Fiduciary Accounting (#278)
/In this podcast episode, we discuss fiduciary accounting. Key points made are noted below.
Trust Accounting
Trust accounting is about the record keeping for a trust arrangement. You have a trust when a trustee holds assets on behalf of one or more beneficiaries. The trustee is responsible for managing the assets, and also has to issue periodic reports to the beneficiaries. These same activities apply to an estate, where a fiduciary has the same responsibilities to whoever is inheriting the estate of the person who has died, who’s called the decedent. The accounting concepts that apply to estates and trusts are about the same, so I’m going to lump them together and call the whole thing fiduciary accounting.
The Uniform Principal and Income Act
Fiduciary accounting is not covered anywhere in Generally Accepted Accounting Principles, or in IFRS, and that’s because there’s no single accepted way to do it. Instead, the overriding rule for the handling of a trust or estate is that you follow the rules laid down in the will of the decedent, or in the trust agreement, regarding which funds go where, and how to treat specific transactions. If there are no instructions, then you might follow the rules stated in the Uniform Principal and Income Act. In this Act, the key word is Uniform, which means that Congress passed a law that’s intended to be uniformly applied to trusts and estates in all 50 states, but only if those states accept the Act, which not all of them have done. Or, they can modify the rules stated in the Act. This means that fiduciary accounting not only varies by will or trust agreement, but also by state. So as I go through the rest of this episode, just keep in mind that there is no one, universal way to do the accounting. In fact, a professional fiduciary might be overseeing ten different trust arrangements and estates, and the accounting for each one of them is unique.
Objectives of Fiduciary Accounting
When setting up an accounting system, a fiduciary has to deal with two offsetting objectives. One is to keep the accounting simple enough to avoid imposing an unreasonable expense on the estate or trust; that’s because the fiduciary is acting on behalf of the beneficiaries, so creating an awesome accounting system that’s really expensive cuts into the funds available to the beneficiaries. On the other hand, the second objective is to produce some fairly in-depth reports for the beneficiaries, which of course requires at least a moderately detailed level of record keeping. So, the fiduciary has to strike a balance between the spending on the accounting system and the level of detail to include in beneficiary reporting.
Cash Basis of Accounting
Next, the basis of accounting is the cash basis. There is no accrual basis in fiduciary accounting. All you care about is cash inflows and cash outflows, which are called receipts and disbursements. The types of transactions you’ll record are things like cash receipts from dividends or bond interest, gains or losses on the sale of assets, distributions to beneficiaries, and disbursements for fiduciary expenses.
Income and Principal
And then there’s probably the single largest issue in fiduciary accounting, which is income and principal. Income is the money that a fiduciary receives as a current return on an asset, while principal is property that’s being held for distribution to a remainder beneficiary – which I’ll get back to in a second.
Trusts and estates have two classes of owners, which are those with an interest in the income and those with an interest in the principal. The first party is the income beneficiary, and the second party is the remainder beneficiary. For example, Mrs. Smith dies, and states in her will that the income from her estate will go to her daughter until the daughter reaches the age of 21, after which everything left in the estate will be given to a designated charity. In this case, the daughter is the income beneficiary, and the charity is the remainder beneficiary. This means there’s an inherent conflict between the beneficiaries, because a receipt that’s paid out to an income beneficiary is cash that won’t be paid to a principal beneficiary, and vice versa. Because of this built-in conflict, it’s reasonable for the fiduciary to deal with accusations from the two types of beneficiaries that they’re being shortchanged, depending on how individual transactions are being accounted for.
The rules for deciding between whether a receipt or disbursement should be charged to income or principal are pretty detailed. Here’re some of the rules listed in the Uniform Principal and Income Act. First, you have to figure out if a receipt is periodic. It’s classified as periodic if it’s paid at recurring intervals, such as a monthly interest payment. When that’s the case and a due date is prior to a decedent’s death, the receipt is allocated to principal. But, if the due date is after the decedent’s death, then the receipt is allocated to income.
What if a receipt is not classified as periodic? When that’s the case, it’s considered to be accruing on a day-to-day basis. For example, an estate could be getting an income tax refund, which is clearly a one-time event. The amount that’s accrued prior to the decedent’s death is allocated to principal, while the amount accruing afterwards is allocated to income.
Here’s another one. A property is taken by the government through eminent domain proceedings. The proceeds are usually classified as principal. But, if a portion of this payment represents lost profits or future lease rentals, then that portion is allocated to income.
And another rule relates to the proceeds from property insurance. When proceeds are received from an insurance policy that insures against property damage, then it’s classified as principal, since it offsets property damage.
And then we have rent receipts. All rent receipts are allocated to income. But, refundable deposits are allocated to principal, from which they’re deducted when the deposits are eventually returned. If a deposit is forfeited, this amount is reclassified as income. And as another variation, when part of a rent payment includes a capital improvements reimbursement, the reimbursement amount is allocated to principal.
Any my personal favorite, lottery winnings. When ongoing payments are coming in from a lottery win, the amount received should be allocated 10% to income and 90% to principal. Conversely, if the fiduciary had exchanged a winning lottery ticket for a lump sum payment, the entire amount received is allocated to principal. What is the logic for this rule? I really don’t know. But, the 10%/90% allocation keeps coming up. For example, the net receipts from the sale of minerals is allocated 10% to income and 90% to principal. And so on. When there’s no clear rule for how to allocate a receipt, the default is to allocate it to principal.
There’re dozens more rules like this, and some really arcane ones when you have receipts coming in from the sale of timber or water. But, you get the general idea, which is that fiduciary accounting is not principles-based – it’s most definitely rules based.
In general, it looks to me as though a lot of these rules were the result of a series of lawsuits, and whatever the courts decided ended up being included in the Act as the accepted way to conduct fiduciary accounting.
Reporting to Beneficiaries
So, getting back to the responsibilities of the fiduciary, what goes into a report to beneficiaries? The exact contents will vary by – well, everything – the requirements of the individual probate court could apply, or what the applicable judge wants to see, or it can even be stated in the trust agreement or will. Usually, though, the report includes separate schedules for receipts, disbursements, distributions, and gains and losses, as well as a listing of assets on hand.
The fiduciary generally wants to be pretty detailed with this reporting; otherwise a beneficiary could claim that information was being withheld, and then sue the fiduciary personally for damages. This is not an issue that accountants usually have to deal with in other industries.
There’s a lot more to this topic, but the general issue is obvious – the rules are entirely separate from the normal accounting frameworks, so you really have to be a specialist in order to do this type of accounting.