by Debbie L. Zumoff
Business leaders are surprised to learn their true obligations concerning unclaimed property and the potential threat of a state audit for noncompliance.
The normal, everyday operation of your business results in the generation of unclaimed financial obligations that become known as “unclaimed property.” You may not know it, but managing unclaimed property and reporting to the states in a timely fashion is one of your job responsibilities. When not correctly managed and reported, the risk of a state audit —and subsequent fines and penalties for noncompliance—becomes a distinct reality. I hope this article will help explain some of the common misperceptions about unclaimed property and help you understand and mitigate any areas of risk.
What is Unclaimed Property?
Basically, it is any financial obligation that is due and owing to another party (customer, vendor, employee, investor, etc.). The key rule to remember is that this property never becomes the company’s property; it always belongs to the person or entity owed. Unfortunately many companies—title companies included—don’t realize that uncashed checks, escrow balances, mysterious credits, and unclaimed payroll and insurance benefits are considered unclaimed property. Nor do they realize that by virtue of state laws if this property cannot be returned to the rightful owner, it must be reported and remitted (escheated) to the state in which the owner was last known to live once the “dormancy period” for that type of property has expired. With typical dormancy periods in most states of three to five years, that means that a company can only keep these items on their books and retain the associated funds for this period of time.
It is indeed a big issue. According to statistics compiled by the National Association of Unclaimed Property Administrators (NAUPA), the annual reporting of unclaimed property by corporations is approximately $3 billion each year. Unclaimed property is the fastest growing source of state revenue, and the widely held belief is that the overwhelming majority of unclaimed property is not reported. In fact, most state estimates suggest only 10 to 35% of companies are in full compliance with the laws.
Complex State Laws
The challenge with regard to unclaimed property laws is that they are complex. Each state has its own set of laws. Even if you only have property to report to one state, many states require the filing of “negative” reports, meaning it is your obligation as a company to tell them you have nothing to report. But you very likely have liability to more than one state, each with its own dormancy periods and rules on how to report the more than a hundred different property types that can become classified as unclaimed property.
For this reason, it’s very safe to say that there’s a great deal of confusion over how and when to report unclaimed property. To help clear some common misconceptions, here are the basics. To be “in compliance” means that your company is
Whereas this noncompliance was largely ignored in years past, it is now on the front burner. The primary driver is state budget deficits. Though most states have departments committed to return unclaimed property to the actual owner, less than 30% on average is ever returned. Recognizing this fact and strapped for cash, most states use the majority of the unclaimed property money they collect to fund various public interest projects. The remainder is placed in a small reserve fund from which owner claims are paid. Therefore unclaimed property represents, in essence, a “quiet” source of revenue that most people don’t know about and that doesn’t require the government to raise taxes. As a result, state enforcement efforts have steadily grown and audits to drive corporate compliance are at an all-time high.
Failing to comply with state unclaimed property laws can be costly for private and public companies alike. Inappropriately accounting for unclaimed property can have a material effect on financial statements and lead to monetary risk and equally real risks to a company’s reputation and brand. All of these threats are exacerbated in the event a firm is targeted for state audit. Those found to be out of compliance are subject to significant penalties (typically 12% of the underreported liability) and interest for failure to account for and report this property. As reported in the February 2004 issue of the Journal of Accountancy, “The administrative and economic stake is much higher once the state issues an audit assessment.” Under these circumstances the audit liability “could double or triple after penalties and interest.” Plus, corporations face the additional burden of navigating through an audit and reviewing or refuting the auditors’ findings.
How Does This Impact Title Companies?
One specific example with regard to title insurance companies is the improper management of unclaimed escrow funds. As an escrow agent, title companies receive funds from purchasers, sellers, borrowers and lenders; prepare documents and closing account statements; and disburse escrow funds at the close of escrow. Companies routinely aggregate customers’ escrow funds in demand deposit accounts with various banks. If customers fail to instruct the title company to disburse all the funds on deposit or parties to whom funds are disbursed at the close of escrow fail to cash the check, an unclaimed property obligation has been created.
