Vol.

2 , Issue 1/2018

► PEER-REVIEWED
Accounting for
Islamic Finance:
Application
of IFRS and the
Shari’ah differences
► EDITORIAL
Islamic Finance Reporting: Focus has to be on realizing the objectives

► TECHNICAL ARTICLE
Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis
in the Perspective of IFRS 9

► INDUSTRY UPDATE
Islamic Finance Development in 2017: Towards Sustainability

Bank Muscat - Meethaq

is the proud lead sponsor of JOIFA AAOIFI´s Technical Bulletin
Become an AAOIFI
Certified Islamic Professional
Accountant “CIPA”
The 'CIPA' Fellowship program is aimed at developing top-quality human resources in the
field of Islamic finance accountancy. First launched in 2006, and recently revamped over a
period of three years, the new CIPA program comprises of 4 modules and a 1-year Practical
Experience Requirement (PER).

Register today and become part of the +1800 AAOIFI Fellows who have mastered the
AAOIFI standards and are now enjoying decision-making roles as CFOs, Directors &
Partners at top professional firms, and Internal & External Shari'ah Auditors.

For further details, visit us at www.aaoifi.com

KINGDOM OF BAHRAIN
Tel: +973 17 244 496
Fax: +973 17 250 194
 AAO I F I ´s Te c h n i c a l Bu l l e t i n
JOIFA seeks to publish original theoretical or
empirical research papers in English; reports from
conferences and symposiums; developments in
the field of Islamic accounting and related areas
including auditing, Sharia auditing, governance, tax,
corporate laws, ethics etc., (collectively mentioned as
accountancy); and book reviews; as well as, documents
ISSN 2535 - 9746 and archives related to Islamic accountancy.

Vol. 2 , Issue 1/2018

Bank Muscat - Meethaq
is the proud lead sponsor
of JOIFA
MESSAGE
• MESSAGE OF THE • Editorial Team:
ACTING SECRETARY GENERAL, AAOIFI 3 Editor: Muhammad Ayub
Managing Editor: Omar Mustafa Ansari
AAOIFI UPDATES Sub-Editor & Secretary: Dr. Irum Saba

• Technical Updates 4 Associate Editors: Farhan Noor

• Professional Development Updates 9 Syed Siddiq Ahmed

EDITORIAL • Editorial Board:

Dr. Adel Sarea
• Islamic Finance Reporting:
Focus has to be on realizing the objectives 10 Dr. Shahul Hameed Ibrahim
Dr. Bello Lawal Danbatta

PEER-REVIEWED PAPERS Irshad Mahmood

Muhammad Nadeem Aslam
• Accounting for Islamic Finance:
Application of IFRS and the Shari’ah differences 13
• Advertising & Marketing:
Mohamad Khaled
• Strengthening the Shari’ah Governance for
Islamic Banking Institutions: The case of Pakistan 23
• Design:

TECHNICAL ARTICLES Yaser Rifat

• Towards Broader Understanding of AAOIFI’s • Contact us:

FAS 30:Impact analysis in the perspective of IFRS 9 3 5 P.O. Box: 1176, Manama,
Kingdom of Bahrain
• AAOIFI’s FAS 30: Impairment, Credit
Losses and Onerous Commitments 43 Tel : +973 17244496
Fax: +973 17250194

INDUSTRY UPDATES Editorial Office: editor.joifa@aaoifi.com

Website: http://www.aaoifi.com
• A New Approach to Corporate Governance:
Embodying the core values of Shariah objectives
• For Advertising & Marketing:
in developing growth strategies 53
mkhaled@aaoifi.com
• Islamic Finance Development in 2017: Towards yrifat@aaoifi.com
Sustainability 58

• Islamic Banking: © 2018 AAOIFI All Rights Reserved

A new player in the Eurozone SRI Market 62
MESSAGE OF
Mr. Omar Mustafa Ansari
ACTING SECRETARY GENERAL, AAOIFI

It gives me immense pleasure to present, on

behalf of the AAOIFI Secretariat, the second issue of
AAOIFI’s Journal of Islamic Financial Accounting
– JOIFA.

Firstly, we would like to thank the industry

and the experts on the overwhelming support
and encouragement that they demonstrated on
the maiden issue of JOIFA. The way we were
encouraged and supported, was phenomenal to say
the least. It helped us greatly in preparing better
for the second issue, which is now in your hand.
We also thank for the critical comments received,
as these will help us greatly in improving the end
product, in the times to come InshaAllah.
Mr. Omar Mustafa Ansari
Secondly, we would like to thank the contributors
Acting Secretary General, AAOIFI
to the current issue, including the authors, the peer
reviewers and the editorial team; as without their
hard work, this issue would not have been in your As a quick recap of our recent activity, we would
hand. also like to update you that over the last six months
AAOIFI published three new accounting standards
It cannot be over emphasized that with the growing and two governance / auditing standards, taking
international presence of Islamic finance there is the total to 108 issued standards, besides several
an equally increasing need for robust and in-depth exposure drafts issued for Shari’ah, accounting
research for the industry’s standards to be in line with and governance standards. In this period, AAOIFI
the globally accepted reporting standards. AAOIFI held three Shari’ah Board, two Accounting Board
has already been playing its part, but taking a step and two Governance and Ethics Board meetings
further, JOIFA aims to provide a breeding ground and conducted 19 public hearing events in multiple
for new research to target areas of convergence with countries.
them. This is also an endeavor to forge stronger ties
between Shari’ah, academia, professionals and the Last, but not the least, we would like to express
industry. We anticipate and plan in a manner that the our gratitude for the great support provided by
papers published in JOIFA with robust technical and Bank Muscat – Meethaq as the lead sponsor to the
academic scrutiny will be able to feed into AAOIFI’s project.
standard setting process, in due course.
With much aspiration ahead, we wish you an
The objective of JOIFA is not only to publish up- enriching read of this issue, and look forward
to-date, high-quality and original research papers towards your support, both in terms of your
but also to publish alongside, relevant and insightful constructive feedback for the improvement and
technical papers, case studies, industry and your contributions to JOIFA.
AAOIFI updates. It aspires to be vibrant, engaging
and accessible, and at the same time, integrative
and challenging. Research papers, will be more
traditional in form and will demonstrate a sound
theoretical and / or methodological underpinning
and a clear contribution to knowledge in the areas
of AAOIFI’s core mandates. Needless to say, any
papers that you wish to submit, either individually
or collaboratively, are much appreciated and
will make a substantial contribution to the early
development and success of JOIFA.

Vol. 2 , Issue 1/2018 3

AAOIFI Updates

AAOIFI welcomes IMF endorsement of IFSB’s CPIFR

AAOIFI is delighted to note and congratulates the Islamic Financial Services Board (IFSB) on receiving an
endorsement from the Executive Board of the International Monetary Fund (IMF) of its proposal on ’Core
Principles for Islamic Finance Regulation (CPIFR)’, which it developed alongside the Secretariat of the Basel
Committee on Banking Supervision (BCBS). AAOIFI believes that the CPIFR will prove to be a leap forward
for the Islamic finance industry in strengthening its presence in different financial jurisdictions around
the globe. CPIFR are intended to provide a set of core principles for the regulation and supervision of the
Islamic banking industry and are designed to take into consideration the specificities of Islamic banks.

The IMF Board rightly noted that Islamic banks undertake distinct operations with risk profiles and
balance sheet structures that differ in important respects from conventional banks, with associated financial
stability implications. The approach to regulating and supervising Islamic banking should reflect the nature
of risks to which Islamic banks are exposed and the financial infrastructure needed for effective regulation
and supervision, which requires additional or different regulation and supervisory practices to address
risks inherent in the Islamic banking operations.

The CPIFR will complement the international architecture for financial stability, while providing
incentives for improving the prudential framework for Islamic banking industry across jurisdictions. The
CPIFR and their associated methodology will be applied in financial sector assessments undertaken in fully
Islamic banking systems and, as a supplement to the Basel Core Principles for Effective Banking Supervision
(BCP), in dual banking systems where Islamic banking is systemically significant (15 percent or more).

AAOIFI Conferences:
The 16th Annual Shari’ah Conference (April 2018)
AAOIFI’s 16th Annual Shari’ah Conference was held on 8 and 9 April 2018, in the Kingdom of Bahrain under
the auspices of the Central Bank of Bahrain. The event featured participation from distinguished speakers
consisting of 30 experts from around 15 countries. The conference comprised panel sessions as well as the
presentation of a number of research papers across seven sessions of the two-day conference. AAOIFI’s
Annual Shari’ah conference is a key global event across the global Islamic finance industry which discusses
most relevant and important Shari’ah issues and topics, both in theory and practice.

As such, it is a much-anticipated event by the industry’s leaders, experts, and professionals. This year’s
event was attended, as usual, by high-profile participants including dignitaries and ministers, senior officials,
honorable Shari’ah scholars, representatives of the World Bank and international organizations, central banks,
and regulatory and supervisory authorities, as well as a host of Islamic financial institutions’ personnel
and senior managers, representatives of accounting and auditing firms, legal firms, universities and higher
education institutions, and the media, from around the world.

The 12th Annual AAOIFI–World Bank Conference (Nov 2017)

The 12th AAOIFI-World Bank Annual Conference with the theme: “Towards Quantitative Growth and
Standardization of Islamic Finance” was held on 5 and 6 November 2017 in the Kingdom of Bahrain, under
auspices of the Central Bank of Bahrain and in partnership with the World Bank. The conference consisted of
seven sessions, attended by 889 delegates from 48 countries and 33 speakers and panelists from 16 countries.

The conference hosted prominent keynote speakers, including H.E. Dr. Ahmed Abdulkarim Alkholifey,
Governor, Saudi Arabian Monetary Authority and H.E. Dr. Ahmad Mohamed Ali Al Madani (Ex-President of
IDB Group). The conference discussed a number of key topics that converge with its main theme through a
number of panel discussions, presentations, and research papers covering an array of focused topics.

The AAOIFI-World Bank Conference is one of the key annual, technical and professional events for the
Islamic finance industry, which has been keenly attended by a vast number of the industry’s figures, experts
and specialists, practitioners, representatives of senior management of Islamic financial institutions, accounting
and auditing firms, legal firms, higher-education institutions, the media establishment from across the global
Islamic finance industry.

4 Vol. 2 , Issue 1/2018

 Bahrain - Pakistan - Riphah
Bahrain - BIBF Pakistan - ICAP Pakistan - ICAP Bahrain - UOB
AAOIFI Office Intl University

1st Nov 15th Nov 16th Nov 27th Dec 5th Apr AAOIFI Updates
30th Apr
2017 2017 2017 2017 2018 2018

Boards’ Meetings:
Public Hearings conducted for Accounting
Meeting No. 51standards
of the AAOIFI Shari’ah Board was
held in Makkah, Kingdom of Saudi Arabia from 28
December 2017 to 31 December 2017. The meeting
During the last six months, AAOIFI held eight
discussed the comments of the public hearings of
technical board meetings to discuss various GSIFI 10 Ratings
draft Shari’ah standard on Sale of Debt.
exposure draftsASIFI 6
of the standards ASIFI 6and standards GSIFI 9 GSIFI 9
under progress.
External Shari'ahThe
Audit brief activity of Audit
External Shari'ah such meetings Shari’ah
Shari'ah Compliance Function Board’s
Shari'ah meeting Nos. GSIFI
Compliance Function 52 and 10 Ratings
53 which
is summarized below: were held in Medina Munawwarah, Saudi Arabia
Bahrain - Pakistan -
Bahrain - BIBF Pakistan - ICAP
Al Baraka HQ from 8 March Turkey -2018
KGK to 10 March 2018Riphahand 26 April
Intl University
AAOIFI Shari’ah Board: 2018 28toMar28 April 2018, respectively, discussed the
1 Nov st 14 Nov 4 Feb
th th
30 Apr th th

AAOIFI
2017 Shari’ah Board2017 held its meeting No. 2018
50 in exposure2018 draft of Shari’ah standard 2018 on Sale of Debt
the Kingdom of Bahrain on 16-18 November, 2017. and the notes of the public hearings of the standard
Public Hearings conducted for
The exposure draft of Waqf standard was presented onGovernance
Waqf. standards
in the meeting for discussion and deliberation.

Waqf

Algeria -
Sale of Debt Waqf Islamic Supreme Council Waqf Waqf

Sudan - Morocco - Kuwait -

Malaysia - ISRA Riyadh - Future Inv
Islamic Fiqh Academy Al Maali Grp Shura Shari'ah Con

3rd Nov 11th Dec 14th Dec 15th Dec 20th Dec
2017 2017 2017 2017 2017

Public Hearings conducted for Shari’ah standards

AAOIFI Accounting Board:
AAOIFI Accounting Board (AAB) held its eighth The ninth meeting of the Board was held on 24
meeting on 29 and 30 December 2017 in Bahrain. and 25 March 2018 in Bahrain. The Board approved,
The Board approved, in principle, the Financial in principle, the Financial Accounting Standard
Accounting Standard (FAS) 31 ‘Investment Agency (FAS) 34 Financial Reporting for Sukuk-Holders’
(Al-Wakala Bi Al-Istithmar)’ and FAS 29 ‘Sukuk in and exposure draft of Revised FAS 25 ‘Investment
the Books of the Issuer’. in Sukuk, Shares and Similar Instruments’.

FAS 29 - Sukuk issuance FAS 29 - Sukuk issuance FAS 31 - Investment Agency FAS 31 - Investment Agency FAS 35 FAS 35
(Sukuk in the books of the issuer) (Sukuk in the books of the issuer) (Al-Wakala Bi Al-Istithmar) (Al-Wakala Bi Al-Istithmar) Risk Reserve Risk Reserve

FAS 34 - Financial FAS 34 - Financial

(Reporting for Sukuk-holders) (Reporting for Sukuk-holders)

Bahrain - Pakistan - Riphah

Bahrain - BIBF Pakistan - ICAP Pakistan - ICAP Bahrain - UOB
AAOIFI Office Intl University

1st Nov 15th Nov 16th Nov 27th Dec 5th Apr 30th Apr
2017 2017 2017 2017 2018 2018

Public Hearings conducted for Accounting standards

AAOIFI
FAS 29Governance and
- Sukuk issuance FAS 29 -Ethics Board:
Sukuk issuance Governance
FAS 31 - Investment Agency and Agency
FAS 31 - Investment Ethics Board
FAS 35 (AGEB)FAS
on355 and 6
(Sukuk in the books of the issuer) (Sukuk in the books of the issuer)
March(Al-Wakala
(Al-Wakala Bi Al-Istithmar)
2018 BiatAl-Istithmar)
AAOIFI Head office in Risk
Risk Reserve
Bahrain.
Reserve
The
AAOIFI FAS held the sixth meeting
34 - Financial of its Governance
FAS 34 - Financial
Board deliberated on
GSIFI 10 Ratings the exposure draft of ‘Waqf
and Ethics Board (AGEB) (Reporting
(Reporting for Sukuk-holders)
on 6-7 December 2017 at
for Sukuk-holders)

ASIFI 6 ASIFI 6 GSIFI 9 Governance’. GSIFI In 9 addition, Sukuk Governance

AAOIFIExternalhead office in Bahrain. The
External Shari'ah Board
Audit adopted GSIFI 10 Ratings
Pakistan - Riphah
Shari'ah
Bahrain - BIBF Audit Pakistan - ICAP Shari'ah Compliance
Pakistan standard
- ICAP Function andUOB Internal
Shari'ah-Compliance
Bahrain Shari’ah
Function Bahrain -
Audit preliminary
auditing standard on ‘External Shari’ah Audit’ and AAOIFI Office Intl University

studies were presented to the Board that- discussed

exposure
1 Nov
st
draft of governance
Bahrain - BIBF 15 Nov standard
th
Pakistan - ICAP on ‘Shari’ah
16 Nov Bahrain -
th
27 Dec th
Turkey - KGK 5 Apr Pakistan
30
th
Apr th

2017 2017 2017 Al Baraka HQ

the 2017
key areas of the 2018projects and Riphah
2018the general
Intl University
Compliance and Fiduciary Ratings for Islamic
1 Nov 14 Nov th
4 Feb th
approach
28 Mar and directed the relevant
th
30 Apr working group
th

2017 Institutions’. Public Hearings conducted for Accounting standards 2018

st

Finance 2017 2018 2018

to start documenting the exposure draft
AAOIFI held the seventh meeting of its
Public Hearings conducted for Governance standards

GSIFI 10 Ratings

ASIFI 6 ASIFI 6 GSIFI 9 GSIFI 9

External Shari'ah Audit Waqf Function GSIFI 10 Ratings
External Shari'ah Audit Shari'ah Compliance Shari'ah Compliance Function

Algeria -
Sale of- BIBF
Bahrain Debt Waqf
Pakistan - ICAP
Bahrain - Supreme Council
Islamic TurkeyWaqf
- KGK Waqf
Pakistan -
Al Baraka HQ Riphah Intl University

1st Nov 14 Novth

4 Feb
th
Sudan - 28 Mar th
Morocco - 30 Apr
th
Kuwait -
Malaysia - ISRA 2017 Riyadh - Future Inv 2018
2017 Islamic Fiqh Academy 2018 Al Maali Grp 2018
Shura Shari'ah Con

3rd Nov
Public
11 Dec
Hearings conducted
14 Dec
for Governance
15 Dec
standards
20 Dec
th th th th

2017 2017 2017 2017 2017

Public Hearings conducted for Shari’ah standards

Vol. 2 , Issue 1/2018 5
Waqf

Algeria -
AAOIFI Updates

Delegation of Islamic Bank of Afghanistan Co-Signed

Admission Agreement as Institutional Member of AAOIFI
At AAOIFI’s premises, in Kingdom of Bahrain, Islamic Bank of Afghanistan has been officially admitted
as institutional member of AAOIFI, on a signing ceremony, chaired by H.E. Shaikh Ebrahim bin Khalifa Al
Khalifa, Chairman of AAOIFI’s Board of Trustees, and H.E. Mr. Amer Khalil ur Rahman, Chief Executive
Officer, Islamic Bank of Afghanistan (IBA).
During the visit, Mr. Omar Mustafa Ansari, AAOIFI’s Acting Secretary General, delivered a detailed
overview on AAOIFI’s recent activities and achievements as well as the all-important role assumed by
AAOIFI as a standard setter, including the mechanism it follows in developing its standards, and the on-
going projects, in addition to the potential areas of cooperation between the two institutions at various levels.

Free Access to Online Version of AAOIFI Shari’ah Standards

Arabic and English online versions of AAOIFI’s Shari’ah Standards so far issued have been made accessible
and downloadable for personal use through AAOIFI’s website and social media portals. This includes any
yet to-be issued, reviewed or updated Shari’ah standards up to 1 January 2020. In this regard, an official
signing ceremony was held for signing an agreement at the headquarters of the Saudi-British Bank (SABB)
in Riyadh, Saudi Arabia. The bank will sponsor the online version of the standards for two years.

A A OIFI S ta n dar ds Updat e

New AAOIFI Standard issued:
Over the course of last six months, AAOIFI
issued 2 Accounting standards and 1 Governance
standards. The details are summarized below:
Accounting Standards issued:
FAS 28 “Murabaha & Other Deferred Payment Sales”:
This standard aims at setting out the accounting
rules for measurement, recognition and disclosure
of the transactions of Murabaha and other deferred
payment sales that are carried out by Islamic
financial institutions. However, this standard shall
not apply to investments made in instruments like
equity instruments or Sukuk, where the underlying
asset for such instrument is any Murabaha or
deferred payment sale. It will also not apply on
Commodity Murabaha and Tawarruq transactions
on which a separate standard is already in the
development phase. Overall approach towards
development of the standard included a focused
effort to bring the standard closer to the international
best practices of accounting, without compromising
Shari’ah principles and rules. The revised standard
supersedes earlier FAS 2 “Murabaha and Murabaha
to the Purchase Orderer” and FAS 20 “Deferred
Payment Sales”.
FAS 30 “Impairment, Credit Losses and Onerous
Commitments”:
This standard sets out the classification of assets
and exposures in view of credit risk and other risks
involved. The idea is to apply the forward looking
approach in line with other standard setters for the
assets and instruments that are financial instruments
from Shari’ah perspective. It also defines other
globally acceptable impairment and write down
and provisioning approaches for other assets and
exposures, without compromising on Shari’ah
principles. It further covers situations where onerous
commitments exist which mandate a provision
for anticipated losses on the same. This standard
provides the related accounting treatments for the
credit losses approach, impairment approach and net
realizable value approach including provisions for
onerous contract or commitment to acquire an asset.
The revised standard, along with the FAS 35 “Risk
Reserves”, which is under finalization stage, is to
supersede earlier FAS 11 “Provisions and Reserves”.
FAS 31 “Investment Agency (Al-Wakala Bi Al-
Istithmar”:
The objective of this standard is to establish the
principles of accounting and financial reporting for
the investment agency (Al-Wakala Bi Al-Istithmar)
instruments and the related assets and obligations
from both the principal (investor) and the agent
perspectives. Earlier there was no standard on
this topic, and the increasing use of these products
in Islamic finance mandated an accounting
standard on the topic. The standard provides a
broad classification where at the inception of the
transaction, the principal (investor) shall evaluate
the nature of investment as either a ‘pass-through

6 Vol. 2 , Issue 1/2018


investment’ – as a preferred option; or the ‘Wakala
venture’ approach. On the other hand, the agent
shall generally keep the assets off-balance sheet as
these relate to the principal, unless the specified
criteria for on-balance sheet accounting are met
under different situations.
Governance / Auditing Standard issued:
ASIFI 6 “External Shari’ah Audit:
AGEB issued its Auditing Standard for Islamic
Finance Institution (ASIFI) No. 6 “External Shari’ah
Audit (Independent Assurance Engagement on
an Islamic Finance Institution’s Compliance with
Shari’ah Principles and Rules)”. This standard
provides comprehensive guidance to professionals
who perform external Shari’ah audits of Islamic
Financial Institutions in line with the global best
practices. The standard outlines the criteria for
performing a direct external Shari’ah audit and an
attestation external Shari’ah audit. It specifies the
subject matter and subject matter information and
provides guidance on principal procedures and key
considerations for such engagements. The standard
also includes the reporting formats in preparing
the external Shari’ah auditor’s report, in line with
industry best practices.
Exposure Drafts issued:
During the last six months, AAOIFI issued
Exposure Drafts of 3 Accounting standards and 2
Governance standards. The details are summarized
below:
Accounting Exposure Drafts issued:
• FAS 29: Sukuk Issuance
• FAS 34: Financial Reporting for Sukuk-holders
• FAS35: Risk Reserves
Governance Exposure Drafts issued:
• GSIFI 9: Shariah Compliance Function
• GSIFI 10: Shari’ah Compliance and Fiduciary
Ratings for Financial Institutions
Other Standards’ updates:
Ratified Amendment to the Guidance Note 1 on
Reporting of “KEY AUDIT MATTERS (KAM)
The AAOIFI Governance and Ethics Board (AGEB),
upon the recommendation of the AAOIFI Professional
Auditing Standards Committee (PASC) ratified an
amendment to the Guidance Note No. 01 on reporting
of “Key Audit Matters” (KAM). The objective of
the amendment is to allow one year deferment
for application of Guidance Note No. 01 in view
of numerous requests received from professional
practice firms and industry desiring guidance on
a uniform audit report. It is generally believed that
practitioners and stakeholders in the industry have
not been given enough time to prepare for reporting
and dealing with KAMs.
AAOIFI Updates
AAB Approved Transitional Arrangement for Early
Adoption of FAS 30
AAB approved the early adoption of FAS 30 along
with the existing provisions related to reserves in
FAS 11. The Board noted that although the exposure
draft for FAS 35 “Risk Reserves” has already been
issued, the finalization of the same would need some
time to complete the due process. Therefore, the
Board decided to allow a transitional arrangement:
“Islamic Financial Institutions (IFIs) may early
adopt FAS 30 “Impairment, Credit Losses and
Onerous Commitments” (in line with paragraph 62
of FAS 30), with effect from 01 January 2018. In such
situation, they shall also apply the existing clauses
of FAS 11 “Provisions and Reserves” related to risk
reserves (paragraphs 3/1 to 3/5/5 of FAS 11). This
transitional arrangement shall be applicable till the
period beginning on or after the date of issuance of
FAS 35.”
AAB Approved Amendment to FAS 25: “Investment
in Sukuk, Shares and Similar Instruments”
The objective of this amendment to FAS 25 is
to allow the accounting for debt-type instruments
under the third category of “investment at fair
value through equity” in line with the global best
practices. Different comments from the industry
indicate that IFRS 9 allows this third category,
and Islamic banks feel deprived because this is not
currently allowed by AAOIFI FAS 25. Therefore,
Islamic banks, particularly investment banks are
at a comparative disadvantage. While FAS 25 is
being revised (and exposure draft of the revised
standard already in pipeline), it is understood that
this treatment will be allowed, it was considered
important to allow the same for the current year
with immediate effect.
CLARIFICATION:
The abstract of article published in JOIFA’s
first issue titled: A Comparison of MASB and
AAOIFI Accounting Conceptual Frameworks,
on page 30 states “..conceptual framework of
the MASB shows substantial replication of the
AAOIFI conceptual framework”. MASB has
provided following clarification in this regard:
“MASB first issued its Framework for the
Preparation and Presentation of Financial
Statements in June 2007, which was an adoption
of the framework issued by the International
Accounting Standards Board (IASB) in 1989. In
November 2011, it adopted a revised Conceptual
Framework for Financial Reporting issued by
the IASB in 2010, which superseded the earlier
conceptual framework. AAOIFI Conceptual
Framework was issued in July 2010”
Vol. 2 , Issue 1/2018 7
AAOIFI Updates

A A O I F I S ta nda rds Rev iew/Rev ision P r oject

With rapid expansion of Islamic finance industry over the past few decades, it has become an increasingly
important component of the global financial architecture. Present-day Shari’ah-compliant products and
services cover a variety of product structures in a wide spectrum of financial markets, including banking,
capital markets, Asset management and insurance (takaful) markets. AAOIFI’s mandate is especially
pressing in the light of this expansion and to cater to more diverse international stakeholders with
extensive financial reporting requirements.

Additionally, in its pursuit to issue comprehensive standards to the global Islamic finance industry and
to keep up with global best practices, AAOIFI has initiated a project to revisit existing financial accounting
standards (FASs) and to review and revise them. The exercise will entail detailed analysis of each standard,
including benchmarking against other comparable standards and global best practices to identify and
recommend areas of improvement or a thorough overhaul.

The scope will also include a wide-ranging survey by AAOIFI Secretariat through which views and
comments from the stakeholders are gathered and presented to a dedicated working group formed for the
purpose. AAOIFI welcomes your participation in this initiative in the form of your feedback, comments,
or suggestions to any of its standards. You may kindly send them to accounting@aaoifi.com.

AAOIFI held its 10th Accounting

Board meeting and Public Hearing
of its standards in Lebanon
Meets Governor and Vice Governor of BDL
New Board Members
AAOIFI is pleased to announce appointment of
new members to its Accounting and Governance
Boards to fill in casual vacancies in the respective
boards. These included three members to the AAOIFI
Accounting Board (AAB) and one member to the
AAOIFI Governance and Ethics Board (AGEB). The
details of the new members are as follows:

AAOIFI held a public event and public hearing of

two of its standards hosted by Banque du Liban (BDL)
(Central bank of Lebanon) in Beirut, Lebanon. AAOIFI’s Mr. Irshad Mahmood Mr. Sulaiman AlBassam
Accounting Board (AAB) also held a closed-door Partner | Audit & Assurance Board member, Kuwait
meeting with His Excellency, Riad Salamé, Governor Deloitte & Touche , Bahrain Accountants & Auditors
AAB Member Association ( KWAAA), Kuwait
of BDL and His Excellency Raed H. Charafeddine, AAB Member
First Vice-Governor of BDL. AAOIFI also held its 10th
meeting of the AAB at the Gefinor Rotana Hotel, Beirut,
Lebanon on 21st and 22nd June 2018. AAOIFI’s public
interaction with the Lebanese local banking and finance
professionals, Shari’ah scholars, professionals from
accounting and audit firms, academicians and other
professionals was aimed at getting the pulse of Lebanese
Islamic banking and finance industry to better focus
AAOIFI’s efforts to help develop Islamic finance market
in Lebanon. The public hearings of exposure drafts of Mr. Tarik Bolukbas Mr. Hasan Gul
each of its Governance and Accounting standards: Expert - Department of Head of Auditing Standard
“Shari’ah Compliance Function” (GSIFI 9) and revised Accounting Standards, Turkish Department, Turkish Public
Public Oversight Authority Oversight Authority
Financial Accounting Standard (FAS) 25 “Investment in AAB Member AGEB Member
Sukuk, Shares and Similar Instruments” were held.

