Mezbah Uddin Independant Scholar Romzie Rosman International Shari’ah Research Academy for Islamic Finance
Malaysia pioneered the Islamic finance industry in many ways. Islamic banking, takaful, or sukuk, the country perpetuates to maintain its leading position in terms of market share and market growth. According to the forthcoming Global Islamic Finance Report 2015, Malaysia is maintaining its second position on the Islamic Finance Country Index (IFCI), second to Iran. With US$249 billion Islamic financial assets (both in the formal and informal sectors) at the end of 2014, the country has grown its Islamic banking and finance market with an average annual rate of over 20% between 2007 and 2014. The same report forecasts, Islamic banking assets of Malaysia will reach US $643 billion in 2019. Bank Negara Malaysia, the central bank of the country, aims to boost Islamic banking market share in local market to 40% by 2020, currently which stands at 20.7%. In takaful sector, Malaysia emerged as the world’s largest family takaful market. In terms of gross takaful contribution, however, Malaysia comes in the second position, only lagging behind Saudi Arabia, by representing 21.55 of forecasted total gross takaful contributions for 2014. The prospects for takaful industry in Malaysia are bright, with 22% growth rate.
In sukuk issuance, Malaysia is an unparalleled global leader. Since 2012, the country’s share of new sukuk issuance has consistently been more than 60%. MIFC Insights reported in 2013 that Malaysia’s market share of global sukuk issuance was 69%.
The rapid growth and the optimistic outlook of the Islamic finance industry in Malaysia have been made possible because of its comprehensive Islamic financial system that is supported by strong regulatory, legal, and Shari’a governance frameworks. The enactment of Islamic Financial Services Act 2013 (IFSA) is a great leap ahead for Malaysian Islamic financial industry. Malaysia is among the countries that have well developed Islamic financial system that promotes the development of the industry. To be the global hub and the leader of Islamic finance is in its national agenda. Malaysia frequently hosts international events welcoming leading Shari’a scholars and industry practitioners. The country is also the founding member and the host country of Islamic Financial Services Board (IFSB) that sets international prudential standards and guiding principles to promote and enhance the soundness and stability of Islamic financial services industry.
Nonetheless, amidst all of the achievements, challenge remains on adoption of unanimously accepted financial reporting standards that must address the unique nature of Islamic financial instruments.
Islamic finance refers to a system that complies with the rules of Shari’a, also known as Islamic law. The underlying philosophy of Islamic financial instruments is fundamentally different than the traditional financial instruments. For instance, Islamic banking instruments are entrepreneurship and trade driven which results risk and profit sharing between the provider of fund (investor) and the user of fund (entrepreneur). In contrast, traditional banking instruments are purely lending and borrowing arrangements whereby the borrower pays interest to the lender based on the amount and duration of borrowing. The differences in philosophies raise the question whether it is appropriate for Islamic financial institutions to apply the same set of accounting standards that In recent years, there have been significant initiatives taken towards international convergence of a single set of financial reporting standards. The single set of standards aims to enhance comparability and understandability of the financial statements, and increase cross-border investments. The convergence initiatives are being steered primarily by the International Accounting Standards Board (IASB) – the issuing body of International Financial Reporting Standards (IFRS). Many international organisations, including the G20, World Bank, IMF, Basel Committee, International Organization of Securities Commissions (IOSCO), and International Federation of Accountants (IFAC) has been publicly supported the convergence projects. At present, 114 jurisdictions in the world require IFRS-based financial reporting for all or most of their listed companies and financial institutions.
Effective from 1st January 2012, non-private entities in Malaysia are required to apply Malaysian Financial Reporting Standards (MFRS), which is identical to IFRS, in preparing their financial statements. This brings Islamic financial institutions in Malaysia under provisos of IFRS. Alongside Malaysia, the biggest Islamic finance markets, such as Saudi Arabia and Dubai, also require or permit IFRS-based financial reporting for Islamic financial institutions.
IASB adopted a principle-based approach in developing its financial reporting standards. The Malaysian Accounting Standard Board (MASB) is of the opinion that MFRS can be applied for Islamic financial instruments without entailing any difficulty, and the application of MFRS in financial reporting also apply for traditional financial institutions.
In recent years, there have been significant initiatives taken towards international convergence of a single set of financial reporting standards. The single set of standards aims to enhance comparability and understandability of the financial statements, and increase cross-border investments. The convergence initiatives are being steered primarily by the International Accounting Standards Board (IASB) – the issuing body of International Financial Reporting Standards (IFRS). Many international organisations, including the G20, World Bank, IMF, Basel Committee, International Organization of Securities Commissions (IOSCO), and International Federation of Accountants (IFAC) has been publicly supported the convergence projects. At present, 114 jurisdictions in the world require IFRS-based financial reporting for all or most of their listed companies and financial institutions.
Effective from 1st January 2012, non-private entities in Malaysia are required to apply Malaysian Financial Reporting Standards (MFRS), which is identical to IFRS, in preparing their financial statements. This brings Islamic financial institutions in Malaysia under provisos of IFRS. Alongside Malaysia, the biggest Islamic finance markets, such as Saudi Arabia and Dubai, also require or permit IFRS-based financial reporting for Islamic financial institutions.
IASB adopted a principle-based approach in developing its financial reporting standards. The Malaysian Accounting Standard Board (MASB) is of the opinion that MFRS can be applied for Islamic financial instruments without entailing any difficulty, and the application of MFRS in financial reporting of Islamic financial institutions does not sanctify or nullify the Shari’a validity of Islamic financial transactions as financial reporting is a recording function only. Therefore, MASB argues, development of a separate framework for Islamic financial institutions is not essential (AOSSG, 2010). On the other hand, the Bahrain-based accounting standard setter for Islamic financial institutions – the Accounting and Auditing Organisation for Islamic Financial
Institutions (AAOIFI) – established differences in objectives of financial reporting between an Islamic bank and a traditional “Western model” bank, and reasons that the accounting standards developed for traditional banks may not be relevant for Islamic banks. AAOIFI states in its objectives and concepts of financial accounting standards:
- Islamic banks were developed on a foundation that does not permit the separation between temporal and religious matters.
