HOSPITALITY MANAGEMENT ACCOUNTING CHAPTER 1 BASIC FINANCIAL ACCOUNTING

HOSPITALITY MANAGEMENT ACCOUNTING CHAPTER 1 BASIC FINANCIAL ACCOUNTING REVI EW

Introduction Accounting has been developed to accumulate, maintain, and provide financial information regarding internal business transactions. In this chapter we will discuss and use basic accounting principles and procedures common to a manual system. Computerized systems incorporate all of the fundamental accounting principles of the manual system.

Accounting Principles A common language has developed from the practice of accounting with its own set of rules or assumptions, commonly called principles and concepts. It is important to have a good understanding of each of these principles and concepts to be able to interpret financial information correctly.

Accounting Principles (Contd. ) 1. 2. 3. 4. 5. These assumptions include the following: Business entity principle Monetary unit principle Going concern principle Cost principle Time period principle 6. Conservatism 7. Consistency 8. Materiality 9. Full disclosure 10. Objectivity principle 11. Matching principle

G E N E R A L LY A C C E P T E D ACCOUNTING PRINCIPLES Accounting is not a static system; it is a dynamic process that incorporates generally accepted accounting principles (GAAP) that evolve to suit the needs of financial statement readers, such as business managers, equity owners, creditors, and governmental agencies with meaningful, dependable information.

BUSINESS ENTITY PRINCIPLE From an accounting, if not from a legal, point of view, the transactions of a business entity operating as a proprietorship, partnership, or corporation are considered to be separate and distinct from all personal transactions of its owners. Only the effects to assets, liabilities, ownership equity, and other transactions of the business entity are entered to the organization’s accounting records. The ownership’s personal assets, debts, and expenses are not part of the business entity.

MONETARY UNIT PRINCIPLE The assumption of the monetary unit principle is that the primary national monetary unit is used for recording numerical values of business exchanges and operating transactions.

GOING CONCERN PRINCIPLE the going concern principle makes the assumption that a business entity will remain in operation indefinitely. This continuity of existence assumes that the cost of business assets will be recovered over time by way of profits that are generated by successful operations. The balance sheet values for longlived assets such as land, building, and equipment are shown at their actual acquisition cost. Since there is no intention to sell such assets, there is no reason to value them at market value.

COST PRINCIPLE The assumption made by the monetary concept is tied directly to the cost principle, which requires the value of business transactions be recorded at the actual or equivalent cash cost.

TIME PERIOD PRINCIPLE The time period principle requires a business entity to complete an analysis to report financial condition and profitability of its business operation over a specific operating time period. An accounting year, or fiscal year, is an account period of one year. A fiscal year is for any 12 consecutive months and may or may not coincide with a calendar year that begins on January 1 and ends on December 31 of the same year.

CONSERVATISM PRINCIPLE A business should never prepare financial statements that will cause balance sheet items such as assets to be overstated or liabilities to be understated, sales revenues to be overstated, or expenses to be understated. Situations might exist where estimates are necessary to determine the inventory values or to decide an appropriate depreciation rate. The inventory valuation should be lower rather than higher. Conservatism in this situation increases the cost of sales and decreases the gross profit.

CONSISTENCY PRINCIPLE The consistency principle was established to ensure comparability and consistency of the procedures and techniques used in the preparation of financial statements from one accounting period to the next.

MATERIALITY CONCEPT Theoretically, items that may affect the decision of a user of financial information are considered important and material and must be reported in a correct way. The materiality concept allows immaterial small dollar amount items to be treated in an expedient although incorrect manner.

FULL DISCLOSURE PRINCIPLE Financial statements are primarily concerned with a past period. The full disclosure principle states that any future event that may or will occur, and that will have a material economic impact on the financial position of the business, should be disclosed to probable and potential readers of the statements. Such disclosures are most frequently made by footnotes. For example, a hotel should report the building of a new wing, or the future acquisition of another property. A restaurant facing a lawsuit from a customer who was injured by tripping over a frayed carpet edge should disclose the contingency of the lawsuit.

