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Unmasking the Fraud at Toshiba

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DOI: 10.2308/iace-52429

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 Unmasking the Fraud at Toshiba

Dennis Caplan

SUNY-Albany, NY

Saurav Dutta

Curtin University, Perth, Australia

David Marcinko

Emeritus- SUNY Albany

This is a pre-print version of the article to be published in the Issue in Accounting Education.

doi.org/10.2308/iace-52429

1
 Unmasking the Fraud at Toshiba

Abstract

Following its purchase of Westinghouse and subsequent macroeconomic events, Toshiba faced

declining profits. In response, Toshiba engaged in earnings management through two accounting

treatments. First, it delayed the recognition of losses under long-term contracts. Secondly, it

inappropriately applied price masking to account for transfers of components between itself and

contract manufactures. Students using this case will assess how business risks and corporate

culture relate to audit risk, and how accounting for price masking transactions can lead to

increased fraud risk. Students will also research aspects of auditing standards related to fraud and

accounting estimates. The case is designed for auditing courses and capstone courses with an

auditing component.

Keywords: Price masking, audit risk and materiality, internal control, corporate governance,

earnings management, fraud triangle.

2
 CASE

Toshiba was formed in 1939 through a merger between Shibaura Engineering Works and

Tokyo Electric Company, and subsequently pioneered the development of electrical equipment

in Japan. Prior to World War II, Toshiba developed the first fluorescent lamps and radar in

Japan, and had ambitions to become one of the world’s leading electrical machinery

manufacturers. In the favorable postwar climate, Toshiba’s financial status was secure. The

company first listed its shares on the Tokyo Stock Exchange in 1949 and went on to produce

Japan's first broadcasting equipment in 1952, launched Japan's first digital computers in 1954,

and developed Japan's first microwave ovens in 1959. Despite these technical and marketing

successes, the company resisted the adoption of modern business policies—its executives

adhered to a feudal system of hierarchy and status.1

By 2000, Toshiba had become the world’s fourth largest chip manufacturer and third

largest notebook computer manufacturer. By then the company was organized into six divisions.

Information & communications and industrial systems was the largest division, accounting for

30 percent of sales. Digital media and Electronic devices & components were two divisions that

each accounted for over 20 percent of sales. Power systems and Home appliances each

accounted for approximately 10 percent of sales. Smaller product lines comprised the sixth

division, which accounted for the remaining sales. Shortly thereafter, the company refocused its

corporate strategy to place greater emphasis on building nuclear power plants, which was

expected to be driven primarily by increased demand in China and the United States. In 2005,

1
For a history of Toshiba, see http://www.referenceforbusiness.com/history2/71/Toshiba-
Corporation.html#ixzz5026pA91A, last accessed July 5, 2018). The remainder of the case relies heavily
on Toshiba Corporation—Independent Investigation Committee’s Investigation Report (2015). On May
8, 2015, Toshiba established this committee and charged it with investigating the fraud. The Committee
issued its report on July 20, 2015.

3
when British Nuclear Fuels put its U.S. power plant division Westinghouse up for sale, Toshiba

was so eager to be the winning bidder that it paid $5.4 billion, which was about three times the

seller’s projected sales price. Toshiba anticipated that it would install 45 new reactors worldwide

by 2030.

Declining oil prices, emergence of alternative energy sources such as solar and wind, and

the 2008 global financial crisis wreaked havoc on Toshiba’s growth strategy in the nuclear power

plant industry. Indeed, Toshiba and all of Japan’s economy suffered during 2008 and 2009 in

what was the deepest recession in post-war Japan. The country’s gross domestic product fell by

nine percent. An increase in foreign demand coupled with large government stimulus packages

led to recovery of most of the lost output by mid-2010. Toshiba seemed to be sharing in this

rebound. But then, on the afternoon of March 11, 2011, all of Japan suffered yet another horrific

setback. A magnitude 9.1 earthquake northeast of Tokyo set off a tsunami with waves up to 128

feet striking the Japanese coast. Nearly 20,000 people lost their lives, and direct material damage

was estimated at ¥25 trillion, approximately four times the damage caused by Hurricane Sandy.2

The damage to infrastructure was so severe that all 54 of the country’s nuclear reactors were

taken offline. By mid-2018, only nine were back online. Following the tsunami, China

temporarily froze nuclear plant approvals and revised downward its projection of nuclear energy

capacity by 2020. In the United States, plans to build 12 power plants were canceled or

suspended, and construction was stopped at two plants. The worldwide response to the tsunami

dealt a massive blow to Toshiba’s expansion strategy for its nuclear power division.

2
Hurricane Sandy, which devastated the Northeast United States in October 2012, caused damages of
approximately $71 billion (http://academic.eb.com/levels/collegiate/article/Superstorm-Sandy/601219),
last accessed July 5, 2018).
4
 The disaster caused a 2.6% decline in Japan’s gross domestic product in the first half of

2011. A rebound in the second half of 2011 gave way to yet another recession in mid-2012. The

time series of Japanese gross domestic product levels compared to those of the Euro area, the

United States, and the member countries of the Organization for Economic Co-operation and

Development is shown in Figure 1.