8 Vol. 2 , Issue 1/2018


A AOIFI ‘Professional Development’ Update
AAOIFI, in addition to standards development, is
also actively involved in professional development
and training activities mainly through its flagship
fellowship programs such as ‘Certified Islamic
Professional Accountant’ (CIPA) and ‘Certified
Shari’ah Advisor and Auditor’ (CSAA), as well as,
through technical workshops.
CSAA is being split into two separate
fellowships: CSAD and CSAU
The CSAA fellowship is currently undergoing
a revamping exercise which started last year. It
was decided that CSAA would be split into two:
‘Certified Shari’ah Advisor’ (CSAD) and ‘Certified
Shari’ah Auditor’ (CSAU) fellowships, respectively.
Syllabus for both fellowships have been developed.
Study-texts development will start from August
2018 onwards with the expected launch date of
early 2019. The last CSAA exam was held on
21 February 2018. Over 300 candidates from 22
countries registered for it.
Update on revamped CIPA fellowship
The first two exams of the revamped CIPA
fellowship program were held in December 2017
and May 2018. In total, 47 candidates from 6
countries registered for CIPA. The revamped CIPA
is now an internationally benchmarked fellowship;
candidates are required to pass 4 modules and
complete a 1-year Practical Experience Requirment
(PER) in order to become CIPA Fellows. There are
two exam windows every year: June and December.
Exemptions and discounts are also offered. For
details, please contact us at cipa@aaoifi.com
AAOIFI fellowships are recognized
by Tamkeen, Bahrain
Tamkeen of Bahrain recogizes both CIPA as
well as CSAA fellowships for Bahraini students
and because of that they can now pursue either
or both the programs through full sponsorship.
Furthermore, Tamkeen eligible students can also
benefit from fully sponsored CIPA crash courses
which are offered by BIBF in partnership with
AAOIFI.
Introducing new benefits for
AAOIFI fellows
Recently, we decided to publish the names of
those fellows whose fellowship have not expired,
on the AAOIFI website. All AAOIFI fellows are
requested to submit their profiles to AAOIFI at their
earliest so that we may promote them for potential
AAOIFI Updates
jobs. To submit your profile, please visit these links:
CIPA fellows: http://aaoifi.com/aaoifi-cipa-members
CSAA fellows: http://aaoifi.com/aaoifi-csaa-members
AAOIFI has also decided to include its Fellows in
the standards development process—particularly
in the areas of accounting and governance—by
involving them in respective working groups.
Those interested are required to send us an email
with their CVs at cipa@aaoifi.com.
AAOIFI fellows also get a 20% exclusive discount
on the purchase of AAOIFI Shari’ah and Accounting
standards’ publications.
Establishment of the AAOIFI
Education Board (AEB)
In April 2018, AAOIFI established the AAOIFI
Education Board and held its first meeting
at the AAOIFI Headquarters in Bahrain. The
Board comprises of following leading industry
practitioners, experts, and academicians:
• Dr. Abdullah Qurban Turkistani – Chairman
• Dr. Mehmet Asutay – Deputy Chairman
• Dr. Abdulrahman Alrazeen
• Mr. Shadi Zahran
• Dr. Mughees Shaukat
• Prof. Dr. Mohamad Akram Laldin
• Mr. Khairul Nizam Md Som
Expanding reach through strategic
partnerships
Ever since the launch of the revamped CIPA,
AAOIFI has been actively pursuing industry
partnerships and alliances. Till date, we have
signed upto 27 Education Partners, 2 Training
Centres, and 23 Exam Centres, for the CIPA and
CSAA fellowships, respectively. Our footprint is
now in more than 20 countries. We also signed an
MoU with ACCA-UK for the promotion of AAOIFI
Fellowships to ACCA qualified accountants and
students. Universties, training centres, and other
consultancy firms who are interested in partnering
with AAOIFI for capacity building initiatives,
please contact us at fnoor@aaoifi.com
AAOIFI delivers free-of-cost
training in CIPA “FAR” module
One of the key modules of the CIPA fellowship
is the “Financial Accounting and Reporting” (FAR)
module. Given that there are no specialized Islamic
finance training centres in the country, AAOIFI took
upon itself the task to provide free-of-cost training
to a group of CIPA candidates in Kyrgzystan.
Vol. 2 , Issue 1/2018 9
EDITORIAL

EDITORIAL

Islamic Finance Reporting:

Focus has to be on realizing the objectives
Muhammad Ayub 1

Business entities present the state of affairs and performance of their business through the
language of accounting. Banks and other financial institutions undertake a specific type of
direct or indirect intermediation business for channeling the savings to commodity producing
and services sectors and the consumers. Distribution of income of the business entities depends
largely on the accounting and financial reporting procedures and processes.

Islamic banking and finance institutions (IBFIs) have even more specific features and principles
that require re-defining the accounting concepts in general, as well as, changing the accounting
treatments for the transactions, in particular. Islamic finance with current assets estimated at
US$2.2 trillion at global level is expected to grow at a CAGR of 9.4% to reach US$3.8 trillion
by 2022 (Zawya, 2017/18)2. Islamic banks have to engage in real business, trading, leasing and
investments in various sectors in the economy.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has
done a commendable job by issuing so far around 58 Shariah standards serving as the basis
for accounting treatment of respective transactions. It has also issued 33 Islamic Financial
Accounting Standards (IFAS). A number of them are under review and development while
exposure drafts have been issued for 5 accounting and governance standards.

But, the issue is that not all countries / jurisdictions
have adopted the AAOIFI’s Standards. While
Shariah standards have been fully adopted or being
adopted in Afghanistan, Bahrain, Krygyz Republic,
Nigeria, Oman, Sudan, Qatar and Syria and Yemen,
accounting standards have been made part of
regulatory requirement in Bahrain, Jordan, Oman,
Qatar, Sudan, and Syria. Accounting standards are
used as basis of developing national accounting
standards in jurisdictions such as Indonesia,
Kazakhstan, and Pakistan, while other jurisdictions
such as Bangladesh, Brunei Darussalam, Iraq,
Kuwait, Labuan, Lebanon, Palestine, Maldives,
apply AAOIFI standards as guidance in their
respective regulatory regimes.
According to a study updated with data for 2016,
out of total 132 Islamic financial institutions (IFIs),
52% were not using IFRS – they applied local GAAP
(33%), 17% of them used AAOIFI’s FAS, while 2%
did not specify in their financial statements the
accounting standards or law complied. “As a result,
the differing recognition and measurement bases impede
users’ ability to meaningfully compare the financial
statements” concluded the study3. With regard to
Ijarah related accounting, the study found that the
majority of the samples (61%) reported Ijarah as
financial assets in accordance with IAS 39 / IFRS 9 /
IAS 17. The treatment by 35% was to recognize Ijarah
as fixed assets in accordance with AAOIFI’s FAS
No. 8 for Ijarah and Ijarah Muntahia Bittamleek. As

1- Mr. Muhammad Ayub is the Editor of JOIFA. He is also the Director Research and Training at the Riphah Centre of Islamic Business
(RCIB), Riphah International University, Islamabad, the Editor of Journal of Islamic Business and Management (JIBM), and Secretary of
International Conference on Islamic Business (ICIB).
2- State of the Global Islamic Economy (SGIE) Report 2017/2018: Outpacing the Mainstream; https://www.zawya.com/mena/en/ifg-
publications/231017085726C/
3- Asian-Oceanian Standard-Setters Group (AOSSG), Islamic Finance Working Group; Financial Reporting by Islamic Financial Institutions:
An update to the 2014 study of financial statements of Islamic financial institutions; 17 Jan, 2017. The study included the items / transactions:
i) Financial reporting framework; ii) Accounting for Ijarah contracts that transfer ownership; iii) Classification of customer investment
accounts; and iv) Measurement of finance income. http://www.aossg.org/images/docs/aossg_fi_wg_jan_2017.pdf

10 Vol. 2 , Issue 1/2018


a result, the IFIs are applying differing recognition
and measurement bases that impede users’ ability
to meaningfully compare the financial statements.
While some countries are in the process of
adaptation of the Standards according to their
market scenario and the tolerance levels, many
jurisdictions and institutions do not feel the need
even to observe any special conditions for recording
their investments and business transaction. It may be
because their products and investment instruments
closely mimic the conventional products. They are
apparently of the opinion that the assumptions
underlying the conventional accounting are not
incompatible with Islamic values (Velayutham,
20144). This is highly challenging as it could harm
the integrity of the system of Islamic finance across
the world.
The systems evolve over time, and accordingly,
AAOIFI also revises its standards keeping in view
the issues that arise in the application of standards.
For example, AAOIFI issued in 2016 FAS No.
27 on Mudaraba based investment accounts that
superseded two earlier accounting standards for
investment accounts (FAS Nos. 5 and 6). FAS 27
allows for the concept of substance over form in
classifying investment accounts and considers them
an independent intermediary element between
liabilities and owners’ equities (quasi-equity).
The Scope and Objectives of Islamic
Accounting
Among other things, relevance and reliability
of information have been emphasized as the
primary characteristics of accounting and financial
reporting in Islamic framework. It includes all such
information that the stakeholders may need to
accomplish their business and investment decisions
and fulfill their regulatory, tax related and religious
obligations including zakah and other benevolent
payments.
As Islamic finance developed, many accounting
and finance professional indicated some crucial
differences between the conventional and the
emerging systems thus warranting the different
reporting and accounting principles. These
differences pertain mainly to the prohibition of
interest leading to negation of time value of money
as ‘opportunity cost’, uniformity of substance and
form, and fair value vs. historical cost. Accounting
for zakah and waqf institutions that are the two
pillars of Islamic beyond-market economy have been
indicated as the new areas in financial reporting.
Going in detail, the differences are in the conceptual
4- Sivakumar Velayutham, Conventional Accounting vs Islamic Accounting: the Debate Revisited; Journal of Islamic Accounting and
Business Research (Emerald); Vol.5, No. 2, 2014; Pp 126-141.
5- Including, inter alia, Business Entity Concept, Historical Cost Principle, and Opportunity Cost of Money concept.
EDITORIAL
framework of accounting including the scope and
purpose (objectives) of financial accounting and
reporting and the functions and responsibilities of
the personnel involved in the conventional and the
Islamic accounting.
The features of accounting and financial
reporting in Islamic perspective include: i) Honesty
concept; ii) Accountability for control concept; iii)
Adalah (justice) concept which has close relevance
to the maqasid al shariah; iv) Competence and sincere
effort concept; v) Disclosure and transparency in
line with the Quranic verses (2:282; 65:6); and the
most importantly, vi) Al- naseehah (well-wishing for
all) Concept.
Al-naseehah concept seems to be the most
salient feature of Islamic accounting discipline
which requires the personnel involved in financial
reporting to be well-wishing for all stakeholders,
also including society. It refers to sincerity to one
another, compassionate behaviour and advice
to others for their best benefit. According to a
famous hadith, the Prophet (peace be upon him)
said, “The religion is naseehah (sincerity).” We said,
“To whom?” He (peace be upon him) said, “To
Allah, His Book, His Messenger, and to the leaders of
the Muslims and their common folk.” [Sahih Muslim].
The above features of Islamic accounting and
financial reporting refer to the ‘Venn relationship’
among the accountants, organizations, society
and, at broader level, the mankind. It implies that
as Muslims’ life means to be pure, honest, well-
wishing and sincere to oneself, to fellowmen, to
employees, employers, the weak and to the society,
the personnel involved in accounting and auditing
need to work for the benefit of all stakeholders
without any contrived efforts aimed at ‘earnings
management’ for the majority shareholders and, in
turn, for their own pay packages and perks.
It is due to some basic assumptions5 of conventional
accounting, on the other hand, that problems arise
in recognition, classification and valuation that, in
turn, affect financing (capital structure), investing
(organization’s assets portfolio) and operating
decisions (about generating revenues, managing
expenses and managing working capital). In addition
to the assumptions, there are certain procedural
issues that have created integrity problem not only
for the financial information and reports in Islamic
framework, but also in the conventional perspective.
Most of such issues leading to maneuvering for
‘earnings management’ and problems, as sometimes
accepted by FASB /AASB also, are:
Vol. 2 , Issue 1/2018 11
EDITORIAL

1. Two or more methods of accounting accepted for
the same facts.
2. Less conservative accounting methods being
used (without sufficient verification about
expenses and losses before entering a claim to
any profit);
3. Reserves are used to artificially smooth earning
fluctuations; a former Chairman, IASB termed
them as “cookie jar reserves” that result in unfair
treatment with any of the stakeholders;
4. Financial statements fail to warn of impending
liquidity crunches;
5. Deferrals are followed by write-offs;
information they need to make the right decisions
about how to allocate their capital”6. Such matters
are even more important in Islamic finance as the
revenue accruals, expense charged and the profit
to be distributed depend on how the underlying
contracts perform and how the same are reported.
Therefore, the prime effort of Islamic finance
regulators and the practitioners has to be achieving
the ultimate objective of fair dealing with all
stakeholders and providing correct and relevant
information to them. It also would require
harmonization of financial reporting by adopting
the AAOIF’s standards, using them as a basis for
Shariah opinions and financial reporting with as
low adaptation as possible.

6. Unadjusted optimism exists in estimates of
recoverability;
7. Off balance-sheet financing (disclosure in
financial statements only, even that partial) is
common;
8. An unwarranted assertion of immateriality to
justify non-disclosure of unfavorable information
or departures from standards; and the most
importantly,
9. Form is given precedence over substance.
The non-effective implementation of the
recognition, classification and evaluation principles
may have serious implications. Russell G. Golden,
the sitting Chairman of the FASB, commented
in this regard, “Effective implementation of the
revenue recognition standard is critical to its success
in providing financial statement users with the
AAOIFI has provided a benchmark against IFRSs
or other global standards to ensure consistency
with globally accepted standards. It is also in the
process of modifying them, where necessary, in
order to ensure that financial statements present
fairly the cash flows, revenue recognition, and
financial position and performance of the Islamic
financial institution. Till the time, the AAOIFI’s
standards are generally adopted, all out efforts
are needed, even within the current framework,
to avoid the procedures / practices that may cause
non-Shari’ah compliance in legal term, or injustice
to any of the stakeholders, for compliance in spirit.
Shariah Standard 47 on “Rules for Calculating
Profit in Financial Transactions” is of prime
importance in this context. The ultimate objective
of Islamic finance professionals, accountants as
also auditors, is to evolve reporting processes in
such a way that the objectives of Islamic finance
are achieved.

MAKE
AN IM
a p e r s”
ll for P
Get yo PACT
“Ca
ur pap
er pub
lished
in JOI
FA

AAOIFI invites “Call for Papers” for the next issue of JOIFA
with special focus on AAOIFI,s newly issued standards and
exposure drafts and / or related topics .

Your research paper / technical article will be read by regulators,

Shari’ah scholars, academicians and practioners from more than
45 countries around the world.

Please send your papers and contributions to editor.joifa@aaoifi.com,

or call 17244496 973 for queries.
For more details on submission visit www.aaoifi.com

6- FASB, News item, “FASB and IASB to form joint transition resource group for revenue recognition” July 26, 2013; accessed from: http://
fasb.org/cs/ContentServer?c=FASBContent_C&cid=1176163129249&d=&pagename=FASB%2FFASBContent_C%2FNewsPage

12 Vol. 2 , Issue 1/2018

 Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences

PEER-REVIEWED

Accounting for Islamic Finance:

Application of IFRS and the Shari’ah differences
Omar Mustafa Ansari 1
Haroon Tabraze 2

Abstract
Financial reporting by Islamic financial institutions is generally considered to be different
from the procedures employed by conventional accounting under the IFRS due to application of
Shari’ah principles mainly derived from Islamic law of contracts. A Shari’ah conscious user of
financial statements requires additional qualitative characteristics in the information provided by
any entity. The user of financial statements is conscious about recognition and measurement of
various elements of financial statements due to additional information requirements for decision
making.

This paper discusses similarities and distinguishing factors between the IFRS and the Islamic
accounting concepts espoused in the AAOIFI’s financial accounting standards (FAS). The
specific information needs of Shari’ah conscious users of financial statements such as Zakah
obligations and the differences in principles i.e. debate between historical cost and the fair value
in terms of various forms of assets are also examined.

Finding out solutions to the issues indicated is the need of the hour. This paper only focuses on
pointing out the areas of work, while the experts and institutions like AAOIFI and country based
bodies like SOCPA, ICAP and others need to take these factors and aspects into consideration.

1. Introduction applied by Islamic Financial Institutions (IFIs)

Islamic finance is evolving rapidly, especially
in countries with a Muslim majority population.
The dominant strand of research in Islamic finance
relates to its products and comparison with the
conventional banking (Abdel Gader, 1994). Research
is scarce in the area of reporting information, both
financial and non-financial, to the stakeholders.
The predominant debate is about the need of a
separate set of financial reporting standards. One
view is that the International Financial Reporting
Standards (IFRSs) issued by International
Accounting Standards Board (IASB) cannot be
because Shari’ah compliant products are structurally
different from conventional financial products and
IFRS are not able to faithfully depict essence of
these transactions (Archer & Abdel Karim, 2007).
The recording, measurement and reporting tends
to differ from the generally accepted accounting
principles (GAAPs) (Hashimi, 1987). Therefore
separate financial reporting standards are required
to be used by IFIs (Karim, 1990).
Many practitioners hold the opposing view that
IFRS being a general purpose reporting framework,
is able to portray all types of financial transactions,
both conventional and Islamic. This view is also

Keywords: IFRS, AAOIFI, Inventories, Fair Value, Intangible Assets, Zakah, Ushr.

1- Omar Mustafa Ansari is the Deputy Secretary General, Accounting and Governance, AAOIFI.
2- Haroon Tabraze is the Chairperson, Accounting and Law at Institute of Business Administration (IBA), Karachi, Pakistan.

