MW-40 -- Five-Percent Yields in Japan?

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 40
Thursday, August 21, 2003

++ Viewpoint: Five-Percent Yields in Japan?

The Bottom Line:
Top-Down: Improving Accounting Visibility to Foster Efficiency
o On the surface, Japan's sweeping accounting system reforms
that started in the late 1990s are nearing completion as the
Diet moves to pass a revision to the certified public
accountant (CPA) law.

o However, some of the Liberal Democratic Party痴 old guard and
its coalition partners want to turn back the clock on
accounting rules and plan to introduce a bill to do just than.
The plan calls for an effective suspension of fair-value
accounting rules, allowing companies to opt out of fair-value
accounting for long-term shareholdings and present these
shares at acquisition cost. The coalition also wants to delay
by two years the scheduled mandatory adoption of asset
impairment accounting rules.

o The most important aspect of the changes in auditing standards
is that auditors are now required to evaluate the viability of
businesses instead of simply checking their compliance with
the accounting rules (and then being pressured to bend how the
rules are applied).

o While the accounting Big Bang so far in Japan has had a
significant impact on reported earnings and even the solvency
of some companies, rule changes still in the pipeline --
including asset impairment accounting, those notorious
deferred tax assets (DTAs), pooling-of-interest accounting for
mergers and the discussion at the International Accounting
Standard Board of mark-to-market for life insurers -- could
still have substantial impact on reported Japanese profits
over the next few years.

Bottom-Up: Five-Percent Yields
o Japan's budding real estate investment trust (REIT) market,
launched with much fanfare in September 2001, has languished,
just as US REITs did in their first few years. Recent changes
in: a) the investment environment for domestic institutions,
which are desperately searching for better yields; b) changes
in the treatment of REIT dividends in FY2003; and c) relaxed
restrictions on investment trust holdings of both domestic and
foreign REITs certainly are positive factors in promoting
further growth of the secondary market for REITs in Japan.

o The number of issues (only six) and limited shares available
(only just over 1 million) still make the budding market
difficult for full-fledged participation by institutions, but
the investment vehicles have shown they can produce 5-percent
yields in a country where interest rates have been effectively
at zero for the last five years. The REIT market in Japan may
just be approaching the critical take-off stage.

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++ Viewpoint: Five-Percent Yields in Japan?

On the surface, Japan's sweeping accounting system reforms that
started in the late 1990s are nearing completion as the Diet moves to
pass a revision to the certified public accountant (CPA) law.

These changes included the introduction of consolidated accounting in
1997, cash flow statements, R&D accounting, retirement-benefit
accounting and tax-effect accounting in 1998, and accounting for
financial instruments (including fair-value accounting) in 1999.

An independent body for accounting standards, the Financial Accounting
Standards Foundation, was inaugurated in July 2001. Auditing standards
were completely reviewed and revised within fiscal 2002, including the
auditing of going concerns, adoption of a risk approach, enhancement
of fraud detection, a quality control practice review and a CPA
Investigation and Examination Board (CIEB).

Critics of stricter accounting disclosure requirements argue that new
accounting standards are making corporate financial statements look
much worse than they really are. They also maintain that booking
stockholdings at market value and recognizing pension liabilities --
both of which were foreign accounting concepts to Japanese firms until
a decade ago ・ are further damaging businesses' bottom lines.

In fact, some of the Liberal Democratic Party痴 old guard and their
coalition partners want to turn back the clock on accounting rules and
plan to introduce a bill to do just than. The plan calls for an
effective suspension of fair-value accounting rules, allowing
companies to opt out of fair-value accounting for long-term
shareholdings and present these shares at acquisition cost. The
coalition also wants to delay by two years the scheduled mandatory
adoption of asset-impairment accounting rules.

Politicians may be genuinely concerned about how the accounting
reforms affect the financial standings of many corporations, but this
does not justify their intervention in the way accounting rules are
applied. There is no denying that valuation losses on securities
holdings, accounting for substantial underfunding of future pension
benefit obligations and restructuring charges have cause large swings
in reported net income.