***Insert Figure 1 Here***

Toshiba’s performance over this period as measured by net sales and net income

attributable to common shareholders is detailed in Table 1. These economic events and

circumstances placed significant pressure on Toshiba executives, whose compensation packages

depended heavily on meeting short-term performance targets.3 At the executive monthly

meetings between Toshiba’s CEO and division heads, the CEO set income targets, called

“challenges,” for each division. These targets emphasized current period’s sales and profits and

often were so aggressive as to exceed the capabilities of the divisions. Yet Toshiba’s CEO

suggested that they needed to be achieved, and sometimes implied that underperforming

divisions would be sold or liquidated. The pressure imposed by the CEO filtered down from the

division heads to the middle managers and employees. While the CEO did not explicitly instruct

that fraud be committed, he apparently relied on the Japanese corporate culture of obedience and

loyalty that led employees to do whatever was necessary to meet these targets (IESBA 2015).

3
The compensation of Executive Officers was comprised of a base compensation and a role
compensation (or bonus). About forty percent of the role compensation was based on performance of the
overall company or business department of which the Officer was in charge. (Toshiba Corporation—
Independent Investigation Report 2015, 74)
5
 ***Insert Table 1 Here***

The Japanese cultural value of unquestioned obedience was reinforced by the lack of job

rotation of key personnel in the Accounting and Finance Division at Toshiba. Most employees

worked in the same division from hiring until retirement. The resulting sense of camaraderie

made it difficult for an employee to correct or question an inappropriate accounting treatment.

Furthermore, the corporate level internal audit function (called the Corporate Audit Division)

reported to Toshiba’s CEO, and served primarily in a consulting role to management. Although

the corporate internal auditors recommended improvements in controls that would have

prevented or detected inappropriate accounting treatments, they did not recommend changes to

the actual accounting. Company executives prepared improvement plans in response to the audit

findings, but those plans were never executed.

In Japanese corporate governance, the board of directors emphasizes its operational

executive function over its supervisory/stewardship function. Many directors ascend to the board

from the employee ranks after years of service. Consequently, most board members know the

company and the employees intimately and their allegiances are to people inside the company

(IESBA 2015). Further, their mental attitude tends toward the pursuit of company interest rather

than personal gain (Ueda 2015). Japanese boards tended to be large, consisted mostly of middle-

aged Japanese men,4 and had few outside directors. These boards did not conduct business

through a committee structure, which is a hallmark of Western companies. Only in 2003 were

4
In 2013 a total of only 51 women served on Boards of Japanese companies.
6
the three committees, the audit committee, nominating committee, and compensation committee,

introduced to harmonize the Japanese system with the Western system. Toshiba, along with

Sony, Hitachi and Nomura, were leaders in adopting these corporate governance reforms.

While Toshiba had an audit committee, it was headed by former Toshiba CFO Mr.

Muraoka from 2011 to 2014, who was then succeeded by yet another former CFO, Mr. Kubo,

beginning in 2014. The audit committee included three independent directors, but these directors

had limited knowledge of accounting.5 Also, the staff assigned to support the work of the audit

committee possessed inadequate accounting expertise.

Ernst & Young ShinNihon had audited Toshiba for sixty years. During the years relevant

to the case, Toshiba followed U.S. GAAP for financial reporting purposes and was audited under

Japanese auditing standards. In Japan, auditors are paid hourly rates that are lower than in other

advanced industrialized countries (Khondaker and Bremer 2016, 92). This is partly due to the

fact that Japan once imposed limits on audit fees. For FY 2014, Toshiba paid ¥982 million (about

$8 million) as audit fees to E&Y. This was about 0.015% of Toshiba’s revenue, whereas

comparably-sized U.S. firms pay, on average, four times as much.

Against this backdrop, Toshiba embarked on a seven-year fraud commencing in 2008.6

The multi-dimensional fraud involved a variety of transactions at four divisions, and inflated

cumulative profits by ¥150 billion (Toshiba Corporation—Independent Investigation Report

2015, 17-18). This case focuses on schemes at two of those divisions: Digital Products and

5
This is not uncommon in Japan. Less than five percent of outside directors have a CPA or the equivalent
qualification (Ueda 2015).
6
Khondaker and Bremer (2016) reviews the Toshiba fraud, including the role of percentage-of-
completion accounting, the low price of audits in Japan, and Japanese corporate culture. Mehta and
Bhavani (2017) examines Toshiba’s fraudulent behavior using analytical procedures, including the
Beneish Model, Altman’s Z-score, and Benford’s law. The current teaching case focuses on the auditing
implications of the methods used to commit the fraud.
7
Power Systems. Table 2 identifies key personnel at Toshiba from 2007 to 2014 who are relevant

to this case.

