Case Studies: Auditing

The Baptist Foundation of Arizona: Related Party Transactions
Synopsis The Baptist Foundation of Arizona (BFA) was organized as an Arizona nonprofit organization primarily to help provide financial support for various Southern Baptist causes. Under William Crotts's leadership, the foundation engaged in a major strategic shift in its operations. BFA began to invest heavily in the Arizona real estate market and also accelerated its efforts to sell investment agreements and mortgage-backed securities to church members. Two of BFA's most significant affiliates were ALO and New Church Ventures. It was later revealed that BFA had set up these affiliates to facilitate the sale of its real estate investments at prices significantly above fair market value. In so doing, BFA's management perpetrated a fraudulent scheme that cost at least 13,000 investors more than $590 million. In fact, Arizona Attorney General Janet Napolitano called the BFA collapse the largest bankruptcy of a religious nonprofit in the history of the United States.1 Background The Baptist Foundation of Arizona (BFA) was an Arizona religious nonprofit 501(c)(3) organization that was incorporated in 1948 to provide financial support for Southern Baptist causes. It was formed under the direction of the Arizona Southern Baptist Convention, which required BFA to be a profitable, self- sustaining independent entity (that is, it could not accept money from any other source). In BFA's early days, it focused its attention on funding church start-ups and providing aid for children and elderly people. In 1962 Pastor Glen Crotts became its first president and was succeeded in 1984 by his son, William P. Crotts.
Under William Crotts's leadership, BFA began to invest heavily in the Arizona real estate market, and also accelerated its efforts to sell investments to church members. Although Arizona real estate prices skyrocketed in the early 1980s, the upward trend did not continue, and property values declined substantially in 1989. Soon after this decline, management decided to establish a number of related affiliates. These affiliates were controlled by individuals with close ties to BFA, such as former board members. In addition, BFA gained approval to operate a trust department that would serve as a nonbank passive trustee for individual retirement accounts (IRAs). To do so, BFA had to meet certain regulatory requirements, which included minimum net worth guidelines. Related Parties Two of BFA's most significant affiliates were ALO and New Church Ventures. A former BFA director incorporated both of these nonprofit entities. The entities had no employees of their own, and both organizations paid BFA substantial management fees to provide accounting, marketing, and administrative ser- vices. As a result, both ALO and New Church Ventures owed BFA significant amounts by the end of 1995. Overall BFA, New Church Ventures, and ALO had a combined negative net worth of $83.2 million at year-end 1995, $102.3 million at year-end 1996, and $124.0 million at year-end 1997.2 New Church Ventures Although the stated purpose of New Church Ventures was to finance new Southern Baptist churches in Arizona, its major investment activities were simi- lar to those of BFA. That is, New Church Ventures raised most of its funds through the sale of investment agreements and mortgage-backed securities, and then invested most of those funds in real estate loans to ALO. Thus the majority of New Church Ventures' assets were receivables from ALO. New Church Ventures' two main sources of funding were BFA's marketing of its investment products to IRA investors and loans it received from BFA.3 ALO Contrary to its intended purpose to invest and develop real estate, one of ALO's primary activities in the 1990s was to buy and hold BFA's nonproducing and overvalued investments in real estate so that BFA could avoid recording losses (write-downs) on its real estate. In fact, ALO owned many of the real estate investments that were utilized as collateral for IRA investor loans. However, BFA's 1991 through 1997 financial statements did not include a set of summarized financial statements for ALO. ALO incurred operating losses each year since its inception in 1988. By the end of 1997, ALO's total liabilities of $275.6 million were over two times its assets, leaving a negative net worth of $138.9 million. In total, ALO owed New Church Ventures $173.6 million and BFA $70.3 million, respectively.4 BFA's Religious Exemptions BFA operated in a manner similar to a bank in many respects. Its investment products were similar to those sold by financial institutions. Its trust department, which was fully authorized by the federal government to serve as a passive trustee of IRAs, was similar to a trust department at a bank. BFA also made real estate loans in a manner similar to a bank. Because of its bank like operations and products, BFA faced several risk factors that affect banks and other savings institutions, such as interest rate risk and liquidity risk.5 Yet 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.6 That is, although BFA underwrote its own securities offerings and used its staff to sell the investment instruments (like a bank), it was able to claim a religious exemption from Arizona statutes that regulate such activities. BFA also claimed exemption from Arizona banking regulations on the basis that its investment products did not constitute deposits as defined by Arizona banking laws.7 Passive Trustee Operation BFA gained approval to operate a trust department that would serve as a nonbank passive trustee for IRAs. To operate a trust department, BFA had to comply with certain regulatory requirements, such as maintaining an appropriate minimum net worth. In addition to the minimum net worth requirement, treasury regulations also required BFA to conduct its affairs as a fiduciary; that is, it could not manage or direct the investment of IRA funds. In addition, BFA had to subject itself to an audit that would detect any failures to meet these regulatory requirements. In cases where the minimum net worth was not achieved, treasury regulations prohibited a trustee from accepting new IRA accounts and required the relinquishment of existing accounts.8
1. Consult Paragraphs 5-8 of PCAOB Auditing Standard No. 8 and Para- graphs 7-10 of PCAOB Auditing Standard No. 12. Based on your under- standing 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.
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?
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?