- Those who deal with Islamic banks are concerned, in the first place, with obeying and satisfying Allah in their financial and other dealings. So, the information need differs from the traditional banks.
- Islamic banks must comply with the principles and rules of Shari’a in all their financial and other dealings. The functions of Islamic banks are significantly different from those of traditional banks.
- The relationship between Islamic banks and the parties that deal with them differ from the relationship of those who deal with traditional banks.
Islamic Finance Working Group of the Asian- Oceanian Standard-Setters Group (AOSSG), which is led by the MASB, in its 2010 research paper identified two key accounting principles that challenge IFRS-based financial reporting for Islamic financial instruments: (i) the substance over form; (ii) and the notion of time value of money.
- Substance over form
In IFRS-based financial reporting, transactions are recorded based on their substance and economic reality. The Conceptual Framework of IASB explains, “in assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form” (Para 4.6). If substance over form applies in recording of Islamic financial transactions, there will be no likely difference in the recording of a Shari’a-compliant trade or equity-based financing and a traditional loan financing; hence, raises question whether IFRS-based financial reporting can reflect the true nature of Islamic financial instruments.
- Time value of money
The notion of effective interest rate applies in IFRS-based financial reporting even when a financial arrangement is interest-free; this is due to the traditional wisdom of time value of money. For example, in IFRS-based reporting, at initial recognition, receivables from a murabaha deferred payment sale is recorded after discounting future cash flows to present value; the difference between the discounted amount and the nominal value is recorded as interest revenue over the period receivables amount pays back (IAS 18: 11). The concept of time value of money and application of effective interest rate raises two concerns for Islamic financial institutions. First, unwinding of receivables discounting imitates traditional interest-based financial arrangements and results recognition of notional interest revenue.
Second, according to Shari’a, money does not have a time value aside from the value of goods; thus assigning a notional time value for deferred cash flows conflicts the requisites of Shari’a.
MASB has had a project on Islamic financial reporting and geared towards formulation of a separate set of standards for Islamic financial institutions, but subsequently distanced itself from that objective.
Taking account of the concerns, IASB has set up an Islamic finance consultation group in 2013 to find ways to address financial reporting issues related to Islamic financial instruments. However, IASB has yet to come-up with a work plan and timeline addressing its agenda in this regard.
AAOIFI issued twenty-six accounting standards pertaining a number of Islamic financial instruments. The accounting standards developed by AAOIFI are driven by principles of Shari’a and addresse the disparate nature of Islamic financial instruments.
The disclosure requirements stipulated by AAOIFI standards are unique to Islamic financial institutions and its instruments, which is absent in IFRS. Nevertheless, AAOIFI standards are not robust and comprehensive enough to deal with every aspect of Islamic banking transactions. Consequently, a recent (2013) survey conducted by Islamic Finance Working Group of AOSSG reveals that in some jurisdictions where Islamic financial institutions apply AAOIFI accounting standards as primary standards, they also apply IFRS in financial reporting in cases where AAOIFI is silent.
Survey respondents from Bahrain, Lebanon, and Oman commented that the traditional financial institutions in their jurisdictions apply IFRS, whereas the Islamic financial institutions apply AAOIFI accounting standards. In UAE, though, where IFRS is mandatory, Islamic financial institutions can still apply AAOIFI accounting standards based on permission from regulators.
An earlier survey conducted by AOSSG in 2011, where twenty-four standard-setters from around the world participated, reveals that the Islamic accounting standards applied by Islamic financial institutions globally are not a homogenous set of standards. Islamic accounting standards in some jurisdictions are similar to IFRS, whereas in some others similar to AAOIFI standards. Some jurisdictions have locally developed Islamic accounting standards that may or may not be based on AAOIFI standards. Pakistan, for example, developed standard on murabaha independently, but taking AAOIFI standards as a base; whereas it developed the standard on ijara based on IAS 17 Leases. Indonesia, as another example, develops its own Islamic accounting standards, and do not use AAOIFI as a base. The different Islamic accounting standards practiced in different jurisdictions may result markedly different requirements for similar Islamic finance transactions. Hence, the key challenge remains as to concur on a single set of high-quality financial reporting standards to present increasingly complex Islamic financial instruments that give a true and fair view by taking account of Shari’a precepts, as well as meet the information needs of the users who are particularly acute on disclosures pertaining Shari’a aspects of the instruments and the Islamic financial institution operation.
The government of Malaysia have been taking initiatives to boost investments in country’s Shari’a complainant financial instruments. This advances the issue of addressing the peculiarity of Islamic financial instruments in financial reporting. A complete and sole adoption of IFRS is not the widely-accepted solution as many argues against its compatibility for Islamic financial instruments. Developing a complete separate set of standards for Islamic financial institutions will require a long span of time, therefore not a practical alternative in the short run. The approach of Bahrain can be a convenient solution at the initial stage; that is to apply AAOIFI accounting standards as the primary set of standards for financial reporting of Islamic financial instruments, and apply IFRS where AAOIFI standards are silent. An alternative way ahead can be development and inclusion of dedicated IFRS implementation guidelines and disclosure requirements for Islamic financial instruments and Islamic financial institutions, so that the financial statements remain convergent to IFRS, but at the same time avoids criticisms pertaining Shari’a precepts.
