Proportionate regulation: reporting accountant requirements
Purpose of the consultation
This consultation seeks views on proposed changes to the SRA Accounts Rules 2011 ("the Accounts Rules") which form the second phase of a programme of reform. The proposals are part of the SRA's wider programme of reform, designed to ensure that regulation is proportionate and targeted, with the aim of removing unnecessary regulatory burdens, while providing appropriate levels of consumer protection. Read further details about the SRA's approach to regulation and its reform.
We are consulting separately on proposed changes to the Accounts Rules which apply to entities and individual authorised persons 'practising overseas'. That consultation is open until 22 December 2014.
We are keen to hear a wide range of views on the proposed changes as well as views on how we approach the third and final phase, a wider review of the Accounts Rules as a whole.
We recognise that any significant changes to the requirements to obtain and deliver an accountant's report will have an impact upon a broad range of SRA regulated firms as well as on the accountants responsible for completing the reports. Both firms and accountants play a key role in mitigating the risks posed to client money. We have therefore sought to engage widely in preparing this consultation in order to formulate our proposals on the way forward and to ensure that stakeholders are well-placed to respond.
The introduction, more than two years ago, of the role of the Compliance Officer of Finance and Administration (COFA) has given a clear focus to the requirement for compliance with the Accounts Rules, with a greater emphasis on systems and controls within firms. It is our intention to build on and enhance the compliance culture within our regulated community and we believe these proposals will contribute to this objective.
The primary purpose of the current Accounts Rules is simple - to keep client money safe. We need to balance a proper degree of oversight and control to ensure client funds are safeguarded, while ensuing that the regulatory burdens we impose are necessary and proportionate.
We have previously signalled our intention as part of this review to undertake a more significant piece of work in relation to the holding of client money. We have said that this will include consideration of the current Accounts Rules with the aim of reducing both their length and complexity and a consideration of alternatives to the holding of client money and the risks and incentives related to the holding of such money.1 We appreciate that this is a complex issue and any change might have a significant impact and will need to be carefully thought through.
This is the SRA's second consultation paper on proposals to amend the requirements to obtain and deliver an accountant's report. Having considered responses to the first consultation, the SRA Board decided to proceed with a phased approach to reforming these requirements and to engage closely with stakeholders as we make progress.2
The first phase has been implemented through rule changes that came into effect on 31 October 20143 and which:
- a. introduced an exemption from the requirement to obtain an accountant's report for the small number of firms which receive 100% of their client money from Legal Aid Agency work. This is on the basis that the blanket requirement can no longer be justified by the limited risks posed to client money;
- b. retained the existing requirement on all other firms to obtain an accountant's report within six months of the end of the accounting period to which the report relates but only require qualified reports to be delivered to the SRA within the same timeframe; and
- c. updated the format of the accountant's report to remove unnecessary information fields.
The proposals for phase two involve the redefinition of the circumstances in which accountants' reports are qualified and consequential amendments to the Accounts Rules and the format of the report. We are also considering whether there may be circumstances in which the relatively lower risks posed by certain firms would allow us to exclude them from the requirement to obtain an accountant's report as we have done for those firms that receive 100% of their money from Legal Aid Agency work.
The third and final phase of the reforms will involve a wider review of the Accounts Rules as a whole, to be implemented in April 2016. A detailed timetable for that review has not been set but at this stage we are inviting respondents, to comment broadly on our approach and to suggest any specific issues they would like us to include.
Background and Description of Issues
The Accounts Rules place a mandatory requirement on the majority of firms that hold client money to obtain an annual accountant's report. As part of our wider regulatory reform programme, the SRA has been looking at whether the obligation to obtain an accountant's report is always justified by the specific risks posed.
The first consultation, which outlined our proposal to remove the annual requirement to obtain and deliver an accountant's report, generated a great deal of debate. A number of important points were raised which have informed our decision to proceed with a phased approach. For instance, respondents expressed broad support for the SRA's desire to move towards more proportionate and targeted regulation of the risks in this area but also highlighted the importance of retaining a degree of independent scrutiny of the way that firms safeguard client money. We have also heard from accountants that we should rely more on their professional judgement. In fact this approach is already reflected in the Accounts Rules which already provide that the accountant "should exercise his or her professional judgment in adopting a suitable 'audit' programme".
The themes of independent scrutiny and of the need for more targeted and proportionate regulatory interventions underpinned the phased approach outlined in our response to the consultation. Now that the implementation of phase one is complete, this consultation sets out in more detail our proposals for phase two which, subject to the outcome of this consultation, we plan to introduce through rule changes to take effect in April 2015.
