Notes for Reporting Exam

8/8/2019 Notes for Reporting Exam

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Notes for Reporting Exam

Short Answer Questions:

1. FAS 17 – Classified investments into 3 categories

AAOIFI has adopted FAS 17 on Investment in 2002. The reasons given for the

Standards include the following:

- The importance of investment items in the statement of financial position of

the institutions in size as compared to the other types of assets.

- Differences in the basis applied by institutions in the treatment of investments

either financed from the own funds of the institution or financed by

commingling own funds and the funds of unrestricted or restricted investment

account holders.

- The need for standardised policies which show the treatment of realised and

unrealised gains or losses resulting from investments which may affect the

allocation of investment operation results (gains or losses) between investment

account holders and owners’ equity.

- Differences in the basis applied in treating investments in real estate.

Classification of Investments:

Investments in sukuk are classified as follows:

• Held for trading purposes

• Available for sale

• Held to maturity

Investments in shares are classified as follows:



• Held for trading purposes

• Available for sale

Investments in real estate are classified as follows:

• Held for periodical consideration

• Held for capital appreciation

The jurists of the Maliki School have classified trading assets into the following:

- Assets that are meant for buying and selling and the person doing business in

this way is called trader or short term investor

- Assets that are held for sale in the expectation of making profits through price

appreciation in the future and the person trading in this way is called a

medium term investor

- A trader who acquires the assets not for trade, but for personal use or

consumption with the aim that they will be sold if a better deal comes along

Investments held for trading purposes – An investment is held for trading if acquired

or originated principally for the purpose of generating a profit from short-term

fluctuations in price or dealer’s margin. Any investments that form part of a portfolio

where there is an actual pattern of profit taking are also classified as ‘held for trading’

Investments available for sale – These investments are those that are not held for

trading, originated or held by maturity investments.

Investments held to maturity – These are investments that an institution has the

positive intent and ability to hold to maturity.

*Accounting Treatment of Shares and Sukuk – page 486*

*Photocopy Illustration on page 490*



Fair value – The amount for which an asset could be exchanged or an obligation

settled between well-informed, willing parties (seller and buyer) in an arm’s length

transaction.

Underlying the definition of fair value is a presumption that an institution is a going

concern without any intention or need to liquidate, curtail materially the scale of its

operations or undertake a transaction on adverse terms. Fair value is not, therefore,

the amount that an institution would receive or pay in a forced transaction,

involuntary or distress sale.

Investments in real estate are treated as a portfolio and measured using one of the

following methods:

Fair Value Method – According to this method, investments in real estate shall be

measured at their value in the statement of financial position. Any subsequent change

in the fair value shall be accounted for.

Cost Method – According to this method, investments in real estate shall be treated

as a fixed asset in the statement of financial position and measured at cost less

depreciation and any provision for other than temporary impairment of its value. In

this case, the fair value of such investments is disclosed in the notes.

2. Diagram on Salam Contract (see printed diagrams)



3. Zakat Governance - Definitions, Sources of Zakat, 2 methods of

calculating it, Asnaf

Zakah means blessing, purification, increase and cultivation of good deeds. It is

called Zakah because it blesses the wealth from which it is paid and protects it. In

Shari’ah, Zakah is an obligation is respect of funds paid for a specific type of purpose

and for specified categories. It is a specified amount prescribed by Allah the

Almighty for those who are entitled to Zakah as specified in the Quran. The word

Zakah is also used to indicate the amount paid from the funds that are subject to

Zakah.

Zakah is a compulsory levy on wealth and income, once it exceeds a certain amount.

According to the Quran, it is a right of the poor on the wealth and income of the rich.

Sources of Zakah:

- Agriculture

- Gold, Silver and Cash

- Inventory

- Livestock

Zakah is payable under the following conditions:

Unencumbered Possession – The possession or ownership must be complete. In

other words, the owner must have control over the property especially power of

disposal.

The Asset Must Be Capable of Growing Or Increasing – The growth can be in real

terms by reproduction (livestock) or by potentiality, e.g. stock which is intended to be

traded. Growth by estimation may take place if the asset has the potential to yield a

surplus and this includes cash and cash equivalent including gold and silver, even if

they are not invested.



Methods of Calculating Zakah

In the NET ASSETS METHOD, the asset side of the balance sheet is used to

compute the Zakah base. We exclude fixed assets in the calculation that are not

Zakatable. We first add the current assets which are Zakatable, taking care to value

some of these at cash equivalent values as opposed to historical cost shown in the

balance sheet. The standard requires that assets acquired for trading should be

measured at the cash equivalent value (market selling price) on the Zakah date.

