FINANCIAL AND TAX ANALYSIS -SUGGESTED CITN QUESTIONS AND ANSWERS

FINANCIAL AND TAX ANALYSIS

SUGGESTED QUESTIONS AND ANSWERS

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.

Solution:

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.

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

Solution:

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. 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?

Solution:

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.

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 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.

Solution;

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

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;

(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 subobjectives 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.

BUSINESS ANALYSIS AND VALUATION TOOLS

Suggested Questions and Answers

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

Solution:

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:

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 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 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. What is accounting analysis. Explain those things that must be taken into consideration in performing accounting analysis.

Solution:

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 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

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. Differentiate between accounting and financial analysis

Solution:

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. Distinguish between big bath accounting and aggressive accounting

Solution:

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.

5. Explain the steps necessary in carrying out accounting analysis.

Solution:

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

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.

Accounting analysis: Accounting adjustments

Suggested Questions and Answers

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

Solution:

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

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

Solution:

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

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.

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

Solution:

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 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:

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

Solution:

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.

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

Solution:

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 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

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

Financial statement analysis and accounting ratios

Suggested Questions and Answers

1. Discuss the techniques for financial analysis.

Solution:

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 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. Discuss accounting ratios and list the four major groups of accounting ratios and their components.

Solution:

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.

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

• 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. Discuss the limitations of financial analysis (accounting ratios).

Solution:

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. 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

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.

• 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

• 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. Discuss the steps involved in financial analysis.

Solution:

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 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?

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?

5. Discuss the various types of financial analysis.

Solution:

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.

Strategic tax planning

Suggested Questions and Answers

1. Itemise the components of corporate tax planning.

Solution:

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. Discuss tax planning strategy and the three main tax planning strategies.

Solution:

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 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 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

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

• 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.

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. List the objectives for tax planning

Solution:

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. Discuss tax avoidance and tax evasion.

Solution:

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 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 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.

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. Discuss international tax planning, its objectives and strategies.

Solution:

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

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:

• 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.

Tax strategies for new business

Suggested Questions and Answers

1. Discuss sole proprietorship as a form of business enterprise, giving its advantages and disadvantages,

Solution:

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.

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;

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. Discuss partnership as a form of business enterprise, giving its advantages and disadvantages.

Solution:

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:

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

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. Discuss limited liability company as a form of business enterprise, giving its advantages and disadvantages.

Solution:

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;

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. 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.

Solution:

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

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.

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. Discuss the tax implication of each form of the three types of business enterprise.

Solution:

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

Types of Company Pros Cos

Sole Proprietorship Easy to set up

No double taxation.

Tax rate is low or since it is assessed on personal income basis with maximum rate of 24%. No personal limited liability protection

Cannot raise fund from the capital

Income reported on personal income tax return.

Partnership No double taxation

All income is taxed proportionately to each of the partners who report it on their personal tax returns.

Tax rate as in sole proprietorship. No personal limited protection (unless a limited partner in a limited partnership).

Limited Liability Company (Private and Public) Personal limited liability of members.

Double taxation since profit is taxed at company level and

dividends to shareholder is also

subject to WHT at 10%. Have a better access to fund from money market.

Can raise capital from the capital market, if it is a public limited liability company.

Taxation and business operating strategies

Suggested Questions and Answers

1. Discuss the reasons for gap in company’s accounting profit and tax profit.

Solution:

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.

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. Discuss deferred tax and how deferred tax always arise.

Solution:

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.

3. Discuss FIVE incentives available for businesses under the Nigeria tax regime.

Solution:

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);

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

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. List the tax free dividends incentives under the Nigeria tax regime.

Solution:

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.

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. List the purposes why the government going into tax treaty with other countries.

Solution:

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.

Distributions to business owners

Suggested Questions and Answers

1. Discuss how profits are taxed in a sole proprietorship and partnership business.

Solution:

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.

2. Discuss how profits are taxed and distributed to shareholders of limited liability companies.

Solution:

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. Discuss anti – avoidance scheme on payment of dividend to shareholders under the Nigerian Income Company Tax Act.

Solution:

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.

Strategies for business growth and expansion

Suggested Questions and Answers

1. List the various ways of growing a business.

Solution:

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. Discuss multiple entity business and the purpose for creating a multiple entity business.

Solution:

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.

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.

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. Discuss international business expansion and its advantages and disadvantages.

Solution:

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;

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. Discuss the various barriers that must be taken into consideration when expanding business internationally.

Solution:

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 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. In developing international market strategy, list the various things to be considered.

Solution:

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;

• 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.

Taxation and capital market activities

Suggested Questions and Answers