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

Introduction
Following the collapse of the bubble economy in early 1990s, financial condition of Japanese local governments
has deteriorated. As of March 2011, total debt of Japanese local governments was 197.0 trillion yen, which
amounted to 39.9% of GDPi. This was not caused only by environmental factors such as recession, but was also
caused by structural problems such as increasing social insurance cost due to aging population. Under such
circumstance, administrative and financial reform of local governments was promoted in Japan. Accounting reform
is an important part of such reform, together with personnel cost reform and public services reform. The main issue
of accounting reform is the implementation of accrual based financial statements, which is critical for efficient asset
and liability management and spending control. 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. As a result, 81% of cities with population over 30 thousand
have prepared the required financial statements as of March 2011. However, while preparation of financial
statements has progressed, this has not necessarily led to administrative reform as financial information is not used
effectively.
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. Before discussing the factors, the next part clarifies the purpose of
financial reporting and what it should be utilized for. Then, the following part tries to find out the factors to
improve usefulness of financial reporting by analyzing postal survey results. In the last part, reflecting the findings
of the survey, key factors to improve usefulness of financial reporting will be discussed.

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. Financial information has to be
used for performance evaluation, which enables users to make decisions or to monitor the government. As such,
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.
Besides this big picture overview, specific purpose of financial reporting varies as there are many types of users
in the public sector. In this regard, Governmental Accounting Standards Board (GASB) recognizes following
groups as users of financial report: the citizenry, legislative and oversight bodies, investors and creditors, and
internal managementiv. Among these users, this paper focuses on three users: citizens, councils and internal
management as principal users. This is because these users are considered to be key actors in creating the
performance monitoring mechanism, given the dual representative system of Japanese local governmentsv. In Japan,
head and council members of local governments are elected directly by citizens, respectively. Once elected, the
head is responsible for preparation of the budget and budget execution draft, while council members are entitled

to monitor the local government management and give approval for budget and budget execution. Thus, the
councils monitor the internal management, as representative of citizens. In other words, the monitoring and
decision making cycle of internal management and citizens are intermediated by councils (Chart 1). Consequently,
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it can be said that internal management, councils and citizens are key actors in the performance monitoring
mechanism, whilst interacting closely.

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 paper, to distinguish such status, process of financial informations preparation towards its usage
is defined as financial reporting process and is divided into two parts. 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.
These two processes are divided further into six phases. Setting rules of financial accounting and reporting by the
governing authorities (phase 1), preparation of accrual based financial statements by the reporting entity (phase 2),
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. And the second process toward
utilization of disclosed information comprises of three phases; distribution of information, where the analyzed
information is provided by specialists such as analysts (phase 4), understanding and evaluation of such information
by external users (phase 5) and feedback of such evaluation to reporting entity (phase 6).
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. Chart 1 also shows that financial
reporting process is not developed only for internal users but also for external users. In other words, financial
reporting utilization by various users, such as internal management, councils and citizens can create a conspired
autonomic performance monitoring mechanism.
To analyze the current status of financial reporting usage, postal survey was carried out targeting two groups
among principal actors, internal management and councils. The following part examines their financial reporting
usage and tries to find out the factors for improvement.

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, targeting
two groups, local government management and local councilsvi. 1,186 questionnaires were sent to financial
department, accounting department, auditing department of 786 cities, of which 694 employees responded
(response rate was 59%). As for councils, the questionnaires were sent to the 786 chairpersons, of which 478
replied (response rate was 61%).

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,
in which perception gap is found between the two users, councils and local government employees. As
described in Table 1, chairpersons who replied they would read all or read the summary of accrual based
financial statements comprised 72% of total. While this is below the figure of 86% for budget report, 81% for
budget execution report and 80% for auditors report, the figure is high enough to illustrate that there is certain
interest in financial statements.
Table 2 shows survey outcome from local government employees. 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. However, in terms of usage of financial statements, only 18% replied they utilize
frequently or utilize occasionally. 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
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chairpersons of local councils.

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.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.A.

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, this does not simply mean that local government employees consider the information less important.
For example, as shown in Table 3 and 4, there is no large perception gap between the two users about
importance of financial statements.
Table 3: Importance of financial statements by purposes, conceived by chairpersons of councils
Very
important

Important to
some extent

Neither

Less
important

Not
important

N.A.

