Case # 3.

2 – The Baptist Foundation of Arizona: Related Party Transactions

I. Technical Audit Guidance

To maximize the knowledge acquired by students, this book has been designed to be read in
conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB Auditing
Standards that are referenced in this book are available for free at:
http://pcaobus.org/Standards/Pages/default.aspx.

In addition, the AU Sections that are referenced in this book are available for free at:
http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisions
of the Sarbanes-Oxley Act of 2002 is available for free at:
http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarban
es-Oxley+Act+of+2002.htm.

II. Recommended Technical Knowledge

PCAOB Auditing Standard #5

Paragraph #9

AU Section 311

Paragraphs #3-6

AU Section 334

Paragraphs #4-6

III. Teaching Hints

This case provides students with an opportunity to apply their technical knowledge about

inherent risk and fraud risk to Baptist Foundation of Arizona's changing operational model under

William Crott’s leadership. By providing details about Baptist Foundation of Arizona's

operations at this time, students are able to see the relationship between an audit client's strategy

and inherent risk assessment. In addition, this case provides students with an opportunity to see

an example of how the assessment of fraud risk can change as a result of changes to an audit

client's strategic direction. To meet these objectives, this case illuminates a number of relevant

issues about Baptist Foundation of Arizona’s operational model during this period of time. In
particular, the case focuses on the Baptist Foundation of Arizona’s decision to invest in the

Arizona real estate market and to develop two related affiliates (ALO and New Church Ventures)

that were essentially designed to perpetrate fraudulent activity. In addition, the case provides a

mechanism to show how the lack of regulation can impact investors in an adverse manner.

This case assignment will work best if is scheduled to coincide with the inherent risk or

the fraud risk topic in the auditing course. Alternatively, the case assignment will work well if it

is scheduled to coincide with a discussion of related parties. While much has changed in the

audit environment at publicly traded companies as a result of SOX, an auditor still must take the

time to carefully acquire knowledge about a client’s operations, industry and their overall

strategy. This foundation of company and industry-specific knowledge is essential towards the

completion of an effective and efficient audit.

First, the company and industry-specific knowledge enables the auditor to carefully

assess the organization's business risk, which is a precursor to assessing all aspects of overall

audit risk, including the assessment of inherent risk at the financial statement assertion level. In

our view, this task is absolutely critical in the new post-Sarbanes audit environment. Thus, we

recommend that instructors be explicit in illustrating the linkage between what is learned during

the risk assessment stage and the identification of relevant financial statement assertions. The

discussion of student responses to question #1 provides an opportunity to make this point clear to

students.

In addition, the company and industry-specific knowledge provides a platform that

enables an auditor to effectively brainstorm (as required by SAS No. 99) about the possible ways

in which a fraud could be perpetrated at the audit client. In this case, the existence of related

parties provides an opportunity for instructors to highlight how related party transactions can be
 used to perpetrate a fraud. As a result, the auditor must pay particular attention to all transactions

made with related parties. The discussion of student responses to question #2 provides an

opportunity to illustrate this point to students. When discussing question #2, we recommend that

instructors take the time to ensure that students understand what is meant by an arm’s length

transaction. Finally, since the Baptist Foundation of Arizona was essentially conducting banking

operations, this case provides an opportunity to discuss the importance of regulation in certain

industries (like banking) and to show the harm that can occur without adequate regulation. The

discussion of student responses to questions #3-4 provides an opportunity to discuss this issue.

The impact of strategy, business risk and industry factors on the various components of

audit risk is a complex consideration. We therefore encourage instructors to allocate an

appropriate amount of time to this topic and to use multiple different cases to help illustrate your

points. In our experience, it is very difficult for audit students to make the connection between

the strategic direction of a client and the identification of key audit risks. In fact, we would

suggest that this can be a hard linkage for more experienced audit professionals as well. So,

please consider assigning at least 2 or 3 (and perhaps even 4 or 5) cases from section 2 to provide

the repetition that is needed for students to master this important topic. It is hoped that such

repeated task performance will help to better sensitize students to the importance of

understanding the client’s business, industry and strategy to the assessment of inherent risk and

fraud risk.

IV. Assignment Questions & Suggested Answers

 1. Consult Paragraph 9 of PCAOB Auditing Standard No. 5 and/or Paragraphs .03-.06
of AU Section 311. Based on your understanding of inherent risk assessment,
identify three specific factors about BFA that might cause you to elevate inherent
risk. Briefly provide your rationale for each factor that you identify.

At the entity and at the financial statements account level, inherent risk refers to the exposure

or susceptibility of an entity’s financial statements to a material misstatement, without regard to

the system of internal controls. A detailed understanding of an audit client’s business model,

including their products and services is an essential part of an auditor’s inherent risk assessment

process at both the entity level and the financial statement account level.

Paragraph #9 of PCAOB Auditing Standard No. 5 relates to the planning of the audit of

internal control over financial reporting. Specifically, the paragraph says that such audit should

be properly planned and assistants, if any, are to be properly supervised. The paragraph then goes

on to explicitly identify matters that will impact the auditor's procedures. Several of the relevant

factors include: 1) Matters affecting the industry in which the company operates, such as

financial reporting practices, economic conditions, laws and regulations, and technological

changes; 2) Matters relating to the company’s business, including its organization, operating

characteristics, and capital structure; 3) Legal or regulatory matters of which the company is

aware; and 4) The relative complexity of the company’s operations.

