New global accounting standards challenging for Islamic banks

In less than two months, the new internationally agreed-on accounting principles of the International Financial Reporting Standards, or IFRS 9, will come into effect, aiming at bringing more transparency, accountability and efficiency to financial markets across the globe through streamlined, high-quality accounting criteria.
While this is not so much of an issue for conventional financial institutions which in some countries already introduced the new bookkeeping rules and are used to tough financial market regulations, it could turn out to be a challenge for Islamic banks, particularly in weak regulatory environments, to adapt to those new reporting requirements. They also need to take into account the differences in how Islamic assets should be treated compared to conventional instruments under IFRS 9, especially with regards to capital adequacy for debt-related products.
In a nutshell, the new accounting standard will change how banks establish and record their allowance for possible future credit losses, and this will affect the flow of their credit loss provisions. Banks will have to be proactive in building up credit loss provisions in advance of an expected economic slowdown in order to prevent the world economy from running into financial crises experienced in the past.
Under a scenario set by credit rating Standard & Poor’s, banks in the Gulf Cooperation Council (GCC) will have to set aside additional provisions equivalent to up to 27% of their net operating income depending on the state of their balance sheet, and that is just a base-case scenario. Some banks which neglected sufficient provisioning in the past could quickly be in the doldrums.
The problem for the Islamic finance sector is that the accounting of most of their financial products, and even their classification, differs significantly from the actual economic substance of a transaction, for example the principle of risk-sharing, which implicates profit-and loss-sharing of all stakeholders of a financial transaction.
This is where the troubles begin.
Under most Islamic finance standards, banks so far have been required to just recognise occurred losses, while IFRS 9 requires also the recognition of possible forward-looking losses. But here, Shariah principles come into play, which outlaw that banking customers or investors are being charged for a possible future loss, or any future event that might impact their investment, financial holdings or borrowings.
It is also not entirely clear how to handle popular Islamic debt structures such as murabaha and musharaka, which are risk-sharing borrowing-plus-profit arrangements used to finance tangible assets or definite businesses. Because they are usually based on partnership contracts, they would rather be determined to be trading activities depending on the specifics of their underlying contract, and not as financial products, and therefore would not fall under the terms of IFRS 9. Or, in the case of ijara, a sale-and-lease-back contract widely used for sukuk, it could lead to the classification of a sukuk as a lease deal, which also would fall under a different accounting standard, IFRS 16, which was introduced last year.
There are other potential misalignments between Islamic banking products and IFRS 9, which will make the latter’s implementation quite tricky for Islamic banks, particularly with regards to provisions and impairments, making it hard to calculate the future effect on funding cost, profitability, overall provisioning and, ultimately, a bank’s credit rating and ability to conduct seamless international business.
Adding to this is the fact that the general adoption of existing IFRS standards as global accounting practice has been rather slow in the GCC member countries, and by far not universal. While Kuwait, Bahrain and Qatar were early adopters to set IFRS requirements for all listed companies, it took more time for the UAE and Saudi Arabia, which followed just in 2016 and 2017, respectively. According to Amr Elsaadani, managing director of global accounting firm Accenture for the Middle East and North Africa, this had to do with cultural challenges, lack of professional skills and the reluctance of involving external auditors in domestic business. There are also regulatory bodies with different levels of enforcement readiness and monitoring mechanisms in the region. Other problems are the absence of a debt default history at many banks, as well as difficulties in precisely assessing collateral values and modelling possible future debt losses. For example, despite fast economic growth and a vivid financial market, the UAE as of late still kept relatively weak regulatory frameworks and enforcement mechanisms in place which reflected in the quality in financial reporting of banks and businesses there.
IFRS 9 is due to be globally implemented on January 1, 2018, not just for banks, but all listed companies. Presently, the standards are adopted in over 125 countries, including Islamic financial hubs such as Malaysia and the UK.