Olympus disclosure shakes auditors’ reputations

Olympus’s disclosure this week of a financial cover-up threatens to shatter the reputation of Japan’s leading auditing firms.

The Japanese camera maker on Tuesday admitted to hiding large losses related to securities investments for two decades. The revelation has cast the spotlight on the role of Olympus’s auditors during that period, KPMG Azsa and Ernst & Young ShinNihon, the Japanese member firms of KPMG and Ernst & Young’s global networks.

The Olympus scandal – which came to light after Michael Woodford, the company’s ousted British president, raised red flags about questionable deals – has prompted questions about whether the auditors knew what the optical equipment company was doing, and, if not, why they had failed to detect the irregularities. The Japan Institute of Certified Accounts said on Thursday it would investigate the role of the auditors in the Olympus affair.

“Why didn’t the auditors function as a check on the cover-up? It is like the robbers had hired the police,” says Tsutomu Okubo, an Upper House Diet member from the ruling Democratic Party.

There is a mystery over why KPMG Azsa, which was Olympus’s auditor until June 2009, signed off on Olympus’s accounts in March 2009, even though it disagreed with the way Olympus accounted for its acquisition of Gyrus, the UK medical equipment maker Olympus acquired in 2008.

Olympus paid its financial adviser about one-third of the $2.2bn it paid for Gyrus, an extremely high fee considering that most M&A advisory fees are about 1 per cent of the purchase price.

Tsuyoshi Kikukawa, then Olympus chairman, admitted in an email to Michael Woodford, the fired chief executive, that Olympus had switched auditors from KPMG Azsa to Ernst & Young ShinNihon after it clashed with the former over the accounting of the Gyrus acquisition.

Questions will also be asked about the extent of information KPMG Azsa provided Ernst & Young ShinNihon, when the latter took over as Olympus’s auditor in June, 2009.

Under Japanese accountancy rules, when an auditor takes on a company it is required to ask its predecessor 13 clearly defined questions, including whether there had been disagreements with the company over the handling of the accounts.

Olympus’s revelation comes at the same time as auditor Deloitte Touche Tohmatsu’s Japanese arm has been criticised after it emerged that the former chairman of Daio Paper, a leading paper company, borrowed nearly Y10.7bn from his firm.

KPMG Azsa, Ernst & Young ShinNihon and Deloitte Touche Tohmatsu all declined to comment.

The two scandals raise questions about the effectiveness of reforms, known as the accountancy “Big Bang,” that were introduced, starting in 2000, that were meant to make financial fraud more difficult to carry out.

Before those reforms were adopted, the cosy relationship between Japanese companies and their accountants, the lack of marking-to-market accounting and the practice of writing off goodwill over many years made it easier for companies to cover up losses.

But public outcry in the 1990s over tobashi – the practice of shifting losses off a company’s books to a subsidiary or outside funds – led to reforms that were supposed to make it more difficult, such as the adoption of consolidated accounting and the marking to market of securities investments.

Industry executives are also shocked because the two scandals involve Japan’s top three accountancy firms, and that the KPMG Azsa accountants assigned to Olympus were considered among Japan’s best.

“Cash was being transferred, so if you analysed things thoroughly it should have raised questions. But there were no claims [by the auditors],” says Shinji Hatta, professor at the Accountancy School of Aoyama Gakuin University in Tokyo.

If the auditor had paid more attention to those signs, it could have sounded the alarm much earlier, he says. “For that, they bear a grave responsibility,” he says.

Douglas Skinner, an accounting professor at the University of Chicago Booth School of Business, said the two audit networks involved in the Olympus affair – particularly KPMG – might lose Japanese clients as a consequence. “The auditors should have been able to identify and do something about this,” he argues.

However, he says the immediate risk of a client exodus was lessened by the fact that auditor switching in Japan tends to happen in the summer if at all, while the dominance of the Big Four accountants – Deloitte, Ernst & Young, KPMG, with PwC trailing far behind – meant that companies had a severely limited choice of alternatives.

Additional reporting by Adam Jones in London