The rule changes, aimed at bringing Japanese accounting standards
(JGAAP) more in line with international accounting standards, came
during a period of economic turmoil and brought to the fore many
deep-rooted problems with the Japanese style of financial management,
notably the widespread habit of hiding losses. But they are also
serving as an accelerator for reform.

In terms of completely harmonizing JGAAP with international accounting
standards, however, a survey conducted earlier this year by a number
of major accounting firms around the world revealed that only three
countries -- Japan, Saudi Arabia and Iceland -- do not plan to
integrate their accounting standards into an international standard.

The most important aspect of the changes in auditing standards is that
auditors are now required to evaluate the viability of businesses
instead of simply checking their compliance with the accounting rules
(and then being pressured to bend how the rules are applied). This
places a greater responsibility with auditors and demands that they be
more independent and work to a higher standard underpinned by solid
professional ethics.

Amid the surge of business failures, fear of shareholder lawsuits is
also making Japanese audit service professionals increasingly
defensive, and terminating contracts with suspect clients is a growing
trend among large auditing firms.

Following the Sarbanes-Oxley Act in the US, corporate scandals in
Japan, and more recently, the effective nationalization of Resona
Holdings (Code: 8308), the role of the CPA in corporate governance has
visibly expanded. CPAs in Japan have in the past been criticized for
their lenient stance in corporate auditing, but a stricter attitude by
the Financial Services Agency and more stringent accounting rules have
led to tightening audits and more accountability for auditors.

More than one year has passed since the Financial Accounting Standards
Foundation (FASF) of Japan began operating. The Business Accounting
Council of the Financial Services Agency, heretofore the point agency
for accounting policies, will soon end its lead role in working out
accounting standards and ostensibly pass the baton to the new entity.
But the number of businesses that have actually signed up with the
FASF is less than half the original target, and member companies have
been reluctant to pay the 200,000 yen annual membership fee. Whether
the FASF can gain the trust of the capital markets appears to depend
on its accelerated efforts to seek speedy solutions to thorny
accounting problems.

Slow start for the FASF notwithstanding, the planned amendments to the
CPA Law include a clearer definition of the accountant's
responsibilities, a ban on auditors continuously serving the same
company and restrictions on the ability of auditing firms to supply
non-auditing services for the companies they audit. Changes to the
certification system for accountants are aimed at increasing the
number of certified public accountants to about 50,000, up from the
current number of only 15,000.

The Global Standard -- A Moving Target
While the proposed revisions current in the Diet are supposed to
complete the makeover of the nation's bookkeeping regime, there will
still remain a host of issues that must be addressed in the future,
partly because the accounting rule changes occurring on a global scale
are a moving target. The government has been slow to respond to steps
taken in the US to crack down on corporate fraud and the European
Union plan to introduce international accounting standards fully in
2005. In addition, one of the elements crucial for ensuring that the
accounting system works effectively -- namely powerful market
watchdogs with broad enforcement authority like the Securities and
Exchange Commission in the US -- is weak in Japan. Currently, the FSA
is the closest equivalent and is negotiating with US authorities to
give Japanese companies, auditors and lawyers quarter in complying the
strict provisions of the Sarbanes-Oxley Act.

Among the remaining issues are recognition of losses for impairment in
the value of assets held for long periods such as land, buildings and
machinery. More adequate accounting rules to cope with corporate
mergers and the comprehensive income concept, which involves the
inclusion of market values of assets and liabilities in the profit and
loss account, will also have to be dealt with. The internal audit
function and corporate governance in general at Japanese firms is also
under the microscope following the Sarbanes-Oxley provisions. Here's a
closer look at the issues accountants face:

l. Impairment accounting is due in fiscal 2005, but the old guard
politicians want to delay it another two years. One notable feature of
remaining accounting standards changes is that most of them concern
the evaluation of land. The overall value of Japan's land was 1,450
yen at the end of 2001, including 350 trillion yen worth of land owned
by companies, according to the latest national economic accounting
report. Any significant re-evaluation of the value of landholdings
could undoubtedly have a huge impact on the economy and, of course, on
the reported asset values of individual companies, including the value
of their factories, office buildings for rent, golf courses,
headquarters buildings and goodwill. Politicians and corporations are
resisting the new rule because recognition of asset impairment and
the resulting losses will further push profits down, at least over the
short term.

