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THE PROSPECT JAPAN FUND LIMITED

ANNUAL REPORT AND AUDITED FINANCIAL STATEMENTS

For the year from 1 January, 2006 to 31 December, 2006


CONTENTS

Management 2

Chairman's Report 4

Investment Advisor's Report 5

Directors' Report 7

Portfolio of Investments 11

Independent Auditor's Report 13

Financial Statements

Income Statement 14

15

Balance Sheet 16

Cash Flow Statement 17

Notes to the Financial Statements 18

General Information 25

1

Reconciliation of Movements in Shareholders' Funds and Reserves


MANAGEMENT AND THE ADVISORS

DirectorsDavid H. FitzWilliam-Lay (Chairman) John A. Hawkins Trafalgar Court, Trafalgar Court,Les Banques, Les Banques,St Peter Port, St Peter Port,Guernsey, Guernsey,Channel Islands Channel Islands

Rupert A. R. Evans Christopher W. Sherwell Trafalgar Court, Trafalgar Court,Les Banques, Les Banques,St Peter Port, St Peter Port,Guernsey, Guernsey,Channel Islands Channel Islands

Registered OfficeTrafalgar Court,Les Banques,St Peter Port,Guernsey,Channel Islands

Manager CustodianProspect Asset Management (Channel Islands) Limited, HSBC Custody Services (Guernsey) Ltd.,Trafalgar Court, Arnold House,Les Banques, St. Julian's Avenue,St Peter Port, St. Peter Port,Guernsey, Guernsey,Channel Islands Channel Islands

GY1 3NFInvestment AdvisorProspect Asset Management, Inc., Secretary, Registrar and Administrator6700 Kalanianaole Highway, Northern Trust International Fund Administration Suite 122, Services (Guernsey) LimitedHonolulu, Trafalgar Court,United States of America Les Banques,HI 96822 St Peter Port,

Guernsey,Channel Islands

2


MANAGEMENT AND THE ADVISORSContinued

Legal Advisers Corporate BrokerEngland Close Brothers Securities,Slaughter and May, The Atrium Building,35 Basinghall Street, Cannon Bridge,London, 25 Dowgate Hill,United Kingdom London,EC2V 5DB United Kingdom

EC4R 2GAGuernseyOzannes, Crest Agent1 Le Marchant Street, Computershare Investor ServicesSt. Peter Port, (Channel Islands) LimitedGuernsey, Ordnance HouseChannel Islands 31 Pier Road, St. HelierGY1 4HP Jersey

JE4 8PWUnited StatesCarter, Ledyard & Milburn,2 Wall Street,New York,New York 10005-2072United States of America

AuditorErnst & Young LLP,14 New Street,St. Peter Port,Guernsey,Channel IslandsGY1 4AF

BankersHSBC Bank plc,Mariner House,Pepys Street,LondonEC3N 4DA

3


CHAIRMAN'S REPORTfor the year from 1 January, 2006 to 31 December, 2006

Performance – The Japanese small cap market suffered a year of negative returns during 2006, with Topix Smalldown 12.03% for the year. During this review period, the net asset value (“NAV”) per share of the Company returned-8.47% (on a bid basis). A more detailed review of the Company’s performance appears in the Investment Adviser’sReport. The shares ended the year trading at a discount of 4.9% (2005: 5.7%) to the underlying NAV per share.

Dividend – As with previous years and in line with expectation, the Company has not earned sufficient income to paya dividend to shareholders.

Directorate – Mr Rupert A. R. Evans is subject to annual re-election due to his position as a Director of the Managerand, being eligible, has offered himself for re-election. All of the other Directors are totally independent and thisprovides an appropriate balance.

Due to the length of my tenure on the Board I am subject to annual re-election and I offer myself for such re-election.My fellow Directors have met in my absence for the purpose of considering my eligibility for re-election. Theyconsidered that my experience, my independence of mind and the manner in which I have filled the role of Chairmanover the last 13 years has been beneficial to the Company. They confirmed that they wish me to continue as Chairmanand they are recommending that I be re-elected as a Director at the forthcoming Annual General Meeting.

Mr John A. Hawkins is also subject to re-election in accordance with Article 76 of the Articles of Association of theCompany.

The Board has considered the proposal for the re-election of each of the above-named Directors and recommends toshareholders that they vote in favour of the proposals.

Continuation Vote – In accordance with the Articles of Association of the Company, a Special Resolution that theCompany be wound up was considered at the 2005 Annual General Meeting. Shareholders voted against the SpecialResolution in line with the recommendations of the Board. A further continuation vote will be held at the AnnualGeneral Meeting in 2008.

Directors' remuneration – The Board has reviewed the level of remuneration received and intends that Directors’fees for 2007 increase to £20,000 per annum for the Chairman, £17,500 per annum for the Chairman of the AuditCommittee and £15,000 per annum for Directors. A Special Resolution is being put forward at the Company’s AnnualGeneral Meeting to increase the total level of Directors’ remuneration permitted under the Articles of Association.

Annual General Meeting – The Annual General Meeting of the Company is due to take place on 23 May, 2007 at16.00 at the Company’s registered office at Trafalgar Court, St Peter Port, Guernsey. Full details of the meeting aregiven in the Company's Annual Report.

David Fitzwilliam-LayChairman

4


INVESTMENT ADVISOR'S REPORTfor the year from 1 January, 2006 to 31 December, 2006

Market Performance (%), US$ NAV1 Year 3 Year 5 Year

(31.12.2006)Prospect Japan Fund (8.47) 63.88 164.06

Topix Small (12.03) 58.49 136.88

TSE2 (19.21) 81.04 187.83

Prospect Japan Fund Limited's (the Company's") inception date was 20 December 1994. Topix Small is the capitalization-weighted index designed to measure the stocks not included in the Topix 500 Index that are listed on the First Section of theTokyo Stock Exchange. TSE2 is the capitalization-weighted index of all companies listed on the Second Section of the TokyoStock Exchange. As of August 2003, the benchmark of the Company changed from TSE2 to Topix Small since its characteristicswith respect to average market capitalization more closely resemble the investment strategy pursued by the portfolio. The aboveperformance of the Fund is net of fees and expenses and includes reinvestment of dividends and capital gains. Source: ProspectAsset Management, Inc. Topix Small and TSE2 Index performance includes the reinvestment of dividends. Source: Bloomberg.

