What is a company to do when it wants to hide losses? Manipulation of the financial statements is the obvious first choice. It’s not hard. Sure companies have “internal controls,” which are supposed to include policies and procedures which ensure that financial information is properly recorded. But companies of all sizes have problems with their internal controls, such that it’s not terribly difficult to issue fraudulent financial statements.

Michael Woodford was dismissed in October as CEO of Olympus, and subsequently disclosed that he was fired because he raised questions about some acquisitions by the company. He alleges that Olympus paid incredibly high prices for companies it acquired, and also paid huge “advisory fees” to agents who supposedly represented Olympus in the transactions. The purpose behind these transactions? To cover up investment losses that were decades old without drawing any attention to the issue.

This practice is known as “tobashi” in Japan. Companies hide losses by selling bad assets to other companies. When the company has room in their financials to recognize losses (i.e. when earnings are good and they can afford to book some losses against those earnings), the company buys the assets back with payments disguised as advisory fees or transaction fees. Although Olympus ultimately reported the losses, they were not reported until far too late, and were incorrectly reported/classified to hide the true nature of the losses.

The company quickly admitted to wrongdoing at a press conference featuring Olympus President Shuichi Takayama. Prior to the discovery of the fraud, Olympus represented that large payments were advisory fees and purchases of very small venture firms in the areas of medical waste disposal and microwaveable containers. The scheme was allegedly devised and carried out by the company’s chairman, vice president, and corporate auditor at the time.

Olympus hasn’t yet said exactly how large the covered-up losses were, but four deals have been identified as part of the cover up. In a 2008 deal, Olympus purchased a company called Gyrus for $1.9 billion, and a financial advisor in the Cayman Islands received $687 million, or over one-third of the purchase price. A typical fee to a financial advisor in a transaction like this would be 1% or 2% of the price.

Three small Japanese companies were acquired between 2006 and 2008, for a total cost of about $940 million. The companies didn’t appear to be actual businesses. Altis Co. (medical waste disposal), News Chef Inc. (food container maker), and a third company had no revenue, no business history, and no clear relation to Olympus’s business. Olympus quickly wrote down the value of these “businesses” by $700 million.

On November 17, Japanese investigators said they were concerned that an additional $4.9 billion is unaccounted for by Olympus, and may be tied to organized crime groups.  A memo presented at a recent meeting of officials from Japanese law enforcement agencies outlined the following:

Olympus paid a total of ¥481 billion, or $6.25 billion, through questionable acquisition payments, investments and advisory fees from 2000 to 2009, according to the memo, but only ¥105 billion has been written down or otherwise accounted for in its financial statements. That leaves ¥376 billion, or $4.9 billion, unaccounted for, according to the memo.

Japan’s largest organized crime syndicate, Yamaguchi Gumi, has been identified by law enforcement as a recipient of over half of the $4.9 billion not accounted for.

On the same day the investigators said organized crime was involved, the company denied it, explained that all is well, and they are fixing everything. They’re the four deals with exorbitant payments were done to wipe out investment losses from the 1990s, but that the payouts “were not used for money laundering, nor was there any money flowing into [organized crime groups].”

It’s not a very convincing denial. But have no fear, the auditors are here! Olympus management said, “We plan to submit the quarterly report, after getting it reviewed by our auditor, by Dec. 14.”

Well then. Does it make you feel better that the company’s independent auditors, Ernst & Young, are going to look things over? It shouldn’t. These are the very same auditors that missed the financial statement fraud, along with KPMG, who audited Olympus into 2009. It’s the same problem that companies across the board have: Audits do not find fraud, no matter how big or important sounding the auditing firm is.

Olympus says they have set up a “third party committee” to examine the company’s accounting practices. It is not clear what this committee really will do, nor who these “third parties” may be. Management has said that forensic accountants will be needed to unravel everything. Duh.

And to add another wrinkle to the story, there may be Foreign Corrupt Practices Act implications. As Tom Fox mentions in his blog, if corruption is a factor in this fraud scheme and if any money went through the United States banking system, there may be FCPA problems. Tom notes that there could also be UK Bribery Act problems.

Tom points out some red flags as they relate to FCPA issues, and those same red flags are relevant to fraud in general. All one has to do is look at the fees/commissions paid to the advisor in the Caymans. Someone had to know that something was amiss if the fees in a transaction like this normally run 1% to 2%, while this advisor received 36% of the purchase price.

The person who knew something was wrong and apparently showed some ethics was whistleblower Michael Woodford. It seems he was the one person who did the right thing, and interested parties are petitioning the board to reinstate him as CEO.  I think it would be a great move to re-hire Woodford, as it would show a commitment to ethics. And it would be the right thing to do. But I doubt those signing the petition will be successful. Woodford knows too much already, and the company will likely want to just move forward.

Tracy Coenen, CPA, CFF investigates financial statement fraud, and can provide forensic accounting services to follow the trail of money. We have been engaged by boards of directors of both public and private companies to evaluate whistleblower allegations and conduct independent investigations.

Disclosure: As of the date of publication, Tracy holds no position (long or short) in any of the securities mentioned in this article.