The Institutional Relationship Between Tax Accounting and Financial Reporting in Japan: Consideration of the Principle of the Definite Settlement of Accounts

While the purpose of financial accounting is the provision of useful information to those external, related groups who make decisions about a firm, the number of profits calculated in financial accounting is also utilized as the basis for the assessment of taxable income. In Japan, the accounting system under the Commercial Law (ASCL) is a typical financial accounting system. ASCL is closely combined with tax accounting through the principle of the definite settlement of accounts (PDSA) in Japan. PDSA requires that a firm should make the closing accounts in accordance with the Commercial Law as a basis for preparing its tax return. There have been controversies over the interactions between financial reporting and tax accounting in Japan. The main issue in these discussions has been the negative effects of PDSA on financial reporting. In particular, recently, the relation between financial reporting and tax accounting has been discussed from the viewpoint of the harmonization of international accounting in Japan. But opinions as to the most suitable relation between them vary. One of the reason for this is that the traditional normative approach cannot make clear why PDSA exists in the tax accounting system in Japan. In this paper, I consider PDSA from a different perspective, that of contract theory, instead of using the traditional normative approach. First, I show that the taxation costs, including tax collection costs, tax payment costs and political costs, influence the behaviors of both firms and the tax authorities as well as the system structures. I argue here on the supposition that a firm is a set of contracts. Secondly, I define the contents of PDSA. Thirdly, I identify the influences of the combination of PDSA and the taxation costs, and analyze the criticisms of its effects. Finally, I consider the factors that cause the existence PDSA and point out those potential problems with PDSA which have not previously been discussed.