by floyd@marathon-records.com

The Surplus Ledger

Please send all questions and comments to floyd@marathon-records.com

Problem:

Many bookkeepers create a surplus ledger to make the account reconcile. This surplus ledger negates the benefit of the reconciliation process, which is to identify errors or inconsistencies quickly so they can be corrected easily. The number of surplus ledgers has increased because (1) the American Land Title Association’s best practices and many title insurance companies require daily reconciliation and (2) most states’ rules of professional conduct for lawyers require regular reconciliations. Lawyers and title insurance agents are feeling the pressure to balance on a daily basis. A result of this pressure is the surplus ledger.

Definition:

A surplus ledger is a fake client ledger where unidentified funds are moved “on paper” so that all individual client accounts zero out. Total balances in the account (main register and total of all individual ledgers) reconcile with the bank statement, but the records are incorrect in the individual client ledgers. The surplus ledger goes by many different names. Common names for surplus ledger include research, transfer, discharge, escrow, un-identified, or even unknown.

Examples:

(1) A lawyer handles a real estate transaction. He receives the funds and deposits them into his IOLTA / R.E. escrow account. He then creates an individual client ledger in his account records as required by the rules of professional conduct and ALTA best practices. The lawyer then handles the transaction and disburses most, but not all of the funds (e.g. the lawyer needs to hold back a small amount of funds, such as $75.00, in case he needs to record a discharge). The lawyer’s title insurance company and ALTA best practices require him to reconcile the account on a daily basis. The $75.00 he is holding does not allow him to zero out the transaction the same day. For this reason, he creates a “discharge” ledger and moves the money there. The lawyer now neatly has a zero balance in the client ledger and a surplus account in his records.

(2) A lawyer hires a bookkeeper to reconcile her IOLTA account monthly. The lawyer puts everything into an envelope at the end of each month and sends everything to her bookkeeper. The bookkeeper creates the IOLTA account records, but he cannot identify all of the transactions due to lack of information, poor handwriting, or some other reason. The bookkeeper resolves this issue by creating a ledger for “research” that he returns to the lawyer with the transactions identified and a request for more information. The bookkeeper intends to edit the records once the lawyer sends more details about the unknown transactions. The lawyer, however, is busy and she does not send the bookkeeper the additional information for each transaction in the “research” ledger. As a result, the “research” ledger has an outstanding balance, but the lawyer’s account reconciles because the totals all match (main register balance, total of individual client ledgers, adjusted bank statement balance). Every month new transactions are added to the “research” ledger, the number of unidentified transactions grows, and the overall account continues to reconcile.

(3) Many real estate lawyers now use an electronic recording system that takes funds directly from the lawyer’s account for recording fees. Most lawyers have a policy of never allowing a third party to access their IOLTA account. For this reason, the lawyer opens a second IOLTA account and transfers funds from the “main” account to the “second” account so the recording company can withdraw the funds via EFT. This is a good policy to prevent third parties from withdrawing too much money from the main IOLTA account. Problems occur, however, when lawyers only track the funds in the “main” IOLTA account. This account balances perfectly because the funds are shown as being distributed. If the funds are not withdrawn automatically from the second account, the funds sit unidentified.

The Audit:

There are primarily three ways to identify the surplus account during an audit.

First, identify the ledger with an odd name. A thief will often use a name mimicking a legitimate client file. The well-intentioned bookkeeper will often use an easy to spot name such as research, transfer, discharge, escrow, un-identified, or even unknown.

Second, compare the individual client ledgers to the bank statements as funds allocated to the surplus account may not appear on the bank statement. For example, a bookkeeper moving an unidentified $75.00 to the surplus account will enter a transaction in the register with the surplus account as the client matter. No transaction appears on the bank statement because no money actually leaves the account. A surplus account is often present when an auditor identifies a number of transactions in a client ledger that do not match the bank statement.

Third, a client matter ledger that has been open indefinitely is often a surplus ledger. A surplus ledger often has very few disbursements and grows over time instead of shrinking. A normal client matter has a normal time cycle (depending on the type of case). Typically, funds are collected then disbursed until the balance is zero. For example, a personal injury ledger (in an IOLTA account) will show the settlement check deposit then disbursement of the funds within a matter of days. In some instances (e.g. the parties are negotiating settlement of a lien), the matter will remain open for several more weeks. A surplus account, however, does not follow the normal time cycle of other cases because funds seldom leave the account. In other words, the surplus account appears indefinitely. An auditor who sees the same client matter ledger open for an extended period of time has often spotted a surplus account and the auditor should closely dissect the funds within that ledger.

Common problems:

The unattended surplus account causes problems that go beyond auditing the account. The main problem is that the longer a transaction goes unidentified, the harder it will be to properly identify the fund’s owner. Funds held in an IOLTA or R.E. escrow account do not belong to the lawyer. Those funds must be returned to the proper party. Many lawyers, as the result of an outside audit, spend hours auditing an account to identify the proper owner of small amounts of money. Other lawyers spend thousands of dollars to have an accountant reconstruct an account by reviewing bank and transaction records that are sometimes years old.

Problems sometimes arise disbursing the funds once the lawyer has identified the funds’ proper owner. For example: clients who move or die present special difficulties for the lawyer. In such cases, the lawyer may have to conduct additional research to find the client’s new address or the proper owner of the fund. If the funds belong to a corporation, the lawyer may discover that the corporation is out of business, has merged with another entity, or may have already written off the missing funds as a loss. All of these situations require additional time or expense.

(Another issue arises when the surplus account acts as a de facto overdraft protection. For example, the lawyer makes an accounting error that should cause a negative balance. However, due to the surplus in the account, the check does not bounce and the error goes unnoticed. The lawyer may discover these account errors only later, sometimes years later, when an audit-triggering event occurs. An adverse party in a litigation case or lender in a real estate transaction may wire funds to an incorrect account. The lawyer often verifies that the wire has been sent and records the transaction into the account register and client ledger. If enough of a surplus exists in the IOLTA or R.E. escrow account, the lawyer may proceed with the transaction and not bounce a check. The records often show the surplus ledger reduced by the amount of the missing transaction. The missing deposit will be discovered only when a full audit is done when it may be too late to reverse the wire. As a result, the lawyer has misused the client funds in the surplus account. The lawyer will then need to reimburse the party out of pocket.

Auditing the surplus ledger:

The surplus ledger must be audited once it is discovered. Auditing a transaction in the surplus ledger is no different from auditing any other transaction. Volume and age of the transactions pose unique problems with the surplus ledger because older transactions are harder to research. Most importantly, stop using the surplus ledger immediately. The surplus ledger is a crutch that people use to park transactions so they balance immediately, often with the intent to research and properly document the transaction at a later date. Make a habit of documenting transactions properly and researching errors and inconsistencies appearing on the reconciliation report immediately.

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