17
Banking & Securities Update Winter 2011
Banking & Securities Update
Winter 2011
In this issue
3 BanksAudit and accounting update3 Update on the FASB’s Financial Instruments Project,
including credit impairment and fair value3 U.S. Department of Housing and Urban Development
(HUD): Financial statement requirements revised for parent-subsidy structures
4 Deferral of troubled debt restructuring disclosures5 Grant Thornton issues updated guidance on
accounting for loan participations and securitizations5 Overview of the Small Business Lending Fund5 OCC issues updated guidance on common
accounting issues for banks5 The American Institute of Certifi ed Public
Accountants (AICPA) issues Audit Risk Alert: Financial Institutions Industry Developments — Including Depository and Lending Institutions and Brokers and Dealers in Securities
SEC and Public Company Accounting Oversight Board (PCAOB) update6 SEC staff describes common reporting issues for
fi nancial institutions6 SEC issues Proposed Rule on short-term borrowings
and an Interpretive Release on liquidity disclosures6 SEC letter addresses disclosure obligations for
mortgage and foreclosure activities7 SEC issues Final Rules to regulate asset-backed
securities8 PCAOB Alert discusses litigation and other
contingencies related to mortgage activities
Tax update9 Recent trends and opportunities
10 Broker-dealersAudit and accounting update10 Derivatives reform legislation10 SEC assessment of customer assets and the impact on FOCUS reports10 Amending Rule 17a-5 and report11 SEC and PCAOB to place renewed focus on broker-
dealers’ fi nancial statements12 FASB proposes amended guidance on accounting for repos13 Board proposes to converge offsetting of fi nancial assets
and liabilities and derivatives
Financial Industry Regulatory Authority (FINRA), SEC, Public Company Accounting Oversight Board (PCAOB) and corporate governance updates14 Retaining control over customer assets14 Regulatory Notice 10-33, Supplemental FOCUS
Information14 Regulatory Notice 10-22, Obligation of Broker-Dealers
to Conduct Reasonable Investigations in Regulation D Offerings
14 Amendment to FINRA Rule 4560, Short Interest Reporting15 PCAOB: Interim audit inspection program and funding
rules proposed for broker-dealers
Tax update16 Cost-basis reporting16 State nexus issues
17 Resources
About this publicationAudit committees, management and boards of directors alike of banks and securities fi rms must keep pace with emerging regulations, new rules stemming from the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), as well as current and upcoming accounting pronouncements. Grant Thornton LLP’s Banking & Securities Update provides brief updates on the key audit, accounting, regulatory and tax issues you need to know to fulfi ll your responsibilities.
U.S. Department of Housing and Urban Development (HUD): Financial statement requirements revised for parent-subsidy structuresA rule titled Federal Housing Administration: Continuation of FHA Reform — Strengthening Risk Management Through Responsible FHA-Approved Lenders became effective in May 2010. Under this rule, supervised mortgagees with fi scal years ending on or after Jan. 1, 2010, must submit audited fi nancial statements with their 2011 renewal and must also submit annual audited fi nancial statements to HUD within 90 days of their fi scal year-end. This is a shorter timeframe than required by the bank and credit union regulatory agencies, which typically require audited fi nancial statements to be submitted within 120 days of fi scal year-end. Annual audited fi nancial statements now are required for all supervised mortgagees, including some institutions that otherwise are not required to have an audit.
3 Banking & Securities Update – Winter 2011
Update on the FASB’s Financial Instruments Project, including credit impairment and fair valueThe Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) continue to hold frequent meetings on the fi nancial instruments project. These deliberations are expected to continue for most of the second quarter of 2011. As of Jan. 31, 2011, the following tentative decisions have been reached by the boards in its re-deliberations of the exposure draft:
• The FASB decided to defi ne when fi nancial assets should be classifi ed and measured at amortized cost, rather than at fair value. The FASB decided that such determination should consider the entity’s business activity and whether fi nancial assets, such as loans, are managed for the collection of contractual cash fl ows.
• The FASB/IASB agreed on a credit impairment model that would recognize lifetime expected credit losses using a time-proportionate approach for a good book and full recognition of lifetime expected losses for a bad book. Readers should be aware that the boards issued an exposure draft, which is available on the FASB website, to solicit feedback on Jan. 31, 2011.
• The boards have not yet discussed hedging; however, the IASB issued an exposure draft in December 2010, in which the FASB plans to issue a discussion paper to solicit feedback on the IASB’s exposure draft.
Further updates on the Financial Instruments Project, including summaries of Board meetings, can be found in Grant Thornton’s weekly On the Horizon publication at www.grantthornton.com/onthehorizon.