We then deduct current liabilities which are payable within a year. From this subtotal

we deduct that part of equity which belongs to minority interest, unrestricted

investment account holders (these two groups are asked to pay by themselves). We

also deduct that part of the equity belonging to the government, waqfs, endowments,

charities and NGOs unless they are privately owned. This last group of items is not

Zakatable.

In the NET INVESTMENT FUND METHOD, we start on the liability side (the funds

side) and add up all the components which make up the shareholder’s funds and then

we add the long term liabilities (Zakatable) and then we deduct the fixed assets and

investments not acquired for trading as these are not Zakatable. We ignore the

investment account holders’ funds, minority interest and equities of other than

shareholders.



These two methods result in the same amount can be proven by a simple algebraic

expression:

FA = Fixed Assets

CA = Current Assets

CL = Current Liabilities

SF = Shareholders’ Funds

IAH = Investment Account Holders

MI = Minority Interest Equity

LTL = Long Term Liabilities

The asset side of the balance sheet is: FA+CA-CL

Equals, The Liability side of the balance sheet: SF+IAH+MI+LTL

Now using Net Assets Method , we can take CA-CL-IAH-MI as the Zakah base

Using Net Invested Fund Method, we use SF+LTL-FA as the Zakah base

But, FA+CA-CL = SF+IAH+MI+LTL

Rearranging this, we get CA-CL-IAH-MI = SF+LTL-FA



4. Social Responsibility – Qard Al Hasan, Waqf, Charity/Zakat, Sadaqah,

Tabarru

Qard Al Hasan (benevolent loan) - This is a loan extended on a goodwill basis,

and the debtor is only required to repay the amount borrowed. However, the

debtor may, at his or her discretion, pay an extra amount beyond the principal

amount of the loan (without promising it) as a token of appreciation to the

creditor. In the case that the debtor does not pay an extra amount to the creditor,

this transaction is a true interest-free loan. Some Muslims consider this to be the

only type of loan that does not violate the prohibition on riba, since it is the one

type of loan that truly does not compensate the creditor for the time value of

money.

Waqf – A Waqf is an inalienable religious endowment in Islamic law, typically

denoting a building or plot of land for Muslim religious or charitable purposes.

The donated assets are held by a charitable trust.

Zakat – Zakat or "alms giving", one of the Five Pillars of Islam, is the giving

2.5% of one's possessions (surplus wealth) to charity, generally to the poor and

needy. It is often compared to the system of tithing and alms, but it serves

principally as the welfare contribution to poor and deprived Muslims, although

others may have a rightful share. It is the duty of an Islamic community not just to

collect zakat but to distribute it fairly as well.

Sadaqah – Sadaqah is an Islamic term that means "voluntary charity".

This concept encompasses any act of giving out of compassion, love or

generosity.

Tabarru - In order to eliminate the element of uncertainty in the takaful contract,

the concept of tabarru (to donate, to contribute, to give away) is incorporated. In

relation to this concept, a participant shall agree to relinquish as tabarru, certain

proportion of his takaful instalments or takaful contributions that he agrees or



undertakes to pay should any of his fellow participants suffer a defined loss. This

agreement enables him to fulfil his obligation of mutual help and joint guarantee.

In essence, tabarru would enable the participants to perform their deeds in

sincerely assisting fellow participants who might suffer a loss or damage due to a

catastrophe or disaster. The sharing of profit or surplus that may emerge from the

operations of takaful is made only after the obligation of assisting the fellow

participants has been fulfilled. It is imperative, therefore, for a takaful operator to

maintain adequate assets of the defined funds under its care whilst simultaneously

striving prudently to ensure the funds are sufficiently protected against undue

over-exposure. Therefore the provision of insurance cover as a form of business in

conformity with Shariah is based on the Islamic principles of Takaful andMudharaba.



5. Controversies of BBA and Bai Al Inah (issues about the subject

matter/existence of asset)

The main controversy in BBA exists in its use of the Bai Al Inah contract. In Bai Al

Inah, the customer will normally place an Urboun (deposit), say 10%, on the

commodity or asset that they intend to purchase and will then go to an Islamic Bank

requesting the need for financing for the remainder of the deposit amount. Due to the

fact that the customer has paid a deposit for the commodity, in effect they now have

ownership rights over the asset.

