If you work in an industry that takes raw materials and turns them into products for your customers, you know that production is a continuous process. Under U.S. Generally Accepted Accounting Principles (GAAP), any work you’ve started but haven’t yet completed by the end of the accounting period must be reported as work in progress (WIP).
The reported value of WIP depends on estimates made by management, and these estimates are often given special attention by auditors during a financial statement audit. Here’s a quick guide on what to expect.
Inventory classification
Under GAAP, inventory is classified as a current asset. Inventory falls into three categories:
Raw materials
Inventory is classified as raw materials if it consists of tangible inputs that have been received from suppliers but haven’t been worked with yet—a supply of lumber and drywall in the warehouse of a construction firm, for example, would count as raw materials.
Work in progress (WIP)
Partially finished products that still require further work, processing, assembly, and/or inspection are classified as work in progress. WIP includes allocations for raw materials, labor, and overhead.
Finished goods
Finished goods are fully complete items which are ready for purchase by customers (or are available for delivery or title transfer to customers in the case of custom products).
Two ways of allocating costs
One method of allocating costs, known as standard costing, is typically used by companies that produce large volumes of the same product. Management at companies using standard costing will allocate costs as each phase of the production process is completed—so if a production process requires four steps, 50% of the product’s costs might be allocated to the product once the second stage is completed.
Another method, known as job costing, is typically used by companies that are producing unique products, like made-to-order parts or the construction of a factory. Unlike standard costing, job costing allocates materials, labor, and overhead costs as they are incurred.
While the majority of experienced managers use realistic estimates, dishonest or inexperienced managers may inflate the value of WIP inventory. Overstating the value of inventory at the end of an accounting period and understating the cost of goods sold during the current accounting period can make a company appear healthier than it actually is.
Auditors and WIP
Auditors place a significant emphasis on analyzing the way a company quantifies and allocates costs. Companies using standard costing typically record inventory (including WIP) at cost and recognize revenue after they’ve sold the finished goods, and the WIP balance grows depending on the number of completed steps in the production process. During an audit, an analysis will be made of the methods the company uses to quantify a product’s standard costs. Auditors will also look at the way the company allocates costs corresponding to each phase of production.
By contrast, companies using job costing recognize revenue based on the percentage-of-completion or completed-contract method. In this case, auditors will make an analysis of the process the company uses to allocate materials, labor, and overhead to each job. They will also specifically test to make sure that costs assigned to a particular job actually correspond to that product or project.
Questions? We can help
Regardless of the method used, accounting for WIP will affect your balance sheet and income statement. We can help you ensure that your company’s WIP estimates are reasonable—and assist you in staying compliant with recent changes to revenue recognition rules for long-term contracts. For more information, contact us today.