Risk transfer versus risk sharing in the Islamic finance contracts: professional accounting view

Size: px

Start display at page:

Download "Risk transfer versus risk sharing in the Islamic finance contracts: professional accounting view"

Patricia Morton
5 years ago
Views:

1 Risk transfer versus risk sharing in the Islamic finance contracts: professional accounting view 1 O M A R M U S T A F A A N S A R I A S S I S T A N T S E C R E T A R Y G E N E R A L A C C O U N T I N G A N D A U D I T I N G A A O I F I

2 Agenda Islamic finance transactions nature and types Risk sharing based transactions vs. risk taking based transactions Criteria for risk and reward determination Impact of risk and reward on the financial accounting matters Risk transfer vs. risk sharing / taking 2

3 What is the difference? 3 Islamic banking provides banking services free from interest by replacing interest based contracts and other impermissible contracts with contracts providing similar returns. However, with regard to the structure and risks and rewards, particularly, at different stages of the transactions, these are quite different from their conventional counterparts. Islamic finance contracts delink the money lending from the financial intermediation services and link the banking transactions directly with the economic resources and economic transactions. As a result these transactions entail the risks of real economic transactions and events, rather than merely the credit risk.

4 Banking transactions risks of subject matter The banking transactions have a direct and an indirect risk. Direct risk is generally the credit risk on the amount due. Indirect risks include the business and operational risks (or even the personal risks in case of consumption loans). Conventional banking is not concerned about the indirect risks, as the subject matter is the money outstanding. 4

5 Banking transactions risks of subject matter Islamic banking transactions entail a complete structure and their subject matter is not money. When the subject matter is different, the risk characteristics of the transaction and the risk profile of the transaction becomes different against conventional financing. True reflection of these risks and the recording and reporting of transaction in line with the same is necessary for the financial reporting framework. 5

Ijarah Ijarah Muntahia Bittamleek Ijarah with gradual transfer / Diminishing Musharaka

6 Islamic finance transactions nature and types 6 Trade based transactions Deferred payment sales (Murabaha) Deferred delivery sales (Salam / Istisna) Lease based transactions Ijarah Ijarah Muntahia Bittamleek Ijarah with gradual transfer / Diminishing Musharaka Profit and loss sharing / participating transactions Mudaraba Musharaka Service based transactions

7 Risk sharing based transactions vs. risk taking based transactions 7 Risk sharing transactions Risk taking transaction Transactions with risk sharing characteristics Mudaraba Murabaha Ijarah (risks and rewards incidental to ownership) Musharaka Salam Istisna

8 Criteria for risk and reward determination Mostly the criteria of recognition of asset and revenue from Shari a perspective is the same as per generally accepted accounting principles. This is applicable in most of the Islamic finance transactions based on trade and lease. 8

9 Change of risk profiles 9 In Islamic finance contracts, at times the risk profile changes according to the flow of the transaction. Inventory Advance Murabaha receivable Unsecured credit risk on supplier Market risk and operations risk related to inventories Secured credit risk on customer

10 Impact of risk and reward on the financial accounting matters Financial accounting shall reflect the economic substance of the transaction. Users of the financial statements shall be aware of the necessary characteristics of the assets, liabilities and transactions including the aspects related to relevant risks and rewards. 10 Certain stakeholders like regulators also need information with regard to the related risks and their impact on the risk rating, as well as, capital adequacy of the institution.

11 Link of Shari a compliance and accounting treatments In most of the situations the level of Shari a compliance in Islamic finance transactions will determine the accounting treatment. 11 If the transaction genuinely entails risk and reward transfer, it will meet most of the criteria for asset and revenue recognition under generally accepted accounting principles.

12 Example of Ijarah under IAS IAS 17 puts the acid test of the type of transaction on the fact as to whether or not, the risks and rewards incidental to ownership are transferred to lessee at inception of lease. Paragraph 10/11 provide indicators, yet, paragraph 12 puts the matter of determination on the risks and rewards irrespective of whether these indicators are met.

13 Risk transfer vs. risk sharing / taking impacts In short, a conventional lending carries only the credit risk and all the other risks including operational, business and market risks are transferred to the borrower. In Islamic finance contracts, depending on the nature of the contract, the Islamic financial institution carries or shares the other risks of real transactions for some period of time, or throughout the tenure of the transaction. 13

14 Need for separate accounting and regulatory standards Considering these matters, the Islamic financial institutions need increased guidance on the accounting and regulatory reporting matters. AAOIFI is working on the accounting part of such information need. 14 Islamic Financial Service Board (IFSB) is focusing on the regulatory standards in this area.

15 Thank you! 15

Accounting, Auditing & Corporate Governance Standards for Islamic Banks & Islamic Financial Institutions with reference to AAOIFI

Accounting, Auditing & Corporate Governance Standards for Islamic Banks & Islamic Financial Institutions with reference to AAOIFI About AAOIFI The Accounting and Auditing Organization for Islamic Financial