OBJECTIVITY PRINCIPLE This objectivity principle requires a transaction to have a basis in fact. Some form of objective evidence or documentation must exist to support a transaction before it can be entered into the accounting records. Such evidence is the receipt for the payment of a guest check or the acceptance of a credit card, or billing a house account that supports earned sales revenue.

MATCHING PRINCIPLE The matching principle reinforces the accrual basis of accounting. Assets are consumed to generate sales revenue inflows; outflows of assets are identified as operating expenses. The matching principle requires that for each accounting period all sales revenues earned must be recognized, whether payment is received or not. It also requires the recognition of all operating expenses incurred, whether paid or not paid during the period.

End-of-period Adjusting Entries At the end of an operating period, adjustments are made to recognize all sales revenue earned. This might be sales revenue not yet recorded or sales revenue that was earned but will not be received until sometime in the new accounting period. Adjustment must also be made to recognize expenses not yet recorded or expenses that were incurred in the current period but not expected to be paid until sometime in the new operating period. Adjusting entries are needed to ensure that correct amounts of sales revenue and expenses are reported in the income statement, and to ensure that the balance sheet reports the proper assets and liabilities.

Adjusting Entries (contd. ) 1. 2. Adjusting entries are also used for items that, by their nature, are normally deferred. These consist of two types of adjustments: The use or consumption of an asset and recognition of it as an expense. This type of adjustment typically adjusts supplies, prepaid expenses, and depreciable assets. The reduction of a liability and recognition of revenue. This adjustment concerns the recognition of unearned revenue as being recognized as earned.

DISCUSSION QUESTIO NS 1. 2. 3. 4. 5. Explain the major difference between cash and accrual accounting. In what way can a business manager use accounting information? Using examples, give a short description of five accounting principles or concepts using examples. Discuss why adjusting entries are necessary at the end of each operating period are made before the end-of-period financial statements are prepared. A hotel shows office supplies such as stationery on its balance sheet as a $500 asset, even though to any other hotel these supplies might have a value only as scrap paper. Which accounting principle or concept justifies this?

Chapter 2 UNDERSTANDING FINANCIAL STATEMENTS

The INCOME STATEMENT AND The BALANCE SHEET Although the balance sheet and the income statement are treated separately in this chapter, they should, in practice, be read analyzed jointly. The relationship between the two financial statements must always be kept in mind. This relationship becomes extremely clear when one compares the definition and objective of each statement.

The Balance Sheet The purpose of the balance sheet is to provide at a specific point in time a picture of the financial condition of a business entity relative to its assets, liabilities, and ownership equity. By category, each individual account, by name and its numerical balance, is shown at the end of a specific date, which is normally the ending date of an operating period.

The Income Statement The purpose of the income statement is to show economic results of profit motivated operations of a business over a specific operating period. The ending date of an operating period indicated in the income statement is normally the specific date of the balance sheet.

The Income Statement (contd. ) Most hospitality operations are departmentalized, and the income statement needs to show the operating results department by department as well as for the operation as a whole. Exactly how such an income statement is prepared and presented is dictated by the management needs of each individual establishment. As a result, the income statement for one hotel may be completely different from another, and income statements for other branches of the industry (resorts, chain hotels, small hotels, motels, restaurants, and clubs) will likely be very different from each other because each has to be prepared to reflect operating results that will allow management to make rational decisions about the business’s future.

REVENUE Revenue is defined as an inflow of assets received in exchange for goods or services provided. In a hotel, revenue is derived from renting guest rooms, while in a restaurant, revenue is from the sale of food and beverages. Revenue is also derived from many other sources such as catering, entertainment, casinos, space rentals, vending machines, and gift shop operations, located on or immediately adjacent to the property.

Expenses are defined as an outflow of assets consumed to generate revenue. The accrual method requires that expenses be recorded when incurred, not necessarily when payment is made.

DEPARTMENTAL CONTRIBUTORY INCOME The term departmental contributory income is used in this text and shows departmental revenue minus its direct costs to arrive at income before tax. By matching direct expenses with the various revenue-producing activities of a department, a useful evaluation tool is created.

