Accounting For Mfi

P A R T I C I P A N T

C O U R S E

M A T E R I A L S

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 is not intended to serve as a substitute for the full course materials delivered through the Skills for Microfinance Managers training series. Users interested in attending a training course should directly contact CGAP hubs and partners 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 to this participant summary: Michael Goldberg, Ruth Goodwin-Groen, Lorna Grace, Brigit Helms, Jennifer Isern, Joanna Ledgerwood, Patricia Mwangi, Bridge Octavio, Janis Sabetta and all CGAP training hubs and partners. Copyright 2001, The Consultative Group to Assist the Poorest (CGAP).

Contents Overview and Goals ............................................................................................. 4 Overview ........................................................................................................... 4 Goals of the Course ............................................................................................. 4 What is Accounting?.............................................................................................. 5 Basic accounting principles for MFIs: ...................................................................... 5 Double-Entry Accounting ...................................................................................... 6 Conservatism and Prudence .................................................................................. 6 Materiality.......................................................................................................... 7 Realization ......................................................................................................... 7 Matching ............................................................................................................ 7 Financial Statements........................................................................................... 10 Balance Sheet................................................................................................... 10 Income Statement............................................................................................. 14 Cash Flow Statement ......................................................................................... 18 Portfolio Report ................................................................................................. 19 The Accounting Cycle ......................................................................................... 24 Step 1: Classifying Transactions .......................................................................... 25 Step 2: Journalizing ........................................................................................... 27 Step 3: Posting ................................................................................................. 30 Step 4: Trial Balance ......................................................................................... 33 Step 5: Accounting Adjustments .......................................................................... 35

Step 6: Closing Entries....................................................................................... 37 Step 7: Draft Financial Statements....................................................................... 38 Step 8: Closing ................................................................................................. 38 Decision Making Tools......................................................................................... 39 Management Information Systems ....................................................................... 39 Internal Controls................................................................................................. 44 Internal Controls ............................................................................................... 44 Sources of Risk ................................................................................................. 44 External Audits ................................................................................................. 45 Glossary of Terms for Financial Statements ........................................................ 46 Balance Sheet................................................................................................... 46 Income Statement............................................................................................. 53 Bibliography........................................................................................................ 58

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 of o Underlying accounting principles o 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

CGAP

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

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

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 5

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. CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 6

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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 7

Financial Accounting versus Managerial Accounting

Financial Accounting

Managerial Accounting

Presents a summary view of the

Tracks and presents projected and

financial results of past operations for a

historical operations, at a detailed level,

wider audience

intended for use by managers

External

Internal

Summary

Detailed

Historical Only

Historical and Projected

Standardized Format

Open Formats

Annual

Daily/Weekly/Monthly/Quarterly/etc..

Final, Precise

Ongoing, Flexible

End (e.g., Independent Audit)

Means (management tool)

Reporting and Disclosure

Analysis and Action

Source: Tony Sheldon, SEEP Training Notes, 1997.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 8

Three key accounting issues relevant to MFIs:

Cash versus Accrual Accounting

Accounting for Interest Revenue

Accounting for Grants and Concessional Funds Concessional

Cash

Accrual

Revenue is not reported until cash is received and expenses are not reported until cash is disbursed.

Recognizes transactions when they take place whether or not cash changes hands. According to IAS, financial statements should use accrual accounting. It also recognizes that some situations, such as the collectability of doubtful receivables, require “the exercise of prudence.”

CGAP

Cash Records interest revenue when cash is received. This is the most conservative or prudent methods – when interest is paid with each installment of the loan. However, if interest is paid up-front, it overstates the revenues of the MFI.

Accrual Records interest revenue when it falls due rather than when it is received in cash

Grants

Loans

Not included in profits or retained earnings from operations

Loans made to the MFI at less than market rate of interest

Recorded separately below the operating profit/(loss) on Income Statement

Recorded separately from commercial loans (in order to identify ‘subsidy’)

Transferred to Balance Sheet as donated equity

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 9

Financial Statements

!

