In response to Prime Minister Hashimoto's call for financial reporting reforms, the BADC reorganized in February 1997 by designating the Accounting Division to work on a new standard for consolidations and by setting up special groups to deal with corporate pensions, financial instruments, and R&D costs. The BADC took into account international harmonization when establishing new standards or revising existing ones, and the Council carried out research into accounting practices in other major industrialized countries, as well as International Accounting Standards (Maki 1997, 70). In the one-year period between June 1997 and June 1998, the BADC issued more accounting opinions than in the previous ten years (Hiramatsu 1998, 25).

In the new accounting standards, the BADC pointed out the need for reform of Japan's financial reporting system in order to enable investors to make better informed decisions based on a more accurate representation of a company's financial condition and operating results. The new standards also specifically mention the objectives of promoting the participation of foreign and domestic investors in Japan's securities markets and of establishing a disclosure system on par with international standards and based on consolidated financial statements (Kigyô Kaikei Shingikai 1997a, 1999).

In June 1997, the BADC issued accounting opinions on consolidated financial statements, financial instruments (interim report), income tax accounting, cash flow statements, R&D costs, and interim financial reporting. The BADC published its pension accounting standard in June 1998 and its final version of the financial instruments accounting standard in January 1999.

This chapter critically examines these recent accounting changes and their effects. Part A analyzes the revisions in the three key areas of consolidations, fair-value accounting, and pension accounting. Part B explores the responses of companies to the accounting changes. Part C points out several weaknesses in Japan's financial reporting system that will remain after complete implementation of the Big Bang financial reforms and the accounting standard changes.

A. Examination of Accounting Changes in Three Major Areas

The new accounting standards issued between 1997 and 1999 have drastically changed the rules by which companies must report their financial condition and operating results. Although this section only reviews the changes made in the three major accounting areas of consolidations, fair-value accounting, and pensions, the BADC issued new standards in other significant areas of accounting. For example, R&D costs now must be reported as current period expenses, with companies no longer having the option to defer the reporting of expenses by capitalizing R&D costs.

Consolidations

When the new rules take effect, Japanese parent companies will be forced to make decisions based on their effect on the entire business group, and they will have great difficulty carrying out transactions with non-consolidated subsidiaries and affiliates such as executing tobashi transactions to hide troubled assets, increasing sales and profits through intercompany transactions, and transferring excess personnel.

Some limited consolidation reporting requirements went into effect before fiscal year 1999. The new rules on consolidations required companies to disclose contingent liabilities on a consolidated basis starting for fiscal year 1998. The MOF also required a consolidated marketable securities report starting for fiscal year 1997.

The 1997 BADC standard on consolidation accounting expands the number of subsidiaries required to be consolidated, and the BADC issued a statement in October 1998 with more specific guidance to determine whether a parent company has effective control of a subsidiary or can substantially influence an affiliate's decision making. A parent company must use consolidation accounting for an entity in any of the following situations (Kigyô Kaikei Shingikai 1998a; Yoshii 1999a, 63):

(1) Parent company holds more than 50 percent of other entity's voting shares of stock (with limited exceptions such as a bankrupt entity that the parent company no longer effectively controls)
(2) Parent company holds between 40 and 50 percent of voting shares and one of the following conditions is met:

(a) More than 50 percent of other entity's voting shares held by parent company and other companies with a close relationship to parent company through investment, personnel, technology, business transactions, or other factors
(b) Majority of other entity's board of directors made up of current or former employees of parent company
(c) Parent company controls important financial or operating policies of other entity (for example, through franchise, license, technical assistance agreement, or subcontracting relationship)
(d) Majority of other entity's liabilities provided by loans (including loan guarantees and collateral) from parent company or closely related companies (see definition above in (2)a.)
((e) Existence of other factors that indicate parent company controls other entity

The new rules on consolidations also cover the determination of affiliated companies subject to the equity method of accounting. Rather than use of a strict 20 to 50 percent ownership criterion to determine when equity accounting should be applied, the new standard requires that the ability to substantially influence an entity's decision making also be considered when determining whether the equity method should be applied to affiliated companies. Specifically, a parent company that owns 15 to 20 percent of an entity and meets one of five specified conditions must apply the equity method to the entity's earnings (Kigyô Kaikei Shingikai 1998a).

