A member of the audit team of Ernst & Young in Canada became concerned about the accounting for inventory by its Canadian client, Sino-Forest, a Chinese company in the forestry business and headquartered in Ontario province. He sent an e-mail to the manager: How do we know the trees owned by the company? They could show us trees anywhere and we wouldnt know the difference. The manager answered, Yeah, its possible.

Background:

Sino-Forest owned and managed tree plantation as well as other manufacturing operations in China. Based in Mississauga, in Southern Toronto, Canada, and headquartered in Hong Kong with operations in mainland China, Sino-Forest was once the largest forestry firm listed in Canada, boasting a market valuation in excess of $6 billion. The company raised more than $3 billion from investors hoping to cash in on Chinas soaring economic growth through the timber sector. Sino-Forest share price imploded in 2011 when short-seller Carson Block and his form Muddy Waters LLC labeled the company a fraud in a research report, questioned the ownership of its forestry assets, and likened the company to a Ponzi scheme.

A Toronto Globe and Mail investigation raised serious questions about the companys operations and in March 2012, the company was granted court protection from its creditors under the Companys Creditors Arrangement Act. In May 2012, the Ontario Sec. Commission (OSC) filed a fraud allegations against the company and six of its long executive including the co-founder and former Chairman Allen Chan. The OSC alleged the company and some of its former executives were involved in a complexscheme to inflate the assets and revenue of Sino-Forest, made materially misleading statements, and falsified the evidence of ownership for the vast majority of its timber holdings by engaging in a deceitful documentation process. The scheme allegedly involved transactions between companies that Sino-Forest secretly controlled.

In an e-mailed statement at the time of the investigation, E&Y which was the companys auditor from 2007-2012, said it was confident it did its work in compliance with GAAS and met all professional standards. The evidence we will present to the OSC will show that E&Y Canada did extensive audit work to verify ownership and existence of Sino-Forests timber asset,

On Sep 30, 2012, E&Y admitted no wrongdoing in its audits of Sino-Forest Corp. but it did agree to pay an $8 million penalty to the Ontario Sec Com, cooperate with the investigation and change its internal policies on emerging markets. The OSC approved a $117 million settlement with E&Y in 2013 to resolve allegations that it performed negligent work. A separate settlement was reached with former Sino-Forest CFO David Horsley for $5.6 million.

On January 26, 2015, a group of big-name Bay street financial institutions that underwrote stock and debt issues for Sino-Forest agreed to pay $32.5 million to burned investors. In the settlement deal filed with the OSC, the underwriters made no admissions of liability and denied any liability in the plaintiffs claims. But the $32.5 million payment released them from needing to defend themselves in the class action.

Business in China:

The company case reveals that business is done in China through the informal agreements with state or party officials, who grant access to licenses, resources, and markets only if they are paid under the table. There can be no official records of these payments. Typically, auditors are not allowed to see bank accounts, and transactions are muddled by a proliferation of secret arrangements through authorized intermediaries.

The main job of foreign managers in China is not business per se but the cultivation and maintenance of personal relationship with officials. If they play this game well, they win- as did Sino-Forest prior to these embarrassing disclosures.

Sino-Forests earnings depend on how its management divides surpluses between the company and its Chinese patrons. If they become greedier and demand more generous payoffs, reported earnings suffer. In effect, confidential agreements and corruption determine earnings per share more than real business operations.

Companys annual report references the three key risk factors that an insider to Chinese business would understand, but outsiders would likely miss:

We rely on our relationship with local plantation land owners and/or plantation land use rights holders authorized intermediaries, key customers, suppliers, and third-party service providers.

We are heavily dependent on the expertise of our senior management and the relationships cultivated by them with our major customers and others. This concentration of authority creates risk in terms of measurement and completeness of transactions, which may lead to the possibility of inaccurate financial reporting.

Violations of PRC laws or regulation could result in civil and criminal penalties, including the revocation of licenses required for our business.

Cultural Issues:

Lawyers for executives of collapsed Sino-Forest, once a high flyer on the Toronto Stock Exchange, said their clients never committed fraud but followed common business practices accepted in China. To refute such claims, Hugh Craig and OSC lawyer said: It was a Canadian company, it raised money from Canadians in Canada. A culture of accountability must be recognized. But a lawyer for Allen Chan, as well as legal representative for four other, was quoted as saying Canadian regulators made the mistake of looking through a North American lens when interpreting Sino-Forest timber ownership and sales contract in China. These events did not take place on Bay Street or even rural Ontario. Emily Cole, a lawyer for Mr. Chan, told a three-member panel of OSC commission. The panel should not draw conclusions about them as if they did.

