Report on Accounting for Islamic Financing Transactions

Introduction of the Islamic finance institutions

The aim of this assessment is to provide deep insights regarding the financial reporting of Islamic finance institutions. The rules of IFRS are designed by keeping the conventional accounting techniques in mind and are not considered suitable for application in the IFIs (Islamic Financial Institutions). AAOIFI has established the rules for the IFIs. For harmonizing the financial reporting of Islamic finance institutions there are many issues that should be addressed before harmonizing the financial reporting of IFIs. The key issuers which may occur include recoding of interest, time value of money, smoothing expectations, less balance sheet, etc.

Reviewing the Report “Global alignment: bringing consistency to reporting of Islamic finance through IFRS.”

Financial reporting regarding Islamic Finance

In many countries around the world, many organizations prepare their financial statements and perform financial reporting according to the standards set by IFRS (International Financial Reporting Standards). The rules of IFRS are designed by keeping the conventional accounting techniques in mind and are not considered suitable for application in the IFIs (Islamic Financial Institutions). AAOIFI has established the rules for the IFIs. The main conceptual issues which arise here is to state whether the financial reporting of financial institution is different from conventional financial institutions or not. Another issue is that if Islamic accounting principles have to apply for financial reporting than these principles should be properly defined ( ACCA and KPMG, 2012).

Key issues of harmonizing the financial reporting of Islamic finance

For harmonizing the financial reporting of Islamic finance institutions, there are many issues that should be addressed before harmonizing the financial reporting of IFIs. The key issuers which may occur include recoding of interest, time value of money, smoothing expectations, less balance sheet, etc (Elsiefy, 2014). The treatment of Islamic finance transactions is different from conventional financial institutions. Therefore, it is important to understand how these transactions are going to be recorded accurately in the light of financial reporting standards. The report has highlighted various issues which occur in harmonizing the financial reporting which are reviewed below:

Time value of money of the Islamic finance institutions

In Islamic finance the interest is strictly prohibited. Islamic finance institutions do not perform those transactions in which interest is involved. In other words it can be said that this is one of the major factors that differentiate Islamic Finance Institutions from conventional financial institutions. Under IFRS the market value is evaluated using the discounted cash flow model. The time value of money is evaluated using interest rates. It means that IFRS can be applied in Islamic Institutions because Sharia principles do not allow interest (Abdul-Rahman, 2009).

Matching rules with principles of the Islamic finance institutions

The rules and regulations of IFRS are different from the rules and regulations which AAOIFI have establish. In other words there is a clear difference between the practices of IFRS and the practices which AAOIFI has developed for the IFIs for recording the financial information. As discussed earlier when the AAOIFI is implemented in the organization it becomes very difficult for the organization to implement IFRS along with AAOIFI. There is a need to create such rules and regulations throu8gh which IFRS can be implemented in the Islamic financing Institutions (Bellalah & Masood, 2013).

Interest of the Islamic finance institutions

The interest rate factor is a major issue and a major factor that distinguishes conventional financial institutions and Islamic financial institutions. In Islamic financing the Interest is prohibited which means that the Islamic financial institutions will not perform such activities in which the interest is involved. The IFRS have the treatment of interest however as Islamic bank does not include interest various transactions are treated according to the rules set by AAOIFI ( ACCA and KPMG, 2012).

Mudaraba based investment of the Islamic finance institutions

The term Mudaraba is commonly in use of Muslims who take services of Islamic banking systems. The term is derived from al-darb fil al ard which a word written in Quran. In sharia standard 13, conditions and specifications of mudaraba contract are presented. The term mudaraba represent a contractual arrangement for specified duration. Muadarba is used in the banking system as trust-based contract. In this contract, partners do not have any debt relation with each other and profit can be distributed on the basis of asset’s selling price. Islamic financial instruments are treated in different ways than conventional financial instruments. In conventional financial instruments, the rate of interest is involved, and the discounting cash flow model is implemented for evaluation. However in Islamic financing Sharia Laws are implemented, which does not involve interest. Therefore IFRS cannot be implemented for the Islamic financial instrument and such rules have to be defined through which Islamic instruments can be implemented (Alamad, 2019).

Lesser Balance Sheet of the Islamic finance institutions

The Islamic instruments are recorded in the balance sheet. The conventional instruments are also recorded in the balance sheet. The treatment of Islamic finance transactions is different from conventional financial institutions. Therefore, it is important to understand how these transactions are going to be recorded accurately in the light of financial reporting standards. The rules and regulations of IFRS are different from the rules and regulations which AAOIFI have establish. In other words there is a clear difference between the practices of IFRS and the practices which AAOIFI has developed for the IFIs for recording the financial information.

Challenges in Islamic Accounting of the Islamic finance institutions

There are many issues which the Islamic accounting practices face. The corporate governance issues, cloning of business models and money market yields are some of the key issues which the Islamic accounting will face. Strong corporate government is required in which the top management of the institution will create such strategies that will address the needs and preferences of every stakeholder of the company.

Corporate Governance of the Islamic finance institutions

The financial institutions around the world require high corporate governance so that the operations of the financial institutions can be performed efficiently. In Islamic banking the corporate governance plays a significant role in operations and the management of various activities including Islamic accounting. The business model which the Islamic institutions adopt requires strong corporate governance otherwise different issues can arise in accounting practices. For instance in case of profit distribution among different stakeholders of the company, the organization will have to keep the interests of the shareholders in mind. There are different stakeholders of the financial institutions which are highly important for the institutions because such stakeholders are responsible for the financing of different assets which the organization required for performing business activities ( ACCA & KPMG, 2010).

It is evident that if the stakeholders of the financial institutions are not managed appropriately, then the investment which the Islamic financial institutions required will not be given by its stakeholders. Ultimately the performance, efficiency, and profitability of the Islamic Financial Islamic institutions will decline significantly. For this a strong corporate governance is required in which the top management of the institution will create such strategies that will address the needs and preferences of every stakeholder of the company. But the managed challenge here is that achieving strong corporate governance is not easy at it seems, and many institutions unable to achieve higher corporate governance. Low corporate governance can affect Islamic accounting practices.

Industry Success should not turn into Complacency

Over the years the real estate industry has experienced a significant amount of growth. Due to raise in this industry many Islamic institutions have target real estate industry, and their overall strategy moves towards asset finance. Islamic institutions are gaining success because the market is currently experiencing growth however it is not known what will happen if the economic environment changes. Current, the macro environment is stable and in favor of Islamic institutions. The macro-environment changes have huge impact on the performance, profitability, and efficiency of the organization. The downturn in economy might affect the Islamic institutions, and therefore the Islamic institutions should consider the macroeconomic environment while creating the strategy of the institutions (Soumare, 2008).

If the current situation of the financial institution is analyzed then it can be said that the financial institutions are taking benefit from the success of the industry and have not considered the factors such as downturn in the industry. The industry not always experience growth. The downturn in the industry is part of the industry cycle, which must be considered while making business strategies. If the industrial factors are ignored then there is chance that the Islamic financial institutions can face decline in the upcoming future if the macroeconomic environment changes ( ACCA & KPMG, 2010).

Cloning of Business Models of the Islamic finance institutions

Today there are many Islamic financial institutions that are working around the world. Due to the growth in Islamic banking industry in many parts of the world, new Islamic financial institutions have immerged, which are copying the strategies and accounting practices that current Leading financial institutions have made. Although cloning of business models is helping the small Islamic institutions to grab the market share but it is highly important to come up with their own strategies if they want to sustain in the long run. With the same business models there will be no difference in the services of the Islamic Institutions, and it will become highly difficult for the institutions to gain competitive edge over their competitors. Furthermore the same errors in accounting practices will also immerge in different businesses because they are copying practices of each other. 

In the market, such organizations service, which has significant competitive edge over their competitors. The consumers prefer such organizations whose services are more superior to others. If there will be no difference in product/services than the corporations will lose the opportunity to gain competitive edge in the market, and their overall profit will decline. That is why it is suggested to the Islamic Financial Institutions to come up with such business models that allow them to stand out in the market and help them to gain competitive edge over the competitors.

Islamic Money Market Yields & Sharia Principles of the Islamic finance institutions

One of the major risks or challenges which the Islamic institutions face is the interest rate risk exposure. The money market yields of Islamic institutions move in sync with traditional rates. It means that (IIMM) would suffer from the same level of interest rate exposure like other financial institutions do. The financial institution's main purpose is to perform it operations in which the factor of interest should not be involved. The Sharia principle restricts Islamic financial institutions to involve in any kind of interest related activity. However the issue arises here is that Islamic institutions are created so that such market can be created where the intuitions can perform their activities with interest rate risk, but the reality is that these institutions, in the end, end up with same level of interest rate risk as conventional financial institutions. Therefore it can be said accounting practices will affect a lot due to the above-discussed scenario (Gamaleldin, 2015).

It can be said that the Islamic financial institutions which are working in a conventional environment cannot save themselves from the interest rate risk completely, and here the Islamic accounting practices face a challenge regarding reporting of interest. For instance when the IIMM instruments are utilized for liquidity management any change in interest rate which occurs in the conventional market would be transmitted toward the Islamic financial Institutions. Therefore it can be said that it is major challenge for the Islamic financial institutions to perform their operations with interest rate risk exposure.

Yield & Price of IIMM of the Islamic finance institutions

Due to the possibility of pure arbitrage, the yield and price of IIMM instruments will unvaryingly join with conventional market. The instruments of IIMM will face huge costs because of the increase in interest rate.

Conclusion of the Islamic finance institutions

If all the above discussion is summarized than it is evident that in many countries around the world many organizations prepare their financial statements and perform financial reporting according to the standards set by IFRS (International Financial Reporting Standards). The rules of IFRS are designed by keeping the conventional accounting techniques in mind and are not considered suitable for application in the IFIs (Islamic Financial Institutions). The main conceptual issues which arise here is to state whether the financial reporting of financial institution is different from conventional financial institutions or not.

 References of the Islamic finance institutions