***Insert Table 2 Here***

Price Masking at Toshiba’s PC Division

In the 1990s Tim Cook, borrowing an established practice in other industries, moved

Apple Computer away from in-house domestic manufacturing to manufacturing its products

overseas, using contract manufacturers like Foxconn. This strategy was a key component in

allowing Apple to grow as phenomenally as it has. Soon thereafter, other hi-tech companies

worldwide including Motorola, HP and Dell began outsourcing their manufacturing to third

parties. The companies that design and engineer the products are known as original equipment

manufacturers (OEM), and the off-shore manufacturer is the contract manufacturer (CM).

Toshiba’s PC division also relied on contract manufacturing.

When resorting to contract manufacturing, OEMs have two options: to procure the

components needed by the CM, or to delegate the procurement responsibility to the CM. The

latter, called the ‘turnkey’ arrangement, makes the CM responsible for all upstream activities

prior to the delivery of the final product to the OEM. On the other hand, most OEMs retain in-

house procurement by using the buy-sell process, under which an OEM buys components from a

supplier and resells those components to its CM with an agreement to repurchase those

components after the CM completes its portion of the manufacturing process. When the OEM

“sells” the components to the CM rather than merely transferring them, it effectively passes on

the physical risk of ownership such as losses due to waste and spoilage to the CM. Because of

8
the repurchase agreement, inventory risk associated with a decline in the market value of the

inventory remains with the OEM.

The globalization of manufacturing and supply chain for OEMs has necessitated sharing

of information and disclosure among trading partners. However, in order to maintain strategic

advantage and company secrets, many OEMs have resorted to a practice known as price

masking. Price masking allows OEMs to hide their component costs from their supply chain

partners, typically via buy-sell agreements. The objective of price masking is to allow the

agreements between the OEM and its parts suppliers to remain confidential, thereby preserving

the OEM’s potential price advantage over its competition. For suppliers, the practice allows them

to offer preferential pricing to certain OEM customers, without having to reduce prices for all

customers or all projects. Basically, price masking facilitates the suppliers selling the same

product at different prices to different customers or markets. The CM is indifferent to price

masking as it never actually pays for the parts and the charges are reversed upon reselling the

finished product back to the OEM.

Accounting for price masking

Figure 2 illustrates a typical ‘buy-sell’ arrangement between an OEM and a CM. The

OEM procures components from a supplier for $50. It then sells those components to the CM at

a masking price of $200. The CM assembles the components and charges the OEM a price of

$20. The OEM buys back the finished product from the CM for $220. Thus, the CM receives $20

in this transaction and the finished good in the OEM’s inventory is valued at its cost of $70.

9
 ***Insert Figure 2 Here***

Based on the details provided in the Investigation Report (pp. 51–54), we infer Toshiba’s

journal entries for these transactions were as follows:

Procurement of components from outside supplier for $50:

Inventory 50
Cash 50

Transfer of components to CM at a masking price of $200:

Accounts Receivable 200
Production Costs 150
Inventory 50

Repurchase of the finished product from the CM which includes $20 fee to CM:
Inventory 70
Production Costs 150
Accounts Receivable 200
Cash 20

Sale of finished product to end-user for $100:

Accounts Receivable 100
Revenue 100
Cost of Goods Sold 70
Inventory 70

The account “Production Cost” is similar to Cost of Sales, a temporary account, which is

closed to the Income Summary at the end of each accounting period. The effect of transfers of

10
components to the contract manufacturer can be understood by analyzing the corresponding T-

accounts.

Production Costs

When components are

transferred to CM
When finished products are
transferred from CM
__________________ __________________
Closing entry with Ending balance
corresponding credit going to
Income Summary account

Thus, when components transferred from the OEM to the CM exceed finished products

sent back from the CM to the OEM, the production cost account has a credit balance. At the end

of the period, the account is closed with a debit, with the corresponding credit to Income

Summary, thereby reducing reported costs and overstating reported income for that period. The

internal auditors understood that this accounting was technically incorrect but were informed that

the impact on income would be immaterial because parts held by the CMs were limited to

approximately three days of production (Investigation Report 2015, 58). Based on this assurance,

the internal auditors approved the accounting.

In contrast, in accounting periods when the CM sends more finished products to the OEM

than components transferred by the OEM to the CM, the production cost account would have a

debit balance. At the end of the period, the account is closed with a credit, with the

corresponding debit to Income Summary, thereby reducing reported income for that period.

Toshiba inflated income in many accounting periods by shipping more components to the CM

11
than needed to fulfill production needs. When these outbound shipments exceeded finished

products received from the CM, Toshiba generated more credits to the Production Cost account

than debits, thereby inflating reported income. This strategy to inflate income is similar to the

practice of channel-stuffing, in which companies encourage customers to absorb ever-increasing

quantities of product.7 Customers might be incentivized to do so by more favorable credit terms,

or liberal return policies.

