Takashi Yamaguchi, English Speaking Japanese Tax Accountant

For whom financial statements be prepared?

A Japanese stock company (Kabushiki Kaisha or KK) will prepare financial statements each year when the business year ends.
The financial statements will be finalized upon approval by the general shareholders meeting, then the company will file tax returns based on the finalized financial statements.
I am sure quite a few people are under the impression that financial statements are prepared for tax return filing.
But the financial statements are not necessary only for tax return filings.
Rather, I am under the impression that the financial statements are “diverted” for tax purposes.

Merchants’ commitment

From a small private company to listed companies, all KKs need to prepare accounting books (Article 432 Para 1 of the Companies Act), and based on it, the financial statements (balance sheet, income statement, etc.) and supplementary statements (Article 435 Para 2 of the Companies Act).
The same rules apply to the Membership Company (companies without shares, i.e., Limited Liability Company, Limited Partnership Company, General Partnership Company) (Article 615, 617 of the Companies Act).
However, the content of the financial statements is simplified (Article 617 Para 2 of the Companies Act, Article 71 Para 1 Item 1 of the Rules of Corporate Accounting)such as the preparation of the income statement is not mandatory.
“Merchants” such as individual business operators must also prepare commercial books (accounting books and balance sheet) (Article 19 Para 2 of the Commercial Code).
In the end, anyone doing business is obliged by the law to prepare accounting books and financial statements regardless of corporations or individuals.

So, why do the Companies Act and the Commercial Code mandate to prepare accounting books and financial statements?
The financial statements are indeed useful for corporate executives to look back on their own management results.
However, the law seems to oblige merchants to prepare their financial statements for a different purpose.

For investors

First of all it is for shareholders and other equity investors.
Financial statements are tools that report on how the company used the money (capital) contributed from the company owner and how much profit or loss had been made as a result of it.
Looking at the report, shareholders make their decision, i.e., approval or disapproval of the agenda at the general shareholders meeting, withdrawal of investment selling shares, or making further investment believing the future of the company.

The financial statements of KK are submitted to the annual general shareholders meeting and are ultimately finalized upon approval by shareholders (Article 438 of the Companies Act).
This is to let the shareholders check the financial condition (use of capital) and profit and loss (result of investing capital).
By the way, approval at the shareholders’ meeting is unnecessary for the financial statements audited by Financial Auditor (Certified Public Accountant) (Article 439 of the Companies Act) assuming that there should be no mistake in the financial statements audited by CPAs who is a professional in financial audit and there should be no problem if check by the shareholders is omitted.
Therefore, at the general shareholders’ meeting of “Company with Financial Auditor” like a listed company, the financial statements are mere “report” to shareholders, and it is not a “proposal” subjecting to the shareholders’ approval.
That said, there are cases of like Toshiba and Olympus, so it is becoming common sense that audit by Financial Auditor should not be taken as absolutely reliable.
It would be impossible for an amateur to find out a financial dressing even professionals overlooked (rather structured so as not to understand), so general shareholders would not be able to help in any event.

As for the Membership Company, there is no procedure like “general shareholders meeting” of the company because equity investor and management of the Membership Company are integrated therefore there is no need for running the company’s business getting approval from the investor.
Accordingly, although the management of the Membership Company is obliged to prepare the financial statements, it is not necessary to obtain approval by the equity investor.
However, since the equity investor of the Membership Company has the right to review the financial statements (Article 618 of the Company Act), you can always check the financial statements any time you want.

For creditors

Secondary, it is for creditors such as business partners and financial institutions.
A creditor can request the company to review the financial statements at any time within the business hours of the company (Article 442 para 3 of the Companies Act).

As the company continues its business, it will be to purchase goods on credit from business partners or borrow business funds from financial institutions.
For creditors entering business relationships based on the company’s credit in this way, the company’s solvency is a major concern.
Because it is expected that the recent financial statements will provide the creditors with information for their analysis whether there is no concern from default risk point of view, the company is able to maintain solvency with current profitability etc., the Companies Act is also trying to secure transactions by allowing creditors to review the financial statements.

