Home | Other Papers and Essays

A Critical Evaluation of Japanese Accounting Changes Since 1997

Bill Gordon

November 1999


The world does not trust financial reporting by Japanese companies. A series of bankruptcies and financial scandals in the 1990s shocked both the domestic and international financial communities. The Japanese government failed for several years to reveal the extent of bad loans held by financial institutions. In response to various financial system weaknesses and international pressures, the government finally recognized the need for greater transparency in corporate financial reporting and for accounting practices closer to international standards. Between June 1997 and January 1999, the government announced details of an 'Accounting Big Bang' that involved sweeping reforms of financial reporting and accounting regulations. Nearly all of these changes will be implemented between fiscal years 1999 and 2001.

The objective of this dissertation is to examine the principal reasons and major effects of the accounting reforms announced since 1997. Chapter I looks at the historical events and foundations essential to understanding and evaluating the recent accounting changes. The next chapter discusses the Accounting Big Bang's major causes, including a consideration of the business and regulatory environment. Chapter III critically evaluates the recent accounting changes, their effects, and remaining weaknesses. The final section provides conclusions and some reflections on where Japanese corporate financial reporting now stands.

This dissertation draws on both primary and secondary literature sources, with the use of statistics and various individual company examples to support and illustrate the arguments. Although the sections dealing with the three major accounting areas of consolidations, fair value accounting, and pensions discuss some basic accounting rules, the dissertation focuses on an analysis of the historical development, environmental framework, pressures for change, impact of revisions, and remaining weaknesses related to these three areas rather than a detailed description of accounting regulations.

The process of reporting accounting information has several participants. 'Accounting' as used in this dissertation refers to the preparation and publication of financial statements by corporations. Various stakeholders such as company shareholders, potential investors, banks and other creditors, tax authorities, and governmental regulatory agencies have a substantial interest in fair and complete disclosure of accounting information. For example, financial reporting disclosure requirements have developed to require companies to disclose financial results and financial position to enable investors and creditors to assess risks and returns. Company managers, who have responsibility to determine accounting policies and to prepare financial statements, and auditors, who have responsibility to check financial statements and to express an opinion on their propriety, also play key roles in the process of reporting accounting information to stakeholders. This dissertation explores the roles played by various financial reporting process participants in the Accounting Big Bang in Japan.

I. Japanese System of Accounting to 1997

This chapter provides historical background information necessary to evaluate the recent Japanese accounting changes. Part A presents the three key legal foundations of the Japanese system of financial reporting and accounting. Part B discusses the three most significant events affecting Japanese accounting since World War II. Part C highlights the accounting rules in place until the recently announced changes go into effect between fiscal years 1999 and 2001.

A. Key Foundations

Japan's so-called 'triangular legal system', not seen elsewhere in the world, prescribes financial accounting and reporting rules. The Commercial Code (CC), the Securities and Exchange Law (SEL), and the Corporate Income Tax Law each have their own accounting requirements to address their peculiar objectives, but the three laws exert influence on each other in various ways. Although Shiratori (1998, 27) comments that these three laws have created a chaotic and confusing situation, Daisai (1998, 47-8) points out that the three separate laws have substantial similarities, and each law has an equivalent requirement that generally accepted accounting principles must be used in the absence of a specific published rule.

The following sections examine the objectives, history, and principal requirements of each law making up Japan's 'triangular legal system'.

Commercial Code (CC)
The Commercial Code (CC), enacted in 1890, introduced into Japan a financial reporting system modeled after the German commercial code oriented towards creditors and tax collection. The Ministry of Justice (MOJ) administers and enforces the CC. Every joint-stock company (kabushiki kaisha) must prepare non-consolidated (single-company) annual financial statements in accordance with CC rules and must submit these statements for approval at the annual general meeting of stockholders. These statements focus on determining profits available for dividend payments.

