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October 30, 2013 Articles

PCAOB and SEC Alter Audit Landscape for Broker-Dealers

The lingering consequences of Sarbanes-Oxley, Dodd-Frank, and the Bernie Madoff scandal continue to reverberate in both the accounting profession and the broker-dealer industry.

By Gabriel A. Mendel, Sarah S. Peters, Gregory S. Amoroso, and Mac Knox

The lingering consequences of Sarbanes-Oxley, Dodd-Frank, and the Bernie Madoff scandal continue to reverberate in both the accounting profession and the broker-dealer industry. The intersection of the two has seen significant recent activity in the form of new rules from the Securities and Exchange Commission (SEC) and new standards and inspection reports from the Public Company Accounting Oversight Board (PCAOB). The evolution of these increasingly specialized standards and practices may pose a significant challenge to auditors of broker-dealers, particularly to the hundreds of smaller accounting firms—already sharply criticized in the PCAOB’s interim inspection reports—that audit just a single broker-dealer client or that do not audit public companies.

The PCAOB’s Second Interim Inspection Report
The PCAOB established an interim inspection program in August 2011 pursuant to new oversight responsibilities granted to it by the Dodd-Frank Wall Street Reform and Consumer Protection Act. See Exchange Act Release No. 65163. Dodd-Frank amended the Sarbanes-Oxley Act to grant the PCAOB the same oversight authority for audits of broker-dealers as it has for audits of SEC issuers, including the authority to carry out inspections, set standards, and conduct investigations and disciplinary proceedings. The interim inspections are intended to assess and monitor the compliance of registered public accounting firms with Sarbanes-Oxley, PCAOB and SEC rules, and professional standards in their audits of broker-dealers. The results of the interim program also will provide the PCAOB with guidance in establishing a permanent inspection program for auditors of broker-dealers.

On August 19, 2013, the PCAOB issued its second report on the progress and findings of its interim inspection program. See PCAOB Release No. 2013-006. The bulk of the report describes observations noted in the PCAOB’s inspection of 60 audits conducted by 43 registered public accounting firms between March 1, 2012, and December 31, 2012, and concluded that 57 of the 60 audits inspected contained deficiencies.

The PCAOB further found that 22 of the 60 audits it inspected had failed to satisfy the independence rules codified at Rule 2-01(b) and (c) of Regulation S-X and incorporated by SEC Rule 17a-5(f)(3). The PCAOB stated that, in contravention of these rules, the auditors conducting 22 of the 60 audits also performed bookkeeping or other services related to the accounting records or financial statements, including the preparation of trial balances or other source data underlying the financial statements. While only 8 percent of audits conducted by firms that also audited issuers (and were thus already subject to an inspection program) had independence issues, 80 percent of audits performed by firms that did not audit issuers were found to have independence issues.

In 41 of the 60 audits reviewed, the PCAOB found that auditors failed to perform sufficient audit procedures to obtain reasonable assurance that any material inadequacies existing at the date of the examination would be disclosed in the accountant’s supplemental report. While these auditors performed a risk assessment and inquired of management regarding internal controls, the PCAOB found that they failed to sufficiently test the controls related to the accounting system, internal accounting controls, or procedures for safeguarding securities of the broker-dealer. Several firms did nothing more than ask questions of management.

The PCAOB found deficiencies relating to the broker-dealer’s computation of net capital in over one-third (23) of the audits reviewed. In 10 of the audits, the auditors failed to assess the operations of the broker-dealer to determine whether the firm met the requirements of the minimum net capital figure it claimed. Additionally, the PCAOB found that these auditors had failed to perform sufficient procedures to test for the proper classification of allowable and non-allowable assets, to test the accuracy of operational charges deducted from net capital, and to determine that the appropriate haircuts had been deducted from securities positions.

In more than half (37) of the audits reviewed, the PCAOB found the auditors failed to perform sufficient audit procedures to address the risk of material misstatement due to fraud: In 4 audits, the auditors failed to identify a fraud risk related to revenue recognition or overcome the presumption that such risk existed, while in 11 audits the auditors failed to perform audit procedures sufficient to address the risk of fraud for revenue recognition that had been identified. In 35 audits, the auditors failed to perform sufficient journal-entry testing to respond to the risk that management might record potentially fraudulent journal entries or other adjustments.

