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Home > Accountancy Best Practice > Procedures for Reporting Financial Risk in Islamic Finance

Accountancy Best Practice

Procedures for Reporting Financial Risk in Islamic Finance

by Daud Vicary Abdullah andRamesh Pillai

Executive Summary

  • Uncertainty is a defining feature of the economic environment. Economic agents’ perceptions of risk, together with their willingness and ability to bear it, fundamentally shape decisions, transactions, and market prices. Well-considered decisions should be based on information that helps to highlight existing risks and uncertainties. An important component of the information system of an organization or economy is financial reporting, through which an enterprise conveys information about its financial performance and condition to external users, often identified with its actual and potential claimants. It stands to reason, therefore, that financial reporting should provide a good sense of the impact of those risks and uncertainties on measures of valuation, income, and cash flows.

  • It is important to reconcile the perspectives of accounting standard setters on the one hand, and prudential authorities on the other, on what information should be reported, and on how it should be portrayed. The final goal is a financial reporting system that is consistent, as far as possible, with sound risk management and management practices and that can serve as a basis for well-informed decisions by outside investors as well as prudential authorities.

  • Outside investors, be they equity or debt holders, would normally require certain information about the financial performance of a firm so as to guide their decisions. First, they would surely wish to form a view about the firm’s past and current profitability, solvency, and liquidity at a given point in time. Second, they would probably also like to develop a picture of the risk profile of those attributes over time and, hence, of their potential future evolution. Third, they might additionally wish to gain a sense of how reliable or accurate those measures are. Combined, these three elements would provide the raw material to inform views about expected returns properly adjusted for risk and for the inevitable uncertainties that surround measurement. These three types of information correspond to the key categories into which the ideal set can be divided—namely, first movement, risk, and measurement error—and they are equally applicable to financial reporting in an Islamic finance environment.

Introduction

The key elements of Islamic finance can be summarized as follows:

  • Materiality and validity of transactions: There is no profit sharing without risk taking, and earning profit is legitimized by engaging in economic venture. Money is not a commodity but a medium of exchange, a store of value, and a unit of measurement.

  • Mutuality of risk sharing: Clearly defined risk and profit sharing characteristics serve as an additional built-in mechanism. There are clearly laid out terms and conditions.

  • Avoidance of riba (interest), maysir (gambling), and gharar (uncertainty).

The key elements of Islamic financial risk can be summarized as follows:

  • The reporting of financial risk in an Islamic financial institution (IFI) requires greater transparency and disclosure than does its conventional counterpart.

  • This is particularly true with respect to additional shariah governance and some risk areas that are unique to Islamic finance.

  • IFIs have greater fiduciary duties and responsibility to their stakeholders than do conventional institutions.

  • The additional duties and responsibilities of IFIs are overseen by the IFI’s shariah board.

First-movement information describes income, the balance sheet, and cash flows at a point in time. It is the type of information with the longest tradition by far in accounting.

Risk information is fundamentally forward looking. Future profits, future cash flows, and future valuations are intrinsically uncertain. Risk information is designed to capture the prospective range of outcomes for the variables of profit as measured at a particular point in time.

Measurement error information designates the margin of error or uncertainty that surrounds the measurement of the variables of profit, including those that quantify risk. The need for this type of information arises whenever these variables have to be estimated. For instance, measurement error would be zero for first-movement information concerning items that were valued at observable market prices for which a deep and liquid market existed. But it would be positive if, say, such items were marked to model and/or traded in illiquid markets, since a number of assumptions would need to be made to arrive at such estimates.

There has been a wide array of change and development in Islamic finance in recent years. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has tackled several of the pertinent issues in its Financial Accounting Standards (FAS). In particular, FAS 1 relates to general presentation and disclosure in the financial statements of Islamic banks and financial institutions. FAS 5 relates to the disclosure of bases for profit allocation between owners’ equity and investment account holders. FAS 17 concerns Investment. FAS 22 and FAS 23 deal with segment reporting and consolidation, respectively. AAOIFI Governance Standards 1–6 also provide relevant guidance. In particular, Governance Standard 6, Principles of Governance Section 7, gives guidance in respect of risk management.

Understanding Islamic Banking Risk

Islamic financial institutions are exposed to all the risks that a conventional one is. However, there are some fundamental differences, particularly in the aspect of shariah compliance, where noncompliance can lead to reputational risk and worse.

Typical banking risk exposure includes the following:

  • financial: balance sheet, capital adequacy, credit, liquidity;

  • operational: fraud, product, business services, system failure, delivery, and process management;

  • business: country, reputational, regulatory, legal, macropolicy;

  • event: political, banking crisis, contagion.

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Further reading

Books:

  • Greuning, Hennie Van, and Sonja Brajovic Bratanovic. Analysing and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk Management. Washington, DC: World Bank, 2000.
  • Karim, Rifaat Ahmed Abdel, and Simon Archer (eds). Islamic Finance: The Regulatory Challenge. Singapore: Wiley, 2007. See in particular Sundararajan, V. “Risk characteristics of Islamic products: Implications for risk measurement and supervision,” pp. 40–68.

Article:

  • Grais, Wafiq, and Zamir Iqbal. “Corporate governance challenges of Islamic financial Institutions.” Paper presented at Seventh Harvard University Forum on Islamic Finance, 2006.

Websites:

  • AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions): www.aaoifi.com
  • IFSB (Islamic Financial Services Board): www.ifsb.org
  • PRMIA (Professional Risk Managers’ International Association): www.prmia.org

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