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Friday, July 27, 2007

J-GAAP: Financial Instruments

General

In Japan, the BADC issued Accounting Standard for Financial Instruments in 1999. BADC's Accounting Standard was amended by the Accounting Standards Board of Japan (ASBJ) in 2006 and reformatted as ASBJ Standard No. 10, Accounting Standard for Financial Instruments.

ASBJ 10 and IAS 39 (revised 2000), Financial Instruments: Recognition and Measurement, both establish a comprehensive set of standards for various aspects of accounting for financial instruments. IAS 32 (revised 1998), Financial Instruments: Disclosure and Presentation, sets forth requirements for disclosure and presentation of financial instruments.

Recognition and Derecognition

Japanese GAAP and IAS 39 both state that a financial asset or financial liability must be recognized when parties are agreed on a contract that gives one party a right to receive cash or other financial assets and poses the other party an obligation to pay cash or other financial assets. Both also adopt the “financial-component approach” to derecognition of financial assets and liabilities.

Measurement

As for subsequent measurement of financial assets, Japanese GAAP provides different measurement methods for loans, securities, and derivatives. It states that loans must be carried at the face amount or amortized cost. Japanese GAAP categorizes investments in securities into four categories; (a) securities held for trading purposes, (b) equity investments in subsidiaries and affiliates, (c) debt securities held to maturities, and (d) others. Trading securities must be marked to market with recognizing changes in fair value in net income. Equity investments in subsidiaries and affiliates must be carried at cost on the parent-only financial statements unless the fair value declines significantly below the cost. Debt securities held to maturities must be carried at amortized cost. Amortization is based on either the interest method or the straight-line method. “Other” securities, which would be categorized in “available-for-sale” investments under IAS 39, must be carried at fair value in the balance sheet. Resulting increases in fair value from remeasurment of “other” securities, net of tax, are presented in a separate component of net assets, but not included in shareholders’ equity. Resulting loss are presented in a separate component of net assets or included in net income.

IAS 39 identifies all financial assets into four categories; (a) financial assets held for trading, (b) financial assets held to maturity, (c) loans originated, and (d) financial assets available for sale. Although such categorization is different, measurement methods required by IAS 39 generally concur with those required by Japanese GAAP. However, several minor differences can be identified. For example, as for available-for-sale financial instruments (compared with “other” securities under Japanese GAAP), IAS 39 allows entities to recognize changes in fair value in net income. Japanese GAAP requires entities to recognize gains in equity, but give them a choice to recognize losses in equity or in net income. Japanese GAAP also allows the average of fair value during the closing month of the fiscal year. As for restoration of the value of loans, IAS 39 requires restoration, but Japanese GAAP does not allow restoration.

As for financial liabilities (except for obligation resulting from derivative instruments), IAS 39 requires applying the amortized cost method to subsequent measurement of financial liabilities. Japanese GAAP previously required measuring those financial liabilities at face amount. Under the former Japanese GAAP, if an entity issues bonds at the amount less than the face amount, the discount was displayed as an asset (like a prepaid interest). Such discount asset was required to be amortized by the straight-line method. The current ASBJ 10 requires that financial liabilities should be measured at amortized cost, as similarly required by IAS 39.

Derivatives

Derivative financial instruments are generally measured at fair value in the balance sheet under both IAS and Japanese GAAP. As for interest rate swaps and forward foreign exchange contracts, which are frequently-used instruments in practice, Japanese GAAP provides some exception to fair value measurement of derivative instruments. Japanese GAAP allows accrual accounting to “plain-vanilla” interest rate swaps that are held for hedging interest-bearing financial assets or liabilities that have essentially the same duration. It also allows entities to adopt the “synthetic instrument approach,” as discussed earlier, to forward foreign exchange contracts that hedge foreign currency risk exposures.

Japanese GAAP also gives entities an option to adopt either of deferral hedge accounting and mark-to-market hedge accounting. If deferral hedge accounting is adopted, deferred gains and losses on hedging instruments are carried as a separate component of net assets, but not included in shareholders' equity on the balance sheet. IAS 39 states that if exposures to the volatility of fair value of the existing assets and liabilities and firm commitments are hedged (fair value hedge), an entity may accelerate recognition of changes in fair value on hedged items whereas the hedging instruments are measured at fair value with recognizing changes in fair value through net income. If exposures to the volatility of future cash flows of anticipated transactions, entities may defer changes in fair value on hedging instruments in the shareholders’ equity.

Combined Financial Instruments

As for combined financial instruments, Japanese GAAP generally applies a separate accounting to bond with warrants and convertible bonds. Undetachable bonds with warrants and convertible bonds are now termed as bonds with stock options, according to the 2001 amendment to the Commercial Code. As for bonds with stock options that require holders to substitute the amount redeemed at the exercise of the stock option as the payment at the issuance of the new stock (previously referred to as convertible bonds), an issuer may or may not adopt the separate accounting. If it does not adopt such accounting, bonds with stock options, as a whole, would be presented as a liability section in the balance sheet.

J-GAAP: Intangible Assets

In Japan, the BADC issued Accounting Standard for Research and Development Costs in 1998. The Standard states that research and development costs should be charged to expense immediately when they are paid. This treatment is identical to that of U.S. GAAP. IAS 38 (1998), Intangible Assets, requires that research costs must be charged to expense immediately, but that development costs can be recognized as assets if certain criteria are met. Software production costs are recognized in Japan, depending on how the software will be used, unless they meet the definition of research and development costs.

