1666 K Street, N.W. Washington, DC 20006 Telephone: (202) 207

- 9100

Facsimile: (202) 862

- 8430 www.pcaobus.org

THIRD REPORT ON THE PROGRESS

OF THE INTERIM INSPECTION PROGRAM

RELATED TO AUDITS OF BROKERS AND DEALERS

PCAOB Release No. 2014

- 003 August 18 , 2014Executive Summary

The Public Company Accounting Oversight Board (the " PCAO B" or the " Board " ) is issuing this third report on the progress of its interim inspection program for auditors of brokers and dealers registered with the Securities and Exchange Commission ( " SEC "

or the " Commission " ). This report describes observations noted during inspections performed during 2013; summarizes the observations from inspections performed under the interim inspection program since inception through December 31, 2013; and

d escribes actions needed by registered public accounting firms and next steps of the interim inspection program. The Board issued its first progress report on August 20,

2012 (the " First Progress Report ") and its second report on August 19, 2013 (the

" Second Progress Report ")

.

The observations discussed in this report are not necessarily indicative of the population of firms or of audits of brokers and dealers because the selection of firms

and of audits of brokers and dealers for inspection is not necessarily representative of these populations.

Inspections of Registered Public Accounting Firms During 2013

This report describes audit deficiencies and independence findings, collectively

referred to as " observations ," noted in the Board ' s inspections during 2013 of 60 firms

, covering portions of 90 audits . At the time of the inspections, 25 of the 60 firms were subject to regular inspection as they also audited issuers, generally referred to as public companies. Inspections staff identified observations in 5 6 of the 60 firms whose audits were selected for inspection. The f our firms with no observations in the portions of audits inspected were firms that also audited issuers. One of these firms audited more

than 100 brokers and dealers.

Failure to Satisfy Independence Requirements

In 21 of the 90 audits selected for inspectio n, it appeared to Inspections staff

, that contrary to the requirements of SEC independence rules, auditors were involved in the preparation of the financial statements they audited

. This conduct was observed in 19, or approximately 48 percent, of the 40 au dits selected for inspection that were performed by firms that did no t also audit issuers

. Further

, independence findings were

observed in two, or four percent, of the 50 audits selected for inspection that were performed by firms that also audit ed issuers

. Apparent independence violations have been, and will continue to be, reported to the SEC as such violations may haveExecutive Summary Third Report on the Progress of the

Interim Inspection Program

Related to Audits of Brokers and Dealers August 18, 2014 Page ii

implications to the broker ' s or dealer ' s compliance with the requirements of Securities Exchange Act of 1934 ( " Exchange Act " ) Rule 17a

- 5 ( " Rule 17a

- 5 " )

.

Audit Deficiencies

Inspections staff identified audit deficiencies in portions of 7 0 of the 90 audits selected for inspection , which represent s approximately 7 8 percent of these audits. The

20 audits where Inspections staff did not identi fy any audit deficiencies in the portions of

audits inspected were performed by 1 3 firms, of which 11 also audited issuers.

The most frequ e nt a udit d eficiencies were noted in the following areas: the report on material inadequacies, the net capital rule

, the r isk of m aterial m issta t ement d ue to

f raud

, revenue recognition , and reliance on records and reports.

Summary of Inspections Since Inception of the Interim Inspection Program

Since the inception of the interim inspection program through the end of 2013

, the Board has inspected 10 1 firms, covering portions of 17 3 audits. Nine firms have been inspected more than once

. At the time of the inspections, 3 5 of the 101 firms were subject to regular inspection as they also audited issuers

. These firms perfor med 95 of the 173 audits selected for inspection.

Observations were identified in portions of 151 , or approximately 87 percent, of the 173 audits selected for inspection. The 22 audits where Inspections staff did not identify observations in the portion s of audits inspected were performed by 12 firms, of

which 11 also audited issuers.

Inspections staff identified observations in a high percentage of the audits and areas inspected

. Observation s were identified across various stratifications of firm

char acteristics , such as whether or not the firm audited issuers and the number of

broker or dealer audit s performed by the firm. Firms that did not also audit issuers were noted to have a higher percentage of observations than the firms that also audited

issu ers. Firms that audited 100 or fewer brokers and dealers had a higher percentage of

observations than firms that audited more than 100 brokers and dealers.

Observations were identified in portions of selected audits across the spectrum of

brokers and deal ers in terms of their characteristics , such as reported actual net capital

, revenue s

, and assets. Except for lower percentages noted for the selected audits of

brokers and dealers with the largest amounts of reported actual net capital, revenue s

, or

assets , t he re did not appear to be a discern i ble relationship between the percentage of

observations and these broker and dealer characteristics

. In addition

, the percentage of

observations for audits of brokers or dealers that did not claim an exemption underExecutive Summary Third Report on the Progress of the

Interim Inspection Program

Related to Audits of Brokers and Dealers August 18, 2014 Page iii

E xchange Act Rule 15c3

- 3 ( " Rule 15c3

- 3 " or the " Customer Protection Rule " ) was lower

than for audits of brokers or dealers that claimed an exemption under Rule 15c3

- 3

.

The percentage of observations in the audits and areas inspected in 2013 was

lower than that from the inspections performed during the interim inspection program through the end of 2012

. For the nine firms that were inspected more than once during the interim inspection program, Inspections staff noted a lower percentage of

observations when comparing inspections performed during 2013 to inspections performed through 2012. Nevertheless, the percentage of observations remain ed high.

Actions Needed by Firms and Next Steps of the Interim Inspection Program

The Board is concerned by the nature and number of these audit deficiencies and independence findings. M any of the observations in this report and the two previous
progress reports are similar in nature and relate to fundamental auditing principles. The Board emphasizes the need for firms t o improve the quality of their broker and dealer audits to achieve compliance with applicable standards and rules.

The Board reminds firms that information obtained through the interim inspection program may lead the Board to commence an investigation or d isciplinary proceeding concerning the conduct of a firm or associated persons of such firms. In addition, w hen

it comes to the Board ' s attention that the financial statements appear not to be fairly

stated , in all material respects, in conformity with gene rally accepted accounting principles ( " GAAP " ), or there are possible violations of laws, rules, or regulations, the

Board ' s practice is to report that information to the SEC and designated examining

authorities

.

Actions Needed by Firms

In light of the o bservations that continue to be identified by Inspections staff

, combined with the need to adapt to amended SEC rules and to follow PCAOB standards, t he Board urges registered public accounting firms that audit brokers and

dealers to re

- examine their audit approaches

.

All r egistered public accounting firms that audit brokers and dealers, and other interested parties, should read this report in its entirety and consider whether the audit deficiencies and independence findings described in this report migh t be present in audits they currently perform, and take appropriate action to prevent or correct any such

audit deficiencies and independence findings

.

The Board also encourages registered public accounting firms that audit brokers

and dealers to review the Staff Guidance for Auditors of SEC

- Registered Brokers andExecutive Summary Third Report on the Progress of the

Interim Inspection Program

Related to Audits of Brokers and Dealers August 18, 2014 Page iv

Dealers issued on June 26 , 2014, and to attend the Board ' s periodic Forums on Auditing Smaller Broker

- Dealer s.

Next Steps of the Interim Inspection Program

The Board will continue to conduct inspections of registered public accounting

firms that audit brokers and dealers under the interim inspection program until rules for a permanent inspection program take ef fect. During 2014, the Board plans to select approximately 60 firms and inspect portions of approximately 100 audits

. The firms the

Board selects will primarily include firms not previously inspected

, but will also include

some firms previously inspected u nder the interim inspection program. In addition, the

Board may inspect audit s of broker s or dealer s whose past audit s were previously inspected. In that context, t he Board may evaluate whether, or how, firms addressed audit deficiencies or independence fi ndings identified in previous inspection s

.

The Board is continuing to take a careful and informed approach in establishing a permanent inspection program

. The Board continues to obtain available information to

evaluate the risk of loss to customers

. The PCAOB staff is currently working to develop a rule proposal for the Board to issue during 2016 to establish a permanent inspection program and its scope, which will address whether to exempt any category of registered public accounting firm

.

The Board wi ll continue its efforts to protect the interests of investors and further the public interest in informative, accurate, and independent audit reports for brokers

and dealers. Such efforts will continue to include issuing future progress reports that will

d escribe significant observations from inspections, issuing guidance for audits of

brokers and dealers

, conducting forums

, and participating in various other outreach

initiatives. In addition, the Board will use information obtained from the interim inspect ion program and other research and outreach efforts to inform its future

standards

- setting activities relevant to the audits of brokers and dealers.

* * * *1666 K Street, N.W. Washington, DC 20006 Telephone: (202) 207

- 9100

Facsimile: (202) 862

- 8430 www.pcaobus.o rg

____________________________________ _ ) ) )

THIRD REPORT ON THE PROGRESS ) PCAOB Release No. 201 4- 003

OF THE INTERIM INSPECTION PROGRAM )

RELATED TO AUDITS OF ) August 18 , 2014

BROKERS AND DEALERS ) ) )

____________ _

________________________ )

Background

The PCAOB is issuing this third report on the progress of its interim inspection

program 1 for auditors of brokers and dealers registered with the SE C. 2

Under the interim inspection program the Board conduct s inspections of registered public accounting firms in connection with their performance of audits, issuance of audit reports, and related matters involving brokers and dealers registered

with the Commission 3 to assess compliance with the professional standards, rules of the Commission and the Board, and the Sarbanes

- Oxley Act of 2002 (the " Act " ).

The interim inspection program also helps to inform the Board ' s eventual determinations about the scope and elements of a permanent inspection program, including whether and how to differentiate among classes of brokers and dealers, whether to exempt any categories of registered public accounting firms, and the establishment of minimum inspection frequency schedules.

1 On June 14, 2011, the Board adopted Rule 4020T to establish an interim inspection program related to the audits of brokers and dealers. See PCAOB Release

No. 2011

- 001 (June 14, 2011). The SEC approved this rule on August 18, 2011. See Exchange Act Release No. 65163 (August 18, 2011).

2 The Board issued its F irst Progress Report on August 20, 2012 and its

S econd Progress Report on August 19, 2013, both of which are available on the

PCAOB website at: http://pcaobus.org/Inspections/Pages/PublicReports.aspx

.

3 Under Section 15 of the Exchange Act, most brokers and dealers must register with the SEC and join a self

- regulatory organization, such as the Financial Industry Regulatory Authority (" FINRA ") . Hereinafter, the use of the terms " broker(s) and dealer(s) " or " broker (s) or dealer(s) " refers to brokers and dealers registered with

the SEC.PCAOB Release No. 2014

- 003 August 18, 2014 Page 2

RELEASE

The Board ' s inspections of auditors under the interim inspection program assess

the auditor ' s compliance with the requ irements that govern the conduct of the audit. All

of the audits selected for inspection discussed in this report relate to fiscal years that

ended on or before June 30 , 2013. Those audits were conducted before certain changes to applicable SEC rules took effect, including changes that now require audits of brokers and dealers to be performed in accordance with PCAOB standards. 4 See the Appendix for references to certain releases issued by the SEC or PCAOB related to

standards and rules for brokers and deal ers and their auditors.

The audits selected for inspection were evaluated against the standards and

rules applicable at the time of the audit, and this report ' s discussion of those audits

refers to those standards and rules

. For all audits selected for in spection discussed in this report, Rule 17a

- 5 generally required brokers and dealers to file with the SEC and other regulators, among other things, (1) annual financial statements, (2) supporting

schedules relat ed to the computation of net capital and the customer reserve, and (3)

an accountant ' s supplemental report on material inadequacies. Refer to the Appendix of

the Second Progress Report for an overview of net capital, customer protection, and annual reporting requirements for SEC

- r egistered brokers an d dealers.

This report contains three parts: Part I describes the inspections of registered public accounting firms, audits selected and observations id entified by Inspections staff

for inspections performed during 2013 ; Part II provides a summary of ins pections performed under the interim inspection program since its inception through December
31, 2013 ; and Part I II describes actions needed by registered public accounting firms

and next steps of the interim inspection program of the PCAOB.

4 On July 30, 2013, the SEC adopted amendments to its net capital, customer protection, books and records, and notification rules for brokers and dealers under the Exchange Act, s e e Exchange Act Release No. 70072 (July 30, 2013), and adopted amendments to Exchange Act Rule 17a

- 5, Reports to be Made by Certain

Brokers and Dealers ( see Exchange Act Rule 17 C.F.R. § 240.17a

- 5), and Exchange

Act Rule 17a

- 11, Notification Provisions for Brokers and Dealers ( " Rule 17a

- 11 ," 17

C

. F

. R . § 240.17a

- 11)

, see Exchange Act Release No. 70073 (July 30, 2013). Among other things, the amendments to Rule 17a

- 5 require that audits of brokers and dealers be performed in accordance with PCAOB standards, ef fective beginning with audits for fiscal years ended on or after June 1, 2014. With respect to audits for earlier fiscal years, such as those discussed in this report, Rule 17a

- 5, required that the audits be performed in accordance with generally accepted auditing standards ("GAAS"), which are promulgated by the American Institute of Certified Public Accountants ("AICPA").PCAOB Release No. 2014

- 003 August 18, 2014 Page 3

RELEASE

P art I: Inspections of Registered Public Accounting Firms During 2013

The following section d escribes registered public accounting firms that audit brokers and dealers, the selection of audits inspected during 2013, and independence findings and audit deficienci es identified by Inspections staff.

Firms that Audit Brokers and Dealers

For fiscal periods ended during the period from July 1, 2012 through June 30,

2013 , t here were 790 registered public accounting firms that issued audit reports on the

financial sta tements of brokers and dealers that were filed with the SEC

. Many of the registered public accounting firms audited as few as one broker or dealer, while several

firms audited more than 10 0 brokers and dealers.

Number of Broker or

Dealer Audits per Firm Number of Firms 5 Percentage of Firms

1 367 46%

2 to 20 6 385 49%

21 to 50 24 3%

51 to 100 8 1%

More than 100 6 1%

Total 790 100%

There were 4,302 brokers and dealers that filed audited annual financial statements with the SEC for fiscal years ended during the period from July 1, 2012

throu gh June 30, 2013

. The following table expands on the information above to provide

further information on which firms also audited issuers and the number of their broker

and dealer audits : 7

5 Information about the number of firms that audited brokers and dealers

and their broker or dealer audits is based on financial stateme nts filed with the SEC through May 27 , 201 4 , for fiscal years ended during the period from July 1, 2012 through June 30, 201 3 . These firms were registered with the PCAOB at the time the audit reports were issued.

6 There were 294 firms that audited 2 to 5 brokers and dealers that represented approximately 37 percent of the total firms that audit brokers and dealers.

7 I nformation about the firms that audit issuers is derived from data obtained from the most recently submitted annual reports on Form 2 file d through July 15 , 201 4

. PCAOB Rule 2201 requires each registered public accounting firm to file an annualPCAOB Release No. 2014

- 003 August 18, 2014 Page 4

RELEASE

Also Audited Issuers Did Not Audit Issuers

Number of

Broker or Dealer Audits

Per Firm Number of

Firms Number of

Brokers and

Dealers Number of

Firms Number of

Brokers and

Dealers

1 110 110 257 257

2 to 20 8 157 883 228 897

21 to 50 10 290 14 395

51 to 100 4 270 4 278

More th an 100 6 922

- - Total 287 2,475 503 1,827

Selection of Firms and Audits

During 2013, the Board inspected 60 firms and portions of 90 audits of brokers

and dealers

. The 90 audits selected for inspection had financial statement periods

ended on June 30, 2012 through June 30, 2013. The s election of firms for inspection

took into consideration the number of broker or dealer audits performed by the firm s

, whether they also issued audit reports for issuers and

, thus, were subject to regular inspec tion by the PCAOB, as well as other characteristics, to obtain a cross section of

firms that audit brokers and dealers. This approach for the selection of firms has been

consistent since the inception of the interim inspection program

. The selection of fir ms and audits of brokers and dealers is not necessarily representative of the population of

firms or of audits of brokers and dealers . Further, the population s of firms and brokers

and dealers are not homogenous. Therefore, the observations presented are n ot necessarily indicative of the population of firms or of audits of brokers and dealers.

The following table presents the number of firms inspected by the number of

broker or dealer audits per f irm as determined at the time of inspection :

report on Form 2 by June 30 of each year. The report covers the twelve

- month period ending March 31. Information about the number of firms that audit ed brokers and

dealers and the number of their broker or dealer audits is based on financial statements

filed with the SEC through May 27 , 201 4, for fiscal years ended during the period from July 1, 2012 through June 30, 2013. These firms were registered w ith the PCAOB at the time the audit reports were issued

.

8 There were 309 brokers and dealers audited by 99 firms , which also

audited issuers and audit ed 2 to 5 brokers and dealers. There were 562 brokers and dealers audited by 195 firms , which did not audit issuers a nd audit ed 2 to 5 brokers and

dealers.PCAOB Release No. 2014

- 003 August 18, 2014 Page 5

RELEASE

Number of Br oker or Dealer Audits per Firm Number of Firms Inspected Number of Audits

Selected

1 11 11

2 to 20 31 34

2 1 to 50 10 21

51 to 100 3 6

More than 100 5 18

Total 60 90

At the time of the inspections, 25 of the 60 firms were subject to regular inspect ion as they also audited issuers. 9 The remaining 35 firms did not audit issuers and were not subject to inspection other than under the interim inspection program.

Registered Public Accounting Firms Number of Firms Inspected Number of Audits

Selected

Al so a udit ed issuers 25 50

D id not audit issuers 35 40

Total 60 90

The selection of audits of brokers and dealers considered various characteristics

of brokers and dealers , such as the broker ' s or dealer ' s minimum net capital requirement and reported ac tual net capital under Exchange Act Rule 15c3

- 1 ( " Rule

15c3

- 1 " or the " Net Capital Rule " ) 10 and whether or not the broker or dealer maintained a Special Reserve Bank Account 11 under Rule 15c3

- 3. The Board did not exclude any registered public accounting firm s or any audits of brokers or dealers from being eligible

for selection.

The 90 audits of brokers or dealers selected for inspection included 2 1 brokers and dealers that maintained a Special Reserve Bank Account and 6 9 brokers and

dealers that did not. T he following table presents the minimum net capital requirements and actual net capital reported for these brokers and dealers:

9 Of these, nine firms selected for inspection audited more than 100 issuers

and 16 firms selected for inspection audited 100 or fewer issuers.

10 17 C.F.R. § 240.15c3

- 1.

11 Brokers and dealers who d o not claim an exemption under Rule 15c3

- 3

, 17 C.F.R. § 240.15c3

- 3, are generally required to maintain a bank account for the exclusive benefit of customers. At the time of the audits discussed here, Rule 15c3

- 3 referred to a "Special Reserve Bank Account for the Exclusive Benefit of Customers," referred to in this report as " Special Reserve Bank Account. " Effective March 3, 2014,

Rule 15c3

- 3 refers to the relevant account as the "Customer Reserve Bank Account."PCAOB Release No. 2014

- 003 August 18, 2014 Page 6

RELEASE

As indicated in the Board ' s release related to the adoption of Rule 4020T

, the

decision to inclu de certain auditors in the scope of the interim inspection program should not be construed as a decision on the likely scope of a permanent inspection program or suggest that every auditor of a broker or dealer will be inspected as part of the interim insp ection program. In addition, the criteria that were considered in making selections for the interim inspection program are not necessarily representative of any

decision that the Board will make in its determination of the scope of a permanent inspection p rogram

.

Independence Findings and Audit Deficiencies from Inspections

The inspections focused on portions of 90 audits performed pursuant to Rule

17a

- 5 that related to audit procedures on certain aspects of the financial statements and compliance with the Net Capital Rule and the Customer Protection Rule.

The following tables present a summary of the independence findings and audit deficiencies in the order they are discussed in this report: Number of

Audits

Selected Range of Minimum Net Capital Requirements Range of Actual Net Capital Reported at Fiscal

Year End

Sp ecial Reserve Bank

Account 21 $250,000

- $600,000,000 $390,000

- $6,250,000,000

No Special Reserve

Bank Account 69 $5,000

- $1,230,000 $8,000

- $2,340,000,000

Independence Findings Number of

Audits with

Findings Number of Applicable

Audits Percentage

of Audits

with Findings

Failure to Satisfy Independence Requirements 21 90 23 %PCAOB Release No. 2014

- 003 August 18, 2014 Page 7

RELEASE

The term " a udit deficiencies

, " as used in this report, refer s to failures by firms to perform, or perform sufficiently, certain required audit procedures. Audit deficiencies that exceeded a certain level of significanc e were communicated to the firms in writing. This report summarizes those audit deficiencies that Inspections staff determined were important to convey within this report based on their nature, severity, or frequency. The term "observations," as used in th is report

, refers to audit deficiencies and independence findings, collectively.

Observations described in this report were identified in 56 of the 60 firms whose audits were selected for inspection and in portions of 71 of the 90 audits selected for insp ection. This includes a udit deficiencies identified by Inspections staff in 55 of the 60 firms inspected and in portions of 70 of the 90 audits selected for inspection , as well as

one firm

, which did not audit issuers, where Inspections staff identified an independence violation but did not identify an audit deficiency in the portions of the audit s inspected

.

The 19 audits with no observations in the portions of audits inspected were performed by 12 firms, of which 11 also audited issuers. For 8 of the se 1 2 firms, more

than one audit was selected for inspection and Inspections staff identified observations

in one or more of the other audits.

The f our firms with no observations in the portions of audits inspected were firms

that also audited issuers

. One of these firms audited more than 100 brokers and

dealers. Audit Deficiencies Number of

Audits with

Deficiencies Number of Applicable

Audits Percentage

of Audits

with

Deficiencies

Related to Customer Protection and Net Capital Rules:

Report on Material Inadequacies 3 8 78 49 %

Customer Protection Rule 5 21 24 %
Net Capital Rule 26 73 36 %

Related to the Financial Statement Audit:

Risk s of Material Misstatement

Due to Fraud 3 6 90 4 0 %
Related Party Transactions 15 90 17 %
Revenue Recognition 53 90 59 %
Reliance on Records and Reports 40 90 44 %

Financial Statement Presentation

and Disclosures 27 90 30%

Fair Value Estimates 8 32 25 %

Evaluation of Internal Control

Deficiencies 6 90 7 %

Auditor ' s Report 5 90 6%PCAOB Release No. 2014

- 003 August 18, 2014 Page 8

RELEASE

Failure to Satisfy Independence Requirements

The independence of the registered public accounting firm is required under SEC

rules and plays an important role in fostering high quality audits. SEC rules require auditors of brokers and dealers to comply with SEC independence requirements, 12
which differ from AICPA independence requirements. SEC rules provide, among other things, that an accountant is not independent if the accountant provides bookkeep ing or other services related to the accounting records or financial statements of the audit

client unless it is reasonable to conclude that the results of these services will not be subject to audit procedures performed by the accountant during an audit o f the client ' s financial statements. 13

Inspections staff identified independence findings in 21 of the 90 audits selected for inspection and communicated these to the firms in writing. I ndependence findings

were identified in two of the audits selected fo r inspection performed by firms that

audited brokers and dealers and also issued audit reports for 100 or fewer issuers. In contrast, independence findings were identified in 19 of the audits selected for inspection that were performed by 18 firms that aud ited brokers and dealers but did not

audit issuers.

Inspections staff observed 21 audits, by 20 firms, where the firms performed bookkeeping or other services related to the accounting records or financial statements

of the brokers or dealers. All of th ese firms prepared, or assisted in the preparation of, the financial statements or supporting schedules required by Rule 17a

- 5. In addition, some of these firms also prepared journal entries or source data underlying the financial

statements of the broker s or dealer s , each of which is prohibited under the SEC independence rule s

.

Audit Deficiencies Related to Customer Protection and Net Capital Rules

Accountant ' s Supplemental Report on Material Inadequacies

At the time of the audits discussed here, Rule 1 7a

- 5(g)(1) require d the scope of the audit and review of the accounting system, the internal accounting controls, procedures for safeguarding securities, and the practices and procedures in making the periodic computations of aggregate indebtedness, net ca pital, and the customer reserve to be sufficient to provide reasonable assurance that any material inadequacies existing

12 Rule 17a

- 5 provides that the auditor must b e independent in accordance

with Rule 2

- 01 of SEC Regulation S

- X . At the time of the audits discussed here, that requirement had been articulated since 1972 in Rule 17a

- 5(f)(3). It is now articu lated in

Rule 17a

- 5(f)(1).

13 See Rule 2

- 01(c)(4)(i ) of Regulation S

- X , 17 C.F.R. § 210.2

- 01(c)(4)(i).PCAOB Release No. 2014

- 003 August 18, 2014 Page 9

RELEASE

at the date of the examination are disclosed in the accountant ' s supplemental report on material inadequacies

. 14

Inspections staff ide ntified deficiencies in 38 of the 78 audits selected for inspection where one or more o f the requirements of the accountant ' s supplemental report on material inadequacies was inspected

. In 4 o f the 78 audits, Inspections staff

identified deficiencies in bo th categories set forth in the table below :

At the time of the audits discussed here, w hen a broker or dealer claim ed an exemption under the Customer Protection Rule, auditors we re required under Rule 17a

5(g)(2) to ascertain whether the conditions of the exemption were complied with as of the examination date, and whether facts came to the auditor ' s attention to indicate that

the broker or dealer was not in compliance with the exemption during the period since

the last examination. In 31 of the 6 9 audits of brokers and dealers that claimed an exemption from the requirement to maintain a Special Reserve Bank Account, Inspections staff found that firm s failed to comply with this requirement . In several instances, Inspections staff found that firms failed to perform any procedures to

ascertain that the broker or dealer complied with the con ditions of the exemption. In

14 Effective for fiscal years ending on or after June 1, 2014, Rule 17a

- 5(g) requires an examination by an auditor of the financial statements and supp orting schedules of the broker or dealer and, depending on the report filed by the broker or dealer, an examination of the compliance report or a review of the exemption report.

15 This area was inspected for the 69 audits of brokers and dealers that

cla imed an exemption from the requirement to maintain a Special Reserve Bank

Account.

16 One or more requirements of this area were inspected for 20 audits of brokers and dealers based on certain characteristics, including whether the broker or

dealer was r equired to maintain a Special Reserve Bank Account or whether errors or

deficiencies were identified that could have been considered indicators of a material inadequacy. Of the 20 audits, 11 brokers or dealers claimed an exemption under Rule

15c3

- 3 and 9 d id not. Deficiencies Related to: Number of

Audits Number of

Audits Inspected
Exemption claimed under Rule

15c3

- 3 31 69 15

Other procedures to test the

accountant ' s supplemental report
on material inadequacies 1 1 20 16PCAOB Release No. 2014

- 003 August 18, 2014 Page 10

RELEASE

other instances

, the firms limited their procedures to inquiry alone and did not perform sufficient other inquiries or other procedures related to the exemption claimed by the

brok er or dealer under the Customer Protection Rule.

In addition to the deficiencies noted above, Inspections s taff observed that in 1 1

audits

, firms failed to perform sufficient audit procedures with respect to the

accountant ' s supplemental report on mate rial inadequacies. In five audits

, firms did not perform sufficient procedures to obtain reasonable assurance that any material inadequacies existing at the date of the examination would be disclosed. Inspections

staff noted some of these firms did not suf ficiently test controls related to the broker ' s or dealer ' s practices and procedures in making the periodic computations of aggregate indebtedness, net capital, or the customer reserve. Inspections staff also found that in

seven audits

, 17 firms identified e rrors or deficiencies during other audit procedures but

d id not sufficiently assess whether these error s or deficiencies indicated the existence of a material inadequacy.

Procedures Regarding Compliance with the Customer Protection Rule

Rule 17a

- 5(g) st ates that b rokers a nd dealers shall include supporting schedules with the financial statements that present the customer reserve computation and information relating to requirements for possession or control of securities

. Rule 17a

5(g) also state s that th e audit shall include all procedures necessary under the circumstances to enable the independent public accountant to express an opinion on, among other things, the customer reserve computation and information relating to the possession or control requirem ents under Rule 15c3

- 3

. AU

- C sec. 725, Supplementary

Information in Relation to the Financial Statements as a Whole

, addresses the auditor ' s responsibility when engaged to report on whether supplementary information is fairly stated, in all material respec ts, in relation to the financial statements as a whole

. In order to opine on whether supplementary information is fairly stated, in all material respects, in relation to the financial statements as a whole, the auditor should perform certain procedures usi ng the same materiality level used in the audit of the financial

statements. 18

Inspections staff identified one or more deficiencies in 5 of 21 audits selected for inspection where brokers or dealers did not claim an exemption from the requirement to

maint ain a Special Reserve Bank Account. In three of the f ive audits with deficiencies

related to the Customer Protection Rule , Inspections staff identified more than one

deficienc y in the categories set forth in the table below :

17 One audit was included in the previous example of five audits.

18 See Paragraph s .05 and .07 of AU

- C s ec. 725

. For audits conducted under pre

- clarified AICPA standards, see Paragraph s .05 and .07 of AU s ec. 551

, Supplementary Information in Rel ation to the Financial Statements as a Whole.PCAOB Release No. 2014

- 003 August 18, 2014 Page 11

RELEASE

Deficiencies Related to: Numbe r of

Audits
Completeness and accuracy of customer debits or

credits 3

Special Reserve Bank Account 2

Possession or control requirements 3

Completeness and Accuracy of Customer Debits or Credits

In 3 of the 21 audits

, Inspections staff noted that firm s failed to sufficiently test the completeness and accuracy of customer debits or credits included in the customer reserve computation. Inspections staff observed that these fi rm s limited their procedures to agreeing the amounts reported in the computation to schedules prepared by the broker or dealer and did not perform procedures to determine whether customer

debits or credits were consistent with Exhibit A of Rule 15c3

- 3.

Special Reserve Bank Account

Rule 15c3

- 3(f) requires a broker or dealer that ma intains a Special Reserve Bank Account to obtain and preserve written notification from each bank that all cash and/or qualified securities on deposit are being held by the bank for the exclusive benefit of customers, are kept separate from the broker ' s or dealer ' s other bank accounts, and assets in the account may not be used by the bank as collateral nor may the bank attach any claim to the account.

Inspections staff observed in 2 of the 2 1 audits, firm s failed to verify the existence of a Special Reser ve Bank Account or failed to determine whether the a ccount agreement s contained the required restrictive provisions of Rule 15c3

- 3(f).

Possession or Control Requirements

Rule 15c3

- 3 (b)(1) requires a broker or dealer to promptly obtain and maintain the physical possession or control 19 of all fully

- paid securities 20 and excess margin

securities 21 carried by the broker or dealer for the accounts of customers.

19 Generally, " possession " of securities means the securities are physically

located at the broker or dealer and " control " of securities means the securities are located at an approved " control " location, such as a clearing corporation or depository.

20 Generally, fully

- paid securities are securities that are purchased in transactions for which the customer has made full payment. See Rule 15c3

- 3(a)(3).

21 Generally, e xcess margin securities in a customer acco unt are those

securities with a market value greater than 140 percent of the customer's debit balance.

See Rule 15c3

- 3(a)(5).PCAOB Release No. 2014

- 003 August 18, 2014 Page 12

RELEASE

Inspections staff observed in 3 of the 21 audits, firms failed to perform sufficient procedures to t est compliance with the possession or control requirements. Inspections staff noted that firms did not perform sufficient procedures to test the stock record,

determine whether instructions were timely to reduce items to possession or control, or

sufficien tly test whether securities were located at an approved control location.

Procedures Regarding Compliance with the Net Capital Rule

Rule 17a

- 5 (g) states that b rokers and dealers shall include a supporting schedule to the financial statements that presen ts the computation of net capital

. Net capital is also generally disclosed in the notes to the financial statements. S imilar to the procedures regarding compliance with the Customer Protection Rule noted above, Rule

17a

- 5(g) and AU

- C sec. 725 were applicab le to audits described in this section

.

Inspections staff identified one or more deficiencies in 26 of the 7 3 audits

selected where one or more components of the net capital computation was selected for inspection. In 10 of the 26 audits with deficiencies related to the Net Capital Rule

, Inspections staff identified more than one deficiency in the categories set forth in the

table below :

Deficiencies Related to: Number of

Audits

Minimum net capital requirements 10

Additions to net worth 1

Allowable ass ets 19

Haircuts 6 Operational charges 2

Minimum net capital requirements

Generally, a broker ' s or dealer ' s required minimum net capital is the greater of (1)

one of a number of fixed

- dollar amounts prescribed in Rule 15c3

- 1 applicable to the

broker or dealer relative to its line ( s ) of business

, 22 or (2) an amount computed using

one of two financial ratios. 23 In 9 of the 10 audits, Inspections staff found that firms

failed to assess the nature of the broker ' s or dealer ' s operations in relation to the

requ ired minimum net capital amounts in accordance with Rule 15c3

- 1. In 3 of the 10 24
audits, Inspections staff found that firms failed to sufficiently test whether aggregated

22 See Rule 15c3

- 1(a)(2)

.

23 See Rule 15c3

- 1(a)(1)

.

24 This number i ncludes two audits referenced in the previous sentence.PCAOB Release No. 2014

- 003 August 18, 2014 Page 13

RELEASE

indebtedness was calculated in accordance with Rule 15c3

- 1 (c) (1)(i), and therefore

, f ailed to evaluate whether the calculated minimum net capital was in accordance with

Rule 15c3

- 1(a).

Additions to Net Worth

Under Rule 15c3

- 1

, as interpreted by SEC staff, c ertain discretionary liabilities

are allowed to be added back to net worth in the determination of net capital. 25 In one audit, Inspections staff found that the firm failed to test whether the amount of the liability for employee bonuses that was added to net worth in the determination of net capital was payable solely at the discretion of the broker or dealer, in accordance with

Rule 15c3

- 1.

Allowable assets

Rule 15c3

- 1 requires that assets not readily convertible into cash ( " non

- allowable

assets " ) be deducted from equity when computing net capital. 26 Inspections staff

observed 19 audit s where firms did not perform sufficient procedures to test the broker ' s or dealer ' s classification of allowable and non

- allowable assets when computing net capital.

Under Rule 15c3

- 1 , as interpreted by SEC staff, b roker s and dealers are permitted to off set certain receivables and payables when specific conditions are met. In

5 of the 1 9 audits, Inspections staff observed that firms failed to perform sufficient procedures to verify that the conditions necessary for the right of offset of certain

receivabl es by related payables were met in accordance with the applicable sections of

Rule 15c 3

- 1. For example, in three of the se audits, firms failed to test whether

commissions receivable pursuant to Exchange Act Rule 12b

- 1 ( " Rule 12b

- 1 " ) 27 were allowable asset s under Rule 15c3

- 1. As Rule 15c3

- 1 is interpreted by SEC staff, Rule

12b

- 1 commissions rece ivable can be classified as an allowable asset only to the extent the receivables are offset by Rule 12b

- 1 commissions payable to sales representatives. Among other t hings, t he sales representatives must sign a written agreement with the broker or dealer waiving payment of their commissions until the broker or dealer is in receipt of the Rule 12b

- 1 commissions

. 28

25 Se e Interpretation 15c3

- 1(c)(2)/02. This citation form refers to a compilation of the substance of certain SEC staff interpretations available at http://www.finra.org/industry/regulation/g uidance/for/ . The interpretation referred to here

is identified as number /02 associated with Rule 15c3

- 1(c)(2) in that compilation

.

26 See Rule 15c3

- 1(c)(2)(iv).

27 17 C.F.R. § 270.12b

- 1

.

28 See Interpretation 15c3

- 1(c)(2)(iv)(C)/09.PCAOB Release No. 2014

- 003 August 18, 2014 Page 14

RELEASE

When a broker or dealer has its proprietary assets and cl earing deposit in a proprietary account held by a clearing broker, Rule 15c3

- 1, as interpreted by SEC staff, permits these assets to be classified as allowable assets in the net capital computation provided certain conditions are met. 29 In 6 of the 19 audit s

, Inspections staff observed

that brokers and dealers reported assets held by a clearing broker as allowable assets,

but the firms failed to test whether the se assets met the requirements of an allowable

asset under Rule 15c3

- 1 (c)(2)( iv )(E)

.

Rule 15c3

- 1( c)(2)(iv)(C) states that commissions receivable from other brokers or dealers that are outstanding longer than 30 days from the date they arise are non

allowable assets. In 6 of the 19 audits, Inspections staff observed that firms failed to perform suffici ent procedures to test the aging of commissions receivable to determine

whether the amount reported as an allowable asset met the requirements of Rule 15c3

- 1 (c)(2)(iv)( C )

.

Haircuts

When computing net capital, Rule 15c3

- 1 generally requires brokers and dealers to apply percentage reductions (referred to as " haircuts " ) to the values of securities owned by the broker or dealer. 30 As a result, the valuation of the securities and the appropriate haircut percentages can be critical to the net capital computati on. Inspections staff observed six audits w here firms did not perform sufficient procedures

related to haircuts on securities.

In all six audits

, Inspections staff found that firms failed to perform procedures to evaluate whether the appropriate haircut percentages were applied by the broker or dealer, including tests of the relevant characteristics of the securities positions

. For example, firms failed to test whether haircut s on securit ies positions were based on the

percen tages applicable to the catego r ies of securit ies and maturity dates, if applicable, pursuant to SEC Rule 15c3

- 1(c)(2)(vi). In one of the audits, Inspections staff found that the firm failed to perform sufficient procedures to test the completeness and accuracy of supporting records obt ained from an external party that provided the amount of haircuts

used in the computation of net capital

.

Operational charges

In computing net capital, Rule 15c3

- 1 requires brokers and dealers to deduct amounts related to operational charges such as a ged fail to

- deliver balances. 31 In two

29 See Interpret ation 15c3

- 1(c)(2)(iv)(E)/021

.

30 See Rule 15c3

- 1(c)(2)(vi).

31 See Rule 15c3

- 1(c)(2)(ix).PCAOB Release No. 2014

- 003 August 18, 2014 Page 15

RELEASE

audit s , Inspections staff observed that firm s failed to perform sufficient procedures to test the completeness or accuracy of operational charges deducted from the broker ' s or dealer ' s net capital.

Deficiencies Rela ted to the Financial Statement Audit

Consideration of Risk s of Material Misstatement Due to Fraud

An auditor conducting an audit in accordance with GAAS is responsible for obtaining reasonable assurance that the financial statements as a whole are free f rom material misstatement, whether caused by fraud or error

. 32 AU

- C sec. 240 describes the

auditor ' s responsibilities for, among other things, identifying, assessing, and responding

to the risks of material misstatement due to fraud. 33 The two types of misst atements that

are relevant to the consideration of fraud in a financial statement audit are misstatements resulting from fraudulent financial reporting and misstatements resulting

from misappropriation of assets. 34

Inspections staff identified one or more deficiencies in 3 6 of the 90 audits selected for inspection. In 1 3 of the 3 6 audits with deficiencies related to the consideration of risks of material misstatement due to fraud, Inspections staff identified more than one deficiency in the categories set forth in the table below :

32 Paragraph .0 5 of AU

- C sec. 240 , Consideration of Fraud in a Financial

Statement Audit. For audits conducted under pre

- clarified AICPA standards, paragraph

.01 o f AU sec. 316, Consideration of Fraud in a Financial Statement Audit

, provides that "[t] he auditor has a responsibility to plan and perform the audit to obtain reasonable

assurance about whether the financial statements are free of material misstatement,

w hether caused by error or fraud. "

33 For audits conducted under pre

- clarified AICPA standards, see AU sec.

316.

34 See Paragraph . 03 of AU

- C sec. 240

. For audits conducted under pre

clarified AICPA standards, see Paragraph .06 of AU sec. 316. Deficiencies Related to: Number of

Audits

Identification and a ssessment of the risks of

material misstatement due to fraud 1 1

Responses to the assessed risks of material

misstatement due to fraud

– management override 3 2

Re sponses to fraud r isk related to revenue recognition 6PCAOB Release No. 2014

- 003 August 18, 2014 Page 16

RELEASE

Identification and Assessment of the Risks of Material Misstatement Due to

Fraud

When identifying and assessing the risks of material misstatement due to fraud

, the auditor should , based on a pre sumption that risks of fraud exist in revenue recognition, evaluate which types of revenue, revenue transactions, or assertions give

rise to such risks

. 35 If the auditor has concluded that the presumption that there is a risk

of material misstatement due to fraud related to revenue recognition is overcome in the circumstances of the engagement, the auditor should include in the audit documentation

the reasons for that conclusion. 36

The auditor should treat those assessed risks of material misstatement due to fraud as significant risks and, accordingly, to the extent not already done so, the auditor should obtain an understanding of the entity ' s related controls, including control activities, relevant to such risks, including the evaluation of whether such controls have been suitably designed and implemented to mitigate such fraud risks. 37

In 10 audits, Inspections staff observed that firms did not identify a fraud risk related to revenue recognition or document their conclusion that no such risk existed. In

one audit

, a firm identified a fraud risk related to revenue recognition but failed to obtain an understanding of the broker ' s or dealer ' s control activities related to r evenue in order to evaluate whether such controls were designed and implemented to mi tigate the

identified fraud risk

.

Responses to the Assessed Risks of Material Misstatement Due to Fraud

– Management Override

The auditor should address the risk of management override of controls apart from any conclusions regarding the existence of mor e specifically identifiable risks by designing and performing audit procedures to : (a) test the appropriateness of journal entries recorded in the general ledger and other adjustments made in the preparation of the financial statements, including entries p osted directly to financial statement drafts ; (b) review accounting estimates for biases and evaluate whether the circumstances producing the bias, if any, represent a risk of material misstatement due to fraud ; and (c) evaluate whether the business ration ale (or the lack thereof) of significant

35 Paragraph .26 of AU

- C sec. 240. For audits conducted under pre

- clarified AICPA standards, see Paragraph .41 of AU sec. 316.

36 Paragraph .46 of AU

- C sec. 240

. F or audits conducted under pre

- clarified AICPA standards, see Paragraph .83 of AU sec. 316.

37 Paragraph .27 of AU

- C sec. 240. F or audits conducted under pre

- clarified AICPA standards, see Paragraphs .44 through .45 of AU sec. 316.PCAOB Release No. 2014

- 003 August 18, 2014 Page 17

RELEASE

transactions that are outside the normal course of business suggests that they may have been entered into to engage in fraudulent financial reporting or to conceal misappropriation of assets

. 38

Inspections staff ob served in 32 audits that firms failed to perform sufficient procedures to address risk s related to management override of controls, including sufficiently testing the appropriateness of journal entries recorded in the general ledger and other adjustments m ade in the preparation of the financial statements . In 2 4 of

these audits, firm s failed to : (i) obtain an understanding of the entity ' s financial reporting process and controls over journal entries and other adjustments, and the suitability of design and i mplementation of such controls ; (ii) make inquiries of individuals involved in the financial reporting process about inappropriate or unusual activity relating to the processing of journal entries and other adjustments ; (iii) consider fraud risk indicators

, the nature and complexity of accounts, and entries processed outside the normal

course of business ; (iv) select journal entries and other adjustments made at the end of a reporting period ; or (v) consider the need to test journal entries and other adjust ments throughout the period. 39 In addition, in 9 of the 32 audits, Inspections staff noted that

firms failed to r eview accounting estimates for bias, or evaluate significant transactions

outside the normal course of business

, or that otherwise appear unusua l

, to address the risk of management override of controls

.

In 9 of the 32 audits, Inspections staff observed that firms did not test the completeness of the population of journal entries from which they selected a sample for journal entry testing

. 40

Resp onses to Fraud R isk Related to Revenue R ecognition

Inspections staff observed six audits where firms failed to design or perform audit procedures whose nature, timing, and extent were responsive to the assessed risks of

material misstatement due to fraud related to revenue recognition. 41 For example,

38 See Paragraph . 32 of AU

- C sec. 240. F or audits conducted under pre

clarified AICPA standards, see Paragraphs .58 through .67 of AU sec. 316.

39 See Paragraph .32a of AU

- C sec. 240. F or audits performed under pre

clarified AICPA standards

, see Paragraphs .58 through .62 of AU sec. 316

.

40 See Paragraph .09 of AU

- C sec. 500, Audit Evidence . F or audits performed under pre

- clarif ied AICPA standards

, see Paragraph .10 of AU sec. 3 2 6

, Audit Evidence

.

41 Paragraph .06 of AU

- C sec. 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained . For audits conducted under pre

- clarified AICPA standards, see Paragraph .07 of AU sec. 318,PCAOB Release No. 2014

- 003 August 18, 2014 Page 18

RELEASE

Inspections staff noted that in instances where the firm ' s approach to address the identified fraud risk consisted only of substantive procedures, some firms used substantive analytical procedures but did not p erform test s of details as required by AU

C sec

. 33 0

. 42 In another example, a firm identified cutoff to be a fraud risk but did not perform sufficient procedures to respond to this risk

.

Auditing Related Party Transactions

Related parties often play a si gnificant role in the operations of brokers and

dealers

, for example, through direct participation in the activities of the brokers and dealers by principals or affiliates under shared service agreements. The nature of related party relationships and trans actions may, in some circumstances, give rise to higher risks of material misstatement of the financial statements than transactions with unrelated parties

. 43 For example, related parties may be improperly used by brokers and

dealers in scenarios such as: o verpaying for goods or services and disguising capital withdrawals; avoiding the imposition of higher capital requirements and various capital charges; structuring a broker ' s or dealer ' s business to avoid certain rules; and transferring customer assets to parties that are not approved custodians.

Auditors have a responsibility to perform audit procedures to identify, assess, and respond to the risks of material misstatement arising from a broker ' s or dealer ' s failure to appropriately account for or disclos e related party relationships, transactions,

or balances. 44 The auditor should design and perform audit procedures to obtain sufficient appropriate audit evidence about the assessed risks of material misstatement

Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit

Evidence Obtained

.

42 See Paragraph .22 of AU

- C sec. 330. For audits conducted under pre

clarified AICPA standards, see Paragra ph .54 of AU sec. 318

.

