The External Auditor System in Japan: Who Can Be Appointed? What are Their Duties and Liabilities?

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

In the governance framework of Japanese Kabushiki Kaisha (K.K., or joint-stock companies), particularly for larger entities and those with specialized governance structures, the role of the External Auditor, known as kaikei kansanin (会計監査人), is indispensable. Tasked with the independent audit of a company's financial statements, the external auditor system is a cornerstone for ensuring the reliability and transparency of corporate financial reporting, thereby protecting shareholders, creditors, and other stakeholders. This article provides a comprehensive overview of when an external auditor is required in a Japanese K.K., who qualifies for appointment, their core duties and powers, and the scope of their potential liabilities.

When is an External Auditor (Kaikei Kansanin) Required?

The Japanese Companies Act (Kaisha-hō) mandates the appointment of an external auditor for certain categories of K.K.s, recognizing the heightened public interest and stakeholder reliance on the financial information of these entities.

Mandatory Appointment for Certain K.K.s

  1. Large Companies (Taigaisha) (Article 328, paragraphs 1 and 2): As discussed in a previous article, a "Large Company" (defined by having stated capital of JPY 500 million or more, OR total liabilities of JPY 200 billion or more on its last balance sheet) must appoint an external auditor.
  2. Companies with a Nominating Committee, etc. (Shimei Iinkai tō Setchi Kaisha) (Article 327, paragraph 5): K.K.s that adopt this specialized governance model, which separates executive and oversight functions more distinctly, are required to have an external auditor.
  3. Companies with an Audit and Supervisory Committee (Kansa tō Iinkai Setchi Kaisha) (Article 327, paragraph 5): Similarly, K.K.s opting for this governance structure, where an Audit and Supervisory Committee within the board handles audit functions, must also appoint an external auditor.

Voluntary Appointment

Beyond these mandatory categories, any K.K., regardless of its size or specific governance model (unless it's one of the above where it's already mandatory), can choose to appoint an external auditor by providing for it in its articles of incorporation (teikan) (Article 326, paragraph 2). Smaller companies might voluntarily opt for an external audit to enhance their credibility with lenders, investors, or business partners.

Rationale for Mandatory Appointment

The mandatory appointment of external auditors for these specific company types is driven by several key policy considerations:

  • Protection of a Wider Range of Stakeholders: Large companies and those with specialized (often more public-facing) governance structures typically have a broader and more dispersed group of stakeholders (shareholders, creditors, employees, etc.) who rely on accurate financial information.
  • Ensuring Reliability of Financial Reporting: An independent external audit provides an objective verification of the company's financial statements, bolstering their credibility and reducing the risk of material misstatement, whether due to error or fraud.
  • Complexity of Operations: Larger companies often have more complex financial operations, making a professional audit essential.

Qualifications and Appointment of External Auditors

The Companies Act sets specific criteria for who can be appointed as an external auditor and the process for their appointment, designed to ensure competence and independence.

Who Can Be Appointed? (Article 337, paragraph 1)

An external auditor must be either:

  1. A Certified Public Accountant (kōnin kaikeishi - CPA); or
  2. An Audit Firm (kansa hōjin). An audit firm is a legal entity specifically established by CPAs for the purpose of conducting audits.

Independence Requirements (Article 337, paragraph 3)

Crucially, the external auditor must be independent of the company they audit. The Companies Act lays down several disqualification grounds to safeguard this independence. For instance, a person or entity cannot be an external auditor of a company if:

  • They are a subsidiary of the company or a director, statutory auditor, executive officer, or employee of such subsidiary.
  • The company holds a significant portion of their shares or capital contributions.
  • They have certain close business or financial relationships with the company or its management that could compromise their impartiality.
    These independence rules are fundamental to the credibility of the audit.