As part of the BBA contract, the Bank will then buy the asset from the customer (for

example, if the customer wants to purchase a house, the bank will pay the remainder

of the purchase price to the developer/owner). In effect the customer sells the asset

(property) to the Bank for the purchase price. The Bank will then re-sell the asset

back to the customer for the purchase price plus profit (the Bai Al Inah aspect of the

contract). Although this is considered to be two separate contracts, the fact that it is

usually done in one sitting, and therefore almost simultaneously has led some

Shari’ah scholars to criticise the Bai Al Inah contract as they argue that it contains

elements of riba, because the asset is bought for one price and then sold for a different

price. They argue that although it is two different contracts, the intention is still there

from both parties to buy and sell at different prices. When the asset sold back to the

customer, it is usually done over a deferred period (which makes the contract BBA).

Jurists argue that the Bai Al Inah element of the BBA contract makes in controversial

and potentially incompliant with the rules and laws of Shari’ah. As a result, countries

that accept the use of Bai Al Inah as a Shari’ah compliant contract (such as Malaysia)

have started to move away from it and instead are now moving more towards

Tawarruq, which involves a third party and is therefore considered a more Shari’ah

compliant alternative.



Long Answer Questions:

1. Multi Topic Question

As per question from PES

2. Shariah Auditing vs. Shariah Review

Shari’ah Auditing

Shari’ah Auditing can be defined as a systematic process of obtaining sufficient and

appropriate evidence to form an opinion as to whether the subject matter (processes,

personnel, financial and non-financial performance, financial positions, systems,

marketing, products, transactions, contracts, etc.) corresponds with the criteria (the

Shari’ah rules and principles) which is broadly accepted by the Islamic community

and to report to stakeholders thereon.

- Shari’ah auditing is a process, i.e. a series of steps or work

- Sufficient and appropriate (reliable and good quality) evidence needs to be

collected

- The subject matter of the Shari’ah audit should be wider than a financial

statement audit. In line with the broader ambit of Shari’ah including Akhlaq,

not only should the financial statements, but the banks processes, personnel,

financial and non-financial performance, financial position, information and

IT systems, marketing of the bank’s products and of course, the financial

contracts employed by the bank.

- The criteria normally are the Shari’ah principles and rules developed by the

Shari’ah Supervisory Board.

GSIFI No. 2 from AAOIFI defines Shari’ah Review as “an examination of the extent

of an IFI’s compliance, in all its activities, with the Shari’ah”. GSIFI No. 2 places the

responsibility for Shari’ah compliance squarely on the management of the IFI.

However, unlike the role of the external auditor, the SSB is supposed to play a role in

advising, providing guidance and training the management of IFI to ensure its



Shari’ah compliance. The management is also required to provide all information

relating to the IFI’s compliance with the Shari’ah. To ensure a measure of

independence, the scope of work of Shari’ah review cannot be restricted. And if such

restrictions are imposed by the IFI on the SSB, such will be reported to the

shareholders.

The Internal Shari’ah Review is conducted to “examine and evaluate the extent of

compliance with Islamic Shari’ah rules and principles, fatwas, guidelines, and

instructions issued by the IFI’s Shari’ah Supervisory Board (SSB)”.

Whereas the responsibility for the Shari’ah review is placed on the SSB, the Internal

Shari’ah Review should “be carried out by an independent division/department or part

of the internal audit department, depending on the size of an IFI. It shall not be

established within an IFI”.

The Internal Shari’ah review is an integral part of the organs of governance of the IFI

and operates under the policies established by the IFI. It shall have a statement of

purpose, authority and responsibility (charter). The charter shall be prepared by

management and shall be consistent with Islamic Shari’ah rules and principles. The

charter shall be approved by the SSB of the IFI and issued by the Board of Directors.

The charter shall be regularly reviewed.

Definition of Shari’ah Supervisory Board (SSB) – A SSB is an independent body

of specialised jurists in Fiqh Muamalat (Islamic commercial jurisprudence).

However, the SSB may include a member other than those specialised in Fiqh

Muamalat, but who should be an expert in the field of Islamic Financial Institutions

and with knowledge of Fiqh Muamalat. The SSB is entrusted with the duty of

directing, reviewing and supervising the activities of the Islamic Financial Institution

in order to ensure that they are in compliance with Islamic Shari’ah Rules and

Principles. The fatwas and ruling of the SSB should be binding on the IFI.

The Shari’ah review is an examination of the IFI’s transactions, processes,

products, financial statements, etc. to ensure that all of its activities comply with the

Shari’ah.



The Shari’ah Review can be carried out broadly in three phases:

1. Planning and designing the Shari’ah review procedures

- The plan should be adequately developed to include a complete understanding about

the IFI’s operations in terms of products, size of operation, locations, branches,

subsidiaries and divisions. The planning should include obtaining a list of all fatwas,

ruling and guidelines issued by the SSB.