IAS 38 and Japanese GAAP both require that intangible assets must be amortized over their useful lives and must be reviewed as to whether they are impaired when events indicated that any impairment might exist for such assets. In Japan, useful lives for amortization of intangible assets that are prescribed by tax laws are generally used for financial reporting purposes as well.

J-GAAP: Provisions and Contingencies

In IAS 37 (1998), Provisions, Contingent Liabilities and Contingent Assets, provisions are built on the definitions of liabilities. Uncertainty in amount and timing of future cash outflows involves recognition of provisions. The definition of provisions includes constructive obligations as well as legal obligations.

In Japan, recognition criteria for provisions were set forth based on the revenue and expense view. This approach allows entities to recognize liabilities that are not legal obligations, such as provisions for bad debt loans and provisions for future asset-maintenance expenditures. Japanese GAAP sets forth the following criteria; (a) future outflows of cash and other resources are identified, (b) the outflows occur as a result of the events during current or past accounting periods, (c) it is probable that such outflows occur, and (d) the outflows are measurable with reliability. Those criteria are generally consistent with recognition criteria prescribed by IAS 37.

If it is not probable that future outflows of resources occur, contingent liabilities are not recognized under Japanese GAAP. Such treatment is not inconsistent with IAS 37, which states that a contingent liability is not recognized if future outflow of resources is not probable to occur or if it is not measurable with reliability. However, interpretation about “probability” criterion in both standards does not look similar. Japanese GAAP generally requires that it must be “highly probable,” as literally translated in English so as to be recognized in the balance sheet.

J-GAAP: Impairment

In Japan, the BADC issued Accounting Standard for Impairment of Long-Lived Assets in August 2002. Japanese Standard and IAS 36 (1998), Impairment of Assets, both set forth procedures that require companies to take similar steps, including identification of impairment indicators, performing recognition tests, and measuring impairment losses.


The major difference can be found in recognition criteria. IAS 36 says that if the carrying amount of the asset in question exceeds the collectible amount (defined as the higher of value in use or net selling price), an impairment loss must be recognized. Japanese GAAP, which is rather similar to the U.S. GAAP regarding recognition criteria, states that if the carrying amount exceeds the undiscounted sum of future cash flows from continuous use and eventual disposal of the asset, an impairment loss must be recognized. Japanese GAAP is based on a belief that an impairment is an irreversible event and an impairment loss must be recognized only when such impairment has a high degree of certainty of existence, because estimates of future cash flows are highly subjective.


Another difference is related to restoration. IAS 36 requires recognition of a restoration of the asset that meets certain criteria for restoration. Japanese GAAP, like U.S. GAAP, prohibits any restoration.


In determining future cash flows, Japanese GAAP states that only cash flows based on plans for future events committed by the management must be incorporated into the estimation. IAS 36 prohibits that cash flows from future events, including future capital expenditures and future restructuring, should not be included in determination of recoverable amount.


Treatment of corporate assets is also different. IAS 36 requires that if an impairment loss is recognized in a cash generating unit, a proportionate portion of the carrying amount of corporate assets attributable to the units must be subject to recognition of an additional impairment loss for corporate assets. Japanese GAAP requires applying either the IAS 36 method or U.S. GAAP method. Under U.S. GAAP method, an entity is required to set forth a higher level grouping of assets, in which additional impairment may be recognized attributable to corporate assets.
This Standard will be fully effective for fiscal years ending on or after March 31, 2005. Earlier applications are allowed for fiscal years ending during March 31, 2003 to March 30, 2005.

J-GAAP: Consolidations

IAS 27 (reformatted 1994), Consolidated Financial Statements and Accounting for Investments in Subsidiaries, utilizes the concept of control as a determinant of the scope of subsidiaries. Control is defined as an authority to make a decision on the other entity’s financial and management policy, from which the entity receives economic benefits.

The BADC’s Accounting Standard for Consolidated Financial Statements was revised in 1997, which adopts the concept of control as a determinant of subsidiaries as well. It states that all controlled entities are defined as subsidiaries, which must be consolidated for the parent’s reporting purposes. The BADC issued additional implementation guidance to determination of the scope of subsidiaries, which requires that if more than 40 percent of outstanding shares of an entity is purchased by the investing entity, such entity is deemed as a subsidiary unless other counter evidence exists.

Associates are defined as entities significantly influenced in their financial and management policy by the investing entity. Both standards require the investing company to account for their investments in associates by the equity method on consolidated financial statements. Japanese GAAP requires that investments in unconsolidated subsidiaries must be accounted for by the equity method as well, while IAS 27 requires that such investments should be accounted for as an available-for-sale investments in accordance with IAS 39.

J-GAAP: Foreign Currency Translations

Foreign currency transactions are translated at the exchange rates as of the translations under the both Japanese GAAP and IAS 21 (revised 1993), The Effects of Changes in Foreign Exchange Rates. It was noted as a symbolic difference that Japanese GAAP used to require applying the current exchange rates to short-term monetary assets and liabilities and the historical exchange rates to long-term monetary assets and liabilities. The existing BADC’s Accounting Standard for Foreign Currency Transactions, which was revised in 1999, requires applying the current exchange rates to all monetary assets and liabilities.

