Chapter 8-The Accounting Environment of Islamic Banks and Risk Management in Islamic Banking.pptx

Slide ini digunakan untuk pelajar Master MIBS & MIFB di UUM. Juga berguna untul pelajar yang ingin mendalami ilmu Contemporary Islamic Banking.

1. CHAPTER 8: The Accounting Environment of Islamic Banks and Risk Management in Islamic Banking. MAJOR DR. MOHD ADIB ABD MUIN, IFP, CQIF (WEALTH MANAGEMENT) Senior Lecturer Islamic Business school ( Ibs ), uum BWSB5053 Contemporary Islamic Banking - 2024

2. OUTLINE BWSB5053 Contemporary Islamic Banking 2 Accounting process in Islamic Banking. Accounting principles. Financial Statement Submission. Report by Syariah Committees. Risk types (credit risk, market risk, operational risk) Shariah-compliant risk management practices Basel III and its implications for Islamic banks

3. The accounting process in Islamic banking is designed to align with the ethical and legal requirements of Shariah. It involves specific principles, types of accounts, standards, and rigorous auditing to ensure transparency, fairness, and compliance. This unique approach not only differentiates Islamic banking from conventional banking but also ensures that financial activities promote ethical and socially responsible behavior.

4. Islamic Accounting is an accounting that integrates the Shariah Framework, which is based on Qur'an . There are two General Principles in the Islamic Accounting System – Justice and Benevolence. Islamic accounting focuses on various stakeholders in addition to shareholders and creditors, measures and reports on Shari'ah compliance in addition to economic activities, and may use non-financial quantitative and qualitative measures in its reporting. Conventional accounting involves materialism, profit and wealth maximization regardless of legitimacy of contracts (without considering halal and haram), while Islamic accounting takes into account the optimum profits, and legitimacy of contracts based on Sharia principles. Based on the deductive approach that they use, Adnan and Gaffikin (1997) assert that the primary objective of Islamic accounting information is the provision of information to satisfy an accountability obligation to the real owner (Allah). 4 BWSB5053 Contemporary Islamic Banking Accounting process in Islamic Banking

5. Accounting Standards and Regulations Islamic banks adhere to specific accounting standards and regulatory frameworks: Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) : Provides standards for accounting, auditing, governance, and Shariah compliance. International Financial Reporting Standards (IFRS) : While AAOIFI standards are specifically for Islamic banks, IFRS standards are also used to ensure compatibility with global accounting practices. 5 BWSB5053 Contemporary Islamic Banking

6. Recording Transactions Islamic banks must accurately record transactions according to their nature: Recognition of Income and Expenses : Income from profit-sharing investments is recognized when the right to receive the payment is established. Expenses are recognized as incurred. Valuation of Assets and Liabilities : Assets are valued based on fair value, and liabilities are recognized based on the contractual obligations under Shariah principles. 6 BWSB5053 Contemporary Islamic Banking

7. Financial Reporting Islamic banks prepare financial statements that reflect their operations and adherence to Shariah principles: Balance Sheet : Reflects assets, liabilities, and equity. Unique items include investment accounts where the bank acts as a trustee. Income Statement : Reports revenues and expenses, highlighting profit-sharing income, and income from trade-based transactions. Cash Flow Statement : Shows the cash inflows and outflows from operating, investing, and financing activities, ensuring transparency in liquidity management. Statement of Changes in Equity : Details changes in equity, including profit-sharing investments and retained earnings. 7 BWSB5053 Contemporary Islamic Banking

8. Audit and Governance Islamic banks undergo rigorous audits and governance to ensure Shariah compliance: Shariah Audit : Ensures all transactions and operations comply with Shariah principles. Internal and External Audits : Regular audits are conducted to ensure financial integrity and adherence to accounting standards. Shariah Supervisory Board : A group of Islamic scholars who oversee and guide the bank’s activities, ensuring compliance with Islamic law. 8 BWSB5053 Contemporary Islamic Banking

9. Accounting Principles in Islamic Banking Prohibition of Riba (Interest) - Islamic banking strictly prohibits earning or paying interest. Instead, banks engage in profit-sharing agreements, trade-based transactions, and lease-based contracts. Risk Sharing – Islamic banking emphasizes shared risk and reward. In Mudarabah, the bank provides capital while the entrepreneur provides expertise, and profits are shared according to a pre-agreed ratio. Asset-Backed Financing - All financial transactions must be backed by tangible assets or services. This ensures that the transaction has real economic value and reduces speculative risk. 9 BWSB5053 Contemporary Islamic Banking

