«Outreach on Shariah-Compliant Instruments and Project Transactions Issues in the application of IFRS 9 to Islamic Finance Paper topic A paper ...»
Outreach on Shariah-Compliant Instruments and
Issues in the application of IFRS 9 to Islamic Finance
A paper prepared by the IASB Staff
The views expressed in this paper reflect the views of the IASB staff and not those of the IASB or the IFRS
Foundation. Comments on the application of IFRSs do not purport to set out acceptable or unacceptable
application of IFRSs.
1. This paper has been prepared by the staff of the International Accounting Standards Board® (IASB) to provide insight into the discussions of the IASB’s Consultative Group on Shariah-Compliant Instruments and Transactions (‘the Group’) about application of IFRS® Standards to Islamic finance transactions. In particular, the paper focusses on the application of the classification and measurement requirements of IFRS 9, Financial Instruments, to those transactions. It does not discuss the application of the impairment rules in IFRS 9, which are significantly different from those in its predecessor Standard IAS 39. 1
2. Our objective is to provide a document that can be helpful to financial statement preparers, their auditors, and the users of their financial statements. The paper reflects the views of its authors. Official positions of the IASB on accounting matters are determined only after extensive due process and deliberation.
Background of the Group
3. In 2011 The IASB conducted a consultation on topics to be included in its agenda and consequently decided to establish the Group. Appendix A shows a list of its 1 The IASB staff would like to acknowledge the assistance provided by standard-setters who are members of the working group on Financial Reporting Relating to Islamic Finance of the Asia-Oceania Standard Setters Group. Members of the working group were instrumental in framing the issues discussed in this paper and provided helpful comments throughout its development.
The IASB is the independent standard-setting body of the IFRS Foundation, a not-for-profit corporation promoting the adoption of IFRSs. For more information visit www.ifrs.org Page 1 of 27 members. The Group first met in Kuala Lumpur in July 2013. The most recent meeting, which was cosponsored with the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), was held in Bahrain on 9 April 2015. The group outreach meetings also included interested accounting professionals, academics and bankers.
4. The Group does not judge whether products are compliant with the requirements of Shariah law. Members are aware that there are differing views on whether particular products are Shariah-compliant; however, dealing with those views is beyond the remit of the Group. Practitioners participating in outreach events conducted by the advisory group observed that standards and information published by AAOIFI are often useful when considering Shariah compliance. (Refer to Appendix 3 for selected definitions from AAOIFI Financial Reporting Standards.)
5. Instead. the Group’s discussions focus on challenges that may arise in the application of IFRS Standards to instruments and transactions commonly referred to as Islamic finance. The Group does not supplant the roles of the IASB and the Interpretations Committee, but will advise both on issues as necessary in relation to the application of IFRS Standards to Islamic finance.
6. In applying IFRS Standards, the focus of the analysis is on the economic substance, which considers among other things whether payments made pursuant to the contract are equivalent to payments of principal and/or interest (profit). Members of the Group and others have noted that the analysis performed to determine whether an instrument is Shariah-compliant can be helpful in understanding the underlying economic substance of a transaction.
7. This paper is not a complete analysis of the many instruments and transactions used in Islamic finance. There are many useful texts and articles on the subject, including many produced by banking authorities in Islamic countries. That said, members of the Consultative Group found the taxonomy that follows useful in performing their analysis of the features and accounting requirements.
8. Islamic financial instruments do not include interest on money (riba). Instead, a financier earns returns from trade-based and other permitted transactions, which
(a) mark-up in purchase and sale contracts with deferred payment—Murabaha, Musawama, Bai' Bithman Ajil, and Istisn'a;
(b) certificates of undivided interest in assets—Sukuk;
Page 2 of 27 (c) profit-share in ventures and other partnership-like contracts—Musharaka, Mudaraba;
(d) rent in lease contracts—Ijarah;
(e) fee from agency contracts—Wakalah and service Ijarah, and (f) profit, profit-share, rent or fee from undivided pro rata ownership contracts— Sukuk.
9. A distinguishing characteristic of Islamic finance is its emphasis on transactions that involve tangible or intangible assets (as in, for example, Murabaha transactions) rather than solely financial assets. This leads some to use the phrase ‘time value of resources’ rather than ‘time value of money’. We recognise the importance of this distinction; however, our analysis in this paper is on the asset that arises from the transaction, which is in all likelihood a financial asset, and how that asset should be classified under IFRS 9. Appendix 2 provides information drawn from the financial statements of 18 Islamic banks and shows the relative importance of Islamic products in their total assets.
Background on the issue
10. In 2009, the IASB issued the chapters of IFRS 9 dealing with the classification and measurement of financial assets. IFRS 9 reduced the number of categories of financial assets to three main categories: instruments reported at fair value through profit and loss, instruments reported at fair value through other comprehensive income, and instruments initially measured at fair value, plus transaction costs, and subsequently measured at amortised cost. 2 In July 2014, the IASB issued the final version of IFRS 9, which created a ‘held for collection and sale’ category and included some expansions of the previous guidance on classification but did not change the basic approach.
11. Lease contracts, and therefore Ijarah transactions that meet the definition of a lease, are excluded from the scope of IFRS 9. Instead, they fall under IASB 17, Leases, and its replacement IFRS 16, which was issued in January 2016.
12. Paragraph 4.1.2 of IFRS 9 describes two conditions that must be satisfied for an asset
to be classified and measured at amortised cost:
2 Added in the 2014 amendments.
(a) the financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows and (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. [Emphasis added.] Paragraphs B4.1.1–B4.1.26 provide guidance on how to apply these conditions.
13. Paragraph 4.1.2A of IFRS 9 describes two conditions that must be satisfied for an asset to be classified and measured at fair value through other comprehensive
A financial asset shall be measured at fair value through other
comprehensive income if both of the following conditions are met:
(a) the financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets and (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
Paragraphs B4.1.1–B4.1.26 provide guidance on how to apply these conditions.
14. Paragraph 4.1.3 explains what constitutes ‘interest’:
For the purpose of applying paragraphs 4.1.2(b) and 4.1.2A(b):
(a) principal is the fair value of the financial asset at initial recognition.
Paragraph B4.1.7B provides additional guidance on the meaning of principal.
(b) interest consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period of time and for other basic lending risks and costs, as well as a profit margin. Paragraphs B4.1.7A and B4.1.9A–B4.1.9E provide additional guidance on the meaning of interest, including the meaning of the time value of money. [Emphasis added.]
Page 4 of 2715. Paragraph 4.1.4 reads:
A financial asset shall be measured at fair value through profit or loss unless it is measured at amortised cost in accordance with paragraph 4.1.2 or at fair value through other comprehensive income in accordance with paragraph 4.1.2A. However an entity may make an irrevocable election at initial recognition for particular investments in equity instruments that would otherwise be measured at fair value through profit or loss to present subsequent changes in fair value in other comprehensive income (see paragraphs 5.7.5–5.7.6).
16. The guidance on classification in Section B4 of the Standard is extensive, amounting to several hundred words, and is not reproduced here. It expands on, but does not change, the basic principles quoted in the preceding paragraph. In this paper, we focus on classification and measurement at amortised cost or at fair value through profit or loss, which are the two classifications that have raised the most interest among Islamic financial institutions.
17. IFRS 9 requires the use of the effective interest rate in subsequent measurement of financial assets classified and measured using amortised cost. Appendix A defines
the effective interest rate as:
The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses.
The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see paragraphs B5.4.1–B5.4.3), transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).
Page 5 of 27Ijarah
18. As mentioned earlier, contracts that meet the definition of a lease are excluded from IFRS 9. The IASB has decided to leave lessor accounting unchanged from IAS 17, except for minor adjustments and disclosure requirements. Ijarah contracts, including Ijarah Muntahia Bittamleek (ie, hire purchase or rent-to-own), make up a significant part of the Islamic finance portfolio for several of the banks included in Appendix 2.
Most of the leases in those portfolios are treated as finance leases, and the banks that assert compliance with IFRS Standards use finance-lease accounting.
19. The initial recognition and subsequent measurement of finance leases in the statements of a lessor are similar to the amortised cost accounting prescribed in IFRS 9, with necessary adjustments for the particular characteristics of leases.
Applying IFRS 9 to Islamic banking instruments Experience of Islamic banks
20. Purchase and sale contracts with deferred payment made up approximately 40 per cent of the total assets of the 18 banks shown in Appendix 2. Ijarah contracts and assets made up approximately 15 per cent. Sukuk made up approximately 4 per cent, although the proportions varied significantly among the banks. Contracts structured as joint ventures and contracts with other risks made up approximately 6 per cent although, again, with significant variation in proportion.
21. Three of the banks shown in the Appendix have adopted the classification and measurement provisions of IFRS 9 (without the 2014 amendments) and concluded that many Islamic contracts, including, it appears, some with profit-sharing features, qualify for amortised cost measurement. We present the extracts from the notes to their financial statements as information for readers. 3
22. The Notes to the 2013 Consolidated Financial Statements of Dubai Islamic Bank
include the following discussion:
3 The IASB staff is not in a position to express a view on the financial statements and disclosures of any entity.
Financial assets that are measured at amortized cost are those assets that are held within a business model whose objective is to hold assets in order to collect contractual cash flows and the contractual terms give rise on specified dates to cash flows that are solely payments of principal and profit.
23. Note 4 to the 2013 financial statements of Sharjah Islamic Bank PJSC includes the
A financial asset shall be measured at amortised cost if both of the
following conditions are met:
24. Note 2 to the 2013 financial statements of Bank AlJazira includes the following
i. Business model for managing financial assets In making an assessment whether a business model’s objective is to hold assets in order to collect contractual cash flows, the Group considers at which level of its business activities, such assessment should be made.