Japan's Financial Secrets Pour Out
Things have been looking grim indeed for Japanese corporations lately. Companies have just wrapped up earnings season, when annual results were published. The total announced losses, from big names such as electronics giant NEC Corp. to carmaker Nissan Motor Co., have run into the billions, far bigger than anyone imagined.
But don't think all the bad news is out of the way. Far from it. In many ways, the hardest test is yet to come. That's because the Japanese government is forcing through amendments to the securities laws that will radically change the way companies report earnings, fund their pension obligations, and value their stock portfolios. "We call it Japan's accounting Big Bang," says Tsuguoki Fujinuma, a partner at Showa Ota Ernst & Young International in Tokyo. The result could be the clearest picture yet of Japan Inc., which has long cherished its secrets. Airing the dirty linen will be good in the long run, but short-term losses revealed under the new accounting rules will be painful for companies and stockpickers alike.
PAINFUL PROCESS. The Finance Ministry, eager to restore the credibility of Japanese companies in financial markets, is phasing in these tougher accounting standards over the next several years (table). The painful cleansing process starts this fiscal year with a mandate forcing companies to consolidate their results more realistically.
Until now, parent companies only counted operations as subsidiaries if they had more than 50% ownership. In reality, big companies often controlled these small fry with far smaller stakes, moving excess employees to the affiliates instead of firing them, and often shifting unwanted losses from the parents' books to affiliates. Investors could never figure out how profitable the company's entire operations really were. Under the new rules, if the parent exercises de facto control by financing the affiliate's debt or making appointments to its board, the parent must treat the affiliate as a full-blown subsidiary.
Now, companies are owning up to controlling subsidiaries that have been hidden from investor view for years. The results can be disturbing. Japan's No. 5 auto maker, Mazda Motor Corp., recently confessed to financial analysts that the accounting change will make it much harder to sustain its comeback. Mazda must now consolidate 88 more dealers and parts suppliers onto its books as subsidiaries, many of them mired in red ink. If these struggling suppliers had been part of Mazda's accounts for the last fiscal year, then the company's reported profit of $320 million would have shriveled to $12 million. Net debt would have jumped to $6.8 billion from $4.8 billion.
Mazda isn't alone. Nissan Motor will have to include the assets and debts of roughly 100 more parts suppliers and real estate ventures as subsidiaries on its books. Kawasaki Steel Corp.'s recorded debt will increase $5 billion, after it acknowledges control of some dodgy assets. Even goliath Toyota Motor Corp. may have to include as many as 50 affiliates as subsidiaries this year. "That will lower Toyota's return on assets," says automotive analyst Takaki Nakanishi at Merrill Lynch Japan Inc. "[So] it is rapidly changing its strategy to improve return on investment." Toyota is already planning to shed plants and equipment it no longer needs in Japan's sluggish auto market.
The pressure to shape up won't stop there. Starting next year, companies will have to reveal how healthy their pension funds really are. That's a big change. At present, not much disclosure is required. The new rules will probably confirm what analysts now suspect: that companies are sitting on $661 billion in unfunded pension liabilities. That equals 20% of Japan's total market capitalization. Nissan, for example, admits it could be sitting on a $4.8 billion pension deficit.
The final change: new reporting rules on valuing the shares companies often hold in each other to reinforce business ties and the cohesion of the keiretsu. When the new regulations kick in, companies will have to report these shareholdings at their actual market value, not their historical cost. If these shares have plunged in value, then companies will have to come clean on the loss. That revelation, says Warburg Dillon Read's Timothy Marrable, will unleash an enormous selloff that will totally change the stock portfolios of Japanese companies. The big companies are already tackling the issue. "We are reexamining the necessity of our cross-shareholdings," admits Shintaro Nogi, a manager in investor relations at Toshiba Corp.
The impact of these changes will separate the winners from the losers in Japan's recovery. Twenty-four Japanese blue chips, including Sony Corp. and Honda Motor Co., already follow U.S. accounting standards. They will suffer little from the drive for greater disclosure. But an estimated one-third of listed Japanese companies that have never issued even partially consolidated accounts will have some unpleasant surprises to reveal. "The result will be further polarization within the stock market," says Kathy Matsui, strategist at Goldman Sachs (Japan) Ltd.
LASHING OUT. Little wonder that corporate behavior is changing in anticipation of these changes. Trading companies like Nissho Iwai Corp. plan to slash their networks of subsidiaries by a fifth, now that many such affiliates will be in the red. And by dropping affiliates, companies will no longer have places to send their hordes of passed-over executives. Says Ryoji Itoh, director of Bain & Co. Japan: "That era has come to an end."
Even Japan's previously compliant accountants are starting to bite back as the new rules kick in. Some are being sued for the first time for signing off on the audits of bankrupt companies. So they are lashing out and turning away high-risk clients: They don't want to be accused of papering over losses that new disclosure laws later bring to light. "Until now, accountants operated within the confines of Japan Inc. Now, we're trying to stand on our own," says Hiroshi Nakachi, chairman of the Japanese Institute of Certified Public Accountants.
Some companies are asking the government for measures to ease the pain, such as permitting companies to use cross-shareholdings in trusts to make up for their pension deficits. But there is no turning back. "Not everybody is happy about the changes," admits Hiroshi Kishimoto, a deputy director in the Financial System Planning Bureau of Japan's Ministry of Finance. "But you cannot change yourself just by closing your eyes." That's a good point. Corporate Japan needs to take a long, hard look at itself--even if what it sees isn't pretty.