This content is from: Local Insights

Internal control over financial reporting

The system of internal control over financial reporting in Japan under the Financial Instruments and Exchange Act (FIEA) was implemented as of the fiscal year starting on April 1 2008. Under this system, executive officers of listed companies are obligated to evaluate their company's internal control over financial reporting and to file the results of such evaluation in the form of an internal audit report with the Financial Services Agency (FSA). In this report, executive officers should state material weakness if they judge any material weakness exists in the company's internal control over financial reporting. The report should also be audited by outside accounting auditors before being filed with the FSA. Since most Japanese companies have a fiscal year that ends in March, June 2009 will be the first time most companies file such a report.

When the internal control system was introduced, it made reference to the Sarbanes-Oxley Act of the US. Under the Japanese system, clear standards were set regarding the set-up of internal controls over financial reporting in an effort to prevent the creation of excessive documentation and to control costs, two issues which had occurred in the US. However, even with such standards, some uncertainty exists. In particular, uncertainty arises regarding the connection between this system under the FIEA and the rules of the Companies Act.

Connection between the two internal control systems

The aim of the internal control system over financial reporting under the FIEA is to ensure the credibility of disclosure in the capital markets. On the other hand, the internal controls under the Companies Act were introduced for the purpose of improving risk management. Therefore, the purposes of the two systems differ. However, the internal control system under the Companies Act is considered to also require effective controls over financial reporting. Thus, the framework of the internal controls over financial reporting must be set by board resolution and disclosed in the operating report under the Companies Act.

The responsibility of directors

Failure to submit the internal audit report or submission of false statements can lead to liabilities and criminal penalties under the FIEA. However, if there is a material weakness in the company's internal controls over financial reporting and executive officers disclose such material weakness in the internal audit report, no sanctions will be imposed under the FIEA, nor will it directly lead to the director's liabilities under the Companies Act. Rather, disclosure of such material weakness is thought to be desirable, because by disclosing such material weakness, a company can improve the quality of its internal control over financial reporting, which will enable the company to submit more accurate financial reports in the future.

The role of company auditor

With regard to the role of company auditors, a type of executive officer of the company, two issues arise: the so-called interlaced audit issue and the time lag issue.

The interlaced audit issue is as follows: under the internal control system of the Companies Act, company auditors must audit the method and the results of the accounting audit conducted by outside accounting auditors. On the other hand, the internal control system of the FIEA requires the outside accounting auditors to audit the company auditors' monitoring of internal financial controls. Therefore, company auditors that audit outside accounting auditors under the Companies Act are audited by the same outside accounting auditors under the FIEA. This interlaced audit however is expected to make each audit more effective because the company auditor and the outside accounting auditor will each monitor the audit of the other.

The time lag issue is expected to arise due to the timing of the submissions of the various audit reports required under the FIEA and the Companies Act. Company auditors will need to prepare and submit audit reports regarding the execution of duties by directors for the fiscal year as required by the Companies Act. However, it is expected that these audit reports will be submitted before the internal audit report required under the FIEA is submitted and audited by the outside accounting auditors. Thus, if the internal audit report points out a material weakness that was not referred to in the audit reports prepared by the company auditor, the company auditor will be placed in a difficult position and will need to decide whether to amend and make changes to the audit reports as such audit reports should also disclose such weaknesses. However, if the directors, the company auditors, and the accounting auditors are cooperating properly, this issue would not arise.

It is expected that the system of internal control over financial reporting will prompt companies to build better control systems through cooperation between the directors, company auditors and outside accounting auditors.

Masayo Furukawa and Akira Matsuda

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