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

○I have a question. I don’t understand why there have been cases in which nothing was mentioned by the auditor on such transactions where the sales price of a component from a manufacturer to a manufacturing subcontractor increased by multiple times over the manufacture’s purchase price in the manufacturing industry. I would like to ask the criteria for the decision by the auditor.

Separately, with respect to cost allocation, I heard that it was not necessarily an uncommon practice to defer the cost when the business is performing badly, or conversely, to front-load the cost when the business is performing well. What is the general view of the auditors for such practices? What sorts of standards are being applied for their decision? I would like to ask on these points.

Here I would like to present three opinions of mine. Auditors often claim that it is next to impossible to detect a fraud when such an action involving the management was taken systematically. On the other hand, the market views the failure to detect such fraud as negligence on the part of auditors. There are even harsher views that doubt whether the audit is actually useful.

Having said that, there remains a question as to whether auditors are solely responsible for such problems. Rather, in the case of a systematic fraud involving the management, shouldn’t we establish other measures to appropriately sanction both the management and organization itself? This is my first point.

The second point is concerned with the viewpoints of third parties. At the moment, an ordinary inspection to the audit firm is conducted by the Certified Public Accountants and Auditing Oversight Board (CPAAOB) mainly in an indirect form of examining the review of the Japanese Institute of Certified Public Accountants (JICPA). The problem is that the indirect inspection system is causing delay of the inspection timing. Don’t we need a system that allows for conducting a direct review?

My last point is again concerned with the viewpoints of third parties. Audit firm rotation is not yet introduced in overseas countries including the United States, other than European countries. But, considering the fact that each audit firm adopts a different method of audit, shouldn’t we discuss the pros and cons on audit firm rotation, although I’m aware that there remains some details to be scrutinized such as a rotation period?

○Credibility of audit is very important as it affects not only individual companies but also the whole market as well as Japanese economy, and it is getting widely accepted globally that the audit system is a part of the social infrastructure. Both the International Auditing and Assurance Standards Board and the JICPA have produced frameworks; there is now a proposal to examine the audit system not from what belongs simply to companies or auditors but from the viewpoint of financial reporting supply chain to support the provision of reliable financial information.

I believe it is desirable to have all stakeholders, preparers and users of financial statements, auditors, and representatives from stock exchanges and regulatory authorities to meet and discuss the appropriate audit system. When concern is expressed about the credibility of an audit, I think it is suggesting in a way that the audit is weak. Of course, the auditors have to perform their duties to the best of their abilities, but I also believe that a different perspective will be needed as to how to strengthen the audit system as a part of the financial reporting supply chain. I would like to make some suggestions on individual issues later but hope to contribute to our discussions here from such perspectives.

○Systematic fraud involving the management is quite probable. If it is systematic, it will take a very brave person to prevent such fraud. Therefore, I believe only an auditor can function as a bulwark to such a fraud. The issues concerning the audit should be debated only after its positioning is properly acknowledged. Here I would like to clarify that one of our major objectives of this meeting is to conduct debate whether the current audit system is actually sufficient from this standpoint to define an audit as a last resort.

I have another point to make. Triggered by the Enron scandal, the internal control report system was introduced with considerable efforts with companies also investing large expenses for the introduction of the system. I request we discuss why this system didn’t function as expected because I believe this is critically important.

Although I have claimed that audit is a last resort, my personal impression is that almost every auditor is working for the management, and it is imperative to vigorously investigate why such lenient attitudes to the management are prevalent despite the various measures formally put in place to prevent them.

Moreover, regarding the internal control, it is often said that an audit cannot detect a systematic fraud involving the management, but I very much doubt this notion. Whether it is concerned with percentage of completion method or inventory evaluation, they are all traditional areas already identified in the risk-based approach. Rather, I think a big problem is such thick-skinned comment as “internal control failed to discover any frauds.”

Taking the percentage of completion method as example, the current status of each project is often discussed and reported at the project progress meetings and other occasions within the company. I almost want to say, “If an audit is impossible to detect the fraud, why don’t we stop all the audit works?” Therefore, it is my wish that we scrutinize why the internal control report system hasn’t functioned as anticipated.

○I reckon we will discuss systematic responses in this Advisory Council Meeting, but reflecting on many accounting frauds over the past 15 to 20 years, there seem to have existed some patterns such as off-balance-sheet structures, premature revenue recognition, and overstatement of assets. The most important response to be taken by auditors to these fraudulent actions is to recognize the audit risk corresponding with the business risk while also taking into account the quantitative materiality of monetary impact and to determine how to respond. This will be the most critical part of audit practices. While on the other hand, regulatory authorities, putting emphasis on the risk-based approach, have recently released the Standards to Address Risks of Fraud in an Audit. Although I personally believe these are very good standards, I have the impression at the same time that audit practitioners are not thoroughly implementing these standards.

