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Corporate Governance in ContextCorporations, States, and Markets in Europe, Japan, and the US$

Klaus J. Hopt, Eddy Wymeersch, Hideki Kanda, and Harald Baum

Print publication date: 2005

Print ISBN-13: 9780199290703

Published to Oxford Scholarship Online: March 2012

DOI: 10.1093/acprof:oso/9780199290703.001.0001

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The Changing World of the CPAs in Japan

The Changing World of the CPAs in Japan

(p.663) The Changing World of the CPAs in Japan
Corporate Governance in Context

Hiroshi Oda

Oxford University Press

Abstract and Keywords

This chapter discusses CPA system reform in Japan. The necessity for reform of the accounting system, aimed at increased transparency for investors, has been recognised in Japan for some time. It coincided with the Japanese Big Bang, a major reform intended to create a free, fair, and global financial system. In the late 1990s, the reform proposals became broader in scope following growing criticisms of the profession concerning the CPAs' failure to expose the window-dressing which brought down some securities companies and banks. These proposals largely resorted to self-regulation by the Japan Institute of Certified Public Accountants (JICPA). The JICPA accordingly introduced various measures to increase the effectiveness of the audits by the CPAs. However, after the Enron/WorldCom affairs, influenced by the US, the tide seems to have changed. Further reinforcement of the independence of the CPAs from the client companies, and above all broader grounds for interference by the government, were proposed and eventually became law. The amended CPA Law has been significantly influenced by the Sarbanes–Oxley Act, although the profession has managed to reach some compromises.

Keywords:   accounting, CPA law, auditing, accountants, Sarbanes–Oxley Act

  1. I. The Background to the Reform

  2. II. The Amended CPA Law

  3. III. Measures to Increase the Effectiveness of the Audit by the CPAs

  4. IV. The Independence of the CPAs’ Audit from the FSA – the Resona Bank and the Ashikaga Bank Cases

  5. V. Conclusion

I. The Background to the Reform

In Japan, accountancy as a profession was introduced in 1948 when the Securities and Exchange Law was enacted.1 A professional body – the Japan Institute of Certified Public Accountants (JICPA) – was founded.2 As of 1 March 2004, there were 14,826 accountants and 151 accounting firms.3 Not many changes occurred for half a century, but since the late 1990s the profession has been going through a rather difficult time. This culminated in a major amendment of the Law on CPAs in 2003. This was not necessarily a result of the US Sarbanes-Oxley Act4 (hereinafter, the SOA); in fact, some reforms preceded the SOA. Japan had its own problems and was addressing them, although in a gradual manner. In a way, one might say that the reform which had already started in Japan was distorted by the SOA.

For many years, the Japanese accounting and audit system was not seen as reflecting the true state of the finances of listed companies. There were instances where the same company prepared financial statements in accordance with both the Japanese standards and the US standards. While the company was in the red under the US standards, it was profit-making under the Japanese standards. Such discrepancies have led to the requirement of a ‘legend’, a footnote to the audit report, stating that the financial documents have been prepared under the Japanese standards, a practice which started in 1999. In the audit report, which is attached to the English annual report prepared by the Big Five accounting firms, a footnote that the financial statements and the audit report have been prepared in (p.664) accordance with Japanese accounting standards and audit practices was added. Other countries which were required to attach a legend were Korea and Indonesia; this undermined the credibility of the Japanese system.5

In a survey of 3,500 public companies by the Ministry of Economy, Trade and Industry in 2002, 36.7% of the companies prepared the annual report in English. Of the companies which prepared an annual report in English, 6.1% used the US standards, while 0.8% used the IAS. The rest of the companies resorted to the Japanese standards. Of those companies, 52% responded that there was a legend attached to the audit report.6

In the first place, this was a problem of accounting standards. Japan has been slow to harmonise accounting standards with international developments. It was only in 2001 that the consolidated accounting system was introduced in company law accounting, although this had been a requirement of the Securities and Exchange Law for some years. The evaluation of assets at current value was also introduced, but there are various exceptions.

In the above-cited survey, although 54.5% of the companies support the recent changes to the accounting standards, 21.1% are of the view that the changes do not suit business practices in Japan, and 38.8% consider that the changes are happening too fast. It is more or less the perception of businesses that the changes in the accounting standards affect company management. More than 54% of the respondents confirmed that the 1999 standards on financial products had some effect.

There is still some resistance against introducing changes to the accounting system. When the chairman of the JICPA was in discussion with the members of the parliament, he was told that the recession was caused by the accounting standards and the audit system!7 In the wake of the financial crisis which began in 1997, the government delayed the changes to the accounting standards in order to avoid further collapse of the banks. There was concern among the bureaucrats and politicians at that time that a full implementation of the accounting reform would affect the banks. Such views still remain. The latest example of resistance relates to the introduction of the impaired accounting system. The ‘financial policy project team’ of parliamentary members from the ruling political party has urged the Accounting Standard Board of Japan to defer the introduction of the system, and has also proposed that the current value accounting of securities held for the long term should be optional, but this was eventually rejected by the board.8

(p.665) The necessity for the reform of the CPA system was already recognised in Japan in the 1990s. After all, the last major reform of the CPA Law took place in 1966; since then there have been no major changes to the system.

In 1996, on the eve of the 50th anniversary of the CPA Law, a reform of the accounting system came onto the agenda. There was a proposal for reforms by the JICPA. Already at that time, in the wake of the housing credit institution (Jusen) problems and the collapse of regional financial institutions, doubts were raised concerning the reliability of auditing by the CPAs. This concern was shared by the CPAs themselves, and thus proposals were made in order to regain the confidence of the market participants.

