Question

A member of the audit team of Ernst & Young in Canada becameconcerned about the accounting for inventory by its Canadianclient, Sino-Forest, a Chinese company in the forestry business andheadquartered in Ontario province. He sent an e-mail to themanager: “ How do we know the trees owned by the company? Theycould show us trees anywhere and we wouldn’t know the difference.”The manager answered, “ Yeah, it’s possible.”

Background:

Sino-Forest owned and managed tree plantationas well as other manufacturing operations in China. Based inMississauga, in Southern Toronto, Canada, and headquartered in HongKong with operations in mainland China, Sino-Forest was once thelargest forestry firm listed in Canada, boasting a market valuationin excess of $6 billion. The company raised more than $3 billionfrom investors hoping to cash in on China’s soaring economic growththrough the timber sector. Sino-Forest share price imploded in 2011when short-seller Carson Block and his form Muddy Waters LLClabeled the company a fraud in a research report, questioned theownership of its forestry assets, and likened the company to aPonzi scheme.

A Toronto Globe and Mail investigation raised serious questionsabout the company’s operations and in March 2012, the company wasgranted court protection from its creditors under the Company’sCreditors Arrangement Act. In May 2012, the Ontario Sec. Commission(OSC) filed a fraud allegations against the company and six of itslong executive including the co-founder and former Chairman AllenChan. The OSC alleged the company and some of its former executiveswere involved in a “complex…scheme to inflate the assets andrevenue of Sino-Forest,” made “materially misleading statements,”and falsified the evidence of ownership for the vast majority ofits timber holdings by engaging in a deceitful documentationprocess.” The scheme allegedly involved transactions betweencompanies that Sino-Forest secretly controlled.

In an e-mailed statement at the time of the investigation,E&Y which was the company’s auditor from 2007-2012, said it wasconfident it did its work in compliance with GAAS and met allprofessional standards. “The evidence we will present to the OSCwill show that E&Y Canada did extensive audit work to verifyownership and existence of Sino-Forest’s timber asset,”

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

On January 26, 2015, a group of big-name Bay street financialinstitutions that underwrote stock and debt issues for Sino-Forestagreed to pay $32.5 million to burned investors. In the settlementdeal filed with the OSC, the underwriters made no admissions ofliability and denied any liability in the plaintiff’s claims. Butthe $32.5 million payment released them from needing to defendthemselves in the class action.

Business in China:

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

The main job of foreign managers in China is not business per sebut the cultivation and maintenance of personal relationship withofficials. If they play this game well, they win- as didSino-Forest prior to these embarrassing disclosures.

Sino-Forest’s earnings depend on how its management dividessurpluses between the company and its Chinese patrons. If theybecome greedier and demand more generous payoffs, reported earningssuffer. In effect, confidential agreements and corruption determineearnings per share more than real business operations.

Company’s annual report references the three key risk factorsthat an insider to Chinese business would understand, but outsiderswould likely miss:

We rely on our relationship with local plantation land ownersand/or plantation land use rights holders authorizedintermediaries, key customers, suppliers, and third-party serviceproviders.

We are heavily dependent on the expertise of our seniormanagement and the relationships cultivated by them with our majorcustomers and others. This concentration of authority creates riskin terms of measurement and completeness of transactions, which maylead to the possibility of inaccurate financial reporting.

Violations of PRC laws or regulation could result in civil andcriminal penalties, including the revocation of licenses requiredfor our business.

Cultural Issues:

Lawyers for executives of collapsed Sino-Forest, once a highflyer on the Toronto Stock Exchange, said their clients nevercommitted fraud but followed common business practices accepted inChina. To refute such claims, Hugh Craig and OSC lawyer said: “Itwas a Canadian company, it raised money from Canadians in Canada. Aculture of accountability must be recognized.” But a lawyer forAllen Chan, as well as legal representative for four other, wasquoted as saying Canadian regulators made the mistake of lookingthrough “a North American lens” when interpreting Sino-Foresttimber ownership and sales contract in China. “These events did nottake place on Bay Street or even rural Ontario.” Emily Cole, alawyer for Mr. Chan, told a three-member panel of OSC commission.“The panel should not draw conclusions about them as if theydid.”

