1 Chapter 5 Merchandise Accounting & Internal Control

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Chapter 5

Merchandise Accounting&

Internal Control

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Key Concepts & Objectives

Sales Adjustments Net Sales– Discounts: Trade, Quantity & Prompt Pymt.

– Returns & Allowances Inventory Recording Systems

– Perpetual vs. Periodic Inventory Systems Cost of Goods Sold model Cost of Goods Purchased model Internal Control Systems Safeguard Assets

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Sales of Merchandise – Review effect on the Accounting Equation

-----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE + Revenues - Expenses

GAAP:GAAP: Revenue is recognized when Revenue is recognized when earnedearned. . Example:Example: In this case (merchandise sale) when the In this case (merchandise sale) when the exchangeexchange takes place. takes place.

+ Cash or+ A/R

+Sales Revenue

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Internal Income Statement for a Merchandising company

Cash sales $ 350,000Credit sales 124,000

Total 474,000Less: Sales returns &

allowances* ( 12,400) Sales discounts* ( 34,600)

Net Sales (on I/S) $ 427,000

*Contra-accounts used for control and analysis purposes. What information do they provide? Why is that useful? To whom?

A Contra-Account must be used along with another account.Above are examples of Contra-Revenue accounts.

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Sales Returns and Allowances - effect on the Accounting Equation

Decreases Sales Revenue, this is a Contra-Revenue account.

Sales Revenue xxxLess: Sales R&A xx Sales Dis. xxNet Sales xx


(Cash) or (A/R)

(Sales Returns andAllowances)

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Trade & Quantity Discounts

Not always recorded separately in company’s accounting records; Should they? Why?

Trade DiscountsOffered to special class of customers

Quantity DiscountsOffered to

customers willing to buy in larger

quantities

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n/30n/30 Payment due 30 days from invoice date

1/10, n/301/10, n/30 Deduct 1% of invoice amount if paid within 10 days; otherwise gross amount is due in 30 days

2/10, n/302/10, n/30 Deduct 2% of invoice amount if paid within 10 days; otherwise

total invoice amount is due in 30 days

Credit Terms and Sales Discounts(used B2B in certain industries to encourage prompt payment)

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Credit Terms and Sales Discounts(used B2B in certain industries to encourage prompt payment)

n/30 Payment due 30 days from invoice date

1/10, n/30 Deduct 1% of invoice amount if paid within 10 days; otherwise gross amount is due in 30 days

2/10, n/30 Deduct 2% of invoice amount if paid within 10 days; otherwise

total invoice amount is due in 30 days

Does “n” (for “net”) make sense? Wouldn’t a better symbol be “g” (“gross”) or “t” (total). But this is a term that’s been used for many years and it has become accepted in practice over time!

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Recording Sales Discounts: ExampleAssume a credit sale of $5,000 with payment terms of “1/10, net 30.” Effect on the B/S Equation?

Using the Gross Sales Method, Sales Discount is not recordednot recorded unlessthe discount is taken.

Sales Revenue xxxLess: Sales R&A xx Sales Dis. xxNet Sales (on I/S) xxIt might mean Net Sales are OVERSTATED.


Accounts SalesReceivable $5,000 Revenue $5,000

What could this mean about the Net SalesNet Sales reported on the I/SI/S fora company using the Gross MethodGross Method?

Recording Sales Discounts: ExampleIf customer pays withinwithin the discount period, they receive a 1% discount. What is the effect on the B/S Equation?

A: A/R R: Sales

$5,000

CR: Sales Discounts

$5,000 $5,000 $50

A: Cash

$4,950

FORMULA: Sales Discount = Gross Sales x Discount % $50 = $5,000 x 1 %

Cash Received = Gross Sales - Sales Discount $4,950 = $5,000 - $50

$0 Customer’s Balance after payment.

How would this event be recordedrecorded?

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Recording Sales Discounts: ExampleIf customer pays within the discount period, they receive a 1% discount. What is the effect on the B/S Equation?

