What, if anything, does Toshiba’s accounting scandal tell us about the current state of Japanese corporate governance?
Since the beginning of the year, improving corporate governance has been a hot issue in the Japanese market. The Japanese government has pushed, first through amendments to the Companies Act and then with the principle-based, comply-or-explain Japanese Corporate Governance Code. Public companies have seemingly embraced the idea too, as evidenced by a notable increase in the number of outside directors joining boards, as well as improved (and slightly earlier) disclosure of proxy materials. But then Toshiba happens: an accounting scandal that perhaps indicates that companies are publicly supporting the idea of improving their corporate governance, but not actually substantively changing for the better.
The Toshiba Group employs more than 200,000 people and is the second largest Japanese electronics conglomerate, which manufactures a wide variety of products ranging from LCD TVs to semiconductors and nuclear power plants. Until recently, it was believed that the electronics giant had been steadily restoring its performance after the global financial crisis in 2008 and the Great East Japan Earthquake in 2011. However, the independent investigation report published on July 20th (the “Independent Report”) uncovered the ugly truth behind their strong figures. The Toshiba Group had systematically fabricated its financial results, including overstating its profits by ¥156.2 billion ($1.26 billion) over a 7-year period from 2008 to 2014. The Group had inflated its pre-tax income by approximately 30% in a number of accounting areas such as (i) the percentage of completion method to manage the profitability of long-term projects of the infrastructure business; (ii) the parts transactions of the visual products business and the PC business; (iii) the recording of operating expenses of the visual products business and the PC business; and (iv) the valuation of inventory of the semiconductor business.
Such improper accounting practices were continuously in place during the terms for at least the last three presidents, Mr. Atsutoshi Nishida (2005-2009), Mr. Norio Sasaki (2009-2013) and Mr. Hisao Tanaka (2013-2015). At the CEO monthly meetings, the CEOs were said to have placed strong pressure on each of the divisional presidents to achieve an unrealistic target called “Challenge” regardless of the remaining time left until the end of that quarter. The Independent Report identified the Challenge as one of the direct causes of the fraud as it seems that the divisional presidents were often forced to use inappropriate accounting methods, “in order to overstate profits as the only way available to them to achieve the Challenge.”
Where was the Audit Committee and the Outside Auditor?
Even if CEO’s pressure to meet the Challenge targets was a root cause of the fraud, investors would hope that the audit committee and the outside auditor would detect these issues. Unfortunately, this was not the case.
Before the scandal, Toshiba’s corporate governance was not considered problematic by Japanese market standards and in certain aspects was seen as proactive. For example, in 2003 Toshiba voluntarily shifted to a Western-style system of a one-tier board with three committees. Further, Toshiba has appointed four independent directors — fairly progressive and certainly considerably higher than most Japanese companies.
However, the positive features of Toshiba’s governance may have ended there. Toshiba’s majority independent audit committee is under fire for not properly or sufficiently performing its oversight duties. The committee chairman did not proceed with repeated requests to review certain accounting treatments when submitted by the other members; as the former CFO of the company, the chairman presumably knew of these accounting irregularities. To further dishearten investors, the Independent Report also pointed out that the audit committee was not comprised with enough members who had an adequate knowledge of finance and accounting.
Moreover, with such governance in practice, the Company’s independent auditor Ernst & Young ShinNihon, member firm of the Big Four audit firm in Japan, was unable to detect the company-wide irregularities in the course of its accounting audit.
After receiving the Independent Report, half of the 16 board members resigned. The recent three presidents, including a non-director advisor, and six other directors stepped down from their positions. On July 22, inside chairman Masashi Muromachi assumed the representative director and president position, and at an upcoming special shareholder meeting in late September, the Company is expected to propose a slate consisting of Muromachi as the president with a majority of independent directors including the chairman of the board.
For the independent auditor, the Financial Service Agency is reportedly considering to impose an administrative action. This penalty might become more severe than the business improvement order the firm received for the failure to detect the Olympus’ long-lived illicit accounting practices in 2012.
Unfortunately, we do not believe such symptomatic treatments at company levels are enough to eliminate investors’ concerns about Japanese corporate governance practices: only formality but no proper substance nor execution. Toshiba’s scandal has certainly cast a shadow over the seemingly upward trend in the Japan’s corporate governance practices created by the recent legislative and regulatory efforts.