Recent PCAOB Developments in the Broker Dealer World

By Charles Pagano

Another Annual Inspection Report

It’s late summer, which means the PCAOB Annual Report on the Interim Inspection Program Related to Audits of Brokers and Dealers (“Sixth”) results are in.  The Sixth brought more information for consideration, but no clarity on the PCAOB’s direction in proposing the final inspection program.  A permanent inspection program was expected as last year’s annual report noted that the PCAOB would in late 2016; issue a proposal for the final inspection program.  The process could be lengthy as SEC approval is also required.

The Sixth was issued on August 18, 2017 and brought many of the same comments, and high deficiency rates of the preceding five inspection reports.

The PCAOB provides auditors substantial feedback on their performance through their Annual Interim Inspection Reports (2012-2017), Staff Inspection Briefs, various industry forums, staff guidance and other communications.   Areas of improvement continue to be outlined.  This feedback enables auditors to improve and design audits to meet auditing requirements under PCAOB standards (in effect since June 2014).  The consequences, to the broker-dealer can be dire and costly if an audit is not performed in accordance with PCAOB standards.  The PCAOB has in various forums, webinars, publications and  meetings with the Stock Brokerage Committee of the New York State Society of Certified Public Accountants  stated that deficient audits can and have caused a re-performance, a recall of reports and potentially referrals to regulators, namely the SEC and FINRA.  The Sixth notes where various censures and referrals have occurred.

Annual Inspection Report Selection

For the year ended June 30, 2016, the population consisted of 531 audit firms who audited 3,933 broker dealers, (down from 2012 when approximately 800 firms audited approximately 4,400 broker-dealers).

The sample size for the Sixth inspection was 75 firms and 115 audits, which was identical to the prior year’s selection.

The PCAOB selected 11 firms to review randomly and another 64 based on firm characteristics defined in the report, including:

  • the number of broker dealer audits performed
  • whether the firm audits issuers
  • previous history of inspections
  • history of the firm or firm personnel in auditing broker-dealers
  • existence of disciplinary actions against the firm or engagement partner

It is interesting to note that the PCAOB’s selection process has resulted in 334 inspections of 264 firms, and 514 audits, (some of which have been inspected multiple times).  Approximately 50% of auditors who audit broker dealers have been inspected since the program started.  However, approximately a third of those accounting firms that audit only one broker dealer has been inspected (approximately 150).

The Findings

83% of the inspections noted a deficiency, up from 77% from the prior year’s inspection. Additionally the percentage of those audits that were inspected, which had independence issues was 10%, up from 7% from the previous year.

The engagements inspected had the following rates of deficiency

  • Independence (10%)
  • Revenue (66 %)
  • Risks of material misstatements due to fraud (57%),
  • Engagement quality review (57%)

Other deficiencies included net capital, fair value measurement, exemption and compliance reports, and related parties.


The PCAOB and SEC continue to bring independence sanctions against auditors of broker dealers.  SEC Rule 17a-5 requires that an auditor must be independent in accordance with Rule 2-01 of SEC Regulation S-X.  Currently, certain carve outs exist under PCAOB standards for non-issuer broker-dealers. The carve outs include partner rotation and the ability to perform tax compliance services for those in financial reporting roles.

Considerations where a mutual or conflicting interest may exist, or where  the accountant is placed in the position of auditing his own work, or acts in a management capacity, or an accountant advocates for the client  are all prohibited pursuant to SEC Rule 2-01.

The Sixth inspection revealed, as in prior inspections, instances where the auditor prepared or assisted in the preparation of the financial statements. This shows an apparent disregard for, or lack of awareness of, this prohibition under the independence rules. While editorial suggestions and educational materials can be supplied to the client, it is important to realize that the auditor is not the decision maker in the financial reporting process.  Additionally, in one instance an engagement letter included an indemnification clause, which is also prohibited.


The PCAOB states that one continuing issue has been that when testing revenue the extent of testing was not sufficient (43 instances).  Examples include the auditor did not:

  • Test the material classes of revenue
  • Sufficiently test controls when the auditor placed reliance on their controls to reduce substantive testing
  • Appropriately design and perform sampling procedures to test revenue transactions.

These comments should cause the auditor to ask whether adequate testing of income streams have been considered, as aggregated income line items may have different characteristics.    Are controls designed to enable the auditor to reduce substantive testing? When using sampling the auditor needs to ensure that all items in the population have a chance of being selected, and that specific time periods or amounts do not limit sampling.

