Japan’s ‘Window Dressing’ Hid Olympus Fraud: Douglas J. Skinner
The recent disclosure of a longstanding accounting fraud at Olympus Corp. (7733) has drawn fresh attention to Japan’s corporate-governance practices, and raises important concerns for investors in companies there.
Based on what we know to date, Olympus sustained investment losses of at least $1.4 billion during the 1990s, and was able to cover up the shortfall until recently using various forms of “window dressing.” Although large accounting frauds occur periodically throughout the world, what is striking about Olympus is that the losses took so long to come to light. This raises troubling questions about Japan’s financial reporting and auditing practices, which are historically quite different from those in the U.S. and other Western countries.
Investors interested in Japanese equities -- for which valuations appear low using conventional metrics such as price- to-book -- are now left to wonder whether there are other companies with nasty surprises buried in their books, and more generally about the quality of corporate governance in Japan.
To address this, it’s necessary to understand some of the recent history of Japanese corporate governance. After the bursting of the bubble in equity and real-estate prices in the early 1990s, the Japanese economy went into a long slump. As its economic problems deepened, a consensus began to emerge that the country’s unusual financial system needed an overhaul.
Beginning in the late 1990s, a series of reforms, collectively known as the “Big Bang,” were made to the financial system, including changes intended to move corporate- governance practices more into line with those in the major Western countries.
The big question raised by Olympus then is whether such reforms have had any effect, or are themselves a form of window dressing that disguises an underlying resistance to change in corporate Japan.
While there have been significant legal and institutional changes in Japan -- hostile takeovers now are allowed, for example -- there also has been much foot-dragging, most notably from the business establishment. Because of this opposition, those activist investors who have emerged over the past 10 years, both domestic and foreign, have had limited success in extracting value from companies.
Recent research I conducted with Kazuo Kato and Meng Li investigated whether corporate governance has improved in Japanese companies. We addressed this question by looking at firms’ cash holdings, which are often used by economists as a barometer of corporate-governance quality.
In most countries, the extent to which firms hold cash is one of the biggest sources of tension between management and outside investors. While managers generally like to hold as much cash as they can (it provides them with a buffer against unforeseen events), investors are concerned that large cash reserves provide executives with the opportunity to engage in value-destroying projects (such as “empire building” acquisitions) or otherwise simply to waste that money. Conversely, well-run companies tend to distribute excess cash to their stockholders through dividends and share buybacks.
Historically, Japanese companies have had cash holdings that are much larger than those of their counterparts in other countries. Many experts view this behavior as a symptom of poor governance.
We found evidence that Japanese enterprises still hold large amounts of cash, often in excess of 10 percent of assets, levels similar to those that prevailed in the early 1990s.
However, we also found that these firms are now much more likely to manage their cash in the same way as U.S. companies, in that these holdings are now more responsive to sensible economic determinants.
For example, Japanese firms tend to hold more cash when they are in industries with more volatile operating cash flows, a relation that wasn’t evident in the 1990s. So it seems that managers in Japan are now paying more attention to how they take care of their firms’ cash holdings.
Perhaps more importantly, we found an inverse relationship between changes in firms’ cash holdings and economic performance: Companies that lower their cash holdings experience improved performance; those that increase them did worse. This suggests that Japanese firms that strengthen governance practices -- by reducing cash holdings -- do better.
We also examined how investors value these holdings. The idea here is that for well-run companies with disciplined managers, $1 of cash should be valued at about $1 by investors. On the other hand, for poorly run concerns, investors will value $1 of cash at less than $1, given the risk it will be wasted.
We found that, investors in the 1990s heavily discounted the cash holdings of Japanese companies: at less than face value and at levels well below those of U.S. firms. Beginning in the late 1990s, however, the valuation of the cash holdings of Japanese companies improved steadily, consistent with better governance and management of cash.
We concluded that a substantial fraction of Japanese companies are doing a better job of governance today than was the case 15 to 20 years ago, and that there is a clear payoff to improved governance, in terms of both valuation and performance.
All of this means that Japan’s corporate governance might be improving, so cases like Olympus, while important, are increasingly rare.
(Douglas J. Skinner is professor of accounting at the University of Chicago Booth School of Business and a contributor to Business Class. The opinions expressed are his own.)
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