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October 21, 2003

Seeking International Collaboration
on Accounting Standards

Nippon Keidanren
(Japan Business Federation)


Given the globalization of capital flows through capital markets, and the diversification and increasing sophistication of economic transactions, there is an urgent need to develop internationally-accepted corporate accounting standards that ensure the comparability of corporate financial statements. However the three major markets - the United States, Europe, and Japan - have adopted different accounting standards.

In the European Union, the consolidated financial statements of listed companies within the region must conform to the International Financial Reporting Standards (IFRS/IAS) prepared by the International Accounting Standards Board (IASB) from 2005, in accordance with the integration of currency and capital markets.

In the United States, which has the largest capital markets, the Financial Accounting Standards Board (FASB), the US standard-setting body for accounting, reached a basic agreement with the IASB on the future convergence of the two bodies' standards in October 2002. In practice, however, the US uses Generally Accepted Accounting Principles (US GAAP) which prescribe the most strict and detailed rules under the oversight of the Securities and Exchange Commission (SEC).

In the past few years, Japan has been energetically reviewing its accounting and auditing standards with an eye to harmonizing them with those in the West wherever possible.

Given the coexistence of these different accounting standards from 2005, Nippon Keidanren would like to make the following proposals with respect to the international collaboration on accounting standards and the desirable form of standard-setting by the IASB.

I. International Collaboration on Accounting Standards

1. Development of Japan's accounting and auditing standards

Japan has been reforming its financial markets since 1997 in order to make them "free, fair, and global." As part of this effort, it has formulated and introduced a series of new standards for corporate accounting and auditing systems that form the infrastructure of the capital markets. With respect to the remaining issues, accounting for business combinations is mandatory as of FY 2006. Impairment accounting will be applied voluntarily from FY 2003 and made mandatory as of FY 2005.

In addition, the Accounting Standards Board was established in 2001 as an independent, private-sector standing body for the setting of accounting standards. As a result, standard-setting capabilities have been strengthened, and from a basis of solid independence and transparent and fair procedures, accounting standards are being developed rapidly to meet the fast-changing economic environment.

Based in part on the US Sarbanes-Oxley Act of 2002, Japan's Certified Public Accountant Law was revised in 2003 to improve and strengthen provisions relating to certified public accountants, and to assure the independence of certified public accountants (CPAs). The examination system for CPAs is also being revised.

In the past there were criticisms by some that Japanese accounting standards lagged behind those in other countries, and that accounting and auditing in Japan was unreliable. However, developments such as those referred to above have already raised Japan's accounting and auditing standards to a level that compares favorably with international levels. It is imperative that this should be fully understood by people involved in the market both within Japan and overseas.

2. Mutual recognition of accounting standards in Japan, the United States, and Europe

In the current debate on accounting standards, the IASB has set the goal of achieving convergence for the purpose of developing "a single set of high-quality, understandable and enforceable global accounting standards." Given the rapid globalization of capital flows and fund-raising, Nippon Keidanren would urge that accounting standards in the three major capital markets-the United States, Europe, and Japan -move in a direction in which the basic principles are unified to the greatest extent possible. To that end, the business community has been contributing to the IASB's activities.

At this stage, however, differences ramain between countries in a number of areas, including capital market systems, the fundamental character of accounting standards (whether rule-based or principle-based), and the relationships between accounting standards and company laws and tax laws.

In order to make accurate comparisons and to ensure the appropriateness of disclosure of actual conditions - all the while responding to the globalization of capital markets - Nippon Keidanren believes it is essential to move accounting standards in Japan, the United States, and Europe closer to each other.

At present, financial statements prepared by Japanese companies in accordance with Japanese standards are accepted in European countries. Subject to the approval of the Director General of the Financial Services Agency (FSA), financial statements prepared by foreign companies in accordance with their own national standards are accepted in Japan, as are consolidated financial statements prepared by Japanese companies in accordance with US GAAP.

Given the present state of global capital markets and existing disparities surrounding accounting standards, Nippon Keidanren considers it important to create a system in which Japan, the United States, and Europe accept financial statements based on each other's standards. Doing so would constitute a first step towards removing the barriers to international capital flows and towards common global accounting standards. To achieve this goal, the FSA of Japan must make rapid and forceful approaches to the SEC, the European Commission, supervisory authorities in European Union countries, and other relevant bodies concerning the acceptance of Japanese accounting standards.

II. The Desirable Form of the IASB

1. Large-scale review of IASB governance

The presence of the IASB in the international community is growing and its influence is being felt in many quarters. Its very prominence means that it is necessary for the IASB to be recognized as a genuine, legitimate international institution.

That said, there are mounting concerns not only about the content of the accounting standards that the IASB has been studying, but also about its governance and the procedures it adopts for its studies. Indeed, criticism of the IASB is not only voiced in Japan, but also within France and other European Union countries.

After their meeting at the Evian Summit in May 2003, the finance ministers stated: "We favor the emergence, through open and public processes involving the private sector, of high-quality internationally recognized accounting standards that are applied, interpreted and enforced, with due regard to financial stability concerns."

