J-GAAP: Business Combinations

The Business Accounting Deliberation Council, the former public-sector standard-setting body in Japan, issued in October 2003 Accounting Standard for Business Combinations.

The Standard allows entities to select the purchase method and the pooling-of-interest method, depending on the economic substance of business combinations.

If a business combination is qualified as a "purchase transaction," the purchase method should be applied; otherwise, the combination is categorized as "uniting of interests," and the pooling-of-interest method should be applied. Relative ownerships of shareholders of combining entities should be essentially the same, in order to categorize the combination as "uniting of interests." Quantitative threshold is set forth; i.e., 55% v. 45% merger can be accounted for by the pooling-of-interest method. So, business combinations that are categorized as "uniting of interests" would be very rare in practice.

Under the purchase method, an acquiring entity must be identified. Assets and liabilities of the acquired entity should be measured at fair value as of the agreement date. Any excess of acquisition cost over the net assets of the acquired entity should be recognized as goodwill. Goodwill should be amortized over the useful lives but no more than 20 years. If goodwill is impaired, impairment loss should be recognized.

In-process research and development costs of the acquired entity should be recognized, and immediately charged to expense. Restructuring provisions may be recognized when certain criteria are satisfied, but should be written off within 5 years. Any negative goodwill should be amortized over no more than 20 years.

Under the pooling-of-interest method, assets, liabilities, and components of equity of the combining entities should be carried forward as if those entities are merged into without adjustments to book values. No goodwill is recognized.

IFRS No. 3 and SFAS No. 141 eliminated the pooling-of-interest method as an alternative for accounting for business combinations. Those standards also prohibit amortization of goodwill. In those respects, Japanese GAAP for business combinations is different.

Editorial: Academic Perspective in Japan

In Japan, academic community has been heavily involved in the process of standard-setting. Influences of academic community is relatively significant in Japan.

Major schools in academics generally states as follows:

• The asset and liability approach is not only one approach to determining elements of financial statements. The revenue and expense approach is still needed. Information about inflow and outflow is primarily useful for investors' decision making. Investors would form their own expectation on the entity's future cash flows based on such information. Matching, allocation, and realization are still important in accounting.
• Net income is more useful than comprehensive income. Changes in fair value of certain assets and liabilities would deteriorate usefulness of income. Investors generally favor a sustainable concept of income rather than volatile concept of income. Empirical evidences generally support this view. Net income also should be determined as such attributable to common shareholders.
• Fair value accounting should not be applied to non-financial assets and liabilities, and even to financial instruments whose fair value is not readily determinable. Internally generated goodwill should not be recognized because such goodwill is the management's own assertion and is not verifiable.

Editorial: Nikkei Discusses Convergence

During September 6-8, 2007, Nikkei Newspaper discussed convergence of Japanese accounting standards with IASB standards in its series of articles.

Nikkei described in detail how Tokyo Agreement announced on August 8, 2007 was reached. It reported that Chairman Tweedie of the IASB recommended that Japanese companies should have an option to adopt IFRS as an alternative set of acceptable standards for the purpose of preparation of their financial statements that are filed with the Financial Services Agency in Japan. Such initiative was not included in the final agreement, but the next issue became clear.

One of the issues that would be revisited under the agreement is accounting for goodwill. The existing Japanese GAAP requires companies to amortize goodwill that are recognized when the purchase accounting is applied to certain business combinations. Amortization is widely accepted in Japan, mainly because amortization is tax-deductible when companies amortize goodwill in their accounting statements. Prohibiting amortization by accounting standards would require negotiation with tax authority.

Another is performance reporting. Japanese standard setter has repeatedly insisted that net income is necessary to provide information about entity's sustainable financial performance. Nikkei says that on international arena, comprehensive income, which is defined as net change in shareholders' equity, is focused as primary performance indicator. Especially, Japanese companies do not want to include changes in fair value of investments in the periodic net income, which is sometimes boosted by cherry picking unrealized gains on the investments. Comprehensive income is not affected by such practice, because realized and unrealized income is included in it regardless of whether the investment is selectively sold. Business community says that net income (realized income) still should be disclosed even when comprehensive income is disclosed.

Anyway, Tokyo Agreement was announced. Standard-setting process is moving toward international convergence. Recently, the ASBJ issued two exposure drafts on construction contracts and segment reporting, which are essentially the same as IASB standards.

