MFI Audit

Course
Handbook


Aclaim Africa


MFI Audit Course Handbook
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Overview and objectives

This programme is based on materials found in the CGAP Operational
Risk Management Course, a CGAP one-day seminar capacity
development for MF external auditors, the CGAP auditors handbooks
volume 1 and 2, and audit work programmes developed by Sam
Lankester for Carr Stanyer Simms & Co.

Objectives
Obtain overview of MF and MF methodologies
Identify the major stakeholders of MF external audit and
understand their expectations
Distinguish the inherent risks and unique features of MFI audit
Appreciate the risk of major MFI account components and the audit
approach
Learn about the inconsistencies in MF accounting with International
Accounting Standards (IAS)
Learn about MF accounting disclosure best practice
Learn about difficulties in applying ISA in MF audit report

Target group Auditors in AMFIA

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MFI Audit Course Handbook
Contents

1 The MFI Industry................................................................................... 6
1.1 Background.............................................................................6
1.2 Industry prospects ...................................................................7
1.3 The MDI Act 2003 ....................................................................7
1.4 Characteristics of MFI clients......................................................8
1.5 Characteristics of MFI operations ................................................8
1.6 Individual vs group lending........................................................9
1.7 Consultative Group to Assist the Poorest (CGAP)...........................9
1.8 Significant challenges ...............................................................9

2 MFI audits stakeholder expectations and audit risks........................ 10
2.1 Definition of audit...................................................................10
2.2 Stakeholder expectations ........................................................10
2.3 Sustainability.........................................................................11
2.4 MFI Audit Features .................................................................12
2.5 Key account balances .............................................................13

3 Auditing basics revision....................................................................... 14
3.1 Audit planning - overview........................................................14
3.2 Gathering evidence.................................................................15
3.3 Evaluating evidence................................................................16
3.4 Review and completion ...........................................................16

4 Auditing approach cash and equivalents........................................... 17
4.1 Background...........................................................................17
4.2 Cash - risks summary .............................................................17
4.3 Liquidity risk..........................................................................17
4.4 Fraud risk .............................................................................17
4.5 Control risk ...........................................................................18

5 Auditing approach loan portfolio ...................................................... 19
5.1 Loan portfolio characteristics....................................................19
5.2 Loan portfolio business risks ....................................................19
5.3 Overview of loan portfolio testing process..................................20
5.4 Effective controls testing .........................................................20
5.5 Substantive tests ...................................................................22
5.6 Summary of tests on loan portfolio ...........................................24
5.7 Example audit programme extract ............................................25

6 Auditing approach loan loss provision .............................................. 27
6.1 Provisioning methods small MFIs ...........................................27
6.2 Provisioning methods larger MFIs...........................................27
6.3 Write-offs..............................................................................28
6.4 Loan loss provision tests of controls .......................................28
6.5 Loan loss provision substantive procedures .............................29
6.6 Importance of delinquency ......................................................29
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Contents (contd)

7 Auditing approach interest ............................................................... 30
7.1 Interest accounting policy........................................................30
7.2 Interest income testing: analytical review..................................30
7.3 Yield gap analysis...................................................................30

8 Compliance with International Accounting Standards ......................... 31
8.1 Accounting for interest income .................................................31
8.2 Accounting for grant income ....................................................31

9 Accounting Disclosure best practice .................................................... 33
9.1 CGAP Disclosure Guidelines .....................................................33
9.2 Segmental reporting...............................................................33
9.3 Portfolio accounting................................................................34
9.4 Portfolio quality and management ............................................34
9.5 Donations .............................................................................35
9.6 Other significant accounting disclosures.....................................35

10 Audit reports and management letters................................................ 36
10.1 Compliance with CGAP Disclosure guidelines ...........................36
10.2 Compliance with IAS............................................................37
10.3 Management letter ..............................................................37
10.4 Management letter points to consider.....................................38


MFI Audit Course Handbook
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MINI ACTION PLAN

What Have I learned? What are the
important points for me?
How can I apply this after training? How
can I ensure that I use this?


































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1 The MFI Industry
1.1 Background
There is a long history of informal finance in Uganda. The Micro
Finance Industry began with social welfare objectives, initiated mostly
by cooperatives and NGOs. The last 10 years have seen significant
growth in this industry, although it is now levelling off. Best practice
in the industry is relatively young, although it is now quite clearly
defined.

The MFI Industry is unusual in straddling the boundary between
business and NGO. They have a double bottom line: sustainable
services for the poor. The increasing recognition for the need for
financial sustainability has led to more and more MFIs aiming to move
towards commercial viability.

Uganda has the leading MFI in Africa, with over 500 outlets in 52 of
Ugandas 56 districts. There are some 600,000 active clients, of whom
70% are women, but only 20% are rural. There is a greater
concentration in Central and Western regions. MFIs are grouped into
different categories:

Cat. No. Characteristics
A 6
Over 20,000 active clients
Company structure or in transformation
>90% financially self sustaining (FSS)
Well documented procedures / MIS
Compliant with MF best practice
B 10
5000-20000 active clients
NGO, SACCO or company
50-89% FSS
Fair documentation of procedures / MIS
Applying best practice
C 40
500-5000 active clients
NGO, SACCO, FSA or company
35-49% operating self sufficiency
Business plan reflecting good practices
Know whats going on in the Industry
D >300
<500 active clients
NGO, SACCO, FSA, ROSCA, ASCA or company
Savings & credit core activity
Not so aware of whats going on in the Industry
Little awareness of Best Practice
E 1000s
Multipurpose NGOs, cooperatives, projects /
programmes and support institutions promoting
microfinance
Microfinance not core activity
Potentially important linkage partners
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1.2 Industry prospects
Prospects for the industry are very good because there is a very
conducive environment for growth. There is excellent cross sector
coordination, including donors, government, MFIs, consultants and
auditors, greatly facilitated by the existence of associations such as
AMFIU and AMFIA. In all areas of the industry there is a commitment
to International Best Practice as the way forward, and a determination
to overcome the obstacles in seeing it implemented. Since 2003 there
is also a stringent regulatory framework embodied in the Microfinance
Deposit Taking Institutions Act 2003.

For auditors, some investment is likely to be necessary to build skills
and capacity to carry out effective audits. This is well worth it, as
donors and even MFIs themselves are hungry for effective audits that
meet their needs. The market is ripe!

