How to improve usefulness of financial reporting

by Japanese local governments for better performance management

Ayako Sato, Ph.D. Candidate
The Okuma School of Public Management, Waseda University, Japan


while preparation of financial statements has progressed. which enables users to make decisions or to monitor the government. 2 . In other words. administrative and financial reform of local governments was promoted in Japan. In Japan. the monitoring and decision making cycle of internal management and citizens are intermediated by councils (Chart 1). Financial information has to be used for performance evaluation. together with personnel cost reform and public services reform. Governmental Accounting Standards Board (GASB) recognizes following groups as users of financial report: the citizenry. Then. total debt of Japanese local governments was 197. In this regard. As such. This move for reform accelerated in 2006 as Ministry of Internal Affairs and Communications (MIC) requested local governments to prepare 4 schedules of financial statementsii based on accrual accounting within the next 3 years. Financial reporting process for better performance management Purpose and users of financial reporting The purpose of financial reporting is not limited simply to release of documents. Accounting reform is an important part of such reform. Among these users. financial condition of Japanese local governments has deteriorated. The main issue of accounting reform is the implementation of accrual based financial statements. the councils monitor the internal management. which amounted to 39. given the dual representative system of Japanese local governmentsv. head and council members of local governments are elected directly by citizens. respectively. Before discussing the factors. legislative and oversight bodies. Thus. As of March 2011. In the last part. this paper focuses on three users: citizens. Consequently. This is because these users are considered to be key actors in creating the performance monitoring mechanism. Once elected. councils and internal management as principal users. As a result.9% of GDPi. the following part tries to find out the factors to improve usefulness of financial reporting by analyzing postal survey results. This was not caused only by environmental factors such as recession. specific purpose of financial reporting varies as there are many types of users in the public sector. which is critical for efficient asset and liability management and spending control. This paper aims to find out factors to improve usefulness of financial reporting so that they can be utilized for better management of local governments.Introduction Following the collapse of the bubble economy in early 1990s. key factors to improve usefulness of financial reporting will be discussed.0 trillion yen. while council members are entitled to monitor the local government management and give approval for budget and budget execution. the next part clarifies the purpose of financial reporting and what it should be utilized for. the head is responsible for preparation of the budget and budget execution draft. this paper is based on the view of decision usefulness approachiii and it defines the monitoring cycle in which users of financial reporting evaluate and give feedback for better government management as the performance monitoring mechanism. but was also caused by structural problems such as increasing social insurance cost due to aging population. this has not necessarily led to administrative reform as financial information is not used effectively. investors and creditors. and internal managementiv. as representative of citizens. Besides this big picture overview. However. 81% of cities with population over 30 thousand have prepared the required financial statements as of March 2011. Under such circumstance. reflecting the findings of the survey.

The first part is the process up to disclosure by the reporting entity and the second part is the process that leads to utilization of disclosed information by users. 3 . And the second process toward utilization of disclosed information comprises of three phases. financial reporting utilization by various users. process of financial information’s preparation towards its usage is defined as financial reporting process and is divided into two parts. To analyze the current status of financial reporting usage. disclosure of financial report which is a media that can be used by external users as first hand information (phase 3) – these three phases comprise the first process up to disclosure of information. Setting rules of financial accounting and reporting by the governing authorities (phase 1). In other words. internal management and councils. to distinguish such status. preparation of accrual based financial statements by the reporting entity (phase 2). councils and citizens are key actors in the performance monitoring mechanism. councils and citizens can create a conspired autonomic performance monitoring mechanism. distribution of information. The effect of financial reporting process is as described in Chart 1 in the Check stage of Plan-Do-Report-Check-Action process of local government management. understanding and evaluation of such information by external users (phase 5) and feedback of such evaluation to reporting entity (phase 6). These two processes are divided further into six phases. The following part examines their financial reporting usage and tries to find out the factors for improvement. where the analyzed information is provided by specialists such as analysts (phase 4). postal survey was carried out targeting two groups among principal actors. Financial reporting process To find out the factors to improve usage of financial information. it is necessary to examine the usage status of each users. In this can be said that internal management. whilst interacting closely. Chart 1 also shows that financial reporting process is not developed only for internal users but also for external users. such as internal management.

