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

2. 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. Operating Cycles
Sell
Services
Service Collect
Company Cash
Incur
Operating
Expenses

4. Operating Cycles
Sell
Products
Buy Merchandising Collect
Products Company Cash
Incur
Operating
Expenses

5. Operating Cycles
Sell
Products
Make Manufacturing Collect
Products Cash
Company
Incur
Buy Raw
Operating
Materials
Expenses

6. 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 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.

7. Common Control Principles
Principle Explanation Examples
Assign each task to only one Each Wal-Mart cashier uses a
Establish responsibility
person. different cash drawer
Do not make one employee Wal-Mart cashiers, who ring up
Segregate duties responsible for all parts of a sales, do not approve price
process. changes.
Do not provide access to Wal-Mart secures valuable
assets or information unless it assets such as cash and
Restrict access
is needed to fulfill assigned access to its computer
responsibilities. systems (passwords, firewalls).
Prepare documents to show Wal-Mart pays suppliers using
Document procedures
activities that have occurred. prenumbered checks.
Check others' work. Wal-Mart compares cash
balances in its accounting
Independently verify records to the cash balances
reported by its bank, and
accounts for any differences.

8. Control Limitations
Internal controls can never
completely prevent and detect
errors and fraud.
Human Error or
Benefits vs. Cost
Fraud

9. Controlling and Reporting Cash
Internal control of cash is
important to any organization.
Cash is valuable
Volume of cash and “owned” by
is enormous. person
possessing it.

10. Cash Received in Person
Segregate
Duties
Cashier Recording
Custody

11. Cash Received in Person

12. Cash Received in Person

13. Cash Received from a Remote
Source
Cash Received
by Mail
Cash Received
Electronically

14. Cash Payments
Cash Payments
Electronic
Writing a
Funds
Check
Transfer
A voucher system is a process for approving
Most companies pay cash to their employees
and documenting all purchases and
through EFTs, which are known by
payments on account.
employees as direct deposits.

15. Bank Procedures and Reconciliation
Banks provide services that help businesses to control
cash in several ways:
Restricting Documenting Independently
Access Procedures 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.

16. Bank Statement
1
2 3 4 5

17. Reconciling Differences
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.
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.

18. Bank Reconciliation
To determine the appropriate cash
balance, these balances need to be
reconciled.

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

20. Bank Reconciliation

21. 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.

22. Controlling and Reporting Merchandise
Sales
Inventory Inventory Financial
Quantities Costs Statements
Unsold Balance
Inventory Sheet
Sold Income
Inventory Statement

23. 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.

24. Periodic Inventory System
In 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.

25. Inventory Control
Perpetual Periodic
Inventory Inventory
System System
No Up-to-
Continuous
Date
Tracking
Records
Can Can’t
Estimate Estimate
Shrinkage Shrinkage

26. 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).

27. Sales Transactions
Every merchandise sale has two components,
each of which requires an entry in a perpetual
inventory system.
Selling
Price
Cost

28. 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.
1 Analyze
Assets = Liabilities + Stockholders' Equity
(a) Cash +400 Sales Revenue (+R) +400
(b) Inventory -350 Cost of Goods Sold (+E) -350
2 Record

29. 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.

30. 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.
1 Analyze
Assets = Liabilities + Stockholders' Equity
(a) Cash -200 Sales Returns and Allowances (+xR) -200
(b) Inventory +175 Cost of Goods Sold (-E) +175
2 Record

31. Sales on Account and Sales
Discounts
A sales discount is a sales price reduction
given to customers for prompt payment of
their account balance.

32. 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.
1 Analyze
Assets = Liabilities + Stockholders' Equity
(a) Accounts Receivable +1,000 Sales Revenue (+R) +1,000
(b) Inventory -700 Cost of Goods Sold (+E) -700
2 Record

33. 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.
1 Analyze
Assets = Liabilities + Stockholders' Equity
Cash +980 Sales Discounts (+xR) -20
Accounts Receivable -1,000
2 Record
(2% × $1,000)

34. Summary of Sales-Related
Transactions
The sales returns and allowances and sales
discounts introduced in this section were
recorded using contra-revenue accounts.

35. Gross Profit Percentage
Gross Gross Profit
= 100
Profit % Net Sales

36. Comparing Operating Results
Across Companies and Industries
Gross Profit Percentage
by Industry
40.0%
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
Wal-Mart’s Gross Profit
Percentage
0.0%
2009 2008 2007

37. In class problem #1: Bank reconciliation
The 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.

38. In class problem #2
The 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.

39. In class problem #3
Prepare 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)