Paragraphs #3-6 of AU Section 311 also relate to the planning of the audit. Importantly, the

factors identified in AU Section 311 are entirely consistent with the factors identified in

paragraph #9 of PCAOB Auditing Standard No. 5. In fact, it is important to point out to students

that the factors that are likely to impact the audit of internal control over financial reporting

mirror the factors that are likely to impact the assessment of inherent risk in a financial statement

audit. This is a key learning point for this question. In the case, there were a number of factors

that are likely to impact the audit of internal control over financial reporting, including:
  Under William Crotts’ leadership, the foundation engaged in a major strategic shift in its

business operations. It is not clear whether BFA had the requisite expertise to conduct

business operations in the new areas of strategic focus;

 BFA began to invest heavily in the Arizona real estate market;

 BFA accelerated its efforts to sell investment agreements and mortgage-backed securities

to church members;

 Arizona real estate prices declined substantially in 1989;

 management decided to establish a number of related affiliates that were each controlled

by an individual with close ties to BFA;

 BFA gained approval to operate a trust department that would serve as a nonbank passive

trustee for individual retirement accounts (IRAs). Thus, BFA now had to meet certain

regulatory requirements, which included minimum net worth guidelines;

 BFA is engaging in activities that are normally highly regulated, but is being shielded by

its status as a religious organization; and

 BFA’s affiliates owe the organization a large amount of money, and combined, there is a

large net worth deficit.

2. Consult Paragraphs .04-.06 of AU Section 334. Comment on why the existence of

related parties (such as ALO and New Church Ventures) presents additional risks to
an auditor. Do you believe that related party transactions deserve special attention
from auditors? Why or why not?

The auditing standards make clear that auditors need to pay special attention to transactions

with related parties. According to paragraph # 4 of AU Section 334, “the auditor should be

aware of the possible existence of material related party transactions that could affect the

financial statements.” Moreover, paragraph #5 of AU Section 334 states that “in determining the

scope of work to be performed with respect to possible transactions with related parties, the
auditor should obtain an understanding of management responsibilities and the relationship of

each component to the total entity. He should consider controls over management activities, and

he should consider the business purpose served by the various components of the entity.”

Stated simply, the existence of related parties does cause concern for auditors because of the

possibility that related party transactions are consummated on a basis other than an arm’s length

basis. An arm’s length transaction is one that is consummated in the normal course of business

operations in an objective and unbiased manner between unrelated parties. In an arm’s length

transaction, the parties dealing from equal bargaining positions, with neither party subject to the

other’s control or dominant influence; and the transaction is treated with fairness, integrity and

legality. Given the inherent bias that exists between related parties, the question of economic

substance in any transaction between related parties demands special attention by auditors. The

primary issue is whether the related party transaction truly has economic substance or whether

the transaction is being used as a mechanism to perpetrate a fraud. For example, if the affiliates

of BFA have absolutely no intention to repay their debts, BFA’s assets and income would be

misstated. Overall, related party transactions can have numerous effects on the organization and

on the financial statements, all of which should be considered by the auditor.

3. Assume you are an investor in BFA. As an investor, what type of information would
you be interested in reviewing before making an investment in BFA? Do you believe
that BFA should have been exempt from Arizona banking laws? Why or why not?

An investor in BFA is likely to be interested in reviewing the same type of information that

he or she would want to review before investing in a for-profit organization. As such, he or she

would be interested in reviewing all pertinent financial statement information and any other

information that would allow a thorough assessment of the capabilities of the management team

and the financial position of the organization.

 Interestingly, as noted in the case, because of its status as a religious organization, BFA’s

product offerings were not subject to the same regulatory scrutiny as a bank’s products.

However, since the economic substance of BFA’s operations was essentially the same as those of

a bank, it should also be subjected to the same stringent banking regulations. While it is a

religious organization, some of its activities are not in that capacity, and regardless of its non-

profit status, it competes with banks, engages in the same activities, and is subject to the same

risks regarding interest rates and liquidity. Not requiring BFA to be subject to the same

regulations enables BFA to act in ways that are potentially harmless to investors and defies the

purpose of why the laws were enacted to begin with. Additionally, it puts those that are subject to

and in compliance with the regulations at a disadvantage simply by not being categorized as a

religious organization, when they essentially have the same functions and activities.

4. Consider the planning phase for the audit of BFA’s trust department operations. As
an auditor, what type of evidence would you want to collect and examine to
determine whether BFA was meeting the U.S. Treasury regulations for nonbank
passive trustees of IRA accounts?

An auditor would need to gather sufficient and competent evidence to ascertain whether BFA

was meeting the treasury regulations for nonbank passive trustees of IRA accounts. When

planning the nature, timing, and extent of the substantive tests to be used to gather evidence to

determine whether BFA was meeting the U.S. Treasury regulation, the auditor must consider the

inherent risks related to the client. Any audit areas that have an elevated level of inherent risk

must be subject to additional audit attention. BFA, because of its bank-like operations and

products faced several risks related to interest rate risk and liquidity risk. As a result of this

elevated inherent risk, the auditor must offer additional audit attention to the regulations that

pertain to BFA’s ability to sever as a nonblank passive trustee of IRA accounts.

 One of these regulations was the regulation that includes a minimum net worth requirement.

This area is of particular concern during an audit of BFA. The auditor, when gathering sufficient,

competent evidence, must carefully consider the valuation assertion for invested assets. BFA has

additional risk because of the related party transactions (with New Church Venture for example)

that were being used to avoid massive write-downs on the valuation of the real estate holdings.

The auditor should have obtained additional evidence related to the transactions between BFA

and ALO and New Church Venture to be sure that the asset valuation of BFA’s balance sheet was

presented fairly. In addition, BFA had to conduct its affairs as a fiduciary, that is, it could not

manage or direct the investment of IRA funds. It would be critical for the auditor to commit

audit attention to gathering evidential matter that would support the assertion of management

that BFA was not managing or directing the investment of IRA funds.