How to prevent channel stuffing

Accounting Case Study-Toshiba Case

Finish Requirement 1-3

Requirement 1

a. Does the use of masking prices violate GAAP? Why? Is it appropriate for Toshiba to increase

profit (by the amount of the masking difference) at the time of supplying parts to ODMs?

Why? When and how should Toshiba record the masking differences in its consolidated

financial statements? Explain.

b. For the PCs that are manufactured by its subsidiary TIH, is it appropriate for Toshiba to record

the masking difference as a reduction in the cost of goods manufactured? Why?

Requirement 2

a. Refer to the table of masking differences in the ‘Practice of Channel Stuffing’ section of the

case. For each fiscal year from 2008 to 2014, compute the income misstatement and specify

whether the reported income is overstated or understated. For simplicity, assume that there

were no masking differences at the beginning of FY 2008. Present your answer in the

following table:

FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 FY 2014

Income misstatement

Overstated or understated?

b. The table of masking differences indicates that the total masking difference declined

noticeably in FY 2010. Why do you think Toshiba’s management was willing to reduce the

masking difference in FY 2010? The masking difference was again reduced sharply in FY

2014. What could have caused that to happen?

Requirement 3

Assume that TTIP, a fully-owned subsidiary of Toshiba, purchased key PC parts and supplied

them to Pegatron, an Original Design Manufacturer (ODM) in Taiwan, for assembling PCs. The

price paid by TTIP was ¥24,000 per PC. However, to keep Pegatron from knowing TTIP’s true

cost, the parts were supplied at the masking price of ¥84,000 per PC. In other words, the

Channel Stuffing Reinvented: The inside story of Toshiba’s Personal Computers Division1

Introduction

In one of the most egregious instances of wrongdoing in Japanese corporate history, Toshiba

Corporation (hereafter, Toshiba, or the Company) was accused in February 2015 by Japan’s

Securities and Exchange Surveillance Commission (SESC) of overstating operating profit by

¥151.8 billion ($1.22 billion). Realizing the seriousness of the issue, Toshiba set up an in-house

investigation committee (hereafter, the Committee) which issued its 334-page report2

(hereafter, the Report) on July 20, 2015. The Committee’s investigations led to the uncovering

of a wide range of accounting improprieties conducted since at least 2008. This case describes

the events that transpired and the accounting practices that were followed in Toshiba’s

Personal Computers (PC) business from 2008 to 2014. The profit adjustment to Toshiba’s PC

business was ¥59.2 billion, 39% of the total misstatement. The Report indicated that no

adjustments were needed to the sales reported by Toshiba, but profits were overstated in most

of the years.

Toshiba Corporation and its PC Business

Founded in 1875, Toshiba Corporation is one of Japan’s oldest, largest and most diversified

manufacturers of consumer electric and electronic products, and industrial and social

infrastructure systems. In FY 20143, with sales of over ¥6.5 trillion (approximately, $63 billion),

and about 200,000 employees, Toshiba ranked as the tenth largest industrial conglomerate in

Japan. Although more than 60 percent of its sales were domestic, Toshiba brought Japan to the

forefront of international business through its overseas sales. 16 percent of its sales in 2014

were in North America, 11 percent in Asia, and 10 percent in Europe.

Toshiba’s business segments (groups) were comprised of seven companies, one of which (in

2014) was the Personal & Client Solutions Company (PCS Company). The PCS Company was part

1 This case is developed by Professors Mahendra Gujarathi and Amitabh Dugar of Bentley University for the purpose of class discussion. Please do not quote without permission. 2 The English translation of this report can be accessed at:

https://www.toshiba.co.jp/about/ir/en/news/20151208_2.pdf 3 All companies in Japan, including Toshiba, are required to follow a uniform fiscal year (FY) that starts on April 1 and ends on March 31 of the following year.

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of Toshiba’s Digital Products segment and engaged in the manufacture and sale of personal

computers. This business was restructured and reorganized several times over the years.4

Toshiba’s history of manufacturing and selling PCs is long and impressive. In the quarter

century after it released the world’s first laptop PC in 1985, Toshiba sold over 100 million

notebook PCs. The business was not always profitable, however. Poor performance of the

segment during FY 2001, FY 2002, and the first half of FY 2003 prompted the PC Division to

launch a project in January 2004 to (a) improve business performance by concentrating on

differentiated products, (b) migrating from in-house production to ODMs (Original Design

Manufacturers), (c) strengthening procurement capabilities, and (d) reducing fixed costs. These

initiatives resulted in increased sales and profits, both of which reached record levels in 2007.

