The latest earnings reports from Japanese corporations listed on the Tokyo Stock Exchange provide a running commentary on their predicament. Reflecting a drawn-out recession, both sales and profits plunged in the year to March 1999 (fiscal 1998). On average, sales in all industries except financial services shrank about 10 percent from fiscal 1997, due notably to sluggish consumer spending, and falling prices.

In a desperate effort to stop the hemorrhage, money-losing businesses cut payrolls and took other restructuring steps. However, unable to make up for shrinking sales, they suffered an average 20 percent decline in current profits, a bellwether of profit performance in a given term. This is the second consecutive year-on-year slump in pretax profits. The consolation, however, is that although the slide in sales is likely to continue through fiscal 1999, profits are expected to rise thanks to restructuring efforts.

Nevertheless, a profit rebound aided by restructuring — which generally involves passive responses to the recession — is likely to be short-lived. If earnings are to be improved on a sustainable basis, it is essential to go beyond downsizing and develop forward-looking strategies to open up new vistas in the Japanese economy.

One thing that is particularly notable about the financial reports is that net profits plummeted nearly 50 percent from the previous year. The main reason is that many companies, still suffering from the collapse of the bubble economy, took large extraordinary losses from a range of restructuring measures, such as writing off bad debt, closing unprofitable operations and deficit-running subsidiaries, and early retirement plans that entailed huge extra payments of separation bonuses.

There is another crucial reason why Japanese companies took large special charges in fiscal 1998: new accounting rules will take effect in fiscal 1999. One major change will be a full introduction of the consolidated accounting system, whereby large companies with subsidiaries and affiliates will file financial statements on a group basis. As a result, firms effectively controlled by the parent company — in ways other than equity ownership, such as executive appointments — will also be covered.

The shift to group accounting shows that Japan has no choice but to follow the global trend. Combined financial statements give investors a more accurate picture of how corporate giants are managed. That is bound to affect the way Japanese corporations keep their books. For example, a parent company with poorly performing subsidiaries and affiliates will have to take account of their losses as well.

Japan’s large established companies have extensive networks of smaller firms under their control. In the last business year, major steel, trading and construction companies, for example, took special losses to prop up their deficit-plagued subsidiaries. Manifest in these moves was a desire to improve their overall financial health and lay the groundwork for the switch to consolidated accounting.

Traditionally, Japanese companies set up a new firm when starting a new business and, once it begins making money, absorb it into their own organization. To dress up their balance sheets they often pass on their losses to their subsidiaries. Group accounting will make it difficult to continue these practices.

Another important change is a shift to market-value accounting for equities and other securities. The current method of carrying portfolios at book (purchase) value conceals their real (market) value. The market valuation method will show their true worth in the form of holding profits or losses — that is, differences between book and market values.

The market-value principle will also affect another tradition of corporate Japan: cross-shareholding. Companies that hold each other’s equities as a way to cement their business ties will find it difficult to hold these nominal shares under market-value accounting because these shares usually yield low returns. No wonder more and more companies are moving to get rid of these long-term holdings.

Accounting rules will also be updated to give a better picture of corporate pensions — in the form of a balance sheet. With many companies beset by huge funding shortfalls, how to close the gap is a knotty question. If a company shows a large deficit in its balance sheet, its credit standing will almost certainly drop. To gain a better market rating, companies will likely step up cost-cutting efforts, including payroll cuts. That may be unavoidable to a certain extent, but restructuring without a well-focused strategy of expansion will not likely open up new business frontiers.

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