islamic accounting need or formality

ISLAMIC ACCOUNTING: NEED OR FORMALITYOmar Mustafa AnsariHead of Islamic Financial Services GroupErnst & Young Ford Rhodes Sidat Hyder A member firm of Ernst & Young Global Limited

BACKGROUND AND NEED

8 & 9 February 2011 Islamic Accounting: Need or FormalityBy: Omar Mustafa Ansari

Islam: a deen

► ISLAM, by nature, is not a religion as is understood in general. It is a “Deen”, which stands for a complete way of living.

► It provides us with a complete set of instructions to be followed in the entire life of a Muslim. One should always bear in mind that the matter of being a practicing Muslim duly include the state of adherence to the set of instructions made available to us through the Holy Quran and Sunnah.


Difference in conventional & Islamic accounting

Conventional accounting

► Accounting is defined by the AICPA as: “the art of recording,

classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.“

Islamic accounting

► Islamic Accounting is: “Accounting process which provides appropriate information not necessarily limited to financial data to stakeholders of an entity which will enable them to ensure that entity is continuously operating within the boundaries of Shari’a and delivering on its socioeconomic objectives.”


Emergence of Islamic finance

► Riba Prohibition► Other impermissible

transactions like Gharar► Islamic financial

transactions are primarily based on either or combination of:► trade-based contracts;► lease based contracts;

and ► profit and loss sharing

based, or participatory contracts.


Islamic accounting standard setting

► Most prominent and pioneering effort is that of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Bahrain.

► Islamic Financial Services Board (IFSB) is also a key body; developing risk management, governance, capital adequacy and other relevant standards.

► In Pakistan, ICAP has set up a committee for development of Islamic Financial Accounting Standards.

► It has issued two Islamic financial accounting standard for the following products:► Murabaha (IFAS 1); and ► Ijarah (IFAS 2).

DIFFERENCES BETWEEN ISLAMIC AND CONVENTIONAL ACCOUNTING


Differences in Islamic & conventional accounting

► Following are the fundamental and elementary differences:► Objectives► Type of information dealt

with► To whom it aims the

communication► Uniformity of substance

and form► Time value of money► Fair value vs. historical cost► Additional information needs► Concept of redeemable-

capital / quasi-equity.


Islamic accounting vs. accounting for Islamic finance

► Islamic accounting► for the need of Muslim

user, like information on Halal vs. impermissible income, and information for Zakat etc.

► For general treatments in respect of accounting e.g. time value of money and substance over form, as well as, finance element in different transactions.

► Accounting for Islamic finance► A sub-set of Islamic

accounting► Focusing on accounting

for Islamic financial institutions and Islamic finance transactions (both sides)

DIFFERENT APPROACHES TOWARDS ACCOUNTING TREATMENTS


Two approaches to accounting for Islamic financial transactions

► There are two main approaches to accounting for Islamic financial transactions:► A separate set of Islamic

accounting standards is required.

► International Financial Reporting Standards (“IFRS”) can be applied to Islamic financial transactions, albeit with additional guidance and/or clarification.

► The first approach is predominantly taken by AAOIFI, and the countries adopting the AAOIFI standards.

► Malaysia, which is one of largest and strongest players in the Islamic financial markets, is adopting the second approach.


Time value of money

► On the other hand, if time value of money concept is accepted in accounting for Islamic finance then Islamic banking may no longer be termed as Islamic in its essence.

► In an interest free economic system, the discount rate should always be zero and hence the present value of receivables should be equivalent to their par value.

► This is a fundamental issue.

► There is a view that for the purpose of better accounting, comparability and transparency, the concept of time value of money should be applied in accounting for Islamic finance.


Substance over form

► There is a school of thought amongst accountants that views the substance of Islamic finance transactions different from their legal form.

► It needs to be re-emphasized that Islamic finance products are different in principle and shall be construed as such, as well as, shall be implemented and executed in a manner consistent with their legal form.

► These have to be uniform in substance and form, in line with Shariah.


Purity issue

► In general all Islamic finance transactions, in the infancy phase, have been developed to mimic or replicate the conventional financial products.

► This, on one hand, had make Islamic banking possible, while on the other hand has made it difficult for people to believe that it is Islamic and that it is “different”.

