Sorimachi Speaks

'THE SHAPE OF JAPAN IN THE 21st CENTURY' SERIES,
No. 21

PROPOSALS FOR REFORMING THE PUBLIC ACCOUNTING SYSTEM AND UPDATING CORPORATE ACCOUNTING SYSTEMS TO ACCOMMODATE INTELLECTUAL PROPERTY

Introduction

Today Japan is in the throes of the first major overhaul of its systems since the Meiji Restoration. One of the targets of these reforms is public-sector accounting practices. The central bureaucracy has been using cash-basis accounting and single-entry bookkeeping since 1889. Another topic requiring urgent attention is intellectual property, which, as early as the 1960s, was recognized as the core of our nation's wealth and our main source of strength. Since Japan boasts few material resources, I am not in disagreement with this view, but would like to emphasize that our policies on intellectual property are very much behind the times.

My analysis of the current state of public (governmental) accounting and intellectual property policy in Japan follows.

II.

Reforming the Public Accounting System

Public Accounting Principles: Background and Current Situation

The central bureaucracy (including the Diet and the courts) and local government both use cash-basis accounting and single-entry bookkeeping. When the public accounting system was established in 1889, Japan adopted single-entry bookkeeping, emulating the Prussian system. In 1878, double-entry bookkeeping was introduced. However, the Accounting Law, based on contemporary European and American systems, which had also adopted the Prussian model for governmental accounting, was enacted in conjunction with the promulgation of the Meiji Constitution (1889). Toward the end of the Meiji Era, the law was amended, in view of the changing times. However, the basic principles set forth therein (cash-basis accounting and single-entry bookkeeping) remained in use. Even when the Public Finance Law and a new Accounting Law were enacted in 1947, these two methods continued to prevail.

The Decentralization Promotion Law was enacted in 1995, and with the revision of the Local Government Law in 1999, the practice of delegating administrative functions to local government, which had endured since the Meiji era (1868-1912), was abolished. The role of local government is becoming increasingly important, since the hope of conquering the current structural recession lies in the invigoration of Japan's outlying regions. Accordingly, many local governments have launched an administrative assessment program, which involves adopting aspects of private-sector accounting practices (balance sheets, cash flow statements, and operating cost statements).

Four shortcomings of current national and local public accounting

1. Lack of inventory data
With single-entry bookkeeping, only cash revenue and expenditures are recorded, with no further details or explanations. For instance, no distinction is made between civil servants' salaries and the land purchases. Since the amount of assets purchased to date is not reported, it is impossible to compile a balance sheet. National and local government deficits are obvious, but there is no information in financial statements describing the amount of assets purchased, or their value. Real-estate holdings and their dimensions are recorded in a ledger, but not purchase prices.

2. Lack of cost data
As I mentioned earlier, national and local governmental accounting are done on a cash basis. However, costs arise at the moment when services are rendered. There is a discrepancy between the payment of civil servants' salaries and the provision of services. Deferred payments for electric power and telephone charges exist, just as they do in the private sector. In the private sector, discrepancies between the date on which payments are made and the date on which expenses are incurred are adjusted via deferred and accrued accounts. In the public sector, when municipal bonds are amortized, amortized principal and interest payable are disbursed in a lump sum, under the category of "debt service." But the amortized principal is the repayment of a debt, and not an expense. Even though the only expense involved here is the payment of interest, no distinction is made between the two. Transactions between local governments and commercial corporations are credit transactions, just as they are in the private sector. Therefore, the period commencing on April 1 and ending on May 31 is referred to as the "account adjustment period." Transactions involving income and disbursements during this period are considered to have taken place on or before March 31. This is called "modified cash-basis accounting," but all it does is adjust discrepancies in expenses over a particular period. It does not solve the problem of the recovery or repayment of assets or debts.

3. Lack of accountability
Financial accounting is one aspect of the administrative work done by each branch of Japan's bureaucracy. Prefectures are obliged to submit financial reports to the minister for public management, home affairs, posts and telecommunications; cities, towns, and villages submit their reports to prefectural governors (Articles 219, 233 (6) of the Local Government Law). However, the obligation to disclose budget summaries to residents (Articles 219, 233 of the same law) and to issue financial reports twice yearly (Article 243 (3)) has only minor significance in terms of accountability, which is not the main focus of the law. Japan's administrative laws were not drafted with taxpayers' rights (public service) in mind, and reflect the attitude of civil servants prior to World War II.

