Accrual Land Mines in Hotel Financial Statements-Ignore At Your Own Peril

Are you ignoring warning signs of an accrual land mine in hotel financial statements?

Are you sacrificing precious profit dollars by not paying attention?

I am not exaggerating this situation.

It can indeed be disastrous if not nipped in the bud.

What am I talking about you ask?

One of the most insidious damage that can be caused to hotel profit is a phenomenon called accrual.

As a hotel senior manager including a general manager, have you heard of accruals?

If not, it is high time you know about it.

I will lay out a case for identifying and tackling this killer phenomenon called accrual.

This Blog Post will cover:

What is an Accrual?

Are you falling prey to this insidious land mine?

Much before we talk about accruals and what they are, let me ask you this.

Do you go through your Hotel department Profit and Loss Statement carefully each month?

In particular, do you sit with your Finance and Accounting department to analyze expense line items?

This is before going into your monthly Profit and Loss Statement meetings.

Where you are required to explain the behavior of your department expenses.

Why is this critical?

What does it achieve you ask?

I will get to that shortly.

Why are Accruals a Land Mine?

Consider this common scenario.

Say, you are the Director of Food and Beverage.

At a monthly Profit and Loss meeting, your General Manager asks you this question.

Why are Banquet Expenses so high when it has been a low month of business?

Say, you have not sat with the Finance department and gone through ledger account details of that expense.

You will have no clue why!

Not a good situation for you.

But why am I calling it a land mine?

And I have still not explained what accruals are!

Hang on, I am getting to both of those.

Accruals as Ad Hoc Expenses

Accruals can be described simply as ad hoc expenses.

Ad hoc, as in temporary.

Or actually expense placeholders.

They are used when it is not clear at that point how much that particular expense will finally turn out to be.

So, in the meanwhile, an ad hoc number is plugged into that line expense item.

Note the term “plugged in.”

It will play a critical role later in this post.

An accrual is like a provision in the books of account.

An expense whose figure is not clear yet.

Having defined accrual, let us get to why I called it a land mine.

What are land mines?

Land mines are bombs planted into the ground.

They are insidious since they are not visible to the naked eye.

You cannot see them since they are buried underground.

You will only know when you step on them.

And then they detonate!

Now you see how dangerous they are.

Accruals are land mines when misused.

And they are often misused.

I will explain with an example.

Examples and How to Identify Accruals

Before we look at an example, let us visit some quick accounting basics.

Basics you will benefit from remembering.

And avoiding accrual land mines.

Aha, that got your attention.

But let me push on.

Every expense line item in a hotel Profit and Loss Statement can be of the following categories:

1. Expense that is not inventories related
2. Expense that is inventories related
3. Expense that is purely an accrual

Often expense line items are combinations of all three of the above categories.

The first category of expense is something for which the hotel is not carrying any inventories.

These are expenses that have been incurred in that month and invoice charged to the hotel.

Example 1

Reservation Commission expenses in Rooms department.

The second category of expense is where the hotel is carrying inventories related to that expense.

This is where purchases of consumption items have been made in the month.

These purchases are kept in hotel stores.

They are issued to the operation during the month.

Expense recorded in the hotel Profit and Loss Statement is based on cost of consumption of those items during the month (see example below).

Example 2

Food Cost and Beverage Cost

Food Cost that is charged to the hotel Food and Beverage department Profit and Loss Statement is calculated as:

Opening Stock of Food at the beginning of the month

ADD

Purchases of Food in the month

LESS

Closing Stock of Food at the end of the month

IS EQUAL TO

Cost of Goods Sold (for food items)

or what is commonly known as Food Cost.

A similar process is used for beverage items.

Let us come to the third and potentially a dangerous category of expense.

Why are Accruals Used?

This third category is that of an expense that is purely based on an accrual.

Earlier we saw that an accrual is an ad hoc expense.

An expense that is incurred during month but we do not know exactly how much it cost us.

Often a Purchase Requisition may provide some clues to the amount.

At the same time, often accrual items may not have a purchase requisition to support them.

So, the hotel has incurred an expense but does not know what the liability is for that expense.

So, the hotel creates an ad hoc expense in that month's Profit and Loss Statement as an accrual.

Or adds the accrual to an existing expense line item.

Often a budget amount is used as an accrual for that expense.

As we all know, a budget amount is an overall estimate of what an expense item could be in a particular month.

But the warning signs are not so much about the accrual item as how it is actually recorded in the hotel's books of account.

Remember I asked a question earlier.

Let me reproduce that here:

“Do you sit down with your Finance and Accounting department to analyze expense line items?”

“This is before going into your monthly Profit and Loss Statement meetings.”

It is fair to say that if you did not do this, you will not be able to detect any warning signs.

Moreover, you will not realize the land mine you may be stepping on soon.

You are looking at me baffled.

Hang on, I will clear the air right here.

What do Accruals do to your financial statement and profit?

The land mine is related to what the accrual could be doing to your profit in your Profit and Loss Statement.

