Discussion Summary of Second Meeting
Advisory Council on the Systems of Accounting and Auditing
Friday, November 20, 2015, 15:30-17:30
Common Special Conference Room No.1,
13th Floor, Common Government Office No. 7
Discussion on the Systems of Accounting and Auditing
4. Summary of Discussion:
The discussion is summarized below.
○For quality of audit, it is important that there are cooperation and adequate interaction with stakeholders of audit, such as management, kansayaku, users of financial statements, and regulatory authorities. To date, despite the significance of interaction with stakeholders, I am afraid that it is difficult to achieve their understanding pertaining to audit firms and practices.
For audit, it is based on the premise that audit firms and auditors thoroughly conduct their audit works, and a high-quality audit should be accomplished by the engagement teams with the following requirements. First, with respect to input, they have sound ethics and wealth of knowledge and experience; furthermore, they allocate adequate time to audit works. Second, with respect to audit process, they go through or apply strict audit processes and quality control procedures based on laws and regulations as well as auditing standards. Third, with respect to output, they submit an effective and timely auditor’s report.
Therefore, in order to improve effectiveness of audit, I think that it is appropriate for the stakeholders of audit, such as management, kansayaku, users of financial statements, and regulatory authorities in the financial reporting supply chain to discuss how audit is required.
It may be necessary to secure the transparency of audit, and, the consideration of the application of the Audit Firm Governance Code may be required. Moreover, I think that long-form auditor’s report, which is under consideration in foreign countries and already used in some European countries, may contribute to ensuring the transparency of audit because such reports provide information about points to be noted for an audit.
The Center for Audit Quality, which is an affiliated organization of the American Institute of Certified Public Accountants (AICPA), and the Public Company Accounting Oversight Board (PCAOB) are publishing a plan for Audit Quality Indicators (AQI). We have to watch its effects from now on, but it may also lead to ensuring the transparency of audit firms and audit.
In terms of environmental improvement to practice profound audit, it may be desirable to improve such environment because in Japan, auditors complete an audit in quite a short duration compared with Europe and the United States.
For the quality control review of the Japanese Institute of Certified Public Accountants (JICPA) and inspection of the Certified Public Accountants and Auditing Oversight Board (CPAAOB), I think there is a point of argument that the audit procedure may only become the corresponding review and inspection procedure.
For audit firm rotation, I think it will be necessary to study its merits, demerits, or feasibility, including the issues such as pertaining to the rotation target being audit firms or whole engagement teams.
About the system of quality control review, I think continued improvements should be necessary corresponding to various environmental changes such as introduction of Japan’s Corporate Governance Code.
With respect to the corporate governance of audit clients, it may be required that auditors conduct an audit on the application situation of Japan’s Corporate Governance Code as part of internal control audit.
For the internal control report system, I am afraid it may partly become a mere facade because both companies and auditors have got used to it. For example, numerical criteria for selecting significant business locations or definitions for material weakness are making the system superficial. The consideration of direct reporting, which is used in the United States, may be required.
Pertaining to the disclosure system, in case of listed companies, I think unification of financial information for the disclosure in the Companies Act and the Financial Instruments and Exchange Act will improve the quality of disclosure and audit. For the operation of accounting standards, by expressing management ideas about issues such as accounting policy of revenue recognition or the condition of accounting estimate in a more detailed manner may let management contemplate the accounting procedures.
I also think that it is very important to ensure proper auditor remuneration based on the costs required not to deteriorate the audit quality, including improvement of audit technique using IT and establishment of independent system of engagement quality review.
For the training of auditors, it may be necessary to clarify the requirements and scope of operations according to each one’s level, review once again the reporting and communication within engagement teams, and clarify an ideal situation for the training system according to each one’s level.
○The predecessor of current monitoring by the PCAOB practiced in the United States was peer review, which started in the 1970s. However, only with peer review, audit industry could be self-serving; therefore, the Public Oversight Board (POB), established as an affiliated organization of the AICPA from 1977 to 1978, has been monitoring peer review as an independent public organization. Having said that, the POB operated by funding of audit industry and triggered by affairs such as Enron scandal, criticism that the POB may be short of public interest and independency was raised. Therefore, the PCAOB was established within the framework of the Public Company Accounting Reform and Investor Protection Act of 2002.
Even at that time, there was an opinion that overlapped monitoring could be a burden in terms of practice. Furthermore, in Japan, there is a request to unify the inspection of the CPAAOB and quality control review of the JICPA. I wonder if we can discontinue quality control review of the JICPA, for example, and thereafter handle all the situations only with the inspection of the CPAAOB.
This is my personal opinion; however, because any industry of profession could become ineffectual without a pillar of self-regulation, the function of the JICPA as a self-regulated organization should be secured. Therefore, I think that we have to reform the JICPA to a self-regulated organization and a kind of mutual aid association. For example, Japan’s stock exchanges have an independent self-regulated organization. I believe that the JICPA as a self-regulated organization and the CPAAOB should more closely cooperate with each other and share their roles.
○I do not think that today’s audit environment in Japan, considering the scale of the market, flooded with more than 200 audit firms, is appropriate. Perhaps many audit firms are in charge of only one listed company. High-quality audit cannot be ensured in such environment. Inspection authority cannot handle all of them, including small firms.
Therefore, the shakeout of firms in a good way may be desirable to qualify Japanese auditing system and enhance international competitiveness. It makes sense to set an appropriate bar for audit firms to conduct an audit on listed companies in a way that is acceptable for third parties.
○It is for sure that inspection of the CPAAOB and quality control review of the JICPA are overlapped. Although these two have different approaches, they seem to be almost the same; therefore, it must be timely considered if both of them are really required. Particularly, major audit firms have established their own proper quality control system regardless of the quality control review of the JICPA.
Various problems occur because their system is not perfect, but I request to begin with estimating internal control from the perspective of audit firms. It is ordinary to have a review on several audit works of individual companies as a test, but in addition to that, on the premise that audit firms themselves should create an environment to improve their audit quality, I request to check if the framework for this objective is adequately set up and operated.
Audit firms, would like to discuss these issues after estimating the primary points, including if they understand the risks lie in business situation of the clients and significant items of financial statements and to the level at which they should perform their procedures, if they fulfill the work they decided to do with responsibility, and if they reflect audit results in auditor’s report without making compromises.
I understand that the inspection does not focus on each audit process or number of procedures, but I think it is a good time to rely on the internal control of each audit firm to solve these issues.
○I believe that the points of discussion are how to cultivate competent accountants and ensure the environment to conduct an adept and varied audit. If the development of the Audit Firm Governance Code could be a useful measure, it may be important to discuss Japanese own code referring to those of the United Kingdom and the Netherlands. We would like to discuss it after having our specific ideas or outlines.
Regarding the inspection system for audit firms, it may be reasonable to check if the system works effectively after audit firms themselves create a proper system according to Audit Firm Governance Code.
○Listening to the discussion so far, there seem to be two issues: one is an issue on motivation where some audits were performed with the motivation different from that for shareholders, and the other is an issue on cognitive ability, including the quality of auditors. Regarding the latter, basically it all depends on the efforts to enhance audit quality in each firm. Looking at the Audit Firm Governance Codes of the United Kingdom and the Netherland, it is surprising that professional accountants do not notice such easy points until they are told, however, you may want to introduce the Audit Firm Governance Code since it seems harmless, though I am not sure the benefit of this. I also agree that AQI that evaluate audit quality should be considered.
On the other hand, for the issue on motivation, what we are facing is that motivation in audit, which was not for shareholders, provoked the serious situation. To handle this, I think we should consider first the system where shareholders’ governance works on audit and financial reporting. In Japan, the appointment and dismissal of company executives and auditors institutionally ought to be decided by shareholders. Although shareholders’ governance is formally equipped, their authority does not work substantively if shareholders lack information and knowledge. With respect to this, we should consider the system where shareholders can access necessary information and knowledge with reasonable cost.
