Accounting firm Ernst Young LLP is facing new allegations from the Ontario Securities Commission that it failed to properly audit the books of a small Chinese athletic-shoe manufacturer.

The OSC case unveiled Monday is the second in the past year in which Ernst Young is accused of doing poor work auditing the books of a Chinese-based company. In December, the OSC alleged the firm was negligent as auditor of failed forestry company Sino-Forest Corp.

The latest allegations involve manufacturer Zungui Haixi Corp., which listed its shares on the TSX Venture Exchange in 2009, raising $39.8-million in its initial public offering.

Ernst Young audited the firm’s books in preparation for the IPO, but the OSC has alleged the audit was not in accordance with generally accepted auditing standards.

The OSC alleged the auditors “failed to treat multiple red flags about the company’s revenue and earnings with appropriate skepticism” and said Ernst Young “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.”

Ernst Young identified a risk that Zungui could use fictitious distributors to fraudulently inflate its revenue, but allegedly disregarded evidence that suggested the company had “grossly exaggerated its sales to purported distributors,” the OSC alleged.

The OSC also alleged Ernst Young did not do appropriate work on Zungui’s 2010 year-end audit.

Ernst Young said in a statement
Monday it will “vigorously defend” itself against the OSC allegations.

“Issues concerning Zungui Haixi came to light as a result of actions we
took during our 2011 audit,” the firm said. “We brought these issues to the
attention of the audit committee and management, and eventually resigned as
auditor. We have co-operated with the OSC throughout its subsequent
investigation.

“A statement of allegations, by its nature, is
designed to present one side of events, and not the whole picture. The evidence
will show that the OSC allegations do not fully describe all of Ernst
Young’s audit work, which met all professional standards.”

The OSC said the initial senior manager on the audit file informed the partner in charge of the file that she was not the right person to handle it because she did not speak Chinese and had no experience with audits of China-based companies. She was replaced with another senior manager who also did not speak Chinese and had no experience with Chinese company audits, the OSC alleged.

The manager on the IPO audit was a new employee who had recently joined the firm from a South African auditor, the OSC added. He had never audited a China-based firm and had never done an audit with Ernst Young before.

“However, despite this limited experience, the manager was given significant responsibility for overseeing and reviewing key audit work,” the OSC alleged.

When Zungui announced in August, 2011, that Ernst Young suspended its audit of the firm, the company’s shares fell 75 per cent in a single day of trading. The company’s independent directors and chief financial officer resigned days later.

In November, 2011, the OSC filed allegations against the company and its remaining directors, alleging multiple violations, including a failure to file financial statements. The company’s shares were permanently cease-traded in 2012.