A: A/R R: Sales

$5,000

CR: Sales Discounts

$5,000 $5,000 $50

A: Cash

$4,950


$0

Accounts SalesReceivable ($5,000) DiscountsCash $4,950 ($50) Notice the net increase in assets and equity (revenues) is $4,950$4,950 from SaleSale and CollectionCollection

$4,950 $4,950

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Inventory Recording Systems:Two Alternate Approaches

Concept: Different approaches are used to update accounting records for key inventory transactions

Transactions:– Purchases of goods from vendors (increase inventory)– Sales of goods to customers (decrease inventory)

Approaches: When to update?1. Perpetual inventory system Constant updates2. Periodic inventory system End-of-period updates

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Perpetual Inventory Systems

Traditionally used for low-volume, high-priced inventory items (e.g., autos or jewelers)

Recently, Point of Sale (POS) terminals have improved ability of mass merchandisers (like grocery stores) to utilize perpetual inventory systems

Why do some stores (e.g., Jewel) use scanners, while others (e.g., 7-11’s) don’t? Impact on customers?

Concept: Inventory records are perpetually perpetually updatedupdated – i.e., with each purchase or sale.

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Periodic Inventory Systems

Reduces record-keeping (and costs), but Decreases ability to:

– track theft, breakage, etc., – provide high service levels to customers, and– prepare interim financial statements.

Predominant method used for financial financial reportingreporting! (Cost vs. Benefit)

Concept: Inventory records are periodicallyperiodically updatedupdated – only after physical inventory counts.

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Beginning Inventory (B/S) $ 10,000

+ Cost of Goods PurchasedCost of Goods Purchased 40,000

Cost of Goods Available for Sale 50,000

- Ending Inventory (B/S) (20,000)

Cost of Goods Sold (I/S) $ 30,000

The Cost of Goods Sold ModelPeriodic InventoryPeriodic Inventory

Determined by physical count & shown on B/S’s

“Pool” of goodsavailable to be soldduring the period

Let’s see how Cost of Goods PurchasedCost of Goods Purchased is calculated

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The Cost of Goods Purchased ModelPeriodic Inventory

Less:

Purchase Returns Purchase Returns

& Allowances& Allowances

Purchase DiscountsPurchase Discounts

Plus: Transportation-inTransportation-in

Cost of Goods PurchasedCost of Goods Purchased

PurchasesPurchasesGross invoice price

Shipping cost to buyer, if any

Opposite of Sales R&A

Opposite of Sales Discounts

Internal calculation; not an account nor reported in F/S’s

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Cost of Goods Purchased: Periodic Inventory

What type of What type of ACCOUNTSACCOUNTS would these be in the B/S Equation? would these be in the B/S Equation?

Less:




Plus: Transportation-inTransportation-in


PurchasesPurchases??Expense AccountExpense Account………. ………..but WhyWhy?

1.1. Periodic InvPeriodic Inv. assumes all inventory is SOLDSOLD!

2. So PURCHASESPURCHASES are really the same as COGS i.e., an EXPENSEEXPENSE in I/SI/S.

3. (COGS COGS is not an account in the G/LG/L but it is a

calculated amountcalculated amount for I/SI/S.)

4. So at end of periodend of period COGS COGS & & INVINV must be updated to proper balances for F/S purposesF/S purposes.

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Less:




Plus: Transportation-in?Transportation-in?


PurchasesExpenseExpense account; it is part of COGS

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Less:




Plus: Transportation-in


Purchases

Contra-Expense account to Purchases

Contra-Expense account to Purchases

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Assume a credit purchasecredit purchase of $1,000$1,000 with payment terms of 2/10, net 30. Record effecteffect on B/S equation

E: Purchases L: Accounts Payable

$1,000 $1,000


RECORDING PURCHASE DISCOUNTS:

PERIODIC INVENTORY SYSTEMPERIODIC INVENTORY SYSTEM

Accts. Purchases Payable ($1,000)

$1,000

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If company pays pays within discount perioddiscount period, they can deducta 2% discount2% discount. Determine the effect on the B/S equation.

E: PurchasesL: Accts Payable

1,0001,000

A: Cash

Formula: Purchase Discount = Purchase Price x Discount % $20$20 = $1,000 x .02

Cash Paid = Gross Purchase - Purchase Discount $980$980 = $1,000 - $20

CE: Pur. Discount

$1,000$1,000 $20$20$980$980

$0

RECORDING PURCHASE DISCOUNTS:

PERIODIC INVENTORY SYSTEMPERIODIC INVENTORY SYSTEM

A/P is fully paid!

