Merchandise Accounting Chapter 5 Merchandise Accounting & Internal Control

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

Sales of Merchandise – Review effect on the Accounting Equation -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE + Revenues - Expenses + Cash or + A/R +Sales Revenue GAAP: Revenue is recognized when earned. Example: In this case (merchandise sale) when the exchange takes place.

Internal Income Statement for a Merchandising company Cash sales $ 350,000 Credit sales 124,000 Total 474,000 Less: Sales returns & allowances* ( 12,400) Sales discounts* ( 34,600) Net Sales (on I/S) $ 427,000 A Contra-Account must be used along with another account. Above are examples of Contra-Revenue accounts. *Contra-accounts used for control and analysis purposes. What information do they provide? Why is that useful? To whom?

Sales Returns and Allowances - effect on the Accounting Equation -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE + Revenues - Expenses (Cash) or (A/R) (Sales Returns and Allowances) Decreases Sales Revenue, this is a Contra-Revenue account. Sales Revenue xxx Less: Sales R&A xx Sales Dis. xx Net Sales xx

Trade & Quantity Discounts Trade Discounts Offered to special class of customers Quantity Discounts Offered to customers willing to buy in larger quantities Not always recorded separately in company’s accounting records; Should they? Why?

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

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!

Recording Sales Discounts: Example Assume a credit sale of $5,000 with payment terms of “1/10, net 30.” Effect on the B/S Equation? -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE + Revenues - Expenses Accounts Sales Receivable $5,000 Revenue $5,000 Using the Gross Sales Method, Sales Discount is not recorded unless the discount is taken. What could this mean about the Net Sales reported on the I/S for a company using the Gross Method? Sales Revenue xxx Less: Sales R&A xx Sales Dis. xx Net Sales (on I/S) xx It might mean Net Sales are OVERSTATED.

Recording Sales Discounts: Example If customer pays within the discount period, they receive a 1% discount. What is the effect on the B/S Equation? FORMULA: Sales Discount = Gross Sales x Discount % $50 = $5,000 x 1 % Cash Received = Gross Sales - Sales Discount $4,950 = $5,000 - $50 How would this event be recorded? A: Cash A: A/R R: Sales CR: Sales Discounts $4,950 $5,000 $5,000 $5,000 $50 $0 Customer’s Balance after payment.

Recording Sales Discounts: Example If customer pays within the discount period, they receive a 1% discount. What is the effect on the B/S Equation? -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE + Revenues - Expenses Accounts Sales Receivable ($5,000) Discounts Cash $4,950 ($50) Notice the net increase in assets and equity (revenues) is $4,950 from Sale and Collection $4,950 A: Cash A: A/R R: Sales CR: Sales Discounts $5,000 $4,950 $5,000 $5,000 $50 $0

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 updates 2. Periodic inventory system  End-of-period updates

Perpetual Inventory Systems Concept: Inventory records are perpetually updated – i.e., with each purchase or sale. 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?

Periodic Inventory Systems Concept: Inventory records are periodically updated – only after physical inventory counts. 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 reporting! (Cost vs. Benefit)

The Cost of Goods Sold Model Periodic Inventory Beginning Inventory (B/S) $ 10,000 + Cost 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 Determined by physical count & shown on B/S’s Let’s see how Cost of Goods Purchased is calculated “Pool” of goods available to be sold during the period

The Cost of Goods Purchased Model Periodic Inventory Less: Purchase Returns & Allowances Purchase Discounts Plus: Transportation-in Cost of Goods Purchased Purchases Gross 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

Cost of Goods Purchased: Periodic Inventory What type of ACCOUNTS would these be in the B/S Equation? Less: Purchase Returns & Allowances Purchase Discounts Plus: Transportation-in Cost of Goods Purchased Purchases? Expense Account………. ………..but Why? Periodic Inv. assumes all inventory is SOLD! So PURCHASES are really the same as COGS  i.e., an EXPENSE in I/S. (COGS is not an account in the G/L but it is a calculated amount for I/S.) So at end of period COGS & INV must be updated to proper balances for F/S purposes.

