Documente Academic
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2 , Issue 1/2018
► PEER-REVIEWED
Accounting for
Islamic Finance:
Application
of IFRS and the
Shari’ah differences
► EDITORIAL
Islamic Finance Reporting: Focus has to be on realizing the objectives
► TECHNICAL ARTICLE
Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis
in the Perspective of IFRS 9
► INDUSTRY UPDATE
Islamic Finance Development in 2017: Towards Sustainability
Register today and become part of the +1800 AAOIFI Fellows who have mastered the
AAOIFI standards and are now enjoying decision-making roles as CFOs, Directors &
Partners at top professional firms, and Internal & External Shari'ah Auditors.
KINGDOM OF BAHRAIN
Tel: +973 17 244 496
Fax: +973 17 250 194
AAO I F I ´s Te c h n i c a l Bu l l e t i n
JOIFA seeks to publish original theoretical or
empirical research papers in English; reports from
conferences and symposiums; developments in
the field of Islamic accounting and related areas
including auditing, Sharia auditing, governance, tax,
corporate laws, ethics etc., (collectively mentioned as
accountancy); and book reviews; as well as, documents
ISSN 2535 - 9746 and archives related to Islamic accountancy.
The IMF Board rightly noted that Islamic banks undertake distinct operations with risk profiles and
balance sheet structures that differ in important respects from conventional banks, with associated financial
stability implications. The approach to regulating and supervising Islamic banking should reflect the nature
of risks to which Islamic banks are exposed and the financial infrastructure needed for effective regulation
and supervision, which requires additional or different regulation and supervisory practices to address
risks inherent in the Islamic banking operations.
The CPIFR will complement the international architecture for financial stability, while providing
incentives for improving the prudential framework for Islamic banking industry across jurisdictions. The
CPIFR and their associated methodology will be applied in financial sector assessments undertaken in fully
Islamic banking systems and, as a supplement to the Basel Core Principles for Effective Banking Supervision
(BCP), in dual banking systems where Islamic banking is systemically significant (15 percent or more).
AAOIFI Conferences:
The 16th Annual Shari’ah Conference (April 2018)
AAOIFI’s 16th Annual Shari’ah Conference was held on 8 and 9 April 2018, in the Kingdom of Bahrain under
the auspices of the Central Bank of Bahrain. The event featured participation from distinguished speakers
consisting of 30 experts from around 15 countries. The conference comprised panel sessions as well as the
presentation of a number of research papers across seven sessions of the two-day conference. AAOIFI’s
Annual Shari’ah conference is a key global event across the global Islamic finance industry which discusses
most relevant and important Shari’ah issues and topics, both in theory and practice.
As such, it is a much-anticipated event by the industry’s leaders, experts, and professionals. This year’s
event was attended, as usual, by high-profile participants including dignitaries and ministers, senior officials,
honorable Shari’ah scholars, representatives of the World Bank and international organizations, central banks,
and regulatory and supervisory authorities, as well as a host of Islamic financial institutions’ personnel
and senior managers, representatives of accounting and auditing firms, legal firms, universities and higher
education institutions, and the media, from around the world.
The conference hosted prominent keynote speakers, including H.E. Dr. Ahmed Abdulkarim Alkholifey,
Governor, Saudi Arabian Monetary Authority and H.E. Dr. Ahmad Mohamed Ali Al Madani (Ex-President of
IDB Group). The conference discussed a number of key topics that converge with its main theme through a
number of panel discussions, presentations, and research papers covering an array of focused topics.
The AAOIFI-World Bank Conference is one of the key annual, technical and professional events for the
Islamic finance industry, which has been keenly attended by a vast number of the industry’s figures, experts
and specialists, practitioners, representatives of senior management of Islamic financial institutions, accounting
and auditing firms, legal firms, higher-education institutions, the media establishment from across the global
Islamic finance industry.
1st Nov 15th Nov 16th Nov 27th Dec 5th Apr AAOIFI Updates
30th Apr
2017 2017 2017 2017 2018 2018
Boards’ Meetings:
Public Hearings conducted for Accounting
Meeting No. 51standards
of the AAOIFI Shari’ah Board was
held in Makkah, Kingdom of Saudi Arabia from 28
December 2017 to 31 December 2017. The meeting
During the last six months, AAOIFI held eight
discussed the comments of the public hearings of
technical board meetings to discuss various GSIFI 10 Ratings
draft Shari’ah standard on Sale of Debt.
exposure draftsASIFI 6
of the standards ASIFI 6and standards GSIFI 9 GSIFI 9
under progress.
External Shari'ahThe
Audit brief activity of Audit
External Shari'ah such meetings Shari’ah
Shari'ah Compliance Function Board’s
Shari'ah meeting Nos. GSIFI
Compliance Function 52 and 10 Ratings
53 which
is summarized below: were held in Medina Munawwarah, Saudi Arabia
Bahrain - Pakistan -
Bahrain - BIBF Pakistan - ICAP
Al Baraka HQ from 8 March Turkey -2018
KGK to 10 March 2018Riphahand 26 April
Intl University
AAOIFI Shari’ah Board: 2018 28toMar28 April 2018, respectively, discussed the
1 Nov st 14 Nov 4 Feb
th th
30 Apr th th
AAOIFI
2017 Shari’ah Board2017 held its meeting No. 2018
50 in exposure2018 draft of Shari’ah standard 2018 on Sale of Debt
the Kingdom of Bahrain on 16-18 November, 2017. and the notes of the public hearings of the standard
Public Hearings conducted for
The exposure draft of Waqf standard was presented onGovernance
Waqf. standards
in the meeting for discussion and deliberation.
Waqf
Algeria -
Sale of Debt Waqf Islamic Supreme Council Waqf Waqf
3rd Nov 11th Dec 14th Dec 15th Dec 20th Dec
2017 2017 2017 2017 2017
FAS 29 - Sukuk issuance FAS 29 - Sukuk issuance FAS 31 - Investment Agency FAS 31 - Investment Agency FAS 35 FAS 35
(Sukuk in the books of the issuer) (Sukuk in the books of the issuer) (Al-Wakala Bi Al-Istithmar) (Al-Wakala Bi Al-Istithmar) Risk Reserve Risk Reserve
1st Nov 15th Nov 16th Nov 27th Dec 5th Apr 30th Apr
2017 2017 2017 2017 2018 2018
AAOIFI
FAS 29Governance and
- Sukuk issuance FAS 29 -Ethics Board:
Sukuk issuance Governance
FAS 31 - Investment Agency and Agency
FAS 31 - Investment Ethics Board
FAS 35 (AGEB)FAS
on355 and 6
(Sukuk in the books of the issuer) (Sukuk in the books of the issuer)
March(Al-Wakala
(Al-Wakala Bi Al-Istithmar)
2018 BiatAl-Istithmar)
AAOIFI Head office in Risk
Risk Reserve
Bahrain.
Reserve
The
AAOIFI FAS held the sixth meeting
34 - Financial of its Governance
FAS 34 - Financial
Board deliberated on
GSIFI 10 Ratings the exposure draft of ‘Waqf
and Ethics Board (AGEB) (Reporting
(Reporting for Sukuk-holders)
on 6-7 December 2017 at
for Sukuk-holders)
GSIFI 10 Ratings
Algeria -
Sale of- BIBF
Bahrain Debt Waqf
Pakistan - ICAP
Bahrain - Supreme Council
Islamic TurkeyWaqf
- KGK Waqf
Pakistan -
Al Baraka HQ Riphah Intl University
3rd Nov
Public
11 Dec
Hearings conducted
14 Dec
for Governance
15 Dec
standards
20 Dec
th th th th
Algeria -
AAOIFI Updates
investment’ – as a preferred option; or the ‘Wakala AAB Approved Transitional Arrangement for Early
venture’ approach. On the other hand, the agent Adoption of FAS 30
shall generally keep the assets off-balance sheet as AAB approved the early adoption of FAS 30 along
these relate to the principal, unless the specified with the existing provisions related to reserves in
criteria for on-balance sheet accounting are met FAS 11. The Board noted that although the exposure
under different situations. draft for FAS 35 “Risk Reserves” has already been
issued, the finalization of the same would need some
Governance / Auditing Standard issued: time to complete the due process. Therefore, the
Board decided to allow a transitional arrangement:
ASIFI 6 “External Shari’ah Audit:
“Islamic Financial Institutions (IFIs) may early
AGEB issued its Auditing Standard for Islamic adopt FAS 30 “Impairment, Credit Losses and
Finance Institution (ASIFI) No. 6 “External Shari’ah Onerous Commitments” (in line with paragraph 62
Audit (Independent Assurance Engagement on of FAS 30), with effect from 01 January 2018. In such
an Islamic Finance Institution’s Compliance with situation, they shall also apply the existing clauses
Shari’ah Principles and Rules)”. This standard of FAS 11 “Provisions and Reserves” related to risk
provides comprehensive guidance to professionals reserves (paragraphs 3/1 to 3/5/5 of FAS 11). This
who perform external Shari’ah audits of Islamic transitional arrangement shall be applicable till the
Financial Institutions in line with the global best period beginning on or after the date of issuance of
practices. The standard outlines the criteria for FAS 35.”
performing a direct external Shari’ah audit and an
attestation external Shari’ah audit. It specifies the AAB Approved Amendment to FAS 25: “Investment
subject matter and subject matter information and in Sukuk, Shares and Similar Instruments”
provides guidance on principal procedures and key The objective of this amendment to FAS 25 is
considerations for such engagements. The standard to allow the accounting for debt-type instruments
also includes the reporting formats in preparing under the third category of “investment at fair
the external Shari’ah auditor’s report, in line with value through equity” in line with the global best
industry best practices. practices. Different comments from the industry
indicate that IFRS 9 allows this third category,
Exposure Drafts issued: and Islamic banks feel deprived because this is not
currently allowed by AAOIFI FAS 25. Therefore,
During the last six months, AAOIFI issued
Islamic banks, particularly investment banks are
Exposure Drafts of 3 Accounting standards and 2
at a comparative disadvantage. While FAS 25 is
Governance standards. The details are summarized
being revised (and exposure draft of the revised
below:
standard already in pipeline), it is understood that
Accounting Exposure Drafts issued: this treatment will be allowed, it was considered
• FAS 29: Sukuk Issuance important to allow the same for the current year
• FAS 34: Financial Reporting for Sukuk-holders with immediate effect.
• FAS35: Risk Reserves
Governance Exposure Drafts issued:
• GSIFI 9: Shariah Compliance Function CLARIFICATION:
• GSIFI 10: Shari’ah Compliance and Fiduciary The abstract of article published in JOIFA’s
Ratings for Financial Institutions first issue titled: A Comparison of MASB and
Other Standards’ updates: AAOIFI Accounting Conceptual Frameworks,
on page 30 states “..conceptual framework of
Ratified Amendment to the Guidance Note 1 on the MASB shows substantial replication of the
Reporting of “KEY AUDIT MATTERS (KAM) AAOIFI conceptual framework”. MASB has
The AAOIFI Governance and Ethics Board (AGEB), provided following clarification in this regard:
upon the recommendation of the AAOIFI Professional
Auditing Standards Committee (PASC) ratified an “MASB first issued its Framework for the
amendment to the Guidance Note No. 01 on reporting Preparation and Presentation of Financial
of “Key Audit Matters” (KAM). The objective of Statements in June 2007, which was an adoption
the amendment is to allow one year deferment of the framework issued by the International
for application of Guidance Note No. 01 in view Accounting Standards Board (IASB) in 1989. In
of numerous requests received from professional November 2011, it adopted a revised Conceptual
practice firms and industry desiring guidance on Framework for Financial Reporting issued by
a uniform audit report. It is generally believed that the IASB in 2010, which superseded the earlier
practitioners and stakeholders in the industry have conceptual framework. AAOIFI Conceptual
not been given enough time to prepare for reporting Framework was issued in July 2010”
and dealing with KAMs.
Additionally, in its pursuit to issue comprehensive standards to the global Islamic finance industry and
to keep up with global best practices, AAOIFI has initiated a project to revisit existing financial accounting
standards (FASs) and to review and revise them. The exercise will entail detailed analysis of each standard,
including benchmarking against other comparable standards and global best practices to identify and
recommend areas of improvement or a thorough overhaul.
The scope will also include a wide-ranging survey by AAOIFI Secretariat through which views and
comments from the stakeholders are gathered and presented to a dedicated working group formed for the
purpose. AAOIFI welcomes your participation in this initiative in the form of your feedback, comments,
or suggestions to any of its standards. You may kindly send them to accounting@aaoifi.com.
EDITORIAL
Business entities present the state of affairs and performance of their business through the
language of accounting. Banks and other financial institutions undertake a specific type of
direct or indirect intermediation business for channeling the savings to commodity producing
and services sectors and the consumers. Distribution of income of the business entities depends
largely on the accounting and financial reporting procedures and processes.
Islamic banking and finance institutions (IBFIs) have even more specific features and principles
that require re-defining the accounting concepts in general, as well as, changing the accounting
treatments for the transactions, in particular. Islamic finance with current assets estimated at
US$2.2 trillion at global level is expected to grow at a CAGR of 9.4% to reach US$3.8 trillion
by 2022 (Zawya, 2017/18)2. Islamic banks have to engage in real business, trading, leasing and
investments in various sectors in the economy.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has
done a commendable job by issuing so far around 58 Shariah standards serving as the basis
for accounting treatment of respective transactions. It has also issued 33 Islamic Financial
Accounting Standards (IFAS). A number of them are under review and development while
exposure drafts have been issued for 5 accounting and governance standards.
But, the issue is that not all countries / jurisdictions According to a study updated with data for 2016,
have adopted the AAOIFI’s Standards. While out of total 132 Islamic financial institutions (IFIs),
Shariah standards have been fully adopted or being 52% were not using IFRS – they applied local GAAP
adopted in Afghanistan, Bahrain, Krygyz Republic, (33%), 17% of them used AAOIFI’s FAS, while 2%
Nigeria, Oman, Sudan, Qatar and Syria and Yemen, did not specify in their financial statements the
accounting standards have been made part of accounting standards or law complied. “As a result,
regulatory requirement in Bahrain, Jordan, Oman, the differing recognition and measurement bases impede
Qatar, Sudan, and Syria. Accounting standards are users’ ability to meaningfully compare the financial
used as basis of developing national accounting statements” concluded the study3. With regard to
standards in jurisdictions such as Indonesia, Ijarah related accounting, the study found that the
Kazakhstan, and Pakistan, while other jurisdictions majority of the samples (61%) reported Ijarah as
such as Bangladesh, Brunei Darussalam, Iraq, financial assets in accordance with IAS 39 / IFRS 9 /
Kuwait, Labuan, Lebanon, Palestine, Maldives, IAS 17. The treatment by 35% was to recognize Ijarah
apply AAOIFI standards as guidance in their as fixed assets in accordance with AAOIFI’s FAS
respective regulatory regimes. No. 8 for Ijarah and Ijarah Muntahia Bittamleek. As
1- Mr. Muhammad Ayub is the Editor of JOIFA. He is also the Director Research and Training at the Riphah Centre of Islamic Business
(RCIB), Riphah International University, Islamabad, the Editor of Journal of Islamic Business and Management (JIBM), and Secretary of
International Conference on Islamic Business (ICIB).
2- State of the Global Islamic Economy (SGIE) Report 2017/2018: Outpacing the Mainstream; https://www.zawya.com/mena/en/ifg-
publications/231017085726C/
3- Asian-Oceanian Standard-Setters Group (AOSSG), Islamic Finance Working Group; Financial Reporting by Islamic Financial Institutions:
An update to the 2014 study of financial statements of Islamic financial institutions; 17 Jan, 2017. The study included the items / transactions:
i) Financial reporting framework; ii) Accounting for Ijarah contracts that transfer ownership; iii) Classification of customer investment
accounts; and iv) Measurement of finance income. http://www.aossg.org/images/docs/aossg_fi_wg_jan_2017.pdf
a result, the IFIs are applying differing recognition framework of accounting including the scope and
and measurement bases that impede users’ ability purpose (objectives) of financial accounting and
to meaningfully compare the financial statements. reporting and the functions and responsibilities of
the personnel involved in the conventional and the
While some countries are in the process of Islamic accounting.
adaptation of the Standards according to their
market scenario and the tolerance levels, many The features of accounting and financial
jurisdictions and institutions do not feel the need reporting in Islamic perspective include: i) Honesty
even to observe any special conditions for recording concept; ii) Accountability for control concept; iii)
their investments and business transaction. It may be Adalah (justice) concept which has close relevance
because their products and investment instruments to the maqasid al shariah; iv) Competence and sincere
closely mimic the conventional products. They are effort concept; v) Disclosure and transparency in
apparently of the opinion that the assumptions line with the Quranic verses (2:282; 65:6); and the
underlying the conventional accounting are not most importantly, vi) Al- naseehah (well-wishing for
incompatible with Islamic values (Velayutham, all) Concept.
20144). This is highly challenging as it could harm
the integrity of the system of Islamic finance across Al-naseehah concept seems to be the most
the world. salient feature of Islamic accounting discipline
which requires the personnel involved in financial
The systems evolve over time, and accordingly, reporting to be well-wishing for all stakeholders,
AAOIFI also revises its standards keeping in view also including society. It refers to sincerity to one
the issues that arise in the application of standards. another, compassionate behaviour and advice
For example, AAOIFI issued in 2016 FAS No. to others for their best benefit. According to a
27 on Mudaraba based investment accounts that famous hadith, the Prophet (peace be upon him)
superseded two earlier accounting standards for said, “The religion is naseehah (sincerity).” We said,
investment accounts (FAS Nos. 5 and 6). FAS 27 “To whom?” He (peace be upon him) said, “To
allows for the concept of substance over form in Allah, His Book, His Messenger, and to the leaders of
classifying investment accounts and considers them
the Muslims and their common folk.” [Sahih Muslim].
an independent intermediary element between
liabilities and owners’ equities (quasi-equity). The above features of Islamic accounting and
financial reporting refer to the ‘Venn relationship’
The Scope and Objectives of Islamic among the accountants, organizations, society
Accounting and, at broader level, the mankind. It implies that
as Muslims’ life means to be pure, honest, well-
Among other things, relevance and reliability
wishing and sincere to oneself, to fellowmen, to
of information have been emphasized as the
primary characteristics of accounting and financial employees, employers, the weak and to the society,
reporting in Islamic framework. It includes all such the personnel involved in accounting and auditing
information that the stakeholders may need to need to work for the benefit of all stakeholders
accomplish their business and investment decisions without any contrived efforts aimed at ‘earnings
and fulfill their regulatory, tax related and religious management’ for the majority shareholders and, in
obligations including zakah and other benevolent turn, for their own pay packages and perks.
payments.
