The change in donors' approach towards audit requirement was discussed in a recently held workshop at Karachi. The workshop stressed the need to regulate the audit system in relation to MFI.
Donors' audit requirements pose challenges, especially in the common case where an MFI is dealing with more than one donor. First and foremost, donors should avoid requiring any duplication of the MFI's regular financial statement audit. This problem occurs surprisingly often.
It can be eliminated by simply getting all the relevant stakeholders to agree on the terms of reference for the annual financial statement audit and on the selection of the auditor. Donors should try to accommodate themselves to terms of reference that meet the needs of all the other stakeholders.
However, donors often require special audits, or additional work within the context of the financial statement audit, to track the uses of their funds and to confirm compliance with the terms of their grant or loan agreements.
For several reasons, donors should reconsider these special audit requirements. MFIs are different from many other donor projects. In a food distribution project, for instance, donor needs to know that its money has been spent on food, and that the food has reached the intended recipients, in order to be assured that the project's goal has been met.
Microfinance- the provision of banking services for the poor- has been a growth industry for the past 20 years. In 1997 an estimated 7,000 MFIs around the world were offering tiny loans to microenterprises, deposit services tailored to the needs of poor households, and other financial services such as transfers. To date most of these institutions have been non-profit, non-governmental organisations (NGOs). But many credit unions, especially in Africa, are offering microfinance services, and a few licensed finance companies and commercial banks are beginning to enter the market.
At present donors and governments fund most microfinance. But stronger MFIs are realising that the demand for their services far outstrips the limited supply of donor and government funds. At the same time, they have shown that they can provide microfinance on a financially sustainable basis. Customers find MFIs so valuable that they are willing to pay the full cost of their services. When an MFI becomes financially sustainable, it can begin funding its loans with deposits and other commercial sources of capital.
In doing so it escapes the limitations inherent in donor funding, while providing a safe and convenient savings service to its customers.
In this context, boards of directors and managers of MFIs, as well as the donors that fund them, are focusing more closely on MFIs' financial reports. External audits have traditionally been the principal means of assuring the accuracy and meaningfulness of those reports.
But experience has shown that external audits often fail to produce an adequate review of an MFI's financial position and internal controls, especially when it comes to information on its loan portfolio. There are three main reasons external audits often fall short.
Customers requesting external audit boards, managers, and donors often do not understand what audits can and cannot be expected to do. Nor do they understand what special procedures, beyond the scope of a normal statutory audit may be needed to address certain issues, or how to craft terms of reference that communicates their needs to the auditor.
Donors often provide terms of reference for external audits, but these usually focus on compliance with the donors' loan or grant agreements and on tracking the specific uses of the donors' funds, rather than on the financial health of the audited institution's microfinance business.
Few external auditors have much experience with microfinance. Thus they seldom understand the unique features of the microfinance business, which call for different audit procedures than those used in conventional financial businesses. A further problem with audits of MFIs is that they often absorb too much time of auditors and MFI staff with issues that are not especially material to the main risks inherent in the microfinance business.
Audit firms tend to assign junior staff to MFI audits and these staff often focuses on checking compliance with detailed lists of accounting and operational prescriptions. Many of which are highly irrelevant to the basic soundness of the MFI's financial reporting or the security and efficiency of its operations. For this reason, emphasis on a "risk-based" audit approach is preferred.
The external auditor must evaluate the relative importance of various areas of risk and focus most of the audit work on those areas that are most material to the business being audited. For example, voluminous loan documentation and multilevel approval procedures are standard in normal commercial banking but may be utterly impractical in a microcredit setting.
Discriminating between important and less important issues requires an exercise of judgement that is possible only if the auditor understands the MFI's business. Most auditors will have to devote considerable time to learning this business, but this effort should be amply rewarded by saving time that would otherwise be devoted to elaborate testing of items that are in fact less material.
Donors sometimes look at a project with an MFI in the same way they frame their objectives in terms of delivery of a certain quantity of product, usually loans to a given number of beneficiaries.
A donor's intervention with an MFI is framed this way with the purpose of the project to help the institution develop sustainable capacity to deliver financial services to an ever-increasing clientele. Then meticulous tracking of the specific application of the donor's funds and detailed confirmation of compliance with the terms of a lengthy grant agreement are much less relevant to achieving that goal.