INTERNATIONAL ACCOUNTING REGULATIONS FOR ISLAMIC BANKS
SIMON ARCHER AND NOOR ABID
From the point of view of the economic theory of the business firm, the role of accounting standards for Islamic banks can be seen in the context of Agency Theory.
This body of theory deals with the ‘agency problem’, that is, the type of problem that arises from: (a) the divergence of the economic interests of the manager of the Islamic bank (agent), from those of the investor in the bank (principal), in whose interests the manager is supposed to act; and (b) the existence of information asymmetry between the manager and the investor as to what activities the former has undertaken.
Accounting and financial reporting are meaning whereby the investor may be able to mitigate the information asymmetry by monitoring the activities of the manager, so as to detect activities which are not in the investor’s interest.
However, insofar as the accounting and financial reporting systems are themselves controlled by the manager; this reduces the investor’s monitoring capabilities. Accounting standards, together with auditing, are ways in which the investor’s control over these systems may be enhanced, and his monitoring capabilities reinforced.
Agency theory is relevant to the situation of an Islamic bank in at least two ways. On the liabilities side, the bank is accountable to various categories of investors, including investment account-holders whose returns must be calculated on a profit-sharing basis.
Islamic investment accounts operate on the basis of the Mudaraba contract, according to which the investors receive the profits or bear their share of the losses from the pool of assets in which the funds are invested, while the bank as entrepreneur (Mudarib) receives a commission which consists of a share of the profit, being zero in the case of a loss or zero profit.
In the case of restricted investment accounts, the bank must invest the funds in a designated pool of assets, while funds in unrestricted investment accounts are normally commingled with the bank’s own funds and invested in the bank’s general pool of assets (bilateral Mudaraba, discussed below). In the latter case (and also in the former if the bank has invested part of its own funds in the designated pool of assets), profit calculations involve apportioning the profit or loss on the pool of assets between shareholders and holders of investment accounts.
The latter are entitled to their proportionate share of profit, less the bank’s share of the profit as Mudarib; the bank (i.e., the shareholders) receives the proportionate share of profit on any of its own funds which have been invested in the pool, plus its commission. In the case where the return on the pool of assets has been negative, the losses are shared as indicated above, while the amount of the Mudarib share will be zero. These profit-and-loss calculations are not observable by the investors, and this is a particular instance of information asymmetry.
While for the ordinary company, it is the relationship between management and shareholders which gives rise to an agency problem (the so-called ‘internal agency problem’), a further ‘internal agency problem’ thus arises in the case of an Islamic bank.
This problem is due to the combination of the existence of profit-sharing investors other than shareholders, and of the incentives the management of the bank may have to favour one category of investors over another. For example, shareholders have the right to vote in General Meetings and thus have some control over the Board of Directors and the appointment of independent auditors, but investment account-holders do not.
The non-observability of the accounting calculations made to determine the returns due to the various categories of investor thus becomes a crucial agency problem. This indicates that in an Islamic banking context there is a potential role for accounting standards (and for auditing) over and above what is the case for the conventional firm.
In this paper, we wish to argue that such non-observability becomes much less of a problem if known rules (laid down by an accounting standards body) are being followed and their correct application is being monitored by independent auditors.
Accounting standards are concerned with the amount of information disclosed and the formats used to do so (disclosure standards), and also with the accounting methods used to calculate the amounts disclosed (measurement standards). Measurement issues comprise those of recognition (e.g., of income) and valuation (e.g., of assets).
The object of financial accounting standards is to ensure that the provision of financial information by reporting entities meets certain minimum standards of informational quantity and quality. Reporting entities in this context include any organisations that have accounts to render to external stakeholders (‘ accountees ‘); in the case of commercial entities, the law generally makes the investors the main accountees.
Accounting standards are a form of regulation of the financial reporting process. As such, they may be provided, at least in part, by self-regulation. Islamic banks may have an incentive to collaborate in the development and promulgation of accounting standards, since they are an efficient method of reducing the ‘agency problem’ discussed earlier. However, there may also be limits to what can be achieved by self-regulation.
