Client accounts - Requirement to pay interest on client money

Learning Outcomes

This article explains the obligation under the SRA Accounts Rules for firms to account for interest on client money. It covers the principle of paying a 'fair sum', the requirement for a written policy, the distinction between holding money in general client accounts versus separate designated deposit client accounts, and the associated accounting entries. After reading this article, you will understand the key compliance requirements regarding interest on client money for the SQE1 assessment.

SQE1 Syllabus

For SQE1, you are required to understand the practical application of the SRA Accounts Rules concerning interest payments on client money. This involves knowing when interest is payable, how it should be calculated and paid, and the relevant record-keeping obligations. Your understanding will enable you to apply these rules to given scenarios.

As you work through this article, remember to pay particular attention in your revision to:

• the general requirement to account for a fair sum of interest on client money (Rule 7.1)
• the possibility of agreeing alternative arrangements with the client in writing (Rule 7.2)
• the necessity and content of a firm's written interest policy
• the different treatment and accounting for interest depending on whether money is held in a general client account or a separate designated deposit client account (SDDCA)
• the specific accounting entries required for interest payments.

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. Under SRA Accounts Rule 7.1, when must a firm account for interest on client money?
   1. Only if the client requests it in writing.
   2. Only if the amount held exceeds £1,000.
   3. When it is fair and reasonable to do so in all the circumstances.
   4. Only when the money is held for more than 30 days.
2. A firm holds £50,000 in its general client account for Client X for six months. The firm's policy is to pay a fair sum in lieu of interest. Where do the funds for this payment primarily come from?
   1. The specific interest earned on the £50,000 within the general client account.
   2. The firm's business bank account.
   3. A deduction from the £50,000 held for Client X.
   4. The SRA Compensation Fund.
3. A firm holds £200,000 in a separate designated deposit client account (SDDCA) for Client Y. The SDDCA earns £400 interest. Who is entitled to this £400 interest?
   1. The firm.
   2. Client Y.
   3. The SRA.
   4. It is shared equally between the firm and Client Y.

Introduction

Law firms frequently hold money belonging to clients while providing legal services. This money is termed 'client money'. The Solicitors Regulation Authority (SRA) imposes strict rules, the SRA Accounts Rules ('the Rules'), to ensure this money is kept safe. A key aspect of these rules, found in Rule 7, is the obligation to account to clients for interest earned while the firm holds their funds. This prevents firms from unfairly benefiting from client money and maintains client trust. Understanding this obligation is essential for compliance and SQE1 assessment success.

Key Term: client money
Money held or received by a firm relating to regulated services delivered to a client; on behalf of a third party in relation to those services; as a trustee or holder of a specified office; or for fees and unpaid disbursements before a bill is delivered.

Key Term: client account
A bank or building society account in England and Wales, held in the firm’s name and including the word ‘client’, used for holding client money separately from the firm’s own money.

The Obligation to Pay Interest (Rule 7)

Rule 7.1 establishes the fundamental requirement: a firm must account to clients (or third parties for whom money is held) for a 'fair sum' of interest on any client money held on their behalf.

The fundamental principle is fairness. When a firm holds client money, the client cannot use or invest that money themselves. Therefore, it is generally fair for the client to receive some compensation in the form of interest.

Rule 7.2 permits firms to agree different arrangements with clients in writing, provided the client gives informed consent based on sufficient information. This might apply if, for instance, a client objects to receiving interest on religious grounds. Without such a written agreement, the Rule 7.1 obligation applies.

Written Interest Policy

While the current Rules (2019) don't explicitly mandate a written interest policy as the previous 2011 Rules did (Rule 22.3), SRA guidance makes it clear that having one is essential for demonstrating compliance with the 'fair sum' requirement. The policy should typically specify:

• The circumstances under which interest will be paid (e.g., minimum balance, minimum time held).
• The method and rate used for calculation.
• Any 'de minimis' threshold below which interest is not paid.

Clients should usually be informed of the policy at the start of the retainer.

Calculating a 'Fair Sum'

The Rules do not define 'fair sum', leaving it to the firm's professional judgment, guided by their written policy. Key factors include:

• The amount of money held.
• The period for which the money is held.
• Current interest rates available on comparable instant-access accounts (reflecting Rule 2.4's requirement for money to be available on demand unless agreed otherwise).
• The administrative cost of calculation and payment.

Key Term: fair sum
An amount of interest paid to a client on money held by the firm, calculated reasonably based on the amount, time held, and prevailing interest rates, as outlined in the firm's policy.

A common feature of interest policies is a 'de minimis' provision.

Key Term: de minimis
A minimum threshold amount of calculated interest (e.g., £20 or £50) below which a firm will not pay interest to a client, because the administrative costs outweigh the small sum involved. The threshold must be reasonable.

Worked Example 1.1

A firm holds £15,000 for Client A for 60 days in its general client account. The firm’s policy states interest is paid at 1% per annum for sums over £10,000 held for more than 30 days, with a de minimis threshold of £25.

Is the firm required to pay interest to Client A?

Answer: Calculation: (£15,000 x 1% x 60) / 365 = £24.66. This amount is below the firm's £25 de minimis threshold. Therefore, under its policy, the firm is not required to pay interest, and this would likely be considered 'fair' under Rule 7.1.

