Accounting for MFI

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Accounting for MFIs: Fundamentals of Accounting for

Microfinance Managers

C O N S U L T A T I V E G R O U P T O A S S I S T T H E P O O R E S T

NOTE These are participant course materials of the main technical messages and concepts delivered in this course. It isnot intended to serve as a substitute for the full course materials delivered through the Skills for MicrofinanceManagers training series. Users interested in attending a training course should directly contact CGAP hubs andpartners for course dates and venues or visit the CGAP Web site at www.cgap.org/html/mfis_skills_microfinance_manag.html.CGAP would like to thank those who were instrumental to the development and design of the original course that led tothis participant summary: Michael Goldberg, Ruth Goodwin-Groen, Lorna Grace, Brigit Helms, Jennifer Isern, JoannaLedgerwood, Patricia Mwangi, Bridge Octavio, Janis Sabetta and all CGAP training hubs and partners. Copyright 2001,The Consultative Group to Assist the Poorest (CGAP).

http://www.cgap.org/html/mfis_skills_microfinance_manag.html

Contents

Overview and Goals ............................................................................................. 4Overview ........................................................................................................... 4Goals of the Course ............................................................................................. 4

What is Accounting?.............................................................................................. 5Basic accounting principles for MFIs: ...................................................................... 5Double-Entry Accounting ...................................................................................... 6Conservatism and Prudence .................................................................................. 6Materiality.......................................................................................................... 7Realization ......................................................................................................... 7Matching............................................................................................................ 7

Financial Statements........................................................................................... 10Balance Sheet................................................................................................... 10Income Statement............................................................................................. 14Cash Flow Statement ......................................................................................... 18Portfolio Report................................................................................................. 19

The Accounting Cycle ......................................................................................... 24Step 1: Classifying Transactions .......................................................................... 25Step 2: Journalizing........................................................................................... 27Step 3: Posting ................................................................................................. 30Step 4: Trial Balance ......................................................................................... 33Step 5: Accounting Adjustments .......................................................................... 35

Step 6: Closing Entries....................................................................................... 37Step 7: Draft Financial Statements....................................................................... 38Step 8: Closing ................................................................................................. 38

Decision Making Tools......................................................................................... 39Management Information Systems....................................................................... 39

Internal Controls................................................................................................. 44Internal Controls ............................................................................................... 44Sources of Risk ................................................................................................. 44External Audits ................................................................................................. 45

Glossary of Terms for Financial Statements ........................................................ 46Balance Sheet................................................................................................... 46Income Statement............................................................................................. 53

Bibliography........................................................................................................ 58

CGAP Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 4

Overview and Goals !!!!

Overview

International best practice for microfinance suggests that good financial analysis is the

basis for successful and sustainable microfinance operations. Quality financial analysis

depends on the quality of recorded information to be analyzed. This information comes

largely from the accounting system, so accounting information is fundamental for achieving

sustainability.

Goals of the Course

• To understand how financial statements are created

• To obtain basic knowledge ofo Underlying accounting principleso How the results of accounting can assist a manager to identify and analyze

problems

• To process accounting transactions

• To create financial statements that account for loan losses, interest revenue, and

donor funds

• To generate useful information for an MFI using accounting data


What is Accounting? !!!!

Accounting

• Is the process of recording, classifying, and summarizing economic events

• Leads to the preparation of financial statements

• Provides essential information that allows the manager to choose actions that will

redirect the enterprise’s activities to be more consistent with the mission and

objectives of the business plan

Basic accounting principles for MFIs:

• Double entry

• Conservatism and prudence

• Materiality

• Realization

• Matching


Double-Entry Accounting

Assets = Liabilities + Equity

• Any given transaction will affect a minimum of two accounts within assets,

liabilities, or equity.

• If the accounting equation is to remain in balance, any change in the assets must

be accompanied by an equal change in the liabilities or equity, or by an equal but

opposite change (increase or decrease) in another asset account.

Revenue or expense items record non-stock transactions. Non-stock (or flow)

transactions begin within a reporting period and expire at the end of the period.

Ultimately, the revenue and expense accounts are netted out to result in a final profit or

loss. This profit or loss is then transferred to the Balance Sheet as equity, thereby

ensuring that the Balance Sheet balances.

Conservatism and Prudence

Conservatism means recording financial transactions such that assets, revenues, and

gains are not overstated and liabilities, expenses and losses are not

understated. It is intended to result in the fair presentation of financial results.


Materiality

Each material item should be presented separately in the financial statements. Material

items are those that may influence the economic decision of a user.

Realization

Realization requires that revenue be recognized in the accounting period it is earned,

rather than when it is collected in cash. It defines the point at which revenue is

recognized.

Matching

Organizations incur expenses to earn revenues. Expenses should be reported on the

Income Statement during the same period as the revenues they generate.


Financial Accounting versus Managerial Accounting

Financial Accounting Managerial Accounting

Presents a summary view of the

financial results of past operations for a

wider audience

Tracks and presents projected and

historical operations, at a detailed level,

intended for use by managers

External

Summary

Historical Only

Standardized Format

Annual

Final, Precise

End (e.g., Independent Audit)

Reporting and Disclosure

Internal

Detailed

Historical and Projected

Open Formats

Daily/Weekly/Monthly/Quarterly/etc..

Ongoing, Flexible

Means (management tool)

Analysis and Action

Source: Tony Sheldon, SEEP Training Notes, 1997.


Three key accounting issues relevant to MFIs:

Cash versus AccrualAccounting

Accounting forInterest Revenue

Accounting for Grantsand Concessional

Funds

Cash Accrual Cash Accrual GrantsConcessional

Loans

Revenue is notreported untilcash is receivedand expenses arenot reported untilcash is disbursed.

Recognizestransactionswhen they takeplace whether ornot cash changeshands.

According to IAS,financial state-ments should useaccrual account-ing. It alsorecognizes thatsome situations,such as thecollectability ofdoubtfulreceivables,require “theexercise ofprudence.”

Records interestrevenue whencash is received.

