July 26, 2018
UNCLAIMED PROPERTY AUDITS
A. Records Reviewed
Before any unclaimed property audit occurs, the holders should do their own internal audit to determine potential exposure and the possible weaknesses and strengths of any audit positions that the state may assert. Generally, in an unclaimed property audit, every holder will be asked to produce the following documents for audit review: chart of accounts; general ledger/trial balance; annual report; journal entries; bank reconciliations; organizational charts; accounting policies and procedural manual; and an analysis of other income/expense accounts. Depending upon the business involved, the auditor may also do an analysis of: gift certificates; lay-a-ways; credit vouchers and customer refunds; possibly patient credit balances and patient credit refunds; royalties; customer deposits; rentals; unidentified remittances; uncashed checks; payroll registers; and rebates.
It is important to remember that auditors can only review records related to abandoned property compliance, only years within the statute, only records what they (including other audit firms working for the same state(s)) haven’t looked at previously, and only records what the auditors request specifically. Auditors must review addresses on the holder’s records, any documents that establish defenses, and any documents or records which demonstrate compliance and effective policies and procedures. Some states are moving toward more friendly record review requirements for holders. For example, the State of Michigan enacted a new law effective October 29, 2013 whereby a party who has been audited or whose records have been examined must have access to a copy of the audit report containing a specific set of information.
B. Audit Triggers/Red Flags
Some common audit triggers include: State of incorporation, Specific industry or issue, Mergers and acquisitions, Media event and publicity, Public company, Incomplete filing history, Transfer agent filing security-related property, but no filing of general ledger property, Filing with state where the company is headquartered, in lieu of adherence to the priority rules, and Foreign-owned companies. Some red flags for states when conducting an audit include: Decentralized accounting or recordkeeping, Conducting business in many states, reporting to few, and Property types that generate large unclaimed volumes including but not limited to large transaction volumes, bad incentives, physical forms of payment, high employee turnover, and low-quality accounting.
C. Audit by State Auditor
Unclaimed property audits are similar to state tax audits. In both cases, a state auditor (either an employee or a contract auditor) conducts an audit of the company’s (the “holders”) books and records to determine how much money or property the auditor believes should be turned over to the state. Moreover, estimation techniques similar to those used in state tax audits may be used in these unclaimed property audits. The unclaimed property auditor may be employed by the same agency that audits the state’s taxpayers (e.g., the Texas Comptroller’s Office); provided, however some state unclaimed property auditors are unrelated to the state tax auditors. In any event, this does not mean that state tax and unclaimed property audits are identical.
In an unclaimed property audit, a state auditor’s principal objective is to determine the correctness of a holder’s unclaimed property report (or if no report was filed, the amount that should have been reported by the holder). Normally, an unclaimed property auditor will issue a notice to a business that an unclaimed property audit has been scheduled. A list of types of records to be reviewed is generally included as part of the notice. However, this list may be sent in a follow-up notice.
An unclaimed property audit may be conducted for one state or, in many instances, on behalf of a number of states. Most states have interstate agreements with other states, authorizing an auditor from one state to calculate the amount of unclaimed property due from many states at once.
After an audit is conducted, a report is given to the business setting forth the amount of unclaimed property believed to be owed. A report may also contain an amount of interest and/or penalties due.
State auditors are generally not as aggressive as third-party auditors, and are more amenable to settle and resolve issues amicably. Usually, budget is constrained, so not much time is spent on-site unless the state auditor uses the holder’s facility as an office.
D. Third Party Audits
Third-party audit firms, e.g., Kelmar Associates, LLC (Kelmar), ACS Unclaimed Property Clearinghouse (ACS), and Revenue Discovery Services (RDS), have brought increased attention to state abandoned property audits by performing audits on a contingency-fee basis for the states. These third-party audit companies normally contract with multiple states to conduct abandoned property audits on these state’s behalf. From the holder’s perspective, however, the utilization by states of thirdparty audit firms present a number of thorny issues. First of all, what limitations should be imposed on these third-party audit firms to conduct state abandoned property audits?
Are these contract auditors subject to the same constraints imposed upon state auditors? Is the holder entitled to a copy of the contract between the state and these firms? Is the holder entitled to a written schedule and outline of an audit plan? Must these firms reduce all audit requests to written form?
Another major concern arises over the use of contingent fee contracts. The auditors normally receive a percentage of the unclaimed property collected from the holder. However, there is an underlying question as to the validity of these contracts based on the state’s public policy and the incentive they create for the auditor to inflate the amount of unclaimed property due and ignore holder errors that would result in lower assessment. In addition, excessive payments to auditors will reduce funds available to owners and to general revenue fund. Apparently, state jurisdictions differ on this public policy argument.
