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A Critical Evaluation of Japanese Accounting Changes Since 1997

Bill Gordon

November 1999

B. Internationalization and Innovation

In addition to the accounting and auditing weaknesses examined in the previous part, the internationalization of capital markets and accounting standards and the rapid innovation in financial markets have also played a major role in the development of new accounting standards in Japan.

Globalization of Investing and Financing
Capital markets have in recent years become increasingly internationalized. After the Japanese government removed restrictions on banks' overseas financial activities through an amendment to the Foreign Exchange Law in 1980, large Japanese companies increasingly raised funds through the issuance of bonds on international capital markets. The amount of overseas bonds issued by non-financial corporations increased rapidly from 0.2 trillion yen in 1980 to 2.3 trillion yen in 1985 to 9.5 trillion yen in 1989, with a slight decrease in the early 1990s after the bursting of the bubble economy (Aoki, Patrick, and Sheard 1994, 9). International bondholders and other creditors demanded that Japanese companies present consolidated financial statements on par with US GAAP or other generally accepted international standards of accounting.

The 1985 Plaza Accord exposed Japanese companies and the financial system to global market forces and principles, and the strengthening of the yen and increased cost of doing business domestically caused Japanese companies to increase overseas production and investment. The overseas production ratio of Japanese companies increased nearly four times from 3.0 percent in 1985 to 11.6 percent in 1996 (Tsûsan Sangyô Shô 1998, Ch. 4, Par. 1). These expanded overseas activities have heightened Japanese companies' awareness of the higher-level accounting standards required in other countries.

Foreign investors, accustomed to greater transparency of financial disclosure in other industrialized countries, have found difficulties when reviewing financial statements of Japanese companies. A 1995 survey of 145 foreign banks and brokers operating in Japan found that 'inadequate public disclosure by financial firms' was one of the principal reasons for dissatisfaction with Tokyo as a financial market (Hartcher 1998, 180).

International Accounting Standards (IASs)
The development and growing acceptance of International Accounting Standards (IASs) have put much pressure on Japan to reform its financial reporting rules and practices. In response to the increasing internationalization of investing and financing as discussed above, the international financial community has called for harmonization in accounting and financial reporting practices between countries. Harmonization provides comparable information on companies throughout the world and increases the compatibility of accounting practices by setting bounds to their degree of variation. In 1973, nine industrialized countries formed the International Accounting Standards Committee (IASC), an independent, private-sector organization, to improve and harmonize financial reporting by the issuance of IASs that address key topics affecting the financial statements of business enterprises. The organization has grown rapidly to a current membership from about 80 countries.

Although the JICPA was one of the nine founding members of the IASC and has agreed to harmonize its rules with IASs, until 1997 the BADC had taken few steps to harmonize its accounting standards with IASs. Only one Japanese company (Sasebo Heavy Industries) in the early 1990s prepared financial statements consistent with IASs, and by October 1997 the number of companies reporting with IASs had increased to only seven (Cooke 1994, 50; Yokoyama 1999c).

The stock exchanges in many countries accept the IASs for cross-border listings, with Japan and the US being the principal exceptions. For example, the London Stock Exchange has accepted IASs for over 20 years. Although the US does not accept IASs for cross-border listings, the US SEC requires companies to use US GAAP, generally considered to be as rigorous as IASs, or at a minimum to present a reconciliation of their financial statements to US GAAP.

The IASC has been working for several years with the International Organization of Securities Commissions (IOSCO), who represents the world's securities markets regulators including the MOF. IOSCO has been working to obtain agreement on a set of accounting standards that can be used to prepare reliable, high-quality financial statements that will satisfy the listing requirements in different countries. In 1995, the IASC agreed with IOSCO to complete a core set of accounting standards to be used for cross-border listings (Kino 1999, 90). The IASC finished the core set in 1998 through the issuance of new standards and the revision of existing standards in order to make them more comprehensive and to eliminate certain optional accounting treatments.

Financial Market Innovations
The need of companies and financial institutions to hedge against interest rate and exchange rate fluctuation risk by using derivatives has increased with economic internationalization and financial market deregulation. During the past two decades, rapid innovation in global financial markets has led to a dramatic increase in the types and uses of derivative financial instruments such as options, swaps, and futures. Combinations of derivative instruments to produce specific payoff patterns have become more prevalent, and users have spread to all sizes of financial institutions and non-financial companies. Global over-the-counter (OTC) derivative transactions in 1995 reached US$40.7 trillion in notional amount and US$1.7 trillion in market value, with Japan's activity being 20 percent of the worldwide notional amount and 37 percent of the global market value. Derivatives traded on exchanges totaled about 40 percent of the OTC activity, and Japan's exchanges constituted about one quarter of the worldwide total (Kusumoto 1997, 200).

