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Make Every Audit a Success

Every designated broker can be certain of three things … death, taxes and an audit by the Department of Licensing, every three years (or thereabouts).  With good policies in place and brokers who adhere to the policies, DBs can ensure that the audit is a good experience. 

Creating a successful audit outcome when an auditor unexpectedly walks through the door requires daily attention to compliance with solid office policies.  Designated broker needs to create the office policies and brokers must comply with the policies.  For brokers who are less inclined to responsibly adhere to the policies, DB needs to proactively encourage and incentivize compliance.  It is important to remember that audits are not pre-scheduled.  There is no opportunity for a firm to get their files in shape for an audit if the files are not always in good shape.  Rather, an audit will happen with no notice and the firm must be prepared for the audit.  If it appears that DB is scrambling to quickly assemble files or other documents, that will be a red flag to the auditor.

Successful audits are important not only to designated brokers but also to the brokers licensed to the firm.  If the firm is penalized because a broker failed to provide a complete transaction folder, Washington law holds the firm and the individual broker responsible.  It is important to remember that every broker is personally responsible, under Washington law, for timely submission of documents and client funds.  While a firm’s policies should set clear expectations and designated brokers should relentlessly demand compliance, every broker should eagerly submit documentation and client funds, timely, to the firm.  Negative audit findings can result in disciplinary action against firms and brokers alike.

Clear office policies are the foundation of positive audit outcomes.  Firms should consider what they expect of their brokers and create policies around those requirements.  This article will not provide specific policy language because every firm needs to write its own policies.  Rather, this article will discuss a philosophy of constant preparation in a variety of areas.  Designated brokers should reflect on his/her own office operations in light of this discussion.  If a firm’s existing policies are consistent with achieving positive audit outcomes, DB should focus on compliance with existing office policies.  If DB sees weaknesses in the firm’s office policies, DB should first revise or amend policies and then begin a rigorous compliance effort.

Compliance Begins With Education  

DBs need to constantly promote the office policies through office meetings, written and oral communications regarding updates, written reminders when compliance lags and consistent application of office policy during file reviews. Ultimately, if brokers ignore firm policies, DB will have to develop an incentive program. For example, with respect to document submission policies, some firms withhold compensation until broker has tendered all required transaction documents.

When an auditor walks in the door, expect a thorough review of: a) the firm’s trust account (if any); b) property management trust accounts (if any); c) property management agreements (if any); d) broker licenses; e) the firm’s transaction log; f) transaction folders for transactions handled by brokers licensed less than two years; g) transaction folders from a sampling of other brokers; and h) delegation agreements.

Trust Accounts (Earnest Money and/or Property Management)

When the auditor arrives, the auditor will ask to see the firm’s prior monthly bank reconciliation for the trust account along with all deposit records, checks that were written, journal entries and anything else that might affect the account balance since the last reconciliation. The auditor will then recreate the firm’s account balance from the last bank statement. If the auditor cannot get his or her numbers to match the firm’s, then the firm has to be able to show how it arrived at its balance. If the firm cannot demonstrate accuracy in the firm’s balance while the auditor is on site, the firm will be “written up” and given a time period in which to prove the firm’s trust account is in balance.

To avoid problems when the auditor is in the office, the most important thing a firm can do is balance the trust account daily and confirm timely and accurate entries into the firm’s ledger. It is critical that records are posted and up to date every single day.  Reconciliation is a 3-part process, assuring the monthly bank statement is reconciled with the check register and the detailed list of client liability (trial balance or ledger). The goal of reconciliation is to show that all three (statement, register, trial balance) are in balance with each other.  This assures that the firm is holding the proper funds, properly designated for each consumer (buyer, landlord, or tenant).  This reconciliation must be saved monthly in a non-alterable format.  The daily balance is less formal but equally important. 

Property Management Agreements

The auditor will want to see several property management agreements (the management contract signed by firm and the owner of the managed property), mostly to ensure that the agreements are signed by the appropriate firm licensee.  Property management agreements MUST be signed, on behalf of the firm, by the designated broker unless the designated broker has delegated that authority to another managing broker, through a written delegation agreement.  All managed property must have a written, signed management agreement in the file.

Broker Licenses

The auditor will inspect every license issued to the firm.  Recall that the firm or branch license must be displayed so that it is visible to the public.  Every broker/managing broker license issued to the firm must be available to the public, but need not be publicly displayed.  It is common for a firm to retain all broker/managing broker licenses in a binder or some other organizational system.  The auditor will want to see all broker and managing broker licenses to confirm that every licensee practicing from the firm has a license and that every license is active and not expired.

Transaction Log

Every firm must maintain a transaction log accounting for every Real Estate Brokerage Service provided by the firm.  For example, when a firm takes a listing, that listing should be entered on the firm’s transaction log.  Similarly, when an offer is made or a letter of intent is delivered or a broker’s price opinion is given, each of those actions should result in an entry on the firm’s transaction log.  The log should include reference to: the property address, party name(s), the brokerage service provided, and the broker who provided the service.  In addition, for brokers licensed with the firm less than two years, the log should reference the name of the managing broker responsible for review.

