Islamic Accounting and International Financial Reporting Standards - Assignment Example

Islamic Accounting and IFRS Name: Institution: Course: Lecturer: Date: Part 1 Substance over Form: The AAOIFI (Association of Accounting and Auditing Organisations for Islamic Financial Services) has ambiguous view regarding substance over form. According to SFA (Statement of Financial Accounting) AAOIFI, it is always prudent to account for transactions and treat them in accordance to economic substance and the legal form. The use of FAS1 AAOIFI Murabaha as well as Murabaha towards the purchase order necessitates treatment of murabaha-contract as trading other than a financing arrangement (Hanif & Iqbal, 2009). This scenario suggests that AAOFI accord priority to the contract’s legal form over substance related to the transaction. The consideration is normally based on purchase as well as sale of murabaha asset in which the transaction has been concluded between two parties; that is, Islamic financial institution as well as the customer. Consideration is not given on customary business of Islamic financial institution acting as financial intermediary where the objective of the finalised contract is facilitation of financing of aspired asset by the consumer (Kieso, Weygandt & Warfield 2010). For example, a lesser may lease an item to a lessee without necessarily transferring the item during the end of lease. Such type of lease might (in substance) be considered as finance lease if the overall lease term is considerably covering the asset’s useful life. An alternative case is, if the agreement of the lease gives the lessee prerogatives to purchase the item during the lapse of lease-term at a nominal price, of which it is likely that the lessee will definitely exercise this option within the prevailing circumstances (Lipe 2001). Time Value of Money: The consideration of measurement regarding murabaha contract is as well an issue. The SFA 2 AAOIFI states that the concept of time value of money is quite inconsistent with the Islamic Shariah. SFA 2 AAOIFI paragraph 8 highlights that in light of Shariah, money does not possess time-value apart from the value of goods which gets exchanged via use of money. However, a substantial number of Muslim scholars recognise the concept of time value of money as a unit of business profitability, which hold justice amongst contracting parties; that is; the deferred price should always be higher than spot price in order to obtain a balance of benefit regarding future assumptions. According to SAC (Shariah Advisory Council of BNM (Bank Negara Malaysia), the usage of time value of money within the Islamic financial reporting point of view is allowable in only instances of exchange contracts which entails deferred payment with prohibition exercised in respect to loan’s deferred payment. Therefore, it was the conclusion of MASB (Malaysia Accounting Standard board) that conflict does not arise when IFRS is applied by IFIs (Islamic Financial Institutions) while reporting financially (Hanif & Iqbal, 2009). For instance, the value of one pound today is not equivalent to the pound at a future date or period of time. The major reason behind the concept of time value of money is that a pound obtained today can be invested to generate more money. Moreover, when an individual opt to receive money is future, it is deemed that this money is lend at a risk comprising of default and inflation risk (Lipe 2001). Buy and Sell over Loan contracts: The Islamic Finance and Accounting applies murabaha as a mode regarding Islamic financing. The concept is also referred to as mark-up financing. Basically, murabaha entails sale of an items on profit. However, the concept has been modified to suit the techniques of financing. In time of need of financing, the client approaches Islamic bank to obtain finance of purchasing a commodity. In usual scenarios, interest-based institutions lend money to customers in order to acquire goods. The option is never exercised by Islamic banks. The bank does not operate on interest basis. The murabaha model mandates the bank to acquire the required commodity. The bank then sells the item to the consumer at a higher margin. However, the most usual case is when the customer lacks money to purchase on cash basis. Thus, the consumer obtains the item on deferred payment basis (Kamali, 2007). The major differences between the aforementioned principles is been reconciled though harmonization of IFRS and AAOIFI. The whole world is trending towards a single and high-quality reporting system. It is therefore impossible for the IFI to avoid momentum for harmonization. Harmonization is quite ideal in accommodating Islamic finance issues into IFRS. This is the major area that is being explored. The approach is being based on IFRS. However, AAOIFI should consider moving towards developing conceptual framework and developing guidelines which respect to Shariah law (Accounting and Auditing Organization