The Complex Equilibrium Paths towards International
Financial Reporting Standards (IFRS) andthe Anglo-American Model: The Case of Japan*
Noriyuki Tsunogaya†

Department of International Economy and Business
Kyushu University

Parmod Chand

Department of Accounting and Corporate Governance
Macquarie University

ABSTRACT
We adopt the accounting ecology framework of Gernon and Wallace (1995) to investigate
the unique Japanese process of accounting reforms and convergence. The uniqueness of theJapanese accounting framework is primarily the result of the integration of the Japanesetraditional accounting system and its surrounding infrastructures with International
Financial Reporting Standards (IFRS), the Anglo-American model, and the liberal market
economies (LMEs). The objective of this study is to demonstrate that accounting as thelanguage of business is deeply embedded in the historical, legal, business and economic
environments of each country and that these contextual factors cannot be ignored in theprocess of significant accounting reforms, including accounting convergence. The paper
provides evidence that even in the process of global accounting convergence countries are
not achieving de facto convergence because optimal mechanisms of the accounting system
and its surrounding infrastructures are contextual and embedded in the accounting ecologyof each country.
JEL Classification: M40; M41; M48
Key Words: Global Convergence of Financial Reporting; International Financial ReportingStandards (IFRS); Japanese Accounting System* We would like to appreciate the helpful comments and suggestions of the editor and anonymous reviewers. Any remaining faults
are the authors’ own. This research is supported by the Zengin Foundation for Studies on Economics and Finance.
† Corresponding Author. Address Kyushu University 6-19-1 Hakozaki, Higashi-ku, Fukuoka, 812-8581, JAPAN.
Telephone +81(92)642-2473 E-mail tsuno@en.kyushu-u.ac.jp
Received July 20, 2012; accepted October 9, 2012
Copyright©2012 Research Institute for Economics & Business Administration – Kobe University.

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1. Introduction
The International Accounting Standards Board (IASB) and other national standard setting
bodies seek to achieve a high quality financial reporting system and more than one hundred twenty
countries appear to have adopted International Financial Reporting Standards (IFRS) to improvetheir accounting practices. The arguments in favor of global convergence of financial reporting
include achieving similarity in both accounting standards (de jure) and accounting practices (defacto). However, developing financial reporting standards seems easier than addressing controversial
issues in each country adopting IFRS such as differences in the regulatory environment, businesspractices, language, culture and the judgment of accountants (Doupnik and Richter 2003, 2004;
Ball 2006; Doupnik and Riccio 2006; Patel 2006). We argue that a research topic concerning the
global convergence of financial reporting must take into consideration local contexts such as theaccounting ecology of each country, particularly when examining de facto convergence.
In adopting IFRS the consideration of local context is more important in non- AngloAmerican countries. This is because IFRS have been developed in accordance with Anglo-American
values, practices, and principles (Hellmann et al. 2010). The Anglo-American model, which has
been adopted in countries such as the U.K. and the U.S., has developed over a long period of timein an environment characterized by investor orientation, common law, separation of accounting andtax schemes (i.e. double-reporting regime), and extensive application of professional judgments.
In contrast, the Continental-European model, which has been adopted in countries such as
France, Germany, and Japan, is characterized by creditor orientation, code law, interdependence ofaccounting and tax schemes (i.e. single-reporting regime), and weak accounting profession (Nobes
1992; Doupnik and Perera 2012; Nobes and Parker 2012).
Furthermore, economies can be of two types, namely the “Liberal Market Economies (LMEs)”
such as those that are evident mainly in Anglo-American countries, and the “CoordinatedMarket Economies (CMEs)” that exist mainly in Continental-European countries. In the LMEs,
competition through challenges in the marketplace is encouraged. In contrast, long-term cooperative
relationships between firms and banks, between different firms, and between firms and the labor
force are fostered in the CMEs (Franks and Mayer 1997; Kaplan 1997; Schmidt and Spindler 2002,
2006; Leuz and Wüstemann 2003; Schmidt and Tyrell 2004; Hackethal et al. 2005).
Countries converging towards IFRS can adopt either of the two convergence approaches.
One is the “direct adoption approach” in which IFRS are adopted as domestic standards while
the other is the “cautious convergence approach” in which domestic standards are applied and thedisparities between IFRS and domestic standards are consistently reduced over a period of time. It
is important to note that Japan has adopted the cautious convergence approach. Indeed, Japan iscurrently undergoing a controversial and complex process to reduce disparities in financial reportingand other infrastructures to align the entire system with IFRS, the Anglo-American model, and theLMEs.
A number of prior studies have examined various issues concerning financial reporting systems
in Japan (Arai and Shiratori 1991; Cooke 1991; Nobes 1991; McKinnon 1994; Hamamoto
1995; Hiramatsu 1998; Chiba 2001; Kikuya 2001; Benston et al. 2006; Koga and Rimmel 2007;
Kaneko and Tarca 2008). While previous research provided valuable insights, the topics relating
to the Japanese contextual factors such as historical, legal, business, economic, and accounting
environments, and the relevant infrastructures such as financial, governance, and employment
systems have been largely ignored. We adopt the accounting ecology framework of Gernon andTsunogaya and Chand: The Complex Equilibrium Paths towards International Financial
Reporting Standards (IFRS) and the Anglo-American Model

119

Wallace (1995) to investigate the unique Japanese process of reforms and convergence. 1 The
uniqueness of the Japanese accounting framework is primarily the result of the integration of theJapanese traditional accounting system and its surrounding infrastructures with IFRS, the AngloAmerican model, and the LMEs. The objective is to demonstrate that accounting as the languageof business is deeply embedded in the historical, legal, business and economic environments of eachcountry and that these contextual factors cannot be ignored in the process of significant accounting
reforms, including accounting convergence.
We provide evidence that the unique Japanese process of accounting convergence originatesin various factors. Unlike other countries that have just adopted IFRS, Japan has prepared acomplete set of accounting standards, auditing standards, and conceptual frameworks to competewith IFRS and International Standards on Auditing (ISA). These standards have been preparedby the Japanese standards-setting bodies, namely the Business Accounting (Deliberation) Council(BAC) and the Accounting Standards Board of Japan (ASBJ). The Japanese CME also has wellorganized infrastructures, which include one of the largest capital markets in the world, namely the
Tokyo stock exchange, stable financial systems, modernized governance structures, and systemicallycombined laws and ordinances. Therefore, Japan has recognized that it would be futile to adopt
IFRS without reforming these and related facilities and resources.
The remainder of this paper is organized as follows. Section two briefly outlines the accounting
ecology f ramework developed by Gernon and Wallace (1995). Using some aspects of thisframework, section three outlines the historical, legal, and business environment of Japan. Section
four describes the Japanese-specific process towards accounting convergence and section five
analyzes the immediate pressures and conflicts between the cautious Japanese convergence approachand intrusive events such as the strategies of the European Union (EU) and the U.S. Securities andExchange Commission (SEC). Section six investigates recent significant reforms in Japan such as
disclosure, financial, governance, and employment systems. The last section concludes this paper bysummarizing the unique Japanese process of accounting convergence.