SummaryAfter an exceptional year in 2005, the Japanese small cap market retracted significantly in 2006. The Company'sbenchmark index, the Topix Small, which represents the Topix’s smallest stocks by market capitalization, fell12.03% in 2006 (Source: Bloomberg, USD Total Return). The Company's NAV also fell by 8.86% for the year;however, strategic holdings in JREITS, one of the best performing sector indices of the Japanese stock market in2006, contributed positively to the Company's performance.

Small cap has underperformed large cap since the Livedoor scandal in January. The valuation premium of small capover large has narrowed to the point where several brokers recently upgraded their view on small cap from negativeto neutral. The large cap market rally at the end of the year was fuelled by a series of strong macro economic datareleased throughout the month, in particular, the December Tankan, which indicated business confidence is at a twoyear high. Despite the strong indicators, the Bank of Japan postponed a rate hike until sometime in 2007.

JREITs which comprise a significant part of the Company's exposure have been a bright spot for the Company. In2006, the Tokyo Stock Exchange REIT Index had a total return of 27.53% in USD for the year (Bloomberg). Whilethe valuation story is intact, it would appear this latest upward move is being driven by both individuals searching foryield and by simple weight of money. The REIT Index even now carries an average yield of 2.6% versus 1.7% onJGBs and 1.1% on companies in the Topix Index (Bloomberg). December saw several REIT specific funds launchedby domestic brokers, and we expect several more given the current picture of the 2007 pipeline.

OutlookMacro data aside, other reasons to be sanguine for 2007, in our view, include the following factors. On the policyfront, we believe there are several government tax reform proposals which should prove to be bullish for equities.Among these proposals are extensions of tax breaks for capital gains and dividends. The December macro datacaused a sell off in JGBs, and we expect going into next year asset re-allocation out of fixed income and into equities.Many of these investors will continue to search for yield, which should continue to underpin the REIT market.

5


INVESTMENT ADVISOR'S REPORT Continuedfor the year from 1 January, 2006 to 31 December, 2006

ATSE REIT Index is a capitalization-weighted index of all Real Estate Investment Trusts listed on the Tokyo Stock Exchange.

The Prospect Japan Fund Limited is a closed-end investment company incorporated in Guernsey, and listed on the LondonStock Exchange. The Company's investment objective is to achieve long-term capital growth from a portfolio of securitiesprimarily of smaller Japanese companies listed or traded on Japanese Stock Markets. Past performance is no indication offuture results. This report does not constitute an offer of shares of Prospect Japan Fund nor the solicitation of an offer to buysuch shares. There are risks involved with investing, including possible loss of principal. In addition to the normal risksassociated with investing, narrowly focused investments, investments in smaller companies, illiquid investments and investmentsin single countries typically exhibit higher volatility. International investments may involve risk of capital loss from unfavorablefluctuation in currency values, from differences in generally accepted accounting principles or from economic or politicalinstability in other nations.

The Board of the Company decided that the Company should become a member of the AIC (The Association of InvestmentCompanies) in 2005. The AIC only accepts valuations where the underlying assets are valued on a 'Fair' basis, which in the case of the Company, means on a bid basis (per the AIC). While the Annual Financial Statements for the year ending 31 December,2005 and Interim Financial Statements for period ended 30 June 2006 were reflected at Bid Values to comply with newaccounting standards effective from 1 January, 2005, the trading NAV continued to be reflected at mid values. Upon the Board'sapproval, the Company's administrator Northern Trust made a change to the pricing methodology in February 2006 in thetrading NAV, whereby underlying assets in the Company are also valued using the ‘last bid price.’ Consequently, theCompany’s Net Asset Value and performance from February 2006 reflects the change in this pricing methodology. In addition,in newsletters from February to September 2006, as a result of the new pricing methodology, Prospect had been calculatingperformance based on an un-rounded Net Asset Value. In October 2006, Prospect made a decision to calculate performancebased on a Net Asset Value rounded to the nearest hundredth. Therefore, the monthly performance from February to Septemberwas modified to reflect this change. The performance from October 2006 and going forward will incorporate this change.Additional information regarding policies for calculating and reporting returns is available upon request

Prospect Asset Management Inc. is registered as an investment adviser under the United States Investment Advisers Act of 1940,as amended, with Securities and Exchange Commission number 801-47749.

Prospect Asset Management, Inc.March 2007

6


DIRECTORS' REPORT

Increase in cash

The Directors present their Annual Report and the Audited Financial Statements of the Company for the year ended 31December, 2006.

The Company's BusinessThe Company was registered under the laws of Guernsey on 18 November, 1994 as a Limited Company listed on theLondon Stock Exchange. It is a closed-ended investment company established to achieve long-term capital growthfrom an actively managed portfolio of securities primarily of smaller Japanese companies listed or traded on JapaneseStock Markets.

Results and DividendThe results for the year are set out in the Income Statement on page 14. The Directors do not recommend the paymentof a dividend for the year.

PerformanceThe Board considers that Prospect Asset Management (Channel Islands) limited, the theCompany, is managing the Company's investments in a manner that is most likely to achieve the objective of long termcapital appreciation for its shareholders.

Corporate Governance PrinciplesThe Committee on Corporate Governance published its latest report on the principles of good governance and code ofbest practice (the “Combined Code”, or the “Code”) in July 2003. The Company is a Guernsey incorporated company,and as such is not required to comply with the Code. However, the Directors place a high degree of importance onensuring that high standards of corporate governance are maintained and have therefore adopted the spirit of the Code.

The Board having reviewed the Code, considers that it has maintained procedures during the year ended 31 December,2006 to ensure that it complies with the spirit of the Code subject to the exceptions explained below and its specialcircumstances as an offshore company.

Directors' ResponsibilitiesThe Board comprises four non-executive directors. All members of the Board other than Mr Evans are independent ofthe Manager. None of the Directors has a contract of service with the Company.

The Board meets on at least four occasions each year, at which time the Directors review the investment management ofthe Company’s assets and all other significant matters so as to ensure that the Directors maintain overall control andsupervision of the Company’s affairs. The Board is responsible for the appointment and monitoring of all serviceproviders to the Company.

The Directors are responsible for preparing the Annual Report and the Financial Statements in accordance withapplicable laws and United Kingdom Accounting Standards. The Directors are responsible for preparing FinancialStatements for each financial year which give a true and fair view of the state of affairs of the Company and of thereturn for that Company for that period.

