Question

Your company has just adopted a just-in-time philosophy, allowing it to combine all parts of an order and it is sold as soon as it is completed. You notice two of the plants estimate their ending Work-in-Process inventories at 80%. This allows the plant managers to meet their profit goals and receive a bonus. The managers feel calculating the percent complete takes judgement and they will finish the Work-in-Process inventory first thing next year. Evaluate the manager’s reasoning and explain the effects this could have on the current and future year’s financial statements. Include any ethical issues created by the managers. Identify the options your company has, and what consequences does this create for the company.

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Answer 1

Solution:

Merchandise business who buys and sells inventory need not worry about the concept of work in progress. Accurately evaluating the work in progress is very important when it comes to manufacturing industries. There are two types of inventories in the manufacturing industries one is partially completed inventories and the other one to finished inventories. Finished inventories are ready for sale inventories in which the production process is completed. Work in progress inventories are the materials that are processed for production but not completed. The direct material cost associated to work in progress inventory is 100%, direct labour cost associated to the work in progress inventory is in accordance to percentage of work in progress inventory’s completion, and allocated overhead cost is also traceable to extent of work in progress inventory’s completion.

The ending inventory valuation of work in progress is very important in the financial statement because part of total production cost is used for work in progress inventory. The work in progress inventories appears under the current asset side of the balance sheet and all the expenses (such as allocated overhead) that is associated with production of work in progress inventory are accounted in the income statement.

Evaluating management reasoning:

Every production management aims for optimal production. Optimal production is seen when the finished inventories are maximized and work in progress inventories are minimized. If more work in progress inventories are there then the cost associated to store work in progress inventories will increase. The cost such rent for warehouse, utilities expense to preserve, man power and other cost involved to store will increase. These costs have to be accounted in the calculation of work in progress inventories. The finance of the business will be blocked in storing work in progress inventories. Therefore, management prefer to show less work in progress inventories.

Effect in the current financial statements:

Here it is observed that ending work in progress inventory is valued at 80% by 2 of the plants. That means the cost of production associated to work in progress inventories are valued at 80%. As the total cost of production remains unchanged, major part of the cost will be accounted for finished inventories. This will increase the cost of goods sold and reduce the gross profit for the company. The gross profits, operating profit and net profit shown in the financial statement is undervalued. The tax calculated on the operating profit is incorrect. The ending inventory of work in progress in the balance sheet is also undervalued. It is also observed that the cost associated to store the work in progress inventories is also accounted for finished goods inventories in the current financial statement.

Effect in the future financial statements:

The management decides to finish the work in progress inventory as a first thing next year. The opening work in progress inventories is under valued in the future financial statement. This will lead to incorrect calculation of future cost of goods sold, gross profit, operating profit, tax calculation and net profit.

Ethical issue created by the management and the consequences:

This is considered as fraud and risk in the misrepresentation of financial statement. The management will be held accountable for the fraud. The incorrect presentation of financial statement gives a wrong picture to the shareholders of the company and government official in tax calculation. Financial statement evaluated by bank for loan is incorrect and bank will not approve loan based on the incorrect financial statement presented.

Option the company has:

The management has to evaluate the closing work in progress inventory accurately and have to account for all the cost associated to store the closing work in progress inventory to closing work in progress inventory. The opening work in progress inventory will not be undervalued in the future financial statements. The management have to optimise the production process so that more finished inventories are produced and sold and less work in progress inventories have to be accounted.