Views on improving the integrity of global capital markets
28 July 2015

Toshiba Accounting Scandal: Should Auditor Ernst & Young ShinNihon Get a Mulligan?

Mulligan: a free shot sometimes given a golfer in informal play when the previous shot was poorly played. Merriam–Webster Dictionary

Recently Toshiba Corporation reported that due to accounting irregularities, its profits were inflated by $1.2 billion for the period of 2008 through the third quarter of 2014. This overstatement represents approximately one-third of Toshiba’s pre-tax profits during this period, as reported by the New York Times. Of course this is a material misstatement, and understandably it caused a corporate governance shake-up at Toshiba leading to the resignation of its president and CEO, in addition to a number of its board members.

So where was the auditor? It has been reported that the improper accounting dating back to 2008 was intentional, that it would have been difficult for Toshiba auditor Ernst & Young ShinNihon LLC to detect. It is hard to understand the nature of the difficulties that the auditor would have encountered, but given the sheer size of the misstatement, it begs the question: Why was the auditor blind to the accounting irregularities? More about this will probably come out in the future.

It is also curious that, according to Toshiba’s action plan to correct these past accounting irregularities, the amounts identified for correction by Toshiba’s independent investigation committee will first be verified by the company and then audited by Ernst & Young ShinNihon LLC — the very auditor under whose watch the irregularities occurred. Having another audit firm review the corrections seems a more reasonable strategy given what Ernst & Young ShinNihon missed, for whatever reason, over the span of six years. Doing so would provide another set of eyes on the circumstances that led to the accounting inaccuracies and independently verify the accuracy of the restated amounts. This independent look would help restore confidence in Toshiba’s financial results and possibly identify further improvements to the audit process.

Should Ernst & Young ShinNihon be given a “mulligan” to try to get it right the second time around? We don’t think so.

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About the Author(s)
Matt Waldron

Matt Waldron was a director of financial reporting policy at CFA Institute. He drafted position papers and comment letters, representing membership interests regarding financial reporting and disclosure proposals issued by the FASB, the IASB, and others.

32 thoughts on “Toshiba Accounting Scandal: Should Auditor Ernst & Young ShinNihon Get a Mulligan?”

  1. Stephen Campisi says:

    Great post. Relevant points that deserve and require attention and answers. We all know that you don’t hire the fox to guard the henhouse. Neither do you hire the firm that makes the initial error to identify errors or sign off on what was identified In the investigation. For this investigation to be legitimate and accepted by investors, the entire process must have the credibility and objectivity that comes from the work of a third-party firm. The initial accounting firm must be informed of the results of the investigation; they cannot investigate themselves or validate the results of the investigation.

    1. Ivy Hesse says:

      This sounds like something they didn’t need anyone to tell them to do in these circumstances.

    2. Yes, but oversight by independent firm would be suggested.

  2. James Crawshaw says:

    I wonder what Olympus’ ex CEO Michael Woodford would say.

  3. Ashok says:

    What are the shareholders (institutional) of Toshiba doing? I don’t think this is an issue of auditor change alone. What is the market regulator doing about this?

  4. Matt Waldron says:

    Thank you for your comments.

  5. Zach says:

    how is no one going to jail? No one is talking about JSOX. People need to go to jail.

  6. Shbeilat says:

    More investigations should be done to see if there are collusions with executives.

  7. Ivy Hesse says:

    The extent and years involved in such a misstatement should make it pretty obvious that an independent eye is required to restore confidence. This should be non-negotiable. It may even be a better idea to consider changing auditors too at this point and underscores the need to rotate auditors every now and then so you have a fresh set of eyes. Isn’t it about time that a mandatory auditor rotation requirement is put in place?

    1. Bahrin says:

      Maybe we need to set 5 years rotation

  8. So far, it seems the auditors are being treated like one of the victims of this scandal, instead of being held partly responsible for it. I think this reflects the very difficult conditions that exist for auditors in Japan, rather than the thesis that they actively participated in financial shenanigans, or willfully neglected the possibility of it, although some people do have a more critical view. There will probably be some repercussions, but they will not be Arthur Andersonian.