Some third-party audit firms do offer voluntary disclosure services on behalf of the holder.
E. Confidentiality Concerns
Confidentiality and proprietary technology issues are also a concern atthird-party audits, raising a serious issue of the release of this confidential information to non-government personnel. There should be a satisfactory confidentiality provision either in state law or in the agreement between the third-party auditor and the state to preclude these firms from conducting audits and then possibly disseminating, either directly or indirectly, confidential and proprietary information to third parties. In this regard a number of questions are raised, including can these third-party firms distribute audit information to states that have not joined the audit that they are currently involved in? Also, can holders require a separate agreement with these third-party auditors to ensure confidentiality?
F. Audit Periods
Depending upon the state’s unclaimed property laws, an unclaimed property audit period may range anywhere from a few years to more than 20 years. The length of the audit depends upon the statutory dormancy period (e.g., one to seven years) for the property being audited and the statute of limitations period, if any, for the audit. Many times the state auditor will limit the number of years being audited by state audit practice, even if there is a lack of a specific state statute of limitations. An example would be that in a normal 5-year dormancy period, an audit going back an additional 10 years would be looking at records up to 15 years old to determine whether the amount of unclaimed property being reported to the state was correct.
It is common practice for auditors of unclaimed property to use some type of estimation or extrapolation technique to calculate the amount of unclaimed property due for the audit. Estimation techniques often have to be used because most businesses do not keep records for the lengthy period of an audit by the unclaimed property auditor. Because of this, records may be available only for the most recent years of this period. Accordingly, an auditor would normally try to apply some type of estimation technique in order to extrapolate the results of his audit of available records of the entire audit period. Auditors' use of estimates also could significantly increase a holder's unclaimed peoprty liability. Estimation occurs when an auditor calculates an unclaimed property error rate as a percentage of a holder's revenue and uses it to extrapolate an amount of liability for the entire audit period. And because the estimates are by definition not tied to a particular owner and will never be returned, as unclaimed property is supposedly intended to work, these amounts are straight revenue for the state and profits for the contingency fee auditor.
Under the 1995 Act:
“If, after the effective date of this [Act], a holder does not maintain the records required by Section 21 and the records of the holder available for the periods subject to this [Act] are insufficient to permit the preparation of a report, the Administrator may require the holder to report and pay to the Administrator the amount the Administrator reasonably estimates, on the basis of any available records of the holder, or by any reasonable method of estimation, should have been but was not reported.”
Uniform Unclaimed Property Act of 1995, Section 20(f). Similarly, the 1981 Uniform Unclaimed Property Act specifically provides that when a holder fails to maintain/keep adequate records of its unclaimed property for the audit period, the state is allowed to “estimate” the amount of unclaimed property due from any available records of the holder. Section 30.
Most states have adopted some type of provision that allows their auditors to estimate or extrapolate unclaimed property for a period where inadequate records were kept by the holder. These estimation techniques allow auditors in some cases to project an unclaimed property amount for an entire audit period where available records are kept for only a portion of the period. In some cases, auditors may attempt to use records from outside an audit period to project unclaimed property owed for the audit period. In other cases, an auditor may even use “industry averages” to calculate a business’s unclaimed property liability. See, Uniform Unclaimed Property Act of 1995, Section 20(f), Comments Section.
Some states may be limited in their estimation techniques by the actual wording of the state’s statute. For instance, Illinois law requires that any estimation technique must “conform to either generally accepted auditing standards or generally accepted accounting principles.” 765 ILCS 1025/11.5(a). In addition, Michigan just enacted a new law which it prohibits the auditor from using estimated figures if the holder provides substantially complete records. The Michigan statute defines substantially complete as "90 percent of the records necessary for unclaimed property examinations as defined under the principles of internal controls." The 90 percent calculation is to be based not only on the volume of records, but also on materiality. The law also provides that if a holder's records are deemed not substantially complete for one class of property, it "does not result in the extrapolation of error in those areas in which a person has filed all the required reports and maintained at least 90 percent of the overall records for that particular class."
Moreover, in those states that do not provide any estimation technique in their law, it can be argued that estimation or extrapolation techniques cannot be used in their audits. These states may be limited to reviewing the actual documentation available. Generally, however, it is difficult for a holder to argue that no projection or estimation is allowed when available records reveal an unclaimed property liability and the holder has not kept records for a portion of the audit period. See Baptist Health v. Wingfield, No. 95-5627 (Chan. Ct. Ark, 8/20/96).
