Chapter 6

Internal Control and Financial

Reporting for Cash and
Merchandising Operations
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 This Chapter focuses
on companies that
sell MERCHANDISE to
customers, and the
way they control and
report their
operating results.
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 Learning Objectives

1. 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.

3
Distinguish among service,
merchandising, and
manufacturing operations

4
 Operating Cycles for Service, Merchandising,
and Manufacturing Companies
Sell
Services
Service Company
Collect
Cash

Incur
Operating
Expenses
5
Operating Cycles for Service, Merchandising,
and Manufacturing Companies
Sell
Products

Merchandising
Buy Collect
Company
Products Cash

Incur
Operating
Expenses
6
Operating Cycles for Service, Merchandising, and
Manufacturing Companies
Sell
Products

Manufacturing
Makes Collect
Company
Products Cash

Incur
Buy Raw
Operating
Materials
Expenses
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Explain common principles
of internal control

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 Internal Control
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 designed to:

- Protect against theft of assets,
- enhance the reliability of accounting information,
- promote efficient and effective operations, and
- ensure compliance with applicable laws and regulations.

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 Principles of Internal Control
Principle Explanation
Assign each task to only one
Establish responsibility
employee
Do not make one employee
Segregate duties
responsible for all parts of a process
Do not provide access to assets or
Restrict access information unless it is needed to
fulfill assigned responsibilities.
Prepare documents to show activities Wal-Mart pays supplies using
Document procedures
that have occurred.
Independently verify Check others' work.
Example
Each Wal-Mart cashier uses a
different cash drawer
Wal-Mart cashiers, who ring up sales,
do not also approve price changes.
Wal-Mart secures valuable assets
such as cash and restricts access to its
computer systems (via password,
firewalls).
prenumbered checks.
Wal-Mart compares the cash balances
in its accounting record to the cash
balances reported by its bank, and
accounts for any differences.
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 Control Limitations
Internal controls can never completely prevent
and detect errors and fraud for two reasons:
1. An organization will implement internal
controls only to the extent that their benefits
exceed their costs.
2. Internal controls can fail as a result of human
error or fraud.

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 Apply internal control
principles to cash
receipts and payments

12
 Applications of internal control
principles to cash receipts
Internal control principles require that:
1. Cashiers be held individually responsible for the cash they receive,
2. Different individuals be assigned to receive, maintain custody of,
and record cash,
3. Cash be stored in a locked safe until it has been securely deposited
in a bank,
4. Cash register receipts, cash count sheets, daily cash summary
reports, and bank deposit slips be prepared to document the cash
received and deposited, and
5. Cash register receipts be matched to cash accounts and deposit
slips, to independently verify that all cash was received and
deposited. 13
 Applications of internal control principles
to cash receipts
Which principles
associated with each
1. Just one employee 2. Cash receipts are
box?
received cash. summarized and their
total is calculated.

3. A different
employee deposits
the cash at the bank.
5. A manager
compares 2 with 4.
4. The bank stamps
the deposit slip.

6. No other employees are allowed

to handle cash.
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 Applications of internal control principles
to cash payments
Internal control principles require that:
1. Only certain individuals or departments initiate purchase
requests,
2. Different individuals be assigned to order, receive, and pay for
purchase,
3. Access to checks and valuable property be restricted,
4. Purchase requisitions, purchase orders, receiving reports, and
prenumbered checks be used to document the work done, and
5. Each step in the payment process occurs only after the preceding
step has been independently verified using the documents listed
in (4).
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 STEPS DOCUMENTATION
Request that goods or Purchase requisition
services be ordered
Order goods or services Purchase order
Receive goods or services Receiving report
Obtain bill for goods and Supplier invoice
service
Write check to pay the bill Company check

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Perform the key control of
reconciling cash to bank
statements

17
 Internal Control
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 designed to:

- Protect against theft of assets
- Enhance the reliability of accounting information
- Promote efficient and effective operations
- Ensure compliance with applicable laws and regulations

18
19
20
 Need for Bank Reconciliation
One effective internal A bank reconciliation is a
control over cash is the key internal control
bank reconciliation. because it provides
The bank reconciliation independent verification
identifies differences of all cash transactions
between the book balance that the bank has
for cash and the cash in processed for the
the bank account. company.

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 Reconciling Differences
The bank reconciliation requires determining two
categories of items:
1. Those that have been recorded in the company’s books
but not in the bank’s statement of account.
2. Those that have been reported in the bank’s statement of
account but not in the company’s books.

Your bank may not know about . . .
Errors made by the bank.
Time lags:
Deposits that you made recently.
Checks that you wrote recently.
You may not know about . . .
Interest the bank has put into your account.
Electronic funds transfers (EFTs)
Service charges taken out of your account.
Customer checks you deposited but that bounced.
Errors made by you.

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 Bank Reconciliation

Let’s prepare a June 30 bank

reconciliation statement for WMT. The
June 30 bank statement indicated a
balance of $10,638.40, while WMT’s
ending Cash balance shown in the T-
account on that date was $11,391.40.

