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13 March 2015

Each year the magazine Islamic Finance News publishes an annual guide. While the magazine is only available to subscribers, the 2015 Annual Guide can be downloaded free by everyone.

Page 6 of the 2015 Annual Guide contains an article by me which is reproduced below.

Accounting and tax developments

Accounting and tax are often thought of together, and commonly involve the same profession since tax practice in many parts of the world is dominated by accountants. However, they are very different and will be covered separately. MOHAMMED AMIN dissects the two fields to look at the differences particularly those that involve Islamic financial transactions.

Accounting

Accounting lends itself to global harmonization, since investors want to compare the accounts of companies from different countries. Today companies in most countries, especially those with publicly traded shares or securities, account using International Financial Reporting Standards (IFRS) promulgated by the International Accounting Standards Board (IASB). The only significant exception is the USA, using standards from the Financial Accounting Standards Board (FASB). However, the IASB and FASB have agreed to converge over time.

AAOIFI was established in 1990 to standardize accounting for Islamic financial institutions (IFIs). However, the author’s article ‘AAOIFI’s proper accounting standards role’ in Islamic Finance news on the 9th February 2011 explained that almost all IFIs, apart from those based in a few countries, account under IFRS.

Accordingly, Islamic finance (IF) practitioners were frustrated by the IASB ignoring Islamic finance when publishing IFRS or issuing guidance on how IFRS should be applied. This resulted in inconsistency between IFIs when applying IFRS to account for similar transactions. The most important recent IF accounting development was in early 2013 when the IASB set up a ‘Working group on Shariah compliant instruments and transactions’. It held its first meeting on the 2^nd July 2013 in Kuala Lumpur and identified four areas for initial focus:

1. the application of IFRS 9’s classification and measurement principles
2. the application of the IASB’s proposed lease standard to ijarah
3. whether restricted and unrestricted investment accounts are to be presented on or off balance sheet
4. profit equalisation reserves due to significant differences in practice.

The working group discussed the first subject in some detail at its second meeting held on the 5^th September 2014 in Kuala Lumpur.

The key issue is that under IFRS 9 a financial instrument must be measured at fair value with value changes taken to the profit and loss account or other comprehensive income (as appropriate) unless the financial instrument qualifies for amortized cost accounting. There are two tests for amortized cost accounting and both must be passed:

1. a business model test and
2. a characteristics-of-the-instrument test.

In the second test, the cash flows from the financial instrument must be ‘solely payments of principal and interest from the principal amount outstanding’. How should these tests be applied in IF when interest is not charged explicitly or when IFIs use partnership-type contracts such as diminishing Musharakah? The meeting on the 5^th September also had a preliminary discussion on the appropriate IFRS accounting for Murabahah contracts.

It is not feasible to cover the detailed discussion here, but the minutes of the meeting in audio and written forms are available on the IASB website at http://www.ifrs.org/Meetings/Pages/Sharia-compliant-financial-instruments-and-transactions-meeting-September-2014.aspx. At that time, AAOIFI was not involved in the IASB discussions. However, AAOIFI issued a news release on the 20^th December 2014 reporting on a meeting with the IASB held on the 16^th December, which stated:

“During the meeting, AAOIFI formally accepted the invitation from IASB, the body that develops International Financial Reporting Standards (IFRS), to participate in its newly formed Consultative Group on Shariah Compliant Instruments and Transactions. AAOIFI has also offered to arrange the next meeting of the Consultative Group in the first quarter of 2015 in the Arabian Gulf region. The IASB welcomed and accepted this offer.”

This is a welcome development as the 2011 article mentioned above suggested that, in accounting, AAOIFI’s key role should be to partner with the IASB.

Tax

Unlike accounting, tax law is inherently local, since countries jealously guard their sovereign power to make and change tax law. It is not practical in a short article to enumerate specific tax law changes around the world.

The overall trend, however, is for countries to enact legislation with the aim of ensuring that IF transactions do not suffer greater taxation than conventional financial transactions. Even countries with negligible Muslim populations are making such changes as they recognize the growing commercial importance of IF. For example in December 2014 it was reported that South Korea is looking to amend its tax law to facilitate the issuance of Sukuk.

Conclusions

Accounting

The expertise that the IASB has brought together, and the collaboration of AAOIFI, should result in much greater consistency between IFIs when accounting under IFRS. It is quite possible that AAOIFI may eventually withdraw altogether from issuing accounting standards.

Tax

The continued growth of IF should result in more countries adapting their tax systems to enable IF transactions to be carried out within their jurisdiction without adverse tax costs.

Mohammed Amin is an Islamic finance consultant and was previously the UK Head of Islamic finance at PwC.