Chapter 6

Internal Control and Financial Reporting for Cash

and Merchandise Sales

Learning Objectives1. Distinguish among service, merchandising, and

manufacturing operations.2. Explain common principles and limitations of internal

control.3. Apply internal control principles to cash receipts and

payments.4. Perform the key control of reconciling cash to bank

statements.5. Explain the use of a perpetual inventory system as a

control.6. Analyze sales transactions under a perpetual inventory

system.7. Analyze a merchandiser’s multistep income statement.

Operating Cycles

CollectCash

CollectCash

IncurOperatin

gExpenses

IncurOperatin

gExpenses

Service Company

SellServices

SellServices

Operating Cycles

CollectCash

CollectCash

IncurOperatin

gExpenses

IncurOperatin

gExpenses

BuyProducts

BuyProducts

MerchandisingCompany

SellProducts

SellProducts

Operating Cycles

SellProducts

SellProducts

CollectCash

CollectCash

IncurOperatin

gExpenses

IncurOperatin

gExpenses

Buy RawMaterialsBuy RawMaterials

MakeProducts

MakeProducts

ManufacturingCompany

Internal ControlAll companies include as part of their operating

activities a variety of procedures and policies that are referred to as internal controls.

All companies include as part of their operating activities a variety of procedures and policies that

are referred to as internal controls.

Internal controls are the methods a company uses to:1. Protect against the theft of assets.2. Enhance the reliability of accounting

information.3. Promote efficient and effective operations.4. Ensure compliance with applicable laws

and regulations.

Common Control PrinciplesPrinciple Explanation Examples

Establish responsibility Assign each task to only one person.

Each Wal-Mart cashier uses a different cash drawer

Segregate duties Do not make one employee responsible for all parts of a process.

Wal-Mart cashiers, who ring up sales, do not approve price changes.

Restrict access

Do not provide access to assets or information unless it is needed to fulfill assigned responsibilities.

Wal-Mart secures valuable assets such as cash and access to its computer systems (passwords, firewalls).

Document procedures Prepare documents to show activities that have occurred.

Wal-Mart pays suppliers using prenumbered checks.

Independently verify

Check others' work. Wal-Mart compares cash balances in its accounting records to the cash balances reported by its bank, and accounts for any differences.

Control Limitations

Internal controls can never completely prevent and detect

errors and fraud.

Benefits vs. CostHuman Error or

Fraud

Controlling and Reporting Cash

Internal control of cash is important to any organization.

Volume of cash is enormous.

Cash is valuable and “owned” by

person possessing it.

Cash Received in Person

Segregate Duties

Cashier

Custody

Recording

Cash Received in Person

Cash Received in Person

Cash Received from a Remote Source

Cash Received by Mail

Cash Received Electronically

Cash Payments

Cash Payments

Writing a Check

Electronic Funds

Transfer

A voucher system is a process for approving and documenting all purchases and

payments on account.

Most companies pay cash to their employees through EFTs, which are known

by employees as direct deposits.

Bank Procedures and Reconciliation

Banks provide services that help businesses to control cash in several ways:

Restricting Access

Documenting Procedures

Independently Verifying

A bank reconciliation is an internal report prepared to verify the accuracy of both the bank statement and the cash accounts of a

business or individual.

Bank Statement

1

2 3 4 5

Reconciling Differences

You May Not Know About . . .3. Interest the bank has put into your account.4. Electronic funds transfer (EFT)5. Service charges taken out of your account.6. Customer checks you deposited but that bounced.7. Errors made by you.

Your Bank May Not Know About . . . 1. Errors made by the bank. 2. Time lags: a. Deposits that you made recently. b. Checks that you wrote recently.

Bank ReconciliationTo determine the appropriate cash balance, these balances need to be

reconciled.

Bank Reconciliation

Bank Reconciliation Goals1.Identify the deposits in transit. 2.Identify the outstanding checks. 3.Record other transactions on the bank statement.4.Determine the impact of errors.

Bank Reconciliation

Reporting Cash and Cash Equivalents

Cash includes money or any instrument that banks will accept for

deposit and immediate credit to a company’s account, such as a check,

money order, or bank draft.

Cash equivalents are short-term, highly liquid investments purchased

within three months of maturity.

Controlling and Reporting Merchandise Sales

Inventory Quantities

Inventory Costs

Financial Statements

Unsold Inventory

Balance Sheet

Sold Inventory

Income Statement

Perpetual Inventory System

In a perpetual inventory system, the inventory records are

updated “perpetually,” that is, every time inventory is bought,

sold, or returned. Perpetual systems often are combined with bar codes and optical

scanners.

Periodic Inventory SystemIn a periodic inventory system,

the inventory records are updated “periodically,” that is, at the end of the accounting period. To determine

how much merchandise has been sold, periodic systems require that inventory be physically counted

at the end of the period.

