Legal Framework for Financial Settlement Procedures under Japanese Corporate Law

In Japan, the financial settlement conducted by joint-stock companies at the end of each fiscal year is not merely an accounting task. It is a series of legal procedures strictly defined under the Japanese Companies Act. These procedures form the backbone of corporate governance, designed to accurately grasp the financial position and profit and loss of a company, and to ensure transparency in management for stakeholders such as shareholders and creditors. This article systematically explains the overall picture of the legal procedures involved in this financial settlement, grounded in the specific provisions of the Japanese Companies Act. Specifically, we will follow the entire process, starting from the obligation to prepare financial documents, through audits by statutory auditors or accounting auditors, approval by the board of directors and the shareholders’ meeting, to the final disclosure of information to stakeholders. Correctly understanding and complying with the legal requirements at each stage is essential for maintaining corporate compliance and reducing the legal risks for individual directors.

Overview of Financial Settlement Procedures Under Japanese Corporate Law

The financial settlement procedures defined by Japanese Corporate Law mark the end of each fiscal year (accounting period) with the conclusion of the regular shareholders’ meeting (usually held within three months after the end of the fiscal year), forming an annual series of processes. This process consists of the following four major legal stages:

1. Preparation: Corporations must prepare documents each fiscal year to represent their financial position and management performance. This is a fundamental obligation stipulated in Article 435 of the Japanese Corporate Law.
2. Audit: The prepared documents are subject to checks by auditing bodies such as statutory auditors or accounting auditors, depending on the company’s organizational design. This audit is an important process to ensure the reliability of the documents and is based on Article 436 of the Japanese Corporate Law.
3. Approval: Documents that have passed the audit are first approved by the board of directors and then receive final approval from the shareholders at the regular shareholders’ meeting or are reported to them. This approval process is regulated by Articles 436 and 438 of the Japanese Corporate Law.
4. Disclosure: The financial statements confirmed at the shareholders’ meeting are publicly disclosed (announced) in the manner prescribed by law and are also made available at the company’s principal office for inspection by shareholders and creditors. This is an obligation based on Articles 440 and 442 of the Japanese Corporate Law.

Day-to-day accounting tasks such as recording transactions in the books and making adjusting entries for financial settlements are prerequisites for carrying out these legal procedures. However, this article will focus not on the specific methods of accounting treatment but on the legal procedures themselves as required by the Corporate Law of Japan.

Mandatory Financial Documents Under Japanese Corporate Law

Article 435, Paragraph 2 of the Japanese Companies Act mandates that joint-stock companies must prepare specific financial documents and business reports, along with their accompanying detailed statements, for each fiscal year. Collectively referred to as “financial documents, etc.,” these records serve as the foundation for presenting the financial condition and management status of the company to stakeholders.

Legally required documents include the following:

Financial Documents

Defined by Article 59, Paragraph 1 of the Japanese Corporate Accounting Regulations, the financial documents consist of the following four items:

• Balance Sheet: A document that shows the state of the company’s assets, liabilities, and net assets at the end of the fiscal year, clarifying the financial position.
• Profit and Loss Statement: A document that contrasts revenues and expenses over a fiscal year to show profit or loss, clarifying the operating results.
• Statement of Changes in Shareholders’ Equity: A document that illustrates how the net assets section of the balance sheet has changed during the fiscal year.
• Notes to Financial Statements: A document that supplements the content of the above financial documents by detailing significant accounting policies and noteworthy items.

Business Report

While financial documents primarily provide financial information, the business report explains in narrative form important matters related to the company’s business activities, the status of officers, the status of shares, and other current conditions of the company.

Supplementary Detailed Statements

Documents that provide more detailed information on important matters supplementing the content of the financial documents and business report.

Although the Japanese Companies Act does not explicitly specify who is responsible for the preparation of these documents, it is generally understood that the representative director, who is in charge of the company’s business execution, bears this responsibility.

Audit of Financial Documents Under Japanese Corporate Law

Article 436 of the Japanese Companies Act stipulates that financial documents must be audited by an auditor or an accounting auditor before being approved by the board of directors or the shareholders’ meeting. This audit is an extremely important process that verifies the appropriateness of the documents from an independent perspective, separate from the management. Depending on the size and type of the company, Japanese corporate law provides for two types of auditing bodies.

