|II. Reasons for Accounting Changes Since
The first chapter reviewed the historical background and key foundations of Japanese accounting. This chapter examines the three major influences that impelled the BADC to take action to reform Japanese accounting standards. Prime Minister Hashimoto's announcement in November 1996 to implement significant financial system reforms, referred to as the Japanese Big Bang, gave the BADC a clear mandate to pursue changes to bring the financial reporting of Japanese companies more in line with international standards. In addition, numerous accounting and auditing weaknesses induced accounting standard reforms, especially since these weaknesses contributed directly to Japan's bad loan crisis and to a string of financial-related scandals at financial institutions and other companies. Rapid financial market innovations such as derivative financial instruments and increasing internationalization of accounting standards and company financial activities also provided a strong impetus for the BADC to make changes to address the new economic realities. The following chart summarizes the three major reasons for the accounting changes since 1997, in addition to showing the interrelationships between these factors.
Japan's accounting and auditing weaknesses developed as a result of
the country's distinctive business and regulatory environment, which the
next part examines. The second part of this section identifies the major
loopholes and weaknesses in the accounting rules. The final part looks
at the reasons for Japan's weak auditing practices.
Business and Regulatory EnvironmentThe unique aspects of Japan's business and regulatory environment have contributed to several accounting and auditing weaknesses, such as the lack of transparent disclosure of financial information to stockholders. This part examines three aspects of the business and regulatory environment: the keiretsu and main bank system, the governmental organization that sets accounting standards, and the Japanese government's approach to financial regulation.
Keiretsu and Main Bank SystemThe keiretsu and main bank business structure has contributed significantly to the shortcomings in corporate financial disclosure. The keiretsu business groups play a major role in the modern Japanese economy, with the six largest keiretsu (Mitsui, Fuji, Mitsubishi, Sumitomo, Sanwa, and Daiichi Kangyô) producing as much as 25 percent of the Japanese gross national product (Darrough, Pourjalali, and Saudagaran 1998, 315). Companies in a typical keiretsu group maintain close relations with one another through cross-shareholdings (mochiai kabushiki), interlocking directorates in which many of the same personnel sit on the boards of several keiretsu firms, sharing of a common main bank, financing fellow group companies, and regular presidents' meetings for informal coordination of the group. Companies with reciprocal shareholding arrangements in a keiretsu have access to private accounting information not available to the general investing public and to non-members of the keiretsu.
The main bank provides corporate control and monitoring to keiretsu member companies because the bank serves as a focal point in a complicated nexus of cross-shareholdings between group member firms (Beason and James 1999, 67). Although banks are not allowed under Japanese law to own more than five percent (ten percent until 1987) of industrial companies, the proportion of listed manufacturing company stock owned by all banks in total was on average 19 percent in 1980 (Aoki 1988, 127). With several banks in total owning a substantial stake in a company, a hostile bidder has great difficulty taking control over a company.
Since banks have direct access to their customers' accounting information, they have relatively little incentive to improve external financial reporting to investors. The main bank often plays the role of first lender by reviewing and monitoring a company's investment projects, and the main bank then coordinates with other banks to supply the remainder of the requested funds. The close relationship of keiretsu firms and the main bank have allowed companies to take a long-term perspective rather than focusing on short-term profits since the cross-held shares effectively prevented hostile takeovers. In times of financial trouble, the main bank often serves as a lender of last resort or takes the lead in restructuring a company, including the dispatch of its own executives to take over company management (Sunamura 1994, 296-9).
Japanese companies have historically relied much more heavily on debt rather than equity as their primary financing source. In addition, institutions such as banks, insurance companies, and non-financial companies have dominated the ownership of company shares of stock. As a result, financial accounting information tended to be directed toward the needs of financial institutions and other keiretsu-related companies rather than individual stockholders and potential investors.
