The basic principles (part 2)
The Business Entity Principle
This principle dictates that - unless a sole proprietor - the assets of the business and any rights to use these assets are separate and distinct.
For example, if Henry Ford was still alive and CEO of the Ford Motor Company, the cars sitting on the factory’s assembly line belonged to the shareholders of the Ford Motor Company and not Henry Ford.
The assets and liabilities of the company are separate and maintained distinctly from its executives, principles and employees. This principle also means that only the transactions directly pertaining to the business are entered into the company’s books. We hear in the public from time to time how executives use certain company assets like jets to transport family on a holiday. The company assets are not assets belonging to the executives and, therefore, should not be treated as such. This also is an area where the claim of abuse of power causes trouble for some people.
The Full Disclosure Principle
This principle is necessary because of the financial statements. The numbers only tell part of the financial picture, more accurately, what has happened financially to date.
Any forward-looking event that might have a material impact on the business needs to be disclosed in writing for the shareholders and stakeholders. Items like outstanding lawsuits, union matters, competition, environmental issues, pending changes in laws, insurance claims and more. Anything that may have a negative effect on future stability and earnings for the business must be disclosed.
These are represented in the business reporting as footnotes to the financial statements. In the case of the hotel, the monthly hotel executive commentary, property report or managers’ report is the instrument for full disclosure. It is designed to include all of the items that “could” negatively impact future earnings, as well as more information on what happened in the current reporting period. In addition, the commentary includes detailed information on market conditions and the business outlook going forward.
Basically, investors and all the stakeholders need to know what is going to happen in the future, or at least as much information as possible to make the best decisions possible for financial stability.
The Conservatism Principle
This principle states that the financials must fairly and conservatively represent the business’s current financial situation. The principle states to never overestimate revenues and never underestimate expenses.
For example, a tenant might prepay rent for a year, but 100 percent of the revenue for that payment would not apply to the P&L that month, but rather take 1/12 and apply it each month. Another example was a cancellation fee. Sales contracts might include such an agreement with a client and if this clause needed to occur, the revenue would not be recognized until it was paid.
On the flip side, all possible negative activity should be captured that affects the period reported on. For instance, the hotel had not yet received the electricity bill for the month and it was needed to close the books; err on the side of accruing the largest consumption to date rather than the smallest.
If aware of pending litigation, provide for the possible, probable future expense now with a liberal estimate of exposure.
The essence of the conservatism principle is that information is reported in a way that minimizes negative future financial results today and does not take any chances that future expenses resulting from a current situation will not materialize. The bad stuff was reported and it was not assumed anything positive would happen unless it had already happened.
The Objectivity Principle
The objectivity principle states that we must show proof of every financial transaction in the business. This might seem a bit erroneous, but it is not. For every sale, there was a posting, a room charge, a restaurant slip, a bar bill, a banquet check. For every purchase, there was a purchase order, a receiving slip, an invoice and a check for payment. For every hour worked there is a schedule, a time card and a payroll register.
In all, this principle stated evidence is needed to support everything. When transactions turn from the operation into the books this also applies. A manager could not just make up transactions and record them; the backup must prove the entry. For example, the director of maintenance might want to accrue for an emergency plumbing repair that happened on the 30th of the month. There is no invoice, so a work order estimate or a purchase order that describes the problem, location and estimated cost are required.
The Consistency Principle
The last business principle to write about is the consistency principle. This means to follow a consistent process from one period to the other in the financial world. If the process needs to be changed, the necessary people are informed through the full disclosure principle.
For example, if changes are needed in an inventory method. In the past, the “first in, first out” (FIFO) method was used to measure the value of beverage inventory. Then it was decided that the most efficient way to measure the value going forward was to use an average weighted cost. Disclosure of the change is required during the month the change was made, so the stakeholders in the business see and understand the variance attributable to the change in accounting methods.
Teaching these to my leaders meant they understood the why. This creates the buy-in that is necessary to get the non-financial leaders in the game.
David Lund – The Financial Coach Helping Hotel Teams and Leaders with Financial Coaching and Educational workshops Contact David at (415) 696-9593. |
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