ACCOUNTING AND AUDITING ISSUES IN ISLAMIC BANKING
ANNE SIMPSON AND PAUL WILLING
Islamic banking is still a relatively new sector of the financial services industry, having started in essentially its current form approximately 20 years ago. The last five years have seen an upsurge in interest in Islamic finance generally, particularly from some of the larger names more usually associated with Western-style banking.
It is the relative infancy of the industry generally that is linked to most of the current issues in the financial reporting and auditing of Islamic banks. The recent introduction of new participants has placed increased significance on these various issues.
The relevance of the industry’s infancy is highlighted by the continued lack of an internationally accepted framework of uniform and comprehensive accounting standards or auditing guide-lines.
Because of this, different Islamic banks have developed their own accounting treatment for essentially similar transactions, leading to different revenue recognition methods, and differing bases of classification and disclosure in the financial statements of Islamic banks.
The variety of treatment is in turn encouraged by the local regulatory requirements of the countries in which the banks operate, which can differ dramatically, and is typified by the treatment of investment accounts, which is discussed later. The end result of this is to render the comparison of financial statements of individual Islamic banks difficult, and sometimes impractical.
As a response to this situation, the Financial Accounting Organisation for Islamic Banks and Financial Institutions was established in Bahrain in 1991 and has recently been renamed the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).
This organisation has been responsible for developing various statements for financial accounting by Islamic banks, and has so far released three, which were approved in October 1993. The existing statements cover the objectives and concepts of financial accounting for Islamic banks, as well as the presentation and disclosure of their financial statements, relating to matters such as the accounting treatment of Murabahas and Musharakas.
Some of the more common accounting issues to which Islamic banks and financial institutions are exposed are:
1. Treatment of Investment Accounts
Currently, some Islamic banks include investment accounts on their balance sheet, whilst others present them as funds under management, shown off balance meet. Such classification is often determined by the regulatory environment in which the Islamic bank operates.
Islamic banks may distinguish between on and off-balance sheet investment accounts by applying the risk and recourse criteria in classifying such accounts. Funds managed at the client’s risk are reflected off balance, but when investors place funds with the Islamic bank at the bank’s risk, such funds are presented as part of the bank’s own assets and liabilities.
Other Islamic banks may similarly differentiate between discretionary and non-discretionary investment accounts which are required to be reflected off balance sheet.
Any such method of differentiation will always be subject to the interpretation of the contracts governing the management of the investment accounts.
2. Income Recognition
Islamic banks often adopt different policies for the recognition of income arising from investments in Islamic instruments.
Certain banks are known to recognise such profit immediately at the inception of the transaction, whilst profit is recognised by other banks when actually received or amortised over the life of the instrument.
Such differing methods of income recognition, apart from affecting the comparability of financial statements of Islamic banks, have wider implications owing to their effect on the allocation of profits between investors and shareholders.
3. Allocation of Expenses and Overheads
Similarly, there is currently no consistent basis for the allocation of expenses and overheads to investment accounts.
Certain Islamic banks deduct only direct investment related expenses from profits paid to customers, while others also apportion indirect overheads, such as depreciation and directors’ remuneration to the returns accruing on investment accounts.
The adoption of such diverse bases for the allocation of expenses and overheads to investment accounts results in undesirable fluctuations between Islamic banks in respect of the profits payable on investment accounts.
4. Disclosure of Social Activities
Non-profit activities which make a positive contribution to society are actively advocated by the Sharia.
Islamic banks are therefore required to undertake social activities, and disclosure of such is likely to be one of interest to users of such banks’ financial statements. No consistent level of disclosure is currently practised, with such disclosure varying from nothing to extreme detail.
There is therefore a need for uniquely Islamic accounting matters such as this to be addressed.
Auditing Issues
There are a number of audit issues arising from both the accounting issues dealt with above, and from the nature of the operations of Islamic banks. Some of these are:
1. Investment Accounts
There are a number of auditing issues related to investment accounts:
a) The inclusion of such managed funds on a bank’s balance sheet will obviously inflate the assets and liabilities of that bank.
This can have a significant impact on the capital adequacy and lending ratio requirements of the bank under certain regulatory regimes. The effects of any non-compliance must be considered by the bank’s auditor.
b) Due to the nature of many Islamic financing activities, such as Mudarabas, it is common for the bank’s own funds and client funds to be invested in the same venture. Although not a problem unique to Islamic banks, this does raise the question of clear segregation of client funds. The auditor must therefore satisfy himself as to the adequacy of the internal controls to ensure proper segregation of such funds, and their related risks and rewards.
c) There is no formal requirement in many jurisdictions regarding the financial statement disclosure of off-balance sheet funds. Given the nature, and often significant volume, of such funds, disclosure of such matters as maturity profile and geographical analysis, may be considered essential information for the users of the financial statements. The auditor must often consider the balance between ensuring a true and fair view, and disclosing potentially competitor-sensitive information.
2. Liquidity Management
The absence of liquidity and maturity parameters in many jurisdictions, combined with investment in long-term Islamic financial projects, may increase the liquidity exposure of Islamic banks.
The ability to manage such an exposure may also be hindered by the difficulty in obtaining suitable off-the-shelf management information systems, which are normally designed for Western-style operations. The extent of the bank’s ability to manage this risk must clearly be considered by the auditor.
3. Rates of Return to Investors
Islamic banks are competing with established Western-style banks for investors’ funds, and must often therefore demonstrate that the products provided by them generate a comparable rate of return.
The nature of many Islamic finance products is, however, often inconsistent with the generation of a steady income stream that is comparable with those generated by interest-based products.
The Islamic bank may therefore ‘smooth’ the reported profits, through the operation of provisions and reserve accounts, in order to report a ‘marker’ rate of return.
The auditor must always consider whether such activities are permissible under the relevant legislation, and are rarely presented to investors, who may thus be misled.
4. Sharia Compliance
Clearly the question of Sharia compliance is significant to the audit of any Islamic financial organisation, and the role of the external auditor must address this. This significance may be considered greater when the Islamic bank is operating within an Islamic jurisdiction, and is therefore subject to the Sharia courts.
However, even when not directly governed by the Sharia, compliance must be essential, given the impact on the bank’s operations should, for instance, its products be no longer considered acceptable by its target market.
The Religious Supervisoi7 Board of most Islamic banks is responsible for ensuring the Sharia compliance of the bank’s activities and products. The external auditor’s role in this issue is complex, due largely to the lack of sufficient experience of most auditors of the Sharia law. As a result, reliance will often be placed on the competence of the bank’s own Religious Supervisory Board, which should theoretically be independent from the commercial interests of that bank.
While the auditor must take steps to satisfy himself on this matter, as he would if relying on any other expert, his task is complicated by the subjectivity of interpretation of the Sharia, which has seen many conflicting opinions given by the Religious Boards of different banks over recent years.
The establishment of rules and regulations covering specific investment products would go a long way in effectively ensuring that Islamic banks comply with the covenants of the Sharia as well as in the performance of their fiduciary duties and obligations to their investors.
The Future
As mentioned earlier, the Islamic banking market has expanded considerably in recent years. This growth has necessarily focused the attention of conventional banks on this sector, and it remains to be seen what impact this will have.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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