2. Deferred tax accounting in Japan calls for calculating the sum of
DTAs based on the revenue a company is expected to earn in the years
to come and assumes the firm can get a refund of some of its past tax
payments. To assess the amount of these assets, accountants need to be
able to correctly project a company's future income. If accountants
overlook optimistic company forecasts and a company subsequently goes
under, the auditors then possibly face a lawsuit filed by

Currently, earnings are forecast in five- or 10-year timeframes to
calculate DTA figures for the current year's balance sheet. Pension
obligation accounting, for example, is used as one reference point,
while the asset impairment accounting for fixed assets, due to be
introduced in fiscal 2005, is another. The FSA, however, would like to
see auditors use three-year-forward earnings forecasts to determine
the appropriate level of DTAs for the major banks. Indeed, one
manifestation of toughening audit standards was the controversial
Resona Bank case. Resona was not the only, but certainly the most
visible, firm that was driven to post losses due to tougher auditor
standards on DTAs.

Companies like Resona and Mitsui Mining slid into negative net worth
following the recalculation of their DTAs. The treatment of DTAs has
been one of the major sticking points in the ongoing debate about
banking-sector reform.

3. A draft released by the FSA痴 Business Accounting Council calls for
the adoption of the purchase method of accounting for business
combinations starting in April 2006. This will be a big change because
pooling-of-interests is still the mainstream method of accounting for
business mergers in Japan. Japan currently lacks clear-cut accounting
standards for business combinations, leaving companies to decide on a
case-by-case basis, often based on tax and Commercial Code

Under pooling, the surviving firm gets the assets and liabilities of
the target company at existing book value, which means any latent
losses or gains remain hidden. Unrealized gains (on securities
holdings and property) had long been a source of hidden wealth for
Japanese companies, a form of savings for a rainy day.

Pooling is popular in Japan because it prevents having to reveal
latent losses. Moreover, it helps perpetuate the "merger of equals"
myth that Japanese companies find so convenient as it helps avoid
potential opposition from employees and clients. Under the purchase
method, companies will have to show that a combination is truly a
merger of equals. The shareholding percentages in the combined entity,
for example, would have to be within about 5 percentage points of a
50-50 split between the acquirer and the acquired firm. Effective
control of the combined firm, as signaled by the division of board
seats and other factors, would also have to be shared equally.

The FSA痴 Business Accounting Council is now soliciting feedback on
the exposure draft until September 3. The council hopes to have a
final set of standards as early as the end of this year.

4. The International Accounting Standards Board (IASB) is considering
mark-to-market accounting for life insurance policies, and this has
the Japanese (as well as foreign) life insurers concerned. Currently,
Japanese life insurers set aside reserves for future payouts, but
under current accounting rules, they can assume that they will earn
enough of a return on their investments to meet their guaranteed
yields for policyholders and provide reserves based on this
assumptions. Market-price accounting, however, would require them to
base the provisions on market interest rates. Market rates lower than
the guaranteed returns would lead to a shortage of reserves.
Conversely, market rates higher than guaranteed yields would produce
excessive reserves. Moreover, life insurers would need to book the gap
as losses or profits each year during terms of life insurance
contracts generally continuing for 20-30 years.

Under mark-to-market accounting policies, profits at the life insurers
could swing by a margin of trillions of yen. Some life insurers could,
as a result, suddenly fall into the red. But the standards recommended
by the IASB have no binding power, and only the European Union has
stated so far that it would adopt mark-to-market accounting.

