Brokers and Dealers in Securities - AICPA Audit and Accounting Guide

Containing authoritative accounting and auditing literature with which financial managers and auditors must comply, the Brokers and Dealers in Securities Audit and Accounting Guide has been revised to reflect the Risk Assessment Standards and other conforming changes as of May 1, 2007, as well as recent PCAOB standards, and relevant new pronouncements issued by the FASB, the ASB and regulatory bodies.  It summarizes applicable practices and delivers "how-to" advice for handling almost every type of financial statement.

Preface

Purpose

This American Institute of Certified Public Accountants (AICPA) Audit and Accounting Guide has been prepared to assist brokers and dealers (broker-dealers) in securities in preparing financial statements in conformity with generally accepted accounting principles (GAAP) and to assist independent accountants in reporting on financial statements (and other written management assertions) of those entities.

Applicability

This guide applies to preparation and audit of financial statements of entities that are broker-dealers in securities. The activities of broker-dealers in securities are described in Chapter 1. Operations of such entities are subject to the rules and regulations of the Securities and Exchange Commission (SEC) and other regulatory bodies.

Broker-dealers in securities are subject to regulation under the Securities Exchange Act of 1934. Some broker-dealers are also futures commission merchants for commodity futures and commodity option contracts subject to regulation under the Commodity Exchange Act.*

Members of the National Association of Securities Dealers, Inc. (NASD)†are subject to the rules of that association, and members of securities exchanges are also subject to the rules of the exchanges of which they are members. Some of these rules, as currently in effect, are discussed in this guide. However, the rules, regulations, practices, and procedures of the securities and commodities futures industries have changed frequently and extensively in recent years. Still further changes are under consideration as this guide goes to press, and the auditor should keep abreast of these changes.

Limitations

The guide is intended to highlight significant matters and establish general guidance. It is not intended to provide comprehensive discussion of all possible matters of significance in an audit of financial statements or all audit situations that an independent accountant might encounter in an audit of the financial statements of a broker-dealer.

* The Commodity Practice Aid Task Force of the AICPA is in the process of revamping the Audits of Futures Commission Merchants, Introducing Brokers, and Commodity Pools practice aid to reflect changes in accounting and auditing guidance and regulatory rules that occurred since the original issuance of this publication. The revised practice aid will provide practitioners with nonauthoritative, practical guidance on auditing financial statements of futures commission merchants, introducing brokers, and commodity pools. Readers should be alert to further developments.

† The NASD and New York Stock Exchange (NYSE) consolidated their member regulation, enforcement and arbitration functions into a single self-regulatory organization (SRO) in July, 2007. This new entity has been named Financial Industry Regulatory Authority (FINRA). For more information go to the Web site at finra.org.

Consulting the accounting and financial reporting and auditing sections of the guide cannot take the place of a careful reading of specified authoritative literature. Other professional literature and authoritative guidance that may be issued by the Accounting Standards Executive Committee (AcSEC), the Financial Accounting Standards Board (FASB), including its Emerging Issues Task Force (EITF), the Auditing Standards Board (ASB) or the Public Company Accounting Oversight Board (PCAOB) may affect audits of the financial statements of broker-dealers. Further, the nature, timing, and extent of audit procedures applied in a financial audit is ultimately determined by the independent accountant in the circumstances. The procedures discussed in the auditing section of the guide are not intended to be comprehensive and, performed by themselves, would not necessarily constitute an audit in accordance with generally accepted auditing standards (GAAS). Nor would omission of certain procedures set forth in the guide necessarily result in a violation of GAAS. Internal control over financial reporting and possible tests of controls are discussed in the context of a financial statement audit. While they may correspond to controls that are subject to procedures performed in an engagement performed in accordance with PCAOB standards or Statement on Standards for Attestation Engagements (SSAEs), internal control over financial reporting and possible tests of controls are not presented in that context and are not intended to address the considerations of such engagements.

Impact on Other Literature

This guide supersedes the AICPAAudit and Accounting GuideAudits of Brokers and Dealers in Securities.

The guide incorporates and supersedes SOP 90-3, Definition of the Term Substantially the Same for Holders of Debt Instruments, as Used in Certain Audit Guides and a Statement of Position, to the extent SOP 90-3 amended previous editions of the AICPA Audit and Accounting Guide Audits of Brokers and Dealers in Securities. The guide incorporates and supersedes the following SOPs:

a. SOP 89-1, Reports on Audited Financial Statements of Brokers and Dealers in Securities

b. SOP 89-4, Reports on the Internal Control Structure in Audits of Brokers and Dealers in Securities

Effective Date and Transition

For accounting and financial reporting provisions of this guide that describe other authoritative literature, effective dates should be applied as provided for in the related literature. All other accounting and financial reporting provisions of the guide, shall be effective for annual financial statements issued for fiscal years beginning after December 15, 1997, and for interim financial statements issued after initial application. The auditing provisions of this guide shall be applied prospectively to audits of broker dealers' financial statements for fiscal years ending after December 15, 1997. Earlier application of the accounting, financial reporting, and auditing provisions of this guide is permitted but not required.

