With no single interpretation of Islamic law, differences in rulings between scholars over whether products are sharia-compliant has led to a lack of standardisation in the industry. Resolving this issue is key to bringing about greater efficiency, transparency and cohesion – ultimately helping to raise the curtain for more Islamic business, says AAOIFI deputy secretary general Khairul Nizam.

Established as an industry body responsible for international Islamic finance standards on sharia, accounting, auditing, governance and ethics, Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) plays an important role in promoting standardisation and harmonisation of Islamic finance practices. To date, AAOIFI has issued 44 sharia standards, 26 accounting standards, seven governance standards, five auditing standards and two codes of ethics.

Sharia and accounting standards

By definition, products and services that are offered by Islamic finanical institutions must conform to sharia – the code of conduct or religious law of Islam. It is therefore important for the Islamic finance industry to have clear guidelines as to what makes products and services sharia-compliant, and AAOIFI’s standards serve that objective in prescribing the minimum criteria that must be adhered to.

AAOIFI covers an extensive range of globally accepted Islamic finance products, services and practices. Some of the sharia standards focus on specific products including ijarah, investment sukuk, Islamic insurance and reinsurance, istisna’a, murabaha, musharaka and salam.

Other sharia standards, meanwhile, give guidance on more general services and practices including card services, contracts, credit agreements, documentary credit, guarantees, indices, shares and tawarruq.

Furthermore, AAOIFI accounting standards have been developed to incorporate the intricacies and uniqueness of Islamic finance practices. For example, the financing and deposit-taking structures that are used in Islamic financial institutions’ operations are conceptually different from those found in conventional banking and finance. Therefore, some accounting standards for conventional finance cannot be applied as they do not capture all the components of Islamic financial transactions. 

Equally, if not more importantly, AAOIFI accounting standards aim to achieve convergence of financial reporting by Islamic financial institutions across the globe so that their performance can be easily understood and compared throughout different markets. The standards also remove distortions that may otherwise be present if Islamic financial institutions use conventional parameters for their financial reporting, and therefore help in presenting an accurate view of their overall performance.

New accounting standard

AAOIFI has recently issued a new accounting standard on the conceptual framework for financial reporting by Islamic financial institutions to update and replace its previous standards. Pertinent points that have been incorporated in the new standard include updated guidance on accounting treatment for on-balance sheet and off-balance sheet investment accounts.

Investment accounts refer to funds received from investors for the purpose of investment in a mudaraba (investment management) arrangement where the investor retains the risk in relation to invested funds or assets.

The new standard introduces the concept of authority to make decisions in relation to the use of and deployment of funds received from investment account holders in determining the treatment of such funds as on-balance sheet or off-balance sheet items. In contrast to the previous standards, the new conceptual framework standard stipulates that the accounting treatment for such funds is not dependent merely on whether the mudaraba contract is designated as unrestricted or restricted investment accounts. 

Under the new standard, on-balance sheet accouting treatment is required for investment accounts that provide Islamic financial institutions with the authority for decision-making and strategic policy, as well as day-to-day administrations and operations in relation to where, when and how the investment funds will be deployed. 

AAOIFI is also developing a new specific accounting standard for investment in real estate to replace the existing general standard, which includes investments in financial instruments such as shares and sukuk

Khairul Nizam

In cases where Islamic financial institutions have little authority or limited or no discretion in respect of the use of and deployment of the funds, they qualify for an off-balance sheet treatment. Notwithstanding, such off-balance sheet treatment needs to be accompanied with sufficient appropriate disclosure or even separate financial statements.

Distribution of mudaraba profits

A new sharia standard that has been issued in recent months is on distribution of profits relating to mudaraba (investment management) contracts. It complements the existing sharia standard on mudaraba. The new standard covers sharia rules pertaining to investment accounts managed by financial institutions on behalf of their account holders on the basis of mudaraba contracts.

The standard stipulates sharia rules on distribution of profits between the investment manager and investment account holders. The profit-sharing ratio must be included in the investment management contracts. Nevertheless, if during the course of investment, the manager decides to relinquish part of its share of the profit for the benefit of the investment account holders, proper disclosure must be made.