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E: PurchasesL: Accts Payable

$1,000$1,000

A: Cash CE: Pur. Discount

$1,000$1,000 $20$20$980$980

$0

Cash Accts. Purchase ($980) Payable Discounts

($1,000) $20

RECORDING PURCHASE DISCOUNTS:PERIODIC INVENTORY SYSTEM

If company pays pays within discount perioddiscount period, they can deducta 2% discount2% discount. Determine the effect on the B/S equation.


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FOB Destination Point(Freight On Board)

Sale or purchase is not recordednot recorded until inventory reaches its destination pointdestination point.

SellerSeller responsible for inventory while in transit. Importance: Year-end “cut-off” or Damage claim

Seller Buyer

TitlePasses at

Destination

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FOB Shipping Point

Sale and purchaseSale and purchase are both recorded upon shipmentshipment – when “truck leaves the dock”

BuyerBuyer responsible for inventory while in transittransit Importance: F/S Cut-offs and Damage claims

Seller Buyer

TitlePasses when

Shipped

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Internal Control Systems(require 3 components)

Control Environment

AccountingSystem

InternalControl

Procedures

CONCEPT: Techniques used to safeguard & protect assets of company

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Responsibilities for Internal Control

External Auditors

CPA’sInternal Auditors

Audit Committee of Board of

Directors

Managementhas the

primaryresponsibility

Management: Sets and enforces policies

Internal Auditors: Test for compliance

CPA’s: Verifies and reports to Audit Comm.

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The Control Environment:An Attitude

Reflect management’s understanding of controls, competence and operating style

Necessitate certain control policies and practices

Require influence and support of Board of Directors

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The Accounting System:A Necessity

Systems can be manual, automated or a combination of both

Use of documentation (audit trail) is integral part of any system and internal controls

DEFN: Methods, records and systems used to record transactions and report

financial information

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Internal Control Procedures:Key Safeguards used in Practice

SafeguardingAssets and

Records

ProperAuthorizations

IndependentVerification

Design& Use of Business

Documents

IndependentReview andAppraisal

EstablishingAudit Trail

Segregationof Duties

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Proper Authorizations

Concept: Authorizations are required before assets are transferred, used or exchanged

LOANAPPROVED

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Segregation of duties

Concept: Separate the physical custody of assets from the accounting for assets

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Independent Verification

Concept: Another individual or department (e.g., Internal Auditors) serve to verify or double-check the work of another

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Protecting Assets and Records

Concept: Protect assets and accounting records from loss, theft, unauthorized use, etc.

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Independent Review and Appraisal

Concept: Conduct periodic review of internal controls and appraisal of the accounting system as well as the people operating it.

CPA’s AuditReport

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Design and Use of Business Documents

Concept: Capture all relevant information about a transaction in order to properly record and classify financial effects.

Requires: “Audit trail” capabilities

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Limitations on Internal Control

No system can be entirely foolproof; breakdowns can occur– Employee collusion can override

the best controls

– Cost vs. benefit tradeoff’s exist

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Summary: Key Concepts & Objectives

Adjustments to Sales Net Sales– Discounts: Trade, Quantity & Prompt Pymt.

– Returns & Allowances Inventory Recording Systems

– Perpetual vs. Periodic Inventory Systems Cost of Goods Sold model Cost of Goods Purchased model Internal Control Systems Safeguard Assets

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Appendix 5A

Internal Control for a Merchandising Company

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Controls Over Cash

All cash receipts deposited intact daily

All cash disbursements made by check

Paycheck for

Dept. of Treasurer

John Doe

Payche

ck for

Date

Dept.

of Tre

asurer

Jane D

oeDate

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Controls Over Cash Received Over the Counter

Cash registers

Prenumbered customer receipts

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Controls Over Cash Received in the Mail

Two employees open mail

Prelist prepared Customer statements Investigation of

recurring discrepancies

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Document Flow for Merchandise

Checkprepared

PurchaseRequisition

Receiving Report

Purchase Order

Invoice Approval

Purchase Invoice