The dual audit system for joint stock companies in Japan

Abstract

The origin of the statutory audits of joint stock companies in Japan can be traced back to the Commercial Code of 1890 (CC) when audits by appointed individuals who served within the company as corporate auditors were established. These CC auditors, selected by shareholders, sought to protect the interests of existing stockholders not those of prospective public market investors. In contrast, Western style external independent auditing in Japan can be traced back to proposed but unsuccessful legislation at the beginning of the twentieth century, which subsequently came into effect in 1951 under the Securities and Exchange Law (SEL). This paper examines the circumstances and differences regarding the development of Japan's dual audit system in order to contribute to our understanding of comparative audit processes in developed economies.

Keywords:

• independent public auditor
• accountability
• commercial code
• Securities and Exchange Law
• public interest

Acknowledgements

We would like to thank Professor Lee D. Parker (South Australia), Professor Trevor Boyns (Cardiff), Professor Masayoshi Noguchi (Tokyo Metropolitan), and participants at the Accounting, Business & Financial History workshop at Kobe University 2009 for their comments on an earlier draft of this paper.

Notes

In the 1999 accounting year, Asahi & Co. (affiliated with Andersen Worldwide) added the following statement to its English audit report for the Mazda Motor Corporation.

Statement on Accounting Principles and Audit Standards

This statement is to remind users that accounting principles and auditing standards and their application in practice may vary among nations and therefore could affect, possibly materially, the reported financial position and results of operations. The accompanying financial statements are prepared based on accounting principles generally accepted in Japan, and the auditing standards and their application in practice are those generally accepted in Japan. Accordingly, the accompanying financial statements and the auditors’ report presented above are for users familiar with Japanese accounting principles, auditing standards and their application in practice.

The BADC is a public sector consultation committee for the Financial Services Agency (FSA). The BADC currently sets Japan's auditing standards, on the basis of which the FSA establishes ‘rules (ministerial ordinances)’. In Japan, the FSA rather than the JICPA has the authority to regulate the CPA profession, including taking action such as suspending a CPA's right to practice. Japan's system is different from that of the US where each state board of CPAs has the authority to regulate the CPA profession. This is so partly because the Japanese CPA system was not voluntary but was imposed by the US government to institute the SEL audit. The Japanese government (the Ministry of Finance or FSA) had authority to regulate the SEL. The FSA (successor of the Ministry of Finance) did not want to relinquish its authority over CPAs but has relinquished the authority for setting ‘accounting standards’ to the independent standards-setting board, although the authority for fulfilling ‘global standards’ remains with the FSA. On the basis of BADC's auditing standards, the JICPA issues guidelines for members’ audit practices.

Many classic books provide operational or unambiguous definitions of independence. For example, Carey (1956), Carey and Doherty (1966), and Carmichael and Swieringa (1968) provide definitions of professional independence (integrity) and auditor independence (objectivity). The most famous operational definitions, made by Sharaf and Mautz (1960), consider independence in each aspect of the audit process. Wolnizer (1987) describes in detail independence as a conventional accounting concept when comparing the US, UK and Australian standards. However, note that all of these definitions are from the perspective of the accountant, not of the user.

The Commercial Code was largely revised in 2005 and divided into the Companies Act, which regulates companies, and the Commercial Code, which regulates commercial transactions. The legal purpose, however, remains the resolution of conflicts of interest on the basis of the existing contracts.

During the Meiji era (1868–1912), the government sought to make Japan a democratic state with equality among its people, promulgating the Meiji Constitution (1889) to ensure the individual's rights and duties. Once individuals were protected, the government then established the Company Act (included in CC) in 1890 to introduce Western-style capitalism and to establish a joint stock company system.

‘Discharging’ the accountability of the CC auditors is accomplished by approving their report at the stockholders’ meeting.

This structure bears some similarity to that of a UK joint stock company under the Companies Acts. However in the UK, the 1947 Companies Act required members of the independent accounting profession to serve as auditors (Hein 1978).

In theory, if the auditors provide a ‘no legitimacy’ opinion, the shareholders could punish management by withholding their compensation or even dismissing them. In practice, this almost never happens. Ideally, the threat of a ‘no legitimacy’ opinion compels management to produce an annual report which accurately reflects the state of the company.

The SEL has been recently revised and the filing of quarterly reports was required in addition to an annual report in Japan beginning on 1 April 2008.

An Act for the Registration, Incorporation, and Regulation of Joint Stock Company, 1844, §38, provided for the appointment of one or more auditors for examining statements of accounts. The Board of Trade supervised the appointment of auditors based on the stockholder's request when an auditor was not appointed as a representative of stockholders (Hein 1978, 159). The Companies Clauses Consolidation Act, 1845, §102 provided that an auditor shall be a stockholder.

A copy of this Bill is contained in JICPA (1975).

The events following the presentation of the first bill in the 31st (1914) Imperial Diet are as follows: 36th (1915) – withdrawn because of incomplete deliberation in the House of Representatives; 37th (1915) – approved by the House of Representatives, but withdrawn because of incomplete deliberation in the House of Lords; 40th (1918) – withdrawn because of incomplete deliberations in the House of Representatives; 41st (1919) – approved by the House of Representatives, but withdrawn because of incomplete deliberation in the House of Lords; 42nd (1920) – approved by the House of Representatives, but withdrawn because of incomplete deliberation in the House of Lords; 50th (1925) – approved by the House of Representatives, but withdrawn because of incomplete deliberation in the House of Lords. Because of domestic disorders following the First World War that began in July 1914, the Diet did not meet regularly.

In the UK, however, the 1845 Company Clauses Consolidation Act reduced the qualification for the auditor to be a shareholder and approved employment of a professional accountant with the burden on the company for executing the audit. In addition, when the model article of Table B in the 1856 Joint Stock Companies Act eliminated a shareholder requirement for the auditor, a professional accountant was chosen much more frequently (Edey and Panitpakdi 1978, 362).

Dickinson (1904) suggested that one of the most important functions of accounting is the ‘distribution of profit’.

Alletzhauser (1990) indicates that before the Second World War, CC auditors could be employees of the company, and Cooke and Kikuya (1992) also note that the role of the CC auditor is similar to that of an internal auditor in companies in many Western countries.