Through analyzing Kuwait Finance House's financial ratios and accounting practices, this document aims to evaluate the current state of financial reporting in Islamic banking. The analysis finds that KFH has weak liquidity and declining profitability ratios from 2009-2011. Its use of debt financing has also increased its credit risk. KFH's accounting practices are also inconsistent, as it selectively follows IFRS and AAOIFI standards without fully adhering to either. This creates gaps in disclosure and transparency. Moody's has downgraded KFH's ratings due to asset quality issues and an overreliance on volatile investment income. The document recommends KFH improve its financial reporting consistency and practices.

1. Kuwait Finance House: A
Case-Study of Issues and
Concerns in the Financial
Reporting of Islamic Banks
BY: CAMILLE PALDI

2. Introduction

In this financial analysis of Kuwait Finance House Group (KFH), I
have conducted a ratio analysis of key liquidity, profitability, and
efficiency ratios and compared KFH to one of its main
competitors, Gulf Finance House (GFH) in order to illuminate the
financial health of KFH.

I have also examined the accounting and business
practices, disclosure, corporate and Shari’ah governance
mechanisms, and Notes to the Financial Statements .

I conclude with recommendations to KFH and the industry for the
best way forward in terms of financial reporting practice.

3. Aim
Through financial analysis of Kuwait Finance House, I aim to show the
current state of financial reporting in the Islamic finance industry and
make recommendations for improvement.

4. Objective
By examining KFH accounting, disclosure, and reporting practices and
their suitability for an Islamic bank, remuneration practice, corporate
and Shari’ah governance, strategy and their possible financial
impact, and through discussing risk mitigation and capital structure, I
plan to provide a snapshot of the financial and nonfinancial health of
the institution for the benefit of a potential investor/depositor and also
the state of financial reporting for the Islamic finance industry.

5. Kuwait Finance House

KFH is organized into three major business segments including
treasury, investment, and banking (KFH 2011: 78).

In 2011, KFH had 54 branches and was ranked among the best
Islamic banks in the world.

KFH activities are conducted in accordance with the Shari’ah as
approved by the Bank’s Fatwa and Shari’ah Supervisory Board
(SSB) (KFH 2011: 51).

6. Ratio Analysis: Current Ratio

Kuwait Finance House (KFH) has a fairly consistent current ratio for
2009 (.73:1), 2010(.73:1), and 2011(.70:1). Although the ratio is
below 1:1, this doesn’t necessarily indicate that KFH is headed for a
financial disaster, however, it does mean that KFH is working with
negative working capital.

The current ratio for Gulf Finance House (GFH) gives a gloomy
outlook for this international financial institution in 2009 (.48:1), 2010
(.08:1), and 2011 (.01:1). In 2011, GFH only had .01 cents of assets
for every $1 of liability. Both banks are relying heavily on the fact
that depositors do not withdraw their deposits, however, GFH
seems to be in a more vulnerable position.

7. Earnings Per Share

In terms of Earnings Per Share (EPS), initially, a potential investor
may feel uncomfortable with KFH as KFH starts in 2009 with (18. 1
cents), 2010 (15.4 cents), and ends in 2011 at (10.8 cents).

However, the reason for the sudden decline in EPS may be due to
a bonus share issue.

8. Earnings Per Share

GFH starts out in 2009 with an EPS of 272.17 cents, 2010 (76.84
cents), and ends in 2011 with .04 cents.

This is an alarming rapid decline and also means that for every 1$
invested, the return for GFH is only .04 cents, indicating very low
profitability for GFH.

9. Debt-to-Equity

KFH has a debt- to- equity ratio of 5.9 in 2009, 6.5 in 2010, and 7.3 in
2011. GFH’s debt-to-equity ratio is 2009(2.7), 2010(7.7), and
2011(2.53).

It seems that KFH has been more aggressive than GFH in financing
its growth with debt in 2011 and appears to be a credit risk.

If the cost of debt-financing becomes greater than the return, this
could negatively impact KFH’s business.

Therefore, KFH should seek the right balance of debt and equity
finance so as to leverage its assets correctly, especially with a
declining EPS and turbulent economic conditions.

