Audits of financial statements of Japanese subsidiaries

When a foreign parent company invests funds in its Japanese subsidiaries in the form of loans or capital, several tax issues are to be considered.

Regarding the ratio of capital to loan, the tax advisors will advise the following from a tax perspective: Japanese thin capitalization rules, Japanese earnings stripping rules, transfer pricing, per capita levy, size-based business tax, registration tax, the tax position of Japanese consumption tax, applicability as a small and medium-sized company for tax purposes, and other tax issues.

There are cases where tax advisors do not advise on the “necessity of audit” since they are not CPAs.

Whether a company must be audited by independent CPAs or not has a significant impact on the company. Therefore, it is important to understand the criteria under which a company must be audited.

Under what conditions must a Japanese subsidiary be audited?

It is not only listed companies that need to be audited by independent CPAs.
In the case of a Kabushiki Kaisha (KK), a stock company (*1), an audit is required under the Companies Act if the company falls under any of the following categories.

(*1) A Godo Kaisha (GK), a limited liability company, is not required to be audited.

1. Large companies (Article 328, Paragraphs 1 and 2 of the Companies Act)
2. Companies with a “Company with Committees” corporate governance system (Article 327, Paragraph 5 of the Companies Act)
3. Companies that have voluntarily appointed an external auditor in their articles of incorporation (Article 326, Paragraph 2 of the Companies Act)

A large company is defined as a joint company with a stated capital of at least 500 million yen or total liabilities of at least 20 billion yen (Article 2, Item 6 of the Companies Act).

When a foreign parent company invests funds in its Japanese subsidiaries in the form of loans or capital, the case of large companies described in 1 above should be considered.

For example, suppose a company has been advised by a tax advisor in Japan to increase the stated capital of a Japanese subsidiary to mitigate the influence of the thin capitalization rules. Suppose also that the Japanese subsidiary’s stated capital reaches at least 500 million yen. In that case, the company must be audited under the Japanese Companies Act.

The timing of when an audit will be required depends on the timing of the increase of stated capital and total liabilities.
For example, a company with stated capital of less than 500 million yen and total liabilities of less than 20 billion yen in the fiscal year that ended March 2020 may have a stated capital of more than 500 million yen on the balance sheet for the fiscal year that ended March 2021 due to a capital increase from the parent company. In this case, when the balance sheet for the fiscal year ending March 2021 is approved and reported at the annual shareholders’ meeting in June 2021, the company is determined to function as a large company from the fiscal year ending March 2022. It is therefore required to be audited under the Companies Act from the fiscal year ending March 2022 (Article 2, Item 6 and Item 24 of the Companies Act).

As the Companies Act does not distinguish between Japanese subsidiaries of foreign companies and Japanese companies, if a Japanese subsidiary falls under this category, it must be audited under the Companies Act.

In the meantime, in cases where a foreign parent company is audited in its home country, even if its Japanese subsidiary does not have to be audited under the Companies Act, the subsidiary may be audited under the direction of the auditor of the foreign parent company in order to prepare consolidated financial statements for that company. However, this is not the same as an audit under the Companies Act, which may be required as a result of a decision (e.g., capital increase of a Japanese subsidiary) made by the company.

What are the implications if a Japanese subsidiary must be audited?

Payment of audit fees

Since an audit is usually performed by several CPAs and requires a lot of person-hours, it works out as more expensive than tax compliance fees. In addition, various documents are in English, and communication in English is often required. Since there are few CPAs who are skilled in such work, the audit fees would be higher than those of Japanese companies of the same size.

Difficulty of finding an auditor

In Japanese subsidiaries, various documents are in English, and communication in English is often required. Small and medium-sized audit firms may be hesitant to take on such jobs since they are not used to working in English. If a company hires a large audit firm, the audit fee will be expensive. In addition, large audit firms may be reluctant to accept clients whose audit fees are low under the circumstances of human resource shortages and work style reform in Japan.
As a result, it may be difficult for Japanese subsidiaries to find an appropriate auditor immediately.

Heavy workload in handling audits

Although this is not limited to Japanese subsidiaries, the auditor will request that a company provide many documents and respond to the auditor’s inquiries.
In addition, the company needs to prepare for the inspection of physical assets such as cash, notes receivable, securities, and other items, and the observation of inventory counting by the auditor. The company also needs to prepare confirmation letters for transactions with financial institutions, customers, and vendors. Since an auditor will request interviews with a representative director and other key persons, the company has to prepare for them.

Advantages to being audited

There are several advantages to being audited.
It could be difficult for foreign parent companies to manage and supervise subsidiaries in other countries. Also, there are language and cultural barriers to be considered.
If a subsidiary is audited, the auditor will express an opinion from an independent standpoint on whether the financial statements are free from material misstatement. Therefore, the foreign parent company can be assured about the financial statements of the Japanese subsidiary. From the Japanese subsidiary’s perspective, the audit makes it easier for the subsidiary to convince the foreign parent company that its financial statements are presented fairly.

Audits are beneficial to strengthening corporate governance. For this reason, some Japanese subsidiaries choose to be audited even where it is not required under the Companies Act.

Having said that, it is necessary to avoid unintentionally getting into a situation where a Japanese subsidiary must be audited.

Summary

When a foreign parent company invests funds in its Japanese subsidiaries in the form of loans or capital, it is advisable to confirm whether or not an audit will be required.

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