Accounting for Islamic finance

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08 Nov 2012

The Malaysian Accounting Standards Board (MASB) has published a two-part staff-prepared paper discussing Islamic finance, accounting treatments for various Islamic finance instruments, and the reasons why the MASB chose to require Islamic financial institutions to follow Malaysian Financial Reporting Standards, which are equivalent to IFRS. The paper concludes with a call for the IASB to consider Islamic accounting issues.

The two part paper, prepared by the MASB staff and which contains views that "do not necessarily represent the official views of the MASB", provides an overview of Islamic finance and its origins in the modern global economy before exploring various accounting issues.

The first part of the paper explains the background to many Islamic finance transactions, describing them as characterised by the use of trade contracts instead of loans, and that the subject of trade must usually be a tangible item or a permitted intangible.  Sharia'a law matters such as not charging interest on loans, prohibited items of trade and related considerations are also discussed.

The paper then goes on to compare and contrast the treatment of Islamic finance under standards produced by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and IFRS.  The paper observes that "historically, AAOIFI has been less welcoming to two key concepts in IFRS: substance over form and time value of money".

In relation to substance over form, the paper notes that "[a]lthough Islamic and conventional finance greatly differ in philosophy and in legal form, the former is often structured to provide the same economic effect as the latter" and provides examples of accounting for the same instrument under AAOIFI and IFRS.

The first part of the paper concludes on the issue of using IFRS as follows:

In MASB’s opinion, information on the economic effect is as valuable as, if not more than, information on the legal contractual form. Despite their contractual differences, many Islamic finance products are meant to replicate the economic effect of conventional products. Thus the MASB is more congenial to IFRS recognition and measurement bases which emphasise the economic substance of transactions. The MASB understands that the form of contract is also important from an Islamic perspective, and hence also encourages appropriate disclosures (which may include disclosures recommended by AAOIFI) to highlight adherence or departure from Shariah and to differentiate between Shariah-compliant and conventional contracts that are recognised and measured in a similar manner.

This reasoning, together with concerns about the AAOIFI standards being "designed for specific uses of limited types of contracts" and that "having separate Islamic standards could create undesirable opportunities for arbitrage and abuse", led the MASB to provide no exemption for Islamic financial institutions under MFRS.

The second part of the paper provides an analysis of some of the current topics in applying IFRS to Islamic transactions.  It covers:

  • Islamic leasing (ijarah), both under IAS 17 Leases and the IASB's project on leases, noting the current approach of usually classifying such arrangements as 'operating leases' will rarely achieve off balance sheet treatment
  • Islamic deposits (based on mudarabah and wakalah), which are commonly presented as a liabilities (effectively a deposit), but which the Malaysian central bank, Bank Negara Malaysia, is encouraging to be treated as an 'investment account', which may be treated off balance sheet, but may potentially be consolidated under IAS 27 or IFRS 10 in some cases
  • Islamic insurance (takaful), where the issue arises of how to account for qard, an interest-free loan that a takaful operator extends to its participants’ funds, as to whether it should be accounted for under IAS 39, treated as akin to an investment in a subsidiary under IAS 27, or simply expensed.

The second part of the paper concludes that it is "cause for concern" that these issues are being dealt with within the Malaysian context with little IASB involvement and that "MASB staff believe it is high time that the IASB itself tackle Islamic financial reporting issues".

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