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Case # 3.2 - The Baptist Foundation of Arizona: Related Party Transactions
Case # 3.2 - The Baptist Foundation of Arizona: Related Party Transactions
Case # 3.2 - The Baptist Foundation of Arizona: Related Party Transactions
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.
Paragraph #9
AU Section 311
Paragraphs #3-6
AU Section 334
Paragraphs #4-6
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
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
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.
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
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.
At the entity and at the financial statements account level, inherent risk refers to the exposure
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
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
BFA accelerated its efforts to sell investment agreements and mortgage-backed securities
to church members;
management decided to establish a number of related affiliates that were each controlled
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
BFA is engaging in activities that are normally highly regulated, but is being shielded by
BFA’s affiliates owe the organization a large amount of money, and combined, there is a
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
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
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
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.