Tracking Financial Performance Standards of ... - Sa-Dhan

Tracking Financial Performance Standards of Microfinance Institutions4.2. ACCOUNTING FOR LOAN LOSSES – KEY ISSUES FOR STANDARD SETTING4.2.1 Allowances for Loan LossesFor an MFI the loan portfolio is the main business and asset. The values of this asset i.e. loans is therefore a keyissue for good management and income and thus for setting standards for financial performance. This issueneeds to be understood by two dimensions viz.A.)B.)The institutional policy of an MFI should be in place to consider and account for change in quality ofits loan portfolioChange in quality of loans has substantial effect on MFI’s balance sheet and income statement.The reasons for having a system for accounting for change in quality of loan portfolio are:‣ Maintaining loans on the books that are unlikely to be repaid in normal course overstates the size of loanportfolio.‣ A well-defined policy that establishes a loan loss reserve and periodically declares loans non-recoverable saves aprogramme from declaring a large amount unrecoverable all at once and thereby drastically reducing as assets.While the accounting systems are based on ‘historical’ costs, the accounting for quality of loans is a change initself – it is a shift from traditional system that hinges on only historical costs (i.e. keeping an asset at its originalvalue for all times).How does the asset – loan portfolio – perform? For an MFI, as lender, loan performs by repayment of theprincipal amount and the interest (and other fees, if any levied on loan). Since repayment of loan is over afuture period, the present status of a loan and estimation of its future performance are the core issues. Maintainingloan portfolio at the realistic level helps MFI project the actual picture. This removes that portion of the assetthat is found not to be ‘performing’.Here it is also interesting to understand that evaluating loan portfolio is not always a negative aspect i.e. issuefor loss only. A low/non-performing loan can revive and therefore become performing. This gives a positiveeffect to an MFI’s balance sheet and income. But practically such chances of revival are much less than loansturning worse to bad, so the elaborations here will centre around most happening chances – that of losses inloan portfolio.Accounting for change in loan portfolio, has two steps. (a) Periodic review of all loans are made and ‘loan lossprovision’ is made to bring the real picture of performance of loans; (b) The provision is given effect intospecific ‘loan loss reserve’ for loan portfolio (also see section 3.2.2.2 & 3.3.2.1 in chapter 3).Though Loan loss provision is a non-cash expense in anticipation of possible loss in value of loan outstanding,whereas, actual loan losses or write-offs occur when it is recognised (only for accounting purpose) that loans areunrecoverable. The process of recognising an uncollectable loan is called a write-off.Because the possibility that some loans would be unrecoverable has been provided for in the books of accountsthrough reserves, loan losses are written off against loan loss reserves and are also removed from the outstandingportfolio. In other words, they decrease the reserve and the outstanding portfolio.Loan write-off is a significant policy decision that requires attention to several aspects related to loan recovery.In normal course, loans are written-off only after the loan term expires. However, in exceptional circumstances,like death or permanent migration of the borrower, the loan is written-offs even before the loan term is over.Loan losses or write-offs occur only as an accounting entry. They do not mean that loan recovery shouldnot be pursued. In fact, it should be identified.58