Posted by Robert Blech, a professional practices partner at Legal Futures Associate MHA
Blech: Interest rates have brought residual balances into the spotlight
The Solicitors Regulation Authority (SRA) is currently sending out questionnaires to firms, asking when they completed their last accountant’s report (AR1) and to upload a copy. They are further enquiring as to whether this was qualified and carried out within the required six months after the period end.
This seems a logical set of questions as there is currently no process for determining if a report was undertaken if not qualified and submitted to the SRA.
The questionnaire then goes on to ask how often the firm carries out a review of residual balances with options ranging from ‘0-3 months’ to ‘never’. There are subsequently a series of further questions, including the total value of residual balances held, the largest and the oldest balance, as well as how many matters have non-moving balances.
Residual balances have been on the SRA’s radar for several years and seen as potentially a material breach of the accounts rules, so why include them in a questionnaire about AR1s?
Whether an AR1 is qualified or not, is up to the professional judgement of the reporting accountant, but a high number of residual balances both in matters and value can indicate a deeper issue.
Processes to close files should ensure that any residual balances are dealt with promptly and returned to the client. There is guidance as to the payment of such balances to charity if efforts to locate the client are unsuccessful.
Further, when the compliance officer for finance and administration (COFA) or a manager reviews and signs the client bank reconciliation, the back-up documentation should include the matter listing. Most accounts systems will show the last movement on the individual ledger or when time was most recently posted.
This is something we as reporting accountants use to test residual balances. Of course, this does not mean a balance is ‘residual’, but may indicate it is. Therefore, the COFA/manager should ask questions as part of the review and signing process of the reconciliations.
This then raises a further question – if procedures surrounding residual balances are inadequate, are other areas falling short as well? The framework of the 2019 accounts rules is very much focused on the systems and controls that management put in place to protect client money. Often, firms with good procedures in one area of compliance will extend this to others.
There may be another reason why residual balances are taking centre stage with the SRA again. Interest rates have risen and steadied over recent months, meaning law firms are earning on monies they hold in client account. Whilst there is an obligation under rule 7.1 of the accounts rules to pay a ‘fair sum’ to clients, there is little doubt that practices are taking advantage of these rate rises.
If a client account includes a large amount (especially in total value) of residual balances, then firms are earning interest when they shouldn’t be holding that money anymore. When long-standing residual balances are paid back to the client, it will be interesting to see whether interest is added to the amount.
In the SRA’s consultation on client money – The model of solicitors holding client money – published last November and closing this Friday, there are a few questions on residual balances:
- We want to ensure we fully understand the issues firms encounter in returning excess funds to clients or third parties – please outline:
- the circumstances in which residual balances may arise on a particular matter;
- the steps that firms can take to make sure their client contact details remain up-to-date and any challenges with doing this; and
- mechanisms that firms use to trace clients/third parties and any challenges with this.
- Do you agree that we should replace the term ‘promptly’ in rule 2.5 of the accounts rules and introduce more prescriptive requirements around returning funds to clients and third parties?
- Would a 12-week timeframe from the conclusion of a case provide sufficient time in which to identify an excess balance on a client account and return the funds to the client or third party where the firm holds their up-to date contact details? If not, please give your reasons and include any specific examples of relevant issues.
- Should it not be possible to return excess funds to the client or third party within 12 weeks of the conclusion of a matter, is a further 12 weeks a reasonable timeframe to make all reasonable attempts to trace the relevant client/third party and where this is unsuccessful, donate the residual balance to charity or apply to us for approval to do so?
These questions suggest that the SRA may be looking at the commerciality of firms dealing with residual balance by asking if a 12-week period is sufficient time to return funds to clients and challenges that may occur in tracing clients.
However, it also raises the issue about what exactly ‘promptly’ means after the prescriptive nature of the accounts rules were removed in 2019. It may be that solicitors want to know exactly what they should be doing rather than the possibility of a potential misunderstanding as to the timeframe the rules refers to.
What is for certain is that residual balances are not about to be forgotten by the SRA, even if they are by law firms…
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