The CPA Review Board, which was attached to the Ministry of Finance at that time, took up the JICPA proposals, and after some deliberation it published a ten-point proposal for reform.9

The proposals were based upon the perception that in order to galvanise the securities market, truthful disclosure was indispensable, and that this could be achieved by addressing the accounting standards and audit practice. The introduction of a quality control of audits, peer reviews of the US type, and continuous training systems was proposed.

Conspicuously lacking was any reference to measures ensuring the independence of the accountants from the companies they audit, which can be found in the later arguments and in the amended CPA Law. This only became an issue after the financial crisis in 1997, which cast doubt on the capability and independence of the CPAs in performing their role in relation to the failed companies.

It was proposed that information should be provided in the audit report regarding matters which significantly affect the issuer as a going concern. This was a significant step forward from the existing practice.

On the other hand, the goal of the report was to ‘remove concerns regarding the CPA audit held by market participants by strengthening voluntary measures by the CPAs’. There was little discussion of any strengthening of government supervision over the profession.

The move for reform coincided with the Japanese ‘Big Bang’ – a major reform of the financial system which was launched in 1996. The Big Bang, which encompassed the banking, securities, and insurance industries, was aimed at the creation of a free and fair financial market open to the global market. This included increased competition between financial institutions (and the gradual dismantling of the barrier between banking and securities businesses), the diversification of the means of corporate finance, and the creation of a fair and transparent market. One underlying idea was the shift from the bank-dominated financial system to a system resorting more to the securities market. This presupposes that investors are provided with accurate information concerning the financial (p.666) state of the companies. The improvement of the accounting system was regarded as essential for this purpose. This naturally worked in favour of the reform of the CPA system.

There were also some negative incidents which enhanced the CPA reform. In 1997 a major financial crisis began to unravel. After the collapse of a medium-sized securities company, one of the 19 ‘city banks’ collapsed, followed by the termination of business by Yamaichi Securities. Two long-term credit banks failed the next year and a significant amount of public funds was injected into the banks. The problem was that the banks and securities companies which had failed had all had their accounts audited by CPAs and had been given a ‘true and fair’ opinion without any qualification before the collapse. There was growing criticism not only of the government and the industry, but also of the CPAs.

Yamaichi Securities, one of the Big Four securities companies, applied for bankruptcy and was declared bankrupt in 1999. The company had concealed losses by shifting them to domestic and overseas ‘paper companies’. An independent body set up to investigate the incident after the collapse found that the CPA was also responsible for having failed to detect the problem. Administrators brought an action vis à vis the accounting firm, Chuo, for compensation amounting to 6 billion yen. The accountants were accused of neglecting their duty, which resulted in their failure to detect the window-dressing by the management.10 The parties ultimately settled in 2004. The accounting firm agreed to pay back five years’ worth of fees without acknowledging any fault on their part.

The progress of the CPA reform slowed down after 1998. It was only in June 2000 that a sub-committee of the board published an interim report on the ‘direction of the reform’.11 This was an outcome of the discussions of the expanded working group set up in April 1999 and of the board sub-committee since December 1999. Then, in January 2001, the prime minister formally consulted the Financial Systems Council on the review of the CPA system.

The interim report of June 2000 was based upon the premise that in order to increase the credibility of the disclosure of financial information by companies with the aim that companies could be financed smoothly in and outside Japan, it was important to improve the auditing by CPAs and raise its reliability.

For the first time, the independence of the CPAs formally came to the agenda. The problem of the same accountant auditing the same company for a long period of time was raised. While the newly introduced self-regulation (Quality Control Review) of the JICPA mandated the rotation system of ten years, the report proposed seven years, which ‘is in line with the international standard’. Another problem which was identified was that of a single CPA who does not belong to an accounting firm auditing a large company. There was no self-regulatory rule on (p.667) this matter, but some regulation by law was suggested, namely regarding the auditing of listed companies. The problem of simultaneous provision of auditing and non-auditing service was mentioned, and the creation of a fire wall between these divisions was suggested.

The general tone of the interim report still placed faith in self-regulation by the JICPA. The report endorsed the initiatives of the JICPA in their quality control review. However, the JICPA was urged to introduce a system whereby it could instruct its members to take necessary corrective measures and thus ensure the effectiveness of the quality control review. There was, though, a suggestion that the JICPA should be under an obligation to report the result of the quality control review to the Financial Services Agency (FSA).

By 2002, although more than five years after the launch of the Japanese Big Bang, the securities market in Japan had so far failed to show any sign of recovery, let alone being a driving force for a prosperous economy. Measures comprising the Big Bang were intended to be completed and a free, fair, and global market was to have been created by March 2001, but not all of the measures were implemented as planned, primarily due to the serious state of the economy after the financial crisis.

In 2002, the government reconfirmed its commitment to the structural reform of the securities market in its “Fundamental Policies for the Management of the Economy and Finance and the Structural Reform”. This included an ‘improvement of the infrastructure to increase the credibility of the securities market among the general public’. This was followed by the Programme for the Promotion of the Reform of the Securities Market published by the FSA in August 2002. It should be noted that this was after the US American enactment of the SOA, which strengthened the independence of the CPA/accounting firms and the supervision of (p.668) accounting firms in the wake of the Enron/WorldCom saga that began to unravel in late 2001.

