The Public Company Accounting Oversight Board found deficiencies in all of the firms it inspected that audit broker-dealers, according to a report released Monday, and in 95 percent of the individual audits that the PCAOB inspected.
The overwhelmingly negative results appeared in the PCAOB’s
“The number of firms and audits inspected are greater than those we reported on last year, but the inspection results are similar and, in one word, disappointing,” said PCAOB member Jay Hanson during a conference call with reporters Monday. “We observed deficiencies in all of the firms inspected. Because a number of the firms inspected also audit issuers, some of the firms covered in this report are already subject to PCAOB inspections of issuer audits, which includes all of the large firms that we inspect annually in connection with our regular inspections of issuer audits, and 10 firms that we inspect once every three years. Of the firms inspected, 24 do not audit issuers, and, therefore, this is their first experience with a PCAOB inspection. The results point to a need for the firms we inspected to improve their performance, which will require focused effort and a desire to improve.”
For the latest report, PCAOB inspectors reviewed 43 audit firms covering portions of 60 audits of brokers and dealers registered with the Securities and Exchange Commission. Of the 43 audit firms inspected, 19 were subject to regular PCAOB inspection, as they also audited public companies or other issuers. The remaining 24 firms were not subject to PCAOB inspection other than under the interim inspection program.
The broker-dealer audits inspected were required to be conducted under generally accepted auditing standards issued by the American Institute of CPAs, and not under PCAOB standards. Deficiencies were noted in the audits of all of the firms inspected, and in 95 percent (57 of 60) of the individual audits selected for inspection. Inspection staff did not identify deficiencies in every selected portion of the audits.
Audit deficiencies were most frequently noted with respect to audit procedures related to the computations of the customer reserve and net capital requirements, and audit procedures related to financial statement areas, including procedures regarding tests of revenue, related parties, and the risk of material misstatement due to fraud.
In addition, PCAOB inspection staff found that, contrary to the requirements of SEC independence rules, some auditors were involved in the preparation of the financial statements that they audited. Independence findings were identified in more than one-third (22 out of 60) of the audits selected for inspection, and in approximately 80 percent of the audits selected for inspection that were performed by firms that audited brokers and dealers but did not audit issuers.
“In the report we don’t generally distinguish between the results in the firms that are subject to our normal inspection procedures regularly, either annually or triennially, versus the ones that just audit broker-dealers, with the exception of the independence findings, and there we saw a sharp difference,” said Hanson. “I think the deficiency rate on independence findings was around 8 percent for the firms that are subject to our oversight because they audit issuers, and it was 80 percent for the other firms. Other than that, we don’t publicly report on the differentiation. But we saw findings of a similar nature in virtually all of the firms.”
Hanson pointed out that even the auditors that have been inspected for the first time should be familiar with the SEC’s independence rules that they should not be auditing broker-dealers for whom they prepare financial statements. “With respect to the individual auditor’s knowledge of the SEC rules relative to independence, that’s not new news and it shouldn’t be new news to any of them, but I think sadly, it is news to some of them even though it shouldn’t be,” he said. “Last year we pointed it out in our report. We’ve covered it extensively in our forums on auditing for the smaller auditors of broker-dealers, so they’ve been put much more on notice in the last year than they had been in the past. In some respects there’s no excuse that they shouldn’t know it if they’re in the business of auditing a broker-dealer because that’s a highly complex, very technical exercise, and that’s one of the many things that they need to do a better job of paying attention to the rules about.”
“The nature and extent of audit deficiencies and independence findings included in this report are troubling,” said Robert Maday, deputy director of the Division of Registration and Inspections and Program Leader of the Broker-Dealer Inspections Program. “We encourage registered public accounting firms to take action and conduct audits with due professional care, including professional skepticism.”
Dodd-Frank Requirements
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 in the aftermath of the financial crisis and included provisions related to audits of brokers and dealers, specifically in response to the Ponzi scheme scandal involving Bernie Madoff and his former auditing firm, Friehling & Horowitz, which more or less rubber-stamped Madoff’s fraudulent statements. “Prior to these provisions, auditors of brokers and dealers registered with the PCAOB, but were not otherwise subject to our rules, standards, inspection or enforcement activities,” Hanson noted. However, the inspection results point to continuing problems with broker-dealers, particularly after more recent financial scandals such as with MF Global and Peregrine Financial Group.
Hanson and Maday were asked if the PCAOB had seen any difference in its inspection findings for introducing brokers and those that hold customer funds. “There are differences because the audit requirements are different for the two, and we have identified audit deficiencies related to those specific audit requirements for the brokers and dealers that carry customer accounts or clear customer trades,” Maday responded. “Similarly we have audit deficiencies for the brokers and dealers that claim an exemption related to the area of compliance with the provisions of the exemption they claimed and other procedures around that. Across all of those we have audit deficiencies related to the report on material inadequacies and whether or not the auditor performed sufficient procedures to obtain reasonable assurance that any material inadequacies would be identified and disclosed.”