Hedging instruments, including foreign currency forward contracts and other types of foreign currency derivative instruments, are accounted for in conformity with accounting standard for financial instruments. That is, hedging instruments are separately recognized as an asset or liability at fair value. The changes in fair value may be deferred if an entity adopts the deferral hedge accounting. If the entity adopts the mark-to-fair-value hedge accounting, the hedged assets or liabilities may be measured at fair value.

Foreign currency hedging instruments may also be accounted for by the “synthetic instrument approach.” Under the approach, the hedging instrument and the hedged item are accounted for as if those instruments are a combined instrument. Under the international accounting standards, foreign currency hedging instruments are accounted for in conformity of IAS 39 (1998), Financial Instruments: Recognition and Measurement.

For purposes of translating foreign currency financial statements, foreign operations are categorized into (a) foreign branches (part of legal entity) and (b) foreign subsidiaries (a separate legal entity). Financial statements of foreign branches should be translated by the temporal method. That is, financial statement items must be translated as if those items are a direct extension of the headquarter office. Financial statements of foreign subsidiaries should be translated by using the current rate method. All financial statement items, except for inter-company transactions, are translated at the current rates or average rates.

J-GAAP: Post-Employment Benefits

In Japan, the BADC issued Accounting Standard for Post-Employment Benefits in 1998. The Standard requires that accrual accounting must be applied to post-employment benefits, including one-time retirement payment (unique to Japanese practice) and monthly pension payments. Previously, entities recognized provisions for one-time benefit payments, but pension liabilities were not recognized because contributions to pension plans were charged to expense when paid.

Basic concept of the new Standard applying to accounting for post-employment benefits is not materially different from IAS 19 (revised 2002), Employee Benefits. It requires that pension obligations must be measured as projected benefit obligations, which means that any long-term inflationary trends in benefits must be reflected in the measurement. Post-employment benefit liability is measured as the excess of projected benefit obligations over pension assets, which are measured at fair value.

For allocation of projected post-employment benefit obligations over past service period and future service period, Japanese GAAP provides a choice among the straight-line method, the salary payment method, and the benefit multiplier method. IAS 19 requires that an entity must choose a method used for benefit calculation formula. Both require risk-free interest rate in discounting the accrued portion of the projected benefit obligation. Because Japanese GAAP allows use of an average of interest rates for past several years, in which abnormal interest rates were often excluded, the discount rates today are generally higher than the closing market interest rates.

Past-service cost must be allocated over the weighted average of remaining service years of employees under Japanese GAAP. IAS 19 requires the vested past-service cost must be recognized immediately, but allows entities to allocate the remaining unvested portion of past-service cost over the weighted average of remaining service years.

Adjustments of accounting changes by first-year application of new standard must be allocated over 15 years in Japan, but 5 years under IAS 19.

IAS 19 adopts the “corridor” approach to adjusting actuarial differences, while Japanese GAAP adopts the “materiality” approach. Under the “materiality” approach, an entity can leave any difference unrecognized if the difference falls within the 10 percent materiality threshold of changes in pension assets or benefit obligations. If the difference exceeds the 10 percent materiality threshold, it must be allocated over the remaining service years.

In Japan, the excess of pension asset over benefit obligation (plus any unrecognized differences), if any, are recognized as prepaid pension costs unless the excess stems solely from increases in past-service obligation or actuarial difference.

J-GAAP: Revenue Recognition

Japanese GAAP promulgates that revenue should be recognized based on the realization principle. Although the concept of realization is not specifically defined in GAAP, it is interpreted that revenue is realized if the following two conditions are met; (a) a transfer of goods or services and (b) receipts of cash or cash equivalents (including accounts receivable).

Construction contract is accounted for alternatively by the completion method or the percentage-of-completion method. Such treatment is different from IAS 11 (revised 1993), Construction Contracts, which requires the percentage-of-completion method when the outcome of the contract can be reliably estimated.

J-GAAP: Tangible Fixed Assets

Property, plant, and equipment should be measured at cost less accumulated depreciation in both Japanese GAAP and international accounting standards.

The original cost of the asset is determined in an essentially similar way, but accounting for closure and removal costs is different from each other. IAS 16 (revised 1998), Property, Plant and Equipment, requires that a liability that results in future cash flows for closure and removal activities should be recognized, and that accrued costs must be added to the original cost. In Japan, such future closure and removal cash flows is generally deducted from the salvage value of the asset or is recognized as a provision for closure and removal on an accrual base, which would result in allocating the cost over the useful life of the asset.

Major difference would be found in practice of revaluation, which is an allowed alternative by IAS 16. In Japan, GAAP does not allow revaluation, but Land Revaluation Law, which was enacted originally in 1998, gave large companies, as defined in the Commercial Code, and financial institutions a chance of one-time optional revaluation of land for operating purposes for fiscal years ending March 1998-March 2002.

IAS 40 (2002), Investment Property, requires an entity to select either of the cost model or the fair value model on subsequent measurement of investment properties. If the cost model is selected, fair value information about investment properties must be disclosed in the accompanying footnote to the financial statements. Japanese GAAP neither set forth a definition of investment properties for measurement purpose (but require presentation as a separate line item on the balance sheet), nor require fair value disclosure about investment properties. The BADC’s Accounting Standards for Impairment of Long-Lived Assets, which was issued in August 2002, revisited the issue and stated that the BADC decided not to require fair value information for investment properties.

