Auditor FAQs

• Why MFI Audits Are Unique
  • Should MFIs be audited as social or financial organizations?
    
• MFI Standards of Performance
  • How are MFI ratings relevant to audits?
  • How can we use the microbanking bulletin peer group data to improve MFI audits?
    
• Key Issues for Audit Planning
  • How much time should be budgeted to the loan portfolio review?
  • What data should we be compiling when we are conducting manual sampling in the field?
    
• MFI Internal Control Systems
  • If the Board Members have no Stake, how do we Review Board Quality?
  • What are the factors that most likely increase the inherent risk?
    
• Characteristics of an MFI Loan Portfolio 
  • What is "flat" interest?
  • With "flat" interest, should an audit adjustment be proposed?
  • What are accepted norms for loan loss provisioning? 
  • How can we minimize the risks due to rescheduling delinquent loans?
  • What analytical procedures should be used to test the loan portfolio?
• Auditing an MFIs Savings Liabilities
  • How do we confirm that an unregulated MFI is not intermediating deposits?
  • How can MFI savings be audited most efficiently?
• Questions on Auditing MFI Grants
  • Should all donor contributions be specifically reflected in the financials?
  • How should concessionary donor guaranteed debt be treated on the financial statements?
• CGAP Recommended Disclosure Guidelines 
  • What are the disclosure guidelines?
  • What if the MFI does not want to observe the guideline?
• Audit Opinions
  • Why is the audit important to MFIs?
  • Should we consider the CGAP recommended guidelines in issuing our opinion?
  • Is there any special requirements for reporting on the MFI financial statements?
• Good and Bad MFI Audits 
  • What are the fundamental keys to a "good" MFI audit?

Why MFI Audits Are Unique

Although it is difficult to generalize, some differences between banks and MFIs include:

Most auditors will have to devote considerable time to learning this business, but this effort should be amply rewarded by saving the time that would otherwise be devoted to elaborate testing of items that are in fact less material. Discriminating between important and less important issues requires an exercise of judgment that is possible only if the auditor understands the MFI 's business.

Furthermore, these differences require both an altered approach to the assessment of the risk of the MFI and a more qualitative approach to assessing it, in order to obtain the required level of assurance in the reporting of the MFI. MFI clients themselves are the real source of this verification. Auditors will have to rely on alternative audit procedures like observing many of the procedures "in action" to assess whether they were followed properly. Also, portfolio quality must be assessed based on the MFIs actual track record in repayment rather than through traditional means.

Should MFIs be audited as social or financial organizations?

Many MFIs have characteristics of a charitable organization in that they receive donations, rather than equity investments, pay no dividends, and have at their core a belief that what they are doing helps families in poverty over the long-term.

Although MFIs are usually capitalized and subsidized by donor funds, MFIs expect full repayment on the lent assets, and full protection of liabilities held. Their funding is frequently donor derived but in every other way, MFIs strive to work as professional financial institutions. This is the key distinguishing factor of MFIs from other social organisations. Others may disburse food, healthcare, education, and the like, but these disbursements are debited to the income statement rather than the balance sheet. To be able to assert that the financial statements are stated fairly, all the clients related debits to the balance sheet, namely the loan portfolio, need to be tested, as well as any deposit liabilities.

Designing audit tests for an MFI without taking into account the fact that the "disbursement debits" are assets and need to be tested would cause the audit firm to underbid the engagement as well as perform inadequate work on the loan portfolio.

MFI Standards of Performance

For effective MFI auditing, there is a strong need for MFIs established standards or benchmarks. These would provide useful information on what auditors should be looking for, and where and how to find it. They also assist in the auditor's analytical procedures in the light of ISA 520.

For different types of institutions there may be completely different primary indicators of operational quality. MFIs exhibit a great deal of disparity across regions, methodologies, volumes, and product lines. In order to assess an MFI adequately one needs to place them into peer groups of like institutions and compare their results.

Different mechanisms are being developed to assist in this peer group assessment. Several organisations are offering rating services, which assess an MFI, its policies, procedures, and results against peers. So far, relatively few MFIs have taken advantage of this (fee based) service.

