Research Paper (printed copy)
As the Islamic finance industry steadily grows in the global market, measures to ensure transparency are much needed. Transparency in financial reporting is defined as the extent to which financial reports reveal an entity's underlying economics in a way that is readily understandable to those using the financial reports (Barth and Schipper, 2008). Among the benefits of transparency are reduced cost of capital and reduced information risk. It also contributes to a stable market and increased market confidence for investors in the related sector. The measures related to transparency in the Islamic finance industry are to be championed by the regulators and by standard setters at the international level such as the International Accounting Standards Board (IASB), the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). Accounting standards boards in the countries that practice Islamic finance should engage with international standard setters and industry practitioners responsible for accounting and reporting of Islamic financial transactions to rationalize the design of accounting standards. For transactions in Islamic financial institutions (IFIs), another dimension of transparency is the disclosure of the relevant contracts that make up the Islamic financial transactions.
This is the second of two ISRA research papers focusing on the issues arising from the application of International Financial Reporting Standards (IFRS) in Islamic financial transactions. Part 1 examined the basic question of whether the key underlying principles of IFRS are acceptable from the Shari’ah perspective. This paper is Part 2 of the research; it aims to study issues that arise when accounting for Islamic financial transactions using IFRS; in particular, covering transactions related to takaful, mudharabah and leases. IFRS applicable to takaful transactions are IFRS 4 Insurance Contracts, IAS 27 Separate Financial Statements and IAS 137 Provisions, Contingent Liabilities and Contingent Assets. Accounting for Islamic financial instruments is related to IFRS 7 Financial Instruments: Disclosures, IFRS 9 Financial Instruments and IAS 137 Provisions, Contingent Liabilities and Contingent Assets. Islamic financial instruments that were identified as having issues are mudharabah-related transactions, including deposit and investment products. When IFRS are adopted, possible issues arise where such accounting and reporting would not truly reflect the nature of the Shari’ah contracts.
Based on analysis using library research of previous academic and industry literature, the paper highlights the following issues:
• With regard to takaful contracts, the three main issues relate to the (i) definition of takaful, which is not covered in IFRS, (ii) classification of the qarÌ provided by the takaful operator, and (iii) the nature of financial statement reporting in takaful companies.
(a) On issue (i), the latest Malaysian Institute of Accountants (MIA) Guidance for preparers of accounts—i.e., The Guidance on Special Matter No. 2 on Presentation of Financial Statements for Takaful Companies; and Classification and Measurement of Qard issued by the MIA Council Deliberation in May 2013 (MIA, 2013)— remained silent on the issue of the definition of takaful. However, the Guidance highlighted that takaful companies should in general adhere to the MFRS beginning on or after 1 January, 2012, which includes IFRS 4 Insurance.
(b) Regarding issue (ii), the MIA (2013) Guidance viewed qard from three different perspectives for the purpose of accounting and reporting: the takaful operator’s, the takaful fund’s and that of the takaful company. Firstly, from the takaful operator’s perspective, it is to be treated as an investment by the takaful operator in the takaful fund. Secondly, from the takaful fund’s perspective, the qard should be classified as a liability because the takaful fund has an obligation to repay the qard. Thirdly, in the takaful company’s statement of financial position upon consolidation, the qard payable as recorded in the takaful fund’s statement of financial position would be eliminated against the investment recognised in the takaful operator’s statement of financial position.
(c) Regarding issue (iii), the Malaysian Accounting Standard Board (MASB) Discussion Paper i-1 provided a tentative conclusion that the takaful operator is required to present a consolidated financial statements for itself and the participants’ fund that it controls in accordance with MFRS 127 Consolidated and Separate Financial Statements. The Discussion Paper i-1 also highlighted that the takaful operator can provide additional disclosures about the separate individual funds if it finds it is important for financial statement users as it is not prohibited under IFRS.
• With regard to Islamic financial instruments, three issues were specifically examined: (i) classification and presentation of mudharabah investment accounts in the financial statements, (ii) profit equalisation reserves under mudharabah investment accounts and (iii) impairment of financial assets.
(a) Regarding issue (i), mudharabah investment reflects the relationship between the bank and the investment account, regardless of whether it is a restricted or unrestricted investment account, because IFRS treats both similarly for consolidation purposes based on the principle of control.
(b) On issue (ii), Bank Negara Malaysia (2011), in its Guidelines for Profit Equalisation Reserve, proposed an accounting treatment where there would be a debit to the statement of comprehensive income. In this recognition, the bank’s portion is recognised in reserves and the account holders’ portion is recognised as a sub-classification of customers’ deposits.
(c) On issue (iii), the application of expected credit loss might trigger Shari’ah concern as the bank may have to recognise credit losses (i.e., cash shortfalls) over the lifetime of the financing even before they occur. This would have an impact on the amount of profit to be distributed to the bank and, possibly, on the respective investment accounts which have been mobilised to provide such financing in the first place.
• Regarding ijarah transactions, it seemed that the new lease proposal better reflects Shari’ah principles for ijarah as it reflects the true conditions for lease situations using the right-of-use approach. This solves the issues of incorrect treatment of a finance lease as a sale transaction. This approach also mitigates the deficiency of IAS 17 to cater for the off-balance-sheet problem arising from operating leases.
The Application of the International Financial Reporting Standards (IFRS) in Islamic Financial Transactions: Some Issues