Revised criteria for qualification of accountants' reports
We have already made amendments to the Accounts Rules so that only qualified reports must be delivered to the SRA. We are now proposing a further redefinition of the circumstances in which accountant's reports must be qualified and then delivered to us.
The first of our proposals is to amend the Accounts Rules and the format of the accountant's report to remove the amount of prescribed testing that is required and to place a greater reliance on the professional judgement of the accountant, by asking them to focus on those activities which provide for an effective system for accounting for client money.
The current version of the Accounts Rules sets out the steps the reporting accountant is required to undertake4:
- the completion of detailed test procedures;
- recording of the results of the checks or tests, using a prescribed checklist;
- completion of a report which sets out the results of the examination of the accounting records by comparing on two separate dates, the money owed to clients, the money held and any difference between the two; and
- qualification of the report if it appears that there has been a failure by the firm to comply with Parts 1, 2 and 4 of the Accounts Rules and, if so, setting out the detail of the failure.
Although the Accounts Rules provide that the accountant does not need to report on trivial breaches, our experience to date is that the qualified reports we receive often do not reveal any significant risk to client monies. This is partly due to the level of detail prescribed in the Accounts Rules and in the test procedures, which means that accountants are not able to exercise their professional judgement only to notify us of significant areas of concern.
One of the issues raised in the first consultation was the need for a review of these detailed checks and tests to ensure that the reports are fit for purpose and place only proportionate burdens (and therefore cost) on the firms concerned. While some minor amendments to the format of the report have been made as part of phase one, we considered that a more comprehensive review was needed.
We are also responding to the view expressed to us by accountants that we should rely more on their professional judgement in being able to identify significant risks to client money. The underlying purpose of the requirement to obtain an accountant's report is to ensure that client money is being properly safeguarded and, if it is not, then the firm's managers and the SRA, is made aware of that fact. The Accounts Rules already specify which professionals are qualified to prepare the reports5 - each has a high degree of skill and expertise in this area. We therefore consider it entirely appropriate that they should exercise their judgement over the degree of risk posed and to reflect that judgement in their reports.
Do you agree with the proposal that we should rely more on the professional judgement of the accountant completing the report? Do you see any specific issues or concerns with this approach?
In our view, redefining the criteria in which the accountant's reports need to be qualified, to focus more on issues that may adversely affect client money, will allow us to retain a crucial element of independent oversight over firms that hold client money - but in a more proportionate and targeted way. An amended version of the format of the report we are proposing is attached at Annex 1 of this consultation paper together with a draft of how the Accounts Rules could be changed to reflect this new approach. The revisions ask the reporting accountants to carry out work on a sample basis to ascertain whether the firm has maintained an effective client money accounting system which has enabled the firm to substantively comply with the Accounts Rules. We suggest that reporting accountants are required to examine whether the firm has incorporated the following elements into its client money accounting system:
- the segregation of client and office monies;
- a robust system of controls and checks to ensure accuracy and protect against fraud;
- effective oversight by management;
- appropriate authorisation of transfers and payments out of client account;
- ledgers and other entries are maintained on a timely basis;
- an appropriately designed double entry accounting system;
- that proper office and client bank account reconciliations are performed
- adequate segregation of duties (for example, one person to prepare the client account reconciliation, but another person to check and sign it off)
- controls over incoming funds
If there are substantive deficiencies in any of these areas, the form will require the accountant to set these out. The report will be regarded as qualified and must be submitted to the SRA, in accordance with the Accounts Rules. We refer to this issue further below. If the change we have proposed is approved, we would remove Rule 39 which sets out the detailed test procedures from the Accounts Rules in their entirety. We would, however, be interested in views about whether we should issue some guidance in support of the change, setting out the sorts of tests and checks that we might expect the reporting accountant to undertake and if so the level of detail that may be appropriate.
Do you agree with the revised criteria for qualification as reflected in amendments to the format of the accountant's report located at Annex 1?
Do you have any specific comments on the proposed revisions to the format of the accountant's report in particular do you think:
- that the wording covers the main areas accountants should be reporting on?
- that the level of detail we suggest is given by the accountant in the report if deficiencies are found is right?
Do you think that the revised approach will have an impact on fees charged by accountants to do the work?
Do you consider that the revised approach will have any impact on attitudes to compliance by COFAs/the firms?
Do you think that the proposed changes should be supported by separate guidance to aid the accountants in the work they should be undertaking?
Other issues arising
In our informal engagements, prior to preparation of this consultation paper, some stakeholders have raised a number of issues that we consider it appropriate to deal with here.
