Accounting Rife with Estimates Haunted Toshiba

David M. Katz

9 September 2015

CFO.com

The Japanese conglomerate’s woes may have much to do with percentage-of-completion accounting.

Toshiba’s ongoing accounting scandal, which reached a peak on Monday, when the company announced a reported $1.9 billion earnings writedown involving fiscal periods reaching back seven years, has spotlighted a broader financial reporting problem that has bedeviled standard setters for years: how to keep fraudulent earnings management out of revenue recognition.More precisely, the Japanese conglomerate’s woes largely stem from a method of accounting common to a variety of industries, including defense contractors, airlines, and energy, transportation, and software development companies.

Traditionally called “percentage of completion” [POC], the method “refers to accounting treatment for contract work where the total income from contract work and total cost of contract work, along with the extent of contract progress as of the fiscal year end, are reasonably estimated,” according to a July 20 translation of the  report of the results of an internal investigation by Toshiba.

Under POC accounting, the income and the costs of the contract are recorded based on those estimates. Because the method is so dependent on estimates, is “little understood,” and is prone to much more material effects if results are misstated or fraudulently manipulated, “the risk level for a company that employs percentage of completion is higher” than it is for companies that don’t use it, says Charles Mulford, a Georgia Tech accounting professor.

Besides providing a greater possibility for error or fraud, POC accounting also lured regulators to Toshiba, thereby beginning the process that led to the company’s massive restatement. On February 12, 2015, Toshiba Corp. received an order from Japan’s Securities and Exchange Surveillance Commission (“SESC”) informing the company that it was “subject to a disclosure inspection with respect to some projects in which the percentage-of-completion method was used, among others,” according to the translation of the company’s internal investigation report.

Following that, in the course of a self-investigation by Toshiba, the company “noted that some matters require investigation in respect of some infrastructure projects in which the percentage-of-completion method was used during FY 2013,” according to the report.

Based on that situation, the company on April 3 formed a Special Investigation Committee headed by Toshiba Corp. board chairman Masashi Muromachi and launched an investigation.

“During the course of the investigation by the Special Investigation Committee, it was found that, in respect of some infrastructure projects in which the percentage-of-completion method was used, the total amount of the contract cost was underestimated and contract losses (including provisions for contract losses) were not recorded in a timely manner,” according to the investigation report.

Toshiba has “misapplied [percentage of completion accounting] throughout, and it’s impacted their expense accounting, their revenue accounting, and their profit accounting, in particular, significantly,” Mulford said after reading the report.

“The biggest part of Toshiba’s problem,” he said, is misstating “what total estimated contract cost[s] would be.”

To be sure, Toshiba didn’t really have a choice about whether to use POC accounting, according to Mulford, who estimates that about 12% of U.S. public companies use the method. The only alternative would have been to issue financial statements after the work on each contract was done and the revenue for it was collected. That’s an alternative that’s unacceptable for large companies in today’s world, the professor says.

The Rot Inside Japan Inc.

10 September 2015

The Wall Street Journal Europe

Industrial giant Toshiba Corp. announced this week that it overstated profits by nearly $2 billion in a string of frauds from 2008 to 2014. Japan’s largest-ever accounting scandal is now even bigger than first thought.

The abuses, which came to light in February, have resulted in the resignation of three successive CEOs and a 28% plunge in the share price. The scandal underscores the importance of deepening the overdue corporate-governance reforms pushed in recent years by Prime Minister Shinzo Abe.

An independent investigative panel reported in July that Toshiba executives had issued unrealistic sales targets, sometimes right before the end of reporting periods, which pressured subordinates to fudge their numbers. Toshiba’s board — once lauded for including independent directors — approved the bogus financial statements.

Accounting fraud happens everywhere, but the top-down management and lax oversight in the Japanese boardroom sometimes allow the problem to fester. In 2011 Olympus Corp., which produces cameras and medical devices, came under fire for hiding $1.5 billion in investment losses. These were exposed only after the company hired a foreign CEO, who raised the alarm.

Regulators sometimes look the other way as companies employ creative accounting while they dig themselves out of a hole, especially when such forbearance is politically convenient. The biggest scandal was the entire banking system’s concealment of bad loans after the bursting of the bubble economy in the early 1990s. The Finance Ministry aided in this effort until Prime Minister Junichiro Koizumi reformed and recapitalized the banks in the early 2000s.

