Many types of businesses — such as homebuilders and manufacturers — turn raw materials into finished products for customers. Production is a continuous process. So, any work that has been started but is not yet completed before the end of the accounting period is reported as work in progress (WIP) under U.S. Generally Accepted Accounting Principles (GAAP).
The value of WIP relies on management’s estimates. Auditors often give special attention to these estimates during fieldwork. Here is what to expect during a financial statement audit.
Inventory is classified as a current asset on the balance sheet under GAAP. There are three types of inventory:
1. Raw materials: These are tangible inputs that have been received from suppliers but have not yet been worked with. For example, a construction firm may have a supply of lumber and drywall in a warehouse that counts as raw materials.
2. Work in progress: This term refers to partially finished products at various stages of completion. Items classified as WIP still require further work, processing, assembly, and/or inspection. It includes raw materials, labor, and overhead allocations.
3. Finished goods: These items are fully complete. They may be ready for customers to purchase or, in the case of custom products, available for delivery or title transfer to customers.
Standard vs. Job Costing
When a company produces large volumes of the same product, management allocates costs as each phase of the production process is completed. This is known as ‘standard costing.’ For example, if a production process involves eight steps, the company might allocate 50 percent of its costs to the product once the fourth stage is completed.
On the other hand, when a company produces unique products — such as the construction of a factory or made-to-order parts — a ‘job costing’ system is typically used to allocate materials, labor, and overhead costs as incurred.
Most experienced managers use realistic estimates, but inexperienced or dishonest managers may inflate WIP values. This can make a company appear healthier than it really is by overstating the value of inventory at the end of the period and understating cost of goods sold during the current accounting period.
Eye on WIP
Auditors focus significant effort on analyzing how companies quantify and allocate their costs. Under standard costing, companies typically record inventory (including WIP) at cost, and then recognize revenue once they sell finished goods. The WIP balance grows based on the number of steps completed in the production process. Auditors analyze the methods used to quantify a product’s standard costs, as well as how the company allocates the costs corresponding to each phase of production.
Conversely, with job costing, revenue recognition happens based on the percentage-of-completion or completed-contract method. Auditors analyze the process to allocate materials, labor, and overhead to each job. In particular, they test to verify that costs assigned to a particular product or project correspond to that job.
Get it Right
Under both methods, accounting for WIP affects the balance sheet and the income statement. We can help determine whether your company’s WIP estimates are reasonable and whether your accounting practices comply with the recent changes to the revenue recognition rules for long-term contracts, if applicable. Contact us for more information.