RUNNING HEAD: CASE STUDY RESEARCH ASSIGNMENT: TOSHIBA |1

Introduction

Toshiba was established in 1938 through a merger between Shibaura Seisaku-sho and
Tokyo Denki (Mehta, 2016). By 2000, it had become one of the world’s largest chip and
notebook computer manufacturers. Soon after, the company changed its strategy to focus on
developing nuclear power plants due to increases in demand from China and the United States.
Toshiba estimated that they would be installing 45 new reactors worldwide by 2030 (Caplan,
Dutta, & Marcinko, 2019).

Despite their previous performance, the company’s profits began to decrease in the
upcoming years as Japan faced two consecutive recessions from 2008 to 2012. This caused the
company to manipulate its earnings in order to remain attractive to investors. Toshiba used two
accounting practices to do this: (1) delaying the recognition of losses under long-term contracts
and (2) applying inappropriate price masking techniques to record transfers of components
between itself and contract manufacturers (Caplan et al., 2019). The fraud had started under CEO
Astutoshi Nishida in the middle of the 2008 global financial crisis and was finally detected on
July 21, 2015 due to a whistleblower, which then uncovered ¥152 billion in overstated earnings
(Mehta, 2016). An internal investigation committee was assembled by the company to
investigate its accounting records from fiscal 2009 to the third quarter of fiscal 2014. It is
important to note that this was an independent investigation committee that only contained
members outside of the organization, as opposed to the other company-appointed committees
that Toshiba had made (Mehta, 2016). This investigative committee uncovered the following
major issues within Toshiba’s business units in Japan:

1. Weak corporate governance,

2. Poor internal controls, and

3. Malpractice of external auditors.

This report analyzes the nature and causes of these issues to find the mistakes made
during the internal and external audits as well as the deficiencies in governance which made this
fraud possible. The recommendations outlined in this report could have helped Toshiba and its
auditors detect the fraud before it began or at least stop it from causing as much damage as it did.
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Issue #1: Weak Corporate Governance

Description

Japanese corporate governance is vastly different from Canadian corporate governance.

In Japan, the board tends to place more focus on their operational executive function role over its
supervisory responsibilities. Many members of the board of directors reach their position after
being an employee at the company for years. These boards tend to have very few directors who
are complete outsiders to the company and lack overall diversity since the majority of directors
tend to be middle-aged Japanese men. Toshiba developed a hybrid approach to its governance in
2003 which involved creating an audit committee in order to create consistency between the
Japanese and Western governance systems. This audit committee consisted of two former CFOs
of Toshiba and three independent directors who had limited accounting knowledge. In addition
to this, the employees assigned to assist this committee also lacked the necessary level of
competency in accounting to do their job effectively (Caplan et al., 2019). Also, the committee
chairman was one of the former CFOs and had refused to proceed with the repeated requests
submitted by the other members to review certain accounting treatments (Yoshizu, 2015).

The corporate culture at Toshiba was also deeply influenced by Japanese cultural values
which include unquestioned compliance of orders made by superiors as a way to show respect.
This cultural value paired with the unrealistic demands of senior executives created a work
environment that discouraged employees from challenging the decisions of those above them in
the organization (Caplan et al., 2019).

Analysis

Toshiba’s Japanese-Western hybrid committee board system did not address any of the
major weaknesses in their corporate governance structure. The primary issue with Toshiba’s
board of directors is the lack of director independence. The way Toshiba structured its majority
independent audit committee looked progressive on paper but resulted in no real improvements
to governance. The audit committee consisted of two extremely knowledgeable former Toshiba
CFOs who knew the company and its employees intimately and thus favoured the interests of
those within the company over other stakeholders (Caplan et al., 2019). It also featured three
independent directors but those individuals lacked the accounting expertise to be able to perform
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their oversight duties. Despite creating this committee, the chairman of the committee would still
unilaterally decide on matters discussed by the committee. Therefore, even if certain issues were
brought up by other members of the board, the chairman would make the final resolution without
any opposition (Dutta & Menon, 2018). This means that if the chairman is involved in the fraud,
then the board would be automatically authorizing all of corporate’s inappropriate actions which
is what happened at Toshiba. While there were more independent directors on this committee,
the lack of independence was still as prevalent as before. This suggests that Toshiba’s CEO
perpetuated the fraud by developing a governance system that allowed for the fraud to get past
the board of directors.

