Final Report on Financial Operations of the Grand Hyatt Hotel and Percentage Rental Paid by Regency-Lexington Partners for 1986 Report Number GHYBA November 21, 1989 Office of the Auditor General Karen Burstein, Auditor General Donna Freireich, First Deputy Auditor General Cris G. Gonzales, C.P.A., Section Head Cheryl A. Gerernia, Auditor Rose A. Simineri, C.P.A., Auditor Id OAG Report: GHYSA Final Report on Financial Operations of the Grand Hyatt Hotel and Percentage Rental Paid by Regency-Lexington Partners for 1986 Executive Summary The Office of the Auditor General (GAG), as the agent of UDCz?Commodore Redevelopment Corporation (UDC), and at the request of UDC and the Real Property Division of New York City?s Department of General Services, reviewed the financial operations of the Grand Hyatt-New York Hotel for the year ended December 31, 1986, in order to verify the accuracy and propriety of the Percentage Rental payment for that year made to the City I{through UDC) by Regency- Lexington Partners. The Partners--Refco Properties, lnc., a subsidiary of Grand Hyatt, inc. {50 percent interest), and Wembley Realty, whose President is Donald Trump (50 percent interestl??lease the Hotel property (land and building) from LTDC and the City under a long~term agreement. For 1985, the Partnership paid Percentage Rental of $3,742,380; its payment fer 1986 fell to $667,155, despite the fact that the Hotel?s gross revenues had increased. Although we originally sought to audit Hotel operations and Percentage Rental payments for both years, the Partnership denied us access to any books or records for 1985. On the basis of our review. we concluded that the Partnership, in its statement submitted to the City, understated its 1986 net profit by $5,087,132, due to improper adjustments it made to the Hotel's operating income for that year;"? in addition, the Partnership improperly allowed itself a credit of to reflect the cumulative, retroactive effect of one of those adjustments for 1982 through 1985. As a result, it understated the Percentage Rental due the City for 1986 by $2,870,259, which amount, with interest is still due and owing. ?These adjustments were not made on either the Hotel?s or the Partnership?s 1986 certified financial statements; only the City?s rent statement was affected. TABLE OF CONTENTS Baas Executive Summary .. i l. introduction .. A. Background .. B. Hotel Operations .. 3 C. Lease Provisions .. 4 II. Audit Scope, Methodology and Related 6 A. Access to Records and Accounts .. 7 13. Changes in Accounting Policies .. 10 C. Audit Scope and Methodology .. 13 Findings and Recommendations .. 16 IV. Conclusion .. 39 Appendices introduction A. Background As agent of UDCz?Commodore Redevelopment Corporation and by request of UDC and the Real Property Division (DRP) of New York City?s Department of General Services, the Office of the Auditor General (DAG) reviewed the results of operations of the Grand Hyatt-New York Hotel (Grand Hyatt or Hotel} for the year ended December 31, 1986. UDC and New York City are owners of the Hotel property (building and land), which is leased by Regency?Lexington Partners (the Partnership)2 for a term of 99 years. The purpose of the GAO audit was to verify the accuracy and propriety of the Percentage Rental payment made by the Partnership on account of lease year 1986,3 pursuant to the lease agreement (Lease) between UDC as landlord and Wembley Realty, Inc. (the Partnership's predecessor in interest) as tenant. The Percentage Rental payment made for 1936 was $677,155; the payments for 1984 and 1985 had been $3,163,870 and 333342390, respectively. The arrangements governing the property have their roots in a series of complicated transactions beginning a decade and a half ago during the City?s financial crisis. What follow are a brief chronology and catalog of relevant events and documents. in early 1975, the Partnership?s predecessor in interest?-Wembley Realty. inc., a subsidiary of The Trump Organization-?began negotiations with the trustees of the Penn Central Transportation Company (Penn Central) to purchase the defunct Commodore Hotel (land and building). In May of 1975, Wembley and Grand Hyatt, Inc., entered into an agreement pursuant to which Grand Hyatt, Inc. would operate the newly-renovated Hotel using lUDC/Commodore Redeveiopment Corporation is a subsidiary of the Urban Development Corporation (UDC). 2Regency Lexington?s two partners--each with a 50% interest-?are: Refco Properties, Inc. (a subsidiary of Grand Hyatt, inc.) and Wembley Realty, Inc., whose President is Donald J. Trump. 3In 1985. the lease year was changed to coincide with the calendar year (it previously ran from June 1?May 31). The change was made retroaCtive to (and including) calendar year 1981. -1- OAG Report GHYBA November 21, 1989 the Hyatt name. In the fall of 1975, Wembley and New York City began_' discussing tax abatement for the proposed renovation work. Outside counsel, appointed by the City to review the tax abatement plan, suggested that UDC act as the tax-exempt developer. In January, 1976, then Mayor Beame announced that the Commodore Hotel tax abatement plan would be the first project under the new Mayor?s Investment Program. The next month, the City formally invited UDC to participate in the redevelopment plan. In April of 1978, Wembley and Grand Hyatt, Inc. signed a first amendment to their management agreement, authorizing Wembley to convey the property (upon title's passing to it from the Penn Central trustees} to a governmental agency, and to subsequently lease it back from the agency under a long-term ground lease. A month later, the Board of Estimate passed a resolution in favor of the project, and in September, Board of Directors voted its approval of the plan. Detailed lease negotiations among UDC, the City and The Trump Organization began in the fall of 1976. In January, 1977, the bankruptcy court approved Wembley?s purchase of the Commodore. In October, Regency~Lexington Partners was organized. with a view toward its acquiring Wembley?s interests in the management agreement and the Lease. In return for Wembley's payment of the negotiated purchase price of $10 million, the Penn Central trustees, by deed dated December 19, 197?, agreed to convey the Commodore Hotel (land and building) to UDC and the City of New York, for the sum of $10. By agreement of the same date, present holder of legal title to the property {see belowI?-1eased the property back to Wembley for a term of 99 years. In May of 1978, the purchase price was paid by Wembley; title passed under the deed from the Penn Central trustees to UDC and the City; and the 99?year term of the ground lease commenced. Also in May, Wembley?s interests in the management agreement and the Lease were assigned to the Partnership, and construction of the new Hotel began. A temporary certificate of occupancy was issued on September 8, 1980, and the Hotel opened for business on the following day; a final certificate of occupancy was issued on July 21,1981. The deed executed by the Penn Central trustees vests legal title to the property (land and building) in UDC for a term of 99 years. or until the -2- OAG Report GHYSA November 21, 198's earlier occurrence of one or more specified events (see sec. 10 of the' Project Agreement between UDC and the City, dated December 19, 1977, and Article 24 of the Lease}. During that period, the City has a beneficial interest in the property, and UDC serves as its trustee, collecting and remitting rent and otherwise enforcing its rights as landlord under the lease {see sec. 4 of the Project Agreement and secs. 3 and 4 of the Three Party Agreement among UDC, the City and Wembley, dated December 19, 1977). At the end of 99 years, or upon the earlier occurrence of one of the specified events, the legal and beneficial interests to the property merge in the City (see, sec. 2 of the Three Party Agreement). B. Hotel Operations The Grand Hyatt-~former1y the Commodore-?ls a four-star hotel located at Lexington Avenue and 42nd Street, in midtown Manhattan. It has 134? rooms, which in 1985 and 1986 were available at an average daily rate of $125.03 and $135.63, respectively. Occupancy rates for the same years were 84.3% and 82%; the staff during the period numbered approximately 1300. In addition to room rental, the Hotel provides restaurant service, bar and lounge entertainment, laundry and valet service, and banquet rental. The Hotel is one of many operated and maintained by Grand Hyatt, Inc.- ~a privately held company with a central office in Chicago. The management agreement with the Partnership obligates Grand Hyatt, Inc. to operate the Hotel under its name, in return for a basic fee of four percent of the Hotel's total gross revenue (excluding tenant--i.e., store-? rentals), as well as an incentive fee of 20% of the Hotel?s operating profit. Both fees are deductible from the Hotel?s net profit for the purpose of determining the Percentage Rental due the City (see Lease, Exhibit F, sec. the results of Hotel operations are reflected in the Partnership?s financial statements. For the last three years, the Hotel?s reported revenue, net profit and Percentage Rental were as follows: 1985 1986 1987 Revenue $78,256,432 $79,948,941 $85,647,008 Net Profit 10,534,779 5,057,695 8,255,355 Rental Paid 3,742,380 557,155 2,603,178 OAG Report GHYBA November 21, 1989 C. Lease Provisions Under the Lease, the Partnership must make three annual payments to the Cityf1 Net Rent, the Tax Equivalency Fee, and Percentage Rental. Net Rent is a flat amount of $100, payable in advance each May 19 {the Commencement Date of the Lease) throughout the 99-year term. The Tax Equivalency Fee (TEF)--payable in advance at the same time as Net Rent- ?is a payment in lieu of real property taxes, which increases over the term of the lease until-?in 2020?-it equals the full real property tax payable. For the period May, 1978 through May, 1980, the TEF was $1 per year; for the period May, 1980 through May, 1985, it was $250,000 per year; for the period May, 1985 through May, 1990, it is $350,000. Thereafter, the amount due is the lesser of the full real property tax or the amount set forth in the schedule shown in Exhibit of the Lease. The amounts in the schedule increase from $600,000 I{for the year ending May, 1991} to $2,775,000 for the period ending in May 2020. For the remainder of the lease term (from May, 2020 through May, 2077) the full property tax is payable. Any unpaid amount of the TEF is deemed additional rent payable pursuant to Lease sec. 4.6. Between tax years 1978?79 and 1989-90, almost $60 million of tax abatements have accrued to the Partnership.5 Finally, the Percentage Rental payable annually by the Partnership is equal to stated percentages of the Hotel's lease year (now calendar year) profits {see Lease sec. The percentages are as follows: a) 10% of the first $500,000 of Profits; 12-17?207?0 Of the next $1,000,000 of Profits; c) 15% of the next $1,000,000 of Profits; d} 20% of the next $1,000,000 of Profits; e} 30% of the next $1,000,000 of Profits; f) 40% of the next $1,000,000 of Profits; aHere and throughout this report, we refer to Lease payments as money owed the City, rather than UDC, since the City is the ultimate payee, and UDC acts only as its collecting agent. 5The full tax liability for the period (with increases phased in over five years) would have been as follows: 1978-79: $1,531,250; 1979-80: $1,400,000; 1980-81: $2,275,000; 1981-82: $6,041,250; 1982-83: $6,273,450; 1983?84: $6,293,025; 1984- 85, 1985-86, 1986?87, and 1987?88: $6,385,500; 1988-89: $6,467,850; and 1989-90: $6,524,676. -4- DAG Report GHYSA November 21, 1989 g) 50% of any additional Profits profits over $5.5 million} The definitions of ?profits' and other terms related to calculation of Percentage Rental are set forth in Exhibit of the Lease. The aggregate of the TEF and Percentage Rental payable for any year is not to exceed full tax equivalency. Thus, from calendar year 2020 onward, Percentage Rental will no longer be payable. Percentage Rental is payable within 90 days after the close of the lease (calendar) year (Lease sec. 4.9.2). With its annual payment, the Partnership must also submit a CPA-certified statement "reasonably acceptable to landlord showing the amount of profits for said period prepared in accordance with generally accepted accounting principles consistently applied." (Lease sec. Lease sec. 4.9.5. requires the Partnership to: keep and maintain in the Demised Premises or in the City of New York, full and accurate books of account and records from which Profits for each lease year during the term can be determined. Such records shall be so kept and maintained for at least two (2) years after the end of the period in question. Pursuant to Lease sec. 4.9.6., UDC or its agent has the right for a period of two years after the close of any lease year: to inspect and audit all such books and records and all other papers and files of Tenant lyiz., the Partnership]. Tenant shall produce same on request of Landlord or Landlord's agent. . ~5'n OAG Report GHYBA November 21, 1989 Audit Scone, Methodology and Related Matters Before audit scope and methodology can be detailed, two matters which significantly influenced them must be discussed: 1) the Partnership?s refusal to make available to us certain records and accounts, and its failure to produce others which it was legally obliged to provide; and 2} the Partnership?s retroactive adoption in 1987 of several changes in accounting policy,6 the effect of which was to reduce its 1986 Percentage Rental payment by 80 percent (or over $2.6 millionlfr Moreover, we found that the Partnership?s accountants, Laventhol 8; Horwath initially calculated the Percentage Rental owed for 1986 as $3.3 million {virtually the same amount we calculate here), instead of the $677,155 actually paid, but revised their calculations several times: first to incorporate two changes, one of which--according to L&H--was authorized by the Partnership?s attorneys, and which together reduced Percentage Rental by $1.1 million; and again, in response to the Partnership?s request that L8H find ways to reduce payments to the City and to tax authorities. In fact. revised its calculations at least three times before its final report was submitted, over a month late, in May of 1987. In addition to the earlier changes, the final submission reflects four changes in capitalization policy formally authorized by Donald Trump and Refco, which reduce Percentage Rental by another $1.2 million. Despite the substantial impacr. of these capitalization changes, none is disclosed, either as notes to the schedule or in accompanying auditor's report. The report itself-- even more curiously--is dated January 29, 1987, although it was submitted in May and reflects changes authorized by the Partnership in late April. Generally accepted auditing standards provide that the date of an auditor's report "establishes the end of the period for which an auditor takes responsibility for events occurring after the end of the fiscal year.?8 The partnership?s retroactive adoption of new accounting policies and Ne BAH but one of the accounting changes was made retroactive to January 1. 1986; the remaining adjustment was made retroactive to January 1, 1982. Neither the Partnership?s nor the Hotel's 1986 certified financial statements reflect these changes; the adjustments were made solely for Percentage Rental purposes. aSee, Sullivan et al.. Montgomery?s Auditing, 10th ed., John Wiley 8: Sons, York, 1985, at p. 820. See also, Statement on Auditing Standards (SAS) in No. -5- OAG Report GI-IYSA November 21. 1989 resulting recalculations constitute subsequent events requiring disclosure,_ and hence the report should have been either redated or dual dated. A. Access to Records and Accounts By letters dated May 20, 1987, and June 1. 198? (attached hereto as appendices and the City??acting through DRP-?requested UDC to exercise its rights under the Lease to "inspect and audit all books, documents and records related to the Annual payment of Percentage Rent" for lease years 1986 and 1985. The City further stated its intention-4f UDC did not so act?-to exercise its own right, as third-party beneficiaryI to enforce Lease sec. 4.9.6 and conduct the audit. By letter dated June 4, 1987 (see Appendix E), UDC notified the Hotel of the City?s intention to audit books and records relating to 1985 and 1988; copies of DRP's May 29 and June 1 letters were attached. No response to this communication was received either by UDC or DRP. On March 11, 1988. DRP corresponded direcrly with the Hotel, notifying it that the GAO would be conducting the audit relating to 1985 and 1988; identifying the members of the audit team: specifying the books, records and other documents that would be reviewed; requesting that an audit liaison formally be designated; and confirming that the audit team would visit the Hotel on March 14. 1988. for the purpose of conducting an initial survey (see Appendix F). By letter dated March 18, 1988 I{Appendix G1, the Hotel?s Controller wrote to DRP, informing it that Hotel staff had met with the GAO team on March 15, 1988; that Mr. Merrill Matsuda had been appointed audit liaison; and that another meeting would be held at the Hotel on March 23, conduct a of the hotel to familiarize the Auditor General's staff with hotel operations. policies and procedures and information flow." Other matters--the letter continues--would also be discussed on the 23rd1 so that the Hotel could "providlel the audit team with the accommodations and information needed in a timely manner." On April 13, 1988--the day before the audit team was scheduled to begin the on-site fieldwork phase of the review?-the Partnership?s lawyers (Dreyer and Traubl called DRP to say that the Partnership declined the City?s request-?and denied its power-?to conduct an audit (see Appendix H). Only UDC, the Partnership maintained, had the right to audit under the Lease and its rights could not be delegated to the City; moreover, it argued, the time limit for auditing 1985 books and records had expired. vaud- wMaz- .. .. GAO Report GHYSA November 21, 1989 However, the Lease provides that UDC jg agent may conduct an audit. - And, by the terms of the Project Agreement between UDC and the City, as well as the Three Party Agreement among the City, UDC and the Partnership, the City-?as third-party beneficiary {see sec. 3 of the Project Agreementl??has the independent power to enforce UDC's rights under the Lease. The June 4, 1987 letter from UDC to the Hotel--which referenced and attached the May 20 and June 1, 198?, letters from DRP to provided ample notice to the Partnership that the City--in accordance with its rights under the Lease and the Project and Three Party Agreements" was acting in stead and with its knowledge, approval and authorization. The contention that the time had expired to audit 1985 records and accounts is, we believe, similarly inapt. Again, UDC provided notice well within the Lease limitations. Moreover, as mentioned above, the Partnership adopted in 198':r a retroactive change in accounting policy which adjusted the previously reported 1985 accounts. Neither nor the City had notice of this change until May, 1987, when the Partnership not only submitted its 1986 statements and payment (several weeks late} but also allowed itself a recoupment of amounts previously paid for 1982- 85. This unilateral action??without prior notice or approval--must be deemed to have renewed the City?s audit rights. Indeed, unless that is so the audit right is rendered utterly nugatory, since the Partnership would be free to adjust its accounts for prior years and retroactively reduce its Percentage Rental, without recourse or review by UDC or the City. Moreover, in addition to denying us access to 1985 books and records for the purpose of verifying the payment of Percentage Rental for tha_t year, the Partnership also denied us??improperlyg--access to 1985 documents for the purpose of verifying the Percentage Rental payment for 1988. The effect of the Partnership?s objections was to delay by four months Our commencement of fieldwork at the Hotel.m Nor did our difficulties cease upon gaining entry. In September, 1988, informed us that the 9Generally Accepted Auditing Standards require comparison of current balances with prior years? balances. had been due to begin on April 14, 1988, but did not receive the Partnership?s permission to review even 1988 books and records until early July; by that time, our entry could not be rescheduled until August. -3- 9. wasp?av .