1. While this is below the figure of 86% for budget report. local government management and local councilsvi. Local government employees are expected to be important users in the financial reporting process as they are involved both as reporting entity and as internal users.186 questionnaires were sent to financial department. As for councils. of which 694 employees responded (response rate was 59%). councils and local government employees. the questionnaires were sent to the 786 chairpersons. in terms of usage of financial statements. only 18% replied they “utilize frequently” or “utilize occasionally”. 81% for budget execution report and 80% for auditors’ report. However. This figure is very low in comparison to the utilization figure of 97% for budget report and 94% for budget execution report and is very different from the result obtained from 4 . auditing department of 786 cities. Table 2 shows survey outcome from local government employees. chairpersons who replied they would “read all” or “read the summary of” accrual based financial statements comprised 72% of total. targeting two groups. Gap between the two users The result of the survey with regard to usage of finance related materials are summarized in Table 1 and 2.Chart1: Performance monitoring mechanism is created by utilizing financial reporting process Check Discussion/Evaluation by Citizens Preparation of Financial Reporting Utilization of Financial Reporting Discussion/Evaluation by Councils Phase 6 Phase 5 Phase 4 Phase 3 Phase 2 Phase 1 Feedback Understanding / Evaluation Distribution of Information Disclosure by Financial Report Preparation of Financial Setting rules Discussion/Evaluation by Internal Management Report Action Do Plan Results of postal survey – challenges and driving forces in utilizing financial report Methodology The postal survey on usage of financial statements was conducted during October and December 2010. As described in Table 1. of which 478 replied (response rate was 61%). in which perception gap is found between the two users. the figure is high enough to illustrate that there is certain interest in financial statements. accounting department.

A.A. Table 1: Survey on usage of finance related materials by chairpersons of local councils Read all Read Read summary only interested area only 42% 13% Rarely read Do not read N. Table 3: Importance of financial statements by purposes. For example. Planning / Budgeting 58% 33% 6% 0% 0% 2% Monitoring/Supervision of management 53% 37% 8% 0% 0% 2% Accountability 53% 36% 8% 0% 0% 3% 51% 38% 8% 0% 0% 3% 18% 46% 30% 1% 2% 3% Improvement of efficiency/effectiveness in finance Adjustment of generation interest gap 5 . conceived by chairpersons of councils Very important Important to some extent Neither Less important Not important N.chairpersons of local councils. Budget Report 86% 11% 1% 1% 0% 1% Budget Execution Report 72% 22% 2% 2% 1% 1% Auditors' report on budget execution 14% 35% 20% 21% 8% 1% Financial Statements 4% 14% 25% 31% 24% 2% However.A 0% 0% 0% Budget Report 44% Budget Execution Report 38% 43% 17% 1% 0% 0% Auditors' report on budget execution 63% 27% 8% 1% 0% 0% Financial Statements 36% 36% 16% 4% 0% 0% Table 2: Survey on usage of finance related materials by local government employees Utilize frequently Utilize occasionally Neither Do not use well Hardly use N. this does not simply mean that local government employees consider the information less important. as shown in Table 3 and 4. there is no large perception gap between the two users about importance of financial statements.

in order to read such statements. workload and further education has exceeded that of usefulness in promoting utilization of financial documents. On the other hand. Chart2: Challenges over utilization of financial statements recognized by local government employees Costly and laborious Lack of employees' knowledge over book keeping and management Difficulty of comparison with other local government Lack of accuracy and reliability Lack of knowledge to utilize Difficulty to link budgeting Difficulty to link performance measurement % of agreed respondent Others 0% 20% 40% 60% 80% Challenges in satisfying qualitative characteristics of financial report Besides these challenges other challenges suggested in Chart 2 are related to qualitative characteristics of financial information. effectiveness and employees' cost Adjustment of generation interest gap Challenges of cost and workload Part of this gap can be attributed to the situation of each user. the usage of financial statements means “Read the prepared statements” to understand them and evaluate. they have to prepare the statements by themselves as they are not only users. one can speculate that recognition of the cost.Table4: Importance of financial statements by purposes. In case of government employees. In this survey. In this regard. but also reporting entity. In other words. GASB vii identifies the following as qualitative characteristics of 6 . conceived by local government employees Important Important to some extent Neither Less important Not important N. 50% 40% 8% 0% 0% 2% 44% 35% 15% 3% 1% 2% 23% 44% 26% 4% 1% 2% Accountability and transparency Improvement of efficiency. 75% of local government employees considered utilization of financial statements as “costly and laborious”. for council members. The result of a survey on challenges over utilization of financial statements (Chart 2) provides in part an answer to why local government employees have not been as supportive in usage of financial statements despite the recognition over their usefulness.A.

