Builders: Why work in progress accounting may be the answer you’re looking for
Construction is a unique business. Typically, a build can stretch over numerous reporting periods, presenting significant accounting challenges.
Work in progress accounting (WIP) may be the best way for your business to manage these challenges.
Let’s look at what WIP is and then an example of how it can help.
What is work in progress accounting?
Work in progress accounting is a technical accounting method used to represent a fair/true profit position in each respective reporting period.
Without using this method, each reported profit would be heavily dependent on the timing of invoicing – both the issuing of invoices to clients and the receipt of invoices from suppliers and contractors.
In short, accountants like to use this method because it shows a more accurate profit position of your business at any given point in time. A WIP figure can be used whenever a build stretches over reporting periods e.g. over two financial years.
Given that builds can be varied in terms of when costs are incurred by the business and when the client is invoiced, the financial position of the business ‘on paper’ will also vary. Often, a business can appear to be less profitable than it actually is. This affects how favourably a business is perceived by financial institutions, e.g. banks for loan applications or by Warranty for limit increases.
Like many aspects of accounting, the benefits of work in progress accounting are perhaps best illustrated with an example…
Are you in Billy the Builder’s situation?
Billy the builder has a contract to build a new home. The contract value is $1m and Billy expects it to cost $800k and take 12 months to complete, commencing 1st January.
Here’s what happens WITHOUT work in progress accounting…
On 30th June, the banks and Warranty Insurance are waiting to see the accounts.
Billy is making good progress on the build with no unforeseen delays. He expects to complete it on schedule. As of 30th June, Billy has invoiced the client $380k and incurred costs of $400k.
Without WIP reporting, Billy would be showing a loss on the job of $20k (very simple math: income of $380k the minus cost of $400k equals $20k loss.)
If everything went to plan and the job was finalised according to schedule, Billy would incur a further $400k of cost and bill a further $620k to his client in the second six-month period. The reported profit for the period would be $220k.
Billy was halfway through the job at 30th June, yet he reported a loss of $20k versus a $220k profit in the second period.
This means that Billy’s position with a bank or Warranty would be unfairly understated in the first year – potentially preventing loan applications or Warranty limit increases.
Work in progress reporting can be used to fix that…
Here’s what happens WITH work in progress accounting…
Taking another look at Billy’s job profit using WIP reporting, at 30th June Billy is exactly halfway through the job. This can be easily seen as he has spent $400k on costs and he expects the total build to cost $800k.
With work in progress accounting, because you’ve completed half the work, you report half the profit.
Simplistically, as the job is half-complete, Billy needs to recognise half the total income, being $500k (50% x $1m). But he has only invoiced for $380k, so he needs to adjust this for the $120k difference.
Billy, therefore, recognises an additional $120k income on 30th June, resulting in a reported profit of $100k for the first six months.
The WIP adjustment is balanced out in the following six months, resulting in a reported profit of $100k for that period.
See the difference that work in progress accounting can make?
For the same job, with combined profit the sam,e under both scenarios, work in progress accounting results in a “smoothing” of the profit between the two reporting periods.
The timing of the invoicing doesn’t impact on the orted profit; WIP simply adjusts it to make the reported profit fair.
Better yet, not only does WIP improve the Profit & Loss, it is also considered an asset on your balance sheet, which Warranty will count towards your business’s financial strength.
You can make your work in progress accounting as simple as possible by following these basic guidelines:
- Use Xero or similar accounting software, which will allow your accountant easy access to the data;
- Track your job income and costs, again using Xero or similar to make it simple;
- Be vigilant with contract values and expected costs to complete, which just makes good business sense anyway;
- Use the WIP calculation template that the insurer provides. Without an approved template, Warranty will not count the WIP asset towards your financial strength.