1.3 The MDI Act 2003
In 1999, the BoU categorised all Financial Institutions into 4 Tiers:
Tier 1: Commercial Banks
Tier 2: Credit Institutions
Tier 3: Microfinance Deposit Taking Institutions
Tier 4: Institutions in microfinance that do not qualify for 1, 2 or 3

This tier structure should not be confused with the categories A-E
described above. An MFI in Category A may be in a position to and
choose to apply for registration under the MDI Act. Once accepted,
that Category A MFI w moves from Tier 4 to Tier 3. Belonging to
Category A does not automatically mean that the requirements for
registration as an MDI are met, or that an MFI wishes to register as an
MDI. Registration brings with it the benefit of credibility, which
attracts clients and donors. In June 2005, only 1 Ugandan MFI
(FINCA) has registered under the bill, and 3 applications are in
process.

The overall objective of the Act is regulation and supervision of Tier 3
Financial Institutions. Some of the key areas covered in the Act
include
Licensing (allowing) or restricting certain types of transactions and
dealings,
Stringent requirements for ownership and corporate governance:
e.g. no shareholder may own more than 20%
Supervision, receivership & liquidation
Sustainability & outreach


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1.4 Characteristics of MFI clients
MFI clients often operate tiny informal businesses. There is usually no
perceived difference between the individual and the business, and
rarely are formal books or records maintained. Traditionally, micro-
entrepreneurs have not had access to bank loans. The loans they need
- anywhere from $25 to $1,000-are too small for conventional banks
to handle economically. Because of their lack of collateral,
bookkeeping methods, and informal status, most bankers view micro-
entrepreneurs as unacceptable credit risks. As a result their sources of
credit have mainly been limited to family members, suppliers, and
informal moneylenders who charge extremely high interest rates.

But over the past decade a wide variety of institutions, mainly non-
profit social service organizations, have developed methods that
enable them to deliver loans to micro-entrepreneurs and other poor
clients at a manageable cost while maintaining high repayment rates.
In many developing countries microfinance has grown dramatically: it
is supporting the income and welfare of tens of millions of customers

1.5 Characteristics of MFI operations
In meeting the needs of their clients, MFIs generally give out quite
small loans, and require small regular repayments. There are
therefore huge volumes of tiny transactions to be captured and
reported. The key to the success of MFIs lies in their innovative
lending methodologies, as shown in the table below:

Achievement Methodology
Low transaction costs Low level approval
Little segregation of duties
High outreach Decentralisation
Cash
Speed of processing Simple standardized procedures
Few documents
Unsecured loans Character based assessment
Group lending and cross guarantees
High repayment rates Incentive of access to future credit
Good loan officer relationship
Start small, graduated loan sizes
Training
Tough on delinquency
Peer pressure

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1.6 Individual vs. group lending
One of the key characteristic of MFI methodology is group lending.
The following table compares individual and group lending.

Individual Lending Group Lending
Collateral Loans guaranteed by collateral Mutually guaranteed with
other borrowers
Participant
Screening
Potential clients screened by
credit checks
Potential clients screened
by their peers
Loan Analysis Loan amount based on
thorough viability analysis
Little or no analysis of
the business, except by
peers
Loan Flexibility Tailored to needs of the
business
Follows pre-set gradual
growth curve
Loan Size and
Term
large sizes, medium to long
terms
Generally short and
amounts small
Staff-Client
Relationships
Close, long-term relationships
with clients
More distant relationship
with large numbers of
clients
Cost per Client High lower volume Low high volume
Cost per Loan Low larger size High small size

1.7 Consultative Group to Assist the Poorest (CGAP)
CGAP is a multi-donor consortium dedicated to the advance of
sustainable micro-finance worldwide. They have three main teams:
Client end issues relating to clients needs / product development
/ impact on poverty reduction
MFI team Investment grants and capacity building for MFIs
Industry team Industry wide issues e.g. accounting policies, loan
tracking software, financial reporting, auditing etc

CGAP has become the definer of Best Practice in the MFI Industry
worldwide. The course materials presented in this course were
developed largely by CGAP.

1.8 Significant challenges
There are many challenges facing the industry, but some of the most
acute relate to accounting, reporting and auditing:
Accounting inconsistency in accounting policies, lack of
integration between loan tracking and accounting software
Reporting Financial Statements often contain insufficient
information to assess portfolio performance or financial
sustainability
Auditing auditors find standard procedures are ineffective,
managers and donors find audit reports are not helpful
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2 MFI audits stakeholder expectations and audit risks
2.1 Definition of audit
The financial statement audit is the most common type of external
audit. In this audit the external auditor expresses an opinion as to
whether an MFIs financial statements are fairly presented in
conformity with an identified financial reporting framework-that is, a
defined set of accounting standards. The audit is conducted with an
identified auditing standard.

2.2 Stakeholder expectations
Stakeholder Legal
compliance
F/S
presents
fair view
Sustainability
Donor High Medium High
Regulatory Body High Medium High
Mgmt Medium High High
Members Low Low High

Donors: The donors primary concern is whether the MFI has
complied with the terms of the grant agreement. Most donor
personnel are from a non-finance background and thus have limited
knowledge about understanding and interpreting financial
statements.

MFI sustainability is also not always a big issue unless it is
specifically mentioned in the grant agreement. Donor projects
always work on a fixed time frame and poverty focused programs
mostly have a purely development orientation (e.g. education,
health, etc.) and thus are delivery oriented with a relief/charity
mindset. The goal of a self-sustaining program for the poor, as in
the case of microfinance, is a new concept for which most donor
personnel are not properly equipped or trained.

Regulatory bodies: These have been formed either from NGO or
Central Bank perspective and thus are not really suitable for MFIs.
Financial statements and sustainability are not critical factors for
regulating NGOs. Central Banks have their own bank supervisors
and MFIs are still very new to them. Banks have been around for
hundreds of years.

MFI Management: Like most auditees, auditors are a pain in the
neck and have to be tolerated as it is required by the donor and/or
regulatory authority. All the management wants is a clean audit
report.

Members: No MFI members know about the external audit. But it
is this group which is most affected by the performance of a MFI.
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2.3 Sustainability
An MFI is operationally sustainable when it can meet all its expenses,
including loan write-offs, from its interest income. Financial
sustainability of micro-finance projects has been a hard lesson to
learn; one that flew in the face of the signals that donors were giving
pioneers in the microfinance business in the 1970s and 1980s. In
those early days, any amount of funding was available to any
microfinance provider able to show that they could disburse loan funds
to the poor in substantial amounts rapidly and with good
documentation. This is easy to do if you offer potential clients heavily
subsidised interest rates. However, as donor funds dried up and official
aid flows declined in both relative and absolute amounts in the 1990s,
financial sustainability of microfinance programs became a life and
death issue for MFIs.

Even now many donor and government funded programs have the
characteristics of a welfare program and not a financially viable vehicle
for the long-term delivery of financial services to the poor. As many
case studies show, poor people are more than willing to pay the full
cost for the microfinance products that they need, including a profit
margin sufficient to keep the microfinance provider in business.
Financial viability leads to management demands that are focused on
serving poor people instead of donors or governments, with every
possibility that the administrative requirements are significantly less
complex than those required for donor accountability and reporting.

