Breaches of the SRA Accounts Rules - Accounting entries required to rectify breaches

Learning Outcomes

This article details the requirement under the SRA Accounts Rules to correct breaches promptly upon discovery. It outlines the accounting entries necessary to rectify common breaches, such as incorrect withdrawals from a client account or misuse of client money. For the SQE1 assessment, you will need to understand the principle of prompt rectification and be able to identify the correct accounting steps to remedy breaches. This knowledge will enable you to apply the SRA Accounts Rules effectively to practical scenarios presented in SQE1-style multiple-choice questions.

SQE1 Syllabus

For SQE1, you are required to understand the practical implications of breaching the SRA Accounts Rules and the steps needed to correct such breaches. Your understanding should include the following areas:

• The overriding duty to correct breaches promptly upon discovery (Rule 6.1).
• The specific requirement to immediately replace money improperly withheld or withdrawn from a client account.
• The accounting entries required to reverse incorrect transactions.
• The accounting entries required to make correct transactions following a reversal.
• The use of the firm's business money to rectify client account shortages.
• The importance of maintaining accurate accounting records to identify and correct breaches.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. According to Rule 6.1 of the SRA Accounts Rules, when must breaches be corrected?
   1. Within 14 days of discovery.
   2. Promptly upon discovery.
   3. At the end of the accounting period.
   4. When instructed by the SRA.
2. If £100 of client money is incorrectly used to pay a firm's business expense, what is the immediate action required regarding the client account?
   1. Notify the client immediately.
   2. Obtain SRA authorisation before acting.
   3. Replace the £100 in the client account immediately using business money.
   4. Wait for the next bank reconciliation before correcting.
3. Which ledger account is typically debited when correcting a client account shortfall using the firm's own funds?
   1. Client ledger client account.
   2. Client ledger business account.
   3. Cash sheet client account.
   4. Interest payable ledger.

Introduction

Compliance with the SRA Accounts Rules (the Rules) is fundamental to maintaining public trust and safeguarding client money. However, errors and breaches can occur. Rule 6.1 imposes a clear duty on firms and individuals to correct any breach of the Rules promptly upon discovery. This article focuses on the practical accounting steps required to rectify common breaches, ensuring compliance and protecting client funds. Understanding these corrective procedures is essential for SQE1 assessment purposes.

The Duty to Correct Breaches Promptly

Rule 6.1 of the SRA Accounts Rules is unequivocal: any breach must be remedied promptly upon discovery. This principle applies to all breaches, but it carries particular urgency where client money is involved. Specifically, Rule 6.1 mandates that any money improperly withheld or withdrawn from a client account must be immediately replaced.

Key Term: Breach
A failure to comply with any requirement set out in the SRA Accounts Rules.

This means that if a firm discovers, for example, that client money has been used incorrectly, or that a client account has been overdrawn using other clients' funds, the firm cannot delay rectification. The correction, especially the replacement of missing client money, must happen immediately.

Key Term: Rectification
The process of correcting a breach of the SRA Accounts Rules, including making the necessary accounting entries and replacing any improperly used client money.

Failure to correct breaches promptly can lead to further breaches, potential loss for clients, and disciplinary action by the SRA. The duty to remedy breaches rests jointly and severally on all principals (partners, members, directors) in the firm.

Common Breaches and Rectification Entries

Understanding the correct accounting entries is essential for demonstrating compliance upon rectification. The process typically involves reversing the incorrect entry and then making the correct entry. Often, this will necessitate a transfer of funds between the business bank account and the client bank account.

Use of Client Money for Business Payments

One serious breach is using money from the client bank account to pay for a business expense when insufficient funds are held for that specific client, or using client money designated for one purpose for another unauthorised purpose. This breaches Rule 5.3 (only withdrawing client money if sufficient funds are held for that specific client) and potentially Rule 5.1 (only withdrawing for the purpose held or on instruction).

Rectification:

1. Identify the Error: Determine the amount improperly withdrawn from the client account.
2. Replace the Client Money: Immediately transfer the exact amount from the business bank account to the client bank account.
3. Record the Correction:
   • Transfer out of business account:
     • Debit (DR) the relevant Client Ledger Business Account (to show the firm funded the correction).
     • Credit (CR) the Cash Sheet Business Account (showing money leaving the business bank).
   • Transfer into client account:
     • Credit (CR) the relevant Client Ledger Client Account (restoring the client's balance).
     • Debit (DR) the Cash Sheet Client Account (showing money entering the client bank).