For the ministers' statement to be realized, the International Organization of Securities Commissions (IOSCO), which groups together national supervisory authorities that have the power to approve accounting standards, must work closely with the IASB. Furthermore, a structure should be created to ensure that in the study of standards by the IASB, the opinions of national governments, regions, preparers and users of financial statements, and others, are properly considered. In parallel, economic organizations throughout the world must collaborate and voice their opinions timely in order to contribute to the IASB's deliberations from the perspective of business practices.

2. Opinions on specific points at issue

Because the current IAS due to be adopted in Europe by 2005 is virtually the same as Japanese accounting standards, we are able to endorse mutual recognition today. But proposals now being studied by the IASB include those that in the future will involve principles that differ radically from the current standards, and that may lead to dramatic changes. Accordingly, we set out our opinions below with respect to the items that are the immediate principal points at issue.

(1) Reporting Performance

In the Reporting Performance Project, consideration is being given to abolishing the concept of net income in income statements in their present form, as well to the prohibition of the recycling (an accounting treatment to recognize the changes in the fair value, once presented as unrealized gains and losses) of financial instruments and others in income statements at the time they are realized. Thereby the IASB is seeking to introduce income statements that use comprehensive income based on valuation differences (the amount of change in fair value) in stock between the beginning and end of periods.

In the IASB discussions, however, with respect to the superiority of comprehensive income over conventional net income, it is inconceivable that comprehensive income could be chosen after full deliberation is carried out based on logical and empirical examination. Moreover, whereas we have heard no evidence whatsoever that investors and analysts require information on comprehensive income only, the need for information on net income remains strong.

Even if considered from the perspective that the value of information on comprehensive income is extremely high, according to current Japanese standards, the items of comprehensive income, including changes in the fair value of financial instruments and the foreign exchange adjustment account, are included in the shareholders' equity section of the balance sheet. It is therefore possible for users of financial statements to obtain information on comprehensive income. In addition, if recycling is prohibited, information on net income based on the realization concept would not be available, thus making it impossible to measure income resulting from the cost of a company's investment.

In consequence, we strongly oppose the IASB's proposal for discarding the concept of net income in income statements in their present form and prohibiting recycling. Our counterproposal is that the present realization concept should be retained.

(2) Full fair value accounting for financial instruments

The current Japanese standards, US GAAP, and IAS hold in common that accounting for financial instruments differs according to the purpose for which the instruments are held, and that changes in fair value are presented in profit and loss only in the case of trading securities.

In December 2000, the Joint Working Group (an informal organization of the IASC, the IASB's predecessor) released a draft standard for full fair value accounting which would have required the measurement of all financial assets and liabilities at fair value, and the recognition of changes in fair value in profit and loss. The proposal was abandoned when it met with nearly unanimous opposition from business communities and other quarters around the world.

The IASB has included the full fair value accounting project among matters to be studied in the future, and formal study has been suspended. However, the exposure draft released in June 2002 for the revision of the current standard proposes a standard that makes it possible to opt for full fair value accounting in which changes in the fair value of financial instruments are recognized in profit and loss, irrespective of the purpose for which they are held. In addition, there is concern that if the Reporting Performance Project referred to above proceeds, it will ultimately have the same result as the introduction of full fair value accounting.

Beyond the inherent problems in terms of accounting theory, IASB should be aware that since the JWG proposal there have been no changes in the environment that call for the introduction of full fair value accounting, nor has there been any softening in the world's business community of its opposition to full fair value accounting.

In studying the standard, the IASB should recognize and give serious consideration to the concern expressed in the markets, including those of users of financial statements, that accounting information based on full fair value accounting will mislead investors. Considering the circumstances of the JWG draft, IASB would do well to remember that the concepts behind full fair value accounting has been rejected worldwide.

Furthermore, the study of accounting standards for insurance should be advanced with care in light of the fact that the fair valuation of insurance liabilities presents various issues.

(3) Accounting for post-employment benefits including pensions

The IASB has reached tentative agreement on the immediate aggregated recognition of actuarial losses arising as a result of factors, such as changes in projected benefit obligations, and on the removal of the corridor rule which carries forward the recognition of actuarial gains and losses within certain limits (10 percent of the larger of either [a] projected benefit obligations or [b] pension assets). As with the Reporting Performance Project, this thinking has the effect of anticipating future gains and losses as results for the current period, based on the measurement of assets and liabilities at fair value, and therefore represents a fundamental change from current thinking.

However, with respect to retirement benefit systems, which do not have the character of financial investments, it is essential that great caution be exercised when considering the meaning of measurement at fair value. At present, net actuarial gains and losses are amortized over the average remaining tenure of employees participating in a plan. Because this is also a commonly-accepted business practice, there are no indications of any requirements for change on the part of users of financial statements.

The corridor rule is not used in Japanese standards, but adopted under US GAAP and current IAS from the standpoint that post-employment benefit accounting is by its nature premised upon estimation based on future assumptions, and that it is suitable to alleviate the burden on preparers of financial statements. The necessity for it is widely recognized.

Based on the thinking tentatively agreed by the IASB, given that there can be very large fluctuations in the base rates upon which estimations are premised, and that these impact profit and loss, this raises the concern that it will make it difficult for companies to sustain defined benefit pension plans. Accordingly, we oppose the aggregated recognition of actuarial losses and the removal of the corridor rule.

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