The Public Company Accounting Oversight Board said in a
The PCAOB received the authority to conduct inspections of auditors of broker-dealers with the passage of the Dodd-Frank Act of 2010. Beginning last year, the PCAOB inspected an initial group of 10 audit firms and 23 of their audits of securities brokers and dealers. The new report covers that group. The inspections took place over a five-month period from October 2011 to February 2012. PCAOB inspectors identified deficiencies in all of the audits inspected.
“The findings tell us that there is a need for improvement in the audit work being performed, and that other auditors of broker-dealers should look closely at our findings and assess their own work,” said PCAOB board member Jay Hanson in a conference call with reporters.
Among the problems uncovered were with audit procedures for customer protection and net capital requirements. Exchange Act Rules (17a-5) require that the scope of the audit procedures be sufficient to provide reasonable assurance that any material inadequacies in the accounting system, internal accounting controls, and procedures for safeguarding securities would be disclosed in the accountant’s supplemental report on material inadequacies, PCAOB board member Jeanette Franzel said during the conference call.
“In 21 of the 23 audits, we found that auditors failed to perform sufficient audit procedures to provide reasonable assurance that any such material inadequacies would have been found in the accounting system internal accounting controls, and procedures for safeguarding securities,” she said.
The customer protection rule, Rule 15c3-3, is designed to protect customers by requiring brokers and dealers to segregate customer securities and cash from the broker’s or dealer’s proprietary business activities. “For two of the nine audits of brokers and dealers that were required to maintain a customer reserve, inspections staff found that firms failed to verify that the special reserve bank accounts were designated for the exclusive benefit of customers and that the account agreements contained the required restrictive provisions,” said Franzel. “For all 14 audits of brokers and dealers that claimed an exemption from the Customer Protection Rule, inspections staff found that firms did not perform sufficient audit procedures to determine whether the broker or dealer complied with the conditions of the exemption.”
SEC rules also prescribe liquidity standards requiring brokers and dealers to maintain certain specified levels of net capital based on the types of activities and business lines. In seven of the 23 audits, PCAOB inspections staff found that firms failed to sufficiently test components of the broker’s or dealer’s minimum net capital computation, Franzel noted.
“In the majority of the audits inspected, the auditors did not conduct sufficient work to comply with auditing standards,” she added. “Those findings were in the areas of the auditors’ consideration and response to the risk of fraud, auditing related party transactions, auditing revenue recognition, establishing a basis for reliance on books and records, auditing fair value measurements, evaluating control deficiencies, and testing the accuracy and completeness of disclosures.”
Violations of Independence Requirements
The PCAOB also found deficiencies in meeting auditor independence requirements, especially in complying with SEC rules on auditor independence that apply to auditors of brokers and dealers. Those rules state that an accountant is not independent if the accountant provides bookkeeping and other accounting and financial reporting services related to the financial statements of the audit client. In two audits, the PCAOB found that the auditors prepared, or assisted in preparing, the financial statements that they were auditing
“While only two audits were noted for independence problems, this is of particular concern to the board, because we think it is due to a lack of understanding and information about the rules,” said Hanson. “Broker-dealer auditors are required to comply with the independence rules of the SEC. However many have told us they thought they only needed to abide by AICPA rules, which are not as strict.”
“Even with this small group of audits inspected thus far, the results are disturbing,” said Franzel.
The audits inspected were required to be conducted under generally accepted auditing standards issued by the American Institute of Certified Public Accountants, and not under PCAOB standards. However, there may be some confusion between what the AICPA rules allow and what the PCAOB and SEC allow.
“As Jeanette points out, the confusion is that under the AICPA independence rules, preparation of financial statements on behalf of a client is acceptable and it’s commonplace for the auditors to do the first draft of putting the numbers into the financial statements and assisting with the drafting of the footnotes,” said Hanson. “It’s just that under the SEC rules, that’s not acceptable.”
“There are also some unique SEC rules that apply to the audits of broker-dealers,” Franzel noted.
Expanding Inspections in 2013
The PCAOB plans to continue its interim inspection program to provide information for a permanent inspection program for brokers and dealers to protect the public interest and investors. This year, the PCAOB intends to inspect approximately 40 firms and approximately 60 audits. Through 2013, the PCAOB plans to inspect approximately 100 audit firms and 170 audits to have a better cross-section of firms and provide information for different types of brokers and dealers. The interim program will continue beyond 2013, until rules for a permanent inspection program take effect.
“While the results of these initial inspections cannot be generalized to all securities broker and dealer audits and represent only a small portion of the inspections planned for the interim program, the nature and extent of the findings are of concern to the board,” said PCAOB Chairman James R. Doty in a statement.
Armed with information from the interim program, the board will be in a better position to determine the objectives, nature and frequency of inspections for audit firms; to decide on possible exemptions from oversight; and to justify those determinations and decisions, Hanson noted. The PCAOB’s original goal was to propose rules governing the scope and elements of a permanent program in 2013.
Three of the 10 firms whose audits were inspected were already subject to PCAOB inspection because they audited public companies. Seven were newly subject to inspection under the interim inspection program. Hanson noted the findings were reminiscent of when some auditing firms were first subject to inspection by the newly created PCAOB nearly a decade ago.
“Some of these findings remind us of the findings that we first saw when we started our initial inspection program of issuers in 2003 and the full program in 2004,” he said. “We really did not know what to expect when we looked at this, but certainly there are some reminders of the types of issues that we saw. And those types of issues change over time. Some of the issues that we are seeing now as a first-time inspection of broker-dealers we don't see as often in the issuer audits anymore.”
“I think that these have an additional twist in that there are special SEC rules that apply,” said Franzel. “That’s why we saw some issues with independence and also there are some unique SEC rules that apply to broker-dealers, financial reporting and audits, that we’re also seeing some issues with.”
The audits and firms selected are not representative of all broker and dealer audits, or all auditors for SEC-registered brokers and dealers, the PCAOB noted.
The broker-dealer audits selected for the first group of inspections met certain criteria. The audits selected included nine brokers and dealers with Special Reserve Bank Accounts and minimum net capital requirements ranging from $250,000 to approximately $6,500,000. The other 14 brokers or dealers selected don’t have Special Reserve Bank Accounts, and their minimum net capital requirement ranged from $5,000 to approximately $6 million.
Disciplinary Actions
During the inspections, PCAOB inspectors discussed the deficiencies with each firm, Hanson noted. Any deficiencies that were considered significant were communicated in writing.
“In circumstances where the board determines that a firm fails to take appropriate action related to its deficiencies, the failure may be grounds for a board disciplinary sanction,” he added. “And we will refer information about potential broker-dealer violation of laws or rules to the SEC and to certain other authorities, including FINRA.”