-- . Iw*wwu aubu? alas h. .ww- .mguq .0 1 OAG Report GHYBA November 21, 19813 Partnership?s lawyers had instructed them not to allow us to review their' working papers. (Such review is not a right of auditors, but a courtesy extended to them so that they may determine whether-?and to what extent-?they may rely on the results and, in particular, on their evaluation of internal controls.) Nevertheless, offered to make selected papers available to us, and we did review and (to the extent noted below) rely on that documentation. More significant, in light of Lease requirements,H was the quantity of 1988 documentation that the Hotel-~for one reason or anather?-could not or did not provide. In September, 1988, the Hotel informed us that it could not locate seven of the twelve general ledgers,12 because they "were discarded after they were severely damaged by water when the room in which they were stored was flooded.? (Letter dated October 1988, from Hyatt?s Controller to the Auditor General.) Since these records are maintained on a computerized system, we requested that the ledgers be reproduced from tapes kept in the Chicago office; the Assistant Controller informed us, however, that the Chicago office no longer had the tapes. Eventually (not until December, 1988] the December ledger-?containing summary information for the prior eleven months--was located at the Hotel?s storage site in New Jersey.13 We determined the summaries would be sufficient for our purpose, although their use entailed substantial additional labor to reconstruct the details of the transaCtions. In December, 1988, we were told the Hotel could not locate five of its twelve detailed ledgers for 1986. Two of the five were later found, but the remaining three were never located and could not be replicated due to changes in the Hotel?s computerized recordkeeping system. We therefore had to reconstruct them from daily batch documents-an extraordinary and extremely time-consuming procedure. 1?ISee the text of Lease sec. 4.9.5, at p. 5 above. 12The missing general ledgers were for January, February, August, September, October, November and December. 13Lease sec. 4.9.5 states that lease year records must?-until two years after the end of the year in question??be kept and maintained the Demised Premises or in the City of New York." Transfer to the New Jersey site was thus premature. -9- ?bib .1 a? cub? W~ww un\ Wuhan..- . OAG Report GHYBA November 21, [989 In addition, the Hotel said it had lost 25 of the B7 requested income-- journals, and could not locate them either on the Hotel premises or at the New Jersey storage site. Moreover, cash register tapes and guest checks supporting food and beverage revenue had been {not by accident, but in accordance with a Hotel policy violating Lease sec. 4.9.5) discarded at year-end; thus, we could not vouch food and beverage revenue. Finally, the Hotel could not provide one of five requested payroll cycles, or 26 of 84 requested expense vouchers.14 Many supporting documents-? including some revenue and all payroll records??are microfilmed by the Hotel; the source documents are then discarded. The missing microfilmed payroll cycle could not be reproduced, therefore, since the source documents had been thrown out. Moreover, the microfilm data we reviewed were, for the most part, illegible and the reels we examined were not arranged in sequential order. Both the Partnership?s resistance to our review and the Hotel's lapses in recordkeeping had substantial impact upon our inquiry?s scope and methodology. B. Changes in Accounting Policies As mentioned above, the Partnership?s accountants initially??in working papers dated February 4, 1987--calculated the Percentage Rental owed for 1986 as approximately $3.3 million. Between that date and the date in May when its final Report eventually was submitted {several weeks late), revised its working papers and calculations at least three times. First, in working papers dated February 5, 1987, incorporated two adjustments which--we were told been authorized by the Partnership?s attorneys: l} accounting for revenues was changed to the cash basis (while accounting for expenses continued on the accrual basis); and 2) debt service was increased to include two condemnation awards (totalling $575,896) received by the Partnership. The combined effect of the two adjustments was to reduce Percentage Rental by $1.1 million {from $3.3 million to $2.2 million). H"Although the Hotel claimed it had given us the 26 vouchers, we have no record of ever receiving them. -10- - .. . d. u. ?amewd?-?mh. 54". scum A OAG Report GHYBA November 21, 1983 Next, in response to the Partnership?s "request for any connection with potential cash savings which might be possible for tax and UDC purposes," in a letter dated March 25, 1987, proposed five additional accounting changesI four of which were changes in capitalization policy (see Appendix BII Exhibit A third set of working papers--also dated March 25, 1987-?demonstrates the effect of adopting the four new capitalization policies:1S Over $4 million dollars (or 51%} of the Hotel's $7.97 million dollars of capital expenditures for 1986 would be expensed rather than capitalized. This compares with $24,825 {or that would have been expensed under the prior capitalization policy. as calculated by the GAO. By letters dated April 20 and April 22 respectively (attached hereto as Appendix B, Exhibits 2 and 4), Refco?s Vice PresidentiTreasurer and Donald Trump formally authorized adoption of a set of changes in capitalization policy based upon suggestions. Two of proposals were adopted unamended; the ?de minimus? policy was revised by adopting a $250 per item cut?off and by eliminating the ?per invoice' exemption. A fourth changeI not proposed in letter-?reduction of the lives of furniture. furnishings and equipment from eight or more years to six years~ -was also adopted. The third set of recalculations is in the form of handwritten revisions to its March 25 working papers. These reverse some of the typewritten adjustments and apparently are intended to effectuate the Partnership?s authorized changes. {Errors and inconsistencies are nevertheless apparent.)I The final result is to allow $2.758 million (or 35%) of 1986 capital expenditures to be expensed. This is 105 times (10.500941) the amount that would have been expensed under the prior capitalization policy.15 The final Percentage Rental statement submitted to the City incorporates the accounting changes allegedly authorized by the Partnership?s attorneys, as well as the capitalization policy changes adopted by the Partners in late T5The working papers utilize the higher of two sets of numbers proposed: viz., a $500 per item and a $2000 per invoice ?de minimus? policy, rather than $250 and $1000, respectively. 1?lnterestingly, the Partnership's 1986 certified financial statement??prepared in accordance with generally accepted accounting principles--does not expense any of the $2.758 million. -11- on . uh I Wm OAG Report GHYBA November 21, 198%: April. In addition, the statement allows a credit of $370,923, to reflect a' retroactive change from the accrual to the cash basis of accounting for revenues, applied to the years 19824935. As a result of all these changes. Percentage Rental is reduced from the $3.289 million shown in initial working papers to $677,155. This chronology raises questions as to the prepriety of: ll the substance of the polices adopted: 2) the timing of their adoption; and 3) the manner of their adoption. The fact that the changes were implemented for the purpose of reducing payments to the City does not, alone, invalidate them. Scrutiny is required, however, to assure that the changes conform to applicable requirements--here, generally accepted accounting principles (GAAP), unless otherwise provided by the Lease. As regards timing: The changes were not apparently initiated by in the ordinary course of updating accounting policies; had that been the case, the changes would most likely have been suggested on a prospective basis. Instead, revisions were prompted by the Partnership?s request that the accountants reduce rental payments for the year already concluded. Most significantly, the changes in capitalization policy (and perhaps the other revisions as well) were not authorized by the Partnership until several weeks ire; its payment to the City was already overdue.? Regarding the manner of adoption: None of the changes in capitalization policy--despite their $1.2 million impact on Percentage Rental-?was disclosed in the Percentage Rental statement or by in its repert. Moreover, dating of its report (with a date that precedes all the 1?Ely letter dated March 26, 1987 (the day after letter responding to the Partnership?s request for means of reducing the Percentage Rental payment), the Hotel?s Controller wrote to UDC to request an extension for submission of its Percentage Rental Payment and statement, from March 31 to April 30. The letter was forwarded by UDC to DRP on April 13, 1987. Since had by February 4, 1987 calculated the Percentage Rental due on the basis of the Partnership's previous accounting policies, the extension apparently was requested for the sole purpose of adopting new policies to reduce the Percentage Rental payment. -12- OAG Report GHYBA November 21, 1983 accounting changes and recalculations discussed abovelm runs counter to' standard auditing practice, according to which the appropriate date of an auditor?s report is "the date when the auditor and the client executives agree, usually in a 'cIearance conference?, on the amounts and other disclosures to be included."19 In a case such as this, where events and procedures subsequent to preparation of the Hotel and Partnership financial statements materially affect the Percentage Rental statement, the auditor normally would ?duai date' its report, disclosing the specific events and/or procedures to which the second date applies. Such practice makes clear that the auditor does not accept responsibility for (and the report does not reflect) events or procedures materially affecting the statement which occur after the earlier date, for those set forth. C. Audit Scope and Methodology We conducted our audit of the Grand Hyatt?s results of operations for the year ended December 31, 1986 in accordance with Generally Accepted Auditing Standards, and performed such reviews of systems and procedures, and such tests of records, as we considered necessary. The primary objective was to verify the accuracy and propriety of the Percentage Rental payment made by the Partnership to the City (through for calendar year 1986. Our compliance testing of the adequacy of the Hotel's internal controls included a review of Lani-Vs working papers documenting their internal control tests, as well as supplemental substantive tests of selected revenue and expense accounts. As mentioned above, the Hotel and Partnership recognize revenues on the accrual basis li.e., when they are earned, regardless of when payment is received) for purposes of financial statement preparation; this practice accords with GAAP. However, for the purpose of calculating Percentage Rental, the Partnership in 1987 began retroactively recognizing revenues on the cash basis lie. when cash is actually received by the Hotel). 15[The date used--January 29, 1987?-was the date completed field work for the Hotel and Partnership financial statements. The accounting changes here at issue were not made on either of those statements. 19Sullivan et al., pp. c_it., at pp. 820-21. -13- OAG Report GHYSA November 21, 1989 Expenses are recognized by the Hotel and Partnership on the accrual basis' when they are incurred, regardless of when they are paid} for financial statement and Percentage Rental purposes. All expenditUres to 7 be made by the Hotel are sent to the Hyatt Corporate Office in Chicago, where checks are processed, signed and forwarded to New York. We limited our review of revenue items to the two sources accounting for 94% of the Hotel?s total gross revenue reported for 1986: room revenue of $52,829,531 and food and beverage revenue of $22,204,858 To determine the reasonableness of room revenue as reported on the financial statements, we drew a sample from the population using a 95% confidence level with a 5% expected rate of occurrence and a precision level. We then selected the sample items at random, using a Random Number Table. Using the sample items selected, we traced the amounts in the source documents to the general ledgers. As stated earlier, we could not vouch the food and beverage (F813) revenue, since the source documents (cash register tapes and guest checks} had been discarded. As an alternative procedure, we performed an analytical review,? comparing 1986 and 198? 17:51:13 revenues. We could not use 1985 figures, because the Partnership denied us access to those records. To test the reasonableness of reported expenses, we scanned the expense accounts and judgmentaily identified those that could have been affected by the Partnership's revised capitalization policy, adopted in 1987 retroactive to January 1, 1986. We performed substantive tests on those accounts using the same sampling and testing procedures used to analyze room revenue (see above}. For those expense accounts not affected by the new capitalization policy, we limited our tests of reasonableness using analytical judgmental} procedures. To verify the validity and accuracy of the Partnership?s adjustments, we: 20Analytical methods are comparisons of recorded amounts {or ratios drawn from recorded amounts) with the auditor?s expectations (based on judgment}. They are an acceptable substitute for substantive tests (see Statement 011 Audit Standards No. 56). -14- ?o ?VA?mu OAG Report GHYSA November 21, 1989 I) examined the text of the Lease, Management Agreement and other- relevant documents, as well as 2) obtained or prepared a analysis of each adjustment; and 3) vouched the amount of each item in the detailed analyses, by tracing back to the supporting documentation. Our Draft Report, dated August 16, 1989, was submitted to the Partnership and its attorneys for their review and written response. An exit conference, at which the Partnership was represented by its attorney and by the Hotel?s Controller, was held at the offices of Dreyer and Traub on August 24, 1989. The Partnership declined the opportunity to respond in writing to the instead it submitted to UDC a response and cover letter signed by the Hotel?s Controller, 3 copy of which was provided to the DAG. We excerpt in the following pages relevant portions of the Partnership?s response to UDC, followed-~where appropriate-43y a brief reply. The entire Partnership response and cover letter are attached to this Report as Appendix I. -15- 4? OAG Report GHYSA [11. November 21, 1983 Findings and Recommendations . I. For the purpose of determining Percentage Rental, the Partnershi improperly accounted for the Hotel?s revenues on the cash basis. while it continued to account for expenses on the accrual basis. For purposes of financial statement preparation, the Hotel and Partnership?-in conformity with GAAP~-account for Hotel revenues and expenditures on the accrual basis. For five years, the Partnership followed the same procedure to calculate Percentage Rental payments. In 1987, however, without prior notice to, or acquiescence by, the City, the Partnership retroactively adopted?