##### Table of Contents



As filed with the Securities and Exchange Commission on July 23, 2004   UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 20-F (Mark One) o
    
    REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR 12(g) OF
THE SECURITIES EXCHANGE ACT OF 1934
 OR þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 For the fiscal year ended March 31, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from _______ to _______ Commission file number: 0-30204 Kabushiki Kaisha Internet Initiative  Internet Initiative Japan Inc.  Japan
(Jurisdiction of incorporation or organization) Jinbocho Mitsui Bldg.
1-105 Kanda Jinbo-cho
Chiyoda-ku, Tokyo 101-0051, Japan
(Address of principal executive offices) Securities registered or to be registered pursuant to Section 12(b) of the Act: Title of each class
    
    Name of each exchange on which registeredNone
    
    None
 Securities registered or to be registered pursuant to Section 12(g) of the Act: Common Stock, no par value
(Title of Class) Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act: None
(Title of Class) Indicate the number of outstanding shares of each of the issuers classes of
capital or common stock as of the close of the period covered by the annual
report. As of March 31, 2004, 38,360 shares of common stock were outstanding, including
7,263 shares represented by an aggregate of 14,526,000 American Depositary
Shares. Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes o  No þ Indicate by check mark which financial statement item the registrant has elected to follow: Item 17 o  Item 18 þ




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TABLE OF CONTENTS CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
    
    
    1PART I
    
    
    2Item 1. Identity of Directors, Senior Management and Advisers.
    
    
    2Item 2. Offer Statistics and Expected Timetable.
    
    
    2Item 3. Key Information.
    
    
    2Item 4. Information on the Company.
    
    
    13Item 5. Operating and Financial Review and Prospects.
    
    
    41Item 6. Directors and Senior Management and Employees.
    
    
    67Item 7. Major Shareholders and Related Party Transactions.
    
    
    72Item 8. Financial Information.
    
    
    74Item 9. The Offer and Listing.
    
    
    75Item 10. Additional Information.
    
    
    76Item 11. Quantitative and Qualitative Disclosures about Market Risk.
    
    
    88Item 12. Description of Securities Other than Equity Securities.
    
    
    89PART II
    
    
    89Item 13. Defaults, Dividend Arrearages and Delinquencies.
    
    
    89Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds.
    
    
    89Item 15. Controls and Procedures.
    
    
    89Item 16A.
Audit Committee Financial Expert.
    
    
    90Item 16B. Code of Ethics.
    
    
    91Item 16C. Principal Accountant Fees and Services.
    
    
    91Item 16D. Exemptions from the Listing Standards for Audit Committees.
    
    
    92Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers.
    
    
    92PART III
    
    
    92Item 17. Financial Statements.
    
    
    92Item 18. Financial Statements.
    
    
    92Item 19. Exhibits.
    
    
    93EX-1.1 ARTICLES OF INCORPORATIONEX-1.2 SHARE HANDLING REGULATIONSEX-1.4 REGULATIONS OF THE BOARD OF STATUTORY AUDITORSEX-4.5 INDIVIDUAL AGREEMENT BETWEEN INTERNET INITIATIVE JAPAN INC. AND ASIA INTERNET HOLDING CO., LTD.EX-4.21 SERVICE AGREEMENT BETWEEN INTERNET INITIATIVE JAPAN INC. AND IIJ AMERICA INC.EX-4.23 AGREEMENT ON LIMITED LIABILITY BETWEEN INTERNET INITIATIVE JAPAN INC. AND OUTSIDE DIRECTORSEX-11.1 INTERNET INITIATIVE JAPAN CODE OF CONDUCTEX-12.1 CERTIFICATIONS REQUIRED BY SECTION 302EX-13.1 CERTIFICATIONS REQUIRED BY SECTION 906
  i




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Cautionary Note Regarding Forward-Looking Statements This annual report contains forward-looking statements about us and our
industry that are based on our current expectations, assumptions, estimates and
projections. These forward-looking statements are subject to various risks and
uncertainties. These statements discuss future expectations, identify
strategies, discuss market trends, contain projections of results of our
operations and our financial condition, and state other forward-looking
information. Known and unknown risks, uncertainties and other factors could
cause our actual results to differ materially from those contained in or
suggested by any forward-looking statement. We cannot provide any assurance
that our expectations, projections, anticipated estimates or other information
expressed in these forward-looking statements will turn out to be correct. We
do not undertake any obligation to update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise. Important risks and factors that could cause our actual results to differ
materially from our forward-looking statements are generally provided in Item
3.D. and elsewhere in this annual report on Form 20-F and include, without
limitation:  
    
    that we may not be able to achieve or sustain profitability
in the near future,
    
    that we may not be able to compete effectively against
competitors which have greater financial, marketing and other
resources, and
    
    that we may not be able to sufficiently maintain existing
customers or acquire new customers to sustain or increase our
systems integration business in the face of fierce competition. 1




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##### Table of Contents



PART I 
 Item 1. Identity of Directors, Senior Management and Advisers. Not required. 
 Item 2. Offer Statistics and Expected Timetable. Not applicable. 
 Item 3. Key Information. A. Selected Financial Data. You should read the selected consolidated financial data below together
with Item 5. Operating and Financial Review and Prospects, of this annual
report on Form 20-F and our consolidated financial statements and the notes to
the financial statements beginning on page F-1. The consolidated statement of
operations data and per share and ADS data below for the fiscal years ended
March 31, 2000, 2001, 2002, 2003 and 2004, the consolidated balance sheet data
below as of March 31, 2000, 2001, 2002, 2003 and 2004 and consolidated
statements of cash flows for the fiscal years ended March 31, 2000, 2001, 2002,
2003 and 2004 under operating data below are derived from our audited financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States, or U.S. GAAP, and audited by Deloitte
Touche Tohmatsu, independent auditors. 2




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##### Table of Contents



As of and for the fiscal year ended March 31,2000
    
    2001
    
    2002
    
    2003
    
    2004
    
    2004(millions of yen, except per share and ADS data)
    
    (thousands of U.S.dollars, except pershare and ADS
data(1))Statement of Operations Data:REVENUES:Connectivity and value-added
services revenues:Dedicated access
    
    ¥
    9,999
    
    
    ¥
    12,953
    
    
    ¥
    14,303
    
    
    ¥
    13,815
    
    
    ¥
    12,862
    
    
    $
    123,461Dial-up access
    
    
    4,496
    
    
    
    4,423
    
    
    
    3,644
    
    
    
    3,155
    
    
    
    3,088
    
    
    
    29,646Value-added
    
    
    884
    
    
    
    1,962
    
    
    
    3,100
    
    
    
    3,603
    
    
    
    4,296
    
    
    
    41,238Other
    
    
    408
    
    
    
    592
    
    
    
    1,668
    
    
    
    1,726
    
    
    
    2,118
    
    
    
    20,328Total connectivity and
value-added services
revenues
    
    
    15,787
    
    
    
    19,930
    
    
    
    22,715
    
    
    
    22,299
    
    
    
    22,364
    
    
    
    214,673Systems integration revenues,
including related equipment sales
    
    
    7,640
    
    
    
    10,556
    
    
    
    14,356
    
    
    
    15,013
    
    
    
    11,848
    
    
    
    113,723Equipment sales
    
    
    1,875
    
    
    
    1,390
    
    
    
    2,834
    
    
    
    6,706
    
    
    
    4,567
    
    
    
    43,839Total revenues
    
    
    25,302
    
    
    
    31,876
    
    
    
    39,905
    
    
    
    44,018
    
    
    
    38,779
    
    
    
    372,235COST AND EXPENSES:Cost of connectivity and
value-added services revenues
    
    
    15,091
    
    
    
    18,983
    
    
    
    19,800
    
    
    
    20,387
    
    
    
    20,047
    
    
    
    192,431Cost of systems integration
revenues, including related
equipment sales
    
    
    6,272
    
    
    
    9,117
    
    
    
    12,314
    
    
    
    13,090
    
    
    
    9,852
    
    
    
    94,564Cost of equipment sales
    
    
    1,807
    
    
    
    1,289
    
    
    
    2,540
    
    
    
    6,417
    
    
    
    4,346
    
    
    
    41,719Total cost of revenues
    
    
    23,170
    
    
    
    29,389
    
    
    
    34,654
    
    
    
    39,894
    
    
    
    34,245
    
    
    
    328,714Sales and marketing expenses
    
    
    2,604
    
    
    
    3,252
    
    
    
    3,038
    
    
    
    3,176
    
    
    
    3,528
    
    
    
    33,859General and administrative
expenses
    
    
    1,234
    
    
    
    1,618
    
    
    
    1,840
    
    
    
    2,205
    
    
    
    2,098
    
    
    
    20,143Research and development expenses
    
    
    364
    
    
    
    287
    
    
    
    319
    
    
    
    414
    
    
    
    358
    
    
    
    3,436Total cost and expenses
    
    
    27,372
    
    
    
    34,546
    
    
    
    39,851
    
    
    
    45,689
    
    
    
    40,229
    
    
    
    386,152OPERATING INCOME (LOSS)
    
    
    (2,070
    )
    
    
    (2,670
    )
    
    
    54
    
    
    
    (1,671
    )
    
    
    (1,450
    )
    
    
    (13,917
    )OTHER INCOME (EXPENSES):Interest income
    
    
    362
    
    
    
    454
    
    
    
    122
    
    
    
    67
    
    
    
    38
    
    
    
    360Interest expense
    
    
    (277
    )
    
    
    (643
    )
    
    
    (659
    )
    
    
    (733
    )
    
    
    (702
    )
    
    
    (6,739
    )Other  net
    
    
    (830
    )
    
    
    1,088
    
    
    
    (406
    )
    
    
    (604
    )
    
    
    1,646
    
    
    
    15,807Other income
(expenses)  net
    
    
    (745
    )
    
    
    899
    
    
    
    (943
    )
    
    
    (1,270
    )
    
    
    982
    
    
    
    9,428LOSS FROM OPERATIONS BEFORE INCOME
TAX EXPENSE (BENEFIT)
    
    
    (2,815
    )
    
    
    (1,771
    )
    
    
    (889
    )
    
    
    (2,941
    )
    
    
    (468
    )
    
    
    (4,489
    )INCOME TAX EXPENSE (BENEFIT)
    
    
    (1,280
    )
    
    
    (926
    )
    
    
    1,099
    
    
    
    911
    
    
    
    (2,133
    )
    
    
    (20,474
    )MINORITY INTERESTS IN
CONSOLIDATED SUBSIDIARIES
    
    
    (70
    )
    
    
    160
    
    
    
    24
    
    
    
    153
    
    
    
    236
    
    
    
    2,264EQUITY IN NET LOSS OF EQUITY
METHOD INVESTEES:(2)(3)Equity method net loss
    
    
    (3,180
    )
    
    
    (4,015
    )
    
    
    (5,482
    )
    
    
    (5,625
    )
    
    
    (286
    )
    
    
    (2,748
    )
 3




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As of and for the fiscal year ended March 31,2000
    
    2001
    
    2002
    
    2003
    
    2004
    
    2004(millions of yen, except per share and ADS data)
    
    (thousands of U.S.dollars, except pershare and ADS
data(1))Impairment loss on
investment, advance and
deposits for Crosswave
    
    ¥
    
    
    
    ¥
    
    
    
    ¥
    
    
    
    ¥
    (7,153
    )
    
    ¥
    (1,720
    )
    
    $
    (16,510
    )Total equity in net
loss of equity method
investees
    
    
    (3,180
    )
    
    
    (4,015
    )
    
    
    (5,482
    )
    
    
    (12,778
    )
    
    
    (2,006
    )
    
    
    (19,258
    )NET LOSS
    
    ¥
    (4,785
    )
    
    ¥
    (4,700
    )
    
    ¥
    (7,446
    )
    
    ¥
    (16,477
    )
    
    ¥
    (105
    )
    
    $
    (1,009
    )Per Share and ADS Data:Basic and diluted net loss per share
    
    ¥
    (225,791
    )
    
    ¥
    (209,085
    )
    
    ¥
    (331,234
    )
    
    ¥
    (732,955
    )
    
    ¥
    (3,316
    )
    
    $
    (32
    )Basis and diluted net loss per ADS
equivalent
    
    
    (112.89
    )
    
    
    (104.54
    )
    
    
    (165.62
    )
    
    
    (366.48
    )
    
    
    (1.66
    )
    
    
    (0.0
    )Weighted average number of shares
    
    
    21,190
    
    
    
    22,480
    
    
    
    22,480
    
    
    
    22,480
    
    
    
    31,711Weighted average number of ADS
equivalents (thousands)
    
    
    42,380
    
    
    
    44,960
    
    
    
    44,960
    
    
    
    44,960
    
    
    
    63,422Balance Sheet Data:Cash and cash equivalent
    
    ¥
    16,158
    
    
    ¥
    13,571
    
    
    ¥
    11,046
    
    
    ¥
    3,588
    
    
    ¥
    12,284
    
    
    $
    117,914Total assets
    
    
    39,001
    
    
    
    50,641
    
    
    
    45,263
    
    
    
    32,064
    
    
    
    42,737
    
    
    
    410,222Short-term borrowings
    
    
    13,690
    
    
    
    5,620
    
    
    
    3,820
    
    
    
    4,824
    
    
    
    6,564
    
    
    
    63,007Current portion of long-term borrowings, including capital
lease obligations
    
    
    2,255
    
    
    
    1,644
    
    
    
    3,374
    
    
    
    4,660
    
    
    
    3,936
    
    
    
    37,781Long-term borrowings, including capital lease obligations
    
    
    2,300
    
    
    
    5,479
    
    
    
    6,262
    
    
    
    7,092
    
    
    
    5,188
    
    
    
    49,801Convertible
notes(4)
    
    
    
    
    
    
    15,000
    
    
    
    15,000
    
    
    
    15,000
    
    
    
    11,832
    
    
    
    113,573Shareholders equity (capital deficiency)
    
    
    15,001
    
    
    
    16,928
    
    
    
    7,725
    
    
    
    (10,004
    )
    
    
    6,214
    
    
    
    59,648Operating Data:Capital
expenditures, including capitalized leases(5)
    
    ¥
    3,465
    
    
    ¥
    3,963
    
    
    ¥
    3,773
    
    
    ¥
    4,893
    
    
    ¥
    3,523
    
    
    $
    33,813Operating margin(6)
    
    
    (8.2
    )%
    
    
    (8.4
    )%
    
    
    0.1
    %
    
    
    (3.8
    )%
    
    
    (3.7
    )%Net cash provided by (used in):Operating activities
    
    ¥
    1,199
    
    
    ¥
    (271
    )
    
    ¥
    1,161
    
    
    ¥
    1,582
    
    
    ¥
    1,923
    
    
    $
    18,462Investing activities
    
    
    (7,135
    )
    
    
    (9,544
    )
    
    
    (2,457
    )
    
    
    (7,878
    )
    
    
    (852
    )
    
    
    (8,183
    )Financing activities
    
    
    22,192
    
    
    
    6,428
    
    
    
    (1,462
    )
    
    
    (872
    )
    
    
    7,669
    
    
    
    73,609
   (1)
    
    The U.S. dollar amounts represent translations of yen amounts at the rate
of ¥104.18, which was the noon buying rate in New York City for cable
transfers in foreign currencies as certified for customs purposes by the
Federal Reserve Bank of New York prevailing as of March 31, 2004.(2)
    
    Equity method net loss of ¥5,514 million for the fiscal year ended March
31, 2003 was based on unaudited financial information made publicly
available by Crosswave and the impairment loss on investment, advance and
deposits for Crosswave was determined to be the amount required to reduce
the carrying amount of investment in and deposits for Crosswave at March
31, 2003 to zero.(3)
    
    The audit report of Deloitte Touche Tohmatsu in respect of our financial
statements as of and for the fiscal year ended March 31, 2003 was qualified as
to the effects of such adjustments, if any, as might have been determined to be
necessary if sufficient evidence regarding the equity method loss, the
impairment loss on investment, advance and deposits for Crosswave and the
related summary information of Crosswave for the year ended March 31, 2003 was
available. As described elsewhere in this annual report, Crosswave is
undergoing corporate reorganization proceedings in Japan and has not prepared
audited financial statements for the year ended March 31, 2003 or other
sufficient evidence of its results of operations to permit our auditors to
issue an audit report or our financial statements as of and for the year ended
March 31, 2003 without such qualification.(4)
    
    In April 2000, we issued 1.75 percent unsecured yen convertible notes due
March 2005 in the aggregate principal amount of ¥15,000 million. In
November 2003, we repurchased and cancelled a portion of them, in the
aggregate principal amount of ¥3,168 million. 4




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##### Table of Contents



(5)
    
    Further information regarding capital expenditures, including
capitalized leases and a reconciliation to the most directly comparable
GAAP financial measure can be found below.(6)
    
    Operating income (loss) as a percentage of total revenues. Reconciliations of the Disclosed Non-GAAP Financial Measures to the Most
Directly Comparable GAAP Financial Measures Capital expenditures We define capital expenditures as purchases of property and equipment plus
acquisition of assets by entering into capital leases. We have included the
information concerning capital expenditures because our management uses this
measure to manage these expenditures and believes that it is useful to
investors to analyze and compare companies on the basis of such investments.
Capital expenditures, as we have defined it, may not be comparable to a
similarly titled measure used by other companies. The following table summarizes the reconciliation of capital expenditures
to purchase of property and equipment as reported in our consolidated
statements of cash flows prepared and presented in accordance with the U.S.
generally accepted accounting principles. For the fiscal year ended March 31,2000
    
    2001
    
    2002
    
    2003
    
    2004(millions of yen)Capital expenditures:Acquisition of assets by entering into capital leases
    
    ¥
    2,309
    
    
    ¥
    2,596
    
    
    ¥
    2,536
    
    
    ¥
    3,578
    
    
    ¥
    1,866Purchases of property and equipment
    
    
    1,156
    
    
    
    1,367
    
    
    
    1,237
    
    
    
    1,315
    
    
    
    1,657Total capital expenditures
    
    ¥
    3,465
    
    
    ¥
    3,963
    
    
    ¥
    3,773
    
    
    ¥
    4,893
    
    
    ¥
    3,523
 Exchange Rates Fluctuations in exchange rates between the Japanese yen and U.S. dollar
and other currencies will affect the U.S. dollar and other currency equivalent
of the yen price of our shares and the U.S. dollar amounts received on
conversion of any cash dividends, which in turn will affect the U.S. dollar
price of our ADSs. We have translated some Japanese yen amounts presented in
this annual report into U.S. dollars solely for your convenience. Unless
otherwise noted, the rate used for the translations was ¥104.18 per $1.00 which
was the noon buying rate in New York City for cable transfers in foreign
currencies as certified for customs purposes by the Federal Reserve Bank of New
York prevailing as of March 31, 2004, the date of our most recent consolidated
balance sheet contained in this annual report. Translations do not imply that
the yen amounts actually represent, or have been or could be converted into,
equivalent amounts in U.S. dollars. The following table presents the noon buying rates for Japanese yen per
$1.00 in New York City for cable transfers in foreign currencies as certified
for customs purposes by the Federal Reserve Bank of New York; Fiscal year ended March 31,
    
    High
    
    Low
    
    Average(1)
    
    Period-end2000
    
    
    124.45
    
    
    
    101.53
    
    
    
    110.02
    
    
    
    102.732001
    
    
    125.54
    
    
    
    104.19
    
    
    
    111.65
    
    
    
    125.542002
    
    
    134.77
    
    
    
    115.89
    
    
    
    125.64
    
    
    
    132.702003
    
    
    133.40
    
    
    
    115.71
    
    
    
    121.10
    
    
    
    118.072004
    
    
    120.55
    
    
    
    104.18
    
    
    
    112.75
    
    
    
    104.18
 5




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##### Table of Contents



Calendar year 2004
    
    High
    
    Low
    
    Average(1)
    
    Period-endJanuary
    
    ¥
    107.17
    
    
    ¥
    105.52
    
    
    ¥
    106.27
    
    
    ¥
    105.84February
    
    
    109.59
    
    
    
    105.36
    
    
    
    106.71
    
    
    
    109.26March
    
    
    112.12
    
    
    
    104.18
    
    
    
    108.52
    
    
    
    104.18April
    
    
    110.37
    
    
    
    103.70
    
    
    
    107.66
    
    
    
    110.37May
    
    
    114.30
    
    
    
    108.50
    
    
    
    112.20
    
    
    
    110.18June
    
    
    111.27
    
    
    
    107.10
    
    
    
    109.43
    
    
    
    109.43July (through July 19, 2004)
    
    
    109.52
    
    
    
    108.21
    
    
    
    108.73
    
    
    
    108.28
   (1)
    
    For fiscal years, calculated from the average of the exchange rates on
the last day of each month during the period. For calendar year months,
calculated based on the average of daily exchange rates. The noon buying rate on July 19, 2004 was ¥108.28 per $1.00. B. Capitalization and Indebtedness. Not required. C. Reasons for the Offer and Use of Proceeds. Not applicable. D. Risk Factors You should carefully consider the following information, together with the
other information contained in this annual report onForm 20-F, including our
financial statements and the related notes, before making an investment
decision. Any risks described below could result in a material adverse effect
on our business, financial condition or results of operations. We have experienced operating and net losses in recent years and may be
unable to achieve or sustain profitability in the near future. We incurred an operating loss of ¥1.4 billion and a net loss of ¥0.1
billion for the fiscal year ended March 31, 2004. We have incurred operating
losses and net losses in each of the past six fiscal years, with the exception
of operating income turning slightly positive for the fiscal year ended March
31, 2002. In August 2003, Crosswave Communications Inc., our former equity
method investee, filed a voluntary petition for the commencement of corporate
reorganization proceedings in Japan, and as a result of our equity method net
loss and an impairment loss taken in respect of our investment in Crosswave,
our net loss for the fiscal year ended March 31, 2003 was ¥16.5 billion, the
highest net loss that we have ever experienced. We also wrote off ¥2.1 billion
of loans and accounts receivable outstanding from Crosswave for the fiscal year
ended March 31, 2004. We had unaudited operating income of ¥0.2 billion and net
income of ¥2.0 billion for the third quarter of the fiscal year ended March
31, 2004 and unaudited operating income of ¥0.3 billion and net income of ¥0.7
billion for the fourth quarter of the fiscal year ended March 31, 2004. Our
accumulated deficit as of March 31, 2004 was ¥34.8 billion. Operating and net losses may continue into the foreseeable future due to a
number of factors, including, but not limited to:  
    
    price reductions as a result of severe competition or failure
to retain existing customers or attract new customers;
    
    deterioration of or a lack of improvement in the Japanese
economy ,which could significantly curtail demand for our services
in Japan; 6




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
    
    costly investments in network infrastructure, research and
development and other similar investments which we may make in the
future in order to remain competitive;
    
    our ability to efficiently manage our backbone capacity;
    
    increased expenses relating to the leasing of additional equipment;
    
    reduced revenues and margins from systems integration
business and Internet data center business and;
    
    strong competition in the retail Internet Service Provider,
or ISP, market. Please see Item 5., Operating and Financial Review and Prospects, for
more detailed information concerning our operations and net losses and other
results. We may not be able to compete effectively, especially against competitors
with greater financial, marketing and other resources. Our major competitors for the connectivity and value-added services
business are major telecommunications carriers like NTT Communications, KDDI,
Japan Telecom, PoweredCom and their affiliates. Recently, there has been a
significant amount of consolidation in the telecommunications industry in
Japan. For example, Softbank Group, an operator of Yahoo! BB, a low-price ADSL
service for individual customers, announced that it is planning to buy Japan
Telecom, which is one of the largest telecommunications carriers in Japan. This
trend may result in increased pressure from corporate customers to reduce our
prices, and our revenues in connectivity services may be adversely affected.
For the Internet data center services business, our major competitors are the
providers like NTT Communications, KDDI, PoweredCom and Japan Telecom. Once we
lose customers for such services to another service provider, it is generally
difficult to reacquire those customers in the future. For the systems
integration business, our major competitors are large hardware vendors like
IBM, NEC and Hitachi and systems integrators like NTT Data. Our major
competitors have the financial resources to reduce prices in an effort to gain
market share. Even though NTT and NTT Communications purchased shares in our
company in September 2003, which resulted in the NTT Group becoming our largest
shareholder, we plan to continue to operate our company separately and
independently from the NTT Group, and will therefore continue to compete with
the NTT Group. Our competitors have advantages over us, including, but not
limited to:  
    
    substantially greater financial resources;
    
    more extensive and well-developed marketing and sales networks;
    
    higher brand recognition among consumers;
    
    larger customer bases; and
    
    more diversified operations which allow profits from some
operations to offset operations with lower profitability, such as
the network services for which we are competitors. With these advantages, our competitors may be better able to:  
    
    sustain downward pricing pressure, including pressure on
low-price Internet-access services offered to corporate customers,
which are our target customers; 7




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##### Table of Contents




    
    develop, market and sell their services;
    
    adapt quickly to new and changing technologies;
    
    obtain new customers; and
    
    aggressively pursue mergers and acquisitions to enlarge their
customer base and market share. We may not be able to sufficiently maintain existing customers or acquire
new customers to sustain or increase our systems integration revenues in the
face of fierce competition. A significant portion of our expected future revenue depends on our
ability to maintain our existing customers and acquire new customers for our
systems integration business. Our existing systems integration customer base
may not be large enough to provide us with a desirable level of dependable
revenues, as the addition or cancellation of a single project can result in
significant fluctuations in our revenues. Margins with respect to the systems
integration business also tend to be more favorable for the provision of
additional services to existing customers than for the initial provision of
services to new customers. Competition in the systems integration business in
Japan has greatly intensified, with competitors expanding their sales forces
and offering more attractive products. We may not be able to attract as many
new customers as we need to maintain profitable systems integration operations
due to factors such as increased competition and weak corporate investments in
technology in Japan despite some recent signs of improvement in the Japanese
economy. Price competition may also hurt our profitability. If we are unable to
maintain our current systems integration customer base and acquire new systems
integration customers and contracts or if price competition becomes more
severe, our revenues may decline, and the profitability of our systems
integration business and our results of operations and financial condition
could be materially and adversely affected. NTT, our largest shareholder, could exercise influence over us. NTT and its affiliates currently own 31.6% of our outstanding shares. In
September 2003, we entered into a subscription agreement with NTT in which we
granted to NTT pre-emptive rights to subscribe to its pro rata portion of any
future issuances of shares by us in order to maintain its shareholding
percentage. In addition, under this subscription agreement, we have agreed to
allow NTT to nominate up to three persons as either directors or statutory
auditors, subject to approval by our shareholders at our general shareholders
meeting. At our general shareholders meeting on June 24, 2004, two directors
nominated from NTT Group were appointed, one of which was nominated as an
executive vice president. As a result, NTT may be able to exercise substantial
influence over us. In addition, as part of this subscription agreement, we have
agreed to collaborate with NTT in various businesses. While we intend to
conduct our day-to-day operations independently of NTT and its group companies
and believe that NTT also plans for us to operate independently, NTT may decide
to exercise substantial influence over us in a manner which could impair our
ability to operate independently. Furthermore, NTT may take actions that are in
its best interests, which may not be in the interests of us or our other
shareholders. We have indebtedness and any difficulties we may have in dealing with
financial institutions may have a negative impact on our financial condition. At March 31, 2004, we had indebtedness of ¥27.5 billion, including ¥11.8
billion of 1.75% convertible notes due in March 2005, and we had ¥12.3 billion
in cash and cash equivalent and ¥6.6 billion in available-for-sale securities.
We repurchased and cancelled ¥0.7 billion of 1.75% convertible notes in June
2004, and we plan to redeem or may repurchase the remaining ¥11.1 billion of
1.75% convertible notes using our cash and cash equivalent as well as
available-for-sale securities. A declining fluctuation in the stock
price of such available-for-sale securities may have a negative
impact on our ability to repurchase or redeem the notes. 8




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The continued operation of our business is dependent on our ability to
obtain continuous financing from banks in Japan. Although we currently have
good relationships with our banks, due to increasing pressure from the Japanese
government and Japanese bank regulatory institutions to improve the quality of
their loan portfolios, Japanese banks, including those with which we have
traditionally had good relations, may become reluctant to lend us money, or may
only do so on less favorable terms. We provided banks with collateral for
outstanding loans by means of establishing a second priority pledge against the
refundable guarantee of ¥1.7 billion at March 31, 2004.We may be required to
offer additional collateral to secure our borrowings. Any reluctance on the
part of banks to provide needed financing may have a negative impact on our
financial condition. To offer Internet-access services and network solutions to our customers,
we typically lease important components such as routers, servers, network
machines, high-capacity and high-speed digital transmission lines, software and
other items needed to perform our operations. Although we currently have good
relationships with our leasing companies, if we are unable to lease necessary
components, or are only able to do so on less favorable terms, we may be
required to purchase the components ourselves, which could negatively impact on
our cash flow. We depend on our ability to attract and retain qualified personnel. Our network, services, products and technologies are complex, and as a
result, we depend heavily on the continued service of our engineering, research
and development, and other personnel and, as our business grows, we may need to
hire additional engineers, research and development and other personnel.
Competition for qualified engineers, research and development personnel and
employees in the telecommunications service industry in Japan is intense, and
there is a limited number of persons with the necessary knowledge and
experience. The realization of any or all of these risks may result in material
adverse effects on our business, financial condition and result of operations. We depend on our executive officers, and if we lose the service of our
executive officers, our business and relationship with customers, our major
shareholders and those of other IIJ Group companies and employees could
suffer. Our future success depends on the continued service of our executive
officers, particularly Mr. Koichi Suzuki, who is our president, chief executive
officer and representative director, as well as the president and chief
executive officer and representative director of most of the other IIJ Group
companies. Mr. Suzuki was also president and representative director of
Crosswave. We rely on his expertise in the operation of our businesses and on
his relationships with our shareholders, the shareholders of the IIJ Group
companies, our business partners and employees. None of our officers or
employees, including Mr. Suzuki, is bound by an employment or noncompetition
agreement. Our business may be adversely affected if our network suffers
interruptions, errors or delays. Interruptions, errors or delays with respect to our network may be caused
by a number of factors, many of which are beyond our control, including, but
not limited to, damage from fire, earthquakes or other natural disasters, power
loss, sabotage, computer hackers, human error, computer viruses and other
similar events. Much of our computer and networking equipment and the lines
that make up our network backbones are concentrated in a few locations that are
in earthquake-prone areas. Any disruption, outages, or delays or other
difficulties experienced by any of our technological and information systems
and networks could result in a decrease in new accounts, loss or exposure of
confidential information, reduction in revenues, delay in repayment of
outstanding borrowings, costly repairs or upgrades, reputational damage and
decreased consumer confidence in our business, any or all of which could have a
material adverse effect on our business, financial condition and results of
operations. 9




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##### Table of Contents



The confidential customer information that we keep and manage may be
leaked. We keep and manage confidential information and trade secrets obtained
from our customers. We exercise care in protection the confidentiality of such
information and take steps to ensure the security of our network, however, our
network, like all Information Technology systems, is vulnerable to external
attack from computer viruses, hackers or other such sources. In addition,
despite internal controls, misconduct by an employee could result in the
improper use or disclosure of confidential information. If any material leak of
such information were to occur, we could be subject to lawsuits for damages
from our customers, incur expenses associated with repairing or upgrading our
security systems and suffer damages to our reputation that could result in a
severe decline in new customers as well as an increase in service
cancellations. The realization of these or similar risks may have a material
adverse effect on our business, financial condition and result of operations. We rely greatly on other telecommunications providers and other suppliers,
and could be affected by disruptions in service or delays in the delivery of
their products and services. We rely on telecommunications carriers such as NTT Communications, KDDI
and Japan Telecom for a significant portion of our network backbone and
regional NTT companies and electric power companies and their affiliates for
local access lines for our customers. Prior to Crosswave filing a voluntary
petition for the commencement of corporate reorganization proceedings in Japan
in August 2003, we procured significant portions of our network backbone and
data centers from Crosswave under operating lease arrangements. Most of
Crosswaves business operation were transferred to NTT Communications in
December 2003. Currently, NTT Communications is our largest provider of network
infrastructure. We are subject to potential disruptions in these
telecommunications services and, in the event of such disruption, we may have
no means of replacing these services, on a timely basis or at all. In the Asia-Pacific region, we depend on telecommunications carriers in
various countries including less-developed countries whose quality of service
may not be stable or who are more susceptible to economic or political
instability. We also depend on third-party suppliers of hardware components like
routers that are used in our network. We acquire certain components from
limited sources, typically from Cisco Systems. A failure by one of our
suppliers to deliver quality products on a timely basis, or the inability to
develop alternative sources if and as required, may delay our ability to expand
the capacity and scope of our network. Any problems experienced by our telecommunications carriers and other
suppliers could have a material adverse effect on our business, financial
condition and results of operations. If we fail to keep up with the rapid technological changes in our
industry, our services may become obsolete and we may lose customers. Our markets are characterized by:  
    
    rapid technological change,
    
    frequent new product and service introductions,
    
    changes in customer requirements, and
    
    evolving industry standards. 10




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The introduction of services using new technologies, such as the
transition from version four of Internet Protocol, or IP, to version six, and
the emergence of new industry standards could render our existing services
obsolete. If we fail to obtain access to new or important technologies or to develop
and introduce new services and enhancements that are compatible with changing
industry technologies and standards and customer requirements, we may lose
customers. Our pursuit of necessary technological advances may require substantial
time and expense. Many of our competitors have greater financial and other
resources than we do and, therefore, may be better able to meet the time and
expense demands of achieving technological advances. Additionally, this may
allow our competitors to respond more quickly to new and emerging technologies
and standards or invest more heavily in upgrading or replacing equipment to
take advantage of new technologies and standards. Rapid growth and a rapidly changing operating environment may strain our
limited resources. We have limited operational, administrative and financial resources, which
could be inadequate to sustain the growth we want to achieve. As the number of
our customers and their Internet use increases, as traffic patterns change and
as the volume of information transferred increases, we will need to increase
expenditures for our network and other facilities in order to adapt our
services and to maintain and improve the quality of our services. If we are
unable to manage our growth and expansion, the quality of our services could
deteriorate and our business may suffer. If we fail to execute our systems integration projects in a timely or
satisfactory manner or if we fail to manage customer data in a professional
manner, we could be sued and our reputation could suffer. A significant portion of our future revenue depends on systems integration
projects which we, in cooperation with IIJ Technology, Net Care and IIJ Media
Communications, have been contracted to perform. We may not be able to perform
our responsibilities under these contracts to the satisfaction of our
customers, or at all, if we lack a sufficient number of qualified engineers,
lack sufficient task-management capabilities for software-development vendors
or fail to manage customer data adequately. If we do not execute these
services/projects as contracted or fail to manage customer data in a
professional manner, our receipt of revenues may be delayed or lost altogether
and we could be sued by our counterparties, which could in turn have an adverse
impact on our reputation, results of operation and financial condition. Regulatory matters and new legislation could impact our ability to conduct
our business. The licensing, construction and operation of telecommunications systems
and services in Japan are subject to regulation and supervision by the Ministry
of Public Management, Home Affairs, Posts and Telecommunications, or MPHPT. We
operate pursuant to licenses and approvals that have been granted by the MPHPT. Our licenses have an unlimited duration. They are however, subject to
revocation by the MPHPT if we violate any telecommunications laws and
regulations in a manner that is deemed to harm the public interest, if we or
any of our directors are sentenced to a fine or any more severe penalty under
the telecommunications laws, if we employ a director who was previously
sentenced to a fine or more severe penalty thereunder or if we have had a
license revoked in the past. We believe our licenses and approvals are in good
standing and we expect to be able to continue to fulfill the terms of our
licenses and approvals to the satisfaction of the MPHPT. However, there can be
no assurance that we will be able to do so. Existing and future governmental regulation may substantially affect the
way in which we conduct business. These regulations may increase the cost of
doing business or may restrict the way in which we offer 11




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##### Table of Contents



products and services. As a result of the amendment in April 2004 of the
Telecommunication Business Law and deregulation including elimination of the
regulatory distinction between carriers providing telecommunications services
through networks owned by other telecommunication carriers and carriers which
own or have long-term leases for the networks through which they offer
telecommunication services, competition may increase. Furthermore, we cannot
predict future regulatory changes which may affect our business. Any changes in
laws, such as those described above, or regulations or MPHPT policy affecting
our business activities and those of our competitors could adversely affect our
financial condition or results of operations. For more information, see Item
4., Business Overview  Regulation of the Telecommunications Industry in
Japan. There are risks associated with our international business. By operating our network internationally, we expose ourselves to the risks
of international markets and to other risks that do not exist or are less
significant in Japan. One of the components of our strategy is to continue to
expand our network reach through our network between the United States and
Japan to maintain our network quality. In addition, we have invested in data
center businesses in South Korea and the Philippines. Our international
business operations continue to require management attention and financial
resources, both of which are in limited supply. We face significant exposure to
risks in connection with our international operations, including:  
    
    the impact of economic conditions outside Japan,
    
    unexpected changes in or delays resulting from regulatory requirements,
    
    the rate of the development of the Internet industry in countries in Asia,
    
    political and economic instability, and
    
    potential unsatisfactory financial returns from our
investments in Asia, including the data center businesses in which
we have invested in South Korea and the Philippines. These factors could adversely affect our future international expansion
and, consequently, our business, financial condition and results of operations. Our investments in affiliated companies may not produce the returns we
expect and may require additional funding. As part of our business strategy and for the purpose of maintaining
various strategic business relations, we have, in the past, invested in a
number of companies, including Crosswave. There can be no assurance that we
will be able to maintain or enhance the value or performance of such companies
in which we have invested or may invest in the future, or that we will achieve
the returns or benefits sought from these investments. Our substantial
investment in Crosswave, for example, became worthless due to Crosswaves
financial condition and commencement of corporate reorganization proceedings.
We also had an impairment loss relating to our investment in Asia Internet
Holding for the fiscal year ended March 2004. In addition, telecommunications
companies and other technology companies have experienced a variety of negative
developments in recent years, including increased competition and significant
volatility in share prices, and have experienced financial difficulties. To the
extent that these investments are accounted for by the equity-method and to the
extent that the investee companies have net losses, our financial results will
be adversely affected to the extent of our pro rata portion of these losses.
Furthermore, we may lose all or part of our investment in these
companies if their value decreases as a result of their financial
performance or if these
companies go bankrupt. 12




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We have invested in affiliated companies, such as IIJ Technology and Net
Care, to expand the service offerings available to our customers. If our
affiliated companies need additional financing, we may need to provide
additional financial support in the form of loans to or additional equity
investments in these affiliated companies to enhance or maintain our business
synergies with these affiliated companies. We may consider reorganization of
IIJ Group companies in the future and it may require additional investments by
cash, equity or others. Fluctuation in stock price of companies in which we have invested may
significantly influence our financial condition. We have invested in non-affiliated companies in order to further our
business relationships with these companies. Other investments on our balance
sheet, which includes among other items, investments in these non-affiliated
companies, were recorded at a book value of ¥7.9 billion at March 31, 2004,
which is relatively large in relation to other items on our balance sheet. We
also had a significant positive income tax effect due to increases in
unrealized gains from these available-for-sale securities during the fiscal
year ended on March 31, 2004. However, the book value can change significantly
due to changes in the financial condition of non-affiliated companies, general
economic conditions in Japan or fluctuations in the Japanese stock markets.
Fluctuations in the stock price of companies in which we have invested will
have a significant effect on our financial results. In addition, should we
choose to dispose of all or a portion of these shares to fulfill our cash flow
needs, it is not certain that we will be able to do so on favorable terms. We may be named as defendants in litigation, which could have an adverse
impact on our business, financial condition and results of operations. We are involved in normal claims and other legal proceedings in the
ordinary course of our business. We believe that there are no cases currently
pending which will have a significant financial impact on us, but we cannot be
certain that we will not be named in a future lawsuit. Any judgment against us
in such a lawsuit, or in any future legal proceeding, could have an adverse
effect on our business, financial condition and results of operations. In the event we need to raise capital, we may have to sell additional
shares of our common stock or securities convertible into our common stock,
which may cause shareholders to incur substantial dilution. In June and September 2003, we completed private placements of an
aggregate of 15,880 shares of our common stock to investors in Japan in order
to raise funds for working capital and repayment of convertible notes. We may
raise additional funds in the future to raise additional working capital and for other
financial needs. If we choose to raise such funds from the issuance of equity
shares of our common stock or securities convertible into our common stock,
existing shareholders may incur substantial dilution. 
 Item 4. Information on the Company A. History and Development of the Company. We are incorporated in Japan as a joint stock corporation under the name
of Internet Initiative Japan Inc., or IIJ. We were incorporated in December
1992 and operate under the laws of Japan. We began operations in July 1993,
making us one of the first commercial Internet service providers in Japan to
offer Internet-access services. In February 1994, we acquired a Type II
Telecommunications license, which enables us to operate our own international
backbone networks. We became a public company in August 1999 with our initial
public offering of ADSs on the Nasdaq National Market, or Nasdaq. In October 1998, we established Crosswave Communications Inc. as a joint
venture with Sony Corporation and Toyota Motor Corporation with the goal of
providing advanced, high-speed, cost-effective, 13




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end-to-end data communications services to customers in Japan and to take
advantage of market growth and demand for broadband data communications
networks. Crosswave offered broadband data communication services on Japans
first nationwide fiber-optic network specifically designed and dedicated to
data traffic. ADSs representing Crosswaves shares of common stock were quoted
on Nasdaq from the time of its August 2000 IPO until being removed by Nasdaq on
August 29, 2003. On August 20, 2003, Crosswave and two of its subsidiaries filed voluntary
petitions with the Tokyo District Court for the commencement of corporate
reorganization proceedings, which are proceedings to rehabilitate an insolvent
company similar in some respects to Chapter 11 bankruptcy proceedings in the
United States. As a result, we have written-off our investment in Crosswave and
no longer consider Crosswave to be an IIJ Group company. On December 15, 2003,
the business operations of Crosswave were transferred to NTT Communications.
Due to the transfer, the operation of Crosswaves network that we relied on for
our network was also transferred to NTT Communications and we have contracted
with NTT Communications for its continued use. On June 26 and September 16, 2003, we completed private placements of a
total of 15,880 shares of our common stock to investors in Japan for an
aggregate amount of ¥13.3 billion for working capital and repayment of our
outstanding 1.75% convertible notes due on March 31, 2005. As a result of these
transactions, the total number of our issued shares of common stock increased
to 38,360 and shareholding of NTT Group increased to 31.6%. We have also agreed
with NTT that it has the right to nominate three persons to serve as either our
directors or statutory auditors, subject to shareholder approval of any
nomination. In addition, we and NTT agreed to undertake efforts to jointly
engage in the development of broadband and Information Technology and other
related business, to expand the business relationship between IIJ and NTT in
connection with new business opportunities and to discuss secondment of
employees to each other. Our head office is located at Jinbo-cho Mitsui Bldg., 1-105 Kanda
Jinbo-cho, Chiyoda-ku, Tokyo 101-0051, Japan, and our telephone number at that
location is (813) 5259-6500. Our agent in the United States is IIJ America
Inc., 1211 Avenue of the Americas, Suite 2900, New York, New York 10036 and the
telephone number at that location is (212) 440-8080. We have a web site that
you may access at http://www.iij.ad.jp/. Information contained on our web site
does not constitute part of this annual report on Form 20-F. For a discussion of capital expenditures and divestitures currently in
progress and those for the past three years, see Capital Expenditures in Item
4.B. B. Business Overview. We offer a comprehensive range of Internet-access services and network
solutions to our customers in Japan. We offer our services on one of the most
advanced and reliable Internet networks available in Japan. Our services are
based upon high-quality networking technology tailored to meet the specific
needs and demands of our customers. We offer, together with other companies or independently, a variety of
services to our customers as part of our total network solutions. Our primary
services are our Internet-access services, value-added services, which includes
Internet data center services and systems integration services. Our
Internet-access services range from low-cost dial-up access to high-speed
access through dedicated lines for individual and corporate customers. Our
value-added services include a variety of data storage and management options
for corporate customers as part of our Internet data center services as well as
network security and other services. Our systems integration services are
tailored to our customers requirements, which include consulting/project
planning, systems design, construction of network systems and systems
outsourcing. We also sell a significant amount of network-related equipment to
our systems integration customers as part of our provision of total network
solutions. 14




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Most of our revenues are generated in Japan and in Japanese yen. The table
below provides a breakdown of the percentage of total revenues for our primary
services over the past three years. For the fiscal year ended March 31,2002
    
    2003
    
    2004Connectivity services
    
    
    45.0
    %
    
    
    38.6
    %
    
    
    41.1
    %Value-added services
    
    
    7.8
    %
    
    
    8.2
    %
    
    
    11.1
    %Systems integration services
    
    
    36.0
    %
    
    
    34.1
    %
    
    
    30.6
    %
 We also offer independently, or together with our group companies, a
variety of other value-added services, including:  
    
    security services, such as managed firewalls with VPN
function (virtual private networks, which provide private capacity
transmission services), network intrusion detection and
comprehensive network security services,
    
    mail server outsourcing services,
    
    web hosting services, and
    
    content development, distribution and Internet broadcasting services. This extensive variety of Internet-access services, value-added services
and systems integration services enables our customers to purchase all of their
Internet-related services and products through a single source. To support our
services and for the convenience of our customers, we offer a variety of
hardware, software and other products, such as network equipment, which are
mostly sourced from third-party vendors. We aim to be the leading supplier of
total network solutions in Japan. We have created an Internet network that extends throughout Japan. Our
backbone is one of the highest capacity Internet backbones in Japan. Our
backbone network is formed by leasing lines from telecommunications carriers.
As of June 30, 2004, we operated 27 network operation centers, eleven Internet
data centers and 17 POPs, the main points at which our customers connect to our
backbone, throughout Japan. Our policy on the management of backbone is that we
upgrade the bandwidth depending flexibly on the demand and with cost
effectiveness. Our backbone network also extends to the United States, with a
total capacity of 4.8 Gbps (2 STM-16 trunk lines) and to China, with a capacity
of 600 Mbps (STM-4 trunk line) as of June 30, 2004. In addition to our network, we currently own 26.7% of Asia Internet
Holding, the company that operates the A-Bone network. The A-Bone is an
Internet network using leased lines that connects several Asian regions
including China, Hong Kong and South Korea. Using our network and engineering
expertise pursuant to an agreement with Asia Internet Holding, we operate and
manage the A-Bone. Our total network solutions We are a provider of total network solutions. We provide our customers
with tailored, end-to-end Internet and private network solutions. The diversity
of services we offer permits each customer to purchase individual services or a
bundle of services that we believe provide the most efficient, reliable and
cost-effective solution for that customers particular needs. The primary resources that we use to provide total network solutions to
our customers include: 15




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
    
    our Internet-access services,
    
    our line-up of value-added services, which includes security and server outsourcing,
    
    our Internet data center services,
    
    our systems integration services, which includes ongoing
consulting, systems design and construction, operation and
management, and
    
    other network and application services that our group
companies provide. Our total network solutions for business users are one of the primary
focuses of our business. We consult with businesses and other customers to
identify their particular situations and needs. We then draw upon our extensive
resources to address those needs. Our Internet Access Services We offer two categories of Internet-access services: dedicated access
services and dial-up access services. Dedicated access services are based on
dedicated local-line connections provided by carriers between our backbone and
customers. Dial-up access services require customers to connect to our POPs
through the public-switched telephone network. The Internet-access part of our
total network solutions ranges from cost-effective, entry-level dial-up
connections from home personal computers to customized Wide-area network
solutions deploying a range of the dedicated and dial-up services listed below
to connect headquarters, data centers, branch offices and mobile personnel.
Currently, large telecommunications carriers such as regional NTTs and other
providers are rapidly increasing the variety of last-mile access with ADSL,
fiber optic and ethernet-based lines. Such new lines provide inexpensive
high-speed, high-capacity last mile access, and we continue to introduce new
variations to our Internet-access service to accommodate such developments. The following table shows the number of our Internet-access service
subscribers as of the dates indicated: As of March 31,2000
    
    2001
    
    2002
    
    2003
    
    2004Dedicated access service contracts:IP service64 kbps  128 kbps
    
    
    484
    
    
    
    295
    
    
    
    142
    
    
    
    112
    
    
    
    73192 kbps  768 kbps
    
    
    155
    
    
    
    80
    
    
    
    42
    
    
    
    35
    
    
    
    201 Mbps  2 Mbps
    
    
    140
    
    
    
    240
    
    
    
    270
    
    
    
    268
    
    
    
    2183 Mbps  1.2 Gbps
    
    
    71
    
    
    
    111
    
    
    
    156
    
    
    
    248
    
    
    
    427Total IP Service
    
    
    850
    
    
    
    726
    
    
    
    610
    
    
    
    663
    
    
    
    738IIJ data center connectivity service
    
    
    
    
    
    
    56
    
    
    
    110
    
    
    
    156
    
    
    
    196Other dedicated access services
    
    
    1,154
    
    
    
    1,870
    
    
    
    2,900
    
    
    
    4,489
    
    
    
    6,292Total dedicated access service contracts
    
    
    2,004
    
    
    
    2,652
    
    
    
    3,620
    
    
    
    5,308
    
    
    
    7,226Dial-up access service contracts:IIJ4U
    
    
    75,170
    
    
    
    95,273
    
    
    
    89,213
    
    
    
    79,464
    
    
    
    67,105Others
    
    
    54,970
    
    
    
    66,857
    
    
    
    171,363
    
    
    
    450,320
    
    
    
    628,762Total dial-up access service contracts
    
    
    130,140
    
    
    
    162,130
    
    
    
    260,576
    
    
    
    529,784
    
    
    
    695,867
 As of June 30, 2004, we offered the following Internet-access services. 16




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##### Table of Contents



PricingService Type
    
    Summary Description
    
    (excluding consumption tax)Dedicated access servicesIP Service
    
    Full-scale dedicated line
service with high-speed access
for businesses and other
network operators with
demanding bandwidth
requirements.
    
