FINANCIAL REPORTING OF ISLAMIC FINANCIAL INSTITUTIONS (IFI): ISSUES AND CHALLENGES FOR TRANSPARENCY, DISCLOSURE AND GOVERNANCE

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FINANCIAL REPORTING OF ISLAMIC FINANCIAL
INSTITUTIONS (IFI) ISSUES AND CHALLENGES FOR
TRANSPARENCY, DISCLOSURE AND GOVERNANCE
Workshop 3.1.7 Accounting Standards for the
Islamic Financial Institutions
Dr. Syed Musa Alhabshi Assoc. Professor,
Universiti Tun Abdul Razak, MALAYSIA Principal
Consultant, IIIF Inc syedmusa_at_amanie.com.my
November 16 2006
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Purpose Scope of Presentation

• To discuss the distinguishing nature of
  relationships and behavior of Islamic Financial
  Activities and Institutions influencing reporting
  process of IFI information needs of investors
  and stakeholders
• Scope of presentation
• Factors influencing the historical development of
  IFI
• Primordial Covenant of Islamic Finance
• Investor Expectations Information Needs
• Impact of Supporting Institutions, Industry
  Standards On Information Infra Structure Reforms
  In Islamic Financial Industry
• The Way forward.

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FACTORS INFLUENCING THE DEVELOPMENT OF ISLAMIC
FINANCIAL INSTITUTIONS
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Early Development An Alternative Financial
Intermediation Model

• 1960s Addressed the religious and social
  welfare needs of the Muslims formulating
  alternate financial intermediary and
  intermediation models
• Need for Large scale mobilization of Muslim
  (Islamic) Funds.
• Nasser Social Bank, Egypt and Pilgrimage Funds
  Board Malaysia are special purpose investment
  institutions addressing specific needs of
  Muslims
• From 1970s Islamic Development Bank Dubai
  Islamic Bank were the first development finance
  and commercial financial institutions
  respectively that chart the new frontiers in
  Islamic Finance

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Critical Phases of Development of Islamic Finance
1970s
1980s
1990s
2000s
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Dual vis a vis Single Financial System

• Early developments are manifested in two systems,
  namely,

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Other Exogenous Considerations

• Driven by Private Initiative or Government
  Directed?
• Focus on Banking or Capital Market Orientation?
• Directed towards Domestic (Retail) or
  International (Institutional) Trends?

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Country Analysis of IFI Government Private
Initiatives
Private Initiative
Government Initiative
Malaysia (S) Kuwait (S) Bahrain (S) Jordan
(S) Pakistan (NS) Iran (NS) Sudan (NS )
UAE (S) Bahrain (S) Prince Faisal (S) Sh. Saleh
Kamil(S) Sh.Suleiman Ar-rajhi (S) Egypt (NS)
Early Adopters (Prior 1990)
S Sustainable NS Non Sustainable
Thailand Singapore Brunei Indonesia UK Lebanon Qat
ar
Saudi Arabia Indonesia UK Lebanon
Later Adopter (Post 1990)
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Country Analysis Banking Operations Capital
Market
Banking
Capital Market
United Arab Emirates Bahrain Saudi
Arabia Malaysia Indonesia Pakistan Kuwait Jordan S
ingapore (?)
United Arab Emirates Bahrain Saudi
Arabia Malaysia Indonesia Singapore
Domestic Operations
United Arab Emirates Bahrain Kuwait Saudi Arabia
United Arab Emirates Bahrain Malaysia(?) Saudi
Arabia
International Operations
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Main Drivers of Growth of Islamic Financial
industry
It represents the core of Islamic financial
activities particularly from Muslim investor
expectation
Shariah Directed Growth
Main Growth Drivers
Government Regulation Policies
Human Capital Capacity
Facilitate the growth and development of Islamic
Financial Industry
Essential component that synthesizes and promotes
Islamic financial products and services
Institutions, Products Markets
Essential components that enable effective
Shari'ah compliance requirement and facilitate
competitive market performance
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Islamic Financial Systems Institutions
Strategies Jurisdiction
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Development of Islamic Capital MarketsIslamic
Stock Index

• Chronology of Events
• 1996 RHB Islamic Equity Index
• 1999 (February) Dow Jones Islamic Equity Index
• 1999 (April) Kuala Lumpur Shari'ah Index
• 1999 FTSE Global Islamic Index (dormant)
• 2006 FTSE SGX Islamic Index

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Other Factors facilitative, stability and
confidence generating elements for IFI

• Regulatory system
• Regulatory structure
• Licensing conditions
• Shariah compliance process
• Currency controls
• Foreign ownership policies
• Compliance with international Standards Best
  Practices
• Harmonization Comparability of International
  Reporting Standards
• Dispute resolution process
• Industry organizations
• International co-operation
• Ease of doing business

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Islamic banks have achieved comparative higher
asset growth than conventional banks
Source McKinseys World Competitiveness Report
2005
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Islamic bonds/Sukuk are increasingly being issued
Source Islamic Finance Information Service (ISI
Emerging Markets) LMC Global Sukuk table Bank
Negara Annual Report 2005
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Impacting the Need for Accounting Standards in
Islamic Banking

• Developments of Islamic Banking demand financial
  reporting framework and information useful for
  investors and stakeholders.
• Existing financial reporting standards on
  conventional financial institutions are not
  adequate to address the information needs of
  Islamic financial Institutions.
• Nature of Islamic banking emphasizes importance
  of lawful and equitable banking business and
  financial activities - require accounting
  treatment of unique features of IFI activities

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Primordial Covenant in Islamic Finance The
Premise of Islamic Financial Activities
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Man as an Economic Social Unit - Islamic
Financial Activities

• Existence Servant (Abd) Vicegerent
  (Khilaafah)
• Purpose Worship (ibaadah)
• Role Administer trust (amaanah)
• Function To make the right choice (ikhtiyaar)
• Guidance Prescribed Path to Lawful Goodness
  (Shariah Quran Sunnah)
• Wealth Gods Absolute Ownership
• Relationships Man God (Seeking His Pleasure)
  as well as Man fellow beings (mutual consent)
• Social Responsibility Zakat, Charity Waqf

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Nexus of Contractual Rights Obligations in
Islamic Financial Activities
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Impact of Nexus of Contractual Rights
Obligations on Financial Reporting of IFI

• Accounting in Islam deals with contractual rights
  obligations based on the prescribed
  relationships
• Interest based financial institutions as an
  entity (shareholders interest) mobilize
• deposits for financing in the forms of loans and
  advances
• IFI as an entity mobilizes
• Investment Account Holders funds based equity
  profit sharing contracts for financing and
  investment in the forms of trade and equity
  profit sharing contracts.
• Hence a lacunae of proprietor interest of profit
  sharing contracts in entity based reporting
  needs to be addressed based on Shariah
  requirements

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Impact of Shariah Contractual Conditions of
Transactions on Reporting Process
Distinguishing contractual relationships render a
distinct reporting process to address the lacunae
of entity based reporting
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View of Capital Performance Measurement
Shariah Principles

• Capital derives its value from real assets in
  lawful economic activities.
• Loan capital by itself is non productive
  (interest being contracted return is prohibited)
• Equity capital - financial claims recognized
  based on profit loss sharing contracts for an
  expected return derived from exchange
  transactions involving real assets.
• Trade credit and asset based financing such as
  sales receivables and lease investments are
  priced from transactions of real assets.
• Performance measurement of IFI should relate to
  real economic activities based on underlying
  contractual rights and obligations.

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Terms of Trade in Classification of Islamic
Financing Contracts

• Various features have been identified in
  classifying contracts as follows
• Price
• Cost Price (Tawliya)/ Mark up price with
  disclosure (Murabaha) / Negotiated price
  (Musawamma)/Discounted Price (Wadhi)
• Payment
• Cash Payment/ Deferred Payment (Muajjal)
• Delivery
• Immediate delivery/Deferred delivery (Salam)
  /Piecemeal Delivery (Istisnaa)
• These features also influence classification and
  reporting of types IFI Financing assets.

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Investor Expectations Information Needs
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Reporting Impact IFI IAH Multi-contract
Financing

• PLS features of restricted and unrestricted IAH
  are addressed in AAOIFI standards.
• Adoption of various contracts in IFI products and
  services advocate the need for segment reporting
  of contracts type for each product
• Sources and of asset financing and its related
  returns risk exposures to IAH
• to be distinguished in terms of IAH risk
  preference
• Distributable income to IAH using pooling or
  separate investment account method in terms of
• deductible expenses
• PER allocation
• time varying deposit period allocation

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Entity PerspectiveUnique Risks of Islamic
Financial Institutions

• Rate of return risk
• relates to market factors affecting rate of
  return on assets vis a vis rate of return for IAH
• Displaced commercial risk
• relates to market factors affecting rate of
  return on assets vis a vis rate of return for
  Shareholders
• Equity investment risk
• relates to risk characteristics of equity
  investments in the form of Mudaraba and Musharaka
  (including transformation of risks at various
  stages of investment life cycle)
• Operational risk
• fiduciary risk relates to Shariah non-compliance
  structure, process and policies.
• Impacting soundness, stability and going concern
  of IFI

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ANATOMY OF FUNDING RISK EXPOSURES
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Anatomy of Asset Risk Exposures
Pecking order of risk exposure mitigation?
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Meeting Investment Account Holders
ExpectationScenario Analysis Expected versus
Actual Yield
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Meeting Investment Account Holders
ExpectationScenario Analysis Expected versus
Actual Yield
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• Impact Of Supporting Institutions, Industry
  Standards On Information Infra Structure Reforms
  In Islamic Financial Industry

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AAOIFI ACCOUNTING FRAMEWORK, REPORTING, AUDITING,
GOVERNANCE SHARIAH STANDARDS
STATEMENTS OF FINANCIAL ACCOUNTING
SHARIAH STANDARDS
FINANCIAL REPORTING STANDARDS
ISLAMIC FINANCIAL INSTITUTIONS (IFI)
GOVERNANCE STANDARDS
AUDITING STANDARDS
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IFSB STANDARD, GUIDELINES PRINCIPLES
GUIDING PRINCIPLES ON CORPORATE GOVERNANCE
GUIDING PRINCIPLES OF RISK MANAGEMENT
DISCLOSURE PRINCIPLES TO PROMOTE TRANSPARENCY
MARKET DISCIPLINE
INSTITUTIONS OFFERRING ISLAMIC FINANCIAL SERVICES
(IFSI)
CAPITAL ADEQUACY STANDARDS
GUIDANCE ON KEY ELEMENTS SUPERVISORY REVIEW
PROCESS
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FINANCIAL REPORTING, AUDITING GOVERNANCE
INSTITUTIONS
ROLE OF INTERNATIONAL AGENCIES?
AUDIT COMMITTEE
SHAREHOLDERS
AAOIFI
IFSB
INVESTMENT ACCOUNT HOLDERS
SHARIAH SUPERVISORY BOARD
ISLAMIC FINANCIAL INSTITUTION
OTHER STAKEHOLDERS
GOVERNANCE COMITTEE
REGULATORY AUTHORITIES
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Multi-Disciplinary Perspectives onRole of
Shariah Audit, Audit Governance
Prudential Guidelines Standards Promulgated By
IFSB to Ensure Risk Management
Disclosure Framework Related to Capital Adequacy,
Corporate Governance Market Discipline
Financial, Statements, Reports and other Useful
Information Required by AAOIFI Relevant
International Financial Reporting, Auditing
Governance Standards
Shariah Goals, Opinions Rulings Propounded by
Shariah Scholars
SHARIAH COMPLIANCE AUDIT
Regulatory requirements by Central
Banks, Monetary Authorities or Supervisory
Agencies
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THE WAY FORWARD

• Integrated representation and communication
  between various institutions that promulgate
  financial reporting, auditing, governance and
  prudential standards and guidelines pertinent to
  the development of Islamic Financial Industry
• Enhance global collaborative efforts towards
  convergence in adopting Financial Reporting
  Standards of IFI as part of International
  Financial Reporting Standards.
• Mutual recognition of distinguishing reporting
  requirements will enable reporting of IFI and
  activities as distinct from conventional
  financial institution and activities.
• Harmonization of practices in the international
  reporting environment to reflect comparable and
  consistent practices of both conventional and
  Islamic financial institutions and activities.

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Thank You Wassalam