From time to time, journalists contact me with Islamic finance questions, since my website makes me easy to reach.
Last August, a journalist asked me some questions about the apparent choice between the accounting standards promulgated by AAOIFI, and the IFRS accounting standards promulgated by the International Accounting Standards Board.
I used my response as the basis for my September 2017 Letter from Amin column in the magazine Islamic Finance News with the title "All Islamic banks should be allowed to account using IFRS." Below are:
Below are the incoming questions, lightly edited to correct typos etc., along with my responses.
In most countries, governmental authorities prescribed the accounting standards to be used by stock exchange listed companies and by regulated financial institutions. Accordingly, in most countries, Islamic financial institutions do not have a free choice about whether to use IFRS or some other accounting standards.
For example, in Bahrain and Qatar, when I last checked, Islamic financial institutions were required to use AAOIFI accounting standards.
Conversely, in the United Kingdom all financial institutions, including Islamic banks, are required to use IFRS. That was also the case in Malaysia when I last checked.
See my article “Islamic Financial Institutions and the Implications of Accounting under IFRS.”
In the rare cases where an IFI may have a choice regarding whether to use IFRS or some other accounting standards, the main benefit of using IFRS is that it makes the accounts more comparable with accounts of Islamic financial institutions in other jurisdictions since IFRS is by far the most predominant accounting standard globally.
As stated in my article mentioned above:
The principal drawback [from the use of IFRS] is that, because IFRS concentrates upon the economic substance rather than the legal form of the transactions, users of the IFI’s accounts may not receive sufficient information to form an informed view on whether the IFI’s transactions are Shariah compliant.
The article also explains the appropriate solution:
However this risk can be mitigated by providing good quality additional disclosures. IFRS prescribes the basic accounting (for example requiring the sale and leaseback to be accounted for as a financing transaction), but IFRS does not prohibit the IFI from making additional informative disclosures in the notes to the financial statements. Accordingly the IFI can, and should, provide supplementary disclosures so that its shareholders and customers can satisfy themselves about the Shariah compliance of its transactions.
At a greater level of technical detail, there are sometimes inconsistencies between IFI’s regarding the detailed accounting under IFRS which in theory should not arise. For example, IFI’s may take a different approach to the accounting for specified designated assets held which have been purchased using funds received by the IFI from specific customers under mudarabah contracts. Occasionally IFI’s treat such assets as being off-balance sheet, which I regard as being inappropriate.
IFRS accounting and AAOIFI accounting are not meant to work together. They are separate accounting frameworks, each intended to be complete in their own right. Either an IFI accounts under IFRS or it accounts under AAOIFI; it cannot partially account under IFRS and partially account under AAOIFI.
As the above article explains, very few countries prescribe the use of AAOIFI accounting standards for Islamic financial institutions. Those countries which do are, in my opinion, likely to continue doing so.
IFRS is prevalent in virtually the whole of the rest of the world apart from the USA which uses US GAAP.
In my 2011 article “What is AAOIFI’s Proper Accounting Standards Role?” I proposed that AAOIFI should cease setting accounting standards. However, there is no sign of it doing so at present.
In my view, the fundamental problem with AAOIFI accounting standards is that their objective is not to devise the best possible way of reporting the economic substance of the transactions that the IFI has undertaken.
Instead, as stated in the article “What is AAOIFI’s Proper Accounting Standards Role?” their objective is:
AAOIFI’s "Statement of Financial Accounting No. 1: Objectives of Financial Accounting for Islamic Banks and Financial Institutions" was published in 1993. The introduction to that statement says: "Financial accounting in Islam should be focused on the fair reporting of the entity's financial position and results of its operations, in a manner that would reveal what is halal (permissible) and haram (forbidden)."
Section 6/2 of the standard sets out the objectives of financial reports in six paragraphs of which the first is "6/2(a) Information about the Islamic bank’s compliance with the Islamic Shari’a and its objectives and to establish such compliance; and information establishing the separation of prohibited earnings and expenditures, if any, which occurred, and of the manner in which these were disposed of."
In comparison, the purpose of IFRS accounting standards is stated in that article as follows:
In 2001 the IASB adopted its "Framework for the Preparation and Presentation of Financial Statements." Paragraph 12 states: "The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions."
In my opinion, financial statements prepared under IFRS give more useful information to IFI investors and IFI customers than financial statements prepared under AAOIFI.
The principal barrier to IFI’s embracing IFRS is that some countries such as Bahrain and Qatar require them to use AAOIFI, so IFI’s in such countries do not have a choice over the matter.
Otherwise, there are no significant barriers to IFI’s embracing IFRS.
Obviously, they need to ensure that their accounting staff are appropriately trained and that their IT systems have been programmed to generate the data required to produce accounts in accordance with IFRS standards.
As explained above, regulators should prescribe the use of IFRS. At the same time, they should require IFI’s subject to their regulations to provide the additional disclosures which Shariah compliant investors will require (such as levels of impure income which need to be donated to charity) in the form of footnote disclosures.
However, Shariah requirements should never be allowed to interfere with the preparation of the balance sheet and income statement in accordance with your IFRS requirements. Such interference would mean that the accounts no longer gave a true and fair view in accordance with IFRS.
Last month a journalist asked me a question I have often encountered before. Very briefly, she wanted to understand the relative merits for Islamic finance of the accounting standards published by AAOIFI (the Accounting and Auditing Organisation for Islamic Financial Institutions) and IFRS (International Financial Reporting Standards) which are published by the IASB (International Accounting Standards Board.)
Looking at detailed accounting technicalities is not the way to address this question. Instead, we need to focus on two facts:
Leaving Islamic finance to one side, virtually the whole world accounts under IFRS. The only significant exception, consistent with the general attitude of “American Exceptionalism” is the USA with US GAAP (Generally Accepted Accounting Principles) published by the FASB (Financial Accounting Standards Board).
When it comes to Islamic finance, a few countries require Islamic financial institutions to use AAOIFI accounting standards. In particular, Bahrain (where AAOIFI is based) and nearby Qatar. However, the largest Gulf Cooperation Council country, Saudi Arabia, uses IFRS, as do Malaysia, Pakistan, and the leading OECD country in Islamic finance, the United Kingdom. The accounts of Bank Melli of Iran, (the country with the largest Islamic finance sector since all Iranian banks are required to be Islamic) do not mention either IFRS or AAOIFI. Instead Bank Melli uses local Iranian standards. Similarly, the accounts of Islami Bank Bangladesh Limited show that Bangladesh has its own local accounting standards, which I expect to be influenced by external standards from both AAOIFI and the IASB.
Overall, apart from a few countries which have particular loyalty to AAOIFI, most countries with a significant Islamic banking sector use IFRS accounting standards.
Secondly, the most important point to appreciate is that IFRS standards and AAOIFI standards seek to achieve entirely different goals.
The IASB, promulgator of IFRS, states in its Framework for the Preparation and Presentation of Financial Statements that “The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.”
Conversely, AAOIFI states in its Objectives of Financial Accounting for Islamic Banks and Financial Institutions that “Financial accounting in Islam should be focused on the fair reporting of the entity's financial position and results of its operations, in a manner that would reveal what is halal (permissible) and haram (forbidden).”
Focusing reporting on revealing what is halal and what is haram is of course quite different from focusing reporting on providing information that is useful to a wide range of users in making economic decisions. Accordingly, one would not expect accounts prepared under IFRS and under AAOIFI to be comparable. Indeed they are not.
In my view, regulators should prescribe the use of IFRS for all Islamic banks within their jurisdiction. This would result in Islamic banks’ accounts conveying the maximum amount of information useful to shareholders, customers, and other economic actors. It would also lead to maximum comparability of Islamic banks’ accounts within and between countries. Any necessary additional information regarding halal and haram can be included in additional notes.
This would make AAOIFI’s accounting standard setting role redundant. In turn, that would save much standard setting effort that is presently largely wasted, given the low international usage of AAOIFI accounting standards.
The articles listed below also cover on the same subject.