It is due to some basic assumptions5 of conventional
As Islamic finance developed, many accounting accounting, on the other hand, that problems arise
and finance professional indicated some crucial in recognition, classification and valuation that, in
differences between the conventional and the turn, affect financing (capital structure), investing
emerging systems thus warranting the different (organization’s assets portfolio) and operating
reporting and accounting principles. These decisions (about generating revenues, managing
differences pertain mainly to the prohibition of expenses and managing working capital). In addition
interest leading to negation of time value of money to the assumptions, there are certain procedural
as ‘opportunity cost’, uniformity of substance and issues that have created integrity problem not only
form, and fair value vs. historical cost. Accounting for the financial information and reports in Islamic
for zakah and waqf institutions that are the two framework, but also in the conventional perspective.
pillars of Islamic beyond-market economy have been Most of such issues leading to maneuvering for
indicated as the new areas in financial reporting. ‘earnings management’ and problems, as sometimes
Going in detail, the differences are in the conceptual accepted by FASB /AASB also, are:
4- Sivakumar Velayutham, Conventional Accounting vs Islamic Accounting: the Debate Revisited; Journal of Islamic Accounting and
Business Research (Emerald); Vol.5, No. 2, 2014; Pp 126-141.
5- Including, inter alia, Business Entity Concept, Historical Cost Principle, and Opportunity Cost of Money concept.
1. Two or more methods of accounting accepted for information they need to make the right decisions
the same facts. about how to allocate their capital”6. Such matters
are even more important in Islamic finance as the
2. Less conservative accounting methods being revenue accruals, expense charged and the profit
used (without sufficient verification about to be distributed depend on how the underlying
expenses and losses before entering a claim to contracts perform and how the same are reported.
any profit);
Therefore, the prime effort of Islamic finance
3. Reserves are used to artificially smooth earning regulators and the practitioners has to be achieving
fluctuations; a former Chairman, IASB termed the ultimate objective of fair dealing with all
them as “cookie jar reserves” that result in unfair stakeholders and providing correct and relevant
treatment with any of the stakeholders; information to them. It also would require
harmonization of financial reporting by adopting
4. Financial statements fail to warn of impending
the AAOIF’s standards, using them as a basis for
liquidity crunches;
Shariah opinions and financial reporting with as
5. Deferrals are followed by write-offs; low adaptation as possible.
6. Unadjusted optimism exists in estimates of AAOIFI has provided a benchmark against IFRSs
recoverability; or other global standards to ensure consistency
with globally accepted standards. It is also in the
7. Off balance-sheet financing (disclosure in process of modifying them, where necessary, in
financial statements only, even that partial) is order to ensure that financial statements present
common; fairly the cash flows, revenue recognition, and
financial position and performance of the Islamic
8. An unwarranted assertion of immateriality to
financial institution. Till the time, the AAOIFI’s
justify non-disclosure of unfavorable information
standards are generally adopted, all out efforts
or departures from standards; and the most
are needed, even within the current framework,
importantly,
to avoid the procedures / practices that may cause
9. Form is given precedence over substance. non-Shari’ah compliance in legal term, or injustice
to any of the stakeholders, for compliance in spirit.
The non-effective implementation of the Shariah Standard 47 on “Rules for Calculating
recognition, classification and evaluation principles Profit in Financial Transactions” is of prime
may have serious implications. Russell G. Golden, importance in this context. The ultimate objective
the sitting Chairman of the FASB, commented of Islamic finance professionals, accountants as
in this regard, “Effective implementation of the also auditors, is to evolve reporting processes in
revenue recognition standard is critical to its success such a way that the objectives of Islamic finance
in providing financial statement users with the are achieved.
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AAOIFI invites “Call for Papers” for the next issue of JOIFA
with special focus on AAOIFI,s newly issued standards and
exposure drafts and / or related topics .
6- FASB, News item, “FASB and IASB to form joint transition resource group for revenue recognition” July 26, 2013; accessed from: http://
fasb.org/cs/ContentServer?c=FASBContent_C&cid=1176163129249&d=&pagename=FASB%2FFASBContent_C%2FNewsPage
PEER-REVIEWED
Abstract
Financial reporting by Islamic financial institutions is generally considered to be different
from the procedures employed by conventional accounting under the IFRS due to application of
Shari’ah principles mainly derived from Islamic law of contracts. A Shari’ah conscious user of
financial statements requires additional qualitative characteristics in the information provided by
any entity. The user of financial statements is conscious about recognition and measurement of
various elements of financial statements due to additional information requirements for decision
making.
This paper discusses similarities and distinguishing factors between the IFRS and the Islamic
accounting concepts espoused in the AAOIFI’s financial accounting standards (FAS). The
specific information needs of Shari’ah conscious users of financial statements such as Zakah
obligations and the differences in principles i.e. debate between historical cost and the fair value
in terms of various forms of assets are also examined.
Finding out solutions to the issues indicated is the need of the hour. This paper only focuses on
pointing out the areas of work, while the experts and institutions like AAOIFI and country based
bodies like SOCPA, ICAP and others need to take these factors and aspects into consideration.
Keywords: IFRS, AAOIFI, Inventories, Fair Value, Intangible Assets, Zakah, Ushr.
1- Omar Mustafa Ansari is the Deputy Secretary General, Accounting and Governance, AAOIFI.
2- Haroon Tabraze is the Chairperson, Accounting and Law at Institute of Business Administration (IBA), Karachi, Pakistan.
supported by the banking regulators who require 2. 2 Valuation and measurement basis
identification and recognition of risks integral to
Islamic banking in order to be able to compare them For valuation of cash and the debts, the
with conventional banks (Aziz, 2007). conventional concepts of computation of fair value
through discounted value of future expected cash
The objective of AAOIFI, as available on its flows (IASB, 2016) is in conflict with the Islamic
website, is to “develop accounting thought taking concepts of accounting. Therefore, the IFRS
into consideration the international standards permitting fair valuation of assets and liabilities
and practices which comply with Islamic Shari’ah using the discounting method cannot be used in the
rules”. It is slightly different from the objective current form for Islamic transactions.
of IASB, “to develop, a single set of financial
reporting standards based upon clearly articulated The Islamic perspective is to carry tangible assets
principles” (Deloitte, 2018). AAOIFI takes into at fair value and carry cash, cash equivalents and
consideration international accounting practices, receivables at ‘par’ or ‘notional’ value. Investments
but requires additional information to be provided according to Islamic economic principles are
for the Shari’ah conscious investors. Therefore, it primarily not cash equivalents; hence, also need to
is safe to assume that IFRS and AAOIFI standards be carried at fair value.
will have many similarities, with differences only
The contemporary jurists have divergent views
where the Shari’ah rules render certain transactions
on using the historical cost convention for allocating
impermissible or require different treatment. To
profit or loss between partners in an ongoing
sum up, the core differences arise because:
enterprises working under the Islamic principles of
Shari’ah conscious investors have specific Musharaka and Mudaraba. The partners may agree
information needs that are not fulfilled by on using historical costs for the purpose of periodic
presenting information prepared through IFRS profit and loss distribution, but this principle
cannot be applied in case of eventual liquidation or
The transactions of Islamic Financial Institutions dissolution of the partnership.
(IFIs) are structurally different from that of the
conventional banks, therefore cannot be presented The principle of applying fair value is applicable
in their true essence through IFRS while distributing inheritance and computing
obligation for zakah for individuals. However,
2. Key Shari’ah Issues in case of entities, inheritance may be created in
the form of Musha‘ or Shirkat-ul-milk i.e. joint
2.1 T
he information need of Shari’ah ownership, in which case fair value is preferred, but
conscious investors can be avoided if the parties mutually agree on a
price different than the current market price.
The user of financial statements of an IFI
requires additional information to make certain The fair value less cost of selling the asset
decisions i.e. obligation of Zakah, as historical cost approximates ‘net realizable value’ (NRV) that is
is not useful for the purposes of Zakah computation used to measure inventories in Islamic financial
(Gambling & Abdel Karim, 1999). Balance sheets transactions. However, fair value less cost of selling
prepared on current values better serve the needs the asset is different from the current market value
of Shari’ah conscious users compared to those (that does not take into account the selling cost).
prepared on historical cost (Baydoun & Willett,
The Islamic financial transactions use another
1997). Similarly, while distributing inheritance,
term ‘face value’ (value agreed between the parties).
assets are required to be valued at fair value. In
This valuation method is not prescribed in IFRS.
the traditional Fiqh, almost all computations for
profit and loss distribution between partners and 2.3 Property, Plant and Equipment (PPE)
participatory stakeholders have to take place at
fair value, although in contemporary Fiqh certain Property, plant and equipment (PPE) comprise of
exceptions have been allowed. In all such matters tangible items held for use in production or supply
the sense of accountability’ to Almighty is the factor of goods or services, or rental to others (except land
that determines the favored objective of financial and building given on rent), or for administrative
statements for the Shariah conscious persons purposes and are initially recognized at cost, and
(Gambling & Abdel Karim, 1999) subsequently measured either through ‘cost’ or
‘revaluation’ model (IASB, 2016).
Traditionally, assets have been valued at historical
cost according to conventional accounting, but in A Shari’ah conscious user requires disclosure
recent years some types of assets e.g. investments of fair value of PPE at the reporting date for the
and investment properties (IASB, 2016) are allowed, purposes of Zakah and inheritance. If PPE is
while biological assets (IASB, 2016) are required to subsequently measured on revaluation basis, it
be valued at fair value. may closely approximate the fair value if the last
revaluation was made not long ago. However, even Where investment property is acquired through
when using the revaluation model, there is always Diminishing Musharaka arrangement or in rare cases
a chance of the carrying value of the asset to be through gradual transfer Ijarah arrangement, the
significantly different from the fair value of the asset. accounting treatment is not clearly defined by any
standard. Further discussion and research is required
A Shari’ah conscious user of the financial whether the accounting treatment prescribed by
statements also requires classification of assets into IAS-40 would be applicable on proportionate basis
those that are Shari’ah compliant, or otherwise. PPE depending on ownership interest in the asset, or
generally do not include assets that are Shari’ah such a treatment is not required at all.
non-compliant.
The authors believe that the fair value
2.4 Intangible Assets measurement should be preferred while disclosing
Wealth (Maal) includes services, usufruct and investment property. Where it is difficult to get fair
intangibles (Obaidullah, 2002). A small segment values of assets, the cost model may be followed
of Shari’ah scholars claim that identification and to present the financial information, with a note
determination of intangible asset as property disclosing the closest estimate of fair value at the
raises Shari’ah issues. But, their arguments are not reporting date annexed with the financial statements.
considered rational compared to that of the majority
A Shari’ah conscious user of financial statements
of scholars who recognize that such assets possess
requires additional information regarding
financial value (Bouheraoua, et al., 2015).
classification of investment property - for
AAOIFI considers intangible assets as property rental purposes or for capital appreciation. This
having monetary value (AAOIFI, SS. 42, 2015). information is relevant for determination of Zakah,
Shari’ah scholars have conflicting views on whether as the property primarily for rental purposes is
intangible assets would be subject to Zakah, and exempt from the obligation3 .
at what value? Majority of scholars appears to be
in favor of not levying Zakah on intangible assets Scholars have conflicting views on applicability
unless it is a separable intangible asset acquired for of Zakah on subsequent classification to investment
further disposal and gain; therefore considered to property. One view is that asset is not subject to
be a trading asset (Bouheraoua , et al., 2015). Zakah if it was purchased with the intention of own
use and was subsequently classified as investment
A Shari’ah conscious user would require additional property. However, many scholars believe that as
information regarding control of intangible assets, the intention of the user changes with the change
and the risks and rewards incidental to ownership in classification, therefore Zakah will be applicable.
of such assets. Where an intangible asset is acquired
through a Shari’ah compliant Ijarah, it may generally The predominant view is that long-term lease
not be considered an asset of the entity as the entity of land is subject to Zakah in the hand of lessor
is only entitled for using the benefits (usufruct) of because risks and rewards incidental to ownership
such asset and does not have the risks and rewards of the asset are not completely transferred to the
incidental to ownership. lessee. In case of asset given on Shari’ah compliant
Ijarah contract accounting treatment is similar to
In case where an intangible asset is purchased or the treatment of operating lease.
produced for internal use, there will be no Zakah
implication. An asset developed by the entity for 2.6 Agricultural assets and income
eventual sale is to be considered as inventory.
International Accounting Standard – 41
2.5 Investment Property ‘Agriculture’ prescribes the accounting treatment
of biological assets (animals and plants) and
Land or buildings held to earn rentals or for agricultural produce. IAS-41 does not have any
capital appreciation are classified as investment adverse Shari’ah implications, and provides the
properties and are subsequently measured in the Shari’ah conscious user of financial statements with
financial statements either at cost or fair value (IASB, improved information.
2016). AAOIFI has a separate standard FAS-26 that
requires investment properties to be measured at Biological assets and agricultural produce are
fair value. Fair value measurement allows better subject to specific rules in relation to Zakah and
profit and loss sharing between participating Ushr, so a Shari’ah conscious user will require
stakeholders (or with minority shareholders). It is supplementary information regarding classification
also relevant for the stakeholders of an IFI who have of assets apart from the fair values. The assets
invested with the IFI through instruments of quasi- subject to Ushr must be reported as a separate class
equity. FAS-26 also provides for Shari’ah compliant of assets and not be included in the assets subject
allocation of gains from these properties. to Zakah. It is also important to indicate that Ushr
is leviable on the produce of crops and plants / be computed at a value that is different from the
gardens, and not on the land or the plants. Further, recorded value in the books of accounts.
the financial statements should preferably provide
The treatment of spare parts, consumable stores
a statement or reconciliation for the assets subject to
and loose tools depends on the measurement
Zakah at different rates or formula, with separate
model. Where the intention is to treat them as part
disclosure of assets subject to Ushr. The financial
of asset, they will be carried under the models
statements prepared under IFRS do not give this
prescribed under IAS-16, and will not be subject to
information.
Zakah. However, if the entity chooses to apply the
It is important to note that according to Shari’ah model prescribed in IAS-2 on the basis that these
principles the Zakah on agricultural produce in are convertible into saleable material, these items
excess of the minimum limit (nisab) of produce is will be subject to Zakah based on their net realizable
applicable as Ushr, instead of normal Zakah that is value.
on the wealth in excess of normal use by the owner.
We need to classify inventories in primarily two
2.7 Inventories categories from the Shari’ah perspective i.e. those for
sale (as they are, or after conversion or processing)
Inventories are the assets that are either held for and those for consumption or use in production
sale in the ordinary course of business, or in the such as spare parts. A further category will be for
process of production for such sale, or are in the the items of inventory such as precious stones or
form of materials or supplies to be consumed in the minerals that do not attract Zakah or Ushr at all.
production process or in the rendering of services
(IASB, 2016). It is important for a Shari’ah conscious stakeholder
to have sufficient information available. For
Islamic financial products are concentrated inventories, additional disclosures are sufficient
towards ‘trading’ rather than ‘financing, therefore without changing the accounting treatment.
most of the products include, or involve, inventories
at different stages of the transaction. AAOIFI is 2.7.1 I nventories held under Islamic modes
trying to classify and define inventory in line with of financing
the IFRS (for example see the new standard on
Murabaha and deferred payment sales). The Islamic finance products of Murabaha, Salam
or Istisna’a involve holding of inventory at particular
The debate amongst scholars in relation to points. AAOIFI has been actively working to align
inventories is regarding assigning their values, both the accounting treatment of inventory under these
from the perspective of Zakah and for the purpose products, especially through its newer standards.
of distribution of profits. A Shari’ah conscious user However, it still falls short of the information needs
will be interested in the disclosure identifying of a Shari’ah conscious user of financial statements.
whether inventories are Shari’ah compliant in their An additional disclosure about the fair value and
very nature, or not? applicability of Zakah is required.
IAS-2 requires inventories to be subsequently
In case of Murabaha, the inventory needs to
measured in financial statements at lower of
be valued at cost at which the goods are being
historical cost or the net realizable value (NRV).
purchased by an entity. An NRV adjustment may
Zakah is to be assessed based on the realizable value
be required where the total cost of inventory
(i.e. fair market value) instead of historical cost exceeds the NRV. This adjustment may not be
or the NRV. A point can be made that both these easily understood by the Shari’ah conscious user,
values are almost identical to each other in most of particularly because the Zakah is applicable on
the cases, but it might not always be the case. An the fair value. The ideal treatment for profit and
example specifically related to inventories is where loss distribution is also on fair value basis, but the
the entity expects to complete the production cycle, AAOIFI standards require lower of cost or NRV
or process the asset and then sell it, the fair value basis for subsequent measurement.
of inventory can be significantly different from its
NRV. Where the fair value is significantly different 3. Financial Assets and Liabilities
from the recorded value of the inventory, it needs
to be disclosed as additional information in the Investments
financial statements.
A Shari’ah conscious investor needs supplemental
In case where the purchase price of inventory information about the types of investments made
is not the cash equivalent value i.e. the transaction by an entity, specifically identifying any non-
includes a credit period that is more than normal Shari’ah compliant investments. Such information
credit period, the value of such inventories must is important in respect of all investments and other
be reconciled as obligation of Zakah, inheritance similar financial assets, by whatever classification
and profit and loss determination may have to reported.
3.2 Advances and other Receivables The conventional accounting disclosures include
identification of the banks from which financing is
Amount(s) of receivables which are not in availed, rate of profit, and the terms and conditions
compliance with the principles of Shari’ah must attached thereto including the repayment period.
be separately disclosed. The credit period allowed A Shari’ah conscious investor also wants further
in respect of non-interest bearing securities, along classification of borrowing(s) into long and short
with amount and information about the parties term nature, and fair value of collateral(s) held in
from which it is receivable should also be disclosed respect of the financings obtained.
in the notes to the financial statements.
Further, disclosures are also required for the
It is also important to ascertain that the debt has maximum aggregate amount of borrowing at any
been established, and is represented in full keeping time during the year including the portion of Shari’ah
in view the non-permissibility of discounting. non-compliant borrowings at that point of time.
of contracts, ownership of the leased asset is not Such income is required to be contributed towards
transferred to the lessee, who gets only the benefit charity, rather than taking income of the entity.
of use of the asset in exchange of rentals (Usmani,
2000:60). However, if we consider the Ijarah 6.1 Earnings per share (EPS)
transaction to be a sale of usufruct and amend the
Earnings per share is a fundamental information,
FAS-8 in line with the new IFRS-16, the accounting
especially for potential investors, that although
treatment will be similar with an exception that the
not being a part of financial statements directly, is
time value of money concept will still need to be
required to be disclosed at the end of the profit and
avoided for payments to be made after one year.
loss account according to conventional accounting
It is interesting to note that in classic texts of Fiqh, standards. Shari’ah compliant earnings per share
the lease transaction is considered analogous to sale may be calculated by dividing profit or loss from
but with a difference that in Ijarah the corpus of the Shari’ah compliant operations attributable to
property remains with the owner (Usmani, 2000). ordinary equity holders of the parent entity (the
Even in the case of usufruct, the issue remains as numerator) by the weighted average number of
to whether an Ijarah transaction is a Ba‘i (sale) of ordinary shares outstanding (the denominator)
usufruct for the overall period, or Ba’i for a series of during the period.
intermittent periods i.e. monthly, quarterly or half-
A particular difficulty will arise in disclosing
yearly for which the rentals are agreed and paid.