10. CONT.. Prohibition of Gharar (Uncertainty) - Transactions with excessive uncertainty or ambiguity are prohibited. This principle ensures that all parties have clear information and understanding about the terms of the contract. Contracts must be clear and transparent to all parties involved. Ethical Investments - Investments must comply with Shariah law and cannot involve activities considered haram (forbidden), such as alcohol, gambling, and pork-related products. Investments should promote social welfare and economic justice. Profit and Loss Distribution - Profits and losses must be distributed fairly among the parties involved based on their respective contributions and pre-agreed terms. Zakat (Almsgiving) - Islamic banks are required to calculate and distribute Zakat, a form of almsgiving that is one of the Five Pillars of Islam. Zakat funds are used for social welfare purposes, helping to reduce poverty and promote economic equity. 10 BWSB5053 Contemporary Islamic Banking

11. CONT.. Compliance with Shariah - Islamic banks have a Shariah Supervisory Board comprised of Islamic scholars who ensure that all financial activities and products comply with Shariah law. Regular audits are conducted to ensure ongoing compliance with Islamic principles. Transparency and Disclosure - Islamic banks must provide full disclosure of financial information, ensuring that stakeholders have a clear understanding of the bank’s financial position and performance. Financial reports must be accurate, honest, and reflective of the bank’s adherence to Shariah principles. 11 BWSB5053 Contemporary Islamic Banking

12. Financial Statement Submission Financial Statements reflect outstanding balances in the books of the Bank on a given date . This schedule disseminates important information about the balances reflected in each schedule. Financial statement submission in Islamic banking follows specific guidelines to ensure compliance with Shariah principles, transparency, and accountability. Islamic banks prepare their financial statements based on standards set by both the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and International Financial Reporting Standards (IFRS), ensuring they reflect the unique nature of Islamic financial transactions. 12 BWSB5053 Contemporary Islamic Banking

13. Purpose and Principles Transparency and Accountability : Islamic banks aim to provide a clear and accurate picture of their financial position and performance to stakeholders, including regulators, investors, and customers. Shariah Compliance : Financial statements must comply with Shariah principles, ensuring that all transactions are ethical and lawful according to Islamic law. Standardization : Adherence to AAOIFI and IFRS standards ensures consistency, comparability, and reliability of financial information. 13 BWSB5053 Contemporary Islamic Banking

14. Components of Financial Statements Islamic banks typically prepare the following key financial statements: Statement of Financial Position (Balance Sheet) Assets : Includes tangible assets (e.g., properties, equipment), Islamic financing assets (e.g., Murabaha receivables, Ijara assets), and investments (e.g., Sukuk). Liabilities : Includes customer deposits, profit-sharing investment accounts, and Islamic financing liabilities. Equity : Shareholders’ equity, retained earnings, and reserves. Statement of Income (Profit and Loss Statement) Income : Income from financing activities (Murabaha, Ijara ), investment income, fees, and commission income. Expenses : Operating expenses, finance costs, provisions for impairment, and Zakat contributions. Net Profit : Difference between total income and total expenses. Statement of Cash Flows Operating Activities : Cash flows from core banking operations, including profit from financing and investment activities. Investing Activities : Cash flows related to the purchase and sale of long-term assets and investments. Financing Activities : Cash flows from capital raising activities, repayment of financing, and profit distribution. Statement of Changes in Equity Details changes in equity components, including new equity issuance, dividend distribution, and changes in retained earnings. Statement of Sources and Uses of Qard Hasan Funds Sources : Donations, Zakat, and charitable contributions. Uses : Disbursements for Qard Hasan (benevolent loans) and other charitable activities. Notes to the Financial Statements Additional Information : Detailed notes providing further explanation of the financial statements, including accounting policies, risk management, and compliance with Shariah principles. 14 BWSB5053 Contemporary Islamic Banking