This issue has recently been in the news. In January 2005 a California Appeals court ruled that one of the large national title insurance underwriters must pay damages of more than $22 million stemming from material misstatement of the company’s unclaimed property liabilities. A field audit by the state department of insurance in 1999 revealed that the company had been putting unclaimed escrow funds into income since 1980. The company filed an unclaimed property report and remitted funds to the state for the first time in 1992. Reports filed for 1992 to 1994 and 1997 understated the full amount of reportable funds. It’s worth noting that the damages award was a separate matter from the company’s past-due unclaimed property obligation of $9,551,527.89, which they were also required to remit to California.
From my conversations with state unclaimed property auditors and administrators, it’s clear that they don’t believe this type of non-compliance is isolated to this one company. The title insurance industry is among several that will be specifically targeted by state auditors in the near future. In general, it’s safe to say that “taking balances into income” is an audit red flag. You should review such practices in light of unclaimed property compliance laws.
Further complicating compliance is that it crosses over into many departments including payroll, treasury, accounts payable, and investor relations. And since businesses are not focused on these unclaimed property issues, a significant financial statement exposure can develop. For example, if a business consistently takes credit balances into income, nets outstanding debits against outstanding credits, voids outstanding checks, or fails to explore seemingly insignificant reconciliation issues, accounts may become severely overstated, rendering the company’s financial statements suspect. While there are no silver bullets in terms of steps a company can take to avoid an audit, there are many simple red flags that can be eliminated to minimize the likelihood that you are selected for audit. As states become more sophisticated in their efforts to identify unclaimed property, the events that can trigger an audit have become more predictable. Among the more common, and perhaps obvious, indicators are
Mistakes like those above result from ignorance or negligence. However, there are everyday events which can generate new unclaimed property concerns for companies that are already compliant. Acquisitions and mergers are one example, especially for public companies with unexchanged shares of stock. If the owners of the acquired company don’t respond to company solicitations to exchange their old shares for shares of the new company, then the new stock must be reported as unclaimed property. Look back in your books to see if you have any old acquisitions that weren’t fully exchanged since these are commonly underreported and may represent a past-due liability. Insurance companies who have completed demutualization (converting from private policy holders to public shareholders) may also have issues. A demutualization triggers unclaimed proceeds as policy holders must claim shares of stock and/or cash for the first time. Unclaimed shares or cash must be reported. Either of these events should be triggers for any CFO to start asking questions about what your company is doing to comply with unclaimed property laws.
Unclaimed Property and Sarbanes-Oxley
In 2002 Congress passed the Sarbanes-Oxley Act of 2002 to protect investors by improving the accuracy and reliability of corporate disclosures. It creates some much needed structure around financial reporting and internal controls. The requirement of many companies to comply with the Sarbanes-Oxley Act is likely to produce good results in terms of unclaimed property compliance. As if by design, the reforms prescribed by Sarbanes-Oxley coincide with states’ historic efforts to enforce and ensure unclaimed property compliance. As such, Sarbanes-Oxley compliance should directly improve unclaimed property management practices and in the process reduce financial and reputational risk. Protection from state audits, and the associated negative publicity, is almost a by-product of Sarbanes-Oxley, as issues once swept under the rug must be proactively addressed.
