Merry-Go-Round (MGR), a clothing retailer located primarily in shopping malls, was founded in 1968. By the early 1990s, the company had gone public and had expended to approximately, 1500 stores, 150,000 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 if the top 25 companies in the late 1980s. However, in the early 1990s, the company faced many challenges. One of its co-founders died, and the other left to pursue unrelated business interests. The company faced stiff competition from the other retailers (e.g. Gap and Banana Republic), fashion trends changed and mall traffic declined. Sales fell, and experts speculated that MGR failed to anticipate the 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 co-founders to manager the company 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 evidence of its newly hired law firm Swidler and Berlin, hired turnoaround specialists from Ernst & Young (EY) to help overcome the financial crisis and develop a long-term business plan. However, the company's decline continued, and it filled Chapter 10 reorganization in 1994. In 1996, the remaining assets were sold for pennies 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 EY, which the creditor sued for $4 billion in punitive and compensatory damages (EY's fees from MGR totalled $4.5 million).

The lawsuit alleged that EY'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 USA and with retail firms, and two recent college graduates.

EY charged exorbitant hourly rates and charged unreasonable expenses (e.g. charges included reimbursement for a dinner for three of the consultants totalling excess of $200).

EY declined any wrongdoing, but in April 1999 agreed to pay $185 million to settle the injured parties.

EY gad a close relationship with Rouse Co., one of MGR's primary landlords (EY was soliciting business from Rouse and provided significant tax services).

Swidler (the law firm that recommended EY to MGR) and EY had participated in at least 12 different business arrangements, some of which resulted in Swidler receiving significant fees from EY.

EY did not disclose either of these relationships to MGR.

Required

a) Consider whether there should be specific professional standards for independent auditors who consult. Given that non-auditors who consult do not have formal professional standards to adhere to, describe the advantages and disadvantages that result from having such standards.

(25 marks)

b) Do you think that EY acted unethically given it had these relationship?

(10 marks)

c) How could these relationship have affected EY's advice to MGR? In other words, refer to the charges above and speculate as to whether any of the charges against EY may have stemmed from the relationships described above.

(15 marks)