Japan will see more accounting scandals – but it’s still a buy

Japan has seen another big accounting scandal.

Conglomerate Toshiba is perhaps best-known over here for its TVs, but it's also involved in making nuclear reactors and laptops.

In any case, this week the chief executive and various others walked the plank, as an independent committee concluded that the company had inflated operating profits by more than 25% over the course of seven years.

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Another sign that you should avoid this closeted, shareholder-hostile market altogether?

Long-time readers might not be surprised to hear me say: "Au contraire"

The latest Japanese accounting scandal

Japanese blue-chip Toshiba has found itself at the centre of one of Japan's biggest accounting scandals.

In short, the company has been overstating its profits since about 2008. In total, we're talking about $1.2bn more than the company actually made. That's a lot of money, even in an era where rampant money printing has made a billion seem somewhat smaller than it was maybe ten years ago.

It's certainly the messiest corporate scandal in Japan since camera group Olympus was found to have done something similar back in 2011.

The market knew something was coming. The company had already warned in April that there were accounting problems, and the shares have fallen by around a quarter since concerns first arose.

It'd be nice to think that this was down to Japan's corporate governance reforms, but in fact it was down to whistleblowing. Indeed, Toshiba was viewed as one of Japan's better companies when it comes to shareholder-friendliness.

So is this a sign of a deeper rot that Japanese investors should worry about? Or is it more in the nature of a turning point?

The big difference: loyalty to the company rather than shareholders

John Gapper makes some good points in the FT this morning. One big problem is that Japan hasn't had a culture of kitchen sinking'.

We're all very familiar with kitchen-sinking over here, and in the US. It's a bit like when you get a new builder or a plumber to come in and look at something in your house. They'll wander around, poke at a few things, tut under their breath, and proceed to decry the skills and question the parentage of whichever cowboy was last in your house.

Meanwhile, your mental estimate of the cost of the work needed doubles with every exaggerated grimace.

And that's basically what a new chief executive often does when they take over in your average British or American company. With varying degrees of subtlety, they take a long look at the firm, point out all the mistakes made by the previous management, and plant the seeds of all their own future mistakes.

There's a predictability about all this, and you don't want to end up with a company that's constantly being reinvented that's not good for anyone. But the occasional shake-up is not a bad thing.

The new boss has every incentive to find fault. It lowers the bar for impressing shareholders in the future, so makes their life easier. As a result, loose ends and failing strategies get tied up or binned, stuff gets swept out from under the carpet by the new broom, and the things that are hidden in the woodwork tend to crawl out.

This, says Gapper, doesn't happen in Japan. Instead, the culture of loyalty to the corporation, rather than accountability to shareholders, means that "losses get handed down across generations, hidden on behalf of previous bosses. There is no such thing as the kitchen sink." So what might start out as sloppiness, bad habits and short-term backside-covering, turns into long-term rot.

Japan is going to suffer growing pains and that's a good thing

Of course, Japan is hardly unique here. In the UK, Tesco is a good, if less extreme, example. You had a widely-admired CEO with a dominant personality, replaced by one who was really just a continuation of the old regime. It took the structural shift in the supermarket business and another change of CEO to reveal the major problems at the company.

More to the point, there is pressure for change. Activist investors (we have more on these in the latest issue of MoneyWeek magazine, out tomorrow) are starting to make some headway in what's traditionally been a really difficult market for them. Robotics leader Fanuc recently yielded to pressure from hedge fund Third Point to improve returns to shareholders.

And scandals like this one, combined with a government that is pushing for more shareholder engagement, will only put more scrutiny on companies. If I were an activist, for example, I'd be hunting for the next scandal or turnaround story to hit.

Change is rarely comfortable. And the Japanese economy and market are going to suffer from growing pains. But in the longer run, this is good news and it's certainly not a reason to sell out.

We covered Japan and the best ways to buy in recently in MoneyWeek magazine. If you're not already a subscriber, get your first four issues free here.