the Pearson’s correlation is higher for financial statements at 0. all of these characteristics can be regarded as foundation for increasing understandability. As for the rest of the answers. 1992). In other words. because these characteristic are basic requirements. users need to be educated to understand the disclosed information. satisfying these characteristics is not enough to activate the usage of financial report. “Difficulty to link budgeting(38%)” and “Difficulty to link performance measurement(25%)” to relevance.345** 0. the answers such as “lack of employees’ knowledge over the double entry book-keeping and management(67%)” and ”Lack of knowledge to utilize financial statements(40%)” can be categorized as lack of understandability. other actors. reliability. As indicated in Chart report.304** 0.Pressure from an external actor Why local governments have been able to prepare financial statements despite these challenges? One can find an explanation for this in the survey questioning whom local government employees considered as influential actors for the promotion of public accounting reform. respectively.518** N=430 Driving force . in a broader sense. followed by “ Lack of accuracy and reliability(45%)” to reliability. In the following stage of utilization. Yet. 69% of employees considered “Central government (MIC)” as the top driving force for reform. Considering that the concept of understandability is broad. which was considered second driving force by 46% of employees.345) or for budget execution report (0. For example. rather than driving force of utilization. these characteristics assist the users in understanding. such as external stimulation advocated in the contingency model (Luder. In the next part. multiple efforts have to be made to compensate for the lack of understandability at each phase of financial reporting process. and comparability. which leads to sophisticated utilization of financial reporting.304). However. In Chart 2. are examined.01 Budget report Budget excution report Financial statements 0. followed by “Leadership of prefectures”. other factors. 7 . effectiveness and usage of financial documents for council chairpersons Usage of Awareness of Understandability Effectivness **p<0. Table 5: Correlation between awareness of understandability. the reporting entity is required to devise a reporting format which meets the need for comparability or relevance. more observation has to be made on other factors. consistency. at the preparation stage. The challenge of understandability can also be found in the survey of local council chairpersons.502** 0.329** 0. relevance.518 than that for budget documents (0. understandability. According to this table. “Difficulty of comparison with other local governments (49%)“ can be related in a narrow sense to comparability . On the contrary. Table 5 is a summary of correlation between “understandability” and “usage” of financial statements for chairpersons. timeliness. Consequently.317** 0.

although it was not mandatory. the answer of “useful” and “useful to some extent” was lower at 40%. This suggests the necessity of other stimulus to promote the utilization. it should also be noted that the vertical influence was not enough to promote usage of materials. no employee sees citizens as the top driving force. the current awareness level is not high enough to lead to utilization of financial reporting and there is an interesting result from the survey. higher correlation is found for financial statements than for budget documents or budget execution documents. In this table. For example. On the other hand. 1% of employees consider them as top driving force. Regarding accountability. followed by 1% as second and as third. the combined ratio of “Important” and “Important to some extent” by local government employees is high at 90%. in reaction to the question asking the importance of accountability itself. it is apparent that the vertical pressure from the authority towards municipalities was the effective driving force for preparation of financial statements. However. Although the correlation of financial statement usage and awareness of effectiveness was found for council chairpersons 8 . as for the question asking the usefulness of financial statements for accountability. However. respectively. considering the gap of preparation ratio and usage ratio of financial statements. for example. tendencies of respondents who use financial statements are analyzed. regarding councils. This implies that awareness of usefulness of financial statements can be a potential driver for better usage of financial reporting. to find out potential stimulus to promote utilization of financial statements.such as citizens or councils. followed by 5% as second and 10% as third. Chart 3 Influential actors to the promotion of public accounting reform of local governments recognized by local government employees 0% 20% 40% 60% 80% 100% Mayor Financial department 1st Planning department Reform related Council 2nd Advisory committee of local government Prefectural order 3rd Central government (MIC) Possible driving force –Awareness of financial statements usefulness In this part. Consequently. Table 5 is summary of correlation between usage of financial statements and awareness of its usefulness and understandability by council chairpersons. Similar indication is found in table 6 and 7. Similarly. are less recognized.

