Discussion Summary of Third Meeting
Advisory Council on the Systems of Accounting and Auditing

○For the organizational design of audit firms, as it is established under the partnership system without any strong legal restrictions, each firm contrives various ways to do so; however, such specialty causes difficulty in understanding from the outside. The introduction of the Audit Firm Governance Code (Code) as a common standard may enable comparison of audit firms and realize transparency enhancement, which will lead to enhancement of management and appropriate competition.

Therefore, I believe that the Code should be made mandatory for big firms which are conducting audits for more than a certain number of listed companies, and the security of its effectiveness as well as improvement of governance should be achieved by a quality control review by the Japanese Institute of Certified Public Accountants (JICPA), as these firms, have a lot of audit work to do and also have a lot of stakeholders. For the other audit firms, credibility of audit should be secured by direct inspection of individual audit works.

○I agree with the introduction of the Code. It will improve the transparency and work as a part of self-discipline for audit firms as the Code implies the declaration of audit firms as being responsible to the society.

However, pertaining to the practical implementation of quality control, it is necessary for each firm to improve the required structure that is consistent with the quality control standards and establish the self-checking system, as in the case for the internal control report system of business companies. I hear that many audit firms have implemented these measures; however, they do not evaluate as far as operational status. The entire audit industry should declare such initiative and promote it in a standardized manner to a certain level, which may contribute to practical quality control.

Regarding the quality control review of the JICPA and inspection of the Certified Public Accountants and Auditing Oversight Board (CPAAOB), they should begin the review by targeting the internal control of audit firms and its operational status.

○Regarding the Code, I appreciate the efforts put in by the JICPA; however, we also have to consider the fact that very serious frauds could not be prevented despite JICPA’s self-regulation. It may be difficult to achieve the confidence of markets as well as secure substantive improvement of audit quality by following traditional ways.

I recognize that the current situation is an emergency; therefore, it is necessary to contemplate if the conventional ways were correct and we should consult various stakeholders. Given this, as regulatory authorities, the Financial Services Agency should take a lead in establishing the Code by taking into account various stakeholders’ views to restore confidence of markets.

It is important to improve the level of audit firm governance to those of other business companies and make its operational status understandable from outsiders.

○As I think that the core argument about management and governance is the argument of internal control, the most important factor for internal control is the intention of top management, in other words, control environment. For business companies or audit firms, internal control is a set of frameworks, processes, and procedures required for managers that are in charge of the organization to recognize their essential role and fulfill it in an effective and efficient way. To correct most of frauds that occur in business companies, it is necessary to reform the internal control system.

From another perspective, we should consider if the organizations of audit firms have positive atmospheres where they can acquire timely and adequate information in the case of any problem and take corrective and appropriate measures or countermeasures. As observed from recent cases, I do not think that each auditor can act with a common recognition and same values inside an audit firm. To reform such situations, we cannot deny introduction of the Code in a uniform way at a certain level.

From the perspective to secure healthy capital markets, as it is important to achieve the credibility of listed companies/public companies, certain strict regulations may be required for audit firms that conduct audits of public companies, irrespective of major or second-tier audit firms.

There are many audit firms in Japan. When we consider measures like audit firm rotation in the future, we need a certain number of high-quality audit firms to improve an environment where each firm is able to improve its quality in an appropriate competition. However, in cases of audits for multinational public companies, audit firms have to deal with their audit works internationally and may be required some connection with networks of global audit firms. Considering this restriction, it is impossible to have 20 or 30 firms of that kind. Consequently, it makes no sense to only raise the number of medium scale audit firms.

I think that with respect to such audit firms that conduct audits of multinational public companies, it is desirable to make internationally comparable regulations. However, for other audit firms, self-regulation by the JICPA is able to take major responsibility, as in the case of the American Institute of Certified Public Accountants being responsible for quality control. It may be required to consider such division of roles along with the argument about role-sharing of the CPAAOB and the JICPA.

○To secure credibility of capital market information, the same level of audit quality is required in audits for listed companies. Firstly the JICPA conducts the quality control review, which needs to be improved, and then the inspection by the CPAAOB complements it. A certain level of the quality of audit firms, which conduct audits for listed companies, is secured under the Registration System for Listed Company Audit Firms of the JICPA. To further improve the quality control, it is required to enhance audit firm governance by using the Code as it is impossible for the JICPA to check all the works of audit firms that conducts audits of a lot of companies. However, for example, regarding audit firms that audit only one listed company, it is possible to directly check each audit work.