How much do auditors need to consider which accounting area in the relevant company’s business is critical and contains risk to be assessed by the audit? The key to the audit process is to recognize crucial areas without failure from the whole picture, and I feel this is the area where auditors have to make more efforts.

In general, whenever an accounting fraud is identified, all focus tends to be directed toward the audit methodology of the auditor. But, it is inevitable to rely on the internal control of the pertinent company on auditing a giant company. Then I think that the publication of correct financial statements is not only the duty of auditors but also the responsibility of the relevant company, including the essential roles played by kansayaku who are entrusted with monitoring various operations within the company as well as of the shareholders and investors.

In that regard, it is critically important for kansayaku to express opinions from the viewpoint of kansayaku in the company and discuss the risk recognized by auditors and their adopted audit procedures, since they are the first people to whom auditors reveal the risk recognized and audit procedures adopted by them. Maybe, this is already practiced at some companies, but I feel it is not practiced well at many companies.

Furthermore, another thing I felt in my practice is that when studying the examples of past inappropriate accounting treatments, one always comes across the internal control, and that the problematic part within the internal control is more often than not so-called “management override.” There seems to be too many instances where the internal control established by the management was functioning effectively with pertinent report submitted, but the final management decision was made contrary to such report.

My understanding is that the current internal control report system is equipped with a supervisory function over both the board of directors and kansayaku who are appointed to supervise management override in addition to the narrowly defined internal control. Then, investigation should be made whether internal control is set up to cover such areas and operated to such specifications. In practice, though I haven’t necessarily seen many examples myself, I have to wonder if a certain part of the internal control, which is equivalent to corporate governance such as the supervisory function of the board of directors and kansayaku, has a satisfactory mechanism in place to test the maintenance and operation of its functionality even though it is adequately designed for such purposes. I wonder who is responsible for checking it. For example, is the internal audit department within a company capable of such checkup? These are the areas that I feel very questionable in practice.

From such a perspective, though it is essential to discuss about the system, we may need to reconsider once more whether the audit is implemented in a manner expected by the public to meet their expectations. Obviously, this is the issue most concerned with auditors, but other stakeholders should consider with auditors this issue, if some sort of guidelines that lead to further practical actions for an auditor to promote more effective audit works is produced, it will be actually helpful in real practice.

○I would like to make two general remarks.

With the incidence of fraud, we are currently debating the appropriate countermeasures and naturally have to consider various measures. But it is impossible to eliminate fraud from the world, and no matter how well established a system is, there still will be incidence of fraud with a certain probability. Therefore, in order to determine to what extent efforts should be made to prevent frauds from occurring, we may have to rely on the cost and benefit viewpoint in principle.

For example, if we establish a new system before thoroughly analyzing why the current internal control report system hasn’t functioned properly, since quite possibly it may just end up increasing cost without producing sufficient benefits, it is essential that we should take into account of the cost and benefit equation at any time. This is my first point.

Another point is a possibility that accounting standards as basis of an audit may not always conform to the audit practice. As for this point, we need to go back to the starting point of why disclosure of accounting information is necessary in the first place.

Accounting information is disclosure of facts by the management who have advantages on information access than investors. Meanwhile, the management does not always have better information than investors with respect to the future forecasts of performance. I believe that future forecasts of performance should be the investors’ task by its nature, and that the responsibility of the management concerning the information disclosure is how to disclose the facts. In disclosing facts, there have been more and more estimates involved recently, which is certainly inevitable. However, in doing so, I think that the estimates needed to disclose facts should be treated separately from those needed to forecast future performance. In a similar vein, estimates that can be audited should be treated separately from those estimates that cannot be audited, and we should set up standards only for the estimates required to disclose facts as well as those that can be audited in the regulating disclosure system.

Looking at the percentage of completion method as example, previously in Japan, either the percentage of completion method or completed contract method had been selectively applied, and then the percentage of completion method was adopted in principle following the trend at the International Accounting Standards Board (IASB). Since then, however the IASB has given up the persistence to the percentage of completion method. In percentage of completion method, usually revenue is recognized by multiplying the contract price by the percentage of completion, which is determined based on the ratio of cost incurred so far to the total cost estimate for calculation purposes. This makes it possible to manipulate the timing of revenue recognition front-loaded by disguising a higher percentage of completion by setting optimistic future cost estimates. Even if auditors have some doubt about the future cost estimates and raise questions about it, it will be very hard for them to disagree with the expert staff members of the company who claim that the future cost estimates are feasible. I think this is a very uncomfortable standard for audits.

From this context, similar problems will keep occurring in future unless we concurrently consider accounting standards that are easy to adopt for audit purposes or those that are at least not impossible to apply to audit works.