The complexity of many derivative instruments has led to calls for greater transparency in financial reporting to ensure financial statement readers understand the purpose and risk structure of a company's derivatives. Accounting standards in Japan for derivative instruments have developed slowly. Japanese companies have been required to provide little detail information to shareholders regarding risk exposures, use of derivatives to address these exposures, market values of derivatives, or the quantification of a firm's potential gain or loss from hypothetical changes in market rates or prices.

C. Big Bang Financial System Reforms

Japan's position as a major financial market has rapidly declined in the 1990s. The Tokyo Stock Exchange's share of global stock trading dropped to 17 percent in 1995 from 41 percent in 1990. In contrast, after Great Britain initiated its financial Big Bang plan in 1986, the London Stock Exchange's share has shot up from 5 percent in 1985 to 17 percent in 1990 to 23 percent in 1995 (Katayama 1997).

Prime Minister Hashimoto announced major financial system reforms in November 1996 to counteract this decline in Japanese financial markets. Some Japanese government officials recognized the urgent necessity of reforms as they witnessed the continuing bad loan crisis of Japanese financial institutions throughout the 1990s and several financial-related scandals and bankruptcies. The first two parts of this section examine the bad loan crisis and the financial-related scandals and bankruptcies. The third part looks at the announcement and implementation of the financial system Big Bang.

Bad Loan Crisis
During the bubble economy from 1985 to 1989, banks extended a large amount of credit with land or buildings as collateral. When the stock and real-estate bubble burst in 1990, financial institutions were exposed to significant amounts of non-performing loans.

Throughout the 1990s, the MOF delayed recognition of banks' bad loan losses and expressed reluctance to take actions against troubled or insolvent financial institutions. For example, the collapse of the bubble economy especially hurt jûsen companies (financial institution subsidiaries concentrating in real estate lending), but the MOF allowed the jûsen to hold bad loans without special write-offs even though the Ministry had made examinations in 1991-1992 that revealed 67 percent of the jûsen's loans were already non-performing. With a plan to address the jûsen problem predicated on an increase in land prices, the MOF permitted various accounting practices that delayed or concealed reporting the effect of land and stock price declines on the value of reported assets. The extent of the problem did not finally get reported until August 1995, when 9.6 trillion yen of the total 13 trillion jûsen loans were considered non-performing, with 6.4 trillion yen deemed completely unrecoverable (Cargill, Hutchison, and Itô 1997).

Japanese companies' non-transparent financial reporting and the international financial market's perception of the high risk of Japanese companies have led to the 'Japan premium', which is additional interest Japanese companies must pay in order to borrow money in international markets. After three major Japanese financial institutions declared bankruptcy in November 1997, this premium exceeded one percent in December 1997 and remained over 0.5 percent for several weeks (Hall 1998, 186).

Beason and James (1999, 84) note that the opaqueness of Japanese financial reporting, compounded by the MOF's unwillingness to disclose the magnitude of the crisis, helped fuel unrealistic and irresponsible estimates of the magnitude of Japan's bad debt problem. However, the government seems to have realized that realistic reporting is preferable to unfounded speculation. The Bank of Japan's Deputy Governor (Fujiwara 1999) now admits the financial reporting weaknesses of the past:

. . . the dominant view used to be that 'disclosing the amount of non-performing loans required careful consideration because it might induce disturbance in the financial system'. In addition, the accounting systems and practices tended to obscure the real business condition of financial institutions. Such circumstances increased the lack of transparency with respect to the management of financial institutions, and, accordingly, accelerated the deterioration in the credibility of Japan's financial system as a whole.

Financial Scandals and Bankruptcies
Lax disclosure rules allowed financial institutions and other companies to hide questionable transactions and to conceal losses and contingent liabilities. Wide-scale financial scandals and bankruptcies throughout the early and mid 1990s put great pressure on the Japanese government to reform financial reporting rules and strengthen governmental financial supervision. Even after Prime Minister Hashimoto called for financial system reforms in November 1996 and the BADC announced several significant accounting reforms in June 1997, the scandals and bankruptcies continued since most of the announced reforms had not yet been implemented. This increased the pressure on the Japanese government to hasten implementation of changes to the financial system and financial reporting regulations.

