Can’t See the Trees in the (Sino-)Forest?

Sino-Forest has been the centre of a major accounting scandal in Canada since June 2011, when the first word of missing trees came out. The gist of the scandal is that Sino-Forest, a Chinese tree farm/lumber company listed as a publicly-traded company on the Toronto Stock Exchange, claimed to own hundreds of thousands of acres of forest in China. It turned out that those forests were as fictional as Treebeard and the rest of his clan in The Lord of the Rings.

How does one lose a forest? You might have thought that the auditors (Ernst & Young) would have checked for their existence, and they probably did. But auditing forests is not an easy job. Auditors might ask management to take them to the forests to see them first hand, but would have no way to know if the trees they were looking at actually belonged to Sino-Forest. I also suspect you could almost blindfold any auditor, spin them around three times, clap your hands, and the forest would look different enough that you could claim they were looking at a different package of land.

Things were also complicated by the fact that many of the documents were in Chinese, and most of the audit staff didn’t read Chinese.Its difficult to consider a purchase/sale document for a hunk of land as solid audit evidence when very few people could actually read the document. So, we have a “potential” case of audit failure. Again. (Sigh.)  Ernst & Young (Canada) has settled all civil litigation related to this failure for $117 million—the largest such settlement in Canadian history. I should point out that the settlement clearly states that there is NO admission of guilt.

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The Sino-Forest scandal and Ernst & Young’s settlement comes right on the heels of all the Big 4 accounting firms getting their knuckles rapped for violating some US SEC audit rules about disclosure of audits of foreign (primarily Chinese) companies. But if an audit firm does disclose the necessary information to keep the SEC happy, it breaks a Chinese rule about privacy and non-disclosure—a can’t-win situation. Nonetheless, the SEC has kicked over 40 Chinese companies off American stock exchanges in the past few years for various violations.

What’s going on here? I suspect that Chinese companies that are growing and need access to capital look to North America (NYSE, TSE, etc.) with eyes wide with anticipation. These companies are greeted by North Americans who have been told time and time again that they should invest in the red-hot Chinese economy (Sino-Forest shares were recommended as recently as May 2011, less than a month before things unraveled). In order to be listed in North America, a Chinese company must enlist the help of one of the Big 4 North American accounting firms. The Big 4 are all too happy to help since they want to hold on to market share and grow their billings. Combine uninformed investors with compliant auditors and a massive language barrier and you get the obvious result: Sino-Forest.

From an accounting perspective, what went on at Sino-Forest? To keep it simple, money was flowing out of the company supposedly for the purchase of massive tracts of forest. In reality, the money disappeared into the hands of a select few executives. So Sino-Forest had no cash, massive debt, no forests, and hence no future revenue. Its stock plummeted and the firm went bankrupt.

Stories like this make investing in Walmart or Apple substantially more appealing, don’t they? I can drive down the street and see a Walmart store with my own eyes; I can see and hear the massive crowds in the store buying merchandise. I can sit at my local coffee shop and observe that more than half the people there are using iPhones. But I can’t easily see, hear, or smell the forests “owned” by Sino-Forest. They were supposedly halfway around the world in some remote area of China, and since one forest looks pretty much like any other forest out there, I couldn’t have told them apart even if I had seen them. What’s the lesson here? KISS (keep it simple stupid), I think. Invest where you can see, hear, feel, or smell the business. At least then you’ll have some assurance that Treebeard won’t sweep in and steal the business out from under your eyes/ears/nose.

Note: this blog was originally posted on my site hosted by Pearson Education(