Inside Toshiba’s Accounting Scandal: The High Stakes of Crisis Management and Brand Survival

“The damage to Toshiba’s brand image, arguably the most significant in its 140-year history, will take time to rectify.”

The following is a quote from a press conference held by Hisao Tanaka, the then-president of Toshiba, who resigned on July 21, 2015 (Gregorian calendar), taking responsibility for the accounting fraud scandal.

The accounting fraud, which was carried out systematically and involved top management to hide deteriorating performance, inflicted significant damage on the brand image, leading to a drop in stock prices and alienation of investors.

In the event that a company experiences a deterioration in its financial situation, the likelihood of accounting fraud rises due to a number of factors, including the pursuit of bank loans or the need to safeguard the management team, particularly in instances where internal controls are found to be ineffective.

Once accounting fraud is exposed, legal measures such as criminal penalties and liability for damages are imposed. Additionally, the intangible corporate value, such as the social credibility and brand image built up over many years, may plummet, causing severe damage that is difficult to recover.

However, there is a possibility to mitigate the damage by swiftly implementing appropriate measures after discovering accounting fraud.

In this article, we will provide a comprehensive explanation of how to manage the damage to a company’s reputation when accounting fraud is exposed. We will use the example of Toshiba’s accounting fraud scandal to illustrate the points discussed.

What is Toshiba’s Accounting Scandal?

Three Categories of Accounting Issues

In the realm of corporate accounting, there are three primary issues to be aware of: inappropriate accounting, fraudulent accounting, and window dressing.

Inappropriate Accounting

Inappropriate accounting refers to incorrect accounting processes, regardless of whether they are intentional or due to carelessness, such as not using correct information or misuse.

Although “fraudulent accounting” and “window dressing”—which are violations of laws—are also included in inappropriate accounting, many media outlets use the term to distinguish between these two concepts when the illegality is not clear.

Fraudulent Accounting

Fraudulent accounting involves the deliberate inclusion of false information in financial statements, such as the concealment of revenue, with the intent of presenting a misleading picture of financial health. In a broader sense, it also includes “window dressing.”

Window Dressing

Window dressing refers to the manipulation of financial documents, such as ‘Profit and Loss Statements’ and ‘Balance Sheets,’ for the benefit or protection of management, thereby presenting a more favorable and accurate picture of the company’s financial and managerial status than is actually the case.

Overview of Fraudulent Accounting at Toshiba

The Toshiba accounting scandal refers to an incident where profit manipulation exceeding 150 billion yen was carried out over a long period from the fiscal year 2008 to the fiscal year 2014 (April to December).

Toshiba encountered its most significant financial setback due to the global economic downturn triggered by the Lehman Shock in 2008. Additionally, the company’s primary business at the time, the nuclear power plant industry, encountered significant challenges due to the Great East Japan Earthquake in March 2011.

Consequently, the management team, characterizing it as a “challenge,” demanded the achievement of challenging profit targets from the field, resulting in the recording of apparent profits through fraudulent accounting.

However, an internal report submitted to the Securities and Exchange Surveillance Commission in February 2015 triggered the discovery of Toshiba’s fraudulent accounting.

The investigation report by the third-party committee, which included 98 lawyers and certified public accountants, concluded that management at the company was significantly involved in a coordinated fraudulent accounting scheme.

What Happens When Fraudulent Accounting is Conducted?

Various legal measures are established against fraudulent accounting under laws such as the “Japanese Financial Instruments and Exchange Act,” “Japanese Companies Act,” “Japanese Penal Code,” and “Japanese Civil Code.”

About Criminal Penalties

False Statement in Securities Report

If a false statement is made on a significant matter in the securities report and submitted, both the perpetrator and the company will face consequences.

According to Article 197, Paragraph 1, Item 1 of the Japanese Financial Instruments and Exchange Act, the following penalties are applicable for the perpetrator: imprisonment for up to 10 years or a fine of up to 10 million yen, or both.

The company may be subject to a fine of up to 700 million yen, as stipulated in Article 207 of the Japanese Financial Instruments and Exchange Act.

Special Breach of Trust

A director or similar person who engages in fraudulent accounting for their own benefit or that of a third party and causes damage to the company may face a prison sentence of up to 10 years, a fine of up to 10 million yen, or both. In accordance with Article 960 of the Japanese Companies Act,

Furthermore, in the event the surplus funds generated by fraudulent accounting are distributed to shareholders, the director or similar person may be subject to a prison sentence of up to five years or a fine of up to five million yen, or both. This is in accordance with Article 963 of the Japanese Companies Act.

Fraud

Individuals who seek financing from financial institutions by presenting a false and misleading picture of their performance and financial situation through fraudulent accounting may face criminal prosecution and a maximum sentence of 10 years’ imprisonment for fraud. According to Article 246 of the Japanese Penal Code.

About Civil Liability

Directors’ Liability for Damages

In cases where a director or similar individual makes a false statement in financial documents or similar records with malice or gross negligence, resulting in damages to a third party, they will be held liable for the damages incurred. The Japanese Companies Act stipulates this in Article 429.

In the situation where false statements are made in securities registration statements, or important facts are omitted, the company’s directors will be held liable for damages to those who acquire or dispose of the securities without being aware of the false statements (Articles 21, 22, and 24-4 of the Japanese Financial Instruments and Exchange Act).

