CFA Level 1

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






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