FINANCIAL REPORTING QUALITY OF FAMILY-CONTROLLED SMALL AND MEDIUM-SIZED ENTITIES: A JAPANESE CASE STUDY

Japan has not yet adopted International Financial Reporting Standards (IFRS) for small and medium-sized entities (SMEs). Consequently, differences in accounting standards and practices prevail between large corporations and SMEs in Japan. We argue that the apparent auditor role of the National Tax Agency of Japan could drive some of the observed differences in earnings quality between large corporations and SMEs. To address this, we examine the financial reporting quality (FRQ) of Japanese SMEs and consider whether they engage in accrual- or tax/cash-based earnings management activity. We first examine the characteristics of 153 Japanese firms conforming to the European Union definition of an SME. We then consider a smaller sample of 20 firm-year observations and formulate a hypothesis regarding a particular insurance contract. We find that the FRQ of family-controlled SMEs tends to be higher if they purchase insurance with cash after forecasting their insurance payments. This is because SMEs can more easily make the decision to purchase insurance than can large corporations, plus Japan 's accounting standards for SMEs accord with the Corporation Tax Act, and therefore their current net income is their taxable income. As a result, good performing SMEs tend to choose the managerial accounting activity that allows their accounting profits to decrease as a means of reducing taxes payable.