The International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) are increasingly becoming the usual accounting framework for Islamic financial institutions. Many jurisdictions that did not adopt the IFRS or AAOIFI standards instead used national accounting standards, often with specific recognition for Shariah compliant transactions. The most developed of these were the Malaysian standards, but Malaysia now uses IFRS. KEN EGLINTON assesses the situation.
Review of 2016
AAOIFI is also working on convergence with the IFRS. As part of this process, during 2010, AAOIFI amended its conceptual framework. The amended framework introduced the concept of ‘substance and form’ replacing AAOIFI’s historical concept of ‘form over substance’. The framework states that it is necessary that information, transactions, etc, are accounted for in accordance with their substance and economic reality as well as their legal form. In contrast, under the IFRS, transactions are generally accounted for in accordance with their economic substance, regardless of their legal form.
It is interesting in this regard to note that in the policy document ‘Financial Reporting for Islamic Banking Institutions’ issued by Bank Negara Malaysia in February 2016, it states that in the event of inconsistency, the Shariah places greater importance on substance than form.
Preview of 2017
IAS 39 has for many years been the principal IFRS standard for financial instruments. In 2014, the IASB issued IFRS 9 to replace IAS 39. While early adoption is permitted, mandatory application is from the 1st January 2018. IFRS 9 contains radical differences from IAS 39. Islamic financial institutions that are not already working hard on a project for implementation of IFRS 9 have left it rather late.
The IFRS 9 projects at conventional banks are concentrated on the new impairment model, with work also being done on classification and hedging. In these areas, Islamic financial institutions are in the same position as conventional banks, so instead of covering those subjects, this article will cover some issues that are unique to Islamic finance.
In very simple terms IFRS 9, to a greater extent than IAS 39, requires equity-type products to be accounted for at fair value while, in most circumstances, permitting basic debt-like products to be accounted for at an amortized cost. Apart from the difficulty and cost of determining fair values, an amortized cost produces less volatility to income statements. Consequently, most financial institutions prefer to use an amortized cost as far as possible.
Sukuk
Prior to 2008, most Sukuk included an obligation by the originator to buy back the Sukuk asset(s) at a future date at a price fixed at the time of the issuance. This fixed price might be quite different from the market value of the asset(s) at that future date. The buyback obligation provided a fixed maturity date and capital certainty to investors. From 2008, it was concluded that this fixed price buyback obligation did not comply with the Shariah principle that risk should be shared equally between partners to a transaction, because the majority of the risk lay with the originator.
Consequently, AAOIFI and others encouraged subsequent Sukuk issuances to be on the basis that the buyback price of the Sukuk asset(s) is not fixed in advance but is at the market value at the date of maturity.
The practice developed that when marketing a Sukuk facility, rather than offering a fixed price buyback, an expected return would be stated, subject to the performance of the underlying asset(s). The originator selected assets with the aim of generating the expected return.
The resultant lack of capital certainty did not affect the accounting treatment for Sukuk, which continued to be mainly at an amortized cost. This is because IAS 39 requires consideration to be given to ‘expected’ cash flows.
IFRS 9, however, refers to ‘contractual’ cash flows rather than expected cash flows. Some argue that this means that without a fixed price buyback, it may be difficult to account for Sukuk at an amortized cost. Sukuk would then have to be accounted for at fair value.
Mudarabah and Wakalah
For many unrestricted investment accounts-type Mudarabah transactions, it may be that the accounting under IFRS 9 will be the same as under IAS 39. However, because the returns can be characterized as profit-sharing, some argue that Mudarabah transactions fail to meet the criteria for an amortized cost, and therefore will have to be accounted for at fair value. The Malaysian Accounting Standards Board (MASB) is lobbying the IASB to obtain greater clarity, and indeed flexibility, so as to ensure that these transactions continue to be accounted for at an amortized cost.
This situation may also be relevant to some Wakalah structures, although Wakalah has not been the subject of lobbying by the MASB.
Conclusion
In 2013, the IASB established a consultative group to focus on challenges that may arise in the application of IFRS 9 to Islamic finance. Unsurprisingly, one of the group’s main conclusions was that for any transaction or product, an analysis of contractual terms is critical. I can only concur.
Ken Eglinton is a partner of financial services at EY. He can be contacted at [email protected].