Thinking Points

  • Paying attention to the accrual ratio (or Sloan ratio) helps spot dodgy accounting.
  • That said, Toshiba was able to circumvent the Sloan ratio, staying in the “safe zone” leading up to its 2015 accounting scandal.
  • Taking a closer look at contextual clues and cash flows wouldn’t have identified Toshiba’s fraud. Instead, this would’ve highlighted the company’s long term poor business performance, which may have prevented some heartaches.

Last week, we talked about Japan’s corporate governance and how it became the way it is today (which is widely considered poor). The main issue with poor governance is that poor behavior goes unnoticed until it’s too late, resulting in things like Toshiba’s (TSE: 6502) 2015 accounting scandal. Today, we’ll talk more about how you can avoid the all too iconic public apology commonly seen when a corporate scandal hits the headlines in Japan.

Source: Toyo Keizai

The picture above is former Toshiba management apologizing for its accounting scandal back in 2015. For investors, this was a rude awakening.

Pay attention to accruals

My preference for bottom-up and case-by-case analysis of companies tends to give me a neutral stance on standard metrics, like ROE or Debt-Equity ratio. That said, there are several metrics I regularly look at, like the accrual ratio (which I recently added).

Here is a description of the accrual ratio (also called the Sloan Ratio) by Stockopedia:

The accrual ratio is a way to identify firms with low non-cash or accrual-derived earnings relative to their cash flow.

The formula is (net income – free cash flow), divided by total assets.

When free cash flow is greater than net income, cash earnings are higher than accrual earnings, and the accrual ratio is negative (good).


Richard Sloan from the University of Michigan discovered that companies with small or negative accruals outperform those with large accruals. If you think about it, this isn’t a particularly novel discovery. When all else is equal (like gross & operating margins), receiving cash sooner is better than later. The sooner you receive the cash, the sooner you can reinvest it to grow your snowball.

In Japan, where P/E and P/B ratios are still the common metrics used by individual value investors, comparing reported earnings with cash flows isn’t a standard practice yet. The thing with accruals is that it can be used for dodgy accounting. After all, buying a pack of gum for a dollar and selling it for two makes for great gross margins, until you discover that the cash isn’t coming in during the course of your lifetime.

From what I can tell, most experienced value investors tend to pickup on accruals without explicitly calculating anything. They glance at historical financials and notice when the cash flows don’t match up with reported earnings.

Sneaky Toshiba

Generally, a Sloan ratio of between negative 10% and positive 10% puts a company in the “safe zone”. Interestingly, however, paying close attention to accruals wouldn’t have helped us avoid the Toshiba trainwreck.

In the 10 years leading up to the scandal (2005-2014), Toshiba’s Sloan ratio remained in the safe zone. Many news sources (like here and here) point at corporate governance and culture as the key reasons for the scandals. But did you know Toshiba was the poster child for progressive corporate governance in Japan before the scandal?

I’m guessing not.

The Japan Corporate Governance Network issues a survey each year. The answers are used to measure a company’s governance system, and is recorded as a part of the JCGIndex. In 2014, Toshiba tied for 19th out of 118 total respondents (Japanese source).

Toshiba’s manipulation was difficult to see. It mainly involved:

  • Underestimated construction costs coupled with dodgy percentage of completion based accounting in infrastructure business.
  • Avoiding goodwill impairment for nuclear business.
  • Avoiding inventory valuation loss in semiconductor business.
  • Padded profits in computer business.

In effect, Toshiba pushed the losses to tomorrow, where unlimited productivity and value lies (both in life and business). After nearly a decade, the stink started coming out.

Toshiba the court noble

If we wanted to spot Toshiba’s fraud beforehand, we effectively had to be looking for every sign, including the contextual ones. I’m certain I wouldn’t have spotted it, but it’s worth going over to avoid  future heartaches.

Toshiba was one of the three big heavy electronic machinery companies in Japan. The other two are Hitachi (TSE: 6501) and Mitsubishi Heavy (TSE: 7011). Needless to say, the three companies have had a long standing rivalry. In the industry, each company’s culture is described as:

  • Hitachi, the masterless samurai (野武士の日立, nobushi no hitachi)
  • Toshiba, the court noble  (公家の東芝, kuge no toshiba)
  • Mitsubishi, the feudal lord (殿様の三菱, tonosama no mitsubishi)

In a 2017 Aera article (Japanese source), journalist Osamu Katayama explained the cultural description for Hitachi and Toshiba, which I summarized below.

Hitachi’s masterless samurai association can be attributed from its approach to problem solving, which is essentially fighting with skill and technology. A prime example is Hitachi’s international rail business, which started by sending one person to the UK in 1999. After early struggles, Hitachi focused on localizing its rail business. With the help of industry expert Alistair Dormer, Hitachi pried its way into the UK rail business and expanded its offerings. Today, the company offers a full line of rail systems and competes with the majors (Siemens, Bombardier, Alstom).

Toshiba, on the other hand, relied on its connections to get things done, as a court noble from the old times would. Its international expansion came through M&A rather than building from the ground up like Hitachi. With the acquisition of Westinghouse, Toshiba dove head first into international nuclear business, an industry with strict regulations which differ in just about every region across the globe. Moreover, Toshiba paid 3 times what industry experts thought Westinghouse was worth. After the misfortune of the Fukushima nuclear disaster, its domestic nuclear business suffered as well. In hindsight, Toshiba leaped further into a complicated industry than it should’ve and wasn’t able to follow through with adequate management.

Competitive pressures

Throughout the 1980s and 90s, Toshiba and Hitachi were neck and neck, delivering comparable business performance. More recently, however, Hitachi gained a long lead over Toshiba, establishing itself as the clear number 1 player in heavy electronic machinery. By fiscal 2014 (before the Toshiba scandal), Hitachi’s revenue was 9.6 trillion yen ($87 billion USD) while Toshiba’s revenue was 6.5 trillion yen ($59 billion USD).

Presumably, the longstanding rivalry had some influence on Toshiba management. What’s more interesting is the stark difference in the cash flow situation of both companies. In the 10 years leading up to Toshiba’s scandal, Hitachi had free cash flow of 1,107 billion yen ($10.1 billion USD) while Toshiba delivered negative 26 billion yen (negative $237 million USD). That’s a long-time to be free cash flow negative for an established business. Also note that my free cash flow calculation was a simplistic Operating cash flow minus Investment cash flow.

Though the cash flow situation isn’t a clear sign of fraud, it does point to Toshiba’s precarious business strength. Again, I wouldn’t have spotted Toshiba’s fraud. Going forward, however, the scandal is a reminder for us to pay closer attention to some of the soft factors that might drive management teams to fudge numbers.

The bottom line

In dealing with Japan’s middle-of-transition corporate governance system, investors need a way to avoid watching their CEOs apologizing on TV. Though there is no perfect formula for this, paying attention to cash flows and contextual clues help triangulate the driving forces behind fraudulent practices. And when it doesn’t help expose fraud, it does a pretty good job of spotting weak performance.


Kenkyo Investing
Kenkyo Investing

Kenkyo Investing applies a value investing approach to Japanese equities, providing insights that are often unavailable to non-Japanese speakers.