Company’s Liability for Damages

The company will be liable for damages equivalent to the difference in market price to those who acquired the securities in response to the solicitation or sale in the event of false statements on important matters in securities registration statements, or omission of important facts. Please refer to Articles 18 and 19 of the Japanese Financial Instruments and Exchange Act.

Additionally, there is a possibility that damages may be sought against you under Article 709 of the Japanese Civil Code (Tort).

Order to Pay Surcharge

If a company submits a securities registration statement etc. with false statements on important matters or omission of important facts, it will be ordered to pay a specified surcharge to the national treasury. (Article 172-4 of the Japanese Financial Instruments and Exchange Act)

Measures to Minimize Damage to Brand Image

To mitigate potential damage to your brand image, it is essential to respond appropriately in accordance with applicable laws and regulations, and to disclose information promptly and accurately.

Investigation by a Third-Party Committee, Not an Internal Organization

When financial misconduct is uncovered, it is essential to conduct an objective investigation. Typically, a “third-party committee” composed of impartial experts is established to investigate the facts, identify the cause, and consider measures to prevent recurrence.

In the case of Toshiba, an initial “special investigation committee” was established, consisting of four out of six members who were current Toshiba executives, with the then-Muromachi chairman as the chairman. The following month, a “third-party committee” was established.

In addition to this scenario, the establishment of a “third-party committee” composed of impartial and objective experts, along with the prompt disclosure of the investigation report, can mitigate the repercussions of a company’s scandal. This approach can minimize any potential damage to its social credibility and brand image.

The reasons behind Toshiba’s decision to not pursue an investigation by the “third-party committee” from the outset remain unclear. However, if they had requested an investigation by the “third-party committee” when the financial misconduct was uncovered, the facts would have been revealed at an earlier stage.

The “special investigation committee” revealed that the amount of profit manipulation was 4.4 billion yen. Additionally, the “third-party committee” established a month later found an additional 151.8 billion yen of profit manipulation.

Trust in a Company Can Vary Greatly Depending on How It Handles the Media

Whether for individuals or corporations, the best media response when misconduct is uncovered is to quickly and honestly disclose the facts. Concealing or distorting the facts will only worsen the situation.

Toshiba’s initial media response to this issue is documented as follows:

• April 2015: The company has announced the establishment of a special investigation committee. This committee has been formed in response to matters requiring investigation that were found in relation to accounting treatment for some infrastructure-related construction progress standards.
• May 2015: Announced in a press release the establishment of a “third-party committee” for the purpose of requesting investigation, cause identification, and prevention measures, as “improper accounting treatment” related to infrastructure-related cases was found in the investigation by the special investigation committee.
• June 2015: The “special investigation committee” has reported that there was “improper accounting treatment” in the self-check.

As the flow of information illustrates, Toshiba consistently failed to acknowledge any “financial misconduct” and continued to assert “improper accounting treatment.” Consequently, the investigation by the third-party committee revealed systematic violations of laws and regulations, resulting in significant damage to social credibility and brand image.

Prompt Disclosure of Information to Investors

Listed companies are obligated to provide investors with important company information in a timely manner, as outlined in the “Securities Listing Regulations” of the Tokyo Stock Exchange, where Toshiba is listed.

If a fact that has a significant impact on investors’ investment decisions occurs in relation to the operation, business, or property of the listed company or the listed securities, etc., the content must be disclosed immediately in accordance with the enforcement rules. Please refer to Article 402, Paragraph 1, Item (2) x for more information.

The loss suffered by investors due to false statements in securities reports cannot be undone; however, it is possible to prevent further losses by promptly disclosing information.

In the case of Toshiba, the Japan Custody Bank and the Japan Master Trust Bank initiated legal action for damages due to a decline in stock prices, resulting in a compensation order amounting to approximately 160 million yen. Additionally, the total amount of claims from lawsuits filed by investors in Japan and abroad is estimated to be approximately 178 billion yen.

If information had been disclosed immediately when the financial misconduct was uncovered, the amount might not have been so large, and it might have been possible to avoid losing the trust of investors.

Early Reporting of Violations to the Securities and Exchange Surveillance Commission

Under the Financial Instruments and Exchange Act, a system has been established to reduce the fine by 50% if the violator reports the fact of the violation before the authorities take action for violations such as false statements in securities reports. (Article 185-7, Paragraph 14)

If Toshiba’s management had reported the violation before the inspection or report collection by the Securities and Exchange Surveillance Commission and the Financial Services Agency, etc. had begun, the fine of 7,373.5 million yen that was ordered to be paid could have been reduced by 50%.

This is not directly related to a company’s social credibility or brand image, but continuing to hide financial misconduct that would be revealed if experts investigated it for many years only widens the wound.

Summary

If mishandled, the revelation of fraudulent accounting can significantly damage the social credibility and brand image that a company has built over many years.

Furthermore, there are numerous related laws and regulations, and appropriate responses are required not only for stakeholders but also for relevant authorities such as the Public Prosecutor’s Office, the Fair Trade Commission, the Financial Services Agency, listed stock exchanges, and the media.

Therefore, when fraudulent accounting is uncovered, we recommend consulting with a lawyer who has extensive knowledge and experience, rather than making independent judgments about how to proceed.

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