ACCOUNTING STANDARDS AND PRINCIPLES (PART 2)
The Financial Accounting Standards Board (FASB), together with the Securities and Exchange Commission (SEC), establishes the rules and regulations that govern all accounting and financial reporting. These principles are known as Generally Accepted Accounting Principles (GAAP). As a result of the 2002 Sarbanes-Oxley Act, hospitality companies are now investing large sums of financial and human resources to ensure these principles are correctly followed. Failure to apply these principles to the company’s financial system properly can result in the termination, and in some cases imprisonment, of management, including the CEO of the company. Here is a brief recap of these principles: The cost principle states that all transactions, including the purchase or sale of an asset, must be recorded at its transaction price (cost) rather than its market value. In addition, fixed assets, like hotel buildings, must be depreciated over time on the company’s records. The application of this principle prevents management from arbitrarily inflating the value of an asset on the company’s balance sheet and from artificially increasing profits on its income statement as the market value of the asset increases over time. Unfortunately, the application of this principle can result in the value of a company’s assets being understated. An example of this is a hotel like the Waldorf-Astoria located in the heart of Manhattan. While its balance sheet shows the value of the hotel at its original cost less many years’ worth of depreciation expense, the true market value of the hotel is significantly higher than the value shown on the balance sheet. Unless you are aware of how this principle works, you could significantly underestimate the true value of the company.
4. The monetary unit principle states that only transactions that can be expressed in terms of money should be shown on a company’s financial statements. It is because of this principle that businesses have begun to debate the feasibility of measuring human capital. No agreement, however, has been reached, and therefore the value of a company’s employees cannot be reflected on its financial statements.
5. The economic entity principle separates the dealings of a business from the private dealings of its owners. It prevents the commingling of a company’s assets, liabilities, and net worth with those of the owners. This principle protects limited partners from becoming the target of lawsuits filed by disgruntled guests or suppliers. For example, if a guest is injured, sues the hotel for damages, and wins the lawsuit, the only assets affected are those of the company. The guest cannot go after the owner’s personal assets if he wins the lawsuit.
6. The going concern principle requires businesses to assume they will continue to operate long into the foreseeable future. Thus, assets that have a useful life of several years are depreciated over the life of the asset rather than when they are acquired. This is consistent with the matching principle in that the cost of a hotel building is matched against the revenues it helps generate over time. The going concern principle requires that the cost of all operating equipment be depreciated over its useful life rather than expensed in the month it was purchased.
7. The time period principle states that the company must set specific time periods for measuring its financial results. For example, a company could elect to prepare its financial statements monthly, quarterly, annually, or a combination thereof. In each case, the financial statements should clearly state the time period being reported.
8. The last accounting principle, materiality, states that if a revenue or expense is significant, it should have its own account on the income statement. For example, if banquets are an important source of revenue, a banquet revenue account should be included in the chart of accounts and shown on the income statement. On the other hand, if banquets are not a significant source of revenue, they should be recorded as part of food and/or beverage revenue.
A clear understanding of how the application of these accounting principles can impact a company’s financial statements will enable you, as a hospitality manager, to effectively read, analyze, and interpret financial statements so you can make intelligent financial business decisions.
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