Broker-Dealer Audits Still Badly Broken

By Francine • Sep 3rd, 2013 • Category: Latest, Pure Content, The Case Against The Auditors

On August 19, 2013, the Public Company Accounting Oversight Board, the audit industry regulator, released its second report on its interim inspection program for auditors of brokers-dealers registered with the Securities and Exchange Commission.

The PCAOB’s second “progress” report found deficiencies in all of the audit firms inspected and in 57 of the 60 audits inspected. The Board’s first interim progress report in August 2012 reviewed ten audit firms covering portions of 23 audits. Deficiencies were also identified in all of the audits inspected at that time.

That’s not much progress.

Violations of auditor independence rules were rampant, found in more than one-third (22 of 60) of the audits selected for inspection this time. The PCAOB inspections staff found, in particular, that auditors had violated independence rules by performing services for clients prohibited under SEC independence rules. For example, audit firms prepared the financial statements the firm was paid to “independently” audit on behalf of customers and investors.

Until now audits of the broker-dealer have been performed under AICPA standards. This goes for even the public companies such as Goldman Sachs and JP Morgan where the rest of the audit is performed according to PCAOB standards – that is, the ones now required by the Sarbanes-Oxley Act. And on July 30, 2013, the SEC finally approved amendments to Exchange Act Rule 17a-5 required by the Dodd-Frank Act. These amendments include the requirement that the audits of brokers and dealers must be conducted in accordance with PCAOB standards for fiscal years ending on or after June 1, 2014.

It’s no wonder that auditors, even of these large public companies, were confused about independence.

Well, not really.

One year ago, in Forbes on August 22, 2012, I published Already Behind The Eight-Ball: Auditors of Broker-Dealers Are A Disaster. That was followed up with a post on this blog on August 30, Four Years After Madoff, Audits and Auditors of Broker-Dealers Still Lousy.

I wrote:

The broker-dealers that were inspected by the PCAOB were not judged by any new rules. The auditors operate, for now, under generally accepted auditing standards (“GAAS”) issued by the American Institute of Certified Public Accountants (“AICPA”). The new “surprise” examination of investment advisors who have custody of customer funds or securities is also performed under AICPA attestation standards.

Broker-dealer audit firms will soon have to start auditing those firms under PCAOB standards. One wonders how most of them will ever be able to make the transition and stay in business given their poor performance under well-known AICPA standards.

From my Forbes column:

One very difficult complication is that auditors of broker-dealers are required to be independent of their clients under SEC rules, not AICPA rules. AICPA independence rules are more lenient and do not prohibit auditors from also preparing the financial statements they audit and supporting firms with accounting software and IT expertise.

The PCAOB says in its report even firms that audit public broker-dealers — who should know better — broke the independence rules.

These independence findings were identified in approximately eight percent of the audits selected for inspection performed by firms that audited brokers and dealers and also audited issuers. In contrast, independence findings were identified in approximately 80 percent of the audits selected for inspection performed by firms that audited brokers and dealers but did not audit issuers.

In July of 2012, after the failure of PFGBest because of massive fraud, I told readers that the smaller audit firms, in particular, had problems with the independence rules.

But one issue that provoked heated discussion at the Chicago forum was auditor independence. It seems many of these Certified Public Accountants and broker-dealer auditors were under the mistaken impression that it’s the AICPA’s rules for auditor independence that apply to them, not the SEC’s. SEC rules, post-Sarbanes-Oxley Act of 2002, prohibit an auditor of an SEC-registered firm from performing a list of nine prohibited services including bookkeeping and systems design and implementation for its audit clients.

Several audit firm professionals tried to convince the SEC and PCAOB staff that they were mistaken in the belief that broker-dealer auditors could not sign the broker-dealer audit opinion as well as help implement accounting software, prepare period-end journal entries and compile those same financial statements and regulatory reports that they would audit. PCAOB staff told me that this issue has come up at every forum.

Those audit firm professionals were dead wrong.

On August 27, the SEC published, Broker-Dealer Reports: A Small Entity Compliance Guide to more fully explain the expectations for broker-dealers registered with the Commission with regard to the amended reporting, audit, and notification requirements under 17 CFR Parts 240 and 249.

One overlooked addition to the legal obligations of the broker-dealer auditor is a Securities and Exchange Act of 1934 Section 10A-type requirement. This new rule requires the auditor to report to the SEC if the broker-dealer fails to notify the SEC of any instances of non-compliance with Exchange Act Rules 15c3-1 and 15c3-3(e) and the broker-dealer’s internal control over compliance with Rules 15c3-1, 15c3-3, Exchange Act Rule 17a-13, and applicable designated examining authority (DEA) rules that require broker-dealers to send account statements to customers (collectively, the “financial responsibility rules”).

