McGraw-Hill/IrwinCopyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6Internal Control and Financial Reporting for Cash and Merchandise Sales

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIAFred Phillips, Ph.D., CA

Learning Objective 1

Distinguish among service, merchandising, and

manufacturingoperations.

6-3

Operating Cycles

CollectCollectCashCash


IncurIncurOperatingOperatingExpensesExpenses


Service Service CompanyCompany

SellSellServicesServices

SellSellServicesServices

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Operating Cycles





BuyBuyProductsProducts

BuyBuyProductsProducts

MerchandisingMerchandisingCompanyCompany

SellSellProductsProducts


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Operating Cycles







Buy RawBuy RawMaterialsMaterialsBuy RawBuy RawMaterialsMaterials

MakeMakeProductsProducts

MakeMakeProductsProducts

ManufacturingManufacturingCompanyCompany

6-6


Explain common principles and limitations of internal

control.

6-7

Internal Control

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

are referred to as are referred to as internal controlsinternal controls..

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

are referred to as are referred to as internal controlsinternal controls..

Internal controls are the methods a company Internal controls are the methods a company uses to:uses to:

1.1. Protect against the theft of assets.Protect against the theft of assets.

2.2. Enhance the reliability of accountingEnhance the reliability of accounting information. information.

3.3. Promote efficient and effective operations.Promote efficient and effective operations.

4.4. Ensure compliance with applicable lawsEnsure compliance with applicable laws and regulations. and regulations.

6-8

Common Control Principles

Principle 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.

6-9

Control Limitations

Internal controls can never completely prevent and detect

errors and fraud.

Benefits vs. CostHuman Error or

Fraud

6-10


Apply internal control principles to cash receipts and

payments.

6-11

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.

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Cash Received in Person

Segregate Duties

Cashier

Custody

Recording

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6-14


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Cash Received from a Remote Source

Cash Received by Mail

Cash Received Electronically

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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. 6-17


Perform the key control of reconciling cash to bank

statements.

6-18

Bank Procedures and Reconciliation

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

Restricting Restricting AccessAccess

Documenting Documenting ProceduresProcedures

Independently Independently VerifyingVerifying

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

business or individual.business or individual.

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Bank Statement

1

2 3 4 5

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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.

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Bank Reconciliation

To determine the appropriate cash balance, these balances need to be

reconciled.

6-22

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.

6-23

Bank Reconciliation

6-24

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.

6-25


Explain the use of a perpetual inventory system as a control.

6-26

Controlling and Reporting Merchandise Sales

Inventory Quantities

Inventory Costs

Financial Statements

Unsold Inventory

Balance Sheet

Sold Inventory

Income Statement

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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.

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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.

6-29

Inventory Control

Perpetual Inventory System

Continuous Tracking

Can Estimate

Shrinkage

Periodic Inventory System

No Up-to-Date Records

Can’t Estimate

Shrinkage

6-30


Analyze sales transactions under a perpetual inventory

system.

6-31

Sales Transactions

Merchandisers 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).

6-32

Sales Transactions

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

inventory system.Selling Price

Cost

6-33

Sales Transactions

Assume 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

6-34

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.

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Sales Returns and Allowances

Suppose 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

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Sales on Account and Sales Discounts

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

their account balance.

6-37


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

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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)

6-39

Summary of Sales-Related Transactions

The sales returns and allowances and sales discounts introduced in this section were recorded using contra-revenue accounts.

6-40


Analyze a merchandiser’s multistep income statement.

6-41

Gross Profit Percentage

GrossProfit %

=Gross ProfitNet Sales

× 100

6-42

Comparing Operating Results Across Companies and Industries

6-43

Chapter 6Solved Exercises

M6-11, M6-19, E6-5, E6-7, E6-10, E6-17

M6-11 Calculating Shrinkage in a Perpetual Inventory SystemCorey’s Campus Store has $50,000 of inventory on hand at the beginning of the month. During the month, the company buys $8,000 of merchandise and sells merchandise that had cost $30,000. At the end of the month, $25,000 of inventory is on hand. How much shrinkage occurred during the month?

Beginning inventory $50,000 Purchases +8,000 Cost of Goods Sold -30,000 Ending balance 28,000 Inventory count -25,000 Shrinkage $3,000

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M6-19 Calculating the Impact of Changes in Gross Profit Percentage on Operating IncomeLuxottica Group, the Italian company that sells Ray Ban and Killer Loop sunglasses, reported a gross profit percentage of 68.3 percent in 2007 and 66.5 percent in 2008. In each of these two years, the company’s net sales was fairly steady at approximately 5 million euro. Assuming that Luxottica’s operating expenses were 2.6 million euro in each year, how much more (or less) income from operations did Luxottica report in 2008 than in 2007?

