ACCT7385FraudExamination

Fall2016Test2Due112816
CaseStudyOlympusCorporation

CaseStudy:FraudinFinancialStatements:OlympusCorporations$1.7Billion
AccountingFraud

BackgroundTokyobasedOlympusCorporation,foundedin1919,manufactures
digitalcamerasandelectronicequipment,includingmedicalimagingequipment.
Salesforthe2011fiscalyearwere$10.6billion.Olympussharesaretradedonthe
TokyoStockExchangeanditsAmericanDepositoryReceiptsaretradedonthe
U.S.overthecountermarket(i.e.,thePinkSheets).

AccordingtoReuters,themarketvalueofthecompanyssharesdroppedby76
percentbetweenOctober14,2011andNovember9,2011,wipingoutmorethan
$6billionforshareholders(StempelandCruise2011).Theeventthattriggered
thedeclineinstockpricetookplaceonOctober14,2011,whenthecompany
fireditsCEO,MichaelWoodford,twoweeksafterhisappointment.

Asbackgroundforthiscase,theJapaneseeconomyenjoyedtremendous
prosperityduringthe1980s.Oneindicatorofthisprosperity,theNikkei225
index,rosefromlessthan6,000inJanuaryof1980toapeakof38,915attheend
ofDecember1989anincreaseof550percentovertenyears.ButJapans
successalsocausedtheyentoriseduringthisperiod.InJanuary1985,the
exchangerateofyenperdollarwasapproximately254.ByDecember1989,that
ratehaddroppedby43.7percentto143.Therisingyenincreasedpressureonthe
operatingprofitsofJapanesecompanies,whichreliedheavilyonexports.

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Inthisenvironment,Olympusbegantoincreasinglyrelyoninvestmentincomeas
partofitsbusinessstrategy.UnfortunatelyforOlympus,theJapaneseequities
marketsawaprecipitousdeclineinthe1990s.TheNikkei225indexhadlostover
50percentofitsvaluebyDecember31,1999.Giventheaccountingstandardsin
Japanatthetime,Olympusdidnotfeelcompelledtoreporttheunrealizedlosses
theyhadincurredonthefirmssecuritiesinvestments.However,JapansBusiness
AccountingDeliberationCouncilexpressedincreasinginterestinfairvalue
accountingduringthisperiod,anditbecameapparentthatOlympuswould
eventuallyberequiredtoreporttheselosses.Infact,theBusinessAccounting
DeliberationCouncilannounceditsintentiontointroducefairvalueaccountingin
1997andcompleteditsaccountingstandardforfinancialinstrumentsinJanuary
1999(Gordon1999).

Olympusofficialsadmittedthatmanagementhadhiddenunrealizedinvestment
lossesdatingbacktothe1990sandthat,in2008,thecompanyusedaseriesof
overpricedacquisitionstohidetheselosses.Thegoodwillinsomeofthese
acquisitionswasthenquicklywrittendowntoconcealthelosses(Stempeland
Cruise2011).Aninterestingaspectofthiscaseisthatthefinancialstatement
fraudoccurredwhenmanagementusedfraudulentaccountingtoconceal
unrealizedlosses,whichdonotappeartohavebeencausedbyillegalor
inappropriatebusinessactivities.Insteadofreportingmaterialnonoperating
lossesonsecuritiesinvestments,Olympuscreatedunconsolidatedentitiesto
purchasethesesecuritiesfromitatbookvalue.Managementthenexecuteda
seriesoftransactionsamongacomplexwebofrelatedentities,essentially
convertingtheunrealizedlossesintofeesandgoodwill.Olympusindependent
auditorslaterrequiredthewriteoffofmostofthisgoodwill.So,inessence,these
verycostlyschemesconvertedunrealizedinvestmentlossesintofeeexpenseand
lossesreportedaswriteoffsofgoodwill.

InDecember2011,Olympusfiledfiveyearsofrestatedfinancialstatementsplus
overduefirsthalfresults,revealinga$1.1billionhittoitsbalancesheet.

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TheWhistleblower
InApril2011,MichaelWoodfordwasnamedpresidentofOlympus.AU.K.citizen,
hewasOlympusfirstnonJapanesepresident.InAugust2011,Mr.Woodford
expressedconcernaboutpossibleinappropriateacquisitionsandlargepayments
tofinancialadvisorswiththechairmanofOlympusandanexecutivevice
president(Osawa2011).OnSeptember23,Mr.Woodfordsentlettersto
membersoftheOlympusboardquestioningthetransactionsanddemanding
explanations,especiallyfortheexcessof$600millionissuedtounnamed
recipientsintheCaymanIslandsItisinexplicabletomewhyOlympuswould
makeapaymentofthismagnitude(Greenfeld2012).Healsosentcopiesofthe
lettertothefirmsexternalauditors.OnOctober1,Woodfordwasappointed
CEO.OneofhisfirstactionswastocommissionPricewaterhouseCoopersto
investigatethequestionabletransactions.