The principal objective of the CC is to protect creditors by ensuring companies calculate income available for dividends to shareholders in a conservative manner. For example, the CC requires that asset values be recorded at acquisition cost with no provision for including asset value increases in income available for dividends.

Even though the CC focuses on income available for dividends, the CC requires only the balance sheet to be published in the official gazette or in a leading daily newspaper, with a large company also being required to make public its income statement (Someya 1996, 47). Not even one percent of the corporations follow this limited requirement for balance sheet publication, with companies listed on a stock exchange or over-the-counter (OTC) being almost the only ones complying with this regulation. Tanaka (1998, 17-8) gives two reasons for the widespread disregard of this CC requirement. First, the MOJ does little to enforce the regulation because of the impracticability of having over one million companies publish even a summarized balance sheet. Second, except for large companies like those listed on a stock exchange, the financial statements do not get audited by certified public accountants (CPAs), so any published figures lack credibility and provide very little value to users. Since the income statement does not need to be disclosed publicly, if stockholders and creditors want to see it, they must visit a company's home office, where the corporation must make available for inspection all financial statements prepared under CC rules.

Securities and Exchange Law (SEL)
Although Japan has over one million kabushiki kaisha, the Securities and Exchange Law (SEL) applies only to about 2,600 companies with shares publicly traded on stock exchanges or over-the-counter (OTC) (Nobes 1998, 247). The MOF has responsibility to administer and enforce the SEL. The SEL requires disclosure of consolidated and non-consolidated financial statements not only at the time of issuing new securities but also through submissions of annual and semi-annual reports. A company must file its financial statements with the Ministry of Finance (MOF) within three months of the fiscal year-end and with any stock exchange on which it is listed.

The law does not require that shareholders receive financial statements, but they are available for public inspection at the MOF and the stock exchanges, or copies may be obtained from the MOF's Printing Bureau for a charge. In contrast, the US Securities and Exchange Commission (SEC) requires annual financial statements to be distributed to shareholders without charge.

Corporate Income Tax Law
Japanese corporate income tax laws and regulations have a significant effect on income measurement and financial reporting by limiting the amounts of certain types of tax deductions. Examples of these deductions include allowances for bad debts and non-performing loans, depreciation of fixed assets, and expenses for employee pensions and severance indemnities. The Corporate Income Tax Law's primary purpose is to obtain tax revenues for the government, so companies often are not allowed to record tax deductions even though a decline in the value of an asset or an increase in a liability has occurred from an economic standpoint.

The Corporate Income Tax Law generally requires expenses to be shown in a company's CC financial statements if the company wants to record expense deductions for the purpose of calculating taxable income. This requirement often leads a company to choose an accounting practice or alternative that lowers taxable income rather than one that more accurately reflects economic reality (Nobes 1998, 250). The marginal tax rate of about 50 percent for most Japanese companies provides a strong incentive to adopt accounting practices that result in the lowest possible tax payments.

If accounting standards under the CC or SEL do not address a specific accounting issue, then companies use tax guidelines to prepare financial statements. Except for a few small differences, such as entertainment expenses not deductible for tax purposes, a company's reported income under the CC or SEL usually agrees with its taxable income (Shiratori 1998, 46).

Principal Objectives
The Japanese accounting and financial reporting system's principal objectives have been the determination of the amount of a company's profits available for dividends and the calculation of the taxable income amount. Japanese corporations have generally given precedence to the CC and corporate income tax rules rather than providing to investors and shareholders a fair representation of financial condition and operating results (Nikkei Business 1997b, 95). Shibata Hideki (1999, 231) considers the Corporate Income Tax Law to occupy the highest position of the three laws since a company generally put the highest priority on reducing taxes and since auditors will rarely ask a client to revise its financial statements if prepared in accordance with the tax rules.

