Major Changes for Broker/Dealer Aufts

Preparing for PCAOB Inspections, More Rigorous Auditing Standards, and Additional Reporting Requirements

With the SEC's approval of the final Rule 34-70073, auditing a broker/dealer under the PCAOB's auditing standards will certainly be very different. Auditing under the new standards will be effective for fiscal years ending on or after June 1,2014, but broker/dealers and auditors will benefit by planning now. As noted in SEC Release 34-70073, "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 also has greater confidence in the quality of audits conducted by an independent accountant registered with, and subject to regular inspection by, the PCAOB."

Changes for Small Broker/Dealers

For those who had hoped that auditing a small broker/dealer might have received an exemption to continue to audit under GAAS, the PCAOB's reasoning clearly indicated otherwise in October 2011, when the PCAOB and SEC, along with the Financial Industry Regulatory Authority (FINRA), presented their position to 300 auditors at a forum in Jersey City, New Jersey. Tim Gustafson, associate director for policy support of the PCAOB's Office of Research and Analysis, noted the following two findings, which made it extremely difficult for decision makers to exclude smaller broker/dealers from the PCAOB requirements due to size or type of business:

* Of all FINRA firms, 53% have fewer than 10 employees.

* Excluding the Madoff claims, 82% of all Securities Investor Protection Corporation (SIPC) liquidations and 65% of customer advances were for nonclearing broker/dealers.

Effects of PCAOB Inspections

In early 2012, the PCAOB began inspections of auditors who make up the nearly 900 firms that audit registered brokers and dealers, according to FINRA statistics provided by the PCAOB during the aforementioned presentation; those audits were prepared under GAAS. The PCAOB's initial report, which was issued in August 2012 and sampled 10 auditing firms and 23 audits, disclosed many deficiencies-in fact, deficiencies were noted in all firms. Many firms revised their audit procedures to address those issues.

The PCAOB issued a second report on August 19,2013; it reported on 43 auditing firms and 60 audits. Once again, the PCAOB noted numerous audit deficiencies, in 57 of the 60 engagements. Among the areas noted in the report were deficiencies in audit procedures with regard to revenue recognition, related parties, consideration of fraud, net capital, and compliance with the exemption provisions of SEC Rule 15c-3-3 (see below). Independence continues to represent a problem area: a significant number of audits (22 of 60) noted that auditors were involved in the preparation of financial statements.

The third and final inspection report, due in the summer of 2014, will include audit engagements for the period ending December 31, 2013. It might be the final impetus for another round of changes because the inspection process will be used as the basis for additional recommendations on broker/dealer audit standards. Information gathered from the inspection program will also be the basis for a permanent inspection program by the PCAOB. According to the 2013 report, the proposal for the permanent inspection program is targeted for 2014 or later.

Auditing under PCAOB Standards

Many might ask what auditing under PCAOB standards means and how it will affect broker/dealers. Audits under PCAOB standards (as opposed to GAAS) will include, but are not limited to, the following additional requirements:

* Engagement quality review (EQR). A second audit partner, also known as a concurring partner, familiar with audits of broker/dealers must provide concurring approval prior to the issuance of the audit. The EQR must perform a review of the engagement in accordance with Auditing Standard (AS) 7, Engagement Quality Review. Smaller accounting firms will presumably hire more partners or an outside consultant with the experience required to perform the review in accordance with PCAOB standards.

* Access to audit documentation. Broker/dealers will have an additional layer of regulation as the PCAOB periodically examines public accounting firms; the examination frequency depends upon the size of the firm. The PCAOB will have the ability to review the auditor's workpapers and, if necessary, refer matters to the SEC and FINRA. The PCAOB can also choose to discipline auditors itself.

* Annual independence affirmation. All members of the audit engagement team are required to attest to their independence. The EQR is required to perform procedures and attest to the independence of the firm on the engagement.

* Audit documentation standards. These rules are significantly more stringent under PCAOB standards, such as AS 3, Audit Documentation. For example, PCAOB auditing standards require the completion of a formal document-"Engagement Completion Document"-that acts as a road map to the audit and requires discussion of facts, evidence, and outcomes for numerous areas, including significant issues, results of procedures, and circumstances that caused significant difficulties for the auditor.

Reporting Requirements

One of the key differentiators of broker/dealers is whether they carry customer accounts or clear transactions. Broker/dealers that perform these functions clearly pose more systemic risk for the financial markets because they are responsible for the safety of the financial assets held in their customers' accounts; therefore, they are subject to additional regulatory and reporting requirements. Specifically, these broker/dealers are subject to full compliance with SEC Rule 15c3-3, often called the Customer Protection Rule. Principally, it establishes requirements for the physical possession and control over customer accounts, as well as minimum amounts that must be segregated on behalf of customers in a reserve account.