In preparing these Financial Statements, the Directors are required to:

* select suitable accounting policies and then apply them consistently;* make judgements that are reasonable and prudent; and* prepare the Financial Statements on the going concern basis unless it is inappropriate to assume that the Companywill continue in business.

7

Investment Manager to


DIRECTORS' REPORTContinued

The Directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at anytime the financial position of the Company and to enable them to ensure that the Financial Statements comply with TheCompanies (Guernsey) Law, 1994. They are also responsible for safeguarding the assets of the Company and hencefor taking reasonable steps for the prevention and detection of fraud, error and non-compliance with law or regulations.

Chairman, Senior Independent Director and Chief ExecutiveThe Chairman of the Board is David FitzWilliam-Lay. A biography for Mr FitzWilliam-Lay and all other Directorsappears on page 26. In considering the independence of the Chairman, who has served as a Director for more than tenyears, the Board has taken note of the provisions of the Code relating to length of service of Directors, but considersthat lengthy service on the Board does not of itself compromise independence. It believes that Mr FitzWilliam-Lay is anindependent Director. As the Chairman is an independent Director, no appointment of a senior independent director hasbeen made. The Company has no employees and therefore there is no requirement for a chief executive.

Re-electionIn accordance with the Company’s Articles of Association, all newly appointed Directors stand for election by theshareholders at the next Annual General Meeting following their appointment. The Directors retire by rotation and offerthemselves for re-election every three years. Directors who have served on the Board for more than nine years aresubject to annual re-election. The non-independent Director is subject to annual re-election.

Supply and Agenda of InformationThe quarterly board meetings are the principal source of regular information for the Board enabling it to determinepolicy and to monitor performance and compliance. The Manager attends each Board meeting either in person or bytelephone thus enabling the Board to fully discuss and review the Company’s operation and performance. EachDirector has direct access to the Company Secretary, and may, at the expense of the Company, seek independentprofessional advice on any matter that concerns them in the furtherance of their duties.

Nomination CommitteeThe Board as a whole fulfils the function of a Nomination Committee. Whilst the independent Directors take the lead inthe appointment of new Directors, any proposal for a new Director will be discussed and approved by all of the Board.

Directors’ RemunerationThe level of Directors’ fees is determined by the whole Board on an annual basis and therefore a separate RemunerationCommittee has not been appointed. When considering the level of Directors’ remuneration the Board considers theindustry standard and the level of work that is undertaken. Since all Directors are non-executive, the Company is notrequired to comply with the principles of the Code in respect of executive directors’ remuneration. Directors’ fees aredisclosed in this report.

For the year ended 31 December, 2006, the Directors were entitled to receive an annual fee of £10,000, the Chairman ofthe Audit Committee £12,000 and the Chairman of the Board £15,000. The Board has reviewed the level ofremuneration received and in light of the industry standard level of fees for similar investment companies, will put aspecial resolution before the shareholders at the Annual General Meeting in 2007 to amend the articles to increaseaggregrate directors fees that can be paid from US$100,000 annually to £150,000 annually. It is proposed to increasefees as follows: Chairman of the Board £20,000, Director £15,000, and Chairman of the Audit Committee £17,500.

Going ConcernThe Directors believe that it is appropriate to continue to adopt the going concern basis in preparing the accounts sincethe assets of the Company consist mainly of securities which are readily realisable and, accordingly, the Company hasadequate financial resources to continue in operational existence for the foreseeable future.

8



Increase in cash

Audit Committeeappointed comprising the independent Directors, with John Hawkins appointed as

Chairman. The Audit Committee operates within clearly defined terms of reference which have been approved by theBoard and provides a forum through which the Company’s external Auditors report to the Board. The Board is satisfiedthat the Audit Committee contains members with sufficient recent and relevant financial experience.

The Audit Committee has considered the requirement for an annual internal audit of the Company. On the basis that theCompany is an investment company with no employees, the Audit Committee believes that an internal audit function isnot necessary for the Company.

Management and Engagement CommitteeAt a Board Meeting held on 18 April, 2007 it was resolved that a Management and Engagement Committee beappointed comprising the independent Directors, with John Hawkins appointed as Chairman. The Management andEngagement Committee operates within clearly defined terms of reference which have been approved by the Board. TheBoard is satisfied that the Management and Engagement Committee contains members with sufficient recent andrelevant financial experience.

The purpose of this committee is to review the performance of the Investment Advisor and the third party serviceproviders to the Company.

Dialogue with ShareholdersThe Investment Adviser maintains a regular dialogue with institutional shareholders, feedback from which is reported tothe Board. In addition, Board members and representatives of the Manager are available to answer shareholders'questions at the Annual General Meeting. The Company Secretary is available to answer general shareholders' queries atany time during the year.

Internal ControlThe Board is responsible for establishing and maintaining the Company’s system of internal control and for maintainingand reviewing its effectiveness. The system of internal controls is designed to manage rather than to eliminate the risk offailure to achieve business objectives and as such can only provide reasonable, but not absolute assurance againstmaterial misstatement or loss.

The Board considers on an ongoing basis the process for identifying, evaluating and managing any significant risksfaced by the Company. The process includes reviewing reports from the Company Secretary on risk control andcompliance, in conjunction with the Manager’s regular reports which cover investment performance.

The Board has contractually delegated to external parties various functions as listed below. The duties of investmentmanagement, accounting and custody are segregated. Each of the contracts entered into with the parties was entered intoafter full and proper consideration by the Board of the quality and cost of services offered, including the control systemsin operation as far as they relate to the affairs of the Company.

• Management is provided by Prospect Asset Management (Channel Islands) Limited, a company licensed and regulatedby the Guernsey Financial Services Commission. The key terms of the Investment Management Agreement and specifically the fee charged by Prospect are set out inNote 5 to the Financial Statements. • Investment Advisory Services are provided by Prospect Asset Management Inc., a company registered with the SEC.• Administration, Registrar and Company Secretarial duties are performed by Northern Trust International FundAdministration Services (Guernsey) Limited, a company licensed and regulated by the Guernsey Financial ServicesCommission.• CREST agency functions are performed by Computershare (CI) Limited, a company licensed and regulated by theJersey Financial Services Commission.• Custody of assets is undertaken by HSBC Custody Services (Guernsey) Ltd, a company licensed and regulated by theGuernsey Financial Services Commission.