During FY 2008, the PC business was hit by major shrinkages in demand; in response, the

Company launched an initiative (called the “Action Program to Improve Profitability”), aiming to

restore its profitability even if the level of sales did not increase. However, the declining trend

of sales and profits could not be arrested during 2009 because the demand for PCs continued to

shrink, unit prices of PCs continued to fall, and the yen strengthened. In FY 2010, Toshiba

experienced higher sales and continuing decreases in costs and raw material prices. This

helped the PC business return to profitability.

In FY 2011, the impact of a strong yen, lower sales of PCs in the United States and Europe, and

price erosion led to lower sales and but operating income improved due to implementation of

cost reduction measures and lower parts costs. In FY 2012, the PC business recorded

significantly lower sales due to a continued demand decline in Japan and sluggish sales in North

America. In FY 2013, Toshiba released of the world’s first Ultrabook, a thin and light computer,

fitted with a high-definition LCD touch panel. This competitive edge helped improve sales but

profits suffered due to the competition from tablets and smartphones.

The sales and operating profits of the PC business from 2004 to 2013 are presented in the table

below.

4 Toshiba’s PC business was conducted through the following in-house companies:

Up to December 2003: Digital Media Network Company (DM Company)

From April 2004: PC & Network Company (PC Company)

From April 2010: Digital Products & Network Company (DN Company)

From April 2011: Digital Products & Service Company (DS Company)

From April 2014: Personal & Client Solutions Company (PCS Company)

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Toshiba Sales & Profits - PC Business (in billions ¥)

Financial Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Sales 767.9 852.7 971.8 1,040.4 955.3 888.1 916.0 822.9 705.1 733.9

Operating profit 8.2 3.4 6.9 41.2 14.5 (9.9) 7.3 11.4 8.2 (19.9) (Source: The Report, p. 228)

Corporate Governance and Performance Evaluation at Toshiba

Each of Toshiba’s major business segments (groups) was headed by a Group CEO (GCEO). In

1999, Toshiba introduced an in-house performance evaluation system, under which each group

operated independently. Within each segment, every company had a profit and loss

responsibility and its president (called Company President or CP) had the authority over most

business execution matters. Toshiba evaluated the performance of its business segments

based on segment operating income (loss). The segment’s operating income (loss) was derived

by deducting the segment’s cost of sales and selling, general and administrative expenses from

net sales.

The CPs reported to the GCEOs, who in turn reported to the President and CEO of Toshiba

Corporation. The reports submitted by CPs to their GCEOs were deemed to be reports

provided directly to the President and CEO of Toshiba Corporation (Report, page 27). The

Group CEOs were required to report any material violation of laws and regulations to Toshiba’s

Audit Committee. Toshiba also had a Corporate Audit Division, which served as its internal

audit department. This department’s general manager reported directly to Toshiba’s President

and CEO. The general manager also reported to the Board of Directors on the internal audit

results.

Toshiba’s performance evaluation system was designed to energize the organization, promote

autonomous responsible management, and improve Toshiba’s corporate value through

continuous operational innovations. Every month, each division/company submitted its

performance results and forecasts for the upcoming one-month and six-month periods to the

Corporate Finance & Accounting Division, which was headed by Toshiba’s CFO (Chief Financial

Officer). The CFO compiled and reported this information to Toshiba’s CEO. The Corporate

Accounting & Finance Division also submitted proposals to the CEO designed to improve

performance (called "Challenges") and the CEO determined the content of each Challenge (

Report, page 36). Company Presidents reported on their respective companies' performance

results relative to forecasts at CEO Monthly Meetings, and at these meeting the CEO issued

“Challenges” to them as necessary.

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The practice of issuing “Challenges” to the President of the PC Company (and other Toshiba

companies) began with CEO Atsutoshi Nishida in FY 2008. The practice was continued by

Nishida’s successors in that role, Norio Sasaki (2009-2013) & Hisao Tanaka5 (2013-2014). As

described in a later section, each of these CEOs appealed to employees’ loyalty, and shamed,

bullied and threatened the CPs to ensure that their orders were carried out.

Use of ODMs and Masking Price in the PC Division

To reduce the procurement, production, and fixed costs, Toshiba outsourced a large part of the

business of designing, developing, and producing PCs to ODMs (Original Design Manufacturers) in

Taiwan. Key PC parts including the CPU, HDD, memory, ODD, and LCD were purchased by Toshiba

or its wholly owned Subsidiary, TTIP (Taiwan Toshiba International Procurement Corporation).

