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The OSC has alleged the Ernst & Young audit of China’s Zungui Haixi was not in accordance with generally accepted auditing standards.Peter Power/The Globe and Mail

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

The case unveiled Monday is the second from the OSC in the past six months 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 giant Sino-Forest Corp., which collapsed in 2011.

No allegations have been proven in either case.

The latest allegations involve shoe 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 also alleged Ernst & Young did not do appropriate work on Zungui's 2010 year-end audit.

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."

The OSC also alleged Ernst & Young identified a risk that Zungui could use fictitious distributors to fraudulently inflate its revenue, but then disregarded evidence that suggested the company had indeed "grossly exaggerated its sales to purported distributors."

Ernst & Young said in a statement that problems at Zungui were revealed as a result of its audit work, and 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 alleged 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.

Zungui announced in August, 2011, that Ernst & Young had suspended its audit of the firm, sending its share price plummeting. 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.

The case involving Ernst & Young's audit of Sino-Forest is still ongoing and hearing dates have not been scheduled. The firm has also denied the allegations.