By David Lund
I tell my Introductory Hospitality Financial Leadership Workshop participants that the concept behind the matching principle is “the most important concept today.” Why? When it comes to producing financial information, it’s the cornerstone of understanding why we do almost everything the way we do it in the business world. The profit and loss statement cannot exist and be in any way accurate without using the matching principle every step of the way. Grasp this and you are well on your way to understanding the other principles and most importantly putting these principles to work in your day-to-day hotel leadership role.
Some of you are probably thinking this is for the bean counters and the propeller heads to chew on. Nothing could be further from reality. Being a financial leader means you understand and employ business principles. These principles are universal and without them, you’re akin to a plumber who doesn’t understand why water flows the way it does. So read on and get your schtick together.
You most likely have endured the wrath of someone when the financial statement came out in your hotel and you had expenses that month from a few months back. This was probably because someone else lost the invoice or failed to put it through to accounts payable. That is the matching principle getting abused! Here is what it’s all about and how to use it properly.
What does the matching principle mean? Why is it so important to grasp if you want to be a leader who has or wants financial leadership skills? The matching principle, because of its name and the definition, is a bit confusing at first glance. The matching principle states, in order to have meaningful financial information we must match all revenues with their costs at the time the revenue was earned. Here comes the confusing part, match all revenues with costs “regardless of when the money exchanges hands.”
That’s right! We want to consistently match the revenues with costs at the time the revenue is earned, regardless of when the money comes or goes. This is technically the definition of accrual accounting which is the polar opposite of cash accounting. Cash accounting realizes revenues and expenses when the money changes hands. You can compare the cash accounting system to the old shoe box. Money goes in the shoe box when people pay us, and money comes out when we pay for our costs. If there is money left in the shoe box that’s our profit.
The matching principle provides a much clearer and very precise picture of profitability because we don’t need to take into consideration the timing of payments either coming or going. It’s not the case that the payments are not important. It’s just not necessary to take the payments into consideration when we calculate our profit using the matching principle and accrual accounting.
So how does all of this relate to hotels? Here is an example from a client who I recently helped convert from the cash basis to the accrual basis in his four hotels. He was confused because his monthly financial statements didn’t always make sense. We discussed why the statements seemed too good to be true certain months and downright awful in other months. He knew that he paid his people every two weeks, which means that every month you’re only recording two pay periods. It also means that every six months you come across a month with three pay periods (that’s just the way the calendar works). He also knew that annually, in June, he needed to pay the real estate taxes that covered the first half of the year and the next six months. Other items also made the statements wonky, like insurance, utilities, and benefits. What he knew was the statements were bogus because he had a timing problem. What he didn’t know was how to fix it.
Introducing the two stars of this matching principle show: Mr. Pre-Paid and Mrs. Accrual. These might sound like ominous characters but really they are simple and straightforward. Mr. Pre-Paid acts to allow the insurance payment to be paid now and then split the cost evenly into the next 12 months. This allows for a smooth ride of the profit and loss statement rather than having it all show up this month, which is what would happen under the cash system. Mr. Pre-Paid only goes one way, pay it up front and then spread the cost evenly into the months that are covered. This is the matching principle in action.
Now let’s look at Mrs. Accrual. She is a bit different in that she must go two ways. Any time she goes one way she must eventually go the other way. Let’s use payroll as an example. Every month I have two pay periods and to properly match my revenues and expenses I need to accrue for the missing days. Well, guess what? Next month I need to do the same thing, but I also need to reverse the previous month’s accrual, so I match that month’s costs to the revenues. Accruals bring expenses into my month’s statement before I have the actual invoice, or with the example of payroll into my P&L before I pay people. In both expenses and payroll, I need to include everything that has been spent this month regardless of whether I have paid for it yet. Once the accrual is booked I’m now matched and expenses line up with the revenue earned. Once the accrual is recorded it’s normally reversed the next month because the actual invoice showed up and the payroll got paid.
I’m going to repeat myself, but it’s worth it because it is so important to understand this. The matching principle works on the idea that expenses and revenues all need to be included in each profit and loss reporting period, regardless of when the money is collected for the revenue earned or when the cash is paid out for the expenses or payroll.
Get this into your DNA and make sure all your departments’ expenses get booked properly or accrued each month. Those invoices and packing slips on your desk need to be sent down the hall so they are included in this month’s results. Without the matching principle working smoothly and completely in your hotel you will be in for a rough ride.