Question

On September 25, 2012, Japanese camera and medical equipment maker Olympus Corporation and three of its former executives pleaded guilty to charges related to an accounting scheme and cover-up in one of Japan’s biggest corporate scandals. Olympus admitted that it tried to conceal investment losses by using improper accounting under a scheme that began in the 1990s.

The scandal was exposed in 2011 by Olympus’s then-CEO, Michael C. Woodford. As the new president of Olympus, he felt obliged to investigate the matter and uncovered accounting irregularities and suspicious deals involving the acquisition of U.K. medical equipment manufacturer Gyrus. He called the company’s auditors, PwC, to report it. The firm examined payments of £1.1 billion (US$687) related to financial advice on the acquisition paid to a non-existent Cayman Islands firm. A fraud of $1.7 billion emerged, including an accounting scandal to hide the losses. Along the way, the Japanese way of doing business came under attack by Woodford.

Olympus initially said that it fired Woodford, one of a handful of foreign executives at top Japanese companies, over what it called his aggressive Western management style. Woodford disclosed internal documents to show he was dismissed after he raised questions about irregular payouts related to mergers and acquisitions. Without any serious attempt by management to investigate, he went behind the board’s back and commissioned a report by PwC into the Gyrus deal, including the unusually high advisory fee and apparent lack of due diligence. On October 11, 2011, he circulated the report to the board and called on the chair of the board, Tsuyoshi Kikukawa, and executive vice president Hisashi Mori to resign. Three days later, the board fired Woodford.

Ultimately, the accounting fraud was investigated by the Japanese authorities. “The full responsibility lies with me, and I feel deeply sorry for causing trouble to our business partners, shareholders, and the wider public,” Kikukawa told the Tokyo district court. “I take full responsibility for what happened.”

Prosecutors charged Kikukawa, Mori, and a former internal auditor, Hideo Yamada, with inflating the company’s net worth in financial statements for five fiscal years up to March 2011 due to accounting for risky investments made in the late-1980s bubble economy. The three former executives had been identified by an investigative panel, commissioned by Olympus, as the main suspects in the fraud. In December 2011, Olympus filed five years’ worth of corrected financial statements plus overdue first-half results, revealing a $1.1 billion hole in its balance sheet.

An Olympus spokesman said the company would cooperate fully with the investigative authorities. It is under investigation by law enforcement agencies in Japan, Britain, and the United States. On April 2, 2015, Olympus reached an ¥11 billion ($92 million) out-of-court settlement in Japan with institutional investors over allegations of accounting fraud.

Olympus Spent Huge Sums on Inflated Acquisitions, Advisory Fees to Conceal Investment Losses

Olympus’s cover-up of massive losses has shed light on several murky methods that some companies employed to clean up the mess left after Japan’s economic bubble burst. Many companies turned to speculative investments as they suffered sluggish sales and stagnant operating profits. The company used “loss-deferring practices” to make losses look smaller on the books by selling bad assets to related companies.

To take investment losses off its books, Olympus spent large sums of money to purchase British medical equipment maker Gyrus Group PLC and three Japanese companies and paid huge consulting fees. Olympus is suspected of having deliberately acquired Gyrus at an inflated price, and in the year following the purchase, it booked impairment losses as a result of decreases in the company's value.

To avert a rapid deterioration of its financial standing, Olympus continued corporate acquisitions and other measures for many years, booking impairment losses to improve its balance sheet. Losses on the purchases of the three Japanese companies amounted to $34.5 billion. With money paid on the Gyrus deal included, Olympus may have used more than $62.5 billion in funds for past acquisitions to conceal losses on securities investments.

The previous method that recorded stocks and other financial products by book value—the price when they were purchased—was abolished. The new method listed them by market value (mark-to-market accounting). Under this change, Olympus had to report all the losses in its March 2001 report. However, Olympus anticipated this change a year in advance and posted only about $10.6 billion of the nearly $62.5 billion as an extraordinary loss for the March 2000 settlement term. The company did not post the remainder as a deficit; rather, it deferred it using questionable measures.

Olympus’s Tobashi Scheme

At the heart of Olympus’s action was a once-common technique to hide losses called tobashi, which Japanese financial regulators tolerated before clamping down on the practice in the late 1990s.Tobashi, translated loosely as “to blow away,” enables companies to hide losses on bad assets by selling those assets to other companies, only to buy them back later through payments, often disguised as advisory fees or other transactions, when market conditions or earnings improve.

Tobashi allows a company with the bad assets to mask losses temporarily, a practice banned in the early 2000s. The idea is that you pay off the losses later, when company finances are better.

Olympus appears to have pushed to settle its tobashi amounts from 2006 to 2008, when the local economy was picking up and corporate profits were rebounding, in an effort to “clean up its act.” Business was finally strong enough to be able to withstand a write-down. It was during those years that the company engineered the payouts that came under scrutiny: $687 million in fees to an obscure financial adviser over Olympus’s acquisition of Gyrus in 2008, a fee that was roughly a third of the $2 billion acquisition price, more than 30 times the norm. Olympus also acquired three small Japanese companies from 2006 to 2008 with little in common with its core business for a total of $773 million, only to write down most of their value within the same fiscal year.

