Webinar Slides: New Reporting Requirements for Broker-Dealers

CBIZ & MHM Executive Education Series™ Broker-Dealer Update

Mike Loritz, Malcolm McDermid

May 13, 2014

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Today’s Presenters

Malcolm McDermid, CPA Shareholder, MHM 612.376.1230 | [email protected] Located in MHM’s Minneapolis, MN office, Malcolm has 30 plus years of experience in financial reporting for both public and private companies. In addition to his other audit and tax responsibilities, Malcolm manages the technical audit practice in the Minneapolis office. Areas of client industry specialization include wholesale and distribution, financial services, software and manufacturing.

Mike Loritz, CPA Shareholder, MHM 913.234.1226 | [email protected] Mike has 18 years of experience in public accounting with diversified financial companies and other service based companies, including banking, broker/dealer, investment companies, and other diversified companies ranging from audits of public entities in the Fortune 100 to small private entities. He is a member of MHM's Professional Standards Group, providing accounting knowledge leadership in the areas of derivative financial instruments, investment securities, share-based compensation, fair value, revenue recognition and others.

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Changes to SEC Rules/Regulations Financial Responsibility Rule Changes Reporting, Audit & Notification Requirements SEC Q&A’s

Independent Public Accountant’s Responsibility Attestation Standards Audit Standard No. 17 Interim Inspection Findings

PCAOB Conforming Rule Changes

Today’s Agenda

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SEC RULES & REGULATIONS


Changes to Financial Responsibility Rules (June 30, 2013) Changes to Rule 15c3-1 (Net Capital) Changes to Rule 15c3-3 (Customer Protection Rule) Changes to the Recordkeeping and Notice Requirements

(Rule 17a-3 & 4) Over $20 million in net capital or $1 million in credit adjustments -

Requirement to document procedures for managing risk & liquidity : “the credit, market, and liquidity risk management controls established and

maintained by the broker-dealer to assist it in analyzing and managing the risks associated with its business activities.”

Regulatory Activities – Summary


Enhance the ability of the SEC to oversee broker-dealer custody practices and, among other things, to: Increase the focus of broker-dealers that maintain custody of customer funds

and securities (“carrying broker-dealers”) and their independent public accountants on compliance, and internal control over compliance, with certain financial and custodial requirements;

Strengthen and clarify broker-dealer audit and reporting requirements in order to facilitate consistent compliance with these requirements;

Facilitate the ability of the PCAOB to implement the explicit oversight authority over broker-dealer audits provided to the PCAOB by the Dodd-Frank Act;

Ensure that SIPC receives the necessary information to assess whether the liquidation fund it maintains is appropriately sized to the risks of a large broker-dealer failure;

Enable Commission and DEA examiners to conduct risk-based examinations of carrying and clearing broker-dealers by assisting the examiners in selecting areas of focus for their examinations; and

Provide the Commission and the DEAs with a comprehensive overview of a broker-dealer’s custody practices

Regulatory Activities – Why?


Requirement to deduct certain liabilities or expenses assumed by third parties

In calculating net capital, deduct from net worth “… any liability or expense relating to the business of

the broker or dealer for which a third party has assumed the responsibility, unless the broker or dealer can demonstrate that the third party has adequate resources independent of the broker or dealer to pay the liability or expense.” (emphasis added) SEC Rule 15c3-1(c)(2)(i)(F) Rule change effective October 21, 2013

Changes to Rule 15c3-1


In calculating net capital, deduct from net worth capital contributions w/ intent to withdraw:

SEC Rule 15c3-1(c)(2)(i)(G) “… any contribution of capital to the broker or dealer: (1) Under an

agreement that provides the investor with the option to withdraw the capital; or (2) That is intended to be withdrawn within a period of one year of contribution. Any withdrawal of capital made within one year of its contribution is deemed to have been intended to be withdrawn within a period of one year, unless the withdrawal has been approved in writing by the Examining Authority for the broker or dealer.”

Rule change effective October 21, 2013



Previous Rule 15c3-1(e) (3)(i): LIMITATION ON WITHDRAWAL OF EQUITY CAPITAL

Temporary Restrictions on Withdrawal of Net Capital The Commission may by order restrict, for a period up to twenty business

days, any withdrawal by the broker or dealer of equity capital or unsecured loan or advance to a stockholder, partner, sole proprietor, employee or affiliate if such withdrawal, advance or loan: When aggregated with all other withdrawals, advances or loans on a net basis

during a 30 calendar day period exceeds 30 percent of the broker or dealer's excess net capital; and

The Commission, based on the facts and information available, concludes that the withdrawal, advance or loan may be detrimental to the financial integrity of the broker or dealer, or may unduly jeopardize the broker or dealer's ability to repay its customer claims or other liabilities which may cause a significant impact on the markets or expose the customers or creditors of the broker or dealer to loss without taking into account the application of the Securities Investor Protection Act.



