Financial Report

This activity provides an opportunity for students to work effectively in a team environment, either as a team leader or as a member. This exercise also allows students to become globally aware about current issues facing hospitality managers, and enhance their critical thinking and problem solving skills. More importantly, this team activity allows students to demonstrate their understanding of the theoretical tools of the course as applied in real world setting.

Each team will regularly monitor current global issues facing hospitality managers by reading quality newspapers and relate these issues with the hospitality finance lessons at hand. Your task is to work together by regularly monitoring, analyzing, and assessing these current global issues.

The topic: Responsibility accounting, ROI, Budgets

Your team report must include the following components:

1. Title, author, and the source of the news article, including a URL link if the news article is from an online source;

2. In your own words, an executive summary of the news article and how it relates with the cumulative lessons for the period;

3. A team analysis, interpretation, assessment of this news article on hospitality managers and/or hospitality operations; and

6. A summary of the team’s resolve how you intend to apply these lessons into your personal and professional careers- hospitality
Accounting Essentials for Hospitality Managers

For non- accountant hospitality managers, accounting and fi nancial management is often perceived as an inaccessible part of the business, yet understanding it is crucial for success. Using an “easy-to-read” style, this book provides a comprehensive overview of the most relevant accounting information for hospitality managers. It demonstrates how to organ- ise and analyse accounting data to help make informed decisions with confi dence.

With its highly practical approach, this third edition:

● quickly develops the reader’s ability to adeptly use and interpret accounting information to further organisational decision making and control;

● demonstrates how an appropriate analysis of fi nancial reports can drive your business strategy forward from a well- informed base;

● develops mastery of the key accounting concepts through fi nancial decision making cases that take a hospitality manager’s perspective on a range of issues;

● sets fi nancial problems in the context of a range of countries and currencies; ● includes two new chapters concerning managerial fi nance issues and revenue

management; ● includes accounting problems at the end of each chapter, to be used to test know-

ledge and apply understanding to real- life situations; ● offers extensive web support for tutors and students, providing explanation and

guidelines for instructors on how to use the textbook and examples, PowerPoint slides, solutions to end of chapter problems, and student test bank and additional exercises.

This book is written in an accessible and engaging style, and is structured logically with useful features throughout to aid students’ learning and understanding. It is an essential resource for all future hospitality managers.

Chris Guilding is Professor of Hotel Management in the Department of Tourism, Leisure, Hotel and Sport Management at Griffi th University, Australia. His teaching specialism is in management accounting and he has taught on the MBA, Masters in Hospitality Management, Professional Golfers Association, Australian Institute of Company Directors Course and undergraduate programmes.

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Accounting Essentials for Hospitality Managers

Third edition

Chris Guilding

First published 2014 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN

and by Routledge 711 Third Avenue, New York, NY 10017

Routledge is an imprint of the Taylor & Francis Group, an informa business

The right of Chris Guilding to be identifi ed as the author of this work has been asserted by him in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers.

Trademark notice : Product or corporate names may be trademarks or registered trademarks, and are used only for identifi cation and explanation without intent to infringe.

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data Guilding, Chris. Accounting essentials for hospitality managers / Chris Guilding. pages cm Includes bibliographical references and index. 1. Hospitality industry—Accounting. 2. Hospitality industry—Management.

I. Title. HF5686.H75G848 2013 657′.837—dc23 2013023756

ISBN: 978–0–415–84107–8 (hbk) ISBN: 978–0–415–84109–2 (pbk) ISBN: 978–0–203–76666–8 (ebk)

Typeset in Sabon and Frutiger by Refi neCatch Limited, Bungay, Suffolk

To Dawne, Logan and Matthew

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vii

Contents

List of fi gures xi List of tables xii List of boxes xiii List of schedules xv List of exhibits xvi List of fi nancial decision making and control in action cases xviii Preface xix

1 Introduction: hospitality decision makers’ use of accounting 1 Key characteristics of the hospitality industry 2 Accounting and business management 7 Accounting and hospitality decision makers 9 Uniform system of accounts 11 Organisational forms 13

2 Analysing transactions and preparing year- end fi nancial statements 19 The balance sheet and income statement 20 Classifying transactions according to assets, liabilities and owners’ equity 22 The importance of understanding fi nancial accounting basics 27

3 Double entry accounting 33 Double entry accounting: some background concepts 33 Double entry accounting: a worked example 36 Journal entries 42

4 Adjusting and closing entries 47 Why do we need closing entries? 47 Why do we need adjusting entries? 48 Worked examples highlighting types of adjusting entry 49

5 Financial statement analysis 67 Profi t performance 68 Financial stability 75 Ratios using operational measures 77

Contents

viii

6 Internal control 89 Internal control principles 91 Internal control procedures used for specifi c hotel activities 94 Bank reconciliation: an important internal control procedure 97 Accounting for petty cash 104

7 Cost management issues 116 Management’s need for cost information 117 Major cost classifi cation schemes 118 Qualitative and behavioural factors in management decisions 128

8 Cost- volume-profi t analysis 137 Contribution margin 137 Breakeven analysis 139 The assumptions of cost- volume-profi t analysis 147

9 Budgeting and responsibility accounting 154 Responsibility accounting 155 Issues of cost, revenue, profi t and investment centre design 158 Roles of the budget 163 Behavioural aspects of budgeting 166 Technical aspects of budget preparation 169

10 Flexible budgeting and variance analysis 181 Flexible budgeting 182 Variance analysis 184 Benchmarking 190

11 Performance measurement 199 Shortcomings of conventional fi nancial performance measures 200 Key issues in performance measurement system design 202 The balanced scorecard 208

12 Cost information and pricing 219 Factors affecting pricing 221 Traditionally applied pricing methods 223

13 Working capital management 238 Cash management 239 Accounts receivable management 246 Inventory management 249 Accounts payable management 250 Working capital management 252

14 Investment decision making 260 Accounting rate of return 261 Payback 262 Net present value (NPV) 263 Internal rate of return 269 Integrating the four investment appraisal techniques 270

Contents

15 Other managerial fi nance issues 279 What should be the over- riding business objective in fi nancial management? 280 Agency issues 283 Trading shares in publicly listed companies 290 Share valuation 291 Dividends 293 Operating and fi nancial leverage 296

16 Revenue management 307 Business characteristics conducive to revenue management application 308 Demand forecasting 310 Gauging a hotel’s need for revenue management 311 Revenue management system requirements 315 Using rate categories and demand forecasts 318 Length of stay controls 319 Managing group bookings 321 Revenue management implementation issues 324 Words of caution in applying the revenue management philosophy 325

Solutions to fi rst three problems in each chapter 331 Index 355

A range of further resources for this book are available on the Companion Website: www.routledge.com/cw/guilding

http://www.routledge.com/cw/guilding

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Figures

9.1 An example of a hotel’s organisation chart 156 9.2 A responsibility centre and its dimensions of accountability 156 9.3 A hierarchical perspective of responsibility centres’ accountability 157 9.4 Budget diffi culty and management performance 167 9.5 Kitchen and restaurant physical sequencing of events 170 9.6 The sequence in which budget schedules relating to kitchen

activities are prepared 170 11.1 Overview of strategy- based balanced scorecard development 211 13.1 The impact of seasonality on asset investment 252 15.1 Different spans of leverage 297 16.1 Internal analysis of lost revenue 312

xii

Tables

14.1 Present value factors for a single cash fl ow (PV) 264 14.2 Present value factors for an annuity (PVA) 265 15.1 Operating leverage – impact of sales increase on EBIT 297 15.2 Financial leverage – impact of EBIT increase on EPS 299 16.1 Competing hotels revenue comparison 313 16.2 Competing hotels occupancy, ADR and Revpar penetration 314

xiii

Boxes

1.1 Dimensions of sales volatility in the hospitality industry 3 1.2 The accounting implications of distinctive hospitality industry

characteristics 6 1.3 Perspectives of hospitality decision makers on aspects of

accounting 9 2.1 The main sections of a balance sheet 21 3.1 Key principles of double entry accounting 34 4.1 Adjusting entries and the nature of the accrual concept 48 4.2 A scenario highlighting the need for depreciation 57 5.1 Revpar: a comprehensive indicator of room sales performance 79 5.2 Revenue yield per seat: a comprehensive indicator of restaurant

sales performance 81 6.1 The four objectives of internal control 90 6.2 Issues to consider when developing cash internal control

procedures 95 6.3 Factors causing a difference between a company’s recorded bank

account balance and the bank statement balance 98 6.4 Internal control procedures that can be used to counter

hotel- specifi c theft and fraud threats 107 7.1 Exploring cost objects: examples found in large restaurants 117 7.2 The nature of opportunity cost 118 7.3 Determining fi xed and variable costs using the “high- low”

method 124 7.4 The danger of treating average cost per unit as a constant 125 7.5 Using variable cost as a short- term pricing threshold 126 8.1 Calculating safety margin 142 8.2 Calculating breakeven: the case of two room types with

different contribution margins 143 8.3 Determining the sales necessary to achieve a targeted profi t 146 9.1 Highlighting a problem with ROI accountability 161 9.2 Calculating residual income 162 9.3 Factors affecting the accountability of a department’s

performance 167 11.1 11 key issues in performance measurement system design 203

Boxes

xiv

11.2 Four dimensions of balance in performance measures 205 11.3 Key features of the balanced scorecard (BSC) framework 209 11.4 Examples of hotel performance measures 214 12.1 Rule of a thousand approach to setting room rates 225 12.2 Relative room size approach to pricing 225 12.3 Revpar: a comprehensive room sales performance measure 229 12.4 Applying contribution pricing 231 13.1 Why is profi t not the same as cash? 244 13.2 The fi ve C’s of credit management 246 13.3 Accounts receivable collection techniques 248 13.4 Using the EOQ model to determine optimal order size 249 13.5 The profi t/risk trade- off in current liability fi nancing 253 14.1 Finding an investment proposal’s accounting rate of return 261 14.2 Finding an investment proposal’s payback 262 14.3 Using discounting tables to fi nd the present value of future

cash fl ows 266 14.4 Finding an investment proposal’s net present value 267 14.5 Calculating the cost of capital 268 14.6 Finding an investment proposal’s internal rate of return 269 15.1 The importance of EPS return timing 281 15.2 Everyday agency relationship challenges 284 15.3 Misalignment of manager and shareholder goals 286 15.4 Problem with management contract fee determination 289 15.5 Valuing a share that provides a consistent annual dividend 292 15.6 Dividend payment – accounting implications and timeline 294 16.1 Using rate categories and demand forecasts to maximise revenue 318 16.2 Length of stay revenue management 320 16.3 Changing the timing of a group booking 321 16.4 Changing the size of a group booking 323

Schedules

2.1 The impact of Exhibit 2.1’s ten transactions on the balance sheet 24

xvi

Exhibits

1.1 Summary Income Statement prepared in USALI format 12 1.2 Key differences across organisational forms 14 2.1 Illustration of how transactions affect the balance sheet equation 23 2.2 Illustration of how the income statement is linked to the balance

sheet via the statement of owners’ equity 26 3.1 The double entry accounting framework 35 3.2 The Cash “T account” 35 3.3 Illustration of a general journal 42 4.1 Determining stock used in a periodic inventory system 54 5.1 Celestial Hotel Ltd Income statement for the year ending 31/12/20X1 68 5.2 Celestial Hotel Ltd Balance sheet as at 31/12/20X1 69 5.3 Dissecting ROI into profi t margin and asset turnover 70 7.1 HighRollers’ unallocated income statement for the three months

ending 31 December 20X1 119 7.2 Methods used to allocate HighRollers’ indirect costs to profi t centres 121 7.3 HighRollers’ income statement based on allocated indirect costs for

the three months ending 31 December 20X1 122 7.4 RockiesResort income statement analysis 127 8.1 The DapperDrake Resort Income statement for the year ending

30 June 20X1 (Conventional format) 138 8.2 The DapperDrake Resort Income statement for the year ending

30th June 20X1 (Contribution margin layout) 138 8.3 Graphing breakeven 142 9.1 JazzFest pastry production labour costs 171 9.2 JazzFest projected sales demand for pastries 171 9.3 JazzFest budgeted production of pastries 172 9.4 JazzFest budgeted purchase of fl our schedule (in kilograms) 172 9.5 JazzFest budgeted labour cost for pastry production 173 10.1 The Poplars Hotel Rooms Department Flexible budget performance

report – month ending 30th April 20X1 183 10.2 Calculation of labour rate and effi ciency variances 185 10.3 Calculation of material price and effi ciency variances 187 10.4 Calculation of the selling price and sales volume variances 189 12.1 Comparing price discretion for wine and a room night 220

Exhibits

xvii

12.2 Poisson Restaurant – cost of ingredients used in fi sh salad 223 12.3 Using required rate of return to set room rates 227 13.1 BackWoods Retreat budgeted income statements for January,

February and March 240 13.2 Information relating to BackWoods’ projection of cash fl ows 241 13.3 Schedule of projected cash receipts for BackWoods Retreat 242 13.4 Schedule of projected cash disbursements for BackWoods Retreat 243 13.5 A cash budget for BackWoods Retreat 244 13.6 Accounts receivable aging schedule 247

xviii

Financial decision making and control in action cases

2.1 The General Manager’s use of balance sheet information 27 3.1 The General Manager’s interpretation of the retained earnings

account 41 4.1 The F&B manager’s choice of inventory control procedures 55 5.1 The Financial Controller and analysing ROI 74 6.1 Small business owner bank reconciliation statement preparation 103 7.1 The F&B manager and the decision to outsource 129 8.1 The Rooms Division Manager and breakeven analysis 140 9.1 Human Resource Managers’ use of budgets when planning

staffi ng levels 165 10.1 The Rooms Division Manager and variance analysis 186 11.1 Senior management establishing a balanced scorecard

performance measurement system 212 12.1 The Sales and Marketing Manager and revenue management 230 13.1 The Financial Controller determining whether to take a trade

discount 251 14.1 The Chief Engineer and investment appraisal 270 15.1 The Financial Controller and fi nancial leverage 301 16.1 The Revenue Manager and price elasticity of demand 316

xix

Preface

Welcome to Accounting Essentials for Hospitality Managers . This is the third edition of the book, although the book’s fi rst edition was entitled Financial Management for Hospitality Decision Makers . The re- titling of the book resulted from a concern that the words “fi nancial management” convey a particular meaning to many accounting and fi nance academics. This meaning suggests a curriculum that encompasses corporate fi nance topics such as the cost of capital and capital structure. Such topics would be of interest to fi nance specialists working in the corporate head offi ce of large hotel chains. They are not particu- larly pertinent, however, to managers operating at the hotel property level. This book is concerned with the key accounting tools and techniques that facilitate effective management in a hotel property. Hence the words ‘’accounting” and ‘’essentials” are included in the new title.

This edition of the book contains two new chapters: Chapter 15, which is concerned with fi nancial management topics not addressed elsewhere in the book, and Chapter 16, which provides an accounting perspective on revenue management, which has become an increasingly important facet of hotel manage- ment in recent years. The number of problems appearing at the end of each chapter has also been expanded to a minimum of 12. For each chapter, solutions for the fi rst three problems are provided at the back of the book. This is a self- help feature designed to further facilitate learning and enable students to review their understanding of concepts covered by the book.

The current era of growth and dynamic change in hospitality signifi es that it is an exciting time to be involved with the industry. Like many other industries, the hospitality sector is experiencing heightened levels of competition and a growing need to apply appropriate management techniques to ensure commercial success. These factors increasingly signify that a hotel manager needs a working know- ledge of accounting tools, techniques and procedures.

From my experience as an instructor of accounting generally, and hospitality management accounting in particular, I have found students tend to approach their fi rst class with a degree of trepidation and an expectation that the subject will be dry and diffi cult to master. Through this book, I endeavour to make the subject material accessible and to demonstrate the relevance of accounting to all hotel managers in all but the smallest hotels. Recognition of the way that accounting can be usefully applied by the modern manager is a critical factor that

Preface

can stimulate a student’s desire to master the material covered. Once relevance is appreciated, the student starts to explore the range of ways in which accounting can serve the hospitality manager.

The approach to topics covered has been designed to maximise the reader’s sense that they are quickly mastering key accounting concepts. Such mastery will help the reader develop the courage to demand excellence of the hotel’s accounting department where he or she works. This is a key step in the design of a quality accounting system. Too frequently, managers are “turned- off” by accounting jargon and the way accounting reports are presented. It is an unfortu- nate reality that accounting reports frequently appear to be designed by accoun- tants for accountants. This problem is partially attributable to the fact that most qualifi ed accountants have gained their qualifi cation through demonstrating their understanding of the rules of external reporting (i.e., fi nancial accounting, which is the branch of accounting concerned with the preparation of annual accounts for external parties, such as shareholders). When providing accounting information to managers within the hotel, however, reports should be designed with the decision making needs of the managers in mind. Hotel accounting systems can be greatly improved if managers play an active role in ensuring that accounting reports developed for their use are designed to be of maximum relevancy and are structured in a format that facilitates easy interpretation and use.

The book has been written with two specifi c audiences in mind. Firstly, it can serve as a valuable self- help tool for the practising hospitality manager interested in improving their appreciation of accounting techniques and procedures. Secondly, it has been designed to serve as a text that can be used in an accounting course in a hospitality- related programme of study. While the depth of the material covered signifi es it would serve well as a stage two text, it can certainly be used in a fi rst year of study, as no prior study of accounting is presumed.

In my view, not only can a well- designed book meet the needs of both the prac- titioner and student audiences, a well- balanced book is likely to result from addressing the needs of both audiences. Addressing the practising manager audi- ence ensures that the book imparts information that is relevant to today’s hospi- tality manager in a direct and readily accessible style. The reader will be able to quickly see the wood from the trees and gain an early appreciation of how concepts introduced can be applied in practice. Addressing a student audience ensures that the material covered provides a broad foundation. The problems provided at the end of each chapter give students the chance to practice applying issues raised in the chapters and also to gain exposure to the type of problems that can be encountered in examination situations. A review of these problems will also prove extremely benefi cial to the practising manager, as deeper under- standing of the material covered in the text will result from exposure to a range of real world decision making scenarios.

A distinctive aspect of the book is its international orientation. The hospitality industry is becoming increasingly international with large multi- national chains dominating the 5 and 4 star market segments. This factor, together with the drawing together of countries to form economic alliances such as the European

Preface

xxi

Economic Union signifi es that a hotel manager’s career path can involve some international work experience. Further, the clientele base of hotels is becoming more international as a result of increased international business and tourist travel. In combination, these factors highlight the need for a book that views hospitality accounting in a globalised context. Scenarios introduced and problems posed will draw on a range of international settings. This will develop the reader’s familiarity with addressing fi nancial problems in the context of a range of coun- tries and currencies.

A second distinctive aspect of the book is its hospitality decision makers’ orien- tation. This theme will be apparent from the problem solving approach used throughout the text. In each chapter this approach is reinforced by the inclusion of a case that takes a particular hospitality manager’s perspective on an issue raised. Each of these cases is headed “Financial decision making in action” or “Financial control in action” and has a sub- heading relating to the hotel function and also the aspect of accounting in question.

The book can be viewed as comprising four main parts. After the introductory chapter, Chapters 2 to 5 focus on fi nancial accounting. Chapters 6 to 12 focus on management accounting, Chapters 13 to 15 focus on fi nancial management issues and Chapter 16 concerns revenue management. Each part can be approached independently of the other parts, i.e., if the reader is exclusively interested in management accounting, they can commence their reading at Chapter 6 or Chapter 7.

In Chapter 1, in the course of providing an overview of the nature of accounting, the contents of the book are introduced. Chapters 2, 3 and 4 build on one another to provide a grounding in fi nancial accounting. While fi nancial accounting does not represent the primary orientation of the book, a basic understanding of the workings of the fi nancial accounting system can be highly benefi cial to the hospi- tality manager, due to the importance of fi nancial statements such as the balance sheet and income statement. It is diffi cult to overstate the importance of these statements as they represent a key resource used by outsiders to gauge an organ- isation’s performance. The need for management to understand the mechanisms by which they are judged externally is clearly important. Chapter 5 provides a structured approach that can be taken to analysing the statements produced by the fi nancial accounting system.

Chapters 6–16 have more of an internal (i.e., within a hotel) orientation. Chapter 6 outlines signifi cant internal control challenges that arise in hotels and describes procedures that can be implemented to counter these challenges. Chapters 7–16 consider hospitality management decision making from the following perspectives:

● Classifying costs in order to facilitate decision making, ● Using cost- volume-profi t analysis, ● Applying budgeting and responsibility accounting, ● Applying fl exible budgeting and variance analysis, ● Designing appropriate performance measurement systems,

Preface

xxii

● Drawing on cost information to inform pricing decisions, ● How optimal decisions can be made with respect to working capital (i.e., cash,

accounts receivable, inventory and accounts payable management), ● What fi nancial techniques can be used in investment appraisal, ● How operating and fi nancial leverage can be manipulated to increase net

profi t, ● What revenue management steps can be taken in an effort to increase total

revenue.

The book has been designed to facilitate a fl exible teaching and learning approach. While the sequencing of the chapters results from my view of the most appro- priate order in which to present the material covered, many of the chapters can be read out of sequence. The only chapters that build on one another to such a degree that they should be read consecutively are Chapters 2, 3 and 4 and Chapters 9 and 10.

Should you have any suggestions in connection with how the book could be further strengthened in the next edition, it would be a pleasure to hear from you. Please contact me at my email address noted below.

I hope you fi nd this book to be a stimulating read and that your career benefi ts from you gaining an enhanced appreciation of the merits of applying appropri- ately chosen accounting techniques and procedures in hospitality management.

Finally, I would like to thank the publisher, John Wiley and Sons for allowing me to draw some of Chapter 6’s material from the following book:

The Key Elements of Introductory Accounting , Guilding C., Auyeung, P. and Delaney, D.; John Wiley and Sons Australia Ltd; © 2006, 3rd edition; Reprinted with permission of John Wiley & Sons Australia.

Chris Guilding c.guilding@griffi th.edu.au

mailto:c.guilding@griffith.edu.au

Chapter 1

Introduction: hospitality decision makers’ use of accounting

Learning objectives

After studying this chapter, you should have developed an appreciation of:

1. the accounting implications of key hospitality industry characteristics, 2. the nature of accounting and fi nancial management, 3. some of the ways hospitality managers become involved in accounting, 4. what is meant by the “ Uniform System of Accounts for the Lodging Industry ”, 5. the basic differences between sole proprietorships, partnerships and companies, 6. the focus of this book.

1) Introduction

This book describes accounting and fi nancial management procedures and analytical tech- niques in the context of hospitality decision making. The purpose of this introductory chapter is to set the scene for the remainder of the book.

The fi rst section of this chapter describes key characteristics relating to the hospitality industry and outlines accounting implications associated with these characteristics. Then, an overview of the nature of accounting is provided. In the course of describing the nature of accounting, the overall structure of the book will be introduced. We will see that Chapters 2–5 provide a grounding in hospitality fi nancial accounting. Chapters 6–12 introduce a range of topics relating to management accounting and will show how management accounting techniques and procedures are critically important to a host of hospitality decision making situations. Chapters 13–15 focus on managerial fi nance issues and Chapter 16 provides a fi nancial perspective on revenue management.

This chapter’s subsequent section highlights some of the many ways that different hospi- tality managers can apply accounting techniques and procedures to inform their decision making. The following section introduces an important accounting report: the income statement. This statement is introduced in the context of a description of the Uniform System of Accounts for the Lodging Industry . This system was developed in the US and is being

Introduction: hospitality decision makers’ use of accounting

increasingly used in large hotels internationally. This signifi es increased standardisation of the classifi cation scheme used by hotels to record their fi nancial transactions, and also greater standardisation of the fi nancial performance reports produced by hotels. The chapter’s fi nal section describes the three main types of commercial organisation: sole proprietorship, part- nership, and company.

2) Key characteristics of the hospitality industry

The hospitality industry encompasses a broad range of activities and types of organisation. Some of the industry’s particularly visible players include restaurants and bars that provide dining and beverage services and also lodging operations that offer accommodation facilities. Restaurant organisations range from multinational companies to small street corner cafés. Similarly, lodging operations range from multinational hotels offering thousands of rooms worldwide to bed and breakfast operations offering a single guest room. At the bed and break- fast extreme, we have small family- run concerns with a limited service range, while at the other extreme we have multinational companies offering a range of services that include accommo- dation, dining and frequently conference, sports and leisure facilities. The hospitality industry’s heterogeneity becomes apparent when we recognise that its diversity encompasses the following:

● Hotels ● Motels ● Restaurants ● Fast food outlets ● Pubs and bars ● Country and sport clubs ● Cruise liners.

This book is primarily focused on hotel management. This focus has been taken because the majority of large hotels provide most of the service elements offered by the hospitality organisations listed above. In addition, as many large hotels have to co- ordinate provision of a range of hospitality services under one roof, they confront a degree of management complexity not encountered in many other hospitality organisations that offer a narrower range of services. For example, a large hotel’s organisational structure and accounting system must be designed with due regard given to co- ordinating a range of disparate functions that, in most cases, will at least include the provision of accommodation, restaurant and bar facilities. The disparity of these functions is apparent when we recognise that the sale of rooms can be likened to the sale of seats in the airline or entertainment industries, a parallel exists between food preparation in restaurant kitchens and production activities in the manufacturing industry, and bar opera- tions can be likened to retailing. In addition to managing this disparate range of services, a hotel needs to co- ordinate a set of distinct support activities such as laundry, building and grounds maintenance, information systems, training, marketing, transportation, etc.

This disparate range of hospitality activities is housed within a single site (i.e., building and surrounds), that we refer to as a hotel. This creates a degree of site complexity which is exacerbated when we recognise that the location of the service provider is also the place where the customer purchases and consumes the services offered. While this is patently obvious to anyone who has been to a hotel, we should not forget that it is not the case in many other service industries (e.g., banking, transportation, telecommunications, law, accounting), or the manufacturing industry. This factor highlights a further dynamic of the hotel industry. Not

Key characteristics of the hospitality industry

only is a hotel site the place where a broad range of activities are undertaken, it is the focal point of extensive and continual vigilance with respect to cleaning, maintenance and security. We can thus see that a hotel represents a complex site where distinct activities are conducted in close proximity to one another. Where the performance of one functional activity (e.g., cleaning) can be affected by the way another is conducted (e.g., maintenance), high inter- dependency is said to exist. Such high interdependency can create problems when attempting to hold one functional area (e.g., cleaning) accountable for its performance.

Not only is functional interdependency an issue when trying to hold a manager account- able for costs, it can be a problem when attempting to hold a manager responsible for a particular department’s level of sales. For example, through no fault of her own, a food and beverage (F&B) manager may see her profi ts plummet as a result of a relatively low number of rooms sold by the rooms division. Such cross- functional interdependency needs to be recognised when identifying what aspect of a hotel’s performance a particular manager should be held accountable for.

Sales volatility

The hotel industry experiences signifi cant sales volatility. The extent of this volatility becomes particularly apparent when we recognise it comprises at least four key dimensions:

● economic cycle volatility, ● seasonal sales volatility, ● weekly sales volatility, ● intra- day sales volatility.

These dimensions of sales volatility and the implications they carry for hotel accounting are elaborated upon in Box 1.1.

Box 1.1

Dimensions of sales volatility in the hospitality industry

1) Economic cycle volatility : Hotels are extremely susceptible to the highs and lows of the economic cycle. Properties with a high proportion of busi- ness clients suffer during economic downturns due to signifi cantly reduced corporate expenditure on business travel. Hotels offering tourist accom- modation also suffer during economic downturns due to families reducing discretionary expenditure on activities such as holidays and travel. This high susceptibility to the general economic climate highlights the impor- tance of hotels developing operational plans only once careful analysis has been made of predicted economic conditions.

2) Seasonal sales volatility : Many hotels experience seasonal sales volatility over the course of a year. This volatility can be so severe to cause off- season closure for some resort properties. The decision whether to close

Introduction: hospitality decision makers’ use of accounting

High product perishability

Relative to many other industries, there can be limited scope to produce for inventory in food- service operations. A signifi cant proportion of food inventory is purchased less than 24 hours prior to sale, and much food preparation is conducted within minutes of a sale. There is thus a very short time span between order placement, production and sale. Many menu items cannot be produced in advance of sales due to their high perishability.

Perishability is even more apparent with respect to room and banquet sales. In these contexts, perishability can be described as “absolute”, as, if a room is not occupied on a particular night, the opportunity to sell that room that night is lost forever. No discounting of a room’s rate the following day can reverse this loss. This situation also applies to conference and banqueting activities. The high perishability associated with rooms, confer- encing, banqueting and food underlines the importance of accurate demand forecasting. With respect to food, an accurate forecast of the mix and level of demand can result in the mainte- nance of all options on a menu during high demand periods, and minimal cost of food scrapped during low demand periods. With respect to rooms, an accurate forecast of room demand can enable appropriate pricing decisions to be made as part of an attempt to maximise revenue. Appropriate room demand management is particularly important, as

should be informed by an appropriately conducted fi nancial analysis such as that described in Chapter 7. Seasonal sales volatility can also pose particular cash management issues. During the middle and tail- end of busy seasons, surplus cash balances are likely to result, while in the off- season and the build up to the busy season, defi cit cash balances are likely to arise. The need for careful cash planning and management is discussed in Chapter 13.

3) Weekly sales volatility : Hotels with a high proportion of business clients will experience high occupancy (i.e., a high proportion of rooms sold) from Monday to Thursday, and a relatively low occupancy from Friday to Sunday. By contrast, many resort hotels have relatively busy weekends. As will be seen in Chapter 16, accurate forecasting of demand will inform management’s decision making with respect to the amount and timing of room rate discounting. Forecasting is also discussed in the context of budgeting in Chapter 9.