- Understanding the activities, products and management’s awareness and attitude

towards compliance with the Shari’ah is essential. This will have a direct effect on

the nature, extent and timing of the Shari’ah review products.

- The plan shall be properly documented including the sample selection criteria and

sizes, taking into consideration complexity, and frequency of transactions.

- The review procedures shall be designed based on the above input. The review

procedures shall cover all activities, products and locations. These procedures shall

ascertain whether the SSB approved transactions and products have undertaken and

all elated conditions have been met.

2. Executing Shari’ah review procedures and preparation and review of

working papers

At this stage all the planned review procedures are executed. The SSB review

procedures shall normally include:

• Obtaining an understanding of the management’s awareness, commitment and

compliance control procedures for adherence to Shari’ah

• Reviewing of contracts, agreements, etc.

• Ascertaining whether transactions entered into during the year were for

products authorised by the SSB

• Reviewing other information and reports such as circulars, minutes, operating

and financial reports, policies and procedures, etc

• Consultation/co-ordination with advisors such as external auditors

• Discussing findings with an IFI’s management



The execution of the above review procedures shall be documented in work papers

which shall be complete, neat and cross referenced to review procedures.

3. Documenting conclusions and report

The SSB shall document their conclusions and prepare their report to the shareholders

based on the work done and discussions held. The SSB report shall be read at the

annual general meeting of the IFI. A detailed report, when warranted, shall also be

issued to an IFI’s management.

Quality Assurance

The SSB shall implement adequate quality control policies and procedures to ensure

that the review is conducted in accordance with this standard.

Quality control procedures may include review of all work papers to ensure that

review procedures were properly understood and executed. Additional discussion

may be held with the IFI’s management, if required, to ensure that all significant

matters were covered during the review.



3. Question from Harmonising Article (3 accounting issues and 3 possible

approaches)

Scope of Report:

This report assesses the extent to which institutions offering Islamic finance report in

a common financial reporting language and what drives their reporting practices. It

further outlines key practices in Islamic finance that are markedly distinct from those

found in conventional finance and that could therefore lead to misrepresentations of

financial information if they were accounted for using IFRS.

As the number of countries requiring the application of IFRS increases, and therefore

more financial institutions offering Islamic finance are compelled to use those

standards, these challenges will become more apparent for standard setters.

The wider project will aim to resolve some of these issues and, ultimately, to inform

answers to the key question as to whether Islamic financial institutions would benefit

from reporting:

• Within the existing IFRS framework

• Within the IFRS framework but with a specific standard for Islamic finance

• Through a globally recognised suite of Islamic financial standards?

The varying degrees of flexibility accorded to Islamic finance transactions and

products have in instances led to conflicting conclusions on Shari’a compliance. Not

surprisingly, the financial reporting frameworks that Islamic financial institutions

(IFIs) apply also vary, often depending on the jurisdictional requirements imposed on

them. Although this is not due to differences in Shari’a interpretation, but rather

dictated by the prevailing general requirements for companies within a country, there

is a clear lack of a single financial reporting framework, meaning that comparability

across borders for similar entities becomes difficult. With increasing demands by

investors in IFIs, as with other entities and industries, who look to global markets for

optimal opportunities, this lack of consistency could be a major drawback.



AAOIFI developed its own financial accounting standards (FAS) essentially for two

reasons:

1. Owing to the specifics of Islamic banking and finance, IFRSs cannot be adopted en

masse as they can either cause Shari’a compliance issues or do not fully cover

characteristics of Islamic banking transactions, and

2. There were areas of IF not adequately covered by prevailing international

standards; where financial transactions and practices were unique to IF, equivalent

standards for topics covered in IFRS had to be developed.

Questions remain as to whether the increased application of IFRS by IFIs:

• Actually leads to consistency, both between IFIs themselves and with

conventional institutions

• Provides a faithful representation of the transactions being conducted

• Can lead to conflicting accounting treatments with requirements from national

regulators

• Leads to decision-useful information for the main users of their reports



3 Accounting Issues

1. LACK OF STANDARDISED ACCOUNTING

As Islamic financial institutions are founded in these countries and conventional,

multinational financial institutions offer Shari’a-compliant products, new challenges

are faced by the industry. This is especially the case as those institutions seek to

operate, invest and access funding across borders and in countries where the

regulatory and financial reporting frameworks are quite different.

In most countries, the accounting standards used by IFIs are usually independent of

their status as an IFI, with IFRS being the predominant set of standards. Even so, it is

not uncommon, even where the banks are required to use IFRS, for them also to have

to adhere to additional local reporting requirements, specific to IFIs.