Banks
Audit and accounting update
4 Banking & Securities Update – Winter 2011
HUD recently issued Mortgagee Letter 2011-05, Revised Audited Financial Statement Reporting Requirements for Supervised Lenders in Parent-Subsidiary Structures and New Financial Reporting Requirements for Multifamily Mortgagees. The letter permits supervised lenders in parent-subsidiary structures (subsidiaries) approved by the Federal Housing Administration (FHA) to submit the audited consolidated fi nancial statements of the parent company, accompanied by internally prepared consolidating schedules, if one of the following conditions is met:
• The subsidiary accounts for at least 40 percent of the parent company’s assets.
• The subsidiary provides the FHA with an executed corporate guarantee agreement, acceptable to the secretary of HUD, between it and the parent company in which the parent company guarantees the ongoing net worth and liquidity compliance of the subsidiary.
The letter also introduces reporting requirements for mortgagees participating in FHA’s multifamily programs by requiring them to report loan fees earned in excess of fi ve percent of the insured loan amount on each FHA-insured loan of more than $2 million endorsed during the fi scal year period covered in their audited fi nancial statements. Such fees should be reported on a separate schedule included with the annual audited fi nancial statements submitted to HUD. In addition, HUD released a frequently asked questions document to address common questions related to Mortgagee Letter 2011-05. The provisions of the Mortgagee Letter are effective immediately.
Deferral of troubled debt restructuring disclosuresThe FASB has issued Accounting Standards Update (ASU) 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20, which temporarily defers the date when public-entity creditors are required to provide the new disclosures for troubled debt restructurings specifi ed in ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The deferred effective date will coincide with the effective date for the clarifi ed guidance about what constitutes a troubled debt restructuring, which the Board is currently deliberating in a separate project. That clarifi ed guidance, expected by March 31, 2011, is expected to apply for interim and annual periods ending after June 15, 2011. Grant Thornton submitted a comment letter to the FASB on this matter. It is important to note, however, that the deferral in ASU 2011-01 applies only to the troubled debt restructuring disclosures for public-entity creditors in FASB Accounting Standards Codifi cationTM (ASC) 310-10-50-31 through 50-34, Receivables. The deferral in ASU 2011-01 does not affect the effective date of the other disclosure requirements in ASU 2010-20. Public entities must initially provide those other disclosures as follows:
• For disclosures required as of the end of a reporting period, for the fi rst interim or annual reporting period ending on or after Dec. 15, 2010.
For a public company with a calendar year-end, those disclosures are initially required for the year ended
Dec. 31, 2010.
• For disclosures about activity that occurs during a reporting period, for the fi rst interim or annual reporting period beginning on or after Dec. 15, 2010. For a public company with a calendar year-end, those disclosures are initially required for the interim period ending March 31, 2011.
For nonpublic entities, the effective date for the troubled debt restructuring disclosures in ASU 2010-20 continues to be for the fi rst annual reporting period ending on or after Dec. 15, 2011 — that is, the annual period ending Dec. 31, 2011 for nonpublic entities that have a calendar year-end.
Potential impactThe new disclosures on credit quality and the allowance in ASU 2010-20 are still required but requested new disclosures about troubled debt restructurings have been deferred. All fi nancial institutions should consider implementation issues associated with these disclosures. In addition, it is important to note that non-calendar year fi nancial institutions must adopt the new disclosures in ASU 2010-20 beginning with the fi rst interim period ending after Dec. 15, 2010. For example, a fi nancial institution with a June 30 year-end would need to apply the disclosures in ASU 2010-20 (as amended by ASU 2011-01) beginning with the quarter ended Dec. 31, 2010.
The new disclosures on credit quality and the allowance in ASU 2010-20 are still required but requested new disclosures about troubled debt restructurings have been deferred.
5 Banking & Securities Update – Winter 2011
Grant Thornton issues updated guidance on accounting for loan participations and securitizationsGrant Thornton recently issued expanded implementation guidance on FASB Statement 166, Accounting for Transfers of Financial Assets: An Amendment of FASB Statement No. 140. Effective Jan. 1, 2010, for calendar year-end companies, Statement 166 changes the accounting for securitizations, loan participations, and other transfers of fi nancial assets.
Overview of the Small Business Lending FundCreated by the Small Business Jobs Act, the Small Business Lending Fund (SBLF) is a $30 billion fund that encourages lending to small businesses by providing Tier 1 capital to qualifi ed community banks with assets of less than $10 billion. The price a bank pays for SBLF funding will be reduced as the bank’s small business lending increases. The U.S. Department of the Treasury (Treasury) will purchase Tier 1-qualifying preferred stock or equivalents in each bank to provide the capital. Small business lending is defi ned as providing certain loans of up to $10 million to businesses with up to $50 million in annual revenues. Banks can visit the Treasury website for information about the Small Business Lending Fund. Information currently only relates to C corporation depository institutions and holding companies.
Next stepsPlease note that Treasury is working on separate SBLF terms for S corporations, mutual institutions and community development loan funds. Treasury will publish separate SBLF terms for these institutions at a later date. As part of the period certifi cation to the Treasury, the entity must provide its auditor’s annual certifi cation stating that the processes and controls used to generate supplemental reports to the Treasury are satisfactory. It is still unclear what the form of this certifi cation will be.