The alleviation of poverty through microfinance services requires
sustained effort. One round of loans is not enough to ensure that poor
households will lift themselves above the poverty line and remain
above it. If MFIs are to be there to provide service to their clients over
the long period, they themselves must become financially viable.

Making a profit is important to enable the MFI to build up equity,
attract investment capital, service loans taken up for on-lending to
poor clients, and instil a philosophy into programme implementation
staff that is consistent with what they themselves expect of their poor
clients who similarly seek to scale-up their enterprises. Earning a
profit, in turn, requires that their income, which largely comes from
the interest they charge on loans, must be able to cover all operating
costs (including depreciation on assets), a reasonable loan loss
provision, and the costs of funds (including protection of the loan fund
from depletion by inflation), and still leave an adequate surplus to
build up equity. These are the building blocks of full financial
sustainability.

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2.3 Sustainability (contd)
It is the poor member who stands to lose the most if the MFI fails. If
the MFI fails, the members may lose their only opportunity to get
financial service at a reasonable cost. The loss to the society of a MFI
collapse is much more than that of a commercial bank or an NGO. As
the more fortunate economic group in the society, we auditors have an
obligation to the less fortunate ones. If the MFI is to be sustainable in
the long run, it must fulfil the other two expectations in the short run.

2.4 MFI Audit Features
MFI audits have very high inherent control risks. Auditors who have
experience in the banking, NGO or business sectors, find that MFIs are
actually quite different to any of them. They are certainly complex.

Internal control risks
MFI managers have social work background, not financial services
Good deal of physical cash transfers
Limited segregation of duties
Decentralisation of authority
Inadequate information systems
Inexperienced accountants

Unlike traditional banking practices
Simple loan documentation
Symbolic value of guarantees
Undocumented financial analysis of clients business
Approvals at low level
Lack of segregation of duties between approval and collection

Unlike other NGOs
Financial self sufficiency is a key factor in MFIs being able to have a
sustainable effect on poverty alleviation.
Disbursement of grants cannot be treated as an expense
Need to consider more business like aspects such as product
costing and sophisticated MIS

Unlike most business or for-profit institutions
Weak governance structures
Ineffective external supervision
Non-performance driven financial statements
Unique equity structures
Financial policies do not conform to GAAP

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2.5 Key account balances
Cash and equivalents are important because cash transactions
comprise the major part of an MFI with its consequential inherent
risks (fraud?) and we should always keep that in mind during all
stages of our audit.
Loan portfolio & loan loss reserve are the most important
account balances as they include most of the institutions assets
and are the source of the most serious risk of misstatement.
Savings and deposits are increasingly becoming an important
account balance in some MFIs
Capital accounts (fund balance) require special attention as
most MFIs receive grant fund from donors.
Creditors and accruals are important because MFIs are
exposed/susceptible to possible understatement in these accounts
Revenues and expenses require attention because MFIs are often
inconsistent in their treatment of them.

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3 Auditing basics revision
In summary, this section deals with the following aspects of the audit:
Audit planning
Gathering evidence
Evaluating evidence
Review and completion

3.1 Audit planning - overview
Time spent effectively planning the audit before launching into
fieldwork can ensure that the audit is efficient and adequately
addresses the key risk areas.
Engagement letter
Document review
Understanding business and systems
Pre-audit meeting
Preliminary Analytical Review of draft financial statements
Materiality assessment
Risk assessment
Sample sizes for control and substantive tests
Detailed audit programmes may need to be tailored
Time / budget and logistics

3.1.1 Engagement letter
This may need to be modified if some special procedures are to be
followed as recommended by CGAP. See Auditors handbook which
may be downloaded from CGAP website, or AMFIA has a hard copy.

3.1.2 Document review
Last years accounts and management letter, correspondence file,
points forward from last years file, PAF, grant agreement etc

3.1.3 Understanding the business and systems
Appreciate the contextual variables: markets, who the current
borrowers are, competition in the area, local repayment culture,
planned growth.
Review the credit policies: loan approval, credit history, rate of
increase in loan size, required savings, multiple loans.
Understand the accounting and loan tracking how are loans,
repayments and interest entered in the ledger and MIS, loan loss
write off and provision policy.
Assess the attitude of management do they know the PAR?
What do they consider to be acceptable levels of delinquency? How
many clients should there be per loan officer? Are they on top of
portfolio trends?

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3.1.4 Risk assessment
Audit risk is the risk of issuing an incorrect opinion on whether the
financial statements present a true and fair view. Audit risk is a
function of 4 other types of risk that make up the risk equation:

AR = IR x CR x DR x ER

Inherent: risk of a material error arising in the financial
statements. The auditor measures this risk (both entity and
account specific risks), usually via use of standard questionnaires.
Control: risk of a material error that has arisen not being found by
the clients own internal control systems. The auditor measures
this risk by assessing the adequacy of control procedures and
testing to see effectiveness.
Detection: risk that the auditor fails to detect a material error that
has arisen. The auditor manipulates sample sizes to give low
enough detection risk given the significance of the other risks.
Ethical: risk that a material identified error is not reported or
disclosed. The auditor minimizes this by removing threats to
objectivity, independence and integrity.

3.2 Gathering evidence
There are two main types of tests that may be done: compliance tests
check whether the internal control procedures are being complied with,
whereas substantive tests check actual account balances, either by
tests of detail or analytical review.

3.2.1 Best times of year to gather evidence
When the controls route is used (which makes more sense when there
are large volumes of small transactions), it is often better to do tests
of controls before the year end at an interim audit. Testing of year
end account balances may then be done after the year end.

3.2.2 Directional testing for substantive tests of detail.
Debits are tested for overstatement, starting with the ledger and
tracing to the source documentation / evidence. Credits are tested for
understatement, starting with the source documentation / evidence
and tracing through to the ledger.
DOLS CUSL - (Debit Overstatement Ledger to Source / Credit
Understatement Source to Ledger)

For example, debtors are debits, so the auditor takes the balances
shown in the ledger and verifies that they are recoverable by reference
to supporting evidence. Income is a credit, so the auditor started with
a complete population of receipt numbers and traces them through to
the ledger to confirm that they are all recorded correctly.

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3.3 Evaluating evidence
Summarise the effect of extrapolated errors and compare with
materiality levels set in the planning stage, both for specific account
balances and overall opinion materiality. Carry out more tests as
necessary, prepare audit adjustments and draft the audit report
accordingly.

3.4 Review and completion
The following elements may be seen on audit file completion checklists
Audit programmes signed off
Lead Schedules updated
Final analytical review
International Accounting Standard compliance checklists
Management letter drafted
Manager / Partner review points raised and cleared
Letter of representation
Audit opinion agreed
PAF updated
Time analysis
Points forward noted
Fee notes
Such checklists are a crucial aspect of auditor quality control.