Appointment Process (Articles 329, 345)

  • Shareholders' Meeting Resolution: External auditors are appointed by a resolution of the shareholders' meeting, typically an ordinary resolution (Article 329, paragraph 1).
  • Role of Statutory Auditors / Audit & Supervisory Committee / Nominating Committee's Audit Committee: A key feature of the Japanese system is the involvement of the company's internal audit organ (statutory auditors, Audit & Supervisory Board, or the audit committee of a Company with Nominating Committee, etc.) in the external auditor appointment process. This internal audit organ has the authority to determine the content of proposals to be submitted to the shareholders' meeting regarding the appointment, dismissal, or non-reappointment of the external auditor (Article 344). This mechanism is designed to act as a check on management's influence over the external auditor selection, thereby reinforcing the auditor's independence.

Term of Office and Reappointment (Article 338)

  • Term: The term of office for an external auditor is one year (more precisely, until the conclusion of the annual general shareholders' meeting for the business year ending within one year from their appointment) (Article 338, paragraph 1).
  • Deemed Reappointment: An external auditor is deemed to have been reappointed at the annual general shareholders' meeting unless a resolution to the contrary (e.g., not to reappoint, or to appoint a different auditor) is passed (Article 338, paragraph 2). This "deemed reappointment" system provides for continuity unless there is a specific decision to change auditors.

Dismissal (Article 340)

  1. Dismissal by Statutory Auditors, etc.: The statutory auditors (or the Audit & Supervisory Board by unanimous consent of all its members, or the audit committee of a Company with Nominating Committee, etc.) can dismiss an external auditor if certain grounds exist, such as:
    • Breach of professional duties.
    • Conduct unbecoming of an external auditor.
    • Inability to perform duties due to mental or physical incapacitation.
      If dismissed by this internal audit organ, the fact and reason for dismissal must be reported to the first shareholders' meeting convened thereafter.
  2. Dismissal by Shareholders' Meeting: An external auditor can also be dismissed at any time by an ordinary resolution of the shareholders' meeting. A dismissed external auditor has the right to attend the shareholders' meeting where their dismissal (or non-reappointment) is proposed and state their opinion (Article 345, paragraph 1 and 4).

Duties and Powers of External Auditors

The primary role of the external auditor is to provide an independent opinion on the company's financial statements.

Primary Duty: Audit of Financial Statements (Article 396, paragraph 1)

The external auditor must audit the company's:

  • Financial Statements (Keisan Shorui): This includes the balance sheet, income statement, statement of changes in net assets, and individual notes.
  • Accompanying Detailed Schedules (Fusoku Meisaisho).
  • Extraordinary Financial Statements (Rinji Keisan Shorui), if prepared.
  • Consolidated Financial Statements (Renketsu Keisan Shorui), if the company is required to prepare them.

Based on this audit, the external auditor must prepare an audit report (kansa hōkoku), expressing their opinion on whether the financial statements fairly present the company's financial position and results of operations in accordance with generally accepted accounting principles.

Powers Necessary for Audit (Article 397)

To perform their duties effectively, external auditors are granted significant investigative powers:

  1. Access to Books and Records: They can, at any time, inspect and copy the company's accounting books and related materials, or request accounting reports from directors, accounting advisors, and employees (Article 397, paragraph 1).
  2. Investigation of Business and Assets: They can investigate the company's business operations and financial condition when necessary for their audit (Article 397, paragraph 2).
  3. Investigation of Subsidiaries: They can also investigate the affairs of the company's subsidiaries when necessary for auditing the parent company's financial statements or consolidated financial statements (Article 397, paragraph 3). This often involves requesting reports or access to the subsidiary's external auditor.

Reporting Obligations

  • Reporting Misconduct to Internal Audit Organs (Article 397, paragraph 4): If an external auditor, in the course of their duties, discovers any wrongful act by a director concerning the execution of their duties, or any material fact constituting a violation of laws or the articles of incorporation, they must report it to the statutory auditors (or the Audit & Supervisory Board or Audit & Supervisory Committee, as applicable).
  • Attendance and Opinion at Shareholders' Meetings (Article 398): The external auditor (or a designated member if it's an audit firm) has the right and, if requested, the obligation to attend shareholders' meetings where financial statements are presented. They must state their opinion if there is a discrepancy between their audit report and the financial statements, or if shareholders raise questions about the audit report.

