AAOIFI vs IFRS:

Accounting for Islamic Finance

Industry Guides by IslamicBanker.com

December 2014

Contents

Background: from niche to mainstream

Accounting for Islamic finance

AAOIFI Standards

IFRS Standards

AAOIFI vs. IFRS

References

Background: from niche to mainstream...

Total Islamic banking assets with commercial banks in excess US$ 1.70

trillion in 2013 (Ernst & Young - EY), with 18% annual growth.

Internationalization of the industry leading to new opportunities. Qatar,

Indonesia, Saudi Arabia, Malaysia, UAE and Turkey (QISMUT countries)

expected to account for two thirds of customers for the industry.

Access to greater capital flows and expansion of world trade will provide

further growth momentum over the coming years.

But challenges increasing: compared to conventional banks, Islamic banks

shareholder returns are lower by 19% (EY). And technology constraints are
leading to more inefficiencies in operations.

As the industry moves to the mainstream, regulatory and accounting

challenges remain.

Accounting for Islamic finance

Islamic finance contracts are commercial agreements that are based on shariah
principles.

Due to this important distinction some analysts and commentators argue that
the Islamic finance industry needs different accounting standards that take into
account its unique requirements.

Conventional banking generally relies on a contractual liability to

recover monies exchanged as loans and deposits, together with an
interest margin for the lender. In contrast, Shariah-compliant
banking requires an underlying physical asset or trading
transaction and may at times be more akin to either profit sharing
or an agency/investment management contract.
(PricewaterhouseCoopers - PwC)

Hence the Islamic finance industry standards body, AAOIFI (Accounting

and Auditing Organization for Islamic Financial Institutions), has been
developing shariah and accounting standards since the 1990s.
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AAOIFI Standards

AAOIFI is the leading voice on separate accounting standards for the

Islamic finance industry.

AAOIFI accepts generally accepted accounting principles, unless there is a

conflict with Shariah. In particular, AAOIFI has shied away from two of the
key IFRS (International Financial Reporting Standards) principles:

Substance over form: economic substance of transactions must be

recorded instead of just their legal form.
Time value of money: Given by the market risk free interest rate.

Example A: House Purchase

Year 1: Bank buys a house for $500,000 and sells it to the customer for
$696,650. (On 10 year financing/mortgage).
Year 1 to 10: Customer pays in monthly installments over the period of 10
years.
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AAOIFI Standards(cont.)

In the case of the Example A - if we only consider the legal objective, then
it can be argued that this is a sales of goods, with profit of $196,650.

However, it would be most unusual for a bank to immediately report... a

profit (Malaysian Accounting Standards Board - MASB).

Indeed AAOIFIs Financial Accounting Standard (FAS) No. 2, Murabaha and

Murabaha to the Purchase Orderer, notes that the profit is recognised over
the repayment period, as the bank receives the installments.

But, what about the outstanding principal amount, for the house?

FAS 2 was prepared in accordance with AAOIFIs original

conceptual framework, which propounded that money does not
have a time-value. Hence, AAOIFI does not require the pattern of
profit recognition to be related to the amount of principal
outstanding. (MASB)
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IFRS Standards

IFRS, issued by the International Accounting Standards Board (IASB), have

become the de facto international standards for generally accepted
accounting principles.

Advocates of using IFRS Standards, instead of AAOIFI, generally argue:

most Islamic banking products have the same economic impact as
conventional products, i.e. the economic substance is largely
comparable (PwC).

So, how would Example A work under IFRS? The principle of time value of
money is key to IFRS requirements. For example, IAS 18, Revenue,
recognises the difference between the fair value and nominal value
($196,650 in Example A) as interest revenue or financing
revenue (MASB).

Following page shows a comparison between AAOIFI and IFRS standards,

where the customer, on a monthly payments, fails to make one payment in
Year 3. How can the bank measure its income over 10 years?
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AAOIFI vs. IFRS

Comparison of AAOIFI and IFRS, on how a bank can recognise its income over 10 years, if a
customer fails to make one payment in Year 3.
Under AAOIFI Standards

Under IFRS

Relevant paragraph(s)

FAS 2, paragraph 2/4/2 (a)

FAS 2, paragraph 2/4/2

(b)

IAS 18, paragraphs 11, 29, 30 IAS 39,

paragraphs 9, AG5-AG8

Requirement

Proportionate allocation of
profits over period of credit ($)

Profits recognised as
and when installments
are received ($)

Difference between fair value and nominal

amount of consideration recognised as interest
revenue in accordance with IAS 39 ($)

Year 1

19,665

19,665

33,866

Year 2

19,665

19,665

31,278

Year 3

19,665

18,026

28,503

Year 4

19,665

21,304

25,527

Year 5

19,665

19,665

22,337

Year 6

19,665

19,665

18,915

Year 7

19,665

19,665

15,247

Year 8

19,665

19,665

11,313

Year 9

19,665

19,665

7,094

Year 10

19,665

19,665

2,571

Total Profit / Interest

Income

196,650

196,650

196,651

Source: IslamicBanker.com; MASB

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AAOIFI vs. IFRS (cont.)

Product
Investment Account Funds
in Islamic Finance Institutions (IFIs)*

AAOIFI vs. IFRS

Ijarah (Leasing)*

Takaful (Islamic insurance)

An IFIs major source of funds is unrestricted investment account funds from its
customers.
These funds are generally managed by IFI based on Mudaraba investment management
profit-sharing agreement.
Under Mudaraba investment management, IFI is not liable for loss arising from
investments (except due to IFIs misconduct, negligence, etc) Sharia standard.
AAOIFI standards require unrestricted investment account funds to be presented in
statement of financial position as a separate item between liabilities and owners equity.
In contrast, based on IFRS these would be presented as liabilities (along with other
deposits).
An IFIs major financing mechanisms are Operating Ijarah and Ijarah Muntahia Bittamleek
(leasing that ends with transfer of asset ownership to lessee).
For both, asset ownership rests with IFI throughout the lease term.
In Ijarah Muntahia Bittamleek, there must be independent contract for transfer of asset
ownership.
AAOIFI standards require both Operating Ijarah and Ijarah Muntahia Bittamleek to be
treated similar to Operating Lease.
In contrast, based on IFRS, both Operating Ijarah (especially if lease term is for major
part of economic life of lease asset) and Ijarah Muntahia Bittamleek (due to the transfer
of asset ownership by the end of lease term) would normally be classified and treated as
Finance Lease.
According to research by International Shariah Research Academy for Islamic Finance
(ISRA) research paper: there are three key issues related to Takaful: (i) definition of
takaful, which is not covered in IFRS, (ii) classification of the qard provided by the takaful
operator, and (iii) the nature of financial statement reporting in takaful companies.

Source: AAOIFI; IslamicBanker.com; ISRA; PwC. *Comparisons from AAOIFI - International Standards for Islamic finance:
http://www.islamicbanker.com/publications/aaoifi-accounting-standards-ifrs
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AAOIFI vs. IFRS (cont.)

Product

AAOIFI vs. IFRS

Takaful (cont.)

Many takaful operators are concerned of some of the principles in IFRS 4.

According to PwC the takaful operator retains responsibility for the assets and
liabilities and, ultimately, an obligation to meet liabilities arising from the fund,
including putting aside money for the provision of a benevolent loan (qard) in the
event of a shortfall. As a result, the operator will usually need to include the assets,
liabilities and financial performance of the fund in its financial statements, despite the
ring-fencing..

Zakat

AAOIFI FAS 9 recognises Cash Equivalent Value (CEV); whereas IFRS prefers Fair
Value (FV).
If shareholders or investors acquired the shares for long-term investment or as a
way to gain control over the companys capital (Held to Maturity), or as a
participation (stake) in the companys capital, the shares are considered as fixed
assets. Thus, only its income generated (i.e. dividend) will be 19 subjected to Zakat at
10% (as for agriculture produce). [Prof. Dr. Abdul Rahim Abdul Rahman].

Source: AAOIFI; IslamicBanker.com; ISRA; PwC

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References
1. A Word about Islamic Finance: Part I & II, (2012), Malaysian Accounting Standards Board (MASB). [ONLINE], Available
at: http://www.masb.org.my/images/stories/A%20Word%20about%20Islamic%20Finance-Part%201%20Nov.pdf and http://
www.masb.org.my/images/stories/A%20Word%20about%20Islamic%20Finance%20-%20Part%202%20Dec.pdf [Accessed
13 December 2014].
2. World Islamic Banking Competitiveness Report, (2014), Ernst & Young. [ONLINE], Available at: http://www.ey.com/
Publication/vwLUAssets/World_Islamic_Banking_Competitiveness_Report_2013-14/$FILE/World%20Islamic%20Banking
%20Competitiveness%20Report%202013-14.pdf [Accessed 13 December 2014].
3. Open to comparison: Islamic finance and IFRS, (2010), PricewaterhouseCoopers. [ONLINE], Available at: http://
www.pwc.com/en_GX/gx/financial-services/islamic-finance-programme/assets/comparison-Islamic-finance-IFRS.pdf
[Accessed 13 December 2014].
4. Accounting for Islamic finance, (2012), Deloitte. [ONLINE], Available at: http://www.iasplus.com/en/news/2012/
november/islamic-finance [Accessed 13 December 2014].

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