Cole explained that her witness, Dr. Randall Peerenboom, anAmerican who had lived in China for more than 20 years, wouldexplain how business practices viewed as surprising, if notshocking, to Canadian regulators were the only way to do businessin China where money could not be exchanged freely and local bankaccounts were impossible to get. She claimed the OSC’s fraudaccusations centered in part on Company’s practice of buying andselling timber assets without any cash passing through the company.Purchasers bypassed the company entirely by paying Sino-Forest’ssuppliers. Cole explained that the accusation presupposed theycould have sent money to Sino-Forest, but that wasn’t 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 formersenior Sino-Forest executives Alfred Hung, Albert Ip, George Ho andSimon Yeung, spent more than two hours walking the panel throughsuch concepts at guanxi or relationship building. He saidunderstanding the key component of Chinese business that goes wellbeyond networking would clear up concern over declaring revenuebased on agreements made in farmer’s field, and the perceivedimpropriety of a series of close business connections betweenSino-Forest and key customers and suppliers. The OSC had allegedthat Sino-Forest’s top executives hid these relationships thathelped perpetrate the fraud and included the fabrication of assetand revenue.

Charges against E&Y

The OSC alleged that E&Y failed to properly understand thelegal basis of Sino-Forest’s claim to its assets and relied on anopinion prepared by the forestry company’s legal firm Jingtian andGongchen Attorneys at Law. The OSC also accused EY ofinappropriately relying on the valuation work of Poyry ForestIndustry, Ltd., a company hired by Sino-Forest to prepare periodicvaluation of its timber holdings.

The OSC alleged that EY failed to adequately review or questiondocumentation related to Sino-Forest’s ownership of standing timberreserves the company held in China. The purported assetsconstituted the vast majority of Sino-Forests assets and producednearly all of its reported revenue.” “E&Y’s lack of diligencein these areas therefore resulted in significant negativeconsequences for Sino-Forest’s shareholders.”

The OSC stated it had found significant evidences that the firmdid not go far enough to prove that Sino-Forest’s stated timberholding exist, pointing out the E&Y never obtained two keyelements of the company’s purchase contracts: the villager’s letterof authorization and the certificate of forest proprietorship. Theprecise location of the forestry assets was also not described inthe purchase contracts. “Both of these deficiencies should haveprompted E&Y to make further enquiries of Sino-Forestmanagement and to perform further audit procedures.”

In its statement of allegation, the OSC alleged that E&Yfailed to verify the ownership and existence of Sino-Forest’s mostsignificant forestry assets. The OSC said that the specificlocation of purchased assets was not delineated in purchasecontracts, which should have raised questions by auditors. And thecommission said EY did “very limited” site visits to inspect thefirm’s purported assets, which were widely scattered throughoutChina. The regulator said an internal email between members ofE&Y’s audit team shows staff were asking questions about sitevisits, which were done along with third-party forestry consultantsPoyry Forest Interest Ltd., hired by Sino-Forest.

OSC enforcement director Tom Atkinson said that “If auditorsfail to abide by Canadian auditing standards and securities laws,we will hold them accountable.” Class action lawyer DimitriLascaris who had represented Sino-Forest’s shareholders said hebelieved audit firms would now “exercise a higher degree ofprofessional skepticism going forward.” “Any time you areconfronting circumstances of this nature and a liability of thismagnitude, you are going to have a very powerful economic incentiveto be very careful.”

The OSC maintained the company did not show enough “professionalskepticism” in conducting its audits. OSC lawyer told thesettlement hearing that the accounting firm overlooked flaws in itsclients’ accounting and did not conduct proper reviews. But shealso said there is no evidence of “dishonest” conduct by theaccounting firm. The OSC also expressed a concern about the auditteam itself. It noted that several of the senior EY partnersinvolved in the Sino-Forest audits did not speak Chinese, and thefirm did not translate many of the key Sino-Forest documents intoEnglish.

E&Y ‘s lawyer told the hearing that the “honesty andintegrity of E&Y and its people were never in question.” Shesaid the settlement avoids the time, expense, and uncertainty ofwhat would have been lengthy hearings.

In addition to the financial payment, E&Y told the OSC thatit put in place new policies for auditing companies that havesignificant 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 argumentthat individuals or organizations are not motivated to signno-contest settlements because of a concern over follow-up civilsuits. The real motivation for no contest settlements is that firmsand individuals want to protect their reputations, and theirability to generate new business.

Overall, the settlement should send a message to E&Y, andother capital markets participants, that audits need to beconducted with proper levels of diligence. OSC vice-chairman JamesTurner, who approved the settlement, said it underlines the vital“gate keeping” role that auditors play, and that auditors need toshow sufficient scrutiny, skepticism, and diligence.

“This is a wake-up call for the audit profession.” Said forensicaccountant Charles Smedmor, who teaches accounting at TorontoSeneca College. “It underlines the need to drill down to getsufficient appropriate audit evidence to support auditopinions.”

Questions:

1.Should operational and culturalconsiderations play a role in determining whether Sino-Forestcommitted a fraud? Explain

2.Did Sino-Forest manageearnings?

3.Critically evaluate the audit work ofE&Y from the perspective of GAAS and professional ethics. Wasthis a failed audit?