This is the mostconservative orprudent methods– when interest ispaid with eachinstallment of theloan. However, ifinterest is paidup-front, itoverstates therevenues of theMFI.

Records interestrevenue when itfalls due ratherthan when it isreceived in cash

Not included inprofits orretained earningsfrom operations

Recordedseparately belowthe operatingprofit/(loss) onIncomeStatement

Transferred toBalance Sheet asdonated equity

Loans made tothe MFI at lessthan market rateof interest

Recordedseparately fromcommercial loans(in order toidentify ‘subsidy’)


Financial Statements !!!!

MFIs commonly use four types of financial statements:

• Balance sheet

• Income statement

• Cash flow statement

• Portfolio report

Balance Sheet

A balance sheet is a summary of the financial position at a specific point in time. It

presents the economic resources of an organization and the claims against those

resources.

Assets Liabilities Equity• Represent what is owned

by the organization orowed to it by others

• Are items in which anorganization has investedits funds for the purpose ofgenerating revenue.

• Represent what is owed bythe organization to others.

• Represents the capital ornet worth of theorganization.

• Includes capitalcontributions of members,investors or donors,retained earnings, and thecurrent year surplus.

Assets = Liabilities + Equity


Sample Balance SheetAccounting

PeriodAssets

1. Cash and due from banks2. Reserves in central bank3. Short-term investments in money market instruments4. Loan portfolio5. (Loan loss reserve)6. Other short-term assets7. Long-term investments8. Net fixed assets9. Total assets

Liabilities

10. Savings accounts: forced11. Savings accounts: voluntary12. Time deposits13. Loans: commercial banks14. Loans: Central Bank15. Loans: subsidized16. Other short-term liabilities17. Other long-term liabilities18. Total liabilities

Equity

19. Paid-in equity from shareholders plus members20. Donated equity—prior years, cumulative21. Donated equity—current year22. Prior years retained earnings/losses23. Current year retained earnings/loss24. Other capital accounts25. Total equity

26. TOTAL LIABILITIES AND EQUITY

Source: Format for Appraisal of Microfinance Institutions, CGAP Secretariat, July 1999.


Balance SheetAccount Comments About UsageAssets1. Cash and due from banks Cash on hand, sight deposits, checking accounts or other instruments paying little or no

interest

2. Reserves in Central Bank Relevant only for licensed financial intermediaries

3. Short-term investments in money marketinstruments

Interest-bearing deposits and investments in financial instruments, where the principalpurpose is liquidity management

4. Loan portfolio Total outstanding balances of loans to clients, including loans past due but not written off

5.(Loan loss reserve) A negative asset account: set-aside for estimated future losses on problem loans thathave not yet been written off

6. Other short-term assets Accounts receivable, accrued interest on loan portfolio, etc.

7. Long-term investments Other long-term, illiquid assets that earn returns

8. Net fixed assets Land, building, equipment, net of accumulated depreciation

9. Total assets

Liabilities10. Savings accounts: compulsory Compulsory savings required as part of the credit methodology

11. Savings accounts: voluntary Liquid deposits from the general public

12. Time deposits Certificates of deposit from the general public

13. Loan: commercial Loans to the MFI at market rates from banks or other financial institutions

14. Loans: Central Bank Rediscount or other special lines of credit from the Central Bank

15. Loans: subsidized Concessional loans from donors, etc.

16. Other short-term liabilities Accounts payable, accrued interest to be paid on loans and deposits. Etc.

17. Other Long-term liabilities Long term loans for property, etc.

18. Total liabilities

Equity19. Paid-in equity from shareholders Equity contribution of owners of stock20. Donated equity--prior years, cumulative Equity received through cash donations from sources that do not receive stock

21. Donated equity--current year All Cash Grants/Donations (from Income Statement)

22. Prior years retained earnings/losses, notincluding cash donations

Accumulated earnings from prior periods only

23. Current year profit/loss Current year operating profit/(loss) (from Income Statement)

24. Other capital accounts Any special reserves or other capital accounts

25. Total equity

26. TOTAL LIABILITIES AND EQUITY


Effects of Transactions on the Balance SheetA demonstration of how double-entry works

The effect of the following transactions on the Balance Sheet is shown by drawing an up

arrow (!) to show an increase in the accounts affected and by a down arrow (") to

show a decrease.

Assets Liabilities Equity

Transaction Cash

CurrentLoans

Outstanding

LoansPastDue

Invest-ments

FixedAssets

Short-term

BorrowingClient

Savings

Long-termDebt

Restricted/DeferredRevenue Equity

1. Purchase land on credit ↑↑↑↑ ↑↑↑↑2. Disburse loan to client ↓↓↓↓ ↑↑↑↑3. Purchase motorcycles

for staff - pay half cash;half short-term credit

↓↓↓↓ ↑↑↑↑ ↑↑↑↑

4. Purchase office furnitureon short-term credit

↑↑↑↑ ↑↑↑↑5. Take loan from bank at

commercial rate ofinterest (> 1 year)

↑↑↑↑ ↑↑↑↑

6. Purchase a Treasury Billfor cash

↓↓↓↓ ↑↑↑↑7. Client withdraws

savings↓↓↓↓ ↓↓↓↓

8. A current loan becomespast due

↓↓↓↓ ↑↑↑↑Source: Joanna Ledgerwood and Kerri Moloney. Accounting: Study Guide. Calmeadow, Toronto, Canada, 1996.


Income Statement

An income statement reports the organization’s financial performance over a specified

period of time. It summarizes all revenue earned and expenses incurred during a

specified accounting period. An institution prepares an income statement so that it can

determine its net profit or loss (the difference between revenue and expenses).

Revenue Expenses

Refers to money earned by an organization for

goods sold and services rendered during an

accounting period, including

• Interest earned on loans to clients• Fees earned on loans to clients• Interest earned on deposits with a bank,

etc.

Represent costs incurred for goods and services

used in the process of earning revenue. Direct

expenses for an MFI include

• Financial costs• Administrative expenses• Loan loss provisions

An income statement

• Relates to a balance sheet through the transfer of cash donations and net profit (loss) as well as

depreciation, and in the relationship between the loan loss provision and the reserve.