The parts were then supplied to ODMs at the Masking Price, which was higher than the

procurement cost of the parts (the "Parts Transactions"). The use of masking prices prevented

ODMs from knowing Toshiba’s procurement cost and eliminated the possibility of the ODMs

leaking Toshiba’s purchase prices to its competitors. This was important because many of those

competitors also used the same ODMs to outsource their PC production.6

Using the parts supplied by Toshiba (or TTIP), the ODMs assembled the PCs and shipped them

back to Toshiba (or to TTIP), who in turn sold them to Toshiba’s independent distributors in

various regions. When the ODMs sold PCs to Toshiba or TTIP (the "Completed Products

Transactions"), they would invoice Toshiba (or TTIP) at the masking price that they had been

charged, plus a processing/assembling charge (their profit). Together, the Parts Transactions and

Completed Products Transactions were referred to within Toshiba as “Buy-Sell Transactions”

and their combined effect on the company’s profit was called “Buy-Sell Profit”.

The difference between the price at which Toshiba (or TTIP) procured the parts from the vendors

and the price at which they were supplied to the ODMs was called the "Masking Difference". For

instance, if Toshiba’s procurement price was 50 and the parts were supplied to ODMs at 300, the

masking difference would be 250, and the masking ratio (computed by dividing the masking

difference by the procurement price) would be 5.0 (250/50). Toshiba’s masking ratio was 2.0 in

fiscal 2008 but it rose significantly each year, as can be seen in the table below:

5 Tanaka progressed upwards through the ranks at Toshiba within its PC business, leading the start of the Buy-Sell transactions described later in this case and rising to the position of General Manager, Procurement Division at the PC & Network Company in 2004. 6 Toshiba’s use of Masking Prices was not uncommon; its competitors used the same technique as well.

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FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 FY 2013

Masking ratio 2.0 times 2.2 times 3.6 times 4.2 times 5.2 times 5.2 times

(Source: The Report, page 233)

Masking prices for the parts supplied to ODMs were stipulated by Toshiba without any

negotiation. ODMs did not object to the high masking prices because Toshiba agreed to purchase

all the assembled PCs, and any unused parts at the masking prices charged to the ODMs, and also

pay them the stipulated processing/assembling charge. If PC production exceeded the quantity

that Toshiba could sell, the excess inventories were considered to be Toshiba’s responsibility.

This shielded the ODMs from inventory risk because Toshiba guaranteed that it would purchase

any unused parts plus the entire quantity of PCs it asked the ODMs to assemble.7

Toshiba’s accounting for the ‘Parts’ and ‘Completed Products’ Transactions

Although Toshiba followed accounting principles generally accepted in Japan, certain

adjustments and reclassifications were made in its consolidated financial statements to

conform to the accounting principles generally accepted in the U.S.8 Income recognition in the

PC business had an additional quirk, the masking profit. When recording the ‘Parts’ transaction,

Toshiba included the masking difference in the accounts receivable due from the ODMs, and

increased profits by an equivalent amount by reducing the cost of goods manufactured.9 As an

example, the supply of parts that cost Toshiba 50 and was invoiced to ODMs at a masking price of

300, would be reflected in Toshiba’s consolidated financial statements (ignoring transactions

among subsidiaries) via the following summary journal entry:

Accounts Receivable - ODM 300

Cost of Goods Manufactured 250

Accounts payable - Parts Vendor 50

7 On several occasions, Toshiba had to buy back parts that had become obsolete because they had been sitting

with the ODMs for too long. It had to incur additional costs to dispose them off.

8 This practice is acceptable to Japanese regulators. Indeed, Japanese companies can choose from one of the four

sets of accounting standards to file their consolidated financial statements: Japanese GAAP, IFRS, U.S. GAAP, and

Japan’s Modified International Standards. (Accounting Standards Board of Japan, accessed at:

https://www.asb.or.jp/en/jp-gaap/about.html)

9 In other words, Toshiba recorded effects on profits directly through cost of goods manufactured; it did not record the parts supplied to ODMs as sales. In most fiscal periods, the cost of goods sold was the same as the cost of goods manufactured.