EPS by conventional financial institutions that have
If we consider it to be a single contract, the “right
Islamic windows (operations). This might also be
to use asset” can be recorded and the difference
relevant for normal companies wishing to classify
with IFRS can be minimized except for the fact that
the nature of operations and income according to
it would be recorded at par value and not at the
permissible and prohibited income.
fair value being the discounted cash flow (DCF) of
minimum lease payments. According to MASB Tri-3 Presentation of Financial
Statements of Islamic Financial Institutions:
5. P
rovisions, contingent liabilities
Para 28: ‘’An IFI shall present, either in the
and contingent assets statement of changes in equity or in the
Profit Equalization Reserve and (PER) and notes, the amount of dividends recognized as
Investment Risk Reserve (IRR) are said to be set distributions to owners during the period, and
aside by the IFIs as profit smoothing and risk the related amount per share.’’ This shows there
management techniques (Taktak, et al., 2010). Both is no apparent conflict with IFRS.
PER and IRR by definition do not meet the criteria Para 29: ‘’The disclosure of dividends per
of either a provision or a liability; these reserves are share may not be applicable to Islamic banking
allocation out of profits. activities carried out by a conventional bank or
financial institution.’’
Most provisions do not meet the definition of
a liability from Shari’ah perspective, in particular Entities may be encouraged to disclose the effect
with regard to Zakah. In case, when cost of onerous of dilution on its state of Shari’ah compliance from
contracts becomes an established liability, Zakah will the perspective of Shari’ah conscious investors. This
be adjustable. This will vary depending on the case; disclosure would be applicable if, and only if, the
as such, costs do not always result in an established status changes from a Shari’ah compliant entity to
liability. Provisions can be adjusted for PLS purpose, a Shari’ah non-compliant entity or vice versa. Such
but not for Zakah. However, for inheritance purposes a situation arises when the effect of dilution results
each case has to be evaluated separately. in significant changes in the Shari’ah non-compliant
debt vs. equity ratio, as well as, the proportion of
Shari’ah does not allow discounting the liabilities Shari’ah non-compliant expenses or income. In such
on the basis of time value of money. However, scenarios, it would be imperative to disclose such
the provisions are not established liabilities or effect for the benefit of the relevant stakeholders.
dayn, hence a point can be made to discount them
using DCF method. We need more research and 7. Statement of cash flows
deliberation on this issue.
Cash and cash equivalents
6. Revenues and expenses
Shari’ah conscious users will be interested to
There is generally no difference in the way know the classification of cash and cash equivalents;
revenue is recognized in conventional accounting whether they are Shari’ah compliant or not. Due to
or the accounting for Islamic products. A Shari’ah nascent state of Islamic economics, many Shari’ah
conscious investor requires certain additional scholars allow entities to keep 80-90% of their
information to the disclosures required by IFRS i.e. cash equivalents in Shari’ah compliant products,
income from Shari’ah non-compliant operations. instead of keeping the full amount. Disclosure of
such policies will be advantageous for the Shari’ah or with the AAOIFI’s standards. For a common entity,
conscious user of financial statements. the IFRS would be applicable without any problem.
Savings account with a conventional bank can Distribution of profits amongst stakeholders
be considered cash equivalent from both Islamic
and conventional perspectives. It is because the The only issue that might need some
conventional accounting treats such accounts as consideration is the treatment of adjusting events on
cash equivalent - readily convertible into known the distribution or allocation of profits and losses to
amounts of cash (IASB, 2016) but a saving account the stakeholders (other than common shareholders)
on Mudaraba basis with an Islamic bank is not a i.e. investment account holders and PLS depositors
cash from Shari’ah perspective. For an IFI, these or policyholders of Takaful companies.
funds have been invested on Mudaraba basis;
therefore are a form of quasi-equity. The Shari’ah debate is whether the distribution
of profits among stakeholders is to be done as ad-
Apart from IFIs, normal trading or manufacturing hoc distribution or as per constructive liquidation.
companies may also use this classification for the If it is ad-hoc distribution, then it shall be adjusted;
benefit of Shari’ah conscious users and Shari’ah however, in case of constructive liquidation it will
compliant mutual funds, for their investment be based on the judgment of the management.
screening purposes.
Adjusting events and Zakah
Classification issues – for cash flow purposes
Any adjusting event, which might have an impact
Murabaha and other similar products are on common accounting and reporting information,
trading products according to Shari’ah principles. but might not be adjustable either for computation
Therefore, receivables in such modes are not to of Zakah basis or for the purpose of profit and loss
be included with the cash and cash equivalents. computations, has to be identified and disclosed
Classification of sales and purchases in trade based separately.
modes needs further research and deliberations
amongst scholars. 9. Related party relationships
The distribution of profit to investment account Definition of related party as provided in IAS-
holders and PLS deposit holders need to be classified 24 does not cover relatives up to second degree.
uniformly, as these may be ambiguously considered IFRS considers only close relatives for the purpose
as operating activity or financing activity. Similarly, of related party disclosure. However, this is not
assets purchased for leasing on Ijarah basis are something that may have any major impact except
usually considered an investing activity, but critics for when transactions are being carried into by an
object that these may be classified as ‘financing’ entity with related parties up to second degree
and consequently be disclosed under operating (other than close relatives) and not being at arm’s
activities. length.
In conventional banks, the increase and decrease In situations involving trade, particularly credit
in savings and deposit accounts are classified as trade and financial transactions with related
operating activity. In IFIs the practice of classifying parties, the Shari’ah conscious users would like to
them is diverse between jurisdictions. The overall have additional information about transactions
treatment as approved by the MASB is conflicting between the group companies, and whether these
with the AAOIFI pronouncements. This presents a transactions were Shari’ah compliant such as spot
gap for researchers to explore and to find the best purchase by one company and subsequent sale to a
option for accounting needs of Shari’ah conscious group company on credit which may have adverse
users. Shari’ah implications.
A Murabaha transaction for acquisition of raw According to para 30 of FAS 12, the transactions
materials may be classified as operating activity, with related parties that are carried at non arm’s
whereas a similar Murabaha transaction for length are required to be disclosed with the total
acquisition of fixed assets may be classified as amount of claims paid, and the contribution rate
investing activity. The profit component from such offered to the related parties. Further, the terms and
transactions shall not be separately identified and conditions should also be disclosed, if they differ
reported in cash flows. All these treatments need from the prevailing practice.
to be settled by the standard setters to present
information uniformly for the user. 10. Operating Segments
8. Events after the reporting period There is no major difference between the
disclosure requirements prescribed by the IFRS
There is no conflict in IFRS with Shari’ah principles 8, ‘Operating Segments’ and AAOIFI’s FAS 22,
‘Segment Reporting’. Scope of FAS 22 expands to prescribed has prospective implications only.
such companies whose shares or debts are held Accordingly, for changes in estimates, generally
privately, in addition to publicly traded companies there would not be any significant additional
and companies in the process of issuing publically disclosure or treatment required.
traded instruments.
It is important to note that AAOIFI standard
While considering segment disclosures, the talks about adjustment to policyholders’ liabilities
management may also consider disclosing Shari’ah and equity in a manner similar to that of the normal
compliant businesses and Shari’ah non-compliant shareholders. Same treatment needs consideration
businesses separately. Mostly, this will be the case for adjustments to the IAH / PLS depositors or other
of banks and insurance companies offering both stakeholders in case of IFIs.
Shari’ah compliant and Shari’ah non-compliant
services to their customers. An entity should disclose any income component
that is not considered to be compliant with Shari’ah
According to a study by the Asian-Oceanian that is directly taken to equity in respect of prior
Standard Setter Group (AOSSG), “Some entities periods. In case an item of income being non-
that purport to engage in Islamic operations may compliant with Shari’ah, for example interest
not disclose information about that component as income, is credited directly to equity, it needs to be
an operating segment” [2010]4 . While disclosing disclosed in a manner similar to that of the current
the overall performance of segments (segment-wise period’s income as a Muslim investor needs to
comprehensive income), requirement for additional be informed about all income, that is not Shari’ah
disclosures needs to be considered with respect to compliant, irrespective of the method being used.
Shari’ah compliant and Shari’ah non-compliant
A change in accounting policy or correction of an
income of each segment along with reconciliation
error may have effect on zakah bases for the current
of the same with overall segment performance.
as well as previous years. In respect of accounting
policies, any effect has to be taken to current year’s
11. C
hange in accounting policy and zakah base; therefore, there is no need for a separate
estimates disclosure.
The treatment of modification in allocation and
distributions to or from various stakeholders by
12. Accounting in other currencies
an IFI poses an interesting question. Are these The accounting principles applicable on foreign
modifications in allocations and distributions exchange related aspects are generally neutral from
‘change in accounting policy’? The ensuing question Shari’ah perspective. However, Shari’ah has specific
is about requirement for this change to be disclosed. requirements with regard to Bai al sarf i.e. dealing
The modification in workings for PLS distributions, in foreign currencies.
or in actuarial workings, or in the proportion
of Wakalah fee are examples of allocations and Zakah is applicable on the fair value of assets and
distributions or some of the illustrations of such a hence the fair value of assets in foreign currency
scenario. The apparent answer could be ‘No’, but shall reflect the fair value including the impact of
further research and deliberations are required. fair translation of foreign currency balances.
Retrospective restatements are possible; however, There can be a debate with regard to applicability
the effect of such a restatement on all stakeholders of functional currency with regard to computation
needs to be deliberated especially in relation to of Zakah. Difference may be arising through
the practice of constructive liquidation. Many translation of assets in net value although such
IFIs follow constructive liquidation technique for differences would be immaterial or rather negligible.
the purpose of profit distribution periodically;
meaning that the amounts are finally adjusted for Exchange differences on assets and liabilities
the stakeholders. The question is that to whom such that are considered to be Shari’ah non-compliant,
adjustments relate? shall be disclosed separately from those considered
Shari’ah compliant. This disclosure should be
Similar to accounting policies, the issue of preparing applicable for the two types i.e. the gain taken to
estimates for shareholders and other stakeholders the income statement, and the gain carried through
(investment account holders, PLS depositors, or the ‘other comprehensive income’.
policyholders) is also important especially in the case
of creating provisions and reserves. 13. B
usiness combinations,
For any change in estimate that is not considered
consolidation and associates
to be a prior period error, the accounting treatment The key issue that arises in the review of accounting
standards for consolidation and separate financial shareholders, for example depositors or takaful
statements from Shari’ah perspective is the assessment participants, if their investments are utilized in
of need of such information from the perspective of investments in these ventures?
Shari’ah conscious users.
Another key issue is the accounting treatment for
The key information needs of Shari’ah conscious consolidation of a special purpose vehicle company
users of the financial statements primarily include (SPV). Such entities include the SPV structures
the matters relating to determination of Zakah, created to offer sukuk, as the underlying structure
availability of information for determination of of sukuk is considered to be “stronger” and
inheritance, and the information related to profit “strongly ring-fenced” and commonly entail real
and loss computation and distribution according to ownership of the underlying assets as compared to
Shari’ah principles, amongst various participating conventional SPV based structures.
stakeholders. The questions that may arise in this
Generally, we will assume that for the purpose
context include:
of Zakah each entity has to apply the principles of
Whether or not Zakah needs to be determined Musha‘ (combined ownership for Zakah purposes)
on a consolidated basis or on the basis of separate and hence each entity will pay its own Zakah. The
and individual financial statements; financial statements of the group on a consolidated
basis will just combine the necessary figures, and
Whether or not this treatment should remain
will not be considered a means of computation of
consistent for stakeholders who prefer Musha‘
Zakah.
on Zakah (i.e. Zakah on the assets of an entity
irrespective of individual stakeholders) or those Consolidated reconciliations of Zakah would be
who do not prefer it on a combined basis (normally prepared with a disclosure note that these are the
relating to Hanafi school of thought); responsibilities of various entities and not that of
the group as a whole.
Whether or not Zakah should be payable by
the participating stakeholders of the parent entity
on the assets which are under the ownerships of
14. Insurance contracts
the subsidiaries or other group companies which The most important issue that needs to be dealt
are not directly in control (with right to use and with by the accountants is choosing between ‘single
consume)? or consolidated accounts’ and ‘two separate sets
Whether the true profits and losses (or of accounts for the operator and the participant’.
comprehensive income) of the shareholders of According to the AAOIFI’s standards, two different
a parent entity are those which appear in the sets of accounts within the same format of financial
consolidated accounts, or those which appear in the statements are required.
separate financial statements. Generally, the practice is in line with the
Considering either of the above to be true, conventional insurance practices, but the assets,
whether or not it is necessary to prepare the other liabilities, revenues and expenses pertaining to the
set of financial statements from the perspective of operator and to the participants are disclosed in
Shari’ah conscious users? tabular or notes form.
Do the reconciliations required for zakah In our view a single set can be used if the
purposes or for profit and loss determination for concept of quasi-equity and equity of other than
Shari’ah conscious stakeholders need to be prepared owners become acceptable. Few practitioners
for both sets of the financial statements or only for believe that this definition excludes takaful
the relevant set of financial statements? arrangements because it involves risk-sharing
among policyholders, rather than risk-transfer from
Similarly, what information needs does a Shari’ah policyholders to the takaful operator.
conscious stakeholder expect to be fulfilled by a
group’s parent entity, and to what extent necessary The fundamental argument is whether there is
disclosures and reconciliations need to be prepared any risk-transfer in takaful? Here, the risk-transfer
for the consumption of such user of the financial is from an individual policyholder to a group of
statements in the consolidated, as well as, separate policyholders, rather than from the policyholders
financial statements? to the takaful operator.
Another question that arises is related to entities On the assumption that it is not risk sharing,
other than subsidiaries, i.e. as to whether the rather a risk-transfer from individual policyholders
principles that we may define for the subsidiaries to a group of policyholders, some may conclude
should be applied in a similar manner for associates that the group of policyholders i.e. the pool or the
and joint ventures. Waqf is the insurer. If that was the case, then the
Participants’ takaful fund or the Waqf in different
What should be the treatment in respect of models will be subject to these provisions and not
participating stakeholders other than common the takaful operator.
From the perspective of a Shari’ah compliant While subsequently measuring the values,
investor additional disclosures may be required whether to charge impairment or not, is again an
for understanding and identifying Shari’ah non- issue requiring further research and deliberations.
compliant activities including investments in funds An option could be to make an estimation of
and income from such investments. impairment, performed at periodic intervals
through DCF or a similar model. However, even
15. Qard Hasan in such a case, the discounting effect should not be
reflected in accounting and financial reporting.
There are certain situations in which a Qard
Hasan is given, particularly by the takaful operator Summary
to the takaful fund or Waqf. Accountants raise the
question as to whether such Qard Hasan needs to Having discussed the above examples and
be measured at fair value, and if so, how? instances of differences, additional information
needs and Shari’ah compliance requirements for
The issue that arises here is related to the initial various transactions and balances, we may conclude
measurement of the interest-free loan, which that there are numerous differences between IFRS
according to IFRS 9 paragraph B5.1.1 (read with and Islamic accounting standards. While most
paragraph 5.1.1) should be accounted for at fair of these can be addressed through additional
value whereby: disclosures, there are some issues that need separate
accounting treatments or classification changes.
“…the fair value of a long-term loan or receivable
that carries no interest can be estimated as the This paper is an attempt to identify gaps for future
present value of all future cash receipts discounted research. The standards setters like AAOIFI and
using the prevailing market rate(s) of interest for country based institutions like SOCPA and ICAP
a similar instrument (similar as to currency, term, need to take these differences into consideration
type of interest and other factors) with a similar while developing standards and practices for the IFIs.
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PEER-REVIEWED
Abstract
Equity, participation, ownership, risk sharing, possession and sanctity of contracts are the
key features of Islamic finance. It implies that financing can only be extended to productive
activities, trade, and real assets. Islamic system of finance can thus serve the purpose of financial
intermediation as a means to create sustainable value in the real economy at national and global
levels. For this, the banking and the non-banking financial institutions have to apply the divine
principles of the Shari’ah in letter and spirit. However, Islamic banks and financial institutions
(IBFIs) are lacking in this regard. Instead of learning the right lesson of avoiding products that led
to instability, injustice and crises in the global finance, IBFIs have been replicating conventional
products to get comparable returns in financial markets. This has caused credibility problem for
Islamic system of finance4.
This paper, based on analytical study of the available material on features of Islamic finance
and regulations applicable in Pakistan, evaluates the effectiveness of the Shari’ah governance
framework and steps taken for ensuring Shari’ah compliance. It suggests reorientation of the
regulatory and governance framework to enable the Islamic banking to realize its objectives. To
avoid distortions in the market, structured products need to be approved only after broad based
dialogue among the Shari’ah scholars, banking and finance experts and the economists. There
has to be one basis for such broader level dialogue, products approval and decision making, and
AAOIFI’s Shari’ah set of Standards could be one such basis to ultimately avoid products and
practices that cause crises, apart from other structural and prudential guidelines published by
other standard setting bodies. Based on these standards, a commission comprising regulators,
Shari’ah scholars, Islamic banking practitioners and economists may decide on controversial
issues to promote homogeneity of practices at least at the national level. The regulators, Shari’ah
scholars and the product developers need to adopt a long-term vision for developing banking and
finance for financial and social inclusion, welfare and sustainable development of economy.
5- As from 1971, money is created by making loans depending upon banks’ own reserve ratios and the discount rate, and through the
purchase and sale of government securities by the central banks.
6- It is accepted globally: “With the eurozone debt crisis deepening and the US in financial turmoil, investors are increasingly looking to
move away from a speculative and profit-based financial system. Within the new world order of austerity and caution, Islamic finance’s
fundamental tenets of risk-sharing and a prohibition on interest have helped boost its image as a safe haven”. (The Banker - Nov 2011)
not been able to establish its identity by offering their ownership and leasing of assets can be used for
equitable solution of finance problem to all groups financing, in addition to partnership based modes.
in economies and to bring stability in the national Islamic banks are required, of course, to observe
and the global markets. Therefore, the move essential features of such modes of business and
to Islamic finance is very slow even in Muslim finance. However, their main portfolios practically
majority countries. Replication of almost all comprise the structured products and instruments
conventional products and synthetic instruments innovated to replicate the conventional products
has caused much harm to integrity of the emerging with Shari’ah compliance in letter by getting
system. The twin-challenge of equitable economic certification from their Shari’ah boards / advisors
growth and financial stability is rather difficult to (El Gamal, 2007; Hussain; WP/15/120)
undertake through debt-financing (Askari et al,
2010). It requires an effective regulatory framework Many IFIs are investing in Islamic profit rate
with different approach aimed at adoption of the swaps, Islamic cross-currency swaps, credit default
principles of Islamic finance in letter as also in spirit. swaps, Islamic repos, fund index-linked derivatives
and other toxic instruments using the concepts of
Pakistan is the country where pioneering wa’ad, tawarruq and muqassah (netting-off)7 by
work on Islamic banking and finance is being invoking the simple principles of maslahah and
conducted since 1970s. Major changes were made ibāhah (Kamali, 2000). In some markets, where
in 2002, 2008 and then in 2015 when the ‘Shari’ah AAOIFI’s Shari’ah standards are considered as
Governance Framework’ (SGF) was introduced for guideline for products development, and in case
Islamic banking institutions (IBIs) operating in the of many institutions across the globe, financial
country in parallel with the conventional banks. derivatives are not used by the IFIs, and Pakistan is
Regulators in the countries namely the State Bank one such market. However, controversial structured
of Pakistan (SBP) and Securities and Exchange products are used by some institutions even in such
Commission, Pakistan (SECP) are playing active markets and this requires more careful governance
role in promotion of Islamic banking and finance by the regulators. To discuss issues relating to
with emphasis on Shari’ah compliance. SECP took governance in such markets we have selected
a strategic step by issuing the Shari’ah Advisors Pakistan as a case study.