43 See Paragraph . 03 of AU

- C sec. 550

, Related Parties

. For audits conducted under pre

- clarified AICPA standards, Paragraph .31 of AU sec. 314, Understanding the Entity and Its Environment and Assessing the Risks of Material

Misstate ment , provides that " the business risk of significant transactions with related parties may increase the risk of misstatement of a range of significant account balances

and relevant assertions

. "

44 See Paragraph . 04 of AU

- C sec. 550

. For audits conducted u nder pre

clarified AICPA standards, Paragraph . 01 of AU sec. 334

, Related Parties

, provides that

" when he [the auditor ] is performing an audit of financial statements in accordance with generally accepted auditing standards to identify related party relati onships and

transactions and to satisfy himself concerning the required financial statement accounting and disclosure

. "PCAOB Release No. 2014

- 003 August 18, 2014 Page 19

RELEASE

associated with related party relationships and transactions and should remain alert when inspecting records or documents for arrangements or other information that may indicate the existence of related party relationships or transactions that have not previously been identified or disclosed. 45

Insp ections staff identified one or more deficiencies in 15 of the 90 audits selected for inspection. In 5 of the 1 5 audits with related party deficiencies, Inspections staff identified more than one deficiency in the categories set forth in the table below:

Inspections staff observed seven audits where firms failed to perform suff icient procedures to determine the existence of related parties and material related party

transactions. In five of the seven audits, Inspections staff found that firms limited their procedures to inquiries of management and did not inspect records and doc uments for the purpose of identifying significant related party relationships or material transactions that had not been previously identified or disclosed.

In 1 3 audits, Inspections staff observed that firms identified related parties or

material relat ed party transactions

, including service agreements, fee agreements, or intercompany balances, yet the firms did not perform procedures necessary to obtain sufficient appropriate audit evidence to respond to the assessed risks of material

misstatement asso ciated with related party relationships and transactions. For example,

firms did not perform sufficient test s for th e completeness and accuracy of identified related party transactions. In three of these audits, Inspections staff observed that the

firms fa iled to perform procedures to evaluate the financial capability of related parties
to pay their debts to the brokers or dealers in order to test the valuation of the related party receivables

.

Auditing Revenue Recognition

Brokers and dealers may generate revenue from a variety of securities

- related

lines of business. When testing revenue, t he auditor should design and perform audit procedures whose nature, timing, and extent are based on, and are responsive to

, the

45 See Paragraph s

. 16 and .21 of AU

- C sec. 550

. For audits conducted under pre

- clarified AICPA standards, see Paragraphs .07 through .09 of AU sec. 334. Deficiencies Related to: Number of

Audits

Existence and i dentification of r elated p arty

r elationships and or t ransactions 7

Examining i dentified r elated p arty t ransactions 1 3PCAOB Release No. 2014

- 003 August 18, 2014 Page 20

RELEASE

assessed risks of material misstatement at the relevant assertion level. 46 The auditor must obtain sufficient appropriate audit evidence to be able to draw reasonable

conclusions for his or her opinion on whether the financial statements are presented fairly, in all material respects, in conformi ty with GAAP

. 47

Inspections staff identified one or more deficiencies in 53 of the 9 0 audits selected for inspection. In 3 0 o f the 53 audits with deficiencies related to revenue recognition, Inspections staff identified more than one deficiency in the cat egories set

forth in the table below:

Inspections staff observed that in 29 audits, the extent of t esting was insufficient for material classes of revenue transactions, including trading gains and losses, commission revenue, and advisory fees. For example, Inspections staff observed

instances where firms : (a) did not perform any procedures to test mater ial classes of revenue transactions; or, (b) sampling procedures for testing revenue were insufficient

because : (i) firms did not have a basis to reduce the extent of substantive tests of

material classes of revenue transactions

, because some of these firm s did not sufficiently test controls yet reduced the extent of their substantive tests; (ii) the sample was not designed to address the relevant risks and other characteristics of the population; or (iii) firms failed to select a sample of revenue transact ions for testing that was representative of the underlying population.

When designing and performing analytical procedures, either alone or in combination with tests of details, as substantive procedures, the auditor should : (a) determine the suitability of substantive analytical procedures for given assertions; (b) evaluate the reliability of data from which expectations are developed; ( c ) develop an expectation and evaluate whether the expectation is sufficiently precise to identify a misstatement; and ( d ) determine the amount of difference from the expectation that can

46 See Paragraph .0 6 of AU

- C sec. 330

. For audits conducted under pre

clarified AICPA standards, see Paragraph .07 of AU sec. 318.

47 See Paragraph .01 of AU

- C sec. 500

. For audits conducted under pre

clarified AICPA standards, see Paragr aph .01 of AU sec. 326. Deficiencies Related to: Number of

Audits

Extent of testing 29 Substantive analytical procedures 24 Other procedures to test revenue recognition 3 6PCAOB Release No. 2014

- 003 August 18, 2014 Page 21

RELEASE

be accepted without further investigation

. 48 If analytical procedures performed identify fluctuations or relationships that are inconsistent with other relevant information or that

differ from expected values by a significant amount, the auditor should investigate such differences by (a) inquiring of management and obtaining appropriate audit evidence relevant to management ' s responses and (b) performing other audit procedures as

necessary in the circumstances. 49

Inspections staff observed 24 audits where firms performed substantive analytical procedures that did not provide the intended level of assurance because the

firms failed to (a) develop expectations that we re sufficiently precise t o identify

misstatements ; (b) investigate significant unexpected differences; (c) test the completeness and accuracy of the underlying data used in the analytical procedures ; or (d) determine that the substantive analytic al procedure s were based on plausib le

, predictable relationships.

Inspections staff identified deficiencies in 3 6 audits selected for inspection that related to the failure of firms to perform sufficient procedures to test the relevant

assertions for revenue. For example, firms failed to: (a) evaluate, or evaluate sufficiently, the effect of specific terms or provisions of significant contractual
arrangements related to the recognition of revenue; (b) test whether revenue wa s recorded in the correct period ; (c) determine whether assets und er management used to calculate fees were complete and accurate ; (d) determine whether the commission rates used to calculate commission revenue were consistent with the underlying agreements ; or (e) evaluate whether revenue recognition policies were in co nformity

with GAAP.

Procedures to Establish a Basis for Reliance on Records and Reports

Inspections staff identified one or more deficiencies in 40 of the 9 0 audits selected for inspection. In six audits with deficiencies related to establishing a basis for reliance on records and reports, Inspections staff identified more than one deficiency in the categories set forth in the table below:

48 See Paragraph .05 of AU

- C sec. 520, Analytical Procedures . For audits conducted under pre

- clarified AICPA standards, see Paragraphs . 13 through .20 of AU

sec. 329

, Analytical Procedures

.

49 See Paragraph .07 of AU

- C sec. 520. Fo r audits conducted under pre

clarified AICPA standards, see Paragraph .21 of AU sec. 329.PCAOB Release No. 2014

- 003 August 18, 2014 Page 22

RELEASE

Auditing Information Produced by Service Organization s

Many brokers and dealers use the services of other brokers and dealers to perform trade processing and related back

- office functions, pr imarily in the clearing and settling of customer transactions. AU

- C sec. 402

, Audit Consid erations Relating to an Entity U sing a Service Organization, applies to audits where a n entity uses services

from a service organization that affect the company ' s inf ormation system, including related business processes, relevant to financial reporting

. 50 AU

- C sec. 402 also

discuss es the user auditor ' s requirement to obtain an understanding of how the company uses the services of a service organization in the company ' s operations, the

user auditor ' s requirement to obtain an understanding of internal control relevant to the audit, and the user auditor ' s response to assessed risk of material misstatement, whether through further audit procedures or tests of controls. 51 In r esponding to the assessed risk of material misstatement, the auditor should (a) determine whether sufficient appropriate audit evidence concerning the relevant assertions is available

from records held at the broker or dealer and if not, (b) perform furthe r audit procedures to obtain sufficient appropriate audit evidence or use another auditor to perform those procedures at the service organization on the user auditor ' s behalf

. 52

Inspections staff observed in 31 audits that firms did not perform sufficient procedures on information produced by service organization s that were used to perform substantive audit procedures or test of controls

.

Inspections staff observed in 30 of those 31 audits that firms used information produced by a service organization, su ch as records or reports from a clearing broker,

but failed to obtain sufficient appropriate audit evidence on such information. Some firms used clearing broker statements as audit evidence and did not perform sufficient substantive audit procedures on the statement

. In several instances

, firms limited their

50 See Paragraph .03 of AU

- C sec. 402

. For audits conducted under pre

clarified AICPA standards, see Paragraph .03 of AU sec. 324, Service Organizations

.

51 See Parag raphs .0 9 through .2 2 of AU

- C sec. 402

. For audits conducted under pre

- clarified AICPA standards, see Paragraphs .05 through .21 of AU sec. 324.

52 See Paragraph .15 of AU

- C sec. 402. Deficiencies Related to: Number of

Audits

Auditing information produced by service organizations 31

Testing records and reports produced by brokers

and dealers 15PCAOB Release No. 2014

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RELEASE

procedures to agreeing the clearing broker statement to cash receipts or the general ledger. Other firms obtained and evaluated a service auditor ' s report to rely on the operating effectiveness of contr ols at the service organization

, but did not perform sufficient substantive audit procedures to address the relevant assertions related to the

account balance.

Inspections staff observed that in s even audits , six of which are included in the

30 audits di scussed in the previous paragraph, firms obtained a service auditor ' s report

, but failed to sufficiently evaluate the service auditor ' s report or consider whether the

service auditor ' s report provided evidence about the design and operating effectiveness

o f the controls being relied upon. For example , Inspections staff observed instances

where firms failed to sufficiently evaluate whether t he broker or dealer had designed and implemented the necessary user entity controls identified in the service auditor ' s report or sufficiently test ed those controls

.

Testing Records and Reports Produced by Brokers and Dealers

When information produced by the entity is used by the auditor in designing and performing audit procedures, the auditor should evaluate whether t he information is sufficiently reliable for the auditor ' s purpose, including obtaining audit evidence about the accuracy and completeness of the information and e valuating whether the information is sufficiently precise and detailed for the auditor ' s purpo ses

. 53

Inspections staff observed that in 1 5 audits, firms failed to perform procedures to

obtain evidence about the completeness or accuracy of records and reports produced by the brokers and dealers that were used in the performance of tests of controls or substantive tests. Examples of the se records and reports included trade blotters, account statements, and schedules or spreadsheets prepared by broker or dealer personnel. Such records and reports were used by firms in performing tests of certain

accou nts or disclosures without testing the completeness or accuracy of the information in those records and reports.

Auditing Financial Statement Presentation and Disclosures

The auditor should evaluate whether the financial statements

, in conformity with

G AAP

, provide adequate disclosures to enable the intended users to understand the effect of material transactions and events on the information conveyed in the financial

statements. 54 In addition, the auditor should evaluat e (a) the overall presentation,

53 See Paragraph . 09 of AU

- C sec. 500

. For audits conducted under pre

c larified AICPA standards, see Paragraph .10 of AU sec. 326.

54 See Paragraph .16e of AU

- C sec. 700, Forming an Opinion and Reporting

on Financial Statements

. For audits conducted under pre

- clarified AIC P A standards, Paragraph .02 of AU sec. 431, Adequacy of Disclosure in Financial Statements

,PCAOB Release No. 2014

- 003 August 18, 2014 Page 24

RELEASE

str ucture, and content of the financial statements and (b) whether the financial statements, including the related notes, represent the underlying transactions and events in a manner that achieves fair presentation. 55

Inspections staff reviewed the audit wor k performed related to financial statement disclosures for those areas included in the inspections. Inspections staff identified one

or more deficiencies in 2 7 of 9 0 audits selected for inspection. In 6 of the 2 7 audits with

deficiencies related to financi al statement presentation and disclosure

, Inspections staff identified more than one deficiency in the categories set forth in the table below :

In nine audits, Inspections staff observed instances in which firms failed to identify and evaluate the omission of required disclosures pertaining to areas such as related parties and relat ed party transactions or revenue recognition policies

.