9

An Audit Committee has been



Number of shares Percentage of issued share capitalClearstream Banking S.A. 6,044,757 5.87%Citivic Nominees Limited 95,356,894 92.74%

Directors' and Other InterestsAt 31 December, 2006 D. H. FitzWilliam-Lay and C.W. Sherwell have beneficial interests of 90,742 (2005: 150,000)and 9,940 (2005: 9,940) Ordinary Shares respectively of the Company. No other Directors holding office at 31December, 2006, or their associates, had any beneficial interest in the Company's Shares. There have been no changesin these interests between the end of the year and the date of this report.

R.A.R. Evans is a director of the Manager and a former partner in the firm of the Guernsey legal advisers, Ozannes.Both J. A. Hawkins and C.W. Sherwell are directors of a range of funds.

Substantial ShareholdingsAt 31 December, 2006 the following interests in share capital of the Company exceeded 5% of the issued share capital:

Share buybacksAt the Extraordinary General Meeting of the Company held on 7 August, 2002, it was resolved to amend the Articles ofAssociation to permit the Company to make market purchases of its own Ordinary Shares, up to 1,652,445 (14.99% ofthe issued share capital at that date). Following the share split on 9 June, 2004, the maximum number of share buybackspermitted became 16,524,453.

As at 31 December 2006, the Company may purchase, subject to various terms as set out in the Articles, a maximum of9,460,950 Ordinary Shares. During the year, the Company purchased shares - further detail of these buybacks can befound in Note 10 on page 22 of the financial statements. AuditorsThe Auditors, Ernst & Young LLP have indicated their willingness to continue in office and offer themselves for re-appointment at the forthcoming Annual General Meeting.

David H. FitzWilliam-Lay (Chairman)

John A. Hawkins

18 April, 2007

10


PORTFOLIO OF INVESTMENTSas at 31 December, 2006

Number of Investments Fair Value Percentage of Securities in U.S. Dollars Net Asset Value

CONSUMER DISCRETIONARY

Consumer services1,415,000 Ask Planning Centre 4,760,503 2.14

497,700 Joyfull 4,345,116 1.95106,350 Kappa Create 1,458,013 0.66

10,563,632 4.75

Retailing380,400 5,403,891 2.43212,100 Giga's K's Denki 6,225,905 2.80381,300 Nishimatsuya Chain 7,199,786 3.24161,150 Pal 6,465,247 2.91196,900 Right On 7,551,739 3.40356,000 Sekichu 1,257,580 0.57133,800 United Arrows 2,357,635 1.06

36,461,783 16.41

CONSUMER STAPLES

Food & Staples Retailing131,400 Welcia Kanto 4,067,051 1.82

4,067,051 1.82

FINANCIALS

Real Estate1,148 Advance Residence REIT 4,625,022 2.08

489,600 Arnest One Corporation 7,284,599 3.286,162,600 12,076,923 5.43

333 Blife Investment REIT 1,288,364 0.58981 Creed Office Investment REIT 4,274,006 1.92

1,643 Crescendo Investment REIT 7,241,112 3.2638 Da Office Investment REIT 198,158 0.09

517 Easset Investment REIT 2,230,716 1.001,870 FC Residential Investment REIT 7,124,858 3.20

145 Fukuoka REIT 1,080,533 0.49378,900 3,317,506 1.49

90 Global One Reit 893,226 0.40247,100 IIDA Home Max 4,229,349 1.90

99 Japan Retail Fund 806,855 0.36310 Japan Single-Residence REIT 1,209,807 0.54

75 Japan Excellent 476,891 0.21

11

Azel Corporation

Fuso Lexel Inc

ARC Land Sakamoto


PORTFOLIO OF INVESTMENTS Continuedas at 31 December, 2006

Number of Investments Fair Value Percentage of Securities in U.S. Dollars Net Asset Value

544 2,493,629 1.12378 Kenedix Realty Investment REIT 2,174,625 0.98

2,286 New City Residence Investment REIT 10,536,423 4.74773 Nippon Commercial 3,153,244 1.42

58 Nippon Hotel Fund Investment 228,302 0.101,403 Nippon Residential Investment REIT 7,658,413 3.44

189 1,263,762 0.57347 Premier Investment REIT 2,206,417 0.99

1,915 Prospect Residential Investment REIT 6,507,086 2.93716 Re-plus Residential 2,703,932 1.22

635,100 Ryowa Life Create 5,042,554 2.272,146,800 11,592,124 5.21

400,000,000 Shinnihon Tatemono 3,979,981 1.793,106,700 Shin-Nihon Tatemon 16,723,059 7.52

2 Starts Proceed Investment 3,062 - 21 Tokyo Reiy 183,692 0.0875 United Urban Investment 492,663 0.22

8,206 4,789,910 2.151,421 TGR Investment REIT 4,673,123 2.10

414,200 Touei Housing 6,831,626 3.07498,000 5,068,169 2.28

2,417 Zephyr 6,383,263 2.87

163,046,984 73.30

INDUSTRIALSCapital Goods

244,400 Japan Cash Machine 2,614,717 1.17

2,614,717 1.17

Textiles950,000 Nitto Boseki 3,307,961 1.49

3,307,961 1.49

Total Investments 220,062,128 98.94

Other net assets 2,347,753 1.06

NET ASSETS 222,409,881 100.00

12

Joint REIT Investment Corporation

ORIX JREIT

Shinnihon Corporation

Suncity

Yasuragi


INDEPENDENT AUDITOR'S REPORT TO THE MEMBERS OF THE PROSPECT JAPAN FUND LIMITED

We have audited the Company's Financial Statements for the year ended 31 December, 2006 which comprise theIncome Statement, Reconciliation of Movements in Shareholders’ Funds and Reserves, Balance Sheet, Cash FlowStatement and the related notes 1 to 13. These Financial Statements have been prepared on the basis of the accountingpolicies set out therein.

This report is made solely to the Company’s members, as a body, in accordance with Section 64 of the Companies(Guernsey) Law, 1994. Our audit work has been undertaken so that we might state to the Company’s members thosematters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permittedby law, we do not accept or assume responsibility to anyone other than the company and the Company’s members as abody, for our audit work, for this report, or for the opinions we have formed.

