This month we switch to a not so interesting but necessary and important accounting topic, the dreaded Work in Progress (WIP). This article will show how WIP can be easy and more importantly, very useful.
WIP in a project environment can be messy, difficult, and time-consuming to nail down, however once set up will produce great results.
Different approaches can be used:
- Ignore it altogether. This understates a company’s worth and profitability.
- After a bank or investors demand an update; try to count labour and material for incomplete projects on large spreadsheets.
- Accurate monthly update with minimal effort. How-to below...
Understanding true profit for a project business can be difficult, because project costs can incur months before invoicing.
Let’s look at the Profit and Loss (P&L) accounts for the ‘Sprawling Global Project Company Ltd’. They spend $5,000 on Project X in one month and invoice $10,000 in the next month.
|Month 1||Month 2|
|Direct (Project) Costs||$5,000||0|
|Gross Profit (Sales – Costs)||$(5,000)||$10,000|
It’s not possible to understand a true profit for each month by reading the P&L. Understanding company profitability for multiple projects, with extended execution times, progress (milestone) payments and deposits, especially if they cross over financial years, is very difficult, because costs do not match revenue in the same accounting period.
For this reason, major international accounting standards such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) have cost-matching principles, mandating companies report costs at the same time as the revenues they are related to. Using this principle, Mr. Been, SGPC Ltd.'s CFO, can report results in one of two ways,
1. Defer cost reporting to the same time-period as the invoice. Use this if most invoicing is done after the costs are incurred.
|Cost Recognition Method||Month 1||Month 2|
|Direct (Project) Costs||$5,000|
|Gross Profit (Sales – Costs)||$5,000|
2. Defer reporting of revenue if most of your invoicing - deposits and progress payments, are invoiced before costs are incurred. Larger project companies with conservative accounting will use this method.
Cautionary tale: the collapse of Enron, $60 Bn of assets and the dissolution of, at that time, a tier-one accounting practice, Arthur Andersen, was triggered by the opposite (fraudulent) practice of recognising all the revenue for new long-term contracts immediately on their P&L, before any milestone invoicing. It was done to overstate profitability and boost share price. Cost mismatching was not the best idea.