    Setup and monthly fees vary according
to carrier, line speed, line type and
distance involved.IIJ Data Center Connectivity Service
    
    Full-scale dedicated line
service for customers hosted
in IIJ Data Centers, with
asymmetrical speeds of
upstream (from the Internet to
data center) and downstream
(from the data center to the
Internet) transmissions.
Upstream speed of 1 Mbps to 4
Mbps is provided with 10
BASE-T interface (downstream
10 Mbps) and 6 Mbps to 48 Mbps
with 100 BASE-T interface
(downstream 100 Mbps).
    
    Initial setup fee of ¥100,000. Monthly
fees range from ¥400,000 to
¥100,000,000, depending on the speeds
of upstream transmissions.IIJ FiberAccess/F
    
    Service for dedicated line
Internet-access using optical
lines at either 10 Mbps or 100
Mbps targeted primarily at
small- and medium-sized
enterprises requiring for
high-capacity, high-speed
transmissions. SLA (Service
Level Agreements), a quality
assurance program, is
available.
    
    Initial setup fee of ¥50,000. Monthly
fees range from ¥14,000 to ¥190,000,
depending on the speed of connection
and the number of IP addresses
allocated. Monthly fees do not include
optical line charges, which are paid
directly by the customer to the optical
line provider.IIJ T1 Standard
    
    Packaged dedicated line
service offering 1.5 Mbps
connection but not including
certain features of full-scale
IP Service such as dynamic
routing and unlimited IP
addresses.
    
    Initial setup fee of ¥50,000. The
monthly access fee is ¥117,000 for up
to eight IP addresses and ¥167,000 for
up to 16 IP addresses.IIJ DSL/F Service
    
    Service for dedicated-line
Internet-access using ADSL
lines at speeds up to 40 Mbps
targeted primarily at small-
and medium-sized offices and
home offices. SLA is
available.
    
    Initial setup fee of ¥30,000. Monthly
access fees range from ¥9,800 to
¥49,800, depending on the number of
allocated IP addresses. Monthly charges
do not include ADSL charges which are
to be paid directly by the customer to
the ADSL service provider.IIJ ISDN/F Service
    
    Service for dedicated-line
Internet-access using ISDN
lines at speeds up to 128
kbps targeted primarily at
small- and medium-sized
offices and home offices
where ADSL lines are not
available.
    
    Initial setup fee
of ¥5,000 and
monthly access fees
range from ¥4,800
to ¥6,800,
depending on the
number of allocated
IP addresses.
Monthly charges do
not include ISDN
charges, which are
to be paid directly
by customers to
ISDN providers.
 17




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##### Table of Contents



PricingService Type
    
    Summary Description
    
    (excluding consumption tax)IIJ Economy
    
    Service for dedicated-line
access to the Internet with
inexpensive monthly fees
primarily for small- and
medium-sized businesses and
local and regional offices of
corporate groups.
    
    Initial setup fee
of ¥40,000. Monthly
access fees of
¥38,000 for 64 kbps
service and ¥45,000
for 128 kbps
service.Dial-up access servicesIIJ Dial-up Standard
    
    Service for corporate users
permitting simultaneous
Internet-access from several
dial-up lines under a single
contract.
    
    Initial setup fee
of ¥5,000. Monthly
basic fee of ¥2,000
plus access charges
of ¥10 per minute.Enterprise Dial-up IP Service
    
    Service for businesses
offering multiple dial-up
accounts at a fixed monthly
fee.
    
    Initial setup fee
of ¥20,000. Monthly
basic fees range
from ¥3,000 to
¥4,900 per account
depending on the
number of accounts.IIJ Dial-up Advanced
    
    Service for corporate users
offering bundled low-cost
dial-up accounts.
    
    Initial setup fee
of ¥5,000. Monthly
basic fee of
¥10,000 for the
first 50 e-mail
accounts including
the first two hours
access per account,
plus ¥5 per minute
after two hours.IIJ4U
    
    Service for individual users,
which includes
Internet-access and 5
megabytes of disk space for
personal Web pages and e-mail
account options for multiple
users. Various access options
such as ISDN and ADSL are
available.
    
    Initial setup fee
of ¥1,900. Monthly
service fee of ¥800
for the first eight
hours and a charge
of ¥5 per minute,
with a ceiling of
¥4,900.IIJmioDSL/DF Service
    
    Service for individual users
offering Internet
connectivity over ADSL at up
to 40 Mbps. ADSL access is
limited to FLETS lines
provided by regional NTTs.
The IP address is changed
every time a connection is
made.
    
    This service does
not charge an
initial setup fee.
Monthly charge is
¥1,400. Monthly
charges do not
include ADSL
charges, which are
to be paid directly
by the customer to
the relevant
regional NTT.IIJmioFiberAccess/DF Service
    
    Service for individual users
offering Internet connectivity
over optical fiber network at
10 Mbps or 100 Mbps. Optional
fiber access is limited to
BFLETS lines provided by
regional NTTs. The IP address
is changed every time a
connection is made.
    
    The service does not charge an initial
setup fee. Monthly charges range from
¥2,000 to ¥7,000. Monthly charges do
not include optical fiber access
charges, which are to be paid directly
by the customer to the regional NTTs.
 18




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##### Table of Contents



PricingService Type
    
    Summary Description
    
    (excluding consumption tax)IIJmioDSL/SF Service
    
    Service for individual users
offering Internet connectivity
over ADSL at up to 40 Mbps.
ADSL access is limited to
FLETS lines provided by
regional NTTs. A fixed IP
address is provided with this
service.
    
    The service does not charge an initial
setup fee. The monthly charge is
¥4,800. Monthly charges do not include
ADSL charges, which are to be paid
directly by the customer to the
regional NTTs.IIJmioFiberAccess/DC Service
    
    Service for individual users
offering Internet connectivity
over optical fiber network at
50 Mbps or 100 Mbps. Optical
fiber access is limited to
Access Commufa lines
provided by Chubu Electric
Power Company.
    
    The service does not charge an initial
setup fee. The monthly charge is
¥2,000. Monthly charges do not include
optical fiber access charges, which are
to be paid directly by the customer to
Chubu Electric Power Company.IIJmioFiberAccess/SF Service
    
    Service for individual users
offering Internet connectivity
over optical fiber network at
10 Mbps or 100 Mbps. Optical
fiber access is limited to
BFLETS lines provided by
regional NTTs. A fixed IP
address is provided with this
service.
    
    The service does not charge an initial
setup fee. The monthly charges range
from ¥8,000 to ¥12,000, depending on
the type of access line. The monthly
charges do not include optical fiber
access charges, which are to be paid
directly by the customer to the
regional NTTs.IIJmioMobileAccess Service
    
    Service for individual users
offering mobile Internet
connectivity through several
data communications services
provided by mobile
telecommunication companies.
    
    The service does not charge an initial
setup fee. The monthly charge is ¥300.
The monthly charges do not include
service charges to IIJs access points,
which are paid directly by the customer
to the mobile telecommunication
companies.
 Our Dedicated Access Services Our lineup of dedicated line access services includes: IP Service, IIJ
Data Center Connectivity Service, IIJ FiberAccess/F, IIJ T1 Standard, IIJ
DSL/F, IIJ ISDN/F and IIJ Economy. The total bandwidth allocated to our
dedicated access services has increased approximately 191% to 80.1 Gbps as of
March 31, 2004, up from 42.0 Gbps a year earlier. IP Service.Our IP Service is a full-scale, high-speed access service that
connects a customers network to our network and the Internet. This is the core
service we offer. As of March 31, 2004, we had 738 customers for our IP Service
compared to 663 for our IP Service as of March 31, 2003. The customer chooses
the level of service it needs based upon its bandwidth requirements. As of
March 31, 2004, we offered service at speeds from 64 kbps to 1.2 Gbps. Our IP Service revenues, including revenues of IIJ Data Center
Connectivity Service, represented 25.6% of our total revenues for the fiscal
year ended March 31, 2004 and 23.4% for the fiscal year ended March 31, 2003.
We believe that as businesses continue to develop Internet capabilities, this
service will continue to be the foundation of our total network solutions
offerings. 19




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##### Table of Contents



Subscribers pay a monthly fee for the leased local access line from the
customers location to one of our POPs. The amount of this fee varies depending
on the carrier used and the distance between the customers site and our POPs.
As the bandwidth that customers subscribe increases, customers use ATM
(Asynchronous Transfer Mode) or Ethernet local access line, that supports over
2 Mbps bandwidth. We collect this fee from the customer and pay this amount to
the carrier. Although fees are charged on a monthly basis, the minimum contract length
is one year. For contracts of at least three years, a 10% per month discount is
given. Of our IP Service contracts as of the end of March 2004, 3.6% were for
at least three years. We also offer various IPv6-capable Internet-access services, namely IPv6
Tunnel, IPv6 Native and IPv6/IPv4 Dual Stack Services. In addition to corporate
users, IPv6 Tunnel Service has been available to individual users. IPv6 is the
next generation Internet Protocol, which allows IPv6 technology to overcome the
problems, such as limited IP address availability, of IPv4, the protocol
generally used. IPv6 Tunnel Service is a service to enable customers to use
IPv6 technology via IPv4 access network, by encapsulating IPv6 data with IPv4
data. IPv6 Native and IPv6/IPv4 Services are services to provide IPv6
environment to customers without encapsulating it with IPv4 data. IPv6 technology
enables customers to hook-up a vast range of electronic appliances and
equipment, including cellular phones, AV equipment, car navigation devices and
home electronics. We are the first commercial ISP in Japan to offer IPv6
service and our management believes that we will reap first-mover benefits
from our initiative. In an effort to promote the dissemination and use of IPv6,
we are not currently charging service fees for IPv6 Tunnel Service. For our IP Service, we offer Service Level Agreements to our customers to
better define the quality of services our customers receive. We were the first
ISP in Japan to introduce this agreement. We guarantee the performance of the following elements under our Service Level Agreements:  
    
    100% availability of our network,
    
    the maximum average latency, or time necessary to transmit a
signal, between designated POPs, and
    
    prompt notification of outage or disruption. We are able to offer these Service Level Agreements because of the high
quality and reliability of our network. Our Service Level Agreements provide
customers with credit against the amount invoiced for the services if our
service quality fails to meet the prescribed standards. Subscribers to our IP Service receive technical support 24 hours a day and
seven days a week. IIJ Data Center Connectivity Service.We also provide connectivity
services with respect to our data centers. Our data center connectivity
services are an important part of being able to provide high-quality,
high-speed, seamless service to our customers. Our connectivity services are
asymmetric, meaning that transmission speeds in both directions are not the
same  with the downstream transmission being faster to accommodate greater
amounts of information being accessed from the Internet versus being sent to
the Internet. The fee structure depends on the transmission capacity required
for upstream and downstream transmissions. For downstream transmissions, we
offer either 10BASE-T connectivity (10 Mbps) and 100BASE-T Connectivity (100
Mbps). For upstream transmissions, we offer bandwidths from 1 Mbps to 4 Mbps
for 10BASE-T connectivity contracts, and 6 Mbps to 48 Mbps for 100BASE-T
Connectivity. As of March 31, 2004, we had 196 customers for IIJ Data Center
Connectivity Service. In addition to the above, we offer IPv6-capable data
center services, which offer the same services using IPv6. As of March 31,
2004, we had 196 Internet data center connectivity contracts, compared with 156
as of March 31, 2003. Total 20




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contracted bandwidth for Internet data center connectivity service was
15.6 Gbps as of March 31, 2004, up from 9.9 Gbps as of March 31, 2003. IIJ FiberAccess/F Service.IIJ Fiber Access/F services is a dedicated
Internet-access service that uses BFLETS fiber optic access lines provided
by regional NTT companies allowing service at 10 Mbps or 100 Mbps on a
best-efforts basis. We began offering this service in August 2001. The service
is available in four variations (Business, Basic, Family and Mansion),
optimizing each customers needs in speed and connection interface. Customers
also can choose the number of allocated IP addresses from: 1, 4, 8, 16, 32, 64
and 128. We support this service by providing guarantees of latency rates under
Service Level Agreements. As of March 31, 2004, we had 6,292 customers for IIJ
FiberAccess/F Service, IIJ T1 Standard, IIJ DSL/F Service, IIJ ISDN/F services
and IIJ Economy. IIJ T1 Standard.Our IIJ T1 Standard is a connectivity service at 1.5 Mbps
that we introduced in October 1999. It is a packaged dedicated line service
limited to static routing and allocations of 8 or 16 IP addresses. Last mile
access must be through NTTs Digital Access 1500 or similar services from other
carriers. IIJ DSL/F Service.IIJ DSL/F Service provides dedicated line Internet
connectivity via ADSL with speeds up to 40 Mbps. We began offering this service
in May 2001. IIJ DSL/F Service is primarily targeted at small- and medium-sized
offices and home offices that have access to ADSL lines provided by regional
NTT companies under the name of FLETS ADSL. We support this service by
providing guarantees of the maximum average latency between designated POPs
under service agreements. IIJ ISDN/F Service.IIJ ISDN/F Service provides dedicated line
Internet-access via ISDN lines with speeds up to 128 kbps. We began offering
this service in March 2003. IIJ ISDN/F Service is primarily targeted at
small-and medium-sized offices and home offices where ADSL lines are not
available but have access to ISDN lines provided by regional NTT companies
under the name of FLETS ISDN. IIJ Economy.IIJ Economy is a packaged Internet connectivity service via a
dedicated line at 64 kbps or 128 kbps, targeting small- and medium-sized
businesses. We introduced IIJ Economy in November 1997. We currently guarantee
latency rates under Service Level Agreements for IIJ Economy. Our Dial-up Access Services We offer a variety of dial-up access services. Our dial-up access services
are an important resource in offering total Internet solutions to corporate
customers. Our dial-up services allow frequent travelers to access our network
or their own corporate networks through one of our POPs or through our roaming
access points. Our dial-up access services are also an important option for
large corporate groups that will be linking many offices through our network.
Although these corporate groups use dedicated lines for the main offices and
their larger regional and local offices, they also typically use our dial-up
access services for their smaller branch offices or as a remote-access tool for
employees out of the office. We also offer traditional dial-up access service
for individuals and an OEM (where we provide services for other companies which
sell those services under their own name) service for other network operators,
such as Sharp, NTT East and NTT West. Our main dial-up access services are our IIJ Dial-up Standard, Enterprise
Dial-up IP Service, IIJ Dial-up Advanced, IIJ4U, IIJmioDSL/DF Service, IIJmio
FiberAccess/DF Service, IIJmioDSL/SF Service, IIJmioFiberAccess/DC Service,
IIJmioFiberAccess/SF Service and IIJmioMobileAccess Service, all as described
in the table above. We also provide Network-type Dial-up IP Service,
Terminal-type Dial-up IP Service and UUCP Service to customers, but we are no
longer promoting these services. We have expanded access to our network through roaming agreements that are
an important part of our dial-up access services. We offer global Internet
roaming service in 152 countries with approximately 36,000 21




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##### Table of Contents



access numbers as of June 30, 2004. Additionally, in the United States and
Canada through IIJ America, we have roaming access through a toll-free number
for areas where we dont already have local POPs through roaming agreements or
otherwise. We have also expanded our provision of Content Delivery Network
Platform, (IIJ CDN Platform) on an OEM basis to major broadband service
providers, such as Excite Japan. Our Value-Added Services Although our primary service to our customers has been Internet-access,
our customers are increasingly seeking additional network-related services. We
provide our customers with a broad range of value-added services and products
such as network security services, mail hosting services, and managed router
services, which complement and enhance our Internet-access services and systems
integration services. Generally, the service period is for one year and
customers are billed monthly. We recognize revenues for these services on a
straight-line basis during the service period. Any initial set-up fees received
in connection with our value-added services are deferred and recognized over
the contract period or estimated average period of estimated to customers. We believe that business customers will continue to increase their use of
the Internet as a business tool and will increasingly rely on an expanding
range of value-added services to enhance productivity, reduce costs and improve
service reliability. Our value-added services include:  
    
    Security solutions.As of March 31, 2004, we offered nine
main security services that protect customers internal networks
from unauthorized access and secure remote connections to internal
networks: IIJ Security Standard, IIJ Security Premium, IIJ Security
Lite, IIJ Security Scan Service, Network Intrusion Detection
Service, IIJ Secure Remote Access, IIJ Web Gateway Service, IIJ URL
Filtering Service and IIJ VPN Standard. We were the first ISP in
Japan to provide firewall services, which we first offered in 1994.IIJ Security StandardIn October 1999, we began offering Security
Standard Service pursuant to which we install and manage a
round-the-clock operation of firewall systems. The initial setup fee
ranges from ¥120,000 to ¥300,000, and the monthly fee ranges from
¥60,000 to ¥130,000 depending on a number of factors including the
number of users, packet filtering performance and 3DES (VPN) (an
encryption technology) performance. Since February 2001, a VPN option
is available for this service with an initial cost of ¥20,000 and a
monthly fee of ¥10,000 per computer.IIJ Security PremiumIn July 2000, we began offering IIJ
Security Premium, a high value-added firewall operation and
management service based on Firewall-1, a product which we license
from Check Point Software Technologies. The service combines of
Firewall Management Service and Firewall Rental Service and both
services should be contracted. For Firewall Management Service, the
initial setup fee is ¥200,000 and the monthly fee ranges from ¥150,000
to ¥230,000, depending on the redundancy of firewall equipment. For
Firewall Rental Service, the initial setup fee ranges from ¥200,000
to ¥300,000 and the monthly fee ranges from ¥67,000 to ¥161,000
depending on a number of factors including the number of users and
packet filtering performance. The fees of Firewall Rental Service
become doubled in case that the customer requires redundancy of the
firewall equipment.IIJ Security LiteIn December 2002, we began offering IIJ
Security Lite, an economical version of a managed firewall service
with limited features of operation and maintenance 22




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targeting small- and medium-sized enterprises. The initial setup
fee ranges from ¥30,000 to ¥50,000, and the monthly fee ranges from
¥25,000 to ¥35,800.IIJ Security Scan ServiceIn March 2002, we began IIJ Security
Scan Service, a package of services targeting small- and medium-sized
enterprises to identify security weaknesses in order to prevent
illicit access from external networks and to avert virus infection of
in-house servers. It is available in two forms: regular monthly scans
and one-time spot checks. The form of service can be selected to meet
the specific needs of the customer, such as checks for protocol and
network configuration or for vulnerability to specific illegal network
intrusion. The service was developed with NRI Secure Technologies, a
Japanese security assessment and auditing solutions provider. For the
regular monthly scan service, the initial charge is ¥5,000. The
monthly charge for scanning is ¥25,000 for one IP address, and ¥24,000
will be added per one additional IP address. For the spot scan
service, the basic charge for scanning one IP address is ¥30,000, and
¥29,000 will be added per one additional IP address.Network Intrusion Detection ServiceIn April 2001, we began
Network Intrusion Detection Service, which offers around-the-clock,
non-stop network monitoring and intrusion-detection capabilities, as
well as packet information for analyzing detected illicit accesses.
The initial cost for the service is ¥300,000, and the monthly fee
starts from ¥300,000 and depends on the customers traffic volume.IIJ Web Gateway ServiceIIJ Web Gateway Service is a service
which provides a proxy function for accesses to websites from
companys internal network, and online detection and elimination of
viruses and blocking access to inappropriate websites as options. We
started the service in May 2003 and the service is provided based on
the technology of Trend Micro and Network Appliance. The initial cost
for the service starts from ¥300,000, and the monthly cost starts from
¥350,000 depending on the bandwidth of Internet connectivity from
companys internal network and an absence or addition of options.IIJ URL Filtering ServiceIIJ URL Filtering Service is a service
which blocks access to inappropriate websites by use of IIJs proxy
server. The initial cost for the service is ¥30,000, and the monthly
fee is ¥40,000 as a basic fee plus an additional fee depending on the
number of users in the customers internal network.IIJ VPN StandardIIJ VPN Standard is a service which provides
Internet VPN connectivity among a companys branch and remote offices
based on encryption technology. IIJ rents encryption equipment at
customer sites, configures the equipment for the customer and provides
remote monitoring of the encrypted sessions. Initial cost for the
service starts from ¥30,000, and monthly fees start from ¥6,900
depending on the equipment features.IIJ Secure Remote AccessIIJ Secure Remote Access is a packaged
service combining the new IIJ Dial-up Advanced with ID Gateway, which
controls remote access to in-house servers protected by firewalls. In
addition to the 50 dial-up accounts covered by the base rate, the
service will ensure a secure remote environment by controlling
accessible servers and utilization protocols for each dial-up account.
In May 2002, IIJ Secure Remote Access was upgraded by adding a remote
VPN function. The upgrade enables remote users to transmit and receive
data with encryption, offering a secure enterprise network environment
with a greater variety of access, such as connections from overseas
via local ISPs.
    
    E-mail related solutions.As of March 31, 2004, we offered
eight main e-mail related services enabling customers to outsource
administrative tasks for e-mail server related functions: IIJ Post
Office Service, IIJ Mail Box Service, IIJ Mail Gateway Service, Mail
Operator Service, 23




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Mass Mail Distribution Service, Mailing List Server Service, IIJmio
Prime Mail Service and IIJmioSafety Mail Service.IIJ Post Office ServiceIIJ Post Office Service is an e-mail
operation outsourcing service performed by our e-mail server, enabling
a customer to allocate and maintain a number of e-mail accounts under
its own domain name for its employees, members or other relevant
users. The customer can administer e-mail accounts online through our
customer support Web interface. In addition, in December 2002, we
added a virus checking option for incoming and outgoing e-mails and an
audit option to check the content of outgoing e-mails and suspend
the ones containing keywords specified in advance.IIJ Mail Box ServiceIIJ Mail Box Service is also an e-mail
operation outsourcing service performed by our e-mail server. Unlike
IIJ Post Office Service, customers do not have to obtain their own
domain names. A customer can administer e-mail accounts online through
our customer support Web interface.IIJ Mail Gateway ServiceIn November 2002, we renovated IIJ Mail
Gateway to expand the service from large corporate customers to other
corporate segments. The service has three options. The first one is
virus protection to check the viruses on incoming and outgoing
e-mails. The second one is audit to detect the keyword set in advance
on the outgoing e-mails. The third one is a combination of the
features above. The initial cost is ¥10,000, and the monthly fee
ranges from ¥30,000 to ¥50,000 for the first 50 e-mail accounts and an
additional fee per account after the first 50 e-mail accounts ranges
from ¥300 to ¥650.Mail Operator ServiceMail Operator Service is an outsourcing
service for e-mail distribution to large amount of e-mail addresses up
to 9,000 addresses. The service enables users to manage the e-mail
addresses to which e-mails are distributed with e-mail with commands
or through the website. This service also provides a virus check
function.Mass Mail Distribution ServiceMass Mail Distribution Service is
an outsourcing service for e-mail distribution to so large amount of
e-mail addresses that can not be covered by Mail Operator Service.Mailing List Server ServiceMailing List Server Service is an
outsourcing service to provide mailing list function to include up to
9,000 e-mail addresses with a virus-check function.IIJmio Prime Mail ServiceIIJmioPrime Mail Service is a deluxe
e-mail account service for individuals, emphasizing security,
stability and reliability. To achieve tighter security, we pioneered
the use of POP/SMTP over SSL, together with SMTP authentication to
ensure a higher level of encryption and authorization than currently
available in general use. The service places no restrictions on the
number of incoming mail items or on incoming mail size. It also offers
e-mail backup storage for three months, along with forwarding
functions, Authenticated Post Office Protocol (APOP) compatibility,
and virus detection and elimination. The basic monthly charge for this
service is ¥10,000. In June 2002, we introduced the SLA program to
provide quality assurance for our subscribers. Under the SLA program,
if the server is down for more than 15 minutes, we will give its
subscribers a 10% credit against the amount invoiced for the following
months services. The SLA covers only the availability of servers and
not value-added functions such as virus elimination.IIJmio Safety Mail ServiceIIJmioSafety Mail Service is a
standard e-mail service with an anti-virus function for individual
users launched in December 2001. The service employs the 24




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InterScan VirusWall developed by Trend Micro Incorporated, and
features POP/SMTP over SSL which provides secure e-mail transmission
by encrypting the e-mail transmission between the users and our mail
server, in addition to SMTP authentication, which ensures a higher
level of encryption and authorization than what is currently available
for general use. There is no initial charge and the monthly charge is
¥500.
    
    Value-added hosting solutions.As of March 31, 2004, we
offered four value-added hosting solutions that enable our customers
to manage their web content: IIJ Web Standard, IIJ Download Site
Service, IIJ Document Exchange Service and IIJmioPersonal Domain
Name Service.IIJ Web StandardThe IIJ Web Standard allows customers to use
their own domain names while providing them with up to 200 megabytes
of web hosting space. By limiting specifications, the pricing of the
service is kept to a minimum ¥5,000 per month. Additionally, through
careful traffic management of the storage space, a high-performance
web-server environment for users is ensured. This service mainly
targets small- and medium-sized enterprises.IIJ Document Exchange ServiceThis service is an online storage
service with which customers can upload files onto IIJs storage
server and share them with authorized users. The initial cost is
¥40,000 and the monthly fee is ¥20,000, which includes 1GB of disk
space and 50 accounts. The fee for each additional set of 10 accounts
is ¥3,000, and each 1GB of additional disk space is ¥10,000 per month.IIJ Download Site ServiceIIJ Download Site Service is a hosting
service dedicated to high-volume content downloads from the Internet.
The service started on a trial basis in November 2001, and the
full-fledged service was launched in February 2002. A dedicated
hosting server and dedicated bandwidth are established for each
contract to ensure constant stable performance. With disk capacity of
500 megabytes per contract on our hosting servers, access is provided
at a maximum transmission bandwidth per contract of up to 80 Mbps. The
initial charge for the service is ¥50,000. The monthly charge ranges
between ¥60,000 and ¥340,000, depending upon the bandwidth. In April
2003, we added the option of 1 Gbps maximum transmission speed for an
additional fee.IIJmio Personal Domain Name ServiceIIJmio Personal Domain Name
Service is a service for individuals to build their own web sites of
up to 100 megabytes and use e-mail addresses under their original
domain names. The service was launched in March 2002. The initial
charge is ¥5,000 and the basic monthly fee is ¥3,800.
    
    Our Streaming Solutions.We provide Internet streaming
services for live broadcasts over the Internet, as well as streaming
server hosting services with our Streaming-On-Demand Channel.
    
    Our Network Management Solutions (Omnibus).Omnibus, launched
in February 2002, was developed specifically to enable corporate
customers to integrate their various network systems by
interconnecting them at our Internet data centers. The Omnibus
service also integrates customers security systems, including
firewalls and intrusion detective systems. The initial charge is
¥300,000 plus ¥50,000 for usage of a rack in the data center.
Monthly charges depend on the number of ports to be used for the
service and the space in the rack to be used, ranging from ¥180,000
(six ports) to ¥330,000 (12 ports) plus ¥25,000 per one unit of
space in the rack. 25




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
    
    Customer support and help desk solutions.We provide
comprehensive customer support and help desk solutions that include
network monitoring and trouble-shooting services. Most of our
customer support services are provided as an integral part of other
services we sell.
    
    IIJ DNS Services.We offer domain name related services that
consist of domain name administration services and domain name
server outsourcing services. Domain names such as .jp, .com,
.net and .org are available.
    
    IIJmio Simple DNS Service.IIJmio Simple DNS Service is a
service for individuals that provides domain name registration and
DNS primary and secondary servers. By enabling customers to edit the
DNS records for themselves, customers can build web and mail servers
at customer sites more easily.
    
    IIJ NetLightning.IIJ NetLightning is a service based on
Netli, Inc.s technology that improves web application performance.
By utilizing this service, end users can make faster access to the
customer website without any settings and customers can reduce the
cost to place mirror sites.
    
    IP Phone.We began IP Phone service for individual users of
IIJ4U and IIJmioin May 2003, and for corporate users who are using
IIJs Internet connectivity services through NTT FLETS network in
December 2003. The telephone service is provided via NTT FLETS
network and customers can make telephone calls with other users
connected to NTT FLETS network or legacy telephones by
interconnection with Public Switched Telephone Network, the legacy
telephone network.
    
    IIJ SMF.IIJ SMF (SEIL Management Framework) is a service
which provides remote configuration and monitoring features of
SEIL/neu Series routers at customer remote sites from central
management servers at IIJ and customer main office/data center. The
technology is patent pending. When a customer at a remote site
connects the router to the circuit, the router is automatically
configured and connected to the network. If system integrators
utilize this technology, they can reduce the configuration work and
maintenance costs at the remote site. Our Internet Data Center Services As part of our value-added services, we offer Internet data center
services. Our Internet data center services comprise three primary services
which are typically bundled together for our customers: IIJ data center
facility services, IIJ data center connectivity services and management and
monitoring services. Generally, the service period for all Internet data center
services is one year and customers are billed monthly. We recognize revenues
for these services on a monthly-billed basis during the service period. Any
initial set-up fees received in connection with our value-added services are
deferred and recognized over the contract period or estimable average period of
service to customers. Our Internet data center facility services are co-location services which
allow companies to house their servers and routers off-site on our premises.
Our Internet data center facilities are leased from NTT Communications and CRC
Solutions Corp. and are equipped with robust security systems, 24-hour-a-day
non-stop power supplies and fire extinguishing systems, and have
earthquake-resistant construction and high-speed Internet connectivity with IIJ
backbones. We also offer basic monitoring and maintenance services for the
equipment. This service enhances reliability because we provide 24-hours-a-day
monitoring and have specialized maintenance personnel and facilities. The
initial charge of our Internet data center facility service is ¥250,000, and
the basic monthly charge for the service is ¥300,000 per rack. We offer
management and monitoring services that we tailor in accordance with our
customers requirements. 26




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We recognize revenues for these services on a monthly-billed basis during
the service period. Any initial set-up fees received in connection with our
value-added services are deferred and recognized over the contract period. Our Systems Integration Services We offer systems integration services tailored to our customers
requirements, which include consulting/project planning, systems design,
construction of network systems and systems and operations outsourcing. Our
systems integration services mainly focus on Internet business systems and
Intranet and Extranet corporate information systems. We have built a strong
record in various business fields, including the representative below: Examples of systems integration services are:  
    
    connecting over a handled branches or shops such as gas
stations via Internet-VPN, transmission of data over Internet
with an encryption feature,
    
    virtual campus systems including both Internet
connectivity and Intranet information services,
    
    outsourcing of broadband Internet connectivity services
and large-scale portal sites for PDA users,
    
    online brokerage systems for securities firms,
    
    outsourcing of websites for online business
    
    outsourcing of large-scale e-mail servers,
    
    systems for Internet CATV (Cable TV) infrastructure,
    
    re-construction of overall corporate network systems
suited to increased traffic data, and
    
    consultation on corporate network security. The fee structure of our systems integration services is based upon the
complexity and scale of the project required by the customer. We bill our
customers for these services on a fixed fee basis and recognize the revenue
when the network systems and equipment are delivered and accepted by the
customer. In the planning phase of a systems integration project, we form special
project management teams formulated for every new assignment from the customer.
We analyze and design the customers network and systems with three engineering
focuses: reliability, flexibility and extendibility. In the network systems construction phase, we procure equipment such as
servers and manage application development and software programming tasks which
are outsourced to third parties. The task of network systems construction
usually incorporates many of our other access and value-added services. In the operation phase, by utilizing data center facilities directly
linked to our network, we provide a range of outsourcing services, which take
maximum advantage of the Internet system, network operation and management
know-how of the IIJ Group companies. Rather than simply looking after the
customers content, we take care of the customers entire computing environment
and provide round-the-clock operation and 27




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management services, as well as custom-designed monitoring systems. These
outsourcing services enable customers to free themselves from the burden of
operating the network systems, which demands professional operation and
maintenance to ensure prompt and flexible responses to unexpected system
problems. We also provide our customers with basic, easy-order systems integration
services, which we refer to as IBPS, a service to provide network resources
such as network equipment, data storage systems, network monitoring and systems
operation management for monthly rental on demand that allows our customers to
launch their internal network system in the securely and cost effectively. Our Equipment Sales In
addition to the Internet-access and value-added services and systems
integration, we sell our originally developed network equipment,
SEIL/neu Series, to connect to
the Internet and provide other features. SEIL/neu Series.We started to sell our developed high-end routers
SEIL/neu Series in October 2001 through sales agents. The series includes three
types, SEIL/neu 128 for ISDN or 64 k/128 kbps leased line based Internet
connection, SEIL/neu T1 for T1 leased line based Internet connection and
SEIL/neu 2FE for broadband connection with NTT FLETS ADSL or BFLETS services.
In November 2002, we added SEIL/ATM for ATM based Internet connectivity and in
June 2003 added SEIL/TURBO with more throughput and enhanced VPN features. By
combining SEIL/TURBO and other SEIL/neu Series routers, we are able to provide
Internet-VPN solutions connecting corporate branches and remote offices of
medium and small enterprises. In addition, we are providing rental services for
these routers directly to customers. We also sell
third party equipment to meet the one stop needs of our customers. Network Our network is one of our most important assets. We have developed and
operate a high-capacity network that has been designed to provide reliable,
high-speed, high-quality Internet-access services. We are able to achieve and maintain high speeds through our advanced
network architecture, routing technology and load balancing that optimize
traffic through our multiple Internet connections. The primary components of our network consist of:  
    
    our backbone, which includes leased lines and network
equipment such as advanced Internet routers;
    
    POPs in major metropolitan areas in Japan;
    
    data centers; and
    
    a network operations center, or NOC. Backbone Leased lines Our network is anchored by our extensive Internet backbone in Japan and
between Japan and the United States. As of June 30, 2004, we had a total
capacity of 4.8 Gbps between Japan and the United States and 600 Mbps between
Japan and China. We use our expertise in developing and operating our network
to organize and connect these leased lines to form a backbone that has
substantial transmission capacity. 28




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We lease high-capacity, high-speed digital transmission lines in Japan
from various carriers. The table below shows our international backbone
capacity and cost. Average total capacity is calculated by averaging the
international capacity at the end of each month. International Backbone Capacity and Cost For the fiscal year ended March 31,2000
    
    2001
    
    2002
    
    2003
    
    2004Backbone cost (thousand yen)
    
    
    5,660,277
    
    
    
    5,548,527
    
    
    
    2,469,002
    
    
    
    1,644,170
    
    
    
    829,120Average total capacity (Mbps)
    
    
    620.00
    
    
    
    1,162.50
    
    
    
    1,778.33
    
    
    
    3,408.33
    
    
    
    4,700.00Average cost per 1 Mbps (thousand yen)
    
    
    9,129
    
    
    
    4,773
    
    
    
    1,388
    
    
    
    482
    
    
    
    176
 In the United States, our network backbone connects to the following major
interexchange (IX) points:  
    
    MAE West ATM in San Jose, California,
    
    Equinix GigE Exchange in San Jose, California,
    
    PAIX (Palo Alto Internet Exchange) in Palo Alto, California,
    
    NYIIX (New York International Internet Exchange) in New York,
    
    MAE East ATM in Ashburn, Virginia,
    
    Equinix GigE Exchange in Ashburn, Virginia, and
    
    LAIIX (Los Angeles International Internet eXchange) in Los Angeles. Through these IX points we connect to many other ISPs in the United
States, including Verio and Sprint. In Asia, we have established a backbone connection through the A-Bone, the
Internet backbone network covering the Asia-Pacific region. The A-Bone is
operated by Asia Internet Holding, of which we own 26.7%. Asia Internet Holding
commissioned us to design and build the A-Bone, and we currently manage it. Network upgrades We have placed a high priority on the continued upgrade of the capacity of
our networks in order to maintain and improve quality. We first will enhance
the quality of our domestic network and our network between Japan and the
United States. We will also look to upgrade our network in the Asia-Pacific
region as opportunities arise. Network equipment We use advanced equipment in our network. Our primary routers in our
network are Cisco routers. The size of our routers varies depending on the
number of customers and volume of traffic served by our POPs. At each POP we
connect our dedicated line and dial-up access routers to Cisco backbone routers
which then transmit and receive information throughout our network. We
primarily lease our network equipment under capital lease arrangements. 29




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POPs Points of Presence, or POPs, are the main points at which our customers
connect to our backbone. We provide Internet-access from our POPs to commercial
and residential customers through leased lines and dial-up connections over
local exchange facilities. As of June 30, 2004, we had 27 primary POPs which
allow for dedicated access and include the main Internet backbone routers that
form our network. As of the same date, we also had 18 POPs for dial-up access.
The number of POPs for dial-up access include one POP that can be accessed from
anywhere in Japan with the minimum local telephone charge. We have introduced
this POP in March 2004 to increase customers ease of usage of our Internet
connectivity services. Many of our POPs are located in, or in close physical proximity to,
carrier hotels. Carrier hotels are facilities where we and other major
carriers and ISPs have POPs. These are mainly located at facilities of various
carriers in Japan like NTT Communications, KDDI and Japan Telecom. We lease the
physical space from these carriers or use such space under other arrangements
with terms ranging from one to two years and which can usually be terminated by
either party on three to six months notice. We maintain our routers and other
networking equipment at these POPs. The actual location of our POPs in, or in
close proximity to, the same buildings in which the switches and routers of
these carriers and ISPs are located offers us the ability to quickly and easily
interconnect our equipment with theirs. Internet Data Centers We operate at eleven Internet data centers nationwide in Tokyo, Osaka,
Sapporo, Sendai, Kawaguchi, Yokohama, Nagoya, Kyoto, Fukuoka and second data
centers in Tokyo and in Yokohama which we use to offer our value-added data
center services. These data centers are specifically designed for application
hosting, co-location services and high capacity access to our networks. All of
these data centers are leased from NTT Communications and CRC Solutions Corp. These data centers have 24-hours-a-day, seven-days-a-week operations and
security and are equipped with uninterruptible power supplies and backup
generators, anti-seismic damage precautions, fire suppression equipment and
other features to optimize our ability to offer high-quality services through
these data centers. In addition, we have invested in data center development outside Japan. We
have entered into the i-Heart joint venture with Samsung Corp., which
operates in Korea with a total investment by us of ¥89 million in May 2000. Network operations center and technical and customer support Our network operations center, or NOC, in Tokyo operates 24 hours a day
and seven days a week. From our NOC, we monitor the status of our network, the
traffic on the network, the network equipment and components and many other
aspects of our network including our customers dedicated access lines leased
from carriers. From our NOC, we monitor our networks to ensure that we meet our
commitments under our Service Level Agreements. Our Group Companies We offer our services directly and together with our group companies. Our
group companies work closely together in providing total network solutions to
our customers. We collaborate on the development of various services and
products and market our services and products together as a group. However, our
group companies specialize in different aspects of the Internet and networking.
Our customers main point of contact is IIJ itself. We then draw upon the
resources and specialization of the group companies to offer total Internet
solutions. 30




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The table below sets out our group companies, including our subsidiaries
and principal equity method investees and our ownership of each of them as of
June 30, 2004: Proportion of ownershipCompany Name
    
    and voting interestIIJ Technology
    
    
    67.9
    %IIJ Media Communications
    
    
    60.1
    %IIJ America*
    
    
    97.2
    %Net Care
    
    
    52.5
    %Asia Internet Holding
    
    
    26.7
    %Internet Multifeed*
    
    
    28.6
    %atom
    
    
    40.0
    %
   (*)
    
    Includes our indirect investment to our subsidiaries and principal equity method investees. IIJ Technology Inc. IIJ Technology Inc. is an important element in our providing total
Internet solutions to our customers. IIJ Technology Inc. is incorporated under
the laws of Japan. IIJ Technology provides comprehensive network systems
integration and consulting services, focusing on design, operation, and
consulting for corporate networks (LANs, enterprise networks, Intranets) and
their security systems. IIJ Technology assists customers in creating private IP
networks, such as Intranets or virtual private networks, that securely isolate
internal network traffic from public Internet traffic and provide each site on
the private IP network access to other sites as well as to the Internet. IIJ
Technology can integrate an organizations multiple sites in different
locations in Japan. On April 27, 2004, IIJ Technology completed a private placement of 10,000
shares of common stock to us and other shareholders for an approximate
aggregate amount of ¥1,000 million. We accepted ¥850 million of the total
amount. On June 30, 2004, 430 shares of 8,500 shares that we accepted were
transferred to an employee stock holding association of IIJ
Technology. As a result of
those transactions, our shareholding in IIJ Technology became 67.9%. IIJ Technology had sales of approximately ¥12,964 million for the fiscal
year ended March 31, 2004. As of March 31, 2004, IIJ
Technology had 163
full-time employees, and 28 were seconded from us. IIJ Media Communications Inc. IIJ Media Communications Inc. provides expert services to help customers
exploit the potential of the Internet as a new communications medium. IIJ Media
Communications is incorporated under the laws of Japan. IIJ Media
Communications core business is providing various hosting and home page
development services as well as Internet broadcasting services. For this
purpose, IIJ Media Communications engages in research and development of the
newest technologies for media communications, such as streaming technologies
including multicast and portal service applications, and incorporates the
technologies into various applications. IIJ Media Communications also provides total support for customers
content and systems, particularly those customers who engage in e-commerce
related activities. IIJ Media Communications provides consultation, planning,
configuration (including selection of hardware and choices of applications),
content production and ongoing support for its customers. Other basic media
services offered by IIJ Media Communications include information management
services related to the Internet. IIJ Media Communications also offers servers
to manage mailing lists and provide simultaneous distribution services. 31




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As of June 30, 2004, we own 60.1% of IIJ Media Communications. IIJ Media Communications had sales of approximately ¥843 million for the
fiscal year ended March 31, 2004. As of March 31, 2004, IIJ Media
Communications had 33 full-time employees, 33 of whom were seconded from us. Net Care, Inc. Net Care Inc. provides a broad array of support services, from monitoring
and troubleshooting to network operations and an end-user help desk. Net Care,
Inc. is incorporated under the laws of Japan. As of June 30, 2004, we own 52.5% of Net Care. Net Care had sales of approximately ¥2,066 million for the fiscal year
ended March 31, 2004. As of March 31, 2004, Net Care had 224 employees, and 12
were seconded from us. IIJ America Inc. IIJ America Inc. is a U.S.-based Internet-access provider, catering mostly
to U.S.-based operations of Japanese companies. IIJ America is incorporated
under the laws of the state of California. As of June 30, 2004, we own 91.3% of IIJ America and IIJ Technology own
8.7%. IIJ America had revenues of $10,399 thousand for the fiscal year ended
December 31, 2003. As of March 31, 2004, IIJ America had 13 employees, 5 of
whom were seconded from us. Asia Internet Holding Co., Ltd. Asia Internet Holding Co., Ltd. was created to own and manage the A-Bone,
which is a high-speed Internet backbone network that connects countries in the
Asia-Pacific region to a common network infrastructure. Asia Internet Holding
is incorporated under the laws of Japan. Currently, the A-Bone ties into networks in Japan and several regions
including China, Hong Kong and South Korea. Asia Internet Holding has network
operations centers in each of these countries. The A-Bone also connects to the
United States through our network. The primary customers of Asia Internet
Holding are telecom carriers and ISPs throughout Asia including Japan. As of June 30, 2004, we own 26.7% of Asia Internet Holding. We operate and
manage the A-Bone pursuant to an agreement with Asia Internet Holding. The
amount of payment from Asia Internet Holding to IIJ for the operation and
management is ¥6 million per month, with the renewed agreement dated July 1,
2004. Asia Internet Holding had sales of approximately ¥1,354 million for the
fiscal year ended March 31, 2004. As of March 31, 2004, Asia Internet Holding
had 13 employees, 2 of whom were seconded from us and three of whom worked part
time. Internet Multifeed Co. Internet Multifeed Co. provides the location and facilities for directly
connecting high-speed Internet backbones with content servers to make
distribution on the Internet more efficient. Internet Multifeed is incorporated
under the laws of Japan. We developed their technology jointly with NTT Group.
Internet 32




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Multifeed launched new IX (Internet eXchange  where major ISPs exchange
network traffic) services named JPNAP in Tokyo in May 2001 and expanded the
service to Osaka in December 2001. Through its multifeed connectivity and multifeed housing services,
Internet Multifeed has already connected major ISPs to its premises. Having
such an environment, Internet Multifeed provides multifeed housing services for
content providers, which allows them to distribute content more efficiently by
reducing the number of networks that data must travel through. Major news
company customers include Asahi Shimbun, Nikkei, Mainichi and Yomiuri. Matsui
Securities, one of Japans largest Internet security companies, is also one of
its customers. As of June 30, 2004, we own 26% of Internet Multifeed and IIJ Technology
and IIJ Media Communications each own 2%. Internet Multifeed had sales of
approximately ¥1,746 million for the fiscal year ended March 31, 2004. As of
March 2004, Internet Multifeed had 19 full-time employees, and four employees
were seconded from us. atom Co., Ltd. atom Co., Ltd., which is incorporated under the laws of Japan, is
primarily a web page design company that aims to define new forms of design
work using digital technology in all network-based aspects of design from
content production to graphic design. As of June 30, 2004, we own 40% of atom, which had sales of approximately
¥672 million for the fiscal year ended March 31, 2004. As of March 31, 2004,
atom had 61 employees, one of whom was seconded from us. Capital Expenditures The table below shows our capital expenditures, which we define as amounts
paid for purchases of property and equipment plus acquisition of assets by
entering into capital leases, for the last three years. For the fiscal year ended March 31,2002
    
    2003
    
    2004(millions of yen)Capital expenditures,
including acquisition of
assets by entering into
capital leases
    
    ¥
    3,773
    
    
    ¥
    4,893
    
    
    ¥
    3,523
 Our future capital expenditures are difficult to predict given the rapid
changes and uncertainties in our business. Most of our capital expenditures
relate to the expansion and improvement of our existing network, including the
leasing of lines that form our network backbone and the installation of the
routers and servers necessary to offer services on our network. Our current
plans call for us to make capital expenditures, including acquisition of assets
by entering into capital leases, of approximately ¥3.0 to ¥5.0 billion in each
of the next few years to increase the access to our networks to maintain the
current network quality. In addition, we will continue to add equipment to our
network as we expand the capacity of our network. We have not made any material divestitures in the current or past three
fiscal years, except the loss on disposal of property and equipment of ¥112
million in March 2003 that was primarily due to our move to new headquarters. 33




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Seasonality See Item 5.D., Trend Information  Factors Affecting Our Future Financial
Results  Systems integration revenues including related equipment sales
revenues  Seasonality. Sales and Marketing Our sales headquarters are in Tokyo. We also have branches in Osaka,
Nagoya, Sapporo, Sendai, Toyota, Toyama, Hiroshima, Fukuoka and Okinawa in
order to cover the major metropolitan areas in which the majority of large
Japanese companies operate. As of March 31, 2004, we had approximately 210
people working in sales and marketing. We organize our sales personnel into seven distinct, separate divisions:
five Sales Divisions, New Business Development Division and Marketing Division. Sales Divisions consists the five following Divisions:  
    
    Three of Divisions focus on our total network solutions and
work with large corporate clients, including telecommunications
carriers and ISPs, financial institutions, manufacturing, government
institutions, universities and other schools, or focus on expansion
of sales agents for IIJ services and network equipment. In order to
provide total network solutions, personnel in our sales divisions
work closely with other IIJ Group companies such as IIJ Technology
as well as with other important service providers.
    