A major company has an internal process “credit screening” to review solvency of its business counter party.
In that case, you would not be able to start trading unless you clear this process.
It is usual that this credit screening is regularly carried out not only for new customers but also for on-going business partners.
No matter how much you can build a good and intimate relationship with a sales representative at your business partner, the transaction may be terminated if you cannot pass the credit screening, so you should cooperate with this screening process.
Therefore, even if your business partner does not explicitly exercise the “review right” under the Companies Act, you would better to submit your company’s financial statements if he/she just ask you to do so.
If your business partner is a large company, it may have a team such as “Research Division” or “Credit Research Department”, etc., dedicated to credit screening.
They do discreet analysis based on your financial statements for past several years and business projection for next several years then judge if you are qualified as a business partner for them.
They assume that you have prepared proper financial statements in accordance with the Companies Act and they are readily available.
So excuse like “Sorry I don’t have them as I couldn’t afford the time to prepare them a couple years ago” never work for them.
The future business projection should be realistic one based on past business result and it will be subject to consistency check with past financial statements.
Especially, financial institution’s credit screening is quite intensive.
They will refuse the transaction without mercy unless the analysis result of your financial statements has reached their internal standards even if you are trusted by other business partners or have good business prospects.
Recently, some banks leave the credit screening to AI (Artificial Intelligence) and become to emphasize “visible figures” more and more.

Incidentally, even if you were able to pass the credit screening with a dressing of your financial statements, you may be accused of criminal offense.
The CEO of “Hare-no-hi” (Yokohama city), a Kimono sales and rental company collapsed in January 2018, was arrested by Kanagawa prefectural police for fraudulent financial statements.
If he is prosecuted and guilty, he will receive a maximum of 10 years imprisonment (Article 246 of the Penal Code).
You should never attempt.

Besides, you may have to submit accounting books for lawsuit at the order of the court (Article 434, 619 of the Companies Act).
You should retain record in line with the truth for such event.

For tax filing?

Neither the Companies Act nor the Commercial Code has provision relevant to “tax return filing”, but the tax laws provide tax base calculation on the assumption that financial statements are prepared by corporate taxpayers.
In particular, the Corporation Tax Law stipulates that taxable income shall be calculated according to “accounting standard generally accepted as fair and reasonable” (Corporation Tax Law Article 22 Para 4).
For tax purpose, the financial statements prepared in accordance with the provisions of the Companies Act (including the Rules of corporate accounting and Business Accounting Standards) are regarded as being prepared according to “accounting standard generally accepted as fair and reasonable”.
However, there are several provisions that do not allow using financial accounting outcome intact for tax purpose.
So it is rather unusual that the profit amount on the income statement prepared in accordance with the Companies Act is directly used as taxable income for tax return purpose.
Nevertheless, the fact that the foundation of the tax return is the financial statements based on the Companies Act remains the same.
A final return of the corporation tax should be filed with certain documents such as balance sheet and income statement (CTL Article 74 Para 3), and statements of gross receipts and necessary expenses related to real estate income, business income, and forest income should be attached to a final return of individual income tax (Income Tax Law Article 120 Para 6) must be attached.
It is because of this attachment obligation that it is said that the financial statements are required for tax returns.
Although it is certainly necessary to attach the financial statements to the final tax returns, it is only a means for the tax office to confirm that the taxable income is calculated based on the financial statements prepared in accordance with the Companies Act etc.
The calculation of the taxable income for individual income tax does not rely on the “standard” as much as the corporation tax.
However, as for the “business income” of the individual business operator that is obliged to prepare the commercial books under the Commercial Code, the tax return forms are designed on the premise of posting amounts from the commercial books.
In addition, taxpayers who prepare books properly are entitled to tax incentive (“blue tax return special deduction” that can reduce taxable income by up to 650,000 yen) .

Currently, a tax return of consumption tax is also prepared based on accounting books (Ledger System).
In light of the purpose of the consumption tax imposed transaction by transaction basis, it is probably because “books” that record transaction individually are more suitable for the tax base calculation than “financial statements” that comprehensively report transaction results.

The intention of the tax laws having taxpayers to prepare tax returns based on the financial statements is to facilitate tax audit.
Based on the uniform rule, it would be easy to judge what is IN or OUT and easy to convince taxpayers with “generally fair and reasonable” rules (accepted as common sense by many people) if they need to argue.

It is hard for the tax law to independently establish “generally fair and reasonable” rules, so the laws diverted the rules for financial accounting.


To the last, the purpose the financial statements is for the sake of stakeholders of the company such as shareholders and creditors, not for tax returns.
However, since you can not file final tax returns without the financial statements, you can say that you substantially prepare them for tax return purposes.

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