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

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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
Constructing Loan Repayment Schedule Aging Schedule and Loan Portfolio Report for an MFI4.2.2 Calculating Loan Loss using Aging AnalysisNow we have understood that MFIs should have clear allowances for loan losses. However, some questions stillhaunts the mind of a manager of an MFI, as to what amount would be appropriate to set aside as loan lossprovision and what should be the basis to arrive at that figure. This section is focused around addressing theabove questions, where we will try to understand the basis of making loan loss provision and the process ofcalculating the amount to be provisioned.A practical approach to arrive at amount to be provisioned for loan loss is based on “aging analysis’’ of all loanoutstanding. In ‘aging analysis’, all loans are reviewed for their present position in relation to the repaymentschedule as decided when each of the loans was sanctioned. Given below is the step-wise method to calculateloan loss provision based on aging analysis.1. The first step towards aging analysis is to draw an ‘aging schedule’ with following categories:Loan CategoryExplanationRegular LoansLoans where repayments have been made as per the duedates or all repayments (that are due) have been paidLoans overdue for < 30 daysLoans with payments overdue for less than 30 days(from the scheduled date)Loans overdue between 31-60 daysLoans with payments overdue for between 31 – 60 days(from the scheduled date)Loans overdue between 61-90 daysLoans with payments overdue for between 61 – 90 days(from the scheduled date)Loans overdue between 91-180 days Loans with payments overdue for between 91 – 180days (from the scheduled date)Loans overdue between 181-365 days Loans with payments overdue for between 181 – 365days (from the scheduled date)Loans overdue for above 365 daysLoans with payments overdue for over 365 days (fromthe scheduled date)Here each category depicts a range of quality of loans. At the same time, each category also depicts therange of risk (probability) of losing money (loan may not come back from borrower). However, the level ofrisk or probability of loan loss in each category will differ from context to context.2. Having understood the method of deriving age of an overdue loan from repayment schedule in section 4.2(18) of this chapter, now calculate the age of all outstanding loans and club them under appropriatecategory (as given above) based on their age.3. After classifying all the loans under age group, now sum up the outstanding figure of all loan accounts foreach age group.4. Establish rate of provisioning (% of loan outstanding that need to be kept aside) for each age group, basedon risk perspective (of default) attached to each category. An historical precedence of client behavior is thebest guidance mechanism towards establishing rate of provisioning. Especially, if there is a cause to believethat there could be something that is specific to the context that requires the establishment of risk ratesunique to that context.59
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TECHNICAL TOOL SERIES 1TRACKING FIN
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INTRODUCTION TOMICROFINANCE STANDAR
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5. PERFORMANCE STANDARDS - CONCEPT,
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TermStatement of Profit and LossStr
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REFERENCESBarrel, Margaret, Michael
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