In 1991, several Japanese securities firms, including the Big Four (Nomura, Daiwa, Nikko, and Yamaichi), admitted to the illegal practice of compensating favored clients for stock trading losses totaling up to 173 billion yen, in addition to other improper activities such as tax evasion and ignoring MOF directives. The Japanese Fair Trade Commission issued decrees against the Big Four securities firms ordering them to promise never to compensate clients for losses again and clearly stating that repeat offenses would lead to criminal sanctions (Hall 1998, 43; Taka 1996). However, the illegal compensation persisted after 1991, especially at Yamaichi Securities.

Thirteen Japanese financial institutions went effectively bankrupt during 1995. The magnitude of the bad loans at the failed institutions turned out to be much worse than previously reported. For example, Cosmo Credit Cooperative's 2.4 billion yen of non-performing loans reported prior to the institution's failure rose to 350 billion yen, and Kizu Credit Cooperative's previously disclosed 32 billion yen in bad loans grew to 800 billion yen. The financial institutions understated the extent of their non-performing loans by a combination of illegal fraud and of accounting trickery designed to produce misleading financial numbers but allowed under the loose disclosure requirements in place at the time (Ozaka 1998, 28-9; Schaede 1996).

Daiwa Bank disclosed a loss of US$1.1 billion due to unauthorized trading of US Treasury bonds over 11 years by an individual trader in its New York branch, which resulted in the resignation of the bank's top officials in October 1995, an order to close its US operations by February 1996, and a fine of US$340 million. Daiwa Bank pleaded guilty to misleading US bank regulators and obstructing justice by an attempted cover-up. The MOF ended up admitting after previous denials that it knew about the undisclosed losses six weeks before notifying US authorities (Hall 1998, 45-6).

In June 1996, Sumitomo Corporation announced that it had uncovered about US$1.8 billion (later adjusted upward to US$2.6 billion) in unreported losses related to unauthorized trades of copper futures by one of its employees. Sumitomo disclosed that the trader falsified books and records to conceal the unauthorized trades, but the competence and integrity of Japanese corporate management, as well as the adequacy of external supervision and audits, were again called into question by international financial market participants (CNNfn 1996a, 1996b; Hall 1998, 46).

The life insurance industry also experienced problems when stock prices dropped in the early 1990s. They had promised to pay policy holders annual returns of about 5 percent, but the major life insurance companies' returns on their investments in 1994 ranged from 1.3 to 3.5 percent, resulting in a negative spread. In April 1997, Nissan Life declared bankruptcy with its liabilities exceeding assets by more than 300 billion yen primarily due to previously undisclosed valuation losses on securities the company held. The MOF had received financial reports from Nissan Life for four years prior to bankruptcy which showed the company's negative capital position if hidden securities losses were included, but the company continued to solicit new insurance policies and make payments to existing policy holders since the MOF did not make public the company's precarious financial condition (Hartcher 1998, 160; Nihon Keizai Shimbunsha 1997, 154, 159; Ozaka 1998, 90-1).

In March 1997, Nomura Securities, the largest brokerage firm in Japan, admitted to making illegal payoffs to sôkaiya (corporate racketeers) to ensure they did not interrupt shareholders' meetings with embarrassing questions to company management. The firm also confessed to compensating preferred clients for trading losses. In addition to certain punitive actions, the MOF required implementation of a plan to improve compliance with laws and regulations, reinforce internal controls, improve internal operating procedures, and terminate all relationships with sôkaiya. As a result of the scandal, Nomura's president and 15 board members resigned, and the firm lost several key customers. Daiichi Kangyo Bank, Daiwa Securities, Nikko Securities, and Yamaichi Securities also suffered from MOF financial penalties and the loss of corporate customers as a result of payoffs to sôkaiya (Hall 1998, 44-5).