-solely for the purpose of determining Percentage Rental--an accounting ?methodology? that is both aberrant and distortive: revenues were accounted for on the cash basis, while expenses continued to be accounted for on the accrual basis. This mixed method not only is inconsistent with generally accepted accounting principles it also violates their most fundamental premises. Revenues and expenses are mismatched, and thus one cannot--hy setting them off against one another-?accurately derive profits. (Percentage Rental is defined in terms of profits; see Lease sec. 4.9.1 and Lease Exhibit F.) The inevitable effect of this practice is to understate revenues relative to expenses, thereby reducing net profit. This result is consonant with that of the other accounting changes adopted by the Partnership in 1987': it postpones {potentially indefinitely) the payment of portions of Percentage Rental. In this case, the amount postponed grows with the accounts receivable balance; thus, ironically, when--as in 1986-?revenues increase and collections do not keep pace, the amount deferred also increases. As justification for its accounting practice {we know of no other instance of revenues and expenses being accounted for on different bases), the Partnership relies on certain language in Lease Exhibit F. As noted above, the Lease defines Percentage Rental in terms of ?profits?. Exhibit defines ?profits? as amount by which Gross Income in any Lease year exceeds Expenses for such Lease year." And, whereas Expenses are defined in Exhibit as "the aggregate amount of any incurred by in any Lease year" (emphasis added)--which language dictates the accrual basis-~Gross Income is defined as "the aggregate amount of monies actually received by Tenant in any Lease Year for goods, services rendered or merchandise language would seem to dictate the cash basis. -15- . OAG Report GHYBA November 21, 1989 We readily agree thats-looking at this language alone-~one is faced with - ambiguity as to whether the accrual or the cash basis is to be applied: However: i) it is not an acceptable resolution of this ambiguity to employ one basis for revenues and another for expenses; 2} other provisions of the Lease and the Exhibit make plain that the accrual basis is intended; and 3) the Partnership?s five?year course of conduct??refiecting, as it does, the mutual understanding of the parties to the Lease?corroborates the fact that the accrual method was to be utilized. Regarding point one: We can find Qt; support for such mixed treatment in any known accounting text or manual, or in any source whatsoever; we know of no other instance in which such a practice has been either followed or countenanced. Point two: Lease sec. 4.9.4 requires the Partnership to submit each year in support of its Percentage Rental payment statement certified by an independent Certified Public Accountant reasonably acceptable to Landlord showing the amount of Profits for such period prepared i_n accordance with generally accepted accounting principles consistently applied." (Emphasis added.) GAAP mandate use of the accrual method; "consistent application" (see Cited text) forbids a change from an acceptable accounting method (here, the accrual} to an unacceptable method (here, the ?mixed?l. Moreover, Exhibit defines the accounting principles to be used for purposes of determining Percentage Rental as follows: In determining Gross income, Expenses, Excluded Receipts and Excluded Expenses, Landlord and Tenant agree that the Uniform System of Accounts for Hotels dated 1971, adopted by the American Hotel and Motel Association, as such system may be subsequently revised, shall be utilized to the extent such system is not inconsistent with the provisions hereof. The Uniform System of Accounting for Hotels (USAH, 8th revised edition, 1986} presumes and is predicated upon adherence to GAAP and the accrual method. Regarding the specific question here at issue, it states: it should be noted that there are comprehensive bases of accounting other than generally accepted accounting principles under which financial statements can be -17- OAG Report GHYSA November 21, 1989 prepared. Examples include the cash basis and income tax basis. While the usefulness of such statements is recognized, the principles and practices relating 13 their preparation g5 beyond th_e scepe o_f t_hj? book. (Uniform System of Accounts for Hotels, p.1; emphasis addedJ Thus, to establish--as exhibit does--the USAH as the standard of practice is-?ipso facto--to adopt the accrual basis required by GAAP. Exhibit F?s qualification that the USAH shall be utilized "to the extent such system is not inconsistent with the provisions hereof? must be read as applying to the treatment of specific items?31 rather than to the underlying accounting basis employed. Otherwise, it would be nonsense for the Lease to establish the USAH as the relevant standard of practice, since even consistent use of the cash basis?to say nothing of the Partnership?s mixed method~~is by definition "outside the scope" of that system. if the Lease?s drafters had intended such a radical departure from GAAP {in violation of Lease sec. from USAH, the designated standard of practice [in violation of the definition of ?accounting principles']; and from common sense, an unequivocal expression of that intent would surely be manifest. Point three: For five years, the Partnership employed the accrual basis for both revenues and expenses in determining Percentage Rental. In 1987-- at the same time that it adopted a menu of other accounting adjustments for the sole stated purpose of reducing rental payments to the City and tax payments to government authorities??it also adopted, without notice to UDC or the City, the mixture of accounting bases here at issue, whose effect was identical. The new treatment contradicts the Partnership's prior, long-standing practice, as well as the mutual understanding of the parties. The change to the cash basis to account for revenues resulted in reduction of net profit for 1986 of $1,571,596. The Partnership, in addition, reduced the Percentage Rental payable for 1986 by $370,923 to reflect the cumulative effect of the change from January 1, 1982 through December 31, 1985. The combined effect of the two adjustments was to reduce Percentage Rental for 1986 by $1,112,491. 21For example, the definition of Debt Service. -13- OAG Report GHYBA November 21, 1989 Recommendations 3. Disallow the reduction from net profit of $1,571,596 by restating the Hotel's revenue on the accrual basis. b. Reverse the $370,923 adjustment reflecting the cumulative effect of the change to the cash basis for 1982 through 1985. Partnership Response: matter how unconventional the may be. it is the formula mandated in the Lease for such purpose. The use of any other formula would be a deviation from the plain requirements of the Lease.? Reply: To state that the Lease "mandates" use of the mixed method is to give controlling force to the two words while ignoring entirely the words of Lease sec. 4.9.4; Lease exhibit F?s definition of Accounting Principles; the substance of the accounting principles expressly adopted by the Lease; and the five-year prior course of conduct by both parties to the Lease. If the meaning of the Lease??and the consensus of the parties?is. indeed, clear and undisputable" (Appendix 1. it is difficult to understand why the Partnership consistently utilized the accrual method for the five previous years. 2. The Partnership's April. 1987 changes in capitalization policy?-made retroactive to lanuaryr l. 1986??resulted in expensianr of items that must be capitalized. As detailed above. the Partnership in late April of 1987 (almost a month after its payment and certified statement for the prior fiscal year had become due) adopted four changes in capitalization policy, solely for Percentage Rental purposes. Three of the four changes permit expensing of normally capitalized items; the fourth (discussed separately as Finding 4. below) reduces the lives of capitalized furniture. furnishings and equipment from eight or more years to six years. The first three of the new policies are as follows (see Appendix B. Exhibits 2?and 4): l. Purchases of furniture. furnishings and equipment having an individual item cost of less than $250 shall be expensed. _19_ DAG Report GHYBA November 21, 1989 2. Certain items which normally have a life of greater than one year but less than five years and which are in the nature of replacement and recurring each year shall be expensed. Recurring, for this purpose, means that each year certain of these items are bought and used as replacement on a rather continuous basis. These items include, but are not limited to, bedspreads, draperies, carpeting, wall covering, window shades and painting. 3. Labor utilized in the delivery andfor installation of furniture, furnishings and equipment which does not produce a significant enhancement of the property shall be expensed. As a result of these retroactive changes, an additional $2,758,194 of capital expenditures was instead charged against operating income, thereby reducing net profit by the same amount; Percentage Rental was correspondingly reduced by almost $1.38 million. All of the above modifications run counter to GAAP and to the treatment specified in the Uniform System of Accounts for Hotels, which serve as the applicable standards for purposes of calculating Percentage Rental under the Lease. The expenditures in question?-virtually all of which were related to the Hotel?s 1986 renovation-?were for fixed assets providing benefits for more than one accounting period more than one year). The cost of such assets--as stated in Accounting Principles Board Statement No. allocated to the periods in a systematic and rational The allocation method used should appear reasonable to an unbiased observer and should be followed systematically."32 Normally, these items would be shown as assets in the Furniture, Furnishings and Equipment account and be depreciated over their useful lives; each year, only the amount of applicable depreciation would be expensed. It is accepted practice to apply a ?de minimus' policy to capital purchases, thereby exempting from capitalization requirements items whose individual value is small and whose aggregate value does not have a material impact upon the amount capitalized. (A standard criterion of materiality is 22Accounting Principles Board, Basic Concepts Accounting Principles mm Statements g_f Business Enterprises, APB Statement No. 4 (New York: AICPA, OCTOBER, 1970), par. 159, pp. 61-62. -20- . . OAG Report GHYBA Nevember 21, 1988 anything over 1% of the quantity being measured?-here, 1% of $7.97' million, or The fundamental point, however, is that materiality is based upon the aggregate value of all exempted items: Acquisitions of small dollar value items, with a cost of less than $200, for example, may be routinely expensed even though the item may be properly capitalizable. Such a policy is followed to reduce the clerical effort involved in maintaining detailed records for many small dollar value items. Materiality, however, should be determined on the basis of the aggregate of these small dollar items rather than on the basis of each individual acquisition. Otherwise, a department that is authorized to purchase and expense components below the $200 limit could purchase components as replacement parts and use them to construct an asset at a cost of $2,000 that would not have been approved.23 Under the Partnership?s prior capitalization policy, items costing less than fifty dollars were expensed, as well as groups of several items purchased together whose cumulative value was not significant. Applying that policy. $24,825 {or of the Hotel?s $7.97 million of capital purchases would have been expensed-?an amount falling within the 1% test of materiality}: Had the Partnership increased the ?de minimus? dollar value to $250--as it did-~but also retained a materiality limitation, the 1% level still would not have been breached. In fact, we applied the following ?de minimus? policy- -incorporating the Partnership?s $250 cut?off, a common form of materiality limitation--to the Hotel's 1986 capital purchases: A capital expenditure is a fixed asset with a useful life of more than one year and a cost of at least $250; or a group of similar such items with a minimum total group cost of $1000 and either a minimum unit cost of $100 or a useful life of at least three years. The effect of this hypothetical policy is to allow unlimited aggregation only if the unit cost of a group of items is less than $100 am; if the useful lives of the items is less than three years. The result of applying this 23Sullivan et al., pp. c_it., at p. 709. a I . 2 We note, however, that in the Partnership?s 1986 certified flnanCIal statement??prepared in accordance with GAAP--none of its capital acquisitions is expense?d. -21- DAG Report GHYBA November 21, 1981: policy to the Hotel?s 1986 capital purchases is to increase the value of expensed items from approximately $25,000 to approximately $52,000uan' amount still within the 1% materiality limitation. instead, however, the Partnership applied n_q materiality limitation. As a result, purchases of items costing, $252,718.77; $128,507.03; and $92,057.73 were expensed. Overall, 35% of total 1986 Capital purchases were expensed; that is 105 times more than the amount that would have been expensed under the Partnership?s prior capitalization policy. and 50 times more than would have been expensed under the hypothetical policy above. The Partnership?s second policy change?allowing expensing of FREE items with lives of less than five25 years, on the ground that a portion is replaced every year-~is also unjustified. These items were purchased as part of the Hotel?s first renovation since its opening in late 1980.?26 The Uniform System of Accounts for Hotels expressly provides that furnishings of the type at issue--i.e., drapes, carpets, etc.??are carried as assets in the Property and Equipment account}? Property operation and maintenance expenses include only repair of curtains, draperies and other furnishings. There is no provision for converting to profit and loss the purchase or replacement of these items. Indeed, The Partnership's designation of these items as ?replacements? constitutes precisely the sort of circumvention of GAAP referred to by Sullivan et al. in the last sentence of the quotation cited above, at p. 21. Similarly, the third policy change?-which exempts certain labor costs from normal capitalization requirements-?contravenes a guiding principle of expenditure classification, that "expenditures made to place a fixed 25In fact, the Partnership expensed items with 8?year and 20?year lives as well. 26The separately allowed expense of $4.1 million for repairs and maintenance included certain replacement items, such as mirrors, etc., not purchased as part of the renovation. Zia Uniform ?ystem _o_f Accounts Hotels, 3th revised edition, New York, 1986, p. 17. -22- OAG Report GHYBA November 21, 1989 asset in condition, in position, and ready for use, should be capitalized.?2?" The labor costs in question?-incurred to move FREE in and out, and otherwise prepare affected areas for the installation of the new purchases? ~fall squarely within this rule. Finally, none of the above changes in capitalization policy was authorized by the Partnership until several weeks after its 1986 Percentage Rental payment and statement had become due. On that ground alone, we do not believe they are sustainable. Despite the breadth of these changes, and their substantial impact upon the Percentage Rental paid, no notice was given to UDC or the City of their adoption. Neither the auditor?s report nor the Percentage Rental schedule disclosed the substance of the changes or even the fact that changes had been made; only the bare constituted depreciation was provided. This silence violates the provisions of the Uniform System of Accounts for Hotels, which state: "[Tlhe accounting methods used to depreciate and amortize property and equipment should be disclosed in notes to the financial and policies footnotes should be followed by such additional notes as are necessary to provide for full disclosure of all significant events or conditions reflected in the financial USAH gives, as the first example of such disclosures, "changes in accoonting methods."30 The fact that the Percentage Rental statement is a special?purpose report does not exempt the Partnership or from these reqoirements. Statement on Auditing Standards No. 14, (Interpretation of sec. 621), the then controlling provision,? read: The extent to which the special-purpose financial statement differs from a complete financial statement should be limited to that necessary to meet the special purpose for which the presentation 2E'James H. Russell and William W. Frasure, Financial Acgounting Concept Charles E. Merrill Books, lnc., Columbus, Ohio, p. 136. p. 17. ?out, p. 14. 31Effective July 1, 1989, SAS No. 14 was superseded by SAS No. 62. The new Provision did not amend the disclosure requirements cited. -23- . OAG Report GHYBA November 21, 1989 was prepared and, accordingly, in all other respects. including? matters of informative disclosures, generally accented accounting principles should be followed. {Emphasis added.) Recommendations a. Restore to the FREE account the $2,733,369 of capital items improperly expensed as a result of the Partnership?s changes in accounting policy. b. Allow additional depreciation on for the above capital items (see Finding 3, below). c. Require, pursuant to Lease sec. 4.9.4, that the auditor's report on the Percentage Rental statement: 1} certify that the statement is prepared in accordance with generally accepted accounting principles except where otherwise required by specific Lease provisions; and 2) disclose all accounting policies and treatments not in accordance with GAAP that have been utilized to arrive at Percentage Rental. Partnership Response; "The changes implemented in 1985 changes in accounting policy at all, but rather an update of the threshold criteria selected to serve as the standards for determining which acquisitions fall within and without the ?de minimus' Reply: We cite the letters of Refco?s Vice President/Treasurer and of Donald Trump {dated April 20 and April 22, respectively) authorizing adoption of "revised accounting policies." Similarly Lani-I, in its letter of March 25, 1987, refers to its proposed changes as accounting "policies." (See Appendix B, Exhibits Partnership Response: "[Ulnlilte the anachronistic $50 per item threshold used in prior years, the $250 per item test (constituting .000005 of the gross operating income of the Hotel) was sufficiently high to be useful in identifying those items whose costs were too inconsequential for capitalization, but yet not so high that the aggregate value of the items costing under such amount would likely be substantial." OAgi Reply: The Partnership?s response might hear some relationship to reality if, under its policy, only individual purchases of items costing under -24- OAG Report GHYBA November 21, 1981-} $250 had been expensed. (Although the ratio of $250 to the Hotel?s gross? operating income would, in any event, have no relevance.) In reality, however, it; limit on aggregation was imposed; individual purchases of hundreds of thousands of dollars were expensed; and, in total, 35% {and about $3 million) of capital items were written off. That amount is indeed "substantial"; and a policy permitting such a result cannot be considered ?de minimus?. Partnership Response: "Him a by Laventhol 8; Horwath, 14 of the 17 major New York City hotels surveyed that have a fixed ?de minimus? capitalization policy reported that they had adopted guidelines generally calling for the expensing of acquisitions costing $250 or less per item (one selected a $500 per item ?de minimus? threshold, while two selected a $100 per item thresholdl." gag Reply: Since neither the questions asked nor the responses received have been provided. we cannot comment upon the accuracy or significance of ?survey?. We think it extremely unlikely, however, that the 14 hotels referred to failed to incorporate any materiality test or aggregation limit into their policies. Without that information, the survey is meaningless. Of ultimate significance is not whether the amount chosen is $50, $100, $250 or $500, but whether as applied the policy exempts a material amount of capital expenditures from normal accounting treatment. Perhaps the critical question, however, is this: if these changes in capitalization policy were-?as the Partnership maintains?