C-2029

HOTEL CALIFORNIA*

Bill and Dot Wordsworth purchased Hotel California near Windermere in the English
Lake District in March x7. The former owner had named it after the famous song. The
hotel, a former farmhouse, has six guest rooms on the second and third floors. The price
of a room includes breakfast but evening meals are available on a reservation-only basis.
Mrs. Wordsworth also prepares pack lunches on request, an option which many hikers
staying at the hotel take advantage of.

The Wordsworths’ first year (x7) was a successful one. They both worked full-time at the
hotel and hired a part-time employee to help with cleaning and other chores. They
closed the hotel at the end of December for two months and planned to take a holiday
in Italy in February x8. However, in January x8 they became concerned about reports in
the press of an imminent UK recession and decided to discuss the financial position of
their business with their accountant, Sam Coleridge, before embarking on a costly
foreign trip.

The only accounting records the Wordsworths keep are a cash book – in which they note
down details of all payments they’ve made and received – and a file containing invoices
from suppliers. Mrs. Wordsworth reckons the hotel made a profit in x7 because their
bank balance increased by £27,450 in the year.

Coleridge decided to prepare a set of financial statements for x7. The first thing he did
was to draw up a balance sheet as of 31 March x7 when the Wordsworths took over the
hotel (see Exhibit 1). He noted they invested £150,000 of their own capital and had
borrowed the remaining amount to finance the purchase of the business. Next, he
prepared a summary of cash receipts and payments based on the Wordsworths’ cash
book (see Exhibit 2). Once he had completed these statements, he began to assemble
the information (summarised below) which he needed to prepare the accounts for x7:

(a) The Wordsworths do not accept credit cards. Moreover, when they began operating
the hotel, they introduced the policy of requiring a deposit of £25 with each
reservation. By 31 December x7, they had collected deposits totalling £2,350 for
reservations in x8. These advance payments had been deposited in the bank
account and were included in the £80,020 collected from customers.

(b) Coleridge calculated that, out of the £30,900 mortgage payments, £25,200 was
interest and the remaining £5,700 was repayment of part of the principal. He
learned that principal payments in x8 would be £8,000.

* IESE Business School. Based on a case by Prof. Tim Sutton. Revised September 2020. Copyright © 2020

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Hotel California C-1929

(c) The £3,320 paid for insurance provided fire, theft and personal injury coverage for
the year to 31 March x8.

(d) The Wordsworths purchased food and supplies on account. At year-end, they owed
£820 to various suppliers. In addition, they estimated that year-end stocks of food
and supplies totalled £340.

(e) Employee wages and advertising expenses had been paid in full by year-end.
Utilities (e.g. electricity, etc.) consumed but unpaid at 31 December were estimated
at £250.

(f) The Wordsworths reckoned that the furnishings and equipment had, on average, a
five-year useful life, would fetch little or nothing on disposal, and would yield
benefits evenly over their estimated life. Depreciation is charged on the building,
valued at £550,000 at the end of March x7, at the rate of 2% a year.

(g) During the year, land representing 20% of the value assigned to the land at 31 March
x7 was sold for £12,230.

(h) A dividend of 12,500 was paid to the owners.

Required

(1) Prepare journal entries to record the transactions and events that occurred during
x7. Post these entries to the appropriate T-accounts.

(2) Prepare an income statement for the nine-month period from 1 April to 31
December x7, and a balance sheet at 31 December x7. Ignore income taxes.

(3) Review the figures in Wordsworths’ x7 accounts. Was their first trading period a
success?

Check figure:
Profit in x7 £20,750

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Hotel California C-1829

Exhibit 1

HOTEL CALIFORNIA
Balance sheet at 31 March x7

Current assets Current liabilities

Cash £1,800 Current portion of mortgage payable £5,700
Food and supplies inventory 1,200 Accounts payable (food and supplies) 1,000
3,000 6,700
Long-term liability
Mortgage payable 474,300
Non-current assets
Land 50,000 Owners’ equity
Building 550,000 Share capital 150,000
Furnishings and equipment 28,000 Retained profits 0
628,000 150,000

Total assets £631,000 Total liabilities & owners’ equity £631,000

Exhibit 2

HOTEL CALIFORNIA
Summary of Cash Receipts and Payments
1 April to 31 December x7

Receipts
Cash collected from customers £80,020
Sale of land 12,230
Total £92,250

Payments
Mortgage interest and principal £30,900
Insurance 3,320
Food and supplies 9,080
Wages 4,920
Advertising 1,200
Utilities 2,880
Dividend to owners 12,500
Total £64,800