After building up such a system, then, it is important to wait for the shareholders’ decision. When shareholders with enough knowledge and information judge an audit firm rotation to be unnecessary, it is inefficient to compel them for audit firm rotation by a uniform regulation. In foreign countries, in terms of the system where shareholders can access necessary information, there is an idea of using insurance. In case shareholders suffer losses because of financial reporting, creating a system that insurance companies deal with claim for loss. The premium rate and payment limit will be offered to shareholders’ meeting, and if shareholders think it does not pay for their risk, they can consider any measures such as changing audit firm. If shareholders also get AQI for their information, they can use it as a reference when they appoint and dismiss auditors.
I understand that in Japan, unlike in foreign countries, the feedback of inspection results of the CPAAOB is offered just up to the JICPA. I am not sure about the good reason why Japanese people, who usually want to adopt foreign systems, are sticking to the system different from that in foreign countries like this.
It might be one option if we have no other way, but I think uniform system represented by audit firm rotation is very perilous. As we, including regulatory authorities, do not know exactly how practice it in advance, it would be more difficult to deal with any defect of the system where everything is unified because if the choice of system goes wrong, the effect is more serious, as compared with the situation in which the different systems are simultaneously used in the market. I believe it is necessary to give shareholders information and incentives in a way that unnecessary uniformity should not arise.
Recently, we often hear about “comply or explain” or “principle-based approach.” I think that there is not much difference between these two once we consider them as a system. The system can be unified depending on who evaluates the explanation, and even if we use principle-based approach, it must be virtually concluded to be rule-based when it is used as regulation. In this context, I recommend contemplating the system which can offer proper incentives to shareholders minimizing the uniformity since once we get involved in the unified system, it may result in a serious issue when this choice goes wrong.
○Audit firms conduct an audit in the position of third party, whereas at the same time, they have a character as an internal organization of audit client and that ambiguity underlies the problems.
With respect to the incidences of fraud, I often have heard arguments pertaining to audit firms being sued by shareholders or the audit client if they don’t express an unmodified opinion; I presume there are such arguments since the support of audit is insufficient. From this perspective, the Financial Services Agency better draw up something like financial inspection manual, though we cannot treat audit in the same way as regulatory administrations for banks. This measure will strengthen the authority; therefore, I presume self-regulation is more ideal, and in this context, the Audit Firm Governance Code might be one option. It will be effective not only for audit firms but also for company managements to deal with the issues with a tense feeling.
The Standards to Address Risks of Fraud in an Audit has a clause that “When the auditor uses a positive confirmation request to address assessed risks of fraud, but the confirming party fails to respond or does not fully respond to such a positive confirmation request, the auditor shall carefully determine if the auditor will be able to obtain sufficient appropriate audit evidence using an alternative procedure;” however, I wonder if this really works as standards since it is unclear for me what to do. Looking at the Case Report from Audit Firm Inspection Results, there was a case where audit firm was pointed out since the managing partner did not understand the contents of quality control standards, which is surprising and cannot happen to general companies.
○Recently, the CPAAOB clarifies the framework for disclosing the inspection results by the CPAAOB to kansayaku board of the company on which the audit firm conducts an audit or with which the audit firm will enter into an audit engagement, with an increased interest because kansayaku board has been recently given the discretion in the appointment of auditors. I think this type of disclosure of inspection results will increase from now on.
○I would like to make three remarks.
First point is concerned with the Audit Firm Governance Code. For audit firm rotation, I think it is not the only solution, given the situation that foreign countries will not necessarily start it at once. Because the contents of the work of audit firms look like a black box, audit firms are required to make an effort such that it is understandable from outside that the audit quality is improving. In this context, it is very important to consider preparing the Audit Firm Governance Code. It is necessary to focus on the audit quality as the market emphasizes it. Therefore, we have to enhance the efficiency of operations of audit firms to create enough time for quality control. Auditors may need to make investments in IT, education and so forth. Because money-losing audit firms cannot make such investments, the Audit Firm Governance Code achieving a balance between enhancing the audit quality and maintaining audit firms’ profitability will be necessary.
