2016 CBI Study Guide - Module 4 - 16a

CPA PROGRAM
CONTEMPORARY
BUSINESS ISSUES
MODULE 4
Version 16a
Published by Deakin University, Geelong, Victoria 3217 on behalf of CPA Australia Ltd,
ABN 64 008 392 452
First published July 2010, updated January 2011, July 2011, revised January 2012,
reprinted with amendments July 2012, revised January 2013, reprinted with amendments July 2013,
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Authors
Terence Brooks Manager of the Forensic Investigation Unit,
Professional Standards Command of Victoria Police
Courtney Clowes Director, KnowledgEquity
Keith De La Rue Independent Consultant, Speaker and Director, AcKnowledge Consulting
Dr Jane Hamilton Independent Consultant
Marina Kelman General Manager, Mergers and Acquisitions, National Australia Bank
Dr Hayat Khan Lecturer, La Trobe University
Dr Julie Margret Senior Lecturer, La Trobe University
Dean Newlan Consultant to McGrathNicol Forensic
Roger Simnett Professor, University of New South Wales
Dr Siri Terjesen Assistant Professor, Indiana University, USA
2016 updates
Terence Brooks Manager of the Forensic Investigation Unit,
Professional Standards Command of Victoria Police
Keith De La Rue Independent Consultant, Speaker and Director, AcKnowledge Consulting
Susan Jones Founder, Ready Set Startup and Lecturer in Entrepreneurship,
Swinburne University of Technology
Dr Hayat Khan Lecturer, La Trobe University
Dr Tehmina Khan Lecturer, RMIT University
Dr Rahat Munir Senior Lecturer, Macquarie University
Dean Newlan Consultant to McGrathNicol Forensic
Acknowledgments
George Apostolos Senior Forensic Accountant, ASIC
Betty Ferguson Consultant
Dr Dean Hanlon Senior Lecturer, Monash University
Professor Karen Jansen Senior lecturer, Australian National University
Tui McKeown Senior Lecturer in the Department of Management, Monash University.
Dr Áron Perényi Lecturer, Swinburne University of Technology
Advisory panel
Desley Ward CPA Australia
Dianne Harvey Latrobe University
Gavin Ord CPA Australia
John Purcell CPA Australia
Sarah Scoble CPA Australia
Stephen Zigomanis 72 Financial
Terence Brooks Victoria Police
CPA Program team
Kerry-Anne Hoad Alisa Stephens Sarah Scoble
Kristy Grady Yvette Absalom Belinda Zohrab-McConnell
Desley Ward Nicola Drury
Kellie Hamilton Elise Literski
Educational designer
Jan Williams DeakinPrime
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Extracts used from International Accounting Standards are Copyright © International Accounting Standards Committee Foundation.
CONTEMPORARY BUSINESS ISSUES
Module 4
FINANCIAL REPORTING AND BEYOND
DR JANE HAMILTON, DR HAYAT KHAN AND DR SIRI TERJESEN
(REVISED BY CATHERINE POZZI AND ROGER SIMNETT)*
* The authors wish to acknowledge use in this module of content previously prepared by
Dianne Harvey and Dr Diane Kraal, as well as the assistance of Brad Potter in updating the material.
278 | FINANCIAL REPORTING AND BEYOND
Contents
Preview 281
Introduction
Objectives
Teaching materials
Part A: Developments in financial reporting and

banking regulations 283
Introduction 283
International Financial Reporting Standards 283
Application of IFRSs
Development of IFRSs
Current IASB projects
Public sector accounting standards 286
Introduction
Development of International Public Sector Accounting Standards (IPSASs)
International Public Sector Accounting Standards in Australia
Impact of the Global Financial Crisis on accounting standards 287
Causes of the Global Financial Crisis (GFC)
IASB response
Liquidity risk 290
Introduction
Global liquidity risk position before the GFC
Evolution of the Global Financial Crisis
Liquidity management post-GFC
Eurozone sovereign debt crisis
Basel III reforms 311
Basel III measures aimed at individual banks
Basel III measures aimed at the banking system as a whole
Potential impact of Basel III on corporate borrowers
Conclusion: Implications of Basel III for accountants
Possible return to protectionism 318
Islamic finance 320
Introduction
What is Islamic finance?
Principal contracts underlying Islamic finance structures
Challenges for Islamic banking
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Islamic finance in Australia

Developments in director reporting 333
Australian directors’ report
United Kingdom strategic report
Summary 336
Part B: Integrated reporting 337

Introduction 337
Factors leading to the development of integrated reporting (IR) 337
Background to IR 338
IR framework 338
What is IR?
Guiding principles of IR
Content of IR
Who uses IR?
What is the relationship between IR, financial reporting and sustainability reporting?
What type of organisations could benefit from IR?
Potential pathways to developing an integrated report
Summary 345
CONTENTS | 279
Part C: Non-financial reporting frameworks 346

Introduction 346
Sustainability reporting 346
Factors affecting demand for sustainability reporting
Global Reporting Initiative (GRI) 348
G4 guidelines
Implications for accountants
Carbon Disclosure Project (CDP) 356
Water accounting 358
Natural capital 361
What is natural capital and why is it important?
How is natural capital currently reflected in financial reporting?
If it is so important, why aren’t we currently reporting on it?
The future of reporting and the Natural Capital Coalition
Verification and assurance of non-financial reporting disclosures 364
Summary 367
Review 368
Readings 369
Reading 4.1 369
Reading 4.2 370
Reading 4.3 371
Reading 4.4 372
Reading 4.5 373
Reading 4.6 374
Suggested answers 375
References 385
Optional reading
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MODULE 4
Study guide | 281
Module 4:
Financial reporting and
beyond
Study guide
Preview
Introduction
In Part A of this module, we examine developments in financial reporting and banking regulation.
We begin by discussing the application of and developments in International Financial Reporting
Standards (IFRS). We then consider Public Sector Accounting Standards and their impact on
reporting in the public sector. As part of this discussion, we look at the impact of the Global
Financial Crisis (GFC) and how it has affected, and continues to affect, accounting standards.
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We then discuss liquidity risk and its effect on the banking sector. The GFC has impacted
on banking regulations, so we will review the Basel III banking regulations and finish with a
discussion of the increasing trend towards protectionism.
In the final sections of Part A, we review an alternative to traditional banking—Islamic banking—

and discuss developments in director reporting.
In Part B, we investigate integrated reporting, an approach to reporting that allows an organisation

to tell its value creation story. Integrated reporting takes into account all resources and relationships
available to an organisation and enables broader based reporting to meet the needs of disparate
stakeholders. Integrated reporting goes beyond current, more traditional approaches to reporting,
which focus on periodic financial performance and the needs of lenders and shareholders.
Finally, in Part C of the module, we consider other major forms of non-financial reporting.
These include disclosures on carbon and natural resource impacts and water accounting.
The development of assurance services in sustainability reporting is also discussed.
Opportunities for accountants to meet the business needs of new services and provide
information on environmental, sustainability and governance reporting are also discussed.
Objectives
After completing this module, you should be able to:
• evaluate international developments in accounting standards and banking regulations;
• outline the causes of liquidity issues and assess the impact on businesses of the
liquidity crisis;
• examine the purpose and key components of Islamic financing;
• examine the reasons for the increased demand for and extent of non-financial
reporting activities;
• explain key features of new forms of non-financial reporting for public and private sector
organisations; and
• evaluate the concept of integrated reporting, highlighting its stated advantages and
key challenges.
Teaching materials
• Readings
Please note that these readings are available on My Online Learning.
Reading 4.1
‘The socio-economic impacts of the adoption of IFRS: A comparative study between
the ASEAN countries of Singapore, Malaysia and Indonesia’
D. Kraal, P. Yapa and M. Joshi
Reading 4.2
‘International accounting standards essential for growth’
T. Ochi
Reading 4.3
‘State-owned assets—setting out the store’
T. Ball
Reading 4.4
‘Background information about banking’
Reading 4.5
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‘Background to the eurozone sovereign debt crisis’
Reading 4.6
‘Building sustainability into investment decisions’
J. Purcell
• Online glossary
Explanations for some terms used in the ‘Liquidity risk’ section are available from the online
glossary located in My Online Learning.
Study guide | 283
Part A: Developments in financial

reporting and banking regulations
Introduction
International Financial Reporting Standards (IFRSs) are adopted for mandatory or voluntary use
by many countries around the world, including Australia. IFRSs are not yet fully converged with
all nations’ accounting standards, particularly those issued by the Financial Accounting Standards
Board (FASB) in the United States.
In this section, we review the progress of the convergence process and explain some of the
difficulties still facing the International Accounting Standards Board (IASB) and FASB. We also
note the rate of progress of IFRSs adoption around the world. We then discuss Public Sector
Accounting Standards.
Next we look at the effect the Global Financial Crisis (GFC) of 2007–08 had on accounting
standards. The GFC played a part in driving changes in international regulations and is a factor
in the possible return to protectionism in several countries.
We consider liquidity risk in banks, examine the effect of the new requirements for banking
under Basel III and discuss Islamic finance.
International Financial Reporting Standards

This section considers how and why IFRSs were developed, as well as the current progress on the
global adoption of IFRSs. In 2001, the IASB was given a mandate to develop IFRSs as the basis
for companies participating in globalised trading. Each country’s government and/or accounting
body would then be tasked with incorporating or harmonising IFRSs into their own reporting
standards. The aim is for one set of standards to apply worldwide or, at least, for multiple sets of
standards to be consistent in all material respects.
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The vision of global accounting standards has been publicly supported by many international
organisations, including the Group of Twenty nations (G20), World Bank, International Monetary
Fund (IMF), Basel Committee, International Organization of Securities Commissions (IOSCO),
and the International Federation of Accountants (IFAC) (IFRS Foundation 2015a).
Application of IFRSs
IFRSs have been adopted by around 130 different jurisdictions (Deloitte 2015). Some countries
have replaced their previous accounting standards for specific sectors with the equivalent IFRS—
for example, for listed entities in the European Union.
Other countries, including Australia, have largely adopted IFRSs with some exceptions.
For example, in Australia, the accounting standards have been developed to be ‘transaction
neutral’. This means that a guiding principle for the work of the Australian Accounting Standards
Board (AASB) is that the same transactions and events should, where possible, be subject to
the same accounting requirements for entities preparing their financial statements. This has
implications for entities regardless of their profit (or not-for-profit) motive, entities in the public
and private sectors, and those entities that can apply the reduced disclosure requirements.
Development of IFRSs
The IASB is an independent, private sector body that develops and approves IFRSs. It operates
under the oversight of the IFRS Foundation. Formed in 2001, the IASB superseded the
International Accounting Standards Committee (IASC).
Standards developed and approved by the IASB are identified as IFRSs. The International
Accounting Standards (IASs) were issued by the IASC and were adopted by the IASB when it
was created.
The IASB has amended the IASs, but it is only when a standard is replaced that the new standard
is identified as an IFRS. A recent example is the issuance of IFRS 9 Financial Instruments, in July
2014. IFRS 9 replaces IAS 39 Financial Instruments: Recognition and Measurement and is effective
for financial reporting periods beginning on or after 1 January 2018. Further discussion of this
standard is provided later in this module in the section headed ‘Impact of the Global Financial
Crisis on accounting standards’.
The due process (shown in Figure 4.1) of developing an IFRS comprises six stages:
1. setting the agenda;
2. planning the project;
3. developing and publishing the discussion paper, including public consultation;
4. developing and publishing the exposure draft, including public consultation;
5. developing and publishing the standard; and
6. procedures after an IFRS is issued.
Figure 4.1: The process of developing an IFRS

Agenda consultation Research programme Standards programme Implementation
IFRIC
Request for 3–5 year Discussion Exposure Final
Research Proposal PIR
information plan paper draft IFRS Narrow-
scope
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Source: IFRS Foundation 2015b, ‘How we develop IFRSs’, accessed July 2015,
http://www.ifrs.org/How-we-develop-standards/Pages/How-we-develop-standards.aspx.
© IFRS Foundation 2015. Reproduced with the kind permission of the IFRS Foundation. All rights reserved.
After an IFRS is published, subsequent procedures exist for any interpretational issues that
may arise. When considered appropriate, the issue may be referred to the IFRS Interpretations
Committee (previously known as the International Financial Reporting Interpretations Committee,
or IFRIC). This committee is responsible for the maintenance of IFRSs, and its objective is to
provide timely guidance on financial reporting issues that are not specifically addressed in the
standard. Interpretations issued by the IFRS Interpretations Committee are called ‘International
Financial Reporting Standards Interpretations’ (IFRICs). In some cases, issues submitted to the
IFRS Interpretations Committee for consideration are not added to its agenda, but they are
Study guide | 285
published as ‘IFRIC rejection notices’. The issue and the rejection notice are published along
with a description of the issue and a detailed explanation of why further action is not required.
Rejection notices do not have the authority of IFRSs. These are not mandatory requirements
but may be used as guidance for understanding issues. Interpretations issued by the Standing
Interpretations Committee (SIC), a predecessor of the IFRS Interpretations Committee,
are identified as ‘SIC Interpretations’. The idea behind the IFRS Interpretations Committee is
to achieve a balance between the principles-based approach that underpins the IFRSs and
providing enough guidance to those applying the standards in preparing financial statements
(IFRS Foundation 2015c).
Current IASB projects

Some of the IASB’s ongoing projects include:
• Conceptual Framework Project. The IASB has not reviewed its conceptual framework
since its joint project with the FASB in 2010. As a result, according to the IASB, although
the existing framework has helped the board in developing and revising the International
Financial Reporting Standards, some important areas have not been covered. Additionally,
some existing guidance is unclear and some aspects are out of date. The comment period
on the ‘Exposure Draft of the Conceptual Framework’ ended on October 2015. At the time of
writing, the board was reviewing feedback, and a revised conceptual framework is scheduled
to be released during 2016. It is envisaged that this project will ultimately affect the content
of a number of specific standards.
• Principles of Disclosure Project. The objective of this project is to help entities better
determine the basic structure and content of their complete set of financial statements.
At this stage, the project will not consider the removal or addition of specific disclosure
requirements in other standards. Rather, disclosure requirements in all standards will be
reviewed systematically in light of the revised conceptual framework and of work undertaken
in this project. At the time of writing, the IASB is drafting a discussion paper on this project
for release in late 2015 or early 2016.
• Redeliberations on the leases project. The current classification of accounting for leases is
not viewed as meeting the needs of financial statement users because it does not provide
sufficient information about the assets and liabilities that may arise from operating leases.
This project has been ongoing for a number of years, with an initial exposure draft issued in
2010. In response to feedback on the proposals contained in the 2010 exposure draft, a new
exposure draft was issued in 2013. The IASB is currently considering the responses to this
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exposure draft. At the time of writing, the new leases standard is expected to be released in
late 2015 or early 2016.
The IASB publishes details of current and ongoing projects in its work program. For more details
about IFRS projects, visit the IFRS website at: http://www.ifrs.org/Current-Projects/IASB-Projects/
Pages/IASB-Work-Plan.aspx.
Also, keep up to date on the progress of IFRSs adoption by accessing www.ifrs.org and by viewing
pronouncements from accounting standards bodies and the IASB.
Next, read Readings 4.1 and 4.2. Reading 4.1 is a report containing research into the socioeconomic
impacts of adopting a global accounting model (IFRS) in ASEAN countries. Reading 4.2 highlights
the importance of international accounting standards for supporting global growth and how they
contribute to Japan’s growth.
Public sector accounting standards

Introduction
The accounting standards developed by the IASB focus on for-profit entities. Given this, there is
a need for accounting standards applicable to the other types of entities. The International Public
Sector Accounting Standards Board (IPSASB) develops International Public Sector Accounting
Standards (IPSASs) for use by governments and other public sector entities.
The IPSASB is an independent accounting standing-setting board supported by the International

Federation of Accountants (IFAC). Its role is the development of accounting standards, guidance
and resources for use by public sector entities in preparing general purpose financial statements.
The IPSASB aims to ‘enhance the quality, consistency and transparency of public sector financial
reporting worldwide’ (IFAC 2015a).
Since 1997, the IPSASB has developed and issued a suite of 32 accrual standards, and a cash
basis standard for countries moving toward full accrual accounting. Governments that report
on a cash-basis do not account for significant liabilities, such as pensions and infrastructure
development; as a result, the IPSASB encourages public sector entities to adopt the accrual basis
of accounting—which will improve financial management and increase transparency resulting in a
more comprehensive and accurate view of a government’s financial position. Many governments,
jurisdictions, and international institutions have already adopted IPSASs—many more are on the
road to implementing the standards
Development of International Public Sector Accounting

Standards (IPSASs)
The IPSASB follows a structured and public due process in the development of IPSASs.
This process is followed to allow the involvement of all interested parties.
The development of a new IPSAS is usually started by the preparation and distribution of
a consultation paper that ‘explores the subject in detail and provides the basis for further
discussion, development, and policy formation’ (IFAC 2015a). After consideration of any
views expressed on the consultation paper, an exposure draft (ED) is prepared. EDs are
often developed with the input of a task-based group of IPSASB members. EDs have open
and finite comment periods (IFAC 2015a).
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To date, the IPSASs have been based on IFRSs to the extent that their requirements are relevant
to the public sector. Therefore, the current IPSASs have drawn on the concepts and definitions
contained in the IASB Conceptual Framework with modifications where required. This is set
to change as the IPSASB has recently drafted a conceptual framework of its own. According
to the IPSASB, the purpose of the framework is to provide the IPSASB with the concepts that
will underpin the development of IPSASs and Recommended Practice Guidelines (RPGs) in the
coming years. In doing so, the IPSASB believes it will improve the consistency of its standard
setting through greater linkage between standards (IFAC 2015b).
The development of a robust set of accounting standards applicable in the public sector,
particularly for governments, has taken on more importance since the sovereign debt crisis
(discussed later in this module):
The sovereign debt crisis has illustrated the dire consequences of insufficient transparency and
accountability of governments and poor public finance management and reporting.
Governments are not risk-free and the failure of fiscal management in the public sector has
an economic impact that will far exceed the impact of losses incurred by corporate failures.
This jeopardizes both the interests of the public as well as investors.
Study guide | 287
Today, many key decision-makers, politicians and public finance management leaders are taking
the key steps towards meaningful reform, including the adoption and implementation of accrual
accounting and IPSASs (IFAC 2015c).
According to the IFAC fact sheet (IFAC 2014), 10 countries and five bodies or organisations
have adopted or have plans to adopt IPSASs. However, this listing does not include countries
identified by Ball (2014) in his article on current issues with accounting for state-owned assets.
Now read Reading 4.3. This article ‘State-owned assets—setting out the store’ highlights issues in
accounting for state-owned assets.
International Public Sector Accounting Standards in Australia

Australian accounting standards are prepared on a transaction-neutral basis and, where
appropriate, incorporate the requirements of the IPSASs. The impact of this can be seen in
the separate not-for-profit standards collated by the AASB and the inclusion of Australia-
specific paragraphs in accounting standards applicable to not-for-profits. This is in line with
the membership obligations imposed on CPA Australia, the Chartered Accountants Australia
and New Zealand and the Institute of Public Accountants. This is also in accordance with the
IFAC Statement of Membership Obligation 5 ‘International Public Sector Accounting Standards
and Other Pronouncements’, which was issued by the IPSASB to encourage the AASB as the
entity responsible for Australian accounting standards to follow the IPSASs.
➤➤Question 4.1
Explain the issues with accounting for state-owned assets on a historical cash basis (which is often
done using a cash system rather than an accrual system).
Impact of the Global Financial Crisis on

accounting standards
Causes of the Global Financial Crisis (GFC)
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The overall causes of the GFC were complex; they included world trade imbalances,
excess leverage and continuously low interest rates. According to the chair of the Basel
Committee on Banking Supervision, key factors were ‘excess global liquidity, too much
leverage, too little capital of insufficient quality, and inadequate liquidity buffers’ (Wellink 2011).
The role of fair value (mark-to-market) accounting in causing and spreading the GFC was the
subject of debate in the early days of the crisis. Fair value accounting was seen as an important
factor because markets stopped functioning in the usual ways, causing the value of financial
instruments to fall or to be less transparent. Where banks took action to write down their financial
assets, they increased the risk of breaching their capital adequacy standards. Under banking
regulations, banks were required to maintain adequate capital reserves. As their asset values fell,
banks had to either find additional capital or stop lending. In many cases, banks had insufficient
buffers to absorb the write-downs.
Another key area of concern was the use of special purpose entities (SPEs). An SPE is a legal
entity—usually a limited company or a limited partnership—created to fulfil narrow, specific or
temporary objectives. The focus on the contribution of off-balance sheet financing to the GFC
was driven by concerns that some entities used SPEs to hide the results of certain transactions
from stakeholders. When the SPEs were not fully consolidated in a transparent way, it was difficult
for all stakeholders to identify and assess the risks associated with the parent entity or the
financial instruments themselves.
The international focus on accounting standards for SPEs began in earnest after the collapse of
Enron in 2002, because Enron used SPEs to reduce the transparency of its financial operations
(SEC n.d.). US Generally Accepted Accounting Principles (GAAP) and the IASs were not aligned
at the time of the GFC.
IASB response
The criticism of fair value accounting’s role during the crisis was a key factor in the G20’s call for
global accounting standard-setting bodies to improve standards in this area, especially when
markets are weak (G20 2008).
The IASB responded to the G20 directives by reaffirming its work to reach convergence with
the Japanese Accounting Standards Board and the FASB. In addition, the IASB promoted the
discussion of fair value accounting to a priority position in its work program and sped up the
development process by shortening the usual consultation times (IASB 2011). The convergence
programs and the improvements to fair value accounting standards were seen as necessary by
the IASB because the IFRSs and US GAAP have multiple and different impairment models that
relate to different financial asset types in different ways (IASB 2011). The FASB and IASB were still
struggling in 2013 to find a joint solution to accounting for financial instruments. By the end of
2013, it was clear that convergence on accounting for financial instruments was unlikely. The IASB
and FASB have each separately revised their accounting standards for financial instruments.
In October 2011, the IASB response to the G20 directives was summarised in their report under
five main headings as follows:
Consistent with the G20 recommendations, the IASB has:
• Completed its review of off-balance sheet financing, resulting in amendments to IFRS 7
Financial Instruments: Disclosure and the issuance of three new standards, IFRS 10
Consolidated financial statements, IFRS 11 Joint arrangements and IFRS 12 Disclosure
of interests in other entities.
• Completed its reform of fair value measurement requirements, resulting in a new standard,
IFRS 13 Fair value measurement.
• Completed the first phase of the reform of financial instruments accounting by issuing IFRS 9
Financial instruments addressing classification and measurement, introducing additional
disclosure requirements for financial assets and financial liabilities subject to offsetting
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arrangements and is mid-way through completing the phases addressing impairment and
hedge accounting.
• Completed the majority of projects described by its Memorandum of Understanding with
the FASB, and prioritised the completion of the three remaining MoU projects and the joint
Insurance Contracts project to a high standard.
• Significantly enhanced its outreach and stakeholder engagement activities, with particular
reference to the needs of emerging economies (IFRS Foundation 2011, p. 1).
Please note that IFRS 9 was further revised and updated, with the final version of the standard
published in July 2014. According to the IASB, the new standard includes a logical model for
classifying and measuring instruments, a single forward-looking impairment model based on
‘expected losses)’ and a substantially reformed approach to hedge accounting. In doing so,
the IASB seeks to address the concerns of the G20 which revolved around the timeliness of
the recognition of expected credit losses and the complexity of multiple impairment models.
For further information regarding IFRS 9, see: http://www.ifrs.org/current-projects/iasb-projects/

