Islamic Finance – The Accounting Challenge

This is the first of a two-part article discussing the peculiarities and nuances unique to Islamic accounting .

Islamic finance is a sub-set of the overall, global conventional financial system. It is not a parallel system to the conventional financial system. Whereas the conventional financial system has been in operation and has evolved significantly in sophistication over the past 300+ years, Islamic finance is relatively new and has been in existence for just over 30 years.
Due to this age difference and practical reasons, the financial markets, banking industry, regulators, tax authorities, investors and general public are all familiar with IFRS (International Financial Reporting System) format which is broadly used for capital adequacy, taxation, investment, credit analysis and industry comparison purposes.

That explains why globally, out of 57 Islamic countries and 10+ non-Islamic countries hosting Islamic finance, only eight jurisdictions viz. Bahrain, DIFC (Dubai), Oman, Jordan, Lebanon, Qatar, Sudan and Syria have made compliance with AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) standards mandatory. Some larger jurisdictions like Malaysia, Indonesia, Pakistan, Saudi Arabia, South Africa and Australia have issued guidelines based on AAOIFI Standards.

Thus, IFRS are the global financial standards of choice and are used or permitted in over 100 countries. They were designed however, with conventional finance in mind and do not recognise the Islamic modes of financing.

Applying IFRS to IFIs (Islamic Financial Institutions) has therefore, led to difficulties in interpretation and ignoring the nuances of Islamic finance principles.

AAOIFI has resultantly addressed this gap and developed standards which accommodate Sharia precepts for recording and disclosure of IFI’s financial transactions

Chairman of the Malaysian Accounting Standards Board (MASB) stated on the subject: ‘We feel that we can use the International Financial Reporting Standards (IFRS) unless someone can show us that there is a clear prohibition in the Sharia, and then we will amend it accordingly. Until such a time, we’ll use the IFRS’.

Islamic Finance Nuances:
There are peculiarities and nuances unique to Islamic finance which are not recognised the same way by IFRS. Some of these are discussed in further detail below.

Time Value of Money for valuation of assets and recognising that money could grow without being employed in trade is not permitted in Islamic finance Among the three traditional functions of money, i.e. being the ‘medium of exchange’; the ‘unit of measurement’ and ‘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, conventional financial system is heavily dependent on money being the store of value not just for pricing assets, but assigning cost and revenue to capital and exchange rates etc.

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

Morabaha for example, is considered buying or selling of asset by AAOIFI, but a mere interest-based financing transaction by IFRS ignoring the underlying asset sale/purchase.

Modaraba: IFRS determines the “Constructive Obligation to return” as Liability status otherwise they are treated as Equity, which is also supported by established practice and regulatory expectations. AAOIFI however splits them as:

Restricted and Unrestricted Investment Accounts (RIA and URIA):
IFRS treats RIAs as “Fund Investments” and hence, they’re booked off-balance sheet. On the other hand URIAs are considered as liabilities. AAOIFI treats them at Mezzanine level between liabilities and equity. For Capital Adequacy purposes, IFSB does not consider them as eligible capital, which is similar to Basle II treatment.

Displaced Commercial Risk (DCR) is a concept unique to Islamic banking and is applicable to URIA and meant to provide competitive returns to Islamic Modaraba depositors. Creation of two reserves for investments made from URIA funds is mandatory under DCR concept:

Profit Equalisation Reserve (PER) – created out of profits before application of Mudarib’s share for the purpose of matching current market returns

Investment Risk Reserve (IRR) – created out of profits after application of Mudarib’s share (Investors’ profits) exclusively for the purpose of absorbing principal losses on investments

AAOIFI treats both reserves as equity under URIA and Mudaribs and under URIA holders’ statement of financial position respectively. Malaysia however treats PER as liabilities for both URIAs and Mudarib’s portions

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

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

Sukuk Assets stay on the books of IFI or SPV. If the latter, SPV is consolidated with parent with respective liability. Valuation is on historical basis rather than fair value of assets.