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 Bank Reconciliation
1. Identify the deposits in transit: WMT made a deposit of $1,800
on June 30 that was not listed on the bank statement.
2. Identify the outstanding checks: Checks numbered 103 and 105
were still out standing at the end of June, totaled $960.
3. Record other transactions on the bank statement:
(a). Interest received from the bank of $20.
(b). Electronic funds transfer received from customer of $100.
(c). NSF check rejected, $18.
(d). Service charges, $6.
4. Determine the impact of errors, $9
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 WMT Bank Reconciliation
At June 30, 2010
Bank Balance, June 30 $ 10,638.40
Add: (1) Deposit in Transit 1,800.00
12,438.40
Less: (2) Outstanding Checks 103
103 $ 145
105 815 960.00
Up-to-date ending cash balance 11,478.40

Book Balance, June 30 11,391.40

Add: (3a) Interest from bank 20.00
(3b) EFT received from customer 100.00
11,511.40
Less: (3c) NSF check of R. Smith $ 18.00
(3d) Bank services charges $ 6.00
(4) Error in recording check 104 $ 9.00 $ 33.00
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Up-to-date ending cash balance 11,478.40
 Bank Reconciliation
Now that we know the up-to-date cash balance is
$11,478.40, we need to prepare and record journal entries
that will bring the Cash account to that balance.
Only the items on the Company’s Books side of the
bank reconciliation need to be recorded in the
company’s records.

(3a). Interest Received:

Accounts Debit Credit
Cash (+A) 20
Interest Revenue (+R, +SE) 20
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(3b). EFT Received from customer:
Accounts Debit Credit
Cash (+A) 100
Account Receivable (-A) 100
(3c). Customer’s check rejected as NSF
Accounts Debit Credit
Accounts Receivable (+A) 18
Cash (-A) 18
(3d). Service Charges:
Accounts Debit Credit
Office Expenses (+E, -SE) 6
Cash (-A) 6
(4). Company Error (Understated Payment to Supplier):
Accounts Debit Credit
Accounts Payable (-L) 9
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Cash (-A) 9
Explain the use of a
perpetual inventory
system as a control

28
Operating Cycles for Service, Merchandising,
and Manufacturing Companies
Sell
Products

Merchandising
Buy Collect
Company
Products Cash

Incur
Operating
Expenses
29
Controlling and Reporting Inventory
Perpetual Inventory System
In a perpetual inventory system, inventory records are
updated “perpetually”, every time inventory is
bought, sold, or returned. With the introduction of
relatively low cost computers, almost all companies
use the perpetual system.

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Controlling and Reporting Inventory
Periodic Inventory System
Inventory records are updated “periodically”, at the
end of the accounting period. A physical count of
inventory is used to update the inventory record.

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Benefits of Perpetual Inventory System
Provide the best inventory control because its continuous
tracking of transactions allows companies to instantly
determine the quantity of products on the shelves and to
evaluate the amount of time they have spent there. Using
this information, companies can better manage their
inventory and save a great deal of money in financing and
storage charges.

Allows manager to estimate shrinkage, the term for loss of

inventory from theft, fraud, and error.
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 Inventory Control
1. Determine what’s on hand at the beginning of the period.
2. Monitor every piece of inventory entering and exiting your stock
during the period.
• Add purchases.
• Subtract goods sold.
3. Count the inventory to determine what’s actually there.

Information in the company’ perpetual records

Equation Quantity Cost per Unit Total Cost Physical
Beginning Inventory 3 x $100 = $300 Inventory count
+ Purchases 3 x $100 = 300 vs.
- Goods Sold (2) x $100 = (200)
= Ending Inventory 4 x $100 = $400
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Analyze purchase and
sales transactions
under a perpetual
inventory system

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 Sales Transactions
The revenue principle requires that
revenues be recorded when they are Recall from
earned, rather than when cash is chapter 3!!!
received for them.
Sell
Merchandisers earn Products
revenues by making
a “sale”, which
Buy Merchandising Collect
means transferring Company
Products Cash
ownership of
merchandise to a
customer, either for Incur
Operating
cash or on credit. Expenses
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 Sales Transactions
For a retail merchandiser, this transfer of
ownership occurs when a customer buys and
takes possession of the goods at checkout.

For a wholesale merchandiser who is shipping goods

to customer, the transfer of ownership occurs at a
time stated in the written sales agreement, which
specifies 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).
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 Sale of Merchandise in a Perpetual System
Example: Wal-Mart sells two bikes at a selling price of $200 per bike,
for a total of $400 cash. The bikes had previously been recorded in Wal-
Mart’s Inventory at a total cost of $350.

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

Record Accounts Debit Credit

Cash (+A) 400
Sales Revenue (+R, +SE) 400

Accounts Debit Credit

Cost of Goods sold (+E, -SE) 350
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Inventory (-A) 350
 Sales Returns and Allowances
Sales returns and allowances are refunds and price
reductions given to customers after goods have
been sold and found unsatisfactory.