Respective responsibilities of Directors and AuditorsThe directors are responsible for the preparation of the Financial Statements in accordance with applicable Guernseylaw as set out in the Statement of Directors’ Responsibilities.

Our responsibility is to audit the Financial Statements in accordance with relevant legal and regulatory requirementsand International Standards on Auditing (UK and Ireland).

We report to you our opinion as to whether the Financial Statements give a true and fair view and are properly preparedin accordance with the Companies (Guernsey) Law, 1994. We also report to you if, in our opinion, the Directors'Report is not consistent with the Financial Statements, if the company has not kept proper accounting records, or if wehave not received all the information and explanations we require for our audit.

We read the other information contained in the Annual Report and consider whether it is consistent with the auditedFinancial Statements. This other information comprises the Chairman’s Report, Investment Adviser’s Report,Directors’ Report, Portfolio of investments, and General information. We consider the implications for our report if webecome aware of any apparent misstatements or material inconsistencies with the Financial Statements. Ourresponsibilities do not extend to any other information.

Basis of audit opinion We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by theAuditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts anddisclosures in the Financial Statements. It also includes an assessment of the significant estimates and judgementsmade by the Directors in the preparation of the Financial Statements, and of whether the accounting policies areappropriate to the Company's circumstances, consistently applied and adequately disclosed.

We planned and performed our audit so as to obtain all the information and explanations which we considerednecessary in order to provide us with sufficient evidence to give reasonable assurance that the Financial Statements arefree from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we alsoevaluated the overall adequacy of the presentation of information in the Financial Statements.

OpinionIn our opinion the Financial Statements give a true and fair view, in accordance with United Kingdom AccountingStandards, of the state of the Company’s affairs as at 31 December, 2006 and of its return for the year then ended andhave been properly prepared in accordance with The Companies (Guernsey), Law 1994.

Ernst & Young LLPGuernsey19 April, 2007

13


INCOME STATEMENTfor the year from 1 January, 2006 to 31 December, 2006

Revenue Capital Total Revenue Capital Total

01.01.2006 to 01.01.2006 to 01.01.2006 to 01.01.2005 to 01.01.2005 to 01.01.2005 to

31.12.2006 31.12.2006 31.12.2006 31.12.2005 31.12.2005 31.12.2005Notes In U.S. Dollars In U.S. Dollars In U.S. Dollars In U.S. Dollars In U.S. Dollars In U.S. Dollars

(Losses) / gains 7 on investments - (20,120,554) (20,120,554) - 74,794,486 74,794,4864 Other gains / (losses) - 286,525 286,525 - (1,659,304) (1,659,304)

Investment income:Dividends 4,508,557 - 4,508,557 1,976,420 - 1,976,420Interest 12,868 - 12,868 15,236 - 15,236

4,521,425 (19,834,029) (15,312,604) 1,991,656 73,135,182 75,126,8385 Management fee (3,442,395) - (3,442,395) (2,974,534) - (2,974,534)6 Other expenses (1,898,594) - (1,898,594) (1,671,577) - (1,671,577)

(Deficit) / return on ordinary activities before tax (819,564) (19,834,029) (20,653,593) (2,654,455) 73,135,182 70,480,727

Withholding tax (312,211) - (312,211) (138,349) - (138,349)

(Deficit) / return on ordinary activities for the year (1,131,775) (19,834,029) (20,965,804) (2,792,804) 73,135,182 70,342,378

2 (Deficit) / return per Ordinary Share - Basic & Diluted (0.011) (0.191) (0.202) (0.027) 0.693 0.6663

The above results relate to continuing operations of the Company.

14

The notes on pages 18 to 24 form an integral part of these Financial Statements.

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s


BALANCE SHEETas at 31 December, 2006

31.12.2006 31.12.2005Notes In U.S. Dollars In U.S. Dollars

Assets7 Securities at fair value through profit and loss 220,062,128 222,256,720

Current assets8 Debtors 1,578,511 10,642,397

Bank deposits 1,933,210 17,062,149

Total Current Assets 3,511,721 27,704,546Liabilities falling due within one yearBank overdraft 203,529 -

9 Creditors 960,439 1,176,550

Net current assets 2,347,753 26,527,996

Net assets 222,409,881 248,784,716

Represented by:

SHARE CAPITAL AND RESERVES10 Share capital 102,824 105,35410 Redemption reserve 96,730,082 102,139,11310 Capital redemption reserve 312,685 310,15511 Other reserves 125,264,290 146,230,094

Shareholders' funds attributable to equity interests 222,409,881 248,784,716

Ordinary Shares in issue 102,824,520 105,354,520

2 Net Asset Value per Ordinary Share 2.16 2.36

David H. FitzWilliam-Lay (Chairman)

John A. Hawkins


The Financial Statements on pages 14 to 24 were approved by the Board of Directors on 18 April, 2007 and signed on its behalf by:

16


CASH FLOW STATEMENTfor the year from 1 January, 2006 to 31 December, 2006

01.01.2006 to 01.01.2005 to

31.12.2006 31.12.2005Notes In U.S. Dollars In U.S. Dollars

Operating activities12 Net cash outflow from operating activities (2,075,197) (2,634,431)

Financial investmentPurchase of investments (209,418,486) (126,739,575)

Sale of investments 201,283,721 141,038,281

(8,134,765) 14,298,706

(10,209,962) 11,664,275

Financing 10 Repurchase of shares (5,409,031) (2,766,973)

Net cash outflow from financing (5,409,031) (2,766,973)

(Decrease)/increase in cash (15,618,993) 8,897,302

Reconciliation of net cash flow tomovement in net funds

Net cash (outflow)/inflow (15,618,993) 8,897,302

Effects of foreign exchange rate changes 286,525 (1,659,304)

Net funds at beginning of year 17,062,149 9,824,151

Net funds at end of year 1,729,681 17,062,149

17


Net cash (outflow)/inflow from financial investment

Net cash (outflow)/inflow before financing


NOTES TO THE FINANCIAL STATEMENTSfor the year from 1 January, 2006 to 31 December, 2006

Note 1 Principal Accounting PoliciesAccounting ConventionThese Financial Statements have been prepared in accordance with United Kingdom Accounting Standards,the Statement of Recommended Practice: Financial Statements of Investment Trust Companies 2005 and TheCompanies (Guernsey) Law, 1994.

