Internal Auditing & Risk Management Year XIV, No 1(53) March 2019

YES, BUT WAS IT A REAL AUDIT?

THE TOSHIBA CASE

Gökçe Sinem Erbuğa, PhD Candidate

Dokuz Eylul University, Izmir, Turkey
gokce.erbuga@deu.edu.tr

Abstract: In the accounting literature, the Japanese Toshiba has taken an

important place with its accounting scandal that occurred in 2015. Toshiba’s
accounting records have been systematically changed and the company’s
operating profit has been inflated for many years. Toshiba’s financial
statements irregularities, non-rational profit targets, failure in reflecting the
loss of value in its financial statements, the occurrence of arbitrary practices
of the company’s top management caused multiple serious problems in the
management of the company. The fact that even a huge company, such as the
Japanese giant Toshiba, is managed away from the corporate governance,
causes other companies to question the importance of audit once again. The
fact that we still face such large accounting scandals today, and they bring
about the issue of whether the internal audit systems of the companies are
established or not if they are established how efficiently they are operated,
and how effective the independent audit is. This research, which emphasizes
the importance of auditing process for companies is based on the Toshiba’s
corporate accounting scandal case. The Toshiba case has been evaluated and
the necessity of independent auditing and the issue of how to ensure audit
quality have been handled. This research intends to take lessons from the
Toshiba case in order to raise awareness, to encourage corporate partners to
increase audit quality and to communicate with each other in order to ensure
audit quality.

Keywords: audit quality, Toshiba, accounting scandals, corporate governance

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Introduction
In today’s intricate world, nearly all companies can fall for an accounting
scam. Although a single piece of a scam evidence has been never adequate for
moral certainty of accounting fraud, embezzlement or financial irregularities,
companies shouldn’t forget that they are not scam-proof. Over the last few
decades, companies have suffered several recent incidences of scam, especially
high-volume frauds which end up with huge economic losses. Despite their
massive economic shrinkage, they all know the last thing they want to hear
is “it’s only money”. Because it’s not just money. In some cases, the cost of
accounting scam can be much higher than it’s ever been like tragic downfalls
of companies, life incarceration, climate of distrust and skepticism among the
market actors, irregular and unpredictable economic fluctuations in the capital
markets, negative stock market reactions and some other enforcements like
fines or penalties.
The financial dimension of the costs that companies face accounting
scams bear may just be the tip of the iceberg which means the collateral
damage can go further in its financial results (PwC 2007). The bad news is that
as given financial results become more likely to be measured, companies may
underestimate or misevaluate the collateral damage, while, at the same time,
paying sufficient attention to their adversely affected, damaged reputation,
brands, and images, and maintaining the motivation of their personnel.
The topic for the recent years’ digging deep is “Achieving and sustaining
accountability and transparency in companies” (Carothers and Brechenmacher
2014). Corporate fraud which can be articulated as a social phenomenon; not
just an accounting problem (Wells 2004) came to the fore after accounting
scandals that came to light one after another over recent decades. In many
incidences of accounting scam, it is clearly seen that scams are primarily
based on violation of stated codes which are defined as any rules, guidelines,
procedures, or codes that guide the company employees in his/ her moral and
ethical practices (Perlmutter and Schoen 2007), misapplying GAAP (Generally
Accepted Accounting Principles), IFRS (International Financial Reporting
Standards), IAS and GAAS (Generally Accepted Auditing Standards), and
building unhealthy relationships with the C-Suite.
After the big serious accounting scandals that the world has
experienced like The Bank of Credit and Commerce International (BCCI)
in 1991, HIH Insurance in 2001, WorldCom and Enron Corporation in
2001, Kmart Corporation in 2002, Arthur Andersen LLP in 2002, Sunbeam
in 2002, Parmalat S.p.A. in 2003, American International Group (AIG) in

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2008, Satyam Computer Services in 2009, and Lehman Brothers Holdings

Inc. in 2010 (Wikipedia 2019a) have come to light, public concern has grown
exponentially (Lee, Al, and Gloeck 2008). Toshiba is the actor of the latest
corporate accounting scandal that ends up with a huge loss of faith and trust
in the auditing process by investors. Yet, as bad all that beforementioned
corporate accounting scandals were, the Toshiba Corporation scandal has also
led to a gigantic economic devastation, several job losses, insolvency, debt
restructuring, and nationalization (Khondaker and Bremer 2018).

