Chapter 6
Internal Control and Financial
Reporting for Cash and
Merchandising Operations
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Distinguish service,
merchandising, and
manufacturing
operations.
6-2
Service, Merchandising, and
Manufacturing Operating Activities
Service Company
Sell
Services
Receive
Cash
Incur
Operating
Expenses
6-3
Service, Merchandising, and
Manufacturing Operating Activities
Sell
Products
Buy
Products
Merchandising
Company
Receive
Cash
Incur
Operating
Expenses
6-4
Service, Merchandising, and
Manufacturing Operating Activities
Sell
Products
Makes
Products
Buy Raw
Materials
Manufacturing
Company
Receive
Cash
Incur
Operating
Expenses
6-5
Learning Objective 2
Explain common
principles of internal
control.
6-6
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 designed to . . .
1. ensure adequate records are maintained.
2. ensure transactions are authorized and properly
recorded.
3. prevent or detect unauthorized activities
involving the company’s assets.
6-7
Principles of Internal Control
Principle
Establish responsibility
Segregate duties
Restrict access
Document procedures
Independently verify
Explanation
Example
Each Wal-Mart cashier uses a
Assign each task to only one person.
different cash drawer
Do not make one employee
The Time Warner clerk who deposits
responsible for all parts of a
cash in the bank does not also open
transaction.
the mail.
Do not provide access to assets or
Bank of America uses a vault and
information unless it is needed to
electronic controls (passwords,
fulfill assigned responsibilities.
firewalls).
AMC Entertainment pays movie
Prepare documents to show activities
distributors using prenumbered
that have occurred.
checks.
Ebay compares cash balances in its
accounting records to the cash
Check others' work.
balances reported by its bank, and
accounts for any differences
6-8
Controlling and Reporting Cash
1. Cash handling is segregated from cash
recordkeeping.
2. Cash receipts are promptly (daily)
deposited in a bank.
3. Cash disbursements are made by check.
6-9
Learning Objective 3
Perform the key
control of reconciling
to bank statements.
6-10
Need for Reconciliation
One effective control
over cash is the bank
reconciliation. The bank
reconciliation identifies
differences between the
book balance for cash
and the cash in the bank
account.
6-11
Reconciling Differences
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.
Service charges taken out of your account.
Customer checks you deposited but that bouced.
Errors made by you.
6-12
Bank Reconciliation
Let’s prepare a July 31 bank reconciliation
statement for Matrix, Inc. The July 31 bank
statement indicated a balance of $9,610,
while the cash general ledger account on that
date shows a balance of $7,430.
Additional information necessary for the
reconciliation is shown on the next screen.
6-13
Bank Reconciliation
o Outstanding checks totaled $2,417.
o A $500 check mailed to the bank for deposit had not
reached the bank at the statement date.
o The bank returned a customer’s NSF check for $225
received as payment on account receivable.
o The bank statement showed $30 interest earned during
July.
o Check No. 781 for supplies expense cleared the bank
for $268 but was erroneously recorded in our books as
$240.
o A $486 deposit by Acme Company was erroneously
credited to our account by the bank.
6-14
Bank Reconciliation
Matrix, Inc.
Bank Reconciliation
July 31, 2008
Bank Balance, July 31
Add: Deposit in Transit
Less: Bank Error
Outstanding Checks
Adjusted Balance, July 31
Book Balance, July 31
Add: Interest
Less: Recording Error
NSF Check
Adjusted Balance, July 31
$ 9,610
 500
$ 486
 2,417
(2,903)
$ 7,207
$ 7,430
30
$
28
225
(253)
$ 7,207
6-15
Bank Reconciliation
Matrix, Inc.
Bank Reconciliation
July 31, 2008
Bank Balance, July 31
Add: Deposit in Transit
Less: Bank Error
Outstanding Checks
Adjusted Balance, July 31
Book Balance, July 31
Add: Interest
Less: Recording Error
NSF Check
Adjusted Balance, July 31
$ 9,610
 500
$ 486
 2,417
(2,903)
$ 7,207
$ 7,430
 30
$  28
225
(253)
$ 7,207
6-16
Bank Reconciliation
We must prepare journal entries to adjust the book
balance to the adjusted book balance. Only
amounts shown on the book portion of the
reconciliation require an adjusting entry.