4) Intra- day sales volatility : Restaurants experience busy periods during meal times, while bars tend to be busiest at night times. This intra- day demand volatility has led to widely- used pricing strategies such as “early bird specials” in restaurants and “happy hours” in bars. Hotel pricing issues are discussed in Chapters 12 and 16. In addition to these dimensions of intra- day sales volatility, staffi ng needs have to be considered in light of issues such as the front desk experiencing a frenetic early morning period processing check- outs and a second, more protracted, busy period in the late afternoon processing check- ins.

Key characteristics of the hospitality industry

room sales can be the prime driver of sales of many of a hotel’s other services (e.g., restaurant, bar, etc.).

High fi xed component in cost structure

A high proportion of a hotel’s costs do not vary in line with sales levels. These costs are referred to as “fi xed”. The high fi xed cost structure of hotels results from rent (a signifi – cant investment is required to buy land and build a hotel), as well as fi xed salary costs associated with administrative and operational staff needed to manage, operate and maintain a hotel. The high proportion of fi xed costs signifi es that an important issue in hotels concerns the determination of the level of sales necessary to achieve breakeven (i.e., cover all fi xed costs).

A considerable proportion of fi xed costs result from periodic refurbishment of rooms and also investment in the hotel’s physical infrastructure such as kitchen and laundry equipment. In accounting, we refer to such long- held assets of the organisation as “fi xed assets”. In Chapter 4 we will see how the purchase of a fi xed asset results in depreciation (the allocation of a fi xed asset’s cost over its useful life), and in Chapter 14 techniques that can be used to appraise fi xed asset investment proposals are described.

Labour intensive activities

If you visit the typical modern factory, you are likely to be struck by the highly automated and capital- intensive nature of the production process. Procedures are scheduled by computers and robotic engineering is used extensively in physical processing. This capital intensity in the conduct of work lies in stark contrast to what you see when entering a hotel. Major hotel activities include room housekeeping, restaurant food preparation and service as well as bar service. Despite the advent of the machine and computer age, the physical conduct of all of these activities has changed little over the last fi fty years. They continue to have a high labour component. Relative to many other industries, we can conclude that activities conducted in the hotel industry are still highly labour intensive.

This high labour intensity highlights the need to develop performance measures that monitor labour productivity. Performance indicators such as restaurant sales per employee hour worked are described in Chapters 5 and 11. In addition, the need to analyse the difference between the actual cost of labour and the budgeted cost of labour can represent a signifi cant dimension of labour cost management. In Chapter 10 we will see how differences between budgeted and actual labour cost can be segregated into labour rate and labour effi ciency variances.

The distinctiveness of these hotel characteristics that have just been described underlines the degree to which hotel accounting systems need to be tailored to the particular needs of hotel management. In combination, these characteristics signify that a hotel represents a fasci- nating arena in which to consider the application of accounting. Box 1.2 provides a summary of accounting implications associated with each of the hospitality industry characteristics just described.

Introduction: hospitality decision makers’ use of accounting

Box 1.2

The accounting implications of distinctive hospitality industry characteristics

Hospitality Industry Characteristic

Accounting Implication

1. Disparity and interdependency of functions

Care must be taken when determining a functional area’s scope of accountability. Due to their infl uence on sales and expenses, some managers can be held profi t accountable (e.g., a restaurant manager). Due to no direct infl uence on sales, others can only be held cost accountable (e.g., a training manager). Factors affecting departmental performance can be complex in hotels, however. If room occupancy affects F&B sales, care must be taken if attempting to hold an F&B manager profi t accountable.

2. High sales volatility

Hotel activity can be highly volatile over the course of an economic cycle, a year, a week, and a day. As noted in Box 1.1, this issue highlights the importance of accurate budgeting and forecasting systems to aid discounting decisions with respect to room rates and restaurant menu prices.

3. High product perishability

The absolute perishability of rooms, conference and banquet services and the relative perishability of food underlines the importance of accurate hotel demand forecasting as part of the budgeting process. Generally, the most important aspect of forecasting is room occupancy, as room sales drive the sales levels of other hotel activities. Accurate restaurant forecasting provides the basis for maintaining a full menu of options and minimising the cost of food wastage. With respect to rooms, forecasting accuracy can enable appropriate room rate discounting decisions.

4. High fi xed costs Hotels involve considerable investment in fi xed assets such as buildings on prime land as well as extensive furnishings, fi ttings and equipment. This investment generates high rent and depreciation cost (discussed in Chapter 4), which, together with signifi cant salary costs, result in hotels having a high fi xed cost structure. High investment highlights the importance of using appropriate fi nancial analysis when appraising the relative merits of proposed investments.

5. Labour- intensive activities

The high labour intensity apparent in many hotel activities highlights the importance of monitoring differences between actual labour cost and budgeted labour cost and also using performance measures that focus on labour productivity.

Accounting and business management

3) Accounting and business management

Accounting is often referred to as the “language of business”. Accounting concerns informa- tion systems that record business activities in fi nancial terms and consolidate the information recorded to produce reports that convey a business’s fi nancial achievements to decision makers such as managers and shareholders. Two distinct arms are evident in accounting: fi nancial accounting and management accounting.

Financial accounting concerns the preparation of fi nancial reports for external users such as shareholders, banks and government authorities. In order for these fi nancial reports to be meaningful, it is important that they are produced in a standardised way and are seen to be reliable. Consider the implications arising if investors lost faith in the reliability of accounting reports produced by companies. As fi nancial accounting reports represent a key source of information used by the investing community when deciding whether to buy a company’s shares, a lack of confi dence in accounting systems would translate into a sense of defi cient information and a reluctance to invest. This would inhibit the ability of economically viable companies to expand, which in turn would carry negative implications for employment, avail- ability of goods and services, and our standard of living. For the sake of a healthy economy, it is therefore critically important that a reliable fi nancial accounting system that engenders trust in reported data is established. The importance of reliability in fi nancial reporting is a signifi cant factor that lies behind the considerable resources expended in connection with auditing company accounts. This book provides an introduction to the basics of fi nancial accounting, to provide hotel managers with an appreciation of the fi nancial accounting reporting process and the ability to conduct an informed analysis of the statements produced by the process.

Management accounting concerns the provision of fi nancial information to internal management. This information is designed to help managers in their decision making and control of businesses. Financial information sought by hotel managers includes determining the cost of providing a meal to inform the menu pricing decision, determining how many delegates need to attend a conference in order to achieve breakeven, and determining what level of profi t is made by each selling unit of a hotel to inform any rationalization decision to close down a unit. The provision of all these types of fi nancial information falls within the scope of management accounting. In addition to introducing the basics of fi nancial accounting, this book describes management accounting and tools and techniques that can aid hospitality managers in their efforts to ensure effi cient and effective management of resources.

For most organisations, the accounting system represents the most extensive and all- encompassing information system. This is because accounting information is based primarily on the most fundamental common denominator in business, i.e., money. A front offi ce manager might talk of the number of check- ins processed, a restaurant manager may talk of the number of covers served, a laundry manager may talk of the weight of linen processed and a housekeeping manager may talk of the number of rooms cleaned. While each manager refers to different operational factors when talking of their respective activities, they are all familiar with the terms “cost” and “profi t”. Cost and profi t are denominated in monetary terms and this underlines the degree to which the accounting system is the organisation’s most pervasive and all- encompassing information system. It is also the only information system that measures the economic performance of all departments within an organisation. When we recognise the pervasive nature of the accounting information system and the fact that we are living in a time that is frequently described as “the information age”, we begin to appreciate the critically signifi cant role of accounting in promoting effective business management.

Introduction: hospitality decision makers’ use of accounting

Individuals from different functional areas should play an active accounting role by demanding excellence in the design of accounting systems. We sometimes need to remind ourselves that accounting system design is too important to be left solely to accountants. Specifi c accounting information needs that fall outside the scope of conventional accounting system design will have to be fl agged by managers with decision making and control respon- sibilities. There is boundless scope for tailoring an accounting information system, however the onus is on managers to inform the accounting service providers how the information provided should be tailored to meet their decision making needs.

In the last few years, there appears to have been a strong movement away from account- ing’s traditional “command and control” philosophy to more of an “inform and improve” philosophy. Despite this, some question the appropriateness of using fi nancial measures to direct and control businesses. Criticisms include:

● Financial measures focus on symptoms rather than causes. Profi t may decline because of declining customer service. It might therefore be more helpful for management to focus on monitoring the quality of customer service delivery, rather than profi t.

● Financial measures tend to be oriented to monitoring past short- term performance. This can hinder forward- looking, longer- term initiatives such as a quest to develop a strong hotel chain image amongst customers.

Some of these criticisms have led to greater importance being attached to a breadth of fi nan- cial and non- fi nancial performance indicators, e.g., Kaplan and Norton talk of the “Balanced Scorecard” (Kaplan and Norton 1996). Developing a mix of fi nancial and non- fi nancial performance measures in the context of a balanced scorecard management approach is discussed in Chapter 11. Despite such developments, given the importance attached to published fi nancial statements by the investing community, continued management emphasis on fi nancial controls is to be expected.

Chapters 2, 3, 4 and 5 provide a progressive introduction to the workings of fi nancial accounting systems. In Chapter 2 we will see how, like a coin, a fi nancial transaction has two sides. These two sides signify that all fi nancial transactions have a double impact on the busi- ness. In Chapters 3 and 4 we will see how the two sides of the “fi nancial transaction coin” are referred to as debits and credits. It is important that you gain an understanding of the double entry bookkeeping system as it is a fairly fundamental aspect of accounting. An analogy can be drawn between the manner in which knowing the alphabet serves reading and writing and the way in which an appreciation of the double entry accounting system will aid your capacity to exercise appropriate fi nancial management. Once you have mastered the basics of double entry accounting, you will have a grounding that will allow you to begin considering how accounting information can be tailored to the specifi c fi nancial decision making needs that arise in a hotel. It is from the information stored in the double entry accounting system that an income statement (profi t and loss statement) and balance sheet are periodically prepared. These statements, which represent key indicators of an organisation’s fi nancial health and performance, are also described in Chapters 2 and 3. Chapter 5 provides an overview of how year end fi nancial accounts can be analysed.

The book’s subsequent chapters have more of a management decision making and control orientation. The management issues addressed concern: the importance of internal control in hotels and what steps can be taken to strengthen internal control (Chapter 6), facilitating deci- sion making and control through cost analysis and management (Chapters 7 and 8), respon- sibility accounting and budgetary control (Chapters 9 and 10), performance measurement (Chapter 11), using cost information to inform pricing decisions (Chapter 12), managing

Accounting and hospitality decision makers

elements of working capital such as cash, accounts receivable, inventory and accounts payable (Chapter 13), and conducting fi nancial analyses of investment proposals (Chapter 14). Chapter 15 reviews a range of managerial fi nance issues and Chapter 16 provides a fi nancial perspective on revenue management.

4) Accounting and hospitality decision makers

A theme of this book concerns viewing accounting from a range of different hospitality manage- ment functional perspectives. This theme will be evident from the book’s many worked exam- ples that show how particular accounting applications are pertinent to a broad array of hospitality management decision making situations that can arise. To underline the theme still further, however, each chapter contains a particular case that shows how an accounting issue raised in the chapter can be considered from a particular hotel function’s perspective. Each case is headed “Financial Decision Making in Action” or “Financial Control in Action” and has a sub- heading relating to the hotel function and also the aspect of accounting in question.

To provide you with an early sense of the importance of accounting to a range of hospi- tality decision makers, an overview of these cases is provided in Box 1.3. The particular hospitality functions identifi ed are based on Burgess’ (2001) listing of the typical membership of an executive committee in a large leisure hotel.

Box 1.3

Perspectives of hospitality decision makers on aspects of accounting

Hotel Function

Accounting aspect or tool Signifi cance of the accounting aspect or tool

General Manager

A general manager needs to understand the nature and workings of the main fi nancial statements. Many managers incorrectly believe that asset values recorded in the balance sheet represent the assets’ worth (see Chapter 2).

Senior managers are increasingly benchmarking the performance of hotels within chains. Real estate infl ation rates need to be considered if conducting an analysis using asset values of hotels bought in different time periods. This is because balance sheets report historical cost and not current value of assets.

Senior managers with no accounting training also sometimes incorrectly believe that the retained earnings account in the balance sheet represents cash that can be accessed (Chapter 3).

Retained earnings is frequently a large account appearing in a balance sheet. It represents the accumulation of all profi ts reinvested in the hotel since its inception. Poor cash planning will occur if senior management believe it represents cash.

Introduction: hospitality decision makers’ use of accounting

Hotel Function

Accounting aspect or tool Signifi cance of the accounting aspect or tool

Rooms Division Manager

The Rooms Division Manager can use cost- volume-profi t analysis to determine occupancy levels necessary to achieve breakeven (Chapter 8).

Appreciating the dynamics of breakeven will help a Rooms Division Manager take steps to ensure that sales do not fall below the breakeven level.

Variance analysis is a tool that can help a range of managers, including the Rooms Division Manager, when investigating differences between budget and actual performance (Chapter 10).

Appraising the effi ciency of activities such as room cleaning represents an important and on- going aspect of management. Variance analysis is a technique that helps a manager determine the factors causing room cleaning costs to be above or below budget.

F&B Manager What type of inventory recording system should be used? (Chapter 4).

If stock loss represents a problem in F&B, a perpetual rather than a periodic system may be warranted.

Appropriately using cost information to support decision making such as whether to outsource (Chapter 7).

Hotels are increasingly outsourcing, and managers need to know how to correctly draw on cost data when making such decisions.

Small hotel owner

Periodic preparation of bank reconciliation statements (Chapter 6).

An important step in seeking internal control over cash involves reconciling the difference between a bank account balance per a bank statement and the balance per a business’s records.

Human Resource Manager

Determining staffi ng needs from budgeted sales levels (Chapter 9).

In light of the hospitality sector’s volatility, matching labour supply with hotel activity is an important aspect of human resource management.

Financial Controller

Analysing return on investment (ROI) to identify poor performing areas of a hotel (Chapter 5).

As ROI is a comprehensive indicator of performance, it is key that managers understand what factors drive ROI.

Uniform system of accounts

Applying an appropriate fi nancial analysis when deciding whether to take a supplier’s offer of a discount for early payment (Chapter 13).

Many suppliers offer a discount for early settlement of an account. In light of this, it is important that the accounts payable department is appropriately informed on when to make an early payment.

Use of debt fi nancing to lever up returns to shareholders (Chapter 15).

Appropriate use of debt fi nance can have a signifi cant impact on returns earned by shareholders.

Senior Management

Performance measurement system design (Chapter 11).

It is often said that what gets measured is what gets managed. This highlights the importance of carefully determining what should be measured in a hotel’s performance measurement system.

Sales & Marketing Manager

The use of revenue management in pricing (Chapters 12 and 16).

Demand volatility highlights the importance of sales staff varying room rates charged through the year as part of a strategy to maximise profi t.

Chief Engineer

Financial analysis of investment proposals (Chapter 14).

Chief Engineers are key players in building equipment investment decisions. Appropriate investment analysis is vital, as these decisions often involve large amounts of money.

5) Uniform system of accounts

There is a uniform accounting system for the hotel industry that has been developed in the US. It was initiated in 1925 by the Hotel Association of New York City. Application of this uniform system has grown in the US and it is now increasingly used across the world. The current version of the uniform system, entitled the “ Uniform System of Accounts for the Lodging Industry ” ( USALI ), was produced in 2006 by the American Hotel & Lodging Educational Institute. The following signifi cant benefi ts derive from this uniform system:

● it represents an “off the shelf” accounting system that can be adopted by any business in the hotel industry,

● the system can be viewed as “state of the art” as it benefi ts from the accumulated experi- ence of the parties that have contributed to the system’s development over many years,

Introduction: hospitality decision makers’ use of accounting

● by promoting consistent account classifi cation schemes as well as consistent presentation of performance reports, it facilitates comparison across hotels,

● it represents a common point of reference for hotels within the same hotel group.

A profi t report for Canberra’s KangarooLodge Hotel is presented in Exhibit 1.1. This state- ment is presented in a format consistent with USALI . While increased accounting interna- tional standardization has resulted in this statement being offi cially titled an “income statement”, in much of the English- speaking world, many managers continue to refer to the statement as a “profi t and loss (P&L) statement”.

Exhibit 1.1

Summary Income Statement prepared in USALI format

KangarooLodge Hotel Summary Income Statement

For the year ended 30 June 20X1

Net Revenue

Cost of Sales

Payroll and Related

Expenses

Other Expenses

Income (loss)

Operated Departments

Rooms $ 1,232,000 $ 0 $ 193,000 $ 101,000 $ 938,000 Food 404,000 171,000 159,000 48,000 26,000 Beverage 221,000 54,000 58,000 27,000 82,000 Telecommunications 64,000 59,000 4,000 2,000 (1,000) Total Operated

Departments 1,921,000 284,000 414,000 178,000 1,045,000

Undistributed Operating Expenses Administrative and General 51,000 28,000 79,000 Sales and Marketing 25,000 36,000 61,000 Property Operation and Maintenance 29,000 6,000 35,000 Utilities (energy, water, etc) 0 79,000 79,000 Total Undistributed Operating Expenses 105,000 149,000 254,000 Gross Operating Profi t 791,000 Rent, Rates and Insurance 182,000 Depreciation 123,000 Net Operating Income 486,000 Interest Expense 102,000 Income Before Tax 384,000 Tax 110,000 Net Income $ 274,000

Organisational forms

The income statement provided in Exhibit 1.1 shows the sources of a hotel’s revenue and also the nature of its expenses. By deducting expenses from revenue, we fi nd a hotel’s profi t, which is referred to as “income” in the statement (see the statement’s last line). To be consis- tent with international accounting standards, in income statements presented in this book, the term “income” will be used when referring to profi t. However, to refl ect the reality of language used by many managers in everyday business settings, the word “profi t” will also be used extensively in the text. The USALI income statement comprises three sections. In the top section, net revenue (i.e., net sales) for each functional area is identifi ed in the fi rst data column. This is followed by three columns that identify expenses that can be directly related to the departmental areas listed, i.e., cost of sales, payroll and related expenses, and other expenses. Cost of sales refers to the cost of items that are sold, e.g., the cost of wine sold through a restaurant. Each depart- ment’s income (profi t) is determined by deducting the sum of the three expense items from net revenue. The statement’s middle section is headed “undistributed operating expenses”. In this section the expenses relating to a hotel’s service departments (e.g., administrative and general, sales and marketing, etc.) are identifi ed. The distinction between a hotel’s service departments and the departments listed in the top section of the statement is that no revenue can be traced directly to the service departments. The statement’s lower section includes expenses that are generally not traceable to a hotel’s operating management. Expenses such as rent, insurance and interest on debt are generally traceable to a tier of management that lies above a hotel’s operational staff. The last line of the statement presents the net income (profi t), i.e., all hotel revenue minus all hotel expenses.

It is apparent from Exhibit 1.1 that an income statement presented in accordance with the USALI provides much profi tability information at the hotel department level (e.g., rooms, food, beverage department, etc.). This format supports fi nancial management, as it allows a hotel’s managers to consider the relative profi tability levels of its different functional areas, e.g., from Exhibit 1.1, it can be determined that following the deduction of expenses directly related to rooms, 76.14 per cent of room revenue remains as a contribution to covering general hotel expenses and then providing a profi t ($938,000 � $1,232,000 × 100).

The USALI has been introduced in this fi rst chapter in order to give you an early apprecia- tion of a typical hotel’s income statement. Your understanding of the nature of the income statement will be reinforced in the next chapter which, amongst other things, focuses on the relationship between the income statement and the balance sheet.

6) Organisational forms

There is some variation in accounting terminology used across different forms of commercial organisation. As shown in Exhibit 1.2, there are three main types of commercial organisation: (1) sole proprietorship, (2) partnership, and (3) company. An appreciation of each type of organisation will help you develop your understanding of how accounting terms are used in different business forms.

Introduction: hospitality decision makers’ use of accounting

Sole proprietorships

A sole proprietorship (sometimes called a “sole trader”), is owned by one person. In most cases, the owner also manages the business. Sole proprietorships are the most common type of business, especially in those areas of the economy where we see many small businesses, such as in the restaurant sector.

In legal terms, a sole proprietorship is not really distinct from its owner. This signifi es that the owner of a sole proprietorship will report the profi t of his or her business as part of their taxable income. It also signifi es that a sole proprietorship’s owner has to take personal respon- sibility for all debts of his or her business. This responsibility is generally referred to as “unlimited liability”, as if a sole proprietorship has large debts outstanding, the owner must draw on their personal assets to pay off their business debts. This means that if a sole propri- etorship becomes insolvent (has more debts than assets), the owner may lose more than the amount that they originally invested in the business.

Exhibit 1.2 indicates that the life of a sole proprietorship is limited. This is because the sole proprietorship’s existence ends at the time that the owner decides to stop operating the busi- ness. If the sole proprietorship owner is able to sell their business, the sole proprietorship’s life comes to an end, and it will be up to the new owner to decide under what organisational form they will operate their newly acquired business.

Partnerships

A partnership arises when two or more people decide to run a business together. Although partnerships tend to be larger than sole proprietorships, it is not the case that all partnerships are bigger than sole proprietorships. The size of partnerships varies greatly, from a small coffee shop owned by a husband and wife team, right through to large multinational accounting partnerships, such as KPMG or PricewaterhouseCoopers.

Exhibit 1.2 shows that business partnerships have many characteristics similar to sole proprietorships. Like a sole proprietorship, it is the owners (the partners) of a partnership that

Exhibit 1.2

Key differences across organisational forms

Characteristics Sole proprietorship

Partnership Company

Number of owners One Two or more Generally many

Business size Small Generally small

Larger and can be very large

Key decision makers Owner Partners Board of directors

Owner liability Unlimited Unlimited Limited

Organisation life Limited Limited On- going

Organisational forms

tend to be the business’s decision makers. Like a sole proprietorship, the life of a partnership is limited, as in most situations, a new partnership is formed every time a new partner is created, or whenever a partner retires from the organisation. Also like sole proprietorships, the owners of a partnership have unlimited liability with respect to the debts of their business. If your partnership is sinking under a weight of debt, you, as a partner, are liable for all of the debts of the business, regardless of what proportion of the business you own. If your partner, who originally invested 75 per cent of the start up funds (widely referred to as “capital”) for your partnership, has become personally bankrupt, you will need to pay off all debts of the partnership, even though you only invested 25 per cent of the partnership’s initial capital.

A decision to enter a business partnership can be likened to the decision to get married. Just as in a marriage, business partners have to interact extensively with one another. Most successful partnerships are built on the bedrock of a solid and trusting relationship. It can make a lot of sense to team up with a business partner who has a set of complimentary skills. For instance, you may be a great chef with poor business skills and your partner may have great marketing and organisational skills appropriate for running a restaurant. However, just as many marriages that were initially blessed with a happy honeymoon period fi nish up in a divorce court, experience indicates that business partnerships can quickly turn pear shaped and acrimonious. Be very careful if going into a business, as business partnerships can be like marriage partnerships; they often break down.

Companies

A company is often referred to as a “corporation” in the USA. A company is an artifi cial entity that is created by law. Unlike sole proprietorships and partnerships, a company is legally distinct from its owners. Companies are run by boards of directors and their existence continues independently of changes in their ownership.

Company ownership works in the following way. The capital raised by a company from its owners is broken into units that we call shares (the word “share” signifi es a share in the ownership of a company). It could be that a company originally raised $1,000,000 of capital from its original owners through the issuance and sale of 500,000 shares that were each initially priced at $2 each. If you bought 5,000 of these shares for $10,000, you would in effect own 1 per cent of the company as you would be the owner of 1 per cent of its 500,000 shares. Two years following your purchase of 1 per cent of the initial share offering, you might sell your 5,000 shares on the stock market for $3 each. You would receive $15,000 for the sale of your shares and will have made a 50 per cent profi t on your original $10,000 investment. Note, however, that the company will be unaffected by your share sale, as it is really not involved in your second- hand market (that’s what a stock market is) sale of your 1 per cent stake in the company.

This description of the sale of a company’s shares highlights one of the principle advantages of a company. Owners of a company can relatively easily liquidate their company ownership investment by selling their shares on the stock market. It is much harder to liquidate your business ownership if the business in question is a sole proprietorship or a partnership.

A further distinguishing feature of companies concerns the fact that the liability of owners is limited. Following your purchase of 5,000 shares for $10,000 that was just referred to, if the company you have invested in were to go bankrupt, the shares that you own might well become worth nothing. So you would lose your $10,000 invested, but, unlike an owner of a sole proprietorship or a partnership, you would not be required to pay any more money to

Introduction: hospitality decision makers’ use of accounting

satisfy any outstanding debts of the business. This signifi es that your liability is limited to losing no more than your original investment. For this reason, for those companies where this limited liability feature applies, in many countries the company name must conclude with the word “Limited” (widely abbreviated to “Ltd.”).

7) Summary

This chapter has set the scene for the remainder of the book. We have reviewed the particular characteristics of the hospitality industry and considered their implications for accounting. We have also considered the nature of accounting in general and also its relevance to a range of hospitality decision makers. The chapter provided a short introduction to fi nancial accounting by outlining the nature of an income statement presented according to the stan- dard that is generally referred to as the “ Uniform System of Accounts for the Lodging Industry ”. Finally distinctions between the three basic organisational forms were described. The three organisational forms are sole proprietorships, partnerships and companies. All three types of business are well represented in the hotel industry. The small English hotel depicted in the BBC TV comedy series Fawlty Towers that is run (perhaps “run” is the wrong word to use given Basil Fawlty’s manic behaviour) by a husband and wife team would likely be a sole proprietorship or a partnership. Large hotel companies such as Hilton Worldwide and the Hyatt Hotels Corporation represent classic examples of American- based international hotel companies. Accor is a company based in France that owns well- known hotel brands such as Novotel and the Mercure.

Having read this chapter you should now know:

● some of the hospitality industry’s particular characteristics and their accounting implications,

● what is meant by accounting and how it relates to fi nancial management, ● some of the ways that different hotel functional areas draw on accounting information and

analyses in decision making and control, ● the nature of information provided in an income statement, ● the basic differences between sole proprietorships, partnerships and companies.

References

Burgess , C. ( 2001 ) Guide to Money Matters for Hospitality Managers , Oxford: Butterworth Heinemann: Chapter 1.

Harris , P. ( 1999 ) Profi t Planning , 2nd edition, Oxford: Butterworth Heinemann: Chapters 1 & 2.

Jackling , B. , Raar , J. , Wines , G. and McDowall , T. ( 2010 ) Accounting: A Framework for Decision Making , McGraw-Hill: Chapter 1.

Kaplan , R.S. and Norton , D.P. ( 1996 ) The Balanced Scorecard – Translating Strategy into Action , Boston, MA : Harvard Business School Press .

Schmidgall , R.F. ( 2011 ) Hospitality Industry Managerial Accounting , 7th edition, East Lansing, MI: American Hotel & Lodging Educational Institute: Chapter 3.

Weygandt , J. , Kieso , D. , Kimmel , P. and DeFranco , A. ( 2009 ) Hospitality Financial Accounting , Hoboken, NJ: John Wiley & Sons: Chapter 1.

Problems

Problem 1.1

a) Describe what is meant by functional interdependency. b) Describe why functional interdependency is an issue that needs to be considered when

designing a hotel’s system of accountability.

Problem 1.2

a) What are the four main dimensions of sales volatility in the hotel industry? b) What are the accounting implications arising from these four dimensions of sales

volatility?

Problem 1.3

Identify six examples of business decisions requiring the use of accounting information.

Problem 1.4

a) Describe what is meant by high perishability of the hotel product. b) Describe the accounting implications arising from high product perishability.

Problem 1.5

Describe the factors causing hotels to have a high proportion of fi xed costs.

Problem 1.6

a) Describe the manner in which hotel activities tend to be labour intensive. b) Describe the accounting implications arising from the high labour intensity of hotel

activities.

Problem 1.7

What is the difference between fi nancial accounting and management accounting?

Problem 1.8

Who are the main users of accounting information?

Problem 1.9

Why is it important that fi nancial accounting systems are seen to be reliable?

Problem 1.10

Give one example of how a particular accounting tool or technique might be drawn upon in the context of a particular hospitality management function.

Introduction: hospitality decision makers’ use of accounting

Problem 1.11

Identify three advantages that derive from using the “ Uniform System of Accounts for the Lodging Industry ” ( USALI ).

Problem 1.12

List the three main forms of commercial organisation and identify the main differences between the forms.

Problem 1.13

In the context of a new business starting up, what is meant by the term “capital raised”.

Chapter 2

Analysing transactions and preparing year- end

fi nancial statements

Learning objectives

After studying this chapter, you should have developed an appreciation of:

1. how there is a double fi nancial implication arising from every fi nancial transaction under- taken by an organisation,

2. the nature and format of the balance sheet, 3. the nature and format of the income statement, 4. how profi t computed in the income statement fl ows into the owners’ equity section of the

balance sheet via the statement of owners’ equity.

1) Introduction

This is the fi rst of the three chapters concerned with fi nancial accounting . Financial accounting concerns the preparation of fi nancial reports that are made available to external users such as shareholders. This chapter provides an overview of the main fi nancial accounting statements that appear in annual reports prepared by publicly listed companies (i.e., com – panies with shares listed on a stock exchange). Although this is not a long chapter, the material presented is fairly concentrated. A considered review of this material will provide you with a good basic appreciation of the nature of the year- end fi nancial statements. To achieve this appreciation you will need to carefully follow through the chapter’s worked example that illustrates how a set of fi nancial transactions impact on the year- end accounts. Once you have gained an appreciation of the nature of the year- end fi nancial statements, the next chapter will introduce the “debit/credit” double entry record keeping process that underlies the fi nancial accounting system. Finally, Chapter 4 introduces some more advanced aspects of double entry record keeping by reviewing year- end adjustments that need to be made to the fi nancial records in order to recognise time- related issues such as asset depreciation.

