The 2nd Japan-EU Monitoring Meeting on Developments in Accounting and Auditing Issues was held in Tokyo on March 23 and 26. This article provides the outline of equivalence assessments by the European Union (EU) on accounting standards and audits as background issues for this meeting.
I. Concerning the EU Equivalence Assessment on Accounting Standards
1. Outline
The Prospectus Directive (adopted in December 2003), which relates to disclosure at the time of issuance of securities, and the Transparency Directive (adopted in December 2004), which relates to continuous disclosure, required EU companies listed on EU stock markets to use the IFRS (International Financial Reporting Standards), starting in January 2005.
Third-country companies listed on EU stock markets are also scheduled to be required to use the IFRS or ''equivalent'' standards, and the European Commission (EC) has been proceeding with equivalence assessments in regards to the standards used in Japan, the United States, Canada, etc. Initially, the EC planned to apply the requirement that the IFRS or equivalent standards be used in January 2007. However, it has decided to postpone the application for two years and continue its equivalence assessment until June 2008 in light of progress in the convergence of standards around the world.
2. Recent Movements Concerning EU Equivalence Assessments of Accounting Standards
Recent movements concerning EU equivalence assessments of accounting standards are as follows:
*July 2005: The Committee of European Securities Regulators (CESR) published a ''technical advice'' document concerning equivalence assessments. The CESR recognized equivalence with regard to the Japanese standards as a whole, although it pointed out 26 points of divergence.
*April 2006: The EC proposed a two-year extension of the equivalence assessment.
*July 2006: The Business Accounting Council’s Planning and Coordination Committee published a position paper entitled ''Toward the International Convergence of Accounting Standards.''
*October 2006: The Accounting Standards Board of Japan (ASBJ) published its ''Project Plan Concerning the Development of Japanese Accounting Standards -- Initiatives Towards the International Convergence of Accounting Standards in Light of the EU Equivalence Assessment.''
*November 2006: The FSA and the EC held the First Japan-EU Monitoring Meeting on Developments in Accounting and Auditing Issues.
*December 2006: The EC decided to extend the equivalence assessment for two years.
*March 2007: The second Japan-EU Monitoring Meeting on Developments in Accounting and Auditing Issues was held.
3. Future schedule
The schedule for the EU’s equivalence assessment on accounting standards is as follows:
*By April 2007: With regard to the accounting standards used in Japan, the United States, Canada, etc., the EC will compile an initial report on the work schedules of the accounting standard authorities of these countries and report its findings to the European Securities Committee and the European Parliament.
*By May 2007: The CESR will provide advice to the EC in regards to an equivalent assessment mechanism.
*By January 2008: The EC will determine the definition of equivalence and decide on the equivalence assessment mechanism.
*By April 2008: The EC will submit a final report to the European Securities Committee and the European Parliament.
*By June 2008: The EC will determine the equivalence assessment.
*In January 2009: The application of the requirement for use of the IFRS or equivalent standards will begin.
II. Concerning EU Equivalence Assessment on Auditing
1. Outline
The EU adopted the Statutory Audit Directive in June 2006. This directive establishes requirements for statutory
audits to be implemented within the EU by auditors following the end of June 2006. To be more specific, the directive establishes requirements for auditor attributes, audit standards and rules concerning independence that must be observed by auditors in the implementation of audits, disclosure requirements for auditing firms and provisions for inspections and supervision by authorities.
Meanwhile, regarding third-country audit firms auditing third-country companies listed on EU stock markets, the directive stipulates that such audit firms (1) must be registered with the authorities of the EU countries and subject to oversight thereby and (2) must be subject to a third-country oversight regime recognized as equivalent to the regime required by the EU directive. The EC is now proceeding with equivalence assessment in this regard.
It should be noted that requirements established by this directive must be put into legislation by the end of June 2008.
2. Recent movements concerning EU equivalence assessment on auditing
Recent movements concerning the EU’s equivalence assessment on auditing are as follows:
*March 2004; The EC published a draft of the Statutory Audit Directive.
