Japan has made great strides in modernizing its accounting standards. Now its auditors need to step up and use them decisively.
By Charles Smith
December 2002
Institutional Investor Magazine
Iwao Tomita doesn't exactly fit the model of a buttoned-up Japanese accounting executive. The semiretired 78-year-old senior partner of Deloitte Touche Tohmatsu often sports baggy, light-colored suits and prefers taxis to the chauffeur-driven limos favored by Japanese businessmen of his stature. His casual style extends to conversation, in which he's more likely to reminisce about his two years as a lieutenant in the Imperial Navy at the end of World War II than to weigh in on Japan's latest political or economic foible. But what most distinguishes Tomita from his accounting colleagues is a fierce independent streak.
Working in a system long notorious for allowing bureaucrats to order weak-kneed auditors to sign off on the accounts of shaky companies -- especially banks and securities firms -- Tomita is renowned for going his own way. In 1968 he co-founded Japan's first modern auditing partnership, Tohmatsu Awoki & Co., a forerunner of Deloitte Touche Tohmatsu. Tomita was still a full-time partner at Tohmatsu in 1999 when the firm declined to approve the accounts of Toho Mutual Life Insurance Co., a midtier life insurer that collapsed shortly thereafter. In the postwar period no Japanese firm had taken such bold action against a relatively large financial institution.
Tomita, who earned his MBA in 1963 from the University of Pennsylvania's Wharton School, is also credited with instituting Tohmatsu's prohibition against the practice of employing retired Ministry of Finance bureaucrats as senior executives. It is widely assumed that this sort of hiring, known as amakudari (literally translated as "descent from heaven" and referring to government officials' sudden arrival in the top ranks of an industry they once regulated), assured that auditors, until recently, were rarely prosecuted by their regulator, the MoF, when corporate clients failed. "We were the only firm that refused amakudari," says Tomita.
Since the mighty ministry fell into disgrace in 1998 for overseeing several botched bank rescues, other big kansa hojin, as the auditing firms are known, have quietly allowed their ex-MoF directors to resign. Today Tohmatsu, which refused to buy this kind of insurance against litigation in the first place, is the only member of Japan's Big Four accounting firms not caught up in the recent wave of criminal and civil suits brought against the auditors for initialing the accounts of failed companies.
Now, when he could be enjoying a quiet retirement, Tomita is again challenging Japan's accepted practices in accounting. With an ally, Yasuhisa Shiozaki, a former central banker who is now a member of Parliament for the ruling Liberal Democratic Party, Tomita is using his knowledge and contacts to push for the creation of a Japanese version of the U.S.'s Securities and Exchange Commission, with a brief to regulate Japan's capital markets and supervise the disclosure requirements, including auditing standards, for the country's roughly 3,500 listed companies. The proposal pits Tomita against the current accounting regulator, the Financial Services Agency, and senior members of the accounting industry, who would prefer less radical changes.
An independent Japanese SEC reporting directly to the prime minister, says Tomita, would guarantee the transparency of Japan's markets, because it would be free of the country's traditional bureaucratic entanglements. It would help attract more local and foreign investors, who could at last see and understand the financial condition of Japanese companies. And such a shift could also help reignite interest in Japan's dismal stock market, which has lost 75 percent of its value since 1989.
Greater transparency might accelerate Japan's progress toward an economy driven by its capital markets, rather than one in which capital is allocated by banks beholden to government bureaucrats. "What Japan needs to do now," says Noriko Hama, head of economic research at Mitsubishi Research Institute, "is to allow markets rather than banks to decide the allocation of resources." Why Japan hasn't made this transition already is clear to Tomita: "Lack of credibility of corporate accounts," he says, "is the main reason for the market's failure to attract investors, and that implies a lack of trust in external audits."
Tomita is hardly alone in pushing for reform. Even members of the FSA, which would prefer to keep auditing within its regulatory domain, agree about the importance of cleaner accounting: "What we are talking about here is something that goes to the root of the capitalist system" in Japan, says a senior FSA official.
The country has already made strides. "What was a medieval accounting system only four years ago has been dragged into the 21st century," says Timothy Marrable, former banking analyst for Crédit Agricole Indosuez Securities in Tokyo. Between 1998 and 2000 Japan adopted new accounting standards that rival those used in the U.S. and Europe. In 2000 the government got rid of the cozy regulatory system by taking financial accounting oversight away from the Ministry of Finance (it still regulates tax accounting) and giving it to the FSA. In 2001 legislation introduced by Shiozaki created the independent Accounting Standards Board of Japan, the nation's version of the U.S.'s Financial Accounting Standards Board. This month a blue-ribbon panel is expected to report to the FSA on the state of Japan's accounting industry with a long list of recommendations for solving problems that range from excessive corporate influence to conflicting legal guidelines to ambiguous rules. Next year the FSA will for the first time require auditors to offer opinions on their clients' business risks, a shift that is already making some accountants nervous.
