SAAD NAQI KHAN questions how investors report transactions under Islamic finance in different parts of the world, and discusses the challenges faced by Islamic financial institutions in adopting Islamic accounting standards.
Islamic financial institutions (IFIs) are operating within the same financial system as their conventional model market players and users of their financial information are required make similar decisions to those of conventional banks. Therefore, for competitive reasons, some IFIs are more prone to report using global accounting standards like IFRS.
IFIs are fundamentally different from their conventional counterparts. Many countries require their Islamic banks to use accounting standards that take into account those differences rather than merely applying the more neutral International Financial Reporting Standards (IFRS) suite of standards. This is usually seen in Europe and some Middle East countries.
Institutions are reporting similar transactions in different ways, posing a significant problem for them and for the development of Islamic finance.
To combat the above issue, AAOIFI was founded in 1991 and issued 26 accounting standards for IFIs.
Key issues for consideration
A recent report shows that a several reporting frameworks currently prevail across the industry. However, many regulators use IFRS, while some use partly IFRS-based standards, some use IFRS with additional modified requirements for Islamic banks, and others use standards solely for Islamic banks. The latter is rarely seen, however, as only Qatar and Bahrain have adopted full AAOIFI-based standards.
A key question emerges as to whether IFIs would benefit from reporting within the existing IFRS framework but with an additional standard for Islamic finance, through a globally recognized suite of Islamic financial standards.
The issuance of Islamic financial accounting standards does not solve the problem but simply provides an additional layer of complexity on how to adopt these standards. This requires in-depth knowledge,which can be taken from Islamic financial advisors to assist IFIs in applying the relevant standards.
Before getting into the challenges faced by IFIs in this adoption, it is important to look into accounting frameworks adopted by countries where major Islamic institutions exist.
As depicted in Table 1, different accounting standard are used by IFIs in different parts of the world,creating several challenges for IFIs to grow and to allowing users to compare the information geographically.
Potential issues
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Lack of harmonization of accounting standards
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Substance over form
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AAOIFI to promote accounting standard and certification course
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IFRS framework contradicts Islamic accounting principles
Lack of harmonization of accounting standards
In several countries, the accounting standards used by IFIs are independent of their status as an IFI, with IFRS being the primary set of standards. It is usual practice that banks are required to use IFRS and also conform to specific local reporting requirements, pertinent to IFIs. Only two countries, Bahrain and Qatar, require their IFIs to use AAOIFI standards, named as the Islamic Financial Accounting Standard (IFAS) in its entirety.
Countries including Pakistan and some Asian Countries primarily require use of IFRS or national accounting standards based on IFRS, but also require the application of specific Islamic finance standards, as issued locally by the regulator.
It is evident that multinational conventional banks that offer Islamic finance through window operations will report according to their local requirements. IFRS is the most common form of reporting mechanism. Using different accounting standards for reporting similar transactions presents significant challenges for the comparison of information across the industry.
Substance over form
IFRS is focused on a strong framework of principles that consider the economic nature of transactions, whereas in Islamic finance the contractual aspect of the transaction is pivotal for Shariah compliance. Further contracts under Shariah principles (such as Mudarabah, Musharakah, Murabahah, Istisnah and Salam) are distinctive to the industry and have different rights and obligations associated with them, therefore organizations operating within the ambit of an Islamic framework need to adopt AAOIFI standards.
Lack of seminars on accounting standards and certification courses
To adopt Islamic Financial Accounting Standards (IFAS) there is a greater need for market participants to get updated and receive training on the application of Islamic financial accounting standards. Therefore, AAOIFI along with training partners should periodically conduct training to promote the cause. AAOIFI has already taken an initiative with Ernst & Young to introduce a software certification program for the Islamic banking industry. AAOIFI recently also launched Islamic accounting and Shariah certificates but there is a greater need of scholarship schemes to attract potential; along with more candidates to obtain that certification and work towards Islamic finance.
IFRS framework contradicts Islamic accounting principles
One of the basic pillars of Shariah compliant finance is the prohibition of dealing in interest (Riba). Interest in the conventional system supports the theory of time value of money. This concept is central to IFRS, which allows users to evaluate the ability of an organization to generate cash and cash equivalents in the future often require the use of discounted cash flow (DCF) technique to measure assets and liabilities.
Many IFIs clearly prefer to use DCF techniques when calculating variables for impairment testing and valuation techniques for their financial instruments measured at fair value.
However, the relevant paragraph of the AAOIFI Shariah standard on Mudarabah clearly states:
“In measuring receivables, neither time value (interest rate) nor discount on current value for extension of period of payment shall be taken into consideration.”
IFIs are an economic reality, so responsibility rests on every individual associated with the institution or in any other capacity to promote Islamic finance. AAOIFI should work with Islamic finance experts directly to promote the adoption of accounting standards and streamline them to promote harmonization and enhance international adoption.
Saad Naqi Khan is the senior auditor in Internal Audit and Business Risk Review Department at Meezan Bank. He can be contacted at
[email protected]
.