THE APPLICATION OF INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) BY ISLAMIC FINANCIAL INSTITUTIONS (IFIs): BENEFITS AND CHALLENGES Sutan Emir Hidayat, Ph.D! Abstract The purpose of this study is to comparatively analyze the benefits and the challenges in the application of the International Financial Reporting Standards (IFRS) by Islamic financial institutions (IFIs) The study employs literature/library based method which is a kind of qualitative research approach. Using exploratory analysis, the study identifies and compares several benefits and challenges from the application of the IFRS into Islamic financial products and transac- tions. The study concludes that despite the benefits offered by the TERS, a complete implementation of the standards by IFIs have been proven to genuinely violate the Shariah principles, Therefore, a sepa- rate accounting framework for Islamic financial products and trans- actions is required, as the existence of the AAOIFI is still relevant and essential for the development Islamic finance industry. However, continuous dialogue and consultation between the International Accounting Standard Board (IASB) and the AAOIFI is needed to harmonize and minimize the differences between the two accounting frameworks. This study is expected to benefit the accounting standards setting bodies as an input for them to make decisions whether to require full application of the IFRS by IFls operating in their jurisdictions or not. However, the scope of the paper is general and brief and not detailed and elaborate, so it is not a tool for the authoritative comparative analysis on accounting treatments of specific products between the AAOIFI and the IFRS. Therefore, further studies are needed and recommended in this regards. 1 Assist University College of Babrain‘The Application of International Financial Reporting Standards (Its) By Islamic Financial 14 1. INTRODUCTION Islamic banking and finance has been experiencing an incredible phase of evolution from the year 1960's to 2000's, In 1960's, there was an Islamic rural bank within the industry (Mith Ghamr Rural Bank). In 1970's, the first and foremost pioneer Islamic commercial banks (DIB, KFH and BIB) and a Takaful company (Islamic insurance company of Sudan) got established mainly in the Middle East and North African (MENA) regions. In 1980's, the practice of Islamic banking and finance has reached the other parts of Muslim countries especially in Malaysia. The extent of Islamic banking and finance across the Muslim world has created a need to have an accounting standard for Islamic financial institutions (IFIs). As a result, the turing point was in 1990's when the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFD was established as a standard setting body of accounting, auditing, ethics, ‘governance and Shariah for IFIs. Since 2000's, Islamic banking and finance has been integrating into the main stream financial market with the emergence of Islamic securi- ties (sukuk) in the capital and money markets. This period also witnessed the involve- ‘ment of major conventional financial institutions in the industry by opening their Islamic subsidiaries and windows (Hidayat, 2011). Currently, moder Shariah compliant products are available in the full spectrum of banking, capital markets, asset management and, insurance (Takaful) business (PwC, 2010). As almost all segments of the conventional finance have been covered by Islam- ic banking and finance, it is essential to have an accounting framework that is analo- ‘gous to the conventional finance framework, atthe same time which also collabo- rates the Shariah precepts. This prerequisite is particularly necessary for the multina- tional and global financial institutions that have significant Islamic finance activities (c.g. HSBC, Citi Group) (PWC, 2010). As a result, there is a call within the Islamic finance industry to apply International Financial Reporting Standards (FRS) for IFIs in ‘order to align with the existing accounting practices, Therefore, this paper attempts to provide a comparative analysis between the benefits and the challenges in applying the IFRS in Islamic financial institutions by reviewing the available literature. The explor- atory analysis steered in this paper is expected to benefit the accounting standards, setting bodies as an input in order to make judgments whether to fully apply the IFRS for the IFls operating in their jurisdictions or not. However, the scope of the paper is ‘general and brief and lack minute details, soit is not a tool for a detailed comparative analysis on accounting treatments of specific products between the AAOIFI and the IFRS. ‘The paper is divided into 6 sections. Section 2 discusses the available previous studies that compare the AAOIFI and the IFRS. Section 3 provides the research methodology employed in this study. Section 4 elaborates the benefits of applying IFRS for IFIs.115 Journal of Islamic Economics, Banking and Finance, Vol-12, No. 2, April - June, 2016 Section 5 highlights the issues of applying the IFRS for IFIs, Section 6 concludes the discussion. 