: therecent discussion memorandum on consolidation outlines

: therecent discussion memorandum on consolidation outlines

: A CaseStudyInternationalization of Accounting Standards for Consolidation – Japan: A CaseStudyThe purpose of this paper will be to examine problems with internationalizationof accounting standards for consolidations on methods from an internationalperspective – specifically, in the US and Japan.

This is an especially timelytopic as standardization of financial markets is a prerequisite to internationalfree trade. Given the trends toward greater globalization, the motivations ofcompanies for seeking a uniform accounting system are strong. If companies haveto prepare their accounts according to several different sets of rules, in orderto communicate with investors in the various capital markets in which theyoperate or for other national purposes, they incur a considerable cost penaltyand feel that money is wasted. This significantly limits global opportunitiesfor multinational businesses. Thus, it is important to understand what thedifferences are between accounting standards, why they exist, and what problemsthey pose.

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It is worth noting that no one nation has a set of accounting rules whichappears to have such clear merits that they deserve adoption by the whole world.No one country can claim to have a uniquely correct set of rules. The UnitedStates has the longest history of standard setting. It has the largest standardsetting organization which is characterized by high standards of professionalism.

But, even the rules of the United States exhibit compromises between differentinterests of a kind which could have reasonably been decided otherwise.Furthermore, no unanimity exists among U.S. accountants about the merits of theprecise details of the compromises that have been struck. For example, therecent discussion memorandum on consolidation outlines three different methodswhich are GAAP in the US (Beckman, 1995). No one nation has a clear right, onthe basis of existing achievements, to be regarded as predominant in accounting.

A great deal more work is needed by accountants from different countries beforewe can reach the point of having a well founded basis for uniformity.People who study differences among systems of accounting rules are inclined togroup countries into two categories. On the one hand, there are countries wherebusiness finance is provided more by loans than by equity capital, whereaccounting rules are dominated by taxation considerations and where legalsystems customarily incorporate codes with detailed rules for matters such asaccounting. The effect of taxation systems can be particularly pervasive. Often,the taxation system effectively offers tax breaks for businesses by allowinggenerous measurement of expenses and modest measurement of revenues on conditionthat these measurements are used for general reporting purposes. Companies havestrong incentives to take advantage of these taxation concessions as real cashis involved. But the penalty is a jack of full transparency for investors.

Majorcountries in this category include France, Germany and Japan( AAA, 1995).The other group of countries is one in which equity sources of finance are moreimportant, accounting measurements are not dominated by taxation considerationsas tax breaks can be enjoyed independent of the way result are reported toshareholders, and common law systems prevail. These countries generally havesome private sector system for setting accounting standards, often with ageneral statutory framework. The role of equity finance is important becausecapital market pressures are then brought to bear most strongly to improve thequality of information available. The absence of detailed codes leavesflexibility to respond to pressures. The United States, the United Kingdom,Australia and the Netherlands are examples of countries in this category (AAA,1995).

US consolidation policy begins with a definition of control. It is based on thesimple legal concept that the majority shareholder controls a company and thateven without a majority, a stockholder can exert significant influence. Thus,consolidated financial statements reflect the financial position and results ofthe firm as well as all subsidiaries upon which the firm may exert thisinfluence. Furthermore, the entity about which the consolidated financialstatements are prepared is not an entity in legal form. It is an abstractioncreated solely for the purpose of these statements and does not have an ongoingset of books as a normal corporation would (Beams, 1992). The details ofconsolidation in the US are based on one of two theories as outlined in theDiscussion Memorandum. The economic unit theory considers the consolidatedgroup to be one economic entity for financial accounting purposes.

Thus, thefull fair market value of the subsidiary’s net assets at the date of acquisitionas well as the minority interest in those assets are included in theconsolidated financial statements. The parent company theory holds that onlythe parent company’s shareholders’ ownership interest should be reflected.There are many more detailed controversies in US accounting for consolidations,but this illustrates how even the US, with the most developed set of accountingstandards in the world can have disputes about the most fundamental aspects ofconsolidation (Beckman, 1995). However, because the US has been the first toconceptualize accounting for consolidations, our form has come to be accepted bythe international financial community (Lowe, 1990). While this may be good forus because our method of consolidation is consistent with our culture, it doeshave some negative effects on the substance of reporting in other countries withincompatible cultures.Japan is an excellent example of how the international acceptance of accountingstandards can actually lower the value of the information provided if thestandard is incompatible with the culture of the country. The Japanese began touse consolidated financial statements at least half a century later than many ofthe other industrialized countries of the world.

Responding to external pressurethey reluctantly adopted the accounting practices applicable to consolidatedreporting employed in the United States and have made a determined effort toadapt them to their own business environment (McKinnon, 1984). The results,however, have been terrible. While US GAAP for preparing consolidated financialstatements recognizes groups based upon the legal relationships arising from themajority ownership of voting shares, Japanese corporate groups tend to form fromsubstantive relationships of a non-legal nature. The nature of Japan’s corporategroup associations reflect that nation’s cultural and historical interpersonaland intergroup relationships (Lamb, 1993). These corporate related entities dealwith each other much in the same manner as we in the United States expect ofparent and subsidiary company groups. It is because of this kind of specialrelationship that we in the U.

S. insist upon consolidated reporting. But becauseJapanese groups are often not connected through legal ownership they are notconsolidated. Instead entities with weak relationships are consolidated becausethey are tied together legally (Lowe, 1990). Consequently, American users ofJapanese consolidated statements assume they are analyzing the financialposition and results of operations of a group of companies operating as aneconomic entity.