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4 Auditing approach cash and equivalents
4.1 Background
These include cash held at banks as well as cash on hand with cashiers
and collectors. Due to resource constraints most MFIs have the same
person (collector and cashier) responsible for both handling and
recording cash.

Fraud risk is a serious threat in many MFIs. External auditors should
ensure their MFI clients understand that, while cases of fraud may be
identified in the normal course of audit activities, detecting fraud is not
the primary focus of the audit. Rather, auditors should identify control
weaknesses that increase opportunities for fraud and propose
recommendations for improvement. Fraud through staff collusion is
not uncommon in MFIs. An adequate number of branch and client
visits need to be made and including a thorough analysis of the
internal controls. The auditor needs to think like the crooked employee
what are the loopholes in the system which will allow me to steal
some money.

4.2 Cash - risks summary
Potential business risks
Liquidity risk
Fraud risk

Potential audit risks
Inherent risk
Control risk

4.3 Liquidity risk
Liquidity risk is higher for MFIs than for commercial banks or other
businesses. MFI clients motivation to repay their loans is closely linked
to their expectation that good repayment performance will result in
repeat loans. When a liquidity crisis forces an MFI to defer loan
disbursements, word spreads quickly, often resulting in severe
outbreaks of delinquency by other loanees.

The auditor should evaluate whether the MFI is managing liquidity; a
number ignore the function and operate on ad hoc basis in terms of
responding to branch requests for liquidity - and whether the MFI has
an adequate system for projecting its sources and uses of cash.
Obvious weaknesses should be noted in the management letter.

4.4 Fraud risk
Fraud, both external and internal, and robbery are significant risks for
MFIs. The absence of guards or security cameras in branches makes
MFIs susceptible to robbery. Collection and transfers outside the
branches compound the risk. The external auditor should enquire
whether robbery has been a problem for the MFI.
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4.4 Fraud risk (contd)
The primary sources of fraud in micro-credit operations include
phantom loans, kickback schemes and other bribes, and non-reporting
of client payments. Such unethical behaviour is not effectively
detected by audits of paper trails as the loan officer alone is
responsible for generating and following through on loan disbursement
and recovery. Traditional audit procedures, external or internal, are
ill-equipped to detect this type of fraud because they do not usually
involve extensive client visits. Traditional procedures tend to focus on
tracking the documentation of loan agreements and cash payments.

4.5 Control risk
A major cause of control risk is lack of proper segregation of duties for
cash transactions. The auditor should examine segregation of duties or
internal controls for cash transactions at all levels of the MFI. Fraud
control measures built in at the operational level are often more
effective than an auditors ex post review. If an MFI has internal
auditors, which most MFIs do not, their work should be considered
when testing controls on cash. But even strong, independent internal
auditors are not always effective in controlling fraud in an MFI, given
their traditional accounting orientation.

From traditional audit perspective, MFIs may appear weak in their
internal controls. They do not, and should not, develop the paper trails
and hierarchical decision making found in commercial banks. But
successful MFIs do exert substantial operational control on their loan
officers and cashiers, who are the principal originators of fraud.



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5 Auditing approach loan portfolio
In summary, this section deals with the following aspects of auditing
the loan portfolio:
Characteristics
Business risks
Effective controls
Sample sizes
Substantive tests
Loan loss write off / provision
Audit programme

5.1 Loan portfolio characteristics
Large no of loans, tiny repayments
Decentralized operations
Inadequate controls due to cost efficiencies
Rapid growth
Inadequate provisioning
Non integrated information systems
Accounting information
Loan tracking

The accounting system receives information about individual loan
transactions, but its purpose is to generate aggregate information that
feeds into the financial statements. The loan tracking MIS is focused
on information about individual loans. Some of the data recorded in
the loan tracking MIS are also recorded in the accounting system- such
as disbursements, recoveries, and accrued interest.

Ideally, the loan tracking MIS should be seamlessly integrated with the
accounting system. In practice this is unusual. MFIs cannot use
integrated software designed for banks as their loan systems are too
different from those of banks. Many MFIs have found that a standard
accounting system (computerized or manual) can be adjusted to fit
their requirements, but they need to develop their own loan tracking
MIS (computerized or manual).

5.2 Loan portfolio business risks
Credit risk: delinquency rates typically low but volatile
Systems for managing delinquency critical
Fraud risk: high and difficult to detect
Interest rate risk: long term financing
Exchange rate risk: donor loans

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5.3 Overview of loan portfolio testing process

Audit process overview
Tests of controls
Sample size
Substantive tests
Head Office
Branch
Client visits
Reconciliation
and analytical
review


5.4 Effective controls testing
We have seen that the normal controls one would normally be
expected to find in a bank cannot be applied to an MFI. But many
successful MFIs have managed to implement effective controls.

5.4.1 Head Office controls testing
Credit policies design
Management Information Systems
Loan Officer incentives
Internal audit

Credit policies these are the core of the MFIs business. Whether
documented in a manual or not, it is crucial the policies are well
designed, understood and practiced by all. More details are in the MFI
External Audits Handbook issued by CGAP. (AMFIA has a copy).

Elements of a credit policy:
Client qualifications: age, no of years in business, gender,
independence in business activity, criminal record etc
Repayment capacity: method of establishing, minimum levels,
fluctuations, type of activity being financed
Credit history: With the program, with other programs, with basic
services (e.g. water, electricity)
Size of loan and repayments: Fixed?, based on business, collateral,
previous loans
Credit delivery methodology: Group size, rate of increase in loans,
forced savings, client to Loan officer ratio, client training
Interest fee structure
Loan approval procedures
Action on delinquent loans, including refinancing or re-scheduling
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5.4 Effective controls testing (contd)
Management Information systems As substantive tests of detail
for MFI portfolios are burdensome, auditors and managers need to be
able to rely on the integrity of the loan tracking MIS. If no one in the
organization expects the loan tracking MIS to be 99% accurate, people
tend to let down their guard. Thus it needs to be checked for accuracy,
security and effectiveness.

Internal audit The auditor should look, in particular, whether the
MFI has, or should have, an operational audit function bearing in mind
the limitations of traditional internal audit procedures when applied to
microfinance portfolios.

Compensation policy The auditor should examine how the MFI
measures loan officer or branch performance in managing the loan
portfolio, especially if incentive pay or promotions are tied to such
measurement. For example, if heavy weight is given to increasing loan
volume-especially where a compensating weight is not given to high
repayment rates the incentive structure may lead loan officers to make
too many risky loans.