-perfectly consistent with GAAP, why were they applied only to the Partnership?s Percentage Rental statement, and not to its regular financial statement, which certifies as being in accordance with The Partnership had, in fact, capitalization policies in the same year: one it applied to its financial statements {and to Hotel operations for purposes of calculating the management fee) and one it applied to its Percentage Rental statement. But in matters of capitalization policy, the Percentage Rental statement must??by the terms of the Lease?vbe prepared in accordance with GAAP. We therefore see no justification for the divergence in treatment. Partnership Response: The "soacalled ?changes in accounting policy? avoid the administrative nightmare that would result if such items were capitalized and depreciated, requiring [the managing agent] to track the -25- OAG Report GHYBA November 21, 1989 acquisition, use and disposal of a large quantity of relatively inexpensive? or short-lived, regularly replaced items." Reply: There is no ?administrative tracking nightmare', because the Hotel has adepted the half?year convention. As a result, items purchased or disposed of in any year are presumed to have been so purchased or retired at mid?year. The only information to be recorded is that which, in any event, would be kept: the cost of the items, their service lives and their salvage value. Partnership Response: "lTlhe decision to write off in the year of acquisition that portion of the Hotel?s Stock of items having a useful life of three years or less that required replacement in such year cannot result in a significant distortion of the operating results of the Hotel for such Assuming the level consumption of these items, one third of the Hotel?s stock of the same would require replacement in each year, rendering the treatment of these items as either capital acquisitions or acquisitions to be expensed identical with respect to each year." Reply: We note, as an initial matter, that the Partnership?s poliCy is to write off all such items with a useful life of less than fi_ve years {see Appendix B, Exhibit 2). Despite that policy, the Partnership also expensed items with 8-year and 20?year lives. The contention that the treatment of these items as capital or expense is identical ignores three facts: 1) consumption is [lot level; 2) inflation; and 3) the windfall in the first several years after transition to this policy. Thus, the three-year items purchased in 1985 totalled $1,075,143; one third of that amount ($385,381) was expensed in 1986 (as well as 1/3 of the three?year capital items purchased in 1984 and 1/6??using the half?year conventionnof such items purchased in 1983). In addition, three-year items purchased in 1986 (totalling $1,515,943, and thereby disproving the theory of level consumption) were expensed i_n m. According to the Partnership's past practice (and its concurrent practice for purposes of its financial statement), as well as practice mandated by the USAH, only ?using the half-year convention?of the $1,515,943 (or $252,657) should have been expensed. That the difference (over $1.28 million) constitutes a "significant distortion" seems beyond cavil. Partnership Resoonse: "The expensing of outside and in?house labor used to place capital items in a condition and position ready for use [was] never -25- OAG Report GHYBA November 21, 1989 Implemented at the Hotel. Only the cost of the in-house labor used to' clean and otherwise prepare the general area in which a capital item was to be installed was expensed." pic; Reply: To the contrary, of the $489,865 of capital labor costs expensed, 72% (or $354,829) was for outside labor, used to mave furniture and perform other renovation?related work (see, invoices of Supreme Building Richard Aitherr, etc.) Whether in-house or outside, all such labor costs are capitalized under GAAP. Partnership Response: "{Flreight charges and sales taxes incurred in connection appropriately capitalized??only the freight charges and sales taxes incurred in connection with the acquisition of properly expensed items were themselves expensed.? Reply: The response begs the question: Since over 99% of the contested items should have been capitalized, so should the associated freight charges and sales tax. The response is also inaccurate: ln at least two cases, sales tax {totalling over on capitalized items was also expensed. Partnership Response: "Although the certified Percentage Rental Statement, a specialized report, did not contain footnotes describing the accounting methods used to depreciate and amortize property and equipment, the certified financial statement of the Hotel for the 1986 calendar year contained such a description" delivered to UDCfCommodore contemporaneously." Reply: Since none of the adjustments at issue was made on the Hotel?s financial statement, the notes there did not provide any relevant information regarding the policies used to arrive at the Percentage Rental payment. 3. Allowable depreciation for capital expenditures in excess of the First Leasehold Mortgage should be increased. As a result of the changes in accounting policy applied to their Percentage Rental statement, the Partnership improperly expensed $2,733,369 of items that should have been capitalized to the account (see Finding 2, above}. This amount should therefore be capitalized and depreciated over -27- OAG Report GHYBA Noyember 21, 198:5: a) three years on 56.7% of the amount; bl eight years on 42.7% of the amount; and c) twenty years on the remainder Recommendation Increase the Allocation for Capital Expenditures in Excess of First Leasehold Mortgage account by $337,982 for additional depreciation on the amount to be capitalized. 4. With no apparent iustification. the Partnership reduced the service lives of the 1985 additions to the account from eight to six According to the Hotel's Controller, the 1986 additions to the account, totalling $l,399,054, consisted predominantly of items that require replacement due to excessive wear and tear. Up until 1986, such items would have been accorded an eight?year life for depreciation purposes. in 1986, however, a six year-life was assigned instead; as a result, the depreciation expense increased by $29,147 and Percentage Rental decreased by $14,574. We found no evidence to support the claim that the items will have to be replaced in six years. No adjustment was made to the Accumulated Depreciation and FREE accounts to reflect the retirement in 1986, after six years, of any of these eight?year items. Recommendation In the absence of any evidence to substantiate the claim that the items at issue will require replacement in six years, reduce the 1986 depreciation expense by $29,147. Partnership Resoonse: "The most basic accounting procedures require that a determination be made each year as to the useful life of each item purchased during such Clearly, the best and most appropriate criterion available to estimate the service life in replacement items is the length of service actually experienced with respect to the equivalent items being replaced." -23- who 11' -.. OAG Report GHYBA November 21, 1989 OAG Reply: There is no evidence that items equivalent to those purchased- in 1986 actually had lives shorter than eight years, since no adjustment was made in the accounts to reflect that fact. 5. The Partnership improperly included in Debt Service $500,000 of additional interest and $575346 of condemnation awards, thereby improperly deducting those amounts from net profit. For purposes of calculating Percentage Rental, the Partnership included as Debt Service $8,929,846: $1,144,028 of principal; $6,709,972 of ?minimum interest?; $500,000 of ?additional interest?; and $575,346 of condemnation awards received in 1986 from New York State. "Minimum interest" is the interest paid by the Partnership each month as part of its constant payment of principal and interest to the mortgagee. "Additional interest? is a supplemental intereSt payment made annually under the terms of the mortgage and based upon a percentage of the Hotel?s annual room revenue. The amount of Debt Service which may be included as an expense and deducted from Gross Income for purposes of determining Percentage Rental is defined in Lease Exhibit as follows: the aggregate of the payments to interest and amortization of principal payable in th_e first twelve- month period during which constant payments t_o interest amortization o_f principal at: reguired under mg initial Leasehold Mortgage having maturity of ten or more years from its original date {emphasis added}. The "initial First Leasehold Mortgage" as so defined is the one currently in force?-namely, the Mortgage Modification and Extension Agreement, dated November 25, 1980, among the Partnership, the Equitable Life Assurance Society of the United States,and the Bowery Savings Bank The "first twelve-month period during which constant 32The original mortgage, dated May 19, 1978, between the Partnership and Manufacturer?s Hanover Trust Company, does not qualify because it called for Payment of interest but not for amortization of principal, and because its term was less than ten years. -29- DAG Report GHYBA November 21, 1989 payments to interest and amortization of principal were payable" under the FLM ran from December 1, 1981 through November 30, 1982 (see pars. and D). Thus, allowable Debt Service under the Lease equals the "aggregate of the payments to interest and amortization of principal payable" under the FLM during that period. The FLM, during the period in question, required constant payments of principal and interest in the amount of $654,500, or $7,854,000 annually (FLM, pars. and D). Also payable during that on May 1, 1982-?was "additional interest? equal to the lesser of 3) $500,000 or bl one and a half percent of the Hotel?s room revenue during the previous calendar year33 (see FLM, par. Fl. Room revenue is defined as gross room revenue, calculated on the basis.34 Mg rebates, overcharges and travel agents? commissions, as well as occupancy and other taxes or charges paid to any governmental authority (FLM, par. Fl. Therefore, to calculate the amount of Debt Service allowable under the Lease for purposes of determining Percentage Rental, one must know: ll the amount of room revenue for calendar year 1981, calculated on the cash basis; and 2) the amount of rebates, overcharges, travel agents? commissions, occupancy taxes, and other government taxes and charges to be deducted from such amount. To the difference, multiplied by one and a half percent, one must add the $7,854,000 of constant principal and interest payments also payable during the applicable period; the sum equals allowable Debt Service. Moreover, the sum arrived at equals the amount of allowable Debt Service for of the forty years that Debt Service is permitted as an expense for purposes of calculating Percentage Rental (see definitions of "Expenses" and "Debt Service? in Lease Exhibit F). Actual payments of principal andfor interest are irrelevant; no matter how much more or less 33Additional interest "shall be due and payable on the date occurring one hundred twenty (120) days after the end of each Computation Year shall mean and refer to the calendar year." (FLM, parRoom revenue includes credit transaCtions only "as and when collected" (FLM, par. F). -30- DAG Report GHYBA November 21, 1989 the Partnership pays, allowable Debt Service remains the same.35 The only' exception is if the FLM is refinanced or replaced lg original maturity in 19951 and if the original principal ($70 million} is not fully amortized at that time (as it presumably will not be). In that case, and at such time, Debt Service may increase (but not decrease) to equal the annual amount of interest and amortization of principal payable on the remaining balance of the amount originally borrowed under the Refinancing before the original maturity does not alter or affect the amount of allowable Debt Service. At least until 1995, then, Debt Service equals--as stated plus the amount payable on May 1, 1982 as ?additional interest" under the FLM. Unfortunately, the Partnership refused us access to the books and records relating to 1981 operations necessary to determine the amount of "additional interest? payable on May 1, 1982 pursuant to the FLM, and therefore necessary to determine the amount of Debt Service allowable under the Lease until approximately 2021. Again, we were denied such access even for the limited purpose of verifying the 1988 Percentage Rental payment. We know, however, that the amount claimed as Debt Service by the Partnership for 1986 ($8,354,000, excluding the condemnation awards) exceeds what is allowable by an amount necessarily greater than $76,433; how much greater, we are unable to ascertain. For, in addition to the $7,854,000 of constant payments of principal and interest, the Partnership included in Debt Service $500,000 of "additional interest", or the maximum payable under the FLM.37 Yet, according to Hotel books we 3'SThe definition of allowable Expenses states: "All of the foregoing items shall be the actual expenses incurred by the Hotel Operator or Tenant except item which, shall be the annual amount equal to Debt 36m other words, if any additional loan is made at the time of refinancing, the associated principal and interest payments are excluded from Debt Service: moreover, the amortization rate on the pig principal may not be accelerated under the-refinancing agreement. 3fThe Partnership erroneously utilized calendar year 1982 (rather than 19811 as the applicable Computation Year, and claimed that one and a half percent of room revenue, as defined, for that period was $499,995. The "additional interest" for 1982-?whatever its true amount (we. of course, could not veriny--was not payable OAG Report GHYBA November 21, 1989 were permitted to review, one and a half percent of 1981 room revenue,? calculated on the accrual basis and before deductions for rebates, overcharges, travel agents? commissions, occupancy taxes and other government taxes and charges, equalled $423,567. The amount claimed by the Partnership is therefore excessive by an amount between $76,433 and $500,000. Because we are unable to determine the allowable amount of Debt Service under the Lease; because that inability will extend through A the remaining years (over 30} that Debt Service is allowed as an expense under the Lease; because that inability is solely the result of the Partnership?s refusal to grant access to the necessary books and records; and because such refusal is a violation of Lease sec. 4.9.5, we have no alternative but to disallow in its entirety the $500,000 of "additional interest" claimed by the Partnership. The Partnership also included in Debt Service for 1986 the $575,846 of condemnation awards it received in June of 1986 from New York State for the taking of a part of the Grand Hyatt property. Pursuant to provisions of the Lease (Article 18) and the FLM (par. 16}, these amounts were transferred to the mortgagee to be held in reserve until disbursement is required,38 and were applied in the interim against principal to effect a reduction in the amount of interest payable under the Loan. As explained earlier, the amount of Debt Service allowed as an expense under the Lease remains constant over a forty-year period (except, as noted above, upon certain refinancing); see definition of Expenses, Lease Exhibit F. The amount allowed equals the principal and interest payable by the Partnership between December 1, and November 30, 1982. Nothing may licitly be added to or subtracted from that amount. Thus, the temporary reduction in actual interest paid does not serve to reduce during the applicable period (December 1, 1981 through November 30, 1982) under the Lease; instead, it was payable on May 1, 1983. In any event, we do not know why the Partnership nevertheless charged $500,000. 353"No disbursement has as yet been made. -32- OAG Report GHYSA November 21, 1989 allowable Debt Service;39 nor can the condemnation awards themselves serve to increase it. Recommendations 3. Disallow from Debt Service the $500,000 of "additional interest" included by the Partnership, unless and until access is granted to the books and records necessary to verify: 1) 1981 room revenue, as defined in the and 2) the amount of additional interest therefore properly includable in Debt Service. b. Disallow from Debt Service the condemnation awards of $575,846 wrongly included by the Partnership. Partnership Response: Regarding the "additional interest" properly includable: "Clearly. the provision was designed to interest payable for the first year during which the Hotel was fully opened and operational after the conclusion of its initial ?shakedown? period. Thus, the measuring year was established as the first year during which the Hotel?s operations had sufficiently stabilized to permit the commencement of amortization payments." Reply: Neither the Lease nor the FLM mentions anything about a "Shakedown period" or "sufficient The Lease unambiguously defines Debt Service as the amount payable in the first twelve months during which constant payments of interest and amortization are required. Neither the twelve month period nor the amount payable during such period is in dispute. Partnership Response: Regarding the condemnation awards: "lTIhe Draft Report correctly points out that the Lease does not permit" deduction of this amount as Debt Service. its treatment in the certified Percentage Rental statement, this payment was properly deductible as a reserve for repairs and restoration to the 39We note that the Partnership??properly--did not reduce Debt Service to reflect their lower payments of interest. -33- OAG Report GHYBA November 21, 1989 Reply: While the condemnation award may be held as a reserve for_' future disbursement {and as such should not be considered additional revenue}. it cannot be deducted as an expense, either by adding it to debt service or by treating it as a repair and restoration expense. The amount which may be deducted as repair and restoration expense is defined in Lease Exhibit as the greater of: 1) actual expenses for repair and maintenance; 2} the amount required by the FLM to be expended for repairs and maintenance or--to the extent not expended-?placed in the "Reserve for Replacement Account"; or 3) the amount required to be placed in the "fund for replacement of and additions to furnishings and equipment? under the operating agreement with Hyatt Corporation. In 1986, the greatest of the three amounts was that for actual repair and maintenance ($4,144,275) and the Partnership correctly deducted that amount. 6. In violation of Lease Article 6. The Partnership deducted as an expense $70.97? in interest penalties paid to the State and City of New York in connection with prior Ears? sales. use. occupancy and telephone rental taxes. Article 6 of the Lease provides that Tenant the Partnership] shall pay or cause to be paid, before any fine, penalty, interest or cost may be added thereto for the non?payment thereof, all lmpositions, all [Lease sec. 6.1) If the Partnership wishes to contest the amount or validity of the tax, it may do so after payment of such Imposition, unless such payment would operate as a bar to Such contest or interfere materially with the prosecution He, the Partnership] covenants that payment would constitute a bar or material interference, the Partnership may postpone or defer payment o_r_1_l_y if certain conditions are met?