Historical Development of Toshiba Corporation

Founded in July, 1875 as Tanaka Seisakusho Engineering Works, Toshiba
looks back on more than 140 years of success. Although Toshiba has such
a long history, its modern institutional structuring started in 1938 as Tokyo
Shibaura Electric Company Limited by merging Tanaka Engineering Works
(1875) with Tokyo Denki K.K. - A Tokyo Electric Company, which was
established as Hakunetsu-sha Company Limited in 1890 (Wikipedia 2019b).
In 1984, Kabushikigaisha Toshiba which is mostly known as Toshiba got its
recent name as Toshiba Corporation. Toshiba is renowned for its successful
introduction of Japanese culture in both Japan and other countries (Khondaker
and Bremer 2018).
Throughout its long operating period, Toshiba has encountered several
company takeovers, acquisitions, reestablishments, alliances, and mergers. It
is possible to say that there are two eras can be defined for the purpose of
Toshiba’s histography. Before its latest corporate accounting scandal became
public knowledge in 2015, the milestone which is known as Toshiba-Kongsberg
scandal (Toshiba of Japan and Kongsberg Vaapenfabrikk of Norway) in the
history, separates these two spans of time is the Cold War in 1987 (The New
York Times 1987). During the Cold War years, its subsidiary, Toshiba Machine
Company sold a kind of control milling machine (a military sensitive milling
machine which means militarily useful technology) to the Soviet Union forces.
After the Toshiba-Kongsberg scandal, both chairman and the president of
Toshiba Corporation step aside (UPI 1987).
On the other hand, Toshiba has made a major breakthrough over Japan’s
prewar era and postwar era economic growth and has supported financially by
the government of Japan throughout its early life stage. Especially when talking
about the postwar era, the government of Japan built a system to mobilize and
allocated a fund from its budget to support the key industries for accelerated

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economic evolution (Otsubo, 2007). Also Toshiba grabbed its piece of that pie
and branched out over the years by expanding its product range with Japan-
first products such as radar (1912), digital computer (1954), microwave oven
(1959), color video phone (1971), MR image health device (1982), laptop
(1986), DVDs (2005) and some others (Khondaker and Bremer, 2018). After
the postwar era Toshiba collaborated with some other companies, started to
operate in different sectors like hard engineering and primary industry and
took its final form as a corporate company group.
And today, Toshiba operates in five main sectors: energy and
infrastructure, community solutions, healthcare systems and services, electronic
devices and components, and lifestyle products and services (Toshiba 2015). In
the year 1971 Toshiba adopted corporate social responsibility (CSR) principles
endogenously pointing both its staff members and consumers. In 1973, “going
green phenomena” was accepted as a part of its corporate culture to be more
environmentally friendly and ecologically responsible and sustainable for
current and future generations. Hereat, its first environmental plan report was
released in 1993. Although Toshiba fell on hard times because of its nuclear
energy plans because of the Fukushima Nuclear Disaster in 2011, it still has
been ranked on the Dow Jones Sustainability Indices (DJSI) World Index since
2000 except one year. The company was dropped out of the index in 2015
because of its corporate accounting scandal (Elghandour and Toka 2016).

The Corporate Accounting Scandal of Toshiba: How It Happened?

In the postwar era, Toshiba’s products were either at the beginning or at the
end of their life cycles – they can be identified as stars or cash cows. In the
long run they were expected to generate high cash flows (high liquidity) which
brings high market shares. But ironically, 2015 corporate accounting scandal
of Toshiba damaged these profitable product lines, thereby many products
lost their place in the stars and turned into dogs. In order to camouflage the
company’s ineffectualness, the C-Suite manipulated its earnings for roughly
seven years (Khondaker and Bremer, 2018).
Toshiba’s reported operating profit was artificially inflated and it was
overstated by US$1.2 billion, with its top executives’ knowledge for over the
years (Reuters 2015a). As the BBC News reported, the overstatement was
roughly triple an initial the company’s estimate (BBC 2015). According to
the statements issued to the press (press releases), the scandal derived from a
serious misconduct of the accounting method named “percent of completion

