In 2004 and 2005, China Energy, a Nevada shell company, indirectly acquired ownership of Shenzhen Dicken Industrial Development based in China. In 2006, China Energy, which was listed on NASDAQ, had its securities delisted. On Dec. 4, 2006, the SEC filed suit against the company and a Chinese national, Chiu Wing Chiu, who it later determined controlled China Energy. and others alleging violating securities laws. In May 2009, the parties were permanently enjoined from violating antifraud and registration provisions of securities laws. They were required to pay various penalties and about $35 million in disgorgement and prejudgment interests.
Yamagata's involvement started in 2004 when his firm conducted an initial assessment of the risks associated with the China Energy engagement. The audit team rated the risks relating to improper revenue recognition, management override of controls and overstated assets as "high." The team also concluded that revenue recognition was "the key issue" in the engagement.
During its audit, the team concluded internal controls over sales and over cash receipts and disbursements were not operating effectively and could not be relied upon. The firm disclaimed an opinion about effectiveness of controls because it was unable to complete its assessment.
Problems continued during a visit to China when the audit team found inventory wasn't located at the Dicken Industrial facilities in Shenzhen, China, as claimed in China Energy's annual report, but was instead in three other locations including two cities hundreds of miles away. Because the U.S. audit team could not observe inventory or obtain bank or customer confirmations during its fieldwork in China, it hired an affiliated Beijing firm for those jobs. Because Chain Energy lacked personnel trained in U.S. GAAP, the accounting firm calculated initial earnings per share, but overestimated that figure by about 40 percent when the accountant used the wrong number of shares in that calculation. The SEC said Yamagata failed to detect that error.
The SEC also said that in fiscal year 2005, China Energy prematurely recognized revenue from two customers and improperly recognized revenue from two more - about $30 million at current exchange rates. Although MSWFT questioned revenue recognition, Yamagata accepted the company's explanations, even though those explanations were inconsistent with previous company representations, contracts and other company records. He did not insist on seeing copies of contracts or underlying documentation, and instead asked the company to add a statement to its management representation letter that the transactions were regular sales contracts. MSWFT then gave China Energy an interim review report that contained no reservations.
And despite the problems, the firm gave China Energy and unqualified opinion on the 2004 and 2005 financial statement audits.