for Islamic Financial Institutions 2008). Part 2 Finance lease while using IFRS: Under the IFRS, a finance lease entails a substantial transfer of the entire risks and rewards prior to ownership of asset, to the lessee. In an event where both risks and rewards stays with the lessee, the substance prevailing is that even if the lessee is not ascribed as legal owner of asset, the commercial reality existing is that the asset have been acquired through finance from leasing company (Kieso, Weygandt & Warfield 2010). Therefore, a liability or an asset should be recognised. The main test tests regarding finance lease includes: 1. During the inception of a lease, the present value regarding minimum lease payments equates to considerably the overall fair value pertaining the asset. 2. The transfer agreement of the lease transfers the ownership of item to the lessee at the lapse of the lease period. 3. The leased item is normally of specialised nature. 4. The lessee has exclusive rights and option of purchasing the asset at a price deemed to be considerably lower than fair value at the moment the option turns out to be exercisable. Finance lease while using AAOIFI: Under Shariah standpoint, the arrangement of handover ownership is strictly prohibited within two agreements. For instance, lease and sale never take place in a single contract. According to the Islamic jurisprudence regarding specific transaction types, it is not possible to type a transaction with another with a view of making the former transaction precondition of the other. If both lease and sale gets included in a single contract, the entire transaction may be viewed as deferred sale containing a deferred payment that is not acceptable within the Shariah principles (Hanif & Iqbal, 2009). AAOIFI recommends the followings ways to be used in regard to ownership of asset under Ijarah Muntahia Bittamleek; Transfer through gift. Transfer through sale pertaining token consideration or any other amount specified within the lease. Transfer through sale before the lapse of the lease period for a price that is equivalent to the residual Ijarah (lease amount). Transfer via gradual sale of leased asset. It is important to note that the Ijarah itself must not contain condition of gift and or sale at the lapse of lease term. However, the lesser has a right to enter into separate unilateral promise disposing the leased item to the lessee after the lapse of the lease period at specified and mutually acceptable price when the lessee has settled the rental amounts (Accounting and Auditing Organization for Islamic Financial Institutions 2008). Accounting Treatment in the books of the lessee: AAOIFI Under AAOIFI, during the inception of the lease term, the lessee is bound to recognise the finance leases as assets as well as liabilities within the statements of financial position. Recognition should be at an amount equating the fair value of leased item or if at all lower, present value of minimum lease payments. Each of this should be ascertained at the start of the lease. The discount rate applicable while calculating present value of minimum lease-payments is interest rate present in the lease; that is, if it is possible to determine. If it is not possible, lessee’s incremental-borrowing rate should be used. Any amount acting as direct costs for the lessee is included in the recognisable value of the asset (Lipe 2001). In-case of Ijarah that lapse with transfer of ownership, the lessee is supposed to recognise lease sums as expenses throughout the period of the lease. After transferring an asset to the lessee, then the lessee should recognise an asset acquired in his books (Atmeh & Serdaneh 2012). IFRS Under IFRS, after commencement of the lease, lessee is supposed to recognise both the use of asset and liability. The right to use the asset is measured at an amount of lease liability and any other initial direct-cost that is accounted by the lessee. There may-be a need to make adjustments regarding lease incentives, payments (before and during commencement) as well as restoration obligations. Under IAS 40, the right-of-use of asset relates to an investment property emanating from fair value of the investment property. Moreover, the right-of-use of the asset is directly related to class of PPE through which lessee applies revaluation model, in which all right-of-use of the asset regarding the class of PPE ought to be re-valued. Lease liability at the inception period is measured by present value of lease payments that are payable within lease term, discounted at the rate of the lease if it can be determined. If it is hard to determine, then the lessee is bound to use incremental borrowing rate. Application of Substance in leases: Substance over form is applied in finance lease and accounts for differences in treatment. The contract entails two parties; that is, the lesser and the lessee. In practical terms, lesser acts as the legal owner of property while the