Significant Developments Affecting Broker-Dealers and their Auditors

PCAOB oversight of broker-dealer audits
The Public Company Accounting Oversight Board (PCAOB) conducted an open meeting on June 14, 2011 to consider the adoption of certain rules as implementation begins of its expanded oversight responsibilities for audits of broker-dealers under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

The PCAOB meeting discussed two significant rule proposals, both subject to approval by the Securities and Exchange Commission (SEC):

1. Establishing an interim inspection program for registered public accounting firms’ audits of broker-dealers. Two principal purposes of the rule are to: a) allow the PCAOB to assess registered public accounting firms’ current compliance with laws, rules and standards in performing audits of broker-dealers, and b) allow the PCAOB to determine significant elements of a permanent inspection program, including whether to differentiate among classes of broker-dealers (clearing versus introducing), whether to exempt any categories of public accounting firms and what minimum inspection frequency schedules to maintain.

The PCAOB expects to propose rules governing the scope and elements of a permanent program in 2013. During the interim program, the PCAOB will provide public reports on the progress of the program and any significant issues identified. In the absence of unusual circumstances, however, the PCAOB will not issue firm-specific inspection reports before inspection work is performed under the permanent program and will not issue such reports on any firms that are eventually excluded from the scope of the permanent program.

2. Adopting rules to assess and collect a portion of its accounting support fee from broker-dealers to fund the PCAOB oversight of audits of broker-dealers. As proposed, the fee would be based on “tentative net capital,” which is defined as net capital before deductions for securities “haircuts” and charges for certain commodities transactions, which the regulators consider to be a more consistent measure of net capital. Those broker-dealers with less than an average quarterly tentative net capital of $5 million would pay no accounting fee, thereby eliminating approximately 86 percent of the roughly 4,600 broker-dealers registered with Financial Industry Regulatory Authority (FINRA).

SEC-proposed changes to broker-dealer financial reporting rule (Rule 17a-5)

Management of broker-dealers should anticipate significant changes to SEC Rule 17a-5 (“Reports to Be Made by Certain Brokers and Dealers”) that will have an impact on the extent, nature and timing of audit procedures and the resultant auditor’s reports.

This rule stipulates the timing and nature of various financial statements and reports by broker-dealers and the audit objectives, testing and reports to be issued by their auditors.

As in the case of the PCAOB’s involvement in broker-dealer audits, the proposed SEC rule changes are a result of the Bernard Madoff fraud scandal. There was also a need to align the SEC rules with updated and ever-changing auditing standards. They are principally focused on the custody of customer assets and securities and have been drafted to be consistent with the recently adopted investment adviser custody rules. The proposed changes are:

• The definition of a new term, “Financial Responsibility Rules,” which refers to the net capital (Rule 15c3-1), customer protection (Rule 15c3-3), security count and verification (Rule 17a-3) and account statement rules.
• Broker-dealers who maintain custody of customer securities and cash would prepare and submit a report asserting their compliance with the Financial Responsibility Rules as of their fiscal year end and whether internal control over compliance with the Financial Responsibility Rules was effective during the fiscal year (“Compliance Report”).
• For broker-dealers who do not maintain custody of customer securities and cash, the proposed rules would require them to file a report (“Exemption Report”) asserting an exemption from the custody rules.
• Auditors would issue a report on either the broker-dealer’s Compliance Report (the “Examination Report,” an attestation report) or Exemption Report (a review report). These reports would replace the present Report on Internal Controls. (It is interesting to note, however, that the proposed rules would allow for the Examination Report to satisfy both the reporting requirements under Rule 17a-5 and the Investment Adviser’s Internal Control Report, as appropriate.)
• Finally, the proposed amendments would change the audit standards applicable to broker-dealer audits, examinations of the Compliance Report and reviews of the Exemption Report from Generally Accepted Auditing Standards (GAAS) to standards promulgated by the PCAOB.

We believe that these changes will require a significant adjustment in documentation and testing by broker-dealers in order for them to issue their Compliance Report as well as an undeterminable increase in the work performed by their auditors.

For instance, the Compliance Report would require an assertion that the internal controls over compliance with the Financial Responsibility Rules were effective the entire fiscal year, as compared to the Report on Internal Controls, which requires testing as of the fiscal year end. (Note that the SEC is proposing that this requirement be deferred until fiscal years ending after Sept. 15, 2012.)

Although the SEC is not proposing an assessment of internal control over financial reporting (Section 404 of the Sarbanes-Oxley Act), there are significant differences between GAAS and PCAOB audit standards. For example, certain audit documentation requirements contained in PCAOB Audit Standard 3 (“Audit Documentation”) and the engagement quality review requirement in PCAOB Auditing Standard 7 (“Engagement Quality Review”) are not required by GAAS. We understand that the PCAOB is developing new auditing and reporting standards focused specifically on audits of broker-dealers.

In addition, the proposed rule changes include provisions which would allow the SEC staff to have conversations with and/or review the underlying audit documentation of auditors of broker-dealers that clear customer transactions or self-custody their proprietary securities. We believe this is the regulator’s attempt to determine how much work the SEC needs to perform to supplement the work performed by those auditors as it completes its field examinations.

Finally, the proposed rules would require all broker-dealers to file a quarterly report related to custody of customer cash and securities with the SEC (“Form Custody”). The form is designed to elicit information regarding whether a broker-dealer maintains custody of customer and non-customer assets and, if so, how such assets are maintained. This report would not be audited and would serve as a starting point for examinations by regulators.

Other topics of importance

• It should be noted that FINRA may start to review auditor’s workpapers.
• Regarding dual registrants (broker-dealers and futures commission merchants), the Commodity Futures Trading Commission (CFTC) is assessing amending its rules that require an agreed-upon-procedure report be issued by auditors of futures commission merchants. The procedures would be performed on the supplemental schedules (net capital as well as segregation and secured computations). The CFTC would still require the Report on Internal Controls.
• On June 22, 2011, the SEC approved a series of rules related to Title IV of the Dodd-Frank Act affecting investment advisers. Two important considerations are:
• Even though the rules are effective now, the mandatory registration of investment advisers has been deferred to March 30, 2012.
• Because Wyoming, Minnesota and New York do not have inspection programs, investment advisers whose principal operations are in these states with assets under management exceeding $25 million will be required to register with the SEC.
• The Cayman Island Monetary Authority (CIMA) has proposed that master funds in a master-feeder structure with a Cayman Island feeder fund would be required to register with CIMA.

For more information
If you have any questions about these issues, please contact John Hague at 312.634.3354 or your local McGladrey & Pullen financial services representative.