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THE CHARTERED INSTITUTE OF

TAXATION OF NIGERIA

NEW SYLLABUS STUDENT’S STUDY GUIDE ON

FINANCIAL TAX ANALYSIS

EFFECTIVE DATE: APRIL 2020

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VISION

To be one of the foremost professional association in Africa and

beyond

MISSION

To build an Institute which will be a citadel for the advancement of

taxation in all its ramifications

MOTTO

Integrity and Service

2
First edition published by
Chartered Institute of Taxation of Nigeria

© CITN, January 2020

All rights reserved.

No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording, scanning or otherwise, without the prior permission in
writing of CITN, or as expressly permitted by law, or under the terms agreed with
the appropriate reprographics rights organisation.

You must not circulate this book in any other binding or cover and you must
impose the same condition on any acquirer.

ISBN: …………………………………………………..

3
Notice:

CITN has made every effort to ensure that at the time of writing the
contents of this study text are accurate, but neither CITN nor its
directors or employees shall be under any liability whatsoever for any
inaccurate or misleading information this work could contain.

4
Foreword
The Nigerian tax laws have been undergoing reformations and re-
enactments, most especially as the revenue from oil continues to dwindle
and tax revenue is becoming the major source of government revenue.
The impact of these reformation on tax professionals and the skills set
needed by professional tax administrators and tax practitioners to perform
their various roles have been profound. These developments have made
it inevitable for the Institute’s syllabus and training curriculum to be
changed to align its contents with current and future needs of the tax
professionals.

In order to help the candidates sitting for the Institute’s examination, the
Council approved that a new set of learning materials (study packs) be
developed for each of the new subjects.

Therefore, renowned writers and reviewers which comprised eminent

scholars and practitioners with tremendous experiences in their areas of
specialisation, were sourced locally to develop learning materials for the
12 subjects as follows:
Foundation
1. Principles of Taxation
2. Financial Accounting
3. Business Law
4. Economics
Professional Taxation I
5. Financial Reporting
6. Income Tax
7. Indirect Tax
8. Governance, Risk & Ethics
Professional Taxation II
9. Tax Audit and Investigation
10. International Taxation
11. Financial / Tax Analysis
12. Income Tax for Specialised Businesses

Although the study packs were specially produced to assist candidates

preparing for the Institute’s Professional Examinations, we are persuaded
that students of other professional bodies and tertiary institutions will find
them very useful.
5
Kolawole Ezekiel Babarinde
Chairman, Examination Committee.

Acknowledgement

The Institute is deeply indebted to the underlisted writers and

reviewers for their scholarship and erudition which led to the
successful production of these study packs. They are:

Principles of Taxation
1. Sanni Dahiru Writer
2. Ojuolape Fajuyitan Writer
3. Femi Enigbokan Reviewer

Financial Accounting
1. Jubril Lawal Writer
2. Benjamin Omonayajo Writer
3. Taorid Ramon Reviewer

Business Law
1. Kola Oyekan Writer
2. Sylvester Akinbuli Writer
3. Olayiwola Oladele Reviewer

Economics
1. Agbor Baro Writer
2. Sampson Adebayo Writer
3. Gbemi Onakoya Reviewer

Financial Reporting
1. Joseph Ogunwede Writer
2. Samuel Okoye Writer
3. Ojo Ajileye Reviewer

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Income Taxation
1. Moniru Adebayo Writer
2. Olugbenga Obatola Reviewer

Indirect Taxation
1 David Sobande Writer
2 Jayeola Olabisi Writer
3 Sunday Kajola Reviewer

Governance, Risk & Ethics

1. Tade Adegbindin Writer
2 Olutoyin Adepate Reviewer

Tax Audit and Investigation

1. Femi Aribisala Writer
2. Julius Adesina Writer
3. Ojo Peter Reviewer

International Taxation
1. Sandra Momah Writer
2. Jonathan Adejuwon Reviewer

Financial / Tax Analysis

1. Julius Adesina Writer/ Reviewer
2 Phillip Olowolaju Writer/Reviewer

Income Tax for Specialised Businesses and Processes

1. Sandra Momah Writer
2. Folarin Akanni-Alimi Writer
3. Anthony Clever Reviewer

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 Professional Taxation II
Financial/Tax analysis

S
Syllabus

Aims and Objectives of the Course

At the end of this course, candidates will be able to understand the followings:
i. Comprehensive framework for financial statement analysis and financial reporting;
ii. Important strategy points for the analysis of financial statements;
iii. The purpose of accounting analysis to evaluate the degree to which firm’s accounting is
captured in business reality;
iv. Ability to understand analysis required to adjust a firm’s accounting numbers using cash
flow information;
v. The assessment of performance of a firm in the context of its stated goals and strategy;
vi. How to summarise the view developed in the analysis with an explicit forecast; and
vii. Forecasting at first and second stage of prospective analysis and valuation.

Course contents
1. Framework for business analysis and valuation using financial statements
i. The role of financial reporting in capital markets
ii. From business activities to financial statements
Iii. Influences of the accounting system on information quality
Iv. Alternative forms of communication with investors
V. Public versus private corporations

2. Business analysis and valuation tools

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 i. Industry

ii. Ii. Applying industry analysis

iii. Competitive strategy analysis
iv. Corporate strategy analysis

3. Accounting analysis: The basics

i. Factors influencing accounting quality
ii. Steps in accounting analysis
iii. Recasting financial statements
iv. Accounting analysis pitfalls
v. Value of accounting data and accounting analysis

4. Accounting analysis: Accounting adjustment

i. Recognition of assets
ii. Asset distortions
iii. Recognition of liabilities
iv. Liability distortions
v. Equity distortions
5. Financial analysis
i. Ratio analysis
ii. Cash flow analysis
iii. Trend analysis
iv. Common size analysis

6. Strategic tax management and planning

i. Introduction
• Definition of tax planning.
• Tax planning and management strategies.
• Taxation and present value analysis.
• Basic principles of tax planning.
• Factors affecting tax planning.
ii. Tax strategies for new business
• Organisational forms for business entities, corporate formation, partnership formation,
single proprietor formation. Basic tax consequences of entity choice. • Sale or lease of
property to controlled entities.

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 • Other strategies for transferring property to controlled entities.

iii. Employee compensation strategies

• Proprietor compensation, employee compensation, fringe benefits.
• Deferred compensation, equity-based compensation, employee stock plans/option.
• Partnership interest as payment for services.
iv. Taxation and business operating strategies
• Profit measurements and reporting.
• The entity’s accounting year, tax accounting methods.
• Differences (permanent and temporary) between book profit and taxable profit.
• Accounting for income taxes: deferred tax assets and liabilities, corporate tax
payment requirements.
v. Tax incentive provisions:
• Tax incentives and after-tax business value, criticisms of tax incentives; and
• Restrictions on their benefits.
vi. Tax implications of profit distributions - corporate, partnership and sole proprietorship.
vii Tax implications of Anti-Avoidance Schemes.
viii. Taxation and Capital Marketing Activities.
ix. Tax planning and management, using holding companies and group structures;
x. Tax implications and tax management in mergers and acquisition of business entities.
xi. Tax planning through the use of derivative instruments.

xii. Tax considerations and tax planning in intellectual properties management.

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Professional Taxation II
Financial/Tax analysis

T
Table of Contents

1. Syllabus……………………………………………………………………… i-iii
2. Table of contents…………………………………………………………….. iv
3. Framework for business analysis and valuation using financial statements… 1- 16
4. Business analysis and valuation tools………………………………………. 17- 58
5. Accounting analysis: The basics……………………………………………. 59 - 74
6. Accounting analysis: Accounting adjustments……………………………… 75 - 92
7. Financial statements analysis and accounting ratios………………………… 93 - 131
8. Strategic tax planning……………………………………………………….. 132 - 158
9. Tax strategies for new business……………………………………………… 159 - 177
10. Taxation and business operating strategies………………………………….. 178 - 198
11. Distribution to business owners……………………………………………… 199 - 203
12. Strategies for business growth and expansion……………………………….. 204 - 216
13. Taxation and capital market activities……………………………………….. 201 - 235
14. Use of holding companies…………………………………………………… 236 - 240
15. Financing activities………………………………………………………….. 241 - 249
16. Tax planning through the use of derivative instruments…………………… 250 - 255
17. Intellectual property………………………………………………………… 256 - 268
18. Bibliography………………………………………………………………… 269 - 271

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 Professional Taxation II

Financial/Tax analysis

Chapter
1
Framework for business analysis and valuation using financial statements

Contents

i. The role of financial reporting in capital market

ii. The classification of business activities
iii. Financial statements element and accounts
iv. Accounting equations
v. The influence of using accounting information systems on the quality of accounting
information
vi. Public vs private company
vii. End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

i. Know comprehensive framework of financial reporting in capital market.

ii. Understand the links from business activities to financial statement
iii. Assess the influence and effect of accounting information system on accounting quality
iv. Have a clearer understanding about the alternative forms of communication with investors
v. Have a clear and concise understanding on the difference between public and private
corporation.
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1.1 The role of financial reporting in capital market

The capital market refers to interactions among firms or organisations with funding needs and
investors with surplus funds for investments whereby firms raise debt and equity capital for their
operations and investors make funds available to firms either in the form of debt or equity
investments at a return. Therefore, capital market participants depend on financial information to
make various decisions

Firms usually provide financial information through the financial reports they publish. The
financial reports often comprise: financial statements, management discussion of those financial
statements and other regulatory filings. Some firms engage in additional voluntary communication,
such as management forecasts, analysts ‘presentations, other corporate reports and press releases
on key issues.

It has been said that no perfect stock market exists anywhere in the world, and that most stock
markets exhibit weak form market efficiency. Weak form efficiency implies that the market uses
historical corporate financial information in making investment decisions. Capital market
participants are provided with information that forms a basis for making fair decisions regarding
stock prices in order to make and execute reasoned investment and financing decisions. The
financial information are useful to investors for the following reasons:

1. Capital market participants are provided with information that forms a basis for making
fair decisions regarding stock prices in order to make and execute reasoned investment
and financing decisions;
2. Financial statements prepared using global financial reporting benchmarks help investors
to be better equipped and appreciate risk associated with decisions about flows of
economic capital;
3. market participants use financial information to make general investments decisions to
reduce financial risks and optimize returns on investments;
4. Financial reporting by corporate entities aids the functioning and development of the
capital market; and

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 5. Financial statements measure and summarise the economic consequences of business
activities.
It should be noted that information by entrepreneurs to investors is not completely credible
because entrepreneurs have an incentive to inflate the value of their idea to encourage investors

1.2The classification of business activities

Accountants give similar accounting treatment to similar types of business transactions.

Therefore, the first step in understanding financial reporting mechanics is to understand how
business activities are classified for financial reporting purposes. Business activities may be
classified into three groups for financial reporting purposes: operating, investing, and financing
activities.

❖ Operating Activities: are those activities that are part of the day- to- day business
functioning of an entity. Examples include the sale of meals by a restaurant, the sale of
services by a consulting firm, the manufacture and sale of ovens by an oven-
manufacturing company, and taking deposits and making loans by a bank.
❖ Investing Activities: these are activities associated with acquisition and disposal of
long- term assets. Examples include the purchase of equipment or sale of surplus
equipment (such as an oven) by a restaurant (contrast this to the sale of an oven by an
oven manufacturer, which would be an operating activity), and the purchase or sale of an
office building, a retail store, or a factory.
❖ Financing Activities: these are activities related to obtaining or repaying capital. The
two primary sources for such funds are owners (shareholders) or creditors. Examples
include issuing common shares, taking out a bank loan, and issuing loan notes
.

Understanding the nature of activities helps the analyst understand where the company is doing
well and where it is not doing so well. Ideally, an analyst would prefer that most of a company’s
profits (and cash flow) come from its operating activities. The following provides examples of
typical business activities and how these activities relate to the elements of financial statements.

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Typical business activities and financial statement elements affected

Operating activities ■ Sales of goods and services to customers: (R)

■ Costs of providing the goods and services: (x)

■ Income tax expense: (x)

■ Holding short- term assets or incurring short- term liabilities

directly related to operating activities: (A) or (L)

Investing activities

■ Purchase or sale of assets, such as property, plant, and

equipment: (A)

■ Purchase or sale of other entities’ equity and debt securities: (A)

Financing activities

■ Issuance or repurchase of the company’s own preferred or

common stock: (E)

■ Issuance or repayment of debt: (L)

■ Payment of distributions (i.e., dividends to preferred or common

stockholders) (E)

NOTE: Accounting elements: Assets (A), Liabilities (L), Owners’ Equity (E), Revenue (R),
and Expenses.
Not all transactions fit neatly in this framework for purposes of financial statement presentation.
For example, interest received by a bank on one of its loans would be considered part of operating
activities because a bank is in the business of lending money. In contrast, interest received on a
bond investment by a restaurant may be more appropriately classified as an investing activity
because the restaurant is not in the business of lending money

Business activities resulting in transactions are reflected in the broad groupings of financial
statement elements: Assets, Liabilities, Owners’ Equity, Revenue, and Expenses. In general terms,
these elements can be defined as follows: assets are the economic resources of a company;
15
liabilities are the creditors’ claims on the resources of a company; owners’ equity is the residual
claim on those resources; revenues are inflows of economic resources to the company; and
expenses are outflows of economic resources or increases in liabilities. Accounting provides
individual records of increases and decreases in a specific asset, liability, component of owners’
equity, revenue

1.3 Financial statement elements and accounts

Within the financial statement elements, accounts are sub classifications. Accounts are individual
records of increases and decreases in a specific asset, liability, component of owners’ equity,
revenue, or expense. For financial statements, amounts recorded in every individual account are
summarized and grouped appropriately within a financial statement element. Unlike the financial
statement elements, there is no standard set of accounts applicable to all companies. Although
almost every company has certain accounts, such as cash, each company specifies the accounts in
its accounting system based on its particular needs and circumstances. For example, a company in
the restaurant business may not be involved in trading insecurities and, therefore, may not need an
account to record such an activity. Furthermore, each company names its accounts based on its
business. A company in the restaurant business might have an asset account for each of its ovens,
with the accounts named “Oven- 1” and “Oven- 2.” In its financial statements, these accounts
would likely be grouped within long- term assets as a single line item called “Property, plant, and
equipment.” A company’s challenge is to establish accounts and account groupings that provide
meaningful summarisation of voluminous data but retain enough detail to facilitate decision
making and preparation of the financial statements. The actual accounts used in a company’s
accounting system will be set forth in a chart of accounts. Generally, the chart of accounts is far
more detailed than the information presented in financial statements. Certain accounts are used to
offset other accounts. For example, a common asset account is accounts receivable, also known as
“trade accounts receivable” or “trade receivables.” A company uses this account to record the
amounts it is owed by its customers. In other words, sales made on credit are reflected in accounts
receivable. In connection with its receivables, a company often expects some amount of
uncollectible accounts and, therefore, records an estimate of the amount that may not be collected.
The estimated uncollectible amount is recorded in an account called allowance for bad debts.

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Because the effect of the allowance for bad debts account is to reduce the balance of the company’s
accounts receivable, it is known as a “contra asset account.” Any account that is offset or deducted
from another account is called a “contra account.” Common contra accounts include allowance for
bad debts (an offset to accounts receivable for the amount of accounts receivable that are estimated
to be uncollectible), accumulated depreciation (an offset to property, plant, and equipment
reflecting the amount of the cost of property, plant, and equipment that has been allocated to
current and previous accounting periods), and sales returns and allowances (an offset to revenue
reflecting any cash refunds, credits on account, and discounts from sales prices given to customers
who purchased defective or unsatisfactory items).

1.4 Accounting equations

The five financial statement elements noted previously serve as the inputs for equations that
underlie the financial statements. This section describes the equations for three of the financial
statements: statement of financial position, income statement, and statement of retained earnings.
A statement of retained earnings can be viewed as a component of the statement of shareholders’
equity, which shows all changes to owners’ equity, both changes resulting from retained earnings
and changes resulting from share issuance or repurchase. The statement of financial position
presents a company’s financial position at a particular point in time. It provides a listing of a
company’s assets and the claims on those assets (liabilities and equity claims). The equation that
underlies the statement of financial position is also known as the “basic accounting equation.” A
company’s financial position is reflected using the following equation: Assets = Liabilities +
Owners’ equity. Presented in this form, it is clear that claims on assets are from two sources:
liabilities or owners’ equity. Owners’ equity is the residual claim of the owners (i.e., the owners’
remaining claim on the company’s assets after the liabilities are deducted).

The concept of the owners’ residual claim is well illustrated by the slightly rearranged statement
of financial position equation, roughly equivalent to the structure commonly seen in the statement
of financial positions : Assets – Liabilities = Owners’ equity. Other terms are used to denote
owners’ equity, including shareholders’ equity, stockholders’ equity, net assets, equity, net worth,
net book value, and partners’ capital. The exact titles depend upon the type of entity, but the
equation remains the same. Owners’ equity at a given date can be further classified by its origin:

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capital contributed by owners, and earnings retained in the business up to that date: Owners’ equity
= Contributed capital + Retained earnings. The income statement presents the performance of a
business for a specific period of time. The equation reflected in the income statement is the
following: Revenue – Expenses = Net income (loss), Note that net income (loss) is the difference
between two of the elements: revenue and expenses. When a company’s revenue exceeds its
expenses, it reports net income; when a company’s revenues are less than its expenses, it reports a
net loss. Other terms are used synonymously with revenue, including sales and turnover. Other
terms used synonymously with net income include net profit and net earnings. Also, as noted
earlier, revenue and expenses generally relate to providing goods or services in a company’s
primary business activities. In contrast, gains (losses) relate to increases (decreases) in resources
that are not part of a company’s primary business activities. Distinguishing a company’s primary
business activities from other business activities is important in financial analysis; however, for
purposes of the accounting equation, gains are included in revenue and losses are included in
expenses. The statement of financial position and income statement are two of the primary
financial statements. Although these are the common terms for these statements, some variations
in the names occur. A statement of financial position can be referred to as a “balance sheet”,
Income statements can be titled “statement of operations,” “statement of income,” “statement of
profit or loss,” or some other similar term showing that it reflects the company’s operating activity
for a period of time.

1.5 The influence of using accounting information systems on the quality of

accounting information

As a result of technological, economic developments and globalization have become information

systems occupies an important position in all areas, where information systems have evolved at a
rapid pace, numerous applications in all administrative levels, have been used in operational,
technical and strategic activities, Accounting information systems achieved many advantages
through what they provide important information for all users of accounting information. Always,
companies aim to achieve reasonable profits, high market share, good reputation, acceptable from

18
society, and high return on investment and assets through usage of available resources and take
correct decisions based on the available information,

Accounting Information System (AIS) is very important to all companies to facilitate and organise
their activities and helping to achieve their goals with high degree of control. AIS for any company
does not exist by itself, therefore, the most important issues is how to build, organise and maintain
it. Protecting the AIS is not an easy issue because of a number of factors associated with the success
of such systems. We need to understand the workflow procedure to ensure the success of the
system by using different methods, techniques and principles that are characterised by
comprehensive, precise, right and quality information. AIS is designed to help management in
controlling company's activities, forecasting and with decision making process. Quality of
accounting information system incorporate different elements that are working together such as
hardware, software, brain ware, telecommunication network, and database quality, to make sure
that users’ satisfaction are achieved. Also, AIS should be characterised with flexibility, efficiency,
ease of access and timeliness to make decisions correctly. AIS is the total associated components
that are working together to collect, store and summarise, distribute data to be helpful in planning,
control, direction, coordination, analysis and decision making

Accounting information systems components: Accounting information system is composed of

several units which has specific function. They can be presented as shown in fig. 1 below.

Fig 1.1 Accounting information system

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1. Collecting data unit: This unit collects data from the entity’s surrounding environment. This
data is represented in the events and facts that the accountant cares about and considers important
and should be acquired and recorded. The nature of the project’s objectives and the outputs has a
great impact over the type of the data collected and recorded in the system. Also, the nature of
outputs affects the type of data to be collected.

2. Data operating unit: The collected data by the accounting information system might be used
immediately if they were useful for the decision-maker the moment they are collected, but, in most
cases, these primary data needs to be processed and prepared to be useful information in the
decision-making process, thus it is sent to the storage unit in the accounting information system.

3. Data storage and retrieval unit: This unit is responsible for storing data in case they were not
used immediately and keeping it for future use or to be processed before being sent to decision-
makers.

Information delivery unit (information channels): This unit is the means of transferring and
delivering data and information from one unit to another within the accounting information system,
until it reaches the makers of administrative decisions. Communication channels might be
automatic or manual (monitors or papers) according to the institution’s available means. When
choosing the hardware and software components for the accounting systems, the costs and
expenses of such components should be less than the benefit of using the system. Moreover, audit
and control members should be knowledgeable about accounting information systems, supporting
software, and the tools because the auditing process will be done through the computer. The
auditing team should be familiar with automation and automatic control. It also has an impact over
the accountant’s work. It also affects data recording, new systems and networks, and auditing
methods to be used in future.

Accounting information systems’ objectives

Accounting information system aims at achieving a general objective represented by providing the
accounting information that benefits its users. Achieving this general objective leads to achieving
several sub-objectives at the same time, the most important among which are:

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• Measuring all economic events that take place within the entity through the processes of data
collecting and storage, recording, labeling and summarising in the accounting registers.
• Delivering the accounting information through a set of documents and reports to all those who
can benefit from it, among which is the entity’s management which uses this information in
performance evaluation and making appropriate decisions.
• Achieving internal control over all material elements that exist in the entity.

The quality of financial data

Quality is defined as the standard measure of something or a certain level of excellence. Quality
is good if the information used is relevant and reliable, and the relevant information is that which
can be used for decision-making. The quality of accounting information indicates the good
performance of the accounting information system and the appropriateness of the accounting
system applied, in order to reach efficiency and effectiveness in the operations of an organisation
to reach its objectives, protect its assets, serve senior management and help it achieve the
maximum productivity. The dimensions of the accounting information quality are determined by:

➢ Appropriateness: This means the efficiency of financial statements and reports, and their
success in serving their users through their ability to provide adequate and appropriate
information to make appropriate decisions, so that this information is recognised for being
suitable for decision-making and is presented properly besides its timely availability;

➢ Reliability: This is associated with the information integrity and the ability to rely on it.
Accounting information is characterised as being reliable or can be relied on if it has the
ability to express the veracity of the information, to be free from error and bias, and to
represent it fairly and honestly;

➢ Consistency: This characteristic is realised when the company uses the same accounting
treatment for the same event from one period to another without any change;

21
➢ Understandability: it is a qualitative accounting information characteristic that helps a
prudent wise user to identify the meaning and importance of financial reporting; and

➢ Comparability: This characteristic enables users of financial reports to identify similarities

and differences between economic phenomena and events. The use of an incomparable
accounting standard results in increased differences in the expression of economic
phenomena and events.

However, accounting information system (AIS) has a great impact on the quality and effectiveness
of accounting information which leads to the organisational performance of a firm. Research
indicate that the quality of accounting information is influenced by the quality of accounting
information system, determined by four key factors: service quality; information quality; data
quality; and system quality.

1.6 End of chapter questions and solutions

1.6.1 End of chapter questions

1. The conceptual framework, the underpinning regulations, of published financial statements,

states that information contained in the statements should have certain specified, qualitative
characteristics. Discuss these characteristics.

2. Business activities may be divided into three major groups. Discuss the activities involved
in these three groups.

3. Financial reporting is critical to the effective operations of a capital market. What are the
roles of financial reporting and its importance to the various stakeholders?

4 Provision of quality accounting information is determined by the accounting information

system put in place. You are required to state the various units that must be in place to ensure
the preparation of good account information.

1.6.2 Solutions to end of chapter questions

22
1. The quality of financial statement can be measured by the qualitative characteristics it must
possess for it to be of value to the users of financial statement. Quality is good if the information
contained in a financial statement is relevant and reliable, and the relevant information is that
which can be used for decision-making. The quality of financial statements is determined by the
good performance of the accounting information system and the appropriateness of the accounting
system applied, in order to reach efficiency and effectiveness in the operations of an organisation
in achieving its objectives

The qualitative characteristics of financial statements are stated below.

Appropriateness: Appropriateness means the efficiency of financial statements and reports, and
their success in serving their users through their ability to provide adequate and appropriate
information to make appropriate decisions, so that this information is recognised for being suitable
for decision-making and is presented properly and timely.

Reliability: Reliability is associated with the information integrity and the ability to rely on it.
Accounting information is characterised as being reliable or can be relied on if it has the ability to
express the veracity of the information, to be free from error and bias, and to represent it fairly and
honestly.

Consistency: This characteristic is realised when the company uses the same accounting treatment
for the same event from one period to another without any change. This characteristic allows for
easy comparison of organisational performance over a period of time

Understandability: it is a qualitative accounting information characteristic that helps a prudent

wise user to identify the meaning and importance of financial reporting.

Comparability: This characteristic enables users of financial reports to identify similarities and
differences between economic phenomena and events. The use of an incomparable accounting
standard results in increased differences in the expression of economic phenomena and events.

The above stated qualitative characteristics are basic elements that can make financial statements
useful for the users of financial statements in making good decisions by them.

23
2. Business activities consist of operating, financing and investing activities for financial reporting
purposes. These three groups of activities are necessary for the achievement of goals of any
business organisation.

Operating activities: These are activities that form part of the day- to- day business activities of
an entity. Examples include the sale of meals by a restaurant, the provision of services by a
consulting firm, the manufacture and sale of goods by a manufacturing company, and taking
deposits and granting loans by a bank.

Investing activities: These are activities associated with acquisition and disposal of long- term
assets. Examples include the purchase of equipment or sale of equipment (such as unserviceable
equipment) by a construction company, however, the sale of equipment by equipment supplying
company would be an operating activity.

Financing activities: These are activities related to obtaining or repaying capital. The two
primary sources for such funds are owners (shareholders) or creditors. Examples include issuing
equity shares, taking out a bank loan, and issuing loan notes.

Understanding the nature of activities helps the analyst understand where the company is doing
well and where it is not doing so well. Ideally, an analyst would prefer that most of a company’s
profits (and cash flow) come from its operating activities.

3. The capital market refers to interactions among firms or organisations with funding needs and
investors with surplus funds for investments whereby firms raise debt and equity capital for their
operations and investors make funds available to firms either in the form of debt or equity
investments for a return. Therefore, capital market participants depend on financial information to
make various decisions

Firms usually provide financial information through the financial reports they publish. The
financial reports often comprise: financial statements; management discussion of those financial
statements; and other regulatory filings. Some firms engage in additional voluntary
communication, such as management forecasts, analysts ‘presentations, other corporate reports
and press releases on key issues.
24
It has been said that no perfect stock market exists anywhere in the world, and that most stock
markets exhibit weak form of market efficiency. Weak form efficiency implies that the market
uses historical corporate financial information in making investment decisions. Capital market
participants are provided with information that forms a basis for making fair decisions regarding
stock prices in order to make and execute reasoned investment and financing decisions. The
financial information are useful to investors for the following reasons:

a. Capital market participants are provided with information that forms a basis for making
fair decisions regarding stock prices in order to make and execute reasoned investment
and financing decisions;
b. Financial statements prepared using global financial reporting benchmarks help investors
to be better equipped and appreciate risk associated with decisions about flows of
economic capital;
c. Market participants use financial information to make general investments decisions to
reduce financial risks and optimise returns on investments;
d. Financial reporting by corporate entities aids the functioning and development of the
capital market; and
e. Financial statements measure and summarise the economic consequences of business
activities.
It should be noted that information by companies to investors is not completely credible because
companies have the tendency to inflate the value of their performance to encourage investors.
However, the provision of accounting standards helps in ensuring fair presentation of financial
statements

4. Accounting information system (AIS) is very important to all companies to facilitate and
organise their activities and helping to achieve their goals with high degree of control. AIS for any
company does not exist by itself, but the most important issues are how to build, organise and
maintain it. Protecting the AIS is not an easy issue, because a number of factors are associated
with the success of such systems, such as comprehensive, precise, right and quality information.
AIS is designed to help management in controlling the company's activities, forecasting and
decision making process. AIS should be characterised with flexibility, efficiency, ease of access
and timeliness to make decisions correctly. AIS is the total associated components that are working
25
together to collect, store, summarise and distribute data helpful in planning, control, direction,
coordination, analysis and decision making.

In order to have good accounting information, the following units must be in place in an
organistation. These units can be placed under cost and management accounting or financial
accounting.

Cost and Management Accounting: This unit primarily provide accounting information for internal
purposes. The information provided is used to take decisions about the future, emphasis is on
products, processes, etc. This unit will be responsible for:

(i) Preparation of reports to management;

(ii) Coding and classification of cost;
(iii) Collecting and analysing cost information;
(iv) Preparation of production budgets;
(v) Recording labour time; and
(vi) Recording of inventory.

In a manufacturing concern, stores may be under the management accounting unit. The stores
section is responsible for storage of raw material, receiving and issuing of materials. The section
maintains necessary store records.

Financial Accounting: Financial accounting provides information for external reporting;

information being provided by financial accounting unit is stewardship in nature. The unit records
what has happened in a true and fair manner which must comply with statute and accounting
standards. Under this unit we can have sections like:

(i) cash office, which is responsible for receipts and payment of cash. Though these day
payment and receipt of cash is done through banks but all the necessary records relating
to receipts and payments are prepared in the cash office;
(ii) bank reconciliation. This section is responsible for preparation of reconciliation
statements so as to detect any possible errors in banking transactions;
(iii) creditor/debtors, section that maintains the account of customers and suppliers;
(iv) Salaries section is responsible for preparation of salaries and wages;
26
 (v) General ledger, this section maintains the account of all other items that are not in the
specialised ledgers
(vi) Budget section: In some big organisations budget section may be created, however in
small organisations there may not be separate sections for budget, the function could
be assigned to a budget officer;
(vii) Final accounts section is responsible for the preparation of final accounts; and
(viii) Any other sections that may be created to help in provide good information for
stewardship reporting.

Accounting information system aims at achieving a general objective of providing the accounting
information that benefits its users. Achieving this general objective leads to achieving several sub-
objectives at the same time, the most important among which are:

i. Measuring all economic events that take place within the organisation through the processes
of data collection and storage, recording, labeling and summarising in the accounting
registers.
ii. Delivering the accounting information through a set of documents and reports to all those
who can benefit from it, among which is the organisation’s management which uses this
information in performance evaluation and making appropriate decisions.
iii. Achieving internal control over all material elements that exist in the organisation.

27
 Professional Taxation II
Financial/Tax analysis

Chapter
2
Business analysis and valuation tools

Contents

i. Industry analysis
ii. Requirement for effective analysis
iii. Corporate and business strategy definitions
iv. Approaches to strategy formulation
v. Environmental appraisal
vi. SWOT analysis
vii. PESTEL analysis
viii. Porter’s model
ix. Internalisation strategies
x. End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

i. Understand how business analysis is carried out.

ii. Understand the requirements for effective analysis.
iii. Know the importance of environmental scanning in business analysis

28
 iv. Know the various valuation tools in business analysis such as SWOT, PESTEL and
Porter Model
v. Understand competitive strategy analysis.
vi. State what are entails in corporate strategy analysis.

2.1 Industry analysis

In performing business analysis, it is a necessity to embark on industry analysis for any meaningful
business analysis to be carried out. In this chapter we would first consider business analysis before
looking at other strategic tools. Industry analysis is the process of reviewing a business
environment, its challenges and opportunities, and combining it with current trends in the
technology sector. Domain knowledge, which implies an understanding of common business
terminology from the operating context, combined with industry structure and operating processes,
is a pre-requisite for industry analysis.

Information technology has been the leading force behind major industry shifts and business
disruptions in the last half century. Therefore, manager have to play an important role in industry
analysis. Managers bridge the gap between business and technology by identifying developments
in technology that can address prevailing industry problems and deliver positive outcomes to a
business. The range of business outcomes can vary from strengthening existing business
capabilities for competitive advantage to transforming a business or industry or ultimately creating
new industries.

Industry analysis involves observation and analysis of factors such as market behaviours,
competitive forces and financial, regulatory, socio-economic and technological trends that
influence the domain. Industry analysis delivers insights into business drivers and key success
factors relevant to the domain.

Industry analysis is a business owned activity to assess the existing business environment and its
competitive position. It is one of the preliminary steps in strategic planning. A manager will
interpret industry analysis and combine it with knowledge of existing and emerging technology
and managerial issues. Business stakeholders require manager to function as advisory, guiding
workers to address prevailing business problems. Industry analysis capability enhances a

29
manager's involvement in understanding business needs and facilitates a consultative approach in
requirements development.

Managers should have an understanding of business, both in context of business fundamentals and
domain processes, in order to meaningfully engage with business stakeholders. Managers are
expected to keep track of trends so that their technology and business skills are constantly
improved. Industry analysis requires a manager to develop a broad external perspective and
analytical skills to research information and interpret data drawn from or initiative on hand.
Common tasks in industry analysis involve drawing information from multiple sources related to
an industry. These include business, trade sources and technology analysis.

Information is commonly available through industry communities, forums, publications and data.
Managers study technology adoption by peers or first movers in the industry, as well as interpreting
emerging technology trends that will have relevance to business. As business leadership may
usually engage external advisory organisations for analysis, managers must be involved in the
strategy formulation process which include among others the following:

• Develop an "outside-in thinking” and understand the business from a customer viewpoint;
• Build an understanding of business motivation (why and how businesses exist and survive)
generally and in the organisation where the manager works;
• Study industry reference models such as value chain analysis, Porter’s Five Forces model,
PESTEL and SWOT;
• Follow information sources on industry e.g. technology trend, trade publications, business
journals, etc.; and
• Develop domain knowledge through knowledge sharing with various managers in and
outside the organisation, business glossaries or training on industry fundamentals.

2.2 Requirement for effective analysis

Industry Research

Industry research is the acquisition of corporate intelligence on a broad range of issues including
macro environment, market and competitive landscape and consumer analysis. As a rule, a

30
manager will be required to perform secondary type of industry research i.e. research is derived
from aggregation of existing sources of information and data, as well as broader research reports
published by dedicated research and analyst firms. A manager should have a broad understanding
of business operations and knowledge of the specific domain. Domain knowledge pertinent to
industry research includes understanding industry codes, markets, product offerings, regulatory
requirements, financial information, as well as international variations, if needed.

Information analysis

Information analysis is the process of discovery and quantification of patterns in industry-specific

data and trends. A manager will perform information analysis to interpret macro and mega trends,
financial indicators, market growth indicators and influence of technology in shaping business
outcomes.

Industry segmentation

Industry segmentation is the process of defining and subdividing a large homogenous market into
clearly identifiable components having similar needs, wants, or demand characteristics. Industry
segmentation is driven by factors such as products, target markets, geography, demographics and
size of businesses that constitute an industry. Industry segmentation determines key factors such
as product, pricing, business composition and resources required for operation. A manager needs
to understand industry segmentation as it has an influence on technology resources and technology
enablement within the industry.

Industry trends

An assumed tendency of a given industry to move in a particular direction over time, primary
trends for medium time frames, and secondary trends lasting for many years has been a primary
and rapid disruptive force for managers in the last fifty years making the role of managers very
important in signaling industry changes arising from technology trends. Managers combine
industry and technology trends to provide input and direction for technology strategy.

2.3 Corporate and business strategy definitions

Strategy can be broadly defined as the match an organisation makes between its own resources
and the threats or risks and opportunities created by the external environment in which it operates.
31
Therefore, strategy can be seen as a key link between what the organisation wants to achieve, its
objective and the policies adopted to guide its activities. An organisation can have a single
strategy or many strategies, and that strategies are likely to exist at a number of levels in the
organisation.
Corporate strategy is concerned with the type of businesses the firm, as a whole is in to or should
be in. It addresses such issues as the balance in the organisation's portfolio by directing attention
to questions like the attractiveness of entire businesses, with reference to important strategic
criteria, such as markets, contribution to corporate profits and growth in a particular industry.
Issues concerning diversification and the structure of the firm as a whole are of corporate concern.
Business strategy is concerned with how an operating unit within the corporate whole can compete
in a particular market. Strategic business units (SBUs) are created at corporate level, and can be
subsumed under it. The strategies of SBUs can be regarded as the parts which require and define
the organisational strategies as a whole. A firm's operating level strategy is concerned with how
the various functions - finance, marketing, operations, research and development etc. - contribute
to both business and corporate strategy. At this level the focus is likely to be on the maximisation
of resources’ productivity.

2.4 Approaches to strategy formulation

Figure 3.1 is a simple model that captures the key elements in strategy-formulation, but it must be
recognised that these variables will vary from organisation to organisation and also that the nature
and type of influences on the formulation process may vary at each level in the three-tier structure.
However, those involved in the process tend to focus at a single level. For example, at the corporate
level managers are concerned with analyses across SBUs rather than becoming deeply involved in
issues within an SBU; corporate analysts will be more concerned with the fit of the operating units
in the organisation. Obviously the levels are interdependent because strategy at one level should
include and be consistent with the strategy at the next level down. In addition, the model depicted
in Figure 3.1 is useful regardless of level because, although the variables differ by level the
approach, they are essentially the same.

32
 Global
Corporate Level
Portfolio Analysis
Corporat Decisions about: diversification
e primary structure

Business Level
Business Business Strategy
Division Plans

Operational Level
Operational Products market plans
Functional or Departmental plans

Local

Levels of strategy

Figure 3.1

Strategy formulation

Strategy-formulation can be viewed as a decision-making process which is primarily concerned

with: the development of the organisation's objectives; the commitment of its resources; and
environmental constraints; so as to achieve its objectives. This process has several elements that
are showing in Figure 3.2. The components in the model can be distinguished in that the first set
of elements is concerned with the identification of a number of strategic options, while the second
group deals with the selection of a preferred strategy or strategies. The figure shows the structure
of the formulation process and it concentrates on the analysis of objective elements. It also
incorporates the key-role of values in the formulation process.

33
 Present corporate objectives
and strategy

Environmental Internal
appraisal appraisal

Strategy options

Societal values and Values and aspirations

expectations of managers

Strategic selection

Revise corporate objectives

and strategy

Figure 3.2
Strategy-formulation model

34
 .
The examination of the components in the formulation model, reveals, that the processes are
interconnected. However, the process as depicted in the figure is not to indicate that this represents
the way in which the process might work in practice. Because of the interrelationship between the
elements in the strategy formulation process, it is likely to be iterative in nature, containing
negotiation and compromise

The present situation

The formulation process in an existing organisation does not and cannot commence in a vacuum,
constraints usually exist that impact on the process. The firm's current situation, strategy, plans, or
commitments obviously present a starting-point for analysis. Thus, the firm may be in a situation
where 'formulation' as such is unnecessary as the requirement is to develop and fine-tune existing
strategies, or to modify short-term objectives to fit with the long-term aims. An illustration of this
scenario might be where a firm implemented a decision to acquire another organisation in pursuit
of a policy of vertical integration. Money spent on the acquisition and its implementation, or on
the construction of new facilities, and their impact on debt or equity ratios could limit future
financial options. New fixed-cost levels associated with such a policy would also affect future
product choice and profit requirements. The present situation of course should not preclude the
firm from taking advantage of opportunities in unrelated areas. The key point is that the existing
organisational structure and what the firm does well will have an effect on the formulation process.

Environmental and internal appraisal

A firm can be viewed as an open system with respect to the environment in which it operates. It is
involved in a continuous process of exchange with external parties - suppliers, customers,
employees, government bodies - to obtain the necessary inputs and to disperse its output. So, it
competes with the other organisations for these resources. As such, the environment represents a
source of both opportunities and threats. Environmental appraisal is a central element in
formulating strategy.

35
Additional analysis is required to identify strategic options, involving an appraisal of the
organisation's own resources with the objective of identifying the firm's strengths and weaknesses.
Such analysis will reveal capability of the firm to counter external threats and to take advantage of
present opportunities. An important feature of this process concerns the identification of
'distinctive competencies', that is, those things at which the organisation is particularly good in
relation to its competitors.
The generation of strategic options is not a random process but may be stimulated, for example,
by a shortfall in current performance and the level of performance expected by key decision-
makers. It is also more complex than merely seeking to fit a range of variables affecting the firm
and its environment.

Five features that affect the identification of strategic options are:

• Organisational learning’
• Distinctive competence and the location of slack resources;
• Past performance and type of search activity;
• Power differences within the organization; and
• Absorption of uncertainty through politics.

Strategic selection
The methods of evaluating which strategic option(s) will be selected vary from organisation to
organisation. The effect of rational and non-rational factors has effect on decision-makers.
Strategic decisions emanating from the formulation process may often be presented as utilitarian,
in most cases the decisions are reached as a result of, or in spite of, a wide range of influences on
those involved. Such influences will include, for example, individual needs, values and
perceptions, coupled with wider societal values and expectations impacting on managers as
individuals and the organisation as a whole.

2.5 Environmental appraisal

Environment as stated earlier can be divided into external and internal environment. It is necessary
to consider in more detail these internal and external environments in which an organisation
36
operates.

Internal and external environments

The internal environment refers to all factors within an organisation that impact strengths or cause
weaknesses of a strategic nature. The external environment includes all the factors outside the
organisation which provide opportunities or pose threats to the organisation.

The environment in which an organisation exists can, therefore, be described in terms of the
strengths and weakness existing in the internal environment and the opportunities and threats
operating in the external environment.

The four environmental influences could be described as follows:

Internal environment:
• Strength is an inherent capacity which an organisation can use to gain strategic advantage.
Examples of strength are good reputation among customers, resources, assets, people,
experience, knowledge, data and capabilities.
• Weakness is an inherent limitation or constraint which creates strategic disadvantages.
Examples of weakness are gaps in capabilities, financial deadlines, low morale and
overdependence on a single product line.

External environment
• Opportunity is a favourable condition in the organisation’s environment which enables it to
consolidate and strengthen its position Examples of opportunity are economic boom,
favourable demographic shifts, arrival of new technologies, loosening of regulations,
favourable global influences and unfulfilled customer needs.
• Threat is an unfavourable condition in the organisation’s environment which creates a risk for,
or causes damage to, the organisation. Examples of threat are: economic downturn,
demographic shifts, new competitors, unexpected shifts in consumer tastes, demanding new
regulations, unfavourable political issue or legislation, and new technology.

37
An understanding of the external environment, in terms of the opportunities and threats and the
internal environment, in terms of the strengths and weakness, is crucial for the existence, growth
and profitability of any organisation. A systematic approach to understanding the environment is
the SWOT analysis.

2.6 SWOT analysis

Strength, weaknesses, opportunities and threat (S'WOT) analysis, evolved during the 1960s at
Stanford Research Institute, it is a very popular strategic planning technique having applications
in many areas including management. Organisations perform a SWOT analysis to understand their
internal and external environments. Through such an analysis, the strengths and weaknesses
existing within an organisation can be matched with the opportunities and threats operating in the
environment so that an effective strategy can be formulated. An effective, organisational strategy,
therefore, is one that capitalises on the opportunities through the use of strengths, protects itself
from threats and minimising the impact of weaknesses, to achieve pre-determined objectives.

A simple application of the SWOT analysis technique involves the following steps:

➢ Setting the objectives of the organisation or its unit;

➢ Identifying its strengths, weaknesses, opportunities and threats;
➢ Asking four questions
a. How do we maximise our strengths?
b. How do we minimise our weaknesses?
c. How do we capitalise on the opportunities in our external environment?
d. How do we protect ourselves from threats in our external environment?
➢ Recommending strategies that will optimise the answers from the four questions.

The SWOT analysis is usually done with the help of a template in the form of a four-cell matrix,
each cell of the matrix representing the strengths, weaknesses, opportunities and threats. The
analysis for preparing the SWOT matrix could be done by a group of managers in a workshop
session. The session could use the brainstorming technique for generating ideas about the SWOT
factors. A typical SWOT analysis matrix for an organisation is shown below.

