Financial & Managerial
Accounting 2002e
Belverd E. Needles, Jr.
Marian Powers
Susan Crosson
----------Multimedia Slides by:
Harry Hooper
Sante Fe Community College
Copyright©2002 by Houghton Mifflin Company. All rights reserved.
1
Chapter 6
Merchandising
Operations and
Internal Control
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2
LEARNING OBJECTIVES
1. Identify the management issues related
to merchandising businesses.
2. Define and distinguish the terms of sale
for merchandising transactions.
3. Prepare an income statement and
record merchandising transactions
under the perpetual inventory system.
4. Prepare an income statement and
record merchandising transactions
under the periodic inventory system.
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3
LEARNING OBJECTIVES
(continued)
5. Define internal control, identify the five
components of internal control, and
explain seven examples of control
activities.
6. Describe the inherent limitations of
internal control.
7. Apply internal control activities to
common merchandising transactions.
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4
Supplemental Objective
Apply sales and purchases
discounts to merchandising
transactions.
8.
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5
Management Issues in
Merchandising Businesses
OBJECTIVE 1
Identify the management issues
related to merchandising businesses.
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6

Merchandising businesses differ
from service businesses in that they
have goods on hand for sale to
customers and engage in a series of
transactions, listed below, called the
operating cycle.
Purchase of inventory for cash or credit
Payment for purchases made on credit
Sales of inventory for cash or credit
Collection of cash from credit sales
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7
The Operating Cycle of Merchandising Concerns
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8
Cash Flow Management
• Purchases of merchandise are usually
made on credit. Suppliers of merchandise
usually require payment before inventory is
sold. The merchandiser must plan for cash
flows from prior sales, additional
stockholders’ investment, or from
borrowing to finance the inventory until it
is sold and resulting revenue is collected.
• Operators of a merchandising business
must carefully manage cash flows or
liquidity.
• If a company can’t pay its bills when due, it
may be forced out of business.
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9
Profitability Management
• A company must sell its merchandise at a price
that exceeds its cost by a sufficient margin to
pay operating expenses and have enough left
to provide sufficient net income or profitability.
• Profitability management includes:
 Setting appropriate prices for merchandise.
 Purchasing merchandise at favorable prices
and terms.
 Maintaining acceptable levels of operating
expenses.
• An effective tool for controlling expenses is the
operating budget.
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10
Features of the Perpetual
Inventory System
• Continuous records are kept of the
quantity and, usually, the cost of
individual items as they are bought
and sold.
• More effective for providing current,
real time information about actual
quantities and dollar amounts of
inventory available for sale and
sold.
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11
Features of the Periodic
Inventory System
• Physically count inventory, usually
at end of accounting period.
• No detailed records of the actual
inventory available or sold are
maintained during the accounting
period.
• Less costly than perpetual
inventory method, but provides
less information.
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12
Control of Merchandising
Operations
• Principal transactions of merchandising
businesses are vulnerable to theft and
embezzlement.


Cash and inventory are easy to steal.
These asset accounts are usually involved in a
large number of transactions.
• Management’s responsibility is to establish
an environment, accounting systems, and
control procedures that will protect the
company’s assets.
• These systems and procedures are called
internal control.
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13
Discussion
Q. What four issues must be faced by
managers of merchandising businesses?
A. The four issues that must be faced by
managers of merchandising businesses
are (1) cash flow management, (2)
profitability management, (3) choosing
between the periodic and the perpetual
inventory systems, and (4) establishing an
internal control structure that protects the
business’s assets.
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14
Terms of Sale
OBJECTIVE 2
Define and distinguish the
terms of sale for
merchandising transactions.
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15
Sales Terms
• Trade discount.
A
reduction of the list price.
 Not shown in accounting records.
• Sales discount.
 Discount
given for early payment.
 Taken if payment is made within the
terms of sale. For example, “2/10,
n/30.”
 Practice of giving sales discounts has
been declining.
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16
Sales Terms
(Continued)
• FOB shipping point.
 Title
passes at origin.
 Buyer pays the freight.
• FOB destination.
 Title
passes at destination.
 Seller pays the freight.
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17
Perpetual Inventory System
OBJECTIVE 3
Prepare an income statement and record
merchandising transactions under the
perpetual inventory system.
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18
Applying the Perpetual Inventory
System
Inventory and cost of Goods Sold
are continually updated during
the accounting period, as
purchases, sales, and other
inventory transactions take
place.
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19
Transactions Related to Purchases of
Merchandise
• Purchases of Merchandise on Credit