4. Lack of management
Management is a matter of acting rationally, efficiently, and prudently to achieve a specific goal. The methods used to establish that purpose, and the efficiency, effectiveness, and prudence demonstrated in achieving it are the same in both the public and private sectors. The processes most commonly involved are planning (compiling a budget), execution, assessment, and review (the "plan", "do", "check", and "act" so often mentioned by management specialists. Commercial corporations prepare business plans, but they are not always able to carry them out. More important are the assessment and review processes. But the philosophy of the administration is that once the budget has been compiled, all allocations should be used as planned. If funds are insufficient, a supplementary budget is prepared. Where budgets are concerned, the top priority of Japan's ministries and agencies is competing successfully against their counterparts for budget allocations, not good financial results. Resolutions are required for budgets (Article 211 of the Local Government Law), but financial statements need only be authorized by local assemblies (Article 233 (3) of the same law) ? no approval formalities are required. In the private sector, it is assumed that operating plans (budgets) are subject to revision. If the administration bears no responsibility for the assessment and review of the execution aspect of the management process, it can certainly not claim to be engaging in sound management.

Trends in Overseas Accounting Practices

1. United States
Accounting at the federal level is done on a modified accrual basis , but state and local governments shifted to full accrual accounting in June 2001.

2. United Kingdom
In fiscal 1994, local government abolished modified accrual-basis accounting, adopting full accrual accounting in its place. On the national level, the UK introduced full accrual-basis accounting based on current market prices for the 1999 accounting year.

3. New Zealand
New Zealand is noteworthy for having made radical changes to its public accounting system early on, introducing accrual accounting based on current market prices in 1989. In 1994, the nation changed from a single-year to a multi-year (five to 10 years) budget. The national budget is based on accrual accounting.

Thus, all other advanced nations have been quick to adapt to global and IT economies by reforming the financial practices of national and local government.

Toward a New Public Accounting System To Resolve the Current Deficiencies

The objective of system and legal reforms is the adoption of corporate accounting by the public sector. Since the purposes of commercial corporations and administrative bodies obviously differ, their accounting systems cannot be identical. In 1997, the Japanese Institute of Certified Public Accountants issued "Principles of Public Accounting," which proposes accounting systems for national and local government. A revised proposal followed in May 2002, with a request for comments from the public. An explanation of some of the points raised follows.

1. Balance sheets will make up for the lack of inventory data. Since local governments includes many public corporations and extra-ministerial groups (usually nonprofit organizations, subsidiaries of ministries and agencies), they would also need to be included in consolidated balance sheets.

2. Administrative cost statements will furnish cost data. They would include all revenue and expenses in the fiscal year in question, and would make it possible to evaluate the efficiency and effectiveness of administrative activities.

3. Disclosing information to the public via official bulletins and Internet announcements will provide accountability. Also needed are a freedom of information law and regulations requiring local government to disclose information, thereby affording the public the "right to know."

4. With administrative assessment, emphasizing evaluation and review, there will be genuine management. Currently, local governments are considering the adoption of NPM (New Public Management). Furthermore, the Law Governing the Assessment of Administrative Policies (the Administration Assessment Law) was enacted in June 2001 and went into force in April 2002. Japan's local governments have responded by conducting administrative assessments, which should help them reduce deficits and adjust to decentralization. As of July 2001, 37 out of 47 prefectures, including Tokyo and Mie (79%); seven out of 12 designated cities (58%), and 150 out of 3,235 cities, towns and villages (5%) have conducted such assessments. However, for administrative assessment to be meaningful, public accounting principles (including accrual accounting and double-entry bookkeeping) must be adopted. The assessments currently conducted by local government are, of course, based on modified cash accounting and single-entry bookkeeping. The formats are the same used in the private sector, but the resulting figures are far from accurate.

III.

Updating Corporate Accounting Systems To Accommodate Intellectual Property

Definition of Intellectual Property and Intellectual Assets

Nearly 40 years ago, Peter F. Drucker indicated the importance of knowledge in economic activities. In his The Age of Discontinuity (1968), Drucker described his perception of the ideal future society (the knowledge society), and knowledge workers and knowledge professions. Let us examine the role of knowledge creation, a concept that is now familiar to everyone, in the context of the law.

The WIPO (World Intellectual Property Organization), defines intellectual property as "the rights relating to: literary, artistic and scientific works; performances of performing artists, phonograms, and broadcasts; inventions in all fields of human endeavour; scientific discoveries; industrial designs; trademarks, service marks, and commercial names and designations; protection against unfair competition; and all other rights resulting from intellectual activity in the industrial, scientific, literary or artistic fields."

