Islamic Financial Institutions - Literature review Example

Islamic Accounting and Financial Reporting Contents 0)Introduction 3 2.0)Substance Over Form 3 3.0)Time Value of Money 4 4.0)AAOIFI Concept of Substance over Form 5 5.0)IFRS of Substance over Form 5 6.0)AAOIFI Concept of Time Value of Money 6 7.0)IFRS Concept of Time Value of Money 7 8.0.) Discussion of Differences 7 9.0)Examples of Differing Contracts 8 10.0)Harmonising Issues 10 11.0)Conclusion 13 1.0) Introduction The financial industry for Muslims is unique especially in its definition and application of both the time value of money and substance over form concepts. As a result, it as difficult to transact at the international scale and this locks out possibilities for expanding the market for its financial services. The International Financial Reporting Standards( IFRS) should also consider ways for making assimilating the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards into its broad system. This paper considers some of the issues raised by the differences between the two standards and recommends some ways by which they may be dealt with. 2.0) Substance Over Form This is an accounting principle by which accountants when accounting for business transactions report its economic impact rather than its legal form. In other words, the financial statements adhering to this accounting principle reflect the general reality of the entity in question or the economic substance but not its legal form. Specifically, this principle has more relevance when reporting on cases relating to revenue recognition principle and cost principle (Randall, Harold, & Hopkins, David, 2012). For instance, a company that is short of funds may decide to sell its machinery to the bank and after it sells lease the same machinery from the bank. Typically, this arrangement is known as sale and lease back. Legally, the machinery has been transferred to the bank but under the substance-over-form principle the sale and the subsequent leaseback are recorded as one transaction since they don’t alter the economic reality of the business entity. Another example is in an instance where two companies arrange to exchange their inventories. In this regard, the substance under form principle does not allow these transactions to be recorded as sales despite the fact that the two companies have entered into legally enforceable contracts. 3.0) Time Value of Money According to Randall, Harold, & Hopkins, David (2012), this is a principle of finance that provides that money can earn interest with time, meaning any amount of money is worth more the sooner one gets it. In this case, money available at the present time is worth more than the same amount in future given that money has the potential to earn more. In the view of Weygandt, Kimmel & Kieso (2015), this principle tells us that it is more valuable to receive some amount of money today than to receive the same amount of cash in the future. The reasoning behind this principle is that if the cash received today is invested immediately, it will begin to grow in value. This principle is important in accounting because of the cost principle and the revenue recognition principle. For instance, assuming the interest rate today is 5% per annum, $100 invested today at the end of the year will be $105. Normally, the prevailing interest rate is the measure of the time value of money. For the example of 5% interest rate implies that $105 received after one year is the same as receiving 100 today. In accounting, for this interest rate of 5%, it means that a company offering services today in exchange of $105 in one year has earned $100 service revenues for today. The $5 difference is the interest income that the company earns waiting one year from now. Apparently, both the substance over form principle and the value of money principle are applicable in accounting when relating to cases relating to cost principle and revenue recognition principle. Harold, & Hopkins, David explain that the cost principle in accounting requires that the assets be recorded at the cash amount or its equivalent at the time that it is acquired (2012). On the other hand, the revenue recognition principle states that, under the basis of accrual accounting, revenue should be recorded when an entity has completed a revenue generation process. In other words, revenue should be recorded when it is earned. 4.0) AAOIFI Concept of Substance over Form AAOIFI does not specifically endorse the concept of ‘substance over form’ (Agha, 2013). Agha explains that with regard to the importance of transactions in Islam, the emerging reality must be constructed to be as the form. As evidence Visser (2013) observes that, in the treatment of sales based transactions and leased assets, sales contracts imply a sales transaction and hence the ownership title is passed to the purchaser upon the acquisition of the item. Nevertheless, the financier can require the purchaser to pledge the assets acquired as collateral for the financing amount but it is illegal for the financier to buy back the assets from the purchaser. According to Agha, Shariah interprets form over substance to emphasize on the form of contracts in their Arabic terminology for example, Murabaha (during a sale one should let the buyer know the profit) and Musharaka among others, as in their economic substance. This economic substance often appears the same after conducting a sequence of contracts named in Arabic. As a result, in a legal setting a judge is not supposed to guess the intentions of any contractual parties but rely on the meaning of the particular contract in front of them to make a decision. The reason why one is not supposed to guess the ‘intentions’ comes from the fear to commit injustice to either of the parties. Furthermore, the hesitance to guess intentions offers a procedural means with which to get evidence from each of them. 5.0) IFRS of Substance over Form According to IRFS, Substance over form is a financial statements concept that requires that the disclosures accompanying the financial statements should reflect the underlying accounting transaction realities. Further, the concept requires that the information appearing on the financial statement should not only adhere to the legal form but should also reflect economic reality (Ashok, 2014). Conversely, a transaction should not be recorded in a manner that hides the true intent of the transaction hence misleading those who read the financial statements of the organization The IFRS framework is more principles-based so that it becomes more difficult for someone to justifiably hide the transaction intention when using it. Visser argues that the IFRS argument of Substance over Form assumes that someone is trying to deliberately hide the true intent of a transaction if they dont truly ascertain its substance (2013). However, Visser concedes, it accepts that a case may arise because of extremely complex transactions for which even law-abiding accountants may find it difficult to ascertain the substance. 6.0) AAOIFI Concept of Time Value of Money The conceptual framework of AAOIFI does not recognize that money has a time value. Therefore, money does not require the process of profit recognition to be related to the outstanding amount principal. Specifically, Financial Accounting Standard (FAS)2 of the AAOIFI states that , ‘Murabaha to Murabaha Purchase Order’ establishes profit proportionately over the repayment period or, different from the accrual concept, as and when receiving instalments. Further, FAS13 ‘Mudaraba’ states that when measuring receivables, neither interest rate nor discount on the current value shall be considered. Again, in FAS 10, ‘Istisna’a and parallel Istisna’a ‘, an Istisna’a financing receivable is normally valued at historical cost. In this regard, there is no use of valuation methods that are discounted for future cash flows in the active market. Consequently, taking an interest-based transaction is prohibited in AAOIFI (Aaoifi.com, 2015). The graph below shows the growth of bank incomes when using the two different standards when the customer defaults one payment in year three. 7.0) IFRS Concept of Time Value of Money According to IFRS 39/IFRS 9, ‘Financial instruments assets shall be measured are measured at amortised costs considering the prevailing interest rate so as to take into consideration the time value of money. Under IFRS 36 ‘Impairment of Assets’ recoverable amount is to be based on discounted cash flows (Ifrs.org, 2015). In this case, impairment is used to mean the carrying value and hence it should be greater than the recoverable amount. This implies, the IFRS standard authorizes the use of discounted cash flows so as to estimate the current market value of a future transaction. 8.0.) Discussion of Differences The main differences between IFRS and AAOIFI accounting standards spring from the objectives of accounting by the two standard setting bodies. On the subject of Substance over Form, IFRS focuses on reporting the economic substance of the transaction undertaken. Sometimes it happens that the substance of a transaction is not consistent with their legal form. Contrary, the AAOFI objective is that the IFI’s accounting should show its compliance with Shariah. Another difference is that sine IFRS standards are applied by more countries (120 countries), its follows that its ‘substance over form’ is more acceptable compared to the interpretation of AAOIFI that is applied in about twenty countries (Daly & Frikha, 2014). However, this difference has a lot of impacts when companies using IFRS standards transact with those using AAOIFI standards. Generally, when two parties applying these different standards transact, in most cases the IFRS interpretation applies. Moreover, more countries are adopting the IFRS interpretation than they are moving to the AAOIFI interpretation. Consequently, in IFRS, a lease transfer means that ownership of the asset moves from the lessor to the lessee then irrespective of the legal form of the agreement it is treated as a finance lease. Moreover, under IFRS an Ijara contract is assessed individually and is classified as an operating lease only if all the rewards and risks remain with the lesser. In contrast, the AAOIFI Standard accounts for all leases as operating leases with different types of leases requiring additional disclosures. Apparently, the interpretation of the time value of money offers another significant difference between AAOIFI and IFRS. At one hand, the AAOIFI in interpreting the concept of the time value of money declares money to have no time value. In this regard, it is against the Islamic banking practices to make future transaction calculations that are based on interest rates. Islamic banks perform financial assets transactions based on Mudaraba contract or an Agency contract. According to the Mudaraba contract, the bank receives a percentage of the returns in case of a profit and no reward, despite its efforts to provide funds, when a loss occurs. In the case of an agency contract, a bank is bound to receive a percentage of the invested funds or a lump sum regardless or not a profit is achieved. On the other hand, IFRS generally bases all financial asset calculations on the effective interest rate. According to IFRS, failing to discount the value of future transactions results to a loss since with time money increases in value. 