The new accounting standard on consolidations will significantly increase the number of subsidiaries that parent companies will be required to consolidate. For example, Tôkyû Dentetsu will increase the number of consolidated subsidiaries from about 200 to 300 (Komiya 1999, 25), and Kawasaki Steel will expand the number of consolidated subsidiaries nearly four times to 200 starting in the fiscal year ending March 31, 2000 (Nikkei Kin'yû Shimbun 1999a, 1).

The 3-5 percent materiality rule for non-consolidation of subsidiaries and for non-inclusion of the parent company's share of affiliated companies' net income still remains in effect (Kawamura 1999a, 7 September; Ôta 1998, 80), which means corporations still have an opportunity to intentionally exclude certain subsidiaries and affiliates from their financial statements. In contrast, American and European companies consolidate all subsidiaries as a common business practice (Shiratori 1998, 182, 196-7).

Fair-value Accounting

In January 1999, the BADC completed its new standard for financial instruments. The accounting for changes in fair value differs depending on the type of security, and the following section summarizes the basic rules (Kigyô Kaikei Shingikai 1999):

(1) Trading securities are measured at their fair value, and any unrealized gains and losses are included in earnings reported on the income statement. Trading securities include stocks and debt securities held principally for resale in the near future with the objective of generating short-term profits.
(2) Debt securities that management intends to hold to maturity are measured at amortized cost, so a company does not report gains and losses for changes in market value.
(3) Subsidiary or affiliate stock held by a parent company is reported at historical cost. In consolidated financial statements, the parent company consolidates the assets and liabilities of subsidiaries and applies the equity method of accounting to affiliates.
(4) Available-for-sale securities include investments in securities not classified as (1) to (3) above. A company may hold these securities for maintaining relations with the invested entities or may hold them for selling depending on market conditions. This category of securities includes cross-shareholdings so common among Japanese businesses. A company must measure these securities at fair value, but unrealized gains and losses are reported in a section of shareholders' equity on the balance sheet rather than in earnings on the income statement.

The BADC's new comprehensive standard on financial instruments covers several other topics. One section addresses deferral of gains and losses on financial instruments used to hedge against such market risks as exchange rate, price, or interest rate changes. Another section gives guidelines on estimating loan losses by categorizing loans into three groups: normal, doubtful, and failed.

The new rules on accounting for financial instruments do not go into effect until fiscal years beginning on or after April 1, 2000. The full implementation of the rules for reporting gains and losses on available-for-sale securities has been deferred even further to one year later. The Keidanren strongly argued for this deferral because they believe the effects of suddenly recording cross-held stock at fair value would be too great in this current period of depressed stock prices, and companies need time to implement strategies to get rid of certain cross-stockholdings (Murakami 1998, 26; Nihon Keizai Shimbun 1998, 17).

BADC Chairman Wakasugi (1999b, 17) says it was important to first introduce fair-value accounting in whatever form, but he believes the lack of consistency in reporting gains and losses for different types of stocks will probably lead to criticism from overseas. He personally believes that fair-value accounting should be applied to all types of stocks to prevent company management from having the ability to significantly control reported profits. In addition, Wakasugi supports reporting all gains and losses on the income statement rather than recording gains and losses on available-for-sale securities directly to the equity section on the balance sheet. In contrast, the Keidanren criticizes the method of reflecting market valuations of stocks on the income statement, saying 'it's strange to have business results influenced by market price levels not connected with management's efforts' (Nikkei Business 1997a, 93).

Lax reporting standards have made it difficult to do a true accounting of the amount of non-performing loans held by Japanese financial institutions, but the government finally adopted a broader definition of bad loans for financial institution reporting as of March 1998. The new regulations require a wider range of disclosure of actual and potential non-performing loans, similar to standards required by the US SEC. For example, past due loans in arrears by three months or more must now be reported as a bad loan, whereas the previous rules used a less stringent criterion of six months or more. The FSA reported 35 trillion yen as the estimated total of bad loans for all financial institutions as of March 1998, whereas the amount would have been only 25 trillion yen under the previous reporting rules. In addition, the FSA also disclosed 66 trillion yen of loans requiring close monitoring and risk management to ensure they do not become non-performing (Kin'yû Kantoku Chô 1998b). However, the estimate of 35 trillion yen still turned out to be low, with the Japanese government spending about 70 trillion yen through May 1999 to cover the losses incurred by financial institutions disposing of non-performing loans (Fujiwara 1999).