Regulations, 2017 (SAR, The Regulations) on 15th
November, 2017. This paper will also discuss these 2.1 N
eed for Distinctive CG Structure for the
regulations briefly. IFIs
1.1 Research Method and Plan of the Paper For the institutions offering Islamic financial
products as alternative to conventional financial
This paper is based on qualitative research
products, stakeholders expect that their business
method which is the most suitable for research on
and operations would be carried out according to
matters that need to discuss any new paradigm.
the principles of Shari’ah. A corporate structure
We plan here to evaluate the regulatory framework that enables such an institution to implement
and measures that govern Islamic banking by good governance through Shari’ah-compliant
focusing on Pakistan as a case study. Before this, operations is therefore essential. Mainly two
we shall briefly discuss in Section 2 how Islamic types of governance issues are specific to the IFIs:
finance evolved globally and why governance i) assuring the stakeholders that the institutions’
structure needs to be changed. Section 3 discusses business activities fully comply with principles
the governance structure for IBs in Pakistan that of the Shari’ah; and ii) to safeguard stakeholders
encompasses all features of governance of financial business interests while being an efficient, stable,
institutions and an additional but the most crucial and trustworthy provider of financial services
aspect of ensuring compliance of their operations (although this aspect is common to conventional
and business contracts with the principles of institutions as well, yet Islamic finance gives greater
Islamic law of contracts. Section 4 is on evaluation emphasis to fair dealing, justice and equity related
of SGF introduced by the State Bank of Pakistan, responsibilities). As a result, depositors and finance
while section 5 suggests measures to improve the seekers need to feel confident that the business
SG framework. Section 6 concludes the paper. is being conducted ensuring their religious and
financial needs.
2. Islamic Finance’s Global Evolution
Regulatory framework for Islamic banking
Islamic banks’ financing could genuinely be institutions (IBIs) comprises both internal and
based on trading in goods or papers representing external aspects of governance including legal
7- “Daily net positions dictate the overall net stock balances, i.e. how much is encumbered and how much is free to be used for new tawarruq
transactions” [Salman H. Khan; Organised Tawarruq in Practice: A Sharī‘ah Non- compliant and Unjustified Transaction; NewHorizon,
October-December, 2010.]
framework and corporate governance. It has to [Appendix-A, IBD Circular 2 / 2008]. The IBIs have
be supplemented by the regulator’s guideline on been advised to consider the ‘Shari’ah Essentials’
capital adequacy, smooth payments system, risk of modes approved by the SBP’s Shari’ah Board as
management, and most importantly, the Shari’ah the minimum requirement for Shari’ah compliance.
governance. For the Islamic modes for which essentials have not
been prescribed, AAOIFI Shari’ah standards may be
Corporate governance in Islamic finance is used as guidelines by IBIs in consultation with IBI’s
understood as a set of systems and processes Shari’ah Boards. Six Shari’ah Standards of AAOIFI
to ensure proper accountability, integrity and [Nos. 3, 8, 9, 12, 13 and 17] have been adapted with
transparency in business operations of the IFIs some clarification and/ or Amendments. The State
while ensuring care and just relationship with all Bank also clarified that in case of any conflict with
stakeholders (Grais, 2006 - WB W/P-40522). Further, the Shari’ah Standards adapted vide its Circulars,
External Shari’ah Audit is now considered a crucial ‘Essentials of Islamic Modes of Financing’ shall
part of the SGF for Islamic banking. prevail.
Keeping in view the above, we shall focus on The State Bank recently exempted Islamic banks
analyzing the Shari’ah Governance Framework from using interest-based benchmarks for some
as implemented by the State Bank of Pakistan financing products (SBP, IBD Circular No. 01, 2016).
(SBP) since July 2015 and also suggest measures It also reduced SLR by 5 % enabling IBIs to enhance
to strengthen the Shari’ah governance system in their financing to business and commodity sectors.
Islamic banks across the world. IBIs have been In a continuing process, three centers of excellence
required to comply with the Code of Corporate have been established for enhancing education and
Governance (CCG) contained in Regulation No. awareness about Islamic banking in the country.
G-1 of the Prudential Regulations for Corporate /
Commercial Banking issued by SBP. 3.1 SGF 2015 for IBIs in Pakistan
3. I slamic Banks’ Regulations and Prior to 2015, the instructions and guidelines
issued vide SBP’s IBD Circular No.2 0f 2008
Governance in Pakistan8 provided the basis for Shari’ah compliance for
In Pakistan, the world’s second most populous Islamic banks. Keeping in view the developments
Islamic country with around 95 percent Muslim both at local and the global levels, some instructions
population, the Islamic banking industry held 11.6 and guidelines were revisited and the Shari’ah
percent share in assets in June 2017, a slight increase Governance Framework, 2015 made effective since
from a year ago (11.4 %), and well below levels of July 1, 2015. The SGF 2015 provides guidelines for
around 25 percent in Gulf Arab states and even the central Shari’ah Board in the SBP, Shari’ah Boards
Malaysia where Muslims are around 61.3 percent (SBs) in the IBIs, Resident Shari’ah Board members
of the population. (RSBM) in each IBI, Board of Directors (BoD) of
the IBIs, Executive Management (EM) and Shari’ah
SBP is among the few regulators who have Compliance Department (SCD) of each IBI, Shari’ah
introduced a comprehensive legal, regulatory, and Review Officers, internal auditors, external auditors,
Shari’ah compliance framework for the Islamic personnel involved in product development, risk
Banking Industry. Some important measures management, liquidity management and other staff
have been taken by the Government and SBP to for business development.
facilitate the banks and the businesses / industry
to convert to Islamic finance. Islamic financial As per the SGF, BOD of each IBI is responsible
institutions face some additional risks as compared and accountable for ensuring conformity of the
to their conventional counterparts. SBP has also Bank’s operations with the Shari’ah principles. The
introduced a comprehensive corporate governance BOD has to ensure that the SB is not subjected to any
system including appropriate board and senior undue influence or pressure from the management.
management oversight to keep a close watch on The BOD and EM are responsible for establishing
implementation of these measures. an organizational Shari’ah compliance environment
and mechanism within the bank. The BOD is
Pakistan is following the AAOIFI’s Shari’ah required to meet the SB at least on half yearly basis
Standards based mainstream approach of Islamic and ensure timely and effective enforcement of
finance avoiding Bai al Dayn, Bail Inah and financial the SB decisions and recommendations. SB is also
derivatives to promote Islamic banking with clear required to specify the process / procedures for
emphasis on Shari’ah compliance. SBP advised IBIs changing, modifying or revisiting fatawa / rulings/
in 2008 to take prior approval for use of tawarruq guidelines already issued by SB.
8- Islamic finance industry in Pakistan consists of Islamic banks, microfinance banks, Islamic mutual funds, Modaraba
companies, Takaful companies and Islamic REITs. Commercial and microfinance banks operate under SBP non-bank finance entities are
supervised by the Securities and Exchange Commission of Pakistan (SECP). Here we will be focusing on regulation of IBIs only.
Shari’ah Board has to review the scope, entity registered, licensed, and/or regulated by the
methodology, checklists/work programs, Shari’ah Commission, but are not applicable to the Insurance
audit manual and format of internal Shari’ah audit or Takaful Companies, Banking Companies or any
report and the annual Audit Plan. It should also give other Companies regulated by the SBP. The SECP
advice on issues pointed out in internal and external shall maintain a register of Shari’ah Advisors out
Shari’ah audits and Shari’ah compliance review of which the companies could engage any of the
and take up unresolved issues with Management Shari’ah advisors, and inform the Commission
and the BOD. If warranted, SB may include the within seven (7) days of appointment.
outstanding issues in Annual Shari’ah Compliance
Report. It may also refer Shari’ah issues to SBP for As per the SAR, any person included in the SECP
seeking opinion of the central Shari’ah Board. List may be appointed as Shari’ah advisor subject to
the limit of maximum four concurrent appointments
All inspection /review reports by the internal applicable with effect from July 1, 2018. However,
auditors, State Bank’s inspection team and the appointment as a Shari’ah advisor in any banking
external auditors are to be shared with the Shari’ah company, regulated by the SBP is not included in
Boards and remedial actions recommended this limit. It implies that one Shari’ah scholar (other
by the Shari’ah boards are binding on the IBIs’ than Resident Shari’ah Board Member of Islamic
management. In the light of all these reports, the banking institutions) is eligible to be on the panel
Shari’ah Boards have been advised to furnish of 3 banks (under SGF, 20159 ) and 4 non-banking
report(s) to the SBP about the remedial actions companies (under SAR, 2017).
taken by the management and the role of the BOD.
The SAR requires Shari’ah advisors to thoroughly
The RSBM is required to provide explanation understand and analyse the relevant issues before
to management and staff of the bank on products, giving any Shari’ah opinion. They must provide
documents, etc. in the light of decisions, rulings, the underlying reasoning and references in detail
fatawa issued by the SB; and such explanations covering: i) the extent to which the arrangement,
or clarifications are binding on the bank. The structure and the contract(s) are consistent with
Shari’ah Compliance Department (SCD) is Shari’ah principles; ii) how that is free from riba; iii)
required to keep a continuous watch on the IBI’s how gharar involvement has been addressed; iv)
Shari’ah compliance environment to ensure that extent to which consistent or inconsistent with the
all organs of Shari’ah Governance including the relevant AAOIFI’s Shari’ah standards; v) exceptions,
BOD oversight mechanism, internal Shari’ah audit, reservations, qualifications regarding compliance,
and enforcement of the SB’s directives by EM are if any; and vi) any other needed details.
operative and are effectively discharging their
respective functions and responsibilities as defined The provision about the AAOIFI’s Shari’ah
in the Framework. SCD is also required to conduct Standards lacks clarity. The Commission may issue
Shari’ah compliance review (in addition to internal a clarification to the effect that the AAOIFI’s Shari’ah
audit) to re-ensure that the IBI’s operations are in Standards would be the basis and benchmark for
conformity with decisions/guidelines issued by the giving Shari’ah related opinions on any instruments,
SB of the IBI and directives, regulation, instructions products or investment activities. It is necessary to
and guidelines issued by SBP in accordance with regulate the flexibility in the Shari’ah rulings, to
the rulings of SBP’s Shari’ah Board. avoid market distortions, and to bring harmony
in the national market. So far, any institutional
SCD is also responsible for enforcement of arrangement for regulated use of flexibility in
Shari’ah Audit Reports and take corrective actions Shari’ah rules is missing. It could harm integrity of
directed by the SB on the reports of ‘internal Islamic finance and become a constraining factor in
Shari’ah review’ and ‘SBP Shari’ah compliance its growth.
inspection’. The Board Audit Committee (BAC)
of BOD is to ensure compliance of the corrective 4. Evaluation of the SGF 2015
actions determined by SB on the reports of internal
The SGF 2015 covers all instructions given
and external Shari’ah audits.
by AAOIFI in its standard, and the IFSB (2009)
3.2 SECP’s Shari’ah Advisors Regulations with addition of external audit. Making the BOD
accountable ultimately for the Shari’ah compliance
As indicated in the introduction, SECP issued and decisions of the Shari’ah boards and the RSBM
the Shari’ah Advisors Regulations, 2017 (SAR, binding for the management and instructions
The Regulations) on 15th November, 2017. The for education and training of all organs of the
SAR are applicable to every person providing management and operational staff are crucial areas
Shari’ah advisory services to a company or an of the SGF. Intensive role of the internal reviewers,
9- As per SGF 2015, it is for three years (up to June 30 2018). This provision has to be applied, and henceforth, members of the IBIs’ Shariah
Boards may not be allowed to have multiple memberships in banks.
requirement for external audit, inspection by It may be the reason that even after introduction
the regulator (SBP), enforcement of internal and of the new SGF in 2015, the critiques of the Islamic
external audit reports, etc. also tend to imply banking system have increased both in print and
strengths of the Framework. electronic media and among the relevant circles
in the society, negatively affecting the public
Detailed instructions have been given regarding perception. Serious criticisms have been made by
all areas also including conflict resolution. All the academicians, media personnel and the public
inspection /review reports by the internal auditors,
opinion makers in general10 . It is due to two major
State Bank’s inspection team and the external
gaps that cause failure to the system in achieving
auditors are to be shared with the Shari’ah board
the goals of Shari’ah compliance and value creation
and remedial actions recommended by the Shari’ah
in real terms for investors/customers:
boards are binding on the IBIs’ management. For
safeguarding rights of the stakeholders and stability Absence of any Solid Basis for Shari’ah
and soundness of the system, sufficient emphasis Pronouncements: Despite the ‘Shari’ah Essentials’
has been laid down on disclosure, transparency, of modes suggested by the SBP (IBD Circular
deposits pools management, profit sharing 02 2008) and general instructions that AAOIFI
ratio (PSR), Profit Equalization Reserve (PER), standards be followed, there is no solid common
Investment Risk Reserves (IRR) and parameters of basis for deciding the Shari’ah matters. Shari’ah
Hiba (gift as return on deposits), if any, to the pools Advisors and Boards are free to decide and take
and not to any individuals in any pools. Timely and any position taking benefit from any contemporary
full disclosure has to be made about the PSR, the practice under contagion / path dependency effect.
weightages assigned to various deposit pools while This gap exists both at the level of SBP’s Shari’ah
the practice of Hiba, if any, has been restricted to board as also the IBIs’ SB level. The former’s
pools only. example, among others, is approval of the liquidity
management product named ‘Bai al Miajjal of
It is for the banks now to launch Shari’ah-
(GoP) Ijarah Sukuk’11 . At the level of the IBIs’
compliant products to finance production of
Shari’ah Boards, the examples of misuse of such
commodities, services and other business sectors
freedom in products approval are ‘Currency Salam’
for facilitating growth in various industries, such as
as alternative to ‘bills discounting’, commodity
agriculture, infrastructure, communication, trade
murabaha / sukuk murabaha as organized / banking
and business. Particularly, banks need to finance
tawarruq, and running musharaka as alternative
for purchases of industry raw materials, inputs
to Over Draft (OD) in the conventional finance
and machinery required by SMEs and agriculture,
(JIBM, Vol.6, No.1, Dec. 2016). None of the three
develop dairy, cattle and fish farming, and other
products has been allowed formally by the SBP’s
areas of Halal business.
Shari’ah Board, but most of the IBIs are using these
4.1 The Issues still to be taken care of products. SBP’s Shari’ah Board has not taken any
initiative to standardize the products in the country
Despite all strengths as indicated above, the or to undertake detailed studies prior to approving
ultimate outcome in terms of Shari’ah compliance the products. The lack of such standardization is
and credibility of the Islamic banking system in the a big hurdle in enhancing the outreach of Islamic
country is unlikely to improve. This is due to some banking in the country12 .
intriguing built-in issues in products approval,
decisions / pronouncements with regard to Shari’ah Issues and Conflicts of Interests in Shari’ah
certification, lack of finance related knowledge, Advisory Framework: There are a number of
and an increasing number, categories and levels of conflicts of interests in the Shari’ah advisory
conflicts of interests. According to Wright (2006), framework. Earlier, there was only one Shari’ah
the real challenge for Islamic finance is to find Advisor serving as an employee in an IBI, paid
such scholars that have sufficient knowledge and directly by the respective banks. Now that position
experience in finance and banking. According to has been assigned to the RSBM with additional
Wilson (2009) and Hanim Hamzah (2010), shortage requirement of Shari’ah Board comprising at
of quality SC members is a problem for Islamic least three Shari’ah scholars13 . As a result, the
finance in achieving its objectives and gaining increased demand for scholars associated with such
increasing credibility. institutions / madaris that have flexible approach
10- As evident from Columns, papers, comments etc. in various Newspapers and Journals; some people have approached even the Federal
Shariat Court as a part of the on-going hearing of long-standing Riba case to declare Islamic banking in vogue as void / un-Islamic.
11- See for the details and Shariah related issues: JIBM Discussion Forum on Bai Muajjal of GoP Igarah Sukuk introduced vide SBP DMMD
Circular 17 dated Oct 17, 2014. Vol 5; No. 2; Dec; 2015 http://jibm.org/?q=node/82
12- Dr. Shamshad Akhtar, former SBP Governor, (SBP, Islamic Banking Sector Review: 2003 to 2007).
13- The rational for full-fledged Shariah Board in an IBI becomes fragile in the wake of SGF’s instruction that banks Shariah boards shall be
deciding in accordance with pronouncements of SBP’s Shariah Board.
towards replicating conventional banking products specifically by any IBI in Pakistan, it tends to oblige
has increased the intensity of conflict of interest. Shari’ah Boards of other IBIs to approve it as it has
Shari’ah compliance level has thus deteriorated, happened in the case of organized tawarruq and
due to a variety of issues and conflicts of interest as ‘Running Musharaka’. IBIs’ management obliges
discussed below: their Shari’ah Board to approve on the basis that
others have approved.
A special kind of employer-employee relationship:
While the RSBMs are regular employees of all IBIs, Business Proposition vs. Shari’ah Compliance:
the banks’ management generally agrees to pay Having got a good business proposal, IBIs find one
relatively higher monthly remuneration to them, way or the other to avail that by getting approval
and also to other Shari’ah board members who from the respective SB. Some IBIs’ tawarruq based
attend meeting once in a quarter of year. This may secured lending by way of lien mark of interest
cause a formal pressure on them to be flexible in based T-bills and PIBs just to improve capital
approval of products and Shari’ah certification adequacy ratio (CAR) that deteriorated due to
ignoring loopholes, if any14 . tawarruq based clean lending, is the worst example,
among others, of this trend.
The Issue of Time and Multiple Memberships:
In the draft SGF issued by the SBP in 2014 seeking The aforesaid issues may imply that despite the
comments from the banks, SBP had required the strengths of SGF as discussed above, there are some
RSBM to give full time to the bank enabling him to built-in flaws, loopholes and conflicts of interests
review thoroughly the practices of the banks. But pertaining to tricky role of the Shari’ah scholars, and
some senior Shari’ah scholars put pressure on the inability of the regulator to enforce the framework
regulator to allow them to undertake teaching and so far, as per its objectives, that may lead to even
research work at Madaris despite being RSBM in worse situation, if not taken care of forthwith.
any bank, and ultimately in the final SGF issued
4.2 S
hari’ah Governance and the Role of
in April 2015, the RSBMs were allowed not only
to give some time daily to teaching / research Shari’ah scholars
activities at madaris, but also to take positions as Shari’ah scholars have been assigned the divine
member of Shari’ah board in any non-bank financial responsibility of ensuring a Shari’ah compliant,
institutions. The Shari’ah advisors who were earlier trustworthy and robust system that could be
working for only one IBI have taken positions in helpful in enhancing financial and social inclusion
other IFIs as well with lucrative packages, vis-à-vis and provide necessary support for sustainable
the time given, in each institution. Now the ground growth and development of the economies and
reality is that neither most of the RSBM desire to the societies. SBP has advised special ‘fit & proper’
give full time to the bank, nor the IBIs’ management criteria for the Shari’ah scholars as members of
obliges them to give full time as in case of their the IBIs Shari’ah Boards. But their expertise for
other employees. understanding investment and financing products,
nature and extent of involvement, function and
Senior-Junior or Teacher- student Relationship:
remuneration give rise to a number of concerns and
The environment and practice in ‘madaris’ is such
sensitive issues that need to be taken care of.
that the juniors / students always have to accept
what their teachers or seniors say or opine. Any Practically, the ability of the Shari’ah boards
renowned scholar serving as a Chairman of the /advisors to fulfill their mandate may be
central Shari’ah board of the country is considered constrained by the time given and activity for the
to mean that all scholars and boards shall have banks affairs, their understanding and access to
to accept this as final pronouncement15 . This, monitoring systems, complexity of the products
combined with lack of any solid basis for fatawa, and transactions, and effectiveness of their
as discussed above, and majority principle in independence (Grais W and Pellegrini, 2006).