Capital Withdrawals Rule 15c3-1(e)(3)(i) – “The Commission may by order restrict, for a period up to twenty business days, any withdrawal by the broker or dealer of equity capital or unsecured loan or advance to a stockholder, partner, sole proprietor, member, employee or affiliate under such terms and conditions as the Commission deems necessary or appropriate in the public interest or consistent with the protection of investors.”

Any amount of a withdrawal could be restricted, presumably excess net capital

would be difficult to determine Applies to withdrawal, advances and loans Rule change effective October 21, 2013



Solvency Requirements

A broker-dealer must be solvent. Considered insolvent if: Placed in a voluntary or involuntary bankruptcy or similar proceeding; Has a trustee, receiver, or similar official appointed; Makes a general assignment for the benefit of its creditors; Makes an admission of insolvency; or Is not able to make computations necessary to establish compliance with

the net capital rule.

If insolvent, must cease conducting business Notice sent to SEC, DEA, CFTC Rule change effective October 21, 2013



Potential Obligations when Guarantees Exist – Capital Contributions from Parent, Using Borrowed Funds Interpretation to SEA Rule 15c3-1(c)(2)/08 The parent of a broker-dealer may borrow funds and

infuse those funds as additional paid-in capital into the firm without adverse net capital consequences provided the broker-dealer: Is not, in any way, a party to the lending arrangement: Has no assets, directly or indirectly, pledged to secure the

loan; and Is not subject to any recourse of any kind to the lender for

collection of the loan against the parent. (emphasis added)

Rule 15c3-1: Other Matters


Source of Capital Contributions Acceptable contributions for regulatory purposes may be made by

existing owners or parties which receive newly issued ownership interests in exchange for their contributions.

Capital contributions from any other party will be considered a “loan” and excluded from regulatory capital.

Basis for the Limitation on Contributors Ownership and capital structures are deliberately designed. Capital contributions should be made in a manner consistent with the

capitalization structure of the firm. By-passing ownership structure creates potential risk to the

broker/dealer. Contributions from non-owners could be claimed in a lawsuit. Potential claims due to the insolvency of the contributing party

Rule 15c3-1: Other Matters


Proprietary Accounts Aligns the definition of customer with SIPC to include

introducing B/Ds Carrying Broker/Dealer Require a separate reserve computation for proprietary

accounts of other broker dealers In addition to the customer reserve computation previously required

Establish and fund a separate reserve bank account for the benefit of PAB account holders

Obtain and maintain physical possession or control of non-margin securities carried for PAB accounts



Proprietary Accounts Customer and PAB reserve accounts may not be held at A bank affiliated with the broker-dealer holding the PAB

account; A bank, to the extent that the amount of cash deposited in

the reserve account exceeds 15% of the bank’s equity capital (based on the bank’s most recently filed Call Report or Thrift Financial Report).

May use account for its own purposes provided the PAB

holder consents



Form Custody Require a broker-dealer to file a new quarterly report (called

Form Custody) within 17 business days of period end Contains information about whether and how the BD maintains

custody of its customers’ securities and cash. The reports will establish a custody profile for the broker-dealer that

examiners can use as a starting point to focus their custody examinations.

Designed to elicit information concerning whether a broker-dealer maintained custody of customer and non-customer assets, and, if so, how such assets were maintained.

Filed by all brokers and dealers without exception

Reporting Requirements


Form Custody Nine Items:

1. Accounts Introduced on a Fully Disclosed Basis 2. Accounts Introduced on an Omnibus Basis 3. Carrying Broker-Dealers 4. Carrying for Other Broker-Dealers 5. Trade Confirmations 6. Account Statements 7. Electronic Access to Account Information 8. Broker-Dealers Registered as Investment Advisers 9. Broker-Dealers Affiliated with Investment Advisers



New Reporting Requirements A broker-dealer that has custody of the customers’ assets

must file a “compliance report” with the SEC. The broker-dealer also must engage a PCAOB-registered independent

public accountant to prepare a report based on an examination of certain statements in the broker-dealer’s compliance report.