○I do not deny that the relation between quality control and audit firm management or argument about the Code is important; however, there is a more important issue. As the organization of audit firms originally started as a partnership that comprised professionals only, it is now a special organization that is difficult to manage and sometimes lacks a feeling of unity.

However, looking at the substance, there are huge audit firms comprising thousands of Certified Public Accountants (CPA) including hundreds of partners. Despite the fact that they are too large as a type of partnership to be managed well, experienced managers are not necessarily managing them now.

I certainly think that all audit firms, that conduct audits of listed companies, need a certain level of quality control and to that end, they have the organizational principle. However, the larger the organization, the more there will be a need to function well as an organization; therefore, the gap between the necessity and reality will be widened for large size audit firms.

One of the underlying factors of this issue may be the current Certified Public Accountants Act which defines regulations only for audit firms that are an extension of partnerships. As major and second-tier audit firms are different from other small firms, I think we have to provide a new perspective: in addition to quality control, what is required to make the organization perform successfully?

On the issue of who should take responsibility for creating the Code, given the current situation, discussion only among auditors is not constructive. I believe that we need a broader perspective such as ideas from ex-management of large organizations including business companies.

○We must distinguish between the argument on quality control to improve the quality of audit works and the argument on how to establish the governance of audit firms as business organizations.

○Regarding the development of the Code, we should promote it if we agree that it is significant. That being said, when we begin to create the Code with an objective of enforcing audit firm management, there is a concern that the Code may be extremely across-the-board and ambiguous, as in the cases of the United Kingdom and the Netherland.

Currently, there are three main issues for audit in the capital markets: First, audit firms have to adequately secure the quality of audit works and check it. Second, if any problem is found during the course of the check, audit firms should make an appropriate decision about personnel management such as reshuffling a part of or entire members. Third, audit firms should share that information with audit clients as much as possible and let them decide if they would continue their contract with such audit firms. We must focus on these three issues.

I agree with the Code with the objective of enforcing audit firm management; however, I feel that it is necessary to lower the objective of the Code to a more practical level and thus we should take an approach to create a Code consistent with it.

If audit quality is improved instantly after creating the Code, we may be criticized as we had done nothing about it before that. We rather need to take an approach to the Code by focusing on second and third issues mentioned above, that is to say, how to choose members in case of necessity, or how to help shareholders of audit clients make their decisions by sharing information with them.

○I appreciate the objective to ensure audit firm governance by creating the Code; however, it is important how to enhance its effectiveness. To convey a practical image of the Code, we can make a model case during the process where regulatory authorities monitor business improvement plan of the audit firm with problems and show the enhancement of effectiveness by comparing the model case with the Code.

○I sometimes ask to auditors as a joke about starting a business to check the level of other audit firms. I have a vague notion that it is possible to check audit levels as a business to provide information to shareholders of audit clients—if it is difficult to use Audit Quality Indicators (AQI)— about the index or rating to measure audit levels, which was pointed out in our last meeting.

○Regarding the audit evaluating company mentioned above, the quality control review of the JICPA is taking on such a role in a sense because the result of the review is given to kansayaku of an audit client. As Japan’s Corporate Governance Code defines that kansayaku has to evaluate external auditors, the framework to provide information of such evaluation may be needed.

Each audit firm is disclosing the result of inspection of the CPAAOB upon its approval to make an explanation to audit clients. However, in the United States, the Public Company Accounting Oversight Board (PCAOB) discloses the inspection results under certain restrictions. We can use their way as a reference.

○I know that the PCAOB discloses the comment on each audit review, while they do not immediately disclose the comment associated with quality control of audit firm. However, they disclose it if the quality control has not improved in a certain period. Using this way as a reference, we need to consider the disclosure of inspection results in Japan.

As for the improvement of transparency in an auditor’s report, the current auditor’s report does not include any more information than the appropriateness of financial statements and audit methodology. To cite an example of information required by shareholders, it is about where the significant risks are and how auditors accept such risks even when they give an unmodified opinion. However, more consideration is needed to institutionalize the inclusion of such information to an auditor’s report.

As communication between auditors and kansayaku board seems to have been developing, it is important to discuss audit risks and their evaluation by exchanging ideas between kansayaku board and auditors. For example, it is possible to provide an opportunity where both of them explain their ideas together to the board of directors.

At the end of audit, auditors usually report to kansayaku board. In addition to the audit results, it may be significant to report information on significant matters noticed during an audit, status of internal controls, and the appropriateness of accounting policies directly to the board of directors; particularly, outside board members may need such information.