MicroBanking Bulletin, a semi-annual bulletin looking at the results of 114 MFIs in 14 peer groups, is a helpful tool for auditors and others to assess the results of MFIs in terms of their peers, and to identify areas of significant deviation. This can be an important tool for auditors in identifying areas of operational weaknesses and strengths. Some of the key indicators are

• Trend analysis
• Net interest margin
• Administrative efficiency
• Staff productivity
• Portfolio quality
• Adjusted ROA

Other assessment tools are used to evaluate MFIs within the MFI industry. Although these are not audit tools per se, they can provide an important insight to auditors in gaining a better understanding of the MFI audit. Among the most popular and widely used methodologies to assess risks are the following:

• CAMEL (adapted for MFI use, by ACCION International),
• PEARLS ()(developed and utilized for Credit Unions),
• GIRAFFE () (developed by Planet Finance as an MFI rating tool), and
• MICRORATE () (another rating tool developed by MicroRate).

MicroRate and Planet Finance post results of the ratings exercises on their web sites.

How are MFI ratings relevant to audits?

In general, the rating tools help the auditor to understand areas of industry focus in order to design and execute a more effective audit. Comparing one MFI's experience through the focus of one of the rating tools can be valuable in pointing out areas of risk, e.g., an administrative expense ratio that is very high relative to peers, or a loan loss reserve that is relatively low. These help the auditor to understand the audited institution in the context of its peers, and help them to identify areas for further inquiry. Therefore, the ratings may be of great help during the analytical procedures in the preliminary stages of the audit.

The auditor must remember that these tools were constructed for management guidance purposes and not audit purposes. Thus, the information contained in them may not have gone through the audit level scrutiny.

How can we use the CAMEL tool to improve MFI audits?

CAMEL is a tool that borrows an acronym that banking supervisors use in the evaluation of banks. Adapted by ACCION () for application in Microfinance, this tool provides an important guideline for the analysis of MFIs. It is not an audit tool, though it can assist auditors in better understanding of MFIs and their operations.

ACCION uses the CAMEL tool to evaluate its affiliates with respect to qualitative and quantitative factors. Auditors may be interested in learning about the questions and ratios that this network organisation feels appropriate to evaluate its affiliates by reading about the implementation of this tool. Many other network organisations have similar tools for tracking performance over time of their affiliates or partners, however; only ACCION has chosen to make their tool public.

Reviewing ACCION's CAMEL (): ACCION's Experience with the CAMEL Instrument provide an important understanding of both methods of assessing MFIs as well as a critique of these methods. These should help auditors identify additional lines to improve their level of confidence in the presentation of financials and the general internal control structure of the MFI being audited.

How can we use the microbanking bulletin peer group data to improve MFI audits?

The Microbanking Bulletin () does for Microfinance what Robert Morris and Associates has done for larger industries: It has gathers together financial and operational data from many organisations, standardizes the data, and then groups it based on the location, scale of operation, and target market. Although the samples are still relatively small, and the participants are self-selected for inclusion, the averages presented provide the reader with some benchmarks of what is reasonable to expect from certain organisations.

External auditors may have little experience auditing MFIs. One of the tests early on in planning an audit involves benchmarking the financial performance of the MFI against its peers. The Microbanking bulletin is free and allows the auditor to perform this analysis in a straightforward fashion.

Several articles are included which feature discussion items that are currently of interest to those in the Microfinance industry. By skimming these articles, auditors can come up to speed with the current debate in Microfinance, with the eye of improving their audits.

Key Issues for Audit Planning

It is important to recognize that "good" audits are fundamentally based on a strong understanding of the uniqueness of the MFI business, good planning and audit techniques, and the quality of staff involved. When these are lacking the audit has limited value to MFIs, donors, or investors.

MFIs have a unique risk structure and operational procedures; therefore, the audit planning process must reflect these specific issues of MFIs. Issues of credit risk, audit risk and control risks need to refocused in relation to MFI audits. Furthermore, special audit considerations should be given due to the development of new products and MFI practices that may not be matched by the concurrent development of accounting principles and auditing practices.

