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.