We must discuss transparency improvement and longer-form of auditor’s report after enhancing communication between auditors and the board of directors.

○I do not agree with the tendency to increase information because even now I feel that information of financial statements is extremely high in volume, difficult, and too detailed from the perspective of ordinary investors. However, enhancing information pertaining to audit to the shareholders is a global trend. Auditing is a highly professional work, as is the contents of accounting service; and the content of an audit is almost like a black box because of its confidentiality. I presume that investors including shareholders are dissatisfied with only one or two sheets of auditor’s report and the high remuneration charged for that.

I do not agree with the introduction of longer-form of auditor’s report. In case of an audit guaranteeing financial statements toward many and unspecified investors, a short-form report that states “adequate or not” is good enough and investors should be able to make an investment decision with complete confidence in it. Note that there may be more information required for analysts, institutional investors, rating agencies, and professional market players.

Regarding what kind of deterrent is required against frauds in line with the issues of this meeting, types of frauds associated with top management window-dressing accounting—will never disappear unless kansayaku works effectively as in Japan’s legal system, kansayaku evaluates the reasonability of audit methodology and audit results.

Referring to the data in the United States over ten years, among many frauds, over half of window dressings were associated with top management officials such as the CEO or CFO. We must remedy such situations and reform the system considering points like what kind of commitment should the kansayaku make to an auditor’s work or how kansayaku should corporate with auditors.

On the issue of provision of information, as the results of the inspection by the CPAAOB and the quality control review of the JICPA are reported to kansayaku and are shared in the entire company, I think that level of information is sufficient.

○I think that the reason why the transparency and accountability of companies has been required in various situations is that there are the needs from general investors which require and want to utilize information related to audit, and such needs will increase. There would be some people among general investors who can appropriately utilize information associated with the points of concern in an audit. Given it is pointed out that an audit is like a black box, information about how auditors conducted audit is quite useful especially for institutional investors. Audit firms should fulfill their accountability so that stakeholders can utilize such information. From such perspective, we should consider the long-form auditor’s report.

Information about replacement of auditors and its reason is also important for shareholders. Although companies have to disclose how and why they replaced auditors and the replaced auditor’s opinion, the content of the disclosure has been a boilerplate expression. In most cases, companies have given their explanations merely “expiration of the term” for reasons of replacements and auditors haven’t expressed any opinions. If any measures are taken to improve the quality of explanations of replacements, it would be quite useful for shareholders.

○When any change of an accounting policy occurs, companies are required to explain its reason. However, the reason why companies chose the accounting method from several approved methods is not disclosed. I don’t think this is sufficient. For an audit, I do not actively claim that companies should disclose the reason for auditors’ selection. However, given that companies are required to disclose the reason for the replacement of auditors, it would be consistent that companies are also required to disclose the reason for selection.

In some cases, the actual reason why a major audit firm does not renew its contract is that audit’s risk is too high or cost-benefit performance is too bad, though the official reason is the expiration of the term. In such cases, a small audit firm takes over such audit contract from the precedent major audit firm. As mentioned above, I do not actively claim that companies should disclose the reason for auditors’ selection, but with such cases in mind, it would not be sufficient that companies are not required to disclose the reason for selection, while they are required to disclose the reason for the replacement.

○Regarding the enhanced information provision to shareholders, there would exist a perspective of who will take a role of safety device when any problem occurs, in addition to a perspective of whether shareholders need such information. I mean, some argue that kansayaku should primarily take appropriate measures for the problem and they fulfill their own responsibilities adequately; however, they failed to work in recent cases. In such cases, nobody but shareholders can prevent the problem from occurring. The recent argument whether companies should change the audit firm is largely attributed to the fact that companies eventually care about the shareholders’ opinion. Given those facts, besides the issue if shareholders need information, there would be a policy debate whether we expect shareholders to take the role of safety device.

Under the current regulation, companies have the responsibilities of disclosing the replacement of auditors including an auditor’s opinion. In the past, there was an argument that the JICPA would establish a system of “timely disclosure” so that audit firms can explain their opinions by themselves. I want to ask if this system is likely to be set up in the future.

○The reason why the disclosure of auditor’s opinion is included in companies’ event-based disclosure is that audit firms are unable to disclose their opinions by themselves due to confidentiality. If this hurdle is cleared by any means, it would be the case the disclosure through the JICPA or stock exchange.