J-GAAP: Segment Reporting

International accounting standard for segment reporting was originally set forth as IAS 14 (1981), Reporting Financial Information by Segment. IAS 14 was revised in 1997 and the title of the standard was changed as IAS 14 (revised 1997), Disclosures about Segments of an Enterprise and Related Information. Revised IAS 14 requires an entity to select either of business segments or geographic segments as primary segments, based on internal structure of the business entity. The other segments that are not selected as primary segments are named as secondary segments. For primary segments, IAS 14 requires extensive disclosures, including revenue, income, assets, liabilities, capital expenditures, depreciation expense, other non-cash expenses, and impairment loss. For secondary segments, it requires only limited disclosures.

Japanese reporting standard is rather similar to the former IAS 14 (1981). It requires public companies to disclose information about both industrial and geographic segments, regardless of how the companies are organized internally. For industrial segments, operating revenue, operating income, identifiable assets, depreciation expenses, and additions to the assets should be disclosed. For geographic segments, operating revenue, operating income, and identifiable assets should be disclosed.

J-GAAP: Income Taxes

Japanese accounting standard for income taxes, which specifically requires recognition of deferred tax assets and liabilities on a parent-only basis, was issued in 1998. Previously, inter-period allocation for income taxes was at the entity’s option when it was required to present its consolidated financial statements to be filed with the MOF since 1970’s, and was required first on the consolidated financial statements in 1997 by accounting standards for consolidated financial statements.

Japanese GAAP and the international accounting standards both adopt the asset and liability approach to accounting for income taxes. That is, both require identifying temporal taxes and applying effective tax rates to the temporary differences. Deferred tax assets would be recognized to the extent that deductible temporary differences can be collected through future taxable income.

IAS 12 (revised 2000), Income Taxes, requires an entity not to discount cash flows from income taxes. Japanese GAAP does not mention about discounting, but are generally understood that discounting is not an accepted practice.

J-GAAP: Cash Flow Statements

Japanese accounting standard for cash flow statements is relatively new. It was issued in 1998. Previously, statements of fund flows, which presented direct inflows and outflows of cash and other short-term investments or monetary items, were attached to the financial statements that are filed with the then Ministry of Finance.

Formats of cash flow statements required by current Japanese GAAP are almost similar to those required by IAS 7 (revised 1992), Cash Flow Statements. Cash flow statements in Japan have three categories; i.e., cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Cash flows from operating activities are presented by either of the direct method or the indirect method.

Minor differences remain in presentation of cash receipts and payments of interest and dividends, and payments of income taxes. Japanese GAAP requires an entity to choose one of the two alternative methods. If an entity chooses the first method, it must present receipts of interest and dividends and payment of interest in the category of cash flows from operating activities. Under the second method, an entity must present receipts of interest and dividends in the category of cash flows from investing activities, and payments of interest and dividends in the category of cash flows from financing activities. IAS 7 states that receipts of interest and dividends are alternatively presented in either of the categories of cash flows from operating or investing activities, and payments of interests and dividends in either of cash flows from operating or financing activities.

IAS 7 allows presentation of income taxes in the cash flows from operating activities or presentation after allocating income taxes into the three categories when such cash flows for income taxes can be specifically identified into investing and financing activities. Japanese GAAP requires to present cash flow from income taxes only in the category of cash flows from operating activities.

J-GAAP: Set of Financial Statements

A full set of financial statements in Japan are:

  • balance sheet,
  • income statement,
  • cash flow statement,
  • statement of changes in net assets, and
  • the related schedules.

Japanese Companies are required to present two sets of financial statements: consolidated statements; and parent-only, separate financial statements.

International accounting standards do not require presentation of parent-only financial statements. Types of consolidated financial statements required by the international standards are not materially different from those required by Japanese GAAP.

For income statements, differences may be identified on presentation of extraordinary items and accounting changes. Extraordinary gains and losses contain generally non-recurring items and prior-period adjustments. Although the definition of non-recurring items by Japanese GAAP may be literally concurred with what are reported as extraordinary items under the international accounting standards, it includes gains and losses on sales of long-term investments in properties, equipments, real estates, and other-than-trading securities.
In Japan, income taxes are presented in a format of subtracting them from pretax net income. Extraordinary items are presented above the pretax income, and, therefore, are presented as a pretax amount, between the ordinary income and the pretax net income.

Changes in accounting methods are generally prohibited under Japanese GAAP except when such changes are justified by supportable reasons, such as because those changes are resulted from changes in laws and accounting standards or because those changes would bring more fair representation. However, it is generally said that entities are likely to change their accounting policies more frequently in Japan than entities that comply with international standards. In addition, Japanese GAAP does require disclosure about effects of accounting changes but does not specify how accounting changes should be accounted for and how they should be presented in income statements. In practice, for example, changes in depreciation method for a fixed asset are treated prospectively; that is, any gains or losses on the adjustment are not recognized currently but deferred to be recognized over the remaining useful years through depreciation process.

Changes in estimates are accounted for prospectively under the IASs. Japanese GAAP generally requires prior-period adjustments should be presented currently as an extraordinary items in income statements, but does not specify what kind of changes in estimates must be treated as prior-period adjustments. In practice, any adjustment of changes in estimates of useful lives or salvage values of long-lived assets is recognized as extraordinary gains or losses during the period of adjustments.

As of July 2007, the ASBJ exposed Issues Paper on Accounting Changes. Retroactive restatements are now under deliberation.

