The many auditors who inspect the financial statements of brokerage firms appear to be cutting corners and not doing all the work they should do, a worrisome sign after the collapse of the Peregrine Financial Group, a leading commodities brokerage firm, where a fraud had gone undetected for many years.
Having completed the first review of such brokerage firm audits, the said on Monday that it had found deficiencies in every audit its inspectors reviewed.
“The auditors,†said Jeanette M. Franzel, a member of the board, “were not properly fulfilling their responsibilities to provide an independent check on brokers' and dealers' financial reporting and compliance with S.E.C. rules.â€
That does not mean that any of the statements misrepresented the financial conditions of the 23 brokerage firms whose audits were reviewed by inspectors from the board. In most cases, the accounting board concluded that the audit firm had failed to do the necessary work to ensure that the financial statements were accurate or that the firms had sufficient capital.
“In 13 of the 23 audits,†the board reported, auditors “did not perform sufficient procedures to identify, assess and respond to the risks of material misstatement of the financial statements due to fraud.â€
Lynn Turner, a former chief accountant of the Securities and Exchange Commission, called the report “mind-boggling†and said it indicated that audit firms had failed to respond to the disclosure of Bernard Madoff's . It was that fraud that led Congress to authorize the oversight board to review audits of brokerage firms.
The Peregrine fraud was uncovered after the National Futures Association, a self-regulator, stopped relying on paper copies of bank records in its own inspections. Peregrine had forged such records for years. Its independent auditor, a one-person firm, did not discover the fraud even though bank accounts are supposed to be confirmed.
A significant question for auditors of brokerage firms to evaluate is whether the brokers are subject to consumer protection rules specifying what can be done with customer money, and, if so, whether they are in compliance with the rules. Generally, brokers who do not handle customer cash are not covered by the rule, and auditors of those smaller firms have been pushing to be exempted from inspections by the accounting oversight board when final rules are established.
Of the 23 firms, 14 claimed to be exempt from the rule, but the board said none of the auditors of those 14 smaller firms had gone to the trouble of establishing whether that was actually the case. It added that auditors for two of the nine bigger brokerage firms had failed to verify that the firms maintained special reserve bank accounts that “were designated for the exclusive benefit of customers and that the account agreements contained the required restrictive provisions.â€
The accounting oversight board, which was established by the Sarbanes-Oxley Act a decade ago, initially was authorized only to review audits of companies that issue securities in the public market. Audit firms that audited only broker dealers were not subject to inspection by the board.
That was changed in 2010 by the Dodd-Frank law, as lawmakers reacted to the Madoff scandal, which was carried out through his brokerage firm. The Madoff enterprise was audited by a tiny firm that was not subject to board inspection. The audit firm's principal, David G. Friehling, has since pleaded guilty to nine criminal charges, admitting he did not perform adequate audits.
The new report covers work conducted by 10 audit firms, seven of which were previously exempt from board review because they did not review the financial statements of any public companies.
The board said that about 800 accounting firms perform audits of brokerage firms, and that about 500 of those were previously exempt from board inspection. Most of them could continue to escape board oversight if the board decides against reviewing audits of smaller brokerage firms, as many auditors have urged.
One issue with such audits that emerged in the board report was compliance with independence rules. Auditors of nonpublic companies often essentially prepare the books that they then audit, and that is allowed under the rules of the American Institute of Certified Public Accountants. S.E.C. rules prohibit such practices at public companies or at brokerage firms.
But the board said that auditors of two of the brokerage firms had violated those independence rules by helping in the preparation of the reports that they then audited. “This is of particular concern to the board,†said Jay D. Hanson, a board member, “because we think it is due to a lack of understanding†of the rules. He said that many auditors of small broker dealers had told the board they believed that they were exempt from the S.E.C. independence rules.
Those rules have been around for many years, but there was never before any way to police whether or not they were being obeyed, and it now appears that in many cases they were not.
Other findings of the report included:
¶ Auditors failed to adequately test whether seven of the 23 firms had sufficient capital.
¶ At 10 firms, auditors did not do enough work to identify and assess transactions with related parties.
¶ At 15 firms, auditors “did not perform sufficient procedures to test the occurrence, accuracy and completeness of revenue.
¶ In six of nine audits where auditors needed to review the values of securities, the auditors failed to do enough work to assure that the valuations were reasonable.
¶ Auditors of seven firms “did not perform sufficient audit procedures to test the accuracy and completeness of certain financial statement disclosures.â€
Ms. Franzel said that by the end of next year the board expected to have inspected about 100 audit firms and looked at the audits of 170 brokerage firms. She said information gained from such inspections would be used in considering how a permanent inspection program should be conducted.
