Ethical Obligations and Decision Making in Accounting, 4/e 1
Case 7-8 Sino-Forest: Accounting for Trees
A member of the audit team of Ernst & Young in Canada became concerned about the
accounting for inventory by its Canadian client, Sino-Forest, a Chinese company in the forestry
business and headquartered in Ontario province. He sent an e-mail to the manager: “How do we
know the trees are trees owned by the company? They could show us trees anywhere and we
wouldn’t know the difference.” The manager answered, “Yeah, it’s possible.”1
Background
Unless otherwise indicated, all quoted material in the case is drawn from an investigative article
by Janet McFarland, Andy Hoffman, and Jeff Fray, “OSC Cracks Down on Sino–Forest
Auditors.”
Sino-Forest owned and managed tree plantations as well as other manufacturing operations in
China. Based in Mississauga, in Southern Toronto, Canada, 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
Ethical Obligations and Decision Making in Accounting, 4/e 2
“Independent” Directors Report
In response to the criticism from Muddy Waters, Sino-Forest appointed an independent
directors’ committee to investigate.
The quoted information in this and the next section is taken from the independent directors’
report as reported by Ian Austen in “Sino–Forest Report Rejects Fraud Claims, With Caveats.”5
The central claim raised by Block and others was that the company had greatly overstated its
revenue and its timber holdings in China. The report said they were able to confirm the vast
majority of Sino-Forest’s claimed timber holdings although they had challenges assessing the
value placed upon them. But they also noted that the majority of the company’s timber holdings
relied on informal agreements with government-owned forestry agencies rather than clearly
Business in China
The Sino-Forest case reveals that business is done in China through informal agreements with
state or party officials, who grant access to licenses, resources, and markets only if they are paid
under the table. There can be no official records of these payments. Typically, auditors are not
allowed to see bank accounts, and transactions are muddied by a proliferation of secret
arrangements through authorized intermediaries (AIs).
Sino-Forest’s annual report references the three key risk factors that an insider to Chinese
business would understand, but outsiders would likely miss:
1. We rely on our relationships with local plantation land owners and/or plantation land use
2. We are heavily dependent on the expertise of our senior management and the
3. Violations of PRC laws or regulation could result in civil and criminal penalties,
including the revocation of licenses required for our business.6
Cultural Issues
Lawyers for executives of collapsed Sino-Forest, once a high flyer on the Toronto Stock
Exchange, said their clients never committed fraud but followed common business practices
Cole explained that her witness, Dr. Randall Peerenboom, an American who had lived in China
for more than 20 years, would explain how business practices viewed as surprising, if not
shocking, to Canadian regulators were the only way to do business in China where money could
not be exchanged freely and local bank accounts were impossible to get. She claimed the OSC’s
fraud accusations centered in part on Sino-Forest’s practice of buying and selling timber assets
without any cash passing through the company. Purchasers bypassed the company entirely by
Charges against EY
The OSC alleged that Ernst & Young failed to properly understand the legal basis of Sino–
Forest’s claim to its assets and relied on an opinion prepared by the forestry company’s legal
firm Jingtian and Gongchen Attorneys at Law. The OSC also accused EY of inappropriately
relying on the valuation work of Poyry Forest Industry Ltd., a company hired by Sino-Forest to
prepare periodic valuations of its timber holdings.
The OSC alleged that EY 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
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. Class-action lawyer Dimitri Lascaris at Siskinds LLP, who had represented Sino-
Forest’s shareholders, said he believed audit firms would 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.”
EY’s lawyer Linda Fuerst told the hearing that “the honesty and integrity of Ernst & Young and
its people were never in question.” She said the settlement avoids the time, expense, and
uncertainty of what would have been lengthy hearings.
In addition to the financial payment, EY told the OSC that it put in place new policies for
auditing companies that have significant operations in emerging markets, and it had done a
“focused assessment” of audits on companies based in China.
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1. Should operational and cultural considerations play a role in determining whether
Sino-Forest committed a fraud? Explain.
It is true that Chinese culture is different than that of North Americans. According to Hofstede’s
work on cultural variables as discussed in Chapter 1 and repeated below, Chinese culture is more
secretive than in North American countries. There also exists a collective mentality that imposes
an obligation to support the group/work organization and highly authoritative society whereby
people accept that the government wields a great deal of power and influence over their lives.
If auditors were to include cultural variables in their assessment of fraud, the financial results of
companies in the same industry would not be comparable. The underlying economic factors
would be shoved aside for practical expediency. That would be no way to have a global standard
for fraud detection and reporting.
Exhibit 1.2
Hofstede’s Cultural Dimensions*
Countries/Scores
Cultural Variables
Brazil
Russia
India
China
Japan
U.S.
Power Distance (PDI)
69
93
77
80
54
40
Individualism (IDV)
38
39
48
20
46
91
Masculinity (MAS)
49
36
56
66
95
62
Uncertainty Avoidance (UAI)
76
95
40
30
92
46
Long-Term Orientation (LTO)
65
61
80
29
2. Did Sino-Forest manage earnings? Refer to the discussion in this chapter about
different perspectives on earnings management in responding.
This is an opportunity to review the various definitions of earnings management in the chapter.
Schipper defines it as a “purposeful intervention in the external reporting process, with the intent
of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of
the process).” Schipper says that might be the case when earnings are manipulated to get the
stock price up in advance of cashing in stock options.
Thomas E. McKee wrote a book on earnings management from the executive perspective. He
defines earnings management as “reasonable and legal management decision making and
reporting intended to achieve stable and predictable financial results.” McKee believes earnings
management reflects a conscious choice by management to smooth earnings over time and it
does not include devices designed to “cook the books.” He criticizes Schipper, Healy and
Wahlen, and Dechow and Skinner for taking “unnecessarily negative view[s] of earnings
management.” McKee contends that a more positive definition is needed that portrays managers’
motives in a positive light rather than the negative view adopted by others.
3. Critically evaluate the audit work of Ernst & Young from the perspective of
generally accepted auditing standards and professional ethics. Was this a failed
audit?
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Reviewing the facts of the case, the OSC alleged that Ernst & Young failed to properly
understand the legal basis of Sino-Forest’s claim to its assets and relied on an opinion prepared
by the forestry company’s legal firm. The OSC also accused EY of inappropriately relying on the
valuation work of Poyry Forest Industry Ltd., a company hired by Sino-Forest to prepare
periodic valuations of its timber holdings.
The OSC alleged that EY 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.”
Tom Atkinson, director of enforcement at the Ontario Securities Commission, was quoted as
saying in the settlement with EY that “A major focus [of the Sino investigation] has been on
whether gatekeepers such as auditors and other corporate advisors properly performed their role
in protecting investors. If auditors fail to abide by Canadian auditing standards and securities
laws, we will hold them accountable.”
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