The issue with Islamic Financial Institutions (IFIs including Islamic Banks and takaful Operators) is their dependence on Sharia contract types with which to define their various bilateral transactions. Contract types are a unique feature of sharia compliant transactions. Unlike modern contracts for which the terms and conditions binding the parties to the contract are set out in detail within the contract, with contract types the name of the contract (and thus the “contract type”) already predefines the obligations of the parties to the transaction. Thus, given that the contract type predefines the obligations of the parties to the transaction, there is little room for misunderstanding as to the required performance under the contract. All that is left for parties to the contract to do is to agree on the monetary compensation each party expects from the transaction.
Islamic banking relies heavily on the various Sharia contract types to package “modern” banking products. Let us consider one very common Islamic banking product in Malaysia, Ijarah Muntahia Bittamleek. Under this product there is effectively a lessee (the bank customer) and the lessor (the bank). During the term of the Ijarah (the lease period), the lessee is only deemed to be renting the assets. In addition to the Ijarah contract, there is also a promise (wa’ad) by the lessor to sell the assets, and correspondingly a promise by the lessee to purchase the assets, at the end of the Ijarah period. Thus, at the end of the contract period, a separate sale and purchase agreement is entered into where effectively the lessee buys the assets from the lessor at a predetermined price. However, the Islamic bank’s financial statements, prepared in Malaysia under IFRS, would recognise this arrangement as only one transaction and not two transactions. In this circumstance this transaction is recorded as a “hire purchase” agreement by combining both sharia contracts. The Sharia contract types used in the transaction would instead be included as disclosures to the accounts.
This in a nutshell is the accounting conundrum currently facing the takaful operators in Malaysia. The Malaysian Accounting Standards Board (MASB), in a recent paper (the Paper) on the application of IFRS 17 to takaful entities, recommended that from the perspective of the takaful entity as a whole, the combined Takaful Funds and Takaful Operators activities would constitute insurance services to be accounted for under MFRS 17. Effectively while the MASB recognizes the need to retain the current practice under IFRS 4 with the columnar approach (in particular, the need to show a separate column for the transactions under the Takaful Funds) at the takaful entity level, when considering substance over form the takaful operator is instead conducting insurance services. This conclusion is based on the requirement under paragraph 95 of the Islamic Financial Services Act 2013 that requires the takaful operator to provide a qard (an interest free loan) or other forms of financial support to the Takaful Funds should the Takaful Funds run into insolvency issues. So how exactly do you interpret substance over form? In the International Accounting Standards Board’s (IASB) Conceptual Framework for Financial Reporting 2010 (see the Appendix for an explanation of the purpose and history of the Conceptual Framework), it is set out under paragraph BC 3.26 that: Substance over form is not considered a separate component of faithful representation because it would be redundant. Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. Representing a legal form that differs from the economic substance of the underlying economic phenomenon could not result in a faithful representation. We can draw the following conclusions from this paragraph:
- The IASB is concerned that the financial accounts may not faithfully represent the economic substance of the underlying economic phenomenon if the consideration is based purely on its legal form.
- Clearly the IASB standards are not there to change the “underlying economic phenomenon” but rather to ensure that the entity’s accounts faithfully represent such economic phenomenon. iii) The paragraph BC 3.26 does not define circumstances in which the economic substance indeed differs from the legal form of the transaction. This is left for the account preparers and their auditors to decide.
In the case of the Ijarah Muntahia Bittamleek and its accounting as a hire purchase contract in the Islamic bank’s financial statement, this can be argued as a good example of the application of the principle of substance over form. Effectively from the expected economic outcome perspective to both the bank and its customer this is similar to a hire purchase arrangement. However, the conclusion is not as simple when one considers the business of takaful. Specifically, notwithstanding the “fancy” Sharia contract types applied in takaful, is takaful simply no more than a plain vanilla insurance company in the eyes of the MASB?
IFRS Standards (the Standards) are based on the “expected” model; the model considers something which has not yet occurred but is expected to occur. This is a change from the Standards’ previous dependence on the “incurred” model. This change can be clearly seen in the migration from IFRS 139 to IFRS 9 with the application of the “Expected Credit Loss” (ECL) model to the reporting entity’s financial assets. Now with ECL comes the application of the concept of “probability”.
Indeed paragraph 4.40 of the 2010 Conceptual Framework refers to the use of probability when determining future economic benefits: The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. The concept is in keeping with the uncertainty that characterises the environment in which an entity operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared. For example, when it is probable that a receivable owed to an entity will be paid, it is then justifiable, in the absence of any evidence to the contrary, to recognise the receivable as an asset. For a large population of receivables, however, some degree of non-payment is normally considered probable; hence an expense representing the expected reduction in economic benefits is recognised.