5. In the first major overhaul of hospital accounting in 20 years, the
Ministry of Health, Labor and Welfare is pushing to introduce a new
unified set of accounting rules for public and private hospitals in
fiscal 2004. The hope is that these accounting standards will make
them more efficient, and work to defray soaring medical costs. The new
accounting standards from medical institutions ostensibly will
incorporate many of the reforms made in corporate accounting standards
in the 1990s.

6. In an effort to enhance transparency and avoid wasteful spending of
tax revenues, the Finance Ministry wants to make government accounting
standards as strict as corporate accounting standards in the private
sector. The ministry will direct other ministries and agencies to
produce consolidated financial statements that will include the
public-sector companies under their sponsorship as early as fiscal

The ministry is also focusing on the special-account budgets, an area
in which control of profits and losses is considered to be
particularly lax. It will adopt fair-value accounting standards in the
formation of special-account financial statements, requiring the
accounts to book reserves covering potential losses on loans, for
example. The Fiscal System Council, an advisory body to the finance
minister, unveiled a report recently on governmental accounting in
which it recommends that ministries and agencies produce annual
financial statements that reflect flow and stock information.

With the accounting information now provided, it is virtually
impossible to grasp how annual profits and losses affect the assets
and liabilities of individual ministries and agencies, for example, or
how funds flow from the general-account budget to the special accounts
and from there to various public-sector corporations as part of the
government's fiscal investment and loan program.

These financial statements are also expected to make it easier to
evaluate the effectiveness of policies because it will be possible to
compare performance across ministries and agencies in such areas as
cost-cutting or asset losses. It will also be easier to uncover cases
in which public-sector corporations in seemingly sound financial
condition are receiving huge subsidies through the special-account
budgets. The big sticking point, however, is how to allocate the
roughly 500 trillion yen in long-term debt issued by the government.

Bottom-Up: Those Five-Percent Yields
One of the first casualties of the US economic downturn was yields on
fixed income products and time savings accounts, which plummeted as
the US Federal Reserve lowered interest rates to levels not seen in 40
years. Japan on the other hand, has been the land of non-existent
fixed-income and time-savings yields essentially for the past 10
years. Quoting interest rates to potential savers in Japan must get
embarrassing. Quotes should be in basis points instead of percentage
points. Interest rates on demand deposits are 0.001 percent. On 3-year
time deposits it is 0.04 percent, and on 5-year bank debentures it is
0.102 percent. The yield on the 10-year Japanese government bonds was
until fairly recently less than 0.50 percent.

To say that Japanese investors are hungry for yields is an
understatement. Non-existent yields on fixed income investments, and,
over the past three years, massive losses on equities, has domestic
institutions searching for alternatives -- in the form of
"alternative" investments. In fact, the amount of money being
allocated to alternative investments in conservative Japan continues
to increase, especially after corporate pension funds have returned
that portion of their pension assets that had been managed under the
welfare pension program.

While still very tentative and almost negligible compared to the total
pool of pension fund assets in Japan, alternative investments,
including hedge funds, private equity and commodities such as gold and
REITs have been attracting increasing interest. In the initial stages,
the actual money that was put to work appears to be mainly going into
private equity and hedge fund "funds-of-funds."

The Government Pension Investment Fund (GPIF) has set up an
alternative investment allocation of some 15 billion yen, mainly to be
invested in North American private equity. Corporate pension funds
such as those at Toyota and KDDI have also set up allocations for
alternative investments, while Norin Chukin reportedly has allocated
funds for alternative investments in the range of 300-500 billion yen.

Japan Alternative Investments, an affiliate of Mitsui & Co., estimates
that the total Japanese investment pool for alternative investments is
approaching 2 trillion yen. This money is just as likely to go into
overseas investments as it is into domestic investments. This search
for returns by pension funds will also likely be channeled into major
corporate restructuring through funds designed like Ripplewood
Holdings and increasingly into REITs.