The dominance of creditors over shareholders in Japanese companies can be observed by examining the ratio of debt to total assets, which was 86 percent in 1970 and 73 percent in 1985. In comparison, US and UK firms had an average debt ratio of about 50 percent for these same years (Nobes 1998, 251). Borrowings from financial institutions constitute over 60 percent of the debt of Japanese corporations (McKinnon 1986, 299). Through the mid 1990s, Japanese companies continued to rely heavily on borrowing rather than equity (stocks) to meet their long-term financing needs. In 1995, borrowing from financial institutions provided 52 percent of Japanese companies' financing needs, whereas equity financing made up 40 percent and company-issued bonds 8 percent. In contrast, US firms used stocks for 76 percent of their financing requirements, bonds for 14 percent, and borrowing from financial institutions for only 10 percent (Katayama 1997).
Institutional shareholders dominate the ownership of Japanese companies, so few incentives have existed to address the financial information needs of individual shareholders. In 1950, as a direct result of the zaibatsu dissolution mandated by the Allied Command, individual share ownership rose to 69 percent of the total market value of listed companies, but this figure steadily declined to less than 25 percent in 1985 and has remained at about the same level through 1995 (Aoki 1988, 117, 124; Tokumasu and Katô 1997, 123). This level is quite low for industrialized countries, with US individual investors, for example, holding about half of total outstanding shares (Darrough, Pourjalali, and Saudagaran 1998, 315).
The decrease in individual share ownership in Japan occurred as several keiretsu formed and rapidly grew in the 1950s and 1960s (Aoki 1988, 125; McKinnon 1986, 295). The former zaibatsu groups initially set up cross-shareholding arrangements to circumvent the rules established by the Allied Command against holding companies. Between 1985 and 1995, financial institutions and non-financial corporations owned over 40 percent and about 25 percent respectively of the total value of stock of listed companies (Tokumasu and Katô 1997, 123).
Cross-shareholding has weakened the effectiveness of corporate governance in Japan. With banks and affiliated companies holding the majority of shares in most large Japanese companies, the system of accountability to stockholders that operates in the US and other industrialized countries has not developed much in Japan. Japanese companies can readily obtain shareholder approval of management proposals at annual shareholder meetings. Boards of directors usually consist almost entirely of company executives or executives of financial institutions and other companies with cross-shareholdings. This lack of external independent directors deprives small shareholders of someone to look after their interests.
Since 1993, when the Commercial Code was amended to strengthen shareholder
rights, numerous shareholder class action lawsuits have been filed against
company directors and executives for bankruptcies or for scandals that
caused shareholders to suffer significant losses due to declines in share
prices. For example, compensatory damage claims of US$1.1 billion have
been filed against 38 Daiwa Bank directors and statutory auditors for illegal
transactions at the bank's New York branch. Even though shareholders have
not yet won a lawsuit in the case of a bankruptcy or scandal, company directors
have become more aware of the need to prevent scandals and bankruptcy by
having effective internal control systems and internal audits (Yokoyama
Accounting Standard Setting GroupIn contrast to independent non-governmental groups that establish accounting standards in other industrialized countries such as the US, Great Britain, and Germany, the Japanese government effectively controls all aspects of financial accounting and reporting. The Ministry of Finance controls the Business Accounting Deliberation Council (BADC), which establishes financial accounting standards for businesses. The MOF also has responsibility for the administration and enforcement of the SEL and related accounting regulations. Although the BADC has members from industry, universities, and the accountancy profession in addition to the government, the MOF must approve the appointment of members to the Council (Cooke 1994, 58). The MOF's control over the BADC can lead to decisions made for the purpose of politics rather than improved financial reporting. For example, the MOF made a temporary change only in 1998 and 1999 to let financial institutions revalue their land holdings in order to improve their capital ratios, even though this revaluation was inconsistent with the historical cost method that had been required for several decades.
Governmental RegulatorsThe Japanese approach to financial regulation builds on favors, deals, and reciprocal obligations. The Japanese government, specifically the MOF, has long provided administrative guidance and supervision to banks and other financial institutions, oftentimes behind closed doors according to unwritten rules. Until the bankruptcies of several financial institutions in 1997, the MOF had emphasized the prevention of bankruptcies and implicitly guaranteed the viability of banks, life insurance companies, and other financial institutions. Regulators used an 'escorted convoy' (gosô sendan) approach, which kept financial institutions moving along in the same direction at the same pace, making sure none of them sank including virtually bankrupt institutions.
