Like my fellow Board members, I support the adoption of the standards for attestation engagements related to broker and dealer compliance or exemption reports and for auditing supplemental information accompanying audited financial statements.
Broker-dealers are subject to extensive regulation, including the requirement for an annual audit, to protect customers and the operations of the securities markets. This system of regulation and controls — implemented by the Securities and Exchange Commission ("SEC" or "Commission"), the Financial Industry Regulatory Authority, and other self-regulatory organizations — helps to ensure that a customer's funds are actually invested in the company in which the customer wants to buy shares, that the customer's request to sell shares are carried out as instructed, and that customer securities held by the broker-dealer exist. The system of regulation includes, for example, requirements around a broker-dealer's capital level, designed to ensure the safety and soundness of the entity. Likewise, certain broker-dealers must maintain a reserve of funds or qualified securities that equals in value the amount of funds owed to customers. Adequate capital and reserves may be necessary, for example, to provide a cushion when a market disruption occurs. Therefore, while a customer may not worry too much about the financial statements of a broker-dealer, whether or not the broker-dealer meets regulatory requirements for the minimum level of capital and maintains adequate reserves is critical information.
Broker-dealers must annually file with the Commission reports including financial statements and either (1) a report stating the broker-dealer complied with rules such as those governing net capital and reserves or (2) a report explaining why the broker-dealer is exempt from these requirements. Historically, the auditor's work to provide assurances regarding the broker-dealer's annual financial statements and supporting schedules has been conducted under AICPA standards. But on July 30 of this year, the SEC adopted rule amendments to SEC Rule 17a-5, which, consistent with the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"), require that the audits of broker-dealers be conducted pursuant to PCAOB standards. The PCAOB today is adopting final standards for audits of broker-dealers, taking into account the terms of Rule 17a-5 and the comments that we received on the standards we had previously proposed in 2011.
First, we are adopting two attestation standards applicable to (1) examination engagements regarding compliance reports by broker-dealers and to (2) review engagements regarding exemption reports by broker-dealers. Generally, SEC Rule 17a-5 provides that broker-dealers that hold customer securities or funds — and are not exempt from SEC Rule 15c3-3 throughout the year — must prepare and file the compliance report. A broker-dealer must prepare and file the exemption report if it claimed that it was exempt from SEC Rule 15c3-3 throughout the most recent fiscal year.
Attestation Standard No. 1 — the "examination standard" — requires auditors to provide reasonable assurance about whether the broker-dealer (1) had effective internal controls over compliance; (2) was in compliance with the net capital rule and reserve requirements rule; and (3) based its assertion regarding compliance on information derived from the books and records of the broker-dealer. The standard is designed to, among other things, focus the auditor on the matters that are most important to the auditor's conclusions about the broker-dealer's assertions; incorporate consideration of fraud risks; be scalable based on the size and complexity of the broker-dealer; and facilitate coordination of the examination engagement with the audit of the financial statements and supplemental information.
Attestation Standard No. 2 — the "review standard" — establishes requirements that apply to an auditor's review of the broker-dealer's statements in an exemption report. Under this standard, the auditor must obtain moderate assurance regarding the broker-dealer's assertion that it identified and met the conditions for an exemption provision under SEC Rule 15c3-3, and, if applicable, that the broker-dealer identified and described each exception to meeting the identified exemption. Like the examination standard, the review standard is designed to facilitate coordination with the audit of the financial statement and supplemental information and to allow the auditor to scale the review engagement based on the broker-dealer's size and complexity.
We are also adopting AS No.17, setting forth required procedures when the auditor of the financial statements is engaged to provide reasonable assurance on whether supplemental information accompanying the financial statements is fairly stated, in all material respects, in relation to the financial statements as a whole. Although targeted specifically at supplemental information required to be filed by broker-dealers, including net capital calculations and reserve requirement calculations, the standard also applies more broadly to certain other types of supplemental information that is required to be presented by a regulatory authority or is voluntarily included. Such other supplemental information would include, for example, certain schedules required by the U.S. Department of Labor that may be included in filings on SEC Form 11-K relating to the annual reports of employee stock purchase, savings and similar plans.
AS No. 17 sets forth audit procedures designed to give reasonable assurance on whether the supplemental information is fairly stated, in all material respects, in relation to the financial statements as a whole. It requires auditors to perform procedures to determine that the supplemental information reconciles to the underlying accounting and other records or to the financial statements; to test the completeness and accuracy of the supplemental information; and to evaluate whether the supplemental information complies with relevant regulatory requirements. AS No. 17 retains the requirement in existing standards that the auditor's assurance be given on the supplemental information "in relation to" the financial statements as a whole. In addition, like the attestation standards, AS No. 17 is designed to facilitate coordination with the audit of the financial statements and is scalable depending on the amount and complexity of the relevant supplemental information.