Inspections staff also observed in 1 6 audits that firms failed to identify incomplete disclosures or respond to evidence that was inconsistent with disclosures included in

the financial statements. In another four audits , Inspections staff observed that firms

failed to evaluate the broker ' s or dealer ' s classification of fair value measurements of securities owned within the hierarchy required by FASB ASC 820

, Fair Value

Measurement ( " ASC 820 " )

.

In a ddition, Inspections staff observed in four audits that firms failed to evaluate

whether the financial statements presented and disclosed the underlying transactions in

a manner that complie d with GAAP . For example, in some of these audits

, f irm s failed to identify and address that the broker or dealer reported multiple revenue streams as a single line item on the statement of income, which is in consistent with the financial

statement format contained in Form X

- 17

- 5 Part II or Part IIA in accordance with Ru le

17a

- 5(d)(2).

provides that "[t]he presentation of financial statements in conformity with generally accepted accounting principles includes adequate disclosure of material matters."

55 See Paragraph .17 of AU

- C sec. 700. For audit s conducted under pre

clarified AICPA standards, see Paragraph .02 of AU sec. 431. Deficiencies Related to: Number of

Audits

Omitted disclosures 9 Incomplete or inaccurate disclosures 1 6

Fa ir value disclosures (FASB ASC 820) 4 Fair presentation 4PCAOB Release No. 2014

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Auditing Fair Value Accounting Estimates

Brokers and dealers account for and disclose securities at fair value. 56 AU

- C sec. 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and

Related Disclosures

, describes the auditor ' s responsibilities relating to accounting estimates, including fair value accounting estimates, in an audit of financial

statements

. 57 The term accounting estimate is used for an amount measured at fair

value when there is estimation uncertaint y, as well as for other amounts that require

estimation. 58

In respon ding to the assessed risk s of material misstatement

, taking in to account
the nature of the accounting estimate , the auditor should undertake one or more of the following: (a) d etermine wh ether events occurring up to the date of the auditor ' s report

pro vide audit evidence regarding the accounting estimates ; (b) test how management

made the accounting estimate and the data on which it is based ; (c) t est the operating

effectiveness of the con trols over how management made the accounting estimate, together with appropriate substantive procedures ; (d) d evelop a point estimate or rang e to evaluate management ' s point estimate

. 59

Inspections staff identified deficiencies in 8 of the 32 audits wher e the auditor ' s procedures to test securities valuation were selected for inspection. T he following presents a summary of the deficiencies discussed below:

56 See FASB ASC 820 and FASB ASC Subtopic 940

- 320, Financial Services

- Broker s and Dealers, Investments

- Debt and Equity Securities , ( " ASC 940

- 320 " )

.

57 See Paragraph . 0 1 of AU

- C sec. 540

. For audits conducted under pre

clarified AICPA standards, AU sec. 328, Auditing Fair Value Measurements and

Disclosures

, established standards and provide d guidance on auditing fair value

measurements and disclosures contained in financial statements ; see Paragraph .01

.

58 See Paragraph .07 of AU

- C sec. 540. For audits cond ucted under pre

clarified AICPA standards, Paragraph .01 of AU sec. 342, Auditing Accounting

Estimates provides that "an accounting estimate is an approximation of a financial statement element, item, or account."

59 See Paragraph

. 13 of AU

- C sec. 540. For audits conducted under pre

clarified AICPA standards, Paragraph .23 of AU sec. 328 provides that the auditor's approach to performing substantive tests of fair value measurements may involve: (a) testing management's significant assumptions, the valuation model, and the underlying data; (b) developing an independent estimate of fair value for corroborative purposes; or (c) reviewing subsequent events or transactions.PCAOB Release No. 2014

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Deficiencies Related to: Number of

Audits

Auditing f air v alue a ccounting e stimates 6

Auditing a cc ounting for i nvestments 2

In 6 of the 32 audits, Inspections staff observed that firms did not perform sufficient procedures to test the valuation of securities. For example, in two audits

, Inspections staff observed that firm s relied on the fair values provided by the brokers or

dealers and failed to undertake

, or sufficiently undertake

, one or more of the procedures

described in the second paragraph of this section

.

B rokers and dealers are excluded from the scope of FASB ASC Topic 320

- 10

- 15

- 3

, Investm ents

– Debt and Equity Securities ( " ASC 320 " )

. B rokers and dealers

should account for investments at fair value, 60 with changes in fair value recorded as income from operations in the statement of income. In two audits, Inspections staff

observed that firms failed to identify that the brokers or dealers had applied ASC 320

, and therefore, had inappropriately accounted for investments as securities that were held to maturity or available for sale

.

Evaluation of Internal Control Deficiencies in the Financial Statement Audit

In a financial statement audit

, t he auditor should obtain an understanding of control activities relevant to the audit, which are those control activities the auditor judges necessary to understand in order to assess the risks of material misstatement at the assertion level and design further audit procedures responsive to assessed risks

. 61
During the course of an audit, the auditor may become aware of deficiencies in internal

control

. If the auditor has identified one or more deficiencies in internal control, the auditor should evaluate each deficiency to determine, on the basis of the audit work performed, whether, individually or in combination, they constitute significant

deficiencies or material weaknesses

. 62 If the auditor determines th at a deficiency

, or a combination of deficiencies, in internal control is not a material weakness, the auditor should consider whether prudent officials, having knowledge of the same facts and

60 See Paragraph .30 of ASC 940

- 320

.

61 See Paragraph . 21 of AU

- C sec. 315

, Understandin g the Entity and Its Environment and Assessing the Risks of Material Misstatement. For audits conducted under pre

- clarified AICPA standards, see Paragraph .40 of AU sec. 314.

62 Paragraph . 09 of AU

- C sec. 265

, Communicating Internal Control Related

Matte rs Identified in an Audit. For audits conducted under pre

- clarified AICPA standards, see Paragraph .08 of AU sec. 325, Communicating Internal Control Related

Matters Identified in an Audit

.PCAOB Release No. 2014

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circumstances, would likely reach the same conclusio n

. 63 In addi tion , the auditor should consider whether a deficiency , or a combination of deficiencies, identified in internal

control is an indicator of a material inadequacy that would be disclosed in the

accountant ' s supplemental report on material inadequacies.

In spections staff identified one or more deficiencies in 6 of the 9 0 audits selected for inspection. In one audit with deficiencies related to the evaluation of internal control deficiencies, Inspections staff identified more than one deficiency in the categ ories set

forth in the table below :

Deficiencies Related to: Number of

Audits

Assessment of the severity of a control deficiency 2

Evaluation of errors performed as part of substantive testing 5

In two of the six audits, Inspections staff observed tha t firms identified one or more internal control deficiencies while performing procedures to obtain an understanding of internal control. Although the firms identified these deficiencies, the evaluations by the firms did not include a sufficient assessment of the severity of the control deficiency to determine whether the deficiency, individually or in combination, represented a significant deficiency or material weakness.

When evaluating the operating effectiveness of relevant controls, the auditor

should evaluate whether misstatements that have been detected by substantive procedures indicate that controls are not operating effectively

. 64 In five of the six audits, Inspections staff observed that firms identified errors during the performance of

substantiv e tests. However, the firms failed to evaluate the severity and nature of the errors, both individually and in combination , and the circumstances of their occurrences, including whether the errors were evidence of one or more control deficiencies

.

Audito r ' s Report

Generally, brokers and dealers are required under Rule 17a

- 5 to file with the SEC audited financial statements and supporting schedules on the computation of net capital, the computation of the customer reserve requirement, and information rel ating to the possession or control requireme nts of the Customer Protection R ule . At the time

63 Paragraph . 10 of AU

- C sec. 265. For audits conducted under pr e

- clarified AICPA standards, see Paragraph .16 of AU sec. 325.

64 Paragraph . 16 of AU

- C sec. 330

. For audits conducted under pre

- clarified AICPA standards, see Paragraph .34 of AU sec. 318.PCAOB Release No. 2014

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of the audits discussed here, Rule 17a

- 5 also required brokers and dealers to file an

accountant ' s supplemental report on material inadequacies. The auditor ' s repo rt on the supporting schedules should include the elements required by AU

- C sec. 725

, 65
including an opinion on whether the schedules are fairly stated, in all material respects,

in relation to the financial statements taken as a whole.

Inspections staff i dentified deficiencies in 5 of the 90 audits selected for inspection related to the auditor ' s report

. In spections staff found that in four of the five audits, the auditor ' s report on the supporting schedules failed to include one or more of

the elements re quired by AU

- C sec. 725, such as a statement that the supplementary information is the responsibility of management and was derived from, and relates directly to, the underlying accounting and other records used to prepare the financial

statements.

65 See Paragraph .09 of AU

- C sec. 725. For audits conducted u nder pre

clarified AICPA standards, see Paragraph .09 of AU sec. 551.PCAOB Release No. 2014

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Part II: Summary of Inspections of Registered Public Accounting Firms Since Inception of the Interim Inspection Program

Since inception of the interim inspection program through December 31, 2013

, the Board has inspected 10 1 66 registered public accounting fir ms that conduct ed audits

of the financial statements and other requirements of brokers and dealers. Nine of these

firms were inspected more than once

. These inspections cover ed portions of 17 3 audits.

The following discussion summarizes the selection of firms and audits made during the interim inspection program through December 31, 2013, and independence findings and audit deficiencies identified by Inspections staff from these inspections.

The Board advises readers to consider the information presented within the remainder of this section in light of the following factors . The selection of firms and audits of brokers and dealers made since inception of the interim inspection program is not necessarily representative of the population of firms or of audi ts of brokers and dealers. Further, the populations of firms and brokers and dealers are not homogenous. Therefore, the observations presented are not necessarily indicative of the population of

firms or of audits of brokers and dealers. In addition, the i nformation presented within this section cannot support a conclusion that audit quality has improved or deteriorated for the reasons just mentioned.

Nevertheless , the continued occurrence and percentage of audits selected for inspection with audit deficie ncies and independence findings observed during the interim inspection program provide a useful point of reference for discussions about areas for improvement when performing audits of brokers and dealers

.

Selection of Firms and Audits

The firms and the audits were selected in order to have a cross section of firms,

as well as a cross section of broker s and dealers, based on varying characteristics of

both

. Selection of registered public accounting firms for inspection took into

consideration various char acteristics, including the number of audits of brokers and

dealers per formed by the firm s or whether the firm s also issued audit reports for issuers.

The selection of brokers and dealers considered various characteristics

, such as

whether or not the broker s or dealers maintained a Special Reserve Bank Account

under Rule 15c3

- 3

, the minimum net capital requirement, and reported actual net capital

under Rule 15c3

- 1. The Board did not exclude any audits of brokers or dealers from being eligible for selection.

66 This number represents the inspection of 10 firms reported in the First Progress Report, 43 firms reported in the Second Progress Report, and 60 firms covered in Part I of this repor t. Three firms were included in all three reports and six firms were included in two reports.PCAOB Release No. 2014

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Further, the selections were intended to meet the following objective s : 1) assess compliance with the applicable audit standards and rules of the Commission and the

Board , and the Act ; 2) help inform the Board ' s eventual decisions regarding the scope

and elements of a permanent inspection program; and 3) assist in the development of the approach to inspections under a permanent inspection program

.

Nine firms were inspected more than once since the inception of the interim inspection program. None of the audits selected for inspection were inspected more than once.

