Citing problems that included its Toshiba audit, the Financial Services Agency (FSA) imposed sanctions on Ernst & Young ShinNihon LLC on December 22, 2015. The firm changed its name to EY ShinNihon LLC on July 1, 2018.
This is a good opportunity to reconsider what audit firms are.
An audit firm is an incorporated group of certified public accountants, so its role is almost the same as that of a certified public accountant.
In Japan, they are treated much like companies as “corporations,” whereas overseas, the limited liability partnership (LLP) is common.
(If you would like to check the difference between a corporation and a partnership, see this article.)
Japan also recognizes the form of a “limited liability audit corporation,” and some firms have transitioned from ordinary audit firms to limited liability audit firms. From a client company’s perspective, a limited liability audit firm and an ordinary audit firm are the same except for the difference in liability.
Reviewing the Basics of Capital Markets
The stock company, by separating managers from owners (investors), made it possible to run enduring businesses and expand businesses on a large scale. Some call it one of humanity’s greatest inventions.
Because managers and owners are separated, owners provide the money, and managers report the results of their management to the owners.
As a way of reporting those results, bookkeeping techniques developed and spread.
But managers are human too, and sometimes make false reports. If falsehoods become pervasive, the very arrangement of the corporate form—entrusting management to people who are good at it (managers)—cannot work and collapses.
That is where certified public accountants take on their role as the “watchdogs of capital markets.”
They determine whether the reports submitted by managers are accurate and report to the owners. The owners assess the managers’ abilities based on accurate information. This is how the corporate system works well.
Money is invested with capable people (managers), the economy enters a virtuous cycle, and the public benefits from it.
Reviewing the Mission of Certified Public Accountants (≒ Audit Firms)
The mission of certified public accountants is set out in Article 1 of the Certified Public Accountants Act.
The mission of certified public accountants, as experts in auditing and accounting, is to contribute to the sound development of the national economy by ensuring, from an independent standpoint, the reliability of financial documents and other financial information, thereby promoting fair business activities by companies and other entities and protecting investors and creditors.
Put simply, the important points are probably professional competence, an independent position, and investor protection.
As explained in the basics of capital markets, certified public accountants occupy the third most important position among the participants in capital markets. Investors are first, managers are second, and certified public accountants are third.
The Toshiba Case Involving Shin Nihon Audit Corporation
The Certified Public Accountants and Auditing Oversight Board, a council of the Financial Services Agency, which supervises audit firms, issued its inspection findings and recommendation. In effect, this body supervises certified public accountants and audit firms.
As a result of our inspection of this audit corporation, its operations are recognized as being grossly inappropriate, as set forth below.
Omitted below.
(Certified Public Accountants and Auditing Oversight Board, 2015/12/15 (Japanese))
The supervisory authority described the firm as “grossly inappropriate,” but reading the reasons, they can be summarized as follows.
- Although deficiencies in its systems and processes had been pointed out before, nothing improved at all (the PDCA cycle was not functioning)
- There were problems with quality control and the review (checking) system by responsible persons
- Partners (equivalent to directors in an ordinary company) lacked competence
I am also a certified public accountant, and as a fellow professional I am disappointed and drained. The wording hints at a little self-justification: the Board had raised these issues repeatedly, so the FSA was not to blame. We should probably discount the account by about 30%; even then, it is awful.
This Toshiba audit scandal seems likely to come down to a lack of professional competence.
As noted in the discussion of the mission of certified public accountants, among the elements of “professional competence, an independent position, and investor protection,” there are examples where professional competence existed but an independent position was not maintained: ChuoAoyama Audit Corporation, which was ultimately dissolved following the Kanebo incident, and Arthur Andersen, which caused the major Enron problem.
At the time, ChuoAoyama Audit Corporation had the strongest connections with the Financial Services Agency and was the leading audit firm.
However, its collusion with Kanebo management came to light; accounting fraud exceeding ¥200 billion at Kanebo was uncovered, and it received a business suspension order from the Financial Services Agency. In monetary terms, the Toshiba case seems likely to be larger.
In ChuoAoyama Audit Corporation’s case, its competence was not the problem—it was capable enough to work out together how to conceal accounting fraud through “tobashi” schemes—but its independence (collusion with management) was the problem, and the high degree of maliciousness led to a business suspension.
I think Japan has a culture that tolerates a lack of competence, so this time the sanctions will probably not be very severe. It would be different if, in an unexpected twist, facts emerged showing a problem with independence.
It would be better if Shin Nihon, too, received relatively light sanctions along the lines of: we lacked competence, and we are sorry.
- Surcharges and sanctions from the Financial Services Agency
- Shareholder derivative lawsuits
Shin Nihon, which was given a passing grade in “auditing,” the foundation of its business, has lost the trust of its client companies.
Whatever the sanctions, a difficult road seems to lie ahead.
In the end, properly fulfilling one’s mission leads to trust and to a thriving business.
Added December 23, 2015
The details of the sanctions have been announced.
Over Toshiba’s accounting scandal, the Financial Services Agency formally announced administrative sanctions on the 22nd, ordering Shin Nihon Audit Corporation, which handled the accounting audit, to suspend new business for three months. It will also impose a surcharge of approximately ¥2.1 billion, the first of its kind against an audit firm. The FSA found that the firm “failed to exercise due care and was unable, for a prolonged period, to conduct verification from a critical perspective.” It issued business suspension orders of one to six months to seven certified public accountants directly responsible for Toshiba (Nikkei, 2015/12/23 (Japanese)).
Compared with ChuoAoyama Audit Corporation, this is a relatively light sanction, perhaps about one-hundredth as severe. I was surprised that sanctions were imposed on people other than the responsible certified public accountants who signed off. Going forward, certified public accountants in management positions will recognize that they may be held accountable even if they did not sign, creating an incentive for them to take an active role in ensuring accurate audits; that makes this a useful sanction. The surcharge was the first of its kind because it was established after the sanctions against ChuoAoyama Audit Corporation. Subsequently, on January 22, 2016, an order was finalized requiring payment of a surcharge of ¥2.111 billion. ¥2.1 billion feels like a large amount, but Shin Nihon Audit Corporation Group received ¥2.9 billion in fees from Toshiba in 2014, so it is roughly one year’s worth.