OCC issues updated guidance on common accounting issues for banksIn November 2010, the offi ce of the Comptroller of the Currency (OCC) updated its Bank Accounting Advisory Series, which expresses the views of the OCC’s Offi ce of the Chief Accountant on accounting issues of interest to national banks. The views in the series are neither offi cial rules nor regulations of the OCC. Rather, they represent either interpretations by the Offi ce of the Chief Accountant or interpretations of regulatory capital requirements by the OCC.
AICPA issues Audit Risk Alert: Financial Institutions Industry Developments — Including Depository and Lending Institutions and Brokers and Dealers in SecuritiesThe AICPA recently released its Audit Risk Alert entitled Financial Institutions Industry Developments — Including Depository and Lending Institutions and Brokers and Dealers in Securities. This alert provides an overview of recent economic, industry, technical, regulatory, and professional developments that affect audits and other engagements related to those industries. The alert is available through the AICPA website.
SEC letter addresses disclosure obligations for mortgage and foreclosure activitiesThe SEC’s Division of Corporation Finance (CorpFin) recently sent a letter to certain public companies as a reminder of their potential disclosure obligations in SEC fi lings related to representations and warranties made to purchasers of mortgages and mortgage-backed securities, and reviews of loan documentation and foreclosure practices, including, in some cases, a temporary halt of foreclosure proceedings. CorpFin posted a sample letter on the SEC website to inform entities that may be impacted by these issues but did not receive a letter. The letter notes that the issues and related disclosures addressed affect not only fi nancial institutions, but also issuers engaged in activities related to residential mortgages, such as mortgage servicing, mortgage insurance, and title insurance.The letter lists examples of representations and warranties that issuers may have made to purchasers of mortgages or mortgage-backed securities. It also reminds issuers of their obligation under Regulation S-K, Item 303, to disclose in Management’s Discussion and Analysis any known trends or demands, commitments, events,
6 Banking & Securities Update – Winter 2011
SEC staff describes common reporting issues for fi nancial institutionsThe SEC published on its website a presentation titled Areas of Frequent Staff Comment – Financial Institutions to provide an overview of issues that the staff of the Division of Corporation Finance frequently encounters when reviewing fi lings for banks. Although focused on banks, the information in the presentation could provide useful observations for all types of fi nancial services companies and their auditors. Some of the signifi cant areas discussed in the presentation include:• Asset quality and loan accounting• Loss contingencies• Securities and goodwill impairment• Valuation allowance on deferred tax
assets• Variable interest entities and
accounting for transfers of fi nancial assets
• Liquidity and risk management• Mortgage- and foreclosure-related
matters• Regulatory actions• Acquisition of troubled fi nancial
institutions and FDIC-assisted transactions
The presentation also highlights other issues with a special focus on banks:• Implications on risk factors• Loan accounting and allowance for
loan losses• Investments and other than
temporary impairment• Modifi cations versus troubled debt
restructuring• Disclosures around liquidity• Internal control over fi nancial
reporting
SEC issues proposed rule on short-term borrowings and interpretive release on liquidity disclosures The proposed rule is not effective for Dec. 31, 2010, 10-K fi lers, but consideration of expanded liquidity disclosures, as noted in the interpretive release, is necessary for all current fi lings. More information is available in this Oct. 5, 2010, Grant Thornton New Developments Summary. Visit www.grantthornton.com/nds.
SEC, PCAOB and regulatory update
Banks
SEC issues Final Rules to regulate asset-backed securitiesThe SEC recently issued two Final Rules to implement various sections of the Dodd-Frank Act relating to asset-based securities (ABS) offerings.
Disclosure of repurchases related to outstanding ABSThe Final Rule, Disclosure for Asset-Backed Securities Required by Section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, prescribes disclosure requirements related to representations and warranties in ABS offerings. The Final Rule requires securitizers of ABS to disclose a security’s repurchase history. The Final Rule requires disclosure of the following information for ABS offerings:
• For securitizers of ABS: For outstanding ABS subject to a covenant to repurchase or replace an underlying asset for breach of a representation or warranty, tabular disclosure of fulfi lled and unfulfi lled repurchase requests on Form ABS-15G, regardless of whether the securities were issued in a transaction registered with the SEC, to permit investors to identify asset originators with clear underwriting defi ciencies. In an initial fi ling by Feb. 14, 2012, securitizers are required to disclose their repurchase history for the three years ended Dec. 31, 2011. Thereafter, securitizers are required to fi le updated information quarterly that includes the repurchase history for all outstanding ABS and includes the history of all fulfi lled and unfulfi lled repurchase requests. Municipal securitizers have an additional three-year phase-in period for these disclosure requirements. In addition, there are disclosures required to inform investors of an issuer’s repurchase history in prospectuses and ongoing reports, with the phase-in period beginning Feb. 14, 2012.