The first is the suggestion that firms should have to submit an annual declaration to us, on bulk renewal of the firm's practising certificates or elsewhere, to confirm that they have a) obtained an accountant's report and b) submitted it to us if it was, in fact, qualified. Although we can understand why such an approach may seem initially attractive in light of concerns about possible levels of compliance, on reflection we do not consider that such a declaration is necessary. We have tried to avoid regulation by 'declaration', especially when the requirement to do something is set out clearly in our rules. The proposal would in effect ask the firm's managers to confirm that they have complied with the Accounts Rules. Compliance with the Accounts Rules is already one of strict liability, clearly resting with all of the firm's managers. We expect (and moreover trust) firms regulated by us to comply fully with their regulatory obligations - our Rules make this clear.
Further, it is not inconceivable that if a firm had chosen not to comply with the rules, it would also make a false declaration of compliance. A separate confirmation that the Rules have been complied with does not seem to us to be appropriate in these circumstances.
We do, of course, realise that there is a risk that some firms will not comply with the Accounts Rules and will neither obtain nor deliver qualified reports to us. We intend to mitigate this risk by asking for the accountant's reports to be provided to us whenever we engage with firms. This will provide some degree of assurance that the obligations are being met. Any failures to comply with the obligation will attract robust enforcement action. We will also retain our current ability to impose conditions on firms requiring the delivery of reports to us, either on an annual or more frequent basis. In addition the current Accounts Rules already provide that the accountant's terms of engagement must contain a requirement that the accountants must immediately notify the SRA if they discover theft /dishonesty or other circumstances that make the firm not fit to hold client money6. This reflects the statutory obligation in section 34 of the Solicitors Act 1974. We would be interested in views about whether these existing obligations should be tightened or enhanced in any way. Receipt of immediate reports in firms where significant concerns are identified will allow us to prioritise our resource to tackle immediate threats to client funds.
Do you consider that it would be helpful to require a declaration of compliance by the firm with their obligation to obtain/deliver a report in accordance with the Accounts Rules as some stakeholders have suggested to us? If you do it would be helpful if you could explain why.
Do you think that the existing obligations on reporting accountants to notify us immediately of significant concerns during the course of preparation of their reports should be tightened or enhanced in any way?
Another issue which has been raised with us is whether we should transfer the obligation to submit the reports to the SRA from the firm (where it currently rests) to the reporting accountants. The rationale seems to be that requiring reporting accountants to submit the reports to the SRA would enable us to track compliance with the obligation to obtain the reports and/or would lessen the risk that firms may choose not to submit qualified reports to us. While we understand this suggestion, our view is that such an approach is not desirable. As stated above, compliance with our rules properly rests with firms and to delegate this responsibility to a third party over which we have no regulatory control would not be consistent with our overall approach. In addition allowing non SRA regulated entities to access our on line systems would require significant IT development with attendant costs. For both these reasons, we consider we should retain the requirement on firms to only deliver qualified reports to us. Again, we would be interested in views as to whether we should be exploring this option, perhaps in the longer term as part of phase 3.
Do you think we should be exploring the option to require reporting accountants to deliver reports to us as opposed to leaving the obligation on the firms?
Criteria for exclusion of lower risk firms
A core driver for the original proposal to remove the requirement for all firms to obtain and deliver an accountant's report was our concern that such a requirement placed an undue burden on firms. Our original consultation on this issue estimated that the cost to a small firm of obtaining an accountant's report was in the region of £800. While we decided not to proceed with the original proposal in respect of all firms, earlier this year we identified a small number of firms where the requirement could no longer be justified by the limited risks posed to client monies. The changes implemented in phase one therefore exempted those firms that only hold client money received from the Legal Aid Agency, approximately 115 firms.
We have since been considering if there are any further circumstances in which firms should be excluded from the requirement to obtain an accountant's report, again on the basis of the risks posed. We are keen to ensure that we strike the right balance between retaining a degree of oversight of client money while minimising unnecessary burdens on firms. As part of our consideration of this issue we reviewed the general circumstances in which waivers of the requirement to obtain an accountant's report have been granted by the SRA over the last 12 months. Note (xi) to Rule 32.2 of the Accounts Rules already provides that "When only a small number of transactions is undertaken or a small volume of client money is handled in an accounting period, a waiver of the obligation to obtain a report may sometimes be granted".