*June 2006: The EC adopted the Statutory Audit Directive.
*January 2007: The EC published data concerning consultations about detailed rules regarding the implementation of Articles 45-47 of the Statutory Audit Directive.
*March 2007: Japan sent a letter of comment concerning the above consultations.
*For details, please access ''The second Japan-EU Monitoring Meeting on Developments in Accounting and Auditing Issues'' at ''Press Releases'' (March 27, 2007) of the FSA’s web site.
The Financial Services Agency (FSA) conducted a survey on hedge fund activities for the first time in 2005 for the purpose of investigating the status of hedge fund investments by domestic financial institutions as of the end of March 2005 and how they had been involved in the establishment and sale of hedge funds over the past five years, and published its findings in the ''Summary of Hedge Fund Survey Results and the Discussion Points'' on December 22, 2005.
As regulatory authorities as well as industry officials remained high interest to hedge fund activities thereafter, the FSA conducted a latest survey as of the end of March 2006 in order to update its findings, with the survey results published on March 15, 2007.
1. In the latest survey, the FSA applied the same definition of hedge fund as the one used in the previous survey, whereby a hedge fund is defined as a fund that (1) uses leverage, (2) charges a performance fee and (3) uses hedge fund strategies. The FSA sent a questionnaire to a total of 1,252 financial institutions regulated by the agency, with responses provided on a voluntary basis.
2. The survey showed that as of the end of March 2006, 348 domestic financial institutions held a total of approximately 7.4 trillion yen invested in hedge funds, up about 22% from approximately 6.1 trillion yen at the end of the previous year. As a trend was that a broad range of financial institutions continued to invest in hedge funds, with insurance companies accounting for 26% of the total outstanding investments in hedge funds, with city banks(major banks) accounting for 24%, regional banks for 15% and others (including credit associations and cooperatives) for 20%.
3. With regard to hedge fund sales, 101 domestic financial institutions sold approximately 3.0 trillion yen worth of funds to financial institutions, corporations, individuals, etc. during the period covered by the survey (from April 1, 2005 to March 31 2006), up about 40% from 2.1 trillion yen in the previous year. As a trend of the sales activities was an expansion in sales to individuals, with the proportion of such funds among total sales rising to 20%. Another prominent feature was that more than 50% of hedge funds sold in Japan were foreign-registered funds, registered primarily in the Cayman Islands, as was the case in the previous year.
4. The summary of the latest survey address to the way in which Japanese authorities deal with hedge funds. The FSA does not impose regulations or supervision that specifically targets hedge funds. Nevertheless, the FSA is engaged in the monitoring of hedge fund activity with a view to (1) providing investor protection, (2) maintaining market fairness and transparency and (3) avoiding systemic risks. Moreover, the FSA is actively exchanging information and views with overseas authorities in this regard on a continuous basis and participating in discussions at international forums such as IOSCO (International Organization of Securities Commissions).
*For details, please access ''Hedge Fund Survey Results (2006)'' (March 15, 2007)at ''Press Releases'' of the FSA’s web site.
1. Introduction
The Financial Services Agency revised its Inspection Manual for Deposit-Taking Institutions (hereinafter referred to as ''Financial Inspection Manual'') and issued the revised edition in the name of the general of the Inspection Bureau on February 16, 2007. Since its formulation on July 1, 1999, the Financial Inspection Manual has been revised several times. The latest revision is an extensive one that involves changes to the structure of the entire manual and the addition of new checklist items. Major characteristics of the revised edition include conformity with Basel II, emphasis on the proactive involvement of the management team in the establishment of the internal control system and the addition of the customer protection management system as a checklist item.
Below, we provide an outline of the revised Financial Inspection Manual.
