OSC cracks down on Sino-Forest auditors

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Accounting firm Ernst & Young LLP has been accused by regulators of failing to properly scrutinize the books of failed forestry company Sino-Forest Corp., marking a rare case of auditors facing allegations of wrongdoing by the Ontario Securities Commission.

The case was announced Monday just as lawyers for Sino-Forest's shareholders were also revealing they had reached a record $117-million settlement with E&Y late last week. The settlement is the largest class-action lawsuit payment by an audit firm in Canadian history.

Both developments are expected to have a broad impact on the work of auditors, especially those working for companies like Sino-Forest who trade on Canadian stock exchanges but have all their operations based in another country.

"This is a wake-up call for the audit profession," said forensic accountant Charles Smedmor, who teaches accounting at Toronto's Seneca College.

"It underlines the need to drill down to get sufficient appropriate audit evidence to support audit opinions," Mr. Smedmor said.

The OSC alleged that E&Y failed to adequately review or question documentation related to Sino-Forest's ownership of standing timber reserves the company held in China.

"The purported assets constituted the vast majority of Sino-Forest's assets and produced nearly all of its reported revenue," the OSC said in its statement of allegations. "Ernst & Young's lack of diligence in these areas therefore resulted in significant negative consequences for Sino-Forest's shareholders."

Based in Mississauga 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. Between 2003 and 2010, the company raised more than $3-billion from investors hoping to cash in on China's soaring economic growth through the timber sector. However, Sino-Forest's share price imploded in 2011 when short-seller Carson Block and his firm Muddy Waters LLC labelled the company a fraud in a research report, questioned the ownership of its forestry assets and likened the company to a Ponzi scheme.

A Globe and Mail investigation also raised serious questions about the company's operations, and in March, 2012, Sino-Forest was granted court protection from its creditors under the Companies' Creditors Arrangement Act. In May, the Ontario Securities Commission filed fraud allegations against the company and six of its top executives including co-founder and former chairman and chief executive officer Allen Chan. That case has not yet proceeded to a hearing. The commission said at the time that its investigation was continuing into the work of so-called "gatekeepers" who helped the company list its shares for sale in Canada, including auditors and underwriters.

The OSC said Monday it does not expect to level allegations against others, however. "The investigation into this matter is ongoing," said OSC spokeswoman Carolyn Shaw-Rimmington. "However, at this stage and based on the evidence presently available, we do not anticipate initiating proceedings against additional parties."

In an e-mailed statement, E&Y, which was Sino-Forest's auditor from 2007 to 2012, said it is confident it did its work in compliance with generally accepted auditing standards and met all professional standards. "The evidence we will present to the OSC will show that Ernst & Young Canada did extensive audit work to verify ownership and existence of Sino-Forest's timber assets," the statement said. The company declined an interview request.

In its statement of allegations, the OSC alleged that E&Y failed to verify the ownership and existence of Sino-Forest's most significant forestry assets. The OSC said the specific location of purchased assets was not delineated in purchase contracts, which should have raised questions by auditors. And the commission said E&Y did "very limited" site visits to inspect the firm's purported assets, which were widely scattered throughout China.

The regulator said an internal e-mail between members of E&Y's 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.

According to the OSC, one member of the audit team asked in an e-mail, "how do we know that the trees that Poyry is inspecting (where we attend) are actually trees owned by the company? E.g. could they show us trees anywhere and we would not know the difference?"

The OSC alleges another auditor replied: "I believe they could show us trees anywhere and we would not know the difference."

The OSC has only twice before accused an audit firm of improper work on a case, and E&Y's audit of Sino-Forest is the highest profile to date.

One previous case in 2005 involved accounting firm Miller Bernstein & Partners LLP, which was accused of inadequate work on the audit of Buckingham Securities Corp. A second case in 1988 involved then-named Price Waterhouse, which was accused of failing to adequately audit the 1987 financial statements of National Business Systems Inc., whose $14.2-million profit in 1987 was restated to a loss of $33.8-million following an audit by another firm.

OSC enforcement director Tom Atkinson said the OSC launched the case because investors rely on auditors, especially when foreign companies are listing in Canada.

"If auditors fail to abide by Canadian auditing standards and securities laws, we will hold them accountable," he said in a release. Mr. Smedmor said it is also likely to make audit firms "think long and hard" about taking on cases involving foreign-based companies, especially those that list in Canada through a quick reverse takeover by acquiring a shell company that already has a stock exchange listing.

Class-action lawyer Dimitri Lascaris, who represents Sino-Forest's shareholders, said he believes audit firms will now "exercise a higher degree of professional skepticism going forward." he said. "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."