7 Banking & Securities Update – Winter 2011
or uncertainties that could reasonably be expected to have a material impact on operations, liquidity, and capital resources. In addition, the staff letter notes that Regulation S-K, Item 103, requires disclosure of legal proceedings, including those known to be contemplated by government authorities, while Part II, Item 1 of Form 10-Q requires discussion of legal proceedings both when they fi rst become a reportable event and when material developments occur. These disclosures are in addition to those required under FASB ASC 450-20, Contingencies: Loss Contingencies. The letter advises issuers to provide clear and transparent disclosures about representations and warranties made in connection with mortgage sales and securitization activities. In addition, it notes that issuers should discuss the implications associated with any foreclosure reviews, including potential delays in completing foreclosures. The disclosures should address an issuer’s role as a loan originator, securitizer, servicer, and investor, as applicable.
The staff asks issuers to consider several points in drafting their disclosures, including, but not limited to, the following:
• Risks and uncertainties associated with potentially higher repurchase requests, as well as any changes to
the methodology or processes used to estimate any repurchase reserve
• Litigation risks and uncertainties associated with any known or alleged
– Defects in the securitization process, including potential defects in mortgage documentation or in the assignment of the mortgages, and the potential effects of such defects – Breach of pooling and servicing criteria, including potential defects in the foreclosure process, and the potential effects of such defects• Potential impact to the issuer’s
liquidity and any effects on asset valuation and impairment resulting from changes in the timing of sales of loans, other real estate owned, and mortgage-backed securities
Finally, the letter requests that fi lers consider disclosing a roll-forward of any reserve related to representations and warranties associated with loans they have sold.
Finally, the letter requests that fi lers consider disclosing a roll-forward of any reserve related to representations and warranties associated with loans they have sold.
• gathering suffi cient and appropriate evidence for litigation, claims, and assessments;
• auditing accounting estimates when relevant factors differ from those considered in the past;
• evaluating fi nancial statement presentation and disclosure to determine whether management has omitted information required by GAAP or whether other information accompanying the fi nancial statements is materially inconsistent with the fi nancial statements; and
• communicating with the audit committee about management’s judgments and accounting estimates and on matters that signifi cantly impact representational faithfulness, such as disclosures about representations and warranties related to securitization activities.
Practice Alert 7 also observes that the December 2008 Staff Audit Practice Alert 3, Audit Considerations in the Current Economic Environment, which addresses matters related to the 2008 economic environment that might affect audit risk, continues to apply.
Please note: The statements contained in Staff Audit Practice Alerts are not Board rules and are not Board judgments on the conduct of any fi rm, auditor, or other person.
8 Banking & Securities Update – Winter 2011
• For nationally recognized statistical rating organizations (NRSROs): A description of both of the following in any report accompanying a credit rating of ABS:
– the representations, warranties, and enforcement mechanisms available to investors; and – how the representations, warranties, and enforcement mechanisms differ from those in issuances of similar ABS.
NRSROs are required to provide that information for reports issued six months or more after the effective date of the Final Rule.
The Final Rule is effective 60 days after its publication in the Federal Register.
Review of underlying assets required in offerings of registered ABSThe Final Rule, Issuer Review of Assets in Offerings of Asset-Backed Securities, requires an issuer of registered ABS to perform a review of the underlying assets that, at a minimum, provides reasonable assurance that the disclosure in the prospectus is accurate in all material respects. The issuer is required to disclose the nature, as well as the fi ndings and conclusions, of that review in the prospectus. Under the Final Rule, an issuer may engage a third party to perform the review of the underlying assets. If a third party is used, disclosure must be clear concerning whether the fi ndings and conclusions are those of the issuer or those of a third party. If the issuer attributes the fi ndings and conclusions to the third party, the third party must be named in the registration statement and consent to being named as an expert.
Any registered ABS initially offered after Dec. 31, 2011, must comply with the new rules and forms. The Final Rule is effective March 28, 2011.
PCAOB Alert discusses litigation and other contingencies related to mortgage activitiesThe PCAOB recently issued Staff Audit Practice Alert 7, Auditor Considerations of Litigation and Other Contingencies Arising from Mortgage and Other Loan Activities, to inform auditors of public companies about their responsibilities when auditing loss contingencies, disclosures, and related items associated with mortgage and foreclosure activities. The staff issued the Practice Alert as a result of a report by the Congressional Oversight Panel in November 2010, which indicated that fi nancial institutions might have misrepresented the quality of loans sold for securitization and could be required to repurchase the affected mortgages. The report also alleged that fi nancial institutions might not have performed procedures legally required to foreclose on homes. According to the reports, estimates of potential costs, including litigation, associated with mortgage repurchases and foreclosure irregularities could represent a substantial exposure to the fi nancial institutions involved. Practice Alert 7 discusses the professional guidance auditors should consider when auditing loss contingencies and disclosures and notes in particular how that guidance relates to mortgage- and foreclosure-related activities and exposures. Topics addressed include the following:
9 Banking & Securities Update – Winter 2011
Recent trends and opportunitiesBanks, their boards, audit committees and management should be aware of a number of tax trends and opportunities.