The PCAOB will continue to conduct inspections under the interim inspection program and to provide annual reports regarding the progress of the interim program until a permanent inspection program is established. The results of the interim inspection program will inform the PCAOB’s proposal for a permanent inspection program, including the scope, methodology, and frequency of inspections as well as whether any categories of registered public accounting firms will be exempt from the program.

The PCAOB is also evaluating whether the risk of loss to customers can be assessed by different characteristics of broker-dealers and thus provide for potential differentiation of different classes of broker-dealers under a permanent inspection program. Characteristics of broker-dealers being evaluated for potential differentiation include: (1) whether they receive, handle, or hold customer securities; (2) whether they maintain a special reserve bank account or are exempt from the customer-protection rule; (3) lines of business; (4) financial characteristics, including net capital, revenues, and assets; (5) potential correlations between types of past fraudulent activities and characteristics of the broker-dealers; and (6) coverage by the Securities Investor Protection Corporation (SIPC).

A rule proposal for a permanent inspection program is not expected until 2014 or later.

New Rules from the SEC
In addition to the existing deficiencies noted in the PCAOB’s interim inspection reports, accounting firms with broker-dealer audit clients face the additional challenge of shifting reporting and auditing requirements imposed by the SEC on July 30, 2013, when it adopted amendments to SEC Rule 17a-5 governing broker-dealer financial reporting and audits.

These amendments significantly alter the specific reporting and audit requirements for broker-dealers, and any accounting firm that audits a broker-dealer will need to review and understand these requirements and the related SEC rules. In general, the amendments require all broker-dealers to prepare one of two new annual reports:

  • Carrying broker-dealers (those firms subject to the full provisions of the customer protection rule, SEC Rule 15c3-3) must file an annual compliance report that includes specified information about internal controls and compliance with certain SEC Rules.
  • Non-carrying broker-dealers (those firms operating pursuant to an exemption from SEC Rule 15c3-3) must file an exemption report that indicates the exemption under which the broker-dealer is operating and whether it was in compliance with that exemption.

In addition, auditors of broker-dealers will be required to provide not just a report based on an examination of the broker-dealer’s financial report but also a report based on an examination of the broker-dealer’s newly required compliance or exemption report.

Importantly, under the amendments, the auditors’ reports on broker-dealers must be prepared in accordance with the standards of the PCAOB, in addition to the generally accepted auditing standards (GAAS). The SEC stated that using PCAOB standards is “consistent with the provision of the Dodd-Frank Act that provide the PCAOB with explicit authority to establish standards with regards to audits of broker-dealer reports filed with the Commission.”

In the course of its examination, should the auditor determine that a material weakness exists or that there is noncompliance with one or more of the financial-responsibility rules (established either by the SEC or a designated examining authority (DEA) such as the Financial Industry Regulatory Authority), the accountant must immediately notify the broker-dealer’s chief financial officer. Importantly, unlike the proposed rule, the final rule does not limit the notification requirement to instances of so-called material noncompliance. The broker-dealer then is required to notify the SEC if notification of the instance of noncompliance is required under applicable SEC rules. The broker-dealer must, within one business day, send a copy of the notification to its accountant. If the accountant does not receive the notice or does not agree with the notice, the accountant itself must provide a report to the SEC, again within one business day.

The amendments to SEC Rule 17a-5 also require that each clearing or carrying broker-dealer include a representation in its financial statement regarding its independent public accountant that grants access to the SEC and the DEA staff to review audit documentation and authorizes its auditor to discuss findings related to the audit, with the SEC or DEA staff.

In an effort to remove what it views as at least one obstacle to holding auditors liable for misstatements in broker-dealer financial statements, the SEC also amended the rule requiring that broker-dealers file their annual reports with the SIPC at the same time they are filed with the SEC and the DEA. The SEC noted that the SIPC has a legitimate interest in receiving the reports that relate to the maintenance of the SIPC fund and trends in the broker-dealer industry. The rule change is designed to make clear that the SIPC is an intended user of the financial statements.

The requirement to provide copies of audited reports to the SIPC is effective as of December 31, 2013. All other material changes to the rule are effective on June 1, 2014.

The PCAOB’s New Standards for Broker-Dealer Audits
Consistent with the SEC rule amendments requiring broker-dealer audits to be conducted pursuant to new PCAOB standards, and for broker-dealers to file audited annual compliance or exemption reports, on October 10, 2013, the PCAOB adopted two attestation standards and an auditing standard governing the audits of brokers and dealers.