○In the United States, the system of accounting and auditing began the in the securities market from the 1930s, and it began after the second world war in Japan under the Securities and Exchange Act, so over half a century has already passed since its inception. But, reflecting on its history, I have noticed a dramatic change, an almost a paradigm shift, between the audit environment in the 20^th century and 21^st century.

The Enron scandal in 2001 was a symbolic event in this regard. In Japan, we also had problems with companies like Kanebo and Nikko Cordial, and the root cause for these problems in both countries may be the same one deep down. The audit in the 20^th century was conducted on a test basis, relying on manpower if not to say on obtention of handwritten evidences. Especially in the case of Japan after the second world war, based on a big assumption that internal control of the company is functioning effectively, the audit sampling method, which is a partial sampling inspection, was adopted but has so far failed to eliminate fraud after all. Foreign countries are also suffering from similar issues.

To address these issues in Japan, the Certified Public Accountants Act was revised, and numerous amendments were made to the auditing standards one after another in addition to establishing the Standards to Address Risks of Fraud in an Audit. Considering all these regulatory responses, I wonder whether regulations by laws and standards have come to a saturation point. As often mentioned in the discussion on the internal control, a vessel has been prepared but is lacking in spirit. It may be probably something to do with competence of the relevant accountants.

The point is, under the highly developed and complex economic environment, immature people are unfit for auditors when they are eagerly expected to play the role of an anchor in the audit under the current disclosure system. The auditors have to be experienced and mature grownups: those with an ample knowledge and sense of corporate activities and business world. Furthermore, in this changing environment, such auditors should have sharp sensibility or sensitivity. If so, naturally, it may be that such auditors should be at or over a certain age. Or I think that we may have to comprehensively review the whole structure of the education process, examination system, and instruction and training to turn out auditors.

In particular, anybody can take the CPA examination under the current system in Japan, and it has sometimes produced qualified accountants in their teens. I’m not trying to discredit such exam-ready teens, but the auditors cannot be expected to argue or discuss on an equal footing with the middle or senior managers of the company without some cultural education, business sense, and a certain level of social common sense. Especially, in order to have a meaningful conversation with senior management, of course age is not only an important factor, the auditors should have sufficient intelligence and knowledge, because senior officers of the company won’t waste any time for them. There are very bright people in charge of finance and accounting in listed companies, and it may be a little rude to say this, but it will be quite easy for them to play tricks against auditors with five-to-six years of experience.

Therefore, without changing the system which can turn out auditors with a wealth of experience and diverse background, the same problem would continue. Here in Japan, we have seen a large number of accountants qualified between 2007 and 2009 due to the change in the CPA examination system. However, audit firms were unable to hire all of the newly qualified accountants, resulting in the problem of many unemployed accountants. As a result, since then, the number of applicants has declined drastically and currently about 10,000 applicants, almost a third of the peak level, sit for the exam. As is the case with any industry, a lower volume would affect the quality.

In the case of the Enron scandal, although accountants from the reputable Arthur Andersen were in charge of the audit, why they couldn’t detect fraud? There must be various reasons, but reviewing the background of accountants who managed the site in their 40s, they must be graduated in the 1980s, 20 years earlier. This was exactly the period of ordeals for accountants in the United States. Accused among the storm of litigations, confidence in the audit industry plunged straight away and the number of applicants for CPA qualification also nosedived. In the United States, many people who aspire to be successful in the business world try to obtain CPA qualification so that they can utilize their qualification in actual business rather than working in accounting firms. So CPA qualification is popular and the level of qualification retains high as well. It has been also highly respected by the society. That’s why many students study the subject. However, that prestige fell to the earth with a thud around 1980. Consequently, bright young students stopped sitting for the qualification exams and the number of applicants for the exam declined dramatically. Again it is rude to say, but some of those who passed the exam around that time were not necessarily brilliant. Twenty years have passed since then, and I have read an article that has plausibly claimed that the cause of the Enron scandal lies in this historical background.

Meanwhile in Japan, unfortunately, the large number of newly qualified accountants is in general adversely affecting the quality of accountants. Moreover, in order to make room for these newly qualified accountants, it is said that the experienced accountants have left their audit firms. Consequently, each audit firm now has fewer accountants who are experienced and can train and instruct young accountants, while there are many fledgling accountants who need instructions and guidance. If the latter has high quality, there wouldn’t be any problems, but it doesn’t necessarily seem to be the case. Those who passed the exam around 2007 and have been practicing as accountants are now likely to be working in a position of manager-in-charge or something like that with seven-to-eight year experience. I wonder if these accountants are able to debate on equal or better terms with company officials who are tasked with the responsibilities to deal with the core of the organization such as financial and accounting departments of the so-called blue-chip companies even when they have some suspicion or they are at unease. I myself suspect it pretty much.

