Confirming that auditor independence continues to be a regulatory priority, the Securities and Exchange Commission (SEC or Commission) and the Public Company Accounting Oversight Board (PCAOB) issued orders on December 8, imposing sanctions against 15 accounting firms for violating auditor independence rules in audits performed for approximately 150 broker-dealer clients. In each instance, the regulators complained about the level of the audit firm’s involvement in the preparation of the clients’ financial statements on which the audit firm opined.

The SEC Orders

Every registered broker or dealer is required to file with the SEC annual financial statements that have been audited by an independent accounting firm. The accounting firm is required to be independent in accordance with the provisions of Rules 2-01(b) and (c) of Regulation S-X and in accordance with generally accepted auditing standards (GAAS). Regulation S-X provides that accountants are not independent if at any point during the audit and professional engagement period, the accountant provides prohibited non-audit services to an audit client including, for example, bookkeeping and other services related to the accounting records or financial statements of the audit client. Prohibited bookkeeping services are defined in Rule 2-01(c) to mean:

Any service, unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client’s financial statements, including:

(A) Maintaining or preparing the audit client’s accounting records;

(B) Preparing the audit client’s financial statements that are filed with the Commission or that form the basis of financial statements filed with the Commission; or

(C) Preparing or originating source data underlying the audit client’s financial statements.

The SEC orders each state that Rule 2-01(c)(4)(i) of Regulation S-X “specifically prohibits an audit firm from preparing an audit client’s financial statements that are filed with the Commission.” The SEC orders go on to define “preparing financial statements” to include, but not be limited to: “aggregating line items from internal books and records to the financial statements; changing line item descriptions; drafting or editing notes to the financial statements; and converting FOCUS reports or bookkeeping software program reports into financial statements.” The rationale behind this prohibition is that providing such services for an audit client “impairs the auditor’s independence because the auditor will be placed in the position of auditing the firm’s work when auditing the client’s financial statements. … In addition, keeping the books is a management function, the performance of which leads to an inappropriate mutuality of interests between the auditor and the audit client.”1

The conduct that the SEC deemed to violate auditor independence requirements, with regard to these eight orders, involved in general terms the following: The client provided certain information to the auditor, including a trial balance, financial statements, financial reports filed with the Financial Industry Regulatory Authority (FINRA) (called “FOCUS Reports”), accounting records and ledgers, and source data. The accounting firm performed audit tests and procedures on this information and the underlying financial data, and then based upon that information typed, revised, updated or created the financial statements and notes to the financial statements, using its own computers and firm-issued engagement software. The accounting firm presented the financial statements it had prepared to the client’s management for approval, and thereafter issued an audit report representing that it was independent of the client.

The accounting firms had varying degrees of involvement in the preparation of the financial statements being audited. At one end of the spectrum, an accounting firm “provided [the client] with financial statement footnotes from the prior year’s audit that [the client] updated and [the accounting firm] then reviewed,” and “made some suggestions for the grouping of accounts to be incorporated into the financial statements.” At the other end of the spectrum, an audit team used data derived from the client’s Quickbooks reports to enter a trial balance; uploaded the reports into the accounting firm’s software to produce the financial statements and notes; reviewed and tested those documents; updated the financial statements and notes to be filed with the SEC; and then provided the set of financial statements it had prepared to the client’s management for approval.

Each of the auditing firms was found by the SEC to have engaged in improper professional conduct, violated the auditor independence rules, and caused each of the broker-dealer clients to fail to file an annual report audited by an independent accountant. Each of the firms was censured and ordered to cease and desist from any future violations of Section 17(a) of the Exchange Act and Rule 17a-5 promulgated thereunder. Each firm undertook, as part of the settlement, to establish, revise or supplement its policies regarding auditor independence; to establish a policy ensuring training of its audit personnel on auditor independence and to begin such training; and to provide a copy of the SEC’s Order to its audit personnel who serve broker-dealer clients as well as to any client for which the firm has performed or been engaged to perform an SEC Registered Broker-Dealer Engagement. Six of the eight firms were ordered to pay a civil monetary penalty ranging from $10,000 to $55,000.

The PCAOB Orders

The PCAOB issued settled disciplinary orders related to different accounting firms than the SEC orders, and each involved only one broker-dealer audit client. The conduct found by the PCAOB to violate auditor independence rules followed the same general pattern as described in the SEC orders: From documents obtained from the client, the accounting firm prepared the client’s financial statements to be audited, but departed from the client’s internal documents or filed FOCUS Reports to aggregate and disaggregate line items, add or change line item descriptions, add captions, and reclassify line items.

Some of the PCAOB orders specifically noted engagement letters or audit work papers documenting that the audit firm was undertaking to prepare the financial statements, to draft notes to the financial statements, or to provide significant assistance or revision to the financial statements and notes. In one instance, the PCAOB noted the audit team’s conclusion in its work papers that such activities “constituted only a ‘clerical task’ and a ‘word processing function’ that did ‘not impair our independence.’” In another instance, the audit team drafted a note to the financial statements stating that the broker-dealer had few customers, that the departure of one or more of those customers would materially affect the broker-dealer’s financial statements, and that the broker-dealer’s management considered this risk remote; the audit engagement partner cited the inclusion and quality of that disclosure (drafted by the audit team) as the reason for the accounting firm’s decision not to include a going concern paragraph in its audit opinion.

Each of the firms named in the PCAOB orders was censured; was ordered to pay a civil monetary penalty of $2,500; and was required to undertake certain remedial measures, including establishing policies and procedures directed toward satisfying independence criteria applicable to audits of brokers and dealers.