Actually they may be analyzing something quite irrelevantbecause the statements do not represent the substance of the actual businessrelationships. This obviously impairs the ability of readers to make appropriatejudgments from these statements.The Japanese form of business grouping is called the keiretsu. This termindicates a grouping or alignment when stockholder control is formally lacking.It enables companies to share risk and allocate investment to strategicindustries (Lamb, 1993).

Lowe outlines the characteristics of a keiretsu:(1) Members are all “independent” major firms in their own oligopolistsindustries. (2) The keiretsu is a confederation of firms excluding competitionbut aiming at representing all lines within the confederation(3) Service firms such as banking, trading, insurance and shippingcompanies from within the keiretsu perform special functions for industrialmember firms to the complete exclusion of outsiders.(4) Between the firms there are many cross ties.

Examples are borrowingfrom the same bank, mutual shareholdings, interlocking directors, using the sametrademark, or selling their products through the same trading company.(5) The presidents of each member firm meet together once a month anddiscuss matters of mutual interest to the member corporations. These are backedup with meeting of directors and of upper level managers.(6) Interfirm business within the group has a high priority.

(7) Holding companies at the top are prohibited so the relationshipbetween the firms in these groups is based on cooperation not control as wouldbe the case in the U.S.Each of these groups is centered around a bank and includes a trading company, areal estate company, an insurance company, and numerous other companies eachperforming a special function useful to the group. For example, the Mitsui Groupincludes the Mitsui Bank, Mitsui and Co.

(Trading Co.), The Mitsui Real EstateCompany, The Tashio Marine Insurance Company, The Mitsui Life Insurance Co., theMitsui Chemical Co., et al. Each of these major companies has from a few tohundreds of affiliated firms many with small and others with large intercompanystockholdings. Each also holds a small fraction of the outstanding voting sharesof the other “parent-like” firms in the group. This is not done for controlpurposes but to create good relationships and stimulate the feeling ofinterdependence.

It is difficult to determine the size of these corporategroups. They exist as a matter of fact but not as a matter of record. Sales, netincome, or asset information is not published on a group basis (McKinnon, 1984).Each company may own up to 10 percent of each other’s voting shares but none hasvoting control over any of the others. Human ties within the group insure thecohesiveness through intercompany meetings, interlocking directorates, andtransfers of personnel. It is difficult for the typical American to understandthe forces which bind together on a stable and permanent basis a group ofcorporations of the type described (Lowe, 1990).

If legal control by a parent isnot present an American would say a stable group does net exist. However, thisis perfectly rational for a person reared in the Japanese culture and tradition.The vital factors in the maintenance of the keiretsu are the generallyrecognized characteristics of group consciousness and interdependence.Japanese consolidated statements patterned after American standards havesurvived only because foreign users have been largely unaware of theirinappropriate focus and innocent misrepresentation.

No financial statements yetdeveloped are capable of dealing with the typical Japanese sphere of influenceconcept of economic interdependence (McKinnon, 1984). Parent-company onlyfinancial statements do alert readers to the fact that they are seeing only asegment of the financial position and results of operations of the totaleconomic entity. Consolidated statements prepared in such circumstances have theserious weakness of tending to mislead users into believing they are getting afull picture of the group when obviously they are not.

Many of the mostimportant firms affecting the future fortunes of the group are not evenrepresented in these statements.Cultural and historical influences provide significant contrasts betweencorporate group associations and corporate behavior in Japan and the UnitedStates. Evidence of these contrasts in Japan are found in the stable ownershipof a majority of the shares, the decentralized cross-holding pattern of shareownership, the predominance of small shareholdings, and the importance of non-share ownership criteria as a basis for forming corporate groups. The corporategroup associations tend to be maintained by the cultural characteristic of groupconsciousness with a strong orientation toward interdependence. The notion ofcontrol through direct or indirect majority share ownership and the presence ofa holding company or a dominant parent company are foreign concepts to thetypical Japanese executive. Share ownership is generally regarded as of minorsignificance in the forming and maintaining of corporate groups.

Consequently,American practices of consolidation tend to group Japanese corporations in amanner co ntrary to their normal functioning. Such practices tend to break upthe complex and dynamic reality of the natural groups into American-typecorporate groups attempting to portray an American perspective to somethinguniquely Japanese.Japan’s experience with consolidated statements pinpoints an unexpected problemassociated with the process of harmonizing accounting standard. All nations havetheir own peculiar cultural features. It is expected that each country will makean effort to harmonize its own financial reporting methods with internationalreporting standards in order to make its reports more useful to foreign users.But it will do so only as fast as it is able to reconcile these standards withits culture. In contrast to this, Japan adopted harmonizing consolidatedreporting standards without reconciling them with its culture and it attempts toapply these standards meticulously.

Consequently, its unique businessorganizational structure often makes its consolidated financial report lessrather than more useful to readers.BibliographyAmerican Accounting Association. “German Accounting Principles: AnInstitutionalized Framework” Accounting Horizons. September, 1995.

Pp. 92-99Beams, Floyd A. Advanced Accounting.

Englewood Cliffs, NJ: Prentice-Hall 1992Beckman, Judy K. “Economic Unit Approach to Consolidated Financial Statements”. Journal of Accounting Literature. Vol.14, 1995.

Pp. 1-23Lamb, Charles W. Principles of Marketing.

Cincinnati: South-Western Publishing.1993Lowe, Howard. “Shortcomings of Japanese Consolidated Financial Statements”. Accounting Horizons.

September, 1990. Pp. 1-9.McKinnon, Jill.

“Application of Anglo-American Principles of Consolidation toCorporate Financial Disclosure in Japan”. Abacus. Vol.20, No. 1, 1984, pp.


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