Guidelines for Fund Managers Investing in Japan

Back to Contents of Issue: January 2002

Sometimes disclosures are only skin-deep -- insights from due diligence performed in the field.

by By Todson Page

The recent well-publicized accounting issues at Enron in which dealings with related parties resulted in massive write-downs and prior year financial restatements have left many investors with burnt fingers. The primary culprit in that fiasco was not the lack of appropriate accounting principles or disclosure guidelines, but rather their application and the subsequent independent review of that application. As corporate Japan nears the end of its first full fiscal year for reporting under the revised accounting regulations, foreign investors would be wise to take the Enron lesson to heart.

Japan has labored for years with a reputation as an opaque market for investors. Recent changes in the country's accounting standards, most of which came into effect since the start of the current fiscal year, have brought reporting and disclosure requirements, for the most part, up to par with international standards. New rules governing fair value of investments, impairments, consolidated accounting, pensions, and cash flows have all been introduced over the past two years. These guidelines represent a considerable improvement from years past. Nevertheless, as in the Enron case, standards and guidelines are only effective if they are fully and consistently applied. 

Historically, in evaluating potential investments, conversion of Japanese financial information into fair-value-based data that complies with international accounting principles was necessary. Prior to the recent changes in Japan's accounting rules, financial records were based almost exclusively on historical costs. As a result, values under Japanese accounting principles, particularly in periods of asset deflation, which have been prevalent in Japan, tended to be higher than under international accounting principles.
Areas of Continued Focus 
While the areas with the most significant valuation impacts have seen rule changes, there remain several areas where fund managers should remain vigilant. 

Consolidated financial statements are now the primary accounts filed by listed Japanese companies. Historically, Japan's parent company financial statement format allowed for considerable latitude in determining which entities to consolidate, resulting in a variety of practices that have served to mask problems of under-performing businesses and enabled off-balance-sheet "parking" of liabilities. Despite the recent changes in consolidation rules for listed companies, in the near term a rather loose application of the new criteria can be expected. 
A particularly troublesome factor in the current environment is that for non-listed companies, all of the rules outlined above and discussed herein are encouraged but not required. What this means is that if an investor company appropriately consolidates its non-listed investee companies, there is no guarantee that the figures being consolidated accurately reflect the new accounting rules.

The arrival of mark-to-market accounting for investments this year has already begun to reconfigure the financial position of many Japanese companies. Yet, these rules only apply to listed companies, and application of the new rules is likely to lack conformity for several years. 
In particular, cross-shareholdings in vendors, customers, and suppliers result in a disproportionately large amount of non-listed investment securities on the balance sheet of Japanese public companies. This presents two potential problems: (1) The fair value of these investments are not readily determinable for purposes of the "mark to market" exercise, thus resulting in no adjustment to recorded book values despite potentially steep devaluations in the underlying businesses; and (2) As discussed previously, for non-listed companies these rules are not mandatory. Thus, the danger exists that any analysis that is performed on the financial statements of those companies for valuation purposes is inherently flawed by the fact that the new accounting rules have not been applied.

Receivables are an area where, regardless of accounting rule changes, underlying business practices and procedures still have a long way to go to meet international standards. After years of government-subsidized financing and cross-shareholding relationships, credit discipline can be hard to find in Japan. Front-end credit- check policies that were loosely defined to begin with are also loosely applied. Bad-debt provisions are treated as a mathematical exercise rather than as an objective analysis of borrowers' financial viability. Identification of specific customer accounts requiring reserves is rare, with write-offs occurring only after bankruptcy or dissolution of the customer. When analyzing potential investments, good old-fashioned warning indicators such as increasing Days Sales Outstanding should be taken to heart.

Inventory provisions in Japan seldom address core issues such as excess or obsolete products, aged stocks, or inventory held throughout the distribution channel. The use of inventory turns and/or agings as a management tool is not widespread outside of global giants such as Sony or NEC. 
In a recent due diligence involving a component parts manufacturer and distributor in an industry subject to constant technological change, inventories (on-hand plus in-channel) represented on average 15 years' worth of supply, with no inventory provisions recorded. Management of the closely held company maintained that such levels assured availability to end customers, while acknowledging that newly released products presented a "marketing challenge." The short message here is that trends of increasing inventory should be considered with a level of skepticism. 

Off-balance-sheet liabilities and commitments present a huge challenge in Japan, where contractual arrangements are more likely to follow legal form than economic substance. More troubling still are the countless varieties of undocumented commitments that, although lacking contractual substance, may be practically binding due to custom and past practice. These "oral commitments of support" for investee company loans, often in excess of the investment amount itself, are not uncommon and can be quite significant. Aside from commentary to the effect that certain guarantees of investee-financing exists, no detail analysis of these support arrangements is typically included in the financials or related disclosures.
When performing diligence, this area requires a thorough, firsthand analysis of all documented arrangements, coupled with detailed discussions with management and sales and operations personnel who can shed light on the true nature of particular arrangements. From an outside investor perspective, where such a review is not possible, a thorough reading of financial statement footnotes for clues to the existence of contingent liabilities is a must. Descriptions of guarantees with no related quantification should be treated with extreme caution. 

Pension schemes and Japan's new accounting and disclosure requirements have been receiving considerable attention. The level of underfunding of pension liabilities can be extreme, with recent estimates of a total around $800 billion. 
While the rules have in fact changed, the application of those rules has yet to become consistent. Further exacerbating the situation, contributions to tax-qualified pension plans are often based on the assumption of returns of 3% to 5.5%, whereas actual returns can be as low as 1.5%. Investors would be wise to allow for a period of adjustment over the next 12 to 18 months as companies fine-tune their treatment of these significant liabilities. At a minimum, don't assume that a lump sum charge in the first period after adoption of the new rules marks the end of the problem. As with all things new, it takes time to work out the bugs in the system.
On the topic of under-funded liabilities, investors should note that from April 1, 2002, regulatory changes will require companies to maintain a minimum level of funding for their defined benefit pension plans.
Opportunities for the Vigilant
The recent changes to Japanese accounting and disclosure rules are but one in a series of positive steps currently being taken in Japan's march towards financial transparency. As in the Enron case, it is the application rather than the letter of the guidelines that is important. The process of fine-tuning that application should not be expected to occur swiftly or decisively. Yet, for those investors who exercise prudence and care in analyzing Japanese financial statements, the near-term opportunities could be significant. ii

Todson Page is a Partner with PricewaterhouseCoopers in Tokyo, specializing in mergers and acquisitions

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