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 Proposed Standards for Attestation Engagements Related to Broker and Dealer Compliance or Exemption Reports 

DATE: July 12, 2011 
SPEAKER: Jay D. Hanson, Board Member 
EVENT: PCAOB Open Board Meeting 
LOCATION: Washington, DC 

Today, the Board is considering two proposed attestation standards related to the audits of brokers and dealers:Examination Engagements Regarding Compliance Reports of Brokers and Dealers and Review Engagements Regarding Exemption Reports of Brokers and Dealers. We will also separately be considering a proposed standard on auditing supplemental information that will apply to all types of engagements. Consistent with the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act, these proposed standards are intended to increase investor protection by supplementing and clarifying the existing regulatory framework related to the activities of brokers and dealers.

Already, brokers and dealers are subject to regulation by the United States Securities and Exchange Commission as well as by the Financial Industry Regulatory Authority and other self-regulatory organizations. Brokers and dealers currently must file certain quarterly and annual reports with the SEC. These reports include a registered public accountant's report providing assurances regarding the broker or dealer's annual financial statements and supporting schedules. The broker-dealer's auditor also must perform a review of the accounting system, the internal accounting control, and procedures for safeguarding securities. Amendments recently proposed by the SEC update these reporting requirements and, consistent with the Dodd-Frank Act, require that the audits of the relevant reports be conducted pursuant to PCAOB standards. The standards we are proposing today are intended to establish parameters for these audits that are derived from the requirements of the amendments to SEC Rule 17a-5 that were proposed by the Commission on June 15.

More specifically, the proposed standards redefine and strengthen the audit requirements applicable to the audits of brokers and dealers, by requiring auditors to focus on the primary risks associated with the activities of brokers and dealers. With respect to the audits of so-called "carrying" brokers and dealers — those that maintain custody of customer funds or securities — the proposed examination standard aims to ensure that broker-dealers have established and consistently follow appropriate custody procedures for the assets of their clients. The proposed standard requires auditors to focus on compliance by the broker or dealer with specified SEC rules related to net capital requirements, reserves, and custody and reporting requirements. In addition, the auditor must understand and evaluate the internal controls of the broker-dealer that are designed to prevent investor losses of securities or funds in the hands of the broker-dealer.

The activities of brokers and dealers that do not maintain customer funds or securities — and therefore meet the exemption conditions of proposed Rule 17a-5 — are deemed to pose less risk to investors. As a result, the proposed review standard mandates fewer and less burdensome procedures and requires the auditor to provide moderate assurance, as opposed to reasonable assurance, on the broker's or dealer's assertions in the exemption report.

Both proposed standards contemplate that the auditor will conduct a risk based audit and permit the audit to be scaled depending on the broker-dealer's size and complexity. Likewise, the proposed standards contemplate that the auditor will be able to leverage the work conducted on the financial statement audit in connection with the examination of management's compliance assertions or the review of management's exemption assertions. Thus, the proposed standards are intended to strike an appropriate balance between increasing investor protection — primarily by increasing the focus on broker-dealer procedures intended to safeguard investor assets — and the incremental increase in audit costs that may result.

I would be particularly interested in comments about whether the proposed standards achieve an appropriate balance in this regard. For example, with regard to the examination report, do the standards focus the auditor on the most relevant risks associated with the broker-dealer's compliance process? Are the required procedures to test internal controls likely to discover weaknesses that put investors at risk? Is it appropriate for the standard to require (as the proposal does, consistent with proposed Rule 17a-5) that a single instance of material non-compliance or one material weakness in internal controls during the period specified in the broker or dealer's assertion requires the auditor to issue a qualified opinion, even if the broker-dealer has taken action to remedy the problems? Likewise, in the context of the review report, are the proposed procedures likely to identify broker-dealers that fail to meet the exemption conditions of SEC Rule 15c3-3? And in the context of both standards under consideration, do the proposed improvements justify the incremental cost increase of the proposed requirements as compared to current audit requirements?

Finally, I would like to highlight two issues related to the proposed standards that are not reflected in the standards themselves and which commenters may wish to consider in formulating their views on the proposed standards. First, as some of my fellow board members have pointed out previously, the proposed standards, and the Board's oversight generally, do not extend to the audit work performed in connection with the client asset custody arrangements of investment advisors, which are governed by SEC rules. While investment advisors are required to have their audits performed by auditors registered with the Board, neither the Sarbanes-Oxley Act nor the Dodd-Frank Act authorizes the Board to exercise oversight — including inspections, enforcement or standard setting — over those audits. Of course, in some cases broker-dealers are also investment advisors. In other situations, investment advisors work with particular broker-dealers to maintain custody of client assets. In those situations, the proposed standards would apply to the audits of the respective broker-dealer functions. But the Board does not have the authority to oversee directly the audits of investment advisors or their investor protection procedures. Nothing in the standards we are considering today affect the client asset custody procedures of investment advisors or provide any investor protection in connection with the activities of investment advisors.

Second, when we approved the Board's interim broker-dealer inspection program in June, several of my fellow Board members and I expressed concern about whether the risks associated with the activities of introducing broker-dealers justify the costs of PCAOB oversight and inspections. We indicated that, consistent with the Dodd-Frank Act, after studying the relevant issues during the interim inspection program, the Board may choose to exempt certain broker-dealer auditors from PCAOB oversight. However, it is important to understand that the proposed audit requirements in SEC Rule 17a-5 do not contemplate an exemption for any broker-dealers. Under the proposed SEC rule amendments, all auditors engaged to attest to a broker-dealer's exemption report would have to perform that engagement pursuant to the review engagement standard we are proposing today.

Like my fellow Board members, I would like to thank the staff in the Office of the Chief Auditor and the Office of General Counsel, particularly Marty Baumann, Barbara Vanich, Keith Wilson, Bob Burns and Nina Mojiri-Azad. As usual, you have delivered a high-quality, comprehensive proposal. I expect that your work will trigger thoughtful and robust comments to aid the Board in establishing well-balanced and effective final standards for the audits of brokers and dealers.

 

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