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

Table4: Importance of financial statements by purposes, conceived by local government employees

Important

Important to
some extent

Neither

Less
important

Not
important

N.A.

50%

40%

8%

0%

0%

2%

44%

35%

15%

3%

1%

2%

23%

44%

26%

4%

1%

2%

Accountability and transparency

Improvement of efficiency,
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. In case of government employees, in order to
read such statements, they have to prepare the statements by themselves as they are not only users, but also
reporting entity. On the other hand, for council members, the usage of financial statements means Read the
prepared statements to understand them and evaluate. 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. In this survey, 75% of
local government employees considered utilization of financial statements as costly and laborious. In other
words, one can speculate that recognition of the cost, workload and further education has exceeded that of
usefulness in promoting utilization of financial documents.
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. In this regard, GASB vii identifies the following as qualitative characteristics of
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financial report; understandability, reliability, relevance, timeliness, consistency, and comparability. In Chart 2,
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. As for the rest of the answers, Difficulty of comparison with other local governments
(49%) can be related in a narrow sense to comparability , followed by Lack of accuracy and
reliability(45%) to reliability, Difficulty to link budgeting(38%) and Difficulty to link performance
measurement(25%) to relevance, respectively. However, in a broader sense, all of these characteristics can be
regarded as foundation for increasing understandability. In other words, these characteristics assist the users in
understanding, which leads to sophisticated utilization of financial reporting.
The challenge of understandability can also be found in the survey of local council chairpersons. Table 5 is a
summary of correlation between understandability and usage of financial statements for chairpersons.
According to this table, the Pearsons correlation is higher for financial statements at 0.518 than that for
budget documents (0.345) or for budget execution report (0.304).
Considering that the concept of understandability is broad, multiple efforts have to be made to compensate
for the lack of understandability at each phase of financial reporting process. For example, at the preparation
stage, the reporting entity is required to devise a reporting format which meets the need for comparability or
relevance. In the following stage of utilization, users need to be educated to understand the disclosed
information.
Yet, satisfying these characteristics is not enough to activate the usage of financial report, because these
characteristic are basic requirements, rather than driving force of utilization. Consequently, more observation
has to be made on other factors. In the next part, other factors, such as external stimulation advocated in the
contingency model (Luder, 1992), are examined.
Table 5: Correlation between awareness of understandability, effectiveness and usage of financial
documents for council chairpersons
Usage of

Awareness of
Understandability
Effectivness
**p<0.01

Budget report

Budget excution report

Financial statements

0.345**

0.304**

0.502**

0.317**

0.329**

0.518**

N=430

Driving force - 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. As indicated in Chart 3, 69% of employees
considered Central government (MIC) as the top driving force for reform, followed by Leadership of
prefectures, which was considered second driving force by 46% of employees. On the contrary, other actors,
7

such as citizens or councils, are less recognized. For example, regarding councils, 1% of employees consider
them as top driving force, followed by 5% as second and 10% as third. Similarly, no employee sees citizens as
the top driving force, followed by 1% as second and as third, respectively. Consequently, it is apparent that the
vertical pressure from the authority towards municipalities was the effective driving force for preparation of
financial statements, although it was not mandatory. However, it should also be noted that the vertical
influence was not enough to promote usage of materials, considering the gap of preparation ratio and usage
ratio of financial statements. This suggests the necessity of other stimulus to promote the utilization.
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, to find out potential stimulus to promote utilization of financial statements, tendencies of
respondents who use financial statements are analyzed. Table 5 is summary of correlation between usage of
financial statements and awareness of its usefulness and understandability by council chairpersons. In this
table, higher correlation is found for financial statements than for budget documents or budget execution
documents. This implies that awareness of usefulness of financial statements can be a potential driver for
better usage of financial reporting. However, the current awareness level is not high enough to lead to
utilization of financial reporting and there is an interesting result from the survey. Regarding accountability,
for example, in reaction to the question asking the importance of accountability itself, the combined ratio of
Important and Important to some extent by local government employees is high at 90%. On the other
hand, as for the question asking the usefulness of financial statements for accountability, the answer of
useful and useful to some extent was lower at 40%. Similar indication is found in table 6 and 7. Although
the correlation of financial statement usage and awareness of effectiveness was found for council chairpersons
8

in table 5, the correlation of the usage and awareness of effectiveness by purposes is not so high as shown in
table 7. This suggests that the awareness has not been sophisticated enough to utilize effectively to meet its
purposes.
Consequently, improving understandability has two important aspects. One is to have users understand the
usefulness of financial reporting, such as how to utilize them for each purposes. The other is to have users
understand the information of the financial report, which includes understanding specific information of
accounting.
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

