Reference no: EM131069502

Resona, the Auditor, and Japan's Banking Industry
Concept

An auditor must consider company and industry background before accepting an audit client Story

"Auditors shouldn't be allowed to act like God," said Hideyuki Aizawa, a senior member of Japan's major political party the LDP. "Resona should be the first and last time this happens." Mr. Aizawa's comments came in reaction to the government's decision to inject Y2,000 billion ($17 billion, £10.4 billion) into Resona after auditors found that Japan's fifth largest bank was badly undercapitalized. (Pilling 2003)
The Resona filing was the first-ever test of emergency assistance under the Deposit Insurance Law. Resona had already received around Y1,000bn ($8.5bn) from the government in two previous rounds of fund injections.

Auditor Says No

Shin Nihon, one of Japan's Big Four accounting firms, in effect forced Resona to seek government help by refusing to accept the bank's estimate of how much deferred tax assets it should be allowed to include as capital. This was after co-auditor Asahi & Co refused to sign off on the banks accounts. Shin Nihon's move stunned the Japanese business community, which had been accustomed to more lenient treatment from auditors.

Troubles at Resona

Resona Bank was created after the integration of Daiwa Bank and Asahi Bank, and began operating March 3, 2003. Neither bank wanted to merge, but both were forced to do so by the combined efforts of the Ministry of Finance and the Financial Services Agency, which were overseeing the consolidation of Japan's banking industry from 13 large lenders to five mega-lenders. (Ibison 2003)
Resona admitted that its capital-adequacy ratio (i.e. its capital divided by its assets, weighted by risk) had fallen to around 2 percent, half the required minimum for domestic banks that do not have international operations
Resona's Tier 1 capital comprised 70 percent deferred tax assets (DTAs) according to Moody's Investors Service, the credit rating company.

This compares with about 40 percent at Japan's four other largest banks - Mizuho, SMFG, MTFG and UFJ - and is enormous compared with US regulations, which limit banks to using DTAs of just 10 percent of their capital
Deferred tax assets are generated through the losses from taxable bad-loan write-offs by entities such as banks. The losses can be set off against future taxable income. Since the tax burden on the bank is effectively reduced, the deferred amount is counted toward the entity's shareholders' equity

Combined with the dual pressures of a more strict calculation of its non-performing loans and exposure to a declining stock market, the circumstances for Resona's bailout were created. Their solvency was also affected by participation in government development schemes.
Japan's Banking Industry in Early 2004

Resona is an example of the problems that are occurring in the Japanese banking industry. Other major banks staved off a crisis in March 2003 by procuring more than 2 trillion yen in capital from the government, but by year end 2003, they still needed to bolster their capital bases.

At that time Japan's seven biggest banks held around Y6,510 billion ($60.5 billion) as deferred tax assets. Mizuho Holdings held over Y1,500 billion in net deferred tax assets - accounting for over 41 percent of its tier 1 capital - even though it reduced them by 22 percent in March and December 2003. Bank of Mitsubishi-Tokyo Group and Sumitomo Trust Bank have made similar-sized efforts to reduce their deferred tax assets, which at the beginning of 2004 accounted for 30 percent and 26 percent of their tier 1 capital, respectively. Mitsui-Sumitomo Banking Group, Mitsui Trust and UFJ Holdings made virtually no effort to reduce their deferred tax asset levels, cutting them by just single-digit percentage amounts. The most worrying in early 2004 was Mitsui Trust, with deferred tax assets accounting for 77 percent of its capital.

Discussion Questions
¦ If Shin Nihon will not audit Resona in 2004, what concerns would a replacement auditor have?
¦ What kind of industry risks would be encountered by audit firms wishing to audit a Japanese bank in 2004?