The transaction log should reflect all agreements and contracts produced by any licensee of the firm.  For example, a property could show up on the log for a listing agreement and then the same property may be identified on the log when a broker licensed to the firm writes an offer on the same property. The purpose of the transaction log is two-fold.  The log allows the Department’s auditor to easily view the transactions that occurred within a firm during a given time.  The log should also serve as a management tool for the designated broker.  Since the log should serve as a tool for the DB, the Department of Licensing does not dictate the form the log must take, so long as the log includes all of the information identified above, for each entry.  The log may be created electronically or manually.  Many firms use an electronic document submission program that creates a log when documents are submitted by brokers to the firm.

Different auditors approach audits differently but some auditors will walk in the door and the first thing the auditor will ask to see is the firm’s transaction log.  The auditor will use the log to select the files that the auditor will review.

Transaction Folder

A transaction folder must be retained by the firm, for a minimum of three years, on all transactions.  “Transactions” include: all listings; closed transactions; sale failed transactions; offers that were never accepted; delivery of a broker price opinion and delivery of a letter of intent.  A “transaction folder” must include: “all agreements, receipts, contracts, documents, leases, closing statements and material correspondence….” (WAC 308-124C-105(2)(c).)  The Department defines “documents” and “material correspondence” to include advertising.  Thus, a transaction folder must include, at a minimum: all agency agreements (listing agreements, buyer agency agreements); all transaction documents (PSA including all addenda, regardless of when the addendum was mutually accepted and even if the addendum was never mutually accepted, notices from either party); receipts showing broker’s handling of earnest money and/or the deposit of earnest money to the holder identified in the PSA; leases for any occupancy of the property by a non-owner of the property (in a traditional sale transaction, this may include a pre or post-closing rental agreement); a settlement statement showing, at a minimum, the settlement of funds for the party represented by the firm; all material correspondence; and all advertising.  If any of the identified documents do not exist in a transaction or were never provided to broker, there is no requirement to retain those documents.  For example, if broker represented the buyer but buyer never signed a buyer agency agreement, there will be no agency agreement in the buyer broker’s firm’s folder.  Similarly, if buyer deposited earnest money directly to escrow, bypassing buyer’s broker, there will be no receipt showing buyer broker’s handling of the earnest money in either the listing or the selling firm’s file, but there should be a receipt showing delivery of the funds to escrow in the transaction folder for both firms.

Typically, the auditor will check closed files handled by new agents (licensed two years or less).  In addition to reviewing the file, the auditor will want to see evidence that the transaction was timely reviewed by a managing broker.  All transaction documents prepared by a broker licensed less than two years must be reviewed by a managing broker within five days following mutual acceptance of that document. The auditor will also review a sampling of files handled by 4 or 5 other agents as well.  The auditor may review closed files, pending files and listing files.  When reviewing a file that is not closed, the auditor will expect to see that the file is up-to-date, evidencing timely delivery of documents by brokers.  The auditor will usually review about 10 files unless problems are found and then the auditor will review additional files. The auditor may review files handled by managing brokers and brokers alike. Often, the auditor will ask DB to print the files so the auditor can review a hard copy. Every firm must have the equipment and supplies available to enable printing of any documents requested by the auditor. The auditor should never remove a file from the office.

During file review, the auditor’s initial focus will almost always be earnest money documentation. The auditor will make sure the transaction folder reflects proper handling of the earnest money.  The file should evidence who, within the firm, received the earnest money and when.  The transaction folder should also prove timely delivery to the escrow company or timely deposit if the earnest money is retained in the firm’s trust account. Specifically, the auditor will look for a Form 89 (or other receipt showing the firm received earnest money from buyer) and a receipt from the escrow company or proof of timely deposit. If the buyer deposited funds directly to escrow, the firm will not have a receipt showing delivery from buyer to the firm but the firm must have proof of buyer’s deposit to escrow.  Earnest money documentation must be included in transaction folders for listing and selling firms.  If a selling firm fails to provide earnest money documentation to listing firm, the listing firm’s transaction folder must show proof of listing broker’s efforts to obtain proof of delivery from selling broker’s firm.  Moreover, listing firm’s transaction folder must show proof of deposit to escrow or listing broker’s efforts to obtain proof of deposit into selling firm’s trust account.

Additionally, with respect to earnest money, if the file reflects that buyer delivered earnest money to buyer’s broker more than three days prior to the date on which buyer’s broker could deposit the earnest money to escrow or the firm’s trust account, the file must show that buyer’s broker timely delivered the earnest money to broker’s managing broker for safe keeping until the earnest money could be deposited or returned to buyer.

The auditor will also review the closing statement for consistency between earnest money requirements and earnest money deposits, the remaining transaction documentation and will confirm that broker’s correspondence is included in the file.