To report sales returns and allowances, a contra-

revenue account (such as Sales Returns and
Allowances) is used to reduce the total in a revenue
account (such as Sales Revenues).
A contra-account (xA) is an account that is an offset to, or
reduction of, another account.
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 Sales Returns and Allowances
Example: Suppose that after Wal-Mart sold the 2 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.

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

Record Accounts Debit Credit

Sales Returns & Allowances (+xR, -SE) 200
Cash (-A) 200

Accounts Debit Credit

Inventory (+A) 175
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Cost of Goods Sold (-E, +SE) 175
 Sales on Account and Sales Discounts
Sales discount: A sales price reduction given to customers
for prompt payment of their account balance.
Number of days in “Net” sale
discount period (after returns and allowances)

Discount
percentage
offered 2/10, n/30 Maximum
credit period

2% discount
period

November 1 November 10 November 30

Date of sale End of discount End of credit
period period
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 Sales on Account and Sales Discounts
Example: Suppose Wal-Mart sells printer paper on account to
a local business for $1,000 with payment terms of 2/10, n/30.
The paper cost Wal-Mart $700.

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

Record Accounts Debit Credit

Accounts Receivable (+A) 1,000
Sales Revenue (+R, +SE) 1,000

Accounts Debit Credit

Cost of Goods Sold (+E, -SE) 700
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Inventory (-A) 700
 Sales on Account and Sales Discounts
Example: Suppose the customer pay Wal-Mart within 10 days, he will
deduct the $20 discount (2% x $1,000) from the total owned ($1,000),
and then pay $980 to Wal-Mart. Wal-Mart accounts for the $20 sales
discount using a contra-revenue account, as follows:

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

Record Accounts Debit Credit

Cash (+A) 980
Sales Discounts (+xR, -SE) 20
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Accounts Receivable (-A) 1,000
Effects of Sales-Related Transactions on
Net sales
Sales Revenue $1,400 *
Less: Sales Returns and Allowances (200)
Sales Discounts (20)
Net Sales $1,180
*$1,400 = $400 (bikes) + $1,000 (printer paper)

Contra-revenue accounts

43
Analyze a merchandiser’s
multi-step income
statement

44
 Multi-Step Income Statement
Multi-step income statement
Presents important subtotals, such as gross profit, to
help distinguishing core operating results from other,
less significant items that affect net income.

Gross profit percentage

(also called gross margin or simply margin)
Net sales minus cost of goods sold. It is subtotal, not an
account.
45
 Multi-Step Income Statement
WAL-MART STORES, INC.
Income Statement
For the Years Ended January 31
(amounts in millions)
2009 2008 2007
Net Sales $ 405,607 378,476 348,368
Cost of Goods Sold 306,158 286,350 263,979
Gross Profit 99,449 92,126 84,389
Selling, General, and Administrative Expenses 76,651 70,174 63,892
Income from Operations 22,798 21,952 20,497
Other Expenses 2,253 2,332 2,859
Income Before Income Taxes 20,545 19,620 17,638
Income Tax Expenses 7,145 6,889 6,354
Net Income $ 13,400 $ 12,731 $ 11,284

46
 Gross Profit Percentage
Measures the percentage of profit earned on each dollar
of sales. The higher ratio means that greater profit is
available to cover operating and other expenses.

This ratios is used:

1. To analyze changes in the company’s operations over time,
2. To compare one company to another,
3. To determine whether a company is earning enough on each
sale to cover its operating expense.

Net Sales - CGS x 100 Gross Profit

= x 100
Net Sales Net Sales
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 Gross Profit percentage
WAL-MART STORES, INC.
Income Statement
For the Years Ended January 31
(amounts in millions)
2009 2008 2007
Net Sales $ 405,607 378,476 348,368
Cost of Goods Sold 306,158 286,350 263,979
Gross Profit 99,449 92,126 84,389
Selling, General, and Administrative Expenses 76,651 70,174 63,892
Income from Operations 22,798 21,952 20,497
Other Expenses 2,253 2,332 2,859
Income Before Income Taxes 20,545 19,620 17,638
Income Tax Expenses 7,145 6,889 6,354
Net Income $ 13,400 $ 12,731 $ 11,284

WAL-MART’S GROSS PROFIT PERCENTAGE

2009 2008 2007
Gross Profit
24.5% 24.3% 24.2%
Percentage 48
Comparing Operating Results across
Companies and Industries

Gross profit percentage can vary

greatly between companies.

Gross profit percentage can vary across

industries too.

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 Homework
• Demonstration case: Bank reconciliation (pp.
229-231):
– Must read
– Try to answer all questions
– Check your answers with solutions
– Submit Excel Template
• Exercises:
- Multiple choice: 1-10 (p. 282)
- E6: 1, 5, 7, 13, and 18 (pp. 286-291)
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End of Chapter 6

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