External auditors spend a lot of time during fieldwork evaluating how businesses report work in progress (WIP) inventory. Here’s why this warrants special attention and how auditors evaluate whether WIP estimates seem reasonable.
Valuing WIP
Companies may report various categories of inventory on their balance sheets, depending on the nature of their operations. For companies that convert raw materials into finished goods, a key element is WIP inventory. This refers to partially finished products at various stages of completion. Management uses estimates to determine the value of WIP. In general, the more materials, labor and overhead invested in WIP, the higher its value.
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.
Accounting for costs
Companies assign costs to WIP depending on the type of products they produce. When a company produces large volumes of the same product, they allocate costs as they complete each phase of the production process. This is known as standard costing. For example, if a production process involves six steps, at the completion of step two the company might allocate one-third of their costs to the product.
On the other hand, when a company produces unique products — such as the construction of an office building or made-to-order parts — it typically uses a job costing system to allocate materials, labor and overhead costs as incurred.
Auditing WIP
Financial statement auditors closely analyze how companies quantify and allocate their costs. Under standard costing, the WIP balance grows based on the number of steps completed in the production process. Therefore, 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 the process.
With job costing, auditors analyze the process to allocate materials, labor and overhead to each job. In particular, auditors test to ensure that costs assigned to a particular product or projects correspond to that job.
Recognizing revenue
Auditors perform additional audit procedures to ensure that a company’s recognition of revenue complies with its accounting policies. Under standard costing, companies typically record inventory (including WIP) at cost, and then recognize revenue once they sell the products. For job costing, revenue recognition typically happens based on the percentage-of-completion or completed-contract method.
Get it right
Under both the standard and job costing methods, accounting for WIP affects the balance sheet and the income statement. Contact us if you need help reporting WIP. We can help you make reliable estimates based on your company’s specific production process.