Labor can be a tricky topic in accounting journals, especially on the balance sheet. Most students learn that labor and wages are a cost item on the profit and loss statement (P&L). However, labor expenses appear on the balance sheet as well, and in three notable ways: wages payable, works in progress, and capitalized expenses.
- Wages payable – current liability account
- Works in Progress (a.k.a WIP) – current asset account
- As a capitalized expense – long term asset account
Wages payable are the current liability account that holds salaries waiting to be paid, usually at the end of the month. When we record a sale on the P&L, we list the indirect labor costs used to generate it on the P&L as well. But if we don’t actually pay the salaries at that time, we record them in the Wages payable liability account on the balance sheet.
Understanding these wages is critical to the company’s margins. Inventory is not just raw materials purchased and resold at a higher price. Instead, raw materials that the company purchases are “reworked” by employees before becoming sales, which allows them to be sold at a higher value.
In other words, employees’ salaries are a labor cost that must be considered as part of the raw materials’ transformation. More specifically, these labor costs are included as part of the inventory asset on the balance sheet in an account called Works in Progress (WIP).
You should also be careful to remember that WIP become normal inventory on the balance sheet before they are sold. The inventory value itself become COGS, whereas the margin on top of the raw materials becomes gross profit on the P&L. On the balance sheet it’s another asset altogether — either cash or accounts receivable. If this sounds complex, don’t worry, we’ll run through examples and journal entries below.
Of the three ways labor shows on the balance sheet, wages payable and works in progress are connected. However, capitalized labor expense is an independent concept. It refers to the way in which labor that produces long-term assets can be capitalized on the balance sheet, meaning the current period’s book record of labor is only a portion of the total value created in the current period. This technique helps companies maximize their net profit.
In this article, we’ll walk through some accounting journal entries to make sure we really understand what’s happening with wages payable and works in progress. Then we’ll cover how capitalized expenses help a company maximize profits.
At the end, you’ll be able to explain the inventory journey and explain how the financial statements remain in balance throughout, with particular attention to labor and its movement on the balance sheet.
Conceptual Journey of Inventory & Wages Across Financial Statements
At its core, inventory is nothing more than raw materials purchased by the company and transformed into a sellable product or service. The way this plays out on the balance sheet is that raw materials are added as a current asset — but NOT yet inventory — and accounts payable is credited.
You can think of this as the “load up” phase in which liability accounts are concerned. Until we pay down those short term obligations, we won’t need the liabilities again in our inventory journey. The next step is to get those raw materials to another current asset account called Works in Progress.
|Asset and P&L Movements||Liability Movements|
|Raw materials||Accounts payable (load up)|
|Raw materials to Works in Progress||Wages payable (load up)|
|Works in Progress to Inventory||No liability change|
|Inventory to COGS on P&L, leads to Cash increase||No liability change|
|Decrease in cash||Decrease in accounts payable/wages payable (load down)|
You don’t need to modify liabilities since this is just a transfer of assets from one asset account to another. However, since employees are going to work on the raw materials to transform them into a sellable product, you need to add their wages to the WIP account. We do this by debiting the WIP account and crediting the Wages payable account, as well as debiting the wages expense account.
Now we have both raw materials and wages in our WIP account, which we then need to transfer to the inventory account as products are completed. Since this is an asset to asset transfer, we don’t make any changes to liabilities.
Finally, the company can sell the inventory. At this point, we need to credit (decrease) inventory for every sale we make. This increases cash or accounts payable not only by the value of the inventory, but also by the margin we make on it. The decrease to inventory value and increase in cash value (COGS + margin) will lead to a net positive change in total assets, the margin will later be included as retained earnings in the equity portion of the balance sheet, thereby balancing it.
For example, imagine you have 10 apples purchased at $1 each that you sell for $1.50. Inventory starts at $10. The sale of these apples resulted in balance sheet movements of +$15 in cash and -$10 in inventory. Your assets thus undergo a +$5 net change. Now there’s an imbalance — assets are higher than liabilities. These +$5 are the same as your profit on the P&L, which will become retained earnings in equity, balancing your balance sheet.
Finally, any accounts payable and wages payable we earlier credited (when debiting raw materials and wages to assets) should be debited once they are paid. This means cash will also be credited, thereby balancing our balance sheet.
Example of Inventory Journey Using Journal Entries
To best understand the specific journal entries related to inventory, as well as the relevant labor costs, let’s look at an example of a manufacturing company.
Manufacturing Company Example
Imagine you work for a watch manufacturing company called Watch World. You only make one watch because it sells so well and with such a good gross margin (30%).
Each month, you receive raw materials in the amount of $50,000. Typically, you resell them at $65,000 the month after. You have a team of laborers that work on the watch during that time whose salaries total $5,000, which means this is a case of inventory that starts as raw materials, becomes works in progress, and finishes as inventory and COGS. How would this look in terms of journal entries? Let’s see.
|Step||Debit (Dr) / Credit (Dr)||Account type||Value Direction||Financial Statement|
|1. Purchase Raw Materials||Dr Raw materials 50,000||Asset||↑||Balance sheet|
|Cr Accounts payable 50,000||Liability||↑||Balance sheet|
|2. Work starts on raw materials||Dr Works in progress 50,000||Asset||↑||Balance sheet|
|Cr Raw materials -50,000||Asset||↓||Balance sheet|
|Dr Works in progress 1,500||Asset||↑||Balance sheet|
|Cr Wages payable 1,500||Liability||↑||Balance sheet|
|3. Finish work on raw materials||Dr Inventory 51,500||Asset||↑||Balance sheet|
|Cr Works in progress 51,500||Asset||↓||Balance sheet|
|4. Sell inventory||Dr Cost of Sales 51,500||Cost||↑||Profit and loss|
|Cr Inventory 51,500||Asset||↓||Balance sheet|
|Dr Cash 65,000||Asset||↑||Balance sheet|
|Cr Sales 65,000||Income||↑||Profit and loss|
|Cr Retained earnings 13,500||Equity||↑||Balance sheet|
In addition to these steps, we could also note that our accounts payable and wages payable liability accounts still have a balance of 51,500. In an additional entry, we would pay those down with cash.
Labor as a Capitalized Expense
We’ve seen that labor appears on the balance sheet as wages payable and in Works in progress, as well as part of inventory. There’s a third way: capitalized expenses.
To understand capitalized expenses, you need to know what depreciation and amortization are. When a company buys a big asset, such as a building, it doesn’t include the cost of the building in one period on the profit and loss statement.
Instead, it will divide the cost of the building by a small whole number such as 3 or 5 and expense the building by that fraction over the next 3 or 5 years. The reason they do this is to avoid showing a very poor financial performance in one period when the value of the building lasts many years. This is depreciation. Amortization concerns intangible assets.
Sometimes, in very specific cases, companies can do the same with salaries and wages. We won’t go into the details on how and when this is allowed. Just know that when they do, this is the final way labor can appear on the balance sheet — as a capitalized expense.