Olympus Scandal Raises Questions about the “Japan Way” of Doing Business

The scandal rocked corporate Japan, not least because of the company’s succession of firings, denials, admissions, and whistleblowing. It also exposed weaknesses in Japan’s financial regulatory system and corporate governance.

“This is a case where Japan’s outmoded practice of corporate governance remained and reared its ugly head,” according to Shuhei Abe, president of Tokyo-based Sparx Group Company. “With Olympus’s case, it will no longer be justifiable for Japan Inc. to continue practicing under the excuse of the ‘Japan way of doing things.’”

On the surface, Olympus seemed to have checks on its management. For example, it hired directors and auditors from outside the company, as well as a British president who was not tied to corporate insiders. In reality, however, the company’s management was ruled by former chairman Kikukawa and a few other executives who came from its financial sections.

The company’s management is believed to have been effectively controlled by several executives who had a background in financial affairs, including Kikukawa and Mori, both of whom were involved in the cover-up of past losses. Olympus’s board of auditors, which is supposed to supervise the board of directors, included full-time auditor Hideo Yamada, who also had financial expertise.

After Woodford made his allegations, he was confronted by a hostile board of directors that acted based on the premise that whistleblowing offended their corporate culture. Subsequently, the board fired him saying that he had left because of “differences in management styles.” Employees were warned not to speak to him or jeopardize their careers.

One problem with corporate governance in Japan is truly independent non-executive directors are unusual. Many Japanese do not see the need for such outside intervention. They question how outsiders can know enough about the company to make a valuable contribution. Moreover, how could they be sensitive to the corporate culture? They could even damage the credibility of the group.

Accounting Explanations

Olympus hid a $1.7 billion loss through an intricate array of transactions.

A one-paragraph summary of what it did appears in the investigation report:

The lost disposition scheme is featured in that Olympus sold the assets that incurred loss to the funds set up by Olympus itself, and later provided the finance needed to settle the loss under the cover of the company acquisitions. More specifically, Olympus circulated money either by flowing money into the funds by acquiring the entrepreneurial ventures owned by the funds at the substantially higher price than the real values, or by paying a substantially high fee to the third party who acted as the intermediate in the acquisition, resulting in recognition of a large amount of goodwill, and subsequently amortized goodwill recognized impairment loss, which created substantial loss.

Here is a more understandable version of the event:

Olympus indirectly loaned money to an off-the-books subsidiary and then sold the investments that had the huge losses to the subsidiary at historical cost, eventually paying a huge premium to buy some other small companies and writing off the underwater investments as if they were goodwill impairments.

A more detailed bookkeeping analysis of the complicated transactions appears in Exhibit 1.

Auditor Responsibilities

Arthur Andersen was the external auditor through March 31, 2002, after which Andersen closed its doors for good in the post-Enron era. Then KPMG AZSA LLC was the auditor through March 31, 2009. The 2010 and 2011 fiscal years were audited by Ernst & Young ShinNihon LLC.

The investigative report noted that the fraud was hidden quite well. Three banks were involved in hiding information from the auditors. The summary report said that all three of them agreed not to tell auditors the information that would normally be provided on an audit confirmation.

KPMG did come across one of the tobashi schemes carried out through one of the three different routes that had been set up. According to the investigative report:

Not everything was going smoothly. The report said that in 1999, Olympus’s then-auditor, KPMG AZSA LLC, came across information that indicated the company was engaged in tobashi, which recently had become illegal in Japan. Mori and Yamada initially denied KPMG’s assertion, but the auditor pushed them that same year to admit to the presence of one fund and unwind it, booking a loss of $10.5 billion. The executives assured KPMG that that was the only such deal, the report said. However, the schemes expanded, without detection, for another six years or so and was in place, without detection, until the last component was unwound at the end of fiscal year 2010.

Olympus Finally Had Enough of the Deception

The last part of the bad investments was finally written off in March 2011. That was the last month of the fiscal year, when Ernst & Young took over the audit from KPMG. Mori and Yamada had finally decided to unwind and write off the underwater financial assets and repay the loans that Olympus had made through its unconsolidated subsidiary. Of course, by then, the financial press had gotten wind of what was going on at Olympus.

1. Olympus attempted to cover up the losses by writing investments off as ___________.

a. Market-to-market trading securities

b. Goodwill impairments

c. Discontinued operations

d. Deferred taxes due to countries outside Japan

Answer 1

Answer is option B

Goodwill impairments

The show its balance sheet good and impressive, Olympus Corporation has adopted the practice of deferring losses so that losses look smaller on the books. It pays high amount for acquiring companies and thus then recognize the large amount of goodwill. Then it goes for amortizing goodwill recognized impairment losses.