CFA Level 1

AAA

Financial Statements - Revenue Recognition Effects on Cash Flows and Financial Ratios

Both methods - the percentage-of-completion and completed-contract methods - produce the same net cash flow effect.

Cash Flow Effects

  • Percentage-of-completed contract method
    • Net income (NI) will be higher in the first years and lower in the last year.
    • Net Income will be less volatile.
    • Total assets will be greater.
    • Liabilities will be lower.
  • Completed contract method
    • Net income will be nonexistent in the first years and higher in the last year.
    • Net income will be very volatile.
    • Total assets will be smaller.
    • Liabilities will be higher (no recognition of retained earnings).
    • Stockholders equity will be lower.
    • Stockholders equity will be more volatile.

Impact on Financial Ratio

Ratio Formula % of Completion Method Reason Completed Method
Current Ratio

Current Assets
Current Liabilities

Higher Construction in progress includes portion of estimated profits Lower
Revenue
Turnover

Revenues
Average Receivables

Higher Revenues are reported Lower - Not measurable prior to completion
Assets to Equity

Total Assets
Equity

Higher Retained earnings are reported Lower - Not measurable prior to completion
Total Debt Ratio

Total Liabilities
Total Liabilities + Total Equity

Lower Liabilities are smaller and the denominator includes equity which is higher Higher


The Cash Flow Statement
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