financial-instruments-a-replacement-of-ias-39-financial-instruments-recognitio/Pages/financial-
instruments-replacement-of-ias-39.aspx.
Study guide | 289
The IASB and FASB updated their report to the G20 in early 2013. In the report, they explained
the difficulties in reaching agreement on several aspects of accounting for impairment of financial
instruments and the insurance contracts project (IASB & FASB 2013, p. 1). Example 4.1 is an
extract of an article that was written just after the 2014 meeting of the G20 finance ministers
and central bank governors. It highlights the continuing difficulties in reaching agreement on
accounting standards convergence.
Example 4.1: T
he 2014 meeting of the G20 finance ministers
and central bank governors
• [The meeting] ended without a call for international standard setters to continue ongoing efforts
to converge accounting standards.
• Under Australia’s G20 host presidency, the finance ministers and central bank governors are
expected to meet throughout the year ahead of the G20 leaders’ summit to be held in Brisbane
in November 2014 when Australia finishes its presidency.
• In previous years the statement published after the G20 leaders summits used to include a
paragraph which acknowledged the importance of continuing the work on accounting standards
convergence.
• After the 2013 summit in Saint Petersburg, G20 leaders urged the International Accounting
Standards Board (IASB) and the Financial Accounting Standards Board (FASB) ‘to complete by
the end of 2013 their work on key outstanding projects for achieving a single set of high-quality
accounting standards’.
• A spokesperson of Australia’s Treasury told The Accountant [magazine] that converging accounting
standards for the IASB and FASB remains an important piece of work to undertake.
• ‘However, it will not be included in the G20 communiqué where no material developments have
occurred nor major new issues raised’, the spokesperson said.
• Although not conclusive, the omission on February’s G20 communiqué comes at a time when FASB
has announced to put on hold the convergence of insurance accounting standards with the IASB.
Source: Tornero, M. C. 2014, ‘IFRS convergence loses momentum ahead of G20 summit’,
The Accountant, 24 February, accessed July 2015, http://www.theaccountant-online.com/news/ifrs-
convergence-loses-momentum-at-g20-meeting-4183386. Reproduced with permission from Timetric.
➤➤Question 4.2
(a) What are special purpose entities (SPEs)?
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(b) How could an unconsolidated SPE be used to hide a fall in the value of investments?
(c) How might the application of IFRS 10 Consolidated Financial Statements change how SPEs
are accounted for?
Note: You are not required to have or to apply a detailed knowledge of IFRS 10 in answering
this question.
Liquidity risk
Introduction
Liquidity risk is the risk that an entity will encounter cash flow difficulties in meeting its financial
obligations. It is a risk that all entities face. Disclosure of how an entity manages liquidity risk
inherent in its financial liabilities is required in accordance with IFRS 7 Financial Instruments:
Disclosures.
Liquidity risk in business is discussed in Module 5 and in the Financial Risk Management subject of
the CPA Program.
Liquidity risk is of particular importance to banks and similar financial institutions. The main
functions of a stable banking system are:
• accepting deposits;
• granting loans and advances; and
• acting as an intermediary mechanism between depositors (those with surplus cash)
and borrowers (those with a deficit of cash).
Background information on key banking functions and the history of banking is available in
Reading 4.4, which should be read now.
We now consider two key types of liquidity risk:

1. funding liquidity risk at specific institutions; and
2. systemic shortage of funding and market liquidity risk.
Liquidity risk is often a binary issue: either there is sufficient liquidity available and the financial
institution and/or the financial system functions well, or the financial institution/financial system
suffers a shock, which leads to insufficient liquidity.
1. Funding liquidity risk at specific institutions

As described in Reading 4.4, banks are intermediaries between depositors and borrowers.
Funding liquidity risk is defined broadly as the risk that a bank may not be able to meet its
expected and unexpected current and future cash flow and collateral needs without affecting
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its regular daily operations or its financial performance.
Depositors prefer to have quick and easy access to their funds, such as that provided by
automated teller machines (ATMs), while borrowers tend to prefer to borrow for the longest
time possible. This is referred to as an ‘asset/liability mismatch’, or a ‘maturity mismatch’
(see the CBI Glossary), and gives rise to liquidity risk, which is the risk that banks might not be
able to meet depositors’ demands.
A degree of liquidity risk is inherently present for banks. Managing this risk is central to the
business model of banking.
In ordinary circumstances, most banks can manage liquidity risk. There are a number of methods
used to do this, but the following two are critical:
1. maintaining the trust that depositors have in the banking system in general and in a given
bank, so as to minimise the possibility of a ‘bank run’ (discussed later); and
2. maintaining a sufficient base of available liquid funds to meet the daily obligations of the
bank. This level will vary, and banks estimate the level of reserve funds required based on
their particular circumstances.
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At the same time, banks typically hold only the minimal reserves of liquid assets because of
considerable opportunity costs in the form of lower income.
An orderly banking system is critical to a well-functioning economy. Governments in most

countries regulate, or at least provide strong guidance, to banks on managing liquidity risk.
During the GFC, several national regulators implemented schemes to ensure that the banking
sector continued to work effectively. For example, the Australian government set up two
guarantee schemes during the GFC to promote confidence and assist banks to continue to
access funding:
1. Financial Claims Scheme: This scheme is administered by the Australian Prudential
Regulation Authority (APRA), which initially provided protection for deposits of up to
$1 million per customer. The cap on deposits guarantee was subsequently reduced to
$250 000 in February 2012.
2. Guarantee Scheme for Large Deposits and Wholesale Funding: Under this scheme,
eligible authorised deposit-taking institutions (ADIs) were able to access a guarantee for
both their deposit-holders that held more than $1 million and wholesale funding providers
for a fee. This scheme closed to new liabilities in March 2010.
From a central bank perspective, a funding liquidity shortage affecting a specific institution can
be managed more easily than if the funding shortage is systemic and affects multiple institutions
(as occurred in the global financial markets in 2008).
An example of this is the debt crisis that has engulfed parts of Europe, particularly Greece,
in recent years. Greece became the centre of Europe’s debt crisis after it announced in late 2009
that its national account deficits were far larger than previously reported, which in turn raised
alarms about the country’s finances. Global financial markets reacted quickly, shutting out the
country from further borrowing. The situation was dire, with the country seemingly headed
towards bankruptcy by the spring of 2010. To avert complete disaster, the International Monetary
Fund (IMF), the European Central Bank (ECB) and the European Commission (EC) issued the first
of two international bailouts for Greece, which would eventually total more than EUR 240 billion.
The bailouts came with conditions, widely referred to as ‘austerity measures’, which included
requirements for the Greek government to implement deep budget cuts and steep tax increases.
The measures also sought to overhaul the country’s finances by streamlining the government,
ending tax evasion and making Greece an easier place to do business (New York Times 2015).
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2. Systemic shortage of funding and market liquidity risk
A systemic shortage is the more destructive type of liquidity risk. A systemic shortage of funding
affects multiple banks and is often caused by the loss of market participants’ confidence in the
stability of banks, as occurred during the GFC.
Market liquidity risk is the risk that a bank will not be able to offset or liquidate a position at an
adequate price because of insufficient market depth or market disruption.
A market liquidity shortage, similar to a funding liquidity shortage, is generally caused by a loss
of confidence among market participants. A significant drop in confidence by market participants
leads to a sharp rise in uncertainty about asset values and the financial strength of potential
counterparties. Confidence in the market is necessary to promote a healthy level of activity—
with buyers and sellers establishing clearing prices. Lack of confidence can lead to market
players disengaging from financial markets, resulting in illiquid markets. This occurred following
the collapse of Lehman Brothers in September 2008.
A direct consequence of market illiquidity is that assets that may have been thought to be
easily convertible into cash are not, at least not at the prices expected previously, which creates
liquidity problems for individuals and institutions. This, in turn, heightens the credit risk of market
participants, leading to a further exacerbation of market illiquidity. The impact of this circularity
is illustrated in Figure 4.2.
Figure 4.2: Mutually reinforcing feedback process
Confidence of a large number of market participants
Uncertainty about asset values and financial strength
Market participants attempt to liquidate positions and disengage from the market (‘fire sales’)
Illiquid markets
Liquidity problems for individuals and institutions
Perception of increased counter-party credit risk
Source: CPA Australia 2015.
Global liquidity risk position before the GFC

Banks’ liquidity risk management
Because of their large customer base and their ability to predict how large groups of individuals
will behave, banks are usually able to manage liquidity risk and therefore the mix of funding they
require to maintain liquidity in normal circumstances. This is similar to how an insurance company
models the risk of a loss. Although the likelihood of any one insurance claim eventuating is
difficult to predict, most insurance companies can predict with some degree of accuracy the size
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and types of insurance claims expected to occur in a large population.
Banks rely on the assumption that a large proportion of the deposit base is ‘sticky’, meaning that
the depositors will not withdraw their savings in large quantities at the same time. Banks also
assume that the majority of borrowers will continue to meet their interest and repayment
obligations, after allowing for a small degree of loss.
While the liquidity needs of an individual household or firm may be difficult to foresee, in normal
circumstances some individuals’ and firms’ high demands for liquidity will be offset by others’ low
demands (Kroszner 2008, p. 2).
Banks maintain a buffer of liquid assets that they and the regulators determine is prudent to have
in ordinary circumstances.
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Role of trust in the banking system

An important element that helps the banks manage liquidity risk is the trust depositors have in
the banking system—depositors keep their money in the bank because they believe it will be
safe there.
A ‘run on the bank’ occurs when depositors lose this trust and attempt to withdraw their money,
causing a sudden and unexpected increase in withdrawals from a bank. Banks generally only
hold minimal liquid funds to satisfy ‘ordinary’ demands for cash and may be unable to meet
extraordinary demands for liquidity by depositors quickly enough, which has been shown to
lead to depositors’ increasing panic. In these circumstances, a bank may be forced to seek a
lifeline in the form of a short-term or long-term credit line from another financial institution or
the government. This is a good description of what has occurred in Greece in recent years. In the
context of rapidly declining confidence in the country’s financial system, for some time Greece’s
banks have been under stress from customers seeking to withdraw their funds. In December 2014
alone, more than EUR 2.5 billion was reported to have been withdrawn from banks in Greece and
transferred to overseas institutions. Further, in the lead up to the 30 June 2015 deadline for the
country to make a large repayment on its outstanding loan to the IMF, more than EUR 600 million
was withdrawn from Greek banks in one day, with Reuters reporting that nearly one-third of bank
ATMs ran out of cash on that day (Dyer 2015).
One way to measure a bank’s ability to withstand liquidity shocks is based on ratio analysis,
for example by examining the deposits/loans ratio and deposits/total funding ratio. Consistent
with this, Australian banking regulators are currently considering action to further ensure
the security of Australian banks. In a recent report, the national banking regulator APRA
recommended that Australian banks needed to lift their holdings of cash and similar assets
by 2 percentage points to rank among the safest in the world. In dollar terms, this is likely to
mean the setting aside of somewhere between $15 billion and $20 billion across the sector
(Whalley 2015).
Funding liquidity position of the global banking system pre-2007

The funding liquidity position (i.e. the amount of liquid assets, such as actual cash, a bank has on
hand) and the balance sheet composition of a significant number of global banks, especially in
the United States and Europe, set the scene for the GFC that commenced in 2007 and gathered
momentum in 2008.
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For example, the loan/core deposit ratio of large commercial banks in the United States had
increased significantly since 1992, growing from just under 100 per cent in 1992 to more than
140 per cent in 2000 (Wetmore 2004, p. 103). Across all US commercial banks, the loan/deposit
ratio grew from around only 20 per cent in 1945 to over 100 per cent in 2001 (Wetmore 2004,
p. 99). This indicated that total loans advanced to borrowers exceeded total deposits,
effectively meaning that advances to borrowers were partially financed by other sources,
including foreign loans. At the same time, the loans/assets ratio also grew from around
20 per cent in 1945 to almost 60 per cent in 2001 (Wetmore 2004, p. 99).
A number of factors contributed to this:

• a decline in deposits
–– declining interest rates and strongly performing stock markets encouraged individuals
to move funds from savings accounts to other investments; and
–– consumption boomed in the benign economic environment, leading to a decrease
in the rate of savings
• an increase in lending
–– a growing economy encouraged increasing lending activity by both firms and
individuals; and
–– low interest rates increased the demand for cheap forms of capital.
During the same period, the loan/deposit ratio in the Asian banking system remained below
70 per cent. For example, the loan/deposit ratio of China’s banking institutions was 69.3 per cent
as at 31 December 2007 (SinoCast China Business Daily News 2008). Similarly, the credit-to-
deposit ratio of Indian banks as at 8 May 2009 was 69.6 per cent (Hindu Businessline 2009).
Nature of wholesale funding

A bank accepts deposits and extends loans to borrowers. If lending growth exceeds the
level of client deposits, a bank funds the gap via ‘wholesale money’, which is money received
from third-party sources other than the bank’s clients. Wholesale funds can be sourced from
both domestic and global capital markets, and are generally sourced in large quantities from
financing syndicates or individual funding sources.
Wholesale funding is considered to be ‘nervous money’, which means that it is not as secure as
retail funding. A significant proportion of wholesale funding is short term (e.g. a very common
type of wholesale funding is for a three-month term). Wholesale funding providers are generally
sophisticated market players who react swiftly to changes in the perceived risk of a financial
institution and in pricing (e.g. if the pricing of other market alternatives appears more attractive,
wholesale funders will immediately move their funds towards more attractive market opportunities).
Banks depending heavily on wholesale funding have little discretionary control over rates and
may be positioned for the risk of a serious liquidity shock. The funds market could ‘dry up’ without
warning (Wetmore 2004, p. 99).
A bank could manage the risk of ‘wholesale money flight’ by reducing its reliance on wholesale
funding. One approach could be to narrow the gap between deposits and loans, which could be
achieved by attracting more retail deposits and/or limiting lending.
The impact of having to change how a bank funds it operations was demonstrated by BankWest
prior to its acquisition by the Commonwealth Bank in 2008.
According to Mr McLernon [a director of the litigation funder IMF Australia, who spearheaded a
lawsuit against CBA on behalf of former BankWest clients] the Reserve Bank appeared to have had
BankWest ‘on a drip’ from August to December 2008 as the lender struggled to source funding for
its loan book. Banking statistics lodged with the Australian Prudential Regulatory Authority show
that either the Reserve Bank or Australian financial institutions were providing monthly cash to
BankWest (West 2012).
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Generally, the easiest lever for banks to regulate is the volume of lending because it is more
challenging to attract new deposits without increasing the rate being offered.
As discussed earlier, US commercial banks were at a risk of ‘wholesale money flight’ by virtue of
an excess of loans over deposits.
In February 2012, the funding of major Australian banks was:

• approximately 60 per cent from deposits;
• 20 per cent from money borrowed for less than 12 months from other banks, pension funds
and investors from Australia and overseas; and
• 20 per cent borrowed for a longer period from foreign banks and investors (Australian Bankers’
Association 2012).
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Growth of complex structured products

In addition to sourcing wholesale funding to finance balance sheet expansion, many global banks
engaged in employing various sophisticated portfolio management techniques during 2003–07.
This allowed them to pass on the risk of certain assets to other market participants, most often
other financial institutions. These techniques included:
• credit derivative instruments;
• collateralised loan obligations;
• hedging; and
• various forms of insurance.
Banks traded the complex structured products with each other, and this interbank diversification
allowed banks to further expand balance sheets and take on higher risks.
Example 4.2: The funding crisis at Northern Rock

Northern Rock, a UK bank, aggressively increased its assets by approximately 250 per cent from 2002
to 2007, funded mainly by wholesale market funding. The ratio of wholesale funding to Northern Rock’s
overall funding mix was 77 per cent as at 30 June 2007.
Table 4.1: Northern Rock’s financial position
GBP billion 31.12.2002 30.06.2007 Growth
Customer loans 24.8 96.7 290%
Assets 32.5 113.5 249%
Retail deposits 16 30.1 88%
Equity 1.2 2.3 92%
Deposits/assets (%) 49 27 (44%)
Loans/deposits (%) 155 321 107%
Source: Based on data from Northern Rock Financial Reports December 2002 and June 2007,
accessed July 2015, http://www.n-ram.co.uk/corporate/investor-relations/corporate-reports/2015.
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In August 2007, Northern Rock started to experience decreased access to wholesale funding and had to ask
the Bank of England for a liquidity support facility.
This led depositors to fear that they may not be able to recover their savings should Northern Rock go into
receivership. This loss of trust resulted in the first public run on a bank in the United Kingdom in 150 years
(Ryan 2008, p. 1). On one day alone, depositors withdrew approximately GBP 1 billion, or nearly 5 per cent of
the total deposit base. This occurred despite the government, via the Bank of England, offering a credit line
to the bank. The depositors still formed long queues at the bank’s branches, preferring the sight of real cash.
Eventually, the bank run was brought to a halt by the UK Government guaranteeing the safety of deposits,
and the bank was nationalised in February 2008, after the private sector’s attempts to rescue the bank failed.
Northern Rock was restructured in January 2010 into two separate legal entities: Northern Rock Plc and NRAM
Plc. In 2012 Northern Rock Plc was sold to Virgin Money. NRAM plc remains in public ownership, and its
core business is now mortgage servicing. Following nationalisation, NRAM Plc was closed to new business
(NRAM 2014). This meant it no longer offered new mortgage deals and could not extend existing terms.
It therefore now concentrates only on managing the existing loan book as it runs out.
➤➤Question 4.3
What gives rise to liquidity risk in the banking system?
➤➤Question 4.4
What are the two main ways that a bank can manage liquidity risk?
Evolution of the Global Financial Crisis

The GFC evolved over 2007 and 2008 in phases, which can be summarised as follows:
• the rise of sub-prime loan losses;
• the worsening of the banking crisis; and
• the impact on the global economy.
Rising sub-prime losses

From 1980 onwards, global long-term interest rates progressively declined. This decline was
accompanied by falling savings rates in the developed world. According to Desroches and
Francis (2007), world real interest rates declined from approximately 8 per cent in 1981 to less
than 2 per cent in 2005. At the same time, savings as a proportion of GDP declined from over
24 per cent in 1981 to 21 per cent in 2005. Investment as a proportion of GDP also declined
from 24 per cent in 1981 to 21 per cent in 2005.
The abnormally low interest rates created a vast pool of depositors seeking higher returns
in riskier investments. In addition, investors borrowed funds to increase the amount of their
investments, which fuelled consumption and GDP growth, particularly between 1999 and 2007.
Investors, in search of extraordinary returns, turned to increasingly complex higher-yielding

products. Situations where banks originated mortgages and then sold them on, thereby passing
on credit risk to investors through mortgage-backed securities, grew significantly (see Figure 4.3).
Mortgage originators maximised the quantity of loans they sold at the expense of quality.
Figure 4.3: European and US structured finance issuance (USD billion)

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3000
2500
2000
USD ($bn)
1500 CDOs
ABS
1000
MBS
500
0
2000 2001 2002 2003 2004 2005 2006 2007
Year
(Note: CDOs = collateralised debt obligations; ABS = asset-backed securities, including auto and credit
card, but excluding MBS; and MBS = mortgage-backed securities, excluding US agency MBS.)
Source: International Monetary Fund 2008, Global Financial Stability Report:

Containing Systemic Risks and Restoring Financial Soundness, IMF, Washington, DC, April, p. 56,
accessed July 2015, https://www.imf.org/external/pubs/ft/gfsr/2008/01/index.htm.
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Lending standards in the US sub-prime mortgage market (loans to borrowers with a relatively low
credit rating) progressively deteriorated, particularly in 2006 and early 2007, as banks and mortgage
originators chased volume to satisfy strong demand for structured products. After originating
sub-prime mortgages in the United States, banks increasingly sought to distribute them into the
financial system using more and more complex forms. Figure 4.4 demonstrates how sub-prime
loans led to multiple structured credit products being originated in the financial system.
Figure 4.4: Origination of structured finance products

