In December 2023, Toshiba Corp. ended 74 years as a publicly-listed company.
Once counted among the world’s most respected corporations, Toshiba’s downfall was ignominious because it was linked to a massive accounting scandal which shocked investors and dismayed the Japanese public.
The scandal first surfaced on May 8, 2015, when Toshiba pulled its earnings outlook and cancelled its annual dividend due to delays caused by an internal probe into accounting irregularities. A week later, the company announced an independent investigation.
Toshiba’s President, Hisao Tanaka, revealed at a press conference on July 21 that the company had falsified its earnings by at least $1.2 billion since the onset of the global financial crisis in 2007. Tanaka and two of his predecessors stepped down in the wake of the announcement.
An independent investigation found that 98 executives were actively engaged in the fraud while senior executives turned a blind eye and even encouraged the improper accounting practices. The investigation blamed the scandal on unrealistic management targets.
Like so many previous accounting scandals, Toshiba’s iconic status shielded the company from critical scrutiny. AI software designed to detect account manipulation, however, pays no heed to reputation and is unmoved by past corporate achievement. It treats all companies equally as it hunts for patterns indicating risk manipulation in a company’s financial accounts.
In this way, Transparently.AI’s Manipulation Risk Analyzer (MRA) found evidence of significant manipulation risk at Toshiba, not only in the years covered by the scandal, but also in the decades prior to the scandal when the company was seen as a global powerhouse. Toshiba offers an excellent example of the value of augmenting human analysis with AI.
Table of contents
Toshiba’s history
In 1939, two long-established Japanese companies, respective leaders in heavy electric equipment and consumer electronics, merged to form Tokyo Shibaura Denki (Tokyo Shibaura Electric Co). A Tokyo Stock Exchange listing followed a decade later.
Soon known as “Toshiba”, the company did not formally adopt this name until 1978, by which time it was regarded as one of the world’s most innovative companies. In the 1980s alone, for example, Toshiba introduced the world’s first inverter aircon, NAND flash memory and the first mass-produced laptop PC among many other innovations.
Among Toshiba's many innovations were Japan's first electric rice cookers (1955). Image source: Toshiba website
Toshiba began to stumble from the mid-1980s due to a series of missteps. In 1987, the company violated international embargoes by selling precision milling equipment to the Soviets, essential for the manufacture of advanced nuclear submarines. A subsequent ban on Toshiba products in the US, albeit temporary, impacted sales and damaged the company’s reputation.
More important, the US switched support to Taiwan's fledgling semiconductor industry, marking the end of Japanese semiconductor dominance. Prior to the shift, Toshiba was the world’s second-largest chip maker.
With its semiconductor division in relative decline and the yen appreciating, Toshiba was wrong-footed when Japan’s bubble economy burst in 1992. Like most Japanese companies, the company was heavily in debt.
Nevertheless, Toshiba continued to invest heavily. In the mid-1990s, Toshiba underestimated the fledgling internet and invested heavily in HD DVD technology in the mistaken belief that DVD was the future of multimedia and digital connectivity.
In 1999, Toshiba lost a class action suit over defective floppy disc drives in its laptops. Costing almost $1 billion in damages, the suit caused a terminal decline in Toshiba’s laptop business.
From the early 2000s, Toshiba faced challenges from the opening of China, which exposed its consumer electronics and home appliance divisions to intense price competition. Meanwhile, the internet began to impact demand for DVDs and other memory products.
Fukushima disaster
Desperate for growth, Toshiba acquired Westinghouse Electric for $5.4 billion in 2006. The winning bid was three times higher than the vendor’s estimate of its own worth and predicated on strong projected demand for reactors in China.
Chinese demand was indeed strong but increasingly furnished by domestic suppliers. The 2008 financial crisis crippled the funding of long-term power projects, causing delays and cost overruns. The final icing on the cake came with the Fukushima disaster of 2011, which caused a moratorium on nuclear projects outside of China. Westinghouse was one of the makers of the wrecked reactors that caused the meltdowns at Fukushima.