So, how does the Sarbanes-Oxley Act of 2002 help you avoid unclaimed property risk? First, Section 404 of the act outlines the rigorous scrutiny that must be imposed on a company’s financial operation both annually and quarterly. Two specific actions are required each and every year: 1) an internal review of all financial controls and 2) an audit on the effectiveness of those financial controls. Throughout the year, progress must be monitored on any changes made as a result of the annual audit findings. This annual review is highly valuable for flushing out and quantifying all current and past-due unclaimed financial obligations. Under Sarbanes-Oxley, significant outstanding monetary obligations will typically constitute material conditions, which must be reported in financial disclosures. Enhanced requirements of accountability under Sarbanes-Oxley are forcing these types of disclosures to be made routinely, even at staff levels in financial operations. The Section 404 rules demand a higher level of scrutiny and accountability at all levels to enable the CFO/CEO certifications that are required. (The certifications make the signers accountable for the figures.) Section 302 of the act requires the disclosure of accuracy conditions in the operation of internal control systems so that weaknesses and deficiencies in financial reporting can be identified and corrected. These controls are critical in the unclaimed property arena to ensure effective long-term management. The new standards better prepare firms for mergers and acquisitions, as the acquiring firm is able to clearly understand and value the target’s unclaimed property reporting status. This ensures the company is not acquiring unknown unclaimed property liabilities.
Using the Sarbanes-Oxley guidelines as a starting point is a good first step towards minimizing your risks. By that I mean establish a good set of internal controls and follow the best practices outlined below.
Define the Liabilities Impacting Your Company. Begin by assessing and analyzing the various property sources in your organization contributing to unclaimed property. Take a big picture, global view of your entire enterprise to engage all possible contributors to your unclaimed property liability. In the wake of Sarbanes-Oxley, it becomes important to define what is material in terms of your firm’s annual financial statement, thus mandating disclosure. Are your company’s outstanding unclaimed financial obligations material? Might they impact your firm’s earnings statements if disclosed? Where are the bulk of your liabilities? Typically, 80% of your unclaimed property exposure value lies in only 20% of the outstanding obligations. Identify and focus on resolving those to bring down your total liability!
Try to determine why unclaimed property is being generated at your company or why individuals or businesses have failed to take action with regard to the sums you owe them. Customers often relocate, get acquired, or their businesses simply fail. Duplicate or alternate modes of payment can go unidentified if not properly reconciled. Do you have miscellaneous income entries without adequate explanation? Are accounting policies and practices implemented consistently across your entire company? Do you have comprehensive and written unclaimed property policies and procedures in place? Are they being followed consistently throughout your organization?
Preemptively Resolve Outstanding Liabilities. Obviously, the primary threat presented by past- due obligations is a state (or multi-state) audit. Often it’s the most well-intentioned companies that unwittingly overlook or misinterpret their obligations. The complex and dynamic laws of unclaimed property reporting leave them out of compliance and facing financial fines and penalties, as well as undeserved reputational risk. Undergo a rigorous self audit or third-party evaluation to make sure that historical practices and reporting are sound. If holes in compliance are identified, it’s important to take action as soon as possible. There are still opportunities in most states to take advantage of amnesty and voluntary compliance programs which provide leniency with respect to delinquent reporting.
Develop a Corporate Due Diligence Philosophy. As heavyweight champion Jack Dempsey was fond of saying, “the best defense is a good offense.” In the unclaimed property world, due diligence is the practice of mitigating unclaimed property liability at its source—by finding missing people and helping them take action to reconcile their accounts. Unfortunately, under most state laws, due diligence is only required once—typically within 120 days of when the property must be remitted. At this point, the property has been unresolved for potentially many years, and the likelihood of locating the property owner at the original address is minimal. The best approach is to conduct a due diligence effort within 90 days of original loss.
Address the undeliverable mail population in your outreach strategy. Undeliverable mail can be a significant problem, stalling many efforts to reunify owners with their financial property. Ideally you should research new addresses and re-mail or telephone those vendors or customers where appropriate. But locating businesses can be daunting since there are no available databases designed to locate commercial entities. And the IRS and Social Security Administration won’t help you. Reconcile Accounts to Prevent Overpayment. Part of the due diligence process should include a reconciliation of all accounts to identify and eliminate duplicate payments and other costly accounting errors. For instance, it is important to reach out to vendors to reconcile apparent outstanding balances. It is common when scrutinizing uncashed check files to find vendor obligations that appear to be unpaid, which were in fact paid in full via an alternate account. Reducing these accounting oversights creates instant savings by preventing an unnecessary cash outlay.