This guide requires two changes in financial reporting: (1) it does not allow combining of subordinated debt with stockholders' equity and (2) it requires that delayed delivery transactions be reported in the statement of condition on the settlement (delivery) date instead of the trade date.

The changes are effective for annual financial statements issued for fiscal years beginning after December 15, 1997. If comparative annual financial statements are presented for earlier periods, restatement is recommended but not required.

Auditing Guidance Included in This Guide

In March 2006, the ASB issued Statements on Auditing Standards (SAS) Nos. 104-111 (the "risk assessment standards"). Collectively, the risk assessment standards establish standards and provide guidance concerning the auditor's assessment of the risks of material misstatement (whether caused by fraud or error) in a non-issuer financial statement audit; the design and performance of tailored audit procedures to address assessed risks; audit risk and materiality; planning and supervision; and audit evidence. The most significant changes to existing practice that the auditor will be required to perform are as follows:

• Obtain a more in-depth understanding of the audited entity and its environment, including its internal control
• Perform a more rigorous assessment of the risks of where and how the financial statements could be materially misstated (defaulting to a maximum control risk is no longer permitted)
• Provide a linkage between the auditor's assessed risks and the nature, timing and extent of audit procedures performed in response to those risks

The statements are effective for audits of financial statements for periods beginning on or after December 15, 2006. Early adoption is permitted. See Appendix Q for a more detailed comparison between the risk assessment standards and the existing standards.

This guide has been conformed to the new risk assessment standards to indicate, at a minimum, where these standards need to be applied. Additional implementation guidance, specific to this industry, is being developed and will be incorporated in the 2008 edition.

For additional guidance on the risk assessment standards, please refer the AICPA Audit Guide, Assessing and Responding to Risk in a Financial Statement Audit, and the AICPA Audit Risk Alert, Understanding the New Auditing Standards Related to Risk Assessment.

References to Professional Standards

In citing the professional standards, references are made to the AICPA Professional Standards publication. In those sections of the guide where specific PCAOB auditing standards are referred to, references are made to the AICPA's PCAOB Standards and Related Rules publication. Please refer to Appendix P AAG-BRD x of this guide for a summary of major existing differences between AICPA Standards and PCAOBStandards. Additionally, when referencing professional standards, this guide cites section numbers and not the original statement number, as appropriate. For example, SAS No. 54 is referred to as AU section 317.

Applicability of Requirements of the Sarbanes-Oxley Act of 2002, Related Securities and Exchange Commission Regulations, and Standards of the Public Company Accounting Oversight Board

Publicly-held companies and other "issuers" (see definition below) are subject to the provisions of the Sarbanes-Oxley Act of 2002 (Act) and related SEC regulations implementing the Act. Their outside auditors are also subject to the provisions of the act and to the rules and standards issued by the PCAOB.

Section 205(c)(2) of the Act amended Section 17 (15 U.S.C. 78q) of the Securities Exchange Act of 1934 to require all broker-dealers (both public and private) to be audited by a public accounting firm registered with the PCAOB. However, on December 12, 2006, the SEC extended its Order, which permits nonpublic broker-dealers to file with the SEC and to send to their customers documents and information required by Section 17(e) certified by an independent public accountant, instead of by a registered public accounting firm for fiscal years ending before January 1, 2009. (see SEC Web site at www.sec.gov/rules/other/2006/34-54920.pdf. The original Order, issued on August 4, 2003, and extended on July 14, 2004 and December 7, 2005, was set to expire on January 1, 2007.

Presented below is a summary of certain key areas addressed by the act, the SEC, and the PCAOB that are particularly relevant to the preparation and issuance of an issuer's financial statements and the preparation and issuance of an audit report on those financial statements. However, the provisions of the Act, the regulations of the SEC, and the rules and standards of the PCAOB are numerous and are not all addressed in this section or in this guide. Issuers and their auditors should understand the provisions of the act, the SEC regulations implementing the Act, and the rules and standards of the PCAOB, as applicable to their circumstances.

Definition of an Issuer

The Act states that the term "issuer" means an issuer (as defined in section 3 of the Securities Exchange Act of 1934 [15 U.S.C. 78c]), the securities of which are registered under section 12 of that Act (15 U.S.C. 78l), or that is required to file reports under section 15(d) (15 U.S.C. 78o(d)), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 (15 U.S.C. 77a et seq.), and that it has not withdrawn.