38
 STRENGHT
• Favourable location
• Excellent distribution network
• Established R & D centre
• Good management reputation
WEAKNESSES
• Uncertain cash flow
• Weak management information system
• Low worker commitment

OPPORTUNITIES THREATS

• Favourable industry trends • Unfavourable political environment

• Low technology options available • Obstacles in licensing new business
• Possibility of niche target market • Uncertain competitors' intentions
• Availability of reliable business • Lack of sustainable financial backing
partners

Benefits of SWOT analysis

SWOT analysis has several benefits, which include:

• Simple to use;
• Low cost;
• Flexible and can be adapted to varying situations;
• Leads to clarification of issues;
• Development of goal-oriented alternatives; and
• Useful as a starting point for strategic analysis.
Pitfall of using SWOT Analysis
The disadvantages of using SWOT are:
• Simplicity of use may turn to be simplistic by trivialising the reality that may be more complex
than represented in SWOT matrices;
• May result in just compiling lists rather than think about what is really important for achieving
objectives;
• Usually reflects an evaluator’s position and viewpoint that can be misinterpreted to justify a
previously decided course of action, rather than be used as a means to open new possibilities;

39
• Chances exist where strengths may be confused with opportunities or weaknesses with threats;
and
• May encourage organisations to take a lazy course of action of looking for strengths that match
opportunities rather than developing new strengths that could match the emerging
opportunities.
General versus relevant environment

The external environment, as stated earlier, consists of all the factors which provide opportunities
or pose threats to an organisation. In a wider sense, the external environment encompasses a variety
of sectors like international, national and local economy, social changes, demographic variables,
political systems, technology, attitude towards business, energy sources, raw materials and others
resources and many other macro-level factors. We could designate such a wider perception of the
environment as the general environment. All organisations, in one way or the other, are concerned
about the general environment, but the immediate concerns of any organisation are confined to
just a part of the general environment which is of high strategic relevance to the organisation. This
part of the environment could be termed as the immediately relevant environment or simply, the
relevant environment as shown in figure 3.3

GENERAL ENVIRONMENT

ORGANISATION

RELEVANT
ENVIRONMENT

40
Figure 3.3 The business environment of an organisation

A conscious identification of the relevant environment enables the organisations to focus its
attention on those factors which are intimately related to its mission, purpose, objectives and
strategies. Depending on its perception of the relevant environment, an organisation takes into
account those influences in its surrounding which have an immediate impact on its strategic
management process. Having identified its relevant environment, an organisation can
systematically appraise it and incorporate the results of such an appraisal in strategic planning. In
order to cope with the complexity of the environment.

Classification of Environmental Sectors

Different kind of information are required from different environment , a categorisation scheme
for grouping different kinds of information related to the environment into sectors are customers,
competitors, suppliers, technology; social, political, economic conditions, etc., the sector
categorisation should be such that these sectors must be exhaustive, i.e., each item of information
should find a place in one of the sectors; the sectors must be mutually exclusive so that any given
item of information must belong to one of the category; and the classification must be functional
and relate to actual scanning practice. There are several sectors into which the external/general
environment could be divided into. But, in a given context, there are certain sectors that merit
greater attention than the others.

2.7 PESTEL analysis

PESTEL or PESTLE analysis, also known as PEST analysis, is a tool for business analysis of
political, economic, social, and technological factors. These factors determine the extent to which
a government may influence the economy or a certain industry. For example, a government may
impose a new tax or duty which can cause the entire revenue generating structures of organisations
to change. Political factors include tax policies, fiscal policy, trade tariffs etc. that a government
may levy around the fiscal year and it may affect the business environment (economic
environment) to a great extent

41
The PESTLE Analysis tool can be used for business planning, strategic planning, market
planning, product development, and organisational planning. The PESTLE tool provides its users
with factors that need to be well researched and brainstormed.

Political factors

Every business has both internal politics and external politics that affect their operations. The
internal politics like team jealousies and personal interests occur in all organisation and must be
considered and managed by stakeholders. The external politics refer to those which the
stakeholders do not control. These events include all political events like employment laws, tax
policies, trade restrictions, trade reforms, environmental regulations, political stability, tariffs, etc.
These are all about how and to what degree a government intervenes in the economy. This can
include; government policy, political stability or instability in overseas markets, foreign trade
policy, tax policy, labour law, environmental law, trade restrictions and so on. It is clear from the
list above that political factors often have an impact on organisations and how they do business.
Organisations need to be able to respond to the current and anticipated future legislation, and adjust
their marketing policy accordingly.

42
43
 Economics

Political Legal

PESTEL

Technological Social

Environmental
Figure 3.4 - All the external environmental factors (PESTEL factors)

Economic Factors

Economic factors have a significant impact on how an organisation does business and also how
profitable they are. Factors include – economic growth, interest rates, exchange rates, inflation,
disposable income of consumers and businesses and so on.

44
These factors can be further broken down into macro-economic and micro-economic factors.
Macro-economic factors deal with the management of demand in any given economy.
Governments use interest rate control, taxation policy and government expenditure as their main
mechanisms for this. Micro-economic factors are all about the way people spend their incomes.
This has a large impact on organisations that produce consumer goods in particular.

Social Factors

Also known as socio-cultural factors, are the areas that involve the shared belief and attitudes of
the population. These factors include – population growth, age distribution, health consciousness,
career attitudes and so on. These factors are of particular interest as they have a direct effect on
how marketers understand customers and what drives them.

Technological Factors
We all know how fast the technological landscape changes and how this impacts the way we
market our products. Technological factors affect marketing and the management thereof in three
distinct ways as follows:
• New ways of producing goods and services
• New ways of distributing goods and services
• New ways of communicating with target markets

Environmental Factors

These factors have only really come to the forefront in the last two decades. They have become
important due to the increasing scarcity of raw materials, pollution targets, doing business as an
ethical and sustainable company, carbon footprint targets set by governments (this is a good
example where one factor could be classified as political and environmental at the same time).
These are just some of the issues organisation are facing within this factor. More and more
consumers are demanding that organisation should ensure that the products they buy are sourced
ethically, and if possible, from a sustainable source.

45
Legal factors

Legal factors include - health and safety, equal opportunities, advertising standards, consumer
rights and laws, product labelling and product safety. It is clear that companies need to know what
is and what is not legal in order to trade successfully. If an organisation trades globally this
becomes a very tricky area to get right as each country has its own set of rules and regulations.

On the completion of PESTEL analysis, it could be used to identify the strengths and weaknesses
of the organisation in a SWOT analysis.

Advantages and disadvantages of a PESTLE analysis

The advantages of using the PESTLE tool are:

➢ The tool is simple and easy to understand and use;

➢ The tool helps in understanding the business environment better;
➢ The tool encourages the development of strategic thinking;
➢ The tool helps reduce the effect of future business threats; and
➢ The tool enables organisation to spot new opportunities and exploit them effectively.

The disadvantages of using the PESTLE tool are:

➢ The tool allows users to over-simplify the data that is used. It is easily possible to miss
important data;
➢ The tool needs to be updated regularly to be effective;
➢ The tool is most effective when users come from different perspectives and departments;
➢ The tool requires users to have access to data sources which could be time consuming and
expensive;
➢ Much of the data used by the tool is on an assumption basis; and
➢ The business environment is changing drastically. Thus, it is becoming increasingly difficult
for projects to anticipate developments.

46
 If used properly, the PESTLE analysis can be very effective in its scope for understanding
market and business position. The PESTLE analysis alongside SWOT can be used as a basis for
analysing the business and environmental factors of an organization. Every manager needs to
know the importance of PESTLE analysis in helping to focus on the objectives and strategies of
an organisation.

2.8 Porter’s model

Porter has made immense contribution in the development of the ideas of industry and completive
analysis and their relevance to the formulation of competitive strategies. He advocates that a
strategy analysis should be made so that a firm is in a better position to identify its strengths and
weaknesses. Porter’s Model consists of five competitive forces--threat of new entrants, rivalry
among competitors, bargaining power of suppliers, bargaining power of buyers and threat of
substitute products—that determine the intensity of industry competition and profitability. Figure
3.5 depicts Porter’s five forces of competition

Potential threats from

firms which make
substitute products
or services

Suppliers’ bargaining Forces of competition Buyers’ bargaining

power created by rivalry power

Potential threats from

47
entry
of new firms
Figure 3.5 - Porter’s five forces model of competition in an industry

A description of each of these five forces are as follows:

Threat of new entrants

Any industry that is perceived as being profitable tends to attract new entrants. These new entrants
are firms that are interested in investing in the industry to share the growth prospects. Such new
entrants augment the existing production capacity and often possess a desire to make large
investment and secure substantial market share. The existing firms have either to share a growing
market with a larger number of competitors or part with some of their own market share to the new
entrants. Either way new entrants may cause comparatively lesser sales volume and revenue and
lower the returns for all the firms in the industry.

The chance that new entrants will enter into an industry depends on two factors: the entry barriers
to an industry and the expected retaliation from existing firms. Of these, entry barriers are
significant demotivators for new entrants. The concept of entry barriers implies that there are
substantial costs involved in entering into a new industry. The higher the entry barriers in an
industry, the less likely are the new entrants to enter that industry. So, higher entry barriers serve
to keep out potential entrants into an industry.

The entry barriers may arise as a consequence of several factors such as:

• Economies of scale in production and sale of products leading to lower costs for existing firm;
• Capital requirements being very high may prevent new entrants from making investments;
• Switching costs from the existing products or services to a new one may discourage customers
from making new commitments owing to the costs incurred in buying new ancillary
equipment, retraining employees or establishing a new network of relationship;
• Product differentiation by existing firms based on perceived distinctiveness by the customers,
based on effective advertising, reputation as a service provider, brand loyalty of customers
towards existing firm or some such other factor;

48
• Access to distribution channel can be monopolised by the existing firms on the basis of their
long-term relationship with the distributors;
• Cost disadvantages independent of scale may arise from proprietary products technology,
exclusive access to raw materials, favourable location and benefit of governmental subsidies;
and
• Government policies through licensing and other means can prevent the entry of new firms to
an industry.
Besides the entry barriers, the expected retaliation to the new entrants from the existing firms may
be potential threat to entry. Any potential entrant to an industry would have to predict the likely
moves that the existing firms could make. For instance, an existing firm with a large stake in the
industry may lower its price to create a difficult situation for the new entrant. Or an existing firm
with substantial resources may attempt to alter the basis of competition so that the new entrant is
discouraged from making a foray.

Despite the formidable hurdles posed by existing firms, new firms do enter industries if they find
them to be promising. The popular strategy for doing so is finding market niches not served by
existing firms and to gradually build up a presence in the industry.

Rivalry among competitors

Competition is a game in which normally, one player loses at the expense of the other. A move on
the part of a player may cause other players to make countermoves or initiate efforts to protect
themselves from the danger posed by the initial move. In this manner, firms within an industry are
mutually dependent. The situation in an industry keeps changing with the actions and reactions of
the constituent firms. The desire to be the market leader or to corner a larger market share leads to
rivalry among competitors. The extent of the rivalry among competitors in an industry affects the
competition within that industry. When the rivalry is weak, there is likely to be lesser competition;
when such rivalry is high, the level of competition is higher. This has implications for existing
firms as well as those firms contemplating entry into the industry.

The dimensions of rivalry among competitors are several. Some of the major ones are described
below.

49
• Competitive structure refers to the number of competitors, their size and their diversity.
Different types of competitive structures have different implication for the existing firms and
for the new entrants.
Structure could either be fragmented or consolidated. A fragmented structure means that there
are large numbers of small or medium-sized companies none of them in a position to dominate
the industry. This structure is characterised by low entry barriers and less or no differentiation,
leading to products becoming commodities. Competition is intense and the industry faces
booms and bursts, leading to frequent changing of the structure. A consolidated structure
consists of a few large companies (an oligopolistic market) or of just one large firm (a
monopoly). Such a structure has a closely-knit group of companies whose actions and reactions
are matched: the actions of one lead to reactions from others. Competitive actions of the
competitors are under close watch by the others as they affect the distribution of market share.
The intensity of competition may range from been tolerance to fierce rivalry. In some
industries, the competitors may adopt a policy of ‘live and let live’, while in others, there might
be cut-throat competition leading to underpricing or severely fought competitive battles on the
basis of other factors such as delivery, advertising or after-sale service. Diversity among
competitors means that different firms in an industry have different ideas on the basis of which
to compete, different set of goals to achieve, or different organisational cultures. An industry
with greater diversity poses a higher potential challenge to existing firms or new entrants for
devising competitive strategies.

• Demand conditions refer to the nature of the customer demand existing in an industry. A high
demand of a growing demand tends to moderate competition as each firm has enough for it
and need not grab it from others. Stagnant demand may lead to competitive strategies designed
to snatch market share from others. Declining demand may cause companies to maintain their
market shares. Existing firms or new entrants need to take the demand conditions in the
industry into account for the purpose of formulating business strategies.
• Exit barriers restrict the firms in an industry and prevent them from leaving, even though the
returns might be low or might even be sometimes negative. The exit barriers are economic,
strategic or emotional factors preventing companies from moving out after divestment of their

50
 businesses. Economic factors could be the high investments committed to plant and equipment
that have no alternative usage and high fixed costs of exit, such as, high retrenchment costs or
high severance pay owing to labour agreements. Strategic factors could be interlinkages
between the different businesses of a company such as a firm being its own supplier or buyer
or different businesses sharing a common pool of resources. Emotional factors could be a
sentimental attachment to a business, it being an ancestral business or one founded by the
entrepreneur on his own, or unwillingness to part with a business owing to loyalty to employees
or distributors.

Collectively, the three factors of competitive structure, demand conditions and exit barriers
determine the business strategies that a firm is likely to adopt. As we described, these three factors
constitute the force of competitive rivalry within an industry, it must be noticed that business
strategies are critically dependent on the industry environment. The nature of industry environment
varies across industries and also with time. There might be embryonic or introductory industries,
growth or sunrise industries, mature or stable industries and declining or sunset industries. Each
of these industries would require a different approach to the formulation of business strategies. It
is also important to note that industries respond to time and follow a life cycle. An industry in
mature stage today might be a declining industry tomorrow. Here again, it is important for firms
to align their business strategies to the changing conditions in the industry environment. The
competitive equations change, so do the demand conditions. Entry barriers erected today may fall
by the wayside as soon as some development takes place. Such is the dynamic nature of strategic
management where anything that a firm might do today does not guarantee success tomorrow,
unless there is a willingness to respond to environmental conditions as they arise in between.

Bargaining Power of Buyers

The bargaining power of buyers constitutes the ability of the buyers, individually or collectively,
to force a reduction in prices of products or services, demand a higher quality or better service or
to seek more value for their purchases in any way. A high buyer bargaining power constitutes
negative feature for existing firms or new entrants of an industry. A low buyer bargaining power
enables firm to pass on the cost escalation to buyers or to make the buyers accept a lower quality
of product and service at a higher price.

51
The bargaining power of buyers is high under the following conditions:

• When the buyers are few in number;

• When the few buyers place large orders individually;
• When alternative suppliers are present, willing to supply at a lower price or on favourable
selling conditions;
• When the switching costs of buyers from one supplier to the other is low;
• When the buyer itself charges a low price for its products and is sensitive to price increases;
• When the purchased product constitutes a high percentage of a buyer’s costs, making it look
around for lower-priced supplies; and
• When the buyer itself has the ability to integrate backwards and create its own captive supply
source.

Bargaining power of suppliers

Like the bargaining power of buyers, suppliers too have a level of bargaining power. The
bargaining power of suppliers constitutes their ability, individually or collectively, to force an
increase in the price of the products or services or make the buyers accept a lower quality of
product or level of service. A high supplier bargaining power constitutes a positive feature for the
existing firms or new entrants of an industry. A low supplier bargaining power prevents a firm
from passing on its cost increases to the buyers or to make the buyers accept a lower quality of
product and service at a higher price.

The bargaining power of suppliers is high under the following conditions:

• When the suppliers are few and the buyers are many;
• When the products or services are unique and are not commonly available;
• When the substitutes of the products or services supplied are not freely available;
• When the switching costs of a supplier from one buyer to the other is low;
• When the supplier is not critically dependent on the products or services supplied;
• When the buyer buys in small quantities and, therefore, is not important to the supplier; and
• When the suppliers have the ability to integrate forward and use their own supplies for

52
 production of the end product or service.

Threat of substitute products

Substitute products or services are those that apparently are different, but satisfy the same set of
customer needs. Example of substitute are tea and coffee, Margarine and butter. Other examples
of substitute products and services could be alternative modes of transportation, postal, fax and
courier services and electrical gadgets like bulbs and tube lights. The platform for substitutability
in every case, is the serving of the customer need. The issue of threat of substitute product is very
key in completive strategy, an organisation that is not considering this may soon go out of existence

The availability of close substitutes constitutes a negative competitive force in an industry. In other
words, those industries which have no close substitutes are more attractive than those that have
one or more of such substitutes. Obviously, firms in an industry having no close substitutes can
charge a higher price and earn higher returns. For industries where close substitutes are available,
the level of price of products chargeable is restricted by the price of the substitute available. Thus,
firms have to formulate their business strategy keeping in view the intensity of the competitive
force arising out of the presence or absence of the threat of substitutes.

The purpose of an industry analysis, in the context of strategic choice, is to determine the industry
attractiveness and to understand the structure and dynamic of the industry with a view to finding
out the continued relevance to strategic alternatives that are there before a firm. It follows that, for
instance, if the industry is not, or is no longer sufficiently attractive (i.e., it does not offer long-
term growth opportunities) then the strategic alternatives that lie within the industry should not be
considered. It also means that alternatives may have to be sought outside the industry, calling for
diversification moves.

Using the five forces model of industry competition, a firm can analyse its critical strengths and
weaknesses, its position within the industry, the areas where strategic changes may yield the
maximum profits and the significant opportunities and threats.

2.9 Internationalisation strategies

Internationalisation are type of expansion strategies that require organisations to market their
53
products or services beyond domestic or national market, for doing so, organizations would have
to assess international environment, evaluates its own capabilities and devise strategies to enter
foreign markets. Porter has therefore, extended his idea of the competitive advantage of firms to
the competitive advantage of nations

Porter Diamond Model, also known as the Porter Diamond theory of national advantage or Porters
double diamond model, has been given this name because all factors that are important in global
business competition resemble the points of a diamond. Porter assumes that the competitiveness
of businesses is related to the performance of other businesses. Furthermore, other factors are tied
together in the value-added chain in a long-distance relation or a local or regional context.

Organisations can use the Porter’s Diamond Model as shown in figure 3.6 to establish how they
can translate national advantages into international advantages. The Porter Diamond Model
suggests that the national home base of an organisation plays an important role in the creation of
advantages on a global scale. This home base provides basic factors that support an organisation,
including government support but they can also hinder it from building advantages in global
competition. The determinants that Porter distinguishes are:

Factor conditions

This is the situation in a country relating to production factors like knowledge and infrastructure.
These are relevant factors for competitiveness in particular industries. These factors can be
grouped into material resources- human resources (labour costs, qualifications and commitment)
– knowledge resources and infrastructure. But they also include factors like quality of research or
liquidity on stock markets and natural resources like climate, minerals, oil and these could be
reasons for creating an international competitive position.

Related and supporting industries

The success of a market also depends on the presence of suppliers and related industries within a
region. Competitive suppliers reinforce innovation and internationalisation. Besides suppliers,
related organisations are of importance too. If an organisation is successful this could be beneficial

54
for related or supporting organisations. They can benefit from each other’s know-how and
encourage each other by producing complementary products.

Home demand conditions

A successful home market and the size of the market plays a prominent role in devising an
international strategy. There always exists an interaction between economies of scale,
transportation costs and the size of the home market. If a producer can realise sufficient economies
of scale, this will offer advantages to other companies to service the market from a single location.

4. Strategy, structure and rivalry

This factor is related to the way in which an organisation is organised and managed, its corporate
objectives and the measure of rivalry within its own organisational culture. Furthermore, it focuses
on the conditions in a country that determine where a company will be established. Cultural aspects
play an important role in this. Regions, provinces and countries may differ greatly from one
another and factors like management, working morale and interactions between companies are
shaped differently in different cultures. This could provide both advantages and disadvantages for
companies in a certain situation when setting up a company in another country. According to
Porter, domestic rivalry and the continuous search for competitive advantage within a nation can
help organisations achieve advantages on an international scale.

5. Government

Governments can play a powerful role in encouraging the development of industries and
companies both at home and abroad. Governments finance and construct infrastructure (roads,
airports) and invest in education and healthcare. Moreover, they can encourage companies to use
alternative energy or alternative environmental systems that affect production. This can be effected
by granting subsidies or other financial incentives.

6. Chance events

55
Porter also indicates that in most markets chance plays an important role. This provides
opportunities for innovative companies that are not afraid to start up new operations. Entrepreneurs
usually start their companies in their homeland, without this having any economic advantages,
whereas a similar start abroad would provide more opportunities.

Advantages

By using the Porter Diamond Model, an organisation may identify what factors can build
advantages at a national level. The Porter Diamond Model is therefore often used during
internationalisation efforts. Porter is of the opinion that all factors are decisive for the
competitiveness of a company with respect to their foreign competitors. By considering these
factors a company will be better able to formulate a strategic goal.

Government

Firm Strategy,
structure
and rivalry

Factor Demand
Conditions Condition

Related and
Supporting
Industries
56 Serendipity
Figure 3.6 Porter’s Diamond Model

2.10 End of chapter questions

1. Explain the different aspects of internal and external environment emphasising the nature
of their impact on the capability of an organisation and ultimately on its strategic
advantage.
2. Select an industry of your choice. Identify Porter’s five forces of competition in that industry.
Perform a competitive analysis from the point of view of the market leader in the industry.
3. What is industry analysis? Discuss the basic requirements necessary in performing an
effective industry analysis.
4. Distinguish between corporate and business strategies and explain the various approaches to
strategy formulation
5. SWOT analysis is very useful in the formulation of an organisation strategy. Explain SWOT
analysis and the steps involved in carrying out SWOT analysis.

Solutions to end of chapter questions

1. The environment of an organisation is very crucial to it success and relevant strategies must
be formulated in line with the factors operating in the environment of an organisation.
Organisation has both internal and external environments.
The internal environment refers to all factors within an organisation that impact strengths or
cause weaknesses of strategic nature. The external environment includes all the factors outside
the organisation which provide opportunities or pose threats to the organisation.

The environment in which an organisation exists can, therefore, be described in terms of the
57
strengths and weakness existing in the internal environment and the opportunities and threats
operating in the external environment.

The four environmental influences that can impact on the capability of an organization and its
strategic advantage are as follows:
Internal environment:
• Strengths are inherent capacity which an organisation can use to gain strategic
advantage. Examples of strengths are: good reputation among customers, resources,
assets, people, experience, knowledge, data and capabilities.
• Weaknesses are inherent limitations or constraints which create strategic disadvantages.
Examples of weaknesses are gaps in capabilities, financial deadlines, low morale and
overdependence on a single product line.

External environment
• Opportunity is a favourable condition in the organisation’s environment which enables
it to consolidate and strengthen its position. Examples of opportunity are economic
boom, favourable demographic shifts, arrival of new technologies, loosening of
regulations, favourable global influences and unfulfilled customer needs.

• Threat is an unfavourable condition in the organisation’s environment which creates a

risk for, or causes damage to, the organisation. Examples of threat are economic
downturn, demographic shifts, new competitors, unexpected shifts in consumer tastes,
demanding new regulations, unfavourable political or legislation and new technology.

An understanding of the external environment, in terms of the opportunities and threats and
the internal environment, in terms of the strengths and weaknesses, is crucial for the existence,
growth and profitability of any organisation as well as crafting of appropriate strategies to
take advantage of opportunities and strength and to minimise the impact of threats and
weaknesses.

58
2. This question requires a candidate to select one industry of his choice, therefore the industry
selected will determine what is to be discussed, However, highlight of what is expected in the
solution are as follows:

Identification of Porter’s five forces of competition;

(i) Threat of new entrants

The chance that new entrants will enter into an industry depends on two factors: the entry barriers
to an industry and the expected retaliation from existing firms.

The entry barriers may arise as a consequence of several factors such as:

➢ Economies of scale in production and sale of products leading to lower costs for existing firm;
➢ Capital requirements being very high may prevent new entrants from making investments;
➢ Switching costs from the existing products or services to a new one may discourage customers
from making new commitments owing to the costs incurred in buying new ancillary
equipment, retraining employees or establishing a new network of relationship;
➢ Product differentiation by existing firms based on perceived distinctiveness by the customers
based on effective advertising, reputation as a service provider, brand loyalty of customers
towards existing firm or some such other factors;
➢ Access to distribution channel can be monopolised by the existing firms on the basis of their
long-term relationship with the distributors;
➢ Cost disadvantages independent of scale may arise from proprietary products technology,
exclusive access to raw materials, favourable location and benefit of government subsidies;
and
➢ Government policies through licensing and other means can prevent the entry of new firms to
an industry.

Rivalry among Competitors

Competition is a game in which normally, one player loses at the expense of the other. A move on
the part of a player may cause other players to make countermoves or initiate efforts to protect
59
themselves from the danger posed by the initial move. In this manner, firms within an industry are
mutually dependent. The situation in an industry keeps changing with the actions and reactions of
the constituent firms.

The dimensions of rivalry among competitors are several. Some of the major ones are:

➢ Competitive structure refers to the number of competitors, their size and their diversity.
Different types of competitive structures have different implication for the existing
firms and for the new entrants;

➢ Demand conditions refer to the nature of the customer demand existing in an industry;
and

➢ Exit barriers restrict the firms in an industry and prevent them from leaving, even
though the returns might be low or might even be sometimes negative. The exit barriers
are economic, strategic or emotional factors preventing companies from moving out
after divestment of their businesses.
Bargaining Power of Buyers

The bargaining power of buyers constitutes the ability of the buyers, individually or collectively,
to force a reduction in prices of products or services, demand a higher quality or better service or
to seek more value for their purchases in any way. The bargaining power of buyers is high under
the following conditions:

➢ When the buyers are few in number;

➢ When the few buyers place large orders individually;
➢ When alternative suppliers are present, willing to supply at a lower price or on favourable
selling conditions;
➢ When the switching costs of buyers from one supplier to the other is low;
➢ When the buyer itself charges a low price for its products and is sensitive to price increases;
➢ When the purchased product constitutes a high percentage of a buyer’s costs, making it look
around for lower-priced supplies; and
60
➢ When the buyer itself has the ability to integrate backwards and create its own captive
supply source.

Bargaining Power of Suppliers

Like the bargaining power of buyers, suppliers too have a level of bargaining power. The
bargaining power of suppliers constitutes their ability, individually or collectively, to force an
increase in the price of the products or services or make the buyers accept a lower quality of
product or level of service. The bargaining power of suppliers is high under the following
conditions:

➢ When the suppliers are few and the buyers are many;
➢ When the products or services are unique and are not commonly available;
➢ When the substitutes of the products or services supplied are not freely available;
➢ When the switching costs of a supplier from one buyer to the other is low;
➢ When the supplier is not critically dependent on the products or services supplied;
➢ When the buyer buys in small quantities and, therefore, is not important to the supplier;
and
➢ When the suppliers have the ability to integrate forward and use their own supplies for
production of the end product or service.

Threat of Substitute Products

Substitute products or services are those that apparently are different, but satisfy the same set of
customer needs. Example of substitute are tea and coffee, margarine and butter. The availability
of close substitutes constitutes a negative competitive force in an industry.

Competitive analysis

Competitor analysis focuses on each company with which a firm competes directly, competitive
analysis therefore, deals with the actions and reactions of individual firm within an industry.
Components of competitive analysis include:

61
 ➢ Future goals of competitor;
➢ Corporate goals of competitor;
➢ Key assumptions made by competitor; and
➢ Capabilities of competitor.

Candidates in answering this question should be able to draw examples on company selected based
on the above outline.

3. Industry analysis involves observation and analysis of factors such as market behaviours,
competitive forces and financial, regulatory, socio-economic and technological trends that
influence the domain. Industry analysis delivers insights into business drivers and key success
factors relevant to the domain.

Industry analysis is a business owned activity to assess the existing business environment and its
competitive position. It is one of the preliminary steps in strategic planning. A manager will
interpret an industry analysis and combine it with knowledge of existing and emerging technology
and managerial issues. Business stakeholders require manager to function as advisory, guiding
workers to address prevailing business problems. Industry analysis capability enhances a
manager's involvement in understanding business needs and facilitates a consultative approach in
requirements development.

In order to perform effective industry analysis, the following steps should be followed:

Industry research

Industry research is the acquisition of corporate intelligence on a broad range of issues including
macro environment, market and competitive landscape and consumer analysis. As a rule, a
manager will be required to perform secondary type of industry research i.e. research derived from
aggregation of existing sources of information and data, as well as broader research reports
published by dedicated research and analyst firms. A manager should have a broad understanding
of business operations and knowledge of the specific domain. Domain knowledge pertinent to
industry research includes understanding industry codes, markets, product offerings, regulatory
requirements, financial information, as well as international variations if needed.

Information analysis
62
Information analysis is the process of discovery and quantification of patterns in industry-specific
data and trends. A manager will perform information analysis to interpret macro and mega trends,
financial indicators, market growth indicators and influence of technology in shaping business
outcomes.

Industry segmentation

Industry segmentation is the process of defining and subdividing a large homogenous market into
clearly identifiable components having similar needs, wants, or demand characteristics. Industry
segmentation is driven by factors such as products, target markets, geography, demographics and
size of businesses that constitute an industry. Industry segmentation determines key factors such
as product, pricing, business composition and resources required for operation. A manager needs
to understand industry segmentation as it has an influence on technology resources and technology
enablement within the industry.

Industry trends

An assumed tendency of a given industry to move in a particular direction over time has been a
primary and rapid disruptive force for managers in the last fifty years, making the role of managers
very important in signaling industry changes arising from technological trends. Managers combine
industry and technological trends to provide input and direction for technological strategy.

4. Strategy can be broadly defined as the match an organisation makes between its own resources
and the threats or risks and opportunities created by the external environment in which it operates.
Therefore, strategy can be seen as a key link between what the organisation wants to achieve, its
objective and the policies adopted to guide its activities. An organisation can have a single
strategy or many strategies, and those strategies are likely to exist at a number of levels in an
organisation.

Corporate strategy is concerned with the type of businesses the firm, as a whole is in to or should
be in. It addresses such issues as the balance in the organisation's portfolio by directing attention
to questions like the attractiveness of the entire businesses, with reference to important strategic
criteria, such as markets, contribution to corporate profits and growth in a particular industry.
Issues concerning diversification and the structure of the firm as a whole are of corporate concern.

63
Business strategy is concerned with how an operating unit within the corporate whole can compete
in a particular market. Strategic business units (SBUs) are created at corporate level, and can be
subsumed under it. The strategies of SBUs can be regarded as the parts which require and define
the organisational strategies as a whole. A firm's operating level strategy is concerned with how
the various functions - finance, marketing, operations, research and development etc. contribute
to both business and corporate strategy. At this level the focus is likely to be on the maximisation
of resources productivity.

Strategy-formulation can be viewed as a decision-making process which is primarily concerned

with the development of the organisation's objectives, the commitment of its resources and
environmental constraints so as to achieve its objectives. Strategy formulation process can be
sumarrised as it appears in the following diagram:

Present corporate objectives

and strategy

Environmental Internal
Appraisal Appraisal

Strategy Options

Societal values and Values and aspirations

expectations 64 of managers

Strategic selection
 .
The examination of the components in the formulation model. reveals, that the processes are
interconnected. However, the process as depicted in the diagram is not to indicate that this
represents the way in which the process might work in practice. Because of the interrelationship
between the elements, the strategy formulation process is likely to be iterative nature, containing
negotiation and compromise.

65
The present situation
The formulation process in an existing organisation does not and cannot commence in a vacuum,
constraints usually exist that impact on the process. The firm's current situation, strategy, plans, or
commitments obviously present a starting-point for analysis. Thus, the firm may be in a situation
where 'formulation' as such is unnecessary as the requirement is to develop and fine-tune existing
strategies, or to modify short-term objectives to fit with the long-term aims. The present situation
of course should not preclude the firm from taking advantage of opportunities in unrelated areas.
The key point is that the existing organisational structure and what the firm does well will have an
effect on the formulation process.

Environmental and internal appraisal

A firm can be viewed as an open system with respect to the environment in which it operates. It is
involved in a continuous process of exchange with external parties - suppliers, customers,
employees, government bodies - to obtain the necessary inputs and to disperse its output. So, it
competes with the other organisations for these resources. As such, the environment represents a
source of both opportunities and threats. Environmental appraisal is a central element in
formulating strategy.

Additional analysis is required to identify strategic options, involving an appraisal of the

organisation's own resources with the objective of identifying the firm's strengths and weaknesses.
Such analysis will reveal capability of the firm to counter external threats and to take advantage of
present opportunities. An important feature of this process concerns the identification of
'distinctive competencies', that is, those things at which the organisation is particularly good in
relation to its competitors.
An understanding of the external environment, in terms of the opportunities and threats and the
internal environment, in terms of the strengths and weaknesses, is crucial for the existence, growth
and profitability of any organisation

The generation of strategic options is not a random process but may be stimulated, for example,
by a shortfall in current performance and the level of performance expected by key decision-

66
 makers. It is also more complex than merely seeking to fit a range of variables affecting the firm
and its environment. Five features that affect the identification of strategic options are
organisational learning, distinctive competence and the location of slack resources, past
performance and type of research activity, power differences within the organisation and
absorption of uncertainty through politics.

Strategic selection
The methods of evaluating which strategic option(s) will be selected vary from organisation to
organisation. The effect of rational and non-rational factors has effect on decision-makers.
Strategic decisions emanating from the formulation process may often be presented as utilitarian,
in most cases the decisions are reached as a result of, or in spite of, a wide range of influences on
those involved. Such influences will include, for example, individual needs, values and
perceptions, coupled with wider societal values and expectations impacting on managers as
individuals and the organisation as a whole.

5. Strength, weaknesses, opportunities and threat (S'WOT) analysis, evolved during the 1960s at
Stanford Research Institute, it is a very popular strategic planning technique having applications
in many areas including management. Organisations perform SWOT analysis to understand their
internal and external environments. Through such an analysis, the strengths and weaknesses
existing within an organisation can be matched with the opportunities and threats operating in the
environment so that an effective strategy can be formulated. An effective organisational strategy,
therefore, is one that capitalises on the opportunities through the use of strengths, protects from
threats and minimises the impact of weaknesses, to achieve pre-determined objectives.

A simple application of the SWOT analysis technique involves the following steps:

i. Setting the objectives of the organisation or its unit;

ii. Identifying its strengths, weaknesses, opportunities and threats;
iii. Determine what can maximise strengths;
iv. Determine those things that can minimise weaknesses;
v. Identify how to capitalise on the opportunities in external environment;
67
vi. Ascertain how to protect the organisation from threats in external environment; and
vii. Recommending strategies that will optimise the above points.
The SWOT analysis is usually done with the help of a template in the form of a four-cell matrix,
each cell of the matrix representing the strengths, weaknesses, opportunities and threats. The
analysis for preparing the SWOT matrix could be done by a group of managers in a workshop
session. The session could use the brainstorming technique for generating ideas about the SWOT
factors. A typical SWOT analysis matrix for an organisation is shown below.

STRENGHT
• Favourable location
• Excellent distribution network
• Established R & D centre
• Good management reputation
WEAKNESSES
• Uncertain cash flow
• Weak management information system
• Low worker commitment

OPPORTUNITIES THREATS

• Favourable industry trends • Unfavourable political environment

• Low technology options available • Obstacles in licensing new business
• Possibility of niche target market • Uncertain competitors' intentions
• Availability of reliable business • Lack of sustainable financial backing
partners

The external environment consists of all the factors which provide opportunities or pose threats to
an organisation. In a wider sense, the external environment encompasses a variety of sectors like
international, national and local economy, social changes, demographic variables, political
systems, technology, attitude towards business, energy sources, raw materials and others resources
and many other macro-level factors. All organisations, in one way or the other, are concerned
about the environment, but the immediate concerns of any organisation are confined to just a part
of the environment which is of high strategic relevance to the organisation. This part of the
environment could be termed as the immediately relevant environment

68
A conscious identification of the relevant environment enables the organisations to focus its
attention on those factors which are intimately related to its mission, purpose, objectives and
strategies. Depending on its perception of the relevant environment, an organisation takes into
account those influences in its surrounding which have an immediate impact on its strategic
management process. Having identified its relevant environment, an organisation can
systematically appraise it and incorporate the results of such an appraisal in strategic planning, in
order to cope with the complexity of the environment

69
 Professional Taxation II
Financial/Tax analysis

FFinancial/Tax analysisFffF

Chapter
Accounting analysis: The basics
3
Contents
i. Accounting information systems
ii. Determinants of quality of accounting information
iii. Quality of accounting information system
iv. Accounting analysis
v. Steps in performing accounting analysis
vi. End of chapter questions
Purpose

At the end of this chapter, readers should be able to:

i. Understand accounting information systems.

ii. Know the determinants of quality of accounting information
iii. Differentiate between accounting and financial analysis
iv. Understand steps in carrying out accounting analysis
v. Know the difference between aggressive and big bath accounting

70
3.1 Accounting information systems

Some features of accounting information system have been considered in chapter one, however
this section on accounting analysis will still consider some other issues of accounting information
system not covered in chapter one.

Investors evaluate their decisions based on the financial statements, thus they will always be
concerned about the quality of provided accounting information. However, some investors did not
consider that a financial report is helpful in their decision - making process, while other users were
of the opinion that the financial statements fail to satisfy their information needs. Many
stakeholders of a company are not taking advantage of the investment information available in
taking decisions but prefer to make investment decisions with the advices from their family and
friends. This indicates that the investors lose their confidence and reliance on the provided
financial information. In Nigeria, many investors are not taking advantage of the investment
information available. The factors that influence the quality of accounting information include
organisational structure, organisational culture and internal control system.

Accounting information system is a system that processes and transforms the economic data into
accounting information that is relevant and reliable for the users in planning and managing
business operations. From the point of view of users, the efficiency and effectiveness of accounting
information system determine the quality of accounting information, this also impact on
company’s performance, profitability and efficiency of operation. The availability of quality
accounting information would enable the organisation to have the opportunity to gain competitive
advantage. The quality of the accounting information is the key issue in the provision of accounting
information. For example, the largest corporate bankruptcy in America in 2001 that had shocked
the whole world is Enron’s case. Enron’s kept huge debts off statement of financial position that
eventually misled the financial accounting users. Meanwhile, Enron executives embezzled the
investment funds of investors as well as misrepresented the earnings reported. The exposure of
accounting irregularities at Enron had caused a heavy loss to the shareholders and investors who
depended on the misleading accounting information. Those major financial scandals have raised
criticisms of the accounting profession which has led to decreasing users’ trust in the faithfulness
and accuracy of accounting information. Hence, the users of financial statements should have the
71
fundamental understanding on the quality of accounting information to prevent them from
misinterpretation that may substantially lead to a wrong decision making.

3.2 Determinants of quality of accounting information

Management commitment

Management commitment is a total commitment not only to participative management and

employee empowerment but also to intra and interdepartmental teamwork and improved
communication throughout the organisation. Commitment management is a form of management
which is aimed at eliciting a commitment so that behaviour is primarily self-regulated rather than
controlled by sanctions and pressures external to the individual, and relationship within the
organization, commitment should be based on high levels of trust. Management commitment, in
the development of information systems is influenced by the participation of the top management,
middle management in goals formulation, development of information systems, and clear
commitment to documenting the work plan performance, in order to direct, approve, measure, and
supports the organization’s activities. Characteristics of strong management commitment include
top management advocating change and empowering employees to make changes, performance
measures are aligned with corporate goals, investment in, and realised return on technology and
systems development and retention of human capital, communication of goals and results. High
commitment management approach encompasses key components such as: the presence of formal
teamworking initiative, the use of sophisticated reward incentives and consistency of policy in the
implementation process.

Organisational culture

The culture of a group, is a pattern of assumptions which is learned by a group to solve problems
of external adaptation and internal integration. Culture is a social knowledge among members of
the organisation. Members of organisations should learn the important aspects of cultures. Culture
can be studied through the transfer of knowledge in the form of communication, as well as simple
observation, so that the organisational culture can shape attitudes and employee behaviours, based
on control system for all employees. Organisation value and norms are key component of
organisation culture. Value, is the basis of faith, and is a source of inspiration and motivation in

72
moving and controlling human behaviour to the formation of corporate culture while norms are
members behaviour in guiding an organisation in the form of unwritten rules.

The application of accounting information system is highly relying on the organisational culture
so that the accounting system can run in a proper way. Organisational culture has an impact on the
effectiveness of development of new information system. Organisational cultures have different
criteria in implementing the accounting information system. Organisational culture is taking into
consideration in developing and implementing the accounting information system.

Organisational structure

Organisational structure is a main element that should be considered in the development of

accounting information system. Organisational structure is formally defined as an arrangement of
divisions or work units within an organisation. Organisational structure can also be regarded is a
framework which describes the distribution and coordination of job tasks between the individuals
and groups within the organisation. Organisational structure encompasses the relationship of
responsibilities and authority that controls the integration of employees’ actions and performance
in achieving the goals of organisation. Managers are involved in organisational design that takes
into consideration the need to develop or improve the structure of the organisation. The
organisational culture functions as a mechanism to unite the activities of individuals within an
organisation who are from various backgrounds. Moreover, culture is a social knowledge which
the employees can learn from others within an organisation. The members of organisation can have
a consensus cultural understanding through the transfer of knowledge in the form of
communication and explicit observation.

Internal control system

An effective internal control system significantly affects the success of business operations as well
as helps the accounting information system in generating information with higher reliance for the
users. Internal control is the process and policies designed and adopted by the management to
achieve the organisational goals and missions. An effective internal control is to provide a
relevant and reliable financial report, comply with the applicable laws and regulations as well as

73
ensure an effective and efficient operation of the organiation. An internal control system comprises
of five key components which includes control environment, risk assessment, control activities,
information and communication, and monitoring to assist in accomplishing the organisational
goals. The organisation also designed the transaction processing internal control to ensure each
component of internal control system has been successfully applied. The main goal of designing
an internal control is to monitor and maintain the quality of information during the input, process
and generation of output. The internal control functions is a means to assure that all transactions
are recorded accurately in the correct accounts, in proper accounting periods to enable the
organisation to prepare financial statements in compliance with accounting principles and legal
standards. A sound internal control may help the organisation to achieve the attributes of a good
accounting system and also provide the relevant and reliable information to the management for
carrying out the business activities effectively. With the existence of an effective internal control
system, the effectiveness and efficiency of accounting information system can be enhanced
through appropriate recording and processing of data, safeguarding of assets, and reliability and
accuracy of accounting information generated. Internal control system is important to be
implemented in an accounting system to prevent frauds and reduce the likelihood of errors and
material misstatements resulted from ineffective information system. An effective internal control
can guarantee the appropriateness of financial reporting as well as enhance the quality of
accounting information.