In the PCAOB's "Second Report on the Progress of the Interim Inspection Program Related to Audits of Broker and Dealers," of the 4,227 broker/dealers audited, only 311 were subject to SEC Rule 15c3-3; the remaining broker/dealers claimed an exemption (Aug. 19, 2013). The broker/ dealers that claimed exemptions did not carry customer accounts or clear transactions; therefore, they were considered exempt from the provisions of the rule. Specific provisions in the SEC rules define each of the exemptions. Whether a broker/dealer is exempt from the provisions of the Customer Protection Rule is a key question that needs to be asked and answered as part of the audit of the financial statements.

When Rule 34-70073 goes into effect on June 1, 2014, broker/dealers will be required to issue reports about their compliance with the Financial Responsibility Rules; in addition, auditors of broker/dealers will need to issue a report concerning the broker/dealer's statements. A broker/dealer that did not operate under the exemption provisions of the Customer Protection Rule during the complete fiscal year must issue a compliance report, and the auditor must issue its report on the examination of the broker/dealer's compliance report. A broker/dealer that operated subject to the exemption provisions must issue an exemption report, and the auditor must issue a report upon review of that report.

Compliance report Hie new compliance report for broker/dealers subject to the Customer Protection Rule requires the broker/dealer to make statements about the establishment and effectiveness of its internal controls over compliance, defined as internal controls that have the objective of providing the broker/dealer with reasonable assurance that noncompliance with the Financial Responsibility Rules will be prevented or detected on a timely basis. Specifically, the statements assure the following:

* The broker/dealer has established and maintained internal controls over compliance.

* The broker/dealer's internal controls over compliance were effective during the most recent fiscal year.

* The broker/dealer's internal controls over compliance were effective as of the end of the most recent fiscal year.

* The broker/dealer complied with Rule 15c3-l (i.e., the Net Capital Rule) and paragraph (e) of Rule 15c3-3 ("Special Reserve Bank Account for the Exclusive Benefit of Customers") as of the end of the most recent fiscal year.

* The information that the broker/dealer used to determine its compliance with the Net Capital Rule and paragraph (e) of the Customer Protection Rule was derived from the broker/dealer's books and records.

In the report, the broker/dealer must describe each material weakness of its internal controls over compliance, as well as any instances of noncompliance with certain mies. The auditor is then required to examine and report on these statements and, if applicable, the descriptions.

Exemption report Currently, broker/dealer financial statements subject to the exemption provisions of the Customer Protection Rule must include a supplementary statement identifying which of the specific exemptions the firm is using to claim the exemption, as well as a report on internal control.

This separate report does not require the expression of an opinion on the effectiveness of the broker/dealer's internal control, but does include a statement indicating that the auditor has "made a study" that included tests of compliance with the broker/dealer's exemption from the Customer Protection Rule, as well as periodic computations of net capital. For broker/dealers subject to the Customer Protection Rule, this report has been expanded to include the "study" of specific requirements of frie Customer Protection Rule.

The new exemption report requires the broker/dealer claiming exemption from the Customer Protection Rule to report the following in its statement:

* The broker/dealer must identify the provisions in the Customer Protection Rule under which it claimed an exemption.

* The broker/dealer must state that it met file identified exemption provisions of the Customer Protection Rule throughout the most recent fiscal year without exception, or that it met the identified exemption provisions in the Customer Protection Rule throughout the most recent fiscal year, except as described in the exemption report.

* The broker/dealer must identify, if applicable, each exception during the most recent fiscal year in meeting the identified provisions in the Customer Protection Rule and briefly describe the nature of each exception and the approximate dates on which the exception existed.

The auditor is then required to review and report on the statements in accordance with PCAOB standards. The procedures under the PCAOB standards that the auditor must follow include inquiry of appropriate personnel with responsibility for monitoring compliance with the exemption, as well as corroboration of the same. The exemption report allows for exceptions to compliance during the period under audit, as long as those exceptions are stated in the report, which is subject to review by the auditor.

Signature requirement The final rule requires that the broker/dealer compliance and exemption reports be executed by the person who makes the oath or affirmation required under Rule 17a-5.