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When Toshiba subsequently purchased the assembled PCs from the ODMs (i.e. at the time of

‘completed products’ transaction), the masking profit recorded in the ‘parts’ transaction was

removed. As an example, if the ODMs charged 20 for assembling the PCs, and TTIP added its own

processing charge of 10, the summary journal entry in the consolidated financial statements to

record the receipt of assembled PCs would be as follows:

Cost of goods manufactured 330

Accounts payable - ODM 320

Charge income of TTIP 10

The combined effect of the ‘parts’ and ‘completed products’ transactions in Toshiba’s

consolidated financial statements after the payments were made to the ODMs and the parts

vendors (ignoring transactions among subsidiaries) would be as follows:

Cost of goods manufactured 80

Cash (paid to ODMs) 20

Cash (paid to Parts Vendor) 50

Charge income of TTIP 10

An overview of the accounting effects of the ‘Parts” and ‘Completed Products’ Transactions is

presented in Figure 1.

Toshiba also manufactured PCs through another subsidiary, TIH (Toshiba Information Equipment

Hangzhou Co. Ltd.). Normally, the parts supplied to TIH either directly or via yet another Toshiba

subsidiary, TTI (Toshiba Trading Incorporated) were not at the masking price, because both TTI &

TIH were Toshiba’s wholly-owned subsidiaries and no masking of original purchase prices was

necessary. However, during each of the last three quarters of FY 2012, Toshiba did use masking

prices, which were four to eight times its cost of procurement, to supply parts to its own

subsidiaries. As before, the resulting masking difference was recorded as reduction in the cost of

goods manufactured. TIH retained these inventories at the quarter-end, and transferred them in

the subsequent quarter to TTIP for supplying to ODMs with no additional masking.

Practice of Channel-Stuffing

One method used by Toshiba to achieve the CEO’s “Challenges” was to enhance profits through

the channel stuffing of ODM parts. In this method, Toshiba (or TTIP) sold volumes of parts to

ODMs in excess of the volume needed for normal production (and sales) and required the ODMs

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to hold the excess as inventory. The masking difference embedded in these Parts Transactions

caused profit to surge by an equivalent amount. However, the cost of good manufactured

subsequently increased (and profit declined) by the amount of the Masking Difference when

completed products were purchased from the ODMs in the following month or beyond. 10

The process of channel stuffing of ODM parts was executed as follows. First, the company

presidents (CPs) determined monetary amounts of such transactions. Second, the production

and procurement departments of the (subsidiary) companies and Toshiba’s corporate

procurement department would, in conjunction with TTIP, negotiate with ODMs on the type

and volume of parts to be sold, and finally have the ODMs purchase the parts to complete the

channel stuffing process. Within Toshiba this practice was euphemistically referred to as the

“early recording of cost reductions (CR)” (The Report, page 243).

The term “early recording of CR” had more to do with overstatement of profits through the

channel stuffing of ODM parts rather than lower prices secured from the suppliers of parts.

For instance, at the October 2008 CEO monthly meeting, the President of PC Company

reported that the operating profit was being overstated by ¥17.3 billion through the early

recording of CR and that if this is excluded, the attainable profit would be only ¥6.4 billion. He

also stated that "early supply of parts was possible because of the Anniversary of the Founding

of the People's Republic of China in September, but obtaining agreement will be difficult in

December because that's the end of the accounting period for the ODMs."

The total amount of Masking Difference at any point in time would depend on (a) the volume of

parts inventories supplied by Toshiba but not yet used by the ODMs, and (b) the volume of PC

inventory assembled by the ODMs but not shipped back to TTIP. The report mentions the

following amounts of masking differences over the years for the inventory of unused parts and

the unshipped PCs11:

Amounts in ¥ billion

Masking Difference FY

2008

FY

2009

FY

2010

FY

2011

FY

2012

FY

2013

Q1-3, FY

2014

Parts inventories 16.4 41.2 28.9 46.1 71.5 72.1 39.2

Completed inventories 3.4 7.2 8.8 8.3 9.8 12.1 19.9

10 Normally, the parts that are sold through channel stuffing to ODMs at the end of each quarter are processed and purchased by Toshiba as completed products in the following month or the month after that, and the masking difference is recognized as a deduction from profits. For this reason, the masking difference (sometimes called “debt”) would revert back to zero if there was no new channel stuffing of ODM parts during the period (The Report, page 243). 11 The report also mentions that the masking differences in FY 2007 and before were insignificant.