• Various issues are emerging in combined reporting for fi nancial institutions, particularly in the treatment of broker-dealer subsidiaries in California and certain other states.
• Market state sourcing for apportionment purposes is an emerging trend.
• Seventeen states have adopted rules to source apportionment values associated with asset management fees from regulated investment companies (RICs), hedge funds and funds of funds based on shareholder locations.
• We continue to see more states assert economic nexus, which creates a liability when coupled with the market state sourcing of apportionment values.
• Our professionals have had success with clients obtaining signifi cant refunds for the Texas margin tax, mostly due to signifi cant reductions in apportionment factors.
• With regard to real estate mortgage investment conduit (REMIC) investments, banks should consider taxation of excess inclusion income and the impact on state net operating loss (NOL) carryovers.
• Our clients have had success in obtaining credits and incentives.
Tax update
Banks
10 Banking & Securities Update – Winter 2011
For accounting purposes, CDS are classifi ed as derivatives and not insurance contracts, and are subject to the Financial Accounting Standards Board (FASB) ASC 815, Derivatives and Hedging, (formerly FASB Statement 133, Accounting for Derivative Instruments and Hedging Activities). Under the rule, CDS are carried at fair value.
SEC assessment of customer assets and the impact on FOCUS reportsCurrently, the value of a customer’s fully paid assets is not included in a broker-dealer’s fi nancial statements. These assets are refl ected by quantity only in the stock record of the broker-dealer and released only on a memorandum basis.
Next steps and potential impactBroker-dealers should be alert to the response of the Securities Industry and Financial Markets Association (SIFMA) to address regulators’ concerns.
Derivatives reform legislationAs part of efforts to reform the U.S. fi nancial system, the Obama administration has proposed legislation that would bring the over-the-counter (OTC) derivatives market, including credit-default swaps (CDS), under federal regulation. The Dodd-Frank Act would require the clearing of OTC derivatives and would also institute capital and margin requirements for broker-dealers. The legislation will continue to evolve as the SEC and Commodity Futures Trading Commission (CFTC) promulgates additional rules; broker-dealers need to be aware of the legislation’s scope and unanswered questions that will remain until these rules are defi ned.
Next steps and potential impactThe legislation needs to determine whether CDS will be considered derivatives or insurance contracts for regulatory purposes — it is not clear if state insurance regulators could claim oversight of these products.
Audit and accounting update Under the proposed changes, assets belonging to customers would be carved out and reported separately in an amendment to the Form X-17A-5, Financial and Operational Combined Uniform Single Report (FOCUS report). Should this type of reporting become required, both auditors and broker-dealers must be prepared for additional work validating prices and reconciling the settlement-date stock record to the trade-date customer position.
Amending Rule 17a-5 and reportAccounting fi rms should follow AT Section 601, Compliance Attestation, which makes reference to Rule 17a-5, Reports to Be Made by Certain Brokers and Dealers. However, while the 17a-5 report does not meet AT 601 standards, the types of compliance testing regarding safeguarding securities and practices and procedures should be consistent with AT 601 standards and the audit guide. The SEC expects to send out a proposal for revisions and amendments to Rule 17a-5 (potentially to require a compliance examination report or an integrated audit report) in the fi rst half of 2011.
Broker-dealers
11 Banking & Securities Update – Winter 2011
The staff advises auditors to ensure that they comply with applicable SEC rules, as well as professional standards including AICPA attestation standards, when planning and performing audits of broker-dealers. Rule 17a-5 demands a heightened level of performance compared with the level of assurance provided in the internal control report that has been previously used to meet this reporting requirement. The sample report on internal control, as published in the AICPA Audit and Accounting Guide — Brokers and Dealers in Securities, will be acceptable while the SEC considers changes to Rule 17a-5 and the PCAOB considers audit standards for broker-dealers’ fi nancial statements. In the interim, broker-dealers and their auditors should plan on providing clear documentation, as well as conducting thorough reviews and testing of the accounting and internal control procedures for compliance with safeguarding securities and net capital computations. The AICPA Stockbrokerage and Investment Banking Expert Panel recently held a teleconference with the PCAOB and the Offi ce of the Chief Accountant of the SEC to discuss the SEC’s Nov. 18 letter. Mark Ramler, Grant Thornton LLP Financial Services Audit partner, is a member of the panel. The four major themes discussed on the December 2010 call are as follows:
1) Since the 17a-5 is an attestation report, the Expert Panel believed that there should be assertion-type representation points in the management representation letter. (The PCAOB was neutral on this point and did not provide a viewpoint either way.) The guidance and examples were expected in January 2011 from Expert Panel members. The management representation points on custody are very robust.