Material inadequacy report Some might wonder what happened to the original report on internal controls, often referred to as the material inadequacy report-this requirement has been eliminated. Compliance reports or exemption reports, and the related reports by independent public accountants, are required for fiscal years ending on or after June 1, 2014. In the interim, broker/dealers must continue to file material inadequacy reports in accordance with the provisions of Rule 17a-5 as they existed before this amendment. It is important to note that these new reports do not change the responsibilities of a broker/dealer in monitoring its exemption throughout the period under audit; rather, they clarify the auditor's responsibility for reporting on it. Owing to the seriousness of whether a broker/dealer is exempt from the Customer Protection Rule and the clarity of the new exemption report being applicable to the entire period under audit, auditors must ensure that their procedures are adequate to opine on that entire period. Although the new reports will not be applicable to audits for years ending on December 31, 2013, firms that audit broker/dealers will need to plan for these new reports quickly thereafter. In October 2013, the PCAOB adopted "Standards for Attestation Engagements Related to Broker and Dealer Compliance or Exemption Reports Required by the U.S. Securities and Exchange Commission and Related Amendments to PCAOB Standards" (2013-007), which establishes requirements for the auditor with respect to compliance or examination statements prepared by broker/dealers. The standard is pending SEC approval. It will be effective for examination and review engagements for fiscal years ending on or after June 1, 2014; this effective date would coincide with the effective date for the corresponding amendments to the SEC's Rule 17a-5.

Reports intended for use by the SIPC Effective for years ending on or after December 31, 2013, Rule 34-70073 requires that the annual report, which consists of the annual audited financial statements and applicable footnotes, and the independent auditor's report on internal control be filed with SIPC, which will be able to monitor broker/dealers and their potential impact. The SIPC report will no longer have to be filed with the SEC. SIPC will need to agree to the rule change before the change in filing becomes effective. Accountants will also need to perform procedures in the SIPC report in accordance with PCAOB standards.

Confidentiality

The SEC has also modified the confidentiality election by a broker/dealer in its annual audit filing. Under the existing rule, broker/dealers were allowed to file, in addition to the full financial statements available to all regulatory bodies, a report that contained the statement of financial condition and notes (commonly called a short report). The shorter statement of financial condition report is available to the public on the SEC website. The modification, pursuant to SEC Rule 17a-5(e)3, still requires that the statement of financial condition and notes be separately bound from the annual report; however, those pages where confidential treatment is requested should be stamped accordingly. In addition, the new compliance or exemption reports, when effective, will also be deemed confidential if marked as such.

Independence

In the release, the SEC reminds all auditors that broker/dealers and auditors are subject to the independence requirements of Rule 2-01 of Regulation S-X. Recent SEC and PCAOB conferences have stressed prohibited services, including 1) bookkeeping, 2) preparing source documents, and 3) report writing and assistance in the preparation of reports filed pursuant to SEC Rule 17a-5 ("Reports to Be Made by Certain Brokers and Dealers"). Independence in report writing includes the annual audit and focus report. In its release, the SEC stated that certain independence requirements are applicable only to issuers, such as partner rotation and audit committee preapproval.

The Custody Rule

Rule 206(4)-2 of the Investment Advisers Act of 1940 (i.e., the Custody Rule) established regulations regarding the custody of funds or securities of clients by investment advisors. Specifically, it requires a registered investment advisor to use a qualified custodian to maintain customer funds and securities (with certain additional requirements). Under this rule, only banks, certain savings associations, registered broker/dealers, futures commission merchants, and certain foreign financial institutions may act as qualified custodians. Without going into the details of tie Custody Rule, it also requires that an investment advisor or related entity that maintains client funds and securities as qualified custodian in connection with advisory services obtain a written internal controls report, along with the opinion of an independent public accountant registered with and subject to regular inspection by the PCAOB. The auditor's opinion must state whether the controls have been placed into operation as of a specified date; are suitably designed; and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held by tie advisor or related entity on behalf of advisory clients.

Broker/dealers that act as qualified custodians (i.e., carrying broker/dealers) are responsible under the new rules for preparing the compliance report described previously. It should be noted that the SEC has determined that the independent public accountant's report, based upon an examination of the compliance report, will satisfy the internal control report requirements under Rule 206(4)-2 because the operational requirements of the financial responsibility mies are consistent with the control objectives outlined in the SEC's guidance on the Custody Rule. Essentially, those broker/dealers subject to the compliance reporting requirement are not required to have a separate internal control report under the Custody Rule. The annual verification required under the Custody Rule remains unchanged.

As noted previously, a broker/dealer must prepare either a compliance or exemption report. The exemption report is for broker/dealers that don't carry funds or securities, and it is subject to review by an independent accountant; thus, it would not meet the conditions and objectives necessary to meet the scope of the internal controls report requirement in the Custody Rule.