The practice of amakudari weakens the credibility of official supervisory policy and undermines its effectiveness. Amakudari, which literally means 'descent from heaven' in Japanese, refers to the practice of high-ranking retiring MOF officials taking high-paying positions in private companies regulated by the MOF. In the early 1990s, the presidents of one-quarter of Japan's 150 largest private-sector banks had obtained their positions through the amakudari system. The MOF directly controls 92 quasi-governmental special corporations, such as the Japan Development Bank, Export-Import Bank, and Housing Loan Corporation, which employed over 500 thousand people in 1994 and held capital totaling about 25 trillion yen. Retired MOF officials held 58 percent of the directorships of these special corporations. Several top MOF officials have 'retired' multiple times, moving from the MOF to a position at one of these special corporations and then to a private-sector firm, each time receiving a substantial lump-sum retirement payout (Hartcher 1998, 34-6, 43, 120). The amakudari system has the potential for favor trading between regulators and regulated institutions, such as the MOF expressing willingness to overlook a firm's violation of laws in exchange for lucrative positions for retiring or retired MOF officials.
The MOF's extremely close relationship with the financial institutions
that it regulated sometimes led to corruption. In early 1998, several MOF
officials from the bank inspection division were accused of extortion,
taking bribes, and influence peddling related to providing banks with advance
warning of impending inspections from 1994 to 1996. Ten large banks and
five large securities firms engaged in giving bribes to bank inspectors
(Hall 1998, 46-7; Kin'yû Kantoku Chô 1998a).
Loopholes and Weaknesses in Accounting RulesJapanese accounting rules have many loopholes that have allowed companies to manage earnings to their advantage. Companies frequently have used hidden gains and losses, non-consolidated subsidiaries and affiliates, and undisclosed pension liabilities to manipulate their reported profits and to understate their actual and contingent liabilities. This part examines a company's motivation for managing earnings and analyzes the major weaknesses in Japan's accounting standards, with specific company examples used to demonstrate the significance of these weaknesses.
Management of EarningsFrom a company's standpoint, the best financial statements are those that bring about the highest possible stock price and minimum cost of capital, not ones that display the company's financial condition and results most fully and fairly. Most companies try to downplay contingent liabilities, maximize growth expectations, and minimize actual and perceived risk in order to achieve these objectives. Companies can boost reported net income through such methods as shifting current expenses to a later time period, selling assets whose market value exceeds book value, and failing to record or disclose liabilities such as debt guarantees.
Tanaka (1998, 20-3) explains that Japanese companies consider accounting
rules to be maximum standards and almost never voluntarily disclose information
not required by law. In contrast, American and British companies generally
consider accounting regulations to be minimum standards and will disclose
information beyond the requirements as a means to meet market demands for
disclosure, attract investors, and provide company public relations. For
example, American financial institutions quickly announced losses related
to the 1997 Asian currency crisis, whereas many Japanese financial institutions
did not disclose their losses specifically related to the crisis.
Hidden Profits and LossesIn the period up to the bursting of the bubble economy in about 1990, most Japanese companies built up a huge amount of hidden profits as overall inflation and rising stock and real estate prices continued for many years. Hidden profits arise when the market value of a company asset exceeds its book value, usually original acquisition cost, reported on a company's balance sheet. Up to 1990, even if companies encountered a financial downturn, they easily could use hidden profits whenever necessary to cover losses by selling off assets with book values less than market values (Endô 1999, 68). Even after the downturn in stock prices during the 1990s, some Japanese companies continue to hold huge amounts of hidden profits that can be used as a 'safety value' in whichever accounting period they need to lift up sagging earnings or prevent showing a loss. For example, Toyoda Automatic Loom Works, Ito-Yokado, Fuji Electric, and Keisei Electric Railway all have hidden profits in marketable securities more than double the amount of their stockholders' equity. Ito-Yokado holds 1.6 trillion yen in hidden profits, more than any other Japanese non-financial company (Nikkei Business 1997a, 91).