The cost of merchandise purchased is placed in the
Merchandise Inventory account at the time of purchase.
• Transportation Costs on Purchases


Accumulated in a Freight In / Transportation In account.
In some cases, the seller pays the freight charges and
bills them to the buyer as a separate item on the invoice.
• Purchases Returns and Allowances

Returned merchandise is removed from the Merchandise
Inventory account.
• Payments on Account

Payments by cash (or checks) to suppliers.
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20
Transactions Related to Sales of
Merchandise
• At the time of sale, the cost of
merchandise is transferred from the
Merchandise Inventory account to
the Cost of Goods Sold account.
• In the case of a return, the cost of
the merchandise is transferred from
Cost of Goods Sold back to
Merchandise Inventory.
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21
Transactions Related to Sales of
Merchandise
(continued)
• Sales of Merchandise on Credit
 Two entries are necessary
Record the sale as a debit to Accounts
Receivable
Update the Cost of Goods sold by
transferring from Merchandise Inventory
• Cash sales of Merchandise
 Debit Cash for the amount of the sale
• Payment of Delivery Costs
 Accumulated in the Freight Out Expense
account
 Shown as a selling expense on the income
statement


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22
Transactions Related to Sales of
Merchandise
(continued)
• Returns of Merchandise Sold


Accumulated in the Sales Return and
Allowances account, a contra-revenue
account, with a normal debit balance,
deducted from Sales in the income statement
The cost of merchandise must also be
transferred from the COGS account back into
the Merchandise Inventory account
• Receipts on Account