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(PoC)” method. The percent of completion (PoC) method which is a non-

cash flow accounting method of work-in-progress evaluation, with the aim of
recording long-term contract, is mostly used in managing long term projects
and it recognizes revenue and expenses as a percentage of the project’s
completion during the period (CFI 2019). According to the PoC method, total
income and total cost along with the degree of the process made in one single
accounting year is estimated and the income and the cost of the contract for the
accounting year are broadcast according to this rule (Independent Investigation
Committee or IIC of Toshiba 2015).
Toshiba declared that the profit targets from the projects related
to electricity generation, railways, and some other related works were set
unachievable high and to achieve meet this target, Toshiba preferred to decrease
its expenses. But in the end, it was unsuccessful in adjusting its costs for the
truly existing progress made (Khondaker and Bremer, 2018). With respect to
the financial investigation’s findings, the scandal’s roots were much deeper and
the execs of the company were manipulating Toshiba’s earnings for more than
7 years (Financial Times 2015a). Independent Investigation Committee (IIC)
of Toshiba brought to light that Toshiba inflated its operating profit artificially
and overstated them in fifteen projects in these three beforementioned areas and
suffered from the harm that follows from accounting malpractice (accounting
negligence). Although the scandal had a broad repercussion in press, Toshiba
went on its fraudulent actions and hid financial information about its final
situation. On the other hand, in 2016 Toshiba’s losses was massive because of
its nuclear plant subsidiary Westinghouse in the US and the book value of the
company was negative (Khondaker and Bremer 2018).
As uncovered by the IIC, Toshiba’s corporate scandal was a multi-
dimensional case. For this purpose, it does seem that whoever is responsible
for having and breeding this scandal should be identified clearly. This paper
examines the responsible partners of the scandal in three groups: C-Suite (top
management), auditing parties, and auditing system in Japanese culture. The
first actors of the case that should be raised here is the manner of the C-Suite
against middle management and lower level employees. C-Suite of Toshiba had
unrealistic profit targets to meet by managers and that situation brought tons of
pressure on subservient managers. On the other hand, managers were forced
to hide losses until getting profits and offset actual losses with future profits
(Japan Times 2015). Besides, the perception of unconditional obedience to the
authority (chief executive) was the dominant approach within the body of the
company. When unrealistic demands and unachievable profit targets of the top

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execs declared to the managers, they had to attain these goals no matter what
happens (IIC, 2015). Actually, the scandal was not just an ordinary accounting
fraud case. It was mostly part of a major dilemma in management and corporate
governance implications. The execs were hiding their heads in the sand not to
see that they were failing, but of course it didn’t make it go away. Frankly
speaking, the majority of these fraud-related actions were caused by the firms
C-suites including executive officer (CEO) and his predecessors Atsutoshi
Nishida and Norio Sasaki and also his denial of failing, and rejection the reality
of that fact (Japan Times 2015).
Although not many companies are applying international financial
accounting standards in Japan, Toshiba was a distinguished example for its
peers and outstanding company because of its social responsibility perception
and successful corporate governance implications. Apart from the fact that
there are some obligations about the board of directors’ structures of companies
in Japan, there were four external directors within the body of its board of
directors. In spite of the fact that this structure of the Toshiba’s board of
directors was a quietly desired structuring, these external members of the board
of directors were not very component of their job, and quite inexperienced to
meet the standards (Khondaker and Bremer 2016a). As a whole, Toshiba’s top
management - especially the CEO, paved the way for the accounting scandal
by putting tons of pressure on subordinates to achieve the unachievable profit
targets after the big global recession worldwide which was the result of the
global financial crisis. Actually the top management’s primarily the CEO’s
feelings and powerful desires to attain unrealistic targets put his head in the
noose (Elghandour and Toka 2016).
The second actors that should be referred here is the malpractice of audit
parties. Although this paper mostly refers to the independent external auditors
by the term of audit actors, it is also so obvious that Toshiba’s internal auditors
abused their duty of report fraud. Both independent external auditors and
internal auditors are responsible to stockholders, companies, potential investors,
governments, and other actors of the stock market. Firstly, speaking for the
external audit part, independent external auditors have several responsibilities
to their customers, public authorities, and general public. The auditor has to
design and conduct the audit process in order to provide reasonable assurance
regarding the reliability of financial reporting and financial statements, if any
material weaknesses exist (PCAOB 2002) - SAA99 and SAS 113 (Mehta and
Bhavani, 2017).Toshiba’s auditor was Ernst & Young ShinNihon LLC which
was one of the leading audit companies in Japan. For the year 2014, Toshiba