• Uses a portfolio report’s historical default rates (and the current reserve) to establish the Loan

Loss Provision.

• Relates to a cash flow statement through the net profit/loss as a starting point on the cash

flow (indirect method).

• Starts at zero for each period (in contrast to the Balance Sheet which is cumulative since the

beginning of the organization’s operation).


Sample Income StatementAccounting

Period

Operating Income

1. Interest and fee income from loans2. Income from other finance-related services3. Income from investments4. Total operating income

Operating Expenses

5. Interest and fee expense6. Loan loss provision expense7. Administrative expense – personnel8. Other administrative expenses9. Total operating expenses10. NET OPERATING PROFIT (LOSS)

Nonoperational Income and Expenses

11. Cash donations12. Other non-operational income13. Total non-operational expenses14. TOTAL CONSOLIDATED PROFIT/LOSS

Source: Format for Appraisal of Microfinance Institutions, CGAP Secretariat, July 1999.


Income StatementAccount Comments About UsageOperating Income1. Interest and fee income from loans All income on loans made to clients2. Income from other finance-related services(indicate which)

For example, fees from savings accounts

3. Income from investments Interest from bank accounts or investments in money market instrumentsused primarily for liquidity management

4. Total Operating IncomeOperating Expenses5. Interest and fee expense Interest and fee expenses for all loans, deposits, or other liabilities funding

the financial service operation6. Loan loss provision expense Cost of creating/maintaining the loan loss reserve7. Personnel expense All staff and consultant costs, including payroll taxes and fringe

benefits(preferably on an accrual basis, especially in the case of majorfuture benefits like severance pay obligations)

8. Other administrative expenses Broken out into no more than ten categories (e.g. rent, transportation,supplies, utilities, fees, depreciation, other)

9.Total Operating Expense10. NET OPERATING PROFIT (LOSS)Nonoperational Income* and Expenses11. Cash donations All cash grants/donations. Do not include in-kind donations of goods and

services.12. Other nonoperational income (If any) Income from investments which play no role in the delivery of financial

services, income from non-financial services, sale of land, consultancies,etc.

13. Non-operational expense (if any) Any expenses not related to the MFI’s financial services business, such asan evaluation or impact study mandated by a donor

14. TOTAL CONSOLIDATED PROFIT (LOSS) Net operating profit (loss) plus non-operational income, minus non-operational expenses

*All income that does not come from financial service operations.


Comparison of Balance Sheet and Income Statement

A Balance Sheet is a snapshot of the

organization's financial position at a

specific point in time. All amounts are

cumulative since the organization

began.

An Income Statement portrays the

events that have occurred between the

dates of two consecutive balance

sheets.


Cash Flow Statement

A cash flow statement shows where an institution’s cash is coming from and how it is

being used over a period of time.

A cash flow statement

• Classifies the cash flows into operating, investing and financing activities.

o Operating activities: services provided (income-earning activities).

o Investing activities: expenditures that have been made for resources intended to

generate future income and cash flows.

o Financing activities: resources obtained from and resources returned to the

owners, resources obtained through borrowings (short-term or long-term) as

well as donor funds.

• Can use either

o The direct method, by which major classes of gross cash receipts and gross cash

payments are shown to arrive at net cash flow (recommended by IAS)

o The indirect method, works back from net profit or loss, adding or deducting

noncash transactions, deferrals or accruals, and items of income or expense

associated with investing and financing cash flows to arrive at net cash flow.

Note: The Balance Sheet and Income Statement are accounting reports. The figures can be influenced by management’s choices

regarding accounting policies. A Cash Flow Statement cannot be changed by any accounting policy.


Portfolio ReportA portfolio report provides information about the lending and savings operations of anMFI. It provides timely and accurate data about the quality of the portfolio. It usuallyalso includes other key portfolio performance indicators (e.g., outreach).

• Information usually includes

o Number and value of loans outstanding end of period

o Total value and number of loans disbursed during the period

o Average outstanding balance of loans

o Value of outstanding loan balances in arrears, value of payments in arrears

o Value of loans written off during period

o Portfolio aging analysis

o Information on loan terms, loan officers, savings accounts and balances, etc.

• Portfolio quality ratios can be calculated from portfolio information. This information

together with the aging analysis can give a picture of the health of the portfolio and

can also give valuable insight into an MFI's sustainability.

• Relates to income statement in that it is the portfolio that generates the income for

the MFI.

• Relates to the balance sheet in that it provides information on the value of the

outstanding loan portfolio and value of loans written off during the period.


• Relates to the balance sheet and income statement in that the portfolio data is

used as an input to calculate the loan loss reserve on the balance sheet, from

which the amount of loan loss provision on the income statement is calculated.


Relationships Between Financial Statements

Previous Year

Balance Sheet

Current Year

Balance Sheet

Current Year

Cash Flow

Non-CashItems

Profit/Loss

Current Year

Income

Statement

Profit/LossDonations

Loan Loss

Depreciation

Changes


How does “Accounting for MFIs” treat donor funds andthe equity account?

Income Statement • Donor funds are treated "below the line."

• Donor money is recorded after net operating profit.

Balance Sheet There are three separate sources of equity from the Income

Statement:

• Retained earnings/losses, current year

• Donations, current year

• Other capital accounts, including net nonoperational income

This is important because it allows you to see over time the proportion of equity that is

generated from the MFI itself versus the amounts contributed by donors.


Three Ways in Which MFIs Treat Cash Donations

Goals: 1. Grants are separated from operating income

2. Grants are fully disclosed in equity

Most transparent

treatment of grants

and equity

A. Current year’s grants and donations are first recorded in the Income

Statement, below Operating Profit/Loss, but the restricted grants or donations

for which the conditions had been met, are divided according to purpose: e.g.,

Operations, Loan Fund or Fixed Assets. The grants and donations are then

transferred according to their purposes on the Balance Sheet, separated from

the Operating Profit/Loss.

