Merry-Go-Round and Ernst and Young Lawsuit

Merry-Go-Round (MGR), a clothing retailer located primarily in shopping malls, was founded in 1968. By the early 1990's, the company had gone public, and had expanded to approximately 1,500 stores, 15,000 employees, and $1 billion in annual sales. The company'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 many challenges - one of its cofounders died and the other left to pursue unrelated business interests. The company faced stiff competition 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 its customer market. To try to regain its strong 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 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 from Ernst and Young (E&Y) to help overcome the financial crisis and develop a long-term business plan. However, the 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 9,000 creditors (including former employees and stockholders) began litigation against parties it 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 the 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.
- While store closings were key to MGR's survival, by 1995 only 230 of 1,434 stores had been closed and MGR still operated two stores in some malls.
- The turnaround team included inexperienced personnel?a retired consultant, a partner with little experience in the United States and with retail firms, and two recent college graduates.
- E&Y charged exorbitant hourly rates and charged unreasonable expenses (e.g., a dinner for three of the consultants in excess of $200).

E&Y denied any charges but, in April 1999 it agreed to pay $185 million to settle with the injured parties.

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?

Describe your reasoning for each recommendation.

b. Which MGR account has the highest likelihood of being misstated and 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?

In your answer, discuss the two types of fraud and include reasons why each type of fraud is or is not likely to be present for MGR. Which accounts are most susceptible to 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?