    Auditors do rely on management representation of the numbers given to them, their scope is limited, and independently confirming the numbers with professional skepticism is a difficult task given the unusual nature of some projects, all exacerbated with vulnerable accounting policies. While these reasons may be met with some cynicism, they are very real challenges, especially in places like Japan.

    I can understand the questions about using the same auditor for checking the independent committees’ investigative report, but I am not sure a much different conclusion would be reached if another auditor was used. I appreciate my view may be controversial, but this investigative report did not actively examine the role of the external auditor in the required detail; instead its focus was to look at the company’s various causal internal issues. Moreover, another auditor may even have some empathy towards the challenges that external accountants face in Japan.

    Consequently, I think the question to ask is what are auditors doing to improve the integrity of numbers used to form the basis of their audited opinions in a particularly difficult environment. Working with regulators to improve the auditing process may be a better solution compared to a witch hunt. Moreover, investors need to accept that there will always be varying levels of accounting risk across the board, and meet this by beefing up their forensic accounting capabilities to the extent that they can better assess the reliability of financial reports. The benefits will be enhanced performance in portfolios. This is something that the CFA does encourage, and I would welcome an even greater emphasis in this area.

  9. Deepak Singh Dhami says:

    Yes Auditor Should Responsible for True and Fair of Financial Reporting. The Auditor Should be Guilty For his inconsistency of Auditing. I think So Being Indian Chartered Accountant…

  10. Abdallah says:

    you are absolutely right about hiring another auditor to audits the firms financials. But hiring another auditor want solve the problem. A more strict corporate governance and internal control should be applied.
    As reported by Toshiba’s website earning fudging was done through estimating higher profit using percentage of completion method and delay in recognizing provision loss.
    Another reasons to use cash flow analysis, rather that using old traditional method. If the analyst use NOCF, they we’ll realize Toshiba has a very low NOCF/SALES which will indicate a problem in the company’s working capital

  11. Matt Waldron, CPA says:

    I appreciate the comments generated by my recent blog post. I think that the nature of the comments really show that investors and others are engaged in the important work that independent auditors provide to support the effective functioning of the capital markets. At CFA Institute we find that our focused efforts advocating for improved audit quality and transparent reporting by the auditors and audit committees play a significant role in shaping the outcomes. As always we welcome your views which help develop our positions.

  12. Every shortcut means has time limit now it’s show times” more audit is needed

  13. Balachandran says:

    Auditors repeatedly get away with murder. They are given more than due share of leeway under multiple disclaimer clauses which virtually amounts to disowning all responsibility for the work they profess to perform. If the auditors have failed to detect profit overstatement for seven years at a stretch they have definitely let down the stake holders and their profession. Own up and pay up please.

  14. Syed Ahmed Abid says:

    This is definitely an inexcusable oversight by the auditors and a case of negligence by the regulators too. The very fact that the discrepancy existed for several years speaks on the quality of the audit and the vigilance of the regulator.
    Assigning the responsibility of investigation to the same auditors is just an attempt to put the matter under the carpet. The regulator concerned must intervene and order an independent auditor to conduct the enquiry and necessary reprimands be issued to the management and auditor alongwith penalties as may be prescribed

  15. Matt Waldron, CPA says:

    Thank you for your continued feedback on this topic.

  16. Yumiko Kokuryu says:

    This Toshiba accounting scandal has been reported on a large scale in Japan. I think more investigations should be done to solve the problem.

  17. Startoffs says:

    It is the responsibility of a company’s director to prepare honest financial reports.

    It is the duty of auditors to check that prepared financial reports reasonably reflect the true position of the company.

    Where the dubious financial reports are deliberately and consistently prepared by a company, auditors are being lied to and the longer the occurence, the harder it is to detect.

    Changing the auditor might help to give an appearance of independence but unless the auditor also helped to hide the fraud, the directors should be solely responsible.

    The auditors should resign anyway.