Although the new accounting rules require fair-value accounting for some financial instruments, companies still do not have to disclose the fair value of their land holdings and other fixed assets.

Pension Accounting

The new pension accounting standard provides a hardship exception that allows companies to extend implementation until fiscal years beginning after March 31, 2001. The standard states the exception applies to companies with hardships in applying the standard by the required date because of problems in arranging for actuarial services (Kigyô Kaikei Shingikai 1998b, Section 5.1). However, companies must still publish the pension liability and other details in their financial statement footnotes for fiscal year 2000, even though they are not required to reflect the pension liability on the balance sheet and pension expense on the income statement.

For fiscal years 1998 and after, the Ministry of Health and Welfare permitted more flexibility in setting an expected rate of return on pension plan assets. Rather than mandating a 5.5 percent return, the Ministry allowed more flexibility in setting the expected return by allowing each fund to choose a rate between an upper limit of 6.5 percent, which will expire after fiscal year 2001, and a lower limit based on the average interest rate of ten-year government bonds issued in the prior five years (Imafuku 1998a, 217). The previous minimum 5 percent return specified by a Corporate Income Tax Law regulation was also reduced, and the minimum rate in 1999 is 1.5 percent (Kawamura 1999a, 9 October). The use of a lower interest rate to calculate a company's pension liability leads to a more realistic and higher annual pension contribution and expense.

B. Effects of Accounting Changes

The recent accounting changes are having a profound effect on Japanese companies. This part discusses the reactions and responses of companies to the BADC's significant accounting changes announced from 1997 to 1999.

Corporate Restructuring

Itô (1998, 30) comments that the introduction of the new accounting standards will have severe impact on corporations' reported financial results and near-term employment for two reasons. First, most companies' stockholders' equity and assets will expand with the implementation of fair-value accounting, which will cause their return on equity (ROE) and return on assets (ROA) to fall. Institutional investors will not permit this, so companies will have no other choice but to generate profits by selling their cross-held stock so their ROE or ROA does not drop. Second, company groups will not be able to avoid restructuring since the new standards force them to consolidate the results of some poorly performing companies not previously consolidated. A March 1999 survey by the Nihon Keizai Shimbun found that leading OTC companies believe the requirement for consolidated disclosures is the change that will impact them the most (Hara 1999, 17). The new BADC consolidations standard will put pressure on employment in the short-term as company groups seek to restructure before the end of their fiscal year at March 31, 2000, when the new consolidation accounting rules must be applied.

With Japanese companies' divestitures of unprofitable business units and subsidiaries and with the dismantling of barriers to foreign acquisitions as part of the Big Bang financial system reforms, acquisitions of Japanese firms by foreign companies increased over six-fold from US$1.1 billion in 1997 to US$6.9 billion in 1998, although Japan still has an extremely low share of the total 1998 international M&A activity of US$544 billion (KPMG 1999). Shibata Yôko (1998, 44) explains that recessionary conditions have led to M&A growth in Japan, but 'changes in accounting regulations are playing an even more important role' as companies will no longer be able to hide unprofitable subsidiaries and affiliates, which creates a powerful incentive to sell these companies.

Japanese companies will be pressured by investors to shed stocks in subsidiaries and affiliates that do not improve their return on equity (ROE). Goldman Sachs Securities estimates that the ROE for first-tier companies listed on the Tokyo Stock Exchange will fall to 0.45 percent when they begin to record true pension expense and apply fair-value accounting to marketable securities (Nikkei Business 1999, 27). This return does not even exceed the rate companies can earn in fixed-income securities, so many companies are considering seriously the sale of their stocks in underperforming keiretsu-related companies. Keidanren leaders have pointed out that when companies apply fair-value accounting to cross-shareholdings, shareholders' equity will greatly expand, which will cause financial indicators such as ROE to deviate greatly from international standards. As a result, a company's credit rating may fall, which will lead to problems in raising capital (Kino 1999, 91).

With the Big Bang financial reforms deregulating the Japanese financial markets and encouraging greater participation by foreign companies, several foreign financial firms have expanded their presence in the Japanese market since 1997. Large financial institutions such as GE Capital Services, Citigroup, Dresdner Bank, and Merrill Lynch have made substantial investments or have established joint ventures with Japanese companies to provide services for specific financial market segments.