An alternative way to account for the transfer would be to retain the inventory on the

balance sheet of the OEM and to recognize any consideration received from the CM in advance

of the repurchase as a deferred liability. That liability is relieved upon payment to the CM for the

finished goods. The journal entries for the example above might be as follows:

Procurement of components from outside supplier for $50:

Inventory 50
Cash 50

Transfer of components to CM at a masking price of $200:

Accounts Receivable 200
Deferred Liability 200

Repurchase of finished product from the CM, which includes the $20 fee to CM:
Inventory 20
Deferred Liability 200
Accounts Receivable 200
Cash 20

7
Examples of companies that have channel-stuffed include Sunbeam and Bausch & Lomb. See Crockett
(1996) for a case on Bausch & Lomb, and Caplan, Dutta, and Marcinko (2017) for a case that includes
allegations of channel-stuffing at Green Mountain Coffee Roasters.
12
 Sale of finished product to end-user for $100:
Accounts Receivable 100
Revenue 100
Cost of Goods Sold 70
Inventory 70

Deferred Liability

When components
transferred to CM
When finished products
transferred from CM
______________________ __________________
No closing entry required Ending balance

Deferred Liability, in contrast to Production costs, is a permanent balance sheet account

that does not have to be closed at the end of each accounting period.8 Hence, the difference

between goods transferred to the CM and goods transferred from the CM affects the balance of

the Deferred Liability account and not the income statement. Had Toshiba used a Deferred

Liability account, it would have had no incentive to channel-stuff components with the CM since

doing so would not affect income. However, sending the CM more components than necessary

requires cash to purchase the components from the vendor.

8
The accounting described here is based on ASC 470-40-25-1 and ASC 470-40-25-2a, and is also
described in a PwC document: US GAAP: Issues and solutions for the medical technology industry 2016
edition: https://www.pwc.com/us/en/health-industries/pharma-life-sciences/publications/pdf/pwc-pharma-
life-sciences-us-gaap-medtech-issues-and-solutions.pdf, p. 17 (last accessed July 5, 2018). As mentioned
earlier, Toshiba was following U.S. GAAP for all years covered in this case. In 2017, Toshiba switched to
IFRS.
13
Earnings Management through Price Masking

In 2008, as a consequence of the U.S. financial crisis and the onset of the global

economic recession, Toshiba was concerned about its financial results. In August 2008, at a

high-level corporate meeting, then CEO Atsutoshi Nishida demanded an additional profit of ¥5

billion from the PC division. This additional profit was a ‘Challenge’ that was over and above

the division’s forecasted first half-year budget. The PC division met this ‘Challenge’ by

transferring ever-increasing quantities of components to its CM. These transfers were recorded at

exorbitantly high masking prices, which was estimated to reach ¥14.3 billion by September

2008, and further increased to ¥27.3 billion by the end of the first quarter 2009, when Mr.

Nishida resigned from his position as the CEO of Toshiba (Investigation Report 2015, 54-55).

Channel stuffing continued to take place at the end of every quarter even under the new

CEO Norio Sasaki. While Mr. Sasaki wanted to decrease the magnitude of profits generated

through channel-stuffing, he wanted to wait until the PC business reported excess profit and

believed it should not be reduced when the PC business was reporting a loss. On September 27,

2012, Mr. Sasaki ‘strongly demanded’ an improvement of ¥12 billion in the operating profit of

the PC business to be achieved in three days before the quarter-end, September 30, 2012.

Consequently, the Division engaged in an additional ¥3.9 billion of ‘buy-sell’ arrangements and

¥6.5 billion of ‘carry-over.’ As a result of these transactions, the balance of “buy-sell” profits

recorded was estimated to reach ¥65.4 billion when Norio Sasaki resigned from his position as

the CEO (Investigation Report 2015, 55).

Under the next CEO, Mr. Hisao Tanaka, Toshiba began to resolve the overstated profits

from channel stuffing and by the third quarter of 2014, the balance of the buy-sell profits was

estimated to have been reduced to ¥39.2 billion. The resulting large losses reported by the PC

14
Division caught the attention of an Audit Committee member, Mr. Seiya Shimaoka who

suggested to the Chairman of the audit committee, Mr. Makoto Kubo, to conduct a thorough

examination of whether or not there was inappropriate accounting treatment. Mr. Kubo, who as a

former CFO of Toshiba was well aware of the channel stuffing at the PC division, ignored the

request (Investigation Report 2015, 58).

Long Term Contracts at Toshiba’s Power Systems Division

The Power System Division of Toshiba worked on multi-year, multi-billion dollar

contracts to build power plants all over the world. Its clients were mostly governmental agencies

that grant contracts to the lowest cost bidder. Toshiba was among a handful of companies

worldwide that has the technical expertise to build and install nuclear power plants.

Typically, revenue from these long-term contracts is recognized using the percentage-of-

completion method.9 To use this method, the company must be able to estimate:

 The total income to be derived from the contract;

 The total cost to perform the services required under the contract; and

 The extent of contract progress as of quarter- and year-end.

