Japanese Cultural Values May Have Enabled the Cover-up of Fraud

Most financial statement frauds extend for about 3-5 years before someone blows the whistle, the company makes a mistake, or it all catches up with them as the house of cards that built the fraud collapses. Not at Olympus Corporation, the Japanese maker of cameras and medical imaging equipment, where the fraud lasted more than two decades.

The Olympus fraud has a real life whistle-blower – Michael C. Woodford – the newly appointed president and CEO at the time of the fraud. It is quite unusual for the top manager to blow the whistle on his company’s fraud; kudos to Woodford for doing the right thing.

It turns out the motivating factor for the fraud was an effort to make the company’s books accurate — at least in terms of its balance sheet — that led to the suspicious transactions noticed by Woodford. He thought they showed theft from the company by its chairman, and he confronted him. Instead, the chairman had only tried to clean up an accounting mess without damaging the reputation of Olympus. The chairman felt there was no need to tell Woodford about what had happened because the fraud was finally behind the company when Woodford took the job.

New York Times reporter Floyd Norris points out that a report by an investigating committee shows that two changes in accounting rules, one caused by the Enron scandal, eventually led to the collapse of the scheme. It shows that KPMG AZSA, the Japanese affiliate of the international accounting group, failed to notice what was going on for years but finally did complain about the somewhat clumsy transactions intended to put the losses on Olympus’s books. Ernst & Young Sjin Nihon, a Japanese affiliate of that network, was brought in and did sign off.

The scandal also highlights the controversy over mark-to-market accounting. The Financial Accounting Standards Board (FASB), the U.S. accounting standard-setter, started to require it for some financial instruments in 1997. However, the fraud had begun seven years earlier so covering up the losses was easy. One reason is took so long to uncover the fraud was  at the time accounting rules in Japan, as well as in other countries, allowed investments to be carried at cost. Theoretically, there should eventually have been a write-down to a lower market value, but there never was.

At Olympus, it appears the company held at hope that with additional risky investments, the losses could somehow be made up. They were not. Over time, the company tried securities speculation and private equity investing in promising start-up companies. It didn’t work and eventually the losses grew to more than $1 billion.

Olympus seems to have been content to sit on the losses until 1997, when accounting rules required some investments had to be marked to market. To hide the fraud, the company developed a plan to “sell” the losing investments, at original cost, to shell companies (off-balance-sheet-entities) set up by Olympus for that purpose. The sales were financed with loans from banks, which received cash from Olympus to secure the loans. Under lenient accounting rules at the time, those shell companies did not have to be consolidated with Olympus, so the losses could remain hidden. These rules were tightened after the Enron fiasco.

The plan was to phase out the losses, either by more investments or through overpriced acquisitions, with the extra cost of the acquisitions going to the off-balance-sheet-entities to make them whole. That was done through a variety of means, one of which was retaining the shell companies as high-priced investment advisers. The “cost” would appear on the company’s balance sheet as good will, and eventually written off. When that was done, the balance sheet would show an accurate value for Olympus.

From 1999 to 2003, Olympus managed to get out of some losses, or at least to convert them to good will. No one outside the company was the wiser. KPMG, the auditor, did not notice, the committee report says, in part because some of the information it received was false.

However, in 2003 the FASB changed the rules for off-balance-sheet entities controlled by sponsoring entities (i.e., Olympus) so that these entities would have to be consolidated on the sponsor’s books and losses could no longer be hidden. One of Olympus’ ways to manufacture phony profits was to “sell” assets to the off-balance-sheet entities it controlled, and to book profits on those sales. That technique was negated by the new rules.

In Japan, the rules changed in 2007 and the fraud started to unravel. The off-balance-sheet-entities would have to be consolidated. Olympus had until March 31, 2008, the end of its fiscal year, to clean up its books. Efforts to continue to hide the fraud fell apart when in April of that year Woodford became president and chief executive in September. He was told to not worry about such history, but he did. With the assistance of PricewaterhouseCoopers, he unraveled the transactions but not their purpose, and concluded that company money was being stolen. He confronted the chairman and was fired. He forced an investigation, which resulted in the December 2011 report.

The report says the top officers of Olympus knew what was going on throughout and that new presidents always accepted the decisions made by their predecessors. It does not say why Woodford evidently was not told, but some have speculated that it was some combination of not trusting a foreigner who had not worked in Japan and a belief that, with the balance sheet now reflecting reality, there was no need to involve him.

On December 20, 2011 -- nearly two months after Woodford blew the whistle -- Japanese authorities raided the company’s headquarters in Tokyo, emerging several hours later with boxes of documents. The company’s stock market value had already dropped by 50 percent. Foreign investors had started to question the culture of old-style Japanese companies that attempt to thwart disclosures of negative information.

The eventual Olympus salvage plan could be a Japan-wide effort. Last week, the Nikkei business daily reported that Olympus might issue about 100 billion yen (about $1.3 billion) in new preferred shares, and that Japanese technology companies like Fujifilm or Sony might be possible buyers. Those two companies, though, denied that any such investment was in the works.

Top Olympus executives acknowledged in November 2011 that the company had conducted a decades-long effort to cover up $1.7 billion in investment losses in a global scheme that sparked public investigations on three continents. Last month, Olympus acknowledged some of the losses in five years’ worth of revised statements. Three executives implicated in the scheme have left the company. But the rest of the Olympus board has been scrambling to retain control. Backing them are the country’s biggest banks, which have significant influence over top Japanese corporations, serving as major lenders and as major shareholders.

The ethics lesson to be learned from the Olympus affair is that a lack of underlying ethical values trumps full disclosure even in the post-Enron era of transparency. In fact, underlying cultural values such as secrecy may continue to rule the day in countries like Japan that seem to place not “losing face” ahead of ethical values such as full disclosure and the rights of investors and creditors to be fully informed about both good and bad financial dealings.

Blog posted by Steven Mintz, aka Ethics Sage, on January 6, 2012