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«Outreach on Shariah-Compliant Instruments and Project Transactions Issues in the application of IFRS 9 to Islamic Finance Paper topic A paper ...»

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Leverage is a contractual cash flow characteristic of some financial assets. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest. Stand-alone option, forward and swap contracts are examples of financial assets that include such leverage. Thus, such contracts do not meet the condition in paragraphs 4.1.2(b) and 4.1.2A(b) and cannot be subsequently measured at amortised cost or fair value through other comprehensive income. [Emphasis added.]

Subsequent accounting

41. An instrument that does not qualify for amortised cost classification is measured in subsequent periods at fair value. IAS 39 included an exception from this principle for ‘... investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured...’ (paragraph 46(c)). After considerable deliberation, the IASB concluded that IFRS 9 should not Page 14 of 27 include such an exception. 7 Some have observed that the lack of market information makes it difficult to determine fair values for instruments in Islamic finance. A discussion of fair value measurement is beyond the scope of this paper. However, Islamic financial institutions that comply with IFRS Standards are required to disclose the fair value of all financial instruments, including those that are classified as measured using amortised cost. The financial statements that we reviewed in developing this paper appear to comply with that requirement.

42. An instrument that is measured at amortised cost is measured using the effective interest method (see paragraph 17). This method is similar to the effective profit rate method included in Appendix 3. That method appears to be based on a set of computations that are similar, if not the same as, those used in determining the effective interest rate; that is, cash flows are allocated between principal and interest (profit) using a constant rate of return. The amount of revenue is a function of the remaining principal and the original rate. This differs from other methods such as those used to allocate revenue under IFRS 15, such as straight-line allocation, in that the amount of revenue is a function of the remaining principal and the original rate.

43. While both IFRS Standards and AAOIFI standards describe the balance as the consequence of allocations, the carrying amount can also be described prospectively;

in other words, the carrying amount at the end of any period equals the present value of the remaining expected cash flows, discounted at the original rate.


44. In this paper, we have explored the application of the classification and subsequent measurement provisions of IFRS 9 to instruments in Islamic finance. We have tried to keep a tight focus on our subject-matter and have not ventured into other areas of the Standard, such as credit impairment or modification of terms. Although important, those topics do not appear to pose unique challenges in their application to Islamic finance.

7 In December 2012, the IASB published education material titled Illustrative examples to accompany IFRS 13 Fair Value Measurement, Unquoted equity instruments within the scope of IFRS 9 Financial Instruments.

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(a) IFRS 4 Insurance Contracts;

(b) IFRS 11 Joint Arrangements;

(c) IFRS 13 Fair Value Measurement, and (d) IAS 17 Leases and its successor IFRS 16 Leases.

46. In our view, many of the contracts that arise from permitted transactions in Islamic finance meet the criteria in IFRS 9 for classification and measurement at amortised cost. However, a thorough analysis and understanding of the contract terms, rather than their mere form, is critical to reaching that conclusion. The restrictions in IFRS 9 are explicit about contract provisions that introduce factors other than those found in a basic lending arrangement and would disqualify the contract from amortised cost classification.

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B1. The accompanying PDF file is a spreadsheet that compares 18 Islamic banks and the Islamic products offered. The banks were identified through Google searches and we attempted to include at least one from each country represented on the consultative group. We deleted the names of the banks and identified them as ‘Bank A’ and so forth.

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(a) the bank does not appear to provide financial statements online, although some provide annual reports without statements;

(b) the bank provides annual reports online, but they are not in English; or (c) the bank provides financial statements online, but they do not provide enough explanatory information about Islamic products to complete the spreadsheet analysis.

B3. The last reason is not a comment on the quality of the financial statements involved. They simply did not include the information needed for this analysis.

B4. A working group of the Asia-Oceania Standard Setters Group recently completed a study titled Financial Reporting by Islamic Financial Institutions 8.

That study captured a larger set of institutions but had a somewhat different focus.

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(a) The analysis makes no attempt to common-size the information presented into a single currency unit.

(b) The banks typically did not show allowances for impairment and deferred profits by individual contract type. We used the gross information, so the percentages overstate the amounts relative to total assets. They are, we think, representative of different product mixes.

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(b) Nine of the remaining banks use IFRS Standards, including three that have adopted IFRS 9. Four follow AAOIFI standards. Three follow local standards that are based, to some extent, on IFRS Standards.

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From Financial Accounting Standard No 1, General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions Istisna’a A contract whereby the purchaser asks the seller to manufacture a specifically defined product using the seller’s raw materials at a given price. The contractual agreement as Istisna’ has characteristic similar to that of Salam in that it provides for the sale of a product not available at the time of sale. It also has a characteristic similar to the ordinary sale in that the price may be paid when the deal is concluded. A third characteristic of the contractual agreement of Istisna’ is similar to Ijarah (employment) in that labour is required in both.


Sale of goods with an agreed upon profit mark up on the cost. Murabaha sale is of two types. In the first type, the Islamic bank purchases the goods and makes it available for sale without any prior promise from a customer to purchase it. In the second type, the Islamic bank purchases the goods ordered by a customer from a third party and then sells those goods to the same customer. In the latter case, the Islamic bank purchases the goods only after a customer has made a promise to purchase them from the bank.


