Times of Oman
Aug 02, 2015 LAST UPDATED AT 01:20 PM GMT
Reporting and disclosure dilemma
February 11, 2013 | 12:00 AM

Islamic finance is a sub-set of the conventional global financial system. It is not a parallel system to the conventional financial system. The conventional financial system has been in operation and has evolved significantly over the last 300 years, whereas Islamic finance is relatively new and has been in existence for just over 30 years.

As a result of this age difference and for practical reasons, financial markets, the banking industry, regulators, tax authorities, investors, and the general public are all familiar with the IFRS (International Financial Reporting System) format, which is broadly used for capital adequacy, taxation, investment, credit analysis, and industry-comparison purposes.

This explains why, globally, out of 57 Islamic countries and more than 10 non-Islamic countries hosting the Islamic finance system, only eight jurisdictions — Bahrain, DIFC (Dubai), Oman, Jordan, Lebanon, Qatar, Sudan, and Syria —h ave made compliance with Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) standards mandatory. Some larger jurisdictions, such as Malaysia, Indonesia, Pakistan, Saudi Arabia, South Africa, and Australia, have issued guidelines based on AAOIFI standards.

Thus, the IFRS is the global financial standard of choice and is used or permitted in more than 100 countries. It was designed, however, with conventional finance in mind and does not recognise Islamic modes of financing.

Applying the IFRS to Islamic financial institutions (IFIs) has, therefore, led to difficulties in interpretation that ignore the nuances of Islamic finance principles.  AAOIFI has addressed this gap and developed standards to accommodate Sharia precepts in the recording and disclosure of an IFI's financial transactions.

The chairman of the Malaysian Accounting Standards Board (MASB) spoke on the subject: "We believe that we can use the IFRS unless someone can show us that there is a clear prohibition in the Sharia', and then we will amend it accordingly. Until then, we'll use the IFRS."

Islamic finance nuances
There are peculiarities and nuances unique to Islamic finance that are not recognised in the appropriate way by the IFRS. Some of these issues are discussed in further detail below.
The concept of assets increasing in value over time and the idea that money can grow in value without being used in trade are not permitted in Islamic Finance.

Among the three traditional functions of money, that is, as a "medium of exchange," a "unit of measurement," and a "store of value," only the last function is not recognised in Islamic finance. Money does not beget money in Islamic Finance. On the other hand, the conventional financial system is heavily dependent on money being used as a store of value not just for pricing assets but also for assigning cost and revenue to capital, exchange rates, and so on. 

Islamic Sharia recognises modes of financing in Islamic finance that are based on assets, trade, or sale contracts. AAOIFI standards provide recognition to those forms and modes of financing and prescribe an appropriate accounting treatment. The IFRS, on the other hand, ignores the form in favour of the substance and treats Islamic modes of financing by drawing a parallel to their financial equivalents in conventional finance.

Morabaha, for example, is considered the "Buying or Selling of Assets" by AAOIFI, but a mere interest-based financing transaction under the IFRS ignores the underlying asset sale/purchase.

Modaraba: The IFRS considers the "Constructive obligation to return" to be a liability status; otherwise the item is treated as equity, which is also supported by established practice and regulatory expectations. AAOIFI, however, splits them into Restricted and Unrestricted Investment Accounts (RIAs and URIAs).

The IFRS treats RIAs as "Fund Investments," and hence, they're booked off the balance sheet. On the other hand, URIAs are considered liabilities.

AAOIFI treats them at the mezzanine level between liabilities and equity. For capital adequacy purposes, the IFSB does not consider them to be eligible capital, which is similar to the Basle II treatment.

Displaced Commercial Risk (DCR) is a concept that is unique to Islamic Banking and is applicable to URIAs. It is meant to provide competitive returns to Islamic Modaraba depositors. The creation of two reserves for investments made from URIA funds is mandatory under the DCR concept:

1. The Profit Equalisation Reserve (PER) is created out of profits before the application of Mudarib's  share for the purpose of matching current market returns.

2. The Investment Risk Reserve (IRR) is created out of profits after the application of Mudarib's share (investors' profits), exclusively for the purpose of absorbing principal losses on investments.

AAOIFI treats both reserves as equity under URIAs and Mudarib's shares and under the URIA holders' statement of financial position. Malaysia, however, treats PER as liabilities for both URIAs and the Mudarib's portions.

The IFRS allows provisions and reserves on an incurred loss basis only (not on expected losses).

Ijara Muntahia Bittamleek (IMB): The IFRS treats this as a finance lease because the title of ownership of the asset stays with the lessor and remains on the lessor's balance sheet. AAOIFI, on the other hand, considers it to be Ijara (an operating lease) with a separate agreement for the lessee to buy the asset at the end of the lease period.

Under sukuk, assets stay on the books of the IFI or SPV. In the case of the latter, the SPV is consolidated with the parent with the respective liability. Valuation is on a historical basis rather than on the fair value of assets.

Challenge going forward
Both the IFRS and AAOIFI standards are mutually exclusive and were designed without consideration of the requirements of the other.

AAOIFI standards appropriately recognise the Sharia' requirements applicable to Islamic modes of financing such as Morabaha, Musharaka, and Modaraba. The financial statements prepared for IFIs duly complying with AAOIFI standards, therefore, represent the true nature and spirit of Islamic transactions.

The stakeholders and users of information in this format benefit conceptually but not practically.

Practically, in all countries practicing a dual system (recognising and practising both conventional and Islamic financial systems), all financial data in the AAOIFI format is transformed into the IFRS format by the following:

• Regulators — Since they need to produce national financial statistics in the IFRS format. Upon periodic receipt of data and reports from IFIs, they transform their data into the IFRS format for consolidation with the rest of the industry, preparing their own financial statements and producing national financial statistics.

•Tax Authorities — In order to ensure a fair and equitable system for all taxpayers, they need to ignore any anomalies or aberrations created by differences in accounting treatments of financial products and services.

• Rating & Credit Agencies — In order to issue ratings, compare results with industry benchmarks, and assess credit worthiness, the financial results of IFIs are converted into the IFRS format to make them comparable and uniform for the purpose of analysis.
• Basel Rules — For capital adequacy purposes because the risk-weighting of assets is considered uniformly by all financial institutions. Hence, the results of IFIs need to be recast into the IFRS format to measure their capital adequacy requirements.

Sudan is the only country where a single (Islamic finance) system exists, and AAOIFI standards are mandatory for all banks, insurance companies, and other companies conducting trade by following the recognised Islamic modes of financing. There, the transformation into the IFRS may not be required at the national level, but it may still be necessary for international dealings between financial institutions and other companies seeking credit lines or correspondent banking relationships.

Another practical difficulty is highlighted by the General Council for Islamic Banks and Financial Institutions, based in Bahrain. One of their mandates is to generate global data for Islamic banks and other financial institutions. Since most IFIs prepare their financials in the IFRS format and the rest follow AAOIFI standards, the IFIs need to recast their results for consolidation into meaningful global data. For various reasons, the availability of this data is always delayed by two to three years and loses significance when it becomes available.

The challenge in the way forward is to achieve convergence between AAOIFI and the IFRS.

The KPMG and ACCA projects identified the issues and nuances of Islamic finance through a series of roundtable discussions in London, Dubai, and Kuala Lumpur.
Their results were made available through a report that highlights the essential nuances of Islamic finance and the incompatibility between the AAOIFI standards and the IFRS. More effort is needed to address the differences, find solutions, and achieve uniform accounting standards for all financial institutions.

*Khalid Yousaf is an expert in Islamic banking and Director (Islamic Finance Advisory Services) of KPMG in Oman

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