    One of Divisions focuses on total network solutions and works
with governmental institutions.
    
    One of Divisions focuses on sales outside of Tokyo. Our New Business Development Division focuses on new business development
or partnerships with other service providers. Our Marketing Division has two
sections: Strategic Sales and Promotion & Research. Strategic Sales is
responsible for the planning and management on the sales figures, processes and
other information. Promotion & Research promotes marketing communications
through advertisement activities as well as organizes conferences and seminars
given for targeted customers in order to enhance awareness of our total network
solutions. Customers We have approximately 6,000 business and other institutional customers and
approximately 696,000 individual subscribers, which includes individuals
through OEM services, as of March 31, 2004. Our main customers continue to be
major corporations including ISPs. We were awarded the best service provider
title in a major annual survey conducted by Nikkei Communications, a leading
telecom industry trade magazine, for two consecutive years of 2001 and 2002 (The survey was not
conducted in 2003). According to the survey in 2002, which included responses
from 856 Japanese companies, we were ranked number one in qualifying categories
of broadband services, dedicated access services and dial-up access services. Research and Development We have always focused on advancing the use of networking technologies,
including the Internet in Japan. Many of our engineers regularly participate in
industry organizations and government-sponsored research projects such as
researching new Internet protocol standards, namely Internet Protocol Version 6
(IPv6). These engineers have continued to develop innovative services,
applications and products, many of which have set the standard for the Internet
industry in Japan. In addition to our efforts to develop innovative 34




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services, we have engaged in the research and development of new basic technology by
establishing IIJ Research Laboratory since 1998. Our research and development expenses averaged less than 1.0% of total
revenues for the past two consecutive years. For the fiscal years ended March
31, 2004, 2003 and 2002, our research and development expenses were ¥358
million, ¥414 million and ¥319 million, respectively, most of which was
personnel expense. The level of research and development expenditures is low in
relation to our total costs primarily because we do not engage in extensive
research and development of new technologies and products that require large
investments. Rather, as noted above and as set forth in more detail below, we
are intensively engaged in daily research and development activities. We focus
on monitoring the developments in the industry and in developing new and
innovative services and applications by using and modifying existing
technologies and products. As of March 31, 2004, we had approximately 54 people working in our
research and development organization, including the staff in IIJ Research
Laboratory, all of whom also have additional responsibilities in the Business
Development Department and the Development Department. Our research and
development staff works very closely with our sales and marketing personnel and
technical engineers to ensure that our research and development efforts are
closely aligned with the demands of our customers. Research and Development Organization We have organized our research and development staff to promptly and
effectively address the rapidly changing technological environment in the
Internet. Research and development on practical applications of new and
developing technologies is the responsibility of the IIJ Research Laboratory,
the Development Department and the Product Development Division in Business
Development Department. IIJ Research Laboratory. We established the IIJ Research Laboratory in
April 1998 to engage in the research and development of new basic network
technologies. Through the IIJ Research Laboratory, we are
participating in various research and development activities in cooperation
with organizations from the private and academic sectors to promote the
deployment and implementation of IPv6. The output of the joint
undertaking with WIDE project is distributed freely in order to promote the
introduction of IPv6 on a worldwide scale. IPv6 is designed to solve problems
inherent in the current version of IP, which is IPv4, such as IP address space
depletion. In addition, IPv6 is expected to provide new network features such
as ubiquitous networking. Development Department.As of March 31, 2004, the Development Department
comprised the following divisions:  
    
    Network Engineering Division, which designs network
infrastructures including Internet data centers and software
development aimed at enhancing network monitoring and traffic
management; and
    
    System Design and Development Division, which develops
network security technology and applications such as firewalls, and
manages technology implementation for various new services. Product Development Division. The Product
Development Division designs network-related products, such as network
monitoring devices and routers. In April 2004, we reorganized the Development Department and the Business
Development Department into the Technology Department, aiming to establish a
more efficient service development structure. 35




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Research and Development Strategy Our primary research and development objective is to continue to develop
innovative services, applications and products that will meet the current and
future demands of our customers and that will continue to be at the forefront
of the Internet industry in Japan. In furtherance of this objective, our
research and development efforts currently are focused on a variety of
projects, including:  
    
    continued improvement of our SEIL router and SEIL Management
Framework, systems which we developed specifically to be integrated
into IIJs network-related services;
    
    research relating to the methodology of configuration of routers and other servers;
    
    research relating to behavior of Internet routing systems;
    
    software development for management of border gateway
protocol, or BGP, which is protocol that allows routers to exchange
routing information on the TCP/IP network;
    
    research for Internet traffic monitoring and management;
    
    development of software and evaluation of hardware relating
to improving the operations of routers located on our customers
premises; and
    
    research and development of IPsec, which is a secure version
of IP that provides secure communication channels over the Internet. A second research and development objective is to continue participating
in or otherwise closely monitoring the new products, developments and
initiatives of manufacturers and standards-setting and research groups. Through
these efforts, we seek to ensure that we have timely and effective access to
new technologies and that we implement these technologies effectively. Because
the rate of change in technology relevant to our business is so rapid, we
believe that the sophistication and experience of our research and development
personnel is an important part of our success. Proprietary Rights Although we believe that our success is more dependent upon our technical,
marketing and customer service expertise than our proprietary rights, we rely
on a combination of trademark and contractual restrictions to establish and
protect our technology. Licenses We have acquired a license from Check Point Software Technologies that
allows us to provide managed firewall services for high-end users using Check
Points Firewall-1 and Provider-1 products. Since June 1999, we are also a
licensee under an agreement with WatchGuard Technologies, Inc. for the right to
use WatchGuards managed firewall service products that provide the ability to
manage, update and configure firewalls remotely. We have acquired a license
from Trend Micro Incorporated that will allow us to add the option of virus
scanning to our e-mail hosting and e-mail services. We are also a licensee
under an agreement with RSA Security Inc. that enables us to provide advanced
secure remote access service to our customers. Additionally, we are a licensee
under an agreement with NRI Secure Technologies, Ltd. which enables us to
provide service to investigate and identify any security problems in our
customers networks. 36




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Trademarks We have applied for trademark registrations of our corporate name,
Internet Initiative Japan Inc. and certain other corporate and product names
in Japan, the United States and certain European countries. As of June 30,
2004, there were no applications pending and 28 which have been granted. Legal Proceedings We are involved in normal claims and other legal proceedings in the
ordinary course of business. Except as noted below, we are not involved in any
litigation or other legal proceedings that, if determined adversely to us, we
believe would individually or in the aggregate have a material adverse effect
on us or our operations. In December 2001, a class action complaint alleging violations of the
federal securities laws was filed against us in the United States District
Court for the Southern District of New York, naming as defendants IIJ; Koichi
Suzuki, our President, Chief Executive Officer and Representative Director;
Yasuhiro Nishi, our former Director, Chief Financial Officer and Chief
Accounting Officer; and the Goldman Sachs Group Inc. and Morgan Stanley Dean
Witter, Inc., both of which served as underwriters of our initial public
offering. Similar complaints have been filed against over 300 other issuers
that have had initial public offerings since 1998, and all such actions have
been included in a single coordinated proceeding in the Southern District of
New York. An amended complaint was filed on April 24, 2002. The amended
complaint alleges, among other things, that the underwriters of our initial
public offering (i) entered into certain alleged compensation arrangements with
the underwriters clients, such as undisclosed commissions or tie-in agreements
to purchase stock in the after-market, and (ii) engaged in manipulative
practices to artificially inflate the price of our stock in the after-market
subsequent to the initial public offering. The IIJ defendants are named in the
amended complaint pursuant to Sections 11 and 15 of the Securities Act of 1933,
as amended, and Sections 10(b) and 20(a), and Rule 10b-5 of the Securities
Exchange Act of 1934, as amended, on the basis of an alleged failure to
disclose the underwriters alleged misconduct. The complaint seeks unspecified
damages. On July 15, 2002, we joined in an omnibus motion to dismiss the
amended complaint filed by the issuers and individuals named in the various
coordinated cases. In June 2003, we approved a settlement with the plaintiffs
in this matter. In June 2004, we along with the plaintiffs, the insurers, and
virtually all of the other solvent issuer companies in the coordinate cases,
executed an agreement of settlement, which has been submitted to the United
States District Court for the Southern District of New York for preliminary
approval. The settlement releases us and the individual defendants for
liability for the conduct alleged in the action. Under the settlement, we
agreed to assign away, not assert, or release certain potential claims we may
have against our underwriters. As to financial impact on us, the settlement
provides that the class members will be guaranteed $1 billion dollars in
recoveries by the insurers of the issuers. In addition to IIJs portion of the
proposed settlement, some of the continuing legal expenses incurred in
connection with the partial settlement would be borne by
our insurer based on the settlement agreement and an individual agreement
between us and our insurer. Consequently, we believe that there will be no
significant financial impact on us as a result of this matter. Regulation of the Telecommunications Industry in Japan The MPHPT regulates the Japanese telecommunications industry. Carriers,
including us, are regulated by the MPHPT primarily under the Telecommunications
Business Law. The Telecommunications Business Law The Telecommunications Business Law was considerably amended in July 2003.
The amendments to the Telecommunications Business Law, which came into force on
April 1, 2004, include, among other things: 37




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
    
    the elimination of the classification of Type I Carriers and
Type II Carriers;
    
    deregulation of regulations on charges and terms and
conditions for providing services by Carriers; and
    
    the introduction of certain terminal-equipment-suppliers
declaration system regarding technical standard conformity. The Prior Telecommunications Business Law stipulated that the Carriers
shall be classified as either Type I Carrier or Type II Carrier, and imposed
regulations in accordance with such classification of Carriers. Prior Type I
Carriers, such as NTT East, NTT West, provided telecommunications services by
establishing their own telecommunications circuit facilities. Prior Type II
Carriers, including us, engaged in the businesses of telecommunications circuit
resale and the provision of Internet services by using the telecommunications
facilities of Type I Carriers. However, from the viewpoint of encouraging telecommunications carriers to
carry out diverse business, etc, the Telecommunications Business Law was
amended so as to abolish the classification of Type I Carriers and Type II
Carriers, and thereupon the rules pertaining to services (i.e., start-up,
abolition, charges and tariffs, etc.) were deregulated in principle while
establishing rules to protect the users, and the rules pertaining to
infrastructure were reviewed as necessary while maintaining the basic framework
stipulated under the prior Telecommunications Business Law. For example, (i)the
approval system for business entries and withdrawals was replaced by a
registration/notification system, (ii)regulations pertaining to service
offerings, tariff setting and interconnection between carriers were
liberalized, (iii)regulations to protect service users such as announcement of
withdrawal, explanation of important matters on services and swift processing
of complaints were introduced, and (iv)an authorization system allowing
priority usage of public utilities conducive to facilitation of circuit
facilities deployment was introduced. The following table summarizes changes by the amendment above in some of
the major regulatory requirements applicable to telecommunications carriers: (Before Amendment) Type I Carriers
    
    Type II CarriersSpecial Type II
    
    General Type IIStart-up of services
    
    Permission from
MPHPT required
    
    Registration with
MPHPT required
    
    Notification to
MPHPT requiredRates and charges
    
    Notification* to
MPHPT required
    
    Notification to
MPHPT required
    
    UnregulatedShare
acquisition by foreign investors
    
    Unregulated**
    
    Unregulated
    
    Unregulated
   *
    
    Type I Carriers which operate Category I Designated Telecommunications
Facilities are required to receive MPHPT approval for their
Interconnection charges.**
    
    Prior notification is required under the Foreign Exchange and Foreign
Trade Law. This is not applicable to purchasers of ADSs. A one-third
foreign ownership restriction is applicable only to NTT (which was changed
from a 20% foreign ownership restriction on November 30, 2001). 38




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(After Amendment) Telecommunications CarriersRegistration required
    
    Registration exemptedStart-up of services
    
    Registration with
MPHPT required*
    
    Notification to MPHPT required****Rates and charges
    
    Notification to
MPHPT required**
    
    UnregulatedShare acquisition by foreign investors
    
    Unregulated***
    
    Unregulated
 Before the amendments to the Telecommunications Business Law, we were
classified as a Special Type II Carrier. After the amendments, we are deemed by
the effect of Supplementary Provisions to the amended Telecommunications
Business Law to have filed the notification to MPHPT under the amended
Telecommunications Business Law. In practice, we filed an actual notification
to MPHPT in April 2004 according to the request of MPHPT.   *
    
    Applicable to telecommunications carriers which install certain large
scale circuit facilities unless an exemption applies as designated by the
applicable ministerial ordinance of MPHPT from the viewpoint of the scale
of the telecommunications circuit facilities and the scope of areas where
such telecommunications circuit facilities are installed.**
    
    Applicable to universal services and services which have the control
power over the market provided by the telecommunications carriers which
install what is called the bottle-neck facilities.Telecommunications carriers which operate Category I Designated
Telecommunications Facilities are required to receive MPHPT approval for
their Interconnection terms and charges.***
    
    Prior notification is required under the Foreign Exchange and Foreign
Trade Law for acquisition of shares of telecommunications carriers to
which registration for start-up services is applicable. This is not
applicable to purchasers of ADSs. A one-third foreign ownership
restriction is applicable only to NTT.****
    
    Currently, carriers which meet the following two requirements
established by the ministerial ordinance of MPHPT are exempted from
registration with MPHPT: (i) areas of installation of terminal-related
transmission facilities are limited to only within a single municipal
(city, town or village) and (ii) areas of installation of relay-related
transmission facilities are limited to only within a single prefecture. Regulations of telecommunications carriers The following regulations apply to telecommunications carriers defined in
the Telecommunication Business Law. Start-up of Services  
    
    Carriers with registrationRegistration with the MPHPT required for telecommunications carriers
which exceed criteria established by MPHPTs ordinance in relation to
the scale of the telecommunications circuit facilities and the scope
of areas where such telecommunications circuit facilities are
installed.
    
    Other CarriersNotification to the MPHPT required for telecommunications carriers
other than the above. We do business under this category. Charges and Tariffs 39




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
    
    Unregulated, in general. The requirement that standard terms
and conditions be applied equally to all users was repealed.
    
    Prior notification to the MPHPT required for Basic
Telecommunications Services (universal services such as basic fee,
local call and emergency telecommunication service) and Designated
Telecommunications Services (i.e., services which have the
controlling power over the market provided by the telecommunications
carriers which install what is called the bottle-neck facilities).
Among the Designated Telecommunications Services, the
telecommunications services to be specified by MPHPT at least once a
year will be subject to price cap regulations, under which carriers
will be required to obtain approval from the MPHPT if a proposed
change of charge exceeds the price cap. Providing these
telecommunications services other than pursuant to the terms and
conditions notified to the MPHPT is prohibited, unless minor
exceptions apply. Articles of Interconnection Agreements  
    
    Unregulated, in general.
    
    Approval from the MPHPT required for Category I Designated
Telecommunications Facilities.
    
    Prior notification to the MPHPT required for Category II
Designated Telecommunications Facilities. Telecommunications Facilities of Carriers.  
    
    A telecommunications carrier that owns telecommunications
circuit facilities must maintain its telecommunications facilities
(except telecommunications facilities stipulated in MPHPTs
ordinances as those having a minor influence on the users benefit
in the cases of damage or failure thereof) in conformity with the
technical standards provided in the applicable MPHPTs ordinances.
Such Carriers shall confirm itself that said telecommunications
facilities are in compliance with such technical standards specified
in the applicable MPHPTs ordinances.
    
    A telecommunications carrier that provides Basic
Telecommunications Services, must maintain their telecommunications
facilities for provision of their Basic Telecommunications Services
in conformity with the technical standards provided in the
applicable MPHPTs ordinances.
    
    Telecommunications Carriers that own telecommunications
circuit facilities or provide Basic Telecommunications Services must
establish their own administrative rules in accordance with MPHPTs
ordinances in order to secure the reliable and stable provision of
telecommunications services. These administrative rules must
regulate the operation and manipulation of telecommunications
facilities and the safeguarding, inspecting and testing regarding
the construction, maintenance and administration of
telecommunications facilities, etc. as provided for by the
ministerial ordinance of MPHPT. Such administrative rules must be
submitted to the MPHPT prior to the commencement of operations, and
changes must be submitted to the MPHPT after they are implemented
without delay. Order to Improve Business Activities  
    
    The Minister for MPHPT may, if it is deemed that business
activities of a telecommunications carrier falls under the
inappropriate items set forth in the Telecommunications Business
Law, 40




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insofar as necessary to ensure the users benefit or the public
interest, order said telecommunications carrier to take actions to
improve operations methods or other measures. Right of Way Privilege for Authorized Carriers  
    
    Authorization on the entire or a part of a carriers
telecommunications business by MPHPT for the privileged use of land
or other public utilities for circuit facilities deployment is
required. Right of Way privilege is available to carriers
irrespective of registration. Merger, Business Transfer or Divestiture of Carriers  
    
    Post facto notification to MPHPT without delay is required. Business Suspension, Abolition or Dissolution of Carriers  
    
    Post facto notification to MPHPT without delay is required.
Prior announcement of withdrawals to service users is required in
accordance with MPHPTs ordinance. Foreign Capital Participation  
    
    Unregulated. Prior notification is required under the Foreign
Exchange and Foreign Trade Law for acquisition of shares of
telecommunications carriers to which registration for start-up
services is applicable. This is not applicable to purchasers of
ADSs. The one-third foreign ownership restriction is applicable only
to NTT.  C.
    
    Organizational Structure. The information required by this item is in   Our Group Companies
above.  D.
    
    Property, Plants and Equipment. The information required by this item is in   Network,   Backbone, 
 POPs, and   Internet Data Centers above. 
 Item 5. Operating and Financial Review and Prospects.  A.
    
    Operating Results. You should read the following discussion of our financial condition and
results of operations together with Item 3.A. of this annual report on Form
20-F and our consolidated financial statements and the notes to those financial
statements beginning on page F-1 of this annual report. This discussion and
analysis contains forward-looking statements that involve risks, uncertainties
and assumptions. Our actual results may differ materially from those
anticipated in these forward-looking statements as a result of factors
including but not limited to those in Item 3.D. of this annual report on Form
20-F. Overview We are a leading provider of a comprehensive range of Internet-access
services and network solution services in Japan. We were founded in December
1992 and began offering Internet-access services commercially in July 1993. We
were one of the first commercial ISPs in Japan. 41




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Our primary sources of revenues are connectivity services, comprised of
dedicated Internet-access services and dial-up Internet-access services,
systems integration services, equipment sales as part of our provision of total
network solutions and other value-added services such as Internet data center
services, security services, and mail server outsourcing services.
Substantially all of our revenues are from our customers in Japan. We also provide various applications services and systems operation and
maintenance services, such as systems development and integration for
business-to-business and business-to-consumer networks, outsourcing projects,
Web design, content development and distribution, network monitoring and call
center support. We are the main point of contact for customers for these
various services. We categorize our Internet-access services revenues into dedicated access
services and dial-up access services; however, there is no reasonable means to,
and accordingly we do not, allocate the leasing fees for leased lines, other
than customers local access lines, and the lease payments, depreciation and
other charges for network equipment to each such category of our
Internet-access service revenues. Revenues were ¥39.9 billion, ¥44.0 billion and ¥38.8 billion for the
fiscal years ended March 31, 2002, 2003 and 2004, respectively. In recent
years, revenues from connectivity and value-added services have been stable
overall, but revenues can fluctuate significantly based on the results of the
systems integration business and equipment sales. The decrease in revenues for
the year ended March 31, 2004 as compared to the previous fiscal year largely
reflects the decline in systems integration service and equipment sales
revenues in the first half of the fiscal year ended March 2004, which were
adversely affected by weak corporate investment in Japan and influence of
Crosswaves commencement of corporate reorganization proceedings in that
period, though revenue has increased, especially in the systems integration business,
in the second half of the fiscal year ended March 2004. Systems integration revenues are typically stronger in the second
half of the fiscal year. Operating losses in the fiscal year ended March 2004 was ¥1.4 billion, an
improvement from an operating loss of ¥1.7 billion in the fiscal year ended
March 2003. As a result of the increase in revenue in the
systems integration business and the decrease in total costs and
expenses, operating income for the fiscal year ended March 31, 2002 was ¥54
million. Operating income has started to show signs of improvement in the
second half of the fiscal year ended March 31, 2004. We had unaudited operating loss of ¥12.1
billion for the first quarter and ¥0.8 billion for the second quarter and
unaudited operating income of ¥0.2 billion for the third quarter and ¥0.3
billion for the fourth quarter of the fiscal year ended March 31, 2004.
Positive operating income in the third quarter and the fourth quarter were not
sufficient to cover the first half of the fiscal years operating loss. Net loss in the fiscal year ended March 2004 was ¥105 million, a
significant improvement from ¥16,477 million in the fiscal year ended March
2003, and ¥7.4 billion for the year ended March 31,
2002 when net loss was
negatively impacted by losses associated with our investment in Crosswave.
In addition to the improvement in operating income for the second
half of the year ended March 31, 2004, the improvement reflected a special gain from the sale of an equity investment and income tax
benefits associated with increased unrealized gains from certain
available-for-sale securities. On June 26 and September 16, 2003, we completed private placements of a
total of 15,880 shares of our common stock to investors in Japan for an
aggregate amount of ¥13.3 billion for working capital and repayment of our
outstanding 1.75% convertible notes due on March 31, 2005. As a result of these
transactions, the total number of our issued shares of common stock increased
to 38,360 and NTT Group 42




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##### Table of Contents



shareholding increased to 31.6%. We plan to redeem or
repurchase the remaining ¥11.1 billion of 1.75% convertible notes due on March
31, 2005 using our cash and cash equivalent as well as available-for-sale
securities. In order to provide our customers with total network solutions, we provide
our services directly or by working together with the subsidiaries and
affiliates of the IIJ Group. We refer to our subsidiaries and certain
affiliates as our group companies, and we have invested heavily in and exercise
significant influence over these companies. We have consolidated four of our
group companies  IIJ Technology, IIJ Media Communications, IIJ America and Net
Care. We account for our non-consolidated group companies by the equity method. We accounted for Crosswave under the equity method for the fiscal years
ended March 31, 2002 and 2003. As a result of Crosswaves financial condition,
we recognized an impairment loss for the full value of our investment in
Crosswave at March 31, 2003. As a result of Crosswaves commencement of
corporate reorganization proceedings in August 2003, we wrote off ¥1.7 billion
of outstanding loans extended to Crosswave and ¥0.4 billion of accounts
receivable owed to us by Crosswave in the fiscal year ended March 31, 2004 and
no longer account for Crosswave under the equity method. For the fiscal year
ended March 31, 2003, we have written off our equity method investment as well
as a ¥5.0 billion security deposit advanced to four Japanese commercial banks
on behalf of Crosswave in connection with financing provided by these banks to
Crosswave. In December 2003, Crosswave transferred its business operations to
NTT Communications. For a discussion of factors affecting our future financial results, see
Item. 5.D. Trend Information. 43




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##### Table of Contents



Results of Operations As an aid to understanding our operating results, the following tables
show items from our statement of operations for the periods indicated in
millions of yen amounts (or thousands of U.S. dollars) and as a percentage of
total revenues. Fiscal year ended March 31,2002
    
    2003
    
    2004(millions of yen except for percentage data)
    
    (Thousandsof U.S.dollars)REVENUES:Connectivity and value-added services
revenues:Dedicated access:IP Service including Data Center
Connectivity Services
    
    ¥
    10,326
    
    
    
    25.9
    %
    
    ¥
    10,298
    
    
    
    23.4
    %
    
    ¥
    9,927
    
    
    
    25.6
    %
    
    $
    95,289Others (including IIJ FiberAccess/F,
IIJ Ethernet Standard, IIJ DSL/F,
IIJ T1 Standard, IIJ Economy)
    
    
    3,977
    
    
    
    9.9
    
    
    
    3,517
    
    
    
    8.0
    
    
    
    2,935
    
    
    
    7.6
    
    
    
    28,172Total dedicated access
    
    
    14,303
    
    
    
    35.8
    
    
    
    13,815
    
    
    
    31.4
    
    
    
    12,862
    
    
    
    33.2
    
    
    
    123,461Dial-up access
    
    
    3,644
    
    
    
    9.1
    
    
    
    3,155
    
    
    
    7.2
    
    
    
    3,088
    
    
    
    8.0
    
    
    
    29,646Value-added:Data Center facility and operation
services
    
    
    1,448
    
    
    
    3.6
    
    
    
    1,442
    
    
    
    3.3
    
    
    
    1,405
    
    
    
    3.6
    
    
    
    13,484Other
    
    
    1,652
    
    
    
    4.2
    
    
    
    2,161
    
    
    
    4.9
    
    
    
    2,891
    
    
    
    7.5
    
    
    
    27,754Total value-added
    
    
    3,100
    
    
    
    7.8
    
    
    
    3,603
    
    
    
    8.2
    
    
    
    4,296
    
    
    
    11.1
    
    
    
    41,238Other
    
    
    1,668
    
    
    
    4.2
    
    
    
    1,726
    
    
    
    3.9
    
    
    
    2,118
    
    
    
    5.4
    
    
    
    20,328Total connectivity and
value-added services
    
    
    22,715
    
    
    
    56.9
    
    
    
    22,299
    
    
    
    50.7
    
    
    
    22,364
    
    
    
    57.7
    
    
    
    214,673Systems integration, including related
equipment sales
    
    
    14,356
    
    
    
    36.0
    
    
    
    15,013
    
    
    
    34.1
    
    
    
    11,848
    
    
    
    30.5
    
    
    
    113,723Equipment sales
    
    
    2,834
    
    
    
    7.1
    
    
    
    6,706
    
    
    
    15.2
    
    
    
    4,567
    
    
    
    11.8
    
    
    
    43,839Total revenues
    
    
    39,905
    
    
    
    100.0
    
    
    
    44,018
    
    
    
    100.0
    
    
    
    38,779
    
    
    
    100.0
    
    
    
    372,235COST AND EXPENSES:Cost of connectivity and value-added
services:International backbone cost
    
    
    2,469
    
    
    
    6.2
    
    
    
    1,644
    
    
    
    3.7
    
    
    
    829
    
    
    
    2.1
    
    
    
    7,959Domestic backbone cost
    
    
    3,187
    
    
    
    8.0
    
    
    
    3,591
    
    
    
    8.2
    
    
    
    3,891
    
    
    
    10.0
    
    
    
    37,344Local access line cost
    
    
    3,872
    
    
    
    9.7
    
    
    
    3,862
    
    
    
    8.8
    
    
    
    3,500
    
    
    
    9.0
    
    
    
    33,600Other connectivity cost
    
    
    1,375
    
    
    
    3.4
    
    
    
    1,532
    
    
    
    3.5
    
    
    
    1,422
    
    
    
    3.7
    
    
    
    13,648Depreciation and amortization
    
    
    2,474
    
    
    
    6.2
    
    
    
    2,957
    
    
    
    6.7
    
    
    
    3,135
    
    
    
    8.1
    
    
    
    30,095Other
    
    
    6,423
    
    
    
    16.1
    
    
    
    6,801
    
    
    
    15.4
    
    
    
    7,270
    
    
    
    18.8
    
    
    
    69,785Total cost of connectivity and
value-added services
    
    
    19,800
    
    
    
    49.6
    
    
    
    20,387
    
    
    
    46.3
    
    
    
    20,047
    
    
    
    51.7
    
    
    
    192,431Cost of systems integration, including
related equipment sales:Cost of equipment sales related to
systems integration
    
    
    3,303
    
    
    
    8.3
    
    
    
    3,377
    
    
    
    7.7
    
    
    
    1,546
    
    
    
    4.0
    
    
    
    14,837Other
    
    
    9,011
    
    
    
    22.6
    
    
    
    9,713
    
    
    
    22.0
    
    
    
    8,306
    
    
    
    21.4
    
    
    
    79,727Total cost of systems integration
    
    
    12,314
    
    
    
    30.9
    
    
    
    13,090
    
    
    
    29.7
    
    
    
    9,852
    
    
    
    25.4
    
    
    
    94,564Cost of equipment sales
    
    
    2,540
    
    
    
    6.4
    
    
    
    6,417
    
    
    
    14.6
    
    
    
    4,346
    
    
    
    11.2
    
    
    
    41,719Total cost of revenues
    
    
    34,654
    
    
    
    86.9
    
    
    
    39,894
    
    
    
    90.6
    
    
    
    34,245
    
    
    
    88.3
    
    
    
    328,714Sales and marketing
    
    
    3,038
    
    
    
    7.6
    
    
    
    3,176
    
    
    
    7.2
    
    
    
    3,528
    
    
    
    9.1
    
    
    
    33,859General and administrative
    
    
    1,840
    
    
    
    4.6
    
    
    
    2,205
    
    
    
    5.0
    
    
    
    2,098
    
    
    
    5.4
    
    
    
    20,143Research and development
    
    
    319
    
    
    
    0.8
    
    
    
    414
    
    
    
    1.0
    
    
    
    358
    
    
    
    0.9
    
    
    
    3,436Total cost and expenses
    
    
    39,851
    
    
    
    99.9
    
    
    
    45,689
    
    
    
    103.8
    
    
    
    40,229
    
    
    
    103.7
    
    
    
    386,152OPERATING INCOME (LOSS)
    
    
    54
    
    
    
    0.1
    
    
    
    (1,671
    )
    
    
    (3.8
    )
    
    
    (1,450
    )
    
    
    (3.7
    )
    
    
    (13,917
    )
 44




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##### Table of Contents



Fiscal year ended March 31,2002
    
    2003
    
    2004(millions of yen except for percentage data)
    
    (Thousandsof U.S.dollars)OTHER INCOME (EXPENSES):Interest income
    
    ¥
    122
    
    
    
    0.3
    %
    
    ¥
    68
    
    
    
    0.1
    %
    
    ¥
    38
    
    
    
    0.1
    %
    
    $
    360Interest expense
    
    
    (659
    )
    
    
    (1.6
    )
    
    
    (733
    )
    
    
    (1.7
    )
    
    
    (702
    )
    
    
    (1.9
    )
    
    
    (6,739
    )Foreign exchange gains (losses)
    
    
    255
    
    
    
    0.6
    
    
    
    (280
    )
    
    
    (0.6
    )
    
    
    (7
    )
    
    
    (0.0
    )
    
    
    (62
    )Other  net
    
    
    (661
    )
    
    
    (1.6
    )
    
    
    (324
    )
    
    
    (0.7
    )
    
    
    1,653
    
    
    
    4.3
    
    
    
    15,869Other income (expenses)  net
    
    
    (943
    )
    
    
    (2.3
    )
    
    
    (1,269
    )
    
    
    (2.9
    )
    
    
    982
    
    
    
    2.5
    
    
    
    9,428LOSS FROM OPERATIONS BEFORE INCOME TAX
EXPENSE (BENEFIT)
    
    
    (889
    )
    
    
    (2.2
    )
    
    
    (2,940
    )
    
    
    (6.7
    )
    
    
    (468
    )
    
    
    (1.2
    )
    
    
    (4,489
    )INCOME TAX EXPENSE (BENEFIT)
    
    
    1,099
    
    
    
    2.8
    
    
    
    912
    
    
    
    2.1
    
    
    
    (2,133
    )
    
    
    (5.5
    )
    
    
    (20,474
    )MINORITY INTERESTS IN CONSOLIDATED
SUBSIDIARIES
    
    
    24
    
    
    
    0.1
    
    
    
    153
    
    
    
    0.4
    
    
    
    236
    
    
    
    0.6
    
    
    
    2,264EQUITY IN NET LOSS OF EQUITY METHOD
INVESTEES:(1)(2)Equity method net loss
    
    
    (5,482
    )
    
    
    (13.8
    )
    
    
    (5,625
    )
    
    
    (12.8
    )
    
    
    (286
    )
    
    
    (0.8
    )
    
    
    (2,748
    )Impairment loss on investment, advance
and deposits for Crosswave
    
    
    
    
    
    
    
    
    
    
    (7,153
    )
    
    
    (16.2
    )
    
    
    (1,720
    )
    
    
    (4.4
    )
    
    
    (16,510
    )Total equity in net loss of
equity method investees
    
    
    (5,482
    )
    
    
    (13.8
    )
    
    
    (12,778
    )
    
    
    (29.0
    )
    
    
    (2,006
    )
    
    
    (5.2
    )
    
    
    (19,258
    )NET LOSS
    
    ¥
    (7,446
    )
    
    
    (18.7
    )%
    
    ¥
    (16,477
    )
    
    
    (37.4
    )%
    
    ¥
    (105
    )
    
    
    (0.3
    )%
    
    $
    (1,009
    )
   (1)
    
    Equity method net loss of ¥5,514 million for the fiscal year ended March
31, 2003 was based on unaudited financial information made publicly
available by Crosswave and the impairment loss on investment, advance and
deposits for Crosswave was determined to be the amount required to reduce
the carrying amount of investment in and deposits for Crosswave at March
31, 2003 to zero.(2)
    
    The audit report of Deloitte Touche Tohmatsu in respect of our financial
statements as of and for the fiscal year ended March 31, 2003 was
qualified as to the effects of such adjustments, if any, as might have
been determined to be necessary if sufficient evidence regarding the
equity method loss, the impairment loss on investment, advance and
deposits for Crosswave and the related summary information of Crosswave
for the year ended March 31, 2003 was available. As described elsewhere in
this annual report, Crosswave is undergoing corporate reorganization
proceedings in Japan and has not prepared audited financial statements for
the year ended March 31, 2003 or other sufficient evidence of its results
of operations to permit our auditors to issue an audit report or our
financial statements as of and for the year ended March 31, 2003 without
such qualification. Year Ended March 31, 2004 Compared to the Year Ended March 31, 2003 Total revenues Our total revenues decreased 11.9% to ¥38.8 billion for the fiscal year
ended March 31, 2004 from ¥44.0 billion for the previous fiscal year. These
decreases were primarily due to decreases in systems integration revenues and
equipment sales. Total revenue of connectivity and value-added services were
almost same level as the previous fiscal year. Connectivity and value-added services revenues.Revenues from connectivity
services and value-added services, which comprise our dedicated access, dial-up
access and value-added services and other services, increased 0.3% to ¥22.4
billion for the fiscal year ended March 31, 2004 from ¥22.3 billion for the
previous fiscal year.  
    
    Dedicated access.Revenues from dedicated access services
decreased 6.9% to ¥12.9 billion for the fiscal year ended March 31,
2004 from ¥13.8 billion for the previous fiscal year. This decrease
reflected decreasing unit prices as a result of increased
competition. Decreased 45




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revenues from IP Service, IIJ T1 Standard and IIJ Economy were
partially offset by increased revenue from our IIJ FiberAccess/F
Service and IIJ DSL/F Service.  
    
    Dial-up access.Revenues from dial-up access services
decreased 2.1% to ¥3.1 billion for the fiscal year ended March 31,
2004 from ¥3.2 billion for the previous fiscal year. This decrease
was the result of declining revenues from our dial-up access
services for corporate and individual customers. For corporate
users, the revenue decreased primarily due to an increase in demand
for lower-cost broadband services, and for individual customers the
revenue decreased primarily due to the declining revenues from IIJ4U
Service. The decrease in individual customer revenue was offset
partially by growing demand for dial-up access services provided on
an OEM basis.
    
    Value-added services.Our value-added services revenues
increased 19.2% to ¥4.3 billion for the fiscal year ended March 31,
2004 from ¥3.6 billion for the previous fiscal year. This increase
reflected growth in security-related services, mail support services
and virtual private network services, in part as a result of
focusing sales efforts more on these higher margin services.
Internet data center services amounted to ¥1.4 billion for the
fiscal year ended March 31, 2004, a decrease of 2.5% from the
previous fiscal year.
    
    Other.Other revenues, which included rental fees for network
equipment, customer support service, and sale of Wide-area Ethernet
services, amounted to ¥2.1 billion for the fiscal year ended March
31, 2004, a 22.7% increase from the previous fiscal year. The
increase reflected improved performance by Net Care and increased
sales of Wide-area Ethernet services. Systems integration revenues.Our revenues from systems integration, which
include equipment sales related to systems integration, decreased 21.1% to
¥11.8 billion for the fiscal year ended March 31, 2004 from ¥15.0 billion for
the previous fiscal year. This decrease largely reflected the first half of the
fiscal year decline in systems integration revenues, which were adversely
affected by weak corporate investment in Japan in that period. Equipment sales.Our equipment sales decreased 31.9% to ¥4.6 billion for
the fiscal year ended March 31, 2004 from ¥6.7 billion for the previous fiscal
year. The decrease in equipment sales revenues reflected our efforts to focus
on higher margin systems integration and weak corporate investment in Japan. Total cost of revenues Total cost of revenues decreased 14.2% to ¥34.2 billion for the fiscal
year ended March 31, 2004 from ¥39.9 billion for the previous fiscal year. The
decreases in total cost of revenues reflected primarily decreases in cost of
systems integration revenues and cost of equipment sales, and decreases in
backbone costs. Cost of connectivity and value-added services revenues. Cost of
connectivity and value-added services revenues decreased 1.7% to ¥20.0 billion
for the fiscal year ended March 31, 2004 from ¥20.4 billion for the previous
fiscal year. The gross margin in connectivity and value-added services revenues
increased to 10.4% for the fiscal year ended March 31, 2004 from 8.6% for the
previous fiscal year. This increase is mainly a result of the decreases in
international backbone costs due to price competition among international
backbone providers and local access line costs due to the shift of the
dedicated access service customers to the broadband services connected through
NTTs regional access networks (FLETS). International backbone costs decreased
49.6% to ¥0.8 billion for the fiscal year ended March 31, 2004 from ¥1.6
billion for the previous fiscal year. Local access line costs decreased 9.4% to
¥3.5 billion from ¥3.9 billion for the previous fiscal year. Domestic backbone
costs increased 8.3% to ¥3.9 billion due to an increase in connection fees with
NTTs regional access networks. 46




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Cost of systems integration revenues.Our cost of systems integration
revenues decreased 24.7% to ¥9.9 billion for the fiscal year ended March 31,
2004 from ¥13.1 billion for the previous fiscal year. The gross margin in
systems integration revenues increased to 16.8% for the fiscal year ended March
31, 2004 from 12.8% for the previous fiscal year, due to our efforts to focus
on higher margin systems integration including operational outsourcing
services. Cost of equipment sales.Our cost of equipment sales decreased 32.3% to
¥4.3 billion for the fiscal year ended March 31, 2004 from ¥6.4 billion for the
previous fiscal year. The gross margin in equipment sales increased to 4.8% for
the fiscal year ended March 31, 2004 from 4.3% for the previous fiscal year. Total costs and expenses Total costs and expenses, which includes total cost of revenues, sales and
marketing expenses, general and administrative expenses and research and
development expenses, decreased 11.9% to ¥40.2 billion for the fiscal year
ended March 31, 2004 from ¥45.7 billion for the previous fiscal year. The
decrease in total costs and expenses was primarily a result of the decrease in
cost of systems integration, cost of equipment sales and backbone costs. Sales and marketing.Sales and marketing expenses increased 11.1% to ¥3.5
billion for the fiscal year ended March 31, 2004 from ¥3.2 billion for the
previous fiscal year. The increase was primarily due to the write-off of
accounts receivable from Crosswave amounting to ¥396 million in the fiscal year
ended March 31, 2004. General and administrative.General and administrative expenses decreased
4.8% to ¥2.1 billion for the fiscal year ended March 31, 2004 from ¥2.2 billion
for the previous fiscal year. The decrease in expenses was mainly due to the
absence in the previous fiscal year of costs associated with our move into a
new headquarter. Research and development.Research and development expenses decreased
13.6% to ¥358 million for the fiscal year ended March 31, 2004 from ¥414
million for the previous fiscal year. The decrease is primarily due to reduced
development expenses relating to IPv6 technology and our originally developed
network equipment, SEIL/neu Series. Operating income (loss) As a result of the foregoing factors, operating loss decreased 13.2% to
¥1.4 billion for the fiscal year ended March 31, 2004 from ¥1.7 billion for the
previous fiscal year. Other income (expenses), net Net other income of ¥1.0 billion was recorded for the fiscal year ended
March 31, 2004 compared to net other expenses of ¥1.3 billion for the previous
fiscal year. The improvement was primarily a result of a gain generated by the
sale of our stake in DLJdirect SFG Securities Inc., and a gain that came from
repurchasing and canceling a portion of convertible notes due in March 2005. Interest income.Interest income decreased to ¥38 million for the fiscal
year ended March 31, 2004 from ¥67 million for the previous fiscal year. The
decrease is mainly due to the fact that we no longer had substantial amounts of
dollar-denominated deposits or expenses. Interest expense.Interest expense, comprised of interest expense in
respect of outstanding loans, convertible bonds and capital lease obligations,
amounted to ¥702 million for the fiscal year ended
March 31, 47




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##### Table of Contents



2004 compared to ¥733 million for the previous fiscal year.
Interest expense decreased due to the decrease in interest expense for
convertible notes. Foreign exchange gains (losses).Foreign exchange loss decreased for the
fiscal year ended March 2004 compared to the previous fiscal year as a result
of a decrease in the U.S. dollar denominated monetary assets. Other-net.For the fiscal year ended March 31, 2004, we recorded other
income of ¥1.6 billion, which reflects a gain of ¥1.6 billion generated by the
sale of our stake in DLJdirect SFG Securities Inc., and a gain of ¥0.1 billion
that came from repurchasing and canceling a portion of convertible notes due in
March 2005. The income was partially offset by losses of ¥0.2 billion on the
write down of investments in marketable and nonmarketable securities to reflect
the decline in value considered to be other than temporary. Loss from operations before income tax expense (benefit) Loss from operations before income tax expense (benefit) was ¥0.5 billion
for the fiscal year ended March 31, 2004, a decrease from ¥2.9 billion for the
fiscal year ended March 31, 2003. This decrease was largely the result of an
increase in other income (expenses), net due to an extraordinary gain of ¥1.6
billion generated by the sale of our stake in DLJdirect SFG Securities Inc. Income tax expense (benefit) For the fiscal year ended March 31, 2004, we recorded an income tax
benefit of ¥2.1 billion compared to an income tax expense of ¥0.9 billion for
the previous fiscal year. The benefit is due to a decrease in the valuation
allowance for deferred tax assets attributable primarily to the income tax
effect of increasing unrealized gains for the fiscal year on certain
available-for-sale securities. Minority interests in consolidated subsidiaries Minority interests in consolidated subsidiaries amounted to income of ¥236
million for the fiscal year ended March 31, 2004, compared to income of ¥153
million for the previous fiscal year. The increase mainly resulted from a net
loss by IIJ Technology. Equity in net loss of equity method investees Equity in net loss of equity method investees consist of equity method net
loss in our equity method investees and impairment loss on investment, advance
and deposits for Crosswave. Equity method net loss decreased to ¥0.3 billion for the fiscal year ended
March 31, 2004 from ¥5.6 billion for the previous fiscal year. This decrease
was mainly due to the absence of equity method net loss from Crosswave, since
Crosswave is no longer accounted for under the equity method. Impairment loss on investment, advance and deposits for Crosswave for the
fiscal year ended March 31, 2004 was ¥1.7 billion, as a result of write-off of
loans to Crosswave. Impairment loss on investment, advance and deposits for
Crosswave for the fiscal year ended March 31, 2003 was ¥7.2 billion, due to an
impairment loss of investment in Crosswave. Net loss Net loss for the fiscal year ended March 31, 2004 decreased to ¥0.1
billion from ¥16.5 billion for the previous fiscal year. The decrease in net
loss primarily reflects a decrease in equity in net loss of equity 48




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##### Table of Contents



method investees comprised primarily of equity method net loss and
impairment loss on investment, advance and deposits for Crosswave. Income tax
benefit and net non-operating income also decreased the net loss. Year Ended March 31, 2003 Compared to the Year Ended March 31, 2002 Total revenues Our total revenues increased 10.3% to ¥44.0 billion for the fiscal year
ended March 31, 2003 from ¥39.9 billion for the previous fiscal year. The
primary drivers of this growth were increases in equipment sales, which are
closely linked to our systems integration business, and increases in systems
integration revenues. Value added services revenues also increased. Connectivity and value-added services revenues.Revenues from connectivity
services and value-added services, which comprise our dedicated access, dial-up
access and value-added services and other services, decreased 1.8% to ¥22.3
billion for the fiscal year ended March 31, 2003 from ¥22.7 billion for the
previous fiscal year.  
    