The disclosure situation based on Japan’s Corporate Governance Code varies depending on companies, but with some companies that are not sophisticated in such disclosure but have a sincere motivation to make it, I recognize the situation is moving in the right direction for users. Moreover, for the Audit Firm Governance Code, it should not be a hard-law type code forcing audit firms to be followed but should be a soft-low type code that could make audit firms prepare for it, and practice and improve it by themselves.
Second point is concerned with the inspection system for audit firms by the authority. It may be necessary to reconsider current two overlapped review systems: the quality control review by the JICPA and the inspection by the CPAAOB. I have an impression that the quality control review by the JICPA focuses on check of the detailed procedures and can be described as a checklist type review procedure. Given this, we need to consider if the CPAAOB inspection should focus on audit procedures or on a more comprehensive point of view such as general ideas and personnel training system of audit firms or if they are improving their system of engagement quality control review and so forth.
Third point is concerned with the JICPA. First, I expect the JICPA will promote utilization of IT in audit as an organizer of the audit industry. For example, is it possible for the JICPA to plan to establish an industry-wide study group considering automatization of audit procedures such as vouching, and for the Financial Services Agency to monitor it? Along with that, I expect the JICPA to focus on the education associated with the essence of an audit, including how to make decisions based on the auditing standards, how to detect the indication of fraud, or how to exercise professional skepticism as well as to re-consider how the quality control review system should be.
I think the credibility of audit firms is facing a crisis situation. I think every audit firm and the JICPA have to straighten themselves and establish the system to be able to conduct more adequate audits. I am extremely worried about the current situation.
○Regarding two overlapped review and inspection system, I hear some saying that each objective is different from each other. The quality control review of the JICPA, originally started with the objective for raising the quality control level of each audit firm, has changed its character to supervision. It seems to be sure that major audit firms feel burdened of having both the quality control review of the JICPA and inspection of the CPAAOB every 2 years respectively, but I hear that both help to enhance internal control system. I guess that there are various opinions about this issue.
There was an opinion expressed earlier that currently in Japan, there are too many, about 160 audit firms conducting an audit of listed companies, including individual and joint audit firms. In this respect, it is not an exact figure, but I am informed that in the United States, audit firms conducting an audit of listed companies are around 500 out of about 1,000 firms registered in the PCAOB. I suggest checking these figures.
To date, the JICPA has been improving quality control review as well as providing education with an emphasis on ethics from the perspective of enhancing audit and maintaining credibility in capital markets.
Regarding utilization of IT in audit, the IT committee of the JICPA is now considering not only digital forensic investigation but other several measures such as screening of all data using IT, adding our past audit experience to screening and also connecting to external data. The International Auditing and Assurance Standards Board is conducting the same study and major audit firms have just started the operation as a trial. We will deal with this issue so that Japan can take initiative in this area.
○In response to the case where the companies collude in the fraud, some people claim that counterparty contact is necessary, but I believe the essential part of the discussion should be the following: first, from what viewpoint, the management of audit client is facing financial reporting and how can auditors face the management rigidly and execute their primary missions? Because the fraud which comes to a social issue is at least associated with senior management, it is important to know if internal control works on the fraud.
Frauds will not disappear even if the internal control is perfect. However, from the perspective of preventing them as much as possible, it is important how the structure and the system to supervise top management, particularly kansayaku, an outside director and internal audit department, sincerely fulfills its roles and contributes to faithful business activities.
To ensure that three-way audit (external audit, kansayaku audit and internal audit) achieves its primary purpose, an external auditor, kansayaku and internal audit department need to cooperate closely. Accompanied by amendment of Companies Act, presently on the occasion of electing auditors, kansayaku and audit committee are obtaining and evaluating various information. They may create more specific evaluating standards to deal with issues in near future. While I appreciate these efforts, I believe auditors also should sufficiently verify kansayaku board, audit committee, board of directors and internal audit department, who play an important role in control environment.