10. Return- on- Equity

Return on equity for KFH amounts to 2009(22%), 2010(4%), 2011(9%)
and for GFH 2009(13%), 2010(7%), 2011(31%).

It appears that in 2011, GFH has a better ROE than KFH.

Furthermore, KFH’s ROE steadily declined from 2009 to 2011.

This is a worrying signal for potential KFH investors.

11. Return- on- Assets

Return on assets for KFH in 2009 is 6.4%, 2010(5.7%), and 2011(.01%)
and for GFH in 2009(.03%), 2010(7.96%), and 2011(.09%).

Once again, GFH is more efficient in terms of return on assets
although GFH also has a low figure and KFH sees a rapid decline in
ROA from 2009 to 2011, possibly worrying investors.

12. Moody’s

In fact, in 2011, Moody’s was reviewing a downgrade for KFH due
to the fact that the overall coverage level of provisions to problem
loans remained relatively low, approximately 73%.

Provisioning needs also continued to weigh down KFH's profitability,
with the bottom-line only stabilizing through relatively volatile
investment income.

Moody’s cited inefficient reporting as one KFH’s key problems in
addition to weak asset quality, financing, and loan books, and
problems in management and internal controls.

13. Moody’s

Moody’s stated that the poor asset quality was due to
concentrated exposures to non-banking financial institutions, real
estate, and underperforming investments.

In fact, in May 2013, Moody's downgraded KFH’s long term ratings
by one notch to A1 from Aa3. Moody's also downgraded KFH's
baseline credit assessment (BCA) and bank financial strength
rating (BFSR) by two notches to ba1/D+ from baa2/C- respectively.

14. Moody’s

The Prime-1 short term rating was confirmed.

All ratings assigned to KFH in 2013 carry a negative outlook.

Moody’s reported that the rating actions reflect (1) continued
asset quality pressures; (2) an increasing reliance on volatile
investment income; and (3) the current organizational complexity
and overall risk profile inconsistent with global peers.

15. Overextension and Wrong Direction

The exposure from excessive derivatives trading most likely added
to the poor asset quality.

In addition, the bank may be overextended in real estate and
investment.

16. Overextension and Wrong Direction

In 2011, KFH launched a one billion KD real estate portfolio in
collaboration with the Kuwait Investment Authority and KFH
initiated several real estate and special purpose financial funds
including a gold traded fund and introduced investment portfolios.

KFH also partnered with Grosvenor Fund Management to invest up
to £380m in US healthcare real estate, having a combined
investment capacity of £900m (Gassner 2011).

Perhaps KFH should redirect some of these efforts towards its
banking section.

17. Accounting Practices

Although an Islamic bank and an associate member of AAOIFI, KFH
Group does not officially adhere to the AAOIFI standards in its
financial reporting.

KFH financial statements are prepared in accordance with
IFRS, however, KFH selectively and unofficially follows FAS guidelines
in some areas of reporting.

18. Accounting Practices
IFRS does not equip KFH with the necessary degree of disclosure and
transparency in light of Islamic modes of finance, as risk exposures of
assets vary according to different types of contracts and the mode
may be used for sale or finance, which would result in different
reporting implications.

19. Accounting Practices

Furthermore, there are many rules in the Shari’ah, which the IFI must
abide by, which may affect reporting requirements.

General disclosures unique to IFI’s are information about the
Shari’ah Advisory Board, policies on zakat, policies of profit
distribution with IAHs, disclosures on prohibited earnings and
disclosures of concentration of asset risks involving unrestricted
investment accounts.

Many gaps in disclosure occur due to use of conflicting standards.

20. Accounting Practices

For example, in regards to investment accounts, some IFIs treat
such accounts as equity or liability, while others report them as offbalance sheet items.

Jordan Islamic Bank, Bahrain Islamic Bank and Qatar Islamic Bank
treat investment accounts that are based on mudarabah
contracts as liabilities and report them on- balance sheet.

Other banks treat investment accounts as fiduciary investments
and report them off-balance sheet (Al Rajhi Bank and Shamil Bank
of Bahrain)(Sarea 2012:27).