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paid roughly US$8 million, which means 1.5 basis points of the company’s
turnover for that year (Khondaker and Bremer 2016a). As Reuters articulated,
the six year average of Toshiba was 1.8 basis points (Reuters 2015b) which
means that Toshiba was paying a lower fee for the audit services received by
EY ShinNihon. This dilemma puts a question mark in the minds that whether
the audit services received by Toshiba from EY ShinNihon is sufficient and
establishes the appropriate standard of professional attention and care. It is
widely believed that the quality of audit directly and highly related to audit
fees. The fee paid to the auditor plays a critical role in assessing the quality of
the audit process. The fee level of audit dictates the selection process of the
auditors that will conduct the audit process effectively and follow due control
mechanism. In other words, a successful selection of auditors is playing a
crucial role in enhancing audit quality and providing auditors’ independence
(Khondaker and Bremer 2016b).
Ernst & Young ShinNihon LLC made serious errors when conducting
the audit process and failed. Just before the Toshiba’s corporate accounting
scandal came out into the open, EY was one of the biggest auditing companies
in the world and biggest domestic auditing corporation in Japan and made
a business contract with Toshiba so its auditor for almost sixty years. When
the auditors within the body of EY failed in detecting the malpractice and
fraud for almost seven years, this business collaboration ended up badly. The
Financial Services Agency of Japan (FSA) which is a government agency and
an integrated financial regulator and responsible for overseeing capital markets
in order to ensure the stability of the financial system of Japan (Wikipedia
2019c) denied EY ShinNihon to make new audit agreements for three months
from January and fined EY ShinNihon US$17.4 million (Financial Times
2015b) which was roughly equal to the total of two year auditing service fees
would be paid by the Toshiba to the EY ShinNihon (Reuters 2015c).
Seven auditors that took part in the audit process were accused of
malpractice (for abusing their duty of care and approving fraudulent financial
statements). The chief executive of EY ShinNihon Koichi Hanabusa resigned
after the accounting scandal and for nineteen employee who took part in the
scandal were suggested temporary reduction in pay (Financial Times 2015c).
Taking into consideration that Ernst & Young ShinNihon failed in conducting
the external audit process, Toshiba signed up its new audit agreement with
PricewaterhouseCoopers (PwC) Aarata in April, 2016. Toshiba decided to take
the action that produces the least harm after the scandal and intended to review
its auditing structure every five-seven years to manage its bad experiences. In

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addition to these precautions, Toshiba thinks out to reorganize its institutional

structuring in order to be more transparent. For this purpose, Toshiba chose to
spread knowledge and information companywide, share information oftener
and supply core knowledge and information to its audit committee (Glass,
Lewis & Co. 2017). From many different perspectives, the main responsible
actor of this massive corporate accounting scandal was the auditor of the
audit process. Of course the auditor was not the sole responsibility of this
scandal, but he was the main actor. In spite of the fact that the auditor was the
lemon, EY ShinNihon has obtained quite small sanctions when the scale of
the accounding scandal taken into consideration. It is very unlikely that the
auditors working in the country’s best audit firm would be unable to identify
the years of accounting irregularities.
EY ShinNihon has been hiring well-educated and successful people
that graduated from top universities, so the rumor mill went wild over times.
According to the speculations, both sides of the audit process- both Toshiba
employees and EY ShinNihon auditors, were aware of the fraudulent actions
that triggers the scandal. There was a plenty of room for the rumor mill to keep
turning and everybody was in the mix asking how the auditors didn’t realize the
scandal coming by fraudulent financial statements. Although EY ShinNihon
was hiring top talents throughout the country, their managers or supervisors
created a big pressure on the auditors. The supervisors banned the auditors
from speaking of this scandal and noising the backwashes around. Anyways,
the employees of EY ShinNihon were identified as the informal whistleblowers
of the accounting scandal and with the help of these whistleblowers, Toshiba’s
window dressing was talked over to some extent (Khondaker and Bremer
2016b).
The accounting scandal of Toshiba burst out after years of EY
ShinNihon’s negligent. This situation brought up this question: “Why the
auditor was blind to all these fraudulent accounting implications or accounting
irregularities?” (CFA 2015). According to the investigation results by FSA
Japan, one of the auditors that took part in conducting the audit process of
Toshiba, realized some extreme outcomes of the Toshiba Computer Division’s
accounting transactions, but the auditor didn’t pursue legal proceedings against
the accounting irregularities and dropped the subject or didn’t share information
and opinion with the other audit team members. To add, it is also mentioned that
the audit process was conducted according to the information gained from the
Toshiba’s consolidated subsidiary (Taiwan Toshiba International Procurement
Corp. -TTIP), but the auditor should have taken the company’s consolidated

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financial statements into consideration in order to dig up further information

for getting reliable audit evidences. From this perspective, the independent
external auditor had the ultimate responsibility for fulfillment of the audit
process (Khondaker and Bremer 2016b).
To sum up, in short, the audit committee of Toshiba didn’t carry out
its tasks meticulously which means the internal control implications were not
enough as the internal control system was not working properly. Toshiba’s
internal audit system was totally cowered in the face of accounting scandal
danger and didn’t declare and report corrupt accounting practices (IIC
2015). The internal auditors didn’t monitor injustices within the company
and the internal audit team consisted of insufficient people who were lack of
professional skepticism in a technical sense (Khondaker and Bremer 2016a).
On the other hand, EY ShinNihon was in a totally awkward position against
the fraudulent accounting transactions so that the large segment of the society
claimed that EY ShinNihon was aware of this potential danger and cooperated
with Toshiba in glossing over the accounting scandal.
The third and the last factor that should be mentioned in this paper
is the auditing system in Japanese culture. In Japan, internal control systems
of many companies are not running properly. It is a widely held belief that
Japanese corporate business culture is hierarchical and the underlying roots
of this corporate culture is loyalty and leaving no avenue unexplored not to
bring shame to its own employers (Chambers 2015). Japanese members of
the accounting profession should shоuld tаke all thе prеcаutiоnary measurе
to avoid from any fraudulent actions or accounting irregulations. As a
prеcаutiоnary measurе, an effective whistle-blowing system will be a useful
tool for detecting any wrongdoing in the company. An effective whistle-
blowing system has the power to prevent organizational wrongdoing in some
matters (Near and Miceli 1995). Nowadays, in many companies benefit from
the whistle-blowing system as an internal control tool and whistle-blowing on
accounting irregularities becomes commonly accepted (Mesmer-Magnus and
Viswesvaran 2005). Whistle-blowing enables reporting fraudulent accounting
transactions and accounting wrongdoings in terms of corporate governance
via internal and external reporting ways. According to the researches, almost
every whistblowers mainly prefer internal reporting channels rather than an
external one when they face an accounting wrongdoing and has to report it
(Miceli and Near 1992). Researches on this issue tend to mean white-collar
crime, corporate criminal behaviors, and illegal corporate behaviors by using
the term of “wrongdoing” (Miceli, Near, and Dworkin 2008). Although the