IncomeIncome arising on the investments is recognised when the right to receive such income has been obtained bythe company and is included in the income statement gross of withholding tax. Bank interest is accounted foron an accruals basis.

InvestmentsInvestments have been designated as fair value through profit or loss in accordance with FRS 26 FinancialInstruments: Measurement. Investments are initially recognised at cost, being the fair value of theconsideration given, any transaction costs are expensed in the income statement. After initial recognition,investments are measured at fair value.

Listed investments held at the balance sheet date are valued at bid prices quoted on the principal stockexchange on which the investments are traded. There were no unlisted investments held at 31 December,2006. The difference between cost and valuation is included in the Capital Reserve/Unrealised. Realisedgains and losses on disposal of investments are included in the Capital Reserve/Realised.

All "regular way" purchases and sales of financial assets are recognised on the "trade date", i.e. the date thatthe Company commits to purchase / sell the financial asset. "Regular way" purchases or sales are purchasesor sales of financial assets that require delivery of assets within the time frame generally established byregulation or convention in the market place.

Foreign Currencies(i) Functional and presentation currencyThe Company's functional currency is Japanese Yen and presentational currency is United States Dollor.

(ii) Foreign currency transactionsForeign currency assets and liabilities, including investments at valuation, are translated into U.S. Dollars atthe rate of exchange ruling at the balance sheet date. Investment transactions and income and expenditureitems are translated at the rate of exchange ruling at the date of the transactions. Gains and losses on foreignexchange are included in the Capital Reserve/Exchange Differences.

Operating ExpensesThe Company is responsible for all normal operating expenses including audit fees, stamp and other dutiesand charges incurred on the acquisition and realisation of investments. All expenses are accounted for on anaccruals basis. Expenses are allocated to the revenue account including those which are incidental to thepurchase or disposal of an investment as required under FRS 26.

Cash and cash equivalents Cash on hand and in banks is carried at cost. Cash and cash equivalents are defined as cash in hand, deemeddeposits and highly liquid investments readily convertible to known amounts of cash and subject toinsignificant risk of change in value.

Revenue and capital accountsAll items in the Income Statement are allocated to the revenue account other than Gains on investments andother (losses) / gains i e foreign exchange (losses) / gains which are allocated to the capital account

18


NOTES TO THE FINANCIAL STATEMENTSContinued

Note 2 (Deficit) / Return per Ordinary Share - Basic & Diluted and Net Asset Value per Ordinary Share - Basic & Diluted

31.12.2006 31.12.2005In U.S. Dollars In U.S. Dollars

Net Asset Value per Ordinary Share - Basic and Diluted 2.16 2.36

Note 3 Taxation

Increase in cash

Note 4 Other Gains/ (Losses) 31.12.2006 31.12.2005In U.S. Dollars In U.S. Dollars

Foreign exchange gain / (loss) 286,525 (1,659,304)

Note 5 Management Fee

The management fee is payable to the Manager, Prospect Asset Management (Channel Islands) Limited, monthly inarrears and is 1.5% of the Net Asset Value per annum, which is calculated as of the last business day of each month.Total management fees for the year amounted to US$3,442,395 (2005: US$2,974,534) of which US$283,790 (2005:US$307,856) is due and payable at the year end. The Management Agreement dated 1 December, 1994 shall remainin force until determined by the Company, or upon the Manager giving the Company not less than three months'notice in writing, subject to additional provisions included in the agreement regarding a breach by either party.

The Company has been granted Exempt Status under the terms of The Income Tax (Exempt Bodies) (Guernsey)Ordinance, 1989 to income tax in Guernsey. Its liability is an Annual Fee of £600.

Some investments are subject to taxes in the investing country.

The revenue deficit per Ordinary Share - Basic and Diluted has been calculated based on the weighted averagenumber of Ordinary Shares of 103,723,178 and a net revenue deficit of US$1,131,775 (2005: on 105,579,020Ordinary Shares and a net revenue deficit of US$2,792,804). The capital return per Ordinary Share has beencalculated based on weighted average number of Ordinary Shares of 103,723,178 and a net capital deficit ofUS$19,834,029 (2005: on 105,579,020 Ordinary Shares and a net capital return of US$73,135,182).

There were no dilutive elements to shares issued or repurchased during the year.

The Net Asset Value per Ordinary Share - Basic and Diluted has been calculated based on the number of shares inexistence at the balance sheet date 102,824,520 (2005: 105,354,520) and shareholders' funds attributable to equityinterests of US$222,409,881 (2005: US$248,784,716).

19



Note 6 Other Expenses31.12.2006 31.12.2005

In U.S. Dollars In U.S. Dollars

Administration and secretarial fees* 573,711 495,755Brokers' commission 615,281 570,376Custodian's fees and charges** 357,305 281,996General expenses 227,571 201,902Directors' remuneration 81,608 85,771Auditors' fees 43,118 28,949Bank interest - 6,828

1,898,594 1,671,577

Note 7 Investments31.12.2006 31.12.2005

In U.S. Dollars In U.S. DollarsInvestments listed on recognised investment exchanges 220,062,128 222,256,720

Opening valuation 222,256,720 172,510,268Implementation of FRS 26 - Conversion from Mid to Bid valuation basis - (937,634)Purchases at cost 209,144,749 126,690,372Proceeds on sale (191,218,787) (150,800,772)Realised gains on sale 44,911,547 44,171,028Movement in unrealised (depreciation)/appreciation (65,032,101) 30,623,458

Closing valuation 220,062,128 222,256,720

Closing book cost 223,234,305 160,396,796Closing unrealised (depreciation)/appreciation (3,172,177) 61,859,924

220,062,128 222,256,720

Realised gains on sales 44,911,547 44,171,028Movement in unrealised (depreciation)/appreciation (65,032,101) 30,623,458

(Losses)/gains on investments for the year (20,120,554) 74,794,486

*The administration and secretarial fees are payable to Northern Trust International Fund Administration Services(Guernsey) Limited, monthly in arrears and is 0.25% of the Net Asset Value of the Company, which is calculated asof the last business day of each month. Total administration and secretarial fees for the year amounted to US$573,711(2005: US$495,755) of which US$92,200 (2005: US$51,309) is due and payable at the year end.

