CFA Practice Question

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CFA Practice Question

Which of the following would appear more favorable under the percentage-of-completion contract in the earlier stages of a contract?

A. Return on assets.
B. Cash flows from operations.
C. Construction costs.
D. Billings on construction contract.
Correct Answer: A

Cash flows, construction costs and billings on construction contract are all the same under either method. Income would be higher, making the return on assets larger under the percentage-of-completion method.

User Contributed Comments 13

User Comment
jike The cash flow won't change, since we are comparing two revenue recognition methods: a firm still receives cash from its customers in the middle of the project life cycle even if it uses complete contract method. The difference is when to recognize the revenue.
cfairs Would not cash flow be better too?
The very fact that % completion will permit to bill the client and assuming cash is received from client, cash flow should be better..

Now contrast this if you can't recognize the revenue and not bill the client till the completion of contract..
apiccion I think the question should clarify what is meant by 'favourable'.
golflover it means higher.
poomie83 ROA is higher due to the recognition of revenue which increases net income - the numerator in ROA formula
johntan1979 Under the indirect method, net income goes into the first line of cash flow from operating activities.

So B is also correct.
Gouldenone2 Return on assets is based on Net income. Any revenue recognized is matched with expense recognition as far as I am aware. Revenue comes in as cash as Asset and assets will be lower in early stage making the divisor smaller???
Shaan23 Gould

and if divisor is smaller that means ROA is higher. You answered your own question.
Shaan23 Where I'm confused is...doing the questions after this one --- Assets are higher in the earlier stages as well ---> which would make the denominator Increase --- Decreasing ROA.

Are we assuming the change in NI is greater then the change in Assets?
HolzGe1 Shaan, that's what I was thinking too. Inventory should increase by the same amount that revenue increases, but we're measuring NI / Assets.
1) Completed Contract (before completion):
Assets = 8 (costs only)
Revenue = 8 (the increase in assets)
Expenses = -5
NI = 8 - 5 = 3
ROA = 3/8 = 0.375

2) POC:
Assets = 10 (costs + profit margin)
Revenue = 10 (increase in assets)
Expenses = -5
NI = 10 - 5 = 5
ROA = 5 / 10 = 0.5

So although revenue increases along with assets, ROA is higher under POC.
holtz HolzGe: thank you based god
HarperWang My questions actually is what's the meaning of " would appear more favorable"..........
CJHughes "Appear more favourable" + "early stage". Would seem to me that the Completion Method would not have a +%ROA until Completion. So, % of Completion Method gives the "appearance" of a more favourable (higher) ROA earlier.
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