Hanson pointed out that the report includes a table on page 29 related to the provisions of Rule 15c3-3, which requires the brokers that carry customer accounts to maintain a special reserve bank account. “It’s interesting that there are only 311 out of the 4,200+ brokers and dealers that have to maintain a special reserve account, so only 7 percent are in the category of carrying customer accounts,” he noted.
The board issued its first progress report in August 2012. In that initial report, PCAOB inspectors reviewed 10 audit firms covering portions of 23 audits of brokers and dealers registered with the SEC, and identified deficiencies in all of the audits inspected.
Inspection Plans
During 2013, the board plans to inspect approximately 60 audit firms covering portions of about 90 audits. The PCAOB expects that, by the end of 2013, the interim inspection program will include inspections of portions of more than 170 audits of brokers and dealers conducted by approximately 100 registered public accounting firms.
The PCAOB currently anticipates presenting a rule proposal for a permanent inspection program in 2014 or later. Meanwhile, the board will continue the interim inspection program until new rules for a permanent program are adopted and become effective.
On July 30, 2013, the SEC approved amendments to Exchange Act Rule 17a-5 that affect certain annual reporting, audit, and notification requirements for brokers and dealers. These amendments include the requirement that the audits of brokers and dealers be conducted in accordance with PCAOB standards for fiscal years ending on or after June 1, 2014.
The interim inspection program was implemented in August 2011 in response to new oversight authority given to the Board over auditors of SEC-registered brokers and dealers by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The interim program has two purposes. First, it enables the PCAOB to assess the compliance of registered firms and their associated persons conducting audits of brokers and dealers with the Sarbanes-Oxley Act, PCAOB and SEC rules, and professional standards. Second, it informs the board’s eventual determinations about the scope and elements of a permanent inspection program.
Maday noted that at this time, the PCAOB has not made any determinations with respect to the scope or elements of a permanent inspection program of broker-dealers. “We continue to gather information,” he said. “We have made progress in obtaining data about brokers and dealers, which is sometimes difficult to do, as much of the information is not publicly available. The broker-dealer industry is rather complex and, as a result, the board is taking a careful and informed approach with the objective of protecting customers of brokers and dealers. In order to determine the scope of a permanent inspection program, the board is working to identify ways to differentiate the risk of loss to customers and to determine whether any particular differentiation provides a basis to inform the board’s determination of the scope of a permanent inspection program.”
He noted that the PCAOB is evaluating whether the risk of loss to customers can be assessed from various attributes that characterize brokers and dealers and thus, provide for differentiation between classes of brokers and dealers. He noted that the problems identified in the report with independence and audit deficiencies are troubling. “Firms should take appropriate action to prevent or correct any such audit deficiencies,” said Maday. “Our interim inspections program continues, as we are well into our inspections for 2013. We hope firms take advantage of our inspections and take appropriate action to improve the quality of the audits they perform.”
Broker-Dealer Auditing Forums
Separately, the PCAOB announced the dates Monday for two Forums on Auditing Smaller Broker-Dealers and the agenda for the first session.
The forums are designed to share important information about board activities with PCAOB-registered public accounting firms that audit brokers and dealers. The forums also provide an opportunity for board members and PCAOB staff to hear the questions, comments and concerns of auditors working with smaller brokers and dealers.
The first forum this year will be held in Jersey City, N.J., on Thursday, Oct. 31. The second forum will be in Las Vegas on Nov. 20.
“These meetings allow the PCAOB to highlight important program areas and engage in a dialogue with auditors of smaller broker-dealers about current audit issues,” said PCAOB chairman James R. Doty in a statement. “It is imperative to have these conversations now as the regulatory landscape for broker-dealers continues to develop.”
The forums will discuss the SEC’s recent amendments to Exchange Act Rule 17a-5 that affect certain annual reporting, audit, and notification requirements for brokers and dealers, including the requirement that the audits of brokers and dealers be conducted in accordance with PCAOB standards for fiscal years ending on or after June 1, 2014.
In addition to these recent amendments, forum discussion topics will include audit deficiencies and independence findings related to the PCAOB's interim inspection program for audits of brokers and dealers, and guidance for transition to PCAOB auditing standards for audits of brokers and dealers.
The program also will include presentations from the staff of the SEC and the Financial Industry Regulatory Authority, as well as a regulatory panel discussion.
Each forum will be hosted by a PCAOB board member and will be open to members of PCAOB-registered firms that audit brokers and dealers. There is no fee to participate in the events, but preregistration is required. Attendees also have the opportunity to earn continuing professional education credits.
More information on the Forums on Auditing Smaller Broker-Dealers is available on the
