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 Statement Regarding the Second Report on the Progress of the Interim Inspection Program Related to Audits of Brokers and Dealers  

DATE: Aug. 19, 2013 
SPEAKER: Jay D. Hanson, Board Member 
EVENT: Release of the Second Report on the Progress of the Interim Inspection Program Related to Audits of Brokers and Dealers 
LOCATION: Washington, DC 

Today, the Board issued the Second Report on the Progress of the interim Inspection Program for Audits of Brokers and Dealers. This report covers inspections conducted in 2012 of a sample of auditors of brokers and dealers. This is our second progress report on our interim inspection program that began in 2011. 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. 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.

Before highlighting more of the results, I will provide some background about the new role we have in regulating auditors of brokers and dealers and some context for our interim inspection program.

First, however, I must note that the views expressed in this statement are my personal views and do not necessarily reflect the views of the Board, any other Board member, or the staff of the PCAOB.

Background

As you know, the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was passed as a result of a financial reporting and auditing crisis. Companies like Enron, WorldCom, Tyco, Adelphia and Xerox were in the news almost daily. Unfortunately, the impressive financial results these companies reported, even after they were audited by a major firm, turned out to be erroneous and, in some cases, fraudulent. The need to reform aspects of management responsibility and accountability, as well as corporate governance, was clear. The audit profession needed a wake-up call, and the era of self-regulation for auditors came to an end. What had been in place was a system of peer review, involving one audit firm reviewing the quality of the work of another firm. This was not sufficiently rigorous, and Congress recognized that, to protect the interests of investors, an independent regulator was needed to oversee audit work performed in connection with publicly held companies. As a result, Congress passed the he Sarbanes-Oxley Act and created the PCAOB.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd Frank Act") was passed in the wake of the financial crisis of 2008-2010. This law included provisions related to audits of brokers and dealers, which were also enacted in response to a scandal, this time associated with the Ponzi scheme of Bernie Madoff. 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.

Brokers and dealers historically have been subject to regulation by the U. S. Securities and Exchange Commission as well as by the Financial Industry Regulatory Authority and other self-regulatory organizations. This is still the case today. 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's or dealer's annual financial statements and supporting schedules. Under SEC rules, the broker's or dealer's auditor also must perform a review of the accounting system, the internal accounting control, and procedures for safeguarding securities. Currently, those audits are performed in accordance with AICPA standards, not PCAOB rules and standards.

In June 2011, the SEC proposed amendments to SEC Rule 17a-5 to 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. Shortly thereafter, the PCAOB proposed standards intended to establish parameters for these audits that are derived from the requirements of the proposed amendments to SEC Rule 17a-5. Our 2011 proposed standards are intended to increase investor protection by supplementing and clarifying the existing regulatory framework related to the activities of brokers and dealers. On July 30 of this year, the SEC adopted its final rule amendments to SEC Rule 17a-5, and the PCAOB also will issue final standards, taking into account the SEC's final rule and comments that we received on our proposals. It is important to note, however, that the audits that are addressed in today's PCAOB report were conducted under the SEC's old rules, and under AICPA auditing standards.

The work of the PCAOB for investor protection is very different for audits of issuers compared to those of brokers and dealers. Our oversight activities since 2003 in connection with audits of issuers help investors because we regulate and inspect the work auditors do on issuers' financial statements and internal controls. Reliable financial statements, supported by independent audits, are one important factor used by investors making in their investment decisions. However, investors do not simply call up a company and ask to invest. In order to buy or sell shares of a company, investors generally use a broker to access the shares.

Brokers and dealers are subject to extensive regulation, including requiring an annual audit, to protect customers and the operations of the securities markets. This system of regulation and controls helps to ensure that a customer's funds are actually invested in the company in which the customer wants to buy shares and that the customer's request to sell shares is carried out as instructed. The system of regulation also includes requirements around a broker's or dealer's capital level, designed to ensure the safety and soundness of the entity. These requirements include minimum net capital levels based on the broker's or dealer's size and activities and the need for its auditor to examine the calculation of net capital. Adequate capital is necessary to provide a cushion when a market disruption occurs, among other things. The market crash in October 1987 is a stark reminder of what can happen in a very short time. When the market dropped suddenly by 30%, many brokers and dealers failed. The calculation of net capital starts with equity as determined by generally accepted accounting principles, then is reduced by a number of adjustments based on the nature of the entity's investments and other factors. Therefore, while a customer may not care much about the financial statements of a broker, whether the broker meets regulatory requirements for the minimum level of capital is a critical piece of information.

Our current interim inspection program is designed to look at whether auditors are complying with the AICPA standards that have been in place for decades. In the future, when the PCAOB issues — and the SEC approves — new auditing standards for brokers and dealers, we will inspect whether auditors are complying with those PCAOB standards. As the report notes, the nature and scope of our permanent inspection program has not been determined. Before we can make that determination, we face difficult decisions about whether to exempt any audit firms from our oversight. The report also discusses some of the considerations relevant to those decisions.

2012 Inspection Results

I would like to highlight a few key items regarding the inspection results described in the report:

  • PCAOB inspectors reviewed 43 audit firms covering portions of 60 audits of SEC-registered brokers and dealers in inspections performed from March 2012 — December 2012.
  • Of the 43 audit firms inspected:
    • 19 (including the nine annually inspected firms and 10 triennial inspected firms) were already subject to PCAOB inspection in connection with their audits of public company clients
    • 24 were not subject to previous inspection because they have not audited public companies.
  • Audit deficiencies were noted in each of the firms inspected, and in 95 percent (57 of 60) of the audits selected for inspection.
  • Many deficiencies were identified for testing procedures related to Customer Protection and Net Capital under the (SEC) Exchange Act rules
  • We also noted deficiencies in audit procedures related to financial statement areas, including procedures regarding tests of revenue, related parties, and the risk of material misstatement due to fraud
  • Independence findings were identified in more than one-third (22 of 60) of the audits selected for inspection. The biggest concentration is in audits that were performed by auditing firms that audited brokers and dealers but not issuers. The finding rate was approximately 80 percent for these audits. The primary independence deficiency related to the auditors' drafting of the financial statements, which is allowable under AICPA standards for audits of private companies, but not allowable for an audit of a broker or dealer, since SEC independence rules must be followed.

Actions Needed

All public accounting firms that issue audit reports for SEC-registered brokers and dealers should consider whether the audit deficiencies and independence findings described in this report might be present in audits they currently perform, and should take appropriate action to prevent or correct any such deficiencies. Firms that assist their broker and dealer clients prepare their financial statements should stop providing that service if they intend to continue auditing those broker and dealer clients.

Accounting firms that audit brokers and dealers should continually stress to their personnel the critical need to conduct audits with due professional care, including professional skepticism. The staff of the firms should be encouraged to not think of the audit or a broker or dealer as a "compliance exercise." Audits are an important component of the oversight of brokers and dealers, including the protection of customers.

Firms should also take action to help prevent the types of deficiencies and findings identified in this report from occurring in the future by reviewing the following:

  • Arrangements with brokers and dealers and quality control procedures to help ensure that SEC independence rules are not violated;
  • Guidance and training to determine whether the topics noted as observed audit deficiencies identified in the report are given appropriate attention; and
  • Policies for supervision and review to help ensure their partners and supervisory personnel are placing appropriate attention on these areas.

In addition, management and audit committees, or the equivalent, of brokers and dealers may want to consider inquiring of their auditor how these areas are being appropriately addressed in their audits.

 

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