Reconciling accounting standards and religious principles is challenging Islamic banks and regulators as they adapt to new international book-keeping rules due to come into force in 2018. The new rules, known as IFRS 9, will leave their mark on all major products used by Islamic banks - from simple savings accounts to Islamic bonds - and impact their bottom-lines. Banks around the globe are gearing up to implement IFRS 9 from January 2018, posing a particular challenge for many Islamic finance contracts as they change the way financial assets are classified and measured, requiring lenders to book expected losses in advance. The problem for most Islamic financial products is that their accounting treatment can often diverge from the actual economic substance of a transaction, a key concept behind IFRS 9. This has prompted the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) to set up a working group to look at ways to revise its rules for Islamic financial institutions, which now hold assets worth around $2 trillion. AAOIFI issues guidelines that are followed wholly or in part by Islamic financial institutions across the world, so its efforts would help align the industry to global practices. The working group is revising AAOIFI's accounting standard for provisions and reserves and developing a new one for impairments and expected losses, secretary-general Hamed Hassan Merah told Reuters. These changes will be discussed at a workshop in Jordan on Dec. 14 and at a meeting of AAOIFI's accounting board starting on Dec. 26, with an exposure draft expected to be released for public comment early next year, Merah said.
AAOIFI will also look at amendments to its standard for investment accounts and a new standard covering Islamic derivatives such as waad and khayar, Merah added. LACK OF GUIDANCE A potential clash with Islamic principles could make IFRS implementation tricky for Islamic banks when it comes to accounting of provisions and impairments.
"We still see diverging practices in a number of aspects," Abdelilah Belatik, secretary-general of the General Council for Islamic Banks and Financial Institutions, a Bahrain-based non-profit organization, said."Some of these different practices are due to regulatory reasons, and in other cases to the lack of guidance."Islamic banks' credit ratings, profitability and the cost of funding to customers could be affected by IFRS, Hamad Abdulla Eqab, chairman of AAOIFI's accounting board, said during the organization's annual conference earlier this month. For instance, while IFRS 9 requires recognition of expected losses, AAOIFI rules only permit recognition of incurred losses.
Islamic law does not allow customers to be charged for a future event or a future loss, said Eqab, who is also group chief financial officer at Albaraka Banking Group BARKA. BH. Another issue related to IFRS 9 is how some Islamic finance transactions are classified, such as murabaha and musharaka. Murabaha is a cost-plus-profit arrangement widely used to structure Islamic loans, while musharaka is a partnership contract where two or more parties share profits according to a stipulated ratio. They could be deemed trading activities depending on the specific details of each contract, Belatik said. Islamic bonds, or sukuk, may also be affected. A popular sukuk structure is a sale and lease-back contract known as ijara. However, some sukuk could be classified as leases and therefore fall under a different standard, IFRS 16.
The reason people assume the risks of investing in the first place is the prospect of achieving a higher rate of return than is attainable in a risk free environment…i.e., an FDIC insured bank account. Risk comes in various forms, but the average investor’s primary concerns are “credit” and “market” risk… particularly when it comes to investing for income. Credit risk involves the ability of corporations, government entities, and even individuals, to make good on their financial commitments; market risk refers to the certainty that there will be changes in the Market Value of the selected securities. We can minimize the former by selecting only high quality (investment grade) securities and the latter by diversifying properly, understanding that Market Value changes are normal, and by having a plan of action for dealing with such fluctuations. (What does the bank do to get the amount of interest it guarantees to depositors? What does it do in response to higher or lower market interest rate expectations?)
You don’t have to be a professional Investment Manager to professionally manage your investment portfolio, but you do need to have a long term plan and know something about Asset Allocation… a portfolio organization tool that is often misunderstood and almost always improperly used within the financial community. It’s important to recognize, as well, that you do not need a fancy computer program or a glossy presentation with economic scenarios, inflation estimators, and stock market projections to get yourself lined up properly with your target. You need common sense, reasonable expectations, patience, discipline, soft hands, and an oversized driver. The K. I. S. S. Principle needs to be at the foundation of your Investment Plan; an emphasis on Working Capital will help you Organize, and Control your investment portfolio.
Planning for Retirement should focus on the additional income needed from the investment portfolio, and the Asset Allocation formula [relax, 8th grade math is plenty] needed for goal achievement will depend on just three variables: (1) the amount of liquid investment assets you are starting with, (2) the amount of time until retirement, and (3) the range of interest rates currently available from Investment Grade Securities. If you don’t allow the “engineer” gene to take control, this can be a fairly simple process. Even if you are young, you need to stop smoking heavily and to develop a growing stream of income… if you keep the income growing, the Market Value growth (that you are expected to worship) will take care of itself. Remember, higher Market Value may increase hat size, but it doesn’t pay the bills.
First deduct any guaranteed pension income from your retirement income goal to estimate the amount needed just from the investment portfolio. Don’t worry about inflation at this stage. Next, determine the total Market Value of your investment portfolios, including company plans, IRAs, H-Bonds… everything, except the house, boat, jewelry, etc. Liquid personal and retirement plan assets only. This total is then multiplied by a range of reasonable interest rates (6%, to 8% right now) and, hopefully, one of the resulting numbers will be close to the target amount you came up with a moment ago. If you are within a few years of retirement age, they better be! For certain, this process will give you a clear idea of where you stand, and that, in and of itself, is worth the effort.
Organizing the Portfolio involves deciding upon an appropriate Asset Allocation… and that requires some discussion. Asset Allocation is the most important and most frequently misunderstood concept in the investment lexicon. The most basic of the confusions is the idea that diversification and Asset Allocation are one and the same. Asset Allocation divides the investment portfolio into the two basic classes of investment securities: Stocks/Equities and Bonds/Income Securities. Most Investment Grade securities fit comfortably into one of these two classes. Diversification is a risk reduction technique that strictly controls the size of individual holdings as a percent of total assets. A second misconception describes Asset Allocation as a sophisticated technique used to soften the bottom line impact of movements in stock and bond prices, and/or a process that automatically (and foolishly) moves investment dollars from a weakening asset classification to a stronger one… a subtle "market timing" device.
Finally, the Asset Allocation Formula is often misused in an effort to superimpose a valid investment planning tool on speculative strategies that have no real merits of their own, for example: annual portfolio repositioning, market timing adjustments, and Mutual Fund shifting. The Asset Allocation formula itself is sacred, and if constructed properly, should never be altered due to conditions in either Equity or Fixed Income markets. Changes in the personal situation, goals, and objectives of the investor are the only issues that can be allowed into the Asset Allocation decision-making process.
Here are a few basic Asset Allocation Guidelines: (1) All Asset Allocation decisions are based on the Cost Basis of the securities involved. The current Market Value may be more or less and it just doesn’t matter. (2) Any investment portfolio with a Cost Basis of $100,000 or more should have a minimum of 30% invested in Income Securities, either taxable or tax free, depending on the nature of the portfolio. Tax deferred entities (all varieties of retirement programs) should house the bulk of the Equity Investments. This rule applies from age 0 to Retirement Age – 5 years. Under age 30, it is a mistake to have too much of your portfolio in Income Securities. (3) There are only two Asset Allocation Categories, and neither is ever described with a decimal point. All cash in the portfolio is destined for one category or the other. (4) From Retirement Age – 5 on, the Income Allocation needs to be adjusted upward until the “reasonable interest rate test” says that you are on target or at least in range. (5) At retirement, between 60% and 100% of your portfolio may have to be in Income Generating Securities.
Controlling, or Implementing, the Investment Plan will be accomplished best by those who are least emotional, most decisive, naturally calm, patient, generally conservative (not politically), and self actualized. Investing is a long-term, personal, goal orientated, non- competitive, hands on, decision-making process that does not require advanced degrees or a rocket scientist IQ. In fact, being too smart can be a problem if you have a tendency to over analyze things. It is helpful to establish guidelines for selecting securities, and for disposing of them. For example, limit Equity involvement to Investment Grade, NYSE, dividend paying, profitable, and widely held companies. Don’t buy any stock unless it is down at least 20% from its 52 week high, and limit individual equity holdings to less than 5% of the total portfolio. Take a reasonable profit (using 10% as a target) as frequently as possible. With a 40% Income Allocation, 40% of profits and dividends would be allocated to Income Securities.
For Fixed Income, focus on Investment Grade securities, with above average but not “highest in class” yields. With Variable Income securities, avoid purchase near 52-week highs, and keep individual holdings well below 5%. Keep individual Preferred Stocks and Bonds well below 5% as well. Closed End Fund positions may be slightly higher than 5%, depending on type. Take a reasonable profit (more than one years’ income for starters) as soon as possible. With a 60% Equity Allocation, 60% of profits and interest would be allocated to stocks.
Monitoring Investment Performance the Wall Street way is inappropriate and problematic for goal-orientated investors. It purposely focuses on short-term dislocations and uncontrollable cyclical changes, producing constant disappointment and encouraging inappropriate transactional responses to natural and harmless events. Coupled with a Media that thrives on sensationalizing anything outrageously positive or negative (Google and Enron, Peter Lynch and Martha Stewart, for example), it becomes difficult to stay the course with any plan, as environmental conditions change. First greed, then fear, new products replacing old, and always the promise of something better when, in fact, the boring and old fashioned basic investment principles still get the job done. Remember, your unhappiness is Wall Street’s most coveted asset. Don’t humor them, and protect yourself. Base your performance evaluation efforts on goal achievement… yours, not theirs. Here’s how, based on the three basic objectives we’ve been talking about: Growth of Base Income, Profit Production from Trading, and Overall Growth in Working Capital.
Base Income includes the dividends and interest produced by your portfolio, without the realized capital gains that should actually be the larger number much of the time. No matter how you slice it, your long-range comfort demands regularly increasing income, and by using your total portfolio cost basis as the benchmark, it’s easy to determine where to invest your accumulating cash. Since a portion of every dollar added to the portfolio is reallocated to income production, you are assured of increasing the total annually. If Market Value is used for this analysis, you could be pouring too much money into a falling stock market to the detriment of your long-range income objectives.
Profit Production is the happy face of the market value volatility that is a natural attribute of all securities. To realize a profit, you must be able to sell the securities that most investment strategists (and accountants) want you to marry up with! Successful investors learn to sell the ones they love, and the more frequently (yes, short term), the better. This is called trading, and it is not a four-letter word. When you can get yourself to the point where you think of the securities you own as high quality inventory on the shelves of your personal portfolio boutique, you have arrived. You won’t see WalMart holding out for higher prices than their standard markup, and neither should you. Reduce the markup on slower movers, and sell damaged goods you’ve held too long at a loss if you have to, and, in the thick of it all, try to anticipate what your standard, Wall Street Account Statement is going to show you… a portfolio of equity securities that have not yet achieved their profit goals and are probably in negative Market Value territory because you’ve sold the winners and replaced them with new inventory… compounding the earning power! Similarly, you’ll see a diversified group of income earners, chastised for following their natural tendencies (this year), at lower prices, which will help you increase your portfolio yield and overall cash flow. If you see big plus signs, you are not managing the portfolio properly.
Working Capital Growth (total portfolio cost basis) just happens, and at a rate that will be somewhere between the average return on the Income Securities in the portfolio and the total realized gain on the Equity portion of the portfolio. It will actually be higher with larger Equity allocations because frequent trading produces a higher rate of return than the more secure positions in the Income allocation. But, and this is too big a but to ignore as you approach retirement, trading profits are not guaranteed and the risk of loss (although minimized with a sensible selection process) is greater than it is with Income Securities. This is why the Asset Allocation moves from a greater to a lesser Equity percentage as you approach retirement.
So is there really such a thing as an Income Portfolio that needs to be managed? Or are we really just dealing with an investment portfolio that needs its Asset Allocation tweaked occasionally as we approach the time in life when it has to provide the yacht… and the gas money to run it? By using Cost Basis (Working Capital) as the number that needs growing, by accepting trading as an acceptable, even conservative, approach to portfolio management, and by focusing on growing income instead of ego, this whole retirement investing thing becomes significantly less scary. So now you can focus on changing the tax code, reducing health care costs, saving Social Security, and spoiling the grandchildren.