Should financial reporting for Islamic finance be different?

June 29, 2010

a6fa3e5b3359be4eSYARIAH-BASED financial transactions, more commonly known as Islamic finance, have grown in strength and are being accepted beyond their traditional Muslim market. The originally niche solutions to cater for Muslims who wish to participate only in financial transactions which comply with syariah principles are now being offered by traditional financial institutions as far as Europe.

There is no doubt that Islamic finance is growing, moved by promoters in a number of epicentres, Malaysia included. The establishment of the Islamic Financial Services Board, which issues global prudential standards and guiding principles for the Islamic finance industry which includes banking, capital market and insurance sectors, demonstrates the maturity of the industry.

As Islamic finance products become more globalised, the issue whether they should be reported using conventional accounting standards or using a specialised “syariah-compliant” accounting standards becomes something that needs quick resolution.

In 1991 the Accounting and Auditing Organisation for Islamic Financial Institutions or AAOIFI was established to develop accounting and auditing standards for this sector. The thinking behind this was that due to the difference in concepts between Islamic finance and conventional finance, financial transactions based on syariah need to be accounted in such a way to reflect the principles, in harmony with traditional accounting standards. Since AAOIFI was established before convergence became the main stream mantra in accounting standards setting, such an approach was considered appropriate by market participants.

With the establishment of the International Accounting Standards Board (IASB) in 2001 carrying the mission of developing a single high-quality standard for the world, there seems to be some issues pertaining to financial reporting for Islamic finance.

Given that convergence in accounting standards is gaining momentum and the world is looking forward towards having the International Financial Reporting Standards (IFRS) as the ultimate set of standards, should the standards developed by AAOIFI be abandoned and should IFRS be adopted wholesale by institutions offering Islamic finance products for the sake of convergence?

Before contemplating the answer to this question, let us consider some differences between the principles of the financing models.

Essentially, Islam prohibits interests on loan and speculative trading.

The parties in syariah-based financial transactions are supposed to take risks and share profit or loss in transactions backed by productive assets. Due to this, Islamic finance products create different relationship structures between the provider of funds and the user of funds compared to lender and borrower relationship in conventional financing.

All Islamic financial products must go through a validation process by syariah advisers of the institutions intending to issue the products. This is then translated into legal agreements between financial institutions, customers and other related parties, structured based on the types of financing.

Since IFRS is supposed to be free of any ideology (except for the belief that market is always perfect), transactions including Islamic finance would be reported based on the contracts. Additionally, the principle of substance over form has always been applied in conventional accounting. AAOIFI accounting standards provide accounting treatments based on the financial products and additional disclosures deemed necessary in line with Islamic principles. This is perhaps where the risks of divergence between IFRS and AAOIFI standards could appear.

It is quite interesting that IASB and the Financial Accounting Standards Board of the United States (FASB) are in the process of developing a common conceptual framework for financial reporting. This process is ongoing.

If the proponents of Islamic finance sincerely believe Islamic finance should be in the mainstream rather than remaining as a niche sector, the opportunity of being seriously involved in the development of the financial reporting framework should be taken seriously.

Since AAOIFI has done a lot of good work in the area of accounting for Islamic finance, it could engage IASB and argue for Islamic finance to be accommodated in the newly minted framework. The IFSB working model with the Basel Committee on Banking Supervision could be considered by AAOIFI.

What could be the options for the accounting profession and other players in Islamic finance in Malaysia?

Given the competitive environment, Malaysia has to start its own initiative in promoting and positioning Islamic finance into the mainstream of global financial reporting framework.

We have well-established institutions which can be leveraged upon to enhance the understanding and knowledge on financial reporting for syariah-based financial transactions. The International Centre for Education in Islamic Finance (INCEIF) and its sister organisation, the International Syariah Research Academy for Islamic Finance (ISRA), together with universities in Malaysia with Islamic finance interests could be the knowledge-base that could be used by the accounting profession for this purpose.

The Malaysian Accounting Standards Board (MASB) could continue to be the link to IASB while regulators such as Bank Negara Malaysia and the Securities Commission would continue to provide the regulator perspectives on accounting for Islamic finance transactions.

Initiatives similar to the Financial Reporting Standards Implementation Committee (FRSIC) initiated by the Malaysian Institute of Accountants (MIA) can also be considered in moving this forward. This FRSIC-like committee could anchor the work using the IFRS platform and leverage on the resources and input from the institutions mentioned above in determining the way forward and providing input to IASB.

It would also be natural for accounting firms and professional accounting bodies to support such an initiative.

Written by Nik Mohd Hasyudeen Yusoff