Three Way Reconciliation and Trust Accounting Tips

A Division of Real Estate Broker Advisory

For those of us who grew up in the pre “internet everything” generation, and had to balance our checkbooks monthly, we likely know what a two-way reconciliation is, but the three way reconciliation seems to create confusion for some. The intent of this newsletter is to offer a refresher on the concepts surrounding the required monthly reconciliations as well as offer some training on some of the key elements of license law surrounding trust accounting, the challenges auditors and investigators often see, including issues surrounding software.

Demonstrating A Reconciliation: Two-Way vs. Three-Way

A Two Way Reconciliation: At the end of each month, our bank sends a bank statement with all of the monthly transactions, along with the beginning and ending balance for that period. This is our starting point for a reconciliation. We need to have our checkbook register handy. This is our journal where we track all of our transactions for the month, along with the running total. We will also need a worksheet handy as we start our process.

First, we start with the ending balance. If the bank statement for the August 31, 2019 security deposit trust account has an ending balance of $100,000, our starting point for our two way reconciliation is $100,000. From the bank’s perspective, there is $100,000 of available funds. Most of the time, however, we know this is not an accurate figure. Why? Because there are typically deposits into the account and uncleared checks written not reflected on the statement. For our example, let’s assume that we received our bank statement on September 5, 2019. As of September 5, 2019 our journal shows we have 108,000 in our account. On the surface, it appears they don’t reconcile, which is why we need to do a reconciled bank statement, or worksheet.

The two match and therefore in our two-way reconciliation example, we have reconciliation. Unfortunately, when brokers are performing reconciliations, this is where they often stop. When a broker is holding money belonging to others, there is a third component that must be compared to the reconciled bank statement and journal total, and this is the total of the liability ledgers.

Returning to our scenario, on September 5, 2019 we have 108 doors we are managing. We are holding $1000 security deposit for each tenant. If all of the tenants move out on the same day, and are entitled to their full deposit back, we would have to write checks totaling $108,000. In other words, our liabilities are $108,000.

Worksheet Example

Worksheet Example Continued

A and B represent two-way reconciliation and A, B and C represent the 3 way reconciliation.

Assets

Assets (cash in the trust account) always have to match the liabilities for the trust account. Liabilities in the account can also include sales tax held for short-term rentals, and money belonging to the broker within the trust account. The later has restrictions and will be discussed in subsequent sections. Each individual or entity for whom the broker holds funds must have an individual ledger that feeds into the total.

Without the resulting cash balance for the account after each entry, it will be impossible to do a three-way reconciliation as the journal total is one of the three components.

Because different programs refer to the reports by different names, it is critical that the responsible broker understand the required elements of the report. For example, many software reports refer to the journal as the General Ledger. It has the same components as the journal and is therefore the journal. The General Ledger is NOT the liability ledger.

If you manage minimal properties and do not use software, please use the Division’s 3-Way Reconciliation Worksheets
Additionally, find the Reconciliation Template the auditors send to brokers to use as a cover sheet for the three way reconciliations.

3-Way Reconciliation Worksheets

3-Way Reconciliation Worksheets 6-11-19.xlsx

A journal has to include the following:

date of receipt and deposit,
the name of the person who is giving the money,
the name of the person and property for which the money was received,
the purpose of the receipt, the amount, and
a resulting cash balance for the account.

For funds disbursed, the records maintained in the system must include:

the date of payment,
the check number,
the name of the payee,
a reference to vendor documentation or other physical records verifying purpose for payment,
the amount paid, and a resulting cash balance for the account. (E-1 (o)(1))

Reconciliation Template

Reconciliation Worksheet.pdf

The Software Dilemma

Software can be an essential tool for brokers managing a large volume of properties. However, auditors have noticed that software reports used for the reconciliations often do not comply with Colorado license law. In one case, the software has an option to run a three-way reconciliation. On the surface, it appears this would be a great tool. However, upon closer review, the three-way reconciliation does not include a liability ledger total and is therefore a two-way reconciliation. As a broker, you cannot determine if the assets = liabilities, if you do not review the total liabilities on the same day you reconcile the bank balance. Remember, it is your responsibility to confirm your trust accounts, including reconciliations, comply with license law.

Negative Liability Ledger Balances, What’s the Big Deal?

When reviewing liability ledgers, we are often seeing a negative ledger balance. License law specifically states that no liability ledger can ever be negative. (See E-1 (o)(2)) Why does this matter? First, in doing the reconciliation, if negative balances are included in the reconciliation, it underestimates the liability, and is therefore not actually reconciling. The second reason that negative ledger balances are of concern is often the reason why they are negative. A broker will often pay a bill to a vendor on behalf of the owner when the owner does not have enough funds in the account, or distribute money to the owner before a rent check from the tenant check has cleared, and the check later bounces. Both result in the trust account being owed money and therefore a negative ledger balance. Remember, when the liability ledger is positive, the broker owes the money, if the ledger is negative, the trust account is owed money. What has happened in these scenarios is that someone else’s money, also held in the trust account has covered the check, which in most cases is an indicator of diversion/conversion prohibited in E-1 (p).

Can A Broker Have a Cushion (Extra funds in trust account) “Just In Case?”

This simple answer is no. Outside of the minimum amount to keep the account open or to cover monthly fees, a broker cannot keep money in the account as a cushion for a bounced check or emergencies. If broker money is held in the account to cover the fees, the broker must maintain a liability ledger; otherwise, there will be a discrepancy in the total liability for the month end reconciliation.

What if there is an emergency and a check has to be written on behalf of an owner and the owner does not have enough funds? E-1(e)(4) discusses a provision in this case. A broker can advance an owner funds, but it must be recorded and reported properly. Specifically, “Any amount advanced to an escrow or trust account must be identified and recorded in the escrow journal, the beneficiary ledger and disclosed in periodic accounting to the beneficiary.” (E-1(e)(4).

Cash or Accrual Accounting: Does it Matter?

Yes, it does. E-1(o)(7) states the following: “In the absence of a written agreement to the contrary, the “cash basis” of accounting shall be used for maintaining all required escrow or trust accounts and records.” It goes on to state, if a beneficiary of a trust account wishes to have the accrual basis of accounting, those funds must be separated.

An increasing number of brokers are hiring outside accountants to handle the trust accounts. Often times the accountants are not familiar with license law and assume an accrual basis is acceptable. Why does it matter? The reason is rooted in the distinction between cash basis vs accrual basis. In cash accounting, revenue is not recognized until cash is actually received. Accrual accounting records monies when they are earned and expenses when they are billed, but not paid. Under the accrual method, if rents in are recognized when they are due, not when they are actually received, and a bill is paid on behalf of an owner, or owner distributions are made, there is not actual funds to cover the payment and therefore diversion/conversion is a likely and common occurrence when accrual accounting is used.

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