B. Historical Development Since 1945

Although Japan introduced the CC in 1890 as the first formal corporate reporting regulation, the key events shaping Japan's system of financial reporting and accounting occurred after the end of World War II. McKinnon (1986, 72-3) identifies the three most significant events after World War II based on the coverage and importance attributed to these events in the academic literature. This section examines these three key events: the introduction of several new laws and organizations during the Allied Occupation after World War II, the revision of the CC in 1974 to require large companies to undergo independent audits, and the requirement implemented in 1977 for consolidated financial statements.

Allied Occupation
The Allied Command, during their occupation of Japan between 1945 and 1952, introduced investor-oriented financial reporting and established the framework for Japanese accounting and financial regulation, which still essentially exists today. The US, the driving force behind the Occupation Forces, sought to democratize Japan by breaking up the zaibatsu (huge privately-owned industrial conglomerates such as Mitsubishi and Sumitomo) and selling their shares to investors in the general public.

The Allies set up a financial reporting system modeled primarily on the US system, with the cornerstone being the Securities and Exchange Law (SEL) passed in 1947. Cooke (1994, 54) points out that 'the aim of the new regulatory system was to protect investors in what the Occupation Forces anticipated would be a shareholder democracy'. The Securities and Exchange Commission (SEC) was established in 1948 as a regulatory body independent of the government, but soon after the Allied Forces left in 1952, the Diet abolished the SEC and transferred its responsibilities to the MOF.

Business Accounting Deliberation Council (BADC)
The Economic Stabilization Board of the Occupation Forces established in 1948 the Investigation Committee on Business Accounting Systems (ICBAS) as an entity independent of the government. In 1949, the ICBAS issued Business Accounting principles to provide generally accepted accounting principles (GAAP) to be followed by corporations. These principles addressed the occupying authorities' criticism of the lack of detail in financial statements and numerous differences in corporate accounting practices (McKinnon 1986, 178). These principles were to be considered in any amendments to the laws affecting financial statements (i.e., CC, SEL, tax laws), and certified public accountants (CPAs) were to follow these standards in their audits of financial statements (Cooke 1994, 58). In 1950, the ICBAS became an advisory body reporting to the MOF, and the MOF changed its name in 1952 to the Business Accounting Deliberation Council (BADC). The BADC continues to have primary responsibility to issue opinions on matters of financial accounting and reporting.
Certified Public Accountants Law
The Allied Forces established the Japanese Institute of Certified Public Accountants (JICPA) under the Certified Public Accountants (CPA) Law enacted in 1949. The JICPA exists as an organization independent of the government, but the MOF exerts strong influence over its activities since the MOF has responsibility for administering the CPA Law and the CPA examination. The CPA Law makes it compulsory for all CPAs to be members of the JICPA. Although the JICPA has no authority to issue official accounting standards, they issue implementation guidance, especially in areas where BADC accounting statements leave room for interpretation or do not exist.
MOF Dominance
As part of the regulatory changes brought about by the Allied Forces to ensure adequate disclosure to protect general investors, the MOF ended up in a predominant position to control corporate financial reporting requirements. As shown in the following chart, the MOF has responsibility for administration and enforcement of the SEL and Corporate Income Tax Law. The MOF also supervises the National Tax Administration Agency and the issuance of accounting standards by the BADC, and it effectively controls the JICPA through its administration of the CPA Law and CPA examination.

The MOF has other powers, such as direct regulatory power to license financial institutions to participate in specific market segments such as life insurance underwriting and foreign exchange trading. The MOF also provides direct unwritten administrative guidance to financial institutions under its control.

Although the Allied Forces originally established the SEC, BADC, and JICPA as independent bodies separate from the direct control of any ministry, each organization ended up under the MOF's umbrella. McKinnon (1986, 185) points out the Diet carried out these changes based on its 'preference for centralized governmental control of the regulation system rather than the devolution of control to independent authorities'.