~among them, that it shall have either: I) paid to the mortgagee or UDC the amount contested and unpaid, plus associated interest and penalties and all charges that may or might be assessed against or become a charge on the Property; or 2) posted a bond by a -34- OAG Report GHYBA November 21, 1989 Landlord shall not suffer or sustain any costs or any liabilities in connection with any such proceeding. (Lease secs. 6.4 and 6.5.) The Partnership improperly deducted the $70,977 of interest penalties on overdue taxes from Gross income, and thereby reduced Percentage Rental by over $35,488. Recommendation Disallow the $70,977 deduction from net profit. Partnership Response: [Tlhe interest expense was in fact an unavoidable cost incurred by the There is no authority in the Lease or otherwise for the proposition that these otherwise legitimate costs should somehow be disallowed.? gag Reply: The penalties were avoidable by timely paying the taxes in the first place. The effect of the cited Lease provisions is to hold the City harmless for Tenant?s failure to pay taxes owed. it would be ironic- ?tp say the least-~if the tenant could recoup taxes owed to the City and State of New York by charging them back to the City as deductions in rent. 7. The Partnership improperly charged to operations legal fees incurred for preparing and amending operating leases and management agreements. in 1986, the Partnership paid the law firm of Dreyer and Traub $146,989 for various professional services rendered. The Hotel?s share of the fee ($81,075) was for preparation or amendment of management and three- party agreements and of leases for six of the Hotel?s commercial tenants. The entire $31,076 was expensed instead of being capitalized and amortized over the life of the leases and management agreements. The Hotel's Controller claimed the fees represented normally recurring expenses of Hotel operation and cited section 19(c} of the AlCPi?i?s?11 surety company in amount, form and content reasonably acceptable to UDC (Lease sec. ?American institute of Certified Public Accountants. -35- OAG Report GHYBA November 21, 1959 Financial Accounting Standard (PAS) Statement 13 as support for this. treatment. The cited provision reads, in relevant part, as follows: "Initial direct costs? shall be deferred and allocated over the lease term in proportion to the recognition of rental income. However, initial direct costs may be charged to expense as incurred th_e effect i_s n_ot materiallyr different from that which would have resulted from Lise p_f th_e method prescribed i_n th_e preceding sentence." in determining material difference, then, one must-?in accordance with the above provision-?compare the results of the two treatments. Instead, the Partnership erroneously compared the fees to the operating budget of the Hotel? and concluded on that basis that they were immaterial??3 Had the Partnership followed the ordinary requirement to capitalize, $8.108 would have been expensed in 1986, as compared with the $81,076 aetually expensed. This represents a ten?fold or 1000 percent difference, which we find material. Recommendation Capitalize the Hotel?s share of the expense $81,076) and amortize it over at least ten years, since that is the shortest term of any of the leases and agreements at issue. Partnership Response: "[TIhe tautology be dispositive of the issue. By simple mathematics, a current reduction of an item otherwise to be amortized over ten years will always result in a ten-fold The appropriate analysis called for under PAS 13 is not whether, in absolute terms, a $72,968 increase in current expenses is material, but rather whether such an increase is material in the context of the budget in question." [Emphasis in origina1.l azlnitial direct costs are defined by the FAS as: "Those incremental direct costs incurred by the lessor in negotiating and consummating lease transactions commissions and legal fees)." _43Letter dated March 14. 1989 from Controller Blagojevic to the Auditor General, p. 3. -35- OAG Report GHYBA November 21, 1989 OAG Reply: The effect of expensing these costs rather than capitalizing them is, "by simple mathematics," 3 function of the l_e.a_se terms in question. Were the lease terms at issue two or three years rather than a minimum of ten years, the magnitude of the difference woold be significantly smaller. 8. The incentive fee payable to Hyatt ggorporation must be recalculated to reflect the effect on Hotel Operating income of certain of the above adjustments. The calculation of the Hyatt Corporation?s incentive fee (part of its management fee) is based upon the Hotel?s profit from operations (see 3, above). The recommended adjustments based upon Findings 5 through 7, above, affect profit from operations as defined in the management agreement. {The changes to the allowable depreciation expense?-Findings 3 and 4, above??do not figure in the calcolation of incentive fee; instead, the management agreement allows, as a deduction from operating profit, the Hotel?s provision for replacement of which in 1985 was $2,117,018.) The recaICuiated management fee, after giving effect to the above adjustments, is $6,042,661, or an increase of $128,789. The increased incentive fee reduces Percentage Rental owed by $64,395. WM increase the incentive fee by $128,789 to reflect adjustments 5 through 7, above. 9. The Hotel failed to complv with Lease secs. 4.9.5 and 4.9.8. Financial records of the Hotel relevant to the determination of profit and Percentage Rental for 1986 were either missing or denied to us upon request. Further, we were denied access to books and records we were legally entitled to review for the purpose of verifying Percentage Rental for 1985. Recommendations a. Advise the Partnership that it did not keep full and accurate books and records of Hotel operations for 1986 for the required period, thus violating Lease sec. 4.9.5. _37- OAG Report GHYBA November 21, 1989 b. Reiterate the request to review certain records from prior' years, in particular those for 1985, and those from 198! which are necessary to calculate the amount of Debt Service allowable under the Lease. Partnership Response: "The Draft Report takes the position that the Lease requires every guest check, every cash register receipt, every fiscal summary and every other scrap of paper potentially useful or convenient to any degree, regardless of how remote, to the verification of the amount of Percentage Rental payable during a calendar year to be retained in New York City for a period of two However, the Lease clearly does not require the managing agent to undertake the herculean task of safekeeping every scrap of paper that might have some remote relevance to the fiscal affairs of the Reply: The Lease requires that and "accurate" records be kept for at least two years either in the Hotel or in the City of New York. Neither the Draft Report nor this one (see pp. 9?10, above, taken verbatim from the Draft Report} refers to "scraps of paper", but rather to the Hotel?s general ledgers, detailed ledgers, income journals and supporting documentation. The Partnership?s apparent belief that these are "scraps of paper" may explain the extraordinary lapses in recordkeeping we discovered. 10. Sufficiency o_f Internal Controls ln tracing expense amounts from the manually-prepared and general journals to the computerized general ledgers, we found 56 entries (out of approximately 1300 examined) that were misclassified, posted to the wrong expense account. We determined, however, that this misclassification had no effect on total reported expenses. In our opinion, apart from those errors, and from deficiencies cited in Finding 9 and at pages 9?10, above, the Hotel's internal controls were adequate to ensure that its 1986 financial statements fairly presented net profit before Partnership adjustments. -33- OAG Report GHYBA IV. November 21, 1989 Our recalculation of Percentage Rental due for lease {calendar} year 1986- ?attached hereto as Appendix A??demenstrates that the Partnership still owes the City (through UDC) $2,870,259. We recommend that the Cit),r and UDC serve prompt demand upon the Partnership for payment of that amount, plus interest from April 1, 1987 to the date of payment. -39- APPENDIX A EXHIBIT PAGE 1 3F 2 GRAND TORK RECALCULATIDN OF CONTINGENCY RENTAL YEAR ENDED DECEMBER 31, 1936 AS CALCULATED BY JAG PARTNERS CALCULATION SALES AND ROOMS 552,629,531 352,629,531 FCOD 3 BEVERAGE 22,204,656 22,204,356 TELEPHONE 2,666,649 2,666,649 VALET 2 LAUNDRY 431,526 431,526 TENANT RENTALS 51,443,516 1,443,516 OTHERS $166,557 166,651 GROSS REVENUE 519,946,941 519,946,941 DEPARTMENTAL ROOMS $12,222,241 $12,222,241 FOOD A 16,441,126 16,441,126 TELEPHONE 2,126,240 2,126,240 PALET 6 LAUNDRY 316,111 316,111 $33,110,364 $33,110,364 GROSS OPERATING INCOME $46,236,551 546,236,557 6 A AND OPERATING EXP. ADMIN 6 GENERAL $7,217,916 11431945} $7,073,971 MARKETING 2,516,651 2,516,651 ENERGY COSTS 2,104,461 2,104,461 REPAIRS 6 MTCE. 4,144,215 4,144,215 CAPITAL ITEMS ENPENSED 2,156,194 (2,133,369) 24,625 UNALLOCATED OPERATING EXP. $19,343,691 $16,466,383 BEFORE FIXED CHARGES 526,694,660 629,772,174 RECORDED FIXED CHARGES MANAGEMENT FEE 55,913,612 126,169 66,042,661 TAX EQUIVALENCY FEE 316,200 I 316,200 56,292,072 56,420,661 INCOME FROM OPERATIONS $20,602,788 $23,351,313 SEE EXHIBIT 1A FOR DETAILED CACULATION. GRAND YORK RECALCULATION OF CONTINGENCY RENTAL YEAR ENDED DECEMBER 31, OTHER DEDUCTIONS ALLOC FOR CAP EXP IN EXCESS OF FIRST HOLD MORTGAGE DEBT SERVICE ON FIRST LEASEHOLD MORTGAGE ADJ OF RECEIVABLES TO REFLECT CASH BASIS TOTAL OTHER DEDUCTIONS PERCENTAGE RENTAL AS COMPUTED LESS: PERCENTAGE RENTAL ADJ REFLECTING THE CUM EFFECT OF CASH BASIS THRU 12f31]85 NET PERCENTAGE RENTAL 1986 1986 AS CALCULATED BY PARTNERS $5,043,650 8,929,846 1,571,596 $1,048,078 370,923 BALANCE OUTSTANDING PER AUDIT NOTE: THE RECALCULATED PERCENTAGE RENTAL OF $3,547,414 WAS THE RESULT OF: A) USING FULL ACCRUAL (REVENUE AND USING THE SAME CAPITALIZATION AND APPEND A EXHIBIT 1 PAGE 2 OF 2 GAO 308,835 {1,075,846} DEPRECIATION POLICY AS IN PRIOR AND DISALLOWING FROM DEBT SERVICE THE CONDEMNATION AWARDS OF $575,846 AND ADDITIONAL INTEREST (KICKER) OF $500,000. REVERSAL OF THE ADJUSTMENT TO REFLECT CASH BASIS OF ACCOUNTING. REVISED CALCULATION $5,352,485 7,854,000 $3,547,414 APPENDIX A EXHIBIT 1A PAGE 1 Of 2 SUPPORTING CACULATION TO DAG ADJUSTMENTS IN RECALCULATING CONTINGENCY RENTAL ADMINISTRATION GENERAL A) INTEREST EXPENSE (PENALTIES) DISALLOWED: 1) INTEREST ON OCCUPANCY TAX DUE TO CITY FOR PRIOR YEARS ADJUSTING ENTRY ($10,979) 2) INTEREST ON UTILITY TAX ON TELEPHONE RENTALS DUE TO THE CITY FOR PRIOR YEARS ADJUSTING ENTRY {28,968} 3) INTEREST ON SALES AND USE TAXES DUE TO THE STATE FOR PRIOR YEARS (LSH ADJUSTING ENTRY (31,030) E) LEGAL FEES CAPITALIEED AND AMORTIZED OVER 10 YEARS. ADJUSTING ENTRY NOS. 15 a 16). (81,076 a 10%) (72,968) CAPITAL ITEMS EXPENSED AMOUNT EXPENSED BY FOR FREIGHT, SALES TAXES, EQUIPMENT, MATERIALS, LABOR {$2,758,194} LESS: ITEMS TO BE EXPENSED BY DAG 24,825 DIFFERENCE ($2,733,369) LAVENTHOL HORWATH, SUPPORTING CACULATION TO OAG ADJUSTMENTS IN RECALCULATING CONTINGENCY RENTAL MANAGEMENT FEE ADDITIONAL INTEREST (KICKER) ADMIN. GENERAL INCENTIVE FEE RATE ALLOCATION FOR CAPITAL EXPENDITURES IN EXCESS OF FIRST LEASEHOLD MORTGAGE: A) ALLOWABLE DEPRECIATION ON THE DISALLOWED CAPITAL ITEMS EXPENSED APPENDIX A EXHIBIT 1A PAGE 2 of 2 500,000 143,945 20% $337,982 B) ADJUSTMENT: DEPRECIATION ON 1986 ADDITIONS TO FURNITURE, FIXTURES EQUIPMENT OF $1,399,054. CHANGED FROM SIX TO EIGHT YEARS. {115,533 37,441) DIFFERENCE DEBT SERVICE ON FIRST LEASEHOLD MORTGAGE: A) CONDEMNATION AWARDS B) ADDITIONAL INTEREST (KICKER) {29,147} ($575,846) {500,000} pos I - Curn?cd March 25, 1987 To the Partners _Regency~Lexington Partnership. Gentlemen ?IBurs'uantl: to your request for any 'suggestio?s Ijjm'i'ghg" Ha offer in connection with potential cash savings?which hi -1fitems 'presently being ?amight expensedh . .Iehoa'lpoe . - A "de Minimus" policy be '-costingi less {thanfxa' .and' any'i-invoice'f'g in amount" (say $1000 .to_ $2000) _-be state' that_ any item certain amount {say $250 to $500) less than a certa A. policy' be established to eXpense acertain.5items"u which normally have a life of greater than one year but. probably less nature of replacement 'and. recurring' each. year. Recurring, in _this sense, means each year .these items are bought ?and replaced on' a continuous basis. _These items would, include bedspreads, draperies, carpeting, wallcovering, window shades and painting and any related purchasing and design fees- A policy be established that in connection with;a renovation program, any in?house labor that 15 utilized that does not produce an _enhancement of the property be expensed. A poliCy be established that all freight charges and sales taxes be expensed. Since the partnership is investing the bulk of its cash flow in renovations and improvements of physical facilities of the hotel rather than withdrawing the money, it would seem to me that UDC should be approached on' allowing the interest on the second mortgage financing as a deduction f0: purposes of calculating the UDC rent. A member of Horwach Horwath International with af?liated of?ces worldwide. 1 . P-u .. {212) 980-3100 - -f .27: 3x: 296501 UR . linepsw?ix;a? 'qsrniarf'l' a vegto?ih siblejfor-tax and UDC purpOSes,.I offer the following:}f- 1-- than five years and -.are,jin_ the a APPENDIX EXHIBIT 1 -PAGE 2 OF - mgency Lexinton Partnership illafch '26, 1987 - aage 2 . ?he .effect' of the- adoption r?f policies. enumerated .4lgj: 'would be timing differences.. For instance, ?if_itdeceh,_ Pmounts for these four items aggregated $4,000,000 for'1986fdthe? an rent saving_would be $1,694,000. However, if by not?having?theh?f? amortization 511 future years put you :hi the 50% bracket, then*3 the future cost would be $2,000,000 or a $305,000 {without giving effect to the-present value of 4-. Alsop'if the_policies enumerated above as 21 to'4_are adootedf? the partnersuwould have to determine if these items are?toTbeT 1- expensed to repairs and maintenance on the hotel's accounts and? thereby effecting, unless otherwise modified, the computation of~15 the management fee; or, expensed (H1 the separate'partnership??. accounts a5" repairs and maintenance without-'effecting: the computation c?i the nmnagement fee; In this case,_management . each year would have to determine which items yould.effect which. repairs and maintenance accounts. -- The item enumerated as 5 above would result in?a permanent type cash saving. - - you have any questions on the items discussed herein, please call me. Sincerely yours, QMG) 55a Robert Leone 0 !cc: Ken Posner I Allen Weisselberg i APPENDIX EXHIBIT 2 Refco Properties, Inc; 200 W. Madison, ?lst-Ploor PAGE Chicago, Illinois 60606 A a FEDERAL EXPRESS - i- . . .. ?L.Robert Leone I v; 1 hi?p, menthol Horwath I I..J rl__u B-Third Avenue 9 York, New York 10022 ?new I Regency?Lexington Partners ,{Than ?you for your letter of.Harch 25, partnership wherein you offer cer Ill?1 n-rn 14Purchases of furniture, furnishin gs and equipment having' an individual item cost of less han $250 shall be expensed.- 2. Certain items which norma one year but less than 5 years and which are replacement and recurring each year shall he expensed. Recurring, for this purpose, means that each year certain of these items are bought and used as replacement on a rather_ continuous basis. These items include, but are'not'limited to, bedspreads, draperies, carpeting, wall covering,.window shades and painting. - 3- Labor utilized in the delivery and/or installation of furni? ture, furnishings and eou1pment which does not produce a significant enhancement or the property shall be expensed- 4. All capitalized furniture, furnishings and equipment a?QUirEd on or after January 1, 1986 shall be depreciated for finan~ cial reporting purposes over a six year life. - .. e' I I .- v-m- p' h~unmw a gstatEm?ntSfa_diinc?mggt? .a I r. ~l FEDERAL EXPRESS Licdfi Hf: Dongld '35Mr.?Alleq Weisselberg a concurring letter Mr; Tru ?pleas??give?effect to_the$e policies and complete the financialf?hj.r fot,the Kenvne th. Polisher HEELNULA 5 EXHIBIT 311:": you for yourz?a-r- 5- ?pagtnership?aslquigklyia . 41.x} Iii-1"- n1 .. .. 1 Vice President and T?ea??r?rffji . . APPENU Chicago, IllihOiS 60606 VIA FEDERAL EXPRESS- April 22, 1987 En. Robert Leone Laventhol Horwath 919 Third Avenue New Eork,'New York 10022 Regency?Lexington Partners Dear Hr.-Leone: In my letter to you of April 20, 1987, I recommended certain- accounting policies which, if concurred with by our partner in the above referenced partnership, would be deemed to have been adopted by the Partnership as of January 1, 1985. It occurs to me that a - questiOn.could arise as to the impact, if any, of these revised accounting policies on the financial statements of the Grand Hyatt New jerk ("Hote1f]- It is the view of Refco Properties, Inc. that these golicies are relevant only for the Partnership and, accordingly, do hot?impact the operating results of the Hotel? Specifically; pursuant to the Management Agreement between the Partnership and Hyatt - Corporation,'acquisitions of furniture, furnishings and equipment are charged against the related reserve for replacement of these items- The Hotel's financial statements only reflect an expense for the periodic addition to this reserve for replacement and are, therefore: tmaffected by the actual acquisition of these items. Please contact me with any questions regarding this-letter or my letter of April 20, 198?. Sincerely, Refco Properties, Inc. teem Kenneth R. Posner vice President and Treasurer IELEEDERAL EXPRESS CC- Hr. Donald Trump Hr- Allen Heisselberg . . . {-vj/Jf 3 4' April 22, 1937 MESSENGER i }Ml Robert P. Leone SLaventhol E: Horwath mrtified Public Accountants P19 Third Avenue MW York, New York 10022 Re: Eggency?Lexington Partners ?ear_Mr; Leone; I acknowledge receipt of a copy of Kenneth R. Posner?s ?tter'to you dated April 20, 198? relative to the adoption of certain revised accounting policies for Regency-Lexington Partners. For convenience, a copy of the said letter dated rpril 20th is enclosed herewith. This letter'will serve-to confirm that the undersigned concurs in the adoption of the revised accounting policies as stated in the said letter dated April 20, 1987yours, i . i DJTzab Enclosure Cc: Kenneth R. Posner I (Federal_Express} Allen Weisselberg 1 4 I I THE mums oneamzmlom 725 FIFTH AVENUE NEW YORK, N. 1W12 832'2000 427715 931?. APPENDIX I l' ll'l'lir YURI-3., Y. [Elli Shh-15.1? f23}* IERHENCEMHAN 'e a UrpuryL'uumr?mnf 1 A I I I . May 20, 1937 .. MAY 2 1987 Satisl Sood I Hector, ?roject Administration BY HAND r? York :tate I ornament ?an Devalopment Corporation Broadway . mJank, H.Y. 10036 . Re: Block #1280, Lot #30 Borough of Hanhattan UDC/Commodore RedevelOpment Corporation tear Hr. Sood; Please take notice that the City of New York hereby requests that Jmf?omnercial Redevelopment Corporation .acting as Landlord, exercise its :mht pursuant to Article 4.9.6. of their lease with Regency Lexington Partners, ?ned Detemher 19, 1977 for the aboVe referenced property, to inspect and audit allb 0' cuments, and records related to the Annual payment of Percentage Rent 1986 ease year. Further, pursuant to Article of the Three Party Agreement dated December 19,"l977, fnlure by UDCfCommodore to proceed with such audit within the required twenty My period will result in the City of New York, as the third party beneficiary. tcexercise it's own right to enforce Article 4.9.6 of the lease agreement to audit we lessee- Therefore, kindly advise as to how you are to proceed with this matter Lna diligent and timely manner. We request specific information concerning ?m audit process and the projected timeframe in which such will be conducted. Very truly yours, IA J. Pocci, P.E. bredr_? nss'stant Commissioner Property Hanagement and Leasing- Division of Real Property Holenbough Trinchetto M4 Ui MINERAL SERVICES. LAFAYETTE STREET NEW Y. {Ell} Ebb-7510 more JUN 1987 :conramtres promoter I HADLEY ooLn Drpury June 1, 1987 BY BAND Hr. Satish Sooc Director, Projett Administration New York State Urban Corporation 1515 Broadway Hen York, ELY. 10036 _Re: Block #1280, Lot #30 Borough of Manhattan - UDC/Commodore Redevelopment Corporation_ Dear Hr. Sood;? Please take notice that the City of New York hereby requests that UDCI Commercial Redevelopment Corporation, acting as Landlord, exercise its right pursuant to Article A.9.6 of their lease with Regency Lexington Partners, dated December 19, 197? for the above referenced property, to inapect and audit all booksI document, nd records related to the Annual payment of Percentage Rent for the -ase year. . .. Further, purSuant to Article 4 of the Three Party Agreement dated December 19, 197?. failure by UDCKCommodore to proceed with such audit within the required twenty day period will result in the City of New York, as the third -- Party beneficiary, to exercisc it's own right to enforce Article h.9.6 of the leaSe agreement ot audit the lessee. kindly adVise as to how you are to proceed with this a diligent and timely manner. We request specific information concerning audit process and the projected timeframe in which such will be conducted]. ?1 7:1 .. I: . Fir; ?14:3 As. tant Commissioner 2 _ri_ q.me 7r" .4Hi Pro-erty Management and Leasing.; -: Division of Real Property. ?rtf- F?:ETIEI -.