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
Consu
mer
Ele
ctro
nics
Drug
Stor
e
Non-a
lcoho
lic B
ever
ages
Oil an
d Gas
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)