3.3 Quality of accounting information system

An accounting information system is an integrated system with the components such as hardware,
software, procedures, database and network communication. Accounting information system
(AIS) is designed to collect the data and process them into useful information for the users of
financial information. The main purpose is to generate useful information for business decisions
making. Accounting information systems process and transform the financial data into accounting
information that is needed by internal and external users. Organisations use accounting information
systems (AIS) for planning, evaluating and identifying their operational performance and financial
conditions. The management of an organisation applies the accounting information system as a

74
means to achieve a competitive advantage especially in this fierce and dynamic competitive
environment

3.4 Accounting analysis

Accounting analysis assesses the degree to which the firm’s accounting reflects the underlying
business reality. This is done by identifying any accounting distortions and evaluating their impact
on profits and the sustainability of profits. Having identified any accounting distortions, analysts
can then adjust a firm’s accounting numbers using cash flow and footnote information to “undo”
the distortions. In evaluation of any business, industry and strategy analysis need to be carried
out, also the business will be assessed through the financial statements by carrying out financial
analysis. The purpose of the analysis is to evaluate the degree to which the firm’s accounting
captures its underlying business reality. The basic issue in carrying out accounting analysis is the
consideration of whether the accounting numbers match the business reality/nature of the firm.
Prelude to a quality accounting analysis are to:
(i) Understand the business;
(ii) What the business is doing;
(iii) Understand the accounting policy;
(iv) Understand the business areas where accounting quality is most needed; and
(v) Understand situations in which management are particularly tempted to manipulate.

Difference between accounting and financial analysis

From accounting analysis, we can have historical data of a company from which stakeholders can
have idea about the consistency of the company’s operational performance. It reveals the data of
business's profit, loss, assets, liabilities etc. On the other hand, financial analysis focuses on the
financial performance, fund management, cash flow, leverage, equity, loan etc. Financial analysis
includes the experienced based process of interpreting and translating the past figures into current
and future suggestions, actions or activities to achieve the organisation’s desired goals.

To simplify the issue of differentiating between accounting and financial analyses, is to distinguish
between accounting and finance, accounting is more focused on the past and finance is more
focused on the future. Accounting is a system for the delivery of financial information. It involves

75
the recording of transactions and preparation of the financial statements, along with financial
statement analysis regarding financial health of firms. Accountants are tasked with ensuring that
events have been accurately recorded and that the financial statements accurately reflect the
financial condition of the business.

Finance takes the organised information provided by accounting and uses it to help run a company
on a daily basis and make long term financing and budgeting decisions. Finance is dedicated to
ensuring that there will be sufficient cash flowing into a business in the future to achieve the goals
of the business. Because finance deals with the future, it must deal with risk and uncertainty,
anticipating, evaluating, and managing these risks and uncertainties is a large part of the
responsibility of financial managers.

Potential sources of bias in providing quality accounting information

It is not optimal to use accounting regulation to completely eliminate managerial flexibility.
There are some potential sources of bias in accounting data, these are:
(i) Rigidity in accounting rules;
(ii) Random forecast errors;
(iii) Manager’s accounting choices (systematic reporting choices);
(iv) Accounting-based debt covenants;
(v) Management compensation;
(vi) Tax considerations; and
(vii) Decisions to influence regulatory outcomes.

Institutional situations where manipulation is more likely

➢ The firm is in the process of raising capital or renegotiating borrowing: When a firm is in
the process of raising new capital, there may be a lot of manipulations in the account so as
to convince the lender that the company is doing well, This is particularly common among
some private firms that normally have different sets of financial statement for different
purposes

76
 ➢ Debt agreements are likely to be violated: When debt agreement terms are not honoured,
manipulation of accounts may take place to present to the lender that the company is not
in a position to pay as and when due
➢ A change in management: Management may bring likely manipulation when a new
management want to present that they are doing well than the former management whereas
they are not. Also, a change in auditor is likely to cause some manipulation if the change
is due to the fact that previous auditor fails to connive with management to manipulate the
financial statements.
➢ Asset impairment decisions is another source of manipulation. Asset impairment decision
may be used to intentionally manipulate the asset figures as may be desired by the
management of the company.
➢ Good corporate governance is very important for a company: A weak corporate governance
structure where inside management dominate the board and there is a weak audit committee
or none at all will also lead to possible manipulation of financial statements.
➢ Transactions are with related parties rather than at arm's length is another source of possible
manipulation in a company. To avoid this, transactions should as much as possible be carried
out at arm’s length.

Aggressive and big bath accounting

Aggressive accounting refers to an accounting department's deliberate and purposeful tampering
with its company's financials in order to outwardly characterise its revenues as higher than they
truly are while big bath in accounting is an earnings management technique whereby a one-time
charge is taken against income in order to reduce assets, which results in lower expenses in the
future. The write-off removes or reduces the asset from the financial books and results in lower
net income for that year.

3.5 Steps in performing accounting analysis

In order to carry out accounting analysis to minimise the issue of aggressive or big bath accounting
the following steps should be taken:

77
• Identify key (principal) accounting policies: Accounting policies have effect on figures
presented in a financial statement. The way each organisation treats issue like material,
depreciation, capitalisation of some expense contributes to variation in profit to be reported
in a financial statement. In carrying out accounting analysis, some of these issues would be
looked into to ensure that the accounting policies are still within the normal acceptable for
financial reporting;
• Identify and evaluate the policies and estimates the firm uses to measure critical business
factors and key risks. It is very pertinent in carrying out accounting analysis to identify and
evaluate the policies as well as estimates an organisation is using to measure critical business
factors and risk. Such evaluation will inform the analyst on how these policies effect the
organisation;
• Financial reporting provides that the organisation can be flexible in the preparation of their
financial statement as long as it is within the normal accounting practices. In performing
accounting analysis, this accounting flexibility must be assessed. Understanding flexibility
and resulting information contents are very necessary - If managers have little flexibility in
choosing accounting policies and estimates related to their key success factors, accounting
data are likely to be less informative for understanding the firm’s economics;
• it is necessary to evaluate accounting strategy because if managers have accounting
flexibility, they can use it either to communicate their firm’s economic situation or to hide
true performance.
• It is necessary to evaluate how the firms accounting policies compare to that of the industry
in which the organisation operates. In some industry they practice uniform costing and
accounting system. In performing accounting analysis, how much a firm has conformed with
the industry practice should be assessed;
• The quality of disclosure must be evaluated as well as determining the adequacy of such
disclosure. It should be determined that all necessary disclosures are made in the financial
statements; and
• Identification of potential red flags (accounting distortions) should be carried out and any of
this distortion should be corrected when performing accounting analysis.

78
3.6 End of chapter questions and solutions
3.6.1 End of chapter questions
1. The quality of accounting information is very important to all stakeholders of a company as
it enhances the reliance to be placed on it. Discuss the determinants of the quality of
accounting information
2. What is accounting analysis. Explain those things that must be taken into consideration in
performing accounting analysis.
3. Differentiate between accounting and financial analysis
4. Distinguish between big bath accounting and aggressive accounting
5. Explain the steps necessary in carrying out accounting analysis.

3.6.2 Solutions to end of chapter questions

1. Accounting information system is a system that processes and transforms the economic data
into accounting information that is relevant and reliable for the users in planning and managing
business operations. The quality of this accounting information is a very important factor to be
considered by the users of accounting information. From the point of view of users, the efficiency
and effectiveness of accounting information system determine the quality of accounting
information, this also impact on company’s performance, profitability and efficiency of operation.
The determinant of good accounting information are as follows:

(i) Management commitment: Management commitment is a total commitment not only to

participative management and employee empowerment but also to intra and interdepartmental
teamwork and improved communication throughout the organisation. Commitment management
is a form of management which is aimed at eliciting a commitment so that behaviour is primarily
self-regulated rather than controlled by sanctions and pressures external to the individual, and
relationship within the organisation. Commitment should be based on high levels of trust. All
strata of management must be committed to the development of sound information systems in any
organisation.

Organisational culture: The culture of a group, is a pattern of assumptions which is learned by a

group to solve problems of external adaptation and internal integration. Culture is a social

79
knowledge among members of the organisation. Members in organisations should learn the
important aspects of cultures. Culture can be studied through the transfer of knowledge in the
form of communication, as well as simple observation. The application of accounting information
system highly relies on the organisational culture so that the accounting system can run in a proper
way. Organisational culture has an impact on the effectiveness of development of new information
system. Organisational cultures have different criteria in implementing the accounting information
system. Organisational culture is taken into consideration in developing and implementing the
accounting information system.

Organisational structure: Organisational Structure is a main element that should be considered

in the development of accounting information system. Organisational structure is formally defined
as an arrangement of divisions or work units within an organisation. Organisational structure can
also be regarded is a framework which describes the distribution and coordination of job tasks
between the individuals and groups within the organisation. Organisational structure encompasses
the relationship of responsibilities and authority that controls the integration of employees’ actions
and performance in achieving the goals of organisation. The Organisational culture functions as a
mechanism to unite the activities of individuals within an organisation who are from various
backgrounds.

Internal control system: An effective internal control system significantly affects the success of
business operations as well as helps the accounting information system in generating information
with higher reliability for the users. Internal control is the process and policies designed and
adopted by the management to achieve the organisational goals and missions. An effective internal
control is essential for an organisation to provide a relevant and reliable financial report, comply
with the applicable laws and regulations as well as ensure an effective and efficient operation of
organisation The internal control functions is a mean to assure that all transactions are recorded
accurately in the correct accounts in proper accounting periods to enable the organisation to
prepare financial statements in compliance with accounting principles and legal standards.

A sound internal control may help the organisation to achieve the attributes of good accounting
and also provide relevant and reliable information to the management for carrying out the business
activities effectively. With the existence of an effective internal control system, the effectiveness

80
 and efficiency of accounting information system can be enhanced through appropriate recording
and processing of data, safeguarding of assets, and reliability and accuracy of accounting
information generated. Internal control system is important to be implemented in an accounting
system to prevent frauds and reduce the likelihood of errors and material misstatements resulted
from ineffective information system. An effective internal control can guarantee the
appropriateness of financial reporting as well as enhance the quality of accounting information.

2. Accounting analysis assesses the degree to which the firm’s accounting reflects the underlying
business reality. This is done by identifying any accounting distortions and evaluating their impact
on profits and the sustainability of profits. Having identified any accounting distortions, analysts
can then adjust a firm’s accounting numbers using cash flow and footnote information to “undo”
the distortions. In evaluation of any business, industry and strategy, analysis need to be carried
out, also the business will be assessed through the financial statements by carrying out financial
analysis. The purpose of the analysis is to evaluate the degree to which the firm’s accounting
captures its underlying business reality. The basic issue in carrying out accounting analysis is that
consideration of whether the accounting numbers match the business reality/nature of the firm.
Prelude to a quality accounting analysis are to:
(i) Understand the business;
(ii) Understand what the business is doing;
(iii) Understand the accounting policy;
(iv) Understand the business areas where accounting quality is most; and
(v) Understand situations in which management are particularly tempted to manipulate.
accounting figures
In order to carry out accounting analysis to minimise the issue of aggressive or big bath accounting
the following steps should be taken:
i. Identify key (principal) accounting policies: Accounting policies have effect on figures
presented in a financial statement. The way each organisation treats issue like material,
depreciation, capitalisation of some expense contributes to variation in profit to be reported
in a financial statement. In carrying out accounting analysis, some of these issues would

81
 be looked into to ensure that the accounting policies are still within the normal acceptable
policies for financial reporting

ii. Identify and evaluate the policies and estimates the firm uses to measure critical business
factors and key risks. It is very pertinent in carrying out accounting analysis to identify and
evaluate the policies as well as estimates an organisation is using to measure critical
business factors and risk. Such evaluation will help the analyst to know how these policies
effect the organisation.

iii. Financial reporting provides that the organisation can be flexible in the preparation of their
financial statement as long as it is within the normal accounting practices. In performing
accounting analysis, this accounting flexibility must be assessed. Understanding
flexibility and resulting information contents are very necessary. If managers have little
flexibility in choosing accounting policies and estimates related to their key success factors,
accounting data are likely to be less informative for understanding the firm’s economics

iv. It is necessary to evaluate accounting strategy because if managers have accounting

flexibility, they can use it either to communicate their firm’s economic situation or to hide
true performance.

v. It is necessary to evaluate how the firm’s accounting policies compare to that of the
industry in which the organisation operates. In some industry, they practice uniform costing
and accounting system. In performing accounting analysis, how much a firm has
conformed with the industry practice should be assessed.

vi. The quality of disclosure must be evaluated as well as determining the adequacy of such
disclosure. It should be determined that all necessary disclosures are made in the financial
statements

82
vii. Identification of potential red flags (accounting distortions) should be carried out and any
of this distortion should be corrected when performing accounting analysis

3. From the accounting analysis mainly we can have historical data of a company from which
stakeholders can have idea about consistency in the company’s accounting information system. It
reveals the data of business's profit, loss, assets, liabilities etc. On the other hand, financial analysis
focuses on the financial performance, fund management, cash flow, leverage, equity, loan etc.
Financial analysis includes the experienced based process of interpreting and translating the past
figures into current future suggestions, actions or activities to achieve the organization desired
goals

In order to simplify the issue of differentiating between accounting and financial analysis, we have
to distinguish between accounting and finance, accounting is more focused on the past and finance
is more focused on the future. Accounting is a system for the delivery of financial information. It
involves the recording of transactions and preparation of the financial statements, along with
financial statement analysis regarding financial health of firms. Accountants are tasked with
ensuring that events have been accurately recorded and that the financial statements accurately
reflect the financial condition of the business.

Finance takes the organised information provided by accounting and uses it to help run a company
on a daily basis and make long term financing and budgeting decisions. Finance is dedicated to
ensuring that there will be sufficient cash flowing into a business in the future to achieve the goals
of the business. Because finance deals with the future, it must deal with risk and uncertainty,
anticipating, evaluating, and managing these risks and uncertainties is a large part of the
responsibility of financial managers.

4. Aggressive Accounting refers to an accounting department's deliberate and purposeful

tampering with its company's financials in order to outwardly characterise its revenues as higher

83
than they truly are while big bath in accounting is an earnings management technique whereby a
one-time charge is taken against income in order to reduce assets, which results in lower expenses
in the future. The write-off removes or reduces the asset from the financial books and results in
lower net income for that year.

5. In order to carry out accounting analysis to minimise the issue of aggressive or big bath
accounting the following steps should be taken:
i. Identify key (principal) accounting policies: Accounting policies have effect on figures
presented in a financial statement. The way each organisation treats issues like material,
depreciation, capitalization of some expenses contributes to variation in profit to be reported
in a financial statement. In carrying out accounting analysis, some of these issues would be
looked into to ensure that the accounting policies are still with the normal acceptable for
financial reporting

ii. Identify and evaluate the policies and estimates the firm uses to measure critical business
factors and key risks. It is very pertinent in carrying out accounting analysis to identify and
evaluate the policies as well as estimates an organisation is using to measure critical business
factors and risk. Such evaluation will help the analyst to know how these policies effect the
organisation.

iii. Financial reporting provides that the organisation can be flexible in the preparation of their
financial statement as long as it is within the normal accounting practices. In performing
accounting analysis, this accounting flexibility must be assessed. Understanding flexibility
and resulting information contents are very necessary. If managers have little flexibility in
choosing accounting policies and estimates related to their key success factors, accounting data
are likely to be less informative for understanding the firm’s economics

84
iv. it is necessary to evaluate accounting strategy because if managers have accounting flexibility,
they can use it either to communicate their firm’s economic situation or to hide true
performance.

v. It is necessary to evaluate how the firms accounting policies compare to that of the industry in
which the organisation operates. In some industry they practice uniform costing and accounting
system. In performing accounting analysis, how much a firm has conformed with the industry
practice should be assessed.

vi. The quality of disclosure must be evaluated as well as determining the adequacy of such
disclosure. It should be determined that all necessary disclosure are made in the financial
statements

vii. Identification of potential red flags (accounting distortions) should be carried out and any of
this distortion should be corrected when performing accounting analysis.

85
 Professional Taxation II
Financial/Tax analysis

Chapter
4
Accounting analysis: Accounting adjustments

Content

.1 Introduction
.2 Accounting adjustments
.3 Assets recognition
.4 Assets distortions
.5 Liability recognition
.6 Liability distortions
.7 Equity
.8 Equity distortions
.9 End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

• Understand the need for accounting analysis before preparation of financial statement
analysis;
• Understand accounting adjustments
• Define assets and assets distortions
• Define liability and liability distortions

86
• Define equity and equity distortions

4.1 Introduction

Analysis means a systematic examination of data and facts, by breaking it into its component
parts to uncover and understand cause-effect relationships, thus providing basis for problem
solving and decision making.

While accounting analysis is the process of evaluating the extent to which a company’s
accounting numbers reflect economic reality. In accounting analysis, analysts also adjust the
financial statements to better reflect the economic reality. Accounting analysis involves a
number of different tasks, such as evaluating a company is accounting risk and earning quality,
estimating earning power, and making necessary adjustments to financial statements to both
better reflect economic reality and assist in financial analysis. Accounting analysis is defined as
“the process an analyst uses to identify and access accounting distortions in a company’s
financial statements”. It also includes the necessary adjustments to financial statements that
reduce distortions and make the statements useful for financial analysis.

Accounting analysis is the assessment of the degree to which an entity’s accounting reflects the
underlying business reality. This is done by identifying any accounting distortions and evaluating
their impact on profits and … of profit. The analyst therefore, has to analyse the elements of the
financial statement for possible distortions to allow him better understand the economic
substance of the firm’s transactions and its impact on the financial performance and financial
position.

4.2 Accounting adjustments

Once the financial analyst has considered the accounting distortions present in the entity’s
financial statements, the analyst will evaluate whether accounting adjustments are needed to
correct the distortions in the financial statements.

Adjustments may be as a result of:

• Accounting policies of the entity do not reflect the underlying economic situation of the
entity;
87
• The management deliberately decided to distort the entity’s performance; and or
• The management intends to make the financial statements comparable over time.

Therefore, adjustments to financial statements are made for the following reasons:

• Accounting standards may not reflect economic reality of the entity;

• To remove management bias that have been introduced in the preparation of the financial
statements; and
• To make the financial statements comparable across the years or across entities.

Some distortions that call for adjustments include:

• Assets distortions;
• Liabilities’ distortions; and
• Equity distortions.

The areas subject to manipulations are:

• Recognition of revenues and expenditure: adjustments are needed to match expenses incurred
to generate revenue with the revenue generated in a particular period;
• Adjustment is necessary for transactions and events that extends over more than one period.
These result in two types of adjustments:
▪ Adjustments for expenses paid but not yet incurred and revenue received but not yet
earned. These result in prepaid expenses and revenue received in advance; and
▪ Adjustments for expenses incurred but not yet paid for and revenue earned for which
cash has not been received. These give rise to accrued expenses and receivables.

The above adjustments will affect the reported assets and liabilities of the entity and may lead to
distortions in the financial statements, if not properly accounted for.

Another area of distortion is in the treatment of non – current assets. Non – current assets can be
distorted as a result of provision or non – provision for depreciation and impairment. Provision
for depreciation is normally based on the accounting police adopted by the management of the
entity, if such policy is not realistic, given the business reality of the entity, the assets figure in
the financial statements will be distorted. So also, if the policy is not consistently applied over
88
time, it may lead to distortions and the analyst need to make adjustment for this. In the same
way, if impairment of non – current assets are not provided for when such has occurred, it will
result in distortion of the assets’ value reported in the financial statements.

4.3 Recognition of assets

According to IASB conceptual framework, an asset is a present economic resource controlled by

the entity as a result of past events. An economic resource is a right that has the potential to
produce economic benefits.

Rights
Rights can take many forms including the right to receive cash, exchange resources on
favourable terms, rights over physical objects and rights to use intellectual property. Many rights
are established by contract, legislation or similar means.
However, rights might be obtained in other ways (e.g. developing know-how that is not in the
public domain).
Some goods or services are received and immediately consumed (e.g. employee services). The
right to obtain the economic benefits produced by such goods or services exists momentarily
until the entity consumes the goods or services.
In order to be an asset, rights must both have the potential to produce economic benefits for the
entity beyond those available to all other parties and be controlled by the entity. Therefore, not
all rights are assets (e.g. right to use public infrastructure is not an asset).

Potential to produce economic benefits

An economic resource is a right that has the potential to produce economic benefits.
A right can be an asset, even if the probability that it will produce economic benefits is low.
However, low probability might affect decisions about what information to provide about the
asset and how to provide that information, including decisions about whether the asset is
recognised and how it is measured.

Control

89
Control links an economic resource to an entity. Control is the ability to obtain economic
benefits from the asset, and to restrict the ability of others to obtain the same benefits from the
same item.

Therefore, if entity financial statements are prepared based on IFRS, the recognition of assets in
the statement of financial position need to meet their definition that provided by Conceptual
framework. Based on the definition, the entity would recognise assets in its statement of financial
position only if those resources meet these conditions:

• Assets are the resources to which the entity has right;

• Assets are expected to provide economic inflow into the entity in the future; and
• Assets are the resources that control by the entity.

That means that even though assets are controlled by the entity, but they are not expected to have
future economic inflow, then the entity could not be recognised.

4.4 Assets distortion

Assets distortion can arise due to the following situations:

Provisions: There are various provisions that are required to be made in connection with the
various assets in the financial statements, for example:

• Provision for depreciation on PPE;

• Provision for inventories, due to loss in value as a result of obsolescence, slow moving
items, etc.;
• Provisions for prepaid expenses and revenue not yet earned; and
• Bad debt allowance on receivables.

Recognition of too much or too little provisions on the above can distort the total assets value of
the company reported in the financial statement. At the same time, management has the
discretion to determine what obligation is probable and what the estimate should be. It may also
be that what management states as contingency liabilities as a note to the financial statement has
actually crystallise.

90
Asset impairment: Recognising too much or too little asset impairment of PPE, investments and
intangibles can cause distortions in the asset value. This is because estimation of fair value is
subjective and can be a veritable ground for management bias and management can therefore,
delay reporting impairment in the financial statements.

Timing of revenue recognition: The management can manage the earnings reported in the
financial statements through aggressive revenue recognition. This will affect the figures stated
for both revenue and trade receivables in the financial statements.

Expenses capitaliation: As a form of earnings management, expenses could capitalised or

deferred to much or too little. Management, under IAS 38, has discretion in deciding whether to
capitalise or expense interest and expenditure required to get PPE and inventory to current
location and condition. Deferred expenditure is capitalized into the cost of the asset and this will
impact income. However, if the management decides that the potential future benefits cannot be
reliably measured, the standard allowed the management to expense the expenditure.

Leased assets: If the entity uses substantial leased assets and these are not brought into the
financial statements, it will lead to reduction in the value of the entity’s assets which will result
in distortion.

4.5 Recognition of liability

According IASB conceptual framework, a liability is “a present obligation of the entity to

transfer an economic resource as a result of past events”.

For a liability to exist, three criteria must all be satisfied:

• the entity has an obligation;

• the obligation is to transfer an economic resource; and
• the obligation is a present obligation that exists as a result of past events

Obligation

An obligation is a duty or responsibility that an entity has no practical ability to avoid. An

obligation is always owed to another party (or parties) but it is not necessary to know the
identity of the party (or parties) to whom the obligation is owed.
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Obligations might be established by contract or other action of law or they might be constructive.
A constructive obligation arises from an entity’s customary practices, published policies or
specific statements when the entity has no practical ability to act in a manner inconsistent with
those practices, policies or statements.

Transfer of economic resource

An obligation must have the potential to require the entity to transfer an economic resource to
another party (or parties). An obligation can meet the definition of a liability even if the
probability of a transfer of an economic resource is low. However, low probability might affect
decisions about what information to provide about the liability and how to provide that
information, including decisions about whether the liability is recognised and how it is measured.

Present obligation as a result of past events

A liability is an obligation that already exists. An obligation may be legally enforceable as a

result of a binding contract or a statutory requirement, such as a legal obligation to pay a supplier
for goods purchased.

Obligations may also arise from normal business practice, or a desire to maintain good customer
relations or the desire to act in a fair way. For example, an entity might undertake to rectify
faulty goods for customers, even if these are now outside their warranty period. This undertaking
creates an obligation, even though it is not legally enforceable by the customers of the entity.

Past transactions or events

A liability arises out of a past transaction or event.

A present obligation exists as a result of past events only if:

• the entity has already obtained economic benefits or taken an action; and
• as a consequence, the entity will or may have to transfer an economic resource that it would
not otherwise have had to transfer.

For example, a trade payable arises out of the past purchase of goods or services, and an
obligation to repay a bank loan arises out of past borrowing.

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Recognition Criteria of Liabilities

If the entity financial statements are prepared according to IFRS, then those liabilities should
meet the recognition criteria of liabilities in the conceptual framework.

Liabilities are classified into two main headings: current liabilities and non-current liabilities. As
per the definition above, the entity could recognise the liabilities in statement of financial
position only if:

• The liabilities result from past event or transaction

• The entity has a legal obligation on those transactions or event
• There will be economic outflow from an entity when they are settled.

That means the entity could not recognise the liabilities in the statement of financial position just
because they have the future obligation and economic outflow when they are settled. These
liabilities need to be as a result of past transactions.

Summary of Recognition criteria:

The following are the recognition criteria of liabilities from the conceptual framework:

Statement of financial position when it is probable that an outflow of resources embodying

economic benefits will result from the settlement of a present obligation and the amount at which
the settlement will take place can be measured reliably. In practice, obligations under contracts
that are equally proportionately unperformed (for example, liabilities for inventory ordered but
not yet received) are generally not recognised as liabilities in the financial statements. However,
such obligations may meet the definition of liabilities and, provided the recognition criteria are
met in the particular circumstances, may qualify for recognition. In such circumstances,
recognition of liabilities entails recognition of related assets or expenses.

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4.6 Liability distortion

Distortions in liabilities generally arise because there is ambiguity about whether an obligation
has really been incurred or the obligation can be measured. Can the obligation be measured? In
most of the cases it is very clear but for example if a company is responsible for an
environmental clean-up clearly has incurred an obligation, but the amount is highly uncertain.
And post-employment benefits for employees are very uncertain as well. Of course, there are
accounting rules but as mentioned before accounting rules are imperfect.

The most common forms of liability understatements arise when the following conditions exist:

• Unearned revenues are understated through aggressive revenue recognition

• -Provisions are understated
• -Loans from discounted receivables are off-balance sheet
• -Non-current liabilities for leases are off balance sheet
• -Post-employment obligations, such as pension obligations, are not fully recorded (Duco
Dekker) (ducodekker@gmail.com)lOMoARcPSD

4.7 Equity

According to IASB conceptual framework, equity is “the residual interest in the assets of the
entity after deducting all its liabilities”.
Equity claims are claims on the residual interest in the assets of the entity after deducting all

its liabilities. In other words, they are claims against the entity that do not meet the definition

of a liability. Such claims may be established by contract, legislation or similar means, and

include, to the extent that they do not meet the definition of a liability:

(a) shares of various types, issued by the entity; and

(b) some obligations of the entity to issue another equity claim.

Different classes of equity claims, such as ordinary shares and preference shares, may

confer on their holders’ different rights, for example, rights to receive some or all of the

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following from the entity:

(a) dividends, if the entity decides to pay dividends to eligible holders;

(b) the proceeds from satisfying the equity claims, either in full on liquidation, or in part

at other times; or

(c) other equity claims.

Equity is the residual interest in the assets of the entity after deducting all the liabilities (IASB
Framework).

Equity is what the owners of an entity have invested in an enterprise. It represents what the
business owes to its owners. It is also a reflection of the capital left in the business after assets of
the entity are used to pay off any outstanding liabilities.

Equity therefore includes share capital contributed by the shareholders along with any profits or
surpluses retained in the entity. This is what the owners take home in the event of liquidation of
the entity.

4.8 Equity distortions

Pre- 2016, unrealized gains and losses on assets held for sale (vs for short-term trading) were
reported in the Statement of comprehensive income and therefore affect equity without
impacting earnings until realized (recycling gains). Available-for-sale securities are reported at
fair value; changes in value between accounting periods are included in comprehensive income
until the securities are sold. -IFRS 9 now requires recognition through income statement but for
prior years, analysts may restate to remove the distortion of return on equity

4.9 End of chapter questions and solutions

4.9.1 End of chapter questions

1. Discuss accounting adjustments and the need for accounting adjustments before carrying
out financial statements analysis.

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2. Discuss the provision of the IASB conceptual framework on assets recognition in the
financial statements.

3. Discuss the provisions of the IASB conceptual framework on recognition of liability in the
financial statements.

4. Discuss assets distortions and the causes of assets distortions.

5. Discuss the provisions of the IASB conceptual framework on equity recognition.

4.9.2 Solutions to end of chapter questions

1. Once the financial analyst has considered the accounting distortions present in the entity's
financial statements, the analyst will evaluate whether accounting adjustments are needed
to correct the distortions in the financial statements.

Adjustments may be as a result of:

• Accounting policies of the entity do not reflect the underlying economic situation of
the entity;

• The management deliberately decided to distort the entity's performance; and or

• The management intends to make the financial statements comparable over time.

• Therefore, adjustments to financial statements are made for the following reasons:

• Accounting standards may not reflect economic reality of the entity;

• To remove management bias that have been introduced in the preparation of the
financial statements; and

• To make the financial statements comparable across the years or across entities.

Some distortions that call for adjustments include:

• Assets distortions;

• Liabilities' distortions; and

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 • Equity distortions.

The areas subject to manipulations are:

• Recognition of revenues and expenditure: adjustments are needed to match

expenses incurred to generate revenue with the revenue generated in a particular
period;

• Adjustment is necessary for transactions and events that extends over more than one
period. These result in two types of adjustments:

• Adjustments for expenses paid but not yet incurred and revenue received but not yet
earned. These result in prepaid expenses and revenue received in advance; and
• Adjustments for expenses incurred but not yet paid for and revenue earned for
which cash has not been received. These give rise to accrued expenses and
receivables.

The above adjustments will affect the reported assets and liabilities of the entity and may
lead to distortions in the financial statements, if not properly accounted for.

Another area of distortion is in the treatment of non - current assets. Non - current assets
can be distorted as a result of provision or non - provision for depreciation and
impairment. Provision for depreciation is normally based on the accounting police
adopted by the management of the entity, if such policy is not realistic, given the business
reality of the entity, the assets figure in the financial statements will be distorted. So also,
if the policy is not consistently applied over time, it may lead to distortions and the
analyst must need made adjustment for this. In the same way, if impairment of non -
current assets are not provided for when such has occurred, it will result in distortion of
the assets' value reported in the financial statements.

2. According to IASB conceptual framework, an asset is a present economic resource

controlled by the entity as a result of past events. An economic resource is a right that has
the potential to produce economic benefits.

Rights

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Rights can take many forms including the right to receive cash, exchange resources on
favourable terms, rights over physical objects and rights to use intellectual property.
Many rights are established by contract, legislation or similar means.

However, rights might be obtained in other ways (e.g. developing know-how that is not
in the public domain).

Some goods or services are received and immediately consumed (e.g. employee
services). The right to obtain the economic benefits produced by such goods or services
exists momentarily until the entity consumes the goods or services.

In order to be an asset, rights must both have the potential to produce economic benefits
for the entity beyond those available to all other parties and be controlled by the entity.
Therefore, not all rights are assets (e.g. right to use public infrastructure is not an asset).

Potential to produce economic benefits

An economic resource is a right that has the potential to produce economic benefits.

A right can be an asset, even if the probability that it will produce economic benefits is
low. However, low probability might affect decisions about what information to provide
about the asset and how to provide that information, including decisions about whether
the asset is recognised and how it is measured.

Control

Control links an economic resource to an entity. Control is the ability to obtain economic
benefits from the asset, and to restrict the ability of others to obtain the same benefits
from the same item.

Therefore, if entity financial statements are prepared based on IFRS, the recognition of
assets in the statement of financial position need to meet their definition that provided by
Conceptual framework. Based on the definition, the entity would recognise assets in its
statement of financial position only if those resources meet these conditions:

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 • Assets are the resources to which the entity has right;

• Assets are expected to provide economic inflow into the entity in the future; and

• Assets are the resources that control by the entity.

That means that even though assets are controlled by the entity, but they are not expected
to have future economic inflow, then the entity could not be recognised.

3. According IASB conceptual framework, a liability is “a present obligation of the entity to

transfer an economic resource as a result of past events”.

For a liability to exist, three criteria must all be satisfied:

• the entity has an obligation;

• the obligation is to transfer an economic resource; and

• the obligation is a present obligation that exists as a result of past events

Obligation

An obligation is a duty or responsibility that an entity has no practical ability to avoid.

An obligation is always owed to another party (or parties) but it is not necessary to
know the identity of the party (or parties) to whom the obligation is owed.

Obligations might be established by contract or other action of law or they might be

constructive. A constructive obligation arises from an entity’s customary practices,
published policies or specific statements when the entity has no practical ability to act in
a manner inconsistent with those practices, policies or statements.

Transfer of economic resource

An obligation must have the potential to require the entity to transfer an economic
resource to another party (or parties). An obligation can meet the definition of a liability
even if the probability of a transfer of an economic resource is low. However, low
probability might affect decisions about what information to provide about the liability

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and how to provide that information, including decisions about whether the liability is
recognised and how it is measured.

Present obligation as a result of past events

A liability is an obligation that already exists. An obligation may be legally enforceable

as a result of a binding contract or a statutory requirement, such as a legal obligation to
pay a supplier for goods purchased.

Obligations may also arise from normal business practice, or a desire to maintain good
customer relations or the desire to act in a fair way. For example, an entity might
undertake to rectify faulty goods for customers, even if these are now outside their
warranty period. This undertaking creates an obligation, even though it is not legally
enforceable by the customers of the entity.

Past transactions or events

A liability arises out of a past transaction or event.

A present obligation exists as a result of past events only if:

• the entity has already obtained economic benefits or taken an action; and

• as a consequence, the entity will or may have to transfer an economic resource

that it would not otherwise have had to transfer.

For example, a trade payable arises out of the past purchase of goods or services, and an
obligation to repay a bank loan arises out of past borrowing.

Recognition Criteria of Liabilities

If the entity financial statements are prepared according to IFRS, then those liabilities
should meet the recognition criteria of liabilities in the conceptual framework.

Liabilities are classified into two main headings: current liabilities and non-current
liabilities. As per the definition above, the entity could recognise the liabilities in
statement of financial position only if:

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 • The liabilities result from past event or transaction

• The entity has a legal obligation on those transactions or event

• There will be economic outflow from an entity when they are settled.

That means the entity could not recognise the liabilities in the statement of financial
position just because they have the future obligation and economic outflow when they
are settled. These liabilities need to be as a result of past transactions.

Summary of Recognition criteria:

The following are the recognition criteria of liabilities from the conceptual framework:

Statement of financial position when it is probable that an outflow of resources

embodying economic benefits will result from the settlement of a present obligation and
the amount at which the settlement will take place can be measured reliably. In practice,
obligations under contracts that are equally proportionately unperformed (for example,
liabilities for inventory ordered but not yet received) are generally not recognised as
liabilities in the financial statements. However, such obligations may meet the definition
of liabilities and, provided the recognition criteria are met in the particular
circumstances, may qualify for recognition. In such circumstances, recognition of
liabilities entails recognition of related assets or expenses.

4. Assets distortion can arise due to the following situations:

Provisions: There are various provisions that are required to be made in connection with
the various assets in the financial statements, for example:

• Provision for depreciation on PPE;

• Provision for inventories, due to loss in value as a result of obsolescence, slow

moving items, etc.;

• Provisions for prepaid expenses and revenue not yet earned; and

• Bad debt allowance on receivables.

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 Recognition of too much or too little provisions on the above can distort the total assets
value of the company reported in the financial statement. At the same time, management
has the discretion to determine what obligation is probable and what the estimate should
be. It may also be that what management states as contingency liabilities as a note to the
financial statement has actually crystallise.

Asset impairment: Recognising too much or too little asset impairment of PPE,
investments and intangibles can cause distortions in the asset value. This is because
estimation of fair value is subjective and can be a veritable ground for management bias
and management can therefore, delay reporting impairment in the financial statements.

Timing of revenue recognition: The management can manage the earnings reported in
the financial statements through aggressive revenue recognition. This will affect the
figures stated for both revenue and trade receivables in the financial statements.

Expenses capitaliation: As a form of earnings management, expenses could capitalised

or deferred to much or too little. Management, under IAS 38, has discretion in deciding
whether to capitalise or expense interest and expenditure required to get PPE and
inventory to current location and condition. Deferred expenditure is capitalized into the
cost of the asset and this will impact income. However, if the management decides that
the potential future benefits cannot be reliably measured, the standard allowed the
management to expense the expenditure.

Leased assets: If the entity uses substantial leased assets and this are not brought into the
financial statements, it will lead to reduction in the value of the entity’s assets which will
result in distortion.

5. According to IASB conceptual framework, equity is “the residual interest in the assets of
the entity after deducting all its liabilities”.

Equity claims are claims on the residual interest in the assets of the entity after
deducting all its liabilities. In other words, they are claims against the entity that do not
meet the definition of a liability. Such claims may be established by contract, legislation

102
or similar means, and include, to the extent that they do not meet the definition of a
liability:

(a) shares of various types, issued by the entity; and

(b) some obligations of the entity to issue another equity claim.

Different classes of equity claims, such as ordinary shares and preference shares, may

confer on their holders’ different rights, for example, rights to receive some or all of the

following from the entity:

(a) dividends, if the entity decides to pay dividends to eligible holders;

(b) the proceeds from satisfying the equity claims, either in full on liquidation, or in part

at other times; or

(c) other equity claims.

Equity is the residual interest in the assets of the entity after deducting all the liabilities
(IASB Framework).

Equity is what the owners of an entity have invested in an enterprise. It represents what
the business owes to its owners. It is also a reflection of the capital left in the business
after assets of the entity are used to pay off any outstanding liabilities.

Equity therefore includes share capital contributed by the shareholders along with any
profits or surpluses retained in the entity. This is what the owners take home in the event
of liquidation of the entity.

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 Professional Taxation II

Chapter
Financial/Tax analysis

5
Financial statement analysis and accounting ratios

Contents

5.1 Introduction
5.2 Financial analysis
5.3 Types of financial analysis
5.4 Techniques for financial analysis
5.5 Ratio analysis
5.6 Types of accounting ratios
5.7 Profitability ratios
5.8 Liquidity ratios
5.9 Efficiency/activity ratios
5.10 Operating cycle
5.11 Long-term solvency ratios
5.12 Investment ratios
5.13 Example for illustration
5.14 Steps in financial analysis
5.15 Limitations of financial analysis
5.16 End of chapter questions

Purpose
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At the end of this chapter, readers should be able to:

• Explain financial statement analysis;

• Explain the types of financial analysis;

• Discuss the techniques for financial analysis;

• Discuss accounting ratios;

• Calculate the various types of accounting ratios

• Discuss and calculate operating cycle.

• Discuss steps in performing financial analysis

• Explain the limitations of financial analysis

5.1 Introduction

The purpose of this section is to equip tax administrators with the accounting tool for reviewing
financial statements upon which tax computation, capital allowance computations which form
the basis of tax payable are based. With ability to analyze financial statements through
accounting ratios and other analytical techniques, tax officials will be able to determine whether
there are areas within the financial statements which are aimed at reducing tax liabilities.

5.2 Financial analysis

Financial analysis is defined as the process of identifying financial strengths and weakness of a
business by establishing relationship between the elements of Statement of Financial Position
and Statement of Comprehensive Income. It is through the process of financial analysis that the
key performance indicators such as liquidity, solvency, profitability, and efficiency of operations
of a business entity are determined and the short terms and long term prospects of a business can
be evaluated.

Financial statement is an organized and systematic collection of data based on logical and
consistent accounting principles and procedures for the purpose of conveying an understanding
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of some financial aspects of a business entity. It reveals the financial position of the entity at a
moment of time and the results of the series of activities over a given period of time. The
contents of the financial statements are:

• Statement of comprehensive income;

• Statement of financial position;
• Statement of changes in equity; and
• Statement of cash flow.

The objective of financial analysis is to draw information which will facilitate:

• The evaluation of the strength and weaknesses of the business entity;

• The measurement of profitability of the business entity;
• The determination of the future earning capacity of the business entity;
• The determination of the liquidity and solvency of the business entity; and
• A decision on the future prospects of the business entity.

5.3 Types of financial analysis

There are various types of financial analysis these are:

External analysis: This is an analysis carried out by external parties to the entity and the entity’s
published financial statements form the basis of this analysis.

Internal analysis: This is an analysis being carried out by the entity’s financial managers to
provide information to top management for decision making;

Short term analysis: This is concerned with the analysis of an entity’s working capital. It
involves the analysis of the entity’s current assets and current liability to be able to determine the
short-term liquidity or cash position of the entity. It shows whether the entity will be able to
meet its short-term cash commitments;

Horizontal analysis: This involves comparative analysis of financial statements for number of
years. It is also known as Dynamic Analysis; and

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Vertical analysis: This involves calculation of financial ratios based on a single year’s financial
statements. It is also known as Static Analysis.

5.4 Techniques for financial analysis

A number of techniques are normally employed in analysing a business entity’s financial

statement. These include:

Comparative financial statements: This involves a comparison of an entity’s financial

statements over a period of time, say at least over two-year period. It compares the entity’s
Income statement and statement of financial position over the period. It provides meaningful
information when compared to similar data of prior periods. The comparison of the Income
statement enables a review of the operational performance of the entity over a period of time so
as to draw conclusions as to the direction of the entity’s performance. So also, a comparison of
the Statement of financial positions during the period will reveal the effects of operations on the
assets and liabilities of the entity. This is carried out by determining the absolute and percentage
changes in the compositions of the Income Statements and Statement of Financial positions
within the periods chosen.

Common size statements: This analysis is done by converting the figures of the financial
statements to percentages. For the income statement, the figure for Revenue is taking as 100
percent and the figures of the other items of the income statement are expressed as a percentage
of the Revenue figure. Also, for the statement of financial position, the figure for the total assets
is taking as 100 percent while the other items of the statement of financial position are expressed
as a percentage of the total assets.

Statement of changes in working capital: The statement of changes in working capital

provides information in relation to working capital between the financial periods. The amount of
working capital for each period is determined by deducting the total of current liabilities from the
total of current assets. The explanation for this change is expressed by breaking the changes into
the makeup of the total current assets.

Trend analysis: Under this analysis, ratios of different items of the financial statements for
various periods are calculated and then comparison made accordingly. This analysis reveals the
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trend or direction of the company. Trend analysis is used to determine whether the financial
health of a business entity is improving or deteriorating and whether the results of its operation is
improving or on a downward trend.

Ratio analysis: This is the most popular way of carrying out a financial analysis. It is a widely
used tool for analysing financial statements. Financial ratios show the relationship between the
individual items or group of items of the entity’s income statement and statement of financial
position. Ratios can be grouped under the five major headings – profitability ratios, liquidity
ratios, activity or efficiency ratios, leverage ratios and shareholders – return or investment ratios.
Ratios therefore highlight the key performance indicators, such as profitability, efficiency,
liquidity, solvency, etc. of a business entity. It also reveals a lot about the changes in the
financial condition of a business entity.

5.5 Ratios analysis

The term ratio refers to the mathematical relation between any two inter-related variables. It
establishes the relationship between two items expressed in quantitative form.

Accounting ratio can be defined as the significant relationships between figures shown in the
Statement of financial position and Income statement. Melville (2014), in International
Financial Reporting (pg. 354) described an accounting ratio as “a measure of the relationship
which exists between two figures shown in a set of financial statements. Financial ratios assist in
the analysis and interpretation of financial statements.

In comparing and evaluating the performance of a business entity, accounting ratio is a useful
tool as it eliminates the problem of comparability using absolute figures. It is also a useful tool
in the hand of tax administrators as it helps to reveal areas the tax authority needs to beam their
search light in a taxpayer’s financial statements submitted with tax returns. Accounting ratios
are used as a means of comparing an entity’s performance over two or more periods as well as a
means of comparing an entity’s performance with that of another entity in the same industry, and
of course with the industry average. With such comparison, the tax authority may be able to
determine taxpayers that need to be visited for a tax audit to really determine the cause of
taxpayer’s constant low tax compared to others in the same industry.

