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Merry-Go-Round (MGR) Reorganization

Merry-Go-Round (MGR), a clothing retiler located primarily in shopping mall,was founded in 1968. By the early 1990's the company hd gone public, and had expanded to approcimately 1500 stores, 15000 employess and $1 billion in annual sales. The compan's locations in malls targeted the youth and teen market. The company was listed by Forbes magazine as one of the top 25 companies in the late 1980's. However, in the early 1990's, the company faced stiff competitiion from other retailers (e.g/. The Gap and Banana Republic), fashion trends changed, and mall traffic declined. Sales fell and experts speculated that MGR failed to anticipate key industry trends and lost sight of it customer market. To try to regain its stron position, the company acquired Chess King, Inc., a struggling chain of men's clothing stores located in malls, in 1993.

The company's sales continued to fall and, later in 1993, it brought back and, later in 1993, it brough back one of its cofounders and wrote down a significant amount of inventory. However, this inventory write-down caused the company to violate loan covenants. Facing bankruptcy, the company, based on the advice of its newly hired law firm Swidler and Berlin, hired turnaround specialists form Ernst and Young (E&Y) to help overcome the financial crisis and develop a long-term business plan. However, teh company's decline continued and it filed for Chapter 11 reorganization in 1994. In 1996, the remaining assets were sold for cents on the dollar.

Subsequently, a group of 9000 creditors ( including former employees and stockholers) began litigation against parties if deemed responsible for their losses. These parties included E&Y, who the creditors sued for $4 billion in punitive and compensatory damages (E&Y's fees totaled $4.5 million).
The lawsuit alleged that E&Y's incompetence was the main cause of MGR's decline and demise. The lawsuit alleged in part that:
The turnaround team did not act fast enough
The leader of the team took an eight-day vacation at a critical point during engagement.
The cost-cutting strategy called for only $11 million in annual savings, despite the fact that the company was projected to lose up to $200 million in 1994.

Assume that you are MGR's auditor for the year ended December 31, 1995. Consider who is likely to be using MGR's financial statements and why they are using them.

Required:
a) Would you recommend setting materiality and audit risk relatively high or low?
Decribe your reasoning for each recommendation.

b) Which MGR account has the highest likelihood of being misstated?
Why?
Is your answer based on factors that are related more closely to inherent risk or control risk?

c) What is the risk that MGR's financial statements are misstated because of fraud?

d) Is engagement risk high or low for the 12/31/95 audit? Why?

e) Is the client's business risk high or low for the 12/31/95 audit? Why?

Solution Preview

Required:
a) Would you recommend setting materiality and audit risk relatively high or low?
The materiality would be low and so the audit risk would be high. The reason is that there might be several misstatements in the accounts of Merry-Go-Round (MGR) as it has been It is necessary to keep materiality low because several creditors are employees who have not got their dues and stockholders who had invested their hard earned money in good faith. Since, every transaction matters it is important to keep materiality low. This means that the audit risk will be high.

b) Which MGR account has the highest likelihood of being misstated? Why?
The fixed asset account of Merry-Go-Round (MGR) is most likely to be misstated. The purpose is to create an impression that the claims of the creditors are secured by assets and that the company should be granted Chapter ...

Solution Summary

This solution discusses audit risk as it relates to materiality and control risk for certain accounts. It also discusses elements of engagement risk and business risk. This solution is 489 words.

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