Accounting for CDFIs (#385)
/What is a CDFI?
A CDFI is a financial organization that been certified by the U.S. Department of the Treasury to provide affordable loans and financial services to underserved communities. There are actually four types of CDFIs, but I’m going to focus on just one, which is nonprofit loan funds. What they do is issue loans to entities like small businesses, minority-owned startups, and affordable housing developers.
CDFI Accounting Issues
This might sound like a finance topic, but there’s an accounting component to it, as well. The key issue is that the loan fund is making loans into a segment of the economy that’s at higher risk of default. So in addition to the usual accounting, which is recording a note receivable and interest income, the accountant needs to pay a lot of attention to the collectability of those loans. The outcome is usually a fairly hefty loan loss provision.
For the accountant, the loan loss reserve can be a real challenge, especially during volatile conditions when the default risk goes up. Instead of waiting for actual defaults, a CDFI uses a forward-looking model that incorporates macroeconomic indicators like unemployment rates, inflation, and GDP contraction. It then adjusts the reserves as conditions worsen or improve.
On top of that, loans are grouped by risk characteristics, such as the borrower profile or the industry type, and each segment is stress tested using different economic scenarios. In essence, these “what if” models are used to ensure that the reserve is adequate if economic conditions really head downhill.
The goal is to ensure that a CDFI remains solvent and credible, and given its customer base, this is not easy.
And on top of that, the accountant will need to prepare the footnote disclosure for the financial statements. This includes a description of the methodology used to estimate credit losses, and the policy for charging off delinquent loans.
CDFI Funding Sources
Now, let’s talk about funding sources. A CDFI can get cash from three sources, which are grants, program-related investments, and debt.
It used to be quite common for a CDFI to receive grants from the CDFI Fund of the U.S. Treasury, but that group was just fired in early October by the Trump administration – all of them – so that funding source is gone, at least until the next administration comes along. That still leaves a few other sources of grants, which are local governments and foundations.
Keep in mind that a CDFI is a nonprofit, so it records grant funds as contributions. If a grant includes donor restrictions, such as only allowing the money to be used for loans to minority-owned businesses, then it’s recorded by the nonprofit as a net asset with donor restrictions.
Or, a foundation might lend money to a CDFI at below-market rates, which is done to support affordable lending. When this happens, the nonprofit records it as notes payable or long-term debt, depending on what the terms are.
In addition, if the organization is structured as a depository institution, then it also takes in customer deposits, which it can then loan out. These deposits are recorded as liabilities.
Because of the variety of funding sources, a CDFI has to be pretty careful about segregating the funds it receives, where some funds are unrestricted, and some are restricted and have to be monitored to ensure compliance with donor requirements.
CDFI Revenue Recognition
The revenue recognition for a CDFI is a bit different. Part of its revenue comes from interest income on its loan portfolio, but some of it comes from contributed revenue. As I already mentioned, a CDFI might receive a grant from a government or a foundation. When it does, it recognizes the grant as revenue; however, it can only do this when it meets the conditions associated with the grant. For example, a grant might be spread over three years, so the associated revenue can only be recognized over those three years. Or, if the grant requires matching funds from some other source, then there’s no revenue until the matching requirement is met.
Once loans are issued by a CDFI, the accountant then monitors the status of each loan, and can only record an interest income accrual if loans are being paid on time. Once they’re classified as nonperforming, then the accrual has to stop. This is usually when a loan payment is 90 days past due. When a loan is classified as uncollectible, it’s written off against the allowance for loan losses. If a borrower later repays part of that amount, it’s recorded as a recovery, which increases income in the period when the payment was received.