The fact that institutions can report and disclose similar transactions in different ways

poses problems for those institutions themselves as well as for the development of

Islamic finance in general.

A review of leading international Islamic financial institutions shows that a number of

reporting frameworks are used across the industry. Although many use IFRS, some

use partly converged IFRS-based standards, some use IFRS with additional

requirements for Islamic banks, and others use standards exclusively for Islamic

banks. Questions over comparability and consistency within the industry and the

broader financial services sector as well as the impact such issues can have on funding

and investing are fairly obvious.

Differing accounting practices can not only restrict cross-border operations but can

also cause difficulties in the preparation of financial statements. For institutions

offering Islamic finance products and services, these differences and difficulties are

particularly acute, as applied standards may not cover the concerned products or do

not offer appropriate disclosure requirements.



It is not uncommon, even where the banks are required to use IFRS, for them also to

have to adhere to additional local reporting requirements, specific to IFIs

Most multinational conventional banks that offer Islamic finance ‘windows’ will

report according to their local requirements. Owing to the jurisdictions in which most

of these are located for reporting purposes, IFRS is the most common form of

reporting. Even though their Islamic finance operations are often substantial, there is

little evidence that these financial instruments and transactions are reported distinctly

from their conventional alternatives.

The fact that the banks reviewed are significant global IFIs highlights the

heterogeneity of financial reporting, and even where IFRS are used, the local

reporting requirements may well impose rules that are not necessary consistent with

these standards. This ultimately means that information for investment decisions by

users of the IFI financial reports can be severely restricted, in comparison with that

available for both other IFIs internationally, and conventional financial institutions

locally

2. COMPATIBILITY OF IFRS WITH ISLAMIC FINANCE

Islamic finance by definition is distinct from conventional finance. Because of the

nuances inherent within it, many countries require their Islamic banks to apply

accounting standards that take into account those differences, rather than simply

applying the more neutral IFRS suite of standards.

A crucial objective of financial reporting from an Islamic perspective is to be able to

assess whether the entity is abiding by the ‘principles of Shari’a and its concepts of

fairness, charity and compliance with business values’.

IFIs are faced with the very real dilemma of reporting their performance and position

against the same set of user objectives as their conventional counterparts, while often

carrying out transactions that are quite distinct from theirs.

One of the cornerstones of Shari’a-compliant finance is the aversion to payment or

receipt of interest, i.e. the prohibition of riba. Interest in the conventional sense



includes an intrinsic assumption of the time value of money. This concept is central to

IFRS, which in aiming to allow users to evaluate the ‘ability of the entity to generate

cash and cash equivalents in the future’6 often require the use of discounted future

cash flows to measure assets and liabilities.

Substance over form

The conflict between accounting based on economic substance as opposed to Shari’a-

compliant form appears to be a recurring theme. IFRS is reliant on a strong

framework of principles that emphasise the economic nature of transactions, whereas

in Islamic finance the contractual aspect of the transaction is crucial for Shari’a

compliance. Underpinning those contracts are Shari’a principles that give rise to

products (e.g. Mudaraba, Musharaka, Salam and Istisna) that are unique to the

industry and that have different rights and obligations associated with them.

3. ISLAMIC FINANCE NOT COVERED IN IFRS

Classification and presentation of financial instruments

Most Islamic financial institutions operate a Mudaraba-based investment structure,

which is a popular form of deposit mechanism for customers. The specific features of

these accounts create a distinct difference between them and conventional deposit

accounts, which in turn affects how they might be reported under IFRS.

From a prudential standpoint, the Islamic Financial Services Board (IFSB) also does

not include any profit sharing (Mudaraba) investment accounts as eligible capital for

capital adequacy purposes, similar to requirements under Basel II.

Restricted Mudaraba investment accounts are in many respects more akin to a pure

investment management undertaking by the IFI, restricted to the specific conditions

imposed by the investors. As the IFI is acting as an agent in a fiduciary capacity for

the accounts, such contracts would be treated as ‘off-balance sheet’.

Points for consideration

1. Would the treatment of restricted investment accounts be different under IFRS?

Most Islamic banks, whether they apply IFRS (eg Kuwait Finance House (KSC))

or AAOIFI standards (eg Al Baraka Banking Group (BSC)) use the off-balance



sheet treatment, as the ‘clients bear all of the risks and earn all of the rewards on

these investments’.13

2. How common are comingled restricted Mudaraba investment accounts where the

IFI also receives an investment return and thereby partakes in the risk and rewards

or control of the related investment? Would bringing these on to balance sheet as a

joint venture be a more faithful representation than simple disclosure?