Toshiba’s nuclear division was doomed. This was a major problem because in the 2000s Toshiba was essentially an infrastructure company. In the decade to FY2011, the social infrastructure division, which housed the nuclear reactor business, was responsible for 84.2% of Toshiba’s net operating income. The other divisions enjoyed hefty sales but lacked profit.
Remarkably, Toshiba failed to recognize any impairment from Fukushima until 2016 and 2017, when it took charges of $2.3 billion and $6.3 billion, respectively. Toshiba’s auditor, PwC, thought the 2017 losses due to Westinghouse were too low and twice refused to sign off on Toshiba’s accounts.
This was a disturbing sign considering the recent scandal. Westinghouse filed for Chapter 11 in March 2017 and was eventually sold in 2018.
The lack of impairment charges immediately following Fukushima raised eyebrows.
The lack of impairment charges immediately following Fukushima raised eyebrows. After Fukushima, Toshiba stopped separating nuclear orders and operating income from non-nuclear orders. Operating income from the social Infrastructure division was flat in FY10, the year of Fukushima.
In subsequent years it fell -15%, -1% and -54%, respectively. Given the immediate moratorium on nuclear power in key markets, it is surprising that the hit to operating income failed to surface until FY2013 which, coincidentally, is the year in which accelerating smartphone sales saw a revival in NAND flash memory profits. The timing was certainly convenient. Toshiba sold its chip division in 2018 for $18 billion to help stem the bleeding from Westinghouse.
Toshiba's poor accounting history
The Transparently.AI MRA was never a fan of Toshiba’s accounting quality.
For those not familiar with the MRA, the tool is trained via machine learning to recognise signs of fraud in financial statements. The MRA assigns a 0-100% risk score to a company, as well as a A+ to F rating, which together measure the probability and extent to which a business is manipulating its accounts.
Figure 1 shows the MRA scores and ratings for Toshiba from FY1993 until FY2019. Over this period, Toshiba’s average risk score was 64%, which equates to an average rating of D.
D is a particularly poor score for a company as large as Toshiba and with 140 years of history. It means that Toshiba was typically in the bottom third of all companies globally for transparency and accounting quality. Risk scores in this zone are typically dominated by small caps and recent start-ups, not large well-established companies.
Companies with such a poor score invariably have some history of accounting or governance problems. This was true of Toshiba. The submarine scandal of 1987 was a major black mark for corporate governance. In addition, Toshiba suffered a public accounting scandal in October 2013 when it announced that its medical subsidiary, Toshiba Medical information Systems, had overstated results for several years.
Figure 1: Toshiba’s manipulation risk score and rating from FY93 to FY19
Source: Transparently.AI
Toshiba’s best scores over the period covered by Figure 1 occurred during periods of very rapid growth, typically when demand for semiconductors and infrastructure was strong, such as in FY2000, FY2007 and FY2010.
This cyclicality in Toshiba’s account quality is a red flag and is characteristic of companies that engage in smoothing and aggressive use of accruals. The score of such firms improves markedly in boom years as the company uses abnormal profits to claw back previous exaggerations of net income. Toshiba tended to exhibit extreme negative accruals in boom years, such as 2004 through 2007. This kept the risk score high even though other risk clusters showed improvement.
In the period from FY1994 until FY2015, prior to the news of the scandal, Toshiba managed to exhibit red flags in every single risk cluster examined by the MRA. This is no mean feat. Even Enron managed to skip a couple.
Frequent red flags
Figure 2 shows the frequency of each risk cluster over the entire period. The most frequent red flags were in gearing and working capital signals, while the least frequent were for business manipulation and investing activity. Nevertheless, even these infrequent risk signals were flagged every four years.
The risk clusters for gearing and working capital had an incidence rate of 100%, meaning that risk in these clusters was flagged every single year. Both of these risk clusters measure financial stress with respect to overall debt sustainability and working capital strain. They are powerful indicators of manipulation risk because financial stress is the primary motive for companies to manipulate their accounts.
Other risk clusters also demonstrated that Toshiba had a strong motive to manipulate earnings. These were the risk clusters for valuation, credit and margin signals. The MRA flagged valuation risk in three out of every four years in the period leading up to the 2015 scandal.
Initially, the system flagged valuation because Toshiba appeared too expensive relative to fundamentals and versus peers. In later years, it appeared too cheap. Both over- and under-valuation can be a powerful motive to manipulate earnings. Unusually, Toshiba’s size or market capitalization was flagged as a risk in most years. This is an unusual occurrence. This signal is often flagged when there is too little transparency or too many odd things happening in the accounts of a large company.
Credit risk was flagged after the downturns in 2000 and 2008. The MRA flagged margin signals for several reasons. One reason was that EBIT margins were very low, especially in relation to other performance metrics. This can be a sign that a business is far less profitable than it appears and thus can be a motive to inflate earnings.
Figure 2: Incidence rate of risk clusters flagged by Toshiba from FY1994 to FY2015
Toshiba’s third most common risk signal was for asset quality. Asset quality was judged risky for three main reasons:
- Exceptionally high investment in associates;
- High level of intangible assets as a share of total assets;
- Volatile depreciation policy.
The high level of intangibles and investment in associates gave Toshiba considerable opportunity to manipulate earnings. If a business has a large number of associates and subsidiaries, this is typically where account manipulation takes place since it is difficult to see in the consolidated accounts.
Aggressive accounting
Toshiba’s volatile depreciation policy, combined with occasional large changes in long-term assets, demonstrated that Toshiba was willing to be aggressive in its accounting treatment of assets and might also be engaged in improper expense capitalization.
Toshiba consistently exhibited patterns that the MRA associates with a high probability of account manipulation. These patterns were evident in a range of risk clusters pertaining to margins, cash quality, income quality and business manipulation. Signals in these risk clusters are normally triggered when a company demonstrates an unusual reliance on income from affiliates, non-operating or non-cash sources.
Toshiba consistently exhibited patterns that the MRA associates with a high probability of account manipulation.
They are also triggered when a company demonstrates abnormal patterns in the relationship between cash flow, production, income, margins and working capital requirement. For example, between 2011 and 2105, Toshiba demonstrated trends in operating margins that were inconsistent with other operating metrics.
Toshiba demonstrated all of the patterns listed above. In addition, there were frequent discrepancies between tax expense recorded in the income statement and tax actually, and discrepancies between reported interest expense and actual interest paid. Toshiba frequently restated earnings and frequently reported abnormal gains and losses. The company demonstrated aggressive use of accruals 50% of the time and exhibited smoothing behaviour about a third of the time.
Put simply, when considering the risk clusters that relate most closely to income and earnings manipulation, Toshiba triggered a lot of red flags.
Poor corporate governance
Moreover, Toshiba exhibited many classic signs of poor corporate governance such as dilutive options issuance. Toshiba triggered several proprietary Transparently.AI signals for governance due to unusual consolidation adjustments in its accounts. The MRA disliked the lack of transparency in Toshiba’s accounts.
The aggressive use of accruals, frequent use of smoothing techniques and red flags for governance all pointed to aggressive accounting and thus risk of manipulation.
In short:
- Toshiba was under severe financial strain and was thus strongly motivated to manipulate,
- The accounts were complex and lacked transparency due to the high number of affiliates and other factors. This allowed significant opportunity for account manipulation,
- Toshiba’s accounting method was highly aggressive and thus consistent with a high risk of deeper manipulation, and
- Toshiba exhibited many of patterns across a broad range of risk clusters that the MRA associates with poor governance and account manipulation.
These four factors explain why the system only gave Toshiba an average rating of D.
Without a deeper knowledge of the company, it is difficult to say exactly what the nature of any potential manipulation might have been. We can say, however, that the nature of the manipulation likely changed as the profitability of Toshiba’s different divisions waxed and waned.
Through most of the 27-year period under review, Toshiba had four main divisions:
- Digital products: PCs, laptops, HDDs, DVDs, cell phones, digital TVs and office equipment,
- Electronic devices: Mostly semiconductors and LCD displays,
- Social infrastructure: Power generation, building and industrial systems, and
- Home appliances: Air conditioners, refrigerators, lighting etc.
