As the microfinance industry gains greater public attention and recognition, microfinance institutions (“MFIs”) are under pressure to provide more transparent financial information either at the request of board of directors and managers or donors and investors. External audits tend to be a traditional and standard answer to solving a financial information assurance problem. However, according to the Consultative Group to Assist the Poor (“CGAP”), there is a gap as to what external audit can/cannot help MFIs achieve and how an external audit is conducted between external auditors and MFIs.

This article aims to provide a brief introduction to external audits, explain its importance to MFIs and general practice in performing audit procedures, and provide tips to help MFIs prepare for external audit, with the intention of narrowing the information gap mentioned above.

What is external audit?
Auditors may sometimes leave the impression that they are a group of people who are always in black and white suits, using abstract jargons and worrying about every cent in the financial statements. Notwithstanding, external auditing is the process by which professional public accountants (who are independent from the organization being audited) perform reviews to express an opinion on whether the financial statements are prepared, in all material respects, in compliance with the General Accepted Accounting Principles (GAAP) and whether these statements are giving a true and fair view of the organization’s financial position and performance. The main components of financial statements include balance sheet, income statement, cash flow statement and additional notes. External auditing also ensures the books of accounts and legal documents are maintained properly and in accordance with the law of business associations.

The wide adoption of auditing can be dated back to the Industrial Revolution, during which period business activities grew exponentially. Companies gradually realized that they needed standard reporting mechanism to record transactions, costs and other operations. Also techniques were requested to help firms detect fraud and maintain financial accountability. Such a need became more critical after corporations entered the capital markets and financial statements became the main resources for investors to make economic decisions.

Generally, public companies are subject to extensive reporting requirements, emphasizing the responsibilities of management and auditors in maintaining effective internal control system and fair financial reporting, audited by external independent Certified Public Accounts (CPA) firms. Private companies, on the other hand, are more flexible to choose whether to be audited or not. Usually many of the private companies choose to be audited for reasons such as tax filing, shareholders’ or potential investors’ request, and loan application, etc.

Why external audit is important for microfinance institutions?
Usually MFIs are not listed companies and there is no regulatory auditing requirement. Also external auditing requires fees for audit services as well as time and human resources to be devoted by the institutions to facilitate audit procedures. So why should we bother? This question can be answered from both benefits enjoyed internally and expectations raised externally.

Whether a private company or a non-profit organization, accounting records are critical to an entity because they capture the entity’s activities using the international business language. The records help management keep track of revenue generated, costs spent, assets accumulated and debts incurred. Management can use the data to improve resource management and maximize the value of the entity. Existing shareholders can have a better understanding about the entity’s operations and make better informed business decisions. On the other hand, external auditors usually perform auditing by analyzing the daily accounting records of the entity and inquiring staff for clarification if there is any confusing or missing information. Such procedures force the entities to maintain clean bookkeeping and to understand every transaction conducted. In addition, auditors review the internal control system before they design an audit approach; and an effective internal control system is actually beneficial for the entity since it mitigates shareholders’ agency problem by reducing the risk from employees’ misappropriation of assets and management’s abuse of authority. According to CGAP, MFIs are particularly vulnerable to some fraud risks, such as inappropriate loan authorization to fraudulent borrowers or phantom loans and kickback schemes or bribes to employees, due to the decentralization structure and limited resources of most MFIs. The involvement of external auditors may not eliminate the chance of fraud, but there is a higher chance of exposing such fraud with external audit procedures that can help control the loss before it is too late.

Outside stakeholders also have expectations for the entities to maintain transparent financial information. For potential investors and borrowers of MFIs, the major source of information before any further conversation is the financial reports provided by MFIs. The financial statements allow investors and borrowers to have a preliminary assessment of the target MFI. Whereas unaudited financial reports provide limited creditability since management is motivated to manipulate the figures for window-dressing purposes, an audit opinion from an independent auditor can provide reasonable assurance and add significant credibility of the financial information.

How do external auditors work?
As mentioned, auditors assess the risk of the entity before they develop the strategy for carrying out detailed audit work. Major audit procedures can include random checks of accounting vouchers and supporting documents, physical observations of assets, and external confirmations to banks/debtors/creditors for balance validation. for example

What MFIs should prepare for external auditing?
So what MFIs should prepare to avoid investing additional energy or resources when auditors knock on the door? First and most important of all, establish and maintain an effective internal control system. The main objectives for such a system are to achieve the effectiveness and efficiency of operations and financial reporting operations, and to ensure the compliance with applicable laws and regulations. The core of an internal control system is the segregation of duties, that is to delegate the functions of authorizing transactions (especially loan granting and payment transfer), recording activities (mainly bookkeeping duty) and custody of assets (e.g. bank account access) to different team members. All those activities and records should be reviewed by supervisors, if any, on a periodic basis. Sometimes, newly established MFIs may have limited staff. In that case, periodic rotation and peer review may be the solution. Regular management review then becomes critical to prevent collusion among employees. Once the internal control is in place, accounting staff can record activities with a true and fair view. Supporting documents such as loan agreements, repayment collection, and expense authorization forms should be collected from relevant departments and kept with accounting vouchers/ledgers in an organized and chronological way. Once MFIs expand their business and accumulate sufficient resources, they may further consider the establishment of internal audit functions to monitor the effectiveness of their internal control system, according to SEEP’s toolkit.

As for the account captions in the financial statements, there is no doubt that auditors will pay extra attention to loan receivables and notes payables. Traditionally, audit confirmations are sent to debtors/creditors to confirm the entity’s receivables/payables balances. In the case of MFIs, usually a large number of borrowers/lenders with limited balance are involved. Auditors may use different audit procedures. But there is one thing certain that auditors will look at is the lending/borrowing terms in agreements with borrowers/lenders to make sure which party will be responsible if there is a default by ultimate borrowers and whether sufficient provision has been prepared in case of default. Auditors may also be interested in the revenue recognition point for each revenue stream since various services are provided by MFIs to different parties at different points of time. In addition, nowadays an array of microfinance transactions is conducted through an online platform, such as lending group. The accuracy, completeness and reliability of data collected by the platform are of particular importance. An IT audit may be proposed to check the data input, processing and output procedures performed by the platform as well as the data integration between the platform and the accounting software.

Though usually entities need to pay certain fees to receive audit services, hiring external auditors is actually an effective way to improve public creditability and internal financial management. These benefits will significantly overweigh the price the entity pays. By: Min Liu, a former auditor with KPMG-Hong Kong.