Provisions and reserves

Under strict Shari’a rules if there is a loss from a Mudaraba investment, it is only the

depositing customer who bears the full loss. In practice, in such circumstances or

when the overall profit levels are low, as was the case during the recent financial

crisis, IFIs have forgone their own share of profits in favour of their customers.

The IFSB describes this provision of competitive returns as ‘displaced commercial

risk’. Principally applied to URIA, an IFI achieves this risk-sharing by using reserves

set aside from Mudaraba profits.

The accounting for these reserves under IFRS would depend on whether the IFI is

deemed to have an obligation (either contractual or constructive) to pay depositors

from the reserve. A further issue is that in the case of PER in particular, the IFI’s

share of the profits is included, thereby effectively creating an expected loss

provision, currently not permitted under IAS39.

Profit-sharing reserves

Profit-sharing reserves are usually of two types:

• In profit equalisation reserves (PER), the reserves are set aside from profits

before applying the profit-sharing distribution. Typically, in such arrangements the

IFI gives up a part, or its entire share, of profits, in order to match current market

returns.

• In investment risk reserve (IRR), the reserves are set aside from the part of

the profits allocated to investors, which can only be used to absorb losses during a

financial period.



Addressing the Issues

Issue 1 - LACK OF STANDARDISED ACCOUNTING

In most countries, the accounting standards used by IFIs are usually independent of

their status as an IFI, with IFRS being the predominant set of standards.

Greater standardised financial reporting will be important for both Islamic finance and

the institutions offering it to reach their full potential. Whether such reporting will be

within the IFRS framework or through a set of globally accepted accounting standards

for the Islamic finance industry depends on the needs of all stakeholders in the

industry. Careful debate and assessment of the different alternatives is the only way to

reach a satisfactory solution.


The key considerations would include general conceptual issues, such as:

• Identifying the users, and the objectives, of financial reporting by Islamic

financial institutions and whether they differ from those of conventional

financial institutions

• The need to use distinct Islamic accounting principles to provide a faithful

representation of the nature of Islamic finance transactions

• Whether non-financial institutions that consume Islamic finance products have

different accounting issues to Islamic financial institutions?

Common accounting essential for access to global markets

There is little question that IFRS is the only language for financial reporting that has

true global recognition and clearly offers cross-border comparability for users of IFI

financial reports. This is of vital importance for large multinational IFIs as well as

conventional banks offering Shari’a windows that are seeking to access funding and

break into new markets. Regional standards, and especially those geared specifically

towards IFIs, cannot yet offer these benefits.



Issue 2 – COMPATIBILITY OF IFRS WITH ISLAMIC FINANCE

More specific questions arise over the compatibility of IFRS with Islamic finance

practices such as:

• The prohibition on partaking in interest-based transactions and whether this

should affect the use of discount rates for measuring financial instruments

• Whether concepts such as ‘control’, ‘risks and rewards’ or ‘rights and

obligations’, essential in determining the accounting treatment under IFRS,,

are readily translatable to Islamic finance, where the sanctity of contractual

form is so important

• The unique structures in Islamic finance that can confer rights and obligations

on institutions, which are quite distinct from apparently similar conventional

products (e.g. profit-sharing investment accounts based on Murabaha)

• Whether potential changes to IFRS, such as in the areas of lease accounting,

financial instruments, insurance accounting and consolidation may have an

impact on institutions applying IFRS, in the future.


1. While the accounting under current IFRS appears to diverge from that of Islamic

accounting standards used in other countries, IFRS do not in any way affect the

Shari’a compliance of the transaction itself.

2. Would the accounting for certain Islamic finance contracts using the principles of

IFRS produce an accounting treatment that would generate information that was

either not useful or non-compliant from a Shari’a perspective?

Issue 3 - ISLAMIC FINANCE NOT COVERED IN IFRS

Unique f eatures of Islamic finance need to be considered

Specific financial reporting standards can offer a more tailored model for IFI

reporting. By taking into account the nature of their transactions they would

potentially be able to provide more decision-useful information. For example, many



IFIs reporting under IFRS report URIAs simply as liabilities and there is little

information to enable users of the accounts to distinguish URIAs from conventional

customer deposits.

POSSIBLE APPROACHES

IFRS by default

IFRS could be used as the default reporting framework, although guidance based on

existing Islamic financial reporting models would need to be used to supplement the

standards for those IF transactions that do not fit simply into the framework. This

guidance would be presentation and disclosure related, allowing for additional

transparency for such things as underlying assets and terminology required by users.

It is also worth noting that even within the existing IFRS suite of standards, there are

standards dealing with specific industries, and therefore a specific standard aimed at

Islamic finance transactions could be another possibility.

Islamic accounting standards by default

Alternatively, a set of globally recognised Islamic accounting standards could be used

by IFIs. Where possible these would be based on IFRS, but would include specific

recognition, measurement, presentation and disclosure requirements relevant to

Islamic finance products and transactions. In order to assist IFIs and ultimately, the

users of their financial reports, reconciliation to IFRS could be also being provided.

As Islamic finance moves beyond its traditional geographic boundaries and

increasingly becomes a mainstream form of accessing finance around the world,

greater standardised reporting will be important to all Islamic finance and theinstitutions offering it to reach their full potential.



4. Calculation of investment account holders (Explain PER and IRR). Are

these reserves acceptable under the IFRS regime? How are the reserves

presented in the financial statement?

*CALCULATION IN NOTES FOR PER & IRR*

Profit Equalisation Reserve (PER) – The PER is the amount appropriated by the

Islamic bank out of the Mudaraba income, before allocating the Mudarib share, in

order to maintain a certain level of return on investment for investment account holder

and increase owners’ equity.

Investment Risk Reserve (IRR) – The IRR is the amount appropriated by the

Islamic Bank out of the income of investment account holders, after allocating the

Mudarib share, in order to cater against future losses for investment account holders.

Disclosure in financial statements of IFIs on the bases for profit allocation

between Owner’s Equity and Investment Account Holders and Equity of IAH

FAS 5 prescribes the following:

Unrestricted Investment Accounts:

Disclosure should be made in the note on significant accounting policies

a. The bases applied by the Islamic Bank in the allocation of profits between owners’

equity and unrestricted investment account holders

b. Of the bases applied by the Islamic Bank for charging expenses to unrestricted

investment account holders

c. The bases applied by the Islamic Bank for charging provisions, and the parties to

whom they revert once they are no longer required

Disclosure should be made in the notes accompanying the accounts of

d. Of the total administrative expenses charged to unrestricted investment accounts

along with a brief description of their major components based on the material

significance of the amounts



e. The percentages for profit allocation between owner’s equity and various

unrestricted investment account holders which the Islamic Bank has applied in the

current financial period. When the Islamic Bank has a number of different types of

unrestricted investment accounts involving different contractual conditions, the

required disclosure applies to such type of accounts only when the total amount by

type of account is of material significance

f. The increase in the Islamic Bank’s percentage of profits as a Mudarib, after

fulfilling the necessary Shari’ah requirements, during the financial period, if any

g. Whether the Islamic Bank has included unrestricted investment accounts in the

sharing of profit resulting from investing current accounts funds or any other funds

(which the Islamic Bank did not receive on the basis of a Mudaraba contract).

Disclosure should also be made on the bases that have been applied.

h. Whether the Islamic Bank has included unrestricted investment accounts in the

sharing of revenue from banking operations. If so, the types of such revenue and the

bases applied should be disclosed

i. Of which of the two parties (owners’ equity or investment account holders) was

given priority, in cases where the Islamic Bank is unable to utilise all funds available

for investing

Restricted Investment Accounts

Disclosure should be made in the note of significant accounting policies, of

a. The bases applied by the Islamic Bank in the allocation of profits between owners’

equity and restricted investment account holders

b. The bases applied by the Islamic Bank for charging provisions, and the parties

whom they revert once they are no longer required

Disclosure should be made in the notes accompanying the financial statements of

c. The percentages of profit allocation between owners’ equity and restricted

investment account holders. When the Islamic Bank has a number of different types

of restricted investment accounts involving different contractual conditions, the

required disclosure applies to such type only when the total amount by type of

account is of material significance

d. Bases applied by the Islamic Bank for determining the incentive profits which it

receives from the profits of both unrestricted and restricted investment accounts if

such profits are of material significance



e. In the case of agency based investment, disclosure should be made of the bases

applied for allocating incentive profits if such profits are of material significance



5. List and explain 4 financial ratios that are unique to Banking. 3 Maqasid

Shariah financial ratios which are unique

Performance Analysis

Financial Analysis refers to an assessment of the viability, stability and profitability of

a business, sub-business or project. It is performed by professionals who prepare

reports using ratios that make use of information taken from financial statements and

other reports.

Financial analysts often assess the firm's:

1. Profitability- its ability to earn income and sustain growth in both short-term and

long-term. A company's degree of profitability is usually based on the income

statement, which reports on the company's results of operations;

2. Solvency- its ability to pay its obligation to creditors and other third parties in the

long-term;

3. Liquidity- its ability to maintain positive cash flow, while satisfying immediate

obligations;

Both 2 and 3 are based on the company's balance sheet, which indicates the financial

condition of a business as of a given point in time.