**The custodian's fees and charges are payable to HSBC Custody Services (Guernsey) Limited, monthly in arrearsand is 0.10% of the Net Asset Value of the Company, which is calculated as of the last business day of each month.Total custodian's fees and charges for the year amounted to US$357,305 (2005: US$281,996) of which US$18,027(2005: US$74,765) is due and payable at the year end.

20



Note 8 Debtors31.12.2006 31.12.2005

In U.S. Dollars In U.S. DollarsAmounts due from brokers 180,177 10,245,111Dividends receivable 1,398,334 370,812Other debtors - 26,474

1,578,511 10,642,397

Note 9 Creditors31.12.2006 31.12.2005

In U.S. Dollars In U.S. DollarsAmounts due to brokers 355,709 629,446Other creditors 604,730 547,104

960,439 1,176,550

Note 10 Share Capital, Redemption Reserve & Capital Redemption Reserve

Authorised Share Capital 31.12.2006 Number of shares In U.S. Dollars150,000,000 Ordinary Shares of US$0.001 each 150,000

60,000,000 "C" Ordinary Shares of US$0.01 each 600,000

Issued Share CapitalCapital

Ordinary Shares Share Capital Redemption Reserve Redemption ReserveIn U.S. Dollars In U.S. Dollars In U.S. Dollars

105,354,520 Balance at 1 January, 2006 105,354 102,139,113 310,155Shares acquired and cancelled

(2,530,000) during the year (2,530) (5,409,031) 2,530

102,824,520 Balance at 31 December, 2006 102,824 96,730,082 312,685

At the Extraordinary General Meeting of the Company held on 7 August, 2002, it was resolved to amend the Articlesof Association to permit the Company to make market purchases of its own Ordinary Shares. This would be permittedonly if the Ordinary Shares were trading on the London Stock Exchange at a discount to the lower of the undiluted ordiluted Net Asset Value. This authority to make market purchases of its own Ordinary Shares was last renewed in theAnnual General Meeting of 31 May, 2006.

21



Note 10 Share Capital, Redemption Reserve & Capital Redemption ReserveContinued

Price per Share Percentage ofDate Shares In U.S. Dollars share capital

1,000,000 2.134 0.97%225,000 2.224 0.22%650,000 2.144 0.63%425,000 2.180 0.41%

30,000 1.940 0.03%100,000 1.904 0.10%100,000 2.054 0.10%

2,530,000 2.46%

There are no "C" Ordinary Shares in issue at 31 December, 2006. (31 December, 2005: Nil)

Note 11 Other Reserves

Capital Capital Capital Reserve/Accumulated Reserve/ Reserve/ Exchange

Losses Realised Unrealised Differences TotalIn U.S. Dollars In U.S. Dollars In U.S. Dollars In U.S. Dollars In U.S. Dollars

Balances at 1 January, 2006 (12,965,499) 97,585,899 61,859,924 (250,230) 146,230,094

Movements during the yearRealised gains on investments sold - 44,911,547 - - 44,911,547Movement on unrealised loss on revaluation of investments - - (65,032,101) - (65,032,101)Gain on foreign exchange - - - 286,525 286,525Deficit on ordinary activities (1,131,775) - - - (1,131,775)

Balances at 31 December, 2006 (14,097,274) 142,497,446 (3,172,177) 36,295 125,264,290

Note 12 Reconciliation of Deficit on Ordinary Activities to Net Cash Outflow from Operating Activities

31.12.2006 31.12.2005

In U.S. Dollars In U.S. Dollars

Revenue deficit on ordinary activities for the year (1,131,775) (2,792,804)Increase in dividends receivable and other debtors (1,001,048) (50,668)Increase in other creditors 57,626 209,041

Net cash outflow from operating activities (2,075,197) (2,634,431)

27 September, 200629 December, 2006

25 August, 2006

21 March, 200611 May, 200617 May, 200619 May, 2006

The Company may purchase, subject to various terms as set out in the Articles, a maximum of 9,460,950 OrdinaryShares, equivalent to 9.2% of the Issued share capital of the Company as at 31 December, 2006. During the year,shares were purchased as follows:-

22



Note 13 Financial Instruments

The Company's net currency exposure is as follows:31.12.2006 31.12.2005 Investments Investments

Investments In US Dollars In US Dollars Japanese Yen (Yen 26,164,286,709) 220,062,128 222,256,720

Other Net AssetsUS Dollars (704,371) (292,654)Sterling (£3,068) (6,005) (221,148)Japanese Yen (Yen 2,347,753) 3,058,129 27,041,798

2,347,753 26,527,996

In accordance with its investment objectives and policies, the Company holds financial instruments which at any onetime may comprise the following:

* securities held in accordance with the investment objectives and policies* cash and short-term debtors and creditors arising directly from operations* borrowing used to finance investment activity* derivative transactions including investment in warrants and forward currency contracts * options or futures for hedging purposes

The financial instruments held by the Company principally comprise equities listed on the stock market in Japan.The specific risks arising from the Company's exposure to these instruments, and the Manager / Investment Adviser'spolicies for managing these risks, which have been applied throughout the year, are summarised below.

Market Price RiskThe Company's investment portfolio - particularly its equity investments - is exposed to market price fluctuations whichare monitored by the Manager / Investment Adviser in pursuance of the investment objectives and policies. Adherenceto investment guidelines and to investment and borrowing powers set out in the scheme particulars mitigates the risk ofexcessive exposure to any particular type of security or issuer.

Exceptional risks associated with investment in Japanese smaller companies may include:a) greater price volatility, substantially less liquidity and significantly smaller market capitalisation, andb) more substantial government intervention in the economy, including restrictions on investing incompanies or in industries deemed sensitive to relevant national interests.

Foreign Currency RiskThe Company principally invests in securities denominated in currencies other than United States Dollar, thepresentation currency of the Company. Therefore, the balance sheet may be affected by movements in the exchangerates of such currencies against the US Dollar. The Manager / Investment Adviser has the power to manage exposureto currency movements by using forward currency contracts. No such instruments were held at the date of theseFinancial Statements.

It is not the present intention of the Directors to hedge the currency exposure of the Company, but the Directors reservethe right to do so in the future if they consider this to be desirable.

The treatment of currency transactions other than in US dollars is set out in Note 1 to the Financial Statements under"Foreign Currencies".