    Dedicated access.Revenues from dedicated access services
decreased 3.4% to ¥13.8 billion for the fiscal year ended March 31,
2003 from ¥14.3 billion for the previous fiscal year. This decrease
was the result of contract cancellations by ISPs affiliated with
regional electric power companies and decreasing unit prices as a
result of increased competition. Decreased revenues from IIJ T1
Standard, IP Service and IIJ Economy Service were partially offset
by increased revenue from our IIJ fiber access/F Service and IIJ
DSL/F Service.
    
    Dial-up access.Revenues from dial-up access services
decreased 13.4% to ¥3.2 billion for the fiscal year ended March 31,
2003 from ¥3.6 billion for the previous fiscal year. This decrease
was the result of declining revenues from our conventional dial-up
access services and IIJ4U services. This decrease in IIJ4U revenues
was due not only to the decrease in the number of subscribers but
also to a shift to the lower-end IIJ4U fixed price service by users
of NTTs FLETS services. The decrease was offset partially by
growing demand for dial-up access services provided on an OEM basis.
    
    Value-added services.Our value-added services revenues
increased 16.2% to ¥3.6 billion for the fiscal year ended March 31,
2003 from ¥3.1 billion for the previous fiscal year. This increase
reflected growth in security-related services and mail support
services, in part as a result of focusing sales efforts more on
these higher margin services. Internet data center services amounted
to ¥1.4 billion for the fiscal year ended March 31, 2003, the same
general level as the previous fiscal year.
    
    Other.Other revenues, which included rental fees for network
equipment, customer support service, and sale of Wide-area Ethernet
services, amounted to ¥1.7 billion for the fiscal year ended March
31, 2003, a slight increase from the previous fiscal year. The
increase reflected improved performance by Net Care and increased
sales of Wide-area Ethernet services, which offset the decrease in
rental fees for network equipment. Systems integration revenues.Our revenues from systems integration, which
include equipment sales related to systems integration, increased 4.6% to ¥15.0
billion for the fiscal year ended March 31, 2003 from ¥14.4 billion for the
previous fiscal year. Systems integration revenues accounted for 34.1% of our
total revenues during the period compared to 36.0% in the previous fiscal year.
This growth in our systems integration business reflected primarily the
increase of recurring fees from systems operation and monitoring services. 49




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Equipment sales.Our equipment sales increased 136.6% to ¥6.7 billion for
the fiscal year ended March 31, 2003 from ¥2.8 billion for the previous fiscal
year, mainly as a result of a larger than expected increase in sales of
telecommunications equipment. Sales of our original SEIL series of routers,
which are expected to serve as a core of the IIJ Groups system management
services, also increased. Total cost of revenues Total cost of revenues increased 15.1% to ¥39.9 billion for the fiscal
year ended March 31, 2003 from ¥34.7 billion for the previous fiscal year. The
increase in total cost of revenues reflected primarily an increase in cost of
systems integration revenues and cost of equipment sales. Cost of connectivity and value-added services revenues. Cost of
connectivity and value-added services revenues increased 3.0% to ¥20.4 billion
for the fiscal year ended March 31, 2003 from ¥19.8 billion for the previous
fiscal year. The gross margin in connectivity and value-added services revenues
decreased to 8.6% for the fiscal year ended March 31, 2003 from 12.8% for the
previous fiscal year. This decrease is mainly a result of higher depreciation
and amortization costs and higher domestic backbone costs. Domestic backbone
costs increased 12.7% to ¥3.6 billion for the fiscal year ended March 31, 2003
from ¥3.2 billion for the previous fiscal year, attributable to an increase in
connection fees with NTTs regional access networks (FLETS). International
backbone costs decreased 33.4% to ¥1.6 billion for the fiscal year ended March
31, 2003 from ¥2.5 billion for the previous fiscal year. International yearly
unit backbone costs decreased 66%. Local access line costs remained at the
level of ¥3.9 billion compared to the previous fiscal year. Cost of systems integration revenues.Our cost of systems integration
revenues increased 6.3% to ¥13.1 billion for the fiscal year ended March 31,
2003 from ¥12.3 billion for the previous fiscal year. The gross margin in
systems integration revenues decreased to 12.8% for the fiscal year ended March
31, 2003 from 14.2% for the previous fiscal year. Cost of equipment sales.Our cost of equipment sales increased 152.6% to
¥6.4 billion for the fiscal year ended March 31, 2003 from ¥2.5 billion for the
previous fiscal year. The increase reflected increased equipment sales to our
systems integration customers. The gross margin in equipment sales decreased to
4.3% for the fiscal year ended March 31, 2003 from 10.4% for the previous
fiscal year as a result of higher sales of lower-margin equipment. Total costs and expenses Total costs and expenses, which includes total cost of revenues, sales and
marketing expenses, general and administrative expenses and research and
development expenses, increased 14.6% to ¥45.7 billion for the fiscal year
ended March 31, 2003 from ¥39.9 billion for the previous fiscal year. The
increase in total costs and expenses was primarily a result of the increase in
domestic backbone costs, depreciation and amortization and cost of equipment
sales. Sales and marketing.Sales and marketing expenses increased 4.5% to ¥3.2
billion for the fiscal year ended March 31, 2003 from ¥3.0 billion for the
previous fiscal year. Increases in other sales and marketing expenses,
including sales personnel expenses were partially offset by decreases in
advertising expenses. General and administrative.General and administrative expenses increased
19.8% to ¥2.2 billion for the fiscal year ended March 31, 2003 from ¥1.8
billion for the previous fiscal year. The increase in expenses was due mainly
to our move to a new headquarters building and an increase in our
administrative staff as a result of the growth of our operations. 50




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Research and development.Research and development expenses increased
29.8% to ¥0.4 billion for the fiscal year ended March 31, 2003 from ¥0.3
billion for the previous fiscal year. These expenses were mainly due to
research and development on IPv6 and our proprietary router SEIL. Operating income (loss) As a result of the foregoing factors, an operating loss of ¥1.7 billion
was recorded for the fiscal year ended March 31, 2003 compared to operating
income of ¥0.1 billion for the previous fiscal year. Other income (expenses), net Net other expenses of ¥1.3 billion were recorded for the fiscal year ended
March 31, 2003 compared to net other expenses of ¥0.9 billion for the previous
fiscal year. The increase primarily reflected the recording of a foreign
exchange loss of ¥0.3 billion as compared with a foreign exchange gain in the
previous fiscal year. Interest income.Interest income decreased to ¥0.1 billion for the fiscal
year ended March 31, 2003 compared to the previous fiscal year, as a
substantial portion of our U.S. dollar-denominated monetary assets were used to
fund the operations of our subsidiary IIJ America. Interest expense.Interest expense, comprised of interest expense in
respect of outstanding loans, convertible bonds and capital lease obligations,
increased slightly to ¥0.7 billion for the fiscal year ended March 31, 2003
compared to the previous fiscal year. The increase reflected primarily the
increase in capital lease obligations which amounted to ¥6.4 billion as of
March 31, 2003 from ¥4.8 billion as of March 31, 2002. Foreign exchange gains (losses).For the fiscal year ended March 31, 2003,
we recorded a foreign exchange loss of ¥0.3 billion compared to a gain of ¥0.3
billion for the previous fiscal year. The loss is due to a foreign exchange
loss on the U.S. dollar denominated monetary assets attributable to the
appreciation of the Japanese yen against the U.S. dollar. Other-net.Other expenses for the fiscal year ended March 31, 2003
included losses of ¥0.3 billion on the write down of investments in marketable
and nonmarketable securities to reflect the decline in value considered to be
other than temporary. Loss from operations before income tax expense (benefit) Loss before income tax expense (benefit) for the fiscal year ended March
31, 2003 of ¥2.9 billion increased primarily as a result of an operating loss. Income tax expense (benefit) Income tax expense decreased 17.1% to ¥0.9 billion for the fiscal year
ended March 31, 2003 from ¥1.1 billion for the previous fiscal year. This
income tax expense was a result of an increase in the valuation allowance for
deferred tax assets, attributable primarily to the income tax effect of
unrealized gains which decreased in this period on certain available-for-sale
securities. Minority interests in consolidated subsidiaries Minority interests in consolidated subsidiaries amounted to income of ¥153
million for the fiscal year ended March 31, 2003 compared to income of ¥24
million for the previous fiscal year. The increase resulted from a net loss by
IIJ Technology. 51




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Equity in net loss of equity method investees Our equity in net loss of equity method investees increased to ¥12.8
billion for the fiscal year ended March 31, 2003 from ¥5.5 billion for the
previous fiscal year. This increase reflected the impairment loss on
investment, advance and deposits for Crosswave of ¥7.2 billion, our equity
method net loss in Crosswave of ¥5.5 billion and our equity method net loss in
other equity method investees of ¥0.1 billion. Equity method net loss in
Crosswave was based on unaudited financial information made publicly available
by Crosswave and the impairment loss on investment, advance and deposits for
Crosswave was determined to be the amount required to reduce the carrying
amount of investments in and deposits for Crosswave at March 31, 2003 to zero.
Even if the actual net loss of Crosswave for the fiscal year ended March 31,
2003 was higher than the publicly announced unaudited amount, the aggregate of
our equity method net loss and impairment loss on investment, advance and
deposits for Crosswave would remain unchanged at ¥12.8 billion and our
operating loss and net loss would remain unchanged for the fiscal year ended
March 31, 2003. Net loss Net loss for the fiscal year ended March 31, 2003 increased to ¥16.5
billion from ¥7.4 billion for the previous fiscal year. The increase in net
loss primarily reflects equity in net loss of equity method affiliates of ¥12.8
billion, comprised of equity method net loss and impairment loss on investment,
advance and deposits for Crosswave and a ¥1.7 billion operating loss. Application of Critical Accounting Policies In reviewing our financial statements, you should consider the sensitivity
of our reported financial condition and results of operations to changes in the
conditions and assumptions underlying the estimates and judgments made by our
management in applying critical accounting policies. The preparation of financial statements requires the use of estimates,
judgments and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses for the periods presented. Actual results may differ from
these estimates, judgments and assumptions. Note 1 to our consolidated
financial statements includes a summary of the significant accounting policies
used in the preparation of our financial statements. Certain accounting
policies are particularly critical because of their significance to our
reported results and because of the possibility that future events may differ
significantly from the conditions and assumptions underlying the estimates used
and judgments made by our management in preparing our financial statements. We have discussed the development and selection of critical accounting
policies and estimates with our board of directors, and the board of directors
has reviewed the disclosure relating to these, which are included in this
Operating and Financial Review and Prospects. For all of these policies, we
caution that future events rarely develop exactly as forecast, and even the
best estimates may require adjustment. Useful lives of property and equipment Property and equipment, net recorded on our balance sheet was ¥8,602
million at March 31, 2004, comprising 20.1% of our total assets. The values of
our property and equipment, including purchased software and property and
equipment under capital leases, are recorded in our financial statements at
acquisition cost, and are depreciated or amortized on a straight-line basis
over the shorter of the lease term or estimated useful life of the asset. Our
total depreciation and amortization expenses for the fiscal years ended March
31, 2002, 2003 and 2004 were ¥2,906 million, ¥3,470 million and ¥3,909 million,
respectively. We estimate the useful lives of property and equipment, in order to
determine the amount of depreciation and amortization expense to be recorded in
each fiscal year. We determine the useful lives of our 52




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assets at the time the assets are acquired and base our determinations on expected use, experience with similar
assets, established laws and regulations as well as taking into account anticipated technological or other
changes. Estimated useful lives at March 31, 2004, were as follows: Item
    
    Useful LivesData communications, office and other equipment
    
    
    2 to 15 yearsLeasehold improvements
    
    
    3 to 15 yearsPurchased software
    
    
    5 yearsCapitalized leases
    
    
    4 to 7 years
 If technological or other changes were to occur more rapidly or in a
different form than anticipated or new laws or regulations are enacted or the
intended use changes, the useful lives assigned to these assets may need to be
shortened, or we may need to sell or write off the assets, resulting in
recognition of increased depreciation and amortization or losses in future
periods. Our losses on disposal of property and equipment for the fiscal years
ended March 31, 2002, 2003 and 2004 were ¥23 million, ¥112 million and ¥110
million, respectively. Ordinary maintenance and repairs are charged to income as incurred. Major
replacements and improvements are capitalized. When properties are retired or
otherwise disposed of, the property and related accumulated depreciation
accounts are relieved of the applicable amounts and any differences are
included in operating cost and expenses. Impairment of long-lived assets Long-lived assets consist primarily of property and equipment, including
capitalized leases. We perform an impairment review for our long-lived assets,
whenever events or changes in circumstances indicate that the carrying amount
of the assets may not be recoverable. This analysis is separate from our
analysis of the useful lives of our assets, but it is affected by some similar
factors. Factors that we consider important which could trigger an impairment
review include, but are not limited to, the impact of the following trends or
conditions:  
    
    significant decline in the market value of an asset;
    
    current period operating cash flow loss;
    
    introduction of competing technologies or services;
    
    significant underperformance of expected or historical cash flows;
    
    significant or continuing decline in subscribers;
    
    changes in the manner or use of an asset;
    
    disruptions in the use of network equipment under capital lease arrangements; and
    
    other negative industry or economic trends. When we determine that the carrying amount of specific assets may not be
recoverable based on the existence or occurrence of one or more of the above or
other factors, we estimate the future cash inflows
and outflows expected to be generated by the assets over their expected
useful lives. We estimate the sum of expected undiscounted future cash flows
based upon historical trends adjusted to reflect our best estimate of 53




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future
market and operating conditions. If the sum of the expected undiscounted future
net cash flows is less than the carrying value of the assets, we record an
impairment loss based on the fair values of the assets. Such fair values may be
based on established markets, independent appraisals and valuations or
discounted cash flows. If actual market and operating conditions under which
assets are used are less favorable or shorter than those projected by
management, resulting in reduced cash flows, additional impairment charges for
assets not previously written-off may be required. There was no impairment loss
for long-lived assets for the fiscal years ended March 31, 2002, 2003 and 2004. Allowance for doubtful accounts and uncollectible contractual prepayments We maintain allowances for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. At
March 31, 2003 and 2004, we maintained allowances for doubtful accounts of ¥125
million and ¥493 million, respectively. Management specifically analyzes
accounts and loans receivable including historical bad debts, customer
concentrations, customer credit-worthiness and current economic trends when
evaluating the adequacy of the allowances for doubtful accounts. If the
financial condition of our customers or debtors were to deteriorate, resulting
in an impairment of their ability to make payments, additional allowances may
be required. Deferred tax assets To date, our deferred tax assets have been offset by a valuation
allowance. We record a valuation allowance to reduce our deferred tax assets to
the amount that is more likely than not to be realized. While we have
considered future taxable income and ongoing prudent and feasible tax planning
strategies in assessing the need for the valuation allowance, in the event we
were to determine that we would be able to realize the deferred tax assets in
the future in excess of the net recorded amount, an adjustment to the valuation
allowance and deferred tax benefit would increase income in the period such
determination was made. Valuation of investments The balance of our investments in securities is significant, and the
valuation of such investments, requires us to make judgments using information
that is generally uncertain at the time, such as assumptions regarding future
financial conditions and cash flows. As at March 31, 2004, we had investments
in securities classified as other investments in the amount of ¥7,932 million.
We routinely assess the impairment of our investments by considering whether
any decline in value is other-than-temporary. The factors we consider are:  
    
    the length of time and the extent to which the market value
has been less than cost;
    
    the financial condition and near-term prospects of the
issuer, including any specific events which may influence the
operations of the issuer such as changes in technology that may
impair the earnings potential of the investment; and
    
    our intent and ability to retain the investment in the issuer
for a period of time sufficient to allow for any anticipated
recovery in market value. If a decline in value occurs and is deemed
to be other-than-temporary, an impairment loss will be recorded to
write-down the carrying value of the investment to fair value. If,
after taking into account these considerations, the decline is
judged to be other than temporary, the cost basis of the individual
security is written down to a new cost basis and the amount of the
write-down is accounted for as a realized loss. Losses on write-down of investments in certain marketable and
nonmarketable securities for the fiscal years ended March 31, 2003 amounted to
¥191 million and losses on write-down of investements in certain 54




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nonmarketable
equity and debt securities for the fiscal year ending March 31, 2004 amounted
to ¥230 million and are included in other expenses. In addition to investments in securities, we also have investments in
equities for which we have significant influence over the investees operations
and financial policies and are accounted for by the equity method. For other
than temporary declines in the value of such investments below the carrying
amount, the investment is reduced to fair value and an impairment loss is
recognized. For example, at March 31, 2003, we recognized an impairment loss of
¥7,153 million for our investment in and deposits for Crosswave, our former
equity method investee. In determining and estimating the amount of the
impairment loss, we considered the likeliness of the elimination of the common
stock investment by operation of law upon approval of a reorganization plan or
liquidation, the nature of deposits which are subordinate to the bank loans of
Crosswave under the Cash Deficiency Support Agreement, the recoverability of
the underlying net assets through sale or future operations upon Crosswaves
emergence from bankruptcy and other factors. New Accounting Standards In November 2002, the Emerging Issues Task Force, or EITF, reached a
consensus on Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables. EITF Issue No. 00-21 addresses certain aspects of the accounting
by a vendor for arrangements under which it will perform multiple
revenue-generating activities and how arrangement consideration should be
measured and allocated to the separate units of accounting in the arrangement.
The provisions of EITF Issue No. 00-21 apply to revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. The adoption of EITF
Issue No.00-21 will not have a material effect on our consolidated financial
position and results of operations. In
January 2003, the FASB issued FASB Interpretation No. 46 (FIN46),
Consolidation of Variable Interest Entities, an Interpretation
of ARB No. 51,
Consolidated Financial Statements, and subsequently revised in December 2003
with the issuance of FIN 46 (revised 2003). The interpretation requires
certain variable interest entities to be consolidated by the primary
beneficiary of the entity if the equity investors in the equity do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. The Company is required to
apply this interpretation for periods ending after April 1, 2004. The adoption
of the revised FIN 46 will not have an effect on the Companys consolidated
financial position or results of operation.  B.
    
    Liquidity and Capital Resources. Liquidity and Capital Requirements Our principal capital and liquidity needs in recent years have been for
capital expenditures for the development, expansion and maintenance of our
network infrastructure, lease payments, payment of principal and interest on
outstanding borrowings, investments in current and former group companies and,
other working capital. Capital expenditures.Our capital expenditures relate primarily to the
development, expansion and maintenance of our network. Our future capital
expenditures are difficult to predict given the rapid changes and uncertainties
in our business, but under current plans we expect capital expenditures,
including acquisition of assets by entering into capitalized leases, to range
between ¥3.0 billion and ¥5.0 billion in each of the next few years. The table below shows our capital expenditures, which we define as amounts
paid for purchases of property and equipment plus acquisition of assets by
entering into capital leases, for the last three years. 55




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For the fiscal year ended March 31,2002
    
    2003
    
    2004(millions of yen)Capital expenditures,
including acquisition of
assets by entering into
capital leases
    
    ¥
    3,773
    
    
    ¥
    4,893
    
    
    ¥
    3,523
 Most of our capital expenditures relate to the expansion and improvement
of our existing network, including the leasing of lines that form our network
backbone and the installation of the routers and servers necessary to offer
services on our network. We have not made any material divestitures in the current or past three
fiscal years, except the loss on disposal of property and equipment of ¥112
million in March 2003 that was primarily due to our move to new headquarters. Lease payments.We have operating lease agreements with telecommunications
carriers and others for the use of connectivity lines, including our domestic
and international backbone as well as local access lines that customers use to
connect to IIJs network. The leases for our domestic backbone are primarily
non-cancelable for a minimum one-year lease period. The leases for our
international backbone available as of March 31, 2004, were entered into with
carriers for a lease period ranging from one to two years and are substantially
non-cancelable. We also lease office premises and certain office equipment
under non-cancelable operating leases which expire on various dates through the
year 2007 and also lease network operation centers under non-cancelable
operating leases. Lease expenses related to backbone lines for the fiscal years ended March
31, 2002, 2003 and 2004, amounted to ¥5,656 million, ¥5,236 million and ¥4,720
million, respectively. Lease expenses for local access lines for the fiscal
years ended March 31, 2002, 2003 and 2004, which are only attributable to
dedicated access revenues, amounted to ¥3,872 million, ¥3,862 million and
¥3,500 million, respectively. Other lease expenses for the fiscal years ended
March 31, 2002, 2003 and 2004, amounted to ¥2,764 million, ¥3,551 million and
¥3,787 million, respectively. We conduct our connectivity and other services by using data
communications and other equipment leased under capital lease arrangements. The
fair values of the assets at the execution of the capital lease agreements and
accumulated depreciation amounted to ¥10,811 million and ¥5,000 million at
March 31, 2003 and ¥10,421 million and ¥5,422 million at March 31, 2004. As of March 31, 2004, future lease payments under non-cancelable operating
leases, including the aforementioned non-cancelable connectivity lease
agreements (but excluding dedicated access lines which we charge outright to
customers), and capital leases were as follows: Payment due by period(millions of yen)Totalcontractual
    
    Less than
    
    1 to
    
    4 to
    
    More thanamount
    
    1 year
    
    3 years
    
    5 years
    
    5 yearsConnectivity line operating leases
    
    ¥
    235
    
    
    ¥
    190
    
    
    ¥
    45
    
    
    ¥
    
    
    
    ¥
    Other operating leases(1)
    
    
    3,520
    
    
    
    1,722
    
    
    
    1,658
    
    
    
    37
    
    
    
    103Capital leases
    
    
    5,508
    
    
    
    2,525
    
    
    
    2,628
    
    
    
    336
    
    
    
    19Total minimum lease payments.
    
    ¥
    9,263
    
    
    ¥
    4,437
    
    
    ¥
    4,331
    
    
    ¥
    373
    
    
    ¥
    122
  (1)
    
    See note 7 to the consolidated financial statements included in this annual report. 56




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Payments of principal and interest on outstanding borrowings.We require
capital for payments of interest and principal on our outstanding borrowings. Short-term borrowings. As of March 31, 2004, our short-term borrowings
were bank overdrafts of ¥6.6 billion. The weighted average interest rate of our
short-term borrowings was 1.464%. We increased our short-term borrowings by
¥1.7 billion and refinanced ¥0.4 billion of long-term borrowings in the year
ended March 31, 2004 for the repayment of ¥1.9 billion of long-term borrowings.
We also had ¥0.8 billion in borrowings as of March 31, 2004 by bank overdraft
agreements. Long-term borrowings. As of March 31, 2004, we had ¥3.9 billion of
outstanding long-term borrowing, including current portions, which consisted of
unsecured, fixed-rate loans from banks of ¥1.0 billion with a weighted average
interest rate of 1.686%, unsecured, variable rate loans from banks of ¥2.4
billion with a weighted average interest rate of 0.987% and secured, fixed-rate
installment loan from a leasing company of ¥0.5 billion with an interest rate
of 2.55%. We entered into interest rate swap contracts to manage our interest
rate exposure resulting in a fixed interest rate for a portion of our long-term
debt. The effective weighted average interest rate for ¥2.4 billion of the
long-term loans outstanding at March 31, 2004 after giving effect to such swap
agreements was 1.748%. Convertible notes. On April 11, 2000, we issued ¥15.0 billion of 1.75%
unsecured convertible notes due 2005. These notes are subject to conversion at
¥19,874,689 per share on or before March 15, 2005. These notes are currently
redeemable at our option at any time before March 15, 2005, in whole or in
part, at par with unpaid and accrued interest provided that the closing for our
shares for a certain period prior to giving notice of redemption is at least
140% of the conversion price. In October and November 2003, we repurchased a
portion of these notes, with an aggregate face value of ¥3.2 billion for ¥3.0
billion in the open market, resulting in a realized gain of ¥0.1 billion. The
repurchased notes were subsequently retired on November 19, 2003. Annual maturities of long-term borrowings and convertible notes
outstanding as of March 31, 2004, were as follows: Thousands ofFiscal year ending March 31
    
    Thousands of yen
    
    U.S. dollars2005
    
    ¥
    13,380,246
    
    
    $
    128,4342006
    
    
    1,152,056
    
    
    
    11,0582007
    
    
    1,155,963
    
    
    
    11,096Total
    
    ¥
    15,688,265
    
    
    $
    150,588
 Collateral for borrowings. Substantially all of our long- and short-term
borrowings contain conditions that allow the banks to require us to provide
collateral or guarantees with respect to the borrowings as is customary in
Japan. Our primary banking relationships are with Sumitomo Mitsui Banking
Corporation, Mizuho Corporate Bank and UFJ Bank. The banks are also
shareholders and customers of ours. Our loans from a leasing company are
secured by a first priority pledge against a claim for the guarantee deposits
of ¥1.7 billion and loans from banks are secured by a second priority pledge
against its deposits as of March 31, 2004. Investments in current and former group companies.In the past, we have
made substantial investments in current and former group companies. We are not
currently contemplating substantial additional investments in our group
companies at this time, but we may need to provide additional
investment in our group companies to enhance or maintain our business
synergy with our affiliated companies in the future. See Item 4.B.,  Our
Group Companies for information on investment in equity method investees. 57




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Working capital needs.Our principal working capital requirements are for
operating lease payments for our domestic and international backbone and local
access lines. We also require working capital requirements for personnel
expenses, office rents and other operating expenses. Capital Resources We seek to manage our capital resources and liquidity to provide adequate
funds for current and future financial obligations. We have traditionally met
our capital and liquidity requirements through cash flows from operating
activities, long-term and short-term borrowings from financial institutions and
from the issuance of convertible bonds, capital leases and issuances of equity
securities. At March 31, 2004, we had cash and cash equivalent of ¥12.3 billion
and available for sale securities of ¥6.6 billion. We had ¥11.8 billion of
unsecured 1.75% convertible notes due in March 2005 at March 31, 2004. We
repurchased and cancelled ¥0.7 billion of them in June 2004, and we have ¥11.1
billion outstanding of convertible notes. We currently expect that cash from
operating activities, any proceeds from the sale of available for sale
securities, the proceeds from our private placements in June and September 2003
and our other sources of liquidity will be sufficient to meet our requirements
through the year ending March 31, 2005, including the redemption of
convertible notes due in March 2005. Short-term and long-term Borrowings.We borrow substantial amounts to
fund our accumulated deficit. See  Payments of principal and interest on
outstanding borrowing. Cash flows from operating activities.We generated ¥1.9 billion in net
cash provided by operating activities for the year ended March 31, 2004. See 
cash flows. Capital Leases.Capital leases also provide us with an important source
of financing. See note 7 to our consolidated financial statements included in
this annual report on Form 20-F. Issuances of Equity Securities.We raised approximately ¥13.2 billion in
process from our private placements in June and September 2003. We have no
current plans for issuing additional equity securities. Cash Flows We had cash and cash equivalent of ¥12.3 billion at March 31, 2004
compared to ¥3.6 billion at March 31, 2003. The following table presents information about our cash flows during the
fiscal years ended March 31, 2002, 2003 and 2004: Fiscal year ended March 31,2002
    
    2003
    
    2004(Thousands of yen)Net cash provided by operating activities
    
    ¥
    1,161,213
    
    
    ¥
    1,581,692
    
    
    ¥
    1,923,366Net cash used in investing activities
    
    
    (2,457,198
    )
    
    
    (7,877,921
    )
    
    
    (852,463
    )Net cash provided by (used in) financing activities
    
    
    (1,461,901
    )
    
    
    (872,066
    )
    
    
    7,668,599Effect of exchange rate changes on cash
    
    
    233,098
    
    
    
    (289,272
    )
    
    
    (43,615
    )Net increase (decrease) in cash and cash equivalent
    
    
    (2,524,788
    )
    
    
    (7,457,567
    )
    
    
    8,695,887Cash at beginning of the year
    
    
    13,570,707
    
    
    
    11,045,919
    
    
    
    3,588,352Cash at end of the year
    
    ¥
    11,045,919
    
    
    ¥
    3,588,352
    
    
    ¥
    12,284,239
 58




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Year Ended March 31, 2004 as Compared to the Year Ended March 31, 2003 Net cash provided by operating activities was ¥1.9 billion for the fiscal
year ended March 31, 2004 compared to ¥1.6 billion provided for the previous
fiscal year. The increase in net cash provided by operating activities for the
fiscal year ended March 31, 2004 compared to the previous fiscal year was due
mainly to the ¥0.4 billion increase in provision for doubtful accounts, the
¥0.4 billion increase in depreciation and amortization and the ¥0.2 billion
decrease in operating loss. A decrease of ¥0.9 billion in changes in operating
assets and liabilities partially offset this increase. Account receivable
decreased by ¥0.8 billion for the fiscal year ended March 31, 2004 compared to
the previous fiscal year, and accounts payable decreased by ¥1.1 billion for
the fiscal year ended March 31, 2004 compared to the previous fiscal year due
to the decrease in systems integration revenues and equipment sales in the
fourth quarter of the year ended March 31, 2004. The increase in inventories,
prepaid expenses and other current and non-current assets for the fiscal year
ended March 31, 2004 included the payment in advance of ¥0.2 billion to the
leasing company. Net cash used in investing activities was ¥0.9 billion for the fiscal year
ended March 31, 2004 compared to ¥7.9 billion for the previous fiscal year. The
decrease reflected primarily the absence of the ¥5.0 billion deposit of
restricted cash under a cash deficiency support agreement paid in the previous
fiscal year and proceeds from the sale of investments, primarily our investment
in DLJdirect SFG Securities Inc., of ¥2.2 billion and the absence of payments
of guarantee deposits due to the leasing of a new head office space in the
previous fiscal year. The decrease was partially offset by ¥1.7 billion of
advances to Crosswave. Net cash provided by financing activities was ¥7.7 billion for the fiscal
year ended March 31, 2004 compared to ¥0.9 billion used in financing activities
for the previous fiscal year. Cash provided by financing activities increased
primarily as a result of ¥13.3 billion of proceeds from the issuance of common
stock. This increase was offset partially by the repurchase of ¥3.0 billion of
1.75% convertible notes, and the repayments under capital leases of ¥2.7
billion. Long-term borrowings of ¥1.9 billion were repaid for the fiscal year
ended March 31, 2004, which were funded by the increase in short-term
borrowings. Year Ended March 31, 2003 as Compared to the Year Ended March 31, 2002 Net cash provided by operating activities was ¥1.6 billion for the fiscal
year ended March 31, 2003 compared to ¥1.2 billion for the previous fiscal
year. The change primarily reflected the impact of depreciation and
amortization, which increased to ¥0.6 billion for the fiscal year ended March
31, 2003 compared to the previous fiscal year, net changes in operating assets
and liabilities which increased by ¥1.5 billion for the fiscal year ended March
31, 2003 compared to the previous fiscal year, primarily relating to an
increase in accounts receivable, an increase in accounts payable and a decrease
in inventories. The increase in net cash provided by operating activities was
partially offset by an operating loss of ¥1.7 billion
for the year ended March 31, 2003 as compared to operating income of ¥0.1 billion
for the previous fiscal year. Net cash used in investing activities was ¥7.9 billion for the fiscal year
ended March 31, 2003 compared to ¥2.5 billion for the fiscal year ended March
31, 2002. Cash used in investing activities for the fiscal year ended March 31,
2003 increased primarily as a result of a ¥5.0 billion deposit of restricted
cash under a cash deficiency support agreement. Payments of a greater amount
of guarantee deposits for the leasing of a new head office space also
contributed to the increase in net case used in investing activities. Net cash used in financing activities was ¥0.9 billion for the fiscal year
ended March 31, 2003 compared to ¥1.5 billion in the previous fiscal year. Cash
used in financing activities for the fiscal year ended March 31, 2003 decreased
as compared to the previous fiscal year primarily as a result of a net increase
in short-term borrowings. 59




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Contingencies We do not have any contingencies that related to the liquidity and capital
requirements. See Item 4.B.,  Legal Proceedings for information on
investment in equity method investees.  C.
    
    Research and Development, Patents and Licenses, etc. See the information in Item 4.B., Business Overview  Research and
Development.  D.
    
    Trend Information. Factors Affecting Our Future Financial Results We expect that the following are the most significant factors likely to
affect our financial results and those of our consolidated subsidiaries. You
should also consult Item 3.D., Risk Factors and the other portions of this
annual report on Form 20-F for additional factors affecting our financial
results. Revenues We derive our revenues primarily from recurring monthly fees from our
Internet-access services and our value-added services, as well as one-time
project fees and monthly operating fees from systems integration services. We
have been enhancing and will continue to enhance our Internet-access services
through the introduction of a greater variety of access options and bandwidth
options, by expanding our value-added services and systems integration services
under our total network solutions strategy, and by focusing our efforts on
capturing market share in high-end corporate markets that are most attractive
to us. Connectivity and value-added services revenues Connectivity and value-added services revenues are our dedicated access
services, our dial-up access service revenues and our value-added services
revenues. Our connectivity and value-added services revenues accounted for
57.7% of our revenues for the fiscal year ended March 31, 2004, 50.7% for the
fiscal year ended March 31, 2003, and 56.9% of our revenues for the fiscal year
ended March 31, 2002. As our connectivity services customer tend to use our
value-added services or systems integration services as their network needs develop,
connectivity services are also important for the growth of our value-added
services or systems integration business. Dedicated access services Dedicated access services accounted for 33.2% of our revenues for the
fiscal year ended March 31, 2004, 31.4% for the fiscal year ended March 31,
2003, and 35.8% for the fiscal year ended March 31, 2002. Dedicated access
service revenues depend on the size of our customer base, the average
contracted bandwidth and unit price of our services. The market for dedicated
access services has become increasingly polarized with increased demand for
higher bandwidth services at the higher end of the market and a shift to
lower-priced services by lower bandwidth customers.  
    
    Average contracted bandwidth and the demand for higher
bandwidth services.Demand for higher bandwidth services continues
to increase. Total contracted bandwidth for dedicated access
services including Internet Data Center Connectivity Services
increased to 80.1 Gbps for the fiscal year ended March 31, 2004 from
42.0 Gbps for the previous fiscal year. In addition, average
contracted bandwidth for our IP Service jumped to approximately 45
Mbps for the fiscal year ended March 31, 2004 from 20 Mbps for the
previous fiscal year. The number of IP Service contracts for the
highest range of bandwidth, 3 Mbps-1.2 Gbps, increased to 427 for
the fiscal year ended March 31, 2004, 57.9% of our IP service
contracts for that fiscal year. 60




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In the previous fiscal year, there
were 248 IP service contracts for the highest range of bandwidth,
37.4% of our IP service contracts for that fiscal year. Despite the
increase in IP Service contracts and average contracts and average
contracted bandwidth, average revenues per contract for IP Service
have decreased to approximately ¥1.0 million at the end of March
2004 from ¥1.1 million at the end of March 2003, reflecting fierce
competition. Though revenue per contract is decreasing, we expect
that customer demand for higher bandwidth will continue as the use
of broadband by corporate customers expands, and we will try to
acquire new customers and increase the bandwidth of existing
customers as well as maintain the quality of our services and
differentiate them from those of our competitors.
    
    Shift to lower-priced services by lower-bandwidth customers.
Lower-bandwidth subscribers have opted to shift to lower-cost
services such as our second-tier connectivity services and the
service offerings of other ISPs because these subscribers prefer
lower-priced services. To increase the number of subscribers to our
other dedicated access services, we continue to provide second-tier,
lower-priced new Internet-access services in order to remain
competitive, though these lower-priced services generate lower total
revenues due to lower unit prices resulting from fierce price
competition. As a result, the number of dedicated access service
contracts increased to 7,226 for the fiscal year ended March 31,
2004 from 5,308 for the fiscal year ended March 31, 2003. We had a
rapid increase in the number of subscribers to our second-tier
service that we refer to as IIJ DSL/F, an access service over ADSL
lines at maximum 40 Mbps speed, and IIJ FiberAccess/F, and access
services over optical lines at maximum 100 Mbps. In this second-tier
category, IIJ Economy and IIJ T1 Standard used to be the growth
driver, but due to the advent of inexpensive DSL and optical access
lines subscribers have been switching from IIJ Economy to IIJ DSL/F
and IIJ FiberAccess/F, which is faster and more inexpensive. In
addition, inexpensive second-tier services have started to be used as
connectivity lines for Internet VPN solutions connecting multiple
location of corporate customers and we have received orders from
customers with several hundred customer locations to connect.
Though these services are inexpensive compared to IIJ Economy and
IIJ T1 Standard, we expect that the numbers of contracts for these
services will continue to increase and contribute to connectivity
services revenues. We also expect that it will also contribute to
the increase of value-added services and systems integration
revenues as usage and implementation of these connectivity services
will increase the demand for value-added services such as security
services and network systems integration. Dial-up access services Dial-up access services, which include both services for corporate
customers and individual users, accounted for 8.0% of our revenues for the
fiscal year ended March 31, 2004, 7.2% for the fiscal year ended March 31,
2003, and 9.1% for the fiscal year ended March 31, 2002. Dial-up service
revenues depend on the size of our customer base and pricing. The size of our
customer base depends primarily on the popularity of OEM services, and the
attractiveness of our service offerings which is measured primarily
by the quality of service provided to subscribers and our ability to
attract new customers by offering remote access solutions in combination with
dial-up access and security services. Although we also market some services under the IIJ name, due to our
limited brand name recognition among consumers not familiar with the Internet
and our limited marketing budget, a primary focus of our efforts to increase
our revenues from individual consumers is our range of OEM services, which have
steadily been increasing. We have reduced our advertising expenditures
substantially and do not expect our brand name recognition to substantially
increase as we focus on OEM services. For example, Excite Japan markets and
sells Internet-access services to individual customers under their own names
but provides such services through our Internet network infrastructure. 61




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Value-added services revenues Our value-added services consist of network security services, data center
facility services and operation and management services. For the fiscal year
ended March 31, 2004, value-added services revenues increased to ¥4,296 million
for the fiscal year ended March 31, 2003 from ¥3,603 million for the fiscal
year ended March 31, 2003 and from ¥3,100 million for the fiscal year ended
March 31, 2002. The increase is primarily due to the increasing demand for
these services from our connectivity customers. The growth of this segment is primarily due to the increase in demand for
security services and network outsourcing services such as e-mail and web
server hosting services. We expect that business customers will continue to
increase their usage of Internet as a business tool and will increasingly rely
on an expanding range of value-added services to enhance productivity, reduce
costs and improve service reliability. As a result, we expect our
revenue from value-added services to grow. Systems integration revenues, including related equipment sales revenues We are currently targeting systems integration to drive growth in revenues
and operating income. Systems integration revenues, including related equipment
sales revenues for the fiscal year ended March 31, 2004 decreased by 21.1% from
the previous fiscal year. The decrease is primarily due to the adverse effect
of weak corporate investment in Japan in the first half of the fiscal year
ended March 2004. However, the Japanese economy is showing signs
of recovery and we expect that the demand for systems integration, especially integration
relating to corporate information network systems, will increase as the amount
or purposes for usage of network expand in corporate customers. We believe that
systems integration will continue to be a key driver for our growth of our
revenue. Along with the recovery of Japanese economy, our systems integration
revenues increased in the second half of the fiscal year ended March 2004. The primary seasonal variations in systems integration revenues appear to
relate to budgetary cycles of Japanese companies and typically result in
greater revenues from systems integration at the end of the fiscal year as
companies attempt to complete large systems integration projects during those
periods. This seasonality may affect our revenues on a quarter-to-quarter
basis. Systems integration revenues can fluctuate significantly, in accordance
with the absence or addition of a single large order, and are accordingly
difficult to forecast. Other equipment sales revenues. Our other equipment sales revenues consist primarily of sales of
networking and other related equipment, other than that provide in connection
with our systems integration services. Other equipment sales revenues can
fluctuate significantly, in accordance with the absence or addition of a single
large order, and are accordingly difficult to forecast. Additional factors affecting revenues A number of other factors may affect demand for our services and in turn
our revenues, including overall increases in business usage of Internet and
network solutions and our range of service offerings.  
    
    Increase in business usage.Our revenues will be affected by
the extent and speed with which businesses in Japan exploit the
Internet and network solutions to their full potential, including,
for example, electronic transactions between businesses and
expanding the range of devices that access the Internet. Such
services require high-quality and high-capacity connectivity 62




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services for both businesses and individuals. Such services also
require provision of total network solutions including various
Internet-access services, systems integration and other value-added
services which we believe we are well positioned to provide. The
degree of business usage will also depend upon a variety of factors
including:  
    
    technological advances, reliability of security systems
and users familiarity with and confidence in new technologies;
    
    the rate at which Japanese companies in certain
industries significantly increase their Internet usage,
particularly the financial, manufacturing and retail segments;
and
    
    corporate budgets for expenditures for information
technologies, including Internet-related items.  
    
    Range of service offerings.To increase our revenues from
business users, we have increased the access and connectivity
options to include fiber optic lines and ADSL lines. We have also
completed our multi-site Internet data centers and expanded our
service offerings to include systems management and monitoring. We
believe these steps will allow us to sell a greater variety of
services to our high-end corporate users and to capture a greater
amount of the current growth and demand. However, we will still be
strongly dependent on increasing acceptance of our services by large
Japanese companies and by increases in their Information Technology
budgets. We expect Internet usage to continue to grow rapidly in
Japan and that businesses will continue to diversify their uses of
the Internet. Our ability to offer a broad range of services to meet
our customers demands will significantly influence our future
revenues.
    
    Synergies between connectivity services and systems
integration services.Most of our systems integration customers
become Internet-access service customers as well, and we expect
these relationships to continue. As part of our systems integration
business, we offer solution services for corporate information
network systems, consulting, project planning, system design and
systems/operation outsourcing or Internet VPN solution services
which combines the FLETS Internet connectivity services with the
SEIL, adopted by customers who have multiple locations, such as
branches, offices and factories. The number of contracts concerning
these services is steadily increasing and we seek to enlarge these
network integration services with relatively high gross margin
services. The ability to introduce a wide range of services,
including solutions necessary to build corporate information network
systems, like disaster recovery services and Internet VPN, Voice
over IP (VoIP), SEIL and the network service operating system SEIL
Management Framework (SMF), wireless LAN, is an important
competitive factor. Costs and expenses Costs and expenses include cost of connectivity and value-added services
revenues, cost of systems integration revenues and equipment sales, sales and
marketing, general and administrative and research and development expenses. Cost of connectivity and value-added services revenues Our primary cost of connectivity services and value-added services
revenues is the leasing fees that we pay for the leased lines which comprise
our network and for the dedicated local access lines that our subscribers use
to connect with our network. Other primary components of our costs are
depreciation and amortization of capital leases for network equipment, cost of
equipment sold, personnel and other expenses 63




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for technical and customer support
staff and network operation center costs. Most of our network equipment is
leased rather than purchased to take advantage of the financing provided by a
capital lease arrangement. We have invested heavily in the past few years in developing and expanding
our network, however, due to a decrease in procurement prices for international
backbone lines, our costs have decreased as a result. For the fiscal year ended
March 31, 2004, our leased line and other connectivity costs were equal to ¥9.6
billion or 43.1% of our connectivity and value-added services revenues. For the
previous fiscal year, these costs were equal to ¥10.6 billion, or 47.7% of our
connectivity and value-added services revenues.  
    
    Domestic backbone cost.Domestic backbone cost increased to
¥3.9 billion for the fiscal year ended March 2004 from ¥3.6 billion
for the fiscal year ended March 2003. We expect domestic backbone
costs to continue to rise for the fiscal year ending March 31, 2005.
    
    International backbone cost.Our international backbone costs
have declined to ¥0.8 billion for the fiscal year ended March 2004
from ¥1.6 billion for the fiscal year ended March 2003. This
decrease was due to a decrease in procurement prices for
international backbone lines. These lower prices in the procurement
market helped us reduce our international backbone costs. As prices
have already dropped substantially, even though we expect
international backbone costs continue to drop in the next fiscal
year, we do not expect decreases to be substantial.
    
    Dedicated local access line costs.We collect dedicated local
access line fees from subscribers and pay these fees over to the
carriers. Dedicated local access line costs decreased to ¥3.5
billion for the fiscal year ended March 2004 from ¥3.9 billion for
the fiscal year ended March 2003. Other connectivity costs decreased
to ¥1.4 billion for the fiscal year ended March 2004 from ¥1.5
billion for the previous fiscal year. Depreciation and amortization cost increased to ¥3.1 billion for the
fiscal year ended March 2004 from ¥3.0 billion for the fiscal year ended March
2003. Capital expenditures for the fiscal year ended March 2004 decreased to
¥3.5 billion from ¥4.9 billion for the fiscal year ended March 2003. Our
current plans call for us to make capital expenditures, including acquisition
of assets by entering into capital leases, of approximately ¥3.0 to ¥5.0
billion in each of the next few years. We do not expect that the depreciation
and amortization will change significantly compared with recent fiscal years. Costs of systems integration revenues and equipment sales Our cost of systems integration revenues and equipment sales generally
increases or decreases in tandem with systems integration revenues and
equipment revenues. In addition, as we incur significant systems integration
costs up front in connection with the provision of new types of systems
integration
service or commencement of a systems integration project, our margins tend
to improve as the number of our customers grows and to the extent we provide
ongoing systems integration work for existing customers. The main determinant
of whether our costs will be high relative to our revenues is whether we are
able to generate significantly higher margin systems integration work. To do
so, we must generate systems integration work that relies more heavily on our
engineering and technological expertise instead of systems integration work
that primarily focuses on the delivery of networking equipment. By doing more
planning, designing and engineering-related work rather than just equipment
procurement, we believe that not only will we be able to increase our margins,
but we will also be able to increase customer satisfaction and our subscriber
retention and repeat business rates because we will be able to provide our
customers with advanced and cost-effective total Internet solutions. Our IBPS systems integration services started to generate higher margins
for the fiscal year ended March 2004, as most of the time and expense required
for development of this service has been already incurred. 64




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Over the long term, we seek to improve gross margins through systems
integration sales. The gross margin for systems integration services was 16.8%
for the fiscal year ended March 31, 2004 in comparison with 12.8% for the
fiscal year ended March 31, 2003. We seek to retain our systems integration
customers as our customers for higher-margin consulting, co-location services,
operation and maintenance, software development and upgrades included in
systems integration. Sales and marketing Our sales and marketing expenses consist primarily of costs related to
marketing and general advertising, written-off accounts receivable, sales and
marketing and personnel expenses. Our sales and marketing expenses will
increase to the extent that we expand our operations and increase our sales and
marketing activities. Currently we do not expect that our sales and marketing
expenses will increase significantly as compared with recent fiscal years. General and administrative Our general and administrative expenses include primarily expenses
associated with our management, accounting, finance and administrative
functions, including personnel expenses. Our general and administrative
expenses will increase to the extent that we grow our business and add staff.
Currently we do not expect that our general and administrative expenses will
increase in a substantial level compared with recent fiscal years. Research and development Our research and development expenses include primarily expenses
associated with personnel expenses related to research and development
activities. Our research and development expenses will increase to the extent
that we expand our research and development activities. Currently we do not
expect that our research and development expenses will increase significantly
as compared with recent fiscal years. Other income (expenses) Our other income and expenses include, interest income and expenses and
other items such as foreign exchange gains or losses and impairment losses on
available-for-sale securities.  
    