2. The Accounting Ecology Framework
The accounting ecology framework developed by Gernon and Wallace (1995) describes five“slices” within the framework: social, organizational, professional, individual, and accounting, toprovide a holistic analysis of the accounting environment in each country. Gernon and Wallace(1995) focused on the synthesis and interrelationships of these factors because they influence and are
influenced by the accounting environment in each country.
The five slices of the accounting ecology framework can be defined as follows. First, the social
slice refers to structural, demographic, and cultural elements that may affect the demand for financial
accounting services. Second, the organizational slice encompasses such elements as organizationalsize, technology, complexity, culture, and human and capital resources that may affect rationalizationof the choice and design of accounting systems. Third, the professional slice refers to the education,
training, registration, discipline, and ethics of accountants and auditors. Fourth, the individual
slice refers to accounting policy choices made by individuals and covers the total setting in which
1

Gernon and Wallace (1995) used the term ‘accounting ecology’ to describe the specific environment in which accounting operates
in each country.

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reporting enterprises, professionals, and other individuals lobby standard setters to pursue their selfinterests. Finally, the accounting slice refers to accounting practices, rules and/or trends that affect orare affected by the other slices of the environment (Gernon and Wallace 1995, p.60).
Prior studies have also used the accounting ecology framework to analyze the accounting
practices of various countries. For example, Heidhues and Patel (2011) applied this accounting ecology
framework and suggested that international accounting research may be further enhanced by taking into
account contextual factors such as political, legal, social, and historical factors. In particular, they applied
this framework to provide additional insights into the factors that differentiate the German accounting
model from other accounting models, such as the conservative nature of accounting practices and theimportance of merchants’ privacy in Germany. This framework is also applied by Perera and Baydoun(2007), Baker et al. (2010), and Hellmann et al. (2010) to clarify the unique features of accounting
systems in Indonesia, China, and Germany respectively. Based on the accounting ecology framework
developed by Gernon and Wallace (1995), the following sections provide a detailed analysis of thehistorical, legal, business and economic environment in Japan.

3. Aspects of the Japanese Accounting Ecology
3.1 Historical Environment: The Influence of Germany and the U.S.
The Japanese accounting system has been primarily influenced by the German and the U.S.
accounting systems since World War II. Specifically, the Japanese Commercial Code was enacted
in 1890 after the opening of Japan to foreign countries in the Meiji Era (1868-1912) based ona draft prepared by a German scholar, K. F. H. Roesler (Arai and Shiratori 1991; Benston et al.
2006). Because the Commercial Code regulated measurement practices in Japan, the German
influence largely determined the accounting environment in Japan. Under this Japanese Commercial
Code, creditor protection and the reconciliation of interests among stakeholders were achieved byconservative measurement rules such as a less than market price basis (Fujita 1966; Iino 1967).
Significant changes in the accounting environment of Japan resulted from the U.S. occupation
after World War II. The General Headquarters of the Allied Forces dissolved powerful familycontrolled holding companies (called zaibatsu) to establish a democratic Japanese economy andaccelerated the improvement of the corporate reporting system in Japan (McKinnon 1986). The
implantation of the U.S. Accounting system was based on the complete overhaul of the Japanese
accounting system, which included the establishment of the Japanese SEC in 1948, the Certified
Public Accountants Act in 1948, and the Investigation Committee on Business Accounting Systems(ICBAS) in 1948 (Fujita 1981; Someya 1989; Chiba 2001).
The Japanese Securities and Exchange Law established in 1948 was modeled after the U.S.
Securities Act of 1933 and the Securities Exchange Act of 1934. The primary focus of this law isto provide useful information for investment decision-making by shareholders and other investors(Arai and Shiratori 1991). Additionally, among seven general principles of A Statement of BusinessAccounting Principles (Kigyo Kaikei Gensoku), which was released in 1949, the “principle of unity”
demanded ‘one and the same’ accounting numbers even for different reporting purposes such as
financial reporting, submission to a general meeting of shareholders, credit guarantee, and calculationof taxable income purposes. Although this statement was patterned after the U.S. accounting
principles, the ICBAS did not adopt it unquestioningly but arranged it so that this statement would
cover the specific demands within Japan to reform the Japanese accounting system simultaneouslyTsunogaya and Chand: The Complex Equilibrium Paths towards International Financial
Reporting Standards (IFRS) and the Anglo-American Model121

and complementarily. Importantly, the principle of unity played a significant role until 1980s
in improving the three accounting-related laws, namely the Securities and Exchange Law, theCommercial Code, and the Corporation Tax Law (Ando 2010).
3.2 Legal Environment: The Triangular Legal System
The Japanese Commercial Code and the Japanese Securities and Exchange Law had both
German and U.S. influences. These laws had some similarity because in both, the prudent andconservative nature of measurement bases was adopted. Furthermore, with the revision of theCommercial Code in 1981, the principle of unity was substantially achieved, and the reciprocating
move to reduce disparities in accounting rules between these laws was mostly achieved (Ando 2010).
In addition to the principle of unity, the Financial Instruments and Exchange Act (enacted in 2006
as a full revision to the Securities and Exchange Law), the Companies Act (enacted in 2005 as a fullrevision to the Commercial Code), and the Corporation Tax Law (enacted in 1947) have influenced
accounting practices in Japan. Because these three laws are connected systemically to one another,
this unique style of accounting regulation is called the “triangular legal system”.
Each of the regulations in the triangular legal system plays an important role. The objective of
the Financial Instruments and Exchange Act is to support the strong development of the national
economy by providing useful information for investors (Article 1). The purpose of the Companies
Act is to reconcile the interests of stakeholders and to protect creditors. To achieve this objective, thislaw prescribes the maximum amount of surplus available for distribution to avoid over-outflow ofresources from a company (Article 461-2).2
The objective of the Corporation Tax Law, on the other hand, is to ensure the fair calculation of
the taxable income of companies. This law allows corporations to deduct only those expenses that areincluded in the income calculation according to the Companies Act (Articles 2-25) and are settled by
the general meeting of shareholders (Articles 74-1). The former is called “the principle of recognizing
as expense (Sonkin Keiri Youken)” and the latter is called “the principle of definite settlement of accounts(Kakutei Kessan Syugi)” which originates from “the authoritative principle (Mab geblichkeitsprinzip)”
adopted in Germany. These principles have been criticized in Japan because when a company has theoption of selecting one of several accounting methods, the corporation inevitably adopts the method
prescribed by the Corporation Tax Law to achieve tax saving, even if the method does not reflect theeconomic substance of the transaction. This company activity is caused by the “principle of reverse
authoritativeness (umgekehrte Mab geblichkeit)” which also originated in Germany.3
The objective of the Financial Instruments and Exchange Act also includes providing useful
information for investors. This law entrusts the ASBJ with the development and/or revision of
accounting standards, which includes the significant process of global convergence of financial
reporting. However, the objectives of the Companies Act and Corporation Tax Law are to calculate
distributable surplus and taxable income in order to reconcile interests among managements,
shareholders, creditors, tax authorities, and other stakeholders. In these laws, the prudent andconservative nature of measurement bases is given priority to ensure verifiability and objectivity,
which has caused problems in relation to the adoption of IFRS in Japan.
Under the Commercial Code, retained earnings were the main source for the income available for dividends. However, theCompanies Act prescribes the surplus available for distribution and allows distribution not only from retained earnings but also
from other capital surplus (Article 446).
3
In Germany, the Act to Modernize Accounting Law (Bilanzrechtsmodernisierungsgesetz: BilMoG) was established in May 2009
and abolished the principle of reverse authoritativeness to prepare more informative financial reporting (Ernst and Young 2009).
2

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3.3 Business Environment: Long-term Corporative Relationships
The economic environment of Japan, as with Germany, has been based on the CMEs, inwhich long-term cooperative relationships between various stakeholders are fostered. As alreadynoted, the economic environment of the U.S. has been based on the LMEs, in which competition
through challenges in the marketplace is encouraged (Kaplan 1997; Vogel 2001, 2006; Schmidt andSpindler 2006). In the CMEs, as is shown in Table 1, the ownership of a company is concentrated,
capital markets are relatively illiquid, and managers in the company are allegedly monitored by
a combination of banks, large corporate shareholders, and other inter-corporate relationships.
In the LMEs, by contrast, capital markets are liquid, the ownership of a company is relatively
unconcentrated, and managers are supposedly monitored by an external market and by boards of
directors that are usually dominated by outsiders (Kaplan 1997).
Additionally, various stakeholder groups in the CMEs such as managements, institutional
investors, creditors, banks, and employees enter into the corporate governance and make crucial
decisions based on mainly internal information, whereas in the LMEs, market mechanisms, stock
markets, corporate takeovers, and public information play a large role in corporate governance.
Furthermore, long-term relationships between firms and employees through life time employment
and seniority payment systems are emphasized in the CMEs, whereas external flexible labor markets,
performance-based merit payment, and stock option systems are more important in the LMEs thancooperative relationships (Franks and Mayer 1997; Kaplan 1997; Schmidt and Spindler 2002, 2006;
Leuz and Wüstemann 2003; Schmidt and Tyrell 2004; Hackethal et al. 2005).
Importantly, these features of the CMEs are consistent with the prudent and conservative
nature of accounting practices in Japan, as they are in Germany, especially through hidden reserves,
provisions, and retained earnings (Hamamoto 1995; Leuz and Wüstemann 2003; Siebert 2005;
Heidhues and Patel 2011). Japanese and German managements generally valued their freedom tohide profits and losses and to manipulate the income statement to smooth out earnings over time.
This prudent and conservative nature of accounting practices in Japan and Germany also emphasized
the non-consolidated financial statements to calculate distributable and taxable income (Arai and
Shiratori 1991; Hamamoto 1995; Leuz et al. 1998; Leuz and Wüstemann 2003; Vogel 2006; Furuichi
2008; Hellmann et al. 2010).

4. The Process towards Accounting Convergence
4.1 Dysfunction of the Japanese Accounting System in the Early 1990s
The Japanese and German CMEs encouraged widespread interest in the competitive advantages
associated with their organization-oriented institutions in the 1980s (Konzelmann 2005). Indeed,long-term cooperative relationships of the Japanese and German CMEs between firms and banks,
between different firms, and between firms and the labor force through the main bank system(Hausbank system), keiretsu (inter-firm networks), and lifetime employment system (collective
bargaining) promoted economic development in the 1980s. However, because of the profoundeconomic crises in the early 1990s, Japan and Germany were compelled to reform the constellationsof relevant infrastructures that linked to form distinct national systems in the 1980s.
Japan faced the worst economic crisis in history in the 1990s. The Nikkei Stock Index fell
sharply from nearly 40,000 in December 1989 to under 15,000 in August 1992. Land prices also
fell 40 percent on average between 1989 and 1993, which contributed to the crises of the mortgage

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Table 1: A Comparison of Japanese, German and U.S. Governance, Finance, Employment andDisclosure Systems
Coordinated Market
Economies (CMEs)

Governance System
Interested party

Board of directors
Finance System
Main financing

Traditional JapaneseModel

Traditional German
Model

Stakeholder-oriented

Stakeholder-oriented

Liberal Market
Economies (LMEs)
The U.S. Model

Shareholder-oriented

Primarily insidedirectors

Primarily insidedirectors

Primarily outside
directors

Relational (indirect)
finance

Relational (indirect)
finance

Market (direct) financePrimarily owned bysmall scale shareholders
and institutional
investors such aspension and mutual
fundsCapital concentration

Less concentrated

Concentrated

Capital ownership

Primarily owned byinstitutional investors
such as groupcompanies and financial
institutions

Primarily owned byblock holders suchas allied companies,
financial institutions
and founding family

Capital markets

Somewhat liquid

Relatively illiquid

Very liquid

Hausebank system

Fragmented

Takeover markets

Banking System

Minor

Main Bank system

Minor

Job market

Insider job market

Insider job market

Employment System
Lifetime employment

Dispersed

Major

Outsider job market

AppliedAppliedStock option

Seniority-based
payment

Less common

Seniority-based
payment

Performance-based
merit payment

Measurement

Conservative

Conservative

Fair presentation

Dismissal

Payment system
Disclosure System
Disclosure

Principal financial

statements

Protected

Protected

Less common

Lax disclosure

Lax disclosure

financial statements

financial statements

Non-consolidated

Non-consolidated

Not applied

Not protected (flexible)

CommonFull disclosure

Consolidated financial
statements

Sources: Based on Kaplan (1997), Schmidt and Spindler (2002, 2006), Schmidt and Tyrell (2004), Leuz and
Wüstemann (2003), Hackethal et al. (2005).

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lending institutions (called jûsen) and the banking industries (Beason and James 1999; Hoshi and
Kashyap 2001). To make matters worse, the Japanese government did not disclose information about
the jûsen and banking crises. This secretive policy of the Japanese government added to the economiccrisis. It was only after 1995 that the Ministry of Finance (MOF) “seems to have realized that thetruth is probably better than unfounded speculation, and the magnitude of the crisis has been moreor less openly revealed” (Beason and James 1999, p.84).
These economic crises intensified criticism of the Japanese reporting system. Indeed, during
the long-term economic depression of the 1990s, the practice of strict historical cost accounting
contributed to the ability to hide substantial unrecognized losses from bad loans, tangible assets, andpension liabilities. Because of strict historical cost accounting, the Japanese reporting system also
failed to disclose the risk concerning financial instruments including derivatives. Moreover, becauseof the dependence on non-consolidated financial statements, accounting fraud using a complexityof subsidiaries and affiliate companies occurred (Hiramatsu 1998; Vogel 2001; Benston et al. 2006;
Furuichi 2008).
In essence, the principle of unity, the triangular legal system, and the prudent and conservative
nature of the Japanese accounting system were seen as obstacles to convergence with internationallyaccepted accounting standards. A code-oriented system implemented through a strong central
government was slow to respond to the fast-changing environment (Gernon and Meek 2001).
4.2 Significant Accounting Reforms: The Accounting Big Bang
Due to the profound economic crises in the 1990s, significant reforms were initiated in Japan
with the introduction of the “Financial Big Bang” in 1996 and the “Accounting Big Bang” in 1997.
The term “Big Bang” has been used in Japan to reflect the significant financial, accounting, andpolitical changes that took place in the late 1990s and early 2000s.
To address the economic crisis and the repetition of manipulation that resulted from strict
historical cost accounting and dependence on non-consolidated financial statements, the Big Bangwas implemented by the adoption of three principles; namely, the establishment of free, fair and global
capital markets. Because the objective of the Big Bang included introducing competition throughmarket mechanisms into accounting, financial, governance, and employment systems, enhancing theJapanese disclosure system including financial statements, and accelerating the internationalization ofJapanese accounting system, these reforms inevitably pushed Japan to move toward IFRS, the AngloAmerican model, and LMEs.
In fact, principal financial reporting was changed to consolidated financial statements in 1997,
which involved the application of consolidated statements of cash flows, interim consolidated
financial statements, and tax effect accounting. By adopting the “control criterion”, which reflects thepower to govern the financial and operation policies of an entity, the scope of consolidation enlarged
considerably compared to the over 50 percent criterion. These changes accelerated group-wide
management and restructured non-performing subsidiaries and associates (METI 2004; Furuichi
2008).
Moreover, fair value measurement was introduced for trading securities, derivatives, andavailable-for-sales securities in 1999. The introduction of fair value measurement overcame thedefectiveness of strict historical cost accounting because fair value constrains profit equalization
management and discloses the result of risk management. Similarly, fair value and present value wereintroduced into the accounting standard for retirement benefits in 1998. According to this standard,
provisions are calculated by the difference between the amount of retirement benefits obligations

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Reporting Standards (IFRS) and the Anglo-American Model

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valued at present value and the amount of pension assets valued at fair value. This change accelerated
the adjustment of an ossified lifetime employment system.4
These significant reforms of accounting standards highlight substance-over-form by adopting
the concept of control for consolidated financial statements and by introducing future-oriented
measurement attributes such as fair value and present value for financial instruments and pension
assets and liabilities. Consistent with these accounting reforms, auditing standards were fully revised
to enhance auditing for detecting frauds, to apply risk approach for clients’ internal control systems,
to incorporate auditing for going concerns (auditors’ information about bankruptcy risk), and torequire substantial exercise of professional judgment (BAC 2002). Moreover, in accordance with the
U.S. Sarbanes-Oxley Act of 2002, which was enacted to respond to the Enron scandal, the JapaneseCertified Public Accountants (CPA) Law was fully revised for the first time in 60 years. To enhanceauditor independence and oversight, the CPA Law incorporated: (1) prohibition of the provision ofcertain non-audit services simultaneously with audit services (Article 24-2), (2) requirement of audit
partner rotation (Articles 24-3; 34-11-3), and (3) establishment of the Certified Public Accountantsand Auditing Oversight Board (CPAAOB) (Articles 35-42).
As with the IASB and the U.S. Financial Accounting Standards Board (FASB), the ASBJ wasestablished as a private-sector accounting standards-setting body in July 2001. The objective of the
ASBJ is to promote corporate disclosure and soundness of capital markets by developing generally
accepted accounting standards through transparent and fair procedures. The fact that the ASBJ wasestablished as a private standards-setting body is of significance, because this change implies that the
ASBJ is expected to develop accounting standards to meet the fast-changing economic environment
beyond the restrictions of the Financial Instruments and Exchange Act, the Companies Act and the
Corporation Tax Law (Egashira 2005; Saito 2007).
Through these significant reforms of the accounting, auditing, and standards-setting body,which highlighted competition through marketplaces, transparency of disclosure system, and theinternationalization of the Japanese accounting and auditing standards, the Japanese accounting
system has moved toward IFRS and the Anglo-American model. As a result of these achievements,
the Financial Service Agency (FSA), the ASBJ, and the Japan Institute of Certified Public
Accountants ( JICPA) announced in a joint statement that “Accounting, auditing and disclosuresystems in Japan are essentially equivalent to and consistent with internationally recognized systems”(FSA et al. 2004).
Additionally, to examine the quality of financial reporting system in Japan, the Committee ofEuropean Securities Regulators (CESR) conducted the assessment of the equivalence of Japanese
Generally Accepted Accounting Principles (GAAP) with IFRS (CESR, 2005). The CESR’s
conclusion was that Japanese GAAP, taken as a whole, is mostly equivalent to IFRS, subject tolimitations of 26 differences which needs to be addressed. The ASBJ eliminated the major differences
between Japanese GAAP and IFRS by the end of 2008. The accomplishment of the Big Bang andrecent reforms towards IFRS and the Anglo-American model resulted in a reasonably high quality
financial reporting system. Eventually, the European Commission (EC) accepted that the Japanese
GAAP is equivalent to IFRS that are adopted by the EU (EC 2008a, b).
4

In addition to these accounting standards, the following standards were newly established and/or revised during 1998-2004.
Research and development costs (1998), Foreign currency transactions (1999), Impairment of fixed assets (2002), Treasury sharesand reversal of legal reserves (2002), Earnings per share (2002), Business Combination (2003). These standards followed either
IFRS or U.S. GAAP.

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5. Further Reforms towards the Anglo-American Model
5.1 The Cautious Convergence Approach by Design
During the Big Bang, long-periods of adjustment were prepared until new accounting standards
were applied mandatorily. For example, though accounting for impairment and business combinations
standards were issued, it was three and a half years before these newly-established accounting
standards were applied mandatorily.5 These deferments were caused by firms’ resistance to adopting
new accounting standards. In fact, most newly-established accounting standards constrained freedom
to hide profits and losses, made it difficult to manipulate accounting figures, and restricted traditional
Japanese business customs such as cross-shareholdings, keiretsu, defined benefits pension plan, andlifetime employment system (Vogel 2001, 2006; Furuichi 2008). However, it is also important tonote that the Japanese government adopted a cautious convergence approach by design to align new
accounting standards with auditing standards, the Commercial Code, and the Corporation Tax Law.
The evidence shows that, consistent with the Accounting Big Bang, surrounding infrastructures
such as the Commercial Code and the Corporation Tax Law were reformed significantly. The
objectives of the Commercial Code and the Corporation Tax Law were to calculate distributable andtaxable income based on verifiable and objective measurement models. In these laws, the applicationof the consolidated financial statements and fair value measurements had not been recommended(Arai and Shiratori 1991). However, consistent with the revision of accounting standards, theselaws adopted fair value measurement for certain financial instruments and retirement benefits. The
Commercial Code allowed large companies to disclose consolidation financial statements and the
Corporation Tax Law allowed companies to adopt a consolidated taxation system under a specificcondition.
Moreover, as Japanese accounting standards moved towards the investor-oriented AngloAmerican model, the Commercial Code reinforced provisions for pursuing the efficiency of capitaland accelerating business restructuring. The objective of this change was to promote competition in
the marketplace. These new provisions included the introduction and relaxation of share buy-backs,
treasury stocks, share exchanges, reduction of regal reserves, and distributable amount of surplus.
Even the Corporation Tax Law, which is irrelevant to investors’ perspective in nature, followed someparts of these revisions such as provisions on treasury stocks and share exchanges. This reconciliation
process among accounting standards, the Commercial Code, and the Corporation Tax Law is shownin Table 2.
These changes indicated that accounting standards, the Commercial Code, and Corporation
Tax Law were moving towards the Anglo-American model and the LMEs simultaneously andcomplementarily. Surrounding infrastructures such as governance and employment systems were also
reformed towards the Anglo-American model and the LMEs by seeking efficiency through market
mechanisms. Indeed, the outside auditor system was introduced in 2001 under the Commercial
Code, whereby it is a requirement that more than half members of auditors in large companies mustbe outside auditors (Article 335). An optional committee system was introduced in 2002 and theU.S governance style featuring an outside director system is allowed (Article 400). Similarly, many
companies introduced elements of the U.S. employment style, such as merit payment and defined5

The accounting standard for the impairment of fixed assets was issued in August 2002 but adopted mandatorily from the beginningof the fiscal year April 2005. Similarly, the accounting standard for business combinations was issued in October 2003 but adopted
mandatorily from the beginning of the fiscal year April 2006.

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Table 2: Reconciliation Among Accounting Standards, The Commercial Code, and The
Corporation Tax Law

Significant Changes

Accounting Standards

The Commercial Code

The Corporation Tax Law

Consolidated financial
statements

Accounting standard
for consolidated
financial statements
revised (1997)

Disclosure of
consolidated financial
statements for large
companies required(2002)

Consolidated taxation
system introduced(2001)

Fair value
measurements

Accounting standard
for retirement benefits
issued (1998)

Allowance for
employees’ retirement
benefits de-escalated(1998)

Accounting standard for Fair value measure­ment
financial instruments
for certain securi­ties
issued (1999)
allowed (1999)

Fair value mea­surement
for certain financial
instruments applied(2000)

Accounting standard
for treasury shares andreversal of legal reserves
issued (2002)

Taxation of sale oftreasury stocks revised(2001)

Deregulation regarding
the reduction of capitaland regal reserves

Stock options and sharebuy-backs deregulated(1997)
Share buy-backs andcancella­tion of shares
further deregulated(1998)
Legal reserves, capital
reduction, and treasury
stocks deregulated(2001)
Distributable amountof surplus deregulated(2001)

Business reorganization

Accounting standard for Establishment of bankbusiness combinations
hold­ing companies
issued (2003)
allowed (1999)
Share ex­change sys­tem
introduced (1999)

Exception to taxation ofshare exchanges issued(1999)
Taxation of corporate
reorganization revised(2001)

Corporate spin-offs sys­
tem introduced (2000)
Note: The cautious and continuous reconciliation processes can be recognized from this table. For example,
a new accounting standard introduced fair value measurements for certain financial instruments in 1999.
Consistent with this change to the new accounting standard, the Commercial Code and the Corporation
Tax Law also introduced fair value measurements for such items in 1999 and in 2000 respectively.

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The Japanese Accounting Review, 2 (2012), 117-137

contribution plan (Nippon Keidanren 2000; METI 2004; Furuichi 2008). However, these U.S. stylesystems were mostly introduced as “choice” which enabled new practices, rather than being imposed
as mandatory requirements.
In addition to these reforms, the optional adoption of IFRS commenced in Japan at the end of
the fiscal year March 2010 for the consolidated financial statements of listed companies. Importantly,
it will be obligatory to change from the cautious convergence approach to the direct adoption
approach if the government decides to enact the mandatory adoption of IFRS. According to theoriginal plan in 2009, the decision concerning the adoption of IFRS will be made around 2012 andis likely to come into effect after 2015 (BAC 2009). However, in June 21, 2011, Shozaburo Jimi,
the Minister of Financial Services, delivered a statement about the postponement of the decision
concerning the adoption of IFRS. The Minister suggested that the mandatory adoption of IFRS
should not take place before 2015, and a sufficient time period of five to seven years should be
required for preparation if the mandatory adoption of IFRS is confirmed in Japan.6
It is also important to note that although the Cabinet Office Regulation No.73 issued in
December 2009 described a prohibition on the use of U.S. GAAP with effect from the fiscal year
March 2016, the Minister announced the finalization of the removal of this time limit in June 2011
( Jimi, 2011). Consistent with this announcement, the Cabinet Office Regulation No.44 issued inAugust 2011 removed this time limit so that Japanese firms can continue their use of U.S. GAAP.
This policy change clearly indicated that the Minster supported the “cautious convergence approach”
rather than the “direct adoption approach.”
5.2 More Focus on Intrusive Events than Domestic Reconciliation
Reforms of disclosure, financial, governance, employment systems progressed simultaneously
and complementarily during the Japanese Big Bang period, as already noted. After 2005,
however, when IFRS were adopted mandatorily in the EU, intrusive events such as the strategiesof the EU and the SEC became more important than domestic reconciliation. In the EU, theadoption of IFRS was made mandatory for European listed companies from January 2005 (EC2002, 2003, 2004).
Similarly, in the U.S. the move towards convergence commenced by the so-called “Norwalk
Agreement” between the IASB and the U.S. FASB in 2002. In response to this agreement,
the U.S. SEC Chief Accountant Donald T. Nicolaisen prepared a roadmap in April 2005. This
roadmap, which was officially approved by the SEC Chairman Christopher Cox, eliminated thereconciliation requirements for non-U.S. registrants that adopted IFRS from November 2007
(SEC 2005, 2007a, 2007b). Moreover, the U.S. SEC published a roadmap in November 2008,
which includes two proposals, namely the optional adoption of IFRS for certain U.S. issuers
from January 2010 and several milestones for the potential use of financial statements preparedin accordance with IFRS (SEC 2008).7

The Minister’s decision was influenced by several factors: (1) the announcement to postpone the adoption of IFRS in the U.S.
by the SEC; (2) the strong request to postpone the adoption of IFRS in Japan by the representatives of twenty-one leading
Japanese companies together with the Japan Chamber of Commerce and Industry; (3) the resistance of the Japanese Trade Union
Confederation; (4) the unprecedented earthquake and tsunami in March 11, 2011; and (5) contextual factors characterizing Japan’s
institutional environment such as the economy and legal system ( Jimi 2011).
7
The U.S. SEC issued a commission statement in February 2010, which rescinded a regulation concerning the optional adoption of
IFRS for certain U.S. issuers (SEC 2010).
6

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129

Consistent with these decisions made by the EU and the U.S. SEC, the ASBJ madesignificant agreements with the IASB in 2007, which was the so-called “Tokyo agreement,” toaccelerate convergence. As a result of these agreements, optional adoption of IFRS commenced
in Japan at the end of the fiscal year March 2010 for the consolidated financial statements oflisted companies. These global trends promoted the establishment of the Companies Act in July
2005 and the Financial Instruments and Exchange Act in June 2006. These laws were revised
significantly to incorporate important parts of the U.S. Corporation Act and the Sarbanes-Oxley
Act of 2002.
Prior to its revision in 2002, the Commercial Code regulated measurement practices, which
supported the prudent and conservative nature of accounting practices for creditor protection.
However, the Companies Act abandoned the setting of measurement rules in 2005 and has cometo rely on other measurement rules described by the Financial Instruments and Exchange Act.8
The concrete rules regarding the distributable amount of surplus are enacted by the Ministry ofJustice ordinance (Article 461-2). These functional decompositions were accelerated so that Japanesestandards-setting bodies could revise accounting standards quickly according to the revision of IFRS
beyond the restrictions of the Financial Instruments and Exchange Act, the Companies Act and the
Corporation Tax Law (Egashira 2005; Saito 2007). In other words, Japanese standards-setting bodies
have come to prepare accounting standards without being influenced by the principle of unity, thetriangular legal system, and the principle of recognizing as expense.
As Japanese accounting standards moved towards the Anglo-American model, theCompanies Act highlighted the “efficiency of capital” rather than the “maintenance ofcapital” by the further relaxation of regulations regarding the reduction of capital and regal
reserves (Articles 447-448). Such deregulation is contrary to the conventional principle in theCommercial Code that creditor protection is achieved by avoiding over-outflow of resourcesfrom a company through dividend regulation. As such, the Companies Act changed its policy ofreconciliation of interests from “the capital maintenance model with strict dividend regulation”
into “the full disclosure model with flexible dividend regulation.” These changes imply themove from the German Commercial Code towards the U.S. Corporation Act (Hamada 2005).
Similarly, the Financial Instruments and Exchange Act introduced Internal Control Reporting
over the Financial Reporting System (Naibu Tôsei Hôkoku Seido) in 2006, which is patterned
after the corporate governance system in the Sarbanes-Oxley Act of 2002 (Article 24-4-4). Thischange is expected to improve the reliability of the Japanese disclosure system by enhancing theinternal control system in Japan.

6. The Complex Equilibrium Paths toward Convergence
6.1 Unique Reforms of the Japanese Accounting System
Initially, the Japanese regulatory authorities such as the BAC and the FSA suggested thatboth consolidated and non-consolidated financial statements should be prepared by IFRS,
8The Companies Act states that: “The financial reporting of a joint-stock corporation (Kabushiki Kaisha) is subject to generally
accepted accounting practices for business enterprises” (Article 431). Generally accepted Japanese accounting practices include themeasurement rules described by the Financial Instruments and Exchange Act and accounting standards prepared by the BAC andthe ASBJ.

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if the mandatory adoption of IFRS is enacted in Japan (BAC 2009). 9 Hidenori Mitsui, thehead of the business disclosure section of the FSA, explains the reason to recommend thisapproach as follows. “Consolidated financial statements are based on non-consolidated financial
statements within an enterprise group thereby financial statements of both parent company andits subsidiaries must be prepared in accordance with the same generally accepted accounting
standard” (Mitsui 2009, p.35).
Japanese business federations, however, including the Nippon Keidanren, have consistently
opposed the adoption of IFRS for non-consolidated financial statements. Instead, the Nippon
Keidanren has suggested for the more prompt response to IFRS adoption for certain global
enterprises that prepare consolidated financial statements in order to revitalize capital markets,
whilst the simplification of non-consolidated financial statements to reduce the preparation costs forthe other entities (Nippon Keidanren 2008, 2009, 2010).10 Under this separation of consolidationand non-consolidation approach (hereinafter, “separation approach”), the connection between thesefinancial statements will be made separate. The dependence between the Financial Instruments andExchange Act, which regulates mainly consolidated financial statements, and the Companies Act,
which regulates mainly non-consolidated financial statements, will also inevitably be made separate.
As such, this approach makes the maintenance of the principle of unity and the triangular legal
system less important.
This separation approach induces further argument concerning the separation of the connection
between financial reporting and tax law. Indeed, Japan has adopted the single-reporting regime
in which accounting standards and tax law are highly dependent. The principles of recognizing as
expense and the definite settlement of accounts have permeated accounting practices. However,opinions that reexamination of these principles is needed are widely encountered, especially for
listed companies, in order to make the consolidated financial statements converge with IFRS
promptly (Nippon Keidanren 2008, 2009, 2010). At the same time, opinions that these principles
should be maintained are rigid, especially regarding the financial statements for SMEs, considering
the burden of preparation costs and lack of human resources. Because the accounting systems of
SMEs are oriented towards calculation of taxable income, the simplification of accounting standards
and elimination of fluctuant accounting figures caused by the extensive application of fair value
measurement are strongly recommended ( JICPA 2010).
As intrusive events increase in influence, domestic reconciliation becomes more difficult. Indeed,
the differentiation of the functions between consolidated and non-consolidated financial statements,
between the Financial Instruments and Exchange Act and the Companies Act, between financial
reporting and the calculation of taxable income, and between the accounting standards for large
companies and SMEs is progressing through complex paths. Contrary to the claim that convergence
directs the “best design” practices closely akin to the Anglo-American model (McDonnell 2002;
Hansmann and Kraakman 2004; Pinto 2005), the move towards the Anglo-American model andthe LMEs do not represent a complete break with past Japanese patterns of disclosure, financial,governance, and employment systems.
More specifically, they suggested that consolidated financial statements should be converged on IFRS swiftly, while nonconsolidated financial statements should be converged after finishing domestic reconciliation with other systems including
distinctive trade practices, traditional accounting practices, the Companies Act, and the Corporation Tax Law (BAC 2009).
10
The Nippon Keidanren ( Japan Business Federation) is a broad-based economic organization whose members include over 1,600
major Japanese corporations, 129 industry organizations, and 47 regional economic organizations in 2010.
9

Tsunogaya and Chand: The Complex Equilibrium Paths towards International Financial
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131

6.2 Unique Reforms of Other Infrastructures
The banks’ shareholding ratio and cross-share holding ratio have declined from 42.8% in
1991 to 29.7% in 2010 and from 27.7% in 1991 to 6.5% in 2009 respectively, whereas the foreign
investors’ ratio increased from 6.0% in 1991 to 26.7% in 2010 (Ito 2010; Tokyo Stock Exchange2011). Consistent with these changes, a long-term corporative relationship between a bank and acompany through lending, cross-shareholdings, and interlocking directors is dissolving significantly.
However, in the face of the recent financial crisis stemming from the subprime loan problem in 2008,
most companies have increased bank borrowings as a stable financing method. In other words, mostcompanies maintain a close network with their main banks. This is because Japanese companies still
expect that the main banks will furnish funds in a financial crisis and will bail out in financial distress,
thereby reducing financing risks and hedging bankruptcy risks (Hirota 2009; Japan Cabinet Office2010). Cross-shareholdings are still utilized for forming capital alliances to expand business and to
defend against hostile takeovers (Ito 2008).
The evidence that not all systems are moving towards LMEs can also be seen in the reforms tocorporate governance. In the CME countries, the board of directors is dominated by insiders such as
executives of the company, interlocking directors, managers of closely associated companies, and bankrepresentatives. However, an optional committee system was introduced in Japan in 2002 as a resultof revisions to the Commercial Code. In a company with a committee system, the functions of theboard of directors and corporate executives are separated and more than half members of directors
must be chosen from outside directors.11 This revised Commercial Code facilitated the adoption of
U.S. governance style, but was designed as an “option” that enabled rather than mandated change.
This reform as “choice” represents an important political compromise to enable new practices, rather
than imposing strict mandatory requirements. Importantly, “choice” was the product of compromise,
not overwhelming consensus on the advisability of moving towards U.S. style corporate governance(Gilson and Milhaupt 2004).
Similarly, the employment system has changed towards the LMEs. As shown in Table 3, 58.2%
of Japanese companies introduced merit payment. However, 29.8% of Japanese companies are stillclassified as CMEs (traditional Japanese model), 18.3% are LMEs (the U.S. model), 39.9% are theHybrid Model (new Japanese model), and 12.0% are the Inverse Hybrid Model (inversely mixed
model) ( JILPT 2005). The survey also shows that 69.7% of Japanese companies maintain a longterm employment system ( JILPT 2005). It is well-known that Japanese companies have managed
human resources flexibly to preserve a long-term employment system by transferring redundant
employees to group companies, by introducing an early retirement plan with a premium allowance,by cutting wages without violating commitment to stable employment, and by restricting the longterm employment system to core employees (Vogel 2001, 2006; MHLW 2008). As such, the U.S.
employment style was introduced in ways that were consistent with the existing employment system.
Importantly, Japanese companies still expect that employee-oriented policy will make employees’
long-term commitment possible. These long-term corporative relationships have boosted efficiency,
innovation, and competitiveness in Japanese manufacturing firms (Aoki 1994; Dore 2000; Itami
2000; Jacoby 2000; Vogel and Zysman 2002; Konzelmann 2005; Vogel 2006; Clarke 2007; Jackson
and Miyajima 2007; Tatsumichi and Morishima 2007; JILPT 2010).