A broker-dealer that does not have custody of its customers’ assets must file an “exemption report” with the Commission citing its exemption from requirements applicable to carrying broker-dealers. The broker-dealer also must engage a PCAOB-registered

independent public accountant to prepare a report based on a review of certain statements in the broker-dealer’s exemption report.



New Reporting Requirements A broker-dealer that is a member of SIPC also must file its

annual reports with SIPC. Allows SIPC to better monitor industry trends and enhance

its knowledge of particular firms.

The examination or review of the new reports as well as the audit of the financial statements must be conducted in accordance with PCAOB Audit & Attestation standards.



New Reporting Requirements – Workpaper Access

Requires broker-dealers with custody (and/or clearing) to agree to allow the SEC or DEA to review the work papers of the independent public accountant if requested in writing for purposes of an examination of the broker-dealer. They must allow the accountant to discuss their findings with the

examiners.



Compliance Report The compliance report will be filed by a broker-dealer that maintains custody of customer funds or securities and includes management assertions that address: Whether it was in compliance in all material respects with

the specified rules related to net capital requirements and other items

Whether the information used to assert compliance was derived from the books and records of the company

Whether internal control over compliance was effective during the most recent fiscal year such that there were no instances of material weaknesses



The Compliance Report includes five specific statements 1. The broker-dealer has established and maintained Internal

Control Over Compliance 2. Internal Control Over Compliance was effective as of and

during the fiscal year 3. Internal Control Over Compliance was effective as of the end

of the fiscal year 4. Broker-dealer was in compliance with Rule 15c3-1 (the Net

Capital Rule) and Rule 15c3-3(e) (the Customer Reserve Requirement of the Customer Protection Rule) as of the end of the fiscal year

5. The information was derived from the books and records of the broker-dealer


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Compliance Report The Compliance Report must also include the

following, if applicable Each identified material weakness in the Internal Control

Over Compliance during and as of the end of the fiscal year

Any instances of non-compliance with the Net Capital and the Customer Reserve Requirement of the Customer Protection Rules as of the end of the fiscal year


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Compliance Report Carrying broker-dealer could not assert compliance with the Financial Responsibility Rules if it identifies one or more instances of material non-compliance Material non-compliance: A failure by the broker-dealer to

comply with any of the requirements of the Financial Responsibility Rules in all material respects

Material weakness: A deficiency, or a combination of deficiencies, in internal control over compliance with the Financial Responsibility Rules, such that there is a reasonable possibility that material noncompliance with those provisions will not be prevented or detected on a timely basis

Regulatory Activities – Summary


Exemption Report The exemption report will be filed by a broker-dealer that

claims exemption from the requirements of the SEC rule related to the safeguarding of customer assets Will also identify the specific conditions that form the basis

for the exemption Includes the following statements: Identified the exemption claimed under Rule 15c3-3(k) Met the identified exemption provision of Rule 15c3-3(k)

during the fiscal year without exception or exceptions are described in the Exemption Report

If applicable, identification of exception during the fiscal year (include nature and approximate date)



The SEC released a Frequently Asked Q&A document on March 6, 2014 related to the changes to the Financial Responsibility Rules: Clarify expense sharing arrangements are included in the 15c3-1

changes Clarify definition of affiliate (bank) May borrow securities for compliance with 15c3-3 Notice and other clarifications (PAB accounts) Free credit balance transactions

SEC Q&A – March 6, 2014


The SEC release a Frequently Asked Q&A document on April 4, 2014 related to the changes to the Reporting, Audit and Notification Requirements: Clarify reporting period for the compliance report (June 1, 2014) Accountant’s report must cover internal controls since the date of the

last examination Accountant’s report does not satisfy the Custody Rule requirements Reporting dates regarding accountant (10th day of the month of the

fiscal year end – i.e. Dec 10 for December 31) PAB reserve requirements calculation included in the supporting

schedules Clarifies instances in which an exemption report may be filed Various clarifications regarding Form Custody

SEC Q&A – April 4, 2014

INDEPENDENT PUBLIC ACCOUNTANT’S RESPONSIBILITY


Amended Rule 17a-5(d)(5) to replace the term “annual audit report” with “annual reports”

Annual reports include Financial report (Audited financial statements and

supplemental schedules) Compliance or Exemption report issued by management Reports prepared by an independent public accountant

covering either the compliance or exemption report Due date: 60 calendar days after the fiscal year end