When the asset price 'bubble' burst, real estate and stock prices fell dramatically between 1989 and 1993. Equity prices, as measured by the Nikkei Stock Index, fell sharply from an all-time high of nearly 40,000 in December 1989 to 21,000 in September 1990 to just under 15,000 in 1992. Land prices fell 40 percent on average between 1989 and 1993 (Beason and James 1999, 82; Someya 1996, 142).
When the stock market turned downward, the hidden stock profits of Japan's 21 major banks dropped from 46 trillion yen in 1990 to 17 trillion yen in 1992, and life insurance companies' hidden profits slid from 45 trillion yen in 1988 to 17 trillion yen in 1992. Although financial institutions in the aggregate still held hidden profits in 1992, some weaker banks and life insurance companies reached the point of holding hidden losses (Hartcher 1998, 103-4). By August 1998, the total estimated amount of hidden stock losses for the 19 largest banks had reached 2.6 trillion yen (Hiramatsu 1998, 29).
Japanese accounting regulations allow a choice of two methods, cost basis or lower of cost or market, to value marketable securities such as stocks. Someya (1996, 144) questions the desirability of allowing corporations to select different accounting techniques that lead to significantly different reported profit figures. When the Nikkei Index fell almost 50 percent from December 1989 to September 1990, nine of the twelve largest banks used the cost basis method to value their marketable securities, which allowed them to avoid recording an estimated one trillion yen in losses. In contrast, three of the banks had to report market valuation losses since they used the lower-of-cost-or-market method. Accounting rules require companies that use the cost method to write down the value of financial instruments in the case of permanent impairment, but company management can easily get around this requirement by convincing its auditors that the decline in value is considered temporary, not permanent, in order to avoid reporting a loss.
In the mid 1990s, Japanese financial institutions needed profits to offset the write-off of problem loans, so they converted hidden profits to realized profits by selling large amounts of their stock portfolio. For example, for the fiscal year ending March 31, 1994, the 21 major Japanese banks used 2.4 trillion yen in profits from stock sales to cover 63 percent of their total write-offs of problem loans. In the following year, stock sale profits of 4.1 trillion yen offset about three-quarters of the non-performing loan write-offs. Even though the banks sold a huge amount of stocks to realize profits, most of the banks bought back stocks in the same companies at a higher price in order to preserve their long-term relationship and to respond to MOF pressure that banks not be net sellers of stocks in order to prop up stock prices. After the selling and buying back of stocks, banks still owned 26 percent of the total market value of stocks in 1995, the same percentage as banks owned in 1990 (Hartcher 1998, 153-4).
Japanese non-financial companies also have significant hidden losses or gains related to marketable securities. Listed non-financial companies' parent-only financial statements had a total of 34 trillion yen in hidden profits at March 31, 1997, down slightly from 51 trillion yen at March 31, 1996. Even with this decline in stock prices, total hidden profits exceeded annual ordinary income by 2.6 times (Tokumasu and Katô 1997, 160-1). Although many non-financial companies have hidden profits, some large companies have a significant amount of hidden losses. For example, the following three large non-financial companies (i.e., capital greater than 5 billion yen) had hidden losses in marketable securities that exceed their stockholders' equity as of March 31, 1997: Ikeda Bussan, Ôkura Shôji, and Janome Sewing Machine with 82, 15, and 3 billion yen of hidden losses respectively (Nikkei Business 1997a, 91). This means they would fall to a negative capital position (i.e., liabilities exceed assets) if their marketable securities had to be recorded at market prices rather than cost. According to Japanese law, a company in a negative capital position can not pay dividends for five years and will suffer the revocation of the listing of their company's stock on a securities exchange if the situation continues for three years.