J-GAAP: Institutional Background

Standard-Setting

Before we identify differences between Japanese GAAP and IASs, it would be beneficial for readers to review accounting standard-setting process in Japan.

Since the end of World War II, Japanese GAAP have been set forth by the Business Accounting Deliberation Council (BADC) and its predecessors. The BADC was originally formed as an advisory body to the Minister of Finance (MOF), and is now an advisory body to the Prime Minister of Japan and the Commissioner of Financial Services Agency (FSA), based on recent restructuring of the government. More specific missions of the BADC include establishing accounting and audit standards and recommending strategic plans for domestic and international activities.

In July 2001, a new accounting standard-setting body was formed in private sector. The Financial Accounting Standards Foundation (FASF) is a supervisory foundation, and, as an independent force, the Accounting Standards Board of Japan (ASBJ) is now working on developing Japanese GAAP. The FASF is funded mainly by business community and public accountants. The ASBJ has currently 13 voting members, including 3 full-time members. It issues or revises accounting standards, implementation guidelines, and practice bulletins applicable to business enterprises. The Board is supported by approximately 15 staff members, most of which are fellow members from major accounting firms and larger listed companies. The BADC has just issued accounting standards for business combination in October 2003, which was one of the accounting issues that were previously addressed before the establishment of the ASBJ, and will no longer add a new project for pursuing setting accounting standards.
The ASBJ is now actively working toward developing accounting standards or implementation guidelines relating to various issues, including presentation of shareholders’ equity and its changes during the period, earnings per share, stock compensations, leases, impairment of assets, business combinations and other implementation issues.

The purpose of the establishment of the ASBJ is to develop domestic accounting standards in its own independent decision making, through a distillation process of experience in financial markets and accounting community. It also presumably includes contributing to international harmonization or convergence of accounting standards.

Financial Reporting Environment in Japan

In Japan, financial reporting is governed by two different sets of laws and regulations. The Commercial Code (CC) requires that all “merchants,” including joint stock companies, must keep books and prepare balance sheets. Especially, joint stock companies must submit their accounts to the annual shareholders’ meetings for their approval. The Securities and Exchange Law (SEL) requires public companies to file their consolidated and parent-only financial statements with financial regulators. Thus, public companies must prepare three sets of financial statements. Financial statements required by the CC and those required by the SEL are essentially the same, but still different in some respects. For example, the CC does not require companies to prepare cash flow statements, while the SEL do require public companies to prepare cash flow statements. There still remain minor differences in display of financial statements, and the SEL generally requires additional extensive footnote disclosures.

In addition, the Corporate Income Tax Law and its regulations set forth comprehensive tax rules in very detail, so that financial statements prepared under the CC and the SEL are significantly influenced by the tax rules. The accounting system in Japan is comprised of three different regulations; the CC, the SEL, and the tax rules. The three components are closely tied and have affected each other. In this sense, the accounting system in Japan has been characterized as “Triangular Legal System.” However, recent moves relating to the accounting system are generally recognized as going toward harmonization of financial statements required by the CC and the SEL. The CC recently removed their own accounting requirements, which are now moved to the ordinances of Ministry of Justice, and requires that larger companies must prepare consolidated accounts, which would be identical, for public companies, to the consolidated financial statements required by the SEL and its related regulations and GAAP.

Tax laws and regulations are becoming relatively independent from accounting treatments prescribed by GAAP. Because interperiod allocations of income taxes are now in practice since 1999, conformity between accounting earnings and taxable income have become less important.

Another important move was that the FSA amended its regulations in 2002, allowing Japanese SEC registrants to file with Japanese financial regulators their consolidated financial statements that are in accordance with U.S. GAAP. Previously, only SEC registrants that had already prepared consolidated financial statements in accordance with U.S. GAAP before Japanese regulators first required preparation of consolidated financial statements during 1970’s have been allowed to file U.S. GAAP consolidated statements, while other SEC registrants must prepare their consolidated financial statements in accordance with Japanese GAAP to file with Japanese regulators even though they prepare consolidated financial statements in accordance with U.S. GAAP for U.S. filing.

Update

In 2005, the Commercial Code is reorganized into newly enacted "Company Act" and "Commercial Code (for non-company merchants)."

The Company Act continues to rely on accounting professionals to set forth generally accepted accounting principles, which is applicable to preparation and presentation of financial statements by all companies. The Company Act eliminates most of the previous accounting requirements.

In 2007, the Securities and Exchange Law and other regulations are integrated into the "Financial Instruments Law." The new Law encompasses traditional securities transactions and relatively new financial instruments. Accounting and disclosure rules specified in the SEL are carried forward to new Law.

The Financial Instruments Law requires FSA registrants to report the effectiveness of "internal control," which will be mandatory for 2008 fiscal years.

J-GAAP: General Principles

Overview

BADC Accounting Principles for Business Enterprises set forth a broad set of "general principles." The set of general principles includes the following seven principles, which cover every aspects of accounting and reporting:
  • True and Fair View
  • Orderly Bookkeeping
  • Distinction between Capital and Earnings
  • Clear Presentation
  • Continuity
  • Conservatism
  • Consistency

The principle of materiality is set forth in Supplementary Notes to Accounting Principles for Business Enterprises, and is not included in the set of general principles. However, it is understood that the principle of materiality is as important as other seven general principles.

