Broker Dealer Auditing Changes Are Here
By Charles Pagano
On August 2, 2013 the Securities and Exchange Commission (“SEC”) issued final rule, Release No. 34-70073, Broker Dealer Reports, (the “Release”), which requires significant changes for broker-dealers, including on audits of non-listed, but registered broker-dealers. Areas affected include additional reporting requirements, notification, amending SEC Rule 17a-5 (Reports to Be Made by Certain Brokers and Dealers), and 17a-11 (Notification Provisions for Brokers and Dealers). The final rule has various effective dates which range from 60 days after the rule was published in the Federal Register (August 21, 2013) to June 1, 2014.
The most significant change for auditors and their non-listed broker dealer clients is that auditing will now fall under Public Company Accounting Oversight Board (PCAOB) standards rather than the AICPA generally accepted auditing standards (GAAS), which have been the standards for decades.
The SEC noted in the Release, “The change from GAAS to PCAOB auditing standards will facilitate the Commission’s regulatory oversight because the Commission has direct oversight over the PCAOB… The Commission has greater confidence in the quality of audits conducted by an independent public accountant registered to and subject to regular inspection by the PCAOB.” This change is effective for years ending on or after June 1, 2014.
Auditing under PCAOB standards requires additional procedures, such as a concurring partner review, annual independence affirmation, and audit documentation standards, including an engagement completion document. It also allows for access to audit work papers by additional regulatory bodies, namely, the PCAOB, SEC and the Designated Examining Authority (“DEA”) and the Financial Industry Regulatory Authority, Inc. (“FINRA”).
The Release clarifies that despite concerns of broker dealers, auditor’s partner rotation rules will not be implemented, as is currently the case with issuers.
Although the SEC did not differentiate between standards of auditing small and large firms, the new rule does provide some different requirements between clearing and carrying firms, versus introducing firms. A clearing firm receives and executes customer securities transactions for its customers and possibly for those of another broker dealer.
A carrying broker dealer holds customer funds and securities, both for its own customers and possibly for those of other broker dealers. In the Release, the SEC discusses clearing and carrying firms together. An introducing firm accepts orders from customers, and elects to clear those orders through another broker dealer.
Firms that carry customer accounts are now obligated if requested by the SEC, or its DEA to review the accountants work papers for the purpose of facilitating their regulatory examinations.
The Report on Internal Control has been replaced by either a Compliance Report or Exemption Report, and a corresponding report by the auditor. The type of report depends on whether the broker dealer is non-exempt or exempt from SEC Rule 15c3-3 (Customer protection). Broker dealers will prepare the appropriate report and the independent public accountant registered with the PCAOB will then be asked to prepare its report.
In the case of the Compliance Report, required for carrying broker dealers, the auditor will examine the statements noted in the Compliance Report. Those statements include whether the broker dealer has established and maintained internal control over compliance, and whether it was effective for the most recent fiscal year, and at year end. Additional statements include whether the broker dealer was in compliance with SEC Rule 15c3-1 (net capital requirement for brokers and dealers). Any material weakness or any instance of noncompliance during or at year end would need to be described.
In the case of the Exemption Report for non-carrying broker dealers, the accountant will review the statements in the broker dealer’s report. Those statements include:
- An identification of what exemption the broker dealer is operating under;
- Whether the broker dealer met the exemption provisions;
- If any exceptions, the nature and date of such exception.
Other changes include the requirement to file the Annual Report with the Securities Investor Protection Corporation (SIPC) effective December 31, 2013, but only after SIPC approval. Previously, only a SIPC Report was filed with that body. The Annual Report currently consists of the audited financial statements and the Independent Auditor’s Report on Internal Control. The Annual Report for years ending after June 1, 2014 will include the Exemption or Compliance report, which will replace the Report on Internal Control.
A new quarterly custody report will be filed by all broker dealers (effective December 31, 2013). However, the information required for non-carrying broker dealers is not expected to be burdensome.
The changes enacted by the Release above will likely be supplemented by additional changes after the PCAOB completes its three year inspection program in August 2014.
PCAOB Inspection Program
The initial PCAOB inspection report entitled Report on the Progress of the Interim Inspection Program Related to Audits of Broker and Dealers, released on August 20, 2012, reported significant deficiencies. The initial report, with a sample of ten public accounting firms and 23 audit engagements, raised significant concerns over the quality of auditing.
