Revise lecture 26 1

IAS 18 Revenue 2

What is revenue? Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity. Revenue is measured by the fair value of the consideration received or receivable 3

Measurement of revenue The term revenue could apply in any of the following situations: 1.The supply of goods on cash or credit sale terms 2.The provision of services on cash or credit terms 4

Measurement of revenue 3. Rent received or receivable from equipment or property hired out 4. Interest or dividends received or receivable on a trade investment 5

Measurement of revenue Revenue should be measured at the fair value of the consideration received or receivable 1.If the sale is a cash sale, then the revenue is the immediate proceeds of sale. Allowance may be made for expected returns. 2.If the sale is a credit sale, i.e. a sale for a claim to cash, then anticipated cash is revenue. Allowance for irrecoverable debts and returns are usually computed as a separate exercise and disclosed separately. 6

Traditional approach to revenue recognition Traditionally, two conditions must be met before revenue can be recognised: 1.The revenue must be earned, i.e. the activities undertaken to create the revenue must be substantially completed. 7

Traditional approach to revenue recognition 2. The revenue must be realised, i.e. an event has occurred which significantly increases the likelihood of conversion into cash. This also means that the revenue must be capable of being verifiably measured. In most cases, realisation is deemed to occur on the date of sale. Thus, the date of the sale transaction is the moment that the revenue is recognised in the financial statements. 8

Revenues from the sale of goods According to IAS 18 Revenue, the following conditions must be satisfied before the revenue from the sale of goods should be recognised: 1. The seller has transferred the significant risks and rewards of ownership to the buyer. 9

Revenues from the sale of goods 2. The seller does not retain continuing managerial involvement to the degree usually associated with ownership and does not have effective control over the goods sold. 3. The amount of revenue can be measured reliably 4. It is probable that the economic benefits associated with the transaction will flow to the seller. 10

Revenues from the sale of goods 5. The cost incurred or to be incurred in respect of the transaction can be measured reliably. 11

Revenue from services Revenue from services should be recognised, according to the stage of completion at the reporting date, when all of the following conditions are me: 1.The amount of revenue can be measured reliably 2.It is probable that the economic benefits associated with the transaction will flow to the entity. 12

Revenue from services 3. The stage of completion of the transaction at the reporting date can be measured reliably 4. The cost incurred for the transaction and the costs to complete the transaction can be measured relaibly If these conditions are met, revenue should be recognised only to the extent of the expenses recognised that are recoverable 13

Interpreting financial statements 14

Interpreting financial information Financial statements on their own are of limited use. In this lecture we will consider how to interpret the financial statements and gain additional useful information from them. 15

Interpreting financial information Users of financial statements When interpreting financial statements it is important to ascertain who are the users of accounts and what information they need. Shareholders and potential investors, primarily concerned with receiving an adequate return on their investment, but interpreting financial information it must at least provide security and liquidity. 16

Interpreting financial information Users of financial statements Suppliers and lenders concerned with the security of their debt or loan. Management concerned with the trend and level of profits, since this is the main measure of their success. 17

Interpreting financial information Users of financial statements Other potential users include: Bank managers Financial institutions Employees Professional advisors to investors Financial journalists and commentators 18

Interpreting financial information Ratio analysis A number of ratios can be calculated to help interpret the financial statements. Some important ratios need to be consider: 1.Choose those relevant to the situation 2.Choose those relevant to the party you are analysing for 3.Make use of any additional information given the situation to help your choice 19

Interpreting financial information Further information needs Analyst will, in practice, be limited in the analysis that can be performed by the amount of information available. They are unlikely to have access to all facts which are available to a company’s management. 20

Interpreting financial information Commenting on ratios The following points should have as a useful checklist for commenting on ratios: 1.What does the ratio literally mean? 2.What does a change in the ratio mean? 3.What is the norm? 4.What are the limitations of the ratio? 21

Diagram 22

Interpreting financial information 1. Profitability ratios 2. Liquidity and working capital ratios 3.Long term financial stability 4.Investors ratios 5. Limitations of financial statements and ratio analysis 6.Related parties 23

Profitability ratios Gross profit margin or percentage is Gross profit / Sales revenue * 100% This is the margin that the company makes on its sales, and would be expected to remain reasonably constant. 24

Gross profit margin ratio Since the ratio is affected by only a small number of variables, a change may be traced to a change in: selling price sales mix purchase cost production cost inventory 25

Comparing gross profit margin over time If gross profit has not increased in line with sales revenue, you need to establish why not. Is the discrepancy due to: 1.Increased ‘purchase’ costs: if so, are the costs under the company’s control. 2.Inventory write-offs (likely where the company operates in a volatile marketplace, such as fashion retail 3.Other costs being allocated to cost of sales, for example, research and development expenditure. 26

Gross profit margin ratio Low margins usually suggest poor performance but may be due to expansion costs (launching a new product) or trying to increase market share. Lower margins than usual suggest scope of improvement. Above-average margins are usually a sign of good management although unusually high margins may make the competition keen to join in and enjoy the ‘rich pickings’. 27

Operating profit margin (net profit) ratio Can be calculated as: PBIT / Sales revenue * 100% Any changes in operating profit margin should be considered further: 1.Are they in line with changes in gross profit margin? 2.Are they in line with changes in sales revenue? 28

Operating profit margin (net profit) ratio 3. As many costs are fixed they need not necessarily increase/decrease with a change in revenue. 4. Look for individual cost categories that have increased/decreased significantly. 29

ROCE ratio ROCE = Profit / capital employed * 100% Profit is measured as: Operating (trading) profit, or The profit before interest and tax (PBIT) Capital employed is measured as: Equity + interest bearing finance 30

ROCE ratio ROCE for the current year should be compared to: 1.The prior year ROCE 2.A target ROCE 3.The cost of borrowing 4.Other companies ROCE in the same industry 31

Net asset turnover Sales revenue / Capital employed (net assets) = times pa It measures management’s efficiency in generating revenue from the net assets at its disposal The higher, the more efficient 32