Avoid Trust Accounting Pitfalls through Proper Internal Controls

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1 January 2015 Unique Monthly Visitors: 1,918 JANUARY 2015 Avoid Trust Accounting Pitfalls through Proper Internal Controls By Steven A. Davis and Marc Feigelson Many attorneys run into issues related to the improper management of trust accounts, and some firms don't have the appropriate safeguards and checks in place to help prevent issues. Implementing proper controls can help reduce the risk of trust accounting improprieties and errors. As an attorney, you have a responsibility to act as a fiduciary over client funds, including adhering to all applicable laws and rules regarding trust accounts. The consequences of mismanaging trust accounts can be severe. Trust account violations and abuses can be damaging to your firm's reputation and can result in problems with the state bar association and, in some cases, have led to the ultimate demise of an entire firm. For example, the Florida Supreme Court has disciplined hundreds of attorneys in the past year for violating Florida Bar rules, including dozens who were sanctioned for trust account violations. Recent court orders include several references to trust account improprieties, such as: " misappropriating client trust funds." " failure to maintain trust account records and procedures in compliance with Bar rules." " commingling his personal assets with the trust account." " gross neglect of his trust accounts through his failure to supervise the management of the trust accounts." No matter in which state you practice, the mechanics of handling a trust account are basically the same, although the nuances of laws and bar rules may be different from state-to-state. You should take the necessary steps now to proactively assess your firm's policies and procedures over trust accounting and make sure your firm is in compliance with state laws and bar rules. This article explores six common trust accounting pitfalls and provides questions that you should be asking about your firm's internal policies and procedures surrounding trust accounts. 1. Comingling of Client Funds Above all, it's important to remember that funds deposited in a trust account belong to the client, not to the attorney or the firm. In order to avoid any appearance of impropriety, attorneys are required to separate client funds from the attorney's personal funds and firm funds. Large or long-term deposits of client funds, including any advances for fees, costs and expenses, are generally required to be held in separate bank accounts that are clearly labeled and designated as trust accounts and have the

2 Continued Page 2/5 potential to earn interest for the client. The client's name is typically included in the account name, and the account is set up using the client's federal ID number. Deposits that are either short-term or too small to earn significant interest income for the client would typically be held in an Interest on Lawyers' Trust Account (IOLTA). An IOLTA is a single, pooled trust account that doesn't generate interest for individual clients, but rather, generates collective interest that the bank forwards to the corresponding state's IOLTA program, which in turn uses the money to fund a variety of charitable causes. IOLTA programs currently operate in all 50 states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands, according to the American Bar Association. See, Are separate, interest-bearing bank accounts maintained for each trust account containing large or long-term client funds? Is each account clearly labeled as a trust account with the client's name? How is the interest on these accounts tracked and accounted for? Are any firm or attorney funds (not belonging to a client) held in trust accounts? Are any client funds held in firm or attorney operating accounts? What is the firm's policy for deciding to place funds in an IOLTA or segregated account for a specific client? What criteria are considered? How is the interest on IOLTAs tracked and accounted for? If terms of the engagement agreement require retainers to be held in trust, are such procedures adhered to consistently? 2. Failure to Maintain Required Records and Properly Track Client Funds Creating a firm culture in which all attorneys prioritize a strict adherence to trust account best practices can be a challenge, especially at a large firm with multiple locations. Your firm should have a policies and procedures manual that includes guidance on the handling of trust accounts, and attorneys should be encouraged to take their approval and review responsibilities seriously. When we consult with law firms on trust accounting procedures, we often recommend that every month, each attorney at the firm should be provided with a summary report of all of the trust account balances for which he or she is responsible. This provides an opportunity for attorneys to identify unusual or stale items or balances. If there are any questions, the attorney should request a complete activity report for that client trust matter. We also recommend that each attorney be required to sign off regarding the accuracy of the information reflected on his or her reports. In addition, it's imperative that proper supporting documentation be maintained and reviewed for trust disbursements and appropriate records be kept for trust fund deposits.

3 Continued Page 3/5 For all trust funds received, are the date and source clearly identified as well as the client matter for which the funds were received? For all disbursements and transfers from the trust account, is appropriate supporting documentation maintained? Is that supporting documentation reviewed before disbursements are authorized? Does someone in upper management oversee the trust account report review process and hold attorneys accountable for adhering to the firm's policies and procedures regarding trust accounts? Trust account violations sometimes stem from a failure to maintain trust account records in compliance with bar rules. Maintaining adequate records is imperative for helping your firm avoid these types of violations and providing an audit trail for the tracking of client funds. Records to be maintained may include: Checkbook with stubs or electronic check registers; Deposit slips with copies of both sides of the checks deposited; Cancelled checks for all funds disbursed from the trust account; Wire transfer information forms that include all relevant information such as the names of the individuals who requested and authorized the transfer; Bank statements and related bank reconciliations; Cash receipts and disbursements journals; Copies of receipt and disbursement notices to clients, if any; All documents relevant to receipt and disbursement of funds, including retainer agreements, real estate closing documents, and other supporting transaction documents; or Sub-ledger for each client matter reflecting all receipts and disbursements activity and the unexpended trust money held for each client matter. 3. Lack of Timeliness In Performing Trust Account Reconciliations It is good practice to perform monthly reconciliations of all trust bank accounts. In addition, someone in upper management who is not regularly involved in the process should review reconciliations on an unannounced basis at least once a year. In addition, the total sub-ledger trust balances need to be in agreement with the general ledger balances and the related bank reconciliations. Are trust bank account balances regularly reconciled to the sub-ledger balances and are the sub-ledger balances regularly reconciled to the general ledger balances? Does the firm have detailed, step-by-step instructions for the individuals who prepare and review trust bank reconciliations? Is someone assigned to verify that the sign-off section on the bank reconciliation form indicates who prepared and reviewed the reconciliation and on what date?

4 Continued Page 4/5 Are all of the trust account bank reconciliations regularly reviewed by someone in upper management? 4. Improper Trust Disbursements Not requiring adequate authorization and failing to adhere to strict authorization policies and procedures can lead to improper "borrowing" from trust accounts. This may come in the form of disbursing fees from the trust account before there are adequate funds in the account or even outright theft. Requiring dual signatures can help prevent improper authorizations for trust disbursements. Consider requiring dual signatures on trust checks over a certain amount (e.g., $500) as well as on the bank forms needed to complete a wire transfer, with one person initiating and another person authorizing the transfer. In some cases, banks may also require phone or written confirmations for disbursements, which adds another control to the process. The authorizing party should receive an appropriate amount of supporting documentation whereby he or she is able to determine if the disbursement is appropriate. In addition, many law firms do not have a clear policy that is consistently applied regarding the payment of client costs. To maximize cash flow and minimize risk, firms may want to review their policies regarding the disbursement of client costs and clearly indicate in their policies and procedures manual and in client engagement letters how client costs will be funded. What controls are in place to confirm that disbursements of legal fees are not made before the attorney has earned those funds? What controls are in place to confirm that disbursements are not made before there are adequate funds in the trust account? What controls surround proper timing of transfers so that legal fees are not transferred from a trust account to the firm's operating account before the attorney has earned those funds? How does the firm educate attorneys regarding the need for adequate documentation for disbursements? Are attorneys required to attend training on the firm's policies and procedures regarding trust accounts? What documentation is provided to the authorizing party in order to approve a trust disbursement? 5. Lack of Segregation Of Duties To reduce the risk of fraud and error, the performance of critical functions should be separated among more than one individual. Ideally, no one person at the firm should be the sole individual responsible for more than one of the following functions in the same process: authorization, custody of assets, record keeping and reconciliation. When possible, it's also a good idea to rotate employees who hold these key responsibilities on a periodic basis and make sure key people take vacation and have trained back-ups. Can the preparer of the check request forms also be the approver?

5 Continued Page 5/5 Who has the authority to process checks? Who has the authority to sign checks? Can an account signor also prepare checks? Does someone other than the preparer of the bank reconciliation review and approve the reconciliation and compare the balance on the bank reconciliation to the total of the sub-ledgers and general ledger on a monthly basis? 6. Number of Accounts At large firms, there tend to be many attorneys requesting to open trust accounts, and with multiple offices, the accounts may be spread out in different locations. The volume of accounts, as well as the number of signers on each account, creates administrative challenges and can make it harder to verify that attorneys are adhering to trust accounting policies. Implementing a formal process for requesting and approving new trust accounts can help make this situation more manageable. Management or its designee should have the ultimate approval over who can open and close trust accounts. Small firms with fewer trust accounts and locations may have an easier time managing trust account activity, but no matter the size of your firm, it's imperative to implement proper, documented internal controls related to the establishment of client trust accounts. Are there policies and procedures in place regarding the authorization to open additional trust accounts in different banks or different branches of the same bank? Does management have a clear understanding of the purpose of each client account? Evaluating Your Firm's Internal Controls The strength of an internal control system depends on whether adequate and competent internal control procedures are properly designed, whether those controls are operating as designed, and whether proper segregation of duties exists to prevent circumvention of controls. You may want to have a qualified accounting firm or other third-party consultant evaluate your firm's current internal controls around trust accounts and test your internal policies and procedures to confirm that adequate controls are in place, are operating as designed and that duties are segregated properly. An independent consultant can advise you on best practices for staying in compliance with state laws and bar rules and assist in determining if your firm has the appropriate safeguards in place to comply with your fiduciary responsibilities. Steven A. Davis, CPA, is an entrepreneurial services principal in Kaufman Rossin's Miami office. A member of our Board of Editors, he can be reached at sdavis@kaufmanrossin.com. Marc Feigelson, CPA, is an assurance and advisory services principal in Kaufman Rossin's Miami office. He can be reached at mfeigelson@kaufmanrossin.com.