MFIs commonly use four types of financial statements: • Balance sheet • Income statement • Cash flow statement • Portfolio report

Assets = Liabilities + Equity

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 •

•

CGAP

Represent what is owned by the organization or owed to it by others Are items in which an organization has invested its funds for the purpose of generating revenue.

Liabilities •

Represent what is owed by the organization to others.

Equity •

•

Represents the capital or net worth of the organization. Includes capital contributions of members, investors or donors, retained earnings, and the current year surplus.

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 10

Sample Balance Sheet Accounting Period Assets 1. 2. 3. 4. 5. 6. 7. 8. 9.

Cash and due from banks Reserves in central bank Short-term investments in money market instruments Loan portfolio (Loan loss reserve) Other short-term assets Long-term investments Net fixed assets Total assets

Liabilities 10. 11. 12. 13. 14. 15. 16. 17. 18.

Savings accounts: forced Savings accounts: voluntary Time deposits Loans: commercial banks Loans: Central Bank Loans: subsidized Other short-term liabilities Other long-term liabilities Total liabilities

Equity 19. 20. 21. 22. 23. 24. 25.

Paid-in equity from shareholders plus members Donated equity—prior years, cumulative Donated equity—current year Prior years retained earnings/losses Current year retained earnings/loss Other capital accounts Total equity

26.

TOTAL LIABILITIES AND EQUITY Source: Format for Appraisal of Microfinance Institutions, CGAP Secretariat, July 1999.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 11

Balance Sheet Account Assets

Comments About Usage

1. 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 market instruments

Interest-bearing deposits and investments in financial instruments, where the principal purpose 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 that have 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

Liabilities 10. 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

Equity 19. Paid-in equity from shareholders

Equity contribution of owners of stock

20. 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, not including 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 CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 12

Effects of Transactions on the Balance Sheet A 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 Transaction

Cash

Current Loans Outstanding

Loans Past Due

Liabilities Investments

3. Purchase motorcycles for staff - pay half cash; half short-term credit 4. Purchase office furniture on short-term credit 5. Take loan from bank at commercial rate of interest (> 1 year) 6. Purchase a Treasury Bill for cash 7. Client withdraws savings 8. A current loan becomes past due

↓

Shortterm Client Borrowing Savings

Longterm Debt

↑

1. Purchase land on credit 2. Disburse loan to client

Fixed Assets

↑

↓

Equity Restricted/ Deferred Revenue

↑

↑

↑

↑

↑

↑

↑

↓

↑

↓

↓ ↓

↑

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

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 13

Equity

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

Represent costs incurred for goods and services

goods sold and services rendered during an

used in the process of earning revenue. Direct

accounting period, including

expenses for an MFI include

• • •

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

• • •

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). CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 14

Sample Income Statement Accounting Period Operating Income 1. 2. 3. 4.

Interest and fee income from loans Income from other finance-related services Income from investments Total operating income

Operating Expenses 5. 6. 7. 8. 9. 10.

Interest and fee expense Loan loss provision expense Administrative expense – personnel Other administrative expenses Total operating expenses NET OPERATING PROFIT (LOSS)

Nonoperational Income and Expenses 11. 12. 13. 14.

Cash donations Other non-operational income Total non-operational expenses TOTAL CONSOLIDATED PROFIT/LOSS Source: Format for Appraisal of Microfinance Institutions, CGAP Secretariat, July 1999.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 15

Income Statement Account

Comments About Usage

Operating Income 1. Interest and fee income from loans 2. Income from other finance-related services (indicate which) 3. Income from investments 4. Total Operating Income Operating Expenses 5. Interest and fee expense 6. Loan loss provision expense 7. Personnel expense

8. Other administrative expenses 9.Total Operating Expense 10. NET OPERATING PROFIT (LOSS) Nonoperational Income* and Expenses 11. Cash donations 12. Other nonoperational income (If any)

13. Non-operational expense (if any) 14. TOTAL CONSOLIDATED PROFIT (LOSS)

All income on loans made to clients For example, fees from savings accounts Interest from bank accounts or investments in money market instruments used primarily for liquidity management

Interest and fee expenses for all loans, deposits, or other liabilities funding the financial service operation Cost of creating/maintaining the loan loss reserve All staff and consultant costs, including payroll taxes and fringe benefits(preferably on an accrual basis, especially in the case of major future benefits like severance pay obligations) Broken out into no more than ten categories (e.g. rent, transportation, supplies, utilities, fees, depreciation, other)

All cash grants/donations. Do not include in-kind donations of goods and services. Income from investments which play no role in the delivery of financial services, income from non-financial services, sale of land, consultancies, etc. Any expenses not related to the MFI’s financial services business, such as an evaluation or impact study mandated by a donor Net operating profit (loss) plus non-operational income, minus nonoperational expenses

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

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 16

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.

CGAP

An Income Statement portrays the events that have occurred between the dates of two consecutive balance sheets.

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 17

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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 18

Portfolio Report A portfolio report provides information about the lending and savings operations of an MFI. It provides timely and accurate data about the quality of the portfolio. It usually also 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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 19

• 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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 20

Relationships Between Financial Statements

Previous Year Balance Sheet

Changes

Current Year Balance Sheet

Profit/Loss Donations Loan Loss Depreciation

Profit/Loss

Current Year

Current Year

Cash Flow

Income Non-Cash Items

CGAP

Statement

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 21

How does “Accounting for MFIs” treat donor funds and the equity account? Income Statement

Balance Sheet

•

Donor funds are treated "below the line."

•

Donor money is recorded after net operating profit.

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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 22

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

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

treatment of grants

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

and equity

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

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

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

and not compliant

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

with IAS 20

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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 23

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.

1. TRANSACTION OCCURS 8. CLOSING Books are prepared for next cycle.

2. JOURNALIZING Transactions are entered in a general journal.

7. DRAFT FINANCIAL STATEMENTS Balance Sheet, Income Statement, and Cash Flow Statement are prepared.

3. POSTING Journal entries are transferred to ledger accounts.

6. CLOSING ENTRIES Clear and close revenue and expense accounts, transfer to statements.

4. TRIAL BALANCE 5. ACCOUNTING ADJUSTMENTS

Accounts are verified, totaled and balanced.

Adjustments are made in order to prepare financial statements. CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 24

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

CGAP

•

The structure and level of detail of the chart of accounts will determine the type of information management 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, it is fundamentally important to be able to differentiate between the grant income given by donors from the operational income earned from the MFI’s products and services. Operational income is the basis for financial analysis, not grant income, and the importance of accurately tracking it cannot be overstated.

•

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

•

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

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 25

Sample Chart of Accounts Assets

Liabilities

Equity

101 102 103 104 105 106 114 115 116 117 118

201 202 203 204 205

301 302 303 304 305 306

Cash Reserves Short term investments Loan portfolio Loan loss reserve Other current assets Long-term investments Property Fixed assets Accumulated depreciation Other assets

Short-term borrowing Client savings Long-term debt (commercial) Long-term debt (concessional) Restricted/deferred revenue

Revenue

Expenses

401 402 403 404 405 410

501 502 503 505 510 512 513 514 515 516 517 518 519 520 521 522 523 524 525 526 527 528 529 530

CGAP

Interest on current and past due loans Interest on restructured loans Interest on investments Loan fees on loans Late fees on loans Donations—unrestricted

Paid in equity Donated equity prior year Donated equity current year Prior year profit/loss Current year profit/loss Other capital accounts

Interest paid on short-term borrowing Interest paid on client savings Interest paid on long-term debt Provision for loan losses Salaries and benefits Communications Courier/postage Rent Utilities Equipment Equipment leasing Depreciation Bank charges Advertising and promotion Insurance Supplies Maintenance Travel and accommodation Legal fees Professional development (training) Computer software Printing Fees/dues Miscellaneous

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 26

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 CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 27

• 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

CGAP

Credit

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 28

Effect of Accounting Transactions on the Balance Sheet Assets Debit

Credit

Increase

Decrease

Normal Balance

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

Decrease

Normal Balance CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 29

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 July

1

3

31

CGAP

Account Title and Explanation

Ref.