The following table presents the number of firms inspected and audits selected for inspection stratified by the number of broker or dealer audit s per f irm

, as determined

at the time of the ins pections :

Number of Broker or Dealer

Audit s per Firm Number of Firms Inspected Number of Audits

Selected

1 19 19

2 to 20 4 8 60

2 1 to 50 22 4 5

51 to 100 8 14

More than 100 5 35

Total 101 67 173

The next table presents the number of firms inspected a nd audits selected for inspection based on whether or not the firms audited the financial statements of an

issuer a t the time of the inspections :

Firms that Audit ed

Brokers and Dealers Number of Firms Inspected Number of Audits

Selected

Firms that also audit ed issuers 3 5 95

Firms that d id not audit issuers 66 78

Total 101 173

The 17 3 audits of brokers and dealers selected for inspection had financial statement periods ended on December 3 1 , 2010 through June 3 0 , 2013. The se audits

included 43 brokers or dealers that maintained a Special Reserve Bank Account and

1 30 brokers or dealers that did not. The following table presents the ranges of minimum net capital requirements and actual net capital reported for these brokers and dealers:

67 The sum of the number of firms inspected does not add to 101 because one firm that was inspected more than once is reported in multiple stratifications due to a change in the number of broker or dealer audits performed by the firm.PCAOB Release No. 2014

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Independence Findings and Audit Deficiencies from Inspections

Observations were identified in portions of 151, or approximately 87 percent, of the 173 audits selected for inspection. The 22 audits where Inspections staff did not identify observations in the portions of these audits inspected were performed by 12 firms, of which 11 also audited issuers.

Independence Findings

I ndependence findings relating to a firm ' s involvement in the preparation of the

financial statements were identifi ed in approximately 26 percent of the 173 audits selected for inspection. Inspections staff noted a significantly higher percentage of audits inspected with independence findings for the audits performed by firms that d id

not audit issuers. The following t able presents a summary of independence findings by

whether or not the firms also audit ed issuer s :

Exhibit 1: Independence Findings

68 Excluded from the range of actual net capital reported at fiscal year end is one instance of reported negative net capital.

69 The independence findings were identified at firms that issued audit reports for 100 or fewer issuers. Number of

Audits

Selected Range of Minimum Net Capital Requirements Range of Actual Net Capital Reported at Fiscal

Year End

Special Reserve Bank

Account 43 $ 250,000

- $ 600,000,000 $ 310,000

- $ 6,250,000,000
No Special Reserve

Bank Account 130 $ 5,000

- $ 6,100,000 $ 8,000 68

- $ 2,340,000,000

Number of

Audits with

Findings Number of Applicable

Audits Percentage

of Audits

with Findings Failure to Satisfy Indepen dence Requirements

Firms that also audit ed issuers 5 69 95 5%

Firms that d id not audit issuers 40 78 51%PCAOB Release No. 2014

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Audit Deficiencies

Inspections staff identified audit deficiencies in portions of 15 0 of the 173 audits

selected for inspection

. The 23 a udits where Inspections staff did not identify any audit

deficiencies in the portions of audits inspected were performed by 13 firms, 11 of which

also audited issuers. The following table presents a summary of certain areas that were reported in the First and Second Progress Reports and in Part I of this report : 70

Exhibit 2: Audit Deficiencies

The remainder of this section present s observations stratified by certain firm

characteristics or broker and dealer characteristics, a comparison of inspections

70 Audit deficiencies related to understanding the entity (approximately two percent) that were reported in the Second Progress Report are not included in this

table.

71 Seven audits that were reported wi thin the Accountant’s Supplemental Report on Material Inadequacies section in the First Progress Report have been re

categorized to Auditor’s Report to conform to the presentation in the Second Progress Report and this report. Number of

Audits with

Deficiencies 71 Number of Applicable

Audits Percentage

of Audits

with

Deficiencies
Related to Customer Protection and Net Capital Rules:

Re port on Material Inadequacies 102 161 63%

Customer Protection Rule 12 43 28%

Net Capital Rule 57 156 37%

Related to the Financial Statement Audit:

Risk of Material Misstatement

Due to Fraud 86 173 50%

Related Party Transactions 50 173 29 %

Revenue Recognition 110 173 64%

Reliance on Records and Reports 82 173 47%

Financial Statement Presentation

and Disclosures 63 173 36%

Fair Value Estimates 19 60 32%

Evaluation of Internal Control

Deficiencies 16 173 9%

Auditor ' s Report 30 173 17%PCAOB Release No. 2014

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performed during 2013 to inspections performed through the end of 2012 , and information on firms inspected more than once

.

Observations Stratified By Certain Firm Characteristics

Number of Broker or Dealer Audit s per Firm

Inspections staff identified a high percentage of audits and areas inspected with

observations. O bservatio ns were identified in 100 percent of audits selected for inspection for auditors with only one broker or dealer client, while the percentage was slightly lower for firms that audited 2 to 100 brokers and dealers

, and significantly lo wer for firms that audi ted more than 100 brokers and dealers. The following table presents

the percentage of audits and areas inspected with observations stratified by the number

of broker or dealer audit s per firm as determined at the time of inspection :

Exhibit 3: Number of B roker or Dealer Audit s per Firm

Percentage of Audits

with Observations Percentage of Areas

with Observations 72

1 100% 52%

2 to 20 93% 42%

21 to 50 91% 40%

51 to 100 93% 38%

More than 100 63% 19%

Firms that Audit ed Issuers C ompared to Firms t hat D id Not Audit Issuers

Inspections staff noted that t he percentage of audits and areas inspected with

observations was significantly higher a t firms that d id not audit issuers. Of the 95 audits

selected for inspect ion that were conducted by firms that also au dited issuers, there

were 21 audits where Inspections staff did not identify any independence findings or

audit deficiencies in the portions of the audits inspected

.

72 The term " areas " used with in this section represents the portions of audits

included in the i nspect ion (revenue recognition, related party transactions, net capital, etc.) by Inspections staff and reported within the First and Second Progress Reports and Part I of this report, as p resented in Exhibits 1 and 2 . The "Percentage of Areas

with Observations" presented within Exhibits 3 through 8 represents the sum of the

" Number of Audits with Findings " and " Number of Audits with Deficiencies " disclosed

within Exhibits 1 and 2 above divi ded by the sum of the " Number of Applicable Audits "

disclosed within Exhibits 1 and 2 above.PCAOB Release No. 2014

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The following table presents the percentage of audits and areas inspected with

observati ons stratified by firms that also audit ed issuers and those that d id not audit

issuers , at the time of the inspection:

Exhibit 4 : Firms that also A udited Issuers and F irms that did not Audit Issuers

Percentage of Audits

with Observations Percentage of Ar eas

with Observations

Firms that also audited issuers 78% 29%

Firms that did not audit issuers 99% 48%

Observations Stratified by Certain Broker and Dealer Characteristics

Reported Actual Net Capital , Revenues, and Assets

Inspections staff not ed a hi gh percentage of audits and areas inspected with

observations across the spectrum of audits of brokers and dealers in terms of their characteristics, such as reported actual net capital, revenues and assets . T here did not appear to be a discern i ble relatio nship between the percentage of audits and areas inspected with observations and these broker or dealer characteristics

, except for lower percentages noted for the selected audits of brokers and dealers with the largest

amounts of reported actual net capit al, revenues, or assets

.

For illustrative purposes, t he following table presents the percentage of audits and areas inspected with observations stratified by the reported actual net capital of the

brokers and dealers at the time of the audit :

Exhibit 5 : Reported Actual Net Capital by Brokers and Dealers

Percentage of Audits

with Observations 73 Percentage of Areas

with Observations

Less than $100,000 89 % 42%

$100,001 to $ 2,000,000 96 % 45 %

$2,000,001 to $ 1 5,000,000 90 % 37 %

$ 1 5,000,001 to $6,250,000,000 69 % 24 %

Special Reserve Bank Account

Inspections staff noted a high percentage of audits and areas inspected with

observations , regardless of whether the broker or dealer maintained a Special Reserve

73 The number of audits selected for inspection for e ach of these

stratifications is 28, 56, 50, and 39, respectively.PCAOB Release No. 2014

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Bank Account

. T he percentage of audits and areas ins pected with observations was higher for audits of brokers or dealers that did not maintain a Special Reserve Bank

Account

.

Inspections staff also noted that for firms that also audited issuers

, the percentage of audits and areas inspected with observatio ns was higher for audits of brokers and dealers that did not maintain a Special Reserve Bank Account compared to

those that di d

. For firms that did not audit issuers, t here was no discern i ble relationship

between the percentage of audits and areas inspecte d with observations and these types of brokers or dealers.

The following table presents the percentage of audits and areas inspected with

observations stratified by whether or not the broker or dealer maintained a Special

Reserve Bank Account at the time of the audit :

Exhibit 6 : Special Reserve Bank Account

Percentage of

Audits with

Observations Percentage of

Areas with

Observations

No Special Reserve Bank Account 90% 39%

Special Reserve Bank Account 79% 31%

Comparison of Inspections during 2013 to I nspections t hrough the end of 2012

The Board began conducting inspections under the interim inspection program during October 2011. Observations from the inspections performed through the end of

2012 were compared to those from the inspections performed during 2013. There were slightly fewer audit deficiencies and independence finding s in portions of audits inspected during 2013 than in portions of audits inspected pr e viously , but nevertheless,

observations remained high.

The following table shows a comp arative summary of the percentages of audits and areas inspected with observations for inspections performed during 2013 with inspections performed through the end of 2012 :

Exhibit 7: Comparison of Inspections during 2013 to Inspections through 2012

Perce ntage of Audits

with Observations Percentage of Areas

with Observations

2013 79% 30%

Inspections through 2012 96% 45%PCAOB Release No. 2014

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Inspections staff did not identify any observations in the portions of 19 audits inspected during 2013 and portions of 3 audits inspec ted through 2012. All but 1 of the

22 audits was performed by firms that also audited issuers.

I ndependence Findings

Inspections staff noted that, in the 2013 inspections, the percentage of independence findings among audits that were performed by firms that did not audit

issuers w as slightly lower than for inspections through 2012. The following table
present s the percentage of audits selected for inspection during the interim inspection

program with i ndependence findings :

Exhibit 7A: Comparison of Inde pendence Findings

Audit Deficienci es

Inspections staff noted a lower percentage of audits selected for inspection with audit deficiencies when comparing 2013 to i nspections through 2012 for each of the

areas inspected

. For both periods, the areas with the highest frequency of deficiencies

were: report on material inadequacies, revenue recognition, reliance on records and
reports, and the risk of material misstatement due to fraud

. The following table presents

the percentage of applicable audits with deficiencies for the portions of 173 aud its inspected during the interim inspection program : Percentage of Audits with Findings

2013 Inspections through 2012

Failure to Satisfy Independence Requirements

Firms that also audit ed issuers 4% 7%

Firms that d id not audit issuers 48% 55%

Total 23% 29%PCAOB Release No. 2014

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Exhibit 7B: Comparison of Audit Deficiencies

Firms Inspected M ore Than Once

There were n ine firms that were inspected more than once during the in terim inspection program through the end of 2013. Inspections staff noted a lower percentage
of audits and areas inspected with observation s when comparing inspections pe rformed during 2013 to inspections performed through 2012.