Analysing transactions and preparing year- end fi nancial statements

It may appear a little strange that a book concerned with hospitality decision making has devoted three chapters to fi nancial accounting. There are, however, several reasons why a hotel manager should have a basic familiarity with fi nancial accounting. Of particular signifi cance is the fact that most professional accounting courses of study have a bias towards fi nancial accounting, rather than management accounting, which is the branch of accounting concerned with the provision of accounting information for management decision making and control. Once qualifi ed, many accountants secure jobs working in industries such as the hospitality sector, with the result that a fi nancial accounting mentality frequently prevails in organisations’ internal accounting departments. It is important that all managers appreciate the potential for this tendency and have an ability and willingness to “think outside the square” by asking for accounting information and analyses to be presented in a way that supports management decision making rather than the needs of external reporting .

An example of “thinking outside the square” might be a marketing manager who feels that a customer profi tability analysis would help management deliberations concerned with allocating a promotion budget. The manager might feel reluctant to ask for such information, however, as the accounting system has never provided it in the past. If you review the material presented in Chapter 4 , it will become apparent that a key concern of fi nancial accountants is the accurate allocation of profi t earned to particular periods of time. The fi nancial accounting system does not require, however, that profi t be allocated across customer segments. As the impetus for allocating profi t across customer segments is unlikely to come from an accounting department, it will have to be initiated by the manager needing the information. A second reason why a hotel manager should understand the basics of fi nancial accounting is that two outputs of the fi nancial accounting system, the balance sheet and the income statement , represent important sources of information that can further management control of the company. The manner in which these statements can be used to facilitate management control will be extensively explored in Chapter 5 .

2) The balance sheet and income statement

In most Western countries, four fi nancial statements are presented in the published annual reports of publicly listed companies. These reports are the balance sheet, the income state- ment, the statement of owners’ equity and the statement of cash fl ows.

The elements comprising the balance sheet, income statement and statement of owners’ equity are described in this section. Following this, the worked example in the next section will show the extent to which these statements can be seen as direct outputs of the fi nancial accounting record keeping process. No detailed review will be undertaken of the statement of cash fl ows which classifi es cash infl ows and outfl ows and identifi es the net change in cash held by the fi rm over the reporting period. Relative to the balance sheet and income statement, this statement is not used as much for decision making and control purposes. Although it will not be considered further in this book, if you see a cash fl ow statement you will have an imme- diate rudimentary understanding of it, due to its resemblance to an aggregated version of your monthly bank statement.

The balance sheet is a schedule summarising what is owned and what is owed by a company at a particular point in time. Its three main sections which comprise assets, liabilities and owners’ equity, are described in Box 2.1.

The balance sheet and income statement

Box 2.1

The main sections of a balance sheet

● Assets are “things” that are owned (most usually purchased) by the organisation. They are assets if the organisation can derive some future value from ownership. Typical hotel assets include: cash, accounts receiv- able, prepayments, inventory (sometimes referred to as “stock”), cars, china, silver, glass, linen, uniforms, equipment, land and buildings. Assets are generally recorded in the accounting system at their cost, although in some countries such as Australia, New Zealand and the UK, asset revaluations can be made (asset revaluation is not permitted under the generally accepted accounting principles of Canada and the US).

● Liabilities may be seen as the opposite of assets. They refl ect fi nancial obligations of the organisation. Typical liabilities include: wages and salaries payable, accounts payable and bank loans.

● Owners’ equity refl ects the fi nancial investment of the owners in the organisation. It includes the owners’ original investment plus all profi ts not paid out to the owners (i.e., profi ts retained in the business). For fi nancial accounting purposes, profi t is typically determined on an annual basis. This computation is achieved through the income statement . In the income statement, expenses for the year (which represent resources consumed such as housekeeping wages and cost of beer sold through a bar) are deducted from revenue earned during the year to give profi t for the year. Money earned from selling room nights and also sales made in a restaurant and bar represent some of the main examples of revenue in a hotel. If expenses are greater than revenue, a loss results. Some profi t may be withdrawn from the business by the owners. That portion of profi t that the owners choose not to withdraw is effectively a further contribu- tion to the business by the owners. It is therefore treated as an addition to owners’ equity (at the end of the accounting year), and is generally termed “retained earnings” or “retained profi t”. Computation of the year- end owners’ equity balance is achieved through the statement of owners’ equity . The fi rst line of this statement identifi es the owners’ equity balance at the beginning of the accounting year. To this we add net profi t for the year as well as any new equity capital raised. Finally, any profi ts distrib- uted to the owners during the year (termed “drawings” or “dividends”) are deducted to give the closing owners’ equity balance.

From Box 2.1 it is apparent that profi t earned increases owners’ equity. It is also evident that the profi t computed through the income statement can be seen to feed into the owners’ equity section of the balance sheet via the statement of owners’ equity. For this reason, at the year- end we need to prepare the income statement and statement of owners’ equity in advance of preparing the balance sheet.

Analysing transactions and preparing year- end fi nancial statements

One key difference between the income statement and the balance sheet pertains to time. The income statement (like the statement of owners’ equity) always relates to a period of time, i.e., the time taken to make the profi t reported in the income statement. The balance sheet, however, relates to a particular moment in time.

Let’s draw on the analogy of your own fi nancial situation to highlight this important time distinction. If you were asked “How much do you earn?” you can only respond in the context of a time period, i.e., you could talk of your earnings last month or your earnings last year. Your earnings are analogous to the profi t of a fi rm, in fact, a fi rm’s profi t represents what the business has earned for the owners of the fi rm (note how a time period is referred to in the heading of the income statement presented in Exhibit 2.2 below). If you were asked “what is your wealth”, however, your answer would have to be in the context of a particular moment in time, as the value of your assets are constantly changing, i.e., you might receive weekly payments for work rendered, you buy and consume things such as food on a daily basis, etc. To determine your wealth you would have to identify everything you own (your assets) and deduct everything that you owe (your liabilities) at a particular point in time. The issue of determining personal wealth is analogous to the preparation of a company’s balance sheet which can be seen as a representation of the wealth of the fi rm, i.e., it summarises assets and liabilities. Like the wealth of an individual, the wealth of a fi rm can only be conceived in the context of a particular moment in time (note how a point in time is referred to in the wording of the balance sheet heading presented in Exhibit 2.2 below).

A balance sheet can be presented in one of the following two basic formats:

Assets – Liabilities = Owners’ Equity

Assets = Liabilities + Owners’ Equity

As both formats represent an equation, some people talk of “the balance sheet equation”. Underlying the fi rst equation is the notion that the value of the owners’ equity (the owners’ stake) in the company equals the surplus assets that would remain after the acquittal of all liabilities. Underlying the second equation is the notion that money raised by a business is invested in various assets. The “money raised” notion is on the right- hand side of the equation as liabilities include sources of fi nance such as bank loans, while owners’ equity refers to money invested in the business by the owners. With respect to the left- hand side of the second equation, the money raised fi nances the purchase of assets and any money raised but not used to purchase assets must be held as cash, which is itself an asset.

3) Classifying transactions according to assets, liabilities and owners’ equity

Like a coin, a fi nancial transaction has two sides. These two sides signify that all fi nancial transactions have a double impact on a business. We will now consider a set of transactions and see how, as a result of their double impact, the balance sheet equation is always left intact. In this worked example the balance sheet equation is stated as “assets = liabilities + owners’ equity”. The same exercise could be performed using a format based on the alternative balance sheet equation, however.

Classifying transactions according to assets, liabilities and owners’ equity

Exhibit 2.1

Illustration of how transactions affect the balance sheet equation

May 1 Owner contributes $30,000 cash to commence business. 2 Purchased a van for $12,000, paying $3,000 in cash and obtaining a loan for the

balance. 3 Purchased non- perishable food stock including a large maple syrup shipment on

credit for $800. 4 Billed clients $19,000 for use of conference facilities. 5 Received $6,000 from customers billed in (4) above. 6 Paid $500 to trade creditors to reduce amount owing for inventory stock purchased. 7 Owners withdrew $1,500 from the business. 8 The accountant has determined that $600 of inventory stock has been used. 9 Paid $250 for miscellaneous expenses (telephone, electricity, etc.). 10 Repaid $5,000 of the loan taken out for the van.

Balance Sheet Equation Assets = Liabilities + Owners’ Equity

May Cash at

Bank

Accounts

Receivable

Inventory Vehicles Accounts

Payable

Loan

Payable

Capital Profi t

or Loss

1 +30,000 +30,000

2 −3,000 +12,000 +9,000

3 +800 +800

4 +19,000 +19,000

5 +6,000 −6,000

6 −500 −500

7 −1,500 −1,500

8 −600 −600

9 −250 −250

10 −5,000 −5,000

Total $25,750 $13,000 $200 $12,000 $300 $4,000 $28,500 $18,150

$50,950 = $4,300 + $46,650

Analysing transactions and preparing year- end fi nancial statements

In Exhibit 2.1, transactions undertaken in the fi rst ten days of trading for Joe Blow, a small sole proprietorship hotel offering seminar facilities close to Montreal’s Ile Notre-Dame Formula One Grand Prix circuit, are summarised. Following this, the way in which each of the transactions affect the balance sheet are noted in the “account” columns appearing under the main balance sheet headings: assets, liabilities and owners’ equity. In the interests of capturing all of the transactions in one matrix, transactions that affect profi t (i.e., a sale or the incurrence of an expense) appear in the fi nal column headed “profi t or loss”. As profi t affects owners’ equity, this column appears under the owners’ equity heading. Investments in the business by the owners are recorded in the “capital” column which also appears under the owners’ equity heading.

Following the steps undertaken in Exhibit 2.1 represents a learning activity designed to develop your appreciation of the fact that every transaction has a double impact on the balance sheet equation. As will be seen later in Exhibit 2.2, in reality transactions affecting profi t fl ow fi rst into the income statement and then fl ow into the balance sheet via the state- ment of owners’ equity.

Following through the steps involved in Exhibit 2.1 is an important exercise. Not only do they clearly demonstrate how every transaction has a double impact on the balance sheet, the exercise also lays the basis for your appreciation of the workings of the balance sheet. You should approach Exhibit 2.1 by considering each transaction in turn and noting its double impact on the balance sheet in a manner that leaves assets equal to the sum of liabilities and owners’ equity. A description of how each transaction results in a double impact is provided in Schedule 2.1.

Schedule 2.1

The impact of Exhibit 2.1’s ten transactions on the balance sheet

Transaction date Description of balance sheet impact

1 May The business now has $30,000 in cash (increase cash account). The capital account records all fi nancial investments in the business made by the owners (increase capital account).

2 May This transaction is slightly awkward as it affects three accounts. The business now has a motor vehicle which is an asset that cost $12,000 (increase vehicles account). It paid for the van by using $3,000 cash (reduce the cash account) and by borrowing $9,000 (increase loan payable account).

Classifying transactions according to assets, liabilities and owners’ equity

We can present the results of the ten transactions described in Exhibit 2.1 in a more conven- tional accounting format by compiling Joe Blow’s income statement and statement of owners’ equity for the fi rst ten days of May and also Joe Blow’s balance sheet as at 10th May. These statements are presented as Exhibit 2.2. Note how the column totals in the balance sheet equation matrix appearing at the bottom of Exhibit 2.1 feed into the statements compiled in Exhibit 2.2. Also note how the profi t determined in the income statement feeds into the balance sheet via the statement of owners’ equity.

3 May The business now has $800 in inventory (increase inventory account). It owes money for this purchase (increase accounts payable account).

4 May The business is now owed $19,000 for services rendered (increase accounts receivable account). The business has now made a sale (increase the revenue account – treated in this exercise as positively affecting owners’ equity by increasing profi t).

5 May The business now has a further $6,000 in cash (increase cash account). The money it was owed with respect to the sale made on 4th May is now $6,000 less (reduce accounts receivable account).

6 May Cash has now declined by $500 (reduce cash account). The amount owing with respect to the purchase made on 3rd May is now $500 less (reduce accounts payable account).

7 May The business cash balance has now declined by a further $1,500 (reduce cash account). The net investment in the business made by the owners has declined by $1,500 (reduce capital account).

8 May The cost of stock held in the business has declined by $600 (reduce inventory account). This decline in stock signifi es that resources have been consumed (increase cost of sales account – treated in this exercise as negatively affecting owners’ equity by reducing profi t).

9 May Cash has declined by $250 (reduce cash account). The use of telephone and electricity signifi es resources have been consumed (increase miscellaneous expense account – treated in this exercise as negatively affecting owners’ equity by reducing profi t).

10 May Cash has declined by $5,000 (reduce cash account). The amount owing on the loan taken out for the van is now $5,000 less (reduce loan payable account).

Analysing transactions and preparing year- end fi nancial statements

The balance sheet presented in Exhibit 2.2 has been compiled according to a horizontal format whereby assets appear on one side and liabilities and owners’ equity appear on the other. You may also encounter balance sheets presented using a vertical format in which the totals of assets, liabilities and owners’ equity appear one above another (see, for example, the balance sheet presented later in the book as Exhibit 5.2).

Exhibit 2.2

Illustration of how the income statement is linked to the balance sheet via the statement of owners’ equity

Joe Blow Hotel Income Statement

for the fi rst 10 days of May

$ $ Sales revenue 19,000 less Expenses Cost of sales 600 Miscellaneous 250 850 Income (Profi t) $18,150

Joe Blow Hotel Statement of Owners’ equity

10 days ending 10th May

$ Owners’ equity contribution 30,000 plus Net income 18,150 48,150 less Drawings 1,500 Owners’ equity at end of period $46,650

Joe Blow Hotel Balance Sheet as at 10th May

Assets $ Liabilities $ $ Cash 25,750 Accounts payable 300 Accounts receivable 13,000 Loan payable 4,000 Inventory 200 4,300 Vehicles 12,000 Owners’ equity Capital 46,650 $50,950 $50,950

The importance of understanding fi nancial accounting basics

While both the horizontal and vertical balance sheet formats are widely used within the same countries, some different balance sheet formatting conventions do exist internationally. Relative to other English- speaking countries, some distinct conventions are evident in the United Kingdom. In Australia, Canada, New Zealand and the US, the convention is to present assets in order of liquidity, i.e., the assets that are closest to cash are presented fi rst. If a busi- ness has cash, marketable securities, accounts receivable and inventory, then cash is presented fi rst, marketable securities are second (marketable securities are readily convertible into cash), accounts receivable are third (accounts receivable are converted into cash in the short- term in the normal course of business), and inventory appears fourth (with the exception of cash sales, a sale from inventory will become an account receivable prior to translation to cash). In these countries, a similar rationale is applied to the sequencing of liabilities, i.e., those liabilities with the shortest term to payment appear fi rst.

In the UK, however, there has been a convention to reverse this sequencing. This signifi es that the fi rst assets presented are long- held assets such as land and buildings (least liquid) and the asset presented last is cash (most liquid). Similarly, in the UK, the fi rst liabilities presented are long- term liabilities such as loans payable, and liabilities that will be paid in the short- term, e.g., amounts owing to suppliers, are listed last.

4) The importance of understanding fi nancial accounting basics

In your working life you are highly likely to meet senior managers who have a poor under- standing of the mechanics of fi nancial accounting. In the fi nancial decision making case presented below, we see how an unfamiliarity with the basics of fi nancial accounting can be a recipe for poor decision making.

FINANCIAL DECISION MAKING IN ACTION CASE 2.1

The General Manager’s use of balance sheet information Senior managers are increasingly using the performance of other hotels as a bench- mark for appraising their own performance. A widely quoted performance indi- cator is return on investment (ROI) which is computed by stating a hotel’s annual profi t as a percentage of the investment in its assets (ROI will be more extensively discussed in Chapter 5 ). Considerable care needs to be exercised in this type of analysis, however, as balance sheets record assets (i.e., investment) at their histor- ical cost and not their current value.

Imagine hotels A and B are in the same hotel chain and are highly comparable in terms of markets served, size, quality and profi ts generated. Hotel A was purchased seven years ago at a price that was 30 per cent less than the price paid for Hotel B fi ve years ago. The difference in the amount invested resulted from

Analysing transactions and preparing year- end fi nancial statements

5) Summary

In this chapter we have seen how two fi nancial implications arise from every fi nancial transac- tion undertaken by a business. We have also reviewed the nature and content of the main fi nancial reports: the balance sheet and the income statement. We have seen that the balance sheet comprises assets, liabilities and owners’ equity accounts. The income statement comprises revenue and expense accounts.

Having read the chapter you should now know:

● the main account headings in a balance sheet and income statement, ● the layout of a balance sheet and income statement, ● how to classify transactions according to their impact on assets, liabilities and owners’

equity accounts, ● how profi t is determined in the income statement and fl ows into the balance sheet via the

statement of owners’ equity, ● the importance of senior managers having a basic understanding of the balance

sheet.

References

Harris , P. ( 1999 ) Profi t Planning , 2nd edition, Oxford: Butterworth Heinemann : Chapter 2. Jackling , B. , Raar , J. , Wines , G. and McDowall , T. ( 2010 ) Accounting: A Framework for

Decision Making , 3rd edition, Macquarie Park, NSW, Australia: McGraw-Hill : Chapter 3. Jagels , M.G. ( 2007 ) Hospitality Management Accountin g , 9th edition, Hoboken, NJ : John

Wiley & Sons : Chapter 1. Schmidgall , R.F. ( 2011 ) Hospitality Industry Managerial Accounting , 7th edition, East

Lansing, MI: American Hotel & Lodging Educational Institute : Chapters 2 and 3. Weygandt , J. , Kieso , D. , Kimmel , P. and DeFranco , A. ( 2009 ) Hospitality Financial

Accounting , Hoboken, NJ: John Wiley & Sons : Chapter 2.

rapid infl ation around the time the two hotels were acquired. If ROI is calculated based on conventional accounting records, it will appear that Hotel A is the better performer. This will be attributable more to the time when it was purchased than good management by the general manager, however. To provide a better basis for benchmarking the relative management performance in the two hotels, current market value rather than historical cost could be used as the basis for valuing the investment in each hotel.

This issue of assets being recorded at their historical cost is also pertinent to insurance decisions taken. Senior managers should ensure that all assets are insured for what it would cost to replace them. Replacement cost can be signifi – cantly different from the historical cost recorded in a balance sheet.

Problems

Problem 2.1

Describe what is meant by: a) an asset b) a liability c) owners’ equity.

Problem 2.2

Describe what is meant by the term “balance sheet equation”.

Problem 2.3

Identifi ed below are a set of transactions for the SerenitySleep Hotel which commenced busi- ness in Wellington, New Zealand on 1st June.

June 1 Owner commenced business by depositing $20,000 in a new business bank account. 2 Purchased some basic offi ce furniture for $3,000 cash. 3 Purchased inventory stock for $900 cash. 4 Purchased more inventory stock on credit for $1,400. 5 Purchased an offi ce computer for $6,000, paying $1,500 in cash and obtaining a loan for

the balance. 6 Billed clients $1,000 for use of conference facilities. 7 The owner withdrew $800 from the business. 8 Banked the fi rst week’s cash revenue $1,300. 9 It was determined that $400 of inventory has been used since the commencement of

business. 10 Paid $240 for miscellaneous expenses (telephone, electricity, etc.).

Required: Using a format similar to that appearing in Exhibit 2.1, demonstrate the impact each transac- tion will have on the balance sheet equation.

Problem 2.4

Describe the difference between an income statement and a balance sheet.

Problem 2.5

“Both owners’ drawings and expenses reduce equity. So owners’ drawings are really the same as expenses”. Explain whether you agree with this statement.

Problem 2.6

The heading of a balance sheet and the heading of an income statement usually provide a reference to a date. Describe how the balance sheet differs to the income statement with respect to the time that it relates to.

Analysing transactions and preparing year- end fi nancial statements

Problem 2.7

Classify each of the following accounts as either an asset, liability, revenue, expense or owners’ equity item:

Buildings Wages Drawings Sales Loan owed Cash Accounts payable Loan interest paid Inventory used Inventory on hand Bank account interest earned.

Problem 2.8

Using a schedule similar to that appearing in Exhibit 2.1, record the following ten transac- tions that occurred for Jane Long’s LusciouslyLong restaurant in the fi rst ten days of May.

May 1 Purchased inventory stock for $350 on credit. 2 Restaurant makes sales of $2,000, $1,200 for cash and $800 on account. 3 Paid staff wages $750. 4 Received $660 in connection with customers billed in (2) above. 5 Jane Long withdrew $2,400 from the business. 6 Paid $330 for miscellaneous expenses (telephone, electricity, etc.). 7 Paid $350 to trade creditors. 8 Took up a loan of $4,200 from the bank. 9 Restaurant makes sales of $2,800, $1,500 for cash and $1,300 on account. 10 Purchased furniture costing $3,160 on credit.

Problem 2.9

The Johnson Hotel is located in Perth, Western Australia. Identifi ed below are the account balances for the Johnson Hotel following its commercial activities through the month of December 20X1.

Accounts payable $ 10,000 Accounts receivable 12,000 Cash 5,000 Linen 8,000 Uniforms 7,500 Buildings 250,000 Loan payable 100,000 Owners’ equity 148,000 Sales revenue 38,000

Problems

Inventory stock used 6,500 Miscellaneous expenses 3,000 Owner’s drawings 4,000

Required :

a) Prepare the Johnson Hotel’s income statement for December 20X1. b) Prepare Johnson Hotel’s statement of owners’ equity for December 20X1. c) Prepare Johnson Hotel’s balance sheet as at 31 December 20X1.

Problem 2.10

In April 20X1, Jock MacNoodle opened the MacNoodle Italian Restaurant in Glasgow. Identifi ed below are the restaurant’s fi nancial transactions in its fi rst month of business.

Date Transaction

1 April Jock MacNoodle deposited £10,000 in a newly opened business bank account.

2 April Paid £400 cash for non- perishable food items to build up an inventory of food.

4 April Purchased a photocopier costing £1,000. 10 per cent of the purchase price was paid in cash and a loan was taken to cover the balance.

5 April Purchased £500 of wine stock on credit.

7 April Banked the £350 received for cash sales made in fi rst week.

8 April Paid £450 rent for April.

14 April Paid a kitchen assistant and waiter wages of £100.

18 April Paid £300 as part settlement of the wine merchant’s account.

27 April It was noted that half of the stock of wine purchased on 5th April had been sold.

28 April Banked £460 received from cash sales.

29 April Paid a kitchen assistant and waiter wages of £280.

30 April It was noted that £60 of food inventory had been used.

30 April It was noted that credit sales made in the fi rst month of business were £340.

Required:

Using a format similar to that appearing in Exhibit 2.1, demonstrate the impact each trans- action will have on the restaurant’s balance sheet equation.

Problem 2.11

In connection with the information provided in the previous problem, prepare the following:

Analysing transactions and preparing year- end fi nancial statements

a) The MacNoodle restaurant’s income statement for April 20X1. b) The MacNoodle restaurant’s statement of owners’ equity for April 20X1. c) The MacNoodle restaurant’s balance sheet as at 30 April 20X1.

Problem 2.12

Paul Eastwell owns a Robina tennis resort complex. The resort has a 30th June fi nancial year- end. The resort’s account balances are as follows:

Paul Eastwell tennis resort account balances – 30th June 20X1

Accounts payable $ 22,000 Wages owing 4,600 Bank overdraft 7,300 Accounts receivable 12,000 Food inventory 3,800 Beverage inventory 2,400 Cleaning supplies 1,100 Tennis equipment 800 Land 230,000 Buildings 125,000 Loan payable 100,000 Furniture 13,000 Tax payable 14,200 Sales revenue 115,000 Food and beverage used 23,000 Wages 41,700 Miscellaneous expenses 4,200 Owner’s drawings 6,000 Owners’ equity 199,900

Required :

a) Prepare the income statement for Paul Eastwell’s tennis resort complex for the year ended 30th June 20X1.

b) Prepare the statement of owners’ equity for Paul Eastwell’s tennis resort complex for the year ended 30th June 20X1.

c) Prepare the balance sheet for Paul Eastwell’s tennis resort complex as at 30th June 20X1.

Chapter 3

Double entry accounting

Learning objectives

After studying this chapter, you should have developed an appreciation of:

1. the mechanics of double entry bookkeeping, 2. how the terms “debit” and “credit” are used in fi nancial accounting, 3. the fact that asset and expense accounts normally have a debit balance, 4. the fact that liability, owners’ equity and revenue accounts normally have a credit balance, 5. how to produce a trial balance, 6. the distinction between current assets and fi xed assets and also current liabilities and long-

term liabilities, 7. how to record transactions in a general journal.

1) Introduction

This chapter focuses on the fundamentals of double entry accounting and will reinforce the understanding of the balance sheet and income statement that you acquired from reading Chapter 2. The chapter introduces the use of “T accounts” to record transactions and also the layout of the general journal.

2) Double entry accounting: some background concepts

In Chapter 2 we saw how a double impact arises from any fi nancial transaction. In light of this, it is not surprising that the fi nancial accounting recording process is based on a system of double entries. In this chapter we will see that the columns in the previous chapter’s Exhibit 2.1 represent “accounts” in a real accounting system. In Exhibit 2.1 there were columns pertaining to cash, accounts receivable, inventory, etc. In double entry accounting we have a cash account, an accounts receivable account, an inventory account, etc. Further, we will see that the “+” and “−” symbols that indicated the directional change for each of the accounts in Exhibit 2.1 represent a “debit” or “credit” in double entry accounting. An important word of caution is warranted at this point, however. A “+” does not always represent a debit or

Double entry accounting

credit and a “−” does not always represent a debit or credit. As we will see in Exhibit 3.1 presented below, the relationship between the “+” and “−” used in the last chapter and the debit and credit terms used in double entry accounting depends on the nature of the account in question.

Before exploring the workings of the double entry bookkeeping system, it is helpful to review the nature of the fi ve basic account categories. The fi ve basic account categories in an accounting system comprise: assets, liabilities, owners’ equity, revenues and expenses. Asset, liability and the owners’ equity accounts relate to a certain point in time (they are sometimes referred to as “snapshot” accounts). Their “snapshot” nature should be apparent from the fact that they all appear in the balance sheet. We noted in Chapter 2 that the balance sheet refers to a particular point in time, and not a period of time. Revenue and expense accounts are “fl ow” accounts (they only make sense when referring to a period of time). Again, this should be apparent from the fact that expense and revenue accounts appear in the income statement which, unlike the balance sheet, refers to a time period and not a particular point in time. A company’s set of accounts is referred to collectively as its “ general ledger ”.

Let us now turn to the fundamentals of double entry accounting. In Box 3.1 there is a summary of key principles that can help when fi rst confronting the debits and credits of double entry accounting.

Box 3.1

Key principles of double entry accounting

● With respect to balance sheet accounts: asset accounts normally have a debit balance, liabilities and owners’ equity accounts normally have a credit balance. Although this is a helpful rule, be warned that in some situations it can be broken, e.g., while we normally think of a bank account as an asset (i.e., debit balance), if it becomes overdrawn it will represent a liability (i.e., credit balance).

● With respect to income statement accounts: revenue accounts have a credit balance, expense accounts have a debit balance.

● For every debit entry, there must be an equal credit entry. ● Where there is a cash infl ow we debit the cash account. For a cash outfl ow,

we credit the cash account.

The fi rst two principles in Box 3.1 provide a framework that can serve as a highly valuable reference point when learning the double entry accounting process. This framework is also depicted as a matrix in Exhibit 3.1. From this matrix we can see that asset accounts usually have a debit balance (column 1). It follows that a debit entry is made to record an increase in an asset account (column 2), and a credit entry is made to record a decrease in an asset account (column 3). Similarly, it is also evident from Exhibit 3.1 that liability accounts usually have a credit balance (column 1), we credit a liability account to increase it (column 2), and debit a liability account to decrease it (column 3).

Double entry accounting: some background concepts

The fourth principle of double entry accounting referred to in Box 3.1 concerns the workings of the cash account. Gaining a familiarity with the workings of the cash account is a useful fi rst step when attempting to understand the double entry accounting system. This is because many transactions affect cash. Cash is an example of an asset account, and once you have mastered the way this account works, you will have gained an insight into the workings of all asset accounts. As cash is an asset, it is evident from Exhibit 3.1 that a receipt of cash (i.e., an increase in cash) will be recorded by debiting the cash account and a disbursement of cash (i.e., a decrease in cash) will be recorded by crediting the cash account.

The cash account’s workings can be illustrated using a “T account”, as depicted in Exhibit 3.2. The left- hand side of all T accounts (regardless of whether they are assets, liabilities, etc.) is the debit side (sometimes abbreviated as “Dr”) and the right- hand side of all T accounts is the credit side (sometimes abbreviated as “Cr”). Some fi nd it helpful to visualise money fl owing through the cash T account from left to right, i.e., money fl ows into the left- hand side of the account (the arrow on the left in Exhibit 3.2), and fl ows out of the right- hand side of the account (the arrow on the right in Exhibit 3.2). Consistent with this visualisation, a receipt of money is recorded as a debit to the cash account and an outfl ow of cash is recorded as a credit to the cash account.

Exhibit 3.1

The double entry accounting framework

Type of account (1) Usual balance

(2) If increasing the account

(3) If decreasing the account

Asset (balance sheet account) Debit Debit Credit

Liability (balance sheet account) Credit Credit Debit

Owners’ equity (balance sheet account)

Credit Credit Debit

Revenue (income statement) Credit Credit Debit

Expense (income statement) Debit Debit Credit

Exhibit 3.2

The Cash “T account”

Double entry accounting

Because of the terminology used by banks, many students of accounting are confused when introduced to the workings of the cash account. They are used to their bank informing them that a deposit of funds in their account represents a credit. This confusion arises because the bank is using terminology from its perspective and not the account holder’s perspective. This will be illustrated by the following small example. Imagine that Monica Miser deposits $300 in her savings account held with the Loyalty bank. The double entry that the Loyalty bank will record in its accounting system is as follows:

Cash M. Miser Savings Account

300 300

Note that the cash account (which is an asset from the bank’s perspective) has been debited. This is consistent with Exhibit 3.2. Note also that the bank’s record of Monica Miser’s savings account has been credited. This account represents a liability from the perspective of the bank (i.e., it records what the bank owes to M. Miser). As the bank’s liability to Monica Miser has increased, the savings account has been credited (check back to column 2 in Exhibit 3.1). When Monica Miser receives a statement from her bank, she will fi nd that the $300 deposit has been recorded as a credit to her savings account. The confusion for the student of accounting stems from the fact that the savings account represents a liability for the bank, but an asset for the account holder.