The most common method of measuring contract progress is to compute the ratio of the

costs incurred to date to the total estimated cost to complete the contract. Accordingly, an

estimate of total contract costs for each long-term project has to be reassessed in each reporting

9
An alternative method of revenue recognition for long-term contracts is the completed contract method.
In this accounting treatment, the entire revenue and costs of the contract are recognized only upon
completion of the work. However, if the contract is expected to generate a loss, the loss is recognized
immediately.
15
period. Whenever the estimate of total costs exceeds the contract revenue, any anticipated loss

not recognized previously is recognized in that reporting period. Hence, companies undertaking

long-term contracts need to ensure proper policies and procedures that require periodic and

objective assessments of these estimates. Additionally, properly designed internal controls help

ensure timely reporting of contract losses.

There was a systemic failure of timely reporting of contract losses in two divisions

affecting over 15 contracts. The contracts ranged from ¥0.5 billion to ¥858 billion. The length of

most of these contracts was four to six years, and most of the delivery dates ranged between

2009 and 2016.

In some cases the contract losses were already evident at the inception of the contract. In

January 2012 (FY 2011), Toshiba accepted a government contract at a price of ¥7.1 billion when

the internal projection of the costs to fulfill the contract was ¥9 billion.10 That is, the contract was

expected to generate a loss of ¥1.9 billion from the outset. In order to justify the contract, which

was deemed “necessary in terms of business strategy,” a ‘challenge value’ for the contract costs

was set at ¥7 billion, thereby yielding ¥100 million of profits in the best-case scenario. The

reduction of ¥2 billion in contract costs would be achieved through anticipated cost reductions;

however, at the time of the bid, the sources of those savings were not identified. Consequently,

no losses were recorded in FY 2011. Subsequently, in the third quarter of FY 2014, a provision

for contract losses was recorded for the first time. The Independent Investigation Committee

surmised that the division delayed recognizing losses on this project because it would not be

acceptable to the Head of the Power Division, Mr. Igarashi. Apparently, Mr. Igarashi demanded

10
This is noted as Project A in the Investigation Report and is discussed on pages 24 – 25.
16
a “moral certainty of loss or firm loss figure” before approving recognition of losses on these

contracts.

In February 2007, Toshiba’s Power Systems Division received a ¥54.5 billion contract

for delivery in August 2010. By December 2007, the contract costs were expected to reach ¥55.7

billion, resulting in a contract loss of ¥1.2 billion. However, no contract loss was recorded for FY

2007. A loss of ¥6.9 billion was recorded upon completion of the contract in August 2010.11

Arguably, as losses were anticipated by December 2007, and as costs increased thereafter, a

provision for contract losses should have been recorded for FY 2007 and in subsequent years.

From January to March 2008, the sales managers of the division discussed with the division

head, Mr. Hedio Kitamura, the possibility of recording losses, but Mr. Kitamura did not approve

recording the loss provisions. The mid-level managers made no attempt to record losses on

contracts in progress in subsequent years because they thought they would not receive approval

from their superiors, as the result of increasing pressure to meet budget targets.

Between 2007 and 2009, Westinghouse Electric Company (WEC), the recently acquired

U.S. subsidiary of Toshiba, received contracts for $7.6 billion (approximately ¥850 billion) to

build power plants to be delivered from 2013 to 2019. In the second quarter of FY 2013, WEC

estimated losses of $385 million on these contracts due to design changes and delayed

construction work. Toshiba reevaluated WEC’s loss assessments and recorded a loss of $69

million. Subsequently, in the third quarter of FY 2013, WEC increased the loss estimate to $401

million. The auditors, Ernst & Young ShinNihon, insisted that Toshiba record a third quarter loss

of $332 million (the difference between $401 million and $69 million). Toshiba, however,

recorded an additional loss of only $223 million (for a cumulative loss of $293 million). Thus,

11
This is noted as Project E in the Investigation Report and is discussed on pp. 28 – 29.
17
Toshiba underreported losses by $107 million relative to what Ernst & Young ShinNihon

originally demanded. It is not clear how Toshiba derived the $223 million, for which, apparently,

there was no documentation. It appears that Toshiba’s management anticipated that Ernst &

Young ShinNihon would treat the shortfall of $107 million to be less than the materiality

threshold for the audit.12

Toshiba’s corporate governance structures failed to ensure proper accounting for the

long-term contracts. Internal controls were inadequate to detect or correct the failure to report

contract losses. It is difficult for the external auditor to identify the inappropriate application of

the percentage-of-completion method when the audit client makes a concerted effort to conceal

it. Toshiba employees hid facts from the auditors, and “created stories” that contradicted the

facts. External auditors usually rely on the company’s internal control system to obtain some

assurance about percentage-of-completion estimates. Further, while several audit committee

members were aware of inappropriate accounting for some of the long-term contracts, this issue

was not discussed by the audit committee nor was it communicated to company executives.

