Japanese Accounting Scandals: Why?

The second major accounting scandal in five years has hit the Japanese tech industry. This time it’s Toshiba Corporation, which appears to have been padding its earnings reports to show improved results since the global financial crisis began in 2008.

By some estimates, the company inflated its earnings by more than 151 billion yen ($1.2 billion) over the course of six years, making it one of the largest accounting scandals in Japanese history.

This scandal comes just four years after Japanese camera company Olympus was targeted for using fraudulent mergers and acquisitions as a smokescreen to cover $1.7 billion in losses over the last decade. That scandal resulted in a four-year jail sentence for financial advisor Nobumasa Yokoo just a few weeks ago.

Yokoo and three other Olympus executives were arrested and charged with conspiracy, but the scandal involved more than half a dozen executives hiding company losses.

This week, Toshiba’s president, as well as two senior executives, resigned in order to accept the responsibility for fraudulent accounting.

These scandals are as much about old-school Japanese business culture as they are about anything else, and you don’t have to be a direct investor in Japanese tech ADRs for this to matter. Japanese technology companies make a huge contribution to the global consumer tech sector, so it’s important to fully digest these trends.

Toshiba’s Cover-Ups

Toshiba president Tanaka and vice chairman Sasaki reportedly set “unrealistic” performance goals for division heads that subordinates were to meet at any cost. If goals were not met, they were simply fudged. Losses, likewise, were pushed back in the books.

In 2013, Toshiba’s subsidiary Toshiba Medical Information Systems was placed under investigation for its reporting practices. It was found to have been overstating its financial results for years. This served as a springboard for the investigation within the parent company we’re seeing today.

If this kind of misreporting went unnoticed for years within one of Toshiba’s subsidiaries, it was undoubtedly going on elsewhere.

But why would this happen?

In short, tradition.

The Toshiba name is over a hundred years old in the business world. It dates back to Japan’s Meiji era, the country’s first post-feudal economic empire. Because of this, there is a corporate culture in Toshiba that contains some deeply rooted social customs.

Social scientist Geert Hofstede classifies Japan as a “borderline hierarchical society” where observance of corporate rank is extremely prevalent yet not exactly enforced because there is no single person with the most power. Behavior is most often tailored to honor the wishes of superiors, and superiors honor the needs of the company itself.

According to Hofstede’s cultural profile of Japan (emphasis mine):

Some foreigners experience Japan as extremely hierarchical because of their business experience of painstakingly slow decision making process: all the decisions must be confirmed by each hierarchical layer and finally by the top management in Tokyo. Paradoxically, the exact example of their slow decision making process shows that in Japanese society there is no one top guy who can take decision like in more hierarchical societies.

Executive orders are followed without challenge, and employees often have to place compliance with corporate society over compliance with the law. Executives place corporate goals over their own wellbeing and are often willing to go to jail to make the company appear solvent. When the law steps in, executives comply and accept their punishment.

This already appears to be the case at Toshiba, and it was undoubtedly the case at Olympus.

The Olympus Affair

The Olympus scandal vividly illustrated the paradoxical role of Japanese business culture because it involved a non-Japanese executive blowing the whistle on the accounting practices of his Japanese colleagues.

After just six months as president of Olympus, Briton Michael Woodford was ousted for “failing to hew to Japanese cultural practices.”

The Olympus board took only 10 minutes to unanimously vote Woodford out after he blew the whistle on the company for keeping bad books.

It turned out that for more than 14 years, Olympus had gone to elaborate lengths to cover up the fact that it was losing money. This included posting fake multibillion-dollar acquisitions of nonexistent Cayman Island-based companies.

At the time of Woodford’s whistle-blowing, Olympus was the seventh-most indebted company in Japan with a debt-to-equity ratio of almost 500%.

These measures were not done in the name of greed or profligacy. Unlike the multibillion-dollar cover-up at Enron, Olympus executives claimed no material gain from the scandals.

As a result, the Tokyo District Court gave former Olympus chief executive Kikukawa a three-year suspended sentence, and the company was ordered to pay approximately $7 million in fines for falsifying financial documents.

Investors mustn’t view these events in a short-term window. They absolutely have to be viewed on the macro level, because the larger trends in companywide share value actually remain mostly unchanged in the face of investigations and executive ousters.

Good Investing,

Tim Conneally

 @TimConneally on Twitter

For the last seven years, Tim Conneally has covered the world of mobile and wireless technology, enterprise software, network hardware, and next generation consumer technology. Tim has previously written for long-running software news outlet Betanews and for financial media powerhouse Forbes.