9.0) Examples of Differing Contracts One, under Mudaraba investment management by Shariah standard, Islamic Finance Institutions (IFI) is not liable for loss arising from investments except in cases of negligence and misconduct. As a result, AAOIFI requires that ‘unrestricted investment account funds be recorded in a financial statement as a separate item between liabilities and the owners equity.In contrast, the IFRS which emphasises on the substance over form concept assumes that the economic reality is that since the financial institution has raised these investment funds from the customers, they should be recorded as liabilities to the financial institutions along with the other deposits. A second difference is in the Ijara (Leasing) contract. The financing mechanisms of many IFIs are the operating lease (ijara) and Ijarah Muntahia Bittamleek which the AAOIFI requires to be treated as operating leases. Furthermore, the asset ownership remains with the IFI during the lease period except for Muntahia Bittmleek in which one must acquire an independent contract to transfer the ownership. Contrary, under IFRS the ownership of the two transactions would automatically be transferred and treated as finance leases. IFRS considers that the economic reality is that there is a change of ownership in this transaction while AAOIFI emphasizes on the legal appearance in which the transaction should be recorded (Uddin, 2012). Thirdly, Aris, Tapsir, bin Abu Talib and Malaysia (2012) afrter the examination of takaful (Islamic Insurance) learn that it has three attributes that make it different from IFRS standards. First, the definition of takaful is not found in the in the IFRS. In addition, IFRS does not classify the qard (benevolent loan) offered by the takaful operator. Last is in the nature of the financial statements that are used in reporting transactions of the takaful companies. IFRS interpreting the transactions of takaful asserts that the operator of the takaful retains responsibility for assets and liabilities and therefore should include the assets, liabilities and the financial performance of the qard in its financial statements which is not what takaful really does. Another different contract is observed by Chuk (2012);the Zakat which operates as long-term investments, or held at maturity in which case the owner gains control over a company, or as a stake in a companys capital. Such shares in AAOIFI are considered as fixed assets and only the divided will be subjected to Zakat at 10%. In this regard, AAOIFI recognizes the Cash Equivalent Value which hence does not take into account the time value of money. For IFRS, the earnings of these assets should be discounted so as to calculate their present value. Lastly, the revenue recognition of the IFRS standard takes into account the time value of money by recognizing the difference between the fair price and the nominal price. Uddin reports that the AAOIFI uses only the nominal value of money and this leads to different interest revenues and financing revenues from the same principal when calculations are based on the two standards (2012). Murabaha (Profits) requires that either a proportionate allocation of profits over the credit period or as when the instalments are received. IFRS requires that the sale of a good with deferred payment should earn interest as a difference between the fair value and the nominal amount. 10.0) Harmonising Issues After the financial crisis of 2008 and the rapid growth of Islamic Finance has increased pressure for integrating the two standards of accounting by addressing the above two concepts that bring major differences. For this to be done there is a need for contradictory issues of the AAOIFI to be converged with the main accounting mainstream of IFRS. In fact, IFRS is the only financial reporting language with a global recognition. Further, Atmeh and Abu-Serdane (2012) emphasizes that IFRS offers cross-border compatibility so that the users of IFIs can transact outside their boundaries. In evidence offered by Mohammed Sarea and Mohd Hanefah (2013), multinational IFIs and other conventional banks have Shariah windows which enable them to access new markets and get funding. Below are some of the possible approaches that can be used to eliminate the contradictions of these concepts. Foremost, in attempt to resolve the differences in the two issues, there is need for standards setters from the two bodies to facilitate discussions aimed at researching the reasons behind this differences ( Atmeh & Abu-Serdane 2012). This will involve forming a joint body from the representatives of the two sides to look at the key distinct features that found in Islamic finance but not in conventional finance as a result of misinterpretations of financial information with regard to using IFRS. Primarily, the body should have the mandate of finding how to harmonise the two standards by making the IFS, work within the IFRS framework, or work within the IFRS but with specific standards for Islamic Finance, or through an established Islamic Financial Standard that is globally recognised. In this regard, the body should facilitate discussions with major stakeholders and experts concerning the distinct issues in Islamic Finance. The table below confirms that, in the long run, the income to banks when applying different accounting standards will harmonise. Comparison of AAOIFI and IFRS on how a bank recognizes income over ten years if a customer fails to make one payment in year 3 AAOIFI accounting IFRS accounting Relevant paragraph(s) FAS 2 2/4/2 a FAS 2 2/4/2 b IAS 18, paragraphs 