Transitioning Corporate Culture in Japan

Japanese corporate culture in the 1990s was fraternal and corporate boards consisted

exclusively of corporate insiders; there were no independent directors, no diversity, and little

responsiveness to the concerns of investment funds and financial markets. This culture was

reinforced by the underlying Japanese corporate environment of “keiretsus,” networks of

12
This is noted as Project G in the Investigation Report and is discussed on pages 30 – 31.
18
interconnected firms and banks. In the 1990s, foreign investors owned only about 5% of the

Japanese stock markets. As of April 2017, foreign investors held 30.1% of Japanese shares and

were pressuring Japanese companies to adopt American-style governance (Allaire and Dauphin

2016; Statistics Bureau, Ministry of Internal Affairs and Communications 2019).

Lately, Japanese corporate governance structures and board composition have been

subject to intense criticism. In some respects, its corporate governance lags that of some

emerging Asian economies, such as China, India and South Korea. For example, in 2013 about

600 of 1,400 listed Japanese firms did not have a single outside director, whereas China, India

and South Korea all require them. By contrast, for U.S. companies listed on the New York Stock

Exchange, outside directors must comprise more than half of the board. In Japan, only a handful

of companies have at least three outside directors, Toshiba being one of them. Irrespective of

their presence, in general the outside directors in Japan wield very little influence. For example,

commenting on the role of the outside directors at Olympus, ex-CEO Michael Woodford likened

them to “children in a classroom,” totally obedient to the company’s chairman of the board

(Woodford 2012).

In order to lure global funds to invest in Japan, the government of Prime Minister Shinzo

Abe proposed a set of policy imperatives in 2014, popularly known as Abenomics. A key pillar

of Abenomics was the corporate governance code. Though the code is voluntary, it is being be

widely adopted, perhaps because companies will be required to explain their non-compliance

with the code.13 As of July 2017, approximately 26% of companies listed on the Tokyo Stock

Exchange were in full compliance with the code, up from approximately 20% in December 2016.

13
This is similar to the legislative tactic adopted in the Sarbanes-Oxley Act that requires companies to
either adopt a code of ethics for senior financial officers or provide reasons for not doing so.
19
Approximately 89% of companies were in compliance with 90% or more of the code’s principles

(JPX Tokyo Stock Exchange 2017). The code empowers shareholders and encourages them to

voice their opinion when needed. However, not everyone or every corporation in Japan has

accepted Abenomics. Japan’s powerful business lobby, Keidanren, has stonewalled the reforms.

Among Keidanren members, Canon has been the most vocal critic of bringing outsiders onto

boards.

Before the accounting scandal, Toshiba was widely known in Japan as the pioneer of

good corporate governance. Its board had four external directors, and the audit committee

included some of these external directors, a rarity in Japan. As illustrated by subsequent events

and the ensuing investigation, such measures were woefully inadequate. Subsequently, Toshiba

increased the number of outside directors to seven, forming a majority of its eleven member

board. While appointing outside directors to the board is often considered a key to good

corporate governance, it is not a panacea. These external directors have to be qualified and

empowered to provide effective oversight of senior management and the firm’s financial

reporting system.

Aftermath

Following the scandal, Ernst & Young ShinNihon was fined $17.3 M (¥2.1 billion) by

Japan's Financial Services Agency for negligence in connection with the firm’s audit of Toshiba.

Also, Ernst & Young ShinNihon was suspended from taking on new business for three months.

The regulatory agency also suspended seven individuals from working as auditors for a period of

one to six months.

20
 On March 29, 2017, Westinghouse, a once-proud name that symbolized American

supremacy in nuclear power, filed for bankruptcy protection. In 2018, Toshiba sold

Westinghouse to Brookfield Business Partners for $4.6 billion. With the sale of Westinghouse,

Toshiba plans to discontinue its overseas nuclear power business. Toshiba reported a net loss of

$9.6 billion for fiscal 2016. Also in 2018, Toshiba sold one of its crown jewels, the memory chip

business, to a group led by Bain Capital for approximately $18 billion.

21
 CASE REQUIREMENTS

Although the Toshiba audit was performed under Japanese Auditing Standards, these

standards are in substance very similar to standards for U.S. issuers. As a result, and because

Japanese standards require translated versions, please use the standards of the Public

Company Accounting Oversight Board (PCAOB), available at www.pcaobus.org when

answering Requirements 3, 4 and 5.

Requirement 1: Economic events can lead to business risk for companies, which in turn can

lead to audit risk.

a. Briefly describe some of the major events occurring in Japan and worldwide during the

period 2007 – 2013 that negatively impacted the demand for Toshiba’s products and

services. How and why were the accounting choices made by company executives

affected by these events?

b. Describe the audit risk model and its components. How is management’s incentive to

misreport reflected in the auditor’s risk assessment, and how is it incorporated into each

component of the audit risk model? How was audit risk at Toshiba affected by the

incentives and pressures on management described in your answer to part (a)?

c. Why is it important for auditors to obtain a general understanding of the economic

conditions and risks under which a business operates?

