United States: PCAOB’s Report On Broker-Dealer Audit Deficiencies Points The Way For Bds To Improve Their Financial Reporting And Compliance

Last Updated: September 3 2013
Article by Daniel Nathan and Ana-Maria Ignat

PCAOB'S MISSION

For two years, the Public Company Accounting Oversight Board (PCAOB) has been reviewing the work of auditors of broker-dealers, with a view to assessing their work and enabling the PCAOB to develop a permanent program for inspection of broker-dealer audits. Last week, the PCAOB issued its second progress report on this interim inspection program. For broker-dealers, PCAOB's report provides a useful preview of the issues on which their auditors will be increasing their focus in future audits; PCAOB's criticisms of the auditors that it regulates will most likely cause the auditors to beef up their audits in the areas criticized, and broker-dealers are bound to feel the effects in future audits.

Broker-dealers should review the second report, the most significant findings of which are summarized below. The PCAOB found deficiencies in audit procedures related to customer protection and net capital, certain financial statement areas, and auditor independence.

The Dodd-Frank Wall Street Reform and Consumer Protection Act amendments to the Sarbanes-Oxley Act provided the PCAOB with oversight authority with respect to audits of brokers and dealers registered with the Securities and Exchange Commission. A June 2011 rule adopted by the PCAOB and approved by the SEC established an interim inspection program related to broker-dealer audits with the dual purpose of assessing compliance of registered public accounting firms with the applicable statutes, regulations, and professional standards in connection with their performance of broker-dealer audits, and informing the Board's decisions about the scope and elements of a permanent inspection program to be announced in 2014 or later.

SEC Rule 17a-51 requires broker-dealers to file with the SEC and other regulators, among other things: (1) annual financial statements, (2) supporting schedules relating to the computation of net capital and customer reserve, and (3) an accountant's supplemental report on material inadequacies. Rule 17a-5(f)(3) requires auditors of broker-dealers to comply with SEC independence requirements, which provide that an accountant is not independent if it provides bookkeeping or other services related to the accounting record or financial statements of a client unless it is reasonable to conclude that the results of the services will not be subject to audit procedures performed by the accountant during an audit of the client's financial statement.

PCAOB'S FINDINGS

The PCAOB found a high level of audit deficiencies: in every one of the audit firms inspected and in 95% (57 of 60) of the audits selected for inspection. Some of the deficiencies identified relate to fundamental concepts of auditing, and the PCAOB characterized the audit deficiencies and independence findings as troubling.

Specifically, the PCAOB concluded that audits, as they related to customer protection and the net capital, were deficient as a result of:

  • Insufficient testing of controls related to the broker-dealer's procedures for safeguarding securities, and periodic computations of aggregate indebtedness, net capital, or customer reserves;
  • Inadequate inquiries or procedures for determining whether the broker-dealer properly claimed an exemption from the requirement to maintain a special reserve bank account under the customer protection rule;
  • Failing to evaluate whether a material inadequacy existed when the broker-dealer reported a net capital deficiency in its financial statements;
  • Failing to assess whether a net capital rule computation error indicated the existence of a material inadequacy;
  • Failing to notify the SEC or FINRA of material inadequacies related to the customer reserve computation within the required time frame after the broker-dealer failed to provide notification;
  • Failing to sufficiently test the completeness and accuracy of customer credit or debits included in the customer reserve computation;
  • Failing to perform sufficient procedures to test the broker-dealer's classification of allowable and non-allowable assets when computing net capital; and
  • Failing to perform sufficient procedures for haircuts on securities in the net capital computation, including by failing to test the completeness and accuracy of supporting records received from the broker-dealer or third parties.

