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Japan's Enron Reckoning

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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More than a dozen years ago, the U.S. experienced a rash of high-profile accounting scandals. Now it's Japan's turn. Toshiba, one of the country's largest technology firms and an internationally respected brand, revealed that it had systematically overstated its operating profits to the tune of about $1.2 billion during a seven-year stretch. The company's chief executive officer, a number of other high-ranking executives and half of the company's board has resigned. 

The Toshiba scandal isn't the first big case of Japanese corporate fraud to come to light in recent years. In October 2011, CEO Michael Woodford (no relation to the economist of the same name) blew the whistle on accounting fraud at his own company, optical equipment manufacturer Olympus. The fallout from that debacle is still unfolding

The first takeaway from these scandals is that there will probably be more of them. The consensus is that they happened because of problems with Japanese corporate culture. In both cases, observers have blamed secretive and autocratic management styles by top executives, as well as the generally hierarchical, closed nature of Japanese business. But the real problem is corporate governance itself. 

In Japanese companies, boards are almost always made up of people who work for the company. This provides a strong incentive for empire building in which managers try to expand market share -- and their own perks and privileges -- instead of profitability or shareholder value. Basically, Japanese managers can run companies like their own private fiefdoms, splurging on trips, bar girls and other entertainment expenses. More ominously, they tend to let their companies stagnate, since stagnation is cozy and comfortable. Since they are their own boards, there is no one to stop them. 

That style of management looked OK when market share was rocketing upward in the 1970s and 1980s. But since the Japanese economy slowed and international competition intensified, its flaws have taken a heavier toll. Japanese white-collar productivity is horribly low relative to other advanced nations, and its companies have traditionally been far less profitable than those in the West. 

If your profitability goes south for long enough, eventually there will be consequences. Bank loans may dry up. Workers may be afraid to work for you, knowing that you might not be around in a decade. Eventually, even a company that is governed by its own management will be forced to take action to preserve some remnant of its coddled, hidebound lifestyle. That action could be to raise profitability, but maximum coziness might be achieved by simple fraud. If you fake profits, you can keep bank loans rolling and live as a zombie company without actually having to restructure and make sacrifices. 

That's why it's so worrying to see accounting fraud at a company such as Toshiba. Toshiba is one of Japan's star performers, an internationalized company that has been disciplined by global competition. Many of Japan's companies -- traditionally the number is quoted as 80 percent -- focus on the domestic market, where they face much less competition, and are usually less productive. If a flagship company like Toshiba was moved to engage in fraud, the impact of Japan's long economic struggles on the laggards must be even more severe. 

But in crisis there is opportunity. In the U.S., the accounting scandals of the early 2000s in companies such as Enron and WorldCom resulted in the Sarbanes-Oxley Act, a harsh crackdown that many cite as a reason for the reluctance of companies to list themselves on public exchanges. But in Japan, there is the hope that the response will be a different kind of reform -- improvement of corporate governance in general. 

The administration of Prime Minister Shinzo Abe recently introduced a new corporate governance code that requires outside directors on boards and encourages a focus on shareholder value. That is an important step, and its full ramifications have yet to be felt. But the Toshiba scandal -- almost surely not the last of its kind -- should be an impetus to do even more. "More" would mean stronger enforcement of the governance code, which as things now stand is voluntary. It might also mean increasing the number of outside directors -- the current required number is only two -- and more disclosure in general. 

In parallel to this effort, the government should continue trying to cut ties between Japanese companies and the Japanese mafia. Another thing it should do -- which hasn't, to my knowledge, been proposed -- is to stop making entertainment expenses tax-deductible. Encouraging companies to splurge on perks is bad for profitability, and creates a long-term incentive for managers to fight tooth and nail to maintain control of their companies.

Unfortunately, the Abe administration has gone in exactly the wrong direction on this issue, increasing the amount that companies can deduct from their taxes for nights of drunken carousing. An about-face on this issue would be welcome. 

In general, though, there is the hope that the accounting scandals are a bad sign for the short term but a good sign for the long term. If all goes right, problems that are exposed today will be rooted out tomorrow. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net