Our existing waiver policy provides that the firm applying for a waiver will need to show that the circumstances of the application are sufficiently exceptional to justify a departure from the relevant provision(s). Prior to the introduction of the waiver policy in 2011, we implemented a process whereby firms could apply for a dispensation from the requirement to obtain an accountant's report when the total amount of client money received and held during the accounting year did not exceed £250,000 and when we were not aware of any problems with the firm, for example ongoing disciplinary proceedings or repeated requests for dispensations.
In 2013 we granted 227 waivers. 159 of the firms that applied for a waiver are still open. 68 of the firms that applied for a waiver are closed. Some of the firms that are now closed had applied for a waiver from the requirement to deliver a "cease to hold" report. Out of the 227 firms that applied for a waiver 177 had a closing balance value of less than £10,000. Where a waiver was granted, we are not aware that there was any increased risk of client detriment , but will consider whether there is any further evidence.
We do not propose to amend the waiver policy or the requirement on a firm to obtain a cease to hold report in all cases where the firm closes. However, the above research does tend to support the suggestion that we should consider amending our rules to remove the requirement for all firms to obtain a report where the risks to clients' funds are low. This may be, for example, because the amount of client funds held is generally small – perhaps because the firm does mainly employment work and client funds held on account of costs are low, or because the firm mainly does legal aid work and only undertakes a very small number of related conveyancing transactions in any one accounting year.
Proposed criteria that may capture a lower level of risk may include:
- Firms that have handled fewer than a specified number of transactions through its client account during the reporting period;
- Total value of transactions going through the client account during the reporting period does not exceed a set amount;
- Average balance held on the client account during the reporting period does not exceed a set amount;
- Firms that only receive money on account of their own fees into client account; and
- Consideration of other residual categories where the risk is low, such as removing the current obligation in guidance note (ix) to Rule 32.2 to obtain an accountant’s report in the limited circumstances where a firm has not held or received any client money during the course of the accounting year, but where in the course of practice the firm endorses a cheque or draft made out to the firm, over to a client or employer. Under the current rules the firm would therefore have held client money and would be obliged to obtain a report.
Each of these categories has its own difficulties, either for the firms in assessing if they fulfil the criteria, or for the SRA in checking if the test has been properly applied. Although superficially attractive, any criteria based on the number of transactions is likely to be unworkable in practice by, for example, defining in our rules what a transaction actually means for these purposes and then for firms in monitoring if they go over the set threshold. We also do not want to indirectly disincentivise firms from undertaking transactional work in their clients' interests.
Our initial view is if we did wish to exclude some firms from the obligation to obtain a report based on risk to client funds then criteria based around simple client account average balances would be the most suitable measure. It should be simpler for firms to monitor and therefore action. We also already collect this data as part of the annual PCRE exercise so it would not require firms to create any new monitoring systems. According to the most recent data we hold7 the impact of this may be:
- 995 firms have an average balance less than or equal to £10,000 (13.1%)
- 1957 firms have an average balance less than or equal to £50,000 (25.7%)
We would be very interested in views on the above criteria and on our current thinking that the appropriate criteria is to exclude the firms which hold an average balance of client funds of less than £10,000 in each accounting year. We would also like to hear about any other categories of firms or types of client funds (such as the suggestion to exclude firms that only receive their own fees into client account) that we should consider excluding from the requirement to obtain an accountant's report.
Subject to the outcome of this consultation it is proposed that any such criteria is captured in the Accounts Rules and that firms that meet them will be exempt from the requirement to obtain an accountant’s report. We will retain, of course, the ability to impose a condition that an accountant's report is obtained and delivered to us if we think the overall risk posed by the firm requires it. this could be because of a firm's previous poor history of compliance with the Accounts Rules. We will also retain the existing provisions which enable any other firms to apply to the SRA for a waiver if they consider that they should be exempted from the requirement to obtain a report.
Do you agree with the proposal to introduce risk-based criteria that will exempt firms with a certain profile from the requirement to obtain and deliver an accountant's report?
Do you agree that our proposed criteria capture a lower level of risk to client monies? Are there any concerns that these criteria pose an unacceptable level of risk to client monies? Or do you think we have missed other criteria?
If we decide to implement the changes to policy outlined in this document, any formal changes to the Accounts Rules, (including to the form of the report) would be expected to come into effect in April 2015, subject to LSB approval and further consideration about how best to phase in implementation of any criteria to exclude certain firms from the obligation.
We are aware that the Rules in some places may be overly prescriptive. Phase three of our approach will therefore consist of a wider review of the Accounts Rules as a whole, with the intention of implementing rule changes in April 2016. A detailed timetable and scope for the review is yet to be set.
