Would Your Trust Account Survive an Ethics Audit?
Surviving a Trust Account Ethics Audit:
Helpful Tips from Sam Fisher, CPA
Have you or your firm ever received that dreaded letter from the NJ Office of Attorney Ethics (OAE), politely informing you that you have been “randomly selected” to be audited?
You are given exactly two weeks’ notice that an auditor will be at your office at 10 a.m. to audit your trust and business accounts. Panic strikes. “Why me?” you ask yourself. “I have client deadlines to meet, motions to file, etc. This is the last thing I need to worry about right now. I’ll just call the OAE and get this audit postponed until I have time to deal with it.” Well, if any of this sounds familiar, you are not alone. Unfortunately, the OAE does not care about your client workload or how busy you are. The rules clearly state that, as an attorney, you are required to reconcile your accounts monthly and to maintain all of the required books and records (which I will elaborate on below). Unless you have plane tickets already booked to be out of town somewhere, they generally will not postpone the audit. If you are guilty of not being as diligent as you should have been with your trust account reconciliations, you certainly have reason for concern. Many a practitioner has been reprimanded, suspended and even disbarred as a result of neglecting their trust accounts. I have represented many attorneys who have had stellar careers, never receiving a single complaint from any client or ever intentionally taking any trust money to which they were not entitled. Yet, these same attorneys faced possible suspension (or worse) from practicing their lifelong profession because they neglected their trust accounts.
What Does the OAE Look For?
The OAE auditor will ask for the following required records for both the trust and business accounts, covering the two-year period preceding the audit date:
• Bank statements, with either cancelled checks or check images
• Monthly 3-way bank reconciliation reports (2-way reconciliation for business account)
• Monthly cash receipts and cash disbursement journals
• Check registers, reflecting a running cash balance
• Client trust ledgers for all open accounts as of the audit date, as well as all ledger cards that contain any activity during the previous two years
Basically, the purpose of the audit is to verify that all client trust funds are secure. In order to ensure the integrity of client moneys, attorneys are required to perform monthly what is referred to as a 3-way reconciliation. This is more than just reconciling your checkbook to your bank statement, which is known as a 2-way reconciliation. A 3-way reconciliation is a process whereby your running checkbook balance is reconciled both to the bank statement as well as to a listing of all client trust balances, as reflected on their ledger cards as of the end of each month. If the monthly ledger card balances do not match your checkbook and reconciled bank statement balance, you are considered to be out-of-trust.
What is the meaning of being out-of-trust?
If the sum of your client ledger card balances exceed the amount of money in your trust bank account (after adjusting for outstanding checks), you have a shortage in your account. Conversely, if the sum of the client balances is less than the adjusted bank balance, you have a surplus in the account. Either situation will cause your trust account to be out-of-trust. Both conditions are problematic. A shortage indicates client funds were improperly disbursed. A surplus indicates you have excess money in the account, which you cannot assign to a client and therefore don’t know to whom the money belongs. In either case, the OAE will require you to figure it out.
WHAT HAPPENS IF I HAVE NOT BEEN RECONCILING MY TRUST ACCOUNT USING THE 3-WAY PROCESS, MY CLIENT BALANCES DON’T AGREE WITH MY BANK ACCOUNT BALANCE, AND I AM OUT-OF-TRUST?
If you are guilty of not reconciling your accounts regularly and a current reconciliation reveals that you have a shortage or surplus in your trust account, the auditor will give you a reasonable amount of time to get your account in order – generally around 60 days. However, depending on how long it’s been since your account has been reconciled (I’ve seen cases where accounts had not been reconciled for over 10 years), this can be a very laborious, painful and costly process. From my experience, there is almost always a multitude of errors in the accounts, thereby causing the shortage or surplus. It will generally require you to retain a CPA who is experienced with attorney trust accounting rules to reconstruct all of the aforementioned records in order to identify all of the errors and to identify the missing or excess money in your account. In most cases, the errors causing account shortages or surpluses are due to bookkeeping errors, as opposed to a misappropriation of client funds. However, it is not uncommon for an attorney to erroneously overpay a client, a third party or himself, resulting in a shortage in the account. The condition may go undetected for years if there is always enough money flowing through the account to prevent an overdraft. When this occurs, the attorney is actually using another client’s money to cover the shortage, which is referred to by the OAE as a misappropriation.
CATEGORIES OF MISAPPROPRIATION OF CLIENT FUNDS
If the OAE concludes that a misappropriation has occurred, they will make a determination as to whether, in their opinion, it was a “negligent” or “knowing” misappropriation. Negligent misappropriation implies that an overpayment of trust moneys was caused by an error and was not intentional. However, the attorney was negligent in not complying with the recordkeeping and reconciliation rules, which are designed to prevent and detect these errors. If the condition has gone undetected for a prolonged period of time (over a year) or if there were several instances of overpayments, especially if the dollar amounts are significant, the attorney will be charged with negligent misappropriation. The penalty can potentially result in a temporary suspension from the practice of law, for a period of several months to even years, depending on the facts and circumstances and the severity of the case.
“Don’t wait to get that dreaded letter from the Office of Attorney Ethics before taking action.”
Knowing misappropriation implies that the attorney intentionally withdrew moneys from his trust account for his personal benefit, which he knew he was not entitled to. The penalty is disbarment. Although this may seem like an obvious illegal act, the underlying facts and circumstances are not always clear cut. Intent is a state of mind, which ultimately will determine whether an attorney is guilty of knowing misappropriation.
WHAT TO DO NOW
Don’t wait to get that dreaded letter from the Office of Attorney Ethics before taking action. Even if you think your trust account is being properly maintained, have a qualified CPA review your trust records to make sure you are in compliance. If there are deficiencies, they can be corrected and the books and records can be brought into compliance. Be proactive; not reactive. So, if you do get that letter, you can say “Come on in – no problem,” instead of “Why me?”
Here’s what you need to know about Form 1099 and the filing requirements your business may have.Download PDF