SEC and PCAOB to place renewed focus on broker-dealers’ fi nancial statementsThe Dodd-Frank Act amended the Sarbanes-Oxley Act of 2002 (SOX), authorizing the PCAOB to establish auditing and related standards to be used by registered public accounting fi rms in their preparation and issuance of audit reports that will be included in broker-dealer fi lings with the SEC pursuant to Rule 17a-5 under the Exchange Act of 1934. On Sept. 24, 2010, the SEC released interpretive guidance regarding these auditing and related standards. The guidance states that references in SEC rules and staff guidance in the federal securities laws in GAAS (Generally Accepted Auditing Standards) or to specifi c standards under GAAS, as they relate to non-issuer brokers or dealers, should continue to be understood to mean auditing standards generally accepted in the U.S. plus any applicable SEC rules. However, the SEC plans to revisit this interpretation in light of its rulemaking project to update these requirements under the Dodd-Frank Act. On Nov. 18, 2010, the SEC issued a letter to the AICPA Stockbrokerage and Investment Banking Expert Panel reminding auditors of the importance of complying with Rule 17a-5 requirements that apply when reviewing the accounting system and internal control procedures for safeguarding securities for the annual audits of broker-dealer fi nancial statements. The letter states that the fi nancial statement audit and the auditor’s compliance examination procedures are critical compliance elements of the SEC’s oversight of broker-dealers. It also reminds auditors that Rule 17a-5 requires that the “scope of the audit and review…shall be suffi cient to provide reasonable assurance that any material inadequacies existing at the date of the examination…would be disclosed,” which is reiterated in the guidance in the AICPA Audit and Accounting Guide - Brokers and Dealers in Securities.
2) The panel discussed views on how accounting fi rms should execute work and what guidance they can provide to fi rms. The PCAOB said it thought the existing requirements under 17a-5 provide a very high level of assurance, and that nothing has changed — the board just wants all accounting fi rms to have a consistent understanding of SEC rules and compliance requirements. Accounting fi rms should follow AT 601, which makes reference to 17a-5. However, while the 17a-5 report does not meet AT 601 standards, the types of compliance testing regarding safeguarding securities and practices and procedures should be consistent with AT 601 standards and the audit guide.
3) Request for guidance on measurement standards and views on material non-compliance and material inadequacy. The PCAOB will consider this.
4) The SEC said expects to issue a proposal (content to be determined — possibly a compliance examination report or an integrated audit report) for revising and amending Rule 17a-5 in the fi rst half of 2011.
Potential impactIn light of the increased scrutiny of broker-dealers’ audits, broker-dealers should expect a lengthier and potentially more expensive audit process.
The letter states that the fi nancial statement audit and the auditor’s compliance examination procedures are critical compliance elements of the SEC’s oversight of broker-dealers.
12 Banking & Securities Update – Winter 2011
The proposed ASU follows the SEC’s recently issued Proposed Rule, Short-Term Borrowings Disclosure, which addresses investors’ concerns that disclosure of short-term borrowing balances as of the balance sheet date may not provide an accurate picture of a registrant’s liquidity position, especially if the registrant hides its actual liquidity needs by reducing short-term borrowings shortly before reporting dates. Currently under FASB ASC 860-10-40-24, Transfers and Servicing, a transferor must meet four criteria to maintain effective control of securities transferred in a repo and therefore account for the transfer as a secured borrowing rather than as a sale. One of these criteria is that the transferor must be able to repurchase or redeem the transferred securities on substantially the agreed terms, even if the transferee is in default. This criterion for secured borrowing accounting is satisfi ed only
FASB proposes amended guidance on accounting for reposThe Board issued proposed ASU, Reconsideration of Effective Control for Repurchase Agreements, in November 2010 to improve and simplify the accounting for the assessment of effective control of repurchase agreements (repos) and similar instruments. The proposal responds to constituents’ concerns that current guidance does not adequately address when transferors should account for repurchase agreements, or other agreements that both entitle and obligate a transferor to repurchase or redeem fi nancial assets before their maturity, as secured borrowings rather than as sales. These concerns relate, in part, to reports that certain fi nancial institutions had executed repos at the end of a reporting period and accounted for them as sales under U.S. GAAP to reduce their short-term borrowings, thereby lowering their leverage ratios at the reporting date.
if the transferor has cash or collateral suffi cient to fund substantially all of the cost of purchasing replacement securities. The proposed guidance would remove this criterion and its related implementation guidance from the Codifi cation, thereby reducing the criteria that transferors must satisfy to qualify for secured borrowing accounting and likely reducing the number of transfers accounted for as sales. The proposed amendments would not affect other criteria that must be satisfi ed to conclude that sale accounting is appropriate. The amended guidance would be effective for new transfers and existing transactions modifi ed as of the beginning of the fi rst interim or annual period after the Board issues the fi nal ASU, which is expected in the fi rst quarter of 2011. Comments on the proposed ASU were due by Jan. 15, 2011.