Shari’ah approval process, will lead to the failure of
the Shari’ah governance system. Shari’ah opinions According to the instructions of SBP, the burden
have to be based necessarily on Shari’ah principles whether a product passes Shari’ah compliance test
through a well thought-out process. rests on the shoulders of IBIs’ Shari’ah Boards.
Hence, Shari’ah scholars / boards need to be
Path dependence Syndrome: In case a product mindful of their obligations to approve only those
is approved generally anywhere in the world, and products which are truly Shari’ah compliant. Any
14- See for various conflicts: Samy Nathan Garas, (2012) “The conflicts of interest inside the Shari’a supervisory board”, International
Journal of Islamic and Middle Eastern Finance and Management, Vol. 5 Issue: 2, pp.88-105.
:results of the study are: … the relation between the SSB members and the BoDs, and the membership in Islamic funds and issuers of Islamic
bonds are significantly related to the conflicts of interest, whereas remuneration and membership in companies trading in capital markets
have insignificant relation (in GCC countries). ; ii) Shariah Governance: Challenges Ahead by Ahmad Faizal Abdul Aziz (INCEIF).
15- Such top level personalities have to be member of an ‘Elders Council on Islamic Finance’ for resolution of any disputes.
compromise in this regard could make the income foundation for establishing a fair and just society for
so earned non-Shari’ah compliant defeating the very mankind”. Among its ‘values’ ‘social responsibility’
purpose of introducing Islamic banking. Above all, is an important factor. Similarly, Al-Baraka Bank,
it is a source of disrepute to the system tagged with Pakistan, has adopted the following vision, “We
the divine system of Islam. believe that the society needs a fair and equitable
financial system which rewards efforts and
The function of approving any products has
contributes to the development of the community.”
to be accomplished with complete knowledge of
In line with such vision, one important function
all involved matters and suitable arguments and
of Islamic banks is to provide Shari’ah compliant
rationale (Sahih Bukhari, Kitab al ‘Ilm). According
financing to the SMEs and the agriculturists that are
to a hadith reported by Ibne Majah, the Prophet
the basic producing units in any economy providing
(PBUH) said, “In case a pronouncement is given
jobs to a major part of the population. Providing
without proper argument, the sin will be on the
them finance on any of the non-exploitative bases
person who gives fatwa” [chapter on care while
is the basic objective of Islamic banking and finance
giving opinion or doing Qiyas].
(Council of Islamic Ideology, Pakistan, 1980).
A related matter is that of question of
independence of the SBP itself because its role and Next, the issue is whether the SGF could be
policy initiatives with regard to Islamic banking helpful in realizing the objectives as briefly indicated
have become subservient to a few banks and above. As per the theory of Islamic banking, profit
persons - the regulator is compromising on its own rates given by IBIs should be higher than the profits
independence. This creates chaos in the market given by the conventional banks. But practically, the
because the management of other IBIs requires fact is reverse in case of all IBIs in Pakistan. Their
their Shari’ah Boards to approve all such products profits on equity and earning per share (EPS) have
that are being used by any other Islamic Bank(s). increased visibly over past some years,16 but the
Besides, surrendering to the demand of some profit rates for depositors, particularly the general
Shari’ah scholars for allowing them not to give full (savings) deposits have decreased drastically. While
time despite being RSBM has created a loophole for the conventional banks have to pay presently a
the system as a whole. minimum profit of about 4 % per annum on savings
deposits at the time when the benchmark interest
4.3 SGF and Socio-economic Justice rate in Pakistan is the lowest in recent history of the
country, IBIs are paying as low as 2 percent in many
The primary objective of the SGF is “to strengthen
the overall Shari’ah compliance environment of cases, simply because the SBP has not obliged them
IBIs”. The Shari’ah compliance, in turn, is for to pay a minimum due to the features of Mudaraba
realizing the maqasid al-Shari’ah. According to an contract. It seems, therefore, that the practices of
ISRA research study (No. 97/2017), Islamic banks are the IBIs over the last two years– taking deposits,
required to pursue maqasid al-Shari’ah in addition financing and investments, may lead to the contrary,
to doing business for genuine profit. These include, even worse than in the conventional banks.
inter alia, promotion of broad-based economic
An independent and rational analysis cannot
growth and the development and well-being of the
explain this trend except possibly the case that IBIs
society they operate in. It is what the State Bank of
are working under the conventional framework
Pakistan declares in its strategic plan (2014-18) by
where banks are allowed to get all benefits for
indicating the Shari’ah objectives of ensuring ‘risk
themselves without giving the society its due share
and reward sharing’ and equitable and broad based
and resources with which they undertake their
distribution of economic gains.
business. The banking sector in Pakistan that has
Major Islamic banks operating in Pakistan large foreign investments is among the highest
have indicated the same objectives in their vision profit yielding markets in the world and as such
/ mission statements. As per the vision of Meezan huge amounts of profits are remitted abroad due to
Bank, the premier Islamic bank of Pakistan, its foreign ownership of the privatized banks (Dawn,
objective is to “Establish Islamic banking as banking Jan 03 and April 29, 2016.) It is the issue to be
of first choice to facilitate the implementation of considered by the regulator, Shari’ah Boards of SBP
an equitable economic system, providing a strong and the IBIs, and ultimately the Government.
16- For example: MBL’s Profit after tax for the year 2015, increased to Rs 5.023 billion compared to Rs 4.570 billion recorded in 2014. Its EPS
increased during the period from Rs 4.56 to Rs 5.01. The market value of the Share at 42.50 (face value of Rs. 10), the percent earning
for shareholders is 11.79, higher from about 11.4 percent for the previous year (Business Recorder, Feb 26, 2016). [It’s a good study
area for MS and PhD scholars to analyse the earnings of Islamic and conventional banks, dividends paid to the shareholders, profit
paid to various categories of depositors and to find out the impact of Islamic banks’ operations on various stake holders vis-à-vis the
conventional banks.
The rates announced by some IBIs for the first quarter of 2016 are given below:
Annual Profit Rates Announced by some IBI’s in Pakistan (April 2016)
Deposit Categories MEEZAN BURJ BANK ISLAMI ALBARAKA ABL
PLS Saving Profit payment 2.50 % 1.90 % 2.79 % 2.75 % 3.02 %
6 Months On Maturity 4.37 % 5.60 % 5.85 % 4.60 % 4.22 %
1 Year Profit Monthly 4.63 % 5.90 % 5.70 % 5.15 % 4.32 %
Quarterly 4.97 % 5.93 % 5.73 % 5.20 % -
Six Monthly - - - - -
at Maturity 5.12 % 6.07 % 5.85 % 5.45 % 4.63 %
3 Years Profit Monthly 5.38 % - 5.75 % 5.50 % 4.93 %
Quarterly 5.53 % - 5.77 % 5.60 % -
Six Monthly - 6.20 % - - -
at Maturity 5.75 % 6.40 % 5.90 % 5.75 % -
5 Years Profit Monthly 5.82 % - 5.99 % 5.85 % 5.53 %
Quarterly 5.86 % - 6.02 % 6.00 % -
Six Monthly - 6.45 % - - -
at Maturity 5.94 % 6.50 % 6.16 % 6.10 % -
Hence, the serious issue is the ineffective secured or unsecured lending to conventional banks
implementation of the regulatory instructions. by tawarruq simply means that IBIs are interested in
We shall give one example each for deposits and maximizing their earnings only without due regard
financing sides to explain the situation. SBP did a for social contribution or even Shari’ah compliance
good job (Nov. 19, 2012) by prohibiting hibah to in letter.
depositors and phased out the individuals hiba by
July, 2015. But the IBIs circumvented the regulation 5. Suggestions for Filling the Gaps
and offered high weightage based products to their
‘priority’ deposits at the cost of common depositors. The prime factors behind the failure in achieving
As a result, some banks have been giving up to 5 % the objective of Shari’ah compliance in letter and
annual profit to priority Savings Account holders by spirit are non-availability of any single basis for
offering special PLS deposits, for example, against products approval and decision making, allowing
2-2.5 % annual profit to common PLS savings the IBIs implicitly to use any products for which
they may get approval from their Shari’ah Boards,
depositors. On financing side financial reporting by
and SBP’s inability to properly govern the abilities
banks in case of Ijarah financing needs regulatory
and role of the Shari’ah scholars / RSBMs / Shari’ah
over sight. Only three of AAOFI’s Islamic Financial
Boards. Following steps are recommended in this
Accounting Standards (FAS-1, FAS-2, and FAS-3)
regards:
were notified by the SECP over the last 13 years
pertaining to Murabaha, Ijarah and Mudaraba for 5.1 B
asis for Shari’ah Opinions and Products
deposits. IFAS 2 requires that Ijarah income is to be
Approval Process:
recognized on accrual basis - as and when the rental
becomes due (clause 10.4) meaning that full amount There has to be one basis for products approval
of due rent has to be included in the installments and decision making. AAOIFI’s Shari’ah (and other)
for payment of rent and the principal. But, IBIs Standards may be made mandatory; Introduction
normally charge in the initial stage a much higher of an SOP for products development and approval
part as rent and smaller part from the principal that involving practitioners and professionals; Shari’ah
results in loss to the lessee in case of pre-mature Board of the SBP may play role in harmonizing
termination due to theft, major accident or non- the business practices of the IBIs particularly
payment due to any problem with the lessee. with regard to the structured products. It needs
adoption / adaptation of the AAOIFI’s Standards
As regards the objective of facilitating the real while ensuring that the spirit of the Shari’ah is not
sector through enabling sufficient purchasing compromised.
power, the IBIs continue to ignore it and encourage
products with risk free profits by using controversial The process of arranging syndicated finance
products. Replacing genuine Murabaha, Ijarah, needs to be developed and introduced in line
Salam, Istisna, etc. with Running Musharaka (RM), with the AAOIFI’s relevant standard(s). It would
facilitate financing of large projects in Shari’ah institutions. Its training arm, NIBAF, may design and
compliant manner without facing any problems arrange a (6) months intensive training on Islamic
as faced a couple of years ago with respect to fiqh, economics, accounting, banking and finance
Rs. 100 billion financing for the Neelum Jhelum for Shari’ah scholars having sufficient knowledge
Hydropower project (NJHP) for which the National of Islamic law of contracts, banking, finance and
Bank of Pakistan (NBP) served as Mandated Lead accounting, followed by a comprehensive written
Arranger (MLA) and some other IBIs participated Exam. Only the scholars securing (70) % or more
as investors / Sukuk holders17 . It’s good to note marks may be eligible to become Certified Shari’ah
that the SBP has quite recently initiated the process Advisors in Islamic banking system of the country.
of adoption of AAOIFI’s standard on syndicate SBP and SECP may also like to maintain a joint list
finance. of the certified Shari’ah scholars and arrange their
trainings in banking and financial markets.
Products approved by IBIs Shari’ah departments
may be first analyzed thoroughly by the Shari’ah The Islamic Banking Department (IBD) of the
Research Unit of the IBD (SBP) to ensure that SBP may nominate, with prior approval by the
nothing in it is against AAOIFI’s Standards; SBP Shari’ah Board, any of the Panel members for
discussed if needed in ‘Shari’ah Scholars Forum’ any IBIs for the period of three years, after which
and then submitted to the SBP’s Shari’ah Boards for they may be deputed to any other IBIs. IBD (with
approval; IBIs may then be advised not to use any approval of the SBP Shari’ah Board) would also
product unless approved expressly by the SBP’s be deciding the honoraria, allowances, etc. to the
Shari’ah Board18 . IBIs’ Shari’ah scholars, payable by the IBIs. For
this, the IBD may keep in view the knowledge
SBP’s Shari’ah Board: The central Shari’ah board and expertise of the Shari’ah scholar, number of
of the country may be constituted to avoid senior- branches, business, , size of internal Shari’ah control
junior or other types of conflict of interests. Further, and Shari’ah research / review department of the
the full-time Shari’ah advisor in IBIs (RSBM) may concerned IBI, and the level of Shari’ah compliance
not be allowed to sit on the central Shari’ah Board as may be revealed from reports of the external
to ensure independence of decisions and products audit and the regulatory inspection (lower the level,
approval. greater the amount).
Having a Shari’ah Board in all IBIs may not be a The maximum number of Shari’ah Board seats
necessary requirement as it has caused unnecessary allowed for a Shari’ah scholar has to be different
costs to the IBIs without any visible benefit or for someone who is employed only for part time
value addition in terms of Shari’ah compliance. for Shariah advisory responsibilities vs. RSBM,
One Shari’ah Advisor serving full-time could be or someone who is full time invested in SB affairs
sufficient to facilitate the banks in day-to-day and not doing any other job. Of course, both types
business as per standardized products discussed of positions need to be captioned to develop the
thoroughly by the Shari’ah scholars’ forum and Shari’ah advisory system and to avoid cartelisation.
approved by the SBP’s Shari’ah Board. Banks may, The SBP may determine honorarium separately for
however, be allowed, as prior to 2015, to constitute the both categories.
their own Shari’ah Boards at their discretion. The
members of such Shari’ah boards might be paid 5.2 A
dditional measures to be taken by the
the honorarium, if any, for the meetings attended SBP
or work accomplished, and not any regular pay.
Sukuk Market: The primary and secondary
Banks’ BODs may be made responsible for ensuring
market for sovereign sukuk should be opened
Shari’ah compliance in the light of the standardized
for IBIs only, excluding conventional banks.
products approved by SBP Shari’ah board.
This step will also help in curbing the clean and
For appointing IBIs’ Shari’ah Advisors, State collateralized lending by IBIs to conventional banks
Bank may also maintain a panel of ‘Certified Islamic in contravention of the AAOIFI’s Shari’ah Shari’ah
Finance Scholars’ for Islamic banks and finance Standard No. 30 on tawarruq.
17- A complicated structure with about a dozen contracts interlinked with one another and their documentation was approved by the
Shariah advisor of the MLA, without consultation with other consortium members. Other Shariah boards had to approve the structure
despite the fact that it had some flaws and many scholars expressed concern, the most serious of which was that in order to cover the
loss of ‘cost of funds’ on account of possible delay in payments after the due date, a system of rebate was provided. The agreed rental
rate was 6 months KIBOR + 175 bps per annum. However, assuming that NJHPC would delay in making payment, it was provided that
if payments are made within 30 days of the due date, the Bank may give a rebate of 67 bps for SLR eligible portion and 62 bps for non-
SLR eligible portion. A similar provision for charging an enhanced mark-up rate for extra 210 days was made in ‘Non- interest based
Banking’ (NIB) system of 1980 to provide for possible losses due to default in payment by a client . [For details, see Janjua M. Ashraf;
History of State Bank of Pakistan; Vol 3 (up to 1988) P. 636].
18- As per SGF, 2015, IBIs have to inform SBP about any new product approved by their Shariah board 30 days prior to its proposed launch, and
if any reply is not received within 30 days of its intimation to IBD/SBP, such product is considered as implicitly approved by the State Bank.
Based on the resilience that the IBIs have by dint banking in December, 2002. To this end, a number
of specific nature of Islamic finance, the SLR for of constraining factors have been discussed, the
IBIs has to be half the SLR for conventional banks. most crucial of which is the credibility of the system
It will enable the IBIs to invest more funds in the as being operated.
commodity producing sectors like agriculture,
SMEs, industry and the infrastructure related In the process of promoting Islamic banking in
projects. the country, the SBP has not only tried to ensure
independence of the Shari’ah Boards of the IBIs,
Eliminating duplication of review functions but also required the banks’ BODs and Executive
by Shari’ah compliance and Shari’ah Review Management to be fully involved in the process of
departments and Audit departments in Stand-alone development of the new system and be accountable
IB system; for any Shari’ah non-compliance. Still, it has to
play crucial role to enhance credibility of Islamic
Administrative line of officials of Shari’ah
Compliance Department in Islamic banking of banking system.
conventional banks should be the Shari’ah Board, Equity, participation, ownership, possession
not the business head (IBG Head); and sanctity of contracts are the key principles
SBP may enforce a “Code of Conduct - Ethics of Islamic finance. It implies that all contracts
and Principles for approval of Islamic banking in Islamic business and finance have to involve
products”; productive activities, and financing can only be
extended to such activities, trade, and real assets.
Shift required from the maximization of If fully complied with, these principles ensure
shareholders’ value to that of the “aggregate welfare appropriate leverage and help limit speculation and
of the stakeholders”. [WB WP. 4052] moral hazard (Hussain, 2015, IMF WP/15/120).
There has to be minimum thresholds assigned However, the banks are still focusing on cash
to all IBIs (separate from the parent conventional financing and treasury products for risk-free return
banks) for financing the micro businesses, SMEs, even by compromising on the widely accepted
farming community and for serving for the cause of Shari’ah principles. Organized commodity
the society and welfare of weaker groups; murabaha, interbank bai al muajjal of sukuk
Separation of management and the Shari’ah (tawarruq as facilitated by brokers), RM, etc are
board, which would mean separation of earnings being used aggressively by some IBIs for lending
management and Shari’ah compliance; to conventional banks that use such liquidity
or arbitrage. Further, despite all such tactics to
The framework of shareholders value in corporate maximize shareholders profits, the returns paid
governance may be amended to include other to the depositors have decreased vis-à-vis the
stakeholders’ interests like that of the depositors conventional banks.
and the employees. It would require the banks to
take care of all stakeholders including society. There are some built-in flaws and a variety
of conflicts of interests in the Shari’ah advisory
Efforts at integrating finance with technology for function, on account of which success of the
developing innovative projects for development SGF for enhancing the Shari’ah compliance level
(fintech is increasingly emerging as a tool for seems to be doubtful. Removing the conflicts of
improving financial performance and increasing interest in Shari’ah advisory system is an urgent
efficiency and sustainability; it can contribute requirement. A number of products being used by
efficiently to social and financial inclusion and the IBIs keep them away from the desired and real
sustainable development).
objective of financing the commodity producing
and business sectors. What is required is achieving
6. Concluding Remarks full compliance with Shari’ah in line with the
Despite impressive global growth at the rate of regulatory and supervisory standards issued by the
about 20 percent, on average, over the past decade, two Islamic standard-setting authorities including
Islamic finance still represents a very small share of AAOIFI and IFSB. If real Shari’ah compliance is
global financial assets. Same is the case of Muslim achieved it may become a basis for transformation
countries like Pakistan where Islamic banking of the national and the global finance to infuse in
could cover only 13 percent of total banking assets it morality and Divine ethics and to make it really
over the last 15 years since re-launch of Islamic beneficial system for mankind.
