7 FOLDER: 8 AUDITOR GENERAL (AUDITS REPORTS) 1989 THE CITY OF NEW YORK Office of the Auditor General 217 Broadway Suite 206 Mm; New York, N.Y. 10007 KAREN s. BURSTEIN was!? (212) 285-3220 AUDHORGENERAL MEMORANDUM TO: Mayor Edward I. Koch - FROM: Karen S. Burstein DATE: November 14, 1989 RE: Grand Hyatt Audit I would like to meet with you toward the end of this week, when I expect to have the final version of our Grand Hyatt audit. As soon as it is ready, I'll call to 1,set up a meeting. In anticipation of our discussion, I enclose a brief redaction of the issues.* Thanks. cc: Stanley Grayson Hadley Gold *This outline will be updated by the audit, because of our latest research. Still, the attachment continues to capture the main points of our arguments. 1. Landlord, Trustee for City 2. NYC Third Party Beneficiary;has reversionary interest in property (land and improvements) 3. PARTNERS tenant 50% Wembley Realty, D. Trump, pres 50% Refco, wholly owned subsidiary of Hyatt 4. HYATT CORPORATION manager of Grand Hyatt under contract to Partners 3 annual payments by partnership - a. net rent 2 $100 (annually, for 99 years) b. Tax Equivalency Fee: from 1978?5/80 $1 from 1980?5/85 $250,000 from 1985-5/90 $350,000 from 5/90?2020 lesser of full real property tax or amt set out in Exhibit of Lease ($600,000 in 5/91 to $2,775,000 in 2020.) from 5/2020?end full real property tax c. Percentage Rental: . 10% of first $500,000 of Profits 12&1/2% of next $1,000,000 of Profits 15% of next $1,000,000 of Profits 20% next $1,000,000 30% next $1,000,000 40% next $1,000,000 50% of any Profits over $5.5 million NB: The aggregate of and (TEF and Percentage Rental) is not to exceed full tax equivalency; consequently, in 2020, percentage rental necessarily reaches 0. In 1985, when the hotel's reported revenues were $78,256,432, its net profit was reported as $10,534,779. City received $3,742,380 in percentage rental. In 1986, when revenues rose to $79,948,941, profits were reported to decline to $5,057,696. City thus received $667,155 in percentage rental.1 Contrary to Hyatt letter (9/13/89) suggestion that the audit "may relate to the presence of Donald Trump as one of the owners?, 1 (In 1987, the trend continued with revenues at $85,647,008; profit at $8,266,356 and rental at $2,608,178.) OAG: GHYBA October 5, 1989 it was the sharp diminution in the City's percentage rental in 1986 which occasioned the landlord's request to exercise the lease?given ight to audit tenant's books and records. The above diminution in :net 'profits and percentage rent received is mostly attributable to changes in accounting methodology adopted by the tenants in 1987 and retroactively applied, in whole, to 1/1/86 and, in part, to 1982?1986. The Office of the Auditor General (OAG) maintains that those changes run counter to lease expectations and accepted and acceptable hotel accounting practice. Tenants insist, in the alternative, that, for the most part, no changes, merely updates, occurred; as for their new methodology on the profit/loss statement (see description below), that was, they argue, expressly licensed by the lease. May the tenants legally use, for determination of percentage rent owed the City, a profit and loss statement, which presents revenues calculated on the cash basis and expenses calculated on the accrual basis? Tenants: "no matter how is, the formula (is) mandated in the lease.? the practice is more than unconventional; it is irrational; to argue it is mandated is to read the lease as if it contained only a single sentence, unconnected to the balance of the document's language, accounting practice and the parties' history. Facts: Section 4.9.4 requires tenant to submit, within 90 days after close of lease year (now December 3lst), ?a statement certified by an independent Certified Public Accountant reasonably acceptable to Landlord showing the amount of Profits prepared in accordance OAG: GHYSA October 5, 1989 with generally accepted accounting principles consistently applied.? Appendix defines Gross Income as "the aggregate amount of monies actually received by Tenant in any lease Appendix defines Expenses as the ?..aggregate amount of any costs incurred by Tenant Later, it uses the words ?..all the foregoing items shall be the actual expenses Appendix (6), denominated HAccounting Principles? provides that in determining ?Gross Income, Landlord and Tenant agree that the Uniform System of Accounts for Hotels (USAH) dated 1971, adopted by the American Hotel and Motel be utilized to the extent such system is not inconsistent with the provisions hereof.? OAG Arguments: 1. USAH presumes adherence to GAAP mandate the accrual method. 2. Tenants used the GAAP/USAH?sanctioned methodology consistently until 1986. 3. Reading Appendix F. Sections (1) and (2) to reach Tenant's result renders entirely nugatory the provisions that frame them: Section 4.9.4 and Appendix (6). In fact, using Tenant's construction of (2) makes it impossible for Tenant to comply with Section 4.9.4 and creates an exception that swallows Appendix (6) whole. 