Requirement for Independent Audits (1974)
During the 1960s, several companies manipulated profits through transactions with subsidiary companies, which resulted in losses for a large number of investors (Cooke 1994, 71). The bankruptcy of Sanyo Special Steel in 1965 especially led to sharp criticism of Japan's auditing system and the accounting practice of parent-only financial statements. The accounting manipulation by the company had been carried out by sales at inflated prices from the parent company to its subsidiaries and affiliated companies, which were not subject to an audit by a CPA firm under either the CC or SEL. The parent company used these sales to disguise losses or to inflate profits, and they went undetected until investigations following the parent company's bankruptcy.

Before 1974, the CC did not require company financial statements to be audited by a CPA firm. Although the SEL required audits of parent-only financial statements for listed companies, the subsidiaries and affiliates generally did not have audits since they were not listed on a stock exchange. The CC and SEL require that a corporation's statutory auditors examine the financial statements to ensure fraud does not take place and that directors have complied with the law and articles of incorporation. The statutory auditors, with their qualifications not clearly defined in the law, sometimes had no independence or lacked sufficient knowledge of accounting and auditing, which resulted in several cases in the 1960s of financial statement window-dressing not being detected or reported (Someya 1996, 27). Even for those companies that had audits by independent CPAs under the provisions of the SEL, the CPAs for several of the companies that went bankrupt failed to disclose to the MOF, through their audit reports, financial statement window-dressing used by the companies to manipulate profits and disguise their true financial position (McKinnon 1986, 214-5).

In order to address the problems associated with statutory auditors, the Japanese Diet enacted in 1974 a CC amendment to require companies with capital greater than 500 million yen or with liabilities greater than 20 billion yen to have their financial statements examined not only by their appointed statutory auditors but also by an accounting auditor (kaikei kansanin) that must be either a certified public accountant (kônin kaikeishi) or an auditing corporation (kansa hôjin) of CPAs. In order to address the failure of external CPAs to disclose financial statement window-dressing, the MOF implemented several measures to improve the quality of CPA audits and to strengthen financial reporting of companies subject to the SEL (McKinnon 1986, 222-6).

Requirement for Consolidated Financial Statements (1977)
The introduction of consolidated financial statements came about due to financial reporting manipulation by several firms that went bankrupt and due to the growth of multinational companies. Until 1977, consolidated financial statements did not exist in Japan, and both the CC and the SEL required financial statements to be prepared individually for each business entity. Consolidated financial statements present a group of companies as a single economic unit by showing results of operations and the financial position of a parent company and its subsidiaries as if the group were one company.

As discussed in the previous section on the implementation of the requirement for independent audits of large companies, Sanyo Special Steel and other companies in the 1960s manipulated financial statement numbers through transactions with subsidiaries and affiliates. These transactions remained unreported since the parent company did not consolidate the financial results of these subsidiaries and affiliates. The BADC issued an exposure draft on consolidated statements in 1966, one year after Sanyo Special Steel's bankruptcy, but strong opposition from large corporations and their representative organization, Keidanren (Federation of Economic Organizations), delayed final approval by the MOF for many years (McKinnon 1986, 262, 267).

In addition to several bankruptcies by Japanese companies in the 1960s, the rapid growth of Japanese multinational companies in the 1960s and 1970s also caused the MOF to realize the inadequacy of Japan's parent-only financial statements. In the 1960s, the New York Stock Exchange barred the entry of Japanese companies since their accounts were based on the parent company only, and the first listing did not occur until 1970. Moreover, several US companies, along with the US government, lobbied the Japanese government in the early 1970s to allow US companies to be listed on the Tokyo Stock Exchange by filing consolidated financial statements. The Japanese government finally consented, and in 1973 the Tokyo Stock Exchange listed foreign company shares for the first time (Cooke 1994, 74).

C. Accounting Standards in Three Key Areas

Consolidations, fair-value accounting, and pension accounting represent the accounting areas with the most significant changes since 1997 in terms of total financial impact and number of companies affected. This section briefly summarizes basic accounting rules in effect for these three areas until the recently announced changes get implemented from fiscal years 1999 to 2001.