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Total 19.8 48.4 37.7 54.4 81.3 84.2 59.1

(Source: p. 237 and p. 238 of the Investigation Report)

Dynamic of setting and complying with “Challenges”

The operating conditions of the PC business deteriorate d during FY 2008. At a meeting in

January 2009, the president of the PC Company reported a forecasted loss for the second

half of FY 2008. CEO Atsutoshi Nishida12 was disappointed. He said: "Do all that you can as if

your life depends on it. You do not have to make the improvement of ¥10.0 billion, if that is

alright with you. However, this does mean that you will be sold off. If you want to protect

your business, an improvement by ¥10.0 billion is the minimum. Do your best." By the time of

the February CEO Monthly Meeting, the profit forecast for the second half of FY 2008 had

further deteriorated. In the meeting, Atsutoshi Nishida set forth a Challenge of ¥16.0 billion

improvement in profits. In response to the Challenge, the PC Company conducted Channel

Stuffing of ODM Parts, and as a result, the Balance of Recorded Buy-Sell Profit at the end of

the fourth quarter of FY 2008 was estimated to be ¥16.4 billion.

The “Challenges” issued by the CEOs were very difficult to meet not only because they were

aggressive, but also because they were frequently issued near the end of a fiscal quarter, which

made it virtually impossible for business unit to achieve them. As a result, the business units

used deceptive accounting practices to meet the Challenges. For example, at the December

2008 CEO meeting the President of the PC Company reported that the operating profit forecast

for Q3, FY 2008 remained at negative ¥18.4 billion. Nishida responded that “I am ashamed of

these figures so I can’t release them (the Report pg. 244). As a result, channel stuffing was

conducted to record an operating profit of ¥20.7 billion in December 2008, resulting in a

reported net profit of ¥0.5 for the quarter.

Some deadlines to achieve “Challenge” targets were blatantly unrealistic. Faced with a ¥24.8

billion forecasted quarterly loss at the September 27, 2012 meeting Sasaki (CEO) demanded an

improvement of ¥12.0 billion over the remaining three days of the quarter (Report pg. 252). In

response, the President of the Digital Services & Products Company and his team proposed to

improve reported profits by a total of ¥10.4 billion (Report pg. 252), partly through Buy-Sell

transactions; this proposal was approved by Sasaki within the next day. However, given the

12 Atsutoshi Nishida joined Toshiba in 1975. After working in Toshiba’s subsidiaries in Europe and America, he became the general manager of the PC division in 1995. In 2004, he became the President of Toshiba’s PC and Network Company. He served as the President and CEO of Toshiba from 2005 to 2009 and then as the Chairman of its Board from 2009 to 2011.

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short amount of time remaining till the end of the quarter to negotiate with the ODMs, Toshiba

instead sold inventory to its own subsidiary TTI at the Masking Price, which then transferred it

to TTIP via an intermediate entity (TIH) as previously described (Report pg. 253)).13

The “Challenges” were often delivered with explicit or implied threats. For example, at the

January 2011 meeting CEO Sasaki stated: “if you try to repay the Debt14 in a manner that will

cause you to fall short of budget for the second half, you put yourself in a safe place but our

company at risk. If you just repay the Debt and achieve your budget by using the profit from the

third quarter to excessively repay the Debt like last time, I will lower the bonus assessment by

two levels” (Report pg. 248).

CEO responses

The report does not draw definitive conclusions about whether Toshiba’s successive CEOs

Nishida, Sasaki, and Tanaka were directly responsible for the accounting improprieties that took

place under their respective tenures during the period under investigation (FY 2008 – FY 2014).

However, each claimed that he did not know (or understand) that channel stuffing was being

used to inflate profits, and denied encouraging or condoning that practice. Following are some

indicative quotes by the three CEOs:

Nishida: "I was not aware that the large amounts of profit arising at the end of each

quarter were the result of Buy-Sell Transactions. If it had been explained to me in the

reports at the CEO Monthly Meetings that the profit targets were met by early

recording of CR, I think I would have been aware that (i.e. interpreted it to mean) that

early recording of CR meant early recording of cost reductions such as negotiations to

reduce prices with vendors (parts suppliers)."

Sasaki: Soon after I assumed the position of President it was explained to me that

Buy-Sell Transactions were not illegal, but I never gave instructions myself to

overstate profits using Buy-Sell Transactions, and as it is unsound business, I kept on

saying that the volume should be reduced.

Tanaka: "I understood that selling parts to ODMs resulted in profit, but it was never

raised as an issue by the auditor and I thought the accounting treatment was being

13 In these types of parts transactions, TTIP did not make any adjustment to the price at which the parts were sold

to the ODMs since it received the parts at a price that already included the Masking Difference.

14 In this context “Debt” referred to the overstatement of profit achieved through channel stuffing of ODM parts (Report pg. 243).