Mr. Abe has followed in Mr. Koizumi’s reform footsteps for the simple reason that Japan has little choice. With an aging population, Japan needs productivity gains to escape a debt trap. And with retirees drawing down savings, companies will need to attract capital from abroad, which requires global best practices. Outright fraud is one part of a wider problem of losses due to unaccountable management.

A new Corporate Governance Code released in June encourages companies traded on the Tokyo Stock Exchange to comply with certain provisions or provide a reasonable explanation. These include appointing at least two independent directors, disclosing policies for nominating senior management and establishing a framework for whistleblowing. These can serve as a red flag to markets. The giant Government Pension Investment Fund, with more than $1 trillion under management, is predicating its investments on compliance.

The code is good but could be better. Toshiba had four outside directors since 2006 — double the number encouraged by the code. It also remains on the JPX-Nikkei 400, an index launched last year for companies with higher returns and better governance.

Mr. Abe could push for Japan to emulate the New York Stock Exchange in requiring that all audit committee members at publicly listed companies be independent. That would have prevented Toshiba’s former CFO, Makoto Kubo, from chairing the audit committee.

Another improvement would be a requirement that board directors be financially literate. Two of the four independent directors at Toshiba were ex-diplomats with little financial acumen. The new code suggests only that companies provide director training.

Scurrying to bring in more independent directors to comply with the code, some firms have recruited outsiders with impressive resumes but little corporate experience. Chiaku Mukai, Japan’s first female astronaut, and television anchor Yuko Ezure are among the new hires at electronics giant Fujitsu Ltd. and the restaurant chain Gourmet Kineya Co., respectively. Ms. Ezure told The Wall Street Journal in June that she hesitated to accept the offer because of her lack of knowledge.

Undoing decades of poor corporate governance will take more than a new set of guidelines. Employees are still afraid to speak up. Former executives still linger at firms as “advisers” and stifle change, while external auditors have little liability for the accuracy of firms’ disclosures.

Mr. Abe needs all the ammunition he can get to lift Japan’s economy out of its rut. Corporate governance is a rare area in which he has made concrete policy progress. Toshiba shows there’s more to be done.

Scandal has consequences for all of Japan Inc.

10 September 2015

Nikkei Asian Review

TOKYO — Toshiba’s deceptive accounting has damaged trust in the Japanese stock market, and all of corporate Japan can draw lessons from the electronics maker’s bad behavior.

Obscured by the recent volatility in share prices is the increasingly hot light of investor scrutiny. Because improving governance holds a prominent place in Abenomics — the prime minister’s plan for reinvigorating the economy — Toshiba’s dysfunctional oversight easily becomes a poor reflection on Japan as a whole.

This correspondent once asked Sir Adrian Cadbury, who chaired a British committee on corporate governance reform that produced a landmark 1992 report bearing his name, to define good governance. Cadbury replied that governance must not lapse into tokenism. His answer might well have been an indictment of Toshiba, which, as one of the first Japanese companies to adopt committee-style governance, had seemed a higher achiever in this regard.

To restore trust, Toshiba needs to do more than simply go through the motions. The company urgently needs “to change its corporate culture,” said Mitsubishi Chemical Holdings Chairman Yoshimitsu Kobayashi, a nominee for outside director on Toshiba’s new board. Steps such as moving away from top-down budgeting and increasing transparency may prove part of an effective series of reforms.

Investors likely want to see strictness as well as effectiveness in the response to the scandal. Accounting fraud needs to be investigated thoroughly and punished harshly, said Peter Butler, founder partner of Governance for Owners. Such abuses are endemic to the West as well, but unlike in Japan, they result in relentless probes and severe consequences for offenders.

Japan’s Securities Exchange and Surveillance Commission needs to go further than the company-commissioned independent panel in pursuing responsibility for the scandal. The Tokyo Stock Exchange, meanwhile, plans to put Toshiba on its list of “securities on alert,” a label that calls attention to companies with suspect internal controls. Rather than simply lift this designation after a pro forma review, the bourse should subject Toshiba to thorough guidance until its internal controls have been brought up to standard.