Well-respected: Organisations based in the Kingdom draw global attention

Claims by Bahrain to be a global centre of Islamic finance rest not just on the plethora of sharia-compliant institutions which have chosen to headquarter themselves in the country, but also on the large array of industry bodies that call Manama home. Of these, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) is one of the most notable. Its standards have been adopted by jurisdictions across the globe, and in many more it is not uncommon to hear Islamic finance institutions refer to the “Bahrain model” in relation to their sharia-compliant operations or products.

AN IMPORTANT PRESENCE: AAOIFI’s presence in Manama places Bahrain at the centre of a process of regulatory evolution that at times has struggled to keep pace with the rapid expansion of the global Islamic financial services (IFS) industry. Its focus of late has been to ensure its standards remain relevant to the modern era of Islamic finance. To that end, in 2012 it plans to continue a thorough review of its standards which it began in 2011. It has also begun to address the more general strategic question of its future role within a global financial industry where the convergence of accounting standards has become a priority for many jurisdictions.

HISTORY: AAOIFI’s establishment in 1990 was a response to renewed interest in finance conducted according to the principles of sharia in the later decades of the last century. The need for a regulatory structure which could stretch beyond international boundaries brought a number of financial institutions to Algeria to sign the organisation’s agreement of association, and Bahrain’s status as the GCC’s financial hub and its already prominent position in the global IFS arena made it the natural choice as the new organisation’s base.

AAOIFI exists today as an industry-driven international body, funded by over 200 institutional members from 45 countries, including central banks, Islamic banks, Islamic insurance (or takaful) providers and other participants in the global sharia-compliant industry. Its standards have been officially adopted in the Kingdom of Bahrain, Lebanon, Jordan, Qatar, Sudan, Syria and the Dubai International Financial Centre, while authorities in Indonesia, Australia, Malaysia, Pakistan, Saudi Arabia and South Africa have issued guidelines based on its standards and pronouncements.

As of the end of the first quarter of 2012, AAOIFI had formulated 48 sharia standards, covering areas like currency trading, debit cards, commercial papers, murabaha, investment sukuk, insurance, liquidity and its instruments, and bankruptcy, 26 accounting standards, five auditing standards, 7 governance standards and two codes of ethics. It has adopted a consultative approach, in most cases issuing exposure drafts to its members and other interested parties, and frequently following up with public meetings.

REVISITING THE BASICS: While the process of creating standards is an open-ended one, and one which reflects the evolving nature of the global IFS industry, in 2011 AAOIFI decided it was time to revisit the basic principles which underpin all of its pronouncements. “Over the past year we have revised the conceptual framework for accounting in Islamic finance. That is the basis of all our standards. We do this because we want to look at all our standards and make sure that they support what the industry is doing now and what it is doing in the future,” Khaled Al Fakih, the new secretary-general of AAIOFI, told OBG. Updating the conceptual framework, in which AAOIFI also sought the input of the IFS sector by releasing an exposure draft, is important for a number of reasons: the framework acts as the primary guide for the development of future financial accounting standards; it provides a “back-up” reference for transactions or processes not yet dealt with directly by AAOIFI’s standards; it assists national standard-setting bodies in developing domestic accounting rules; it represents the ultimate reference for subjective judgements made by company managers when they are preparing financial statements and other financial reports; and, in the more abstract realm, it represents the philosophy of AAOIFI in its approach to formulating its financial and accounting standards.

STRONG POSITION: With the completion of this process, AAOIFI is in a position to reassess its existing standards in the light of the new framework. It began to do so in 2011 with an examination of investment account and real estate standards. The exposure draft and public hearing connected to the latter revealed proposed changes which focus on valuation methodology, in particular the difference between market-to-market values and book values, as well as the question of how to treat buildings which are still under construction. On the question of Islamic investment accounts, AAOIFI proposes to merge two of its existing standards in order to eliminate the potential for accounting arbitrage, as well as strengthen the requirement to disclose risks surrounding such accounts. As investor accounts perform the same function for Islamic banks as depositor accounts do for conventional ones, the pronouncements of AAOIFI on this subject are of particular interest.

The efforts of AAOIFI to fine-tune its standards in response to industry developments and potential problems exposed by the global economic downturn continue, with the question of takaful expected to become a focus of its attention in 2012. But while it is concentrating currently on the details of its technical framework, AAOIFI is also looking outwards to the wider issue of its place within the global regulatory landscape. The rapid expansion of Islamic finance, with global Islamic financial assets growing at around 150% since 2006 to reach an estimated $1.3trn in 2011, according to financial lobby group TheCityUK, make AAOIFI’s work towards worldwide standardisation of Islamic accounting standards all the more important. However, it has also led to some calls for the world’s leading accounting standards body, the International Accounting Standards Board (IASB), to create sharia-compliant standards of its own in order to bring global Islamic finance within its purview.

SIDE-BY-SIDE: To date, AAOIFI has existed comfortably in the regulatory sphere with the IASB and its International Financial Reporting Standards (IFRS), and has established its standards more as an enhancement to its provisions than a competing framework. “We look at IFRS and if we discover any sharia-compliance issues we come up with alternatives,” said Al Fakih. “In areas were IFRS standards are adequate, we don’t issue standards of our own. So, even in countries that use IFRS only, institutions can still adopt AAOIFI standards where they need to.”

The question of AAOIFI’s future in the global regulatory sphere has risen to greater prominence in recent years as a result of the financial industry’s desire for regulatory convergence. A global reporting standard is seen as preferable by financial institutions and investors which operate across many national borders and regulators who are keen to eliminate potentially dangerous blind spots in the global economy.

However, while the IASB has become the pre-eminent global accounting standard, its provisions are not always a comfortable fit for Islamic institutions. For example, the method by which Islamic banks earn returns while respecting sharia’s ban on interest (by purchasing an asset on behalf of a customer and then leasing it out to them until they can acquire ownership) would be classified by the IASB as a financial lease, requiring the bank to record it as an interest-earning instrument in contravention to sharia law. Should the IASB decide to address the problem of such conflicts by introducing sharia standards of its own, AAOIFI’s future would be cast into doubt. It prefers a collaborative solution. “We have been talking to the IASB for some years, trying to see how we can cooperate in terms of accounting. They have the geographical reach and are becoming the dominant standard for the world. But we have the authority of the sharia standards on which our accounting standards are based. Perhaps, then, there is a way for us to work together, possibly through a common set of standards accepted both by the IASB and AAOIFI,” said Al Fakih.

A DIFFICULT TASK: Such a solution might not be arrived at easily. Three-quarters of respondents in a survey of 24 different standard-setting bodies conducted by the Asian-Oceanic Standard Setters Group in 2011 stated that there should not be separate Islamic accounting standards issued by bodies outside the IASB’s framework. Any development seen as a complicating factor in the IASB’s long-term movement towards global reporting convergence is unlikely to be supported by the financial world. Yet the IASB has yet to show any indication that it is interested in involving itself in sharia-compliant standard-setting, telling Reuters in April 2012 only that the issue of Islamic finance may move onto its agenda as it begins to identify strategic priorities. While institutions prefer to deal with a single organisation for accounting, the authority of AAOIFI suggests a collaborative effort with the IASB may end up the most likely outcome.