Interpreting and Auditing Hotel Accounts in 2016 - Part 7
Key Financial Accounting Issues Replacement Reserve, Current and Fixed Assets, Capitalisation and Depreciation
Hotel operating accounts that follow the USALI standards focus on the elements of revenues and costs that reflect the trading results of the business, down to EBITDA. How other financial costs and movements of assets and liabilities and are controlled and accounted for by the Uniform System of Accounts for the Lodging Industry is covered in the Financial Statements section of the USALI book.
The USALI includes two versions in the Operating Statements section of the Summary Operating Statement, one for Operators and one for Owners. Both are the same down to the EBITDA line.
The Owner version includes the line items below EBITDA that reconcile the operating result with that of the financial accounts, such as interest, taxation, depreciation and amortisation.
Below EBITDA, the Operator version includes a line for Replacement Reserve. This nature of this is described below.
Reference is often made to the existence in management contracts and loan agreements of provisions for reserves to be set aside for future replacements of furniture, fixtures and equipment, and building systems replacements.
Such reserves are commonly based on a percentage of the hotel's revenues. In some cases, the reserve represents a funding charge into an account from which actual expenditure is carried out. In others, it is a memorandum allocation only.
Unusually, the Replacement Reserve is a charge in the current operating period for future expenditure. It is not a reflection of depreciation, that is a charge only relevant to the financial accounts.
Whether such a reserve exists, at what level, and how the reserve balance movements are controlled should all be covered the owner/operator/loan agreements. Care is needed to ensure that the relevant criteria have been followed, especially in respect of the actual expenditure charged against the reserve balance.
For the operator the existence of the reserve serves to give comfort that funds will be available when required to maintain the physical standards of the hotel, and for the owner that the operator has the resources available to maintain the standards of the property. In practice, there can be disputes about the level of the reserve fund and the nature and speed of the expenditure charged against it. Commonly, between 3 and 5 percent of total annual revenue is credited to the reserve. Refurbishment expenditure against the reserve tends to even out over a five year period. The funding in advance of the reserve can be a significant strain on the net cash flow of the hotel.
The nature of the Replacement Reserve and how it applies to an individual hotel will depend on the understanding of the parties involved. It is not a financial accounting standard and does not affect capitalisation and depreciation issues.
Determining how the USALI directs hotels to categorise current and fixed assets requires reference to both the operating and financial statement texts, and the guidelines are not conclusive.
There is a prescribed treatment of Operating Equipment (including china, glassware, silver, and uniforms) covered in the Financial Statements section. This treats items with a useful life of 12 months or less as a Current Asset to be expensed to the relevant department over that period. Items with a longer life can have an extended period of expensing to the departments under a category of Other Assets, the value of which is to be tested periodically by inventory taking.
These asset categories are treated as if they are deferred costs, and depreciation does not apply.
Issues can arise at the opening of a hotel or when new outlets or major refurbishment are involved. The USALI treatment does not provide any alternative treatment, nor does it consider what happens if items such as operating equipment are provided at the cost of the operator as part of the management contract terms.
Whilst the USALI refers to the inclusion in Property and Equipment of land, buildings, furnishings and equipment and leaseholds, it does not go into detail about capitalisation criteria. It also mentions depreciation and amortisation principles without indicating rates relevant to hotels.
Capitalisation and Depreciation
Defining criteria for classifying expenditure as Capital or Operating Expense is an area where financial accounting standards, commercial agreement terms between owners and operators, and taxation aspects all impact on accounting policies.
Each hotel should set its own guidelines as to when expenditure should be considered to be as capital rather than an operating expense based on the useful life and value of an item or group of items. If the item has a relatively short life span, and is of limited value, it will not fulfil the requirement for being treated as a Fixed Asset.
Relevant expenditure might be classified by setting cost levels as a minimum for capitalisation, for example as follows:
a) Individual purchases with a minimum unit cost of £XX and an expected useful life of 1 year or more
b) Bulk purchases of identical items having a unit cost below £XX but greater than £X, and an aggregate cost in excess of £XXX and an expected useful life of 1 year or more.
Guidance Notes for the Hotel Industry on Tangible Fixed Assets published by the British Association of Hotel Accountants (now HOSPA) in 2000. This was the result of a project carried out by hotel finance and real estate professionals at the time. Their findings and conclusions included a schedule of 'useful economic lives' of hotel assets that remains largely valid today. The schedule is reproduced below:
Category Range in Years
Land Freehold Infinite
Leasehold Life of lease
Building Core Freehold Determined by Directors in consultation with qualified advisors
Leasehold Life of lease or useful economic life of building, whichever is less
Building Surface Finishes
and Services 20 to 30 years
Plant and Machinery 15 to 20 years
Soft Furnishings 5 to 10 years
Computers - PMC/PC hardware/software 3 to 5 years
Major systems installations up to 10 years
Motor Vehicles up to 5 years