4. The single purpose Tenant's revised interpretation of the lease accomplishes is to understate revenues in relation to expenses, with the result that stated profits are diminished, thereby reducing percentage rental owed the City until 2020, when the obligation for such rental is extinguished and Tenant begins paying full real property tax. 5. If the intent of the parties were to reduce Tenant?s obligations to the City (in return for the tax abatement tenant now receives), the parties could have done so directly (by establishing no or lower percentages). It 3 - GAG: GHYBA October 5, 1989 is irrational to conclude that the parties instead chose to reach this end by setting accounting theory on its ears, and then only after five years of observing appropriate practice. NB. While the OAG believes it has correctly construed the language and spirit of the agreement among the parties, at the very least the 'Tenant. is incorrect asserting that any other than its current approach "would be a deviation from the plain requirements of the Lease.? Did the Tenant properly expense $2,733,369 of capital items which would have been capitalized under practices it had followed prior to April, 1987? Tenant: We in reality "made no changes in accounting merely adopted "new benchmarks"; ?update(d) criteria.? OAG: The decisions made by the Tenant run counter to Generally Accepting Accounting Principles and the the treatment specified in the USAH. (See below.) Facts: Tenant's accountants, before an April exchange of letters wherein means of reducing Tenant's obligations to the UDC (City) were decided on, prepared schedules capitalizing the items in questions, using, variously, 3, 5 and 8 year lives. The expenditures in questions mostly related to the Hotel's 1986 refurbishing??were for fixed assets providing benefits for more than one accounting period (more than one year). The cost of such assets, under Accounting Principle Board Statement No. 4, ?is allocated to (the relevant) periods in systematic and rational manner..? Normally, the items would be shown as assets in the Furniture, Furnishing and Equipment account and be depreciated over their useful lives, with only the amount of applicable depreciation being expensed each year. OAG: GHYSA SPECIFI a: October 5, 1989 ISSUES UNDER POINT 2 Decision to depreciate, prospectively, over 6 years items purchased ill 1986, when similai? itemsh purchased iJ1 prior years, had been depreciated over an eight year period. Tenant: we changed the useful life from 8 to 6, because items only actually lasted 6 years OAG: the only support for tenant's position is the bare statement above; there was no adjustment to the Accumulated Depreciation and accounts reflecting the retirement (discarding) in 1986 (after 6 years) of any of these 8 year items. b: Decision to expense freight charges, sales taxes, and labor costs associated with formerly capitalized items. C: Tenant: we only expensed charges for items which were themselves expensed. OAG: This begs the question. 99% of what you expensed should have been capitalized; consequently, so should the charges. Decision to change "de minimis" policy from $50 to items under $500. Tenant: First, our policy is $250 not $500. Second, it is rational to expense "both items having 'de minimis' costs and items having relatively short service lives that are recurrently replaced with equivalent fungible items? to spare us administrative tracking nightmares. OAG: First, the Hotel's "de minimis" policy was $500, as borne out by the heading on its submission "Capital Items Expensed.? Second, the formula Tenant uses is so constructed that almost all hotel furnishings fall within it. That is, Tenant expensed items under $500, even though bought in bulk; the aggregate value could be in the tens of thousands. A ?de minimis" policy is OAG: Fact: Fact: GHYSA October 5, 1989 not supposed to distort reality, turning clearly capital items into simple operating costs. Moreover, there is no administrative tracking nightmare, since the hotel uses "a half year convention." That is, all one needs to know is cost of items, service lives and salvage value, not exact acquisition. and (disposalf dates. Instead, items purchased. or (disposed (of any year' are presumed to have been so purchased or retired in mid-year. The Uniform System of Accounts for Hotels expressly provides that furnishings of the type at issue i.e.,drapes, carpets?-?be carried as assets in the Property and Equipment account. Property operation and maintenance expenses include only repair of curtains, draperies, etc. There is no provision to converting to expenses the purchase or replacement of such. d. The practice of "assuming (that there ?will be) level consumption (of items with three year lives and that) one third of the Hotel's stock of the same would require replacement each. year,(so that ..) these items (could equally be treated) as either capital acquisitions or acquisitions to be expensed each year.? (Tenant's response) OAG: this approach permits a windfall in the early years which is theoretically recouped at the end, but only if, in fact, no inflation occurs and identically priced items keep on being purchased in identically sized lots. Three year items purchased in 1985 totalled $1,075,143; 1/3 ($385,381) of this was expensed in 1986. In addition, three?year items purchased in 1986, totalling $1,515,943 were expensed in full. Using past practice and USAH, only 1/6 (half year convention) of the $1,515,943 or $252,657 should have been an allowable expense in 1986; Tenant's act represented a significant distortion of the operating results. Could Tenant properly include $500,000 of additional interest OAG: GHYBA October 5, 1989 and $575,846 Condemnation Award in Debt Service, thus reducing net profit. Tenant: The measuring year for determining the amount of interest and amortization that can be deducted is ?the first year the Hotel's operations had sufficiently stabilized.." We leave aside whether the auditors have a right to check the determining year books. OAG is correct that we can't deduct this as prin? cipal and interest on first leasehold mortgage, but we may deduct it as reserve for repairs and restoration to be made after condemnation award issues are settled. GAG: The First Leasehold Mortgage makes no provision for some "Shakedown" period (Tenant's language). The measuring year is therefore 12/1/81?11/30/82 (see FLM, pars D). We can be sure, using this year and the Lease formula, that Tenant deducted at least $76,433 too much. Whether further adjustment is required depends on the actual gross room rental, calculated on a cash basis, minus