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asiamoney-sep06-shariahscholars/
TECHNICAL ARTICLE
The Perspective
The latest global financial crisis revealed that part of the blame was hidden in the shortsighted
accounting rules applied by the financial institutions. In particular, delayed recognition of
credit losses (i.e. when they already were inevitable or occurred) contributed to the escalation
and acceleration of the crises. Thus, financial institutions ended up booking too little too late
– accounting weakness that disguised their true financial illness until it finally exploded on a
global level.
As one of the responses to the financial crisis, as requested by the G20 leaders, the new accounting
standard, International Financial Reporting Standard 9 (IFRS 9) Financial Instruments,
introduced, inter alia, the expected credit loss (ECL) model (effective from 1 January 2018). New
model addressed the criticism of IAS 39 ‘incurred loss model’ by recognizing losses at the time
when a debt instrument is issued i.e. on day 1. We discuss below this crucial Standard.
1- The author is a Manager in Accounting and Reporting Division, Financial Control Department at the Islamic Development Bank, Jeddah.
• instruments with no delay in payment of contractual Once a financial asset experiences SICR, lifetime
dues; ECLs are recognized instead of 12-month ECLs.
• instruments with low risk of default; Examples of rebutting the presumption include
some administrative errors resulting in non-
• borrowers with strong ability to meet contractual payment of the amounts due or link between
dues; and significant risk of default and payments overdue by
• no evidence that adverse changes in future over 60 days.
economic and business conditions will reduce
the ability of the borrower to fulfil its contractual Credit-impaired financial assets
obligations. (Stage 3)
There are a number of approaches an entity may Under IFRS 9 a financial asset is credit-impaired
adopt to determine whether a financial instrument when one or more events have occurred that have
has low credit risk, such as Internal or external a detrimental impact on the expected future cash
credit risk ratings, or other methodologies. For flows of the financial asset. It includes observable
example, a financial instrument having ‘investment data that has come to the attention of the holder of a
grade’ may be considered to have low credit risk. financial asset about the following events:
Assessment at each • Significant increase in credit risk • Significant or prolonged decline • Change in NRV
reporting date in the FV of investments at FV
through equity
• Impairment (for other than
investments)
Since most of an IFI’s assets are subject to receivables are subject to the said provisioning
credit risk and credit loss approach is the most methodology. Further, all off-balance sheet
complicated, the article will focus and provide exposures related to assets exposed to credit risks
sufficient insight into the ECL methodology. are included in the scope of this approach.
Firstly, all assets subject to credit risk are covered The Standard further requires segmentation of
under credit risk approach. Thus, all products that, assets subject to credit losses depending upon their
at any reporting date, are recognized as contractual credit risk characteristic as indicated below:
Stage 1 Low credit risk and no Significant not meeting the criteria of 30 days delay in 12-Month expected credit loss
change in credit risk contractual payments (12 Month PD) – generally
collective allowance
Stage 2 High credit risk or significant Between 30 – 90 days delay in contractual Lifetime expected Credit Loss
increase in credit risk since initial payments or meeting the other qualitative (Lifetime PD till maturity
recognition indicators of the facility) - generally
collective allowance
Stage 3 Credit impaired financial asset equal to or more than 90 days delay in Lifetime expected Credit
contractual payments or meeting the other Loss – customer/asset specific
qualitative indicators allowance
From the comparison of both the frameworks depositors and financiers, generally absorb losses
it is evident that FAS 30 made ECL approach, resulting from the activities in which their funds
stage categorization and default definition as have been invested.
close to IFRS 9 as possible to enable maximum
comparability between conventional and Islamic One of the major differences affecting Islamic
financial institutions. Financial Institutions (IFI) lies in the area of
allocation of the impairment charge. Under IFRS,
Measuring credit losses it is fully attributed to the assets of the business
owners and is charged against Bank’s income.
Discussion of credit losses under FAS 30 takes For AAOIFI reporting Islamic bank, the charge
into account the concepts analogous to IFRS 9. shall be split between the common shareholders
For example, it prescribes the use of unbiased and (by taking the charge to income statement) and
probability weighed amount as well as reasonable other participatory stakeholders (by reporting
and supportable information. Credit exposure shall accumulated impairment in liabilities).
be reported net of deferred profits. It puts Islamic
products on the same footing as conventional Another issue is how to align Investment Risk
instruments. ECLs shall consider realizable value Reserve (IRR) and/or Profit Equalization Reserve
of collateral. Credit losses shall be measured over (PER) or any other smoothing reserves set aside
the maximum contractual period. IFRS 9 talks by IFIs in the interest of participatory stakeholders
about maximum expected life of the financial asset. with the ECL. Although IRR is based on the income
Finally, probabilities of Default (PDs) shall reflect and not the assets’ carrying amounts (as ECL),
at least two scenarios being (a) credit loss to occur both of them serve to cushion against estimated
even if such probability is hypothetical only and (b) future losses. Further, requiring both IRR and ECL
that it will not occur. allowances is a double burden on the respective
stakeholders.
Further in similar fashion to IFRS 9, FAS 30
prescribes that ECL shall be determined based on It is therefore rational that adoption of ECL approach
best judgment (unbiased, and probability-weighted) shall result in its replacement of IRR to safeguard the
and not on the basis of most prudent judgment. interest of the investment account holders.
At the same time, PER unlike IRR is used to gives general guidance on the topic allowing Islamic
mitigate the rate of return risk and hence is not banks to decide how they will define this key term
accumulated to counter credit losses, unless it is in the context of their portfolios.
unintentionally, erroneously or intentionally used
for credit loss coverage (which occurs in some The Standard clarifies that any approach used
banks). Therefore, as long as PER allocations are should consider:
reasonably justified and are based on certain
• the change in the risk of default occurring since
rational judgements, PER can complement the ECL
initial recognition;
created by IFIs.
• the expected life of the financial instrument;
Another Shari’ah issue faced by IFIs is the need to
rationalize establishment of an allowance for losses • reasonable and supportable information that is
that are yet to be incurred. Aftermath of the global available without undue cost or effort that may
financial crisis vividly demonstrated importance affect credit risk.
of maintaining stability in the financial system
At each reporting date, Islamic Bank shall assess
through such “risk absorbers”. Furthermore,
whether the credit risk on its respective exposures
such accumulated losses result in more equitable
has increased significantly since initial recognition.
treatment of stakeholders in long-run.
This is to be done by comparing the risk of default
occurring on the asset at the reporting date with the
Expected Credit Loss (ECL) Approach risk of a default occurring at the date of its initial
The overall approach when drafting FAS 30 recognition, and assess the extent of increase.
has been to keep it closer to generally accepted
In general, Islamic banks shall use quantitative
accounting standards (specifically IFRS). Therefore,
criteria such as probability of default (PD) (or any
given the proximity of the overall ECL approach in
other numerically evaluated model) as their key
FAS 30 to that in IFRS 9, FAS 30 deliberately skipped
indicator of SICR unless any bank is unable to
articulation of certain details articulated in IFRS 9
sufficiently capture all relevant criteria. In these
and in this paper.
circumstances banks may place greater reliance on
qualitative indicators.
Stage 1: Low Credit Risk
The following are factors, which a bank shall use
The Standard says that if, at the reporting date,
in determining a significant increase in credit risk:
the credit risk on a receivable or exposure has not
increased significantly since initial recognition, an
institution shall measure the loss allowance for
Quantitative factors:
that financial instrument at an amount equal to • Significant deterioration of credit risk rating of
12-month expected credit losses. the customer with consideration to a relative
increase in PD.
The Standard does not specify what is low credit
risk and/or examples of insignificant increase in it. • Movement into a rating/credit grading deemed a
Therefore, we refer to IFRS 9 for detailed guidance, low credit quality.
which says that all of the following shall exist:
• Establishing maximum credit risk level above
• Analysis of the risk of default of the instrument which instrument is considered as having SICR.
itself without comparison to the risk of default of
• Days past due (30 days or more).
other instruments or other considerations, such
as the credit risk of the geographic region within Regardless of the way in which an institution
which the business operates. assesses SICR, there is a rebuttable presumption
that the credit risk on a receivable or exposure
• The customer has a strong ability to meet its
has increased significantly since initial recognition
contractual cash flow obligations in the near term.
when contractual payments are more than 30 days
• It is not evident that adverse changes in future past due unless it is rebutted (with reasonable and
economic and business conditions will reduce the supportable information that is obtainable without
ability of the customer to fulfil its contractual cash undue cost or effort)
flow obligations.
Importance of Qualitative factors
Stage 2: Significant Increase in Credit
Although banks are encouraged to incorporate
Risk (SICR) both quantitative and qualitative factors, the latter
Determination of what constitutes SICR is one play lesser significance if quantitative factors
of the most critical and difficult judgement areas are able to comprehensively cover SICR factors.
in applying the impairment model. The Standard However, banks may include qualitative measures
into their PD models should quantitative factors more delay in contractual payments. Same trigger
alone be insufficient to capture all relevant factors (unless rebutted) is ascribed to the defaulted
and measures of SICR. Such indicators include: exposures.
• Inappropriate quality of data - data reliability The standard also lists few qualitative indictors
issues. such as significant deterioration of credit rating,
breach of covenants or bankruptcy/financial
• insensitivity of quantitative models to certain
reorganization situations.
specific events evaluated qualitatively as SICR.
• delayed capturing of SICR measures by quantitative Banks may additionally consider few other
models. triggers of credit impairment or default, including:
Thus, Banks shall select most applicable and • significant financial difficulty of the client;
relevant qualitative factors indicative of an SICR • the client is unlikely to honor its contractual
and factor them in their models. Few of those are
obligations, without recourse by the bank
listed below.
realizing security (if held)
• Multiple missing payments. • uncustomary concessions granted to the client as
• Breach of covenants a result of its financial difficulties.
• Significant deterioration of financial position and Cure, movement from Stage 3 and
performance/rating Stage 2 (credit risk improvement)
• Cross product/obligor defaults.
FAS 30 has not defined how Islamic banks shall
• Watch list exposure depending on degree of their deal with stage migrations. At the same time,
severity. alignment of credit risk reduction with stage
movements is essential part of the symmetrical
• High risk events (legal cases, significant business
ECL model, i.e. If the credit risk for the financial
risks).
instrument improves, the instrument can move
from Stage 2 back to Stage 1.
Stage 3: Credit Impaired Instruments
Every Islamic bank shall clearly articulate the To justify upward stage movement, Islamic
definition of “credit impaired” and “default” in banks shall assess for enabling indicators of credit
order to move the asset into stage 3 upon meeting risk improvement. Alternatively, they need to
its criteria. prove that factors, which initially triggered move
to stages 2 or 3, are reversed at the reporting date.
FAS 30 provides one quantitative trigger to Some of the criteria, as per ECL, are provided below
classify instrument as credit impaired: 90 days or for guidance:
Shariah supervisory boards of AAOIFI reporters weighted by the probability of default occurring in
may have to discuss the issue of reporting the the next 12 months or over the lifetime of the asset.
‘accrued income’ on the overdue balances as
FAS 30 states that an institution shall measure
required in the ECL model. This is because any
credit losses of a receivable or exposure in
additional return accruable on defaulted Dayn
accordance with a policy developed and applied
amounts has to go to the charity account, as per
consistently, in a way that reflects:
Shariah principles. However, this shall not apply to
a deferred profit earlier, earned legitimately from a. an unbiased and probability-weighted amount
Shari’ah perspective, which can be taken to normal that is determined by evaluating a range of
income (if amortized in line with the requirements possible outcomes;
of FAS 28 “Murabaha and Other Deferred Payment
b. the contractual maturity of the receivable or
Sales”, or any other similar standard.
exposure viz-a-viz the allocation of relevant
income applying the effective rate of return
Collective versus Individual method; and
Assessment
c. reasonable and supportable information that
FAS 30 clearly specifies that provisions on stage 1 is obtainable without undue cost or effort at
and stage 2 exposures shall be made on “collective” the reporting date about past events, current
basis. Stage 3 exposures shall be subject to individual conditions and forecasts of future economic
impairment assessment i.e. through customer/asset conditions.
specific allowance.
From the practical perspective, Islamic banks
The rationale behind this approach is that in shall document their ECL calculation approach
many cases SICR might not be evident when (for all ECL components) to ensure consistency of
assessed individually until the instrument becomes calculation and assumptions with the ECL definition
overdue. For example, Islamic bank might not and the FAS 30. For example the approach could
have up to date financial information (client’s either be based on the expert judgment, or various
financial statements or management accounts), statistics.
or may be collecting such information on annual Naturally, Islamic banks shall aim to develop ECL
basis only. Thus, the Bank’s monitoring procedures estimates using relevant internal data. If internal
will naturally be outdated. Or, on retail products, data is deemed insufficient it shall be supplemented
banks might not collect relevant information on by relevant external data. Expert based approach
individual customers with regular frequency to shall be least preferred.
foresee impairment triggers until customers breach
their contractual obligations. There are a number of ECL measurement
approaches that Islamic banks may use to calculate
For these reasons, SICR might not be faithfully ECL. Moreover, different classes of assets might
captured on individual basis thus resulting in require specifically tailored approaches. However,
reporting misstated financial performance of the most common and proposed approach is
the IFI. Therefore, banks shall assess stage 1 probability of default approach as summarized
and 2 impairment on collective basis using both below:
historical and forward-looking information. This
ECL = Σ i=1
n
approach ensures that Islamic banks recognize (PDti EADti LGDti) dti
lifetime expected credit losses for all financial
instruments for which there has been a SICR since Thus, ECL has four distinct components:
initial recognition, even if SICR is not evident at an
individual level. • Probability of Default (“PD”) – This is an estimate
of the likelihood of default over a given time
To identify SICR at collective level, Islamic banks horizon (e.g. 12 months or lifetime)
may resort to classification of the portfolio based
on the shared credit risk characteristics. Examples • Exposure at Default (“EAD”) – contractual cash
may include ratings, industry/sector, geographical flows due at a future default date, taking into
location, collateral, etc. Alternatively, exposure account expected changes in the exposure after
could be grouped based on types of portfolios i.e. the reporting date, including repayments of
real estate, cars, consumer items, Islamic credit principal and income and expected drawdowns
cards etc. on committed facilities
expressed as a percentage of the EAD management, capital adequacy and other areas.
• Discount Rate (“DR”) – This is used to discount an Therefore, banks must not be deluded by the
expected loss to a present value at the reporting time till 2020. In reality, there is little time left to
date prepare for the major change. Banks must act fast to
assess potential repercussions of the new standard
The ECL calculation considers all reasonable and and manage the preparation process.
supportable information that is available without
At theDouble
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TECHNICAL ARTICLE
1 & 2 - The authors are Partners, KPMG; and Head of Financial Services & Head of Islamic Financial Services, respectively. They can be
contacted at: jalaali@kpmg.com & bmahesh@kpmg.com
portfolio of assets classified as off-balance sheet provision for onerous contract, and adjustments
exposures; off-balance sheet Sukuk or similar to net realizable value each reporting period.
instruments provided that the entity is not exposed
to any credit risk on these off-balance sheet • Changes in estimate (including reversals) shall be
exposures. recognized in the income statement for the period
of their re-assessment and shall be adequately
Effective date: attributed to the common shareholders and
other participatory stakeholders, including, the
The standard is effective for reporting period on unrestricted investment account holders.
or after 1 January 2020, however early adoption is
permitted. Transition impact
• the allocation and transfers from reserves, as We have not elaborated in detail on the calculation
well as, reversals and the outstanding balances aspects of the different loss approaches in FAS 30,
and movement of temporary transfers from as we believe they are expected to be similar to its
shareholders’ equity in accordance with the equivalent IFRS guidance, but rather have focused
transitional provisions of FAS 30; and on what assets classes will be in-scope of FAS 30
• nature and estimated value of, the securities and and subject to different loss measurement approach
guarantees adjusted for determining provisions, as compared to IFRS.
any hair cut applied and valuation methods used.
In order to quantify the potential impact of
In case of jointly financed assets, FAS 30 the standard on the entity, further analysis and
requires allocation of the impairment and credit interpretation has been carried out, in light
losses between the equity shareholders and other of entity’s own facts and circumstances and
participatory stakeholders (including unrestricted individual transactions. The information contained
investment account holders). in this publication is based on initial observations
developed by KPMG Fakhro, Bahrain and these
The application of this standard will result in a
significant change in current policies and practices observations may change.
followed by Islamic financial institutions. It’s Classification and measurement
hoped that this analysis would help the readers in
gaining a greater understanding of FAS 30 and its FAS 30 does not change or modify the existing
implications. classification and measurement guidance for financial
assets and other Shari’ah compliant investment
Introduction transactions.
The objective of our analysis in the publication IFIs apply FAS issued by AAOIFI and for matters
is not to highlight all possible differences between that are not covered by AAOIFI standards, the IFIs
FAS and IFRS but rather bring out key areas of should use guidance from the relevant International
application differences users should consider while
Financial Reporting Standards. FAS 25 remains the
they prepare for full adoption of FAS 30.
primary standard that provides C&M principles
This standard is a significant initiative by AAOIFI for debt-type and equity-type instruments. Only
to harmonise its loss measurement guidelines with for selected instruments where IFIs previously
International Financial Reporting Standards (IFRSs). referred to IAS 39 for C&M guidance, the revised
While the exposures subject to each loss approach guidance under IFRS 9 would now apply. IFRS 9
may differ due to differences in classification and has amended guidance on C&M for some asset
measurement guidelines, we do not expect any classes and hence this would mean IFIs would
significant differences in the application of these have some resulting impact on the effective date of
guidelines between IFI’s and their conventional adoption of IFRS 9.
counterparts. The different approaches reflect an
economic loss measurement and hence each loss We have summarised below our assessment of
approach is expected to reach a similar outcome as impact on classification and measurement guidance
compared to application of its equivalent IFRS. by IFIs on adoption of IFRS 9 and FAS 30:
Table No. 1
Transaction type AAOIFI C&M guidance IFRS guidance applied Changed by IFRS 9
FAS 3 – Mudaraba and FAS 4 – IFRS 7: Disclosure of Yes, only if SPPI test
Profit sharing contracts
Musharaka credit risk and fair values is not met
Investment in Sukuk & funds FAS 25 (C&M and disclosures) Not applicable Yes
Table No. 2
Key areas of difference in C&M between IFRS 9 and FAS
• Equity: As per FAS 25 equity instruments can still be measured at cost less impairment and investments
carried at FVTE will be subject to an impairment test. Under IFRS 9, cost option has been removed and
there is an irrevocable election to re-measure equity as FVOCI without recycling of gains/ losses through
P&L. Hence, equity instruments will no longer be subject to test of impairment but would instead be
measured at fair value either through P&L or through OCI.
• Debt-type: No business model test required by FAS to qualify for measurement at amortised cost. FAS
30 does not currently allow debt instruments to be measured as FVOCI/ FVTE. Sukuk need not meet
the SPPI test, but the “debt-type” instrument definition is consistent with the business model test for
amortised cost classification.
• Funds: can still be classified as FVTE in AAOIFI whereas IFRS 9 mandates FVTPL classification for funds
• AAOIFI does not provide guidance on hybrid contracts and hence going forward all hybrid contracts
need to be measured at FVTPL as per IFRS 9.
