Islamic Finance & ACCA-KPMG

8/10/2019 Islamic Finance & ACCA-KPMG

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Global alignment: bringing consistency toreporting of Islamic finance through IFRS

ACCOUNTANTS FOR BUSINESS

A joint report from ACCA and KPMG


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Islamic finance (IF) is growingrapidly, worldwide. Many IFinstitutions prefer to report in theprincipal global accountingregime, International FinancialReporting Standards (IFRS) butbecause of the particularcharacteristics and nuances withinIF, many jurisdictions require these

institutions to apply accountingpractices that take into accountthose differences, rather thanpurely applying IFRS.

So how can the financial reportingof Islamic Finance be harmonisedand made more consistent

internationally?

ACCA and KPMG held three high-level roundtables in Malaysia,Dubai and London to address thekey issues and produce a packageof recommendations. This reportsummarises the discussions.

About ACCA

ACCA (the Association of Chartered CertifiedAccountants) is the global body for professionalaccountants. We aim to offer business-relevant, first-choice qualifications to people of application, ability andambition around the world who seek a rewarding careerin accountancy, finance and management.

Founded in 1904, ACCA has consistently held uniquecore values: opportunity, diversity, innovation, integrityand accountability. We believe that accountants bringvalue to economies in all stages of development. We aimto develop capacity in the profession and encourage theadoption of consistent global standards. Our values arealigned to the needs of employers in all sectors and weensure that, through our qualifications, we prepareaccountants for business. We work to open up theprofession to people of all backgrounds and removeartificial barriers to entry, ensuring that our qualificationsand their delivery meet the diverse needs of traineeprofessionals and their employers.

We support our 154,000 members and 432,000 studentsin 170 countries, helping them to develop successfulcareers in accounting and business, with the skills neededby employers. We work through a network of over 80offices and centres and more than 8,400 Approved

Employers worldwide, who provide high standards ofemployee learning and development

About Accountants for Business

ACCAs global programme, Accountants for Business,champions the role of finance professionals in all sectorsas true value creators in organisations. Through people,process and professionalism, accountants are central togreat performance. They shape business strategy througha deep understanding of financial drivers and seekopportunities for long-term success. By focusing on thecritical role professional accountants play in economies at

all stages of development around the world, and indiverse organisations, ACCA seeks to highlight andenhance the role the accountancy profession plays insupporting a healthy global economy.

www.accaglobal.com/ri

The Association of Chartered Certified Accountants,November 2012
http://www.accaglobal.com/accountants_businesshttp://www.accaglobal.com/accountants_business


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GLOBAL ALIGNMENT: BRINGING CONSISTENCY TO REPORTING OF ISLAMIC FINANCE THROUGH IFRS 3

Foreword from Helen Brand

ACCA CHIEF EXECUTIVE

Islamic finance (IF) is a subject dear to ACCAs heart. With many of our members being based in the mainIF centres of Malaysia, Pakistan, Indonesia and the Middle-East, as well as in the UK and Ireland wheremomentum in IF is growing fast, ACCA is keen to be at the forefront of developments in this sector. Wehave incorporated an IF option into our core examination syllabus as recognition of the growingimportance of this area.

We also believe strongly in the importance and the benefits to business of global standards. We were thefirst body to qualify accountants in International Financial Reporting Standards and have carried outresearch projects that have shown that IFRS adoption enhances access to capital and reduces its cost more important than ever in these challenging economic times. Many IF institutions want to reportusing IFRS, but the particular nuances within IF mean that adoption of IFRS is not straightforward. If theseissues are to be resolved, standard-setters and the industry need to work together to ensure that thebenefits of global standards can be fully realised.

We have been very pleased to work with KPMG on this report, and on the three high-level roundtables inKuala Lumpur, Dubai and London on which it is based. We believe that, by bringing experts together inthese markets and collecting their thoughts on the key issues, we have taken the debate forward andhope that the report stimulates fresh thinking among all interested stakeholders. We look forward topursuing its recommendations with regulators and standard-setters.

Helen BrandACCA chief executive

Jeremy Anderson,chairman, Global

Financial Services

Practice, KPMG

Foreword from Jeremy AndersonCHAIRMAN, GLOBAL FINANCIAL SERVICES PRACTICE, KPMG

Islamic finance has huge growth potential, with Muslims representing a significant proportion of theglobal population in all corners of the world. The ethics embedded within Islamic finance fit well with aworld looking for more consumer protection.

At KPMG, we are committed to supporting the growth and development of the Islamic finance market.We were named Best Islamic Assurance and Advisory Services Provider by Euromoney this year for thefifth year running an unparalleled achievement and a demonstration of our firmly rooted commitment tohelping clients meet challenges and respond to opportunities in the industry. We have built up a globalnetwork of experts across KPMG offices to ensure that we meet the increasingly sophisticated and globalneeds of clients operating in the industry.

As Islamic finance continues to develop and mature, international financial reporting needs to develop toaccommodate some of its specific complexities. While international financial reporting standards areincreasingly being adopted all over the world, they pose a particular challenge to Islamic financialinstitutions because they have been specifically designed for conventional finance, not for Islamic finance.