Worked Example 1.1

A firm pays its £500 electricity bill using a cheque drawn on the general client bank account by mistake. The error is discovered the next day.

How should this breach be rectified in the accounts?

Answer: This is a breach of Rule 5.1 and 5.3. Client money has been improperly withdrawn. The firm must immediately replace the £500.

Accounting Entries:

1. Transfer £500 from the business bank account to the client bank account.
2. Record the transfer:
   • DR Client Ledger Business Account (Electricity Expense) £500
   • CR Cash Sheet Business Account £500
   • CR Client Ledger Client Account (showing £500 paid back in) £500
   • DR Cash Sheet Client Account £500

The initial incorrect withdrawal (DR Electricity Expense (Business) £500, CR Cash Sheet Client £500) would also need to be recorded and then effectively reversed by the corrective transfer entries. The key is the immediate replacement using business funds.

Client Account Overdrawn (Shortfall)

A client account ledger for a specific client must never be allowed to go into debit (overdrawn), as this indicates that money belonging to other clients has been used (a breach of Rule 5.3). This might occur if a payment is made before a client's cheque clears and the cheque is subsequently dishonoured, or simply due to an administrative error in making a payment exceeding the available funds for that client.

Key Term: Client Account Shortfall
A situation where a payment made from the client bank account on behalf of a specific client exceeds the funds held for that client, resulting in a debit balance on their client ledger and the use of other clients' money.

Rectification:

1. Identify the Shortfall: Determine the amount by which the client ledger is overdrawn (the debit balance).
2. Replace the Client Money: Immediately transfer the exact amount of the shortfall from the business bank account to the client bank account.
3. Record the Correction:
   • Transfer out of business account:
     • Debit (DR) the specific Client Ledger Business Account (to show the firm funded the correction).
     • Credit (CR) the Cash Sheet Business Account.
   • Transfer into client account:
     • Credit (CR) the specific Client Ledger Client Account (to eliminate the debit balance).
     • Debit (DR) the Cash Sheet Client Account.

Worked Example 1.2

A solicitor pays counsel's fees of £1,200 for Client X from the client bank account. However, the client ledger for Client X only shows a credit balance of £1,000. This creates a £200 shortfall.

How should this breach be rectified?

Answer: This is a breach of Rule 5.3. £200 belonging to other clients has been used. The firm must immediately replace the shortfall from its own funds.

Accounting Entries:

1. Transfer £200 from the business bank account to the client bank account.
2. Record the transfer:
   • DR Client Ledger (Client X) Business Account £200
   • CR Cash Sheet Business Account £200
   • CR Client Ledger (Client X) Client Account £200 (This brings the client account balance for Client X from £200 DR back to zero)
   • DR Cash Sheet Client Account £200

Client X now owes the firm £200, reflected in the DR balance on the business side of their ledger.

Exam Warning

Remember that the obligation under Rule 6.1 is to correct breaches promptly, and specifically for improper withdrawals from client accounts, the money must be replaced immediately. Do not select answers suggesting delays, waiting for reconciliations, or seeking client instruction before replacing missing client funds. The firm itself must rectify the shortage using its own business money without delay.

Revision Tip

Visualise the flow of money for corrections. If client money is missing or wrongly used, business money must flow into the client bank account to fix it. The corresponding ledger entries will always involve DR/CR pairs in both the business columns and the client columns to reflect the transfer between the firm's two types of bank accounts.

Key Point Checklist

This article has covered the following key knowledge points:

• The SRA Accounts Rules require breaches to be corrected promptly upon discovery (Rule 6.1).
• Money improperly withheld or withdrawn from a client account must be replaced immediately.
• Breaches often require a transfer of funds between the business and client bank accounts.
• Correcting a client account shortfall involves transferring funds from the business bank account to the client bank account.
• The accounting entries involve debiting the client ledger (business account) and crediting the cash sheet (business account) for the outflow from the business bank, AND crediting the client ledger (client account) and debiting the cash sheet (client account) for the inflow to the client bank.
• Recording the correction accurately in the ledgers is essential for demonstrating compliance.

Key Terms and Concepts

• Breach
• Rectification
• Client Account Shortfall