161** 0. This suggests that the awareness has not been sophisticated enough to utilize effectively to meet its purposes.266** Monitoring/Supervision of manegement 0. One is to have users understand the usefulness of financial reporting. Table 6: Correlation between utilization of financial statements and a of importance on purposes by local government employees Usadge of financial statements Awareness of importance on Accountability and transparency 0.166** 0. in the utilization stage. the correlation of the usage and awareness of effectiveness by purposes is not so high as shown in table 7.274** 0.165** Improvement of efficiency. Up to the phase of preparation. effectiveness and employees' cost sensitivity 0.230** 0. which includes understanding specific information of accounting.265** 0. such as how to utilize them for each purposes. Therefore.212** Adjustment of generation interest gap 0. stimulus to raise the awareness is conceived as a key to 9 .278** Improvement of efficiency/effectiveness in finance 0.316** Accountability 0.240** 0.195** 0. Usage of Budget report Budget excution report Financial statements Planning / Budgeting 0.160** Awareness of importance on Adjustment of generation intereest gap **p<0. vertical pressure from the authority is identified as exceeding the resistance of challenges and having promoted the preparation of documents.01 N=408 Table 7: Correlation between utilization of finance related documents and perception of importance on purposes by local council chairpersons.01 N=408 Discussion and conclusion The factors observed in the survey are summarized as follows.175** 0. it was found that the usage of financial reporting had correlation with the awareness of table 5. The other is to have users understand the information of the financial report. although the pressure was not strong enough to stimulate usage. Consequently. improving understandability has two important aspects. As for the utilization phase.285** 0.122 0.105** **p<0.182** 0.

workload or understandability. It is also described that single effort is not enough to satisfy the understandability and efforts have to be made both by reporting entity and by users at each steps. improvement of disclosure materials by reporting entity is needed to move to Phase 3. In this regard. Needless to say. Apart from the actor related perspective. Regarding councils’ awareness of usefulness of financial reporting. councils’ role is common to institutional investors in the aspect that they both are agents of principal user. Japanese financial institutions were behind other countries in the preparation of financial reporting in 1980s. to promote the financial reporting process from Phase 2 (preparation) to further stages (Chart 4). following the preparation phase of Phase 2. considering the technical nature of financial statements as well as the need to link such information to evaluate public services. This suggests that another external stimulus is necessary for the usage stage. It was not until early 1990s that discussion to improve usefulness of financial reporting started to take place. in the survey to government employees. However. Therefore. In this regard. in the preparation stage.overwhelm the challenges such as burden of cost. the external actor played an important role in stimulating the utilization. institutional investors in this case. the other users became aware of the usefulness and this lead to the creation of performance monitoring mechanism (Chart 1) (Sato 2011). who supports users in understanding the information by showing additional analysis or explanation. it would promote the development of financial reporting process. Lead by this trigger actor. However. The stimulus for this movement was institutional investors that acted as an external actor. Currently. As described earlier. the different nature of market and local government has to be taken into account. This is because although awareness of the usefulness is an important factor in the usage phase. additional stimulus from the authority is not an ideal candidate of external pressure. For example. it is essential that as many stakeholders such as councils and citizens participate in the process of 10 . For example. further explanation is indispensable to support user utilization of the information for evaluation. the possibility of councils acting as stimulus has to be further examined as a next step of this research. Comparatively. vertical pressure could not generate such awareness effectively. the survey showed that the improvement of understandability was key in promoting usage of financial reporting. the way to manage factors shown in the survey for the financial reporting process needs to be discussed. which comprises part of performance monitoring mechanism. release of information to public by local government in most cases means simply uploading 4 schedules of financial statements on their website. Once the awareness by external actor such as councils of usefulness of financial reporting can become stimulus to affect other users awareness through dialogue. when the preparation was lead primarily by the central government. However. it is worth noting that at the private sector where utilization of financial reporting is ahead of local governments. In this modern society where values vary. such as clients who trusted the fund to institutional investors or as citizens who elected the council member as their representative. only 30% of them answered “yes” and “yes to some extent” to the question asking whether they considered the central government to have interest in the information of local government financial statements. councils can be considered as a potential external actor to give stimulus for local governments. the survey shows positive perception as shown in Table 3. while 69% of them considered central government as the most influential actor of public accounting reform. Sato(2011) points out the necessity of intermediary information provider. in other words. For example.