Submission of Transaction Documents

Before a firm can maintain a transaction folder, the broker handling the transaction must submit all transaction documents to the firm.  Washington law is clear. Every broker must submit every transaction document to the firm within two days of mutual acceptance of that document.  For example, a listing agreement must be submitted within two days of seller and firm signing the listing agreement, a purchase agreement must be submitted within two days of mutual acceptance and a Form 35R must be submitted within two days following buyer and seller signing the Form 35R.  For documents where there is no mutual acceptance, the documents must be submitted in accordance with the firm’s office policy but in any event, not later than closing.

It is with respect to file review that a firm can be the most proactive in working with its brokers.  Remember, audits are not pre-scheduled and a firm does not have time to assemble a transaction folder once an auditor arrives.  Designated broker should institute policies that require brokers to timely submit documents and that strive to have transaction folders in order no later than closing so there will be no issues during an audit.  If a broker or DB finds it challenging to properly assemble documents at or prior to closing, imagine trying to assemble those documents 18 months later, when an auditor is in the office, tapping his/her pen on the conference room table.  Every office should institute clear policies and then work hard to educate its brokers so that paperwork and transactions are properly assembled.  For the purposes of this article, the focus of that effort is audit preparation.  In the big picture, however, responsible transaction review and management is a significant element of a firm’s risk reduction practices.

DB or DB’s designee should consider utilizing a listing and sales worksheet, developed by the firm, to ensure proper review of each file. The worksheet should outline documents needed on a garden-variety transaction and should reflect complete assembly of all required documents before the transaction folder is considered complete. The file reviewer must be sophisticated enough to understand that documents required in any transaction will vary based on the uniqueness of the transaction. For example, land sales will include different documents than improved residential sales.  Seller financing transactions will include different documentation than all cash transactions, etc. 

Recall that correspondence is a requirement for all transaction folders.  The file reviewer should confirm that correspondence is included in the transaction folder.  It is not sufficient for broker to have the correspondence on the broker’s phone or in the broker’s computer.  All “material” correspondence must be included in the firm’s transaction folder.  

It is up to DB to determine if correspondence is material but the safest approach, when uncertain, is to retain the correspondence. As a starting point, any time a broker advises a client to seek the advice of another expert (inspector, contractor, lawyer, title officer, etc.) it is a material communication and should be preserved.  Broker should be mindful that material correspondence may include correspondence with broker’s client and with people who are not broker’s client.  For example, broker could have a material communication with an inspector, escrow officer, lender, the other real estate broker, broker’s managing broker, the party on the other side of the transaction and many others.  If the conversation has anything to do with the transaction, chances are that the communication is material and copies of the correspondence must be retained in the firm’s transaction folder.  Additionally, although oral communications do not fall under the definition of “correspondence,” when material communications occur in oral conversation, broker should document the transaction folder with evidence of that conversation so that if necessary, broker can later prove the conversation occurred.

Three specific examples of “material correspondence” are worth noting.  If a buyer chooses not to conduct an inspection, there should be correspondence in the selling firm’s transaction folder showing that buyer’s broker advised buyer to seek the advice of legal counsel or a licensed inspector regarding that decision.  In transactions that include a buyer’s financing contingency but seller failed to deliver a Form 22AL or 22AR, listing firm’s transaction folder should include correspondence from listing broker to seller explaining the benefits of delivering Forms 22AL and 22AR and seller’s instruction to listing broker to refrain from delivering those forms.  When earnest money is not timely paid by buyer, both firms’ transaction folders must reveal timely communication to listing broker or the seller, that buyer’s earnest money is due but not yet paid.

Designated brokers will have to work hard to ensure that brokers know and comply with firm policies regarding document submission.  DB will have to impose consistent training with all brokers when new office policies are implemented and with all brokers who are newly licensed to the firm. DB should consider making him/herself, or a designee, available to review any transaction documents before a client signs, especially when the broker free-hands transaction terms (things that are not boiler plate) to ensure that the language drafted by the broker is understandable and accomplishes the client’s objectives.

Delegation Agreements

The auditor will ask to see delegation agreements.  Recall that all delegation agreements must be in writing, signed by DB and by the managing broker to whom authority is delegated.  A delegation agreement is required anytime a managing broker, other than designated broker, is responsible for reviewing a newly licensed broker’s transaction documents, responsible for receiving earnest money from a broker and/or for signing property management agreements on behalf of the firm.

While the tasks outlined in this article appear daunting to a firm that has not already incorporated some or all of them into daily operations, it is important to remember that audit preparations require vigilance to daily routines and that once incorporated into a broker’s daily practices, the requirements are not so daunting.  DB should ensure that the office policies, if performed, will yield successful audit outcomes.  Then DB should vigilantly demand compliance from every broker licensed to the firm, on every transaction, until the practices become so routine that DB can greet an auditor, in the office doorway, with a firm handshake and a confident smile.


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