    Interest expense.Most of our interest expense is from bank
borrowing, capital leases and unsecured convertible notes issued on
April 11, 2000. Interest income and interest expenses
are also affected by the fluctuation of market interest rates and our
total amount of outstanding borrowings. As we increase capital leases
or borrowings in order to finance further development of our backbone
and data centers and for other investments, interest expenses will
also increase. Due to the repurchase and cancellation of portions of
the unsecured convertible notes in the fiscal year ended March 2004
(in November 2003) and in June 2004, the interest expense from the
convertible notes for the fiscal year ended March 2005 will be
decreased by approximately ¥67 million.
    
    Impairment losses.We also hold other investments, including
available-for-sale securities. The book value of other investments
are affected by the fluctuation in the market price or the decrease
in fair values of non-marketable investments. If a decrease below
cost in the market price or fair value of an investment is judged to
be other than temporary, we will have impairment losses on other
investments. 65




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Equity in net loss of equity method investees We recorded an aggregate equity in net loss of equity method investees of
¥12.8 billion for the fiscal year ended March 2003, comprised primarily of
equity method net loss and impairment loss on investment, advance and deposits
for Crosswave. For the fiscal year ended March 2004, we recorded an aggregate
equity in net loss of equity method investees of ¥2.0 billion, which includes
written-off loans in the amount of ¥1.7 billion extended to Crosswave in May
and June 2003. We have written off our equity investment in and loans and
advances to Crosswave entirely and forfeited a security deposit provided to
commercial banks on behalf of Crosswave, and do not expect any further adverse
impact on our results of operations or financial condition relating to our
investment in Crosswave.  E.
    
    Off-Balance Sheet Arrangements. We do not have any off-balance sheet arrangements as such term is defined
for purposes of Item 5.E. of Form 20-F.  F.
    
    Tabular Disclosure of Contractual Obligations. The following table shows our contractual payment obligations under our
agreements as of March 31, 2004: Payments due by period (in million of yen)less than
    
    
    
    
    
    
    
    
    
    more thanContractual Obligations
    
    Total
    
    1 year
    
    1-3 years
    
    3-5 years
    
    5 yearsLong-term debt obligations
    
    
    15,688
    
    
    
    13,380
    
    
    
    2,308Capital (finance) lease obligations
    
    
    5,508
    
    
    
    2,525
    
    
    
    2,628
    
    
    
    336
    
    
    
    19Operating lease obligations
    
    
    3,755
    
    
    
    1,912
    
    
    
    1,703
    
    
    
    37
    
    
    
    103Purchase obligations(1)Other long-term liabilities
reflected on our balance sheetTotal
    
    
    24,951
    
    
    
    17,817
    
    
    
    6,639
    
    
    
    373
    
    
    
    122
  (1)
    
    Comprises agreements to purchase goods and services that are enforceable
and legally binding on us and that specify all significant terms including
fixed or minimum quantities to be purchased, fixed, minimum or variable
price provisions, and the approximate timing of the transactions.  G.
    
    Safe Harbor 1.  The safe harbor provided in Section 27A of the Securities Act and
Section 21E of the Exchange Act (statutory safe harbors) shall apply to
forward-looking information provided pursuant to Item 5.E. and F. of this
annual report on Form 20-F, provided that the disclosure is made by: an issuer,
a person acting on behalf of the issuer; an outside reviewer retained by the
issuer making a statement on behalf of the issuer; or an underwriter, with
respect to information provided by the issuer or information derived from
information provided by the issuer. 2.  For the purpose of Item 5.G.1 of this Item only, all information
required by Item 5.E.1 and 5.E.2 of this Item is deemed to be a
forward-looking statement as that term is defined in the statutory safe
harbors, except for historical facts. 3.  With respect to Item 5.E. of this annual report on Form 20-F, the
meaningful cautionary statements element of the statutory safe harbors will be
satisfied if a company satisfies all requirements of the same Item 5.E. of this
annual report on Form 20-F. 66




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Item 6.  Directors and Senior Management and Employees.  A.
    
    Directors and Senior Management. The following table provides information about our directors, executive
officers and statutory auditors as of June 30, 2004: Initialdate ofappointmentas director,executive
    
    Number ofofficer
    
    IIJ sharesCurrent term
    
    or statutory
    
    owned as ofName
    
    Position
    
    Date of birth
    
    expires
    
    auditor
    
    June 30, 2004Koichi Suzuki
    
    President, Chief
Executive Officer and
Representative Director
    
    Sept. 3, 1946
    
    June 2005
    
    Dec. 1992
    
    
    2,323Toshiya Asaba
    
    Executive Vice President
and Chief Technology
Officer
    
    June 12, 1962
    
    June 2005
    
    June 1999
    
    
    *Fukuzo Inoue
    
    Executive Vice President
    
    July 6, 1955
    
    June 2006
    
    June 2004
    
    
    Hideshi Hojo
    
    Managing Director
    
    Dec. 22, 1957
    
    June 2005
    
    June 2000
    
    
    *Takamichi Miyoshi
    
    Director
    
    May 5, 1963
    
    June 2006
    
    June 2002
    
    
    *Akihisa Watai
    
    Director, Chief Financial
Officer and Chief
Accounting Officer
    
    Sept. 30, 1965
    
    June 2006
    
    June 2004
    
    
    Kazumasa Utashiro
    
    Director
    
    Sept. 23, 1960
    
    June 2005
    
    June 2001
    
    
    *Yasurou Tanahashi
    
    Director
    
    Jan. 4, 1941
    
    June 2006
    
    June 2004
    
    
    Takashi Hiroi
    
    Director
    
    Feb. 13, 1963
    
    June 2006
    
    June 2004
    
    
    Hideki Matsushita
    
    Standing Statutory Auditor
    
    Sept. 20, 1942
    
    June 2008
    
    June 1998
    
    
    Masaki Okada
    
    Statutory Auditor
    
    Jan. 9, 1959
    
    June 2008
    
    June 2004
    
    
    Masaaki Koizumi
    
    Statutory Auditor
    
    Oct. 4, 1964
    
    June 2008
    
    June 2004
    
    
    
   *
    
    Owns less than 1% of outstanding shares of IIJs common stock. Koichi Suzukihas been our president and representative director since
April 1994, and has over 20 years of experience in the computer and
communication industry. In addition, Mr. Suzuki is the representative director
of IIJ Media Communications, IIJ Technology, Net Care, Internet Multifeed, Asia
Internet Holding, and AIH Korea. He also serves as chairman of IIJ America and
a director of atom and i-Heart, Inc. He has been appointed as a council member
of the Advanced Information and Telecommunications Network Society Promotion
Headquarter established by the Japanese government
since January 2001. From October 1998 to August 2003, Mr. Suzuki was
President and a representative director of Crosswave Communications and its
subsidiaries, and from September 2000 to August 2003, Mr. Suzuki was a
representative director of Crosswave Service Inc. and Crosswave Facilities Inc.
From December 1992 to April 1994, Mr. Suzuki was a director of IIJ. Prior to
joining us, Mr. Suzuki was employed at Japan Management Association where he
served as a general manager. Toshiya Asabahas served as an executive vice president and chief
technology officer since June 2004. Mr. Asaba was a managing director of IIJ
from June 2002 to June 2004, as a co-chief technology officer from May 1999 to
June 2004, as division director of the Business Development Department from
August 2003 to June 2004. Mr. Asaba is also a director of IIJ America, Internet
Multifeed, Asia Internet Holding and NTT Resonant Inc. From October 1998 to May
2000, Mr. Asaba was a director of Crosswave and from May 2000 to August 2003.
From 1995 to June 1999, Mr. Asaba was a general manager of the Network
Engineering Division. Mr. Asaba joined us in 1992. Mr. Asaba has over ten years
of Internet experience including three years of Internet-related research
experience and seven years of Internet backbone engineering experience,
including network design, routing and traffic management. 67




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Fukuzo Inouehas served as an executive vice president since June 2004.
Mr. Inoue joined Nippon Telegraph and Telephone Public Corporation in April
1980 and was executive manager of the Corporate Users Business Division from
July 1999 to July 2002. From July 2002 to June 2004, Mr. Inoue was executive
manager of the Public Relations Office of NTT Communications. Since September
1997, Mr. Inoue has served as a director of Internet Multifeed. Hideshi Hojohas served as a managing director of IIJ since June 2002 and
as division director of the Sales Department since August 2003. Mr. Hojo is
also a director of Net Care and Asia Internet Holding. From February 1998 to
April 2001, Mr. Hojo acted as general manager of the Sales Division, from
April 2001 to June 2002, as deputy division director of the Sales & Marketing
Department and from June 2002 to August 2003, as division director of the
Sales & Marketing Department. Mr. Hojo joined us in 1996. Prior to joining us,
Mr. Hojo had 16 years of experience in the field of sales working for the
Itochu Group. Takamichi Miyoshihas served as a director of IIJ since June 2002 and as general manager of Strategy Planning Division, Business Development Department.
Mr. Miyoshi also serves as chief technical adviser of IIJ Technology. Mr.
Miyoshi joined us in April 1993. From October 1994 to March 1998, Mr. Miyoshi
acted as general manager of Network Operations and Systems Administration
Division, from April 1998 to June 2001 as general manager of the Technology
Planning Division and from July 2001 to August 2002 as general manager of the
Network Operations and System Administration Division. Akihisa Wataihas served as a director, chief financial officer and chief
accounting officer since June 2004. Mr. Watai joined the Sumitomo Bank,
Limited (currently Sumitomo Mitsui Banking Corporation) in April 1989 and was
temporarily transferred to IIJ from August 1996. In February 2000, Mr. Watai
joined IIJ permanently and has been manager, President Office since October
1999 and has been general manager of the Finance Division since April 2004. Kazumasa Utashirohas served as a director of IIJ since June 2001, as our
co-chief technology officer since May 1999 and as general manager of the
Service Administration Division, Business Development Department. From April
1995 to June 1999, Mr. Utashiro was general manager of the Applied Technology
Division. Mr. Utashiro joined us in 1994. Prior to joining us, Mr. Utashiro
worked at Software Research Associates, Inc. Since May 2004, Mr. Utashiro has
served as director general of the Japan Computer Emergency Response Team
Coordination Center (JPCERT/CC). Yasurou Tanahashihas served as a director of IIJ since June 2004. Mr.
Tanahashi joined Fuji Iron & Steel Co, Ltd. and was representative director &
president of Nippon Steel Information & Communication Systems
Inc. from April
2000. Mr. Tanahashi was representative director & president of NS Solutions
Corporation, an affiliated company of Nippon Steel Corporation from April
2001 and has been chairman of NS Solutions Corporation since April 2003. Takashi Hiroihas served as a director of IIJ since June 2004. Mr. Hiroi
joined NTT in April 1986, and was senior manager of Department 4 of Nippon
Telegraph and Telephone Corporation. Since July 2002, Mr. Hiroi has been senior
manager of Department 1 of Nippon Telegraph and Telephone Corporation. Hideki Matsushitahas been a standing statutory auditor of IIJ since June
1998. Mr. Matsushita joined Dai-Ichi Life Insurance Company in April 1967. Masaki Okadahas been a statutory auditor of IIJ since June 2004. Mr.
Okada has been admitted the Dai-ni Tokyo Bar Association and joined Ishii Law
Office since April 1998. Mr. Okada has been a partner in Ishii Law Office since
June 1998. 68




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Masaaki Koizumihas been a statutory auditor of IIJ since June 2004. Mr.
Koizumi is a Japanese Certified Public Accountant and joined Eiwa & Co.
(Currently Azsa & Co.) in October 1987. Mr. Koizumi retired from Azsa & Co. in
September 2003 and established Koizumi CPA Office in October 2003.  B.
    
    Compensation. For the fiscal year ended March 31, 2004, the aggregate compensation we
paid or accrued for all of our executive officers, directors and statutory
auditors was approximately ¥238 million. Presently, our executive officers,
directors and statutory auditors are not entitled to pension, retirement or
similar benefits. For a description of our stock option and warrant issuances
to directors and employees, see Item 6.E.  C.
    
    Board Practices. Information required by this item is in Items 6.A. and 6.B. of this annual
report of Form 20-F. Board resolutions.Our articles of incorporation provide that a resolution
of the board of directors is to be approved by the affirmative vote of a
majority of the directors present at a meeting of the board of directors at
which a majority of all directors are present. There is no provision in our articles of incorporation as to a directors
authority to vote on a proposal, arrangement or contract in which the director
is materially interested, but the Commercial Code of Japan and our Regulations
of the Board of Directors provide that such a director is required to refrain
from voting on such matters at the board of directors meetings. A meeting of the board of directors is to be convened and chaired by the
president/director. Should the president/director be unable to so act, another
director shall convene and chair such meeting in his/her place in the order
predetermined by a resolution of the board of directors. The notice of convocation of a meeting of the board of directors shall be
given to each director and statutory auditor at least three (3) days prior to
the day set for such meeting; provided that this period may be shortened in
extraordinary circumstances. Exemption From Certain Corporate Governance Requirements of Nasdaq.
Nasdaq rules provide that Nasdaq may grant exemptions from the Nasdaq corporate
governance standards to a foreign issuer when those standards are contrary to a
law, rule or regulation of any public authority exercising jurisdiction over
such issuer or contrary to generally accepted business practices in the
issuers country of domicile, except to the extent that such exemptions would
be contrary to the U.S. federal securities laws. In connection with
the initial listing of American Depositary Shares representing our common
stock on the Nasdaq National Market in August 1999, we received from Nasdaq
exemptions from certain Nasdaq corporate governance standards. These
exemptions and the practices we follow are described below:  
    
    We are exempt from Nasdaqs requirement that there be a
distribution to shareholders of copies of our annual report containing
our audited financial statements a reasonable period of time prior to
the our annual meeting of shareholders. In accordance with Japanese
law, we hold an annual meeting of shareholders within three months
after the end of each fiscal year. Also, in accordance with Japanese
law, we distribute to shareholders, prior to the annual meeting of
shareholders, copies of a report of business operations, together with
our audited unconsolidated financial statements prepared in accordance
with Japanese GAAP in Japanese. Concurrently with such distribution,
we distribute Japanese GAAP audited unconsolidated financial statements
in English to the depository for the ADSs, and instruct the depository
to distribute the same to the registered ADS holders in a timely
manner. The English version contains a statement that, upon request by
an interested party, we will provide the party with a copy of our
annual report on Form 20-F. As a reporting company 69




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under the
Securities Exchange Act of 1934, we are required to prepare financial
statements in accordance with U.S. GAAP for inclusion in our annual
report on Form 20-F, which annual report must be filed within six
months after the end of each fiscal year.
    
    We are exempt from Nasdaqs requirement that there be independent
directors on the board of directors. Currently, for a foreign issuer,
Nasdaq requires that there be two independent directors on its board of
directors. For large Japanese companies, including us, which employ a
corporate governance system based on a board of corporate auditors,
Japans company law has no independence requirement with respect to
directors. The task of overseeing management and accounting firms is
assigned to the corporate auditors, who are separate from the companys
management. Large Japanese companies, including us, are required to
have at least one outside corporate auditor who must meet
independence requirements under Japans company law. An outside
corporate auditor is defined as a corporate auditor who has not served
as a director, manager or any other employee of the company or any of
its subsidiaries for the last five years prior to the appointment.
Currently, we have two outside corporate auditors. Starting on the
date of our ordinary meeting of shareholders relating to the fiscal
year ending March 31, 2005 at least 50% of our corporate auditors will
be required to be outside corporate auditors. Also, starting on the
same date, the independence requirements for outside corporate auditors
will be strengthened by extending the five-year period referred to
above to any time prior to the appointment.
    
    We are exempt from Nasdaqs requirement that there be an audit
committee of the board of directors. Currently, for a foreign issuer,
Nasdaq requires that a majority of such an audit committees members be
independent directors. Like a majority of Japanese companies, we
employ the corporate auditor system as described above. Under this
system, the board of corporate auditors is a legally separate and
independent body from the board of directors. The function of the
board of corporate auditors is similar to that of independent
directors, including those who are members of the audit committee, of a
U.S. company: to monitor the performance of the directors, and review
and express opinion on the method of auditing by the companys
accounting firm and on such accounting firms audit reports, for the
protection of the companys shareholders. Large Japanese companies,
including us, are required to have at least three corporate auditors.
Currently, we have three corporate auditors. In addition, as discussed
above, our corporate auditors serve a longer term than our directors.
    
    We are exempt from Nasdaqs requirement that there be a provision
in the by-laws for a quorum for any meeting of the holders of common
stock and that such quorum be not less than 33? percent of the
outstanding shares of such the common voting stock. In accordance with
the Commercial Code of Japan (the Commercial Code), however, under
our Articles of
Incorporation no quorum is required for the adoption of resolutions at a
general meeting of shareholders. This approach is consistent with
generally accepted business practices of publicly-held companies in
Japan.
    
    We are exempt from Nasdaqs requirement that shareholder approval
be obtained for the issuance of the issuers stock in certain
conditions or certain specified transactions described in Nasdaq Rule
4350(i)(1). The Commercial Code requires us to seek shareholder
approval of various matters, and in certain instances a two-thirds vote
of shareholders present is required for approval. In addition, while
the Commercial Code permits, in certain instances, the issuance of
equity securities without shareholder approval, the Commercial Code
also contains provisions requiring the timely dissemination of
information relating to such issuance, allowing for opportunities for
shareholders to voice their concern with such issuance, and mandating
the election of statutory auditors whose fiduciary duty it is to, among
other things, oversee on behalf of the shareholders actions by the
board of directors relating to such issuance. 70




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Starting on July 31, 2005, when the requirements of Rule 10A-3 under the
U.S. Securities Exchange Act of 1934 relating to listed company audit
committees become applicable to foreign private issuers, we expect to rely on
an exemption under that rule which is available to foreign private issuers with
boards of corporate auditors meeting certain criteria. We expect to make a
disclosure regarding such reliance in our annual reports on Form 20-F for the
fiscal year ending March 31, 2006 and thereafter. The rights of ADR holders, including their rights relating to corporate
governance practices, are provided in the deposit agreement which is
incorporated by reference as an exhibit to this annual report on Form 20-F. As is standard practice in Japan, we do not have an audit remuneration
committee. Neither we nor any of our subsidiaries has any service contracts
with any member of our board and neither we nor any member of our subsidiaries
provides benefits to any member of our board upon termination of employment.  D.
    
    Employees. As of March 31, 2004, we had 919 employees, including employees of our
consolidated subsidiaries, and we had 894 employees as of March 31, 2003 and
775 employees as of March 31, 2002. Approximately 70% of these employees were
in our engineering division, 20% in our sales division and 10% in our
administrative division. The trend of percentages has not been changed largely
for three fiscal years. Except for 14 employees in the United States employed in our subsidiary,
IIJ America, all of our employees work in Japan. We have never experienced any labor disputes and consider our labor
relations to be good. To our knowledge, none of our employees is a member of
any union.  E.
    
    Share Ownership. The information on share ownership required by this item is in Item 6.A.
above. Stock Option Plan  
    
    June 2001 Stock Option Plan. In June 2001, we implemented a
stock option plan under which options to acquire a total of 395
shares or 790,000 ADS equivalents, or approximately 1.8% of total
outstanding shares on that date, were granted to 44 directors and
employees on August 2, 2001. The option exercise price for the
 shares was determined by setting the price
5% above the 30-days average of the closing market prices beginning 45
days prior to the date of the grant which was ¥2,018,306 per share and
has been adjusted to ¥1,672,239 as a result of issuances of common
 shares. The options are exercisable at various times from two years to
ten years from the date of grant.
    
    April 2000 Stock Option Plan. In April 2000, we implemented a
stock option plan under which our directors and employees were
granted options to acquire a total of 295 shares or 590,000 ADS
equivalents, or approximately 1.2% of total outstanding shares on
that date. The options were granted to 34 directors and employees on
May 31, 2000. The option exercise price was determined by setting
the price at 5% above the 30-day moving average of closing market
prices beginning 45 days prior to the date of grant, which was
¥13,055,664 per share and has been subsequently adjusted to
¥10,817,086 as a result of issuances of common shares. The options
are exercisable at various times from two years to ten years from
the date of grant. 71




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
    
    March 2001 Warrant Issuance. On March 31, 2001, certain
directors of IIJ were provided with 375 warrants exercisable for
 shares of common stock of IIJ Technology. Each warrant is
exercisable for one share of common stock up to seven or eight years
from the date of grant at an exercise price of ¥300,000 and was
purchased for 1% of the exercise price. Employee Stock Purchase Plan We have an employee stockholding association that holds 355 shares of
common stock, or 0.93% of our outstanding shares, as of March 31, 2004. The
association provides designated employees with the opportunity to purchase
shares at market value. Shares are held in the name of the employee stock
purchase program until the employee resigns or retires. The representative of
the employee shareholders association exercises voting right in
accordance with the
instructions of each employee shareholder. 
 Item 7.  Major Shareholders and Related Party Transactions.  A.
    
    Major Shareholders. The following table shows information regarding beneficial ownership of
our common stock as of June 30, 2004 by each shareholder known by us to own
beneficially more than 5% of our common stock and all directors and executive
officers as a group. We are not required by Japanese law to disclose beneficial
ownership of our common stock. As explained in Reporting Requirements of
ShareholdersReport of Substantial Shareholdings in Item 10.B. of this annual
report on Form 20-F, any person who becomes, beneficially and solely or
jointly, a holder of more than 5% of our outstanding common stock must file a
report with the relevant local finance bureau of the Ministry of Finance. The
information in this table is based upon our shareholders of record and reports
filed with the Financial Services Agency and U.S. Securities and Exchange
Commission. Shares of common stockbeneficially ownedNumber
    
    PercentageNippon Telegraph and Telephone Corporation and affiliates(1)
    
    
    12,135
    
    
    
    31.63
    %Koichi Suzuki and affiliate(2)
    
    
    2,323
    
    
    
    6.06Sumitomo Corporation
    
    
    2,107
    
    
    
    5.49Itochu Corporation
    
    
    2,086
    
    
    
    5.44Directors and executive officers as a group(3)
    
    
    2,547
    
    
    
    6.64
  (1)
    
    Includes Nippon Telegraph and Telephone Corporation, which owns 10,095
shares, or 26.32%, and NTT Communications Corporation, which owns 2,040
shares, or 5.32%.(2)
    
    Includes shares held by Koichi Suzuki, and a holding company 100% held
by Koichi Suzuki.(3)
    
    Includes Koichi Suzuki and affiliates holding which is also separately
set forth above. No other director or executive officer is a beneficial
owner of more than 5%. On June 27, 2003, we issued 3,265 of our common shares to investors in
Japan for an aggregate amount of ¥1,365,423,000 in a private placement in
Japan. As a result of this transaction, the total number of issued common
shares after the private placement increased to 25,745. On September 17, 2003, we issued 12,615 shares of our common stock for an
aggregate amount of ¥12,000,649,500 in a private placement in Japan. As a
result of the transaction the total number of issued common shares increased to
38,360, and Nippon Telegraph and Telephone Corporation and its affiliates
increased their ownership from 5.6% to 31.6%. The new shares were purchased by
Nippon Telegraph and 72




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Telephone Corporation, NTT Communications Corporation,
Itochu Corporation, Sumitomo Corporation and other shareholders in Japan. Our major shareholders have the same voting rights as other holders of our
common stock. Under our share subscription agreement with NTT, we have agreed
that NTT has the contractual right to nominate up to three persons to serve as
either directors or statutory auditors subject to approval by our shareholders
at a meeting of shareholders. We are not controlled directly or indirectly by
any other entity and are not aware of any arrangement to effect a change in
control of us. According to our register of shareholders, as of March 31, 2004, there
were 103 holders of common stock of record worldwide. As of March 31, 2004, the
Bank of New York was the sole recordholder of our common stock in the United
States and its shareholdings represented approximately 18.93% of the
outstanding common stock on that date. According to The Bank of New York,
depositary for our ADSs, as of March 31, 2004, there were six ADR holders of
record with addresses in the United States. Because some of these shares were
held by brokers or other nominees, the number of record holders with addresses
in the United States might not fully show the number of beneficial owners in
the United States. Of the 38,360 shares of common stock outstanding as of March
31, 2004, 7,263 shares were held in the form of 14,526,000 ADSs.  B.
    
    Related Party Transactions. NTT-affiliated Companies.Since April 1, 2003 through March 31, 2004, IIJ
has paid ¥3,686 million for international and domestic backbone and local
access line costs to NTT-affiliated companies such as NTT Communications, NTT
East and NTT West. In addition, we paid ¥845 million for co-location costs and
telecommunication expenses to NTT East and NTT West. We received payments of
¥954 million for OEM services, Internet connectivity services and operation
fees for data centers from NTT Communications, NTT East and NTT West. On an
ongoing basis in the ordinary course of business, we pay NTT-affiliated
companies for international and domestic backbone and local access line costs
and for co-location costs and telecommunications expenses and receive payments
from NTT-affiliated companies for OEM services, Internet connectivity services
and operating fees for data centers. We do not have any outstanding loans
between NTT and its affiliated companies and us. Transactions with equity method affiliates.In the ordinary course of
business, we have various sales, purchase and other transactions with companies
which are owned 20% to 50% by us and are accounted for
by the equity method. Account balances and transactions with such 20% to
50% owned companies as of and for the fiscal year ended March 31, 2004 are
presented as follows: millions of yenAccounts receivable
    
    ¥
    96Accounts payable
    
    
    14Revenues
    
    
    1,329Costs and expenses.
    
    
    1,246
 As of March 31, 2004, IIJ and IIJ Technology had loans to certain equity
method investees of which the carrying amount was ¥51 million. Except as described above, since March 31, 2003, there has been no
transaction with or loan between us and any enterprise that controls, is
controlled by, or in common control with us; any directors, officers,
statutory auditors or their family members; shareholders with significant
influence over us or their family members; or their respective family members
or enterprises over which they exercise significant influence; or any
unconsolidated enterprise in which we have a significant influence or which has
a significant influence over the company. 73




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Crosswave.Prior to the year ended March 31, 2003, we accounted for
Crosswave under the equity method. As a result of Crosswaves commencement of
corporate reorganization, the amounts of balances and transactions of us with
Crosswave as of and for the fiscal year ended March 31, 2004 are presented as
follows: millions of yenAccounts receivable
    
    ¥
    19Accounts payableRevenues
    
    
    1,196Costs and expenses
    
    
    4,816
 Revenues from Crosswave consisted principally of dedicated Internet access
services, monitoring services and sales of network systems. IIJs sale of network systems to Crosswave amounted to ¥28 million for the
fiscal year ended March 31, 2004. Related cost of purchased equipment sold
amounted to ¥27 million. Cost and expenses incurred from transactions with Crosswave mainly consisted of
the cost of dedicated high-speed data communication services. C.  Interests of Experts and Counsel. Not applicable. 
 Item 8. Financial Information. A.  Consolidated Statements and Other Financial Information. Financial Statements The consolidated financial statements required by this item begin on page
F-1. Legal or Arbitration Proceedings The information on legal or arbitration proceedings required by this item
is in Item 4.B. Dividend Policy Due to IIJs accumulated deficit and shareholders capital deficiency, IIJ
is accordingly unable to legally make and currently has no plans for dividend
distributions. B.  Significant Changes. Except as otherwise disclosed in this annual report on Form 20-F, there
has been no significant change in our financial condition since March 31, 2004,
the date of our last audited financial statements. 74




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Item 9. The Offer and Listing. A. Offer and Listing Details. American Depositary Shares representing our common stock have been quoted
on the Nasdaq National Market since August 4, 1999 under the symbol IIJI. The
current ADS/share ratio is 2,000 ADS per 1 share of our common stock. Our
common stock is not otherwise registered for trading on any exchange. The
following table shows, for the periods indicated, the high and low per-ADS sale
price of the ADSs. The table shows the high and low price of our ADSs for the periods indicated: NasdaqFiscal year ended/ending March 31,
    
    High
    
    Low2000*
    
    $
    132.81
    
    
    $
    23.692001
    
    
    73.00
    
    
    
    6.752002
    
    
    11.88
    
    
    
    4.252003
    
    
    7.34
    
    
    
    1.80First Quarter
    
    
    7.34
    
    
    
    3.10Second Quarter
    
    
    6.50
    
    
    
    2.01Third Quarter
    
    
    4.10
    
    
    
    2.00Fourth Quarter
    
    
    3.75
    
    
    
    1.802004
    
    
    14.10
    
    
    
    1.41First Quarter
    
    
    5.35
    
    
    
    1.41Second Quarter
    
    
    14.10
    
    
    
    3.58Third Quarter
    
    
    8.24
    
    
    
    4.00Fourth Quarter
    
    
    7.19
    
    
    
    4.012005First Quarter
    
    
    6.24
    
    
    
    3.19MonthJanuary 2004
    
    
    6.2
    
    
    
    4.08February 2004
    
    
    7.19
    
    
    
    4.75March 2004
    
    
    5.77
    
    
    
    4.01April 2004
    
    
    6.24
    
    
    
    4.35May 2004
    
    
    4.78
    
    
    
    3.19June 2004
    
    
    4.3
    
    
    
    3.21
   (*)
    
    Since our initial public offering in August 1999. B. Plan of Distribution. Not applicable. C. Markets. American Depository Shares representing our common stock have been quoted
on the Nasdaq National Market since August 4, 1999 under the symbol IIJI. Our
common stock is not otherwise registered for trading on any exchange. D. Selling Shareholders. Not applicable. 75




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E. Dilution. Not applicable. F. Expenses of the issue. Not applicable. 
 Item 10. Additional Information. A. Share Capital. Not required. B. Memorandum and Articles of Association. Objects and Purposes in our articles of incorporation Article 2 of our articles of incorporation states our objects and purposes:  
    
    Telecommunications business,
    
    Telecommunications construction business,
    
    Manufacture, construction, development, sale, purchase,
lease, export and import of telecommunications machinery and
equipment, telecommunications facilities, software and
telecommunications systems,
    
    Administration, maintenance and operation of
telecommunications machinery and equipment, telecommunications
facilities, software and telecommunications systems,
    
    Consulting service related to the foregoing,
    
    Research, study, education and training related to the foregoing,
    
    The sale and purchase of telephone subscribers rights, and
    
    Any and all businesses incidental or related to the foregoing. Provisions Regarding our Directors There is no provision in our articles of incorporation as to a directors
power to vote on a proposal, arrangement or contract in which the director is
materially interested, but the Commercial Code of Japan provides that such
director is required to refrain from voting on such matters at the board of
directors meetings. The Commercial Code of Japan provides that compensation for directors is
determined at a general meeting of shareholders of a company. Within the upper
limit approved by the shareholders meeting, the board of directors will
determine the amount of compensation for each director. The board of directors
may, by its resolution, leave such decision to the presidents discretion. 76




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The Commercial Code of Japan provides that a significant loan from third
party by a company should be approved by the board of directors. Our
regulations of the board of directors have adopted this policy. There is no mandatory retirement age for directors under the Commercial
Code of Japan or our articles of incorporation. There is no requirement concerning the number of shares one individual
must hold in order to qualify him or her as a director under the Commercial
Code of Japan or our articles of incorporation. Rights of Shareholders of our Common Stock We have issued only one class of shares, our common stock. Rights of
holders of shares of our common stock have under the Commercial Code of Japan
and our articles of incorporation include:  
    
    the right to receive dividends when the payment of dividends
has been approved at a shareholders meeting, with this right
lapsing three full years after the due date for payment according to
a provision in the Articles,
    
    the right to receive interim dividends as provided for in the
Articles, with this right lapsing three full years after the due
date for payment according to a provision in the Articles,
    
    the right to vote at a shareholders meeting (cumulative
voting is not allowed under the Articles),
    
    the right to receive surplus in the event of liquidation, and
    
    the right to require us to purchase shares when a shareholder
opposes (i) the transfer of all or material part of the business,
(ii) an amendment of the Articles to establish a restriction on
share transfer, (iii) a share exchange or share transfer to
establish a holding company, (iv) split of the company or (v)
merger, all of which must be consummated by a two-thirds affirmative
vote of the voting rights of the shareholders at a shareholders
meeting at which shareholders having not less than one-third of the
total number of voting rights held by all shareholders are in
attendance. A shareholder is generally entitled to one vote per one unit of our shares
at a shareholders meeting. In general, under the Commercial Code of Japan and
our articles of incorporation, a shareholders meeting may adopt a resolution
by a majority of the voting rights represented at the meeting. The Commercial
Code of Japan and our articles of incorporation require a quorum for the
election of directors and statutory auditors of not less than one-third of the
total number of voting rights held by all shareholders. A corporate
shareholder, having more than one-quarter of its voting rights directly or
indirectly held by us, does not have voting rights. We have no voting rights
with respect to our own common stock. Shareholders may exercise their voting
rights through proxies, provided that those proxies are also shareholders who
have voting rights. Our board of directors may entitle our shareholders to cast
their votes in writing. Our board of directors may also entitle our
shareholders to cast their votes by electrical devices. The Commercial Code of Japan requires a quorum of the majority of voting
rights and approval of two-thirds of the voting rights presented at the meeting
of any material corporate actions. Following the April 1, 2003 amendments of
the Commercial Code of Japan, which allow a company to reduce the quorum for
such special resolutions by its articles of incorporation to not less than
one-third of the total number of voting rights held by all shareholders, we
adopted a quorum of not less than one-third of the total number of voting
rights in our articles of incorporation for special resolutions for material
corporate actions, such as: 77




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
    
    a reduction of the stated capital,
    
    amendment of our articles of incorporation (except amendments
that the board of directors are authorized to make under the
Commercial Code of Japan),
    
    the removal of a director or statutory auditor,
    
    establishment of a 100% parent-subsidiary relationship
through a share exchange or share transfer requiring shareholders
approval,
    
    a dissolution, merger or consolidation requiring shareholders approval,
    
    a company split requiring shareholders approval,
    
    a transfer of the whole or an important part of our business,
    
    the taking over of the whole of the business of any other
corporation requiring shareholders approval, and
    
    issuance of new shares at a specially favorable price, or
issuance of stock acquisition rights or bonds with stock acquisition
rights with specially favorable conditions to persons other than
shareholders. The Commercial Code of Japan provides additional specific rights for
shareholders owning a substantial number of voting rights. Shareholders holding one sixth or more of the total number of the voting
rights of all shareholders have the right to oppose:  
    
    short-form share transfer (Kan-i Kabushiki Kokan),
    
    short-form company split into an existing company (Kan-i
Kyushu Bunkatsu) (only in respect of the shareholders of the exiting
company that takes over the target business of the split company),
and
    
    short-form merger (Kan-i Gappei). Shareholders holding 10% or more of the total number of voting rights of
all shareholders have the right to apply to a court of competent jurisdiction,
or competent court, for:  
    
    dissolution, and
    
    commencement of reorganization proceedings as provided for in
The Company Reorganization Law of Japan. Shareholders who have held 3% or more of the total number of voting rights
of all shareholders for six months or more have the right to:  
    
    demand the convening of a general meeting of shareholders,
    
    apply to a competent court for removal of a director or statutory auditor, 78




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
    
    apply to a competent court for removal of a liquidator,
    
    apply to a competent court for reorganization of the company, and
    
    apply to a competent court for an order to inspect our
business and assets in a special liquidation proceeding. Shareholders holding 3% or more of the total number of voting rights of
all shareholders have the right to:  
    
    examine our accounting books and documents and make copies of
them,
    
    apply to a competent court for permission to examine
accounting books and documents of a subsidiary and make copies of
them, and
    
    apply to a competent court for appointment of an inspector to
inspect our operation or financial condition. Shareholders who have held 1% or more of the total number of voting rights
of all shareholders for six months or more have the right to:  
    
    demand that certain matters be made agenda items at a general
meeting of shareholders, and
    
    apply to a competent court for appointment of an inspector to
review the correctness of the convocation and voting procedures of a
general meeting of shareholders. Shareholders who have held 300 voting rights for six months or more have
the right to demand that certain matters be made objects at a general meeting
of shareholders. Shareholders who have held any number of shares for six months or more
have the right to demand:  
    
    us to institute an action to enforce the liability of one of
our directors or statutory auditors,
    
    us to institute an action to recover from a recipient the
benefit of a proprietary nature given in relation to exercising the
right of a shareholder, and
    
    a director on our behalf for the cessation of an illegal or
ultra vires action. There is no provision under the Commercial Code of Japan or our articles
of incorporation which forces shareholders to make additional contributions
when requested by us. Under the Commercial Code of Japan, in order to change the rights of
stockholders which are stipulated and defined in our articles of incorporation, we must amend our articles of incorporation. Amendment must be approved by a
special resolution of shareholders where two-thirds of shareholders vote at a
shareholders meeting at which shareholders having not less than one-third of
the voting rights held by all shareholders are in attendance. Annual general meetings and extraordinary general meetings of shareholders
are convened by a representative director based on the determination to convene
it by our board of directors. A shareholder having held 3% or more of our total
outstanding shares for six months or more is entitled to demand the board of
directors to convene a shareholders meeting under the Commercial Code of
Japan. Under our articles of 79




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incorporation, shareholders of record as of March
31 of each year have the right to attend the annual general meeting of our
shareholders. In order to determine the shareholders entitled to attend
extraordinary general meetings of our shareholders, we are required to make
public notice of record date at least two weeks prior to the record date. A
convocation notice will be sent to these shareholders at least two weeks prior
to the date of the shareholders meeting. Rights of Holders of Fractional Shares of our Common Stock Under the Commercial Code of Japan, holders of fractional shares
representing 1/100th of a share (this ratio can be varied or fractional share
system can be abandoned by being provided in articles of incorporation) or
integral multiples of 1/100th of a share have the following rights:  
    
    to inspect and copy the register of fractional shares,
    
    to receive additional shares or money in the event of
cancellation, consolidation or split of shares, stock transfer,
exchange of shares, company split or merger, and to receive residual
properties,
    
    to request a company to convert the shares if they are the
fractional shares of convertible shares, unless otherwise provided
for in articles of incorporation. Our articles of incorporation do
not contain a provision against such conversion, and
    
    to receive dividend, interim dividend or preemptive rights,
unless otherwise provided for in articles of incorporation. Our
articles of incorporation do not contain a provision against such
receipt. Under the Commercial Code of Japan, a certificate of fractional shares
cannot be issued by a company, and the only way for holders of fractional
shares to recover their investment is to request the
company to purchase their fractional shares. Following the April 1, 2003
amendments of the Commercial Code of Japan, holders of fractional shares are
entitled to purchase fractional shares from the company in such a number that
will, when added to the number of fractional shares originally held by such
share holders, constitute a share, if a provision allowing for additional
purchases of fractional shares is stipulated in its articles of incorporation.
We did not adopt the system for additional purchase of fractional shares in our
articles of incorporation. Restrictions on Holders of our Common Stock There is no restriction on non-resident or foreign shareholders on the
holding of our shares or on the exercise of voting rights. However, pursuant to
a provision of our share handling regulations, a shareholder who does not have
an address or residence in Japan is required to file its temporary address in
Japan or that of a standing proxy having any address or residence in Japan with
our transfer agent. There is no provision in our articles of incorporation that would have the
effect of delaying, deferring or preventing a change in control that would
operate only with respect to a merger, acquisition or corporate restructuring
involving us. There is no provision in our articles of incorporation or other
subordinated rules regarding the ownership threshold, above which shareholder
ownership must be disclosed. Although a shareholder holding more than 5% of the
shares in a public company in Japan is required to disclose such shareholding
pursuant to the Securities Exchange Law of Japan, this is inapplicable to us as
we are not a public company in Japan. 80




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There is no provision in our articles of incorporation governing changes
in the capital more stringent than is required by law. For a description of rights of holders of ADSs, please see the
Description of American Depositary Receipts section in our F-1 Registration
Statement (File No. 333-10584), declared effective on August 3, 1999, as
amended, hereby incorporated by reference. C. Material Contracts. Other than contracts entered into in the ordinary course of business, we
have entered into the following contracts which may be deemed material since
June 30, 2002. Lease Agreement, dated March 14, 2003, between Internet Initiative Japan
Inc. and Mitsui Fudosan Co., Ltd.On March 14, 2003, we entered into a lease
agreement with Mitsui Fudosan Co., Ltd., or Mitsui Fudosan, under which we
lease our headquarters office space from Mitsui Fudosan in the Jinbocho Mitsui
Building, located at 1-105 Kanda Jinbo-cho, Chiyoda-ku, Tokyo. The lease period
is from March 15, 2003 until March 14, 2006. In accordance with the provisions
of this lease agreement, we have deposited ¥1,705,036,213 with Mitsui Fudosan
as a security deposit, and pay Mitsui Fudosan ¥124,941,048 per month in rent
and ¥24,249,606 per month in common area maintenance charges, both of which
include consumption taxes. Sublease Agreements, dated March 15, 2003, between Internet Initiative
Japan Inc. and Crosswave Communications Inc., Crosswave Facilities Inc., IIJ
Technology Inc., Net Care, Inc. and IIJ Media Communications, Inc.On March 15,
2003, we entered into sublease agreements with each of Crosswave Communications
Inc. Crosswave Facilities Inc., IIJ Technology Inc. and Net Care, Inc. under
which we sublease to each of these companies certain portions of the office
space in our headquarters that we lease from Mitsui Fudosan. The sublease
period is from March 15, 2003 until March 14, 2006. The contract with Crosswave
Communications Inc. was transferred to NTT Communications Corporation as of
December 15, 2003. The contract with Crosswave Facilities was terminated on March 2004.
The total sublease amount related to the above sublease agreements was ¥89 million for the year ended
March 31, 2004. Pledge Agreement, dated March 14, 2003, among Internet Initiative Japan
Inc., IBJ Leasing Co., Ltd. and Nissay Leasing Company, Limited.On March 14,
2003, we entered into a pledge agreement with IBJ Leasing Co., Ltd. and Nissay
Leasing Company, Limited, as co-pledgees, under which we created a first
priority pledge on our claim against Mitsui Fudosan for a refund of our
security deposit, to secure our debt to the co-pledgees under an agreement for
entrustment of payment and repayment of debt dated March 14, 2003, under which
co-pledgees paid the security deposit to Mitsui Fudosan on our behalf. Subscription Agreement, dated September 16, 2003, between Internet
Initiative Japan and Nippon Telegraph and Telephone Corporation.On September
16, 2003, we entered into a Subscription Agreement with NTT under which NTT
agreed to purchase 10,883 shares of our common stock for ¥951,300 per share, or
approximately ¥10.4 billion. After the consummation of this agreement, NTT and
its affiliates owned a total of 12,315 shares of our common stock, or
approximately 31.6%. Under the terms of this agreement, we and NTT agreed to
undertake efforts to jointly engage in the development of broadband and
Information Technology and other related businesses, to expand the business
relationship between the two parties in connection with new business
opportunities of IIJ and to discuss secondment of employees between us and NTT.
The agreement also provides NTT with the right to maintain its current
percentage ownership in our company if we issue new shares and provides NTT
with the right to request that we file a registration statement to enable NTT
to sell its shares in the United States or Japanese markets. In addition, the
agreement gives NTT the right to nominate up to three persons to serve on
either our board of directors or our board of corporate auditors subject to
approval of any such nomination by our shareholders at a meeting of
shareholders. 81




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Service Agreement dated, March 25, 2004, between Internet Initiative Japan
and IIJ America Inc.On March 25, 2004, we entered into a Service Agreement
with IIJ America Inc, under which IIJ America Inc. provides the operation and
maintenance services for the U.S. portion of IIJs Internet backbone and IIJ
and IIJ America agree to the method for calculating pricing for the operation
and maintenance of the backbone. Limitation of Liability Agreement dated, June 24, 2004, between Internet
Initiative Japan and outside directors.On June 24, 2004, we entered into a
Limitation of Liability Agreement with our new outside directors, Mr. Takashi
Hiroi and Mr. Yasurou Tanahashi, respectively, under which IIJ limits the
liability of outside directors in accordance to the rules defined in Article
266 of the Commercial Code of Japan. D. Exchange Controls. There are no laws, decrees, regulations or other legislation in Japan that
affect our ability to import or export capital for our use or our ability to
pay dividends to non-resident holders of our securities. E. Taxation. Japanese Taxation The following is a discussion summarizing material Japanese tax
consequences to an owner of shares or ADSs who is a non-resident of Japan or a
non-Japanese corporation without a permanent establishment in Japan to which
the relevant income is attributable. The statements regarding Japanese tax laws
set forth below are based on the laws in force and as interpreted by the
Japanese taxation authorities as at the date hereof. These statements are
subject to changes in the applicable Japanese laws or double taxation
conventions occurring after that date. This summary is not exhaustive of all
possible tax considerations which may apply to a particular investor. Potential
investors should satisfy themselves as to:  
    
    the overall tax consequences of the ownership and disposition
of shares or ADSs, including specifically the tax consequences under
Japanese law,
    
    the laws of the jurisdiction of which they are resident, and
    
    any tax treaty between Japan and their country of residence,
by consulting their own tax advisers. Generally, a non-resident of Japan or a non-Japanese corporation is
subject to Japanese withholding tax on dividends paid by Japanese corporations.
Stock splits, except when treated as dividends in certain conditions, are not
subject to Japanese income tax. The Convention between the Government of Japan and the Government of the
United States of America for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with Respect to Taxes on Income (the Treaty) was
newly signed on November 7, 2003 and the Treaty entered into force on March 30,
2004. Upon the Treaty coming into force, the Convention between Japan and the
United States of America for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with Respect to Taxes on Income, signed on March
8, 1971 (the Prior Treaty) ceased to have effect. The Treaty reduces the
maximum rate of Japanese withholding tax which may be imposed on dividends paid
to a United States resident or corporation not having a permanent
establishment in Japan. A permanent establishment in Japan is generally a
fixed place of business for industrial or commercial activity in Japan. With
respect to taxes withheld at source, the Treaty is applicable for amount
taxable on or after July 1, 2004. Under the Treaty, the maximum withholding rate for most shareholders is
limited to 10% of the gross amount actually distributed. However, the maximum
rate is 5% of the gross amount actually distributed, if 82




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the recipient is a
corporation that owns directly or indirectly, on the date on which entitlement
to the dividends is determined, at least 10% of the voting shares of the paying
corporation. Moreover, withholding tax on dividends is not imposed, if the
recipient is  
    
    a corporation that has owned, directly or indirectly through
one or more residents of either Japan or the US, more than 50% of
the voting shares of the paying corporation for the period of twelve
months ending on the date on which entitlement to the dividends is
determined and which meets additional requirements, or
    
    a pension fund , provided that such dividends are not derived
from the carrying on of a business, directly or indirectly, by such
pension fund. The following table summarizes changes of the maximum withholding rate
imposed on dividends by the Treaty: The Prior Treaty
    