The programme, which was sub-titled the “Second Stage” of the structural reform of the securities market, was quite candid in acknowledging that the securities market still lacked dynamism and was insufficient to form the core of the future financial system. It was admitted that the general public did not have sufficient trust in the issuing companies, intermediaries, the market creators, or even the market mechanism itself. (Incidentally, in a survey conducted by the Cabinet Office on the attitude of the general public towards the securities investment, only 12% of the respondents had an experience or intention to invest in the securities market, and 40% of the respondents thought that the securities companies could not be trusted.)12 Among other problems, the ensurance of the fairness and transparency of the market was focussed in this document. This involved strengthening the supervision of the market and reinforcing the accounting and audit system. The latter included strengthening the supervision of accounting firms in the light of incidents in the US However, no specifics were given on the mechanism of supervision.

Following this initiative, the Sub-Committee on the CPA System of the Finance Systems Council published its final report in December 2002.13 The purpose of the CPA reform, as stated in the report, was the consolidation and improvement of the quality of audits by CPAs. The report emphasised that the protection of investors and creditors and the gaining of confidence in the securities market presuppose an audit which guarantees adequate disclosure of financial information and its credibility.

The reform proposed in the report was aimed at the reinforcement of the independence of CPAs more or less in line with the SOA. The strengthening of government control over the CPAs and over the JICPA was also at the core of the changes. In this context, the introduction of a ‘monitoring system’ by the government over the quality review of the accountants’ work, which had been performed by the JICPA as a self-regulatory measure, was also proposed.

The proposed changes included the following points:

  • Ensuring the independence of the CPAs and the accounting firms from the client companies;

  • Raising the standard of the audit by the accounting firms via effective and appropriate organisation of the audit;

  • Continuation of self-regulatory activities by the JICPA to be supplemented by the government;

  • Reform of the examination system for CPAs;

  • Increase in the number of CPAs (up to 50 thousand by 2022).

In line with this report, a bill for the amendment of the CPA Law was prepared and submitted to the Diet and was adopted on 30 May 2003. The Law took effect in May 2004.

As can be seen from the above developments, the latest amendments to the CPA Law were not necessarily a straight continuation of the reform initiative by the accounting profession which had begun in 1996. Firstly, the original reform proposals were expanded to accommodate problems such as the independence of the CPAs. This resulted from the loss of credibility of the CPAs caused by their conspicuous failures in exposing irregularities when auditing the financial institutions which collapsed during the financial crisis. It should be emphasised that the reform proposals preceded Enron/WorldCom.

Secondly, until 2002 the primary emphasis was on self-regulation by the JICPA rather than government control. In the aftermath of the Enron/WorldCom incidents, the SOA was enacted in the US, and this had a significant impact on the amendments. There was a notable alteration of the policy in the final report by (p.669) the sub-committee in December 2002 on the independence of the CPAs. It was perceived that ‘from a supervisory point of view, it is necessary for the government to play an adequate role in ensuring the fairness, neutrality and effectiveness of self-regulation by the JICPA’. Self-regulatory measures, such as the rules on the rotation of CPAs auditing the same company, were made a statutory requirement.

Thirdly, some new requirements were added, such as the prohibition of simultaneous provision of consulting and auditing services.

Naturally, one may question whether or not the amended CPA Law has gone too far in the direction of the SOA.

II. The Amended CPA Law

1. The Task of CPAs

Unlike most of the laws which serve as the basis for professions such as attorneys, the CPA Law did not have a provision which set out the task of the CPAs. This was always regarded as one of the shortcomings of the CPA Law. The amended Law rectified this situation by introducing the following provision:

CPAs contribute to the sound development of the national economy by ensuring the fair business activities of companies and other entities and protect investors as well as creditors by securing the credibility of financial documents and other information regarding finance, being independent specialists of audit and accounting.

The protection of creditors, not only investors, was inserted, since the CPAs audit not only companies covered by the Securities and Exchange Law, but also companies which fall within the scope of the Special Measures Law on Audit of Large Companies.

2. Reinforcement of Independence

Independence in this context means independence of the CPAs from the clients. Even without Enron/WorldCom affairs, CPAs have been criticised in a series of window-dressing cases in Japan for overlooking irregularities because of their close links with the client company. The government's intention was to increase the fairness and transparency of the audit and to demonstrate that CPAs are, in substance as well as in appearance, independent from the client companies. In the earlier proposals, this was to be left to the self-regulation of the JICPA. Some requirements concerning the independence of the CPAs were introduced as self-regulatory measures by the JICPA in 1999. The amended Law has made these a statutory requirement.

The content of the amended Law in this respect is similar to that of the SOA. The requirements are:

(p.670) a. Prohibition of the Simultaneous Provision of Audit and Non-audit Services

There is a potential conflict of interests if a CPA is allowed to provide both services to the same company. This may result in a situation where the CPA audits the outcome of the service which he has provided. The CPA may become dependent on the income from the non-audit business and close his eyes to the irregularities in the accounts. The amended law prohibits a CPA from providing an audit service to a large company to which he provides non-audit service by himself, his spouse, or an entity which he substantially controls and from which he receives continuous remuneration.

The scope of non-audit business is provided by a cabinet order. It is more or less in line with the SOA:

Preparation of accounting books and financial documents;

  • Certification and valuation of in-kind contributions;

  • Insurance actuary service;

  • Outsourcing of internal audits;

  • Investment advisory service;

  • Securities business;

  • Other services involved in the business decisions of the company.

Normally, ‘large companies’ denote joint stock companies which have 500 million yen or more in capital or 20 billion yen worth of debts.14 These companies are required to have their accounts audited by a CPA or an accounting firm. There are around 10,000 such companies. However, there was an argument that companies which fall within this category still can be medium-sized companies or unlisted venture businesses which rely on accountants to advise them when preparing their accounts. It was considered impractical to apply the prohibition on the simultaneous provision of audit and non-audit services to these companies. Therefore, by virtue of the Implementation Order of the Law, companies with a capital of less than 10 billion yen and debts of less than 100 billion yen are exempted.15

Among matters involving the independence of CPAs from their clients, this had probably been the least-discussed issue in Japan. In recent years, Japanese accounting firms have increasingly become involved in non-audit services such as management consulting and advising on corporate finance matters (for example, M&A). The existence of the problem was acknowledged, as can be seen in the earlier reform proposals, but the problem had been regarded as somewhat remote. As the JICPA president pointed out after the amendments, this was very much an issue which came from the US.16

(p.671) The scope of the non-audit services which were to be banned was debated by the JICPA. The JICPA pointed out that the providing of accounting guidance to the client should not be regarded as a non-audit service. It was pointed out that there should be a distinction between full-fledged work and mere guidance.17

b. Limitation of the Length of Time for which a CPA can Audit the Same Large Company

A rotation system of CPAs was introduced to prevent close links from being developed over the years between a CPA and the client company. The amended Law prohibits CPAs from auditing the same large company for longer than seven years and also provides for a cooling-off period. The SOA sets the period at five years, but in Japan there was strong resistance from the JICPA, and it was settled at seven years. The parliamentary committee chairman was of the view that the Law should adopt five years like the SOA, while the JICPA insisted that it should be seven years. In fact, the self-regulatory rules dictated ten years. The argument by the JICPA was that five years was too short to get to know the company being audited. The resulting limit is a compromise, but this is to be reviewed by the legislature after seven years with a view to shortening it.18 the JICPA is of the view that this does not mean that it will necessarily be reduced to five years after the review.19

The cooling-off period during which the CPA involved is not allowed to return to audit the company in question is five years in the SOA. There were some arguments against this, it being suggested that even in a one-or two-year interval, the succeeding CPA would be able to find an inappropriate audit, and the predecessor would never be allowed to return to audit the same company. In the end, the period was not specified in the Law. It is determined by the implementation order as two years.

There was an argument also that this system should apply not only to CPAs, but that the accounting firms themselves should rotate; that is, the same accounting firm should not continue auditing the same company for more than a certain period. However, there are few jurisdictions (Italy is one of the rare exceptions) which have gone so far, and this proposal was not accepted. Even in the US, the SOA has not gone this far.20 Besides, in Japan the top four firms more or less monopolise the auditing of listed companies. Rotating firms may result in difficulties for the client companies.

(p.672) c. Restriction on the CPA Joining the Client Company

If a CPA audits a company during one financial year, he is not allowed to become a director of that company until the end of the next financial year. The same applies to the CPA who works in an accounting firm and has audited a company as an accountant in charge. This restriction includes those who were CPAs but have ceased to be CPAs.

d. Prohibition of Auditing of Large Companies by a Single CPA

Under the amended Law, CPAs are now under an obligation to work with another CPA or an accounting firm, or to be assisted by another CPA when auditing a large company as defined in the law. In order to maintain the standard of the audit, an organised audit with several CPAs is desirable. If there are several CPAs involved, it is likely to prevent a close link developing with the client.

This was certainly not an SOA-based amendment; it is of Japanese origin. There was an incident of window-dressing involving a listed company in which a small accounting firm was retained and actually assisted the company management in window-dressing. The CPA single-handedly audited the company. The CPA was not only convicted, but also had his registration revoked by the JICPA in 1999 (Mita Industry case).21 Since then, listing rules have required that a newly listed company should have the account audited by more than two CPAs or an accounting firm. The amended Law has made this official after the amendment, in 2004 a large unlisted company, which is the parent company of a listed company, was found to have been providing false information in its securities report. The company had been audited by a single CPA (not even an accounting firm) for more than 20 years.

3. Strengthening of Supervision by the Government

The amended Law strengthened supervision by the government of the accountants by ‘supplementing the limits of self-regulation’ under the JICPA. The goal is to ensure the fairness, neutrality, and effectiveness of the audit by the accountants.22 This expression, ‘limits of self-regulation’, first appeared in the above-cited 2002 December Report of the Sub-Committee of the Financial Systems Council. Until then, the government did not seem to be particularly dissatisfied with the self-regulation system run by the JICPA. Obviously, the idea of government supervision of the profession has come from the SOA.

(p.673) The agency in charge of supervising the accountants is the Financial Services Agency (FSA; as delegated by the prime minister). This function used to be bestowed on the Ministry of Finance, but as a result of the reform since the late 1990s the function has shifted to the FSA. Under the amendment, the Review Board for Accountants and Audit in place of the previous Review Board for Accountants was set up under the FSA in 2004. This is a collective administrative body which comprises nine part-time commissioners and a chairman. They are appointed by the prime minister with the consent of the Diet. The chairman and the members are guaranteed independence when carrying out their duties. The board has a secretariat. Currently, the chairman is a retired law professor and the members include some academics, the president of the JICPA, and a representative of the Keidanren.

Under the amended Law, the new board continues to exercise the power of disciplining CPAs, but in addition it will exercise supervision of accountants via the ‘monitoring’ of the quality control review conducted by the JICPA.

The novelties in the amended Law include:

a. Increased Power of Investigation

Previously, the Law granted such a power to the government agency only in cases where there were grounds for disciplinary measures. It was not possible for the agency to enter an office, for example, for the purpose of investigating the internal control system of an accounting firm. Through the amendment, officials of the agency are now empowered to enter the offices of CPAs, foreign CPAs and accounting firms, and other premises related to their business, and to inspect books and documents which are relevant to the business when they consider it necessary and appropriate for the protection of public interest or of investors.