3) Double entry accounting: a worked example

We are now in a position to explore the nature of double entry accounting through a worked example comprising several transactions. In the following example we will see the double entry recording of a series of transactions and the subsequent preparation of an income state- ment and balance sheet.

The “Joe Blow Hotel” example worked through in the previous chapter was based on a sole proprietorship. The example that will be worked through in this chapter is based on a company. Differences between sole proprietorships and companies were described at the end of Chapter 1. Key accounting differences between sole proprietorships and companies include:

● In companies, equity is raised from investors by way of issuing shares and this equity funding is referred to as “Share Capital”.

● In sole proprietorships, we talk of “drawings” when an owner withdraws capital from the business. In companies, the equivalent payments are viewed more as profi t allocations to owners, and they are referred to as “dividends”.

● In companies, a separate equity account termed “retained earnings” is maintained to refl ect the profi ts retained in the business (i.e., the accumulation of profi ts not paid out to share holders as dividends).

Imagine that on 28th June the Winnie Pooh Hotel Ltd commenced business next to a children’s theme park in Cardiff, Wales. On 30th June, the only balances in W. Pooh Hotel Ltd’s accounting system were as follows:

Double entry accounting: a worked example

Cash £ 8,000 Revenue £ 300 Share capital £ 7,700

Identifi ed below are nine transactions that occurred in July, together with the double entry necessary to record each transaction in the accounting system. The circled numbers in the “T-accounts” highlight the entry necessary to record the transaction in question.

Transaction 1: July 1 : From the £8,000 balance in the bank account, beverage stock was purchased for £200 cash.

Cash Inventory

Opening balance (O.B.) 8,000

200 200

Both cash and inventory are asset accounts. From Exhibit 3.1 it can be determined that the decrease in cash necessitates a credit to the cash account, and the increase of stock necessitates a debit to the inventory account.

n.b. Exhibit 3.1 indicates that we expect to see a debit balance in an asset account (e.g. cash or inventory).

Transaction 2: July 4 : At an American Independence Day banquet function the beverage stock bought on 1st July was sold for £500 cash.

Note: this is a slightly tricky transaction to record as we have to complete two sets of entries. The fi rst set deals with the sales aspect of the transaction, the second set deals with the expense aspect of the transaction.

Cash Revenue

8,000

500

200 O.B. 300

500

n.b. Exhibit 3.1 indicates that we expect to see a credit balance in a revenue account.

Cost of sales Inventory

200 200 200

n.b. Exhibit 3.1 indicates that we expect to see a debit balance in an expense account (e.g. cost of sales). Cost of sales includes the cost of all goods and services consumed in making a sale.

Double entry accounting

Transaction 3: July 5 : Purchased inventory stock on credit from Ripoff Ltd for £1,000.

Inventory Accounts payable

200

1,000 200

1,000

n.b. Exhibit 3.1 indicates that we expect to see a credit balance in a liability account (accounts payable is an example).

Transaction 4: July 10 : Sold conferencing services on credit to Ripoff Ltd for £2,000.

Accounts receivable Revenue

2,000

300 500

2,000

Transaction 5: July 11 : Purchased ten kitchen ovens on credit for £250,000 from Rusting Ltd.

Kitchen equipment Accounts payable

250,000 1,000

250,000

Kitchen equipment is an example of a “fi xed asset”. “Fixed assets” is the term given to all physical assets that will be held by the purchasing company for more than a year. Fixed assets are acquired for use in operations rather than for resale to customers.

Transaction 6: July 18 : Paid Rusting £250,000 to settle the outstanding account.

Cash Accounts payable

8,000

500 200

250,000 250,000

1,000

250,000

Double entry accounting: a worked example

Transaction 7: July 20 : Paid £300 for electricity bill.

Cash Electricity expense

8,000

500 200

250,000

300

300 300

Transaction 8: July 24 : To correct the business bank overdraft, a further £500,000 of share capital is issued.

Cash Share capital

8,000

500

500,000

200

250,000 300

O.B. 7,700

500,000

n.b. Exhibit 3.1 indicates that we expect to see a credit balance in the share capital account.

Transaction 9: July 31 : A dividend of £1,500 is declared and paid to shareholders.

Cash Dividends paid

8,000

500

500,000

200

250,000 300

1,500

n.b. “Dividends paid” is the one account that does not lend itself to interpretation through the framework outlined in Exhibit 3.1. If attempting to use Exhibit 3.1, it is best to view divi- dends paid as having a negative impact on owners’ equity. If more equity is raised by way of a share issue, we will see a credit made to owners’ equity. It follows that a debit to owners’ equity refers to a decrease in owners’ equity. Instead of debiting an owners’ equity account directly, however, when a dividend is declared and paid, we debit the dividends paid account.

As errors can occur in the recording of business transactions, e.g. for transaction 9 we may have erroneously entered a $1,500 credit entry to the “Cash” account and a $150 debit entry to the “Dividends paid” account, it is customary for a trial balance to be prepared at the end of an accounting period. The trial balance simply represents a listing of the debit or credit balance on each of the accounts in a business’s general ledger. It is called a “trial balance” as it repre- sents a trial to see if the total of the accounts’ debit balances equals to the total of the accounts’ credit balances. If transaction 9 had resulted in an erroneous $150 debit entry to the dividends

Double entry accounting

paid account, the trial balance would reveal the debit account balances as $1,350 less than the credit account balances. This would signify that a review must be made in order to locate and rectify the accounting error uncovered through the process of producing a trial balance.

The trial balance also assists in the preparation of the year- end fi nancial statements. This is because it lists in one schedule the year- end account balances that will make up the two end of year statements: the income statement and the balance sheet. The trial balance for the Winnie Pooh Hotel Ltd, following the recording of the nine transactions described above, is provided below.

Winnie Pooh Hotel Ltd Trial Balance as at 31st July

Debit Credit

Cash £ 256,500 Accounts receivable 2,000 Inventory 1,000 Kitchen Equipment 250,000 Accounts Payable £ 1,000 Share Capital 507,700 Dividends Paid 1,500 Revenue 2,800 Cost of Sales 200 Electricity Expense 300

Total £ 511,500 £ 511,500

Following the preparation of the trial balance and check that the total of the debit account balances equates to the total of the credit account balances, the income statement for the W. Pooh Hotel can be produced as follows:

Winnie Pooh Hotel Ltd Income Statement

For the Period ended 31st July

£ £

Revenue 2,800 Cost of Sales 200 Gross Profi t 2,600 Electricity Expense 300 Net Profi t 2,300

In Chapter 2 we saw that the owners’ equity balance can be computed by way of a “statement of owners’ equity”. In companies it is common practice to segregate owners’ equity into two underlying elements: the share capital account and the retained earnings account. The share capital account records direct investments made into a business by shareholders, the retained earnings account records all business profi ts made and not distributed to the owners. The retained earnings account is increased by the profi t made in an accounting period and is reduced by any dividends paid to the owners during the accounting period. For the Winnie Pooh Hotel case, profi t for the period ending 31st July is £2,300 and dividends paid are £1,500. The retained earnings account on 31st July can therefore be computed as £800 (£2,300 – £1,500).

In the following balance sheet for the Winnie Pooh Hotel, assets have been segregated between current assets and fi xed assets. Current assets include cash and other assets that

Double entry accounting: a worked example

through the business’s operating cycle will be converted into cash, sold or consumed within one year of the balance sheet date. As noted earlier, fi xed assets include all physical assets that will not be sold in the next 12 months. Similarly, a distinction can be drawn between current liabilities and longer- term liabilities. Current liabilities include those liabilities that are due for payment in the course of the next 12 months, while long- term liabilities include liabilities that are not due for payment in the next 12 months.

Winnie Pooh Hotel Ltd Balance Sheet as at 31st July

£ £ £ £

Current Assets Current liabilities Cash 256,500 Accounts payable 1,000 Accounts receivable 2,000 Owners’ equity Inventory 1,000 Share capital 507,700

259,500 Retained earnings 800

Fixed Assets 508,500 Kitchen equipment 250,000

£ 509,500 £ 509,500

For well- established companies, the retained earnings account can be one of the largest accounts appearing in a balance sheet. As highlighted in the fi nancial decision making case 3.1, it is an account that is frequently misunderstood by managers.

FINANCIAL DECISION MAKING IN ACTION CASE 3.1

The General Manager’s interpretation of the retained earnings account The retained earnings account records the accumulated profi ts earned by a company and retained in the business. There is a common tendency, however, for managers who have had no accounting training to believe that the retained earnings account represents cash held.

It is imperative that senior management do not fall prey to this misconception of the retained earnings account because:

● As will be seen in Chapter 13, careful cash management is fundamental to maintaining business solvency. The immediate factor that causes a bankruptcy is a shortage of cash.

● The retained earnings account is frequently one of the largest accounts appearing in a balance sheet.

Senior managers should not allow the retained earnings balance to infl uence their thinking in any decision that carries signifi cant cash management implications. To determine how much cash a business holds, look at the cash (or bank) balance that appears as an asset in the balance sheet.

Double entry accounting

4) Journal entries

The previous section has shown you how a business records transactions as debits and credits in its accounts. We have also seen that these accounts are collectively referred to as the general ledger. Prior to posting transactions to the accounts in a general ledger, they are entered chronologically in a record referred to as a journal. While many businesses maintain a set of journals, with each journal tailored to a particular type of transaction (e.g., cash payments journal, cash receipts journal, etc.), most maintain at least a basic form of journal which is referred to as the “ general journal ”.

Journals are maintained in order to:

1. Provide a chronological record of all transactions. If a business was to experience a problem with its accounting system during a particular time period, the journal could be turned to as a record of transactions occurring during that time period.

2. Provide a complete record of each transaction. Note that in the general ledger, transac- tions are recorded in more than one place, e.g., a $300 cash sale is recorded in the “cash account” record and the “sales account” record. Recording all information relating to a transaction in a journal helps in the avoidance and detection of errors.

To illustrate the workings of the general journal, imagine two May transactions for a hotel: on 3rd May it bought $4,015 of wine stock on credit, and on 4th May it collected $1,200 of cash owed by a customer. Exhibit 3.3 illustrates how these two transactions would be recorded in the general journal.

The journal shows the date a transaction is recorded, the title of each account affected by the transaction and also the amount to be debited and credited. The name of the account to be credited and also the amount to be credited have traditionally been indented in the journal. The journal also records the account numbers of the accounts affected (accounts in the general ledger are typically numbered to facilitate easy access), referred to as “posting reference” in Exhibit 3.3. A brief description of the transaction recorded is entered below the transaction.

Exhibit 3.3

Illustration of a general journal

Date Account titles and transaction description

Posting reference

Debit Credit

20X1 May 3 Wine stock 144 4,015

Accounts payable 201 4,015 Purchase of wine stock on credit

4 Cash 101 1,200 Accounts Receivable 170 1,200 Collection of an account receivable

Problems

5) Summary

This chapter has built on Chapter 2’s introduction to fi nancial accounting by describing the “debit and credit” system of double entry bookkeeping. A framework was introduced showing you that a debit increases asset and expense accounts and that a credit increases liability, owners’ equity and revenue accounts. In connection with a worked example, you were shown an accounting transaction affecting each of these main account groupings.

Having read the chapter you should now know:

● how to increase or decrease asset, liability, owners’ equity, revenue and expense accounts, ● how to record transactions in a general journal, ● how to produce a trial balance, ● that profi ts not paid out to a company’s shareholders as dividends are generally credited

to an owners’ equity account called “retained earnings”, ● that current assets include cash and other assets that through the business’s operating cycle

will be converted into cash, sold or consumed within one year of the balance sheet date, ● that current liabilities include those liabilities that are due for payment in the course of the

next 12 months.

References

Jackling , B. , Raar , J. , Wines , G. and McDowall , T. ( 2010 ) Accounting: A Framework for Decision Making , 3rd edition, Macquarie Park, NSW, Australia: McGraw-Hill : Chapter 14.

Jagels , M.G. ( 2007 ) Hospitality Management Accounting , 9th edition, Hoboken, NJ : John Wiley & Sons : Chapter 1.

Schmidgall , R.F. ( 2011 ) Hospitality Industry Managerial Accounting , 7th edition, East Lansing, MI: American Hotel & Lodging Educational Institute : Chapter 1.

Weygandt , J. , Kieso , D. , Kimmel , P. and DeFranco , A. ( 2009 ) Hospitality Financial Accounting , Hoboken, NJ: John Wiley & Sons : Chapter 3.

Problems

Problem 3.1

Describe whether we can say that a debit to an account signifi es that something benefi cial has happened for the business concerned.

Problem 3.2

Are we able to say that in double entry accounting a debit represents a plus and a credit represents a minus?

Problem 3.3

Dublin’s BlarneyStone Pub opened on 1st April and the following six transactions occurred in its fi rst week of business. Record the transactions in appropriately headed T-accounts for the BlarneyStone Pub’s manager.

Double entry accounting

a) Owner invested €4,000 in a newly opened bank account for the pub. b) Purchased €5,000 of “Old Black Creamy” stout on account. c) Paid cash €450 for a delivery of potato crisps and salted peanuts. d) Purchased a cash register for €1,000 on credit. e) Banked the fi rst week’s bar takings of €350. f) Determined that the cost of “Old Black Creamy” sold in the fi rst week was €150.

Problem 3.4

What is the difference between fi xed assets and current assets?

Problem 3.5

In terms of debit and credit record keeping, explain why a manager may think there is an error when he notes the direction of the current bank balance in the accounts of their business and compares it with the direction of the balance on the business’s most recent bank statement.

Problem 3.6

Business transactions are recorded in a general ledger. A general journal is also used to record business transactions. So doesn’t maintenance of a general journal therefore signify signifi cant duplication in record keeping?

Required: Provide two reasons why many businesses maintain a general journal in addition to a general ledger.

Problem 3.7

Develop your own balance sheet by listing your assets and liabilities. From this listing determine your “net worth” which corresponds to “owners’ equity” in a business reporting context.

Problem 3.8

Fill in each of the blank boxes in the matrix appearing below with either the word “debit” or “credit”.

Type of account Usual balance To increase the account . . . .

To decrease the account . . . .

Asset

Liability

Owners’ equity

Revenue

Expense

Problems

Problem 3.9

From the following listing of Jackie Cridland’s CreatureComforts hotel accounts, distinguish between the debit and credit balances.

$ Buildings 120,000 Wages payable 1,300 Bank overdraft 2,240 Trade Creditors 3,300 Soft drink inventory 880 Offi ce supplies 540 Drawings 3,600 Owners equity 78,450 Bank loan 18,420 Accounts receivable 4,500 Sales 24,600 Bank interest revenue 1,210

Problem 3.10

Record a hotel’s following fi ve transactions in appropriately headed T-accounts.

a) Hotel receives $500 for room sales. b) Hotel pays staff $400 in wages. c) Hotel makes $600 of restaurant sales all on credit. d) Hotel owner withdraws $1,000 from the business. e) Hotel buys $700 of inventory stock on account.

Problem 3.11

(a) Using “T-accounts”, record debit and credit entries for each of the following transactions that all occurred in January 20X1 for a San Francisco restaurant. The T-accounts you will need are: Cash, Food Inventory, Beverage Inventory, Accounts Receivable, Furniture and Equipment, Accounts Payable, Bank Loan, Owners’ Equity, Revenue, Food Purchase Expense, Beverage Purchase Expense, Wage Expense, Supplies Expense, Rent Expense, Interest Expense.

a. Mr T. Francis commenced business by investing $30,000 cash in the restaurant. b. Purchased on credit food stock for $4,000 and beverage stock for $6,000. c. Purchased furniture and equipment for $20,000, paying $12,000 cash and owing the

balance. d. The bank extended a loan of $20,000 to the business. e. Made sales of $40,000 during the month – 75 per cent of this was cash sales, the

remainder was on credit. f. Purchased $9,000 of perishable food items (food purchase expense) on credit and paid

$2,000 cash for beverages (beverage purchase expense). The business has established that both these purchases should be immediately expensed.

g. Paid $12,000 to trade creditors. h. Repaid $2,000 of the bank loan plus interest of $100.

Double entry accounting

i. Paid $10,800 of wages. j. Paid $4,000 for miscellaneous supply items. The business has a policy of expensing

these items on purchase. k. On the last day of the month, paid $1,500 rent for January.

(b) Once the T-account entries have been recorded, prepare an income statement for January 20X1 and a balance sheet as at 31st January 20X1.

Problem 3.12

The following transactions occurred during the fi rst month of operations for “Oz Hinterland Ltd”, a new hotel business located in the Australian Kimberleys:

a. $80,000 of share capital was raised. b. In order to provide further capital, a bank extended a loan of $40,000 to the business. c. Paid cash for land and buildings $99,500. d. Purchased kitchen equipment for $20,000. $8,000 of this was paid for in cash, with the

balance owing. e. Purchased on credit a stock of linen and uniforms for $5,800. f. During month received revenue of $12,000 for room sales and restaurant revenue. g. Paid $1,500 for fi rst month’s wages. h. Paid $300 covering one month’s interest on the bank loan. i. Paid $1,200 insurance premium covering the fi rst year of operations. j. Paid $6,000 of the balance owing for kitchen equipment. k. Purchased beverage stock of $1,500 for cash. By the end of the fi rst month it was deter-

mined that one- third of this stock had been sold in the restaurant. l. Determined that during the month the kitchen had purchased $1,800 of perishable food

supplies for cash. No balance of food stock remained at the end of the month. m. Oz Hinterland declared and paid a total dividend of $2,000.

Required:

(a) Enter these transactions on T-accounts. (b) Prepare an income statement for the fi rst month and a balance sheet as at the month end.

Chapter 4

Adjusting and closing entries

Learning objectives

After studying this chapter, you should have developed an appreciation of:

1. what is meant by “closing entries”, 2. what is meant by “adjusting entries”, 3. the distinction between periodic and perpetual inventory accounting systems, 4. how the accountant accounts for bad debts, 5. how the accountant accounts for depreciation.

1) Introduction

This chapter focuses on adjusting entries and closing entries. “ Adjusting entries ” is the term used to describe the set of bookkeeping entries that need to be made in order to update some accounts prior to the preparation of the accounting year- end income statement and balance sheet. “ Closing entries ” is the term used to describe the set of year- end accounting entries that are made in order that all accounts relating to a period of time (i.e., revenue, expense and the drawings or dividends account) begin the new accounting year with a zero balance . It is only once all adjusting entries have been completed that closing entries can be made. This is because closing entries result in the transference of account balances to the income account.

As the mechanics of adjusting entries are more challenging than the mechanics of closing entries, the chapter is structured around the different types of adjusting entries that can be encountered. In the course of considering a range of adjusting entries, the mechanics of making closing entries will also be demonstrated.

2) Why do we need closing entries?

Immediately prior to entering the new accounting year, all accounts that relate to a period of time (i.e., those accounts that do not fl ow directly to the balance sheet) need to be wound back to zero. If these accounts were not wound back to a zero balance on an annual basis, their balances would not refl ect the current year’s sales revenue (for a revenue account) or the current year’s expenses

Adjusting and closing entries

(for an expense account). In effect, failure to close these accounts would result in the revenue account and also all expense accounts showing balances that refl ect sales achieved and expenses incurred since the inception of the business. The term “closing entry” is used to describe the year- end transference of balances in these accounts to the income statement (the income state- ment can be thought of as an account in which revenues are credits and expenses are debits).

In Chapter 2, we saw that the balance on the income statement (i.e., net profi t) is trans- ferred to the owners’ equity section of the balance sheet by way of the statement of owners’ equity. This highlights the fact that all accounts fl ow eventually into the balance sheet. This fl ow is direct for those accounts that are sometimes described as “permanent” (i.e., asset, liability and owners’ equity accounts) and indirect via the income statement for other accounts that are sometimes referred to as “temporary” (e.g., revenue and expense accounts).

3) Why do we need adjusting entries?

In many cases the need for adjusting entries arises because the timing of cash fl ows (either receipts or disbursements) does not coincide with the period in which it is appropriate to recognise the related revenue or expense. This distinction between the timing of a cash fl ow and the timing of the recognition of a revenue or an expense item stems from the accrual concept of accounting. The nature of this concept, as well as some examples of year- end adjusting entries, are presented in Box 4.1.

Box 4.1

Adjusting entries and the nature of the accrual concept

Most year- end adjusting entries arise because of the accrual concept of accounting which holds that:

● revenue is recognised when it is earned and certain, rather than simply when cash is received,

● an expense is recognised in the period when the benefi t derived from the associated expenditure arises (e.g., wages for work conducted during the current period are treated as an expense of the current period, regardless of whether or not they have been paid for during the current period).

Examples of year- end adjusting entries include:

● recording wages accrued (at the year- end there are wages owing for employee work conducted but not yet paid for),

● allocating the cost of a fi xed asset to those accounting periods in which the benefi t of owning the fi xed asset occurs (this is “depreciation”),

● allocating a pro- rated portion of prepaid insurance to the most recent accounting period,

● adjusting accounts receivable (debtors) to recognise that some of the balance appearing in the accounts receivable ledger may prove to be uncollectible.

Worked examples highlighting types of adjusting entry

The examples of year- end adjusting entries provided in Box 4.1 will be more fully explained in the next section which provides worked examples of year- end adjusting entries.

4) Worked examples highlighting types of adjusting entry

In this section, the following four basic types of adjusting entry will be explained by way of worked examples:

● Costs paid for but not yet incurred (i.e., expenses pre- paid), ● Costs incurred but not yet paid for (e.g., money owing for wages), ● Unearned revenue (i.e., cash received prior to delivery of a good or service), ● Revenue earned but no cash received (e.g., interest on an investment account that is earned

but not yet received).

In addition, three further commonly confronted situations that give rise to adjusting entries are explored:

● Supplies used, ● Bad debts (uncollectible account receivables), ● Depreciation.

Adjusting entry type 1: Costs paid for but not yet incurred

This situation arises for insurance and rent (in rental and insurance situations the payee typically pays prior to the period in which the rental or insurance benefi t is received).

Imagine that on 1st January 20X1 Winnipeg’s TrudeauInn took advantage of a special insurance offer and purchased 18 months’ insurance coverage for $3,000. On 30th June 20X2 this policy was renewed for a further 12 months at a cost of $2,400. TrudeauInn’s accounting year- end is on the 31st December.

To compute the insurance expense to be charged to the income statement, prorate the amounts paid to the periods of time in which the insurance coverage expired, i.e.:

20X1 Insurance expense = Two- thirds of $3,000 = $2,000. 20X2 Insurance expense = One- third of $3,000 + half of $2,400 = $2,200.

Accounting treatment:

1 January 20X1:

Insurance prepaid Cash

3,000 3,000

n.b. The insurance cover is paid for in advance of the period of time that it pertains to. This signifi es that immediately following the payment of the insurance premium, we have an asset (i.e., insurance coverage) that runs for the life of the insurance contract. This asset is referred to as “insurance prepaid”.

Adjusting and closing entries

31 December 20X1 (adjusting entry):

Insurance expense Insurance prepaid

2,000 3,000 2,000

n.b. The need to make this year- end entry can be viewed from an asset depletion perspective or an expense incurred perspective. With respect to the asset depletion perspective, two- thirds of the insurance coverage paid for at the beginning of the year has now expired due to the passage of time. This signifi es that the $3,000 asset (i.e., prepaid insurance) has diminished by $2,000. With respect to the expense perspective, 12 months of insurance cover was “consumed” in 20X1. From the prorated calculation above, we found that the 20X1 insur- ance cover effectively cost $2,000.

31 December 20X1 (closing entry):

Insurance expense Income statement

2,000 2,000

2,000

n.b. Prior to entering the new accounting year, all revenue, expense and drawing accounts (i.e., “period related” or “temporary” accounts) need to be wound back to zero in order that their balance at any time refl ects the revenue, expense or drawings for the current accounting year. This process is generally referred to as making closing entries. These accounts are closed by transferring their balances to the income statement, which results in the compilation of a profi t or loss for the year.

30 June 20X2:

Insurance prepaid Cash

3,000

2,400 2,000

2,400

This 30 June 20X2 entry is to record the $2,400 insurance premium paid.

31 December 20X2 (adjusting entry)

Insurance expense Insurance prepaid

2,200 3,000

2,400 2,000

2,200

n.b. Again, we can take an asset depletion or an expense incurred perspective on this adjusting entry. With respect to the asset depletion perspective, in the fi rst six months of 20X2, $1,000

Worked examples highlighting types of adjusting entry

of the $3,000 prepayment expired. In the second six months of 20X2, $1,200 of the $2,400 prepayment expired. From the expense perspective, this signifi es that insurance coverage costing a total of $2,200 is attributable to 20X2. Note also that a rationale can be offered for the $1,200 year- end debit balance remaining on the insurance prepaid account. This represents the cost of acquiring insurance cover for the fi rst six months of 20X3, i.e., the cost of insurance cover that is prepaid as at 31/12/X2.

31 December 20X2 (closing entry)

Insurance expense Income statement

2,200 2,200

2,200

Finally, on 31st December 20X2, all revenue and expense accounts are closed off to the income statement.

In this example, it has been presumed that on payment of the premium, “insurance prepaid” is debited. In some accounting systems this amount may be charged immediately to “insur- ance expense”. This approach is referred to as “expensing on purchase”. If this alternative approach is taken, the year- end adjusting entry will have to set up the prepaid amount. For example, in the case described above, if the company had immediately expensed the $3,000 insurance cover purchased on 1st January 20X1, the year- end adjusting entry would be as follows:

31 December 20X1 (adjusting entry)

Insurance expense Insurance prepaid

3,000 1,000

1,000

n.b. Note how regardless of the initial method taken to record the insurance cover purchased, once the year- end adjusting entries have been made, the insurance expense account has a debit balance of $2,000 and the insurance prepaid account has a debit balance of $1,000. Some fi nd it helpful to approach adjusting entries by fi rst considering what year- end balance is needed in the prepaid account and the expense account. If you can determine what year- end balance needs to be refl ected in these accounts you can work out what adjusting entry needs to be made in order to get to the year- end balance that you seek.

Adjusting entry type 2: Expenses incurred but not paid for (accrued expenses)

Costs incurred but not yet paid are frequently referred to as “accrued expenses”. One of the main examples of accrued expenses arises in connection with wages and salaries. If, at the end of the accounting period, employee work costing $1,000 has been performed but has not yet been paid for, accrued wages are recorded as follows (the wages accrued account is a liability account that refl ects wages owing):

Adjusting and closing entries

Wage expense Wages accrued

1,000 1,000

Like all expense accounts, at the year- end the debit balance of the wage expense account will be closed off to the income statement. In the new accounting year, if the fi rst wage bill paid amounts to $5,000, the following entry will have to be made:

Wage expense Wage expense Wages accrued

5,000 4,000 1,000

1,000

n.b. This fi rst entry in the new accounting year is slightly complicated as it involves three accounts. The cash account credit entry of $5,000 is straightforward as $5,000 has been paid out. The wage expense account starts the new year with a zero balance as a result of the closing entry made at the end of the previous year. Of the $5,000 wage payment, $1,000 relates to the previous year (this is evident from the $1,000 credit balance in the wages accrued account). $4,000 of the $5,000 wage payment must therefore relate to work conducted this year. As the wage expense account is supposed to refl ect the cost of work completed this year, it is appropriate that it be debited with $4,000. Finally, prior to the wage payment, the wages accrued account refl ects a liability of $1,000. Immediately following the payment of wages the liability to employees is removed, therefore it is appropriate that a zero balance be refl ected, i.e., a $1,000 debit entry is warranted. The intricacies of this particular set of accounting entries only arise around the year- end, as in most accounting systems this is the only time that entries are made to the wages accrued account.

Adjusting entry type 3: Unearned revenue

Imagine that on 1st December the Captain Cook Hotel in Whitby, Yorkshire received £50,000 as an advance payment from a conference organiser, covering the cost of a fi ve-day conference that the hotel will host commencing on 30th December. At the close of business on 31st December (the hotel’s accounting year- end), 40 per cent of the conference service can be seen to have been provided (i.e., the hotel has completed the hosting of two days of the fi ve-day conference).

The accounting entries that would be made in the hotel’s books are as follows:

1st December accounting entry:

Cash Unearned revenue

50,000 50,000

n.b. Unearned revenue is the name of the account that is credited when cash is received in advance of the provision of goods or services associated with a sale. This is a liability account. In the above example, in the period following the £50,000 receipt but prior to hosting the convention, the £50,000 can be seen to represent a liability. Under a typical conference

Worked examples highlighting types of adjusting entry

contract, if a contingency arises preventing the hotel from hosting the convention, it will have to refund the conference organiser.

31st December accounting entry (adjusting entry):

Revenue Unearned revenue

20,000 20,000

50,000

n.b. As 40 per cent of the work contracted for (i.e., hosting the conference) has been completed by the year- end, 40 per cent of the original unearned revenue amount can be viewed as earned by 31st December. We therefore make a credit entry of £20,000 (40 per cent of £50,000) to the revenue account and reduce the balance on the unearned revenue account by making a debit entry of £20,000.