But to fully utilize these new rules, Japan will have to devote more manpower to accounting. The FSA, for instance, has only 30 professionals working on financial accounting investigations, and this unit operates as a subsector of the Financial Markets Division, itself a subdivision of the agency's Planning and Coordination Bureau. And there are far too few trained accountants at work. At last count 14,322 Japanese CPAs were plying their trade; the U.S. has about 25 times that number. Even members of the Japanese Institute of Certified Public Accountants, the main trade group for auditors, privately estimate that Japan has about half as many accountants as it needs.
More important, the small, well-heeled group of CPAs needs to overcome decades of passivity and take control of its profession. It has to find ways to create not just more accountants but more number-crunchers with Tomita's spunk and drive who can tackle their expanded brief.
"Japanese auditors need to learn how to measure risk just like the rest of us," says Tetsuo Seki, chief financial officer and executive vice president of Nippon Steel Corp., Japan's largest steelmaker. "But how to produce an auditor who can do that successfully is a question we don't yet seem able to answer."
The country is running out of time to find a response. Recent U.S. scandals have prompted analysts to ask more-pointed questions about the adequacy of Japanese accounting. And the International Accounting Standards Board's pursuit of hard-nosed reform is also prodding Japan (Institutional Investor, July 2002). Lurking in the background is the Sarbanes-Oxley Act of 2002, which seeks an active U.S. regulatory role in reviewing both the external audits of foreign companies that list their shares in the U.S. as well as the auditing firms themselves.
"We have three years to decide" how to reorganize accounting and regulate the capital markets, estimates Seki. The urgency, he explains, also stems from the challenges Japan is facing from other Asian rivals, particularly China. Without a reinvigorated economy, Japan will have a hard time competing.
LIKE MOST ASPECTS OF MODERN JAPANESE LIFE, the state of the accounting business is a direct result of the country's postwar development planning. MRI's Hama explains that accounting practices were part of the "collusion and cohesion" that prevailed in Japan for more than 40 years. Keeping up the appearance of corporate health, she says, was far more important than presenting a warts-and-all picture of a company's financial status. A robust-looking corporate sector promoted social and political stability in the wake of Japan's devastating World War II defeat. Everyone contributed to Japan's command economy, which channeled private savings into a limited number of key industries through banks that could be guided and protected by bureaucrats. The job of an external auditor was to sign off on all results statements -- good or bad -- without qualifying notes.
The MoF enforced its hold on the auditing profession by requiring that all kabushiki kaisha, the Japanese companies that issue shares, file standardized annual results statements known as yuka shoken hokokusho with the ministry's local offices before annual shareholders' meetings. Until a couple of years ago, the MoF's local offices rejected any yuka shoken hokokusho lacking auditor approval. It was left to the company to fix the problem and refile.
Although this system started to break down in the late 1980s when banks overlent to real estate promoters, its legacy lives on in the accounting business. Long protected by their banks and their government, Japanese companies continue to keep their own books -- the role of outside auditors is to check the companies' figures. Says former banking analyst Marrable, "The problem is that corporations still call the shots," and they don't want to face difficult questions from an accounting firm.
If accountants do question bookkeeping methods, corporations aren't above "bullying" the auditors, says Marrable. Because the few full-fledged CPAs that do exist have so little leverage, auditing is a "cursory process," says Ross Kerley, a former U.K. treasury official who is now a managing director at PricewaterhouseCoopers Financial Advisory Services in Tokyo.
The dangers of this arrangement should be clear. Long-Term Credit Bank of Japan and Nippon Credit Bank were both given clean bills of health by auditors shortly before the government declared them insolvent and closed them in late 1998.
And even though they've been tightened, accounting rules still give Japanese companies leeway. An American CPA who works in Tokyo for a big European investment bank explains that "a U.S. consumer goods company that terminates a brand of shampoo would be required to include inventory write-off costs in its sales costs, so the impact would show up in the company's operating income. In Japan a similar company could do that or list the write-off costs as a nonoperating expense. The latter course would massage its bottom line." And that's the course most companies choose to follow.