The consolidation accounting standard, implemented in 1977 for companies subject to the SEL, requires all subsidiaries for which a parent company holds more than 50 percent interest in the voting share capital must be consolidated with certain limited exceptions (e.g., subsidiary in process of liquidation). Even though a parent company does not directly hold a 50 percent interest, the accounting rules require consolidation if a parent company controls directly or indirectly more than 50 percent of the voting stock.

For example, assume parent company A directly owns 30 percent of C and 60 percent of B, and B owns 25 percent of C. Parent company A will consolidate C as a subsidiary even though it directly owns only 30 percent of voting shares. Since A owns the majority of B's shares, B's 25 percent ownership in C is combined with A's 30 percent ownership when determining whether A holds a majority interest in C's voting share capital. However, A will include only 45 percent of C's income in its consolidated income (i.e., 30 percent direct share plus 60 percent of B's 25 percent share) (Kawamura 1999a, 7 September; Yoshii 1999a, 63).

A Japanese parent company must use the equity method of accounting for any affiliated company where the parent company owns 20 to 50 percent of the voting shares. The equity method requires a parent company to recognize in its earnings its ownership share in an affiliated company. This method is frequently called 'one-line consolidation', since a parent company records its investment in affiliates on one line on the balance sheet and its share of affiliated companies' income on one line on the income statement.

Fair-value Accounting
Japanese accounting standards specify that financial instruments such as stocks and debt securities be measured by one of two methods, acquisition cost or the lower of acquisition cost or market, with a required write-down to net realizable value in the case of permanent impairment of value. A company can choose either valuation method. The standards do not permit revaluation of financial instruments to recognize profits related to a rise in market values. Proponents of historical acquisition cost valuation point out the advantage that assets are recorded at an objective and verifiable value.

Japanese accounting regulations do not allow revaluation of fixed assets such as land. These rules are consistent with the conservative rules in the US and Germany but differ from the UK, which allows the revaluation of fixed assets, especially land and buildings (Nobes 1998, 255).

Pension Accounting
Many Japanese companies offer post-employment benefits, often referred to as pensions, with amounts based on an employee's salary, seniority, and reason for leaving. Post-employment benefits include a lump-sum payment made a the time of an employee's retirement, periodic payments made after an employee's retirement, or a combination of the two methods. Some companies allow retiring employees to choose the method of payment.

Japanese pension funds are considered to be defined benefit plans, where premiums or installments paid by companies may fluctuate over time, but the amount an employee receives in the future is determined in advance. Companies can not reduce employee pension payments in the case of installment shortfalls. The Japanese pension system includes employee pension funds (EPFs), which pay a part of what otherwise would be paid by public pension insurance, and tax-qualified pensions (TQPs) managed by companies in-house. Assets in EPFs totaled 68 trillion yen at March 31, 1997 (Miyake 1998). An EPF has a legal existence separate from the sponsoring company, but in practice most EPFs have ultimate recourse to the company in the case of funding shortfalls. In contrast to an EPF, a TQP does not have any separate assets apart from a company's general assets. A sponsoring company clearly has payment responsibility for a TQP, but retired employees may not receive payments if the company goes bankrupt (Beason and James 1999, 130).

Regardless of whether employees receive a lump-sum payment or periodic payments and whether a company's pension is an EPF or a TQP, the accounting for different types of post-employment benefits generally follows the same principles. Japanese accounting rules do not require corporations to recognize a liability for vested pension obligations or for benefits related to employees' service prior to the balance sheet date.

Since 1979, the Corporate Income Tax Law has limited deductions to 40 percent of the total hypothetical pension liability as of the balance sheet date with the calculation made under the assumption that all employees voluntarily retire at that time. Although a company can establish a liability or reserve greater than the 40 percent limit, any amount over 40 percent can not be treated as a deduction in the calculation of taxable income.

Next Chapter

Table of Contents | Acronyms | Introduction | Chapter 1 | Chapter 2 | Chapter 3 | Conclusion | Bibliography

Home | Top | Other Papers and Essays | About the Author