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5.6 Types of accounting ratios

Accounting ratios can be classified into five main groups. These are:

Profitability ratios: These ratios are used to assess the level of profitability of a business entity;

Liquidity ratios: These are ratios that measure the ability of a business entity to pay its day to
day debts as they fall due;

Efficiency /activities ratios: These ratios measure how efficient the business entity has been
utilising the business assets.

Long term solvency ratios: These are ratios that show the capital structure of a business entity.
They show the mixture of the business capital between equity (proprietary capital) and debts
(long term liabilities); and

Investment ratios: These are ratios that are of interest to investors and potential investors. They
show the level of returns that an investor can expect from investing in the business entity.

5.7 Profitability ratios

The main profitability ratios are:

• Return on capital employed;

• Return on equity;
• Gross profit margin; and
• Net profit margin.

Return on capital employed (ROCE)

This ratio expresses a business entity’s profit as a percentage of the amount of capital invested in
the entity. Its common definition is:

ROCE = Profit before long term loan interest and tax (PBIT) X 100
Share capital and reserves plus non-current liabilities 1

It could also be expressed as PBIT

Net Assets
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Where net assets mean total assets less current liabilities.

This ratio (ROCE) can also be broken down into subsidiary components as follows:

ROCE = PBIT X Sales

Sales Net assets

Return on equity (ROE)

It is a variation of ROCE, but it concentrates on the entity’s equity holders and compares the
equity capital with the amount of profit which can be attributed to them. The ratio is calculated
as follows:

ROE = Profit after interest, tax and preference dividend X100

Ordinary shares capital plus reserves 1

Gross profit margin

This ratio expresses the entity’s gross profit as a percentage of sales revenue and is also known
as gross profit percentage. It is simply calculated as:

Gross profit margin = Gross profit X 100

Sales 1

Net profit margin

It expresses the entity’s net profit as a percentage of sales revenue. It is calculated as:

Net profit margin = Net profit X100

Sales 1

5.8 Liquidity ratios

The main liquidity ratios are:

• The current ratio;

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• The quick asset ratio (or acid test); and
• Absolute Liquid ratio.

Current ratio

The ratio establishes the relationship between an entity’s current assets and current liabilities. Its
purpose is to measure the entity’s ability to meet its short-term financial obligations out of its
current assets. It is calculated as:

Current ratio = Current assets

Current liabilities

Quick assets ratio

Since an entity’s inventories may not, in most cases, be quickly turned into cash, within a short
notice, it is eliminated from the current assets in calculating the quick assets ratio. It is a more
stringent test of the entity’s ability to meet its short – term financial commitments. It is
calculated as:

Quick asset ratio = Current assets less inventories

Current liabilities

Absolute liquid ratio

This ratio can also be called cash position ratio or overdue liability ratio. It establishes the
relationship between the absolute liquid assets and current liabilities. Absolute liquid assets
include cash in hand, cash at bank, marketable securities and temporary investment such as
short-term deposits. It is calculated as:

Absolute liquid ratio = Absolute Liquid assets

Current liabilities

5.9 Efficiency / activity ratios

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The main efficiency ratios are:

• Asset turnover;
• Inventory holding period;
• Trade receivable collection period; and
• Trade payable payment period.

Asset turnover

The ratio measures the efficiency with which an entity’s assets are used to generate sales
revenue. It is calculated as follows:

Asset turnover = Sales = Sales

Net assets Capital employed.

Inventory holding period

Inventory holding period measures the average number of days between the time an item if
inventory is bought and sold or used in production. It is calculated as follows:

Inventory holding period (in days) Average inventory X 365

Cost of sales 1

Alternatively, it can be termed inventory turnover and is calculated as follows:

Inventory turnover = Cost of sales

Average inventory

Trade receivables collection period

Trade receivable collection period measures the average number of days which elapse between
making a credit sale and receiving payment from customer. It is calculated as follows:

Trade receivables collection period (in days) = Average trade receivable X365
Credit sales 1

Trade payable payment period

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Trade payable payment period measures the average number of days which elapse between the
date of a credit purchase and the date when payment is made to the suppliers. The ratio is
calculated as follows:

Trade payable payment period in days = Average trade payable X 365

Credit purchases 1

5.10 Operating cycle

A company’s operating cycle is the time it takes the company to convert its investment in
inventory back into cash. It considers the number of days the company ties down cash it invested
in inventory before the cash is realized back after collection of receivables. The operating cycle
of a company that manufactures and sell goods comprises of four phases as follows:

• Raw materials are purchased and goods are produced and kept in inventory;
• Goods are sold from inventory to generate sales revenue which may be on credit, in cash or
both;
• Extend credits to its customers which leads to account receivables; and
• Accounts receivable are collected to generate cash.

However, for a company that only buys goods to resell, the first phase above will not apply, its
operating cycle will only involve the last three phases. The same thing applies to a company that
only renders services to its customers.

Operating cycle is normally measured by number of days in each of the phases listed above. For
example:

The number of days fund is tied up in inventory is measured by:

• The total fund invested on inventory; and

• The average days of cost of goods sold.

Usually, the fund tied up in inventory is represented by the closing inventory shown on the
company’s financial position at the end of the financial year, however, some people felt that the
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average fund invested in both the cost of inventory at the beginning and at the end of the
financial year is more representative of funds tied up in inventory during the year. Both method
of calculating the number of days funds are tied up in inventory is, however, acceptable. The
average days cost of goods sold is the cost of goods sold on average, daily in the year which is
measured by dividing the cost of goods sold by the number of days in the year. The number of
days in the year is normally taken to be 365 days unless otherwise stated. Therefore, the number
of days funds are tied up in inventory is calculated as follows:

Number of days in inventory = Inventory

Average cost of goods sold per day

= Inventory
Cost of goods sold/365

In the same way, we can calculate the number of days funds are tied up between the time goods
are sold on credit before they turn to cash. The accounts receivable in the statement of financial
position at the end of the financial year is used, if this is representative of receivables during the
year, otherwise, the average of accounts receivable at the beginning of the year and at the end of
the year can be used. This is calculated as follows:

Number of days receivables = Accounts receivables

Average days of sales on credit

= Accounts receivable
Sales on credit/365

Net working capital to sales ratio

This ratio shows the relationship between the company’s liquid assets after meeting its short-
term obligations to its need for liquidity which is measured by sales revenue. It is calculated as
follows:

Net working capital to sales ratio = Current assets – current liabilities

Sales revenue

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The addition of the number of days in inventory and the number of days in receivables gives the
operating cycle of the company. The purpose of calculating the operating cycle is to determine
the amount of working capital that will be needed to meet the company’s short-term obligations
or what is referred to as the adequacy of working capital. The longer the operating cycle, the
more the current assets needed, relative to current liabilities, because it takes longer time to
convert inventory back to cash. This means that the longer the operating cycle, the more the net
working capital that will be required.

However, in determining the liquidity required by the company, net operating cycle is more
appropriate because the longer the net operating cycle, the more the liquidity the company will
require. Net operating cycle is determined by removing the number of days the company enjoys
in accounts payable from the operating cycle calculated as above. The same method we used in
calculating number of days in receivables will be used in calculating number of days payable but
we need only to substitute receivable for payable, as follows:

Number of days payable = Accounts payable

Average day’s purchases

= Accounts payable
Purchases/365

Therefore, net operating cycle is calculated as follows:

Net operating cycle = Number of days + Number of day’s - Number of days

of inventory of receivables payables

However, if the organisation is a manufacturing concern, calculation would be made for raw
material conversion period and work in progress conversion period while the calculation for
number of days in inventory will be for the finished goods inventory.

Raw material conversion period: Raw material inventory x 365

Raw material consumed

Work in progress conversion period: Work in progress x 365

Cost of production

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This additional two computation will be added to the operating cycle in a manufacturing
organisation.

5.11 Long term solvency ratios

The main long-term solvency ratios are:

• Capital gearing ratio;

• Debt equity ratio; and
• Interest cover.

Capital gearing ratio

The capital gearing ratio measures the extent to which an entity’s long-term funds have been
provided by lenders. It can be calculated as:

Capital gearing = Preference share capital plus non-current liabilities

Total share capital and reserve plus non-current liabilities

Debit – equity ratio

Debt – equity ratio measures the relationship that debt has to equity capital of an entity.

It is calculated as:

Debt – equity ratio = Debt

Equity

Interest cover

Interest cover measures the number of times that the interest payable for an accounting period
could have been paid out of the available profit. It is calculated as:

Interest cover = Profit before interest and tax

Interest payable

5. 12 Investment ratios
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The main investment ratios are:

• Earnings per share (EPS);

• Price earnings ratio (P/E ratio;)
• Dividend cove; andr
• Dividend yield.

Earnings per share

Earnings per share measure the amount of profit earned during an accounting period for each
ordinary share in issue during the period. It is calculated as:

EPS (in kobo) = Profit after tax and preference dividend X 100
Number of ordinary shares in issue 1

Price earnings ratio (P/E) ratio

The price earnings ratio compares the earning per share with the market price of ordinary shares
to calculate the number of years it would take to recover the market price period for a share if
earnings remained constant in future years.

It is calculated as:

P/E ratio = Market price per ordinary share

Earnings per share.

Dividend cover

Dividend cover measures the number of times the ordinary share dividend for an accounting
period could have been paid out of the available profit for the period. It is calculated as:

Dividend cover = Profit after tax and preference dividends

Ordinary share dividends

Dividend yield

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The dividend yield expresses the dividend per ordinary share as a percentage of the market price
per ordinary share. It is calculated as:

Dividend yield = Dividend per ordinary share X 100%

Market price per ordinary share

5.13 Example for illustration

Sadet Nigeria Plc is a company dealing with distribution of household commodities. The
company’s financial statements for the year to 31 December 2015 (with comparative figures for
2014) are as follows:

Sadet Nigeria Plc

Statement of comprehensive income for the year to 31st December
2015 2014

N’m N’m

Sales Revenue 5,000 4,550

Cost of Sales 3,660 3,330

Gross profit 1,340 1,220

Operating expenses 380 400

Profit before interest and tax 960 820

Interest payable 80 100

Profit before taxation 880 720

Taxation 250 210

Profit after tax 630 510

Statement of financial position as at 31st December

2015 2014
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 N’m N’m

Assets

Non – current assets

Property, plant and equipment 1,730 1,820

Current assets

Inventories (2013, N 670m) 740 690

Trade receivables 820 760

Short term deposit 100 50

Cash in bank and in hand 560 2,220 340 1,840

3,950 3,660

Equity

Ordinary shares of N1 1,000 1,000

Retained earnings 980 680

1,980 1,680

Non – current liabilities:

Long term loan 800 1,000

Current liabilities

Trade payables 920 770

Taxation 250 1,170 210 980

3,950 3,660

Notes:

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Ordinary shares dividends of N330m were paid during the year to 31st December 2015. The
equivalent figure for 2014 was N300m; and

The market price of the company’s ordinary shares was 350kobo per share on 31st December
2014.

Required:

Carry out a financial analysis to evaluate and compare the company’s profitability, liquidity,
efficiency and investment potential for the two years.

Solution

Comparative analysis

Statement of comprehensive income for the year ended 31st December:

2015 2014 Change

Absolute Percentage

N’m N’m N’m %

Sales Revenue 5,000 4,550 450 9.89

Cost of sales 3,660 3,330 330 9.91

Gross profit 1,340 1,220 120 9.84

Operating expenses 380 400 -20 -5.00

Profit before interest and tax 960 820 140 17.07

Interest payable 80 100 -20 -20.00

Profit before taxation 880 720 160 22.22

Taxation 250 210 40 19.05

Profit after tax 630 510 120 23.53

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Statement of financial position as at 31 December:

2015 2014 Change

Absolute percentage

N’m N’m N’m %

Assets

Non – current assets

Property, plant and equipment 1,730 1,820 -90 4.95

Current assets:

Inventories 740 690 50 7.25

Trade receivables 820 760 60 7.89

Short term deposit 100 50 50 100.00

Cash at bank and in hand 560 340 220 64.71

2,220 1,840 380 20.65

3,950 3,660 290 7.92

Equity

Ordinary shares of N 1 1,000 1,000 -

-

Retained earnings 980 680 300 44.12

1,980 1,680 300 17.86

Liabilities

Non – current liabilities:

Long term loans 800 1,000 -200

20.00
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Current liabilities

Trade payables 920 770 150

19.48

Taxation 250 210 40 19.05

1,170 980 190 19.39

3,950 3,660 290 7.92

Common size statements

Statements of comprehensive income

2015 2014

% %

Sales Revenue 100.0 100.0

Cost of sales 73.2 73.2

Gross profit 26.8 26.8

Operating expenses 7.6 8.8

Profit before interest and tax 19.2 18.0

Interest payable 1.6 2.2

Profit before taxation 17.6 15.8

Taxation 5.0 4.6

Profit after tax 12.6 11.2

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Statement of financial position:

2015 2014

% %

Assets

Non – current assets

Property, plant and equipment 43.8 49.7

Current assets

Inventories 18.7 18.9

Trade receivables 20.8 20.8

Short term deposit 2.5 1.4

Cash at bank and in hand 14.2 9.3

Total non – current assets 56.2 50.3

Total assets 100.0 100.0

Equity

Ordinary shares of N 1 25.3 27.3

Retained earnings 24.8 18.6

50.1 45.9

Liabilities

Non – current liabilities

Long term loans 20.3 27.3

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Current liabilities

Trade payables 23.3 21.0

Taxation 6.3 5.7

Total non- current liabilities 29.6 26.7

100.0 100.0

Accounting ratios

Profitability

2015 2014

a. Return on capital employed: 960 X 100 820 X 100

2,730 2,630
= 35.2% = 31.2%

b. Return on equity: 630 X 100 510 X 100

1,930 1,630
= 32.6% = 31.3%

c. Gross profit margin: 1,340 X 100 1,220 X 100

5,000 4,550
= 26.8% = 26.8%

Liquidity

2015 2014

Current ratio = 2,220 1,840

1,120 980
= 2:1 = 1.9:1

Quick assets ratio = 2,220 - 720 1,840 - 690

1,120 980
= 1.3:1 = 1.2:1

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Absolute liquid ratio = 560 + 100 340 + 50
1,120 980
= 0.6:1 = 0.4:1

Efficiency

2015 2014

Asset turnover = 5000 4,550

2,730 2,630

= 1.83 = 1.73

Inventory holding period = 715 X 365 680X 100

3,660 3,330

= 71days = 75days

Receivables collection period = 820 X 365 760X 365

5,000 4,550

= 60days = 61days

Payable payment period = 870 X 365 770X 100

3,710 3,350

= 86days = 84days

Long – term solvency

2015 2014

Capital gearing ratio = 800 X 100% 1,000 X 100%

2730 2,630

= 29% = 38%

Debt – equity ratio = 800 X 100% 1,000 X 100%

1,980 1,680

= 40.4% = 59.5%

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Interest cover = 960 820
80 100

= 12 = 8.2

Investment

2015 2014

Earnings per share = 630 X 100 510 X 100

1,000 1,000

= 63kobo = 51kobo

Price earnings ratio = 350 275

63 51

= 5.6 = 5.4

Dividend cover = 630 510

330 300

= 1.9 = 1.7

Dividend yield = 33 X 100% 30 X 100%

350 275

= 9.4% = 10.9%

5.14 Steps for the preparation of financial analysis

Determine the users of the analysis.

Start by recognising the person or organisation who has asked for the financial analysis. Ask the
following questions:

• Who is the user?

• What information is the user interested in?

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• Why has the user requested the report?

• How should the information be presented to the user?

Background information

Establish some of the basic ‘background’ information about the entity which is the subject of the
analysis, by asking the following questions:

• What industry does the company operate in?

• When is the entity’s financial year end?

• Is the entity’s business seasonal? If so, seasonal trading may ‘distort’ the year-end figures
in the statement of financial position, particularly for inventory, receivables, cash and
payables.

• Have there been any key transactions during the year that may affect comparisons with
previous years? For example, has the company raised a substantial amount of new finance,
or has it acquired a major new subsidiary, entered a new market with a new product, or
disposed of a business operation?

Carry out accounting analysis

Before you start the analysis of the financial statements, carry out accounting analysis of the
entity’s financial statements by, performing a thorough review of the financial transactions and
events that results in the financial statement. Accounting analysis is the process of evaluating the
extent to which the figures in the financial statements reflects the economic reality of the entity.
It includes the evaluation of the entity’s accounting risk and earnings quality, estimating the
entity’s earning power and making necessary adjustments to the financial statements to both
better reflect the economic reality and make the financial statements useful for financial analysis.
The purpose of the accounting analysis is to discover any distortions in the assets, liabilities and
equity of the entity and adjust the figures as the case may be.

Statement of financial position:

• Non-current assets.

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 ➢ Have there been any revaluations? Check the revaluation reserve. Has it changed since
the previous year? (This can also be checked by looking at the statement of profit or
loss and other comprehensive income.)

➢ Capital expenditure. Has the company incurred significant capital expenditure? Look
at the increase in non-current assets since the previous year. How has the expansion
been financed? Look at share capital and reserves, and at levels of debt.

• Investments.

➢ Has the company invested in a new industry?

➢ Has the company acquired a new subsidiary or invested in a new associate or joint
venture? If so, consider the timing of the acquisition – if an acquisition happened in
mid-year the subsidiary’s profits will have been included in profit or loss for only six
months but it will be included in full in the year-end group statement of financial
position.

• Working capital.

➢ Has the total working capital increased or decreased in proportion with the increase or
decrease in sales turnover (compared with the previous year)?

➢ Look at the amounts of current assets and current liabilities. Does the company have
net current assets or net current liabilities?

• Loans.

Have any loans been repaid in the year? If so, how was the repayment financed?

• Share capital and reserves

➢ Have there been any new issues of shares during the year? If so, is it clear why the
new shares were issued? For example, have new shares been issued to raise money to
repay debt? Or to finance an expansion of the business?

➢ Have there been any significant changes in reserves during the year?

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Statement of profit or loss

Compare sales growth with profit growth. Are they about the same rates of growth? If not, you
may need to think about reasons for the different growth rates.

• Interest. Is the interest charge high in relation to the amount of debt in the statement of
financial position? If it is high, has any debt been repaid in the year?

• Dividends. Look at the amount of dividend payments, the dividend cover, and the trend in
dividend payments over the past few years.

• Did the company make a profit or a loss?

• Are there any unusual ‘one-off’ items in profit or loss? If so, what are they?

5.15 Limitations of financial analysis

There are several limitations or weaknesses in the techniques being used in the analysis and
interpretation of companies’ financial statements. Some of these are limitations are based on the
limitations of the financial statement from which ratios are calculated. Most of the data for
calculating financial ratios comes from the financial statements.

Analysis must know that the results of financial statement analysis are as good as the reliability
of the components of the financial statements being analysed. The reliability of the financial
statement can be affected by the following:

Differences in accounting policy: when comparing ratios from different companies, the analyst
must ensure that they all adopt the same accounting policy, otherwise, the comparison will be
meaningless. Therefore, where the companies do not adopt the same accounting policy, the
analyst will need to carry out adjustments that will bring the companies’ financial statements to
the same level before any comparison can be reasonable.

Also, different companies in the same industry has different characteristics which in turn affect
the components of each’s financial statement, therefore, the analyst should consider the
characteristics of the various companies being compared before concluding on his interpretation.

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In the same way, when comparing the ratios of a company with the industry average, the analyst
must ensure that he takes into consideration the nature, size and the position of the company in
the industry.

Another important thing the analyst should note when comparing different companies’ ratios is
that although the companies might have adopted the same accounting policy, their application of
the policy might be different. For example, in accounting policy

One of the uses of financial ratios is to compare the financial position and performance of one
company with those of similar companies for the same period.

Comparisons between companies might not be reliable, however, when companies use different
accounting policies, or have different judgements in applying accounting policies or making
accounting estimates. For example:

• Each company might have different policies about the revaluation of non-current assets.

• Each company might use different methods of depreciation.

• Each company might have used different rates of depreciation for the same group of non –
current assets;

• Each company might use different judgements in estimating the expected profitability on
incomplete construction contracts.

• Each company might use different judgements in assessing whether a liability should be
treated as a provision or a contingent liability.

Limitations of historical cost accounting: Since historical cost accounting do not take into
account the time value of money, financial statements prepared using historical costs can be
misleading as a result of the effect of inflation. When the rate of inflation is high, many non –
current assets will probably be undervalued in the financial statements, when compared with
their current replacement value. In the same way, when the rate of inflation is high, the reported
profit with historical cost accounting will be higher than it would be when any of the inflation

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adjusted accounting systems such as current cost accounting and current purchasing power
accounting are used.

Many of the ratios can be computed using different ways, e. g. return on capital employed
(ROCE) and gearing. So, the analyst should ensure the same basis of calculation is adopted when
comparing ratios of different companies.

Where two companies operate in the same industry, comparisons can still be misleading,
especially because of different nature of each company. The analyst should take into
consideration when interpreting ratios and comparing different companies’ ratios the size of each
company, the market segment each is operating from and the position of the company in its
product’s life cycle.

Ratios can only indicate possible strengths or weaknesses in financial position and financial
performance of companies and raise questions about its performance, position and future
prospects but cannot provide answers to these questions. They are not easy to interpret, and
changes in financial ratios over time might not be easy to explain.

Creative accounting and management bias: Due to intentional bias of management, the
financial statements can be manipulated by management, while still complying with the relevant
accounting standards, through creative accounting. Some of the methods commonly used are:

• Window dressing: an entity enters into a transaction just before the year end and
reverses the transaction just after the year end. For example, goods are sold on the
understanding that they will be returned immediately after the year end; this appears to
improve profits and liquidity. Cheques are issued to pay off overdraft or bank loans at the
end of the year and immediately after the end of the year the cheque is reversed. The only
reason for these transactions is to artificially improve the view given by the financial
statements.

• ‘Off statement of financial position finance: transactions are deliberately arranged so

as to enable an entity to keep significant assets and particularly liabilities out of the
statement of financial position. This improves gearing and return on capital employed.
Examples include sale and repurchase agreements and some forms of leasing.

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• Changes to accounting policies or accounting estimates: for example, an entity can
revalue assets (change from the cost model to the revaluation model) to improve gearing
or change the way in which it depreciates assets to improve profits.

• Profit smoothing: manipulating reported profits by recognising (usually) artificial assets

or liabilities and releasing them to profit or loss as required.

• Aggressive earnings management: artificially improving earnings and profits by

recognising sales revenue before it has been earned.

• Capitalising expenses: recognising ‘assets’ which do not meet the definition in the IASB
Conceptual Framework or the recognition criteria. Examples include: human resources,
advertising expenditure and internally generated brand names.

• Big Bath Accounting: Big Bath in accounting is an earnings management technique

whereby a one-time charge is taken against income in order to reduce assets, which
results in lower expenses in the future. This will result in a lower profit for the year.

Related party relationships and transactions: Related party transactions can also affect the
reliability of the financial statements if such transactions are not at arm’s length.

Useful non-financial information: These are non – financial information that are useful in the
interpretation of accounting ratios and the analyst must take them into consideration. These
include:

• The company’s objectives and strategies;

• The main risks and uncertainties the company is facing and how these risks are being
managed;

• Any significant factors or events that could impact on the company’s performance in
future;

• Any significant factors or events that could impact on the company’s cash flows in
future;

• Information about key relationships with other companies and transactions with related
parties, including management; and
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• A description of the company’s research and development activities (if any) and of any
material intangible assets, including internally generated intangible assets that have not
been recognised in the statement of financial position.

5.16 End of chapter questions and solutions

5.16.1 End of chapter questions

1. Discuss the techniques for financial analysis.

2. Discuss accounting ratios and list the four major groups of accounting ratios and
their components.
3. Discuss the limitations of financial analysis (accounting ratios).
4. Discuss the steps involved in financial analysis.
5. Discuss the various types of financial analysis.

5.16.2 Solutions to end of chapter questions

1. A number of techniques are normally employed in analysing a business entity’s financial

statement. These include:
• Comparative financial statements: This involves a comparison of an entity’s financial
statements over a period of time, say at least over two-year period. It compares the
entity’s Income statement and statement of financial position over the period. It provides
meaningful information when compared to similar data of prior periods. The comparison
of the Income statement enables a review of the operational performance of the entity
over a period of time so as to draw conclusions as to the direction of the entity’s
performance. So also, a comparison of the Statement of financial positions during the
period will reveal the effects of operations on the assets and liabilities of the entity. This
is carried out by determining the absolute and percentage changes in the compositions of
the Income Statements and Statement of Financial positions within the periods chosen.
• Common size statements: This analysis is done by converting the figures of the financial
statements to percentages. For the income statement, the figure for Revenue is taking as

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 100 percent and the figures of the other items of the income statement are expressed as a
percentage of the Revenue figure. Also, for the statement of financial position, the figure
for the total assets is taking as 100 percent while the other items of the statement of
financial position are expressed as a percentage of the total assets.
• Statement of changes in working capital: The statement of changes in working capital
provides information in relation to working capital between the financial periods. The
amount of working capital for each period is determined by deducting the total of current
liabilities from the total of current assets. The explanation for this change is expressed by
breaking the changes into the makeup of the total current assets.
• Trend analysis: Under this analysis, ratios of different items of the financial statements
for various periods are calculated and then comparison made accordingly. This analysis
reveals the trend or direction of the company. Trend analysis is used to determine
whether the financial health of a business entity is improving or deteriorating and
whether the results of its operation is improving or on a downward trend.
• Ratio analysis: This is the most popular way of carrying out a financial analysis. It is a
widely used tool for analysing financial statements. Financial ratios show the
relationship between the individual items or group of items of the entity’s income
statement and statement of financial position. Ratios can be grouped under the five major
headings – profitability ratios, liquidity ratios, activity or efficiency ratios, leverage ratios
and shareholders – return or investment ratios. Ratios therefore highlight the key
performance indicators, such as profitability, efficiency, liquidity, solvency, etc of a
business entity. It also reveals a lot about the changes in the financial condition of a
business entity.
2. The term ratio refers to the mathematical relation between any two inter-related variables.
It establishes the relationship between two items expressed in quantitative form.
Accounting ratio can be defined as the significant relationships between figures shown in
the Statement of financial position and Income statement. Alan Melville in International
Financial Reporting (pg 354) described an accounting ratio as “a measure of the
relationship which exists between two figures shown in a set of financial statements.
Financial ratios assist in the analysis and interpretation of financial statements.

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In comparing and evaluating the performance of a business entity, accounting ratio is a
useful tool as it eliminates the problem of comparability using absolute figures. It is also
a useful tool in the hand of tax administrators as it helps to reveal areas the tax authority
needs to beam their search light in a taxpayer’s financial statements submitted with tax
returns. Accounting ratios are used as a means of comparing an entity’s performance
over two or more periods as well as a means of comparing an entity’s performance with
that of another entity in the same industry, and of course with the industry average. With
such comparison, the tax authority may be able to determine taxpayers that need to be
visited for a tax audit to really determine the cause of taxpayer’s constant low tax
compared to others in the same industry.
Types of accounting ratios
Accounting ratios can be classified into five main groups. These are:
• Profitability ratios: These ratios are used to assess the level of profitability of a
business entity. The main components are:
a. Return on capital employed;
b. Return on equity;
c. Gross profit margin; and
d. Net profit margin.

• Liquidity ratios: These are ratios that measure the ability of a business entity to pay
its day to day debts as they fall due. The main components are:
a. The current ratio;
b. The quick asset ratio (or acid test); and
c. Absolute Liquid ratio
• Efficiency /activities ratios: These ratios measure how efficient the business entity
has been utilising the business assets. The main components are:
a. Asset turnover;
b. Inventory holding period;
c. Trade receivable collection period; and
d. Trade payable payment period.

135
 • Long term solvency ratios: These are ratios that show the capital structure of a
business entity. They show the mixture of the business capital between equity
(proprietary capital) and debts (long term liabilities). The main components are:
a. Capital gearing ratio;
b. Debt equity ratio; and
c. Interest cover.
• Investment ratios: These are ratios that are of interest to investors and potential
investors. They show the level of returns that an investor can expect from investing
in the business entity. The main components are:
a. Earnings per share (EPS);
b. Price earnings ratio (P/E ratio);
c. Dividend cover; and
d. Dividend yield.

3. There are several limitations or weaknesses in the techniques being used in the analysis
and interpretation of companies' financial statements. Some of these are limitations are
based on the limitations of the financial statement from which ratios are calculated. Most
of the data for calculating financial ratios comes from the financial statements.
Analysis must know that the results of financial statement analysis are as good as the
reliability of the components of the financial statements being analysed. The reliability of
the financial statement can be affected by the following:
Differences in accounting policy: when comparing ratios from different companies, the
analyst must ensure that they all adopt the same accounting policy, otherwise, the
comparison will be meaningless. Therefore, where the companies do not adopt the same
accounting policy, the analyst will need to carry out adjustments that will bring the
companies' financial statements to the same level before any comparison can be
reasonable.
Also, different companies in the same industry has different characteristics which in turn
affect the components of each's financial statement, therefore, the analyst should consider
136
the characteristics of the various companies being compared before concluding on his
interpretation.
In the same way, when comparing the ratios of a company with the industry average, the
analyst must ensure that he takes into consideration the nature, size and the position of
the company in the industry.
Another important thing the analyst should note when comparing different companies'
ratios is that although the companies might have adopted the same accounting policy,
their application of the policy might be different. For example, in accounting policy.
One of the uses of financial ratios is to compare the financial position and performance of
one company with those of similar companies for the same period.
Comparisons between companies might not be reliable, however, when companies use
different accounting policies, or have different judgements in applying accounting
policies or making accounting estimates. For example:
• Each company might have different policies about the revaluation of non-current
assets.
• Each company might use different methods of depreciation.
• Each company might have used different rates of depreciation for the same group
of non - current assets;
• Each company might use different judgements in estimating the expected
profitability on incomplete construction contracts.
• Each company might use different judgements in assessing whether a liability
should be treated as a provision or a contingent liability.
Limitations of historical cost accounting: Since historical cost accounting do not take into
account the time value of money, financial statements prepared using historical costs can
be misleading as a result of the effect of inflation. When the rate of inflation is high,
many non - current assets will probably be undervalued in the financial statements, when
compared with their current replacement value. In the same way, when the rate of
inflation is high, the reported profit with historical cost accounting will be higher than it
would be when any of the inflation adjusted accounting systems such as current cost
accounting and current purchasing power accounting are used.

137
Many of the ratios can be computed using different ways, e. g. return on capital employed
(ROCE) and gearing. So, the analyst should ensure the same basis of calculation is
adopted when comparing ratios of different companies.
Where two companies operate in the same industry, comparisons can still be misleading,
especially because of different nature of each company. The analyst should take into
consideration when interpreting ratios and comparing different companies' ratios the size
of each company, the market segment each is operating from and the position of the
company in its product's life cycle.
Ratios can only indicate possible strengths or weaknesses in financial position and
financial performance of companies and raise questions about its performance, position
and future prospects but cannot provide answers to these questions. They are not easy to
interpret, and changes in financial ratios over time might not be easy to explain.
Creative accounting and management bias: Due to intentional bias of management, the
financial statements can be manipulated by management, while yet still complying with
the relevant accounting standards, through creative accounting. Some of the methods
commonly used are:
• Window dressing: an entity enters into a transaction just before the year end and
reverses the transaction just after the year end. For example, goods are sold on the
understanding that they will be returned immediately after the year end; this
appears to improve profits and liquidity. Cheques are issued to pay off overdraft or
bank loans at the end of the year and immediately after the end of the year the
cheque is reversed. The only reason for these transactions is to artificially improve
the view given by the financial statements.
• 'Off statement of financial position finance: transactions are deliberately arranged
so as to enable an entity to keep significant assets and particularly liabilities out of
the statement of financial position. This improves gearing and return on capital
employed. Examples include sale and repurchase agreements and some forms of
leasing.

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• Changes to accounting policies or accounting estimates: for example, an entity can
revalue assets (change from the cost model to the revaluation model) to improve
gearing or change the way in which it depreciates assets to improve profits.
• Profit smoothing: manipulating reported profits by recognising (usually) artificial
assets or liabilities and releasing them to profit or loss as required.
• Aggressive earnings management: artificially improving earnings and profits by
recognising sales revenue before it has been earned.
• Capitalising expenses: recognising 'assets' which do not meet the definition in the
IASB Conceptual Framework or the recognition criteria. Examples include: human
resources, advertising expenditure and internally generated brand names.
• Big Bath Accounting: Big Bath in accounting is an earnings management
technique whereby a one-time charge is taken against income in order to reduce
assets, which results in lower expenses in the future. This will result in a lower
profit for the year.
• Related party relationships and transactions: Related party transactions can also
affect the reliability of the financial statements if such transactions are not at arm's
length.
Useful non-financial information: These are non - financial information that are useful in
the interpretation of accounting ratios and the analyst must take them into consideration.
These include:
• The company's objectives and strategies;
• The main risks and uncertainties the company is facing and how these risks are
being managed;
• Any significant factors or events that could impact on the company's performance
in future;
• Any significant factors or events that could impact on the company's cash flows in
future;
• Information about key relationships with other companies and transactions with
related parties, including management; and

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 • A description of the company's research and development activities (if any) and of
any material intangible assets, including internally generated intangible assets that
have not been recognised in the statement of financial position.

4. Steps for the preparation of financial analysis

Determine the users of the analysis.
Start by recognising the person or organisation who has asked for the financial analysis.
Ask the following questions:
• Who is the user?
• What information is the user interested in?
• Why has the user requested the report?
• How should the information be presented to the user?
• Background information
• Establish some of the basic 'background' information about the entity which is
the subject of the analysis, by asking the following questions:
• What industry does the company operate in?
• When is the entity's financial year end?
• Is the entity's business seasonal? If so, seasonal trading may 'distort' the year-end
figures in the statement of financial position, particularly for inventory,
receivables, cash and payables.
• Have there been any key transactions during the year that may affect
comparisons with previous years? For example, has the company raised a
substantial amount of new finance, or has it acquired a major new subsidiary,
entered a new market with a new product, or disposed of a business operation?
Carry out accounting analysis
Before you start the analysis of the financial statements, carry out accounting analysis of
the entity's financial statements by, performing a thorough review of the financial
transactions and events that results in the financial statement. Accounting analysis is the
process of evaluating the extent to which the figures in the financial statements reflects
the economic reality of the entity. It includes the evaluation of the entity's accounting risk
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and earnings quality, estimating the entity's earning power and making necessary
adjustments to the financial statements to both better reflect the economic reality and
make the financial statements useful for financial analysis. The purpose of the accounting
analysis is to discover any distortions in the assets, liabilities and equity of the entity and
adjust the figures as the case may be.
Statement of financial position:
Non-current assets.
Have there been any revaluations? Check the revaluation reserve. Has it changed since
the previous year? (This can also be checked by looking at the statement of profit or loss
and other comprehensive income.)
Capital expenditure. Has the company incurred significant capital expenditure? Look at
the increase in non-current assets since the previous year. How has the expansion been
financed? Look at share capital and reserves, and at levels of debt.
Investments.
Has the company invested in a new industry?
Has the company acquired a new subsidiary or invested in a new associate or joint
venture? If so, consider the timing of the acquisition - if an acquisition happened in mid-
year the subsidiary's profits will have been included in profit or loss for only six months
but it will be included in full in the year-end group statement of financial position.
Working capital.
Has the total working capital increased or decreased in proportion with the increase or
decrease in sales turnover (compared with the previous year)?
Look at the amounts of current assets and current liabilities. Does the company have net
current assets or net current liabilities?
Loans.
Have any loans been repaid in the year? If so, how was the repayment financed?
Share capital and reserves
Have there been any new issues of shares during the year? If so, is it clear why the new
shares were issued? For example, have new shares been issued to raise money to repay
debt? Or to finance an expansion of the business?

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 Have there been any significant changes in reserves during the year?
Statement of profit or loss
Compare sales growth with profit growth. Are they about the same rates of growth? If
not, you may need to think about reasons for the different growth rates.
Interest. Is the interest charge high in relation to the amount of debt in the statement of
financial position? If it is high, has any debt been repaid in the year?
Dividends. Look at the amount of dividend payments, the dividend cover, and the trend
in dividend payments over the past few years.
Did the company make a profit or a loss?
Are there any unusual 'one-off' items in profit or loss? If so, what are they?
5. There are various types of financial analysis these are:
a. External analysis: This is an analysis carried out by external parties to the entity
and the entity’s published financial statements form the basis of this analysis;
b. Internal analysis: This is an analysis being carried out by the entity’s financial
managers to provide information to top management for decision making;
c. Short term analysis: This is concerned with the analysis of an entity’s working
capital. It involves the analysis of the entity’s current assets and current liability to
be able to determine the short-term liquidity or cash position of the entity. It
shows whether the entity will be able to meet its short-term cash commitments;
d. Horizontal analysis: This involves comparative analysis of financial statements for
number of years. It is also known as Dynamic Analysis; and
e. Vertical analysis: This involves calculation of financial ratios based on a single
year’s financial statements. It is also known as Static Analysis.

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 Professional Taxation II
Financial/Tax analysis

Chapter
6
Strategic tax planning

Contents

6.1 Introduction
6.2 Strategic planning
6.3 Tax planning
6.4 Tax planning strategies
6.5 Tax planning objectives
6.6 Tax avoidance
6.7 Tax evasion
6.8 Tax management
6.9 International tax planning
6.10 End of chapter questions
Purpose

• At the end of this chapter, readers should be able to:

• Explain strategic planning;
• Explain tax planning;
• Discuss tax planning strategies;
• State tax planning objectives;
• Discuss tax avoidance and tax evasion;
• Explain international tax planning strategies; and
• Explain tax management.

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6.1 Introduction

Effective corporate management requires taking full account of tax implications in the decision –
making process. Tax strategy is a part of the firm’s financial strategy which in turns form part of
the firm’s overall corporate strategy. It is usual therefore, that when a company is planning its
business strategy, consideration is given to tax strategy.

Corporate strategic planning is defined as a systematic process of determining goals to be

achieved in the foreseeable future. It consists of:

• Management’s fundamental assumptions about the future political, economic, socio –

cultural, technological, legal and competitive environments;
• An internal and external appraisal of the firm’s situation which comprises of its strengths
and weaknesses, opportunities and threats in the environment, that is, SWOT analysis;
• Setting of objectives and goals to be achieved within a specified time frame;
• Selection of main and alternative strategies that will help management to achieve set
objectives and goals; and
• Formulation, implementation of tactical and operational plans to achieve interim objectives
and monitoring and evaluation of performance from time to time.

This corporate planning process includes planning the corporate’s financial strategies which
includes:

• Financing decision;
• Investment decisions; and
• Dividend decisions

All the above financial management decisions have tax implication. Therefore, in arriving at
corporate financial strategies in its corporate strategic planning process, a firm must consider
adequately its tax strategy which is aimed at reducing the overall corporate tax liability and at the
same time maximise the shareholders’ wealth. This is where strategic tax planning comes into
play.

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Corporate tax strategy includes:

• Proper understanding of the provisions of the tax laws;

• Analysis of, management and optimization of the effective tax rate (ETR);
• International tax strategy, that is, choice of the method used to open offices/plants and
determine location;
• Tax management;
• Computation of taxable income;
• Handling of challenges associated with tax consolidation;
• Optimisation of financing and management of debt ratios;
• Management of flow of dividends, interests and royalties.
• Optimisation of tax losses/securing the deductibility of interest expenses and acquisition
costs;
• Taking benefits of tax agreements, international double taxation;
• Taking into consideration tax effect on acquisitions, disposal of business and or business
restructuring;
• Management of relationship with the tax authorities for tax optimisation by avoiding late
filings, late payment of taxes, etc; and
• Giving consideration to all tax incentives available with a view to take advantage of these
incentives as much as possible.

6.2 Strategic planning

Businesses today not only face constant change; they change in multiple fronts. As a business
evolves, it takes on different needs and opportunities, more so that the world has become a global
village. New laws are introduced while others are revised and regulatory authorities generate an
ongoing stream of guidance, regulations and other communications. And the international and
microeconomic environment – sources, cost and availability of capital, market situation,
consumers’ preference, and so on is in continual flux.

In the light of these, strategic tax planning work to align tax laws, regulations and obligation as
closely as possible with a business’s strategic vision. In doing so, it hopes to minimise tax

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liability and increase the resources available to grow the enterprise and maximises its
shareholders’ wealth.

Strategic planning involves giving consideration to tax effect of all financial management
decisions which includes:

• Capital structure, or financing decisions;

• Sources of financing: Generally, the following means of financing are available – equity
share, debentures/loans, borrowings and lease finance.
• Investment decisions; and
• Dividend decisions

Capital structure - This involves taking a decision on the firm’s capital mix between equity
capital and long-term interest-bearing capital, that is, debentures and other long-term loans. It is
generally known that interest on debenture and other loans are charged before deduction of tax,
whereas dividend paid to equity holders are paid from after tax profit. Therefore, debt financing
has a tax advantage over equity financing. However, there is a limit to which a firm could
finance its capital through debt, it must settle for an optimal mix of equity and debt.

Dividend policy – Dividend is the sum paid to a firm’s shareholders from the after tax profit of
the firm in a particular year. Usually, a tax of 10 percent is deducted from the dividend before
paying the net to the individual shareholders. This means additional tax to the shareholders
whereas, if the profit is used for bonus shares, which will increase the holdings of the
shareholders and their overall wealth, no tax will be deducted. Also, where a shareholder
decides to sell part of his shares, he will not suffer any tax liability as there is no capital gains tax
payable on gains on disposal of shares.

6.3 Tax planning

Corporate tax planning is an integral part of corporate financial planning. The objective of
corporate tax planning is to minimise corporate or personal tax liability. Tax planning is a logical
analysis of a financial situation or plan from a tax perspective, to align financial goals with tax
efficiency planning. The purpose of tax planning is to discover how to accomplish all of the
other elements of a financial plan in the most tax – efficient manner possible. Tax planning thus
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allows the other elements of a financial plan to interact more effectively by minimising tax
liability.

Tax planning is the exercise undertaken to minimise tax liability through the best use of all
available allowances, deductions, exclusions, exemptions etc., to reduce income and/or capital
gains. Tax management means, the management of finance for the purpose of paying the
minimum tax payable.

Tax planning is an integral part of a proper financial plan. It is handling tax proactively and not
reactively. Understanding the impact taxes will have on the corporate financial well – being is
essential. Taking control of your taxes and saving tax Naira is what tax planning is all about.
We must remember that taxes are the single largest recurring expenses that individuals and
corporate organisations must have throughout their life time.

Tax planning encourages many different aspects, including the timing of both income and
purchases and other expenditures, selection of investment types of retirement plans, as well as
filling status and common deduction. However, while tax planning is an important element in
any financial plan, it is important to not let the “tax” tail wag the financial “dog”. This can
ultimately be counterproductive, as virtually all courses of financial action will have some tax
consequences, and they should not be avoided solely on this basis (Investopedia).

6.4 Tax planning strategies

In general terms, the goal of tax planning is to maximise the tax payer’s after tax wealth while
simultaneously achieving the tax payer’s own tax goals. Maximising after – tax wealth is not
necessarily the same as the minimisation of tax payable, specifically maximising after tax wealth
requires one to consider both the tax and non – tax costs and benefits of alternative transactions,
whereas tax minimisation focuses solely on a single cost (i.e. taxes).