While there is no general body of law stating what are proper and improper estimation techniques for unclaimed property audits, there is no doubt that any estimation technique used must at least be a “reasonable” and valid method for determining the amount of unclaimed property not reported for an audit period. State v. Chubb Corp., 570 A. 2d 1313 (N.J. Super. Ct. 1989). Estimation techniques which are arbitrary or not likely to provide a reasonable picture of the amount of unclaimed property not reported would in all likelihood be rejected by a court. See, generally, Epstein v. New York State Tax Comm., 521 N.Y.S. 2d 880 (1987) (audit method must be reasonable); Vitale v. Illinois Dept. of Revenue, 118 Ill. App. 3d 210 (3d Dist. 1983) (audit conclusions must be based on “reasonable statistical assumptions”).
Likewise, under AU Section 342.09 of the AICPA’s Professional Standards, an auditor is required to consider the following factors in doing an estimate:
(1) Significance to the accounting estimate.
(2) Sensitivity to variation.
(3) Deviations from historical patterns.
(4) Subjectivity and susceptibility to misstatement and bias.
While these are the factors used in financial statement audits, they can be used to demonstrate the factors relevant in reaching a reasonable estimate. If in the course of an unclaimed property audit, a holder believes that the estimation technique is not reasonable, the holder has certain options available. First, it can discuss the estimation technique with the auditor to suggest modifications to the technique that will more accurately determine the unclaimed property owed. This should be done before the estimation takes place, in order to head off any later arguments concerning the estimation technique.
Second, if the auditor is unwilling to modify his estimation technique, the auditor’s supervisor or the administrator in charge of the unclaimed property division of the state should be contacted concerning the problem. An alternative estimation technique should be provided, along with specific reasons and an analysis on why the estimation technique used was unreasonable.
Third, if an administrative review of the estimation technique is provided, a formal protest to the estimation technique used can be made to the unclaimed property administrator of the state. This may result in an administrative hearing on the estimation technique. A later appeal of an unfavorable hearing decision can generally be made to the appropriate reviewing court.
If the state refuses to modify the estimation technique, and there is no provision for the filing of an administrative protest of the estimation technique used, then the matter must be decided in court. This can be done either through a declaratory judgment action (if available) or otherwise in the defense of a collection suit brought by the administrator.
H. Interest and Penalties
Depending upon the state, penalties, interest and administrative fees may be levied against a holder who fails to pay or report unclaimed property to the state within the time period described by law. All four uniform acts (1954, 1966, 1981 and 1995) have some provision for fines, penalties or interest to be levied against holders who fail to pay unclaimed property to the state. The 1954 and 1966 acts are very limited, providing for the possibility of fines in certain circumstances, while not providing for interest or penalties. The 1981 and 1995 acts are more expansive and include provisions for interest and penalties for holders who fail to pay or deliver property to the state. Interest and penalty provisions vary widely state by state. In Delaware, penalties can be as high as 50% of the unclaimed property or 75% if fraud is involved. In many cases, however, interest or penalties may be waivable by the administrator of the state unclaimed property law. For example, Section 24 of the 1995 uniform act specifically provides that “the administrator for good cause may waive, in whole or in part, interest under subsection (a) and penalties under subsections (b) and (c), and waive penalties if the holder acted in good faith and without negligence.”
I. Strategies/Audit Strategies
1. Develop a concise policy for the treatment of unclaimed property.
a. Include it in the Accounting/Financial Policies Manual.
b. Policy should define the type of company property which is subject to unclaimed property statutes.
c. Establish accounting procedures for identifying each classification.
d. Buy or create a system to report the property to the state.
e. Assign reporting task to members within the organization, and educate those that maintain books and records as to proper bookkeeping for unclaimed property.
2. Do not write uncashed checks back into income.
3. File current reports in the states in which the company is doing business.
4. For prior years, develop a type of estimation or extrapolation technique for those years in which records no longer exist.
5. Develop a statistical sampling for small amounts by category and be prepared to explain and defend the methodology.
6. When engaging in an audit,
a. Approach the audit as if it will go to litigation;
b. Use outside advisors to communicate with auditors;
c. Negotiate with the auditors regarding information requests;
d. Keep thorough records throughout the audit;
e. Submit all responses with a qualifier;
f. Designate a centralized, internal team to handle the audit; and
g. Learn from the audit, and obtain confidentiality and closing agreements from each audit.
J. Voluntary Disclosure Agreements/Amnesties
Most states have some type of voluntary disclosure program that allows holders to disclose their liability to the state and pay any unclaimed property due without penalty