2. Background to Revision of Financial Inspection Manual
It was necessary to have the Financial Inspection Manual conform to Basel, which was to be introduced in the business year ending in March 2007. Moreover, the FSA believed that revision was also necessary in response to the various changes in the environment surrounding financial institutions over the seven-year period following the formulation of the manual. Therefore, the FSA on October 30, 2006 set up a study group comprised of private-sector business professionals and academics within the Inspection Bureau and the group held eight rounds of discussions. At the same time, the FSA published a draft of the sections of the revised manual pertaining to Basel II on November 16, 2006 and a draft of the remaining parts on December 26, 2006, and solicited public comments. Having taken account of the comments provided, the FSA completed the revision and published the revised edition on February 16, 2007, issuing a notification of the revisions in the name of the director-general of the Inspection Bureau.
The revisions took effect on April 1, 2007 and are applicable for inspections conducted thereafter. (However, with regards to items that involve account-closing procedures such as asset assessment and loan write-offs/loss provisions, the application begins with the business year ended in March 2007.
3. Common Format
The latest revisions were extensive, due in part to the introduction of a format common for all types of system management inspections, and the contents of the previous manual were reworked so as to conform to this format.
As indicated by the fact that the rating grades used in the Financial Inspection Rating System are determined by the extent of the development of the relevant systems by the management team, the roles and responsibilities of the management team are essential in the development of the internal control system. Therefore, the common format adopted for the revised manual clarifies the roles and responsibilities that must be performed by the management team by dividing each checklist, in principle, into three sections: ''I. Development and Establishment of Systems by Management,'' ''II. Development and Establishment of Systems by Managers'' and ''III: Specific Issues.''
Moreover, the revised manual attaches importance to internal controls not only for the purpose of establishing management policies, organizational structures and rules but also as a proactive process aimed at consistently improving existing systems.
To be more specific, the revised manual establishes checkpoints from the viewpoint of whether the management team is (1) formulating plans appropriately, (Plan) (2) developing and establishing rules and organizations appropriately (Do), and (3) implementing assessments (Check) and corrections (Action), specifically from the viewpoint of the so-called PDCA cycle.
Should any problem come to light as a result of reviews conducted by way of the use of the check items listed in Part II or III of the checklists, the manual requires that the inspectors exhaustively examine which process of the PDCA cycle has failed to function effectively, thus causing the problem. In addition, if the institution’s management fails to recognize weaknesses or problems recognized by the inspector, the revised manual requires that the inspector explore in particular the possibility that the internal control system is not functioning effectively.
It should be noted that under the revised Financial Inspection Rating System, if the effective functioning of the assessment (Check) and correction (Action) processes are recognized as producing favorable effects, this should be taken into account as a positive element in the rating process.
4. Scale-, Nature-, and Risk Profile-Oriented Risk Management Systems
In the section entitled ''Points of Attention for Inspectors'' located at the beginning of the revised Financial Inspection Manual, it is noted that ''inspectors should take care not to apply the criteria set forth in the check items in a mechanical and undistinguishing manner'' with due consideration of the ''scale and nature'' of the financial institution inspected. It is also pointed out that ''even a case where a financial institution does not literally meet the requirement of a check item should not be regarded as inappropriate if the arrangements and procedures put in place by the institution are reasonable from the viewpoint of securing of the soundness and appropriateness of its business and are thus deemed as effectively meeting the requirement or as sufficient in light of the institution’s scale and nature.''
For example, a large part of each checklist is devoted to descriptions related to the ''management division,'' and when the management division as such is not in place at the institution inspected, the manual requires that the inspector examine whether the institution’s organization is structured so as to sufficiently perform the functions of the management division described and ensure the functioning of the necessary check and balance mechanisms.
In addition, checkpoints for risk management systems underscore the importance of the development by financial institutions of risk management systems suited to their own strategic objectives, the scale and nature of their businesses and their risk profile. In particular, the manual points out that it is not only unnecessary for financial institutions to adopt overly complex or sophisticated market risk measurement and analysis methods in relation to the scale and nature of their business, etc. but it may even be inappropriate for them to do so.
5. Summary Contents of Checklists for Management Systems
The revised manual comprises ten checklist items, up from the previous manual’s seven items (See the attachment). The following are the major checkpoints included in the checklists.