4. Consult Paragraph 7 of PCOAB Auditing Standard No. 9. 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?

WorldCom: Significant Business Acquisitions
On June 25, 2002, WorldCom announced that it would be restating its financial statements for 2001 and the first quarter of 2002. Less than one month later, on July 21, 2002, WorldCom announced that it had filed for bankruptcy. It was later revealed that WorldCom had engaged in improper accounting that took two major forms: overstatement of revenue by at least $958 million and understatement of line costs, its largest category of expenses, by over $7 billion. Several executives pled guilty to charges of fraud and were sentenced to prison terms, including CFO Scott Sullivan (five years) and Controller David Myers (one year and one day). Convicted of fraud in 2005, CEO Bernie Ebbers was the first to receive his prison sentence: 25 years. Growth through Acquisitions WorldCom started as a long distance telephone provider named Long Distance Discount Services (LDDS), which had annual revenues of approximately $1.5 billion by the end of 1993. LDDS connected calls between the local telephone company of a caller and the local telephone company of the call's recipient by reselling long distance capacity it purchased from major long distance carriers (such as AT&T, MCI, and Sprint) on a wholesale basis.1 LDDS was renamed WorldCom in 1995. A change in industry regulation was the primary catalyst for WorldCom's growth. That is, the Telecommunications Act of 1996 allowed long distance tele- phone service providers to enter the market for local telephone services and other telecommunications services, such as Internet-related services. Like many players in the industry, WorldCom turned to acquisitions to expand into these markets. WorldCom's revenues grew rapidly as it embarked on these acquisitions. Between the first quarter of 1994 and the third quarter of 1999, WorldCom's year-over-year revenue growth was over 50 percent in 16 of the 23 quarters; the growth rate was less than 20 percent in only 3 of the quarters. WorldCom's stock price experienced rapid growth as well, from $8.17 at the beginning of January 1994 to $47.91 at the end of September 1999 (adjusted for stock splits). Importantly, its stock performance exceeded those of its largest industry competitors, AT&T and Sprint.2 MFS and Subsidiary UUNET In late 1996 WorldCom acquired MFS, which provided local telephone services, for $12.4 billion. In that transaction, WorldCom also gained an important part of the Internet backbone through MFS's recently acquired subsidiary, UUNET.3 Brooks Fiber Properties, CompuServe Corporation, and ANS Communications In 1998 WorldCom purchased Brooks Fiber Properties for approximately $2.0 billion and CompuServe Corporation and ANS Communications (a three- way transaction valued at approximately $1.4 billion that included a five-year service commitment to America Online). Each of these companies expanded WorldCom's presence in the Internet arena. MCI In September 1998 WorldCom acquired MCI, using approximately 1.13 billion of its common shares and $7.0 billion cash as consideration, for a total price approaching $40 billion. MCI's annual revenues of $19.7 billion in 1997 far exceeded WorldCom's 1997 annual revenues of $7.4 billion. As a result of this merger, WorldCom became the second largest telecommunications provider in the United States. SkyTel Communications and Sprint In October 1999 WorldCom purchased SkyTel Communications, adding wireless communications to its service offerings, for $1.8 billion. A few days after its Sky- Tel acquisition, WorldCom announced that it would merge with Sprint in a deal valued at $115 billion. In the proposed deal, WorldCom would gain Sprint's PCS wireless business, in addition to its long distance and local calling operations.4 Challenges By 2000, WorldCom started to face some difficult challenges. For starters, World- Com faced fierce competition in its industry. In addition, WorldCom's proposed merger with Sprint failed to receive approval from the Antitrust Division of the U.S. Department of Justice. As a result, the companies officially terminated their merger discussions on July 13, 2000.5 Although WorldCom's revenue continued to grow, its rate of growth slowed. On November 1, 2000, WorldCom announced the formation of two tracking stocks: one—called WorldCom Group—to capture the growth of its data busi- ness, and the other—called MCI—to capture the cash generation of its voice business, which experienced a lower growth rate. WorldCom also announced reduced expectations for revenue growth of the consolidated company, from its previous expectation of 12 percent to between 7 percent and 9 percent in the fourth quarter of 2000 and all of 2001. By the close of market on the day of its announcement, WorldCom's stock price had fallen by 20.3 percent, from $23.75 on October 31, 2000, to $18.94.6 Industry conditions worsened in 2001. Both the local telephone services and Internet segments experienced downturns in demand. The impact of the down- turn in the Internet segment was particularly severe because of the industry's increased investment in network capacity (supply). Many competitors found themselves mired in long-term contracts that they had entered to obtain the capacity to meet anticipated customer demand. As the ratio of their expenses to revenues was increasing, industry revenues and stock prices plummeted. For example, the stock prices of WorldCom, AT&T, and Sprint lost at least 75 percent of their share price values between January 2000 and June 25, 2002.7
1. Consult Paragraphs 7-10 of PCAOB Auditing Standard No. 12. Based on your understanding of risk assessment and the case information, identify three specific factors about WorldCom's strategy that might cause you to elevate the risk of material misstatement.
2. Consult Paragraphs 5-7 of PCAOB Auditing Standard No. 13. Comment about how your understanding of the risks identified at WorldCom (in Question 1) would influence the nature, timing, and extent of your audit work at WorldCom.
3. Consult Paragraph 33 and Paragraph B10 (in Appendix B) of PCAOB Auditing Standard No. 5. If you were conducting an internal control audit of WorldCom, comment about how WorldCom's acquisition strategy would impact the nature, timing, and extent of your audit work at WorldCom.
4. Consult Paragraphs 65-66 of PCAOB Auditing Standard No. 12. Based on your understanding of fraud risk assessment, what three conditions are likely to be present when a fraud occurs (that is, the fraud triangle)? Based on the information provided in the case, which of these three conditions appears to be the most prevalent, and why?