Table No. 3
Classification of assets, commitments and exposures and related impairment/ loss approaches
Loss model Eligible exposures Equivalent IFRS Standard* Illustrative assets that will be covered
Credit losses Assets and exposures subject IFRS 9, Financial • Financing assets
approach to credit risk: Instruments • Rental receivables from Ijarah or
• Receivables “Dain” Ijarah Muntahia Bittamleek contracts
• Off balance sheet exposures • Debt-type Sukuk and similar
including guarantees, letter instruments (FAS 25)
of credits, forward foreign • Any other financial assets carried at
contract and other similar amortised cost
positions
Net Inventories IAS 2, Inventories • Commodities
realizable • Properties held for development
value or sale in the ordinary course of
approach business
Impairment Other financing and IAS 36, Impairment of • Ijarah and Ijarah Muntahia
approach investment assets and Assets Bittamleek Assets (Lease assets)
exposures subject to risks • Investment in Mudaraba and
other than credit risk, Musharaka (equity-type exposures)
excluding inventories and • Investment properties
assets measured at FVTIS • Investment in equity-accounted
associates and JV’s
Provision Onerous contracts and IAS 37, Provisions, • Salam contracts where the value of
for economic commitments Contingent Liabilities and the commodity is expected to be sold
losses Contingent Assets at a loss
• Istisna’a or construction contracts
with negative margins
* The reference to equivalent IFRS standards in the application of these guidelines at the asset
does not imply that FAS 30 is fully convergent with and exposure level between IFIs and conventional
all the requirements of IFRSs. Detailed review of institutions following IFRS. The different
specific facts and circumstances would be required approaches reflect an economic loss measurement
to determine applications under both accounting and hence each loss approach is expected to reach
frameworks. a similar outcome as compared to application of its
equivalent IFRS.
KPMG comments:
Decision tree for use of loss
This standard is a significant initiative by
AAOIFI to harmonise its loss measurement approaches
guidelines with IFRSs. While the exposures subject The following is the decision tree to summarise
to each loss approach may differ due to differences how the standard is applied to various assets and
in classification and measurement guidelines, exposures:
but we do not expect any significant differences
Yes No
Is the exposure
Is it measured at Yes No subject to credit
fair value through Out of scope risk i.e. letter of
income statement? credit, financial
guarantee etc.?
No No
No
- Stage-1 receivables – not meeting the criteria Provision for onerous contract or
of 30 days delay in contractual payments commitment to acquire an asset
– subject to 12-months expected losses
through collective allowances; • The standard requires a provision for situations
- Stage-2 receivables – having a delay in where the Financial Institution is obligated to
contractual payments between 30 days to acquire an asset under a future commitment or
89 days or meeting the other qualitative permissible future contract, and it is expected that
indicators - subject to lifetime expected the obligation under the contract or commitment
losses through collective allowances; and is higher than the economic benefits expected to
flow through acquisition of such asset.
- Stage-3 receivables – having equal to or more
than 90 days delay in contractual payments
or meeting the other qualitative indicators–
Comparing Loss approaches to IFRS
subject to lifetime expected losses through In the below section, we have summarised key
customer / asset specific allowance. areas introduced by FAS 30 in each loss approach
for comparison with equivalent IFRSs.
Net realizable value approach
• This approach applies to inventories recognised KPMG Comments:
at different stages of certain types of Islamic
financing transactions such as Murabaha, In our view, there are no significant differences
Installment sale, Salam and Istisna’a. Inventories in the principles and methods of the different loss
are measured at the lower of cost and net approaches between FAS 30 and IFRS. However,
realizable value. there continue to be differences in C&M and some
application issues to IFI may apply which have
• Net realizable value defined as the estimated
been discussed in the following sections (page 62
selling price in the ordinary course of business
less the estimated costs of completion and the and 63). The Net realizable value approach and
estimated costs necessary to make the sale, provision for onerous contracts guidance are also
considering the factors specific to the institution. consistent with the guidance within IFRSs.
Significant increase in
Definition of default Forward looking measure
credit risk
Significant or prolonged
Grouping of assets (CGU) Impairment indicators
for equity
KPMG comments:
Transition rules Scope
In our view, there are no significant differences in the principles of theofStandard
and methods the different loss approaches
between FAS 30 and IFRS. However, there continue
• Due to existence of allocation principles between to be differences
FAS 30 focuses onsome
in C&M and application
financing andissues to IFI
investment
may apply which
equity have been discussed
of shareholders and inparticipatory
the following sections (page
assets 13 and
(other 14).inventories)
than The Net realizable
which value
is exposed to
approach and provision
stakeholders, for onerous
different contracts
guidance hasguidance
been are also consistent
risks with credit
other than the guidance
risks. within
Hence,IFRSs.
it is not clear
provided (refer pages 62 & 63) whether operating assets such as fixed assets and
intangible assets is covered under FAS 30. However,
Consider credit risk in rate of return for the Impairment Approach guidance of FAS 30 is
impairmentModified or restructured terms
of non-financial assets similar to the IAS 36 impairment guidance for such
- FAS 30.19 requires that if the proceeds of a newassets contract haveguidance
(e.g. been applied for settlement
on CGU, use of of an flows,
cash
Additional guidance for IFIs
(except inventories, for which IAS 2 was applied). Ijarah Muntahia Bittamleek exposures
FAS 30.57 requires all changes in estimates to be Under IFRS 9, financing against mortgage of
recognised through the income statement. However properties are subject to the expected credit loss
as per IAS 36, impairment on goodwill cannot be model provided they meet the SPPI criteria.
reversed. Since FAS 30 does not explicitly include
intangibles and goodwill in its guidance, we believe However, IFI’s provide financing of properties
requirements of IAS 36 shall continue to apply for using Ijarah Muntahia Bittamleek (finance lease)
goodwill. contracts which is accounted under FAS 8. Under
FAS, these assets are considered to be non-financial
Definition of participatory stakeholders assets. For the purpose of loss assessment under
FAS 30, such exposures are segregated into two
FAS 30 does not include a definition of components: physical assets (cost less depreciation)
participatory stakeholders. However, this has been and rental receivable (rental income due but not
introduced in the draft of FAS 35 Risk Reserves. received). For loss assessment under FAS 30, the
We believe the same definition shall apply for the rental receivables which meet the definition of
purposes of FAS 30 as both these standards together receivables, are subject to the credit losses approach
would replace FAS 11 Provisions and Reserves. The and the physical assets are subject to impairment
definition is as follows: approach.
Participatory investors – are the investors However, in practice, we do not expect that these
investing in an IFI on the basis of a participatory differences between FAS 30 and IFRS 9 will have a
arrangement e.g. Mudaraba, Musharaka or Al- significant impact in the way impairment is assessed
Wakala Bi Al-Istithmar (investment agency) for the combined exposure against mortgage of
including Investment Account Holders (IAH), properties due to the following factors:
Sukuk holders etc.
Past due rental receivable is an indication of
Attribution of provision/ impairment impairment for the Ijarah (physical assets);
charges between shareholders and Under the impairment approach, IFI will have
participatory stakeholders to determine the value in use of the physical asset
by considering the estimated of future cash inflows
FAS 30 requires attribution of provision / from Ijarah rentals over the period of the contract
impairment charges, including reversals, between and likely recovery through repossession or sale of
shareholders and participatory stakeholders in the the collateral; and
proportion of their participation. Such attribution
As per FAS 30, the IFI will have to evaluate
shall be based on the current proportions and
credit worthiness of the lessee in addition to other
ratios, ignoring the original proportions and ratios
factors so as to arrive at the effective rate of return
in which they were originally accounted for, with to compute the value in use.
a presumption that constructive liquidations had
happened earlier and hence such changes and These factors are consistent with how ECL
reversals are an event of the period. Provided assessment would have been done under IFRS 9.
that, in certain situations whereby it is decided However, it is not clear how the following will be
by the respective Shari’ah board and accordingly addressed:
stipulated in the contracts with the respective The non-financial component of the finance lease
stakeholders that (either at the time of liquidation exposures will be measured under the impairment
or at any point of time, as stipulated) any excess approach which does not require allocation between
balance which is no more needed shall be paid Stage 1 and Stage 2. It appears that collective
for charitable purposes, such reversal shall be assessment at a portfolio level may be considered
accounted for and disclosed accordingly. In this for such assets; and
respect, whatever is the decision made by the
The provision against the non-financial
Shari’ah supervisory board, the same shall be components will not be presented or disclosed
disclosed in the notes to financial statements. as part of the expected loss provisions and hence
disclosures may not be fully comparable with IFRS.
Previously, under AAOIFI standards, provisions
and reserves attributable to participatory Reversal of transition adjustment
stakeholders were added to their book value
(presented gross). However, under FAS 30, the Under FAS 30, the cumulative charge attributable
provisions shall be netted against the corresponding to participatory stakeholders on the initial
asset. This is now is line with IFRS standards. adoption of the standard shall be first charged to
the Investment Risk Reserve (IRR), any shortfall The temporary funding of the shortfall by
will then be charged to the Profit Equalization shareholders is recoverable from the participatory
Reserve (PER) and any residual balance not covered stakeholders and is in the nature of an asset for
through existing IRR and PER shall be charged as the entity. However, since this shortfall will be
deducted from retained earnings, in our view,
a temporary transfer from shareholders equity
no asset would be recognized in the statement of
(subject to Shari’ah approvals). This treatment in
financial position. However, the standard does not
similar to the Qard funding and recovery process give clear guidance on the treatment of recovery in
followed by Takaful entities. For any subsequent future periods.
improvement in credit quality on the portfolio
funded by participatory stakeholders (e.g. URIA The standard does not provide guidance when
accounts), the reversal of ECL will not be routed there is an excess provision on date of adoption
as compared to FAS 30. We believe there could
through the income statement. Instead this is
be additional Shari’ah matters that would need
expected to be reflected as a transfer between the
consideration such as whether the excess can be
participatory stakeholders and equity. credited to shareholders’ equity in full.
This is significantly different from the transition The following are some of the other key
guidance under IFRS 9 and could be detrimental to differences between FAS 30 and IFRS 9 loss
the income statement of IFI’s in the future. approaches.
Table No. 4
Other key differences: FAS 30 vs IFRS 9
Purchased or originated • IFRS 9 includes treatment for credit-impaired financial assets purchased or originated.
credit-impaired However, this is not covered in FAS 30 since it may not be considered Shari’ah compliant to
financial assets enter into such a transaction on receivables.
Simplified approach • IFRS 9 includes simplified approach for trade receivables and contracts that result from
transactions in the scope of IFRS 15, and lease receivables that result from transactions in
the scope of IAS 17. However, FAS 30 does not include a simplified approach.
Components of interest • Under IFRS 9, interest has been defined and includes time value of money which is reflected
in the effective interest rate used to discount the future cash flows. However, AAOIFI
requires consideration of effective rate of return and does not define its components but
rather refers to a uniform rate of return after considering all cash flows.
Income recognition • IFRS 9 includes a detailed guidance for recognition of interest income on financial
instruments. However, FAS 30 does not cover income recognition.
Allocation between • FAS 30 requires impairment charges to be allocated between the shareholders and other
shareholders and participatory stakeholders (i.e. investment account holders).
other participatory
stakeholders • In instances where the participatory stakeholders equity does not have sufficient IRR and
PER, the standard requires IFI’s to make a temporarily transfer from the shareholder equity
to participatory stakeholders equity. However, reversals related to the cumulative charge
attributable to participatory stakeholders will be recognised as transfer between the equity
and not through the income statement.
• IFRS 9 does not require attribution of charge based on source and composition of funding
of assets and would require all reversals to go through profit or loss account.
Matters requiring Shari’ah approvals/ the respective Shari’ah board and accordingly
stipulated in the contracts with the respective
consideration stakeholders that (either at the time of liquidation
The following are examples of some of the key or at any point of time, as stipulated) any excess
areas which are referred to in FAS 30 requiring balance of expected credit losses provisions which
participatory stakeholders and/ or Shari’ah is no more needed shall be paid for charitable
approvals and consideration: purposes or distributed back to respective
stakeholders. There are different practices in this
• Allocation of FAS 30 expected credit losses regards.
ARE YOU
provision to equity of participatory stakeholders
and the impairment/ provision charge to income • Shari’ah approval for provisions on onerous contracts
generated on assets funded by participatory
KPMG comments:
Looking for
account Shari’ah Standards
holders
• Utilisation of exiting PER and IRR towards In our view, IFI’s would need to revisit their
ARE YOU
participatory accountholders share of provisions existing contracts and policies and would require
or reserves for expected credit losses Shari’ah approvals on new policies and matters
arising from application of FAS 30.
• Charging shortfall on date of adoption of FAS
Looking for Accountingequity
30 to shareholders’ Standards
and approval of a In line with AAOIFI requirements of fair
temporary transfer in the form of Qard Hasan treatment and transparency in dealing between
the IFI and participatory stakeholders, disclosures
• Creation of future PER and IRR (now excluding
would be required on decisions agreed with the
expected credit losses)
Subscribe today to
Shari’ah board of each IFI on the above matters and
• In certain situations whereby it is decided by any other matters arising from adoption of FAS 30.
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INDUSTRY UPDATE
One of the main lessons of the global financial Establishing an effective corporate governance
crisis of 2008-9 learned by financial institutions, framework in Islamic finance requires a ‘corporate
regulators and other stakeholders is the need to purpose’ which serves the society and helps in
strengthen corporate governance, both in terms of application of the fundamentals of Islamic finance
the frameworks and related rules and in terms of principles and achieving the Shariah objectives.
the practices of financial institutions, reported the Philippa Back argues that having a purpose is to
Financial Stability Board (FSB), in a recent thematic have a clear goal of what a business is setting out
peer review on corporate governance. to achieve in serving society by providing products
or services that meet the needs of the people
The peer review offers ‘twelve’ recommendations
(Hawkamah Journal, Issue: 08). She further notes
to FSB member jurisdictions, standard-setting
that the governance has focused, over the years,
bodies and financial institutions. Key to these
on vision, mission and values rather than purpose
recommendations is:
explicitly. She claims that due to the lack of wider
“insuring the basis for an effective corporate connection to society in the past, the business
governance framework – identify and address franchise weakened and the trust in business eroded.
gaps or inconsistencies in cases where corporate The truth of the matter is that this critique also
governance frameworks are found in multiple applies to the Islamic finance industry and in order
sources; and augment enforcement powers available to regain trust in the business model, Institutions
to supervisory authorities to address weaknesses in offering Islamic Financial Services (IIFSs) have to
corporate governance regimes or non-compliance rethink about their corporate governance operating
with corporate governance requirements.” [FSB, models and consider redesigning the organization
2017] structure, oversight responsibilities, talent and
Other sector challenges in Islamic finance culture, infrastructure, functional and operational
include the inconsistency of regulations in different elements with the core Shariah objectives to have a
markets and countries. A recent CIBAFI report, purpose that serves the society.
based on analysis of 77 banks indicates the need for This article discusses the effects of above industry
improving risk governance and Shariah governance.
premise and the need to embrace a continuous
Both scored the lowest scores of the six disciplines
improvement approach in governance practices,
of the corporate governance index formed by the
and augmenting a culture of sustainable and
research (CIBAFI-WB, 2017).
responsible business practices. It provides ‘two’
Professor Laldin of ISRA, Malaysia rightly vivid precepts that can help graft a strategy built
notes that the legal and regulatory frameworks around the noble values of Shariah objectives which
are country-specific, and Shariah governance are often overlooked or undermined in designing
frameworks differ markedly across the jurisdictions business and growth strategies.
(IFN Report, 2018, P.42). This will remain so for
some time and the governance frameworks cannot Renewed Vigor: the Shariah-Based
easily be harmonized. However, what can be Approach to Governance
harmonized is developing governance operating
models that will streamline practices, policies and Establishing an effective corporate governance
procedures. operating model in the Islamic financial industry
1- Dr. Hatim El-Tahir is the Director, Islamic Finance Group and Leader, Deloitte ME Islamic Finance Knowledge Centre (IFKC), Deloitte
& Touche, Bahrain
has been a subject of much debate and differences governance practice in Islamic finance is required
and largely a ‘trial and error’ exercise. Different in the turbulent and challenging scenario as at
institutions in different jurisdictions have followed now. The compact and specific governance along
different paths to build operating models that with the related Shariah stipulations, relevant
reflect their corporate identity, culture and vision. contractual and documentation mechanisms in
Some institutions have been successful in designing Islamic financial services necessitate an exclusive
good governance operating models enabling them Shariah-based governance operating model. The
to achieve business objectives and execute strategies elements of such a model may or may not exist
desired. Others have not been successful and might in practice; albeit, its success and effectiveness
be working for articulating the right frameworks depend on how it can serve the institution’s
that could work for them. strategic business objectives also including the
service to the respective society and contributing to
Nonetheless, the starting point, which many IIFS
local economic growth. Chief to this is aligning the
have likely addressed, is the governance framework,
institution’s business and commercial objectives
such as that we propose in this article (see Exhibit
with needs and aspirations of the society. More
1), developed to help boards and executives assess
precisely, it requires aligning aspirations of the
their institutions’ governance programs. Whether
people with products and services linked to the
the board and management adopt or develop a
Shariah objectives, also aligned with leading
governance framework, it articulates the various
investment practices such as those developed by
elements of the governance program, clarifies the
governance roles of the board and management, organizations like the OECD and United Nations.
and illustrates an appropriate relationship between In practice, however, those elements might not
governance, risk management, and organizational have been streamlined and rationalized to provide
culture. the sustainable growth required by industry
executives, Shariah scholars, entrepreneurs and
The path to building a sustainable culture in governments.
management, operations, products and services
and Shariah compliance is often challenged and The new approach to governance addresses
conflicted with those of the institutions’ stakeholders. some of the challenges discussed above and
As a result, numerous institutions offering Islamic should help the boards and the management
financial services (IIFSs) experienced low-score by providing new model of governance and
levels of adopting international standards of management derived from the basic principles of
corporate governance practice. It is because such Islamic finance business model. It helps industry
institutions were not able to achieve the proverbial strategists and product developers to rethink their
‘Core Shariah Objectives (CSOs CSBs)’. Significant business approach and have systems and processes
changes in the current industry environment are related to the basic Shariah principles, and to
likely to force industry leaders and strategists to follow leading practices of sustainable investment
look for innovative solutions and new approaches to principles to achieve efficiency, better performance
salvage the industry growth and offer a sustainable and sustainable growth. It requires a commitment
economic value to local societies. to the culture of sustainability which can go hand
to hand with embracing the noble values pertaining
Good corporate governance needs to be more to the Shariah objectives.
than just a ‘tick box’ exercise or the announcement
of “institution X or Y has adopted the IFSB’s or Nonetheless, a new approach to corporate
AAOIFI’s good governance standards or any other governance models in Islamic finance should be
international code of practices”. Good governance embraced where the core objective is to initiate and
in Islamic finance should be an exercise in better lead corporate purpose and culture, identifying
defining and adhering to the specificity of Islamic target markets and clients to be served and hence
finance’s operating model and philosophy. It develop products, processes and governance
should, therefore, embody the elements of CSOs systems based on this goal. In doing so, the new
in designing the corporate governance framework corporate governance model will be more resilient
and its oversight and support processes. to achieve the institution’s strategic business and
financial objectives. It would also accommodate
Thus, a renewed vigor is required to manifest the changes and updates as business develops and
and embody a new approach of operating models grows. In other words, corporate governance in
capable of empowering and equipping leadership Islamic finance should not be seen as a requirement
and workforce with products and services, processes to meet regulation; it should have in place internal
and systems that can drive sustainable growth and control systems to ensure regulatory compliance. It
enhance the value proposition of Islamic finance. is an important practice and should be articulated
to design governance system capable of leading
Back to Basics: to growth, resilience and sustainability of the
A new Shariah-based approach to improve institution.