Accountants were not the first to use probability in determining the value of an obligation. Insurance is based on probability and the law of large numbers. It is because of this operating model that your insurance premium is only a fraction of the amount payable by the insurer should an insured claim arise. Insurance is also about risk transfer, where the insurer agrees to underwrite a risk that the insured carries in exchange for a predefined premium. It is important to realize, however, that notwithstanding the amount of computing power at hand, the insurer is still at risk of making an underwriting loss if the premiums collected are insufficient to cover its financial obligations. This risk transfer is what makes insurance non-sharia compliant. Instead of risk transfer to a third party, takaful provides the same protection to the insured through risk sharing among the participants in the takaful fund. Notwithstanding that, in the same way that it is impossible for the insurer to determine in advance whether premiums collected would be sufficient to cover claims, under takaful it would also be impossible to determine whether the tabarru’ collected is sufficient to pay claims. As it would be futile to go back to takaful participants to ask for additional tabarru’ payments should a deficit arise, the concept of qard was introduced.
This qard, if utilized, is repayable from the future surpluses expected from the takaful fund. When determining, should a qard arise, whether a risk transfer has actually occurred, the concept of probability needs to be applied. Specifically, what are the chances that the takaful fund would be unable to repay the qard? Indeed, in Malaysia in most cases the takaful fund has been able to repay any qard to the takaful operator. To my knowledge, in the one case that the qard was not repaid, this can be attributed to operational issues experienced by the operator for which it may rightly be considered that the operator is liable for the ensuing loss. Thus, does the off-chance that the qard may not be repaid make takaful a risk transfer, and hence insurance, from the economic perspective of the shareholders of the takaful entity? This I think is key to determining whether in the case of takaful, form is indeed different from substance. If the takaful business were designed to have a perpetual qard outstanding, then certainly it is not takaful but is instead insurance in the guise of takaful. However, if there is, say, only a 10% chance that the qard will not be repaid, why label the takaful entity’s activity “insurance”? This is something the account preparers would have to decide.
Finally, in a Mutual insurer, the Mutual can issue subordinated debts to external lenders to address any insolvency issues within the Mutual. The Mutual may subsequently default on such loans, but does that make the Mutual less of a mutual? Are the subordinated bond holders carrying the underwriting risk within the Mutual fund or are they simply taking credit risk?
The discussions with the accounting fraternity in Malaysia as to the accounting treatment of takaful under IFRS 17 is ongoing. Given that the application of IFRS 17 has been deferred to 2023, there is still time for the various stakeholders to come together and agree on the application of the standard to takaful. A word of caution though, given the time required to implement IFRS17 and the practical challenges of implementation under COVID-19 conditions which can extend until 2021 and beyond, these takaful issues need to be discussed and resolved during 2020.
Zainal Abidin Mohd Kassim June 2020
IASB’s Conceptual Framework for Financial Reporting
The Conceptual Framework’s purpose is to assist the IASB in developing and revising IFRSs that are based on consistent concepts, to help preparers to develop consistent accounting policies for areas that are not covered by standards or where there is a choice of accounting policy, and to assist all parties to understand and interpret IFRS.
In the absence of an IFRS Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making the judgement management is required to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses.
The IASB views the Conceptual Framework as a practical tool to help it develop Standards. Hence, the Conceptual Framework includes concepts that help the IASB develop Standards and also discusses the factors the IASB needs to consider in making judgements when application of the concepts does not lead to a single answer. In summary, the purpose of the Conceptual Framework is:
· to assist the IASB to develop Standards based on consistent concepts, resulting in financial information that is useful to investors, lenders and other creditors
· to assist preparers of financial reports to develop consistent accounting policies for transactions or other events when no Standard applies or a Standard allows a choice of accounting policies
· to assist all parties to understand and interpret Standards Importantly though the Conceptual Framework is not a Standard and does not override any specific IFRS.
The effective date for the Conceptual Framework 2018 (which is the updated version of the Conceptual Framework, see History below) is for annual periods beginning on or after 1st January 2020 for preparers who develop an accounting policy based on the Conceptual Framework.
History of the Conceptual Framework
The Framework was first approved by the IASC Board (the old name of IASB) and issued in April 1989 as the Framework for the Preparation and Presentation of Financial Statements. It was subsequently published in July 1989 but was only adopted by the IASB in April 2001.
In September 2010 an updated Conceptual Framework for Financial Reporting 2010 was approved by the IASB. Subsequently, in March 2018 a more comprehensive Conceptual Framework for Financial Reporting 2018 was published.
The Conceptual Framework 2018 sets out:
· the objective of financial reporting
· the qualitative characteristics of useful financial information
· a description of the reporting entity and its boundary
· definitions of an asset, a liability, equity, income and expenses
· criteria for including assets and liabilities in financial statements (recognition) and guidance on when to use them
· concepts and guidance on presentation and disclosure
Although the effective date for the Conceptual Framework is for annual periods beginning on or after 1st January 2020 for preparers who develop an accounting policy based on the Conceptual Framework, it applied immediately for the Board and the IFRS Interpretation Committee.