The Financial Stability Board is focused intently on the harmonisation of disclosures, through theExtended Disclosure Task Force, as it continues to help governments and regulators learn the lessons ofthe financial crisis. We need to ensure that the financial reporting of Islamic finance is included in thisharmonisation, balancing the key aims of simplicity, usability, insight and comparability. We are delightedto have worked with ACCA in hosting three high-level roundtables to listen to the thoughts of experts,standard-setters and other key stakeholders in the industry around the world. We are pleased that theseviews and recommendations will develop both the debate and the practice around financial reporting forIslamic financial instruments.


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Some industry observers argue that hadIslamic finance principles been morewidely adopted, the global meltdown infinancial markets could have beenaverted. While it is clear that theinherently conservative discipline thatgenerally underpins Islamic finance wasdistinctly lacking in the centres of theglobal financial crisis, it remains a boldassumption to make. What is moreevident is that Islamic finance hasremained fairly resilient, continuing togrow at unprecedented levels. Thosesustained levels of growth meant that in2011 the global assets managed byIslamic finance reached $1 trillion, ,according to the Banker magazine.

Markets such as Malaysia, the Gulf,

Pakistan and Indonesia continue to beat the forefront of this space.Nonetheless, through innovative andpragmatic regulatory changes, as wellas often ready-made professionalexpertise, the presence of Islamicfinance has become more visible in a

1. Introduction

host of other countries. While the UKand Ireland have been at the forefrontof these, many other non-Islamiceconomies have seen the sustainablevalue in facilitating Islamic finance.

This is reflected in the increasednumber of financial institutions as wellas supportive professional serviceorganisations specialising in andoffering Islamic finance solutions.Similarly, conventional, multinationalfinancial institutions are also offeringShariaa-compliant products in an effortto take advantage of rising marketdemand, alternative investmentopportunities and new means ofaccessing finance.

Islamic financial institutions, whereverthey operate, do so within the sameglobal financial system as theirconventional counterparts and users oftheir financial reports need to makesimilar decisions to those ofconventional banks. Thus for

competitive reasons or rating purposes,it is not surprising that many Islamicfinancial institutions would prefer toreport in the global accountinglanguage of choice, InternationalFinancial Reporting Standards (IFRS).

Islamic finance is, however, by definitiondistinct from conventional finance.Because of the nuances within it, manycountries require their Islamic financeinstitutions (IFIs) to apply accountingpractices that take into account thosedifferences, rather than simply applyingthe IFRS suite of standards.

The fact that institutions can report anddisclose similar transactions in differentways poses problems for those

institutions themselves as well as for thedevelopment of Islamic finance ingeneral. In particular, these relate to theinherent uncertainty created for marketparticipants when assessing andcomparing IFIs with each other and withtheir conventional counterparts.


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In each discussion, participants wereencouraged to share their experiencesand views openly on all aspects offinancial reporting practices pertainingto Islamic finance. In order to givestructure to the discussions, however,participants were also asked to considerand reflect on a series of key questionsof particular interest to the broaderinternational debate.

KPMG and ACCA also recognise thepivotal role that the InternationalAccounting Standards Board (IASB)could play in this process, and arethankful for the support the IASB hasoffered throughout this project, with itsdirector of international activitiesparticipating in the series of debates.

With the spread of IFRS internationallycementing their position as the globalaccounting standards of choice, manycountries where Islamic finance isprevalent have either incorporated IFRSinto their financial reporting frameworksor have committed to doing so. These

include such countries as Indonesia,Iran, Malaysia, Pakistan, Saudi Arabiaand Turkey, many of whom are alsoactive members of the Asian-OceanianStandards-Setters Group (AOSSG). Thisgroup of national standard setters wascreated to look at regional issues in theimplementation and application of IFRSand to lobby the InternationalAccounting Standards Board (IASB)accordingly. Following the first meetingof the group in November 2009, AOSSGhas been at the forefront of attempts toaddress issues relating to financialreporting for Islamic finance.

ACCA and KPMG believe that thisreport, which summarises the keythemes that emerged from the

roundtable discussions, will offer somehigh-level insights andrecommendations to the IASB andother standard setters, to aid thefurther development of policies andpropositions to strengthen the financialreporting of Islamic finance.

SCOPE AND OBJECTIVES

Recognising the growing significance ofIslamic finance and as strongproponents of the overarching benefitsof global standards, ACCA and KPMGfirms have sought to engage withleading experts and stakeholdersinternationally and directly through aseries of round tables in three leadinghubs of Islamic finance: Kuala Lumpur,Dubai and London. These centres haveinfluence throughout the internationalIslamic finance industry, and havealready helped to drive its developmentthrough sound expertise and thoughtleadership. They also offer quite distinctviews on the application of standardsand principles to reporting Islamic

finance.

Delegates at the roundtables includedCFOs, technical experts, lawyers,scholars, auditors, ratings agencies,Islamic and conventional banks, andregulators.


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IFRS are used or permitted in over 100countries around the world because ofthe recognition that they providedecision-relevant information for marketparticipants. Equally, there is littledoubt that these standards weredesigned with conventional finance andoperations in mind, and the needs ofusers akin to dealing with suchinstitutions. Therefore, IFIs and theiraccountants have had to apply them toproducts and transactions for whichthey were not developed. Thisuncertainty has led to differinginterpretations as to how to applygenerally accepted accountingprinciples to IFIs. The Accounting andAuditing Organisation for Islamic

General conceptual issues

It must be established whetherthe users and the objectives of

financial reporting by Islamicfinancial institutions aredifferent from those ofconventional financialinstitutions.

