This is the second of a two-part article discussing the peculiarities and nuances of Islamic accounting.
IFRS Treatment of Musharaka:
Musharaka transactions are classified as financial instrument under IAS 39 (generally loans and receivables) and measured on amortised cost basis, including consideration of fees, points and discounts etc. Finance income is recognised using effective interest rate.
AAOIFI accounting flow:
Initial investment in Musharaka is recognised when it is paid to the partner or made available and presented as “Musharaka financing” in the financial statements. Capital provided is measured at fair value of the assets and any difference between fair value and book value is recognized as profit or loss. Expenses incurred shall not be considered as part of Musharaka capital, unless otherwise agreed by both parties.
Subsequent measurement and profit and loss recognition:
Share in constant Musharaka capital is measured at historical cost. IFI’s share of profits on constant Musharaka financing that continues for more than one financial period is recognized to the extent of profit distribution and Share of losses is recognized to the extent that these are being deducted from Musharaka capital.
If Musharaka transaction commences and ends during the same financial period, profit and losses shall be recognised on liquidation. Share in Diminishing Musharaka (DM) shall be measured at historical cost after deducting the historical cost of any share transferred to partner. The above is also applied on Diminishing Musharaka after taking into consideration the decline in the IFI’s share in Musharaka capital. Disclosure should be made if IFI has made the provision for loss of its Musharaka capital.
For IFI’s preparing their financial statements in accordance with IFRS, Ijara Muntahia Bittamleek should be measured and disclosed in accordance with IAS 17 (Leases).
AAOIFI accounting flow:
Asset shall be recognized upon acquisition in the account as “Investments in Ijara Assets”.
Asset should be measured at historical cost including all expenditures needed to acquire the equipment. Ijara revenue is allocated proportionately to the financial periods in the lease terms and shall be presented as Ijara revenue. Repairs undertaken are recognised as expense.
A provision for repairs is established if repairs are material and differ in amount from year to year.
Ijara muntahia bittamleek:
Assets are booked upon acquisition and reported as Ijara Muntahia Bittamleek (IMB) assets.
Any impairment prior to the end of period is treated as the excess to the fair rental amount and is due to the lessee and charged in the income statement.
Salam and Parallel Salam
IFRS treatment Salam transactions are classified as financial instrument under IAS 39 (Loans and receivables). Both Salam and parallel Salam are treated as linked transactions and net receivable is recognized. They are measured on amortised cost basis and revenue is recognised using effective interest rate method.
Salam financing shall be recognised when the capital of Salam is paid (whether in cash or in kind). The capital is measured by the amount paid or fair value of the asset given in kind.
Subsequently, they are measured at cash equivalent value (i.e. amount paid less impairment).
Parallel Salam shall be recognized when the capital of Salam is received (whether in cash or in kind). The capital is measured by the amount received or fair value of asset received in kind. Subsequently, they are measured at cash equivalent value (i.e. amount received less impairment)
Salam financing transactions are presented as “Salam Financing” in financial statements.
Parallel Salam transactions are presented as “Liability” in the financial statements. Commodity received against parallel Salam is recorded as an asset at historical cost.
Istisna’a and Parallel Istisna’a
Istisna’a costs including direct and indirect costs relating to the contract shall be recognised in an “Istisna’a work in progress” and in case of Parallel Istisna’a “Istisna’a cost” account when payments are made.
When billing is made by IFI to the buyer, the billed amount is booked as “Istisna’a receivable” with corresponding credit to “Istisna’a progress billing”. At period end, Istisna’a profit is calculated by reference to “percentage of completion method”. In the unusual circumstances when the cost-to-complete is unavailable, “completed contract method” should be used.
Income statement is credited with “Istisna’a revenue” (cost + profit), Income statement is debited by “cost of Istisna’a” and difference i.e. profit is debited to “Istisna’a work in progress”. Within balance sheet, Istisna’a work in progress or Istisna’a cost (Parallel Istisna’a) is disclosed net of Istisna’a billing.
In both cases, deferred profits (the difference between the total price and the price received during the construction period) shall be off-set with Istisna’a accounts receivable.
Deferred profits shall be recognised using any of the following methods:
Proportionate allocation (preferred method), or As and when each installment is received.
IFI is required to disclose for Istisna’a / Parallel Istisna’a:
Revenues and profits of Istisna’a contracts recognised in the financial statements Accounting methods used in measuring revenue and profits of Istisna’a for the period Cumulative(actual) cost of Istisna’a work in progress, revenue and profit recognised Amount of retention on contracts in progress Istisna’a receivable and payable, and these shall not be off-set against each other
Disclosure requirements in the notes:
Unsettled claims and any contingent fines Istisna’a contracts signed but not executed and time period these contracts span
Istisna’a and parallel Istisna’a are classified as financial instruments under IAS 39 (generally loans and receivables) and measured on amortised cost basis. Income is recognised using the effective interest method.
The Challenge going-forward
Both IFRS and AAOIFI Standards are mutually exclusive and were designed without consideration for requirements of the other.
AAOIFI standards appropriately recognise the Sharia’ requirements applicable to Islamic modes of financing like Morabaha, Musharaka and Modaraba etc. The financial statements prepared for Islamic Financial Institutions duly complying with the 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 practicing both conventional and Islamic Financial systems), all financial data in AAOIFI format is transformed into IFRS format by the:
Regulators – since they need to produce national financial statistics in IFRS format. Upon periodic receipt of data and reports from Islamic Financial Institutions, they transform their data into 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 fair and equitable system for all tax-payers, need to ignore any anomalies or aberrations created by differences in accounting treatment of financial products and services.
Rating & Credit Agencies – in order to issue ratings, compare results with industry benchmarks and assessing credit worthiness, financial results of IFIs are converted into IFRS format to make them comparable and uniform for analysis purposes.
Basel Rules – for Capital Adequacy purposes because the risk-weighting of assets is considered uniformly for all financial institutions. Hence the results of IFIs need to be recast into 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 carrying on trade by following the recognized Islamic modes of financing. There, the transformation into IFRS may not be required at national level, but 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 General Council for Islamic Banks and Financial Institutions (GCIBAFI) 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 IFRS format and the rest follow the AAOIFI standards, they need to recast their results for consolidation into meaningful global data. For various reasons, availability of this data is always delayed by 2-3 years and loses significance when it becomes available.
The challenge in the way forward is to achieve convergence between AAOIFI and IFRS. KPMG and ACCA project identified the issues and nuances of Islamic Finance through a series of roundtable meetings in London, Dubai and Kuala Lumpur. Their results were made available through a report which highlights the essential nuances of Islamic Finance and incompatibility between AAOIFI and IFRS. More efforts however, are needed to address the differences, find solutions and achieve uniform accounting standards for all financial institutions.