Accounting Definitions in Hotel Management Agreements: Critical Terms Demand Serious Attention
The tenth edition of the Uniform System of Accounts for the Lodging Industry (Uniform System of Accounts) was recently released. It was produced in collaboration with Hospitality Financial and Technology Professionals, the Hotel Association of New York City, the American Hotel & Lodging Association (AH&LA) and AH&LA’s Educational Institute. The Uniform System of Accounts establishes standardized formats and account classifications to be used in the preparation and presentation of financial information in the lodging industry, and has been adopted widely throughout the lodging industry.
The tenth edition of the Uniform System of Accounts includes revisions that are aimed at providing better clarification and consistent financial reporting for the lodging industry as well as guidance with regard to recent business changes in the lodging industry such as the increased popularity of condominium hotels. As hotel operators begin to focus on the changes found in this edition from the ninth edition and incorporate such changes in their operations, it may also be a good opportunity for both owners and operators to review the use of accounting definitions, whether dependent or not on the Uniform System of Accounts for definition, in their hotel management agreements.
Contract Terms Need Deal-Specific Definitions
It is common for a hotel management agreement to reference the Uniform System of Accounts in setting forth the accounting principles to be followed by the operator often without the owner having a full understanding of what the Uniform System of Accounts provides and its relevance to the terms of the hotel management agreement. As discussed above, the Uniform System of Accounts establishes standardized formats and account classifications to be used in the preparation and presentation of financial information in the lodging industry and is intended to be consistent with U.S. generally acceptable accounting principles (GAAP). Accordingly, hotel management agreements typically require the accounting information to be provided by operator to be in accordance with GAAP and the standards contained by the Uniform System of Accounts. The standards contained within the Uniform System of Accounts have evolved to assist hotels in classifying, organizing and presenting their financial information in a uniform manner, which is not stressed under GAAP. The resulting uniformity permits users of the financial statements for hotels to meaningfully compare the financial position and operational performance of a particular property with similar properties within the lodging industry, most critically as part of the competitive set component of operator performance tests.
Accounting definitions are critical in hotel management agreements, including in determining the management fees earned by the operator, owner’s priority or required return on equity (if any), performance test requirements, and, indirectly, termination fees, damages and sales termination fees. Frequently, the operator and owner negotiate the percentage applicable to the calculation of the base management fees on gross revenues and incentive management fees on adjusted net income, as part of the initial overall deal negotiations and include such agreed upon percentages in the letter of intent, without specifically defining the accounting terms to which such percentages are applied. For example, a letter of intent may provide that the incentive management fee is to be 20 percent of “profits” (or another similar accounting term such as “adjusted operating profit” that is used without specific reference to its calculation), without expressly defining the revenues or expenses that are to be taken into account in determining such profits. As the parties have diverging interests with respect to the calculation of profits, it is not uncommon during the drafting of the definitive documents for the parties to discover that they may not have reached agreement with respect to the calculation of the incentive management fee as a result of the parties’ intent differing when the term “profits” was incorporated into the letter of intent. In such instances, the operator may take the position that the typical “owner expenses,” which include items relating to asset ownership, rather than hotel operations, such as property taxes, property insurance, debt service and rent, should not be included in determining profits. The owner, however, may take the position that given the higher incentive management fee percentage, owner expenses should be included in determining profits. Although the parties thought they were proceeding to the drafting of the definitive documents with the understanding that a deal had been reached as to the calculation of the management fees, there actually remains significant required negotiation at the definitive document stage that may affect the outcome of the negotiation of other outstanding items.
The Condominium Hotel Dilemma
In addition to the typical owner expenses described above, there are other revenue and expense sources that are not typically addressed in the letter of intent, but have become more common as a result in the gain in popularity of mixed-use projects and condominium hotel projects (now referred to in the Uniform System as “multi-owner” hotels) such as access fees to other project amenities or facilities, assessments collected for shared facilities maintenance and other related basic services, and amounts paid to hotel condominium unit owners pursuant to rental program agreements. As with owner expenses, the parties’ interests with regards to the treatment of these revenue and expense sources also diverge. With respect to the treatment of payments required by access agreements providing hotel guests access to project amenities or facilities that are not part of the hotel (and may or may not be owned by the hotel owner or its affiliates) and amounts paid to hotel condominium unit owners pursuant to their rental agreements, operators prefer that these should not be included in the calculation of the incentive management fee, while owners prefer to treat these as deductions in the calculation of the incentive management fee. With respect to assessments collected from condominium associations (in the case of condominium hotels) and project associations (in the case there are other residential components within the project) for operator’s maintenance of certain shared facilities, operators prefer to treat these either as revenues or reductions of operating expenses (and accordingly impact the calculation of the management fees), while owners prefer to treat these as a funding source for its funding obligations under the hotel management agreement.
Although the parties often do negotiate and provide some specific accounting definitions to be used in the definitive agreements to reflect the business agreements eventually reached, there are also hotel management agreements that reference only the Uniform System of Accounts in the accounting definitions used without the parties having a complete understanding of the effect in the context of the specific transaction. For example, a hotel management agreement may have the incentive management fee calculated based on the gross operating profit as calculated in accordance with the Uniform System of Accounts without the owner understanding that this may not include a deduction for the typical owner expenses or base management fees paid. More commonly, the hotel management agreement may exclude from operating expenses any fixed charges as calculated in accordance with the Uniform System of Accounts, which has the effect of excluding property taxes, property insurance and rent.
In order for the parties’ intent to be effectively reflected in the letter of intent, hotel management agreement and related documents, it is important that any accounting definitions referenced in such documents be specifically defined and incorporate the business agreement reached – the sooner the better. There is no right or wrong way to address these critical definitions but it is important that the parties understand the impact of the accounting definitions or Uniform System references on the business deal. “Everybody knows what these terms mean” is not a hospitality industry truism.
It’s not a good sign when party’s reaction to its review of the draft management agreement is “20 percent of WHAT?!?” It could mean “no deal.”