ISSN 1347-5495

経営研究Business Research

No. 49
Fumio Naito
Professor, Graduate School of Business Administration,
Kobe University“About the Usefulness of the Accounting and
Audit Function as a Method for Corporate
Governance”
April 16, 2003
Graduate School of Business Administration,
Kobe University

About the Usefulness of the Accounting and Audit Function as a Method for Corporate
Governance ＊Fumio NAITO
I. Introduction
This paper aims to first reconfirm the fundamental roles that accounting and audits
play in corporate governance, and then examine the impacts of recent drastic reforms ofaccounting and audit standards on corporate governance. Among these impacts, this paper pays
special attention to the following two issues: provision of information regarding the “going
concern” of companies and a desirable model of auditing, and the vital importance oforganizations’ internal control.
Behind the awareness of these issues is my perception that the very essence of an audit
is now being questioned. How do we fill the gap between “what should be” and “what is”? Is it
not the essence of an audit to judge the rationality of “what is” by comparing it to “what shouldbe”? If so, we must change what should be changed, but should not alter the essence and basics
that should be preserved. What are, then, the essence and basics that should be preserved? This
paper will examine these extremely important points, focusing on corporate governance.
II. Reconfirmation of Macroeconomic Significance of Accounting and Audits
If accounting is a process of recognizing, measuring, and reporting changes in goods
and money within an organization, an audit verifies this process and gives assurances to thereliability of accounting reports.
When these actions are required as a necessary condition of healthy economies andsocieties, or, more concretely, when their objective is to prevent investors, shareholders, andcreditors from making decisions based on erroneous information (protection of stakeholders),
as stated in the Securities and Exchange Law and the Law for Special Exceptions to theCommercial Code Concerning Audit of Stock Corporations, achieving this objective
contributes, at least, to the effective allocation of scarce resources and development of theeconomy and society of one country, and more recently, is expected to display similar effects on
the global economy as well.
Put simply, effective allocation of scarce resources means investing more resources in
profitable business activities while withdrawing resources from unprofitable activities. And
this, in turn, diminishes unprofitable activities and increases the overall wealth of an economy,
because profitability of a company is an indicator of how well the organization has fulfilled thewants of the economy and the society. However, we cannot allocate scarce resources effectively
unless certain necessary conditions are secured, such as sharing of information and fairtransactions.
＊

The FY2002 Grant-in-Aid for Scientific (Scientific Research (C) ) was awarded to our research project
organized by Fumio Naito. This paper is a part of results of the project.
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This line of thinking demands that the roles and functions of an audit should not beargued solely from the perspective of assuring the reliability of accounting reports. We must
always keep its macroeconomic significance in mind.
III. Impacts of Changes in Accounting and Audit Standards on Corporate GovernanceFirst of all, we can point out that accounting reforms increase the importance ofaccounting judgments so that subjective factors exert greater influence on the calculation of
profits. This issue is related to one of the basics—the question of “for whom accounting andaudits exist.”
If we take the stand that corporate governance serves to increase the efficiency oreffectiveness of internal control systems within an organization, then we may conclude that
accounting and audits exist for the organization itself.
On the other hand, if we take the stand that corporate governance keeps organizations
from excessive pursuit of profits and antisocial behavior, which lead to effective allocation of
scarce resources within the economy and the society, then we may conclude that accounting andaudits exist for the viability of an economic society.
The matter is not about choosing either one of these two lines of thinking but is about
how to balance these two aspects.
As the summary in Table 1 shows, corporate management is affected in many ways by
the series of reforms toward a consolidation-based disclosure system. Accounting is no longer a
simple endeavor of calculating profits.
[Table 1] Reforms of a Consolidated Disclosure System and Their Impacts on Corporate
Management ＊Reforms of a Consolidated Disclosure System
1. Emphasis on ・ Expansion of scope of
consolidated
consolidation: introduction of
accounting
effective control standards

2. Strictapplication ofmarket-value

Impacts on Corporate Management
Many subsidiaries are newly included in consolidated
statements. Liquidation or consolidation of
unprofitable subsidiaries becomes a management issue.
Fluidization of group management and organization(de-conglomeration, holding company, M&A).
Unification of information systems within group・ Unification of accounting
practices between parent
company and subsidiaries
・ Market-value accounting ofassets and liabilities of
consolidated subsidiaries
・ Introduction of consolidated
cash flow statements
・ More detailed segment
information
・ Introduction of interim
financial statements
・ Market-v Stricter estimateof uncollectible
alue accounting of accounts