If there is a need to usedistinct Islamic accountingprinciples to provide a faithfulrepresentation of the nature ofIslamic finance transactions,such principles must bedefined.

2. Financial reporting of Islamic finance

Financial Institutions (AAOIFI) haslooked to address this, by establishingreporting standards for IFIs and takinginto account the nuances of Islamicfinance transactions as well as attendingto the needs of users of IFI financialreports. The sphere of influence ofAAOIFI has, however, been limitedhistorically, and even where there is anacceptance of its standards prevalenceamong IFIs, there has not beenuniversal and consistent application ofthese standards. This has been madeeven more complicated by regulatoryrequirements to report under IFRS insome countries that also requireAAOIFI-based reporting.


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KEY INSIGHTS: MATCHINGPRINCIPLES WITH RULES

In general, it was agreed that the usergroups of financial statements for IFIsand conventional financial institutionswere essentially the same. Even so,users of IFI statements would probablyhave additional needs, over and abovethe requirements of users of thefinancial statements of conventionalinstitutions a review of Shariaacompliance being a desired additionalrequirement of many of the roundtableparticipants. Nevertheless, theoverarching sentiment was that for IFIsto remain competitive with theirconventional counterparts, theirfinancial reports needed to be

comparable. Thus in order to competefor the same sources of finance, IFIsacross borders have to be comparable,while domestically and internationally itis vital for analysts to be able tobenchmark and rate them against theirconventional counterparts.

While it was acknowledged that Islamictransactions are different in nature totheir conventional counterparts, it wasstressed that there must be consistencyin their treatment. There was thereforewidespread support for the use of IFRSas the most applicable globallyaccepted set of accounting standards.Panellists were equally in agreementthat additional guidance in relation to

disclosure requirements for IFIs wouldbe particularly beneficial. For example,with regard to conventional institutionsoperating windows offering Islamicfinance, there was concurrence thatpeople who put their funds in windowswould like to see an indication ofperformance; therefore there should beadditional disclosure and transparencyto observe through that window.

This reflects the strong view that Islamicfinance does present unique accountingissues, both to consumers andproviders of Islamic finance products.

On this front, it was clearly evident thatthere was a more pronounced viewfrom some members of the Dubai

roundtable. Some roundtableparticipants stressed the need forfinancial reports to mention specificallythat the business of the Islamic bankreported on is conducted strictly inaccordance with Shariaa rules, andtherefore strongly argued that theaccounting treatments should reflecthow those transactions wereconducted. They argued forcefully thatthe business models of Islamic banksare quite distinct from those ofconventional banks and thereforedifferences in financial reporting wouldbe inherent, firmly believing that theIASB should include a separate set offinancial reporting standards for Islamicbanking.

Nonetheless, the majority of panellistsacross all the roundtables echoed anearlier statement from the chairman ofthe Malaysian Accounting StandardsBoard (MASB) that: We feel that we canuse the International FinancialReporting Standards (IFRS) unlesssomeone can show us that there is aclear prohibition in the Shariaa, andthen we will amend it accordingly. Untilsuch a time, well use the IFRS. Similarly,from a rating agency point of view, theneed for consistency was paramount,and as they and investors are generallymost concerned about who bears theultimate risk while awarding risk ratings.Thus a sound substance over formprinciple, as underpins IFRS, would bemore appropriate than a dual system of

reporting.

In its survey report entitled Accountingfor Islamic Financial Transactions andEntities, AOSSG note that 78% ofrespondents stated that providingdifferent accounting standards forIslamic finance would be incompatiblewith IFRS convergence. Reflecting theviews of other participants at the Dubairoundtable, Dubai was among five

jurisdictions that argued that IFIs couldbe subject to specific requirements forreporting about Islamic financeoperations, while also applying IFRS largely if those additionalrequirements were disclosure related.


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TIME VALUE OF MONEY

The prohibition of partaking in interest-based transactions is central to Islamicfinance. Increasing aspects of financialreporting require the use of discountedcash flows to derive an approximationof a market value. While this clearly initself does not constitute an interestcharge, discounting and time value ofmoney are generally calculated withreference to interest rates, whichcontinues to raise concerns over thecompatibility of IFRS with Shariaaprinciples.

Measuring the time value ofmoney

This debate has a pervasive

impact on transactions in Islamicfinance. For example:

the profit under a murabaha-type sale contract (see Chapter4) could be viewed as beingakin to interest, and thereforeunder IFRS would beaccounted for as interestrevenue

similarly, the resultingcapitalised asset could be

measured at contractual priceor split between finance costs

there can be problems withmeasuring assets and liabilitiesgenerated through Islamicfinance transactions, especiallyin the absence of activemarkets.

KEY INSIGHTS: WHERES THEINTEREST?

The key issue in this respect was arguedto be that of valuing assets andliabilities. The concept of fair value wasagreed to be wholly appropriate as themeans of measuring those assets andliabilities, especially where there wereactive markets and relevant marketprice mechanisms as a means ofbenchmarking those values.

As Shariaa markets are less liquid thanconventional markets, however, therewas a consensus that discounted cashflow models were commonplace as ameans of valuation in the absence of adirect market price, and that using a

base similar to LIBOR (such as theKLIBOR in Malaysia) to value atransaction for accounting purposesshould not necessarily nullify thecontract itself, which itself has beendeemed Shariaa compliant.