Despite the recent increase in investments by foreign companies, some investors still have not been able to satisfy themselves that they have identified all company financial risks even with a detailed due diligence process. This non-transparency in Japanese financial reporting continues because the first significant accounting changes, namely those related to consolidation accounting, will not get reflected in companies' financial statements until the fiscal year ending March 31, 2000. As an example of foreign investors shying away from the purchase of Japanese companies, DaimlerChrysler expressed great interest in purchasing Nissan Diesel Motor Company in 1998, but the deal eventually fell through with a principal reason being that DaimlerChrysler had great difficulty ascertaining the amount of debt and contingent liabilities not disclosed in Nissan Diesel's consolidated financial statements. The undisclosed liabilities in Nissan Diesel Sales, an unconsolidated subsidiary owned 50 percent by Nissan Diesel, and in Nissan Diesel's 48 keiretsu-related dealers totaled at least 100 billion yen, and some industry estimates put the figure as high as 300 billion yen (Masui 1998, 94).

Revisions to Post-employment Benefits

Companies may try to reduce their future pension liabilities by moving from a defined benefit pension plan to a defined contribution pension plan like the US's 401(k) plan, which specifies the amount the company will contribute to the plan but does not guarantee or define the final benefit amounts to be received by employees. However, unlike the US's 401(k) plans, the Japanese tax system does not allow tax deferrals of contributions and investment earnings for defined contribution plans. Starting in 1999, Japan's leading temporary employment agency, Pasona, will introduce the first American-style defined contribution plan in Japan for its regular employees and for over 50 thousand of its employees contracted out to other companies. Employees may make monthly contributions from 3 to 15 percent of their salary, and Pasona will match the contribution with 1 to 8 percent of monthly salary based on an employee's seniority. Employees have the choice of several investment options varying in risk and expected return (Ueda 1998, 30). Saison Group also plans to move toward a defined contribution pension plan that will lighten the company's current burden by having pension payment amounts vary according to the plan's investment returns (Nikkei Ryûtsû Shimbun 1999, 1).

Several companies have decided to quickly address their pension shortfalls and to disclose pension financial information even before the required implementation of the new accounting standard. For example, Tokyo Gas will record 14 billion yen of total expenses for fiscal years 1998 and 1999 to ensure the company has already recognized the appropriate liability amount when the new standard goes into effect in fiscal year 2000. The company also has reduced its expected return on pension assets from 5.5 percent to a more conservative 4.5 percent. Toshiba decided to record a 27 billion yen extraordinary loss for fiscal year 1998 by shortening the amortization period for prior service liability from 15 years to three years, which is the shortest period allowed by the Japanese taxing authorities to obtain a valid deduction for tax purposes. Although several large companies are addressing their pension shortfalls through additional contributions, the majority have postponed action (Nihon Keizai Shimbun 1999b, 5; Yamashita 1999, 19).

Since the abolishment of the 5:3:3:2 asset allocation rule by the Ministry of Health and Welfare in 1998, pension funds have been free to attempt to improve investment returns by increasing equities and foreign securities holdings rather than maintaining the majority of fund assets in domestic fixed-income securities. However, almost no funds have made radical shifts in asset weightings (Beason and James 1999, 135-7). As a result, many companies will be facing large pension liabilities when the new standard goes into effect in fiscal year 2000.

C. Remaining Weaknesses

Section III.A. pointed out several criticisms of the new accounting standards for consolidations, fair-value accounting, and pensions. Moreover, even after implementation of the new accounting changes, several other significant weaknesses in Japan's system of financial reporting and accounting will remain. This section examines areas where shortcomings will still exist: the Japanese government's unwillingness to radically change, the unchanged triangular legal system, several significant differences with international accounting standards, the MOF's control over corporate financial reporting requirements, and deficiencies in the auditing and corporate governance systems.