(1) Checklist for Business Management (Governance) (for Basic Elements)
Determine whether basic elements such as (1) a business management (governance) system by the representative directors, the non-representative directors and the board of directors, (2) an internal audit system, (3) an audit system by corporate auditors and (4) an external audit system have been implemented and are working effectively, as well as whether the business management (governance) of the institution inspected as a whole is functioning effectively.
(2) Checklist for Legal Compliance
Determine whether the legal compliance system of the financial institution being inspected is functioning effectively across the entirety of the institution’s businesses.
Determine whether the systems for implementing identity verification and dealing with suspicious transactions,
antisocial forces, illegal acts etc. are functioning effectively.
(3) Checklist for Customer Protection Management
Determine whether the systems for ensuring the following conditions are functioning effectively:
Sufficient customer explanations are provided in an appropriate manner.
Customer consultation requests, complaints, etc. are processed appropriately.
Customer information is managed appropriately with a view to preventing information leaks.
Outsourced business is conducted aptly and related customer information is managed appropriately.
Determine whether the systems for ensuring the protection of personal information, appropriate supervision of bank agents and the prevention of conflicts of interest are working effectively.
(4) Checklist for Comprehensive Risk Management
Determine whether the comprehensive risk management system of the financial institution being inspected is suited to the scale and nature of the businesses of the financial institution in question and its risk profile and whether the system is functioning effectively.
Determine whether the risk management process designed to comprehensively identify, assess and monitor control risks faced by the financial institution being inspected is functioning effectively.
*When the financial institution inspected uses a comprehensive risk measurement technique that involves quantitative measurements of various risks with a universal yardstick, check whether measurement is conducted appropriately.
(5) Checklist for Capital Management
Determine whether the system designed to ensure accurate calculation of capital adequacy is functioning effectively.
Determine whether the system for ensuring appropriate assessment of capital buildup is functioning appropriately.
(6) Checklist for Credit Risk Management
Determine whether the systems for ensuring that borrower screening, loan provision management and problem loan management are functioning effectively.
*When the financial institution inspected uses a credit risk measurement technique that conducts quantitative measurement of credit risks with a universal yardstick, check whether said measurement is conducted appropriately.
(7) Checklist for Asset Assessment Management
Determine whether the system for ensuring accurate asset assessment is functioning effectively.
Determine whether the system for ensuing appropriate loan write-offs/loss provisions is functioning effectively.
(8) Checklist for Market Risk Management
Determine whether the system for ensuring appropriate measurement/analysis of market risks regarding both banking and trading accounts, with the use of market risk measurement/analysis techniques suited to the scale and nature of the financial institution being inspected, as well as its risk profile, is functioning effectively.
*When the financial institution being inspected uses a market risk measurement technique that involves quantitative measurement of credit risks with a universal yardstick, check whether said measurement is conducted appropriately.
(9) Checklist for Liquidity Risk Management
Determine whether the system for managing both funding-liquidity risk and market liquidity risk is functioning effectively.
(10) Checklist for Operational Risk Management
Determine whether the system for managing operational risks in a comprehensive manner is functioning effectively throughout the institution.
*When the financial institution being inspected conducts measurements of various types of operational risks with a universal yardstick, check whether said measurement is conducted appropriately.
Determine whether all of the systems for managing ''administrative risk'', ''information technology risk'' and ''other operational risks'' are functioning effectively.
6. Conclusion
The Financial Inspection Manual is intended to serve as a guideline for inspectors in their inspections of financial institutions, and financial institutions, for their part, should operate in a manner suited to the nature and scale of their businessess based on the principle of self-responsibility and by fully exploiting their resourcefulness and creativity.
The FSA expects to enhance the transparency of the financial regulation by clarifying its inspection checkpoints and thereby sharing points of view on necessary issues with financial institutions. It also expects that increased dialogue between financial institutions and inspectors, as well as enhanced efficiency and effectiveness of inspections due to the use of this manual, will lead to an improvement in financial institutions' internal control systems.
On March 22-23, the first meeting of the International Forum of Independent Audit Regulators (IFIAR) was held in Tokyo, with Japan serving as host of the gathering. The following is an outline of the IFIAR.
