Canadian regulator takes Ernst & Young to task on Zungui Haixi

TORONTO, Canada - Accounting firm Ernst & Young (E&Y) conducted improper audits of Chinese clothing and footwear retailer Zungui Haixi before it collapsed in 2011 following claims of fraud, Canada's top securities regulator alleged on Monday.

Toronto-listed Zungui was one of several Chinese companies with North American listings to come under pressure in the wake of fraud allegations against now defunct Chinese forestry company Sino-Forest Corp.

The Ontario Securities Commission (OSC), Canada's largest securities regulator, ordered a halt in trading of Zungui's stock two years ago after the company said Ernst & Young halted its audit pending an investigation into "inconsistencies" in the company's bank documents.

However on Monday, the OSC alleged the accounting firm failed to act on a timely basis, despite seeing a number of red flags in the company's financial statements. It said E&Y failed to conduct a sufficient review, leaving key evidence in the hands of a staff member with limited experience.

A spokeswoman for E&Y said the firm intends to "vigorously defend" itself against the OSC's allegations.

"Issues concerning Zungui Haixi came to light as a result of actions we took during our 2011 audit," said Erika Bennett, a Toronto-based spokeswoman for E&Y. "We brought these issues to the attention of the audit committee and management, and eventually resigned as auditor. We have cooperated with the OSC throughout its subsequent investigation."

However, the regulator alleges E&Y's failure to comply with generally accepted auditing standards during its audits of Zungui Haixi - ahead of its initial public offering in 2009 and a subsequent annual audit in 2010 - constituted breaches of the Ontario Securities Act.

The OSC said to conduct the IPO audit, E&Y assembled a team overseen by a partner in the firm's China Market Group, but the partner did not review any of the underlying evidence gathered during the audit, instead only limiting her review to summary documents.

The regulator said E&Y's original senior manager for the IPO audit did not understand Chinese and had no experience with audits of China-based companies.

It alleged she was removed from the file after she informed the partner that she was "clearly not the right person to review the fieldwork in detail as much of the documentation in the working papers is in Chinese."

Her replacement also did not understand the language and also had no auditing experience with China-based companies, the OSC said.

A hearing on the matter has been scheduled for July 15.