Clarification of excess earning power of subsidiaries

Emphasis on cash flow management. Maximization ofshareholder value
Emphasis on efficiency and profitability of businesscategories such as product lines and regions
From forecasting to reporting of actual results
Inclusion of unrealized profits and losses in the balancesheet
2accounting

3. Introductionof tax effectaccounting

counting ofdebts andcredits

Market-value
accounting of
retirement
allowance
obligations
・ Market-value accounting offinancial products
・ Posting of deferred tax assets
and liabilities

Reviewing the personnel, retirement benefits andpension systems

Inclusion of unrealized profits and losses in the balance
sheet. Termination of cross-shareholding.
Accounting profits and tax amounts match each other.
Allows comparison of accounting profits over different
periods and different companies. But it is a
disadvantage to companies who receive preferential tax
treatments.
Evaluation of accounting judgments, especiallyaccounting estimates is important. In addition tocomplying with accounting principles and standards,
auditors need to emphasize substance over form in their
judgment.

4. More sophisticated, complex audit ofconsolidated statements＊ As of December 2001.

Therefore, some accounting judgments may have a decisive effect on business
management. For this reason, the newly revised audit standards (January 2002), which iscurrently under consideration (published on June 22, 2001), includes two new stipulations: “Inorder to judge the reasonableness of accounting estimates, auditors must obtain sufficient andappropriate audit evidence by evaluating the estimation method used by management,
comparing such estimates with auditors’ own estimates and actual results and other means”(Part III “Standards of Field Work”, Section 3 “Field Work of Audit”, Article 3), and “Whenjudging as to whether financial statements are properly presented in accordance with generally
accepted accounting standards, auditors must evaluate not only whether the accounting policies
adopted by management are consistently applied in accordance with business accounting
standards, but also whether such policies are selected and applied in a way that properly reflects
accounting events and transactions, and whether the method of presentation of financial
statements are appropriate” (Part IV “Standards of Reporting”, Section 1 “Basic Principles”,
Article 2).
Second, we can point out that strengthening internal controls within organizations is
now essential to ensure the effectiveness and efficiency of audits. Internal control is all the more
important as it is directly related to corporate governance. From the perspective of corporate
governance, it is now a social responsibility of corporate managers to ensure internal control.
For this reason, the newly revised audit standards (January 2002) stipulates important
provisions regarding internal control in various places. For example, Section 4 of Part II“General Standards” states that, “Auditors must consider the possibility that financial
statements may contain important, false representations the objective of which is to deceive theusers of such statements or to conceal diversions of assets. Auditors must also keep in mind thatillegal acts may have significant effects on financial statements.” Furthermore, Part III“Standards of Field Work” includes such provisions and phrases as: “[Auditors] must obtain3

information regarding corporate management activities, such as the managers’ management
principles, policies and adopted information technologies and consider their impacts,”“understand the status of internal control,” “review the effect of information technologies on
audits and [adjust] the audit to the use of such technologies,” and “If impropriety or errors arefound in the course of an audit, auditors should report them to the management and request
appropriate actions.”
As stated above, accounting and audits are not unrelated to corporate governance. We
must recognize that accounting and audits support the foundation of corporate governance.
The third issue is the problem of a going concern. For corporate managers, this issuepresents a dilemma between disclosure of risks and keeping trade secrets. It is also related to
how to deal with risks in the future. It is therefore one of the greatest challenges of corporate
governance and requires a solution.
The newly revised audit standards (January 2002) requires auditors to review andreport the following items:①[Auditors] must examine whether it is appropriate for managers to prepare financial
statements based on the assumption that the company will continue its business activities(hereinafter referred to as the “assumption of a going concern”). (Part III “Standards of Field
Work”, Section 1 “Basic Principles,” Article 5)②
In preparing the audit plan, [auditors] must confirm the existence or non-existence of
events or circumstances that pose significant doubts to the assumption of a going concern,such as a trend of deteriorating financial indicators and the possibility of financial collapse.
(Part III, Section 2 “Preparation of Audit Plan,” Article 5)③
If it is determined that events or circumstances that pose significant doubts to theassumption of a going concern exist, [auditors] must review the reasonableness of managers’
actions, such as an evaluation of such doubts over a reasonable period of time and measuresand management plans to resolve such doubts. (Part III, Section 3 “Field Work of Audit,”
Article 5)④
If there are events or circumstances the future results of which are unpredictable, andthe effects of such events or circumstances are multiple and wide-ranging, [auditors] must
carefully determine whether they can state opinions as in the case where they could not
implement important audit procedures. (Part IV “Standards of Reporting,” Section 5“Constraints on Scope of Audit,” Article 4)⑤
If events or circumstances that pose significant doubts to the assumption of a going
concern exist, and important uncertainties remain regarding significant improvements insuch events or circumstances, and it is determined that such events or circumstances and the
managers’ management plans are properly represented in financial statements, [auditors
shall] state an “unqualified opinion of propriety”. (Part IV, Section 6 “Assumption of Going
Concern,” Article 1)
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⑥

If events or circumstances that pose significant doubts to the assumption of a going
concern exist, and managers do not furnish reasonable management plans to resolve suchdoubts, [auditors must] determine whether it is appropriate to state opinions as in the casewhere they could not implement important audit procedures. (Part IV, Section 6, Article 2)⑦
If it is not appropriate to prepare financial statements on the assumption of a going
concern, [auditors must] state the opinion, and reasons thereof, that financial statements
based on the said assumption are inappropriate. (Part IV, Section 6, Article 3)⑧
If auditors determine that it is appropriate to explain or emphasize the following items
and include such information in the audit report, they must clearly distinguish suchinformation from their opinion. (Part IV, Section 7 “Additional Information”)(2) Items related to the events or circumstances that pose significant doubts to theassumption of a going concern(3) Important contingent events(4) Important subsequent events
There are numerous and complex issues that need to be resolved regarding accounting
and audits when there are problems with the going concern, such as what should be disclosed by
the organization regarding such problems, how to audit the propriety of such disclosures, andaccounting judgment on future risks and uncertainties.
However, the problems of a going concern are not rare. Rather they are closely related
to all organizations to varying degrees. Therefore, we should deal with them not from theperspective of disclosure and audits for the sake of going concern problems but from that ofdisclosure and audits of organizations’ future risks and uncertainties. In this sense, we cannot
deny the possibility that if we create a framework that allows information disclosure and anaudit regarding future risks and uncertainties, such a framework will contribute to corporate
governance.
Fourth, we can point out that a new line of thinking is emerging that advocatestransition to a disclosure system, which ensures the usefulness of information, based on thenotion that the function of accounting disclosure is to communicate past business performanceaccurately.
In short, information regarding an organization’s risks and uncertainties forms thebasis of information disclosure regarding corporate governance. If we place importance on theusefulness of information, simple information on business performance is no longer sufficient,and organizations are required to disclose accounting information that includes corporate risks.
But in this case, another line of thinking is possible. It would claim that accounting
disclosure just communicates accurate information, and whether it is useful or not should bedetermined by the users of the information. This issue is related to the meaning of auditors’
opinions regarding the propriety or fair presentation of financial statements. In this sense, thisissue may evolve further and eventually affect the fundamental debate on the essence of an5

audit.
The newly revised audit standards (January 2002) clearly states that the objective ofauditing financial statements is “for auditors to express their opinion, based on audit evidence
obtained by themselves, regarding whether the financial statements prepared by the managers
fairly represent, in all important matters, the company’s financial position, results of operations,and its cash flows in conformity with generally accepted accounting standards. Auditors’
opinions that financial statements are appropriate include their judgment that they obtained
reasonable assurances that the financial statements as a whole do not contain material
misrepresentations.” (Part I “Objective of Audit”) We need to reconfirm the meaning of “fairrepresentation.”
IV. These Changes and Corporate GovernanceRegarding the four impacts discussed above, we can point out two measures thatshould be taken, at the very least, to ensure organizations’ corporate governance. The first isestablishing and enforcing internal control within organizations, and the second isstrengthening the management and disclosure of organizations’ risks and uncertainties.
1. Establishing and enforcing internal control within organizations
It is reported that the International Forum on Accountancy Development (IFAD) is
advocating the following: the development of International Accounting Standards (IAS) into a
global standard; that the international audit standards made by the International Federation of
Accountants be the official listing standards of all stock exchanges in the world; and global
unification of corporate governance. (An article entitled “Struggles over international
accounting (2): Trend for unified standards reaches audits” on Nihon Keizai Shimbun, July 18,
2000)
The third policy is based on a report prepared by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The report lists the following fiveelements as components of internal control: Controlling Environment, which forms the basis ofother elements and includes the honesty and ethical values of constituent members, philosophy
and behavior of managers, allocation of authorities and responsibilities, and recommendations
and orders of the board of directors; Risk Evaluation, which is a mechanism to recognize anddeal with risks related to changes in the economy, industry, and regulations; Controlling
Activities, which are measures to deal with risks and includes approval, granting of authority,
verification, adjustments, performance evaluation, asset preservation, and separation of duties;
Information and Communication, which deal with the effective communication both inside andoutside the organization; and Monitoring Activities, which continually evaluate the functional
quality of internal control systems. The key to improve the effectiveness of corporate
governance is how to construct these elements within organizations.
62. Strengthening the management and information disclosure of organizations’ risks anduncertainties
Pillars that strengthen the management and information disclosure of organizations’risks and uncertainties are the “construction of risk management systems,” “construction of amechanism to monitor such systems,” “disclosure of risks and uncertainties,” and “proactive
use of audits.”
The Statement of Position (SOP) 94-6 of the American Institute of Certified Public
Accountants and the German Commercial Code list the contents of disclosures related to risks
and uncertainties, which are summarized as follows (Table 2).
[Table 2] Contents of disclosures related to risks and uncertainties
AICPA SOP 94-6*1(a) Risks and uncertainties regarding the nature ofbusiness activities (SOP pars. 8/10)◆ Explanation of main products and services, andexplanation of their main markets.
◆ If the company conducts more than one business,
disclose each business’s relative importance in theindustry and its deciding index (amount of assets, sales,
profits etc.).
◆ This information shows the industries to which the main
business activities belong, as well as the significant
influence from such industries and risks anduncertainties based on the business’s degree ofconcentration.

(b) Risks and uncertainties regarding the applicationof estimates used in preparation of financial
statements (SOP pars. 8/11)◆ State that preparation of financial statements involved
managers’ estimates.
◆ This information means that there are inherent
uncertainties in the preparation of financial statements,
especially in the accounting measurement of assets,
debts, revenues, and costs.

(c) Risks and uncertainties regarding specific andsignificant estimates (SOP pars. 8/12-19)◆ Disclosure of estimates used in determining thecarrying value of assets and liabilities and in disclosing

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German Commercial Code(a) Possibility of insolvency (HGB §266 Abs. 3, §268
Abs. 4-7, §285 Abs. 1-3)
◆ State the amount of losses that cannot be covered byequity capital in the asset section of the balance
sheet (§266 Abs. 3).
◆ If there are significant amounts of assets or debts,
which legally come in only after the balance sheet
date, state such amounts in the attached explanation
sheet (§268 Abs. 4-7).
◆ Regarding the responsibilities of debts, gives
assurances to, or furnishing of collateral based on
drawing or assignment of bills, state the right ofpledge and other collateral in the margin of thebalance sheet or the attached explanation sheet(§268 Abs. 4-7).
◆ Regarding the total amounts of debts and right ofpledge with payment terms that are longer than five
years, or type of collateral, forms, total amounts,
their breakdowns, and other financial obligations,the statement of which is important in assessing thefinancial position of the company, state their total
amounts in the attached explanation.
(b) Risks regarding future development (HGB §289
Abs. 1-2)◆ Risks regarding the structure of capital and assets*2.
◆ In general, risks regarding the structure of capitaland assets mean the “possibility of insolvency”*3(Vgl. Rückle 1986, S. 176-177).
◆ As explained in (a) above, notations regarding the“possibility of insolvency” are made in the
explanation sheet of annual financial statements.
However, unrelated to these notations, informationmust be provided in the status report regarding how
the existing or future trend of factors that determine
important revenues and expenditures can eliminate
the risk of insolvency.
(c) Predictive development of company (HGB §289
Abs. 1-2; HGB §266 Abs. 3, §268 Abs. 4)◆ Problems related to the continuation of thecompany.

undetermined gain or loss items.
◆ Condition i: There is at least a reasonable possibility
that the estimated effects from circumstances and thestatus which exists on the date of financial statements
over the financial statements of the current period will
be changed by events that become definite within one
year of the said date.
◆ Condition ii: The effects of such changes are importantto the said financial statements.
[Concrete examples]□ Inventory items that are subject to rapid technologicalobsolescence.
□ Special equipment that is subject to technologicalobsolescence.
□ Valuation reserves for deferred tax assets based on
future taxable income.
□ Cost of computer software that is accounted as assets.
□ Valuation reserves for commercial loans and real estate
lending.
□ Debts related to environmental improvement.
□ Debts related to lawsuits.
□ Liabilities for conditional gives assurances to.
□ Amount of long-term debts such as pension liabilities.
□ Significant decrease in the market value of assets.
□ Significant changes in the degree and means of assetuse.
□ Significant deterioration in legal elements or
management trends that influence the value of assets.
□ Significant accumulation of cost overruns in excess of
initial estimates for acquiring assets or manufacturing.
□ History of losses related to assets or forecasts that prove
continual losses related to assets.
(d) Risks and uncertainties regarding current
vulnerabilities which originate from specificconcentrations (SOP pars. 8/20-24)◆ These vulnerabilities arise from the greater risks thecompany faces due to concentration.
◆ Condition i: Concentration exists on the date offinancial statements.
◆ Condition ii: That concentration poses a risk that thecompany may be “subjected to a significant impact”
within one year of the said date.
◆ Condition iii: There is at least a reasonable level ofpossibility that events that could bring this “significant
impact” may occur within one year.
[Concrete examples]□ Concentration in terms of transaction size with specificcustomers, suppliers, and financial sources.
□ Concentration in terms of revenue from specificproducts, services, or financial sources.
□ Concentration in terms of procurement or acquisition of
raw materials, labor, services, licenses, and other rights
used by the organization in its business activities.
□ Concentration in terms of markets or geographic
territories in which the organization conducts its
business activities.