Filing Annual Reports

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New rules, applicable to audits for year-ends on and after June 1, 2014: Audits of financial reports will be prepared in accordance

with the PCAOB Standards SEC amended Rule 17a-5 to state that examination of

Compliance Reports and review of Exemption Reports will be in accordance with PCAOB Standards

Auditor’s Report on Internal Control previously required by SEC Rule 17a-5(g)(1) is replaced by the auditor’s Examination Report or Review Report, as appropriate

Engagement of the Accountant

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PCAOB issued new standards to align attestation standards more closely with the auditor’s responsibility under the amendments to Rule 17a-5: The PCAOB issued a new auditing standard on

supplemental information accompanying audited financial statements that broker-dealers and issuers file with the SEC, such as supporting schedules.

Two attestation standards related to the auditor's examination of compliance reports and review of exemption reports of broker-dealers.

Auditor’s Responsibility


Requires the auditor to obtain moderate assurance about the following statements in the exemption report: A statement that identifies the exemptive provisions

claimed by the broker-dealer A statement that the broker-dealer

Met the identified exemption provisions throughout the fiscal year without exception OR

Met the identified exemption provisions throughout the fiscal year, except as described in exemption report

If applicable, identification of each exception with descriptions (nature and approximate date(s))

Auditor’s Responsibility - Exemption

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We have reviewed management's assertion, included in the accompanying [title of the exemption report], that ABC Broker is exempt from the provisions of Rule15c3-3 under the Securities Exchange Act of 1934 because it meets conditions set forth in paragraph (k) ([fill in which exemption provision – (1), (2)(i), (2)(ii), or(3)]) of that rule (the "exemption conditions"). ABC Broker's management is responsible for compliance with the exemption conditions and its assertion. Our review was conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States) and, accordingly, included inquiries and certain other procedures to obtain evidence about ABC Broker's compliance with the exemption conditions. A review is substantially less in scope than an examination, the objective of which is the expression of an opinion on management's assertion. Accordingly, we do not express such an opinion. Based on our review, nothing came to our attention that caused us to believe that management's assertion referred to above is not fairly stated, in all material respects, based on the conditions set forth in paragraph (k)([fill-in which exemption provision – (1), (2)(i), (2)(ii), or (3)]) of Rule 15c3-3 under the Securities Exchange Act of 1934.

Sample Review Report


Auditing Standard No. 17, Auditing Supplemental Information Accompanying Auditing Financial Statements Establishes the auditor's responsibilities when performing

audit procedures and reporting on supplemental information that accompanies the audited financial statements of broker-dealers and others (may include employee benefit plans)

Intended to give the SEC and other users greater confidence in the quality and consistency of supplemental information accompanying financial statements

Auditor’s Responsibility - SI

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Auditor performance requirements included in AS 17 include the following: Determine that the supplemental information reconciles to

the underlying accounting and other records or to the financial statements, as applicable

To test the completeness and accuracy of the supplemental information (to the extent it was not tested as part of the annual audit of the financial statements)

To evaluate whether or not the supplemental information, including form and content, complies with the relevant regulatory requirements or other applicable criteria


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Supplemental Information refers to the following items: Supporting schedules required to be filed pursuant to Rule 17a-5 Supplemental information (1) Required to be presented pursuant to the

rules and regulations of a regulatory authority (2) Covered by an auditor’s report on that information related to financial statements that are audited in accordance with PCAOB standards

Although not required, information that is Ancillary to the audited financial statements; Derived from the company’s accounting books and records; and Covered by an auditor’s report on that information related to

financial statements that are audited in accordance with PCAOB standards


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The notification provisions for broker-dealers (Rule 17a-11) have not changed. Replaced “material inadequacies” with “material

weakness” Broker-dealer must provide a copy of the notification to the

auditor within one business day. If the auditor does not receive or agree with the statements

in the notice, the accountant must provide a report to the SEC and DEA regarding the disagreement within one business day.

Auditor’s Responsibility

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Format of inspections: Annual report on significant observations obtained during the

inspections These reports are not firm-specific.