21. Accounting Practices
KFH reports restricted investment accounts off-balance sheet and
discloses joint financial assets and percentages of funds involving
unrestricted investment account funds, which mitigates agency risk
involved with the commingling of funds (FAS1).

22. Accounting Practices

Furthermore, in terms of FAS1, KFH discloses compensating
balances as balances with banks and financial institutions exchange of deposits, both on the assets and liabilities sides of the
balance sheet (Shabbir, 2012).

According to Abdel Karim, reporting off balance sheet allows IFI’s
to hide negative information such as losses because of misconduct
or negligence (Safiddiene 2007:144).

23. Accounting Practices

Under mudarabah investment management, the IFI is not liable for
loss arising from investments according to Shari’ah.

In IFRS, this would be presented as a liability along with other
deposits, however, under AAOIFI, unrestricted investment funds are
to be presented as a separate item between liabilities and owners’
equity.

24. Accounting Practices

In terms of Ijarah, AAOIFI requires both operating ijarah and ijarah
muntahia bittamleek to be treated as an operating lease.

In IFRS, both operating ijarah and ijarah muntahia bittamleek are
classified as finance leases.

Due to Shari’ah requirements, Ijarah contracts cannot be
accounted for as finance leases.

The leased assets are recognized in the books of the bank and not
capitalized in the customers books.

25. Accounting Practices

The leased assets are then depreciated in the books of the
bank, contravening IAS 17 (Ibrahim 2007).

The 2011 KFH Annual report states that capitalized leased assets are
depreciated over the estimated useful life of the asset (KFH
2011:54).

26. Accounting Practices

It is required for leasing with gradual sale that the inventory be
valued at fair values, not lower of historical cost or net realizable
value. Hence, IAS2 cannot be followed (Ibrahim 2007).

The 2011 KFH Annual report states that finance leases are
capitalized at inception of the lease at fair value, or if lower, the
present value of the minimum lease payments (2011:54).

27. Accounting Practices
The special nature of Islamic banking requires tailored standards in
order to promote full disclosure and transparency of the IFI (See Table
on Next Slide).

28. Disclosure Requirements for Islamic Finance
(AAOIFI)
Capital
Based on trust, profit
sharing contract with
no executive
involvement.
Performance of
fund (net asset
value) and/or
dividend return.
State outstanding
balance, change in
value and profit
distributed (FAS 6).
Commingling
of
Funds
IFI can utilise the
funds and pool for
financing or
investment.
Funds utilised are
to be identified
visà-vis
shareholders and
other deposit
funds.
Disclose joint financial
assets and percentages
of
funds involving
unrestricted investment
account funds (FAS 1).
Investment
Policy
IFI can adopt a flexi
investment policy in
utilising IAH funds.
Decisions should
be taken in the
interest of an IAH.
Provide adequate
disclosure on basis of
investment policy when
mobilizing IAH funds.

29. Disclosure Requirements for Islamic Finance
(AAOIFI)
Profit and
Loss
Distribution
Mutually agreed
profit distribution
ratio and basis to be
specified.
Mechanisms are
specified and
effectively
communicated.
Reasonable
Return
Effective return to
IAHs is realised.
Smoothing of rate Report policies, amount,
of return to IAHs.
and movements within
PER (FAS 11).
Capital
Recovery
Fund is safeguarded
by ensuring capital is
recovered prior to
profit distribution.
Accrued profit not
distributed until
assurance
provided that
capital is not
depleted.
State
PSR,
income
determination method,
allocation basis and
reserve management
policy (FAS 5).
Report policies, amount
and movements of
Investment Risk Reserve
IRR (FAS 11).

30. Accounting Practices

Capital adequacy and the use of regulatory capital are governed
by the Basel Committee on Banking Supervision (KFH 2011: 87)
rather than the standards issued by AAOIFI and the IFSB.

However, Islamic finance standards are required to regulate
deposits based on Wadi’ah (guaranteed safe custody) or Qard
Hassan (interest free loan) contracts, which are reported as
liabilities in the balance sheet.

