«Outreach on Shariah-Compliant Instruments and Project Transactions Issues in the application of IFRS 9 to Islamic Finance Paper topic A paper ...»
Generally, a business model is a matter of fact which can be evidenced by the way the business is managed and the information provided to management. However, in some circumstances it may not be clear whether a particular activity involves one business model with some infrequent asset sales or whether the anticipated sales indicate that there are two different business models.
• management’s stated policies and objectives for the portfolio and the operation of those policies in practice;
• how management evaluates the performance of the portfolio;
• whether management’s strategy focuses on earning contractual special commission income;
• the degree of frequency of any expected asset sales;
• whether assets that are sold are held for an extended period of time relative to their contractual maturity or are sold shortly after acquisition or an extended time before maturity.
ii. Contractual cash flows of financial assets The Group exercises judgement in determining whether the contractual terms of financial assets it originates or acquires give rise on specific dates to cash flows that are solely payments of principal and commission income on the principal outstanding and so may qualify for amortised cost measurement. In making the assessment the Group considers all contractual terms, including any prepayment terms or provisions to extend the maturity of the assets, terms that change the amount and timing of cash flows and whether the contractual terms contain leverage.
Analysing instruments in Islamic finance and applying IFRS 9 The terms of the contract drive the classification
25. An analysis of contractual terms is critical to application of the principles in IFRS 9.
This is as true for instruments in Islamic finance as it is for instruments in other types of finance. This paper focusses on basic forms of Islamic banking instruments, but the terms of an instrument may include provisions that are significant and introduce elements beyond the ‘basic lending risks and costs’ described in the paragraphs of IFRS 9 cited earlier.
26. The notion of ‘substance over form’ plays a significant role in the application of IFRS
Standards to Islamic financial instruments. For example:
(a) Murabaha and similar instruments are contractually a sale with a markup that compensates the lender for deferred payment. The contract would seem to suggest that the institution should first apply IFRS 15 Revenue from Contracts with Customers, before applying IFRS 9. In January 2015, the Joint IASB/FASB Transition Resource Group (TRG) discussed a paper on this question. 4 Members of the TRG offered a number of comments. Some of those comments focussed on the substance of the instrument and noted that the contractual sale did not appear to be part of the institution’s ‘ordinary activities’ as contemplated in IFRS 15.
(b) AAOIFI Financial Accounting Standard No 25, Investment in sukuk, shares and
similar instruments, defines Sukuk as:
... certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets or particular projects or special investment activity, however, this is true after receipt of the value of the sukuk, the closing of subscription and the employment of funds received for which the sukuk were issued.
27. The Islamic financial institutions in Appendix 2 shows classify sukuk in different
ways. For example, some classify sukuk as:
(a) ‘debt-like’ assets classified as held to maturity, (b) available-for-sale equity or debt assets, (c) held-to-maturity financial assets (usually those following IAS 39 or local standards based on IAS 39); or (d) financial assets measured at amortised cost (corresponding to one of the three categories of financial asset in IFRS 9).
29. While sukuk instruments are sometimes referred to as ‘the Islamic equivalent of bonds’, the number of different types of sukuk and their terms complicates the analysis. The first point described in this section—understand the contract—is especially important.
30. Applying substance over form arguments, though, has a risk. In May 2015, the IASB issued an Exposure Draft Conceptual Framework for Financial Reporting, which proposes further guidance on this subject. Paragraph BC 3.26 of the Basis for
Conclusions makes the following observation:
Substance over form is not considered a separate component of faithful representation because it would be redundant. Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. Representing a legal form that differs from the economic substance of the underlying economic phenomenon could not result in a faithful representation.
[Footnote reference omitted.]
31. The Exposure Draft’s expanded discussion of substance and form may be useful in understanding the rights and obligations created by instruments in Islamic finance. In
particular, paragraph 4.56 observes:
A group or series of contracts may achieve, or be designed to achieve, an overall commercial effect. In order to report the substance of such contracts, it may be necessary to treat the group or series of contracts as a whole. For example, if the rights or obligations in one contract entirely negate the rights or obligations in another contract entered into at the same time with the same counterparty, the combined effect is that no rights or obligations exist. Conversely, if a single contract creates two or more sets of rights and obligations that would have been identical if each set had been created through separate contracts, the entity may need to account for each set as if it arose from separate contracts in order to faithfully represent the rights and obligations (see paragraphs 4.57–4.63).
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32. There are some important qualifications here. The discussion of substance and form focusses on identifying and understanding the rights and obligations created by contracts. It may also be useful in determining the path through IFRS Standards, as discussed in earlier paragraphs. The concept of substance and form does not extend to using an analysis of economic substance to override the specific requirements of an applicable Standard. In IFRS 9, the IASB intended the phrase ‘solely payments of principal and interest on the principal amount outstanding’, cited in the quote reproduced in paragraph 14 above as a limitation on the application of amortised cost measurement. A notion of substance over form cannot, in our view, overcome that limitation.
Is the asset a financial asset?