In the pre-engagement stage, auditors should be committed to obtaining a sufficient knowledge of the microfinance industry, the entity's business, and governance structure as directed in ISA 300 (Planning) and ISA 310 (Knowledge of the Business). This will require adopting a top down approach; learning about the institution through management and board discussions, preparatory review of financial statements, and visits to non-headquarters operation, before completing the audit plan and preparing the schedule formats for the MFI staff to complete.

MFIs should provide auditors with detailed terms of reference (TOR) for the audit, never the less, auditors can help the MFIs to design a suitable TOR. The TOR should include a review of the MFI's compliance with CGAP disclosure guidelines.

Because of the small size of many MFI's, the unregulated nature of their business activities, and their small audit budgets, auditors may find it difficult to perform all necessary stages within the available. Thus the audit planning process must reflect the specific issues of MFIs and should include the following elements:

• Understanding the microfinance industry. Most of this work is done at the pre-engagement stage. As per ISA 210 (Terms of Audit Engagements), auditors must not agree to conduct an audit without understanding the special nature of risks within an MFI, and the special mechanisms for assessing those risks. Otherwise, they will not be able to appropriately render an opinion on the financial reports of the MFI.
• Gaining knowledge of the MFI's business.
• Understanding accounting methods and standards (ISA 400).
• Understanding accounting systems and internal control systems. Auditors are often surprised at the apparent informality of internal controls in MFIs, but cost efficient controls are what matters.
• Assessing and establishing relationships with the internal audit departments
• Assessing audit risk (ISA 400). The auditor should use a risk-based approach so that audit testing can be concentrated in areas of more material risk (e.g. loan portfolio).
• Defining levels of materiality for each area to be audited (ISA 320).
• Planning audit tests and procedures

Further guidelines for External Audits of Microfinance Institutions are available in the CGAP External Audits Handbook ().

How much time should be budgeted to the loan portfolio review?

Auditors need to use their best judgment in allocating time to audit areas. However, assuming no intermediation of savings, it would be expected that about one-half of the audit time should be allocated on the loan portfolio section of the audit to properly assess portfolio quality and the adequacy of the provision for possible loan losses. First year audits may require as much as two-thirds, decreasing eventually to as little as one-third. The amount of time spent on the loan portfolio is subject to the work done by, and the audit firm's confidence in, the internal auditor (if any).

Audit staff will need to meet with a sampling of clients to confirm manually the balances acknowledged by the client. If possible, it would be advisable for every member of the engagement team (even the partner) to view a borrowing transaction (individual or group) as an education into the components of microlending. Such an activity would be most productive during the audit planning process. Auditors will likely view 1% to 20% of such transactions during control and substantive testing. It is therefore important that there is a very clear understanding of these transactions and the requirements to audit them.

What data should we be compiling when we are conducting manual sampling in the field?

The sampling methodology and sample size are crucial, and this area should be discussed thoroughly with the MFI's management in light of ISA 530 on audit sampling. Auditors should consider gathering evidence that will help them determine if internal controls are being followed so that they can be relied upon as well as substantive data that will allow them to trace amounts to the financial statement being audited.

Many MFIs will keep records differently based on their methodologies, so one single approach is not available. Some will treat one lending group as a client, and others will treat each individual separately, monitoring and managing their accounts accordingly. The auditor should start by considering the level of detail that exists within the accounting system and look to verify that data in the field.

The sample should be selected from the loan portfolio control register based on the unique features of the MFI before the auditor reaches the field.

Items that the auditor may consider collecting could include, and are not limited to:

Control tests

• Compliance with significant loan and savings policies and procedures
• With groups, also review their deposit policies, including the number of borrowers that make the group's deposit, rotation of bank presidency, maintenance of duplicate records, mechanisms for resolution of discrepancies/errors, and responses when a borrower cannot make a payment or doesn't show up for a meeting.
• Other inquiries can be made regarding the nature of other identified internal control strengths.
• Consider visiting a sample of borrowers' businesses.

Detail tests

• Loan balance as of the audit balance sheet date.
• Savings balance as of the audit balance sheet date. This is conducted at different levels of intensity depending on the role of the institution with regards to the savings.
• Recalculate interest paid on the last loan.
• Verify that the client is who s/he says s/he is by observing proof of identity if possible. Many countries have no reliable system of identification.
• Trace the loan payment being made during the visit through the financial records, including bank reconciliation.
• In the case of groups, trace the individual's record to the group's records and then to the MFIs records.
• deposit frequency.

MFI Internal Control Systems

In most situations, the auditor places significant reliance on the MFIs' systems of internal control. This requires a careful evaluation of the control environment and the control procedures to assess the degree of reliance that can be placed in determining the nature, timing and extent of other audit procedures. It is to the extent that fraud risk stems from failures in such compliance, that the external auditor's work can provide some level of fraud control. Samples of MFI fraud cases from around the world can be found at:

• Overview of Microfinance Fraud ()
• Panel on Fraud and Internal Control: BRI, K-Rep, PRODEM ()

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

The auditor should obtain audit evidence through tests of control to support any assessment of control risk that is less than high (ISA 400). The lower the assessment of control risk, the more support the auditor should obtain that accounting and internal control systems are designed suitably and are operating effectively. Auditors need to observe and inquire about many of the procedures in action, that leave no audit trail, to assess weather they were followed properly. This could be done mainly through client interviews, but this has to be handled carefully to gather accurate information without upsetting clients or hurting the client staff relationship.

If Board Members have no stake, how do we review board quality?

In assessing the control environment, the function of the Board, management's philosophy, and operating style should be taken into consideration. The Board of an MFI is only as good as the advice and support that its members give to the organisation. When MFIs are established, it is likely that friends and even family members of the executive director are chosen to be advisors and then Board members of the MFI. The only real link to the MFI is the friendship between the executive director and the Board. Thus, early MFI Boards are often ineffective at monitoring, supervising, and disciplining the executive director due to prior friendship.

Audit assurance that the Board is independent and operates in an appropriate, vigilant role, comes through reviewing the minutes of the Board of directors' meetings and interacting with the Board members. Auditors should interview one or more of the Board members, including at least their point of contact on the Board, and inquire regarding specific familial or other relationships among board members and staff, and about specific levels of effort offered by the different members. At a minimum, the auditor should be aware of the level of independence and authority of the Board, and if appropriate, may suggest through the management letter that Board diversity should be sought.

Auditors should be aware that just because a person is well respected in the community, does not necessarily mean that they are giving all of that creative and management effort to the vigilance of the MFI. Certain individuals may loan their name to the MFI and not contribute much to the overall management of the organisation. Auditors may consider inquiring regarding the level of effort from each Board member, if the Board is going to be relied upon as a key internal control point.

What are the factors that most likely increase the inherent risk?

Unsecured lending places MFIs in a potentially heightened risk category. Inherent risk exists regardless of the nature of the internal control system. This is primarily a function of the nature of the business and the skills of management. Inherent risks can appear at both the financial statement level and the account balance level.

Among the factors that auditors should look for as indicators of high inherent risk of MFI are the following:

• Lending at below the market rate, subsidized rates.
• Paying low salaries to employees below the average market salaries.
• Managers do not understand credit process, because they have been trained in social work.
• Accounting is done by staff with little experience in double-entry bookkeeping, international accounting standards, and so on.
• Business operations are decentralized and geographically dispersed; often in remote regions with inadequate infrastructure.

Characteristics of an MFI Loan Portfolio

The loan portfolio and associated loan loss provision are the crucial accounts in an MFI's financial statement, and are most commonly subject to material misstatements. Most MFI failures stem from the deterioration in the quality of the loan portfolio.

MFI loan operations have unique characteristics that external auditors must understand. The principal uniqueness can be summarized as follows:

• MFIs grant a large number of small loans, and process a very large number of tiny payments. Their operations are often dispersed over a wide area. Thus, MFIs utilize streamlined and decentralized operating structures to be efficient. These factors make it a challenge to maintain effective portfolio information and management systems.
• Decentralization implies that relatively few staff are involved in approving, disbursing, monitoring, and collecting each loan. This structure increases the opportunity for deviation from approved policies, and for fraud, as well as increases the risk of error or manipulation when branches transfer information to headquarters.
• To handle small transactions efficiently, MFIs face great pressure to cut costs sometimes at the expense of adequate portfolio controls and information, as well as sufficient supervision of clients and loan officers.
• Many MFI portfolios are growing rapidly. This growth puts pressure on systems and can camouflage repayment problems. A rapidly growing portfolio has a larger percentage of loans in the early stages of repayment. Delinquency problems are more likely in the later stages of the repayment cycle. Receiving large grants, and the pressure from donor agencies to report impact places pressure on managers to grant loans. This pressure has created an environment for fraud in several cases.
• MFIs generally dislike provisioning for problem loans or writing them off. They want to maintain a good image in the eyes of outsiders, especially donors. This occasionally leads to restructuring or refinancing as a tool to hide delinquency.
• MFI information systems are often weak and thus systems for operational loan tracking are seldom integrated with their accounting systems.

These issues, among others, make the loan portfolio audit rather complicated and time consuming. Auditors will need to allocate significant effort in the review of the loan portfolio and to carry field visits.

CGAP is preparing guidelines for auditing MFI loan portfolios and this should be available at the end of the year.

What is "flat" interest?

Flat interest refers to charging interest on the full original loan amount, rather than on the declining balance. With group based loans, for example, a common "interest rate" is "3% per month, flat, for 4 months". This means that a $100 principal amount lent is multiplied by 3%, and then by 4 months to come up with $12 in interest. Thus, $112 would be repaid over 4 months in equal instalments.

The use of "flat" interest rates are usually explained as facilitating understanding by poorly educated and illiterate clients. "Flat" interest is easier to calculate than declining balance interest. However, "flat" interest also disguises the "effective" interest rate (APR, or internal rate of return) to the loan. Based on how often the principal is collected (weekly, monthly or at the end of the term), and assuming no additional fees, the above loan has an APR of between 39% and 71%.

An additional source for understanding MFI interest rates is the CGAP "Occasional Paper No. 1, August 1996, Microcredit Interest Rates" ().

With "flat" interest, should an audit adjustment be proposed?

Should an audit adjustment be proposed to bring an MFI's calculation of interest income into alignment with declining balance interest principles? The answer is, "generally no". If an MFI loan portfolio is relatively small and there is a concentration of disbursements in any one given month (say 60% of all loans renew in December), then there is a chance that the underpayment of interest in December is significant for consideration. However, if the MFI is larger and has a relatively even disbursal pattern, then the likelihood of a significant audit adjustment is less.

What are accepted norms for loan loss provisioning?

Here are some recommendations of several organisations or tools as to appropriate provision percentages for delinquent MFI loans:

MICRORATE ()
PEARLS ()
MicroBanking Bulletin ()
CAMEL ()
CGAP ()

Other considerations include the loan characteristics (repayment schedule, Maturity) and in country regulations (central Bank or other regulatory body) applicable to MFIs..

For audit purposes, however, the goal is for the reserve to approximate the actual losses that the current portfolio is likely to generate. If losses are consistently and significantly less than reserves, the auditor may consider the reserve too high. It is important to discuss the reasons for this with MFI management who should know their portfolio and understand the particular risk inherent in it. This discussion may result in a recommendation to reduce the reserves.

Occasionally, reserves are insufficient to cover likely losses. Auditors should recommend compliance with a reserve policy that is appropriate for the audited institution. Following one of the above guidelines can provide legitimacy to the claim for reserves.

How can we minimize the risks due to rescheduling delinquent loans?

Delinquency tends to be more volatile in MFIs than in commercial banks. Most MFI loans are not secured by tangible assets that can be seized or sold easily in case of default. The MFI clients' main motivation to repay is their expectation that the MFI will continue providing them with valued services in the future, if they pay promptly today. This motivation is frequently reinforced by peer pressure, especially in group-lending programs. In these circumstances, any serious outbreak of loan delinquency can quickly spin out of control. As clients watch their peers default, they lose confidence in the MFI's ability to serve them in the future, and the peer pressure to repay can dissipate quickly. Many MFIs have died of a repayment cancer that could have been cured, if it had been detected and dealt with earlier.

In some cases, when an MFI client is experiencing repayment difficulties, MFIs will reschedule (restructure/ renegotiate) the loan. Typically, the term of the loan is extended, overdue interest is added to the principal, and a new amortization schedule is established. The old "problem" loan disappears, replaced by a new loan contract that is shown as current, at least until the next payment is due. Such rescheduling can conceal major portfolio problems in the form of loans that appear current, but are unlikely to be paid in full. In fact, rescheduling is often the easiest way to "correct" a poorly performing portfolio. Therefore, meaningful delinquency monitoring is a crucial diagnostic tool for MFIs.

MFIs that do reschedule loans fail to track them separately; therefore, auditors should always investigate through several mechanisms (management, credit staff, clients) in an effort to identify the practice of rescheduling. Auditors must pay particular attention to rescheduled loans as they are a primary indicator of a serious portfolio problem, and should assess the MFI's procedures regarding the following:

• The appropriateness of the rescheduling policy and procedures.
• Loans that the MFI has had to reschedule should be identified separately in the aging report.
• Adequate loan loss provisions are applied to rescheduled loans

The MFI detailed policies and procedures for loan rescheduling should have answers to the following questions, which can be determined by looking at a sample of rescheduled loans:

• What conditions must be present to qualify for rescheduling?
• How many times can a customer reschedule a loan?
• Who has the power to approve a rescheduling?
• How is a loan accounted for once it has been rescheduled?
• Is accrual of interest income discontinued until payments have been received subsequent to the rescheduling?
• Is a rescheduled loan automatically aged in the "current "category, or does a separate category exist?
• Does the loan tracking MIS produce regular reports that automatically identify all rescheduled loans, or at least contain the information necessary to produce a one-time listing of rescheduled loans?
• Is the rescheduling being done with a realistic expectation that it will enable the client to pay in full, or is it being used to camouflage bad loans that are unlikely to be recovered? (Subsequent payment history of current and historical rescheduled loans).

Click icon for further information on meaningful delinquency monitoring ()

What analytical procedures should be used to test the loan portfolio?

Most MFI failures stem from deterioration in the quality of the loan portfolio. Despite auditors' MFI portfolio testing, which is to some extent dictated by prevailing audit standards or by the policies of their firm, there is no single set of portfolio audit procedures appropriate for all MFIs. Thus, the portfolio audit, more than any other area of an MFI audit, needs to be tailored to the circumstances of the institution. The auditor, rather than simply accepting a "one-size-fits-all " portfolio audit determined solely by the auditor 's standards and policies, should try to discuss portfolio procedures with the client and arrive at some definition of the tests and procedures that are appropriate to the client 's needs.

The auditor will need to adapt analytical procedures to test the loan portfolio for issues such as interest rate gaps, interest accruals, trend analysis, branch ratio comparisons, and others. The auditor could address these needs through the use of several assessment tools that were developed by the industry, e.g. the CAMEL () tool, which covers some of these need, like trend analysis and branch ratios.

Among the special features in loan portfolio audit that require special audit procedures are the following:

Interest rate gap testing
Interest income should be evaluated when testing the loan portfolio, analytically and/or by tests of detail. The preferable method is through analytical review, which is performed by developing an independent expectation of income and comparing it with the actual balances recorded by the client. One type of analytical review compares interest income from the current period with interest income from the previous period, taking into account identified changes in the portfolio, such as growth, between the periods.

A more powerful procedure, which should be performed in almost all MFI audits, is a yield gap analysis, which compares actual interest receipts with an independent expectation of what the portfolio should be yielding, based on the loan terms and the average portfolio over the period. By analyzing the terms of an MFI's loan contracts, the auditor can develop a theoretical interest yield (that is, the amount of revenue the portfolio should generate, if all interest is paid on time and according to contract). CGAP provides a method for calculating theoretical yields for the different interest types used by MFIs in the document "Microcredit Interest Rates" (). This theoretical yield should be compared with the actual yield for each period. Loan fees and commissions can be included along with interest income for this purpose, or can be treated separately. If the theoretical yield is different for different types categories of loans within the MFI, weighted averaging based on average outstanding balances can produce an overall yield estimate.