23



Note 13 Financial Instruments Continued

Interest Rate RiskThe Company may invest in fixed and floating rate securities. The income of the Company may be affected bychanges to interest rates relevant to particular securities or as a result of the Manager / Investment Adviser beingunable to secure similar returns on the expiry of contracts or sale of securities. The value of fixed interest securitiesmay be affected by interest rate movements in the future. Interest receivable on bank deposits or payable on bankoverdraft positions will be affected by fluctuations in interest rates, however the value of the underlying cash positionswill not be affected.

As at 31 December, 2006, all of the Company's investments are non-interest bearing equity investments and itsexposure to interest rate risk is not significant.

Fair ValueAll assets and liabilities are carried at fair value.

Short term Debtors and CreditorsShort term debtors and creditors have been excluded from the disclosures of financial instruments, other than inrespect of currency exposures.

Liquidity riskLiquidity risk is the risk that the Company will encounter in realising assets or otherwise raising funds to meet financialcommitments.

As at 31 December 2006, the Company has no significant financial liabilities other than short term creditors arisingdirectly from investing activity.

Credit riskCredit risk is the risk that an issuer or counterparty will be unable or unwilling to meet a commitment that it has enteredinto with the Company.

In adhering to the investment and borrowing powers set out in the principal documents, the Company mitigates the riskof any significant concentration of credit risk.

24


GENERAL INFORMATION

GeneralThe Company is a closed-ended investment company incorporated in Guernsey in November 1994 and waslaunched in December 1994 with an initial asset value of US$70 million. There are 102,824,520 OrdinaryShares in issue, the Company's Ordinary Shares being listed on the London Stock Exchange.

The Ordinary Shares of the Company have not been registered under the United States Securities Act of1933 or the United States Investment Companies Act of 1940. Accordingly, none of the Ordinary Sharesmay be offered or sold directly or indirectly in the United States or to any United States persons [as definedin Regulation ‘S’ under the 1933 Act] other than in accordance with certain exemptions. Investment in theFund is suitable only for sophisticated investors and should be regarded as long-term. Past performance isno indication of future results.

Investment ObjectiveThe Company was established to invest substantially all of its assets in securities issued by smaller Japanesecompanies. The objective of the Company is to achieve long-term capital growth from an actively managedportfolio of securities primarily of smaller Japanese companies listed or traded on Japanese Stock Markets.

Investment RestrictionsThe following investment restrictions have been adopted:

(i) the Company may not invest in securities carrying unlimited liability; or

(ii) the Company may not deal short in securities; or

(iii) the Company may not take legal or management control in investments in its portfolio; or

(iv) the Company may not invest in any commodities, land or interests in land; or

(v) the Company may not invest or lend more than 10% of its assets in securities of any one company orsingle issuer (other than obligations of the Japanese Government or its agencies or of the US Government orits agencies); or

(vi) the Company may not invest more than 10% of its assets in non-corporate investments or securities notlisted or quoted on any recognised stock exchange, for which purpose securities quoted on any of theJapanese Stock Markets will be treated as securities quoted on a recognised stock exchange; or

(vii) the Company may not invest in any company where the investment would result in the Companyholding more than 10% of the issued share capital of that company or of any class of that company’s sharecapital, unless that company constitutes a trading company (for the purposes of the relevant United Kingdomlegislation) in which case the Company may not make any investment that would result in its holding 50%or more of the issued share capital of that company or of any class of that company’s share capital; or

(viii) the Company may not invest more than 5% of its assets in unit trusts, shares or other forms ofparticipation in managed open-ended investment vehicles; or

(ix) the Company may not commit its assets in the purchase of foreign exchange contracts, financial futurescontracts, put or call options or in the purchase of securities on margin other than in connection with or forthe purpose of hedging transactions effected on behalf of the Company.

25


GENERAL INFORMATIONContinued

NAV and Share Price InformationThe prices of Ordinary Shares and the latest NAV are published daily in the Financial Times. Prices (inSterling terms) of the Ordinary Shares appear within the section of the London Share Service entitled"Investment Companies". The NAV (in dollar terms) appears within the section of the Financial TimesManaged Funds Service under Prospect Asset Management (Channel Islands) Limited.

Life of the CompanyFrom inception the Directors have believed that Shareholders should be able to review the progress of theCompany so that a decision can be taken as to whether Shareholders should have an opportunity of realisingthe Company's underlying investments. Accordingly, at the Ninth Annual General Meeting of the Companyheld on 15 June 2006, the Board included in the business to be considered by Shareholders a SpecialResolution that the Company should be wound up. As the resolution was not passed, the Board shallinclude a similar resolution in the business to be considered at every third Annual General Meeting held.

DirectorsBrief biographical details of the Directors are as follows:

David FitzWilliam-Lay retired in 1993 after three and a half years as Chairman of GT Management Plc, aninternational investment management company. Previously he had been Chairman of its principal subsidiarycompanies (US, Japan and Hong Kong) and Group CEO. He joined the GT Management Group in 1978.He was a member of the Board of Governors of the National Association of Securities Dealers, WashingtonDC between 1987 and 1990.

Rupert Evans is a Guernsey advocate and former partner in the firm of the Guernsey legal advisers, Ozannes.He is now a consultant to Ozannes. He is a non-executive director of the Manager and of a number ofinvestment companies. Mr Evans is resident in Guernsey.

John Hawkins is a fellow of the Institute of Chartered Accountants in England and Wales. He was formerlyExecutive Vice President and a member of the Corporate Office of The Bank of Bermuda Limited, withwhom he spent many years in Asia. He retired from the Bank of Bermuda in 2001 after 25 years with theGroup. He is a director of a range of funds which include hedge funds and equity funds investing in Japanand Asia.

Christopher Sherwell was Managing Director of Schroders (C.I.) Limited from 2000 to 2003, and wasInvestment Director with Schroders (C.I.) Limited from 1993 to 2000. Prior to joining Schroders (C.I.)Limited, Mr Sherwell was Far East Regional Strategist with Smith New Court Securities, and from 1977 to1990 worked as a journalist on the Financial Times, including seven years as a foreign correspondent in theFar East and Australia from 1983 to 1990.

Taxation StatusThe Company has obtained exemption from Guernsey Income Tax under The Income Tax (Exempt Bodies)(Guernsey) Ordinance, 1989. There is no capital gains tax in Guernsey.

26

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