Accordingly, we need to address these areas. As one example, since the beginning of the 21^st century, one area most emphasized among the auditing standards sounds more like the theory of spirit. In brief, maintaining independence and professional skepticism is the fundamental requirement of the auditor. This is really theory of spirit. It is needless to say that the required audit procedures such as physical inspection and direct observation must be implemented, and every accountant does that. More indispensable is with how much sense of risk each accountant conducts oneself. Unless the auditor properly understands the importance of recognizing the audit risk and evaluating the underlying business risk, I see that the audit falls into nothing more than a perfunctory formal exercise where an audit finishes with the preparation of certain audit documentation. Please consider and discuss once again how to cultivate suitable auditors in our country.

The internal control has already been mentioned a few times, and the first building block of the system is the control environment. This quite simply reflects the attitudes of the top management of each company. How to assess this is such a qualitative argument and it is very difficult to exercise. For an auditor to tell the top management of the audit client, “Your internal control has weakness here. You have problems here,” I believe such an auditor should have an appropriate standing. I believe it is high time that we take drastic measures to assess the effectiveness of the establishment and operation of the internal control from the starting point of the system in its true meaning.

I’m not suggesting that the internal control report system is not working. Although there are diversified academic opinions about the relationship between the internal control and the so-called corporate governance, at least, we insist that the internal control is the core of overall corporate structure and disciplining framework called corporate governance. And naturally, ownership or accountability of the internal control belongs to management. Accordingly, without focused assessment on management, you cannot argue that the internal control is truly assessed, and I don’t think you can emphasize this point too much. From this context, it will be desirable to review standards or at least actual practices.

○With respect to the competence of accountants, the question is whether they perform primary duties according to their positions, whether they have qualitative expertise to conduct an audit, and whether they have the leadership skills to coordinate a team. With respect to the audit firms, since they are private company, they need solid management foundations, but the question for them is what sort of a management structure is required to produce an assurance properly.

Regarding the audit methodology, 24 years have already passed since the auditing standards adopted the risk-based approach in 1991. It cannot be denied that auditors have utilized IT as they are using the personal computers in an audit; however, the mechanism itself has been hardly revised. When talking about the test-based audit on the risks identified, a change in the corporate environment directly leads to a change in the audit environment. For example, under the current situation where globalization is progressing even with medium-sized corporations, so many companies have transactions in numerous countries. Then each country has its specific trading customs, and corporate activities and bookings are undertaken in such circumstances. Furthermore, with a new corporate structure being constructed in a very swift manner involving M&A activities, less and less companies are now operating on the traditional format in which, for example, they own a factory, keep manufacturing and selling a set of products as before. If this is the case, then what is the risk in the risk-based approach? Previously, all the transactions that do not fall into the category of usual transactions were regarded as unusual and listed as a risk, and the auditors inspected all of them; however, under this approach, a fair number of transactions will fall into the category of unusual transactions these days. Then a concept of the risk-based approach may not be appropriate to all companies any more.

At the moment, a comprehensive inspection of all transactions by IT application is being researched. Because such audit methodologies are not yet included in the International Standards on Auditing, the discussion here may be a bit overblown, but the current environment may demand the research of such methodologies. We would like to contemplate and examine how an audit can adapt to the changing environment at this Advisory Council Meeting.

Concerning the viewpoints of third parties, it is said that the review by the CPAAOB is indirect. The quality control review by the JICPA is conducted in advance as the primary review, which I recognize as one of the viewpoints of third parties. The procedures for quality control review have been reformed as appropriate, and I would like you to regard the quality control review by the JICPA as viewpoints of third parties.

Also, the issue of corporate governance is very significant. Since the credibility of disclosure is doubly safeguarded by the accountability of both preparers and auditors, companies should fulfill their responsibilities as preparers. On that aspect, Japan’s Corporate Governance Code clearly states the significance of accountability and the importance of disclosure to that effect. Furthermore, though auditors are fully aware that they are accountable not to the management of the company but to the shareholders and investors, the company has to understand and accept the nature of the accountability. Based on this premise, supplementary principles of Japan’s Corporate Governance Code are also set forth so that companies have to establish a system to ensure the implementation of a proper audit. This is one of the areas which should be thorough.

Here I want to talk about the current state of audit works. Saturated with standards or with the ever increasing requirements that have piled up every time some problems materialized, auditors are likely to be dealing with more procedures these days. Since audit procedures at the end of the financial year in particular have increased and auditors are supposed to complete audit work within the predetermined settlement period, the burden for auditors at the end of the financial year should be considerable. I strongly request we discuss this audit environment.

Given the scheduling of a shareholders’ meeting as well as Japan’s disclosure requirements in accordance with three systems, streamlining these requirements would be an important issue as well, and I believe that measures to address these areas will lead to reducing a huge disclosure load at the end of financial year while reducing burdens on auditors to respond to that demand and ultimately improve audit quality.

