Toshiba's Accounting Scandal: Catching the Fuzzy Math

SMITH BRAIN TRUST -- Toshiba is known for producing televisions, computers — and, as of this summer, an epic accounting scandal. Its CEO resigned in July after an outside investigator documented that the 140-plus-year-old Japanese company had overstated earnings by $1.2 billion since 2008.

The two previous CEOs also resigned their positions. One had been serving as an adviser, the other as a board vice chairman. The investigation showed that, during their regimes, management had strongly pressured subordinates into meeting earnings goals; they often did this by understating the cost of long-term projects and by improperly valuing inventory.

The crisis led to renewed criticism of Japan's corporate management system, which Prime Minister Shinzo Abe has pledged to reform. Japanese companies are far less likely than American companies to have outsiders on their boards (who, at least in theory, might be inclined to challenge suspicious numbers). A law passed in June decreed that each Japanese company must have at least two outside board members. However, Toshiba had been viewed as ahead of the curve, with four independent board members, so the law wouldn't have mattered in this case.

Progyan Basu, an accounting professor at the University of Maryland's Robert H. Smith School of Business, says that Western companies would be naïve if they thought that their methods of corporate governance are enough to protect them from such scandals. Just think of the WorldCom accounting debacle of the early 2000s, or the lax analysis of mortgage-backed securities in more recent years.

The pressure to meet earnings expectations is relentless everywhere, and detecting the point at which reasonable managerial discretion crosses the line into something more nefarious remains "more of an art than a science," Basu says.

"Most people not in the field tend to think that numbers in a balance sheet are written in stone," he says. "But accounting standards give a lot of flexibility to a company's management in how they treat transactions."

Managers are free to select the period over which they depreciate investments in new equipment, for example, and those choices can have an effect on the bottom line. Accountants shouldn't (and, practically, can't) second guess every instance of managerial discretion, but they ought to be attentive to suspicious patterns and sudden lurches in financial practice.

"If management suddenly tries to change their accounting methods, that is when an accountant ought to ask: 'What's the reason for the change?' Management might have a good answer. 'We've learned that this is what our competitors in the industry tend to do.' Or they might not." Accountants asking these kinds of question might have stopped the Toshiba manipulations from snowballing, Basu says.

The Smith School is at the forefront of nudging the accounting profession toward being more attentive toward suspicious behavior. "Forensic accounting" is a discipline in which analysts study the books after fraud has been exposed to document how the fraud was committed. But the Schilit Scholars in Accounting Program — funded by Howard Schilit, a 1981 Smith School PhD and CEO of Schilit Forensics, and championed by Basu — is designed to make Smith School-trained accountants attuned to the sorts of problems that were clearly bubbling beneath the surface for years at Toshiba, while they are happening.

"I think we are going in the right direction," Basu says. "I do not know of  another school that is specifically doing fraud-prevention accounting."

The scandal need not be a death knell for Toshiba. A similar accounting fraud was exposed at Japan's Olympus in 2011, but that company is now valued at twice what it was worth before the scandal, 10 times what it was at its lowest point.

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