IFRS and Islamic finance – a whole other level of challenge

Accounting meets religion in challenge for Islamic banks, announces Reuters in a recent headline:

Here’s some of what it has to say:

  • “Reconciling accounting standards and religious principles is challenging Islamic banks and regulators as they adapt to new international book-keeping rules due to come into force in 2018.
  • …The problem for most Islamic financial products is that their accounting treatment can often diverge from the actual economic substance of a transaction, a key concept behind IFRS 9.
  • This has prompted the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) to set up a working group to look at ways to revise its rules for Islamic financial institutions, which now hold assets worth around $2 trillion.
  • …Islamic banks’ credit ratings, profitability and the cost of funding to customers could be affected by IFRS, Hamad Abdulla Eqab, chairman of AAOIFI’s accounting board, said during the organization’s annual conference earlier this month.
  • For instance, while IFRS 9 requires recognition of expected losses, AAOIFI rules only permit recognition of incurred losses.
  • Islamic law does not allow customers to be charged for a future event or a future loss, said Eqab, who is also group chief financial officer at Albaraka Banking Group BARKA.BH.
  • Another issue related to IFRS 9 is how some Islamic finance transactions are classified, such as murabaha and musharaka.
  • Murabaha is a cost-plus-profit arrangement widely used to structure Islamic loans, while musharaka is a partnership contract where two or more parties share profits according to a stipulated ratio.
  • They could be deemed trading activities depending on the specific details of each contract, Belatik said.
  • Islamic bonds, or sukuk, may also be affected. A popular sukuk structure is a sale and lease-back contract known as ijara. However, some sukuk could be classified as leases and therefore fall under a different standard, IFRS 16″.

I confess I’ve never had to deal with any of these issues, and certainly won’t claim here to have anything wise or insightful to say about them.  I was primarily engaged not so much by the details themselves, but more by the broader awareness that for some people, IFRS raises doctrinal or ethical or moral issues that don’t apply elsewhere. I mean, I might have a debate from time to time over whether or not a particular item should be measured at a discounted amount to reflect the time value of money, but the reference points for that debate would usually be entirely those defined in IFRS, maybe supplemented with some appeals to economic and behavioural logic. It would seldom be relevant to posit that interest can’t be recognized on a particular item because religious principles tell us so. But presumably, when that does become a reference point,  it dwarfs all other considerations, a potentially scary example of accounting actually affecting one’s eternal fate.

Not knowing anything about it, I wondered if some such issues might actually be beyond reconciliation. This took me to an interesting 2010 publication by PWC, which broadly argues that the differences between Islamic and non-Islamic finance aren’t necessarily as large as is often assumed. For instance, regarding the effect of discounting:

  • Conflicts between IFRS and Shariah principles are often more apparent than real. For example, where there is no quoted price to determine the fair value of a financial asset, IFRS requires the use of a discounted cash flow based on current interest rates to help estimate a proxy market value. However, no actual interest has been charged and therefore the Shariah prohibition of interest has not been contravened.

That is, I suppose, what matters is refraining from charging interest, not applying a form of financial reporting language that carries the appearance of it. This may involve back-pedaling a bit from the dominant philosophy of income statement reporting, which doesn’t usually distinguish between this kind of finance charge and those reflecting actual cash payments: it necessitates acknowledging the underlying fiction more openly. But perhaps we can take it as a sign of the strength of IFRS, that it lends itself to different applications driven by significantly different belief structures. The PWC document emphasizes in various places that additional disclosure may be important in explaining that no religious contravention exists, whatever the initial impression, and adds:

  • Certain aspects of the financial statements will be particularly relevant to users who want to assess the performance and direction of the company from an Islamic perspective. If material, this should include a description of the framework for achieving Shariah compliance in areas such as expert advice and audit. It may also include the reporting of the results of activities which are permitted (halal) or forbidden (haram) under Shariah. Such disclosure may well be different from a segmental analysis of business activities performed for IFRS purposes.

One hopes such a combination of substantive thinking and disclosure will address any issues that IFRS 9 may at present appear to raise. For those of us without  a direct stake in the outcome, it might be at least a little comforting to know that IFRS can withstand challenges not only from our own world, but also from higher planes…

The opinions expressed are solely those of the author

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