This analysis frequently shows a large gap between what the MFI should be earning and what it is actually earning. Ideally, this yield gap analysis should be done for each loan product and as part of the testing of revenue accounts. Among the most common cause of a yield gap are the following:

• Loan delinquency, so this test serves as a crosscheck on portfolio quality.
• If a large percentage of the portfolio is in new loans whose first payment has not yet fallen due.
• Sometimes a yield gap turns out to be due to an inaccurate loan portfolio balance in the accounting system. Errors made in previous years may get passed along undetected to later years when the loan portfolio balance is updated by adding disbursements and subtracting payments and write-offs, with no independent check.

Auditing an MFIs Savings Liabilities

Most MFIs do not yet intermediate savings due to regulatory requirements. Some take required compulsory savings as a condition of the loan (a guarantee fund), and clients have no access to those funds during the period of borrowing. These are often held by the MFI but in most cases, by law they must not be intermediated. The auditors must review the internal policies and the national laws for such deposits, and ascertain the legality of the holding mechanism employed by the MFI.

When prohibited from collecting savings, MFIs may facilitate group savings accounts, often called "internal accounts", and are appropriately maintained off balance sheet. It is important to determine if the MFI is really capturing savings that need to be reported as liabilities, or if they are just assisting the borrowing groups in their management of savings.

Savings is a risky area for MFIs, some generate voluntary savings from clients. Yet, most are ill equipped in terms of personnel capacity coupled with relatively weak control systems. These require critical assessment in light of internal policies, systems, and capacity, as well as the national legal structure. Liquidity, regulatory, and control risks as well as fraud are important considerations with regards to MFI savings products.

The traditional approach of sending confirmation letters to depositors is unlikely to be an effective test for savings in MFIs. Client visits are required to test savings in most MFIs. The auditor can conduct savings balance tests in conjunction with loan balance tests during client visits for savers who are also borrowers or randomly during savers visits to a branch office.

Where MFIs are regulated, auditors should review reports and analyses from the banking regulators, and, where possible, interview the banking supervisors about the MFI. Open communications between MFI and supervisors may help reduce the necessary scope of work for one or both parties.

How do we confirm that an unregulated MFI is not intermediating deposits?

Most MFIs facilitate savings on behalf of their borrowers. A major selling point of MFIs is their ability to bring the poor out of poverty through increased business gains, while saving for future events.

Unregulated MFIs generally use one of four methods of facilitating client's savings:

1. Promote or require savings with a third party financial institution.
   • These are not reported as a liability on the MFI's books.
   • Since they represent collateral for the loans, their existence should be generally confirmed.
2. Promote or require savings with a third party financial institution with the MFI as an account signatory.
   • These are not reported as liabilities on the MFI's books though they require disclosure to reflect the additional risk and control taken by the MFI.
   • Controls over the use of the signatory power must be reviewed.
   • Since they represent collateral for the loans, there existence should be generally confirmed.
3. Promote or require savings held by the MFI in safekeeping (in a consolidated bank account or AAA investment like treasury bills
   • These are treated as liabilities on the books of the MFI
   • Audits must confirm actual safekeeping of the deposits in segregated pools totaling the value of the deposits.
   • Extensive auditing of the relationship between the individual's balance, the group's balance (where there are consolidating groups), and the books of the MFI is required.
   • This practice must be reflected in the notes to the financial statements.
4. Promote or require savings held by the MFI as loan capital for its portfolio.
   • These are treated as liabilities on the books of the MFI
   • Extensive auditing of the relationship between the individual's balance, the group's balance (where there are consolidating groups), and the books of the MFI is required
   • This practice generally represents a serious regulatory breach
   • This practice and its legal status must be reflected prominently in the notes to financial statements.

In all these cases it is also important to assess the level of savings generated from non-members of the MFI as such public savings, which may carry different legal requirements, carry additional risk, and must be accounted for differently since those deposits cannot represent collateral on loans.

An external auditor should design the test of loan balances to simultaneously test the savings balances of the MFIs clients.