With respect to this, some claim an academic idea that traditional financial statements audit is the audit of display, which is different from the audit of actual condition, activity and action. However, because human action, activity and mind always exist behind the disclosure, we have to verify them.
To this end, I would like that the evaluation of credibility for kansayaku board and internal audit department should be included in the evaluation of internal control. In this case, it is important that kansayaku board expresses their opinion by itself as a guardian of internal control and auditors exchange opinions with kansayaku board at the same or superior position to kansayaku board, although it seems difficult to be the case. Usually, exchange of views between auditors and kansayaku board just remain at a formal explanation of audit plan and a preliminary explanation about auditor remuneration, which results in a mere facade. This happens partly because there are few competent accountants. It goes back and forth, but after all it would be important to cultivate experienced accountants who are equipped with competence and knowledge and can gain respect from audit clients.
It is difficult to achieve this goal in current systems, but it is necessary to improve the contents of educational training in addition to approval of credit. For that objective, the JICPA has two main roles: the JICPA as mutual aid association and the JICPA as self-regulated organization to enhance regulatory oversight. And regarding the second role, to check its members’ discipline, we may take the direction that the JICPA deploy professional staffs who have expertise and have no interest relationship with its members.
○For counterparty contact, I am informed that a lot of discussions and consideration were made on the occasion of establishment of the Standards to Address Risks of Fraud in an Audit. In current condition, for example, it may be different from an exact counterparty contact, a procedure to make direct confirmation to business counterparts is implemented during the evaluation on the premises of going concern. However, that procedure is not possible unless management approve. Also, even if management approve, that procedure is not possible when such business counterparts refuse that. Granting to auditors the right of counterparty contact would lead to enhancement of audit, but it is required to solve the problem of the legal system and the problem related to foreign countries.
○First, given the Japanese mentality or mental structure, it would be an issue if it is realistically acceptable that auditors ask questions to third party without advance notice or get information over client’s head. On hearing the word “counterparty contact,” we tend to imagine the situation like tax investigation, in which authorities get information in advance or investigate the clients in between, but this type of investigation is different from the role of audit.
In Japan, when the audit system with external auditors getting involved was introduced, there was a sense of resistance. I understand that Japanese audit system has been developed in the spirit of partnership and collaboration or mutual aid. Some may criticize this spirit eventually brought on cozy relationship, but given the situation like that, I feel it difficult to introduce the system which grants to auditors the right of counterparty contact when any doubts merely arise.
If there are any needs for clarifying the procedure of counterparty contact, it seems necessary to articulate counterparty contact as an item of formal audit procedure, although there may be legal problems. Instead, if we leave the matter to an initiative in audit practice or leave it to specific audit firm, auditors would face a great difficulty in conducting counterparty contact.
I don’t feel the counterparty contact should be always denied on condition that it is possible to articulate counterparty contact in the formal audit procedure, auditors do not feel resistance to counterparty contact since they have already implemented a similar action, and the business circles consent.
○I feel the counterparty contact would be acceptable if it is positioned as one of various inspections. However, before talking about the counterparty contact, auditors must conduct various basic inspections. For example, as for percentage of completion method, if accountants properly get information of the project progress meeting, they could understand to what extent the project is specifically progressing and how an audit client should apply the percentage of completion method.
Looking at the recent incidents of fraud, I feel that auditors significantly lack efforts to find facts behind the figure. It is required to establish the practice confirming the facts which auditors can access. This is not limited to the fact-finding regarding the percentage of completion method. For a part of this practice, counterparty contact could be one option. Speaking of internal control system, we need discuss how to confirm the facts behind the figure.
