On December 8, 2014, the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) announced settlements with fifteen audit firms for violating independence rules applicable to auditors of broker-dealers. The PCAOB sanctioned seven firms for violating independence rules when those firms prepared the financial statements of brokerage firms that were also their audit clients. The SEC sanctioned eight auditors for similar independence violations and for causing those clients to violate SEC rules by submitting financial statements that did not comply with Generally Accepted Accounting Standards.
The Independence Requirement
Violating independence rules means, in short, that the auditors were auditing their own work. Section 17(e)(1)(A) of the Exchange Act (passed as part of the Sarbanes-Oxley Act) requires every registered broker or dealer to file an annual financial statement report with the Commission that must be audited by an independent public accounting firm registered with the PCAOB.
Those broker-dealer audits must be performed by a public accountant that is independent from the audit client, under Exchange Act Rule 17a-5. Rule 2-01(b) and (c) of Regulation S-X specify various independence requirements. Among the most important of the applicable independence requirements is that the auditor is prohibited from preparing an audit client’s financial statements that are filed with the Commission. In this context, “preparing” includes actions such as aggregating, revising, classifying, or supplementing financial information obtained from the audit client. Note that most, but not all, independence rules apply to audits of broker dealers; for example, partner rotation requirements do not apply.
The SEC and PCAOB Settlements
The fifteen cases covered a three-year period, and involved audit firms that lacked independence in audits of as many as seventy firms. In each of the fifteen settled cases, the broker-dealer provided the audit firm with the basic financial materials such as the trial balance worksheet, a FOCUS Report that contained a Statement of Financial Condition, a Statement of Income, and a Statement of Changes in Ownership Equity, among other accounting documents. The auditors then took steps that modified, expanded, or otherwise changed the data received from the client to complete management’s financial statements. Those financial statements were among the materials reviewed as part of the independent audits. The settlement orders did not find that the auditors violated independence rules in each year audited, but in many of the cases the violations affected a number of audits during the client relationship.
Each settlement included a censure against the firm and a cease-and-desist order, and required various undertakings aimed at improving independence on broker-dealer audits. The SEC settlements included penalties that varied from no penalty for two of the auditors (who were found to have violated independence rules in only one audit each) to $55,000. The eight settlements consented to by the firms without admitting or denying the findings, collectively total $140,000 in penalties. In each of its seven settlements, the PCAOB imposed a fine of $2,500.
Broker-dealers should make sure that their auditors do not become involved in the preparation of management’s financial statements in the course of conducting the audit. Discussions with the auditor regarding its audit procedures should focus on what bookkeeping services are prohibited by the independence rules. Furthermore, broker-dealer employees should be educated on what services the auditor can and cannot provide under the independence rules in order to avoid requests to the audit firm that could compromise the auditor’s independence and may result in a violation of SEC rules by the broker-dealer in connection with filing its financial statements with the Commission. The concern is not limited to the immediate audit; if an auditor is violating independence rules with respect to another of its broker-dealer clients, it can compromise its reputation or its ability to complete necessary audits, which can adversely impact all of the firm’s broker-dealer clients.