MW-79 -- Impairment Accounting, Banks and Good News

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
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Issue No. 79
Wednesday, June 9, 2004
Tokyo

CONTENTS
@@ VIEWPOINT: Impairment Accounting, Banks and Good News

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@@ VIEWPOINT: Impairment Accounting, Banks and Good News

We had an oblique look at the banks a couple of weeks ago when considering
the implications of the current valuations of the fixed income market
here in Japan. We are going to have another look at this sorry group
of Japanese institutions again, but from a different angle. Just
as a warning, you can expect them to appear again quite regularly in
this column.

The ability of Japanese Banks to misallocate capital will become
legendary in business schools around the world in the next few years.
The initial scarring is being seen on many a bank's balance sheet with
the appearance of "deferred tax assets" showing up as a very significant
portion of each bank's Tier 1 regulatory capital. For UFJ Bank these
credits now account for 53 percent of their regulatory capital, this
from a bank that has accrued a total of $19.5 billion of losses over the
past three years.

The conundrum for these tax assets is that they are only valuable if
there is some foreseeable way that the bank can make some profit to use
the tax losses accumulated from prior years. After 3 consecutive years
of losses, is it really plausible that UFJ will be able to use these
assetsbefore they expire? You may remember that it was this very issue
that brought on the collapse of Rezona Bank when the auditor deemed
that the bank had no plausible scenario for using the tax assets
(this implies no chance of making a profit) in the future, and so
disallowed them.

Well there is a new issue on the horizon for the banks: Impairment
Accounting. I read with great interest a translation of an article
written by Jun Furukawa of Toranomon Capital, which will be published
in this month's J-RED, published by TP Publishing (see
www.transpacific.jp/publishing for subscription details). In this he
provides a very useful overview of the operation of impairment
accounting, but the more interesting angle is to consider the
ramifications of this change.

The basic operation of this is that if the expected net cash flow,
undiscounted, from a long-term asset for the useful life of the
asset (maximum 20 years) is not equal to or greater than the book
value of the asset, then the asset is subject to impairment
accounting and must be written down. The exact value to which
it is written to and how that is calculated is immaterial here,
but market value would be a reasonable approximation. As Mr.
Furukawa notes, "impairment accounting is expected to result in
the recognition of enormous losses, in particular from construction
and real estate companies and those companies that invested in
real estate during Japan's bubble era."

This is the last of the significant changes planed for Japanese
accounting to bring it more in line with international accounting
standards, but it could be the most significant. The requirement
to write down underperforming assets will have a massive effect
on a number of companies, and those that are most vulnerable will
be those most dependent on the largesse of their banks. With the
banks' Tier 1 capital already under pressure, these accounting
changes could have significant implications for all the
banks, but in particular for UFJ, where another year of losses
has to bring into question the validity of holding the deferred
tax credits as Tier 1 capital.

I will watch this unfold with great interest, but I see all these
changes as good news. Finally, corporations will be forced to
analyze their investments and other assets they hold on their balance
sheet in a rational manner for their shareholders (i.e., considering
what profit can these assets generate, rather than just believing
that owning an asset is an automatic right to capital gains. The
shakeout that I believe will result from these changes should
increase the pressure on the banks and hopefully require a few
more banks to be nationalized, further cleansing of the rot in the
system. This will release assets to those who can use them most
productively, and not necessarily those with the deepest pockets
or the best drinking relationship with their banker. The market
has the opportunity to become more rational and more transparent,
and thus capital should be allocated more efficiently.

That can only encourage our bullishness on Japan.

-- John Charles-Decourcy

================= Entrepreneur's Handbook Seminar =====================
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STAFF
Written by John Charles-Decourcy (jcd@japaninc.com)

Edited by J@pan Inc staff (editors@japaninc.com)

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