0.165**

Improvement of efficiency, effectiveness and employees' cost sensitivity

0.212**

Adjustment of generation interest gap

0.105**

**p<0.01

N=408

Table 7: Correlation between utilization of finance related documents and perception of importance on
purposes by local council chairpersons.
Usage of
Budget report

Budget excution report

Financial statements

Planning / Budgeting

0.182**

0.240**

0.266**

Monitoring/Supervision of manegement

0.161**

0.230**

0.316**

Accountability

0.166**

0.285**

0.278**

Improvement of efficiency/effectiveness in finance

0.195**

0.274**

0.265**

0.122

0.175**

0.160**

Awareness of importance on

Adjustment of generation intereest gap

**p<0.01

N=408

Discussion and conclusion

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

forming judgment over performance of public management. As shown in Chart 1, involving as many
stakeholders in the cycle of management through utilization of financial reports enables creation of a
multilayered mechanism for performance measurement.

To liquidate the information flow and activate the

dialogue, more research has to be made. Following this paper, which summarized the factors to promote or to
prevent the financial reporting process, potential impact of interaction between a key actor and others would
be examined.

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,
regional councils, citizens.
Intermediary
Providing second stage information analyzed by
Information Provider
specialist such as analyst, media.
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), A Statement of Basic Accounting Theory, American
Accounting Association.
DiPiazza,S. and Eccles, R. (2002) Building Public Trust: The future of Corporate Reporting, New York. John
Wiley & Sons, Inc.
Governmental Accounting Standards Board 1987Objective of Financial Reporting, Concepts Statements
No.1, The Governmental Accounting Standards Board
Financial Accounting Standards Board (1980) Qualitative Characteristics of Accounting

Information Statement of Financial Accounting Concepts No. 2, Financial Accounting Standards

Board

Kobayashi,M. (2002) Management Accounting for the Government, Tokyo, Keibundo

Kobayashi,M and Yamamoto,K et al. Usefulness of Accrual information in Non-mandatory Environment: the
case of Japanese Local Government, CIGAR-Comparative International Governmental Research 13th
Biennial Conference, Ghent (2011)
Luder,

(1992)

Contingency

Model

of

Governmental

accounting

Innovations

in

the

Political-Administrative Environment, Research in Governmental and Nonprofit Accounting, Vol.7,

pp.77-129.
Sato,A (2011) The significance of the Performance monitoring Function in Japanese Local Government,
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Journal of Urban management and Local Government Research Vol.26. No.1:pp.55-66

Ssto, A (2011) How to improve usefulness of financial reporting for Japanese local government based on
comparative study of public and private sector, CIGAR-Comparative International Governmental Research
13th Biennial Conference, Ghent (2011)
Shiba,K. and Suda, K, and Usui, A (2008) Disclosure, Chuo Keizai, pp.2-71.

Total debt includes local government bond (137.3trillion yen), debt of local public enterprise bond
repaid by ordinary accounts(26.0trillion yen),and borrowings from special accounts of local allocation
tax and local transfer tax (local finance portion)(33.6 trillion yen).
ii 4 schedules of financial statements include balance sheet, cost statements, cash flow statements
and statement of net asset change based on accrual based accounting.
iii The approach was advocated by American Accounting Association (1966).
iv Para 30, GASB (1987). Among these users, GASB identifies three groups as the primary users of
external state and local governmental financial reports: the citizenry, legislative and oversight
bodies, and investors and creditors because these users have limited access to financial information
compared to internal management.
v Investors and creditors are expected to be an important monitor of local governments also.
However, the monitoring function does not work effectively in Japan as municipal bond market is not
as developed yet.
vi The survey was supported by the Japan Society for the Promotion of Science (No. 22330136,
Representatives: Kiyoshi Yamamoto)
vii Para 62-68, GASB(1987)
i

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