○I think there are two main contents that should be disclosed in annual securities reports. One is the reason of auditors’ selection and the other is the activities of auditors with audit clients, especially with kansayaku.

First, pertaining to the reason of auditors’ selection, we should require audit clients to make further disclosures: how they evaluate audit firm management, management style and training programs, and which trait of the audit firm they appreciate in light of necessary audit for the company. This level of disclosure would have substantial effects on both audit firm and companies, combined with the debate about the Audit Firm Governance Code and the role of kansayaku in Japan’s Corporate Governance Code.

Second, pertaining to the activities of auditors with audit clients, if we introduce the long-form of auditor’s report in accord with overseas trend, the market may welcome it.

Moreover, there was a remark that it is possible for audit firms to disclose information about the result of the inspection by the CPAAOB to kansayaku. However, as there are not many audit clients that are subject to inspection of the CPAAOB, I presume many companies do not know about the inspection. Therefore, we need to consider creating a framework where kansayaku can broadly receive information of the audit firms, taking into the way of the PCAOB. To achieve effective disclosure, the multiple disclosure initiatives such as disclosure by companies and the development/disclosure of the monitoring report by the CPAAOB need to function as a whole.

○I think it is true that the inspection by the CPAAOB is not well-understood by companies. Therefore, I believe it necessary to make efforts to develop and disclose the monitoring report.

○The intent of enhanced information provision to shareholders about audit works is based on the concept that we need to create environment where shareholders can make a well-informed decision on selection of auditors before compelling audit firm rotation institutionally. Therefore, if well-informed shareholders eventually choose low quality auditors, they would have to accept reasonable responsibility.

On the issue of disclosure of the reason for auditors’ selection, I think most companies would select audit firms for passive reasons such as not too bad, rather than choosing them because of their excellent works. For example, there was a remark that the quality of audit works of major audit firms are ensured at the same level. If this is true, companies choose them on for the reason that audit works are at the same level, rather than any special reason. I think companies would be perplexed with to the disclosure requirement of the reason of auditors’ selection.

○Looking at the process and contents of acquisition of a Certified Public Accountant certification, there is little training on how to detect, prevent and deter frauds or very few exam questions about frauds. Considering no end of frauds, more training and knowledge to achieve competency in detecting frauds may be required.

In the United States, after a series of frauds occurred, the National Commission on Fraudulent Financial Reporting was established in the 1980s and the Commission implemented 49 measures to prevent frauds. In the next year, the Association of Certified Fraud Examiners was set up as a private organization. I hear that there are quite a few people including CPAs, internal auditors, and lawyers who have a qualification as a Certified Fraud Examiner—which can be acquired also in Japan—and there are many interesting contents in their way of working such as the way of hearing, how to frame questions, and criminal psychology. It would be necessary to mandate such kind of programs to improve competency of dealing with frauds at the Professional Accountancy Education Program and Continuing Professional Education (CPE) Training. Along with that, it may be needed to mandate regular attendance of training every five or seven years because technology innovations keep happening.

Another remark that I would like to make is to cultivate sensitivity. Even if everybody sees the same phenomenon, some do not have any doubts and some do not speculate very well although they have doubts. To cultivate sensitivity, we just have to create an environment where all auditors can share and learn from actual cases where auditors could not discover frauds. In addition to that, it is important for audit firm management to foster a strong culture which does not absolutely allow frauds.

○For organizational audit by audit firms, it is important to organize audit teams appropriately and exercise a strict quality control. In quality control, it is necessary to clarify the chain of command and job assignment as well as to ensure communication within an audit team. Through on-the-job training under such quality control, the sensitivity against frauds would be developed.

In addition to communication within an audit team, the importance of audit documentation should be emphasized, given that supervision and quality control on the job are conducted based on the audit documentation.

○There are various ways of cultivating sensitivity of audit and risk sense; however, the most important thing is the process to receive a review from the immediate superior and then a higher superior. It is indispensable to have an environment where auditors are not recognized as professionals unless they accomplish their job thoroughly. Recently, I feel that such strictness of review is being loosened.

Particularly, we should again enhance the training against frauds. Personally I think there are not so various patterns of frauds if we organize the precedents. Practical measures must be immediately devised such as compulsory training by the JICPA to learn about such patterns.

Furthermore, as long as auditors conduct audit works as a team, competence and expertise of the team is important. It is necessary for the team to have a person who is familiar with the industry of an audit client to understand their business and industry. It is also indispensable to conduct audits with enough competence as a team by having professionals of information technology or taxation, for example.

