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November 13, 2011

Olympus scandal: Japanese auditors lack ‘power’ to detect fraud

Japanese auditors lack sufficient powers to pick up fraud, according to Yoshinao Matsumoto, a professor of auditing at Kansai University.

Matsumoto told International Accounting Bulletin the Japanese audit profession is blighted by a combination of relatively low audit fees and insufficient legal powers to detect accounting irregularities.

Matsumoto’s comments come in the wake of one of Japan’s largest corporate frauds in which the camera and medical equipment manufacturer Olympus recently revealed it had hidden large securities losses by using payments to merger advisers and venture capital funds. Two of Japan’s largest firms, former Olympus auditors KPMG ASZA and Ersnt & Young ShinNihon (E&Y), are being investigated by authorities to determine whether they could have done more to uncover accounting irregularities.

Matsumoto said it is difficult for audit firms to play a stronger role in fraud detection due to the relatively weak position they hold in their relationship with clients.

“The most typical Japanese audit environment is that the power of business managements is much stronger than CPAs. So CPAs, as auditors, cannot take a firmer attitude toward these directors and managements,” Matsumoto said.

“The fact that auditor’s power is weak compared to the management and that corporate governance, [such as] directors’ mutual monitoring, is not effective like in Japanese traditional companies, makes fraud and irregularities easier.

“If the management did the fraud and irregularities in the financial statements, in general, auditors cannot detect them because the auditors do not have any legal power like the tax collector”.

Low fees

Japanese audit firms are typically paid a fraction of what US auditors receive, adding extra pressure.

Following the Kanebo scandal of 2004, the Japanese Financial Service Agency revised auditing standards, the CPA Law and the Financial Instruments and Exchange Law, while introducing the Internal Control Report and Audit, and quarterly financial statement reviews. This created a great deal more work for auditors but fees have not risen at a high enough rate to cover the additional man hours, which increases the likelihood that audit work may not be as thorough.

“For example, since those reforms, audit fee became 1.5 times as high as 2007. However, comparing it to the US audit fee, the Japanese audit fee is only about 30% in average,” Matsumoto said.

The Japanese Institute of Certified Public Accountants and Japan’s Financial Services Agency are investigating KPMG ASZA and E&Y ShinNihon over their audits of Olympus.

Regardless of the outcome, Matsumoto believes the reputation of Japan’s Big Three is under threat.

The Kanebo scandal destroyed former auditor PwC’s reputation in Japan to such a degree the network need to shut down its former member PwC ChuoAoyama and rebuild from scratch. This led to PwC being much smaller in size than its traditional rivals, a position it still holds.

With only three large firms remaining, the Japanese audit profession can ill afford another major collapse.

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