Less transparent than

A above

B. Current year’s grants and donations are first recorded in the Income

Statement below Operating Profit/Loss. (This would include the total amount of

unrestricted grants and the portion of restricted grants or donations for which

the conditions had been met that year.) These grants and donations are then

transferred as one amount on the Balance Sheet, separate from the Operating

Profit/Loss.

Least transparent

and not compliant

with IAS 20

C. Current year’s unrestricted grants and donations and the funds for operations

are recorded in the Income Statement below the Operating Profit/ Loss. They

are then transferred to the Balance Sheet, separate from the Operating

Profit/Loss. That year’s grants or donations restricted for Loan Fund or Fixed

Assets are recorded directly into equity on the Balance Sheet.

Note: A and B comply with IAS 20 "income" approach. C needs modification to comply with IAS 20 "capital" approach.


The Accounting Cycle !!!!

The eight steps of the accounting cycle describe the accounting for an economic

transaction, from the time it occurs until it is ultimately reflected in the financial

statements.

6. CLOSING ENTRIES

1. TRANSACTION OCCURS

2. JOURNALIZINGTransactions are entered in a

general journal.

3. POSTINGJournal entries are transferred to

ledger accounts.

4. TRIAL BALANCEAccounts are verified,

totaled and balanced.5. ACCOUNTINGADJUSTMENTS

Adjustments are made

in order to prepare

financial statements.

7. DRAFT FINANCIAL STATEMENTSBalance Sheet, Income Statement, and

Cash Flow Statement are prepared.

Clear and close revenue and expense

accounts, transfer to statements.

8. CLOSINGBooks are prepared for

next cycle.


Step 1: Classifying Transactions

A chart of accounts

• Provides the structure for recording and reporting of all financial transactions for

the institution.

• Classifies and determines what financial transactions can be tracked for managerial

purposes and reported in the financial statements.

• Transactions are organized as either asset, liability, equity, revenue (income) or

expense accounts.

Determinants

• The structure and level of detail of the chart of accounts will determine the type of informationmanagement will be able to access and analyze in the future.

• Management must design the chart of accounts and be clear about what it needs. In particular, itis fundamentally important to be able to differentiate between the grant income given by donorsfrom the operational income earned from the MFI’s products and services. Operational income isthe basis for financial analysis, not grant income, and the importance of accurately tracking itcannot be overstated.

• Different end users of the information generated have different needs. Internal management andauditors, tax code, donors, and regulatory demands all influence how the chart of accounts is setup.

• Some charts of accounts and report formats may be legislated and therefore MFIs are obligatedto follow the mandated requirements in these countries.


Sample Chart of Accounts

Assets Liabilities Equity101 Cash 201 Short-term borrowing 301 Paid in equity102 Reserves 202 Client savings 302 Donated equity prior year103 Short term investments 203 Long-term debt (commercial) 303 Donated equity current year104 Loan portfolio 204 Long-term debt (concessional) 304 Prior year profit/loss105 Loan loss reserve 205 Restricted/deferred revenue 305 Current year profit/loss106 Other current assets 306 Other capital accounts114 Long-term investments115 Property116 Fixed assets117 Accumulated depreciation118 Other assets

Revenue Expenses401 Interest on current and past due loans 501 Interest paid on short-term borrowing402 Interest on restructured loans 502 Interest paid on client savings403 Interest on investments 503 Interest paid on long-term debt404 Loan fees on loans 505 Provision for loan losses405 Late fees on loans 510 Salaries and benefits410 Donations—unrestricted 512 Communications

513 Courier/postage514 Rent515 Utilities516 Equipment517 Equipment leasing518 Depreciation519 Bank charges520 Advertising and promotion521 Insurance522 Supplies523 Maintenance524 Travel and accommodation525 Legal fees526 Professional development (training)527 Computer software528 Printing529 Fees/dues530 Miscellaneous


Step 2: Journalizing

All economic transactions are entered into the accounting system by means of a journal

entry.

GENERAL JOURNAL

A general journal is a

• Daily diary of transactions

• Listing of all transactions in chronological order

• Book of original entry

• Record of debits and credits entered in columns, the left column for recording

debits and the right column for recording credits

Sample Headings in a General Journal

Date Account Title and Explanation Ref Num Debit Credit

JOURNAL ENTRY

A journal entry

• Is used to enter transactions into the accounting system


• Records how each transaction affects either an asset, liability, equity, revenue

and/or expense account.

• Has three elements (T-account):

o Title: name of the asset, liability, equity, revenue or expense account

o Increases in the left side of the equation (assets) are recorded as debits

o Increases in the right side (liabilities or equity) are recorded as credits

Sample T-Account

Account Title

Debit Credit


Effect of Accounting Transactions on the Balance Sheet

Assets

Debit Credit

Increase

Normal Balance

Decrease

Liabilities and Equity

Debit Credit

Decrease Increase

Normal Balance

Effect of Accounting Transactions on the Income Statement

Revenues

Debit Credit

Decrease Increase

Normal Balance

Expenses

Debit Credit

Increase

Normal Balance

Decrease


Step 3: Posting

After journalizing, the next step in the accounting cycle is to make entries in the general

ledger.

Posting is the process of copying journal entry

information from the General Journal to the

General Ledger.

GENERAL JOURNAL

The General Journal is a chronological record of transactions.

Sample General Journal

Date Account Title and Explanation Ref. Debit Credit

July 1 Fixed Assets- Computer 116 4,000Cash 101 4,000(purchased computer on cash)

3 Fixed Assets- Motorcycles 116 15,000Cash 101 4,000Short-term Liabilities 204 11,000(purchased motorcycles on cash & credit)

31 Cash 101 51,000Savings Accounts - Forced 201 51,000(collect savings)


GENERAL LEDGER

In contrast, the General Ledger is a record of transactions organized by account number

beginning with the asset accounts and ending with expense accounts

Cash Account No. 101Date Explanation Debit Credit Balance

358,196July 1 purchased computer 4,000 354,196

3 purchased motorcycles 4,000 350,19631 collected savings 51,000 401,196

Fixed Assets Account No. 116Date Explanation Debit Credit Balance

230,504July 1 purchased computer 4,000 234,504

3 purchased motorcycles 15,000 249,504

Ledger accounts represent the accumulation in one place of all information about

changes in an asset, liability, equity, revenue, or expense item.