Document an Annual Compliance Road Map. Formalize all compliance goals and expectations of the individuals who play a role in the system. In today’s corporate governance-driven environment it is critical to establish a working environment where compliant behaviors are the standard and executives are committed to, and encourage, an atmosphere of openness. Create clear timelines of events and milestones to ensure that semiannual report cycles run smoothly. Critical to the plan is a methodology to stay up-to-date on the latest changes to unclaimed property law. A range of unclaimed property software systems and outsourcing options exist to help with planning and execution. If efforts are instead coordinated in-house, carefully document the work flow, staff responsibilities, and information needs at each step in the process.
Eliminate Audit Red Flags. While the A-list for state audits is composed of companies that have never filed reports, the second tier is filled with organizations that call attention to themselves by the manner in which they report. Incomplete reports are certain to raise suspicion, as are reports that don’t match the typical profile for other firms in the same industry. Other obvious signs include failure to report all relevant property types and inconsistent report filings from year to year. In addition, companies that are undergoing or have undergone restructurings, such as mergers, acquisitions, and reorganizations, should consider themselves high on the list for audit consideration since many accounting details—such as old boxes of uncashed checks—can easily get set aside and forgotten.
Perform Sound Recordkeeping and Accounting. Maintain electronic and hard copy documentation of all previous unclaimed property reports for at least ten years so that you can demonstrate your compliance quickly and easily. This practice will help to facilitate internal audits, contribute to long-term compliance efforts, and serve as a strong exhibit of your controls in the event you are audited. Make sure that internal organizations are communicating effectively to disclose all unclaimed property liabilities properly on financial statements as the Generally Accepted Accounting Principles require.
Encourage Continuous Learning and Review. Conduct regular training to discuss legal changes and reinforce policies and procedures. To be more proactive with your unclaimed property strategy, encourage industry interaction by your managers to learn new requirements, understand trends, and stay abreast of impending legislation.
Training, at some level, should be delivered to all relevant departments and executives to ensure organizational consistency. Regularly review performance and modify reference materials to ensure valid “living documents” that staff can use to manage the operation.
The Road to Compliance
When to implement a best practice approach can be a challenge. If you have not reported unclaimed property previously, and are not under state audit, initiate an immediate outreach program to try to return monies to their owners. Make an effort to connect with property owners as soon as you identify and quantify your past- due obligations. Consider the time frames necessary to do so while working with the states to get your voluntary disclosure and reporting arrangements in order. Annual reporting entities can systematically develop an owner outreach program to manage outstanding general ledger obligations spanning the duration of the dormancy periods. One major decision is whether to manage a best practice approach by outsourcing or by using dedicated in-house management resources. The decision depends upon the availability of time, resources, and staff. For some, the demand to embrace such a program is driven by the volume of outstanding obligations, their complexity and value to the firm’s bottom line. Ask whether you have the time to prepare, execute, and process outbound communications and their responses. Consider your experience conducting and managing outbound phone and/or mail campaigns. Question whether you have the research tools to address your undeliverable population of individuals and businesses. Adjust your policies based on the dynamic unclaimed property laws. In summary, the value of an active best-practice approach to your firm’s unclaimed property liability will serve several valuable purposes. First, it will allow you to demonstrate strong internal controls and attention to ensuring unclaimed property compliance. Second, it will legitimately minimize your firm’s unclaimed property reporting obligation and the ultimate burden on your annual reporting cycles. Lastly, it will earn your firm goodwill with the key constituencies that are protected.
Debbie L. Zumoff is chief compliance officer of The Keane Organization, Inc., a compliance and risk-management company, with a division specializing in helping corporations define, manage, and minimize unclaimed property liabilities. She is member of the National Society of Compliance Professionals. For more information on unclaimed property compliance visit www.holderadvocate.com.