2007 2008 Sales € 5,000,000 € 5,000,000 Gross profit percentage x 0.683 x 0.665 Gross Profit 3,415,000 3,325,000 Operating Expenses 2,600,000 2,600,000 Income from Operations € 815,000 € 725,000 Luxottica earned € 90,000 less in 2008 than in 2007.

6-46

E6-5 Preparing a Bank Reconciliation and Journal Entries, and Reporting CashHills Company’s June 30, 2010, bank statement and the June ledger account for cash are summarized here:

Required:1. Prepare a bank reconciliation. A comparison of the checks written with the checks that have cleared the bank shows outstanding checks of $700. Some of the checks that cleared in June were written prior to June. No deposits in transit were noted in May, but a deposit is in transit at the end of June.

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HILLS COMPANY Bank Reconciliation

June 30, 2010 Bank Statement Company's Books Ending balance per bank statement………………….

$6,070

Ending balance per Cash account………………………

$6,400

Additions: Additions: Deposit in transit……………. 1,000* None 7,070 6,400 Deductions: Deductions: Outstanding checks…………

700 Bank service charge…… 30

Up-to-date cash balance…. $6,370 Up-to-date cash balance…… $6,370 *$19,000 – $18,000 = $1,000.

E6-5 Preparing a Bank Reconciliation and Journal Entries, and Reporting Cash

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E6-5 Preparing a Bank Reconciliation and Journal Entries, and Reporting Cash2.Give any journal entries that should be made as a result of the bank reconciliation.

3.What is the balance in the Cash account after the reconciliation entries?

4.In addition to the balance in its bank account, Hills Company also has $300 cash on hand. This amount is recorded in a separate T-account called Cash on Hand. What is the total amount of cash that should be reported on the balance sheet at June 30?

dr Office Expenses (+E,-SE) ................................................................ 30 cr Cash (-A) .................................................................... 30 To record bank service charges.

$6,370 ($6,400 - $30)

Balance sheet (June 30, 2008): Current assets: Cash ($6,370 + $300) ........................................................ $6,670

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E6-7 Identifying Shrinkage and Other Missing Inventory InformationCalculate the missing information for each of the following independent cases:

Case

Beg. Inventory

Purchases

Cost of Goods Sold

Ending Inventory

(perpetual)

Ending Inventory (As Counted)

Shrinkage

A $100 $700 $300 $500 $420 $80

B 200 800 850 150 150 0

C 150 500 200 450 440 10

D 260 600 650 210 200 10

? ?

? ?

?? ?

6-50

E6-10 Recording Journal Entries for Net Sales with Credit Sales and Sales DiscountsUsing the information in E6-9, prepare journal entries to record the transactions, assuming Solitare uses a perpetual inventory system.

Jan. 6 Sold goods for $100 to Wizard Inc. with terms 2/10, n/30. The goods cost Solitare $70. 6 Sold goods to SpyderCorp for $80 with terms 2/10, n/30. The goods cost Solitare $60. 14 Collected cash due from Wizard Inc.Feb. 2 Collected cash due from SpyderCorp. 28 Sold goods for $50 to Bridges with terms 2/10, n/45. The goods cost Solitare $30.

Jan. 6 dr Accounts Receivable (+A) ............................................... 100 cr Sales Revenue (+R,+SE) ........................................... 100

dr Cost of Goods Sold (+E,-SE) .......................................... 70 cr Inventory (-A) ............................................................. 70

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Jan. 6 dr Accounts Receivable (+A) ............................................... 80 cr Sales Revenue (+R,+SE) ........................................... 80

dr Cost of Goods Sold (+E,-SE) .......................................... 60 cr Inventory (-A) ............................................................. 60

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Jan. 14 dr Cash (+A) ($1,000 x 98%) ............................................... 98 dr Sales Discounts (+xR,-SE) ($1,000 x 2%) ...................... 2 cr Accounts Receivable (-A) ........................................... 100

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Feb. 2 dr Cash (+A) ........................................................................ 80 cr Accounts Receivable (-A) ........................................... 80

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Feb. 28 dr Accounts Receivable (+A) ............................................... 50 cr Sales Revenue (+R,+SE) ........................................... 50 dr Cost of Goods Sold (+E,-SE) .......................................... 30 cr Inventory (-A) ............................................................. 30

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E6-17 Inferring Missing Amounts Based on Income Statement RelationshipsSupply the missing dollar amounts for the income statement of Williamson Company for each of the following independent cases:

Case A Case B Case C Sales Revenue ......................................... $ 8,000 $ 6,000 $ 6,195 Sales Returns and Allowances ................. 150 500 275 Net Sales ............................................ 7,850 5,500 5,920 Cost of Goods Sold ................................... 5,750 4,050 5,400 Gross Profit ............................................ $ 2,100 $ 1,450 $ 520

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End of Chapter 6

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