Identify and address with the inspected firm any significant issues in its audit work

Where appropriate, information about potential violations by brokers or dealers would be referred to the SEC and other authorities

May lead to an investigation or disciplinary proceedings regarding the conduct of the firm

PCAOB - Interim Inspection Details


Audit Deficiencies Number of Audits with Deficiencies

Number of Applicable

Audits

Percentage of Audits with Deficiencies

Risk of Material Misstatement Due to Fraud 37 60 62% Related Party Transactions 25 60 42% Revenue Recognition 42 60 70% Reliance on Records and Reports 30 60 50% Fair Value Measurements 5 19 26% Evaluation of Internal Control Deficiencies 6 60 10% Financial Statement Disclosures 29 60 48% Understanding the Entity 4 60 7% Auditor's Report 18 60 30%

Inspections Observations – 2013


PCAOB Observation: Deficiencies noted related to: Audit response to identified fraud risk Presumption that revenue recognition is a fraud risk Journal entry testing

Consideration of Material Mis-statement Due to Fraud


PCAOB Observation Deficiencies noted related to: No procedures performed Existence and identification of related parties and related

party transactions Examining identified related party transactions Other

Related Party Transactions


PCAOB Observation There is insufficient testing of revenues The testing of revenues must be on a disaggregated basis Their expectation for detailed testing of revenue

transaction is high – probably 65-70% or more In order to reduce this level of detailed testing one needs

to do tests of controls Inappropriate use of substantive analyticals

Revenue Recognition


PCAOB Observations Auditing of the company’s net capital information Minimum net capital requirements Allowable assets Haircuts Operational charges

Internal control report Have material inadequacies been disclosed Compliance with exemption claimed under 15c3-3 Evaluation of reported net capital Timely notification of material inadequacy to FINRA/SEC

Auditing Supporting Schedules


PCAOB Observation Deficiencies noted related to: Reasonable assurance to support whether material

inadequacies were disclosed Exemption claimed under Rule 15c3-3 Evaluation of reported net capital deficiencies as indicators

of a material inadequacy Timely notification of material inadequacy to SEC/FINRA

Accountant’s Supplemental Report on Material Inadequacies


Misuse of accounts Inappropriate use of firm error accounts, or other accounts

For the benefit of the firm For the benefit of a customer(s)

Failing to recognize charges to net worth Unsecured debits Open contractual commitment changes

Inappropriate role of affiliates Activity may require the affiliate to register as a broker-dealer Activity which if conducted would result in a higher net capital

requirement

“Borrowing” capital Existence of contingent guarantees

Examination Findings

PCAOB CONFORMING RULE CHANGES


WHY? The Rules include specific references to audits and auditors

of brokers and dealers in the PCAOB’s rules Ensure that the PCAOB can satisfy its explicit oversight authority

granted under the Dodd-Frank Act with respect to audits and auditors of brokers and dealer that are registered with the SEC.

The Rules include amendments that tailor certain of the Board’s rules to the audits of

brokers and dealers, call for relevant broker and dealer audit client information on the

Board’s forms, and amend a number of rules in light of the Board’s experience

administering and enforcing these rules

Key Amendments to Conform PCAOB Rules and Forms to the Dodd-Frank Act


Overall: Added definition of audit committee (Rule 3501 & 3526) Overall framework (Rules 3502 and 3520) Independence Contingent fees (Rule 3521) Tax transactions (Rule 3522) Tax services for persons in a financial reporting oversight role (Rule

3523) PCAOB independence rules applicable to auditors of issuers but not to

auditors of brokers and dealers (Rules 3524 and 3525) Communications with audit committees concerning independence (Rule

3526) No deferred compliance date for Rules 3521-3526



Definition of Audit Committee: The term "audit committee" means a committee (or equivalent

body) established by and among the board of directors of an entity for the purpose of overseeing the accounting and financial reporting processes of the entity and audits of the financial statements of the entity; if no such committee exists with respect to the entity, the entire board of directors of the entity. For audits of non-issuers, if no such committee or board of directors (or equivalent body) exists with respect to the entity, "audit committee" means the person(s) who oversee(s) the accounting and financial reporting processes of the entity and audits of the financial statements of the entity.



Questions?


Join us for these courses: Implementation Issues of the New Private Company Accounting

Alternatives, May 15 Is an ESOP Right for Your Company, May 20 Is Your Company Ready for the New Revenue Recognition

Standards? May 27

Read these related publications: MHM Messenger 14-11: Regulatory Considerations for Broker-

Dealers

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http://www.mhmcpa.com/Resources/Webinars/Is-an-ESOP-Right-for-Your-Company-Repeat.aspx

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Webinar Slides: New Reporting Requirements for Broker-Dealers