IFRS or AAOIFI? On January 1, 2016, private companies in Malaysia officially adopted the International Financial Reporting Standards (IFRS) to streamline cross-border financial reporting. For the Islamic finance industry, Malaysia’s accounting experts say the nation is sticking with IFRS instead of standards issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).
“There are really only two games in town,” Faiz Azmi, chair of the Islamic Finance Consultative Group of the International Accounting Standards Board (IASB) told Salaam Gateway. The IASB is responsible for the development and publication of IFRS standards.
“There is the U.S. GAAP, but the whole of Europe is on IFRS, so is China. Most of Asia is still substantially IFRS. That does seem to be the de facto world standard,” said Azmi.
IFRS was started in the 1970s by a group of professional accounting bodies to push for better comparability and transparency in financial reporting, and it addresses the dissimilarities in these standards among different jurisdictions that may result in cross-border operational complexity and higher costs for investors. Some of its defining aspects include an emphasis on revealing the true economic values of all transactions, and adherence to characteristics of comparability, verifiability, timeliness and understandability. Today, IFRS has been adopted by 126 countries either in part or in full.
Mohamed Raslan, chairman of the Malaysian Accounting Standards Board (MASB), a government-sanctioned body comprising a handful of recognized professional accounting bodies, believes IFRS acts as an aid to key players. “IFRS as the international financial reporting language could accommodate business and capital market growth, enabling investors and market participants to make informed economic decisions,” he told Salaam Gateway.
Raslan explained that Malaysia officially moved to full convergence with IFRS standards in 2012 in an effort to initiate a broad strategic direction to align its accounting standards to those issued by the IASB.
Malaysia’s government appointed the MASB to agree on its own accounting standard, which is known as the ‘Malaysian Financial Reporting Standards (MFRS) Framework’. The MFRS is largely based on the IFRS model, with certain provisions for the local situation.
Azmi explained that more than a decade ago, 40-page booklets were printed to explain the gap between Malaysia’s standards and IFRS, a metaphor for the operational complexities of arbitrating between two different standards. “IFRS is one of those things where there’s no empirical data to prove [its success],” he added.
Today, however, the convergence of the two standards has led to lower operational costs and increased synergies between overseas subsidiaries and product sales across multiple jurisdictions. Costs are pushed down as there is no need for adjustments to be made to group accounts when consolidating accounts of subsidiaries operating in different jurisdictions. The Japanese Financial Services Board surveyed 65 companies in 2015, and found that the majority of the corporations found “contributions to business management” a huge value add of IFRS adoption, which allows for the simplification and consolidation of accounts.
“Now we don’t even bother creating that book because there is no difference,” said Azmi.
In July this year MIA told local newspaper the New Straits Times (NST) that Malaysia could be the first nation to incorporate IFRS into the country’s Islamic finance regulations. Azmi, who is also the president of the MIA, said the institute was working on a book on how to implement IFRS standards in Islamic finance.
He added that IFRS is reassuring for customers and shareholders who want to make comparisons between Islamic and conventional products, whether for investment purposes or to conduct due diligence.
Additionally, the adoption of IFRS could help a country drive up foreign direct investment (FDI) by improving international comparability and compliance. Studies have shown that IFRS adoption has led to increased FDI flows, particularly in developing countries, as investors are more likely to put money into a company whose finances they can more easily understand, and compare with other businesses.
“The use of a set of globally accepted framework means the Islamic financial institutions would be able to assert that the same high standard and best practices are adopted in the preparation of their financial statements,” said MASB’s Raslan. “Investor confidence would improve and this will in turn encourage greater investment and cross-border opportunities.”
Some jurisdictions use accounting standards issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).
Malaysia does not adopt AAOIFI standards, especially since the ratification of IFRS in 2012. MASB said that although AAOIFI may have been a pioneer in formulating accounting standards for Islamic finance, they found discrepancies between it and regulator-approved standards in Malaysia, which resulted in the body deciding not to recognize it, with the exception of certain disclosures.
“In my view, the fundamental problem with AAOIFI accounting standards is that their objective is not to devise the best possible way of reporting the economic substance of the transactions that have been undertaken,” Mohammad Amin, a former tax advisor with PwC with a specialisation in Islamic finance, told Salaam Gateway.
According to both Azmi and Amin, there are two essential problems with using AAOIFI standards, the first being that the Bahrain-based organisation’s purpose is different from IFRS’s. AAOIFI is not necessarily focused on reporting on the true economic value of an asset, but rather on depicting its compliance with Shariah. Both Azmi and Amin noted that while IFRS frameworks will not be able to indicate whether or not such assets are halal, AAOIFI may result in dishonest reporting from entities.
This issue of disparate objectives arises most commonly with financial leasing, explained Azmi. The most common Islamic lease contract is the ijarah, which is seen by AAOIFI as a rental contract as opposed to a straight up asset. This means that the lessee doesn’t record a liability on the books, despite the rental looking like an asset in real terms.
“Although the contract says you’re renting, you’re actually owning it because you’re paying for the entire cost of the object – be it an aeroplane, an oil rig – during the life of the contract,” Azmi explained, adding that AAOIFI doesn’t see it that way.
According to AAOIFI, an ijarah contract must always be treated as a rental, despite a product’s characteristics as an asset. This could result in a situation where companies that don’t want to reveal the true extent of their liabilities can instead rely on AAOIFI standards to disguise the nature of a product’s ownership.
“If you look at airlines for example, all the airlines don’t seem to have aircrafts on their balance sheets; a lot of shipping companies don’t have ships in their balance sheets,” Azmi said.
“[The problem] is that you are calling a dog a duck when it’s actually a dog. We’re saying that you’re lying because you’re pretending it’s a rental, but when you actually look at the terms, you are paying the cost of the asset over a term of five years or so.”
The second issue is that not all conventional companies will implement an Islamic standard, and AAOIFI is in part in direct contradiction with IFRS.
At the moment, only a few countries use AAOIFI as the basis for Islamic financial institutions’ accounting standards, including Bahrain and Oman. According to Azmi, while AAOIFI may have a role to play in setting standards for the Islamic finance industry, their standards are inherently incompatible with IFRS, and it would undo a lot of the global benefits that IFRS would bring.
“Although AAOIFI may have based themselves originally on the International Accounting Standards (IAS), the predecessor framework to IFRS, AAOIFI have made significant changes over time,” said Azmi.
“It doesn’t make sense to have one set of standards for Islamic banks and a different set for a conventional bank because it confuses the investors. Regulators would appreciate a comparable accounting framework applicable to Islamic financial institutions and financial institutions for performance and regulatory assessment,” Azmi added.
He believes the convergence of Malaysia’s domestic standards with IFRS standards will improve business operations not only for foreign investors, but local companies looking to expand into the rest of the region and the world.
“If you intend to only deal with local shareholders, then you probably don’t see the need to adopt these international standards,” said Azmi. “But if you do have foreign investors who will ask questions about your numbers and policies, they won’t have to ask those questions if you’re adopting a standard process or framework which they’re familiar with.”
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