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implemented in accordance with the rules. I was aware that the volumes sold to the

ODMs were increasing, but I thought that there were a number of reasons for that,

such as that they had been implementing an expansion strategy before I became

President, and I was not aware that they were having ODMs buy greater volumes

than required in order to overstate profits.”

Responses from the PC Division

Executives of the PC business made several attempts to curtail channel stuffing but were not

successful. For instance, at the October 2009 CEO Monthly meeting, the President of the PC

business (Fukakushi) suggested recording a "settlement" of negative ¥14.7 billion of the early

recording of CR. In response, Norio Sasaki (CEO) said “You always conduct things like Buy-

Sell Transactions at the end of the period without learning from the past." In response,

Fukakushi said, "That is why we are going to repay a part of the early recorded amount this

quarter and also during the fourth quarter, so that we can normalize the situation as much as

possible." Norio Sasaki replied, "Normalization may not be the best thing to do when the

company is going through such a difficult phase. What you are talking about is a bit strange,

and it may not be in the best interests of the PC Business or Toshiba."

In FY 2011, the DS Company's production and procurement department, Finance &

Accounting Division, Corporate Finance & Accounting Division and CFO jointly prepared a plan

aimed at reducing the volume of channel stuffing in a planned matter because they felt such

transactions were unsound. However, in face of the deterioration in sales and profitability of

the PC business, it was utterly impossible to use operating profits to compensate for the

losses that would result from the settlement of Channel Stuffing of ODM parts, and channel

stuffing of ODM parts actually increased that year (The Report, page 250).

As the volume and frequency of the channel stuffing transactions increased, collusion among

Toshiba’s employees to prevent the transactions from being discovered increased. Some

Toshiba employees continued to push back against this practice but were unable to bring about

meaningful changes. Soon after his appointment as CEO, Tanaka held a confidential meeting

with DS Company Senior Vice President Makoto Kubo in September 2013 during which Kubo

was asked “to increase the Buy-Sell Debt a bit and do whatever it takes to ensure that losses for

the DS Company are no more than ¥9.9 billion. Kubo replied, “While I obey any decisions made

by Hisao Tanaka 100% and do my best, I am opposed to increasing Buy-Sell Transactions

(Report pg. 255).”

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The Buy-Sell Debt grew both in magnitude and in importance as a tool for manipulating

reported profits. After Nishida resigned as CEO to become the Chairman of Toshiba’s Board of

Directors, Tanaka, who was responsible for parts procurement at that time, told him that it

would be possible to achieve the (current) “Challenge” if repayment of the “Debt” could be

deferred. Nishida responded, “It can’t be helped this period but next period you must repay at

least some of the Debt. It is okay to be a little reckless this period so make sure you contribute

to Toshiba’s operating profit.”

While conceding that the Finance & Accounting Division of the PC business unit wanted to

resolve the overstatement of profits but was unable to do so due to pressure from the

President of the unit and Toshiba’s CEOs, the Report blames them for (a) providing insufficient

explanations contrary to the facts and (b) acting in ways designed to conceal the inappropriate

accounting treatment so that no issues would be raised by Toshiba’s external auditors (Report

pg. 262). For example, the statements made by persons in charge of accounting and finance at

the DS Company regarding how to respond to the quarterly audit by the accounting (external)

auditor included the following:

“We can definitely not let them perceive that funds to cover the manufacturing profit

and loss are involved in transactions with TTIP and TTI, and it is necessary to keep

saying that TTIP sells parts materials to the ODMs, as the term ‘company-supplied’

requires picking up profit and loss. It is best to be careful and avoid touching on the

issue as much as possible, and if you think it is even slightly risky you should consult

your superiors.”

“We will be asked about the reason why the monthly profits improve at the end of

each period at every audit with respect to the monthly movement in cost of sales and

operating profit. We are responding by simply saying that it is a bundled CD15 at the

end of the period, but with respect to the fluctuations in the amount, the values for

FY 2012 are extremely abnormal. The operating profit for the single month of

December FY 2012 is ¥80.6 billion, which is the highest profit on record and is an

amount that significantly exceeds the sales amount of ¥63.7 billion.”

Similarly, the audit report issued on DS Company in February 2013 by Toshiba’s Corporate Audit

Division mentioned that “Under the accounting policies, the resale profit from Buy-Sell should

not be realized until it becomes sales revenue after shifting to products. However, Buy-Sell

parts held by ODMs as inventory are ordinarily equivalent to three days’ worth of production.