Booking retail sales discounts as nonoperating expenses is another way in which Japanese companies can raise reported profitability at home. Toyota Motor Corp., Japan's largest carmaker and the Tokyo Stock Exchange's biggest stock by capitalization, declared an operating profit of ¥870 billion ($7.1 billion) by Japanese standards in the fiscal year ended March 2002 but ¥790 billion in its U.S. generally accepted accounting principles results. Why the difference? Discounts reported as sales costs in the U.S. accounts appeared below the line in the Japanese results.
These kinds of anomalies make it hard for investors to evaluate Japanese corporations. "In theory, auditors work for the benefit of shareholders. In Japan no one would claim that is the case," says PwC's Kerley.
Japan is hardly the only country in which companies have so much power: Consider Enron Corp.'s relationship with Arthur Andersen in the U.S. But the amount of accounting wiggle room and the number of pliant auditors is troubling. And the current batch of CPAs isn't particularly well suited to change this environment. "Japanese CPAs aren't used to asking corporations difficult questions. Their idea of their job is to check on the accuracy of figures handed out by corporate accounting departments who've already drawn up a full set of accounts," says Mitsuru Yoshikawa, director of law and tax research at Daiwa Institute of Research.
And even if CPAs were more assertive, there aren't enough of them to spend huge amounts of time poring over corporate books. This too reflects a long-standing government policy that regulates the number of CPAs created each year. Electronics giant Hitachi, which takes great pride in its high accounting standards, runs an internal program to put staff through the government-administered CPA exam. But rigorous training of new recruits doesn't ensure that the FSA will mint more CPAs. "Passing the exam isn't just a question of merit or memory," says Shigeru Watanabe, chief industry specialist on research and consulting at Nomura Research Institute. "It's a question -- or was until very recently -- of a deliberate decision by bureaucrats to keep the profession small."
The JICPA is attempting to address some of the qualitative issues, says its president, Akio Okuyama. The trade association is looking to set up a monitoring group to improve the standards of work done by its members. Already, the Big Four firms each contribute ¥16 million a year (smaller firms kick in lesser amounts), which goes in part to fund educational programs for auditors. The JICPA also has its own team of five that inspects member firms' operations. But that may not be enough. Some JICPA members say privately that a more formal group, like the U.S.'s new Public Company Accounting Oversight Board, overseen by the SEC, may be needed to ensure that audits are properly conducted.
Further complicating the CPAs' task is a confusing legal maze pieced together over the past century. There are different rules for different types of companies, and, in some cases, a single company has to comply with two or more sets of rules. The Shoho, or commercial code, based on a German model and enacted in 1899, applies to all companies with capital of more than ¥500 million or liabilities of at least ¥20 billion. However, this venerable accounting system doesn't recognize many standards that apply to kabushiki kaisha.
Because of its long tenure, the code has spawned an industry of Shoho gakusha, or commercial code scholars, a group of university professors who until the late 1980s were the primary source of guidance on accounting. They've also tended to uphold government policy. Reflecting its origins in a bank-oriented society, the Shoho's main operating principle is to make sure that companies can repay their debts. Beyond prohibiting insolvent companies from paying dividends, the code offers little assistance to shareholders or market-based reform.
A more modern set of auditing guidelines came in 1948 under orders from the U.S. occupation. The Securities Exchange Law, or Shoken Torihikiho, requires all Japanese companies that issue shares, the kabushiki kaisha, to produce accounts approved by outside auditors and is the reason Japan has CPAs at all today -- there weren't any before World War II. But the Shotoriho, as it's known, doesn't have the weight of the century-old Shoho and lacks the huge body of scholarship upholding that code.
And there's yet a third accounting system for tax purposes. Several standards in the Shotoriho are based on the tax accounting system and don't conform to international practices, says NRI's Watanabe. Institutional investors, he notes, often have trouble understanding the Shotoriho system used to account for mergers, which is currently "somewhere between" the pooling and purchase methods applied in other countries. The existence of three different -- and sometimes conflicting -- accounting schemes has tended to slow reform, says Watanabe.
VIRTUALLY ALL OF THESE COMPLEXITIES, AMONG other accounting issues, are expected to be addressed this month in the blue-ribbon panel's wide-ranging study. A senior member of the FSA says the report will take on everything from the role of external audits in strengthening capital markets to the permissible scope of activities that auditing firms can undertake to the internal structure of accounting firms and who is responsible when a firm faces legal action over an incorrect sign-off. Another topic: the proper oversight of accounting -- shorthand for whether the profession should be allowed to regulate itself, as the JICPA advocates, or whether it should be subject to external oversight, as reformers like Tomita and Shiozaki would prefer.
