In this article, we explain the financial accounting requirement of Wa’ad, Khiyar and Tahawwut under the AAOIFI Financial Reporting Standard 38 (“FAS 38”). AAOIFI produces financial reporting standards specifically for Islamic transactions by Islamic financial institutions. Some of the Islamic financial institutions across the world adopt AAOIFI financial reporting framework.
In Malaysia, AAOIFI is not an approved financial reporting framework. Entities in Malaysia, including Islamic financial institutions, adopt the Malaysian Financial Reporting Standards (“MFRS”) or Malaysian Private Entities Reporting Standards (“MPERS”).
MFRS is word-for-word the International Financial Reporting Standards (“IFRS”) while MPERS is similar to the IFRS for SMEs. Financial Reporting Frameworks in Malaysia explains this in further detail. IFRS does not have a specific financial reporting framework to account for Islamic financial transactions.
The definition of Wa’ad, Khiyar and Tahawwut
Let us first understand what is Wa’ad, Khiyar and Tahawwut before we dive deeper into their financial accounting requirements.
Wa’ad is a unilateral undertaking (promise) assumed by a party to the arrangement. In Shari’ah, a unilateral promise is binding on the individual who makes it unless there is a legitimate excuse under Shari’ah that arises and prevents its fulfilment.
Wa’ad may be classified into:
- Binding Wa’ad – where the promise is binding on the promisor if it is pending on a cause and the promisee has incurred costs by reason of the promise or by virtue of the promisor expressly making the same binding on itself.
- Non-binding Wa’ad – this is Wa’ad other than the binding Wa’ad.
Khiyar is an option that allows one party to unilaterally nullify or revoke the contract or to unilaterally amend the contract in a manner that the subject matter is materially changed.
3. Tahawwut (hedging) arrangement
Tahawwut is a mechanism to mitigate the risk of unfavourable future fair value changes or cash flows differentials by way of entering into a Wa’ad or Khiyar arrangement.
Wa’ad and Khiyar are commonly the integral parts of many Shari’ah-compliant products (ancillary Wa’ad or Khiyar). Additionally, an institution may also use Wa’ad and Khiyar as a stand-alone product or for the purpose of Tahawwut. FAS 38 covers the accounting requirements in both situations.
The financial accounting requirements for Wa’ad and Khiyar
The financial accounting requirements for Wa’ad and Khiyar depend on whether they are ancillary or a product Wa’ad or Khiyar.
1. Ancillary Wa’ad or Khiyar
FAS 38 states that an ancillary Wa’ad or Khiyar does not in itself give rise to any asset or liability. However, an institution must assess at the end of each reporting period, whether any of the ancillary Wa’ad or Khiyar has turned into an onerous contract or commitment for the institution.
Although an institution does not need to recognise any asset or liability arising from ancillary Wa’ad or Khiyar, FAS 38 requires an institution to make the following disclosures:
- Qualitative disclosures to explain the nature of Wa’ad or Khiyar arrangements.
- Disclosure of all significant outstanding ancillary Wa’ad or Khiyar under contingent liabilities and commitments (or assets), where practical.
- Presentation and disclosure of an onerous contract or commitment.
2. Product Wa’ad or Khiyar
FAS 38 states that a product Wa’ad or Khiyar gives rise to a “recognised constructive obligation” when:
- It is ‘more likely than not’ that economic resources will flow out of the institution; and
- The institution can reliably measure the amount payable at a future date.
In assessing the probability of the outflow of economic resources, FAS 38 requires an institution to take into consideration:
- Firstly, Legal and regulatory environment under which the institution operates.
- Secondly, Wa’ad or Khiyar has a significant economic incentive for the counterparty.
- Thirdly, the existence of any collateral, security or guarantee held or placed with or issued by the institution, including any margin and/or variation margin maintained as per regulatory requirements.
- Fourthly, the practice followed by the industry in similar situations.
- Fifthly, the fact that the counterparty has incurred any cost in good faith based on the promise made by the institution.
- And lastly, the public expectation and trust placed on the institution as an upholder of Shari’ah principles and rules and moral values.
When the above conditions are met, an institution must recognise constructive rights based on a reasonable estimate of the fair value of the receivable. An institution must review the amount recognised at the end of each financial reporting period. It records any gains or losses on remeasurement in the statement of income unless they relate to a Tahawwut arrangement.
An institution will only derecognise the constructive right when:
- The contractual rights to obtain cash flows from the recognised constructive right expires; or
- It ceases to meet the recognition criteria described above.
An institution recognises any gains or losses on the derecognition in the statement of income.
Presentation and disclosures
FAS 38 also stipulates presentation and disclosure requirements for a product Wa’ad or Khiyar. In this regard, FAS 38 requires an institution to disclose:
- The accounting policies adopted for the Wa’ad and Khiyar transactions, and related significant judgements and estimates.
- The carrying amounts and types of the rights recognised in relation to the Wa’ad and Khiyar arrangements and movement therein.
- The amount of gain or loss recognised in the statement of income in relation to the Wa’ad and Khiyar arrangements. For this, an institution must segregate the initial recognition effect and the effect of subsequent reassessment.
- The gain or loss on a Tahawwut relationship attributed to the hedged item.
Other financial accounting considerations for Wa’ad and Khiyar
FAS 38 additionally explains the accounting requirements for multiple Wa’ad and Khiyar arrangements. For this, FAS 38 states that Wa’ad and Khiyar arrangements involving Shari’ah compliant bilateral or parallel or multi-lateral or series of Wa’ad or Khiyar arrangements by independent parties must be accounted for on each individual Wa’ad or Khiyar separately.
Additionally, there could also be receipt or payment of Hamish Jiddiyyah or Arboun in a product Wa’ad or Khiyar. Hamish Jiddiyyah is an amount deposited as security for execution or fulfilment of a contract or promise or completion of a transaction by one of the parties to the other. Arboun on the other hand is the amount paid by the buyer to the seller in a sale transaction at the time of contract as a security-cum-advance payment against the sales price.
The amount of Hamish Jiddiyyah or Arboun constitutes an asset or liability by the respective parties. An institution accounts for it for in accordance with the relevant AAOIFI Financial Accounting Standards. Additionally, an institution should not net-off the amount of Hamish Jiddiyyah with the recognised constructive obligation or right, unless it is legally enforceable to net off. On the other hand, an institution may adjust Arboun paid with the sale consideration payable or receivable once the sale conclusion.
The financial accounting requirements for Tahawwut arrangements
FAS 38 states that an institution may designate a hedging relationship between a Wa’ad or Khiyar as a hedging instrument and a hedged item where a hedging relationship exist.
The qualification for hedge accounting
A hedging relationship qualifies for hedge accounting only if it meets the following:
- It consists of hedging instruments and hedged items that are formally designated through documentation according to the institution risk management objectives; and
- There is an economic relationship between the hedging instrument and the hedged item.
Accounting for fair value hedge
An institution accounts for a fair value hedge that meets the conditions as follows:
- Recognise the gain or loss arising from the remeasuring of the hedging instrument at fair value in the statement of income; and
- Adjust the gain or loss on the attributable hedged item to the carrying amount of the hedged item and recognised in the statement of income.
Accounting for cash flow hedge
As for cash flow hedge, an institution accounts for it as follows:
- Recognise in equity for the portion of the gain or loss on the hedging instrument that is an effective hedge; and
- To recognise the ineffective portion of the gain or loss in the statement of income.
For other cash flow hedges, the amounts that had earlier been recognised in equity must be recycled from the respective equity accounts to the statement of income in the same period during which the hedged forecast cash flows affect the statement of income.
Discontinuance of hedge accounting
An institution discontinues hedge accounting if:
- The hedging instrument expires or is settled, terminated or exercised.
- The hedge is no longer meets the criteria for hedge accounting.
- The institution revokes the designation of the hedge.
The above financial reporting requirements for Wa’ad, Khiyar and Tahawwut is applicable for financial statements beginning on or after 1 January 2022 with early application permitted. The full FAS 38 is available on AAOIFI’s website.