True and Fair View

The principle of true and fair view is the most prominent principle of the general principles listed in Accounting Principles for Business Enterprises. The Accounting Principles says that an enterprise should provide true and fair view about its financial conditions and operating results.
The concept of true and fair view does not mean absolute truth about enterprises. Financial statements are a product of management's judgements and estimates. The principle of true and fair view requires comparative truth about enterprises' pictures.

Then, what is true and fair view? The Accounting Principles for Business Enterprises do not define the meaning of true and fair view. True and fair view is rather defined operationally; it is thought to be accomplished by complying with all other lower accounting principles.

Orderly Bookkeeping

The principle of orderly bookkeeping requires that an enterprise should keep accurate accounting books in order. In addition, although not directly, the principle of orderly bookkeeping requires that all accounting treatments that enterprise performs be accurate. In this context, the principle of orderly bookkeeping implies the same philosophy of the principle of true and fair view.

Accurate accounting books are those that provide for orderly, complete, and verifiable accounting records.

Distinction between Capital and Earnings

The principle of distinction between capital and earnings requires that an enterprise should distinguish capital and earnings, especially capital surplus and earned surplus.

In Japan, it is emphasized that earnings should be distributable to stakeholders, such as shareholders and tax authorities. From a point of view of distributable income determination, distinction should be made clearly between undistributable capital and distributable earnings.
From a historical point of view, at the time when Accounting Principles for Business Enterprises are promulgated, distinction between capital and earnings was so vague as to cause many financial frauds. The Accounting Principles provided a warning that enlightened business community.

Clear Presentation

The principle of clear presentation requires that an enterprise should present clearly its financial conditions and operating results in a manner that financial statements do not mislead users. This principle applies to display of the body of financial statements and disclosure in notes to financial statements.

In conjunction with the principle of clear presentation, disclosure about accounting principles and post-balance-sheet-date events are required to make users able to understand better financial conditions and operating results.

Continuity

The principle of continuity requires that an enterprise not change its accounting policies without justifiable reasons. If an enterprise changes its accounting policies, the justifiable reasons and the effect on financial statements should be disclosed.

Generally, in practice, the justifiable reasons for accounting changes have been broadly interpreted. Therefore, the principle of continuity has long been criticized for its less rigid application. For example, Fifo method, Lifo method, and average method for inventory cost allocation are applied interchangeably and can be changed flexibly from one period to another.
Moreover, accumulated adjustments of accounting changes are generally not recognized. Accounting changes do not affect retroactively. Enterprises apply newly selected accounting policies without changing the basis of the assets or liabilities to which the former selected accounting policies are applied. Accounting literature is silent about the accumulated adjustments, but tax guidance provides some tax rules that prohibit retroactive adjustments. For example, enterprises do not adjust basis of depreciable assets even when accounting policy for the assets is changed from straight-line method to accelerated depreciation method.

Conservatism

The principle of conservatism, or principle of prudence, requires an enterprise to make prudent accounting choices and estimates when future events would make negative effects on its financial conditions. The principle, however, prohibits too prudent accounting choices and estimates. Many accounting principles, including realization principle, historical cost measurement, and the LOCOM rule, are derived to some extent from the principle of conservatism.

The principle of conservatism is often criticized for its unilateral bias to unfavorable earnings effects. Many accountants say that the principle distorts neutrality of accounting.

Consistency

In Japan, an enterprise often prepares more than one sets of financial statements for different purposes, including purposes of shareholders' approval, extending credits, and filing tax returns. The principle of consistency requires that an enterprise keep one set of accounting records for any different purposes and not distort accounting records by management's intent.

Materiality

The principle of materiality is set forth in the BADC Supplementary Notes to Accounting Principles for Business Enterprises. Therefore, the principle of materiality is not included in general principles of the Accounting Principles.

The principle of materiality requires an enterprise to make cost/benefit judgements on accounting choices and estimates. Every provision of accounting standards do not have to be applied to immaterial items.

The principle of materiality is not inconsistent with the principles of order bookkeeping and fair presentation, because the principle of materiality aims to achieve the purpose of financial statements effectively, which is the same purpose pursued by the principles of order bookkeeping and fair presentation.

J-GAAP: Company Act Regulates Accounting for Equity

Since May 2006, the Comapny Act has been enacted.
The Company Act regulates dividends policies of companies, which are based on the accounting for shareholders' equity. Therefore, the Company Act has its own requirements that regulates companies' accounting for shareholders' equity.
The Company Act states that contributed capital from shareholders must be displayed in "stated capital" but may reclassify no more than half of contributed amount into "capital reserve." Any excess of capital surplus over the legally defied "capital reserve" is "other capital surplus" (typically comes from the legal decrease in stated capital or capital reserve) can be distributed to shareholders.
Of course, retained earings can be distributed to shareholders as dividends, in which companies are required to raise 1/10 amount of the dividends as "earned reserve." The excess of earned surplus over "earned reserve" is called "other earned surplus."
Companies may pay dividends or purchase treasury stock within the total amount of "other capital surplus" and "other earned surplus."

