Bookkeeping – Restricted Accounts (Lesson 81)
The third group of temporary accounts comprise restricted accounts. These accounts are classified with the term ‘restricted’ due to a legally mandated or contractual obligation to limit access to their funds. Most often, restricted accounts consist of cash or some physical asset. It is rare to find a restricted account in the form of an intangible asset. This particular lesson will first explain restricted accounts and how they are presented in financial reports. Next, I’ll illustrate some more common uses, especially with real estate and non-profit accounting. Finally, I’ll finish with the reconciliation and closing procedures used by bookkeepers.
Restricted Accounts – Explanation and Description
Many businesses are mandated by a contract to reserve cash or set aside assets as a risk reduction tool for third parties. Sometimes the business is merely holding money for a third-party as a trustee. For example, many lawyers have a trust account, often called a ‘escrow fund’, that legally holds the attorney responsible to release these proceeds based on legal mandates (court rulings, contract signatures or governmental deadlines).
A very common escrow account is found in real estate transactions. The closing attorney receives money from the buyer and mortgage company. At the same of filing the deed with county and the corresponding deed of trust he pays the seller and the seller’s note holder for that property.
New York law defines a restricted account as money or property whereby title has not fully transferred to agent (account holder). It goes further by generally identifying three elements for cash and one additional element for a physical asset(s):
1) An agreement (contract, fiduciary obligation statement or certificate, business agreement etc.) to the subject matter and a delivery of the funds to the escrow agent; AND
2) Delivery of the deposit to the beneficiary upon the performance of an act (a trigger)or occurrence of an event; AND
3) Relinquishment of control over the funds by the grantor.
4) In the case of a physical asset or real property, the transfer of the title to the agent.
There are many names used with restricted accounts. The following are some of the more common names along with a short description:
* Escrow – A third party agency, the most frequently used term.
* Fund Accounts – Money appropriated for a designated purpose, this term is typically used with non-profits
* Retainers – Many professional firms, utilize a liability account with a cash offset for client prepayments.
* Deposits – This is an account used to hold customer prepayments related to contract work; this is used in residential and commercial construction.
* Impound Accounts – Typically these accounts are used when holding physical assets (as in collateralized arrangements such as pawn shops) that are released by a contractual agreement or via a court order.
* Defeasance – Rarely is this type of account found on the books of a small business. Defeasance monies represent funded offsets to long-term leases or
* Surety Bonds – Money set aside to ensure contractual or legal compliance. A good example is in the mining industry whereby funds are set aside to close out the mine or comply with federal or state regulations at termination.
Restricted accounts are created to notify all parties of management, investors and third-party creditors that this business has reserved certain assets for the purpose of complying with a legal obligation. Often owners get into trouble and are exposed to criminal action when they use restricted monies for their personal or business purposes. New York law states:
, see Peters Griffin Woodward Inc. V. WCSC Inc. 88 A.D. 2d 883, 452 N.Y.S. 2d 599, 600 citing Employees’ Fire Ins. Co. V. Cotten, 245 N.Y. 102.
To help the reader conceptualize restricted accounts, I’ll provide some very common examples as used in small business.
Restricted Account Examples
Most examples of restricted accounts in small business focus in on prepayments from customers. This is commonly referred to unearned revenue or deferred revenue. The following are examples of obligations, labels and a short description.
Trust accounts exist with professional firms for money received from a client to consummate a legal transaction. It is commonly a cash account (a separate bank account) on the books with a corresponding current liability of equal value. The accounting is simple, as money is received from a client and deposited to the bank, a debit increases the value in assets and a credit is assigned to ‘client escrow’ the current liability account. When money is disbursed, both accounts are decreased by the value of the disbursement. Notice that any activity involved has no relationship with income statement accounts.
Retainers are very similar to unearned revenue but it is the term used by professional firms (attorneys, accountants, architects and engineers) to describe client deposits with incomplete or unstarted work. Just like a trust account, a separate bank account is used to deposit funds; the account is named ‘Funded Retainers’ or ‘Retainage’. An offset account exists in the current liabilities section labeled ‘Retainers’. At the end of the billing cycle (usually monthly) an invoice is created for work completed and the client is asked to bring his retainer balance back to the contractually agreed balance as follows:
A,B,C,D & E LAW FIRM, P.C.
Invoice # 70017
November 30, 20ZZ
HRS Description $/Hr Total
17.3 Smith contract review including communications 225.00 $3,892.50
Court Filing Fees 61.25 61.25
Total Invoice Amount $3,892.75
Retainer Balance Forward 5,000.00
Current Balance $1,046.25
Required Engagement Balance 4,500.00
Amount Due by December 15, 20ZZ $3,453.75
In this case, sales is credited for $3,953.75 and the retainer account (current liability) is debited for the same amount. A second entry follows whereby the funded retainers account is credited for the $3,953.75 and the operating account is debited for this amount. Usually this step is triggered by the online transfer between these two bank accounts.
When the client makes his follow-up payment, the funded retainers account is debited and the current liabilities account, retainers, is credited and the cycle starts anew.
Deposits are somewhat similar to retainers except this term is used in the contract based industries such as construction, equipment fabrication and real estate rentals. In this situation your better organized and managed operations have a separate bank account for deposits. Many actually will deposit the money into their operating checking account and classify the balance in this account as available and restricted. The restricted portion matches the current liability account ‘Deposits’.
In most contracts the deposit amount is used as the final payment with the contract. The customer typically is invoiced in stages in accordance with contractually identified completion points.