    The Treaty10% or more of the voting shares
    
    
    10
    %
    
    More than 50% of the voting shares
    
    
    0
    %10% to 50% of the voting shares
    
    
    5
    %Others
    
    
    15
    %
    
    Others
    
    
    10
    %
 For purposes of the Treaty and Japanese tax law, U.S. holders of ADRs will
be treated as the owners of the shares underlying the ADSs evidenced by the
ADRs. Unless an applicable tax treaty, convention or agreement reduces the
maximum rate of withholding tax, the rate of Japanese withholding tax
applicable to dividends paid by Japanese corporations to a non-resident or
non-Japanese corporation is 20%. Japan has entered into income tax treaties,
conventions or agreements, reducing the above-mentioned withholding tax rate
for investors with a number of countries. These countries include, among
others, Australia, Belgium, Canada, Denmark, Finland, France, Germany,
Ireland, Italy, Luxembourg, The Netherlands, New Zealand, Norway,
Singapore, Spain, Sweden, Switzerland, and the United Kingdom. The withholding
tax rate is further reduced if investors and IIJ have some capital relationship
as provided for in an applicable tax treaty. Non-resident holders who are entitled to a reduced rate of Japanese
withholding tax on payment of dividends by IIJ must submit the required form in
advance through IIJ to the relevant tax authority before payment of dividends.
The required form is the Application Form for Income Tax Convention regarding
Relief from Japanese Income Tax on Dividends. A standing proxy for non-resident
holders may provide such application service. See Description of Capital Stock
 General. With respect to ADSs, the reduced rate is applicable if The Bank of
New York, as depositary, or its agent submits two Application Forms for Income
Tax Convention  one form must be submitted before payment of dividends, and
the other form must be submitted within eight months after our fiscal year end.
To claim the reduced rate, a non-resident holder of ADSs will be required to
file proof of taxpayer status, residence and beneficial ownership, as
applicable. The non-resident holder will also be required to provide
information or documents clarifying its entitlement to the tax reduction as may
be required by the depositary. A non-resident holder of shares or ADSs who does not submit an application
in advance will be entitled to claim from the relevant Japanese tax authority a
refund of withholding taxes withheld in excess of the rate of an applicable tax
treaty. Gains derived from the sale outside Japan of the shares or ADSs by a
non-resident of Japan or a non-Japanese corporation are in general not subject
to Japanese income or corporation taxes. In addition, gains derived from the
sale of shares or ADSs within Japan by a non-resident of Japan or non-Japanese
corporation not having a permanent establishment in Japan are in general not
subject to Japanese income or corporation 83




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taxes. An individual who has acquired
shares or ADSs as a distributee, legatee or donee may have to pay Japanese
inheritance and gift taxes at progressive rates. IIJ has paid or will pay any stamp, registration or similar tax imposed by
Japan in connection with the issue of the shares, except that IIJ will not pay
any tax payable in connection with the transfer or sale of the shares by a
holder thereof. United States Taxation The following discusses United States federal income tax consequences of
the ownership of shares or ADSs. It only applies to you if you are a U.S.
holder, as defined below, and you hold your shares or ADSs as capital assets.
It does not address special classes of holders, some of whom may be subject to
other rules including:  
    
    tax-exempt entities,
    
    life insurance companies,
    
    dealers in securities,
    
    traders in securities that elect to mark-to-market,
    
    investors liable for alternative minimum tax,
    
    investors that actually or constructively own 10% or more of the voting stock of IIJ,
    
    investors that hold shares or ADSs as part of a straddle or a
hedging or conversion transaction, or
    
    U.S. holders (as defined below) whose functional currency is
not the U.S. dollar. This discussion is based on the tax laws of the United States, including
the Internal Revenue Code of 1986, as amended, its legislative history,
existing and proposed regulations and administrative and judicial
interpretations, as currently in effect, as well as on the Treaty. These laws
are subject to change, possibly on a retroactive basis. In addition, this
discussion is based in part upon the representations of the depositary and the
assumption that each obligation in the deposit agreement relating to the ADRs
and any related agreement will be performed in accordance with its terms. For purposes of this discussion, a U.S. holder is a beneficial owner of shares or ADSs that is:  
    
    a citizen or resident of the United States,
    
    a domestic corporation,
    
    an estate whose income is subject to United States federal
income tax regardless of its source, or
    
    a trust if a United States court can exercise primary
supervision over the trusts administration and one or more United
States persons are authorized to control all substantial decisions
of the trust. 84




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This discussion addresses only United States federal income taxation. You
should consult your own tax advisor regarding the United States federal, state
and local and other tax consequences of owning and disposing of shares and ADSs
in your particular circumstances. In general, and taking into account the earlier assumptions, for United
States federal income tax purposes, if you hold ADRs evidencing ADSs, you will
be treated as the owner of the shares represented by those ADSs. Exchanges of
shares for ADSs, and ADSs for shares, generally will not be subject to United
States federal income tax. The discussion under the headings Taxation of Dividends and Taxation of
Capital Gains assumes that we will not be treated as a Passive Foreign
Investment Company (PFIC) for U.S. federal income tax purposes. For a
discussion of the rules that apply if we are treated as a PFIC, see the
discussion under the heading PFIC Rules below. Taxation of Dividends Under the United States federal income tax laws, if you are a U.S. holder,
the gross amount of any dividend we pay out of our current or accumulated
earnings and profits (as determined for United States federal income tax
purposes) is subject to United States federal income taxation. If you are a
noncorporate U.S. holder, dividends paid to you in taxable years beginning
after December 31, 2002 and before January 1, 2009 that constitute qualified
dividend income will be taxable to you at a maximum tax rate of 15% provided
that you hold the shares or ADSs for more than 60 days during the 120-day
period beginning 60 days before the ex-dividend date and meet other holding
period requirements. The IRS has announced that it will permit taxpayers to
apply a proposed legislative change to the holding period requirement described
in the preceding sentence as if such change were already effective. This
legislative technical correction would change the minimum required holding
period, retroactive to January 1, 2003, to more
than 60 days during the 121-day period beginning 60 days before the
ex-dividend date. Dividends we pay with respect to the shares or ADSs generally
will be qualified dividend income. You must include any Japanese tax withheld from the dividend payment in
this gross amount even though you do not in fact receive it. The dividend is
taxable to you when you, in the case of shares, or the Depositary, in the case
of ADSs, receive the dividend, actually or constructively. The dividend will
not be eligible for the dividends-received deduction generally allowed to
United States corporations in respect of dividends received from other United
States corporations. The amount of the dividend distribution that you must
include in your income as a U.S. holder will be the U.S. dollar value of the
Japanese yen payments made, determined at the spot Japanese yen/U.S. dollar
rate on the date the dividend distribution is includible in your income,
regardless of whether the payment is in fact converted into U.S. dollars.
Generally, any gain or loss resulting from currency exchange fluctuations
during the period from the date you include the dividend payment in income to
the date you convert the payment into U.S. dollars will be treated as ordinary
income or loss and will not be eligible for the special tax rate applicable to
qualified dividend income. The gain or loss generally will be income or loss
from sources within the United States for foreign tax credit limitation
purposes. Distributions in excess of current and accumulated earnings and profits,
as determined for United States federal income tax purposes, will be treated as
a return of capital to the extent of your basis in the shares or ADSs and
thereafter as capital gain. Subject to certain limitations, the Japanese tax withheld in accordance
with the Treaty and paid over to Japan will be creditable against your United
States federal income tax liability. Special rules apply in determining the
foreign tax credit limitation with respect to dividends that are subject to the
maximum 15% tax rate. To the extent a refund of the tax withheld is available
to you under Japanese law or under the Treaty, 85




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the amount of tax withheld that
is refundable will not be eligible for credit against your United States
federal income tax liability. Dividends constitute income from sources outside the United States, but
generally will be passive income or, if received by financial institutions,
financial services income. Passive income or financial services income must
be treated separately from other types of income for purposes of computing the
foreign tax credit allowable to you. Taxation of Capital Gains If you sell or otherwise dispose of your shares or ADSs, you will
recognize capital gain or loss for United States federal income tax purposes
equal to the difference between the U.S. dollar value of the amount that you
realize and your tax basis, determined in U.S. dollars, in your shares or ADSs.
Capital gain of a noncorporate U.S. holder that is recognized on or after May
6, 2003 and before January 1, 2009 is generally taxed at a maximum rate of 15%
where the holder has a holding period greater than one year. Additionally, gain
or loss will generally be from sources within the United States for foreign tax
credit limitation purposes. PFIC Rules We do not believe that we will be treated as a PFIC for United States
federal income tax purposes for our most recent taxable year. However, this
conclusion is a factual determination made annually and thus may be subject to
change. Because of the nature of our income and assets, we could be determined
to be a PFIC for our current and subsequent taxable years. In general, we will be a PFIC with respect to you if for any of our
taxable years in which you held our ADSs or shares:  
    
    at least 75% of our gross income for the taxable year is
passive income, or
    
    at least 50% of the value, determined on the basis of a
quarterly average, of our assets is attributable to assets that
produce or are held for the production of passive income. Passive income generally includes dividends, interest, royalties, rents
(other than certain rents and royalties derived in the active conduct of a
trade or business), annuities and gains from assets that produce passive
income. If a foreign corporation owns at least 25% by value of the stock of
another corporation, the foreign corporation is treated for purposes of the
PFIC tests as owning its proportionate share of the assets of the other
corporation, and as receiving directly its proportionate share of the other
corporations income. If we are treated as a PFIC and you did not make a mark-to-market
election, as described below, you will be subject to special rules with respect
to:  
    
    any gain you realize on the sale or other disposition of your
 shares or ADSs and
    
    any excess distribution that we make to you (generally, any
distributions to you during a single taxable year that are greater
than 125% of the average annual distributions received by you in
respect of the shares or ADSs during the three preceding taxable
years or, if shorter, your holding period for the shares or ADSs). Under these rules:  
    
    the gain or excess distribution will be allocated ratably
over your holding period for the shares or ADSs, 86




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
    
    the amount allocated to the taxable year in which you
realized the gain or excess distribution will be taxed as ordinary
income,
    
    the amount allocated to each prior year, with certain
exceptions, will be taxed at the highest tax rate in effect for that
year, and
    
    the interest charge generally applicable to underpayments of
tax will be imposed in respect of the tax attributable to each such
year. Special rules apply for calculating the amount of the foreign tax credit
with respect to excess distributions by a PFIC. If your shares or ADSs are treated as stock of a PFIC, you may make a
mark-to-market election. If you make this election, you will not be subject to
the PFIC rules described above. Instead, in general, you will include as
ordinary income each year the excess, if any, of the fair market value of your
shares or ADSs at the end of the taxable year over your adjusted basis in your
shares or ADSs. These amounts of ordinary income will not be eligible for the
favorable tax rates applicable to qualified dividend income or long-term
capital gains. You will also be allowed to take an ordinary loss in respect of
the excess, if any, of the adjusted basis of your shares or ADSs over their
fair market value at the end of the taxable year or over their final sale or
disposition prices, but only to the extent of the net amount of previously
included income as a result of the mark-to-market election. Your basis in the
shares or ADSs will be adjusted to reflect any such income or loss amounts. In addition, notwithstanding any election you make with regard to the
shares or ADSs, dividends that you receive from us will not constitute
qualified dividend income to you if we are a PFIC either in the
taxable year of the distribution or the preceding taxable year. Dividends
that you receive that do not constitute qualified dividend income are not
eligible for taxation at the 15% maximum rate applicable to qualified dividend
income. Instead, you must include the gross amount of any such dividend paid by
us out of our accumulated earnings and profits (as determined for United States
federal income tax purposes) in your gross income, and it will be subject to
tax at rates applicable to ordinary income. If you own shares or ADSs during any year that we are a PFIC, you must
file Internal Revenue Service Form 8621. F. Dividends and Paying Agents. Not required. G. Statement by Experts. Not applicable. H. Documents on Display. We file periodic reports and other information with the Securities and
Exchange Commission. The Securities and Exchange Commission maintains a web
site at www.sec.gov that contains reports and other information regarding us
and other registrants that file electronically with the Securities and Exchange
Commission. You may read and copy any document we file with the Securities and
Exchange Commission at the Securities and Exchange Commissions public
reference room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call
the Securities and Exchange Commission at 1-800-SEC-0330 for further
information on the operation of its public reference room. In addition, you
may also inspect reports filed with the Securities and Exchange Commission and
other information our Tokyo headquarters, located at Jinbocho 87




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Mitsui Bldg.,
1-105 Kanda Jinbo-cho Chiyoda-ku, Tokyo 101-0051, Japan. Some of this
information may also be found on our website at http://www.iij.ad.jp/. This
information is not incorporated by reference into this annual report on Form
20-F. I. Subsidiary Information. Not applicable. 
 Item 11. Quantitative and Qualitative Disclosures about Market Risk. We are exposed to market risks from changes in interest rates, equity
prices and foreign currency exchange rates. Interest Rate Risk The table below provides information about financial instruments held by
us that are sensitive to changes in interest rates, including debt obligations
and interest rate swaps. For debt obligations, the table presents whether the
interest component is fixed or variable, the amount and timing of cash flows,
the expected weighted-average interest rates over the next five years, as well
as the fair value of each debt instrument. For interest rate swaps, the table
presents the notional amounts and weighted average interest rates by expected
maturity dates. Expected maturity dateFairvalue orGainMarch 31, 2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    2009
    
    Total
    
    (loss)(millions of yen)Long-term debt obligations:Fixed rate long-term borrowings,
installment payable and convertible
notes
    
    
    12,380
    
    
    
    152
    
    
    
    756
    
    
    
    
    
    
    
    
    
    
    
    13,288
    
    
    
    13,170Average interest rate
    
    
    1.755
    %
    
    
    2.550
    %
    
    
    1.883
    %
    
    
    
    
    
    
    
    
    
    
    1.773
    %Variable rate long-term borrowings
    
    
    1,000
    
    
    
    1,000
    
    
    
    400
    
    
    
    
    
    
    
    
    
    
    
    2,400
    
    
    
    2,400Average interest rate
    
    
    0.789
    %
    
    
    1.110
    %
    
    
    1.173
    %
    
    
    
    
    
    
    
    
    
    
    0.987
    %Interest rate swap contracts Notional amount  variable to fixed:
    
    
    1,000
    
    
    
    1,000
    
    
    
    400
    
    
    
    
    
    
    
    
    
    
    
    2,400
    
    
    
    (19
    )Average pay rate
    
    
    1.500
    %
    
    
    1.900
    %
    
    
    1.990
    %
    
    
    
    
    
    
    
    
    
    
    1.748
    %Average receive rate
    
    
    0.789
    %
    
    
    1.110
    %
    
    
    1.173
    %
    
    
    
    
    
    
    
    
    
    
    0.987
    %
 Expected maturity dateFairvalue orGainMarch 31, 2003
    
    2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    Total
    
    (loss)(millions of yen)Long-term debt obligations:Fixed rate long-term borrowings,
installment payable and convertible
notes
    
    
    944
    
    
    
    15,548
    
    
    
    152
    
    
    
    756
    
    
    
    
    
    
    
    17,400
    
    
    
    15,004Average interest rate
    
    
    2.304
    %
    
    
    1.755
    %
    
    
    2.550
    %
    
    
    1.883
    %
    
    
    
    
    
    
    1.797
    %Variable rate long-term borrowings
    
    
    1,000
    
    
    
    1,000
    
    
    
    1,000
    
    
    
    
    
    
    
    
    
    
    
    3,000
    
    
    
    3,000Average interest rate
    
    
    0.850
    %
    
    
    0.789
    %
    
    
    1.110
    %
    
    
    
    
    
    
    
    
    
    
    0.916
    %Interest rate swap contracts Notional amount  variable to fixed:
    
    
    1,000
    
    
    
    1,000
    
    
    
    1,000
    
    
    
    
    
    
    
    
    
    
    
    3,000
    
    
    
    (38
    )Average pay rate
    
    
    1.960
    %
    
    
    1.500
    %
    
    
    1.900
    %
    
    
    
    
    
    
    
    
    
    
    1.787
    %Average receive rate
    
    
    0.840
    %
    
    
    0.789
    %
    
    
    1.110
    %
    
    
    
    
    
    
    
    
    
    
    0.913
    %
 88




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Our policy on managing interest rate risk is to hedge our exposure to
variability in future cash flow of floating rate interest payment on long-term
bank borrowings. In order to reduce cash flow risk exposures on floating rate
borrowings, we utilize interest rate swaps to convert a floating rate
borrowings into a fixed rate borrowings. We do not hold derivative instruments
for speculative purposes. Also, we do not hold or issue financial instruments
for trading purposes. See note 14 to our consolidated financial statements
included in this annual report on Form 20-F. Equity Price Risk The fair value of certain of our investments, primarily in marketable
securities, exposes us to equity price risks. In general, we have invested in
highly liquid and low-risk instruments, which are not held for trading
purposes. We are exposed to changes in the market prices of the securities. As
of March 31, 2003 and 2004, the fair value of such investments was ¥1,180
million and ¥6,573 million, respectively. The potential loss in fair value
resulting from a 10% adverse change in equity prices would be approximately
¥118 million and ¥657 million as of March 31, 2003 and 2004, respectively. See
Note 2 to our consolidated financial statements, included in this annual report
on Form 20-F. Foreign Currency Exchange Rate Risk The only significant assets held by us which are exposed to foreign
currency exchange risk are U.S. dollar denominated bank deposits. The carrying
value, which also represents fair value, amounted to $11,524 thousand (¥1,361
million) and $6,368 thousand (¥663 million) at March 31, 2003 and 2004,
respectively. The potential loss in fair value for such financial
instruments from a 10% adverse change in quoted foreign currency exchange rates
would be approximately ¥136 million and ¥66 million at March 31, 2003 and 2004,
respectively. 
 Item 12. Description of Securities Other than Equity Securities. Not applicable. 
 PART II 
 Item 13. Defaults, Dividend Arrearages and Delinquencies. None. 
 Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds. None. 
 Item 15. Controls and Procedures. Disclosure Controls and Procedures As of the end of the fiscal year ended March 31, 2004, our management,
with the participation of Koichi Suzuki, our president, chief executive officer
and representative director, and Akihisa Watai, our director, chief financial
officer and chief accounting officer, performed an evaluation of our disclosure
controls and procedures. 89




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Under Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, disclosure controls and procedures means our controls and other
procedures that are designed to ensure that information required to be
disclosed by us in the reports that we file or submit under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported, within
the time periods specified in the Securities and Exchange Commissions rules
and forms. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed by us in the reports that we file or submit under the Securities
Exchange Act of 1934 is accumulated and communicated to our management,
including our chief executive officer and chief financial officer, as
appropriate to allow timely decisions regarding required disclosure. Based on that evaluation, our chief executive officer and chief financial
officer concluded that our disclosure controls and procedures were effective as
of March 31, 2004. Changes in Internal Control Over Financial Reporting With the participation of our chief executive officer and chief financial
officer, we also evaluated any change in our internal control over financial
reporting that occurred during the fiscal year ended March 31, 2004. Under Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of
1934, internal control over financial reporting means a process designed by, or
under the supervision of, our chief executive officer and chief financial
officer and effected by our board of directors, management and other personnel,
to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial
statements for external purposes in accordance with generally accepted
accounting principles and includes those policies and procedures that:  
    
    pertain to the maintenance of records that in reasonable
detail accurately and fairly reflect the transactions and
dispositions of our assets;
    
    provide reasonable assurance that transactions are recorded
as necessary to permit preparation of our financial statements in
accordance with generally accepted accounting principles, and that
our receipts and expenditures are being made only in accordance with
authorizations of our management and directors; and
    
    provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of our
assets that could have a material effect on our financial
statements. Based on that evaluation, our chief executive officer and chief financial
officer concluded that no changes were made in our internal control over
financial reporting that occurred during the fiscal year ended March 31, 2004
that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting. 
 Item 16A. Audit Committee Financial Expert At our shareholders meeting on June 24, 2004, two statutory auditors were
newly nominated and our board of corporate auditors has determined that one of
the nominated statutory auditors, Masaaki Koizumi is an audit committee
financial expert as defined in Item 16A. of Form 20-F serving on the Board of
Corporate Auditors. An audit committee financial expert is defined in Item 16A. of Form
20-F to mean a person who has the following attributes: 90




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(1) An understanding of generally accepted accounting principles and
financial statements; (2) The ability to assess the general application of such principles in
connection with the accounting for estimates, accruals and reserves; (3) Experience preparing, auditing, analyzing or evaluating financial
statements that present a breadth and level of complexity of accounting issues
that are generally comparable to the breadth and complexity of issues that can
reasonably be expected to be raised by the registrants financial statements,
or experience actively supervising one or more persons engaged in such
activities; (4) An understanding of internal controls over financial reporting; (5) An understanding of audit committee functions. Such person shall have acquired the attributes described above through: (1) Education
and experience as a principal financial officer, principal
accounting officer, controller, public accountant or auditor or experience in
one or more positions that involve the performance of similar functions; (2) Experience actively supervising a principal financial officer, principal
accounting officer, controller, public accountant, auditor or person performing
similar functions; (3) Experience overseeing or assessing the performance of companies or
public accountants with respect to the preparation, auditing or evaluation of
financial statements; or (4) Other relevant experience. A person who is determined to be an audit committee financial expert will
not be deemed an expert for any purpose, including without limitation for
purposes of section 11 of the Securities Act of 1933 (15 U.S.C. 77k), as a
result of being designated or identified as an audit committee financial expert
pursuant to this Item 16A. The designation or identification of a person as an
audit committee financial expert pursuant to this Item 16A does not impose on
such person any duties, obligations or liability that are greater than the
duties, obligations and liability imposed on such person as a member of the
audit committee and board of directors in the absence of such designation or
identification. The designation or identification of a person as an audit
committee financial expert pursuant to this Item 16A does not affect the
duties, obligations or liability of any other member of the audit committee or
board of directors. 
 Item 16B. Code of Ethics. At our Board of Directors Meeting on April 28, 2004, we adopted a Code of
Ethics applicable to all employees and officers, including our chief executive
officer, chief financial officer and chief accounting officer. The Code of
Ethics is attached as Exhibit 11.1 to this annual report on Form 20-F. 
 Item 16C. Principal Accountant Fees and Services. Independent Auditor Fees and Services The Board of Directors engaged Deloitte Touche Tohmatsu, or Deloitte, to
perform an annual audit of our financial statements for each of the fiscal
years ended March 31, 2002 and 2003. The following table sets forth the
aggregate fees billed for services rendered by Deloitte for each of the last
two fiscal years. 91




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Fiscal year ended March 31,2002
    
    2003(millions of yen)Audit
fees(1)
    
    
    57
    
    
    
    70Audit-related fees(2)
    
    
    30Tax
fees(3)
    
    
    4
    
    
    
    3All other
fees(4)Total fees
    
    
    91
    
    
    
    73
   (1)
    
    These are the aggregate fees billed for the fiscal year for professional
services rendered by Deloitte for the audit of our annual financial
statements and services that are normally provided in connection with
statutory and regulatory filings or engagements for those fiscal years.(2)
    
    These are the aggregate fees billed for the fiscal year for assurance and
related services by Deloitte that are reasonably related to the
performance of the audit or review of our financial statements other than
those reported under Audit Fees above. These services include internal
control reviews and consultation concerning financial accounting and
reporting standards.(3)
    
    These are the aggregate fees billed for the fiscal year for professional
services rendered by Deloitte for tax compliance, tax advice and tax
planning.(4)
    
    These are the aggregate fees for the fiscal year for all products and
services provided by Deloitte other than those reported above. Board of Corporate Auditors Pre-Approval Policies and Procedures The Board of Corporate Auditors has adopted policies and procedures for
pre-approving all audit and permissible non-audit work performed by our
independent auditor in accordance with Rule 2-01(c)(7)(i)(B) under Regulation
S-X. Under those policies and procedures, the Board of Corporate Auditors must
pre-approve individual audit and non-audit services to be provided to us by our
independent auditor and its affiliates. Those policies and procedures also
describe prohibited non-audit services that may never be provided by our
independent auditor. All of the services provided by our independent auditor from May 6, when
our pre-approval policies went into effect, through the end of the fiscal year
ended March 31, 2004 were pre-approved by the Board of Corporate Auditors
pursuant to the pre-approval policies described above, and none of such
services were approved pursuant to the procedures described in Rule
2-01(c)(7)(i)(C) of Regulation S-X, which waives the general requirement for
pre-approval in certain circumstances. 
 Item 16D. Exemptions from the Listing Standards for Audit Committees. Not applicable. 
 Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers. Not applicable. 
 PART III 
 Item 17. Financial Statements. Not applicable. 92




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Item 18. Financial Statements. See Financial Statements for Internet Initiative Japan Inc. and
Subsidiaries begins on page F-1. 
 Item 19. Exhibits. 1.1
    
    
    Articles of Incorporation, as amended (English translation)1.2
    
    
    Share Handling Regulations, as amended (English translation)1.3
    
    
    Regulations of the Board of Directors, as amended (English translation)*1.4
    
    
    Regulations of the Board of Statutory Auditors, as amended (English translation)2.1
    
    
    Specimen Common Stock Certificate**2.2
    
    
    Bylaws of the IIJ Employee Shareholders Association (with English translation)**2.3
    
    
    Paying Agent, Conversion Agent and Registrar Agreement, dated April 11, 2000, among
Internet Initiative Japan Inc., The Bank of New York and Banque Internationale à
Luxembourg relating to ¥15,000,000,000 1.75% convertible notes due 2005 (with exhibits)*2.4
    
    
    Form of Deposit Agreement among IIJ, The Bank of New York as depositary and all owners and
holders from time to time of American Depositary Receipts, including the form of American
Depositary Receipt ***4.1
    
    
    Basic Agreement to Delegate Services, dated April 1, 1997, between Internet Initiative
Japan Inc. and IIJ Technology Inc. (with English translation)**4.2
    
    
    Shareholders Agreement Relating to the Establishment of INTERNET MULTIFEED CO., dated
August 20, 1997, between Nippon Telegraph and Telephone Corporation and the Registrant
(with English translation)**4.3
    
    
    Basic Agreement to Delegate Services, dated January 30, 1995, between Internet Initiative
Japan Inc. and IIJ Media Communications Inc. (with English translation)**4.4
    
    
    Basic Agreement to Delegate Services, dated April 1, 1998, between Internet Initiative
Japan Inc. and Net Care, Inc. (with English translation)**4.5
    
    
    Individual Agreement on Entrustment of Business between Internet Initiative Japan Inc. and
Asia Internet Holding Co., Ltd., dated July 1, 2004 (with English translation)4.6
    
    
    Lease Agreement, dated March 14, 2003, between Internet Initiative Japan and Mitsui
Fudosan Co., Ltd. (English translation)*4.7
    
    
    Sublease Agreements, dated March 15, 2003, between Internet Initiative Japan Inc. and
Crosswave Communications Inc., Crosswave Facilities Inc., IIJ Technology Inc., Net Care,
Inc. and IIJ Media Communications, Inc. (English translations)*4.8
    
    
    Pledge Agreement, dated March 14, 2003, among Internet Initiative Japan Inc., IBJ Leasing
Co., Ltd. and Nissay Leasing Company, Limited (English translation)*4.20
    
    
    Subscription Agreement, dated September 16, 2003, between Internet Initiative Japan and
Nippon Telegraph and Telephone Corporation (English translation)*4.21
    
    
    Service Agreement, dated March 25, 2004, between Internet Initiative Japan Inc. and IIJ
America Inc.4.23
    
    
    Agreement on Limited Liability, dated June 24, 2004, between Internet Initiative Japan
Inc. and outside directors****8.1
    
    
    List of Significant Subsidiaries (See Our Group Companies in Item 4.B. of this Form 20-F)11.1
    
    
    Internet Initiative Japan Code of Conduct12.1
    
    
    Certifications required by Section 302 of the Sarbanes Oxley Act of 200213.1
    
    
    Certifications required by Section 906 of the Sarbanes Oxley Act of 200214.1
    
    
    Selected unaudited financial statement data as of and for the year ended March 31, 2003 of
Crosswave Communications Inc. *
   93




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##### Table of Contents



(*)
    
    Incorporated by reference to the corresponding exhibit to our annual
report on Form 20-F (File No. 0-30204) filed on September 30, 2003.(**)
    
    Incorporated by reference to the corresponding exhibit to our Form F-1
Registration Statement (File No. 333-10584) declared effective on August
3, 1999.(***)
    
    Incorporated by reference to the Registration Statement on Form F-6
(File No. 333-110862) filed on December 2, 2003.(****)
    
    IIJ and each of Yasurou Tanahashi and Takashi Hiroi entered
into Agreement on Limited Liability, dated June 24, 2004,
between Internet Initiative Japan Inc. and outside director. Except for Exhibit 2.3, we have not included as exhibits certain
instruments with respect to our long-term debt. Except for Exhibit 2.3, the
amount of debt authorized under each long-term debt instrument does not exceed
10% or our total assets. We agree to furnish a copy of any long-term debt
instrument to the Commission upon request. 94




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SIGNATURE The registrant hereby certifies that it meets all of the requirements for
filing on Form 20-F, as amended, and that it has duly caused and authorized the
undersigned to sign this annual report on its behalf. Internet Initiative Japan Inc.By:
    /s/ Koichi SuzukiName:
Title:
    Koichi Suzuki
President, Chief Executive Officer and Representative Director
 Date: July 23, 2004 95




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Internet Initiative Japan Inc. and Subsidiaries Index to Consolidated Financial Statements PageReport of Independent Registered Public Accounting Firm
    
    
    F-2Consolidated Balance Sheets as of March 31, 2003 and 2004
    
    
    F-4Consolidated Statements of Operations
for Each of the Three Years in the Period Ended March 31, 2004
    
    
    F-6Consolidated Statements of Shareholders Equity (Capital Deficiency)
for Each of the Three Years in the Period Ended March 31, 2004
    
    
    F-8Consolidated Statements of Cash Flows
for Each of the Three Years in the Period Ended March 31, 2004
    
    
    F-9Notes to Consolidated Financial Statements
    
    
    F-12
 F- 1




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##### Table of Contents



Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of
Internet Initiative Japan Inc.: We have audited the accompanying consolidated balance sheets of Internet
Initiative Japan Inc. (IIJ) and subsidiaries (the Company) as of March 31,
2003 and 2004 and the related consolidated statements of operations,
shareholders equity (capital deficiency), and cash flows for each of the three
years in the period ended March 31, 2004 (all expressed in Japanese yen).
These financial statements are the responsibility of the Companys management.
Our responsibility is to express an opinion on these financial statements based
on our audits. We did not audit the financial statements of Crosswave Communications Inc.
(Crosswave), a 37.85 percent owned equity method investee, IIJs investment
in which had been accounted for by use of the equity method. The Companys
equity in net losses of Crosswave of ¥5,421,255 thousand for the year ended
March 31, 2002 are included in the accompanying consolidated financial
statements. The financial statements of Crosswave as of March 31, 2002 and for
the year then ended were audited by other auditors whose report dated June 5,
2002 has been furnished to us, and our opinion, insofar as it relates to the
amounts included for Crosswave referred to above, is based solely on the report
of such other auditors. Except as discussed in the following paragraph, we conducted our audits in
accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits and the report of the other
auditors provide a reasonable basis for our opinion. We were unable to obtain audited financial statements supporting the Companys
equity method net loss of Crosswave for the year ended March 31, 2003 stated at
¥5,514,383 thousand, which is included in net loss for the year then ended and
the related summary financial information of Crosswave as of and for the year
ended March 31, 2003 as described in Note 4 to the consolidated financial
statements; nor were we able to satisfy ourselves as to the equity method net
loss and the related summary financial information by other auditing
procedures. Also, as discussed in Note 4 to the consolidated financial
statements, on August 20, 2003, Crosswave filed a voluntary petition for the
commencement of corporate reorganization proceedings in Japan. As a result,
the Companys investment in and deposits for Crosswave have been fully written
off as of March 31, 2003, and an impairment loss on investment in and deposits
for Crosswave of ¥7,153,087 thousand was recognized by the Company. Because we
were unable to apply audit procedures to the equity method net loss of
Crosswave for the year ended March 31, 2003, we were also unable to satisfy
ourselves as to the amount of related impairment loss for such year. F- 2




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In our opinion, based on our
audits and the report of the other auditors, the consolidated
financial statements for the year ended March 31, 2002, present fairly, in all material respects, the results of its operations
and its cash flows for the year ended March 31, 2002, in conformity with
accounting principles generally accepted in the United States of America. In our opinion, the consolidated balance sheet as of March 31, 2003 presents
fairly in all material respects, the financial position of the Company as of
March 31, 2003, in conformity with accounting principles generally accepted in
the United States of America. In our opinion, except for the effects of such
adjustments, if any, as might have been determined to be necessary had we been
able to obtain sufficient evidence regarding the equity method net loss, the
impairment loss on investment in and deposits for Crosswave and the related
summary financial information of Crosswave for the year ended March 31, 2003,
the consolidated statements of operations and cash flows for the year ended
March 31, 2003, present fairly, in all material respects the results of the
Companys operations and its cash flows for the year ended March 31, 2003, in
conformity with accounting principles generally accepted in the United States
of America. In our opinion, such 2004 consolidated financial statements present fairy, in
all material respects, the financial position of the Company at March 31, 2004,
and the results of its operations and its cash flows for the year then ended in
conformity with accounting principles generally accepted in the United States
of America. Our audits also comprehended the translation of Japanese yen amounts into U.S.
dollar amounts and, in our opinion, such translation has been made in
conformity with the basis stated in Note 1. Such U.S. dollar amounts are
presented solely for the convenience of readers outside Japan. /s/ DELOITTE TOUCHE TOHMATSU
Tokyo, Japan
June 17, 2004 F- 3




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Internet Initiative Japan Inc. and Subsidiaries 
 Consolidated Balance SheetsMarch 31, 2003 and 2004 Thousands ofU.S. DollarsThousands of Yen
    
    (Note 1)ASSETS
    
    2003
    
    2004
    
    2004CURRENT ASSETS:Cash and cash equivalent (Note 14)
    
    ¥
    3,588,352
    
    
    ¥
    12,284,239
    
    
    $
    117,914Accounts receivable, net of allowance for
doubtful accounts of ¥34,712 thousand
and ¥73,357 thousand ($704 thousand)
at March 31, 2003 and 2004, respectively
(Notes 3 and 4)
    
    
    10,253,096
    
    
    
    8,994,156
    
    
    
    86,333Inventories
    
    
    417,666
    
    
    
    438,435
    
    
    
    4,208Prepaid expenses
    
    
    564,501
    
    
    
    557,703
    
    
    
    5,353Other current assets (Note 9)
    
    
    932,873
    
    
    
    325,422
    
    
    
    3,124Total current assets
    
    
    15,756,488
    
    
    
    22,599,955
    
    
    
    216,932INVESTMENTS IN AND ADVANCES TO
EQUITY METHOD INVESTEES (Note 4)
    
    
    1,116,020
    
    
    
    778,152
    
    
    
    7,469OTHER INVESTMENTS (Notes 2 and 14)
    
    
    3,040,189
    
    
    
    7,931,893
    
    
    
    76,136PROPERTY AND EQUIPMENTNet
(Notes 5 and 7)
    
    
    9,151,572
    
    
    
    8,601,905
    
    
    
    82,568INTANGIBLE ASSETSNet (Note 6)
    
    
    189,851
    
    
    
    141,341
    
    
    
    1,357GUARANTEE
DEPOSITS (Notes 7 and 8)
    
    
    2,205,652
    
    
    
    2,075,123
    
    
    
    19,919OTHER ASSETS, net of allowance for doubtful
accounts of ¥90,642 thousand and ¥419,248
thousand ($4,024 thousand) at March 31, 2003
and 2004 respectively
(Notes 3, 10 and 14)
    
    
    604,604
    
    
    
    608,556
    
    
    
    5,841TOTAL
    
    ¥
    32,064,376
    
    
    ¥
    42,736,925
    
    
    $
    410,222
 (Continued) F- 4




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##### Table of Contents



Internet Initiative Japan Inc. and Subsidiaries Consolidated Balance SheetsMarch 31, 2003 and 2004 Thousands ofU.S. DollarsLIABILITIES AND
    
    Thousands of Yen
    
    (Note 1)SHAREHOLDERS' EQUITY(CAPITAL DEFICIENCY)
    
    2003
    
    2004
    
    2004CURRENT LIABILITIES:Short-term borrowings (Note 8)
    
    ¥
    4,823,599
    
    
    ¥
    6,564,093
    
    
    $
    63,007Long-term borrowingscurrent portion
(Notes 8 and 14)
    
    
    1,943,735
    
    
    
    1,548,246
    
    
    
    14,861Convertible notes (Notes 8 and 14)
    
    
    
    
    
    
    11,832,000
    
    
    
    113,573Capital lease obligationscurrent portion (Note 7)
    
    
    2,716,386
    
    
    
    2,387,754
    
    
    
    22,920Accounts payable (Note 4)
    
    
    8,406,170
    
    
    
    7,187,976
    
    
    
    68,996Accrued expenses
    
    
    389,495
    
    
    
    454,366
    
    
    
    4,361Other current liabilities
    
    
    551,985
    
    
    
    483,925
    
    
    
    4,645Total current liabilities
    
    
    18,831,370
    
    
    
    30,458,360
    
    
    
    292,363LONG-TERM BORROWINGS (Notes 8 and 14)
    
    
    3,456,265
    
    
    
    2,308,019
    
    
    
    22,154CONVERTIBLE NOTES (Notes 8 and 14)
    
    
    15,000,000CAPITAL LEASE OBLIGATIONSNoncurrent (Note 7)
    
    
    3,635,780
    
    
    
    2,880,298
    
    
    
    27,647ACCRUED RETIREMENT AND PENSION COSTS
(Note 10)
    
    
    80,601
    
    
    
    72,687
    
    
    
    698OTHER NONCURRENT LIABILITIES
    
    
    185,201
    
    
    
    161,122
    
    
    
    1,547Total liabilities
    
    
    41,189,217
    
    
    
    35,880,486
    
    
    
    344,409MINORITY INTEREST
    
    
    879,495
    
    
    
    642,311
    
    
    
    6,165COMMITMENTS
AND CONTINGENCIES (Notes 4 and 13)
SHAREHOLDERS EQUITY (CAPITAL DEFICIENCY) (Notes 11
and 12):Common stockauthorized, 75,520 shares;
issued and outstanding,
22,480 shares at March 31, 2003 and
38,360 shares at March 31, 2004
    
    
    7,082,336
    
    
    
    13,765,372
    
    
    
    132,131Additional paid-in capital
    
    
    17,068,353
    
    
    
    23,637,628
    
    
    
    226,892Accumulated deficit
    
    
    (34,685,291
    )
    
    
    (34,790,430
    )
    
    
    (333,946
    )Accumulated other comprehensive income
    
    
    530,266
    
    
    
    3,645,558
    
    
    
    34,993Treasury stock120 shares held by an equity
method investee
    
    
    
    
    
    
    (44,000
    )
    
    
    (422
    )Total shareholders equity
(capital deficiency)
    
    
    (10,004,336
    )
    
    
    6,214,128
    
    
    
    59,648TOTAL
    
    ¥
    32,064,376
    
    
    ¥
    42,736,925
    
    
    $
    410,222
 See notes to consolidated financial statements. (Concluded) F- 5




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Internet Initiative Japan Inc. and Subsidiaries 
 Consolidated Statements of OperationsThree Years in the Period Ended March 31, 2004 Thousands ofU.S. DollarsThousands of Yen
    
    (Note 1)2002
    
    2003
    
    2004
    
    2004REVENUES (Note 4):Connectivity and value-added
services:Dedicated access
    
    ¥
    14,303,342
    
    
    ¥
    13,814,977
    
    
    ¥
    12,862,132
    
    
    $
    123,461Dial-up access
    
    
    3,644,091
    
    
    
    3,155,137
    
    
    
    3,088,498
    
    
    
    29,646Value-added services
    
    
    3,099,791
    
    
    
    3,602,847
    
    
    
    4,296,228
    
    
    
    41,238Other
    
    
    1,667,986
    
    
    
    1,725,736
    
    
    
    2,117,794
    
    
    
    20,328Total
    
    
    22,715,210
    
    
    
    22,298,697
    
    
    
    22,364,652
    
    
    
    214,673Systems integration
    
    
    14,355,325
    
    
    
    15,012,633
    
    
    
    11,847,687
    
    
    
    113,723Equipment sales
    
    
    2,834,078
    
    
    
    6,706,231
    
    
    
    4,567,123
    
    
    
    43,839Total revenues
    
    
    39,904,613
    
    
    
    44,017,561
    
    
    
    38,779,462
    
    
    
    372,235COST AND EXPENSES:Cost of connectivity and
value-added services
(Notes 4 and 7)
    
    
    19,799,402
    
    
    
    20,386,887
    
    
    
    20,047,438
    
    
    
    192,431Cost of systems integration
    
    
    12,314,158
    
    
    
    13,090,220
    
    
    
    9,851,726
    
    
    
    94,564Cost of equipment sales
    
    
    2,540,089
    
    
    
    6,416,525
    
    
    
    4,346,243
    
    
    
    41,719Total cost
    
    
    34,653,649
    
    
    
    39,893,632
    
    
    
    34,245,407
    
    
    
    328,714Sales and marketing (Note 15)
    
    
    3,038,412
    
    
    
    3,176,165
    
    
    
    3,527,490
    
    
    
    33,859General and administrative
    
    
    1,839,525
    
    
    
    2,204,504
    
    
    
    2,098,481
    
    
    
    20,143Research and development
    
    
    319,370
    
    
    
    414,149
    
    
    
    357,968
    
    
    
    3,436Total cost and expenses
    
    
    39,850,956
    
    
    
    45,688,450
    
    
    
    40,229,346
    
    
    
    386,152OPERATING INCOME (LOSS)
    
    
    53,657
    
    
    
    (1,670,889
    )
    
    
    (1,449,884
    )
    
    
    (13,917
    )OTHER INCOME (EXPENSES):Interest income
    
    
    121,867
    
    
    
    67,446
    
    
    
    37,516
    
    
    
    360Interest expense
    
    
    (659,101
    )
    
    
    (732,831
    )
    
    
    (702,036
    )
    
    
    (6,739
    )Foreign exchange gains (losses)
    
    
    254,882
    
    
    
    (279,703
    )
    
    
    (6,493
    )
    
    
    (62
    )Gain (loss) on other investments (Note 2)
    
    
    (432,952
    )
    
    
    (277,169
    )
    
    
    1,412,858
    
    
    
    13,562Othernet
    
    
    (227,838
    )
    
    
    (47,183
    )
    
    
    240,375
    
    
    
    2,307Other income (expenses)net
    
    
    (943,142
    )
    
    
    (1,269,433
    )
    
    
    982,220
    
    
    
    9,428LOSS FROM OPERATIONS BEFORE
INCOME TAX EXPENSE (BENEFIT)
    
    
    (889,485
    )
    
    
    (2,940,322
    )
    
    
    (467,664
    )
    
    
    (4,489
    )INCOME TAX EXPENSE (BENEFIT)
(Note 9)
    
    
    1,099,035
    
    
    
    911,365
    
    
    
    (2,133,011
    )
    
    
    (20,474
    )MINORITY INTERESTS IN
CONSOLIDATED SUBSIDIARIES
    
    
    24,467
    
    
    
    153,251
    
    
    
    235,812
    
    
    
    2,264FORWARD
    
    ¥
    (1,964,053
    )
    
    ¥
    (3,698,436
    )
    
    ¥
    1,901,159
    
    
    $
    18,249
 (Continued) F- 6




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##### Table of Contents



Internet Initiative Japan Inc. and Subsidiaries Consolidated Statements of OperationsThree Years in the Period Ended March 31, 2004 Thousands ofU.S. DollarsThousands of Yen
    
    
    
    
    
    (Note 1)2002
    
    2003
    
    2004
    
    2004FORWARD
    
    ¥
    (1,964,053
    )
    
    ¥
    (3,698,436
    )
    
    ¥
    1,901,159
    
    
    $
    18,249EQUITY IN NET LOSS OF EQUITY
METHOD INVESTEES (Note 4):Equity method net loss
    
    
    (5,482,082
    )
    
    
    (5,625,299
    )
    
    
    (286,317
    )
    
    
    (2,748
    )Impairment loss on investment,
advance and deposits for Crosswave
    
    
    
    
    
    
    (7,153,087
    )
    
    
    (1,719,981
    )
    
    
    (16,510
    )Total equity in net loss of
equity method investees
    
    
    (5,482,082
    )
    
    
    (12,778,386
    )
    
    
    (2,006,298
    )
    
    
    (19,258
    )NET LOSS
    
    ¥
    (7,446,135
    )
    
    ¥
    (16,476,822
    )
    
    ¥
    (105,139
    )
    
    $
    (1,009
    )
 Yen
    
    
    U.S. DollarsWEIGHTED-AVERAGE NUMBER
OF COMMON SHARES
OUTSTANDING
    
    
    22,480
    
    
    
    22,480
    
    
    
    31,711BASIC AND DILUTED NET LOSS
PER COMMON SHARE
    
    ¥
    (331,234
    )
    
    ¥
    (732,955
    )
    
    ¥
    (3,316
    )
    
    $
    (32
    )
 See notes to consolidated financial statements. (Concluded) F- 7




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Internet Initiative Japan Inc. and Subsidiaries 
 Consolidated Statements of Shareholders Equity (Capital Deficiency)Three Years in the Period Ended March 31, 2004 Thousands of YenShares of
    
    
    
    
    
    
    
    
    
    
    
    
    
    AccumulatedCommon Stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    OtherOutstanding
    
    
    
    
    
    Additional
    
    
    
    
    
    Comprehensive(Including
    
    Common
    
    Paid-in
    
    Accumulated
    
    Income
    
    TreasuryTreasury Stock)
    
    Stock
    
    Capital
    
    Deficit
    
    (Note 12)
    
    Stock
    
    TotalBALANCE, APRIL 1, 2001
    
    
    22,480
    
    
    ¥
    7,082,336
    
    
    ¥
    17,068,353
    
    
    ¥
    (10,762,334
    )
    
    ¥
    3,539,395
    
    
    
    
    
    
    ¥
    16,927,750Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,446,135
    )
    
    
    
    
    
    
    
    
    
    
    (7,446,135
    )Other comprehensive loss, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,756,334
    )
    
    
    
    
    
    
    (1,756,334
    )Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,202,469
    )BALANCE, MARCH 31, 2002
    
    
    22,480
    
    
    
    7,082,336
    
    
    
    17,068,353
    
    
    
    (18,208,469
    )
    
    
    1,783,061
    
    
    
    
    
    
    
    7,725,281Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,476,822
    )
    
    
    
    
    
    
    
    
    
    
    (16,476,822
    )Other comprehensive loss, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,252,795
    )
    
    
    
    
    
    
    (1,252,795
    )Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,729,617
    )BALANCE, MARCH 31, 2003
    
    
    22,480
    
    
    
    7,082,336
    
    
    
    17,068,353
    
    
    
    (34,685,291
    )
    
    
    530,266
    
    
    
    
    
    
    
    (10,004,336
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (105,139
    )
    
    
    
    
    
    
    
    
    
    
    (105,139
    )Other comprehensive income, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,115,292
    
    
    
    
    
    
    
    3,115,292Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,010,153Issuance of common stock
    
    
    15,880
    
    
    
    6,683,036
    
    
    
    6,569,275
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,252,311Purchase of common stock by an equity method investee
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    ¥
    (44,000
    )
    
