89-F-121 - Mechanics of Trust Accounting

FORMAL ETHICS OPINION 89-F-121


THE MECHANICS OF TRUST ACCOUNTING


The Board issues this Formal Ethics Opinion on the Mechanics of Trust Accounting for the consideration of members of the Tennessee Bar by adopting the following portions of a treatise on Trust and Business Accounting for Attorneys, Second Edition, 1988, by David E. Johnson, Jr., Esquire, Director, Office of Attorney Ethics of the Supreme Court of New Jersey, as follows:
...In most states, whether by rule, statute or case law, attorneys are simply admonished to account in accordance with generally accepted accounting practices. Most attorneys, however, are not accountants and so this general direction, without more, leaves much to be desired.
...(C)omplete compliance with trust accounting duties requires familiarity with only four items:
A. Trust Checkbook...
B. Trust Receipts Book...
C. Trust Disbursements...
D. Client Trust Ledger Book...
A. Trust Checkbook
This is the most familiar of the trust accounting documents. It is, as it says, simply a form of checkbook. It may be identical in form to a personal checkbook, and anyone who can properly keep a personal checkbook can easily maintain a trust checkbook....
There are two parts to the checkbook itself: the checks and the stub. The check itself is self-explanatory. All checks must be pre-numbered. The stub is a miniature accounting sheet which, given a correct beginning balance, allows you to add-in the amount of all deposits and to subtract-out the amount of all the checks (and bank fees), giving you a new correct running balance. For those who like to look at these things horizontally, instead of vertically as the stubs are produced, the information would look like this:
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Date                         Description of Client or Matter             Deposits (ADD)                     Check (Subtract)                   Running Balance

5/2/1987                               John Smith                                        $5,000                                                                                $17,500

5/13/1987                           Rebecca Sands                                                                                   $3,200                                 $14,300

5/20/1987                             John Smith                                                                                       $1,300                                 $13,000

5/20/1987                              John Smith                                                                                      $3,700                                 $ 9,300

5/21/1987                              Burtol Corp                                      $2,000                                                                                $11,300

Monies come into the trust account via deposits, either by the lawyer or by the financial institution. If the attorney deposits the money, a deposit slip... will be completed by filling out the date, amount, client's last name or file number (to protect client confidentiality) and the source of the deposit by recording the bank identification code number of the check that is being deposited. These codes are found at the upper right-hand corner of a check. They are an identification code developed by the American Banker's Association and enable anyone with the code tables to locate the bank on which the check is drawn very accurately.
Some deposit slips are carbonized and the carbon portion, called the duplicate deposit slip, is returned to the attorney by the teller at the time the deposit is made. If carbonized deposit slips are not used, the teller will give the attorney a receipt showing the day, time and amount of the deposit. In this case it is important to record right on the receipt, the client's name or file number and the source bank code of the check that was deposited.
Deposits may also be made by the bank issuing a memorandum (a/k/a credit memo) showing the date, amount and source of the monies so deposited... This is the case where a client wires money directly from her account to the attorney's account.
Monies may be disbursed (a/k/a withdrawn), either by the attorney or the financial institution. Checks written on a trust account are identical to other checks... Checks, like deposits, must list the date and client or legal matter (i.e., purpose). As a corollary to the source, which is required to be noted on the deposit ticket, every check must show the payee.
As with deposits, withdrawals can be made by the financial institution issuing a memorandum (a/k/a debit memo)... Thus, for example, where funds are wired from your account to that of your client in California, your financial institution will issue a memorandum advising the date, amount and source of the monies so transmitted. Debit memos are also issued for service items such as (a) cost of wire transfers, (b) monthly service charges, (c) overdraft notices, (d) check printing charges, (e) returned item notices, and other services rendered to you for which a fee is charged....
That is all there is to handling a trust account checkbook! It is really no different from handling a personal checking account. Three rules, however, make it work. First, all entries (deposits and disbursements) should be recorded contemporaneously (within 24 hours of the event). Second, all entries must be exact, to the penny. There is no room for rounding-off figures. This may be tolerable for personal accounts, but is definitely not acceptable for a trust account. Third, you must always keep a running balance preferably after each deposit or disbursement. ...
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B. and C. Trust Receipts and Disbursements Books
While these items sound foreboding to some, they are in fact much less complicated than the trust checkbook. In fact the Trust Receipts Book is nothing more than a chronological listing of every deposit made to the trust account. Conceptually, a yellow legal pad would serve the purpose! From the point of view of generally accepted accounting
practice, however, a bound book (or journal) which gives these records some permanency is the required form. ...Note that it contains the exact same information required to be maintained in the trust checkbook stub and on the deposit slip or receipt itself, namely:
(a) date;
(b) source;
(c) client name or matter; and
(d) amount.
Similarly, the Trust Disbursements Book is a chronological listing of every disbursement made from the trust account. ...It contains the identical information required to be recorded on the trust checkbook stub and on the check (or a debit memorandum) itself, namely:
(a) date;
(b) payee;
(c) purpose; and
(d) amount.
In defining a Trust Receipts Book I stated that it must contain a chronological list of each and every deposit. This includes all credit memos from the financial institutions. ...Similarly, the Trust Disbursements Book must reflect each and every disbursement including any debit memos received....
At the end of each month, the total of all monies received should be added up as reflected in the Trust Receipts Book. Likewise, the total of all disbursements must be added as shown in the Trust Disbursements Book. These monthly totals should then be placed on the Control Sheet. ...(T)he Control Sheet is one of the first steps in the reconciliation process and filling out the Control Sheet monthly puts you a step ahead in the reconciliation process.
But why record the same information twice, you might ask? Why record all the same information you included in writing out a check in a Trust Disbursements Book? Good question! There are several reasons.
The first relates back to...maintaining an audit trail. The deposit slips, receipts, checks and memoranda are all referred to as source documents. They are the documents which actually "move" money around. Therefore, they must reflect the descriptive information above so they provide a complete audit trail, a direct link, to the trust receipts and disbursements books and to the clients' ledger book which will be covered next. But they are not permanent records. Recording their information in receipts and disbursements books, however, gives them permanency and accords with generally accepted accounting practice. ...
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The other reasons relate to the purposes for the trust receipts and disbursements books, which are three-fold. First and foremost these two records, under the commonly used double-entry bookkeeping method, permit you to double check the running balance in the trust account to make sure it is correct... The second purpose which these two books serve is an easily accessible means of locating items by arranging all deposits together chronologically in one book, and all disbursements together chronologically in another book. This is particularly handy at reconciliation time when a transposition error has occurred. In short, it makes it easy to find mathematical errors chronologically. Finally, and this is very important to realize, trust receipts and disbursements books allow you to look at your trust account activity on a macro-level. Add up all of the deposits listed in your trust receipts book for a particular month (or year) and see how much trust money you took in during that period. Similarly, add up all the disbursements in your trust disbursements book for a year (or a month) and see how much trust money went out during that period. Add the amount of deposits to the amount of disbursements for a given period, say one year, and you can tell the total amount of client funds for which you were responsible.
All of the three records that have been discussed so far--the Trust Checkbook, Trust Receipts Book and Trust Disbursements Book--give the "big picture," the overview. However, while this is very important, it is at least equally important to know, at any given time, exactly how each client's funds stand. This can be ascertained by the fourth and final item -- the Clients' Trust Ledger.
D. Clients' Trust Ledger Book
...(S)eparate clients are separate accounts. Indeed, this is the foundation of trust accounting, maintaining the individual separation and control that each client has the right to expect.
In order to maintain this full control and separate accountability of each individual client's trust funds, we maintain an individual accounting record of every deposit to and disbursement from that particular client's account. We do so by maintaining a separate book, called a Clients' Trust Ledger, with a separate page for each trust client.
The concept of an appropriate ledger book ... contemplates an integrated record which will show the current status of all funds collected or received for the credit of a particular client or beneficiary, all payments out and the amount, if any, remaining due the client. ...The Client Trust Ledger Book itself may be either bound or loose leaf, with removable ledger sheets which may be taken out when the client matter is closed. Original closed ledger sheets should not, however, be placed in the closed case file where they will be lost forever unless the name of the client is recalled. While a photocopy of the closed ledger sheet may properly be placed in the individual client case file, the original should be placed in a closed three ring binder and arranged alphabetically for future reference.
A separate client ledger sheet must... be maintained for each separate trust client. Thus, an entirely separate page must be set up for each client, regardless of the fact that all funds coming into the attorney's hands are disbursed simultaneously. This situation commonly occurs, for example, in real estate transactions. Good record keeping practices indicate that the reverse
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side of a ledger sheet should also be reserved for the sole use of that single client. Do not use the reverse side of one client's ledger for another client's case. Likewise, where a single client has multiple matters being handled by the same attorney, each separate financial matter should be reflected on a separate client ledger sheet.
...Like the trust account checkbook, a running balance on each individual client ledger sheet is maintained. This is so because we must NEVER disburse more money than we have on hand (collected) to the credit of that individual client. Keeping a running balance permits the attorney to know this at a glance.
Also, note the descriptiveness of the client ledger sheet. ...It must reflect:
(1) the source of funds deposited;
(2) the names of all persons (i.e., clients)
for whom funds are or were held;
(3) the amount of such funds;
(4) the description and amounts of all charges
or withdrawals (i.e., disbursements) from such
accounts;
(5) the names of all persons to whom funds
were disbursed.
Putting It All Together
We have separately looked at each of the four items that comprise the basics of correct attorney trust accounting. They are:
A. Trust Checkbook;
B. Trust Receipts Book;
C. Trust Disbursements Book; and
D. Clients' Trust Ledger Book.
Now we shall see how they fit together to form an integrated accounting system.
...(A)s a deposit comes in, say a settlement in a negligence matter, the check is received by the attorney (Step 1). The attorney then prepares a source document, which is a deposit slip (Step 2), and physically makes the deposit and has the duplicate deposit slip returned, stamped received with the date. This information is then entered in the trust checkbook (Step 2). Next, the deposit information is entered chronologically in the Trust Receipts Book (Step 3) and is also
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recorded on the individual client's trust ledger (Step 4).
Set forth below is a simple key to show the trust documents on which deposit and disbursement information must be recorded.
TRUST ENTRY KEY
DISBURSEMENTS
TRUST RECORDS
ENTER DEPOSITS
ENTER
A.
Trust Checkbook
X
X
B.
Trust Receipts Book
X
C.
Trust Disbursements Book
X
D.
Clients’ Trust Ledger
X
X
Reconciliation -- The 3-Way Check
