OSC orders hearing into Ernst & Young audit of footwear maker Zungui Haixi

TORONTO – The Ontario Securities Commission has ordered a hearing into allegations of shortcomings by accounting firm Ernst & Young LLP in its audits of Zungui Haixi Corp.

The commission announced Monday that it will hold a hearing July 15 into claims made by OSC staff that the auditors failed to sufficiently heed “multiple red flags” about the revenue and earnings of the disgraced Chinese footwear and apparel manufacturer and retailer.

The allegations against Ernst & Young go back several years when the accounting giant audited Zungui’s financial statements in preparation for an initial public offering in which the Chinese concern raised $39.8 million and had its shares listed on the TSX Venture Exchange.

The OSC staff allege the account firm “failed to conduct the IPO audit in accordance with generally accepted auditing standards (GAAS), relying on certain audit results that raised more questions than they answered.”

Specifically, they alleged the auditors:

— Identified a risk that Zungui could use fictitious distributors to fraudulently inflate its revenue but then disregarded evidence suggesting that the company had grossly exaggerated its sales to purported distributors.

— Noted that Zungui’s management had an incentive to manipulate the company’s financial results to attract investors for the IPO “but then failed to treat multiple red flags about the company’s revenue and earnings with appropriate skepticism.”

— Failed to conduct a sufficient review of the audit evidence, “leaving the review of key evidence in the hands of a staff member with limited experience.”

“E&Y also conducted an audit of Zungui’s financial statements for its 2010 fiscal year and issued an auditors’ report stating that it had performed the audit in accordance with GAAS. E&Y, however, had also failed to conduct the 2010 audit in accordance with GAAS, as it contained several of the same deficiencies as the IPO audit,” the OSC said.

The OSC stopped trading in the company’s shares in September 2011 after E&Y suspended an audit and advised the company’s audit committee that an independent investigation was warranted.

Subsequently the company’s chairman, Fengyi Cai, and the chief executive, Yanda Cai, were permanently barred from trading securities in Ontario, with the OSC saying they had “demonstrated from their conduct that they are fundamentally ungovernable.”

The OSC also permanently prohibited both from becoming or acting as directors or officers of any publicly traded company in the province.