Access to Accountant and Audit Documentation

Unless the independent accountant's engagement letter agreement is for successive years, a broker/dealer (as defined by Rule 17a-5[d]) must file a statement, "Notice Pursuant to Rule 17a-5(f)(2)," on an annual basis with the SEC and designated examining authority (DEA). The statement identifies, among other things, the existence of an agreement between the broker/dealer and its independent public accountant for the following year's audit services to be provided.

The SEC amended the above stated rule, requiring broker/dealers to add an additional representation to the statement permitting the SEC and DEA access to the audit documentation and workpapers associated with the annual audit as part of their examination process. All requests for audit workpapers and documentation must be submitted in writing. Lastly, the SEC identified that audit documentation has the same meaning as in AS 3.

In addition to gaining access to the workpapers, a broker/dealer would allow its independent public accountant to discuss certain audit-related findings with the SEC and DEA. It is believed that the examination process will be more effective by permitting the SEC and DEA access to this type of documentation, as well as discussions with the independent public accountant. This amendment only affects clearing broker/dealers, due to the complexity of their structures and operations.

Form Custody

Under Rule 17a-5, paragraph (a)(5), the SEC now requires quarterly filing of the Form Custody by all broker/dealers, regardless of whether the broker/dealer maintains custody of customer and noncustomer assets. The Form Custody is intended to help the SEC and DEA examiners identify custody-related risks, violations, and misconduct, along with collecting key information about a broker/dealer's custodial activities. In addition, Form Custody is intended to expedite the examination of the custodial activities because the examiners will already have related information. If an inconsistency or other red flags are observed upon review of the Form Custody, a more focused and detailed regulatory examination of the broker/dealer's custodial activities may be performed.

The initial Form Custody is required with the broker/dealer's Focus filing for the period ending December 31,2013, and for each calendar quarter thereafter. For broker/dealers with a year-end date that is not a calendar quarter, the Form Custody is due within 17 business days of their year-end.

The Form Custody is designed to collect pertinent information about a broker/dealer's custodial activities through nine line items, described in the following sections.

Items 1 and 2-accounts introduced on a fully disclosed basis and on an omnibus basis. These items are intended to identify and confirm the introducing/carrying relationship between broker/dealers on a fully disclosed basis (item 1) and on an omnibus basis (item 2).

It is common for a broker/dealer to enter into carrying agreements with another broker/dealer, where the responsibilities of serving the customers are agreed upon. Generally, the introducing broker/dealer agrees to serve as the customer's account representative, and the carrying broker/dealer agrees to receive and hold the customer's cash and securities, clear transactions, and make and retain records. If the introducing/carrying relationship is introduced on a fully disclosed basis, the carrying broker/dealer maintains-and is liable for-the cash and securities of the introduced customers. If the introducing/carrying relationship is introduced on an omnibus basis, the introducing/carrying broker/dealers are considered the carrying broker/dealers under tiie Net Capital Rules. Because an omnibus account is carried and cleared by another broker/dealer and contains accounts of undisclosed customers on a commingled basis, it is carried individually on the books of the introducing broker/dealer. Form Custody requires the introducing broker/dealer to identify all carrying brokers to which their customers are introduced on a fully disclosed, as well as an omnibus, basis.

Item 3-carrying broker/dealers. This item consists of five subparts intended to gather information about how a carrying broker/dealer holds cash and securities:

* Items 3 A and 3B gather information about the broker/dealer's carried securities account for customers and noncustomers, respectively. Under Rule 15c3-3, persons that are not "customers" include an accountholder who is a general partner, director, or principal officer of the carrying broker/dealer, as well as account holders who are broker/dealers.

* Item 3C requires the carrying broker/dealer to identify, in a chart, the types of locations where the securities are held and the frequency of the reconciliation between their stock record and records of those locations. The locations noted in item 3C are a broker/dealer's vault, another U.S. registered broker/dealer, the Depository Trust Company, the Options Clearing Corporation, U.S. banks, transfer agents, issuers, and foreign locations.

* Items 3D and 3E contain three identical subparts relating to customers and noncustomers, respectively. These items are intended to assess whether the carrying broker/dealer is properly accounting for the type and amount of securities and cash of customers and noncustomers, including free credit balances. In essence, these items encourage the carrying broker/dealer to identify and self-correct its stock record.