Each ledger account is identified by its account name and number as stated on the Chart

of Accounts.


OPENING BALANCES

Ongoing balances are carried forward from period to period and represent the balance

on account on the balance sheet and on the income statement. Each debit and credit

entry in the cash account represents a cash receipt or a cash payment (identified by

journal entries). The amount of cash owned by the organization at a given point in time

(e.g., August 9) is the account balance for that date. The account balance equals the

difference between the total debits and the total credits in the account.

• Balance Sheet accounts are a summary of the organization’s assets, liabilities, and

equity since the beginning of the MFI’s operations.

• Income Statement accounts reflect revenue and expenses over a specified period of

time and therefore are not carried over across accounting period to accounting

period.

The Cash Ledger, Account 101, is used to record all cash and bank transactions. It is the

most important account for MFIs because:

• The number of cash transactions in MFIs is large.

• The chances of committing fraud are higher than with other assets.

• Timely payments are important to the MFI's reputation and financial position.


CASH ACCOUNT AND BANK RECONCILIATION

On a periodic basis (usually monthly) the bank account statement should be

reconciled with the accounting records. This control function allows MFIs to identify

differences between cash and bank balances. These differences may be due to

timing, such as outstanding (unpresented) checks or outstanding (in-transit)

deposits, or to an origination error. This is done by taking the closing cash balance

reported on the bank statement and subtracting any outstanding checks and

adding deposits.

Regular preparation and review of bank reconciliation is a key internal

control function.

Step 4: Trial Balance

A trial balance is used to verify that the debits and credits are in balance (once all

journal entries have been made and posted in the General Ledger).

The trial balance is prepared by:

1. Taking the account balances from the General Ledger

2. Listing the accounts having debit balances in one column and those having credit

balances in the other column

3. Totaling the debit balances

4. Totaling the credit balances


5. Comparing the sum of the debit balances and the sum of the credit balances. (The

sums should be equal in order for the ledger accounts to be in balance.)

A trial balance is a first test of accurate posting in the ledgers. However it does not mean

that the ledger accounts are free from error. Some errors cannot be detected in a balanced

trial balance.


Step 5: Accounting Adjustments

Once the Trial Balance is completed and balanced, adjustments are made to record

transactions that have not previously been recorded. Examples of these include adjusting

for loan losses, depreciation and accruals.

LOAN LOSS RESERVES, PROVISIONS, AND LOSSES OR WRITE-OFFS

Loan Loss Reserve Loan Loss Provision Loan Losses or Write-Offs• An account that

represents an estimateof the amount ofoutstanding principalthat the MFI does notexpect to recovereventually

• Negative asset on thebalance sheet thatreduces the outstandingportfolio. (An alternativepresentation is to show itas a liability.)

• Amount expensed on theincome and expensesstatement.

• Increases the loan lossreserve

• Occur as an accountingentry.

• Do not mean that loanrecovery should notcontinue to be pursued.

• Decrease the reserveand the outstandingportfolio.


Accounting for Loan Loss Provisions and Write-Offs

A loan loss reserve indicates the possibility that an asset in the Balance Sheet is not 100% realizable. The loss of

value of assets may arise through wear and tear such as the depreciation of physical assets, loss of stocks, or

unrecoverable debts.

Loan loss provisions expense this anticipated loss of value in the portfolio gradually over the appropriate periods

in which that asset generates income, instead of waiting until the actual loss of the asset is realized.

Provisions are only accounting estimates and entries, and they do not involve a movement of cash, like saving for

a rainy day.

Loan loss provisions charged to a period are expensed in the Income Statement. The corresponding credit

accumulates over time in the Balance Sheet as reserves shown as a negative asset:

The accounting transaction is:

Dr Loan loss provision

Cr Loan loss reserve

Loan losses or write-offs occur when it is determined that loans are unrecoverable. Because the possibility that

some loans would be unrecoverable has been provided for in the accounting books through reserves, loan losses

are written off against loan loss reserves and are also removed from the outstanding portfolio.

The accounting transaction is:

Dr Loan loss reserve

Cr Outstanding loans

Write-offs do not affect the net portfolio outstanding unless an increase in the loan reserve is made.

When write-offs are recovered, they are booked in the Income Statement as miscellaneous income.

Source: Joanna Ledgerwood. Financial Management Training for Microfinance Organizations, Calmeadow, 1996.


DEPRECIATION

When a capital asset is purchased, the entire cost is not immediately recorded on the

Income Statement as an expense. It is depreciated over time so that each year, an

amount equal to the portion of its useful life is expensed. This entry must be made at the

end of each accounting period.

ACCRUALS

Accruing revenue refers to recording revenue that has not yet been received. Accruing

expenses refers to incurring and recording an expense that has not been paid for.

Step 6: Closing Entries

Close revenue and expense accounts at the end of each accounting period by transferring

their balances to the current year profit/loss account. Closing entries

• Are prepared after the final Trial Balance is completed.

• Leave revenue account with zero balance by debiting the account and crediting the

current year profit/loss account.

• Leave expense account with zero balance by crediting the account and debiting the

current year profit/loss account.

The net effect on the current year profit/loss account is equal to the net operating

profit/loss for the period as recorded in the Income Statement.


The final step is to transfer the amounts from the final Trial Balance to the financial

statements. In addition to the operating profit / loss, the donations for that year get

transferred separately to the Balance Sheet from the income statement.

Step 7: Draft Financial Statements

The Balance Sheet, the Income Statement and the Cash Flow Statement are prepared.

Step 8: Closing

Books are prepared for the next cycle.


Decision Making Tools !!!!

To make decisions, management and shareholders need both the financial statements

themselves and various other reports, particularly reports that present the activity of the

loan portfolio. Furthermore, various indicators can be calculated to facilitate analysis of the

MFI and aid decision making.

Management Information Systems

A management information system is a "series of processes and actions

involved in capturing raw data, processing the data into usable information, anddisseminating the information to users in the form needed.”

Waterfield, Charles and Ramsing, Nick. Management Information Systems for Microfinance Institutions: A Handbook. Technical Tool Series

No. 1. Washington, DC: Consultative Group to Assist the Poorest, 1998.

An accounting system and a portfolio tracking system are the primary components of the

management information system. Together, the financial statements, management

reports, and indicators constitute the output of the MIS.

Good information provided in a useful form on a timely basis empowers all stakeholders

in the institution to participate meaningfully. An MFI must determine its information needs

through identifying the users of information and evaluating the needs of each group of

users.


Indicators for Financial Analysis

An MIS is created to generate information for decision making, the bestinformation for that purpose is in the concise form of a financial or management

indicator.Waterfield and Ramsing, p. 39.

Indicators generally compare two or more pieces of data, resulting in a ratio that provides

more insight than do individual data points.

Loan Portfolio Quality Analysis

• Delinquency rate—portfolio at risk

• Portfolio aging

• Loan loss rate

Efficiency

• Number of active loan clients per staff member

• Number of active loan clients per loan officer

• Outstanding portfolio per loan officer

• Number of clients per branch office

• Yield on portfolio

• Administrative efficiency


• Operating efficiency

• Personnel costs as a percentage of administrative costs

Profitability

• Adjusted return on assets

• Adjusted return on equity

• Operational self-sufficiency

• Financial self-sufficiency


Efficiency Ratios

Staff Productivity Ratios • Number of active loan clients per staff

member

• Number of active loan clients per loan officer

• Number of active loan clients per branch

• Gross portfolio outstanding per loan officer

Financial Productivity Ratio

Yield on Portfolio = Interest and fee income from loansAverage net portfolio outstanding

Cost-Efficiency Ratios

Operating Efficiency = Total operating expenses + In-kind donationsAverage net portfolio outstanding

Administrative Efficiency =

Personnel + Other administrative expenses + In-kind donations Average net portfolio outstanding

Personnel Expense Ratio Personnel expenses + In-kind personnel donations Total administrative expenses + Total in-kind

donations


Profitability Performance Indicators

Term Formula DefinitionAdjusted Operating Profit Operating income – Adjusted operating

expensesMFI’s profit

Adjusted Return on Assets Adjusted operating profitAverage total assets

How productively the MFI hasemployed its assets

Adjusted Return on Equity Adjusted operating profitAverage equity

Return on the equity capital of theMFI

Operational Self-Sufficiency Operating income Operating expenses

Degree to which operating incomecovers operating expenses

Financial Self-Sufficiency Operating income Adjusted operating expenses

Degree to which operating incomecovers the adjusted operatingexpenses


Internal Controls !!!!

Internal Controls

Internal controls

• Preserve the safety of assets,

• Improve quality of customer service,

• Ensure reliability of financial information,

• Ensure staff adherence to policy and guidelines.

Sources of Risk

• Delinquency / Credit risk

• Fraud

• Liquidity risk

• Operating risk

• Security risks

• Risk of computerization


External Audits

An external audit is a formal, independent review of an entity’s financial statements,

records, transactions, and operations, performed by professional accountants, in order to

• Lend credibility to financial statements and other management reports

• Ensure accountability for investor funds

• Identify weaknesses in internal controls and systems

Scopes differ significantly, according to the objectives of each audit.


Glossary of Terms for Financial Statements !!!!

Balance Sheet

A Balance Sheet is a summary (or snapshot) of an organization's financial position at a

specific point in time; therefore it is static. It presents the institution’s stock of assets

(such as cash, loan portfolio, investments or fixed assets), liabilities (such as loans or

accounts payable), and equity capital (net worth, or difference between assets and

liabilities). All amounts are cumulative since the organization began. On a Balance Sheet,

Assets equal Liabilities plus Equity.

Why is it called a "Balance" Sheet? What elements must balance on aBalance Sheet?

All assets of the organization are funded either by outside parties (liabilities) orby investors, including donors or other interested parties (equity or net worth).The total amount of assets therefore must equal the funding sources. The two

sides of the Balance Sheet are two views of the same resources of theorganization: the organization's assets on one side and the funding sources for

those assets on the other.


ASSETS

Assets represent what is owned by the organization or owed to it. They are those items in

which an organization has invested its funds for the purpose of generating future income.

On the Balance Sheet, assets are always equal to the sum of liabilities plus equity.

Assets are divided in order of liquidity into short-term or current assets and long-term

assets including fixed assets.

Current assets Cash and marketable securities, accounts receivable, and inventories

that in the normal course of business will be turned into cash within

a year

Cash and bank current

accounts

All balances available to the organization on a demand basis such as

cash, and funds on deposit in non-interest bearing accounts.

Reserves in central bank Funds held on deposit at the central bank as required by some bank

superintendencies; the amount is generally determined as a

percentage of assets or liabilities held by the MFI. Cash reserves are

applicable only to regulated financial institutions.

Short-term investments Funds on deposit with a financial institution, with a term of less than

one year, that earn revenue for the MFI.

Total or Gross loan portfolio

outstanding

Assets composed of the total amount of loans remaining to be paid

at a point in time, that is, the total amount owed to an institution by

its borrowers. It includes loans outstanding that are current, with no


late payments or defaults, and the total amount of loans outstanding

that have an amount past due. Past due is typically defined as when

a payment is one day late.

Net loans outstanding or Net

loan portfolio outstanding

All loans disbursed and not yet repaid or written off, minus the loan

loss reserve. The net loans outstanding figure reflects only the

principal due and does not include interest expected to be received.

Loan loss reserve Amount set aside to recognize probable future loan losses on the

loan portfolio so that the true value of the loan portfolio is fairly

stated. To create or increase the loan loss reserve, a loan loss

expense (referred to as the loan loss provision) is recorded on the

Income Statement as an expense. The amount of loan loss provision

is then recorded on the Balance Sheet as the negative asset—loan

loss reserve. This negative asset reduces the net outstanding loan

portfolio. Actual loan losses, or write-offs, affect the Balance Sheet

only (and not the Income Statement) as a reduction of the loan loss

reserve and the total loan portfolio.