Those accounting firms that had an issuer practice, performing audits for companies pursuant to the Securities and Exchange Act of 1934 and defined by the Sarbanes Oxley Act of 2002 (“SOX”), were better equipped to address a PCAOB inspection.
With the second PCAOB inspection report released on August 19, 2013, 40 public accounting firms were reviewed, and an additional 60 audit engagements. Once again, the PCAOB noted numerous audit deficiencies, (57 of 60 engagements). Among the areas noted in the report were:
- Deficiencies in audit procedures with regard to revenue recognition;
- Related parties and lack of consideration of fraud in the audit of the financial statements; and
- Lack of sufficient procedures and documentation of net capital and compliance with the exemptive provisions of SEC Rule 15c-3-3.
The above deficiencies are largely consistent with the deficiencies noted in the August 2012 initialreport.
Independence continues to be a problem area as a significant number of public accounting firms (22) were involved in the preparation of financial statements. Those firms were primarily accounting firms that had not previously issued reports for PCAOB audit clients.
The auditor is required to adhere to the independence rules as set forth in both AICPA rules, and SEC Rules 2-01(b) and (c) of Regulation S-X, which prohibit auditors from assisting, preparing the report and performing bookkeeping and support schedules.
The third and final inspection report, due next summer, may be the final impetus to bring another round of changes as the inspection process will be used as the basis for additional recommendations on audit standards applicable to broker dealers.
SEC Release 34-70072 (the “July Release”) Financial Responsibility Rules for Broker Dealers
On July 30, 2013, the SEC released final rule, Release No. 34-70072, Financial Responsibility Rules for Broker-Dealers (the “July Release”). The July Release, effective October 21, 2013(60 days after publication in the Federal Register), includes amendments to the net capital rule for broker dealers that provide securities and lending and borrowing arrangements.
The amendment states that broker dealers providing the financing services noted above are acting in a principal capacity and are therefore subject to applicable capital deductions, resulting in deductions from the net worth of the broker dealer. Those deductions would include the amount by which the value of the securities loaned exceeds the value of the collateral obtained for the loan in accordance with SEC Rule 15c3-1(c)(2). The broker dealer can avoid those charges provided certain steps described in the rule change are taken.
The July Release includes an amendment to 15c-1, requiring a broker dealer to assume the liability should a third party who has assumed the liability not have sufficient resources to pay the liability. To avoid this, the broker dealer would need to demonstrate the capability of the third party’s ability to pay the obligation.
The Commission points out that the guidance it previously issued in its third party expense letter (SEC letter from Michael A. Macchiaroli, To Elaine Mictitisch, New York Stock Exchange, and Susan Demando, NASD Regulation July 11, 2003 and clarified in FINRA Notice to Members 03-6 Expense Sharing Agreements), can be relied on. In enacting the rule, the SEC cites in the July Release a concern that a certain number of broker dealers (289 primarily introducing firms with a minimum net capital requirement of $5000) reflected no liabilities on their financial statements.
A broker dealer which does not record on its books and records expenses associated with the broker dealer such as rent, telephone, and salary registration fees and has the expense recorded on an affiliated company, is not truly representing the proper expenses associated with operating a broker dealer, and furthermore is not reflecting expenses in accordance with generally accepted accounting principles.
The July Release also notes that risk management controls need to be documented for the broker dealer’s business activities thereby amending rules 17a-3 (Records to be Made by Certain Broker Dealers) and 17a-4 (Records to be Preserved by Certain Broker Dealers), collectively, the recordkeeping rules.
This provision is only applicable to those broker dealers who have $1 million in aggregate credit items in the computation of the reserve formula in accordance with SEC Rule 15c3-3 or more than $20 million in capital including subordinated liabilities qualifying for capital treatment in the computation of net capital.
Additionally, the no action letters issued in 1998 on Proprietary Assets of Introducing Brokers (“PAIB”) (SEC Letter from Michael Macchiaroli to Raymond Hennessy, NYSE and Thomas Cassella, NASD Regulation) have been incorporated into the rules. This no action letter stated that a broker dealer need not take a deduction from net capital for those balances and securities held at another broker dealer provided that the other broker dealer had performed a computation and essentially set aside monies.