11

In addition, at least three committees, namely the nominating, audit, and compensation committees, must be established within theboard of directors (Companies Act, Article 2-12).

The Japanese Accounting Review, 2 (2012), 117-137

132

Table 3: Influence of Merit Payment on The Long-Term Employment System: The Percentage
of Companies
Long-term employment
maintained

Long-term employment
abandoned

Total

Merit payment
not introduced

CMEs（29.80%）Inverse Hybrid Model（12.00%）41.80%

Merit payment
introduced

Hybrid Model（39.90%）LMEs（18.30%）58.20%

Total

69.70%

30.30%

Data Source: JILPT (2005)
Note: The survey was conducted from October 15, 2004 to December 24, 2004 for 11,865 privatecompanies with more than 200 employees. Valid responses were 1,214 companies (10.8%).

In aggregate, as shown in Table 4, the equilibrium paths towards the LMEs are controversial
and complex, and include the CMEs (traditional Japanese model), the LMEs (the U.S. model),the Hybrid Model (new Japanese model), and the Inverse Hybrid Model (inversely mixed model).
Japanese firms can choose from a wide menu of market-based options such as direct financing, bondissue, the committee system, stock option, merit payment, and other performance-based incentive
systems to optimize a set of different sub-systems that complement one another. Importantly,
transplanting the Anglo-American model and LMEs without considering the institutional
complements of each country may lead to serious problems later, and these problems may impede, orreverse convergence (Gordon and Roe 2004).

7. Concluding Remarks
Using the accounting ecology framework of Gernon and Wallace (1995), this paper investigates
the interrelationships of the related accounting, historical, legal, business and economic environment
in Japan and provides deeper insights into the Japanese accounting system and surrounding
infrastructures, such as the financial, governance, and employment systems. We provide evidence
that the Japanese government has not adopted IFRS unquestioningly but has arranged it so that newrules reflect specific Japanese demands and contextual factors such as the historical, legal, business,
political, and economical environments.
As a result of the profound economic crises in the 1990s, significant reforms were initiated by
the “Accounting Big Bang” in 1997. The ASBJ was established in July 2001 to develop accounting
standards without being influenced by the principle of unity, the triangular legal system, and theprinciple of recognizing as expense. During the Accounting Big Bang, however, the domestic
reconciliation of accounting standards and surrounding infrastructures such as the Securities andExchange Law, the Commercial Code, and the Corporation Tax Law was promoted by design.

Tsunogaya and Chand: The Complex Equilibrium Paths towards International Financial
Reporting Standards (IFRS) and the Anglo-American Model

133

Table 4: Diversification of The Japanese Financial, Governance, and Employment Systems
Governance System/ Employment System
Financial System

Insider Control/
Insider job market

Outsider Control/
Outsider job market

Relational finance

CMEs

Inverse Hybrid Model

Market financeHybrid Model

LMEs

Note: Financial System: relational-oriented (e.g. bank finance, cross-shareholdings) or market-oriented (e.g.
stock issues, bond finance). Governance System: insider control (e.g. stakeholder-oriented, insider boards)
or outsiders control (e.g. shareholder-oriented, outsider boards). Employment System: insider job market(e.g. lifetime employment, seniority pay) or outsider job market (e.g. merit payment, stock options).

As such, the cautious convergence approach during this period justified the move towards theAnglo-American model and the LMEs. In contrast, after 2005 in particular and following the
mandatory adoption of IFRS in the EU, intrusive events such as the strategies of the EU and U.S.
SEC became more important than domestic reconciliation. During this period, intrusive events
discouraged Japanese regulators and companies from further domestic reconciliation and accelerated
the diversification of domestic business and accounting practices. In other words, convergence haspromoted domestic functional differentiation between consolidated and non-consolidated financial
statements, between the Financial Instruments and Exchange Act and the Companies Act, andbetween financial reporting and the calculation of taxable income. Accordingly, this paper rejects
the simplistic assumption that countries move directly towards the Anglo-American model and theLMEs because of global convergence.
Core reforms of the surrounding infrastructures in Japan were achieved not as a compulsion, but
as a “choice” from a wide menu. These reforms as “choice” do not show consensus on the movement
towards the Anglo-American model and the LMEs but the inclination and ingenuity to create a newJapanese model. Therefore, the Japanese equilibrium paths from the Continental-European model/
the CMEs towards the Anglo-American model/the LMEs have been controversial and complex.
The paths include unique convergence routes such as through the “Hybrid Model” and the “Inverse
Hybrid Model”. Some Japanese companies have adopted the Hybrid Model, which relies on marketoriented financing but retains some traditional Japanese features such as insider-oriented corporate
governance and stable employment system. Others have adopted the Inverse Hybrid Model, whichis still dependent on bank financing but introduces outsider-oriented corporate governance and aperformance-based employment system. Recent research also shows that the Hybrid Model thatcombines contradictory elements such as a market-based financial system, main bank system, insideroriented governance system, and life time employment system is superior to the pure forms of theAnglo-American model and LMEs (e.g. Jackson and Miyajima 2007; Tatsumichi and Morishima
2007; Hirota 2009; Japan Cabinet Office 2010; JILPT 2010).
Our findings are consistent with the institutional complementarity perspective that provides
insights into the divergence of economic, financial, and governance systems based on the

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complementarities of surrounding infrastructures. This perspective assumes a plurality of models
and emphasizes the systemic links between different institutions so that they fit together well andmutually increase their benefits (see Aoki 1994; Gordon and Roe 2004; Schmidt and Spindler 2006).
We conclude by pointing out that it seems unlikely that IFRS would supersede Japanese GAAP
completely, or that the Anglo-American model and the LMEs would replace the ContinentalEuropean model and the CMEs absolutely. Optimal mechanisms of the accounting system andits surrounding infrastructures are contextual and embedded in the accounting ecology of eachcountry. The findings of this study have implications for achieving de facto convergence because
optimal mechanisms of the accounting system and its surrounding infrastructures, such as disclosure,financial, governance, and employment systems, are contextual and are embedded in the accounting
ecology of each country.

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