OnOctober14,2011,theboardofdirectorsremovedMichaelWoodfordfromhis
executiverolesatOlympus.Thereason,perthecorporatetermination
announcement,wasthathehadlargelydivertedfromtherestofthe
managementteaminregardtothemanagementdirectionandmethod,anditis
nowcausingproblemsfordecisionmakingbythemanagementteam(Verschoor
2012,13).Butonlyaonemonthlater,afterlyingtothepublic,Olympusofficials
admittedtotheFBIandtheU.K.'sSeriousFraudOfficethattheypaidfraudulent
advisoryfeesof$1.7billioninadecadelongcoverup(Cohn2012).Hadlesser
employeesattemptedtoblowthewhistle,theirattemptswouldhavebeeneven
lesseffectivebecauseitwassubsequentlyreportedthatthetwoexecutiveswho
oversawthecompanyswhistleblowerprogramwereattheheartofthescandal
(Osawa2012).

AccountingforFraud
Ratherthanmerelyrecognizingtheunrealizedlossesfromafailedinvestment
strategy,managementdevelopedmeasurestoremovetheselossesfromits
books.ThefirststepwastoseparatethelossesfromOlympus,referredtoasthe
lossseparationscheme.Thesecondstepwastodisposeoftheinvestmentsto
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whichthelossesrelated,i.e.,thelossdispositionscheme(TheThirdParty
Committee2011a).

Tooperationalizetheschemes,Olympuscreatedfundswhichwouldnotbe
consolidatedintotheirfinancialstatementsunderexistingJapaneseGAAP.From
thecommentsofanoutsidepanel,TheThirdPartyCommittee,appointedto
investigatethefraud,thesefundsappeartohavebeenlittlemorethanageneral
ledgerwithachecking/brokerageaccountandanotepayable.Theprimary
purposewastoremoveinvestmentsfromOlympus'books.Asecondpurposewas
toobscuretheaudittrail.Olympustransferredinvestmentsandmoneybetween
numerousfundsandentities,makingitdifficulttounwindthetransactionsandto
understandwhatwashappening.Thefundsborrowedmoneyandpurchased
Olympusfinancialinstruments,whichincludedunrealizedlosses,atbookvalue.
ThesolepurposewastoexcludetheselossesfromOlympusbooks.Thesefunds
wereabletoborrowmoneyfromforeignbanksonlybecauseOlympusagreedto
depositmoneyorliquidgovernmentsecuritieswiththefacilitatingbanks.

TheCentralForestCorp.(CFC)andQuickProgressCo(QP)fundswerecentralto
theseschemes(TheThirdPartyCommittee2011:10).CFCandQPwerethe
entitiesthatboughttheOlympussecuritieswiththeunrealizedlosses.Inone
example,OlympusdepositedaJapaneseGovernmentBondwithLGTBankin
Lichtenstein.LGTBankthenprovidedacreditlineandaloantoCFC.Inanother
example,OlympusmadealargeinvestmentinSGBond,aCaymanIsland
partnership.SGBondandother(entities)engagedinadizzyingchainof
transactions,5passingmoneysuppliedbyOlympusfromonetoanotheruntil
entitiesthatwereseveraltimesremovedfromOlympusappearedtobuytroubled
assetsatbookvalue(Rapoport2011).

Inthesecondstep,thelossdispositionscheme,Olympuschanneledmoneyto
thenonconsolidatedfunds,CFCandQP,enablingthemtopayofftheirloansat
thefacilitatingbanks.Oncetheloansofnonconsolidatedfundsweresettled,
Olympuswasnolongerberequiredtomaintaindepositsatthefacilitatingbanks
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andalltiestotheunrealizedlossesweresevered.However,Olympusdidnot
transactdirectlywiththenonconsolidatedentities.Rather,Olympushadaweb
ofotherentitiesexecutemultipletransactionswiththefundstointroduceagreat
dealofcomplexityandtomuddythewater.

Inonelossdispositionscheme,twocontrolledentities(TheThirdParty
Committee2011a,12)purchasedsharesinseveralsmalltargetcompanies.
Olympussubsequentlypaidhighlyinflatedpricestopurchasethetarget
companiessharesfromthecontrolledentities.Thecontrolledentitiesusedthe
proceedsfromthesesalestosettleCFCsloanfromLGTBankofLichtenstein,
consequentlyrelievingOlympusofitsobligationtomaintainadepositatLGT
Bank.Tohidethetrail,Olympusseldompurchasedsharesdirectlyfromthetwo
controlledentities,whichinvestedinthetargetcompanies.Rather,Olympus
orchestratedsequencesoftransactionsbetweennumerouscontrolledentities.
Theprocesswascostly.TheThirdPartyCommittee(2011a,1213)reportedthat
Olympuspaidabout73.2billionyenforsharesthatoriginallycostitscontrolled
entitiesonly700millionyen.

Althoughnotpartofthedispositionscheme,theexternalauditorswouldnot
permitOlympustocarrythegoodwillattheinflatedtransactionprices.Olympus
wasrequiredtowriteoffgoodwillandreportimpairmentlossesof55.7billion
and1.3billionontheseinvestmentsintheir2009and2010financialstatements.