31. Accounting Practices

At 31 December 2011, the total Capital Adequacy ratio for KFH
was 13.73% and Tier (1) 13.51% (2010: 14.22% and Tier (1) 14.15%)
compared to the ratio required by the regulatory authorities of 12%
(KFH 2011 Annual Report, 31).

However, as KFH does not use the IFSB and AAOIFI standards for
capital adequacy, this may not truly reflect KFH’s capital structure
and stakeholders cannot truly assess whether capital structure
decisions were made to maximize shareholder equity.

32. IFSB Capital Adequacy Standard
The IFSB has issued a capital adequacy standard, which is based on the
Basel II standardized approach with a similar approach to risk weights.
However, the minimum capital adequacy requirements for both credit and
market risks are set out for each of the Shari’ah compliant financing and
investment instruments (Van Greuning and Iqbal 2008:83).

33. AAOIFI Statement on Purpose and
Calculation of the Capital Adequacy Ratio
for Islamic Banks
The AAOIFI Statement on the Purpose and Calculation of the Capital
Adequacy Ratio for Islamic Banks takes into account the differences
between deposit accounts in conventional banking and investment
accounts in Islamic banking (Van Greuning and Iqbal, 2008:59)
recommending not including the risk-sharing account deposits in
capital (Van Greuning and Iqbal 2008:81).

34. Accounting Practices

The 2011 KFH Annual Report states that no changes were made in
respect to capital management objectives, policies, and processes
from the previous years, however, the dividend pay- out to
shareholders significantly decreased from 2010 to 2011, while
directors’ salaries increased.

Furthermore, profits distributed to investment account holders
(IAH’s) decreased from 2010 to 2011 as seen in the table on the
next slide.

35. Profits Distributed to Investment Account
Holders (IAH’s) Decreased from 2010 to
2011
Deposit Type
2011% of Profit Distribution 2010 % of Profit Distribution
to IAH’s
to IAH’s
Khumasia:
2011 (1.920%)
Mustamera:
2011(1.728%)
2010 (2.378%)
Sedra:
2011(1.344%)
2010(1.850)
Tawfeer:
2011(1.152%)
2010(1.585%)

36. Investment Accounts

The Bank receives deposits from customers as part of several
unrestricted investment accounts “On Balance Sheet” and
restricted “Off Balance Sheet.” In Unrestricted Deposits, these are
invested by the bank as Mudarib investing funds for limited or
renewable periods at various investment ratios.

Investment returns are distributed among the bank as a Mudarib
and investment account holders on proportionate basis for each
type of these accounts and the elapsed investment period (KFH
2011).

37. Investment Accounts

Investors’ capital is not guaranteed and they incur losses if the
bank does (Van Greuning and Iqbal 2008:35).

KFH acts as an investment agent in restricted deposits.

38. Investment Accounts

In terms of depositors’ accounts, non-investment deposits in the
form of current accounts are not entitled to any profits nor do they
bear any risk of loss as the Bank guarantees to pay the related
balances on demand. Accordingly, these deposits are considered
Qard Hasan from depositors to the Bank under Islamic Shari’ah.

Investment deposits comprising of Khumasia, Mustamera, and
Sedra deposits are for an unlimited period, initially valid for one
year, and are automatically renewable for the same period unless
notified to the contrary in writing by the depositor.

The Tawfeer savings accounts are investment savings accounts
valid for an unlimited period. In all cases, the investment deposits
receive a proportion of the profit as the board of directors of the
Bank determines or bear a share of loss based on the results of the
financial year.

39. Investment Accounts

The bank generally invests approximately 100% of investment
deposits for an unlimited period (Khumasia), 90% of investment
deposits for an unlimited period (Mustamera), 70% of investment
deposits for an unlimited period (Sedra) and 60% of investment
saving accounts (Tawfeer).

The bank guarantees to pay the remaining un-invested portion of
these investment deposits. Accordingly, this portion is considered
Qard Hasan from depositors to the Bank under Islamic Shari’ah.

Investing such Qard Hasan is made at the discretion of the Board of
Directors of the Bank, the results of which are attributable to the
equity-holders of the Bank (KFH 2011:71).

40. Investment Accounts

According to the AAOIFI Shari’ah Standard No. 40 Distribution of
Profit in Mudarabah-based Investment Accounts, section 4/1, the
method of profit distribution should be well-known so that no room
is left for uncertainty and dispute.

Distribution of profits should also be in terms of ratios and not at all
by specifying a lump sum amount or a percentage of the capital
for any party or any other method that could lead to avoidance of
sharing of the profit between the two parties (2004: 723).

KFH has not specified in its annual report the method of profit
distribution, however, has listed the concerned ratio.

41. Investment Accounts

According to section 5/1, Distribution of Profit, Application of
Scoring Method of Profit Distribution, the scoring method for
distribution of profit among the participants of general investment
accounts should be used.

From the 2011 report, we cannot deduce the method used,
however, all we can see is that the ratio of profit decreases from
2010 to 2011 due to a decision of the Board of Directors (AAOIFI
2004: 723).

The dilemma currently experienced in terms of the divergence of
accounting standards and their implementation poses a great
threat to the sustainability of Islamic financial institutions.

42. Investment Accounts

Appropriate management of PSIA, with proper
measurement, control, and disclosure of the extent of risk sharing
and IAH’s can be a powerful risk mitigant in Islamic finance (Van
Greuning and Iqbal 2008:59).

The AAOIFI and the Islamic Finance Supervisory Board recommend
that Islamic banks accurately disclose the returns on IAH and
shareholder funds, the bases and the percentages for the
allocation of assets, and profits and expenses in a way to enhance
transparency and enable investors to monitor the performance of
their investments (Safieddine 2009: 144).

43. Remuneration Committee

The Board of Directors of the Bank proposed a cash dividend of
15% for the year ended 31 December 2011 decreasing from 20% in
2010. At the same time, Directors’ fees increased to KD 260
thousand in 2011 from KD 160,000 in 2010 (KFH 2011: 74).

As the Annual Report does not contain a remuneration committee
report, we cannot see how and why these decisions were made.

44. Shari’ah Governance Board

A transparent financial institution would ideally reveal the
duties, decision-making, competence, and composition of the
Shari’ah Board, as well as publish all fatwa issued by the Board.

However, in a one page report, KFH merely certifies that most
decisions made were Shari’ah compliant and for those that were
not, the funds have been donated to charity and provides the
names and pictures of the members (Van Greuning and
Iqbal, 2008:36).

KFH unofficially adheres to FAS 1 in terms of zakat and qard-hassan
reporting. In 2011, zakat was calculated at 2.5777% and charged
to the consolidated statement of income (KFH 2011:59).

45. Corporate Governance
KFH lacks any meaningful corporate governance structure to address
potential agency problems concerning investment accounts nor for
the organization as a whole, except through unofficial compliance
with minimal FAS standards.

46. Disclosure
Although the statements have been certified by Ernst and Young as a
true and fair representation and KFH compliance with capital
adequacy regulations, if KFH does not adhere to the standards set out
specifically for Islamic banking, the statements may not in reality be a
true and fair representation of the position of KFH and the capital
structure management may not have been carried out in a manner
to truly maximize shareholder’s equity and this would remain unknown
to the stakeholder.

47. Risk Mitigation

KFH slightly reduced liquidity risk even though credit risk increased,
indicating effective capital structure management in the advent of
business expansion and a slightly increasing ability to meet
demand deposit withdrawals.

One cause for concern is the use of derivatives by KFH, which is not
Shari’ah compliant and which exposes the assets of its business to a
whole new set of risks, potentially resulting in loss of profits in the
long-run.

48. Risk Mitigation
KD000’s
2010
2011
Credit Risk Exposure
KD11941780
KD12588420
Liquidity Risk
23%
22%
Equity Price on
KD2740
KD2920
Kuwait Stock
Exchange

49. Notes to Financial Statements
As KFH Group adheres to IFRS, gaps in disclosure may occur and there
runs a risk of non-Shari’ah compliance.