Issuers, as defined by the Act, and other entities when prescribed by the rules of the SEC (collectively referred to in this guide as "issuers" or "issuer") and their public accounting firms (who must be registered with the PCAOB) are subject to the provisions of the Act, implementing SEC regulations, and the rules and standards of the PCAOB, as appropriate.

Non-issuers are those entities not subject to the Act or the rules of the SEC.

Guidance for Issuers†

Management Assessment of Internal Control

As directed by Section 404 of the Act, the SEC adopted final rules requiring companies subject to the reporting requirements of the Securities Exchange Act of 1934, other than registered investment companies and certain other entities, to include in their annual reports a report of management on the company's internal control over financial reporting. See the SEC Web site at www.sec.gov/rules/final/33-8238.htm for the full text of the regulation.

Companies that are "large accelerated filers" or "accelerated filers," as defined in the Securities Exchange Act of 1934 rule 12b-2, are required to comply with these rules for fiscal years ending on or after November 15, 2004. Foreign private issuers that are large accelerated filers or accelerated filers and that file their annual reports on form 20-F or 40-F must begin to comply with the rules for the first fiscal year ending on or after July 15, 2006. "Nonaccelerated filers" including foreign private issuers that are not accelerated filers are required to comply with the rules for the first fiscal year ending on or after December 15, 2007. See the SEC web site at www.sec.gov for further information.

The SEC rules clarify that management's assessment and report is limited to internal control over financial reporting. The SEC's definition of internal control encompasses the Committee of Sponsoring Organizations of the Treadway Commission (COSO) definition but the SEC does not mandate that the entity use COSO as its criteria for judging effectiveness.

Under the SEC rules, the company's annual 10-K must include:

1. Management's Annual Report on Internal Control Over Financial Reporting

2. Attestation Report of the Registered Public Accounting Firm

3. Changes in Internal Control Over Financial Reporting

The SEC rules also require management to evaluate any change in the entity's internal control that occurred during a fiscal quarter and that has materially affected, or is reasonably likely to materially affect, the entity's internal control over financial reporting.

Audit Committees and Corporate Governance

Section 301 of the Act establishes requirements related to the makeup and the responsibilities of an issuer's audit committee. Among those requirements--

† On June 20, 2007 the SEC approved an amendment to new interpretive guidance designed to help management of public companies strengthen internal control over financial reporting and enhance compliance under Section 404 of the Sarbanes-Oxley Act of 2002. The guidance, Release No. 33-8809, Amendments to Rules Regarding Management's Report on Internal Control Over Financial Reporting, provides clarification for management regarding its evaluations of internal control over financial reporting and the auditor's reporting requirements pursuant to Section 404(b) of the Sarbanes-Oxley Act. Under the guidance, management can align the nature and extent of its evaluation procedures with those areas of financial reporting that pose the highest risks to reliable financial reporting. The amendments provide that a company that performs an evaluation in accordance with the new interpretive guidance also satisfies the annual evaluation required by the Securities Exchange Act of 1934 rules 13a-15 and 15d-15. Among other rule changes, the SEC also redefined the term material weakness and revised the requirements regarding the auditor's attestation report on the effectiveness of internal control over financial reporting to require the auditor to express an opinion directly on the effectiveness of internal control over financial reporting and not on management's evaluation process. Readers should refer to the SEC Web site at www.sec.gov for more information.

• Each member of the audit committee must be a member of the board of directors of the issuer, and otherwise be independent.
• The audit committee of an issuer is directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer.
• The audit committee shall establish procedures for the "receipt, retention, and treatment of complaints" received by the issuer regarding accounting, internal controls, and auditing.

In April 2003, the SEC adopted a rule to direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements mandated by the Act.

Disclosure of Audit Committee Financial Expert and Code of Ethics

In January 2003, the SEC adopted amendments requiring issuers, other than registered investment companies, to include two new types of disclosures in their annual reports filed pursuant to the Securities Exchange Act of 1934. These amendments conform to Sections 406 and 407 of the Act and relate to disclosures concerning the audit committee's financial expert and code of ethics relating to the companies' officers. An amendment specifies that these disclosures are only required for annual reports.

Certification of Disclosure in an Issuer's Quarterly and Annual Reports

Section 302 of the Act requires the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of each issuer to prepare a statement to accompany the audit report to certify the "appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer."

In August 2002, the SEC adopted final rules for Certification of Disclosure in Companies' Quarterly and Annual Reports in response to Section 302 of the Act. CEOs and CFOs are now required to certify the financial and other information contained in quarterly and annual reports.