The following table shows a comparative s ummary of the percentage of audits and areas inspected with observation s for the nine firms that were inspected more than

once :

Exhibit 8: Firms Inspecte d More than Once

Percentage of Audits

with Observations Percentage of Areas

with Observations

2013 57% 16%

Inspections through 2012 90% 35% Percentage of Applicable

Audits with Deficiencies

2013 Inspections through 2012

Related to Customer Protection and Net Capital Rules:

Report on Material Inadequacies 49% 7 7 %

Customer Protection Rule 24% 32%
Net Capital Rule 36% 37%

Related to the Financial Statement Audit:

Risk of Material Misstatement Due to Fraud 40% 60%
Related Party Transactions 17% 42%
Revenue Recognition 59% 69%
Reliance on Records and Reports 44% 51%

Financial Statement Presentation and

Disclosures 3 0 % 43%

Fair Value Estimates 25% 39%

Evaluation of Internal Control Deficiencies 7% 12%

Auditor ' s Report 6% 30%PCAOB Release No. 2014

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Part I II : Actions Needed by Firms and Next Steps of the Interim Inspection
Program

The Board is concerned by the nature and number of these audit deficiencies and independence findings. M any of the observations in this report and the two previous progress reports are similar in nature and relate to fundamental audit ing principles. The Board emphasizes the need f or firms t o improve the quality of their broker and dealer audits to achieve compliance with applicable standards and rules

.

The Board reminds firms that information obtained through the interim inspection program may lead the Board to commence an investi gation or disciplinary proceeding concerning the conduct of a firm or associated persons of such firms

. The Board has started this process for certain firms

. In addition, w hen it comes to the Board ' s attention

that the financial statements of a broker or d ealer appear not to present fairly, in all material respects, the financial position, results of operations, or cash flows of the broker or dealer in conformity with GAAP

, the Board ' s practice is to report that information to the SEC, which has jurisdictio n to determine proper accounting of the financial statements of brokers and dealers. Similarly, detailed information related to possible violations of laws or rules, including independence rules, by brokers and dealers may be, and has been, reported to the SEC as well as designated examining

authorities.

Actions Needed by Firms

In light of the observations that continue to be identified by Inspections staff, combined with the need to adapt to amended SEC rules and to follow PCAOB standards, t he Board urg es registered public accounting firms that audit brokers and

dealers to re

- examine their audit approaches

.

All registered public accounting firms that issue audit reports for brokers or dealers should consider whether the audit deficiencies and indepen dence findings described in this report might be present in audits they currently perform, and should take appropriate action to prevent or correct any such deficiencies and independence findings

.

Under GAAS, when audit deficiencies are discovered after t he date of the audit report, a firm must take appropriate action to assess the importance of the deficiencies

to the firm ' s present ability to support its previously expressed audit opinions. 74

74 See AU

- C sec. 585

, Consideration of Omit ted Procedures After the Report

Release Date. For audits conducted under pre

- clarified AICPA standards, see AU sec.
390, Consideration of Omitted Procedures After the Report Date

. The firm might have further responsibilities under AU

- C sec. 560, Subsequent Events and Subsequently

Discove red Facts

. For audits conducted under pre

- clarified AICPA standards, see AU

sec. 561

, Subsequent Discovery of Facts Existing at the Date of the Auditor's Report

.PCAOB Release No. 2014

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Depending upon the circumstances, the firm may do one or more o f the following: (1) perform additional audit procedures; (2) inform a client of the need for changes to its financial statements, supporting schedules, or the firm ' s supplemental report on material inadequacies; or (3) take steps to prevent reliance on pr eviously expressed audit opinions. The Board expects firms to take appropriate action. Many firms have represented that they have taken, are taking, or will take action. The Board has not conducted a review of any remedial actions taken by the firms to add ress audit

deficiencies or independence findings identified in these inspections but may review those actions through its inspection process in the future.

The Board urges registered public accounting firms to be proactive in considering how to prevent s imilar or other deficiencies and findings by seeking ways to better anticipate and address risks that might arise in specific broker or dealer audits. The Board encourages registered public accounting firms to continually stress to their personnel the crit ical need to conduct audits with due professional care, including professional skepticism. The Board also encourages registered public accounting firms to take action to review the following:

Independence:

• Agreements for services performed for broker and dealer audit clients to ensure

that services

, including preparation of financial statements

, that would violate SEC independence rules will not be provided.

• Guidance and training to ensure all professionals are aware of the SEC independence requirements applicable to audits of brokers and dealers.

• Quality control procedures to ensure compliance with applicable SEC auditor independence requirements, including prohibition of involvement in the preparation of financial statements that the firm audits.

Au dit Deficiencies:

• Firm guidance and training to determine that the topic areas of the observed audit deficiencies identified in the report are given appropriate attention

.

• Policies for supervision, including review, to ensure their partners and superviso ry personnel are placing appropriate attention on these areas.

The Board also encourages registered public accounting firms to review the Staff

Guidance for Auditors of SEC

- Registered Brokers and Dealers issued on June 26

, 2014, and to attend the Board ' s periodic Forums on Auditing Smaller Broker

- Dealers

.

In addition to the actions needed by registered public accounting firms

, management and audit committees, or the equivalent, of brokers and dealers may wantPCAOB Release No. 2014

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RELEASE

to consider inquiring of their auditor about h ow these areas are being appropriately

addressed in the ir audit s and take steps to ensure that independence violations are

avoided

.

Next Steps of the Interim Inspection Program

Future Inspections

The Board will continue to conduct inspections under the interim inspection

program of registered public accounting firms that audit brokers and dealers until rules for a permanent inspection program take effect. T here were approximately 750 registered public accounting firms that issued audit reports on the fin ancial statements

of approximately 4,000 brokers and dealers 75 that were filed with the SEC for fiscal periods ended during 2013

.

Number of Broker or

Dealer Audits per Firm Number of Firms 76 Percentage

of Firms

1 355 47%

2 to 20 360 48%

21 to 50 22 3 %

51 to 100 7 1%

More than 100 6 1%

Total 750 100%

During 2014, the Board plans to select approximately 60 firms and inspect portions of approximately 100 audits

. The firms the Board selects will primarily include firms not previously inspected

, but will also include some firms previously inspected under the interim inspection program. In addition, the Board may inspect audit s of

broker s or dealer s whose past audit s were previously inspected

. In that context, the Board may evaluate whether, or how, th e firms addressed audit deficiencies or independence findings from the previous inspection.

75 This information is based on the number of brokers and deale rs who filed financial statements with the SEC through May 27 , 201 4 , for fiscal years ended during

201 3 , that included audit reports issued by firms registered with the PCAOB.

76 Information about the number of firms that audited brokers and dealers

and th eir broker or dealer audits is based on financial statements filed with the SEC through May 27 , 201 4 , for fiscal years ended during 2013

. These firms were registered with the PCAOB at the time the audit reports were issued.PCAOB Release No. 2014

- 003 August 18, 2014 Page 41

RELEASE

During 2015, the Board will inspect audits of brokers and dealers, which are required to be performed in accordance with PCAOB standards, in order to assess compl iance with the applicable standards and rules. In addition, i nformation obtained

from these inspections will be used to identify risk factors relevant for selecting firms

and audits of brokers and dealers for inspection under a permanent inspection program through the analysis of relationships between inspection observations and

characteristics of the firms and the broker s and dealers that were audited

.

Scope of a Permanent Inspection Program

The Board is continuing to take a careful and informed approac h in establishing a permanent inspection program recognizing the complexity and diversity of the brokers and dealers, as well as working through the challenges in obtaining relevant information

for these non

- public companies

. The Board continues to obtain available information to

evaluate the risk of loss to customers and whether this risk can be assessed from

attributes that characterize broker s and dealers in an effort to provide for differentiation

of the broker s and dealers.

The Board plans to review the contents of the compliance and exemption reports

and the respective auditors ' reports related to

, for example, the brokers ' or dealers ' compliance with the provisions of the customer protection rule, to evaluate risk of loss to

customers

. The Board wi ll also continue to gather i nformation regarding customer losses due to fraudulent activities or liquidations of broker s and dealer s , and regulatory sanctions imposed on broker s and dealers to evaluate whether correlations exist

between these matters and c haracteristics of the broker s and dealers.

The PCAOB staff is currently working to develop a rule proposal for the Board to

issue during 2016 to establish a permanent inspection program and its scope, which will address whether to exempt any category of registered public accounting firm

.

Other Board Initiatives

In its efforts and initiatives to protect the interests of investors and further the public interest in informative, accurate, and independent audit reports for brokers and

dealers , the Board ha s

, and will continue to, among other things:

• C onduct forums for auditors of brokers and dealers that provide information about the Board, the interim inspection program, observations from the interim inspection program, and audits of brokers and dealers;

• P articipate in various outreach initiatives, including conferences and other events to inform registered public accounting firms that issue audit reports for brokers

and dealers about observations from the interim inspection program, developments in the Board ' s standards

- setting initiatives, and updates from the SEC and FINRA; andPCAOB Release No. 2014

- 003 August 18, 2014 Page 42

RELEASE

• I ssue guidance for audits of brokers and dealers to assist with the implementation of PCAOB auditing and attestation standards and will consider

utiliz ing communication tool s s uch as webcasts and stored media presentations to effectively deliver guidance and information to auditors of brokers and dealers.

The Board will issue future progress reports that will describe significant observations from inspections, the publication o f which may otherwise be appropriate to protect the interests of investors or to further the public interest. In addition, the Board will use information obtained from the interim inspection program and other research

and outreach efforts to inform its fut ure standards

- setting activities relevant to the audits

of brokers and dealers.Appendix

References to Certain Releases for Standards and Rules Related to Brokers and Dealers and Their Auditors That Were Adopted During 2013 and 2014

Audits of brokers and dealers with fiscal years ended on or after June 1, 2014 are required to follow PCAOB standards. The following table provides a list of PCAOB

releases and guidance that describe requirements applicable to audits of brokers and

dealers

.

Title Release D ate Release and Link

Standards for Attestation Engagements Related to Broker and Dealer Compliance or Exemption Reports Required by the U.S. Securities and Exchange Commission and

Related Amendments to

PCAOB Standards October 10, 2013 See PCAOB Release N o.
2013

- 007

http://pcaobus.org/Rules/Rulem aking/Pages/Docket035.aspx

Auditing Standard No. 17 Auditing Supplemental Information Accompanying

Audited Financial Statements

and Related Amendments to

PCAOB Standards October 10, 2013 See PCAOB Release No.

2013

- 008

http://pcaobus.org/Rules/Rulem aking/Pages/Docket036.aspx

Amendments to Conform the

Board 's Rules and Forms to the

Dodd

- Frank Act and Make Certain Updates and

Clarifications December 4, 2013 See PCAOB Release No.

2013

- 010

http://pcaobus.org/Rules/Rulem aking/Pages/Docket039.aspx

Staff Guidance for Auditors of

SEC

- Registered Brokers and

Dealers June 26, 2014 http://pcaobus.org/News/Relea
ses/Pages/06262014_Staff_Gu
idance.aspxPCAOB Release No. 2014

- 003 August 18, 2014 Page A

- 2

RELEASE

The followin g table lists SEC releases and guidance that describe the

amendments to the reporting requirements for brokers and dealers under Exchange Act

Rule 17a

- 5 and the SEC ' s financial responsibility rules , including Exchange Act Rules

15c3

- 1 and 15c3

- 3

.

Title R elease Date Release and Link

Broker

- Dealer Reports July 30, 2013 See Exchange Act Release No.

34

- 70073

http://www.sec.gov/rules/final/fi

nalarchive/finalarchive2013.sht

ml Financial Responsibility Rules

for Broker

- Dealers July 30, 2013 See Exchange Act Release No.

34

- 70072

http://www.sec.gov/rules/final/fi

nalarchive/finalarchive2013.sht

ml

Frequently Asked Questions Concerning the Amendments to

Certain Broker

- Dealer Financial Responsibility Rules March 6, 2014 http://www. sec.gov/divisions/m arketreg/amendments

- to

broker

- dealer

- financial

responsibility

- rule

- faq.htm

Frequently Asked Questions Concerning the July 30, 2013

Amendments to the Broker

Dealer Financial Reporting Rule April 4 , 2014 http://www.sec.gov/divisions/m arketreg/amendments

- to

broker

- dealer

- reporting

- rule

faq.htm