► Attempts at reporting Islamic financial transactions within the parameters of ‘Islamic accounting’ have been made by the AAOIFI, and several standard-setters like Pakistan, have produced their own Islamic accounting standards which are largely based on AAOIFI’s Financial Accounting Standards (“FAS”).


“Finance” element in Islamic finance

► Is financing allowed in Islam?

► Islamic finance experts do not claim to provide financings, instead they claim to provide Shariah compliant alternatives to conventional financing products.

► How to account for the “finance” element in Islamic financial transactions?

► For example, many Islamic financial transactions are based on sales. Thus, there

is an argument that the proceeds from such transactions should be accounted for as revenue from the sale of goods.

► However, in many cases, like Murabaha and Musawwama, payment for the sold item is deferred. Under IAS 18, revenue on a sale of goods is measured at the fair value of the consideration received or receivable. [IAS 18, para. 9].

► Is there a possibility to have some convergence with IFRS?

ACCOUNTING FOR VARIOUS PRODUCTS – A FEW EXAMPLES


Trade based transactions – deferred payment

► How to account for Murabaha transaction from both the seller and buyers perspective?

► If we take guidance from IFRS, then according to IAS 18, IAS 16 and IAS 2, dealing with “revenue”, “property, plant and equipment” and inventories” respectively it is necessary to separately identify and account for the “finance” element.

► Under AAOIFI’s standard, a deferment of profit recognition is allowed, but the sale shall be recognized upfront at the gross invoiced amount and a Dain created by virtue of the same needs to be accounted for at the par value and not the discounted value.

► However, such deferred profit, in principal is like a reserve, rather than liability.


Trade based transactions – deferred payment

► On the purchase side, the issue is slightly different.

► Even if inventory is not recognized at cash equivalent value and include that it needs to be adjusted for NRV, so it needs to be brought down immediately (if the expected selling price net expenses necessary for sale is less) and the difference to be recognized as expense.

► In case of PPE, NRV adjustment is not required but initial measurement at fair value is required.

► The change in treatment can result in comparability issues between the companies that buy PPE on cash with those who buy the same on credit.


Trade based transactions – deferred delivery

► Questions arise in case of transactions like salam and istisna, whether a seller be permitted to recognize the entire sale? Or if the sale and purchase are recognized at the end of the transaction.

► Under AAOIFI’s standard, any amount advanced for Salam should be considered an interest-free advance, carried at par value and the

sale and any profit should be recognized once the goods are actually delivered, sold and delivered to the eventual buyer.


Ijarah

► Must Ijarah be treated as operating lease?

► Ijarah based transactions, in essence are considered to be operating lease because the “risk and reward” is not transferred to the lessee which is also a Shariah condition for the permissibility of such transactions.

► Upcoming treatment► Exposure draft for the accounting

of leases issued by IFSB is bringing in a drastic change by eliminating the concept of operating lease.

► It talks about accounting for a “right to use asset” in all leases at the present value of minimum lease payments.


Deposits / accounts based on participation

► Are they liability or equity?► According to AAOIFI, as the

entity does not guarantee the return of capital contributed.

► Such investment accounts do not constitute a liability under the present Framework which states that “an essential characteristic of a liability is that the entity has a present obligation”.

► If we strictly follow the definition of equity and liability, according to IFRS, we can identify that the same needs to be classified as equity, because they carry the characteristics of equity.

► AAOIFI’s standards further consider that the profit allocation to investment account holders is an allocation of profit and not an expense.


Takaful

► Single accounts or two different sets of accounts?

► According to the AAOIFI standards, two different sets of accounts within the same format of financial statements is required.

► Does the definition of Insurance contracts include takaful?

► Does the scope of IFRS 4 Insurance Contracts include takaful operators?

► It may, however, be appropriate to either require the Takaful operators to prepare separate set of financials for the fund under IFRS – 4, insofar its provisions are not against Shariah principles.

► However, it will not be a solution. Particularly, the Takaful operator is not an insurer, in any form.


Other significant issues

► Accounting for Sukuk► Derivatives and embedded

derivatives► Qard e Hasana ► Profit equalization reserve

(PER) and investment risk reserve (IRR)

► Islamic sale and buy back agreements

► Additional Shariah related disclosures

► Accounting by other businesses

THANK YOU!

islamic accounting need or formality

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