Methods of Accounting for Interest

The practical handling of interest depends significantly on whether the client money is held in the firm’s general client account or a separate designated deposit client account (SDDCA).

Money Held in the General Client Account

Most firms operate a general client account where money for many different clients is pooled. Interest earned on the overall balance of this account belongs to the firm, not the individual clients whose money contributes to the balance. This interest is business money.

However, the firm still has the obligation under Rule 7.1 to pay individual clients a 'fair sum' of interest where appropriate according to its policy. This payment must come from the firm's business account and is treated as a business expense. The firm calculates this 'sum in lieu of interest' based on the amount held for that specific client and the duration, using the rate defined in its policy.

Key Term: sum in lieu of interest
A payment made from the firm's business funds to compensate a client fairly for interest on money held for them within the pooled general client account.

Key Term: interest payable
An expense ledger account used by the firm to record sums paid or due to clients in lieu of interest.

Accounting Entries (Sum in Lieu of Interest):

This typically involves two stages:

1. Record the Interest Payable Expense:
   • DR Interest Payable ledger (business account columns)
   • CR Client Ledger (business account columns) - This shows the firm owes the interest to the client.
2. Pay the Client (usually via transfer to client account):
   • (Transfer out of Business Account) DR Client Ledger (business account columns); CR Cash Sheet (business account columns)
   • (Transfer into Client Account) CR Client Ledger (client account columns); DR Cash Sheet (client account columns) - The client now has the interest as client money.

Worked Example 1.2

A firm holds £80,000 for Client B in its general client account for 90 days. Its policy requires payment of a sum in lieu of interest calculated at £150. The firm decides to pay this by transferring it to the client ledger.

What are the journal entries?

Answer:

1. Record Expense: DR Interest Payable ledger £150; CR Client B Ledger (Business) £150.
2. Transfer Funds: (Out of Business) DR Client B Ledger (Business) £150; CR Cash Sheet (Business) £150. (Into Client) CR Client B Ledger (Client) £150; DR Cash Sheet (Client) £150.

Money Held in a Separate Designated Deposit Client Account (SDDCA)

For large sums held over long periods, a firm might open an SDDCA specifically for one client.

Key Term: separate designated deposit client account (SDDCA)
A client account opened at a bank or building society specifically for a single client (or trust), often a deposit account, whose title includes the firm's name, the client's identity, and the word 'client'.

In this scenario, any interest earned on the money in the SDDCA belongs to the client, not the firm. The bank usually credits the interest directly to the SDDCA.

Accounting Entries (SDDCA Interest):

1. Bank Credits Interest to SDDCA:
   • DR Deposit Cash Sheet* (client columns)
   • CR Client's Deposit Ledger* (client columns)
2. Transfer Principal + Interest from SDDCA to General Client Account (when needed):
   • (Payment out of SDDCA) CR Deposit Cash Sheet*(client columns); DR Client's Deposit Ledger* (client columns)
   • (Receipt into General Client Account) DR Cash Sheet (client columns); CR Client Ledger (client columns)

(Note: Firms may use separate 'deposit' ledgers/cash sheets or additional columns on main ledgers to record SDDCA transactions).

Worked Example 1.3

A firm holds £300,000 in an SDDCA for Client C. The bank credits £500 interest. The firm now needs to transfer the full balance (£300,500) to the general client account to make a payment for Client C.

What are the journal entries for the interest accrual and the transfer back?

Answer:

1. Record Interest: DR Deposit Cash Sheet (Client) £500; CR Client C Deposit Ledger (Client) £500.
2. Transfer £300,500 to General: (Out of SDDCA) CR Deposit Cash Sheet (Client) £300,500; DR Client C Deposit Ledger (Client) £300,500. (Into General) DR Cash Sheet (Client) £300,500; CR Client C Ledger (Client) £300,500.

Exam Warning

Be clear about the source of interest payments. For general client accounts, the payment to the client is a 'sum in lieu' funded by the firm's business money. For SDDCAs, the interest paid by the bank belongs directly to the client.

Revision Tip

Focus on the distinction: interest on general client accounts benefits the firm initially, but a fair sum must be paid from the firm; interest on SDDCAs belongs entirely to the specific client. The accounting entries reflect this difference.

Key Point Checklist

This article has covered the following key knowledge points:

• Firms must account for a fair sum of interest on client money held (Rule 7.1).
• Alternative arrangements are possible if agreed in writing with informed client consent (Rule 7.2).
• A written interest policy detailing calculation methods and any de minimis threshold is essential for compliance.
• 'Fair sum' considers amount, time held, and current interest rates.
• Interest earned on the general client account balance belongs to the firm.
• Firms must pay clients a 'sum in lieu' of interest from their business account for money held in the general client account, recorded as an expense.
• Interest earned in an SDDCA belongs entirely to the specific client for whom the account was opened.
• Distinct accounting entries apply depending on whether interest relates to a general client account or an SDDCA.
• Accurate record-keeping of interest calculations and payments is required.

Key Terms and Concepts

• client money
• client account
• fair sum
• de minimis
• sum in lieu of interest
• interest payable
• separate designated deposit client account (SDDCA)