High & Low Finance: Sorting Out a Chinese Puzzle in Auditing

To the Canadian affiliate of Ernst Young, the answer to both questions appears to be no.

How, asked one Ernst staff member involved in the audit in an e-mail to a colleague, “do we know that the trees” the auditors were being shown “are actually trees owned by the company? E.g. could they show us trees anywhere and we would not know the difference?” The answer was yes: “I believe they could show us trees anywhere and we would not know the difference,” replied the colleague.

That did not lead Ernst to change its procedures. Nor did it bother to look at documents that it knew were crucial to answering the questions about the Sino-Forest Corporation, which was based in Canada but had its operations in China.

Until the summer of 2011, Sino-Forest appeared to be a real success story, backed by underwriters like Credit Suisse and Toronto Dominion and with shares worth billions of dollars. Its bonds were rated as just under investment grade by Standard Poor’s and Moody’s. Then a short-selling operation known as Muddy Waters said it thought the assets were greatly exaggerated. Sino-Forest appointed a group of its independent directors to investigate, and in due course they concluded they could not even be sure just what trees the company claimed to own, let alone whether it owned them.

This week brought the Sino-Forest case close to a conclusion. Ernst agreed to settle a shareholders’ suit for 117 million Canadian dollars, or about $116 million, while denying it was liable. The company agreed to come out of bankruptcy with its assets, whatever they might be, owned by the creditors. The company had tried to find buyers, and a number looked at the documents, but nobody bid. There still seems to be no certainty about how much, if any, timber the company owns.

While Ernst settled the shareholder suit, it said it would fight new charges by the Ontario Securities Commission that the audit firm failed to follow proper audit procedures. It was the commission suit, filed this week, that disclosed the e-mails exchanged by the auditors.

“We are confident that Ernst Young Canada’s work was conducted in accordance with Generally Accepted Auditing Standards (GAAS) and met all professional standards,” the firm said in a statement. “The evidence we will present to the O.S.C. will show that Ernst Young Canada did extensive audit work to verify ownership and existence of Sino-Forest’s timber assets.”

However extensive the work, the audit failed to uncover the essential truth: the assets were fake.

Frauds, and audit failures, can happen in many countries. But China is a special case because the authorities there seem to be completely uninterested in getting to the bottom of scandals whose victims are American or Canadian investors. Even regulators in Hong Kong have voiced frustration with their mainland colleagues.

Last week China sent another delegation to the United States to talk about these issues with American regulators, and a Chinese official was quoted by The Financial Times as telling a Hong Kong audience that audit working papers should be shared with other regulators — something the Chinese supposedly agreed to a decade ago but had never actually done. “I think we’ll shortly be able to work out a way to deliver those papers,” he said.

The American regulators have heard those stories before. In July, the chairman of the China Securities Regulatory Commission, Guo Shuqing, told Mary L. Schapiro, then the chairwoman of the United States Securities and Exchange Commission, that he thought an agreement could be reached. It turned out that the Chinese insisted they would provide documents only if the S.E.C. promised not to use them in an enforcement proceeding without Chinese permission.

The week the S.E.C. filed court papers, in connection with its pending case against a Chinese affiliate of Deloitte, laying out case after case in which American regulators asked for assistance through obtaining audit work papers or even something as simple as verifying that a Chinese company existed. Repeatedly, the Chinese said something could be worked out, but somehow nothing ever was.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2012/12/07/business/sorting-out-a-chinese-puzzle-in-auditing.html?partner=rss&emc=rss