In any case, we need to thoroughly examine the current status and environment surrounding the audit practice at this opportunity and find measures to strengthen the audit system so desired originally as a part of the social infrastructure.

○Opinion was expressed earlier that audit practices have become especially difficult because many matters have become irregular with the emergence of various business responses under a dramatic change in the business environment. But my understanding is that most of the incidences were not totally unexpected. For instance, we can identify typical risks in manufacturing companies and predict likely incidents more or less. The same would apply to financial institutions where you can identify typical problems and predict what problems are likely to occur in most cases. This is what we should call an appropriate audit under the risk-based approach in a real sense. I do not believe that such an approach would suit the objective of this meeting that we have to widen the scope of considerations because the number of irregular matters in business is increasing and this requires complex measures against them.

Corporate governance issues have been raised a few times earlier, but I don’t believe this is the place to deal with them. I admit there definitely exist corporate governance issues, and systematic misconducts have actually happened even at very reputable companies. But from the perspective of an audit, it comes down to the point that auditors state they don’t express an unqualified opinion and state the reasons for that. The focus of our debate at this meeting should be on the reasons why auditors are unable to stand firm against the management and make the audit system work properly.

About auditors being too busy, especially around the end of the financial year, to deal with numerous problems as they are caught up in a tight schedule, I can easily imagine such situations to arise. While I think we should consider this problem on one hand, it may be an extreme opinion, but I cannot help having the impression that auditors waste so much time dealing with insignificant matters in detail, including at the audit planning stage. Auditor remuneration is determined according to the audit plan, and I become suspicious whether some auditors try to obtain higher auditor remuneration by presenting how many man hours are needed to deal with the list of many insignificant matters determined at the audit planning stage.

I dared to point out problems boldly and please don’t misunderstand me, but it is essential for auditors to fully concentrate on the vital points under the risk-based approach, for example, by narrowing to priority areas during the audit planning stage such as treatments on the percentage of completion method for each construction work, acquisition of operational assets, and inventory evaluation. Spending much time on insignificant matters has hardly led to meaningful audit findings. However, I imagine companies will dislike this approach. The management may put considerable pressure not to approve such an audit plan. But in extreme words, unless auditors discuss with the management about the way of audit which focuses on the vital points even if ignoring insignificant matters, audit will become a mundane and long-winded exercise in order to get paid certain auditor remuneration. I think we need to seriously discuss at this opportunity how to make the practices more adept and varied.

○I think that the competence of accountants involved in audit process are of utmost importance. In essence, whether they can rightly perform the duties of protecting the market or not is a vital issue. There is a concern at the moment that less and less accountants are now capable of expressing adverse opinions whenever any problems are identified. How should we respond to this? Replacement of all accountants would not solve the problem, and we still have to address this problem.

As previously remarked, I agree with the opinion that the risk-based approach should be more thoroughly focused. Though, requirements specified in the auditing standards are, in a way, obligations in the audit procedures and the practitioners cannot ignore them in actual works. In this regard, how do we construct the system that enables auditors to concentrate on significant matters without being fearful of accusations that they haven’t followed the procedures afterward? Today, the JICPA is also conducting the quality control review in the way which focuses on vital issues, and I think that similar approaches may be needed in the audit procedures as well. I believe that it is also the responsibility of this Advisory Council to deliberate on how to create such an environment.

○Regrettably, it is commonly said that you cannot eliminate all fraud from this world and some academic research works point out to that effect too. This means that when handling an issue of fraud, it is crucial how to suppress and prevent frauds and what actions are required for such objectives rather than to investigate how to detect and expose them effectively and efficiently. Since fraud will inevitably occur despite every preventive measure, antifraud measures should include a mechanism to nip such fraud in the bud.

It is vital whether auditors, who play a main role in the disclosure system, are capable of telling the corporate side fairly and squarely that the behaviors likely to lose the confidence of the society and market are not only costly to them but could also adversely affect the viability of the company itself. I wonder that as long as such a perspective is ignored, any minute inspection into the existence or absence of fraud would have limitations and fail to meet the society’s expectations.

Based on such a perspective, in order to perform their duties in an appropriate manner, auditors need to be respected and equipped with certain level of knowledge with social reputation and standing for their credibility; at least, engagement partners need to possess such qualities. However, it is impossible for the members of engagement team who support such engagement partners to properly perform their duties with a good understanding of such partners’ intentions if such supporting members lack of sufficient basic education as an accountant. All in all, I surmise, on this occasion, we had better reconsider introducing a qualification examination system pursuant to the international standards as well as the established education and training system.