Item 4-carrying for other broker/dealers. This item is intended to obtain specific information about whether a broker/dealer carried transactions for any other broker/dealers on a fully disclosed or omnibus basis. Additional information is required about affiliated broker/dealers. Form Custody's instructions define the term "affiliate" as any person who directly or indirectly controls the broker/dealer or any person who is directly or indirectly controlled by, or under common control with, the broker/dealer. Control is deemed if the broker/dealer submitting the Form Custody owned 25% or more of the common stock of the broker/dealer introducing transactions.

Item 5-trade confirmations. This item is intended to obtain information about whether the broker/dealer or a vendor employed by the broker/dealer sends transaction confirmations to customers and other account holders.

Item 6-account statements. This item is intended to obtain information about whether the broker/dealer or another service provider sends account statements directly to customers and other account holders, as well as anyone other than the beneficial owner of the account.

Item 7-electronic access to account information. This item requires a broker/dealer to indicate whether it provides customers and other account holders with electronic access to information about the securities and cash positions in their accounts.

Item 8-broker/dealers registered as investment advisors. This item is intended to obtain information about whether a broker/dealer is also registered as an investment advisor with the SEC under the Investment Advisers Act or with one or more states. Registered broker/dealers must disclose the number of its investment advisor clients, along with additional information, in a chart indicating where client assets are held, the scope of the broker/dealer's or investment advisor's authority over the accounts, whether the broker/dealer or investment advisor has the ability to withdraw funds and securities from the accounts, whether customer account statements are sent directly from file custodian, and whether the investment advisor client assets are included in the broker/dealer's stock record.

Item 9-broker/dealers affiliated with investment advisors. This item asks whether the broker/dealer is an affiliate of an investment advisor. If so, the broker/dealer is required to identify whether it has custody of the advisor's client assets and indicate their approximate U.S. dollar market value.

Additional Considerations

On August 13, 2013, the PCAOB also proposed for public comment a "New Auditing Standard to Enhance the Auditor's Reporting Model" (PCAOB Release 2013-005). Of particular interest to broker/dealers and their auditors, one part of the standard would require auditors to report on critical audit matters. Those matters noted in the proposal would include areas that involved difficult, subjective, complex auditor judgments; areas where the auditor had difficulty in obtaining audit evidence; and areas where the auditor had difficulty issuing an opinion.

The inclusion of the above in the auditor's report would give financial statement users, including regulators, a better understanding of which areas to focus on in their examinations. The PCAOB also proposes that a statement be included in the report noting the auditor's independence pursuant to SEC and PCAOB rules, as well as the auditor's tenure. The PCAOB has asked for comments on whether the proposal should be applicable to the audits of brokers and dealers; the comment deadline is December 11, 2013.

At the same that the SEC released its final rule on auditing broker/dealers, it also released its final Rule 34-70072 ("Financial Responsibility Rules for Broker-Dealers"), which amends the Net Capital Rule, the Customer Protection Rule, the Books and Records Rules (Rules 17a-3 and 17a-4), and the Notification Rule (Rule 17a-ll). Highlights of this final rule include the following:

* It incorporates many of the provisions of a no-action letter issued by the SEC in 1998, concerning proprietary assets of introducing brokers' agreements. The noaction letter is thus withdrawn.

* It amends the Net Capital Rule with respect to securities lending and borrowing and repurchase/reverse repurchase transactions. For example, the rule clarifies that broker/dealers providing securities lending and borrowing settlement services are deemed, for purposes of the rule, to be acting as principal and are subject to applicable capital deductions, unless the broker/dealer takes certain steps to disclaim principal liability.

* It documents risk-management procedures for the management of market, credit, and liquidity risk.

* With regard to certain liabilities or expenses assumed by third parties, the SEC'sJuly 11,2013, letter is formally codified into the Net Capital Rule.

* It modifies the Net Capital Rule to include the conditions under which the SEC may restrict distributions.

A Challenging New Environment

These new developments set the stage for a more challenging environment for broker/dealers and their auditors in the months to come. The changes include a more rigorous auditing standard, new content in auditors' reports, and additional responsibilities for broker/dealers. ?

By Chuck Fong, Rich Fuchs, David Grumer, Mark Levy, Charles Pagano, and Gary Purwin

Chuck Fong, CPA, and Rich Fuchs, CPA, are both senior managers at CohnReznick LLP, New York, N.Y.David Grumer, CPA, is a partner at Citrin Cooperman & Company LLP, New York, N. Y. Mark Levy, CPA, is a director at Eisner Amper LLP, New York, N.Y.Charles Pagano, CPA, is an audit partner at WeiserMazars LLP, New York, N.Y.Gary Purwin, CPA, is the CEO and sole owner ofFINOPLLC, New York, N.Y.