In real estate rental operations such as apartment complexes deposits are used as security to prevent damage to the real estate. Therefore, the accounts are labeled security deposits instead of just ‘Deposits’. Almost every state requires security deposits separated in a bank account to protect the tenants from the apartment complex creditors. Again, this is a simple balance sheet cash account and an offsetting current liability account.
Escrow accounts are different from most restricted accounts as sometimes the business doesn’t actually have control over the physical monies. Instead, the value paid out to the third-party agent is almost exactly like a prepayment traditionally found with warranties and revenue taxes.
The third-party agent having physical control over the proceeds sets up their balance sheet just like the trust accounts above. There is an asset and a current liability on their books. The payer on the other hand has simply reclassified the cash payment as a prepayment identified as a particular escrow account.
For example, in the apartment rental business the complex will have a set of escrow accounts for prepaid taxes, insurance, replacement reserves contract obligations and in some cases a principle offset. The account structure looks like this:
GARDEN APARTMENTS, LLC
Chart of Accounts (Limited Scope)
Type Group Account Sub-Account
A Current Cash Parent-Child Structure
A Current Cash Operating
A Current Cash Payroll
A Current Cash Security Deposits
A Current Accounts Receivable Control Account
A Current Prepaid Control Account
A Current Escrow Parent-Child Structure
A Current Escrow Taxes
A Current Escrow Insurance
A Current Escrow Replacement Reserves
With each payment made on the loan the respective escrow sub-accounts are debited and the cumulative value is included in the credit to cash. Typically, once a month the mortgage company sends a statement of activity to the apartment complex indicating amounts paid to vendors for the respective taxes, insurance and so on. If a payment is made, expense is debited on the books and the corresponding credit is applied to that respective sub-account. This way the total escrow account dollar value on the balance sheet matches the mortgage company’s trust account value held for the apartment complex.
In the world of non-profits it is very common for donors to place restrictions on their gifts. For example, college endowments often receive gifts for a particular purpose such as scholarships, construction, athletics etc. This restricted value is deposited into a restricted cash account with a corresponding liability tied to the respective function.
As an illustration, someone donates to the scholarship fund in the name of John Doe. The John Doe value accumulates inside of a scholarship liability account. The debit is to the restricted cash account which may have a parent-child structure as follows:
– Scholarships $Z,ZZZ,ZZZ
— Library $ZZZ,ZZZ
— Physics Building ZZZ,ZZZ
— Grounds ZZ,ZZZ
Sub-Total Construction Z,ZZZ,ZZZ
– Business School ZZZ,ZZZ
– Sciences ZZZ,ZZZ
– Athletic Program Z,ZZZ,ZZZ
– Music & Arts ZZZ,ZZZ
– Resources (Library/Recruitment) ZZZ,ZZZ
Total Restricted Cash $ZZ,ZZZ,ZZZ
As funds are used for the respective purpose, expenses (uses of cash) are debited and restricted cash is credited. At the same time the sources (receipts) account is credited for full compliance associated with the restricted purpose and the debit goes to the particular function in the liability section of the balance sheet.
Reconciliation and Closing of Restricted Accounts
Reconciliation and management of control accounts is covered in the following lessons:
The confusion for most accountants corresponds with whether or not the balance sheet is supposed to have an asset value only or an asset value with a matching liability in current liabilities. The key is if the business is the holder of someone else’s money or not. If your company is holding the money for a customer, then the company owes (liability) it back to the customer. This requires both an asset and equal offsetting liability on the books. If your company is the payer, then technically the company is merely reclassifying an existing asset (usually cash) to another form of an asset (usually a current asset). Once the third-party agent has fulfilled their obligation to the business then this reclassified asset value is transferred to the expense section of the income statement (profit and loss statement).
Reconciliation involves using some form of a separate tracking program for the individual values. Apartment and real estate management companies use spreadsheets or specialized software to track the individual balances. Fund accounting uses a register of gifts (just like a church does) to determine the respective fund balances and of course the offsetting (obligation) balance.
Those entities paying out monies to a third-party agent use the agent’s monthly statement of activity to reconcile the asset balance.
One of the issues involved with restricted accounts is the monthly closing process. In some situations, a business will collapse the two offsetting accounts on the balance sheet so that they are not displayed in the final financial statements. The reason to nullify the two values is their impact with calculating business ratios, specifically current and quick ratios. To remedy this, some accountants transfer the liability to a contra account in the asset section offsetting the respective asset as illustrated here:
SYMCO ENGINEERS INC.
Balance Sheet (Limited Scope)
December 31, 20ZZ
– Checking $ZZ,ZZZ
– Payroll ZZ,ZZZ
– Money Market ZZZ,ZZZ
– Funded Retainage ZZZ,ZZZ
– Retainers (ZZZ,ZZZ)
Sub-Total Cash $ZZZ,ZZZ
The entry is commonly made on the last day of the year to generate the final reports and is immediately reversed on the first day of the new year. The reversal resets the contra value back into the current liabilities section of the balance sheet.
There are no adjusting journal entries related to pure asset based restricted accounts (funds held by third-party agents).
Restricted accounts are typically monies paid in by clients for a designated purpose or funds paid to third-party agents for a particular function. The most common types of accounts found in small business include:
5) Impound accounts for physical assets
With monies paid by clients, there is customarily a separate cash account and a corresponding liability restricting this value to the balance sheet. For monies paid to a third-party, it is merely a reclassification of cash as another form of a current asset. ACT ON KNOWLEDGE.
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