13 Banking & Securities Update – Winter 2011
The proposed ASU further clarifi es that the right of offset must be enforceable under all circumstances, including during the normal course of business and on the default, insolvency, or bankruptcy of the counterparty. In addition, the right of offset must be unconditional, which means that its exercisability must not be contingent on the occurrence of a future event. The offsetting criteria in the proposed guidance would apply to both bilateral arrangements and to multilateral arrangements that are between three or more parties. It would also apply to the offset of one or more eligible assets and one or more eligible liabilities. If the criteria for offsetting are not met, eligible assets and eligible liabilities would be presented separately, based on the nature of the asset and the liability. The proposed ASU also provides that a reporting entity would not offset assets pledged as collateral, or an obligation to return collateral, against the related eligible liabilities and eligible assets.
Board proposes to converge offsetting of fi nancial assets and liabilities and derivativesBoth the FASB and the IASB issued proposals on Jan. 28, 2011, on a jointly developed approach to converge the accounting guidance on when entities should offset eligible assets and eligible liabilities on the balance sheet. Differences in offsetting requirements currently create the largest single quantitative difference between statements of fi nancial position prepared under U.S. GAAP and those prepared under International Financial Reporting Standards (IFRS). Under the proposed guidance, eligible assets would be limited to fi nancial assets and derivative assets, and eligible liabilities would consist of fi nancial liabilities and derivative liabilities. The proposed approach, presented in the FASB’s proposed ASU, Balance Sheet (Topic 216): Offsetting, would require a reporting entity to offset on its balance sheet a recognized eligible asset and a recognized eligible liability if both of the following conditions apply:
• It has an unconditional and legally enforceable right to set off the eligible asset and the eligible liability.
• It either intends to settle the eligible asset and eligible liability on a net basis or to realize the eligible asset and settle the eligible liability simultaneously. Simultaneous settlement would occur only when the transactions are executed at the same moment.
Under new disclosure requirements that the proposed ASU would require, entities would disclose suffi cient information in tabular format about the rights of setoff and collateral arrangements associated with eligible assets and eligible liabilities to enable fi nancial statement users to understand the effect of the rights and arrangements on the entity’s fi nancial position. The proposed ASU does not specify an effective date, but it does indicate that the proposed guidance would be retrospectively applied to all periods presented. The comment period on the proposed ASU ends on April 28, 2011. Additional information on the proposed guidance is located on the FASB website, including the newsletter FASB In Focus, “Exposure Draft: Offsetting of Financial Assets and Liabilities.”
The proposed ASU further clarifi es that the right of offset must be enforceable under all circumstances, including during the normal course of business and on the default, insolvency, or bankruptcy of the counterparty.
their own due diligence testing. As part of this report, broker-dealers would have to perform an adequate sample test of the outsourced activity to ensure it is in compliance with service-level agreement terms. Learn more in Grant Thornton’s Financial Bulletin on the topic.
Regulatory Notice 10-33, Supplemental FOCUS InformationIn July 2010, FINRA released Regulatory Notice 10-33, Supplemental FOCUS Information, which expanded disclosure of revenue and expense items, as well as the disclosure of the top fi ve underwritings of unregistered offerings.
Regulatory Notice 10-22, Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D OfferingsAs broker-dealers have been increasing their distributions of private placements, FINRA has issued Regulatory Notice 10-22, Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings or RN 10-22, reminding broker-dealers of their obligation to conduct a reasonable investigation of the offering.
Retaining control over customer assetsA clearing broker must retain responsibility for the issuance of instructions or actual movement of customer assets. In addition, the clearing broker has a responsibility to perform due diligence on the capability of the service provider, including compliance with necessary business continuity and retention requirements.
Potential impact and next stepsBroker-dealers will need to demonstrate to both FINRA and the SEC that any movement of customer assets is approved by the regulated broker and completion of adequate due diligence on the third-party provider. As a best practice, broker-dealers should obtain a Service Organization Control Report (such as the AICPA SOC-2 report for broker-dealers that already have a thorough understanding of the organization and its controls) to validate that applicable outsourced activities have been completed, as well as to support
14 Banking & Securities Update – Winter 2011
FINRA, SEC, PCAOB and corporate governance updates
Broker-dealers
Next stepsIn order to conduct a reasonable investigation of securities, broker-dealers will have to develop procedures that address the risks associated with the investments. Broker-dealers are now generally distributing and increasing these Regulation D (or Reg D) offerings to qualifi ed investors to generate profi ts. FINRA is concerned that there is a lack of due diligence being performed by brokers. RN 10-22 lists the due diligence best practices for brokers.
Amendment to FINRA Rule 4560, Short Interest ReportingAn amendment to FINRA Rule 4560, Short Interest Reporting, was recently proposed by the FINRA Board of Governors to ensure consistent reporting (settlement date) and aggregate short reporting by trade desk. In addition, short interest reporting should not be netted by trade desk within a fi rm, but should be reported on an aggregate basis for each individual trade desk.
The PCAOB does not plan to issue fi rm-specifi c inspection reports on procedures performed under the interim program before the rules for a permanent inspection program take effect. It expects that insights gained through the interim inspection program will form the basis for determining the scope and elements of a permanent inspection program, including whether to differentiate classes of brokers and dealers, whether to exempt any category of public accounting fi rm, and what minimum inspection frequency to establish. The Proposed Temporary Rule would not change the SEC rules or professional standards that currently govern audits of broker-dealers. As the SEC has previously explained, its rules continue to require those audits to be carried out under generally accepted auditing standards.
PCAOB: Interim audit inspection program and funding rules proposed for broker-dealersThe PCAOB recently released two Proposed Rules to begin implementation of provisions of the Dodd-Frank Act that expand its oversight to encompass audits of securities brokers and dealers. The comment periods for both Proposed Rules end Feb. 15, 2011.
Interim inspection program for broker-dealer auditsThe Proposed Temporary Rule for an Interim Program of Inspection Related to Audits of Brokers and Dealers would establish an interim inspection program for registered public accounting fi rms’ audits of securities brokers and dealers. The Proposed Temporary Rule would allow the PCAOB to begin inspecting auditors of brokers and dealers and to address any signifi cant issues in those audits with the registered fi rms. At least annually, the PCAOB would issue public reports on the progress of the interim inspection program and on signifi cant issues identifi ed.
15 Banking & Securities Update – Winter 2011
Allocation of accounting support feesThe Proposed Rule, Proposal for Allocation of the Board’s Accounting Support Fee Among Issuers, Brokers, and Dealers and Other Amendments to the Board’s Funding Rules, would establish classes of broker-dealers for funding purposes, describe the method for allocating the appropriate portion of the accounting support fee to each broker and dealer within each class, and address the collection of assessed shares from brokers and dealers. The Proposed Rule would also make certain revisions to the Board’s existing rules for the allocation of the accounting support fee among issuers. For example, it would amend the basis for calculating an issuer’s market capitalization to include the market capitalization of all classes of the issuer’s voting and nonvoting common equity.
Broker-dealers should identify business processes and systems that will need to be updated as a result of cost-basis data requirements — and should prepare implementation strategies, budgets, and project and staffi ng plans.
State nexus issuesStates are increasing their collection procedures for points of revenue origination (i.e., customer location) versus the state where the securities were sold (i.e., branch location). It remains to be seen how this will be applied.
Cost-basis reporting As of Jan. 1, 2011, broker-dealers and other fi nancial intermediaries are now required to track and report not only cost-basis information, but also the adjusted cost basis of any security that is sold. Applicable fi rms must have cost-basis reporting implemented for:
1) all stock transactions acquired on or after Jan.1, 2011;
2) all mutual funds and dividend reinvestment plans acquired on or after Jan. 1, 2012; and
3) all fi nancial instruments, such as debt securities and options, acquired on or after Jan. 1, 2013.
16 Banking & Securities Update – Winter 2011
Tax update
Broker-dealers
We provide a number of articles and webcasts on the topic of fi nancial reform and other topics affecting the banking and securities industries.
• White paper — Financial reform: How the Dodd-Frank Act affects securitization and mortgage lending• Article — Financial reform and beyond: Key issues for broker-dealers• Article — Financial reform: Top 10 considerations for broker-dealers• Article — Financial reform and banks: Top 10 issues to consider• Webcast playback — The Dodd-Frank Act and the impact on the banking and securities industry• FDIC-assisted transactions — Learn more about how to navigate the complexities of these
transactions from our white papers and webcast playbacks by visiting www.GrantThornton.com/troubledbanks.
You can also fi nd these materials on our Financial Regulatory Reform Resource Center at www.GrantThornton.com/fi nancialreform.
17 Banking & Securities Update – Winter 2011
This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed. To the extent this document may be considered written tax advice, in accordance with applicable professional regulations, unless expressly stated otherwise, any written advice contained in, forwarded with, or attached to this document is not intended or written by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code.
The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specifi c circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP.
Resources
About the publicationThis Grant Thornton LLP bulletin provides information and comments on current accounting issues and developments. It is not a comprehensive analysis of the subject matter covered and is not intended to provide accounting or other advice or guidance with respect to the matters addressed in the bulletin. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this document.
ContactFor additional information on topics covered in this document, contact your Grant Thornton LLP adviser or one of the below professionals:
Jack KatzNational Managing PartnerFinancial ServicesT 212.542.9660E [email protected]
Nichole JordanNational Banking and Securities Industry LeaderT 212.624.5310E [email protected]