Original lender: knows who the
borrower is, can perform direct
due diligence, can assess
the risk
Sub-prime mortgage loans
Sub-prime mortgage bonds
High-grade structured finance CDOs Mezzanine structured-finance CDOs
CDO–squared
Ultimate holder of securities: removed from

the borrower, can do some due diligence
but is at least partially reliant on others’
assessment of the risk
(Note: A structured finance CDO is a collateralised debt obligation, the value of which is derived from the
portfolio of underlying fixed-income assets, such as mortgage-backed securities. The intent of high-grade
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CDOs is to have claim to the top ‘AAA’-rated portions of the underlying assets, while mezzanine CDOs are
comprised of the riskier parts of underlying bonds structured to take the first losses, if any. CDO-squared is
backed by income tranches issued by other CDOs.)
As a greater number of increasingly complex products were created, the quality of investors’
understanding of the underlying risk deteriorated, with the real risk of the product becoming
apparent only as the credit crisis unfolded. Figures 4.5 and 4.6 show how structured products
suffered more severe, multiple-notch credit downgrades relative to those experienced
by corporations.
Many market participants accepted the published credit ratings of complex structured products
on face value, implicitly trusting in the assessments made by third-party providers (i.e. credit
rating agencies). As the GFC unfolded, this trust rapidly evaporated. It was later identified in
many cases that the assumed ‘independent’ third-party providers had been paid for the rating
by the issuers of the products.
Figure 4.5: D
owngrades from original issue rating (in per cent) for sub-prime
Residential Mortgage-Backed Securities (RMBS) for 2007–08
BB
BBB
Rating
1 category
A
2 categories
AA 3 categories +
AAA
0 20 40 60 80 100
Percentage
Source: International Monetary Fund 2008, Global Financial Stability Report: Containing Systemic Risks
and Restoring Financial Soundness, IMF, Washington, DC, April, p. 61, accessed July 2014,
https://www.imf.org/external/pubs/ft/gfsr/2008/01/index.htm.
Figure 4.6: Downgrades in rating from 2000 to 2008 (in per cent) for corporations
BB
BBB
Rating
1 category
A
2 categories
AA 3 categories +
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AAA
0 20 40 60 80 100
Percentage
Source: International Monetary Fund 2008, Global Financial Stability Report: Containing Systemic Risks
and Restoring Financial Soundness, IMF, Washington, DC, April, p. 61, accessed July 2015,
https://www.imf.org/external/pubs/ft/gfsr/2008/01/index.htm.
At the end of 2006, introductory ‘teaser’ (low) interest rates ended on a large numbers of
mortgages, making it increasingly hard for borrowers to meet repayments. At the same time,
US house prices began to fall sharply. A large number of sub-prime borrowers had little or no net
equity in the houses they owned, and chose to walk away from the property and relinquish it to
the lender rather than continue to make monthly repayments on the loan. Most of the sub-prime
mortgages in the United States were non-recourse, which meant that generally borrowers who
gave their homes back to the lender would have ended their financial obligations on the mortgage.
A large number of borrowers chose to do this.
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Mortgage delinquency rates in the United States exceeded 20 per cent for sub-prime adjustable-
rate borrowers and 15 per cent for sub-prime fixed-rate borrowers in 2008 (de Michelis 2009,
p. 15). The increase in default rates on US sub-prime mortgages undermined confidence in
structured credit products generally, causing sharp falls in financial asset prices and severe
funding difficulties for many financial institutions.
Worsening of the banking crisis

Arrears on US sub-prime mortgages had been rising gradually for some time, but in July 2007
this provoked a sharp increase in credit spreads on US sub-prime securities. The size of the
residential mortgage-backed security (RMBS) market at the end of 2006 was USD 6.5 trillion,
representing a relatively small portion (4%) in relation to the total assets in the global securities
market, at USD 150 trillion (Bank of England 2009, p. 20). Nonetheless, information problems
amplified uncertainties about the nature and extent of potential losses. These uncertainties
spilled over with unexpected speed and force across global markets, affecting the global
banking system.
Bankruptcies, mergers and government-led bailouts of financial institutions in many countries

followed, with the key ones shown in Table 4.2.
Table 4.2: Key events in the GFC from September 2008 to January 2009
Date Financial institutions affected Events
15.09.2008 Lehman Brothers Bankruptcy
15.09.2008 Merrill Lynch/Bank of America Merger
17.09.2008 Lloyds TSB/HBOS plc Merger
17.09.2008 AIG US Government bailout
25.09.2008 JP Morgan/WaMu Merger
29.09.2008 Bradford & Bingley Nationalisation and partial sale to Santander
30.09.2008 Dexia Capital injection
3.10.2008 Wachovia/Wells Fargo Merger
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6.10.2008 Fortis/BNP Paribas Merger
8.10.2008 Icelandic banking Nationalisation begins
8.10.2008 UK banking UK Government bailout
13.10.2008 RBS, Lloyds TSB and HBOS Receipt of government equity and preference shares
14.10.2008 US banking US Government injects USD 125 billion in nine banks
16.10.2008 UBS Swiss National Bank guarantees USD 60 billion of assets
20.10.2008 ING Dutch Government sponsors €10 billion recapitalisation
9.01.2009 Commerzbank German Government’s Financial Markets Stabilisation

Fund (Soffin) injects €10 billion
19.01.2009 UK banking UK Government launches asset protection scheme
Source: Adapted from various news sources.

In aggregate, the top 50 global banks lost a combined USD 2.4 trillion of market capitalisation
between July 2007 and February 2009, equivalent to about 60 per cent of their market
capitalisation in July 2007.
As the liquidity and solvency problems in the global banking sector became widespread,
the banks’ trust in one another was severely compromised, resulting in a dramatic escalation in
borrowing costs between banks, as shown by movement in credit default swap (CDS) premiums.
A credit derivative is a contingent claim that allows the trading of default risk separately from
other sources of uncertainty; it represents an insurance contract against the default of the
underlying entity. A CDS is the most standard form of this contract available in the financial
markets. For a bank, a CDS premium reflects the cost that it is charged to borrow funds from
another bank.
The significant rise in these costs meant that in a number of instances it became impractical for
banks to borrow funds from each other, and the banking system, which was heavily reliant on the
availability of wholesale funding as described earlier, came close to a collapse.
The governments of the United Kingdom, the United States, Iceland and a number of other
countries had to guarantee the safety of assets of a number of banks to ensure that the banking
system would continue to function. The banks that heavily relied on wholesale funding being
available almost stopped functioning.
Australian banking system

The Australian banks were much better positioned than the majority of their overseas peers,
and the Australian government did not have to bail out any of the Australian banks during
the GFC. Although the Australian banks had a relatively high proportion of wholesale funding
(50%) to total funding, they held limited complex financial instruments on their balance sheets,
had limited exposure to the sub-prime market and had followed more conservative lending
standards than their US and European peers.
However, a number of measures have been taken by the Australian government to strengthen
and maintain liquidity in the financial system:
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• In October 2007, the Reserve Bank of Australia (RBA) widened the range of securities it was
willing to trade under repurchase agreements (REPOs) to include AAA-rated mortgage-backed
prime securities and AUD-denominated asset-backed commercial paper; it also extended the
term of these agreements. By entering into a REPO, the RBA purchases a security and at the
same time agrees to sell it back to the seller on an agreed future date for an agreed price.
The difference between the purchase and resale price reflects the cost of funding being
provided by the RBA.
• In September 2008, the RBA also provided direct liquidity support to the banking sector.
Two of the measures were:
1. a USD 10 billion swap facility with the US Federal Reserve, to allow Australian banks to
access short-term USD funds; and
2. a short-term deposit facility, the RBA Term Deposits (RBATD), to ADIs. Institutions bid
for these deposits under an auction system.
• In October 2008, the Australian government established a Guarantee Scheme for

Large Deposits and Wholesale Funding, guaranteeing all deposits in banks, building
societies, credit unions, Australian subsidiaries of foreign banks and foreign funds loaned
to Australian banks for three years from October 2008. In March 2010, the wholesale
guarantee scheme was closed to new issuance.
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• In October 2008 and again in November 2009, the Australian Office of Financial Management
(AOFM) was directed to invest a total of AUD 16 billion into the RMBS market, to support
competition by a diverse range of lenders in the mortgage market. The Australian government
recognised that the RMBS market provided an important source of funding for smaller lenders
to compete with major banks; it also acknowledged that liquidity in the RMBS market has
markedly decreased since mid-2007, constraining the ability of lenders to access funding
from this source.
Impact on the global economy

The severe crisis of confidence in the financial system translated to the global economy.
Banks began to sell off assets and scale down lending by limiting new debt and/or not rolling
over existing debt. This was driven by:
• preservation of capital ratios—many banks faced substantial losses on the value of assets that
they were holding; these losses were recognised in the equity, and consequently the capital
ratios of banks declined;
• significantly increased conservatism in extending credit; and
• dramatically increased cost and availability of wholesale funding.
Banks focused on their own survival in the core markets and preservation of scarce capital.
As a result, a number of businesses that relied on debt funding found themselves in extremely
challenging situations.
Households reduced their consumption and organisations cut production and investment
as confidence decreased, and the reduced access to credit for corporations and individuals
exacerbated the downturn in output and employment. This further increased banks’ losses and
created a negative feedback loop (in Figure 4.7 below).
Figure 4.7: Negative feedback loop between banks’ lending and economic growth
Banks record substantial

losses on balance sheets Corporations and individuals
and scale down lending have reduced access to credit
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Rising unemployment Growth and
and business failures consumption
is impaired
Activity in the global economy fell sharply. Depressed confidence among both corporations
and households and the fall in asset prices (equities, houses, businesses) negatively affected
each other, which resulted in a global recession. Figure 4.8 shows the dramatic slowdown in
global economic activity over 2007–09 and the slow and unsteady recovery post-2009.
Figure 4.8: Annual GDP growth (actual 2005–12 and projections for 2013–14)
10
7.5
2.5
–2.5
–5
2006 2007 2008 2009 2010 2011 2012 2013 2014
East Asia & Pacific (all income levels) Europe & Central Asia (developing only)
European Union North America
OECD members South Asia
Source: Based on data from: World DataBank, accessed July 2015, http://databank.worldbank.org/data/.
➤➤Question 4.5
What were the key causes of the 2008 liquidity crisis?
Liquidity management post-GFC

Current funding levels in the global financial system
Since the GFC, global banks have focused on increasing liquid assets, searched for stable,
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longer-term funding and bolstered up their capital positions.
Competition for retail deposits has intensified, as the stability of liquidity positions has become
an even higher priority for the banking sector as a whole. Figure 4.9 below illustrates how banks
have attempted to manage their liquidity. Evident from the Figure is that Australian banks have
strengthened their capital ratio in recent years (Reserve Bank of Australia 2015a).
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Figure 4.9: Large banks’ Tier 1 capital
Banks’ Capital Ratios†

Consolidated global operations
% %
Total
12 12
8 8
Tier1 Common Equity Tier 1
4 4
Tier2
0 0
1989 1994 1999 2004 2009 2014
†
Per cent of risk-weighted assets; break in March 2008 due to the introduction of Basel II
for most ADIs; break in March 2013 due to introduction of Basel III for all ADIs
Sources: APRA; Reserve Bank of Australia 2015a,

Financial Stability Review, p. 23, RBA, Sydney, March, accessed July 2015,
http://www.rba.gov.au/publications/fsr/2015/mar/pdf/0315.pdf.
However, the spreads in the eurozone have been volatile, reflecting the uncertainty surrounding
the eurozone sovereign debt crisis, which is discussed in the next section. Increased market
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perception of sovereign risk in a number of European countries (e.g. Greece, Italy, Portugal,
Spain and Ireland) has made it extremely difficult for banks in these countries to access funding
markets, and as a result, they have increasingly used the European Central Bank’s liquidity
facilities. In particular, in 2011, funding conditions again deteriorated across Europe, with some
improvement since, as evidenced by the decline in spreads from late 2011 to mid-2014.
Eurozone sovereign debt crisis

Conditions leading to the eurozone sovereign debt crisis
The eurozone is defined as the economic and monetary union of 19 European countries that have
adopted the euro as their common currency and sole legal tender.
In the decade prior to 2009, a number of eurozone members, including Greece, built significant
levels of borrowings fuelled by expansionary fiscal policies and relatively cheap sources of debt.
In theory, European Union (EU) membership required members to maintain their budget deficits
and debt levels within certain agreed limits. However, due to the absence of enforcement,
the policy aimed at containing sovereign debt levels proved to be ineffective.
The levels of government debt in the eurozone increased further during the financial crisis of 2008–
09, due to decreased tax revenues, fiscal policies applied to stimulate growth and bank bailouts.
Greece became the focal point of the crisis as its economy was one in which the absolute level of
government debt, government debt as a percentage of GDP, current account deficit and budget
deficit reached unsustainably high levels. It therefore required significant assistance in 2010–12
from the EU and the IMF to prevent defaulting on its debt obligations.
Further background information on the economic situation in Europe leading to the eurozone
sovereign debt crisis is available in Reading 4.5, which should be read now.
Crisis trigger
When the Greek government announced a revision of its budget deficit in November
2009, from 6 per cent to 12.7 per cent of GDP, the three major global credit rating agencies
responded soon after by downgrading Greece’s credit rating. By January 2010, Greece’s credit
rating was A2 with Moody’s and two notches lower, at BBB+, with Fitch and Standard & Poor’s
(Eurozone Weekly 2010, p. 2). All three rating agencies placed a negative outlook on the ratings;
this meant that although Greece’s sovereign debt was still rated as ‘investment grade’ by
the credit agencies (assessed as having strong or adequate capacity to meet its obligations),
there was a distinct possibility it could be further downgraded towards the ‘junk’ status (assessed
as vulnerable to favourable financial conditions to meet its obligations). In fact, by July 2011,
Greece had decreased to ‘junk’ status with all three major credit agencies rating them as follows:
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1. Ca by Moody’s (Jackson 2011a, p. 1);

2. CC by Standard & Poor’s (Salih 2011, p. 1); and
3. CCC by Fitch (Jackson 2011b, p. 1).
Background information on the system of credit ratings used by the three major global credit
agencies is contained in the following link: https://www.spratings.com/en_US/Understanding-
Ratings-2.html.
Please note that this background information on the credit ratings system is provided for additional
information and is not examinable.
Study guide | 305
Evolution of the crisis

As Greece revised its budget deficit estimate, and credit agencies responded with downgrades,
allegations surfaced that Greece had attempted to obscure the true levels of its indebtedness
with complex financial instruments. As a result of these developments, investor confidence in
Greece’s finances plunged, as evidenced by the increase in the spreads on 10-year Greek bonds
relative to 10-year German bonds (see Figure 4.10)—a measure of the perceived risk that Greece
may default on its debt repayments.
Figure 4.10: S
econdary market yields for Greek and German government bonds
with a maturity of close to 10 years
35
30
25
20
Greece
15
Germany
10
0
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Source: Based on data available at European Central Bank 2015, ‘Long term interest rates for EU
member states’, accessed July 2015, http://www.ecb.europa.eu/stats/money/long/html/index.en.html.
In 2010, Greece needed to raise new debt and refinance some of its existing debt. Greece needed
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to refinance about EUR 25 billion of existing debt in April–May 2010. Additionally, it needed
to borrow approximately EUR 55 billion of new debt to finance its increased budget deficit.
By January 2010, no fundraising program had been announced by Greece; instead it resorted
to issuing short-term debt, perceived as less risky than longer-term debt (The Economist 2010a,
p. 51). This provided Greece with some breathing space but no long-term solution to its looming
funding requirements. The perceived risk of Greece defaulting on its debt significantly increased in
early 2010 and again exacerbated Greece’s borrowing costs.
Investor nervousness spread to the prices of bonds of other European governments with high
debt, such as Spain, Ireland and Portugal, which investors feared may also face difficulties
in meeting their debt obligations. This nervousness translated to increased bond yields
(see Figure 4.11).
A number of research papers analysing the eurozone sovereign debt crisis have concluded that
there is evidence of contagion affecting several countries in Europe following the sovereign debt
crisis in Greece (Missio & Watzka 2011, p. 3). Contagion is defined as some or all of the following
effects that a country may experience as a result of a financial crisis in another country:
• increase in the perceived likelihood of a financial crisis
• correlated increase in asset-price volatility
• correlations in asset-price movements not driven by fundamentals, but rather by perception
of risk and changes in risk.
Missio and Watzka (2011) found that Portugal, Spain, Italy and Belgium have been particularly
affected by the contagious effects of the Greek sovereign debt crisis, as evidenced by
movements in bond yields (Missio & Watzka 2011, p. 24).
Figure 4.11: S
econdary market yields for government bonds with a maturity
of close to 10 years
30
25
20 Belgium
Germany
15
Spain
Greece
10
Portugal
Italy
5
0
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
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Source: Based on data available at European Central Bank 2015, ‘Long-term interest rates for EU
member states’, accessed July 2015, http://www.ecb.europa.eu/stats/money/long/html/index.en.html.
The private European banking system was also threatened by the unfolding sovereign debt crisis.
The European banking system is highly integrated. At the end of June 2011, total claims of
European banks on borrowers in other European countries stood at EUR 9 trillion. The exposure
was concentrated in countries with larger banking systems—the total exposure of banks in
Germany, the UK and France to other European countries was EUR 5 trillion (Yulek & Randazzo
2012, p. 74). Due to this high level of exposure, increased risk of default of several European
countries threatened to destabilise the European banking system.
Further, significant losses in the private banking system due to a sovereign debt crisis potentially
threatened the tentative economic recovery in Europe.
Study guide | 307
➤➤Question 4.6
What were the causes of the eurozone sovereign debt crisis?
➤➤Question 4.7
Why did the revision of the Greek budget deficit trigger the sovereign debt crisis?
➤➤Question 4.8
What is ‘contagion’ in the context of the eurozone sovereign debt crisis?
Policy responses
As debt maturity loomed near, the costs of borrowing spiralled and the willingness of lenders to
provide funds to Greece decreased. This resulted in Greece facing a choice between declaring
bankruptcy and asking its EU partners for significant assistance.
The EU, the European Central Bank (ECB) and the IMF agreed in early 2010 that Greece
defaulting on its debt would have significant negative ramifications on the European economy.
The immediate impact would be two-fold:
1. investor confidence in other government debts would plunge, increasing those governments’
borrowing costs, thereby increasing their likelihood of default and creating a vicious circle; and
2. European banks exposed to Greek debt would face significant losses.
The EU leaders, the ECB and the IMF have responded to the crisis with a number of measures
over the past three years. Each measure taken by the EU, the ECB and the IMF took months
to negotiate, as there was significant opposition to assistance packages, due to the following
concerns:
• the frustration of EU members with stronger economies, such as Germany, having to provide
financial assistance to other EU members, which according to the stronger economies,
faced financial pressures due to financial mismanagement;
• setting a precedent for bailouts of members in financial distress;
• a dilemma between wishing to prevent a disorderly default of EU members experiencing
financial pressures and creating a ‘moral hazard’ (i.e. creating an effective incentive for a country
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to run a budget deficit on the expectation that other EU members will provide support); and
• IMF’s limited funds, which are normally deployed in assisting developing countries, being
deployed to assist developed countries. Also, the size of each recommended assistance
package was quite large.
The policy measures the EU, the ECB and the IMF implemented in recent years, detailed in
Table 4.3, have focused on:
• preventing a disorderly debt default of several EU members, most notably Greece but also
Ireland and Portugal, and creating a framework that allows these countries to manage their
debt levels down to sustainable levels;
• preventing the spread of the crisis from affecting other EU members’ cost and availability of
funding; and
• broader policy measures aimed at preventing a similar crisis recurring in the future.
The measures have so far achieved the first aim of avoiding a disorderly default by Greece and
other EU members, but have arguably not contained the crisis. However, the measures taken
have probably reduced the severity of the crisis, even though the extent of the crisis is difficult
to measure.
Table 4.3: Key policy measures to resolve the eurozone sovereign debt crisis
Date Policy measure
May 2010 The EU and the IMF provided a credit line of €110 billion to Greece to be available for
the following three years. The EU provided €80 billion and the IMF provided €30 billion
to allow Greece to refinance its near-term maturing debt without having to access
external finance markets.
May 2010 The EU and the IMF set up a €750 billion package for financial assistance to eurozone
members under financial pressure. The package included a temporary three-year loan
facility, the European Financial Stability Facility (EFSF) of €440 billion, IMF contribution
of €250 billion and a €60 billion loan facility by the European Financial Stability
Mechanism (EFSM).
May 2010 The ECB purchased €78 billion of European government bonds between May 2010
and June 2011. Market analysts have estimated that approximately €45 billion of the
purchases related to Greek government bonds.
November 2010 The IMF, the EU and Ireland agreed on a €85 billion package.
March 2011 The EU approved the European Stability Mechanism (ESM), a permanent lending
facility of €500 billion to be set up from 2013 with double the effective capacity of the
EFSF. The ESM is to have regular revision every two years.
May 2011 The EU and the IMF provided a €78 billion, three-year package.
July 2011 The EU provided a second assistance package of €109 billion to Greece. This package
included loans with lower interest rates and longer maturities than the first assistance
package. It also extended maturities of the loans already provided to Greece under
the May 2010 assistance package.
July 2011 The EFSF began to proactively assist countries in the eurozone before they suffer from
financial pressure, by recapitalising banks and buying eurozone government bonds in
the secondary market.
August 2011 The ECB provided emergency loan measures by extending short-term loan maturities
to up to 13 months.
October 2011 A three-pronged agreement was established by the EU members. The first part was to
increase the EFSF to €1 trillion.
January 2012 A fiscal treaty was signed by 25 of the 27 EU members.

