Materiality guidelines for audits of real estate companies. (Auditing)by Peress, Michael
From time to time this column will provide advice to auditors on particular practice problems derived from questions or suggestions submitted by auditors, legal cases, SEC enforcement actions or quality review findings.
In the coming busy season, auditors should be aware that clients may attempt to avoid a writedown of obsolete or slow-moving inventory by exchanging it with a barter company for future services, e.g., an advertising credit. This type of transaction should be accounted for in accordance with APB 29, Accounting for Nonmonetary Transactions." According to Opinion 29, paragraph 26, an exchange of nonmonetary assets should be valued at the fair value of the assets given up or received, whichever is more readily determinable.
Some barter companies structure exchanges of assets for advertising services simply as a device for selling advertising. The inventory exchanged is almost incidental to the transaction. Usually the company exchanging inventory is required to pay the barter company as much or more in cash as the amount of advertising credit used, and the credit will expire unless a certain amount is spent for advertising in a stipulated period.
Auditors should view these barter transactions with an attitude of professional skepticism and carefully consider whether a loss should be recognized on the inventory exchanged. The advertising credit should not be booked as prepaid advertising at the carrying amount of the inventory without challenge.
Materiality Guidelines for Audits of Real Estate Companies
SAS 47 provides guidance on the auditor's considerations of audit risk and materiality when planning and performing an audit in accordance with GAAS. SAS 47 does not explicitly require quantification of the preliminary judgment about materiality, nor does it provide any quantitative guidelines. However, as a planning tool, the use of a single dollar amount for the preliminary judgment about materiality is generally efficient and effective in planning the scope of audit procedures.
Most auditors use practice accepted guidelines to establish a preliminary judgment about materiality for audit planning purposes. The materiality judgment may be used to establish cut-offs for individually significant items, determine sample sizes, and evaluate audit findings. The most common bases for establishing materiality for audit planning purposes are total assets, total revenue, and income before income taxes. Common percentages applied to these bases generally range from .5% to 2% of total assets or revenue, and 5% to 10% of income before income taxes, The appropriate base and percentage vary with client and industry circumstances and considerable professional judgment is required in establishing an appropriate estimate of materiality for audit planning purposes. Too high an estimate may result in an ineffective audit and the assumption of an unacceptable degree of audit risk, whereas too low an estimate may compromise audit efficiency and profitability.
The above guidelines are generally useful for planning audits of most commercial enterprises. With respect to real estate companies, however, these traditional bases and percentages may not always be appropriate for computing a preliminary estimate of materiality. Depending on the nature of a real estate company, income before depreciation and interest expense is a base that should receive consideration. In addition, total expenses may be a relevant base for certain real estate engagements.
Limitations Of Traditional Bases
Alternative bases for real estate companies deserve consideration due to the following limitations of traditional guidelines.
Total Assets. The dollar amount of total assets is generally a meaningful base because it is representative of the size of most commercial enterprises, and is both stable and predictable. For these reasons, an approach commonly used by auditors to establish a preliminary judgment about materiality is to use 1% of the greater of total assets or total revenue. 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. An auditor computing materiality as 1 % of the greater of total assets or total revenue would presumably lower the preliminary estimate of materiality each year until such time when total revenue exceeds total assets, whereupon the materiality judgment would presumably increase each year as the revenue base grows. In this situation the guideline is producing an illogical result due to the fact that the rental property is depreciated for financial reporting purposes even though it is increasing in value (as represented by growth in cash flows from rentals).
Income 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. Further, income before income taxes may not be representative of the size of an entity, as is generally the case when the relationship of income before income taxes to total revenue is significantly less than the normal relationship of 10%. 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.
Most practitioners generally agree that 5% to 10% of income before income taxes is a useful materiality guide for the evaluation of the combined effect of errors detected by auditing procedures. However, because of the limitations of income before income taxes as a base for audit planning purposes, many auditors find it more useful to relate the percentage to total assets or total revenue. Accordingly, 1% of total revenue is a widely accepted guideline based on the "normal" relation between total revenue and income before income taxes. For the reasons stated income before income taxes may be of limited value in establishing materiality for audit planning as well as evaluation purposes for real estate companies. Accordingly, 1% of total revenue may not be an appropriate percentage for many real estate companies.
Use of Cash Flow Measures
An overriding consideration in determining materiality for both audit planning and evaluation purposes is the perceived needs of financial statement users. Owners, lenders and prospective investors in real estate companies generally focus primarily on some measure of cash flow. Cash flow is the primary determinant of the value of rental properties, the amount of financing obtainable, and the amount of cash available for distribution to owners. Considering the limitations of traditional guidelines and the significance of cash flow, a cash flow measure (specifically, income before depreciation and interest expense determined on an accrual basis) should generally receive consideration as a base in planning audits for real estate entities with mature revenue producing properties. Such a cash flow measure is generally stable, predictable and representative of an entity's size. These are highly desirable characteristics of a base for making audit planning decisions.
Use of Total Expenses
Over the past few years, a significant number of rental properties have been converted to cooperative or condominium ownership. Maintenance charges in cooperatives and condominiums are generally set at a level to cover anticipated expenditures, including loan repayments and capital expenditures. The primary users of cooperative and condominium financial statements are the tenant/owners. Tenant/owners could be expected to focus primarily on total expenditures since such expenditures are the determinant of maintenance charges. Accordingly, a useful base for audit planning for a cooperative or condominium may be total expenditures. Similar bases may also be appropriate for planning the audits of statements of certain operating income and certain operating expenses of residential rental properties for purposes of submission to the attorney general in conjunction with plans to convert properties to cooperative or condominium ownership.
Determining an Appropriate Percentage
As previously stated, common percentages applied to bases that are a measurement of earnings generally range between 5% to 10%. A preliminary judgment about materiality for audit planning purposes based on 5% to 10% of income before depreciation and interest expense, or total expenditures, would appear to be a reasonable guideline.
However, an auditor must always bear in mind that general guidelines, such as those discussed herein, should never be substituted for professional judgment and should not be used if they produce a result that the auditor believes does not make sense in the circumstances.
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