The GPIF says it would like to raise its exposure to alternative
investments to 2 percent. If 2 percent of the entire 210 trillion yen
pool of Japanese pension funds were to be funneled through such
channels, the amount of pension funds in so-called alternative
investments could easily rise to over 4 trillion yen, with the entire
amount of Japanese funds in alternative investments rising to above 10
trillion yen. All that is needed are more success stories. Some
corporate pension funds are aiming for as much as a 10-percent
exposure to alternative investments over the next two years.

Japan's Budding REIT Market
When Japan launched its first real estate investment trusts in
September 2001, the concept was that ownership of lots of prestigious
office towers would be bundled together into special investment
vehicles whose shares would be traded on the Tokyo Stock Exchange. All
rent and other income after expenses would be paid to the REIT and
passed on to shareholders. Wooed by rich and steady dividend payments
and the chance that this A-1 real estate would appreciate in value,
investors would flood into REITs, halting an 11-year, 80-percent slide
in commercial land prices.

It didn't exactly work that way, at least so far. But whatever
skeptics may say, Japan's REITs do have their selling points. The
government and the private sector are promoting the REIT market
because it is a proven way to recycle capital into real estate, which
keeps the property market liquid and vibrant. And the returns can be
good. In fact, they offer unheard of levels of yield in
zero-interest-rate Japan.

REITs, are helping real estate developers to reform their business
structure by enabling them to handle projects without having to
purchase any property. In addition, financial institutions have
recently become more accommodating in lending negotiations with such

A cut in the tax rate for REIT dividends in fiscal 2003 also gave a
boost to the market. In addition, real estate developers are altering
their business model from one in which they own buildings and earn
rents to one in which they receive fees by planning real estate
developments and managing buildings, in the belief that deflation,
which is damaging to property owners, is here to stay. An active REIT
market is therefore a prerequisite for further dividing the real
estate sector between owners and managers of property.

The six listed REITs in Japan all finished their annual reporting by
the end of June, with each reporting annualized yields of around 5
percent. The Quick REIT index is now up some 18 percent from a low in
February of this year. Trading values are also improving to around 1.0
billion per day on average. When these funds were first inaugurated,
investor response was mixed. Some believed that REITs would help pave
the way for a massive transfer of funds tied up in real estate into
the capital markets, while others suspected that they would be no more
than a boondoggle, with poorly performing property portfolios.

But recent investment trust (mutual fund) liberalization in Japan now
allows funds-of-funds to freely invest in REITs, including overseas
REITs. The more flexible attitude by the Investment Trust Association
in Japan may have been motivated by pressure from the US. The National
Association of Real Estate Investment Trusts (NAREIT), a US
organization, had been lobbying for the treatment of REITs as
equities, thereby exempting REITs from Japanese restrictions that
allow them to account for up to only 5 percent of a mutual fund's net
assets. NAREIT, of course, was hoping the liberalization would draw
more Japanese money into US REITs.

But this may be the break that Japan痴 REIT market needed. Market
participants and Japan痴 media still talk cautiously of the prospects
for Japan痴 REIT market, as they are fearful that a rush of
increasingly lower-quality issues would essentially kill the budding
market. In addition, some criticize the Investment Trust Association's
recent liberalized rules as not being prudent in also requiring proper
disclosure for the funds-of-funds broadening their exposure to both
domestic and international REITs.

The problem for institutions is that the number of outstanding shares
for the Japanese REITs is limited, at just 1,028,000 outstanding
shares for all six listed REITs, which trade between 220,000 yen and
650,000 yen per share. Consequently, domestic brokerage firms have
been mainly pushing these investments to individual investors. As the
charts of individual REITs show, the performance of Japan's listed
REITs has been good. While there was some consolidation in the second
quarter of 2003, these REITs returned 30-40 percent from September of
2002 to May 2003 highs.

-- Darrel Whitten

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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