22
Requirement 2: The fraud at Toshiba was perpetrated by mid-level managers.

a. How does the Association of Certified Fraud Examiners (ACFE) define the fraud triangle

(www.acfe.com/fraud-triangle.aspx)?

b. Apply the fraud triangle to Toshiba and discuss in detail the ramifications of each

component of the fraud triangle from the perspective of a mid-level manager. Incorporate

relevant aspects of Japanese corporate culture into your answer, if possible.

c. How did the “tone at the top” contribute to the fraud?

Requirement 3: Refer to the authoritative guidance provided by the PCAOB in Auditing

Standard 2401: Consideration of Fraud in a Financial Statement Audit.

a. From the red flags listed in the Appendix, “Examples of Fraud Risk Factors,” identify

those that are applicable to Toshiba.

b. According to AS2401 how might auditors adjust the nature, timing, and extent of audit

procedures in response to the fraud risk factors identified in (a)? Directly cite relevant

sections of the standard.

Requirement 4: Toshiba was masking the price of the components it was transferring to its

contract manufacturers. Also, as noted in the case, at the point of transfer to contract

manufacturers, Toshiba was recording this ‘sale’ as a credit to production costs thereby

increasing income. Alternatively, a credit to a deferred liability account would have had no

transient effect on income.

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 a. Considering the volume of the price-masking transactions, should Toshiba’s external

auditors, Ernst & Young ShinNihon have objected to the treatment of crediting

Production Costs to record transfer of component parts to the contract manufacturers?

Provide specific reasons why or why not.

b. Could internal control activities have prevented the price-masking fraud? List specific

controls that could have prevented this or explain why control activities may not have

prevented the fraud.

c. From the perspective of the external auditors, what audit procedures would have revealed

the magnitude of the financial statement impact created by the accounting for the price

masking transactions?

d. Discuss the impact of unusual transactions on audit risk. Why should auditors pay

particular attention to unusual transactions?

e. What procedures do you think auditors should perform when they encounter unusual

transactions in an audit?

Requirement 5: Under U.S. GAAP, accounting for long-term contracts is remarkably sensitive

to a number of accounting estimates.

a. As an auditor with little or no knowledge of nuclear power plant construction, how would

you assess the reasonableness of management’s estimates of the total cost of the nuclear

construction projects used in the percentage-of-completion method? Draw upon your

knowledge of auditing from the class and textbook, and research PCAOB guidance on the

topic.

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 b. With regard to the contract at WEC, if you were the auditor, would you have required an

adjustment of the full contract loss, or would you have been satisfied with the partial

adjustment recorded by Toshiba?

c. How does your response to (b) depend on whether the amount of adjustment recorded by

management was influenced by management’s assessment of the auditor’s materiality

threshold?

d. Should the auditor have communicated to the audit committee the amount of the

adjusting entry not posted? Support your answer with reference to PCAOB auditing

standards.

Requirement 6: Companies influence reported earnings through accrual earnings management

and real earnings management. In accrual earnings management, earnings are influenced through

discretionary accrual choices either within or outside GAAP. In real earnings management,

earnings are influenced through activities that impact cash flows, such as reducing discretionary

R&D or marketing expenses. (For a brief discussion of the distinction between real and accrual

earnings management, see Fischer and Rosenzweig (1995).)

a. Did the fraud involving masking prices at Toshiba constitute accrual earnings

management, real earnings management, or both? Why?

b. Did the fraud involving long-term contracts at Toshiba constitute accrual earnings

management, real earnings management, or both? Why?

Requirement 7: Corporate governance structures reflect the cultural norms of the societies in

which they arise and operate.

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a. Mr. Nishida and Mr. Sasaki, two successive CEOs of Toshiba, put unrealistic pressure on

the PC division to increase profits. Consequently, the PC Division took advantage of the

“buy-sell” arrangement and resorted to channel stuffing component parts with contract

manufacturers. While Mr. Nishida and Mr. Sasaki did not directly authorize or suggest

fraud, are they culpable for instigating the fraud? Why or why not?

b. An audit committee member’s request for a thorough investigation of the PC Division

was ignored by Mr. Kubo, the chair of the audit committee who was a former CFO. What

recourse does the audit committee member, Mr. Shimaoka, have and how should he have

proceeded under the circumstances? What would you do, if faced with a similar situation

at work?

c. In your opinion, what role did the Japanese culture of “loyalty and obedience” play in the

fraud at Toshiba? In your response, include an analysis of cultural differences based on

Hofstede’s assessment of cultural differences available at https://geert-

hofstede.com/japan.html.

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 REFERENCES

Allaire, Y., and F. Dauphin. 2016. Japan discovers ‘good’ corporate governance, American style.

Japan Today. (April 20). Available at:

https://www.japantoday.com/category/opinions/view/japan-discovers-good-corporate-

governance-american-style (Accessed January 24, 2019).