The issue of fraud is a significant topic overseas as well, especially for auditors. According to one research paper, a data analysis as to what kind of auditor is superior in detecting fraud has concluded that those auditors who have got job at an audit firm from the beginning and engaged only in insular audit work are less adept at detecting fraud. With age and more experience in audit works in various industries, they may improve. However, according to the research, those who have a few years of outside experiences which include working in business companies, seeing the actual business operation or being knowledgeable about business are quite capable of detecting fraud when returning to an accounting firm. According to the research, these auditors are called “boomerang auditors.”

Here in Japan, we have an internship system for junior accountants, but I am doubtful that this system is necessarily helping those newly joined junior accountants in improving their competence as a mature auditor by only telling them to “audit, audit, and audit.” Based on this perspective, I have thought it a great idea to hire and promote once more those who have had actual experience with management and finance when measures were considered to increase the number of accountants before. Unfortunately, the actual CPA examination is still based on the written format test and it was hard to realistically implement the idea. However, it may be worthwhile to investigate this idea once again and to make at least some suggestions.

For auditors to be high-spirited and proud, in cases where the client requests them to take unethical actions, more frankly speaking, when they are asked to quietly condone fraud, in some countries, an ethics class advises them to courageously resign from the task assigned and refuse such demands. Ideally, auditors should express adverse opinions despite such requests, but it may not be pragmatic in the actual situation. When considering healthy management of an audit firm, we cannot ignore directing the spotlight toward this area.

On top of that, I am also informed that there are more than 200 audit firms in Japan, but it is hard to believe that all of them possess the same level of quality. But the same level of quality must be guaranteed for an audit by laws and regulations. Then this means the necessity for some shakeout among audit firms, and I feel a measure to secure the quality of the audit firms is indispensable to some extent.

○Those who are actually involved with audit work or who are tasked with deciding audit rules may be well served to have a debate from the perspective of what would happen without the audit system.

Because accounting disclosure is self-reporting by the management, it cannot secure credibility by itself. Therefore, without the audit system, information users would more cautiously assess the corporate risk of the relevant company, leading to a higher capital cost and lower share price of the company. The management would bring in third-party specialists in an effort to avoid such situations and to secure the credibility of self-reported information even if there is no audit system required by the law.

Audit rules should be laid out after fully examining what sort of responses would take place if there is no such system. And, if there is any deficiency with an auditing standard, that pertinent standard should be modified. If essential areas are not adequately covered by auditing standards and many insignificant minute procedures are obligated, such standards should be eliminated after all. We should be bold in our discussion, and I’m afraid that a mere comparison with foreign systems would not solve any problems.

○We are here to have this discussion because an audit has failed to detect accounting fraud; however, there have also been examples where fraudulent actions have been identified during the audit process or where auditors have found an inappropriate accounting treatment during the audit process and have persuaded the management to file the appropriate financial statements. According to the survey by the JICPA on approximately 1,000 accountants, they have encountered such incidents twice on average over the past 10 years. This is proof that audit is somehow functioning in a certain aspect.

Obviously, there will be many attitudes on the audit methodology, and certainly it is getting more difficult with the dramatic shift in the environment. Having said that, I feel there are still many who believe that the method and essence of an audit should stay the same even though environment changes. As mentioned before, auditors should identify the area of the audit risk once having squarely understood the business and taking into account of both the intentions of the management and the likely consequences of failure to execute such management intentions. Within a limited timeframe, auditors should spend their precious time on the areas which they consider material and highly-risky. I’m sure some accountants are strongly resolved at the bottom of their hearts to concentrate on significant matters even though they missed any problem in the other insignificant areas. Never to miss the point! Actually, I believe that a majority of them are working with such a resolve.

However, saying about the recent situations, especially for young accountants, we have to think about the reviews of audit documentation. For audit firms, there are reviews by the JICPA, the CPAAOB, and the Public Company Accounting Oversight Board (PCAOB) if a client company is also listed in the United States. Having gone through these reviews, it is surely true that the reviews are most concerned with how most significant risks are recognized and whether satisfactory audit works are conducted against them. But in addition to this, quite a significant part of the reviews is devoted to scrutinizing why insignificant matters are recognized as such and how much response to these insignificant matters the relevant auditors judge appropriate to give. If some written explanation is lacking in audit documentation or some necessary procedures are deemed to be missing from the audit, auditors will receive comments in the reviews. It will depend on each audit firm on how to deal with those comments, but generally speaking, it means lower assessment and thus lower compensation for the pertinent auditors. It also adversely affects his/her promotion within the firm. Some strict audit firms even ban accountants who have received comments twice in a row from performing audit services of listed companies.