On the other hand, it was felt that theaccounting treatment should reflect theway the transaction is set up. Forexample, with a murabaha profit rateswap, the mark-up is apportioned overthe time period; therefore, the use ofthe amortised cost method wherebythe financial cost is a function of thebalance of the principal outstandingand hence decreases with eachinstalment paid would beinappropriate. Even if the cash flowsand pricing were identical to those of aconventional swap, it was agreed thatthe substance of the transaction is notan amortised cost type of operationand the accounting treatment shouldreflect this.

3. Compatibility of IFRS with Islamic finance principles


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SUBSTANCE OVER FORM

A key concept which has historicallybeen incorporated in many financialreporting frameworks is the notion ofsubstance over form, whereby atransaction is measured and reported inaccordance with its economicsubstance rather than its legal form. AsIslamic financial transactions are legallyunderpinned by Shariaa principles, it issometimes argued that it would beinappropriate to apply substance overform to such transactions, because it isthe Islamic legal form that will ultimatelydetermine the accounting treatment.

KEY INSIGHTS: SUBSTANTIALLY THESAME

This conflict is particularly salient whenaccounting for mudaraba-basedinvestment accounts (ie profit-sharinginvestment accounts), profitequalisation reserves and ijara (seeChapter 4) transactions. Insightsrelating to these specific items arediscussed in more depth in the nextsection. However, conceptually, almostall participants were clear that it wascrucial to report on the substance of atransaction to provide the most usefulinformation for users. Although therewere specific transactional issues, it wasimportant to report with this generalpremise to ensure that appropriate

guidance and understanding wereavailable to reassure stakeholders thatthere was no contradiction to theintended spirit of the Islamic financetransaction.


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MUDARABA-BASED INVESTMENTACCOUNTS

Many Islamic financial institutionsoperate a mudaraba-based investmentstructure, which is a popular form ofdeposit mechanism for customers. Thespecific features of these accountscreate a distinct difference betweenthem and conventional depositaccounts, which in turn affects how theymight be reported.

The key features of mudarabainvestment accounts include thefollowing.

All mudaraba investment accountswork on a profit-sharing basis, with

the IFI essentially acting as aninvestment manager.

The down-side investment risk fallson the investor only.

Any assets acquired by the IFI inrelation to the account are ultimatelyowned by the investor with returnsand profits shared on a pre-agreedbasis.

There are two common types ofmudaraba investment account:

restricted investment of money inthese funds by the IFI is restricted toinvestments stipulated by thedepositor, while the IFI shares theprofits or losses of the relatedinvestments once realised, and

unrestricted where the IFI hasunconditional rights to managethose funds without restrictionsimposed by the depositor.

The nature of unrestricted investmentaccounts (URIA) means that they aretreated as a quasi form of equity undersome Islamic accounting standards (eg

AAOIFIs FAS6, Equity of InvestmentAccount Holders and their Equivalent).The fact that any losses in theinvestment are borne by the investorsuggests that the latter is in principle atype of residual claimant or equityinvestor. Nonetheless, the losses couldfall on the IFI were it proved to benegligent, and IFIs increasingly providea trespass or omission guarantee tocustomers. This, coupled with thecommercial necessity faced byinternationally competing IFIs ofabsorbing losses from URIA themselves,

in order to ensure a smoothed return tocustomers, would point to a form ofliability not dissimilar to conventionaldeposits.

In practice, Islamic banks in mostcountries present URIA as liabilities ontheir balance sheets, whether they useIFRS or local GAAP (Malaysia), againreflecting the substance of thearrangements. Only IFIs reportingunder AAOIFI standards tend to reportthem at the mezzanine level betweenliability and equity.

From a prudential standpoint, theIslamic Financial Services Board (IFSB)also does not include any profit-sharing(mudaraba) investment accounts as

eligible capital for capital adequacypurposes, which is similar torequirements under Basel II.

Restricted mudaraba investmentaccounts are in many respects moreakin to a pure investment managementundertaking by the IFI, restricted to thespecific conditions imposed by theinvestors. As the IFI is acting as anagent in a fiduciary capacity for theaccounts, such contracts would betreated as off-balance sheet.

4. Reporting unique Islamic finance transactions


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Treatment of mudarabainvestment accounts

A key point for consideration is

whether mudaraba investmentaccounts represent equity, asthere is no obligation to return,or whether there is a constructiveobligation associated with suchaccounts that make them a formof liability. Other issuesconsidered included:

where the bank is essentiallycarrying out a fundmanagement role, whether itwould be appropriate to keep

such mudaraba accounts offbalance sheet, on the basis ofthe level of control over theseassets and what type ofdisclosure should be requiredin such cases

with regard to measurement ofsuch investment accounts,would this essentially dependon whether the return is fixedor variable?

KEY INSIGHTS: SOMEWHERE IN THEMIDDLE?

The debate on legal form versussubstantive reality was classicallyevident in relation to mudaraba. Therewas unanimous agreement thatrestricted investment accountsrepresent funds under managementand should be kept off-balance sheet. Itwas, however, suggested that thereshould be additional disclosures in thefinancial statements regarding this sideof the business, as embedded inShariaa is the requirement to be astransparent as possible, and disclosefully.

It was noted that unrestricted mudaraba

accounts in general are treated as akinto deposits and shown on the balancesheet as liabilities, as although there isno contractual liability of repayment,

there is a constructive obligation arisingout of established practices andregulatory expectations. Nevertheless,there was some agreement that legallysuch accounts did display elements ofequity instruments. In Malaysia, it wasnoted that the national regulator wasproposing changes to the disclosurerequirements such that elements of theinvestment risk disclosure associatedwith such instruments would in thefuture have to be segregated betweenequity and liability elements.

Others were of the opinion thatunrestricted mudaraba accounts areneither liabilities (as there is nocontractual liability on the IFI) norequity (as the depositor has no voting

rights and is not represented in theBoard), and should instead be classifiedas a separate item in the statement offinancial position under Investor Fundsor any other appropriate name.


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PROFIT-EQUALISATION RESERVES(PERs) AND INVESTMENT RISKRESERVES (IRRs)

Under strict Shariaa rules, if there is aloss from a mudaraba investment, it isthe depositing customer who bears thefull loss. In practice, in suchcircumstances or when the overall profitlevels have been low, as was the caseduring the global financial crisis, IFIshave forgone their own share of profitsto ensure that the depositor receives acomparable market return even ifthere is no legal compulsion to do so.

The IFSB describes this provision ofcompetitive returns as displacedcommercial risk. Principally applied to

URIA, an IFI achieves this risk-sharing byusing reserves set aside from mudarabaprofits.

Profit-sharing reserves are usually oftwo types.

In profit equalisation reserves (PERs),the reserves are set aside fromprofits before applying the profit-sharing distribution. Typically, insuch arrangements, the IFI gives upa part, or its entire share, of profits,in order to match current marketreturns.

In investment risk reserves (IRR), thereserves are set aside from the partof the profits allocated to investors,which can be used only to absorbprincipal losses during a financialperiod.

The accounting for these reservesunder IFRS would depend on whetherthe IFI is deemed to have an obligationto pay depositors from the reserve. Aswas noted in the ACCA report,Harmonising Financial Reporting ofIslamic Finance,1there remains starkinconsistency as to how PERs areaccounted for. This was further echoedin the AOSSG survey, which showedthat of the five countries in the surveythat did have Islamic accountingstandards, Indonesia does not permitPER, some Pakistani IFIs accounted forthem within liabilities, and the others,consistent with AAOIFIs FAS11,accounted for them within equity.

1. http://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-af-hfrif.pdf

Accounting for PERs

A key concern was that in thecase of PERs, in particular, the

IFIs share of the profits isincluded, thereby effectivelycreating an expected lossprovision, and this has in turn ledto inconsistency in how IFIsaround the world account forPERs. Thus participants debatedwhether:

this was a true liability underIFRS, or

it was in fact, simply a

regulatory or presentationissue.


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KEY INSIGHTS: SMOOTHINGEXPECTATIONS

A number of panellists raised concernsabout the concept of the PER,especially in the context of accountingfor such variable rate products.Concerns were also raised about thelevel of awareness that depositors hadabout banks keeping their profits asreserves and who should receive theprofits future depositors or thedepositors to whom the profits belong.

Although there is inconsistency in theaccounting treatment for these types ofreserve across the industry, commonpractice in Malaysia is that both theportion due to the bank and the

depositors share of profits areaccounted for as liabilities. There wasacknowledgement that the treatmenthad evolved as a consequence of theneed for IFIs to achieve a counter-cyclical ability to pay profit to customers

during periods of low profitability. Thetreatment does not necessarily reflectthe loss-sharing concept required underShariaa, with the portion due to thebank in particular perhaps moreappropriately reflected as equity (albeitfrozen equity) or deferred profit.

Given the inconsistency around theapplication of some of the requirementsin IFRS relating to provisions, it wasbroadly agreed that supplementarydisclosure on the nature and risks ofsuch arrangements would be beneficial.Indeed, in Malaysia, the nationalregulator was in the process ofreviewing the PER mechanism, and suchreserves were already being reduced bymany IFIs in anticipation of these

guidelines.

The inconsistency in the classification ofPERs across the industry indicates thisas being an important area whereclearer guidance is required.


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IJARA BITAMLEEK: FINANCE-TYPELEASES

Ijara-based finance structures haveproved to be highly common across theIslamic finance industry. Effectivelyforms of leasing arrangement, Ijaracontracts also come in various forms.The pure Ijara is essentially an operatinglease and there is little conflict inaccounting for this (either for the lessoror the lessee) under the requirementsof IAS17.

Increasingly used forms of leasing byIFIs are the ijara muntahia bittamleek(ijara MB) or ijara wa iqtina, which aresimilar to hire purchase agreementspopular in conventional finance. This is

essentially a form of financing which,under IFRS, is treated as a finance leasebecause, as with a hire purchaseagreement, the risks and rewardsassociated with owning the asset are insubstance transferred to the lessee.Thus under IAS17 the asset would bebooked as such by the lessee, while thelessor (the financer) would book areceivable for the rent and relatedinterest receivable.

By contrast, under both IFAS2 Ijarah(asissued by the Institute of CharteredAccountants of Pakistan) and AAOIFIsFAS8, the legal form of the contract isparamount, meaning that the ownershipof the asset remains with the lessor,until legal title is transferred at the endof the lease period. In this case the IFIwould remain the owner, and record theasset on its balance sheet in the sameway as an operating lease or operatingIjara.

In Islamic finance, the salient featureappears to be the fact that both Ijarahand Ijarah MB are purely leasingtransactions in which the subject matteris the usufruct of the asset (ie the rightto enjoy it even though one does not

own it) and not the financing of theasset, as is the case for a finance lease.Thus it has been argued that given thatthe legal title remains with the lessor,for the accounting to be consistent withthe Shariaa principle, the lessor wouldnecessarily have to account for theleased asset hence the treatmentsunder AAOIFI and other Islamicprinciples-based accounting standards.

Accounting for quasi financeleases

Some commentators take the

view that under Shariaaprinciples, a finance lease shouldbe accounted for as two distinctcontracts the leasingarrangement and the transfer ofthe asset. The key considerationthat was posed to participantswas whether combining the twocontracts would conflict withShariaa principles.


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KEY INSIGHT: LESSER BALANCESHEETS

Again, there was a general acceptancethat the key issue in relation toaccounting for ijara contracts revolvedaround the debate on substance overform. Most panellists agreed that underShariaa principles, a typical ijaracontract with purchase option would beseparated into two distinct contracts,one being an operating leasearrangement and the other being thetransfer (sale) of the asset.

Under current IFRS, although the lessorretains a number of responsibilities ofownership, in most cases the treatmentof ijara contracts would tend towards

that of a finance lease, taking thecontract as a whole. Some panellistsagreed that this was the mostappropriate treatment as the two partsto the contract were inextricably linkedand accounting for them as separatecomponents could result in financialengineering.

Even so, certain panellists raisedconcerns that it would be inappropriate,under Shariaa principles, to combinethe purchase option with the lease, inthe same contract.

Panellists were unclear as to whethercurrent proposals from the IASB wouldfacilitate the resolution of the variousaccounting issues from the perspectiveof IFIs. To some extent, the recognitionof the right of use of an asset wouldappear to fall within the principles ofShariaa and therefore reconciledifferences between IFRS and otherShariaa-based accounting standards.Others argued that the new proposalswould broaden the differences,especially if the asset would need to be

recorded on the lessees balance sheetunder any lease contract.

This was a particular area where it wasbelieved that the Islamic financeindustry needed to do fur ther researchand be more engaged with the IASBsstandard-setting process, or else theindustry could be faced with significantreporting dilemmas.


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SUKUK

As sukuk transactions continue to bethe driving force for Islamic financeglobally, it is imperative that reportingissues relating to sukuk are consistentacross jurisdictions and in generallyaccepted accounting principles. Oftenstructured similarly to conventionalbonds, sukuk represents the holdersright to cash flows arising from abeneficial interest in an underlyingasset.

Recognising and valuing sukuk

Key points for considerationinclude whether the asset shouldbe shown in the books of the IFIor the special purpose vehicle(SPV see below), andappropriate valuation methodsfor sukuk.

Given the approach in IFRS 9,which is based on the businessmodel of the entity, would sukukbe generally measured atamortised cost or fair value?

With secondary markets for sukukstill quite limited, would it beappropriate from a Shariaaperspective to measure at fairvalue using techniques wherediscounted cash flows arerequired (in the absence ofobservable traded prices)?

KEY INSIGHTS: HOW SHOULDSUKUK BE BACKED?

There was agreement that theclassification should be based on thecontractual features and structure ofeach sukuk, and as a result could beoff-balance sheet or on-balance sheet.There are strong indications that inpractice the majority of sukuk areasset-backed (as opposed to asset-based) and are therefore, in principle,essentially a form of financing vehicle,with the intention being to sell the assetto an SPV in order to generate the fundsto pay to bondholders.

Thus the key question arises as towhether it should be just the cash flows

that are accounted for.

In practice, it appears that in mostcases SPVs are consolidated with acorresponding liability booked,suggesting that an asset transfer hasoccurred.

The other major issue was aroundvaluation of sukuk. Given the reality ofhow sukuk are traded many ShariaaSupervisory Boards (SSBs) andindividual scholars insist on theseinstruments being held rather thantraded the sukuk market is relativelyilliquid, which in turn makes valuationbased on a quoted price in an activemarket difficult or less relevant. Usingproxies for measurement again raisedthe debate around using interest-basedinstruments as appropriate surrogatesfor ascertaining a fair value, asdiscussed earlier.

Nonetheless, at the same time it wasargued that in reality the majority ofsukuk, held for trading, are measured at

the price they were sold for - their fairvalue (again owing to a lack ofobservable prices). It was not likely thatthe fair value would be calculated onthe basis of the (proportional) value ofthe underlying asset represented by thesukuk.


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Optimising financial reportingof Islamic finance

The question of howharmonisation of financialreporting for Islamic financialproducts, both by IFIs andconventional banks offeringIslamic windows, can beachieved was posed toparticipants. In particular, theywere asked whether IFIs wouldbenefit from reporting:

within the existing IFRSframework, supplemented by

application guidance and/orthe presentation of areconciliation from IFRS toaccepted Islamic accountingprinciples, or

within the IFRS framework butwith a specific standard forIslamic finance, or

through a globally recognisedsuite of Islamic financialstandards and/or the

presentation of a reconciliationto IFRS.

Ultimately, the majority of panellistsagreed that application guidance withinthe suite of IFRS would be the mostappropriate short-to-medium-termrecourse.

It was also suggested that the IASBshould consider establishing aninternational advisory group, akin to theSME Advisory Group that was set upwhen formulating and reviewing theIFRS for SMEs. This should necessarilyinclude an outreach programme acrossrelevant jurisdictions advising on theapplication of IFRS in the context ofIslamic finance, helping to bridgedifferences in interpretation of IFRSapplication in the industry andaccounting treatment requirements

issued by national regulators.