5.4.2 Branch visits
Which ones and how often
Check compliance with policies and procedures
Perform substantive tests on significant number of loans
Visit clients

Branch visits The auditor, not management, should select the
branches to visit. Many MFIs have model branches that are far
superior to other branches. For MFIs with few branches, auditors
should probably visit all branches every year. For MFIs with many
branches, all branches should be visited within at least a two- to
three-year timeframe. To the extent possible, visits should be
unannounced. This element of surprise makes it harder for branch or
regional managers to cover up problems.

Compliance - Throughout the testing at retail outlets, the auditor
should focus on whether loan policies and procedures are being
complied with. Auditors must pay close attention to actual practice in
follow-up on delinquent loans, such as prompt distribution of
delinquency information to loan officers and immediate visits to all
delinquent borrowers. MFIs that fail to respond aggressively to
delinquency seldom survive long.

Client visits External auditors of MFIs must locate and contact a
sample of clients directly. Visits are intended to confirm that the client
exists and that the loan details represented in the files are valid and
accurate. This also includes verifying that the controls around loan
rescheduling and refinancing are effective. Client visits should be
unannounced. Otherwise, loan officers may coach the clients to cover
up problems.
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5.5 Substantive tests
5.5.1 Reconciliation between MIS and ledger
The aggregate figure for outstanding loan portfolio is in the accounting
records. The breakdown by client is in the loan tracking MIS. It is not
unusual to find reconciliation discrepancies between loan MIS and
accounting records in MFIs. The external auditor should decide
whether the reconciliation discrepancies discovered represent
systematic weaknesses. If the discrepancies are large enough to be
material, management should be required to explain them and
reconcile the accounts in order for the audit to proceed. If
management cannot do so, the auditor cannot issue a clean opinion.
Even in cases where the discrepancies are not above the materiality
threshold, they may suggest a serious inconsistency between systems
that should be noted in the management letter.

5.5.2 Analytical review
Because so much reliance is placed on an MFIs controls, substantive
analytical procedures are important tests for the end of the reporting
period. The external auditors should take the loan balance at the end
of the reporting period and compare it with the loan balance that was
subjected to tests of control. In addition, loan portfolio data for the
current year should be compared with data for previous years.
Significant fluctuations should be discussed with management.

Loan MIS of many MFIs segregate loan portfolio into similar
populations for trend and characteristic analysis. For instance, the
portfolio may be segregated by loan product, client or business type,
or geographic location. The comparison of these sub-populations and
trends in their activity or balances can be analyzed. The more detailed
the analysis is, the higher is the level of confidence that sampling has
produced a representative picture of the portfolio, and that no material
misstatement exists.

5.5.3 Sample based tests of detail client visits
To test the year-end balance for the loan account, the auditor tests a
selection of loans. As with tests of control, the auditor rather than
management makes the selection, drawing the sample from a loan list
whose total reconciles to the general ledger.

The sample size for client visits, for the purpose of testing year-end
balances, is usually larger than the sample size for tests of control.
Some auditors visit as many as 10 percent of active clients,
particularly for small MFIs.

There is, however, no universal guideline for the percentage of clients
to be visited. The sample size depends on the materiality level
established and on the auditors conclusions about the reliability of
internal controls.

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5.5.3 Sample based tests of detail client visits (contd)
If materiality is high, errors below that high figure are not material,
therefore sample size may be reduced
If materiality is low, even smaller errors have impact, therefore
sample size needs to increase
If internal controls are found to be effective, sample size may be
reduced
If internal controls are weaker than expected, sample sizes may
need to be increased.

5.5.4 Materiality
Establishing materiality levels is crucial in determining the nature,
extent and timing of audit procedures. A materiality level is a
threshold over which potential errors are considered problematic.
There are no general standards for establishing materiality levels for
an MFI. Auditors of MFIs sometimes use total assets as a critical
component and set 2 percent as a materiality level.

5.5.5 Determining sample sizes
Assume that an MFI has total assets of $1,000,000 of which the gross
loan portfolio balance is $900,000. The MFI has 3,000 clients, whose
average outstanding balance is $300.

If a materiality factor of 1% is used and the critical component is total
assets, then the materiality level is 1% of $1,000,000, or $10,000.
The sample size could then be calculated by dividing the total account
balance by the materiality level (or selection interval). In this case the
sample size would be:

Account balance $900,000
-------------------- = ----------- = 90 selections (3% of clients)
Selection interval $10,000

Provided there is no loan larger than the $10,000 selection interval,
the 90 selections would equal 90 loans.

If the auditor has high confidence in the MFIs internal controls, the
materiality level could be raised to 1.2% of total assets ($ 12,000).
The sample size would then be:

Account balance $900,000
-------------------- = ---------- = 75 selections (2.5% of clients)
Selection interval $12,000

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5.5.5 Determining sample sizes (contd)
If much reliance cannot be placed on the internal controls relating to
the loan balance, the materiality level might be lowered to 0.6% of
total assets ($6,000), giving a larger sample size:

Account balance $900,000
-------------------- = ---------- = 150 selections (5% of clients)
Selection interval $6,000

There is inevitably a subjective element in assessing internal controls
and choosing materiality levels, making it impossible to recommend
specific sample sizes.

5.6 Summary of tests on loan portfolio

Summary of tests of control
At head office
Document credit policies and procedures;
test compliance
Review MIS for accuracy, security and
effectiveness
Determine reliability of internal audit
Examine compensation-based incentive structures
At retail outlets/branches
Assess the control environment
Check compliance with policies and procedures
Perform tests on a significant number of loans
Visit clients


Analytical procedures
Comparison with previous balances
Analysis by sub-population
Detailed tests
Client visits
Reconciliations between g/l and loan tracking
system
Rescheduled and refinanced loans
Loans fully recovered in advance, immediately
followed by another loan
Delinquent loans suddenly cleared
Summary of substantive tests

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5.7 Example audit programme extract

1 Year end balances outstanding agrees to list of individual balances
Test Description Ref Initials Date
1 Obtain a breakdown of the closing balances figure,
into individual balances, or branch sub-totals. For
selected branches, obtain a breakdown of the branch
sub-totals into individual balances.

N11

2 Cast the list / breakdown to ensure the population is
complete.
N12
3 Where the TB figure differs from the list total, pass
an adjustment to bring the TB total into line with the
list total.

N12


2 Analytical review is reasonable
Test Description Ref Initials Date
4 Prepare or obtain a schedule showing Bal Bfwd,
disbursements, interest accrued, principal
received, interest received and amounts written off
for the year, for each branch.

N13

5 Check that the schedule casts and cross casts, and
comment on any unusual trends

N14

6 Ascertain the number of active clients at each
branch and calculate the average balance
outstanding and loan size, for each branch.
Comment on findings

N14

7 Calculate the % portfolio at risk for each branch
and comment on findings.

N14


3 Disbursements and year end balances are not overstated
Test Description Ref Initials Date
8 Calculate the total sample size, based on the
control risk assessment and materiality factor.

N16

9 Select a sample of branches for testing. All
branches should be visited at least every three
years.

N17

10 Select half the sample of loans from the list of
balances carried forward and the other half from
the list of disbursements during the year. Select
on a systematic basis (e.g. every 20
th
figure),
depending on the size of your population.

N17

11 Perform visits for each of the selected clients in the
selected branches and complete the questionnaire.
NB Client visits should be unannounced.

N17

12 Compare the timings and amounts of
disbursements and repayments, and loan terms
from each client with the MIS.

N17

13 Summarise and evaluate your findings N17
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5.7 Example audit programme extract (contd)

4 Repayments made by clients are not understated
Test Description Ref Initials Date
14 Identify the best source documents for loan
repayments, and assess their completeness. (E.g.
receipts check all the receipt books are available
for inspection. Daily / weekly collection forms
check all the forms are there)

N18

15 Select a sample of repayments from the complete
population of source documents identified in 14
above. This sample may be the size of the
sample used in 8 above

N18

16 For each sample in 15 above, trace the amounts
and timings from the source documents through to
the cashbook, loan ledger card and MIS.

N18


5 The delinquency status report at year end is accurate
Test Description Ref Initials Date
17 Obtain a copy of the delinquency status report at
the year end.
N19
18 Ascertain and comment on the basis for calculating
the delinquency ratios
N19
19 For each of the clients visited, confirm that the
status of their balance is correctly classified.
Where a repayment is past due, ensure that the
entire balance is shown as at risk, not just the
overdue repayments.

N19

20 Check the casting of the delinquency report N19

6 Loan provision policy is adequate
Test Description Ref Initials Date
21 Ascertain and comment on the clients loan
provisioning policy
N20
22 Confirm that the calculations have been made in
accordance with the policy
N20

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6 Auditing approach loan loss provision
Every MFI audit should include careful testing of loan loss provisions,
similar to banks. In 1996 Corposol, the largest MFI in Columbia, came
to the brink of collapse. The annual audit by a big six auditing firm
affiliate had failed to detect a drastic deterioration in portfolio quality.

The risk is higher during periods of rapid growth as existing systems
may not be able to cope with the strains. Rapid growth on weak
systems will only aggravate the risk. Global figures and ratios do not
always display the true picture as good loans may average out the bad
ones. Rapid growth has the effect of greening the portfolio and tends
to mask a growing portfolio at risk.

Without adequate allowance for likely losses, the loan account on the
balance sheet can be materially misstated. Likewise, loss provisioning
directly affects the MFIs profit reporting. Finally, an accurate loan loss
allowance gives a good initial indication of the competence with which
the MFI is managing the riskiest aspect of its business-loan
delinquency. The competence of the audit firm is also reflected.
6.1 Provisioning methods small MFIs
Small MFIs may simply provision a fixed percentage of its portfolio
based on its overall loss experience in previous years. Sometimes a
percentage of each loan is provisioned at the time of its disbursement.
The auditor must look at how these loss rates have been determined
and judge their adequacy (MFIs should certainly be encouraged to
perform an aging analysis. They dont always do). Provisioning also
has to take into account the present performance of the portfolio. If
delinquency levels are higher today, provisions should be set at a level
that is higher than the historical loss rate. The same would be true if
there are other factors (flood, draught) that will affect loan recovery.

As many MFIs do not write-off loans aggressively or consistently, the
provision percentage should be related not to accounting write-offs,
but to the real portion of prior loans that have become unrecoverable
as shown in the loan MIS.
6.2 Provisioning methods larger MFIs
Large MFIs, or those that are preparing for massive growth, should
consider the more scientific approach that is customary in the banking
industry. Under this approach the loan portfolio is segmented into
aging categories-that is, according to how many days late the most
recent payment is- and then assigning a different percentage to be
provisioned for each category, depending on the perceived level of
risk.

Loans should be separated out from the current category as soon as
they are even one day late. An illustrative aging schedule, with
provisioning percentages for each aging category is shown below:
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6.2 Provisioning methods larger MFIs (contd)
24
Provisioning % on portfolio age
Rescheduled/
Refinanced
Unrescheduled Age
100 100 > 180 days late
100 50 91-180 days late
50 25 31-90 days late
20 10 1-30 days late
10 0 Current

The provisioning percentage is applied to the entire outstanding
balance of the loans in each category (portfolio at risk, or PAR), not
just to the amount of the late payments. Many MFIs will not have a
provisioning policy and will need guidance to establish one.

6.3 Write-offs
Many MFIs feel-not always justifiably- that formally recognising a loan
as a bad debt sends a message to its loan officers and clients that the
institution is no longer interested in recovering that outstanding
balance, and so carries such loans on its books.

If an MFI has no policy on write-offs, the auditor should suggest one.
A write-off policy needs to recognize that the cost of pursuing some
delinquent clients may be more than the amount collected.

Audited financial statements should always include a clear and precise
explanation of the MFIs provisioning and write-off policy and practice.

6.4 Loan loss provision tests of controls
Accuracy of delinquency report - external auditor must test the
accuracy of the delinquency report, including the aging of arrears.
If the MFI has a computer generated delinquency report, the
auditor should consider testing it using a computer-assisted audit
technique.

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6.4 Loan loss provision tests of controls (contd)
Non-cash loan recovery issues - when a client falls behind on a
loan, many MFIs will reschedule the loan. The rescheduled loan
may be shown as current in the delinquency report, which
misrepresents its real risk level. Another common practice is to
issue a new loan to the delinquent client to pay off the delinquent
loan (refinancing) and show the new loan as a current loan.
Compliance with policy and procedures

6.5 Loan loss provision substantive procedures
Detailed tests
Confirm year end balances
Test components (opening balance, provisions, write offs,
closing balance)
Analytical review
Write offs and % of loans
Subsequent recoveries and % of write offs or loans
Compliance with law and regulations
Reserve and capital requirements

Specifically check that rescheduled and refinanced loans are tracked,
reported and provisioned separately, since their risk profile is different
from current loans.
6.6 Importance of delinquency
Delinquency is the single most common cause of MFI failure. It often
creeps up unexpected because of inadequate delinquency reporting, or
inadequate MIS that cannot track delinquency accurately. There is
therefore a need to focus on policies, practices and systems for
managing delinquency in the loan portfolio.


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7 Auditing approach interest

Because interest is an MFIs main source of income, it needs to be
tested carefully.

7.1 Interest accounting policy
The external auditor should understand the MFIs accrual policies and
evaluate their reasonableness. In particular, the auditor should
determine whether the policy stops accrual of further interest, and
reverses previously accrued but unpaid interest, on loans that have
gone unpaid for so long that the recovery of amounts due is highly
unlikely.

7.2 Interest income testing: analytical review
This is performed by developing an independent expectation of income
and comparing it with the actual balances recorded by the client. One
type of analytical review compares interest income from the current
period with interest income from the previous period, taking into
account identified changes in the portfolio-such as growth-between the
periods.

7.3 Yield gap analysis
A more powerful procedure, which should be performed in almost all
MFI audits, is a yield gap analysis, which compares actual interest
receipts with an independent expectation of what the portfolio should
be yielding, based on the loan terms and the average portfolio over
the period. This analysis frequently shows a large gap between what
the MFI should be earning and what it is actually earning. The most
common cause of a yield gap is loan delinquency, so this test serves
as a cross-check on portfolio quality. The yield gap in a rapidly growing
MFI will be high, as its interest income may be lower than the
theoretical yield because a large percentage of its portfolio is in new
loans whose first payment has not yet fallen due.

Some MFIs charge fees/commissions in addition to interest on loans.
The yield-gap analysis of such organisations may comprise both
interest and fees/commissions.
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8 Compliance with International Accounting Standards
MF accounting practices do not always adhere to IAS

8.1 Accounting for interest income
IAS 1 requires the consistent application of the accrual basis of
accounting on all components. Auditors will want to make
adjustments to convert interest income recognized on a cash basis to
turn it into accrual basis, whereas MFIs want to avoid being un-
prudent, and may not have MIS capable of tracking interest due but
not paid.

Interest arises from a charge for the use of funds (IAS18), no matter
how this charge is presented to clients, either flat basis or declining
balance basis.

Auditors have a hard time understanding the flat basis of interest rates
and question whether it is best practice. They are not enthusiastic
about quoting and charging interest on a flat basis and in some
countries may insist on an adjustment of interest income and loan
portfolio to convert flat basis to declining basis. Supervisors will insist
that MFIs adapt a declining basis before they can be issued with a
banking license (IAS30).

8.2 Accounting for grant income
According to IAS 20, grants must never be booked directly into
income. Receipt of a grant does not of itself provide conclusive
evidence that the conditions attaching to the grant have been or will
be fulfilled. Grants should be recognized as income over the periods
necessary to match them with the related costs which they are
intended to compensate, on a systematic basis. They should not be
credited directly to shareholders interests. Two broad approaches are
given- the income method and the equity method. Our discussion will
be on the income method under which grant receipts should be
recorded as a liability and taken as income or to a restricted fund on
utilization of the grant.

On receipt record as liability
Grant for revenue expenses - transfer to income as the grant is
expended
Grant for fixed assets - set up a restricted fund reduced by
depreciation
Grant for on lending set up a revolving loan fund

Unutilized donor grants are to be refunded or treated as income
depending on the terms of the donor agreement. Grants received for
revenue expenses during the same reporting period, may be booked
into income and offset against the period's expenses. The residual
profit/loss goes to retained earnings.
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8.2 Accounting for grant income (contd)
Grants for fixed assets are booked as deferred income and transferred
to income at amounts equivalent to depreciation on the assets
acquired. The amount transferred to income effectively offsets the
depreciation expense on those assets. Alternative treatment allows a
grantee to offset the depreciation expense for the year by the amount
of depreciation on fixed assets acquired through grant funding.

Grants for on-lending to clients are transferred from the grant liability
account to a restricted revolving fund or loan fund account.

MFI compliance with IAS 20 is spotty and many auditors ignore it
especially where national standards conflict with IAS on the treatment
of grant funds.

The difference is often material and warrants disclosure.

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9 Accounting Disclosure best practice
CGAP is currently the best source for MF accounting guidelines

9.1 CGAP Disclosure Guidelines
Donors, other investors, board members, and managers of MFIs rely
on an MFIs financial statements when they assess its financial
sustainability and condition of the loan portfolio. But many financial
statements do not include enough information to permit such an
assessment. To help address this problem, the donors who make up
the CGAP approved Disclosure Guidelines in 2003, which specify
information that should be included in MFI financial reporting:

Information required in financial statements in order to assess
Financial sustainability
Loan portfolio
Not accounting standards
No requirements for particular chart of accounts or formats

Authoritative guidance on accounting standards can be found in
International Accounting Standards and publications of national
accounting standards boards. The guidelines complement IAS
disclosure requirements, particularly on the loan portfolio reporting for
MFIs.

The examples provided in the guidelines are simply illustrations of one
possible way to present the information; there is no requirement to
use the same formats. Consequently, the guidelines can be used in
any country, regardless of its accounting standards and methods of
financial presentation.

The guidelines require some information not normally found in
financial institutions. Most MFIs are unusual institutions; they use a
financial business to pursue a social mission that is often supported by
grants or soft loans. In addition, MFIs use loan methods that are very
different from those used by conventional banks.

9.2 Segmental reporting
Segment reporting In addition to financial services, many MFIs
provide non-financial services-such as training, production or
marketing assistance, health care, or community development- that
are not essential to the delivery of their financial services. It will be
impossible to determine the sustainability of microfinance operations
unless their financial results are presented separately from those of
other operations. This is in addition to the consolidated income
statement and balance sheet for the institution as a whole.

A clear explanation is to be given of the methods used to allocate
shared costs or revenues between financial and non-financial services.

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Even if a segmented balance sheet is not provided, the financial report
should indicate which balance sheet accounts are completely or almost
completely tied to microfinance services.

9.3 Portfolio accounting
Expenses related to actual or anticipated loan losses should be shown
separately from other expenses in the income statement. The amount
of the loan loss reserve should be shown, usually as a negative asset
deducted from the loan portfolio. The amount of loans written off
during the period must be shown. The underlying accounting policies
should be clearly described.

The financial presentation should include a table that reconciles the
accounts affecting the loan portfolio, including:
Loan loss reserves at the beginning and end of period
Loan loss provision expenses recognized during the period
Write-offs of uncollectible loans.

If an MFI accrues unpaid interest on late loans, there should be a clear
and thorough explanation of its policies on this matter- especially the
point at which further accrual of unpaid interest is stopped and
previous accruals are reversed out of income.

9.4 Portfolio quality and management
Amount of late loans: quality ratios
Renegotiation of delinquent loans (rescheduling and refinancing)
Insider loans

Conventional financial statements usually do not include a delinquency
report. To assess the financial health of an MFI, a delinquency report is
crucial. As most MFIs are not subject to banking regulations, they are
not bound by external rules in setting their loan loss reserves.

The core of a delinquency report is usually a ratio or ratios that
summarize the condition of the loan portfolio. At a minimum the
portfolio report required by these guidelines must contain one or more
of the ratios, along with a precise explanation of what is being
measured.