Departmental Contributory Income The departmental income statement provides the basis for an effective evaluation of the department’s performance over an operating period. In general, the format in condensed form of a departmentalized operation is shown below Departmental sales revenue $580, 000 Departmental Expenses (464, 000) Departmental Contributory Income 116, 000

Departmental Contributory Income (Contd. ) If departmental managers are to be given authority and responsibility for their departmental operations, they need to be provided with more accounting information than revenue less total expenses. In other words, expenses need to be listed item-by-item, otherwise department heads will have no knowledge about which expenses are out of line, and where additional controls may need to be implemented to curb those expenditures.

Sample Income Statement

Understanding the Income Statement As you review the sample departmental income statement, take particular note of the following: (1) each revenue division is identified; (2) the cost of employee meals is deducted from the cost of sales. The cost of employee meals is the actual cost of the food, and no sales revenue was generated or received from those meals. The term net food cost implies that all necessary adjustments to cost of food sales have been made, and represent the actual cost incurred to produce the sales revenue. Cost of employee meals became a part of the employee benefits reported as a departmental expense.

Understanding the Income Statement (contd. ) Income before fixed charges is an important line on an income statement because it measures the overall efficiency of the operation’s management. The fixed charges are not considered in this evaluation because they are capital costs resulting from owning or renting the property (that is, from the investment in land building) and are thus not controllable by the establishment’s operating management.

Control over inventory The control of inventory for sale is important for a number of reasons: If inventories are not known, the possibility exists that inventory may run out and sales will stop. This situation will certainly create customer dissatisfaction. If inventories are in excess of projected needs, spoilage may occur, creating an additional cost that could be avoided. If inventories are maintained in excess of the amount needed, holding excess inventories will create an additional cost such as space costs, utilities costs, and inventory holding costs. If inventories are maintained in excess of the amount needed, the risk of theft is increased and, therefore, the cost of stolen inventory is higher.

Valuation of Inventory § § There are several inventory valuation methods, of which we will discuss four. Specific item cost First-in, first-out Last-in, first-out Weighted average cost

Adjustments to the cost of sales In most food and beverage operations it is necessary to adjust cost of sales—food before it can be accurately labeled net food cost. Here are some possible adjustments: Interdepartmental transfers: For example, in a restaurant, some items like eggs, fruits, etc. might be purchased and received in the kitchen and recorded as food purchases that are later transferred to the café shop for use there. In the same way, some purchases might be received by the café shop (and recorded as beverage purchases) that are later transferred to the restaurant. A record of transfers should be maintained so at the end of each month, both food cost and beverage cost can be adjusted to ensure they are as accurate as possible.

Adjustments to cost of sales (contd. ) Employee meals: Most food operations allow certain employees, while on duty, to have meals at little or no cost. In such cases, the cost of that food has no relation to sales revenue generated in the normal course of business. Therefore, the cost of employee meals should be deducted from cost of food used. Employee meal cost is then transferred to another expense account. For example, it could be added to payroll cost as an employee benefit.

Adjustments to cost of sales (contd. ) Promotional expense: Restaurants sometimes provide customers with complimentary (free) food and/or beverages. This is a beneficial practice if it is done for good customers who are likely to continue to provide the operation with business. The cost of promotional meals should be handled in the same way as the cost of employee meals. The cost should not be included in cost of sales— food or cost of sales—beverage because, again, the food and/or beverage cost will be distorted. The cost should be removed from food cost and/or beverage cost and be recorded as advertising or promotion expense.

RESPONSIBILITYACCOUNTI NG A hospitality business with several departments, each with the responsibility for controlling its own costs and with its department head accountable for the departmental profit achieved, is practicing what is known as responsibility accounting. Responsibility accounting is based on the principle that department heads or managers should be held accountable for their performance and the performance of the employees in their department. There are two objectives for establishing responsibility centers: 1. Allow top-level management to delegate responsibility and authority to department heads so they can achieve departmental operating goals compatible with the overall establishment’s goals. 2. Provide top-level management with information (generally of an accounting nature) to measure the performance of each department in achieving its operating goals.