  18. Chandresh mehta says:

    Good article and comments by learned fellows. We all know how in practice relationship between a company and auditors work. Perhaps what was done was within the acceptable accounting standards but I can’t believe auditors had no idea about it. Nothing can go on for such a long time without auditors knowing it, they may ignore it or let go for other financial benefits. Cash flow analysis, competitive study should be used to understand the underlying trends. Mandatory change of auditors every three years may be a solution to stop such practices.

  19. John says:

    I totally agree with the rest that auditors should get the plame more that Toshiba itself. But Just my personal view here: EY is untouchable. They may get a slap on the wrist in terms of a nominal fine, but nothing more. We really only have four multinational CPA firms remaining, and there is no way the SEC allows that number to fall to three.

  20. Muhammad Irshad says:

    The current auditor i.e Earnst & young should be changed immediatly.
    It is good practice to rotate auditors after every three years.
    By the way where was internal audit department??

  21. Rio Erdiawan says:

    EY auditors should not be blamed for what happened in the company, they are external auditors after all, and we must refresh our mind about AUDIT RISK and MATERIALITY. As long as the external auditors follow the audit procedures, there will be no problem for them.

    And the most important thing, do anyone know about accounting standard in Japan? Since it happened in Japan.

    If someone would like to track what happened behind the scandal, he must be able to understand regulatory in Japan , investment culture in Japan, and also the role of internal audit division of the company (Toshiba).

  22. magawah junior says:

    …it’s the duty of the company through his accountant to maintain proper books of accounts,financial statements however the auditor is bound to give a true and fair view opinion on the same!
    independence is an attitude of the mind,the auditor need to approach with professional skeptism,due care and honesty.the auditor is not an investigator neither is he a’blood hound to detect fraud.
    such rest with the management with its internal controls,the auditor need to test the controls, before placing reliance on them.

  23. Professor Bell says:

    We should keep in mind the role of the auditor as it relates to fraud. It is the auditors responsibility to design and perform an audit that will detect material misstatements whether due to error or fraud.

    This responsibility requires auditors to exercise professional skepticism, which assumes neither honesty or dishonesty. Therefore, when management represents to the auditors that they are making an unbiased judgment call and then present sufficient evidence to support their judgment call – then the auditor can satisfy himself or herself that they have fulfilled their responsibility.

    In the Toshiba case, the auditors were Ernst & Young. Eventually, they will need to answer the question: did you perform an audit in accordance with GAAS, with a specific focus on whether the audit was planned and performed to detect material misstatements due to fraud. The answer to that question will focus on what evidence was obtained and analyzed relating to the accounting for long term contracts and whether the auditors “should have” identified the fraud based on the management representations and other evidence they received.

    The most likely scenario is that EY will settle with the Toshiba shareholders and the general public will never know whether the audits were done in accordance with GAAS or not. But always keep in mind, just because there is fraud in financial statements that are material – it is not a foregone conclusion that the auditors did not do their job.

    1. JPshow says:

      Not true…most engagement letters say the auditors will NOT be held responsible in cases of fraud

  24. asif kiani says:

    after all it creates doubts about professional ethics of auditors, management and accountants of the firm…no one has courage to highlight..

  25. Kamusiime Walter,ACCA, CPA says:

    I think we need to go back to the basics of ISA 240, auditors responsibilities towards fraud. External auditors responsibilities towards fraud are very clear. Internal auditors should have done better instead but earlier on it was reported that similar issues were brought to the attention of the board which quashed the report.

  26. Noneya says:

    I left this organization in May due to a lot of information that I helped deliver to ENY, they are not all to blame. They were fed a lot of “stories” in previous years, Toshiba understood that they
    needed to report profits or what’s the point in doing business. Japanese culture doesn’t allow for anything in red, I believe they robbed Peter to pay Paul… And they honestly believed each year they could get out of the red… But they never understood increase in project scope and forecasting and bidding a project on actual costs plus gross margin. Anyway, EnY finally got enough courage with some help from some honest people, it was only a matter of time before they got caught. Now I’ve been unemployed since and can’t find a job anywhere. Sad state of affairs.

  27. jarot sembodo says:

    Can not agree more with this article.

  28. Lawrence Ansah-Addo says:

    I agree, a new set of eyes would be helpful in unraveling the circumstances behind the irregularities.

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