It is essential for Muslim investors to know how AAOIFI plays a significant role in correlating sharia principles and investment activities. AAOIFI stands for Accounting and Auditing Organization for Islamic Financial Institutions. One of AAOIFI’s goals is to set financial reporting that complies and does not contradict Islamic law (fiqh). This article outlines a brief history of AAOIFI’s establishment, the conceptual framework of financial reporting for Islamic financial institutions (IFI), and how it matters for Muslim investors.
Brief History of AAOIFI
AAOIFI was established in 1991 and is based in Manama, Bahrain. It is the world’s premier non-profit organization dedicated to developing and publishing standards for the worldwide Islamic finance industry. It has institutional members from over 45 countries. These include central banks and regulatory organizations, financial institutions, accounting and auditing businesses, and law firms. Moreover, worldwide Islamic finance has produced 100 standards in the fields of Sharia, accounting, auditing, ethics, and governance. All of the world’s leading Islamic financial institutions now adhere to its rules, which have resulted in a gradual harmonization of international Islamic finance practices.
The Conceptual Framework of Financial Reporting for Islamic Financial Institution (IFI)
In July 2010, AAOIFI released its version of the conceptual framework. Its purpose is to introduce the key objectives and underlying ideas of IFI financial accounting and reporting. The justification for releasing the conceptual framework, according to the AAOIFI, is threefold.
First, to develop a consistent framework and demonstrate that the IFIs are Shariah-compliant in every way. Second, unlike conventional financial institutions, IFIs must comply with Shariah norms and principles, such as the prohibition of riba, gharar, and maysir, in dealing with other parties. Finally, users of IFI financial information have unique and specific information demands. Thus, IFIs must develop financial reports that reflect these needs.
How AAOIFI standards do matter for Muslim Investors
AAOIFI Financial reporting standards harmonize Islamic law and economic substance from the financial transaction. This really matters because modern-day Islamic financial transactions carry several classical contracts arranged in one agreement. AAOIFI assures such an arrangement does not violate sharia principles in financial transactions. As Muslim investors, that kind of approach will be the foremost consideration for investing.
Moreover, Muslim investors need to know AAOIFI’s accounting standard better to predict the company’s actual cash flow. AAOIFI deploys the Straight Line Method (SLM). It is a method of revenues recognition in which an equal distribution of revenues and payment of principal throughout the financing period. For example, a client taking a $2400 Ijarah (lease) facility that is due in 24 months, will regularly pay $240 every month. The amount represents $40 profit plus $200, principal.
Meanwhile, International Financial Reporting Standard (IFRS), as AAOIFI’s counterpart, uses Effective Profit Rate Method (EPRM). It is a method at which expected future cash payments or receipts over the expected life of the financing are discounted exactly to the financial asset’s or liability’s net carrying value. With the same example, a monthly instalment of $240 comprises a higher profit portion and smaller principal in the early months, let’s say $51 profit and $189, principal. Gradually, in the latest months, this distribution alters, for instance, $20 profit and $220 principal.
To sum up, after knowing this divergence of revenue recognition, Muslim investors as capital providers are insightful. Hence, they can consider decision-making with better-equipped information.
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