11, 29,30 IAS 39 paragraphs 9 AGS-AGB Requirement Proportionate allocation of profits over a period of credit $ Profits recognized as or when instalments are received $ Difference between the fair value and the nominal amount of consideration recognized as interest revenue... in accordance with IAS 39 $ Year 1 19665 19665 33866 Year 2 19665 19665 31278 Year 3 19665 18026 28503 Year 4 19665 19665 25527 Year 5 19665 19665 22337 Year 6 19665 19665 18915 Year 7 19665 19665 15247 Year 8 19665 19665 11313 Year 9 19665 19665 7094 Year 10 19665 19665 2571 Total Profit/ interest income 196,650 196650 196650 Source: Islamic banker.com: MASB One issue of concern resulting from the interpretation of the time value of money is (riba) or the prohibition of interest rate. Shariah is against the payment or receipt of interest. Contrary, in the conventional sense, interest assumes the time value of money. Interestingly, , though it is illegal to base transactions in finance on interest rate, using discounted cash flows is for merely approximating market values and does not necessarily imply an interest charge and, therefore, may not be really in conflict with Shariah law. Furthermore, Mohammed Sarea and Mohd Hanefah (2013) argue that many IFIs use discounted cash flows to calculate impairment value in use and also the fair value of their financial instruments. AAOIFI defines fair value as the ‘value agreed between the partners ‘ ,however, there is little reference to how these partners are to arrive to at this value given that it cannot be derived without active markets. On the substance over form issue, the main difference is that IFRS principles rely on the economic substance of transactions while AAOIFI principles must comply with Shariah. Consequently, Islamic Finance has come up with underpinning contracts like Ijarah and Ijara , Mudaraba, and musharaka which are unique and with different unique obligations and rights associated with each. Dima Ş. M., Dima, B, Megan, andPăiuşan (2014)reason that despite that the fact that IFRS accounting diverts from Islamic accounting; it does not affect Shariahs compliance of the transaction itself. In this case, the information disclosed to users of IFI financial reports would be equally meaningful. Alternatively,Malbos (2010) thinks that there is need to compare whether there incompatibilities Shariahs and IFRS legal codes. In this regard, Malbos concludes thatShariah has not accepted the use of IFRS although some countries have chosen it so as to suit their legal needs. This implies that it is possible to adopt IFRS to IFIs. In addition, some Islamic finance contracts, when treated under IFRS, would generate useful information that is compliant to Shariah (Ashok, 2014). A possible approach to harmonization would be to set IFRS as the default reporting framework and then Islamic financial models used to supplement transactions that do not fit into the framework. This procedure will have to be related to the presentation and disclosure hence allowing for more transparency in terms used by users, as well as the underlying assets (Vicary Abdullah & Chee, 2010). Evidently, there are already industry-specific standards within them IFRS framework and therefore it is possible to include a specific standard targeting Islamic finance. An alternative approach would be to set Islamic accounting standard that is recognised globally (Venardos, 2012). This alternative approach would require this Islamic accounting standard where possible to be based on IFRS but also include the necessary recognition, measurement, presentation and disclosure requirements that are specific to the transactions and products of Islam finance. In addition, a reconciliation provision for the financial reports of IFIs and IFRS requirements should be provided. 11.0) Conclusion In conclusion, the necessity of harmonising the two standards is increasing because of the increase in the number of countries that are adopting either of them. Moreover, some of the IFIs are already seeking means to integrate IFRS into their accounting framework so as to freely transact with other countries that dont use Shariah. References Aaoifi.com, (2015). Accounting Standards - Standards - Standards and Definitions - AAOIFI. Agha, O. (2013). Islamic Finance: Principle before Profit. Berkeley Journal of Middle Eastern & Islamic Law, 2(1), 5. Aris, N. A., Tapsir, R., bin Abu Talib, M. K., & Malaysia, J. K. I. (2012). Risk and Risk Management of Takaful Industry. Journal of Global Business and Economics, 4(1), 29-39. Ashok, K. K. (2014). International Financial Reporting Standard (IFRS): Prospects and Challenges. J Account Mark, 3(111), 2. Atmeh, M. A., & Abu-Serdaneh, J. A. R. (2012). A Proposed Model for Accounting Treatment of Ijarah. International Journal of Business and Management, 7(18), p49. Chuk, T. S. (2012). Islamic Finance for Poverty Alleviation Daly, S., & Frikha, M. (2014). Arabian Journal of Business and Management Review. Dima, Ş. M., Dima, B., Megan, O., & Păiuşan, L. (2014). A discussion over IFRS’adoption in Islamic countries. Journal of Accounting and Management Information Systems, 13(1), 35-49. Ifrs.org, (2015). IFRS - Access the unaccompanied Standards. Islamicbanker.com, (2015). AAOIFI vs IFRS - Accounting for Islamic Finance. Malbos, V. (2010). How Does Islamic Banking Fit into IFRS Regulations?. Available at SSRN 1857005. Mohammed Sarea, A., & Mohd Hanefah, M. (2013). The need of accounting standards for Islamic financial institutions: evidence from AAOIFI. Journal of Islamic Accounting and Business Research, 4(1), 64-76. Randall, Harold, & Hopkins, David. (2012). 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