Cost of Goods Purchased: Periodic Inventory What type of ACCOUNTS would these be in the B/S Equation? Less: Purchase Returns & Allowances Purchase Discounts Plus: Transportation-in? Cost of Goods Purchased Purchases Expense account; it is part of COGS

Cost of Goods Purchased: Periodic Inventory What type of ACCOUNTS would these be in the B/S Equation? Less: Purchase Returns & Allowances Purchase Discounts Plus: Transportation-in Cost of Goods Purchased Purchases Contra-Expense account to Purchases

PERIODIC INVENTORY SYSTEM RECORDING PURCHASE DISCOUNTS: PERIODIC INVENTORY SYSTEM Assume a credit purchase of $1,000 with payment terms of 2/10, net 30. Record effect on B/S equation -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE + Revenues - Expenses Accts. Purchases Payable ($1,000) $1,000 E: Purchases L: Accounts Payable $1,000

PERIODIC INVENTORY SYSTEM RECORDING PURCHASE DISCOUNTS: PERIODIC INVENTORY SYSTEM If company pays within discount period, they can deduct a 2% discount. Determine the effect on the B/S equation. Formula: Purchase Discount = Purchase Price x Discount % $20 = $1,000 x .02 Cash Paid = Gross Purchase - Purchase Discount $980 = $1,000 - $20 A: Cash L: Accts Payable CE: Pur. Discount E: Purchases 1,000 1,000 $980 $1,000 $20 $0 A/P is fully paid!

PERIODIC INVENTORY SYSTEM RECORDING PURCHASE DISCOUNTS: PERIODIC INVENTORY SYSTEM If company pays within discount period, they can deduct a 2% discount. Determine the effect on the B/S equation. -----------Balance Sheet------------- --Income Statement-- Assets = Liabilities + OE + Revenues - Expenses Cash Accts. Purchase ($980) Payable Discounts ($1,000) $20 A: Cash L: Accts Payable CE: Pur. Discount E: Purchases $1,000 $980 $1,000 $1,000 $20 $0

FOB Destination Point (Freight On Board) Seller Buyer Title Passes at Destination Sale or purchase is not recorded until inventory reaches its destination point. Seller responsible for inventory while in transit. Importance: Year-end “cut-off” or Damage claim

FOB Shipping Point Seller Buyer Title Passes when Shipped Sale and purchase are both recorded upon shipment – when “truck leaves the dock” Buyer responsible for inventory while in transit Importance: F/S Cut-offs and Damage claims

Internal Control Systems (require 3 components) CONCEPT: Techniques used to safeguard & protect assets of company Control Environment Accounting System Internal Procedures

Responsibilities for Internal Control Auditors Internal External Auditors CPA’s Management has the primary responsibility Audit Committee of Board of Directors Management: Sets and enforces policies Internal Auditors: Test for compliance CPA’s: Verifies and reports to Audit Comm.

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

The Accounting System: A Necessity DEFN: Methods, records and systems used to record transactions and report financial information Systems can be manual, automated or a combination of both Use of documentation (audit trail) is integral part of any system and internal controls

Internal Control Procedures: Key Safeguards used in Practice Proper Authorizations Segregation of Duties Independent Verification Independent Review and Appraisal Establishing Audit Trail Design & Use of Business Documents Safeguarding Assets and Records

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

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

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

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

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 Audit Report

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

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

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

Internal Control for a Merchandising Company Appendix 5A Internal Control for a Merchandising Company

Controls Over Cash All cash receipts deposited intact daily All cash disbursements made by check Paycheck for Dept. of Treasurer John Doe Date Jane Doe

Controls Over Cash Received Over the Counter Cash registers Prenumbered customer receipts

Controls Over Cash Received in the Mail Two employees open mail Prelist prepared Customer statements Investigation of recurring discrepancies

Document Flow for Merchandise Check prepared Purchase Requisition Receiving Report Order Invoice Approval