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June 2012 The EU members agreed to set up a €500 billion fund to:
• allow banks to receive funding directly rather than via their national governments,
thereby reducing the burden on government debt levels and increasing the speed
with which the assistance would be received; and
• buy European government bonds to decrease yields.
July 2012 The Eurogroup granted financial assistance of up to €100 billion to Spain’s banking
sector, to:
• recapitalise the Spanish banking sector; and
• restore market confidence in Spain.
This marked the first instance of financial assistance provided by the ESM, the euro
area’s permanent rescue fund set up in March 2011.
July 2012 Mario Draghi, the president of the ECB, gave a speech in which he said that the ECB
would do ‘whatever it takes’ to save the euro. This increased market confidence,
and borrowing costs in Spain and Italy in particular declined.
September 2012 The ECB announced an Outright Monetary Transactions scheme (OMT), whereby it
would buy up the bonds of distressed eurozone counties such as Spain and Italy in
unlimited quantities.
Study guide | 309
Date Policy measure
September 2012 A proposal is made for the ECB to have power over all eurozone banks, including
the ability to withdraw banking licences. Under the proposal, the ECB would assume
the sole central banking authority across the EU in 2014. The proposal, if enacted,
would move towards an effective eurozone banking union.
February 2013 The European Commission agreed to cut its budget for 2014–20 by 3.3 per cent,
the first spending cut in 56 years.
March 2013 Cyprus reached a bailout agreement with international creditors. In return for a
€13 billion bailout from the EU, Cyprus agreed to drastically reduce its banking
sector (including closing the Laiki Bank), cut its budget, implement economic and
banking reforms and privatise state assets.
May 2013 New legislation came into force with two key objectives:
1. to improve budgetary coordination by introducing a common budgetary timeline
for the eurozone member states and the possibility for the European Commission
to assess national budgetary plans before their adoption; and
2. to improve economic and financial surveillance in the eurozone through a
system whereby a member state experiencing serious financial difficulties
or financial sector instability will be subject to enhanced surveillance by the
European Commission.
December 2013 Ireland exited its IMF/EU funding package on 15 December.
May 2014 The IMF completed its fifth review of Greece’s performance under an economic
program supported by an Extended Fund Facility (EFF) arrangement. This resulted
in the disbursement of €3.41 billion, bringing total disbursements under the
arrangement to around €11.58 billion (USD 15.75 billion).
June 2014 The ECB announced that it had decreased the three main interest rates under its control:
1. the interest rate on the main refinancing operations of the Eurosystem;
2. the interest rate on the marginal lending facility; and
3. the interest rate on the deposit facility.
July 2014 The ECB released results of the July 2014 euro area bank lending survey and report.
The results indicate the following:
• credit standards on loans to enterprises were eased by banks in net terms for the
first time since the second quarter of 2007;
• banks reported a narrowing of their margins on riskier loans to enterprises for
the first time since the start of the survey; and
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• loan demand was positive for all loan categories and recovered further.
April 2015 The ECB released a report that indicated:

• financial integration in the euro area had improved steadily and had reached a
level close to that before the sovereign debt crisis; and
• the establishment of banking union and unconventional monetary policy actions
taken by the ECB were major drivers of the improvement.
June 2015 The ECB announced that pursuant to the decision taken on the Greek referendum
and the non-prolongation of the EU adjustment program, it would continue to work
closely with the Bank of Greece to maintain financial stability and emergency liquidity
assistance (ELA) at existing levels. The ECB would also continue to closely monitor the
situation and its potential implications for future monetary policy.
Sources: Various news sources, including: Kokkoris & Olivares-Caminal et al. 2010, p. 257;
Nelson & Belkin et al. 2011, p. 7; The Economist 2010b; The Economist 2010c; The Economist 2011a;
The Economist 2011b; The Economist 2012; Euroweek 2012; Reuters 2012; Bradley 2013;
Eurozone Portal 2014; Euractive 2013, European Central Bank website:
https://www.ecb.europa.eu/press/pr/date/2014/html/index.en.html;
International Monetary Fund website: http://www.imf.org/external/index.htm.
There has been some criticism in the media regarding how the EU has handled the eurozone
sovereign debt crisis. How could it have been handled better?
Current status and possible outcomes

At the time of writing, the eurozone sovereign debt and liquidity crisis is ongoing. In the EU area,
some economies are growing very slowly, while others remain in recession, with the GDP growth
in the EU area overall being close to nil.
On 5 July 2015, a large majority of Greek citizens (voting in a referendum) rejected a financial
bailout package that had been proposed to allow the country more time to repay its debts to
the EU, ECB and IMF. This sparked fears that the country may be forced to exit the EU. At the
same time, some believe that if Greece were to leave the EU, it would not be such a catastrophe.
Europe has implemented safeguards to keep the problems from spreading to other countries.
Because Greece is a small part of the eurozone economy, those who hold this view would argue
that the country may regain financial autonomy by leaving, and the eurozone would actually be
better off without a country that seems to constantly need its neighbours’ support (New York
Times 2015).
Despite this, there is little doubt that Greece exiting from the EU would lead to severe financial
instability in the European and global economy in the short term. European policy makers have
acted on the principle that the costs of a disorderly exit would be so high that it is to be avoided
at all costs.
Europe is expected to experience a slow economic recovery as the economy responds to

reforms and investor risk appetite increases to levels that will support growth, even though the
signs of recovery to date have been patchy. The economic recovery so far has been very slow
and unsteady, with a ‘double-dip’ recession experienced in a number of countries in 2011–12,
following the GFC-led recession in 2008–09.
In June 2014, the ECB announced that it had lowered the three main interest rates on which
it can act:
1. the marginal lending facility for overnight lending to banks (lowered by 10 basis points
to 0.15%);
2. the main refinancing operations (lowered by 35 basis points to 0.40%; and
3. the deposit rate (lowered by 10 basis points to –0.10% (ECB 2014).
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The main refinancing rate is the rate at which banks can regularly borrow from the ECB,
whereas the deposit rate is the rate banks receive for funds deposited at the central bank.
The negative deposit rate (–0.10%) implemented by the ECB is intended to encourage banks to
lend funds and is part of a combination of measures designed to ensure price stability over the
medium term.
The EU has also embarked on a number of transformative policy initiatives to address some key
flaws that have become apparent in the current structure. The two key flaws are the absence of a
fiscal union and the absence of a banking union.
Regarding the banking union, the EU has made progress towards having a common banking
supervision structure, with the ECB preparing to take on its new banking supervision tasks as part
of a single supervisor mechanism (SSM). The SSM will create a new system of financial supervision
comprising the ECB and the national competent authorities of participating EU countries.
The participating countries include euro currency countries and other members of the EU that
have decided to enter into close cooperation with the SSM. The ECB assumed its new banking
supervision responsibilities in November 2014, which involve the direct supervision of about
130 significant banks and supervisory oversight of all remaining banks in the EU (ECB 2014).
Study guide | 311
The other transformation policy function required to fix the flaws in the current structure of the EU
is a fiscal union. However, this would require a significant shift of sovereignty from the individual
European states to the EU level, which appears unlikely in the near term.
At the time of writing (July 2015), the following websites maintained up-to-date timelines of the
key events of the eurozone sovereign debt crisis. Please refer to these to be informed on the crisis
developments post-July 2015:
http://www.britannica.com/topic/euro-zone-debt-crisis
http://www.greekcrisis.net/
http://www.huffingtonpost.com/news/greece-financial-crisis/
Please note that these links are not examinable.
Basel III reforms

A perceived key problem area in international accounting standard convergence is the different
approaches to the netting or offsetting of derivative contracts and other financial assets and
financial liabilities (FSB 2012, p. 21). With the United States and the IASB standards creating
differences along national lines, the varying approaches result in significant differences in total
assets and liabilities in the balance sheets of large financial institutions. The different accounting
methods appear to hinder the ability of investors and other interested parties to compare banks
internationally. However, the apparent differences between the two sets of accounting standards
may not be as problematic as they seem:
The FSB [Financial Stability Board] noted that differences in the offsetting/netting accounting
standards would adversely affect the efforts to develop an internationally comparable leverage ratio
for capital purposes.
However, from a bank supervisory perspective, there may be more convergence for the Basel III
leverage ratio purpose than is first apparent. While the IASB and FASB have decided to maintain their
different accounting rules for netting/offsetting, the FASB netting approach and the netting approach
that will be carried forward to the Basel III leverage ratio are similar in their effect because both
recognise netting/offsetting for derivatives based on legally enforceable master netting agreements
without requiring the intent or ability to net in the normal course of business (FSB 2012, p. 21).
As noted in this extract from the FSB’s report on progress on accounting standard convergence,
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the accounting standards are important factors in the process of monitoring bank stability.
Bank stability is measured in various ways, including the ratio of loans made to deposits held.
The banking reform known as ‘Basel III’ is part of the regulatory response to the GFC and
has significant implications for banks, their customers and accountants advising large
and small businesses.
The FSB recommendations for action in response to the GFC were endorsed by the G7 and
G20, and were translated by the Basel Committee on Banking Supervision (BCBS) into ‘Basel
III: International framework for liquidity risk measurement, standards and monitoring’, issued in
December 2010 by the Bank for International Settlements (BIS). Basel III has a phase-in period
from January 2013 to January 2018 (BIS 2010).
The previous set of banking regulations, known as Basel II, have been criticised for contributing
to the GFC. In an extensive review of the causes of the GFC, Blundell-Wignall & Atkinson et
al. (2008) demonstrated that the Basel II regulations encouraged banks to change from their
traditional credit culture to an equity culture. The new culture included a focus on making banks
into growth stocks, with faster share price growth and ever-expanding earnings (Blundell-Wignall
& Atkinson et al. 2008, p. 5).
Basel II was published in 2004, and under it the capital weight given to mortgages fell from 50
per cent to 35 per cent (i.e. moved from higher risk to lower risk) and even as low as 15 per cent
under certain circumstances. This rule change increased the return on capital on mortgages for
the banks. Essentially, the rules gave incentives to push mortgages off-balance sheet through
securitisation (Blundell-Wignall & Atkinson et al. 2008, p. 6). The complex financial instruments
that banks used allowed them to obscure the risks, thus contributing to the GFC. The Basel II
reforms encouraged banks to change from being credit-based organisations to being equity-
based organisations that focus on share prices and profits. A credit-based organisation focuses
on mortgage lending.
The Basel III accords seek to address the weaknesses outlined in the financial system. Basel III
aims to introduce a number of measures that address both liquidity risk and strengthening the
capital structure of banks.
The measures that specifically seek to address the liquidity risk are:
• the liquidity coverage ratio (LCR), which requires banks to have sufficient high-quality liquid
assets to fund projected cash flows in a hypothetical 30-day system-wide liquidity shock; and
• the net stable funding ratio (NSFR) requirement, which aims to match the duration of banks’
liabilities and assets more closely by comparing liabilities considered stable (e.g. deposits
and long-term debt) with longer-term assets (e.g. loans).
These changes were introduced effective 1 January 2015, after an observation period that started
in 2011. An observation period was required because of the recognition that the new standards
may not be immediately workable in a number of countries, including Australia. For example,
the Australian market has very low levels of government debt and other non-bank securities,
which are classified as high-quality liquid assets under the Basel III regime. This would make it
difficult for Australian banks to have sufficient liquid assets to meet the proposed NSFR ratio.
Figure 4.12 demonstrates the varying depths of the government debt market around the world.
Figure 4.12: Government gross financial liabilities 2012–2015 by percentage of GDP
250.0
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200.0
150.0
2012
100.0
2013
50.0 2014
2015
0.0
es
)
lia
da
ce
ly
es
an
pa
an
Ita
do
at
tra
an
na
tri
m
Ja
al
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ng
Fr
un
s
Ca
er
Ze
Au
d
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co
G
ite
ew
5
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ite
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ar
ro
Eu
Source: Based on data available at OECD 2015, ‘Statistics’, accessed July 2015,
http://www.oecd-ilibrary.org/economics/government-debt_gov-debt-table-en.
Study guide | 313
Recognising the limited availability of government securities and a short supply of other eligible
liquid assets, the Reserve Bank of Australia (RBA) and APRA jointly stated that Australian banks
would be able to borrow directly from the RBA if they had insufficient liquidity to survive a major
economic shock (Barry 2010). Since 1 January 2015 banks have been able to access a committed
liquidity facility (CLF) created by the RBA and APRA. However, this service does not come free
of charge. Prior to accessing this facility, banks must demonstrate to APRA that they have taken
all reasonable steps towards meeting the required LCR through their own balance sheet
management. Banks also need to offer collateral and pay a fee to the RBA.
The proposed CLF generated some controversy in Australia in early 2013, due to the perception
that the RBA and APRA were effectively creating a ‘backstop’ facility and increasing the risk of
‘moral hazards’ in the Australian financial system (Joye 2013). A ‘moral hazard’ can arise in the
context of subsidised risk taking, whereby if a financial institution takes a financial risk and makes a
profit, it is rewarded; however, should it make a loss, the financial institution does not bear the full
consequences of its actions. Instead, the government and/or the regulator provides a safety net.
However, the Basel Committee has supported the creation of this facility.
The CLF can be seen as a formal extension of liquidity arrangements that were put in place
by the RBA during the GFC. At that time, the RBA expanded the list of eligible securities for
repurchase agreements (‘repos’) with the RBA to include residential mortgage-based securities
(RMBSs) issued by banks, thereby providing an additional source of liquidity to banks. With the
establishment of the CLF, all securities that are eligible for repo arrangements with the RBA are
also eligible to be used as collateral for the CLF (Heath & Manning 2012, p. 29).
Further information regarding the CLF can be accessed at the following website:
http://www.rba.gov.au/mkt-operations/resources/tech-notes/clf-operational-notes.html.
A small number of other countries may be in a similar position to Australia, in not having sufficient
liquid government bonds available to satisfy the new liquidity standards, and may need to
consider solutions similar to the CLF implemented in Australia.
As a result of the proposed introduction of Basel III, Australian Treasury bonds, which were
already in high demand from overseas investors before the new regulations, initially became even
more popular. In early 2012, approximately 80 per cent of Australian Treasury bonds were held by
overseas investors, motivated by the attractive credit rating and yield (Curran 2012, p. 23). This
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figure has declined a little in recent years and at the time of writing sits closer to 70 per cent.
One potential solution for countries with relatively small debt markets could be covered bonds.
These are debt instruments in which banks could invest and that would rank ahead of depositors
in claims on banks’ assets. Since December 2010, Australia has allowed such instruments to be
issued. To protect the depositors, the Australian government established the Financial Claims
Scheme. This scheme has attracted some criticism, but it has helped deepen the bond market
and increase the availability of high-quality liquid assets in Australia (Hepworth 2010).
The Basel Committee issued detailed guidance on the LCR in January 2013. In recognition of the
difficulties that some banks had in meeting the original rules, the guidance was more lenient than
the original proposal issued in 2010 (BIS 2013a).
The following changes were incorporated into the guidance issued in January 2013:
• LCR was phased in. The minimum LCR in 2015 would be 60 per cent, increasing to 100 per
cent by 2019. Previously, the LCR was set at 100 per cent from 2015.
• The definition of high-quality liquid assets (HQLAs) was expanded to include blue-chip stocks
and bonds backed by residential mortgages as part of their ‘liquid assets’. Previously, HQLAs
were restricted to government bonds and cash deposits with central banks.
• Banks must assume that, in a theoretical 30-day crisis, 3 per cent of retail deposits would be
withdrawn. Initial guidance was for 5 per cent.
• Banks must assume that corporate clients would draw down their credit lines by 30 per cent,
down from the initially proposed 100 per cent (BIS 2013a).
In December 2013, APRA issued Prudential Standard APS 210 Liquidity and the Prudential
Practical Guide: APG 210 Liquidity (APRA 2014b). These implement the main elements of the
Basel III liquidity reforms and were effective from 1 January 2014.
In January 2014, APRA released further details to authorised deposit-taking institutions (ADIs) on
the operation of the CLF. APRA recognised that due to the relatively short supply of Australian
dollar HQLAs, the RBA will allow ADIs subject to the LCR requirement to establish a secured CLF
sufficient in size to cover any shortfall between an ADI’s holdings of HQLAs and the requirement
to hold such assets under APS 210. APRA announced that it would engage further with ADIs on
matters including related-party transactions, liquidity transfer pricing and the remuneration of key
persons with liquidity management responsibilities.
During 2013, APRA undertook a trial exercise to determine the appropriate size of the CLF
for each Australian ADI, subject to the LCR requirement. A total of 35 ADIs, including both
locally incorporated ADIs and foreign bank branches, took part in the exercise. In January 2014,
APRA released some observations arising from the exercise, in addition to the changes to the
process discussed above:
• the RBA determined that the amount of Australian dollar HQLAs that could reasonably be held
by LCR ADIs was equivalent to around 30 per cent of the outstanding stock of Commonwealth
Government Securities and securities issued by state and territory governments;
• the aggregate Australian dollar net cash outflow projected by the 35 ADIs for 2014 was
approximately AUD 418 billion; and
• had the LCR been implemented from 1 January 2014, the total notional CLF granted for
2014 would have been AUD 282 billion (APRA 2014a).
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In applying the Basel III requirements, APRA has chosen not to soften the rules for Australian
banks and is following the above-described approach announced by the Basel Committee.
APRA is holding 2015 as the date for the banks to become fully compliant with the LCR,
which is set at 100 per cent from 2015 and is not being phased in.
The Basel Committee is continuing to work on the requirements of the NSFR, with a minimum
standard due to be introduced from 2018. (As noted earlier, the NSFR is the second measure
proposed by Basel III to specifically address the liquidity risk, the first one being the LCR.)
APRA has reaffirmed that the NSFR will come into effect when it is finalised.
Study guide | 315
Basel III measures aimed at individual banks

Other measures that supplement the new liquidity standard and are aimed at individual banks
are as follows:
1. Stricter requirements on the quality of capital that banks must hold

The focus of assessing whether a bank has adequate capital will be on its common equity.
Previously, the definition was broader, but during the GFC it was recognised that credit and
market losses are absorbed by common equity. It is this measure that market participants
appear to be focusing on in assessing a bank’s resilience.
2. Capital ratio
The minimum common equity requirement is to increase from 2 per cent to 4.5 per cent,
with a capital conservation buffer of 2.5 per cent, bringing the total common equity
requirement to 7 per cent.
3. Increased coverage of risks, especially related to capital market activities

Some examples of the exposures that will be subject to increased scrutiny include
the following:
–– Trading book exposures will be subject to a stressed value at risk management.
–– Securitisation exposures will be subject to capital charges similar to those for the banking
book. (Previously, these were given a concessional treatment.) Counterparty credit risk
exposures are to be stress-tested.
–– Banks will be required to hold capital for mark-to-market losses associated with the
deterioration of a counterparty’s credit quality.
–– Higher capital requirements will apply to over-the-counter (OTC) activities, which should
increase incentives to use central counterparties and exchanges. However, this will need
to be appropriately managed to avoid concentrations of risk.
4. Stronger supervision, risk management and disclosure standards
Basel III measures aimed at the banking system as a whole

In addition to the above measures, which are aimed at individual banks, it has been recognised
that the risk of system-wide shocks requires macro-measures, which will now include:
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1. Leverage ratio
The intention of the leverage ratio is to provide a check mechanism against a system-wide
build-up of seemingly low-risk exposures that can nonetheless pose substantial threats to
broader financial stability. This measure is being phased in, but it is not yet fully known how
it will be applied. The specifics of the leverage ratio were issued in January 2014, with the
first disclosure by banks in 2015 and implementation by banks by 2018.
2. Supervision of the 2.5 per cent conservation buffer

Distributions and bonuses by banks will be limited if the conservation buffer falls below
2.5 per cent. The aim is to conserve capital in a downturn and rebuild it during the upswing.
3. Additional loss absorbency capital for systemically important banks

A bank that is determined to be systemically important will be required to hold additional
capital beyond the standard Basel III requirements. The Basel Committee released guidance
for domestic and global systemically important banks in late 2012. Twenty-eight banks were
named as globally systemically important, with the requirement that these banks should hold
additional capital buffers of between 1 per cent and 2.5 per cent of Common Equity Tier
1 (CET 1) capital, depending on how relatively globally important each bank is. The Basel
Committee has adopted a less prescriptive methodology for domestic systemically important
banks, stating that while it would expect these banks to also carry additional capital vis-à-vis
other banks, it would be up to each national regulator (e.g. APRA in Australia) to determine
exactly what the additional capital requirements would be for such banks.
4. Non-regulation-based liquidity management tools

As banks and other corporations increasingly focus on liquidity management, a number
of market-originated tools have emerged to help companies with this task. The following
are three examples of tools that have emerged in response to the increased liquidity risk
management focus:
4.1 Deutsche Bank platform

Deutsche Bank has created an integrated liquidity management module on its Autobahn
e-commerce platform, allowing clients to access strategic and tactical financing tools
(Euromoney 2010, p. 4).
4.2 JPMorgan platform

JPMorgan’s ACCESS® Liquidity platform offers clients ‘real-time information on global
cash positions at J.P.Morgan and other banking providers, details of cash concentration
structures, tools for intercompany loan administration and tracking, investment initiation
and tracking capabilities and flexible reporting’ (Euromoney 2010, p. 8).
4.3 SEB’s corporate financial value chain analysis

Skandinaviska Enskilda Banken (SEB) in Sweden helps clients manage their working
capital needs by analysing each element of the company’s working capital, in terms of
both process and capital efficiency, and then by identifying and delivering improvements.
For example, SEB aims to understand the trade flows and the financial processes
surrounding them and then to construct financing strategies to optimise the flows
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(Euromoney 2010, p. 19).
Since the core components of the Basel III framework were published in 2011, the Basel
Committee has focused on providing more detailed guidance on certain components of
the Basel III framework, in particular providing detailed guidance on the LCR and globally
systemically important banks. It is currently working on the specifics of the leverage ratio and
the NSFR.
The Basel Committee has been monitoring the implementation of the Basel III framework.
As of August 2013, 11 countries have issued the final rules that apply in their jurisdictions and
implemented them, and 17 countries are in various stages of finalising the rules (BIS 2013b).
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Potential impact of Basel III on corporate borrowers

The requirements of Basel III to increase banks’ capital buffers may lead the banks to restrict
provision of loans to corporate borrowers, as banks attempt to limit the growth in their risk
weighted assets in order to meet the new capital ratio standards. Banks may also increase the
cost of providing funding to corporates.
A report released by Standard & Poor’s in May 2012 stated that globally, approximately
USD 30 trillion would be required to refinance loan facilities maturing between 2012 and 2016
(Wong 2012).
Given the ongoing eurozone crisis, Europe is particularly vulnerable. Estimates indicate that
European corporates will need to refinance approximately USD 8.6 trillion of maturing debt by
2016, and a further debt of USD 2 trillion would be needed by the corporates to fund growth.
According to the European Central Bank, various large EU banks intend to reduce their assets
by approximately USD 2 trillion over the next three to four years. This estimate was supported
by the IMF report, which predicted that 58 large EU-based banks could reduce their assets by
approximately USD 3 trillion by the end of 2013, leading to a nearly 2 per cent reduction in
the supply of bank credit compared to the third quarter of 2011 (Dhru 2013). While the initial
reductions were significant, activity has slowed recently in light of growing confidence in the
region’s economic recovery (Thompson 2014).
To a lesser extent, provision of credit in other parts of the world will also be affected, but the
European banks are the ones likely to be most impacted.
The corporations that would feel this change most acutely are small-to-medium enterprises
(SMEs). The equity market for SMEs is not well developed, making SMEs reliant mainly on debt
for funding. At the same time, SMEs’ debt-funding options are generally limited to commercial
banks. For example, SMEs and smaller corporates are generally not able to access debt markets
such as the US high-yield debt market. The high-yield debt market allows non-bank institutions
to participate directly in corporate debt issuing, but it is only open to corporations of a certain
size. If SMEs experience credit rationing, it could hinder their development.
Conclusion: Implications of Basel III for accountants

The main implications of the increased recognition of liquidity risk and focus on its management
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for accountants are in the areas of risk management, financial reporting and finance planning.
Risk management
Given that a significant contributor to the GFC was the mispricing of risk, which was caused at
least partially by the complexity of financial instruments that corporations and banks invested
in, a renewed focus on risk management is expected. Banks subject to Basel III will seek
guidance from the Basel III accords on risk management, and large corporations may consider
developing in-house, or utilising external, risk management tools of the type described in item
4 ‘Non-regulation-based liquidity management tools’ in the ‘Basel III measures aimed at the
banking system as a whole’ section earlier.
Financial reporting
Increased financial regulation (i.e. the Basel III accords) will require increased reporting by banks,
which accountants will have a direct role in. Non-banks and companies unaffected by Basel III
may also want to consider developing their internal management reporting systems further to
highlight financial risks.
Finance planning
Given the expected credit rationing and stricter lending criteria that banks will use in implementing
the Basel III accords, accountants need to educate their clients, particularly SMEs and smaller-sized
corporates of the potential funding risk. They need to encourage them to proactively manage their
banking relationships as part of risk management.
Example 4.3: APRA resists banks request for Basel dilution

It could be argued that one of the reasons Australian banks came through the GFC so well was the
existence of additional prudential rules and more effective governance of its financial system from
the Reserve Bank of Australia and APRA. In the wake of the GFC, members of APRA stated that its
response to the GFC would be ‘modest’; no new regulations were foreseen because of its view that
its supervision of the banking sector had been effective and vigilant (Gluyas 2009). This raises the
possibility that the changes in Basel III could perhaps disadvantage Australia by imposing additional
costs of regulation that does not appear to be necessary.
The banks in Australia appear to agree that additional regulation would be costly. Bank profits are
under threat from the new rules because banks must hold larger amounts of higher-quality capital,
retain more liquid assets and generate more lending from their own deposits to protect themselves
from financial and economic shocks, such as another GFC. Banks wanted APRA to water down the
Basel III proposed capital retention rules that would limit their ability to generate profits (Johnston
2010). However, APRA confirmed in May 2013 that Australian banks would have to be 100 per cent
compliant with the liquidity coverage ratio rules under Basel III by 2015.
Possible return to protectionism

In taking action to respond to the GFC, the G20 promised that it would implement reforms
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that would ‘strengthen financial markets and regulatory regimes so as to avoid future crises’
(G20 2008, p. 2). The G20 recognised that part of this action would be implemented by
encouraging the IASB to set appropriate accounting and disclosure standards, but the action
also required regulators around the globe to ‘support market discipline’ and financial institutions
to ‘strengthen their governance and risk management practices’ (G20 2008, p. 2). The G20 has
also committed to protecting investors from conflicts of interest, illegal market manipulation,
fraudulent activities and abuse, and illicit finance risks arising from non-cooperative jurisdictions
(G20 2008).
The actions taken and promised by the G20 to strengthen financial systems came at a time when
governments around the world were considering, and continue to consider, how to protect their
economies from the negative effects of poor economic decisions taken elsewhere. For example,
the EU has provided assistance packages to prop up several weak economies, including Portugal,
Greece and Ireland, as discussed earlier.
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The Doha Round of talks at the World Trade Organization (WTO) began in November 2001 and
was scheduled to deliver results by December 2011, but by mid-2011 the talks were in trouble
(Miles 2011; Beattie 2011). The plan was to have a package of proposals that would extend
market access to some of the world’s poorest countries. Part of the package was to reduce
cotton subsidies, but this was resisted by the United States because, against WTO rules, it makes
generous payments to politically powerful cotton farmers (Beattie 2011). In addition, a WTO deal
for lesser developed countries would ‘cut across the existing US scheme to give preferential
access to all African countries’ (Beattie 2011).
Trade agreements are a way to encourage trade between countries or to protect the domestic
economy from international competition. However, there are also less obvious measures to
protect some economies at the expense of others. The Basel III reforms are designed to remedy
problems in the financial sector that have flowed into the real economy, but critics have pointed
out that they will further disadvantage less developed countries (Masters 2012). A co-chair of the
B20 (a business advisory group to the G20) recognises the likely disadvantage for these countries
and stated that the ‘rules on liquidity, counterparty risk and trade finance will … cut the supply
and raise the cost of credit in those economies’ (cited in Masters 2012). Further effects will arise
from Western banks’ attempts to dispose of assets domiciled in developing countries as they
attempt to restructure their balance sheets to meet the new rules.
The policies adopted in some countries to encourage domestic manufacturing have also been
branded as a new form of protectionism by some critics. Donohue and Garfield (2012) suggest
that China, Brazil, India, Russia, Nigeria, Indonesia and Argentina are discriminating against
foreign companies. The discriminatory policies include requirements to disclose product
design information before granting access to the country and local standards that differ from
international standards. As well as urging action against such practices, the authors acknowledge
that the United States has its own practices—in the areas of tax, migration and education—
that inhibit free trade.
The WTO’s report on G20 trade measures, issued on 18 June 2014, noted that:
‘G-20 members put in place 112 new trade restrictive measures during the period mid November
2013 to mid-May 2014—slightly down from the 116 new restrictive measures introduced in the
previous period from mid-May to mid-November 2013.’
‘Over the six months to May [2014], G-20 members have continued to introduce trade restrictions—
albeit at a slightly slower rate than before,’ said WTO Director-General Roberto Azevêdo.
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‘While some liberalising measures have also been introduced, it is clear that the coat of trade
restrictions has grown a bit thicker over this period. This will not help our efforts to support growth
and development around the world—and therefore we must remain watchful,’ said DG Azevêdo.
‘One way to reverse this trend is to make progress on the WTO’s post-Bali agenda, aiming at
two things: full implementation of the Bali decisions and rapid conclusion of the Doha round
negotiations. On these issues, as on so many others, the leadership of the G-20 will be essential’
(WTO 2014).
The latest news on the success of the WTO talks (Doha Round) can be found at ‘The Doha Round’:
http://www.wto.org/english/tratop_e/dda_e/dda_e.htm.
There are two WTO issues under negotiation that are relevant to this module.
First, ‘Services’, which includes negotiations on banking and insurance as well as rules on the
accountancy sector.
Second, ‘Trade and environment’, which includes negotiations on trade in environmentally beneficial
goods. The aim is to foster a better dissemination of environmental technologies at lower costs so
that they have a positive impact on climate change.
To become more familiar with current progress in these areas, access the WTO website.
➤➤Question 4.9
How could stronger regulations in banking and accounting lead to increased international
protectionism?
The next section explores the principles applicable to Islamic banking, discusses some of the
recent developments and challenges faced in interactions with Western accounting systems
and describes the current state of Islamic finance in Australia.
Islamic finance
Introduction
Islamic finance refers to business practices that are consistent with the principles of Islamic law
(sharia). These principles are based on ethical considerations that, broadly speaking, classifies
Islamic finance under ethical finance. The scope of ethical finance is as wide as the term ‘ethics’,
which means different things to different people and jurisdictions.
In 2013, an estimated one-fifth of the world’s population was Muslim (PRB 2013). Although
Muslims live around the globe, more than 60 per cent of the global Muslim population is in
Asia and about 20 per cent is in the Middle East and North Africa (Pew Forum on Religion and
Public Life 2011). By 2030, there will be an estimated 2.2 billion Muslims worldwide (26.4% of the
global population)—and double the 1.1 billion Muslims in 1990.
There are over 500 Islamic financial institutions in more than 50 countries. According to Ernst &
Young’s World Islamic Banking Competitiveness Report 2013–2014, the sharia-compliant assets
with commercial banks globally were estimated to be around USD 1.54 trillion in 2012, with a
four-year average growth rate of 17.6 per cent, and projected to reach around USD 1.7 trillion
in 2013 (Ernst & Young 2013). A recent report by Ernst & Young states that emerging markets
will remain central to global growth over the next decade. A group of 25 rapid-growth markets
(RGMs) are shaping the world economy, and 10 of these RGMs have large Muslim populations.
Bahrain and six of the RGMs—Qatar, Indonesia, Saudi Arabia, Malaysia, the UAE and Turkey
(QISMUT)—will continue to drive future internationalisation of the Islamic banking industry
(Ernst & Young 2014). With a market share of more than 80 per cent, QISMUT is expected to be
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more than three times its current size by 2019. Similarly, the global profit pool was expected to
triple by 2015.
The history of modern Islamic finance is relatively short:

The quest for Islamic banking started after the Second World War. This is the period when the
Muslims in different parts of the world rid themselves of colonialism, and independent Muslim
states appeared on the world map (Tahir 2009).
Islamic banking as we know it today began in 1963, when a mutual savings bank was formed in
the Egyptian town of Ghamar (Karasik, T. & Wehrey, F. et al. 2006). Since then, it has evolved,
bringing together classic religious concepts and modern globalised banking needs.
Islamic finance is now starting to take hold in Western markets for a variety of reasons. Western
banks are now setting up sharia-compliant operations, and there has been a flurry of Islamic start
ups, from full-service investment banks to specialist advisory firms.
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What is interesting to note is that ideological considerations, rather than economic considerations
or scientific discovery, are the main factor behind the demand for Islamic finance (Tahir 2009). It is
claimed that Islamic finance showed some resilience during the recent GFC, which contributed
towards its increasing popularity after the GFC. It is argued that most of the factors responsible
for the GFC are prohibited by Islamic finance and that the principles of Islamic finance can be
beneficial in the rethinking of the global financial architecture and in reducing the severity of
financial crisis (Ejaz & Khan 2014).
What is Islamic finance?

The principles of Islamic finance are based on Islamic (sharia) law. The traditional Western
banking system relies on certain business practices that are prohibited by sharia law. These
prohibitions include riba (which includes interest-based loans) and gharar (contractual uncertainty,
including a ban on selling something that is not owned at the time of sale), which are the key
pillars of the conventional financial system.
Sharia business-related directives—referred to as ahkam (plural of hukm)—are simply rules of

equitability (fairness) that ensure counter transactions in a business exchange are equal in value
and that no party unfairly gains at the expense of the other. This, in principle, is not different from
the objective of any other jurisdiction. The difference, however, is in the detail. What is termed
as an equitable exchange in general may not be equitable by sharia standards. The obvious
example is that of interest-based loans. The following highlights some of the principles of Islamic
finance and pinpoints its notion of equitability. (This is followed by a discussion on principal
contracts that are used to structure sharia-compliant products, with examples.)
• A ban on investing in harmful business activities—Islam prohibits investing in activities

that are considered to be socially undesirable, such as pornography, alcohol consumption
and armaments. The primary reason behind this ban is to protect society or individuals
from certain undesirable outcomes associated with the banned activity. Sharia allows such
investments only in instances where it is possible to detach such activities from its effective
cause of prohibition and associate clear benefits to society or individuals. For example,
producing alcohol for direct consumption is clearly prohibited by sharia (the effective cause
of prohibition being intoxication), but its production for use in medicine, for example,
is allowed and encouraged. Therefore, any economic activity that can be identified as having
an undesirable impact on society may be added to the list of undesirable activities—for
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example, industrial processes that cause environmental pollution and sustainability concerns.
This is where Islamic finance might share some commonalities with certain aspects of the
conventional ethical finance.
• Prohibition of riba—This includes but is not limited to any type of interest, although
a minority believes that this applies only to usury or excessive compound interest.
This prohibition further implies the following interrelated principles:
–– Money is not an asset—It has no intrinsic value but is a medium of exchange rather
than something of value in itself.
–– Money cannot earn money—If money is not an asset, it cannot earn money without
making any real contribution. Money when directly exchanged with money must be one
to-one. This principle underpins a reliance on asset- or service-based transactions, which is
why sharia-compliant transactions are also referred to as asset-backed transactions.
–– Debt to be traded at par-debt—In Islam, debt is treated as money and can be traded only
at par, even though it might be a result of a real exchange of money for something else.
–– Risk sharing—All parties must share returns (profit or loss) generated by the underlying
real economic activity, as specified in the underlying sharia-compliant contract.
Interestingly, ‘risk’ is an Arabic word that refers to lending money without requiring a
return unless there is profitable growth (Seccombe 2012).
• No contractual uncertainty (gharar)—Gharar refers to any uncertainty that might result in an

unfair gain to one party at the expense of the other. This type of uncertainty relates mostly to
the essential details of a contract including offer and acceptance, the subject matter, its price
and delivery. This principle is often related to transparency and disclosure in conventional
finance. The scope of gharar in Islamic finance is, however, wider than these terms. It prohibits,
for example, the sale of a thing that is not owned by the seller at the time of sale (e.g. short
selling, which might pass all the transparency and disclosure tests), with careful exceptions
under conditions such as salam and istisna. (These terms will be discussed shortly.)
This principle is also used to justify a ban on gambling, as it is related to uncertainty of
the subject matter or its price and adds unnecessary complexity in contract structures.
• Exchanges must take place at the natural market price—Markets must be left to operate
freely, and all exchanges must take place at prices set by natural market forces of supply and
demand. Islam bans hoarding, outbidding in auctions with the intention of raising the price
and dumping goods to force competitors out of the market.
As is clear from these principles, Islam’s notion of equitability challenges the traditional concept
of ‘time value of money’ (i.e. a dollar today is worth more than a dollar in the future because it
can be invested and earn interest). Islam considers this notion of time value of money inequitable,
as the real-time value of money may be positive or negative depending upon the outcome of the
underlying economic activity. For example, the lender (passive agent) is promised a fixed return
that transfers the entire risk to the borrower (active agent), who might or might not earn profits.
This sort of reasoning is seen as an important aspect of just equitability, as it looks at fairness
from the point of view of all parties to the contract. Islamic finance encourages real exchanges
on a risk-sharing basis and requires the exchange of money or debt to be at par.
The role of Sharia Supervisory Boards

Islamic finance is an evolving field, and some products and structures have yet to be standardised.
In such circumstances, the approval of a sharia adviser is required to ensure that the transaction
is sharia-compliant. Islamic banks and banking institutions that offer Islamic banking products
and services typically establish a Sharia Supervisory Board (SSB) to provide advice and ensure
that the bank’s operations and activities comply with sharia principles. There are many recently
established sharia advisory firms (either stand-alone or subsidiaries of larger financial groups)
providing sharia advisory services to institutions that offer Islamic financial services.
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Example 4.4 provides an example of a company that appointed a sharia adviser to assist with its
transformation to being fully sharia-compliant.
Example 4.4: Vodafone Qatar

In a strategic bid to align its operation with regional trends, Vodafone Qatar recently transformed its
company to be fully sharia-compliant. Although Vodafone Qatar would pass the qualitative screening
because telecommunication is not one of the prohibited industries, its operation was not compliant
according to quantitative screens because it heavily relied on conventional interest-bearing borrowing.
The company refinanced these borrowings through a variant of the wakala contract. The company
has appointed a sharia adviser to oversee the compliance of the company’s operations and to issue
an independent opinion following a quarterly review of the operations (Vodafone Qatar 2015). This
change was well received by the market, and the company’s shares jumped 18.99 per cent month on
month in February 2015 after the transformation in January 2015 (Gonzalez 2015).
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Sharia screening
An important development in the Islamic finance industry is sharia screening for investment
purposes, which involves the screening of conventional stocks for sharia compliance. This allows
religious investors to invest in conventional stocks. This has:
• helped banks with balance sheet management;
• encouraged fund managers to structure ethical investment in general and sharia-compliant
investments in particular; and
• attracted interest from conventional vendors in sharia stock screening.
The first sharia index was launched by Dow Jones in February 1999, followed by the FTSE
in October 1999. Most of the major market players now provide sharia screening. These
providers include:
• regulators (e.g. the Accounting and Auditing Organisation for Islamic Financial Institutions
and the Securities Commission of Malaysia);
• index providers (e.g. Dow Jones, S&P, Morgan Stanley, and the FTSE) and sharia users
(e.g. Azzad Funds, Shariah Capital and Al Meezan); and
• banks (e.g. HSBC Amanah and Dubai Islamic Bank).
The screening involves qualitative and quantitative measures. The qualitative screens, also known
as industry screens, filter out industries with prohibited core businesses or some involvement in
prohibited sectors. The remaining stocks are passed through qualitative screens, also known as
financial ratio screens, which require debt, cash and cash equivalent, account receivables and
income from non-permissible activities to be below threshold values.
The purpose of the quantitative screens is to ensure:

• the stock dominantly represents a real asset (as nominal assets need to be traded at par); and
• involvement in non-permissible activities, such as interest, is minimal.
The list of companies and financial ratio thresholds are determined by independent sharia boards
that differ in their resolve across screening providers.
The Dow Jones Islamic Market Index (DJMI) family, for example, includes thousands of broad-
market, blue-chip, fixed-income, and strategy and thematic indices that pass the qualitative and
quantitative screens approved by the Dow Jones independent committee of sharia scholars.
Sharia-compliant wealth managers typically identify themselves with a particular screening
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methodology and use it as a signal of their compliance to sharia. Crescent Wealth Australia,
for example, is an Australia-based superannuation and investment firm that offers socially
responsible and sharia-compliant investment services that comply with the Accounting and
Auditing Organisation for Islamic Financial Institutions (AAOIFI) screening standard. In contrast,
the Muslim Community Co-operative Australia (MCCA), another Australia-based organisation,
uses the MSCI screening methodology, which is similar to the DJMI’s methods but with more
explicit and conservative qualitative criteria.
Table 4.4: Example of sharia stock screening—Dow Jones screening methodology
To determine their eligibility for the Dow Jones Islamic Market™ Indices, stocks are screened to ensure that
each meets the standards set out in the published methodology.
Industry Screens
• Alcohol
• Pork-related products
• Conventional financial services
• Entertainment
• Tobacco
• Weapons and defense
Financial Ratio Screens
All of the following must be less than 33%:
• Total debt divided by trailing 24-month average market capitalization
• The sum of a company’s cash and interest-bearing securities divided by trailing 24-month average
market capitalization
• Accounts receivables divided by trailing 24-month average market capitalization
Source: http://www.djindexes.com/islamicmarket/?go=shariah-compliance.
➤➤Question 4.10
It is claimed that Islamic finance is an ethical alternative to traditional finance practices. Reflect on
the nature of this alternative and discuss how it differs from other ethical alternatives.
Next, some of the principal contracts used by Islamic banks when structuring sharia-compliant
products will be examined.
Principal contracts underlying Islamic finance structures

The following lists some of the most frequently used principal contracts in Islamic finance.
• Mudaraba (profit-sharing contract): This is when one party contributes capital (known as rab
ul-maal) and the other contributes skills (known as mudarib). Profits are shared as agreed by
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the contracting parties, and losses are borne by the investor.
• Musharaka (profit- and loss-sharing contract): This is when all parties contribute capital and
some may contribute skills as well. Profits are shared as agreed by the contracting parties
whereas losses are shared in proportion to capital contributions.
• Bai bithaman ajil (BBA) or bai muajjal (deferred payment sale): This is a type of deferred
payment sale in which the price and payment details are fixed at the time of sale.
The deferred price may be reasonably greater than the spot price, but it is treated as
a fixed debt once agreed upon by the contracting parties. It is subject to the riba-related
restrictions stated earlier.
• Murabaha (cost plus sale): This is a type of sale—deferred payment in practice—in which the
seller purchases a commodity and sells it to a buyer at cost plus. The seller here, unlike with
BBA, discloses the cost price as well as the mark-up.
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• Ijara (lease): This is when a party transfers the usufruct (i.e. right of use) or services of a leasable
asset to another against rental payment. The concept is similar to an operating lease where
the asset reverts back to the lessor at maturity.
• Salam (advance payment deferred delivery sale): This refers to a deferred delivery sale for
which 100 per cent of the payment is made in advance. The exact quality, quantity, date and
space of delivery are identified. Salam is mostly executed in agricultural goods or goods that
are readily available in the market at the time of delivery. This means that when producers
are unable to produce the good, they can replace it with those available in the market. This
restriction reduces settlement risk.
• Istisna (made to order): This refers to a deferred delivery sale in goods that are manufactured.
The payment in this case can be deferred as well and may be made in a lump sum or in
instalments.
• Wakala (agency contract): This is a person or an entity appointed as an agent (wakil) to

perform certain tasks against a fee.
• Qard al-hasan (interest-free loan): This is also referred to as qarz.
• Wadia wad damana (guaranteed safekeeping): Goods or deposits are kept with a party that
guarantees their safe return on request.
• Hiba (gift): This is a unilateral transfer from one party to another as a gift.
• Wa’d (unilateral promise): This is a unilateral buy or sell promise (without consideration) from
one party to another. Islamic banks use this contract when contracting on commodities they
do not own at the time of contract such as murabaha. Some recent innovations, however,
suggest alternative financing structures that are free from promise (wa’d) (see Tahir 2012).
• Ji’ala or ju’ala contract (performance fee contract).
• Arbun or urbun (down payment or earnest money): This is when a buyer pays part of the price
in advance, with the understanding that the money will be forfeited if the buyer decides not
to purchase the item.
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Islamic banks raise current accounts on the basis of wadia wad damana and qard al-hasan,
and investment accounts on the basis of mudaraba and wakala. The mudaraba deposits may
be restricted (deposited for a specific purpose or project) or unrestricted (at the discretion of
the bank) and may be fixed for a short- to long-term period. The bank may invest deposits in
current accounts in sharia-compliant projects, but it does not share profits or losses with its
depositors. The principal amount in the current account is guaranteed, whereas the amount in an
investment account is not; all losses in mudaraba and wakala contracts are borne by the investor
(see Tables 4.5 and 4.6).
Table 4.5: Examples of current accounts in practice
Dubai Islamic Bank Pakistan Ltd (DIBPL) current account