There are 3 common types of delinquency ratios:
Portfolio at risk the numerator is the outstanding balance of
loans that are at higher risk because a payment is late by a
specified number of dates, and the denominator is the outstanding
balance for the entire portfolio.
Collection or repayment rates the numerator is payments
received and the denominator is payments due.
Arrears rates the numerator is late payments received and the
denominator is some measure of the total portfolio.

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9.4 Portfolio quality and management (contd)
Renegotiated loans
A portfolio report should clearly describe an MFIs approach to
allowing, tracking and provisioning for the renegotiation of delinquent
loans.

Insider loans- whether to members of an MFIs management,
governing body, or parties related to them-should be fully disclosed,
including outstanding amounts, interest rates, collateral, and
repayment status. Loan programs for employees for instance, to buy
motorcycles or for personal emergencies- can be reported as a group.

9.5 Donations
Income from donations shown separately
Source and amount of current period donations
Accounting method
In-kind donations or subsidies
Cumulative amount of all prior period donations (optional)

If donations are included in the income statement, it should be
separated out as non-operational income. If no donations have been
received during the current period, there should be an explicit
statement to that effect.

In-kind donations: A donor may pay the salary of the MFIs executive
director, or it may have free use of vehicles owned by international
organizations. It is important to identify any such in-kind subsidies and
estimate the additional expense the MFI would incur in their absence-
even if the estimate is not based on a rigorous valuation.

Cumulative reporting: Such information will often imply large
accumulated operational deficits that have been funded by donations.
These deficits require careful interpretation, and are not necessarily a
negative reflection on management performance.

9.6 Other significant accounting disclosures
(a) Details of all loans that account for more than 10 percent of the
MFIs total liabilities should be provided.
(b) Any type of deposit account that is tied to clients ability to obtain
future micro-loans should be shown separately from other
deposits, and there should be a general description of the
conditions of the account and its linkage to loans.
(c) Accounting policies on the accrual or deferral of income or expense
should be briefly explained.
(d) MFIs with assets or liabilities denominated in a foreign currency
should disclose any significant currency mismatch (financial assets
balanced against liabilities denominated in a different currency).
Accounting treatment of unrealized gains or losses due to foreign
currency fluctuations is to be reported.
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10 Audit reports and management letters

10.1 Compliance with CGAP Disclosure guidelines
Separate paragraph in audit report or separate letter
Indicating
Comply fully with guidelines; or
Comply substantially with the guidelines; or
Do not comply with the guidelines

The terms of reference for this audit call for the auditor to express a
conclusion as to whether the financial statements comply with CGAPs
Disclosure Guidelines for Financial Reporting by Microfinance
Institutions. These guidelines are voluntary norms recommended by a
consultative group of international donors. Thus an institutions failure
to comply with the CGAP guidelines would not necessarily imply that
the institution or its financial statements are in violation of any legal or
other authoritative accounting or reporting standards.

We conclude that the financial statements herein with accompanying
notes comply with the CGAP guidelines in all material respects".

Possible objections raised by MFIs: The standard audit report format
prescribed by ISA 700 is used by all MFIs. Even if the client MFI issued
the audit terms of reference as desired by the donor, it may not want
to take the risk of any changes in the standard audit report wordings
as the local regulators could make a fuss, particularly if there is some
non-compliance with CGAP guidelines.

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10.2 Compliance with IAS
MF accounting practices may require modification in audit report in
accordance with International Standards on Auditing (ISA). The
following issues are often problematic.

MF accounting practice MF reasons Reason for audit
qualification
1 Interest income is
recognized on cash
basis
Easy accounting.
Be prudent and
not show inflated
income.
Accrual accounting is a
fundamental accounting
assumption per IAS 1
2 Interest on loans is
not calculated on
outstanding loan
balance

Easy for both
client and MF.
Accepted industry
practice.


Calculation of interest on
outstanding loan balance
is considered best practice
by all commercial lending
institutions. The client is
charged on his loan
balance.
3 The full donor grant
is shown as income,
or equity.


Easy accounting.
Shows higher
profit and no
liability.
Contravenes IAS 20.
4 Fixed assets given
by donor not shown
in accounts.
It was not
purchased by MFI.
Value of all assets of the
MFI need to be shown in
the Balance Sheet.
5 Bad loans not
written off in last
five years.
Staff and clients
will think that the
loan does not have
to be recovered.
There will be a
large loss in the
income statement.
Income and assets are
overstated.

Aside from audit qualification, auditors make recommendations for
appropriate adjustments, and reports in the management letter in case
the qualification is not material.

10.3 Management letter
This is the written communication by the external auditor to the client
management identifying significant internal control deficiencies,
offering constructive recommendations, and noting other matters
arising during the audit that the external auditor wants to bring to the
attention of the MFIs management and audit committee.
Knowledgeable donors also invariably ask for a copy of the
management letter.

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This letter is particularly important for MFIs as many have weak
internal controls. It is also the opportunity for the external auditor to
publicise his expertise.

The auditor normally solicits and considers management comments on
a draft of the management letter before issuing the letter in final form.
Management letters normally have at least three sub-headings for
each finding.

1) Fact or issue
2) Recommendation
3) Management response

10.4 Management letter points to consider
Examples of control weaknesses that may be addressed in a
management letter are given below:
Cash
Delays in preparing and reviewing bank reconciliations
Lack of physical security over cash in hand
Inadequate processes surrounding cash counts

Loans
Inadequate checks and balances in loan approval process
Lack of adherence to MFI policies and procedures
Absence of, or non-compliance with, policies for immediate follow-
up on delinquent loans
Improper loan file documentation
Loan tracking system fails to flag loans that are refinanced,
rescheduled, or paid off with something other than cash
Excessive refinancing or rescheduling of loans
Inaccuracy or untimely availability of loan tracking system
information
Material discrepancies between accounting and loan tracking
systems
Existence of related party insider loans
Absence of unannounced visits to branches and clients by
managers or internal auditors

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10.4 Management letter points to consider (contd)
Loan loss provisions
Non-existent or inaccurate aging schedules
Unreasonable aging standards
Growth is masking delinquency problems
Lack of adherence to laws and regulation
Savings and deposits
No segregation of duties
Passbook entries not verified by internal audit
No monitoring of compulsory savings
Equity and Funds
No segregation of restricted and unrestricted funds
No board authorisation of capital transactions
Non-compliance with donor agreements
Revenues and expenses
Interest income recorded incorrectly
Interest charged to branches not eliminated in consolidation
Donor grant revenue incorrectly recognized when received
Improper accounting of fixed assets
Absence of a capitalization policy, or inconsistent application.
Management information systems
System incapable of handling volume of transactions
Faulty programming, resulting in distorted financial reporting
Weakness in access control or other security features
No disaster recovery plan
No offsite storage of backup disks or tapes