There are three parties involves in virtually every transaction – the tax payer, the other
transacting party and the government (i.e. the uninvited silent party that specifies the tax
consequences of the transaction). Effective tax planning requires an understanding of the tax
costs from the tax payers and other party’s perspectives because tax and non-tax factors also

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influence the other party’s preferences. Understanding these preferences will allow the tax payer
to identify an optimal transaction structure.

There are three main strategies for tax planning. These are:

Timing strategy

This exploits the variation across time – i.e., the real tax costs of income decrease as taxation is
deferred; the real tax savings associated with tax deductions increase as tax deductions are
accelerated. The income shifting strategy exploits the variation in taxation across activities.

Basic Timing Strategies are:

• Deferring tax income; and

• Accelerating tax deduction

Its intent is to defer taxable income recognition so as to minimise the present value of tax paid.
While accelerating tax deduction to maximise the present value of tax savings from the
deduction.

This is predicated on the principle of present value of money. Timing strategies are very
valuable. In essence, we are trying to figure out when to take income and when to take
deductions to get the most optimal experience.

We need to understand the present and future value formulas to do the calculations appropriately.

Future value - FV = PV x (1 + r)n

Example

If you investing N1,000 at 10% interest for one year, what will be the value at the end of the
year?

FV = N1,000 (1.10)1 = N1,100

Present value = PV = FV / (1+ r)n

Example

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What will receiving N1,000 in one-year worth today?

PV = N1,000 / (1.10)1 = N909

The essence of tax planning then is to calculate if we would rather pay tax today or in the future.
We do that with a timing strategy by either accelerating income or deferring income and by
accelerating deduction or deferring deductions.

Therefore,

If tax rates are constant:

• accelerate tax deduction into earlier years

• defer taxable income into later tax years

If tax rates are increasing:

• you must calculate whether to accelerate or defer tax deductions,

• you must calculate whether to accelerate or defer taxable income.

If tax rates are decreasing:

• accelerate tax deductions into earlier years.

• defer taxable income into later tax years.

The timing strategy is an important aspect of investment planning, retirement planning and
property transactions. It is also an important aspect of tax planning for everyday business
operations e.g. determining the appropriate period to recognise sales income – upon product
shipment, delivery to customers. Some common example of timing strategy includes
accelerating depreciation.

Income Shifting Strategy

Income shifting strategy exploits the difference in tax rates across tax payers by shifting income
from high – tax payers (jurisdictions) or shifting deductions from low rate tax payers to high –
rate taxpayers. This includes transactions between owners and their business such as:

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• Incorporating a business and thus shifting incomes from an individual to the company which
may result in lower current taxation of the business;
• Shifting income from a company to an owner through tax deductible expenses (e.g
compensations, interest, rent, allows the owner to avoid double taxation on corporate profits.

However, the revenue’s authority posture on related transactions may limit this strategy; and

Transaction across jurisdiction: Income earned in different jurisdiction is often taxed

differently. With a proper understanding of the differences in tax laws across jurisdictions,
taxpayers can use these differences to maximise their after-tax wealth.

Also, revenue authority’s posture on transfer pricing can limit this strategy.

Conversion Strategy

This strategy is based on the fact that:

• Tax rates can vary across different activities; ordinary income is taxed at ordinary rates;
long term capital gains are taxed at preferential rates. Some income is exempted; and
• The conversion strategy is based on the understanding that tax laws do not treat all types of
activities in the same way.

Conversion strategies involve adjusting specific activities (for example between wages and
dividends or between individual expenses and investment and business expenses).

The first step in tax planning is a thorough understanding of the various tax laws as they affect
the company’s operations or individual tax affairs. This understanding will help the company’s
tax manger to discover areas of the laws the company or the individual can explore to its
advantage.

Tax planning is a proactive way of dealing with corporate and individual tax issues so as to
reduce overall tax outlays and the timing of cash outflows for payment of taxes. It involves
arranging affairs to ensure that the maximum exemptions, deductions, concessions, allowances
and other tax reliefs or benefits permitted by law are taking advantage of.

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Tax planning also involves taking a proactive look at a corporate business activities, relevant
legislation and possible tax liabilities and then arranges the business affairs in such a way that
places much of the earnings outside the ambit of the law. That is, business in conducted in such a
way that earnings attract minimal liability or at best, no tax at all.

The OECD Glossary of Tax Terms defines tax planning as “arrangement of person’s business
and / or private affairs in order to minimise tax liability.

In arranging the corporate business affairs, consideration would be given to the timing of fixed
assets purchase and disposal, choice of accounting date and how they are likely to affect
corporate tax liabilities. Also, the impact of commencement rules in the tax legislation should be
considered before deciding on an accounting date for a new business. Planning with regards to
the time that the profit is earned and the timing of the payment of the applicable tax on such
profit could result in significant financial advantage, in the short run, to a continuing business.
So also, time of cessation should be considered as it affects the company’s tax liabilities before
the date to formally cease business permanently is decided upon.

Generally, the following matters should be considered in tax planning:

• List of approved taxes and levies;

• Important dates as they relate to tax issues:

i. Filing of Tax returns;

ii. Filing of Notice of objection;

iii. PAYE monthly remittances;

iv. PAYE Annual Returns;

v Withholding tax monthly returns and remittances;

vi VAT monthly Returns and Remittances;

vii. Monthly Pension Returns and remittances;

viii. Monthly National Housing Fund (NHF) returns and remittances;

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 ix. Yearly Industrial Training Fund Return and remittance.

• It is important to keep to these due dates to avoid penalty and interest;

• Timing of fixed assets acquisition and disposal;
• Timing of capital allowances claim and amount of claim;
• What type of lease should the company adopt – finance lease or operating lease;
• Making a specific provision for bad debts and not a general provision;
• Where to invest and what to invest in;
• Adequate and proper deduction of PAYE
• Adequate deduction of withholding taxes;
• Possibility of claiming Roll-over Relief on Capital Gain;
• What to invest in – property or stock and shares – Capital gains on stock and shares are
free of taxes;
• Consider Current Tax Incentives:
i. Pioneer companies and products;
ii. Rural Investment Allowances;
iii. Export Processing Zone tax incentives;
iv. Export Free Zone tax incentives
v. Gas Industry Incentives;
vi. Agricultural Products tax incentives, etc;
• Using increase in employees’ remuneration to reduce the company’s overall tax; and
• Investment Allowances – by replacing old plant and machinery.

6.5 Tax planning objectives

Proper tax planning can achieve the following goals:

• Lower current year’s tax;

• Defer current year’s tax to future years;
• Reduce your tax in future years;
• Maximise the tax saving from allowable deduction;
• Take advantage of available tax incentives;
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• Maximise the amount of wealth that stays in your family;
• Minimise capital gains tax;
• Avoid penalties for underpayment of estimated taxes;
• Free up cash for investment, business or personal needs by deferring your tax liability; and
• Manage you cash flow by projecting when tax payments will be required.

6.6 Tax avoidance

Tax avoidance is defined as the arrangement of a taxpayer’s financial affairs in a form that would
make him pay the least possible amount of tax. It involves using the tax shelters in the tax laws,
and avoiding tax traps in the tax laws, so as to pay less tax than he or she would otherwise pay.

The principle behind tax avoidance strategies by companies and individuals is not an issue of
morality. Although it has been established that individuals have a moral obligation to contribute
to the society of which they are a part and from which they derive benefits but it is also a fact
that the obligation to pay tax is imposed by law and that there is no obligation on any taxpayer to
pay more tax than the law requires. This principle was fully expressed in the Canadian tax law in
the case of CIR v Duke of Westminister (1936) ACI (HL), where it was concluded that a
taxpayer is entitled to arrange its affairs to minimise the amount of tax payable. This principle
has become a fundamental principle in most countries’ tax systems.

Tax can be avoided in various ways, these includes:

• Incorporating sole proprietorship or a partnership into a limited liability company;

• Ability to claim all allowances and reliefs that are available in tax laws in other to reduce
the amount of income or profit to be charge to tax;
• Acquisition of a loss-making business;
• Minimising tax liability by investing in capital asset so as to have substantial capital
allowances;
• Buying articles manufactured in Nigeria to avoid paying custom duty, and
• Avoiding the consumption of the articles that attract indirect taxes.

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A major tax avoidance strategy is to carry out a critical review of the tax laws, take note of the
loopholes in the law and then implement schemes to exploit the loopholes discovered in the tax
laws to minimise tax liability.

Tax avoidance is permissible in law as it does not always involve the contravention of any law –
it is done within the limits of the law. However, tax avoidance may become the target of
legislative or judicial limits because it is regarded as aggressive. But, it has also been established
that what constitute aggressive or unacceptable tax avoidance is elusive. The term unacceptable
tax avoidance means that some tax avoidance transactions are not successful or do not work
because they are subject to a statutory anti-avoidance rule or a judicial anti-avoidance doctrine.
In general, unacceptable tax-avoidance transactions are transactions that result in tax benefits
that are not intended by the legislature and are not within the purpose of the tax legislation.

6.7 Tax evasion

Tax evasion is a deliberate and willful practice whereby a person uses an illegal means to reduce
his tax liability or avoid paying tax entirely. It is an intentional behaviour designed to reduce a
person’s tax liability through non – disclosure or misrepresentation. Tax evasion is a serious
criminal offence that may result in prosecution and substantial penalties. The Canadian
Department of National Revenue defines tax evasion as, “the commission or omission of an act
knowingly with intent to deceive so that tax reported by the taxpayer is less than the tax payable
under the law, or a conspiracy to commit such an offence. This may be accomplished by
deliberate omission of revenue, the fraudulent claiming of expenses or allowances, and the
deliberate misrepresentation, concealment or withholding of material facts”.

Therefore, the essence for tax evasion is an intentional deceit, misrepresentation or non –
disclosure.

Tax may be evaded through different methods such as:

• Refusing to register with the relevant tax authority;

• Failure to render a return, statement and information or keep records required;
• Making incorrect returns by omitting or understating any income liable to tax;
• Overstating expenses so as to reduce taxable profit or income; and
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• Entering into artificial transactions.

However, the following forms of evasion methods have been identified by the Nigerian tax laws
and appropriate sanctions have been laid down against them, these includes:

• Making an incorrect return by omitting or understating any income;

• Failure to furnish a return, statement, or information or to keep the required records;
• Outright Refusal or neglect to pay tax;
• Omission to state income receipt from landed properties;
• Omission to state income received in or brought into Nigeria from source outside Nigeria;
• False claim of contributions to a pension scheme;
• Reduction of quantum of tax liabilities through fraudulent tax returns;
• Under declaration or dishonest declaration of income, earnings or assets; and
• Giving any incorrect information in relation to any matter or thing affecting the liability to
tax of any taxable person.

Students should note that all tax evasions are illegal and constitute a criminal offence under the
law. The provision for back duty tax audit and investigation is part of the provisions in the tax
laws to catch up with tax evaders and thus bring them to book.

Distinction between tax avoidance and tax evasion

The distinction between tax avoidance and tax evasion is that tax avoidance involves lawful
actions or transactions effected by taxpayers that, if effective for tax purposes, reduce the
taxpayer’s tax liability. While tax evasion involves using a unlawful means to reduce one’s tax
liability. The key factor in making the distinction between tax avoidance and tax evasion is that,
tax evasion involves fraud, deceit, misrepresentation or non- disclosure, whereas tax avoidance
does not. If a taxpayer fully discloses all of the material facts, it is inconceivable that the
taxpayer could be convicted of tax evasion.

6.8 Tax management

Tax management deals with the filing of various tax returns on time, compliance with the
appropriate provisions of laws and making timely payment of taxes so as to avoid payment of

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penalties and interest. It also includes compiling and preserving data and supporting documents
evidencing transactions, claims, etc. Furthermore, tax management deals with responding to
notices received from tax authorities, within the appropriate time limit.

Income tax management.com provides the following differences between tax planning and tax
management:

Tax Planning Tax Management

The objective of tax planning is to The objective of tax management is to

comply with the provision of income tax minimise the tax liability.
law and its allied rules.

Tax planning also includes tax Tax management deals with filling in time,
management. getting the accounts audited, deducting
tax at source etc.

Tax planning relates to future. Tax management relates to past, present,

future.
Past – assessment proceedings, appeals,
revisions etc.
Present – filling of returns, payment of
advance tax etc.
Future – to take corrective action

Tax planning helps in minimising tax Tax management helps in avoiding payment
liability in short – term and long term. of interest, penalty, prosecution etc.

Tax Planning is optional. Tax management is essential for every

taxpayer.

6.9 International tax planning

Objectives
The basic purpose of international tax planning is to exploit differences, gaps and asymmetries in
the relevant domestic legal systems that create opportunities to reduce, defer or eliminate the
multinational enterprise’s overall tax liability. Many of these asymmetries arise from the fact
that, historically, domestic tax rules and bilateral tax treaties have focused primarily on the
avoidance of double taxation rather than on preventing base erosion and profit shifting or
addressing circumstances where a particular item of income is not taxed anywhere.

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According to OECD’s BEPS Action Plan, international tax planning is designed to achieve one
or more of the followings:

• Reduction of both corporate tax and withholding tax in the source country;
• Reduction of tax on any intermediary entities that receive amounts from the entities in the
source country; and
• Reduction of tax on the ultimate parent.

The basic objectives of international tax planning are: “To arrange the affairs of a
multinational group of companies such that profits are earned where they are taxed at the
lowest possible rates and expenses are incurred where their deduction yields the greatest tax
relief”.

Strategy for international tax planning

The commonly used international tax planning strategy is base erosion and profit shifting
(BEPS) strategy. BEPS refers to corporate tax planning strategies used by multinational
enterprises to shift profits from higher tax jurisdictions to lower tax jurisdictions thus eroding
the tax base of the higher tax jurisdiction. This is done by exploiting the gaps and
mismatches in the tax rules. However, it has been observed that intellectual property is
usually used as tools for this strategy.

Base erosion is a tax planning strategy whereby the size of a company’s taxable profit is
reduced in a country with high tax rate. This is achieved by writing off certain expenses
against the profit so as to reduce the taxable profit.

Profit shifting is a tax planning strategy which is used by a group of companies or a

multinational enterprise whereby profit is moved from jurisdiction with high tax rate to
jurisdiction with low tax rate. The essence is to reduce the overall after-tax profit that ia
available to the group shareholders. This strategy uses intra – group payments, such as,
royalties, interest, etc., which are tax deductible.

Together, base erosion and profit shifting (BEPS) are employed by multinational enterprises
to shift profits from jurisdiction with higher tax rate to jurisdiction with lower tax rate, in
order words, taxable profit or tax base is eroded from jurisdiction with higher tax rate.
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Multinational enterprises are able to use this strategy because:

• Their international operations, with companies in different jurisdictions provide such

opportunity;
• Their large volume of capital enables them to set up companies in various jurisdictions
which can be used for that purpose; and
• They have large incomes and are able to take advantage of the services of international
tax consultants that provide appropriate advice on tax regimes in various jurisdictions.

BEPS techniques

Some of the techniques used by multinationals for base erosion and profit shifting are:

• Intellectual property: Intellectual property which includes trademarks and technology

licensing through transfer pricing. This is done through the creation of intellectual
property such as patents, trademarks, designs, etc. in jurisdictions with lower tax rate
and then charging companies in the group high royalties for the use of the intellectual
property;
• Thin capitalisation: This is done through the setting up of subsidiaries with minimal
capital and financing the operations of the subsidiaries through debt from the group
company which will in turn charge interests, such interest has different treatments in
various jurisdictions but the idea is to reduce group tax liability, if structured correctly;
and
• Hybrid mismatch arrangements: This is possible because of different tax regimes in
different jurisdictions which results in unintended effects on double non – taxation.
This is normally exploited by companies to reduce tax burden.

6.10 End of chapter questions and solutions

6.10.1 End of chapter questions

1. Itemise the components of corporate tax planning.

2. Discuss tax planning strategy and the three main tax planning strategies.
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 3. List the objectives for tax planning
4. Discuss tax avoidance and tax evasion.
5. Discuss international tax planning, its objectives and strategies.

6.10.2 Solutions to end of chapter questions

1. Corporate tax strategy includes:

a. Proper understanding of the provisions of the tax laws;
b. Analysis of, management and optimization of the effective tax rate (ETR);
c. International tax strategic, that is, choice of the method used to open offices/plants
and determine location;
d. Tax management;
e. Computation of taxable income;
f. Handling of challenges associated with tax consolidation;
g. Optimisation of financing and management of debt ratios;
h. Management of flow of dividends, interests and royalties.
i. Optimisation of tax losses/securing the deductibility of interest expenses and
acquisition costs;
j. Taking benefits of tax agreements, international double taxation;
k. Taking into consideration tax effect on acquisitions, disposal of business and or
business restructuring;
l. Management of relationship with the tax authorities for tax optimisation by avoiding
late filings, late payment of taxes, etc; and
m. Giving consideration to all tax incentives available with a view to take advantage of
these incentives as much as possible.

2. Corporate tax planning is an integral part of corporate financial planning. The objective
of corporate tax planning is to minimise corporate or personal tax liability. Tax planning
is a logical analysis of a financial situation or plan from a tax perspective, to align
financial goals with tax efficiency planning. The purpose of tax planning is to discover
how to accomplish all of the other elements of a financial plan in the most tax - efficient

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manner possible. Tax planning thus allows the other elements of a financial plan to
interact more effectively by minimising tax liability.
Tax planning is the exercise undertaken to minimise tax liability through the best use of
all available allowances, deductions, exclusions, exemptions etc., to reduce income
and/or capital gains. Tax management means, the management of finance for the
purpose of paying the minimum tax payable.
Tax planning is an integral part of a proper financial plan. It is handling tax proactively
and not reactively. Understanding the impact taxes will have on the corporate financial
well - being is essential. Taking control of your taxes and saving tax Naira is what tax
planning is all about. We must remember that taxes are the single largest recurring
expenses that individuals and corporate organisations must have throughout their life
time.
Tax planning encourages many different aspects, including the timing of both income
and purchases and other expenditures, selection of investment types of retirement plans,
as well as filling status and common deduction. However, while tax planning is an
important element in any financial plan, it is important to not let the "tax" tail wag the
financial "dog". This can ultimately be counterproductive, as virtually all courses of
financial action will have some tax consequences, and they should not be avoided solely
on this basis (Investopedia).
Tax planning strategies
In general terms, the goal of tax planning is to maximise the tax payer's after tax wealth
while simultaneously achieving the tax payer's own tax goals. Maximising after - tax
wealth is not necessarily the same as the minimisation of tax payable, specifically
maximising after tax wealth requires one to consider both the tax and non - tax costs and
benefits of alternative transactions, whereas tax minimisation focuses solely on a single
cost (i.e. taxes).
There are three parties involves in virtually every transaction - the tax payer, the other
transacting party and the government (i.e. the uninvited silent party that specifies the tax
consequences of the transaction). Effective tax planning requires an understanding of
the tax costs from the tax payers and other party's perspectives because tax and non-tax

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factors also influence the other party's preferences. Understanding these preferences
will allow the tax payer to identify an optimal transaction structure.
There are three main strategies for tax planning. These are:
Timing strategy
This exploits the variation across time - i.e., the real tax costs of income decrease as
taxation is deferred; the real tax savings associated with tax deductions increase as tax
deductions are accelerated. The income shifting strategy exploits the variation in
taxation across activities.
Basic Timing Strategies are:
• Deferring tax income; and
• Accelerating tax deduction
Its intent is to defer taxable income recognition so as to minimise the present value of tax
paid. While accelerating tax deduction to maximise the present value of tax savings from
the deduction.
This is predicated on the principle of present value of money. Timing strategies are very
valuable. In essence, we are trying to figure out when to take income and when to take
deductions to get the most optimal experience.
We need to understand the present and future value formulas to do the calculations
appropriately.
Future value - FV = PV x (1 + r)n
Example
If you investing N1,000 at 10% interest for one year, what will be the value at the end of
the year?
FV = N1,000 (1.10)1 = N1,100
Present value = PV = FV / (1+ r)n
Example
What will receiving N1,000 in one-year worth today?
PV = N1,000 / (1.10)1 = N909

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The essence of tax planning then is to calculate if we would rather pay tax today or in the
future. We do that with a timing strategy by either accelerating income or deferring
income and by accelerating deduction or deferring deductions.
Therefore,
If tax rates are constant:
• accelerate tax deduction into earlier years
• defer taxable income into later tax years
If tax rates are increasing:
• you must calculate whether to accelerate or defer tax deductions,
• you must calculate whether to accelerate or defer taxable income.
If tax rates are decreasing:
• accelerate tax deductions into earlier years.
• defer taxable income into later tax years.
The timing strategy is an important aspect of investment planning, retirement planning
and property transactions. It is also an important aspect of tax planning for everyday
business operations e.g. determining the appropriate period to recognise sales income -
upon product shipment, delivery to customers. Some common example of timing
strategy includes accelerating depreciation.
Income Shifting Strategy
Income shifting strategy exploits the difference in tax rates across tax payers by shifting
income from high - tax payers (jurisdictions) or shifting deductions from low rate tax
payers to high - rate taxpayers. This includes transactions between owners and their
business such as:
• Incorporating a business and thus shifting incomes from an individual to the
company which may result in lower current taxation of the business;
• Shifting income from a company to an owner through tax deductible expenses
(e.g compensations, interest, rent, allows the owner to avoid double taxation on
corporate profits. However, the revenue's authority posture on related transactions
may limit this strategy; and

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• Transaction across jurisdiction: Income earned in different jurisdiction is often
taxed differently. With a proper understanding of the differences in tax laws
across jurisdictions, taxpayers can use these differences to maximise their after-
tax wealth.
Also, revenue authority's posture on transfer pricing can limit this strategy.
Conversion Strategy
This strategy is based on the fact that:
Tax rates can vary across different activities; ordinary income is taxed at ordinary rates;
long term capital gains are taxed at preferential rates. Some income is exempted; and
The conversion strategy is based on the understanding that tax laws do not treat all types
of activities in the same way.
Conversion strategies involve adjusting specific activities (for example between wages
and dividends or between individual expenses and investment and business expenses).
The first step in tax planning is a thorough understanding of the various tax laws as they
affect the company's operations or individual tax affairs. This understanding will help
the company's tax manger to discover areas of the laws the company or the individual can
explore to its advantage.
Tax planning is a proactive way of dealing with corporate and individual tax issues so as
to reduce overall tax outlays and the timing of cash outflows for payment of taxes. It
involves arranging affairs to ensure that the maximum exemptions, deductions,
concessions, allowances and other tax reliefs or benefits permitted by law are taking
advantage of.

Tax planning also involves taking a proactive look at a corporate business activities,
relevant legislation and possible tax liabilities and then arranges the business affairs in
such a way that places much of the earnings outside the ambit of the law. That is,
business in conducted in such a way that earnings attract minimal liability or at best, no
tax at all.

The OECD Glossary of Tax Terms defines tax planning as "arrangement of person's
business and / or private affairs in order to minimise tax liability.

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 In arranging the corporate business affairs, consideration would be given to the timing of
fixed assets purchase and disposal, choice of accounting date and how they are likely to
affect corporate tax liabilities. Also, the impact of commencement rules in the tax
legislation should be considered before deciding on an accounting date for a new
business. Planning with regards to the time that the profit is earned and the timing of the
payment of the applicable tax on such profit could result in significant financial
advantage, in the short run, to a continuing business. So also, time of cessation should be
considered as it affects the company's tax liabilities before the date to formally cease
business permanently is decided upon.
3. Proper tax planning can achieve the following goals:
a. Lower current year's tax;
b. Defer current year's tax to future years;
c. Reduce your tax in future years;
d. Maximize the tax saving from allowable deduction;
e. Taking advantage of all available tax incentives;
f. Take advantage of available tax incentives;
g. Maximize the amount of wealth that stays in your family;
h. Minimize capital gains tax;
i. Avoid penalties for underpayment of estimated taxes;
j. Free up cash for investment, business or personal needs by deferring your tax
liability; and
k. Manage you cash flow by projecting when tax payments will be required.

4. Tax avoidance is defined as the arrangement of a taxpayer's financial affairs in a form

that would make him pay the least possible amount of tax. It involves using the tax
shelters in the tax laws, and avoiding tax traps in the tax laws, so as to pay less tax than
he or she would otherwise pay.
The principle behind tax avoidance strategies by companies and individuals is not an
issue of morality. Although it has been established that individuals have a moral
obligation to contribute to the society of which they are a part and from which they

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derive benefits but it is also a fact that the obligation to pay tax is imposed by law and
that there is no obligation on any taxpayer to pay more tax than the law requires. This
principle was fully expressed in the Canadian tax law in the case of CIR v Duke of
Westminister (1936) ACI (HL), where it was concluded that a taxpayer is entitled to
arrange its affairs to minimise the amount of tax payable. This principle has become a
foundamental principle in most countries' tax systems.
Tax can be avoided in various ways, these includes:
• Incorporating sole proprietorship or a partnership into a limited liability company;
• Ability to claim all allowances and reliefs that are available in tax laws in other to
reduce the amount of income or profit to be charge to tax;
• Acquisition of a loss-making business;
• Minimising tax liability by investing in capital asset so as to have substantial capital
allowances;
• Buying articles manufactured in Nigeria to avoid paying custom duty; and
• Avoiding the consumption of the articles that attract indirect taxes.
A major tax avoidance strategy is to carry out a critical review of the tax laws, take note
of the loopholes in the law and then implement schemes to exploit the loopholes
discovered in the tax laws to minimise tax liability.
Tax avoidance is permissible in law as it does not always involve the contravention of
any law - it is done within the limits of the law. However, tax avoidance may become
the target of legislative or judicial limits because it is regarded as aggressive. But it has
also been established that what constitute aggressive or unacceptable tax avoidance is
elusive. The term unacceptable tax avoidance means that some tax avoidance
transactions are not successful or do not work because they are subject to a statutory
anti-avoidance rule or a judicial anti-avoidance doctrine. In general, unacceptable tax-
avoidance transactions are transactions that result in tax benefits that are not intended by
the legislature and are not within the purpose of the tax legislation.
Tax evasion
Tax evasion is a deliberate and willful practice whereby a person uses an illegal means
to reduce his tax liability or avoid paying tax entirely. It is an intentional behaviour

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designed to reduce a person's tax liability through non - disclosure or misrepresentation.
Tax evasion is a serious criminal offence that may result in prosecution and substantial
penalties. The Canadian Department of National Revenue defines tax evasion as, "the
commission or omission of an act knowingly with intent to deceive so that tax reported
by the taxpayer is less than the tax payable under the law, or a conspiracy to commit
such an offence. This may be accomplished by deliberate omission of revenue, the
fraudulent claiming of expenses or allowances, and the deliberate misrepresentation,
concealment or withholding of material facts".
Therefore, the essence for tax evasion is an intentional deceit, misrepresentation or non -
disclosure.
Tax may be evaded through different methods such as:
• Refusing to register with the relevant tax authority;
• Failure to render a return, statement and information or keep records required;
• Making incorrect returns by omitting or understating any income liable to tax;
• Overstating expenses so as to reduce taxable profit or income; and
• Entering into artificial transactions.
However, the following forms of evasion methods have been identified by the Nigerian
tax laws and appropriate sanctions have been laid down against them, these includes:
• Making an incorrect return by omitting or understating any income;
• Failure to furnish a return, statement, or information or to keep the required
records;
• Outright Refusal or neglect to pay tax;
• Omission to state income receipt from landed properties;
• Omission to state income received in or brought into Nigeria from source outside
Nigeria;
• False claim of contributions to a pension scheme;
• Reduction of quantum of tax liabilities through fraudulent tax returns;
• Under declaration or dishonest declaration of income, earnings or assets; and
• Giving any incorrect information in relation to any matter or thing affecting the
liability to tax of any taxable person.
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 Students should note that all tax evasions are illegal and constitute a criminal offence
under the law. The provision for back duty tax audit and investigation is part of the
provisions in the tax laws to catch up with tax evaders and thus bring them to book.
Distinction between tax avoidance and tax evasion
The distinction between tax avoidance and tax evasion is that tax avoidance involves
lawful actions or transactions effected by taxpayers that, if effective for tax purposes,
reduce the taxpayer's tax liability. While tax evasion involves using a lawful means to
reduce one's tax liability. The key factor in making the distinction between tax
avoidance and tax evasion is that, tax evasion involves fraud, deceit, misrepresentation
or non- disclosure, whereas tax avoidance does not. If a taxpayer fully discloses all of
the material facts, it is inconceivable that the taxpayer could be convicted of tax evasion.

5. The basic purpose international tax planning is to exploit differences, gaps and
asymmetries in the relevant domestic legal systems that create opportunities to reduce,
defer or eliminate the multinational enterprise's overall tax liability. Many of these
asymmetries arise from the fact that, historically, domestic tax rules and bilateral tax
treaties have focused primarily on the avoidance of double taxation rather than on
preventing base erosion and profit shifting or addressing circumstances where a
particular item of income is not taxed anywhere.
According to OECD's BEPS Action Plan, international tax planning is designed to
achieve one or more of the followings:
• Reduction of both corporate tax and withholding tax in the source country;
• Reduction of tax on any intermediary entities that receive amounts from the entities
in the source country; and
• Reduction of tax on the ultimate parent.
The basic objectives of international tax planning are: "To arrange the affairs of a
multinational group of companies such that profits are earned where they are taxed at the
lowest possible rates and expenses are incurred where their deduction yields the greatest
tax relief".
Strategy for international tax planning

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The commonly used international tax planning strategy is base erosion and profit
shifting (BEPS) strategy. BEPS refers to corporate tax planning strategies used by
multinational enterprises to shift profits from higher tax jurisdictions to lower tax
jurisdictions thus eroding the tax base of the higher tax jurisdiction. This is done by
exploiting the gaps and mismatches in the tax rules. However, it has been observed that
intellectual property is usually used as tools for this strategy.
Base erosion is a tax planning strategy whereby the size of a company's taxable profit is
reduced in a country with high tax rate. This is achieved by writing off certain expenses
against the profit so as to reduce the taxable profit.
Profit shifting is a tax planning strategy which is used by a group of companies or a
multinational enterprise whereby profit is moved from jurisdiction with high tax rate to
jurisdiction with low tax rate. The essence is to reduce the overall after-tax profit that ia
available to the group shareholders. This strategy uses intra - group payments, such as,
royalties, interest, etc., which are tax deductible.
Together, base erosion and profit shifting (BEPS) are employed by multinational
enterprises to shift profits from jurisdiction with higher tax rate to jurisdiction with
lower tax rate, in order words, taxable profit or tax base is eroded from jurisdiction with
higher tax rate.
Multinational enterprises are able to use this strategy because:
• Their international operations, with companies in different jurisdictions provide
such opportunity;
• Their large volume of capital enables them to set up companies in various
jurisdictions which can be used for that purpose; and
• They have large incomes and are able to take advantage of the services of
international tax consultants that provide appropriate advice on tax regimes in
various jurisdictions.

BEPS techniques
Some of the techniques used by multinationals for base erosion and profit shifting are:

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• Intellectual property: Intellectual property which includes trademarks and
technology licensing through transfer pricing. This is done through the creation of
intellectual property such as patents, trademarks, designs, etc. in jurisdictions with
lower tax rate and then charging companies in the group high royalties for the use
of the intellectual property;
• Thin capitalization: This is done through the setting up of subsidiaries with
minimal capital and financing the operations of the subsidiaries through debt from
the group company which will in turn charge interests, such interest has different
treatments in various jurisdictions but the idea is to reduce group tax liability, if
structured correctly; and
• Hybrid mismatch arrangements: This is possible because of different tax regimes
in different jurisdictions which results in unintended effects on double non -
taxation. This is normally exploited by companies to reduce tax burden.

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 Professional Taxation II

CHAPTER
Financial/Tax analysis

7
Tax strategies for new business

Contents

7.1 Introduction
7.2 Forms of business enterprise
7.2.1 Sole proprietorship
7.2.2 Partnership
7.2.3 Limited liability company

Purpose

At the end of this chapter, readers should be able to:

• Describe the types of business enterprise;

• Give advantages of each form of business enterprise; and

• Explain the disadvantages of each form of business enterprise.

7.1 Introduction

A business organisation is a legally recognised enterprise established to provide goods or

services to consumers for the purpose of gain or profit.

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 One of the first decisions that you will have to make as a business owner is how the business
should be structured. All businesses must adopt some legal configuration that defines the
rights and liabilities of participants in the business’s ownership, control, personal liability,
life span, and financial structure. This decision will have long-term implications, so you
have to consult with appropriate professionals to help you select the form of ownership that
is right for you.

There are various forms of business entity and these vary from a sole proprietorship to a
public limited liability company. Each of these business entities has tax implications.
Therefore, when a businessman wants to start a business, he must first decide whether the
business will be sole proprietorship, partnership, private limited liability company or a public
limited liability company. However, the type of business choice will depend on the nature of
business, the goals of the business and other factors, including taxation. Therefore, in making
a choice, you will want to take into account the following:

• Your vision regarding the size and nature of your business;

• The level of control you wish to have;
• The level of “structure” you are willing to deal with;
• The business’s vulnerability to lawsuits;
• Tax implications of the different organisational structures;
• Expected profit (or loss) of the business;
• Whether or not you need to re-invest earnings into the business; and
• Your need for access to cash out of the business for yourself.

7.2 Forms of business enterprise

The various forms of business enterprise are briefly discussed as follows.

7.2.1 Sole Proprietorship

This is commonly referred to as a sole trader and or one-man business. It is owned and
managed by one man who provides all the capital. He alone bears all the risks in running the
business and enjoys all the profits from the business.

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The sole proprietor has unlimited liability and he is personally responsible for all the debts of
the business. He may be required to sell his personal properties to defray the debt of the
business. This is because there is no legal distinction between the sole trader and his
business. This is why the tax authority personally tax the sole proprietor on the profit made
from his business.

Advantages of the Sole Proprietorship

The advantages of sole proprietorship as a form of business enterprise are:

• The capital needed to start up the business is small. This is why it is easy to form and the
most common form of business;
• The sole proprietorship requires fewer regulations to operate compared to the other forms
of business organisations;
• The sole proprietor has total control over his business and can make timely decisions
without consulting anyone;
• The sole proprietorship does not pay corporate taxes. The sole proprietor does not pay
personal tax separate from the corporate tax of the business. He pays personal tax on
profits made. Therefore, the sole proprietorship is not concerned with double taxation as
some other forms of business;
• All the profits and benefits of the business belong to the sole proprietor;
• The small size nature of the organisation allows the proprietor have a direct and cordial
working relationship with his employees. He can easily manage them effectively and
efficiently for the success of the business;
• The sole proprietorship is a very flexible form of business. This means that the sole
proprietor can easily make a decision or change a decision earlier made at any given time
to be able to adjust to changes in the business environment; and
• Unlike some other forms of business organisations, the sole proprietorship does not
submit its annual accounts to the registrar of companies nor publish it for all to see as
required by the law.

Disadvantages of the sole proprietorship

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 However, sole proprietorship has the following disadvantages:

• The sole proprietor has unlimited liability;

• To run the business successfully, the sole proprietor continues to raise capital to meet the
needs of the business, to pay its debts and sort out any losses, as well as compete with
others in the business environment. This continuous raising of capital is usually difficult
for the sole proprietor to bear alone;
• Limited expansion - Because the sole proprietor is faced with difficulties in raising
capital, it might be difficult to expand the business and even increase profits. For this
reason, sole proprietorships tend to be small and are primarily service and retail
businesses. Even when a sole proprietorship business is successful and tends to expand,
the risks borne by the sole proprietor increases. To minimise those risks, the proprietor
has the option of forming a limited liability company;
• The sole proprietor makes business decisions without consulting anyone. This means that
the advantages of exchanging ideas with others for making better decisions and having
better solutions is lacking;
• The death or incapacity of the sole proprietor may put an end to the business. Even where
the business is taken over by someone else, it may end if the person does not have the
appropriate skills and cannot manage the business effectively;
• The sole proprietor is not separate from the business. This means that he is sued over
issues that concern the business. The business cannot sue and be sued in its name; and
• The sole proprietor bears all the business risk alone.

7.2.2 Partnership

A partnership business is usually owned by a minimum of two to a maximum of twenty

people, who operate the business for the purpose of making profit. A partnership business
can be entered into by individuals or firms (known as corporate members). The partnership
business is governed by an agreement between the partners or by the Partnership Act, 1890.
The partners usually share profits equally, except otherwise indicated in the partnership
agreement. Each partner pays personal tax based on his share of the profit plus other

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 takings like interest on capital, salaries, etc. This means that the business does not pay tax
on its name.

Advantages of partnership

The following are the advantages of partnership business:

• Having a membership above two partners creates the advantage of having a wider pool
of knowledge, skills, resources and business contacts;
• Sufficient resources – The current partners and the newly admitted partners can pool
together more capital for the business;
• Risks and liabilities – Unlike the sole proprietor who bears all the risks and liabilities
alone, in partnership more partners bear the risks and liabilities. This is especially the
case with the general partners who have joint and several liability;
• Sharing of responsibilities – Unlike the sole proprietor who is singly responsible for the
operations and management of the business, in the partnership responsibilities are shared
between or amongst the partners;
• Expansion of the business is made easier – The partnership has more sources of capital
from which the expansion of the business is made easier;
• Easy setup of a partnership business – The partnership is easy to form; and
• Increased productivity and efficiency – With a greater pool of skills, business contacts,
abilities and knowledge, production is increased and resources are utilised efficiently.
Note that the advantages of division of labour/specialisation apply in the partnership,
especially as more partners get admitted.

Disadvantages of a partnership

Partnership business however, having the following demerits:

• Delay in decision making – Timely decisions may not be made at all times as partners will
need to come together to think through issues for the best solutions;

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 • In the sole proprietorship, the business owner gets and enjoys the entire profit, but in the
partnership, the case is the reverse. Partners share in the profits based on the agreements
made in the partnership agreement;
• Unlimited liability – The liabilities of partners are unlimited, except for limited partners.
[Note that a newly admitted partner cannot be held liable for the debts incurred before his
admission into the organisation];
• Life span of the business – The death, disability, bankruptcy, insanity or withdrawal of a
partner may end the business. Also, major disagreements between or among partners could
end the business if not well handled; and
• The business deal entered into by a partner with a third person legally binds every other
partner – Unprofitable or an illegal business deal by a partner legally binds all partners. For
this reason, it is expected that partners have trust for each other. Where there is no trust, the
working relationship between or among partners can be negatively affected, and if not well
managed can affect the life of the business.

7.2.3 Limited liability companies

A company is an artificial person which is recognised by law as a separate legal entity. They
make profit by producing or selling goods and services. It can act through its organs like the
board of directors and shareholders. A company is an artificial entity recognised in law as
having a personality in sense that it may be a party to legal relationships.

This type of companies is owned by shareholders that have contributed funds for the
business in form of shareholdings. Directors are appointed to run the company on behalf of
the shareholders who receive a share of the profits as dividends.

Every company must register with the Corporate Affairs Commission (CAC) and must
have a registered address and a company secretary. There are two types of limited liability
companies. These are:

• Private limited liability companies which are not allowed to sell their shares to the public
through the stock exchange market; and

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• Public limited liability companies which have their shares traded on the stock exchange
market and can raise fund from the capital market.

Private limited company (Ltd)

A private limited company is a legal entity in its own right, separate from those who own it,
the shareholders. The limited liability and simplicity of running the private limited
company makes it the most common of registered business in Nigeria. As a shareholder of
a private limited company, the shareholders' personal possessions remain separate (unless
they are secured against the business for borrowing), and the shareholders' risk is reduced
to only the money they have invested in the company and any shares the shareholder holds
which has not been paid for.

The private limited liability company have very few restrictions which makes it simple but
yet flexible for many businesses concern in Nigeria. The very minimum requirements of a
private limited company are:

The company must have a registered office in Nigeria;

The company name must not be exactly identical to any other company name currently
held in the registry of the Corporate Affairs Commission;

At least twenty five percent of the authorised shares must be allotted at incorporation;

At least two people above the age of 18 must subscribe to the memorandum and articles of
association;

The total number of members in a private limited company must not exceed 50, not
including those who are bona fide in the employment of the company; and

The authorised share capital shall not be less than ?10,000.

Features of private limited liability company in Nigeria

A private company limited by shares is a legally separate business entity. It has an

authorised shareholding which defines the shareholders' liability. This means that the
directors and shareholders of the company have limited liability in the Company.

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 Most often times many that want to register their business with the Corporate Affairs
Commission (CAC) are confused on the option to register between a business name and
private limited liability company. The difference between a business name and a private
limited liability company is that a business name is registered, owned and operated by an
individual(s) only. There is no separate legal entity like the private company and such an
individual is legally liable for all losses accrued to the business.

Features of a private limited company

• A private limited liability company is one incorporated with the CAC as one. It is a
company limited by share, its shares are not offered to the general public.
• To incorporate a company limited by shares in Nigeria, the minimum number of 2
members are required and a maximum of 50 members.
• A private limited liability company must have a minimum of 2 directors.
• The liability of each member or shareholder is limited to the shares he has agreed to
subscribe.
• A private company enjoys perpetual succession. The company exists in the eyes of the
law in the event of death and insolvency except there is a decision to wind up the
company.
• A private company restricts the right of its members to transfer shares and does not send
the invitation to the public for subscription of its shares.

Advantages of private limited company

There are several advantages of operating a private company limited by shares from a
business name in Nigeria, a few of which are stated below.

• A private limited company is a separate legal entity and it is a separate person in the eyes
of the law.

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• There are laws that govern the internal affairs and contain the objectives of a private
company limited by shares, which is enshrined in the articles of association of the
company. Unlike the business name which has no laws guiding its activities, all decisions
are taken the by proprietor(s) of the business.
• A private company is a legal entity that can sue and be sued in its name. This means that
the company is held separately for any wrongdoing. Any legal action is filed against the
company and not its directors.
• A private company uses the word Limited (Ltd) after the name of the company, which is
mandatory for all private companies to use.
• A private company has the advantage of giving the opportunity to an investor who does
not wish to be actively involved in the running of the business to invest capital into the
business.
• Unlike a business name whose powers and functions are performed by an individual, a
private company limited by shares has checks and balances. Hence, the control of a
company is in the hands of the board of directors or by shareholders in their shareholding
capacity.
• Another great advantage is that for a business name, upon the demise of the sole
proprietor or proprietors, the business dies and ceases to exist. But for a private company
limited by shares, the company enjoys perpetuity and can outlive the members upon their
death.

In conclusion, a private company limited by shares must be incorporated with the CAC in
accordance with the Companies and Allied Matters Act, LFN 2004. If any private limited
company deviates from any of the above-mentioned features, it ceases to be a private
limited liability company.

Public limited company

A public limited company differs from the private version in that it is able to sell its shares
to the public and may be quoted on the stock exchange. A public company must have at
least ₦500,000 authorised share capital and the subscribers must take up at least twenty
five percent of the authorised share capital. The cost of running a public limited company is
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 reasonably higher than that of a private limited liability company. It is therefore better
suited for large organisations. The public limited company has similar advantages with the
private limited company and added to these advantages are:

• Shares can be quoted on the stock exchange; and

• Shares are easily transferable.

In Nigeria majority of limited liability companies are private limited companies and the
reason for such is that most companies cannot afford being public because their financial
statements must be published if they are quoted on the stock exchange.

The table below shows comparisons of the various forms of business entity in relation to
tax issues.

Pros Cons

Sole Proprietorship Easy to set up No personal limited liability

protection

No double taxation. Cannot raise fund from the capital market.

Income reported on personal

income tax return.

Tax rate is low or since it is

assessed on personal income
basis with maximum rate of 24%.

Partnership No double taxation No personal limited protection

(unless a limited partner in a limited
partnership).
All income is taxed
proportionately to each of the
partners who report it on their
personal tax returns.

