The Impact of IFRS Adoption on Islamic Financial Institutions

1. The Impact of IFRS Adoption on Islamic Financial Institutions 5th IIUM International Accounting Conference (INTAC) 12-13 July 2011 Kuala Lumpur, Malaysia Mohammad Faiz Azmi Chairman, Malaysian Accounting Standards Board (MASB)

2. Agenda • Convergence with IFRS • Role of AOSSG IF WG • Using IFRS for Shariah-compliant transactions • MASB’s approach to accounting from an Islamic perspective • The impact to IFIs • Next steps

3. Convergence with IFRS 2012 2010 2006 1997 1978

4. Why IFRS? • Accepted globally - IFRS used by more than 100 countries • Common language – reduced reporting costs; no need to reconcile accounts • Credibility of local market to foreign investors • Comparability across boundaries • Cross border listing

5. Convergence with standards issued from 2006 onwards Harmonisation 1997 - 2005 • Standards: • Similar to IFRS • Guidance & other requirements added • Standards: • Word-for-word with IFRS Convergence in Malaysia In Malaysia, convergence with IFRS means FULL compliance with IFRS as a basis for financial reporting. Through December 31, 2011Starting January 1, 2012

6. Asian oceanian standard-setters group (AOSSG)

7. Asian-Oceanian Standard-Setters Group (AOSSG) Members comprised 24 standard setters: Macao Malaysia Mongolia Nepal New Zealand Pakistan Philippines Saudi Arabia Singapore Sri Lanka Thailand Uzbekistan Vietnam Australia Brunei Cambodia China Dubai Hong Kong India Indonesia Iraq Japan Kazakhstan Korea

8. Role of AOSSG Islamic Finance Working Group Objective Assists the AOSSG in providing input and feedback to the IASB on the adequacy and appropriateness of proposed and existing IFRSs to Islamic financial transactions and events. Framework Undertake to make recommendations within the framework of the IASB’s accounting standards.

9. AOSSG Islamic Finance Working Group Members MASB (WG Leader), AASB (Australia), ICAP (Pakistan), SOCPA (Saudi Arabia), DFSA (Dubai), KASB (Korea), Ministry of Finance, China Work done to date AOSSG Research Paper: Financial Reporting Issues relating to Islamic Finance, October 2010. Commented on IASB EDs on Revenue, Leases, Insurance Contracts, Hedge Accounting, Offsetting FA and FL, and FI: Impairment Available at www.aossg.org

10. Using IFRS for Shariah-compliant transactions 2012 2010 2006 1997 1978

11. Potential tension points with IFRS

12. Substance over formBackground and Issue • Background: IASB Conceptual Framework states that substance over form is an integral part of representing a transaction faithfully: • Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. (Par. BC3.26) • Issue: While conventional standard setters deem substance over form integral to financial reporting, there have been some reservations about its acceptability from an Islamic perspective. • Some believe that the application of substance over form would render a Shariah compliant transaction virtually indistinguishable from a comparable conventional transaction.

13. Substance over formExample • Example: IjarahMuntahiaBittamleek • During the Ijarah period, the lessee is only deemed to be renting. • There is also a promise (wa’ad) by the lessor to sell the item, and/or a promise by the lessee to purchase the item at the end of the Ijarah period. • At the end, a separate sale and purchase agreement is entered into. • Form over Substance Approach: The financial statements recognise two separate transactions: • Rental would be recognised throughout the Ijarah period. • A sale would be recognised when the aqadto transfer the Ijarah item is entered into. • Substance over Form Approach: The financial statements recognise one transaction: • Account for two transactions similarly to a ‘hire purchase’ agreement by combining both contracts into one.

14. Probability criterionBackground and Issue • Background: IASB Conceptual Framework calls for the recognition of assets and liabilities when it is probable that future economic benefit will flow to or from the entity: • The concept of probability is used… to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. (Par. 4.40) • IFRS’s also recognizes certain expenses when they are probable. • For example, proposed impairment guidance recognizes impairment when it is ‘expected’ (i.e., ‘probable’ to occur). • Issue: Is there any Shariah prohibition against recognising assets, liabilities, revenues and expenses based on when they are probable to occur?

15. Probability criterionExample • Example: Mudarabah Profit Calculation • Mudarabah is a partnership agreement whereby the profits are shared between the partners at an agreed-upon rate. • In calculating profit, under the IASB’s proposed impairment model, impairment would be recognised when impairment is expected. • Would the use of an expected loss model ‘distort’ the profit that is shared by the partners?  • Probability Approach: • Impairment would impact profit when it is probable. • Incurred Approach: • Impairment could only impact profit when it is incurred.

16. Time value of moneyBackground and Issue • Background: Many IASB Standards use the ‘time value of money’ concept. For example, under IAS 39, certain assets and liabilities are measured at amortised cost (recognising financing income or expense on a constant yield). • Loans and receivables… shall be measured at amortised cost using the effective interest method. (IAS 39, Par. 46) • Issue: Would it be inappropriate to reflect a time value of money in reporting an Islamic financial transaction, when no overt interest is charged or incurred in such transactions? • To some, it is unpalatable that an arrangement to purposefully avoid charging interest would result in the reporting of financing income anyway.

17. Time value of moneyExample • Example: Deferred Sales Contract • A sales contract where payment is deferred for a period of time • Time Value of Money Approach: • Under IAS 18, if the fair value of the asset transferred is less than the cash to be received, the difference is recognised as financing revenue. • Ignoring Time Value of Money Approach: • The entire amount of cash received (or to be received) would be accounted for as sales revenue. • The excess cash received over the fair value of the consideration transferred would be recorded as sales revenue, instead of financing income.

18. Transaction-specific issues Recognising a financing effect • Recognition of profit in sales • De-recognition in sale and buy-back • Transaction fees Profit sharing contracts • Profit Equalisation Reserve (PER) • Classification Takaful accounting issues • Application of IFRS 4 • Classification and measurement of qard • Presentation of financial statements

19. Transaction-specific issues Sukuk • Assets transferred to SPE • Sukuk valuation Embedded Derivatives • Would profit rate cap give rise to an embedded derivative? Ijarah • Accounting treatment for ijarah Shariah related disclosures • Additional disclosures required?

20. MASB’s Approach to accounting from an Islamic perspective 2012 2010 2006 1997 1978

21. History • Initially – wanted separate Islamic accounting standards. • Now: SOP i-1 • MASB approved accounting standards apply, unless there is a clear Shariah prohibition. • Any additional guidance via Technical Releases (TR).

22. MASB’s Islamic pronouncements • SOP i-1, Financial Reporting from an Islamic Perspective • TR i-1, Accounting for Zakat • TR i-2, Ijarah • TR i-3, Presentation of Financial Statements of Islamic Financial Institutions • TR i-4, Shariah Compliant Sale Contracts 22

23. The Impact to IFIs

24. The impact to IFIs in Malaysia MINIMAL impact • MASB standards consistent with IAS/IFRS since 1978. • Previously, exclusions for: • “Islamic leases” in MASB 10 Leases. • “Transactions and events conducted on the basis of Islamic principles” in MASB 24 FI. • Since 2005, no exemptions for Islamic transactions/IFIs from FRS. • Re-confirmed by SOP i-1 in 2009. 24

25. IFRS ‘Stable Platform’ for 2005 established IASC restructured to IASB Our financial reporting framework milestones MIA / MICPA Harmonisation period Convergence period 1978 2005 2006 2007 2008 2009 2010 2012 2004 2001 1997 Rename standards to FRS in line with IFRS First adoption of IAS FRS made identical to IFRS Parliamentary Act established MASB Announced convergence with IFRS in 2012 Convergence with IFRS Introduce 2-sets of financial reporting standards Issue SOP i-1 Financial Reporting from an Islamic Perspective

26. New IFRS and impacts to IFIs

27. The impact outside of Malaysia Other jurisdictions SIGNIFICANT (potentially) - depending on how their current standards compare to IFRS • IFIs currently using AAOIFI • There will be substantial impact since their recognition and measurement may differ significantly • For IFIs not using AAOIFI • Need to assess differences between their current accounting guidance and IFRS 27

28. Next Steps

29. What can you do? What should educators do? • Learn and understand IFRS • Talk to the industry / practitioners / regulators • Tailor your research to industry needs • Keep up to date with changes What should students do? • Question your teachers / professors • Get more involved in the debate! • Understand how IFRS applies to transactions

30. 30 Useful websites 30 • IFRS Foundation & IASB www.ifrs.org • Asian-Oceanian Standard Setters Group www.aossg.org • Accounting & Auditing Organization for Islamic Financial Institutions www.aaoifi.com • FRF & MASB www.masb.org.my

31. Thank you Disclaimer: The views expressed in this presentation are those of the presenter. Official positions of the MASB on accounting matters are determined only after extensive due process and deliberation.