Tokyo calling

Just as scandals at Enron and Worldcom gave rise to the governance reforms of the Sarbanes-Oxley Act, fraud at Japanese companies Seibu Railway, Kanebo and Livedoor have spurred Japan to strengthen regulations. And with so many parallels to US Sox, Japan’s internal control and financial reporting mandates, due to take effect in April 2008, have been tagged J-Sox.

Japan has a history of going easy on corporate fraud; white-collar criminals used to receive little more than suspended sentences. But that is changing as the country moves toward a stricter regulatory regime. In 2006, internet firm Livedoor was fined $2.4 million for accounting fraud and its chief Takafumi Horie was imprisoned for two years. The latest case involves brokerage firm Nikko Cordial, fined $4.24 million for fraudulently inflating profits.

Though the financial penalties are increasing, Japanese regulators still don’t seem to be applying the rules equally. They went light on Nikko’s top executive, some suspect because it is Japan’s third-largest securities firm. Post-J-Sox, with CEOs and CEOs having to certify the accuracy of the financial statements, Nikko would have to ‘accept that the management committed fraud,’ says Yasumi Taniguchi, managing director of ERM and internal audit practice at Protiviti Japan.

The Financial Services Agency (FSA) is stepping up enforcement, performing 163 administrative disciplinary actions against financial institutions last year, up 50 percent from 2005. Yet the concept of examining internal controls is new to Japan. So the J-Sox implementation is proving to be rather contentious. It is especially challenging due to the extent of the range of companies affected: 3,800 Japanese public companies and their consolidated subsidiaries worldwide will have to issue internal control reports.

Take it or leave it

Alice Young, partner and chairman of the Asia Pacific practice group at Kaye Scholer thinks it is important to recognize that the purpose of J-Sox is to ‘overhaul’ the Japanese Financial Instruments and Exchange Law as a way to improve and update existing laws, ‘not to copycat Sarbanes-Oxley.’

J-Sox will redefine securities and shareholder protection, with new measures allowing ‘earlier recognition of the issues and problems,’ says Nicholas Benvenuto Jr, a managing director of Protiviti in the technology risk consulting division. Transparency and the capacity for ‘management to address internal controls and give that perspective to their auditors’ are key drivers, he adds.

Section 404 of US Sox, which requires disclosures on internal controls for financial reporting, and Section 302, which requires CEO and CFO certification, are both replicated in J-Sox. The law will take a different shape, however. Some Sox criteria will be duplicated while others will be passed over; ‘Japan didn’t want to add anything without value,’ says Taniguchi.

Different strokes

The new Japanese regulations blur the line between management and the audit function. In the US management follow rules stipulated by Sox and the SEC, and auditors adhere to Public Company Accounting Oversight Board (PCAOB) guidelines. In Japan both management and auditors follow implementation standards established by the FSA, which include internal controls, evaluation, reporting and auditing.

Management and audit will be regulated by the same department, and under J-Sox external auditors will merely assess ‘management’s evaluation of the effectiveness of internal controls’ not the underlying controls. J-Sox is ‘a bit vague but also easier to comply with,’ than its US equivalent, says Young.

Benvenuto concurs. ‘The FSA … want to make this a less invasive and less costly process than it was in the US,’ he explains, ‘not only because of that perspective on [management’s assessment of] controls, but they’re taking a different cut as to materiality.’

Japan will let go of some ill-defined thresholds that are Sox hallmarks. Studying US models, Taniguchi says the Japanese government concluded ‘it’s difficult to differentiate deficiency versus significant deficiency in material weakness … either it’s material weakness or not.’ Other changed areas include a five percent materiality threshold (the value at which a transaction is considered to be significant to the financial records). Japan also seeks to reduce compliance costs in other ways by demanding less supporting paperwork.

Still, the new amendments will bring new challenges. ‘Many companies use manual recordkeeping, so IT implementation is going to be tough,’ says Young.

Confusing standards

While J-Sox abandons some aspects of US Sox, it expands on others. For instance, reports will be required on internal controls even for non-consolidated affiliates, Taniguchi says. It also covers more companies. Unlike in the US, smaller Japanese companies will not be afforded any latitude in terms of implementation timetables. Centralization may also be difficult for small businesses since Japanese companies ‘usually operate as business units rather than having top-down centralized control,’ Young says.

The Japanese model allows companies to file under the existing US Sox regime, so companies will be able to leverage experience in US markets for their Japanese compliance efforts. Dominick Sabella, senior vice president at The Bank of Tokyo-Mitsubishi UFJ (MUFJ), says his company’s experience in US markets has prepared it well for J-Sox. Because MUFJ is traded on the NYSE, the company is already US Sox 404 compliant. Sabella says the company still finds US Sox more comprehensive than the Japanese equivalent.

Another notable aspect of J-Sox is that it enforces no particular governance structure. For example, companies may choose a statutory audit system or an American-style audit committee with independent directors, like Sony.

The earlier the better

The US has a surplus of CPAs and consultants, not so in Japan. Sabella says ‘there could be a challenge ... in relation to the depth of resources available to support all the Japanese companies.’

With early efforts by the Treadway Commission’s Committee of Sponsoring Organizations, internal controls have been under discussion in the US since the 1990s. ‘In Japan we didn’t have that standard or guidance,’ says Taniguchi. ‘We have to see how Japanese management will self-evaluate their governance system and company-level controls in their J-Sox reports.’

But IT and accounting companies like Oracle Japan are already offering services to help with the transition to the new regulatory environment. Strategic marketing intelligence provider IDC Japan estimates the J-Sox compliance market will reach $2.1 billion in 2008. 

Though Japan may still lag the US, the country is a regulatory trendsetter in Asia. Internal control review is part of the audit in Korea and a white paper on regulation has recently been published in China. Benvenuto envisions wider adoption driven by ‘extremely sophisticated investors looking for more control around the areas in which they’re investing.’

Where J-Sox clearly surpasses US Sox is in early implementation: Japanese companies ‘want to get these processes in place for the 2008 fiscal year,’ says Taniguchi. And given the amount of time they have to iron out the kinks, J-Sox may offer better guidance and hopefully make the transition to more governance-minded companies a little less daunting than it was for their US counterparts.