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Accountant mismatch clogs Japan's IPO pipeline

'Audit refugees' on the rise as startups sidelined for big clients

TOKYO -- Initial public offerings by startups in Japan have hit a snag as auditors take more time checking the books at big clients following an accounting scandal at Toshiba.

The accounting misdeeds at the Japanese industrial group -- which surfaced in 2015 and triggered a slew of investor lawsuits, including one against a local affiliate of global accounting firm Ernst & Young -- prompted auditors to examine their big clients more closely.

This has cut into the number of accountants allocated to audit startups planning to go public. The situation risks turning more such companies into "audit refugees" and dampening enthusiasm for starting new businesses at a time when Japan is struggling to catch up to China and the U.S. in the number of unicorns -- startups worth over $1 billion.

Housmart, a realty services startup in Tokyo, almost gave up on its planned IPO because a leading Japanese auditor suddenly declined to conclude an official contract just before the deal was to be signed.

Companies making an IPO in Japan need an approved audit covering the prior two business years from a certified public accountant. Housmart carried out an IPO by signing a contract with a midsize auditing firm in Kyoto, roughly 500 km away from Tokyo.

A Tokyo-based startup that offers information technology services was declined a contract with any of the large auditors it began contacting last autumn. The company signed an agreement with a smaller firm after negotiating with several peers.

"We could barely avoid becoming an audit refugee," said an executive at the startup.

Startups enjoyed a seller's market a few years ago, letting auditing firms compete for contracts to certify their accounts for IPOs. The situation has reversed as staffing shortages leave big auditors reluctant to work for startups planning stock debuts.

"Toshiba's accounting scandal has prompted big businesses to change their auditors one after another," an IPO official at a major auditing firm said. "To win orders from big businesses, [auditors] have no other choice but to become selective about IPOs."

The 2017 scandal raised questions about the relationship between Toshiba and auditor Ernst & Young ShinNihon, which failed to detect the fraud. With the Japanese Institute of Certified Public Accountants ordering EY ShinNihon to suspend operations for two months, the auditing firm's credibility was damaged and big listed clients such as Fujifilm Holdings switched to other auditors.

Audits of big corporations represent a major source of earnings, and large auditors seeking new business are assigning more accountants to big clients while increasingly shunning time-consuming and low-margin examinations for IPOs. And as more companies planning stock debuts make auditing inquiries, the amount of related work has reportedly more than doubled over the past three years -- exacerbating the problem for startups.

In 2018, privately held companies in Japan raised at least 100 million yen ($892,285) from venture capitalists and other sources, 95 more than a year earlier, according to Japan Venture Research. Also in 2018, 90 Japanese startups carried out IPOs, the same number as in 2017.

In contrast, more than 300 IPOs occurred in China, while Southeast Asia enjoys a boom in unicorns -- privately held startups valued at over $1 billion.

Some analysts expect the number of IPOs in Japan to decline this year. Nevertheless, startups receive some of the blame for the birth of audit refugees.

The IPO market in Japan is dominated by local arms of the world's four leading professional services groups. EY ShinNihon, KPMG AZSA, Deloitte Touche Tohmatsu and PricewaterhouseCoopers Aarata have held a combined share of over 80% since 2010. In the U.S., these four auditors have a total share of just over 50%, leaving more room for work by smaller auditors.

While roughly 210 small and midsize auditing firms operate in Japan, about 120 of them are registered as auditors for listed companies and include many that have leeway for auditing for IPOs.

But securities companies that help startups prepare for listing usually advise them to use big or second-tier auditors for fear of failure in listing as a result of inadequate auditing.

"When it comes to the experience of handling IPOs in the past and qualities of leadership, we deal with only 10 to 15 auditors," said an official at a top brokerage house.

Shunned by securities companies, small and midsize auditors are unable to accumulate the experience of handling IPOs and so are seen as unreliable for the lack of experience.

Big auditors, securities companies and stock exchanges all play a role in the vicious circle that creates audit refugees. The cultivation of Japanese unicorns appears to require curbing the heavy reliance on big auditors through both public and private efforts, in order to pave the way for smooth IPOs.

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