ISLAMIC FINANCE AND STANDARD SETTING

Islamic finance, unlike conventional banking, is a faith-based system of financial management that derives its principles from the Shariah. The code of Shariah is based on the canon law derived from the Qur’an. The basic principle of Islamic banking is the prohibition of receiving or paying riba, or interest. In 1991, the Islamic banking and finance industry decided that international accounting standards were inadequate to meet its needs. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Bahrain, was established to prepare accounting, auditing, governance, ethics, and Shariah standards for Islamic institutions. The membership of AAOIFI consists of 110 members, representing 24 countries. Although it has a long history, a revival of Islamic banking took place in the 1970s. Compared to conventional banking where interest rates fluctuate according to economic conditions, Islamic banking charges a fixed profit rate for the funds provided. The profit rate is determined at the beginning of the financing contract. The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds on a profitand- loss sharing basis. This does not imply that investments with financial institutions are speculative. Any such risks can be excluded by careful investment policy, diversification of risk, and prudent management by Islamic financial institutions.

The concept of profit-and-loss sharing, as a basis of financial transactions, is a progressive one as it distinguishes good performance from poor performance. Islamic banks are structured to retain a clearly differentiated status between shareholders’ capital and clients’ deposits in order to ensure correct profit sharing according to Islamic law.

In recent times, Islamic banks have emerged in Muslim nations such as Saudi Arabia, Egypt, and many others. These banks usually work on the basis of profit-and-loss sharing, and function without interest or usury. Although elimination of interest in all its forms is an important feature of the Islamic financial system, Islamic banking is much more. It aims to eliminate exploitation and to establish a just society by the application of the Shariah or Islamic law to the operations of banks and other financial institutions. To ensure compliance to the Shariah, Islamic banks use the services of religious boards comprised of Shariah scholars.

There is not universal agreement on certain Shariah concepts. To date, the AAOIFI has issued 56 standards on accounting, auditing, governance, ethical, and Shariah standards. These standards have been implemented in leading Islamic banking and finance centers globally, such as Bahrain, Sudan, Jordan, Malaysia, Qatar, and Saudi Arabia, where they are either mandatory or are used as a guideline by the national regulators.

Although Islamic markets and finance have seen unprecedented growth in certain parts of the world, the issue has yet to gain prominence in the agenda of the IASB. The influence of Islamic finance and accounting standard setting in Malaysia is briefly illustrated below.

The Islamic financial system in Malaysia encompasses banking, takaful (or insurance), money markets, and capital markets. Islamic financing has seen unprecedented growth. In Malaysia, for example, the volume traded in the Islamic inter-bank money market has reached RM340 billion to date and the Central Bank reports that the annual growth rate of Islamic banking assets is 15% to 20%.

The Islamic financial transactions in Malaysia have also seen a surge in the use of Islamic leases or Ijarah-based transactions. The form of Ijarah contracts can be compared to conventional leasing arrangements. However, although the principles of Ijarah and conventional leasing are operationally similar, there are fundamental differences between the two that make standards on conventional leasing inadequate under Shariah principles. To date, MASB 10 Leases explicitly excludes any forms of Islamic leases in Malaysia, and an Exposure Draft has been issued specifically for Islamic leases.

Islamic finance is also being experienced in non-Muslim environments or entities. For instance, corporations such as Nestle have floated an Islamic bond (called a sukuk bond), and the Dow Jones maintains an Islamic stock index. The German state of Saxony-Anhalt is due to launch the first Islamic Eurobond, which will be listed on the Luxembourg Stock Exchange.

The foremost principle of AAOIFI is that all Islamic financial institutions should apply, either by regulatory or Shariah requirement, the standards issued by the AAOIFI if such standards are available. If there are no specific standards, the Islamic financial institution may use standards other than those issued by AAOIFI, as deemed appropriate, that do not contravene the Shariah Rules and Principles.

Should the requirements of an alternative be in conflict with Shariah Rules and Principles, and the institution be compelled to use the alternative standards, a disclosure must be made of the point of conflict while adhering to the requirements of Shariah requirements.