Self-regulatory accounting standards bodies have little, if any, power to enforce observance of their standards. The acceptance by the regulatees of the rules proposed by the self-regulatory body, and hence the effectiveness of self-regulation, depend on consensus between the self-regulatory body and regulatees, which the latter will withhold if the former is perceived as ‘too demanding’. The consensus levels of the quantity and quality of financial accounting information may tend to be unsatisfactorily low.
Hence, it is a field in which regulation by governmental or public sector bodies with enforcement powers may play an important role. On the other hand, a wish to avoid governmental regulation is one incentive for self-regulation. Rifaat Karim, in an article in Accounting and Business Research (1990), notes that this was a reason for the setting up of the Financial Accounting Organisation for Islamic Banks and Financial Institutions (FAOIBFI), now renamed the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), in 1991, with the primary objective of establishing and promulgating accounting standards for Islamic banks.
International Accounting Standards
A fairly comprehensive set of international financial accounting standards is provided by the International Accounting Standards committee (lASC) through its International Accounting Standards (lASs). These are particularly relevant here, as in principle they are entirely voluntary (although some countries have chosen to give them legal backing for the purpose of national accounting standardisation). In other words, the lASC provides an interesting example of how an international accounting standard-setting body for Islamic banks, without enforcement powers, might operate.
After its creation in 1973, the lASC proceeded cautiously by issuing flexible standards. It identified for each area of potential standardisation the methods which were ‘generally accepted’ internationally, and, where more than one method was generally accepted, the IAS allowed a choice between two methods. For example, IAS 11 allowed a choice between the percentage of completion and the completed contract methods of accounting for construction contract work-in-process (WIP).
Likewise, IAS 12 allowed a choice between the full provision and partial provision methods of recognition for deferred tax liability. But in 1989, the lASC felt that its international influence was sufficiently well established for it to publish E32, an Exposure Draft setting out its intentions to narrow down the choice in many areas. For example, the completed contract method of accounting for construction WIP was to be eliminated. Following E32, lASC revised other standards by eliminating alternatives and introducing the concept of benchmark treatment.
In general, and especially in its earlier years, the lASC has paid considerable attention to the accounting methods generally accepted in certain countries which are particularly influential in international accounting. However, more recently it has felt able to act more independently.
For example, following E32, IAS22 on Business Combinations was amended so as to disallow the treatment of goodwill most used in the UK (elimination against shareholders’ interest), and to require a 20-year maximum amortisation period for goodwill, whereas the US standard allows a 40-year maximum period. The lASC’s position on goodwill has certainly influenced the discussion of the proposed new UK standard which will cover accounting for goodwill; in particular, it is likely that the new UK standard will disallow elimination against shareholders’ interest and use 20 years as the maximum amortisation period.
We have gone into these matters in some detail, because it is likely that the accounting standard-setting body for Islamic banks, AAOIFI, will find it expedient to take note of the lASC’s experience as an international standards-setting body without enforcement powers.
Regulations of Banks
Because of the key macro-economic role of banks with regard to the supply of credit, and the importance of this for monetary and exchange rate policies, as well as the issue of public confidence, banking is a regulated industry Even in the most liberal politicoeconomic systems, matters such as banks’ liquidity and capital adequacy ratios are subject to regulation by a national central bank or monetary agency. In addition, for signatories to the Basle agreements, national capital adequacy requirements are governed by international rules.
Thus, there are special reasons for the existence of accounting standards for banks. Regulation of liquidity and capital adequacy requires monitoring of banks’ financial statements, which in turn calls for the promulgation and application of appropriate accounting disclosure and measurement rules.
For the reasons just given, financial accounting standards for banks are normally set by the national regulator, i.e., the central bank or monetary agency. In addition, there exist international standards that pre-date those set by the AAOIFI.
In early 1991, the lASC promulgated a disclosure standard, IAS 30, Disclosures in the Financial Statements of Banks and Similar Financial Institutions. The European Union’s directive 86/635 on the Annual Accounts of Banks and Credit Institutions, which was promulgated in December 1986, is also mainly a disclosure standard, though it includes some measurement rules in Articles 35-39.
Limited Applicability
It is, however, not necessary to study Directive 86/635 and IAS 30 for very long in order to notice that their application to Islamic banks would be problematic. With regard to disclosure, many balance sheet and income statement captions are applicable only to the results of interest-based transactions, while captions applicable to Islamic (non-interest-based) transactions are lacking.
For example, how are restricted investment accounts and the related assets to be reported: on or off the balance sheet? So far as measurement is concerned, rules applicable to the results of non-interest-based transactions are absent. For example, profit recognition and asset valuation rules for Islamic finance leasing (Ijara wa-Iqtina) and credit sale (Bai Bithaman Ajil and Murabaha) contracts are not provided. Moreover, there is no guidance as to the balance sheet status of unrestricted investment accounts, which are neither equity nor debt in the conventional sense.
Karim gives some further reasons why accounting standards developed for secular business organisations are of limited applicability to Islamic banks. These include, in particular, the ethical aspect: conceptually. Western (secular) accounting standards are presented in a manner that minimises or even excludes the ethical perspective.
According to Islam, rights and obligations in the provision of financial accounting information are matters to be governed by principles of religious duty, the Sharia, including the duty of trusteeship or Amana.
This, therefore, is the background to the issuance, in October 1993, by the then FAOIBFI of its Financial Accounting Standard No. 1
As its title indicates, this is a disclosure standard, and it may in part be regarded as a major adaptation of the IAS 33 approach (as well as of other applicable lASC disclosure standards) in order to meet the needs of Islamic banks.
One test of the success of this standard is the extent to which it is reflected in the requirements imposed on Islamic banks by national regulators. For example, a number of central banks are considering reflecting it in their disclosure requirements, and some (e.g., the Central Bank of Sudan) have already done so.
There are other specific and unique accounting situations that are relevant only to Islamic banks. For instance, as we noted above, unrestricted investment account-holders share in the income earned by the general pool of the bank’s assets, together with the bank’s shareholders.
The sharing of income is subject to the specific terms of the Mudaraba contract between them and the bank. The unrestricted investment account-holders’ position as regards profit-sharing differs from that of the bank’s shareholders in various respects, depending on the particular version of the Mudaraba contract implemented by the bank.
The Mudaraba may be either uni-lateral (restricted) or bi-lateral (unrestricted). Most Islamic banks use the bi-lateral Mudaraba, acting both as manager (Mudarib) and as provider of funds. In this case, certain expenses may be deemed to be chargeable only against the bank’s (i.e., shareholders’) share of income, while the bank charges a management fee in respect of its role as Mudarib (and may make certain other charges) only against the investment account-holders’ share.
Thus, in the common case of the bi-lateral Mudaraba, the accounting rules used by the bank may affect profit allocation, not just between investment account-holders (depending on the timing of profit recognition), but also between unrestricted investment account-holders and shareholders.
Given that the Board of Directors is legally subject to the authority of the shareholders in General Meetings, while the investment account-holders possess no such power over the Board, the result is a specific ‘agency problem’ with regard to unrestricted investment accounts.
In fact, the current accounting practices of Islamic banks which use the bi-lateral Mudaraba exhibit diversity in the attribution of revenue and expenses to the Mudaraba fund. While a majority tends to restrict the bi-lateral Mudaraba’s revenues and expenses to those which relate to the fund’s assets (thus excluding general overheads as well as revenues from other sources), other banks attribute all their revenues and expenses (except directors’ and external auditors’ remuneration) to the bi-lateral Mudaraba.
