A review of auditors that examine broker-dealers has unearthed an array of deficiencies in the process the firms use to evaluate their clients, including numerous of infractions that could amount to violations of SEC or FINRA rules.
Officials with the Public Company Accounting Oversight Board (PCAOB) stressed that the findings released on Monday only constitute an interim report that drew on an admittedly small sample size. For this preliminary review, the board examined 10 audit firms and reviewed 23 individual audits. All of the audits involved broker-dealer firms with net capital of less than $1 million.
Nevertheless, the review raised alarms at the board, where officials are urging broker-dealers to take a closer look at the practices of their auditing firms.
"While the auditors and audits selected are not representative of all broker and dealer audits and their auditors, the results are of concern to the board," PCAOB member Jeanette Franzel told reporters on a conference call. "The results indicate that in the audits that we inspected, the auditors were not properly fulfilling their responsibilities to provide an independent check on brokers' and dealers' financial reporting and compliance with SEC rules."
By the end of the year, the board intends to complete inspections of about 40 firms and 60 audits, and extend the interim process through 2013, with plans ultimately to complete evaluations of roughly 100 auditors and 170 audits. At that point, the PCAOB will evaluate the findings of the interim reviews as it finalizes its permanent inspection program, a process that will include a public notice and comment period.
The board began its review of broker-dealer auditors in August 2011, drawing on new authorities it was granted by the Dodd-Frank financial reform bill.
Of the 23 audits that the board reviewed, 21 failed to provide reasonable assurance that all material inadequacies in the firm's accounting system and its mechanisms for safeguarding securities would be disclosed in the supplemental report issued to the SEC, as mandated by federal law.
Additionally, seven of the inspections revealed that the auditor had not conducted a sufficiently thorough review of the broker-dealer's calculation of the minimum net capital required to satisfy SEC standards.
"Broker-dealers have a real interest of course in following the SEC rules, and the auditor is the independent check on that," Franzel said.
PCAOB inspectors also cited auditors for failing to meet the independence rules stipulated by the SEC for examinations of broker-dealers, a shortfall that board member Jay Hanson attributed in part to confusion about the requirements in that area.
"The findings tell us that there is a need for improvement in the audit work being performed, and that other auditors of broker-dealers should look closely at our findings and assess their own work. And, while only two audits were noted for independenceproblems, this is of particular concern to the board, because we think it is due to a lack of understanding and information about the rules," Hanson told reporters.
"Broker-dealer auditors are required to comply with the independence rules of the SEC, however many have told us they thought they only needed to comply with the [American Institute of CPAs] rules, which are not as strict," he added.
Other shortfalls in the audits the board reviewed included a failure to comply with auditing standards relating to the risk of fraud and the evaluation of related party transactions, revenue recognition and fair-value measurements. Some auditors also failed to sufficiently evaluate control deficiencies and ensure that disclosures were accurate and complete.
The PCAOB is not disclosing the names of the auditors it reviewed or the broker-dealers involved in the individual audits, but the group said that it has discussed its findings with the subjects of its review, and encourages other industry members to review its interim report.
Hanson said that any deficiencies that were deemed serious were communicated to the auditor in writing, and that a failure to take corrective action could result in disciplinary action by the board.
Additionally, the board intends to notify the SEC, FINRA or other relevant authorities of potential legal violations by broker-dealers.