Chapter 5: The Operating Cycle and Merchandising Operations I. Managing Merchandising Businesses A.

merchandising business earns income by buying and selling goods B. Operating Cycle i. operating cycle purchase of inventory, payment for purchases made on credit, sales of inventory, and collection of cash from credit sales ii. financing period the time between the payment for inventory and the sale of merchandise iii. A company must have a way to pay for inventory before cash from sales is received C. Choice of Inventory System i. perpetual inventory system continuous records are kept of the quantity and cost of individual items as they are bought and sold ii. Under the perpetual inventory system, the cost of each item is added to the inventory account on purchase, and transferred to the cost of goods sold account on sale iii. periodic inventory system inventory on hand is counted periodically iv. Under the periodic inventory system, the cost of each item is added to the inventory account on purchase, and transferred to the cost of goods sold account periodically when inventory is counted D. Foreign Business Transactions i. exchange rate the value of one currency in terms of another ii. If a US company bills in terms of dollars, no special considerations need to be taken into account iii. If a US company bills in terms of a foreign currency, a change in the exchange rate between billing and receipt of payment may result in an exchange gain or loss. This is recorded and shown on the income statement as an expense or revenue. E. The Need for Internal Controls i. internal controls systems and procedures that protect a company's assets ii. physical inventory facilitates control over merchandise inventory iii. A loss in inventory is recorded as a debit to cost of goods sold and a credit to inventory F. Management's Responsibility for Internal Control i. All internal control policies must be documented and certified due to the Sarbanes-Oxley act of 2002. G. Sales and Purchases Discounts i. Terms of sales shown as n/30, which means the net amount is due in 30 days after the sale ii. 2/10, n/30 means a 2% sales discount is available if payment is made in ten days, otherwise the net amount is due in 30 days iii. Discounts are recorded at the time of payment iv. Sales Discount is a contra-revenue account with a normal debit balance v. If a payment is made in time to receive discount, Cash and Sales Discount are debited, and Accounts Receivable is credited vi. A buyer who receives a discount will Debit Accounts Payable and Credit Cash and Purchases Discounts (contra-expense account that reduces cost of goods sold) H. Transportation Costs i. FOB Shipping Point Seller places the merchandise free on board at the shipping point and the buyer pays the price of shipping ii. FOB destination Seller pays the price of shipping

iii. freight-in when the buyer pays the transportation charge iv. When the buyer pays, inventory is debited for the cost of shipping and cash or accounts payable is credited v. freight-out when the seller pays the transportation charge vi. When the seller pays, Freight-Out or delivery expense is debited and cash/accounts payable is credited. I. Terms of Debit and Credit Card Sales i. Debit cards transactions deduct directly from a customer's bank account, and are thus treated the same as a cash transaction ii. Credit card transactions draw cash from a credit card company, which takes a percentage of each transaction. Thus, the seller will debit Cash and Credit Card Expense and credit Sales Revenue. II. Perpetual Inventory System A. Purchases of Merchandise i. Purchases on Credit: a) DEBIT: Merchandise Inventory b) CREDIT: Accounts Payable ii. Purchases Returns and Allowances a) DEBIT: Accounts Payable b) CREDIT: Merchandise Inventory iii. Payments on Account a) DEBIT: Accounts Payable b) CREDIT: Cash B. Sales of Merchandise i. Sales on Credit a) DEBIT 1: Accounts Receivable b) CREDIT 1: Sales or Sales Revenue c) DEBIT 2: Cost of Goods Sold d) CREDIT 2: Merchandise Inventory ii. Sales Returns and Allowances a) DEBIT 1: Sales Returns and Allowances b) CREDIT 1: Accounts Receivable c) DEBIT 2: Merchandise Inventory d) CREDIT 2: Cost of Goods Sold iii. Receipts on Account a) DEBIT: Cash b) CREDIT: Accounts Receivable iv. sales returns and allowances a contra-revenue account with a normal debit balance that measures the amount of unsatisfactory products and dissatisfied customers III. Periodic Inventory System A. cost of goods available for sale the total cost of merchandise that could have been sold for the accounting period (the sum of merchandise on hand at the beginning of the accounting period and purchases of inventory during the period) B. net cost of purchases sum of net purchases and freight-in C. net purchases total purchases less any deductions D. Purchases of Merchandise i. Purchases on Credit a) DEBIT: Purchases b) CREDIT: Accounts Payable

ii. Purchases Returns and Allowances a) DEBIT: Accounts Payable b) CREDIT: Purchases Returns and Allowances iii. Payments on Account a) DEBIT: Accounts Payable b) CREDIT: Cash E. Sales of Merchandise i. Sales on Credit a) DEBIT: Accounts Receivable b) CREDIT: Sales ii. Sales Returns and Allowances a) DEBIT: Sales Returns and Allowances b) CREDIT: Accounts Receivable iii. Receipts on Account a) DEBIT: Cash b) CREDIT: Accounts Receivable IV. Internal Control: Components, Activities, and Limitations A. Components of Internal Control i. control environment created by management's overall attitude, awareness, and actions, it encompasses a company's ethics, philosophy and operating style, organizational structure, method of assigning authority and responsibility, and personnel policies and practices. ii. risk assessment identifying areas in which risks of loss of assets or inaccuracies in accounting records are high so that adequate controls can be implemented iii. information and communication the way the accounting systems gathers information and how it communications individual responsibilities. iv. control activities the policies and procedures management puts in place to see that its directives are carried out v. monitoring management's regular assessment of quality or internal control B. Control Activities i. authorization the approval of certain transactions and activities ii. recording transactions iii. documents and records iv. physical controls controls that limit access to assets v. periodic independent verification someone other than the persons responsible for the accounting records and assets should periodically check the records against the assets vi. separation of duties no one person should authorize transactions, handle assets, or keep records of assets vii. sound personnel practices adequate supervision, rotation of key people among different jobs, insistence that employees take vacations, and bonding of personnel who handle cash or inventory C. Limitations on Internal Control i. No system of internal controls is without weaknesses ii. Errors arise from misunderstandings, mistakes in judgment, carelessness, distraction, or fatigue V. Internal Control over Merchandising Transactions A. Internal Control and Management Goals i. Goals of Internal Control a) Keeping enough inventory on hand to sell to customers without overstocking

b) Keeping sufficient cash on hand to pay for purchases in time to receive discounts c) Keeping credit losses as low as possibly by making credit sales only to customers who are likely to pay on time ii. Use a cash budget to keep adequate cash on hand to pay of liabilities and expenses at due dates, and invest excess cash to collect interest on it until the cash is needed iii. Use separation of duties to help prevent theft during transactions B. Control of Cash Receipts i. Control of Cash Received by Mail: Two or more employees should handle the money, making triplicate copies of each payer's name, purpose for which the money is sent, and the amount. This list should go to the accounting department, cashier, and kept for the mail opener's records. ii. Control of Cash Received over the Counter: Use cash registers and pre-numbered sales tickets. C. Control of Purchases and Cash Disbursements i. Separate duties ii. Use a lot of documents for each step in the process: Purchase Acquisition, Purchase Order, Invoice, Receiving Report, Check Authorization, Check, and Bank Statement