Since the PCAOB even asks about the current treatment within the firm of such auditors who haven’t conducted satisfactory audit procedures, audit firms take strict actions against such auditors. Under these circumstances, young accountants are forced to endeavor and spend more time to avoid any holes and to create a coherent story without abnormality. From a broad perspective, you feel that they don’t have to do that and should spend more time on crucial areas, but these tug-of-wars exist in reality. If every accountant performs his or her duties with a strong sense of mission, that will be great, but in reality, it is not so easy to be oblivious of his/her own evaluation. Should this problem be addressed by any change of the auditing standards? What message should the management of each audit firm give to the onsite staff to address this problem? This, I surmise, is a very important issue.

○I believe that audit methodologies that could replace the risk-based approach have been researched overseas. Previously, any payment other than the payment at regular fixed times drew attention as a target for audit, and an explanation was sought for such an irregularity of the transaction. However, the more businesses become complex today, the more number of irregular transactions among the numerous transactions occur in addition to regular ones. The new study has started based on the thought that the listing and verification of every transaction at equal measure may be more effective than the risk-based approach if we try to cover them comprehensively.

In such a study, data verification technology will be applied as it is impossible to verify all transactions manually. In this process, irregular transactions will be identified by applying computer program, which are something called artificial intelligence, and final judgment shall be made by human. Such an approach is currently under development, though I don’t believe that such an application is already in practice.

However, such an approach is not considered to be included as a part of the international auditing standards. Research has just started regarding what sorts of audit methodology are actually being investigated in the private sector.

○Audit firm rotation is, as is the case with rotation of engagement partners, based on the philosophy that it is better to enable formal check of the independence of an auditor. Another benefit is argued to be that a change of an audit firm carries different viewpoints in audit work and could contribute to the quality of an audit. I have a feeling that the contents reviewed at the previous Financial System Council are still very much relevant today.

Audit firm rotation is extremely costly. It is also said that in some countries, the rotation has resulted in lower quality of an audit due to the remuneration discount competition among audit firms. In a practical sense, a change of auditors would drastically increase audit man-hour and cause a higher cost. We have to bear in mind such realities before examining its necessity.

Earlier, the issue of cost and benefit was raised. There would be an opinion that it is worthwhile to try in spite of the higher cost. In any case, we must have exhaustive discussions here.

○I will touch upon the rotation of engagement team within an audit firm. The report published by the Financial System Council Subcommittee on Certified Public Accountants System in 2006 has pointed out that while audit firm rotation is meaningful from the viewpoint of strengthening the independence of an audit firm, there would be the issue of interrupting the accumulation of knowledge and experience of auditors. From the viewpoint of an audit firm’s management, an audit quality is the most essential and emphasis is placed on how effectively and efficiently the relevant engagement team performs their task. A whole change of all engagement partners at a time is likely to result in the “interruption of accumulation of knowledge and experience” since such an incidence could happen in not a few cases within the same audit firm. Every audit firm is very careful in implementing the rotation of engagement partners when selecting the engagement team, and they make sure not to interrupt accumulating knowledge and experience through retaining one or two engagement partner(s) in the same engagement team rather than a whole change of the engagement partners in one sweep.

Judging from these realities and considering the effectiveness, quality, and efficiency of an audit, a total change of the engagement team would be hardly practical.

○At the moment, rotation is obligatory within audit firms for engagement partners who are authorized to sign off the auditor’s report. In preparation for a contingency such as illness of an engagement partner, multiple numbers of engagement partners, usually three partners, generally sign off the auditor’s report. Taking into account of the relationship with clients, audit continuity and accumulation of knowledge, a comprehensive change of the engagement team is not desirable, and in practice, rotation is carried out with carefully designed planning for the change of personnel with the long-term, five-to-seven year, timeframe in mind. Consequently, changing all the members of an engagement team within an audit firm is unheard of, and in practice, hardly possible.

The objective of rotation within the same audit firm is to introduce a new perspective to audit work. More strictly speaking, I privately reckon that even though the solid internal control is established within the audit firm to ensure a proper and high-quality audit, if the partner in charge fails to perform his/her duties with integrity or continues to do wrong things for a sustained time for whatever reasons, these will cause a serious problems, and that the change of members of engagement team may make it possible to expose certain things kept by individuals into the open. Since a comprehensive change of the engagement team members is not currently being practiced as I pointed out before, each engagement team tends to continue its own methodology. Because young accountants naturally tend to work in reference to the audit documentation of the previous year, I feel that the audit approach and risk recognition of each team have a tendency to be fixated.

○Reflecting on the fact that 10 years have passed since the issue of audit firm rotation was investigated last time and that the audit firm system in Japan will also celebrate its 50th anniversary next year, one question is whether it is desirable for one audit firm to provide audit services to the same company over decades. Expressing my own opinion here, including some speculation, I gather there should be instances where the corporate side has become fully aware of the audit methodology of the pertinent auditor and the extent to which they adopt certain accounting treatments without drawing an adverse opinion from the auditor if the same audit firm has provided audit services over a long period of time. In addition, at the previous discussions, the concern was expressed that it might cause a contortion of the audit firm network across their operations in different countries, especially at global companies, if rotation is made compulsory only in Japan without any foreign countries adopting it. This time around, though it won’t be introduced in the United States, audit firm rotation will start in Europe.

The issue of cost was also discussed then. There are two angles to this problem: one is that a higher cost will lead to an increase in auditor remuneration, and another is that, conversely, a higher cost will be burdened by audit firms by lowering unit-price of audit services as the higher cost is unlikely to be borne by companies. The challenge imposed by the higher cost cannot be ignored, and the way the higher cost is absorbed will also affect the quality of an audit. Ten years after the previous investigation, the situation has changed globally as well.

○Audit firm rotation is an extremely vital issue, and I myself was one of those who opposed to the idea previously due to two reasons.

The first reason was that the introduction of audit firm rotation in Japan seemed a little too drastic a change of the existing system given a lack of clear evidence of its benefits yet, considering that the engagement partner rotation system had just begun in Japan at that time.

As to the second reason, after the idea of audit firm rotation was raised in the United States in reaction to the Enron scandal, the Public Company Accounting Reform and Investor Protection Act of 2002 in the United States stated that the Government Accountability Office would conduct a fact finding survey over the following year and review the likely impacts incurred by the introduction of the audit firm rotation system. Afterward, the relevant report was published and although no conclusion was made, the tone of the debate was equally balanced between for and against. There were two arguments for audit firm rotation: a stronger independence of the auditor and improvement in audit quality. But can the change of audit firms alone really realize these benefits? On the other hand, arguments against audit firm rotation were higher cost and lower motivation for auditors. For example, if a capable auditor has to finish the audit work for a particular company within two years due to the 10-year rotation term despite his/her excellent efforts so far to improve the company, the concerned auditor may have to give up the audit work of said company in order to be more involved in marketing activities to get the next client, resulting in significantly lower motivation for him/her within the firm.

Another argument is that the assignment of new auditors who are not familiar with the actual state of the relevant company in the first couple of years may tempt the client company to act somehow fraudulently. Data suggest that in many cases auditor remuneration have greatly risen, in particular in the first year when the new audit firm has been appointed. Accordingly, I was opposed to the rapid introduction of the audit firm rotation system on the ground that we need to conduct a fact finding investigation or a hearing survey within Japan and to conduct data-based discussions before adopting the idea of audit firm rotation.

I have some concerns that we Japanese have the mental difficulty to deal with people at arm’s length once a friendly relationship is established, so I have some hope that an introduction of this rotation system may have the desirable effects of somehow breaking free of such a relationship. After 10 years from the initial investigation, I believe that the prerequisite for considering audit firm rotation to be meaningful would be the restructuring of Japan’s audit firm industry as I pointed out earlier. For example, the number of audit firms would probably be no more than three to five, which can allocate 50 to 100 accountants in addition to the engagement partners required for audit works of a giant corporation. Since audit quality would not be improved but for healthy competition in the industry, we have a challenge here on how to restructure the industry.

I have also stated before that in order to secure competitiveness among international networks of audit firms, we need to have approximately 10 audit firms employing about 3,000 staff members. Now, it seems we have enough in terms of numbers. As mentioned before, with the same idea being adopted in Europe, I guess it is getting more difficult to oppose outright the idea of audit firm rotation. For instance, since the audit firm rotation has first being applied in both Singapore and Italy to financial institutions that possess the highest public and social nature, we may consider introducing the system first with financial institutions as well.

In brief, what I want to emphasize is that it is also imperative to make Japan’s audit firms more competitive by reducing their numbers to an extent, and the issue of rotation alone will not be properly dealt with unless discussed together in this context.

○Most affected by fraudulent accounting should be investors. When listening to the arguments of a higher cost absorbed either by an audit firm or a company audited as a result of audit firm rotation, I’ve sensed that the viewpoint of investors are somewhat forgotten. Investors assume that audit should be conducted properly. From their perspective, it may not be easy to accept the statement that audit practices are improved only from experts’ point of view while the specifics of audit practices are not well understood by them. Therefore, I hope we also discuss about actions that are externally understandable. Having said that, I certainly have a suspicion myself that the introduction of audit firm rotation alone can solve problems after listening to various stories including overseas experiences. If the introduction of audit firm rotation alone is not sufficient, we may also have to tackle the problem in conjunction with the Audit Firm Governance Code. Or if audit firm rotation cannot be introduced, we may have to more seriously tackle with the Audit Firm Governance Code. We don’t have to establish the same system as in overseas countries, but with a clear understanding of the nature of challenges and priority areas, I would like you to also continue discussions about setting forth effective codes from the next meeting onward.