• The account is based on the wadia contract.
• The safe return of the principal amount on demand is guaranteed.
• The depositor permits DIBPL to use or invest the wadia amount in sharia-compliant projects.
• The depositor is not entitled to a share in investment profit nor does the account holder bear any
risk of loss.
Source: Based on Dubai Islamic Bank 2015a, ‘Current account’, accessed October 2015,
http://www.dibpak.com/Deposits/CurrentAccount.aspx.
Albaraka Bank (Pakistan) Ltd current account

• The account is based on qard or qarz contract, whereby the customer is the lender and the bank is
the borrower.
• The safe return of the principal amount on demand is guaranteed.
• The depositor permits the bank to use or invest the qard amount in sharia-compliant projects.
• The depositor is not entitled to a share in investment profit, and the account holder does not bear
any risk of loss.
Source: Based on: Al Baraka 2015, ‘Al Baraka current account’, accessed October 2015,
http://www.albaraka.com.pk/retail-banking/deposit-accounts/abpl-current-account.
Table 4.6: Examples of investment accounts in practice
Dubai Islamic Bank Pakistan Ltd Saving Account—based on mudaraba

… the depositor (fund provider or Rabbul-Maal) authorizes DIBPL (fund manager or Mudarib)
to invest his/her funds on the basis of unrestricted Mudaraba contract according to the principles
of Sharia. DIBPL invests these funds in its Common Mudaraba Pool with other deposits and
the shareholders’ equity. The profit on the Common Mudaraba Pool is distributed amongst
the shareholders and depositors on the basis of agreed upon weightages which take into
consideration the tenor, amount of deposit and profit payment frequency of the account.
Source: Dubai Islamic Bank 2014b, ‘Savings account’, accessed September 2014,
http://www.dibpak.com/Deposits/Saving-Accounts.
Al Rayan Bank Treasury Deposit Account—based on wakala

The account is operated under the Islamic Finance principle of wakala (agency agreement). Al Rayan
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Bank will act as your agent to achieve an agreed expected profit rate over an agreed number of days,
monitoring the investment on a daily basis.
Should we not think we will achieve the expected profit rate, the initial deposit, plus the profit accrued
to date, will be returned to you. All Wakala Account holders are covered by the Financial Services
Compensation Scheme, the UK government backed scheme which guarantees UK savers’ eligible
deposits up to £85,000.
Sharia principles mean we do not offer you interest, instead, we make Sharia compliant investments
on your behalf to achieve expected profit rates. This arrangement is approved by our Sharia
Supervisory Committee.
Source: Al Rayan Bank 2015b, ‘Wakala treasury deposit account’,

accessed October 2015, http://www.islamic-bank.com/savings/wakala.
Islamic banks use these principal contracts to service a wide variety of client requirements, ranging from
financing personal needs to business needs. BBA murabaha and ijara are fixed-income instruments that are
frequently used by Islamic banks, with suitable modifications, to serve the needs of clients and to manage
risk (see Tables 4.7 and 4.8). These modifications mostly result in hybrids of the principal contracts. The next
section will look at some of the frequently used structures in Islamic finance.
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Financing through commodity murabaha and tawarruq

Commodity murabaha is a liquidity tool used by some Islamic banks, where a bank in need of
liquidity uses a precious commodity in metal exchanges (e.g. the London Metal Exchange (LME))
to obtain cash from a customer.
(i) The customer purchases a precious metal from the market on the spot price S (from broker A).
(ii) The customer sells it to the bank on deferred payment basis at price D.
(iii) The bank immediately sells it to another party (broker B) on the spot price S.
The bank gets instant cash equal to S; the customer earns D – S.
Tawarruq is also known as reverse commodity murabaha. In this case, it is the customer
who needs liquidity and the bank that acts as financier. The two terms are sometimes used
interchangeably. This can be clearly seen in examples of personal financing (Table 4.7). These
structures are often criticised for being too close to mimicking interest-based financing and not
offering a real sharia-compliant solution.
There is a move away from the use of commodity murabaha contracts in some parts of the Islamic
banking industry. As noted in the Ernst & Young’s World Islamic Banking Competitiveness Report
2013–2014, Oman has amended its Islamic banking regulations to disallow the use of commodity
murabaha contracts. This move is due to the perceived long-term misuse of commodity
murabaha and tawarruq (Ernst & Young 2013, p. 31).
Ijara muntahia bitamleek (lease ending with ownership)

This is different from simple ijara in that ownership of the asset is transferred to the lessee at
maturity through a contract of sale or as a gift (hiba) from the lessor. This is also referred to as
AITAB (al-ijara thuma al-bai) (see Table 4.8 for an example).
Diminishing musharaka (diminishing partnership)

Diminishing musharaka is a popular asset financing technique, whereby a financier and a client
start as joint owners of an asset (e.g. a house or a car). The asset is leased to the client, who pays
rent for the portion of asset owned by the financier. The client also gradually purchases the asset.
The financier’s ownership in the asset diminishes over time and that of the client increases until
the asset is owned outright (see Table 4. 8 for an example).
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Parallel salam (back-to-back salam)
Because an Islamic bank might not be the end user of the financed commodity, it faces a price
risk that the bank’s profit will be determined by the price of the commodity at the time of
delivery. One way the bank mitigates this risk is through back-to-back salam, whereby the bank
sells the commodity to an interested end user on a salam basis as the ‘producer’ following its
salam contract with the original producer. The bank’s profit in this case is the difference between
the advance payment received in lieu of the parallel salam and the advance payment made to
the original producer.
Sukuk (Islamic bonds)

Sukuk are asset-backed, sharia-compliant trust certificates of equal value. They represent
undivided shares in the ownership of the underlying asset or funds that are used in generating
sharia-compliant income streams. ‘This Sharia compliant alternative to interest-bearing investment
certificates or fixed income securities has led to the product being commonly referred to as
“Islamic bonds”’ (DIFC 2009, p. 9).
Sukuk are usually structured through a special purpose vehicle (SPV). An SPV is a legal entity—
usually a limited company or a limited partnership—that is created to fulfil a specific objective
in a tax-neutral country. The SPV issues the sukuk and declares an English law trust in favour
of the holders. Sukuk have a maturity that is determined in advance of the settlement of
the transactions.
Sukuk are typically identified with one of the principal contracts listed earlier, such as sukuk al
ijara or sukuk al-musharaka.
Sukuk al-ijara represents undivided shares in ownership of a leasable asset where the rentals
provide periodic profit streams. The SPV usually purchases the asset from the originator of sukuk,
who later acquires the asset on lease. The sukuk’s holder or holders bear the cost of maintenance
of the asset.
Sukuk al-musharaka, on the other hand, represent ownership units of equal value in a musharaka
equity invested with the originator. Profits and losses in this case are shared according to the rules
of musharaka. (See the DIFC Sukuk Guidebook (2009) for further discussions on different types of
sukuk and related issues.) Some of these sukuk are tradable (such as sukuk al-ijara), while others
are non-tradable (such as sukuk al-salam) in the secondary market. The latter, non tradable sukuk
usually represent debt that can only be traded at par for reasons outlined earlier.
Issuance of sukuk in the global market

One area of Islamic finance that has attracted a lot of interest in the last decade or so is the
issuance of sukuk in the global market. This is an important development for a variety of reasons.
First, Islamic banks tend to hold greater excess reserves than conventional banks (one reason
being the lack of sharia-compliant investment opportunities). Sukuk provide Islamic banks with
an excellent opportunity to invest their excess reserves in Islamic bonds, which offer competitive
returns with an active secondary market in some cases. At the same time, they present
conventional investors with an opportunity to diversify their portfolio, as sharia-compliant
instruments are claimed to have a distinct asset class. This is because sukuk rely on the income
stream generated by a real economic activity in which the holders have ownership rights in the
underlying assets. This distinguishes sukuk from conventional debt-based securities.
Second, sukuk allow the private and public sectors to raise funds for productive projects in a sharia-
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compliant manner. Although the sharia compliance aspect of sukuk allows ‘borrowers’ to tap into
halal funds (funds that are available for investment in sharia-compliant projects only), their viability
and competitiveness attract neutral investors as well. Finally, sukuk allow financial institutions and
corporations to securitise their assets to raise funds and reduce or transfer asset risk.
Sukuk have been used to finance a variety of projects of different sizes, ranging from less than
a million USD to more than USD 9 billion. Some of the large projects are in the Persian Gulf,
Malaysia and the UAE. Similarly, mega projects in two regions of Germany have relied on sukuk
for funding (Safari et al. 2014, p. 192).
Some practical examples of sukuk al-ijara, sukuk al-salam, sukuk al-murabaha, sukuk al-musharaka,
sukuk al-mudaraba, sukuk al-istisna and hybrid sukuk can be found in Dar Al Istithmar’s (2006),
‘An introduction to the underlying principles and structure’, which is available at:
https://www.sukuk.com/wp-content/uploads/2014/03/Sukuk-Structures.pdf.
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Whereas most sukuk issued have at least five years to maturity, they are also used to facilitate short-
term and medium-term financing. The Central Bank of Bahrain, for example, uses salam-based
sukuk for short-term financing with a maturity of 91 days. The World Bank, on the other hand,
issued medium-term sukuk to raise funds for its development finance (Safari et al. 2014, p. 177).
The world’s first sovereign sukuk were issued in Malaysia in 2002. More recently, in June 2014,
Britain became the first Western country to issue sovereign sukuk, called the HM Treasury UK Sukuk
(HM Treasury Corporate Report 2014). These sukuk use the al-ijara structure, the most common
structure for sovereign sukuk, where rental payments on property provide the periodic income to
investors. These sukuk underlie three central government properties with a competitive return.
The tables below provide some examples of personal and asset financing using tawarruq and
commodity murabaha in Table 4.7 and house financing in Table 4.8.
Table 4.7: Examples of personal financing in practice
SABB (Saudi Arabia) Personal Finance—based on tawarruq and murabaha

To meet your various financial needs, such as:
Buying a new house or refurbishing your home
Planning your wedding or a family vacation
Enrolling your loved ones in the best schools and universities
Buying your dream car
Any other financial requirements
SABB can provide you with Shariah-compliant Personal Finance, to help you fulfill your ambitions and
achieve your dreams, with attractive features and at competitive rates.
SABB offers Personal Finance on a ‘Tawarruq’ or ‘Murabaha’ basis.
‘Tawarruq’ is a mechanism approved by SABB’s Shariah Supervisory Committee. SABB owns metals
purchased from the global market, then sells them to you at an agreed fixed profit rate, and you pay
for them over a maximum period of 5 years. Soon after buying the metals from SABB, you will issue a
power of attorney to SABB enabling them to sell the metals for cash.
Murabaha is also approved by SABB’s Shariah Supervisory Committee. SABB purchases local Shariah-
compliant shares from the local stock market ‘Tadawul’, then sells them to you at an agreed fixed profit
rate, and you pay for them over a maximum period of 5 years. Soon after buying the shares from SABB,
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you have the choice of either delivery of the shares, or issuing a power of attorney to SABB them to
sell the shares for cash.’
Source: SABB 2015, ‘Personal finance’, accessed October 2015,
http://www.sabb.com/1/2/sabb-en/personal/ifs/financing/mal.
HSBC Amanah Malaysia Anytime Money Personal Financing-i (APF-i)—based on commodity murabaha
… is an Islamic term financing facility with fixed monthly instalment. It is based on Islamic
concept of Commodity Murabahah which refers to buying and selling transaction of an underlying
shariah compliant commodity at an agreed cost and mark up (cost plus profit basis) to effect
the financing transaction.
Source: HSBC Malaysia 2014, ‘Personal finance’, accessed October 2015,
https://www.hsbc.com.my/1/2/personal-banking/personal-loans-line-of-credit/hsbc-anytime-money.
Table 4.8: Examples of asset financing in practice
Al Rayan Bank Home Purchase—based on diminishing musharaka

Unlike a conventional mortgage where the purchaser borrows money from a lender which is then repaid
with interest, Al Rayan Bank’s Sharia compliant Islamic mortgage alternatives (Home Purchase Plans
or HPP) are based upon the Islamic finance principles of a Co-Ownership Agreement (Diminishing
Musharaka) with Leasing (Ijara) …
Our HPP mortgage alternatives are not exclusively for Muslims, Al Rayan Bank provides competitive
rental rates which are attractive to everybody. Finance for your property is generated from ethical
activities considered lawful under Sharia. Our administration fees are low and there are no early
settlement charges, giving you flexibility with your finances.
Source: Al Rayan Bank 2015a, ‘Home purchase plan’, accessed October 2015,
http://www.alrayanbank.co.uk/home-finance/home-purchase-plan/.
Kuwait Finance House Asset Financing—murabaha and ijara-based contracts on a variety of assets
Murabaha for boat financing
See: www.kfh.com/en/commercial/murabahaa/new-and-used-boat.aspx.
Ijara muntahia bitamleek for car financing
See: http://www.kfh.com/en/commercial/cars/new-cars.aspx.
Muslim Community Cooperative Australia Home Financing—based on ijara muntahia bitamleek

Our housing finance products are based on a lease arrangement that ends in ownership also known in
the Islamic Finance industry as Ijarah Muntahiyya Bittamlik. This arrangement has been recognized by
a large number of contemporary Scholars and is widely implemented and utilized by Islamic banks and
financial institutions around the world.
Once you identify the property that you wish to buy, the non-banking financial institution (financier) will
purchase it on your behalf from the seller. The financier will then rent the property back to you over an
agreed period of time.
The duration of the lease is set in advance. During the period of the lease, the property remains in
the ownership of the financier, however the lessee has the right to use the property until the expiry
of the agreement. At that point, ownership of the property is transferred to the customer in the form of
a promissory gift (hiba).
As all parties engage in trade and permissible transaction, namely a lease, this result in a Shari’ah
compliant alternative to conventional interest based home finance.
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Source: MCCA Islamic Finance & Investments 2014, ‘Buy a home’,

accessed October 2015, http://www.mcca.com.au/how-it-works.
➤➤Question 4.11
(a) What are some of the disadvantages of operating leases and how could they be overcome
in a sharia-compliant manner?
(b) Conventional accounting practices mostly rely on interest-based financing. Islamic finance
shifts the focus to asset-based financing. Do you think Islamic finance products require a
different accounting treatment to interest-based products?
Takaful (Islamic insurance)

Another development that needs brief mention is Islamic insurance, or takaful, which is a
relatively new but growing segment of the Islamic finance industry. According to Khan (2015),
the most important feature that distinguishes takaful from conventional insurance is the fact that
conventional insurance is primarily a contract of risk transfer. Conventional insurance transfers
the risk of the loss insured from the policyholders to an insurance company, against an agreed
amount of premium, whereas takaful operates under a risk-sharing arrangement.
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A conventional insurance company owns the premiums written and any surplus or deficit
generated by the insurance operation. In contrast, an Islamic insurance company, referred to
as a takaful operator (TO), merely manages affairs of the business against a variety of financial
incentives. Premiums collected by TOs are, in principle, owned by the policyholders as a group
and so is any surplus or deficit from the insurance operation. Participants in this case insure one
another on a non-profit basis and make contributions to the takaful pool on the basis of tabarru’
(a conditional and irrevocable donation), which is a non-commutative contract. This sector has
attracted Muslim as well as non-Muslim clients and is seen as an important development for
the future.
Example 4.5: Al Madina Takaful

Although Islamic finance is still a very small segment of the global finance industry, its popularity is some
regions, particularly in QISMUT, has been increasing over time. Likewise, the number of sharia-compliant
financial institutions and businesses has been increasing. Some businesses use sharia compliance as
a tool to gain competitive advantage and get access to markets that demand compliance with sharia
principles. For example, as of January 2014, Al Madina Insurance Company, one of Oman’s largest
insurance companies, changed its operation from conventional to Islamic insurance and is now known
as Al Madina Takaful (see http://almadinatakaful.com/#).
Participants under the new arrangement contribute to the takaful pool as donations. Al Madina Takaful
manages the takaful operation on the basis of wakala and mudaraba. It receives 18 per cent of the
gross contributions as wakala fee and 75 per cent of investment income from technical reserves as
mudaraba share. Any surplus or deficit at the end of the financial year belongs to the policyholders.
Surpluses may be retained to strengthen the policyholders’ fund or distributed as dividends subject
to approval from the sharia committee (Al Madina Takaful Annual Report 2014).
Challenges for Islamic banking

Islamic banking is still evolving and faces challenges in interacting with Western economic
systems and in developing consistent frameworks across different Islamic financial institutions.
Some of the current challenges identified are outlined below.
• Higher tax costs when compared to ‘traditional’ transactions

Tax law is unable to ensure that cash flows for transactions under sharia law are treated
comparably with similar transactions of a Western nature. In many cases, Islamic financing is
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disadvantaged as it always requires tying a transaction to an asset and not charging interest.
These disadvantages may vary across countries and across structures.
For example, in traditional home financing, a bank simply gives the customer an interest-
based loan that is used to purchase a home. In contrast, Islamic banks have to purchase
the house first and then sell it to the customer either on a deferred payment basis or using
the diminishing musharaka structure. The asset is therefore sold twice, which means that an
Islamic mortgage results in a double stamp duty. Moreover, an Islamic finance structure may
also be subject to a capital gains tax if the price at which an Islamic bank purchases the asset
differs from the price at which it is sold to the customer. Differences may also arise when rent
is not taxed at the same rate as interest.
Refer to the discussion paper released by the Australian Board of Taxation on the review of the
taxation treatment of Islamic financial products: http://www.taxboard.gov.au/files/2015/07/Islamic_
Finance_Discussion_Paper.pdf.
• Liquidity risk
Given the need for existing underlying assets, there is often a shortage of sharia-compliant
money market instruments. As such, many banks have high concentrations of cash, real estate
and long-terms assets, reducing their ability to respond to changing market conditions.
This requires institutions to have stringent risk management and internal controls. To get
around the liquidity issue, many banks use the Islamic financing instrument known as tawarruq.
• Lack of standardisation
Interpretations of sharia law may vary from one scholar to the next, thus making it difficult to
assess what is truly sharia-compliant. In order to simplify the situation, in 1990 the Accounting
and Auditing Organisation for Islamic Financial Institutions (AAOIFI) was established. AAOIFI
is an international body that prepares accounting, auditing, governance, ethics and sharia
standards for Islamic financial institutions and the finance industry. Other governing global
standard-setting organisations include the Islamic Financial Services Board (IFSB) and the
International Islamic Liquidity Management Corporation (IILM Co.). Furthermore, each bank
has its own sharia board, which interprets these rules. As a result, there is considerable
diversity across banks in the guidance and practice of Islamic finance.
Islamic finance in Australia

The Australian government is working to position the country as a leading financial services
centre and to develop competitiveness in Islamic finance, including sharia-compliant finance
products. This is considered to be a key opportunity for Australian-based banks and financial
institutions (AFCF 2010; Sherry 2010; Farrar 2012).
In September 2008 the Australian Government commissioned a report to guide Australia

towards becoming a leading financial centre, known as the Johnson Report. One key issue
considered in the report was the development of Islamic Finance in Australia.
The Johnson Report made two specific recommendations on Islamic finance:

1. the removal of regulatory barriers to the development of Islamic finance products in
Australia; and
2. a call for an inquiry by the Board of Taxation into whether Australian tax law needs to
be amended to ensure that Islamic financial products have parity of treatment with
conventional products.
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In April 2010, the Government announced that the Board of Taxation would conduct a
comprehensive analysis of Australia’s tax laws as recommended by the Johnson Report
and identify areas that might need fine-tuning. On May 18 2010, the terms of reference for
this review were announced. The board was asked to make recommendations in respect
of Commonwealth laws and findings in respect of state and territory laws that will ensure,
wherever possible, that Islamic financial products have parity of tax treatment with conventional
products. The board submitted its report to the government in 2013, but the government has
yet to issue its response and the report.
The focus of this report was not to give any special treatment to Islamic finance, but to make sure
there is a level playing field for the development of Islamic finance in Australia. This wouldn’t
require large scale re-writing of the Australian law and merely requires targeting neutrality in
treatment. For example, purchasing a home via an Islamic mortgage would result in double
payment of stamp duty. This is because shariah-compliance requires the asset to change hands
twice. A neutral treatment would require amending the law such that the stamp duty is paid once
or an equivalent amount in two instalments. The Victorian government has already introduced
such changes after working together with the MCCA Group. Other states will have to follow suit.
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The most pressing need is in mortgage and superannuation products. Islamic finance made
a slow start in Australia when MCCA introduced its sharia-compliant home financing in 1989.
ICFAL (Islamic Co-operative Finance Australia) and ISKAN Finance recently started offering
shariah-compliant home-financing as well.
In Australia, an individual’s superannuation plan often offers only very broad index-type products,
most of which are not sharia-compliant. MCCA and Crescent Wealth Australia recently started
offering sharia-compliant superannuation products. Crescent Wealth’s superannuation fund offers
socially responsible investment opportunities to all Australians and is claimed to be one of the
fastest growing funds in Australia.
National Australia Bank Ltd (NAB) is one of the major Australian banks that takes keen interest
in the Islamic finance sector and has been looking for opportunities. On August 27 2015,
NAB closed an AUD 19.9 million arrangement to fund a real-estate purchase by Crescent Wealth.
The funding platform is designed by NAB, which uses the wakala contract in its design. This is
expected to attract Islamic investors from the Gulf and South-East Asia (Vizcaino 2015).
Whereas the Australian government announced its ambition to be a hub for Islamic finance in the
region, the progress on regulatory reform is slow, and the industry is still assessing the situation
and looking for opportunities to tap into Islamic finance as an alternative source of liquidity.
Developments in director reporting

The directors’ report is an important accompaniment to a set of financial statements. However,
its nature differs from the financial statements, and its contents are usually dictated by legislation
and regulations rather than by accounting standards.
The disclosures that a listed entity includes in its directors’ report relating to its business and
results are intended to provide shareholders with a narrative and analysis of its operations,
financial position, business strategies and prospects. It differs from the financial statements as
it is more focused on how the entity operates and expects to operate in the future rather than on
historical information.
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Australian directors’ report
The requirement to prepare a directors’ report is contained in the Part 2M.3 of the Corporations
Act 2001 (Cwlth) (Corporations Act). In accordance with s. 292(1), a listed company, registered
scheme or disclosing entity is required to prepare a directors’ report for each financial year.
This directors’ report requirement includes an operating and financial review. The view adopted
by Australian Securities and Investments Commission (ASIC) is that the:
… operating and financial review (OFR) is a key part of annual reporting by listed entities. It must
set out information that shareholders or unit holders would reasonably require to assess an entity’s
operations, financial position, and business strategies and prospects for future financial years.
This information complements and supports the financial report.
A high-quality OFR is important in meeting the information needs of shareholders and unit holders
(ASIC 2013).
ASIC identified issues regarding disclosures included in the OFRs through its accounts surveillance
program. In March 2013, ASIC issued Regulatory Guide 247 Effective Disclosure in an Operating
and Financial Review (RG 247). RG 247 explains how ASIC interprets the requirements of the
Corporations Act and describes the principles that underlie its approach.
As identified in RG 247, the OFR is also different from market announcements and other periodic
disclosures that an entity may make in accordance with its continuous disclosure obligations.
This is because:
(a) the OFR supplements and complements the financial report …;
(b) together with the financial report, the OFR allows shareholders to find relevant information on the entity
in a single location, rather than having to piece together information from various past continuous
disclosure announcements that shareholders may not have necessarily read;
(c) depending on the specific circumstances of an entity, the OFR may contain a more or less detailed
explanation and analysis of information provided in other formats, such as investor presentations
and briefings to analysts, which may, for example, be presented in the form of a slide show without a
supporting narrative; and
(d) the OFR promotes consistency of disclosure because the legislation requires all listed entities to
address particular matters in the OFR. In contrast, while larger listed entities often prepare and publish
investor presentations and briefings, these are generally directed at sophisticated investors and,
in many cases, are not prepared at all by smaller entities (ASIC 2013, para. RG 247.8).
The OFR may also be known as the ‘management commentary’ or ‘management discussion and
analysis’. There are similar reporting requirements in the United States, where a management
discussion and analysis must accompany the financial report, and in the United Kingdom,
where a business review may be included in the directors’ report (ASIC 2013, para. RG 247.10).
The current UK requirement is the inclusion of a separate strategic report, which is discussed in
the following section.
United Kingdom strategic report

In 2013, the reporting requirements for a company complying with the UK Companies Act 2006
were amended by the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations
2013. These regulations came into force for financial years ending on or after 30 September 2013.
The main changes arising from the new regulations are as follows:
• Replacement of the current business review with a separate strategic report (excludes small
companies).
• Requirement for quoted companies to disclose information on greenhouse gas emissions
within the directors’ report.
• Removal of a number of disclosures currently required within the directors’ report, for example,
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the principal activities of the company.