1. Background to the Establishment of the IFIAR
Since 2001, a string of massive accounting scandals in the U.S. and European markets have prompted global moves to enhance the credibility of markets by strengthening audit regulatory regimes, leading to the establishment of a series of audit regulatory bodies in major countries. In this context, the Financial Stability Forum called for the holding of an international conference intended to enable fledgling audit regulatory bodies to exchange information with one another. As a result, the Meeting of Heads of Auditor Oversight Bodies, in essence the predecessor to the IFIAR, was held in Washington in September 2004. Initially, auditing and regulatory bodies from nine countries including Japan and three international organizations participated in this forum. At its second meeting, the forum was renamed the Roundtable of Independent Audit Regulators, and since then, this group has been holding semiannual meetings. In the meantime, the need has grown, in light of the importance of high-quality audits, for the establishment of an international forum intended to strengthen cooperation among audit regulatory bodies. Therefore, the establishment of the IFIAR was formally approved at the Paris meeting in June 2006.
2. Outline of IFIAR Tokyo Meeting
The Tokyo meeting, the IFIAR’s first gathering since its establishment, was held with the participation of audit regulatory bodies from major countries such Japan, the United States, Canada and European nations that function independently from the auditing profession. In addition to these IFIAR members, six international organizations participated in the Tokyo meeting as observers, making this the biggest gathering of its kind since the launch of its aforementioned predecessor in 2004.
The Tokyo meeting provided the participants with opportunities not only to report on the status of activities in specific countries but also to exchange views on a variety of issues common to audit regulators in various countries, such as elements necessary for enhancing the quality of audits, information exchanges among audit regulators and the availability of high-quality audits in situations wherein audit service markets are controlled by a small group of auditing firms. With regard to how to inspect audits and share experiences, which has been one of the major issues for the IFIAR, the participants decided to hold a workshop meeting in the Netherlands at the end of May 2007.
The Tokyo meeting paved the way for future IFIAR activities. The establishment of- and the authority granted to audit regulatory bodies vary from country to country. However, the IFIAR is expected to contribute to the improvement of the quality of audits on a global scale by enabling audit regulators to share their experiences and exchange views among themselves, thus enhancing their cooperation.
Discussion Held by ''Study Group on the Internationalization of Japanese Financial and Capital Markets''
The ''Study Group on the Internationalization of Japanese Financial and Capital Markets'' (hereinafter referred to as ''Study Group''), established under the Financial System Council’s Sectional Committee on Financial System, has conducted intensive discussions based on the results of hearings with group members and outside experts, holding a total of 11 meetings since January of this year.
The basic views expressed in the discussions so far conducted are as follows:
*The role of asset management and financial services is important in ensuring sustainable growth for Japan’s economy amid the aging of society and the declining birthrate.
*It is necessary to enhance the international competitiveness of Japan’s financial market amid intensifying competition among markets around the world.
*To do so, it is essential to establish a market that is attractive to both domestic and overseas market participants by further promoting ongoing efforts to reform Japan’s financial and capital markets and by expanding their base.
It was also pointed out that the above-mentioned tasks should be regarded as national priorities as the implementation thereof is expected to bring about the following benefits:
*A diverse range of available financial instruments and services will provide investors with a variety of asset management opportunities.
*For companies seeking to raise funds, external financing obtained for business expansion will provide them with more growth opportunities.
*An increase in investment returns, combined with added value generated by the financial
services industry in its role as intermediary, will boost the national income.
*The development of the financial and capital markets, through proper utilization of its resource allocation and governance functions, is expected to lead to improvements in the efficiency and productivity of economic activities and produce positive overall economic results.
Based on the above-mentioned points, the Study Group on April 17 presented ''Summary of Issues,'' which outlined the findings of the discussions so far conducted.
As the Summary of Issues includes points that must be discussed further, the Study Group plans to hold more in-depth discussions focusing mainly on these points and deliberate on specific measures for enhancing the international competitiveness of Japan’s financial and capital markets.