by Faizatul Hasliyanti Ghazali

Abstract

Islam, as a religion presents a complete code of life and requires the observance of very high moral and ethical standards in all social and economic activities. Islamic Financial Institutions (IFIs), the central business entities, are presumed to be serious observants to the Islamic economic principles. Published financial reports of the IFIs reflect the modus operandi of these entities. This thesis explores insights into the corporate reporting practices of IFIs in Malaysia in light of the equity prescriptions and principles of Islam. Malaysia has a long history of developing and structuring its economy and financial institutions under Islamic financial principles. However, the existing literature on the reporting practices of these institutions has thus far not addressed the issue of integrity and quality of their reporting. This thesis provides insight into integrity and quality of Islamic corporate reporting practices and disclosure by IFIs in Malaysia from the perspective of legitimacy theory and the Islamic theoretical framework. The thesis applies not only to actual accounting practices, but also to potential accounting practices. In particular, this thesis explores whether any difference exist between the communicated integrity and quality of IFIs (based on the information disclosed in the annual report) and ideal integrity and quality of corporate reporting (disclosure of information deemed vital based on the Islamic reporting framework). In addition, the study investigates the opinions of the senior level personnel of IFIs regarding the actual practice of corporate reporting and how integrity and quality should underpin corporate reporting. To achieve the above objectives, a two stage of research design was developed. The first stage was carried out by examining the disclosure index as part of content analysis of IFIs’ annual reports in order to explore the communicated integrity and quality of corporate reporting. This part of research sought to understand how IFIs managed their pragmatic legitimacy. The second stage was specifically used interview method to investigate the opinions of senior level personnel of IFIs regarding the actual practice of integrity and quality. This stage of research sought to understand how IFIs enacted integrity and quality to achieve moral and cognitive legitimacy.

1.0 Introduction

Islamic financial institutions (IFIs) have been established for almost 30 years around the world with the objective to meet the demand of stakeholders who are motivated by profit maximization based on Islamic laws (Shari’ah). Since then, IFIs (including Islamic banks, Islamic investment companies and Islamic insurance companies), where businesses are far removed from the concept of riba (interest) prohibited, application al-bay (risk), avoidance of gharar (uncertainty), prohibition of maisir (gambling) and prohibition to engage in the production of prohibited commodities by the Shari’ah, have been witnessing vast development in their various activities. IFIs are based on the concept of profit and loss sharing. This concept means that the stakeholders and business institutions share the results of the project in what is considered a justice way. IFIs invest and trade their funds by using Islamic financial instruments namely Murabahah, Musharakah, Bai Bitamal Ajil, Murabahah, Ijarah, Salam, Istisna’, Wakalah and Kafalah contracts, which are the Islamic tools replacing forbidden interest-based transactions.

In 2007 it was estimated that IFIs numbered over 300 and they are presently handling funds of over US$900 billion[1]. Between 2009 and 2014, total global financial assets of Islamic financial industry are estimated to be more than US$2 trillion with growth of around 17.3%[2]. Beyond of this number, today, IFIs are not only popular in Muslim countries, but are also fast gaining in Europe, America and Australia. For example, in 2010, the global market for UK Islamic financial services reached US$1.13 billion[3]. Similar with Australia, referring to conference paper by (M.R.M. Sain, 2013), the Australian government has fully support on the expansion of Islamic finance by developing some effort to facilitate the formation of a full fledge Islamic financial institutions that would fit the requirements of society[4].

With regards to Asian region, Malaysia is among those Muslim countries that are fully committed to developing the Islamic financial system. Malaysia is now recognised as a pioneer and frontrunner in the global arena. Today, the Islamic financial system in Malaysia runs parallel to the conventional financial system and has been accepted by both Muslims and non-Muslims. Currently, the Islamic financial system in Malaysia encompasses four main sectors namely Islamic banking system, Islamic money market, Islamic capital market and Islamic insurance or takaful. According to Bank Negara Malaysia (BNM) website, there are now thirty-seven wholesome Islamic financial institutions in Malaysia referring to four main categories vis-à-vis Islamic banks (local and foreign), Islamic development institutions, Islamic insurance (takaful) institutions and Islamic subsidiary banks (owned by conventional banks, local and foreign). Currently, total assets of Malaysia’s Islamic banking reached US$65.6 billion at an average growth rate of 18-20% annually. Meanwhile, total assets for takaful industry or Islamic insurance were expected to reach US$7.4 billion by 2015[5].

