Labor Audit Guide for Foreign Companies Planning an IPO in Japan: Why Preparation Should Begin in the N-3 Fiscal Year

For foreign and foreign-affiliated companies planning an IPO in Japan, establishing a labor management framework that complies with Japanese labor laws is a critical management priority.

During the IPO preparation and review process in Japan, companies are expected not only to have appropriate internal rules, such as work rules, in place, but also to demonstrate that matters such as working hours, wages, and labor-management agreements are properly managed and implemented in practice.

Particular attention should be paid to issues such as unpaid wages, improper classification of managerial or supervisory employees, and violations of Article 36 Agreements governing overtime and holiday work. If such issues are discovered late in the IPO process, companies may face additional costs and, depending on the corrective actions required, may need to reconsider their listing timetable.

Companies planning an IPO in Japan should therefore work backward from the listing application year, or “N year,” and begin their labor audit at an early stage. This article explains why labor audits should ideally begin in the N-3 fiscal year and outlines the practical steps foreign executives should consider in the lead-up to an IPO.

1. Why Should a Labor Audit Begin in the N-3 Fiscal Year?

In Japanese IPO practice, the fiscal year in which a company applies for listing is sometimes referred to as the “N year.” The preceding fiscal years are referred to as N-1, N-2, and N-3, respectively.

Ideally, a labor audit should begin around the N-3 fiscal year. This is because identifying issues is only the first step in the process. Companies also need sufficient time to implement corrective measures and establish a track record of compliant operations before submitting their listing application.

Actual Operations Matter, Not Just Policies

During the listing review process, it is not enough for a company simply to have appropriate work rules, Article 36 Agreements, and other policies in place. The review also considers whether these rules are being properly implemented in practice.

For example, documents submitted during the application process may require the company to explain matters such as average monthly overtime hours by department and the occurrence of unpaid wages, covering the most recent year as well as the fiscal year in which the application is made.

Simply revising policies immediately before filing the listing application is not sufficient. Ideally, major corrective actions should be completed by the beginning of the N-1 fiscal year so that the company can demonstrate an adequate track record of compliant operations.

System Changes Take Time

Formal amendments to work rules or employment agreements may, in some cases, be completed relatively quickly.

Changes to compensation structures, employment conditions, or time and attendance management, however, can require considerably more time. In addition to designing the new framework, companies may need to communicate the changes to employees, obtain necessary consent or agreement, and establish new operational procedures.

To complete major corrective measures during the N-2 fiscal year and begin building a track record from N-1, it is important to identify potential issues as early as N-3.

Companies may also be asked to provide information covering the preceding three years on matters such as inspections by the Labor Standards Inspection Office and disciplinary actions. N-3 should therefore be viewed not merely as a preparation period, but also as a period that may fall within the scope of the listing review.

2. What Foreign Companies Should Understand About Labor Management in Japan's IPO Review Process

Foreign companies should recognize that “having received no findings from a government authority” is not necessarily the same as “having a labor management framework that is adequate for an IPO review.”

Japan's Labor Standards Inspection Offices are government bodies responsible for overseeing compliance with the Labor Standards Act and other applicable laws. An IPO review, by contrast, examines whether the company has established systems capable of maintaining appropriate labor management as a listed company. This includes reviewing policies and procedures, actual operations, and the company's response to past issues.

For overtime work, for example, it is important not only to execute and file an Article 36 Agreement but also to monitor overtime trends by department and implement measures to prevent excessive working hours.

Similarly, if unpaid wages have occurred in the past, the company should be prepared to explain not only the amount involved but also the cause, the status of settlement, and measures implemented to prevent recurrence.

3. Labor Compliance Timeline from N-3 to the Listing Application

A labor audit is not a one-time exercise. The process should generally proceed through an initial audit, corrective action, establishment of a compliant operating track record, and a final follow-up audit.

The key is to identify issues in N-3, implement major corrective measures during N-2, and build a demonstrable record of compliant operations from N-1 onward.

4. Five Steps in an N-3 Labor Audit

Step 1: Collect Relevant Documents

Collect work rules, compensation regulations, employment agreements, employee rosters, payroll ledgers, attendance records, Article 36 Agreements, social insurance documentation, and any correction recommendations or guidance notices issued by a Labor Standards Inspection Office.

Step 2: Assess Legal Compliance

Review the collected materials for compliance with Japanese labor laws and regulations. In areas subject to frequent legislative amendments, the company should also verify whether it has complied with the applicable requirements from each relevant effective date.