MOVING FORWARD: THE OPTIMALAPPROACH TO FINANCIALREPORTING OF ISLAMIC FINANCE

Whether it is best that reporting forIslamic finance be carried out within thewider IFRS framework or through aparallel set of globally acceptedaccounting standards for the Islamicfinance industry will depend on theneeds of all stakeholders in theindustry.

KEY INSIGHTS: IFRS FRAMEWORK

It was universally agreed that it wasimperative to recognise that there areimportant and genuine challengesunique to Shariaa-complianttransactions, where the form oftransactions is linked to the basicprinciples underlying them.

All panellists agreed that harmonisationof financial reporting for Islamic financialproducts would ideally be within theIFRS framework. While some believedthat the optimal approach wouldinvolve the issuance of separatestandards, specific to Islamic finance, bythe IASB, the majority were comfortablethat the IASB should consider a

presentation and disclosure standard.Something similar to the formerstandard, IAS30 Disclosures in theFinancial Statements of Banks andSimilar Financial Institutions,could bean ideal way to progress.


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The December 2011 survey conductedby AOSSG, Accounting for IslamicFinancial Transactions and Entities,2noted that IFIs and Islamic windows inconventional financial institutions reportthrough various reporting frameworks,on the basis of their own nationalregulatory requirements. While some ofthese take into account the nature ofthe industry, most are universal acrossentities. With the extension of IFRSglobally, IFIs are increasingly reportingthrough such standards.

The joint ACCA and KPMG roundtablediscussions have clearly revealedwidespread support for the use of IFRSas the most applicable globallyaccepted set of accounting standards.

Nonetheless, panellists were equally inagreement that additional guidance inrelation to disclosure requirements forIFIs would be particularly beneficial.Islamic finance transactions needcareful consideration in terms of howthey are accounted for within an

2. The Asian-Oceanian standard-setter Group

(AOSSG), http://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdf

IFRS-based framework. Finance leasingwas one area where it was argued to beparticularly important for the Islamicfinance industry to conduct furtherresearch and be more engaged with theIASBs standard-setting process. If not,it was stressed that the industry couldbe faced with significant reportingdilemmas.

Although there remain issues aroundmeasurement and recognition thatneed further research and insights,concerns around disclosure andtherefore transparency as to howIslamic finance transactions wererecorded were the overwhelmingpriority from a corporate reportingperspective. For example, many IFIs

reporting under IFRS recogniseunrestricted investment accounts asliabilities, and there is little informationto enable users of financial statementsto distinguish these Shariaa-compliantdeposit accounts from theirconventional counterparts. Hence, the

decision-usefulness of financialinformation for users is diminished.Given ACCA and KPMGs views that theinvestor must be placed at the heart offinancial reporting, this is a crucial issue

There is overarching agreement that forIFIs to remain competitive with theirconventional counterparts, theirfinancial reports need to becomparable. This would enable IFIs tocompete for the same sources offinance, and would enable analysts tobenchmark and rate them againstconventional financial institutions andagainst other IFIs in different

jurisdictions.

Although specific financial reporting

standards such as those propagated byAAOIFI can address unique features ofIslamic finance, it is crucial for the futuregrowth of Islamic finance thatconfidence is garnered across allstakeholders through the consistentapplication of IFRS.

5. Observations and conclusions
http://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdfhttp://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdfhttp://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdfhttp://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdfhttp://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdfhttp://www.aossg.org/docs/Publications/AOSSG_Survey_Report_2011_FINAL_CLEAN_29_12_2011.pdf


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RECOMMENDATIONS FROM THEROUNDTABLES TO THE IASB

The IASB should consider the issuanceof guidance on the application of IFRSwhen accounting for certain Islamicfinancial products, in order to achievegreater harmonisation of financialreporting for Islamic financial productsand services, both by Islamic financialinstitutions and conventional banksoffering Islamic finance windows. Giventhe importance of global standardsmost participants in the roundtablespreferred to retain a single set of suchstandards, consistently applied by allentities, regardless of their being IFIs.

Secondly, the IASB should also consider

the issuance of guidance on additionaldisclosures that could be made for thebenefit of stakeholders seekinginformation on the entitys Shariaa-compliant operations.

Thirdly, the IASB should work withorganisations such as AAOIFI and otherleading Islamic finance bodies tofacilitate gap analysis between IFRSand prevalent Islamic accountingstandards, including the overarchingframeworks and assessment of userneeds. This should also include a reviewof terminology/nomenclature withinIFRS, and consider whether sensitiveterms such as interest can beamended or added to.

RECOMMENDATIONS FROM THEROUNDTABLES TO THE ISLAMICFINANCE INDUSTRY

Advisory group linked to IASBIn the view of many of the roundtableparticipants it is essential that that theIslamic finance industry offersimmediate support to the IASB byforming an expert advisory group,crucially including scholars, from various

jurisdictions, if Islamic finance is to bepart of the IASB agenda. in this space.The group could contribute to the dueprocess for new standards and helpwith the overall review and, oralternatively, provide advice on ad hocbasis.

EducationRecognising the need for greatertransparency and understanding,especially for the investor community,further outreach and education by theIslamic finance industry needs to beconducted and maintained. Providers ofprofessional qualifications should lookinto the relevance of Islamic finance totheir syllabuses and their members.