Asecondlossdispositionschemeinvolvedarelationshipwithfinancialadvisors
whoassistedinthe$2.2billionacquisitionofGyrusACMI.TheThirdParty
Committeeconcludedthatthefinancialadvisorswerepaidexorbitantfeeswith
theunderstandingtheywouldusethesefeestosettletheaccountwiththe
aforementionedSGBondoftheCaymanIslands.

InalettertotheChairmanofOlympus,datedOctober11,2011,Michael
Woodford(2011)outlinedodditiesinaseriesofarrangementswithAxesAmerica
LLCandAxamInvestmentsLtd.,anotherCaymanentity.In2006,thefirst
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agreementwithAxes/Axamstipulateda$5milliondollarfeeplusafeeequalto
onepercentoftheacquisitionprice,payableincashandoptions.In2007,a
substituteagreementwasnegotiated,stipulatingthatOlympuswouldpaythe
financialadvisorsfivepercentofthepurchaseprice.Olympuswouldpay15
percentofthefeewithcashandtheremaining85percentwithoptionsand
warrants.WhenOlympusacquiredGyrusACMIfor$2billioninFebruary2008,
thefinancialadvisorsreceived$12millioncash,optionsvaluedat$177million,
andwarrants.InSeptember2008,Olympusnegotiatedtopurchasethewarrants
for$50millionandsettledtheoptionsbyissuingpreferredstockwithaparvalue
of$177millioninGyrus.InMarch2010,Olympuspurchasedthepreferredstock
ofGyrusfromAxamInvestmentsLtd.for$620million.

The$50millionAxamInvestmentsLtd.receivedforitswarrantsandthe$620
millionAxamreceivedforitspreferredstockwerepassedthroughvariousrelated
entitiestoSGBond.SGBondreturnedthemoneytoOlympus,whichremovedthe
investmentinSGBondfromitsbalancesheet,toendaverycomplicatedand
twistedscheme.

JapaneseCorporation;InternationalIssue
LikeLehmanBrothers,Olympusoperatesacrossborders.Inperpetuatingthis
accountingfraud,OlympususedbanksinLichtenstein,Singapore,HongKongand
JapanandfinancialadvisorsinJapan,theUnitedStatesandtheCaymanIslands.
Thefirmusedentitiesinnumerousjurisdictionstoexecutetransactionsand
transfers.Thisfraudwasdifficulttounravel,withtransactionsexecutedacross
internationaljurisdictionswiththeintenttodeceiveandmuddythewater.
OlympusisbeinginvestigatedinJapan,theU.S.andBritain.

ConsequencesforOlympusExecutives
February16,2012,sevenmenwerearrestedforinvolvementinthiscase,
includingTsuyoshiKikukawa,thecompanyschairmanuntilthescandalbroke,
andtwoformerexecutives.Thesethreewerearrestedonsuspicionoffalsifying
financialstatements.Theremainingfourarresteeswereinvestmentbankersand
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theirassociates,accusedifsecuritiesfraud.Ifconvicted,themencouldfaceupto
10yearsinprison(Tabuchi2012).Thecorporationisalsosuing19formerand
currentexecutivesfor3.61billionindamages(NakamotoandSoble2012).

InIndia,policeareinvestigatingwhethertheapparentsuicideoftheJapanese
managingdirectorofOlympusMedicalSystemsIndiawasrelatedtothescandal.
ThesuicidetookplaceinIndiashortlyafterthearrestsinJapan.Inasuicidenote,
thefatheroftwowrote:Iamashamedandsorryforthetrouble(Buncombe
2012).InlateFebruary2012,thecompanyannouncedthatitsentireboardof
directorswouldresignattheApril20,2012shareholdersmeeting.

ConsequencesforAuditors
Ernst&YoungShinNihon(E&Y)becameOlympusexternalauditorin2010,
replacingKPMGAzsa(KPMG).E&Yreliedontheunqualifiedauditreportsissued
byKPMGfor2008and2009.Bothauditingfirmsdeniedanywrongdoing.While
theThirdPartyCommitteedidnot8accuseKPMGorE&Yofbeingcomplicitin
thefraud,theybelievedthattheauditorsshouldhavedonemore.The
Auditorsshouldaimtotrulybenefitthecompany,mustconstantlymaintain
skepticism,thoroughlypursuethetruthoftransactionsandperformtheirduties
fromafairposition(ThirdPartyCommittee2011b:184).

TheThirdPartyCommitteewasparticularlycriticalofthesuccessionprocess.
Thesuccessionatthetimetheauditingfirmswerechangedwasinsufficient,and
theevaluationmustbemadethattheywereunabletosufficientlyfulfilltheir
duties(ThirdPartyCommittee2011b:181).Subsequently,aNonDirector
ManagementInvestigationCommittee(2012)comprisedofattorneyswithno
interestinOlympusinvestigatedpossibleviolationsofthedutyofduecareby
variouspartiesinthefraud.Thecommitteefoundnoinstanceswhereeither
KPMGorE&Yviolatedtheirdutyofduecare(NonDirectorManagement
InvestigationCommittee2012,123and149).
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