Other short-term or current

assets

Items that do not appear in the foregoing, such as

• Accrued interest—interest that has come due and is

recorded but has not yet been received

• Accounts receivable—amounts owed to the MFI for services

already rendered or products already delivered

• Prepaid expenses—for example, rent or insurance premiums


paid in advance for the upcoming period

Long-term investments investments not intended as a ready source of cash, such as stocks,

bonds, promissory notes, and land that will be held for more than

one year or one cycle.

Fixed assets includes property, plant, and equipment; they represent assets that

are not readily redeemable for cash. Examples are land, buildings,

machinery, equipment, furniture, automobiles.

• Cost—property and equipment (fixed assets) are recorded

at cost or current market value at acquisition.

• Accumulated depreciation—an annual, noncash expense

that is determined by estimating the useful life of each

asset. Depreciation represents a decrease in the value of

property and equipment to account for the portion of their

useful life that is used up during each accounting period.

Annual depreciation is recorded on the income statement as

an expense that increases the accumulated depreciation on

the balance sheet by the same amount. Like the loan loss

reserve, accumulated deprecation is a negative asset.

• Net fixed assets—the cost or recorded market value of

property and equipment less accumulated depreciation.


LIABILITIES

Liabilities represent what is owed by the MFI to others either in the form of a loan that has

been extended to it or obligations for the MFI to provide goods and services in the future.

Forced savings accounts Compulsory client savings that have been deposited in the MFI that

the MFI must return, generally when the loan has been repaid or

when the client leaves the MFI. Forced savings may or may not incur

an interest cost for the MFI. If forced savings are held by another

financial institution, they will not appear anywhere on the MFI’s

financial statements.

Voluntary savings accounts Client savings that have been deposited voluntarily with the MFI that

the MFI must return. Although a liability for the MFI, voluntary

savings are different from borrowed funds because there is no due

date or amortization schedule. Voluntary savings generally incur an

interest cost for the MFI. If interest is not paid out to the client, it is

sometimes accrued and increases the liability of the MFI to the client.

Time deposits Amounts deposited with the MFI for a specified period of time. The

rate of interest paid generally increases as the length of the deposit

increases.

Commercial bank loans Outstanding amount that the MFI owes a bank or other lender for

which it is paying a market rate of interest. The loans could be short-

term or long-term. Long-term debt is that portion which is due in

over one year’s time.


Central bank loans Outstanding amount that the MFI owes the central bank for which it

is paying interest, often discounted.

Subsidized, concessional, or

soft loans

Outstanding amount that the MFI owes to a lender (typically from a

donor or government) for which it is paying the lender a rate of

interest below the rate the MFI could have obtained from commercial

sources.

Other short-term liabilities Outstanding amounts that the organization owes to a bank, other

lenders, or other organization (such as past due rent) that are due

within one year or less. Also includes accrued expenses and

unearned/deferred income.

Restricted or deferred

revenue (short-term or long-

term)—

Funds received but restricted for use in future years or for specific

activities are classified as a liability on the Balance Sheet because

they must be returned to the funding organization if the specified

programs are not carried out. Restricted funds are not recorded as

earned until the service or product that they are funding is delivered.

When the organization receives restricted funds, it incurs an

obligation (liability) to provide the services described in the grant

agreement. As the organization provides the services (such as loans

to microentrepreneurs in a certain region), it incurs expenses.

Deferred revenue is then recognized as grant revenue and used to

cover those expenses.

Other long-term liabilities Outstanding amounts that the organization owes to a bank, other

lenders, or other organizations that are due more than one year from

the date of the financial statements.


EQUITY

Equity is also referred to as capital or net worth. Unlike liabilities, the equity of an

organization does not have to be repaid. It therefore represents the value or "net worth"

of the MFI. Equity is equal to the amount of assets less liabilities. It represents the link

between the balance sheet and the income statement in that the current year profit/loss

from the income statement flows into the equity section of the balance sheet at the end of

each period.

Paid in equity from

shareholders

Amount of funds contributed by shareholders to the MFI.

Donated equity, prior years,

cumulative

Cumulative amount of donations received by the MFI.

Donated equity, current year Donations to the MFI in the current year.

Prior years' profit/loss Amount of profit (or loss) accumulated in previous years since the

formation of the organization. This may also be referred to as

retained earnings or earned surplus.

Current year operating

profit/loss

Amount of income (or loss) generated in the current year. Total

operating expenses are subtracted from total operating income to

arrive at the operating profit.

Other capital accounts Other special funds or reserves such as nonrefundable contributions

from clients and/or statutory reserves required by law. Should also

include the difference between nonoperational income and expenses.


Income Statement

The Income Statement is also known as the Profit and Loss Statement or the Operations

Statement. It is a summary of the income, expenses and net profit or loss (the difference

between income and expenses) for a period of time—say, January 1 to December 31,

2001.

INCOME

In accounting terms, revenue refers to money earned by the organization for goods sold

and services rendered during a given period. When an organization renders services to its

clients, it usually receives income in the form of cash or an account receivable.

OPERATING INCOME

Operating Income is produced by an institution’s core business. For a microfinance

organization operating income includes interest earned on loans to clients; fees earned on

loans to clients; interest earned on funds on deposit with a bank, and so forth.

Interest income from loans Amount received from clients for borrowing money from the MFI for

a specified period of time. The interest rate is stated as a percentage

of the loan amount. Interest received refers to the interest that has

been paid by the borrower. Interest earned but not received refers to

the interest that the borrower owes the MFI but has not yet paid.

Note: The principal amount of the loan repaid is not included in income.

Only the Balance Sheet accounts are affected by the principal portion of a


loan repayment; that is, total loan portfolio decreases and cash increases.

The only time the Income Statement is affected by the principal portion of

a loan is when a loan which has been written off is repaid.

Fee income from loans Amount charged to clients for (services associated with) loans

disbursed by the MFI, usually in addition to the interest charged.

They may be stated as a percentage of the loan amount or a flat

amount. These fees or service charges are often charged up front.