Among the 30 Japanese companies listed on the New York Stock Exchange and who submitted financial statements in 1995 according to US accounting standards, which require fair-value accounting for marketable securities, several companies' return on equity (ROE) differed significantly with and without the application of fair-value accounting. For example, Mitsubishi Shôji's ROE dropped from 6.0 percent to 3.9 percent when the company applied fair-value accounting to their marketable securities, and Kubota's ROE declined from 8.5 percent to 5.7 percent (Nikkei Business 1997b, 96-7). This decline in ROE primarily results from a higher equity total when the company revalues marketable securities to higher levels.
Since Japanese accounting rules do not require revaluation of real estate
values, many Japanese companies, especially those who acquired land before
World War II, have significant hidden reserves because real estate has
increased significantly in value since the acquisition date when they recorded
the assets at cost. Although real estate values fell from the peak in 1989,
substantial reserves still exist. For example, the 19 largest Japanese
banks own land as of April 1998 with a total book value of 1.1 trillion
yen and an estimated total market value of 5.5 trillion yen (Hiramatsu
1998, 30). On the other hand, some companies, especially those who bought
land during the speculative bubble economy of the late 1980s, have land
with book values far in excess of current market values.
Non-consolidated CompaniesJapanese accounting rules only considered a company's ownership percentage in another entity when determining whether to apply consolidation accounting (more than 50 percent) or the equity method of accounting for affiliates (20 to 50 percent), rather than taking into consideration other factors that indicated a company effectively controlled the other entity. These strict ownership criteria led to abuses by companies wanting to hide liabilities, poor financial results, or overvalued assets.
One example illustrates how such abuse occurs (Nikkei Business 1997a, 93-4). A parent company Hazama owns 13.4 percent of Hazama Real Estate (HRE). In addition, Hazama's wholly-owned subsidiary, Hazama Industrial, owns 6.2 percent of HRE, so Hazama's total investment percentage, direct and indirect, comes to 19.6 percent, just short of the 20 percent required for consolidation through use of the equity method. However, Hazama's ownership percentage does not accurately reflect its extent of control over HRE's operations. Hazama provided financing of 41 billion yen of long-term loans in addition to providing 89 billion yen in debt guarantees for HRE's loans. Since HRE's liabilities total 153 billion yen, Hazama has ultimate responsibility for 85 percent of them. Personnel relationships are also quite close, with five people serving as directors in both companies. Moreover, in fiscal year 1996, Hazama recorded 5.5 billion yen as an extraordinary loss for write-offs of receivables from HRE.
Even though Hazama appears to have significant influence over HRE's operations, the consolidation accounting rules do not require Hazama to recognize its share of HRE's net income and to disclose the 89 billion yen in debt guarantees of HRE's loans. HRE recorded a 1 billion yen loss for fiscal year 1996 and a 500 million yen loss in the previous year, but the accounting rules do not require Hazama to recognize any of these losses in its income statement. HRE's accumulated losses have grown to a negative capital position of 5.2 billion yen, but Hazama disclosed none of this.
As part of the consolidation accounting standard implemented in 1977, the MOF permitted exemption from consolidation if total assets or sales of non-consolidated subsidiaries were less than 10 percent of those of the parent company and other consolidated subsidiaries. This rule allowed companies to organize subsidiaries in such a way as to avoid consolidation. Even though the MOF extended the 10-percent materiality rule to income in 1983, corporations continued to have significant opportunities to exclude many subsidiaries from consolidation.
Since 1983, parent companies have also been able to apply a separate 10-percent materiality exclusion calculation to their percentage share of the net income of affiliated companies to which the equity method of accounting would otherwise have to be applied. In other words, the parent company did not need to apply the equity method of accounting to affiliates if the following ratio did not exceed 10 percent:
Parent company's share in net income of affiliated
These two materiality exclusion rules have allowed Japanese companies to not consolidate many subsidiaries and to not include in earnings their share of affiliated companies' net income or loss (McKinnon 1986, 275-6, 281, 285-7). For example, Fujikura's 1990 financial statements disclosed that the company consolidated only 14 of 53 subsidiaries and applied the equity method of accounting to only five of 23 affiliates (Beckman 1998, 18). Effective in 1995, the MOF reduced the materiality exclusion rule percentage from 10 percent to 3-5 percent, but even this reduced percentage allows companies to exclude many subsidiaries (Shiratori 1998, 181).