News: ASBJ Issues Exposure Draft on Segment Reporting

On October 4, 2007, the Accounting Standards Board of Japan (ASBJ) issued an exposure draft on segment reporting. The exposure draft is part of the ASBJ's effort toward convergence with IASB standards. Commend period ends on October 19, 2007.

The existing standards on segment reporting requires entities to disclose information disaggregated by business activities and geography. "Risk and reward" approach is adopted.

The ASBJ newly adopted the "management approach," where operating segments are identified based on how the entity is managed internally. An operating segment is defined as a component of entity:

• That relates to operating activities that earn revenues and incur expenses.
• That is reviewed by chief operating decision makers for resource allocation and performance valuation.
• For which, separate financial information is obtainable.

Reportable segments are identified as one or more operating segments. Operating segments are aggregated based on similarities of activities. Certain quantitative criteria should be applied when determining reportable segments.

Information that is required to be disclosed includes:

• Segment profit (or loss) and segment assets (mandatory).
• Segment liabilities, when reviewed regularly by chief operating decision maker.
• External sales, inter-segment sales or transfers, depreciation and amortization, interest income and expenses, proportionate shares of affiliates' income, extraordinary gains and losses, income taxes, and other material non-cash items, when included in segment profit and reviewed regularly by chief operating decision maker.
• Investments in affiliates, additions to tangible and intangible assets, when included in segment assets and reviewed regularly by chief operating decision maker.

Related disclosures are required for each segment as follows:

• Information about goods and services.
• Information about geography.
• Information about major customers.

Impairment losses and amortization of goodwill should be disclosed for each segment regardless of whether they are included in segment profit.

J-GAAP: Balance Sheet

In Japan, balance sheet displays entity's assets, liabilities, and net assets.

Assets should be categorized into current assets, fixed assets, and deferred charges. Liabilities should be categorized into current liabilities and fixed liabilities.

Assets used for discontinued operations are not separated from other assets.

Net assets includes shareholders' equity, remeasurement and translation adjustments (other comprehensive income), minority interest, and stock options and warrants. Shareholders' equity is comprised of stated capital, additional paid-in capital, retained earnings, and treasury shares.

Generally, line items are specifically identified by FSA's regulations. Comparative information for only one prior fiscal year should be disclosed.

News: Exposure Draft on Construction Contracts

On August 30, 2007, the Accounting Standards Board of Japan (ASBJ) issued an exposure draft, which proposes accounting for construction contracts.

The long-lived, existing standards allows constructors to account for construction contracts based on either of "completion method" and "percentage-of-completion method".

Completion method, which is based on a narrower concept of realization, had been widely used in practice, but recently most major constructors are said to have alreadly changed their accounting policies to percentage-of-completion method.

ASBJ's proposed standards would require entities to identify which contracts should be accounted for by percentage-of-completion method. Total revenues and costs must be measurable with reliability. Percentage of completion also must be measurable with reliability. Other unqualified contracts should be accounted for by completion method.

The exposure draft is part of ASBJ/IASB convergence project. The proposed standards would eliminate one of major differences between Japanese GAAP and IASB standards.

Comment period will end on October 1, 2007.

J-GAAP: Income Statement

Display of income statements is specified by Accounting Principles for Business Enterprises.

Income statements are based on "all-inclusive" concepts, in which all gains and losses are included in the statements. General format of income statements is shown as follows:

Sales
Cost of goods sold
--Sales margin
Selling and administrative expenses
--Operating profit
Non-operating (financing) revenues
Non-operating (financing) expenses
--Ordinary profit
Extraordinary gains
Extraordinary losses
--Pre-tax net income
Income taxes--current
Income taxes--deferred
--Net income

Extraordinary gains and losses are generally defined as non-recurring gains and losses and prior-period adjustments. In Japan, retrospective restatement is not allowed in practice.

Extraordinary losses appear to show a rapid increase recently, which include various restructuring or impairment losses. In financial statement analysis, ordinary profit has been deemed as somewhat sustainable income. Entities tend to include more extraordinary losses to boost ordinary profits in future periods.

Discontinued operations are not segregated from continued operations.

Comprehensive income is not displayed elsewhere in financial statements. Changes in components of remeasurement adjustments (other comprehensive income) is displayed on a net or gross basis in statement of changes in net assets.

Currently (as of September 2007), accounting changes are under deliberation toward convergence with IASB standards. Retrospective restatements and prospective adjustments would be required, depending on characteristics of accounting changes.