lessee obtains rights to use the item in return of submitting rental payments (Kieso, Weygandt & Warfield 2010). On historical grounds, it was not allowed to reflect an asset not owned within the statement of financial position, meaning that associated liability was also not reflected. This concept was referred to as off-balance-sheet financing. It was a way used by firms to reduce their liabilities, which resulted to distortion of gearing ratio as well as other key finance ratios. This type of accounting did not do proper presentation pertaining transactions. In normal terms, a company was obliged to own assets and liabilities. In the modern times of accounting however, IASB (International Accounting Standard Board), states that, asset is a resource that is used in an organisation due to past events through which economic benefits are supposed to flow into the entity. The liability under IASB is termed as an obligation of a firm due to past events through which resource possessing economic benefits are expected to flow out of the entity. The substance-based definition forms part of IAS 7 (International Accounting Standard 7) Part 3 Issuance of asset backed Sukuk The Institution operating under AAOIFI will be able to issue an asset backed Sukuk on the lease. The major reason behind this is because asset backed ease have been embraced as attractive investment under the Sharia law. Generally, Sukuk which is often referred to as Islamic bonds are sharia compliant and operates as fixed-income capital-market instruments which have progressively increased their share within the global market (Accounting and Auditing Organization for Islamic Financial Institutions 2008). At the inception stage, susuk operated exclusively at the jurisdictions with mainstream Muslim populations. However, in the recent times, the global market regarding sukuk has considerably developed, with quite a number of sophisticated corporate issuances as well as sovereign individuals tapping the market (Hanif & Iqbal, 2009). Unlike the conventional bond that represents debt obligation of issuer, sukuk technically represents interest within an underlying funding plan structured in accordance to sharia entitling sukuk holder to proportionate share of proceeds generated by the arrangement, within a specified future date. Difference of Substance From an overall economic perspective, the proceeding debate regarding substance over form within the Islamic finance refers to broad view that most modern debt-based structure tend to be trading and leasing of assets; however, they are financing with embedded financing cost. In regard to sukuk, the main debate is if the structure is either asset-based or asset-backed. The main difference is the underlying concept of true sale. In asset-backed sukuk, true sale exists between originator and special-purpose vehicle (SPV) which issues the sukuk whilst susuk-holders never have recourse to originator. The assets are owned by SPV, returns are obtained from assets while asset prices vary over-time. However, majority of sukuk are not asset-backed (Kamali, 2007). Sukuk can be structured in terms of risk and return profile. Asset-backed susuk are closer to equity position since susuk-holders own underlying asset while it has no recourse to originator in case of payment shortfall. Asset-based sukuk are normally closer to debt since sukuk holder has recourse to the main originator in case of payment shortfall. Default pertaining sukuk is a recent phenomenon. How the legal structures would be presented in a law-court vis-a vis conventional bonds proves uncertain (Atmeh & Serdaneh 2012). Treatment between Malaysia and GCC countries in Leasing In Malaysia, accounting treatment regarding sukuk is normally based on IFRS which is adopted locally by Malaysian Accounting Standards Board (MASB). Rather than applying Islamic standards in the treatment of sukuk, Malaysian accounting Standard board provides advanced technical releases that explain how to accommodate Islamic transactions. Further guidance regarding accounting treatment of sukuk emanates from central bank (Accounting and Auditing Organization for Islamic Financial Institutions 2008). The most interesting point to note is that recent discussions between Malaysian regulators as well as local Shariah-advisers confirmed that the adopted financial reporting requirements never conflict with Shariah. Therefore, International Financial Reporting Standard applies on sukuk treatment unless there is an explicit shariah prohibition, which in Malaysia is quite rare (Hanif & Iqbal, 2009). Optimal Sukuk issuances in Malaysia In terms of overall structures adopted regarding sukuk issuance, Malaysian market have witnessed revival of structures that had been designed to strictly adhere to AAOIFI principles and thus make a shift towards hybrid structures that provide great deal of flexibility regarding the types of assets which can be used. The structures offer additional advantage by allowing murabaha- transaction to be part of underlying asset base up-to pre-determined maximum percentage regarding total asset value. The extension of flexible structures has made sukuk market to recover. This has witnessed rapid growth since the worldwide global crisis. In the year 2015, sukuk issuance hit an amount of 63.5 billion dollars. Sukuk is nowadays an important source of capital especially for the GCC countries as well as MENA region that has fast growing Muslim population. Malaysia currently continues to dominate the market followed by countries like Indonesia and Saudi Arabia. Innovation of a Hybrid Sukuk in Overcoming Structuring Limitation The main assumption behind hybrid sukuk is to structure murabaha-based partnership financing tool especially for not so large organisations. If applied correctly, particularly at a small scale via programme issuance for instance, it will result to lower or less incremental costs. Thus, it does provide credible alternative to conservative loans that are increasingly costly as well as inaccessible to consumers. Hybrid susuk if utilised properly could be a breakthrough for GCC countries which may utilise the opportunity in expanding their capital base. Hybrid sukuk are responsible for developing additional equity based contracts far from simple debts. In short, the model can neither be regarded as equity-based partnership where capital investors benefit with all powers as well as upside gain, nor pure collateral-based debt that has a predefined interest rate detached from project’s performance (Kamali, 2007). Part IV Reconciliation of Treatment Leases are applied by Islamic finance as a means through which one party can make a payment to another party for right to use the asset. Therefore, similarities exist with the conventional bank’s treatment. Conventional banking institutions have reconciled these types of transactions into form of finance where the institution buys the asset and then lease it to the consumer. This arrangement necessitates the bank to regain its costs as well as earn a profit as though it had previously loaned money to the customer, who is able to obtain ownership of asset at the lapse of rental term. Under IFRS, such contract is treated as finance lease (and not as operating lease), reflecting that inherent risks and rewards linked to the asset been passed-on to the lessee, who (in substance) is believed to assume ownership (ACCA & KPMG). Fundamental Shariah principle requires that physical asset and or tradable commodity must underpin each transaction. Consequently, Islamic finance transactions get characterised as being asset-based or asset-backed. In regard to asset-based transactions, the overall return is associated with underlying asset. In asset-backed transactions, counterparty possess the right to take custody of underlying asset; for instance, in times of default. The contract terms determines the existing type of arrangement. In respect to IFRS, the accounting is based on breakdown of underlying rights as well as obligations (Hanif & Iqbal, 2009). As aforementioned, it is paramount for sukuk holders to understand whether sukuk is either asset-based and or asset-backed. The later give the holder legal rights over underlying property especially in time of payments’ default. The East-Cameron-Gas sukuk was one of its kinds to be issued by conventional corporate firm within the jurisdiction that was not Sharia compliant; that is, the United States. It was also one of its kinds to default after oil and gas facilities failed tremendously to generate the aspired cash flows. After that, queries arose whether such asset was asset-backed and or asset based, hence the need to reconcile the two (ACCA & KPMG). References ACCA and KPMG. (2010). Accountancy futures: Harmonising financial reporting of Islamic finance.Retrieved from http://www2.accaglobal.com/pubs/general/activities/library/financial_reporting/other/tech-af-hfrif.pdf Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). (2008). Accounting, Auditing and Governance Standards for Islamic Financial Institutions. AAOIFI,Manamah Atmeh, M.A. and Serdaneh, J.A., 2012. A proposed model for accounting treatment of Ijarah. International Journal of Business and Management, 7(18), pp.51-53. Hanif, M. and Iqbal, A.M., 2009. Islamic financing and business framework: A survey. Kamali, M.H., 2007. A shari ‘ah analysis of issues in Islamic leasing. Islamic Economics, 20(1). Kieso, D.E., Weygandt, J.J. and Warfield, T.D., 2010. Intermediate accounting: IFRS edition (Vol. 2). John Wiley & Sons. Lipe, R.C., 2001. Lease accounting research and the G4+ 1 proposal. Accounting Horizons, 15(3), pp.299-310. http://www.ifrs.org/Meetings/MeetingDocs/Other%20Meeting/2015/January/REVREC-TRG-Memo-17-Islamic-Finance-transactions.pdf http://www.ifrs.org/Meetings/MeetingDocs/IASB/Archive/Leases/Leases-0511b02A-app.pdf http://www.pwc.co.uk/assets/pdf/open-to-comparison-islamic-finance-and-ifrs.pdf Read More