4. Corporate purpose and culture where the latter 1. Products and services;
should be influenced by the Shariah objectives.
2. Selling and marketing capabilities;
Process, People and Technology: 3. Markets and new expansions; and
The nuts and bolts of the model are framed to
4. Realizing revenues and profitability.
align key investment influencers – the core Shariah
Objectives (5 objectives) and the sustainable
What this approach means in practice?
investment principles (SDGs, ESG, PRIs). These
principles will be the backbone for developing In practice, it has potential to link the growth
processes, people and technology to derive strategies and its four elements, as mentioned
sustainable growth strategies. above, with at least one of the two categories of
principles. In essence, it means incorporating one
In practice, for the purpose of good governance
or more of the principles pertaining to the Shariah
and management of the new approach (operating objectives, and linking to one or more of the global
model), leadership has to emphasize on the sustainable principles. Obviously, not every
management and accountability of operational and product, business process or marketing strategy
functional roles as identified (twelve functions, can achieve all of the principles mentioned above.
three in each practice area). However, it is essential that product developers,
The proposed approach emphasizes the value strategists, and business leaders are able to
proposition of Islamic finance and offers services understand the merit and value proposition of
and goods linked to societal needs, and yet, incorporating Shariah objectives, aligned with
is structured, delivered and governed, in line good international business practices.
with international best practices of sustainable For example and the purpose of illustration, an
investment principles. Islamic Bank A is considering the development of
growth strategy in a new jurisdiction; and as part
Exhibit 1: of this, its product development team with the right
kind of market and products offerings research,
A New Governance Operating Model, Embracing
have planned a new niche market in financing
Shariah and Sustainable Principles
the ‘disabled’ people. This new product can be
designed and vetted with a matrix of the criteria
or requirements (the bundle of both the Shariah
objectives and SDGs).
Goal 8: Promote
sustained, inclusive and
sustainable economic
growth, full and productive
employment and decent
work for all
References
• Al Rifai, Rami (2016), The Maqasid (Objectives) of Shariah: A Closer Look; available at: https://ghayb.com/2016/01/the-maqasid-
objectives-of-shariah-a-closer-look/.
• General Council for Islamic Banks and Financial Institutions and ‘The World Bank Group’ (CIBAFI and the World Bank, 2017),
Corporate Governance Practices in Islamic Banks, 2017; available at: http://cibafi.org/ControlPanel/Documents/Library/Pdf/
CorporateGovernancePracticesinIslamicBanks2017.pdf.
• Laldin, M. Akram (2018); The Shariah Governance, IFN Annual Guide, 2018 (December, 2017).
• Philippa Foster Back, (2016 ); Corporate Purpose through Corporate Behaviour; The Hawkamah Journal- A journal on corporate
governance & leadership, Issue:08; Hawkamah Institute for Corporate Governance; . Pages 39-44 Accessed from:
https://www.hawkamah.org/attachments/1479809885_58341b5d18ad1_THJ08.pdf
• The Financial Stability Board (FSB), Thematic Review on Corporate Governance, April, 2017.
INDUSTRY UPDATE
The IFDI indicator presents the key numbers In order to adapt to the straitened economic
behind that growth, covering the entire Islamic conditions, Islamic financial institutions have
finance ecosystem in terms of Quantitative been pursuing efficiencies and governments have
Development, Knowledge, Governance, been working to better support the Islamic finance
Corporate Social Responsibility, and Awareness. industry. There has been an increase in industry
Measurements have been taken for 131 countries. consolidation, with mergers agreed between various
Islamic banks and takaful operators in the GCC,
IFDI Global Indicator: Recovery in Indonesia, Malaysia and Pakistan. At the same time,
governments in Iraq, Morocco, Algeria and Tunisia
confidence puts industry back on track are turning to Islamic finance to attract investment
The IFDI average value recovered to 9.9 for 2017 in the face of weakened government revenues.
from 8.8 last year as each of the five main indicators
Newcomers to the industry within major
it measures rose. The overall gain shows a recovery
Islamic finance hubs may soon include Fintech
in confidence following economic slowdowns in
companies given the growth in supporting financial
some of the core Islamic finance markets after oil
technology ecosystems. Islamic finance has also
prices tumbled in 2014. The main contributors
begun attracting new financial institutions beyond
were the Quantitative Development (QD) indicator its traditional centres, as seen in Russia, Africa and
measuring the industry’s size, due to improved South America.
financial performances, and Governance, as
authorities stepped up efforts to strengthen Islamic The single area of weakness within QD was
finance oversight. Sukuk, which failed to match the improvements
shown by other QD sub-indicators despite the
The leading country in IFDI remains Malaysia
addition of new players such as Togo. Previous
and the leading region the GCC. Countries including major sukuk issuers such as the governments of
Tunisia, Morocco, Iraq, Russia, Spain and Poland the GCC resorted to issuing conventional bonds
saw notable developments in their IFDI values and during the period covered in order to reduce
improved their rankings. issuance costs.
Given these developments, total Islamic finance However, Sukuk’s outlook remains bright. A
assets are expected to grow to US$ 3.8 billion by new sovereign sukuk giant, Saudi Arabia, issued
2022 from US$ 2.2 billion in 2016 – a compound its first domestic and international sukuk in 2017.
annual growth rate of 9.5%. Other countries are also planning to issue sukuk in
order to reduce budget deficits, or are encouraging There were 44 countries in 2016 with specific
corporate issuance through newly introduced tax Islamic finance regulations, 12 countries with
concessions. Another noteworthy trend is the push centralised Shariah boards, and 1,075 Shariah
towards socially responsible sukuk, which are a scholars involved in industry governance.
milestone on the road towards Shariah-compliant Efforts are being made to further tighten Shariah
socially responsible investment (SRI) funds. governance, as shown by a growing emphasis on
appointing external Shariah auditors for Islamic
Knowledge Indicator: Islamic finance banks in the core markets. External Shariah scholars
education and literacy could be and centralized Shariah boards are likely to become
improved by government initiatives much more common following the scandal caused
by the announcement by Dana Gas in June 2017 that
This indicator, which encompasses education its sukuk were no longer Shariah-compliant and its
and research, edged up to 7.8 from 7.6, with growth repayments therefore unenforceable.
recorded for both sub-indicators. Between 2014
and 2016, Islamic finance research increased to The Corporate Governance sub-indicator
2,581 papers produced by 830 different affiliations remained weak, however. Only 55% of Islamic
including universities. These included 1,751 peer- financial institutions released financial reports, and
reviewed articles published by 728 journals. The a majority of institutions scored low on disclosure.
countries with the highest number of research However, efforts have been made to improve Islamic
papers were also amongst the most-covered banks’ corporate governance in Brunei and Jordan
countries in those papers. and transparency in Pakistan and Saudi Arabia.
Source: ICD - Thomson Reuters Islamic Finance Development, Report 2017: Towards Sustainability
Malaysia has introduced the concept of the The number of Islamic finance news items
‘charity house’, in which Islamic banks will invest edged slightly higher, but the News sub-indicator’s
donations and disburse profits to designated average value was a little down on the previous
charities. A special task force has been established year because of the slower growth. The Seminars
to study the idea. Also, Malaysia’s central bank has sub-indicator saw strong growth, however, mainly
released a paper on ‘Value-Based Intermediation’ on the back of an increase in seminar numbers in
to help Islamic banks contribute to the social good Africa. Some African countries also made bigger
contributions to the Conferences sub-indicator, with
without impairing financial performance.
Morocco, Tunisia, Kenya and Djibouti taking places
In the UAE, Dubai has established the Awqaf on the sub-indicator’s leaderboard. The Conferences
International Organization to improve the sub-indicator ended a touch lower, however.
management of funds used to fund social projects Many of the seminars and conferences in 2016
such as schools and mosques. It is aimed at examined the mutual values shared by Islamic
improving efficiency and economies of scale while finance with ethical and socially responsible
developing a set of awqaf standards. finance. This can be seen in the rise of Islamic
microfinance seminars held in countries including
Awareness Indicator: Seminars and Nigeria, Pakistan and Sudan, and events in Spain
conferences address Islamic and and the UK that explored the interaction between
Islamic and ethical finance.
ethical finance mutual values
As for news, while developments within the
The Awareness indicator’s average value moved GCC’s Islamic finance industry dominated,
up very slightly, to 13.9 from 13.8, and as a result regulatory developments are beginning to receive
it dropped to the second most developed indicator wider coverage, particularly where they concern
after Governance, for the first time since the Shariah governance, Islamic banking regulation,
introduction of IFDI in 2013. and sukuk tax concessions.
INDUSTRY UPDATE
Islamic Banking:
A New Player in the Eurozone SRI Market
Ahmet Kudsi Arslan1
In March 2015, major news from the Islamic system. Sukuk, sharia-compliant bonds, serve
banking market spread like lightning across the increasingly as an alternative to the conventional
Eurozone banking world – KT Bank AG, the first bond business. At the G20 meeting of finance and
and only fully-fledged bank with Islamic business labor ministers in September 2015 in Ankara, Turkey,
model, coming from a Turkish-Kuwaiti background, Islamic banking was politically acknowledged
was about to start operations in Germany in July of for its positive effects on national economies and
the same year. At the outset, this was a demanding benefits for the society, in the framework of the
challenge: would the implementation of Islamic following statement from the then German Federal
banking as a new, unfamiliar banking concept Minister of Finance, Wolfgang Schäuble: “Islamic
in mainland Europe lead to controversy? Would finance instruments are of growing importance
the Muslim community take on the new products in the world economy“. Schäuble said further
and services enthusiastically, and how would that international finance institutions should
the representatives of the conventional Western increasingly concentrate on integrating Islamic
banking system react to the value-based finance finance models into the global financing structure.
model from the East? It soon became evident that
the domestic bankers shared the cosmopolitan and Islamic banking in Western economies
unifying vision of the Islamic banking concept – the A successful role model for an Islamic banking
market responded friendly and immensely curious enterprise in a Western economy is the flourishing
to this then unknown, yet promising, faith-based development of Al Rayan Bank PLC, the first British
banking model. The Muslim community showed bank operating according to Islamic principles.
great interest and conventional clients and investors The former Islamic Bank of Britain was granted
focusing on socially responsible investments (SRI) authorization by the Financial Services Authority
acknowledged Islamic banking’s ethical value. FSA in August 2004. This was the same year in
The news media exposure of the Islamic banking which the mother bank of KT Bank, Kuveyt Türk
pioneer in Germany and in the Eurozone amounted Participation Bank with headquarters in Istanbul,
to more than 1,500 articles in all major news media established in 1989, started to lay groundwork
within the first few weeks. The bank itself registers in Germany with opening a German branch to
an incessant flow of client inquiries until today. introduce Islamic banking to the Euro area and to
This article aims to explain how the Islamic banking inform the general public about the religious finance
business model progressed from the regulatory model. Kuveyt Türk is the leading participation
introduction, founding and establishment phase bank in Turkey working with Islamic principles,
by its first mover towards its recognition as ethical the largest Islamic bank in Turkey according to
banking alternative for the Eurozone economy. asset size, and has, as of today, more than 5,800
employees, 400 branches in Turkey, and a branch
Islamic finance – a continual global in Bahrain. Kuveyt Türk entered the sukuk market
success story as pioneer in 2010 and has recently even broken the
Turkish market record by carrying out the Sukuk
Islamic finance is a growing business segment issuance of the largest ever amount in Turkish
all over the world – in Muslim and also in non- Lira – 400 million – in a single transaction in the
Muslim countries. More than 500 Islamic financial sector. Kuveyt Türk’s main shareholder is – with
institutions in more than 70 countries administer 62 per cent – the Kuwait Finance House, one of the
estimated sharia-compliant assets of more than foremost Islamic financial institutions in the world.
2 trillion USD. Growth rates of more than 15 % Established in 1977 in Kuwait, todays KFH Group
outnumber those of the conventional banking network spans across seven regions worldwide
from Saudi-Arabia to Malaysia, with 430 branches, in order to introduce the Islamic finance model
over 790 ATMs and approximately 8,600 employees. in the market. KT Bank officially established the
previously unfamiliar Islamic banking model in the
Eurozone Islamic banking trailblazer Eurozone as a solo player. In terms of the required
banking license application, the bank cooperated
In view of this consolidated background, KT Bank strongly with the supervisory authority to ensure
entered the German market in 2010, when it was that it complies with all regulatory, legal, and fiscal
granted a license for non-EEA deposit broking by requirements applicable for conventional banks.
the Federal Financial Supervisory Authority BaFin. With regards to specific challenges, such as Islamic
Following this, in March 2015, after having applied car purchase and real estate financing, the bank
in 2012, the BaFin granted KT Bank as first bank had to develop approaches to comply with the
with Islamic business model a full banking license German legislation. The Islamic real estate financing
under German law for the provision of deposit and products structured as murabaha transaction – a
credit business in Germany. KT Bank commenced
sales contract where the buyer and seller agree on
operations in July 2015 with headquarters in
a markup – serve as example in practice: Following
Frankfurt and – up to today – 4 branches in the
a positive creditworthiness check of the client
cities of Berlin, Cologne, Frankfurt and Mannheim
and a valuation of the property in demand, the
as well as with 90 employees.
bank, together with the client, sets up a civil-law
These efforts are combined with a clear vision partnership in Germany, the so-called “Gesellschaft
for the Euro economy – the bank aspires to be a bürgerlichen Rechts” (GbR) in order to avoid having
leading ethical bank while focusing on Turkish to pay land transfer tax twice. After that, the GbR
and non-Turkish Muslim communities as well as buys the property from the vendor, with both the
SRI customers in mainland Europe, being open to client and the bank receiving shares in the GbR that
clients of all religions and nationalities. correspond to the capital contribution involved.
Then the client buys the bank’s shares in the GbR,
Islamic banking products and and pays off the purchase price over the agreed
services in Germany term. This procedure is not more complicated nor
time-consuming than a „conventional“ real estate
KT Bank provides Islamic deposit and credit financing in Germany. There is only one additional
business products and services and payment signature involved – for a financing package that is
transactions for retail and corporate clients as well true to Muslim ethical convictions. KT Bank’s single-
as services for financial institutions. The bank is a period real estate financing package runs for up to
member of the German Banks Compensation Scheme 10 years and features a fixed monthly instalment. It
(EdB), which secures clients’ deposits up to € 100,000. is called a “single-period” option because the bank
Considering Muslims’ financial requirements, the sells its share in the property concerned as a single
comprehensive, regularly updated portfolio includes transaction to the buyer.
a wide range of products and services, from free-of-
charge current accounts with free online banking, Halal and no hedge funds
debit Mastercards and investment opportunities
based on profit-sharing and participation schemes Besides operating as a trader, buying commodities
up to real estate financing, instalment credits for for its clients and reselling them with a profit
larger acquisitions and investor loans for business markup, KT Bank operates the Islamic deposit
financing. A bank that is not lending money business in Germany as an “entrepreneur” and
conventionally, but financing real goods to avoid participating project partner based on profit and
interest, was, until the launch of KT Bank, unheard loss participation. This partnership basis mirrors
of in the German market. And yet, clients became the general cooperative origin of the whole banking
quickly aware that they can also enjoy all amenities sector. The bank’s clients invest via a participation
of a conventional full-service bank, with services account, the bank invests in the real economy, and
like safe deposit box rental, foreign exchange and, the profit then achieved is shared in accordance with
given the bank’s background, remittances to Turkey. an allocation formula agreed beforehand, e.g. 85 %.
Moreover, KT Bank provides financial institutions The size of the client‘s respective share in the profits
with account & clearing services, vostro account will depend on the term involved and the size of
services and FX trading. the investment. With an allocation formula of 85 %,
the bank’s client receives 85 % and KT Bank 15 % of
Regulatory challenges the profit generated by the deposit. Due to reasons
of sharia-compliancy, KT Bank cannot guarantee
The requirements for establishing a comprehensive, fixed profits for the deposits, yet aspires to achieve
sharia-compliant portfolio in a Western economy profits for its clients that are aligned with the current
are by no means fulfilled by ‘business as usual’ market level.
procedures – hence it took substantial regulatory
cooperation efforts with the German authorities As financing is based on a pool that contains all
client deposits, every depositor gets a share of the during the last 3 years? In the operative field, KT
average return of all projects. Due to the return of Bank identified a large explanation need concerning
the investment into these projects and thus into Islamic banking products within the Muslim
the real economy, “real” and asset-backed values community. This is reflected in the only 5 % of the
are being created. Clients and investors thus German Muslim population that adhere to Islamic
contribute to the productive capital of the economy. banking yet. Client consultancy at KT Bank is thus
These participation investment options differ time-consuming, intense and individual. Measured
substantially from the structures of derivates that against the number of millions of Muslims living
violate the Islamic proposition that money is only in the country, the KT Bank pioneers anticipate a
a medium of exchange, as well as from the concept huge growth potential. Furthermore, net incomes of
of hedge funds with their high affinity to risk. KT Muslim households in Germany are on the rise, and
Bank does not invest into such financial constructs Muslims have a remarkable savings rate of nearly
due to sharia constraints. double the national average.
solutions for Eurozone challenges successfully in the Turkish Islamic banking sector
and is anticipated to also attract a lot of non-Muslim
In 2017, KT Bank officially declared the clients. Most vital is also the strategic enhancement
completion of the founding and establishment of the online direct banking infrastructure as there
phase of the bank in the German market after the is strong demand from currently out of more than
successful market launch. The bank’s key topics in 70 countries to open sharia-compliant accounts in
2017 were the achievement of a growing client base, Germany.
80 per cent asset growth as well as the development
of the retail, corporate and institutional product Inspiring cultural change in the
portfolio and up-to-date services. A 2017 highlight finance industry?
was the upward trend of the German property
market which increased the call of GCC investors Faith and finance, profit and ethics – this group
for sharia-compliant real estate opportunities. of attributes together complete the concept of
Moreover, the historical interest rate low boosted Islamic banking, which has already proven to be
the general appeal for investments into participation an enrichment to western conventional business
accounts, whose profit rates are up to today ethics. Islamic banking captures the global
outperforming those of the conventional fixed economic zeitgeist, prioritizes unequivocal values
deposit sector. According to 2017 year-end results, over a narrow focus on profits, and supports the
total KT Bank assets reached 191 million euro and real economy whilst featuring an universally ethical
total equity was 60 million euro. In 2018, the growth belief system. All of these qualities have triggered
path continues, with a current loan portfolio of huge awareness not only of the Muslim community,
more than 170 million euro. The market will see a but also of Euro clients. Will Islamic banking help
lot of new sharia-compliant products and services, to transform the Western conventional finance
among them Islamic financial showpieces like a sector after a decade of ongoing crisis? The Islamic
credit card with instalment, an Islamic alternative to bankers in the Eurozone believe it will help.
overdraft unheard of in Germany which is running
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