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Christina Chau Mac

on 21 October 2014

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What is the Fraud Triangle Model?
Japanese Business Culture
- The governance structure observed at Olympus was a product of the overall culture of business within Japan
- This consists of 4 main components including dominant leadership, cross ownership amongst companies, long term employment, and a central banking system

Corporate Governance Overview
- Corporate governance consists of the rules for how an organization should ideally be managed and controlled
- A good corporate governance system acts to guide the organization in the proper direction making sure the objectives of all stakeholders are met
- That is where the board of directors comes in who have a fiduciary duty to shareholders to monitor and to approve management decisions such as acquisitions of other companies

Fraud Triangle Analysis
Corporate Governance Issue
Dominant Leadership
- Decision-making within Japanese organizational structures is centralized with very dominant managers

- This type of structure leads to management making decisions unilaterally without taking any input from their subordinates or outsiders

- As a result there is less transparency in the decision-making process and restricted top down information flow as well

Collectivistic Culture
- This approach promotes the group over the individual where personal achievement isn’t emphasized

- This leads employees who work at an organization to view it as their family with the same respect given to their superiors as they would an elder in their household

Long Term Employment
- Employees who start at an organization have their whole career planned out from beginning to retirement

- Japanese organizations almost always promote from within rather than hiring an outsider for senior positions

Cross Ownership System
- The cross ownership system within Japan is referred to as Keiretsu

- The Keiretsu is a network like system where each company has an ownership interest in the other company

- This system is also characterized by large majority share ownerships whose holders are usually the founders of these companies or their family members
Central Bank
- There is a strong emphasis on a central banking system in Japan

- The entire Keiretsu system flow through the Bank of Japan and organizations use it to meet the majority of their financing needs

- The bank also plays a major role in operations such as preventing bankruptcy, providing financial advice, and helping to ensure the continuation of operations long term

Corporate Governance Issues
- The Board members of Olympus whose job it was to monitor management were often insiders of the company

- They were lifetime employees that were promoted from within and often started as junior staff

- The dominant leadership style and centralized decision making at Olympus lead to less transparency with respect to management decisions as was observed within the finance department

- Two senior officials Hideo Yamada and Hiroshi Morie led this department, and together were almost solely responsible for instituting the financial engineering strategies aimed at concealing the unrealized losses for more than 20 years

- The Keiretsu system of cross ownership also played a role in aiding the fraud environment

- Since most companies were owned within the network by a few large majority investors the directors would sit on multiple boards of related companies a scenario referred to as interlocking directorate

- In addition there was collusion within the entire network and amongst government officials towards their shared goals

- Employees of Olympus viewed the company as their family and as such would not do anything to harm or discredit the organization

- They also feared the negative company and social repercussions of speaking out since this is normally frowned upon in Japanese cultures

- This was one of the biggest reasons that fraudulent activity was able to take place for over 20 years

Corporate Governance Reform
- In response to Olympus and other similar corporate scandals amendments to the corporate governance act of Japan was adopted by the industry in 2012 to significantly enhance the governance system in the country

- Listed companies can now choose from two distinct governance structures including the Board of Corporate Auditors system, or The Committee Governance Structure

Auditors’ Role during the Olympus Scandal
- Olympus had set up offshore
companies and a network of Japanese financial advisors to hide $1.6 billion of investment losses from the 1990s.

- Why did Olympus’ external auditors not expose this?

- Were the external auditors complicit?

- Was this an act of criminal negligence?

- The auditors had recognized problems with Olympus’ accounting policies
But...the auditors always gave - -

- Olympus unqualified opinions on their financial statements?

- Japan’s Financial Services Authority ultimately cleared both accounting firms of criminal negligence.