4. Stability- the firm's ability to remain in business in the long run, without having to

sustain significant losses in the conduct of its business. Assessing a company's

stability requires the use of both the income statement and the balance sheet, as well

as other financial and non-financial indicators.

Performance Evaluation refers to making an assessment of achievement as opposed to

objectives, targets, goals or other criteria. Criteria could be:

• Budgets and Strategic Plans

• Other firms in the same industry

• Past years performance

• Social, environmental and Shari’ah Goals (Maqasid)



Fundamental Analysis of a Business

• Fundamental analysis of a business involves analyzing its financial

statements and health, its management and competitive advantages, and its

competitors and markets. The term is used to distinguish such analysis from

other types of investment analysis, such as quantitative analysis and technicalanalysis.

• Fundamental analysis is performed on historical and present data, but with the

goal of making financial forecasts. There are several possible objectives:

- to conduct a company stock valuation and predict its probable price

evolution,

- to make a projection on its business performance,

- to evaluate its management and make internal business decisions,

- to calculate its credit risk.

Special Indicators of Banks

Efficiency and Productivity Indicators

• Operating Expenses Ratio (Operating Expenses/Portfolios)

• Portfolio Yield ( Financial Income/Average Portfolio)

• Cost per Client (Operating Expenses/Number of Clients)

•

Cost per Unit of Capital Allocated (Operating Expenses/Value of Financing )• Staff Ratios ( Active Clients/Officers; Financing/Officer )

• Client Retention (number of new clients, number of clients lost, client

turnover, average number of clients trend )

• Asset Size

UNIQUE RATIOS FOR BANKS:

•Financing: Asset Productivity ( Financing Income/Category of Financing )

• Deposits: Return on Deposits ( Net Operating Income/Average Deposits)

• Capital and Capital Adequacy

• Financing Provisions/Loan Losses

• Profit Margins ( Net operating Income/Total Revenue)

• Sustainability (Operating Revenue/Operating Expenses)



RATIOS UNIQUE TO ISLAMIC BANKS

• Non-Performing Financing/Total Financing

•

Profit Attributable to Depositors/Investment Account Deposits (return oninvestment account deposits)

• Profit Attributable to IAH/IAH Funds Invested

• Profit Attributable to RIAH/Average RIAH Deposits

• Net Income from RIAH Funds/Average RIAH Deposits

• % of RIAH Funds Invested

• % of IAH Funds Invested

Socio-Economic Performance of Islamic Banks (Maqasid Shari’ah Approach)

Maqasid Shari’ah objectives are:

• Educating the Individual

• Establishing Justice

• Promoting Welfare

- Islamic Banks are socio-economic institutions, not capitalist profit making

institutions

- There is the need to also measure non-financial and socio-economic

performance based on Maqasid Shari’ah

- Need to calculate Islamicity ratios based on Maqasid Shari’ah

Educating the Individual

Educating Bank Personnel:

• Customer Service and Retention

• Product Knowledge

• Customer Care; especially retirees, small businesses, old people and poorer

sections of society

• Shari’ah Aspects of Products



• Good Muslim – responsibility to Allah

• Punctuality, cleanliness, friendliness, efficiency, effectiveness

Educating the Public (Customers)

•Avoidance of Riba, Gharar and Maysir in Islamic Financial Products

• Awareness of the Risk and rewards of Islamic Financial Products

Educating the Individual – Appropriate Ratios:

• Education Grant/Total Income

• Research Expense/Total Expense

• Training Expense/Total Expense

• Publicity expense/Total Expense

Establishing Justice and Promoting Welfare

In terms of promoting Socio-Economic Justice:

• Financing of small businesses

• Promotion of small and medium term cost house financing

• Education financing on favourable terms

• Provision of risk sharing products, i.e. Musharaka and Mudaraba as opposed

to fixed income products, i.e. Murabaha and Ijara

• Reduction of controversial products, e.g. BBA, Tawarruq

• Qard Al Hasan financing for education, marriage, etc.

• Contribution to charitable and social causes

• Payment of Zakat

Establishing Justice and Promoting Welfare – Appropriate Ratios

• Risk Sharing Financing/Fixed Income Financing

• Zakat/Share

• Zakat/Investment Account Deposit

• Charitable Contributions/Net Income

• Qard Financing/Total Financing

• Education Financing/Total Financing



• Medium and Low Cost House Financing/Total House Financing

• Prohibited Income/Total Income

• Tawid and Penalty Income/Total Income

Notes for Reporting Exam

Documents