-. .-. - c? B?Le?ba?gh - - r- . R. Trinchetto u_3f if anal-.14 J- .1 fl-tl? file ?n . . New York no Urban Dev 'meant Corporalio Hr. Stan Elagojevic Controller Grand Hyatt-New York 109 East 42nd Street New York, NY Dear Mr. Blegojevic: Should you haVe Thank you. /mda Attachment cc: 8. Johs F. Epcoi R. Trinchetto any questions APPENDIX ISIS Broadway' New York. NY 10035-3950 -, 212:930-9000 .m '1 ul .1- June 4, 1987 RE: Commodore (Grand Hyatt)4Hotel Block 1230, Lot?30 please Call me at (212} 930?0396. Very truly yours, Satish Sood Director Project Administration APPENDIX ILAFAYETTE ET HEW TORK.NY.I 1 {Eli} 556-?510 HADLEY W. GOLD MICHAEL DIRZLLAITIS Commisuonur Acting Deputy March ll, 1988 w. Stan Elagojevio tantroller wand Hyatt-New York m9 East ?End Street {so york, N.Y. 10017 3 m. 35*. Commodore (Grand Hyatt)'Hc Block 1280, Lot 30 \NBorough of Manhattan *har Mr. Blagojevic: -m~un The City of New York acting through its Department of General Kkrvices, Division of Real Property has asked the New York City Auditor kneral (AG) to review the calendar years 1985 and 1986 financial wrformance of your organization. The New York State Urban Development wrporation_(UDC) knows of this recent request. In June, 1987 UDC Fformed your organization that an audit would be conducted (attached in a copy of the letter). As part-of this effort, staff from the iufice will visit your office on April 19, 1988 to conduct an internal ?mrvey. The team will be led by Reynaldo L. Padilla, CPA and supported. Cris Gonzalez. CPA, Louisiana D. Manuel and Jaime Mercado - Diaz. For the survey and subsequent audit, Mr. Padilla and his staff will med adequate working space and access to all the books, records, papers 1md files with particular attention to the 1986 rental entitlement. In nger to verify figures, they may also have to examine prior years' 1mcords and documents. Finally, they will have to see the 1985 and 1986 tmdit work papers of your Certified Public Accountants. To facilitate ?he review, please designate an audit liaison who can assure that the {Ram's requests are answered. If you have any questions please call Jeffrey Nadler at 566?1576.' Thank you, in advance, for your cooperation. Sincerely. 5/4 . Uri. Lori Fierstein Assistant Commissioner Property Managment Leasing I i 1 i i I {fl/:1 J. Nadler 3- Sood f?11.1. WA.- .- I Auditor General: Sta?' with hotel operations, .wm- NEW 'toritc. NEW Vol.1 awn APPENDIX 252 553 12:14 M54101 1 ll March 18, 1938 fe?'ety Nadler Department of General Service: Division of Real Property 2 Lafayette Street .New York, NY. 10007 DearM'r. Nadlen On March 15, 1988 at ll:00am a rneetin . ivas hetd between the New York City Auditor Genera: .tta?'and representatives ofthe hotel. . . nu In attertdencerwere, Auditor General Stajjr - Rey Padilla, Cris Gonzales-Louisiana D. Manuel and Jaime M. Dias. Hotel Representative: ~?Stan Blagojevic and Men-ill Matmda. At this meeting Merrill atsada. Grand Hyatt New York Assistant Controller, has been designated as the audit liaison. - In addition it was determined that another meeting would need to be conducted on March 23, 1988 the purport: of which would be to conduct a of the hotel to familiarize the policies and procedure: and information ?ow. On March 23, 1988 we waitld also like to an'ange the date when the audit will be intiated which will be mutually bene?cial to the both of as, the exact length of time the audit will take and a list of items and record: the team will need to conduct their attdit. This will facilitate us in providing the audit team with the accotnodations and infonnation needed in a timely manner. Sincerely, .- Blagojevic - Controller cc: R. Padilla Sood APPENDIX i i . 1 i i DREYER AND THAUB or '4 Tu?: A WICH Innunn [cl-n? . "Alunt'lu? lime-n1 H.JACDIIDII. I. c- ALAN a. Hal PAH AV E- hltn?lb ~aALu g. Ic?nndl?. P. c. HARE I. IHTIILIOATOI Rain". A Luumnc? anwuummumn HEW YORK IIDIDDH your! noun-r JAVA-lino: I I "1 AIHHUH tztumu. I "g L, no": HITCHILL I. 33:" lucnnwu Mil-anon ?mnuu?. {El?n a, "Ices-nut cuntu: ulna?Hm. r. hum: 43.1.1.1:- I ozone: Tuccn?u I, nmn' lulu-1 c. Ul?l?l?l?lftl? (gluing; Hm? ?unatluu WHITEH a DIRECT DIM. NUMBER I cl H. nun: emu H- no! low lit-WT- an?? 3 4'3 lace BATON. 35?? JR. I. LIIHICAJAJ taut?! Lieu :u-In: I IN IEPII 7? I mi?tulg?nlilhm? 13' "un?t: in roll All-tn I. c. unnum?ru Mu: non-an "nml?u a? MID 3.6. rum-A lluli?? Mun? urn-t- yum DELIVERY Mr. Jeffre Nedler Division og?eal Property New York City Department of General Services 2 Lafayette Street New York, New York 100%? Re: Grand Heatt Hotel Dear Mr. Nadier WM We are counsel to the Regency-Lexington Partnere ("Regency"), the ground tenant of the Grand Hyatt. Reference is made to Ms. Fieretein'e correspondence, dated March 11, 1933, to Mr. Stan Blagojevic, a copy of which is attached. I Please be advised that Regency declines to honor your office's request to audit its financial records for calendar years 1935 and 1986 and denies that your office has any - right to audit the same. Please direct any further questions regarding this matter to the undersigned. Sincerely, M31:bw Marc 3. Intriligator enc. Stan Blagojevic GRAND HvAr.? NEW YORK PARK AVENUE AT GRAND CENTRAL NEW vona NEW some 1001 i? USA APPEND 212 13811234 ?93,136 4% an its-Wm September 13, 1939 "not, waM-The Honorable Vincent Tese, Chairman UDCfCommodore Redevelopment Corporation cfo New York State Urban DeveIOpment Corporation 1515 Broadway New York, New York 10036?8960 Re: Draft Report Number GHYBA dated August 16, 1989 on Financial Operations of the Grand Hyatt Hotel and Percentage Rental Paid by Regency-Lexington Partners for 1985 Dear Chairman Tese: We are the managing agent of The Grand Hyatt Hotel by virtue of a management agreement dated May 23, 1975. In this capacity, we were the principal recipient of the above-referenced draft report, which was prepared by the Office of the Auditor General of the City of New York, the agent appointed by you under the terms of the lease of the hotel for the Limited purpose of conducting an audit of its books and records for the 1936 calendar year. Although we believe that a copy of the draft report has already been delivered to Mr. Seed of your office, we enclose a copy of the same for your convenient reference. Please be advised, as a preliminary matter, that we were greatly disappointed by the hostile tone and ill?concealed bias throughout the Auditor General?s draft report. Rather than an objective and professional discussion of the audit's findings and conclusions, the draft report is replete with diatribes, hyperbole and histrionics. Thus, the Auditor General?s product has more of the flavor of a political position paper than that of an objective audit report. Asthe City is well aware, by virtue of our management agreement, we are fully responsible for the operation and management of the Grand Hyatt Hotel. Among our other responsibilities, we perform the hotel's bookkeeping, as well as implement its accounting practices and procedures, which we likewise do for many of our other hotels. As a reflection of our preeminent position in the hotel industry worldwide, far surpassing our competition in virtually every category, many of the practices and procedures that we have established for our facilites, including most of the accounting practices and procedures discussed by the Auditor General in her draft report,have long since become the standard throughout the hotel trade. In addition to all of the above. 35 i5 PUP flustomary practice, we retained Laventhol 5c Horwath, the leading hotel accounting firm In the United States?and, we understand, a firm frequently consulted by the City of New York when faced with hotel accounting questions to be the hotel's certified PUDIIC accountants and independent auditors. In such capacity, Laventhol or Horwath actually recommended and, indeed, certified without qualification the accounting practices and Procedures that we adopted for the hotel. APPENDIX I The Honorable Vincent Tese September 13, 1989 Page -2- Our involvement with The Grand Hyatt began in the mid?19705, when New York City was on the verge of declaring bankruptcy and the entire Grand Cenm? Terminal area - was a classic example of urban decay and municipal neglect. in this environment, we were extremely reluctant to undertake the massive effort and to commit the Substantial financial resources that would be required to bring to fruition the Grand Hyatt project or any other development in New York City. However, we were pursuaded to do so by the extraordinary vision of Donald J. Trump, as well as his strong commitment and loyalty to the project and to the City. Mr. Trump's efforts to obtain our involvement were bolstered by the strong support of all of New York City's officials, including the then mayor. After many discussions, Mr. Trump and the municipal officials with whom we spoke convinced us that our involvement Would enhance the success of an exciting new Landmark hotel, heralding the renaissance of the entire Grand Central Terminal area and providing a great boost for the morale of this greatly troubled city. Over the course of our day-to?day management of the business and affairs of the Grand Hyatt, we have noted that City auditors seem to be coming more frequently and staying longer. For example, auditors were in the hotel on this audit for nearly seven months. We are not sure of the reason for this. It may relate to the presence of Donald Trump as one of the owners of the Grand Hyatt even though Mr. Trump has had virtually nothing to do with the operation and maintenance of the hotel since shortly after its construction, which was his primary responsibility to the venture. In this context, we followed with great foreboding the saga of Trump Tower, in which the Koch administration unprecedentedly denied Mr. Trump the benefits of a real estate tax abatement program for which the property was clearly qualified and that had been, both before and since, routinely granted to luxury developments throughout the City. Mr. Trump?s position was eventually totally vindicated in a unanimous decision of the New York State Court of Appeals, which found the City's denial of these benefits to be completely unjustifiable. The Auditor General has invited us to comment upon the draft report to her. However, we do not believe that such a course of action would be productive given both the substance and tone of the document. As a result, we have enclosed herewith, for your consideration, a copy of our detailed reaponse to the draft report. While the enclosed report responds in detail to the various allegations of the Auditor General all of which lack any substance and are immediately dismissable, a few issues deserve special mention: The accounting standards established for the Grand Hyatt were recommended by Laventhol a Horwath and certified without qualification as being correct and proper by this leading hotel accounting firm. The accounting standards for capitalization and eXpense used by the Grand Hyatt Hotel are totally in accord with generally accepted accounting principles and are used by the vast majority of larger hotels in New York City. The Auditor General totally disregards the plain language of the hotel lease and creates her own definition of profit one with no foundation in the lease. 1 APPENDIX I The Honorable Vincent Tese September 13, 1989 Page The Auditor General claims that Hyatt approved and used accounting standards that, in fact, have never been used at the Grand Hyatt. - The audit report challenges the Hotel's use of a six year useful life even though the items requiring replacement were six years old at the time they were discarded. Although we believe that the Auditor General?s final report will not vary significantly from the draft report upon which we commented, we must respectfully reserve the right to update our response upon our receipt of the Auditor General's final product. As detailed in the enclosed response, the Auditor General?s draft report is replete with errors of fact, misinterpretations of the provisions of the hotel lease and the other documents described in the draft report, mischaracterizations of the accounting principles utilized by us in preparing, as well as by Laventhol Horwath in certifying, the financial statements and reports issued to you' for the 1986 calendar year and misstatements concerning the requirements and customs of the accounting profession, both in general and concerning hotel accounting in particular. As a result, the conclusions reached by the Auditor General are not supported by fact, relevant accounting standards, or applicable customs in the industries involved. Consequently, the findings and recommendations made by the Auditor General in her draft report should be disregarded. Although we categorically disagree with practically all of the conclusions and recommendations contained in the Auditor General?s draft report, we were pleased to read her espress finding that the hotel?s internal controls were adequate to ensure that its 1936 financial statements fairly presented the net profit of the hotel. Thus, the Auditor General?s own audit confirmed that the revenues reported in the hotel's financial statements were not understated in any respect and that the expenses reported were genuinely incurred for bona-fide hotel purposes. Consequently, all of the issues raised in the draft report relate exclusively to the hotel?s accounting policies and principles, which were certified without qualification as being correct and proper by Laventhol a Horwath. Indeed, many of the policies and principles criticized in the draft report were in fact implemented upon the express recommendation of this prestigious accounting firm. On a more formal note, we were distressed to discover in an "exit conference? held between our representatives and those of the Auditor General that your agent has no intention of keeping the final report confidential, as is required under express terms of the hotel's lease. Rather, such representatives outrageously stated that the Auditor General intends to make the final report available to the general public. Clearly, the Auditor General's authority to audit the books and records of the hotel was derived solely through your appointment of the City as your agent for the circumscribed purpose of performing such an audit . ;rsuant to, and in accordance with, the terms of the lease, which include Specifically and critically the requirenent of confidentiality set forth in Section 4.9.7 of the same. We would consider any release of the draft report, the final report, or any of the other materials and data received or generated by the Auditor General or her staff in connection with the audit, all of which are clearly replete with our trade secrets and other highly confidential information concerning the finances of the to constitute both a contractual default and a material breach of your responsibilities under the lease that would cause substantial damage to the competitive APPENDIX I The Honorable Vincent Tese September 13, 1989 Page position of the hotel as a commercial enterprise and would be the basis for an immediate and substantial lawsuit. Thus, it is incombent upon you to hold, as well as to cause your agent to hold, all of such reports, materials and data in the strictest confidence. We believe that it would be useful for us to come to prompt understandings concerning both the protection of our trade secrets and other highly confidential information concerning the finances of the hotel and the procedures that will be followed in order to bring this matter to its final resolution. Consequently, we would welcome the opportunity to discuss these topics with you or the appropriate members of your staff at the earliest convenient time. Very truly yours, GRAND NEW YORK awe?a Stan Blagoj?fig Controller cc: lerie Ca ro i, Es . aren Burgtepn, APPENDIX I RESPONSE TO DRAFT OAG REPORT: GHYQA DRAFT REPORT ON FINANCIAL OPERATIONS OF THE GRAND HYATT HOTEL AND PERCENTAGE RENTAL PAID BY REGENCY-LEXINGTON PARTNERS FOR 1985 This report has been prepared in response to the Draft Report on Financial Operations of The Grand Hyatt Hotel (the HHotel") and Percentage Rental Paid by Regency?LexingtOn Partners (the 1rPartnership?) for 1986 (the "Draft Report") dated August 16, 1989, prepared by the Office of the Auditor General of the City of New York (the "City"). The Draft Report was prepared by DAG in its capacity as the agent of UDCfCommodore Redevelopment Corp. appointed in a letter to the Partnership dated June 23, 1988 for the limited purpose of conducting an audit of the Hotel's books and records in order to verify the amount of percentage rental payable by the Partnership for the 1986 calendar year. UDCfCommodore is the landlord, and the Partnership is the present tenant, under the Agreement of Lease dated as of December 19, 1977 covering the Hotel (the "Lease"l. As detailed below, the Draft Report is replete with errors of fact, misinterpretations of the provisions of the Lease and the other documents described in the Draft Report, mischaracterizations of the accounting principles utilized by the Hotel's managing agent in preparing, as well as by the Hotel's independent auditors in certifying, the financial statements and reports issued to UDC/Commodore for the 1986 calendar year and misstatements concerning the requirements and customs of the accounting profession, both in general and concerning hotel accounting in particular. As