in the company. When the financing of the share purchases was finalised, Bob advanced part of the money as an increase in the Loan from Shareholders, and the bank supplied the rest as Long-Term Debt. Products Sheet-metal products are generally very low technology products. MML has, however, developed some unique processing devices and machinery that are patented by the company and its owners. All of Kens patent rights had been transferred to the company as part of the sale of his shares by his widow. At the time when Ken and Bob began to franchise the processes to expand, they discovered that their own ability to sell the products was limited. They decided to solicit contractors as franchise dealers and the market for the processes and products expanded. MML maintains quality control over installations aiming at a zero-defect approach. It provides warranty protection for all customers whether serviced by franchise contractors or by the company itself. Quality control and Warranties Quality control activities consists of periodic inspections during and upon completion of each job, as well as regular inspections of equipment in the hands of franchisees to ensure that it is in proper operating condition. Employees of MML make all inspections: checking each job site at least twice during the metalwork phrase and inspecting equipment at least twice a year. Repairs and maintenance are immediately undertaken as needed. Charges for inspections, repairs and maintenance are automatic and contractors pay these fees for each job directly to MML. The warranty fees, income from company jobs, and repair and maintenance charges for franchised equipment have made the company a very profitable operation. Most sheet-metal installations could be repaired if the work is done reasonably carefully, but occasionally the jobs would have to be completely replaced, which is extremely expensive. In the last year, three separate replacements had been made under warranty; only one had ever been made before in the entire history of the company, back in 2016 when the processes were just being developed. Warranty costs are charged against the revenues from inspections and warranty fees, for management purposes, but the annual financial statements do not show them that way. They are included in the administrative costs in the statements. Production and Operations The skills required to manufacture the products and operate the machinery are learned from apprenticeship and training. There is no high technology involved, but the workers have to be able to read and interpret blueprints, and to follow written instructions. The main skill required is to do careful and accurate work, in addition to possessing the attributes of patience and persistence to learn the necessary skills. A few relatively talented workers, and Jim, the shop supervisor, considered to be the best in the company, teach both the trainees and the franchise dealers. Anyone who take the training programme has to meet certain minimum standards to pass. Successful trainees are subject to frequent and detailed inspections for the first six months. Unsuccessful trainees are given an additional six months in addition to taking a refresher course in any obvious problem area. Until 2019, this process had always been successful in weeding out the incompetent workers or the marginal dealers. In 2020, the company is required to pay huge warranty claims. The franchise dealer that had cost the company so much had not appeared to be a threat because his people had passed the training with ease (96% success rate). The big surprise occurred when two other jobs of the same franchisee turned out to 110.303 Assignment 2 (Semester 2, 2020) 5 have serious warranty problems that showed up in the final inspection. In addition, the owner of the franchise suddenly disappeared overseas without a trace, with about $750,000 of payments for these and other jobs. Through subsequent investigation by Peter, the man had a record of fraud and other commercial crimes that had escaped cursory scrutiny. MML was advised by its lawyers to settle the warranty claims, fix all damages, and complete all work, in addition to paying penalties to the three customers for delays and inconvenience so that further legal action could be avoided. Financial Information Exhibits 1 and 2 contain extracts of audited financial statements for the last five fiscal years (ending 31 March). It is evident that the firm has been very profitable up until 2020. Note that the 2020 financial statements have a special warranty charge regarding the settlement of a number of outstanding claims. The financial adjustments in 2020 settled a number of pending legal actions and provided repair and replacements for all known product liability situations. In the past, warranty claims have been handled as administrative expenses, as noted earlier. The special expense of 2020 did not indicate the intention to change to a new accounting procedure, but rather it was a settlement of all legal and warranty claims from all prior years. New warranty claims in 2020 were handled as they had been in the past. MML management have scheduled a meeting to discuss some key issues before a subsequent meeting with the company auditors.

REQUIRED: In preparation for the upcoming meetings, Peter Smart has approached you, a former M.B.A. classmate and a successful business consultant, to give him an independent appraisal of Metal Masters Limited. You will prepare a report for the management team identifying and analysing some of the financial and nonfinancial issues of the company as follows: (a) Quality control problems;

(b) Accounting for warranty claims;

(c) The debt burden and ramifications;

(d) Potential auditing issues; and

(e) Other miscellaneous issues.