• Replacement of the option to provide summary financial information with the option to provide
a strategic report with supplementary information (ICAEW 2014).
In response to the new regulations, the Financial Reporting Council (FRC) issued draft guidance
that deals specifically with the preparation of the strategic report. The introduction to the draft
guidance notes that:
During the course of the development of Exposure Draft: Guidance on the Strategic Report,
the FRC staff became aware of a commonly held misconception that the strategic report would be
an additional higher-level summary of information contained within the annual report; that it would
contain only ‘strategic’ information which may be of a different level of materiality or importance
to the information included in the business review. However, the purpose and required content of
the strategic report does not differ significantly from that of the business review which it replaces
(FRC 2013).
Example 4.6 discusses how BHP Billiton, a dual-listed company required to comply with both
the Australian Corporations Act 2001 (Cwlth) and the UK Companies Act 2006, is addressing
the requirements of directors’ reporting.
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Example 4.6: B
HP Billiton directors’ report—Australian
OFR requirements and UK Companies Act
business review
The detailed disclosures included in BHP Billiton’s directors’ report are included to comply with both
their Australian and United Kingdom reporting obligations.
The detailed disclosures include:

5 Directors’ Report
5.1 Review of operations, principal activities and state of affairs
5.2 Share capital and buy-back programs
5.3 Results, financial instruments and going concern
5.4 Directors
5.5 Remuneration and share interests
5.6 Secretaries
5.7 Indemnities and insurance
5.8 Employee policies
5.9 Corporate governance
5.10 Dividends (BHP 2014, p. 1)
In addition, BHP Billiton includes further disclosures to comply with the UK Companies Act obligations,
with an example from the ‘strategic report’ provided below:
1.1.5 About this Strategic Report
This Strategic Report meets the requirements of the Strategic Reporting required by the
UK Companies Act and the Operating and Financial Review required by the Australian
Corporations Act. This Strategic Report provides insight into BHP Billiton’s strategy, operating
and business model and objectives. It describes the principal risks the Company faces and
how these risks might affect our future prospects. It also gives our perspective on our recent
operational and financial performance (BHP 2014, p. 5).
The passages below are from the BHP 2014 Directors’ Report and provide some indication of the
types of disclosures made:
A review of the operations of the Group during FY2014, the results of those operations during
FY2014 and the expected results of those operations in future financial years, are set out in
section 1, in particular in sections 1.1, 1.3 to 1.5, 1.11, 1.12 and 1.15 and other material in this
Annual Report. Information on the development of the Group and likely developments in
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future years also appears in those sections of this Annual Report. We have excluded certain
information from the Strategic Report in section 1 (which forms part of this Directors’ Report)
on the basis that including the information would cause unreasonable prejudice to the
Group. This is because such disclosure could be misleading due to the fact it is premature
or preliminary in nature, relates to commercially sensitive contracts, would undermine
confidentiality between the Group, and its suppliers and clients, or would otherwise
unreasonably damage the business. The categories of information omitted include forward
looking estimates and projections prepared for internal management purposes, information
regarding the Group’s assets and projects which is developing and susceptible to change,
and information relating to commercial contracts and pricing modules.
Our principal activities during FY2014 were exploration, development, production and
processing of minerals (in respect of iron ore, metallurgical and energy coal, copper, aluminium,
manganese, uranium, nickel, silver and potash), and exploration, development and production
of conventional and unconventional oil and gas. No significant changes in the nature of the
Group’s principal activities occurred during FY2014 (BHP 2014, p. 210).
The report then details a number of significant developments for the entity during FY2014, including:
• On 1 July 2013 Mike Yeager retired from the Group Management Committee (GMC)
and from his role as Group Executive and Chief Executive – Petroleum and Tim Cutt
joined the GMC as President, Petroleum and Potash on 2 July 2013. During FY2014, we
made further announcements relating to GMC changes: Mike Fraser joined the GMC
as President, Human Resources on 27 August 2013 and Tony Cudmore joined the GMC
as President, Corporate Affairs on 3 March 2014.
• On 25 July 2013 we announced the investment of US$1.97 billion (BHP Billiton share) to
sustain operations at Escondida in Chile by constructing a new 2,500 litre per second
seawater desalination plant. On 23 July 2014 we announced the seawater desalination
plant was on schedule and budget, with 12 per cent of the overall project complete …
No other matter or circumstance has arisen since the end of FY2014 that has significantly
affected or is expected to significantly affect the operations, the results of operations or
state of affairs of the Group in future years (BHP 2014, p. 210).
Note: The above are brief extracts only. It is also possible that the full report may not comply with all
of the new strategic reporting obligations.
Source: BHP Billiton 2014, Annual Report, accessed July 2015, http://www.bhpbilliton.com/~/media/
bhp/documents/investors/reports/2014/bhpbillitonannualreport2014_interactive.pdf.
Summary
This part reviewed international developments in accounting standards. One important example
is the release of IFRS 9 Financial Instruments: Recognition and Measurement, which can be
understood as part of the IASB response to the GFC. It also discussed how IASB and FASB
convergence resulted in several joint projects over an extended period, but further significant
progress is less likely. As seen in the discussion on IFRSs, it is important to keep up to
date on the continuing progress of IFRSs adoption. Reading 4.1 provided an overview of
socioeconomic issues affecting Australia’s neighbouring countries and their likely adoption
of IFRSs. Reading 4.2 highlighted Japan’s experience with international accounting standards.
The main implications of the increased recognition of liquidity risk have been considered,
as has liquidity risk’s particular impact on the banking industry. Reading 4.4 provided an
overview of how banks operate. This part also looked at how mispricing of risk was a significant
contributor to the GFC. This mispricing, which was at least partially caused by the complexity
of financial instruments that corporations and banks invested in, means that a renewed focus
on risk management is expected. Following on from the discussion on the GFC, the European
sovereign debt crisis and its continuing effects in EU countries were considered.
Financial reform is also taking place through changes to banking regulations, known as Basel III.
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This part outlined some of the impacts of the new regulations on individual banks and the
banking sector as a whole.
The G20’s actions to protect investors from the impact of economic and financial decisions
taken elsewhere also raise the issue of increasing protectionism. Governments are agreeing to
cooperate on reforms to global financial systems, including taking action to improve standards
and regulation. However, world leaders also need to consider the impact of their global activities
on their own citizens. The WTO’s efforts to liberalise trade have stalled, despite positive
sentiments from G20 leaders about the need to ensure an open global economy.
Next, one form of ethical banking, Islamic banking, was considered. Although it is still very much
in its early stages in some economies, current successes and the potential for growth make it
essential that this industry further develops and becomes integrated into the international
financial system. We considered the different ways that Islamic banking is conducted to ensure
that it is in compliance with sharia law.
IFRSs are applicable to many entities, but an alternative, the public sector accounting standards,
was examined. These standards, which are based on IFRSs, are being developed for use by
public sector entities. Finally, the recent developments in directors’ reporting were considered.
Study guide | 337
Part B: Integrated reporting

Introduction
Part A covered the existing regulation of financial reporting, including extensions and
developments in corporate reporting, such as the recent developments in directors’
reporting. Part B considers the development of integrated reporting (IR). The goal of IR is
to integrate information about an entity’s strategy, governance, performance and prospects
in the management and reporting for the entity. It is a step beyond separate sustainability
and financial reports because it requires a more holistic approach to reporting about the
organisation to its stakeholders. The ways that IR differs from other reporting models are
considered, and the recently developed IR framework is explained.
Factors leading to the development

of integrated reporting (IR)
The IR initiative developed mainly because of concerns about the effectiveness of communication
in the current major reports to stakeholders. The major communication report, the annual report,
is commonly criticised for being ‘cluttered’, meaning that key messages are getting lost in an
overload of information. This causes problems for users, who find it difficult to assess a company’s
progress and performance as relevant information is obscured, and for preparers, who expend
considerable time and effort preparing such disclosures (e.g. FRC 2011; KPMG & FERF 2011;
Vesty & Brooks et al. 2015).
Annual reports are also often criticised for being narrow in scope. Companies are increasingly
likely to produce additional public reports to meet information needs not satisfied by the
annual report, as evidenced by the exponential growth in companies producing stand-alone
sustainability reports over the last 10 years (EY & BC 2014).
Another factor contributing to the development of IR was the lack of evidence regarding linkage
between companies’ sustainability reports and their annual reports (Eccles & Krzus 2010).
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Users reading these reports found that it was very difficult to see these reports as a coherent
view of the value creation story of the organisation. The aim of IR is to integrate information from
these two reports and other sources, and to report that information in meaningful ways in the
one comprehensive report.
The GFC accelerated the push for better reporting with a greater focus on the longer term.
Proponents of IR argue that the GFC resulted from a focus on short-term profits, with no
regard for long-term sustainability. It is argued that this short-term focus was aided by
statutory financial reporting requirements, which emphasise past financial results at the
expense of future strategic plans.
A more integrated form of management and reporting is seen as the solution to these
problems—notice the use of the term ‘management and reporting’. Crucial to IR is the notion
that it is not just a reporting approach, but that it encourages the holistic management of
the organisation. IR connects sustainability or environmental social and governance (ESG)
dimensions of performance, which have a greater focus on longer-term issues, with the
organisation’s business model and strategy. IR helps bring the sustainability and financial data
together to create a more profound and comprehensive picture of the risks and opportunities
the company faces (IIRC 2011a). According to advocates of IR, this provides a more robust basis
for decision-making by those within the entity (IFAC 2013; Vesty et al. 2015) as well as a more
meaningful foundation for reporting.
The professional accounting bodies, together with the Professional Accountants in Business
(PAIB) Committee of IFAC, supported the development of IR through a forum that focused on
how professional accountants in business can help their organisation to improve integration of
ESG factors into their reporting. IFAC reports that key conclusions of the forum were:
• integrated reporting needs to reflect an organisation’s strategy and values, as well as how it is
managed in all social, environmental and economic dimensions of performance;
• the process of integrated reporting, in turn, is a powerful tool to help drive an organisation’s
strategic agenda, providing management with key drivers of performance;
• integrated reporting has to be open and transparent by reflecting both improvements in
performance as well as weaknesses; and
• pension fund investors, as well as some other institutional investors, are increasingly looking
for financial implications of ESG factors to understand how an organisation’s strategy and
operations are affecting the numbers and key measures of performance (IFAC 2011).
Background to IR
In July 2010, the International Integrated Reporting Council (IIRC) was formed to develop
a globally accepted framework for IR. The IIRC is a global coalition of regulators, investors,
companies, standard-setters, the accounting profession and non-government organisations
(NGOs), including the Global Reporting Initiative (GRI), International Federation of Accountants
(IFAC) and the IASB (IIRC 2013b)
An integrated report shows how an organisation’s strategy, governance, performance and

prospects create value over time (IIRC 2013b). The usual form of reporting through financial
statements reflects the current financial position and backward-looking financial performance.
Many organisations supplement their financial report with a management discussion about
current plans, as well as opportunities and threats facing the business. However, the long-term
value effects of events beyond the usual operating horizon are largely absent from current
reports. As explained by KPMG:
Integrated reporting combines financial and non-financial information with a forward-looking
perspective that’s designed to help readers understand all the components of business value—and
how they may be affected by future opportunities and exposure (KPMG 2012, p. 6).
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Because IR tells the business’s value creation story and is driven by the business’s situation,
including its strategic plan, there is no standard format or model report (KPMG 2012, p. 14).
The IIRC has developed a principles-based framework to guide organisations in creating their
integrated reports, and this framework is discussed further below.
IR framework
The IIRC released its International IR Framework in December 2013 (IIRC 2013b). The IIRC
developed the framework after engaging in a global consultation exercise that resulted in
it receiving more than 350 responses to its draft proposals (IIRC 2013a). The IIRC originally
adopted the mission of replacing current financial statements with an integrated report
(IIRC 2011b), although this idea appears to be less prominent in the information put forward
by the IIRC and IR proponents more recently (Potter & Soderstrom 2014). These more recent
documents typically identify an important role for IR as ‘building on’ or ‘complementing’ existing
financial reporting approaches (IIRC 2013b, p. 2),
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The framework is designed to support organisations that are integrating previously separate
internal functions with the goal of presenting higher-quality information to stakeholders
(IIRC 2013b). The IIRC believes that the framework provides a coherent, rigorously developed
set of guiding principles and concepts to help organisations meet stakeholder demands in
a consistent way (IIRC 2013b).
What is IR?
The IIRC defines IR as:
A process founded on integrated thinking that results in a periodic integrated report by an
organization about value creation over time and related communications regarding aspects of value
creation (IIRC 2013b, p. 33).
Integrated thinking
The above definition of IR demonstrates that IR is the outcome of adopting integrated thinking
about the way that the organisation creates value. Therefore, it is necessary to define integrated
thinking and explain how value is created.
The IIRC defines integrated thinking as:

The active consideration by an organization of the relationships between its various operating
and functional units and the capitals that the organization uses or affects. Integrated thinking
leads to integrated decision-making and actions that consider the creation of value over the short,
medium and long term (IIRC 2013b, p. 33).
IR has a coherent theoretical basis that builds upon well-accepted conceptual foundations
commonly located outside the accounting literatures. The IR framework’s fundamental concepts
are identified as the various capitals the company draws from, the company’s business model
and its value creation process (IIRC 2013a, p. 6).
The capitals
In IR, value creation is much broader than just financial value, which is what is currently emphasised
in financial statements. According to the IR framework, organisations do not create value in
isolation but instead do so within the economic, social and environmental context in which they
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operate. Therefore, the IIRC encourages organisations to consider their effects on a number of
‘capitals’, which are defined as follows:
Stocks of value on which all organizations depend for their success as inputs to their business
model, and which are increased, decreased or transformed through the organization’s business
activities and outputs. The capitals are categorized in this Framework as financial, manufactured,
intellectual, human, social and relationship, and natural (IIRC 2013b, p. 33).
These categories of stocks of value are expected to reflect all the resources and relationships
that an organisation brings to bear in its value creation process. The discussion about capitals
(IIRC 2013b, para. 2.15) is summarised below:
1. Financial capital refers to the pool of funds available to the organisation (obtained through
borrowing, equity and grants or generated through profitable operations).
2. Manufactured capital includes non-natural physical objects available to the organisation
(including buildings, equipment and infrastructure).
3. Intellectual capital includes knowledge-based intangibles, such as patents, and organisational
capital, such as systems and procedures.
4. Human capital encompasses people’s competencies, capabilities, experience and motivation
to innovate.
5. Social and relationship capital includes the institutions and relationships within and between
communities and groups of stakeholders, as well as the ability to share information. It is a
widely defined concept of capital and includes the organisation’s social licence to operate.
6. Natural capital is all renewable and non-renewable environmental resources and processes
that support the prosperity of an organisation; it includes air, water and issues relating to
biodiversity.
Clear from the above is that the capitals as defined in the International IR Framework include
resources that are not owned or controlled by an organisation but are in some way available to
the organisation. Some organisations may have very little reliance on certain capitals and may
choose not to report on them. The framework also allows organisations to choose to report on
the capitals in various ways (IIRC 2013b, p. 4). The six capitals are expected to be prompts for
these resources and relationships, and the organisation need not record against these specific
six capitals.
Value creation
The explicit recognition of six types of capital in the framework encourages organisations to
consider the effect of their operations on each and how pursuit of financial value creation could
be at the cost of other capitals. For example, an organisation may use up financial capital in the
development of intellectual capital by providing specialised training for staff. It would do this if it
believes that the increase in value in intellectual capital is greater than the decrease in value for
financial capital, thus increasing the organisation’s overall value. Organisations are not necessarily
required to monetise or quantify value creation, or stocks of capital, but to consider if value has
been created or diminished for the organisation or for others. Some values can more easily be
monetised (e.g. financial capital in accordance with IFRSs) and others quantified (e.g. customer
satisfaction as an aspect of social capital), especially in the early stages of reporting, but others
will need to be described narratively.
Considering these broader capitals will better inform a range of decisions made by organisations,
as demonstrated by Vesty et al. (2015) in their CPA Australia-sponsored book of case studies
entitled Sustainability and Capital Investment Case Studies.
Sustainability and Capital Investment Case Studies can be accessed on the CPA Australia website
at: cpaaustralia.com.au/~/media/corporate/allfiles/document/professional-resources/sustainability/
sustainability-and-capital-investment-case-studies.pdf.
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Similar issues are also considered by IFAC, in a International Good Practice Guide which examines
how project and investment appraisal can incorporate long term sustainability-related factors.
‘Project and Investment Appraisal for Sustainable Value Creation’ from IFAC: can be accessed at
http://viewer.zmags.com/publication/f1c5f6ef#/f1c5f6ef/1.
The business model