Tax rate as in sole proprietorship.

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Limited Liability Company
(Private and Public) Personal limited liability of Have a better access to fund
from
members. money market.

Double taxation since profit is Can raise capital from the

capital
taxed at company level and
dividends to shareholder is also
subject to WHT at 10%.
market, if it is a public
limited
liability company.

7.3 End of chapter questions and solutions

7.3.1 End of chapter questions
1. Discuss sole proprietorship as a form of business enterprise, giving its advantages and
disadvantages,
2. Discuss partnership as a form of business enterprise, giving its advantages and
disadvantages.
3. Discuss limited liability company as a form of business enterprise, giving its advantages
and disadvantages.
4. Two or more people can join together to start a business organisation in form of private
limited liability company. Discuss the advantages and disadvantages of this form of
business organisation.
5. Discuss the tax implication of each form of the three types of business enterprise.

7.3.2 Solutions to end of chapter questions

1. Sole Proprietorship
This is commonly referred to as a sole trader and or one-man business. It is owned and
managed by one man who provides all the capital. He alone bears all the risks in running
the business and enjoys all the profits from the business.

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The sole proprietor has unlimited liability and he is personally responsible for all the
debts of the business. He may be required to sell his personal properties to defray the
debt of the business. This is because there is no legal distinction between the sole trader
and his business. This is why the tax authority personally tax the sole proprietor on the
profit made from his business.
Advantages of the Sole Proprietorship
The advantages of sole proprietorship as a form of business enterprise are:
a. The capital needed to start up the business is small. This is why it is easy to form
and the most common form of business;
b. The sole proprietorship requires fewer regulations to operate compared to the other
forms of business organisations;
c. The sole proprietor has total control over his business and can make timely
decisions without consulting anyone;
d. The sole proprietorship does not pay corporate taxes. The sole proprietor does not
pay personal tax separate from the corporate tax of the business. He pays personal
tax on profits made. Therefore, the sole proprietorship is not concerned with double
taxation as some other forms of business;
e. All the profits and benefits of the business belong to the sole proprietor;
f. The small size nature of the organisation allows the proprietor have a direct and
cordial working relationship with his employees. He can easily manage them
effectively and efficiently for the success of the business;
g. The sole proprietorship is a very flexible form of business. This means that the sole
proprietor can easily make a decision or change a decision earlier made at any given
time to be able to adjust to changes in the business environment; and
h. Unlike some other forms of business organisations, the sole proprietorship does not
submit its annual accounts to the registrar of companies nor publish it for all to see
as required by the law.
Disadvantages of the sole proprietorship
However, sole proprietorship has the following disadvantages:
a. The sole proprietor has unlimited liability;

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 b. To run the business successfully, the sole proprietor continues to raise capital to
meet the needs of the business, to pay its debts and sort out any losses, as well as
compete with others in the business environment. This continuous raising of capital
is usually difficult for the sole proprietor to bear alone;
c. Limited expansion - Because the sole proprietor is faced with difficulties in raising
capital, it might be difficult to expand the business and even increase profits. For
this reason, sole proprietorships tend to be small and are primarily service and retail
businesses. Even when a sole proprietorship business is successful and tends to
expand, the risks borne by the sole proprietor increases. To minimise those risks,
the proprietor has the option of forming a limited liability company;
d. The sole proprietor makes business decisions without consulting anyone. This
means that the advantages of exchanging ideas with others for making better
decisions and having better solutions is lacking;
e. The death or incapacity of the sole proprietor may put an end to the business. Even
where the business is taken over by someone else, it may end if the person does not
have the appropriate skills and cannot manage the business effectively;
f. The sole proprietor is not separate from the business. This means that he is sued
over issues that concern the business. The business cannot sue and be sued in its
name; and
g. The sole proprietor bears all the business risk alone.
2. A partnership business is usually owned by a minimum of two to a maximum of twenty
people, who operate the business for the purpose of making profit. A partnership
business can be entered into by individuals or firms (known as corporate members). The
partnership business is governed by an agreement between the partners or by the
Partnership Act, 1890. The partners usually share profits equally, except otherwise
indicated in the partnership agreement. Each partner pays personal tax based on his share
of the profit plus other takings like interest on capital, salaries, etc. This means that the
business does not pay tax on its name.
Advantages of partnership
The following are the advantages of partnership business:

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a. Having a membership above two partners creates the advantage of having a wider
pool of knowledge, skills, resources and business contacts;
b. Sufficient resources - The current partners and the newly admitted partners can pool
together more capital for the business;
c. Risks and liabilities - Unlike the sole proprietor who bears all the risks and
liabilities alone, in partnership more partners bear the risks and liabilities. This is
especially the case with the general partners who have joint and several liability;
d. Sharing of responsibilities - Unlike the sole proprietor who is singly responsible for
the operations and management of the business, in the partnership responsibilities
are shared between or amongst the partners;
e. Expansion of the business is made easier - The partnership has more sources of
capital from which the expansion of the business is made easier;
f. Easy setup of a partnership business - The partnership is easy to form; and
g. Increased productivity and efficiency - With a greater pool of skills, business
contacts, abilities and knowledge, production is increased and resources are utilised
efficiently. Note that the advantages of division of labour/specialisation apply in the
partnership, especially as more partners get admitted.
Disadvantages of a partnership
Partnership business however, having the following demerits:
a. Delay in decision making - Timely decisions may not be made at all times as
partners will need to come together to think through issues for the best solutions;
b. In the sole proprietorship, the business owner gets and enjoys the entire profit, but
in the partnership, the case is the reverse. Partners share in the profits based on the
agreements made in the partnership agreement;
c. Unlimited liability - The liabilities of partners are unlimited, except for limited
partners. [Note that a newly admitted partner cannot be held liable for the debts
incurred before his admission into the organisation];
d. Life span of the business - The death, disability, bankruptcy, insanity or withdrawal
of a partner may end the business. Also, major disagreements between or among
partners could end the business if not well handled; and

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 e. The business deal entered into by a partner with a third person legally binds every
other partner - Unprofitable or an illegal business deal by a partner legally binds all
partners. For this reason, it is expected that partners have trust for each other.
Where there is no trust, the working relationship between or among partners can be
negatively affected, and if not well managed can affect the life of the business.
3. Limited liability companies
This type of companies is owned by shareholders that have contributed funds for the
business in form of shareholdings. Directors are appointed to run the company on behalf
of the shareholders who receive a share of the profits as dividends.
Every company must register with the Corporate Affairs Commission (CAC) and must
have a registered address and a company secretary. There are two types of limited
liability companies. These are:
• Private limited liability companies which are not allowed to sell their shares to the
public through the stock exchange market; and
• Public limited liability companies which have their shares traded on the stock
exchange market and can raise fund from the capital market.
Advantages of limited liability companies
The advantages of incorporated companies are:
a. Shareholders have limited liability for the company's debts or judgments against the
company;
b. Generally, shareholders can only be held accountable for their investment in stock
of the company. (Note however, that officers can be held personally liable for their
actions, such as the failure to withhold and pay income taxes;
c. Companies can raise additional funds through the sale of shares; and
d. A Company may deduct the cost of benefits it provides to officers and employees,
before arriving at its taxable profit.
Disadvantages of limited liability companies
The disadvantages of limited liability companies include:
a. The process of incorporation requires more time and money than other forms of
organization;

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 b. Companies are monitored by federal, state and some local agencies, and as a result
may have more paperwork to comply with regulations; and
c. Incorporating may result in higher overall taxes. Dividends paid to shareholders
are not deductible from business income, thus this income can be taxed twice.

4. A private limited company is a legal entity in its own right, separate from those who own
it, the shareholders. The limited liability and the simplicity of running the private limited
company makes it the most common registered business in Nigeria. As a shareholder of a
private limited company, the shareholder’s personal possessions remain separate (unless
they are secured against the business for borrowing), and the shareholder’s risk is reduced
to only the money they have invested in the company and any shares the shareholder holds
which has not be paid for.

The private limited liability company have very few restrictions which makes it simple but
yet flexible for many business concerns in Nigeria. The very minimum requirements of a
private limited company are:

a. The company must have a registered office in Nigeria;

b. The company’s name must not be exactly identical to any other company name
currently held in the registry of the Corporate Affairs Commission;
c. At least twenty five percent of the authorised shares must be allotted at
incorporation;
d. At least two people above the age of 18 must subscribe to the memorandum and
articles of association;
e. The total number of members in a private limited company must not exceed 50,
not including those who are bona fide employee of the company; and
f. The authorised share capital shall not be less than ₦10,000

Advantages of private limited company

There are several advantages of operating a private company limited instead of a business
name in Nigeria. These are stated below.

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a. A private limited company is a separate legal entity and it is a separate person in the
eyes of the law.
b. There are laws that govern the internal affairs and contain the objectives of a private
company limited by shares, which is enshrined in the articles of association of the
company. Unlike the business name which has no laws guiding its activities, all
decisions are taken the by proprietor(s) of the business.
c. A private company is a legal entity that can sue and be sued in its name. This means
that the company is held separately responsible for any wrongdoing. Any legal
action is filed against the company and not its directors.
d. A private company uses the word Limited (Ltd) after the name of the company,
which is mandatory for all private companies to use.
e. A private company has the advantage of giving the opportunity to an investor who
does not wish to be actively involved in the running of the business to invest capital
into the business.
f. Unlike a business name whose powers and functions are performed by an individual,
a private company limited by shares has checks and balances. Hence, the control of
a company is in the hands of the board of directors or by shareholders in their
shareholding capacity.
g. Another great advantage is that for a business name, upon the demise of the sole
proprietor or proprietors, the business dies and ceases to exist. But for a private
company limited by shares, the company enjoys perpetuity and can outlive the
members upon their death.

Disadvantages

The major disadvantages of a private limited liability company are:

a. Shares cannot be quoted on the stock exchange; and

b. Shares are not easily transferable.

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 In conclusion, a private company limited by shares must be incorporated with the CAC in
accordance with the Companies and Allied Matters Act LFN 2004. If any private limited
company deviates from any of the above-mentioned features, it ceases to be a private limited
liability company.

5.The table below shows comparisons of the various forms of business entity in relation to tax
issues.

Pros Cons

Sole Proprietorship Easy to set up No personal limited liability

protection

No double taxation. Cannot raise fund from the capital

market.

Income reported on personal income

tax return.

Tax rate is low or since it is

assessed on personal income
basis with maximum rate of 24%.

Partnership No double taxation No personal limited protection

(unless a limited partner in a limited
partnership).
All income is taxed
proportionately to each of the
partners who report it on their
187
 personal tax returns.

Tax rate as in sole proprietorship.

Limited Liability
Company (Private
and Public) Personal limited liability of Have a better access to fund from
members. money market.

Double taxation since profit is Can raise capital from the capital
taxed at company level and market, if it is a public limited
dividends to shareholder is also liability company.
subject to WHT at 10%.

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 Professional Taxation II
Financial/Tax analysis

Chapter
8
Taxation and business operating strategies

Contents

8.1 Profit measurement and reporting

8.2 Deferred tax

8.3 Revaluations of non-current assets

8.4 Tax incentive provisions

8.5 End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

• Explaining differences in treatment of some items of the financial statement by the tax

authority;

• Explain and calculate deferred tax arising from timing differences;

• Discuss tax incentive provisions under the Nigerian tax laws.

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8.1 Profit measurement and reporting

Accounting profit is calculated based on revenues and related costs of doing business. There are
several components that go into calculating accounting profit. Gross profit is the difference
between revenue and cost of sale, or cost of producing the goods. Companies subtract all other
expenses from gross profit to arrive at accounting profit before tax expenses.

Operating expenses include rent, utilities, interest, depreciation, amortization, salaries and other
day –to – day costs of running the business. The accrual method and the matching principle is
followed in reporting accounting profit. This principle ensures that the income generated by an
output and the expenses incurred for that output are recognized in the same period whether they
were paid for or not during the period.

Each company is allowed under the law to select the date for its financial reporting, i.e. its
accounting period which may differ from the Government fiscal year. Corporate financial
reporting is required to follow accounting standards that have been set by independent
accounting standard body. The purpose of these standards is to ensure uniformity of companies’
financial statements and accounting methods.

However, tax rules are contained in tax laws as promulgated by the country’s legislature and are
mostly different from requirements of accounting standards. Therefore, it is possible for the
financial report of a company to differ from the tax returns submitted to tax authority because of
the different accounting methods.

The tax law contains provisions on allowable and disallowable expenses for tax purpose.
Whereas, as long as these expenses are incurred for the purpose of generating the income being
reported, they are taking into consideration before arriving at the accounting profit.

The gap or difference between book and tax income generally results from three categories of
differences:

• temporary differences;
190
• permanent differences; and
• loss carry forwards / carry backs.

Temporary differences are defined by the accounting standard as being differences between the
carrying amount of an asset (or liability) within the statement of Financial Position and its tax
base, i.e., the amount at which the asset (or liability) is valued for tax purposes by the relevant
tax authority.

Permanent differences occur as a result of differences between income as reported in the

financial statement and income as reported based on tax law, as a result of some expenses that
are disallowed for tax purposes but included in the determination of income in the financial
statement. Also, there are some expenses and or income reported on the tax return which are
never reported on the income statement.

8.2 Deferred tax

A deferred tax liability is defined as being the amount of income tax payable in future periods in
respect of taxable temporary differences. Simply put, a deferred tax is tax that is payable in the
future. Taxable temporary differences are those on which tax will be charged in the future when
the asset (or liability) is recovered (or settled).

The most common course of temporary differences which results in deferred tax are:

• Depreciation of non-current assets; and

• Revaluation of non-current assets.

Within the financial statements, non-current assets with a limited economic life are subject to
depreciation. However, within tax computations, non-current assets are subject to capital
allowances (also known as tax depreciation) at rates set within the relevant tax law. Where at the
year-end the cumulative depreciation charged and the cumulative capital allowances claimed are
different, the carrying value of the asset (cost less accumulated depreciation) will then be
different to its tax base (cost less accumulated capital allowances) and thus a taxable temporary
difference arises.

Illustration
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A non-current asset costing N200,000 was acquired by a company at the start of year 1. It is
being depreciated on straight line basis over four years resulting in annual depreciation charges
of N50,000. The capital allowances granted on this asset over the four years are:

Yr. 1 125,000

Yr. 2 25,000

Yr. 3 25,000

Yr. 4 25,000

200,000

Solution

As stated above, deferred tax liabilities arise on taxable temporary differences, i.e those
temporary differences that result in tax being payable in the future as the temporary difference
reverses. So, how does the above illustration result in tax being payable in the future?

Companies pay income tax on their taxable profits. When determining taxable profits, the tax
authority start by taking the profit before tax (accounting profits) of a company from their
financial statements and then make various adjustments – for example, depreciation is
considered a disallowable expense for taxation purposes but instead tax relief on capital
expenditure is granted in the form of capital allowances. Therefore, taxable profits are arrived at
by adding back depreciation and deducting capital allowances from the accounting profits,
companies are then charged tax at the appropriate tax rate on these taxable profits.

The carrying value, the tax base of the asset and therefore the temporary difference at the end of
each year are:

Yr Carrying Value Tax base (cost accumulated

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 (cost accumulated depreciation) capital allowances)
Diff
N N

1 150,000 75,000
75,000

2 100,000 50,000
50,000

3 50,000 25,000
25,000

4 Nil Nil
Nil

In the above illustration, when the capital allowances are greater than the depreciation expense in
year 1 to 2, the company has received tax relief early. This is good for cash flow in that it delays
(i.e. defers) the payment of tax. However, the difference is only a temporary difference and so
the tax will have to be paid in the future, in year 4, when the capital allowance for the year are
less than the depreciation charged, the company is being charged additional tax and the
temporary difference is reversing. Hence the temporary differences can be said to be taxable
temporary differences.

Candidates should notice that overall, the accumulated depreciation and accumulated capital
allowances both equal N200,000 – the cost of the asset – so over the four – year period, there is
no difference between the taxable profits and the profits per the financial statements.

At the end of year 1, the company has a temporary difference of N75,000, which will result in
tax being payable in the future (in year 3 and 4). In accordance with the prudence concept, a
liability is therefore recorded equal to the expected tax payable.

Assuming that the tax rate applicable is 30%, the deferred tax liability that will be recognized at
the end of year 1 is 30% X N75,000 = N22,500. This will be recorded by crediting (increasing) a

193
deferred tax liability in the statement of financial position and debiting (increasing) the tax
expenses in the statement of profit or loss.

By the end of year 2, the company has a taxable temporary difference of N50,000. The liability
therefore, is now 30% X N50,000 = N15,000. The deferred tax liability now needs reducing
from N22,500 to N15,000 and so is debited (a decrease) by N7,500. Consequently, there is now
a credit (a decrease) to the tax expense of N7,500.

At the end of year 3, the company’s taxable differences have decreased to N25,000. Therefore,
the deferred tax liability needs to be reduced from N50,000 to N25,000 X 30%, i.eN7,500. So,
the deferred tax liability is debited (a decrease) by N7,500 and the tax expenses is credited (a
decrease) by N7,500.

At the end of year 4, there are no taxable temporary differences since now the carrying value of
the asset is equal to its tax base. Therefore, the opening liability of N22,500 has been completely
removed at the end of year 4. This is summarised as follows:

Year 1 2 3 4

N N N N

Opening deferred tax liability 0 22,500 15,000 7,500

Increase / (Decrease) in the year 22,500 (7,500) (7,500) (7,500)

Closing deferred tax liability 22,500 15,000 7,500 0

The closing figures are reported in the statement of financial position as part of the deferred tax
liability.

8.3 Revaluations of non-current assets

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Revaluations of non-current assets (NCA) are a further example of taxable temporary difference.
When an NCA is revalued to its current value within the financial statements, the revaluation
surplus is recorded in equity (in a revaluation reserve) and reported as other comprehensive
income. While the carrying value of the asset has increased, the tax base of the asset remains the
same and this give rise to a temporary difference.

Tax will become payable on the surplus when the asset is sold and so the temporary difference is
taxable. Since the revaluation surplus has been recognised within equity, to comply with
matching concept, the tax charge on the surplus is also charged to equity.

Illustration

Suppose that the asset in our previous illustration is revalued to N250,000 at the end of year 2.
The detail is shown below:

Carrying Value Tax base (cost less

(cost less accumulated depreciation) accumulated capital
allowances)
Yr. 2 N N Diff

Opening balance 150,000 75,000 75,000

Depreciation charged /

Capital allowance (50,000) (25,000)

(25,000)

Revaluation 150,000 0
150,000

Closing balance 250,000 50,000 200,000

The carrying value is now N250,000 while the tax base remains N50,000. There is, therefore, a
temporary difference of N200,000 of which N150,000 relates to the revaluation surplus. This
gives rise to a deferred tax liability N200,000 X 30% = N60,000 at the year- end which will be
195
reported in the statement of financial position. The liability was N22,500 at the beginning of the
year (previous illustration) and has now increased by N37,500. The increase in relation to the
revaluation surplus of N150,000 X 30% = N45,000 will be charged to the revaluation reserve
and reported within other comprehensive income. The difference of N7,500 will be treated
under tax expenses as deferred tax now reversed.

The double entry will be as follows:

Dr. Revaluation reserve in equity N45,000

Cr. Tax expense N7,500

Cr Deferred tax liability in SFP N37,500

8.4 Tax incentive provisions

Tax incentives are special provision in the tax laws which aim at:

• Attracting, retaining or increasing investment in a particular sector of the economy;

• Stimulating growth in specific areas of the economy; and
• Assisting companies or individuals carrying on specific activities;

The underlying basis for tax incentives is to ensure the overall growth of the Nigerian economy
and an even development in all sectors of the economy. The Nigerian Government policy is to
ensure that:

• Incentives are sector based and not granted arbitrarily;

• Benefits to the Nigerian economy exceeds the cost of taxes foregone; and
• Incentives are reviewed regularly to confirm if they are serving the expected purposes,

Some of the various tax incentives available to companies in Nigeria are:

Pioneer Companies: Tax holiday between 3 and 5 years, is granted to companies regarded as
having Pioneer Status. A pioneer company is a company that is engaged in manufacturing,
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processing, mining, servicing and agricultural industries whose products have been declared
pioneer products on satisfying certain conditions as determined by Industrial Development
Coordinating Committee (IDCC) of the Government under the Industrial Development (Income
Tax Relief) Act Cap 179 LFN 1990. The pioneer Tax holiday is for an initial period of three
years, subject to further extension of two years or five years (ones and for all without further
extension);

Export Processing Free Zone Exempt Profit: 100% tax exemption for profit obtain from
export-oriented companies established within an export free zone for 3 consecutive assessment
years;

Locally Manufactured Part: 15% investment tax credit is allowed for a company which
produce locally manufactured part, machinery or equipment;

Spare Part Fabrication: For a company engaged wholly in the fabrication of spare part tools
and equipment for local consumption and export; 25% investment tax credit is allowed on
qualifying capital expenditure. S. 28(1) of CITA (Companies Income Tax Act);

Investment Tax Relief: Relief is granted for 3years to companies located at least 20km away
from essential infrastructure such as electricity water, tarred roads an telephone services; when
expenditures are incurred on such infrastructures;

Investment allowance: 10% tax relief for companies in the year of purchase of plant and
machinery used for agricultural production and manufacturing by agricultural manufacturing
companies. This is in addition to the normal initial and normal allowances;

Rural Investment Allowance: Granted to companies established in rural areas lacking

infrastructural facilities. The same rates are applicable as investment Tax Relief as follows:

• No facilities at all 100%;

• No electricity at all 50%;
• No water at all 30%;
• No tarred road at all 15%; and
• No telephone 5%.

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Hotels Income Exempt from Tax: 25% of income in convertible currencies derived from
tourist provided the income is put in reserved fund to be utilised within 5 years for building
expansion of new hotels, conference centres and new facilities for tourism development;

Replacement of Obsolete Plant: 15% investment tax credit is allowed for a company which has
incurred on expenditure for the replacement of all obsolete plant and machinery;

Tax free Investment Relief is granted on the following interest charges: Full tax exemption
on interest on foreign currency deposit account of a non-resident company opened in or after 1,
January, 1990.Full exemption on interest on foreign currency domiciliary account accruing on or
after 01/10/1990

Granted tax Relief on interest on foreign loans or interest payable on any loan granted a bank for
manufacture for export

Interest on loan granted by bank on or before 1 January 1997 to a company engaged in

agricultural trade or business, or for the fabrication of a local machinery by a company
established under the Family Economic Advancement Programme. The incentives are based on
the conditions that the moratorium is not less than 18 months and the interest rate is not more
than the base lending rate at the time the loan was granted;

Deductible Capital Allowance: Full capital allowance is granted to agricultural and

manufacturing companies in respect of assets in use in agricultural production and
manufacturing;

Research and development: 20% investment tax credit on qualifying expenditure is available to
companies engaged in research and development for commercialization. Levies paid to National
science and Technology Fund is also allowed as deduction in arriving at company’s taxable
profits;

Tax-free Dividends: This comes through:

i. Franked Investment Income (FII) provisions.

ii. Three years tax free dividend on foreign currency equity ordinary shares imported into
Nigeria.

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 iii. Five years tax free dividend for companies in priority sectors in Nigeria such as
agricultural production and processing, petrol chemical or liquefied natural gas
production.
iv. Tax free dividends of pioneering companies for the period of tax holidays.
v. Dividend distributed by unit trust companies is free from tax.
vi. Five years tax incentive for dividends from companies in the manufacturing sector.
vii. Dividend received from investments wholly export-oriented businesses.
viii. Dividend, interest, rent and royalty derived from foreign companies.
ix. Profit of the Nigerian company in respect of goods exported from Nigeria provided that
the proceeds are repatriated to Nigeria and used for the purchase of raw materials, plant
equipment and spare parts.
x. The interest on foreign currency domiciliary account in Nigeria accruing on or after 1
January 1990.

Tax Treaties with other countries: This is aimed at:

i. Eliminating double taxation through the granting of credit for tax paid by a Nigerian
company in the other country, etc.;
ii. The protection of tax incentives legislations of the government which would otherwise be
nullified by the tax measures of the other country;
iii. Stable tax regime; and
iv. Concessions of treaty-rules for investment income which are lower than domestic rates
and are available to treaty partners only.

Gas industry meantime: granted to companies engaged in gas utilization (down stream
operations) such as tax-free period of up to 5years and accelerated capital allowances;

Small Business Rate: 20% tax rate for 4 years for a company whose turnover is minimal in the
year of assessment. This applies to companies whose business falls under manufacturing
agricultural production or mining of solid minerals or wholly export trade companies.

8.5 End of chapter questions and solutions

End of chapter questions

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 1. Discuss the reasons for gap in company’s accounting profit and tax profit.
2. Discuss deferred tax and how deferred tax always arise.
3. Discuss FIVE incentives available for businesses under the Nigeria tax regime.
4. List the tax free dividends incentives under the Nigeria tax regime.
5. List the purposes why the government going into tax treaty with other countries.

Solutions to end of chapter questions

1. Accounting profit is calculated based on revenues and related costs of doing business.
There are several components that go into calculating accounting profit. Gross profit is
the difference between revenue and cost of sale, or cost of producing the goods.
Companies subtract all other expenses from gross profit to arrive at accounting profit
before tax expenses.
Operating expenses include rent, utilities, interest, depreciation, amortization, salaries and
other day -to - day costs of running the business. In the accrual method and the matching
principle is followed in reporting accounting profit. This principle ensures that the
income generated by an output and the expenses incurred for that output are recognized
in the same period whether they were paid for or not during the period.
Each company is allowed under the law to select the date for its financial reporting, i.e.
its accounting period which may differ from the Government fiscal year. Corporate
financial reporting is required to follow accounting standards that have been set by
independent accounting standard body. The purpose of these standards is to ensure
uniformity of companies' financial statements and accounting methods.
However, tax rules are contained in tax laws as promulgated by the country's legislature
and are mostly different from requirements of accounting standards. Therefore, it is
possible for the financial reports of a company to differ from the tax returns submitted to
tax authority because of the different accounting methods.
The tax law contains provisions on allowable and disallowable expenses for tax purpose.
Whereas, as long as these expenses are incurred for the purpose of generating the income
being reported, they are taking into consideration before arriving at the accounting profit.

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 The gap or difference between book and tax income generally results from three
categories of differences:
• Temporary differences;
• Permanent differences; and
• Loss carry forwards / carry backs.
Temporary differences are defined by the accounting standard as being differences
between the carrying amount of an asset (or liability) within the statement of Financial
Position and its tax base, i.e., the amount at which the asset (or liability) is valued for tax
purposes by the relevant tax authority.
Permanent differences occur as a result of differences between income as reported in the
financial statement and income as reported based on tax law, as a result of some expenses
that are disallowed for tax purposes but included in the determination of income in the
financial statement. Also, there are some expenses and or income reported on the tax
return which are never reported on the income statement.
2. A deferred tax liability is defined as being the amount of income tax payable in future
periods in respect of taxable temporary differences. Simply put, a deferred tax is tax that
is payable in the future. Taxable temporary differences are those on which tax will be
charged in the future when the asset (or liability) is recovered (or settled).

The most common course of temporary differences which results in deferred tax are:

• Depreciation of non-current assets; and

• Revaluation of non-current assets.

Within the financial statements, non-current assets with a limited economic life are
subject to depreciation. However, within tax computations, non-current assets are subject
to capital allowances (also known as tax depreciation) at rates set within the relevant tax
law. Where at the year-end the cumulative depreciation charged and the cumulative
capital allowances claimed are different, the carrying value of the asset (cost less
accumulated depreciation) will then be different to its tax base (cost less accumulated
capital allowances) and thus a taxable temporary difference arises.

Illustration
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A non-current asset costing N200,000 was acquired by a company at the start of year 1.
It is being depreciated on straight line basis over four years resulting in annual
depreciation charges of N50,000. The capital allowances granted on this asset over the
four years are:

Yr. 1 125,000

Yr. 2 25,000

Yr. 3 25,000

Yr. 4 25,000

200,000

Solution to illustration

As stated above, deferred tax liabilities arise on taxable temporary differences, i.e. those
temporary differences that result in tax being payable in the future as the temporary
difference reverses. So, how does the above illustration result in tax being payable in the
future?

Companies pay income tax on their taxable profits. When determining taxable profits,
the tax authority start by taking the profit before tax (accounting profits) of a company
from their financial statements and then make various adjustments – for example,
depreciation is considered a disallowable expense for taxation purposes but instead tax
relief on capital expenditure is granted in the form of capital allowances. Therefore,
taxable profits are arrived at by adding back depreciation and deducting capital
allowances from the accounting profits, companies are then charged tax at the appropriate
tax rate on these taxable profits.

The carrying value, the tax base of the asset and therefore the temporary difference at the
end of each year are:

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Yr Carrying Value Tax base (cost accumulated
(cost accumulated depreciation) capital allowances) Diff
N N ₦
1 150,000 75,000 75,000
2 100,000 50,000 50,000
3 50,000 25,000 25,000
4 Nil Nil Nil

In the above illustration, when the capital allowances are greater than the depreciation
expense in year 1 to 2, the company has received tax relief early. This is good for cash
flow in that it delays (i.e. defers) the payment of tax. However, the difference is only a
temporary difference and so the tax will have to be paid in the future, in year 4, when the
capital allowance for the year are less than the depreciation charged, the company is
being charged additional tax and the temporary difference is reversing. Hence the
temporary differences can be said to be taxable temporary differences.

Candidates should notice that overall, the accumulated depreciation and accumulated
capital allowances both equal N200,000 – the cost of the asset – so over the four – year
period, there is no difference between the taxable profits and the profits per the financial
statements.

At the end of year 1, the company has a temporary difference of N75,000, which will
result in tax being payable in the future (in year 3 and 4). In accordance with the
prudence concept, a liability is therefore recorded equal to the expected tax payable.

Assuming that the tax rate applicable is 30%, the deferred tax liability that will be
recognized at the end of year 1 is 30% X N75,000 = N22,500. This will be recorded by
crediting (increasing) a deferred tax liability in the statement of financial position and
debiting (increasing) the tax expenses in the statement of profit or loss.

By the end of year 2, the company has a taxable temporary difference of N50,000. The
liability therefore, is now 30% X N50,000 = N15,000. The deferred tax liability now

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needs reducing from N22,500 to N15,000 and so is debited (a decrease) by N7,500.
Consequently, there is now a credit (a decrease) to the tax expense of N7,500.

At the end of year 3, the company’s taxable differences have decreased to N25,000.
Therefore, the deferred tax liability needs to be reduced from N50,000 to N25,000 X
30%, i.e. N7,500. So, the deferred tax liability is debited (a decrease) by N7,500 and the
tax expenses is credited (a decrease) by N7,500.

At the end of year 4, there are no taxable temporary differences since now the carrying
value of the asset is equal to its tax base. Therefore, the opening liability of N22,500 has
been completely removed at the end of year 4. This is summarised as follows:

Year 1 2 3 4

N N N N

Opening deferred tax liability 0 22,500 15,000 7,500

Increase / (Decrease) in the year 22,500 (7,500) (7,500) (7,500)

Closing deferred tax liability 22,500 15,000 7,500 0

The closing figures are reported in the statement of financial position as part of the
deferred tax liability.

Revaluations of non-current assets

Revaluations of non-current assets (NCA) are a further example of taxable temporary

difference. When an NCA is revalued to its current value within the financial statements,
the revaluation surplus is recorded in equity (in a revaluation reserve) and reported as
other comprehensive income. While the carrying value of the asset has increased, the tax
base of the asset remains the same and this give rise to a temporary difference.

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 Tax will become payable on the surplus when the asset is sold and so the temporary
difference is taxable. Since the revaluation surplus has been recognized within equity, to
comply with matching concept, the tax charge on the surplus is also charged to equity.

Illustration

Suppose that the asset in our previous illustration is revalued to N250,000 at the end of
year 2. The detail is shown below:

Carrying Value Tax base (cost less

(cost less accumulated depreciation) accumulated capital
allowances)
Yr. 2 N N Diff

Opening balance 150,000 75,000 75,000

Depreciation charged /

Capital allowance (50,000) (25,000)

(25,000)

Revaluation 150,000 0
150,000

Closing balance 250,000 50,000 200,000

The carrying value is now N250,000 while the tax base remains N50,000. There is,
therefore, a temporary difference of N200,000 of which N150,000 relates to the
revaluation surplus. This gives rise to a deferred tax liability N200,000 X 30% =
N60,000 at the year- end which will be reported in the statement of financial position.
The liability was N22,500 at the beginning of the year (previous illustration) and has now
increased by N37,500. The increase in relation to the revaluation surplus of N150,000 X
30% = N45,000 will be charged to the revaluation reserve and reported within other

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 comprehensive income. The difference of N7,500 will be treated under tax expenses as
deferred tax now reversed.

The double entry will be as follows:

Dr. Revaluation reserve in equity N45,000

Cr. Tax expense N7,500

Cr Deferred tax liability in SFP N37,500

3. Some of the various tax incentives available to companies in Nigeria are:

Pioneer Companies: Tax holiday between 3 and 5 years, is granted to companies

regarded as having Pioneer Status. A pioneer company is a company that is engaged in
manufacturing, processing, mining, servicing and agricultural industries whose products
have been declared pioneer products on satisfying certain conditions as determined by
Industrial Development Coordinating Committee (IDCC) of the Government under the
Industrial Development (Income Tax Relief) Act Cap 179 LFN 1990. The pioneer Tax
holiday is for an initial period of three years, subject to further extension of two years or
five years (ones and for all without further extension);

Export Processing Free Zone Exempt Profit: 100% tax exemption for profit obtain
from export-oriented companies under established within an export free zone for 3
consecutive assessment years;

Locally Manufactured Part: 15% investment tax credit is allowed for a company
which produce locally manufactured part, machinery or equipment;

Spare Part Fabrication: For a company engaged wholly in the fabrication of spare part
tools and equipment for local consumption and export; 25% investment tax credit is
allowed on qualifying capital expenditure. S. 28(1) of CITA (Companies Income Tax
Act);

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Investment Tax Relief: Relief is granted for 3years to companies located at least 20km
away from essential infrastructure such as electricity water, tarred roads an telephone
services; when expenditures are incurred on such infrastructures;

Investment allowance: 10% tax relief for companies in the year of purchase of plant
and machinery used for agricultural production and manufacturing by agricultural
manufacturing companies. This is in addition to the normal initial and normal
allowances;

Rural Investment Allowance: Granted to companies established in rural areas lacking

infrastructural facilities. The same rates are applicable as investment Tax Relief as
follows:

• No facilities at all 100%;

• No electricity at all 50%;
• No water at all 30%;
• No tarred road at all 15%; and
• No telephone 5%.

Hotels Income Exempt from Tax: 25% if income in convertible currencies derived
from tourist provided the income is put in reserved fund to be utilized within 5 years for
building expansion of new hotels, conference centres and new facilities for tourism
development;

Replacement of Obsolete Plant: 15% investment tax credit is allowed for a company
which as incurred on expenditure for the replacement of all obsolete plant and
machinery;

Tax free Investment Relief is granted on the following interest charges: Full tax
exemption on interest on foreign currency deposit account of a non-resident company
opened in or after 1, January, 1990.Full exemption on interest on foreign currency
domiciliary account accruing on or after 01/10/1990

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 Granted tax Relief on interest on foreign loans or interest payable on any loan granted a
bank for manufacture for export

Interest on loan granted by bank on or before 1 January 1997 to a company engaged in

agricultural trade or business, or for the fabrication of a local established by the
company under the Family Economic Advancement Programme. The incentives are
based on the candidates that the moratorium is not less than 18 months and the interest
rate is not more than the base lending rate at the time the loan was granted;

Deductible Capital Allowance: Full capital allowance is granted to agricultural and

manufacturing companies in respect of assets in use in agricultural production and
manufacturing;

Research and development: 20% invest tax credit on qualifying expenditure is

available to companies engaged in research and development for commercialization.
Levies paid to National science and Technology Fund is also allowed as deduction in
arriving at company’s taxable profits;

4. Tax-free Dividends: This comes through:

a. Franked Investment Income (FII) provisions.
b. Three years tax free dividend on foreign currency equity ordinary shares imported
into Nigeria.
c. Five years tax free dividend for companies in priority sectors in Nigeria such as
agricultural production and processing, petrol chemical or liquefied natural gas
production.
d. Tax free dividends pioneering companies for the period of tax holidays.
e. Dividend distributed by unit trust companies is free from tax.
f. Five years tax incentive for dividends from companies in the manufacturing
sector.
g. Dividend received from investments wholly export-oriented businesses.
h. Dividend, interest, rent and royalty derived from foreign companies.

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 i. Profit of the Nigerian company in respect of goods exported from Nigeria
provided that the proceeds are repatriated to Nigeria and used for the purchase of
raw materials, plant equipment and spare parts.
5. The purposes of government entering into tax treaty with other countries are:
a. Eliminating double taxation through the granting of credit for tax paid by a
Nigerian company in the other company etc.;
b. The protection of tax incentives legislations of the government which would
otherwise be nullified by the tax measures of the other country;
c. Stable tax regime; and
d. Concessions of treaty-rules for investment income which are lower than domestic
rates and are available to treaty partners only.

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 Professional Taxation II
Financial/Tax analysis

Chapter
9
Distributions to business owners

Contents

9.1 Introduction

9.2 Sole proprietorship

9.3 Partnership

9.4 Limited liability companies

9.5 End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

• Explain how sole proprietorship are rewarded in terms of profit sharing;

• Explain how partners in a partnership business are rewarded from profit made; and

• Explain how shareholders of limited liability companies are rewarded from profits made.

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9.1 Introduction

The purpose of business is to make profit and maximise the wealth of the owners. When profits
are therefore made, they are to be distributed to the owners and this may take various forms,
depending on the form of business entity.

As noted earlier, there are three major forms of business entity, that is, sole – proprietorship or
one-man business, partnership and limited liability companies. We shall therefore look at how
distributions are made to business owners under each form of business entity.

9.2 Sole proprietorship

Since a sole proprietor own his business, all profits of the business belong to him as much as all
the risks inherent in the business. The sole proprietor can take profit out of the business in form
of salaries and allowances or direct payment to himself. Since he is assessed to tax on the
business profit together with his other earnings, it does not matter in what form he chooses to
take his profit out of the business. He may also choose to leave the profit in the business for
further expansion. This also will have no effect on the tax payable by the sole proprietor as all
his business income is chargeable to tax whether taken out of the business or not.

9.3 Partnership

In a partnership business, profits and losses are shared by the partners in proportion to the
partnership agreement. The profit of a partnership business is taxed in the hands of the partners.
Distribution to the partners could be in form of interest on capital, salaries, allowances, bonuses
and or share of profits.

Each partner will be assessed to tax in the aggregation of whatever he receives from the
partnership business together with his other earnings during the year. Therefore, the partnership
business is not assessed to tax on its name; hence it does not matter in which form distribution is
made to the partners.

9.4 Limited liability companies

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A limited liability company is a separate legal entity from its owners, called shareholders. A
limited liability company is assessable to tax on the profit it made on a yearly basis. It is the
after tax profit that is available for distribution between the shareholders. However, a limited
liability company may choose not to distribute any part of its after tax profit. The company’s
board, subject to the approval of the shareholder determines how much of the after tax profits to
be distributed to the shareholders and the form they are to be distributed.

A company can distribute profits to its shareholder in two forms:

• Cash distribution in form of dividends. Where cash distribution, dividend, is made to the
shareholders, a tax of 10% is deducted in form of withholding tax, though treated as final
tax in the hand of shareholders, removed from the dividend and paid to the relevant tax
authorities; and
• Capital distribution in form of bonus shares or script issues. In this case, cash is not paid to
the shareholders, but the amount that could have been paid as dividend is used to credit the
accounts of the shareholders with additional shares in proportion of their shareholdings.
This will increase the number of holdings of each shareholder. In this case of public
limited liability companies, a shareholder who is in need of cash can easily sell these
additional shares on the stock exchange. At present in Nigeria, the gain from such share
disposed of is not subject to tax, i.e. capital gain tax.

Anti – avoidance scheme on payment of dividend to shareholders

Under the Nigerian Companies Income Tax Act, section 19 (a) and (b) contains an anti-
avoidance provision and it provides that:

“Where a dividend is paid out of profits on which no tax is payable due to:

No total profit; or

Total profits which are less than the amount of dividend which is paid, whether or not the
recipient of the dividend is a Nigerian company;

The company paying the dividend shall be charged to tax at normal company rate (which is 30%)
as if such dividend is the total profits of the company for the year of assessment”.

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The purpose of this provision is to capture a company that refuses to disclose on its financial
statements, submitted for tax purposes, any taxable profit and yet is paying dividend to its
shareholders.

9.5 End of chapter questions and solutions

9.5.1 End of chapter questions

1. Discuss how profits are taxed in a sole proprietorship and partnership business.
2. Discuss how profits are taxed and distributed to shareholders of limited liability
companies.
3. Discuss anti – avoidance scheme on payment of dividend to shareholders under the
Nigerian Income Company Tax Act.

9.5.2 Solutions to end of chapter questions

1. Since a sole proprietor own his business, all profits of the business belong to him as much
as all the risks inherent in the business. The sole proprietor can take profit out of the
business in form of salaries and allowances or direct payment to himself. Since he is
assessed to tax on the business profit together with his other earnings, it does not matter
in what form he chooses to take his profit out of the business. He may also choose to
leave the profit in the business for further expansion. This also will have no effect on the
tax payable by the sole proprietor as all his business income is chargeable to tax whether
taken out of the business or not.
In a partnership business, profits and losses are shared by the partners in proportion to the
partnership agreement. The profit of a partnership business is taxed in the hands of the
partners. Distribution to the partners could be in form of interest on capital, salaries,
allowances, bonuses and or share of profits.
Each partner will be assessed to tax in the aggregation of whatever he receives from the
partnership business together with his other earnings during the year. Therefore, the
partnership business is not assessed to tax on its name; hence it does not matter in which
form distribution is made to the partners.

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2. A limited liability company is a separate legal entity from its owners, called shareholders.
A limited liability company is assessable to tax on the profit it made on a yearly basis. It
is the after tax profit that is available for distribution between the shareholders. However,
a limited liability company may choose not to distribute any part of its after tax profit.
The company's board, subject to the approval of the shareholder determines how much of
the after tax profits to be distributed to the shareholders and the form they are to be
distributed.
A company can distribute profits to its shareholder in two forms:
Cash distribution in form of dividends. Where cash distribution, dividend, is made to the
shareholders, a tax of 10% is deducted in form of withholding tax, though treated as final
tax in the hand of shareholders, removed from the dividend and paid to the relevant tax
authorities; and
Capital distribution in form of bonus shares or script issues. In this case, cash is not paid
to the shareholders, but the amount that could have been paid as dividend is used to credit
the accounts of the shareholders with additional shares in proportion of their
shareholdings. This will increase the number of holdings of each shareholder. In this
case of public limited liability companies, a shareholder who is in need of cash can easily
sell these additional shares on the stock exchange. At present in Nigeria, the gain from
such share disposed of is not subject to tax, i.e. capital gain tax.
3. Under the Nigerian Income Company Tax Act, section 19 (a) and (b) contains an anti-
avoidance provision in respects to dividends payment and it provides that:
“Where a dividend is paid out of profits on which no tax is payable due to:-
No total profit; or
Total profits which are less than the amount of dividend which is paid, whether or not the
recipient of the dividend is a Nigerian company;
The company paying the dividend shall be charged to tax at normal company rate (which
is 30%) as if such dividend is the total profits of the company for the year of assessment”.
The purpose of this provision is to capture a company that refuses to disclose on its
financial statements, submitted for tax purposes, any taxable profit and yet is paying
dividend to its shareholders.

