A $1.7 Billion Fraud Born of Earnings Management and a Poor Ethical Culture

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Sheila Keefe, CFE, CPA
Principal, BDR Advisors LLC

The $1.7 billion Olympus fraud, discovered through whistleblowing of the outgoing CEO Michael Woodford, has sent shockwaves throughout the corporate governance world as many wonder if such a fraud could occur at other organizations. To consider this validity of this concern, let’s look at the accounting piece and the role of poor corporate culture that allowed this fraud to continue for 13 years.

The Numbers

The accounting piece of the Olympus fraud was facilitated by the now-outlawed practice of tobashi, in which organizations spread the recognition of losses over multiple periods rather than immediately. To state it simply, tobashi is a form of earnings management. Olympus executed its tobashi scheme by selling devalued investments to an ‘unrelated’ entity under common control at historical costs. In this way, no loss was recorded by Olympus on the sale of the investment. The losses were recorded eventually as impairment of goodwill.  To do this, Olympus would buy the ‘unrelated’ entity that held the investments, with the price set at the lower market value and then add in significant goodwill to the acquisition such that the new subsidiary would be bought for an amount equivalent to the historical cost of the devalued investments. Olympus would then gradually write-down goodwill from the acquisition of the previously ‘unrelated’ entity as a permanent impairment. At the end of the tobashi scheme, the devalued investment would be restored to Olympus’ balance sheet at the lower market value, and the losses would be recorded through the income statement but not as investment income but rather as impairment of goodwill.

While the tobashi scheme that Olympus initiated is no longer legal, earnings management is still popular with companies interested in avoiding shocks to stock prices. As recently as 2009, General Electric was fined $50 million by the SEC for earnings management.

The Role of Olympus’s Poor Ethical Culture

Accounting issues aside, Olympus has been criticized for having a poor corporate culture. In an investigation report issued by a third-party committee in December 2011, several suggestions for improving Olympus’s corporate culture were outlined:

  • Outside directors should be truly independent, not connected to those in management or the organization’s trade partners.
  • The importance of candid conversations and dissenting opinions in creating a culture of accountability and transparency. Per the report: “Fear of rocking the boat or formalities should be eliminated. Developing people who can discuss what he really thinks.”
  • The need for the board directors to question the consultation of its advisors. As the report instructs, board members should “thoroughly pursue the truth of the transactions” and not allow a “worthless report of an outside expert” to be “blindly trusted.” This applies to all organizations in that board members should be sure that the approval to take on highly complex transactions is supported by a discussion by management that explains how the transaction generates economic growth. Such discussions would identify transactions that are more form than substance. 
  • Use of a whistleblower hotline to “prevent misconduct by executives.”

The report closes with an observation common to many victim organizations that speaks to the need to pursue an ethical work culture as part of any fraud response program, stating, “Olympus had originally been a sound company, with diligent employees and high technical strength. Not all part of the company was involved in this misconduct. Olympus should remove its malignant tumor and literally renew itself.”  Strong words, for certain, but not overstated.

Olympus whistleblower Michael Woodford will formally accept the ACFE's Sentinel Award and speak as a keynote at this June's ACFE Annual Fraud Conference and Exhibition in Orlando, Fla.

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