Responsibility Accounting (contd. ) Within a single organization practicing responsibility accounting, departments can be identified as cost centers, revenue centers, profit centers, or investment centers. A cost center is one that generates no direct revenue (such as the maintenance department). In such a situation, the department manager is held responsible only for the costs incurred. Some establishments also have revenue centers. These departments receive sales revenue, but have little or no direct costs associated with their operation. For example, a major resort hotel might lease out a large part of its floor space to retail stores. The rent income provides revenue for the department, all of which is profit. A profit center is one that has costs but also generates revenue that is directly related to that department. The rooms department is an example where the manager is responsible for generating revenue from guest room sales.

The Balance Sheet Importance of Balance Sheet The balance sheet is important because it can provide information about matters such as the following: A business’s liquidity, or ability to pay its debts when they have to be paid. How much of the operation’s profits has been retained in the business to help it expand and/or reduce the amount of outside money (debt) that has to be borrowed. The breakdown of assets into current, fixed, and other, with details about the amount of assets within each of these broad categories. The business’s debt (liabilities) relative to owners’ equity. In general, the greater the amount of debt relative to equity, the higher is the operation’s financial risk.

Balance Sheet Limitations There are some aspects of a business that the balance sheet may not disclose. For example: True value - Because transactions are recorded in the value of the dollar at the time the transaction occurred, the true value of some assets on the balance sheet may not be apparent. Goodwill - if a business was started from scratch, and has a good location compared to its competitors, and/or a good reputation and faithful clientele, and/or a superior work force with good morale, it is probably worth far more than the balance sheet assets show, simply because the goodwill built up is not reflected on the balance sheet.

Balance Sheet Limitations (Contd. ) Employee investment - Another value similar to goodwill that is not shown on a business’s balance sheet is the investment in its employees. This investment is the time and money spent on recruiting, training, evaluating, and promoting motivated individuals. Obviously, it is difficult to assign a value to these human resources, but nevertheless, they are assets to any hospitality business. Judgment calls - Many items recorded on balance sheets are a matter of judgment or estimate. For example, what is the best depreciation method and rate to use, and what is the best of several available methods for valuing inventories? There are no absolute answers to these questions. For this reason, a balance sheet may not reflect the correct value for all assets.

Balance Sheet Limitations (Contd. ) Changing circumstances - Balance sheets also reflect the financial position of a business at only one moment in time. However, the business is constantly changing, and, therefore, the information on the balance sheet is constantly changing. These changes will not be shown until another balance sheet is produced a month or more later. If a balance sheet shows a healthy cash position at one time, and a week later most of that cash was spent on new furniture, the balance sheet will reveal nothing about the impending use of most of the cash available.

Problems The Purple Rose Restaurant has the following food cost information for a given month. Calculate the food cost of sales and net food cost of sales for March. The following information is provided: Food inventory, March 1 $2, 428 Food inventory, March 31 1, 611 Food purchases, March 8, 907 Employee meals cost 209 Promotional meals cost 278

Exercise Cindy’s Restaurant has three revenue divisions with direct costs and average monthly figures given in the following information: Dining Room Banquet Room Beverages Sales revenue $202, 000 $108, 000 $90, 000 Cost of sales 81, 000 41, 000 28, 000 Wages and salaries 64, 455 34, 795 12, 000 Other direct costs 18, 640 8, 960 1, 600 The restaurant also has the following indirect, undistributed costs: Administrative and general expenses $13, 000 Marketing expenses 9, 000 Utilities expense 6, 000 Property operation and maintenance 12, 000 Depreciation expense 14, 000 Insurance expense 2, 000

a. Prepare a consolidated contributory income statement showing each of the three divisions side by side for comparison. Do not allocate indirect costs. b. Allocate the indirect costs to the divisions and prepare a departmental income statement for each division. Administrative, general, and marketing costs are allocated based on sales revenue. The remaining indirect costs are allocated based on square footage used by each division: Dining 2, 400 sq. ft. Banquet 3, 000, sq. ft. Beverage 600 sq. ft. c. After allocating the indirect costs, would you consider closing any of the divisions? Why or why not?

