A critical analysis of the financial reporting practices of Islamic Financial Institutions – AAFA, Mauritius Sep 2015 Riaz Dhai Lecturer School of Accounting, Economics & Finance University of KwaZulu Natal

Objectives Contextualise the fundamental issues in Islamic accounting Review of literature in Islamic accounting Perform a critical analysis of literature to date to support future research

Islamic finance industry $1.8 trillion of assets under management in 2013 (2012: $1.3 trillion) (E&Y, 2013) Top 20 banks realising growth of 16% over last 3 years Over 200 IFIs in over 63 countries

Primary reasons for strong growth Strong demand for Shari’a compliant products Strengthening of legal and regulatory framework Diversification by conventional investors Increased development of products

Key differences between conventional and Islamic finance Conventional finance Islamic finance Based on capitalist economy Based on Quran & Sunnah Profit maximisation Profits to be made within confines of Shari’a Includes interest and most business activities Prohibition of interest – riba and many business activities Banks are primarily lending based organisations Banks provide both commerical and investment banking services Application of conventional accounting standards e.g. IFRS ???

Islamic accounting The Quran endorses the need to maintain proper accounting records – Gambling & Karim (1986) الحساب – to account Accountability to Allah for deeds and actions Managers and firms are accountable to firm stakeholders for actions in the business – Lewis (2001)

Islamic accounting Stakeholders – the Umma or community Disclosure in Islamic accounting is for businesses to disclose all such information that would be necessary to advise the umma about their operations irrespective of whether this information would work for or against the firm Accounting for financial transactions in parts of the world where Islam is the majority religion

Islamic accounting Covers the overall prohibition of interest & its implications Covers the prohibition of specific business activities Covers the requirement to discharge Zakaah Covers overall compliance with Shari’a

Islamic accounting Islamic accounting can therefore be “broadly defined as a system of information that communicates the economic position and result of operation of an entity and ensures that the information is correct, complies with Shari’a and is free from any misleading information” (Harahap, 2013)

Conventional vs Islamic accounting Baydoun & Willett (2000) summarise these differences under the following specific categories Conventional Economic rationalism Secularism, individualism, profit maximisation & survival of the fittest. Based on commercial law which is permissive rather than ethical Disclosure based on public interest focusing on the individuals who control the resources Islamic Pleasing Allah Religion, community, “reasonable” profit, equity and consideration for the environment. Based on the Quran Disclosure based on the requirements of the Shari’a and on community based in benefiting/using resources

Conventional vs Islamic accounting Time value of money Applies to credit sales e.g. murabaha Cannot be applied to loans Ahmad & Hassan (2006) Economic substance over legal form AOSSG, 2010

Murabaha Customer Goods IFI Profit markup Deferred Payment The customer of the bank wishes to purchase an asset i.e. the goods The goods are sourced from a third party. In some instances the customer is appointed to source the goods. The IFI purchases the goods. Ownership of the goods has to pass first to the IFI. The IFI add a profit markup onto the goods which is known to the customer. Payment is deferred and made over a period of time.

Conventional vs Islamic accounting Time value of money Does Islamic finance recognise that R1 today is not the same as R1 in a year’s time. Refer Ahmad & Hassan (2006) Economic substance over legal form In present valuing the above transaction, the economic effect is the same as recognising interest income

Literature Napier (2009) categorised literature on Islamic accounting as follows: The need for Islamic accounting and its basic principles Practical application of accounting rules to Islamic financial transactions Regulatory challenges facing Islamic accounting

The need for Islamic accounting Initial proposal in academic literature – Abdel Magid (1981) Similar to development of a separate set of accounting standards for banks in the USA – Karim (1990) Prevention of market failure – occurs when a firm is biased in the information reported Achievement of social goals – uniform access to public information

The need for Islamic accounting Gambling & Karim (1991), Pomeranz (1997) Mohamed Ibrahim (2009) have all argued that at a fundamental, macro level, there exists a difference in the conceptual framework adopted by conventional accounting & Islamic accounting Conventional accounting focuses on a decision usefulness framework focused on investors Differences in underlying Islamic financial contracts