Financial analysts for securities firms and other financial institutions
often try to analyze the differences between consolidated and parent-only
earnings to better understand a Japanese company's financial position and
results (Beckman 1998, 18). The weaknesses in Japan's consolidation accounting
rules and practices lead to this type of financial statement analysis.
Parent-only and consolidated earnings or other financial measures can vary
greatly, as shown by the following examples. Mitsui Shipbuilding's parent-only
pre-tax operating income for fiscal year 1996 grew 76 percent in comparison
to the prior fiscal year, but it decreased 88 percent on a consolidated
basis (Nihon Keizai Shimbunsha 1997, 168-70). Return on equity (ROE) can
also vary significantly between the parent-only and consolidated company,
with Dowa Mining's parent-only ROE being only 3.4 percent in 1997 but a
much higher 20.0 percent on a consolidated basis. Tosoh had a parent-only
ROE of 11.3 percent in 1997 but a significantly less consolidated ROE of
7.8 percent (Tokumasu and Katô 1997, 70). The earnings per share
(EPS) of two department store and supermarket competitors, Daiei and Jusco,
show a huge divergence when examined on a parent-only and consolidated
basis. Jusco's EPS for fiscal year 1996 exceeded Daiei's by three times
(49.9 to 16.8 yen per share), but Jusco's EPS was close to 80 times greater
(109.1 to 1.4 yen per share) on a consolidated basis (Kawaguchi 1997).
Undisclosed Company Pension LiabilitiesJapan's pension funds have a serious underfunding problem. Since Japanese companies do not need to disclose their pension liabilities, calculations of company pension liabilities can only be estimated. The size of the pension fund shortfall can be appreciated by looking at 24 Japanese companies listed on the New York Stock Exchange, which requires disclosure of pension financial information in accordance with US GAAP. These 24 companies reported 7.9 trillion yen in total pension liabilities but only 4.5 trillion yen in pension fund assets for fiscal year 1996, which means they have set aside less than 60 percent of the funds needed to pay retiree benefits (Tokumasu and Katô 1997, 103-4). The estimated pension underfunding for all listed companies in Japan exceeds 80 trillion yen, and there are estimates that about one tenth of Japanese companies will have negative equity when they disclose their underfunding amounts (Komiya 1999, 25; Nikkei Business 1999, 24).
Pension fund shortfalls have arisen for two primary reasons. Many pension
funds have hidden losses because the current market value of fund assets
has fallen below the book value recorded at cost. Also, pension funds have
suffered losses since actual yields have fallen short of expected returns
on pension plan assets. Japanese pension funds have typically used an actuarial
assumption that assets would earn 5.5 percent annually based on guidance
from the MOF and the Ministry of Health and Welfare and based on a Corporate
Income Tax Law regulation that the assumed return be at least 5 percent.
However, actual returns for most pension plans have fallen below 5.5 percent
since about 1991. For example, in early 1998, about 75 percent of pension
assets were invested in domestic fixed income financial instruments with
yields ranging from 0.5 to 2 percent. Pension funds have long been restricted
by the government's 5:3:3:2 rule, which requires funds to have a pension
asset portfolio composition of 50 percent minimum in assets with guaranteed
yen principal value such as Japanese government long-term bonds, and maximums
of 30 percent in domestic stocks, 30 percent in foreign-currency-denominated
assets, and 20 percent in real estate (Beason and James 1999, 128-9; Miyake
1998). The restriction to hold a majority of pension fund assets in low-interest
domestic bonds has made it exceedingly difficult for pension fund managers
to achieve returns of 5.5 percent. The portion of the estimated pension
funding shortfall attributable to the use of unrealistic expected rates
of return for pension assets is estimated to be about 20 trillion yen (Yamashita
Weak Auditing PracticesJust as Japan's accounting standards have some major shortcomings as discussed in the previous section, the country's auditing system and practices also suffer from several weaknesses. Throughout the 1990s, CPAs and statutory auditors have failed in many cases to identify and disclose financial statement window-dressing and fraudulent acts by company management and employees. Foreign companies have great dissatisfaction with Japanese CPAs since published financial statements lack credibility (Nikkei Business 1998a, 39). This section examines four reasons why Japan has weak auditing practices.