    
    (44,000
    )BALANCE, MARCH 31, 2004
    
    
    38,360
    
    
    ¥
    13,765,372
    
    
    ¥
    23,637,628
    
    
    ¥
    (34,790,430
    )
    
    ¥
    3,645,558
    
    
    ¥
    (44,000
    )
    
    ¥
    6,214,128
 Thousands of U.S. Dollars (Note 1)AccumulatedOtherAdditional
    
    
    
    
    
    ComprehensiveCommon
    
    Paid-in
    
    Accumulated
    
    Income
    
    TreasuryStock
    
    Capital
    
    Deficit
    
    (Note 12)
    
    Stock
    
    TotalBALANCE, MARCH 31, 2003
    
    $
    67,982
    
    
    $
    163,835
    
    
    $
    (332,937
    )
    
    $
    5,090
    
    
    
    
    
    
    $
    (96,030
    )Net loss
    
    
    
    
    
    
    
    
    
    
    (1,009
    )
    
    
    
    
    
    
    
    
    
    
    (1,009
    )Other comprehensive income, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    29,903
    
    
    
    
    
    
    
    29,903Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    28,894Issuance of common stock
    
    
    64,149
    
    
    
    63,057
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    127,206Purchase of common stock by an equity method investee
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (422
    )
    
    
    (422
    )BALANCE, MARCH 31, 2004
    
    $
    132,131
    
    
    $
    226,892
    
    
    $
    (333,946
    )
    
    $
    34,993
    
    
    $
    (422
    )
    
    $
    59,648
 See notes to consolidated financial statements. F- 8




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##### Table of Contents



Internet Initiative Japan Inc. and Subsidiaries 
 Consolidated Statements of Cash FlowsThree Years in the Period Ended March 31, 2004 Thousands ofU.S. DollarsThousands of Yen
    
    (Note 1)2002
    
    2003
    
    2004
    
    2004OPERATING ACTIVITIES:Net loss
    
    ¥
    (7,446,135
    )
    
    ¥
    (16,476,822
    )
    
    ¥
    (105,139
    )
    
    $
    (1,009
    )Adjustments to reconcile net loss
to net cash provided by
operating activities:Depreciation and amortization
    
    
    3,027,587
    
    
    
    3,580,212
    
    
    
    4,008,324
    
    
    
    38,475Provision for retirement and
pension costs, less payments
    
    
    (23,799
    )
    
    
    (20,240
    )
    
    
    (16,960
    )
    
    
    (163
    )Provision for doubtful accounts
    
    
    78,482
    
    
    
    84,339
    
    
    
    449,164
    
    
    
    4,311Loss on disposal of property and
equipment
    
    
    22,851
    
    
    
    112,052
    
    
    
    109,588
    
    
    
    1,052Loss (gains) on other
investments
    
    
    432,952
    
    
    
    277,162
    
    
    
    (1,412,858
    )
    
    
    (13,562
    )Foreign exchange losses (gains)
    
    
    (219,524
    )
    
    
    277,856
    
    
    
    5,124
    
    
    
    49Gain on retirement of convertible notes
    
    
    
    
    
    
    
    
    
    
    (88,975
    )
    
    
    (854
    )Equity method net loss
    
    
    5,482,082
    
    
    
    5,625,299
    
    
    
    286,317
    
    
    
    2,748Impairment loss on investment,
advance and deposits for Crosswave
    
    
    
    
    
    
    7,153,087
    
    
    
    1,719,981
    
    
    
    16,510Minority interest in net loss of
consolidated subsidiaries
    
    
    (24,467
    )
    
    
    (153,251
    )
    
    
    (235,812
    )
    
    
    (2,264
    )Deferred income tax expense (benefit)
    
    
    1,081,241
    
    
    
    885,784
    
    
    
    (2,163,571
    )
    
    
    (20,768
    )Others
    
    
    11,913
    
    
    
    5,256
    
    
    
    70,652
    
    
    
    678Changes in operating assets and
liabilities:Decrease (increase) in accounts
receivable
    
    
    (3,559,335
    )
    
    
    (1,351,380
    )
    
    
    784,728
    
    
    
    7,533Decrease (increase) in
inventories, prepaid expenses and
other current and noncurrent assets
    
    
    (671,177
    )
    
    
    3,944
    
    
    
    (275,103
    )
    
    
    (2,641
    )Increase (decrease) in accounts payable
    
    
    2,808,704
    
    
    
    1,245,431
    
    
    
    (1,132,209
    )
    
    
    (10,868
    )Increase (decrease) in income
taxes payable
    
    
    (8,433
    )
    
    
    2,711
    
    
    
    2,041
    
    
    
    20Increase (decrease) in accrued
expenses and other current
and noncurrent liabilities
    
    
    168,271
    
    
    
    330,252
    
    
    
    (81,926
    )
    
    
    (785
    )Net cash provided by
operating
activities(Forward)
    
    ¥
    1,161,213
    
    
    ¥
    1,581,692
    
    
    ¥
    1,923,366
    
    
    $
    18,462
 (Continued) F- 9




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##### Table of Contents



Internet Initiative Japan Inc. and Subsidiaries Consolidated Statements of Cash FlowsThree Years in the Period Ended March 31, 2004 Thousands ofU.S. DollarsThousands of Yen
    
    (Note 1)2002
    
    2003
    
    2004
    
    2004Net cash provided by
operating activities(Forward)
    
    ¥
    1,161,213
    
    
    ¥
    1,581,692
    
    
    ¥
    1,923,366
    
    
    $
    18,462INVESTING ACTIVITIES:Purchases of property and equipment
    
    
    (1,237,434
    )
    
    
    (1,315,390
    )
    
    
    (1,657,302
    )
    
    
    (15,908
    )Proceeds from sale-leaseback
    
    
    
    
    
    
    66,940Investments in and advances to
equity method investees
    
    
    (362,714
    )Purchases of other investments
    
    
    (399,600
    )
    
    
    (51,671
    )
    
    
    (325,665
    )
    
    
    (3,126
    )Proceeds from sale of
other investments
    
    
    
    
    
    
    26,078
    
    
    
    2,170,584
    
    
    
    20,835Deposit of restricted cash for,
purchase of stock purchase right of
and advance to Crosswave
    
    
    
    
    
    
    (5,056,250
    )
    
    
    (1,719,981
    )
    
    
    (16,510
    )Payments of guarantee deposits
    
    
    (430,455
    )
    
    
    (1,519,264
    )
    
    
    (9,114
    )
    
    
    (87
    )Refund of guarantee deposits
    
    
    1,830
    
    
    
    31,353
    
    
    
    683,132
    
    
    
    6,557Payment for refundable insurance policies
    
    
    (16,103
    )
    
    
    (19,096
    )
    
    
    (21,007
    )
    
    
    (202
    )Refund from insurance policies
    
    
    6,115
    
    
    
    8,392
    
    
    
    7,432
    
    
    
    71Other
    
    
    (18,837
    )
    
    
    (49,013
    )
    
    
    19,458
    
    
    
    187Net cash used in investing
activities
    
    
    (2,457,198
    )
    
    
    (7,877,921
    )
    
    
    (852,463
    )
    
    
    (8,183
    )FINANCING ACTIVITIES:Proceeds from issuance of long-term
borrowings
    
    
    2,000,000
    
    
    
    2,000,000
    
    
    
    400,000
    
    
    
    3,839Repayments of long-term borrowings
    
    
    
    
    
    
    (1,400,000
    )
    
    
    (1,943,735
    )
    
    
    (18,657
    )Principal payments under capital leases
    
    
    (2,037,133
    )
    
    
    (2,475,433
    )
    
    
    (2,733,012
    )
    
    
    (26,234
    )Net increase (decrease) in short-term
borrowings
    
    
    (1,799,768
    )
    
    
    1,003,367
    
    
    
    1,740,495
    
    
    
    16,707Repurchase of convertible notes
    
    
    
    
    
    
    
    
    
    
    (3,047,460
    )
    
    
    (29,252
    )Proceeds from issuance of common stock,
net of issuance cost
    
    
    
    
    
    
    
    
    
    
    13,252,311
    
    
    
    127,206Proceeds from issuance of subsidiary
stock to minority shareholders
    
    
    375,000Net cash provided by
(used in) financing
activities
    
    
    (1,461,901
    )
    
    
    (872,066
    )
    
    
    7,668,599
    
    
    
    73,609EFFECT OF EXCHANGE RATE
CHANGES ON CASH
    
    
    233,098
    
    
    
    (289,272
    )
    
    
    (43,615
    )
    
    
    (418
    )NET INCREASE (DECREASE) IN CASH
AND CASH EQUIVALENTS
    
    
    (2,524,788
    )
    
    
    (7,457,567
    )
    
    
    8,695,887
    
    
    
    83,470CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
    
    
    13,570,707
    
    
    
    11,045,919
    
    
    
    3,588,352
    
    
    
    34,444CASH AND CASH EQUIVALENTS,
END OF YEAR
    
    ¥
    11,045,919
    
    
    ¥
    3,588,352
    
    
    ¥
    12,284,239
    
    
    $
    117,914
 (Continued) F- 10




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##### Table of Contents



Internet Initiative Japan Inc. and Subsidiaries Consolidated Statements of Cash FlowsThree Years in the Period Ended March 31, 2004 Thousands ofU.S. DollarsThousands of Yen
    
    (Note 1)2002
    
    2003
    
    2004
    
    2004ADDITIONAL CASH FLOW
INFORMATION:Interest paid
    
    ¥
    563,557
    
    
    ¥
    633,649
    
    
    ¥
    625,248
    
    
    $
    6,002Income taxes paid
    
    
    26,227
    
    
    
    22,650
    
    
    
    48,413
    
    
    
    465NONCASH INVESTING AND
FINANCING ACTIVITIES:Acquisition of assets by
entering into capital leases
    
    
    2,535,943
    
    
    
    3,578,084
    
    
    
    1,865,309
    
    
    
    17,905Exchange of common stock
investment due to merger:Market value of common
shares acquired
    
    
    
    
    
    
    55,448Cost of investment
    
    
    
    
    
    
    132,372
 See notes to consolidated financial statements.  (Concluded) F- 11




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##### Table of Contents



Internet Initiative Japan Inc. and Subsidiaries 
 Notes to Consolidated Financial Statements  1.
    
    DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESInternet Initiative Japan Inc. (IIJ), a Japanese
corporation, was founded
in December 1992 to develop and operate Internet access services and other
Internet-related services in Japan and is 31.6 percent owned by Nippon
Telegraph and Telephone Corporation (NTT) and its subsidiary as of March
31, 2004. IIJ and subsidiaries (collectively, the Company) provide
Internet access services throughout Japan and into the United States of
America and into the rest of Asia through a direct connection to the
A-Bone, an Internet backbone connecting the countries in the Asia Pacific
region. The Company also provides Internet systems design and integration
representing principally sales of Internet network systems and equipment
and miscellaneous Internet access-related services.The Company manages its business and measures results based on a single
Internet-related services industry segment. Substantially all revenues are
from customers operating in Japan.The accompanying consolidated financial statements have been prepared on a
going-concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. The Company
has incurred operating losses and net losses in each of the past six fiscal
years, with the exception of operating income turning slightly positive for
the year ended March 31, 2002. In August 2003, Crosswave Communications
Inc. (Crosswave), the Companys former equity method investee, filed a
voluntary petition for the commencement of corporate reorganization
proceeding in Japan. The Company recognized the total equity in net loss
of Crosswave of ¥12,667,470 thousand and ¥1,719,981 thousand for the year
ended March 31, 2003 and 2004, respectively. The Company had taken action
to address Crosswaves corporate reorganization and its financial
performance such as private placements to shareholders and third parties
totaling ¥13,366,073 thousand in June and September 2003. At March 31,
2004, the Company has indebtedness of ¥27,520,410 thousand including
convertible notes of ¥11,832,000 thousand due March 2005 and negative
working capital of ¥7,858,405 thousand. Although the Company is
considering various alternatives to increase revenues and improve
profitability, there can be no assurance that these actions and efforts
will be successful. However, the management believes that  as of
March 31, 2004, the Companys
cash and cash equivalents of ¥12,284,239 thousand and available-for-sale
securities of ¥6,572,985 thousand, including common stock
investment in a single Japanese company of ¥5,447,680 thousand, cash provided by
operating activities and continuing bank financing should provide the
Company with sufficient resources to redeem the convertible notes and meet
its other near term cash requirements. F- 12




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##### Table of Contents



Certain Significant Risks and UncertaintiesThe Company participates in a
dynamic high technology industry and believes that changes in any of the
following areas could have a material adverse effect on the Companys
future financial position, results of operations or cash flows: advances
and trends in new technologies and industry standard; competitive pressures
in the form of new products or price reductions on current products; change
in product mix and overall demand for products offered by the Company;
changes in certain strategic relationship or customer relationship;
litigation or claims against the Company based on intellectual property,
product, regulatory or other factors; risk associated with change in
domestic and international economic and/or political conditions or
regulations; and fluctuation in stock price of available-for-sale
securities which the Company owns.The Company relies on telecommunications carriers for a significant portion
of network backbone, and regional NTT subsidiaries, electric power
companies and their affiliates for local connections to customers, and
third-party suppliers for the use of hardware components such as routers
and servers. In December 2003, in connection with an agreement with NTT
Communications Corporation (NTT Communications), a subsidiary of NTT, all
domestic operations of Crosswave were transferred to NTT Communications.
As a result, almost all the contracts previously entered between the
Company and Crosswave, including domestic
backbone and Internet data center network services have been transferred to
NTT Communications. The Companys contracts for international backbone
services have been cancelled and replaced by contracts with NTT
Communications and other Japanese carriers, effective October 1, 2003.
Currently, NTT Communications is a largest provider of network
infrastructure. The Company believes that its use of multiple carriers,
suppliers and alternative facilities significantly mitigate concentrations
of credit risk. However, any disruption of telecommunication services or
the inability of suppliers to deliver hardware components on a timely basis
or to develop alternative sources of components could have an adverse
effect on operating results.Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash investments,
accounts receivable and guarantee deposits. The Companys management
believes that the risks associated with accounts receivable is mitigated by
the large number of customers comprising its customer base. F- 13




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##### Table of Contents



Summary of Significant Accounting PoliciesBasis of PresentationIIJ maintains its record in accordance with generally
accepted accounting principles in Japan. Certain adjustment and
reclassifications have been incorporated in the accompanying consolidated
financial statements to conform to generally accepted accounting principles
in the United States of America (U.S. GAAP). These adjustments were not
recorded in the statutory accounts.Certain reclassifications have been made to the prior periods to conform to
the current year presentation.Translation into U.S. DollarsIIJ maintains its accounts in Japanese yen,
the currency of the country in which it is incorporated and principally
operates. The U.S. dollar amounts included herein represent a translation
using the noon buying rate in New York City for cable transfers in yen as
certified for customs purposes by the Federal Reserve Bank of New York at
March 31, 2004 of ¥104.18 = $1 solely for the convenience of the reader.
The translation should not be construed as a representation that the yen
amounts have been, could have been, or could in the future be converted
into U.S. dollars.ConsolidationThe consolidated financial statements include the accounts of
IIJ and all of its subsidiaries, Net Care, Inc. (Net Care), IIJ
Technology Inc. (IIJ Technology), IIJ Media Communications Inc. (MC)
and IIJ America, Inc. (IIJ America) which have fiscal years ending March
31, except for IIJ America. IIJ Americas fiscal year end is December 31
and such date was used for purposes of preparing the consolidated financial
statements as it is not practicable for the subsidiary to report its
financial results as of March 31. There were no significant events that
occurred during the intervening period that would require adjustment to or
disclosure in the accompanying consolidated financial statements.
Significant intercompany transactions and balances have been eliminated in
consolidation. Investments in companies over which IIJ has significant
influence but not control are accounted for by the equity method. For
other than a temporary decline in the value of investments in equity method
investees below the carrying amount, the investment is reduced to fair
value and an impairment loss is recognized.Use of EstimatesThe preparation of financial statements in conformity with
generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date
of the financial statements and reported amounts of revenues and expenses
during the reporting period. Significant estimates and assumptions used
are primarily in the areas of impairment loss on investment in and advances
to equity method investees, valuation allowances for deferred tax assets,
allowance for doubtful accounts, and estimated lives of fixed assets.
Actual results could differ from those estimates.Revenue RecognitionRevenues from customer connectivity services consist
principally of dedicated Internet access services and dial-up Internet
access services. Dedicated Internet access services represent full-line IP
services and standard-level IP services (T1 Standard and IIJ FiberAccess/F
Service). Dial-up Internet access services are provided to both
enterprises and individuals (IIJ4U). The term of these contracts is one
year for dedicated Internet access services and generally one month for
dial-up Internet access services. All these services are billed and
recognized monthly on a straight-line basis.Value-added service revenues consist principally of sales of various
Internet access-related services such as firewalls services. Value-added
services also include monthly fees from data center services such as
housing, monitoring and security services. Other revenues under
connectivity and value-added services consist principally of call-center
customer support. The terms of these services are generally for one year
and revenues are recognized on a straight-line basis during the service
period. F- 14




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##### Table of Contents



Initial set up fees received in connection with connectivity services and
value-added services are deferred and recognized over the contract period.Systems integration revenues consist principally of the development of
Internet network systems or design and related maintenance, monitoring and
other operating services. The period for the development of the systems or
designs is less than one year and revenues are recognized when network
systems and equipment are delivered and accepted by the customer under the
completed contract method. The development of the Internet network systems
or design include multiple element arrangements such as planning, systems
design, and construction services, and equipment and software purchased
from third parties. When the equipment or system is delivered prior to
other elements of the arrangement, revenue is deferred until other service
elements are completed and accepted by the customer. Maintenance,
monitoring and operating service revenues are recognized ratably over the
separate contract period, which is generally for one year.Equipment sales represent revenues earned in which the Company acts as
principal in the transaction, takes title to the equipment and has risks
and rewards of ownership while in inventory and are reported gross as the
indicators outlined in the provisions of the Emerging Issues Task Force
(EITF) Issue No. 99-19 Reporting Revenue Gross as a Principal versus Net
as an Agent are met.Cash and Cash EquivalentsCash and cash equivalents includes time deposit
and readily marketable securities with original maturities of three months
or less.Allowance for Doubtful AccountsAn allowance for doubtful accounts is
established in amounts considered to be appropriate based primarily upon
the Companys past credit loss experience and an evaluation of potential
losses in the receivables outstanding.Other InvestmentsIn accordance with Statement of Financial Accounting
Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and
Equity Securities, all marketable equity securities are classified as
available-for-sale securities, which are accounted for at fair value with
unrealized gains and losses excluded from earnings and reported in
accumulated other comprehensive income (loss). The cost of securities sold
is determined based on average cost.The Company reviews the fair value of available-for-sale investments on a
regular basis to determine if the fair value of any individual investment
has declined below its cost and if such decline is other than temporary.
If the decline in value is judged to be other than temporary, the cost
basis of the investment is written down to fair value. Other than
temporary declines in value are determined taking into consideration the
extent of decline in fair value, the length of time that the decline in
fair value below cost has existed and events that might accelerate the
recognition of impairment. The resulting realized loss is included in the
consolidated statements of operations in the period in which the decline
was deemed to be other than temporary.Non-marketable equity and debt securities are carried at cost, however, if
the value of a security has declined and is judged to be other than
temporary, the security is written down to the estimated fair value.InventoriesInventories consist mainly of network equipment purchased for
resale and work-in-process for development of Internet network systems.
Network equipment purchased for resale is stated at the lower of cost,
which is determined by the average-cost method, or market. Work-in-process
for development of network systems is stated at the lower of actual
production costs, including overhead cost, or market. Inventories are
reviewed periodically and items considered to be slow-moving or obsolete
are written down to their estimated net realizable value. F- 15




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##### Table of Contents



Property and EquipmentProperty and equipment are recorded at cost.
Depreciation and amortization of property and equipment, including
purchased software and capitalized leases, are computed principally using
the straight-line method based on either the estimated useful lives of
assets or the lease period, whichever is shorter.The useful lives for depreciation and amortization by major asset classes
are as follows: Range ofUseful LivesData communications, office and other equipment
    
    
    2 to 15 yearsLeasehold improvements
    
    
    3 to 15 yearsPurchased software
    
    
    5 yearsCapitalized leases
    
    
    4 to   7 years
  Impairment of Long-Lived AssetsLong-lived assets consist principally of
property and equipment, including those items leased under capital leases.
On April 1, 2002, the Company adopted SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which addresses financial
accounting and reporting for the impairment or disposal of long-lived
assets. The adoption of SFAS No. 144 did not have a material effect on the
Companys consolidated financial position and results of operations. Prior
to the adoption of SFAS No. 144, the Company accounted for long-lived
assets in accordance with SFAS No. 121, Accounting for Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. The
Company evaluates the impairment of long-lived assets whenever events or
changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. There was no impairment losses for long-lived assets
for the three years in the period ended March 31, 2004.Goodwill and Intangible AssetsOn April 1, 2002, the Company adopted SFAS
No. 142, Goodwill and Other Intangible Assets. Under the statement,
goodwill (including equity-method goodwill) and intangible assets that are
deemed to have indefinite useful lives are not amortized, but are subject
to impairment testing. Impairment testing is required to be performed at
adoption and annually or more frequently if events or changes in
circumstances indicate that the asset might be impaired. The Company
selected March 31 as its annual impairment testing date. Upon the adoption
of the statement, the Company ceased the amortization of goodwill recorded
in past business combinations and acquisitions. Additionally, the Company
ceased the amortization of intangible assets that are deemed to have
indefinite lives. As required by SFAS No. 142, the Company also reassessed
the useful lives and the classification of its identifiable intangible
assets and determined them to be appropriate.Income TaxesThe provision for income taxes is based on earnings before
income taxes and includes the effects of temporary differences between
assets and liabilities recognized for financial reporting purposes and
income tax purposes and operating loss carryforwards. Valuation allowances
are provided against assets that are not likely to be realized.Foreign Currency TransactionsForeign currency assets and liabilities,
which consist substantially of cash and accounts payable for connectivity
leases to international carriers denominated in U.S. dollars, are stated at
the amount as computed by using year-end exchange rates and the resulting
transaction gain or loss is recognized in earnings. F- 16




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##### Table of Contents



Derivative Financial InstrumentsOn April 1, 2001, the Company adopted SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities, as
amended by SFAS No. 138 and No. 149 (collectively, SFAS No. 133) which
requires that an entity recognize all derivatives as either assets or
liabilities in the balance sheet and measure those instruments at fair
value. In accordance with SFAS No. 133, the Company designated interest
swap contracts as a hedge of the variability of cash flows to be paid
related to interest on floating rate borrowings (cash flow hedge) and an
effective portion of the derivatives gain or loss is initially reported as
a component of other comprehensive income and subsequently reclassified
into earnings when the underlying transaction affects earnings. An
ineffective portion of the gain or loss is reported in earning immediately.
The cumulative effect adjustment upon the adoption of SFAS No. 133
resulted in a decrease to other comprehensive income of ¥25,594 thousand.
The Company enters into contracts to hedge interest rate risks and does not
enter into contracts or utilize derivatives for trading purposes. For
transactions occurring after June 30, 2003, the Company adopted SFAS No.149.
The adoption of SFAS No.149 had no effect on the Companys consolidated
financial position or result of operation.Stock-Based CompensationThe Company accounts for stock-based compensation
using the intrinsic value method prescribed in Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees and related
interpretations. Accordingly, the companies recognize compensation expense
in an amount equal to the excess of the quoted market price over the
exercise price of the option at the grant date. For options with a vesting
period, the compensation expense is charged to operations ratably over the
vesting period. The Company has not recognized any stock-based
compensation expense for the years ended March 31, 2002, 2003 and 2004.In accordance with SFAS No. 123, Accounting for Stock-Based Compensation,
as amended by SFAS No. 148, Accounting for Stock-Based
CompensationTransition and Disclosure, the following pro forma net loss
and loss per share information for the years ended March 31, 2002, 2003 and
2004, including the effects of fair values associated with the warrants of
IIJ Technology is presented as if the Company accounted for its stock
options using the fair value method. Under the fair value method, the
estimated fair value of the stock options is charged against income on a
straight-line basis over the options vesting period: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Net loss:As reported
    
    ¥
    (7,446,135
    )
    
    ¥
    (16,476,822
    )
    
    ¥
    (105,139
    )
    
    $
    (1,009
    )Addition: Total
stock-based employee
compensation
determined under
fair value based
method for all awards,
net of tax
    
    
    1,757,087
    
    
    
    267,387
    
    
    
    32,020
    
    
    
    308Pro forma
    
    ¥
    (9,203,222
    )
    
    ¥
    (16,744,209
    )
    
    ¥
    (137,159
    )
    
    $
    (1,317
    )
 Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Basic and diluted net loss
per common shares:As reported
    
    ¥
    331,234
    
    
    ¥
    732,955
    
    
    ¥
    3,316
    
    
    $
    32Pro forma
    
    
    409,396
    
    
    
    744,849
    
    
    
    4,325
    
    
    
    42
  AdvertisingAdvertising costs are expensed as incurred.Basic and Diluted Net Loss per ShareBasic and diluted net loss per share
are computed using the weighted-average number of shares of common stock
outstanding during the year. All potential common shares, shares issuable
upon exercise of stock options or conversion of convertible notes, have
been excluded from the computation of diluted net loss per share for all
periods presented because the effect would be antidilutive. Diluted net loss per share does not include the effects of
the following potential common shares: Year Ended March 312002
    
    2003
    
    2004Shares issuable under stock options
    
    
    685
    
    
    
    675
    
    
    
    615Shares issuable related to convertible
notes on an as-if-converted basis
    
    
    625
    
    
    
    625
    
    
    
    595
 F- 17




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##### Table of Contents



Other Comprehensive Income (Loss)Other comprehensive income (loss)
consists of translation adjustments resulting from the translation of
financial statements of a foreign subsidiary, unrealized gains or losses on
available-for-sale securities and gains or losses on cash flow hedging
derivative instruments.New Accounting StandardsIn November 2002, the EITF reached a consensus on
Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF
Issue No. 00-21 addresses certain aspects of the accounting by a vendor for
arrangements under which it will perform multiple revenue-generating
activities and how arrangement consideration should be measured and
allocated to the separate units of accounting in the arrangement. The
provisions of EITF Issue No. 00-21 apply to revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. The adoption of
EITF Issue No. 00-21 will not have a material effect on the Companys
consolidated financial position or results of operations.In January 2003, the FASB issued FASB Interpretation No. 46 (FIN46),
Consolidation of Variable Interest Entities, an Interpretation of ARB
No. 51, Consolidated Financial Statements, and subsequently revised in
December 2003 with the issuance of FIN 46 (revised 2003). The
interpretation requires certain variable interest entities to be
consolidated by the primary beneficiary of the entity if the equity
investors in the equity do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for the entity
to finance its activities without additional subordinated financial support
from other parties. The Company is required to apply this interpretation
for periods ending after April 1, 2004. The adoption of the revised FIN 46
will not have an effect on the Companys consolidated financial position or
results of operation. F- 18




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##### Table of Contents



2.
    
    OTHER INVESTMENTSPursuant to SFAS No. 115, all of the Companys marketable equity
securities, principally marketable shares of common stock were classified
as available-for-sale securities. Information regarding the securities
classified as available-for-sale at March 31, 2003 and 2004 is as follows: Thousands of YenUnrealized
    
    Unrealized
    
    FairMarch 31, 2003
    
    Cost
    
    Gains
    
    Losses
    
    ValueAvailable-for-saleEquity
securities
    
    ¥
    265,730
    
    
    ¥
    954,679
    
    
    ¥
    40,493
    
    
    ¥
    1,179,916March 31,
2004Available-for-saleEquity
securities
    
    ¥
    351,120
    
    
    ¥
    6,225,560
    
    
    ¥
    3,695
    
    
    ¥
    6,572,985
 Thousands of U.S. DollarsUnrealized
    
    Unrealized
    
    FairMarch 31, 2004
    
    Cost
    
    Gains
    
    Losses
    
    ValueAvailable-for-saleEquity
securities
    
    $
    3,370
    
    
    $
    59,758
    
    
    $
    35
    
    
    $
    63,093
  In November 2003, the EITF partly reached a consensus on Issue No. 03-01,
The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments. The consensus requires additional disclosures about
unrealized losses on marketable debt and equity securities accounted for
under SFAS No. 115 and No. 124, Accounting for Certain Investments held by
Not-for-Profit Organization that are classified as either
available-for-sale or held-to-maturity.The following table provides the fair value and gross unrealized losses of
the Companys investments, which have been deemed to be temporarily
impaired, aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position,
as of March 31, 2004: Thousands of YenLess than12 Months
    
    12 Months or More
    
    TotalFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    UnrealizedValue
    
    Losses
    
    Value
    
    Losses
    
    Value
    
    LossesMarketable equity securities
    
    Nil
    
    Nil
    
    ¥
    10,300
    
    
    ¥
    3,695
    
    
    ¥
    10,300
    
    
    ¥
    3,695
 Thousands of U.S.
DollarsLess than12 Months
    
    12 Months or More
    
    TotalFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    UnrealizedValue
    
    Losses
    
    Value
    
    Losses
    
    Value
    
    LossesMarketable equity securities
    
    Nil
    
    Nil
    
    $
    99
    
    
    $
    35
    
    
    $
    99
    
    
    $
    35
  The Company regularly reviews all of the Companys holdings to determine if
any investment are other-than-temporarily impaired. The analysis includes
reviewing industry analyst reports, sector credit ratings and volatility of
the securitys market price.The Companys unrealized losses on investments in marketable equity
securities relates to common stock of a Japanese bank. The unrealized
losses were primarily caused by the overall decline in the stock markets in
Japan. The fair value of the investment is approximately 26.4% less than
cost. Based on the Companys ability and intent to hold the investment for
a reasonable period of time sufficient for a recovery of fair value, and
the considerable overall market recovery during the current year, the
Company does not consider the
investment to be other-than temporarily impaired at March 31,2004.Other investments include nonmarketable equity and debt securities
amounting to ¥1,860,273 thousand and ¥1,358,908 thousand ($13,043 thousand)
at March 31, 2003 and 2004, respectively. F- 19




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##### Table of Contents



Losses on write-down of investments in certain marketable and nonmarketable
equity securities, included in other income (expense), were recognized to
reflect the decline in value considered to be other than temporary,
totaling ¥301,580 thousand and ¥131,372 thousand, respectively, for the
year ended March 31, 2002, totaling ¥15,515 thousand and ¥175,442 thousand,
respectively, for the year ended March 31, 2003. Such losses on write-down
of investments in certain nonmarketable equity and debt securities,
included in other income (expense) were ¥229,944 thousand ($2,207 thousand)
for the year ended March 31, 2004.Loss on exchange of securities of ¥76,924 thousand ($652 thousand),
included in other income (expense), for the year ended March 31, 2003,
represented a non-monetary loss upon the exchange of marketable common
 shares in a merger transaction.Proceeds from the sale of available-for-sale securities were ¥122,650
thousand ($1,177 thousand) for the year ended March 31, 2004. Gross
realized gain of ¥55,965 thousand ($537 thousand) and gross realized loss
of ¥8,925 thousand ($86 thousand) were included in other income (expense)
for the year ended March 31, 2004.In November 2003, IIJ sold all of its shares of DLJdirectSFG Securities
Inc., which had been held as other investments. Proceeds and gross
realized gain from this sales were ¥1,946,875 thousand and ¥1,571,875
thousand, respectively.3.
    
    ALLOWANCE FOR DOUBTFUL ACCOUNTSAn analysis of allowance for doubtful accounts for the years ended March
31, 2002, 2003 and 2004 is as follows: Thousands of YenBalance at
    
    
    
    
    
    Provision forBeginning of
    
    Credits
    
    Doubtful
    
    Balance atYear
    
    Charged Off
    
    Accounts
    
    End of YearYear ended March 31, 2002
    
    ¥
    139,221
    
    
    ¥
    (69,289
    )
    
    ¥
    78,482
    
    
    ¥
    147,874Year ended March 31, 2003
    
    ¥
    147,874
    
    
    ¥
    (106,859
    )
    
    ¥
    84,339
    
    
    ¥
    125,354Year ended March 31, 2004
    
    ¥
    125,354
    
    
    ¥
    (81,913
    )
    
    ¥
    449,164
    
    
    ¥
    492,605
 Thousands of U.S. DollarsBalance at
    
    
    
    
    
    Provision forBeginning of
    
    Credits
    
    Doubtful
    
    Balance atYear
    
    Charged Off
    
    Accounts
    
    End of YearYear ended March 31, 2004
    
    $
    1,203
    
    
    $
    (786
    )
    
    $
    4,311
    
    
    $
    4,728
  The provision for doubtful accounts for the year ended March 31, 2004
included accounts receivable from Crosswave of ¥395,780 thousand ($3,799
thousand) and certain other customers.4.
    
    INVESTMENTS IN AND ADVANCES TO EQUITY METHOD INVESTEESIIJ utilizes various business units in Japan and neighboring countries to
form and operate its Internet business. Businesses operated by its equity
method investees include dedicated high-speed data communication services,
data center services (Crosswave) through December 15, 2003, connectivity
services in Asian countries (Asia Internet Holding Co., Ltd., AIH),
multifeed technology services and location facilities for connecting
high-speed Internet backbones (Internet Multifeed Co., Multifeed), Web
page design services (atom Co., Ltd.), data center services in Asian
countries (AyalaPort Makati Inc., AyalaPort, and i-Heart Inc.,
i-Heart). F- 20




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##### Table of Contents



The Company had no guarantees or commitments to the equity method investees
as of March 31, 2004.The aggregate amounts of balances and transactions of the Company with
these equity method investees other than Crosswave as of March 31, 2003 and
2004 and for each of the three years in the period ended March 31, 2004
were summarized as follows: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Accounts receivable
    
    
    
    
    
    ¥
    219,019
    
    
    ¥
    95,555
    
    
    $
    917Accounts payable
    
    
    
    
    
    
    62,065
    
    
    
    14,152
    
    
    
    136Revenues
    
    ¥
    1,870,227
    
    
    
    1,460,123
    
    
    
    1,329,482
    
    
    
    12,761Costs and expenses
    
    
    1,036,359
    
    
    
    1,402,293
    
    
    
    1,245,607
    
    
    
    11,956
  During each of the three years in the period ended March 31, 2004, the
Company did not receive any dividends from its equity method investees.The Companys investments in and advances to these equity method investees
and respective ownership percentage at March 31, 2003 and 2004 consisted of
the following: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    
    
    
    
    2004
    
    2004AIH
    
    
    26.69
    %
    
    ¥
    588,452
    
    
    
    26.69
    %
    
    ¥
    362,134
    
    
    $
    3,476Multifeed
    
    
    28.30
    
    
    
    180,647
    
    
    
    28.30
    
    
    
    197,927
    
    
    
    1,900atom
    
    
    40.00
    
    
    
    158,712
    
    
    
    40.00
    
    
    
    148,409
    
    
    
    1,424Other
    
    
    
    
    
    
    188,209
    
    
    
    
    
    
    
    69,682
    
    
    
    669Total
    
    
    
    
    
    ¥
    1,116,020
    
    
    
    
    
    
    ¥
    778,152
    
    
    $
    7,469
  The advances to the equity method investees, included in the above, as of
March 31, 2003 and 2004 were as follows: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004AIH Taiwan
    
    ¥
    75,689i-Heart
    
    
    51,246
    
    
    ¥
    51,246
    
    
    $
    492AyalaPort
    
    
    38,392Total
    
    ¥
    165,327
    
    
    ¥
    51,246
    
    
    $
    492
 F- 21




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##### Table of Contents



Crosswave, was formed in October 1998 with ownership interests held by IIJ
(40 percent), Toyota Motor Corporation (Toyota) (30 percent) and Sony
Corporation (Sony) (30 percent). On August 9, 2000, Crosswave completed
an initial public offering of 17,392,000 American Depository Shares
(ADSs), representing 86,960 shares of common stock at an initial offering
price of $14.00 per ADSs in the NASDAQ National Market in the United States
of America. Concurrently, IIJ purchased 15,000 newly issued Crosswave
common shares amounting to ¥4,565,400 thousand in the aggregate. On
December 27, 2000, IIJ also purchased 3,000,000 ADSs, representing 15,000
shares of Crosswave from the market in the aggregate amount of ¥2,737,200
thousand. As a result of these transactions, the ownership of IIJ, Sony
and Toyota at March 31, 2003 was 37.85 percent, 23.9 percent and 23.9
percent, respectively.On May 21, 2002, in connection with the Crosswave Financing Facilities
Agreement (the Agreement), the Company entered into a Cash Deficiency
Support Agreement (CDS Agreement) with Crosswave and four Japanese
commercial banks. The Agreement consists of six-year-term loans up to
¥15,000,000 thousand (Tranche A) and a short-term line of credit up to
¥5,000,000 thousand (Tranche B). Tranche A could be drawn down by
Crosswave as necessary over the first two-year period, if Crosswave met
certain predetermined operating targets. In December 2002, Crosswave could
not meet the predetermined targets and, consequently, Crosswaves ability
to access funds from Tranche A facility was suspended by the banks. In
accordance with the provisions of the CDS Agreement, the Company deposited
¥5,000,000 thousand into a restricted account with a participating bank in
May 2002. Under the terms of the CDS Agreement, the deposited cash was
restricted over the period in which the Crosswave loans were outstanding
and could only be used for debt service in the event Crosswave was
otherwise unable to meet scheduled payments under the Agreement. Any such
restricted cash used for debt service would result in a corresponding
unsecured funding to Crosswave by the Company that would be subordinate to
the Crosswave loans outstanding under the Agreement.In May and June 2003, the Company made unsecured loans of ¥1,719,981
thousand ($16,510 thousand) in total to Crosswave with interest at the
short-term prime rate plus 0.3 percent (1.675 percent) p.a. in order for
Crosswave to meet its scheduled debt service obligation. Original maturity
of the loans was July 31, 2003, which was extended to September 30, 2003.On August 20, 2003, Crosswave filed a voluntary petition for the
commencement of corporate reorganization proceedings in Japan. On August
28, 2003, Crosswave received an order from the Tokyo District Court for the
commencement of corporate reorganization proceedings. Crosswaves ADSs
were removed from the NASDAQ National Market by NASDAQ effective August 29,
2003. As a result of the commencement of corporate reorganization
proceedings, the Company became unable to exercise shareholder voting
rights during the pendency of corporate reorganization and expects its
equity interest to be eliminated by operation of law upon approval of a
reorganization plan or liquidation of Crosswave. As such, the Company no
longer has had the ability to exercise significant influence over operating
and financial policies of Crosswave thereafter.As a result of the voluntary petition for the commencement of corporate
reorganization proceedings by Crosswave, the ¥5,000,000 thousand deposited
cash was used by the banks for debt service and Crosswave is deemed to have
received a loan from the Company for the same amount. Any recovery from
Crosswave on this loan, however, is required to be paid to the banks until
such point as they have been paid in full. The Company is not liable under
the terms of the CDS Agreement for any amounts in addition to this amount
of ¥5 billion ($47,994 thousand). F- 22




---



##### Table of Contents



The Company recorded an equity method loss of Crosswave of ¥5,514,383
thousand for the year ended March 31, 2003, based on unaudited net loss
information publicly disclosed by Crosswave prior to the commencement of
corporate reorganization proceedings by Crosswave and not reflecting any
adjustments which may have been required in respect thereof. In addition,
the Company assessed the impairment of its investment in and deposits for
Crosswave considering an evaluation of the recoverability of the equity
investees underlying net assets through sale or future operations upon
emergence from bankruptcy and recognized an impairment loss on investment
in and deposits for Crosswave of ¥7,153,087 thousand as of March 31, 2003.
This impairment loss consisted of the carrying amount of the investment of
¥2,098,762 thousand, the realized gain of related foreign currency
translation adjustments of ¥1,925 thousand, stock purchase rights of
¥56,250 thousand and deposits of ¥5,000,000 thousand under the CDS
Agreement.The loans of ¥1,719,981 thousand ($16,510 thousand) made by the Company in
May and June 2003 to Crosswave and accounts receivable from Crosswave of
¥395,780 thousand ($3,799 thousand) as of August 19, 2003 were written off
in the year ended March 31, 2004.On December 15, 2003, all operations of Crosswave, excluding operations for
international services, were transferred to NTT Communications. Almost all
the contracts previously between Crosswave and the Company, including
network operating leases represented approximately 70.9 percent and 46.7
percent of total domestic backbone costs for the years ended March 31, 2003
and 2004, respectively, have been transferred to NTT Communications (no
penalties or additional costs have been or will be charged to the Company
upon the transfer or in the remaining contract periods). The contracts for
international backbone service with Crosswave which represent approximately
29.8 percent and 23.2 percent of total international backbone costs for the
years ended March 31, 2003 and 2004, respectively, were canceled on
September 30, 2003 without penalties, and corresponding international
network contracts were entered into with NTT and KDDI, effective October 1,
2003.The amounts of balances and transactions of the Company with Crosswave as
of March 31, 2003 and 2004 and for each of the three years in the period
ended March 31, 2004 are summarized as follows: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Accounts receivable
    
    
    
    
    
    ¥
    493,694
    
    
    ¥
    19,095
    
    
    $
    183Accounts payable
    
    
    
    
    
    
    670,920Guarantees
    
    
    
    
    
    
    3,200Revenues
    
    ¥
    2,641,976
    
    
    
    2,641,438
    
    
    
    1,196,080
    
    
    
    11,481Costs and expenses
    
    
    4,526,458
    
    
    
    6,199,229
    
    
    
    4,816,146
    
    
    
    46,229
  Revenues from Crosswave consist principally of dedicated Internet access
services, monitoring services and sales of network systems. Revenues, and
costs and expense for the year ended March 31, 2004 , shown in the table
above, include those recognized after Crosswaves filling voluntary
petition of corporate reorganization , which amounted to ¥425,597 thousand
and ¥1,820,518 thousand, respectively.IIJs sale of network systems to Crosswave amounted to ¥1,078,863 thousand,
¥1,160,638 thousand and ¥27,641 thousand ($265 thousand) for the years
ended March 31, 2002, 2003 and 2004, respectively. Related cost of
purchased equipment sold amounted to ¥949,537 thousand, ¥1,106,373 thousand
and ¥26,665 thousand ($256 thousand), respectively.Cost and expenses incurred from transactions with Crosswave mainly consist
of the cost of dedicated high-speed data communication services. F- 23




---



##### Table of Contents



The major financial accounts of Crosswave as of March 31, 2003 and for the
years ended March 31, 2002 and 2003 were as follows: Thousands of Yen2003(Unaudited)Current assets
    
    ¥
    5,523,399Noncurrent assets
    
    
    66,765,619Total assets
    
    ¥
    72,289,018Current liabilities
    
    ¥
    22,447,349Noncurrent liabilities
    
    
    47,559,884Total liabilities
    
    ¥
    70,007,233
 Thousands of Yen2002
    
    2003(Unaudited)Revenues
    
    ¥
    9,487,603
    
    
    ¥
    18,449,852Costs and expenses
    
    
    22,352,415
    
    
    
    31,083,502Operating loss
    
    
    (12,864,812
    )
    
    
    (12,633,650
    )Other income (expense)net
    
    
    (536,337
    )
    
    
    (2,030,892
    )Loss before minority interests
    
    
    (13,401,149
    )
    
    
    (14,664,542
    )Minority interests in consolidated subsidiaries
    
    
    4,623
    
    
    
    13,666Net loss
    
    ¥
    (13,396,526
    )
    
    ¥
    (14,650,876
    )
  5.
    
    PROPERTY AND EQUIPMENTProperty and equipment as of March 31, 2003 and 2004 consisted of the
following: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Data communications equipment
    
    ¥
    846,631
    
    
    ¥
    945,006
    
    
    $
    9,070Office and other equipment
    
    
    480,941
    
    
    
    659,307
    
    
    
    6,329Leasehold improvements
    
    
    409,398
    
    
    
    838,592
    
    
    
    8,049Purchased software
    
    
    4,552,181
    
    
    
    4,890,797
    
    
    
    46,946Capitalized leases, primarily data
communications equipment
    
    
    10,810,872
    
    
    
    10,420,774
    
    
    
    100,027Construction in progress
    
    
    15,000Total
    
    
    17,115,023
    
    
    
    17,754,476
    
    
    
    170,421Less accumulated depreciation
and amortization
    
    
    (7,963,451
    )
    
    
    (9,152,571
    )
    
    
    (87,853
    )Property and equipmentnet
    
    ¥
    9,151,572
    
    
    ¥
    8,601,905
    
    
    $
    82,568
 F- 24




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##### Table of Contents



6.
    
    GOODWILL AND INTANGIBLE ASSETSThe following table provides pro forma results for the year ended March 31,
2002, as if non-amortization provisions of SFAS No. 142 had been applied in
2002, compared with the years ended March 31, 2003 and 2004: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Reported net loss
    
    ¥
    (7,446,135
    )
    
    ¥
    (16,476,822
    )
    
    ¥
    (105,139
    )
    
    $
    (1,009
    )Add back:Goodwill amortization
    
    
    21,324Equity method goodwill
amortization
    
    
    356,734Telephone rights
amortization
    
    
    21,470Adjusted net loss
    
    ¥
    (7,046,607
    )
    
    ¥
    (16,476,822
    )
    
    ¥
    (105,139
    )
    
    $
    (1,009
    )
  Basic and diluted net loss per share for each of the three years in the
period ended March 31, 2004 are as follows: Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Reported net loss per share
    
    ¥
    (331,234
    )
    
    ¥
    (732,955
    )
    
    ¥
    (3,316
    )
    
    $
    (32
    )Add back:Goodwill amortization
    
    
    949Equity method goodwill
amortization
    
    
    15,869Telephone rights amortization
    
    
    955Adjusted net loss per share
    
    ¥
    (313,461
    )
    
    ¥
    (732,955
    )
    
    ¥
    (3,316
    )
    
    $
    (32
    )
  The components of intangible assets as of March 31, 2003 and 2004 are as
follows: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Non-amortized intangible assets:Telephone rights
    
    ¥
    162,323
    
    
    ¥
    113,813
    
    
    $
    1,093Goodwill
    
    
    27,528
    
    
    
    27,528
    
    
    
    264Total intangible assets
    
    ¥
    189,851
    
    
    ¥
    141,341
    
    
    $
    1,357
  The company recorded a disposal loss of ¥48,201 thousand on telephone
rights, which were not used by the Company upon cancellation of the
contracts for the usage of telephone circuits for dial-up access services
and the disposal loss was included in general and administrative expenses
for the year ended March 31, 2004.No goodwill was acquired or impaired during the year ended March 31, 2004. F- 25




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##### Table of Contents



7.
    