The regulatorsMost participants felt that the industryneeded to engage more with localregulators to understand theirexpectations of financial reporting andthe disclosure of Islamic financialinstruments.

6. Recommendations


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KUALA LUMPUR, 6 OCTOBER 2010

The meeting was chaired by Mr AzizTayyebi, head of internationaldevelopment, ACCA, and Mr SamerHijazi, director, Financial Services,KPMG in the UK.

Zaiton HassanACCA Malaysia Advisory Committee

Malkit SinghBank Islam Malaysia

Faizal JaffarBank Negara Malaysia

Azril AzmiECS Solutions Sdn Bhd

Wayne Upton

International Accounting StandardsBoard

Dr Shahul Hameed bin M. IbrahimInternational Centre for Education inIslamic Finance (InCEIF)

Abdulwahab AhmadnasriKPMG in Malaysia

Adrian LeeKPMG in Malaysia

Mohammad Faiz AzmiChairman, Malaysian Accounting

Standards BoardMas Sukmawati Abu BakarMalaysian Accounting Standards Board

Zulfa Abdul RahmanMalaysian Institute of Accountants

Ronnie Royston FernandizMaybank Berhad

Ng Kean KokUniversity Tunku Abdul Rahman

DUBAI, 5 MAY 2011

The meeting was chaired by Mr AzizTayyebi, head of internationaldevelopment, ACCA, and Mr PhilKnowles, partner, Financial Services,KPMG in the UAE.

Khairul NizamAOIFI

Shahid AminAl Hilal bank

Thomas JoeAl Hilal bank

Hisham Al MannaiCentral Bank of Qatar

Alaa El Ghazaly

Central Bank of Qatar

Ahmed Fayed Al-GebaliDubai Islamic Bank

Mohammed ShamimDubai Islamic Bank

Noman AliHSBC Bank Middle East Limited

Muzzafar AhmedIslamic Development Bank

Neil MillerKPMG in the UAE

Muhammad TariqKPMG in the UAE

Faisal AnwarKPMG in the UAE

Abdullah AkbarKPMG in Saudi Arabia

Khalid HowladarMoodys

Raza RashidNoor Islamic Bank

LONDON, 5 MARCH 2012

The meeting was chaired by Mr AzizTayyebi, head of internationaldevelopment, ACCA, and Mr SamerHijazi, director, Financial Services,KPMG in the UK.

Richard Martin, ACCA

Ian Welch, ACCA

Mansur MannanDar Capital

Dr Mehmet AsutayDurham University

Mohammad MemonEurope Arab Bank

Sam PereraEuropean Islamic Investment Bank

Arshad Ur-RahmanFinancial Services Authority

Brandon DaviesGatehouse Bank

Simon ArcherIndependent Islamic finance academic

Mushtak ParkerIndependent Islamic finance journalist

Wayne Upton

International Accounting StandardsBoard

Iain CrawfordIslamic Bank of Britain

Andrew VialsKPMG in the UK

Colin MartinKPMG in the UK

Rukaiya RashidaKPMG in the UK

Zimran Fazal

Standard Chartered BankDavid LowethUK Accounting Standards Board

Peter CaseyDubai Financial Services Authority

Appendix 1: The panellists


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Ijara a lease contract

Ijara muntahia bittamleek a lease contract where the lessee has the option to acquire ownership of the asset atany time

Ijara wa iqtina a lease contract where the lessee has the option to acquire ownership of the asset at

end of lease period

Istisnaa contract to manufacture, where the delivery is deferred the sale price may bepayable at spot or deferred

Mudaraba partnership agreement where one partner (Rab al maal) provides the capital and theother (Mudarib) provides the work/management

Murabaha sale of goods at an agreed mark-up

Musharaka partnership arrangement

Riba literally excess, referring to unfair gain: usually synonymous with interest

Salam a contract where advance payment is made for defined goods to be delivered later ata fixed date

Sharia (or Shariah) the rules and underlying principles of Islamic law

Appendix 2: Arabic terms used in this report


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INVITATION TO COMMENT

This report highlights a number of important avenues for determining the future direction of financial reporting ofIslamic finance.

ACCA and KPMG are keen to hear from all stakeholders interested in this subject. If you would like to comment on any ofthe issues raised in this report please contact either Mr Aziz Tayyebi or Mr Samer Hijazi, who are leading this project forACCA and KPMG respectively.

Samer HijaziSamer is a director in KPMGs Financial Services Audit practice. Samer is currently director on theStandard Chartered Bank audit team responsible for the audit of the Wholesale Bank and Islamicfinance. He also works with a number of Islamic retail and investment banking entities in the UKwhere he has provided accounting and advisory services for the past six years. Samer has alsoprovided accounting and quality assurance advice on Islamic financial products and operations toseveral leading conventional global financial institutions with Islamic windows in [email protected]

AzIz TayyebiAziz is head of international development at ACCA, responsible for developing and supporting keygrowth markets for ACCA. Aziz has been at the forefront of extending ACCAs reputation in thefield of corporate reporting and in particular IFRS, and he leads ACCAs work in the field of Islamicfinance, contributing articles and discussion papers on the subject. Aziz has represented ACCA ona number of key international forums such as Jetcos Indo-UK taskforce on accounting, theFederation of European Accountants (FEE) and the CityUK Islamic finance group, as well as addressingconferences internationally on key issues affecting business and the accountancy [email protected]
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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