Receipts of cash (or checks) from credit
customers recorded as credits to Accounts
Receivable
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23
Discussion
Q. How are merchandising transactions
recorded under the perpetual inventory
system?
A. Merchandising transactions are
recorded during the accounting
periods, as purchases, sales, and other
inventory transactions take place.
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24
Merchandising Transactions
OBJECTIVE 4
Prepare an income statement
and record merchandising
transactions under the
periodic inventory system.
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25
Applying the Periodic Inventory
System
•
•
Cost of Goods Sold must be computed,
because it is not updated for purchases,
sales and other transactions during the
accounting period.
To calculate cost of goods sold:
1.
2.
3.
4.
Net purchases = (total purchases –
deductions)
Net cost of purchases = (net purchases +
freight charges on the purchases
Goods available for sale = (net cost of
purchases + beginning purchases)
Costs of Goods Sold = (Goods available for
sale – ending inventory)
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26
Transactions Related to
Purchases of Merchandise
• Physical inventory is taken and
recorded in the Merchandise Inventory
account at the end of the period.
• A Purchases account is used to
accumulate the purchases of
merchandise during the accounting
period.
• A Purchases Returns and Allowances
account is used to accumulate returns
of and allowances on purchases.
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27
The Components of Cost of Goods
Sold
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28
Transactions Related to Purchases
of Merchandise
• Purchases of Merchandise on Credit
 Purchases, a temporary account, used to
accumulate the total cost of merchandise
purchased for resale during the accounting
period.
 It does not indicate whether merchandise
has been sold or is still on hand.
• Transportation Costs on Purchases
 Usually accumulated in a Freight In account.
 In some cases, the seller pays the freight
charges and bills them to the buyer as a
separate item on the invoice.
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29
Transactions Related to Purchases of
Merchandise
(continued)
• Purchases Returns and Allowances
 Recorded in the Purchases
Returns and Allowances account.
 A contra-purchases account with a
normal credit balance, deducted
form Purchases on the income
statement.
• Payments on Account
 Payments made to suppliers.
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30
Transactions Related to Sales of
Merchandise
• Sales of Merchandise on Credit
 Debit
the Accounts Receivable
account for the amount of the sale.
• Cash Sales of Merchandise
 Debit
Cash for the amount of the
sale.
• Payment of Delivery Costs
 Accumulated
in the Freight Out /
Delivery Expense account.
 Shown as a selling expense on the
income statement.
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31
Transactions Related to Sales of
Merchandise
(continued)
• Returns of Merchandise Sold
 Accumulated
in the Sales Return and
Allowances account.
 A contra-revenue account, with a
normal debit balance deducted from
Sales on the income statement.
• Receipts on Account
 Payments
of cash (or checks) received
from credit customers.
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32
Credit Card Sales
• The seller pays the credit card company
(typically 2 to 6 percent of the total sale) for
the service.
• The cost is treated as a selling expense.
Cash
Credit Card Discount Expense
Sales
960
40
1,000
Made sales on Visa cards
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33
Inventory Losses
• Losses from spoilage, shoplifting, employee
and contractor theft.
• Not identifiable by the periodic inventory
system.
• Identified by the perpetual inventory system
as the discrepancy between physical
inventory (taken at intervals) and the
inventory account balance.
Inventory Shortage
130
Inventory
130
Made adjustment for inventory shrinkage
• Inventory shortage is usually an increase in
Cost of Goods Sold.
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34
Discussion
Q. How are merchandising
transactions recorded under the
periodic system?
A. Merchandising transactions are
recorded at the end of the
accounting period, therefore, Costs
of Goods Sold and Inventory must
be computed at that time.
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35
Internal Control Structure:
Basic Elements and Procedures
OBJECTIVE 5
Define internal control, identify
the five components of internal
control and explain seven
examples of control activities.
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36
Internal Control Defined
• Internal control is all the policies
and procedures management
uses to:
 Protect
the firm’s assets and
ensure the accuracy and reliability
of the accounting records.
 Promote operating efficiency and
encourage adherence to
management’s policies.
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37
Components of Internal Control
• Internal control includes:
1. The control environment.
2. Risk assessment.
3. Information and
communication.
4. Control activities.
5. Monitoring.
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38
The Control Environment
• Created by the overall attitude,
awareness, and actions of management.
• Influenced by:
 Management’s
philosophy and operating
style.
 Organizational structure.
 Methods of assigning authority and
responsibility.
 Personnel policies and practices.
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39
Risk Assessment
The identification of areas where risks of
loss of assets or inaccuracies in the
accounting records are high so that
adequate controls can be implemented.
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40
Information and Communication
Relates to the accounting
systems established by
management to identify,
assemble, analyze, classify,
record, and report a company’s
transactions and to the clear
communication of individual
responsibilities in achieving
these functions.
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41
Control Activities
The policies and procedures
management puts in place to see
that its directives are carried out.
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42
Monitoring
Involves management’s regular
assessment of the quality of
internal control including periodic
review of actual compliance with
all policies and procedures.
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43
Control Activities
1.
2.
3.
4.
5.
6.
7.
Authorization
Recording transactions
Documents and records
Physical controls
Periodic checks
Separation of duties
Sound personnel procedures
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44
Discussion
Q. A good system of internal
controls accomplishes what
broad objectives?
A. It safeguards the company
assets, produces reliable
accounting records, promotes
operating efficiency, and
encourages adherence to
management’s policies.
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45
Limitations of Internal Control
OBJECTIVE 6
Describe the inherent
limitations of internal
control.
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46
Limitations of Internal Control
•
•
•
•
•
•
•
•
•
Human error.
Misunderstandings.
Mistakes in judgment.
Carelessness.
Distraction.
Fatigue.
Collusion.
Dishonesty.
Changes in conditions.
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47
Discussion
Q. Why is the separation of duties
necessary to ensure sound
internal control? What does
this principle assume about the
relationships of employees in a
company and the possibility of
two or more of them stealing
from the company?
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48
A.
The separation of duties is important
to sound internal control because a
person who combines the
responsibilities of keeping records,
operating a department, and
managing assets would be able to
misappropriate assets without
detection. The separation of duties
assumes that two or more employees
will not work together to overcome
the controls.
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49
Internal Control over
Merchandising Transactions
OBJECTIVE 7
Apply internal control
activities to common
merchandising transactions.
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50
Internal Control and
Management Goals
• Key Goals for the success of
a merchandising business.
 Prevent
losses of cash or
inventory owing to theft or
fraud.
 Provide accurate records of
merchandising transactions,
and account balances.
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51
Goals for Management
Broader Goals:
• Keep enough inventory on hand
to sell to customers without
overstocking.
• Keep enough cash on hand to pay
for purchases in time to receive
discounts.
• Keep credit losses as low as
possible by making credit sales
only to customers who are likely
to pay on time.
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52
Controls for Meeting
Management’s Goals
• Cash budget.
• Separation of duties.
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53
Control of Cash Sales Receipts
• Cash is received either by mail or over the
counter. In either case:


It should be recorded immediately in cash receipts
journal.
It establishes a written record of cash receipts.
• Control of cash received through the mail.



Encourage customers to pay by check.
Handle by two or more employees.
Make a list of receipts in triplicate.
• Control of cash received over the counter.


Cash registers.
Pre-numbered sales tickets.
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54
Control of Purchases and Cash
Disbursements
•
•
•
Pay cash only based on
specific authorization
backed by proof of validity
and amount of claim.
Separate purchasing and
payment duties.
Document and verify by at
least 2 people.
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55
Internal Control for Purchasing and Paying for
Goods and Services
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56
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57
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58
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59
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60
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61
Check and Remittance Advice
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62
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63
Discussion
Q. Name the documents needed for
an internal control plan for
purchases and cash
disbursements.
A. Purchase requisition, purchase
order, invoice, receiving report,
check authorization, check with
a remittance advice.
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64
Accounting for Discounts
SUPPLEMENTAL
OBJECTIVE 8
Apply sales and purchases
discounts to merchandising
transactions.
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65
Sales Discounts
Original sale on credit (2/10,n/60)
Sept. 20
Accounts Receivable
Sales
300
300
Customer takes advantage of discount.
Sept. 29
Cash
Sales Discounts
Accounts Receivable
294
6
300
Customer does not take advantage of discount.
Nov. 19
Cash
300
Accounts Receivable
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300
66
Purchases Discounts
Original Purchase Credit (2/10,n/30)
Nov. 12
Purchases
Accounts Payable
1,300
1,300
Take discount when paying.
Nov. 22
Accounts Payable
Purchases Discounts
Cash
1,300
26
1,274
Do not take discount when paying.
Dec. 12
Accounts Payable
Cash
Purchase
1,300
1,300
discounts do not apply to freight, taxes, etc.
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67
Discussion
Q. What is the normal balance of the
Sales Discounts account? Is it an
asset, a liability, an expense, or a
contra-revenue account?
A. The normal balance of the Sales
Discounts account is a debit balance.
Sales Discounts is a contra-revenue
account. It is deducted from gross
sales on the income statement.
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68
OKAY, LET’S REVIEW...
1. Identify the management issues
related to merchandising
businesses.
2. Define and distinguish the terms of
sale for merchandising
transactions
3. Prepare an income statement and
record merchandising transactions
under the perpetual inventory
system.
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69
CONTINUING OUR REVIEW...
4. Prepare an income statement
and record merchandising
transactions under the
periodic inventory system.
5. Define internal control, identify
the five components of internal
control, and explain seven
examples of control activities.
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70
AND FINALLY...
6. Describe the inherent
limitations of internal control.
7. Apply internal control activities
to common merchandising
transactions.
8. Apply sales and purchases
discounts to merchandising
transactions.
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71