Through most of the period under review, the social infrastructure division, which mostly consisted of long term construction contracts, dominated earnings. This was interspersed with bursts of earnings strength from the electronic devices division.
Recording earnings from long-term construction contracts involves considerable discretion and this kind of earnings usually lacks transparency since it is undertaken by affiliates and subsidiaries to limit liability. As a consequence, if Toshiba was manipulating earnings, this is the first place a forensic accountant would look.
Toshiba investigation
In January 2015, Japan’s Securities and Exchange Surveillance Commission (the “SESC”) received an email from a whistleblower alleging that Toshiba was using inappropriate accounting practices in preparing financial reports for its infrastructure-related businesses.
The SESC met with Toshiba executives to discuss the company’s use of the “percentage-of-completion" method to record revenues and expenses for long-term infrastructure contracts. The SESC argued that Toshiba was not following generally accepted accounting principles.
In response, Toshiba launched an internal investigation, as noted in our introduction. This investigation demonstrated that executives were deliberately manipulating earnings. The company therefore ordered an independent investigation of the company’s accounting practices.
The investigation report ran to 90 pages. As noted, it concluded senior executives were involved in the systematic fraud which was carried out with the knowledge of top management to hide deteriorating performance.
Senior executives were involved in the systematic fraud which was carried out with the knowledge of top management to hide deteriorating performance.
The accounting misconduct began under CEO Atsutoshi Nishida in 2008 amid the global financial crisis and continued under the next two CEOs. The fraud was attributed to the corporate culture at Toshiba which demanded unquestioning obedience from employees, unrealistic profit targeting practices, employed poor internal controls and lacked a proper system of corporate governance.
The investigation found profit manipulation to the tune of 156.2 billion yen, which dwarfs the 4.4 billion yen manipulation identified by the initial internal report. The investigators found direct evidence of inappropriate accounting practices and overstated profits in multiple Toshiba business units.
Manipulation techniques varied among the different business units, which had very different cash conversion characteristics and thus different working capital requirements.
Percentage of completion
Those seeking a detailed discussion of Toshiba’s accounting transgressions should refer to the investigation report.
Briefly, the worst manipulation occurred in the social infrastructure division. As noted, this division used the percentage-of-completion method. The percentage of completion is a method of accounting for long-term projects in which revenue and expenses are recognized on the basis of the percentage of work completed during the accounting period.
Using this method, a contractor recognizes project income and expenses as the project progresses. The method requires a projection of the expected total cost, revenue and time to completion of a project. If these metrics change, the subsequent profit or loss adjustment should be recorded.
In many of the projects examined by the investigation, Toshiba recognized revenue ahead of work progress and so overstated both sales and earnings.
Many of Toshiba’s major projects were known to be loss making and this loss should have been recognized. In many of the projects examined by the investigation, Toshiba recognized revenue ahead of work progress and so overstated both sales and earnings.
The account manipulation in the digital products and semiconductor divisions mostly involved traditional efforts to delay expense recognition, mostly through capitalization of expense, or to recognize revenue early as per all of the methods we discussed in the discussion of what the AI software observed.
Aftermath
No charges were laid in response to the Toshiba scandal. However, a slew of lawsuits followed in the wake of the accounting scandal including those laid by Mitsubishi UFJ Trust and affiliate Master Trust Bank of Japan, Japan Trustee Services Bank, and the Custody Bank of Japan.
The Government Pension Investment Fund, the world’s largest pension fund, has already indirectly sued Toshiba with Japan Trustee Services Bank. In addition, several class-action suits were filed by shareholders. These shareholder claims also sought damages from the three former chief executives and two chief financial officers.
Some suits have settled, others are ongoing. The suit filed by Custody Bank of Japan was settled on October 30, 2023. The original claim was for 41.1 billion yen, but the final settlement was for 4.4 billion.
Disclaimer: Views presented in this blog are the author’s own opinion and do not constitute financial research or advice. Both the author and Transparently Pte Ltd do not have trading positions in the companies it expresses a view of. In no event should the author or Transparently Pte Ltd be liable for any direct or indirect trading losses caused by any information contained in these views. All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any of the information contained herein.