Exercise George Jarvis purchased a trailer park on January 1, 0004. It is now March 31. George has no accounting training but has kept a record of his cash receipts and cash payments for the three months (see next page): As Mr. Jarvis’s accountant, you discover the following additional information: a. The building has an estimated life of 20 years and straight-line depreciation is used. b. The office equipment has a five-year life with a trade-in value of $500. c. The insurance was prepaid on January 1 for the entire year.

Chapter 4 Ratio Analysis

Ratio Analysis Ratio analysis in the simplest terms is the comparison of two figures, numerical dollar values or quantity values. Ratio analysis allows an evaluation of balance sheet items in conjunction with some income statement information to determine various relationships between selected items.

RATIO COMPARISONS Ratios are used to help a business entity evaluate financial and economic results of profit-oriented operations over a given accounting period. A ratio standing alone is simply a number and appears to have little value, in that the ratio does not directly show favorable or unfavorable results. For example, a restaurant’s food inventory turnover of four times per month may appear good, but until the turnover ratio is compared with some standard, such as the average turnover ratio in the restaurant industry for that type of restaurant, its true value cannot be determined. For a ratio to have meaning, it must be comparable to a standard or an established base ratio. A standard ratio could be an industry average.

USERS OF RATIOS Generally, three broad groups of people are interested in the evaluation of ratios: internal operating management, current and potential creditors, and the organization’s owners. Management has the responsibility of safeguarding the assets, controlling costs, and maximizing profit for the business operation. Ratio evaluation is a major technique used by management to monitor the operation’s performance against predetermined standards to determine if the operating budget objectives are being achieved.

Users of Ratios (Contd. ) Creditors of a business operation have an equity claim to the assets of the operation. Creditors loan money or extend trade credit to the business operation. As such, creditors are normally interested in certain ratios that may indicate the level of safety of their loaned funds or trade credit. In addition, existing and potential creditors use certain ratios to estimate their potential risk of future loans the business operation may need. In some cases, a creditor may require the borrower to maintain a specified level of working capital, a specific level of current assets greater than current liabilities.

Users of Ratios (Contd. ) The ownership of a business operation can use certain ratios to measure such items as their return on investment, the risk level of their investment, or to estimate the probability of success of future operations.

RATIO CATEGORIES Current liquidity ratios. The primary purpose of liquidity ratios is to identify the relationship between current assets and current liabilities; thus, liquidity ratios provide the basis for an evaluation of the ability of a company to meet its current obligations. Liquidity ratios that provide a direct analysis of current and quick assets in relation to current liabilities are the current ratio (or the working capital ratio) and the quick ratio (or acid test ratio).

RATIO CATEGORIES (Contd. ) Profitability ratios. Resources and assets are made available to management to conduct sales -revenue-generating operations, and the profitability ratios show management’s effectiveness in using the resources (assets) during operating periods. profitability ratios to be discussed are return on assets, profit to sales ratio, return on ownership equity, return on total investment, and earnings per share.

RATIO CATEGORIES (Contd. ) Activity ratios. Activity or turnover ratios indicate how well the managers are using assets. Inventory turnover ratio shows the relationship between inventories held for resale and the cost of sales over an operating period. In addition, the average days of inventory for resale on hand can be determined. Working capital turnover that measures the effectiveness of using working capital and fixed asset turnover that measures the effectiveness of using fixed assets are also explained.

RATIO CATEGORIES (Contd. ) Operating ratios. The final category to be discussed includes analysis of items that are oriented primarily to food, beverage, and rooms operations. Operating ratios are generally summarized on the manager’s daily or weekly report. This chapter concludes with a discussion on financial leverage, or, simply put, the use of debt to obtain capital. Basically, there are two sources of obtaining operating capital—assuming long-term debt or increasing ownership equity by selling additional ownership rights. Financial leverage is the term used to describe the use of debt, rather than equity financing to increase the return on ownership equity.