Auditors were also found to have failed to follow applicable standards in the financial statement area by:

  • Failing to perform audit procedures to respond to the identified risk of fraud for revenue recognition, or failing to identify such fraud risk altogether;
  • Failing to perform sufficient journal entry testing;
  • Failing to perform sufficient procedures to test for related parties or related parties transactions;
  • Performing insufficient testing for material classes of revenue transactions, including trading gains and losses, commission revenue, and principal transaction revenue;
  • Performing insufficient procedures to test the valuation of securities, including the reasonableness of the fair value estimates;
  • Performing insufficient assessment as to whether the control deficiencies identified represented significant deficiencies or material weaknesses, or would affect a financial statement audit;
  • Failing to identify and address omission of disclosures regarding related parties and transactions, fair value of securities, or revenue recognition policies, despite the fact that they exceeded materiality thresholds;
  • Failing to identify incomplete disclosures or address evidence that was inconsistent with the disclosures made in financial statements;
  • Failing to obtain an understanding of the entity and its environment, including its internal control before designing the nature, timing, and extent of audit procedures; and
  • Applying incorrect definitions of "significant deficiency" and "material weakness" in the evaluation of identified control deficiencies.

These detailed deficiency findings illustrate the level of scrutiny which the PCAOB will apply to audit reports in its permanent inspection program, and auditors are likely to apply in their future audits of broker-dealers' financial records.

PCAOB'S EXPECTATIONS

The Board stated that it expects audit firms to consider whether the audit deficiencies and independence findings in the report might be present in the audits they are performing, and should correct such deficiencies.

In connection with the audits analyzed in the report, auditors may need to assess their ability to support previously expressed audit opinions, which may entail performing additional audit procedures, informing the broker-dealer of the need to make changes to its statements, schedules, or the audit report on material inadequacies, or take steps to prevent reliance on previously expressed audit opinions. If the financial statements of a broker-dealer appear not to present fairly, in all material respects, the financial position, result of operations, or cash flows of the broker-dealer in conformity with GAAP, the Board reports that information to the SEC. The Board may report information suggesting violations of law and rules, including independence rules, by broker-dealers to the SEC and other regulators.

PCAOB counseled audit firms to stress to their personnel the need to conduct audits with professional care, including professional skepticism. Audit firms should also heed independence rules, and review policies for supervision and review to ensure that their partners and supervisory personnel are paying attention to various broker-dealer audit aspects.

MORE SCRUTINY AND OVERSIGHT TO COME

For a permanent inspection program, the Board is particularly focused on how the auditor's role contributes to the protection of assets of broker-dealer customers. To make the audit as useful as possible in promoting customer protection, PCAOB is evaluating whether the risk of loss to customers can be assessed based on certain attributes of broker-dealers. For example, PCAOB is considering differentiating among firms based on whether the broker-dealer: (a) receives, handles or holds securities or cash from the purchase or sale of securities by customers; (b) carries customer accounts; (c) engages in lines of business transacting with customers; (d) reports financial measurements of net capital, revenues, or assets that represent a differentiation of risk of loss to customers; (e) has features in its business model potentially indicating heightened fraud risk or has been the subject of regulatory sanctions; and (f) is a member of the Securities Investor Protection Corporation. The Board anticipates presenting a rule proposal for a permanent inspection program in 2014 or later.

PCAOB advised audit firms to stress to their personnel the need to conduct audits with professional care, including professional skepticism. Broker-dealers should pay attention to the deficiency areas identified in the PCAOB's report, so that they can be prepared for the Board's expectations once it establishes its permanent inspection program.

WHAT BROKER-DEALERS SHOULD DO NEXT

In preparation for future audits, broker-dealers should review their procedures for financial reporting and net capital and customer protection calculations with an eye towards the specific deficiencies identified in the PCAOB's report. Additionally, although abiding by independence rules remains an auditor's responsibility, broker-dealers should be at least familiar with the governing independence rules, and stay clear of arrangements with their accountants that might taint the auditors' independence.

Footnotes

1. For a discussion of recent revisions to Rule 17a-5 which expanded auditor responsibilities in connection with broker-dealer audits, increased reporting by broker-dealers, and subjected broker-dealer audits to PCAOB standards, review our Client Alert.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Daniel Nathan
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions