1. 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

2. 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

3. 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

4. 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

5. 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
???

6. 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)

7. 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

8. 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

9. 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)

10. 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

11. 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

12. 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.

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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.

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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)

28. 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

29. Questions?
Riaz Dhai Lecturer School of Accounting, Economics & Finance University of Kwa Zulu Natal, South Africa