Without that, auditors are not able to have substantial conversations with management, kansayaku or audit committee members. It is important for auditors to cooperate with management and kansayaku on daily basis, and it is essential to take measures immediately when auditors detect fraud. It is more important to establish audit system which enables auditors to take immediate measures to prevent frauds amid ongoing fraud rather than to merely audit the organized figures.
Specifying such system in the Audit Firm Governance Code and practicing in an actual audit will lead to cultivating competent accountants and creating the environment where each accountant can adequately exercise professional skepticism. The point of discussion is what should be included in the Audit Firm Governance Code.
In current situation, the daily counterparty of auditors is company’s section chief level. On formulating the Audit Firm Governance Code, it should be included that audit firms should disclose how auditors cooperate with management or kansayaku on a daily basis and that the situation of such cooperation should be taken into account in audit firm evaluation.
○I agree to the remark that the situation around audit stands on the edge of crisis. However, such situation is not new since there were similar incidents in the past and, despite some measures such as establishing the Standards to Address Risks of Fraud in an Audit, typical incidents of fraud risk written in the Standards are arising again. Looking at repeated incidents of fraud, I doubt if audit firms share such critical feeling.
It is often discussed that one of the backgrounds of these situations is that the audit firms have no outside viewpoint. Inspection by the third party or other accountants’ viewpoint because of audit firm rotation could give them a tense feeling. I presume that there are few cases that outsiders participate in management of an audit firm; in most cases people who have the same profession as accountant form the management. There are opinions that despite various incidents, audit firms do not change because the content of audit practice is difficult to see from outside and it is rare for audit firms to be exposed to outside criticism.
How can we take these opinions? They may influence the issue of what contents we should include in the Audit Firm Governance Code.
○I believe audit firms are quite unique to Japan. Audit firm is a special legal entity established based on Certified Public Accountants Act; therefore, the nation exists behind it. Thus, they tend to go forward with their own viewpoint: an attitude of dependence on the government if we use ancient expression. There is also another factor that they are not in competitive environment where they may be exposed to sound criticism as they have exclusive authority of audit.
It may be a leap of logic, but as a matter of bigger audit framework, it would be better to allow audit firms to engage in more profitable businesses on condition of creating a firewall while putting accountants who are responsible for audit in more strict discipline. Strict audit would be difficult to achieve unless audit firms are secured by financial basis where they do not care with losing one or two clients.
Although limited liability audit firms disclose their financial information, enough financial basis is not necessarily secured. On the whole, these situations will naturally lead to the discussion of how governance from outside viewpoint works. It seems necessary to put audit firms in more competitive environment.
○Some audit firms invite outside experts to advisory board or oversight committee supervising management because of the critical feeling that they are in a closed world. We have a feeling that we got very useful opinions about performance level of audit firms and ideal figure as a member of society, but it must be very difficult to discuss the matters such as if audit methodology was adequate or if the measures to the problems were sufficient.
In addition to that, if those experts get involved in discussion about audit, it is required for them to keep every standard of independence that all auditors keep, which is actually very difficult.
○It may be one of the reasons why internal control does not work efficiently and that in audit firms, accountants are divided into teams and these teams do not go together. In some cases of fraud, board members are sued by shareholders, whereas auditors are not sued, which may be another factor to lose a tense feeling of audit.
○I recognize that most major audit firms set up an oversight committee and invite outside experts to it. I suppose that it is still difficult from outside to understand what kind of organizations audit firms are or they feel like audit as a black box.
I believe that audit firms and audit should have a certain level of transparency. Because the disclosure of information means having responsibility for that, it is important to have been checked by exposing what they are doing. From the perspective to improve transparency of audit firms, as is the case with the United Kingdom and the Netherland, the Audit Firm Governance Code may be effective as a measure, although audit firms subject to the Code would be limited in terms of their size.
Similarly, for the issue of audit as a black box, only describing in the auditor’s report the points that they focused on during audit could contribute significantly to transparency of audit. It must be very effective from the perspective of transparency of audit because it means they clearly express what they have been doing, although it needs sufficient consideration as it would produce great deal of friction among audit clients.
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