Is this comfusing? Yes, shareholders' equity is summerized as follows:
  1. Stated capital (legally defined)
  2. Capital surplus (=additional paid-in capital), including (a) capital reserve (legally defined), and (b) 0ther capital surplus (distributable)
  3. Earned surplus (=retained earnings), including (a) earned reserve (legally defined), and (b) other earned surplus (distributable)

J-GAAP: Statement of Changes in Equity

On December 27, 2005, the Accounting Standards Board of Japan (BADC) issued ASBJ Standard No. 6, Statement of Changes in Net Assets.ASBJ Standard No. 5 defines net assets as the excess of assets over liabilities, and defines shareholders' equity separately. For example, stock options and minority interest is not included in shareholders' equity but included in net assets.
ASBJ Standard No. 6 requires entities to present statement of changes in net assets, which shows changes during the period in each components of net assets. Especially important for investors is that that statement displays distributions to shareholders regardless of dividends and treasury stock. (Previously, only changes in additional paid-in capital and retained earnings are disclosed in a "statement of surplus.")
It requires entities to show changes in remeasurement and translation adjustments (so-called "accumulated other comprehensive income," as defined by US GAAP), but allows them to show the "net" change during the period. Investors may obtain, by themselves, "comprehensive income," but are unable to see reclassification adjustment of accumulated other comprehensive income into the current net income.

J-GAAP: Net Assets

On December 9, 2005, the Accounting Standards Board of Japan (ASBJ) issued ASBJ Standard No. 5, Display of Net Assets on Statement of Financial Position.
That Standard defines that net assets is the excess of assets over liabilities, and is required to be displayed as a separate element on statement of financial position. It also specifies components of net assets, which include:
  • Shareholders' equity;
  • Remeasurement and translation adjustments;
  • Minority interest; and
  • Stock options.
It is a common understanding that distinction between liabilities and equity is very difficult, considering the current financial engineering. Definition of liabilities, which is a relatively clear concept, is used when identifying net assets. Therefore, items that are included in net assets but excluded from shareholders' equity are remeasurement and translation adjustments, minority interest, and stock options.
Shareholders equity is subdevided into the following categories:
  • stated capital;
  • capital surplus (additional paid-in capital);
  • earned surplus (retained earnings); and
  • treasury stock.
Remeasurement and translation adjustments include unrealized gains and losses on financial instruments, unrealized gains and losses on land that are allowed to be revalued by the Land Revaluation Law, and translation adjustment recorded when foreign-currency-denominated financial statements are translated into reporting currency. Those adjustments would be attributed to shareholders' interest, but they are considered as a separate component from shareholders' equity until they are released from risk (realized).

J-GAAP: Leases

On March 30, 2007, the Accounting Standards Board of Japan (ASBJ) issued ASBJ Standard No. 13, Leases.
Previously, accounting standards for leases, set forth by the Business Accounting Deliberation Council early 1990's, required entities to distinguish finance leases and operating leases, but allowed them not to capitalize finance leases provided that pro-forma information is disclosed in the notes.
The new Standard requires that all financial leases should be capitalized; i.e., leased assets and liabilities should be displayed on the face of the balance sheet.

Many accountants recognize that the new Standard is a major step forward to more transparent financial reporting. The economic consequence of accounting standards for leases have been considered significant especially for lease industry. Reportedly, there were a lot of political activities until the new standard was finalized.

J-GAAP: Inventories

On July 5, 2006, the Accounting Standards Board of Japan (ASBJ) issued ASBJ Standard No. 9, Masurement of Inventories.
Standard No. 9 revised the then existing standards, where the cost method and the LOCOM method are alternatively allowed for measurement basis, so as to allow, in substance, only the LOCOM method. It would be summerized as follows:
  • Inventories should be carried at cost. If the carrying amount excees the net selling price, the carrying amount should be written down to the net selling price.
  • For certain inventories of which the net selling price is not readily determinable, its replacment cost and other market-based amount can be used in place for the net selling price.
  • Previously recognized written down should not be reversed even when the net selling price regained.
  • Inventories held for trading activities should be measured at fair value at each balance sheet date. Changes in fair value are recognizes as gains or losses during the period.

Statement of Accounting Principles for Business Enterprises, which was set forth by the Business Accounting Deliberation Council (BADC), describes the generally accepted inventory methods: Specific identification method; First-in, first-out method; Last-in, first-out method; Average method; and Retail inventory method.

J-GAAP: Share-Based Compensations

On December 27, 2005, the Accounting Standards Board of Japan (ASBJ) issued ASBJ Standard No. 9, Stock Options and Other Share-Based Compensations.
That Standard is effective for fiscal years beginning on or after April 1, 2006. It requires entities to recognize a cost of labors based on fair value of stock options.
Entities must estimate total cost of stock options based on the fair value at the grant dates and the estimated number of exercisable options.Then, the total cost should be recognized over the vesting periods. Stock options are accumulated and presented in net assets separately from shareholders’ equity. [Note: Shareholders' equity is displayed as one major component included in net assets.]
Stock options are transferred into paid-in capital when exercised, or recognized as a gain when expired without exercise.
It would be noteworthy that fair value measurement for stock options is introduced into J-GAAP. However, there are still some differences between J-GAAP and IFRS:
  • Stock options are displayed in net assets but excluded from shareholders' equity.
  • Stock options that are expired without excercise are reversed into net income.
  • Stock options issued by non-public companies are accounted by the "intrinsic value method," but no remeasurement is required as of each balance sheet date.