If the independent public accountant determines that a broker-dealer is not in compliance with any of the financial responsibility rules during the course of preparing its reports, the independent public accountant must immediately notify the broker-dealer’s chief financial officer of the nature of the non-compliance.  The broker-dealer must then provide notice in accordance with Rule 15c3-1, Rule 15c3-3, or Exchange Act Rule 17a-11 if the non-compliance requires the broker-dealer to provide notice under those rules and must provide a copy of the notification to the independent public accountant.

If the independent public accountant determines that a material weakness exists in the internal control over compliance of the broker-dealer, the accountant must immediately notify the broker-dealer’s chief financial officer of the nature of the material weakness.  The broker-dealer must then provide notice in accordance with Rule 17a-11 and provide a copy of the notification to the independent public accountant.

The broker-dealer is also required to provide a copy of the notice sent to the Commission to the accountant within one business day.  If the accountant does not receive the notice or if the accountant does not agree with any statements in the notice, the accountant is required to provide a report to the Commission and the broker-dealer’s DEA within one business day.

Fulfilling this serious legal obligation to the capital markets, doing your public duty, is not easy thing. An audit firm has to actually be independent, objective, professionally skeptical and not financially beholden to its client. (This recent article by Chicago lawyer Bennett Lasko describes what happened when Deloitte apparently tried to do the right thing. Clients just don’t get it.)

In July of 2012 I wrote at Forbes:

The changes that will have to occur to bring the broker-dealer audit firms, and their clients, in line may mean not only consolidation of audit firms that can not deliver audit-only services cost effectively and per the standards, but also consolidation of broker-dealers who do not want hire competent accounting and systems professionals in-house or contract for them separately from a firm that’s not their auditor.

According to the PCAOB, this consolidation is already occurring but maybe not quickly enough to protect customers, investors, and the markets. There are fewer broker-dealers to audit and fewer audit firms registered with the PCAOB to audit broker-dealers than a year ago. However, 83% of auditors registered to audit broker-dealers do five or fewer such audits and almost half of those registered do only one.

(One quirk in the PCAOB inspection process is that the PCAOB selects broker-dealer audit firms to inspect from amongst those that have registered with the agency. If a broker-dealer files with the SEC as required but its auditor is not registered with the PCAOB, the auditor would never be inspected. It may be helpful for the SEC and the PCAOB to cross-check auditors named in broker-dealer SEC filings against the PCAOB registration list. Bingo! Easy pickings.)

Doing five or fewer broker-dealer audits — definitely doing only one — is not nearly enough, in my opinion, to be competent or cost-effective, let alone profitable and sufficiently objective, professionally skeptical and independent. PCAOB board member Jay Hanson seems to agree. On a call briefing reporters about the second interim inspection results he said, “firms that audit only a small number of broker-dealers may want to get out of that line of work rather than invest the time needed to become an expert.”

So many audit firms can’t, or won’t, follow the SEC independence rules. How can we expect them to fulfill their legal obligation to tell the SEC when a broker-dealer has a material weakness in internal controls over compliance with important rules like customer funds segregation, safeguarding securities, and calculating net capital?

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4 Responses »

  1. Were there any variations in results based on the size of the audited firm? Curious if this applies equally to the big boys of Wall St too but have to assume it does.

  2. @ExDT

    I think the only breakdown they made was for firms that also audit public issuers and firms that don’t. Also this:

    “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.”

    So they looked at engagements in all of the firms that are inspected annually, that is, they audit more than 100 public companies. Then 10 more of the ones that audit less pubic companies and a fair number who audit no public companies. I think they would have looked at some of the engagements at the largest FCMs and broker-dealers. Deficiencies were observed in all firms inspected. They give a pretty good profile of how they chose the firms to inspect.

    “The Board is working to identify ways that the risk of loss to customers can be differentiated through various attributes that characterize a broker or dealer. These include whether or not a broker or dealer:
    -Receives, handles or holds securities or cash from the purchase or sale of securities by customers;
    -Carries customer accounts;
    -Engages in lines of business that transact with customers;
    -Reports financial measurements of net capital, revenues or assets that, on a combined basis, represent a differentiation of risk of loss to customers;
    -Has characteristics that may indicate heightened fraud risk or has received regulatory sanctions; and
    -Is a member of the Securities Investor Protection Corporation (“SIPC”).”

  3. Francine

    Some commentary on 2012 Part A for the Big 4 pls now that they are all out.

  4. Hi, I am working on something about the PCAOB proposed audit report changes. It will be focused on the auditor liability impact. I will add a comment on the Part I reports for the four now that they are all out. Look for it Monday.

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