Accounting Research in the Japanese Setting*D J. S†Booth School of Business
UNIVERSITY OF CHICAGO

ABSTRACTIn this commentary I offer some thoughts on the possibilities for accounting research thatuses the Japanese setting. I argue that the uniqueness of the Japanese setting offers many
opportunities for researchers, and hope that we can encourage more researchers to takeadvantage of this setting to advance the literature on financial reporting and disclosure.

I am honored that Professor Yamaji has asked me to write a commentary for the first issue ofe Japanese Accounting Review (TJAR). e goal of my commentary is to highlight the importanceof doing accounting research that uses the Japanese setting, focusing on my main area of expertise,
which is the capital markets area, and more specifi cally on the way that corporate managers
communicate with capital markets through financial reporting and disclosure as well as throughcorporate payout policy. is includes earnings management and disclosure, areas of prominence inthe mainstream North American literature over the last 20 years.
To this point I have worked on four projects that focus on Japanese capital markets. e topics
include earnings management, management forecasts (disclosure), auditing, and corporate payout
policy.1 I am sometimes asked why I am doing research on Japanese companies, something that is
unusual in the mainstream North American accounting journals. e answer is quite simple: theJapanese setting allows me to identify unique or unusual institutional features that I can use toanswer questions that cannot be answered using data from the U.S. or similar institutional settings.
e goal of this research is not to focus on Japan for the sake of doing so. Instead, the point is to findopen questions in the literature that we can answer by exploiting unusual features of the Japaneseenvironment, and so provide insights not available elsewhere. e beauty of Japan is that it is truly
unique, so there are lots of opportunities for doing this type of work. Let me provide a couple of* is commentary was solicited by Professor Hidetoshi Yamaji, Editor-in-Chief of e Japanese Accounting Review, who hasgiven me useful comments on an earlier draft. I am grateful for the opportunity to write this commentary, which I would like todedicate to the memory of our colleague, Professor Kazuyuki Suda of Waseda University, who passed away earlier this year. I am
grateful to the University of Chicago, Booth School of Business, for financial support.
† Corresponding Author. Address University of Chicago 5807 South Woodlawn Avenue Chicago, IL 60637-1610, USA.
Telephone + 773 702-7137 E-mail dskinner@chicagobooth.edu
1Skinner (2008), Kato et al. (2009), Skinner and Srinivasan (2010), and Kato et al. (2011).
Copyright©2011 Research Institute for Economics & Business Administration - Kobe University.

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examples from my own research.2
In 1998, I published a paper on deferred tax accounting that used U.S. data to investigate
whether the valuation allowance for deferred tax assets was used by managers for earnings
management purposes (Miller and Skinner, 1998). We found little evidence that this was the case.
However, for reasons that are not uncommon in the earnings management literature, that setting
was not very powerful, in part because we could not develop clear predictions about the direction inwhich managers might be managing earnings. A few years later I found myself teaching an MBAclass on financial accounting to a group of Japanese and Korean managers. To make the class more
useful to the students, I asked them to bring in copies of their companies’ annual reports. Oneof these reports was from a large Japanese bank, and I soon noticed the bank’s large deferred tax
assets. is discovery led me on a long journey that led to Skinner (2008), which examines the roleof deferred tax accounting in the Japanese financial crisis of the 1990s. is was a setting where
accounting had large economic consequences, not only for Japanese banks but also for the Japanesefinancial sector as a whole—without being able to include a substantial amount of deferred tax assets
in their regulatory capital, many of the largest Japanese banks would have collapsed, potentiallywreaking havoc on the economy. Strikingly, this issue arose again in the recent financial crisis in the
U.S., with Citigroup including $14 billion of deferred tax assets in its Tier I regulatory capital at
September 30, 2009. ere is currently some controversy about how Basel III should treat deferred
tax assets, with a recent Harvard case focusing on this issue in the context of the Japanese experience(Hawkins et al., 2011).
While the Japanese setting offers many opportunities, there are challenges as well. In particular,
for someone such as myself who is not Japanese and has not lived in Japan, it is costly to be surethat one fully understands the Japanese institutional setting. To do this requires a large investment
in time, both in reading the relevant academic and institutional literature on Japan, as well as
consulting with as many Japanese academics and practitioners as possible. For the deferred tax paper
I was able to rely on the generous support of a group of Japanese MBA students at the Universityof Michigan (where I then was) as well as a network of contacts in Japanese academia and business,notable among them being the late Professor Kazuyuki Suda of Waseda University. Another way ofaddressing this issue is to involve Japanese co-authors, who have a natural advantage in this regard.
I took this approach in my next Japanese project, which is co-authored with Professor Kazuo
Kato of the Osaka University of Economics and Professor Michio Kunimura of Meijo University(Kato et al., 2009). Since early papers by Patell (1976) and Penman (1980), a large literature inaccounting has developed that looks at management earnings forecasts. In most countries suchforecasts are voluntarily issued, which means that any consideration of the capital market effects ofthese forecasts must take into account managers’ incentives to release the forecasts (Verrecchia, 1983).
In Japan, however, these forecasts are effectively mandated, which changes the nature of the setting
considerably, and allows us to examine how the mandatory nature of the disclosure affects both thenature of the forecasts that management provides and their information content.3
My third and final example is ongoing work with Suraj Srinivasan, of Harvard Business
School. Suraj and I study events surrounding the demise of ChuoAoyama, formerly the Japaneseaffiliate of Pricewaterhouse Coopers, and one of the “Big Four” audit firms in Japan. We analyze
how ChuoAoyama’s clients responded to events associated with the revelation of an audit failure23

e goal of this commentary is not to provide a review of the literature, so I apologize in advance for not citing the full set ofpapers that utilize the Japanese setting to address open questions in accounting.
An early paper by Darrough and Harris (1991) had taken a similar approach, but the available data and environment changed
considerably over the two decades between these studies.

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at Kanebo, a large Japanese cosmetics firm that revealed a massive accounting fraud in 2004.
An important but unresolved issue in the auditing literature is to identify the forces that drive
auditors’ incentives to deliver high quality audits (those likely to reveal accounting problems andimproprieties). e literature focuses on two main types of incentives—a litigation/insurance
incentive and a reputation incentive. Under the litigation/insurance argument, the fact that auditors
can be sued for large monetary damages in the event of audit failures provides them with incentives
to deliver quality. Under the reputation argument, auditors’ fees depend on their reputation for
quality, with a likely fee premium available for high quality audits. Empirically, differentiating
between these arguments is difficult because in most countries litigation and reputation effects
are both likely to be important. Because of Japan’s very different legal environment, however, thelitigation role can effectively be ruled out, allowing us to examine the reputation argument more
directly.4
Given the advantages of doing research in Japan, it is puzzling to me that there is not more
research that uses this setting. One obvious issue is that the uniqueness of the Japanese setting isboth a blessing and a curse. e blessings I have already described. e curse is that it is sometimes
difficult to convince reviewers and editors that results from Japan have implications for other settings;
that is, the external validity of this research is subject to question. Moreover, fundamental differences
between the nature of western economies and that of Japan make it hard to draw strong policy
implications about observed differences in financial reporting and disclosure practices—it is hard toconclude, for example, that Japan will necessarily be better off by instituting western-style accounting
and corporate governance practices if other aspects of the economy remain uniquely Japanese. atis, there are likely to good reasons why the Japanese financial reporting system has evolved differently
from those in western countries (e.g., see Yamaji, 1999).
is does not mean, however, that research in this type of different setting cannot provide
useful empirical evidence about the effects of different institutional features of the economy. First,
in accounting, there is an increasing amount of research from non-U.S. settings that speaks to open
research questions in the literature. For example, research using unusual features of the Chinese
setting has flourished over the last ten years. To take just one example, Tang (2011) provides evidence
on the effects of disclosure by looking at price differences between A and B shares of Chinese firms.
A and B shares have equal cash flow and voting rights, but trading in these shares is restricted todifferent sets of investors who face different information environments, which provides a useful
setting in which to consider the effects of disclosure on securities pricing. If researchers are careful toprovide details about the nature of the institutional setting, there is no reason that research such as
this cannot provide useful insights into open questions in the literature.
Second, for some time researchers in corporate finance have exploited the unusual nature of
the Japanese setting to provide new insights into important theoretical issues in that literature.
Examples include Hoshi et al. (1990), Kaplan and Minton (1994), Dewenter and Warther (1998),
and Pinkowitz and Williamson (2001). With some exceptions (e.g., Gramlich et al. 2004), there has
not been a great deal of accounting research that uses the Japanese setting in this way. I think thisprovides an opportunity for researchers in accounting.
A word of warning is probably useful here. It is not sufficient merely to replicate studies donein other countries such as the U.S. or U.K. using Japanese data. Although this might be somewhat
informative (e.g., in telling us whether results are robust to different settings), it will not be of great4

Weber et al. (2008) take a similar approach in the German setting, where auditors’ legal liability is limited to relatively smallmonetary amounts. Other authors who examine the events surrounding the suspension and collapse of ChuoAoyama include
Numata and Takeda (2010) and Murase et al. (2011).

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interest to researchers outside of Japan. Instead, knowledge of the different institutional features
available in Japan can be utilized to craft research questions that allow us to address open questionsin the literature in ways not possible with data from other countries. By providing new insights into
questions of interest to researchers around the world, research in Japan can potentially yield big
payoffs.
For researchers not familiar with the Japanese setting, it is probably useful to provide some sense
for how Japan’s capital markets are different. One important feature of this setting that has received
a lot of attention is the unusual nature of corporate groups in Japan, as characterized by the existenceof relatively large corporate cross-holdings, the central role of banks in many of these groups,
with related implications for financing, and the existence of both horizontal and vertical keiretsu
structures.5 As discussed more fully elsewhere (e.g., Hoshi and Kashyap, 2001), these features allow
Japanese companies to resolve the adverse selection and moral hazard problems (“agency problems”)
that we worry so much about in western economies in very different ways, which has implications
for financial reporting and auditing. For example, by having a main bank at the center of corporategroups, private information is shared between companies and the banks that finance them, mitigating
information asymmetries.
While the very different Japanese system worked well in the 1960s, 1970s, and 1980s, large
questions arose in the mid to late 1990s, after the bubble in Japanese stock and real estate prices
burst, leading to the “lost decade” (Fukao, 2003; Hoshi and Kashyap, 2001). As a result of theseconcerns, the Japanese Government instituted financial reforms on a large scale; these reforms werecollectively referred to at the “Big Bang.” ese reforms occurred throughout the Japanese financial
system, but include reforms of corporate governance, financial reporting, and auditing. Many of thesereforms involved the adoption of what was essentially a western governance model. For example,
in 2001 regulators set up the Accounting Standards Board of Japan (ASBJ), which in many ways ismodeled after the U.S. Financial Accounting Standards Board (FASB). Many of the rules adopted
by the ASBJ are based on those from the U.S. or U.K. Auditing reforms are also moving auditing
practice in Japan towards what are seen to be superior western models.
ese changes offer many opportunities for researchers in accounting. Rarely do we have asetting where there are important changes in accounting rules, the institutional environment, auditing
practice, and so on. While much research addresses the effects of the introduction of IFRS in various
countries around the world (e.g., Daske et al., 2008), the associated changes are in many cases
actually quite modest. For example, in countries such as Canada, the U.K., and Australia, it is hard
to imagine that IFRS changed the accounting infrastructure very much given the similarity of IFRS
to the GAAP rules that previously existed in those countries, as well as the relatively high quality
financial reporting infrastructure (e.g., auditing and securities law enforcement). In contrast, I would
argue that Japan’s accounting rules have changed quite radically over the past 15 years; for example,
Japanese companies were not required to prepare and issue consolidated financial statements until
about ten years ago.
A number of researchers have emphasized the importance of the institutional setting inunderstanding the effect of changes in accounting. As Ball et al. (2003) discuss, it is likely to bedifficult to understand the effect of changes in accounting rules around the world without also
considering the nature of the associated enforcement regimes—changes in accounting rules are not
likely to be effective unless they are properly monitored and enforced. In Japan, there have beensignificant changes not only in the accounting rules, but also in many of the underlying institutions.
5

Two useful references here are Hoshi and Kashyap (2001) and Aoki et al. (1994) but much has been written on this topic.

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By carefully examining the nature of these changes, as well as exploiting differences in their timing
and cross-sectional variation in their impact, we are likely to be able to learn more about causal
relationships between the nature of accounting and disclosure on the one hand and capital markets
on the other. It is much more difficult to do this in economies (such as those of the U.S., U.K,
Canada, etc.) where there is relatively little time-series or cross-sectional variation.
In closing, the Japanese setting offers accounting researchers—both those within Japan andthose from other countries—many opportunities to address important open research questions infinancial reporting and disclosure. I am optimistic that TJAR will help to open the door for more ofthis research in the future, and so play an important role in advancing knowledge in our field.

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