The IFIs are one of the largest components of the wealth management industry in Malaysia. To ensure that IFIs contribute positively towards optimizing wealth distribution in the economy, there is an urgency to re-evaluate its effectiveness and efficiency. Some consider that, there are conflicts between IFIs’ performance and their resultant reporting to an extensive range of stakeholders and to society generally in their trust to achieve corporate reporting justice. (ACCA, 2010) mentions that, even though Islamic finance has grown rapidly throughout the world, but there is a lack in the expansion of a financial reporting framework and the application of the same in IFIs apply also vary, often depending on the jurisdictional requirements imposed on them. They conclude that, this is not due to differences in Shari’ah interpretation, but rather dictated by the prevailing general requirements for companies within a country.

In emerging economies, corporate reporting practice can vary enormously from “good reporting” to “poor or corrupt reporting”. Good corporate reporting is the core of efficient operation of capital market (KPMG, 2013). The companies need to communicate clearly and transparently with shareholders and other stakeholders on their planning and strategic in order to produce an excellent reputation. Due to the challenges emanating from the global financial crisis of 2008, corporate reporting has undergone some transformation in enabling organizations to restore the trust that had been lost (KPMG, 2013).

Generally, in the conventional reporting system, the role of corporate reporting is to promote the usefulness of corporate information (Sterling, 1972) to the stakeholders with the characteristics of timeliness, understandability, credibility and neutrality (Zairi and Letza, 1994). IFIs’ governance system is unique because all the activities are fully compliant with Shari’ah principles while maintaining and improving growth by proving their efficiency, stability and trustworthiness (Grais and Pellegrini, 2006: 2). In the context of Islam, the objectives of corporate reporting are to provide the appropriate information to the stakeholders in assuring that the entity is adopting practices compatible with Shari’ah (Hamid et al., 1993) and to assist in achieving socio-economic justice (Haniffa & Hudaib, 2002). Basically, the principal of corporate reporting from the Islamic perspective is to satisfy the needs of community by bringing up the concept of accountability as priority and decision usefulness. In the context of IFIs’ corporate reporting, the concept of accountability refers to the concept of responsibility towards the entities, user and nature. This concept is suitable with the aims of Islamic corporate reporting to achieve socio-economic justice as many Islamic countries are distressed by corruption and poverty. According to (Askary & Clarke, 1997) in conference paper, the critical part of the Islamic accounting and financial reporting is to provide a true and accurate information for decision making towards religious obligation of distributing the wealth fairly among humanity.

However, it is difficult to draw a conclusion about the integrity and quality of corporate reporting in general. IFIs claim to occupy a high moral ground because they apparently follow Islamic accounting practices. Its claimed that Islamic corporate reports are more transparent and honest. In other words, the degree of integrity and quality of corporate reports is higher than conventional corporate reports. This research explores this claims with the help of longitudinal data on disclosure and then verified with some interview responses from key players.

1.1 Statement of the problem

“Following the corporate financial report scandals that affected global economies in the past few years, audit committees of organisations have been advised to work with the board of their organisations to ensure integrity of the financial reporting process.”[6] (Chima, 26 August, 2013)

“Following business scandals in 2001 and 2002 there has been increase from regulators, governments and business itself in initiatives which reinforce integrity and enhance trust in business and reporting. integrity underpins and supports high quality information that is fit-for-purpose. Reliable information is of critical importance to the efficient functioning of markets and the effectiveness of public policy initiatives.” (ICAEW, 2007)

The word “integrity” and “quality” of reporting in the corporate environment become popular primarily in the beginning of the 21^st century with the onset of huge financial crisis. There are a number of studies that explore on corporate reporting especially in the developed countries. At present, there is voluminous research on the quality of corporate reporting, but little attention has been paid to the integrity of reporting. Some studies equate, the word “integrity” with business ethics (Dodaro, 2013; Duska, 2013; Palaski et al., 2010; Michael, 2009; Kisamore et al., 2007; Chun, 2005 and Schminke et al., 2002) and forms of social responsibility (Enderle, 2004). Bowie (2004) continues to argue that the definition of integrity generally applies to the individual than to corporate integrity. (Erhard & Jensen, 2015) developed a new theory of integrity by adding integrity as a positive phenomenon to the paradigm of financial economics which will create significant increase in economic efficiency, productivity and aggregate human welfare. They define integrity as the value, productivity and quality of life for individuals or organizations related to economic implications. They also concluded that, normally finance scholars manage to avoid discussion or considerations of integrity because it has occurred to them as “normative”. The discussion on measuring integrity has also grasped the attention of professional accounting bodies namely ICAEW (2012), which came out with a research paper discussing ways to promote the integrity for organizations. They used a mix method in conducting their research namely desk research, online survey (quantitative) and interviews (qualitative). They concluded that, “the organizations do not frequently engage in proactive monitoring of integrity and the professional bodies have a role to play in promoting integrity”.

Financial reporting is used to provide information on the economic activities of a company by showing the perfect financial statement (Wolk et. al., 2004) by building up full disclosure of fair presentation on the high-quality of financial reporting (Robinson and Munter, 2004). As claimed by McFee (2006), “quality financial reporting” and “the quality of financial reporting” are different concepts, which is reflected by Francis (2004) in that “quality financial reporting” refers to “excellent” financial reporting, whereas “the quality of financial reporting” alludes to the factors of reliability, understandability, comparability is indicated by a single sign in a study is doubtfully to be or measured is “excellent”. Mostly, the research on quality and financial reporting have been on earnings management (Vanstraelen, 2005); information disclosure (Buniamin, 2010); adoption by accounting standards (Ahmed et. al., 2013; Dehaan et. al., 2013 and Ames, 2013); corporate governance (Cohen et. al., 2004) and ethics management (Labelle et. al., 2010).

The subject of these studies is still important today in light of continuing financial crises such as Enron in the United Kingdom in 200, WorldCom in the United States in 2002, in the US sub-prime crisis in 2008 resulting in the onset of the global financial crisis in 2009 from which the world has still not recovered.  These crises underscore the need to develop accounting standards and policies in order for corporate reporting to be more useful and transparent to facilitate trust from stakeholders. By referring to those studies, this study extends the research on high quality financial reporting by focusing on the integrity and quality corporate reporting practice according to Islamic principles. Corporate reporting herein encompasses the audited financial statements and the entire gamut of information contained within a reporting entity’s annual report.

Although these studies have been numerous and important, the integrity and quality of corporate reporting by Islamic financial institutions in Malaysian has not received adequate attention. It is the contention of this study that this aspect of corporate reporting warrants closer in-depth examination for a variety of reasons. First, there have been no empirical research studies investigating the integrity and quality of corporate reporting by Islamic financial institutions in Malaysia. Although there are many studies in the same area in Malaysia, these studies have concentrated on the integrity or quality of corporate reports in general, not on Islamic corporate reports.

Akin to others countries, Malaysia is not immune from facing the problems on corporate failure and financial crises. According to Lai (2004), after the East Asian Financial crisis in 1997, Malaysia had to improve on corporate governance in firms to regain investors’ confidence. In other words, companies should bring attention to their corporate reports in order to get trust from investors and others stakeholders. There are few cases of corporate failure at the company level in Malaysia namely Perwaja Steel, Tehnology Resources Industries (TRI), Transmile, Megan, Malaysia Airlines System (MAS), Port Klang Free Zone (PKFZ) and the ongoing 1Malaysia Development Berhad (1MDB) scandal. Mohamad (2002) concluded that poor corporate governance, weak investor relations, a low level of transparency in disclosing information could contribute to the collapse several companies.

Even though IFIs initially claim to operate to the level of adherence to Shari’ah principles, they ultimately face corporate failure and financial scandals as could be noted in a few instances between 1988 and 2005. With numerous crises on IFIs namely the closure of the Islamic Investment Company of Egypt, Islamic Bank of South Africa, Ihlas Finans in Turkey and corporate difficulties as in the case of Bank Islam Malaysia Berhad and Dubai Islamic Bank, the need for a good performance and governance system is considered as a crucial part of corporate reporting image (Hassan, 2012, p. 25). Thus, it is crucial to pay attention to the corporate reporting practices of IFIs. The Government of Malaysia has made efforts in putting in place a set of strategies and institutional reforms aimed at combating corruption and promoting integrity in society by establishing of the Malaysian Institute of Integrity (MII) through the introduction of the National Integrity Plan (NIP) in 2004 (Siddiquee, 2009). This NIP is expected to focus on individual, family, private sector, public administration, socio-cultural agencies, NGOs and politicians (GOM, 2004). Secondly, the NIP just focus on the macro institutional level with little focus on how to promote integrity specifically in corporate reporting practice. Thus researcher intends to examine the corporate reporting practice from the context of integrity and quality.

Thirdly, in Islam, corporate reporting must be in line with Shari’ah where information disclosed must accommodate the needs of stakeholders (Haniffa & Hudaib, 2002). As part of this, corporate reporting must be prepared to support all users in their economic and investment decision making with faithful obligations (Askary & Clarke, 1997) by applying the concept of fairness, charity and compliance with Islamic business values (AAOIFI, 2010). Sulaiman & Latif (2005) point out that in the Islamic perspective, the primary objective of corporate reporting is to ensure the system discharges the Islamic concept of accountability satisfactorily. This point has also been argued by Kahf (1991) that the concept of accountability could include social justice and social accountability. Thus, at present most Islamic countries prefer to follow Islamic rules and practices in their economic and business systems without concerning for the differences between what is ordinarily understood to be “secular” vis-à-vis “religious” (Askary & Clarke, 1997). The authors concluded that the critical element of Islamic financial reporting at the micro level is to provid the truth and accuracy of the report by referring to the Quran (Muslim Holy Book).

In the year 1975 to the late of year 1980s, Islamic finance industry growth rapidly in the modern world mechanism. Thus, the industry realised that it was time for its own set of financial reporting standard more to accurately reflect Shari’ah compliant transactions due to the significant differences in IFIs’ transactions from conventional counterpart (Mohammed, Fahmi, & Ahmad, 2015). AAOIFI was established in 1991 with the objective to formulate methods for financial reporting in alignment with Islamic finance’s rules and regulations which will reflect substance and mechanism of business and financial transactions (in promoting transparency and accountability of company) (Alim, 2014). (Mohammed, Fahmi, & Ahmad, 2015) discussed on the relevant issues on the need for Islamic accounting standards of reporting by IFIs in Malaysia context. They conclude that, there is no need for the separate accounting standard by IFIs. Thus the AAOIFI and IASB could be collaborate for the specific guideline being accepted globally. Since the establishment of IFIs, Malaysia Government choose to use IFRS-compliant standards with supported by national guidelines on reporting framework based on Shari’ah requirement namely MASB Technical Release TR i-3: Presentation of Financial Statements of Islamic Financial Institutions; MASB Technical Release TR i-2: Ijara; MASB Technical Release TR i-1: Accounting for Zakat; MASB Technical Release TR i-4: Shari’ah Compliant Sale Contract; Guideline of BNM’s GP8-i: Financial Reporting for Licensed Islamic Bank; and GP8-i : Financial Reporting for Takaful Operators. This research would not concentrate on the standards for reporting by IFIs indeed but used those guideline as benchmark in developing the ideal index in order to promote integrity and quality of corporate reporting by IFIs in Malaysia.

In light of the above, it becomes clear that corporate reporting by Islamic financial institutions is a problem that requires an in-depth study of its different aspects. The fact that such a study comes in the context of a rapidly changing world where today’s corporate reporting standards are constantly being challenged gives such a study additional importance.

Objective of the study:

The study aims to achieve the following objectives:

1. Develop a conceptual framework to facilitate and demonstrate the integrity and quality of corporate reporting underpinned by Shari’ah values.
2. To analyse the integrity and quality of corporate reporting by IFIs in Malaysia using the proposed benchmark Islamic Integrity and Quality of Corporate Reporting Index (IIQCRI).
3. Evaluate the current Islamic corporate reporting practice among IFIs in Malaysia.
4. Examine the understanding of the concept of integrity and quality in Islamic corporate reporting based on Shari’ah principles.
5. Examine the factors that facilitate integrity and quality of current corporate reporting practice in Malaysian IFIs.

In order to fulfil the above objective, the research questions were formulated in two categories as follows:

Communicated integrity and quality

1. How do Malaysian IFIs’ annual reports demonstrate communicated compliance of integrity and quality of Islamic corporate reporting?
2. What are the differences in the communicated compliance of integrity and quality of Islamic corporate reporting among Malaysian IFIs between 2010 and 2014?

Actual integrity and quality

1. How do Malaysian IFIs practice integrity and quality in their current corporate reporting?
2. How do senior manager personnel interpret the concept of integrity and quality in Islamic corporate reporting based on Shari’ah principles?
3. What factors facilitate integrity and quality of current corporate reporting practice in Malaysian IFIs?

[1] Report by PWC (2008)

[2] Report by MGCC Perspective (2015)

[3] Report by UK Islamic Finance Hub (2010)

[4] Conference paper by M.R.M. Sain, M.M. Rahman and R. Khanam (2013), 3^rd Malaysian Postgraduate Conference, Sydney, (4-5 July 2013).

[5] Bank Negara Malaysia (2016)

[6] See news article on ThisDayLive regarding: Ensure integrity of Financial Reporting, Expert Urges Audit Committee. Online website (www.thisdaylive.com/articles/ensure-integrity-of-financial-reporting-expert-urges-audit-committees/157316/1/8)

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