The government continues to manipulate financial reporting rules for political purposes. For example, in 1998 and 1999 the government approved two major temporary changes in accounting requirements in order to provide relief for banks and insurance companies and to ensure financial system stability. First, the Diet approved amendments to allow companies to revalue land upward from cost to market value for fiscal years 1997 and 1998. This provided banks the opportunity to cover the write-off of bad loans and to improve the ratio of capital to total assets to the minimums established by Japanese banking regulations and the Bank for International Settlements (BIS). If the 19 largest banks took advantage of this rule change, the total land value recorded on their books will increase 4.3 trillion yen based on estimated market values at April 1998. The banks will be able to improve their capital ratios by about one percent on average. In addition to the revaluation exception, for fiscal year 1997, the MOF permitted banks to utilize the cost method rather than the lower-of-cost-or-market method to value stocks so they would not have to report valuation losses. However, banks had to recognize losses if the market price for a stock fell below 50 percent of the bank's book value recorded at historical cost. In prior fiscal years, the MOF had required financial institutions to value marketable securities using the lower-of-cost-or-market method, although non-financial companies were allowed to use the cost method. As a result of the relaxed rules on marketable securities valuation, 16 of 19 of the largest Japanese banks switched from the lower-of-cost-or-market method to the cost method for the fiscal year ending March 31, 1998. As of August 1998, the 16 banks using the cost method to value stocks held an estimated total of 3.2 trillion yen in hidden losses (Hiramatsu 1998, 26-9; Isoyama 1999, 19).

A top MOF official (Naitô 1999, 17), when questioned how Japan will recover its international credibility after these actions, answers that these were exceptional steps carried out for a limited time to strengthen banks' capital and to address Japan's credit crunch. He further explains that in the short term the MOF had to succeed in stabilizing the financial system, and beyond these measures the MOF will not play with the system to provide banks relief.

Triangular Legal System

Ishida (1998, 14) contends that, from the standpoint of a company trying to follow the laws, it is desirable to implement consistent accounting treatment and disclosure that will conform to either the CC, SEL, or Corporate Income Tax Law, because the company has only one actual financial condition and results. In addition, other interested parties such as stockholders, creditors, investors, and the government would also be expected to find such consistency to be highly useful.

Although the MOF and MOJ formed a study group in 1997 to investigate coordinating the CC and the BADC accounting standards, the group made no recommendations in its 1998 report to require companies subject to the CC to comply with the new BADC standards (Shôken Kyoku 1998). The Diet did pass CC amendments in 1999 that allow companies to measure marketable securities and derivatives at fair value, cost, or the lower of cost or market. Even though the new BADC standard requires listed companies to generally measure marketable securities and derivatives at fair value, the CC continues to allow non-listed companies to measure them at cost or at the lower of cost or market. Moreover, the BADC consolidation and pension accounting requirements still only apply to listed companies subject to the SEL (Kawamura 1999a, 9 July; Maki 1997, 70)

Differences with International Standards

BADC Chairman Wakasugi (1999b, 17) has expressed his dissatisfaction with the BADC's lack of independence due to the MOF's control over agenda topics covered by the BADC. For example, he personally thinks that impairment accounting for long-lived assets definitely should be implemented, but the BADC has no opportunity to consider what topics should be addressed next. According to Wakasugi, the MOF's explanation is that the submission from the MOF of problems to be considered has been established as the BADC's basic method of operating. He has advocated for a long time that there should be a forum to discuss from a broader viewpoint how the BADC should address issues of the entire accounting system.

Contrary to Wakasugi's opinion, a top MOF official argues that although other countries may have independent non-governmental bodies to set accounting standards, Japan's BADC is carrying out its functions well. The BADC Chairman is an independent scholar, and the Council's members are selected from a wide range of people such as CPAs, company representatives, financial analysts, and academics. 'It's different than an ordinary government Council; the BADC has strong independence. It issues exposure drafts before making a standard, and it prepares specific written opinions based on views from all interested parties.' (Naitô 1999, 17)

Auditors and Corporate Governance

The boards of directors of almost all Japanese companies continue to be made up entirely of executives from the company itself or from keiretsu-related financial institutions and non-financial companies. Most Japanese companies lack an effective corporate governance system that makes company executives accountable to shareholders by having the board of directors critically review company strategies, monitor company top executives to prevent unlawful behavior, and dismiss top executives if necessary. A few companies have started to include outside directors and have reduced their board size to hold the directors more accountable. For example, Sony has reduced its board size from 36 to 10 with three outside directors (Ozaka 1998, 264).

The internal audit function at Japanese corporations also requires improvement to be more effective in identifying financial problems and internal control weaknesses. In contrast to the US where rigorous, technically-competent internal audits are carried out by company employees, in Japan where harmony (wa) is treasured as a cultural value, the lifetime employment system and seniority-based wage system established in large companies continue to present an obstacle to effective internal audits by fellow employees (Yokoyama 1999e).