The need for Islamic accounting Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI) Established in 1991, based in Bahrain Prior to its establishment: IFIs adopted their own accounting policies using local or international standards based on their own interpretations Policies focused primarily on whether accounting treatement conformed to Shari’a Agreed upon by SSBs and external auditors Limited engagement between IFIs thereby limiting comparability

Practical application & regulatory challenges What is the appropriate Islamic accounting benchmark? View 1: A separate set of accounting standards based on a revised conceptual framework is required View 2: Use the existing conventional set of accounting standards as a basis and apply to the principles of Shari’a.

Practical application & regulatory challenges Baydoun & Willett (2000) Propose an entirely new Islamic corporate report Historic cost statement of financial position Current value statement of financial position (Primarily for Zakaah calculation and Mudarib share) Value added statement: Sources of value added and distribution of value to stakeholders e.g. government, employees, owners, poor etc

Practical application & regulatory challenges Vinnicombe et al (2007) Discuss some of the key differences between conventional and Islamic accounting Comparative analysis of accounting treatment of provisions under IFRS and AAOIFI Conclude that there are differences conceptually between objectives of IFRS and Islamic accounting Recommend a more detailed exploration of these differences Note that there has been no involvement of the IASB on Islamic finance

Practical application & regulatory challenges The role of global accounting bodies in Islamic finance AOSSG Islamic Finance Working Group: Financial reporting issues pertaining to Islamic finance – June 2010 Discussion of conceptual issues and transactional issues in Islamic finance Submissions to the IASB on the issue of IFRS 9 and IFRS 15 Malaysian Accounting Standards Board International Accounting Standards Board

Practical application & regulatory challenges Harahap (2003) assesses the compliance of Bank Muamalat Indonesia with conventional standards in Indonesia and AAOIFI Level of compliance with conventional standards significantly better than with AAOIFI

Practical application & regulatory challenges Vinnicombe (2010) developed an benchmark index to assess compliance of 4 IFIs in Bahrain with AAOIFI Categories: SSBs, Mudaraba financing, Murabaha financing, disclosures relating to Zakaah Higher levels of compliance with respect to disclosures relating to Murabaha and Zakaah

Practical application & regulatory challenges Nazim Uddin (2012) examined annual reports of Islamic Bank of Britain (IFRS), Bank Islam Malaysia (MASB) and Bahrain Islamic Bank (AAOIFI) Key differences in disclosure of primary Islamic financial instruments

Practical application & regulatory challenges Wibowo et al (2013) examine the accounting treatment of URIA under Mudaraba by IFIs in Malaysia under MASB Accounts are reported as liabilities in conflict with AAOIFI Conclude that differing treatments of URIA has an impact on profit distribution, capital adequacy ratio, risk management and capital structure of an IFI

Critical analysis Lack of firm conclusion on whether a separate set of Islamic accounting standards is required Lack of documented published work on a summary of the key differences between conventional and Islamic accounting What types of transactions are affected No empirical evidence supporting key differences from practice How are IFIs currently reporting financial statements i.e. IFRS, AAOIFI, Other What types of affected transactions are most pervasive

Critical analysis Conceptual framework debate Revisit the conceptual framework from an Islamic perspective Supported by Gambling & Karim (1991) & Pomeranz (1997) Revised set of Islamic accounting standards Broader disclosure under Islamic accounting Integrated reporting Islamic corporate report (Bayoun et al. – 2000)

Critical analysis Little evidence documenting financial reporting practices of IFIs in terms of: Accounting standards adopted Recognition & measurement of Islamic financial instruments Disclosure of Islamic financial instruments Would disclosure under AAOIFI be materially different to IFRS

Questions? Riaz Dhai Lecturer School of Accounting, Economics & Finance University of Kwa Zulu Natal, South Africa Dhai@ukzn.ac.za