◆ Estimate of future-related existing abilities(Existenzfähigkeit) of the company.
◆ 12 months from the balance sheet date of a normal
business year should be considered as a relevant
period.
◆ In principle, description of predictive development
trends should also be required in areas that are
subject to the reporting of business progression andstatus.
◆ Forecasts must be made as a mandatory
measurement by the managers, and expected data
must have an explicable relationship with the datathat should be found in the annual financial
statements.
◆ As the minimum information regarding predictive
development trends, such forecasts should be madefor two years from the balance sheet date*4.

*1
AICPA Accounting Standards Executive Committee, Statement of Position 94-6, “Disclosure of Certain Significant
Risks and Uncertainties,” Journal of Accountancy (March 1995), pp. 104-107. These risks and uncertainties are disclosed as
notations in annual or interim financial statements.

8*2 Vgl. Moxter, Adolf, “Die Vorschriften zur Rechnungslegung und Abschlußprüfung im Referentenentwurf eines Gesetzes
zur Kontrolle und Transparenz im Unternehmensbereich,” Betriebs-Berater, Heft 14 (3 April 1997), S. 723.
*3 Vgl. Rückle, Dieter, “Finanzlage,” in: Leffson, Ulrich/Rückle, Dieter und Bernhard Großfeld heraus. Handwörterbuch
unbestimmter Rechtsbegriffe im Bilanzrecht des HGB (Köln 1986), S. 176-177.
*4 Vgl. Dörner, Dietrich und Iren Schwegler, “Anstehende Änderungen der externen Rechnungslegung sowie deren Prüfung
durch den Wirtschaftsprüfer,” Der Betrieb, 50. Jg. Heft 6 (7 February 1997), S. 286.

As shown in Table 2, the contents of disclosure regarding risks and uncertainties are
wide-ranging. As a necessary condition to disclose such information, companies must at least
have a system in place that collects and manages basic data regarding these risks anduncertainties. If they do not, they are unlikely to be able to disclose such information unlesssuch systems are utilized properly. Furthermore, we need to establish a system of auditing thereliability of disclosed information regarding risks and uncertainties.
If these prerequisites are met and disclosure of risks and uncertainties is implemented
effectively, they will form a foundation on which organizations’ corporate governance willmaterialize in a more practical manner.
V. Conclusions
Arguments of this paper can be summarized as follows.
◆
Although the basic objectives of accounting and audits are to properly calculate andreport profits and to secure the reliability of such reports, we must not ignore theirmacroeconomic significance related to the effective allocation of scarce resources within theeconomy and society. Indeed, it is quite important to examine ideal models of accounting andaudits from this perspective.
◆
Globalization of accounting and audit standards brings changes to the model ofcorporate governance, and they are not unrelated.
◆
Through the audit of going concern problems and establishment and monitoring ofinternal control, companies will be urged to further ensure the transparency of management.
It is also likely that the notion of transparency itself will change as emphasis shifts fromaccurate information of past performance to forward-looking information regarding risks anduncertainties. In ensuring this new kind of transparency, we must preserve the essence of anaudit, which is to pursue “what should be.”◆
It is now recognized that it is important for corporate managers to assume a social
responsibility not only to deal with, but also disclose, risks and uncertainties associated with
their business activities. Indeed, fulfillment of this responsibility will eventually lead to more
effective corporate governance. Accounting and audits must fulfill their function as the basis
for this improvement.
These issues present a challenge and a need to advance the research of audits from theperspective of ensuring corporate governance.
(Author: Professor of Accounting, Kobe University, Graduate School of Business Administration)

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