By Sarah N. Lynch
WASHINGTON, Oct 10 (Reuters) - The U.S. audit watchdog
adopted new standards on Thursday that would force auditors to
scrutinize securities brokerages more closely, finalizing a
long-awaited reform that came about in the wake of Bernard
Madoff's $65 billion Ponzi scheme.
The Public Company Accounting Oversight Board, which polices
public company auditors, won new powers under the 2010
Dodd-Frank Wall Street reform law to write standards, routinely
inspect and discipline the auditors of broker-dealers.
Under the new PCAOB rules, auditors of brokerages that hold
custody of client money will be required to conduct reviews of
those brokerages' internal controls, make sure the brokerages
are complying with federal net capital rules and make sure
customer money has not been misappropriated.
The PCAOB also adopted a new standard that applies to
auditors of brokers who do not have custody of customer funds,
as well as a third standard laying out requirements for how
auditors should review "supplemental information" that
brokerages often provide to regulators.
Madoff managed to get away with duping investors for so many
years in part thanks to his auditor, David Friehling of
Friehling & Horowitz, who operated his audit firm out of a strip
mall in New City, New York. Friehling pleaded guilty in 2009 to
fraud charges but claimed he did not know that Madoff was
running a Ponzi scheme. He is awaiting sentencing.
"The new standards will enhance consumer protection by
strengthening performance standards for the audit of brokers and
dealers in important areas relating to financial soundness and
compliance with legal requirements," PCAOB board member Lewis
The PCAOB was unable to approve the new standards
immediately after the enactment of the Dodd-Frank law because it
had to wait for the Securities and Exchange Commission to
complete related new rules for brokerages.
The SEC's rule, which was adopted in July, requires
broker-dealers to file certain reports with regulators and hire
an independent public accountant.
The toughest new requirements in the SEC's rule apply to
brokers who, like Madoff, have custody of their clients' money,
a factor that raises the risk for fraud or misappropriation of
The SEC's rule requires brokerages that have custody of
assets to file a "compliance report" with the SEC to verify they
are following the agency's capital requirements and customer
protection rules. Under the PCAOB's new standard, auditors will
be required to scrutinize that document closely.
Brokerages without custody must file an exemption report,
and outside auditors must review that report to help verify it
under the PCAOB's new standards.
Although the PCAOB adopted the new audit standards only on
Thursday, it has been operating an interim inspection program
for two years to check auditors' work.
During that time, the PCAOB uncovered widespread flaws and
issues with auditors failing to check properly for accounting
fraud risks or test controls over customer funds.
In its second annual report released in August, the PCAOB
said it uncovered problems in 95 percent of the 60 audits it
checked - similar to its findings the prior year.
"We have seen significant compliance problems," PCAOB
Chairman Jim Doty said on Thursday. "It is clear many firms will
need to significantly improve their work under any set of
standards to meet the SEC's requirements and more importantly,
the public's expectations."
The PCAOB's standards must be finalized by the SEC before
they take effect.
Until then, the PCAOB will continue to run an interim
inspection program for broker-dealer auditors until rules for a
permanent program can be completed. A rule proposal for a
permanent inspection program is expected to be unveiled in 2014
at the earliest.