Cole explained that her witness, Dr. Randall Peerenboom, an American who had lived in China for more than 20 years, would explain how business practices viewed as surprising, if not shocking, to Canadian regulators were the only way to do business in China where money could not be exchanged freely and local bank accounts were impossible to get. She claimed the OSCs fraud accusations centered in part on Companys practice of buying and selling timber assets without any cash passing through the company. Purchasers bypassed the company entirely by paying Sino-Forests suppliers. Cole explained that the accusation presupposed they could have sent money to Sino-Forest, but that wasnt possible. Keep an open mind about these differences in business and culture. She urged the OSC panel.

During the trial, Markus Koehnen, who was representing former senior Sino-Forest executives Alfred Hung, Albert Ip, George Ho and Simon Yeung, spent more than two hours walking the panel through such concepts at guanxi or relationship building. He said understanding the key component of Chinese business that goes well beyond networking would clear up concern over declaring revenue based on agreements made in farmers field, and the perceived impropriety of a series of close business connections between Sino-Forest and key customers and suppliers. The OSC had alleged that Sino-Forests top executives hid these relationships that helped perpetrate the fraud and included the fabrication of asset and revenue.

Charges against E&Y

The OSC alleged that E&Y failed to properly understand the legal basis of Sino-Forests claim to its assets and relied on an opinion prepared by the forestry companys legal firm Jingtian and Gongchen Attorneys at Law. The OSC also accused EY of inappropriately relying on the valuation work of Poyry Forest Industry, Ltd., a company hired by Sino-Forest to prepare periodic valuation of its timber holdings.

The OSC alleged that EY failed to adequately review or question documentation related to Sino-Forests ownership of standing timber reserves the company held in China. The purported assets constituted the vast majority of Sino-Forests assets and produced nearly all of its reported revenue. E&Ys lack of diligence in these areas therefore resulted in significant negative consequences for Sino-Forests shareholders.

The OSC stated it had found significant evidences that the firm did not go far enough to prove that Sino-Forests stated timber holding exist, pointing out the E&Y never obtained two key elements of the companys purchase contracts: the villagers letter of authorization and the certificate of forest proprietorship. The precise location of the forestry assets was also not described in the purchase contracts. Both of these deficiencies should have prompted E&Y to make further enquiries of Sino-Forest management and to perform further audit procedures.

In its statement of allegation, the OSC alleged that E&Y failed to verify the ownership and existence of Sino-Forests most significant forestry assets. The OSC said that the specific location of purchased assets was not delineated in purchase contracts, which should have raised questions by auditors. And the commission said EY did very limited site visits to inspect the firms purported assets, which were widely scattered throughout China. The regulator said an internal email between members of E&Ys audit team shows staff were asking questions about site visits, which were done along with third-party forestry consultants Poyry Forest Interest Ltd., hired by Sino-Forest.

OSC enforcement director Tom Atkinson said that If auditors fail to abide by Canadian auditing standards and securities laws, we will hold them accountable. Class action lawyer Dimitri Lascaris who had represented Sino-Forests shareholders said he believed audit firms would now exercise a higher degree of professional skepticism going forward. Any time you are confronting circumstances of this nature and a liability of this magnitude, you are going to have a very powerful economic incentive to be very careful.

The OSC maintained the company did not show enough professional skepticism in conducting its audits. OSC lawyer told the settlement hearing that the accounting firm overlooked flaws in its clients accounting and did not conduct proper reviews. But she also said there is no evidence of dishonest conduct by the accounting firm. The OSC also expressed a concern about the audit team itself. It noted that several of the senior EY partners involved in the Sino-Forest audits did not speak Chinese, and the firm did not translate many of the key Sino-Forest documents into English.

E&Y s lawyer told the hearing that the honesty and integrity of E&Y and its people were never in question. She said the settlement avoids the time, expense, and uncertainty of what would have been lengthy hearings.

In addition to the financial payment, E&Y told the OSC that it put in place new policies for auditing companies that have significant operations in emerging markets, and it had done a focused assessment of audits on companies based in China.

Lascaris said the E&Y settlement reinforces his argument that individuals or organizations are not motivated to sign no-contest settlements because of a concern over follow-up civil suits. The real motivation for no contest settlements is that firms and individuals want to protect their reputations, and their ability to generate new business.

Overall, the settlement should send a message to E&Y, and other capital markets participants, that audits need to be conducted with proper levels of diligence. OSC vice-chairman James Turner, who approved the settlement, said it underlines the vital gate keeping role that auditors play, and that auditors need to show sufficient scrutiny, skepticism, and diligence.

This is a wake-up call for the audit profession. Said forensic accountant Charles Smedmor, who teaches accounting at Toronto Seneca College. It underlines the need to drill down to get sufficient appropriate audit evidence to support audit opinions.

Questions:

1.Should operational and cultural considerations play a role in determining whether Sino-Forest committed a fraud? Explain

2.Did Sino-Forest manage earnings?

3.Critically evaluate the audit work of E&Y from the perspective of GAAS and professional ethics. Was this a failed audit?