Everybody makes mistakes when it comes to figures. Even banks and accountants make mistakes on occasion. This should not be surprising because there are a lot of ways that mistakes can be made. Simple arithmetic mistakes in addition or subtraction are common. Transposition errors occur when our eye rearranges the sequence of numbers and we record $122.92 when the correct figure is $129.22. In a similar vein, banks, which process checks and deposits electronically overnight by the millions, will sometimes have an encoding error when one of its coders reads a $1,000 check but encodes the amount at the bottom right-hand corner as $10,000. Other errors which may occur run the gamut from simply skipping one of many lines while transferring figures from one list to another, to perhaps the simplest mistake of all -- forgetting to record a check or deposit at all.
A reconciliation allows the attorney to detect when an error has occurred by showing that items, which should balance, do not balance. Our record keeping rule (and generally accepted accounting practice) requires that a reconciliation be performed at least quarterly.
...Naturally, the more frequently an account is reconciled, the sooner one will be able to detect, and thus correct, an error. The best rule is to reconcile monthly. Copies of all records reflecting quarterly reconciliations must be retained.
Reconciliation is the process by which all required trust records are brought into agreement. More simply, perhaps, it represents a balancing process by which the trust account records are all brought into a state of equilibrium. Based upon our model double-entry bookkeeping system, a full reconciliation requires a three-step review and analysis of the four documents.... By this process:
(1) the balance of all trust receipts and disbursements
is reconciled to the total of individual client
ledger balances on hand;
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(2) the total of individual client ledger balances on hand
is then reconciled to the trust checkbook balance; and
finally,
(3) the trust checkbook balance (as adjusted) is then reconciled with the balance on the trust bank account statement.
STEP NO. 1
The very first step in the reconciliation process is to obtain a correct beginning balance. You can never reconcile an account unless you know the correct balance which you should have on hand to start with. When a new trust account is opened, the first time the account is reconciled the beginning balance will be zero. The beginning balance for each succeeding period for which a reconciliation is prepared will necessarily depend upon the prior reconciled balance being correct. This requires any discovered errors to be resolved. If you are not sure that the beginning trust balance is correct, you should consult a bookkeeper or an accountant. Carrying an incorrect balance only compounds the problem, as time makes finding and correcting the errors more and more difficult.
STEP NO. 2
The second step in the reconciliation process is to add up all items for the reconciliation period (i.e., month or quarter) that have been recorded in the Trust Receipts Book.... The same total is then compiled for the Trust Disbursement Book.... Both of these figures are placed on the Receipts/Disbursements Control Sheet..., together with the beginning balance. The total of trust funds received is then added to the beginning balance. From the resulting figure, the total of trust funds disbursed is subtracted. This results in a new balance figure. It is this figure which will form the bedrock of the reconciliation process. That figure is also placed in the appropriate place on the Trust Reconciliation Sheet.
STEP NO. 3
Next, prepare a list of the names and balances on hand (as of the bank statement date) for all trust clients and place them in the appropriate location on the Trust Reconciliation Sheet. These client figures are obtained by taking the last running balance from each individual Client's Trust Ledger Sheet and inserting the total of all individual ledger balances in the appropriate place on the Trust Reconciliation Sheet. (If there are many clients, a separate
schedule of clients' ledger balances should be made.)
STEP NO. 4
Compare the Control Sheet Balance to the total Clients' Trust Ledger Balance. They must be equal. ...
STEP NO. 5
Place the amount of the checkbook balance in the Trust Checkbook in the appropriate
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place on the Trust Reconciliation Sheet. Compare the amount of the Total Clients' Ledger Balance to the balance in the Trust Checkbook. They must be equal.
STEP NO. 6
List all outstanding checks and outstanding deposits (also called deposits in transit) on the Trust Reconciliation Sheet that are not reflected on the latest monthly bank statement for the reconciliation period. Add the outstanding checks to the Trust Checkbook Balance and place that amount in the place indicated on the Trust Reconciliation Sheet. Subtract from that figure all outstanding deposits and place that amount opposite the entry titled "Reconciliation Balance." Insert the Bank Statement Balance on the Trust Reconciliation Sheet.
STEP NO. 7
Compare the Reconciliation Balance to the Bank Statement Balance - they must be equal.
Congratulations, if both figures are equal! If they are you have successfully, and correctly, reconciled your trust account. If there is a difference between the two figures roll up your sleeves, call in your bookkeeper or check with an accountant. Whatever you do, do not do nothing. Figures which do not reconcile only get harder to reconcile with time.
This 9th day of December, 1989.
ETHICS COMMITTEE:
/s/ Kitty G. Grubb
/s/ Michael E. Callaway
/s/ Charles T. Herndon, III
APPROVED AND ADOPTED BY THE BOARD