Toshiba’s once lauded culture became the cause of its problems

For years, Toshiba, one of Japan’s best known consumer electronics brands, had been a poster child of the country’s efforts to police corporate behaviour. The 140-year-old company even appeared as a case study in books on governance.

But what Seiya Shimaoka, an internal auditor at Toshiba, witnessed in late January was the opposite of exemplary behaviour. Instead, he saw the early signs of what would become one of the country’s most embarrassing corporate scandals, involving a company-wide effort to inflate profits by more than $1bn.

Mr Shimaoka repeatedly asked Makoto Kubo, head of the company’s five-person auditing committee and a former chief financial officer of the company, to examine the accounts at Toshiba’s laptop business. Mr Kubo brushed off the requests with a warning that reopening them would cause the company to miss its deadline for reporting earnings.

According to a 294-page report written by a panel of external lawyers and accountants, profits in its struggling PC division were later found to have been overstated.

Mr Shimaoka, who declined to comment, was one of the few executives who survived the removal of nearly half of Toshiba’s 16-member board, including Hisao Tanaka, chief executive, after the panel found that top executives were involved in accounting malpractices over the past seven years.

The scandal at the Japanese conglomerate with $52bn in annual sales has shaken a country that has embarked on sweeping governance reform championed by Prime Minister Shinzo Abe. It has also raised awkward questions about processes across corporate Japan, in the biggest business scandal since Olympus in 2011.

Toshiba was one of the early adopters of the reforms. It introduced three external directors in 2001 when Japanese boardrooms were still dominated by long-time company insiders. On paper, it had a structure that gave its external directors the authority to name top executives and an auditing committee to monitor behaviour of the company’s leaders.

It was lauded for its efforts. In 2013, the group was ranked ninth out of 120 publicly traded Japanese companies with good governance practices in a list compiled by the Japan Corporate Governance Network, a Tokyo-based non-profit organisation.

The company was also featured in a corporate governance book published in May by Mori Hamada & Matsumoto, one of the country’s biggest law firms. In it, Mr Shimaoka described in detail the multiple layers of checks that were in place to ensure compliance.

Yet the governance framework laid bare by the panel showed woefully ineffective monitoring at the company.

For example, it said Mr Kubo was aware of improper accounting that was systematically carried out from 2008. It added that no action was taken despite the warnings from Mr Shimaoka.

The panel also noted that the three external auditors included former diplomats and a former banker who had no accounting expertise. “Internal controls by the auditing committee were not functioning,” it concluded.

Mr Kubo, who also resigned from the board on Tuesday, declined to comment.

Kota Ezawa, an analyst at Citigroup, says there will be more Japanese companies that will appear to be in compliance with the country’s corporate governance code introduced in June. Many have installed more outside directors, unwound large cross-shareholdings and promised higher returns on equity to investors.

“But look at Toshiba,” he cautions. “We need to make sure that companies understand that having structures that look good is not enough.

“Toshiba was lauded as a frontrunner in governance efforts, but that was a misunderstanding. Its governance structure looked good but the execution was not.”

Similarly, Hiroyuki Kamano, a lawyer who sits on the board of several Japanese companies, says the aggressive pursuit of profits and pressures to meet earnings targets are not unique to Toshiba.

Nearly half of the overstated profits identified by the panel were attributed to the 2012 financial year when many companies, including Panasonic and Fujitsu, were grappling with pressures from the stronger yen and the aftermath of the 2011 tsunami and Fukushima Daiichi nuclear accident.

“Increased profits and better performance lead to promotions so there is always an evil incentive” to make the figures look better, says Mr Kamano.

Under Mr Tanaka, Toshiba had also sought to mitigate its dependence on chipmaking, which accounts for 26 per cent of its annual revenue and is the sole division which generates a double-digit profit margin.

“I was midway in my effort to build a second and third pillar of revenue,” he said at a news conference announcing his resignation. “But building new pillars of revenue should not be equated with improper accounting.”

Mr Tanaka has denied giving instructions to employees to inflate profit figures.

However, analysts including Mr Ezawa say the scandal is not expected to have a significant impact on Toshiba’s earnings outlook despite uncertainties remaining on how far the company will need to write down the value of its assets. This is especially true for Toshiba’s nuclear business, which struggled in the wake of the 2011 nuclear disaster. Others hope the scandal will accelerate pressures to unload underperforming assets.

“The change in earnings may be limited, but even more important is to improve the governance system to rebuild confidence in earnings,” says Mr Ezawa.

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