Let me explain with an example.

Example

Assume you have a low occupancy month.

Occupancies are in the 40% range.

Your hotel profit margins are under stress.

Assume in this month, you have a big accrual posted to your department Profit and Loss Statement.

On the one hand, it is an accrual posted without a realistic basis.

You have not analyzed your department Profit and Loss Statement for the month.

In a low month of occupancy, you can ill afford an accrual which is eating into your profit for this month.

On the other hand, an accrual is a land mine if not monitored carefully.

What do I mean by monitored carefully?

What I mean is that it could be doing damage you do not know about.

So, let me quickly tell you how an accrual impacts your financial statements.

It impacts two financial statements - the Profit and Loss Statement and the Balance Sheet.

The Balance What you say?

If you did that, you are possibly going to step on that land mine soon.

What do I mean.

Be patient, I am going to explain.

How an Accrual Works

In accounting terms, one part of the accrual entry in the hotel's double entry book keeping is in the expense line item.

This part is in the Profit and Loss Statement.

The other part of the accrual entry in the hotel's double entry book keeping is as a liability.

This part is in the Balance Sheet.

It is reasonable to say that most hotel senior managers including a general manager never look at the hotel Balance Sheet.

That is considered the territory of accountants and the Financial Controller.

But are you beginning to see what I am getting at.

On the one hand you do not analyze your expense line items in your hotel Profit and Loss Statement for accruals.

So you do not know what has been “plugged in.”

On the other hand, you have no clue how much of accruals have been accumulated in the Accruals account in the Balance Sheet.

Why?

Because you never look at the Balance Sheet.

Two Parts to an Accrual Entry

See Table above.

So, this is why as a hotel manager you should be on top of your expense line items of your department Profit and Loss Statement.

You will be able to identify accrual entries made which affect your department Profit and Loss Statement.

Now, consider this situation where the accrual amount is exaggerated.

Remember “plugged in.”

In an extreme case, this can become sand bagging.

Sand bagging means plugging in accruals in expense line items without a lot of basis.

It does terrible damage to that month’s profit.

In other words, it does not have a strong basis and hence is overstated.

An overstated accrual expense item is reducing your month's profit.

When it is a low month, the damage is even more.

So, what is the moral of the story?

The moral of the story is that you should not allow any accrual entries to be posted to your hotel department Profit and Loss Statement without your knowledge.

As a former Financial Controller myself, believe me this happens a lot.

I mean without the knowledge of hotel department heads.

On top of that, if accruals are not cleared immediately and allowed to accumulate they cause even more damage.

How to Monitor Accruals for Warning Signs

I would ask you as an immediate course of action upon reading this blog post to do the following:

• Go to your hotel Financial Controller
• Ask him to show you every expense line item in your department Profit and Loss Statement where an accrual is used.
• Find out what is the status of that accrual - meaning, did the invoice finally come in and the accrual adjusted?
• Tell your Financial Controller not to post any accrual entries to your department Profit and Loss Statement without your knowledge.

As a hotel manager and particularly if you are a General Manager, get into the habit of reviewing your accruals in the hotel Balance Sheet.

Set up a session each month before the Profit and Loss Monthly meetings with your Financial Controller.

Find out for yourself whether your hotel Balance Sheet is fraught with accrual land mines.

Believe me, you will sleep much better after that.

Because you have protected the hotel profit.

And probably your bonus too!

And best of all, the chances of you stepping on the accrual land mine is zero.

Wow, what a feeling!

You owe it to yourself.

Can Accruals be Avoided?

You may now be pondering a question.

If accruals are a land mine, is there a way to avoid them totally.

The answer is not a straight yes or no.

Accruals can be broadly avoided if an effective system of purchase requisitions is in place.

Purchase requisitions often are created on the basis of estimates.

If you can get better at this estimation and keep close to the real expense amount, you will have avoided this land mine.

Apart from this, I will repeat what I said earlier.

Get into the habit of analyzing your department expense line items in the Profit and Loss Statement.

Know exactly where the expenses are coming from.

Identify whether they are inventories related or otherwise.

Find out whether they have accruals in them.

This way, you will ensure that no extra dollar of expense is sitting in and reducing your profit in your Profit and Loss Statement without your knowledge.

In Part 2 of this 5 Part blog post series on warning signs, I will take you through how you can defuse the Accounts Receivable Bomb.

Yes, accounts receivables can be dangerous bombs!

Stay tuned.

What do you think of accruals?

Have you looked for accruals in your department Profit and Loss Statement?

Comment below.

I am keen to know your experience with accruals.

Related Posts

Action Steps You Can Take Right Now

Step 1

• Go to your hotel Financial Controller

Step 2

• Ask him to show you every expense line item in your department Profit and Loss Statement where an accrual is used.

Step 3

• Find out what is the status of that accrual - meaning, did the invoice finally come in and the accrual adjusted?

Step 4

• Tell your Financial Controller not to post any accrual entries to your department Profit and Loss Statement without your knowledge.

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