The Scheme
- “Tobashi” - companies would shift losses off their books to subsidiaries or outside funds

- Nomura bankers helped Olympus executives create ways to hide losses, using acquisitions and overseas funds to hide transactions
Similar to Enron

- KPMG AZSA discovered Olympus executives were hiding losses in a fund outside of the company’s balance sheet

- Auditors forced the transaction be unwound, brought the asset back on the financial statements and written down by $700 million

- Great......but there were more of these outside funds that KPMG AZSA didn’t realize

- Olympus had used at least 17 Cayman Island and British Virgin Islands based entities over the course of the fraud

- Why did the auditors never figure this out?
- Olympus interfered with the bank confirmations and requested their 3 banks not to tell KPMG AZSA about collateral (that was used to conceal the investment losses)

- Commerzbank and Societe Generale, and LGT Bank

KPMG AZSA in 2008
- Olympus acquired a UK medical equipment company called Gyrus for $2.2 billion

- Normal advisory fees for acquisitions is 1%
Olympus paid an advisor fee of 33% to a Cayman Island based investment company

- KPMG AZSA thoroughly expressed their concerns about the accounting treatment, advisory fee and the investment company

- Olympus bought 3 tiny venture firms in Japan for $1 billion

- KPMG Azsa said Olympus spent too much on the deal, and tried to get management to bring this up at a board meeting

- The auditors told the executives they that wanted to hear a better explanation of the fees and payments to offshore funds.

- January 2009: KPMG AZSA did an onsite audit of the three venture firms, and warned Olympus that it could face a lawsuit from its shareholders.

- April 2009: KPMG AZSA increased pressure, and threatened to alert authorities.

- May 2009: Demanded the resignation of Olympus’s top executives and threatened to resign as auditors themselves.

2009 Committee Report
- KPMG AZSA relented after Olympus agreed to write off part of the transaction.

- KPMG AZSA asked the Board of Auditors to conduct an operational audit.

- A 2009 Committee Report was prepared by “external experts” who determined there were no problems with how the executives were accounting for the transactions.

KPMG AZSA’s Unqualified Opinion
- KPMG AZSA carelessly relied on the third party committee report

- The auditors gave Olympus’s 2008 financial statements an unqualified opinion

- Why?

Transition between Auditing Firms
- Olympus ended its contract with KPMG AZSA after this.
Ernst & Young ShinNihon took over the audit on the condition their 2008 reports were unqualified

- Hand over process was questionable and the topic about KPMG AZSA’s disagreements with Olympus were not sufficiently addressed

E&Y ShinNihon
- The auditing work by Ernst & Young ShinNipon was similar to KPMG ASZA.

- The new auditors raised concerns with Gyros and whether AXAM was a related party

- Ultimately gave an unqualified opinion, despite concerns.

Key Points and Recommendations

2009 Committee Report – incomplete, qualifying conditions, not to be trusted as neutral third party

- Bank confirmations – KPMG AZSA did not take appropriate procedures to get reconfirmations

- Cash outflows were a red flag that should have been addressed early on


- KPMG’s UK auditors determined problems with Gyrus but this didn’t stop KPMG AZSA from signing off on the group accounts

- Not rare for there to be problems with a subsidiary but ultimately considered immaterial for the consolidated books

- Japan’s accounting firms: lower pay, overwork and punishment was low

- Rotate auditors every 10 years, risks with working with the same people year after year

- Need effective whistle blowing lines separate from executives: there are reasonable fears when you are making allegations against a large company

Question Time!!!!

What is a major reason KPMG AZSA was not aware that Olympus was hiding their losses outside of their balance sheets?

1. KPMG AZSA were not conducting the audit with due care and professional skepticism

2. Olympus told their banks to send incomplete bank confirmations to KPMG AZSA

3. KPMG AZSA made a careless mistake in their audit procedures and did not test the right accounts due to their negligence

Why did KPMG AZSA give Olympus an unqualified opinion on their financial statements in 2008?

1. The 2009 Committee Report by outside professionals said Olympus’ accounting was fine

2. Olympus coerced KPMG AZSA into giving unqualified statements

3. KPMG AZSA did further investigation and decided Olympus’ accounting was correct

4. KPMG AZSA was paid off by Olympus to give their statements an unqualified opinion

What was wrong with the transition between the old auditors, KPMG AZSA and the new auditors, Ernst & Young ShinNihon?

1. The exchange was too simple and formal, KPMG AZSA did not sufficiently elaborate on their disagreement with Olympus on their accounting policies to E&Y ShinNihon

2. Ernst & Young ShinNihon did not attempt to contact or speak with KPMG AZSA

3. KPMG AZSA refused to tell E&Y ShinNihon anything about Olympus
Full transcript