Remuneration of External Auditors (Article 399)

The remuneration (including fees and expenses) of the external auditor is determined by the directors (or the board of directors, if applicable). However, a crucial safeguard for auditor independence is that the statutory auditors (or the Audit & Supervisory Board or Audit & Supervisory Committee) must consent to this remuneration (Article 399, paragraph 1). If the internal audit organ does not consent, the proposed remuneration cannot be paid. The directors must explain their proposal to the internal audit organ, and if consent is withheld, the reasons for withholding consent are usually discussed. This mechanism aims to prevent management from exerting undue influence over the auditor by controlling their fees (e.g., by threatening to reduce fees if the auditor issues an unfavorable report, or by offering excessively high fees to compromise independence).

Liabilities of External Auditors

External auditors are subject to significant legal liabilities for failures in their duties.

Liability to the Company (Articles 423, 427)

  1. Damages for Neglect of Duties (Article 423): If an external auditor neglects their duties (e.g., by conducting a deficient audit that fails to detect material misstatements), and the company suffers damages as a result, they are liable to compensate the company.
  2. Presumption of Negligence for False Statements in Audit Report: If there are false statements or records regarding material matters in the audit report, the external auditor is presumed to have neglected their duties (Article 427).
  3. Partial Exemption and Liability Limitation Agreements: Similar to directors and statutory auditors, the liability of external auditors to the company can be partially exempted by a special resolution of the shareholders' meeting, or by a resolution of the board of directors (or majority of directors) if authorized by the articles of incorporation and with the consent of all statutory auditors (or equivalent). Furthermore, companies can enter into liability limitation agreements with external auditors, limiting their liability for damages caused by negligence to a pre-agreed amount (not less than a statutory minimum), if authorized by the articles of incorporation.

Liability to Third Parties (Article 429)

External auditors can also be held liable to third parties (e.g., investors who relied on audited financial statements) for damages caused by false statements or records regarding material matters in their audit reports (Article 429, paragraph 2, item 2).

  • This liability is considered quite strict. The auditor can escape liability only if they can prove that they did not act with wrongful intent or gross negligence, and they exercised due care in performing their duties (the burden of proof being on the auditor for the due care aspect). This standard is often viewed as close to strict liability unless the auditor can prove they were not at fault.
  • This statutory liability under the Companies Act coexists with potential liability under other laws, such as the Financial Instruments and Exchange Act, which has its own provisions regarding liability for misstatements in securities filings.

Relationship with Statutory Auditors (Kansayaku) / Audit & Supervisory Committee

The external auditor does not operate in a vacuum. Effective corporate governance requires close coordination and a clear division of responsibilities between the external auditor and the company's internal audit organ (statutory auditors, Audit & Supervisory Board, or Audit & Supervisory Committee).

  • Oversight of External Auditor: The internal audit organ is responsible for overseeing the external auditor's work, including assessing the appropriateness of their audit methods and results.
  • Reporting Channel: As noted, external auditors have a duty to report director misconduct or significant legal/regulatory violations to the internal audit organ.
  • Collaboration: While maintaining independence, effective communication and collaboration between external and internal auditors can enhance the overall quality and efficiency of the audit process and corporate oversight.

Conclusion

The external auditor system is a vital component of corporate governance in Japan, particularly for Large Companies and those adopting specialized governance models. By providing an independent and professional examination of a company's financial statements, external auditors play a crucial role in enhancing the reliability and transparency of financial reporting. This, in turn, fosters stakeholder confidence and contributes to the overall health of the capital markets. For U.S. companies and investors interacting with Japanese K.K.s, understanding the appointment process, duties, and potential liabilities of external auditors, as well as their interplay with internal audit organs like Kansayaku, is essential for assessing corporate accountability and making informed investment or business decisions. The integrity of this audit function is paramount for the credibility of Japanese corporations in both domestic and international spheres.