The PCAOB’s new attestation standards for broker-dealer audits. The two new attestation standards designed for broker-dealer audits specifically cover the auditor’s examination of compliance reports and review of exemption reports required by the SEC’s amendments to Rule 17a-5, discussed above. See PCAOB Release No. 2013-007.

Attestation Standard No. 1, governing the examination of broker-dealer compliance reports, requires auditors to obtain sufficient evidence to offer an opinion on the broker-dealer’s statements that internal control over compliance was effective during and as of the end of the fiscal year, that the broker-dealer was in compliance with the net capital and reserve requirements rule, and that the information used to state such compliance was derived from the broker-dealer’s books and records.

PCAOB chairman James R. Doty described the new attestation standard for compliance reports as “risk-based” and emphasized that examinations conducted under the new standard should be “scaled to the size and complexity of the broker's or dealer's business” and “will require coordination with the financial statement audit in order to eliminate duplication of procedures and promote appropriate use of evidence obtained and more effective audit work overall.”

Attestation Standard No. 2, governing the review of exemption reports filed by broker-dealers claiming an exemption under SEC Rule 15c3-3(k), requires the auditor to obtain “moderate assurance” about the statements in the exemption report that identify the provisions under which the broker-dealer claims an exemption; affirm achievement of the exemption provisions throughout the most recent fiscal year without exception or except as described in the report; and, if applicable, identify and briefly describe the nature of any exception and the approximate dates the exception existed.

Regarding this attestation standard for the exemption reports, Doty acknowledged that the “extent of inquiries to make and materials to review will naturally be less for a small, uncomplicated broker,” but he indicated that auditors “should take advantage of evidence obtained in the financial statement audit to identify risks without duplicating effort.”

The PCAOB’s new auditing standard for auditors of broker-dealers. The new auditing standard, Auditing Standard No. 17, establishes the auditor’s obligations when auditing and reporting on the supplemental information accompanying the audited financial statements of broker-dealers. See PCAOB Release No. 2013-008. The standard requires auditors to: (1) assess whether the supplemental information is consistent with the underlying accounting, records, and/or financial statements; (2) test the completeness and accuracy of the supplemental information insofar as that information was not tested in the audit of the financial statements; and (3) gauge compliance with applicable regulatory requirements governing the supplemental information.

PCAOB board member Jay D. Hanson noted that “although targeted specifically at supplemental information required to be filed by broker-dealers, including net capital calculations and reserve requirement calculations, the standard also applies more broadly to certain other types of supplemental information . . . for example, certain schedules required by the U.S. Department of Labor that may be included in filings on SEC Form 11-K relating to the annual reports of employee stock purchase, savings and similar plans.”

The Road Ahead
While the conclusion of the PCAOB interim inspection program is some ways off, and it remains to be seen to what extent the SEC and/or the PCAOB use their disciplinary authority to enforce these new standards, the regulators are clearly concerned. In addition to his comments regarding the new standards, Doty pointed out the significant deficiencies noted in the recent PCAOB interim report and concluded, “Whether or not certain firms are ultimately exempted from the PCAOB’s inspection requirement, because of the nature of their broker-dealer clients, it is clear today that many firms will need to significantly improve their work, under any set of standards, to meet the SEC’s requirements and the public’s expectations.”

Doty’s comments were echoed by Hanson, who stated,

in light of our inspection findings, I urge all firms that choose to conduct broker-dealer audits to consider whether they need to make a fresh start. It is important that firms implementing the new standards be mindful of the need for appropriate quality control processes—especially in the independence area—and robust guidance and training in the new standards, followed by appropriate supervision and review when audits are performed.

Though subject to approval by the SEC, the effective date of the attestation and auditing standards, June 1, 2014, aligns with the SEC amendments to Rule 17a-5, and will govern the audits of broker-dealers with fiscal years ending as soon as June 30, 2014.

Keywords: professional liability litigation, PCAOB, SEC, attestation standards, auditing standards, broker-dealers


Gabriel A. Mendel and Sarah S. Peters are associates with Sutherland Asbill & Brennan LLP, in Atlanta, Georgia. Gregory S. Amoroso and Mac Knox are securities-litigation consultants with the firm.