Will the FSA advisory committee's report usher in an era of transparency? The agency official says that the study will provide a blueprint for a further upgrade of Japanese accounting that will put the country's system on par with those in the U.S. and other advanced nations. Outsiders are skeptical. "One problem with government advisory committees," says Atsushi Kato, a senior partner at ChuoAoyama Audit Corp. who has served on a number of them, "is that they nearly always end up recommending what the government has decided it wants to do anyway." And even if the government develops a bold plan, says MRI's Hama, Japanese businesses will need time to adapt.
That's not to say that change isn't occurring. Since 1998 the FSA and the MoF have added deferred tax treatment, annual expensing of R&D costs, pension liabilities and mark-to-market accounting of financial assets to their existing list of items that corporations must show on their balance sheets. More important, consolidated financial statements based on a wide-ranging definition of what constitutes a subsidiary are now compulsory.
Nippon Steel's Seki says consolidated accounting is easily the biggest auditing reform Japan has seen in decades. Instead of handling cash flows separately at each company in the group, Nippon now operates a subsidiary, Nittetsu Finance Co., which keeps track of daily cash flow throughout the group and adjusts the group's position within its banks at the end of each day. Another subsidiary measures risk, keeping track of Nippon Steel's groupwide credit balance with trading companies and other business partners.
JUST HOW MUCH PROGRESS CFOS AND CPAS HAVE made in the past few years is likely to get a stiff test shortly. The FSA has decided that "going concern" auditing will become compulsory for the accounts of Japan's current fiscal year -- which auditors sign off on in April or May 2003. This measure mandates that auditors express "qualitative" opinions on potential problems at their clients' businesses. These problems can include anything from whether the company can repay bank loans to the impact of a patent expiration. A senior partner at one of the Big Four accounting firms, who requested anonymity, says this switch could turn into a "nightmare" because overly lenient auditors could face lawsuits from shareholders if a company fails, and accountants who are too strict could find themselves with angry clients.
Akito Toi, director of corporate accounting at the Ministry of Economy, Trade and Industry, takes a more measured view. The narratives offering the accountants' qualitative judgments may take a while to match the value of the auditors' quantitative assessments, but they will eventually catch up, he says.
Although its impact is likely to be less dramatic, the U.S.'s Sarbanes-Oxley Act, passed on July 30, requires all foreign firms that audit companies listed on a U.S. stock exchange to undergo inspection by the SEC, or a nominated body, every three years or less. This inspection will include checks on audits of all individual listed companies and a more general look at standards within foreign auditing companies.
Kazuyuki Ohmori, representative partner at Asahi & Co., one of the Big Four auditing firms, says an SEC inspection could create enormous "psychological strain" for Japanese auditors, as well as "skyrocketing" costs for Japanese companies. One fear is that such reviews will highlight just how much less time Japanese auditors spend on projects than their U.S. counterparts. The JICPA has expressed its own concerns about the extraterritorial nature of the Sarbanes-Oxley measure. The hope is that the JICPA will be allowed to carry out inspections on behalf of the SEC, but that's far from certain.
Of course, a credible Japanese version of the SEC might fulfill that role. Although their proposal faces long odds, Tomita and Shiozaki have picked up some important support. In May Japan's largest big-business federation, Keidanren, (renamed Nippon Keidanren after a recent merger), endorsed the concept of a "Japan SEC" to act as a stock market watchdog and supervisor of disclosure by listed companies. It, too, wants these functions separated from the FSA and assigned to an independent body with a private sector head appointed by the prime minister. Another influential backer: the American Chamber of Commerce in Japan, which in September asked the government to create a "genuinely independent" securities market regulator to protect investors. Among its other points, the ACCJ notes that an SEC-style regulator would help channel more of Japan's ¥14 trillion of household savings into productive investment. At present 55 percent of these savings sits in bank accounts. Shiozaki says he's further encouraged by the fact that he's getting progressively more favorable soundings from senior ministers about the idea.
Will it happen? A number of critics think it's impractical to expect politicians and taxpayers to support a huge new agency and hire thousands of regulators with Japan in such straitened circumstances. And because bank reform is so urgent, it will be late 2003 at the earliest before the creation of a securities regulator gets a full hearing, say those who are tracking its progress. Undeterred, Tomita says there's little choice but to embrace changes even if the government drags its feet: "Japan has become an economic superpower, but [many of] its systems and structures are that of a fourth-grade state. We have to change . . . to match our status. But bureaucrats show no sign of changing the status quo."
They may have met their match in Tomita.