Corporate Auditors

Corporate auditors are internal organs of the company, and their primary duty is to audit whether the execution of duties by the directors complies with laws and the company’s articles of incorporation. In the settlement process, they particularly audit the “legality” of the business report and its accompanying detailed statements to ensure they accurately represent the company’s situation.

Accounting Auditors

On the other hand, accounting auditors must be certified public accountants or audit corporations, independent external professionals. The installation of accounting auditors is mandatory for large companies (stock companies with capital of 500 million yen or more or total liabilities of 20 billion yen or more). Their duty is specialized in auditing the “appropriateness” of the financial documents and their accompanying detailed statements against professional accounting standards.

The Relationship Between the Two Types of Auditing Bodies

These two audits are not duplicative but rather play complementary roles. While corporate auditors oversee the legality of the directors’ overall business execution, accounting auditors verify the reliability of the financial statements’ figures from a professional standpoint. This dual-check system is one of the key features of corporate governance in Japan. After completing their audits, both corporate auditors and accounting auditors prepare an audit report (or an accounting audit report for accounting auditors) that includes their findings and opinions, which they then notify to the directors. This audit report serves as a prerequisite for the subsequent approval procedures.

Approval by the Board of Directors and the General Shareholders’ Meeting

Financial statements that have undergone an audit are finalized as the company’s official financial results through a two-tiered approval process by the Board of Directors and the General Shareholders’ Meeting.

First, directors who have received the audit report must submit the financial statements to the Board of Directors for approval. This is a requirement set forth in Article 436, Paragraph 3 of the Japanese Companies Act.

After approval by the Board of Directors, the directors then submit or provide the approved financial statements to the annual General Shareholders’ Meeting (Japanese Companies Act, Article 438, Paragraph 1). The procedures here are divided into two patterns: the principle and the exception.

As a principle, under Article 438, Paragraph 2 of the Japanese Companies Act, the financial statements must receive an approval resolution from the annual General Shareholders’ Meeting. For the business report, it is sufficient to simply report its contents to the General Shareholders’ Meeting.

However, for companies with an accounting auditor, an important exception is provided for in Article 439 of the Japanese Companies Act. If all of the following requirements are met, approval by the General Shareholders’ Meeting is not necessary for the financial statements, and a report by the directors alone is sufficient:

1. The accounting auditor’s audit report expresses an unqualified opinion.
2. There is no opinion in the audit report of the auditor (or Audit & Supervisory Board, etc.) that the method or result of the accounting auditor’s audit is inappropriate.

This exception indicates that the Japanese Companies Act places significant trust in the “seal of approval” from an independent external expert, the accounting auditor. When high-quality external audits are conducted and the accuracy of the financial statements is assured, the legislative intent is to streamline corporate governance by eliminating the cumbersome approval process at the General Shareholders’ Meeting.

The term “unqualified opinion” refers to one type of audit opinion expressed by an accounting auditor. There are mainly four types of audit opinions, and their content is directly linked to the company’s credibility:

• Unqualified Opinion: Expressed when the financial statements are judged to be fairly presented in all material respects, representing the best evaluation.
• Qualified Opinion: Expressed when there are some inappropriate matters, but their impact is limited and the overall fairness is not compromised.
• Adverse Opinion: Expressed when the financial statements are judged not to be fairly presented overall, with significant misrepresentations.
• Disclaimer of Opinion: Expressed when significant audit procedures could not be performed and sufficient evidence could not be obtained to form a basis for an opinion.

The following table summarizes the relationship between these principles and exceptions.

Disclosure of Information to Stakeholders

The financial statements approved or reported at the general shareholders’ meeting are not to be kept solely within the company. Japanese Corporate Law establishes two major disclosure obligations to protect stakeholders such as shareholders and creditors.

Provision and Inspection

Article 442 of the Japanese Corporate Law obligates stock companies to keep finalized financial documents, business reports, and audit reports at their head office for a period of five years from a certain time before the regular general shareholders’ meeting. Shareholders and creditors can request to inspect these documents or obtain copies during the company’s business hours at any time.

This right to request inspection is not merely a formal guarantee of transparency. It is an active tool for stakeholders to protect their rights. For example, creditors can exercise this right to investigate the financial status of their business partners and strategize for debt collection. For shareholders, it becomes a crucial means to monitor the management’s execution of business and to investigate if there is any suspicion of misconduct.

Importantly, when requesting to inspect these financial documents, shareholders and creditors are not required to disclose their reasons. This contrasts with the inspection of the actual accounting books, which requires a legitimate reason for exercising the right, such as for investigative purposes. If a company unjustifiably refuses this inspection request, its directors may be subject to an administrative fine of up to one million yen under Article 976, Paragraph 4 of the Japanese Corporate Law.

Financial Statements Public Notice

Another disclosure obligation is the public notice of financial statements. Article 440 of the Japanese Corporate Law mandates that stock companies must promptly announce their balance sheets (and income statements for large companies) after the conclusion of the regular general shareholders’ meeting. Public notice means disseminating information widely to the general public.

The company will announce in one of the following ways as stipulated in its articles of incorporation:

1. Official Gazette: An official publication issued by the government of Japan. It has the advantage of being relatively inexpensive, and only a summary of the balance sheet and other documents is required for the notice.
2. Daily Newspapers: Daily newspapers that publish current affairs. Like the Official Gazette, a summary is sufficient, but the cost of publication is very high.
3. Electronic Public Notice: Posting on the company’s website or similar platforms. It may be possible to keep costs low, but the full text must be posted, and it must be continuously available for five years from the date of the conclusion of the regular general shareholders’ meeting.

If a company fails to make the financial statements public notice, its directors may also be subject to an administrative fine of up to one million yen under Article 976, Paragraph 2 of the Japanese Corporate Law.

The personalityistics of each public notice method are as follows:

Legal Consequences of Procedural Violations: Lessons from the Daiwa Bank Shareholder Representative Lawsuit

When directors violate the provisions of the Japanese Companies Act related to financial reporting procedures, they become subject to administrative fines. However, the legal consequences do not end there. If procedural deficiencies are indicative of more serious management issues, directors may face the risk of being held personally liable for substantial damages.

The most emblematic lesson comes from the Osaka District Court’s decision on September 20, 2000 (Heisei 12), regarding the Daiwa Bank shareholder representative lawsuit. In this case, employees at Daiwa Bank’s (at the time) New York branch caused a massive loss of approximately 1.1 billion dollars through off-the-books transactions. What compounded the issue was that after the management became aware of this fact, they failed to report to the U.S. financial authorities and engaged in an organized cover-up. As a result, Daiwa Bank was criminally prosecuted in the United States, fined a staggering 340 million dollars, and ordered to exit the U.S. market.

The judgment rendered in this case was groundbreaking in the history of Japanese corporate governance. The court clarified that directors have a duty to establish and operate an internal control system as part of their duty of care as prudent managers, to manage risks within the company and ensure compliance with laws and regulations.

The series of financial reporting procedures discussed in this article, namely, the creation of proper financial documents, audits from an independent standpoint, and a rigorous approval process by the board of directors or equivalent, are at the very core of this internal control system. The directors of Daiwa Bank were found to have not only neglected to establish an internal control system to prevent and detect fraudulent transactions but also decisively breached their duties through illegal acts of cover-up after the problem was discovered. The result was not merely an administrative fine but a severe order for the directors to personally pay damages totaling over 800 million dollars.

This case illustrates that financial reporting procedures are not mere clerical work. They are a litmus test for determining whether directors are properly governing the company. Minor procedural flaws can serve as evidence of a more fundamental breach of the directors’ duty of care, potentially leading to devastating personal liability.

Summary

The financial settlement procedures defined by the Japanese Companies Act, from the preparation of financial documents to auditing, approval, and disclosure, constitute a meticulously designed legal framework to ensure the financial health and management transparency of corporations. This is an obligation that all joint-stock companies must adhere to and is an essential element of a company’s internal control system. Faithfully executing each procedure in accordance with legal statutes is fundamental to gaining the trust of stakeholders such as shareholders, creditors, and business partners, and forms the foundation for sustainable corporate growth. As demonstrated by the case of Daiwa Bank, compliance with these procedures also serves as a minimum line of defense for directors to avoid their legal responsibilities and protect themselves from serious business risks.

Monolith Law Office has a wealth of experience in providing services related to the Japanese Companies Act, including the financial settlement procedures discussed in this article, to numerous clients within Japan. Our firm employs several English-speaking attorneys with foreign legal qualifications, enabling us to offer comprehensive support from a specialized perspective to clients conducting international business, ensuring they comply with Japan’s complex legal regulations and manage legal risks appropriately. If you require expert assistance in establishing a compliance system for financial settlement procedures or advice on the legal obligations of directors, please do not hesitate to consult with us.