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Japan's Olympus Scam Matters More Than You Think: 3 Takeaways

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The legal case surrounding the camera and medical equipment maker is not just another corporate scandal.

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"Anything you can do, I can do better!" That was the message Japan sent out this week. No sooner had the corporate world got wind of the sudden and swift demise of US brokerage MF Global (MFGLQ.PK) than news came out from Japan that Olympus, a leading endoscopy and camera company, had admitted to using money from mergers and acquisitions to hide losses for over 20 years.

At a Tuesday press conference in Tokyo, Olympus president Shuichi Takayama, only two weeks into his job, bowed deeply before the cameras, while admitting that his company had covered up over $1.5 billion in losses from speculative investments in the 1990s through loss-deferring practices. Takayama did not elaborate about what kind of irregular accounting practices it employed to obscure its losses, but Japanese news media have speculated that it employed a method commonly used by Japanese corporations in the past called "tobashi," which is loosely translated as "to blow away." The practice involved selling loss-making bad assets to other companies, usually dummies, and then buying them back later, which allows the losses to be hidden momentarily.

In Olympus' case, the company spent a large sum of money acquiring several companies, paying absurdly high consulting fees, which turned out to be a way to mask its investment losses. Similarly, the three local firms bought by the endoscope maker at inflated prices -- including a health food distributor -- decreased in value a year later, allowing Olympus to book impairment losses on them, thus transferring its investment losses into losses in corporate valuations.

As a result of the scandal, Olympus share prices have fallen 80% in a month, and the fallout continues, with the Tokyo police now investigating the case. So far the impact of this controversy in markets here has been fairly minimal. However, that doesn't mean that the case should fade into the abyss, becoming just another footnote in the long history of corporate scandals. The story of how Olympus managed to scam shareholders and the public for more than 20 years is an important one – here are three reasons why.

1. The case highlights the importance of whistle blowers.
The scandal engulfing Olympus was uncovered last month thanks to its former British CEO Michael Woodford, who was ousted by the Olympus board after only six months on the job. According to the board, Woodford was asked to resign because of a clash of management style with other senior executives, but Woodford revealed the real issue behind his firing when he spoke to the press just following his October firing.

At that press meeting, Woodford explained what made him take notice of the questionable accounting in Olympus' books. After a Japanese financial journal published an investigative piece this past July questioning Olympus's 2008 dodgy deals, Woodford got a foreign accounting firm, PricewaterhouseCoopers, to investigate the case. Upon reading the firm's report, which confirmed the suspicious nature of the acquisitions, Woodford sent out a chain of letters to board members asking why Olympus had paid so much for three acquisitions. He also called for the resignation of board chairman Tsuyoshi Kikukawa, who served as CEO when Olympus made the controversial acquisitions. When the board moved swiftly to remove him, Woodford went on a counteroffensive, bringing the shady transactions to mainstream media attention at his post-firing press conference. The ever-increasing media attention and pressure eventually compelled Olympus to come clean about its loss-hiding schemes.

We now know that the cover-ups began more than 20 years ago, when Olympus bet big on the late 1980s Japanese asset and stock bubble and lost spectacularly when the bubble burst in 1990. Yet it is only now, thanks to Woodford, that a more accurate picture of Olympus's financial state has emerged. Clearly, whistle-blowers like Woodford are to be celebrated for recognizing that they should be loyal to shareholders, who deserve to the truth, and not to management, even if this might cause them their jobs. Imagine if there were a Michael Woodford in MF Global: Perhaps the nearly $600 in client funds would not be unaccounted for right now.

2. Numerous US parties are involved in the scandal.
When Olympus acquired British medical instruments company Gyrus Group in 2008 for $1.92 billion, two firms that allegedly advised Olympus on the deal were American firm Axes America, and Axam Investments, which was registered in the Cayman Islands. Both firms were paid $687 million for the deal, or about 30% of the overall acquisition price, when bankers usually only get around 1% for M&A deals. The FBI is now investigating the matter to find out what really happened to the $687 million. Both firms were owned by ex-Wall Street banker Hajime Sagawa, who's since dissolved them, writes the Wall Street Journal.

Besides Axam Investments and Axes America, law firm Weil Gotshal & Manges and M&A firm Perella Weinberg Partners were also involved in advising Olympus on its 2008 purchase of Gyrus Group. Perella Weinberg, founded by former Morgan Stanley executive Joseph Perella and Goldman Sachs alum Peter Weinberg, was paid less than $8 million, while Weil Gotshal & Manges' compensation has not been disclosed.

Of course, there are American shareholders who have invested in Olympus and are now reeling back from the near 80% drop in Olympus share price since mid-October. The camera manufacturer's top shareholder is Southeastern Asset Management Inc, which holds about 5% of Olympus. Harris Associates, based out of Chicago, has a 4% stake. Both companies are now leading calls for Olympus to reinstate Michael Woodford as CEO.

3. It proves, once again, that the work of accounting firms needs to be given greater scrutiny.
The fact that Olympus was able to get away with hiding huge losses with accounting tricks raises questions about how the 92-year-old company's auditors, the Japanese offshoots of KPMG and Ernst & Young, did not detect that something was amiss.

In the '90s, the Japanese affiliate of Arthur Andersen was Olympus' auditor. After Andersen went bust in 2002, KPMG acquired its Japanese business and took over the Olympus account, before Ernst & Young replaced it in 2009.

During the acquisition of Gyrus, KPMG's British branch did question "the accounting treatment of some of the fees and whether Cayman Islands-based Axam Investments Ltd, which received a big part of the fees, was a related party to Olympus," according to Reuters. KPMG AZSA, the Japanese branch in charge of auditing Olympus, however, gave Olympus accounts the all-clear.

When Ernst & Young took over from KPMG AZSA in 2009, it did ask questions about Axam, but ultimately it found no problems with Olympus' books.

"You just can't hide hundreds of millions of dollars in losses on your balance sheet, and for so long," said Mitsuhiro Fukao, a finance professor at Tokyo's Keio University, to the New York Times. "There would have been signs. More people should have known."

Accounting scandals, of course, are not exclusive to Japan. After all, it was its indictment in 2002 over its conduct as Enron auditor that ultimately doomed Arthur Andersen. Over at MF Global, auditor PricewaterhouseCoopers should have spotted the comingling of client funds. The firm has been subpoenaed by the CFTC for "information on the segregation of assets belonging to clients," notes the American Banker. Clearly, the Big Four needs to reevaluate their products to restore confidence in the accounting profession.

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