However, we are mindful of feedback that we have received — especially from smaller firms — which suggested that a degree of certainty and prescription is helpful for firms in ensuring they have proper controls in place. We will also need to factor in the developing role of the COFA and how that person can assist in ensuing that the underlying aim of the Accounts Rules is met. We are therefore inviting early input at this time by asking respondents to make wide-ranging suggestions of any issues relating to the holding of client money that they think we should consider and specifically which specific areas in the Accounts Rules we should include in that review.
Do you have any suggestions for themes or specific areas or issues we should consider in our forthcoming review of the Accounts Rules as a whole?
Phase 2 - Changes to the reporting accountant’s requirements in the SRA Accounts Rules 2011
Questions and Answers
When will these changes come into effect?
It is proposed that the changes come into effect on 1 November 2015, subject to approval of the amendment rules by the Legal Services Board. Regulated firms and accountants should continue to operate as usual until the date of implementation.
Once the changes come into effect, which firms will be exempt from the requirement to obtain an accountant's report?
We have extended the categories of lower risk firms exempt from the requirement to obtain an accountant's report to include those who, during the relevant accounting year have had both an average client account balance of £10,000 or less, and a maximum client account balance of £250,000 or less.
When and how was this decided?
The Phase 2 consultation was issued on 18 November 2014 and closed on 28 January 2015. The consultation made a number of recommendations designed to, amongst other matters, remove the level of prescription we impose on the way accountants assess compliance and to exempt a greater number of low risk firms from the requirement to obtain a report.
Why have you made these changes?
Although the Accounts Rules provide that accountants do not need to report on trivial breaches, our experience to date is that the qualified reports we receive often do not reveal any significant risk to client monies. This is partly due to the level of detail prescribed in the Accounts Rules and in the nature of the test procedures these prescribe.
The responses to the May 2014 consultation highlighted the need for a review of these detailed tests to ensure that reports are fit for purpose and place only proportionate burdens (and therefore cost) on the firms concerned.
Will these changes mean accountants become responsible for firms’ regulatory requirements?
The obligations to comply with the Accounts Rules remain with the solicitor’s firm and have been unaffected by these changes. There is already an obligation in the Accounts Rules for accountants to notify the SRA directly if there is evidence of theft or fraud or significant concerns about the fitness and propriety of the firm to hold client money.
Will you be issuing guidance for accountants following these changes?
Guidance intended to be used by both firms and accountants is published in the download section below. This is intended to allow practitioners to familiarise themselves with it prior to implementation. The guidance sets out our new approach, namely that reports should only be qualified where the breaches identified are material and are therefore likely to put client money at risk. It clarifies that, whilst we recognise that trivial breaches of the Accounts Rules do occur in many firms, we are not expecting all identified breaches to be notified to us in the form of a qualified report. It goes on to provide assistance to accountants in deciding when breaches are material and when reports should be qualified; setting out (in section 2 of the guidance) some indicative factors indicating a significant weakness in the firm's systems and controls, such as a significant and/or unreplaced shortfall on client account.
Are these changes going to result in an increase in costs to firms?
Having developed accompanying guidance, we anticipate that any impact on costs will be minimised. Further, we would take this opportunity to emphasise that there is no change to the requirements in the Accounts Rules in relation to how firms should treat client money. This means that firms that are already complying with the rules will not need to introduce any additional procedures.
We consider that these proposals could benefit a number of firms by providing an opportunity to adopt practices that are less prescriptive and potentially less costly or burdensome.
Will firms in the exempt categories that are closing down need to obtain a report?
Yes. We have retained the requirement that all firms (including those that will be otherwise exempted) that close down or otherwise cease to hold client money, should obtain a final accountant's report to ensure that they have properly accounted for all client money.
Will firms/accountants need to confirm if a report is deemed unqualified?
We do not require firms to make an annual declaration. The duty to submit reports remains with the regulated firm and its managers. Accountants have an obligation to notify us immediately if they discover that a previously qualified report has not been submitted to the SRA. There is also an additional requirement on the firm and the accountant to retain a copy of the report for at least six years.
What is the SRA planning to do during phase 3 of the changes to the reporting accountant's requirements in the SRA Accounts Rules 2011?
The third and final phase of the reforms will involve a wider review of the Accounts Rules as a whole. A detailed timetable for that review has not been set. In the phase 2 consultation we invited respondents to suggest any specific areas or issues that they would like us to include. The responses included a general consensus for a move towards a less detailed and prescriptive, more principle-based approach, and a review of the impact of internet banking and development in relation to VAT and third party funding. We will feed these issues into the development of our further consultation proposals.