Vol. 2 , Issue 1/2018 13

Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
supported by the banking regulators who require
identification and recognition of risks integral to
Islamic banking in order to be able to compare them
with conventional banks (Aziz, 2007).
The objective of AAOIFI, as available on its
website, is to “develop accounting thought taking
into consideration the international standards
and practices which comply with Islamic Shari’ah
rules”. It is slightly different from the objective
of IASB, “to develop, a single set of financial
reporting standards based upon clearly articulated
principles” (Deloitte, 2018). AAOIFI takes into
consideration international accounting practices,
but requires additional information to be provided
for the Shari’ah conscious investors. Therefore, it
is safe to assume that IFRS and AAOIFI standards
will have many similarities, with differences only
where the Shari’ah rules render certain transactions
impermissible or require different treatment. To
sum up, the core differences arise because:
Shari’ah conscious investors have specific
information needs that are not fulfilled by
presenting information prepared through IFRS
The transactions of Islamic Financial Institutions
(IFIs) are structurally different from that of the
conventional banks, therefore cannot be presented
in their true essence through IFRS
2. Key Shari’ah Issues
2.1 T
 he information need of Shari’ah
conscious investors
The user of financial statements of an IFI
requires additional information to make certain
decisions i.e. obligation of Zakah, as historical cost
is not useful for the purposes of Zakah computation
(Gambling & Abdel Karim, 1999). Balance sheets
prepared on current values better serve the needs
of Shari’ah conscious users compared to those
prepared on historical cost (Baydoun & Willett,
1997). Similarly, while distributing inheritance,
assets are required to be valued at fair value. In
the traditional Fiqh, almost all computations for
profit and loss distribution between partners and
participatory stakeholders have to take place at
fair value, although in contemporary Fiqh certain
exceptions have been allowed. In all such matters
the sense of accountability’ to Almighty is the factor
that determines the favored objective of financial
statements for the Shariah conscious persons
(Gambling & Abdel Karim, 1999)
Traditionally, assets have been valued at historical
cost according to conventional accounting, but in
recent years some types of assets e.g. investments
and investment properties (IASB, 2016) are allowed,
while biological assets (IASB, 2016) are required to
be valued at fair value.
14 Vol. 2 , Issue 1/2018
2. 2 Valuation and measurement basis
For valuation of cash and the debts, the
conventional concepts of computation of fair value
through discounted value of future expected cash
flows (IASB, 2016) is in conflict with the Islamic
concepts of accounting. Therefore, the IFRS
permitting fair valuation of assets and liabilities
using the discounting method cannot be used in the
current form for Islamic transactions.
The Islamic perspective is to carry tangible assets
at fair value and carry cash, cash equivalents and
receivables at ‘par’ or ‘notional’ value. Investments
according to Islamic economic principles are
primarily not cash equivalents; hence, also need to
be carried at fair value.
The contemporary jurists have divergent views
on using the historical cost convention for allocating
profit or loss between partners in an ongoing
enterprises working under the Islamic principles of
Musharaka and Mudaraba. The partners may agree
on using historical costs for the purpose of periodic
profit and loss distribution, but this principle
cannot be applied in case of eventual liquidation or
dissolution of the partnership.
The principle of applying fair value is applicable
while distributing inheritance and computing
obligation for zakah for individuals. However,
in case of entities, inheritance may be created in
the form of Musha‘ or Shirkat-ul-milk i.e. joint
ownership, in which case fair value is preferred, but
can be avoided if the parties mutually agree on a
price different than the current market price.
The fair value less cost of selling the asset
approximates ‘net realizable value’ (NRV) that is
used to measure inventories in Islamic financial
transactions. However, fair value less cost of selling
the asset is different from the current market value
(that does not take into account the selling cost).
The Islamic financial transactions use another
term ‘face value’ (value agreed between the parties).
This valuation method is not prescribed in IFRS.
2.3 Property, Plant and Equipment (PPE)
Property, plant and equipment (PPE) comprise of
tangible items held for use in production or supply
of goods or services, or rental to others (except land
and building given on rent), or for administrative
purposes and are initially recognized at cost, and
subsequently measured either through ‘cost’ or
‘revaluation’ model (IASB, 2016).
A Shari’ah conscious user requires disclosure
of fair value of PPE at the reporting date for the
purposes of Zakah and inheritance. If PPE is
subsequently measured on revaluation basis, it
may closely approximate the fair value if the last
 Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
revaluation was made not long ago. However, even
when using the revaluation model, there is always
a chance of the carrying value of the asset to be
significantly different from the fair value of the asset.
A Shari’ah conscious user of the financial
statements also requires classification of assets into
those that are Shari’ah compliant, or otherwise. PPE
generally do not include assets that are Shari’ah
non-compliant.
2.4 Intangible Assets
Wealth (Maal) includes services, usufruct and
intangibles (Obaidullah, 2002). A small segment
of Shari’ah scholars claim that identification and
determination of intangible asset as property
raises Shari’ah issues. But, their arguments are not
considered rational compared to that of the majority
of scholars who recognize that such assets possess
financial value (Bouheraoua, et al., 2015).
AAOIFI considers intangible assets as property
having monetary value (AAOIFI, SS. 42, 2015).
Shari’ah scholars have conflicting views on whether
intangible assets would be subject to Zakah, and
at what value? Majority of scholars appears to be
in favor of not levying Zakah on intangible assets
unless it is a separable intangible asset acquired for
further disposal and gain; therefore considered to
be a trading asset (Bouheraoua , et al., 2015).
A Shari’ah conscious user would require additional
information regarding control of intangible assets,
and the risks and rewards incidental to ownership
of such assets. Where an intangible asset is acquired
through a Shari’ah compliant Ijarah, it may generally
not be considered an asset of the entity as the entity
is only entitled for using the benefits (usufruct) of
such asset and does not have the risks and rewards
incidental to ownership.
In case where an intangible asset is purchased or
produced for internal use, there will be no Zakah
implication. An asset developed by the entity for
eventual sale is to be considered as inventory.
2.5 Investment Property
Land or buildings held to earn rentals or for
capital appreciation are classified as investment
properties and are subsequently measured in the
financial statements either at cost or fair value (IASB,
2016). AAOIFI has a separate standard FAS-26 that
requires investment properties to be measured at
fair value. Fair value measurement allows better
profit and loss sharing between participating
stakeholders (or with minority shareholders). It is
also relevant for the stakeholders of an IFI who have
invested with the IFI through instruments of quasi-
equity. FAS-26 also provides for Shari’ah compliant
allocation of gains from these properties.
3- Council of the Islamic Fiqh Academy – Resolution 2 (2/2), December 1985.
Where investment property is acquired through
Diminishing Musharaka arrangement or in rare cases
through gradual transfer Ijarah arrangement, the
accounting treatment is not clearly defined by any
standard. Further discussion and research is required
whether the accounting treatment prescribed by
IAS-40 would be applicable on proportionate basis
depending on ownership interest in the asset, or
such a treatment is not required at all.
The authors believe that the fair value
measurement should be preferred while disclosing
investment property. Where it is difficult to get fair
values of assets, the cost model may be followed
to present the financial information, with a note
disclosing the closest estimate of fair value at the
reporting date annexed with the financial statements.
A Shari’ah conscious user of financial statements
requires additional information regarding
classification of investment property - for
rental purposes or for capital appreciation. This
information is relevant for determination of Zakah,
as the property primarily for rental purposes is
exempt from the obligation3 .
Scholars have conflicting views on applicability
of Zakah on subsequent classification to investment
property. One view is that asset is not subject to
Zakah if it was purchased with the intention of own
use and was subsequently classified as investment
property. However, many scholars believe that as
the intention of the user changes with the change
in classification, therefore Zakah will be applicable.
The predominant view is that long-term lease
of land is subject to Zakah in the hand of lessor
because risks and rewards incidental to ownership
of the asset are not completely transferred to the
lessee. In case of asset given on Shari’ah compliant
Ijarah contract accounting treatment is similar to
the treatment of operating lease.
2.6 Agricultural assets and income
International Accounting Standard – 41
‘Agriculture’ prescribes the accounting treatment
of biological assets (animals and plants) and
agricultural produce. IAS-41 does not have any
adverse Shari’ah implications, and provides the
Shari’ah conscious user of financial statements with
improved information.
Biological assets and agricultural produce are
subject to specific rules in relation to Zakah and
Ushr, so a Shari’ah conscious user will require
supplementary information regarding classification
of assets apart from the fair values. The assets
subject to Ushr must be reported as a separate class
of assets and not be included in the assets subject
to Zakah. It is also important to indicate that Ushr
Vol. 2 , Issue 1/2018 15
Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
is leviable on the produce of crops and plants /
gardens, and not on the land or the plants. Further,
the financial statements should preferably provide
a statement or reconciliation for the assets subject to
Zakah at different rates or formula, with separate
disclosure of assets subject to Ushr. The financial
statements prepared under IFRS do not give this
information.
It is important to note that according to Shari’ah
principles the Zakah on agricultural produce in
excess of the minimum limit (nisab) of produce is
applicable as Ushr, instead of normal Zakah that is
on the wealth in excess of normal use by the owner.
2.7 Inventories
Inventories are the assets that are either held for
sale in the ordinary course of business, or in the
process of production for such sale, or are in the
form of materials or supplies to be consumed in the
production process or in the rendering of services
(IASB, 2016).
Islamic financial products are concentrated
towards ‘trading’ rather than ‘financing, therefore
most of the products include, or involve, inventories
at different stages of the transaction. AAOIFI is
trying to classify and define inventory in line with
the IFRS (for example see the new standard on
Murabaha and deferred payment sales).
The debate amongst scholars in relation to
inventories is regarding assigning their values, both
from the perspective of Zakah and for the purpose
of distribution of profits. A Shari’ah conscious user
will be interested in the disclosure identifying
whether inventories are Shari’ah compliant in their
very nature, or not?
IAS-2 requires inventories to be subsequently
measured in financial statements at lower of
historical cost or the net realizable value (NRV).
Zakah is to be assessed based on the realizable value
(i.e. fair market value) instead of historical cost
or the NRV. A point can be made that both these
values are almost identical to each other in most of
the cases, but it might not always be the case. An
example specifically related to inventories is where
the entity expects to complete the production cycle,
or process the asset and then sell it, the fair value
of inventory can be significantly different from its
NRV. Where the fair value is significantly different
from the recorded value of the inventory, it needs
to be disclosed as additional information in the
financial statements.
In case where the purchase price of inventory
is not the cash equivalent value i.e. the transaction
includes a credit period that is more than normal
credit period, the value of such inventories must
be reconciled as obligation of Zakah, inheritance
and profit and loss determination may have to
16 Vol. 2 , Issue 1/2018
be computed at a value that is different from the
recorded value in the books of accounts.
The treatment of spare parts, consumable stores
and loose tools depends on the measurement
model. Where the intention is to treat them as part
of asset, they will be carried under the models
prescribed under IAS-16, and will not be subject to
Zakah. However, if the entity chooses to apply the
model prescribed in IAS-2 on the basis that these
are convertible into saleable material, these items
will be subject to Zakah based on their net realizable
value.
We need to classify inventories in primarily two
categories from the Shari’ah perspective i.e. those for
sale (as they are, or after conversion or processing)
and those for consumption or use in production
such as spare parts. A further category will be for
the items of inventory such as precious stones or
minerals that do not attract Zakah or Ushr at all.
It is important for a Shari’ah conscious stakeholder
to have sufficient information available. For
inventories, additional disclosures are sufficient
without changing the accounting treatment.
2.7.1 I nventories held under Islamic modes
of financing
The Islamic finance products of Murabaha, Salam
or Istisna’a involve holding of inventory at particular
points. AAOIFI has been actively working to align
the accounting treatment of inventory under these
products, especially through its newer standards.
However, it still falls short of the information needs
of a Shari’ah conscious user of financial statements.
An additional disclosure about the fair value and
applicability of Zakah is required.
In case of Murabaha, the inventory needs to
be valued at cost at which the goods are being
purchased by an entity. An NRV adjustment may
be required where the total cost of inventory
exceeds the NRV. This adjustment may not be
easily understood by the Shari’ah conscious user,
particularly because the Zakah is applicable on
the fair value. The ideal treatment for profit and
loss distribution is also on fair value basis, but the
AAOIFI standards require lower of cost or NRV
basis for subsequent measurement.
3. Financial Assets and Liabilities
Investments
A Shari’ah conscious investor needs supplemental
information about the types of investments made
by an entity, specifically identifying any non-
Shari’ah compliant investments. Such information
is important in respect of all investments and other
similar financial assets, by whatever classification
reported.
 Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
In case of held-to-maturity investments, cost
(usually the par value of such investments) is an
important information for any Shari’ah conscious
investors. The Shariah principle regarding dayn
(receivable) is to represent the cost in full due to
non-permissibility of discounting. The carrying
amount and the fair value of investments which
are not in compliance with the Shari’ah should also
be separately disclosed. Apart from identifying
suitability of investment, this information is useful
for a Shari’ah conscious investor in determining
halal income.
3.1 Cash and Bank Balances
Shari’ah conscious investors and IFIs, in addition to
the requirements of IFRS, require an entity to disclose
cash in hand; balance at banks classified into balances
in current and savings accounts; and balances held
with conventional banks, Islamic banks and Islamic
banking branches of conventional banks.
3.2 Advances and other Receivables
Amount(s) of receivables which are not in
compliance with the principles of Shari’ah must
be separately disclosed. The credit period allowed
in respect of non-interest bearing securities, along
with amount and information about the parties
from which it is receivable should also be disclosed
in the notes to the financial statements.
It is also important to ascertain that the debt has
been established, and is represented in full keeping
in view the non-permissibility of discounting.
3.3 Sukuk and Investment Certificates
Sukuk issued as time-bound capital may not
generally represent a financial liability. If we apply
the Shari’ah based accounting concepts in line with
the AAOIFI’s exposure draft on Sukuk; the sukuk
would be accounted as either off-balance sheet (if
there is no control) or on an on-balance sheet basis
(if control exists). On-balance sheet sukuk shall be
classified as either equity or quasi-equity or liability
(only where there is direct monetary or delivery
obligation like in case of Murabaha or Salam
sukuk). It may, however, be argued that even under
the purview of IFRS, some of the sukuk will still be
off-balance sheet.
In addition to meeting the requirement of IFRS
in respect of each class of long term instruments
i.e. Sukuk and Investment Certificates, the entity
should disclose:
A) Name of issuer, expected rate of profit, terms
of redemption (or conversion), and the terms
and conditions attached to each class of Sukuk
and Certificates;
B) The amount of long term instruments that are
not in compliance with Shari’ah. These need to
be further classified into categories appropriate
to the entity; and
C) The maximum aggregate amount of borrowing
at any time during the year including the
portion of borrowing that is non-compliant
with Shari’ah principles.
This information is required for Shari’ah
conscious investors and IFIs for determining the
state of Shari’ah compliance of the entity and
suitability of investments therein.
An entity should also confirm through a
statement provided in the financial statements that
the funds which are raised from any issue, offer
or invitation of sukuk are utilized for Shari’ah-
compliant purposes. A sukuk investor needs this
assurance to ensure that his investment is utilized
in line with the Shari’ah principles only.
3.4 Long and short term financing availed
The conventional accounting disclosures include
identification of the banks from which financing is
availed, rate of profit, and the terms and conditions
attached thereto including the repayment period.
A Shari’ah conscious investor also wants further
classification of borrowing(s) into long and short
term nature, and fair value of collateral(s) held in
respect of the financings obtained.
Further, disclosures are also required for the
maximum aggregate amount of borrowing at any
time during the year including the portion of Shari’ah
non-compliant borrowings at that point of time.
3.5 Current liabilities
A Shari’ah conscious investor is interested in
finding out the liabilities that are not in compliance
of Shari’ah; and the face value of liabilities being
carried at amortized cost. Shari’ah principle
regarding dayn (receivables) is that a dayn has to be
represented in full, without discounting the same.
4. Leases
A major change has come in accounting for
leases with the implementation of IFRS-16 issued
by IASB. The new standard has eliminated all but
few forms of ‘operating leases’ and has raised a
“right to use asset” (IASB, 2016). The right to use
asset is to be recorded at fair value i.e. the present
value of minimum lease payments. In other words,
each lease, for a term of more than one year, will
be considered a finance lease irrespective of the
characteristics of the contract.
The new lease standard (IASB, 2016) has given rise
to an even wider gap between conventional banks
and IFIs regarding the financial reporting creating
problems in comparability of financial statements
between jurisdictions. According to Islamic law
Vol. 2 , Issue 1/2018 17
Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
of contracts, ownership of the leased asset is not
transferred to the lessee, who gets only the benefit
of use of the asset in exchange of rentals (Usmani,
2000:60). However, if we consider the Ijarah
transaction to be a sale of usufruct and amend the
FAS-8 in line with the new IFRS-16, the accounting
treatment will be similar with an exception that the
time value of money concept will still need to be
avoided for payments to be made after one year.
It is interesting to note that in classic texts of Fiqh,
the lease transaction is considered analogous to sale
but with a difference that in Ijarah the corpus of the
property remains with the owner (Usmani, 2000).
Even in the case of usufruct, the issue remains as
to whether an Ijarah transaction is a Ba‘i (sale) of
usufruct for the overall period, or Ba’i for a series of
intermittent periods i.e. monthly, quarterly or half-
yearly for which the rentals are agreed and paid.
If we consider it to be a single contract, the “right
to use asset” can be recorded and the difference
with IFRS can be minimized except for the fact that
it would be recorded at par value and not at the
fair value being the discounted cash flow (DCF) of
minimum lease payments.
5. P
 rovisions, contingent liabilities
and contingent assets
Profit Equalization Reserve and (PER) and
Investment Risk Reserve (IRR) are said to be set
aside by the IFIs as profit smoothing and risk
management techniques (Taktak, et al., 2010). Both
PER and IRR by definition do not meet the criteria
of either a provision or a liability; these reserves are
allocation out of profits.
Most provisions do not meet the definition of
a liability from Shari’ah perspective, in particular
with regard to Zakah. In case, when cost of onerous
contracts becomes an established liability, Zakah will
be adjustable. This will vary depending on the case;
as such, costs do not always result in an established
liability. Provisions can be adjusted for PLS purpose,
but not for Zakah. However, for inheritance purposes
each case has to be evaluated separately.
Shari’ah does not allow discounting the liabilities
on the basis of time value of money. However,
the provisions are not established liabilities or
dayn, hence a point can be made to discount them
using DCF method. We need more research and
deliberation on this issue.
6. Revenues and expenses
There is generally no difference in the way
revenue is recognized in conventional accounting
or the accounting for Islamic products. A Shari’ah
conscious investor requires certain additional
information to the disclosures required by IFRS i.e.
income from Shari’ah non-compliant operations.
18 Vol. 2 , Issue 1/2018
Such income is required to be contributed towards
charity, rather than taking income of the entity.
6.1 Earnings per share (EPS)
Earnings per share is a fundamental information,
especially for potential investors, that although
not being a part of financial statements directly, is
required to be disclosed at the end of the profit and
loss account according to conventional accounting
standards. Shari’ah compliant earnings per share
may be calculated by dividing profit or loss from
Shari’ah compliant operations attributable to
ordinary equity holders of the parent entity (the
numerator) by the weighted average number of
ordinary shares outstanding (the denominator)
during the period.
A particular difficulty will arise in disclosing
EPS by conventional financial institutions that have
Islamic windows (operations). This might also be
relevant for normal companies wishing to classify
the nature of operations and income according to
permissible and prohibited income.
According to MASB Tri-3 Presentation of Financial
Statements of Islamic Financial Institutions:
Para 28: ‘’An IFI shall present, either in the
statement of changes in equity or in the
notes, the amount of dividends recognized as
distributions to owners during the period, and
the related amount per share.’’ This shows there
is no apparent conflict with IFRS.
Para 29: ‘’The disclosure of dividends per
share may not be applicable to Islamic banking
activities carried out by a conventional bank or
financial institution.’’
Entities may be encouraged to disclose the effect
of dilution on its state of Shari’ah compliance from
the perspective of Shari’ah conscious investors. This
disclosure would be applicable if, and only if, the
status changes from a Shari’ah compliant entity to
a Shari’ah non-compliant entity or vice versa. Such
a situation arises when the effect of dilution results
in significant changes in the Shari’ah non-compliant
debt vs. equity ratio, as well as, the proportion of
Shari’ah non-compliant expenses or income. In such
scenarios, it would be imperative to disclose such
effect for the benefit of the relevant stakeholders.
7. Statement of cash flows
Cash and cash equivalents
Shari’ah conscious users will be interested to
know the classification of cash and cash equivalents;
whether they are Shari’ah compliant or not. Due to
nascent state of Islamic economics, many Shari’ah
scholars allow entities to keep 80-90% of their
cash equivalents in Shari’ah compliant products,
instead of keeping the full amount. Disclosure of
 Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
such policies will be advantageous for the Shari’ah
conscious user of financial statements.
Savings account with a conventional bank can
be considered cash equivalent from both Islamic
and conventional perspectives. It is because the
conventional accounting treats such accounts as
cash equivalent - readily convertible into known
amounts of cash (IASB, 2016) but a saving account
on Mudaraba basis with an Islamic bank is not a
cash from Shari’ah perspective. For an IFI, these
funds have been invested on Mudaraba basis;
therefore are a form of quasi-equity.
Apart from IFIs, normal trading or manufacturing
companies may also use this classification for the
benefit of Shari’ah conscious users and Shari’ah
compliant mutual funds, for their investment
screening purposes.
Classification issues – for cash flow purposes
Murabaha and other similar products are
trading products according to Shari’ah principles.
Therefore, receivables in such modes are not to
be included with the cash and cash equivalents.
Classification of sales and purchases in trade based
modes needs further research and deliberations
amongst scholars.
The distribution of profit to investment account
holders and PLS deposit holders need to be classified
uniformly, as these may be ambiguously considered
as operating activity or financing activity. Similarly,
assets purchased for leasing on Ijarah basis are
usually considered an investing activity, but critics
object that these may be classified as ‘financing’
and consequently be disclosed under operating
activities.
In conventional banks, the increase and decrease
in savings and deposit accounts are classified as
operating activity. In IFIs the practice of classifying
them is diverse between jurisdictions. The overall
treatment as approved by the MASB is conflicting
with the AAOIFI pronouncements. This presents a
gap for researchers to explore and to find the best
option for accounting needs of Shari’ah conscious
users.
A Murabaha transaction for acquisition of raw
materials may be classified as operating activity,
whereas a similar Murabaha transaction for
acquisition of fixed assets may be classified as
investing activity. The profit component from such
transactions shall not be separately identified and
reported in cash flows. All these treatments need
to be settled by the standard setters to present
information uniformly for the user.
8. Events after the reporting period
There is no conflict in IFRS with Shari’ah principles
or with the AAOIFI’s standards. For a common entity,
the IFRS would be applicable without any problem.
Distribution of profits amongst stakeholders
The only issue that might need some
consideration is the treatment of adjusting events on
the distribution or allocation of profits and losses to
the stakeholders (other than common shareholders)
i.e. investment account holders and PLS depositors
or policyholders of Takaful companies.
The Shari’ah debate is whether the distribution
of profits among stakeholders is to be done as ad-
hoc distribution or as per constructive liquidation.
If it is ad-hoc distribution, then it shall be adjusted;
however, in case of constructive liquidation it will
be based on the judgment of the management.
Adjusting events and Zakah
Any adjusting event, which might have an impact
on common accounting and reporting information,
but might not be adjustable either for computation
of Zakah basis or for the purpose of profit and loss
computations, has to be identified and disclosed
separately.
9. Related party relationships
Definition of related party as provided in IAS-
24 does not cover relatives up to second degree.
IFRS considers only close relatives for the purpose
of related party disclosure. However, this is not
something that may have any major impact except
for when transactions are being carried into by an
entity with related parties up to second degree
(other than close relatives) and not being at arm’s
length.
In situations involving trade, particularly credit
trade and financial transactions with related
parties, the Shari’ah conscious users would like to
have additional information about transactions
between the group companies, and whether these
transactions were Shari’ah compliant such as spot
purchase by one company and subsequent sale to a
group company on credit which may have adverse
Shari’ah implications.
According to para 30 of FAS 12, the transactions
with related parties that are carried at non arm’s
length are required to be disclosed with the total
amount of claims paid, and the contribution rate
offered to the related parties. Further, the terms and
conditions should also be disclosed, if they differ
from the prevailing practice.
10. Operating Segments
There is no major difference between the
disclosure requirements prescribed by the IFRS
8, ‘Operating Segments’ and AAOIFI’s FAS 22,
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Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
‘Segment Reporting’. Scope of FAS 22 expands to
such companies whose shares or debts are held
privately, in addition to publicly traded companies
and companies in the process of issuing publically
traded instruments.
While considering segment disclosures, the
management may also consider disclosing Shari’ah
compliant businesses and Shari’ah non-compliant
businesses separately. Mostly, this will be the case
of banks and insurance companies offering both
Shari’ah compliant and Shari’ah non-compliant
services to their customers.
According to a study by the Asian-Oceanian
Standard Setter Group (AOSSG), “Some entities
that purport to engage in Islamic operations may
not disclose information about that component as
an operating segment” [2010]4 . While disclosing
the overall performance of segments (segment-wise
comprehensive income), requirement for additional
disclosures needs to be considered with respect to
Shari’ah compliant and Shari’ah non-compliant
income of each segment along with reconciliation
of the same with overall segment performance.
11. C
 hange in accounting policy and
estimates
The treatment of modification in allocation and
distributions to or from various stakeholders by
an IFI poses an interesting question. Are these
modifications in allocations and distributions
‘change in accounting policy’? The ensuing question
is about requirement for this change to be disclosed.
The modification in workings for PLS distributions,
or in actuarial workings, or in the proportion
of Wakalah fee are examples of allocations and
distributions or some of the illustrations of such a
scenario. The apparent answer could be ‘No’, but
further research and deliberations are required.
Retrospective restatements are possible; however,
the effect of such a restatement on all stakeholders
needs to be deliberated especially in relation to
the practice of constructive liquidation. Many
IFIs follow constructive liquidation technique for
the purpose of profit distribution periodically;
meaning that the amounts are finally adjusted for
the stakeholders. The question is that to whom such
adjustments relate?
Similar to accounting policies, the issue of preparing
estimates for shareholders and other stakeholders
(investment account holders, PLS depositors, or
policyholders) is also important especially in the case
of creating provisions and reserves.
For any change in estimate that is not considered
to be a prior period error, the accounting treatment
4- Financial Reporting Issues relating to Islamic Finance, 2010 http://www.aossg.org/docs/AOSSG_IF_WG-Research_Paper_11Oct2010.pdf
20 Vol. 2 , Issue 1/2018
prescribed has prospective implications only.
Accordingly, for changes in estimates, generally
there would not be any significant additional
disclosure or treatment required.
It is important to note that AAOIFI standard
talks about adjustment to policyholders’ liabilities
and equity in a manner similar to that of the normal
shareholders. Same treatment needs consideration
for adjustments to the IAH / PLS depositors or other
stakeholders in case of IFIs.
An entity should disclose any income component
that is not considered to be compliant with Shari’ah
that is directly taken to equity in respect of prior
periods. In case an item of income being non-
compliant with Shari’ah, for example interest
income, is credited directly to equity, it needs to be
disclosed in a manner similar to that of the current
period’s income as a Muslim investor needs to
be informed about all income, that is not Shari’ah
compliant, irrespective of the method being used.
A change in accounting policy or correction of an
error may have effect on zakah bases for the current
as well as previous years. In respect of accounting
policies, any effect has to be taken to current year’s
zakah base; therefore, there is no need for a separate
disclosure.
12. Accounting in other currencies
The accounting principles applicable on foreign
exchange related aspects are generally neutral from
Shari’ah perspective. However, Shari’ah has specific
requirements with regard to Bai al sarf i.e. dealing
in foreign currencies.
Zakah is applicable on the fair value of assets and
hence the fair value of assets in foreign currency
shall reflect the fair value including the impact of
fair translation of foreign currency balances.
There can be a debate with regard to applicability
of functional currency with regard to computation
of Zakah. Difference may be arising through
translation of assets in net value although such
differences would be immaterial or rather negligible.
Exchange differences on assets and liabilities
that are considered to be Shari’ah non-compliant,
shall be disclosed separately from those considered
Shari’ah compliant. This disclosure should be
applicable for the two types i.e. the gain taken to
the income statement, and the gain carried through
the ‘other comprehensive income’.
13. B
 usiness combinations,
consolidation and associates
The key issue that arises in the review of accounting
 Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences
standards for consolidation and separate financial
statements from Shari’ah perspective is the assessment
of need of such information from the perspective of
Shari’ah conscious users.
The key information needs of Shari’ah conscious
users of the financial statements primarily include
the matters relating to determination of Zakah,
availability of information for determination of
inheritance, and the information related to profit
and loss computation and distribution according to
Shari’ah principles, amongst various participating
stakeholders. The questions that may arise in this
context include:
Whether or not Zakah needs to be determined
on a consolidated basis or on the basis of separate
and individual financial statements;
Whether or not this treatment should remain
consistent for stakeholders who prefer Musha‘
on Zakah (i.e. Zakah on the assets of an entity
irrespective of individual stakeholders) or those
who do not prefer it on a combined basis (normally
relating to Hanafi school of thought);
Whether or not Zakah should be payable by
the participating stakeholders of the parent entity
on the assets which are under the ownerships of
the subsidiaries or other group companies which
are not directly in control (with right to use and
consume)?
Whether the true profits and losses (or
comprehensive income) of the shareholders of
a parent entity are those which appear in the
consolidated accounts, or those which appear in the
separate financial statements.
Considering either of the above to be true,
whether or not it is necessary to prepare the other
set of financial statements from the perspective of
Shari’ah conscious users?
Do the reconciliations required for zakah
purposes or for profit and loss determination for
Shari’ah conscious stakeholders need to be prepared
for both sets of the financial statements or only for
the relevant set of financial statements?
Similarly, what information needs does a Shari’ah
conscious stakeholder expect to be fulfilled by a
group’s parent entity, and to what extent necessary
disclosures and reconciliations need to be prepared
for the consumption of such user of the financial
statements in the consolidated, as well as, separate
financial statements?
Another question that arises is related to entities
other than subsidiaries, i.e. as to whether the
principles that we may define for the subsidiaries
should be applied in a similar manner for associates
and joint ventures.
What should be the treatment in respect of
participating stakeholders other than common
shareholders, for example depositors or takaful
participants, if their investments are utilized in
investments in these ventures?
Another key issue is the accounting treatment for
consolidation of a special purpose vehicle company
(SPV). Such entities include the SPV structures
created to offer sukuk, as the underlying structure
of sukuk is considered to be “stronger” and
“strongly ring-fenced” and commonly entail real
ownership of the underlying assets as compared to
conventional SPV based structures.
Generally, we will assume that for the purpose
of Zakah each entity has to apply the principles of
Musha‘ (combined ownership for Zakah purposes)
and hence each entity will pay its own Zakah. The
financial statements of the group on a consolidated
basis will just combine the necessary figures, and
will not be considered a means of computation of
Zakah.
Consolidated reconciliations of Zakah would be
prepared with a disclosure note that these are the
responsibilities of various entities and not that of
the group as a whole.
14. Insurance contracts
The most important issue that needs to be dealt
with by the accountants is choosing between ‘single
or consolidated accounts’ and ‘two separate sets
of accounts for the operator and the participant’.
According to the AAOIFI’s standards, two different
sets of accounts within the same format of financial
statements are required.
Generally, the practice is in line with the
conventional insurance practices, but the assets,
liabilities, revenues and expenses pertaining to the
operator and to the participants are disclosed in
tabular or notes form.
In our view a single set can be used if the
concept of quasi-equity and equity of other than
owners become acceptable. Few practitioners
believe that this definition excludes takaful
arrangements because it involves risk-sharing
among policyholders, rather than risk-transfer from
policyholders to the takaful operator.
The fundamental argument is whether there is
any risk-transfer in takaful? Here, the risk-transfer
is from an individual policyholder to a group of
policyholders, rather than from the policyholders
to the takaful operator.
On the assumption that it is not risk sharing,
rather a risk-transfer from individual policyholders
to a group of policyholders, some may conclude
that the group of policyholders i.e. the pool or the
Waqf is the insurer. If that was the case, then the
Participants’ takaful fund or the Waqf in different
models will be subject to these provisions and not
the takaful operator.
Vol. 2 , Issue 1/2018 21
Accounting for Islamic Finance: Application of IFRS and the Shari’ah differences

It may, however, be appropriate to either require credit rating...”

the takaful operators to prepare separate set of
financials for the fund under IFRS – 4, insofar its
provisions are not against the Shari’ah principles.
We understand that it will not be a proper solution,
particularly because the takaful operator is not the
insurer, in any way.
In case of Qard Hasan for Takaful fund, the
timing of return is also not certain; therefore even
when discount rate is identified; the uncertain
timing would not make it possible to ascertain the
correct fair value.

From the perspective of a Shari’ah compliant
investor additional disclosures may be required
for understanding and identifying Shari’ah non-
compliant activities including investments in funds
and income from such investments.
15. Qard Hasan
There are certain situations in which a Qard
Hasan is given, particularly by the takaful operator
to the takaful fund or Waqf. Accountants raise the
question as to whether such Qard Hasan needs to
be measured at fair value, and if so, how?
The issue that arises here is related to the initial
measurement of the interest-free loan, which
according to IFRS 9 paragraph B5.1.1 (read with
paragraph 5.1.1) should be accounted for at fair
value whereby:
“…the fair value of a long-term loan or receivable
that carries no interest can be estimated as the
present value of all future cash receipts discounted
using the prevailing market rate(s) of interest for
a similar instrument (similar as to currency, term,
type of interest and other factors) with a similar
While subsequently measuring the values,
whether to charge impairment or not, is again an
issue requiring further research and deliberations.
An option could be to make an estimation of
impairment, performed at periodic intervals
through DCF or a similar model. However, even
in such a case, the discounting effect should not be
reflected in accounting and financial reporting.
Summary
Having discussed the above examples and
instances of differences, additional information
needs and Shari’ah compliance requirements for
various transactions and balances, we may conclude
that there are numerous differences between IFRS
and Islamic accounting standards. While most
of these can be addressed through additional
disclosures, there are some issues that need separate
accounting treatments or classification changes.
This paper is an attempt to identify gaps for future
research. The standards setters like AAOIFI and
country based institutions like SOCPA and ICAP
need to take these differences into consideration
while developing standards and practices for the IFIs.

References
• AAOIFI, 2009. Shari’ah Standard 42. Bahrain: AAOIFI.
• AAOIFI, 2018. Objectives. [Online] http://aaoifi.com/objectives/?lang=en
• Abdel Gader, A. E., (1994). Accounting Postulates and Principles from an Islamic. Review of Islamic Economics, 3(2).
• Archer, S. & Abdel Karim, R. A., (2007); Islamic Finance: The Regulatory Challenge. Singapore: John Wiley & Sons (Asia) Pte.
Ltd., pp. 400-407.
• Aziz, Z. A., (2007). In: Islamic Finance: The Regulatory Challenge. Singapore: John Wiley & Sons (Asia) Pte Ltd (Foreword)
• Baydoun, N. & Willett, R., (1997). Islam and Accounting: Ethical Issues in the Presentation of Financial Information. Accounting,
Commerce & Finance: The Islamic Perspective Journal, 1(1), p. 1–25.
• Bouheraoua, S., Mohamad, S., Kasri, N. S. & Abdullah, S., 2015. Shariah issues in intangible assets. Jurnal Syariah, pp. 287-324.
• Deloitte, (2018). Preface to International Financial Reporting Standards. [Online] Available at: https://www.iasplus.com/en/
standards/other/preface
• Gambling, T. & Abdel Karim, R. A., (1999). Business and accounting ethics in Islam. London: Mansell.
• Hashimi, F. A., (1987). The Need and Rationale for Setting up of Accounting Standards for Islamic Banks. Pakistan Accountant,
pp. 23-29.
• International Accounting Standards Board (IASB), 2016. I) The Conceptual Framework for Financial Reporting. In: International
Financial Reporting Standards. s.l.: IFRS Foundation. ii) International Accounting Standard (IAS Nos: 16; 39, 40, 41)
• International Accounting Standards Board, 2016.
• Karim, R. A. A., 1990. Standard Setting for the Financial Reporting of Religious Business Organisations: The Case of Islamic
Banks. Accounting and Business Research, 20(80), pp. 299-305.
• Obaidullah, M., 2002. Islamic Risk Management. International Journal of Islamic Financial Services, 3(4).
• Tactic, N. B., Zohar, S. B. S. & Boudriga, A.,( 2010). Do Islamic banks use loan loss provisions to smooth their results? Journal of
Islamic Accounting and Business Research, 1(2), pp. 114-127.
• Usmani, M. T., (200); An Introduction to Islamic Finance; Idaratul Ma’’arif, Karachi; May.

22 Vol. 2 , Issue 1/2018

 Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan

PEER-REVIEWED

Strengthening the Shari’ah Governance for

Islamic Banking Institutions: The Case of Pakistan
Muhammad Ayub 1
Khurram Khan 2
Abdul Rashid 3

Abstract
Equity, participation, ownership, risk sharing, possession and sanctity of contracts are the
key features of Islamic finance. It implies that financing can only be extended to productive
activities, trade, and real assets. Islamic system of finance can thus serve the purpose of financial
intermediation as a means to create sustainable value in the real economy at national and global
levels. For this, the banking and the non-banking financial institutions have to apply the divine
principles of the Shari’ah in letter and spirit. However, Islamic banks and financial institutions
(IBFIs) are lacking in this regard. Instead of learning the right lesson of avoiding products that led
to instability, injustice and crises in the global finance, IBFIs have been replicating conventional
products to get comparable returns in financial markets. This has caused credibility problem for
Islamic system of finance4.

This paper, based on analytical study of the available material on features of Islamic finance
and regulations applicable in Pakistan, evaluates the effectiveness of the Shari’ah governance
framework and steps taken for ensuring Shari’ah compliance. It suggests reorientation of the
regulatory and governance framework to enable the Islamic banking to realize its objectives. To
avoid distortions in the market, structured products need to be approved only after broad based
dialogue among the Shari’ah scholars, banking and finance experts and the economists. There
has to be one basis for such broader level dialogue, products approval and decision making, and
AAOIFI’s Shari’ah set of Standards could be one such basis to ultimately avoid products and
practices that cause crises, apart from other structural and prudential guidelines published by
other standard setting bodies. Based on these standards, a commission comprising regulators,
Shari’ah scholars, Islamic banking practitioners and economists may decide on controversial
issues to promote homogeneity of practices at least at the national level. The regulators, Shari’ah
scholars and the product developers need to adopt a long-term vision for developing banking and
finance for financial and social inclusion, welfare and sustainable development of economy.

Keywords: Islamic banks, Shari’ah governance, Pakistan, AAOIFI’s Shari’ah Standards.

KAUJIE Classification: J0, L24, L33, T4
JEL Classification: G2, G3, O16
1- Mr. Muhammad Ayub is the Editor of JOIFA. He is also the Director Research and Training at the Riphah Centre of Islamic Business
(RCIB), Riphah International University, Islamabad, the Editor of Journal of Islamic Business and Management (JIBM), and Secretary of
International Conference on Islamic Business (ICIB).
2- Dr. Khurram Khan is Associate Professor and Chairman, Riphah Center of Islamic Business (RCIB), Riphah Int’l University.
3- Dr. Abdul Rashid is Associate Professor at the International Institute of Islamic Economics (IIIE), International University Islamabad.
4- Professor Michael Skully of Monash University, while accepting that the ‘financials’ were the main culprit behind the global crisis observed
that Islamic finance can do better if not being exposed to financials and highly levered companies” (Sadiq, K. and Ann Black, 2012).

Vol. 2 , Issue 1/2018 23

Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan
1. Introduction
Islamic banking and finance has evolved from
a niche to a fast growth segment of the global
financial industry since its inception approximately
half a century back. The new system has been
growing at a rate of 15-20 percent annually over
the three decades. Although the growth rate has
reduced to over the last few years, the market is
expected to rise to US$3.8 trillion by 2022 (TR-ICD,
2017). This growth continued despite recent global
crises, which points to resilience of Islamic finance
and its broader level appeal. Islamic countries
account for almost 95% of the global Islamic finance
industry. Britain is the hub of Islamic finance in the
non-Muslim world where five full- fledged Islamic
banks and twenty two others institutions offer
Islamic finance services (El Hussein, 2013). Markets
for Islamic financial products are also available
in Germany, France, Denmark, USA, Canada,
Africa, China and Australia that offer continued
opportunities for growth and development. While
appeal from large Muslim population around the
world in the wake of severe prohibition of interest
and gambling is obvious, the resilience could be
by dint of distinctive Islamic finance principles
that stay focused on equity participation, risk
and reward sharing and a solid link between real
economy and finance [Hussain: IMF WP 120/15].
On account of SRI (socially responsible investment)
friendly nature, Islamic system of finance can
serve the real purpose of financial intermediation
as a means to create sustainable value in the real
economy at national and global levels.
Causes of the financial crises are generally
divided into three categories namely i) financial
innovations leading to the development of risky
and complex financial products – process may be
termed as ‘financialisation’, ii) built-in fragility
and vulnerability of the financial system; and iii)
inadequacy of the regulatory and supervision
systems over banks and financial markets (El
Hussein, 2013). As the crisis erupted in 2008, a
number of regulatory measures were suggested
and implemented. But mere regulatory approaches
and prudential oversight remained insufficient
to restrict excessive risk taking (Claessens Stijn,
2014, IMF WP/14/214). Use of financial derivatives
sharply increased despite the regulatory measures.
and some market analysts estimated the derivatives
market to be more than 10 times the size of the total
world GDP. Hence, the other two categories of
causes also need to be taken care of which would
5- As from 1971, money is created by making loans depending upon banks’ own reserve ratios and the discount rate, and through the
purchase and sale of government securities by the central banks.
6- It is accepted globally: “With the eurozone debt crisis deepening and the US in financial turmoil, investors are increasingly looking to
move away from a speculative and profit-based financial system. Within the new world order of austerity and caution, Islamic finance’s
fundamental tenets of risk-sharing and a prohibition on interest have helped boost its image as a safe haven”. (The Banker - Nov 2011)
24 Vol. 2 , Issue 1/2018
require moving away from ‘financialisation’ to
risk based and real sector related finance and
investment activities. It, of course, has to be
supplemented by rigorous regulations and their
effective implementation to ensure purposeful
intermediation.
Shari’ah based rules have the capacity of making
Islamic finance a model system that, if implemented
properly, could possibly either prevent occurrences
of financial crises or at least minimize their severity.
It, however, would require adherence to the
principles of Islamic finance by Islamic finance
institutions (IFIs) that, in turn, would require the
regulators to ensure that Islamic banks or other IFIs
implement the moral and ethical principles that
underpin Islamic finance. The system that shuns
interest, short selling and uncertainty (gharar) must
choose an alternative money creation and currency
system that structurally eliminates interest and
other exploitative returns as Islam, Catholic Church
and other divine religions so require5 .
The resilience of Islamic finance can be tested by
analyzing the practices, products and investments
of the IFIs whether they avoid such factors, or apply
products or procedures that are contrary to their
basic principles, but maximize their returns while
competing with their conventional counterparts6 .
IFIs escaped the 2008 global crisis because by
that time the use of structured products leading
to money creation without value addition for the
real sector was minimal. Practically, however,
derivatives are instruments of loss and not gain
as 70% of derivatives trading ends up in loss (Al-
Suwailem 2006:53)
The current asset-base of global Islamic finance
industry stands at US$2 trillion covering all areas
like micro, consumer and corporate finance
products, Sukuk [falsely called Islamic bonds],
hedge funds investing in derivatives, futures and
forward markets, real state, mutual funds, takaful
and wealth management. Sukuk issuance at global
level in 2016 exceeded US$40 billion up 22% from
US$32 billion the previous year. Recently, new
tax reforms have been introduced in countries
like Turkey and Pakistan to make the issuance
of corporate Sukuk more appealing. As regards
equities, the S&P and Dow Jones Shari’ah indices
have evidenced that most Shari’ah portfolios
outperformed their conventional counterparts (IFN
Guide 2017).
The issue of concern, despite the impressive
growth, is that Islamic banking and finance has
 Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan
not been able to establish its identity by offering
equitable solution of finance problem to all groups
in economies and to bring stability in the national
and the global markets. Therefore, the move
to Islamic finance is very slow even in Muslim
majority countries. Replication of almost all
conventional products and synthetic instruments
has caused much harm to integrity of the emerging
system. The twin-challenge of equitable economic
growth and financial stability is rather difficult to
undertake through debt-financing (Askari et al,
2010). It requires an effective regulatory framework
with different approach aimed at adoption of the
principles of Islamic finance in letter as also in spirit.
Pakistan is the country where pioneering
work on Islamic banking and finance is being
conducted since 1970s. Major changes were made
in 2002, 2008 and then in 2015 when the ‘Shari’ah
Governance Framework’ (SGF) was introduced for
Islamic banking institutions (IBIs) operating in the
country in parallel with the conventional banks.
Regulators in the countries namely the State Bank
of Pakistan (SBP) and Securities and Exchange
Commission, Pakistan (SECP) are playing active
role in promotion of Islamic banking and finance
with emphasis on Shari’ah compliance. SECP took
a strategic step by issuing the Shari’ah Advisors
Regulations, 2017 (SAR, The Regulations) on 15th
November, 2017. This paper will also discuss these
regulations briefly.
1.1 Research Method and Plan of the Paper
This paper is based on qualitative research
method which is the most suitable for research on
matters that need to discuss any new paradigm.
We plan here to evaluate the regulatory framework
and measures that govern Islamic banking by
focusing on Pakistan as a case study. Before this,
we shall briefly discuss in Section 2 how Islamic
finance evolved globally and why governance
structure needs to be changed. Section 3 discusses
the governance structure for IBs in Pakistan that
encompasses all features of governance of financial
institutions and an additional but the most crucial
aspect of ensuring compliance of their operations
and business contracts with the principles of
Islamic law of contracts. Section 4 is on evaluation
of SGF introduced by the State Bank of Pakistan,
while section 5 suggests measures to improve the
SG framework. Section 6 concludes the paper.
2. Islamic Finance’s Global Evolution
Islamic banks’ financing could genuinely be
based on trading in goods or papers representing
7- “Daily net positions dictate the overall net stock balances, i.e. how much is encumbered and how much is free to be used for new tawarruq
transactions” [Salman H. Khan; Organised Tawarruq in Practice: A Sharī‘ah Non- compliant and Unjustified Transaction; NewHorizon,
October-December, 2010.]
their ownership and leasing of assets can be used for
financing, in addition to partnership based modes.
Islamic banks are required, of course, to observe
essential features of such modes of business and
finance. However, their main portfolios practically
comprise the structured products and instruments
innovated to replicate the conventional products
with Shari’ah compliance in letter by getting
certification from their Shari’ah boards / advisors
(El Gamal, 2007; Hussain; WP/15/120)
Many IFIs are investing in Islamic profit rate
swaps, Islamic cross­-currency swaps, credit default
swaps, Islamic repos, fund index-linked derivatives
and other toxic instruments using the concepts of
wa’ad, tawarruq and muqassah (netting-off)7 by
invoking the simple principles of maslahah and
ibāhah (Kamali, 2000). In some markets, where
AAOIFI’s Shari’ah standards are considered as
guideline for products development, and in case
of many institutions across the globe, financial
derivatives are not used by the IFIs, and Pakistan is
one such market. However, controversial structured
products are used by some institutions even in such
markets and this requires more careful governance
by the regulators. To discuss issues relating to
governance in such markets we have selected
Pakistan as a case study.
2.1 N
 eed for Distinctive CG Structure for the
IFIs
For the institutions offering Islamic financial
products as alternative to conventional financial
products, stakeholders expect that their business
and operations would be carried out according to
the principles of Shari’ah. A corporate structure
that enables such an institution to implement
good governance through Shari’ah-compliant
operations is therefore essential. Mainly two
types of governance issues are specific to the IFIs:
i) assuring the stakeholders that the institutions’
business activities fully comply with principles
of the Shari’ah; and ii) to safeguard stakeholders
business interests while being an efficient, stable,
and trustworthy provider of financial services
(although this aspect is common to conventional
institutions as well, yet Islamic finance gives greater
emphasis to fair dealing, justice and equity related
responsibilities). As a result, depositors and finance
seekers need to feel confident that the business
is being conducted ensuring their religious and
financial needs.
Regulatory framework for Islamic banking
institutions (IBIs) comprises both internal and
external aspects of governance including legal
Vol. 2 , Issue 1/2018 25
Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan
framework and corporate governance. It has to
be supplemented by the regulator’s guideline on
capital adequacy, smooth payments system, risk
management, and most importantly, the Shari’ah
governance.
Corporate governance in Islamic finance is
understood as a set of systems and processes
to ensure proper accountability, integrity and
transparency in business operations of the IFIs
while ensuring care and just relationship with all
stakeholders (Grais, 2006 - WB W/P-40522). Further,
External Shari’ah Audit is now considered a crucial
part of the SGF for Islamic banking.
Keeping in view the above, we shall focus on
analyzing the Shari’ah Governance Framework
as implemented by the State Bank of Pakistan
(SBP) since July 2015 and also suggest measures
to strengthen the Shari’ah governance system in
Islamic banks across the world. IBIs have been
required to comply with the Code of Corporate
Governance (CCG) contained in Regulation No.
G-1 of the Prudential Regulations for Corporate /
Commercial Banking issued by SBP.
3. I slamic Banks’ Regulations and
Governance in Pakistan8
In Pakistan, the world’s second most populous
Islamic country with around 95 percent Muslim
population, the Islamic banking industry held 11.6
percent share in assets in June 2017, a slight increase
from a year ago (11.4 %), and well below levels of
around 25 percent in Gulf Arab states and even
Malaysia where Muslims are around 61.3 percent
of the population.
SBP is among the few regulators who have
introduced a comprehensive legal, regulatory, and
Shari’ah compliance framework for the Islamic
Banking Industry. Some important measures
have been taken by the Government and SBP to
facilitate the banks and the businesses / industry
to convert to Islamic finance. Islamic financial
institutions face some additional risks as compared
to their conventional counterparts. SBP has also
introduced a comprehensive corporate governance
system including appropriate board and senior
management oversight to keep a close watch on
implementation of these measures.
Pakistan is following the AAOIFI’s Shari’ah
Standards based mainstream approach of Islamic
finance avoiding Bai al Dayn, Bail Inah and financial
derivatives to promote Islamic banking with clear
emphasis on Shari’ah compliance. SBP advised IBIs
in 2008 to take prior approval for use of tawarruq
8- Islamic finance industry in Pakistan consists of Islamic banks, microfinance banks, Islamic mutual funds, Modaraba
companies, Takaful companies and Islamic REITs. Commercial and microfinance banks operate under SBP non-bank finance entities are
supervised by the Securities and Exchange Commission of Pakistan (SECP). Here we will be focusing on regulation of IBIs only.
26 Vol. 2 , Issue 1/2018
[Appendix-A, IBD Circular 2 / 2008]. The IBIs have
been advised to consider the ‘Shari’ah Essentials’
of modes approved by the SBP’s Shari’ah Board as
the minimum requirement for Shari’ah compliance.
For the Islamic modes for which essentials have not
been prescribed, AAOIFI Shari’ah standards may be
used as guidelines by IBIs in consultation with IBI’s
Shari’ah Boards. Six Shari’ah Standards of AAOIFI
[Nos. 3, 8, 9, 12, 13 and 17] have been adapted with
some clarification and/ or Amendments. The State
Bank also clarified that in case of any conflict with
the Shari’ah Standards adapted vide its Circulars,
‘Essentials of Islamic Modes of Financing’ shall
prevail.
The State Bank recently exempted Islamic banks
from using interest-based benchmarks for some
financing products (SBP, IBD Circular No. 01, 2016).
It also reduced SLR by 5 % enabling IBIs to enhance
their financing to business and commodity sectors.
In a continuing process, three centers of excellence
have been established for enhancing education and
awareness about Islamic banking in the country.
3.1 SGF 2015 for IBIs in Pakistan
Prior to 2015, the instructions and guidelines
issued vide SBP’s IBD Circular No.2 0f 2008
provided the basis for Shari’ah compliance for
Islamic banks. Keeping in view the developments
both at local and the global levels, some instructions
and guidelines were revisited and the Shari’ah
Governance Framework, 2015 made effective since
July 1, 2015. The SGF 2015 provides guidelines for
the central Shari’ah Board in the SBP, Shari’ah Boards
(SBs) in the IBIs, Resident Shari’ah Board members
(RSBM) in each IBI, Board of Directors (BoD) of
the IBIs, Executive Management (EM) and Shari’ah
Compliance Department (SCD) of each IBI, Shari’ah
Review Officers, internal auditors, external auditors,
personnel involved in product development, risk
management, liquidity management and other staff
for business development.
As per the SGF, BOD of each IBI is responsible
and accountable for ensuring conformity of the
Bank’s operations with the Shari’ah principles. The
BOD has to ensure that the SB is not subjected to any
undue influence or pressure from the management.
The BOD and EM are responsible for establishing
an organizational Shari’ah compliance environment
and mechanism within the bank. The BOD is
required to meet the SB at least on half yearly basis
and ensure timely and effective enforcement of
the SB decisions and recommendations. SB is also
required to specify the process / procedures for
changing, modifying or revisiting fatawa / rulings/
guidelines already issued by SB.
 Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan
Shari’ah Board has to review the scope,
methodology, checklists/work programs, Shari’ah
audit manual and format of internal Shari’ah audit
report and the annual Audit Plan. It should also give
advice on issues pointed out in internal and external
Shari’ah audits and Shari’ah compliance review
and take up unresolved issues with Management
and the BOD. If warranted, SB may include the
outstanding issues in Annual Shari’ah Compliance
Report. It may also refer Shari’ah issues to SBP for
seeking opinion of the central Shari’ah Board.
All inspection /review reports by the internal
auditors, State Bank’s inspection team and the
external auditors are to be shared with the Shari’ah
Boards and remedial actions recommended
by the Shari’ah boards are binding on the IBIs’
management. In the light of all these reports, the
Shari’ah Boards have been advised to furnish
report(s) to the SBP about the remedial actions
taken by the management and the role of the BOD.
The RSBM is required to provide explanation
to management and staff of the bank on products,
documents, etc. in the light of decisions, rulings,
fatawa issued by the SB; and such explanations
or clarifications are binding on the bank. The
Shari’ah Compliance Department (SCD) is
required to keep a continuous watch on the IBI’s
Shari’ah compliance environment to ensure that
all organs of Shari’ah Governance including the
BOD oversight mechanism, internal Shari’ah audit,
and enforcement of the SB’s directives by EM are
operative and are effectively discharging their
respective functions and responsibilities as defined
in the Framework. SCD is also required to conduct
Shari’ah compliance review (in addition to internal
audit) to re-ensure that the IBI’s operations are in
conformity with decisions/guidelines issued by the
SB of the IBI and directives, regulation, instructions
and guidelines issued by SBP in accordance with
the rulings of SBP’s Shari’ah Board.
SCD is also responsible for enforcement of
Shari’ah Audit Reports and take corrective actions
directed by the SB on the reports of ‘internal
Shari’ah review’ and ‘SBP Shari’ah compliance
inspection’. The Board Audit Committee (BAC)
of BOD is to ensure compliance of the corrective
actions determined by SB on the reports of internal
and external Shari’ah audits.
3.2 SECP’s Shari’ah Advisors Regulations
As indicated in the introduction, SECP issued
the Shari’ah Advisors Regulations, 2017 (SAR,
The Regulations) on 15th November, 2017. The
SAR are applicable to every person providing
Shari’ah advisory services to a company or an
9- As per SGF 2015, it is for three years (up to June 30 2018). This provision has to be applied, and henceforth, members of the IBIs’ Shariah
Boards may not be allowed to have multiple memberships in banks.
entity registered, licensed, and/or regulated by the
Commission, but are not applicable to the Insurance
or Takaful Companies, Banking Companies or any
other Companies regulated by the SBP. The SECP
shall maintain a register of Shari’ah Advisors out
of which the companies could engage any of the
Shari’ah advisors, and inform the Commission
within seven (7) days of appointment.
As per the SAR, any person included in the SECP
List may be appointed as Shari’ah advisor subject to
the limit of maximum four concurrent appointments
applicable with effect from July 1, 2018. However,
appointment as a Shari’ah advisor in any banking
company, regulated by the SBP is not included in
this limit. It implies that one Shari’ah scholar (other
than Resident Shari’ah Board Member of Islamic
banking institutions) is eligible to be on the panel
of 3 banks (under SGF, 20159 ) and 4 non-banking
companies (under SAR, 2017).
The SAR requires Shari’ah advisors to thoroughly
understand and analyse the relevant issues before
giving any Shari’ah opinion. They must provide
the underlying reasoning and references in detail
covering: i) the extent to which the arrangement,
structure and the contract(s) are consistent with
Shari’ah principles; ii) how that is free from riba; iii)
how gharar involvement has been addressed; iv)
extent to which consistent or inconsistent with the
relevant AAOIFI’s Shari’ah standards; v) exceptions,
reservations, qualifications regarding compliance,
if any; and vi) any other needed details.
The provision about the AAOIFI’s Shari’ah
Standards lacks clarity. The Commission may issue
a clarification to the effect that the AAOIFI’s Shari’ah
Standards would be the basis and benchmark for
giving Shari’ah related opinions on any instruments,
products or investment activities. It is necessary to
regulate the flexibility in the Shari’ah rulings, to
avoid market distortions, and to bring harmony
in the national market. So far, any institutional
arrangement for regulated use of flexibility in
Shari’ah rules is missing. It could harm integrity of
Islamic finance and become a constraining factor in
its growth.
4. Evaluation of the SGF 2015
The SGF 2015 covers all instructions given
by AAOIFI in its standard, and the IFSB (2009)
with addition of external audit. Making the BOD
accountable ultimately for the Shari’ah compliance
and decisions of the Shari’ah boards and the RSBM
binding for the management and instructions
for education and training of all organs of the
management and operational staff are crucial areas
of the SGF. Intensive role of the internal reviewers,
Vol. 2 , Issue 1/2018 27
Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan
requirement for external audit, inspection by
the regulator (SBP), enforcement of internal and
external audit reports, etc. also tend to imply
strengths of the Framework.
Detailed instructions have been given regarding
all areas also including conflict resolution. All
inspection /review reports by the internal auditors,
State Bank’s inspection team and the external
auditors are to be shared with the Shari’ah board
and remedial actions recommended by the Shari’ah
boards are binding on the IBIs’ management. For
safeguarding rights of the stakeholders and stability
and soundness of the system, sufficient emphasis
has been laid down on disclosure, transparency,
deposits pools management, profit sharing
ratio (PSR), Profit Equalization Reserve (PER),
Investment Risk Reserves (IRR) and parameters of
Hiba (gift as return on deposits), if any, to the pools
and not to any individuals in any pools. Timely and
full disclosure has to be made about the PSR, the
weightages assigned to various deposit pools while
the practice of Hiba, if any, has been restricted to
pools only.
It is for the banks now to launch Shari’ah-
compliant products to finance production of
commodities, services and other business sectors
for facilitating growth in various industries, such as
agriculture, infrastructure, communication, trade
and business. Particularly, banks need to finance
for purchases of industry raw materials, inputs
and machinery required by SMEs and agriculture,
develop dairy, cattle and fish farming, and other
areas of Halal business.
4.1 The Issues still to be taken care of
Despite all strengths as indicated above, the
ultimate outcome in terms of Shari’ah compliance
and credibility of the Islamic banking system in the
country is unlikely to improve. This is due to some
intriguing built-in issues in products approval,
decisions / pronouncements with regard to Shari’ah
certification, lack of finance related knowledge,
and an increasing number, categories and levels of
conflicts of interests. According to Wright (2006),
the real challenge for Islamic finance is to find
such scholars that have sufficient knowledge and
experience in finance and banking. According to
Wilson (2009) and Hanim Hamzah (2010), shortage
of quality SC members is a problem for Islamic
finance in achieving its objectives and gaining
increasing credibility.
10- As evident from Columns, papers, comments etc. in various Newspapers and Journals; some people have approached even the Federal
Shariat Court as a part of the on-going hearing of long-standing Riba case to declare Islamic banking in vogue as void / un-Islamic.
11- See for the details and Shariah related issues: JIBM Discussion Forum on Bai Muajjal of GoP Igarah Sukuk introduced vide SBP DMMD
Circular 17 dated Oct 17, 2014. Vol 5; No. 2; Dec; 2015 http://jibm.org/?q=node/82
12- Dr. Shamshad Akhtar, former SBP Governor, (SBP, Islamic Banking Sector Review: 2003 to 2007).
13- The rational for full-fledged Shariah Board in an IBI becomes fragile in the wake of SGF’s instruction that banks Shariah boards shall be
deciding in accordance with pronouncements of SBP’s Shariah Board.
28 Vol. 2 , Issue 1/2018
It may be the reason that even after introduction
of the new SGF in 2015, the critiques of the Islamic
banking system have increased both in print and
electronic media and among the relevant circles
in the society, negatively affecting the public
perception. Serious criticisms have been made by
the academicians, media personnel and the public
opinion makers in general10 . It is due to two major
gaps that cause failure to the system in achieving
the goals of Shari’ah compliance and value creation
in real terms for investors/customers:
Absence of any Solid Basis for Shari’ah
Pronouncements: Despite the ‘Shari’ah Essentials’
of modes suggested by the SBP (IBD Circular
02 2008) and general instructions that AAOIFI
standards be followed, there is no solid common
basis for deciding the Shari’ah matters. Shari’ah
Advisors and Boards are free to decide and take
any position taking benefit from any contemporary
practice under contagion / path dependency effect.
This gap exists both at the level of SBP’s Shari’ah
board as also the IBIs’ SB level. The former’s
example, among others, is approval of the liquidity
management product named ‘Bai al Miajjal of
(GoP) Ijarah Sukuk’11 . At the level of the IBIs’
Shari’ah Boards, the examples of misuse of such
freedom in products approval are ‘Currency Salam’
as alternative to ‘bills discounting’, commodity
murabaha / sukuk murabaha as organized / banking
tawarruq, and running musharaka as alternative
to Over Draft (OD) in the conventional finance
(JIBM, Vol.6, No.1, Dec. 2016). None of the three
products has been allowed formally by the SBP’s
Shari’ah Board, but most of the IBIs are using these
products. SBP’s Shari’ah Board has not taken any
initiative to standardize the products in the country
or to undertake detailed studies prior to approving
the products. The lack of such standardization is
a big hurdle in enhancing the outreach of Islamic
banking in the country12 .
Issues and Conflicts of Interests in Shari’ah
Advisory Framework: There are a number of
conflicts of interests in the Shari’ah advisory
framework. Earlier, there was only one Shari’ah
Advisor serving as an employee in an IBI, paid
directly by the respective banks. Now that position
has been assigned to the RSBM with additional
requirement of Shari’ah Board comprising at
least three Shari’ah scholars13 . As a result, the
increased demand for scholars associated with such
institutions / madaris that have flexible approach
 Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan

towards replicating conventional banking products
has increased the intensity of conflict of interest.
Shari’ah compliance level has thus deteriorated,
due to a variety of issues and conflicts of interest as
discussed below:
A special kind of employer-employee relationship:
While the RSBMs are regular employees of all IBIs,
the banks’ management generally agrees to pay
relatively higher monthly remuneration to them,
and also to other Shari’ah board members who
attend meeting once in a quarter of year. This may
cause a formal pressure on them to be flexible in
approval of products and Shari’ah certification
ignoring loopholes, if any14 .
The Issue of Time and Multiple Memberships:
In the draft SGF issued by the SBP in 2014 seeking
comments from the banks, SBP had required the
RSBM to give full time to the bank enabling him to
review thoroughly the practices of the banks. But
some senior Shari’ah scholars put pressure on the
regulator to allow them to undertake teaching and
research work at Madaris despite being RSBM in
any bank, and ultimately in the final SGF issued
in April 2015, the RSBMs were allowed not only
to give some time daily to teaching / research
activities at madaris, but also to take positions as
member of Shari’ah board in any non-bank financial
institutions. The Shari’ah advisors who were earlier
working for only one IBI have taken positions in
other IFIs as well with lucrative packages, vis-à-vis
the time given, in each institution. Now the ground
reality is that neither most of the RSBM desire to
give full time to the bank, nor the IBIs’ management
obliges them to give full time as in case of their
other employees.
Senior-Junior or Teacher- student Relationship:
The environment and practice in ‘madaris’ is such
that the juniors / students always have to accept
what their teachers or seniors say or opine. Any
renowned scholar serving as a Chairman of the
central Shari’ah board of the country is considered
to mean that all scholars and boards shall have
to accept this as final pronouncement15 . This,
combined with lack of any solid basis for fatawa,
as discussed above, and majority principle in
Shari’ah approval process, will lead to the failure of
the Shari’ah governance system. Shari’ah opinions
have to be based necessarily on Shari’ah principles
through a well thought-out process.
Path dependence Syndrome: In case a product
is approved generally anywhere in the world, and
specifically by any IBI in Pakistan, it tends to oblige
Shari’ah Boards of other IBIs to approve it as it has
happened in the case of organized tawarruq and
‘Running Musharaka’. IBIs’ management obliges
their Shari’ah Board to approve on the basis that
others have approved.
Business Proposition vs. Shari’ah Compliance:
Having got a good business proposal, IBIs find one
way or the other to avail that by getting approval
from the respective SB. Some IBIs’ tawarruq based
secured lending by way of lien mark of interest
based T-bills and PIBs just to improve capital
adequacy ratio (CAR) that deteriorated due to
tawarruq based clean lending, is the worst example,
among others, of this trend.
The aforesaid issues may imply that despite the
strengths of SGF as discussed above, there are some
built-in flaws, loopholes and conflicts of interests
pertaining to tricky role of the Shari’ah scholars, and
inability of the regulator to enforce the framework
so far, as per its objectives, that may lead to even
worse situation, if not taken care of forthwith.
4.2 S
 hari’ah Governance and the Role of
Shari’ah scholars
Shari’ah scholars have been assigned the divine
responsibility of ensuring a Shari’ah compliant,
trustworthy and robust system that could be
helpful in enhancing financial and social inclusion
and provide necessary support for sustainable
growth and development of the economies and
the societies. SBP has advised special ‘fit & proper’
criteria for the Shari’ah scholars as members of
the IBIs Shari’ah Boards. But their expertise for
understanding investment and financing products,
nature and extent of involvement, function and
remuneration give rise to a number of concerns and
sensitive issues that need to be taken care of.
Practically, the ability of the Shari’ah boards
/advisors to fulfill their mandate may be
constrained by the time given and activity for the
banks affairs, their understanding and access to
monitoring systems, complexity of the products
and transactions, and effectiveness of their
independence (Grais W and Pellegrini, 2006).
According to the instructions of SBP, the burden
whether a product passes Shari’ah compliance test
rests on the shoulders of IBIs’ Shari’ah Boards.
Hence, Shari’ah scholars / boards need to be
mindful of their obligations to approve only those
products which are truly Shari’ah compliant. Any

14-  See for various conflicts: Samy Nathan Garas, (2012) “The conflicts of interest inside the Shari’a supervisory board”, International
Journal of Islamic and Middle Eastern Finance and Management, Vol. 5 Issue: 2, pp.88-105.
:results of the study are: … the relation between the SSB members and the BoDs, and the membership in Islamic funds and issuers of Islamic
bonds are significantly related to the conflicts of interest, whereas remuneration and membership in companies trading in capital markets
have insignificant relation (in GCC countries). ; ii) Shariah Governance: Challenges Ahead by Ahmad Faizal Abdul Aziz (INCEIF).
15- Such top level personalities have to be member of an ‘Elders Council on Islamic Finance’ for resolution of any disputes.

