Olympus Corp's use of accounting tricks to hide big losses has raised questions about whether its auditors, the Japanese arms of global giants KPMG and Ernst & Young, should have done more to follow up on red flags.

The Japanese maker of cameras and medical equipment shocked investors on Tuesday, admitting it had used payments to merger advisors and venture capital funds to cover up securities losses dating back decades.

Japan's Financial Services Agency will investigate whether Olympus's auditors knew about the hidden losses or were negligent in their checks, a source with knowledge of the matter told Reuters.

Ernst & Young ShinNihon LLC, which took over as Olympus auditor in 2009, declined to comment, citing client confidentiality. KPMG AZSA LLC, which audited Olympus for several years through to 2009, also declined to comment.

A severe penalty would send shivers through the auditing industry in Japan, still reeling from a series of scandals that led to a two-month suspension of ChuoAoyama Pricewaterhouse Coopers in 2006 and the disbanding of its successor firm in 2007.

Ernst & Young ShinNihon is Japan's largest auditor with more than 4,000 clients and 3,000 certified public accountants.

If it (suspension of an audit firm) happens because they did look over the misstatement intentionally or without due care, its impact would be enormous, said Yoshinori Kawamura, accounting professor at Waseda University's School of Commerce.

However, regulators now have more moderate regulatory tools for false audits, which did not exist in 2006, Kawamura added, noting that a 2008 law change meant auditors could escape suspension and face heavy fines instead.

Olympus has provided few details of its accounting maneuvers but says the original scheme to hide investment losses went back to at least the 1990s, when it was being audited by Asahi & Co. Olympus says an independent investigation commissioned by the company is continuing.

Asahi was the Japanese affiliate of Arthur Andersen before Andersen collapsed amid a U.S. accounting scandal. Asahi became a member firm of KPMG International in 2003 and then merged with AZSA & Co in 2004 to form KPMG AZSA LLC.

AUDITORS RAISED RED FLAGS

Olympus removed KPMG AZSA as its group auditor in 2009 after a dispute over how to account for some controversial acquisitions. The camera-maker decided not to disclose this to the stock market, an internal document obtained by Reuters showed.

Instead, Olympus told investors at the time that KPMG's audit contract had expired and it was hiring Ernst & Young.

The problems at Olympus burst into the open when ousted chief executive Michael Woodford said he had questioned excessive advisory payments made by Olympus for its $2.2 billion acquisition of British medical device firm Gyrus in 2008. Olympus paid $687 million in advisory fees, about one third of the purchase price, versus investment banking norms of about 1 to 2 percent.

Olympus on Tuesday said some of those fees were used in part to help hide losses on investment securities.

KPMG's British arm, which audited the subsidiary accounts of Gyrus, questioned the accounting treatment of some of the fees and whether Cayman Islands-based AXAM Investments Ltd, which received a big part of the fees, was a related party to Olympus.

However, KPMG AZSA signed off on Olympus's group accounts without qualifications.

When it took over, Ernst & Young also raised questions about AXAM in auditing Gyrus's accounts but gave Olympus group a clean bill of health.

It is not unusual for an auditor to qualify a subsidiary's accounts in one country and give the parent located elsewhere an unqualified green light if the issue raised is not deemed material to the consolidated accounts, accounting experts said.

But some accounting and legal experts said the inflated advisory fees should have prompted a more critical review of Olympus accounts.

Maybe KPMG AZSA accountants thought it wasn't important, said Shinji Hatta, a professor at Aoyama Gakuin University's Graduate School of Professional Accountancy in Tokyo.

But it was important, and overlooking this in my opinion is a grave issue in terms of auditing.

ASIA A KEY AUDIT MARKET

Both Ernst & Young and KPMG have grappled with problem clients before.

KPMG paid multi-million-dollar settlements over its audits of New Century Financial, a mortgage lender that collapsed during the U.S. housing crisis, and Xerox, a copier-maker accused of manipulating its accounting in the late 1990s.

Ernst & Young has been sued over its audits of China-based Sino-Forest, once the biggest forestry company listed on the Toronto Stock Exchange.

It also still faces a lawsuit by the New York attorney general alleging it helped Lehman Brothers engage in a massive accounting fraud before its 2008 bankruptcy helped trigger the 2008-2009 global financial crisis. Ernst & Young says it acted properly.

In that case, Ernst & Young is accused of standing by while Lehman repeatedly moved up to $50 billion off its balance sheet at quarter ends. The maneuver, dubbed Repo 105, helped hide Lehman's financial problems before its downfall, New York prosecutors allege.

The Olympus scandal also renews long-standing questions about the structure of audit firms, which brand themselves as global networks but in fact are made up of legally separate firms to limit liability when one member gets in trouble.

The main auditor watchdog in the United States has been looking into whether the global networks are properly supervising their disparate arms and ensuring quality.

We have been spending a lot of time on our inspection process as we look at the global-firm audit in determining how seamless it is, James Doty, chairman of the Public Company Accounting Oversight Board, said on Tuesday.

Japanese politicians are also taking renewed interest in the audit industry in light of the Olympus scandal.

We may need to reassess the accounting system as a whole if auditors were unable to fully point out problems their clients were involved in, said Natsuo Yamaguchi, head of New Komeito, Japan's second-largest opposition party.

(Additional reporting by Rachel Armstrong, Nathan Layne, Noriyuki Hirata and Yuko Yoshikawa in TOKYO, and Alexandra Alper in WASHINGTON; Editing by Howard Goller and Mark Bendeich)