Adjusting entry type 4: Revenue earned but not received

The issue of accounting for revenue that has been earned but not received frequently arises when a reporting entity has an investment in an interest bearing account. Imagine Aberdeen’s Scrooge Hotel has an investment of £24,000 yielding 10 per cent annual interest with cash interest paid semi- annually. The last time the Scrooge Hotel updated its records with respect to this investment occurred on 30th September which is when it last received an interest payment of £1,200 earned for the six months commencing 1st April. If the Scrooge Hotel has a 31st December year- end, the year- end adjusting entry required to record the interest that it is owed as a result of holding the investment through October, November and December is as follows:

31st December accounting entry (adjusting entry):

Interest Receivable Interest Revenue

600 600

n.b. The Scrooge Hotel’s investment is earning interest at the rate of £200 per month. At the year- end, it has not recorded the interest earned in the fi nal three months of the year. A £600 credit entry to the interest revenue account updates the hotel’s record of interest earned in the year. The £600 debit entry to the interest receivable account highlights that the hotel has an asset in the form of interest that it is owed at the year- end.

Adjusting entry type 5: Accounting for supplies

Supplies such as offi ce stationery generally represent a relatively small investment for most hotels. As a result, many hotels adopt the relatively simple accounting procedure of periodically determining the supplies balance by conducting a stock- take (this approach is generally referred to as a periodic inventory accounting system). Under a periodic inventory system, the purchases of supplies are simply recorded by debiting a “supplies purchases” account. Operation of a periodic inventory system and the adjusting entry that it gives rise to are demonstrated through the worked example in Exhibit 4.1.

Adjusting and closing entries

The year- end adjusting entries that would have to be made in the scenario described in Exhibit 4.1 can be managed in two stages. Firstly, the purchases account balance can be transferred to the supplies inventory account. Consistent with the philosophy of closing entries, this results in the purchases account starting the new accounting year with a balance of zero.

Supplies purchases Supplies inventory

14,000 14,000

2,800

14,000

Exhibit 4.1

Determining stock used in a periodic inventory system

Suzy Defoe is the offi ce manager of Manchester’s Old Trafford Hotel. The hotel operates a periodic inventory system with respect to offi ce supplies. At the year- end, the hotel accountant asked Suzy to oversee a year- end stock- take of supplies, in order that the cost of supplies used during the year could be determined. The year- end stock- take revealed that £2,000 of offi ce supplies were held on 31st December 20X1. Suzy then consulted the supplies inventory account, which had last been updated 12 months previously (i.e., following the previous year- end’s stock- take), and noted a debit balance of £2,800. Throughout the year she debited the “supplies purchases” account whenever purchasing supplies. She notes that prior to making any adjusting entries, this account had a year- end debit balance of £14,000.

The cost of supplies used in the year can be determined by solving for? in the schedule below.

£ Opening balance 2,800 Add : Supplies purchased 14,000 Supplies made available 16,800 Less : Supplies used ? Closing balance £2,000

As we have determined that the cost of supplies made available is £16,800, and we know that at the end of the year the stock of supplies available cost £2,000, we can conclude that £14,800 of supplies must have been used during the year.

Worked examples highlighting types of adjusting entry

Secondly, the supplies expense account can be debited with the £14,800 cost of supplies used that was calculated above. The corresponding credit entry should then be made to the supplies inventory account. These entries result in the recognition of an expense (the supplies expense account will be closed to the income statement). They also result in a £2,000 debit balance in the supplies inventory account, which refl ects the result of the year- end stock- take. This inventory account balance will comprise part of the total assets recorded in the year- end balance sheet.

Supplies expense Supplies inventory

14,800 2,800 14,000

14,800

Using a periodic inventory control system signifi es that a degree of control is lost with respect to inventory. Between stock- takes the manager responsible for ordering supplies will have no administrative record of the supplies held in stock. If this is believed to represent a signifi cant problem, the manager could consider using a perpetual inventory system. The relative merits of perpetual and periodic inventory systems are outlined in Financial decision making in action case 4.1.

FINANCIAL DECISION MAKING IN ACTION CASE 4.1

The F&B manager’s choice of inventory control procedures Rather than depending on a periodic stock- take to determine what amount of stock is held, a perpetual inventory system can be operated. A perpetual inventory accounting system involves debiting the inventory account every time inventory is purchased and crediting it every time a sale or issue of stock is made. Deciding between a periodic and perpetual inventory approach can be a signifi cant issue for an F&B manager due to the many low- cost food items that can be held.

Perpetual accounting systems are generally more expensive to operate due to the number of individual inventory records that have to be maintained. Despite this, an F&B manager would consider adopting a perpetual inventory accounting approach for particular food and drink items if one or all of the following issues is believed to be signifi cant:

1. Signifi cant stock shrinkage is occurring due to theft. 2. A signifi cant loss of customer goodwill would result if certain menu items were

to become unavailable. 3. Observing whether the stock item in question needs to be reordered is awkward

and time consuming.

Adjusting and closing entries

Adjusting entry type 6: Bad and doubtful accounts

An initial word of warning is warranted here. Without wanting to sound alarmist, accounting for bad debts gives rise to what is probably the most complicated set of accounting entries described in this book. Proceed at a gentle pace through this section!

At the end of the accounting period, an adjusting entry needs to be made to refl ect the fact that some of the balance in “accounts receivable” may prove to be uncollectible. If some of the accounts receivable balance does prove to be uncollectible, the revenue account will be overstated as it will include “bad sale” entries, i.e., sales for which we will obtain no receipt of funds.

The following three steps outline a widely adopted approach to accounting for bad and doubtful debts.

Step 1: The provision Periodically (say, every month end during the accounting year) update records to refl ect and provide for the problem of potentially non- collectible accounts. If every month we make $100,000 of credit sales and we believe that on average 2 per cent will prove to be uncollectible, having already debited “accounts receivable” $100,000 and credited “revenue” $100,000, we can make the following month end “adjusting entry”.

Bad debts expense Allowance for doubtful accounts

2,000 2,000

The “bad debts expense” account can be described as a “contra” account, as it fl ows through to the income statement where it will off- set the revenue account’s credit balance. The “allow- ance for doubtful accounts” account can also be described as a contra account as its credit balance will be recorded in the balance sheet in a manner that off- sets the account receivables’ debit balance.

Step 2: An account turns bad Imagine that half way through the accounting year one of our clients, Untrustworthy Ltd, went bankrupt while owing us $3,500. It is determined that we are unlikely to collect any of the amount outstanding. The “step 1” month- end entry is designed to provide for this type of eventuality. Now the eventuality has been realised and we need to update the books as follows:

a) remove the $3,500 from “accounts receivable” (if we don’t do this, the account will contain a growing amount of entries for amounts that will never be collected),

b) remove the $3,500 from “allowance for doubtful accounts”, as, following removal of the amount from “accounts receivable” we no longer have a need to allow for it, i.e., no need for an off- setting contra entry.

Allowance for doubtful accounts Accounts receivable

3,500 3,500

Worked examples highlighting types of adjusting entry

Step 3: Year- end adjusting entry Following an appraisal of the $150,000 year- end accounts receivable balance, it is estimated that $3,200 may well prove to be uncollectible. An investigation of the books reveals that the “allowance for doubtful accounts” has a balance of $3,000. Therefore, prior to making a year- end adjusting entry, “net” accounts receivable is recorded at $147,000 ($150,000 – $3,000). As we expect to be able to collect $146,800 ($150,000 – $3,200), net accounts receivable is overstated by $200 and we need to make a $200 adjusting entry.

Bad debts expense Allowance for doubtful accounts

200

3,000

200

The debit and credit entries made here are the same as the “step 1” entries. The need for the year- end adjusting entry has arisen because the “step 1” entries during the year had not been suffi cient to create the requisite year- end balance on the “allowance for doubtful accounts”. If at the year- end it is found that there is an over- provision in “allowance for doubtful accounts”, we would need to reverse the above entry by crediting “bad debts expense” and debiting “allowance for doubtful accounts”.

Adjusting entry type 7: Depreciation

Depreciation refers to the process of allocating the cost of a fi xed asset (i.e., an asset with a useful life greater t han one year) across the years in which the asset’s owner can be expected to derive benefi t from owning the asset. If depreciation accounting entries were not made, the type of scenario outlined in Box 4.2 could arise.

Box 4.2

A scenario highlighting the need for depreciation

The following hypothetical discussion between a user of accounting informa- tion prepared by SouthPark, a hotel with an untrained accountant, and one of SouthPark’s managers highlights the need for depreciation.

Accounting information user (e.g., a prospective shareholder):

“How come the SouthPark Hotel had a healthy profi t for the last fi ve years except for 20X1, when you reported a huge loss?”

SouthPark manager:

“Oh, 20X1 just so happened to be the year in which we bought our most expensive fi xed asset. We received delivery of it on 28th December and in fact didn’t get around to using it until 20X2. We had expected the delivery to be made a week later, in which case you would have seen 20X2 as having the big loss”.

Adjusting and closing entries

Main depreciation methods There are several distinct approaches to determining the timing of the fi xed asset cost write off. In the following description of three methods, it will be assumed that a fi xed asset has been purchased for $1,200,000, and that it has been estimated that the asset can be salvaged in fi ve years’ time for $200,000.

a) Straight line method: This widely used method involves apportioning the net cost of the fi xed asset (purchase price – salvage value) equally across the life of the asset.

b) Reducing balance method: Under this method, each year a fi xed percentage of the asset’s net book value (the net book value is the cost of the asset minus the accumulated depreciation charged on the asset since its purchase) is expensed as depreciation. This will result in a reducing depreciation charge as the net book value (NBV) will be reducing. In the following example, suppose 40 per cent has been identifi ed as the annual percentage rate.

$ Opening net book value – year 1 1,200,000 1st year dep’n charge (NBV × 40%) 480,000 Opening net book value – year 2 720,000 2nd year dep’n charge (NBV × 40%) 288,000 Opening net book value – year 3 432,000 3rd year dep’n charge (NBV × 40%) 172,800

c) Usage based method: This is not a widely used method. To demonstrate how it can be applied, imagine that the asset purchased is a small airplane and that it has been estimated that the plane will fl y 1 million kilometres in its life with the company.

If 200,000 kilometres were fl own in 20X1, 20X1 depreciation charge =

(200,000 ÷ 1,000,000) × $1,000,000 = $200,000

If 300,000 kilometres were fl own in 20X2, 20X2 depreciation charge =

(300,000 ÷ 1,000,000) × $1,000,000 = $300,000

Accounting information user: “So what you’re saying is that the profi t fi gure reported for 20X1 is

misleading. It doesn’t really refl ect SouthPark’s underlying performance relative to other years. You know this means that your profi t for 20X1 is understated and your profi t in the other years is really overstated. While 20X1 took a big hit, it’s as if the subsequent years have had use of the asset for free”.

A , t . . . Purchase price – salvage value Annual depreciation charge= — ;—— —— —– —————-————-

Estimated number of years asset will be owned _ $1,200,000 – $200,000 _ $20Q Q0Q

Summary

Recording depreciation Similar to the contra account set up for doubtful accounts, when depreciating, we set up an “accumulated depreciation” account, which acts as a contra account off- setting the balance in the fi xed asset account.

For the 20X2 depreciation charge of $300,000 in the airplane example above, the 20X2 year- end depreciation entry would be as follows:

Depreciation expense Accumulated depreciation

300,000 200,000

300,000

As the depreciation expense account and the accumulated depreciation account have somewhat similar names, it is vital that their very different roles are clearly understood. The depreciation expense account is closed off to the income statement at the year- end. The fact that it is closed off in this manner should be evident from the word “expense” appearing in its title.

The accumulated depreciation account is reported in the balance sheet as a contra account that off- sets the fi xed asset account. The fact that it is an account that accumulates across accounting periods suggests that it is a balance sheet account. Note how, by the end of 20X2, the accumulated depreciation account has accumulated from the $200,000 depreciation expensed in 20X1 to $500,000, as a result of the $300,000 expensed in 20X2. The fi xed asset section of the company’s balance sheet at the end of 20X2 would appear in a format such as that presented below:

$ $ Fixed assets at cost 1,200,000 Less accumulated depreciation 500,000 Net book value of fi xed asset 700,000

5) Summary

Through the use of worked examples, this chapter has outlined the nature of closing and adjusting entries. At the end of each fi nancial year, closing entries are made to all accounts relating to a period of time, i.e., revenue, expense and dividend accounts. If these accounts are not closed at the end of a year, they would not have a zero balance at the start of the new fi nancial year. Adjusting entries need to be made in advance of preparing the year- end state- ments in order to update some accounts. For example, as depreciation is a function of time, periodically an adjusting entry has to be made to update all depreciation accounts.

Having read the chapter you should now know:

● all revenue, expense and dividend accounts have to be closed at the end of the fi nancial year,

● costs paid for but not yet incurred represent prepaid expenses and are treated as assets, ● expenses incurred but not yet paid for represent accruals and are treated as liabilities, ● if a customer pays for a service in advance of receiving the service, the receipt is referred

to as unearned revenue and is treated as a liability, ● the difference between perpetual and periodic inventory accounting procedures,

Adjusting and closing entries

● how to account for bad debts, ● how to account for depreciation.

References

Jackling , B. , Raar , J. , Wines , G. and McDowall , T. ( 2010 ) Accounting: A Framework for Decision Making , 3rd edition, Macquarie Park, NSW, Australia: McGraw-Hill : Chapter 16 .

Jagels , M.G. ( 2007 ) Hospitality Management Accounting , 9 th edition, Hoboken, NJ : John Wiley & Sons: Chapter 1 .

Schmidgall , R.F. ( 2011 ) Hospitality Industry Managerial Accounting , 7 th edition, East Lansing, MI: American Hotel & Lodging Educational Institute : Chapter 1 .

Weygandt , J. , Kieso , D. , Kimmel , P. and DeFranco , A. ( 2009 ) Hospitality Financial Accounting , Hoboken, NJ: John Wiley & Sons : Chapter 4 .

Problems

Problem 4.1

Describe the difference between adjusting entries and closing entries.

Problem 4.2

Given the following information for Dunedin’s CityCentre Hotel, post relevant adjusting entries to CityCentre’s general ledger. Assume 30th June is the year- end.

a) The telephone account of $500 for June is unpaid and unrecorded. b) Rent of $3,600 for the six month period ending 31st August is due to be paid in arrears in

October. c) It was estimated at the time of purchasing a car two years ago for $6,000 that the car

would be salvaged fi ve years later for $1,000. The company uses straight line depreciation for all fi xed assets. This year’s depreciation entry for the car is still to be made.

d) The next fortnightly pay date for the company’s employees is 7th July. The fortnightly payroll is $140,000.

e) On 2nd March received $1,600 cash from a client. This was an advance payment for services to be rendered. At the time of receipt, $1,600 was recorded as a credit to unearned revenue. On 30th June, 75 per cent of this service had been provided.

f) On 1st May received six months’ rent revenue in advance totalling $600. At the time of the receipt, this was recorded as a credit to rental revenue.

Problem 4.3

On 30th November, account balances relating to the accounts receivable management func- tion of Minnesota’s CitySlickers Hotel were as follows:

Accounts receivable $141,500 Debit balance Allowance for doubtful accounts $2,400 Credit balance Revenue $1,320,000 Credit balance Bad debts expense $12,400 Debit balance

Problems

The following transactions occurred in December:

1. Cash collected from credit sale customers was $92,000. 2. Credit sales were $101,000.

On a monthly basis, the manager of accounts receivable has made an allowance of 1.25 per cent of sales to cover the contingency of trade debts turning bad. At the hotel’s year- end, on 31st December, a review of accounts receivable has revealed the following:

Year- end estimate of doubtful accounts

Age of account

Account receivable amount

% Estimated as uncollectible

0–30 days $ 84,000 0.75

31–60 days 44,000 1.25

61–180 days 18,000 5

Over 180 days 4,500 100

$150,500

The company accountant has decided that all accounts with an age of 180 days or more should be written off from the accounts receivable ledger. In addition, the doubtful accounts balance should be revised to refl ect the remaining estimated doubtful accounts following the year- end review of the accounts receivable ledger.

Required:

(a) Record December’s credit sales and cash collected transactions in appropriately titled “T-accounts”.

(b) Record all necessary year- end adjusting entries in appropriately titled “T-accounts”.

Problem 4.4

Classify each of the following accounts as either an asset, liability, revenue, expense or owners’ equity item (you can also use the term “negative asset”, if you feel it is more appropriate for any of the accounts):

Interest revenue Wages accrued Depreciation expense Insurance prepaid Unearned revenue Bad debts expense Supplies inventory Allowance for doubtful accounts Accumulated depreciation

Adjusting and closing entries

Problem 4.5

The general ledger of the Cardigan Arms Pub includes the following accounts:

Sales revenue Inventory Interest revenue Wages accrued Prepaid insurance Insurance expense Accumulated depreciation Depreciation expense Rent expense Prepaid rent Allowance for doubtful accounts

Required:

(a) Indicate for which of these accounts, a year- end closing entry will need to be made. (b) For each of the accounts requiring a year- end closing entry, indicate what account will

need to be debited and what account will need to be credited.

Problem 4.6

Marlow’s WatersEdge Hotel operates a periodic inventory system with respect to its cleaning supplies. A year- end stock- take has identifi ed a balance of £4,200 cleaning supplies held on 31st December 20X1. The cleaning supplies stock account, which has not been adjusted since the previous year- end stock- take, refl ects a debit balance of £3,400. Throughout the year, all cleaning supplies purchased have been debited to the “cleaning supplies purchases” account, which has a closing debit balance of £36,000. In addition, any returns to suppliers have been credited to a “cleaning supplies returns” account, which has a year- end closing balance of £1,020.

Required: Using appropriately titled “T-accounts”, make all required adjusting and closing entries.

Problem 4.7

The accounting manager at Antwerp’s TranquilStay Hotel has prepared the following income statement that pertains to the most recent accounting year.

TranquilStay Hotel Income Statement

for the year- ended 30 June 20X1 € € Sales revenue 420,000 Less: Cost of sales 80,000 Gross profi t 340,000 Add: Interest revenue 11,000 351,000

Problems

Less: Expenses Salaries and wages expense 145,000 Depreciation expense 82,000 Car park rental expense 3,000 Insurance expense 18,000 Sundry expense 14,000 262,000 € 89,000

The accounting manager is uncertain how to handle year- end adjusting entries and has sought your advice. Following a review of the business, you determine the following:

1. A €2,500 advance payment received in connection with a conference to be held in late July has been included in the sales revenue fi gure.

2. Employees have not been paid €4,000 in wages and salaries earned in the last four days of June. 3. Depreciation of €10,000 on a new car purchased this year has not been recorded. 4. The hotel rents a small adjoining property which it uses for patrons’ car parking whenever

the hotel’s underground car park is full. The last rental fee paid was €900. This payment was made on 1st May and covered a three- month period. The account manager recorded this as prepaid rent and no entry has been made to adjust this account at the year- end.

5. The hotel holds an investment that earns €1,000 interest per month. June’s interest, which will be received in July, has not been recorded in the accounts.

6. Annual property insurance of €24,000 is paid semi- annually in advance. The last €12,000 payment, which was made on 1st April 20X1 was debited to prepaid insurance. No adjusting entry to the prepaid insurance account has been made.

Required:

a) Prepare the necessary adjusting entries for the TranquilStay Hotel. b) Following completion of the adjusting entries, prepare TranquilStay’s revised income

statement for the year- ending 30th June 20X1.

Problem 4.8

Given the following information for Ottawa’s Capital Hotel, prepare relevant adjusting entries. Assume that 30th June is the year- end.

a) On 1st June the hotel received $4,000 in advance for services to be rendered. This transac- tion was recorded on 1st June by debiting bank and crediting unearned service revenue. It was determined that by 30th June, 25 per cent of the service paid for had been provided.

b) On 1st May six months’ insurance premium was purchased for $1,800. When the payment was made, the hotel debited prepaid insurance and credited bank.

c) The hotel has an investment that is earning a return of $2,400 interest per annum. The last interest payment was received on 30th April. The accounting records need to be adjusted to refl ect the last two months of interest accrued.

d) In the current fi nancial year, the hotel’s supplies account had an opening balance of $600. $7,000 of supplies have been purchased during the year and debited to the supplies account. A year- end stock- take has revealed $400 of supplies in stock. During the year no accounting entries refl ective of supplies usage have been made.

Adjusting and closing entries

Problem 4.9

Given the following year- end account balances for Boston’s Johnson Hotel, prepare:

a) an income statement for the period ended 30/6/20X1, b) a balance sheet as at 30/6/20X1.

Johnson Hotel Account Balances

as at 30th June 20X1 Debit Credit Cash at bank 2,200 Dividends paid 2,000 Accounts receivable 1,500 Closing inventory 400 Depreciation expense 250 Plant and machinery 11,000 Accumulated depreciation 1,020 Sales revenue 26,500 Cost of sales 16,000 Wage expense 4,500 General operating expenses 140 Accrued wages 100 Accounts payable 2,200 Unearned revenue 200 Share capital 4,800 Retained profi ts 3,170 $37,990 $37,990

Problem 4.10

Match each of the following eight year- end adjustments with the appropriate year- end adjusting journal entry.

Year end adjustments

1. An expense has been incurred but not yet paid. 2. A $5,000 deposit for a conference to commence in two weeks’ time has been received. At

the time the deposit was received, cash was debited and revenue was credited. 3. A bus insurance payment was expensed during the year, but at the end of the year there is

still a period of insurance cover that has not been used up. 4. A car insurance payment was recorded by debiting insurance prepaid during the year, but

at the end of the year there is still a period of insurance cover that has not been used up. 5. Some revenue appears to be unearned at the year end. 6. A new fi xed asset purchased at the beginning of the year was accounted for by debiting the

fi xed asset accounting and crediting the cash account. 7. A portion of rent for a large land parcel was paid in advance three weeks before the year

end, but has not been used up at the year end. When the rent was paid by the hotel, the accountant debited rent expense and credited cash.

Problems

8. Rent for a smaller land parcel has not been paid by the hotel and is owing at the year- end.

Year- end journal entries

a. Debit revenue, credit unearned revenue. b. Debit depreciation expense, credit accumulated depreciation. c. Debit rent expense, credit rent payable. d. Debit expense, credit expense payable. e. Debit prepaid insurance, credit insurance expense. f. Debit prepaid rent, credit rent expense. g. Debit revenue, credit unearned revenue. h. Debit insurance expense, credit insurance prepaid.

Problem 4.11

Prior to making year- end adjusting entries, the accountant at Hong Kong’s KowloonKingdom hotel has produced the following abbreviated income statement for the most recent fi nancial year.

KowloonKingdom Hotel Income statement

for the year ending 31st December 20X1

Revenue $346,000

Less: Operating expenses 102,000

Net profi t 244,000

Information for adjusting entries:

1. Depreciation of $42,000 has yet to be charged. 2. Accrued wages at the year- end are $3,200. 3. The hotel hosted an engineers’ conference that concluded three days before the year- end.

At the year- end, the hotel had still to invoice the conference organiser for the fi nal $13,000 conference instalment payment.

4. The hotel will be holding an accountants’ conference commencing two weeks after the year- end. At the year- end, the hotel had received a deposit of $5,000 from the conference organiser and recorded it as revenue.

5. The hotel’s annual property insurance policy was renewed on 1st April 20X1 with a premium payment of $4,000. This payment was recorded by debiting insurance prepaid.

6. The kitchen cleaning supplies account is maintained on a periodic inventory basis. At the beginning of the year, the supplies account had a $1,100 debit balance. During the year, $5,400 of cleaning supplies were purchased and a year- end stock- take determined a cleaning supplies balance of $800.

Required:

a) Prepare a schedule showing the impact on revenue and operating expenses resulting from preparation of the required year- end adjusting entries.

b) Prepare a revised abbreviated income statement, as it would appear following the comple- tion of the adjusting entries.

Adjusting and closing entries

Problem 4.12

Prior to making adjusting entries, the Tewkesbury Kings Arms pub and guest house manager has provided you with the following fi nancial year-end information:

1. Wages owing at the year end are £340. 2. Rent of £580, covering a two- month period was paid one month before the year- end.

When the rent was paid the rent expense account was debited £580. 3. £212 of interest revenue owed to the pub has not been received or recorded. 4. The £880 prepaid insurance account balance includes $340 of insurance premium paid to

provide insurance cover for the fi rst four months of the next fi nancial year.

Required:

a) Prepare the year end adjusting entries for the Kings Arms pub and guest house. b) If the adjusting entries were not made, demonstrate whether the Kings Arms pub and guest

house profi t would be understated or overstated. c) If the adjusting entries were not made, indicate the effect on the assets, liabilities and

owners’ equity sections of the Kings Arms pub and guest house’s balance sheet.

Chapter 5

Financial statement analysis

Learning objectives

After studying this chapter, you should have developed an appreciation of:

1. how insights can be gained from dissecting ROI (return on investment) into its two underlying elements: profi t margin and asset turnover,

2. how a systematic analysis of a hotel’s profi t performance can be conducted through the use of ratios,

3. how an analysis of a hotel’s short-term and long-term fi nancial stability can be achieved through ratio analysis,

4. how operational ratios can be used as an aid to monitoring the operating performance of hotels,

5. how an aged schedule of accounts receivable can assist the management of receivables, 6. how it is important that an analyst develops the ability to tailor ratios with due regard to

the nature of the hotel under investigation.

1) Introduction

This chapter moves us closer to management accounting and fi nancial management as it focuses on techniques that can be used to analyse the fi nancial performance and stability of organisations. Much of the analysis can be conducted through the use of ratios, e.g., return on investment (ROI tells us the ratio of return to investment), and, as a consequence, we frequently refer to “ ratio analysis ” in a manner synonymous to fi nancial statement analysis.

The results of a ratio analysis convey limited information unless they are put into some context, however. Ratio analyses are most usually conducted in the context of a comparison to one or more of the following four benchmarks:

● a hotel’s ratios from prior years (a trend analysis); ● ratios that have been set as goals (i.e., ratios underlying a hotel’s budget); ● ratios achieved by other hotels (or divisions) in the same company; ● industry average ratios compiled by companies such as Dun and Bradstreet and the large

accounting fi rms (this type of benchmarking is sometimes referred to as a cross-sectional analysis).

Financial statement analysis

In this chapter’s description of a systematic approach to conducting a fi nancial analysis of the year-end accounts, two distinct perspectives will be taken:

● Firstly, we will see how the profi t performance of a company can be appraised. ● Secondly, we will see how to appraise the fi nancial stability of a company.

We will conduct these analyses by drawing on the year-end fi nancial statements of Melbourne’s Celestial Hotel Ltd. These statements are presented in Exhibits 5.1 and 5.2.

Following this overview of a fi nancially oriented analysis, the chapter will review the main ratios used to analyse a hotel’s operational performance. Operational ratios focus more on day-to-day operating issues, e.g., room occupancy levels, restaurant covers served per employee hour worked, etc. Although many operational ratios do not involve fi nancial measures, they represent important performance indicators as a strong operating performance is a precursor to a strong fi nancial performance.

2) Profi t performance

If you were to ask an investor how their investment portfolio performed in a particular year, they would likely answer by referring to their overall return on investment (ROI). This casual observation is important as it highlights the degree to which ROI represents a fundamental indicator of performance. If limited to one ratio in an appraisal of a company’s performance, a fi nancial analyst would most likely use ROI.

Exhibit 5.1

Celestial Hotel Ltd Income statement for the year ending 31/12/20X1

$’000 $’000

Revenue (60% of sales on credit) 100 less Cost of Sales 40 Gross Profi t 60 less Expenses Selling 15 General Administration 5

20 Earnings (profi t) before interest and tax (EBIT) 40 less Interest 10 Taxable profi t 30 less Taxation 15 Net Income after Tax $ 15

Profi t performance

Exhibit 5.2

Celestial Hotel Ltd Balance sheet as at 31/12/20X1

Assets $’000 $’000 Current Assets Cash 5 Accounts receivable 7 Inventory 8

Fixed Assets Equipment 10 Buildings 20

Total Assets $ 50

$’000 $’000

Liabilities Current liabilities Accrued wages 1 Accounts payable 4

Long-term liabilities Loans 15 Total Liabilities 20

Owners’ Equity Paid up capital (100,000 shares) 20 Retained profi ts1 10

Total Liabilities and Owners’ Equity $ 50

1 The company must have started 20X1 with an accumulated loss of $5,000 (i.e., a negative retained profi t account). This is apparent from the fact that the income statement for 20X1 indicates profi t earned and retained during 20X1 to be $15,000, yet the retained profi t at the end of the year is only $10,000 (from the information provided, it appears no dividends were declared for 20X1). Much can be gleaned from a careful review of the accounts!

In the analysis of profi t performance that follows, we will take a systematic approach by fi rst computing ROI and then dissecting it into its underlying components. The perspective of appraising a hotel management’s performance in generating a return (profi t) from the assets available will be taken. This signifi es that EBIT (earnings before interest and tax) is the appro- priate profi t level to focus on. This is because EBIT captures the operating performance of a hotel, as interest expense (the fi rst item appearing after EBIT in the income statement) relates to a fi nancing decision which is frequently outside the infl uence of the hotel general manager. Accordingly, we will calculate ROI in the following way:

Return on investment (ROI) = EBIT ÷ Total assets

Celestial’s 20X1 ROI = 40 ÷ 50 = 0.8 (or 80%)

Financial statement analysis

This 80 per cent ROI can be broken into two elements (a profi t margin and a turnover compo- nent) as illustrated in Exhibit 5.3.

Exhibit 5.3

Dissecting ROI into profi t margin and asset turnover

The equation in Exhibit 5.3 can be verifi ed very simply by cancelling “revenue” in the left- hand circle (or profi t margin component) with “revenue” in the right-hand circle (or asset turnover component) to leave us with the basic ROI formula (EBIT ÷ Total assets).

This dissection of ROI into the two underlying ratios is widely referred to as the “Dupont formula” (the formula was fi rst observed in use in the Dupont company in the USA). The Dupont formula is highly signifi cant as it provides the basis for a systematic analysis of ROI under two headings:

a) profi t margin b) asset turnover.

a) Profi t margin

Following our fi rst step in the ratio analysis, we found Celestial’s ROI to be 80 per cent. While this may appear to represent a healthy return, imagine it is down from last year’s fi gure of 85 per cent. Management would want to know what lies behind this decline. By using the Dupont formula, we can determine whether the decline stems from a decrease in the com – pany’s profi t margin or its asset turnover (or a combination of both). If the profi t margin is down from last year, we can work systematically through the income statement, picking up all profi t fi gures provided and comparing them to revenue. In the Celestial example, the fi rst profi t fi gure in the income statement is gross profi t. Paralleling the approach taken to compute profi t margin in Exhibit 5.3, we compute gross profi t margin (GPM) as follows:

Profi t performance

Gross profi t margin (GPM) = Gross profi t ÷ Revenue

Celestial’s 20X1 GPM = 60 ÷ 100 = 0.6 (or 60%)

If this 60 per cent GPM is similar to last year’s GPM, we would be able to conclude that the lower overall margin has not resulted from a change in the ratio of selling price to cost of sales. It would be apparent that the decline in the ratio of EBIT to revenue must have resulted from a relative increase in selling and general administration costs, as these represent the two expense categories appearing after gross profi t, but before EBIT, in the income statement. By taking this approach of progressively moving down the income statement, comparing every level of reported profi t to revenue, we are able to isolate the category of expense that has caused a change in the overall profi t margin. If we had originally used net profi t margin (net profi t after tax ÷ revenue) in the ROI computed above, we could have computed more profi t margins in the course of systematically progressing through the income statement. Published accounts of large companies generally provide data suffi cient to allow the calculation of several profi t margins.

b) Asset turnover

Returning to the Dupont formula in Exhibit 5.3, now imagine that we have noted that a decline in the total asset turnover ratio has occurred and that this decline lies behind the lower ROI. This observation would lead the analyst to look into those ratios that feed in to the total asset turnover ratio.

Similar to the approach of working systematically through the income statement when exploring for factors resulting in a changed profi t margin, we can work through the balance sheet looking for that group of assets that lie behind a changed asset turnover ratio.

Whenever the term “turnover” is used, it signifi es we are comparing an asset to revenue (or, in the case of inventory, cost of sales). Consistent with the total asset turnover ratio computed above as part of the Dupont formula, for each turnover ratio we divide revenue (or, in the case of inventory, cost of sales) by the particular asset grouping under investigation.

Each “turnover” ratio tells us how “hard” the particular asset has “worked” to generate revenue. For this reason, the turnover ratios are frequently referred to as “effi ciency” ratios. Widely computed “turnover” ratios include:

● accounts receivable turnover ● inventory turnover ● fi xed asset turnover.

Accounts receivable turnover

Accounts receivable turnover = Credit sales ÷ Accounts receivable

Celestial’s 20X1 A.R. turnover = (100 × 0.6) ÷ 7 = 8.57

Many managers fi nd it diffi cult to conceptualise the meaning of the 8.57 computed above. For this reason the information is commonly converted into “number of days” by dividing the number of days in a year by the turnover.

Average number of days to 365

collect accounts receivable A.R. turnover

Financial statement analysis

If the accounts receivable turnover ratio is decreasing, the average number of days to collect accounts receivable will be increasing.

Inventory turnover Calculation of inventory turnover and also the “number of days inventory held” parallel the approach just taken for accounts receivable. There is one key difference, however. Unlike all the other “turnover” ratios, we divide inventory into cost of sales and not revenue. The reason for this difference is that inventory is recorded at cost price and not selling price. If we were to compare inventory to revenue and during the year selling prices doubled, we would see the inventory turnover ratio computed also double. The doubling of the ratio would be the result of a changed selling price and not a changed stocking policy, however. The potential for this misinterpretation is avoided if we compute inventory turnover using a consistent valuation basis, i.e., cost for the denominator (inventory) and cost for the numerator (cost of sales).

Inventory turnover = Cost of sales ÷ Inventory

Celestial’s 20X1 inventory turnover = 40 ÷ 8 = 5

Similar to accounts receivable turnover, inventory turnover can be converted into a measure of the average number of days that inventory is held by dividing 365 by the inventory turnover.

When analysing a hotel’s inventory turnover performance, it is desirable that beverage inven- tory be treated separately from the inventory of food supplies. This is because there might be differing stocking policies in the two areas. Drawing this distinction is particularly important where different personnel exercise stock making decisions in the two areas. Failure to distin- guish between the two types of inventory might mask the existence of a low turnover in one area if there is a high turnover in the other area.

Fixed asset turnover

Fixed asset turnover = Revenue ÷ Fixed assets

Celestial’s 20X1 fi xed asset turnover = 100 ÷ 30 = 3.33

Fixed asset account balances do not tend to be as volatile as accounts receivable and inventory account balances. Nevertheless, due to the large relative size of fi xed assets in hotels, a small percentage movement can have a signifi cant impact on total asset turnover. The large investment in fi xed assets can warrant the calculation of a turnover fi gure for every fi xed asset sub-category identifi ed, if such further information is available, i.e., in the Celestial example we could have computed a turnover fi gure for equipment as well as buildings.

Celestial’s average number of days to collect accounts receivable

_ 365 _ 42.6 days 8.57

Celestial’s average number of days inventory held

365 j = = 73 days

General comments on turnover ratios Except for cash, we have now computed the turnover ratio for each asset in Celestial’s balance sheet. If we had noted a decline in total asset turnover, and had subsequently discovered that none of the turnovers computed above had declined, then there must have been a decrease in the ratio of revenue to cash. Consistent with the other ratios, we could compute a “cash turn- over ratio” by dividing “revenue” by “cash”. Due to the relatively small nature of the cash account, however, this ratio is seldom calculated. If we found that the problem lay in a declining cash turnover ratio, we would know that relative to revenue, the business is now holding more cash. We would then need to turn to question whether this development is desirable.

While it might appear from Exhibit 5.3 that we would like to see increasing turnover ratios (a higher asset turnover will increase ROI), the downside implication of turnover ratios becoming too high should also be appreciated. If inventory turnover becomes very high, we might experience stock-outs, which could result in lost sales and loss of customer goodwill. If the accounts receivable turnover increases, we are on average extending less credit to our customers. If other hotels are extending longer periods of credit, this could result in the loss of some sales.

In the worked example presented above, we took year-end balances of the asset accounts when computing the turnover ratios. A preferred approach, however, would be to take the average balance of the asset account throughout the year. It could be that the year-end inven- tory balance is at an all-time temporary low and that Celestial normally holds twice this amount of inventory. If this is the case, the turnover computed will be a poor refl ection of reality, i.e., the inventory holding period computed will be half the year’s average holding time for inventory. If the asset in question is subject to high seasonal volatility, the average asset balance throughout the year should be sought. This could be done by calculating the average of the 12-month end balances for the year. While using an average asset balance provides a better picture of the asset’s average turnover over the whole year, a new inventory manager who has been in place for only three months would be justifi ed in arguing that her inventory turnover performance should be assessed by appraising average inventory balances since she took up her position, and not inventory balances recorded in advance of her job commencement. The same rationale would apply to a recently recruited credit manager.

The problem of defi ning ROI

It can be confusing trying to “tie down” ROI. It is a generic term that is tailored to many different situations, e.g., it could be used in the sense of the interest rate you earn on a bank account, or the net after tax return made on a portfolio of shares. Its exact calculation depends on the perspective being taken in an analysis. The following is an inexhaustive list of types of ROI that can be used to assess a company’s performance:

● return on assets employed ● return on assets available ● return on long-term funds ● return on equity.

“Assets employed”, “assets available”, “long-term funds” and “equity” are all types of invest- ment. If we wish to judge the performance of a manager who has been placed in charge of a group of assets that include some assets which, for some reason, he cannot currently employ (maybe rooms undergoing refurbishment), we might like to compare EBIT to assets employed

Profi t performance

Financial statement analysis

and not assets available. If we take a shareholder’s perspective, we might like to compare net profi t after tax to shareholder’s equity. It can thus be seen that the defi nition of return and the defi nition of investment is dependent on the context in which the analysis is being made .

A review of how profi t margin ratios and asset turnover ratios both feed into the ROI ratio is provided in Financial decision making in action case 5.1.

FINANCIAL DECISION MAKING IN ACTION CASE 5.1

The Financial Controller and analysing ROI The General Manager of the BeauChandelier restaurant chain is preparing for next month’s year-end meeting with senior staff. He wishes to commend the staff on a great year as the hotel’s ROI (EBIT ÷ Assets × 100) has increased by 38 per cent over the year from 39 per cent in the previous fi nancial year to 64 per cent in the current year. The General Manager has a background in marketing and has never felt particularly comfortable interpreting fi nancial data. Not wishing to appear ill-informed at the meeting he asked the Financial Controller to quickly prepare a more detailed fi nancial analysis that will point to what aspects of the business’s operations lie behind the increased ROI.

The following day the Financial Controller sent the following email to the General Manager:

Hi Sam I’ve completed the following fi nancial analysis of our ROI performance over the last two years. The key data are as follows:

This year Last year

ROI (EBIT ÷ Assets × 100) 64% 39%

Gross profi t margin (Gross profi t ÷ Sales × 100) 55% 40%

Operating profi t margin (EBIT ÷ Sales × 100) 35% 23%

Accounts receivable turnover (Credit Sales ÷ Average Accounts Receivable)

12.5 14.3

Inventory turnover (Cost of sales ÷ Average inventory)

6.5 4

Fixed Asset turnover (Sales ÷ Fixed assets) 2.95 3.22

To understand ROI you need to know that two key things feed into it: profi t margin (which is the ratio of profi t to revenue) and asset turnover (computed by dividing revenue by assets).

Financial stability

Based on our data for the year, I can see that both profi t margin and asset turnover have improved. Both improvements have had a positive impact on our ROI.

Firstly, with respect to profi t margin, the key result is our 37.5 per cent increased gross profi t margin. As this ratio compares gross profi t to sales, we are really looking at the relationship between the cost of goods sold and revenue, as gross profi t equals revenue minus the cost of goods sold. I’ve done some further digging around and can confi rm that last year our cost of goods sold consumed 60 per cent of our revenue and this year it has consumed only 45 per cent of revenue. Most of the change in the operating profi t margin that you see (23 per cent to 35 per cent) is down to the improved gross profi t margin, so don’t get too drawn into the change in that ratio. The change in the gross profi t margin shows that the discounted deal that you struck with our new main food supplier at the end of last year was clearly a master stroke. It’s pushed up the profi t to sales element that feeds into ROI.

Secondly, with respect to asset turnover, the big change to note is the increase in our inventory turnover. We’ve gone from holding inventory for an average of 91.25 days (365 ÷ 4) to holding it for 56.15 days (365 ÷ 6.5), which represents a 38.5 per cent improvement. The quicker and more reliable shipments from that new supplier has helped us get by with less inventory. This has pushed up the revenue to assets element that feeds into ROI.

The other sales to assets ratio changes that you can see (12.6 per cent decline in accounts receivable turnover and an 8.4 per cent decline in fi xed asset turnover) are pretty small relative to our improved inventory turnover performance. Cheers Ray

3) Financial stability

Analysis of fi nancial stability (sometimes referred to as solvency, i.e., the ability to repay liabilities as they fall due) can be broken into short-term and long-term perspectives.

a) Short-term

Appraisal of a company’s short-term fi nancial stability is sometimes referred to as a “liquidity analysis”. Analysis of liquidity concerns assets that in the normal course of business will be converted to cash, sold or consumed within a year (current assets) and also liabilities that are due for payment within a year (current liabilities). One indicator of liquidity is “working capital” (current assets – current liabilities), however, this indicator does not provide a sound basis for comparison across companies of varying sizes. More widely advocated measures of liquidity are the current asset ratio and the quick asset ratio (sometimes called the “acid test ratio”). The current asset ratio is calculated as follows:

Financial statement analysis

Current asset ratio = Current assets ÷ Current Liabilities

Celestial’s current asset ratio as at 31/12/X1 = 20 ÷ 5 = 4

This signifi es that Celestial’s “close to cash” assets cover its liabilities that will fall due for payment in the next 12 months by 4 times. This suggests a highly liquid situation.

If inventory is held for some time in the business prior to conversion to cash, a case can be made for its exclusion from current assets. This approach is taken in the acid test ratio, a liquidity measure which also excludes prepaid expenses from current assets. Prepaid expenses are excluded because in the normal course of business they will not be converted to cash. The acid test ratio is calculated as follows:

Celestial’s acid test ratio as at 31/12/X1 = 12 ÷ 5 = 2.4

In the hotel sector, due to the relatively “liquid” nature of most inventory, it is usual to base an appraisal of short-term liquidity on the current ratio rather than the acid test ratio. If a hotel had a large inventory of slow-moving wine, however, it would be appropriate to calculate a tailored liquidity ratio by deducting the wine inventory from current assets. Tailoring ratios in this manner can be justifi ed if they result in a more accurate insight into the particular aspect of the company that is under investigation.

While we would certainly be concerned to see the current ratio or the acid test ratio fall below “1”, it is diffi cult to provide an optimal current or acid test ratio. Much will depend on hotel-specifi c factors. A lender to the hotel would like to see high liquidity ratios as this would indicate a high ability to pay short-term debts. In fact, some lenders seek to protect themselves by requiring the borrower to maintain liquidity indicators, such as the current ratio, above a certain level. A loan provision can be drafted to this effect, and if the borrower’s current ratio falls below what is stipulated in the loan provision, the lender can require the borrower to immediately repay the loan. If a business experiences liquidity problems, a variety of rectifi ca- tion options can be considered. For instance:

● Some fi xed assets could be sold, maybe under a sale and lease-back agreement (increase to cash, no effect on current liabilities).

● A long-term loan could be sought (increase to cash, no effect on current liabilities). ● Further equity could be sought (increase to cash, no effect on current liabilities).

Caution needs to be exercised in liquidity management, however, as high liquidity ratios do not signify astute management. High liquidity ratios signify sub-optimal use of funds, as funds invested in short-term assets do not provide a high rate of return to owners. If funds can be freed up from current assets, greater investment can be made in long-term assets which can be seen to represent the engine room from which owners derive profi ts. Further discussion of working capital management issues is provided in Chapter 13.

b) Long-term

Over the long term we are concerned with a fi rm’s ability to pay all its debts, not merely short-term debt.

ratio Current liabilities Acid test _ Current assets – Inventory – Prepaids

Ratios using operational measures

The long-term indebtedness of the fi rm is generally referred to as fi nancial leverage or gearing. Two of the most commonly cited fi nancial leverage measures are debt to assets and debt to equity. Debt to assets (sometimes called the “debt ratio”) is calculated as follows:

Debt to assets = Total debt ÷ Total assets

Celestial’s 31/12/X1 debt to assets ratio = 20 ÷ 50 = 0.4 (or 40%)

Debt to equity is calculated as follows:

Debt to equity = Total debt ÷ Total equity

Celestial’s 31/12/X1 debt to equity ratio = 20 ÷ 30 = 0.667 (or 66.7%)

Lenders like to see a low level of fi nancial leverage (low level of debt) as this signifi es that there is a relatively low likelihood of insolvency resulting from an inability to honour debt obligations. While owners would also be concerned by the insolvency implications of high levels of debt, their returns can increase as a result of increased levels of leverage. The way that the raising of debt can lever up the returns for equity investors is demonstrated in Chapter 15.

Again, it is diffi cult to identify an optimal leverage ratio. However, these ratios do provide a means for comparing a fi rm’s long-term liquidity position relative to that of its competitors. In addition, a trend analysis could highlight an alarming trend of increasing levels of indebtedness.

A fi nal ratio can be computed as a further indicator of a fi rm’s capacity to meet its long-term debt obligations. While the above ratios might suggest an insignifi cant level of leverage for a company, the company may be experiencing problems servicing its outstanding debt due to a low level of profi tability. Such a situation would be highlighted by using the following ratio:

Times interest earned = EBIT ÷ Annual interest payment

Celestial’s 31/12/X1 times interest earned ratio = 40 ÷ 10 = 4

The times interest earned ratio is sometimes referred to as a “coverage” ratio, i.e., it indicates the extent to which interest charges are covered by the company’s level of profi t. The above times interest earned ratio of 4 signifi es that Celestial is currently experiencing little problem servicing its debt.

4) Ratios using operational measures

Performance ratios that have more of an operational focus than the fi nancial ratios presented above are grouped below according to whether they relate primarily to rooms or restaurant activities.

Rooms-related performance measures

Occupancy level is a widely quoted performance indicator in the hotel industry. It has become such an established performance indicator that hotels competing in the same geographical area frequently share information on each others’ occupancy levels.

Financial statement analysis

This activity level indicator can be a little misleading in those hotels that let out a signifi cant number of complimentary rooms. As a result, management’s understanding of the exact nature of the occupancy level can be enhanced by modifying the room occupancy measure to provide “paid occupancy” and also “complimentary occupancy” activity indicators. These two indicators are nothing more than adaptations of the room occupancy performance indicator. They again highlight the importance of modifying ratios to fi t the particular circum- stance of the hotel under investigation.

A high paid occupancy percentage does not necessarily signify a high revenue from rooms, however. Not all room sales are made at the rack rate (the rack rate can be defi ned as the maximum price that will be quoted for a room). Similar to the airline industry that sells seats in the same class and fl ight for a range of discounted prices, discounting room prices below the rack rate is a key characteristic of the hospitality industry. Accordingly, a performance measure that indicates the average room rate charged needs to be computed. This can be achieved via the “average room rate” (sometimes called the average daily rate or “ADR”) performance indicator which is calculated as follows:

The room occupancy and the average room rate performance indicators, when considered independently, represent incomplete measures of sales performance. A higher level of total revenue from rooms will not result from an increased occupancy level if the room rate has been disproportionately dropped. Similarly, a higher level of total revenue from rooms will not result if an increase in the average room rate coincides with a disproportionate decline in the occupancy level.

There is a highly intuitively appealing performance measure that circumvents this “incom- pleteness” problem. The manager interested in monitoring room sales performance can calcu- late the average revenue earned by every room in the hotel (both sold and unsold rooms). This “revenue per available room” ratio is widely referred to by the abbreviation “Revpar” and can be calculated as follows:

Box 5.1 demonstrates how revpar circumvents the incompleteness problem of the occupancy and average room rate performance indicators. The more comprehensive nature of revpar is apparent from the fact that it can be calculated by multiplying the occupancy level (stated as a decimal) by the average room rate. The signifi cance of revpar as a performance measure will be further elaborated upon in Chapter 12’s discussion of yield management.

x 100 Number of rooms (beds) let in hotel

Total rooms (beds) in hotel Room (or bed)

occupancy

Paid occupancy %

Number o f rooms sold 100

Complimentary occupancy %

Total rooms in hotel

Number of complimentary rooms let Total rooms in hotel

x 100

Average _ Day’s revenue from room letting room rate Number of rooms let in the day

Revenue per available _ Total daily room letting revenue room (Revpar) Total hotel rooms (both sold and unsold)

Ratios using operational measures

Box 5.1

Revpar: a comprehensive indicator of room sales performance

Imagine you are comparing the room sales performance of two Canadian properties that are part of LuxuryLife’s worldwide chain of hotels. Toronto’s 120-room LuxuryLife property has been achieving an occupancy level of 65 per cent and an average room rate of $100. Vancouver’s 90-room LuxuryLife property has an average occupancy level of 72 per cent and an average room rate of $80. The performance of these two properties highlights how the occupancy level and average room rate are relatively incomplete indicators of room sales performance. The Toronto property has the higher average room rate, but the Vancouver property has the higher average occupancy. The incompleteness of these two measures can be overcome by integrating the two measures into one, i.e., multiply occupancy level by average room rate to generate revenue per available room (revpar), i.e.:

Hotel Occupancy Average room rate

Revpar

Toronto 0.65 × $100 = $65.0

Vancouver 0.72 × $80 = $57.6

We can check that the product of occupancy and average room rate gener- ates revpar, by calculating the Toronto property’s revpar using the “total daily room revenue ÷ total hotel rooms” revpar formula as follows:

Toronto property’s total daily room revenue = 120 × 0.65 × $100 = $7,800 Toronto property’s revpar = $7,800 ÷ 120 = $65.

As the Toronto property is achieving the higher revpar, we would conclude it has the better room sales performance.

The revpar dimension of room sales performance can be measured slightly differently by viewing actual revenue as a percentage of potential revenue. This ratio, which is generally referred to as “room yield”, will always run in tandem with revpar, i.e., a high revpar will signify a high room yield. Accordingly, there is no need to compute both performance indica- tors. Both measures are introduced here because, while most hotel managers use revpar, others also refer to room yield.

Room _ Actual total room revenue yield Potential total room revenue

Financial statement analysis

On the expense side of a hotel’s room sales activities, the effi ciency of room service expendi- ture can be monitored by calculating the service cost per room in the following manner:

Restaurant-related performance measures

A measure providing insight concerning the productivity of restaurant labour is revenue per employee hour worked, and can be computed as follows:

Revenue per employee hour worked can also be applied to beverage sales. If seeking to compare labour productivity across different meal times (where there can be a considerable spread in the profi tability of meals served and also average spend per head), it might be more appropriate to calculate covers sold per employee hour worked in the following manner:

Similar to the room occupancy performance measure used to gauge the rooms activity level, activity in restaurants can be gauged by calculating seat turnover. This provides an indicator of the average number of customers served on each restaurant seat during a day and can be calculated as follows:

Paralleling the trade-off between room occupancy and the average room rate noted above, a trade-off exists in restaurants between seat turnover and expenditure made by each customer. If menu prices are increased, we can anticipate a decrease in seat turnover. Expenditure per customer is generally referred to as “average spend per head” and can be calculated as follows:

Just as average room rate and room occupancy are incomplete measures of rooms perfor- mance, so too are average spend per head and seat turnover incomplete measures of restau- rant performance. Following the approach taken to generate revpar, a more complete indicator of restaurant sales performance can be achieved by multiplying average spend per head by seat turnover. This term, which can be referred to as “revenue yield per seat”, provides an indication of the sales productivity of each restaurant seat. A simple way of computing revenue yield per seat is as follows:

The way in which revenue yield per seat represents a combination of the average spend per head and seat turnover performance indicators is demonstrated in Box 5.2.

Service cost _ Total daily room servicing costs per room Number of rooms serviced in a day

Revenue per employee hour worked

Restaurant revenue Number of employee hours worked

Covers per employee _ Number of covers served in period hour worked Employee hours worked in period

Seat _ Number of covers served per day turnover Number of restaurant seats

Average spend _ Total restaurant revenue in period per head Number of covers served in period

Revenue yield _ Total restaurant revenue per seat Number of restaurant seats

Summary

Box 5.2

Revenue yield per seat: a comprehensive indicator of restaurant sales performance

Imagine that in May 20X1 “MedievalMeals”, which is an 80-seat restaurant adjoining a Welsh castle, was open for 27 days and had a revenue of £67,500 from 2,700 covers sold. In May 20X2 MedievalMeals was open for 28 days and earned £75,264 from 2,688 covers sold. The table below presents the calcula- tion of MedievalMeals’ seat turnover, average spend per head, and average daily revenue yield per seat for the two periods. From these calculations, an improved sales performance in May 20X2 is apparent as the daily revenue yield per seat is £2.35 greater (£33.60 – £31.25), despite the decline in seat turnover from 1.25 to 1.2.

Period Seat turnover

Average spend per head

Average revenue yield per seat

May 20X1 1.25a × £25b = £31.25

May 20X2 1.20 × £28 = £33.60

a: Number of covers served per day = 2,700 ÷ 27 = 100;

Seat turnover = 100 ÷ 80 = 1.25

b: $67,500 ÷ 2,700 = $25

We can check that the product of seat turnover and average spend per head generates revenue yield per seat, by calculating revenue yield per seat for May 20X1 using the “total revenue ÷ number of restaurant seats” formula as follows:

£67,500 ÷ (80 × 27) = £31.25

5) Summary

This chapter has described how a systematic approach can be taken when analysing a com – pany’s profi t performance and fi nancial stability. By segregating the ROI measure into a profi t margin and an asset turnover dimension and working through the elements that affect these two aspects of profi tability, we can ensure a comprehensive profi tability analysis is under- taken. We have also seen that a comprehensive analysis of fi nancial stability can be under- taken by considering a company’s short- and long-term degree of indebtedness. In addition to these fi nancial analyses, the chapter has overviewed operational measures that are widely used in the hospitality industry.

Having read the chapter you should now know:

Financial statement analysis

● how to take a systematic approach when analysing a company’s profi tability, ● how to analyse a company’s short- and long-term fi nancial stability, ● how to compute a range of operational measures that are widely used in the hospitality

industry, ● how an aged schedule of accounts receivable can assist managers involved in accounts

receivable management, ● that it is important to tailor ratios with due regard given to the nature of the organisation

being analysed.

References

Jackling, B. , Raar, J. , Wines, G. and McDowall, T. ( 2010 ) Accounting: A Framework for Decision Making , 3rd edition, Macquarie Park, NSW, Australia: McGraw-Hill : Chapter 5.

Jagels, M.G. ( 2007 ) Hospitality Management Accounting , 9th edition, Hoboken, NJ : John Wiley & Sons : Chapter 4.

Kotas, R. ( 1999 ) Management Accounting for Hospitality and Tourism , 3rd edition, London: International Thomson Publishing : Chapter 15.

Schmidgall, R.F. ( 2011 ) Hospitality Industry Managerial Accounting , 7th edition, East Lansing, MI: American Hotel & Lodging Educational Institute: Chapter 5.

Weygandt, J. , Kieso, D. , Kimmel, P. and DeFranco, A. ( 2009 ) Hospitality Financial Accounting , Hoboken, NJ: John Wiley & Sons : Chapter 7.

Problems

Problem 5.1

HoJo and EasyRest are two companies in the American hotel and catering industry. The following fi nancial data for 20X0 relate to their food and beverage activities:

HoJo EasyRest $m $m Revenue 500 300 Cost of sales 200 220 EBIT 50 15 Total assets 250 75

Required

a) Use the Dupont formula (based on EBIT) to compare the performance of the two com – panies’ F&B activities.

b) Do the two companies appear to be operating different strategies, and if so, in what way?

Problem 5.2

In the last fi nancial year, London’s Enwad Hotel group achieved a revenue of £28.75 million and a gross profi t margin of 40 per cent. Its end-of-quarter inventory balances were as follows:

Problems

Quarter Inventory 1 £ 400,000 2 £ 800,000 3 £ 900,000 4 £ 200,000

Required

a) Calculate the fi rm’s inventory turnover and the average age of inventory. b) Comment on Enwad’s liquidity, assuming most of its competitors operate with an inven-

tory turnover of 40.

Problem 5.3

A friend who owns a Sydney restaurant has presented the following information to you and asked you to comment on the restaurant’s performance in 20X2.

Current Assets Year end 20X1 Year end 20X2

Cash $10,800 $14,300 Accounts receivable 27,000 26,000 Marketable securities 7,500 7,500 Inventories 10,400 12,000 Prepaid expenses 1,500 1,600

Current Liabilities

Accounts payable $ 8,400 $12,200 Accrued expenses 3,600 5,600 Current tax payable 4,500 3,400 Deposits and credit balances 700 400 Current portion of loan 10,700 9,500

Required:

a. For both years calculate the working capital. b. For both years calculate the current asset ratio. c. For both years calculate the acid test ratio. d. Comment on whether the restaurant is becoming more or less liquid.

Revenue for the year 20X2 was $500,000 (55 per cent of this was credit sales) and the cost of sales was $150,000. Calculate the following for 20X2:

e. The accounts receivable turnover. f. The accounts receivable average collection period. g. The inventory turnover. h. The average age of inventory.

Problem 5.4

The following fi nancial information highlights the profi tability and fi nancial stability in the last three years of FlyingFood, one of Heathrow airport’s restaurants:

Financial statement analysis

Year 20X1 20X2 20X3 Current asset ratio 1.20 1.34 1.46 Food inventory turnover 36 times 30 times 25 times Accounts receivable turnover 29 times 25 times 19 times Debt to equity 2.40 2.20 1.85 Return on shareholders’ equity 10.56% 9.44% 9.02% Sales (all on credit) £945,000 £952,000 £948,000

Required: Using the above information, answer each of the following questions, including an explana- tion of why you answered each question in this way.

a. On average, is the restaurant extending a shorter or longer credit period to its customers?

b. Over the years, has more or less money been invested in food inventory? c. During the period, has the liquidity of the restaurant improved? d. Do you expect the shareholders to be satisfi ed with their return on investment? From the

shareholders’ point of view, is the profi tability of the operation improving? e. Imagine that in 20X3 the restaurant wants to fi nance a proposed expansion through a

loan. Relative to its fi nancial position in 20X1, do you think it will be easier or harder for the restaurant to borrow?

Problem 5.5

Imagine you are head of the food and beverage department in a large Los Angeles hotel complex. One of the hotel’s restaurants is currently earning an annual ROI of 14 per cent on the $200,000 of assets attributed to the restaurant. The average profi t margin on covers served is 40 per cent. The restaurant manager believes that if cover prices were dropped by 10 per cent (the average cover currently provides $20 revenue), there would be a signifi cant increase in ROI.

Required:

a) Prior to the proposed price decrease, what is the restaurant’s sales/total assets turnover ratio?

b) If the proposed price decreases are implemented, what level of sales to total assets must be achieved in order to avoid a decline in ROI?

c) Following on from part b), how many more covers must be served in order to avoid a decline in ROI?

Problem 5.6

Imagine you are the rooms manager of Will’sWooms, an 80-room hotel located in Stratford upon Avon. Demand for hotel rooms is signifi cantly affected by the tourist season and the popularity of plays appearing in the nearby Shakespeare theatre. The General Manager has asked you to defend your decision to increase average room rates to £120 during the recent summer theatre season. Occupancy for this year’s summer theatre season was 80 per cent which is down from the previous year’s summer occupancy of 90 per cent. Average room rates charged during the previous year’s summer season were £100.

Problems

Required: Use revpar to defend your decision to increase room rates charged during this summer’s theatre season.

Problem 5.7

A manager of a 120-seat Singaporean restaurant is interested in comparing the sales perfor- mance of two recent years. In 20X1, the restaurant achieved an average lunch spend per head of $15 and a lunchtime seat turnover of 1.4. Also in this year, its dinner average spend per head was $28 with a dinnertime seat turnover of 1.1. In 20X2 the restaurant was open for 312 days and had a revenue of $2,135,000. 37 per cent of the revenue was earned from lunches (56,160 covers served) and 63 per cent was earned from dinners (44,928 covers sold).

Required: Provide the manager with an analysis comparing the relative sales performance of the two years.

Problem 5.8

The following fi nancial data relates to Tokyo’s EasternSunrise hotel.

Last Year This Year

¥ ’000 ¥ ’000

Income statement data

Revenue 5,000 5,250

Cost of Sales 1,000 1,080

Gross Profi t 4,000 4,170

Selling Expenses 800 980

Administration Expenses 1,200 1,900

EBIT ¥ 2,000 ¥ 1,290

Balance sheet data

Cash 200 220

Accounts Receivable 350 360

Inventory 400 440

Fixed Assets 18,600 24,660

Total Assets ¥ 19,550 ¥ 25,680

Required:

a) Using EBIT data, calculate EasternSunrise hotel’s ROI for each year to determine whether the hotel’s profi tability is increasing or decreasing.

b) Conduct further ratio analysis of the data provided to determine what are the main factors that lie behind EasternSunrise’s changed ROI level.

Financial statement analysis

Problem 5.9

The following fi nancial information has been taken from the year-end accounts of Wellington’s TulipTower hotel.

Year 20X1 20X2 Cash at bank $ 20,000 $ 24,000 Accounts receivable 11,500 13,500 Prepaid expenses 3,400 4,200 Inventory 10,900 12,000 Current liabilities 32,000 31,000 Long-term debt 250,000 232,000 EBIT 285,000 321,000 Interest on debt 16,000 14,300 Total assets 450,000 465,000

Required:

a) For 20X1 and 20X2 calculate TulipTower’s:

i. Current asset ratio ii. Acid test ratio

b) From your answers to a), comment on TulipTower’s liquidity status in 20X1 and 20X2. c) For 20X1 and 20X2 calculate TulipTower’s:

i. Debt to assets ratio ii. Times interest earned

d) From your answers to c), comment on TulipTower’s trend with respect to long-term fi nan- cial stability.

Problem 5.10

The information that follows has been extracted from the year-end accounts of Jersey’s SmallIsle restaurant.

Year 20X1 20X2 Accounts receivable £ 15,000 £ 14,000 Inventory 23,500 24,000 Sales revenue (80 per cent on account) 750,000 785,000 Cost of sales 285,000 321,000 Net profi t 31,000 38,000

Required:

a) For 20X1 and 20X2 calculate SmallIsle’s:

i. Average collection period for accounts receivable. ii. Inventory turnover

b) From your answers to a), comment on SmallIsle’s asset turnover trend. c) For 20X1 and 20X2 calculate SmallIsle’s:

Problems

i. Gross profi t margin ii. Net profi t margin

d) From your answers to c), comment on SmallIsle’s profi t trend.

Problem 5.11

The following fi nancial and operating ratios are taken from Singapore’s International Airport Hotel for the years 20X1, 20X2 and 20X3.

20X1 20X2 20X3 Current ratio 2.3 2.5 3.1 Acid test ratio 1.4 1.6 2.1 Times interest earned ratio 3.5 3.1 2.8 Debt to equity ratio 65% 72% 76% Average days inventory is held 15 21 26 Average days to collect accounts receivable 28 32 35 Gross profi t margin 68% 72% 76% Net profi t margin 18% 21% 23% Return on investment (return on assets) 16% 14% 12% Room occupancy 72% 74% 76% Revenue per available room (Revpar) $210 $205 $201

Required (three marks available for each part):

a) Explain whether, from an investment standpoint, the hotel’s overall profi t performance has improved over the three years (you must give a reason or reasons to support your answer).

b) Explain whether the hotel’s short-term fi nancial stability has improved over the three years (you must give a reason or reasons to support your answer).

c) Explain whether the hotel’s long-term fi nancial stability has improved over the three years (you must give a reason or reasons to support your answer).

d) Explain whether the rooms’ department performance has improved over the three years (you must give a reason or reasons to support your answer).

Problem 5.12

CurryinaHurry operates a chain of small food outlets in Germany. Some of the business’s key fi nancial data (in millions) for the current year is as follows:

Beginning of year End of year

Cash € 45 € 125 Accounts receivable 20 30 Inventory 500 600 Prepaid expenses 10 15 Total current assets € 575 € 770 Total current liabilities € 250 € 280

For the current year, revenue was € 20,000 (10 per cent on credit) and the gross profi t margin was 60 per cent.

Financial statement analysis

Required:

a) For the current year, calculate the accounts receivable average collection period and also the average number of days that inventory has been held.

b) For the end of year, calculate the current ratio and the acid test ratio. c) Comment on what the end of year’s current ratio and acid test ratio reveal.

Chapter 6

Internal control

Learning objectives

After studying this chapter, you should have developed an appreciation of:

1. the nature and importance of internal control, 2. particular internal control challenges arising in hotels, 3. the main objectives of internal control, 4. the main principles of internal control, 5. internal control procedures relating to cash management, 6. internal control procedures relating to specifi c hotel activities, 7. how to prepare a bank reconciliation statement, 8. the purpose and operation of a petty cash system.

1) Introduction

Internal control concerns all of the procedures and policies that an organisation takes in order to:

● safeguard its assets; ● promote effi cient operations (i.e., incur lowest cost to achieve a particular outcome); ● maintain accurate and reliable accounting records; ● promote the pursuit of business policies.

These four internal control perspectives are elaborated upon in Box 6.1 . The most effective internal control procedures are preventative, i.e., they are designed to

avoid ineffi ciencies or theft occurring. An example of a theft avoidance procedure is to require cash to always be held in a locked safe. As it is not possible to completely remove the threat of ineffi ciencies and theft, many internal control procedures focus on ineffi ciency and theft detection. An example of a theft detection procedure would be to conduct a surprise search of employee bags as staff leave the hotel at the end of their shift.

Internal control

Box 6.1

The four objectives of internal control

1) Safeguard assets This objective concerns the protection of an organisation’s assets from

theft, ensuring that fi xed assets are maintained so that they can be used effi ciently and safely (e.g. appropriate hotel lift maintenance), and ensuring inventory items are appropriately stored to avoid waste and spoilage.

2) Promote effi cient operations In a labour- intensive business such as a hotel, ensuring appropriate recruit-

ment and training can go a long way towards promoting effi ciency. Adoption of technological advancements, such as providing all banquet staff with earpiece communication devices, can also greatly facilitate effi – cient operations. A system that monitors the adoption of technological advancements made in the sector can ensure a hotel is at the forefront of reaping technology- based operating effi ciencies.

3) Maintain accurate and reliable accounting records This objective requires that procedures are established to ensure the

production of reliable annual reports to outside parties such as share- holders. Users of external fi nancial reports need assurance that the reports provide a fair refl ection of the economic events that have affected an organisation. Managers also need reliable accounting information to assist their operational management decision making and control.

4) Promote the pursuit of business policies It is not worth having internal control procedures if they are not followed.

Many organisations conduct internal audits that contribute towards the maintenance of internal control in several ways, including appraising the extent to which document procedures are adhered to. Other ways to ensure conformity with business policies include training staff to an appro- priate level and video recording staff as they conduct their work (video recording is an extensively used internal control device in casinos).

Internal control procedures permeate an organisation’s operations. They are found in purchasing related systems right through to systems associated with sales and subsequent banking of cash. The systems can be classifi ed into two main types:

● Administrative controls These are systems and procedures that are designed to promote the pursuit of effi ciency and adherence to business policies. A fundamental source of administrative control comes from an organisation’s structure and the lines of authority evident in the structure. An extract of an example of a hotel organisation structure is provided in Figure 9.1 .

Internal control principles

● Accounting controls These refer to procedures put in place to safeguard the organisation’s assets and ensure the maintenance of accurate accounting records.

The need for a broadly based internal control system is not as great in a small business, such as a 20-seater independently operated restaurant, as it is in a large business, such as a 200-room hotel with 100 employees. This is because in a small restaurant, the owner will usually be present and his eyes represent a very powerful internal control tool, i.e. the owner can watch, or personally manage, activities associated with handling cash receipts and cash payments. The scale of operations in large hotels, many of which are open 24 hours per day, signifi es that owners cannot observe all cash transactions, however. As a result, in the place of the owners’ eyes, a system of internal control procedures has to be developed and adhered to.

The early reference to cash management in this chapter is signifi cant. Due to its high susceptibility to theft and embezzlement, cash represents an asset requiring particularly strong safeguards. This is especially the case in hotels due to the large number of cash transactions occurring in restaurants and bars.

Hotels experience high employee turnover and there are many hotel employees who work in close proximity to inventory items that are prone to pilferage. Many activities within hotels are conducted as relatively small independent units. For instance, if a bar is staffed by two individuals, economies of scale that can facilitate the development of segregated roles consis- tent with strengthening internal controls are absent. In combination, these factors signify that hotel managers need to have a sound appreciation of the nature of internal control challenges as well as an awareness of the types of procedures that can be implemented to manage these challenges.

This chapter represents an overview of internal control challenges and also widely applied approaches taken by management in a quest to promote internal control. Initially, we will review 11 internal control principles. Then an overview of some of the main internal control procedures used in connection with particular hotel activities is provided. Next, an approach for preparing a bank reconciliation statement is described and, fi nally, the purpose and oper- ation of a petty cash system is outlined.

2) Internal control principles

To ensure that an adequate level of administrative and accounting control is achieved, several important internal control principles should be observed. The control measures implemented in an organisation will be affected by its size and nature, and also its management’s views on which combination of controls will be most appropriate. This section summarises 11 major principles that should be considered when establishing an organisation’s internal control system.

Establish clear lines of responsibility

Employees should have a clear appreciation of the extent of their responsibility for the tasks that they undertake and it is a supervisor’s responsibility to monitor subordinates’ compliance with established procedures. Control is better served when completion of a particular task is restricted to one person. For example, imagine that the cash in a restaurant cash register is $20 short at the end of a dining period. If there has been only one person working on the register during the dining period, responsibility for the shortage can be quickly established. If two or more people have operated the register, it will likely be impossible to determine who

Internal control

is responsible for the cash shortfall. It is for this reason that you will see supermarket cash registers with removable cash trays. At the end of a checkout operator’s shift, the operator will take the tray to an area of the supermarket where a reconciliation check can be made between the cash held in the tray at the beginning of the shift, the register’s record of receipts during the shift and the cash held in the tray at the shift’s end.

Segregate duties

Segregation of duties is a key feature of internal control systems. There are two main types of segregation:

● Segregating responsibility for related transactions. An example of a set of related transac- tions can be found in the purchasing area where there is a responsibility for: 1) ordering goods, 2) receiving goods and 3) paying for goods received. If the same hotel employee is responsible for overseeing all these functions, they might be tempted to order wine stock for their personal use, arrange for the wine to be delivered to their home and then auth- orise for payment of the wine shipment to be made by the hotel. Alternatively, an employee might place orders with personal friends rather than fi nd the best quality products for the lowest cost. The chances of these types of scenarios occurring are greatly minimised if related transactions are not handled by the same person.

● Separating record keeping and custodianship. Responsibility for initiating transactions and for custody of related assets should be separate from the maintenance of accounting records. For example, a cashier responsible for a sales register should not be responsible for maintaining the cash receipts records in the general ledger. An employee with custody of a hotel asset is unlikely to take the asset for their personal use, if a record of the asset is maintained by a different employee.

Prepare written procedures

Established procedures for all major areas of a hotel’s operations should be documented. For example, with respect to the receipt of food deliveries, procedures such as checking the quality and weight of meat delivered and verifying the number of packaged food items delivered should be documented. Such procedures should be posted in a place of prominence that is close to the food receiving area.

Documentation procedures

Documents provide the basis for determining that events and transactions have taken place. For example, a customer invoice provides an itemised record of the services that a guest has been charged for. Whenever possible, documents should be pre- numbered. Pre- numbering can strengthen control in a variety of situations. Imagine that a restaurant manager conducts a verifi cation of receipts each day by comparing the closing amount in the register to the record of all customer bills submitted at the cash registry. The fact that the increased cash register balance is the same as the total amount of customer bills held at the register is no guarantee that all monies received have been placed in the cash register. This is because the cash register operator may have put one of the customer bills in their pocket, together with the cash received in connection with the missing bill. If all bills are pre- numbered, a restaurant manager could commence their daily cash register reconciliation by determining if any customer bills are missing from the pre- numbered sequence. In addition to pre- numbering,

Internal control principles

it is also important that all documents that are needed for accounting system entry are promptly submitted to the accounting department, in order to facilitate timely recording of transactions.

Restrict asset access

Access to assets that are prone to theft, such as cash and inventory, should be restricted to a limited number of employees. In following this principle, however, care should be taken that restrictions are not so tight that they inhibit the effi cient running of operations.

Use of mechanical and electronic devices

In order to protect assets and improve the accuracy of the accounting process, mechanical and electronic devices should be used wherever possible. Examples of these devices include: a safe or vault, cash registers and swipe cards providing restricted building access. A hotel shop can use barcode scanners to increase the speed and accuracy of the cash register checkout proce- dure and also merchandise inventory record keeping. If the shop stocks expensive merchan- dise items, it could attach electronic sensors that are removed on sale. If a customer attempts to leave the shop with the electronic sensor still attached to an item, an alarm is activated. Another electronic procedure that is widely used in hotels is a staff “clock in and clock out” facility that provides a record of the number of hours worked by staff remunerated on an hourly basis.

Maintaining adequate insurance

Insurance is necessary to protect an organisation’s assets against loss, theft or damage. Insurance can be taken to cover for the replacement cost of an asset, and also to cover for loss of profi ts resulting from any delay associated with replacing an asset.

Conducting internal audits

Internal audits are conducted by employees of the organisation that is to be audited. During the year, internal auditors investigate an organisation’s various record keeping systems and administrative processes in order to ensure operations are being conducted effi ciently and in compliance with documented procedures. If a procedure, or a reporting form that represents a step in a procedure, becomes redundant, an internal audit should fl ag the redundancy and provide a recommended procedural change. Both internal and external auditors conduct tests to verify that appropriate audit trails are being maintained. An example of an audit trail is as follows:

1) purchase order is prepared for a shipment of wine; 2) goods received form is appropriately signed off to verify receipt of correct wine

shipment; 3) stores record is updated to record entry of wine to storage; 4) restaurant requisition form is appropriately approved to initiate wine transfer to fridge in

kitchen; 5) wine sales in restaurant are recorded on customer bills prepared by restaurant waiting staff

(in an audit, the total for wine sales billed can be reconciled to the record of wine held in fridge);

Internal control

6) a reconciliation of cash register receipts to total of customer bills submitted at the cash register is prepared;

7) cash register receipts are recorded in the hotel’s record of bank deposits; and 8) hotel’s record of bank deposits are reconciled to bank statement.

Computer programming controls

These controls are built into a computer system to limit unauthorised and unintentional inter- ference. For example, debits must equal credits, a sales assistant can be prevented from over- riding the price of an item being sold, cheques can be identifi ed if they exceed a predetermined limit, etc.

Physical controls

The safeguarding of physical assets can be achieved by having physical controls such as a safe to hold cash and other valuable items, employee identifi cation cards, lockable storage areas with key code access and external fencing. An important physical control in hotels is the use of combination number door locks to prevent guests accessing hotel administration areas.

Job rotation

Changing the work positions that staff members are assigned to can be a useful internal control strategy. For example, cashiers could be moved across departments, accounts receiv- able offi cers could be assigned to an accounts payable function, etc. Such job rotation increases the chances of any dishonest employee activities being uncovered. It also lessens the chances of “comfortable relationships” developing that can lead to collusion between employees. If collusion is occurring, the length of time that it occurs will be interrupted by moving staff across functions. Job rotation also carries the benefi ts of developing a more fl exible and multi- skilled workforce that can derive satisfaction from increased task variability.

3) Internal control procedures used for specifi c hotel activities

Internal control of cash

As already noted, cash is the asset that is most susceptible to theft. Cash can be readily trans- ferred into another asset, it is easy to conceal and transport, it can be hard to distinguish hotel cash from personal cash held in a wallet by an employee, and cash is highly desirable. It is therefore essential that appropriate internal control systems are established for cash handling and accurate accounting records are maintained with respect to cash. While all of the internal control principles just outlined apply to establishing a good system of cash management, four particular internal control principles warrant particular recognition in connection with cash:

● The responsibility for receiving cash, banking cash and the maintenance of accounting records should be assigned to three different employees.

● Cash receipts for each day should be banked on that day. ● An automated record of a cash register’s receipts in each shift should be printed out by

someone other than the cashier and used as the basis for updating accounting records.

Internal control procedures used for specifi c hotel activities

● All payments should be made by cheque or electronic transfer, with appropriate authorisa- tion provided by designated personnel.

The importance of internal control over cash is such that key issues to be considered are summarised in Box 6.2 .

Box 6.2

Issues to consider when developing cash internal control procedures

1) Cash is highly susceptible to theft Cash can be easily exchanged for another asset, it is easy to hide and carry,

it is not readily distinguishable from personal cash held in a wallet by an employee, and it is highly desirable. These factors signify that strong internal control procedures are warranted to combat the threat of cash theft or embezzlement.

2) Segregate duties associated with cash The responsibility for receiving cash, depositing cash at the bank and

maintaining accounting records relating to cash should be assigned to three different employees. This provides a theft deterrent for the person receiving the cash and also the person who banks the cash.

3) Ensure prompt banking Cash receipts for each day should be banked on the day of the receipt. 4) Use cash register record when updating accounts An automated record of all receipts taken by a cash register in each shift

should be printed out by someone other than the cashier and used as the basis for updating accounting records.

5) Do not make cash payments To the extent possible, all payments should be made by cheque or elec-

tronic transfer, with appropriate authorisation provided by the approved personnel.

Internal control of purchases

An absence of procedures governing who can place orders and what purchase order forms need to be completed would result in organisational mayhem. Without such procedures there would be no way of determining what has been ordered or the expected delivery dates for shipments, with the result that two or more employees might unknowingly order the same items. Clearly, responsibility needs to be established to determine which individuals will be responsible for ordering what type of goods. A particular chef can be assigned to initiating the purchase of meat and fi sh, a laundry manager assigned to initiating the purchase of laundry cleaning supplies, etc. In addition, procedures concerning the forms that should be issued in

Internal control

connection with a purchasing system need to be determined. The four forms that are typically issued in connection with a purchase are identifi ed here in the context of the purchase of laundry detergent:

● A Purchase Requisition Form will be prepared by the laundry manager and submitted to the hotel’s purchasing department. On this form the laundry manager will enter a descrip- tion of the detergent, the amount required, date required and an approval signature.

● The Purchase Order Form , which is prepared by the purchasing department, typically has four copies. One is sent to the detergent supplier, one is sent to the laundry department as the requisitioning party, one is sent to the accounts department and one is held on fi le by the purchasing department. A maximum purchase amount will generally be established for a purchasing offi cer.

● A Receiving Report Form is completed on receipt of the detergent by the hotel employee with responsibility for receiving goods. The receiving report form is marked up as verifi ca- tion that the correct type and amount of detergent has been shipped.

● The Supplier’s Invoice , which typically accompanies shipped goods, will document the nature of the detergent delivered and indicate the fi nancial amount owing. This invoice, together with a copy of the receiving report form, is then sent to the accounts department. The accounts department should cross check the invoice to the original purchase order and also to the receiving report form to verify that all is in order. Once verifi ed, the accounts department should stamp the invoice to indicate that it has been verifi ed and approved for payment.

Internal control and inventory

There are two approaches that can be taken when accounting for stored items (food, bever- ages and other stored materials are widely referred to as “inventory” or “stock”). The fi rst approach is called a “perpetual inventory system”. Under this system, an up- to-date record of what is being held in inventory is maintained perpetually. This perpetual record is achieved by debiting the inventory account with the cost of purchases whenever a delivery is received into inventory, and crediting the account whenever an issue is made from inventory. The second approach is called a “periodic inventory system”. Under this system no record is kept of items issued from inventory. As a result, there is no up- to-date record of what is held in inventory. This type of system can be appropriate for non- critical items that can be quickly replenished or low- value stock items such as offi ce stationery. Under this system, the balance in inventory can be periodically determined by conducting a stock- take.

As a periodic inventory system signifi es that the accounting system can provide no direct way of determining whether any theft of stock is occurring, it tends to be used in those situ- ations where the inventory is not expensive and not prone to theft. Under a perpetual system, if a manager wishes to conduct a check into whether there is a theft problem, he can arrange for a physical stock count to be undertaken by a staff member who is independent of the stores function. If the amount of stock determined by way of the stock count is below the amount recorded in the perpetual inventory system, the manager will have uncovered evidence consistent with theft of inventory.

Internal control and payroll

Payroll is frequently the single largest hotel expense item. This justifi es it receiving particular attention with respect to the establishment of internal control procedures. Responsibilities

Bank reconciliation: an important internal control procedure

should be segregated so that different people are responsible for authorising an individual’s employment and wage rate, verifying hours worked, preparing the payroll, signing payroll cheques, mailing pay cheques to employees and reconciling payroll accounts. Employees who are paid an hourly rate should have their check- in and check- out times recorded on a time clock and their supervisors should sign off on their recorded times (supervisors need to be alert to the possibility of one employee clocking in and clocking out for two or more employees). To facilitate bank reconciliations, one bank account should be maintained for making general payments and a separate account maintained for paying employees. The steps to be taken in preparing a bank reconciliation are described in the next section.

4) Bank reconciliation: an important internal control procedure

A bank account greatly facilitates internal control over cash. This is because:

1. It enables a business to greatly reduce the amount of cash held on its premises; 2. Due to electronic transfer and chequing facilities, it greatly minimises the need for cash

transactions; 3. By preparing periodic bank reconciliation statements, it enables periodic checks

to be made of the accuracy of the cash balance recorded in the hotel’s accounting system.

The way in which a bank reconciliation provides a means for verifying a company’s recorded cash balance is explored in detail in this section. A bank reconciliation should be prepared on a monthly basis, to ensure that management is promptly alerted to any banking anomalies.

Because a business and a bank both maintain a bank account record, you might expect that these records would normally agree. As will be seen below, due to timing differences, at any particular moment in time they actually seldom record the same bank account balance. A bank reconciliation statement provides an overview of differences between a bank’s record and a company’s record of a bank account’s cash movements. Possible reasons for a difference between the cash balance recorded on a bank statement and the record in a company’s accounting system include:

● Timing differences: for example there may be a delay in a hotel cheque payment being presented to the bank.

● Errors: for example an error might be made in recording a deposit amount in a hotel’s accounts.

● Bounced cheque: a customer’s cheque that has been recorded in a hotel’s accounting system might not be honoured by the customer’s bank.

● Other differences: these can occur due to the delay in a hotel recording direct deposits made to its bank account or withdrawals made from its bank account.

Differences between a bank statement and the record in a company’s accounting system are outlined in greater detail in Box 6.3 .

Internal control

Box 6.3

Factors causing a difference between a company’s recorded bank account balance and the bank statement balance

1) Timing differences Several days can elapse between the time that a company mails a cheque to

a supplier and the time that the cheque is paid by a bank. If the supplier is a small operator who is overseas at the time a cheque is mailed, it could take more than a month for the cheque to clear. Also, if a company places deposits in a bank’s night safe, there will be a one day difference between the time the company records the deposit and the time the bank records the deposit.

2) Bank account fees If a bank account is subject to any banking fees, these fees will appear on

the bank statement before they are recognised in a company’s accounting system.

3) Bank account interest If a bank account earns interest on the average balance held in the

account, the interest received by a company will appear on the bank state- ment before it is recognised in a company’s accounting system.

4) Bounced cheques A difference will arise between a company’s records and a bank statement

if a customer’s cheque that has been recorded in the company’s accounting system bounces (i.e., the cheque is not honoured by the customer’s bank). A cheque will bounce if the customer’s account has insuffi cient funds to cover the cheque amount. A bounced cheque is sometimes referred to as a “dishonoured cheque”.

5) Direct deposits If a customer directly deposits funds in a company’s bank account, the

company will wait to see confi rmation that the deposit has been recorded on its bank statement, prior to recording the revenue receipt in its own accounts.

6) Errors Any error made in a company’s accounting system when recording a

payment or bank deposit will cause a difference between the company’s record of its bank account and the bank statement.

By outlining differences between a hotel’s bank account balance recorded in its accounting system and the balance recorded on its bank statement, a bank reconciliation statement serves three functions:

● It provides information that will enable the hotel’s accounting system record of its bank balance to be updated.

Bank reconciliation: an important internal control procedure

● It provides a check of the accuracy of the hotel’s bank account record keeping system.

● It can alert management to some forms of cash embezzlement, e.g., it would highlight any instance of an employee, who is charged with the responsibility of banking cash receipts, keeping the funds for their own personal use.

To prepare a bank reconciliation statement it is necessary to have the following:

1. The previous period’s bank reconciliation statement. 2. The company’s record of bank account payments and receipts. 3. A bank statement covering the period (most banks now provide online electronic facilities

that enable customers to access a bank statement whenever required). 4. The bank account balance per the company’s accounting system at the period end.

It is important to remember that in a company’s accounts, a positive bank account balance represents an asset. Therefore if the company has funds in its bank account, the balance will appear as a debit in its books. If the company’s bank account is overdrawn, the balance in its books will be a credit. From the bank’s perspective, however, if there are funds in an account, the company is a creditor as the bank owes money to the company. As bank statements are prepared by banks, the balance appearing on a statement will be a credit if the company has funds in its account, and it will be a debit if the company has an overdraft.

Bank reconciliation worked example

To illustrate the preparation of a bank reconciliation statement, a simplifi ed case will be used. As part of its internal control procedures, the infrequently opened Excelsior Restaurant prepares end of month bank reconciliation statements. The following documents have been assembled in connection with the preparation of Excelsior’s 31st December 20X1 bank recon- ciliation statement:

Note: the ticks and items appearing in italics have been added during the reconciliation process.

Excelsior Restaurant Bank Reconciliation

as at 30th November 20X1 (end of previous period)

Balance as per bank statement Cr 3,600

Add: outstanding deposits 652 ✓

$4,252

Less: unpresented cheques 236 $210 ✓

242 $ 67 ✓

243 $114

391

Balance as per cash at bank account Dr $3,861

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Cash Receipts Record for December 20X1

Date Details Bank Dr

Accounts Receivable Cr

Cash Sales Cr

Other

Dec 5 Sales 764 ✓ 764

8 M. Smith Events

832 ✓ 832

17 P. Jones Parties

215 ✓ 215

31 Sales 697 697

Total pre- reconciliation $2,508 $1,047 $1,461

Interest 13 13

Total after reconciliation $2,521 $1,047 $1,461 13

Cash Payments Record for December 20X1

Date Cheque No Details $

Dec 2 244 Meat Emporium 232 ✓

14 245 Vital Veggies 675 ✓

23 246 Belle Bakery 246 ✓

27 247 Freshest Fisheries 202 ✓

30 248 Grocery Warehouse 859

Total pre- reconciliation $2,214

Account Fee 12

Total after reconciliation $2,226

Account Statement Business Banking

Loyalty Bank Ltd Account Number 122334

Excelsior Restaurant

Date Details Debit Credit Balance

Dec 1 Balance 3,600 Cr

Deposit 652 4,252 Cr ✓

2 236 210 4,042 Cr ✓

Bank reconciliation: an important internal control procedure

101

Account Statement Business Banking

Loyalty Bank Ltd Account Number 122334

Excelsior Restaurant

Date Details Debit Credit Balance

5 Cash Deposit 764 4,806 Cr ✓

6 244 232 4,574 Cr ✓

9 242 67 4,507 Cr ✓

Deposit 832 5,339 Cr ✓

14 245 675 4,664 Cr ✓

20 Deposit 215 4,879 Cr ✓

26 246 246 4,633 Cr ✓

31 247 202 4,431 Cr ✓

31 Interest 13 4,444 Cr

31 Account Fee 12 4,432 Cr

Extract of bank account record maintained in Excelsior’s double entry accounting system:

Cash at Bank

1 December balance 3,861 31 December payments 2,226

31 December receipts 2,521 31 December Balance 4,156

6,382 6,382

1 January balance 4,156

Using the information above, a bank reconciliation statement will now be prepared. A fi ve-step procedure is described in this book, although it should be noted that not all hotels will use the same standardised procedure in preparing bank reconciliation statements.

The way that a bank reconciliation statement is prepared will be partially dependent on the way that a hotel’s accounting system records its bank account receipts and payments. In the example described here, it is presumed that when the month end bank reconciliation state- ment is prepared, the hotel’s bank account record in its double entry accounting system is updated for receipts and payments made during the month. In many accounting systems this end of month step will not be necessary, as the bank account record will be automatically updated as receipts and payments occur.

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Step 1: Using the bank statement and last period’s bank reconciliation statement, check that last period’s outstanding cheques and deposits have been recorded on the bank statement.

Cheque 243 for $114 has not been presented. This will have to be included in the bank reconciliation for December.

Step 2: Compare the deposits appearing in the company’s cash receipts record and cash payments appearing in the company’s cash payments record to the bank statement.

Deposit on Dec 31 for $697 has not been recorded by the bank. This will have to be included in the bank reconciliation for December.

Cheque 248 for $859 has not been presented to the bank. This will have to be included in the bank reconciliation for December.

Interest of $13 has not been recorded in the company’s cash receipts record. An account fee of $12 has not been recorded in the company’s cash payments

record. Step 3: Update the company’s cash receipts and cash payments records to refl ect any items

recorded by the bank but not by the company. The $13 interest is added in italics to the bottom of the cash receipts record . The $12 account fee is added in italics to the bottom of the cash payments

record . Step 4: Use the company’s cash receipts and cash payments records for the month as the

basis for making entries to the company’s bank account record that is maintained in its double entry accounting system.

Cash at bank per the company’s bank account record at 31 December is $4,156.

Step 5: Prepare the bank reconciliation statement by fi rst recording the balance as per the bank statement, then add any outstanding deposits and deduct any cheques that have yet to be presented to the bank. This should provide a total that equals the bank balance recorded in the company’s double entry book keeping system.

Excelsior Restaurant Bank Reconciliation

as at 31st December 20X1

Balance as per bank statement Cr 4,432

Add: outstanding deposits 697

5,129

Less: unpresented cheques 243 $114

248 $859

973

Balance as per cash at bank account Dr $4,156

A second example of a bank reconciliation exercise is provided in Financial control in action case 6.1.

Bank reconciliation: an important internal control procedure

103

FINANCIAL CONTROL IN ACTION CASE 6.1

Small business owner bank reconciliation statement preparation Cathy Makin, a friend who opened the small BriefBite restaurant six months ago, is concerned that her part time accountant might be making errors. She’s noted that the surplus of BriefBite’s record of bank deposits relative to payments never seems to agree with the bank statement balance. You tell Cathy to get BriefBite’s record of bank deposits and payments and also the business’s most recent bank statement and that you will meet her over tea to determine if there is a problem.

Two days later, Cathy comes to your offi ce armed with the requested docu- ments, two cups and a pot of tea. You note that the business has recorded receipts of $38,240, and $11,560 of payments, for the six months ended 30th June. The 30th June bank statement balance is $26,766. Following the pouring of tea, you explain that the best approach to reconcile a business’s bank statement to its accounting records is to take a structured approach such as the following.

Step 1: Check the last bank reconciliation statement for any items still outstanding from the bank statement

As this is the fi rst bank reconciliation conducted for the business, there are no previous bank reconciliation items to be examined. The fact that BriefBite has prepared no prior bank reconciliations signifi es that in the next step, the review for differences between the bank statements and the business’s banking records will need to cover the whole six- month period since the business opened.

Step 2: Identify all differences between the bank statements and the business’s internal record of bank deposits and payments

You fi nd that two cheques that BriefBite has sent to suppliers for $324 and $171 have yet to clear the bank account, and that a bank deposit of $401 left in the bank’s night safe on 30th June does not appear on the bank statement. You inform Cathy that all these amounts will have to be included in the bank reconciliation statement that you are going to prepare, as the business records are in effect ahead of the bank statement. You also note that the bank has paid interest into the account twice, totalling $14, but it has also charged account fees totalling $22. You tell Cathy that BriefBite’s accounting records will have to be updated to refl ect the bank interest and fees, as these are examples of the accounting records lagging behind the bank statement.

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Step 3: Update the business’s bank deposits and payment records to refl ect items recorded by the bank but not by the business

You add the interest received to the business record of receipts to give a total receipts fi gure of $38,254 ($38,240 + $14). You then add bank fees to the business record of payments to give a total payments fi gure of $11,582 ($11,560 + $22).

Step 4: Record the total of bank deposits and total of payments in the business bank account record maintained in the double entry accounting system

You debit the $38,254 receipts total and credit the $11,582 payments total in the bank account record maintained in BriefBite’s double entry accounting system, resulting in a $26,672 debit balance.

Step 5: Prepare the bank reconciliation statement

You fi rst enter the balance as per bank statement. You then add all outstanding deposits and deduct all cheques that have yet to be presented to the bank. This should provide a total equal to the bank balance recorded in the company’s double entry book keeping system.

BriefBite Bank Reconciliation as at 30th June

$ Balance as per bank statement Cr 26,766 Add: outstanding deposits 401 27,167 Less: unpresented cheques $324 $171 495 Balance as per cash at bank account Dr $26,672

5) Accounting for petty cash

When a hotel needs to pay out small amounts, for things such as taxi fares, postage stamps and other small miscellaneous items, it is impractical to always pay by cheque. As a result, a petty cash fund is frequently maintained. This fund is maintained using an imprest system that involves periodically replenishing the fund with enough cash to return it to its original balance. Responsibility for overseeing the petty cash fund should be given to a responsible and trustworthy employee.

A petty cash fund is operated by: 1) establishing the fund; 2) making payments from the fund; 3) periodically replenishing the fund.

Accounting for petty cash

105

Step 1 – Establishing the fund

● A cheque is written and given to the trustworthy employee put in charge of petty cash (petty cash offi cer).

● The cheque is cashed and the cash placed in a lockable box and kept in a secure place by the petty cash offi cer.

● The establishment of the fund is recorded by debiting “petty cash” and crediting “cash at bank”.

Step 2 – Making payments from the fund

● A pre- numbered petty cash voucher is prepared for every cash payment made from the fund and held in the petty cash box until the fund is replenished.

● Each voucher shows the fi nancial amount, the nature of the payment, the date and usually has a receipt attached in support of the amount spent (e.g., a post offi ce receipt if stamps have been bought).

Step 3 – Replenishing the fund

● From time to time, the fund will need to be replenished. ● To replenish the fund, the amount recorded on all of the paid vouchers is totalled, then a

cheque prepared for this total amount and given to the petty cash offi cer who cashes the cheque and puts the cash in the petty cash box.

● Each voucher is stamped as paid and transferred to the accounting department for recording.

● Expense accounts are debited in line with the information recorded on the petty cash vouchers and “cash at bank” is credited with the amount refunded to the petty cash fund.

To promote appropriate operation of the petty cash fund, random spot checks should be made to ensure that the amount of cash held in the fund plus the value recorded on petty cash vouchers in the petty cash box is equal to the agreed imprest amount. No IOU’s should ever be permitted. If the petty cash fund is used to fund an IOU, it could lead to the dangerous precedent of the fund being regularly used as a funding source for any staff member experi- encing a personal cash shortage.

Petty cash worked example On 1st July 20X1 the TightWad Motel started a petty cash fund with $200. By the end of the month TightWad had vouchers for:

Voucher Number Purpose Total Paid

1 Postage stamps 15.50

2 Stationery 16.00

3 Flowers for staff member 44.00

4 Offi ce supplies 15.28

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The accounting entries to record the establishment of the fund would be as follows:

Dr Petty Cash 200 Cr Cash at bank 200 To establish a petty cash fund

The accounting entries to record the reimbursement of the fund on 31st July would be as follows:

Dr Postage expenses 15.50 Dr Stationery expenses 16.00 Dr Miscellaneous expenses 44.00 Dr Offi ce supplies 15.28 Cr Cash at Bank 90.78 To reimburse the petty cash fund

6) Summary and concluding comments

In a single chapter concerned with internal control, it is impossible to outline all of the internal control challenges that can arise in a hotel. Similarly, it is impossible to overview all of the procedures that can be adopted by hotel management to strengthen internal control. As a consequence, this chapter should serve to highlight a hotel’s vulnerability to fraud and embez- zlement and also highlight examples of procedures that can be adopted to counter this vulnerability.

The chapter has described how some particularly signifi cant internal control challenges arise in hotels. These challenges result from hotels conducting a large number of transactions in cash, having many activities conducted as relatively small independent operating units, having a high employee turnover level and many hotel employees working in close proximity to items susceptible to pilferage. In an effort to equip you to counter these internal control threats, the chapter has presented eleven internal control principles and outlined particular internal control procedures that can be implemented with respect to cash, purchases, inventory and payroll management. The chapter has also described how a bank reconciliation statement can be drawn up and outlined the workings of a petty cash system established on an imprest basis. It is important to recognise that other chapters in this book describe accounting- based procedures and measures that can be used to strengthen internal control. For example:

● In Chapter 5 we examined the way that profi tability can be analysed according to a set of profi t margin ratios (e.g., gross profi t relative to sales, EBIT relative to sales, etc.) that culminate in the calculation of net profi t margin. A gross profi t margin trend of a restau- rant might reveal a sudden decline that coincides with the hiring of a new restaurant cashier. This changed gross profi t margin level suggests that close observation of the cashier’s work practices might be warranted.

● Chapter 10 provides an overview of how cost standards can be compared to actual costs incurred. This type of analysis, if focused on food usage, can provide an insight into whether food pilferage is occurring.

● Exhibit 13.6 in Chapter 13 demonstrates how an aged accounts receivable schedule can be produced to counter losses resulting from old outstanding accounts becoming uncollectible.

Summary and concluding comments

107

These three examples highlight some of the many ways that accounting tools and techniques described in this book can be used to supplement a hotel’s internal control armoury. As hotels come in many shapes and sizes with different activities and varying organisational structures, it is impossible to provide an “off the shelf” set of internal control procedures appropriate for all situations. Nevertheless, management would be lax if it did not ensure that the signifi cant internal control principles and procedures outlined in this chapter are considered. For example, due to the vulnerability of cash, all restaurant managers should ensure that a daily reconciliation is made between cash register receipts and the total of bills issued to customers. Also, all hotels should prepare timely reconciliations of bank statements to internal records of deposits and payments and this reconciliation should not be conducted by an individual who handles cash deposits. Box 6.4 is provided to further your appreciation of the range of internal control threats that can arise in a hotel. This box should help you to realise that you some- times need to think creatively when determining what procedures should be adopted to counter the many internal control threats that can arise in a hotel business.

Box 6.4

Internal control procedures that can be used to counter hotel- specifi c theft and fraud threats

Example of theft and fraud threat Internal control counter measure

Produce delivery

Deliver low quality meat but invoice for high quality.

Chef to inspect meat and other food items that can be prone to variable quality levels.

Place high quality vegetables at top of delivery case and low quality items underneath

Delivery receiving procedures include a check made of produce placed at the bottom of delivery cases. Reject low quality produce and inform purchasing offi cers if certain suppliers repeatedly attempt to hide low quality produce.

Front Offi ce

Record a guest who has paid cash as intentionally not paying (i.e., “doing a runner”), and pocket the amount taken from the guest.

Ensure a credit card swipe is taken for all guests when checking in. This will facilitate contacting the guest if it is claimed they have failed to pay their account. Reviews of daily guest revenue should quickly expose the situation of a front offi ce staff member repeatedly pocketing funds received from guests he claims have not paid.

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108

Alter the hotel’s record of an account to a lower rate following a guest settling their account and leaving.

Encourage payment by credit card.

Cash

Cashier pockets cash and records it as a shortage.

Maintain a record of all shortages and investigate cases of staff repeatedly reporting cash shortages.

Submit personal expenditure receipts for refund claiming the expenditure is business related.

Require heads of departments to sign off on all employee refunds. Conduct periodic reviews of the amount refunded to staff and the nature of the expenses incurred.

Accounts payable

An accounts payable clerk colludes with a supplier by getting the supplier to send infl ated invoices for the clerk’s approval.

Ensure purchasing offi cer is separate from accounts payable function. As part of internal audit procedure, check approved invoices to the details recorded on purchase orders.

The accounts payable clerk establishes a phoney company, arranges for the phoney company to submit invoices and then authorises payment to the phoney company.

As part of internal audit procedure, check approved invoices to the details on purchase orders and receiving report form. Ensure purchasing offi cer is separate from accounts payable function.

Restaurant activities

Kitchen staff with access to packaged food storage areas take food home.

Analyse gross profi t margins as part of an on- going check of the ratio between sales and cost of sales. Periodic random searches of staff when leaving the restaurant can be conducted as a deterrent to theft of stock.

Waiter under- bills friends sitting at a table.

Can be hard to crack this internal control challenge. If a restaurant manager is aware that a waiter is serving friends, a watchful eye should be kept on what is served and billed. Keep an eye on returning customers asking to be served by a particular waiter. For expensive wines, waiting staff could be required to sign the wine out from a bar area and periodic checks made between waiters’ bills and the wine they have signed for.

Problems

109

Bar area

Bar staff systematically under- pour the size of liquor servings provided to customers. They keep a record of the under- pours made in a shift and retain cash equivalent to the selling price of the under- poured amount.

Film cameras placed in bar areas with the knowledge of bar staff can represent an effective deterrent against this type of behaviour.

Bar staff brings to work a bottle of liquor and serves from the bottle and then pockets the takings.

Require all sales to be recorded on a cash register that maintains record of all sales. Camera can supplement attempts to verify this procedure is observed.

In conclusion, it is important to recognise that internal control systems can never ensure permanent or comprehensive control over all facets of a hotel’s business. This is particularly evident when we recognise that it does not make commercial sense to spend more money on a new internal control procedure, if the theft or fraud that would be prevented by the proce- dure represents a cost to the hotel that is less than the cost of implementing and maintaining the new procedure.

References

Geller , A.N. ( 1991 ) Internal Control: A Fraud-Prevention Handbook for Hotel and Restaurant Managers , Ithaca, NY : Cornell University .

Hoggett , J. , Edwards , L. and Medlin , J. ( 2006 ) Accounting , 6th edition, Milton, Qld. : John Wiley & Sons : Chapters 7 and 10.

Jackling , B. , Raar , J. Wines , G. and McDowall , T. ( 2010 ) Accounting: A Framework for Decision Making , 3rd edition, Macquarie Park, NSW, Australia: McGraw-Hill : Chapter 17.

Jagels , M.G. ( 2007 ) Hospitality Management Accountin g , 9th edition, Hoboken, NJ : John Wiley & Sons : Chapter 5.

Schmidgall , R.F. ( 2011 ) Hospitality Industry Managerial Accountin g , 7th edition, East Lansing, MI: American Hotel & Lodging Educational Institute: Chapter 12.

Weygandt , J. , Kieso , D. , Kimmel , P. and DeFranco , A. ( 2009 ) Hospitality Financial Accounting , Hoboken, NJ: John Wiley & Sons: Chapter 10.

Problems

Problem 6.1

Describe the four objectives of internal control.

Problem 6.2

Describe three characteristics of hotels that signify hotel managers should have a well- developed appreciation of internal control system design.

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Problem 6.3

Hong Kong’s HarbourView hotel prepares monthly bank reconciliation statements. You have collected the following information in connection with preparing HarbourView’s 31st December 20X1 bank reconciliation:

1. The bank account record maintained in HarbourView’s double entry accounting system has a 31st December 20X1 debit balance of $33,376 (this is after the hotel’s record of receipts and payments for the month have been recorded in the account).

2. Bank statement balance on 31st December 20X1 is $34,290 credit. 3. Receipts for 31st December totalling $1,240 have been recorded in HarbourView’s books,

but have yet to be deposited at the bank. 4. Cheques issued by the hotel that have not cleared the bank as at 31st December total

$2,170. 5. The bank statement indicates that the HarbourView account has been charged with fees

of $32 during December. 6. The 31st December bank statement indicates interest of $16 has been credited to the

HarbourView account during the month.

Required: Prepare HarbourView hotel’s 31st December 20X1 bank reconciliation statement.

Problem 6.4

Describe three ways that bank accounts greatly facilitate internal control over cash.

Problem 6.5

Following your recent appointment to the CrownTowers hotel group internal audit depart- ment, you have been assigned to conduct an internal control analysis of the Kuala Lumpur CrownTowers hotel. A year ago, the hotel appointed a new General Manager who immedi- ately changed several of the hotel’s systems. He justifi ed these changes on the basis that cost savings could be achieved through more streamlined procedures. In the course of describing some of his cost cutting initiatives, the General Manager tells you:

When I arrived I found some arrangements that really were unnecessarily complex. Two areas I’ve streamlined relate to cash management and purchasing. With respect to cash management, I’m now reaping economies of scale by having one person take care of collecting cash, banking the money collected and recording the deposits in our accounting system. This is saving time and energy, as we don’t need to keep passing information from one person to another. Similarly, with respect to purchasing food items, I now have one person placing our purchase orders. To save on frustration and miscommuni- cation with information being passed around, I get the same person to do a check that the goods ordered have all arrived in good condition. Once he’s satisfi ed that the delivery is in order, he then authorises the supplier’s payment.

Required: Outline any internal control shortcomings that you see in the system changes made by the new General Manager of the Kuala Lumpur CrownTowers hotel.

Problems

111

Problem 6.6

Steve Fitchett has been managing the Kenyan SafariCamp hotel’s souvenir and camera supplies shop for 11 years. Sue Rodwell, who acts as shop assistant, operates the cash register and records the daily takings on a cash receipts form that she signs and gives to Steve. As this is a relatively small shop, Steve performs most of the shop’s management functions including preparing bank account deposit documentation and preparing the shop’s monthly bank reconciliation statement. Stock in the shop is reordered by Steve when items appear low, as no on- going account of the items held in stock is maintained. The stock balance is determined at the end of the year by way of a stock count, conducted by a member of the accounts team.

Required: Identify and describe any internal control shortcomings you see in this SafariCamp hotel shop scenario.

Problem 6.7

There is one or more internal control weakness in each of the following situations. Identify and describe the weaknesses.

a) The multinational Extravagant hotel group has maintained a four- person internal audit team for several years. In addition to conventional internal audit activities, the head of the audit group has always impressed on her staff the importance of gauging the effi ciency of management in the hotels audited. Following an international decline in hotel trade that has spanned two years, the Extravagant group’s Chief Accountant has decided to close the internal audit team as a cost- saving measure.

b) The manager of the 8tillLate bar is responsible for purchasing bar stock, authorising bar purchase invoices for payment and overseeing periodic counts of the bar inventory.

c) Customers at the SublimeSpice restaurant seat themselves in order to save on the cost of a staff member showing customers to their seats.

d) Table cleaners are employed at the MemorableMunch restaurant. The restaurant has a policy of dividing tips in the ratio 20 per cent for table cleaners, 60 per cent for the waiter or waitress serving the table and 20 per cent for the kitchen staff.

Problem 6.8

A single offi ce supplies cupboard serves the 22 administrative staff at the RegalRegis hotel in Bombay. All offi ce staff members have access to the cupboard. The hotel General Manager has become increasingly concerned by the amount of offi ce supplies being used and feels too much of the purchased offi ce supplies are being taken home by the administration staff. Presently, staff help themselves to supplies and record the supplies taken on a note pad attached to the inside of the cupboard door. The General Manager has suggested to you that a new staff member be hired to handle all issues of offi ce stationery to staff as well as stationery purchases.

Required: Explain whether you feel the General Manager’s suggestion is appropriate and what steps you feel should be implemented to achieve an appropriate level of internal control over offi ce supplies.

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Problem 6.9

Nick Sakich has been appointed petty cash offi cer for Vancouver’s ShaugnessySlick hotel. A petty cash fund of $300 operating under the imprest system has been authorised by the hotel’s chief accountant. Nick established the fund by cashing a hotel bank account cheque for $300 on 1st June. The following payments were made through June.

June 2 Stationery purchased from Seigneuret supplies $24.25 June 5 Taxi fare paid for job interviewee (Dawn Enwad) $34.50 June 8 Bought stamps from post offi ce $28.00 June 10 USB stick purchase for Logan Philip $64.90 June 16 Birthday cake for member of staff (Miranda Smythe) $31.30 June 20 Purchase of print cartridge for Matthew Lansdowne $44.20

Required:

a) Prepare the accounting entries required to record the establishment of the petty cash fund.

b) Prepare the accounting entries required to record the replenishment of the petty cash fund on 28th June.

Problem 6.10

The following documentation for the QuaintCottage conference retreat that is located in the English Cotswolds has been made available to you:

● QuaintCottage’s Bank Reconciliation Statement as at 30th April 20X1 ● QuaintCottage’s Cash Receipts record for May 20X1 ● QuaintCottage’s Cash Payments record for May 20X1 ● QuaintCottage’s Bank Statement for May 20X1

Draw on this documentation to:

a) Prepare a bank reconciliation for QuaintCottage as at 31st May 20X1. b) Update QuaintCottage’s bank account record maintained in its double entry accounting

system (use a “T-account” presentation).

QuaintCottage Bank Reconciliation

as at 30th April 20X1

Balance as per bank statement Cr 9,253 Add: outstanding deposits 2,215 11,468 Less: unpresented cheques 5367 £1,345 5422 £899 5423 £2,300 4,544 Balance as per cash at bank account Dr £6,924

Problems

113

Cash Receipts Record for May 20X1

Date Details Bank

Discount Allowed Dr

Accounts Receivable Cr

Sales

May 2 J Smith 1,900 1,900

10 Sales 2,320 2,320

15 T Tops 1,260 1,260

22 Sales 3,500 3,500

30 P Limon 860 860

Totals £9,840 £4,020 £5,820

Cash Payments Record for May 20X1

Date Cheque No Details Bank Accounts Payable

Wages

Cr Dr Dr

May 5 5424 Grocery Green 1,450 1,450

9 5425 GT Electric 2,100 2,100

14 5426 Murphys Liquor 565 565

22 5427 Wages account 1,630 1,630

29 5428 Grocery Green 3,950 3,950

Totals £9,695 £8,065 £1,630

Honourable Bank Ltd

Account Statement Business Banking

Account 55555

QuaintCottage

Date 20X1 Details Debit Credit Balance

May 1 Balance £9,253 Cr

Deposit 2,215 11,468 Cr

2 5367 1,345 10,123 Cr

Deposit 1,900 12,023 Cr

4 5423 2,300 9,723 Cr

9 5424 1,450 8,273 Cr

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114

Honourable Bank Ltd

Account Statement Business Banking

Account 55555

QuaintCottage

Date 20X1 Details Debit Credit Balance

May 10 Deposit 2,320 10,593 Cr

15 Deposit 1,260 11,853 Cr

5425 2,100 9,753 Cr

22 Deposit 3,500 13,253 Cr

Transfer to account 55556

1,630 11,623 Cr

30 Account keeping fees

15 11,608 Cr

31 Interest 41 £11,649 Cr

Problem 6.11

The CrystalIce Hotel in Quebec has just appointed Max Hargreaves to act as petty cash offi cer for its recently established petty cash account. The fund, which is being run under an imprest system, was initiated by Max cashing a hotel bank account cheque for $400 on 1st May. The following payments were made through May.

3 May Train ticket refunded for a job interviewee $42.50 7 May Flowers bought for a retiring staff member $55.00 7 May Pizza delivery for retiring staff member party $88.00 12 May Stationery purchased from Eckington supplies $22.50 18 May Bought stamps from post offi ce $30.00 22 May Kitchen cleaning detergent purchased $8.40 30 May Coffee and biscuits purchase $22.60

Required:

a) Prepare the accounting entries required to record the establishment of the petty cash fund.

b) Prepare the accounting entries required to record the replenishment of the petty cash fund on 31st May.

Problem 6.12

The TeaHouse Retreat has a $350 petty cash fund that is maintained on an imprest system basis. On 31st January the fund is holding $130 in cash and petty cash vouchers for a $70 travel expense, $60 delivery expense and $90 for kitchen supplies.

Problems

115

Required: Prepare the accounting entries required to record the replenishment of the petty cash fund on 31st January.

Problem 6.13

The “Cash at Bank” account in Fellini’s Eco Retreat internal accounting system reports a debit balance of $1,075 on 30th November. Appearing in this account are three outstanding cheque payments totalling $600 that have yet to clear Fellini’s bank account, as well as a $400 bank deposit that has yet to be recorded by Fellini’s bank. Fellini’s most recent bank statement reported a $2,000 credit balance on 30th November. Included in the bank statement was a 29th November direct deposit receipt of $700 that had yet to be refl ected in Fellini’s internal records. Also not refl ected in the internal records was $30 bank account interest that was received on 30th November and an end of month bank fee of $5.

Required:

a) Update Fellini’s “Cash at Bank” record to refl ect items recorded by the bank statement that have yet to be recorded in Fellini’s internal recording system.

b) Prepare the Fellini’s Eco Retreat bank reconciliation at 30th November.

116

Chapter 7

Cost management issues

Learning objectives

After studying this chapter, you should have developed an appreciation of:

1. how the range of decision making and control situations confronted by managers results in many different cost classifi cations,

2. what is meant by an opportunity cost, 3. what is meant by direct and indirect costs, 4. methods that can be used to allocate indirect costs to departments, 5. what is meant by fi xed and variable costs, 6. what is meant by incremental and sunk costs.

1) Introduction

This chapter focuses on the different ways costs are classifi ed in order to support management decision making and organisational control . When referring to costs in everyday hotel affairs, managers use terms suggesting a multitude of cost classifi cation schemes. These classifi cations include: fi xed and variable costs, direct and indirect costs, opportunity costs, incremental costs, sunk costs, non- controllable and controllable costs. It is not surprising that staff without any accounting background become somewhat bewildered by the existence of so many cost classifi cations.

It is important to recognise that the range of cost classifi cations used results from the wide diversity of management decision making and control situations that can arise. Rather than attempting to memorise widely used cost classifi cations, however, it is recommended that you focus on common control and decision making issues that can arise and how cost information can be tailored to suit the particular management issue at hand. This chapter provides an overview of several typical decision making and control scenarios that can arise and the main cost classifi cation schemes that have been developed in light of these scenarios. Before consid- ering this range of scenarios, it is important to recognise that accountants refer to any “thing” that is to be costed as a “cost object”. The range of cost objects that one could confront in a career is limitless. Cost objects that are generally monitored in the hotel industry include: cost of cleaning a room, cost of processing a unit of laundry and food cost in a meal. To further

Management’s need for cost information

117

highlight the range of cost objects that can be encountered, fi ve cost objects that could be referred to in restaurant management are summarised in Box 7.1 .

Box 7.1

Exploring cost objects: examples found in large restaurants

When considering costing for different purposes, it is important that we recognise what it is that we are costing. The “thing” that is being costed is called a cost object. For a large restaurant, possible cost objects include:

1. cost of staffi ng a shift (we might be considering dropping a shift), 2. cost of food in a meal (for the purposes of controlling costs, we might like

to compare actual cost to budgeted cost), 3. cost of providing and serving a meal (we might like this information to aid

menu pricing decisions), 4. cost of cleaning the restaurant (we might like this information if we were

considering outsourcing this function to a cleaning specialist), 5. cost of overhauling the kitchen (we might be considering replacing kitchen

infrastructure).

2) Management’s need for cost information

Accounting information is a resource that has a cost. It is important to recognise that organi- sational resources are expended collecting and analysing cost information. We should not spend more money on collecting and analysing cost information than the decision making or control benefi t that will derive from the costing information. We will begin this chapter’s review of widely used cost classifi cations by fi rst considering some general examples of how cost information can be used in management decision making and control.

a) Decision making

Cost information can be important for decisions such as:

● Should we close a shop? ● Should we outsource laundry activities? ● What rate should be charged for a room? ● Should we promote single room sales more than double room sales?

Cost classifi cation issues that can arise in connection with decision making include the need to distinguish between fi xed and variable costs. As will be seen below, we may want to distin- guish between fi xed costs and variable costs because in the short run it can be in the organisa- tion’s interest to accept a room rate that covers only the variable cost of selling one night’s accommodation.

Cost management issues

118

b) Control

When monitoring the performance of a departmental head, it is desirable that we distinguish between controllable costs (those which the department head can infl uence) and non- controllable costs. If we fail to make this distinction, the performance measure used will not represent an appropriate proxy for appraising the department head’s managerial judgement and effort. As department heads tend to be acutely aware of inappropriately calibrated perfor- mance measures, frustration and resentment typically result from poorly designed perfor- mance measurement systems.

The need for departmental control also raises the issue of how best to deal with those hotel costs that are not readily traceable to a department that sells services. For example, should a portion of training costs be allocated to the F&B and rooms departments? While both these departments benefi t from hotel training programmes provided, can a sound basis be devel- oped for allocating training costs to other departments? As will be seen below, costs that are readily traceable to the cost object in question (in this case the F&B and rooms departments), are referred to as direct costs, and costs that are not readily traceable to the cost object are referred to as indirect costs.

3) Major cost classifi cation schemes

In this section, fi ve cost classifi cation schemes are described. They are:

a) outlay vs. opportunity costs, b) direct vs. indirect costs, c) variable vs. fi xed costs, d) controllable vs. non- controllable costs, e) incremental vs. sunk costs.

a) Outlay vs. opportunity costs

An outlay cost is “real” in the sense that it involves a disbursement of funds. An opportunity cost does not involve a disbursement of funds, it is, however, a cost to the organisation in the sense of an opportunity that is lost. The nature of opportunity cost is illustrated via a hypo- thetical scenario in Box 7.2 .

Box 7.2

The nature of opportunity cost

The nature of opportunity cost can be illustrated by a small worked example. Imagine London’s Victoria hotel is appraising whether to open a new restau- rant that will require fl oor area that is currently leased out to a souvenir vendor for £5,000 per annum. If the Victoria proceeds with the proposed restaurant development, it will no longer be able to lease out the fl oor space and will therefore lose the £5,000 per annum revenue. This loss is described

Major cost classifi cation schemes

119

b) Direct vs. indirect costs

As already noted, a direct cost is readily traceable to a particular cost object, while an indirect cost is not easily traced to a cost object. The term “overhead cost” is also widely used and means the same as “indirect cost”. A cost may be direct with respect to one cost object, but indirect with respect to another; e.g., the cost of a hotel’s sponsorship of a local sporting event is a direct cost with respect to the hotel’s marketing department (one cost object), but will be indirect with respect to rooms and restaurant meals sold (another set of cost objects).

as an “opportunity cost”, as although the Victoria does not have to pay £5,000, it will have lost the opportunity of receiving £5,000.

It is important that this potential loss of the £5,000 annual lease revenue is considered at the time the restaurant development decision is taken. However, if the hotel decided to expand the restaurant, the accounting system would not continue to record the £5,000 opportunity cost. To record all opportunity costs on a continuing basis would be an impossible exercise, as every time an organisation assigns a resource to a particular purpose (the resource could be cash, fl oor space, people, etc.), the organisation has incurred the opportunity cost associated with not assigning the resource to some other purpose.

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