Vol. 2 , Issue 1/2018 29

Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan
compromise in this regard could make the income
so earned non-Shari’ah compliant defeating the very
purpose of introducing Islamic banking. Above all,
it is a source of disrepute to the system tagged with
the divine system of Islam.
The function of approving any products has
to be accomplished with complete knowledge of
all involved matters and suitable arguments and
rationale (Sahih Bukhari, Kitab al ‘Ilm). According
to a hadith reported by Ibne Majah, the Prophet
(PBUH) said, “In case a pronouncement is given
without proper argument, the sin will be on the
person who gives fatwa” [chapter on care while
giving opinion or doing Qiyas].
A related matter is that of question of
independence of the SBP itself because its role and
policy initiatives with regard to Islamic banking
have become subservient to a few banks and
persons - the regulator is compromising on its own
independence. This creates chaos in the market
because the management of other IBIs requires
their Shari’ah Boards to approve all such products
that are being used by any other Islamic Bank(s).
Besides, surrendering to the demand of some
Shari’ah scholars for allowing them not to give full
time despite being RSBM has created a loophole for
the system as a whole.
4.3 SGF and Socio-economic Justice
The primary objective of the SGF is “to strengthen
the overall Shari’ah compliance environment of
IBIs”. The Shari’ah compliance, in turn, is for
realizing the maqasid al-Shari’ah. According to an
ISRA research study (No. 97/2017), Islamic banks are
required to pursue maqasid al-Shari’ah in addition
to doing business for genuine profit. These include,
inter alia, promotion of broad-based economic
growth and the development and well-being of the
society they operate in. It is what the State Bank of
Pakistan declares in its strategic plan (2014-18) by
indicating the Shari’ah objectives of ensuring ‘risk
and reward sharing’ and equitable and broad based
distribution of economic gains.
Major Islamic banks operating in Pakistan
have indicated the same objectives in their vision
/ mission statements. As per the vision of Meezan
Bank, the premier Islamic bank of Pakistan, its
objective is to “Establish Islamic banking as banking
of first choice to facilitate the implementation of
an equitable economic system, providing a strong
16- For example: MBL’s Profit after tax for the year 2015, increased to Rs 5.023 billion compared to Rs 4.570 billion recorded in 2014. Its EPS
increased during the period from Rs 4.56 to Rs 5.01.  The market value of the Share at 42.50 (face value of Rs. 10), the percent earning
for shareholders is 11.79, higher from about 11.4 percent for the previous year (Business Recorder, Feb 26, 2016). [It’s a good study
area for MS and PhD scholars to analyse the earnings of Islamic and conventional banks, dividends paid to the shareholders, profit
paid to various categories of depositors and to find out the impact of Islamic banks’ operations on various stake holders vis-à-vis the
conventional banks.
30 Vol. 2 , Issue 1/2018
foundation for establishing a fair and just society for
mankind”. Among its ‘values’ ‘social responsibility’
is an important factor. Similarly, Al-Baraka Bank,
Pakistan, has adopted the following vision, “We
believe that the society needs a fair and equitable
financial system which rewards efforts and
contributes to the development of the community.”
In line with such vision, one important function
of Islamic banks is to provide Shari’ah compliant
financing to the SMEs and the agriculturists that are
the basic producing units in any economy providing
jobs to a major part of the population. Providing
them finance on any of the non-exploitative bases
is the basic objective of Islamic banking and finance
(Council of Islamic Ideology, Pakistan, 1980).
Next, the issue is whether the SGF could be
helpful in realizing the objectives as briefly indicated
above. As per the theory of Islamic banking, profit
rates given by IBIs should be higher than the profits
given by the conventional banks. But practically, the
fact is reverse in case of all IBIs in Pakistan. Their
profits on equity and earning per share (EPS) have
increased visibly over past some years,16 but the
profit rates for depositors, particularly the general
(savings) deposits have decreased drastically. While
the conventional banks have to pay presently a
minimum profit of about 4 % per annum on savings
deposits at the time when the benchmark interest
rate in Pakistan is the lowest in recent history of the
country, IBIs are paying as low as 2 percent in many
cases, simply because the SBP has not obliged them
to pay a minimum due to the features of Mudaraba
contract. It seems, therefore, that the practices of
the IBIs over the last two years– taking deposits,
financing and investments, may lead to the contrary,
even worse than in the conventional banks.
An independent and rational analysis cannot
explain this trend except possibly the case that IBIs
are working under the conventional framework
where banks are allowed to get all benefits for
themselves without giving the society its due share
and resources with which they undertake their
business. The banking sector in Pakistan that has
large foreign investments is among the highest
profit yielding markets in the world and as such
huge amounts of profits are remitted abroad due to
foreign ownership of the privatized banks (Dawn,
Jan 03 and April 29, 2016.) It is the issue to be
considered by the regulator, Shari’ah Boards of SBP
and the IBIs, and ultimately the Government.
 Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan

The rates announced by some IBIs for the first quarter of 2016 are given below:
Annual Profit Rates Announced by some IBI’s in Pakistan (April 2016)
Deposit Categories MEEZAN BURJ BANK ISLAMI ALBARAKA ABL
PLS Saving Profit payment 2.50 % 1.90 % 2.79 % 2.75 % 3.02 %
6 Months On Maturity 4.37 % 5.60 % 5.85 % 4.60 % 4.22 %
1 Year Profit Monthly 4.63 % 5.90 % 5.70 % 5.15 % 4.32 %
Quarterly 4.97 % 5.93 % 5.73 % 5.20 % -
Six Monthly - - - - -
at Maturity 5.12 % 6.07 % 5.85 % 5.45 % 4.63 %
3 Years Profit Monthly 5.38 % - 5.75 % 5.50 % 4.93 %
Quarterly 5.53 % - 5.77 % 5.60 % -
Six Monthly - 6.20 % - - -
at Maturity 5.75 % 6.40 % 5.90 % 5.75 % -
5 Years Profit Monthly 5.82 % - 5.99 % 5.85 % 5.53 %
Quarterly 5.86 % - 6.02 % 6.00 % -
Six Monthly - 6.45 % - - -
at Maturity 5.94 % 6.50 % 6.16 % 6.10 % -

Hence, the serious issue is the ineffective
implementation of the regulatory instructions.
We shall give one example each for deposits and
financing sides to explain the situation. SBP did a
good job (Nov. 19, 2012) by prohibiting hibah to
depositors and phased out the individuals hiba by
July, 2015. But the IBIs circumvented the regulation
and offered high weightage based products to their
‘priority’ deposits at the cost of common depositors.
As a result, some banks have been giving up to 5 %
annual profit to priority Savings Account holders by
offering special PLS deposits, for example, against
2-2.5 % annual profit to common PLS savings
depositors. On financing side financial reporting by
banks in case of Ijarah financing needs regulatory
over sight. Only three of AAOFI’s Islamic Financial
Accounting Standards (FAS-1, FAS-2, and FAS-3)
were notified by the SECP over the last 13 years
pertaining to Murabaha, Ijarah and Mudaraba for
deposits. IFAS 2 requires that Ijarah income is to be
recognized on accrual basis - as and when the rental
becomes due (clause 10.4) meaning that full amount
of due rent has to be included in the installments
for payment of rent and the principal. But, IBIs
normally charge in the initial stage a much higher
part as rent and smaller part from the principal that
results in loss to the lessee in case of pre-mature
termination due to theft, major accident or non-
payment due to any problem with the lessee.
As regards the objective of facilitating the real
sector through enabling sufficient purchasing
power, the IBIs continue to ignore it and encourage
products with risk free profits by using controversial
products. Replacing genuine Murabaha, Ijarah,
Salam, Istisna, etc. with Running Musharaka (RM),
secured or unsecured lending to conventional banks
by tawarruq simply means that IBIs are interested in
maximizing their earnings only without due regard
for social contribution or even Shari’ah compliance
in letter.
5. Suggestions for Filling the Gaps
The prime factors behind the failure in achieving
the objective of Shari’ah compliance in letter and
spirit are non-availability of any single basis for
products approval and decision making, allowing
the IBIs implicitly to use any products for which
they may get approval from their Shari’ah Boards,
and SBP’s inability to properly govern the abilities
and role of the Shari’ah scholars / RSBMs / Shari’ah
Boards. Following steps are recommended in this
regards:
5.1 B
 asis for Shari’ah Opinions and Products
Approval Process:
There has to be one basis for products approval
and decision making. AAOIFI’s Shari’ah (and other)
Standards may be made mandatory; Introduction
of an SOP for products development and approval
involving practitioners and professionals; Shari’ah
Board of the SBP may play role in harmonizing
the business practices of the IBIs particularly
with regard to the structured products. It needs
adoption / adaptation of the AAOIFI’s Standards
while ensuring that the spirit of the Shari’ah is not
compromised.
The process of arranging syndicated finance
needs to be developed and introduced in line
with the AAOIFI’s relevant standard(s). It would

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Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan

facilitate financing of large projects in Shari’ah
compliant manner without facing any problems
as faced a couple of years ago with respect to
Rs. 100 billion financing for the Neelum Jhelum
Hydropower project (NJHP) for which the National
Bank of Pakistan (NBP) served as Mandated Lead
Arranger (MLA) and some other IBIs participated
as investors / Sukuk holders17 . It’s good to note
that the SBP has quite recently initiated the process
of adoption of AAOIFI’s standard on syndicate
finance.
Products approved by IBIs Shari’ah departments
may be first analyzed thoroughly by the Shari’ah
Research Unit of the IBD (SBP) to ensure that
nothing in it is against AAOIFI’s Standards;
discussed if needed in ‘Shari’ah Scholars Forum’
and then submitted to the SBP’s Shari’ah Boards for
approval; IBIs may then be advised not to use any
product unless approved expressly by the SBP’s
Shari’ah Board18 .
SBP’s Shari’ah Board: The central Shari’ah board
of the country may be constituted to avoid senior-
junior or other types of conflict of interests. Further,
the full-time Shari’ah advisor in IBIs (RSBM) may
not be allowed to sit on the central Shari’ah Board
to ensure independence of decisions and products
approval.
institutions. Its training arm, NIBAF, may design and
arrange a (6) months intensive training on Islamic
fiqh, economics, accounting, banking and finance
for Shari’ah scholars having sufficient knowledge
of Islamic law of contracts, banking, finance and
accounting, followed by a comprehensive written
Exam. Only the scholars securing (70) % or more
marks may be eligible to become Certified Shari’ah
Advisors in Islamic banking system of the country.
SBP and SECP may also like to maintain a joint list
of the certified Shari’ah scholars and arrange their
trainings in banking and financial markets.
The Islamic Banking Department (IBD) of the
SBP may nominate, with prior approval by the
SBP Shari’ah Board, any of the Panel members for
any IBIs for the period of three years, after which
they may be deputed to any other IBIs. IBD (with
approval of the SBP Shari’ah Board) would also
be deciding the honoraria, allowances, etc. to the
IBIs’ Shari’ah scholars, payable by the IBIs. For
this, the IBD may keep in view the knowledge
and expertise of the Shari’ah scholar, number of
branches, business, , size of internal Shari’ah control
and Shari’ah research / review department of the
concerned IBI, and the level of Shari’ah compliance
as may be revealed from reports of the external
audit and the regulatory inspection (lower the level,
greater the amount).

Having a Shari’ah Board in all IBIs may not be a
necessary requirement as it has caused unnecessary
costs to the IBIs without any visible benefit or
value addition in terms of Shari’ah compliance.
One Shari’ah Advisor serving full-time could be
sufficient to facilitate the banks in day-to-day
business as per standardized products discussed
thoroughly by the Shari’ah scholars’ forum and
approved by the SBP’s Shari’ah Board. Banks may,
however, be allowed, as prior to 2015, to constitute
their own Shari’ah Boards at their discretion. The
members of such Shari’ah boards might be paid
the honorarium, if any, for the meetings attended
or work accomplished, and not any regular pay.
Banks’ BODs may be made responsible for ensuring
Shari’ah compliance in the light of the standardized
products approved by SBP Shari’ah board.
For appointing IBIs’ Shari’ah Advisors, State
Bank may also maintain a panel of ‘Certified Islamic
Finance Scholars’ for Islamic banks and finance
The maximum number of Shari’ah Board seats
allowed for a Shari’ah scholar has to be different
for someone who is employed only for part time
for Shariah advisory responsibilities vs. RSBM,
or someone who is full time invested in SB affairs
and not doing any other job. Of course, both types
of positions need to be captioned to develop the
Shari’ah advisory system and to avoid cartelisation.
The SBP may determine honorarium separately for
the both categories.
5.2 A
 dditional measures to be taken by the
SBP
Sukuk Market: The primary and secondary
market for sovereign sukuk should be opened
for IBIs only, excluding conventional banks.
This step will also help in curbing the clean and
collateralized lending by IBIs to conventional banks
in contravention of the AAOIFI’s Shari’ah Shari’ah
Standard No. 30 on tawarruq.

17- A complicated structure with about a dozen contracts interlinked with one another and their documentation was approved by the
Shariah advisor of the MLA, without consultation with other consortium members. Other Shariah boards had to approve the structure
despite the fact that it had some flaws and many scholars expressed concern, the most serious of which was that in order to cover the
loss of ‘cost of funds’ on account of possible delay in payments after the due date, a system of rebate was provided. The agreed rental
rate was 6 months KIBOR + 175 bps per annum. However, assuming that NJHPC would delay in making payment, it was provided that
if payments are made within 30 days of the due date, the Bank may give a rebate of 67 bps for SLR eligible portion and 62 bps for non-
SLR eligible portion. A similar provision for charging an enhanced mark-up rate for extra 210 days was made in ‘Non- interest based
Banking’ (NIB) system of 1980 to provide for possible losses due to default in payment by a client . [For details, see Janjua M. Ashraf;
History of State Bank of Pakistan; Vol 3 (up to 1988) P. 636].
18- As per SGF, 2015, IBIs have to inform SBP about any new product approved by their Shariah board 30 days prior to its proposed launch, and
if any reply is not received within 30 days of its intimation to IBD/SBP, such product is considered as implicitly approved by the State Bank.

32 Vol. 2 , Issue 1/2018

 Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan
Based on the resilience that the IBIs have by dint
of specific nature of Islamic finance, the SLR for
IBIs has to be half the SLR for conventional banks.
It will enable the IBIs to invest more funds in the
commodity producing sectors like agriculture,
SMEs, industry and the infrastructure related
projects.
Eliminating duplication of review functions
by Shari’ah compliance and Shari’ah Review
departments and Audit departments in Stand-alone
IB system;
Administrative line of officials of Shari’ah
Compliance Department in Islamic banking of
conventional banks should be the Shari’ah Board,
not the business head (IBG Head);
SBP may enforce a “Code of Conduct - Ethics
and Principles for approval of Islamic banking
products”;
Shift required from the maximization of
shareholders’ value to that of the “aggregate welfare
of the stakeholders”. [WB WP. 4052]
There has to be minimum thresholds assigned
to all IBIs (separate from the parent conventional
banks) for financing the micro businesses, SMEs,
farming community and for serving for the cause of
the society and welfare of weaker groups;
Separation of management and the Shari’ah
board, which would mean separation of earnings
management and Shari’ah compliance;
The framework of shareholders value in corporate
governance may be amended to include other
stakeholders’ interests like that of the depositors
and the employees. It would require the banks to
take care of all stakeholders including society.
Efforts at integrating finance with technology for
developing innovative projects for development
(fintech is increasingly emerging as a tool for
improving financial performance and increasing
efficiency and sustainability; it can contribute
efficiently to social and financial inclusion and
sustainable development).
6. Concluding Remarks
Despite impressive global growth at the rate of
about 20 percent, on average, over the past decade,
Islamic finance still represents a very small share of
global financial assets. Same is the case of Muslim
countries like Pakistan where Islamic banking
could cover only 13 percent of total banking assets
over the last 15 years since re-launch of Islamic
banking in December, 2002. To this end, a number
of constraining factors have been discussed, the
most crucial of which is the credibility of the system
as being operated.
In the process of promoting Islamic banking in
the country, the SBP has not only tried to ensure
independence of the Shari’ah Boards of the IBIs,
but also required the banks’ BODs and Executive
Management to be fully involved in the process of
development of the new system and be accountable
for any Shari’ah non-compliance. Still, it has to
play crucial role to enhance credibility of Islamic
banking system.
Equity, participation, ownership, possession
and sanctity of contracts are the key principles
of Islamic finance. It implies that all contracts
in Islamic business and finance have to involve
productive activities, and financing can only be
extended to such activities, trade, and real assets.
If fully complied with, these principles ensure
appropriate leverage and help limit speculation and
moral hazard (Hussain, 2015, IMF WP/15/120).
However, the banks are still focusing on cash
financing and treasury products for risk-free return
even by compromising on the widely accepted
Shari’ah principles. Organized commodity
murabaha, interbank bai al muajjal of sukuk
(tawarruq as facilitated by brokers), RM, etc are
being used aggressively by some IBIs for lending
to conventional banks that use such liquidity
or arbitrage. Further, despite all such tactics to
maximize shareholders profits, the returns paid
to the depositors have decreased vis-à-vis the
conventional banks.
There are some built-in flaws and a variety
of conflicts of interests in the Shari’ah advisory
function, on account of which success of the
SGF for enhancing the Shari’ah compliance level
seems to be doubtful. Removing the conflicts of
interest in Shari’ah advisory system is an urgent
requirement. A number of products being used by
the IBIs keep them away from the desired and real
objective of financing the commodity producing
and business sectors. What is required is achieving
full compliance with Shari’ah in line with the
regulatory and supervisory standards issued by the
two Islamic standard-setting authorities including
AAOIFI and IFSB. If real Shari’ah compliance is
achieved it may become a basis for transformation
of the national and the global finance to infuse in
it morality and Divine ethics and to make it really
beneficial system for mankind.
Vol. 2 , Issue 1/2018 33
Strengthening the Shari’ah Governance for Islamic Banking Institutions: The Case of Pakistan

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• Journal of Islamic Business and Management (JIBM), Discussion Forum on Bai Muajjal of GoP Igarah Sukuk introduced vide SBP
DMMD Circular 17 dated Oct 17, 2014. Vol 5; No. 2; Dec; 2015 http://jibm.org/?q=node/82
• Kamali, Mohammad Hashim; Islamic Commercial Law: An Analysis of Futures and Options; Islamic Texts Society, UK; 2000.
• Khan, K. and Nur Sakinah N. N. S. (2017); Promotion of Agricultural and Small Business Financing through Qarḍ Ḥasan in Pakistan;
ISRA Research Paper (IRP) No. 97/2017
• Khan, S. H. (2010); Organized Tawarruq in Practice: A Sharī´ah Non- compliant and Unjustified Transaction; NewHorizon, October-
December.
• Sadiq, K. and Ann Black (2012), Embracing Sharia-Compliant Products through Regulatory Amendment to Achieve Parity of
Treatment; Sydney Law Review [VOL 34:189] see the link: http://sydney.edu.au/law/slr/slr_34/slr34_1/SLRv34no1SadiqandBlack.pdf
• Samy Nathan Garas, (2012) “The conflicts of interest inside the Shari’a supervisory board”, International Journal of Islamic and Middle
Eastern Finance and Management, Vol. 5 Issue: 2, pp.88-105, https://doi.org/10.1108/17538391211233399
• Shamshad Akhtar, SBP, Islamic Banking Sector Review: 2003 to 2007.
• State Bank of Pakistan (Jan, 2014); Strategic Plan Islamic Banking Industry of Pakistan 2014–2018; http://www.sbp.org.pk/departments/
pdf/StrategicPlanPDF/Strategy%20Paper-Final.pdf
• State Bank of Pakistan, (April, 2015); Shariah Governance Framework for Islamic Banking Institutions; Introduced vide IBD Circular
01 0f 2015 April 07 2015; with Encl: Shari’ah Governance Framework for IBIs.
• Thomson Router (TR) (2018); State of the Global Islamic Economy, 2017/18. P.36
• Wilson, R (2009). The development of Islamic finance in the GCC. Working Paper, Kuwait Programme on Development, Governance
and Globalisation in the Gulf States. UK: London School of Economics & Political Science.
• Wright, C. (2006). The Shariah scholar cartel. Asia Money. Retrieved 8 October 2011, from http://www.chriswrightmedia.com/
asiamoney-sep06-shariahscholars/

34 Vol. 2 , Issue 1/2018

 Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9

TECHNICAL ARTICLE

Towards Broader Understanding of AAOIFI’s FAS 30:

Impact Analysis in the Perspective of IFRS 9
Hondamir Nusrathujaev 1

The Perspective
The latest global financial crisis revealed that part of the blame was hidden in the shortsighted
accounting rules applied by the financial institutions. In particular, delayed recognition of
credit losses (i.e. when they already were inevitable or occurred) contributed to the escalation
and acceleration of the crises. Thus, financial institutions ended up booking too little too late
– accounting weakness that disguised their true financial illness until it finally exploded on a
global level.

As one of the responses to the financial crisis, as requested by the G20 leaders, the new accounting
standard, International Financial Reporting Standard 9 (IFRS 9) Financial Instruments,
introduced, inter alia, the expected credit loss (ECL) model (effective from 1 January 2018). New
model addressed the criticism of IAS 39 ‘incurred loss model’ by recognizing losses at the time
when a debt instrument is issued i.e. on day 1. We discuss below this crucial Standard.

IFRS 9 ECL Model basics Stage 3 applies to credit-impaired financial assets.

General approach Depending on the stage that the instrument falls

The new model is applied to all debt instruments
measured at amortized cost or fair value through
other comprehensive income (FVOCI), as well as
to issued loan commitments and the most of the
financial guarantee contracts.
It contains a ‘three stage’ approach, which is
based on the change in credit quality of financial
assets since initial recognition. Thus, three stages
reflect the pattern of the deterioration in credit risk.
At each reporting date, an institution assesses which
stage a financial instrument falls into. The stage
determines the relevant impairment requirements
and the amounts.
Stage 1: includes performing financial assets,
which have no signs of increased credit risk. When
the credit risk of a financial asset has significantly
increased since initial recognition, but the instrument
is not credit-impaired (no objective evidence of
impairment), the instrument will fall into Stage 2.
into, an entity either recognizes 12-month ECLs or
lifetime ECLs.
Assets falling into Stage 1 recognize 12-month
ECL on their gross carrying amounts. The 12-month
ECLs are just a portion of the lifetime ECLs reflecting
the defaults expected over the next 12 months. At
the same time, 12-month ECLs are not credit losses
that could occur in relation to the cash flows due in
the next 12 months.
Stage 2: includes financial assets that have had
a significant increase in credit risk since initial
recognition, but there has been no objective
evidence of impairment. For these items, lifetime
expected credit losses are recognized on their gross
carrying amount.
Stage 3: includes financial assets that have
objective evidence of impairment at the reporting
date. For these items, lifetime expected credit losses
are recognized on the net carrying amount.

1- The author is a Manager in Accounting and Reporting Division, Financial Control Department at the Islamic Development Bank, Jeddah.