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 Professional Taxation II
Financial/Tax analysis

Chapter
10
Strategies for business growth and expansion

Contents

10.1 Introduction

10.2 Multiple entity businesses

10.3 International business expansion

10.4 End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

• Explain various strategies that could used to expand and grow businesses;

• Explain multiple entity businesses, its tax implications; and

• Discuss international expansion, identifying its advantages and disadvantages.

10.1 Introduction

There are various ways of growing business. These include:

• Increasing sales and products in existing market;

• Introducing a new product offering in a new market;

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• Offering existing products in a new market segment
• Start a chain; e.g. a restaurant chain, a supermarket chain etc.;
• Franchising
• Strategic alliance and acquisition
• Go global

Entrepreneurs are known for recognising and pursuing many opportunities in the market place
simultaneously or in a serial fashion. It is not unusual for such serial entrepreneurs to create
multiple business entities to hold their multiple and varied business endeavours. Such business
entities may include a partnership and limited liability company. Each in its own way protects
the entrepreneur’s personal assets from potentials risks such as lawsuits and other claims against
the business. In recent years, the practice of forming layered, multiple business entities has
gained increased interest among entrepreneurs desiring to start a new business.

10. 2 Multiple - entity businesses

This practice has been a common place for large businesses for decades. It involves layering one
form of a business entity either alongside or in conjunction with an operating business. It
functions as follows: One entity is established to serve as the “operating” business and holds
very few assets on its statement of financial position. Another related business is established to
hold valuable assets such as patents, trade secrets, software, websites and other intellectual
property and serves as “holding” company. Also, the real estate needed for operations may be
held in a separate entity.

The purpose for this multiple - entity business is to separate assets of the enterprise from
potential liabilities in the same business enterprise by placing them in two or more separate
business entities.

There are three ways to structure multiple businesses. Each of these methods has a different set
of advantages and disadvantages. However, the right approach depends on the unique needs of
the businesses.

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First, you can incorporate a different limited liability company for each business venture. For
example, you can have a different company for selling household equipment, another for selling
industrial cleaning equipment and yet another for general cleaning business.

This is a straight forward approach but it involves a lot of paper work. You will need to file
separate returns with the Corporate Affairs Commission (CAC), prepare different annual audited
accounts and file tax returns separately for each of the companies.

Second option is to incorporate a single limited liability company and register business names
called “doing business as “(DBA) for each of the ventures within the same country.

This approach will enable each business have the right name and branding for their specific
market, while still enjoying the legal protection of the main holding company. This will enable
annual returns to CAC and filling of tax returns to the relevant tax authority to be done through
one limited liability company.

An example of such a business is one whose businesses are related. One can register a company
as a hospitality business but trading under different names as restaurant, Home catering service,
event managers, hall rental, etc.

Third option is to incorporate many limited liability companies under a common holding
company that has one hundred percent ownership of the companies. Each of these companies
will be trading on its own name but all the assets may be owned by the holding company.

Tax consequences of various combinations of multiple - entity structure

While creating multiple business entity may afford the entrepreneur an opportunity to separate
liability exposure in his business from his personal assets and the assets of his other business
endeavours, certain tax consequences will follow. All tax consequences should be considered
carefully when choosing the form of business entity, regardless of the number of entities formed
by the entrepreneur. Layering multiple entity structures may include one of the following entity
combinations:

• A limited liability company owing multiple limited liability companies;

• A sole proprietorship owing multiple limited liability companies;

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• A partnership owing multiple limited liability companies; and
• An individual shareholder owing multiple limited liability companies.

It must be noted that each form of business entity has its own tax consequences. So, when
considering the entities operating in tandem or layered multiple entities, it is more to consult both
legal counsel and tax advisers familiar with the appropriate tax laws.

Also, care should be given to the decisions related to how assets should be titled and recorded on
the multiple businesses’ accounting records.

10.3 International business expansion

One way of growing a business, as we have noted earlier, is going global. The importance of
global expansion as a growth opportunity has been stated most clearly by Dr. Lucius Riccio, a
professor at Columbia Business School:

“It is a time of global transformation and change made possible by logistics innovation. A time
when the smallest companies can compete with the largest ones – sometimes with the advantages
of being more nimble and quicker to seize opportunities”.

Today, many entrepreneurial and growing companies are considering international expansions as
a marketing and growth strategy. Some advantages and disadvantages of international business
are listed by MOBL Business courses as follows:

Advantages:

• Enhance domestic competitiveness;

• Increase sales and profits;
• Gain global market shares;
• Reduce dependence on existing market;
• Exploit international trade technology;
• Extend sales potential for business expansion;
• Stabilise seasonal market fluctuations;
• Enhance potential expansion of business;
• Utilise excess production capacity; and
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• Maintenance of cost competitiveness in domestic market;

Disadvantages:

• Need to wait for a long-term gain;

• Need to hire staff to lunch international trading;
• Need to modify production or packaging;
• Need to develop new promotional materials;
• Will incur added administrative gaps;
• Frequent travelling by personnel;
• Payments may take longtime;
• Need for additional financing;
• Will deal with special licenses and regulations; and
• Need to set up specialised conferencing and communication tools.

However, when developing a strategic plan to launch an international business programme,

companies and their advisers must always consider the potential barriers and adjustments they
may need to make to their product and service offerings. These barriers, as stated by Andrew
J. Sherman, a partner in Dickstein Shapiro Morin and Oshinsky LLP, are as follows:

Language barriers: Although it may seem simple enough at the outset to translate the features
of a given product or service into the local language, marketing the product or service may
present unforeseen difficulties if the concept itself does not “translate” well. The target
country’s standards for humor, accepted puns or jargon, or even subtle gestures may not be the
same as your domestic country’s norms or idioms and may need to be adjusted accordingly.

Marketing barriers: These types of barriers most frequently go to the deepest cultural levels.
For example, whereas many overseas markets have developed a taste for "fast food" burgers and
hot dogs, differences in culture may dictate that the speed aspect is less important. Many cultures
demand the leisure to be able to relax on the premises after eating a meal rather than taking a
meal to go. These cultural norms can, in turn, be affected by factors such as the cost and
availability of retail space. Direct and subtle messages in advertising campaigns may need to be
modified. The appeal of using a particular celebrity in a campaign may vary, and the channels for
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promotion may also need to be modified to meet the educational patterns and needs of the local
consumer. Even marketing methodologies may need to be modified

Legal barriers: The company or its counsel must research tax laws, customs laws, import
restrictions, corporate organization, and agency/liability laws. Domestic legislation needs to be
examined as well for issues arising under labor law, immigration law, customs law, tax law,
agency law, and other producer/distributor liability provisions.

Access to raw materials and human resources: Not all countries offer the same levels of
access to critical raw materials and skilled labor that may be needed to offer the service or enjoy
the product. The growing company may want to consider what changes in the product or service
may be feasible to accommodate this resources challenge without sacrificing the core business
format.

Governmental and regulatory barriers: The foreign government may or may not be receptive
to foreign investment or expansion. A given country’s past history of expropriation, government
restrictions, and limitations on currency repatriation may all prove to be decisive factors in
determining whether the cost of market penetration is worth the benefits to be potentially
derived.

Intellectual property and quality control concerns: Protection of trademarks, trade names, and
service marks are vital for the ability of an emerging growth company to operate abroad. The
company needs to have a strategy in place for both protecting its intellectual property rights and
enforcing them if violations are discovered.

Dispute resolution: The forum and governing law for the resolution of disputes must be chosen.
On an international level, these issues become hotly negotiated due to the inconvenience and
expense to the party who must come to the other’s forum.

Apart from these barriers, Andrew J. Sherman further stated the need to consider international
marketing strategy.

International marketing strategy

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Going into a new market blindly can be costly and lead to disputes. Market studies and research
should be conducted to measure market demand and competition for your company’s products
and services. Take the pulse of the targeted country to gather data on the following checklist of
relevant considerations:

• Economic trends;
• Political stability;
• Currency exchange rates;
• Religious considerations;
• Dietary customers and restrictions;
• Lifestyle issues;
• Foreign investment and approval procedures;
• Restrictions on termination and non-renewal (where applicable);
• Regulatory requirements;
• Access to resources and raw materials;
• Availability of transportation and communication channels;
• Labor and employment laws technology transfer regulations;
• Language and cultural differences;
• Access to affordable capital and suitable sites for the development of units;
• Governmental assistance programmes;
• Customs laws and import restrictions;
• Tax laws and applicable treaties;
• Repatriation and immigration laws;
• Trademark registration requirements;
• Availability and protection policies;
• Costs and methods for dispute resolution;
• Agency laws; and
• Availability of appropriate media for marketing efforts.

In addition, you may need information about specific industry regulations that may affect the
product or service you offer to consumers, such as health care, financial services, environmental
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laws, food and drug labeling laws. Get going on your research, and you will be poised to take
advantage of global opportunities.

Finally, it is common place today for most individuals and corporate bodies to move their assets
to “tax haven”, a country with lower or no tax. However, international search light is currently
being beamed on such practices and the so called tax havens are changing their tax policies and
laws.

10.4 End of chapter questions and solutions

10.4.1 End of chapter questions

1. List the various ways of growing a business.

2. Discuss multiple entity business and the purpose for creating a multiple entity business.
3. Discuss international business expansion and its advantages and disadvantages.
4. Discuss the various barriers that must be taken into consideration when expanding
business internationally.
5. In developing international market strategy, list the various things to be considered.

10.4.2 Solutions to end of chapter questions

1. There are various ways of growing business. These include:

a. Increasing sales and products in existing market;
b. Introducing a new product offering in a new market;
c. Offering existing products in a new market segment
d. Start a chain; e.g. a restaurant chain, a supermarket chain etc.;
e. Franchising;
f. Strategic alliance and acquisition; and
g. Go global.
2. Entrepreneurs are known for recognising and pursuing many opportunities in the market
place simultaneously or in a serial fashion. It is not unusual for such serial entrepreneurs
to create multiple business entities to hold their multiple and varied business endeavours.

222
Such business entities may include a partnership and limited liability company. Each in
its own way protects the entrepreneur’s personal assets from potentials risks such as
lawsuits and other claims against the business. In recent years, the practice of forming
layered, multiple business entities has gained increased interest among entrepreneurs
desiring to start a new business.
This practice has been a common place for large businesses for decades. It involves
layering one form of a business entity either alongside or in conjunction with an
operating business. It functions as follows: One entity is established to serve as the
“operating” business and holds very few assets on its statement of financial position.
Another related business is established to hold valuable assets such as patents, trade
secrets, software, websites and other intellectual property and serves as “holding”
company. Also, the real estate needed for operations may be held in a separate entity.
The purpose for this multiple - entity business is to separate assets of the enterprise from
potential liabilities in the same business enterprise by placing them in two or more
separate business entities.
There are three ways to structure multiple businesses. Each of these methods has a
different set of advantages and disadvantages. However, the right approach depends on
the unique needs of the businesses.
First, you can incorporate a different limited liability company for each business venture.
For example, you can have a different company for selling household equipment, another
for selling industrial cleaning equipment and yet another for general cleaning business.
This is a straight forward approach but it involves a lot of paper work. You will need to
file separate returns with the Corporate Affairs Commission (CAC), prepare different
annual audited accounts and file tax returns separately for each of the companies.
Second option is to incorporate a single limited liability company and register business
names called “doing business as “(DBA) for each of the ventures within the same
country.
This approach will enable each business have the right name and branding for their
specific market, while still enjoying the legal protection of the main holding company.

223
 This will enable annual returns to CAC and filling of tax returns to the relevant tax
authority to be done through one limited liability company.
An example of such a business is one whose businesses are related. One can register a
company as a hospitality business but trading under different names as restaurant, Home
catering service, event managers, hall rental, etc.
Third option is to incorporate many limited liability companies under a common holding
company that has one hundred percent ownership of the companies. Each of these
companies will be trading on its own name but all the assets may be owned by the
holding company.

3. One way of growing a business is going global. The importance of global expansion as a
growth opportunity has been stated most clearly by Dr. Lucius Riccio, a professor at
Columbia Business School:
"It is a time of global transformation and change made possible by logistics innovation.
A time when the smallest companies can compete with the largest ones - sometimes with
the advantages of being more nimble and quicker to seize opportunities".
Today, many entrepreneurial and growing companies are considering international
expansions as a marketing and growth strategy. Some advantages and disadvantages of
international business are listed by MOBL Business courses as follows:
Advantages:
a. Enhance domestic competitiveness;
b. Increase sales and profits;
c. Gain global market shares;
d. Reduce dependence on existing market;
e. Exploit international trade technology;
f. Extend sales potential for business expansion;
g. Stabilise seasonal market fluctuations;
h. Enhance potential expansion of business;
i. Utilise excess production capacity; and
j. Maintenance of cost competitiveness in domestic market;

224
 Disadvantages:
a. Need to wait for a long-term gain;
b. Need to hire staff to lunch international trading;
c. Need to modify production or packaging;
d. Need to develop new promotional materials;
e. Will incur added administrative gaps;
f. Frequent travelling by personnel;
g. Payments may take longtime;
h. Need for additional financing;
i. Will deal with special licenses and regulations; and
j. Need to set up specialised conferencing and communication tools.

4. When developing a strategic plan to launch an international business programme,

companies and their advisers must always consider the potential barriers and adjustments
they may need to make to their product and service offerings. These barriers, as stated
by Andrew J. Sherman, a partner in Dickstein Shapiro Morin and Oshinsky LLP, are as
follows:
Language barriers: Although it may seem simple enough at the outset to translate the
features of a given product or service into the local language, marketing the product or
service may present unforeseen difficulties if the concept itself does not “translate” well.
The target country’s standards for humor, accepted puns or jargon, or even subtle
gestures may not be the same as your domestic country’s norms or idioms and may need
to be adjusted accordingly.
Marketing barriers: These types of barriers most frequently go to the deepest cultural
levels. For example, whereas many overseas markets have developed a taste for "fast
food" burgers and hot dogs, differences in culture may dictate that the speed aspect is less
important. Many cultures demand the leisure to be able to relax on the premises after
eating a meal rather than taking a meal to go. These cultural norms can, in turn, be
affected by factors such as the cost and availability of retail space. Direct and subtle
messages in advertising campaigns may need to be modified. The appeal of using a

225
 particular celebrity in a campaign may vary, and the channels for promotion may also
need to be modified to meet the educational patterns and needs of the local consumer.
Even marketing methodologies may need to be modified
Legal barriers: The company or its counsel must research tax laws, customs laws, import
restrictions, corporate organization, and agency/liability laws. Domestic legislation needs
to be examined as well for issues arising under labor law, immigration law, customs law,
tax law, agency law, and other producer/distributor liability provisions.
Access to raw materials and human resources: Not all countries offer the same levels of
access to critical raw materials and skilled labor that may be needed to offer the service
or enjoy the product. The growing company may want to consider what changes in the
product or service may be feasible to accommodate this resources challenge without
sacrificing the core business format.
Governmental and regulatory barriers: The foreign government may or may not be
receptive to foreign investment or expansion. A given country’s past history of
expropriation, government restrictions, and limitations on currency repatriation may all
prove to be decisive factors in determining whether the cost of market penetration is
worth the benefits to be potentially derived.
Intellectual property and quality control concerns: Protection of trademarks, trade names,
and service marks are vital for the ability of an emerging growth company to operate
abroad. The company needs to have a strategy in place for both protecting its intellectual
property rights and enforcing them if violations are discovered.
Dispute resolution: The forum and governing law for the resolution of disputes must be
chosen. On an international level, these issues become hotly negotiated due to the
inconvenience and expense to the party who must come to the other’s forum.
5. Going into a new market blindly can be costly and lead to disputes. Market studies and
research should be conducted to measure market demand and competition for your
company's products and services. The following is the checklist of the relevant data to be
gathered:
• Economic trends;
• Political stability;

226
• Currency exchange rates;
• Religious considerations;
• Dietary customers and restrictions;
• Lifestyle issues;
• Foreign investment and approval procedures;
• Restrictions on termination and non-renewal (where applicable);
• Regulatory requirements;
• Access to resources and raw materials;
• Availability of transportation and communication channels;
• Labor and employment laws technology transfer regulations;
• Language and cultural differences;
• Access to affordable capital and suitable sites for the development of units;
• Governmental assistance programmes;
• Customs laws and import restrictions;
• Tax laws and applicable treaties;
• Repatriation and immigration laws;
• Trademark registration requirements;
• Availability and protection policies;
• Costs and methods for dispute resolution;
• Agency laws; and
• Availability of appropriate media for marketing efforts.
In addition, you may need information about specific industry regulations that may affect
the product or service you offer to consumers, such as health care, financial services,
environmental laws, food and drug labeling laws. Get going on your research, and you
will be poised to take advantage of global opportunities.

227
 Professional Taxation II
Financial/Tax analysis

Chapter
11
Taxation and capital market activities

Contents

11.1 Introduction

11.2 Mergers and acquisitions

11.3 End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

• Explain tax implications of capital market activities; and

• Discuss mergers and acquisitions and its various tax implications.

11.1 Introduction

Capital market activities involves buying and selling of private companies’ equity shares and
debt stock; and Government securities. These include ordinary shares, debenture stocks, etc. of
public limited liability companies. Nigerian government securities are defined to include
Nigerian treasury bonds, saving certificates and premium bonds issued under the Saving Bonds
and Certificates Act (Abdulrazaq, ).
228
However, under section 30 of the Capital Gains Tax Act (Exemptions and reliefs) gains accruing
to a person from a disposal by him of Nigeria government securities, stocks and shares are not
chargeable gains under the act.

However, stamp duty is payable on the securities traded in the Capital market and dividend
payments by companies also attract 10% withholding tax which becomes a final tax in the hands
of the shareholders.

11.2 Mergers and acquisitions

There are two principal ways by which a business organisation can achieve growth. Growth can
be achieved organically through product and service innovation or inorganically through external
growth by mergers and acquisition.

Mergers and acquisitions have become a commercial phenomenon, being one of the more
famous external corporate restructuring options utilised by companies globally. Mergers and
acquisition (MA) have become a veritable tool increasingly utilised not only within the rational
landscape, but also consistently on a cross-border basis.

Mergers and acquisitions are generally defined as forms of business combinations that either
result in formation of new companies or assimilation of existing business by others.

The term “merger” may be defined as an arrangement whereby the assets of two companies
become vested in, or come under the control of one company, (which may or may not be one of
the original two companies), which has as its shareholders all, or substantially all the
shareholders of one or both of the merging companies, who exchange their shares (either
voluntarily or as a result of legal operation) for shares in the other or a third company (Sanpath,
2010).

This leads to the amalgamation of the undertakings or part of the undertakings of two or more
independent and autonomous entities under the identity of one of the combined entities or, in
other cases, under the identity of a new corporate entity. Mergers can be three types, horizontal,
vertical and conglomerate.

229
• A merger is horizontal if it involves the combination of two or more companies offering the
same product or services.
• A vertical merger occurs where two or more distinct enterprises engaged in the same
market but operating at different levels of the market combine.
• While a conglomerate is a situation whereby two companies, in different industries which
have no vertical or horizontal relationship, come together.

An acquisition may be defined as a transaction or a series of transactions where an entity

acquires control over assets, either directly or indirectly (Speechley, 2008).

Viewed broadly, an acquisition may generally be achieved through (i) share sale; (ii) and asset
sale; or (iii) a business (. Skilton, 2006).

The regulatory frameworks for mergers and acquisitions in Nigeria are:

• Companies and Allied Matter Act (CAMA);

• Investment and Securities Act, 2007; and
• Other sector specific laws.

The reasons that are commonly adduced for Mergers and acquisition are:

• The creation of more wealth for shareholders;

• The quest for increased market pioneer and reduced competition;
• The building drive of business managers; and
• The prevailing local economic situations in a country can also create favourable conditions
for mergers and acquisition activities.

Due diligence in mergers and acquisition

Regardless of the form of business combinations, it is quite fundamental to conduct due

diligence. This will enable the merging parties (in case of acquisition, the buyer) to ascertain the
nature and the extent of existing liabilities and other potentials legal and commercial risks.
There is a need to ensure that there is accuracy of information supplied to the acquiring company
by the company to be acquired. The reason for this is to ensure that the acquisition is not made

230
on the faulty assumptions or inaccurate information (Bhadmus, 2013). Some of the areas to
focus upon when carrying out a due diligence are:

• Assets and liabilities of the company to be acquired;

• Existing and pending litigations;
• Memorandum and Article of Association;
• Ownership of company;
• Shareholding/ Directors of the company;
• Share capital;
• Taxation;
• Regulatory compliance issues;
• Insurance and liability;
• Employees and related information; and
• Financial information.

Tax due diligence

The major due diligence issues are tax consequences of the divestment by the seller such as
capital allowance recoupment and capital gains tax, which may be factored into the pricing of the
asset because the buyer is able to claim tax benefits on the amount paid to acquire such assets.

Due to the enormous tax costs of some of these types of transactions, investors often use
complex structures to obtain tax reliefs. On asset deals, the historical tax issues for the seller are
not too important except to model any incremental costs for changes in compliance after
acquisition.

For share deals, the tax issues are usually more complex. This requires a detailed tax diligence
to be undertaken to anticipate and mitigate tax liabilities through indemnities and warranties.
Buyers have to understand the attitude of the target entity towards tax compliance, since most tax
due diligence issues result from the target’s existing approach to tax compliance. This is
important in view of the relatively low level of tax compliance in Nigeria, which is partly due to
weak tax enforcement on the part of the authorities. It is also useful to evaluate the effectiveness

231
of the tax function, quality of tax personnel, and competency of tax advisers and overall attitude
of management to corporate governance assessing potential tax risk.

Assessing compliance challenges

Oftentimes there are challenges around incomplete and poor record keeping by target companies.
These businesses are sometimes unable to substantiate their claims of tax compliance, especially
filling of returns and remittances of tax liabilities. This stems in part from the difficulty of
obtaining evidence of tax paid both from third parties and tax authorities.

In assessing tax exposures of a target, investors should consider industry – specific issues that
may affect the target’s tax position. An example of this could be an aggressive industry position
on a tax matter or class action on industry-specific tax issues. A purchaser may also need to
evaluate the risk associated with ambiguous tax rules that might create uncertainties in the
interpretation and application of tax laws as well as variances between the letters of law and what
occurs in practice.

Common risk areas are transaction taxes such as VAT and withholding tax where compliance is
generally low or sometimes overlooked by taxpayers. In group situations, transaction taxes on
inter-company transactions are often taken for granted or treated wrongly. There are also non-
compliance issues associated with employee taxes (and social security contributions), especially
with expatriate staff.

The motives of a business combination and the risk appetite of the investor will usually drive the
focus and approach of the due diligence exercise. An investor who is willing to take on the
liabilities of the target would generally prefer an asset deal to share deal. In some cases,
however, an asset deal may not totally shield an acquirer from the tax liabilities of the target. For
instance, under the PPT Act, the tax authority is empowered to recover tax liabilities relating to
assets transferred from the acquirer if in its view the transaction was consummated for the
purpose of avoiding tax.

With respect to the acquisition of government – owned enterprises the need for a thorough due
diligence is even more important as most government corporations are not diligent in matters of

232
tax compliance. A common remedy is to seek an indemnity to cover identified and potential tax
liabilities as a pre-condition to the acquisition.

When carrying out a tax due diligence on the proposed target, answer to the following specific
questions should be sought:

What is the target’s level of tax compliance with respect to companies income tax (CIT), tertiary
education tax (TET), capital gains tax (CGT), information technology levy and payroll related
tax?

What are the available tax assets (e.g. unrelieved capital allowances, unabsorbed tax losses,
unutilized WHT credits, etc.) on the target book?

What is the quantum of non-allowable tax expenses and / or deductions in the target’s tax
position e.g. filling fees, stamp duties, etc.?

What are the prospects for the application of the commencement and /or cessation rules post –
combination given potential double taxation?

An acquiring party may be able to take advantage of the tax benefits available under Nigeria's tax
laws in relation to interest payments if it finances the business combinations through loan
facilities. Interest expenses are specifically allowable as tax deductions under the relevant tax
legislation.

The above assessment assists counterparties to forestall inheriting unwieldy tax burdens in the
surviving and/or resulting company after the ink has dried on the nuptial papers.

It is the responsibility of the counterparties to ensure that the M&A process is executed in such a
manner that ensures that available tax benefits or assets in the target's books can be utilized by
the surviving or resulting company after completion of the business combination. This inevitably
implies that competent and/or trusted advisors must be engaged and their inputs sought
throughout the M&A value chain. For instance, loss reliefs may be preserved and utilized by the
surviving and/or resulting company depending on the manner the M&A is conducted otherwise,
the parties may be exposed to challenge by tax authorities for “loss trafficking”.

233
In information circular No. 2006/04, of February, 2006, the Federal Inland Revenue Service gave
the following details to properly inform and enlighten Tax payers, Tax consultants and the
general public on relevant tax issues involved in mergers and acquisition process.

The CITA in Section 29(12) Cap (21, LFN, 2004) provides that ‘‘no merger, take-over, transfer
or restructuring of the trade or business carried on by a company shall take place without having
obtained the Service’s direction under sub-section 9 of this section and clearance with respect to
any tax that may be due and payable under the Capital Gains Tax Act’’. The implication of this
provision is that the approval of the Federal Inland Revenue Service is a necessary condition for
the completion of the process in a merger or acquisition bid. Therefore, no merger or acquisition
bids would be fully consummated without the companies involved having obtained consent from
the FIRS.

Procedure for obtaining the Federal Inland Revenue Service’s approval

From the start, the merging companies are required to submit to the FIRS, copies of the scheme
of merger and scheme of arrangement on the consolidation request for its study and proper
evaluation in order to ensure that taxes which may result from the companies’ transactions are
correctly assessed and collected. Herein lies the relevance of the Service’s powers under section
29(9) (i) to require either of the companies directly affected by any direction which is under the
consideration of the Service to guarantee or give security to its satisfaction for payment in full of
all tax due or to become due by the company which is selling or transferring such asset or
business.

Tax issues in mergers and acquisitions

A merger may result in any of the following situations:

• Formation of a new company.

• Continuation of the consolidated business by one of the merging parties, in its name or under
a new name.
• Cessation of business by the other merging parties. In acquisition, there is only an acquiring
company (ies) and the company being acquired.
• Emergence of a New Company
234
Rendition of annual returns

Where a new company emerges from a merger process, then, the new company is expected to
file its returns, in line with the provisions of Section 55(3)(b) of CITA. The section provides that
“every new company shall file with the Service, its audited accounts and returns within eighteen
(18) months from the date of its incorporation or not later than six (6) months after the end of its
first accounting period as defined in section 29(3) of this Act, whichever is earlier’’.

It should however be understood that a mere change of name does not make an existing business
entity a new company. Such companies will continue to be treated as old businesses on an on-
going concern basis.

Basis of assessment

Commencement rule as provided under Section 29(3) will apply to the new company, except
where any of the under-listed circumstances arise:

• Where the merging parties are connected parties, the Service may direct that
commencement rule be set aside, in which case, the new company will file its returns as an
on-going concern and its assessment will be determined on preceding year basis.
• Where the new business is a reconstituted company, taking over the trade or business
formerly run by its foreign parent company.

Claim of allowances

Companies Income Tax Act (CITA) did not categorically address the value at which assets may
be transferred for the purpose of capital allowances claims. However, International Accounting
Standard 22 prescribes that in merger accounting, the assets, liabilities and reserves must be
recorded at their carrying balances, implying that merger process does not permit the recording
of assets at their fair value in the event of consolidation. The new company will therefore not be
entitled to any investment allowance claim or initial allowance on the transferred assets; it will
only be entitled to claim annual allowance on the Tax Written Down Values (TWDV) of the
transferred assets.

Unabsorbed losses and un-utilised allowances brought forward

235
The new company may also not be permitted to inherit the unabsorbed losses and capital
allowances of the absorbed companies, except under the following circumstance:

Where a reconstituted company is carrying on the same business previously carried on by this
company and it is proved that the losses have not been allowed against any assessable profits or
income of that company for any such year; in that case the amount of unabsorbed losses shall be
deemed to be a loss incurred by the re-constituted company in its trade or business during the
year of assessment in which the business commenced.

Taxes and Deductibility of Related Expenses

(i) Stamp Duties

Duty payment will arise on the share capital of the new company, subject to the provisions of
Section 104 of the Stamp Duties Act, in relation to capital and duty relief.

(ii) Consolidated Expenses

Fees paid to statutory bodies such as SEC, NSE, CBN, Land Authorities etc., including
professionals like accountants, stockbrokers, issuing houses, and solicitors are regarded as capital
in nature and will therefore not be allowed as deductible expenses by virtue of Section 27(a) of
CITA.

(iii) Taxation of Consolidation Fees:

Fees paid to professionals for services rendered in connection with consolidation will be subject
to VAT and WHT at the rates of 5% (changed to 7.5% under the Finance Act 2019) and 10%
respectively.

Tax Indemnification

Section 29(9)(i) of CITA provides that the Service may require the new company to guarantee or
give security for payment in full, for any tax due or that may become due by any of the ceased
companies.

Approval for Pension Scheme

236
The new company will need to obtain a Joint Tax Board (JTB) approval for its staff pension
scheme.

Status of a Surviving Company in Relation to Taxation

It is a possibility that one of the merging companies survives and its old name or a new name to
inherit the assets, liabilities, reserves and entire operations of the merging parties. Where this
happens, the following points must be noted:

(i) The surviving company must file its returns in line with the provisions of section 55(3)(a) of
CITA.

(ii) Commencement rules under section 29(3) of CITA will not apply to the surviving company,
as it will be regarded as an existing company.

(iii) The surviving company will not be allowed to claim investment allowance on the assets
which were transferred to it and will also not claim initial allowance on such assets.

(iv) The surviving company may however claim annual allowance only on the tax Written down
Values (TWDV) of the assets transferred to it.

(v) The surviving company may not inherit the unabsorbed losses and capital allowances of the
merging companies, except it is proved that the new business is a reconstituted company.

(vi) All fees payable on merger bids or consolidation will be liable to VAT and WHT just like it
is applicable on the emergence of a new company. Stamp duties will be paid on the increase
in share capital and the company will have to obtain its own staff pension scheme approval
from the JTB.

Ceased Businesses

The merger or consolidation exercise may also result in cessation of business for any of the
merging parties. In this case, cessation rule as applicable under section 29(4) of CITA will apply
to any of the merging companies which have now ceased business permanently, except if any of
the following circumstances occur:

237
(i) Where the merging companies are connected. Here, the Service may direct, in line with its
discretionary powers, under section 29(9) of CITA that the cessation rule may not apply.

(ii) Where a reconstituted company is formed to take over the trade or business formerly run by
its foreign parent company. (See Section 29(10) of CITA.

Capital Gains Tax Shares or Cash Received

Section 32A of Capital Gains Tax Act (CGTA) Cap 121LFN 2004 provides that a person shall
not be chargeable to tax under the Act, in respect of any gains arising from the acquisition of the
shares of a company, either merged with, or taken over or absorbed by another company, as a
result of which the acquired company has lost its identity. However, where shareholders are
either wholly or partly paid in cash for surrendering their shares in the ceased business, the gains
arising from the cash payment will be subject to CGT.

Effect of Taxations on Consolidation Acquiring/Acquired Companies

The tax implications of consolidation on an acquiring company or acquired companies are

similar to those of mergers. Acquisition expenses are non-deductible while fees paid to
professional bodies are equally subject to WHT and VAT.

11.3 End of chapter questions and solutions

11.3.1 End of chapter questions

1. Discuss mergers and acquisitions and why companies go for it.

2. Discuss due diligence and the need for it in mergers and acquisitions
3. Discuss what constitute tax due diligence in mergers and acquisitions.
4. Discuss tax issues that should be taken into consideration in mergers and acquisitions.
5. Discuss tax issues concerning the surviving company in mergers and acquisitions.

11.3.2 Solutions to end of chapter questions

1. Mergers and acquisitions are generally defined as forms of business combinations that
either result in formation of new companies or assimilation of existing business by others.
238
 The term "merger" may be defined as an arrangement whereby the assets of two
companies become vested in, or come under the control of one company, (which may or
may not be one of the original two companies), which has as its shareholders all, or
substantially all the shareholders of one or both of the merging companies, who exchange
their shares (either voluntarily or as a result of legal operation) for shares in the other or a
third company3.
This leads to the amalgamation of the undertakings or part of the undertakings of two or
more independent and autonomous entities under the identity of one of the combined
entities or, in other cases, under the identity of a new corporate entity. Mergers can be
three types, horizontal, vertical and conglomerate.
A merger is horizontal if it involves the combination of two or more companies offering
the same product or services.
A vertical merger occurs where two or more distinct enterprises engaged in the same
market but operating at different levels of the market combine.
While a conglomerate is a situation whereby two companies, in different industries which
have no vertical or horizontal relationship, come together.
An acquisition may be defined as a transaction or a series of transactions where an entity
acquires control over assets, either directly or indirectly4.
Viewed broadly, an acquisition may generally be achieved through (i) share sale; (ii) and
asset sale; or (iii) a business.
There are two principal ways by which a business organisation can achieve growth.
Growth can be achieved organically through product and service innovation or
inorganically through external growth by mergers and acquisition.
Mergers and acquisitions have become a commercial phenomenon, being one of the more
famous external corporate restructuring options utilised by companies globally. Mergers
and acquisition (MA) have become a veritable tool increasingly utilised not only within
the rational landscape, but also consistently on a cross-border basis.
2. Regardless of the form of business combinations, it is quite fundamental to conduct due
diligence. This will enable the merging parties (in case of acquisition, the buyer) to
ascertain the nature and the extent of existing liabilities and other potentials legal and

239
 commercial risks. There is a need to ensure that there is accuracy of information supplied
to the acquiring company by the company to be acquired. The reason for this is to ensure
that the acquisition is not made on the faulty assumptions or inaccurate information.
Some of the areas to focus upon when carrying out a due diligence are:
a. Assets and liabilities of the company to be acquired;
b. Existing and pending litigations;
c. Memorandum and Article of Association;
d. Ownership of company;
e. Shareholding/ Directors of the company;
f. Share capital;
g. Taxation;
h. Regulatory compliance issues;
i. Insurance and liability;
j. Employees and related information; and
k. Financial information.
3. The major due diligence issues are tax consequences of the divestment by the seller such
as capital allowance recoupment and capital gains tax, which may be factored into the
pricing of the asset because the buyer is able to claim tax benefits on the amount paid to
acquire such assets.
Due to the enormous tax costs of some of these types of transactions, investors often use
complex structures to obtain tax reliefs. On asset deals, the historical tax issues for the
seller are not too important except to model any incremental costs for changes in
compliance after acquisition.
For share deals, the tax issues are usually more complex. This requires a detailed tax
diligence to be undertaken to anticipate and mitigate tax liabilities through indemnities
and warranties. Buyers have to understand the attitude of the target entity towards tax
compliance, since most tax due diligence issues result from the target’s existing approach
to tax compliance. This is important in view of the relatively low level of tax compliance
in Nigeria, which is partly due to weak tax enforcement on the part of the authorities. It
is also useful to evaluate the effectiveness of the tax function, quality of tax personnel,

240
and competency of tax advisers and overall attitude of management to corporate
governance assessing potential tax risk.
Assessing compliance challenges
Oftentimes there are challenges around incomplete and poor record keeping by target
companies. These businesses are sometimes unable to substantiate their claims of tax
compliance, especially filling of returns and remittances of tax liabilities. This stems in
part from the difficulty of obtaining evidence of tax paid both from third parties and tax
authorities.
In assessing tax exposures of a target, investors should consider industry – specific issues
that may affect the target’s tax position. An example of this could be an aggressive
industry position on a tax matter or class action on industry-specific tax issues. A
purchaser may also need to evaluate the risk associated with ambiguous tax rules that
might create uncertainties in the interpretation and application of tax laws as well as
variances between the letters of law and what occurs in practice.

Common risk areas are transaction taxes such as VAT and withholding tax where
compliance is generally low or sometimes overlooked by taxpayers. In group situations,
transaction taxes on inter-company transactions are often taken for granted or treated
wrongly. There are also non-compliance issues associated with employee taxes (and
social security contributions), especially with expatriate staff.

The motives of a business combination and the risk appetite of the investor will usually
drive the focus and approach of the due diligence exercise. An investor who is willing to
take on the liabilities of the target would generally prefer an asset deal to share deal. In
some cases, however, an asset deal may not totally shield an acquirer from the tax
liabilities of the target. For instance, under the PPT Act, the tax authority is empowered
to recover tax liabilities relating to assets transferred from the acquirer if in its view the
transaction was consummated for the purpose of avoiding tax.

With respect to the acquisition of government – owned enterprises the need for a
thorough due diligence is even more important as most government corporations are not

241
diligent in matters of tax compliance. A common remedy is to seek an indemnity to
cover identified and potential tax liabilities as a pre-condition to the acquisition.
When carrying out a tax due diligence on the proposed target, answer to the following
specific questions should be sought:
What is the target’s level of tax compliance with respect to companies income tax (CIT),
tertiary education tax (TET), capital gains tax (CGT), information technology levy and
payroll related tax?
What are the available tax assets (e.g unrelieved capital allowances, unabsorbed tax
losses, unutilized WHT credits, etc) on the target book?
What is the quantum of non-allowable tax expenses and / or deductions in the target’s tax
position e.g. filling fees, stamp duties, etc?
What are the prospects for the application of the commencement and /or cessation rules
post – combination given potential double taxation?
An acquiring party may be able to take advantage of the tax benefits available under
Nigeria's tax laws in relation to interest payments if it finances the business combinations
through loan facilities. Interest expenses are specifically allowable as tax deductions
under the relevant tax legislation.
The above assessment assists counterparties to forestall inheriting unwieldy tax burdens
in the surviving and/or resulting company after the ink has dried on the nuptial papers.
It is the responsibility of the counterparties to ensure that the M&A process is executed in
such a manner that ensures that available tax benefits or assets in the target's books can
be utilized by the surviving or resulting company after completion of the business
combination. This inevitably implies that competent and/or trusted advisors must be
engaged and their inputs sought throughout the M&A value chain. For instance, loss
reliefs may be preserved and utilized by the surviving and/or resulting company
depending on the manner the M&A is conducted otherwise, the parties may be exposed
to challenge by tax authorities for “loss trafficking”.
In information circular No. 2006/04, of February, 2006, the Federal Inland Revenue
Service gave the following details to properly inform and enlighten Tax payers, Tax

242
 consultants and the general public on relevant tax issues involved in mergers and
acquisition process.
The CITA in Section 29(12) Cap (21, LFN, 2004) provides that ‘‘no merger, take-over,
transfer or restructuring of the trade or business carried on by a company shall take place
without having obtained the Service’s direction under sub-section 9 of this section and
clearance with respect to any tax that may be due and payable under the Capital Gains
Tax Act’’. The implication of this provision is that the approval of the Federal Inland
Revenue Service is a necessary condition for the completion of the process in a merger or
acquisition bid. Therefore, no merger or acquisition bids would be fully consummated
without the companies involved having obtained consent from the FIRS.
4. Tax issues in mergers and acquisitions
A merger may result in any of the following situations:
Formation of a new company.
Continuation of the consolidated business by one of the merging parties, in its name or
under a new name.
Cessation of business by the other merging parties. In acquisition, there is only an
acquiring company (ies) and the company being acquired.
Emergence of a New Company
Rendition of annual returns
Where a new company emerges from a merger process, then, the new company is
expected to file its returns, in line with the provisions of Section 55(3)(b) of CITA. The
section provides that "every new company shall file with the Service, its audited accounts
and returns within eighteen (18) months from the date of its incorporation or not later
than six (6) months after the end of its first accounting period as defined in section 29(3)
of this Act, whichever is earlier''.
It should however be understood that a mere change of name does not make an existing
business entity a new company. Such companies will continue to be treated as old
businesses on an on-going concern basis.
Basis of assessment

243
Commencement rule as provided under Section 29(3) will apply to the new company,
except where any of the under-listed circumstances arise:
Where the merging parties are connected parties, the Service may direct that
commencement rule be set aside, in which case, the new company will file its returns as
an on-going concern and its assessment will be determined on preceding year basis.
Where the new business is a reconstituted company, taking over the trade or business
formerly run by its foreign parent company.
Claim of allowances
Companies Income Tax Act (CITA) did not categorically address the value at which
assets may be transferred for the purpose of capital allowances claims. However,
International Accounting Standard 22 prescribes that in merger accounting, the assets,
liabilities and reserves must be recorded at their carrying balances, implying that merger
process does not permit the recording of assets at their fair value in the event of
consolidation. The new company will therefore not be entitled to any investment
allowance claim or initial allowance on the transferred assets; it will only be entitled to
claim annual allowance on the Tax Written Down Values (TWDV) of the transferred
assets.
Unabsorbed losses and un-utilised allowances brought forward
The new company may also not be permitted to inherit the unabsorbed losses and capital
allowances of the absorbed companies, except under the following circumstance:
Where a reconstituted company is carrying on the same business previously carried on by
this company and it is proved that the losses have not been allowed against any
assessable profits or income of that company for any such year; in that case the amount of
unabsorbed losses shall be deemed to be a loss incurred by the re-constituted company in
its trade or business during the year of assessment in which the business commenced.
Taxes and Deductibility of Related Expenses
a. (i) Stamp Duties

Duty payment will arise on the share capital of the new company, subject to the
provisions of Section 104 of the Stamp Duties Act, in relation to capital and duty relief.

(ii) Consolidated Expenses

244
 Fees paid to statutory bodies such as SEC, NSE, CBN, Land Authorities etc, including
professionals like accountants, stockbrokers, issuing houses, and solicitors are regarded
as capital in nature and will therefore not be allowed as deductible expenses by virtue of
Section 27(a) of CITA.
(iii) Taxation of Consolidation Fees:
Fees paid to professionals for services rendered in connection with consolidation will be
subject to VAT and WHT at the rates of 5% and 10% respectively.
Tax Indemnification
Section 29(9)(i) of CITA provides that the Service may require the new company to
guarantee or give security for payment in full, for any tax due or that may become due by
any of the ceased companies.
Approval for Pension Scheme
The new company will need to obtain a Joint Tax Board (JTB) approval for its staff
pension scheme.
5. It is a possibility that one of the merging companies survives and its old name or a new
name to inherit the assets, liabilities, reserves and entire operations of the merging
parties. Where this happens, the following points must be noted:
(i) The surviving company must file its returns in line with the provisions of section
55(3)(a) of CITA.
(ii) Commencement rules under section 29(3) of CITA will not apply to the surviving
company, as it will be regarded as an existing company.
(iii) The surviving company will not be allowed to claim investment allowance on the
assets which were transferred to it and will also not claim initial allowance on
such assets.
(iv) The surviving company may however claim annual allowance only on the tax
Written down Values (TWDV) of the assets transferred to it.
(v) The surviving company may not inherit the unabsorbed losses and capital
allowances of the merging companies, except it is proved that the new business is
a reconstituted company.

245
(vi) All fees payable on merger bids or consolidation will be liable to VAT and WHT
just like it is applicable on the emergence of a new company. Stamp duties will be
paid on the increase in share capital and the company will have to obtain its own
staff pension scheme approval from the JTB.

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 Professional Taxation II

Financial/Tax analysis

Chapter
12
Use of holding companies

Contents

12.1 Protection of personal and business assets.

12.2 Options for creating entities;

12.3 Uses of holding company;

12.4 Uses of operating company; and

12.5 End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

• Explain why holding company is used as a business structure; and

• Explain why operating companies are used as a business strategy.