Step 3: Review Actual Operations

The audit should go beyond written documentation and confirm whether policies are followed in day-to-day operations. Where appropriate, attendance records should be reconciled against objective records such as PC logs and building access records.

Step 4: Assess Risks and Financial Impact

Evaluate potential violations of law and their possible impact on the IPO review. Where issues may have a financial impact, such as unpaid wages, an estimated liability should be calculated as necessary.

Step 5: Develop a Remediation Plan

Prioritize issues based on urgency, difficulty of remediation, and the IPO timetable. Matters such as compensation structures and work rules that may require employee communication and a transition to new arrangements should be addressed particularly early.

5. Key Labor and Employment Matters Reviewed in a Japanese IPO

Taking an initial listing application for the Growth Market as an example, companies should pay particular attention to the following labor and employment matters:

Foreign companies should exercise caution when applying global job titles and HR frameworks directly to their Japanese operations.

For example, an employee does not qualify as a “managerial or supervisory employee” under Japan's Labor Standards Act merely because their internal title is “Manager” or “Director.” The determination must be made based on factors such as the employee's actual duties and authority, working arrangements, degree of discretion, and compensation and other treatment.

6. Five Key Risks to Review in a Labor Audit

1. Accurate Tracking of Working Hours

Companies need a system that enables them to accurately determine actual working hours rather than relying solely on employees' self-reporting.

The audit should examine whether there are significant discrepancies between attendance records and objective data such as PC logs or building access records, and whether matters such as work performed before the recorded start time or unrecorded working time during scheduled breaks are properly handled.

2. Proper Management of Article 36 Agreements

In Japan, when employees are required to work beyond statutory working hours or on statutory holidays, an Article 36 Agreement must, in principle, be concluded between labor and management and filed with the relevant Labor Standards Inspection Office.

An audit should verify that agreements have been properly executed and filed for each workplace, employee representatives have been appropriately selected, agreed overtime limits are observed, and appropriate records are maintained when special extension clauses are invoked.

3. Classification of Managerial or Supervisory Employees

In Japan, internal corporate titles and the status of a “managerial or supervisory employee” under the Labor Standards Act are separate concepts.

Classification should not be based on job titles alone. Factors such as the employee's relationship to management, duties and authority, discretion over working hours, and overall treatment must be assessed comprehensively.

Incorrectly treating an employee as managerial or supervisory may result in unpaid statutory premium wages for overtime and holiday work.

4. Fixed Overtime Allowance Arrangements

Where a company uses a fixed overtime allowance arrangement, the audit should confirm that the allowance is clearly distinguished from ordinary wages and that the terms of the arrangement are clearly defined. It should also verify that any statutory premium wages exceeding the fixed overtime allowance are paid separately.

Simply having such a scheme in place is not sufficient. The company must calculate the amounts based on actual working hours and operate the scheme appropriately.

5. Unpaid Wages

Unpaid wages can arise not only from payroll calculation errors but also from a range of underlying issues, including inadequate working-hour management, incorrect classification of managerial or supervisory employees, and improper operation of fixed overtime allowance arrangements.

If unpaid wages are identified, the company should determine the affected employees, relevant period, amount, and underlying cause, and then consider the necessary settlement and measures to prevent recurrence.

Other areas that may fall within the scope of a labor audit include annual paid leave, social insurance, occupational health and safety, statutory employment records, worker classification of independent contractors, and the management of foreign employees.

7. Remediation and Historical Liabilities

If issues are identified during the initial audit, major corrective measures should ideally be completed during the N-2 fiscal year.

When changing compensation structures or time and attendance systems, companies must consider not only system design but also employee communications, necessary internal procedures, and the transition to the new operating model.

Where unpaid wages are identified, historical liabilities should be settled in parallel with improvements designed to prevent future recurrence. This may include not only current employees but also former employees who worked for the company during the relevant period.

When making such settlements, companies should document the relevant period, calculation methodology, payment amount, and process followed. Depending on the circumstances, it may also be appropriate to prepare acknowledgments of receipt or settlement agreements for documentation purposes.

8. Document the Track Record After Remediation

For IPO purposes, it is not enough to demonstrate that a problem has been corrected. The company should also be able to show that the corrected state has been maintained over time.