Vol. 2 , Issue 1/2018 35

Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9
General Impairment Approach
Explanations:
No significant increase in credit risk (SICR) since
initial recognition or low credit risk (Stage 1) These
include:
• instruments with no delay in payment of contractual
dues;
• instruments with low risk of default;
• borrowers with strong ability to meet contractual
dues; and
• no evidence that adverse changes in future
economic and business conditions will reduce
the ability of the borrower to fulfil its contractual
obligations.
There are a number of approaches an entity may
adopt to determine whether a financial instrument
has low credit risk, such as Internal or external
credit risk ratings, or other methodologies. For
example, a financial instrument having ‘investment
grade’ may be considered to have low credit risk.
A significant increase in credit risk
(SICR) (Stage 2)
SICR is defined as a significant increase in
the probability of default (PD) occurring since
initial recognition. The term “default” may vary
from wider judgmental/qualitative measures
and indicators down to the failure to make
contractual payments. For example, there could be
a rebuttable presumption that the SICR occurred
when contractual payments are more than 30
days past due. This presumption may be refuted
by reasonable and supportable information when
available without undue cost or effort. In summary,
36 Vol. 2 , Issue 1/2018
if contractual cash flows have been more than 30
days past due, and the entity cannot rebut this
presumption, it becomes evident in that case that
SICR occurred since initial recognition even without
looking at other factors.
Once a financial asset experiences SICR, lifetime
ECLs are recognized instead of 12-month ECLs.
Examples of rebutting the presumption include
some administrative errors resulting in non-
payment of the amounts due or link between
significant risk of default and payments overdue by
over 60 days.
Credit-impaired financial assets
(Stage 3)
Under IFRS 9 a financial asset is credit-impaired
when one or more events have occurred that have
a detrimental impact on the expected future cash
flows of the financial asset. It includes observable
data that has come to the attention of the holder of a
financial asset about the following events:
• significant financial difficulty of the issuer or
borrower;
• a breach of contract, such as a default or past-due
event;
• the lenders for economic or contractual reasons
relating to the borrower’s financial difficulty
granting the borrower a concession that would
not otherwise be considered;
• it becoming probable that the borrower will enter
bankruptcy or other financial reorganization;
• the disappearance of an active market for the
financial asset because of financial difficulties; or
 Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9
• the purchase or origination of a financial asset
at a deep discount that reflects incurred credit
losses
Either a single discrete event or the combined
effect of several events may result in financial assets
becoming credit impaired.
Further, IAS 39 regarded financial assets past
due by 90 days as having objective evidence of
impairment. Same criterion can still be applied
under IFRS 9 to determine impairment and move
to Stage 3.
Measurement of ECL
The measurement of ECLs reflects:
• a range of unbiased and probability-weighted
outcomes.
• The discounted present value of the ECLs.
• The consideration of historical events, current
conditions and forecasts of future economic
conditions, if the information is available without
undue cost or effort.
ECLs are probability-weighted estimate of credit
losses (i.e., the present value of all cash shortfalls)
over the expected life of the financial instrument.
Finally! it would imply:
The IFRS 9 represents fundamental redesign of
provisioning model for financial assets, financial
guarantees and loan commitments.
Adopting the ECL model of impairment
will enhance transparency thus benefiting key
stakeholders, besides bringing long-term benefits
on the credit risk management.
At the same time, ECL estimation is a highly
judgmental area. As a result, the impairment values
would vary depending on the movements in the
projections and the relative credit quality of the assets.
Therefore, it may cause more bottom line volatility
than the superseded IAS 39 incurred loss model.
Assets & exposures subject to credit risk
Assets in scope • Commodity placements
• Murabaha receivable
• Other deferred sales receivable
• Istisna receivable
• Qard hasan
• Sukuk held to maturity
• Off-balance sheet exposures
Impairment approach • Credit losses
Assessment at each • Significant increase in credit risk
reporting date
Overview of FAS 30
The need for the Standard
Islamic finance is still a nascent industry with
sub-optimal operating and regulatory environment
that is yet to provide necessary support for well-
functioning of the emerging system. To that extent,
Islamic banks try to emulate conventional banks
in the design of their financing products with
greater focus on credit type financing. These factors
translate into significant credit risk exposure of
Islamic financial institutions.
AAOIFI has recognized the need to develop a
more robust and prudent financial reporting setting
that would prompt a more timely recognition of
expected credit losses without compromising on the
broader set of Islamic finance norms and principles.
This is how FAS 30 “Impairment, credit losses
and onerous commitments” (Standard) was
issued in November, 2017. This Standard aims at
setting out the accounting rules and principles for
impairment and credit losses, covering current and
expected losses, in line with global best practices,
taking into account the ever-changing requirements
and the genuine requirements of the Islamic
finance industry across the globe. It also sets out
classification of assets and exposures in view of
the credit risk and other major risks involved. The
Standard adopts forward-looking approach for the
assets and instruments that are financial instruments
from Shari’ah perspective and defines other
globally acceptable impairment and provisioning
approaches for other assets and exposures, without
compromising on Shari’ah principles. It also covers
the situations where onerous commitments exist
which mandate a provision for anticipated losses
on the same.
Salient feature of the Standard is that it shall
apply practically to all assets of an Islamic bank,
as well as various stages at which some assets
are to be recognized. It also applies to off-balance
sheet exposures of an institution and onerous
arrangements.
Other financing and investment
Inventories
subject to other than credit risk
• Ijarah asset • Murabaha asset
• Sukuk investments • Istisna asset
• Investments at FV through equity • Salam
(IFVE)
• Impairment • Net realizable value
• Significant or prolonged decline • Change in NRV
in the FV of investments at FV
through equity
• Impairment (for other than
investments)
Vol. 2 , Issue 1/2018 37
Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9
Since most of an IFI’s assets are subject to
credit risk and credit loss approach is the most
complicated, the article will focus and provide
sufficient insight into the ECL methodology.
Firstly, all assets subject to credit risk are covered
under credit risk approach. Thus, all products that,
at any reporting date, are recognized as contractual
Stage Definition Criteria
Stage 1 Low credit risk and no Significant
change in credit risk
Stage 2 High credit risk or significant
increase in credit risk since initial
recognition
Stage 3 Credit impaired financial asset
From the comparison of both the frameworks
it is evident that FAS 30 made ECL approach,
stage categorization and default definition as
close to IFRS 9 as possible to enable maximum
comparability between conventional and Islamic
financial institutions.
Measuring credit losses
Discussion of credit losses under FAS 30 takes
into account the concepts analogous to IFRS 9.
For example, it prescribes the use of unbiased and
probability weighed amount as well as reasonable
and supportable information. Credit exposure shall
be reported net of deferred profits. It puts Islamic
products on the same footing as conventional
instruments. ECLs shall consider realizable value
of collateral. Credit losses shall be measured over
the maximum contractual period. IFRS 9 talks
about maximum expected life of the financial asset.
Finally, probabilities of Default (PDs) shall reflect
at least two scenarios being (a) credit loss to occur
even if such probability is hypothetical only and (b)
that it will not occur.
Further in similar fashion to IFRS 9, FAS 30
prescribes that ECL shall be determined based on
best judgment (unbiased, and probability-weighted)
and not on the basis of most prudent judgment.
Major Shari’ah differences
The Standard articulates three major Shari’ah
driven differences between the IFRS 9 and FAS
30 as related to the credit loss approach. All of
these differences are driven by different business
modalities of Islamic and conventional finance.
In particular, these relate to issues surrounding
participatory stakeholders (primarily unrestricted
investment account holders and some sukuk
holders). These stakeholders, unlike conventional
38 Vol. 2 , Issue 1/2018
receivables are subject to the said provisioning
methodology. Further, all off-balance sheet
exposures related to assets exposed to credit risks
are included in the scope of this approach.
The Standard further requires segmentation of
assets subject to credit losses depending upon their
credit risk characteristic as indicated below:
Details ECL (Provision Calculations)
not meeting the criteria of 30 days delay in 12-Month expected credit loss
contractual payments (12 Month PD) – generally
collective allowance
Between 30 – 90 days delay in contractual Lifetime expected Credit Loss
payments or meeting the other qualitative (Lifetime PD till maturity
indicators of the facility) - generally
collective allowance
equal to or more than 90 days delay in Lifetime expected Credit
contractual payments or meeting the other Loss – customer/asset specific
qualitative indicators allowance
depositors and financiers, generally absorb losses
resulting from the activities in which their funds
have been invested.
One of the major differences affecting Islamic
Financial Institutions (IFI) lies in the area of
allocation of the impairment charge. Under IFRS,
it is fully attributed to the assets of the business
owners and is charged against Bank’s income.
For AAOIFI reporting Islamic bank, the charge
shall be split between the common shareholders
(by taking the charge to income statement) and
other participatory stakeholders (by reporting
accumulated impairment in liabilities).
Another issue is how to align Investment Risk
Reserve (IRR) and/or Profit Equalization Reserve
(PER) or any other smoothing reserves set aside
by IFIs in the interest of participatory stakeholders
with the ECL. Although IRR is based on the income
and not the assets’ carrying amounts (as ECL),
both of them serve to cushion against estimated
future losses. Further, requiring both IRR and ECL
allowances is a double burden on the respective
stakeholders.
It is therefore rational that adoption of ECL approach
shall result in its replacement of IRR to safeguard the
interest of the investment account holders.
Apparently, ECL appears to serve equity and
fairness principles of Shari’ah in a better way
given that the current practices of IRR (or other
smoothing practices) are not very well established
and defined, and at times take the form of ad hoc
transfers from income as a response to competitive
pressures. Contrarily, the new ECL approach is a
well-structured and is based on robust statistical/
empirical models and computations, which hence
serves the objective of Shari’ah as well as ensures
greater stability in the system.
 Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9
At the same time, PER unlike IRR is used to
mitigate the rate of return risk and hence is not
accumulated to counter credit losses, unless it is
unintentionally, erroneously or intentionally used
for credit loss coverage (which occurs in some
banks). Therefore, as long as PER allocations are
reasonably justified and are based on certain
rational judgements, PER can complement the ECL
created by IFIs.
Another Shari’ah issue faced by IFIs is the need to
rationalize establishment of an allowance for losses
that are yet to be incurred. Aftermath of the global
financial crisis vividly demonstrated importance
of maintaining stability in the financial system
through such “risk absorbers”. Furthermore,
such accumulated losses result in more equitable
treatment of stakeholders in long-run.
Expected Credit Loss (ECL) Approach
The overall approach when drafting FAS 30
has been to keep it closer to generally accepted
accounting standards (specifically IFRS). Therefore,
given the proximity of the overall ECL approach in
FAS 30 to that in IFRS 9, FAS 30 deliberately skipped
articulation of certain details articulated in IFRS 9
and in this paper.
Stage 1: Low Credit Risk
The Standard says that if, at the reporting date,
the credit risk on a receivable or exposure has not
increased significantly since initial recognition, an
institution shall measure the loss allowance for
that financial instrument at an amount equal to
12-month expected credit losses.
The Standard does not specify what is low credit
risk and/or examples of insignificant increase in it.
Therefore, we refer to IFRS 9 for detailed guidance,
which says that all of the following shall exist:
• Analysis of the risk of default of the instrument
itself without comparison to the risk of default of
other instruments or other considerations, such
as the credit risk of the geographic region within
which the business operates.
• The customer has a strong ability to meet its
contractual cash flow obligations in the near term.
• It is not evident that adverse changes in future
economic and business conditions will reduce the
ability of the customer to fulfil its contractual cash
flow obligations.
Stage 2: Significant Increase in Credit
Risk (SICR)
Determination of what constitutes SICR is one
of the most critical and difficult judgement areas
in applying the impairment model. The Standard
gives general guidance on the topic allowing Islamic
banks to decide how they will define this key term
in the context of their portfolios.
The Standard clarifies that any approach used
should consider:
• the change in the risk of default occurring since
initial recognition;
• the expected life of the financial instrument;
• reasonable and supportable information that is
available without undue cost or effort that may
affect credit risk.
At each reporting date, Islamic Bank shall assess
whether the credit risk on its respective exposures
has increased significantly since initial recognition.
This is to be done by comparing the risk of default
occurring on the asset at the reporting date with the
risk of a default occurring at the date of its initial
recognition, and assess the extent of increase.
In general, Islamic banks shall use quantitative
criteria such as probability of default (PD) (or any
other numerically evaluated model) as their key
indicator of SICR unless any bank is unable to
sufficiently capture all relevant criteria. In these
circumstances banks may place greater reliance on
qualitative indicators.
The following are factors, which a bank shall use
in determining a significant increase in credit risk:
Quantitative factors:
• Significant deterioration of credit risk rating of
the customer with consideration to a relative
increase in PD.
• Movement into a rating/credit grading deemed a
low credit quality.
• Establishing maximum credit risk level above
which instrument is considered as having SICR.
• Days past due (30 days or more).
Regardless of the way in which an institution
assesses SICR, there is a rebuttable presumption
that the credit risk on a receivable or exposure
has increased significantly since initial recognition
when contractual payments are more than 30 days
past due unless it is rebutted (with reasonable and
supportable information that is obtainable without
undue cost or effort)
Importance of Qualitative factors
Although banks are encouraged to incorporate
both quantitative and qualitative factors, the latter
play lesser significance if quantitative factors
are able to comprehensively cover SICR factors.
However, banks may include qualitative measures
Vol. 2 , Issue 1/2018 39
Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9
into their PD models should quantitative factors
alone be insufficient to capture all relevant factors
and measures of SICR. Such indicators include:
• Inappropriate quality of data - data reliability
issues.
• insensitivity of quantitative models to certain
specific events evaluated qualitatively as SICR.
• delayed capturing of SICR measures by quantitative
models.
Thus, Banks shall select most applicable and
relevant qualitative factors indicative of an SICR
and factor them in their models. Few of those are
listed below.
• Multiple missing payments.
• Breach of covenants
• Significant deterioration of financial position and
performance/rating
• Cross product/obligor defaults.
• Watch list exposure depending on degree of their
severity.
• High risk events (legal cases, significant business
risks).
Stage 3: Credit Impaired Instruments
Every Islamic bank shall clearly articulate the
definition of “credit impaired” and “default” in
order to move the asset into stage 3 upon meeting
its criteria.
FAS 30 provides one quantitative trigger to
classify instrument as credit impaired: 90 days or
Quantitative indicators
Curing criteria from stage 3 to stages 2/1
If the customer repaid the entire outstanding overdue amount
including accrued income it can be moved to Stage 1
Rating criteria is not met due to rating upgrade, move to stage 2
Curing criteria from stage 2 to stage 1
If the customer repaid the entire outstanding / overdue amount
including accrued income, it can be moved to Stage 1
Rating criteria is not met due to rating upgrade, move to stage
1 provided customers meets certain stabilization parameters (i.e.
depending on the extent of rating upgrade and stability of rating
etc.)
40 Vol. 2 , Issue 1/2018
more delay in contractual payments. Same trigger
(unless rebutted) is ascribed to the defaulted
exposures.
The standard also lists few qualitative indictors
such as significant deterioration of credit rating,
breach of covenants or bankruptcy/financial
reorganization situations.
Banks may additionally consider few other
triggers of credit impairment or default, including:
• significant financial difficulty of the client;
• the client is unlikely to honor its contractual
obligations, without recourse by the bank
realizing security (if held)
• uncustomary concessions granted to the client as
a result of its financial difficulties.
Cure, movement from Stage 3 and
Stage 2 (credit risk improvement)
FAS 30 has not defined how Islamic banks shall
deal with stage migrations. At the same time,
alignment of credit risk reduction with stage
movements is essential part of the symmetrical
ECL model, i.e. If the credit risk for the financial
instrument improves, the instrument can move
from Stage 2 back to Stage 1.
To justify upward stage movement, Islamic
banks shall assess for enabling indicators of credit
risk improvement. Alternatively, they need to
prove that factors, which initially triggered move
to stages 2 or 3, are reversed at the reporting date.
Some of the criteria, as per ECL, are provided below
for guidance:
Qualitative indicators
None of the qualitative indicators for Stage 3 continue to be
satisfied move to stage 2
In case the DPD is less than 90 days, move to Stage 2
If the instrument was modified, and subsequently 25 % of it has
been repaid, move to Stage 2
Instrument under qualitative criteria cannot be moved directly to
Stage 1 and will have a minimum curing period of 1 quarter since
date of movement to Stage 2
If the instrument is restructured to avoid default, and subsequently
25 % of the restructured facility has been repaid and terms of
restructuring have been met and financial performance of the
customer has improved satisfactorily, can be moved to Stage 1
 Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9
Shariah supervisory boards of AAOIFI reporters
may have to discuss the issue of reporting the
‘accrued income’ on the overdue balances as
required in the ECL model. This is because any
additional return accruable on defaulted Dayn
amounts has to go to the charity account, as per
Shariah principles. However, this shall not apply to
a deferred profit earlier, earned legitimately from
Shari’ah perspective, which can be taken to normal
income (if amortized in line with the requirements
of FAS 28 “Murabaha and Other Deferred Payment
Sales”, or any other similar standard.
Collective versus Individual
Assessment
FAS 30 clearly specifies that provisions on stage 1
and stage 2 exposures shall be made on “collective”
basis. Stage 3 exposures shall be subject to individual
impairment assessment i.e. through customer/asset
specific allowance.
The rationale behind this approach is that in
many cases SICR might not be evident when
assessed individually until the instrument becomes
overdue. For example, Islamic bank might not
have up to date financial information (client’s
financial statements or management accounts),
or may be collecting such information on annual
basis only. Thus, the Bank’s monitoring procedures
will naturally be outdated. Or, on retail products,
banks might not collect relevant information on
individual customers with regular frequency to
foresee impairment triggers until customers breach
their contractual obligations.
For these reasons, SICR might not be faithfully
captured on individual basis thus resulting in
reporting misstated financial performance of
the IFI. Therefore, banks shall assess stage 1
and 2 impairment on collective basis using both
historical and forward-looking information. This
approach ensures that Islamic banks recognize
lifetime expected credit losses for all financial
instruments for which there has been a SICR since
initial recognition, even if SICR is not evident at an
individual level.
To identify SICR at collective level, Islamic banks
may resort to classification of the portfolio based
on the shared credit risk characteristics. Examples
may include ratings, industry/sector, geographical
location, collateral, etc. Alternatively, exposure
could be grouped based on types of portfolios i.e.
real estate, cars, consumer items, Islamic credit
cards etc.
Measuring ECLs
ECLs are generally understood as the net present
value of the difference between the expected and
contractual cash flows over the life of the asset
weighted by the probability of default occurring in
the next 12 months or over the lifetime of the asset.
FAS 30 states that an institution shall measure
credit losses of a receivable or exposure in
accordance with a policy developed and applied
consistently, in a way that reflects:
a. an unbiased and probability-weighted amount
that is determined by evaluating a range of
possible outcomes;
b. the contractual maturity of the receivable or
exposure viz-a-viz the allocation of relevant
income applying the effective rate of return
method; and
c. reasonable and supportable information that
is obtainable without undue cost or effort at
the reporting date about past events, current
conditions and forecasts of future economic
conditions.
From the practical perspective, Islamic banks
shall document their ECL calculation approach
(for all ECL components) to ensure consistency of
calculation and assumptions with the ECL definition
and the FAS 30. For example the approach could
either be based on the expert judgment, or various
statistics.
Naturally, Islamic banks shall aim to develop ECL
estimates using relevant internal data. If internal
data is deemed insufficient it shall be supplemented
by relevant external data. Expert based approach
shall be least preferred.
There are a number of ECL measurement
approaches that Islamic banks may use to calculate
ECL. Moreover, different classes of assets might
require specifically tailored approaches. However,
the most common and proposed approach is
probability of default approach as summarized
below:
ECL = Σ i=1
n
(PDti EADti LGDti) dti
Thus, ECL has four distinct components:
• Probability of Default (“PD”) – This is an estimate
of the likelihood of default over a given time
horizon (e.g. 12 months or lifetime)
• Exposure at Default (“EAD”) – contractual cash
flows due at a future default date, taking into
account expected changes in the exposure after
the reporting date, including repayments of
principal and income and expected drawdowns
on committed facilities
• Loss Given Default (“LGD”) – This is an estimate
of the loss arising on default. It is based on the
difference between the contractual cash flows due
and those that the Islamic bank expects to receive,
including from any collateral, and usually is
Vol. 2 , Issue 1/2018 41
Towards Broader Understanding of AAOIFI’s FAS 30: Impact Analysis in the Perspective of IFRS 9

expressed as a percentage of the EAD management, capital adequacy and other areas.

• Discount Rate (“DR”) – This is used to discount an
expected loss to a present value at the reporting
date
The ECL calculation considers all reasonable and
supportable information that is available without
Therefore, banks must not be deluded by the
time till 2020. In reality, there is little time left to
prepare for the major change. Banks must act fast to
assess potential repercussions of the new standard
and manage the preparation process.

events, current conditions and forecasts of future

Participation
undue cost or effort at the reporting date about past OnRates
the other hand, delayed enforcement of
FAS 30 will put AAOIFI reporters in disfavor to
economic conditions. Each parameter shall reflect IFRS reporters. Both will become incomparable.
current and future JOIFA
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42 Vol. 2 , Issue 1/2018

 AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments

TECHNICAL ARTICLE

AAOIFI’s FAS 30: Impairment, Credit

Losses and Onerous Commitments
Jalil Al Aali 1
Mahesh Balasubramanian 2

Background of the study

On 23 November 2017, the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) issued Financial Accounting Standard (FAS) 30 - Impairment, credit
losses and onerous commitments which deals with impairment and provisions on a broad range
of asset types. The main purpose of this standard is to bring all the different impairment models
(new and existing guidance covered in other standards) under one single standard.
The standard introduces the concept of expected credit losses on financing contracts and
other asset classes primarily exposed to credit risk and the provision/impairment model for
investments and other assets (including inventories). FAS-30 supersedes certain sections
of FAS 25, Investment in Sukuk, shares and similar instruments which relate to impairment
and replaces FAS 11, Provisions and Reserves. However, the standard does not address any
classification and initial recognition of assets and exposures. The requirements of classification
and initial recognition for a specific Islamic financing contract, which is currently prescribed
under respective FASs would continue to apply. This standard shall be effective for the financial
periods beginning on or after 1 January 2020, however early adoption is permitted.
FAS 30 introduces a forward looking impairment model for credit losses, prompting timely
recognition of expected impairment and credit losses based on significant increase in credit risk,
and accelerates the recognition of different types of losses in line with the recent accounting
standards issued by various international accounting standard setting bodies.
FAS 30 classifies assets and exposures into three categories based on the nature of risks
involved (i.e. credit risk and other risks) and prescribes three approaches for assessing losses for
each of these categories of assets 1) Credit Losses approach, 2) Impairment approach and 3) Net
Realizable Value approach.

Executive summary similar characteristics and subject to risks other

Scope
The standard applies to all Islamic financing
institutions for:
• Both on-balance sheet and off-balance sheet
exposures are primarily subject to credit risk;
• Investments and certain other assets which have
than credit risks;
• Inventories recognized at different stages of
Islamic finance transactions (i.e. Murabaha,
Installment sales, Istisna’a and Salam); and
• Onerous conditions involved in contracts or
future commitments.
The standard does not apply to restricted

1 & 2 - The authors are Partners, KPMG; and Head of Financial Services & Head of Islamic Financial Services, respectively. They can be
contacted at: jalaali@kpmg.com & bmahesh@kpmg.com

Vol. 2 , Issue 1/2018 43

AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments
portfolio of assets classified as off-balance sheet
exposures; off-balance sheet Sukuk or similar
instruments provided that the entity is not exposed
to any credit risk on these off-balance sheet
exposures.
Effective date:
The standard is effective for reporting period on
or after 1 January 2020, however early adoption is
permitted.
Classification of assets and exposures
The standard categorizes assets and exposures
as:
- Receivables (Dain)
- Inventories;
- All other financing, investment assets and
exposures not within the scope of receivables
and inventories.
Frequency of assessment
- At the end of each reporting period.
Loss Approaches
The standard sets out four loss approaches
covering current and expected losses, in line with
global best practices as follows:
- Credit losses approach for receivables;
- Net realizable value approach for inventories;
- Impairment approach for all other financing,
investment assets and exposures; and
- Provision for economic losses for onerous
contract or commitments.
The standard applies forward looking
approaches in line with other standard setters
for the assets and instruments that are financial
instruments from Shari’ah perspective.
Attribution between common shareholders
and other participatory stakeholders
Impairment losses shall adequately be attributed
to the common shareholders and other participatory
stakeholders, including, the unrestricted investment
account holders.
The attribution between the common
shareholders and other participatory stakeholders
shall be based on the proportions and ratios at each
reporting date.
Changes in estimate and reversals
• The standard requires financial institution to
re-assess the estimates of impairments, credit
losses, provision for off-balances sheet exposures,
44 Vol. 2 , Issue 1/2018
provision for onerous contract, and adjustments
to net realizable value each reporting period.
• Changes in estimate (including reversals) shall be
recognized in the income statement for the period
of their re-assessment and shall be adequately
attributed to the common shareholders and
other participatory stakeholders, including, the
unrestricted investment account holders.
Transition impact
• The standard is applicable on a retrospective
basis and it allows to adjust the impact of the
retrospective application as a cumulative charge
to the opening balance of retained earnings
on the year of adoption instead of restating the
comparative financial statements.
• However, the cumulative charge attributable to
participatory stakeholders shall be first charged
to the Investment Risk Reserve (IRR), then to
the Profit Equalization Reserve (PER) and any
remaining balance as a temporary transfer from
shareholders’ equity.
• The temporarily transfer is recoverable from
the future income of participatory stakeholders.
Further, the temporarily transfer shall not be
against stage 3 losses or any other form of
incurred loss.
• Any reversals of charge related to previous
periods is attributed to respective reserve (i.e. IRR
or PER) or shareholders’ equity from where it was
originally allocated.
Presentation
• Provisions for on-balance sheet assets and
exposure shall be netted against the respective
assets.
• Provisions for off-balance sheet items and
onerous contracts shall be reflected separately
under liabilities of the IFI
Disclosures
In addition to the disclosure requirements stated
in FAS 1: “General Presentation and Disclosure
in the Financial Statements of Islamic Banks and
Financial Institutions” following are the minimum
disclosure requirements:
• the accounting policies adopted and significant
judgments and estimates applied for the purpose
of this standard for each category / class of asset;
• additional allowances, impairment or provisions
in addition to those required by FAS 30 to meet
regulatory requirements;
• income taken directly to suspense account per
regulatory provisions, if any;
 AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments
• the allocation and transfers from reserves, as
well as, reversals and the outstanding balances
and movement of temporary transfers from
shareholders’ equity in accordance with the
transitional provisions of FAS 30; and
• nature and estimated value of, the securities and
guarantees adjusted for determining provisions,
any hair cut applied and valuation methods used.
In case of jointly financed assets, FAS 30
requires allocation of the impairment and credit
losses between the equity shareholders and other
participatory stakeholders (including unrestricted
investment account holders).
The application of this standard will result in a
significant change in current policies and practices
followed by Islamic financial institutions. It’s
hoped that this analysis would help the readers in
gaining a greater understanding of FAS 30 and its
implications.
Introduction
The objective of our analysis in the publication
is not to highlight all possible differences between
FAS and IFRS but rather bring out key areas of
application differences users should consider while
they prepare for full adoption of FAS 30.
This standard is a significant initiative by AAOIFI
to harmonise its loss measurement guidelines with
International Financial Reporting Standards (IFRSs).
While the exposures subject to each loss approach
may differ due to differences in classification and
measurement guidelines, we do not expect any
significant differences in the application of these
guidelines between IFI’s and their conventional
counterparts. The different approaches reflect an
economic loss measurement and hence each loss
approach is expected to reach a similar outcome as
compared to application of its equivalent IFRS.
Table No. 1
Transaction type AAOIFI C&M guidance
FAS 2- Murabaha (fixed
Simple financing contract
rate financing), FAS 7 Salam
(Principal + Pre-defined
(contract financing) and FAS 8 –
measure of profit)
Ijarah (lease financing)
FAS 3 – Mudaraba and FAS 4 –
Profit sharing contracts
Musharaka
Hybrid contracts (with variable
Host financing instrument is
return features e.g. conversion,
separated and accounted for
warrants, asset residual value
under relevant FAS
adjustments etc.)
Investment in Sukuk & funds FAS 25 (C&M and disclosures)
We have not elaborated in detail on the calculation
aspects of the different loss approaches in FAS 30,
as we believe they are expected to be similar to its
equivalent IFRS guidance, but rather have focused
on what assets classes will be in-scope of FAS 30
and subject to different loss measurement approach
as compared to IFRS.
In order to quantify the potential impact of
the standard on the entity, further analysis and
interpretation has been carried out, in light
of entity’s own facts and circumstances and
individual transactions. The information contained
in this publication is based on initial observations
developed by KPMG Fakhro, Bahrain and these
observations may change.
Classification and measurement
FAS 30 does not change or modify the existing
classification and measurement guidance for financial
assets and other Shari’ah compliant investment
transactions.
IFIs apply FAS issued by AAOIFI and for matters
that are not covered by AAOIFI standards, the IFIs
should use guidance from the relevant International
Financial Reporting Standards. FAS 25 remains the
primary standard that provides C&M principles
for debt-type and equity-type instruments. Only
for selected instruments where IFIs previously
referred to IAS 39 for C&M guidance, the revised
guidance under IFRS 9 would now apply. IFRS 9
has amended guidance on C&M for some asset
classes and hence this would mean IFIs would
have some resulting impact on the effective date of
adoption of IFRS 9.
We have summarised below our assessment of
impact on classification and measurement guidance
by IFIs on adoption of IFRS 9 and FAS 30:
IFRS guidance applied Changed by IFRS 9
IFRS 7: Disclosure of
No
credit risk and fair values
IFRS 7: Disclosure of Yes, only if SPPI test
credit risk and fair values is not met
Embedded derivative
accounted for under IAS Yes
39 at FVTPL
Not applicable Yes
Vol. 2 , Issue 1/2018 45
AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments

AAOIFI and IFRS differences still continue in the following areas:

Table No. 2
Key areas of difference in C&M between IFRS 9 and FAS
• Equity: As per FAS 25 equity instruments can still be measured at cost less impairment and investments
carried at FVTE will be subject to an impairment test. Under IFRS 9, cost option has been removed and
there is an irrevocable election to re-measure equity as FVOCI without recycling of gains/ losses through
P&L. Hence, equity instruments will no longer be subject to test of impairment but would instead be
measured at fair value either through P&L or through OCI.
• Debt-type: No business model test required by FAS to qualify for measurement at amortised cost. FAS
30 does not currently allow debt instruments to be measured as FVOCI/ FVTE. Sukuk need not meet
the SPPI test, but the “debt-type” instrument definition is consistent with the business model test for
amortised cost classification.
• Funds: can still be classified as FVTE in AAOIFI whereas IFRS 9 mandates FVTPL classification for funds
• AAOIFI does not provide guidance on hybrid contracts and hence going forward all hybrid contracts
need to be measured at FVTPL as per IFRS 9.

Was not previously or currently Requirements addressed by other FASs

addressed by FAS, but will be impacted and not amended by FAS 30. Has some
on issue of IFRS 9 areas of conflicts with IFRS 9.

Mapping exposures to loss approaches

For the purpose of the standard, assets, commitment and exposures are classified into four categories based
on type of risk, and for each category, a different loss approach is applicable. The following table illustrates
and loss approaches outlined in FAS 30 along with the equivalent standards under International Financial
Reporting Standards (“IFRS”).

Table No. 3
Classification of assets, commitments and exposures and related impairment/ loss approaches
Loss model Eligible exposures Equivalent IFRS Standard* Illustrative assets that will be covered

Credit losses Assets and exposures subject IFRS 9, Financial • Financing assets
approach to credit risk: Instruments • Rental receivables from Ijarah or
• Receivables “Dain” Ijarah Muntahia Bittamleek contracts
• Off balance sheet exposures • Debt-type Sukuk and similar
including guarantees, letter instruments (FAS 25)
of credits, forward foreign • Any other financial assets carried at
contract and other similar amortised cost
positions
Net Inventories IAS 2, Inventories • Commodities
realizable • Properties held for development
value or sale in the ordinary course of
approach business
Impairment Other financing and IAS 36, Impairment of • Ijarah and Ijarah Muntahia
approach investment assets and Assets Bittamleek Assets (Lease assets)
exposures subject to risks • Investment in Mudaraba and
other than credit risk, Musharaka (equity-type exposures)
excluding inventories and • Investment properties
assets measured at FVTIS • Investment in equity-accounted
associates and JV’s
Provision Onerous contracts and IAS 37, Provisions, • Salam contracts where the value of
for economic commitments Contingent Liabilities and the commodity is expected to be sold
losses Contingent Assets at a loss
• Istisna’a or construction contracts
with negative margins

46 Vol. 2 , Issue 1/2018

 AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments

* The reference to equivalent IFRS standards
does not imply that FAS 30 is fully convergent with
all the requirements of IFRSs. Detailed review of
specific facts and circumstances would be required
to determine applications under both accounting
frameworks.
KPMG comments:
This standard is a significant initiative by
AAOIFI to harmonise its loss measurement
guidelines with IFRSs. While the exposures subject
to each loss approach may differ due to differences
in classification and measurement guidelines,
but we do not expect any significant differences
in the application of these guidelines at the asset
and exposure level between IFIs and conventional
institutions following IFRS. The different
approaches reflect an economic loss measurement
and hence each loss approach is expected to reach
a similar outcome as compared to application of its
equivalent IFRS.
Decision tree for use of loss
approaches
The following is the decision tree to summarise
how the standard is applied to various assets and
exposures:

Assets and Exposures

Is the Exposure on balance sheet?

Yes No

Is the exposure
Is it measured at Yes No subject to credit
fair value through Out of scope risk i.e. letter of
income statement? credit, financial
guarantee etc.?

No No

Does it meet the

definition of
Is the asset subject Receivable (i.e.
Is the asset and No No
to other risks such carried at
exposure an
as performance amortised cost)
Inventory?
and market risks? and is primarily
subject to credit
risk?

Yes Yes Yes Yes

Net Realizable value Impairment

Credit losses approach
approach approach

No

Is the entity party to contractual terms where

Onerous contract Yes commitment is higher than the economic benefits
provisions expected to flow through acquisition of such asset or
execution of the contract?

• Source: KPMG Analysis and Summaries

Vol. 2 , Issue 1/2018 47

AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments
Summary of loss approaches
Credit losses approach
• This approach applies to receivables (Dain) and
off balance sheet exposures including guarantees,
letters of credit, promise based foreign exchange
and other similar positions.
• The approach uses a dual measurement approach,
under which the loss allowance is measured as
either 12-month expected credit losses or lifetime
expected credit losses.
• Receivables and other exposures having credit
risk are classified into three categories:
- Stage-1 receivables – not meeting the criteria
of 30 days delay in contractual payments
– subject to 12-months expected losses
through collective allowances;
- Stage-2 receivables – having a delay in
contractual payments between 30 days to
89 days or meeting the other qualitative
indicators - subject to lifetime expected
losses through collective allowances; and
- Stage-3 receivables – having equal to or more
than 90 days delay in contractual payments
or meeting the other qualitative indicators–
subject to lifetime expected losses through
customer / asset specific allowance.
Net realizable value approach
• This approach applies to inventories recognised
at different stages of certain types of Islamic
financing transactions such as Murabaha,
Installment sale, Salam and Istisna’a. Inventories
are measured at the lower of cost and net
realizable value.
• Net realizable value defined as the estimated
selling price in the ordinary course of business
less the estimated costs of completion and the
estimated costs necessary to make the sale,
considering the factors specific to the institution.
Impairment approach
• This approach applies to financing assets,
investments (other than those carried at FVTIS)
and other exposures not eligible for credit losses
approach and net realizable value approach.
• Impairment loss is the amount by which
the carrying amount of an asset exceeds its
recoverable amount.
• The recoverable amount of an asset is the higher of
its fair value less costs of disposal and its value in
use. In rare circumstances and after a reasonable
effort, if the entity is unable to determine the fair
value less cost of disposal then value is use is
48 Vol. 2 , Issue 1/2018
considered as recoverable amount.
• If an asset is held for sale, fair value less cost of
disposal is considered as recoverable amount.
• The estimates of future cash flows, when
dependent on a single customer, shall essentially
take into consideration the credit evaluation
of the respective customer in addition to other
factors.
• In case of Investments at fair value through
equity, a significant or prolonged decline in
fair value below cost is an objective evidence of
impairment.
Provision for onerous contract or
commitment to acquire an asset
• The standard requires a provision for situations
where the Financial Institution is obligated to
acquire an asset under a future commitment or
permissible future contract, and it is expected that
the obligation under the contract or commitment
is higher than the economic benefits expected to
flow through acquisition of such asset.
Comparing Loss approaches to IFRS
In the below section, we have summarised key
areas introduced by FAS 30 in each loss approach
for comparison with equivalent IFRSs.
KPMG Comments:
In our view, there are no significant differences
in the principles and methods of the different loss
approaches between FAS 30 and IFRS. However,
there continue to be differences in C&M and some
application issues to IFI may apply which have
been discussed in the following sections (page 62
and 63). The Net realizable value approach and
provision for onerous contracts guidance are also
consistent with the guidance within IFRSs.
Additional Guidance for IFIs
Modified or restructured terms
• FAS 30.19 requires that if the proceeds of a new
contract have been applied for settlement of an
earlier receivable with the same customer, there
is a rebuttable assumption that there has been
a significant increase in the credit risk or risk of
impairment in respect of the new contract. We
believe the extensions that are not due to credit
risk related reasons may not necessarily lead to
assessment of significant increase in credit risk.
The view taken should be consistent with the
internal risk management policies of the IFI.
Comparing loss
approaches to IFRS
In the below section, we have summarised key areas
with equivalent IFRSs.
introduced
AAOIFI’s byImpairment,
FAS 30: FAS 30 inCredit
each Losses
loss approach forCommitments
and Onerous comparison

Components of ECL: PD 12 month and Life-time

Off-balance sheet items
Credit  losses  approach x LGD x EAD ECL

Significant increase in
Definition of default Forward looking measure
credit risk

Reasonable cost or effort

Low credit risk measure Forward looking measure
to be made

30 day rebuttable 90 days rebuttable Consideration of

presumption (SICR) presumption (default) collateral (LGD)

Probably-weighted Modified or restructured

Transition rules
outcome for ECL terms

Recoverable amount Value-in-use (VIU) Fair value less cost to sell

Impairment
approach

Significant or prolonged
Grouping of assets (CGU) Impairment indicators
for equity

Consideration of cash Components for rate of Consider credit risk in

flows for VIU return rate of return

Similar to IFRS Additional guidance for IFIs

KPMG comments:
Transition rules Scope
In our view, there are no significant differences in the principles of theofStandard
and methods the different loss approaches
between FAS 30 and IFRS. However, there continue
• Due to existence of allocation principles between to be differences
FAS 30 focuses onsome
in C&M and application
financing andissues to IFI
investment
may apply which
equity have been discussed
of shareholders and inparticipatory
the following sections (page
assets 13 and
(other 14).inventories)
than The Net realizable
which value
is exposed to
approach and provision
stakeholders, for onerous
different contracts
guidance hasguidance
been are also consistent
risks with credit
other than the guidance
risks. within
Hence,IFRSs.
it is not clear
provided (refer pages 62 & 63) whether operating assets such as fixed assets and
intangible assets is covered under FAS 30. However,
Consider credit risk in rate of return for the Impairment Approach guidance of FAS 30 is
impairmentModified  or  restructured  terms
of non-financial assets similar to the IAS 36 impairment guidance for such
- FAS 30.19 requires that if the proceeds of a newassets contract haveguidance
(e.g. been applied for settlement
on CGU, use of of an flows,
cash
Additional  guidance  for  IFIs

• This was introduced to specifically address non-

earlier receivable with the same customer, there is a rebuttable assumption that there has been a
discount rates etc.) and hence FAS 30 Impairment
financial assets linkedincrease
significant to financial
in thecontracts
credit risk(refer approach in
or risk of impairment can be applied
respect by contract.
of the new analogy. We believe
to page 63thefor discussion
extensions on not
that are Ijarah Muntahia
due to credit risk related In
reasons may not necessarily lead to assessment
addition, IFRS 9 has different transition of
and
Bittamleeksignificant
contracts).
increase in credit risk. The view taken should be consistent
application guidancewithfortheInsurance
internal riskcompanies.
management policies of the IFI.
However, AAOIFI does not exempt or provide
Application issues any separate guidance for Takaful entities. In the
Transition rules
In our -view,
Duethe following
to existence of are some of
allocation the keybetweenabsence
principles equity of
of specific guidance, we believe Takaful
shareholders and guidance
participatory
entities may refer to the on application
areas of application differences
stakeholders, between
different IFRS
guidance has9been
and provided (refer pages 13 & 14)
and interaction between IFRS 4, 17 and 9. However,
FAS 30 for certain assets and exposures. It needs
FAS 30 would need to be adopted by 1 January
Consider
to be noted credit
that for risk in
matters rate of
where return
FAS doesfor
notimpairment of non-financial assets
2020, whereas IFRS 17 (Insurance contracts) has an
- Thisguidance,
provide specific was introduced to specifically
IFI’s have address non-financial
been applying effective assets linked
date of to financial
1 January contracts (refer to
2021.
page 14 for discussion on Ijarah
IFRS. Hence, accounting policies for impairment Muntahia Bittamleek contracts).
were already in place. Reversals of provisions – Impairment
Changes are expected only due to changes in
approach - Goodwill
©2017  KPMG  Fakhro,  a  Bahrain  partnership  registered  with  the  Ministry  of  Industry,  Commerce  and  Tourism  (MOICT),  Kingdom  of  Bahrain  and  a  member   12
IFRS 9 andfirm  of  the  KPMG  network  of  independent  member  firms  affiliated  with  KPMG  International  Cooperative  (“KPMG  International”),  a
not other applicable IFRSs (IAS 36 and Prior to adoption of FAS 30, IFI’s were applying
Swiss  entity.  All  rights  
IAS 2) which were previously being followed.
reserved.    Printed  in  the  Kingdom  of  Bahrain.   IAS 36 for impairment of non-financial assets
Document  Classification:  KPMG  Public

Vol. 2 , Issue 1/2018 49

AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments
(except inventories, for which IAS 2 was applied).
FAS 30.57 requires all changes in estimates to be
recognised through the income statement. However
as per IAS 36, impairment on goodwill cannot be
reversed. Since FAS 30 does not explicitly include
intangibles and goodwill in its guidance, we believe
requirements of IAS 36 shall continue to apply for
goodwill.
Definition of participatory stakeholders
FAS 30 does not include a definition of
participatory stakeholders. However, this has been
introduced in the draft of FAS 35 Risk Reserves.
We believe the same definition shall apply for the
purposes of FAS 30 as both these standards together
would replace FAS 11 Provisions and Reserves. The
definition is as follows:
Participatory investors – are the investors
investing in an IFI on the basis of a participatory
arrangement e.g. Mudaraba, Musharaka or Al-
Wakala Bi Al-Istithmar (investment agency)
including Investment Account Holders (IAH),
Sukuk holders etc.
Attribution of provision/ impairment
charges between shareholders and
participatory stakeholders
FAS 30 requires attribution of provision /
impairment charges, including reversals, between
shareholders and participatory stakeholders in the
proportion of their participation. Such attribution
shall be based on the current proportions and
ratios, ignoring the original proportions and ratios
in which they were originally accounted for, with
a presumption that constructive liquidations had
happened earlier and hence such changes and
reversals are an event of the period. Provided
that, in certain situations whereby it is decided
by the respective Shari’ah board and accordingly
stipulated in the contracts with the respective
stakeholders that (either at the time of liquidation
or at any point of time, as stipulated) any excess
balance which is no more needed shall be paid
for charitable purposes, such reversal shall be
accounted for and disclosed accordingly. In this
respect, whatever is the decision made by the
Shari’ah supervisory board, the same shall be
disclosed in the notes to financial statements.
Previously, under AAOIFI standards, provisions
and reserves attributable to participatory
stakeholders were added to their book value
(presented gross). However, under FAS 30, the
provisions shall be netted against the corresponding
asset. This is now is line with IFRS standards.
50 Vol. 2 , Issue 1/2018
Ijarah Muntahia Bittamleek exposures
Under IFRS 9, financing against mortgage of
properties are subject to the expected credit loss
model provided they meet the SPPI criteria.
However, IFI’s provide financing of properties
using Ijarah Muntahia Bittamleek (finance lease)
contracts which is accounted under FAS 8. Under
FAS, these assets are considered to be non-financial
assets. For the purpose of loss assessment under
FAS 30, such exposures are segregated into two
components: physical assets (cost less depreciation)
and rental receivable (rental income due but not
received). For loss assessment under FAS 30, the
rental receivables which meet the definition of
receivables, are subject to the credit losses approach
and the physical assets are subject to impairment
approach.
However, in practice, we do not expect that these
differences between FAS 30 and IFRS 9 will have a
significant impact in the way impairment is assessed
for the combined exposure against mortgage of
properties due to the following factors:
Past due rental receivable is an indication of
impairment for the Ijarah (physical assets);
Under the impairment approach, IFI will have
to determine the value in use of the physical asset
by considering the estimated of future cash inflows
from Ijarah rentals over the period of the contract
and likely recovery through repossession or sale of
the collateral; and
As per FAS 30, the IFI will have to evaluate
credit worthiness of the lessee in addition to other
factors so as to arrive at the effective rate of return
to compute the value in use.
These factors are consistent with how ECL
assessment would have been done under IFRS 9.
However, it is not clear how the following will be
addressed:
The non-financial component of the finance lease
exposures will be measured under the impairment
approach which does not require allocation between
Stage 1 and Stage 2. It appears that collective
assessment at a portfolio level may be considered
for such assets; and
The provision against the non-financial
components will not be presented or disclosed
as part of the expected loss provisions and hence
disclosures may not be fully comparable with IFRS.
Reversal of transition adjustment
Under FAS 30, the cumulative charge attributable
to participatory stakeholders on the initial
adoption of the standard shall be first charged to
 AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments

the Investment Risk Reserve (IRR), any shortfall
will then be charged to the Profit Equalization
Reserve (PER) and any residual balance not covered
through existing IRR and PER shall be charged as
a temporary transfer from shareholders equity
(subject to Shari’ah approvals). This treatment in
similar to the Qard funding and recovery process
followed by Takaful entities. For any subsequent
improvement in credit quality on the portfolio
funded by participatory stakeholders (e.g. URIA
accounts), the reversal of ECL will not be routed
through the income statement. Instead this is
expected to be reflected as a transfer between the
participatory stakeholders and equity.
This is significantly different from the transition
guidance under IFRS 9 and could be detrimental to
the income statement of IFI’s in the future.
The temporary funding of the shortfall by
shareholders is recoverable from the participatory
stakeholders and is in the nature of an asset for
the entity. However, since this shortfall will be
deducted from retained earnings, in our view,
no asset would be recognized in the statement of
financial position. However, the standard does not
give clear guidance on the treatment of recovery in
future periods.
The standard does not provide guidance when
there is an excess provision on date of adoption
as compared to FAS 30. We believe there could
be additional Shari’ah matters that would need
consideration such as whether the excess can be
credited to shareholders’ equity in full.
The following are some of the other key
differences between FAS 30 and IFRS 9 loss
approaches.

Table No. 4
Other key differences: FAS 30 vs IFRS 9
Purchased or originated • IFRS 9 includes treatment for credit-impaired financial assets purchased or originated.
credit-impaired However, this is not covered in FAS 30 since it may not be considered Shari’ah compliant to
financial assets enter into such a transaction on receivables.

Simplified approach • IFRS 9 includes simplified approach for trade receivables and contracts that result from
transactions in the scope of IFRS 15, and lease receivables that result from transactions in
the scope of IAS 17. However, FAS 30 does not include a simplified approach.

Components of interest • Under IFRS 9, interest has been defined and includes time value of money which is reflected
in the effective interest rate used to discount the future cash flows. However, AAOIFI
requires consideration of effective rate of return and does not define its components but
rather refers to a uniform rate of return after considering all cash flows.

Income recognition • IFRS 9 includes a detailed guidance for recognition of interest income on financial
instruments. However, FAS 30 does not cover income recognition.

Initial Significant increase Asset Becomes

Recognition in credit risk Credit-Impaired

Impairment 12-month expected

Lifetime expected Credit Losses
Loss credit losses
Interest on assests not EIR applied to
impaired at initial EIR applied to gross amount
amortised cost
recognition
Interest on assests
impaired at initial Credit-adjusted EIR applied to amortised Cost
recognition

Allocation between • FAS 30 requires impairment charges to be allocated between the shareholders and other
shareholders and participatory stakeholders (i.e. investment account holders).
other participatory
stakeholders • In instances where the participatory stakeholders equity does not have sufficient IRR and
PER, the standard requires IFI’s to make a temporarily transfer from the shareholder equity
to participatory stakeholders equity. However, reversals related to the cumulative charge
attributable to participatory stakeholders will be recognised as transfer between the equity
and not through the income statement.

• IFRS 9 does not require attribution of charge based on source and composition of funding
of assets and would require all reversals to go through profit or loss account.

Vol. 2 , Issue 1/2018 51

AAOIFI’s FAS 30: Impairment, Credit Losses and Onerous Commitments

Matters requiring Shari’ah approvals/
consideration
The following are examples of some of the key
areas which are referred to in FAS 30 requiring
participatory stakeholders and/ or Shari’ah
approvals and consideration:
• Allocation of FAS 30 expected credit losses
the respective Shari’ah board and accordingly
stipulated in the contracts with the respective
stakeholders that (either at the time of liquidation
or at any point of time, as stipulated) any excess
balance of expected credit losses provisions which
is no more needed shall be paid for charitable
purposes or distributed back to respective
stakeholders. There are different practices in this
regards.

ARE YOU
provision to equity of participatory stakeholders
and the impairment/ provision charge to income • Shari’ah approval for provisions on onerous contracts
generated on assets funded by participatory
KPMG comments:
Looking for
account Shari’ah Standards
holders
• Utilisation of exiting PER and IRR towards In our view, IFI’s would need to revisit their

ARE YOU
participatory accountholders share of provisions existing contracts and policies and would require
or reserves for expected credit losses Shari’ah approvals on new policies and matters
arising from application of FAS 30.
• Charging shortfall on date of adoption of FAS
Looking for Accountingequity
30 to shareholders’ Standards
and approval of a In line with AAOIFI requirements of fair
temporary transfer in the form of Qard Hasan treatment and transparency in dealing between
the IFI and participatory stakeholders, disclosures
• Creation of future PER and IRR (now excluding
would be required on decisions agreed with the
expected credit losses)

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Shari’ah board of each IFI on the above matters and
• In certain situations whereby it is decided by any other matters arising from adoption of FAS 30.

AAOIFI Online Standards

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information of a general nature and is not intended to address the circumstances of any
particular individual or entity. In many cases further interpretation may be needed in order for an entity to apply FAS 30 to its
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52 Vol. 2 , Issue 1/2018

 A new approach to Corporate Governance: Embodying the Core Values of Shariah Objectives in Developing Growth Strategies
INDUSTRY UPDATE
A new approach to Corporate Governance:
Embodying the Core Values of Shariah
Objectives in Developing Growth Strategies
Dr. Hatim El-Tahir
One of the main lessons of the global financial
crisis of 2008-9 learned by financial institutions,
regulators and other stakeholders is the need to
strengthen corporate governance, both in terms of
the frameworks and related rules and in terms of
the practices of financial institutions, reported the
Financial Stability Board (FSB), in a recent thematic
peer review on corporate governance.
The peer review offers ‘twelve’ recommendations
to FSB member jurisdictions, standard-setting
bodies and financial institutions. Key to these
recommendations is:
“insuring the basis for an effective corporate
governance framework – identify and address
gaps or inconsistencies in cases where corporate
governance frameworks are found in multiple
sources; and augment enforcement powers available
to supervisory authorities to address weaknesses in
corporate governance regimes or non-compliance
with corporate governance requirements.” [FSB,
2017]
Other sector challenges in Islamic finance
include the inconsistency of regulations in different
markets and countries. A recent CIBAFI report,
based on analysis of 77 banks indicates the need for
improving risk governance and Shariah governance.
Both scored the lowest scores of the six disciplines
of the corporate governance index formed by the
research (CIBAFI-WB, 2017).
Professor Laldin of ISRA, Malaysia rightly
notes that the legal and regulatory frameworks
are country-specific, and Shariah governance
frameworks differ markedly across the jurisdictions
(IFN Report, 2018, P.42). This will remain so for
some time and the governance frameworks cannot
easily be harmonized. However, what can be
harmonized is developing governance operating
models that will streamline practices, policies and
procedures.
1- Dr. Hatim El-Tahir is the Director, Islamic Finance Group and Leader, Deloitte ME Islamic Finance Knowledge Centre (IFKC), Deloitte
& Touche, Bahrain
1
Establishing an effective corporate governance
framework in Islamic finance requires a ‘corporate
purpose’ which serves the society and helps in
application of the fundamentals of Islamic finance
principles and achieving the Shariah objectives.
Philippa Back argues that having a purpose is to
have a clear goal of what a business is setting out
to achieve in serving society by providing products
or services that meet the needs of the people
(Hawkamah Journal, Issue: 08). She further notes
that the governance has focused, over the years,
on vision, mission and values rather than purpose
explicitly. She claims that due to the lack of wider
connection to society in the past, the business
franchise weakened and the trust in business eroded.
The truth of the matter is that this critique also
applies to the Islamic finance industry and in order
to regain trust in the business model, Institutions
offering Islamic Financial Services (IIFSs) have to
rethink about their corporate governance operating
models and consider redesigning the organization
structure, oversight responsibilities, talent and
culture, infrastructure, functional and operational
elements with the core Shariah objectives to have a
purpose that serves the society.
This article discusses the effects of above industry
premise and the need to embrace a continuous
improvement approach in governance practices,
and augmenting a culture of sustainable and
responsible business practices. It provides ‘two’
vivid precepts that can help graft a strategy built
around the noble values of Shariah objectives which
are often overlooked or undermined in designing
business and growth strategies.
Renewed Vigor: the Shariah-Based
Approach to Governance
Establishing an effective corporate governance
operating model in the Islamic financial industry
Vol. 2 , Issue 1/2018 53
A new approach to Corporate Governance: Embodying the Core Values of Shariah Objectives in Developing Growth Strategies
has been a subject of much debate and differences
and largely a ‘trial and error’ exercise. Different
institutions in different jurisdictions have followed
different paths to build operating models that
reflect their corporate identity, culture and vision.
Some institutions have been successful in designing
good governance operating models enabling them
to achieve business objectives and execute strategies
desired. Others have not been successful and might
be working for articulating the right frameworks
that could work for them.
Nonetheless, the starting point, which many IIFS
have likely addressed, is the governance framework,
such as that we propose in this article (see Exhibit
1), developed to help boards and executives assess
their institutions’ governance programs. Whether
the board and management adopt or develop a
governance framework, it articulates the various
elements of the governance program, clarifies the
governance roles of the board and management,
and illustrates an appropriate relationship between
governance, risk management, and organizational
culture.
The path to building a sustainable culture in
management, operations, products and services
and Shariah compliance is often challenged and
conflicted with those of the institutions’ stakeholders.
As a result, numerous institutions offering Islamic
financial services (IIFSs) experienced low-score
levels of adopting international standards of
corporate governance practice. It is because such
institutions were not able to achieve the proverbial
‘Core Shariah Objectives (CSOs CSBs)’. Significant
changes in the current industry environment are
likely to force industry leaders and strategists to
look for innovative solutions and new approaches to
salvage the industry growth and offer a sustainable
economic value to local societies.
Good corporate governance needs to be more
than just a ‘tick box’ exercise or the announcement
of “institution X or Y has adopted the IFSB’s or
AAOIFI’s good governance standards or any other
international code of practices”. Good governance
in Islamic finance should be an exercise in better
defining and adhering to the specificity of Islamic
finance’s operating model and philosophy. It
should, therefore, embody the elements of CSOs
in designing the corporate governance framework
and its oversight and support processes.
Thus, a renewed vigor is required to manifest
and embody a new approach of operating models
capable of empowering and equipping leadership
and workforce with products and services, processes
and systems that can drive sustainable growth and
enhance the value proposition of Islamic finance.
Back to Basics:
A new Shariah-based approach to improve
54 Vol. 2 , Issue 1/2018
governance practice in Islamic finance is required
in the turbulent and challenging scenario as at
now. The compact and specific governance along
with the related Shariah stipulations, relevant
contractual and documentation mechanisms in
Islamic financial services necessitate an exclusive
Shariah-based governance operating model. The
elements of such a model may or may not exist
in practice; albeit, its success and effectiveness
depend on how it can serve the institution’s
strategic business objectives also including the
service to the respective society and contributing to
local economic growth. Chief to this is aligning the
institution’s business and commercial objectives
with needs and aspirations of the society. More
precisely, it requires aligning aspirations of the
people with products and services linked to the
Shariah objectives, also aligned with leading
investment practices such as those developed by
organizations like the OECD and United Nations.
In practice, however, those elements might not
have been streamlined and rationalized to provide
the sustainable growth required by industry
executives, Shariah scholars, entrepreneurs and
governments.
The new approach to governance addresses
some of the challenges discussed above and
should help the boards and the management
by providing new model of governance and
management derived from the basic principles of
Islamic finance business model. It helps industry
strategists and product developers to rethink their
business approach and have systems and processes
related to the basic Shariah principles, and to
follow leading practices of sustainable investment
principles to achieve efficiency, better performance
and sustainable growth. It requires a commitment
to the culture of sustainability which can go hand
to hand with embracing the noble values pertaining
to the Shariah objectives.
Nonetheless, a new approach to corporate
governance models in Islamic finance should be
embraced where the core objective is to initiate and
lead corporate purpose and culture, identifying
target markets and clients to be served and hence
develop products, processes and governance
systems based on this goal. In doing so, the new
corporate governance model will be more resilient
to achieve the institution’s strategic business and
financial objectives. It would also accommodate
the changes and updates as business develops and
grows. In other words, corporate governance in
Islamic finance should not be seen as a requirement
to meet regulation; it should have in place internal
control systems to ensure regulatory compliance. It
is an important practice and should be articulated
to design governance system capable of leading
to growth, resilience and sustainability of the
institution.
 A new approach to Corporate Governance: Embodying the Core Values of Shariah Objectives in Developing Growth Strategies
A Sustainable Shariah-based Operating
Model:
Different interpretations and tafseer have been
used to explain or define what encompasses the
Shariah Objectives. An interesting view in this
regard has been offered by Shaykh Rami Al Rifai
(2016), in this context:
Some Muslim scholars of jurisprudence said
that Allah revealed a legislative system or Shariah
in order to achieve Justice. Other jurists said it is
for the purpose of achieving happiness and some
others, such as Imam al- Ghazali, said it is only
for the achievement and the realization of the very
benefits of man on earth. “The jurists believe that the
rules of Shariah follow objectives (maqasid) which
are in harmony with reason. A rational approach
to the discovery and identification of the objectives
and intentions of the Lawgiver (Allah) necessitates
recourse to human intellect and judgment in the
evaluation of the ahkam (laws)”.
The scholar continues by saying that Shariah
objectives explain the ‘wisdoms behind rulings,’
such as ‘enhancing social cohesion’. The latter
being a key objective of several initiatives around
the world to achieve sustainable and business
continuity through social good.
Undoubtedly, enhancing social cohesion should
be achieved through the right products and services
offered by the industry institutions. For the purpose
of our conceptual framework, illustrated below,
we will use the five core objectives as indicated by
Imam Al- Ghazali (d. 111 H) in his interpretation,
which denote the preservation of faith, life, lineage,
intellect and property.
To contextualize the new approach of corporate
governance, it is interesting to observe that the
aforementioned ‘five’ Shariah objectives resemble
those - at least in essence and substance - of the
emerging global sustainable and investment
practices such as those proposed by the OECD
and the United Nations. It includes the widely
publicized UN’s Sustainable Development Goals
(SDGs), Principles of Responsible Investment
(PRIs), and emphasis on Environment, Social and
Governance (ESG).
Hence, this article suggests that articulating
a sustainable growth strategy in Islamic finance
should fundamentally be aligned to the two main
precepts as discussed: the core Shariah objectives
and the global sustainable principles of investment
cited above. The merit of aligning the anchor
Shariah objectives with the principles of sustainable
business for the new governance approach is
paramount as it offers the IIFS a differentiating
edge in operations and management of resources.
This edge can be seen in several ways:
1. Embrace the desired concept of Shariah-based
business model in developing products, which
can drive markets, sectors and ultimately help
grow markets and lead to society’s development.
2. Adopt international best practices and show
support to global sustainable development
objectives and benefit to mankind.
3. Differentiate Islamic financial services from its
counterpart, by offering products, processes and
systems, leading to social cohesion and societal
developments.
4. Contribute to change management knowledge
and invite more researchers and practitioners to
fine-tune Shariah-based business processes and
governance frameworks.
Adopting this approach should ideally be top-
bottom strategy to ensure Board and Executive
Management’s oversight and support, respectively.
Key governance parameters form the outer layer of
the Exhibit 1 shown below – Governance, process,
technology and people. Three specific functions are
involved in each of the four capabilities. This makes
twelve key supporting functions to carry out the
day to day supervision of work flows, policies and
the procedures.
The key components of the Shariah-based
approach, operating model and their relationship
comprise the following:
The Structure:
Based on four faces approach framework
(explained below), interdependent functions and
practice areas designed to ensure support and
management control;
Oversight Responsibilities:
Pertaining to Board and Executive Management
oversight responsibilities, accountability matrices,
and collaborations;
Corporate Purpose & Culture:
Embracing global sustainable investment
principles and the core Shariah objectives, required
for articulating effective business models and
procedures, which are more able to drive sustainable
growth strategies.
The four-facets approach framework consists of
following four capabilities required for building the
new operating model:
The Governance:
1. Organizational structure of the institution.
2. Oversight and responsibilities.
3. Boards and Executive Management.
Vol. 2 , Issue 1/2018 55
A new approach to Corporate Governance: Embodying the Core Values of Shariah Objectives in Developing Growth Strategies
4. Corporate purpose and culture where the latter
should be influenced by the Shariah objectives.
Process, People and Technology:
The nuts and bolts of the model are framed to
align key investment influencers – the core Shariah
Objectives (5 objectives) and the sustainable
investment principles (SDGs, ESG, PRIs). These
principles will be the backbone for developing
processes, people and technology to derive
sustainable growth strategies.
In practice, for the purpose of good governance
and management of the new approach (operating
model), leadership has to emphasize on the
management and accountability of operational and
functional roles as identified (twelve functions,
three in each practice area).
The proposed approach emphasizes the value
proposition of Islamic finance and offers services
and goods linked to societal needs, and yet,
is structured, delivered and governed, in line
with international best practices of sustainable
investment principles.
Exhibit 1:
A New Governance Operating Model, Embracing
Shariah and Sustainable Principles
Sustainability
Principles
Growth
Strategy
Core Shariah
Objectives
Nonetheless, it is widely accepted that the
effectiveness of a governance operating model lies
in its specificity. The required or desired level of
specificity in the operating model will vary from
organization to organization. As demonstrated
above, the proposed operating model defines the
Shariah and Sustainable Development Goals (SDGs)
as key interchangeably enablers in designing
sustainable growth strategies. The latter can be
designed in view of the following main elements of
growth strategy:
56 Vol. 2 , Issue 1/2018
1. Products and services;
2. Selling and marketing capabilities;
3. Markets and new expansions; and
4. Realizing revenues and profitability.
What this approach means in practice?
In practice, it has potential to link the growth
strategies and its four elements, as mentioned
above, with at least one of the two categories of
principles. In essence, it means incorporating one
or more of the principles pertaining to the Shariah
objectives, and linking to one or more of the global
sustainable principles. Obviously, not every
product, business process or marketing strategy
can achieve all of the principles mentioned above.
However, it is essential that product developers,
strategists, and business leaders are able to
understand the merit and value proposition of
incorporating Shariah objectives, aligned with
good international business practices.
For example and the purpose of illustration, an
Islamic Bank A is considering the development of
growth strategy in a new jurisdiction; and as part
of this, its product development team with the right
kind of market and products offerings research,
have planned a new niche market in financing
the ‘disabled’ people. This new product can be
designed and vetted with a matrix of the criteria
or requirements (the bundle of both the Shariah
objectives and SDGs).
The Exhibit 2, shows how a new product –
financing disabled community, can be developed
in view of the different relevant principles of the
Shariah objectives and global sustainable principles.
A product matrix can be developed to analyze
relevance and suitability of chosen principles,
which are essentially achieving the new product
salient features and objectives.
Generally, the governance roles and interactions
between the different business units and operations
will be designed with the specificity of the individual
institution and its business line. In this regard, the
institutions offering Islamic financial services may
benefit from Shariah-based governance operating
model in the following three distinct ways:
Defined Corporate Purpose:
Boards and executive management will have
the opportunity to translate the Shariah-based
governance principles into practices. The new
governance operating model provides a platform
for the Board and the management to address needs
of the society and develop business strategies linked
to these needs and economic requirements. Hence,
designing commercial business objectives would
 A new approach to Corporate Governance: Embodying the Core Values of Shariah Objectives in Developing Growth Strategies

serve the interest of all stakeholders, reflecting the Increased effectiveness:

specificity of the IIFS.
It’s an operating model that specifies the
Improved Shariah-compliance: information that the Board and its management
require – from culturally-oriented and purpose-
Embracing the Shariah Objectives in designing driven (Shariah-based approach) department and
products, processes, and systems and the functions, that may assist the board in executing
overall governance framework will help remove governance more effectively.
ambiguities and conflicts in workflows and
management of day to day business.
Exhibit 2
A new Financing Product: Disabled Business Financing
Sustainable
Shariah Socially Responsible Environmental, social,
Development Goals
Objectives Investing (SRI) and governance (ESG)
(SDGs)
Socially responsible Social Factors : health
investing is community and safety, local
investing, which could be community, human rights,
achieved by allocating funds and human resources Goal 1: End poverty in all
Financing Disabled Community

from other sources, such as its forms everywhere

banks and financial institutions
and create job for this group
community and to involve
them to be apart of the Goal 3: Ensure healthy
community prosperity. lives and promote well-
being for all at all ages

Intellect Goal 4: Ensure inclusive

and equitable quality
education and promote
lifelong learning
opportunities for all

Goal 8: Promote
sustained, inclusive and
sustainable economic
growth, full and productive
employment and decent
work for all

References
• Al Rifai, Rami (2016), The Maqasid (Objectives) of Shariah: A Closer Look; available at: https://ghayb.com/2016/01/the-maqasid-
objectives-of-shariah-a-closer-look/.
• General Council for Islamic Banks and Financial Institutions and ‘The World Bank Group’ (CIBAFI and the World Bank, 2017),
Corporate Governance Practices in Islamic Banks, 2017; available at: http://cibafi.org/ControlPanel/Documents/Library/Pdf/
CorporateGovernancePracticesinIslamicBanks2017.pdf.
• Laldin, M. Akram (2018); The Shariah Governance, IFN Annual Guide, 2018 (December, 2017).
• Philippa Foster Back, (2016 ); Corporate Purpose through Corporate Behaviour; The Hawkamah Journal- A journal on corporate
governance & leadership, Issue:08; Hawkamah Institute for Corporate Governance; . Pages 39-44 Accessed from:
https://www.hawkamah.org/attachments/1479809885_58341b5d18ad1_THJ08.pdf
• The Financial Stability Board (FSB), Thematic Review on Corporate Governance, April, 2017.

Vol. 2 , Issue 1/2018 57

Islamic Finance Development in 2017: Towards Sustainability
INDUSTRY UPDATE
Islamic Finance Development in 2017:
Towards Sustainability
Shereen Mohamed 1
According to the ICD-Thomson Reuters Islamic
Finance Development Indicator (IFDI)2 , the Islamic
finance industry has reverted to growth after a brief
downturn caused by low oil prices and stumbling
economies in some of its key markets, with total
industry assets growing 7% in 2016 to US$ 2.2
trillion. Islamic finance may be young, and still tiny
in comparison with the global financial industry,
but the industry’s rapid development suggests it
will continue to grow. Governments, in particular,
saw the industry as one way to rekindle their
economies.
The IFDI indicator presents the key numbers
behind that growth, covering the entire Islamic
finance ecosystem in terms of Quantitative
Development, Knowledge, Governance,
Corporate Social Responsibility, and Awareness.
Measurements have been taken for 131 countries.
IFDI Global Indicator: Recovery in
confidence puts industry back on track
The IFDI average value recovered to 9.9 for 2017
from 8.8 last year as each of the five main indicators
it measures rose. The overall gain shows a recovery
in confidence following economic slowdowns in
some of the core Islamic finance markets after oil
prices tumbled in 2014. The main contributors
were the Quantitative Development (QD) indicator
measuring the industry’s size, due to improved
financial performances, and Governance, as
authorities stepped up efforts to strengthen Islamic
finance oversight.
The leading country in IFDI remains Malaysia
and the leading region the GCC. Countries including
Tunisia, Morocco, Iraq, Russia, Spain and Poland
saw notable developments in their IFDI values and
improved their rankings.
Given these developments, total Islamic finance
assets are expected to grow to US$ 3.8 billion by
2022 from US$ 2.2 billion in 2016 – a compound
annual growth rate of 9.5%.
1- Shereen Mohamed is Senior Research Analyst - Islamic Finance, Thomson Reuters.
2- To learn more about IFDI 2017 and to download the ICD-Thomson Reuters Islamic Finance Development Report, please visit http://bit.
ly/IFDI-2017.
58 Vol. 2 , Issue 1/2018
Quantitative Development Indicator:
Institutions and governments
adapting to economic conditions
QD advanced the most of the five indicators,
to 5.7 from 4.3, though it remains the weakest.
Progress was assisted by a partial recovery in oil
prices in 2016 that boosted government revenues in
the GCC – a region that holds 45% of global Islamic
finance assets. It was also helped by the improved
performances of Islamic financial institutions and
funds in that region and others around the world.
In order to adapt to the straitened economic
conditions, Islamic financial institutions have
been pursuing efficiencies and governments have
been working to better support the Islamic finance
industry. There has been an increase in industry
consolidation, with mergers agreed between various
Islamic banks and takaful operators in the GCC,
Indonesia, Malaysia and Pakistan. At the same time,
governments in Iraq, Morocco, Algeria and Tunisia
are turning to Islamic finance to attract investment
in the face of weakened government revenues.
Newcomers to the industry within major
Islamic finance hubs may soon include Fintech
companies given the growth in supporting financial
technology ecosystems. Islamic finance has also
begun attracting new financial institutions beyond
its traditional centres, as seen in Russia, Africa and
South America.
The single area of weakness within QD was
Sukuk, which failed to match the improvements
shown by other QD sub-indicators despite the
addition of new players such as Togo. Previous
major sukuk issuers such as the governments of
the GCC resorted to issuing conventional bonds
during the period covered in order to reduce
issuance costs.
However, Sukuk’s outlook remains bright. A
new sovereign sukuk giant, Saudi Arabia, issued
its first domestic and international sukuk in 2017.
Other countries are also planning to issue sukuk in

Islamic Finance Development Indicator 2017 Top Performers
IFDI 2017 Rank
1 Malaysia
2 Bahrain
3 United Arab Emirates
4 Oman
5 Pakistan
6 Kuwait
7 Saudi Arabia
8 Jordan
9 Brunei
10 Qatar
Source: ICD – Thomson Reuters Islamic Finance Development Report 2017 – Towards Sustainability
order to reduce budget deficits, or are encouraging
corporate issuance through newly introduced tax
concessions. Another noteworthy trend is the push
towards socially responsible sukuk, which are a
milestone on the road towards Shariah-compliant
socially responsible investment (SRI) funds.
Knowledge Indicator: Islamic finance
education and literacy could be
improved by government initiatives
This indicator, which encompasses education
and research, edged up to 7.8 from 7.6, with growth
recorded for both sub-indicators. Between 2014
and 2016, Islamic finance research increased to
2,581 papers produced by 830 different affiliations
including universities. These included 1,751 peer-
reviewed articles published by 728 journals. The
countries with the highest number of research
papers were also amongst the most-covered
countries in those papers.
The number of Islamic finance education providers
around the world increased to 677. Of these,
190 provided a total 322 Islamic finance degrees
covering subjects such as Islamic banking, finance
and economics. The majority were Master’s degrees,
followed by diplomas. There were also government
initiatives to improve education and literacy in
Islamic finance in Indonesia, Malaysia and Bahrain.
Governance Indicator: Islamic finance
governance takes the lead in IFDI
Governance became the most developed of the
five main indicators as its value jumped to 14.0
for 2017 from 11.3 in 2016, marginally surpassing
Awareness. Takaful was a particular area of interest
to regulators, with countries including Kenya,
Oman and Uganda amending insurance laws to
accommodate Shariah compliance. Turkey and
Tanzania plan to follow suit. Sukuk also received
its fair share of government attention, with the
introduction of tax concessions in Turkey, Pakistan
and Nigeria to encourage corporate issuance.
Islamic Finance Development in 2017: Towards Sustainability
Country IFDI Value
129
83
64
64
54
51
50
48
47
46
There were 44 countries in 2016 with specific
Islamic finance regulations, 12 countries with
centralised Shariah boards, and 1,075 Shariah
scholars involved in industry governance.
Efforts are being made to further tighten Shariah
governance, as shown by a growing emphasis on
appointing external Shariah auditors for Islamic
banks in the core markets. External Shariah scholars
and centralized Shariah boards are likely to become
much more common following the scandal caused
by the announcement by Dana Gas in June 2017 that
its sukuk were no longer Shariah-compliant and its
repayments therefore unenforceable.
The Corporate Governance sub-indicator
remained weak, however. Only 55% of Islamic
financial institutions released financial reports, and
a majority of institutions scored low on disclosure.
However, efforts have been made to improve Islamic
banks’ corporate governance in Brunei and Jordan
and transparency in Pakistan and Saudi Arabia.
Corporate Social Responsibility
Indicator: Improvements in both
performance and disclosure
The Corporate Social Responsibility (CSR)
indicator value rose to 7.9 for 2017 from 7.1 for 2016,
in line with improvements in both performance and
disclosure by Islamic financial institutions. A total
US$ 683 million in CSR funds were distributed in
2016, up 18% from 2015. However, even though
there was an increase in the number of Islamic
financial institutions reporting CSR activities in
2016, the average disclosure score remained low as
many items were still not reported.
There were several developments in 2016 that
may contribute to stronger CSR readings in the
future. In Indonesia, disbursement of socially
responsible funds by Islamic financial institutions
is set to grow as the government strengthens the
governance and management of zakat and waqf
instruments, which it hopes will increase trust in
the industry and boost financial inclusion.
Vol. 2 , Issue 1/2018 59
Islamic Finance Development in 2017: Towards Sustainability
Source: ICD - Thomson Reuters Islamic Finance Development, Report 2017: Towards Sustainability
Malaysia has introduced the concept of the
‘charity house’, in which Islamic banks will invest
donations and disburse profits to designated
charities. A special task force has been established
to study the idea. Also, Malaysia’s central bank has
released a paper on ‘Value-Based Intermediation’
to help Islamic banks contribute to the social good
without impairing financial performance.
In the UAE, Dubai has established the Awqaf
International Organization to improve the
management of funds used to fund social projects
such as schools and mosques. It is aimed at
improving efficiency and economies of scale while
developing a set of awqaf standards.
Awareness Indicator: Seminars and
conferences address Islamic and
ethical finance mutual values
The Awareness indicator’s average value moved
up very slightly, to 13.9 from 13.8, and as a result
it dropped to the second most developed indicator
after Governance, for the first time since the
introduction of IFDI in 2013.
60 Vol. 2 , Issue 1/2018
The number of Islamic finance news items
edged slightly higher, but the News sub-indicator’s
average value was a little down on the previous
year because of the slower growth. The Seminars
sub-indicator saw strong growth, however, mainly
on the back of an increase in seminar numbers in
Africa. Some African countries also made bigger
contributions to the Conferences sub-indicator, with
Morocco, Tunisia, Kenya and Djibouti taking places
on the sub-indicator’s leaderboard. The Conferences
sub-indicator ended a touch lower, however.
Many of the seminars and conferences in 2016
examined the mutual values shared by Islamic
finance with ethical and socially responsible
finance. This can be seen in the rise of Islamic
microfinance seminars held in countries including
Nigeria, Pakistan and Sudan, and events in Spain
and the UK that explored the interaction between
Islamic and ethical finance.
As for news, while developments within the
GCC’s Islamic finance industry dominated,
regulatory developments are beginning to receive
wider coverage, particularly where they concern
Shariah governance, Islamic banking regulation,
and sukuk tax concessions.

INDUSTRY UPDATE
Islamic Banking:
A New Player in the Eurozone SRI Market
Ahmet Kudsi Arslan1
In March 2015, major news from the Islamic
banking market spread like lightning across the
Eurozone banking world – KT Bank AG, the first
and only fully-fledged bank with Islamic business
model, coming from a Turkish-Kuwaiti background,
was about to start operations in Germany in July of
the same year. At the outset, this was a demanding
challenge: would the implementation of Islamic
banking as a new, unfamiliar banking concept
in mainland Europe lead to controversy? Would
the Muslim community take on the new products
and services enthusiastically, and how would
the representatives of the conventional Western
banking system react to the value-based finance
model from the East? It soon became evident that
the domestic bankers shared the cosmopolitan and
unifying vision of the Islamic banking concept – the
market responded friendly and immensely curious
to this then unknown, yet promising, faith-based
banking model. The Muslim community showed
great interest and conventional clients and investors
focusing on socially responsible investments (SRI)
acknowledged Islamic banking’s ethical value.
The news media exposure of the Islamic banking
pioneer in Germany and in the Eurozone amounted
to more than 1,500 articles in all major news media
within the first few weeks. The bank itself registers
an incessant flow of client inquiries until today.
This article aims to explain how the Islamic banking
business model progressed from the regulatory
introduction, founding and establishment phase
by its first mover towards its recognition as ethical
banking alternative for the Eurozone economy.
Islamic finance – a continual global
success story
Islamic finance is a growing business segment
all over the world – in Muslim and also in non-
Muslim countries. More than 500 Islamic financial
institutions in more than 70 countries administer
estimated sharia-compliant assets of more than
2 trillion USD. Growth rates of more than 15 %
outnumber those of the conventional banking
1- Ahmet Kudsi Arslan, Chairman of the Management Board, KT Bank.
Islamic Banking – A New Player In The Eurozone SRI Market
system. Sukuk, sharia-compliant bonds, serve
increasingly as an alternative to the conventional
bond business. At the G20 meeting of finance and
labor ministers in September 2015 in Ankara, Turkey,
Islamic banking was politically acknowledged
for its positive effects on national economies and
benefits for the society, in the framework of the
following statement from the then German Federal
Minister of Finance, Wolfgang Schäuble: “Islamic
finance instruments are of growing importance
in the world economy“. Schäuble said further
that international finance institutions should
increasingly concentrate on integrating Islamic
finance models into the global financing structure.
Islamic banking in Western economies
A successful role model for an Islamic banking
enterprise in a Western economy is the flourishing
development of Al Rayan Bank PLC, the first British
bank operating according to Islamic principles.
The former Islamic Bank of Britain was granted
authorization by the Financial Services Authority
FSA in August 2004. This was the same year in
which the mother bank of KT Bank, Kuveyt Türk
Participation Bank with headquarters in Istanbul,
established in 1989, started to lay groundwork
in Germany with opening a German branch to
introduce Islamic banking to the Euro area and to
inform the general public about the religious finance
model. Kuveyt Türk is the leading participation
bank in Turkey working with Islamic principles,
the largest Islamic bank in Turkey according to
asset size, and has, as of today, more than 5,800
employees, 400 branches in Turkey, and a branch
in Bahrain. Kuveyt Türk entered the sukuk market
as pioneer in 2010 and has recently even broken the
Turkish market record by carrying out the Sukuk
issuance of the largest ever amount in Turkish
Lira – 400 million – in a single transaction in the
sector. Kuveyt Türk’s main shareholder is – with
62 per cent – the Kuwait Finance House, one of the
foremost Islamic financial institutions in the world.
Established in 1977 in Kuwait, todays KFH Group
network spans across seven regions worldwide
Vol. 2 , Issue 1/2018 61
Islamic Banking – A New Player In The Eurozone SRI Market
from Saudi-Arabia to Malaysia, with 430 branches,
over 790 ATMs and approximately 8,600 employees.
Eurozone Islamic banking trailblazer
In view of this consolidated background, KT Bank
entered the German market in 2010, when it was
granted a license for non-EEA deposit broking by
the Federal Financial Supervisory Authority BaFin.
Following this, in March 2015, after having applied
in 2012, the BaFin granted KT Bank as first bank
with Islamic business model a full banking license
under German law for the provision of deposit and
credit business in Germany. KT Bank commenced
operations in July 2015 with headquarters in
Frankfurt and – up to today – 4 branches in the
cities of Berlin, Cologne, Frankfurt and Mannheim
as well as with 90 employees.
These efforts are combined with a clear vision
for the Euro economy – the bank aspires to be a
leading ethical bank while focusing on Turkish
and non-Turkish Muslim communities as well as
SRI customers in mainland Europe, being open to
clients of all religions and nationalities.
Islamic banking products and
services in Germany
KT Bank provides Islamic deposit and credit
business products and services and payment
transactions for retail and corporate clients as well
as services for financial institutions. The bank is a
member of the German Banks Compensation Scheme
(EdB), which secures clients’ deposits up to € 100,000.
Considering Muslims’ financial requirements, the
comprehensive, regularly updated portfolio includes
a wide range of products and services, from free-of-
charge current accounts with free online banking,
debit Mastercards and investment opportunities
based on profit-sharing and participation schemes
up to real estate financing, instalment credits for
larger acquisitions and investor loans for business
financing. A bank that is not lending money
conventionally, but financing real goods to avoid
interest, was, until the launch of KT Bank, unheard
of in the German market. And yet, clients became
quickly aware that they can also enjoy all amenities
of a conventional full-service bank, with services
like safe deposit box rental, foreign exchange and,
given the bank’s background, remittances to Turkey.
Moreover, KT Bank provides financial institutions
with account & clearing services, vostro account
services and FX trading.
Regulatory challenges
The requirements for establishing a comprehensive,
sharia-compliant portfolio in a Western economy
are by no means fulfilled by ‘business as usual’
procedures – hence it took substantial regulatory
cooperation efforts with the German authorities
62 Vol. 2 , Issue 1/2018
in order to introduce the Islamic finance model
in the market. KT Bank officially established the
previously unfamiliar Islamic banking model in the
Eurozone as a solo player. In terms of the required
banking license application, the bank cooperated
strongly with the supervisory authority to ensure
that it complies with all regulatory, legal, and fiscal
requirements applicable for conventional banks.
With regards to specific challenges, such as Islamic
car purchase and real estate financing, the bank
had to develop approaches to comply with the
German legislation. The Islamic real estate financing
products structured as murabaha transaction – a
sales contract where the buyer and seller agree on
a markup – serve as example in practice: Following
a positive creditworthiness check of the client
and a valuation of the property in demand, the
bank, together with the client, sets up a civil-law
partnership in Germany, the so-called “Gesellschaft
bürgerlichen Rechts” (GbR) in order to avoid having
to pay land transfer tax twice. After that, the GbR
buys the property from the vendor, with both the
client and the bank receiving shares in the GbR that
correspond to the capital contribution involved.
Then the client buys the bank’s shares in the GbR,
and pays off the purchase price over the agreed
term. This procedure is not more complicated nor
time-consuming than a „conventional“ real estate
financing in Germany. There is only one additional
signature involved – for a financing package that is
true to Muslim ethical convictions. KT Bank’s single-
period real estate financing package runs for up to
10 years and features a fixed monthly instalment. It
is called a “single-period” option because the bank
sells its share in the property concerned as a single
transaction to the buyer.
Halal and no hedge funds
Besides operating as a trader, buying commodities
for its clients and reselling them with a profit
markup, KT Bank operates the Islamic deposit
business in Germany as an “entrepreneur” and
participating project partner based on profit and
loss participation. This partnership basis mirrors
the general cooperative origin of the whole banking
sector. The bank’s clients invest via a participation
account, the bank invests in the real economy, and
the profit then achieved is shared in accordance with
an allocation formula agreed beforehand, e.g. 85 %.
The size of the client‘s respective share in the profits
will depend on the term involved and the size of
the investment. With an allocation formula of 85 %,
the bank’s client receives 85 % and KT Bank 15 % of
the profit generated by the deposit. Due to reasons
of sharia-compliancy, KT Bank cannot guarantee
fixed profits for the deposits, yet aspires to achieve
profits for its clients that are aligned with the current
market level.
As financing is based on a pool that contains all

client deposits, every depositor gets a share of the
average return of all projects. Due to the return of
the investment into these projects and thus into
the real economy, “real” and asset-backed values
are being created. Clients and investors thus
contribute to the productive capital of the economy.
These participation investment options differ
substantially from the structures of derivates that
violate the Islamic proposition that money is only
a medium of exchange, as well as from the concept
of hedge funds with their high affinity to risk. KT
Bank does not invest into such financial constructs
due to sharia constraints.
Instead, KT Bank invests into German, regional
projects of many areas like real estate, the food and
automotive sector, as well as wholesale and retail.
Small and medium-sized enterprises, SMEs, play an
important role, as a large part of the bank’s clients
in Germany are successful entrepreneurs of Turkish
origin. In general, 100,000 Turkish entrepreneurs
in Germany are active across 50 different sectors,
creating more than 500,000 jobs.
Germany – emerging market potential
for Islamic banking
Germany was chosen as base to launch Islamic
banking in the Eurozone many years ago and
generally seems the foreordained country to
introduce the Islamic banking model in mainland
Europe. As a strong economy with Frankfurt as
the financial capital of Europe and headquarters
of the European Central Bank, Germany is being
anticipated to profit from Brexit long-term.
Alongside France and the United Kingdom, the
country is being classified as one of the predestined
Western key markets for Islamic finance due to
Muslim migration. The market potential is huge,
with currently 4,7 million Muslims living in the
country, the majority being of Turkish origin.
Moreover, there is an ongoing growth trend
within the Turkish Muslim population in Germany
since the last decade. The contribution of Turkish
companies to the German economy is substantial.
Beyond that, Germany is the biggest producer and
exporter of goods in Europe and also historically
Turkey’s longest trading partner. The MENA region
is also an important market for German companies.
In front of its Turkish-Kuwaiti background, the
first Islamic bank in the Eurozone bridges the
trade between these countries and also creates
extensive cooperation and synergy effect among
intercompany relations.
Huge growth potential within the
Muslim community
How was the concept of Islamic banking adopted
by the main target group, the Muslim community,
Islamic Banking – A New Player In The Eurozone SRI Market
during the last 3 years? In the operative field, KT
Bank identified a large explanation need concerning
Islamic banking products within the Muslim
community. This is reflected in the only 5 % of the
German Muslim population that adhere to Islamic
banking yet. Client consultancy at KT Bank is thus
time-consuming, intense and individual. Measured
against the number of millions of Muslims living
in the country, the KT Bank pioneers anticipate a
huge growth potential. Furthermore, net incomes of
Muslim households in Germany are on the rise, and
Muslims have a remarkable savings rate of nearly
double the national average.
Universally ethical qualities of
Islamic finance models
The performances of the conventional finance
sector during the last decades have shown that
interest and artificial inflation of prices based on
debt rather than on real value are some of the
main reasons why bubbles form, burst, and then
lead to recessions. After the financial crisis, people
around the world, especially those in conventional
economies, became more aware of value-based
finance models, banking regulations and undue risk
taking. Analyzing the value-based methodology
of the Islamic banking model during 3 years of
operational business development in the Euro
market, it became apparent that Islamic banking
principles do not only fulfill the requirements
of the Muslim community, but also the ethical
standards of the German majority society. Euro
clients are becoming increasingly aware of the
universally ethical qualities of Islamic banking’s
Qur’an-based values. The product portfolio of
Germany’s first and only sharia-compliant bank is
thus attracting value-conscious clients of all beliefs.
Islamic banking is currently being established in
Western markets as sub-category of the ethical
banking segment.
Islamic banking client groups in
Germany
Due to the nature of the business model and the
background of the bank, KT Bank has expected from
the beginning that a major part of its client base
would be of Turkish and Arabic origin as well as of
Muslim faith. Whilst there are no exact or detailed
statistics on the origin or religious affiliation of
the clients, as these data are not being queried or
collected, the majority of clients, approximately 50
%, are of Turkish, and 35 % are of Arabic origin.
The remaining 15 % are Germans and German
residents of other nationalities. The client structure
of KT Bank represents 60 nationalities, with many
coming from European neighboring countries like
Denmark.
Future outlook – Islamic banking
Vol. 2 , Issue 1/2018 63
Islamic Banking – A New Player In The Eurozone SRI Market

solutions for Eurozone challenges
In 2017, KT Bank officially declared the
completion of the founding and establishment
phase of the bank in the German market after the
successful market launch. The bank’s key topics in
2017 were the achievement of a growing client base,
80 per cent asset growth as well as the development
of the retail, corporate and institutional product
portfolio and up-to-date services. A 2017 highlight
was the upward trend of the German property
market which increased the call of GCC investors
for sharia-compliant real estate opportunities.
Moreover, the historical interest rate low boosted
the general appeal for investments into participation
accounts, whose profit rates are up to today
outperforming those of the conventional fixed
deposit sector. According to 2017 year-end results,
total KT Bank assets reached 191 million euro and
total equity was 60 million euro. In 2018, the growth
path continues, with a current loan portfolio of
more than 170 million euro. The market will see a
lot of new sharia-compliant products and services,
among them Islamic financial showpieces like a
credit card with instalment, an Islamic alternative to
overdraft unheard of in Germany which is running
successfully in the Turkish Islamic banking sector
and is anticipated to also attract a lot of non-Muslim
clients. Most vital is also the strategic enhancement
of the online direct banking infrastructure as there
is strong demand from currently out of more than
70 countries to open sharia-compliant accounts in
Germany.
Inspiring cultural change in the
finance industry?
Faith and finance, profit and ethics – this group
of attributes together complete the concept of
Islamic banking, which has already proven to be
an enrichment to western conventional business
ethics. Islamic banking captures the global
economic zeitgeist, prioritizes unequivocal values
over a narrow focus on profits, and supports the
real economy whilst featuring an universally ethical
belief system. All of these qualities have triggered
huge awareness not only of the Muslim community,
but also of Euro clients. Will Islamic banking help
to transform the Western conventional finance
sector after a decade of ongoing crisis? The Islamic
bankers in the Eurozone believe it will help.

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