Exhibit 2 METAL MASTERS LIMITED Statement of Financial Position For the fiscal years ending March 31 (in dollars) 2020 2019 2018 2017 2016 39,400 836,900 376 761,335 168 369,955 (33,560) 331,835 668,398 95 190,700 (16,575) 320,770 494,990 53 299,860 (129,510) 221,235 391,638 649,210 1,525,510 429,915 1,191,626 ASSETS Current Assets Cash Accounts Receivable Bad Debt Reserve Inventory Total Current Assets Fixed Assets Plant and Equipment Accumulated Depreciation Net Fixed Assets Loans for Share Purchases Total Assets 1,989,888 (754,340) 1,235,548 900,000 3,661,058 1,732,968 (489,330) 1,243,638 1,656,555 (214,333) 1,442,222 1,569,245 (214,333) 1,354,912 1,563,208 (238,650) 1,324,558 2,435,264 2,110,620 1,849,902 1,716,196 315,480 20,750 117,350 453,580 68,445 188,585 27,050 111,290 395,370 (13,900) 137,720 14,300 144,090 282,210 128,475 124,390 9,940 141,220 404,025 99,525 110,425 5,465 159,050 374,465 LIABILITIES AND EQUITY Current Liabilities Bank Loans Accounts Payable Accruals Current Portion of Long Term Debt Total Current Liabilities Long-term Liabilities Long Term Debt Loans from Shareholders Total Deferred Liabilities EQUITY Share Capital Retained Earnings Total Equity Total Liabilities and Equity 1,543,203 1,353,503 2,896,706 919,225 434,195 1,353,420 1,013,860 461,635 1,475,495 1,086,420 507,075 1,593,495 742,625 947,955 1,690,580 10,000 300,772 310,772 3.661,058 10,000 676,474 686,474 2,435,264 10,000 342.915 352,915 2,110,620 10,000 (157.618) (147,618) 1,849,902 10,000 (358,849) (348,849) 1,716,196 Exhibit 1 METAL MASTERS LIMITED Statement of Financial Performance For the fiscal years ending March 31 (in dollars) 2020 2019 2018 2017 2016 3,796,837 2,166,810 1,630,027 2,921,830 1,563,872 1,357,958 2,219,306 1,102,798 1,116,508 1,583,034 748,864 834,170 1,573,746 744.330 829,416 SALES Cost of Goods Sold Gross Margin EXPENSES Selling Expenses Administration Expenses Financial Expenses Warranty Expenses Total Expenses 282,886 659,792 155,163 907,888 2,005,729 160.286 686,355 148,213 103,738 256,941 218,694 86,645 324,197 209,229 80,101 327,725 225,858 994,854 579,373 620,071 633,684 (375,702) 195.732 Profit before Taxes Taxes Paid Net surplus added to retain Earnings 363,104 29,545 333,559 537,135 36,602 500,533 214,099 12,868 201,231 (375,702) 195,732 Exhibit 2 METAL MASTERS LIMITED Statement of Financial Position For the fiscal years ending March 31 (in dollars) 2020 2019 2018 2017 2016 39,400 836,900 376 761,335 168 369,955 (33,560) 331,835 668,398 95 190,700 (16,575) 320,770 494,990 53 299,860 (129,510) 221,235 391,638 649,210 1,525,510 429,915 1,191,626 ASSETS Current Assets Cash Accounts Receivable Bad Debt Reserve Inventory Total Current Assets Fixed Assets Plant and Equipment Accumulated Depreciation Net Fixed Assets Loans for Share Purchases Total Assets 1,989,888 (754,340) 1,235,548 900,000 3,661,058 1,732,968 (489,330) 1,243,638 1,656,555 (214,333) 1,442,222 1,569,245 (214,333) 1,354,912 1,563,208 (238,650) 1,324,558 2,435,264 2,110,620 1,849,902 1,716,196 315,480 20,750 117,350 453,580 68,445 188,585 27,050 111,290 395,370 (13,900) 137,720 14,300 144,090 282,210 128,475 124,390 9,940 141,220 404,025 99,525 110,425 5,465 159,050 374,465 LIABILITIES AND EQUITY Current Liabilities Bank Loans Accounts Payable Accruals Current Portion of Long Term Debt Total Current Liabilities Long-term Liabilities Long Term Debt Loans from Shareholders Total Deferred Liabilities EQUITY Share Capital Retained Earnings Total Equity Total Liabilities and Equity 1,543,203 1,353,503 2,896,706 919,225 434,195 1,353,420 1,013,860 461,635 1,475,495 1,086,420 507,075 1,593,495 742,625 947,955 1,690,580 10,000 300,772 310,772 3.661,058 10,000 676,474 686,474 2,435,264 10,000 342.915 352,915 2,110,620 10,000 (157.618) (147,618) 1,849,902 10,000 (358,849) (348,849) 1,716,196 Exhibit 1 METAL MASTERS LIMITED Statement of Financial Performance For the fiscal years ending March 31 (in dollars) 2020 2019 2018 2017 2016 3,796,837 2,166,810 1,630,027 2,921,830 1,563,872 1,357,958 2,219,306 1,102,798 1,116,508 1,583,034 748,864 834,170 1,573,746 744.330 829,416 SALES Cost of Goods Sold Gross Margin EXPENSES Selling Expenses Administration Expenses Financial Expenses Warranty Expenses Total Expenses 282,886 659,792 155,163 907,888 2,005,729 160.286 686,355 148,213 103,738 256,941 218,694 86,645 324,197 209,229 80,101 327,725 225,858 994,854 579,373 620,071 633,684 (375,702) 195.732 Profit before Taxes Taxes Paid Net surplus added to retain Earnings 363,104 29,545 333,559 537,135 36,602 500,533 214,099 12,868 201,231 (375,702) 195,732