50. Notes to Financial Statements
Standard
Yes No
FAS No.1 requires that restricted investment accounts should be reported x
off balance sheet in the statement of the changes in restricted
investments.
FAS No.3 disclosure should be made in the notes to the financial
statements for a financial reporting period if the Islamic bank has made
during that period a provision for decline in the value of Mudarabah
assets.
FAS No.4 disclosure should be made in the notes to the financial
statements for a financial reporting period if the Islamic bank has made
during that period a provision for a loss of its capital in Musharaka
financing transactions.
x
x

51. Notes to Financial Statements
FAS No.5 requires bank to disclose percentages for profit-allocation
between investment account holders and the bank.
x
FAS No.6 disclosure should be made, in the notes on significant
accounts, of the percentage of the funds of unrestricted investment.
Distinguishes reporting requirements of unrestricted (on balance sheet
item) and restricted (off balance sheet item) investment accounts.
x
Fas No. 9 on Zakat
x
FAS No.10 requires that the Islamic bank shall disclose in its financial
statements revenues and profits of Istisna’a contracts recognized for the
financial period.
x

52. Notes to Financial Statements
x
FAS No.11 requires that the Islamic bank shall disclose in the notes any
deductions, either as a percentage or an amount, from mudarabah
income. Introduces the Profit Equalisation Reserve (PER) and Investment
Risk Reserve
(IRR) to protect IAHs’ interests by ensuring stable distribution rate of return
to IAHs as well as ensuring capital recovery prior to realisation of
distributable profit.
Fas No. 14 on Investment Funds
FAS No. 17 on Investments
FAS No.20 requires that the bank shall disclose in the notes to the
financial statements the policy adopted in financing deferred payment
sale transactions.
x
x
x

53. Notes to Financial Statements
FAS No.21 require that disclosures shall be made of the accounting
policies adopted in the transfer of assets from unrestricted investment
accounts to restricted investment accounts.
FAS No.23 requires consolidated financial statements shall be prepared x
by combining the financial statements of the IFI.
x

54. Conclusion

It appears that KFH follows the basic disclosure requirements of
AAOIFI even though it officially adheres to IFRS, however, there is a
gap in relation to the more detailed requirements of the AAOIFI
standards.

However, all of these requirements appear to have been met in
the KFH (Bahrain) B.S.C.(c) Public Disclosure Report, as AAOIFI
standards are officially followed in Bahrain prepared in
accordance with the Central Bank of Bahrain’s requirements
outlined in its Public Disclosure Module, Section PD 3.1.6 Additional
Requirements for Semi Annual Disclosures, CBB Rule Book, Volume II
for Islamic banks.

55. Conclusion

Concerns for investors include the worrying debt-toequity, ROE, and ROA ratios, overextension in the real estate and
investment businesses, the declining dividend pay-outs and
increasing salaries along with the decreasing percentage of profits
to investment account holders, and the Moody’s downgrade.

Another destabilizing factor could be the use of derivatives to
hedge risk and/or speculate and the lack of transparency in the
reporting of the investment accounts, remuneration
committee, Shari’ah Board, and the Group as a whole.

Agency problems involving the investment accounts can be
mitigated if KFH Group opted to adopt the structure of the KFH
Bahrain Public Disclosure Report in its financial reporting, which
adheres to AAOIFI standards.

56. Conclusion
My recommendation to KFH is to utilize the Bahrain Public Disclosure
Report in the KFH Group consolidated financial statements either as a
separate additional report or included in the Notes to the Group
consolidated financial statements.

57. Conclusion

Furthermore, I recommend KFH to issue a Remuneration Report and
to develop a comprehensive corporate governance structure as
well as issue a more substantial Shari’ah Supervisory Board Report
so as to ensure Shari’ah compliance.

KFH should also consider taking the lead as one of the first Islamic
banks to introduce a system of guaranteeing deposits in order to
attract greater clientele and ensure industry-wide stability.

Otherwise, KFH remains the best Islamic bank in Kuwait and the
Middle East.

58. Conclusion
Bibliography Available Upon Request.
Full Report and Bahrain Disclosure Report for KFH available on my
Academia Profile.
https://durham.academia.edu/CamillePaldi