20 /RATURE REVIEW Review and evaluation of the existing literature reveals that there ate a few previous studies that has compared the IFRS with the AAOIFI and evaluated the possibility of the application of the IFRS by IFIs (Securities and Investment Institute {SI1), 2006; Asian Oceanian Standard Setters Group (AOSSG), 2010; PwC, 2010; Hidayat, 2011; Uddin, 2012) SII (2006) compares between the IFRS and the AAOIFI accounting standards in terms of the conceptual framework, basic principles of accounting and the accounting treat- ‘ments of Islamic financial transactions in accordance with that of the both existing accounting frameworks. The study acknowledges the necessity of having a separate accounting framework from the IFRS for IFIs in order to unveil a complete financial situation of the financial service providers. Thus, here the AAOIFI plays a compara tively significant role. AOSSG (2010) explores the views of accounting standard setters on the possibility of applying the IFRS into Islamic financial transactions. The study also examines and evaluates some possible concerns in the application of the IFRS into the Islamic finan- cial transactions. The study concludes that accounting standard setters actoss, in their prerogative have different views on the possibility of applying the IFRS into Islamic financial transactions, Some standard setters believe that the IFRS can be fully applied to Islamic financial transactions while some others require a distinct accounting frame- ‘work, due to the incompatibility of the IFRS to Shariah according to their interpreta- tions, PwC (2010) emphasizes on the benefits of the application of the IFRS into Islamic financial transactions. The report concludes that, the application of the IFRS into Islamic financial transactions doesn’t violate Shatiah, as long as necessary explanato- ry disclosures can be provided, Thus, there is a high possibility of applying the IFRS without tainting the essence of Shariah, Hidayat (2011) explores the benefits and challenges of the application of the IFRS by IFls. In the report, he argues that even though there are benefits of the application of the IFRS by IFIs, the challenges or the issues of the application are more than the bene- fits offered, thus having a separate accounting framework is still preferable. ‘Uddin (2012) examines and compares the ways of how Islamic financial transactions are recognized, measured and presented by IFIs in three different jurisdictions. One Islamic bank adopts the AAOIFI accounting framework, the second bank applies the‘The Application of International Financial Reporting Standards (fts) By Islamic Financial 116 IFRS and another one adopts the local accounting standards, The paper argues that there are major challenges in the full adoption of the IFRS by IFIS. The paper concludes that the challenges can still be overcome if the IASB can set more flexibility and consultative efforts in developing relevant accounting standards for the Islamic finan- cial transactions Sareea (2013) investigated the necessity of applying, universally comprehensive accounting standards that are relevant and essential in the activities of Islamic finan- cial institutions. Using exploratory analysis and library/literature based method, the study highlighted several benefits of accounting standards harmonization such as the enhancement in the international comparability, reliability and credibility. In other words, the study highlighted the significant efforts made by the AAOIFI and suggested the mandatory adoption of the AAOIFI standards by all Islamic financial institutions ‘operating in the Muslim countries, Sakib (2015) evaluated the level of conformity and compliance of Bangladeshi Islamic banks with the AAOIFI accounting standards. Using documents’ analysis approach, the study has established that the level of conformity and compliance of Islamic banks in Bangladesh with the AAOIFI standards in the year 2012 stood at 53.79% in average thus, the study recommends the banks to increase their level of conformity and compli- ance with the AAOIFI standards to increase the confidence and reliability of the stake- holders on the commitment of banks towards their compliance with Sharia Laws . In ‘other words, the study supports the adoption of the AAOIFI standards for Islamic banks in Bangladesh since the standards are viewed as universally comprehensive standards which are significant for Islamic banking activities From the above previous studies, it has been found that there are studies which are not in favor of IFRS application by the IFIs and it is essential to formulate a set of different accounting framework for the IFIs (SI, 2006; Hidayat, 2011; Sareea, 2013; Sakib, 2015) ‘There are also studies which believe that the IFRS can still be applied with some modi- fications and additions of extra explanatory disclosure (PwC, 2010; Uddin, 2012). ‘There is also a study which has identified differences in the opinion of accounting standard setters regarding the issue (AOSSG, 2010). Thus, further explorative analysis, is still needed to clarify the issue. The next section discusses the research methodology of this study. 3. RESEARCH METHODOLOGY This study uses literature or library based method which is a kind of qualitative rescarch approach. Using exploratory analysis, available literature is reviewed and relevant information is extracted and utilized to compare the benefits and challenges in117 Journal of Islamic Economics, Banking and Finance, Vol-12, No. 2, April - June, 2016 the application of the international financial reporting standards (IFRS) by Islamic financial Institutions (IFIs). 4, BENEFITS OF THE IFRS FOR IFIs Based on the available previous studies, the application of the IFRS for IFIs obviously will generate some benefits. Among the benefits are (PwC, 2010; Hidayat, 2011) 1. Enhancement in transparency and international comparability. 2. Intemational recognition and usage and; 3. Cost efficiency. Firstly, using a single accounting framework for both the Islamic and conventional products and transactions will evidently improve the level of transparency and interna- tional comparability of financial reporting for IFIs and hence provide an important boost for further investment in, and the development of, the Islamic finance sector. Once a universal accounting standard is initiated, the users of accounting information will be enabled with the facility in making an effective comparison with minimum accounting risks, Secondly, applying the IFRS will provide the benefits of international recognition and ‘usage, transforming it as the most appropriate framework for the global institutions in conforming to Islamic and non-Islamic products and multinational stakeholders. The application of the IFRS is also expected to increase the conviction of more market players to take part with Islamic finance industry. This is due to their familiarity with the accounting and reporting standards that will enable them in making effective decisions Lastly, since the IFRS focuses on the economic substance of a product or transaction rather than its legal form, the standard can easily be applied in any jurisdictions, thus minimizing the cost of financial reporting for global financial institutions with Islamic and non-Islamic products, The cost efficiency can be achieved since the IFRS princi- ples rather than the Islamic legal form will ultimately determine the accounting treat- ‘ment. As a result, there is no need for the global financial institutions to prepare a sepa- rate section or statement for their Islamic finance activities. However, based on the above previous studies, itis found that there are many issues in applying the IFRS by IFls to account their financial products and transactions. The next section will highlight the challenges in applying the IFRS by IFls. 5. CHALLENGES IN APPLYING THE IFRS BY IFIs In general, there are two major issues in applying the IFRS by IFIs 1. The objectives of the users of IFls' and the users of conventional financial institu-‘The Application of International Financial Reporting Standards (its) By Islami Financial 18. tions’ (Fs) accounting information ate different (Hameed, 2009), 2. The contractual relationship between IFIs and their clients are different from the contractual relationship between conventional FIs and their clients (Hidayat, 2011) ‘The differences in the objectives between the users of IFIs' accounting information and the users of conventional Fls are due to the differences in their perspective about the world, SFA1 (Para 21) of AAOIFI accounting standards stresses that those who deal with Islamic banks, in the first place, are concerned with submitting and satisfying Allah in their financial and other dealings (AAOIFI, 2007). As a result, in the case of IFls, shareholders, investors and other users of accounting information have a primary ‘objective to comply with Shariah in all their financial activities and at the same time accomplishing the objectives of the organisations (Hameed, 2009), In fact, the original ‘wisdom behind the establishment of IFIs actually is to realize the objectives of Shariah (Hidayat, 2010). On the other hand, the ultimate purpose of conventional financial accounting users is to efficiently allocate scarce available resources to their most efficient and profitable uses based on informed decisions (Hidayat, 2011) ‘The above differences have some consequences. Firstly, the types of information are identified, Conventional accounting framework concentrates on identifying economic ‘events and transactions (financial information), On the other hand, the users of IFIs are not only interested in financial information, but also interested in non financial infor- ‘mation such as shariah compliance, specific religious requirements and discharge of social responsibilities (Hameed, 2009). Secondly, by estimating the way how assets, liabilities and equities are measured, valued, recorded and communicated. Conven- tional Accounting mainly uses historical cost (or lower) to measure and value assets and liabilities. Although the idea of introducing fair value measurements is there, its implementation is quite difficult due to its complexity and presumed lack of verifiabil- ity, On the other hand, from Islamic point of view at least for the computation of zakah, current valuation is obligatory (Hameed, 2009) Another major issue is the differences in the contractual relationship. FIs have differ- Table 1. Ldentitiod Possible Issues from the Application ofthe IFRS into Islamic Finance Tssues TERS Tslamic Principles Deposit conuact | Conventional Danks geaeally rely on a |slamie banks use Mudarabe (profit contractual liability plus interest fr thet | sharing) for structuring their deposits, deposit contract, Therefore, all deposits | Mudaraba is nat a Habiity since the bank ae treated as lability under the TFRS | (mudarb) isnot obliged to guarantee the (Slt, 2006)" Contractual obligations to | capital and the ret to the depositors119 Journal of Islamic Economics, Banking and Finance, Vol-12, No. 2, April - June, 2016 pay the depositors will clearly tdicate | Gabbal mab (AAOIT, 2010), Treating te the lablites of the insttation, deposit lability at some extent will eliminate the essence of Shariah Tarai Manat Warah Miantahia Bifamisck Te a Tease | Shariah requires larah asset to be Fepored Biamtek contract that ends with the transfer of | inthe lessor’ (ban) books. All ownership Financial Lease | ownership, Under the IFRS this contact | risks suchas maintenance costs are bore falls under the category of financial | by the lessor (bank) daring the late term lease, Under financial lease, the inherent risks and rewards associated with the | The presentation of the lease as a asset have been transfered to the leste, | loaneeceivable onthe bank's hook and an ‘who in substance is deemed to be the | ownership inerest being recorded by the owner (SIL, 2006 lessee (as practiced under IFRS) clearly contadiet the principles of Shariah Financial tease is reported as | Shariah stresses that asset ownership rests receivables/loans on the bank's book and | with the lessor throughout the lease term an ownership interest being recorded by | (Hameed, 2008), the lesee Hameed, 2009) Recognizing a sale |The IFRS requires the eporing for all | The Weaiment of Marabahe as Tnancing of good, with | Islamic financial transactions such as | transactions is opposed at least by {Wo deferred payment | financing transactions. In addition, IAS | accountant associations inthe two biggest (Marabsb) 18 requires the difference between the | Muslim counties (Indonesia and fair value and the nominal amount of | Pakistan), consideration ina sale of goods is recognized as interest revere (AOSSG, | The staff of Indonesian Accountant 2010), institute indicates that) “According to sharia fatwa in Indonesia, murabaha fanat be accounted for as financing transaction, This kind of transaction should he treated as sales transactions, Treating it a5 financing will eliminate the essence of Shariah principle (AOSSG, 2010), The staff of astute of Chartered ‘Accountants of Pakistan (ICAP) mentions that “Deferment of profit. is allowed by scholars, but it! shouldbe separately recorded as a deferred profit and not as interest (AOSSG, 2010) Takatul concept | Under the IFRS, the premium received s | Takai i wot lnurance, We a muta ‘ueatod_as_ the part of the insurance | protection scheme where the underwriting company’s Tevenues fund does not belong t the Takaful company but to the policyholders. Hence ‘we actully have two accounting entities (Hidayat, 2011), Therefore, the Takafl company must segregate between Shareholders” funds and. polieyholers™ funds in its financial report (Hidayat, 2008), Implementing the IFRS will not fully eater forthe contractual reltionstip benween the operator (Takaful company) and policyholder‘The Application of International Financial Reporting Standards (fts) By Islamic Financial 120 ‘Concepial Substance over form principle This | From an Islamic pom of view, alough Aspects, Principle recommends "reeording a | realty (what is) should be taken into transaction according to its reality (what | account in deciding strategies, it eamot be is) not to its legal form (what ough to | a substitute for what ought to be. The ‘be (SU, 2006) reality may reflect @ deviation ffom the Formation precepts of Islam. In Fact, Islam Jus already eternal ethieal and behavioural principles and objectives (Hameed, 2009) cent contractual relationships with their investors, depositors and customers compared to that the relationships which exist between conventional financial institutions and their investors, customers and depositors. Conventional Fis mostly use loan with inter- cst in their contract when they deal with their clients. On the other hand, IFIs use various forms of Islamic commercial contracts when they deal with their clients. For ‘examples, IFIs use the profit sharing contract (Mudaraba) in the case of deposits mobi- lization and other instruments such as Murabaha, Tjarah, Istisna’, Salam, Musharaka in the case of customer financing (Hidayat, 2011). ‘As a consequence of the differences, there are some identified possible issues when IFRS applied for IFIs. The table 1 below describes the issues. In addition to the above identified issues, there are some accounting issues that an IFI needs to disclose which IFRS do not address. Among them are (Hidayat, 2011) 1. The socially responsible financing (ie. Qard Hasan) has not been catered by the conventional accounting standards. One of the important functions of IFIs is social services SFA 2 (AAOIFI, 2010), Failure to perform this function reduces IFIs by becoming capitalist financing institutions. Even IFRS in this case does not encourage the Fls to put any CSR in their additional note. 2. Funds paid out as zakat and /or charity. The users of IFT accounting information may bbe interested in additional analysis of the sources of zakah funds, methods of its collec- tion and its uses, 3. Revenues incidentally made from transactions or relationships, which are not com- pliant to Shariah such as income from the late penalty. The users of IFI accounting information may be interested in more details about the causes of such earnings, their sources, how they are disposed of and procedures established to prevent IFIs entering into transactions prohibited by Shariah 4, Restricted investment accounts: Islamic banks raise deposits through restricted profit sharing contract (mudaraba muqayyodah). In this kind of contract, Islamic banks do not acquire full control over the funds as the depositors (rabbul mal) place restric- tions on where the money should be invested. As a result, the funds from this contract cannot be treated as an asset. A separate statement to disclose the transactions using this contract becomes necessary.121 Journal of Islamic Economics, Banking and Finance, Vol-12, No. 2, April - June, 2016 ‘The IFRS may disclose the above transactions on additional notes. However, the addi- tional notes will not provide the details of those transactions as required by the IFIs, accounting information users. The next section concludes the study. 6. CONCLUSION This study achieves its objective in providing a comparative analysis between the ‘benefits and the challenges of the application of the IFRS by IFIS. The study concludes that though there are benefits offered by the application of the IFRS, full application of the standards by the IFIs towards some extent will violate the Shariah principles. In other words, the financial statements of the IFIs prepared based on the IFRS is not adequate enough to disclose Shariah compliance requirements. In fact, the main reason of IFIs’ establishment is to comply with Shariah. In addition, the full application of the IFRS also will hold back our steps in developing accounting standards that sufficiently ‘gratify for Shariah compliant transactions thus ignoring the significant contributions made by the AAOIFI. It is also found that The IFRS was developed with conventional products and operations in mind. Therefore, the IFRS will treat the Islamic financial products and transactions, in economic substance, as equivalent to their conventional ‘counterparts, Clearly, there are huge obstacles on fully applying the IFRS by IFIs. But, a broad harmonization can be reached by the application of the relevant aspects of the IFRS as long as they don’t conflict with Shariah. In fact, this is the wisdom that the AAOFI does. ‘The findings of this study are somewhat in line with the findings of SII (2006), Hidayat 2011) and AOSSG (2010) who have disclosed some genuine challenges in the full application of the IFRS by IFIs. On the other hand, the findings of this study are in contradictions with PwC (2010) which proposes the application of the IFRS by IFIs. ‘The study also recommends continuous dialogue and consultation between the Inter- national Accounting Standard Board (IASB) and the AAOIFL as an effort to harmonize and minimize the differences between the two accounting frameworks. The study also recommends more detailed comparative analyses to be performed by further studies on the treatment of each Islamic product under the IFRS and under the AAOIFI to get mote clatities in the issue raised by this study. References AAOIFI. (2010). Accounting, Auditing and Governance Stabdards. Manama: AAOIFL AOSSG., (2010). Financial Reporting Issues relating to Islamic Finance, Kuala Lumpur: AOSSG: Hameed, S. (2009). Accounting For Islamic Financial Institutions. Kuala Lumpur: INCEIE Hidayat, S. B. (2009). Islamic Finance News; Vol. 7, No. 31, 23. Hidayat, 5. E, (2010), Takaful: Establishing A Caring Society. 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