As Stella Cox commented in New Horizon (issue 42, August ’95): “Lack of common accounting standards does not assist the banks’ endeavours to establish reciprocal relationships with others. Islamic financial institutions’ accounts must be comprehensible to outside users so that an Islamic bank’s performance over a set period of time can be…. judged ..and consistent (so as) to generate confidence in the banks themselves….”
To some extent, such problems may be mitigated by external regulators or self-regulators. Thus, the AAOIFI’s FASTI addresses the agency problem of asymmetric information by requiring separate disclosure of:
(a) those fund items (assets, revenues, expenses, gains and losses) pertaining to bilateral Mudarabas, i.e., commingled funds; and
(b) those fund items pertaining to investments consisting only of the bank’s own funds.
The AAOIFI has developed accounting standards specifically for application to the three common types of Islamic financing contract: the Mudaraba, as described above, which is the normal source of non-shareholder funds for an Islamic bank; the Musharaka, a form of joint venture; and the Murabaha, or credit sale on a cost-plus basis.
These standards address measurement as well as disclosure issues. However, the lack of standardisation of these contracts impedes the standardisation of accounting measurement.
The growth of Islamic banks and the fact that they operate in a regulated industry makes it imperative that they continue to standardise these contracts and adopt a common set of accounting policies. Thus, most Islamic banks, regulators, customers and other interested parties have welcomed the issuance of accounting standards for Islamic Banks by the AAOIFI.
Finally, there is the matter of auditing and of attestation to compliance with Sharia principles. For this purpose. Islamic banks normally appoint a Sharia Supervisory Board which is primarily responsible for advising the bank on Sharia rules and to ensure compliance with these rules.
Although there is a strong call for greater standardisation, both of contracts and of accounting rules from the global market, the Sharia Supervisory Boards have inevitably taken differing positions on the permissibility of, and also on the accounting rules applicable to, certain forms of contracts.
In such a context, the role of consensus-building is likely to be crucial. Moreover, a worthwhile level of standardisation may be achieved by means of flexible harmonisation, rather than rigid uniformization. In this regard, the example of the lASC, although it operates only at the secular level, may nevertheless be instructive for the international accounting standards body for Islamic banks, the AAOIFI.
The characteristic approach of the lASC in setting its first set of standards was, as described earlier, to promote harmonisation by identifying, in each area of accounting method, a subset of (normally two) accounting methods which were ‘generally accepted internationally’.
A choice would then be allowed between these identified methods, others being excluded. In this way, the lASC was able to build up its authority, while avoiding the risk of trying and failing to exclude methods that had considerable international support.
To some extent, this was a political process: ‘generally accepted internationally’ was generally interpreted to mean acceptance by the national accounting standards of the most influential countries, and use by leading multinational corporations, especially those based in such countries.
In a second phase, with the benefit of established authority, the lASC has sought to promote a further stage of harmonisation by eliminating some previously permitted methods and identifying a preferred method and an alternative (less preferred) method among those still permitted.
In the case of AAOIFI, bearing in mind the foregoing discussion, a similar two-stage process might be envisaged. Moreover, the following criteria might be relevant in drafting its standards:
Existing accepted practices in key countries and institutions:
The views of banking regulators in key countries, whose choice to implement a given AAOIFI standard for Islamic banks will be important for its general acceptance;
Economic consequences for investors (e.g., effects on the calculation of their returns) and for banks (e.g., effects on capital adequacy measures).
Implications for Audit and for Attestation of Sharia Compliance.
Indeed, it is apparent that such considerations have influenced both the structure and composition of the AAOIFI’s own organs of governance, and its ‘due process’.
This paper has endeavored to indicate the role which a set of international accounting standards for Islamic banks may play in facilitating the corporate governance of Islamic banks as well as promoting the success of the Islamic banking movement, and also the challenges raised by such standard-setting. Given the creation of, and the approach taken by, the AAOIFI, there are grounds for hope that this important challenge is being taken up in a manner that will prove fruitful.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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