Company's Close Relationship with CPA FirmA Japanese company and its CPA auditing firm usually maintain very close relations in good times and bad, so the company expects the auditor to provide help when troubles arise. Although stockholders officially select the company's CPA auditing firm, in reality the company nominates the CPA firm beforehand, and changes in a company's auditor rarely occur. This long, close relationship can lead a CPA firm to overlook and condone improper accounting used by a company to window-dress its financial statements. Auditors have been reluctant in the past to press companies to not use improper accounting because of fear their clients may leave them if they get the reputation of not providing help to a company in need (Shûkan Tôyô Keizai 1999b, 60).
Few Shareholder LawsuitsLawsuits and compensatory damage claims against CPA firms rarely occur in Japan, and no lawsuit of this type has been successful. However, recently shareholders of Yamaichi Securities sued company management and the external auditors, Chuo Audit Corporation, in multiple claims totaling over 400 million yen for losses incurred as a result of the collapse of the company because of Chuo's alleged role in concealing losses. Asahi Audit Corporation has been named as a codefendant in a claim of 86 million yen for having responsibility for the audit of Japan Housing Finance Corporation, a jûsen company (non-bank subsidiary of financial institution specializing in housing loans) that reorganized due to excessive non-performing loans (Nikkei Business 1998b, 42; Sakuma 1999, 17). The paucity of shareholder lawsuits against Japanese auditors stems from the strict legal requirement that an investor has the burden of proof to show a cause-and-effect relationship between an auditor's improper report and the investor's loss due to a drop in a company's stock price. MITI's Industrial Structure Council proposes that the system be changed so that a CPA firm has the burden to prove no cause-and-effect relationship exists between a auditor's report and a drop in the company's stock price. The Council also recommends that class action shareholder lawsuits against CPAs be permitted. If such changes were realized, suits against auditors of bankrupt companies would likely greatly increase (Nikkei Business 1998a, 39).
Statutory Auditor's Lack of Independence and QualificationsThe position of statutory auditor in Japan has a long history dating back to the CC enacted in 1890. The CC and SEL require a company's statutory auditor to review the company's financial statements and to verify the adequacy of internal controls, but the statutory auditor's professionalism and credibility are questionable since the law does not require specific qualifications, such as accounting or auditing education or experience, for the position of statutory auditor. In 1993, the CC was amended to require a large company to have at least three statutory auditors, with at least one of them being a person not employed by the company or any of its affiliates within the prior five years. However, even with this requirement, insiders continue to dominate statutory auditor positions, with a company very easily able to nominate 'outside' candidates who will suppress their own opinions and follow the company's direction. The majority of these so-called 'outside' statutory auditors come from the ranks of former company directors or employees or from the company's correspondent banks (Ishida 1998, 16-9; Sangyô Seisaku Kyoku 1998; Shibata Hideki 1999, 66; Tokumasu and Katô 1997, 171).
Limited Number of CPAsJapan has few CPAs when compared to the size of its economy. Japan has only 12 thousand CPAs in comparison to 330 thousand in the US (Yokoyama 1999b). The MOF's control of the CPA examination has led to extremely low pass rates. Between 1995 and 1998, the pass rate has been below 7 percent, resulting in only about 700 new CPAs each year (JICPA 1999). Cooke (1994, 47) argues that the government keeps both the Japanese accounting and legal professions small since a large number of highly mobile professionals violates the cultural value of company loyalty.