This applies to the investment management operations of both unrestricted and restricted investment accounts. Unlike the former, investments of funds from restricted accounts are confined to specific types of investments as stipulated by the investment account holders.

The standard states that realisation of profit in investment accounts must be secondary to protection of capital. In determining the distribution of profit, investment managers are allowed to use a scoring method that takes into account the amount contributed by each investment account holder and the actual tenure of investment. 

While there is no prohibition against setting an expected rate of return that is not considered to be binding, final distribution of profits should be based on realisation of actual profit.

Accounting standards on Islamic insurance

There are a number of AAOIFI sharia and accounting standards that have been issued specifically on Islamic insurance. These include two sharia standards on Islamic insurance and reinsurance. There are also four accounting standards that cover general presentation and disclosure in financial statements of Islamic insurance companies, disclosure of bases in determining and allocating surplus or deficit, provisions and reserves, and contributions made by policy-holders.

AAOIFI is reviewing all the four existing accounting standards relating to Islamic insurance with a view to potentially issuing updated standards to better reflect the general current operations of Islamic insurance companies.

Indeed, with the growth of the Islamic insurance industry over the past few years, there are several accounting issues and challenges that have arisen and need to be addressed. One such issue is on accounting treatment for qard loans (interest-free loans) that are generally given through a shareholders’ fund to a policy-holders’ fund in the event of accounting or regulatory deficit in the latter fund. More accounting guidance is needed on the way such loans are recorded in Islamic insurance companies’ financial reports, including in cases where repayment of such loans is in doubt.

Other issues include accounting of agency fees charged by Islamic insurance companies for managing the investment portfolio of policy-holders’ funds – whether such fees should be recognised upfront or amortised over time.

More consultations with the Islamic insurance industry will be made and exposure drafts of the revised standards are expected to be issued by the second quarter of 2012.

Investment in real estate

AAOIFI is also developing a new specific accounting standard for investment in real estate to replace the existing general standard, which includes investments in financial instruments such as shares and sukuk.  

Given the current significant diversity in the accounting requirements, it was felt that there was a need for separation of the standards for these investments. A new accounting standard on investments in shares, sukuk and similar instruments has since been issued in 2010, while an exposure draft of the proposed new accounting standard on investment in real estate is expected to be issued before the end of 2011 to gather feedback from the industry before the final standard is issued in 2012.

More consultations with the Islamic insurance industry will be made and exposure drafts of the revised standards are expected to be issued by the second quarter of 2012

Real estate investments now comprise a substantial share of the activities of Islamic financial institutions. Complex accounting issues have also evolved over the years in line with the expansion of the real estate sector. The proposed new standard will provide additional guidance regarding issues surrounding the accounting classification of investment in real estate, treatment for under-construction assets and enhancement of disclosure requirements.

Industry outlook

As the Islamic finance industry seeks to carry out a growing volume of cross-border transactions and ventures into an increasing number of new markets across the world, the role of standards in providing an international benchmark on sharia requirements is growing in importance. So as to ensure that the sharia standards continue to support the expansion of the Islamic finance industry, AAOIFI is also working to develop a number of new standards to complement and supplement the existing ones.

New sharia standards being developed cover areas such as purification of prohibited income, promise and bilateral promise (Wa'ad), special purpose vehicles, fiduciary investment contracts, agency investment contracts, contracts termination and compensation, repos and profit rate swaps.

Meanwhile, AAOIFI is also working on the development of potential new accounting standards on sukuk, interim reporting and fair value, as well as revision of existing standards on mudaraba, murabaha and ijarah.

In addition to efforts on standards development, AAOIFI is working with its 200-plus institutional members – including central banks, regulatory authorities, financial institutions, accounting and auditing firms, and financial services providers – in more than 40 countries to encourage wider adoption of the standards. 

AAOIFI is also co-operating with other Islamic finance industry stakeholders throughout the world and international bodies such as the World Bank, the International Monetary Fund and the International Accounting Standards Board to ensure the standards form a robust component of sound financial systems.

Although the industry has certainly made great strides in establishing a clear framework of standards, the challenge today is to ensure ongoing innovation in products and services within the boundaries of sharia-compliance.

Khairul Nizam is the deputy secretary general of the Accounting and Auditing Organisation for Islamic Financial Institutions

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