Solution Examples Considering the Impact of Lease Accounting Standard Revisions (part 1)

1. Issue Identification

Addressing the Challenges Faced by Domestic Manufacturers Assuming a scenario where a domestic manufacturer primarily operates factories within the country and is engaged in a business segment that produces products with declining profitability due to commoditization, as well as facing challenges stemming from the aging of production facilities.

<Assumed Challenges>

- Products manufactured on a production line at a certain factory have become commoditized, and not only is the aging of buildings and equipment significant, but there is also a decline in product profit margins. It is expected that tough price competition will continue in the future, making prospects for profit margin improvement slim.

- With doubts about the recovery of future capital investment amounts, concerns are expected to arise regarding the risk of bearing the burden of equipment investment on a standalone basis.

- With the introduction of revised lease accounting standards, the on-balance-sheet treatment of right-of-use assets and lease liabilities is anticipated to lead to further increases in total assets and total liabilities. There is a presumption that there may be a need to off-balance-sheet owned assets in order to lighten the balance sheet, among other reasons.

<Direction and Benefits of Issue Resolution>

Off-Balancing Using Joint Ventures (JVs)

- To address the existing product manufacturing factory related to a low-value-added commodity business, it is proposed to spin off the factory and accept external capital representing a majority of voting rights. By doing so, it is anticipated that the consolidated balance sheet of the parent company will be lightened by removing the JV company from "factory-by-factory" consolidated subsidiaries.

- Obtaining external capital from companies in the same industry facing similar challenges will allow for shared burden of capital investment, procurement-related scale advantages, and escaping excessive price competition. This will enable stable business continuity and the fulfillment of supply responsibilities to customers.

- Each company can concentrate on investments in high-value-added businesses, contributing to enhancing corporate value through the pursuit of selection and concentration.

2. Joint Venture Formation (JV) and Asset Off-Balancing

When considering off-balancing, it is necessary to treat owned fixed assets and right-of-use assets as a single group.

<Joint Venture (JV) Formation Scheme>

It is possible to consider spinning off the existing manufacturing plants and accepting capital from external sources with a majority of voting rights to exclude them from the consolidation scope.

Case 1: 50% each ownership with other companies in the same industry (Three or more companies are also acceptable).

• Establish a 50:50 Joint Venture (JV) with a company in the same industry, where each party contributes assets or conducts business transfer/division to extract the assets and functions of the factory.
• Ensure equalization of the number of dispatched executives and jointly undertake financial debt guarantees to avoid meeting the de facto control requirements, preventing one party from taking the lead in management.
• Both companies can engage in product supply tailored to their respective customers through OEM contracts or similar agreements if necessary. Employees can be managed through secondments or transfers between the parties.
• Risks include being influenced by the business activities of the other industry players due to the nature of the JV (if the JV's profitability deteriorates, equity-method accounting losses and proportional financial burdens may be necessary). Additionally, difficulties in competition resolution during JV dissolution may arise, and attention is required for issues such as product liability attribution and intellectual property management.
• A separate JV agreement between the shareholders will be required.

Case 2-1: Majority Acquisition through Leasing, Developers, etc.

• Establish a Joint Venture (JV) through majority investment from companies in the same industry, such as leasing companies, developers, real estate firms, excluding other manufacturers.
• Separate manufacturing functions, with only the involved party handling them.
• The involved party maintains less than a majority of voting rights to apply the equity-method accounting.
• For products, if necessary, product supply can be obtained through OEM contracts or similar agreements. Employees involved in manufacturing are primarily managed through secondments or similar arrangements from the involved party.
• Risks include the ultimate decision-making authority of the JV being held by the JV partner (including the consortium) due to the majority being transferred to them.
• With the inclusion of a leasing company, leasing for buildings, facilities, etc., becomes possible, which can be advantageous for financing within the JV. This can create new business opportunities for the leasing company, and the burden of capital investment for the involved party is reduced.
• It is advisable to enter into a separate shareholder agreement.

Case 2-2: JV Formation Including Minority Investment by Third Parties

• Establish a Joint Venture (JV) through investment from companies in the same industry, such as leasing companies, developers, real estate firms, as well as third parties (trading companies, business partners, etc.). Although all parties hold less than a majority of the shares, the involved party and the third parties have a close business relationship, which may allow the involved party to take the lead.
• The manufacturing functions and related real estate are separated only by the involved party through business transfers or similar means, while the other third parties provide funds and capital. This reduces the capital investment burden on the involved party.
• For products, product supply can be obtained through OEM contracts or similar agreements as needed. Employees involved in manufacturing are primarily managed through secondments or transfers from the involved party.
• Third parties with minority investments may benefit from business-related advantages such as stable product supply, potentially limiting their return on investment.
• Additionally, there is a possibility that third parties with minority investments could serve as arbitrators in case of disputes among JV shareholders.