December 21, 1999

Sub-Committee on Corporate Accounting
Financial Research Committee
The Liberal Democratic Party


Introduction

Confidence in the Japanese financial accounting system has deteriorated. Several financial institutions that had received unqualified opinions by independent accountants have subsequently suffered huge unrecorded losses, while a large number of companies have abused old-fashioned cost basis accounting standards to conceal losses on certain financial instruments. In the meantime, improvements in accounting standards and practices are rapidly being implemented through, for example, an introduction of the mark-to-market standard for financial instruments and the enlargement of the scope of consolidation under the control concept, that are compatible to those of the International Accounting Standards. Nevertheless, distrust of the accounting and auditing profession in Japan remains, with all Japanese-affiliated auditing firms of the Big 5 having, for example, added the wording such as "this financial statement is not being intended to present the financial results in accordance with accounting principles and practices generally accepted in countries and jurisdictions other than Japan" in English version audit opinions for financial statements of Japanese companies. Japan's active engagement in the restructuring process of the International Accounting Standards Committee (IASC) in order to set the ground for international accounting standard setting is also being tested.

The financial accounting system is an important component of the capital market infrastructure in Japan as it bears directly on the issue of corporate governance. Japan's Big Bang cannot be completed without a reform in financial accounting. Based on a recognition that swift and fundamental reform in financial accounting is critical, the Sub-Committee on Corporate Accounting has conducted 11 hearings from government agencies, the Japanese Institute of Certified Public Accountants (JICPA), Keidanren, capital market players and academics regarding measures of: (1) enforcement and enlargement of accounting standards setting body; (2) improvement and strengthening of capital market regulatory function; and (3) clarification and development of the accounting profession's roles and responsibility. Following these discussions, the sub-committee has drafted this preliminary proposal of measures to improve in the accounting standards setting function in Japan, that is central to the Japanese corporate accounting system.

The Sub-Committee notes that the framework of the new standard setting body should be established by early 2001 when the new IASC is scheduled to come into effect.


I.Requisites and Framework of Accounting Standards Setting Body

The fundamental mission of a standard setting body is, to develop standards that are:

1. Responsive to changing economic conditions in both timely and substantive manner;
2. Independent from the influence of any specific interested parties; and
   
3. Consistent with international standards.

Considering these requirements, we concluded that a standard setting body should fulfill the following seven key conditions. It should be:

1. A permanent organization;
2. Composed of full-time board members and full-time professional staff;
   
3. Consistent with international standards.
4. Independent from any political, governmental, industrial and academic parties in terms of its policy, budget and human resources;
5. Transparent in terms of due process, including board member nomination process, with board discussions also to be open to the public;
6. Global;
7. Capable of integrating diversified values into accounting and auditing standards; and
8. Dynamic in initiating autonomous standard setting.

Accounting standards in Japan have been set by the Business Accounting Deliberation Council (BADC, an Article 8 council of National Governmental Organization Law), an advisory body of the Finance Minister. Related practical guidelines are developed by the JICPA. In July 2000 the statutory authority of standard setting will be transferred to the newly established Financial Agency.

In the United States, the Securities and Exchange Commission (SEC) has the statutory power to establish financial accounting standards, though it has designated the Financial Accounting Standard Board (FASB), a private organization, as the body responsible for actual standard setting. In the United Kingdom, also, actual standard development process is assinged to a private organization, the Accounting Standard Board (ASB). In Germany, where the public sector has traditionally directly developed standards, the process was recently changed. A newly established private organization, the German Accounting Standard Committee (DRSC), has been officially designated and authorized under the Commercial Code to develop accounting standards for consolidated financial statements. The Justice Minister, based on reports by the DRSC, then publishes the results in an official governmental announcement officially adopting the recommendations. France is the only country, among the major developed countries which still utilizes a Council of the Finance Minister (CNC) to directly establish standards.

In light of the foregoing discussions, the Sub-Committee on Corporate Accounting considers the accounting standard setting an essential issue to be addressed as a part of the national economic strategy. The sub-committee concluded that the following new framework should be established to replace the BADC.

1. A specific governmental agency should be clearly empowered to establish accounting standards;
2. Similar to the Germany system, this agency should, while preserving its statutory authority, designate and assign the responsibility to a private entity that satisfies the above mentioned seven key conditions.
   Note: Some sub-committee members argued that the functioning of BADC, and the related governmental organization should be improved through hiring long-term and full-time staff.
3. Considering the urgency of the issue, as a provisional and temporary measure, the current governmental organization relating to standard setting, including the BADC, should be strengthened by increasing the number of personnel which would facilitate the smooth transition to the new system.

The Sub-Committee also concluded that support from related parties for the transformation process is critical and that the new framework must come into effect by early 2001, so as not to lag behind changes occurring outside Japan.


Upon publicizing above proposals, the Sub-Committee should finalize its proposals as soon as possible by working with the ruling parties, based on open and broad discussions with the JICPA, business community, MOF, MITI, Ministry of Justice and other related governmental agencies given that this is a critical and fundamental issue relating to the entire Japanese economy and business environment.


II.Other Urgent Issues to be Reviewed

Although there were no in-depth discussions due to time limitations, we believe that a comprehensive review should be continued with respect to the items and areas listed below:

1. Clarification of the role and responsibilities of the Securities and Exchange Surveillance Commission, and review of its position in the regulatory framework.
   
   1. In regard to the Securities and Exchange Surveillance Commission, which was established after a series of fraud cases, in the era after the financial Big Bang, some members suggested that "Article 3 committee" under the National Governmental Organization Law, which would be more independent and powerful in line with the SEC in the US, should be established and empowered to develop accounting standards.
   2. Another suggestion was that, during the course of such a review process, particular attention should be paid to possible simplification and unification of the whole governmental structure which oversees the financial sector.
2. Role, Function and Responsibility of Public Accountancy
   Many committee members argued that the existing CPA Law, enacted in 1948, is no longer suited to the current business environment and should be comprehensively reviewed. This review should include redefining the accountancy role, strengthening its function and responsibility, as well as enhancing the independence of the accountancy profession.
3. Harmonization of Financial Reporting requirements under the Securities and Exchange Law and the Commercial Code.
   Committee members have unanimously agreed that accounting standards appropriate to a development of rapidly changing economy, such as e-commerce, is urgently needed. Under such circumstances harmonization with the Commercial Code financial reporting, which has very stringent requirements with respect to the definition of income payable as dividends, will also be an important issue.
4. International Accounting Standards
   Further discussion is needed as to whether Japan should accept International Accounting Standards for domestic reporting.
5. Role, Function and Responsibility of Public Accountancy
   Many committee members argued that the existing CPA Law, enacted in 1948, is no longer suited to the current business environment and should be comprehensively reviewed. This review should include redefining the accountancy role, strengthening its function and responsibility, as well as enhancing the independence of the accountancy profession.