Islamic Modes of Financing and their Accounting treatment both under AAOIFI and IFRS Given the nuances and peculiarities inherent in Islamic modes of Financing, their accounting treatment under AAOIFI and IFRS is different. These Islamic modes of financing are discussed in further detail in the following paragraphs.

Morabaha transactions
IFRS Treatment:
Contracts are assessed as linked transactions with a net effect of financing. These are classified as financial instrument under IAS 39 (generally loans and receivables) and therefore, their measurement is carried out on amortised cost basis, including consideration of fees, points and discounts etc. Finance income is recognised using effective interest rate method.

AAOIFI Accounting Flow
No accounting entry is needed by IFI upon receipt of a binding / non binding promise to purchase. Upon purchase of asset by IFI, initial recognition of the asset is at its purchase price / historical cost. Accounting for subsequent changes in the value of asset is as follows: If the purchase promise is binding, the asset will be carried at its historic cost unless the decline in value is due to damage.

If the purchase promise is non-binding, the asset will be carried at its net realisable value (NRV). Upon sale of asset by IFI and since IFI sells the goods to the client at cost plus profit basis, Morabaha receivable is recognised at its full value (i.e. Cost+ Profit) . Subsequent to initial recognition such receivable is recognised at its cash equivalent value ie amount due less provision for doubtful debts Morabaha profit is deferred and is off set against Morabaha receivable.

Deferred profit is recognised to income using one of the following two methods:

Proportionate allocation of profit over the period of the credit
As and when installments are received. This method is only allowed, if specifically required by Sharia’ Board.

Delay in payment of Morabaha receivable: If delay is caused by insolvency, the IFI is not allowed to ask for any additional amount by way of penalty. However, if delay is willful, IFI is allowed to claim for the cost of lost opportunity.

Impairment of Morabaha receivable: There is no specific guidance in FAS 2 pertaining to impairment methodology of Morabaha receivables. However, FAS 11 provides guidance on provisions.

Early settlement: In case of early settlement, IFI is allowed to reduce part of the profit. The reduced amount is deducted from Morabaha receivables and excluded from profit recognised for that period.

Discounts from supplier: According to AAOIFI standard, if a discount is received from the supplier, it shall not be considered as revenue and instead it should reduce the cost of goods.

The discount may also be treated as revenue if this is decided by the IFI’s Sharia’ supervisory board.

Modaraba transactions

Initial investment: Initial investment in Modaraba is recognised when paid to Modarib or placed under his disposition and is presented as Modaraba financing. Capital provided in cash is measured by the amount paid or amount placed under disposition of Modarib. In case capital is paid in installments, each installment is recognised when paid.

Measurement of Modaraba Capital: If the capital is provided in the form of non-monetary assets, it is reported as “Non-monetary assets”. Capital provided in kind is measured at fair value of the assets and any difference between fair value and book value is recognised as profit or loss. Expenses incurred are not considered as part of Modaraba capital, unless otherwise agreed by both parties.

Profit and loss recognition: Profits or losses on Modaraba transactions which commence and end during the same financial period is recognised at the time of liquidation of Modaraba.

Islamic Bank’s share of profits on Modaraba financing that continues for more than one financial period is recognised to the extent of profit distribution. Share of profits is recognised as receivable due from the Modarib. Any share of losses is deducted from the Modaraba capital.

Subsequent measurement and termination: Subsequent measurement of Modaraba financing is according to initial recognition less any repayments made by the customer. If whole amount of the capital is lost without any misconduct or negligence of Modarib, the Modaraba shall be terminated and Islamic Bank shall recognise the loss. If the Modaraba is terminated or liquidated and capital and the Bank’s share of profit is not repaid it shall be recognised as receivable (interest-free) due from the Modarib.

IFRS Treatment:

Modaraba 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 method.

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