12.1 Protection of personal and business assets

One important reason of using holding and operating companies is because it is a planning
strategy that helps limit liability risks in the business structure. An ideal business structure
consists of an operating entity that does not own any vulnerable assets and a holding entity that
actually owns the business’s assets.
247
The way this is structured is as follows:

• An operating entity that has possession of the assets, but does not own the assets; and
• A holding entity that actually owns the business’s assets.

The operating entity conducts all of the business’s activities and, thus, bears all the risk of loss.
The owner’s limited liability for business debts turns out to be no liability at all, because the
operating entity contains little or no vulnerable assets, and the holding entity is not legally
responsible for the other entity’s debts. At the same time, the owner’s liability for personal debts
is reduced because assets are within the protective framework of a business form (i.e. the holding
company).

12.2 Options for creating entities

There are two options for creating entities for this business structure:

The individual owner can create and fund the holding company. The holding company can then
create and fund the operating company or companies. Technically, the individual owns the
holding company, the holding company owns the operating company (i.e. its subsidiary).

Alternatively, the owner could personally create and fund both the holding company and the
operating company.

However, the better approach is usually one where the holding company owns the operating
company. These companies are then strategically funded to minimise vulnerable assets within
the business.

12.3 Uses of the holding company

In this multi-entity approach, the holding company is where all wealth is located within the
business structure. However, because the holding company conducts no business activities, it
has almost no exposure to liability, and therefore these assets are protected. The owners create
the holding company. Then the holding company creates and owns the operating company or
companies, where actual business operations (and risks) occur. Therefore, because of the
concept of limited liability, the holding company is limited to its investment in the operating

248
company. When founding the companies, the business’s most vulnerable assets should be
owned by the holding company and leased to the operating company; this will secure the assets
from creditors and provides a way of taking vulnerable cash out of the operating company.

Also, the holding company can loan money to the operating company to buy other business
assets, but it should secure the collateral for the loan with liens that run to the holding company.
This will also make the assets secured because the holding company is a priority lien holder, and
vulnerable cash is taken out of the operating company through loan repayment.

Therefore, when properly structured, the multi-entity approach is successful because it seeks to
maximize wealth within the entity with no liability issues, and minimizes assets with the entity
taking all the risks. Since the holding company itself, and not its owners, creates and fund the
operating company, the holding company is liable for the operating company’s debts only up to
the amount it has invested.

This arrangement also has some tax advantages. The operating company will be allowed to
charge its lease expenses against its taxable profit while at the same time, the holding company,
which legally owns the assets, will be able to claim capital allowance on the assets. However,
the rental income is taxable income. Also, no withholding tax is payable on dividend paid to the
holding company by the operating company.

12.4 Uses of operating company

When using holding and operating companies in a multiple – entity business structure, the
operating company is the primary business entity. All business functions occur within that
company. Likewise, all of the risks to the business, except financial risk, will occur within the
operating company.

It is important from an asset protection point of view to minimize vulnerable assets and cash
within the operating company through continuous withdrawal strategies. These should be in
place and operating as part of the normal course of business.

249
Also, separate operating companies should be formed for each operating activity, so that any
liability runs only to that particular company’s assets.

12.5 End of chapter questions and solutions

12.5.1 End of chapter questions

1. Discuss holding company and how it can be used in business operations.

2. Discuss operating companies and how they are used in business operations.

12.5.2 Solutions to end of chapter questions

1. In this multi-entity approach, the holding company is where all wealth is located within
the business structure. However, because the holding company conducts no business
activities, it has almost no exposure to liability, and therefore these assets are protected.
The owners create the holding company. Then the holding company creates and owns
the operating company or companies, where actual business operations (and risks) occur.
Therefore, because of the concept of limited liability, the holding company is limited to
its investment in the operating company. When founding the companies, the business’s
most vulnerable assets should be owned by the holding company and leased to the
operating company; this will secure the assets from creditors and provides a way of
taking vulnerable cash out of the operating company.
Also, the holding company can loan money to the operating company to buy other
business assets, but it should secure the collateral for the loan with liens that run to the
holding company. This will also make the assets secured because the holding company is
a priority lien holder, and vulnerable cash is taken out of the operating company through
loan repayment.
Therefore, when properly structured, the multi-entity approach is successful because it
seeks to maximize wealth within the entity with no liability issues, and minimizes assets
with the entity taking all the risks. Since the holding company itself, and not its owners,
creates and fund the operating company, the holding company is liable for the operating
company’s debts only up to the amount it has invested.

250
 This arrangement also has some tax advantages. The operating company will be allowed
to charge its lease expenses against its taxable profit while at the same time, the holding
company, which legally owns the assets, will be able to claim capital allowance on the
assets. However, the rental income is taxable income. Also, no withholding tax is
payable on dividend paid to the holding company by the operating company.
2. When using holding and operating companies in a multiple – entity business structure,
the operating company is the primary business entity. All business functions occur
within that company. Likewise, all of the risks to the business, except financial risk, will
occur within the operating company.
It is important from an asset protection point of view to minimize vulnerable assets and
cash within the operating company through continuous withdrawal strategies. These
should be in place and operating as part of the normal course of business.
Also, separate operating companies should be formed for each operating activity, so that
any liability runs only to that particular company’s assets.

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 Professional Taxation II
Financial/Tax analysis

Chapter
13
Financing activities

Contents

13.1 Introduction
13.2 Choice between debt and equity
13.3 Uses of intra group financing companies
13.4 assets financing
13.5 End of chapter questions

Purpose

At the end of this chapter, readers should be able to:

• Explain differences between debt and equity financing and their tax implications;

• Explain how companies use intra group financing companies to finance their activities; and

• Explain the various ways assets could be financed by companies and their tax implications.

13.1 Introduction

We observed earlier that financial management involve three key decision areas. These are:

• Investment decisions or long-term asset – mix;

252
• Financing decisions or capital mix; and
• Dividend decisions or profit allocation.

Pandey (2010), in Financial Management, defines financing decision as “when, where, from and
how to acquire funds to meet the firm’s investment needs”.

The focus of the finance manager here is determination of the appropriate proportion of equity
and debt. Financing describes the sourcing of all funds a company uses for acquiring assets and
paying expenses.

There are only two kinds of sources of funds – equity and debts funding. The company’s
financial structure describes the fraction of total funding that comes from each source. Equity
comes from two source – paid up share capital and retained earnings – the after tax profits
retained by the company in the business after paying dividends to shareholders.

Debts are funds acquired through debt financing and come primarily from bank loans and sales
of debenture stock. The company’s debts, however, also includes short term obligation such as
short terms loan notes payable, account payable, etc.

Capital structure is the mix of debt and equity in financing a firm’s assets. In other words,
capital structure describes the source of funds a company uses for acquiring income – producing
assets. It can also be referred to as the way a company finance its assets through combination of
equity and debt.

Every firm should strive to achieve an optimum capital structure, i.e., the best financing mix,
when the market value of the firm’s shares is maximised.

13.2 Choice between debt and equity

When a company makes an investment decision, it is at the same time making a financing
decision. A company must decide whether to finance the investment with equity, debt or
combination of both. This is not an easy decision as it involves determination of what equity and
debt mix that will maximize the market value of the company’s shares. This is referred to earlier
as optimum capital structure.

253
According to Pandey (2010)., in Financial Management, “the primary motive of a company in
using financial leverage (combination of debt and equity) is to magnify shareholders’ return
under favourable economic conditions. This is based on the assumption that fixed – charges
funds (such as debenture, bank, loans, etc.) can be obtained at a cost lower than the firm’s rate of
returns on net assets”2. When this occurs, the different between the earnings generated by assets
financed by the fixed – charges funds and costs of these funds is distributed to shareholders, this
will make the company’s earnings per share (EPS) or return on equity to increase.

Another important consideration as to whether to use debt or equity is to consider the impact of
the interest charges on the company’s tax liability. The interest charges on debt capital are tax
deductible and therefore, provide tax shield, which increases the earnings of the shareholders. It
is this tax deductibility of interest charges that makes the uses of debt in the capital structure
beneficial to the company.

In considering debt financing, the company must also consider the risks inherent as result of the
fact that interest is payable on debt whether the company makes profit or not. This will have the
effect of reducing the company’s shares’ market value.

A company must therefore, strive to determine its optimum capital structure, the one that
maximizes the company’s shares’ market value when deciding to finance an investment by debt
or equity.

13.3 Uses of intra group financing companies

Intra group funding arrangements have long been used as means for centralisation of a group’s
cash and currency, as a means to control and risk management, and as a preferable way to fund
certain transactions.

Many groups enter into intra-group loans for variety of reasons, some because of convenience
(the group member may require finance at a relatively short period of notice and hence the
parent, or another group member, may provide that finance quicker than say, a bank). Another
reason may be that the group member is unable to secure finance because of a bad credit – rating
or may already have existing borrowing and the bank may want to charge a higher rate of interest

254
to reflect the increased risk and the group may not be willing to accept this and hence another
group member may provide the loan.

The company in the group that is giving a loan to the other member of the group is allowed to
charge interest and such interest is tax deductible. However, the tax authority will apply the
principle of arm’s length to ensure that the interest charge is the market rate.

When the financing company is a member of the group, reference will be made to the functions
the company performs when granting loan to group entities which are, in substance comparable
to the functions performed by independent financial institutions supervised by the central bank.
In this case, the arm’s length price for the functions performed (taking into account the assets
used and the risks borne) should be comparable to the price charged by those financial
institutions.

13.4 Assets financing

Capital assets must be financed in a way that allows for proper matching between the life of the
assets and maturity of the funds. To avoid a mismatch, capital investment projects must be
financed by medium- or long-term sources of financing. A company can acquire a capital asset
through any of the following:

• Using its own internal resources to buy the asset or equipment (i.e Retained earnings);
• Raising cash to buy the asset or equipment;
• Buying the equipment under a hire purchase agreement; and
• Buying the equipment under a leasing agreement.

Buying the capital asset with cash

Beside the company’s internally generated funds, cash can be raised to buy a capital asset
through:

• Ordinary shares
• Preference shares
• Loan Stock / Debenture
• Convertible securities
255
• Term loans

“Asset finance is a type of finance used by businesses to obtain the equipment they need to grow.
It usually involves paying a regular charge for use of the asset over an agreed period of time,
thus avoiding the full cost of buying outright. The most common types of asset finance are
leasing and hire purchase”. (Finance and Leasing Association, UK).

Leasing

This is a form of asset finance where a leasing company (called the lessor) buys and sometimes,
owing the asset on behalf of the customer (called lessee). The lessee pays a rental for the use of
the asset over a pre-determined period.

There are two types of lease:

Finance Lease: Under finance lease, the lessee owns the asset and the asset appears on the
statement of financial position of the lessee. The lessee pays rental, which is the addition of the
principal amount and the interest element over a period of time. In finance lease, the lessee is
responsible for all the risks of ownership and also maintains the asset. At the end of the lease
period, the lessee will pay a token to the lessor and the asset becomes that of the lessee
permanently. It is almost like taking a loan to buy the asset needed.

Under the Nigerian tax laws, the lessee will claim capital allowance for the cost of the asset
while the interest element is charged to the income statement, the cost of the asset is treated as a
non-current asset in the statement of financial position of the lessee.

Operating Lease: This is a situation where the lessee does not own the asset but is allowed to
use the asset over a period of time by paying a regular rental to the finance company. The asset
does not appear on the statement of financial position of the lessee and rental paid is charged into
the income statement against profit.

Under the Nigerian tax laws, the lessee cannot claim capital allowance on the asset, since he does
not own the asset. However, the rental payment is an allowable expense for tax purpose.

The lessee does not assume risk for the asset and may not be responsible for maintaining the
asset.
256
Hire purchase

Hire purchase agreement allows a firm to buy an asset on credit. The finance company will buy
the asset on behalf of the customer and the finance company will own the asset until the final
installment is paid. Under hire purchase agreement, the hirer will use the asset and is given an
option to buy the asset at the end of the hire period by paying a nominal sum for the asset.

Under hire purchase agreement, the finance company can re-possess the asset if the hirer default
in its instalmental payment.

A hire purchase agreement is a credit sale agreement by which the owner of the asset or supplier
grant the purchaser the right to take possession of the asset but ownership will not pass until all
the hire purchase payments or installments have been made. The hire purchase payments consist
partly of capital payments towards the purchase of the asset and partly of interest charges.

Advantages of asset finance

The following are the advantages of asset finance:

• Asset finance gives a firm access to the assets they need without cash flow implications for
an outright purchase;
• Asset finance offers flexibility as it can be tailored to business needs with flexible
repayment schedule; and
• Since repayment terms are always fixed, it allows business to budget their cash flow
commitment accurately.

13.5 End of chapter questions and solutions

13.5.1 End of chapter questions

1. Discuss entity’s financing decision and the two types of financing open to an entity.
2. Discuss the reason why firms use debit financing and what is the limitation of using debit
as a source of finance. What then should a finance manager strive to achieve in entity
financing?
3. Apart from outright cash purchases, discuss three ways a company may acquire assets.

257
13.5.2 Solutions to end of chapter questions

1. Pandey in Financial Management, defines financing decision as “when, where, from and
how to acquire funds to meet the firm’s investment needs”1.
The focus of the finance manager here is determination of the appropriate proportion of
equity and debt. Financing describes the sourcing of all funds a company uses for
acquiring assets and paying expenses.
There are only two kinds of sources of funds – equity and debts funding. The company’s
financial structure describes the fraction of total funding that comes from each source.
Equity comes from two source – paid up share capital and retained earnings – the after
tax profits retained by the company in the business after paying dividends to
shareholders.
Debts are funds acquired through debt financing and come primarily from bank loans and
sales of debenture stock. The company’s debts, however, also includes short term
obligation such as short terms loan notes payable, account payable, etc.
Capital structure is the mix of debt and equity in financing a firm’s assets. In other
words, capital structure describes the source of funds a company uses for acquiring
income – producing assets. It can also be referred to as the way a company finance its
assets through combination of equity and debt.
Every firm should strive to achieve an optimum capital structure, i.e., the best financing
mix, when the market value of the firm’s shares is maximised.

2. When a company makes an investment decision, it is at the same time making a financing
decision. A company must decide whether to finance the investment with equity, debt or
combination of both. This is not an easy decision as it involves determination of what
equity and debt mix that will maximize the market value of the company’s shares. This
is referred to earlier as optimum capital structure.
According to Pandey (2010), in Financial Management, “the primary motive of a
company in using financial leverage (combination of debt and equity) is to magnify
shareholders’ return under favourable economic conditions. This is based on the
assumption that fixed – charges funds (such as debenture, bank, loans, etc.) can be
258
 obtained at a cost lower than the firm’s rate of returns on net assets”. When this occurs,
the different between the earnings generated by assets financed by the fixed – charges
funds and costs of these funds is distributed to shareholders, this will make the
company’s earnings per share (EPS) or return on equity to increase.
Another important consideration as to whether to use debt or equity is to consider the
impact of the interest charges on the company’s tax liability. The interest charges on debt
capital are tax deductible and therefore, provide tax shield, which increases the earnings
of the shareholders. It is this tax deductibility of interest charges that makes the uses of
debt in the capital structure beneficial to the company.
In considering debt financing, the company must also consider the risks inherent as result
of the fact that interest is payable on debt whether the company makes profit or not. This
will have the effect of reducing the company’s shares’ market value.
A company must therefore, strive to determine its optimum capital structure, the one that
maximizes the company’s shares’ market value when deciding to finance an investment
by debt or equity.

3. “Asset finance is a type of finance used by businesses to obtain the equipment they need
to grow. It usually involves paying a regular charge for use of the asset over an agreed
period of time, thus avoiding the full cost of buying outright. The most common types of
asset finance are leasing and hire purchase”. (Finance and Leasing Association, UK).
Leasing
This is a form of asset finance where a leasing company (called the lessor) buys and
sometimes, owing the asset on behalf of the customer (called lessee). The lessor pays a
rental for the use of the asset over a pre-determined period.
There are two types of lease:
Finance Lease: Under finance lease, the lessee owns the asset and the asset appears on
the statement of financial position of the lessee. The lessee pays rental, which is the
addition of the principal amount and the interest element over a period of time. In
finance lease, the lessee is responsible for all the risks of ownership and also maintains
the asset. At the end of the lease period, the lessee will pay a token to the lessor and the

259
asset becomes that of the lessee permanently. It is almost like taking a loan to buy the
asset needed.
Under the Nigerian tax laws, the lessee will claim capital allowance for the cost of the
asset while the interest element is charged to the income statement, the cost of the asset is
treated as a non-current asset in the statement of financial position of the lessee.
Operating Lease: This is a situation where the lessee does not own the asset but is
allowed to use the asset over a period of time by paying a regular rental to the finance
company. The asset does not appear on the statement of financial position of the lessee
and rental paid is charged into the income statement against profit.
Under the Nigerian tax laws, the lessee cannot claim capital allowance on the asset, since
he does not own the asset. However, the rental payment is an allowable expense for tax
purpose.
The lessee does not assume risk for the asset and may not be responsible for maintaining
the asset.
Hire purchase
Hire purchase agreement allows a firm to buy an asset on credit. The finance company
will buy the asset on behalf of the customer and the finance company will own the asset
until the final installment is paid. Under hire purchase agreement, the hirer will use the
asset and is given an option to buy the asset at the end of the hire period by paying a
nominal sum for the asset.
Under hire purchase agreement, the finance company can re-possess the asset if the hirer
default in its instalmental payment.
A hire purchase agreement is a credit sale agreement by which the owner of the asset or
supplier grant the purchaser the right to take possession of the asset but ownership will
not pass until all the hire purchase payments or installments have been made. The hire
purchase payments consist partly of capital payments towards the purchase of the asset
and partly of interest charges.

260
 Professional Taxation II

CHAPTER
Financial/Tax analysis

14
Tax planning through the use of derivative instruments

Contents

14.1 Introduction
14.2 Types of derivatives and their features
14.3 Taxation and derivatives
14.4 End of chapter questions
Purpose

• At the end of this chapter, readers should be able to:

• Explain derivates;
• Discuss the various types of derivative and their features; and
• Explain the tax implications of derivatives.

14.1 Introduction

A derivative is defined as “a financial instrument, the value of which is determined by reference

to the value of another asset (i.e. underlying asset)”.
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Derivates are used by mutual funds to manage risk in their portfolios; Banks to guard against
losses; Oil companies to hedge against or contract the prospect of future price changes; Airlines
to try to lock in more favourable fuel prices. Also, cross-border transactions depend upon them
to ameliorate the risk of currency exchange rate fluctuations.

14.2 Types of Derivates and their Features

The common types of derivates are forward contracts, futures, swaps and options. These
financial instruments are becoming increasingly used in the Nigerian financial market in recent
times. We shall discuss each type briefly as follows:

Forward Contract: This is a derivative contract in which the terms are very similar to cash –
and – carry transactions, except that the delivery and transfer of ownership of the underlying
asset is in future in a forward contract. Equity forward contract is defined as “a contract where
one of the parties agrees to purchase (i.e., the “long” party), and the other party agrees to sell
(i.e., “short” party), the underlying equity at a price (i.e., the delivery price) and date set forth in
the contract.

Future Contract: This is a derivative contract under which one party agrees to deliver to
another on a specified date (the “maturity date”) a specified asset at a price (the “strike price”)
agreed at the time of the contract and payable on the maturity date. A future contract is similar
to a forward contract but the difference lies on the fact that a future contract has standard terms
and it is usually traded on organised exchanges. It specifies trading a particular quantity of the
underlying asset at a particular price and time.

Swap: A swap is a derivative in which two counter parties exchange cash flows of one party’s
financial instrument for those of the other party’s financial instrument.

Option: An option is a contract which gives the buyer (the owner) the right, but not the
obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before
a specified future date.

14.3 Taxation and derivatives

262
Under the Nigeria tax laws, there are no specific rules for taxing derivative transactions.
However, the general taxation rules are applicable. And this will require determination whether
there is a gain or loss which will be taxable under the Capital Gains Tax Act (CGTA) or
Companies Income Tax Act (CITA). As usual, the general rule is that capital gains are taxable
under the provisions of CGTA while trading income or losses are taxable under the provisions of
CITA.

Under CITA, where it can be established that a company is trading in the underlying assets of a
derivative, such as shares, as its usual business and income is derived from such transactions,
then the company would be liable to company income tax (CIT) on the profits derived from the
transaction. This is in accordance with the Federal Inland Revenue Service (FIRS) position as
presented in the FIRS information circular on tax implication of the adoption of the International
Financial Reporting Standards (IFRS) in Nigeria, which provides that profits or losses from
derivative contracts will be treated under CITA.

Chargeable assets have been defined as fixed assets, debts, options, incorporeal assets and
currency other than the Nigerian currency. Therefore, gains arising from disposal of chargeable
assets are subject to capital gains tax (CGT) at the rate of 10%.

The CGTA does not give any indication as to how to determine the location of underlying assets
in derivative instruments. It can therefore, be logically assumed that the location is determined
to be where the rights and obligations relating to the sale of the derivative are tied, If it is tied to
Nigeria, it is arguable that the derivative is in Nigeria. Therefore, the gains from the transactions
will be expected to be taxable in Nigeria.

Also, where the underlying asset of a derivative is exempt from capital gains tax, the gains from
the derivative transaction will also be exempted. An example of this is gains realised from the
disposal of Nigeria shares by a company.

Another important implication is that where the derivative is considered to be goods or services,
value added tax is payable on the gains, except if the good or service is exempted by the Value
Added Tax Act (VATA). It should be noted that “options” are not considered to be goods or

263
services but rather, an incorporeal right, therefore it would not be subject to VAT. Any premium
paid by a company for the right in an option is not liable to VAT.

14.4 End of chapter questions and solutions

14.4.1 End of chapter questions

1. Discuss derivatives and the various types of derivatives.

2. What are the provisions of the Nigeria tax laws on taxation of derivatives?

14.4.2 Solutions to end of chapter questions

1. A derivative is defined as “a financial instrument, the value of which is determined by

reference to the value of another asset (i.e. underlying asset)”.
Derivates are used by mutual funds to manage risk in their portfolios; Banks to guard
against losses; Oil companies to hedge against or contract the prospect of future price
changes; Airlines to try to lock in more favourable fuel prices. Also, cross-border
transactions depend upon them to ameliorate the risk of currency exchange rate
fluctuations.

Types of Derivates and their Features

a. The common types of derivates are forward contracts, futures, swaps and options.
These financial instruments are becoming increasingly used in the Nigerian
financial market in recent times. We shall discuss each type briefly as follows:
b. Forward Contract: This is a derivative contract in which the terms are very similar
to cash – and – carry transactions, except that the delivery and transfer of
ownership of the underlying asset is in future in a forward contract. Equity
forward contract is defined as “a contract where one of the parties agrees to
purchase (i.e, the “long” party), and the other party agrees to sell (i.e, “short”
party), the underlying equity at a price (i.e, the delivery price) and date set forth in
the contract.

264
 c. Future Contract: This is a derivative contract under which one party agrees to
deliver to another on a specified date (the “maturity date”) a specified asset at a
price (the “strike price”) agreed at the time of the contract and payable on the
maturity date. A future contract is similar to a forward contract but the difference
ties on the fact that a future contract has standard terms and it is usually traded on
organized exchanges. It specifies trading a particular quantity of the underlying
asset at a particular price and time.
d. Swap: A swap is a derivative in which two counter parties exchange cash flows of
one party’s financial instrument for those of the other party’s financial instrument.
e. Option: An option is a contract which gives the buyer (the owner) the right, but
not the obligation, to buy or sell an underlying asset or instrument at a specified
strike price on or before a specified future date.
2. Under the Nigeria tax laws, there are no specific rules for taxing derivative transactions.
However, the general taxation rules are applicable. And this will require determination
whether there is a gain or loss which will be taxable under the Capital Gains Tax Act
(CGTA) or Companies Income Tax Act (CITA). As usual, the general rule is that capital
gains are taxable under the provisions of CGTA while trading income or losses are
taxable under the provisions of CITA.
Under CITA, where it can be established that a company is trading in the underlying
assets of a derivative, such as shares, as its usual business and income is derived from
such transactions, then the company would be liable to company income tax (CIT) on the
profits derived from the transaction. This is in accordance with the Federal Inland
Revenue (FIRS) position as presented in the FIRS information circular on tax implication
of the adoption of the International Financial Reporting Standards (IFRS) in Nigeria,
which provides that profits or losses from derivative contracts will be treated under
CITA.
Chargeable assets have been defined as fixed assets, debts, options, incorporeal assets
and currency other than the Nigerian currency. Therefore, gains arising from disposal of
chargeable assets are subject to capital gains tax (CGT) at the rate of 10%.

265
The CGTA does not give any indication as to how to determine the location of
underlying assets in derivative instruments. It can therefore, be logically assumed that
the location is determined to be where the rights and obligations relating to the sale of the
derivative are tied, If it is tied to Nigeria, it is arguable that the derivative is in Nigeria.
Therefore, the gains from the transactions will be expected to be taxable in Nigeria.
Also, where the underlying asset of a derivative is exempt from capital gains tax, the
gains from the derivative transaction will also be exempted. An example of this is gains
realised from the disposal of Nigeria shares by a company.
Another important implication is that where the derivative is considered to be goods or
services, value added tax is payable on the gains, except if the good or service is
exempted by the Value Added Tax Act (VATA). It should be noted that “options” are
not considered to be goods or services but rather, an incorporeal right, therefore it would
not be subject to VAT. Any premium paid by a company for the right in an option is not
liable to VAT.

266
 Professional Taxation II
Financial/Tax analysis

Chapter
15
Intellectual property

Contents

15.1 Introduction
15.2 Benefits of IP to business
15.3 Creation of intellectual property
15.4 Protection of intellectual property
15.5 Management of intellectual property (IP)
15.6 Migration of intellectual property (IP)
15.7 Uses of intellectual property as a tax strategy
15.8 End of chapter questions
Purpose

At the end of this chapter, readers should be able to:

• Explain intellectual property;

• Discuss the benefits of intellectual property;

• Explain how intellectual property is created;

• Explain how intellectual property can be protected;

• Explain the management of intellectual property;

267
• Discuss the meaning of migration of intellectual property; and

• Explain the tax implication of migration of intellectual property.

15.1 Introduction

Intellectual property / capital are forms used to describe intangible assets: the results of human
endeavour that have value and are original, such as designs, publications, inventions, computer
software and music. These assets are increasingly making up a large proportion of company’s
net worth. The protection and management of these assets has become a commercial imperative,
requiring the development of a set of policies that are encompassed within the field of
Intellectual Property Management (Checkpoint Daily Newsstand, March, 2016).

IP can be anything from a particular manufacturing process to plans for a product launch, a trade
secret like a chemical formula, or a list of the countries in which your patients are registered.

Intellectual property has also been broadly defined as “the legal rights which result from
intellectual activity in the industrial, scientific, literary and artistic field” (Fisher 111 and
Oberhelzer , ). There are two main reasons why countries have laws to protect intellectual
property. These are:

To give statutory expression to the moral and economic rights of creators in their creations and
the rights of the public in access to those creations; and

To promote, as a deliberate act of Government policy, creativity and the dissemination and
application of its results and to encourage fair trading which would contribute to economic and
social development (Cockburn and Mac Garvie, 2011).

Generally, intellectual property law aims at safeguarding creators and other producers of
intellectual goods and services by granting them certain time-limited rights to control the use
made of those productions (Larner, 1996 and Shane, 2001).

Intellectual property is broadly divided into two branches:

• Industrial property; and

268
• Copyright.

The convention Establishing the World Intellectual Property Organization (WIPO), concluded in
Stockholin on July 14, 1967 (Article 2(viii) provides that intellectual property shall include rights
relating to:

• Literary, artistic and Scientific works;

• Performances of performing artist, phonograms and broadcasts;
• Invention in all fields of human endeavour;
• Scientific discoveries;
• Industrial designs;
• Trademarks, service marks and commercial names and designations;
• Protection against unfair competition; and
• All rights resulting from intellectual activity in the industrial, Scientific, literary or artistic
field (Chesbrough, 2007).

The copyright branch of intellectual property includes literary, artistic and broadcasts are called
“related right”, that is, rights related to copyright.

The industrial property branch includes inventions, industrial designs, trademarks, service marks
and commercial names and designations. Also, protection against unfair competition belongs to
this branch.

WIPO explains that countries have laws to protect intellectual property (IP) for two main reasons
which are related to one another. These are:

• To give statutory expression to the morals and economic rights of creators in their creations;
and
• To promote, as a deliberate act of government policy, creativity and the dissemination and
application of its results, and to encourage fair trading which will contribute to economic
and social development.

269
Canada Business Network on Copyright and IP defines IP as “the legal right to ideas, inventions,
and creations in the industrial, scientific, literary and artistic fields. It also covers symbols,
names, images, designs and models used in business”.

15.2 Benefits of IP to business

Establishing intellectual property protection for goods, services or brand names is important for a
variety of reasons. These are based on the fact that IP can:

• Establish a right to, and ownership of, your intellectual creations so you can profit from
them;
• Prevent competitions from copying or closely imitating your products or services;
• Protect the distinct identity, image and reputation of your business; and
• Build customer trust and loyalty by establishing a unique brand name or image.

Every business should formally identify its IP assets as part of its strategic planning process.
Every business should realize that its IP assets may be more valuable than its physical, especially
for companies like pharmaceutical companies assets.

15.3 Creation of intellectual property

Intellectual property is created through creative activities of human being (including discovered
or solved laws of nature or natural phenomena that are industrially applicable). These include
inventions, devices, new varieties of plants, designs, works, trademarks, trade names and other
marks that are used to indicate goods or services in business activities, and trade secrets and
other technical or business information that is useful for business activities.

Therefore, intellectual property is a creation of intellect that is owned by an individual or an

organization which can then choose to share it freely or to control its use in certain ways. It is
found almost everywhere – in creative works like books, films, records, music, art and software,
and in everyday objects like cars, computers, drugs and varieties of plants, all of which have
been developed thanks to advances in science and technology. The distinctive features that help

270
us choose the products we buy, like brand names and designs, can also fall within the scope of
intellectual property.

15.4 Protection of intellectual property

It is necessary that intellectual property rights are protected to ensure that an invention or
creation is attributed to its creator or producer and also to secure ownership of it and benefits
commercially as a result. By protecting intellectual property, society acknowledges the benefit it
contributes and provides an incentive for people to invest time and resources to foster innovation
and expand knowledge.

Intellectual property is protected by giving the creator of a work or inventor exclusive rights to
commercially exploit his creation or invention for a limited period of time. These rights can also
be sold, licensed or otherwise disposed of by the rights holder.

Intellectual property rights are granted under the national laws of each country or region. In
addition, various international agreements on intellectual property rights harmonize laws and
procedures, or allow intellectual property rights to be registered at the same time in several
countries. Different types of intellectual property such as literary and artistic creations,
inventions, brand names, and designs, etc. are protected in different ways.

The four legally – defined categories of intellectual property that are also protected in different
ways are:

Patents: This is when you register your invention with the government, when this is done you
gain legal right to exclude anyone else from manufacturing it or marketing it. Patents cover
tangible things. They can also be registered in foreign countries, to help keep international
competitions from finding out what your company is doing. Once you hold a patent, others can
apply to license your product. Patent can last for 20 years.

Trademarks: A trademark is a name, a phrase, sound or symbol used in association with service
or products. It often connects a brand with a level of quality on which companies build a
reputation. Trademark protection lasts for 10years after registration and can be renewed “in
perpetuity”. But trademark don’t have to be registered. If a company create a symbol or name it
wishes to use exclusively, it can simply attaché the Tm symbol. This effectively marks the
271
territory and gives the company room to prosecute if other companies attempt to use the symbol
for their own purposes.

Copyrights: Copyright laws protect written or artistic expressions fixed in a tangible medium –
novels, poems, songs, or movies. A copyright protects the expression of an idea, but not the idea
itself. The owner of a copyrighted work has the right to reproduce it, to make derivative works
from it (such as a movie based on a book), or to sell, perform or display the work to the public.
You do not need to register your material to hold a copyright, but registration is a prerequisite if
you decide to sue for copyright infringement. A copyright lasts for the life of the author plus
another 50 years.

Trade secrets: This is a formula, pattern, device or compilation of data that grants the user an
advantage over competitors. To protect the secret, a business must prove that it adds value to the
company – that it is, in fact, a secret – and that appropriate measures have been taken within the
company to safeguard the secret, such as restricting knowledge to a select handful of executives.
Coco-cola, for example has managed to keep its formula under wraps for more than 121 years.
(CXO Media, Inc. a subsidiary of IDG Enterprise).

15.5 Management of intellectual property (IP)

‘Appropriation’, a term that is widely used in literature on innovation, refers to the act of
capturing the value of one’s ideas and investments in developing and bringing them to market. If
a firm is unable to appropriate, or capture the value of, its intellectual property, competitors may
imitate its offerings without significant investment. This could eliminate its competitive edge,
together with the incentive to continue to engage in risky innovative ventures (Teece 1986).

The main objective of IP management strategies is appropriation. In addition to this goal, sound
IP management can help innovative SMEs achieve a range of objectives, including securing
investment, identifying and attracting potential partners or buyers, deriving value from
collaborations, and managing litigation risks. SMEs tend to work to a significant degree with
external partners, in order to fill gaps in their own resources and expertise and also because their
niche expertise is attractive to established players. Collaboration carries the risk of knowledge
leakage to rivals and thus requires judicious management of intellectual assets. Given their

272
limited resources, innovative businesses develop and execute IP management strategies in
pursuit of four key objectives.

First, all firms need to ‘appropriate’, or capture the value of, their ideas and their investments in
developing and bringing them to market.

Second, firms must protect their interests when engaging in collaborations with other companies
and institutions. They must ensure that the intellectual property that results from joint projects is
fairly distributed and managed among the participants.

Third, firms need to ensure freedom to operate (FTO) and to avoid infringement of third-party
IP rights (IPRs), notably patents, or violations of trade secret protections, so as to minimise the
risk of unnecessary licensing costs and litigation.

Fourth, firms can use IPRs to signal their value to investors, potential partners, competitors, and
Customers.

In managing IP, companies must incorporate IP management into their strategic planning
process. This is as a result of the significant values of IP rights to enterprise value. Therefore, IP
management must not be delegated to specialist staff, for example, Legal staff, because such
specialist seldom partake in strategic planning and decision-making process.

Companies must not only obtain patent or copyright protection for developed new products or
services but must ensure a strategic management of its process and utilization.

There are five main ways of extracting values from IP right by companies holding the right1.
These are:

Suppression of competition by preventing potential rivals from offering customers an

identical or similar product or service (Fisher 111 and Oberhelzer – Gee, ). The resultant
market power will enable the firm to raise the prices it charges for its own products or services
and thus increase its profit (Cockburn and Mac Garvie, 2011).

The firm can sell (i.e. assign) the IP right to another enterprise in whose hands it would be more
valuable. Selling is advantages for the firm and society if the IP assets are more valuable in the

273
hands of the new owner (Larner, 1994; Ernst, 2001 and Shane, 2001). This is especially so, if the
innovator lacks the manufacturing or marketing capacities to exploit the asset fully;

The firm can license the rights, perhaps even to competitors. Instead of selling, the innovating
firm may retain ownership of the IP but give one or more licensees the right to use it. In this
type of decision, companies will compare the revenue they could earn in license fees with the
cost of increased competition (Chesbrough, 2007).

Firm can also use the right as a vehicle to organize profit – enhancing collaborations with
competitors, customers, suppliers or the developers of compliments. The potential benefits of
these strategies are large. However, some of them can bring the firm into close proximity with
anti- - trust law or other legal reefs; and

The firm can give away the right. However, many instances of donation of IP rights are non-
strategic. But a growing number of companies are making their IP available, directly or
indirectly, to residents of developing countries – these initiatives can have large humanitarian
benefits (Katz and Sharpiro, 1985).

A strategic reason, however, for giving away IP is to help in reducing future holdup. Donation
can also be motivated by capital market concerns. By disclosing a part of its knowledge, a firm
can signal its value to capital markets and obtain lower- cost equity financing for its innovation
efforts (Bhatta and Ritter, 1980).

However, a firm chooses to manage its IP, it is important that there must be early collaboration
between creators, managers and lawyers. In order to benefit to the greatest possible extent from
novel technologies and products, managers need to collaborate across functional lines. This is
particularly important during the research, development and design phase.

15.6 Migration of intellectual property (IP)

Migration of IP means the transferring of IP right to territory different from that of its creation or
development. According to Hardgrove and Voloshko ( ) , of the typical strategy of transferring
IP is the intention to align foreign revenues and operating income with the use of that IP in
overseas market. They gave the following reasons why firms transfer IP to other jurisdictions:

274
Some companies transfer their IP because there is a commercial purpose behind the move or
because it reduces tax expenses;

• Because some companies can offset all or part of the impact of tax due on the transfer with
losses; and
• Because the value at the time of the transfer is not as great as the future value created in other
geographies;

There is increasing global perception that governments lose substantial corporate tax revenue as
a result of (1) erosion of the taxable base and/or (2) shifting profits to locations where they are
subject to more favorable tax treatment. Several recent high-profile cases illustrate the manner in
which such planning allows multinational enterprises (MNEs) to achieve effective tax rates much
below the applicable statutory rates.

In many cases, MNEs employ strategies that rely on (1) the interactions of tax laws in multiple
jurisdictions and (2) deliberately enacted government policies aimed at enticing local country
investment.

Also, many countries are offering attractive “patent regimes” or “innovation boxes” that offer
preferential tax treatment on income attributable to IP. These favourable IP regimes have led
many US taxpayers to seek ways to transfer their IP to these jurisdictions in recent testimony to
the U.S Senate Finance Committee International Tax Reform group, U.S business reported
increasing pressure by their stakeholders to transfer their U.S IP overseas to access the tax
savings available under these regimes (Checkpoint Daily Newsstand, March, 2016).

As a result of this the US tax authorities have sought to deter transfers abroad by introducing
new punitive rules aimed at preventing these transfers.

15.7 Uses of IP as a tax strategy

Generally, there are two specific tax issues to be considered apart from the strategic decision of
transferring IP to a tax haven, when considering movement of IP to other jurisdictions. These
are:

275
The home jurisdiction may treat the transfer as a sale and therefore consider the capital gains on
fair value basis. This will result in an immediate tax obligation; and

Subsequent income received from the IP transfer in form of royalties will be subject to income
tax as at when received by the transferee entity.

The above issue however, depends on the tax rule of each jurisdiction where the transfer is
taking place. The US has very strict rules, as discussed earlier, on such transfers. The Nigerian
tax laws have no such rules, however.

Multinationals also use intellectual property as a form of profit shifting strategy by creating
intellectual property in jurisdiction with lower tax rate and charging companies in other
jurisdictions royalties for the use of the intellectual property. The purpose of this strategy is to
reduce the overall tax payable by the group.

15.8 End of chapter questions and solutions

15.8.1 End of chapter questions

1. What is intellectual property and how can it be created?

2. What is the meaning of migration of intellectual property and how is achieved?
3. Discuss how intellectual property can be used as a tax planning strategy.

15.8.2 Solutions to end of chapter questions

1. Intellectual property / capital are forms used to describe intangible assets: the results of
human endeavour that have value and are original, such as designs, publications,
inventions, computer software and music. These assets are increasingly making up a
large proportion of company’s net worth. The protection and management of these assets
has become a commercial imperative, requiring the development of a set of policies that
are encompassed within the field of Intellectual Property Management1.
IP can be anything from a particular manufacturing process to plans for a product launch,
a trade secret like a chemical formula, or a list of the countries in which your patients are
registered.

276
Intellectual property has also been broadly defined as “the legal rights which result from
intellectual activity in the industrial, scientific, literary and artistic field”
Generally, intellectual property law aims at safeguarding creators and other producers of
intellectual goods and services by granting them certain time-limited rights to control the
use made of those productions4.
Intellectual property is broadly divided into two branches:
• Industrial property; and
• Copyright.
The convention Establishing the World Intellectual Property Organization (WIPO),
concluded in Stockholin on July 14, 1967 (Article 2(viii) provides that intellectual
property shall include rights relating to:
• Literary, artistic and Scientific works;
• Performances of performing artist, phonograms and broadcasts;
• Invention in all fields of human endeavour;
• Scientific discoveries;
• Industrial designs;
• Trademarks, service marks and commercial names and designations;
• Protection against unfair competition; and
• All rights resulting from intellectual activity in the industrial, Scientific, literary
or artistic field.
The copyright branch of intellectual property includes literary, artistic and broadcasts are
called “related right”, that is, rights related to copyright.
The industrial property branch includes inventions, industrial designs, trademarks, service
marks and commercial names and designations. Also, protection against unfair
competition belongs to this branch.

Intellectual property is created through creative activities of human being (including

discovered or solved laws of nature or natural phenomena that are industrially
applicable). These include inventions, devices, new varieties of plants, designs, works,
trademarks, trade names and other marks that are used to indicate goods or services in

277
 business activities, and trade secrets and other technical or business information that is
useful for business activities.
Therefore, intellectual property is a creation of intellect that is owned by an individual or
an organization which can then choose to share it freely or to control its use in certain
ways. It is found almost everywhere – in creative works like books, films, records,
music, art and software, and in everyday objects like cars, computers, drugs and varieties
of plants, all of which have been developed thanks to advances in science and
technology. The distinctive features that help us choose the products we buy, like brand
names and designs, can also fall within the scope of intellectual property.
2. Migration of IP means the transferring of IP right to territory different from that of its
creation or development. According to Hardgrove, M and Voloshko, A 1, of the typical
strategy of transferring IP is the intention to align foreign revenues and operating income
with the use of that IP in overseas market. They gave the following reasons why firms
transfer IP to other jurisdictions:

Some companies transfer their IP because there is a commercial purpose behind the move
or because it reduces tax expenses;

• Because some companies can offset all or part of the impact of tax due on the
transfer with losses; and

• Because the value at the time of the transfer is not as great as the future value
created in other geographies;

There is increasing global perception that governments lose substantial corporate tax
revenue as a result of (1) erosion of the taxable base and/or (2) shifting profits to
locations where they are subject to more favorable tax treatment. Several recent high-
profile cases illustrate the manner in which such planning allows multinational
enterprises (MNEs) to achieve effective tax rates much below the applicable statutory
rates.

278
 In many cases, MNEs employ strategies that rely on (1) the interactions of tax laws in
multiple jurisdictions and (2) deliberately enacted government policies aimed at enticing
local country investment.

Also, many countries are offering attractive “patent regimes” or “innovation boxes” that
offer preferential tax treatment on income attributable to IP. These favourable IP regimes
have led many US taxpayers to seek ways to transfer their IP to these jurisdictions in
recent testimony to the U.S Senate Finance Committee International Tax Reform group,
U.S business reported increasing pressure by their stakeholders to transfer their U.S IP
overseas to access the tax savings available under these regimes.

As a result of this the US tax authorities have sought to deter transfers abroad by
introducing new punitive rules aimed at preventing these transfers.

3. Generally, there are two specific tax issues to be considered apart from the strategic
decision of transferring IP to a tax haven, when considering movement of IP to other
jurisdictions. These are:
• The home jurisdiction may treat the transfer as a sale and therefore consider the
capital gains on fair value basis. This will result in an immediate tax obligation;
and
• Subsequent income received from the IP transfer in form of royalties will be
subject to income tax as at when received by the transferee entity.

The above issue however, depends on the tax rule of each jurisdiction where the
transfer is taking place. The US has very strict rules, as discussed earlier, on such
transfers. The Nigerian tax laws have no such rules, however.

Multinationals also use intellectual property as a form of profit shifting strategy by

creating intellectual property in jurisdiction with lower tax rate and charging
companies in other jurisdictions royalties for the use of the intellectual property. The
purpose of this strategy is to reduce the overall tax payable by the group.

279
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