However, the amount of total assets of companies with revenue producing real estate often bears a disparate relationship to the size of the entity and to total revenue. Consider that total assets of real estate companies are typically far in excess of total revenue when properties have been recently acquired or constructed. However, as rental properties mature and increase in value, total assets decrease because of depreciation even though total revenue may grow many times over. Before income Taxes For many enterprises, income before income taxes is not an appropriate base since it could fluctuate too widely to be useful in planning an audit. For real estate companies, these limitations may be compounded depending on the extent of financing on the properties.
Most business enterprises borrow to finance business expansion.
Accordingly, as borrowings increase, total assets, total revenue, and income before income taxes would presumably all increase. However, a characteristic of real estate companies is that as cash flows from rental properties increase, owners often borrow additional funds with non-recourse debt based on the increase in the value of the property, and distribute the proceeds for use outside the entity. Since the borrowed funds are not used to finance expansion, income before income taxes would decrease substantially. An auditor computing materiality based on income before income taxes would presumably increase audit scope with each additional borrowing, and related increase in interest expense, even though there may have been no change in overall property operations. Further, consider that significantly different audit scopes for substantially similar properties could result depending on the extent and use of financing.