Improper Influence on Conduct of Audits

Section 303 of the Act makes it unlawful for any officer or director of an issuer to take any action to fraudulently influence, coerce, manipulate, or mislead any auditor engaged in the performance of an audit for the purpose of rendering the financial statements materially misleading. In April 2003, the SEC adopted rules implementing these provisions of the Act.

Disclosures in Periodic Reports

Section 401(a) of the Act requires that each financial report of an issuer that is required to be prepared in accordance with GAAP shall "reflect all material correcting adjustments . . . that have been identified by a registered accounting firm . . . ." In addition, "each annual and quarterly financial report . . . shall disclose all material off-balance sheet transactions" and "other relationships" with "unconsolidated entities" that may have a material current or future effect on the financial condition of the issuer.

In January 2003, the SEC adopted rules that require disclosure of material off-balance sheet transactions, arrangements, obligations, and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses. The rules require an issuer to provide an explanation of its off-balance sheet arrangements in a separately captioned subsection of the Management's Discussion and Analysis section of an issuer's disclosure documents.

Guidance for Auditors||

The Act mandates a number of requirements concerning auditors of issuers, including mandatory registration with the PCAOB, the setting of auditing standards, inspections, investigations, disciplinary proceedings, prohibited activities, partner rotation, and reports to audit committees, among others. Auditors of issuers should familiarize themselves with applicable provisions of the Act and the standards of the PCAOB. The PCAOB continues to establish rules and standards implementing provisions of the Act concerning the auditors of issuers.

Applicability of Generally Accepted Auditing Standards and Public Company Accounting Oversight Board Standards

The Act authorizes the PCAOB to establish auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms in the preparation and issuance of audit reports for entities subject to the Act or the rules of the SEC. Accordingly, public accounting firms registered with the PCAOB are required to adhere to all PCAOB standards in the audits of "issuers," as defined by the Act, and other entities when prescribed by the rules of the SEC. For those entities not subject to the Act or the rules of the SEC, the preparation and issuance of audit reports remain governed by GAAS as issued by the ASB. SEC Interpretive Release No. 33-8422 specifies that effective May 24, 2004, references in SEC rules and staff guidance and in the federal securities laws to GAAS or to specific standards under GAAS, as they relate to issuers, should be understood to mean the standards of the PCAOB, plus any applicable rules of the SEC. The guidance in this release is applicable only to auditors' engagements that are governed by PCAOB rules. Because the PCAOB has not established particular auditing standards for nonissuer broker-dealers, this release is not applicable to such engagements and related filings.

|| On May 24, 2007, the PCAOB adopted Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, to replace Auditing Standard No. 2. The new standard was approved by the SEC on July 25, 2007 and will be effective for all audits of internal control for fiscal years ending on or after November 15, 2007. Earlier application will be permitted. Auditing Standard No. 5 is principles-based. It is designed to increase the likelihood that material weaknesses in internal control will be found before they result in material misstatement of a company's financial statements, and, at the same time, eliminate procedures that are unnecessary. The final standard also focuses the auditor on the procedures necessary to perform a high quality audit that is tailored to the company's facts and circumstances. This version of the guide has not been updated for Auditing Standard No. 5. Readers should refer to the PCAOB Web site at www.pcaob.org for more information.

Major Existing Differences Between GAAS and PCAOB Standards

The major differences between GAAS and PCAOB standards are described in both Part I of volume one of the AICPA Professional Standards and in Part I of the AICPA publication titled, PCAOB Standards and Related Rules. See also Appendix P --Major Differences Between AICPA Standards and PCAOB Standards.

Other Requirements

The Act contains requirements in a number of other important areas, and the SEC has issued implementing regulations in certain of those areas as well. For example,

• The Act prohibits auditors from performing certain non-audit or non-attest services. The SEC adopted amendments to its existing requirements regarding auditor independence to enhance the independence of accountants that audit and review financial statements and prepare attestation reports filed with the SEC. This rule conforms the SEC's regulations to Section 208(a) of the Act and, importantly, addresses the performance of non-audit services.
• The Act requires the lead audit or coordinating partner and the reviewing partner to rotate off of the audit every five years. (See SEC Releases 33-8183 and 33-8183A for SEC implementing rules.)
• The Act directs the PCAOB to require a second partner review and approval of audit reports (concurring review).
• The Act states that an accounting firm will not be able to provide audit services to an issuer if one of that issuer's top officials (CEO, Controller, CFO, Chief Accounting Officer, etc.) was employed by the firm and worked on the issuer's audit during the previous year.