Inventory Control

Perpetual Inventory System

Continuous Tracking

Can Estimate

Shrinkage

Periodic Inventory System

No Up-to-Date

Records

Can’t Estimate

Shrinkage

Sales TransactionsMerchandisers earn revenues by transferring

ownership of merchandise to a customer, either for cash or on credit.

For a merchandiser who is shipping goods to a customer, the transfer of ownership occurs at one of two possible times:1. FOB shipping point —the sale is recorded when the

goods leave the seller’s shipping department.2. FOB destination —the sale is recorded when the

goods reach their destination (the customer).

Sales TransactionsEvery merchandise sale has two components, each of which requires an entry in a perpetual

inventory system.Selling Price

Cost

Sales TransactionsAssume Wal-Mart sells two Schwinn mountain bikes for $400 cash. The bikes had previously been recorded in Wal-Mart’s Inventory at a total

cost of $350.

Assets = Liabilities + Stockholders' Equity(a) Cash +400 Sales Revenue (+R) +400(b) Inventory -350 Cost of Goods Sold (+E) -350

1 Analyze

2 Record

Sales Returns and Allowances

When goods sold to a customer arrive in damaged condition or are otherwise

unsatisfactory, the customer can (1) return them for a full refund or

(2) keep them and ask for a reduction in the selling price, called an

allowance.

Sales Returns and AllowancesSuppose that after Wal-Mart sold the two Schwinn mountain bikes, the customer returned one to Wal-Mart. Assuming that the bike is still like

new, Wal-Mart would refund the $200 selling price to the customer and take the bike back into inventory.

Assets = Liabilities + Stockholders' Equity(a) Cash -200 Sales Returns and Allowances (+xR) -200(b) Inventory +175 Cost of Goods Sold (-E) +175

1 Analyze

2 Record

Sales on Account and Sales Discounts

A sales discount is a sales price reduction given to customers for prompt payment of

their account balance.

Sales on Account and Sales Discounts

Suppose Wal-Mart’s warehouse store (Sam’s Club) sells printer paper on account to a local business for $1,000 with payment terms of 2/10, n/30.

The paper cost Sam’s Club $700.

Assets = Liabilities + Stockholders' Equity(a) Accounts Receivable +1,000 Sales Revenue (+R) +1,000(b) Inventory -700 Cost of Goods Sold (+E) -700

1 Analyze

2 Record

Sales on Account and Sales Discounts

To take advantage of this 2% discount, the customer must pay Wal-Mart within 10 days. If the customer does so, it will deduct the $20 discount (2% $1,000) from the total owed ($1,000), and then pay $980 to Wal-

Mart.

Assets = Liabilities + Stockholders' EquityCash +980 Sales Discounts (+xR) -20Accounts Receivable -1,000

1 Analyze

2 Record

(2% × $1,000)

Summary of Sales-Related Transactions

The sales returns and allowances and sales discounts introduced in this section

were recorded using contra-revenue accounts.

Gross Profit Percentage

GrossProfit %

=Gross ProfitNet Sales

× 100

Comparing Operating Results Across Companies and Industries

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0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%40.0%

Gross Profit Percentage by Industry

0.0%

2009 2008 2007

Wal-Mart’s Gross Profit Percentage

In class problem #1: Bank reconciliationThe June bank statement indicates a balance of $10,638, while

the cash ledger account on that date shows a balance of $11,391. Additional information is:

Deposits in transit $1,800. Bank service charge $6 Interest received from the bank $20. Outstanding checks $960. NSF (not sufficient fund) check of a customer $18 EFT (electronic funds transfer) received from a customer $100. Check No. 104 in payment of an accounts payable cleared the

bank for $65 but was erroneously recorded in our books as $56.

Prepare a bank reconciliation, and give any reconciling journal entries that should be made as a result of the bank reconciliation.

In class problem #2The following transactions were selected from the records of

Evergreen Company:

July 12: Sold merchandise to Sally, who paid $1,000 cash. The goods cost Evergreen $600.

July 15: Sold merchandise to Claudio’s Chair Company at a selling price of $5,000 on account with terms 3/10, n/30. The goods cost Evergreen $3,500.

July 16: Claudio’s Chair Company returned $500 merchandise (original cost of the merchandise was $350) for full credit.

July 21: Collected payment from Claudio’s Chair Company

Requirement: 1) Prepare journal entries for the above transactions.2) Compute net sales and cost of goods sold in July.

In class problem #3Prepare JEs for both Dayton Company and Matrix Company:

Oct. 5: Dayton purchased goods with an invoice price of $100 from Matrix with terms of 2/10, n/30. The goods had cost Matrix $70.

Oct 7, Dayton returned 10% of the purchase of Oct 5 to Matrix for full credit.

Oct. 10: Matrix received payment from Dayton (within discount period)