rebates, overcharges, and travel agent commissions, etc, for that period. To find out, OAG must have access to books; since access has been denied, OAG construes the full amount against tenant. While the amount of award can be classified as a reserve, the maximum amount which may be deducted as repair or restoration expense is set by a formula, under Appendix F. It is, simply stated, the greater of actual expenses for repair and maintenance; (ii) the amount which, under the First Leasehold Mortgage, must be expended for repairs and maintenance or??to the extent not expended-?placed in the Reserve for Replacement Account; or 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 expenses of $4,144,275. Therefore, Tenant correctly deducted the $4 million plus. It cannot add to that, however. Did the Tenant correctly deduct, as an allowable expense, interest penalties paid to City in connection with prior years' sales, use occupancy and telephone rental taxes? DAG: GHYSA October 5, 1989 Tenant: It "unavoidable cost? and therefore deductible. WES an OAG: On this point, the lease is unequivocal. Sec 6.1, 6.4 and 6.5 specifically require tenant to pay all taxes before any interest or cost is added thereto; to the extent tenant wants to Challenge an imposition, it can pay disputed amount and then contest or, if payment would bar vindication of right, simply contest imposition, but, in such event, Tenant "covenants that Landlord shall not suffer or sustain any costs or I May the tenant charge to operations legal fees incurred for preparing and amending operating leases and management agreements, instead of capitalizing the costs over the life of the applicable agreements? Fact: Financial Accounting Standard 13 provides that?Initial direct costs legal fees) 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 if the effect is not materially different from that which would have resulted from the use of the method prescribed in the preceding sentence.? Tenant: To determine materiality, compare the amount of fees, here $81,076, against the hotel's $79 ndllion plus gross revenues. OAG: No, one compares $81,076 actually expensed against what would have been expensed if the normal capitalization method had been used: in this instance, $8,107 (the shortest lease was 10 years.) The difference between those two numbers is material; it wouldn't be if the useful life were, for example, three years. To construe FAS13 differently is consistent with how the Tenant has treated other accounting principles in a way that renders them pointless. records available to Landlord, Did the Hotel meet its lease obligations to keep its books and on the premises, for two years? OAG: GHY8A October 5, 1989 Tenant: OAG takes the ridiculous position that ?every guest check, every cash register receipt, every fiscal summary and every other scrap of paper potentially useful or convenient to any retained in New York City for a period of two years.? OAG: We do not consider it unreasonable to be dismayed because, inter alia, the Hotel could not locate '7 of 12 general ledgers, and 5 of its 12 detailed ledgers (2 of which were subsequently found) and had lost 25 of 87 income journals, or that it could not provide one of five payroll cycles or 26 out of 84 expense vouchers. These egregious recordkeeping lapses do not justify tenant's contention that the "Hyatt was in full compliance with the Lease recordkeeping provisions.? Confidentiality Lease provides, in Section 4.9.7, "Landlord shall hold in confidence all information obtained from Tenant's records, except as may be necessary for the enforcement of Landlord's rights under this Lease.? - FOIL - requires release of all final audit reports; allows auditors to keep confidential "trade secrets." Audit Years We believe we made a timely request to audit 1985 results. Even if not, we had a right to look at 1985 records, for comparison purposes, under generally accepted auditing standards; for financial statement confirmation purposes, we needed earlier records, since the change was made retroactive to 1982. Finally, we needed access to some materials from 81? 82 to verify interest/amortization deduction. All of this was denied. The tenant's accountants, Laventhol and Horwath, signed their certification of the statement due the City for 1986 on 9 OAG: GHYBA October 5, 1989 January, 29, 1987. Working papers we have show an calculation, dated 2/4/87, of more than $3,200,000 owed the City as additional rent. Four days later, another working paper recalculates the amount, using a cash basis for revenues, reducing the amount, for just that year and just that adjustment, by more than $780,000. Later working papers, from March and April, show depreciation calculated first under prior years dispensation and then recalculated, with the result that items previously capitalized have been expensed, effecting a change of several millions. An exchange of letters, dated April, discusses ideas proposed by to answer tenant's request to reduce what they pay The idea of accounting for each side c?f the income statement differently was not broached therein; we were informally told by that the lawyers had thought it up. The final report was sent to UDC in May, 1987. Not only was it late, since March, but it contained the January certification date mentioned above and Q9 footnotes identifying changes in depreciation schedules and treatment or the fact that revenues had been recalculated on the cash basis while expenses remain figured on the accrual basis. The date of an accountant's certification is supposed to be the date agreement is reached with the client on the contents of the financial statements. The January date is therefore false; however, the accountants may have thought it protected them from questions about later recalculations that vary significantly from generally accepted auditing standards.