Companies should therefore continuously maintain records such as:

• Monthly working hours
• Compliance with Article 36 Agreements and records of special extension clauses being invoked
• Use of annual paid leave
• Results of comparisons between attendance records and objective working-time records

Even when operations are compliant in practice, it can be difficult to demonstrate this objectively during an IPO review if adequate records have not been maintained.

9. Conduct a Final Labor Audit in the N-1 Fiscal Year

Around the N-1 fiscal year, companies are advised to conduct a final follow-up labor audit to confirm that corrective measures implemented following the initial audit have become firmly embedded in actual operations.

This audit should review post-remediation operating records, identify any unresolved matters, and confirm the consistency and accuracy of data to be used in the listing application.

Another important consideration is compliance with amendments to Japanese labor laws. IPO preparation typically takes several years, and a system that was compliant at the time of the N-3 audit may require further changes due to subsequent legislative amendments.

10. Business Risks of Starting a Labor Audit Too Late

If significant issues are discovered during the N-1 fiscal year or immediately before the listing application, the company may have to implement system changes, settle unpaid wages, and communicate with employees within a very limited period.

This may leave insufficient time to establish an adequate track record of compliant operations. Depending on the nature of the issues and the status of remediation, the company may also need to reconsider its IPO timetable.

Rapid system changes can place a substantial burden not only on HR and labor teams but also on senior management, finance teams, and line managers.

For foreign companies, changes to Japanese HR and employment practices may also require approval and coordination between the Japanese entity and overseas headquarters. Identifying Japan-specific labor risks at an early stage is therefore particularly important.

11. Benefits of Engaging a Japanese Labor and Social Security Attorney

A Labor and Social Security Attorney, or Shakai Hoken Romushi (“Sharoshi”), is a nationally licensed professional in Japan specializing in labor and social insurance laws and HR and labor management.

A labor audit conducted as part of IPO preparation needs to examine not only documents such as work rules and labor-management agreements but also actual operations, including time and attendance management and payroll processing.

A Labor and Social Security Attorney with IPO support experience can not only identify potential issues but also provide ongoing assistance with the remediation process, including revisions to work rules and compensation regulations, improvements to attendance management, reassessment of managerial or supervisory employee classifications, and responses to unpaid wage issues.

Although an external labor audit is not itself a mandatory requirement under applicable laws or stock exchange rules, in practice, a lead managing securities company may request an audit by an external specialist during the IPO process.

When selecting an advisor, companies should therefore consider not only their knowledge of Japanese labor law but also their experience supporting Japanese IPOs and their ability to assist with post-audit remediation.

12. Frequently Asked Questions

Q. If we cannot begin in N-3, will it be difficult to complete an IPO in Japan?

N-3 is a practical guideline rather than an absolute requirement. Starting in N-2 does not automatically make an IPO more difficult.

However, if significant issues are identified, time will be required to implement corrective measures, settle historical liabilities, and establish a subsequent track record of compliant operations. If preparations have started later than planned, the priority should be to assess the current situation as soon as possible and address issues according to their level of urgency.

Q. Can our internal HR team conduct the labor audit?

Yes. A labor audit can be conducted internally.

However, it requires broad expertise in areas such as Japanese labor laws and regulations, payroll processing, and time and attendance management. It can also be difficult for a company to objectively evaluate systems that it has designed and operated itself.

For companies preparing for an IPO, it may therefore be advisable to consider an independent review by an external specialist with relevant IPO support experience.

13. IPO Labor Audit Support in Japan from RSM Shiodome Partners

RSM Shiodome Partners provides comprehensive labor audit support for companies planning an IPO in Japan, covering the entire process from the initial labor audit and remediation through the establishment of an operating track record, final follow-up audit, and responses to questions during the listing application process.

We assist companies with Japan-specific labor and employment issues, including revisions to work rules and compensation regulations, reviews of fixed overtime allowance arrangements and managerial or supervisory employee classifications, and the resolution of historical unpaid wage issues.

We can also work in coordination with certified public accountants, tax accountants, and attorneys within our group, allowing labor audits to proceed alongside financial, tax, and legal due diligence.

For foreign and foreign-affiliated companies planning an IPO in Japan, labor compliance should not be treated as an issue to address immediately before listing. It should form an integral part of IPO preparation from an early stage.

Using the N-3 fiscal year as a practical benchmark for assessing the company's current position and allowing sufficient time for remediation and the establishment of a compliant operating track record can help facilitate a smoother IPO process.

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