Caplan, D.H., S.K. Dutta, and D.J. Marcinko. 2017. Tempest in a K-Cup: Red Flags on Green

Mountain. Issues in Accounting Education 32 (1): 79-94.

Crockett, J.R. 1996. New Year’s Eve Party? Journal of Accounting Education 14 (3): 401-413.

Fischer, M., and K. Rosenzweig. 1995. Attitudes of Students and Accounting Practitioners

Concerning the Ethical Acceptability of Earnings Management. Journal of Business

Ethics 14 (6): 433-444.

International Ethics Standards Board for Accountants (IESBA). 2015. Toshiba accounting

scandal. Agenda Item F-2 CAG Meeting (September 14) Available at:

https://www.ethicsboard.org/system/files/meetings/files/Agenda_Item_F-2_-

_Toshiba_Accounting_Scandal_0.pdf (Accessed January 24, 2019).

JPX Tokyo Stock Exchange. 2017. How Listed Companies have Addressed Japan’s Corporate

Governance Code. Available at

https://www.jpx.co.jp/english/equities/listing/cg/tvdivq0000008jdy-

att/b5b4pj000001sea2.pdf (Accessed January 24, 2019)

Khondaker, M.R., and M. Bremer. 2016. Accounting Irregularities at Toshiba: An Inquiry into

the Nature and Causes of the Problem and Its Impact on Corporate Governance in Japan.

Global Advanced Research Journal of Management and Business Studies 5 (4): 88-101.

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Mehta, A., and G. Bhavani. 2017. Application of Forensic Tools to Detect Fraud: The Case of

Toshiba. Journal of Forensic and Investigative Accounting 9 (1): 692-710.

Statistics Bureau, Ministry of Internal Affairs and Communications. 2019. Statistical Handbook

of Japan 2018. https://www.stat.go.jp/english/data/handbook/c0117.html (Accessed

January 24, 2019).

Toshiba Corporation—Independent Investigation Committee. 2015. Investigation Report. (July

20). Available at: https://www.toshiba.co.jp/about/ir/en/news/20150725_1.pdf

(Accessed January 24, 2019).

Ueda, R. 2015. How is corporate governance in Japan changing?: Developments in listed

companies and roles of institutional investors. OECD Corporate Governance Working

Papers, No. 17. Paris: OECD Publishing.

Woodford, M. 2012. Exposure: Inside the Olympus Scandal: How I went from CEO to

Whistleblower. New York, NY: Penguin Group.

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 Figure 1

Real GDP levels in an index with the first quarter of 2007 set at 100

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 Figure 2

Price Masking Mechanism Example

The sequence of these transactions is as follows:

a. The OEM purchases parts for $50 cash.
b. The OEM transfers the parts to a contract manufacturer at a masking price of $200.
c. The contract manufacturer assembles the parts and transfers the product to the OEM and
receives a cash payment of $20. The OEM records the transfer-in at $220, reversing the
masking price, thereby valuing the inventory at $70.

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 Table 1

Toshiba

Sales and Net Income (2007 – 2013)

Net Sales Net Sales Net Income Net Income

Year (Original) (Restated) (Original) (Restated)
2007 7,116 6,682 137.4 137.4
2008 7,404 7,209 127.4 127.4
2009 6,513 6,373 (343.6) (398.9)
2010 6,291 6,138 (19.7) (53.9)
2011 6,399 6,264 137.8 158.3
2012 6,100 5,995 73.7 3.2
2013 6,503 5,722 50.8 13.4
- Amounts in billions of yen.

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 Table 2

Key Personnel at Toshiba14

Chair of Audit Division Head: Division Head:

Date CEO CFO Committee Power Systems PC Division*
2007 Atsutoshi Fumio Sadazumi Norio Hisatsugu
Nishida Muraoka Ryu Sasaki Nonaka
2008 Atsutoshi Fumio Sadazumi Hideo Hidejiro
Nishida Muraoka Ryu Kitamura Shimomitsa
2009 Atsutoshi Fumio Shigeo Yasuham Hidejiro
Nishida Muraoka Koguchi Igarashi Shimomitsa
2010 Norio Fumio Shigeo Yasuham Masahiko
Sasaki Muraoka Koguchi Igarashi Fukakashi
2011 Norio Fumio Shigeo Yasuham Masahiko
Sasaki Muraoka Koguchi Igarashi Fukakashi
2012 Norio Makoto Fumio Yasuham Masaaki
Sasaki Kubo Muraoka Igarashi Osumi
2013 Norio Makoto Fumio Yasuham Masahiko
Sasaki Kubo Muraoka Igarashi Fukakashi
2014 Hisao Makoto Fumio Yasuham Masahiko
Tanaka Kubo Muraoka Igarashi Fukakashi

* This division was the Personal Computer and Network Co. until 2011, when it was renamed
the Digital Products and Network Company. In 2013, this division became part of Lifestyle
Product and Services Group.

14
This information was obtained from Reports of General Meeting of Shareholders 2007 – 2014.

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