The scandals and bankruptcy of Yamaichi Securities, the fourth largest securities company in Japan, exemplifies the weaknesses in Japanese financial reporting and regulation. Yamaichi did not disclose significant off-the-book debts for several consecutive years, with the amount finally reaching more than 275 billion yen. The majority of these liabilities resulted from Yamaichi's guarantee of a minimum rate of return to favored customers and then illegally compensating them for any shortfall. In order to avoid disclosing significant losses on these liabilities, Yamaichi engaged in the illegal practice of tobashi in which they temporarily shifted their investment losses to another company's or client's books through repurchase agreements based on non-market prices. Yamaichi executed tobashi transactions with companies having fiscal years ending on a different date and with affiliated 'paper companies' that Yamaichi established specifically for this purpose and did not include in its consolidated financial statements (Ozaka 1998, 31-2; Shibata Hideki 1999, 241; Shôken Torihiki tô Kanshi Iinkai 1998). Yamaichi Securities declared bankruptcy in November 1997. In the same month, Hokkaido Takushoku, Japan's tenth largest bank, and Sanyo Securities, the seventh largest securities firm, also discontinued business.

In a survey (Keizai Kôhô Sentâ 1997), company employees throughout Japan gave the reasons why company scandals occur. The top four reasons given were (1) a company environment where it is difficult to point out a problem even when one exists (54 percent), (2) lack of awareness by management (53 percent), (3) unclear company ethics and standards of conduct (37 percent), and (4) lack of systems for checking within the company (34 percent). When asked what should be done to prevent reoccurrence of scandals, the top two responses were improvement of the company environment so that employees could point out a problem when one exists (58 percent) and implementation of a system of checking within the company (48 percent). The results of this survey indicate that increased disclosure requirements and audit reviews to prevent financial scandals may have limited effectiveness due to a company environment established by management that does not encourage problem disclosure and that does not clearly prohibit unethical and questionable actions.

Big Bang Announcement and Implementation
In response to the financial system weaknesses described in the previous sections, Japanese Prime Minister Hashimoto announced plans in November 1996 to accelerate and broaden financial reforms by creating 'free, fair, and global' markets. He called these reforms the Japanese Big Bang based on its similarity to Britain's 1986 Big Bang, which propelled the London Stock Exchange to increase its share of global stock trading nearly five times over the next ten years by deregulating the stock market, abolishing fixed commissions on securities transactions, and opening the stock market to foreign firms. Japan's Big Bang will not be restricted to the stock market but rather will encompass all financial markets in addition to significantly affecting non-financial companies in such areas as financial reporting and foreign exchange controls.

A principal objective of the reforms is to turn Tokyo into a world class financial center on par with New York and London. Japan's financial system Big Bang will break down barriers between banks, insurance companies, and securities firms; liberalize brokerage commissions and foreign exchange laws; reform the corporate accounting system; open the doors to foreign competitors and new financial products; and institute other measures to deregulate financial markets.

The principles of 'fair' and 'global' directly relate to financial reporting, and Prime Minister Hashimoto (1996) explained that 'global' covers the internationalization of accounting standards and that 'fair' covers full disclosure to protect investors and to achieve transparent, reliable markets. He called for thorough disclosure at all levels, from business accounting to government administration, to ensure fair markets, and he urged changes to the legal system related to derivatives as part of achieving an improved international financial market.

The Prime Minister instructed his Minister of Finance and Minister of Justice to immediately begin examining financial system reform and complete its implementation within five years. In response to Prime Minister Hashimoto's direction, the two Ministers directed the BADC, Securities and Exchange Council, the Financial Systems Research Council, the Insurance Council, and the Committee on Foreign Exchange Transactions to formulate plans for reform measures to be completed by 2001. In June 1997, these councils presented their recommendations for specific reforms with a schedule for implementation.

The Securities and Exchange Council's report (Shôken Torihiki Shingikai 1997, IV 2 (6)) called for full and transparent disclosure through consolidation and fair-value accounting principles in order to provide investors sufficient information to properly assess the risk and return of potential investments. The Council also urged the improvement and strengthening of the review by CPAs in order to improve corporate governance. Recognizing the need for investors to easily obtain disclosed information, the Council advocated providing information through the Internet.

As a result of the MOF's delayed response to address the bad loan problem and the improprieties of MOF bank inspectors reported in early 1998, the Diet approved establishment of the Financial Supervisory Agency (FSA), a governmental body independent of the MOF and reporting directly to the Prime Minister's Office. The FSA began operations in June 1998 by taking over from the MOF the regulatory functions of supervision and examination of private-sector financial institutions, with the MOF continuing to be responsible for planning and formulating policies for the financial and securities system. The MOF's other responsibilities, such as control of corporate financial reporting requirements and administration of the SEL, remained the same.

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

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