    LEASESThe Company enters into, in the normal course of business, various leases
for domestic and international backbone services, office premises, network
operation centers and data communications and other equipment. Certain
leases that meet one or more of the criteria set forth in the provision of
SFAS No. 13, Accounting for leases have been classified as capital leases
and the others have been classified as operating leases.Operating LeasesThe Company has operating lease agreements with
telecommunications carriers and others for the use of connectivity lines,
including local access lines that customers use to connect to IIJs
network. The leases for domestic backbone connectivity are generally
either non-cancelable for a minimum one-year lease period or cancelable
during a lease period of three years, with a significant penalty for
cancellation (35 percent). The leases for international backbone
connectivity as of March 31, 2004 are entered into with carriers for lease
periods ranging from one to two years and are substantially non-cancelable.
The Company also leases its office premises, for which refundable lease
deposits are capitalized as guarantee deposits, and certain office
equipment under non-cancelable operating leases which expire on various
dates through the year 2007 and also leases its network operation centers
under non-cancelable operating leases.Refundable guarantee deposits as of March 31, 2003 and 2004 consist of as
follows: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Head office
    
    ¥
    1,705,036
    
    
    ¥
    1,705,036
    
    
    $
    16,366Sales and subsidiaries offices
    
    
    458,299
    
    
    
    324,003
    
    
    
    3,110Others
    
    
    42,317
    
    
    
    46,084
    
    
    
    443Total refundable guarantee deposits
    
    ¥
    2,205,652
    
    
    ¥
    2,075,123
    
    
    $
    19,919
  Lease expenses related to backbone lines for the years ended March 31,
2002, 2003 and 2004 amounted to ¥5,656,116 thousand, ¥5,235,517 thousand
and ¥4,719,638 thousand ($45,303 thousand), respectively. Lease expenses
for local access lines for the years ended March 31, 2002, 2003 and 2004,
which are only attributable to dedicated access revenues, amounted to
¥3,872,101 thousand, ¥3,861,955 thousand and ¥3,500,468 thousand ($33,600
thousand), respectively. Other lease expenses for the years ended March
31, 2002, 2003 and 2004 amounted to ¥2,764,026 thousand, ¥3,551,006
thousand and ¥3,786,739 thousand ($36,348 thousand), respectively.The Company has subleased a part of its office premises. Lease expenses
mentioned above have been reduced by sublease revenues totaling ¥88,895
thousand ($853 thousand) for the year ended March 31, 2004. F- 26




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##### Table of Contents



Capital LeasesThe Company conducts its connectivity and other services by
using data communications and other equipment leased under capital lease
arrangements. The fair values of the assets upon execution of the capital
lease agreements and accumulated depreciation amounted to ¥10,810,872
thousand and ¥5,000,233 thousand at March 31, 2003 and ¥10,420,774 thousand
($100,027 thousand) and ¥5,422,186 thousand ($52,046 thousand) at March 31,
2004, respectively.As of March 31, 2004, future lease payments under non-cancelable operating
leases, including the aforementioned non-cancelable connectivity lease
agreements (but excluding dedicated access lines which the Company charges
outright to customers), and capital leases were as follows: Thousands of Yen
    
    Thousands of U.S. DollarsConnectivity
    
    
    
    
    
    
    
    
    
    ConnectivityLines
    
    Other
    
    
    
    
    
    Lines
    
    OtherOperating
    
    Operating
    
    Capital
    
    Operating
    
    Operating
    
    CapitalLeases
    
    Leases
    
    Leases
    
    Leases
    
    Leases
    
    LeasesYear ending March 31:2005
    
    ¥
    190,176
    
    
    ¥
    1,722,343
    
    
    ¥
    2,524,685
    
    
    $
    1,825
    
    
    $
    16,532
    
    
    $
    24,2342006
    
    
    45,088
    
    
    
    1,582,036
    
    
    
    1,704,832
    
    
    
    433
    
    
    
    15,186
    
    
    
    16,3642007
    
    
    
    
    
    
    76,119
    
    
    
    923,468
    
    
    
    
    
    
    
    730
    
    
    
    8,8642008
    
    
    
    
    
    
    18,196
    
    
    
    254,148
    
    
    
    
    
    
    
    175
    
    
    
    2,4402009
    
    
    
    
    
    
    18,196
    
    
    
    82,136
    
    
    
    
    
    
    
    175
    
    
    
    7882010 and thereafter
    
    
    
    
    
    
    103,110
    
    
    
    18,745
    
    
    
    
    
    
    
    990
    
    
    
    180Total minimum lease payments
    
    ¥
    235,264
    
    
    ¥
    3,520,000
    
    
    
    5,508,014
    
    
    $
    2,258
    
    
    $
    33,788
    
    
    
    52,870Less amounts representing interest
    
    
    
    
    
    
    
    
    
    
    239,962
    
    
    
    
    
    
    
    
    
    
    
    2,303Present value of net minimum capital
lease payments
    
    
    
    
    
    
    
    
    
    
    5,268,052
    
    
    
    
    
    
    
    
    
    
    
    50,567Less current portion
    
    
    
    
    
    
    
    
    
    
    2,387,754
    
    
    
    
    
    
    
    
    
    
    
    22,920Noncurrent portion
    
    
    
    
    
    
    
    
    
    ¥
    2,880,298
    
    
    
    
    
    
    
    
    
    
    $
    27,647
  Minimum payments have not been reduced by minimum sublease revenues, due in
the future under noncancelable subleases, of ¥412,430 thousand ($3,959
thousand) and ¥393,583 thousand ($3,778 thousand) for the years ended March
31, 2005 and 2006, respectively.8.
    
    BORROWINGS AND CONVERTIBLE NOTESShort-term borrowings at March 31, 2003 and 2004 consist of bank overdrafts.
Short-term borrowings bear fixed-rate interest and their weighted average
rates at March 31, 2003 and 2004 were 1.375 percent and 1.464 percent,
respectively. F- 27




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##### Table of Contents



Long-term borrowings as of March 31, 2003 and 2004 consisted of the
following: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Unsecured long-term loans payable to
banks, maturing at various dates
through 2007 (see Note 14). Weighted
average interest rates were 1.767 percent
and 1.686 percent at March 31, 2003
and 2004, respectively.
    
    ¥
    1,400,000
    
    
    ¥
    1,000,000
    
    
    $
    9,599Unsecured long-term loans payable to
banks, maturing at various dates through
2007 (see Note 14). Interest is payable
at a variable rate based on TIBOR which
was 0.08 percent and 0.09 percent as of
March 31, 2003 and 2004, respectively.
Weighted average interest rates were
0.916 percent and 0.987 percent at March
31, 2003 and 2004,
respectively.
    
    
    3,000,000
    
    
    
    2,400,000
    
    
    
    23,037Long-term installments loan payable at
various dates through 2007. Weighted
average interest rates were 2.55 percent
and 2.55 percent at March 31, 2003
and 2004, respectively.
    
    
    1,000,000
    
    
    
    456,265
    
    
    
    4,379Total
    
    
    5,400,000
    
    
    
    3,856,265
    
    
    
    37,015Less current portion
    
    
    (1,943,735
    )
    
    
    (1,548,246
    )
    
    
    (14,861
    )Long-term borrowings, less current
portion
    
    ¥
    3,456,265
    
    
    ¥
    2,308,019
    
    
    $
    22,154
  The Company entered into interest rate swap contracts to manage its
interest rate exposure resulting in a fixed interest rate for a portion of
its long-term debt. The effective weighted average interest rates for
¥3,000,000 thousand and ¥2,400,000 thousand ($23,037 thousand) of the
long-term loan outstanding at March 31, 2003 and 2004 after giving effect
to such swap agreements were 1.787 percent and 1.748 percent per annum,
respectively (see Note 14).On March 14, 2003, the Company entered into a long-term installment loan
agreement with a leasing company to finance the payment for rental deposits
given to other lessor for its new head office. The principal of the loan
is ¥456,265 thousand ($4,379 thousand) and the loan is secured by a first
priority pledge against a claim for the guarantee deposits of ¥1,705,036
thousand ($16,366 thousand) at March 31, 2004.Substantially all short-term and long-term bank borrowings are made under
agreements which, as is customary in Japan, provide that under certain
conditions the bank may require the borrower to provide collateral or
guarantees with respect to the borrowings and that the bank may treat any
collateral, whether furnished as security for short-term or long-term loans
or otherwise, as collateral for all indebtedness to such bank. Also,
provisions of certain loan agreements grant certain rights of possession to
the lenders in the event of default. The Company provided banks with
collateral for outstanding loans by means of establishing a second priority
pledge against the refundable guarantee of ¥1,705,036 thousand ($16,366
thousand) at March 31, 2004. F- 28




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##### Table of Contents



Annual maturities of long-term borrowings outstanding as of March 31, 2004
are as follows: Year Ending
    
    
    
    
    
    Thousands ofMarch 31
    
    Thousands of Yen
    
    U.S. Dollars2005
    
    ¥
    1,548,246
    
    
    $
    14,8612006
    
    
    1,152,056
    
    
    
    11,0582007
    
    
    1,155,963
    
    
    
    11,096Total
    
    ¥
    3,856,265
    
    
    $
    37,015
  The Company entered into bank overdraft agreements with certain Japanese
banks for which the unused balance outstanding as of March 31, 2004 was
¥800,906 thousand ($7,688 thousand).The 1.750 percent unsecured yen convertible notes due March 2005 in the
aggregate principal amount of ¥15,000,000 thousand ($127,043 thousand) were
issued on April 11, 2000. The notes are convertible at the option of the
holders currently at ¥19,875 thousand ($168 thousand) per share at any time
on or before March 15, 2005. The notes are currently redeemable at the
Companys option at any time before March 15, 2005, in whole or in part, at
par with unpaid and accrued interest; provided that the closing trading
price for the Companys shares for a certain period prior to giving notice
of redemption is of at least 140 percent of the conversion price.In October and November 2003, IIJ repurchased a portion of its 1.750
percent unsecured yen convertible notes, with an aggregate face value of
¥3,168,000 thousand ($30,409 thousand), for ¥3,047,460 thousand ($29,252
thousand) in the open market, resulting in realized gain of ¥120,540
thousand ($1,157 thousand).
A portion of deferred issuance cost, amounting to ¥31,565 thousand ($303
thousand), corresponding to the repurchased convertible notes was charged
to income and was offset against the gain. The net realized gain on
retirement of these convertible notes was presented as other income.9.
    
    INCOME TAXESIncome taxes imposed by the national, prefectural and municipal governments
of Japan resulted in a normal statutory rate of approximately 42 percent
for the years ended March 31, 2002, 2003 and 2004, respectively. Total
income tax recognized for the years ended March 31, 2002, 2003 and 2004 are
applicable to the following: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Income tax expense (benefit):Current
    
    ¥
    17,794
    
    
    ¥
    25,581
    
    
    ¥
    30,560
    
    
    $
    293Deferred (benefit)
    
    
    1,081,241
    
    
    
    885,784
    
    
    
    (2,163,571
    )
    
    
    (20,767
    )Other comprehensive income
    
    
    (1,266,877
    )
    
    
    (888,213
    )
    
    
    2,165,547
    
    
    
    20,786Total income tax expense (benefit)
    
    ¥
    (167,842
    )
    
    ¥
    23,152
    
    
    ¥
    32,536
    
    
    $
    312
  Amendments to Japanese tax regulations were enacted into law on March 31,
2003. As a result, normal Japanese statutory rates will be reduced by 1.0
percent to 41.0 percent, effective from the fiscal year beginning April 1,
2004. F- 29




---



##### Table of Contents



Loss from operations before income tax expense (benefit) consists of the
following components: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Domestic
    
    ¥
    (735,359
    )
    
    ¥
    (2,824,286
    )
    
    ¥
    (535,648
    )
    
    $
    (5,142
    )Foreign
    
    
    (154,126
    )
    
    
    (116,036
    )
    
    
    67,984
    
    
    
    653Total
    
    ¥
    (889,485
    )
    
    ¥
    (2,940,322
    )
    
    ¥
    (467,664
    )
    
    $
    (4,489
    )
  Net deferred income tax assets and liabilities at March 31, 2003 are
reflected on the accompanying consolidated balance sheets under captions of
other current assets in the amount of ¥2,429 thousand ($21 thousand).The approximate effect of temporary differences and carryforwards giving rise
to deferred tax balances at March 31, 2003 and 2004 was as follows: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Deferred
    
    Deferred
    
    Deferred
    
    Deferred
    
    Deferred
    
    DeferredTax
    
    Tax
    
    Tax
    
    Tax
    
    Tax
    
    TaxAssets
    
    Liabilities
    
    Assets
    
    Liabilities
    
    Assets
    
    LiabilitiesUnrealized gains on
available-for-sale securities
    
    
    
    
    
    ¥
    372,988
    
    
    
    
    
    
    ¥
    2,553,894
    
    
    
    
    
    
    $
    24,514Valuation of limited partnership
investments for tax purpose
    
    
    
    
    
    
    34,667
    
    
    
    
    
    
    
    39,374
    
    
    
    
    
    
    
    378Capitalized leases
    
    ¥
    69,197
    
    
    
    
    
    
    ¥
    46,666
    
    
    
    
    
    
    $
    448Accrued expenses
    
    
    152,253
    
    
    
    
    
    
    
    206,437
    
    
    
    
    
    
    
    1,982Retirement and pension cost
    
    
    32,886
    
    
    
    
    
    
    
    26,093
    
    
    
    
    
    
    
    250Convertible notes issue cost
    
    
    
    
    
    
    81,304
    
    
    
    
    
    
    
    32,223
    
    
    
    
    
    
    
    309Stock issue cost
    
    
    635
    
    
    
    
    
    
    
    31,095
    
    
    
    
    
    
    
    299Allowance for doubtful accounts
    
    
    21,617
    
    
    
    
    
    
    
    1,476,628
    
    
    
    
    
    
    
    14,174Depreciation
    
    
    46,808
    
    
    
    
    
    
    
    32,147
    
    
    
    
    
    
    
    309Impairment loss on investment
in and deposits for Crosswave
    
    
    3,748,580Operating loss carryforward
    
    
    8,800,850
    
    
    
    
    
    
    
    11,331,442
    
    
    
    
    
    
    
    108,768Other
    
    
    136,701
    
    
    
    13,629
    
    
    
    119,433
    
    
    
    4,523
    
    
    
    1,145
    
    
    
    44Total
    
    
    13,009,527
    
    
    
    502,588
    
    
    
    13,269,941
    
    
    
    2,630,014
    
    
    
    127,375
    
    
    
    25,245Valuation allowance
    
    
    (12,504,510
    )
    
    
    
    
    
    
    (10,639,927
    )
    
    
    
    
    
    
    (102,130
    )Total
    
    ¥
    505,017
    
    
    ¥
    502,588
    
    
    ¥
    2,630,014
    
    
    ¥
    2,630,014
    
    
    $
    25,245
    
    
    $
    25,245
  As of March 31, 2003 and 2004, the valuation allowance for deferred tax
assets has been provided at amounts which are not considered more likely than
not to be realized. The net changes in the valuation allowance for deferred
tax assets were a decrease of ¥1,558,780 thousand, and an increase of
¥10,252,616 thousand and a decrease of ¥1,864,583 thousand ($17,898 thousand)
for the years ended March 31, 2002, 2003 and 2004, respectively. F- 30




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##### Table of Contents



As of March 31, 2004, IIJ, certain domestic subsidiaries and IIJ America, a
U.S. subsidiary, had tax operating loss carryforwards of ¥25,593,681
thousand ($245,668 thousand), ¥1,101,011 thousand ($10,568 thousand) and
$8,465 thousand, respectively. These loss carryforwards are available to
offset future taxable income, and will expire in the period ending March
31, 2009 in Japan and December 31, 2022 in the United States of America as
follows: Year Ending
    
    
    
    
    
    Thousands ofMarch 31
    
    Thousands of Yen
    
    U.S. Dollars2005
    
    ¥
    2,909,955
    
    
    $
    27,9322006
    
    
    1,233,844
    
    
    
    11,8432007
    
    
    962,372
    
    
    
    9,2382008
    
    
    13,790,992
    
    
    
    132,3772009 and thereafter
    
    
    8,679,362
    
    
    
    83,311Total
    
    ¥
    27,576,525
    
    
    $
    264,701
  Due to the change in Japanese income tax laws and regulations effective for
tax years beginning on or after April 1, 2004, the expiration period for
tax loss carryforwards in Japan was extended from five to seven years for
losses incurred for years beginning on or after April 1, 2001, resulting in
the tax loss carryforward expiring in 2011.A reconciliation between the amount of reported income taxes and the amount
of income taxes computed using the normal statutory rate for each of the
three years in the period ended March 31, 2004 is as follows: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Amount computed by using
normal Japanese statutory
tax rate
    
    ¥
    (373,584
    )
    
    ¥
    (1,234,935
    )
    
    ¥
    (196,419
    )
    
    $
    (1,885
    )Increase (decrease) in taxes
resulting from:Expenses not deductible for
tax purpose
    
    
    (23,214
    )
    
    
    37,324
    
    
    
    11,080
    
    
    
    106Inhabitant tax-per capital
    
    
    17,795
    
    
    
    25,581
    
    
    
    30,560
    
    
    
    293Increase (decrease) in
valuation allowance
    
    
    1,557,870
    
    
    
    10,304,655
    
    
    
    (1,711,538
    )
    
    
    (16,429
    )Realization of tax benefit of
operating loss carryforwards
of subsidiaries
    
    
    (18,275
    )
    
    
    (28,091
    )
    
    
    (51,994
    )
    
    
    (499
    )Tax benefit on losses of
equity method investee
    
    
    
    
    
    
    
    
    
    
    (80,355
    )
    
    
    (771
    )Expiration of operating loss
carryforwards
    
    
    
    
    
    
    
    
    
    
    611,498
    
    
    
    5,870Effect of change in tax rate
    
    
    
    
    
    
    327,811
    
    
    
    (42,034
    )
    
    
    (403
    )Tax benefit on losses of
Crosswave
    
    
    
    
    
    
    (8,550,718
    )
    
    
    (722,098
    )
    
    
    (6,931
    )Othernet
    
    
    (61,557
    )
    
    
    29,738
    
    
    
    18,289
    
    
    
    175Income tax expense (benefit) as
reported
    
    ¥
    1,099,035
    
    
    ¥
    911,365
    
    
    ¥
    (2,133,011
    )
    
    $
    (20,474
    )
 F- 31




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##### Table of Contents



10.
    
    RETIREMENT AND PENSION PLANSIIJ and certain subsidiaries have unfunded retirement benefits and
noncontributory defined benefit pension plans which together cover
substantially all of their employees who are not directors and also
participate in a contributory multi-employer pension plan, the Japan
Computer Information Service Employees Pension Fund (the Multi-Employer
Plan), covering substantially all of their employees.Approximately 70 percent of the employees benefits from IIJs severance
indemnity plan was transferred in May 1997 to its newly established
noncontributory defined benefits pension plan. The following information
regarding net periodic pension cost and accrued pension cost also includes
the 30 percent of severance benefits not transferred to the noncontributory
plan. Under the severance and pension plans, all of IIJs employees are
entitled, upon voluntary retirement with 15 years or more service, or upon
mandatory retirement at age 60, to a 10-year period of annuity payments (or
lump-sum severance indemnities) based on the rate of pay at the time of
retirement, length of service and certain other factors. IIJs employees
who do not meet these conditions are entitled to lump-sum severance
indemnities.As stipulated by the Japanese Welfare Pension Insurance Law, the
Multi-Employer Plan is composed of a substitutional portion of Japanese
Pension Insurance and a multi-employers portion of a contributory defined
benefit pension plan. The benefits for the substitutional portion are
based on a standard remuneration schedule under the Welfare Pension
Insurance Law and the length of participation. The multi-employers
portion of the benefits is based on the employees length of service.
However, assets contributed by an employer are not segregated in a separate
account or restricted to provide benefits only to employees of that
employer, including IIJ. The net pension cost under the Multi-Employer
Plan is recognized when contributions become due.The Company adopted revised SFAS No. 132, Employers Disclosures about
Pensions and Other Postretirement Benefits. The revised standard requires
new disclosures in addition to those required by the original standard
about the assets, obligations, cash flows and net periodic benefit cost of
defined benefit pension plans and other defined benefit postretirement
plans. F- 32




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##### Table of Contents



Net periodic pension cost for the years ended March 31, 2002, 2003 and 2004
included the following components: Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Service cost
    
    ¥
    115,258
    
    
    ¥
    142,432
    
    
    ¥
    150,149
    
    
    $
    1,441Interest cost
    
    
    6,930
    
    
    
    9,433
    
    
    
    8,809
    
    
    
    85Expected return on plan assets
    
    
    (6,733
    )
    
    
    (8,499
    )
    
    
    (11,722
    )
    
    
    (113
    )Amortization of transition
obligation
    
    
    402
    
    
    
    402
    
    
    
    402
    
    
    
    4Recognized net actuarial loss
    
    
    
    
    
    
    509
    
    
    
    575
    
    
    
    6Net periodic pension cost
    
    ¥
    115,857
    
    
    ¥
    144,277
    
    
    ¥
    148,213
    
    
    $
    1,423
  The funded status as of March 31, 2003 and 2004 is as follows: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Change in benefit obligation:Benefit obligation at beginning of year
    
    ¥
    471,656
    
    
    ¥
    587,217
    
    
    $
    5,637Service cost
    
    
    142,432
    
    
    
    150,149
    
    
    
    1,441Interest cost
    
    
    9,433
    
    
    
    8,809
    
    
    
    85Actuarial (gain) loss
    
    
    (23,635
    )
    
    
    207,133
    
    
    
    1,988Benefit paid
    
    
    (12,669
    )
    
    
    (19,339
    )
    
    
    (186
    )Benefit obligation at end of year
    
    ¥
    587,217
    
    
    ¥
    933,969
    
    
    $
    8,965Change in plan assets:Fair value of plan assets at beginning
of year
    
    ¥
    339,951
    
    
    ¥
    468,896
    
    
    $
    4,501Actual return on plan assets
    
    
    (22,903
    )
    
    
    41,713
    
    
    
    400Employer contribution
    
    
    160,086
    
    
    
    158,446
    
    
    
    1,521Benefits paid
    
    
    (8,238
    )
    
    
    (12,612
    )
    
    
    (121
    )Fair value of plan assets at end of year
    
    ¥
    468,896
    
    
    ¥
    656,443
    
    
    $
    6,301Funded status
    
    ¥
    (118,321
    )
    
    ¥
    (277,526
    )
    
    $
    (2,664
    )Unrecognized actuarial loss
    
    
    32,498
    
    
    
    209,065
    
    
    
    2,007Unrecognized transition obligation
    
    
    5,222
    
    
    
    4,820
    
    
    
    46Net amount recognized
    
    ¥
    (80,601
    )
    
    ¥
    (63,641
    )
    
    $
    (611
    )Accumulated benefit obligation
    
    ¥
    420,031
    
    
    ¥
    529,360
    
    
    $
    5,081
  Amounts recognized in the consolidated balance sheets consist of accrued
retirement and pension costs of ¥80,601 thousand as of March 31, 2003,
and prepaid pension costs of ¥9,046 thousand ($87 thousand) and accrued
retirement and pension costs of ¥72,687 thousand ($698 thousand) as of
March 31, 2004. F- 33




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##### Table of Contents



The Company uses a March 31 measurement date for all its plans.Actuarial assumptions as of March 31: Benefit
    
    Net PeriodicObligations
    
    Costs2003
    
    2004
    
    2003
    
    2004Discount rate
    
    
    1.5
    %
    
    
    1.6
    %
    
    
    2.0
    %
    
    
    1.5
    %Expected long-term rate of return
on plan assets
    
    
    
    
    
    
    
    
    
    
    2.5
    
    
    
    2.5Rate of compensation in increase
    
    
    2.0
    
    
    
    3.25
    
    
    
    3.0
    
    
    
    2.0
  The Company sets the discount rate assumption annually at March 31 to
reflect the market yield of Japanese Government Bonds matched against the
average remaining service period of employees.The basis for determining the long-term rate of returns is a combination of
historical returns and prospective return assumptions derived from pension
trust funds managing company.IIJs funding policies with respect to the noncontributory plan are
generally to contribute amounts considered tax deductible under applicable
income tax regulations. Plan assets, including pension trust funds managed
by a life insurance company, consist of Japanese Government Bonds, other
debt securities and marketable equity securities. Plan assets managed by
the insurance company are included in pooled investment portfolios.The Companys investment strategy for the plan assets is to manage the
assets in order to pay retirement benefits to plan participants while
minimizing cash contributions from the Company over the life of the plans.
This is accomplished by preserving capital through diversification in equity
and debt securities based on portfolio determined by the insurance company
forecasting macroeconomics in order to maximize long-term rate of return,
while considering the liquidity need of the plans.The Companys pension plan asset allocations as of March 31, 2003 and 2004
by asset category are as follows: 2003
    
    2004Asset category:Equity securities
    
    
    18.7
    %
    
    
    23.6
    %Debt securities
    
    
    19.9
    
    
    
    18.6Life insurance pooled investment portfolios
    
    
    58.3
    
    
    
    53.0Other
    
    
    3.1
    
    
    
    4.8Total
    
    
    100.0
    %
    
    
    100.0
    %
  The unrecognized net loss and the unrecognized net obligation at the date
of initial application are being amortized over 14 years and 21 years,
respectively.Contributions due and paid during the years ended March 31, 2002, 2003 and
2004 under the Multi-Employer Plan, including its substitutional portion,
amounted to ¥234,148 thousand, ¥309,787 thousand and ¥344,900 thousand
($3,311 thousand), respectively.IIJ expects to contribute ¥155,786 thousand ($1,495 thousand) to its
pension plan in the year ending March 31, 2005. F- 34




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##### Table of Contents



Under the Japanese Commercial Code (the Code), the amount of retirement
benefits for retiring directors and statutory auditors are required to be
approved by the shareholders. The benefit of ¥4,630 thousand to a retiring
director was approved by the shareholders at a general meeting of
shareholders on June 26, 2002, and accrued and paid. There were no
benefits determined or paid to retired directors or corporate auditors for
each of three years other than above benefit.11.
    
    SHAREHOLDERS EQUITY (CAPITAL DEFICIENCY)IIJ is subject to the Code to which certain amendments became effective on
October 1, 2001.Prior to October 1, 2001, the Code required at least 50 percent of the
issue price of new shares, with a minimum of the par value thereof, to be
designated as the common stock account as determined by resolution of the
Board of Directors. Proceeds in excess of amounts designated as the common
stock account were credited to capital surplus. Effective October 1, 2001,
the Code was revised and common stock par values were eliminated, resulting
in all shares being recorded with no par value.Prior to October 1, 2001, the Code imposed certain restrictions on the
repurchase and use of treasury stock. Effective October 1, 2001, the Code
eliminated these restrictions beginning April 1, 2002, there by allowing
IIJ to repurchase treasury stock by a resolution of the shareholders at the
general shareholders meeting and dispose of such treasury stock by
resolution of the Board of Directors. The repurchased amount of treasury
stock, cannot exceed the amount available for future dividend plus amount
of common stock, additional paid-in capital or legal reserve to be reduced
in the case where such reduction was resolved at the general shareholders
meeting.The Code permits, upon approval of the Board of Directors, transfers of an
amount from capital surplus to the common stock account.The Code also permits IIJ, upon approval by the Board of Directors, to
issue shares to existing shareholders without consideration to offset a
stock split. Such issuance of shares generally does not give rise to
changes within the shareholders accounts. Prior to October 1, 2001, the
amount calculated by dividing the total amount of shareholders equity by
the number of outstanding shares after the stock split could not be less
than ¥50,000. The revised Code eliminated this restriction. F- 35




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##### Table of Contents



Prior to October 1, 2001, the Code provided that an amount at least equal
to 10 percent of the aggregate amount of cash and certain other cash
payments which are made as an appropriation of retained earnings applicable
to each fiscal period shall be appropriated and set aside as a legal
reserve until such reserve equals 25 percent of the common stock account.
Effective October 1, 2001, the revised Code allows for such appropriations
to be set aside total capital surplus and legal reserve equals 25 percent
of the common stock account. The amount of total capital surplus and legal
reserve which exceeds 25 percent of the common stock account can be
transferred to retained earnings by resolution of the shareholders, which
may be available for dividends. In addition, the Code permits to transfer
a portion of legal reserve to the common stock account by resolution of the
Board of Directors.On June 27, 2003, IIJ issued 3,265 new shares of common stock at ¥418,200
per share for ¥1,365,423 thousand ($13,106 thousand) by a private placement
to third parties in Japan. The proceeds from the private placement were
used as working capital of the Company.On September 17, 2003, mainly in order to provide for the redemption of the
convertible notes due March 2005, IIJ issued 12,615 new shares of common
stock at ¥951,300 per share for ¥12,000,650 thousand ($115,191 thousand) by
a private placement in Japan to NTT for ¥9,603,374 thousand ($92,181
thousand), NTT Communications for ¥749,624 thousand ($7,195 thousand), a
wholly owned subsidiary of NTT, ITOCHU Corporation and Sumitomo Corporation
for each ¥499,432 thousand ($4,794 thousand) and three other companies for
¥648,787 thousand ($6,228 thousand). As a result of the transaction, the
total number of IIJs outstanding common shares increased to 38,360 shares,
and NTT and its subsidiary own 31.6 percent of IIJs outstanding common
 shares. Concurrently, IIJ entered into a Subscription Agreement with NTT
under which IIJ allows NTT to nominate up to three persons as directors or
statutory auditors, subject to approval by IIJs shareholders. The
agreement also provides NTT with preemptive rights to subscribe to any
additional future issuances by IIJ in order to maintain its shareholding.
In addition, IIJ and NTT agreed to undertake efforts to jointly engage in
the development of broadband and information technology and other related
business, to expand the business relationship between the two parties in
connection with new business opportunities of IIJ and discuss secondment of
employees to each other.Upon completion of this transaction, NTT and its subsidiaries are
significant related parties of the Company. The Company entered into a
number of different types of transactions with NTT and its subsidiaries
including purchases of wireline telecommunication services for Companys
offices. For the Companys connectivity and value added services, the
Company purchases international and domestic backbone services, local
access lines and rental rack space in data centers from NTT and its
subsidiaries. The Company sold to NTT and its subsidiaries its services
including OEM services, system integration services and monitoring services
for their data centers.The amounts of balances and major transactions of the Company with NTT and
subsidiaries as of March 31, 2003 and 2004 and for the each of the three
years in the period ended March 31, 2004, are summarized as follows. Thousands ofThousands of Yen
    
    U.S. Dollars2002
    
    2003
    
    2004
    
    2004Accounts receivable
    
    
    
    
    
    ¥
    68,618
    
    
    ¥
    409,459
    
    
    $
    3,930Accounts payable
    
    
    
    
    
    
    202,336
    
    
    
    721,930
    
    
    
    6,930Revenues
    
    ¥
    250,735
    
    
    
    335,620
    
    
    
    954,341
    
    
    
    9,161Costs and expenses
    
    
    3,498,683
    
    
    
    2,992,477
    
    
    
    4,531,189
    
    
    
    43,494
 F- 36




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##### Table of Contents



Stock Option PlansIn May 2000, IIJ granted 295 options to 34 directors and
employees. The options vested 100 percent on April 8, 2002 and are
exercisable for eight years from that date. In August 2001, IIJ granted
395 options to 44 directors and employees. The options vested 100 percent
on June 28, 2003 and are exercisable for eight years from that date. No
options were available for additional grant as of March 31, 2004. No
compensation expense has been recognized in the consolidated statements of
operations pursuant to APB No. 25, because the exercise price was greater
than the market price on the dates of grant. In March 2000, IIJ Technology
issued bonds with 2,000 detachable warrants in the amount of ¥600,000
thousand. The bonds were repurchased in April 2000 and warrants to
purchase the subsidiarys 775 common shares at an exercise price of
¥300,000 per share based on fair market value were immediately purchased by
certain officers and employees of the Company and the subsidiary. One
thousand warrants were purchased and maintained by the Company. Warrants
are exercisable upon issuance. All of the warrants of IIJ Technology
remain outstanding as of March 31, 2004.The following table summarizes the transactions of IIJs stock option plans
for the three years in the period ended March 31, 2004: Thousands of YenWeighted AverageExercise Price perNumber of Shares
    
    Common SharesUnexercised options outstandingApril 1, 2001
    
    
    290
    
    
    ¥
    13,056Options granted
    
    
    395
    
    
    
    2,018Options exercisedOptions forfeitedUnexercised options outstandingMarch 31, 2002
    
    
    685
    
    
    ¥
    6,691Options grantedOptions exercisedOptions forfeited
    
    
    10
    
    
    
    7,537Unexercised options outstandingMarch 31, 2003
    
    
    675
    
    
    ¥
    6,678Options grantedOptions exercisedOptions forfeited
    
    
    60
    
    
    
    9,364Unexercised options outstandingMarch 31, 2004
    
    
    615
    
    
    ¥
    5,315
 F- 37




---



##### Table of Contents



Summarized information about stock options outstanding as of March 31, 2004
is as follows: Outstanding
    
    ExercisableExercise Price
    
    Number of
    
    Remaining Life
    
    Number of(Thousands of Yen)
    
    Options
    
    (in Years)
    
    Options¥10,817
    
    
    245
    
    
    
    6
    
    
    
    2451,672
    
    
    370
    
    
    
    7.3
    
    
    
    370
  The fair value of IIJs options reported below has been estimated at the
date of grant using the Black-Scholes option pricing model with the
following assumptions: 2001
    
    2002Stock options:Expected life from vesting date (in years)
    
    
    4.0
    
    
    
    4.0Risk-free interest rates
    
    
    1.39
    %
    
    
    0.72
    %Volatility
    
    
    148
    %
    
    
    51
    %Dividend yield
  The Black-Scholes option pricing model was developed for use in estimating
the fair value of traded options that have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input
of highly subjective assumptions, including the expected stock price
volatility. The Companys options have characteristics significantly
different from those of traded options, and changes in the subjective input
assumptions can materially affect the fair value estimate. Based upon the
above assumptions, the fair value of IIJs stock options granted during the
years ended March 31, 2001 and 2002 were ¥11,875 thousand per common share
and ¥621 thousand per common share, as compared to corresponding original
exercise price of ¥13,056 thousand and ¥2,018 thousand, respectively.12.
    
    OTHER COMPREHENSIVE INCOMEThe change in each component of other comprehensive income (loss) for the
years ended March 31, 2002, 2003 and 2004 is as follows: Thousands of YenBefore Tax
    
    Tax (Expense)
    
    Net of TaxAmount
    
    or Benefit
    
    AmountYear ended March 31, 2002:Foreign currency translation adjustments
    
    ¥
    26,933
    
    
    
    
    
    
    ¥
    26,933Unrealized holding gain (loss) on
securities:Amount arising during the period
    
    
    (3,318,017
    )
    
    ¥
    1,393,538
    
    
    
    (1,924,479
    )Less: Reclassification adjustments for
losses included in net loss
    
    
    301,580
    
    
    
    (126,661
    )
    
    
    174,919Net unrealized holding gain (loss) during
the period
    
    
    (3,016,437
    )
    
    
    1,266,877
    
    
    
    (1,749,560
    )Loss on cash flow hedging derivative
instruments:Effect of adopting SFAS No. 133
    
    
    (25,594
    )
    
    
    
    
    
    
    (25,594
    )Amount arising during the period
    
    
    (22,385
    )
    
    
    
    
    
    
    (22,385
    )Less: Reclassification adjustments for
losses included in net loss
    
    
    14,272
    
    
    
    
    
    
    
    14,272Net loss on cash flow hedging derivative
instruments
    
    
    (33,707
    )
    
    
    
    
    
    
    (33,707
    )Other comprehensive income (loss)
    
    ¥
    (3,023,211
    )
    
    ¥
    1,266,877
    
    
    ¥
    (1,756,334
    )Year ended March 31, 2003:Foreign currency translation adjustments
    
    ¥
    (22,423
    )
    
    
    
    
    
    ¥
    (22,423
    )Unrealized holding gain (loss) on
securities:Amount arising during the period
    
    
    (2,207,010
    )
    
    ¥
    927,041
    
    
    
    (1,279,969
    )Less: Reclassification adjustments for
losses included in net loss
    
    
    92,439
    
    
    
    (38,828
    )
    
    
    53,611Net unrealized holding gain (loss) during
the period
    
    
    (2,114,571
    )
    
    
    888,213
    
    
    
    (1,226,358
    )Loss on cash flow hedging derivative
instruments:Amount arising during the period
    
    
    (30,452
    )
    
    
    
    
    
    
    (30,452
    )Less: Reclassification adjustments for
losses included in net loss
    
    
    26,438
    
    
    
    
    
    
    
    26,438Net loss on cash flow hedging derivative
instruments
    
    
    (4,014
    )
    
    
    
    
    
    
    (4,014
    )Other comprehensive income (loss)
    
    ¥
    (2,141,008
    )
    
    ¥
    888,213
    
    
    ¥
    (1,252,795
    )
 F- 38




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##### Table of Contents



Thousands of YenBefore Tax
    
    Tax (Expense)
    
    Net of TaxAmount
    
    or Benefit
    
    AmountYear ended March 31, 2004:Foreign currency translation adjustments
    
    ¥
    (45,582
    )
    
    
    
    
    
    ¥
    (45,582
    )Unrealized holding gain (loss) on
securities:Amount arising during the period
    
    
    5,354,719
    
    
    ¥
    (2,184,739
    )
    
    
    3,169,980Less: Reclassification adjustments for
gains included in net loss
    
    
    (47,040
    )
    
    
    19,192
    
    
    
    (27,848
    )Net unrealized holding gain (loss) during
the period
    
    
    5,307,679
    
    
    
    (2,165,547
    )
    
    
    3,142,132Gain on cash flow hedging derivative
instruments:Amount arising during the period
    
    
    (7,561
    )
    
    
    
    
    
    
    (7,561
    )Less: Reclassification adjustments for
losses included in net loss
    
    
    26,303
    
    
    
    
    
    
    
    26,303Net gain on cash flow hedging derivative
instruments
    
    
    18,742
    
    
    
    
    
    
    
    18,742Other comprehensive income (loss)
    
    ¥
    5,280,839
    
    
    ¥
    (2,165,547
    )
    
    ¥
    3,115,292
 Thousands of U.S. DollarsBefore Tax
    
    Tax (Expense)
    
    Net of TaxAmount
    
    or Benefit
    
    AmountYear ended March 31, 2004:Foreign currency translation adjustments
    
    $
    (438
    )
    
    
    
    
    
    $
    (438
    )Unrealized holding gain (loss) on
securities:Amount arising during the period
    
    
    51,398
    
    
    $
    (20,970
    )
    
    
    30,428Less: Reclassification adjustments for
gains included in net loss
    
    
    (451
    )
    
    
    184
    
    
    
    (267
    )Net unrealized holding gain (loss) during
the period
    
    
    50,947
    
    
    
    (20,786
    )
    
    
    30,161Gain on cash flow hedging derivative
instruments:Amount arising during the period
    
    
    (72
    )
    
    
    
    
    
    
    (72
    )Less: Reclassification adjustments for
losses included in net loss
    
    
    252
    
    
    
    
    
    
    
    252Net gain on cash flow hedging derivative
instruments
    
    
    180
    
    
    
    
    
    
    
    180Other comprehensive income (loss)
    
    $
    50,689
    
    
    $
    (20,786
    )
    
    $
    29,903
 F- 39




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##### Table of Contents



The components of accumulated other comprehensive income (loss) at March
31, 2003 and 2004 are as follows: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Foreign currency translation
adjustments
    
    ¥
    38,145
    
    
    ¥
    (7,437
    )
    
    $
    (71
    )Net unrealized holding gain on
securitiesnet of tax
    
    
    529,842
    
    
    
    3,671,974
    
    
    
    35,246Loss on cash flow hedging derivative
instruments
    
    
    (37,721
    )
    
    
    (18,979
    )
    
    
    (182
    )¥
    530,266
    
    
    ¥
    3,645,558
    
    
    $
    34,993
  13.
    
    COMMITMENTS AND CONTINGENT LIABILITIESThe Company adopted FASB Interpretation No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others (FIN 45). FIN 45 elaborates on the disclosures
to be made by a guarantor about its obligations under certain guarantees.
It also clarifies that a guarantor is required to recognize, at the
inception of a guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. With respect to initial recognition
and initial measurement of guarantees, the adoption of FIN 45 had no effect
on the Companys financial position or results of operations for the year
ended March 31, 2004.In December 2001, a class action complaint alleging violations of the
federal securities laws was filed against the Company, naming IIJ, certain
of its officers and directors as defendants, and underwriters of IIJs
initial public offering. Similar complaints have been filed against over
300 other issuers that have had initial public offerings since 1998 and
such actions have been included in a single coordinate proceeding in the
Southern District of New York. An amended complaint was filed on April 24,
2002 alleging, among other things, that the underwriters of IIJs initial
public offering violated the securities laws (i) by failing to disclose in
the offerings registration statement certain alleged compensation
arrangements entered into with the underwriters clients, such as
undisclosed commissions or tie-in agreements to purchase stock in the
after-market, and (ii) by engaging in manipulative practices to
artificially inflate the price of IIJs stock in the after-market
subsequent to the initial public offering. On July 15, 2002, the Company
joined in an omnibus motion to dismiss the amended complaint filed by the
issuers and individuals named in the various coordinated cases. In June
2003, the Company approved a settlement with the plaintiffs in this matter.
In June 2004, the Company along with the plaintiffs, the insurers, and
virtually all of the other solvent issuer companies in the coordinate
cases, executed an agreement of settlement, which has been submitted to the
United States District Court for the Southern District of New York for
preliminary approval. The settlement releases IIJ and the individual
defendants for liability for the conduct alleged in the action. Under the
settlement, the Company agreed to assign away, not assert, or release
certain potential claims the Company may have against IIJs underwriters.
Approximately 260 defendant issuers participated in this settlement. As to
financial impact on the Company, the settlement provides that the class
members will be guaranteed $1 billion (¥104 billion ) in recoveries by the
insurers of the issuers. In addition to IIJs portion of the proposed
settlement, some of the continuing legal expenses incurred in connection
with the partial settlement would be borne by IIJs insurer based on the
settlement agreement and an individual agreement between IIJ and IIJs
insurer. Consequently, the Company believes that there will be no
significant financial impact on the Company as a result of this matter.In addition to the foregoing, the Company is a party to other suits and
claims that arise in the normal course of business. The negative adverse
outcome of such suits and claims would not have a significant impact on the
financial statements.14.
    
    DERIVATIVE AND OTHER FINANCIAL INSTRUMENTSInterest Rate Swap AgreementThe Company is exposed to changes in interest
rates that are associated with long-term bank borrowings. The Companys
policy on managing the interest rate risk is to hedge the exposure to
variability in future cash flows of floating rate interest payments on the
long-term bank borrowings. In order to reduce cash flow risk exposures on
floating rate borrowings, the Company utilizes interest rate swap
agreements to convert a floating rate borrowing to a fixed rate borrowing. F- 40




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##### Table of Contents



The Company is also exposed to credit-related losses in the event of
non-performance by counterparties to interest rate swaps, but it is not
expected that any counterparties will fail to meet their obligations,
because counterparties are internationally recognized financial
institution.Changes in fair value of interest rate swaps designated as hedging
instrument is reported in accumulated other comprehensive income during the
years ended March 31, 2003 and 2004. These amounts subsequently are
reclassified into interest expense as a yield adjustment in the same period
in which the hedged bank borrowings affect earnings. The term, notional
amount and repricing date of interest rate swaps exactly match those of the
long-term borrowings. The swap terms are at the market, so they have
zero value at inception. Thus, there was no ineffectiveness recognized in
earning for the years ended March 31, 2002, 2003 and 2004. For the years
ended March 31, 2002, 2003 and 2004, net derivative loss of ¥14,272
thousand, ¥26,438 thousand and ¥26,303 thousand ($252 thousand) were
reclassified to interest expense, respectively.Approximately ¥18,275 thousand ($175 thousand) of accumulated other
comprehensive loss related to the interest rate swaps are expected to be
reclassified as an adjustment to interest expense as a yield adjustment of
the hedged bank borrowings within the next 12 months.Fair ValueIn the normal course of business, the Company invests in
financial assets and incurs financial liabilities. To estimate the fair
value of those financial assets, liabilities and derivatives, the Company
used quoted market prices to the extent that they were available. Where a
quoted market price is not available, the Company estimates fair value
using primarily the discounted cash flow method. For certain financial
assets and liabilities, such as trade receivables and trade payables, which
are expected to be collected and settled within one year, the Company
assumed that the carrying amount approximates fair value due to their short
maturities. Investment for which is not practicable are investments in a
number of unaffiliated and unlisted smaller sized companies and the
estimate of their fair values cannot be made without incurring excessive
costs. Refundable insurance policies are carried at cash surrender value.
The carrying amounts or notional amounts and fair value of financial
instruments are summarized below: Thousands ofThousands of Yen
    
    U.S. Dollars2003
    
    2004
    
    2004Carrying
    
    Fair
    
    Carrying
    
    Fair
    
    Carrying
    
    FairAmount or
    
    Value
    
    Amount or
    
    Value
    
    Amount or
    
    ValueNotional
    
    or Gain
    
    Notional
    
    or Gain
    
    Notional
    
    or GainAmount
    
    (Loss)
    
    Amount
    
    (Loss)
    
    Amount
    
    (Loss)Other
investments
for which it is:Practicable to
estimate
fair value
    
    ¥
    1,179,916
    
    
    ¥
    1,179,916
    
    
    ¥
    6,572,985
    
    
    ¥
    6,572,985
    
    
    $
    63,093
    
    
    $
    63,093Not practicable
    
    
    1,860,273
    
    
    
    
    
    
    
    1,358,908
    
    
    
    
    
    
    
    13,043Noncurrent
refundable
insurance
policies
(other assets)
    
    
    42,180
    
    
    
    42,180
    
    
    
    55,753
    
    
    
    55,753
    
    
    
    535
    
    
    
    535Long-term
borrowings,
installment
payable and
convertible
notes,
including
current
portion
    
    
    20,400,000
    
    
    
    18,004,239
    
    
    
    15,688,265
    
    
    
    15,570,181
    
    
    
    150,588
    
    
    
    149,455Interest rate
swap contracts
    
    
    3,000,000
    
    
    
    (37,721
    )
    
    
    2,400,000
    
    
    
    (18,979
    )
    
    
    23,037
    
    
    
    (182
    )
 F- 41




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##### Table of Contents



Cash at March 31, 2003 and 2004 includes U.S. dollar denominated current
bank deposits of ¥1,360,644 thousand and ¥663,432 thousand ($6,368
thousand), respectively.15.
    
    ADVERTISING EXPENSESAdvertising expenses incurred during the years ended March 31, 2002, 2003
and 2004 consist principally of advertisement within magazines, journals
and newspapers and amounted to ¥397,263 thousand, ¥278,474 thousand and
¥106,525 thousand ($1,023 thousand), respectively.16.
    
    SUBSEQUENT EVENTSOn April 28, 2004, the Companys board of directors resolved to
repurchase and cancel a portion of the outstanding convertible notes. Terms of the repurchase of convertible notes are as follows:1. Maximum amount of the repurchase
    
    ¥2.0 billion based on the principal amount2. Maximum unit price of the repurchase
    
    100.5 per unit3. Limit date of the repurchase
    
    June 30, 2004
  Based on this resolution, the Company repurchased a principal amount
of ¥744 million ($7.1 million) of the convertible notes for ¥745.9 million
(100.2 per unit) on April 30, 2004. * * * * * * F- 42