Debit

Fixed Assets- Computer Cash (purchased computer on cash) Fixed Assets- Motorcycles Cash Short-term Liabilities (purchased motorcycles on cash & credit)

116 101

4,000

116 101 204

15,000

Cash Savings Accounts - Forced (collect savings)

101 201

51,000

Credit 4,000

4,000 11,000

51,000

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 30

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 Date July

Account No. 101 Explanation

1 3 31

purchased computer purchased motorcycles collected savings

Debit

4,000 4,000 51,000

Fixed Assets Date July

Explanation 1 3

purchased computer purchased motorcycles

Credit

Balance 358,196 354,196 350,196 401,196

Account No. 116 Debit

Credit

Balance

4,000 15,000

230,504 234,504 249,504

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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 31

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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 32

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

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 33

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.

CGAP

Participant Course Materials: Accounting for MFIs—Fundamentals of Accounting for Microfinance Managers • 34

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,

Loan Loss Reserve •

•

CGAP

An account that represents an estimate of the amount of outstanding principal that the MFI does not expect to recover eventually Negative asset on the balance sheet that reduces the outstanding portfolio. (An alternative presentation is to show it as a liability.)

AND

LOSSES OR WRITE-OFFS

Loan Loss Provision •

•

Amount expensed on the income and expenses statement. Increases the loan loss reserve

Loan Losses or Write-Offs Occur as an accounting entry. • Do not mean that loan recovery should not continue to be pursued. • Decrease the reserve and the outstanding portfolio. •

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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.

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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.

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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.

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Decision Making Tools

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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, and disseminating 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. CGAP

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Indicators for Financial Analysis An MIS is created to generate information for decision making, the best information 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 CGAP

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• 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

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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 loans Average net portfolio outstanding

Cost-Efficiency Ratios Operating Efficiency =

Administrative Efficiency =

Personnel Expense Ratio

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Total operating expenses + In-kind donations Average net portfolio outstanding Personnel + Other administrative expenses + In-kind donations Average net portfolio outstanding Personnel expenses + In-kind personnel donations Total administrative expenses + Total in-kind donations

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Profitability Performance Indicators Term

Formula

Definition

Adjusted Operating Profit

Operating income – Adjusted operating expenses

Adjusted Return on Assets

Adjusted operating profit Average total assets

How productively the MFI has employed its assets

Adjusted Return on Equity

Adjusted operating profit Average equity

Return on the equity capital of the MFI

Operating income Operating expenses

Degree to which operating income covers operating expenses

Operating income Adjusted operating expenses

Degree to which operating income covers the adjusted operating expenses

Operational Self-Sufficiency Financial Self-Sufficiency

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MFI’s profit

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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

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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.

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Glossary of Terms for Financial Statements

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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 a Balance Sheet? All assets of the organization are funded either by outside parties (liabilities) or by 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 the organization: the organization's assets on one side and the funding sources for those assets on the other.

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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

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

accounts

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

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

outstanding

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

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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

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

loan portfolio outstanding

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

• CGAP

Prepaid expenses—for example, rent or insurance premiums

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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.

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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 shortterm or long-term. Long-term debt is that portion which is due in over one year’s time.

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Central bank loans

Outstanding amount that the MFI owes the central bank for which it is paying interest, often discounted.

Subsidized, concessional, or

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

soft loans

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

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

revenue (short-term or long-

activities are classified as a liability on the Balance Sheet because

term)—

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.

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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

Amount of funds contributed by shareholders to the MFI.

shareholders Donated equity, prior years,

Cumulative amount of donations received by the MFI.

cumulative 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

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

profit/loss

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.

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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

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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.

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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 multipurpose institutions, all direct costs of financial operations and an appropriate portion of the institution’s overhead should be included. Interest expense: client

Payments made to clients who deposit savings in the organization

savings

(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.

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ADMINISTRATIVE EXPENSES Expenses that are considered a subset of operating expenses. Personnel: Salaries and

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

benefits

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.

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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.

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Bibliography

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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 958-960920-1). 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.

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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 0-76455314-3). 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.

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