Toshiba’s corporate culture also contributed to the emergence of fraudulent reporting.

While the CEOs never directly instructed employees to falsify accounting records, they created a
culture where employees felt an immense pressure to meet unachievable financial targets
(O’Brien & Aboud, 2015). The board and management are responsible for working together to
create the tone at the top and the culture of the company (Tugman & Leka, 2019). This is why
when upper management presented a “challenge” to those directly below them, the business unit
heads under those executives placed pressure on the employees underneath them and this led
those employees to overstate the company’s earnings in order to meet the demands of their
immediate superiors (Independent Investigation Committee for Toshiba Corporation, 2015). This
highlights the systemic ways that Toshiba’s upper management perpetuated the fraud.

It is clear that the most significant factor that allowed for the fraud to continue is the poor
governance and corporate culture created and maintained by the Toshiba’s CEOs and senior
executives. It would be impossible to address the following issues without implementing changes
to create stronger governance and a better culture first.

Issue #2: Poor Internal Controls

Description

Toshiba had insufficient internal controls throughout all levels of the organization. At the
company level, there were no internal controls put in place to check for inappropriate accounting
treatment. Toshiba’s corporate level internal audit function was also utilized improperly and
heavily dismissed by the company’s executives. The internal audit division reported to Toshiba’s
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CEO and was viewed as mainly a consulting role to management as they only recommended
improvements in controls but did not comment on changes to the actual accounting techniques
being used (Bhattacharyya, 2015). The company’s executives also created plans to improve their
controls in response to the findings of the internal audit division but failed to follow through on
those changes (Caplan et al., 2019). The investigation also found that Toshiba had not
established a risk management structure that had internal controls in place in the case of
inappropriate accounting treatment being carried out by key executives and top management
(Independent Investigation Committee for Toshiba Corporation, 2015).

At the corporate division level, the Securities Report, Etc., Disclosure Committee was not
looking for any independent confirmations or conducting any examination procedures to ensure
the effectiveness of the internal control system in relation to financial reporting. The committee
was merely asking a few questions and requesting explanations from employees of the Legal and
Financial Division based on the materials they had prepared. This is concerning as this
committee was responsible for providing the final confirmation of the effectiveness of these
internal controls (Independent Investigation Committee for Toshiba Corporation, 2015).

Lastly, two general internal control weaknesses faced by Toshiba were lack of job
rotation and insufficient use of the whistle-blower system in place. There was minimal job
rotation for employees in the Finance or Accounting Department and continued to work in the
same department they were hired into until they retired (Independent Investigation Committee
for Toshiba Corporation, 2015). Also, while there was a whistle-blowing system at Toshiba,
there were no reports made regarding the occurrence of fraud. The system was also heavily
underused given the size of the company and the fact that there had only been a few dozens of
cases reported to this system annually (Independent Investigation Committee for Toshiba
Corporation, 2015).

Analysis

The reason that Toshiba lacked proper internal controls for checking inappropriate
accounting techniques was because of the way its internal audit division was used. Per the
findings of the investigation committee, “According to the division of duties rules of Toshiba,
the corporate audit division is in charge of auditing the corporate divisions, the companies,
branch companies, and affiliated companies. However, in reality the corporate audit division
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mainly provided consultation services for the 'management' being carried out at each of the
companies, etc. (as part of the business operations audit), and it rarely conducted any services
from the perspective of an accounting audit into whether or not an accounting treatment was
appropriate." (Independent Investigation Committee for Toshiba Corporation, 2015, pg. 71, para.
5). In order for an internal audit function to be effective, it must be able to be independent of
management. However, an internal audit function can only be independent if the audit committee
is also independent and capable because then the internal audit function can reliably report solely
to the audit committee. At Toshiba, the audit committee was not independent or capable of
handling its oversight duties. Thus, the internal audit function could not be independent from
management (Bhattacharyya, 2015). This combined with the fact that the company’s risk
management system had no internal controls to mitigate the risk of inappropriate conduct by
upper management meant that no internal control could have stopped this fraud from occurring,
which renders these controls futile.

Given the corporate culture of Toshiba, it is understandable why the division would
rather provide only consultation services and not check for inappropriate accounting techniques.
However, as a result of its audits, the internal audit division was aware of the possibility of
inappropriate accounting treatments being used but they did not instruct the treatment be
corrected. Thus, it can be argued that the failure of the internal audit division to act sooner
contributed partially to the weak governance system (Bhattacharyya, 2015). The internal auditor
is meant to be the person within the organization that the audit committee can rely on for inside
information regarding matters that the committee cannot be directly involved in to maintain their
independence. Therefore, their complacency played a role in the perpetuation of the fraud.

Lastly, the lack of job rotation means that even if staff were to notice irregularities or
inappropriate accounting treatment being carried out by an employee in the Accounting or
Finance Division, it would be difficult for them to address and correct the matter so as to not ruin
the level of comradeship they have with the employees in these divisions (Independent
Investigation Committee for Toshiba Corporation, 2015). It can also be inferred that the lack of
activity of the whistle-blowing system can also be attributed to the corporate culture at Toshiba
which makes it difficult for employees to speak up about important matters. Another reason may
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be that Toshiba created this system since it looked good on paper but did not communicate its
existence effectively to employees.

Issue #3: Malpractice of External Auditors

Description

Ernst & Young ShinNihon (EY) was the largest domestic auditing firm in Japan and
Toshiba’s independent auditor for almost sixty years. Due to this accounting scandal, the
auditors that took part in Toshiba’s audit process were accused of malpractice for breaching their
duty of care and for validating fraudulent financial statements (Uranaka & Wada, 2015).

During their audit of Toshiba, one of the auditors revealed some very large discrepancies
within the Toshiba Computer Division’s accounting. Despite their discovery, the auditor did not
disclose their findings to the other members of the audit team, nor did they make any attempt to
initiate legal action against Toshiba for the irregularities. Additionally, the data they had been
audited had been provided by Taiwan Toshiba International Procurement Corp. (TTIP), a
consolidated subsidiary of Toshiba. The external auditor should have taken into considered the
organization’s consolidated financial statements so that they could gather more reliable audit
evidence. The auditor had an obligation to investigate the statements further but failed in their
responsibility to do so (Khondaker & Bremer, 2016).

Analysis

It should be noted that it is not the responsibility of the external auditor to detect fraud.
Their role is to provide reasonable assurance that the financial statements are free from material
misstatement (Tugman & Leka, 2019). Management and those charged with governance are the
ones who are ultimately responsible for ensuring that their financial reporting is free from
fraudulent activities by creating strong governance and control procedures. However, the auditor
is liable to their clients in other ways.

The auditor owes a duty of care to its clients which means that the auditor is expected to
exercise the degree of care and professional skepticism that would be expected of any regular
accountant (Sam Houston State University, n.d.).

Measures to Identify and Stop these Issues at Toshiba

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Recommendations: Issue #1

(1) Increase the number of Outside Directors and revise member structure

Efforts are being made to enhance the corporate governance system and further confirm the
independence of Outside Directors by increasing the number of Outside Directors, and it is
necessary to revise the member structure in light of the variety of expertise required of Outside
Directors. In particular, it is considered necessary to appoint personnel that have legal knowledge
and personnel that have knowledge of finance and accounting as Outside Directors that form the
Audit Committee.

(2) Enhancing the internal control function (supervisory function) of the Board of Directors

In order to enhance the supervisory function of the Board of Directors by increasing the volume
of information provided to the Board, the matters to be reported at the Board of Directors
meeting should be clarified and expanded.

Also, at least for an interim period, materials prepared for the CEO Monthly Meetings should
also be used as material for reports to the Board of Directors.

(3) Enhancing the internal control function (supervisory function) of the Audit Committee

Given the size of the Toshiba Group, enhancement of the structure such as the increase in the
number of members of the Audit Committee who are familiar with finance and accounting,
together with the nomination of an Audit Committee member who is an External Director to be
the chair of the Audit Committee, is desirable. Also, the human resource structures should be
increased and enhanced as the support staff in the Audit Committee with knowledge of finance
and accounting, and there should be enhanced cooperation with the Audit Committee members
who are External Directors. As for the method of auditing, heavy emphasis should be placed on
carrying out interviews with departments that are noted as having a high need for auditing.

5. Reforming corporate culture

The corporate culture in which employees cannot go against the intent of their superiors should
be reformed.
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Also, with regard to rules pertaining to the various types of accounting treatments prescribed to
construct the internal controls at Toshiba mainly regarding financial reporting, all executives and
employees should be informed that such rules must be complied with, regardless of the intent of
any superior. When carrying out accounting treatments in accordance with these rules, any de
facto rules should be abolished which cannot be executed when the immediate superior’s prior
approval is sought but cannot be obtained. Accounting treatments should be carried out based on
the original rules.

Recommendations: Issue #2

(1) Establishment of new and enhanced internal control department

One proposal for measures to improve the Internal Control Department at the in-house
companies is that the Accounting Department of the in-house companies shall increase the
number of personnel in the human resources structures in the Accounting Departments that can
perform sufficient checks and balances, and establish an Internal Audit Department that is
independent from CP’s instructions and orders system within the in-house companies.

Simply improving the Internal Control Department within the in-house companies may not be
adequate in countering inappropriate instructions from corporate top management, such as P and
CP. For this reason, it is considered effective to abolish the Corporate Audit Department and
to newly establish a powerful Internal Audit Department that targets internal audits of Toshiba
and all group companies. The new Internal Control Department should be independent from each
business unit, in-house company, etc., acting as a large-scale unit made up of people who are
proficient in the content of the business of each in-house company and group company, people
who have knowledge of the law and compliance, and people who are sufficiently aware of
finance and accounting matters, and carry out an integrated internal audit of all companies
through persons who have highly expert knowledge of Toshiba and all group companies. This
department should not report to top management such as P or CFO, but should ensure its
independence from top management by reporting to the likes of outside directors, such that its
auditing authority can be appropriately exercised even in the event of any wrongful act by top
management. Furthermore, in order to enable the department to undertake an adequate and
effective audit, it should be granted influential authority, such as the authority to request as much
information as required from executives and employees. In addition, it will be effective to gain
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support from external auditors and legal experts as required. As such, budget measures should
be established therefore.

(2) Appropriate personnel rotations

The responsible people in the internal audit department and Audit Committee members should
implement appropriate personnel rotations, and strive to make changes such as listening to the
opinions of external experts.

In addition, appropriate personnel that are familiar with accounting ideas and auditing business
should be appointed as the personnel group of the internal audit department and other
departments that govern audits.

(4) Utilization of a whistleblower system

A whistleblower system can also be referred to as the last line of defense in the internal control
system. The system should be revised and sufficiently utilized so that whistleblowers can trust it
and state their opinions safely.

Therefore, the entire Toshiba group should be thoroughly informed about the existence and
function of a whistleblower system, various measures taken to revise such whistleblower system
into one that whistleblowers can trust and state their opinions safely, and the use of the
whistleblower system promoted.

6. Reform of all accounting policies and rigorous application

Considering that accounting policies established at Toshiba were not appropriate and that the
cause of inappropriate accounting treatments was in that accounting was not carried out
compliant with accounting policies, there should be reforms in all accounting policies, including
the percentage-of-completion method, as well as enforcement of the rigorous application thereof.

Recommendations: Issue #3

Conclusion