The PCAOB also found 25 instances where the auditor did not properly evaluate the service auditor’s report (“SOC-1” report).  When an auditor relies on controls at the clearing organization with the purpose of limiting substantive testing, the auditor needs to consider several procedures. First, the auditor must consider testing the operating effectiveness of the user controls as noted in the SOC- I report.  If a sub service provider is mentioned in that report, the auditor must also consider that sub service provider’s user controls.  The PCAOB also noted that where the period included in the service organization report does not coincide with the audit period, the auditor would have to perform substantive work for that uncovered period.  The effect of the above could conceivably make the auditor come to the conclusion that substantive procedures and, therefore, increased testing, is the practical approach, and not rely on a service provider’s SOC-1 reports.

Additionally, The PCAOB staff noted numerous instances where the auditor did not sufficiently test the accuracy and completeness of information produced by the broker dealer, noting lack of adequate considerations on reports, trade blotters, tickets, schedules and spreadsheets.  This information needs to be tested in order to satisfy assertions of accuracy and completeness.

Another important note is that auditors need to perform sufficient procedures whenever contractual arrangements exist such as in underwriting agreements, clearing agreements, commission pay outs, and expense sharing agreements.

Fair Value Measurement

The deficiencies in this area included:

  • The auditor failed to understand the broker dealer’s process for fair value measurement, including the description of the methodology. The auditor needs to consider the inputs used in the valuation.
  • The testing of fair value was not adequate. In some instances the auditor tested fair value by using the clearing broker’s confirmation, and did not consider any additional procedures.
  • The testing of management’s process was not sufficient.
  • The pricing used by the auditor was not independent from the external pricing service used by management.
  • The recorded amounts were simply an amount noted by the clearing broker and accepted by the auditor without further audit work performed.

Risks of Material Misstatements

The PCAOB notes “when identifying and assessing the risks of material misstatement due to fraud, the auditor should presume that there is a fraud risk.” The presumption is that revenue recognition is always a fraud risk.  If this is not the case the auditor needs to document the reasons supporting the conclusion that revenue recognition is not a fraud risk.  Additionally, the auditor needs to identify fraud risk and address management override of controls. Journal entry testing should be designed to identify controls in place and needs to include not only a sample during the year, but at the end of the reporting period.

The auditor must also perform inquiries of management and document such procedures.

Engagement Quality Review (“EQR”)

The PCAOB noted in their Sixth report that in 57% of inspections, a deficiency existed in the area of EQR review.

The engagement quality review process is, in many cases, the last control an accounting firm utilizes to ensure a quality audit.  For eight of the engagements selected, an EQR was not performed, which is an obvious disregard of the rules.  The PCAOB’s comments in this area also centered on the insufficient review of the engagements.

The EQR review should include:

  • Reviewing the report and work papers that are essential in developing an opinion
  • Evaluating the audit response to identified risks
  • Reviewing for compliance for independence
  • Reviewing the engagement completion document.

The pertinent areas of the EQR are seemingly accomplished with the diligent completion of an EQR checklist, and substantiating that those steps were indeed performed.  It is essential that the person performing the EQR has the expertise and knowledge to perform his/her responsibilities in accordance with the standards, and that the individual be of partner status or a person in an equivalent position.  The EQR is put in the position of challenging the engagement team  and must not only have the requisite experience,  but be able to withstand  pressure from the engagement team.

The Audit Landscape

Auditor selection should be a serious exercise for the broker dealer. Judging from the statistics released in the Sixth, which reaffirmed inspections one to five, many audit firms may be viewing the risk of auditing a broker dealer to be too high, as standards require a broker dealer to be audited similarly to an issuer.

The expertise required could also be diminishing the market.  There are a large number of auditors who audit only one broker dealer, and many that audit less than twenty.  The expertise may be very difficult to obtain, if a firm is not auditing a significant number of broker dealers.  The PCAOB also noted the correlation between those firms that audit more broker dealers, and issuers who have a lesser deficiency rate in the audits inspected.  Further contraction of the auditor market may result.

The Future

The PCAOB staff is expected to recommend to the Board a permanent inspection plan presumably in late 2017 or early 2018; although it is important to note that this was expected at the end of 2016.  The Board will review the Plan and potentially put it out for comment to the industry.   After the comment period, the Board may pass the proposal along to the SEC or re-propose.  The SEC would then review and also put it out for comment to the industry.  The process could take a bit of time. It’s important for auditors, and broker dealers to give input to the Board’s and SEC’s proposals as the permanent inspection program could have a sizable effect on the industry in terms of cost, frequency of inspection, potential carve outs, and ultimately audit quality.

The PCAOB has scheduled two Forums for Auditors of Broker-Dealers in the next three months, one in Las Vegas on October 20, and another on December 7, in Jersey City. The forums bring additional insight on the PCAOB’s thought process, and enable attendees to address their concerns.


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Disclaimer of Liability

The information provided here is for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.

Mazars USA LLP is an independent member firm of Mazars Group.

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