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term of wrongdoing is identified as “illegal, immoral, or illegitimate practices,

activities, or omissions”, the concept of wrongdoing goes even further than just
illegal behaviors (Warren 2003). On the other part Japan, which is the world’s
second largest developed nations in the world, is the third largest economy in
the world according to its nominal GDP and also fourth strongest economy by
purchasing power parity – PPP (Wikipedia 2019d). Although Japan has one of
the strongest economies and that developed, the Japanese audit system is not
all it’s cracked up to be. When the level of audit fees charged for the audit by an
external audit in Japan is compared to any other developed countries, Japanese
audit firms don’t have the chance to keep up with their peers in developed
countries. Although Japanese audit firms have higher density workloads than
other countries, they get paid less. Furthermore, the number of accounting
professionals is however limited when the volume of the stock markets and
total of the Japanese companies are borne in mind. Not enough people have
been exposed to the accountancy profession in Japan, so that Japan’s need of
accountants is so obvious.
Speaking of not only Japan but also all countries, it is possible to say
that independent auditing companies are not so good at detecting accounting
irregularities and fraudulent accounting transactions and fail sometimes. It is
quite understandable that the urgency of the law enforcement is so big, so
that a couple of legal actions taken like Sarbanes Oxley Law in US, Eight
Directive on Securities Disclosure (Directive No.8) in EU and J-Sox Law in
Japan (Srinivasan and Coates, forthcoming). Although still these legal actions
taken against accounting irregularities, the Toshiba case showed us there is no
motivation to improve corporate governance and compliance with laws and
regulations in Japan (Khondaker and Bremer 2018).

Results of The Toshiba’s Scandal

There are wild swings in the stock markets because of the Toshiba’s corporate
scandal that erupted in April, 2014. Toshiba’s name appeared in the press
across the world and stock market’s reaction to the scandal was too much. The
scandal was swirling around Toshiba’s C-Suite and Ernst &Young ShinNihon
LLC for not carrying out (fulfilling) Toshiba’s duties completely as an auditor.
As Financial Times gave a big place to the scandal in its columns, Toshiba
lost its shine and was far away from the glories of the past decades because of
this scandal. According to the Financial Times, over long years Toshiba was
one of the most powerful and well-known Japanese brands with its electronic
devices and was the poster child of pattern of Japanese corporate business

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behavior. This corporate accounting scandal has generated a climate of distrust

and since such hitches highly endanger Toshiba to maintain their prominence
and gradually to increase their power.
Toshiba’s scandal gave the company a deep shock in the strictest
sense of the word and made people act with suspicion towards internal audit
implications of companies and also the Japanese corporate scheme (Financial
Times 2015a). Between the years 2008 and 2014, the accounting scandal runs
up to US$2 billion of earnings manipulation by window-dressing which refers
to actions taken or not taken prior to issuing financial statements in order to
improve the appearance of the financial statements. Toshiba window dressed
its financial statements to manipulate its financial information, in order to
make its financial disclosures look more attractive to the stakeholders and
hide its recent poor performance. Not like the Toshiba-Kongsberg scandal
before, Toshiba declared that it would launch an extensive investigation about
the accounting manipulation scandal and would make it up to all the harms
of every party that affected negatively. The scandal wiped out the reputation
of both two companies that involved in the accounting scandal. Even though
Ernst &Young ShinNihon LLC was found guilty on all charges of the scandal
and blamed, it went scott free. And today, Ernst &Young ShinNihon LLC
is performing like nothing happened and providing audit services for a vast
number of companies.

Conclusion and Suggestions

In spite of all the legal actions taken like promulgated laws, regulations, legal
requirements, punishments, and judicial arrangements, etc. failed to satisfy the
expectations regarding corporate governance implications in order to prevent
accounting irregularities and scandals. In the direction of nipping accounting
irregularities and scandals in the bud, public authorities should take due
precautions and work at deterring accounting scandals before they come to
light. Independent audit firms should redesign their recruitment policy, hire
and educate the members of the profession as they make these employees
ready for the company. Via independent bodies, all the audit firms should be
inspected in order to secure their independence while conducting audits. This
accounting scandal showed clearly that corporate governance perception in
Japan is still not as strong as it desired to be and some structural adjustments
should be done. Companies should hire people who can resist pressure coming
from the company’s execs. In order to bring audit systems back to life, auditors
should receive the required level of education and trainings. Independent

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auditors should ensure that they are fully aware of and take steps to comply
with relevant laws, policies, and regulations when they are performing their
duties (Kızıl and Doğan 2017). It is also important that, audit firms should be
re-audited by public authorities (Khondaker and Bremer 2018).

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