a result, the conclusions reached in the Draft Report are not supported by fact, relevant accounting standards, or applicable customs in the industries involved. Consequently, the findings and recommendations made in the Draft Report should be disregarded. Although this response takes issue with all of the Draft Report?s criticisms of the accounting principles, policies and standards that formed the basis for the percentage rental statement issued by Hyatt Corporation, the Hotel?s managing agent, and certified by Laventhol d: Horwath, the Hotel's independent auditors, we are pleased to note that the Draft Report does not question in any reapect the amount of revenues received, or the amount or propriety of expenses incurred, by the Hotel during the 1986 calendar year. Indeed, the Draft Report expressly concludes that the Hotells internal controls were adequate to ensure that its 1936 financial statements fairly presented the net profit of the Hotel. Consequently, all of the issues raised in the Draft Report relate exclusively to the accounting treatment in the Hotel's certified percentage rental statement of the Hotel's income and eXpenses with reapect to the year in question. Given the nature of the issues raised in the Draft Report, one must note that the recordkeeping, financial analysis and financial reporting policies and practices utilized at the Hotel, including those criticized in the Draft Report, were adopted with the professional advice and guidance, and in many instances in response to the express recommendation, both of Hyatt Corporation, in its dual capacities as the Hotel?s managing agent and, through an affiliate, as a partner in the Partnership, and of the certified public accounting firm of Laventhol a Horwath, the independent auditors of the Hotel?s books and records. These policies and practices were implemented by Hyatt in the discharge of 1.1- APPENDIX I its reaponsibilities to keep the books and records of the Hotel and to prepare the financial statements and reports in question. Further, the policies and practices were sanctioned by Laventhol in their unqualified certification of such statements and reports after their comprehensive audit of the Hotel's books and records. The credentials and reputation of Hyatt Corporation and Laventhol 5c Horwath are universally recognized in the hotel industry and beyond. Hyatt is renown as one of America?s premier hostelers, lending its outstanding reputation as a premier operator and manager of hotel facilities generally to a wide range of hotels and resorts throughout the United States, Canada, the Caribbean and the rest of the world. By the end of 1989, the Hyatt chain will include over 150 hotels and resorts, all operated and managed by Hyatt. Similarly, in the 75 years since its creation, Laventhol has developed a worldwide reputation as one of the nation?s premier accounting firms. Recognized far and wide for its accounting expertise in general, the firm is also noted for its particular experience in the specialty of hotel accounting, resulting in its engagement as the auditor for a vast number of hotels and hotel chains in the New York Metropolitan area and throughout the world. Not unexpectedly, even the City has had a long-standing relationship with Laventhol, frequently consulting the firm when faced with issues concerning hotel accountancy. As unquestioned authorities in their respective fields, both Hyatt and Laventhol were uniquely suited to appropriately fashion and discharge the accounting requirements of the Lease. The first substantive topic discussed in the Draft Report concerns the formula used in the certified percentage rental statement for determining the "Profit" of the Hotel for the 1986 calendar year. It is this "Profit" upon which the percentage rental payable under the Lease is directly based. On this subject, the terms of the Lease are clear and undisputable. The "Profit" of the Hotel for any calendar year is Specifically defined in the Lease as the amount, if any, by which the revenues "actually received" by the tenant for the services rendered and merchandise sold at the Hotel exceed the costs "incurred" by the tenant or on its behalf. Thus, while the Lease expressly requires the recognition of the Hotel?s expenses as they are incurred, even though they may be actually paid at a later time, the Lease requires that the Hotel's revenues be recognized only when they are actually received, even though they may have been earned on an earlier date. The Draft Report neither disputes that this formula for determining the "Profit" of the Hotel is specifically set forth in the Lease nor claims that the certified percentage rental statement in question deviated in any respect from the mandated formula. Instead, the Draft Report pays rather tepid lip service to the Lease?s express terms before launching into a discussion of various inferences drawn from tangentially?related provisions of the Lease, examples of more conventional definitions of the concept of ?profit?, the impact of the Lease?s definition of "Profit" upon the amount of percentage rental payable for the calendar year in question and the incorrect application of such formula by the Hotel?s managing agent in prior years {which was corrected in the certified percentage rental statement for the 1936 calendar year), all in an attempt to discredit the clear and undisputable terms of the Lease. However, the Draft Report's rhetoric cannot overcome the simple fact that, no matter how unconventional the formula used in the certified percentage rental statement for determining the "Profit" of the Hotel may be, it is the formula mandated in the Lease for such purpose. The use of any other formula, including the formula proposed in the Draft Report, would be a deviation from the plain requirements of the Lease. APPENDIX I The second topic discussed in the Draft Report relates to four so?called "changes in accounting policy" adapted for the Hotel. As a preliminary matter, it must be stated that, contrary to the findings in the Draft Report, there were pg changes in accounting policy adopted for the Hotel with respect to the 1936 calendar year. Indeed, the third and fourth so-ealled "changes in accounting policy? cited in the Draft Report, the expensing of outside and in~house labor used to place capital items in a condition and position ready for use and the expensing of all freight charges and sales taxes, were never implemented at the Hotel. Rather, consistent with past policy and generally accepted accounting principles, only the cost of the in-house labor used to clean and otherwise prepare the general area in which a capital item was to be installed was expensed the cost of the labor used to place such items into service was always preperly capitalized. Additionally, also consistent with past policy and generally accepted accounting principles, the freight charges and sales taxes incurred in connection with the acquisition of capital items during the 1986 calendar year were appropriately capitalized -- only the freight charges and sales taxes incurred in connection with the acquisition of properly expensed items were themselves expensed. Of the two so?called "changes in accounting policy" actually implemented at the Hotel, neither was in reality a change in policy at all. Since its inception, the Hotel has had an established policy of expensing both items having "de minimus" costs and items having relatively short service lives that are recurrently replaced with equivalent fungible items. This policy permits the managing agent to avoid the administrative nightmare that would result if such items were capitalized and depreciated, requiring it to track the acquisition, use and disposal of a large quantity of relatively inexpensive or short?lived, regularly replaced items. The changes implemented in 1986 were thus not changes in accounting policy at all, but rather an Update of the threshhold criteria selected to serve as the standards for determining which acquisitions fell within and without the "de minimus" category. These threshold criteria require periodic review and adjustment based upon changes in the general economy, changes in the Hotel?s gross operating income, changes in the Hotel's purchasing procedures and other similar factors. To assert that a mere update of the standard threshhold criteria used to define a "de minimus" acquisition constitutes a change in accounting policy is a patent mischaracterization. The new benchmarks adopted beginning in the 1986 calendar year were selected from a range of benchmarks recommended by the Hotel's certified public accountants upon their review of all of the relevant factors. In the exercise of their professional judgment and experience, Laventhol d: l-Iorwath suggested that, in view of such factors, the managing agent use a three-prong test for determining which expenses would be treated as "de minimus" that the managing agent treat expenses below a range of between $250 and $500 per item, expenses below a range of between $1,000 to $2,000 per invoice and expenses for redurring replacements of items having a useful life below a range of between three and five years as "de minimus" expenses for financial reporting purposes. Significantly, the "de minimus" threshold was actually reset to reflect a $250 per item amount and a three year useful life, the lowest points in the ranges recommended by Laventhol a Horwath. The "per invoice" category recommended by Laventhol was never adopted. The Draft Report's statement that the managing agent used a $500 per item, a $2,000 per invoice and a five year useful life test is simply untrue. The reasonableness of the $250 per item test cannot be seriously questioned. It is clear that, unlike the anachronistic $50 per item threshold used in prior years, the $250 -3- APPENDIX I per item test (constituting 0.000005 of the gross operating income of the Hotel) was sufficiently high to be useful in identifying those items whose costs were too inconsequential for capitalization, but yet not so high that the aggregate value of the items costing under such amount would likely be substantial. The Draft Report?s emphasis on the degree of increase in the threshold, from $50 to $250, is clearly misplaced the issue is not whether the degree of increase was reasonable, but rather whether the threshold itself was a reasonable amount given the state of the general economy, the amount of the gross operating income of the Hotel and other similar factors. in this regard, it is extremely instructive to note that, in a survey of hotel accounting practices recently conducted by Laventhol a Horwath, 14 of the 17 major New York City hotels surveyed that have adopted a fixed "de minimus" capitalization policy reported that they had adepted guidelines generally calling for the expensing of acquisitions costing $250 or less per item (one hotel had selected a $500 per item "de minimus" threshold, while two had selected a $100 per item threshold). Clearly, the managing agent's use of a $250 per item "de minimus" threshold was well within the mainstream of hotel accounting practice. The three year useful life standard for regularly recurring replacements is similarly appropriate. Clearly, the decision to write off in the year of acquisition that portion of the Hotel's stock of items having a useful life of three years or less that required replacement in such year cannot result in a significant distortion of the operating results of the Hotel for such year. Indeed, assuming the level consumption of these items, one third of the Hotel's stock of the same would require replacement in each year, rendering the treatment of these items as either capital acquisitions or acquisitions to be expensed identical with respect to each year. The only difference between these treatments is the avoidance of the administrative nightmare of tracking the acquisition, use and disposal of each item that would result if such item were instead capitalized and depreciated. Significantly, again it is instructive to note that, in its recent survey of the accounting practices of various major New York City hotels, Laventhol 5.: Horwath discovered that 15 of the 20 hotels that responded on this issue had adopted a policy of expensing items having a useful life of less than ?v_e years, 3 of the surveyed hotels had adopted a policy of inventorying such items and expensing them as they are used and 2 of the surveyed hotels had adopted a policy of eXpensing such items unless their acquisition were part of a project. Only one hotel has of capitalizing such items having a useful life of less than five years. Clearly, the policy adopted at the Hotel is directly in the mainstream of the hotel accounting industry. The third topic discussed in the Draft Report is the appropriate treatment of the foregoing items if they were capitalized rather than expensed. However, given that the expensing of these items was reasonable and appropriate, and thus fully consistent with generally accepted accounting principles, the standards for treating these items if they were capitalized need not be addressed. The fourth topic discussed in the Draft Report deals with the decision to depreciate the expenditures that were capitalized in 1985 over six years, rather than the eight year period selected for similar acquisitions made in prior years. The most basic accounting procedures require that a determination be made each year as to the useful life of each item purchased during such year. This determination requires, in general, an estimate of the length of time that such item will remain in service. Clearly, the best and most appropriate criterion available to estimate the service life of replacement items is the length of service actually experienced with respect to the equivalent items being replaced. -4- APPENDIX I The items in question were replaced as part of a general and extremely costly refurbishment of the Hotel and its furniture, fixtures and equipment accomplished in 1996, made necessary by the degree of actual wear and tear experienced with respect to these items over the first six years of operation of the Hotel. Actual operating experience with reSpect to the precise items in question dictated the establishment of a six year useful life for capitalizing the expenditures incurred to acquire their replacements. In this context, the selection of any other useful life for the replacement items, whether longer or shorter, is impossible to justify. It is important to note, in this regard, that the six year useful life adopted for capital items purchased in 1986 could not, and did not, affect the depreciation of similar items purchased in prior years these items continue to be depreciated over their eight year estimated useful lives. The fifth topic discussed in the Draft Report relates to the amount of debt service deducted as an expense in the Hotel's certified percentage rental statement. Under the Lease, the amount of first leasehold mortgage debt service actually incurred in 1986 with respect to the Hotel is irrelevant. Rather, the Lease calls for the deduction of a constant amount of debt service throughout the forty year term of the first leasehold mortgage, consisting of the debt service payable under the "initial" first leasehold mortgage placed on the Hotel with respect to the first Year when constant payments of principal and interest are due under such mortgage. Of the $8,354,000 of principal and interest deducted in the certified percentage rental statement, the deduction of $7,854,000 is accepted without question in the Draft Report. Similarly, of the $500,000 balance, constituting the "additional" interest payable under the first leasehold mortgage, only $75,433 is actually called into question by the Draft Report the remaining $423,567 was actually accepted in the Draft Report upon the proviso that the Auditor General be given access to the Hotelis books and records for the relevant year to determine whether the amount of additional interest that the Draft Report concedes was actually paid to the lender was in fact the amount payable under the mortgage. Thus, setting aside for the moment the question of whether the Auditor General is entitled to review the Hotel's books and records, assuming that they still exist, for the relevant year (discussed below), the total amount of debt service in dispute is $75,433 out of a total deduction of $3,354,000. The issue concerning the deductibility of the $76,433 in question relates to whether the appropriate measuring year for determining the amount of deductible additional interest is the year from December 1, 1992 through November 30, 1983 (the first year during which constant payments of principal and interest were called for under the "initial" first leasehold mortgage, for which $499,995 in additional interest was paid on or about May 1, 1984) or the year from December 1, 1931 through November 30, 1982 (the year prior to the first year during which constant payments of principal and interest were called for under the "initial" first leasehold mortgage, when only interest was payable under the mortgage, for which in additional interest was paid on or about May 1, 1983). The position taken in the Draft Report hinges upon its interpretation of the governing provision of the Lease as stating that the amount of deductible interest is the amount of interest paid during the measuring year, rather than the amount of interest paid the measuring year. The gloss placed by the Draft Report on the governing provision of the Lease cannot be its appropriate interpretation on a number of grounds. First, as the Draft APPENDIX I Report reiterates in several contexts and on countless occasions, the Lease requires that the expenses of the Hotel be reported on the accrual basis of accounting. Thus, the amount of interest properly recognizable is not the amount of interest actually paid during the measuring year, but rather the amount of interest incurred such year. The appropriateness of this interpretation is confirmed by the clear intent underlying the provision. Clearly, the provision was designed to establish, as a fair standard for a constant deduction that was to be in effect over forty years, the interest payable for the first year during which the Hotel was fully opened and operational after the conclusion of its initial "Shakedown" period. Thus, the measuring year was established as the first year during which the Hotel?s operations had sufficiently stabilized to permit the commencement of amortization payments. Yet the Draft Report's position on this issue would require the use, for the entire forty years of the life of the mortgage, of an additional interest figure predicated upon the Hotel's operation for the year prior to the first year of stabilized Hotel operations. The Draft Report's conclusions therefore cannot be justified. The remaining issue concerning the debt service deducted on the 1986 certified percentage rental statement relates to a condemnation award in the amount of $575,846 received in June of 1986 and paid over to the first leasehold mortgagee. In this regard, the Draft Report correctly points out that the Lease does not permit the