15 Within Toshiba, the term CD was used to imply “cost down”, or cost reduction.

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Therefore, it was explained to the auditor that the impact on unrealized profit and loss from

this situation would be very limited and the approval for the accounting treatment was

obtained.” (Report pg. 264)

Corporate Audit Division and Audit Committee

Toshiba’s internal audit department also raised the issue of channel-stuffing on three separate

occasions (in FY2009, FY2011 and FY2013), going so far as to state that “even if it is Buy & Sell,

the business purpose [of such transactions by the PC Company] is not the sale of major parts,”

and “It is necessary to verify the situation regarding Buy & Sell Parts held at the ODMs. And it is

also necessary to establish a system [at the PC Company] where appropriate internal controls

work to ensure that arbitrary operations are not implemented.” However, despite this the

channel stuffing of ODM parts using Buy-Sell Transactions continued to take place (Report pg.

263).

The internal audit department also expressed concern about the levels of inventory and

masking prices in its audit report, stating: “The appropriate number of inventory days for

inventory subject to Buy-Sell Transactions is five days but the balance at the end of December

2010 was around the same as the procurement amount for that entire month and equivalent to

one months’ inventory. Increases and decreases in the masking amount balance…have a large

impact on the profits for the period and therefore it is necessary to keep a record of approvals

regarding changes to the Masking Price. Further, it is desirable to decrease the Masking Price.”

Although the results of the Corporate Audit Division were regularly reported to the Audit

Committee, it did not discuss the issue of Channel Stuffing or take any action to stop the

practice. An Audit Committee member (Seiya Shimaoka) made three attempts in 2014 and 2015

to draw the attention of the Audit Committee Chairman (Kubo) to this issue but was rebuffed

each time. Specifically, he asked for a thorough examination of the restructuring of the PC

Business which would have shed light on the losses resulting from the reduction of channel

stuffing, and could have revealed the inappropriate accounting that had occurred. However,

Kubo did not agree to Shimaoka’s request and did not meet with him to discuss this issue.

Instead, he dismissed Shimaoka’s suggestion with the argument that “rocking the boat” at that

point would leave insufficient time for closing of accounts and worsen matters.

External Auditors

Toshiba’s auditors – Ernst and Young ShinNihon - did not report any concerns regarding the

effects of Channel Stuffing of ODM Parts in any of their audit reports. They failed to question the

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fact that costs of manufactured goods were reduced on the final day of the quarter, giving rise

to a large gross profit margin. From 2012 onwards, such amounts were higher than that for

production but they accepted Toshiba’s explanation that the gross profit rate improved due to

the of cost reduction (CR) negotiations held every quarter.

Clearing the Stuffed Channels

Overstatement of profits through Channel Stuffing continued during FY 2013, although the

balance of Buy-Sell profit recorded did not grow appreciably. Starting from May 12, 2014, these

matters were discussed at the emergency meetings in which Tanaka (CEO) participated. At the Third

Emergency Meeting held on May 20, 2014, Tanaka suggested eliminating the remaining balance of

masking profits. At the eighth meeting held on July 18, 2014, it was decided to record a loss of ¥50.2

billion in FY 2014. Of that, ¥30.0 billion was due to the loss resulting from the reduction of overstated

profits from Channel Stuffing of ODM Parts. Although this plan was discussed in Toshiba's Corporate

Management Meeting on September 16, 014 and Toshiba's Board of Directors meeting on

September 18, 2014, no details were revealed. Instead the Board was told that of the ¥50.2

billion amount, operating expenses of ¥45.0 billion would be the costs for "sales and inventory

measures, production adjustments, impairment, etc.” It was said that Channel Stuffing of ODM

Parts was stopped in June 2015, and as of the end of the third quarter of FY 2014, “the

overstatement of profits using Buy-Sell Transactions has resolved naturally.”

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Requirements

Requirement 1

a. Does the use of masking prices violate GAAP? Why? Is it appropriate for Toshiba to increase

profit (by the amount of the masking difference) at the time of supplying parts to ODMs?

Why? When and how should Toshiba record the masking differences in its consolidated

financial statements? Explain.

b. For the PCs that are manufactured by its subsidiary TIH, is it appropriate for Toshiba to record

the masking difference as a reduction in the cost of goods manufactured? Why?