In today's world, more and more types of intellectual property are being targeted for legal protection. Intellectual assets, however, are a subset of intellectual property. Some of them are included in financial statements as intangible fixed assets. The spectrum of intellectual property that is entered in financial records differs from nation to nation. There is a distinct difference between intellectual property that is protected by law in accordance with a nation's industrial policy, and intellectual property that is recorded as a corporation's property in a double-entry bookkeeping system. For the knowledge and information industries to achieve the status of the national industries, intellectual property must be recorded as corporate property. Given Japan's situation, it should be in the vanguard on this issue, ahead of the U.S. and the U.K., but sadly, that is not the case.

Japanese Accounting Practices Relating to Intellectual Property

The legal definition of intellectual property in Japan is identical to that of the WIPO. But in the accounting world, intellectual property is viewed as intangible assets. Unfortunately, intangibles do not lend themselves well to corporate accounting. Whether or not they are recorded as intangible assets depends on the likelihood of their providing economic benefits in the future, the same criteria used for other types of assets. Intangibles may be recorded as assets when they are purchased from a third party, but intangible proprietary assets (assets generated through successful internal research and development) may not. The same principle applies to proprietary copyrights. Therefore, the vast majority of intellectual property is not recorded on balance sheets. Japan's accounting practices vis a vis intangible assets emulate those of the U.S. However, Japanese criteria for those assets are much more restrictive than those of the U.S., U.K., or IAS (International Accounting Standards). Now we shall look at provisions for goodwill, and research and development expenses (also intangible assets).

1. Goodwill is the appraised value of the surplus earning power possessed by a corporation, (referred to as noren in the Commercial Code). Goodwill is recorded as an asset when an acquisition for value or a merger takes place. Gifts and assets generated internally may not be recorded as assets (Article 25 of Corporate Accounting Principles).

2. According to "Accounting Standards for Research and Development Expenses" issued by the Corporate Accounting Council, research and development expenses should be entered into accounting records. In Japan, all research and development costs must be processed as expenses at the time they are incurred. The same applies to software . However, expenses involved in the production of software ordered by a third party are handled in the same way as contract work. Therefore, software is sometimes classified as an asset. Furthermore, the expenses incurred in creating product masters (prototypes of software intended for future sale), must be recorded as assets, except for research and development costs. When software for internal use is deemed likely to produce revenue or reduce costs in the future, expenses incurred in its acquisition should be recorded as assets.

Overseas trends in intellectual property strategy

1. United States
In the U.S., the FASB (Financial Accounting Standards Board), a private organization, sets accounting standards for intellectual property. Intangible assets developed by a corporation are processed as period expenses, and cannot be recorded as assets. Furthermore, the assets and liabilities of a corporation absorbed by another corporation through merger or acquisition are valuated at the current market price. Net assets exceeding the purchase price are recorded as goodwill. If the acquired assets are intangibles, they are regarded as intangible assets, whether or not a contract exists. This view makes perfect sense if the assets in question are legally defined as intangible assets. But there may also be assets with future economic benefits, equivalent to noren in Japan. This means that customer lists, outstanding orders, technology for which patents have not yet been awarded, and special-purpose databases, etc., would be recorded as intangible assets.

2. United Kingdom
One step ahead of the U.S., the U.K. allows even internally-developed intangible assets to be recorded as assets, as long as their value is computable, in transactions with third parties.

3. IAS
According to the IAS, in principle, corporations should have the right to record internally-generated intangible assets as assets.

Laying the Groundwork for the Intellectual Products of the 21st Century

In July 2002, the Strategic Council on Intellectual Property issued the "Outline for Intellectual Property Strategy." At an extraordinary session of Japan's Diet, the Basic Intellectual Property Law was enacted. However, the world has moved past the legal protection of intellectual property, and is now focusing on finding ways to incorporate it into accounting systems. For intellectual property to evolve into a mainstay of Japanese industry, we need clear-cut rules that allow accountants to record the tacit and explicit knowledge that are generated at corporations, on a daily basis, as intangible assets. The refusal to recognize internally-generated intellectual property stems from the fear that corporations will abuse the privilege by "inventing" assets and inflating their financial statements. However, all social systems ultimately rely on the morals, ethics, and character of those who run and manage them. If business owners of the 21st century cannot convert intellectual property into assets, society will not accept knowledge creation products. The human race is eminently capable of establishing professional ethics regarding intellectual property, and succeeding in the manufacture of the intellectual products of the 21st-century. And we now know what Japan needs to do to make that happen.

Further information (in Japanese)
Fudeya Isamu and Yoneda Masami, Introduction to Public Accounting and Auditing in Local Government (Gyosei, 2002).

Futamura Takaaki and Kishi Nobuhito, Accounting and Intellectual Property (Bunshun Shinsho, 2002).

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