deduction of principal and interest payments on the first leasehold mortgage other than the amount of interest and principal paid on the "initial" first leasehold mortgage with reapect to the first year during which constant payments of principal and interest are due thereunder. However, the Draft Report fails to recognize that, notwithstanding its treatment in the certified percentage rental statement, this payment was preperly deductible as a reserve for the repairs and restoration to the Hotel that will be required once the existing issues concerning the condemnation are resolved. A short background discussion concerning the creation of the reserve in question would help focus the discussion on this point. In June of 1986, a minimum condemnation award was received from the Metropolitan TranSportation Authority as a result of the taking of various portions of the basement of the Hotel for use as corridors and passageways to improve the flow of pedestrian traffic within the Grand Central subway station. The final amount of the award, which will likely be greater than the minimum award heretofore received, is presently still under negotiation, in large part because of continuing uncertainties as to exactly what was taken. The surveys, maps and other documents filed by the condemnor in connection with the taking in question leaves unclear the impact of the taking upon the operation of the Hotel, as well as the nature, extent and cost of the restoration work that will be required as a consequence of the same. For example, certain pipes, electrical conduits and other installations servicing the Hotel, some of which are major facilities through which a significant portion of the building?s utility services are supplied, run along the ceiling of the area in question. The condemnation documents do not give the Hotel the right of access to inspect, maintain and repair these facilities. The documents are even unclear as to whether the facilities themselves have been taken. If, as a consequence of the taking, these facilities must be replaced or relocated, the cost of performing such restoration work will likely be excessive, perhaps significantly in excess of the minimum condemnation award received from the MTA. APPENDIX I Pursuant to the terms of the first leasehold mortgage and in accordance with the express requirements of the Lease, this award was paid directly to the mortgagee by the condemning authority. Also pursuant to the terms of the mortgage and the Lease, subject to the approval of the mortgagee,'the award is to be made available, in whole or in part, for the purposes of altering, restoring, or rebuilding any portion of the Hotel that is altered, damaged, or destroyed as a result of the taking. Given the uncertainty as to the nature, extent and cost of the restoration work that will finally be required, the mortgagee has not yet been requested to make all or any portion of the condemnation award available for purposes of paying the cost of restoration. Until the lender?s disposition of the eventual request to make all or a portion of such award available for these purposes, the amount paid to the lender has been treated as a reserve fund for such purpose, thus constituting an expense of the Hotel for the year in which such payment'was made. When the amount of the reserve fund is actually paid out, a suitable adjustment will be made, in conformity with generally accepted accounting principles, if the amount paid out is less than the amount reserved. The sixth topic discussed in the Draft Report relates to the deduction of interest paid in conjunction with sales, use, occupancy and telephone rental taxes adjusted as a result of audits. The Draft Report confirms that the deduction taken in the 1988 certified percentage rental statement for the actual amount of the additional sales, use, occupancy and telephone rental taxes paid as a result of the audits was both correct and appropriate. However, the Draft Report calls into question the deductibility of the interest paid as part of the settlement of these items, apparently on the theory that, because the interest in question represents a "penalty" for the initial underpayment of these taxes, the same is not deductible. In support of this proposition, the Draft Report explains that the Lease requires the tenant to pay under protest all taxes that become in dispute. Thereafter, a refund of any overpayment may be sought if the Hotel?s position is upheld in audit. According to the Draft Report, to do otherwise is a technical default under the Lease. The Draft Report's position is defective in two respects. First, the amount finally determined to be due to the taxing authorities could not be paid pending the resolution of the dispute because, in the context of a tax audit, the taxing authority does not make a demand for payment until its field audit work is completed, its audit report is completed and the taxpayer refuses to settle based upon the audit findings. In this instance, the matter was settled with the tax authority based upon such settlement discussions before a demand was made. Thus, there was no technical default under the Lease. Additionally, no liquidated amount existed the payment of which would stop the interest expense running. Thus, contrary to the position taken in the Draft Report, the interest expense was in fact an unavoidable cost incurred by the tenant. Moreover, even assuming that the ?interest clock" could have been stopped by paying an amount to the taxing authority and that the failure to do so was a technical default under the Lease, there is no authority in the Lease or otherwise for the proposition that these otherwise legitimate costs should somehow be disallowed as deductible expenses for {purposes of computing the percentage rental payable by the tenant as some sort 0 additional "default remedy" available to the landlord. The seventh topic discussed in the Draft Report relates to the deduction of legal fees validly incurred in connection with the leasing of space in the Hotel to retail tenants. As noted in the Draft Report, the legal fees in question were expensed under the principles enunciated in Section 19(a) of Financial Accounting Standard 13, which permits it APPEND IX I this treatment if the effect of expensing the fees is not materially different from that which would have resulted from a capitalization of the same. In support of its criticism, the Draft Report points out that the result of expensing the fees is to increase the amount of the current deduction ten-fold. However, the tautology recited in the Draft Report cannot be dispositive of the issue. By simple mathematics, a current deduction of an item otherwise to be amortized over ten years will always result in a ten-fold increase. This, therefore, cannot be the final result of the analysis called for under PAS 13 otherwise, the provision allowing for expensing of immaterial incidental costs coald never be effectuated. The appropriate analysis called for under PAS 13 is not whether, in absolute terms, a $72,963 increase in current expenses is material, but rather whether such an increase is material in the context of the budget in question. Clearly, such an increase cannot be viewed as material in the context of the Hotel's in gross revenues. Thus, the Partnership's treatment of this item was fully consistent with FAS 13. The eighth topic discussed in the Draft Report relates to the amount of outstanding water and sewage charges admittedly due to the City on an old commercial water meter that had long been neglected by the City and eventually discovered by them and billed. As noted in the Draft Report, $64,876 of the amount claimed to be due by the City was confirmed and paid. The $7,512 balance of the amount claimed to be due by the City was under investigation and, consequently, had yet to be paid. The Draft Report apparently takes the position that, because the $17,512 balance had not been actually paid to the City, an accrual for such item was not permissible. In the context of accrual basis accountancy, this position cannot be justified. It is the very essence of accrual basis accountancy under generally accepted accounting principles that cost items are expensed in their entirety in the period when the obligation to pay them accrues. In circumstances where the exact amount of the obligation is under investigation, and therefore a liquidated amount is not available for accrual, a reasonable estimate of the amount of the obligation must be made and accrued, subject to adjustment later if the estimate varies from the eventually liquidated amount. In this context, the full amount of the deduction taken was a combination of the amount actually paid and a bona?fide, reasonable estimate of the amount than remaining to be paid but not then liquidated, as evidenced by the amount actually paid after the investigation of the amount actually due was concluded. The ninth topic discussed in the Draft Report is the recalculation of the incentive management fee payable to Hyatt Corporation. If the other adjustments proposed in the Draft Report were instituted, the amount of profit earned at the Hotel would be increased, thus increasing the amount of the deductible incentive management fee payable to Hyatt as well The Draft Report thus proposes that an adjustment be made in the Partnership's favor to reflect the greater incentive fee that would be payable to Hyatt. However, because all of the other adjustments proposed in the Draft Report are inappropriate, there is no need to increase the amount of the Partnership's deduction for Hyatt?s incentive management fee. The tenth topic discussed in the Draft Report, touched upon both in the section setting forth findings and recommendations and in various other earlier sections, -3- APPENDIX I relates both to the recordkeeping practices of Hyatt Corporation as the Hotel's managing agent and to the Partnership's refusal to permit OAG to inspect the Hotel?s books and records for the 1981 calendar year (for purposes of verifying the amount of additional interest payable under the Hotel's first leasehold mortgage for such year) and the 1985 calendar year (both for the purpose of verifying by comparison the field work done by the DAG staff with respect to the 1986 year and for the purpose of auditing the percentage rental paid under the Lease for the 1985 year). in the context of Hyatt?s recordkeeping, the Draft Report takes the position that the Lease requires every guest check, every cash register receipt, every fiscal summary and every other scrap of paper potentially useful or convenient to any degree, regardless of how remote, to the verification of the amount of percentage rental payable during a calendar year to be retained in New York City for a period of two years. Indeed, it even goes so far as to state that the storage of certain of these voluminous records, as a matter of convenience, in a storage facility in Hoboken, New Jersey was a technical default under the Lease, notwithstanding that these records were susceptible of prompt recall and inspection at the Hotel. However, the Lease clearly does not require the managing agent to undertake the herculean task of safekeeping every scrap of paper that might have some remote relevance to the fiscal affairs of the Hotel rather, Section 4.9.5 of the Lease requires merely the keeping of "full and accurate books of account and records from which Profits for each lease year during the term can be determined". The Draft Report itself confirms that, although its field work might have been made more time?consuming, OAG was able to complete its audit with confidence in the accuracy of its results. Therefore, by definition, Hyatt was in full compliance with the recordkeeping requirements of the Lease. The Draft Report's claim of the right to review the Hotel?s books and records for prior years for various purposes, including the right to audit the 1985 books and records, is not supported by the terms of the Lease. Section 4.9.6 of the Lease clearly provides that the landlord or its agent must be given the portunity to "inspect and audit" the Hotel's books and records until the end of twenty- our months following the conclusion of the fiscal year in question. Contrary to the position taken in the Draft Report, no provision is made in the Lease for the tolling of such twenty?four month period if UDC/Commodore or its agent gives notice of its desire to inspect or its intention to audit during such twenty? four month period, but fails to make such inSpection or commence such audit until after such period's expiration. The clear purpose of Section 4.9.6, to permit the Partnership to close its books and dispose of its voluminous records, receipts, vouchers and other papers after a reasonable period is given to UDC/Commodore or its agent to inspect or audit the same, would be frustrated if the audit right could be preserved forever merely by sending a letter indicating an intent to audit at some time in the future or if the Partnership could be denied a deduction for 1986 and all future years because the books and records for 1982 are no longer available to verify the amount of a category of mortgage interest that was payable, as opposed to paid, in such year. Although the issue of when an audit commences is susceptible of interpretation, it is clear in this instance that, while the Hotel?s managing agent was advised by UDC/Commodore of the City's desire to audit the Hotel's 1935 books and records by letter of June 3, 198?, the City took no steps to begin such audit until, at the earliest, sometime after March 11, 1988, when the initial approach was made by the New York City Department of General Services in a letter to the Managing Agent, stating the names of -9- APPENDIX I the members of the audit team, requesting space at the Hotel in which the audit team would work and demanding access to certain specified books and records. Thus, at the time that the City first began to take steps to perform its audit, only the 1986 and 198'? books and records were required, under the Lease, to be made available for audit by UDC/Commodore or its agent. Besides the ten topics described above, the Draft Report raises various other issues having little or no apparent relevance to the audit findings and recommendation. Notwithstanding their irrelevance to the issues at hand, these issues call for a response. First, the Draft Report repeatedly states that the Hotel's managing agent caused a delay in the commencement of the audit from March of 1988 to June of such year. However, the draft report neglects to point out that, under the Lease, only the landlord, UDC/Commodore, or its agent has the right to inspect or audit the Hotel's books and records. At that point, the City had not been appointed as the agent of UDCfCommodore for purposes of inSpecting or auditing such books and records. The other documents cited in the Draft Report as bearing on this issue do not confer any independent right to audit such books and records upon the City. after June 28, 1983, the date upon which UDC/Commodore appointed the City as its agent for purposes of performing the audit, the Hotel's managing agent advised the City that the audit could immediately commence. Because of own scheduling difficulties, the audit was in fact commenced in August of 1988. Second, the Draft Audit states in various contexts that the managing agent did not cooperate sufficiently with the field audit team. A review of the draft report, however, confirms that the managing agent made available, or caused the Hotel?s auditors to make available, to the field team all of the books and records necessary for the audit field work to be performed and completed. Additionally, a review of the correspondence between the managing agent and DAG confirms that the managing agent was extremely responsive to the requests of the field staff for both supporting materials, to the extent that the same was available for inspection or delivery, and reaponses to questions posed from time to time by the audit team and its supervisors. It is difficult to imagine how the Hotelis managing agent could have been more reaponsive, cooperative, or accommodating to the audit team and other DAG personnel. Third, the Draft Report is replete with disparaging statements concerning Laventhol d: Horwath's reevaluation of Hotel?s accounting practices and procedures, as well as the adoption of certain of the firm's recommendations, before the preparation of the 1986 certified percentage rental statement. Contrary to the Draft Report's assertions that accounting practices and procedures should remain static, a primary reaponsibility of the Hotel?s auditors, like that of all certified public accountants, is precisely to determine from time to time whether changes in prevailing accounting norms and standards, changes in economic conditions, changes in the Hotel's fiscal condition, additional insight into the Hotel's financial affairs obtained through observing changes its operation during the intervening period and other similar factors require an adjustment of one or more of the Hotel?s accounting practices or procedures. Such a periodic reevaluation is not only legitimate and proper, it is also mandated by good accounting practice and professional accounting representation. For a certified public accountant to neglect this responsibility would be tantamount to professional malpractice. Neither the reduction of the amount of percentage rental properly payable under the Lease as one consequence of updating the -10- APPEND IX I Hotel's anachronistic accounting practices and policies, the magnitude of such reduction, nor the goals of the members of the Partnership in encouraging such review and in concurring with the adoption of some of the recommendations made as a result of the same has any relevance to, or hearing Upon, the soundness of the recommendations made by Laventhol dc liorwath or the conformity of the same to the requirements of the Lease. Fourth, the Draft Report criticizes Laventhol a Horwath for failing both to state in the footnotes to the certified percentage rental statement that there were changes in accounting policy implemented starting with the 1988 calendar year and to describe in the footnotes the accounting methods used to depreciate and amortize property and equipment. As discussed at length above, contrary to the position taken in the Draft Report, there were no changes in accounting policy implemented with the 1986 calendar year. Rather, there was an updating of the criteria used to effectuate the Hotel's long standing policy of expensing, rather than capitalizing, "de minimus" expenditures. Further, although the certified percentage rental statement, a specialized report, did not contain footnotes describing the accounting methods used to depreciate and amortize property and equipment, the certified financial statement of the Hotel for the 1985 calendar year contained such a description. Given that this certified financial statement was delivered to UDC/Commodore contemporaneously with the delivery of the certified percentage rental statement, the Draft Report's criticism on this final point is unwarranted. -11_