Accounts
Cash (+A)
Interest Revenue (+R, +SE)
Debit
30
Credit
30
6-17
Bank Reconciliation
We must prepare journal entries to adjust the
book balance to the adjusted book balance.
Only amounts shown on the book portion of
the reconciliation require an adjusting entry.

Accounts
Supplies Expense (+E, -SE)
Accounts Receivable (+A)
Cash (-A)
Debit
28
225
Credit
253
6-18
Bank Reconciliation
After posting the reconciling entries, the cash
account looks like this . . .
Beg. Bal.
End. Bal.
Cash
7,430
30
253
7,207
Adjusted balance on July 31.
6-19
Learning Objective 4
Explain the use of a
perpetual inventory
system as a control.
6-20
Controlling and Reporting Inventory
Perpetual Inventory System
In a perpetual inventory system the inventory
record shows the number of units and cost of
each type of merchandise stocked. The inventory
record is updated every time an item is bought,
sold, or returned. With the introduction of
relatively low cost computers, almost all
companies use the perpetual system.
6-21
Controlling and Reporting Inventory
Periodic Inventory System
Rather than updating the inventory record each
time an item is sold, bought, or returned, the
periodic system updates the inventory record at
the end of the accounting period. A physical
count of inventory is used to update the
inventory record.
6-22
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.
6-23
Learning Objective 5
Analyze purchase and
sales transactions
under a perpetual
inventory system
6-24
Inventory Purchase and Sale
Transactions
Purchases, Purchase
Returns & Allowances, and
Purchase Discounts
6-25
Purchase of Inventory
On May 7, Matrix, Inc. purchased $27,000 of
Inventory on account.
(1) Analyze
Assets
Inventory
27,000
=
Liabilities
Accounts
Payable
27,000
Stockholders'
Equity
+
(2) Record
Accounts
Inventory (+A)
Accounts Payable (+L)
Debit
27,000
Credit
27,000
6-26
Transportation Costs
On May 7, Matrix, Inc. paid $600 cash in
transportation charges to get the inventory to its
place of business.
(1) Analyze
Assets
Cash
Inventory
(600)
600
=
Liabilities
Accounts
Payable
Stockholders'
Equity
+
(2) Record
Accounts
Inventory (+A)
Cash (-A)
Debit
600
Credit
600
6-27
Purchase Returns & Allowances
On May 9, Matrix, Inc. returned $450 of defective
inventory to the seller and received credit on its
account.
(1) Analyze
Assets
Cash
=
Inventory
(450)
Liabilities
Accounts
Payable
(450)
Stockholders'
Equity
+
(2) Record
Accounts
Accounts Payable (-L)
Inventory (-A)
Debit
450
Credit
450
6-28
Payment of Account
On June 6, Matrix, Inc. paid the amount due on
the purchase of May 7.
Accounts
Accounts Payable (-L)
Cash (-A)
Purchases
Debit
26,550
Credit
26,550
$ 27,000
Purchase return
(450)
Balance owed
$ 26,550
6-29
Purchase Discounts
2/10,n/30
Discount
Percent
Number of
Days
Discount is
Available
Otherwise,
Net (or All)
is Due
Credit
Period
6-30
Purchase of Inventory
On May 7, Matrix, Inc. purchased $27,000 of
Inventory on account. Credit terms are 2/10, n/30.
(1) Analyze
Assets
Cash
Inventory
27,000
=
Liabilities
Accounts
Payable
27,000
Stockholders'
Equity
+
(2) Record
Accounts
Inventory (+A)
Accounts Payable (+L)
Debit
27,000
Credit
27,000
6-31
Purchase of Inventory
On May 16, Matrix, Inc. paid the amount owed on
the purchase of May 7, in full.