There are also penalty fees for late or partial payment and these are

charged once a payment is missed.

Income from investments Amount of interest earned by the organization on its investments

such as interest-bearing deposit accounts, term deposits, treasury

bills, and so on.

EXPENSES

Expenses represent the costs incurred for services used in the process of earning revenue.

They are often referred to as the "cost of doing business" since they represent the costs

that are necessary for the organization to generate revenue and thus remain in operation.

Direct expenses for a microfinance organization include financial costs, operating expenses

and loan loss provisions.


OPERATING EXPENSES

Expenses that are specific to delivery of the core business (credit and savings activities) for

a specified time period. For a single-purpose MFI, all costs should be included. For multi-

purpose institutions, all direct costs of financial operations and an appropriate portion of

the institution’s overhead should be included.

Interest expense: client

savings

Payments made to clients who deposit savings in the organization

(either voluntary or forced).

Interest and fee expense Interest paid to banks and other financial institutions for money that

they have loaned to the MFI.

Note: Principal repayment of a bank loan is not included as a financial cost.

Loan loss provision expense Based on the historical default rate and the current outstanding loan

loss reserve, the loan loss provision is the (non-cash) amount

expensed in a period to increase the loan loss reserve to an

adequate level to cover probable defaults of the loan portfolio.

Although the loan loss provision is a non-cash expense, it is treated

as a direct expense for an MFI.


ADMINISTRATIVE EXPENSES

Expenses that are considered a subset of operating expenses.

Personnel: Salaries and

benefits

Payment from the MFI to its staff for services rendered; usually the

largest operating expense for an MFI.

Rent Payments made for lease of land and/or buildings for the purposes of

loan fund management over a specified time period.

Transportation and travel Payment for transportation, room and board, etc., of staff members

working on behalf of the organization.

Depreciation An annual, non-cash expense that is determined by estimating the

useful life of each asset. Using the most common method, called

straight-line depreciation, an asset with an estimated useful life of

five years would have one-fifth of its purchase price reflected as an

expense in each of the five years. The depreciation expense

increases the accumulated depreciation account on the balance sheet

(similar to the loan loss provision [expense] and the loan loss

reserve [negative asset] respectively).

Plus All other expenses related to the MFI’s operations, such as office

materials/supplies, publications/publicity, telephone and postage,

insurance, utilities, staff training, board meeting expenses, legal

services/other service fees, bank charges, repair and maintenance,

courier and delivery, loss on currency conversion, taxes, etc.


NET OPERATING PROFIT/LOSS OR NET INCOME FROM OPERATIONS

Income that is a direct result of the MFI’s lending and savings activities net of the expenses

directly related to these activities.

NONOPERATIONAL INCOME AND EXPENSES

Income not produced by the core business (e.g., donations); expenses not incurred by the

core business.

CASH DONATIONS

Funds donated to the MFI that year (for which the conditions, if any, have been met), to

cover operating expenses, loan fund capital, and so on.

OTHER NONOPERATIONAL INCOME AND EXPENSES

Other revenue earned by the MFI for services provided other than credit and savings, such

as training fees, and expenses incurred in providing these services.


Bibliography !!!!

Following are additional recommended readings on accounting.

Christen, R.P. Banking Services for the Poor: Managing for Financial Success: An Expanded and Revised

Guidebook for Microfinance Institutions. Cambridge, MA: Accion International, 1997 (ISBN 958-96092-

0-1).

Disclosure Guidelines for Financial Reporting by Microfinance Institutions. Washington, DC: Consultative

Group to Assist the Poorest, 2001. Available at http://www.cgap.org/html/p_technifsg.html.

Epstein, Barry, and Ali Mirza, Abbas. Wiley IAS 2001: Interpretation and Application of International

Accounting Standards 2001. New York: John Wiley and Sons, 2001. See

http://www.ids.ac.uk/cgap/static/2043.htm.

External Audits of Microfinance Institutions: A Handbook. Technical Tool Series No. 3. Volume 1, For Audit

Clients: Boards, Managers, Donors, Creditors, and Investors. Washington, DC: Consultative Group to

Assist the Poorest, (1998). Available at http://www.cgap.org/html/p_technical_guides03v1.html.

External Audits of Microfinance Institutions: A Handbook. Technical Tool Series No. 3. Volume 2, For

External Auditors. Washington, DC: Consultative Group to Assist the Poorest, 1998. Available at

http://www.cgap.org/html/p_technical_guides03v2.html.

Financial Ratio Analysis of Microfinance Institutions. Small Enterprise Education and Promotion Network

(SEEP)/Calmeadow, 1995 (ISBN 0-9637044-8-6).

Format for Appraisal of MFIs. Washington, DC: Consultative Group to Assist the Poorest. Available at

http://www.cgap.org/html/p_technical_guides04.html.

http://www.ids.ac.uk/cgap/static/2043.htm

http://www.cgap.org/html/p_technical_guides03v1.html

http://www.cgap.org/html/p_technical_guides03v2.html

http://www.cgap.org/html/p_technical_guides04.html


Helms, Brigit S. Cost Allocation for Multiservice Microfinance Institutions. Occasional Paper No. 2.

Washington, DC: Consultative Group to Assist the Poorest, 1998. Available at

http://www.cgap.org/html/p_occasional_papers02.html.

IASC International Accounting Standards. London: International Accounting Standards Board, 2001.

Ledgerwood, J. Financial Management Training for Microfinance Organizations, Calmeadow, 1996.

Ledgerwood, J. Microfinance Handbook: An Institutional and Financial Perspective. Washington DC:

Sustainable Banking with the Poor, World Bank, 1998 (ISBN 0-8213-4306-8).

Tracy, John A. Accounting for Dummies. Second ed. IDG Books Worldwide, Inc., 2001 (ISBN 0-7645531-

4-3).

Waterfield, Charles and Ramsing, Nick. Management Information Systems for Microfinance Institutions: A

Handbook. Technical Tool Series No. 1. Washington, DC: Consultative Group to Assist the Poorest,

1998.

http://www.cgap.org/html/p_occasional_papers02.html

Documents

Accounting for MFI