Furthermore, the FSA is now entitled to require the submission of a report or materials of the CPAs, foreign CPAs, and accounting firms when it considers it necessary and appropriate for the protection of public interest or of investors.

b. Quality Control Review and its Monitoring

The JICPA has been conducting a ‘quality control review’ of the accountants on their internal management and auditing work since 1999 as a self-regulatory measure. At present, around 300 accounting firms and offices are under review by the JIPCA for their management and audit work. If necessary, the JIPCA issues recommendations for improvement.

As a result of the amendments, quality control reviews have become a statutory requirement. The JICPA is now under a statutory obligation to carry out a quality control review of the audit service provided by accountants and report the result to the board on a regular basis or when it is needed. The government is to (p.674) ‘monitor’ the quality control review conducted by the JICPA. The object of the monitoring covers the JICPA itself as well as accounting firms and even the client companies. The board is empowered to inspect CPAs, accounting firms, and the JICPA and, if necessary, to recommend that administrative measures be imposed on them.

Before the amendment, although the ultimate power of disciplining accountants belonged to the government, there was an existing system of self-regulation by the JICPA which had been strengthened since the late 1990s. In fact, some of the measures for reinforcing the independence of accountants which were introduced by the amended Law had already been implemented by the JICPA as self-regulatory measures. When the move to tighten government control emerged in the aftermath of the Enron/WorldCom incidents, the JICPA became seriously concerned. It had already introduced the ‘quality control review’ voluntarily, and a further involvement of the government on this matter seemed to be superfluous. After all, if self-regulatory measures were beginning to work, why should the government be directly involved? Direct supervision by the government or a quasi-governmental body was thought to be against the global trend of respecting self- regulation by professional bodies.23

An alternative to direct government control was to set up a new body to take up this function of reviewing accountants. Indeed, there was such a proposal. However, in the US the PCAOB was set up under the SEC, albeit not strictly as a government body, and assumed the supervisory role in a direct manner. The Japanese parallel would be a body attached to the FSA. Thus, the existing Review Board was reorganised into a body overseeing accountants.

In light of the developments in the US, there was a feeling of resignation within the profession that strengthening of direct government involvement was inevitable, if only for the time being. If incidents on the scale of Enron/World-Com happen in the US and the US government took certain measures, even if Japan presented alternative measures they would not be internationally accepted. A compromise reached was that the quality control review remains the power of the JICPA, but the Review Board will monitor the result of the review. The president of the JICPA had been of the view that the PCAOB type of regulation of the CPAs was excessive in light of the global tendency in the direction of self-regulation. However, he was satisfied in the end that the government had respected the quality control review by the JICPA and had introduced a system of monitoring it instead of direct supervision. This is midway between total self-regulation and direct government supervision and is regarded as a uniquely Japanese approach.24

(p.675) c. Instruction to Take Corrective Measures

In cases where the CPA is in breach of the Law or has failed to comply with an order based upon the Law, the FSA is entitled to give necessary instruction for correcting the situation to the CPA in question. The same applies to accounting firms. This can precede disciplinary measures imposed by the FSA. The failure to comply with the instruction will entail disciplinary action.

4. Introduction of the Designated Partner System

Under the previous system, all partners in an accounting firm had the power of execution of the business; on the other hand, they also bore unlimited liability. However, with the size of accounting firms increasing, this system which was modelled after partnership under English law became unsuitable.

The amended Law introduced the system of designated partners in line with the attorneys’ law. Audit firms can now designate partners for the audit service of a specific company who will conduct the audit on behalf of the firm. This partner will bear unlimited liability, while other partners bear only limited liability. It should be noted that this only involves the liability vis à vis the client company which has been audited; in relation to a claim by a bona fide third party, all partners still bear unlimited liability.

It should be noted that the US limited liability company system is to be introduced as part of the modernisation of company law in 2005.

III. Measures to Increase the Effectiveness of the Audit by the CPAs

Even prior to the Enron/WorldCom saga and apart from the amendments to the CPA Law, various measures were being taken to strengthen the effectiveness of audits by CPAs.

1. The ‘Going Concern’ Issue

In the past, there have been instances where, shortly after the CPA gave a certified opinion endorsing the accounts, the company met a sudden death. This also happened with the collapse of financial institutions in the late 1990s. This naturally harmed the credibility of audits by the CPAs. Therefore, an ‘early warning system’ in the form of comments on the company as a ‘going concern’ was introduced by the Japan Accounting Standards Board.

(p.676) In 2002 the audit standards were revised, and accountants are now required to consider ‘whether it is appropriate for the company to prepare financial statements upon the premise that the company is to continue as a going concern’.25 They are under an obligation to check whether there are matters or situations that cast serious doubt on the assumption that the company can continue as a going concern, such as the deterioration of financial indices, the possibility of financial collapse, etc. It should be noted that it is not the CPA's duty to determine whether the company can continue as a going concern or not. The CPA's duty is to ensure that relevant information is properly disclosed by the client company. If there are matters or situations that cast serious doubt on the assumption that the company can continue as a going concern, the CPA is to require the company to disclose the existence of such matters or situations, the substance of the problem, the existence of a doubt as to whether the company will continue as a going concern, details of the measures and plans to address the problems, and whether or not they are reflected on the financial statements. The disclosure can be made as a comment to the financial statements or can be otherwise reflected on the statements.26

If it is revealed that such matters or circumstances exist, that there is significant uncertainty whether the problems will be resolved, and that there is serious doubt that the company can continue as a going concern, but nevertheless the matters are properly disclosed in the financial statements, the CPA is to render an opinion endorsing the financial statements without qualification. If the disclosure is insufficient, the CPA is either to endorse the accounts with qualifications (comments) or to render the opinion that the statements are inappropriate.