Requirement 2

a. Refer to the table of masking differences in the ‘Practice of Channel Stuffing’ section of the

case. For each fiscal year from 2008 to 2014, compute the income misstatement and specify

whether the reported income is overstated or understated. For simplicity, assume that there

were no masking differences at the beginning of FY 2008. Present your answer in the

following table:

FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 FY 2014

Income misstatement

Overstated or understated?

b. The table of masking differences indicates that the total masking difference declined

noticeably in FY 2010. Why do you think Toshiba’s management was willing to reduce the

masking difference in FY 2010? The masking difference was again reduced sharply in FY

2014. What could have caused that to happen?

Requirement 3

Assume that TTIP, a fully-owned subsidiary of Toshiba, purchased key PC parts and supplied

them to Pegatron, an Original Design Manufacturer (ODM) in Taiwan, for assembling PCs. The

price paid by TTIP was ¥24,000 per PC. However, to keep Pegatron from knowing TTIP’s true

cost, the parts were supplied at the masking price of ¥84,000 per PC. In other words, the

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masking ratio used was 2.5 [(¥84,000-¥24,000)/ ¥24,000]. Address the following requirements,

ignoring Pegatron’s processing charge.

(a) In January 2008, TTIP purchased parts for 100 PCs and supplied them to Pegatron and no

assembled PCs were shipped back by Pegatron. In February 2008, TTIP did not purchase

or supply additional PC parts to ODMs. However, during that month, Pegatron assembled

the parts that it had received in January 2008, and shipped 100 PCs to TTIP. In March

2008, TTIP purchased parts for 100 PCs and supplied them to Pegatron. It assembled 95

PCs and shipped them back to TTIP. The remaining inventory of parts for 5 PCs remained

in Pegatron’s warehouse but is guaranteed to be purchased by TTIP.

Required: Compute the profit misstatement for each month, and indicate whether it

would be overstated (O/S), or understated (U/S). Present your answer in the following

table:

Period Profit misstatement Over- or Under-statement?

January 2008

February 2008

March 2008

Total for the Quarter

(b) The average number of parts purchased and supplied in FY 2007 and prior was for

approximately 100 PC units per month. However, during the years FY 2008 to FY 2013

(respectively), TTIP decided to purchase and supply to Pegatron the parts for 102, 104,

106, 108, 110, 112 PC units per month (i.e. the number of units for which parts were

supplied per month increased by 2 PC units every year). The number of PC assembled

each month by Pegatron, shipped to Toshiba and sold to independent customers each

month remained at 95 throughout the six years. The PCs were sold for ¥30,000 each.

Compute the profit misstatement for each of the six years, FY 2008 to FY 2013. Assume

that there were no masking differences at the beginning of the investigation period (i.e.,

FY 2007 and before). Present the answer to this requirement and the next requirement

[part (c)] in the table following requirement 3(c).

(c) Continue with (b) above. In addition to supplying more parts to Pegatron, TTIP also

increased the masking ratio to 3.0, 3.5, 4.0, 4.5, 5.0, and 5.5, respectively in FY 2008, FY

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2009, FY 2010, FY 2011, FY 2012, and FY 2013. Compute the profit misstatement for each

of the six years, FY 2008 to FY 2013.

Answer to Requirement 3(b) Answer to Requirement 3(c)

FY 2008

FY 2009

FY 2010

FY 2011

FY 2012

FY 2013

(d) The case mentions that the “operating profit for the single month of December FY 2012 is

¥80.6 billion, which is the highest profit on record and is an amount that significantly

exceeds the sales amount of ¥63.7 billion.” How is it possible for the profit to be higher

than the sales? Explain.

Requirement 4

In interviews conducted by the Investigation Committee, each President and CEO of Toshiba (i.e.,

Nishida, Sasaki, and Tanaka) denied that he was aware of the fact that profits were overstated by

Channel Stuffing of ODM parts. Would you agree to the explanations given by each? Why?

Requirement 5

The presidents of the PC business claimed that the overstating of profit by Channel Stuffing of

ODM parts was dictated by the top management and hence they were not responsible. Do you

agree with this view? If you were the president of the PC business facing similar circumstances,

what other possible courses of action would you have considered?

Requirement 6

Investopedia.com defines channel-stuffing as “a deceptive business practice used by a company

to inflate its sales and earnings figures by deliberately sending retailers along its distribution

channel more products than they are able to sell to the public.” Read the following article on

channel-stuffing. Explain the difference between the technique and effectiveness of typical

channel-stuffing, and channel-stuffing as practiced by Toshiba during the period of

investigation.

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“The SEC wants to know if Diageo used the oldest — and worst — trick in the book to

fudge its numbers” in Business Insider (July 24, 2015). It can be accessed at:

http://www.businessinsider.com/sec-investigates-diageo-how-channel-stuffing-works-

2015-7

Requirement 7