15. Submission Process Internal Preparation and Review Accounting Department : Prepares the financial statements based on transactions recorded throughout the financial period. Internal Audit : Conducts an internal review to ensure accuracy and compliance with accounting standards and Shariah principles. Shariah Supervisory Board (SSB) : Reviews financial transactions and statements for Shariah compliance. External Audit An independent external auditor reviews the financial statements to provide an objective opinion on their fairness and compliance with accounting standards. Regulatory Submission Regulatory Authorities : Financial statements are submitted to relevant regulatory bodies, such as the central bank and financial regulatory authorities, ensuring compliance with national regulations. Annual Reports : Financial statements are included in the bank’s annual report, which is distributed to shareholders and made publicly available. Stakeholder Communication Shareholders : Financial statements are presented at the annual general meeting (AGM) for shareholder approval. Public Disclosure : Published on the bank’s website and other public platforms to ensure transparency and accessibility. 15 BWSB5053 Contemporary Islamic Banking

16. Compliance and Reporting Standards AAOIFI Standards : Ensures that financial statements comply with Islamic accounting and auditing principles. IFRS : Ensures global comparability and consistency in financial reporting. 16 BWSB5053 Contemporary Islamic Banking

17. The submission of financial statements in Islamic banking is a structured process that emphasizes transparency, Shariah compliance, and accountability. By adhering to AAOIFI and IFRS standards, Islamic banks ensure that their financial reporting is reliable, comparable, and reflective of their unique operational principles. This process not only reinforces stakeholder confidence but also promotes ethical and socially responsible banking practices.

18. Report by Syariah Committees As the reference body and advisor to Bank Negara Malaysia on Shariah matters, the SAC is also responsible for validating all Islamic banking and takaful products to ensure their compatibility with the Shariah principles . Shariah Committee responsibilities - Review contract formulas, documents, and existing applications in the bank to consider the extent of compliance with Islamic law . The Shariah Committee's report is a crucial component of the financial reporting process for Islamic banks. This report provides an independent review of the bank's operations, ensuring that all activities comply with Shariah principles. It enhances transparency and trust among stakeholders by affirming the bank's commitment to Islamic ethical standards. 18 BWSB5053 Contemporary Islamic Banking

19. Shariah Committee report might include: Introduction Shariah Committee’s Responsibilities Methodology of Review Shariah Compliance Overview Products and Services Review Zakat Calculation and Distribution Ethical Standards and Practices Training and Awareness Challenges and Recommendations Conclusion Signatures 19 BWSB5053 Contemporary Islamic Banking

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21. Risk types (credit risk, market risk, operational risk) 1. Credit Risk Definition: Credit risk is the risk of financial loss resulting from a counterparty failing to meet its contractual obligations. In Islamic banking, this risk can arise from various Shariah-compliant financing modes such as Murabaha, Ijara , Mudarabah, and Musharakah . Characteristics in Islamic Banking: Murabaha Financing: Credit risk is prominent because the bank purchases goods on behalf of the client and sells them at a profit margin. The risk arises if the client defaults on payment. Ijara (Leasing): The bank retains ownership of the leased asset, reducing risk, but defaults on lease payments pose a credit risk. Mudarabah and Musharakah : These involve profit and loss sharing, where the bank shares in the profit or loss of the business venture. The risk is mitigated by thorough due diligence and monitoring. Mitigation Strategies: Thorough Credit Evaluation: Comprehensive assessment of the counterparty’s creditworthiness. Collateral and Guarantees: Use of collateral and third-party guarantees to secure the financing. Diversification: Spreading exposures across various sectors and clients to minimize risk concentration. 21 BWSB5053 Contemporary Islamic Banking

22. Market Risk 2. Market Risk Definition: Market risk is the risk of losses in on- and off-balance-sheet positions arising from movements in market prices, including foreign exchange rates, equity prices, and commodity prices. Characteristics in Islamic Banking: Commodity Murabaha: Exposed to price fluctuations in the underlying commodities. Sukuk Investments: Prone to interest rate risk and price volatility in secondary markets. Foreign Exchange Risk: Arises from transactions and investments denominated in foreign currencies. Mitigation Strategies: Hedging: Use of Shariah-compliant hedging instruments such as forward contracts, swaps, and options. Diversified Portfolios: Maintaining a diversified portfolio of assets to reduce exposure to any single market movement. Regular Monitoring: Continuous monitoring of market conditions and adjusting positions accordingly. 22 BWSB5053 Contemporary Islamic Banking

23. Operational Risk 3. Operational Risk Definition: Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, systems, or external events. It encompasses a wide range of risks, including fraud, legal risks, physical and cyber threats, and system failures. Characteristics in Islamic Banking: Shariah Compliance Risk: The risk that arises from failure to comply with Shariah principles, which could result in reputational damage and financial loss. Process Failures: Issues in executing contracts and transactions according to Shariah guidelines. Human Errors: Mistakes by staff in adhering to complex Islamic finance structures. Mitigation Strategies: Robust Internal Controls: Establishing strong internal control systems to detect and prevent operational lapses. Shariah Audits: Regular Shariah audits to ensure compliance with Islamic principles in all operations. Training and Education: Continuous training programs for staff to ensure they are well-versed in Islamic banking principles and operational procedures. Technology and Security: Investing in advanced technology and cybersecurity measures to protect against system failures and cyber threats. 23 BWSB5053 Contemporary Islamic Banking

24. In Islamic banking, managing credit risk, market risk, and operational risk involves unique challenges and approaches shaped by Shariah principles. By employing rigorous evaluation, diversification, hedging, internal controls, and continuous education, Islamic banks strive to mitigate these risks and ensure their operations remain compliant and resilient.

25. Shariah-compliant risk management practices Shari'a compliance risk arises from the failure to comply with the rules and principles of Shari'a and, in this respect, is akin to reputation risk. It also includes the risk of legal or regulatory sanctions that the Group or its subsidiaries may suffer as a result of failure to comply with laws and regulations. 4 stages of Shariah risk management: Awareness, training and communication; Assessment of Shariah compliance; Mitigation and control of Shariah risk; and Monitoring and Reporting . https://journals.iium.edu.my/enmjournal/index.php/enmj/article/view/924 25 BWSB5053 Contemporary Islamic Banking

26. Basel III and its implications for Islamic banks Basel III introduced a non-risk-based leverage ratio as a backstop to the risk-based capital requirements. Banks are required to hold a leverage ratio in excess of 3% , and the non-risk-based leverage ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of a bank. Most banks will try to maintain a higher capital reserve to cushion themselves from financial distress, even as they lower the number of loans issued to borrowers . They will be required to hold more capital against assets, which will reduce the size of their balance sheets. Basel III introduces new capital buffer requirements that banks must maintain above the minimum capital ratios . These buffers are designed to ensure that banks build up capital reserves during good times that they can draw down during economic and financial stress periods. 26 BWSB5053 Contemporary Islamic Banking

27. CONT.. The three pillars of Basel III are market discipline, Supervisory review Process, minimum capital requirement . Basel III framework deals with market liquidity risk, stress testing, and capital adequacy in banks. In Basel II, Capital Requirements were refined through Risk-weighted assets, tailoring capital allocation based on the riskiness of assets. Basel III elevated this concept by introducing Capital Buffers - the Capital Conservation Buffer, Countercyclical Capital Buffer, and Systemically Important Banks (SIB) Buffer. Basel III aims to strengthen the requirements in the Basel II regulatory standards for banks . In addition to increasing capital requirements, it introduces requirements on liquid asset holdings and funding stability, thereby seeking to mitigate the risk of a run on the bank. https://www.youtube.com/watch?v=GdZys8lEg2s https://www.youtube.com/watch?v=KpWBf3s4NpI https://www.youtube.com/watch?v=E9tKcBMBzmw 27 BWSB5053 Contemporary Islamic Banking

28. CONCLUSION The accounting environment and risk management practices in Islamic banking are deeply rooted in Shariah principles, requiring specialized approaches that differ significantly from conventional banking. The focus on asset-based financing, profit and loss sharing, and ethical responsibility necessitates a robust and transparent accounting framework. Similarly, risk management in Islamic banking involves unique strategies to address credit, market, and operational risks while ensuring compliance with Islamic law. By adhering to these principles, Islamic banks not only maintain financial stability and integrity but also promote social justice and ethical conduct, aligning financial performance with broader societal goals. This holistic approach underscores the potential of Islamic banking to contribute to a just and equitable financial system. 28 BWSB5053 Contemporary Islamic Banking

29. Dr. mohd adib abd muin [email protected] | [phone]