I believe that the standards we are adopting today appropriately reflect the requirements of SEC Rule 17a-5 and provide a reasonable balance of investor protection and regulatory burden. More specifically, the standards redefine and strengthen the audit requirements applicable to the audits of broker-dealers by requiring auditors to focus on the primary risks associated with the activities of broker-dealers. With respect to the audits of so-called "carrying" broker-dealers — those that maintain custody of customer funds or securities — the examination standard focuses on compliance by the broker-dealer with specified SEC rules related to net capital and reserve requirements. In addition, the auditor must understand and evaluate the broker-dealer's internal controls over compliance that are designed to prevent customer or investor losses of securities or funds in the hands of the broker-dealer.
The activities of broker-dealers that do not maintain customer funds or securities — and therefore claimed an exemption throughout the year — are deemed to pose less risk to investors. As a result, the review standard, which requires a lower level of assurance than an audit, mandates fewer and less burdensome procedures and requires the auditor to provide moderate assurance, as opposed to reasonable assurance, on the broker-dealer's assertions in the exemption report.
Finally, the attestation standards and AS No. 17 each contemplate that the auditor will conduct a risk-based audit and permit the audit to be scaled depending on the size and complexity of the broker-dealer or the supplemental information, as applicable. Likewise, the standards contemplate that the auditor would leverage the work conducted on the financial statement audit in connection with the examination and review engagements and the audit of supplemental information. Therefore, I believe that the standards reflect an appropriate balance of customer and investor protection and potential cost to the affected broker-dealers.
The importance of auditor compliance with these new standards cannot be overstated, particularly in light of the results found by the Board's interim broker-dealer auditor inspection program. During the last two years, our inspectors have inspected 83 broker-dealer audits performed by 53 audit firms. Our findings have been very troubling. In 80 of 83 audits, inspectors found deficiencies. Many of these deficiencies involved audit procedures related to net capital and customer reserve supporting schedules, compliance with the conditions of the exemption claimed by the broker-dealer, and the accountant's supplemental report on material inadequacies. Independence violations — primarily those involving auditors who also were involved in the preparation of the broker-dealer's financial statements — were widespread, particularly among smaller firms.
While each audit firm in the business of auditing broker-dealers will have to consider its own return on the necessary investment to perform high quality audits, in light of our inspection findings, I urge all firms that choose to conduct broker-dealer audits to consider whether they need to make a fresh start. It is important that firms implementing the new standards be mindful of the need for appropriate quality control processes — especially in the independence area — and robust guidance and training in the new standards, followed by appropriate supervision and review when audits are performed.
In the context of our interim broker-dealer inspection program, I should note also that under Rule 17a-5, our new standards will apply to all auditors of broker-dealers, regardless of the decisions the Board ultimately may make with regard to the scope of its inspection oversight program.
These standards will apply to audits of financial statements, supplemental information, examination and review engagements of fiscal years ending on or after June 1, 2014. For broker-dealers with June 30 year-ends, these standards therefore will need to be implemented immediately upon approval by the SEC. This date is beyond the control of the Board, but, the Board's staff will consider issuing some additional staff guidance to help make the transition to the new standards easier. Nevertheless, firms will need to move quickly to implement the new requirements.
Finally, I will note that our work with regard to the rules and standards for broker-dealer audits is not done. In February 2012, we proposed a series of amendments to the PCAOB's rules and forms to reflect the requirements of the Dodd-Frank Act. These proposals included, for example, rule amendments tailoring the Board's professional practice standards to the audits of broker-dealers, as well as a series of other rule and form amendments related to auditors of broker-dealers. In order to make the transition for broker-dealer auditors to the new rules and standards as seamless as possible, the Board will need to move quickly to adopt the final rule amendments.
In conclusion, I would like to join my fellow Board members in thanking Marty Baumann, Barbara Vanich, Keith Wilson, Nick Grillo, Karen Burgess, Jennifer Williams and their colleagues in the Office of the Chief Auditor and the Office of General Counsel. As usual, your work has been comprehensive and thoughtful. I would also like to thank the staff at the Securities and Exchange Commission, who provided food for thought and helpful comments in a particularly technical and challenging area.