Posted by Samantha Griffin, professional development manager at Legal Futures Associate the Institute of Legal Finance & Management [1]
Griffin: A debit balance on a credit ledger is a big warning sign
The client account reconciliation process will be second nature to most people working in legal finance, having completed hundreds of them. And perhaps because the process is so familiar, it is also a potential area for a problem to be undetected until it becomes serious.
The SRA Accounts Rules require firms to carry out a three-way reconciliation between the client ledger balances, the cash book and the bank statement, and to do so at least every five weeks, although in reality this is often carried out much more frequently.
This is well understood but what can the numbers obscure – and what are the consequences when reconciling items are allowed to sit, unexplained, for longer than they should?
The problem with aged reconciling items
A reconciling item on its own is not a problem. Timing differences between when a payment is recorded and when it clears are a normal feature of any reconciliation.
The risk lies in aged reconciling items which are entries that have been sitting unresolved for weeks or months, often carried forward from one reconciliation to the next without anyone flagging them or asking why they are still there.
In a busy accounts team, the temptation is to reconcile to zero and move on. But an item that was a genuine timing difference in week one and is still there in week eight is no longer a timing difference. It is a problem waiting to happen.
Common examples include unpresented cheques that were never actually sent, receipts that have been posted to the wrong ledger, duplicate entries and transfers that were recorded on one side but not the other.
If these are left unresolved, they can distort the picture of what client money the firm is holding and on whose behalf. When left for long periods of time, trying to ascertain who the entries relate to, where they have come from or who they are due to becomes harder establish.
Ledger balances that should not exist
One of the clearest warning signs in any client account is a debit balance on a client ledger – a position where the firm appears to have paid out more in respect of a client matter than it has received.
Under the rules, this should not happen. Client money must be available before it is disbursed. A debit balance, even a small one, means that either another client’s money has been used or the firm’s own money is improperly in the client account.
The practical issue is that debit balances can be easy to miss, particularly in firms with large numbers of active matters. They can arise from genuine posting errors that would be straightforward to correct if caught quickly.
However, if these are left unaddressed, they represent a breach of the rules and, in the event of an SRA investigation or forensic inspection, they will be found.
Residual balances and dormant matters
At the other end of the ledger, credit balances sitting on matters that have long since concluded present a different but equally real compliance risk.
Client money that cannot be returned because contact with the former client has been lost or because no one has got around to closing the matter, still needs to be dealt with. The rules state that client money must be returned promptly when there is no longer a reason to hold it.
Firms with large volumes of historic residual balances often find, when they finally review them properly, that the position is difficult to unravel. Records are incomplete, fee earners have moved on, and the audit trail for how the balance arose has gone cold.
The SRA takes a dim view of firms that cannot account for client money they are holding, regardless of whether there is any suggestion of dishonesty.
What an SRA inspection actually looks at
Forensic investigators are experienced at identifying the patterns that reconciliations can obscure.
They will look at whether reconciliations are being carried out on time and by an appropriately senior member of staff, whether aged items are being followed up and resolved, whether client ledgers contain debit balances, and whether residual balances are being managed.
They will also look at whether the COFA is genuinely engaged with the process or whether compliance has become a box-ticking exercise.
The consequences of getting this wrong range from a requirement to remediate and report a breach, through to referral to the SRA’s forensic investigation team, regulatory sanctions and, in the most serious cases, intervention.
Intervention, where the SRA steps in and takes control of a firm’s files, is the most nuclear option – and not common – but it is preceded by exactly the kind of slow accumulation of unresolved issues that good reconciliation practice is designed to prevent.
The practical answer
Reconciling items should have an owner and a resolution date. Aged items – anything unresolved beyond two weeks – should be reviewed by a senior member of the finance team, not just carried forward.
Where possible, client account reconciliations should be carried out by different members of the finance team to mitigate the risk of these reconciling items and other issues being swept under the rug and left for long periods of time.
Debit balances should trigger an immediate investigation rather than a note on the to-do list. And the COFA should be receiving meaningful information about the reconciliation position, not just a confirmation that it has been done.
The key to managing reconciliations effectively is for a firm to be disciplined in their approach and treat them as an important risk management tool rather than an administrative task.
This will ensure they are given priority and any potential issues are identified early and addressed appropriately – safeguarding the finance team, keeping the firm compliant and protecting client money.