2. which summarized the factors to promote or to prevent the financial reporting process.A (2011) “The significance of the Performance monitoring Function in Japanese Local Government”. To liquidate the information flow and activate the dialogue. Utilization of Financial Preparation of Reporting Financial Reporting Chart 4: Process for utilization of financial reporting Phase 6 Feedback Phase 5 Understanding / Evaluation Phase 4 Phase 3 Phase 2 Phase 1 Distribution of Information Disclosure by Financial Report Preparation of Financial Statements Setting rules Main Constituent Process End User Feedback to reporting entity for better management Understanding financial information and evaluating reporting entity by end users such as investors.M and Yamamoto.S. CIGAR-Comparative International Governmental Research 13th Biennial Conference. Preparation of Financial Report (First hand media Reporting Entity for end user) and Disclosure End User Reporting Entity Preparation of Financial Statements Governing Authority Setting rules of Financial Accounting and Reporting References American Accounting Association in (1966). “Usefulness of Accrual information in Non-mandatory Environment: the case of Japanese Local Government”.7. Intermediary Providing second stage information analyzed by Information Provider specialist such as analyst. Tokyo. Ghent (2011) Luder.77-129. Concepts Statements No. John Wiley & Sons. The Governmental Accounting Standards Board Financial Accounting Standards Board (1980) “Qualitative Characteristics of Accounting Information” Statement of Financial Accounting Concepts No. pp. Sato. DiPiazza. R. American Accounting Association. citizens. As shown in Chart 1. more research has to be made. Following this paper. Inc. (2002) Building Public Trust: The future of Corporate Reporting. regional councils. 11 . New York. Keibundo Kobayashi. and Eccles.K et al. Governmental Accounting Standards Board (1987)”Objective of Financial Reporting”. Vol.forming judgment over performance of public management. “A Statement of Basic Accounting Theory”.M. Financial Accounting Standards Board Kobayashi.1. involving as many stakeholders in the cycle of management through utilization of financial reports enables creation of a multilayered mechanism for performance measurement. K (1992) “A Contingency Model of Governmental accounting Innovations in the Political-Administrative Environment”. potential impact of interaction between a key actor and others would be examined. media. (2002) Management Accounting for the Government. Research in Governmental and Nonprofit Accounting.

cost statements. and Suda.6 trillion yen). Total debt includes local government bond (137. No.3trillion yen). vi The survey was supported by the Japan Society for the Promotion of Science (No.26. K. CIGAR-Comparative International Governmental Research 13th Biennial Conference. v Investors and creditors are expected to be an important monitor of local governments also. and Usui. GASB (1987). the monitoring function does not work effectively in Japan as municipal bond market is not as developed yet. legislative and oversight bodies.1:pp.0trillion yen). ii 4 schedules of financial statements include balance sheet. iii The approach was advocated by American Accounting Association (1966). cash flow statements and statement of net asset change based on accrual based accounting.55-66 Ssto. Among these users. A (2008) Disclosure. pp. Chuo Keizai. Representatives: Kiyoshi Yamamoto) vii Para 62-68. debt of local public enterprise bond repaid by ordinary accounts(26. and investors and creditors because these users have limited access to financial information compared to internal management. GASB identifies three groups as the primary users of external state and local governmental financial reports: the citizenry.2-71. However. GASB(1987) i 12 . Ghent (2011) Shiba. 22330136. A (2011) “How to improve usefulness of financial reporting for Japanese local government based on comparative study of public and private sector”.Journal of Urban management and Local Government Research Vol. iv Para 30.and borrowings from special accounts of local allocation tax and local transfer tax (local finance portion)(33.K.