30. The analysis begins with understanding whether the asset in question is a financial asset. Understanding whether an asset arising outside of Islamic finance is a financial asset is usually straightforward. However, the emphasis on trade-based transactions and the role of tangible and intangible assets in Islamic finance makes the question more difficult. Paragraph 11 of IAS 32, Financial Instruments: Presentation,
provides the following definitions of financial instruments:
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
31. Analysis of the contract is key to determining whether a contract is a financial instrument. Is the contract ‘a contractual right to receive cash’ as outlined in IAS 32, or is it something else—an undivided interest or a partnership interest, for example?
32. The discussion so far suggests that contracts with some of the characteristics described in paragraph 8 may not meet the criteria in IFRS 9 for classification as measured at amortised cost. The Standard’s requirements include two tests—the characteristics-of-the-instrument test and the business-model test. The characteristics test limits application of amortised cost to instruments with terms of a basic lending arrangement, including the collection of principal and compensation for the time value of money and other basic lending risks. (See paragraphs 39 and 40) Even if the business-model test is satisfied, if the instrument fails the characteristics test then the instrument would not qualify for amortised-cost measurement. The converse also applies. An instrument might meet the characteristics-of-the-instrument test, but if it is held in a business model that does not meet the business-model test, the instrument is measured at fair value. Indeed, some see the business-model test as a useful filter to be applied first, before analysing the characteristics of instruments held in different portfolios.
33. For example, the returns on an instrument based on a venture or partnership-like contract may include an element such as project risk. As a result, the returns may not be solely from ‘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’, because of the addition of these extra contract elements.
34. Others have reasoned that the economic substance of many contracts used in Islamic finance is a collection of fixed or determinable contractual cash flows. They conclude that such contracts do qualify for measurement at amortised cost under IFRS 9. For example, returns on instruments based on purchase-and-sale and lease contracts are usually determined with reference to the bank’s cost of funds with, 5 perhaps, an adjustment for the customer’s credit profile.
5 Three of the banks in the study group have adopted IFRS 9 and have concluded that some of their financial assets meet the characteristics-of-the-instrument test. Their auditors’ reports do not take exception to this conclusion.
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35. Some reason that an instrument based on a venture or partnership may also qualify for amortised cost measurement, even though the legal form of returns do not satisfy the definition of ‘interest’ in paragraph 4.1.3 of IFRS 9. Those who hold this view reason that in some cases the contractual cash flows to the holder of the asset are consistent with compensation for passage of time and with a ‘basic lending-type’ instrument.
Again, an understanding of the contract provisions is the key to applying IFRS 9.
36. The references to ‘principal and interest’ are pervasive in IFRS 9’s classification system and in IFRS Standards generally. Shariah-compliant instruments do not include interest, but the same could be said of some instruments in other types of finance, notably zero-coupon bonds. The key difference, and one that is raised several times in this paper, is that the subject-matter of a zero-coupon bond is money.
In the case of Islamic finance the subject-matter is goods, assets, or economic activity.
37. The notion of ‘principal and interest’ in IFRS 9 derives from an analysis of the contractual features of a financial instrument—specifically those features inherent in a basic lending agreement such as credit and time value along with other factors and a profit margin that is consistent with a basic lending arrangement.
38. Some have concluded compensation for time value is not inconsistent with Shariah requirements. For example, Dr Mohamed Fairooz Abdul Khir of the International
Shariah Research Academy offered the following conclusion:
The study establishes that Islam recognizes the legitimacy of the time value of money arising from deferment (ajal), but its application must be in conformity with the Shariah parameters in order to avoid riba. 6
39. The implementation guidance section of IFRS 9 includes several examples of contractual terms and whether the instruments that contain those terms qualify for amortised cost classification. Those examples are useful, but many illustrate contracts not typically found in Islamic finance. The guidance in paragraph B4.1.7A
is useful in understanding the principle driving the classification:
Contractual cash flows that are solely payments of principal and interest on the principal amount outstanding are consistent with a basic lending arrangement. In a basic lending arrangement, consideration for the time 6 The Concept of the Time Value of Money: A Shariah Viewpoint, ISRA Research Paper 38/2012.
Page 13 of 27 value of money (see paragraphs B4.1.9A–B4.1.9E) and credit risk are typically the most significant elements of interest. However, in such an arrangement, interest can also include consideration for other basic lending risks (for example, liquidity risk) and costs (for example, administrative costs) associated with holding the financial asset for a particular period of time. In addition, interest can include a profit margin that is consistent with a basic lending arrangement. In extreme economic circumstances, interest can be negative if, for example, the holder of a financial asset either explicitly or implicitly pays for the deposit of its money for a particular period of time (and that fee exceeds the consideration that the holder receives for the time value of money, credit risk and other basic lending risks and costs). However, contractual terms that introduce exposure to risks or volatility in the contractual cash flows that is unrelated to a basic lending arrangement, such as exposure to changes in equity prices or commodity prices, do not give rise to contractual cash flows that are solely payments of principal and interest on the principal amount outstanding. An originated or a purchased financial asset can be a basic lending arrangement irrespective of whether it is a loan in its legal form. [Emphasis added.]
40. The guidance paragraph B4.1.9 is also relevant: