Bloomberg News

Broker-Dealer Audits to Intensify Under U.S. Regulator Proposal

March 09, 2012

Broker-dealers and public companies would be subject to stricter audits that probe relationships with subsidiaries, shareholders and executive officers for any hint of manipulation or fraud under new standards proposed by the Public Company Accounting Oversight Board.

Under the plan, auditors would also dig into executive compensation agreements and “significant unusual transactions” -- those that seem outside a company’s normal course of business -- for signs of the types of abuses that led to corporate financial failures involving Enron (ENRNQ) Corp., WorldCom Group (WCOEQ) and others, according to Bloomberg’s Financial Regulation newsletter.

The plan calls for penalties -- including potential fines and disbarment -- for auditors who fail to comply. The new standards would apply to broker-dealers because the Dodd-Frank Wall Street Reform and Consumer Protection Act, the most significant financial regulatory reform law since the Great Depression, gave the PCAOB oversight of broker-dealer auditors.

The new standards would be part of the audits that registered financial institutions are required to file each year with the U.S. Securities and Exchange Commission.

“Related parties” are the chief focus of the proposal, and can include subsidiaries, executives, shareholders or relatives tied to the company. The goal of the plan, which the PCAOB opened to public comment last week, is to strengthen audit standards so they can better expose transactions designed to hide fraud.

Few Challenges

The PCAOB’s own inspections and enforcement actions illustrate that historically, auditors have not aggressively challenged related-party relationships and transactions. One- quarter of the board’s settled disciplinary orders cite auditor failures with respect to related-party or similar transactions, PCAOB member Daniel Goelzer said last week.

Following PCAOB approval, the SEC must sign off on the plan. Comments are due May 15.

“When you can influence, you can get special terms and special deals, you can persuade a party to do something for your benefit,” said Greg Scates, deputy chief auditor for the PCAOB, in a phone interview. “You can make the numbers look a little rosier, which can lead to financial fraud.”

The PCAOB is a non-profit that Congress created to oversee public company audits.

Related Parties

The board’s proposal would require auditors to identify a company’s related parties -- those with which it has a potentially symbiotic relationship -- understand the terms and business reasons of the transactions between the company and related parties and note any related-party dealings that a company hasn’t disclosed. Auditors must also be more direct with managers when gathering information on related parties and their business arrangements with a company, discuss such transactions with the company’s audit committee and ensure the accounting and disclosures are adequate.

With regard to executive compensation agreements, auditors would have to consider ways senior executives might be motivated to manipulate accounts to meet performance targets.

The PCAOB recommends this type of auditing diligence, and Generally Accepted Accounting Principles require auditors to disclose close relationships behind business deals and assure the accounting behind them is above-board. But PCAOB member Goelzer said his board’s inspections and enforcement actions indicate not all auditors follow these guidelines diligently.

Legitimate Transactions

Related-party transactions can be legitimate activities that serve practical purposes, such as tax planning and liability insulation. If abused, however, such transactions can be a way to overstate the results of operations or a company’s financial condition, or a way to divert value from the company to benefit an insider.

Issues with related parties played a prominent role in scandals at Enron Corp. (ENRNQ), Tyco International Ltd. (TYC) and Refco Inc. (RFXCQ) For instance, Enron used close relationships with certain entities to paint an inaccurate picture of the company’s financial health. A study by the Committee of Sponsoring Organizations of the Treadway Commission, a group of five auditing and accounting professional organizations, found that companies that engage in fraud also typically have more related- party transactions.

Ralph V. De Martino, chairman of the global securities practice group at Cozen O’Connor, said the proposal should have “a positive effect,” though he noted that audit costs have skyrocketed since adoption of the Sarbanes-Oxley Act of 2002.

“The burden of those costs has been inordinately borne by small- and mid-cap companies,” De Martino said in an e-mail. “Any additional audit procedures will escalate those costs.”

Robust Education

De Martino cautioned that new auditing standards should be paired with robust education -- such as the training offered by the National Association of Corporate Directors -- that provides auditors and companies with examples of the types of fraud they should be watching for.

“Often, the members of audit committees don’t have the sophistication to appreciate how related-party transactions may be used to misstate a company’s financial condition or results of operations,” he said. “There needs to be an additional effort, outside of the PCAOB’s mandate, to educate the community. Changes of this type are most productive when accompanied by the presentation of actual or hypothetical audit failures and the resulting impact on financial reporting.”

To contact the reporter on this story: Dana Wilkie in Washington at

To contact the editor responsible for this story: Maura Reynolds at

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