News: Exposure Draft on Fair Value Disclosure for Financial Instruments

On July 20, 2007, the Accounting Standards Board of Japan (ASBJ) issued an exposure draft that proposes mandatory disclosure of fair value of financial instruments.
The existing standard requires fair value disclosures only for marketable securities and non-hedge derivatives. The finalized standard would require fair value disclosure for all types of financial instruments, disaggregated by classes, maturities, purposes, and so on, unless the fair value is not readily determinable.
The proposed rule states that the currently required descriptive information about management's policies on controls over financial instruments, including derivatives, is extended to those for all financial instruments.
I would say that the proposed rule is quite similar to requirements of IAS 39 and SFAS 133(R). I really appreciate the ASBJ's effort on improvement over fair value disclosures.

Conceptual Framework: Recognition and Measurement

Chapter 4 of ASBJ's Discussion Paper addresses recognition and measurement of financial statements.It generally explay when an element of financial statements should be recognized, and identifies various measurement attributes that are used in current practice.
Recognition criteria is described based on the analyis for what is a trigger for recognition.
Measurement attributes are more widely identified than in FASB/IASB conceptual framework.

You may be interested in the document. Download Discussion Paper (tentative translation version) at:
http://www.asb.or.jp/html_e/asbj/begriff/ConceptualFramework200612.pdf.

Conceptual Framework: Elements of Financial Statements

Chapter 3 of ASBJ's Discussion Paper addresses issues related to elements of financial statements.
It identifies the following elements:Assets; liabilities; net assets; shareholders' equity; revenue; expense; comprehensive income; and net income.
You may be curious why Discussion Paper identifies similar two elements of net assets and shareholders' equity. Net assets are defined as the excess of assets over liabilities, while shareholders' equity is defined as shareholders' interest in claims to assets. Difference between net assets and shareholders' equity includes changes in fair value of certain financial instruments, translation adjustments, minority interest, and stock options.
Comprehensive income and net income are identified as separate elements of financial statements. Comprehensive income is defined changes in net assets during the period from non-owner transactions. Net income is the excess of reveune over expense, as recognized based on the concept of "release from risk," which is silimar concept of realization or matching.

Conceptual Framework: Qualitative Characteristics of Accounting Information

Chapter 2 of Discussion Paper addresses qualitative characteristics of accounting information.
It identifies qualitative characteristics that make information useful for users' decision making.Decision Usefulness is supported by two fundamental characteristics: relevance and reliability.
On the other hand, decision usefulness should be acheived in consideration for comparability and internal consistency. Those two characteristics are regarded as restrictive constrants in reaching for decision usefulness. Internal cosistency is defined as a quality in which information is consistent with the existing fundamental concepts underlying accounting standards and practices.

Conceptual Framework: Objectives of Financial Reporting

Discussion Paper on conceptual framework first sets forth objectives of financial reporting.
As other conceptual frameworks state, Discussion Paper states that objectives of financial reporting is to provide information useful for decision making by investors and other financial statement users.
More specifically, Discussion Paper says that the information should be focused on an entity's financial positions and performance. It also emphasizes that earnings is important to communicate with users the entity's past performance, so that users can establish their own prospects for the entity's future performance and, therefore, the entity's firm value.
Discussion Paper states that the principal role of financial reporting is to provide information about the entity's financial history rather than fortune tale. Based on such information, investors make their own investment decision at their own risk.

Conceptual Framework: Discussion Paper Issued

In December 2006, the ASBJ agreed to issue Discussion Paper on Conceptual Framework.

Many have asked what is conceptual framework in Japan. The Paper states that it enhance communication with standard-setters in the world.
The Paper has contents similar to IASB/FASB conceptual framework: objectives of financial reporting; characteristics of accounting information; elements of financial statements; and recognition and measurement in fiancial statements.
The Paper is an exposure document, because the IASB and the FASB are now reviewing their concept statements toward setting a common set of framework and the ASBJ intends to continue its discussion on the conceptual issues.

I will discuss the Paper in detail here.

J-GAAP: Quarterly Reporting

Did you know that Japanese listed companies will be required to publish quartery reports from April 2008?
Partly because the Tokyo Stock Exchange recommends companies to issue quarterly reporting (require for venture companies), even currently, many liste companies prepare quarterly reporting.
The Financial Instruments Act (formerly, Securities Exchange Act) states that quarterly reporting is mandatory for all registrants with Financial Services Agency (FSA).
The ASBJ has issued accounting standards for quarterly reporting. The FSA exposed for public comments in June 2007 a series of proposed regulations related to quartery reporting and auditing.Accountants are now very busy to be ready for 2008 quartery reporting.

News: Standards Advisory Council

The Financial Accounting Standards Foundation (FASF), an sponsoring organization for accounting standard-setting, established Standards Advisory Council (SAC) in May 2007.
The SAC meets first time on July 9, 2007. The SAC will issue recommendations to Accounting Standards Board of Japan (ASBJ) on adding topics to the ASBJ's agenda and their international and other various activities. The activities of the former "Agenda Committee" was limited to recommendation for agenda issues.
The SAC members selected as chairman Mr. Yoshiki Yagi, chair of audit committee, Hitachi Corporation.

News: Issues Paper on Accounting Changes

On July 9, 2007, the Accounting Standards Board of Japan (ASBJ) issued Issues Paper on Accounting Changes.
In the existing Japanese GAAP, restatements of financial statements for previous years are not allowed.
The Paper identifies and discusses issues related to accounting changes. It is a general expectation that new accounting standards would require restatements for previous financial statements retroactively for comparative purposes. This project is a part of ASBJ's activities toward enhancing international convergence.