A form of partnership between the Islamic bank and its clients whereby each party contributes to the capital of partnership in equal or varying degrees to establish a new project or share in an existing one, and whereby each of the parties becomes an owner of the capital on a permanent or declining basis and shall have his due share of the profits.

However, losses are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise.


It is a partnership in profit between capital and work. It may be conducted between investment account holders as providers of funds and the Islamic bank as mudarib. The Islamic bank announces its willingness to accept the funds of investment account holders, the sharing of profits being as agreed between the two parties, and the losses being borne Page 20 of 27 by the provider of funds except if they were due to misconduct, negligence or violation of the conditions agreed upon by the Islamic bank. In the latter cases, such losses would be borne by the Islamic bank. A Mudaraba contract may also be concluded between the Islamic bank as a provider of funds, on behalf of itself or on behalf of investment account holders, and business owners and other craftsmen, including farmers, traders etc.

Mudaraba differs from what is known as speculation which includes an element of gambling in buying and selling transaction. (It is to the former that this standard applies).

Salam Purchase of a commodity for deferred delivery in exchange for immediate payment according to specified conditions or sale of a commodity for deferred delivery in exchange for immediate payment.

From Financial Accounting Standard No. 8, Ijarah and Ijarah Muntahia Bittamleek Ijarah Ijarah is the transfer of ownership of a service for an agreed upon consideration.

According to fuqaha, it has three major elements:

• a form, which includes an offer and a consent.

• two parties: a lessor (the owner of the leased asset), and lessee (the party who reaps the services of the leased asset).

• the object of the (Ijarah) contract, which includes the rental amount and the service (transferred to the lessee).

Operating Ijarah Ijarah contracts that do not end up with the transfer of ownership of leased assets to the lessee.

Ijarah Munahia Bittamleek Ijarah contracts that end up with the transfer of ownership of leased assets to the lessee.

Ijarah Muntahia Bittamleek may take one of the following forms:

a) Ijarah Muntahia Bittamleek that transfers the ownership of the leased assets to the lessee—if the lessee so desires—for a price represented by the rental payments made by the lessee over the lease term. At the end of the lease term and after the last instalment is

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b) Ijarah Muntahia Bittamleek that gives the lessee the right of ownership of leased assets at the end of the lease term on the basis of a new contract for a specified price, which may be a token price.

c) Ijarah agreements that gives the lessee one of three options that he may exercise at

the end of the lease term:

• purchasing the leased asset for a price that is determined based on rental payments made by the lessee,

• renewal of Ijarah for another term, or

• returning the leased asset to the lessor (owner).

From Financial Accounting Standard No 17, Investments (superseded) 9 Sukuk (a) Mudaraba (Muqaradah) sukuk (bonds) These are investment sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of the share. The owners of such sukuk are the rabbul-mal.

(b) Musharaka sukuk These are investment sukuk that represent ownership of Musharaka equity. It does not differ from the Mudaraba sukuk except in the organization of the relationship between the party issuing such sukuk and holders of these sukuk, whereby the party issuing sukuk forms a committee from the holders of the sukuk who can be referred to in investment decisions.

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9 Financial Accounting Standard No 17 was superseded by Financial Accounting Standard No 25 Investment in sukuk, shares and similar instruments. We have used the definitions from Standard No 17 here because they are more extensive and detailed.

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(d) Salam or Istisna’a sukuk These are sukuk that represent a sale of a commodity on the basis of deferred delivery against immediate payment. The deferred commodity is a debt in-kind against the supplier because it refers to a commodity which is accepted based on the description of the seller. The Istisna’a sukuk are similar to Salam sukuk, except that it is permissible to defer payment in an Istisna’a transaction, but not in a Salam. In both Salam and Istisna’a, the subject-matter of the sale is an obligation on the manufacturer or builder in the case of Istisna’a and the seller in the case of Salam. Hence, both instruments can neither be sold nor traded before their maturity date if either the buyer or the seller of the commodity issues them. Accordingly, these sukuk are treated as investments held to maturity.

From Financial Accounting Standard No. 25, Investment in sukuk, shares and similar instruments Sukuk Investment sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of 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 the purpose for which the sukuk is issued.

Amortised cost

The amortised cost of an instrument is the amount at which the financial asset is measured at initial recognition minus capital/redemption repayments, plus or minus the cumulative amortisation using the effective profit rate method of any difference between that initial amount and the maturity amount, and minus in reduction (directly or through the use of an allowance account) for impairment or uncollectibility.

Page 23 of 27 The effective profit rate method is a method of calculating the amortised cost of a financial asset and of allocating the finance income over the relevant period. The effective profit rate is the rate that exactly equates the estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the asset. When calculating the effective profit rate, and entity shall estimate cash flows considering all contractual terms of the financial instrument, but shall not consider future credit losses. This calculation includes all fees and amounts paid or received between parties of the contract that are an integral part of the effective profit rate, transaction costs, and all other premiums and discounts.

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