It may seem prosaic, but one of the problems that “Western” banks
have with Islamic financial structures is the question of how to account
for them. Under interest-based banking it is an easy call. In most of
the world, you apply IAS 39 (AASB 139 as it is called in Australia) and
in the US you apply FAS 133. The problem with Islamic finance is
that it does not operate in the same way and a good, hard, detailed look
at the way the arrangements will actually work is called for if you are
using these standards, as most of the world’s banks do.
The risk sharing nature of many of the arrangements (Musharakah for
example) means that they are possibly of the nature of a joint
venture (IAS 31), but the precise balance of the risks and control
transferred really matters. The definition of a joint venture in the
standard (“a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control”
IAS 31 para 3) makes it plain that there must be an element, not only
of joint ownership, but joint control. If there is no real control over
the use of the asset by the bank, then is it a financial instrument (IAS
39), merely entitling them to a flow of revenue (say the rental income)
or is it an equity ownership of the asset as they are entitled to a
proportion of the unpaid, residual value? During the life of a
Mudarabah arrangement when does ownership, and equity control really
pass?
A further option would be to account for it as an investment property under IAS 40; but this may, depending upon the terms be excluded if the asset is for sale “in the ordinary course of business”. IAS 17 – Leases? Possibly excluded, again dependent upon the terms, by the operation of the exclusion “investment property provided by lessors under operating leases” in IAS 17 para 2.
Sukuk, fortunately, are reasonably straight forward – perhaps. in most cases these would be accounted for as fair value positions under IAS 39, unless the intent is to hold to maturity – which, in many cases it may well be. For a conventional bond there is normally an active secondary market for the paper, something that is not common for Sukuk issuances. This means that the held to maturity option is a common one and so obtaining a market price for fair value accounting purposes is difficult in any case. As a side issue, and not one that makes an important change to the accounting treatment (but it would to the bank regulatory treatment) these would probably (again, depending upon the terms) need to be treated as equity investments in whatever entity issued the Sukuk.
In all of these, the precise terms of each contract make a big difference to how it is to be accounted for – and this represents something to watch out for if you are going to offer any of these products. Good, strongly worded accounting advice will be what your auditors are looking for.
Most popular