This system of ‘audits on companies as going concerns’ was introduced from the US In the past, there was a similar system whereby the CPA was to add a note to the opinion on ‘special matters’ when the CPA regarded it as particularly necessary. However, CPAs very seldom added such a note, because if the company was listed this may have resulted in the delisting of the company.

The new system came into force in 2003. The JICPA has conducted a survey on its implementation. In the accounting year which ended in March 2003, there were 64 companies about which such special comments had been made by the CPA. In 19 cases the companies’ businesses were deteriorating constantly, while in 15 cases the companies’ debts exceeded their assets.27 In the financial year ending in September 2003, 49 companies had such comments. Of these companies, four went bankrupt.28

(p.677) CPAs are often criticised for triggering the collapse of companies. The JICPA president at that time stressed that the accountants should not listen to the argument that the survival of the client company is important to society, or that the CPA should not give a negative conclusion since it would harm the local economy. If, as a result of a proper audit, the company fails, this cannot be helped.29

2. Stricter Approach by the CPAs

In the past, CPAs tended to be reluctant to confront the client company when they disagreed with the financial statements it had prepared, but this may be changing. In cases where the financial statements prepared by the company are not appropriate and this substantially affects the statements, CPAs will give a negative opinion. If the CPAs are unable to obtain sufficient evidence needed for the audit, they will refrain from giving an opinion. Although the number of cases where the CPA gave a negative opinion has declined since 1998 (naturally, this reflects the state of the economy), the number of cases where the CPA refrained from giving an opinion has more than doubled.30

At one major accounting firm, the number of cases in which a panel of experienced accountants decided on cases where the accountants could not reach consensus has doubled as well. Half the cases are related to deferred tax assets, and cases involving the going concern assumptions are also growing in number.

According to a survey conducted by the JICPA in 2003 regarding the audit required by the Commercial Code, in 2002 there were 39 companies regarding which the CPA gave an opinion that the accounts were inappropriate, and regarding 11 companies the CPA declined to give an opinion.31 The grounds for an opinion of unlawful accounts were:

Insufficient amortisation of fixed assets


Insufficient allowance reserves


Insufficient entry of valuation loss of the inventory, securities, etc


Inappropriate valuation or amortisation of good will


The CPAs declined to give an audit opinion when they were unable to obtain proof of the possibility of debt collection, or of the appropriateness of the valuation of securities for investment (64.7%).

The CPA resigned in 1 out of 11 cases where the CPA refrained from giving an opinion, and in 9 out of 50 cases where a negative opinion had been given.

(p.678) In the accounting year 2002, the number of declined opinions more than doubled compared to the year before. This is because while the disclosure of the going concern assumption was made mandatory as of accounting year 2003, in 33 cases the company failed to disclose information despite the fact that there was serious doubt as to the assumption that the company was a going concern, and therefore the audit could not proceed.

In 74% of the cases where the CPA gave a negative opinion or refrained from giving an opinion, the auditors of the company expressed the opinion that the CPA's opinion was justifiable. On the other hand, in some cases the company merely reported the negative opinion of the CPA but failed to take any measures, which is clearly in breach of the law.

3. Increasing Tension between CPAs and Clients?

The relationship between the client company and the CPA has become somewhat stressed, primarily due to the increase in audit risks. It has been customary for the same auditing firm to audit the same company for many years.

However, between March 2002 and November 2003, there were 107 companies that were audited on the basis of the Securities and Exchange Law which changed their auditing firm.32 According to the survey by the JICPA, in 73.3% of such cases the contract was discontinued upon the initiative of the client. The reasons were as follows:

Unification of auditors upon the request of the parent company


Problem with the fees


Disagreement between the company and the CPA


Other reasons


In cases where the relationship was discontinued upon the initiative of the accountant, the grounds were:

Increase in the audit risk


The opinion or guidance not accepted by the client


Unavailability of requested information from the client


Other reasons


There were 25 cases where the contract was discontinued before the end of the term. There were four cases where the client discontinued the contract due to a disagreement with the CPA, and eight cases where the CPA discontinued due to an increasing risk. Of those companies which changed their CPA during the term, (p.679) four applied for a civil restoration programme, an equivalent of US Bankruptcy Code Chapter 11.

In some cases, after the CPA resigned, the successor CPA was paid lower fees and the time for the audit was reduced. There are some doubts as to whether the governing bodies of the company have properly examined the appropriateness of changing the CPA.

4. Disciplinary Measures Imposed by the JICPA

In the 1990s, even in cases such as the collapse of major banks and securities companies, the CPAs involved were never disciplined for having failed to expose irregularities in the accounts. The JICPA's approach seems to be changing. Disciplinary measures taken by the JICPA are now being published. In 2003, two CPAs were disciplined for allowing a company to leave an irrecoverable claim vis à vis a subsidiary without treating it as a loss and for having given a certified opinion.33 In 2004, an accounting firm and two of its CPAs were disciplined for the failure to detect window-dressing and for giving this company an unqualified certified opinion.34 In the latter case, the client was a company whose shares were traded over the counter. The company falsified its accounts by entering turnovers which did not exist and then paid dividends. The accounting firm had been shown falsified documents, but since the audit procedure was insufficient it failed to discover the falsification and granted an unqualified ‘true and fair’ opinion. This was found to be a failure to exercise reasonable care. The firm's membership in JICPA was suspended for two months.

As of July 2004, there were 15 cases of incidents involving the failure to detect window-dressing at the JICPA. However, in some cases the process of disciplinary action has been delayed; the Yamaichi case, for instance, has been pending since 1998.35

For its part, the FSA imposes administrative measures based upon the CPA Law. For example, in 2004 the FSA suspended the licenses of two CPAs for discrediting the profession.36

(p.680) IV. The Independence of the CPAs’ Audit from the FSA – the Resona Bank and the Ashikaga Bank Cases

The amended Law has mainly addressed the independence of CPAs from their client companies. Recent incidents involving some financial institutions shed light on another problem – the independence of the CPAs from the FSA.

In May 2003, Resona Bank, Japan's fifth largest bank, was forced to apply for public funds worth 17 billion USD after its accounting firm (ShinNihon) determined that the bank had failed to meet the BIS capital adequacy ratio of 4%. Resona is a product of the merger of Daiwa Bank and Asahi Bank. The latter was audited by the accounting firm Asahi,37 while Daiwa was audited by ShinNihon. At first, both firms were jointly auditing Resona, but Asahi withdrew on 30 April. The timing was strange, occurring at a very late stage in the preparation of the financial statements. This was primarily due to a difference regarding the period of allowance of deferred tax assets (DTAs). Asahi was of the view that only three years’ worth of DTAs should be considered as capital, while ShinNihon supported Resona in allowing five years’ worth of DTAs. Asahi asked Resona to correct the statements but Resona refused, and therefore Asahi resigned.38

However, on 15 May ShinNihon informed Resona that it was not going to approve the account. Resona had undergone an FSA inspection which had concluded in April that Resona had cleared the capital adequacy ratio. Despite this, ShinNihon reached the opposite conclusion in May. The FSA had allowed five years’ worth of DTAs, while ShinNihon allowed only three years in light of the state of business of the bank. In this sense, the FSA was lagging behind the accountants.39

The minister in charge of the FSA had announced earlier that DTAs should be calculated strictly. However, this was not yet reflected in the inspection of the Bank by the FSA.40 In the meantime, in February 2003 the president of the JICPA issued a statement requiring a strict approach in the audit of major banks intending to tighten control over the counting of DTAs. This has influenced the auditing firms to take a stricter approach. Asahi responded first, and ShinNihon followed after a while. There is a criticism that the change of attitude of the accounting firms upset the stability and foreseeability of accounting, but the president of the JICPA pointed out later that the client in this case had failed to understand the changes in the environment and had continued to calculate DTAs in the same way (p.681) as the previous year. Resona sources complained that ShinNihon had previously endorsed the Resona statements, but suddenly changed its position.41

In this case, the FSA reportedly tried to influence the CPA's opinion. A note has surfaced that can be interpreted as evidence that the official in charge at the FSA asked the accounting firm to come up with a less rigorous evaluation of the bank's financial standing so that the bank would not need to ask for public funds.42 A parliamentary commission subsequently heard this case.43

Incidentally, in other jurisdictions such changes to accounting methods are regarded as a serious matter which confuses investors. Recently, the UK FSA required the Japanese UFJ Bank, which is also listed in the UK, to explain the changes made to its accounts. In April 2004 the bank announced that they were in the black for the accounting year ending in March 2004. However, in May it announced that it was in the red by 400 billion yen, ‘due to the increase in the allowance reserves for bad loans’. UFJ explained this was a result of the adoption of a stricter approach to assets evaluation. There is a possibility that the UK FSA will impose fines.44

The Resona case was certainly not the first case where an accounting firm changed its stance at the last moment. Another instance involved Tokyo Sowa Bank, a regional bank in Tokyo. Asahi gave a ‘true and fair’ opinion on the accounts in April. However, in June, after an inspection by the FSA, the chairman of Asahi visited the bank and asked them to return the certified opinion. An opinion incorporating the result of the FSA inspection was offered in return. The bank collapsed soon afterwards. Asahi is now being sued by the shareholders who relied upon the inaccurate financial statements and purchased shares of the bank.45

A more recent incident involved Ashikaga Bank, a regional bank. In this case, which took place after Resona, Ashikaga Bank was found to be insolvent by the FSA inspection. However, before the result of the inspection was published, the auditor, Chuo-Aoyama, reached the opposite conclusion. The bank had announced that the capital adequacy ratio was above 4% in April, but in November it was forced to admit that it was 102 billion yen in the red. The capital adequacy ratio in late September was minus 3.7%.46 This was because Chuo-Aoyama denied the five years’ worth of DTAs as proposed by the bank in late November, ostensibly under pressure from the FSA. Thus, in this case the accounting firm changed its view within six months.

(p.682) There were no statements by them regarding the assumption of the bank continuing as a going concern in April.47 The problem with the Ashikaga Bank is that investors relied on the opinion of the accountants and, before September, had subscribed to the share issue by the bank. Shareholders of the bank are now suing the bank and the accounting firm. They argue that despite the fact that the state of business or the accounting standards did not change in the last six months, the accountants changed their view of insolvency, and that this is against accounting rules and the principle of continuity: ‘Although there was strong guidance from the FSA, the audit should have been conducted in a neutral and fair manner.’ There was no comment concerning the company as a going concern earlier, and investors were led to believe that there was no concern as to the future of the bank.48

The above incidents demonstrate the difficult position of the CPAs. All these incidents involve DTAs, the calculation of which is highly discretionary. Although the minister in charge of Financial Affairs announced in 2003 that there would be a clear-cut rule on this matter, the DTA's audit standards are said to remain rather general. As late as June 2004, a sub-committee of the Financial System Council which had been deliberating on this matter issued a report recommending that rules setting the limit on the entering of the deferred tax payment in the assets should be postponed.49 This was despite the fact that it acknowledged the necessity of such rules. Without clear-cut rules, naturally, it is difficult for the CPAs to take a strict approach which would be likely to finish the client. Furthermore, with the increased power of the FSA in overseeing the CPAs, there is a likelihood that CPAs will hesitate to take an independent stance from the FSA.

V. Conclusion

The necessity for reform of the accounting system, aimed at increased transparency for investors, has been recognised in Japan for some time. It coincided with the Japanese Big Bang, a major reform intended to create a free, fair, and global financial system. In the late 1990s, the reform proposals became broader in scope following growing criticisms of the profession concerning the CPAs’ failure to expose the window-dressing which brought down some securities companies and banks. These proposals largely resorted to self-regulation by the JICPA. The JICPA accordingly introduced various measures to increase the effectiveness of the audits by the CPAs.

(p.683) However, after the Enron/WorldCom affairs, influenced by the US, the tide seems to have changed. Further reinforcement of the independence of the CPAs from the client companies, and above all broader grounds for interference by the government, were proposed and eventually became law. The amended CPA Law has been significantly influenced by the SOA, although the profession has managed to reach some compromises.

The recent incidents involving the Resona Bank and Ashikaga Bank have cast some doubt on the reliability of the CPAs. However, in cases involving the auditing of financial institutions, maintaining independence from the FSA while being supervised by it at the same time seems to be a rather difficult task. This seems to represent a negative aspect of increased government interference. Furthermore, the matter involved the exercise of wide discretion on the part of the CPAs without the promised clear-cut rules forthcoming from the government. Perhaps it is too harsh to blame the CPAs.

It is questionable whether the reforms which were going on in Japan at the time of the incidents in the US could have realised their intended goal, or whether they were merely a lukewarm attempt to preserve the self-regulation of the profession when an SOA-type law was genuinely needed. Those self-regulatory measures were simply not given much time to be tested and have been surpassed by the SOA-type approach.


(1) H Hato The Amended CPA Law (Tokyo 2004) 5–12.

(2) 〈www.jicpa.or.jp〉 (22 April 2005).

(3) 〈www.fsa.go.jp〉 (22 April 2005).

(4) See annex 3 in this volume.

(5) T Inoue ‘Commentary on the Amended CPA Law’ (2003) 1668 Shôji Hômu 5.

(6) Research Report on the Corporate Accounting System of Japanese Companies, March 2002 by the Ministry of Economy, Trade and Industry (METI). See 〈www.meti.go.jp〉 (22 April 2005).

(7) 1670 Shôji Hômu 47.

(8) (2003) 1663 Shôji Hômu 44; (2003) 1666 Shôji Hômu 39.

(9) ‘Proposals for the Increased Robustness of Audit by the CPAs’, the Report of the CPA Review Board of 24 April 1997.

(10) (1999) 1547 Shôji Hômu 36.

(11) CPA Review Board ‘Problems of the Audit System and the Direction of Reform’ 29 June 2000.

(12) The Cabinet Office, 〈www.kantei.go.jp〉 (21 April 2005).

(13) The Report of the Sub-Committee on the CPA System, Financial Systems Council ‘Strengthening of the CPA System’ 17 December 2002.

(14) Special Measures Law on the Audit of Large Joint Stock Companies.

(15) Hato (n 1) 108–111.

(16) 1670 Shôji Hômu 43.

(17) ibid 43–44.

(18) Inoue (n 5) 27.

(19) ibid 44.

(20) ibid 26.

(21) ibid 27.

(22) Inoue (n 5) 29.

(23) Access FSA no 11–2003, comment by K Hiramatsu 〈www.fsa.go.jp〉 (21 April 2005).

(24) Access FSA no 11–2003, comment by A Okuyama 1670 Shôji Hômu 45.

(25) Kaisei kônin kaikei-shi-hô kaisetsu [Commentary to the New CPA Law] (Tokyo 2004) 51.

(26) ibid 60–61.

(27) Report by Zeimu Kenkyû-kai 25 August 2003.

(28) Report by Zeimu Kenkyû-kai 22 December 2003.

(29) Okuyama (n 24).

(30) JICPA ‘Result of the Survey on the Audit Opinion based upon the Commercial Code’ 17 February2004.

(31) ibid.

(32) JICPA ‘The Result of the Survey on the Circumstances of the Change of Accountants’ 7 April 2004.

(33) (2003) 1673 Shôji Hômu 44.

(34) JICPA Press Release 19 May 2004.

(35) Nikkei 3 September 2004.

(36) FSA Press Release 16 April 2004 〈www.fsa.go.jp〉 (21 April 2005).

(37) Asahi merged with Azsa and became Azsa & Co in 2004.

(38) M Mikami The Economist (June 2003) 〈www.mainichi.co.jp〉 (21 April 2005).

(39) Asahi Shinbun 23 May 2003 (FT Information Ltd – Asia Africa Intelligence Wire); FT Investor 20 May 2003.

(40) Nikkei 9 December 2003.

(41) 1670 Shôji Hômu 47.

(42) Asahi Shinbun 5 August 2003 (FT Information Ltd – Asia Africa Intelligence Wire).

(43) FT Investor 4 June 2003.

(44) Asahi Shinbun 1 September 2004.

(45) Nikkei 9 December 2003; Y Fujii Kinyû saisei no gosan [Miscalculation of the Financial Restoration] (Tokyo 2003) 266–7.

(46) Nikkei 29 November 2003.

(47) Nikkei 16 January 2004.

(48) Nikkei 28 May 2004.

(49) Nikkei 23 June 2004.