(1) Analyze
Assets
=
Cash
Inventory
(26,460)
(540)
Liabilities
Accounts
Payable
(27,000)
Stockholders'
Equity
+
(2) Record
Accounts
Accounts Payable (-L)
Inventory (-A)
Cash (-A)
Debit
27,000
Credit
540
26,460
6-32
Effects of Purchase-Related
Transactions
Balance forward
$
575,000
Purchases of inventory
100,000
Add: Transportation-in
1,750
Less: Purchase returns & allowances
Less: Purchase discounts
Cost of goods available for sale
(600)
$
(1,950)
674,200
6-33
Sales, Sales Returns & Allowances,
Sales Discounts, and Credit Card
Discounts
6-34
Sales
Perpetual Inventory System
On August 18, Matrix, Inc. sold inventory that has
a cost of $15,500, for $21,000 on account.
(1) Analyze
Assets
=
Liabilities
Accounts
Receivable Inventory
21,000
(15,500)
+
Stockholders'
Equity
Sales/Cost of
Goods Sold
21,000/(15,500)
(2) Record
Accounts
Accounts Receivable (+A)
Sales Revenue (+R, +SE)
Debit
21,000
Cost of Goods Sold (+E, -SE)
Inventory (-A)
15,500
Credit
21,000
15,500
6-35
Sales Returns and Allowances
On August 20, the customer returned inventory
that has a cost $500, and sells for $675. The
customer was given credit on account.
(1) Analyze
Assets
=
Stockholders'
Equity
+
Sales
Returns/Cost of
Goods Sold
(675)/500
Liabilities
Accounts
Receivable Inventory
(675)
500
(2) Record
Accounts
Debit Credit
Sales Returns and Allowances (+xR,-SE)
675
Accounts Receivable (-A)
675
Inventory (+A)
Cost of Goods Sold (-E, -SE)
500
500
6-36
Sales Discount
On August 18, Matrix, Inc. sold inventory that has a cost
of $15,500, for $21,000 on account. Credit terms are
2/10, n/30.
(1) Analyze
Assets
=
Liabilities
Accounts
Receivable Inventory
21,000
(15,500)
+
Stockholders'
Equity
Sales/Cost of
Goods Sold
21,000/(15,500)
(2) Record
Accounts
Accounts Receivable (+A)
Sales Revenue (+R, +SE)
Debit
21,000
Cost of Goods Sold (+E, -SE)
Inventory (-A)
15,500
Credit
21,000
15,500
6-37
Receipt of Payment
On August 22, the account was paid in full.
Accounts
Cash (+A)
Sales Discounts (+xR, -SE)
Accounts Receivable (-A)
Sale
Debit
20,580
420
Credit
21,000
$ 21,000
Discount rate
Discount amount $
2%
420
6-38
Effects of Sales-Related
Transactions
Sales Revenue
$
792,000
Less: Sales Returns & Allowances
2,750
Less: Sales Discounts
7,950
Less: Credit Card Discounts
Net Sales
$
6,275
775,025
Contra-revenue accounts
6-39
Learning Objective 6
Analyze a
merchandiser’s
multi-step income
statement.
6-40
Multi-Step Income Statement
Wal-Mart Stores, Inc.
Income Statement
Fiscal Year Ended January 31, 2006
(amounts in millions)
Net Sales
Cost of Goods Sold
Gross Profit
Selling, General, and Administrative Expenses
Operating Income
Interest and Other Expenses
Income Before Income Taxes
Income Tax Expenses
Net Income
$ 312,427
240,391
72,036
53,506
18,530
1,172
17,358
6,127
$ 11,231
Gross Profit
Gross Profit
=
× 100%
Percentage
Net Sales
6-41
Gross Profit Percentage
Wal-Mart Stores, Inc.
Income Statement
Fiscal Year Ended January 31, 2006
(amounts in millions)
Net Sales
Cost of Goods Sold
Gross Profit
Selling, General, and Administrative Expenses
Operating Income
Interest and Other Expenses
Income Before Income Taxes
Income Tax Expenses
Net Income
Gross Profit
=
Percentage
$72,036
$312,427
$ 312,427
240,391
72,036
53,506
18,530
1,172
17,358
6,127
$ 11,231
× 100% = 23.1%
6-42
Average Gross Profit
Percentages by Industry Sector
Pharmaceutical
Manufacturing
51.2%
Automotive
Manufacturing
22.0%
Convenience Store
24.4%
General Department
Store
35.3%
Restaurants
57.7%
0%
10%
20%
30%
40%
50%
60%
70%
6-43
End of Chapter 6
6-44