○As the JICPA has accumulated research cases, we must enhance the training against frauds including the consideration about making it compulsory.

Conducting a steady audit does not work well without enough audit hours and duration. For example, among current three disclosure systems under the Stock Exchange Rules, the Companies Act, and the Financial Instruments and Exchange Act, Summary of Financial Results under the Stock Exchange Rules is positioned as preliminary figures, and after that comes definite figures following the audit, based on which shareholders exercise their voting rights at the shareholders meeting. This is the normal process that is consistent with the global standard.

In Japan, however, 40% of auditor’s reports are submitted before Summary of Financial Results is disclosed. The average duration from the account closing date to the day of submission of the auditor’s report in Japan and the United States are 42.5 days and 57.8 days, respectively. We also have the data from the research by the JICPA for the average audit remunerations in Japan and the United States, which are 61 million yen and 224 million yen, respectively. Unless we correct such a situation, it is difficult to conduct effective audits and fairly utilize the ability of each auditor or the team.

○Although we generally understand that we focus on the professional skepticism of an individual when we discuss professional skepticism, some conferences point out that organizational skepticism is important. I would like to ask to emphasize this idea of organizational skepticism.

○Regarding rotation system, it is important to know its actual status; therefore, I agree with the research on it. I also request a research about the reason why there are such differences between Japan and the United States relating to audit remuneration.

Additionally, we should discuss the division of roles between the inspection by the CPAAOB and quality control review of the JICPA. Due to the current highly-overlapped situation, we must fundamentally consider the relation between the goal of quality control review and that of the inspection by the CPAAOB, including the positioning of the CPAAOB which complements the quality control review.

I also request a verification of the framework for oversight of audit firms. Currently, we have the business improvement order as a disciplinary action to audit firms; however, the order is left unfinished if the audit firm is dissolved. I think it is a good opportunity to consider this issue including the composition of official policy.

I expect the initiative to enhance the function of the JICPA. Associated with that, I would like to suggest that the JICPA should work on the improvement of audit methods and techniques. Some say that audit methods and techniques are the know-how of each audit firm and there is a competitive situation among audit firms, and accordingly, it is not suitable for the JICPA to develop them. I presume, however, that the JICPA is able to positively take a lead to develop a part of the audit methods and techniques, which is required for every audit firm in common from the aspect of raising the level of audit. Each audit firm is able to compete with each other beyond that common part.

○Regarding the relation between audit firms and companies, the problem is that—in the course of long-term relationship—they are too accustomed to their way of audit routine and such feeling has penetrated into all auditors that are in charge of audits. Enhancement of an auditor’s ability is important, but the vision and philosophy of top management of the audit firm is more important than that. Top management of audit clients also faces problems; therefore, I think it is important to define in the Audit Firm Governance Code and Japan’s Corporate Governance Code about desirable attitude of both sides of audit.

○If we review the framework for quality control and oversight of audit, we should discuss what kind of framework is required to secure the credibility of capital market as a whole, and hear ideas from various stakeholders.

To utilize information technology in audit, as the JICPA is making such efforts now, it is desirable to promote it by exchanging views internationally to ensure global consistency.

○Each of quality control review of the JICPA and inspection by the CPAAOB has a comparative advantage. The advantage of the inspection by the CPAAOB is that it is authorized by law and conducted from the viewpoint of the organization, such as organizational culture and organization of audit teams. In this respect, we should use multiple resources for better quality control.

○I agree with the remark that companies may not be sure about what to say about the reason of auditors’ selection. Till date, pertaining to selecting auditors, companies have only had the reason of “it may be desirable because it is a major audit firm” and they were not interested in the substance of audit firm management, which caused various problems. From now on, companies should pay attention to the way of audit firm management and their philosophy to apply them in their own business.

○For auditing standards, the new phrases such as professional skepticism and measures to frauds were introduced at the time of fundamental revision in 2002, which led to the quality control standards and the Standards to Address Risks of Fraud in an Audit. Future measures should be considered on the basis of such process.

○Although I am not very positive about the disclosure of the reason for auditors’ selection, I think it should be disclosed to maintain consistency if the reason for replacement is disclosed. For the sake of the shareholders, who are responsible for selection and replacement of auditors, correct information should be disclosed.

I do not agree with the note that companies cannot present the reason for auditors’ selection as there may be various possible reasons: “We prefer an audit firm having relation to overseas accounting firms” in case of the global companies, “We prefer an audit firm specializing in finance,” and so on.