The business model is the third fundamental concept of IR. It is defined in the IR framework
as follows:
… an organisation’s system of transforming inputs through its business activities into outputs and
outcomes that aims to fulfil the organisation’s strategic purpose and create value over the short,
medium and long term (IIRC 2013b, p. 33).
The components of the business model and how it integrates with the capitals are set out in
Figure 4.13.
2.22 Those charged with governance are responsible of generating new products and services that
for creating an appropriate oversight structure to anticipate customer demand, introducing
support the ability of the organization to create efficiencies and better use of technology,
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substituting inputs to minimize adverse social 341
value. (See Content Element 4B Governance.)
environmental effects, and finding alternative
uses for outputs.
Figure 4.13: T
he components of the business model and the environment in
which an organisation operates
Figure 2: The value creation process:
Source: IIRC 2013b, The International IR Framework, p. 13, accessed July 2015, http://www.theiirc.org/
wp-content/uploads/2013/12/13-12-08-THE-INTERNATIONAL-IR-FRAMEWORK-2-1.pdf.
www.theiirc.org © December 2013 by the International Integrated Reporting<IR>
The International Framework
Council 13
(the ‘IIRC’).
All rights reserved. Used with permission of the IIRC. Contact the IIRC (info@theiirc.org)
for permission to reproduce, store, transmit or make other uses of this document.
Guiding principles of IR
The International IR Framework has seven guiding principles. These are as follows:
A Strategic focus and future orientation
B Connectivity of information
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C Stakeholder relationships
D Materiality
E Conciseness
F Reliability and completeness
G Consistency and comparability (IIRC 2013b, p. 16).
The first principle guides the selection and presentation of content. Integrated reports should
provide insight into the organisation’s strategy and how it relates to the creation of value.
Information included in the reports should be connected to allow stakeholders to judge how
interrelationships and dependencies between various factors affect value creation. The business
model and the strategy should be linked to changes in the organisation’s environment, and the
changes in capitals over time should be linked to other information being published by the
organisation. The organisation’s relationships with its stakeholders should be reported on,
and the integrated report should enhance those relationships.
Although each of the remaining guiding principles are important for shaping the implementation of
IR, the notions of connectivity and conciseness represent perhaps the greatest shift away from how
we currently think about company reporting. According to Potter and Soderstrom (2014, p. 2):
This approach represents an important departure from existing company reporting practices,
which increasingly involve the production of financial statements in accordance with relevant
accounting standards and a separate, stand-alone sustainability report. Sustainability reports have
a much broader scope than financial statements and generally encompass the social, human,
environmental, and other dimensions of operations. According to IR advocates, having separate
reports makes the interconnections between the different dimensions of performance difficult to
understand—a deficiency that IR approaches purport to overcome.
As mentioned earlier, an important guiding principle for IR is conciseness, with many IR

advocates asserting that this form of reporting will ultimately assist in reducing the reporting
burden for many organisations. Materiality is used in a similar way to how it is used in traditional
financial reporting—to guide decisions about report content and format. The integrated report
should also satisfy the reliability, completeness, consistency and comparability tests. To achieve
conciseness, a different level of materiality is required. An integrated report should disclose those
items that the governing body of the organisation considers, or should consider, in its discussions
about the value creation activities of the organisation.
Content of IR
The IIRC does not prescribe a standard format for integrated reports. There are eight content
elements that are linked to each other, and they are not mutually exclusive (IIRC 2013b).
The organisation must consider issues under each of the eight elements, and then
decide ‘what information is reported, as well as how it is reported’ (IIRC 2013b, para. 4.3).
The organisation should consider its answers to each of the following questions for each of
the content elements in order to determine the content of its IR:
• Organisational overview and external environment: What does the organization do and
what are the circumstances under which it operates?
• Governance: How does the organization’s governance structure support its ability to create
value in the short, medium and long term?
• Business model: What is the organization’s business model?
• Risks and opportunities: What are the specific risks and opportunities that affect the
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organization’s ability to create value over the short, medium and long term, and how is the
organization dealing with them?
• Strategy and resource allocation: Where does the organization want to go and how does it
intend to get there?
• Performance: To what extent has the organization achieved its strategic objectives for the
period and what are its outcomes in terms of effects on the capitals?
• Outlook: What challenges and uncertainties is the organization likely to encounter in
pursuing its strategy, and what are the potential implications for its business model and
future performance?
• Basis of preparation and presentation: How does the organization determine what matters
to include in the integrated report and how are such matters quantified or evaluated?
(IIRC 2013b, p. 5)
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Given the principles-based nature of the IR framework, integrated reports produced by companies
differ in their form and content, although various common themes exist. Potter and Soderstrom
(2014) identify and discuss five themes:
i. summarized and thematic discussion and reporting;
ii. discussion of how social and environmental performance is integrated into management and
decision making;
iii. detailed discussion of governance;
iv. separate consolidated financial, social, and environmental statements; and
v. separate and limited or moderate assurance.
Although the above might, in some respects, seem relatively consistent with information currently
reported by companies, there are some important differences. For example, integrated reports
commonly contain summarised and thematic discussion; diagrams, figures and metrics for
financial, social and environmental performance; and stock market dividends and share information.
Integrated reports typically include a discussion of how social and environmental performance
is integrated into the management and decision-making of the company; they also map the
company’s strategic goals to its initiatives, targets and performance (Potter & Soderstrom 2014).
Integrated reports typically also feature a detailed discussion of governance, which goes
beyond a simple discussion of structures, processes and details of meetings held. Themes such
as trust, transparency and ethics are common (Potter & Soderstrom 2014). Another feature
of many integrated reports is the presentation of separate consolidated financial, social and
environmental statements (with accompanying notes describing reporting principles, policies, etc.).
For example, in the integrated report of the global healthcare company Novo Nordisk, many of
the social and environmental performance metrics are non-financial and include numbers of
patients receiving specific products, employee numbers and turnover, training cost per employee
and lost time through injury (Potter & Soderstrom 2014). Similar to sustainability reports,
integrated reports generally receive independent assurance, although not always by the same
entity that provides financial statement assurance.
You can view an example of an integrated report, by accessing the CPA Australia 2014 Integrated
Report at http://cpaaustraliaannualreport.realviewdigital.com/?iid=115043#folio=OFC.
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➤➤Question 4.12
Describe how the disclosures in an integrated report show the flow and transformation of capitals
through the organisation.
Who uses IR?

The International IR Framework identifies several categories of interested parties in an
organisation, including those charged with governance, providers of financial capital and
stakeholders. Each group is defined in the framework, and stakeholders are:
Those groups or individuals that can reasonably be expected to be significantly affected by
an organization’s business activities, outputs or outcomes, or whose actions can reasonably
be expected to significantly affect the ability of the organization to create value over time.
Stakeholders may include providers of financial capital, employees, customers, suppliers,
business partners, local communities, NGOs, environmental groups, legislators, regulators,
and policy-makers (IIRC 2013b, p. 33).
The financial reporting ‘Framework for the preparation and presentation of financial statements’
(AASB 2009, para. 9) recognises users of financial statements as investors, employees, lenders,
suppliers and other trade creditors, customers, governments and their agencies, and the
public (AASB 2009). Although this extensive list appears to give equal recognition to all users,
the financial reporting framework makes it clear that financial statements cannot meet the needs
of all users. However, as investors are the providers of risk capital, meeting their needs would also
‘meet most of the needs of other users that financial statements can satisfy’ (AASB 2009, para. 10).
The International IR Framework may seem to place greater emphasis on meeting the needs of
parties who do not have a financial investment in the organisation than on financial reporting.
Despite this, the IR framework states that the ‘primary purpose of an integrated report is to
explain to providers of financial capital how an organisation creates value over time’ in both
financial and other ways (IIRC 2013b, para. 1.7). This is clearly more narrow than the interests
of the user groups that integrated reports are likely to actually serve, perhaps indicating the
importance of meeting the needs of financial capital providers of IR if this form of reporting is
to become the norm in future.
What is the relationship between IR, financial reporting and

sustainability reporting?
IR is seen as being consistent with, and supportive of, developments in corporate reporting around
the world. The words ‘corporate reporting’ have been chosen deliberately to represent the suite
of public reporting that an organisation does. IR is not an evolution of either financial reporting
or sustainability reporting. (Sustainability reporting typically covers environmental, social and
governance issues and is discussed in more detail in Part C of this module). The integration of
these and other reports help concisely tell the value creation story of the organisation.
The IIRC believes that integrated reports have the potential to replace current disconnected and
static reports under a number of different approaches. IR is not designed to be an additional report
that is required to be produced by an organisation. It is intended to be a linking document that
makes the connectivity of information explicit to provide a more holistic view of the organisation
(IIRC 2013b). It is in this way that advocates of IR believe that it will ultimately result in reducing
the reporting burden facing companies.
The IIRC’s statements on the place for IR make it clear that it is not seeking to provide guidance
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on a type of sustainability or environmental reporting that organisations can use to demonstrate

their efforts in this area. The IIRC is seeking to redefine the nature of corporate reporting
(for both the public and private sectors) and to change the way that organisations operate
and think about their resources.
The International IR Framework is available from the IIRC’s website (www.theiirc.org).
➤➤Question 4.13
What is the difference between a sustainability report and an integrated report?
What type of organisations could benefit from IR?

The International IR Framework (IIRC 2013b, para. 1.4) indicates that it is primarily written for
private sector, for-profit organisations of any size, but it can be applied and adapted as necessary
for public sector and not-for-profit organisations (NFPs). In fact, it could be argued that the
framework is better suited to these organisations, which have less emphasis on financial returns
than for-profit organisations. As outlined in Example 4.7, KPMG has published an article to help
guide public sector organisations in the development of their IR (KPMG 2012).
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While the opportunity to recognise and report on multiple sources of capital represents a bold
new approach for many for-profit organisations, most NFPs are already actively pursuing ‘shared
value’ (Porter & Kramer 2011), with a social or environmental mission accompanying economic
and financial imperatives and strict governance requirements. In addition, there has recently
been rapid growth in the number and impact of NFPs adopting business- or organisation-like
approaches to service delivery (e.g. social enterprises, social businesses and cooperatives) that
would be well suited to the IR concept. Perhaps not surprisingly, various initiatives are underway
globally to enable the adoption of IR approaches in the public sector and NFP organisations.
For example, the IIRC has developed a Public Sector Pioneer Network to explore why and
how the public sector should be adopting IR. Organisations already signed up include the
World Bank Group, United Nations Development Programme, the City of London Corporation,
the Welsh Government and UK government departments (IIRC 2015).
Example 4.7: IR for public entities

KPMG notes that public sector bodies are usually required to provide a service while achieving
governance excellence in a financially, economically, socially and environmentally sustainable manner.
They are not normally mandated to make a profit, but to deliver a service. As such, stakeholders are
likely to place more weight on the organisation’s ability to deliver the service than to achieve a financial
surplus. In addition, there is a wide range of stakeholders with varied expectations and information
needs, and who have an interest in the performance of a public sector organisation.
KPMG points out that there is increasing pressure for public sector organisations to demonstrate high
performance, and there is greater scrutiny of their ability to achieve outcomes for a reasonable financial
cost. The IR model can help these organisations because it is a business approach to reporting that
embraces stakeholder inclusivity as well as all dimensions of sustainability (KPMG 2012).
Potential pathways to developing an integrated report

Once the decision is made to move to IR, the IIRC recognises that there are a number of
alternative pathways available for. Each of these approaches needs to remain compliant with
regulatory requirements as well as the requirements dictated by an organisation’s constitution
or mission. For example, some organisations may choose to produce a concise, stand-alone
integrated report in addition to the necessary financial compliance filings. Other organisations
may choose, as an interim step, to produce a combined annual report and sustainability report;
this affording them the opportunity and time to further develop systems to measure reliable
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longitudinal data and indicators, to explore materiality and integration within an organisation
and to leverage the learning and best practice that will become available as IR matures. It may also
work for other organisations to explore how existing reporting systems (including management
commentary, operating and financial reports, and strategic information that are used to frame
existing reports) may be adapted to accommodate an IR approach. This exploration can provide
internal benefits to an organisation, even if the report is not publicly released in the first few years.
The journey towards producing an integrated report will be unique for each organisation. As a
next logical step in corporate reporting, IR is expected to mature and to ensure that reporting is
more holistic, strategic, responsive, material and relevant across multiple time frames.
Summary
This part discussed the development of IR and its ability to allow an organisation to tell its value
creation story. The way IR differs from other reporting models has been considered, and the new
International IR Framework was explained. The main components of IR have been explored,
and the types of organisations to which it can be applied have been examined.
Part C: Non-financial reporting

frameworks
Introduction
Part C of this module provides a summary of some of the major non-financial reporting
frameworks. The demand for sustainability reporting and the role of international organisations
in its development are considered. This part also examines the factors associated with the
increased relevance of sustainability issues in business, which has led many companies to
adopt sustainability reporting. As part of this discussion, the Global Reporting Initiative (GRI)
and its G4 guidelines for reporting are reviewed, as are other forms of non-financial reporting,
including company disclosures to the CDP (formerly known as the Carbon Disclosure Project),
water accounting and reporting of natural capital. This part also reviews the role of auditing
and assurance in sustainability reporting and considers the role of accountants in new forms of
accounting and auditing.
Sustainability reporting
Factors affecting demand for sustainability reporting
There is a growing view that sustainability reporting is becoming more mainstream and more
likely to fall within the remit of the chief financial officer (CFO) (EY & BC 2014; KPMG 2013).
The increased emphasis on sustainability issues provides an opportunity for the CFO in an
organisation to analyse, in economic terms, how to better manage the entity’s consumption of
natural resources and formally incorporate environmental, social and governance factors in formal
risk assessment processes. Company management faces the internal organisational challenge
of simultaneously trying to manage environmental and social performance for the benefit of the
community (external stakeholders) while maintaining financial performance for shareholders.
Sustainability issues are relevant for business on a number of levels. Hopwood et al. (2010)
argue that leaders of organisations have ethical responsibilities to create a sustainable society.
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In addition, they argue there is a business case for operating in an environmentally and socially
sustainable manner. Both the ethical and business-based duties are multifaceted and are likely
to involve complex decisions balancing desired outcomes in economic, environmental and
social spheres.
One important element of the business case is that regulation related to climate change is
becoming a significant driver of the costs and benefits to business, although the impacts vary
across different types of business. For example, large businesses in Australia that are high
emitters of greenhouse gases are required, if they exceed the relevant thresholds, to report
their greenhouse gas emissions, greenhouse gas projects, energy use and production under the
National Greenhouse and Energy Reporting Act 2007 (Cwlth) (the NGER Act).
Businesses in different industries are further affected by different legislation. Electricity producers,
being a major factor in greenhouse gas emissions, are likely to be greatly affected by climate
change and related regulations. Less obviously, real estate businesses in Australia could also be
affected by the Building Energy Efficiency Disclosure Act 2010 (Cwlth). Most sellers or lessors
of office space with a net lettable area of 2000 square metres or more are currently required to
obtain and disclose an up-to-date energy efficiency rating (Commercial Building Disclosure 2014).
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In addition to the direct effects of specific regulations, the business case for sustainability
considers other effects on the business, from changing relations with customers, suppliers and
other stakeholders, to the costs and risks of doing business. A rapidly growing body of research
evidence indicates a positive relationship between a business’s credibility on sustainability issues
and its ability to win and retain customers (Hopwood et al. 2010; Lev et al. 2010). This body of
work also draws links between a focus on sustainability and increasing competitive advantage
through innovation and new products, and the business’s ability to attract, motivate and retain
staff. The business is likely both to manage risk better if it has a conscious focus on sustainability
risks and to reap the rewards of direct cost reductions through operational efficiencies and by
avoiding waste, travel and regulatory costs. The increase in business profitability and ability to
manage risk will also benefit the business’s reputation and brand, including its licence to operate
and its ability to raise external funds.
Risk management is further explained in Module 5.
The cost of not adjusting to climate change, for example, can be felt in direct and indirect ways.
The cost of exposure to increasingly common extreme weather events (e.g. floods and heatwaves)
and weather-related events (e.g. bushfires) can be transmitted directly to the business through
increases in the price of resources, including energy and water. Indirect costs could be felt if social
dislocation from these weather events leads to an increasing incidence of disease (e.g. dengue
fever in the southern states of Australia) and heat-related deaths, and subsequent lower demand
for products. For example, Unilever announced in 2014 that climate change was costing the
company EUR 300 million a year (this will be explored further in Example 4.11) (CIMA 2014).
There is a growing sense that traditional financial reporting is not sufficient, or even not working,
particularly given the broader accountabilities that modern organisations appear to face.
The landscape for non-financial reporting has changed at different speeds in different countries
and regions. Governments are making policy changes, and the consequential procedural
changes impose new reporting requirements on companies. In its 2013 survey analysing the
reports of more than 4100 companies globally (including the world’s 250 largest companies),
KPMG concluded that ‘the high rates of CR [corporate responsibility] reporting in all regions
suggest it is now standard business practice worldwide’ (KPMG 2013, p. 11). The survey also
identified that much of this increase was associated with increased regulatory requirements.
In addition, some company managers are voluntarily adopting new reporting practices in
response to the desire for better information for a wider range of stakeholders.
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The responsibility for sustainability reporting varies across entities. In some organisations,
sustainability is part of the finance function. In other organisations, the sustainability unit is
treated as part of operations, and the focus is on controlling waste and energy rather than
reporting to stakeholders. However, changes in technology such as XBRL (a standardised format
that facilitates the exchange and analysis of financial information) and web-based reporting
are in some cases assisting and speeding the dissemination of information. Technology is
also prompting a change in responsibility for sustainability away from operations and towards
combining sustainability and financial reporting functions. However, there is a risk that users
will be overwhelmed by the volume of information. Users could be helped by the provision of
more summarisation and categorisation—tasks that are traditionally the function of accountants.
The new information is neither necessarily financial nor drawn from the traditional reporting
systems within companies. This opens up the possibility that non-accountants will establish
themselves as leaders in information and reporting systems for sustainability, climate change,
water and other non-financial matters.
➤➤Question 4.14
How could higher credibility on sustainability issues affect a business’s relations with staff
and customers?
Example 4.8: Climate change science

The science of climate change is reviewed in a publication from the then Climate Commission,
The Critical Decade: Climate Science, Risks and Responses 2013 (Steffen & Hughes 2013). The report
discusses popular debate about the science of climate change. It states that the effects of climate
change can already be felt in Australia and elsewhere, and with less than one degree of global warming,
the economic, environmental and societal risks of future change are serious (Steffen & Hughes 2013,
p. 60).
Chapter two of The Critical Decade describes the risks associated with a changing climate. Businesses
could suffer negative impacts from each major risk reviewed in the document. For example:
• Sea level rise—likely to impact greatly on businesses in coastal locations and could cause possible
damage to infrastructure in these areas. Examples of specific negative impacts include damage
to ports, roads, water and sewerage plants, as well as population relocation.
• Ocean acidification—most directly affecting fish stocks and tourism (e.g. Great Barrier Reef).
• Water cycle—droughts, floods, less certainty around water supply, change in agricultural use of
land and flow-on impact on water prices and availability.
• Extreme events—bushfire, storms, cyclones (likely to affect food availability and prices), hail damage
(e.g. consider the effect on car yards), temperature extremes (e.g. consider related health effects
on elderly, young or vulnerable people and the strain on government services) and the impact of
all events on customers’ disposable income.
• Abrupt, non-linear and irreversible changes in the climate system—tipping points. For example,
droughts could become permanent changes rather than events followed by recovery. These could
force businesses to relocate (Steffen & Hughes 2013).
Positive impacts could include additional rainfall and/or warmer temperatures in areas south or north of
the tropics. For example, this could make wine-growing more viable in areas that are currently too cold.
Global Reporting Initiative (GRI)

For well over a century, organisations have been reporting information about their non-financial
performance to meet the demands of various stakeholders. Some of the information has been
required under various laws and regulations, and some information has been disclosed voluntarily
to meet the demands of various stakeholders. Since the last decade of the 20th century,
organisations have increasingly disclosed information about their social and environmental
performance and impact.
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A leading organisation in the development and promotion of sustainability reporting since 1997 is
the Global Reporting Initiative (GRI). The GRI’s reporting framework is currently the most extensively
used reporting framework for these reports (KPMG 2013). The GRI is a multi-stakeholder, non-profit
organisation. It has strategic partnerships with the UN, and although it is independent, the GRI has
its roots in the environmental movement in the United States (GRI 2014).
In March 2009, the GRI board of directors issued a declaration, the so-called ‘Amsterdam
Declaration’, in which they stated that the lack of transparency in the existing system for
corporate reporting was the central problem that caused the 2008 GFC.
The GRI declaration states that:

The root causes of the current economic crisis [GFC] would have been moderated by a global
transparency and accountability system based on the exercise of due diligence and the public
reporting of environmental, social and governance performance (GRI 2006, p. 3).
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The GRI has called for sovereign governments to show leadership in corporate sustainability
disclosure and to extend and strengthen the global regime of sustainability reporting.
In particular, the GRI recommends that ‘assumptions about the adequacy of voluntary
reporting must be re-examined’ (GRI 2009, p. 17).
The purpose of sustainability reporting as stated by the GRI is:

… the practice of measuring, disclosing, and being accountable to internal and external
stakeholders for organisational performance towards the goal of sustainable development
(GRI 2006, p. 3).
The GRI also recognises that sustainability reporting is consistent with triple bottom line and
corporate responsibility reporting.
The GRI reporting framework is a practical application of sustainability reporting. Many countries
do not have specific standards on sustainability reporting and are therefore adopting the
comprehensive framework provided by the GRI. There have been several versions of the GRI
sustainability reporting guidelines. G4, the latest version, was launched in mid-2013. The guidelines
can be accessed via the GRI website: http://www.globalreporting.org.
G4 guidelines
Introduction
The fourth major version of the GRI reporting guidelines (G4) was issued in May 2013; it applies
to sustainability reports issued after 31 December 2015, or earlier for new reporters and those
organisations wishing to make the transition before that date. (Note: The G4 guidelines follow
a series of earlier guidelines for sustainability reporting, the most recent of which was G3
(issued in 2006) and G3.1 (issued in 2011)). The following discussion initially explains the aim and
focus of the G4 guidelines, then outlines some of its key features, addresses differences between
the G4 and earlier sets of the guidelines, and finally considers the implications of the guidelines
for accountants.
Aim and focus of G4 guidelines

The aim of the G4 guidelines is to assist any organisation in making the best possible sustainability
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disclosures, in any type of reporting format. Some organisations issue stand-alone sustainability
reports or make specific sustainability-related disclosures, while other organisations incorporate
their sustainability reports into their annual reports. The new guidelines address these reporting
situations and other forms of sustainability disclosures. They also apply to integrated reports,
which were discussed in Part B of this module (GRI 2013a).
The GRI recognised that changes in the reporting landscape, particularly the development of an
integrated reporting framework by the International Integrated Reporting Council (IIRC) as well as
other reporting standards, combined with growing interest from both reporters and stakeholders
in sustainability topics, have increased the demand for higher-quality sustainability reporting
guidance. There are many influences on sustainability reporting that have been recognised by
the GRI in the development of the new guidelines, including:
• Organization for Economic Co-operation and Development (OECD), ‘OECD Guidelines for
Multinational Enterprises’ (OECD 2011).
• United Nations (UN) ‘Guiding Principles on Business and Human Rights, Implementing the
United Nations ‘Protect, Respect and Remedy’ Framework’ (UN 2011).
• United Nations Global Compact (UNGC), ‘Ten Principles’ (UNGC 2015).
• ISO 26000 (GRI 2013a, p. 8).
The project to develop G4 aimed to meet the need for better technical quality of the guidelines
and to enable greater harmonisation with other reporting standards and frameworks in a more
accessible document (GRI 2013a).
The G4 guidelines are laid out in a two-part document. The first part, G4 Sustainability Reporting
Guidelines: Part 1 Reporting Principles and Standard Disclosures, explains the principles of the
GRI approach to sustainability reporting and the standard disclosures that should be included in
a sustainability report. The first part also contains the criteria to be applied by any organisation in
preparing its sustainability report in accordance with the G4 guidelines (GRI 2013b). The second
part, G4 Sustainability Reporting Guidelines: Part 2 Implementation Manual, explains how to
apply the principles, how to prepare the information to be disclosed and how to interpret the
various concepts in the guidelines. The documents also contain definitions, references, a glossary
and notes to support the main content (GRI 2013c).
Key features
Reporting principles
The G4 guidelines are based on a set of reporting principles. The principles govern the content
and quality of the sustainability report. The principles are similar to those that govern financial
reporting because they both focus on providing information to stakeholders for decision-making.
The reporter has to consider how to apply the principles and is encouraged to engage with
stakeholders in a learning process to improve an organisation’s accountability and the credibility
of its reports. The GRI does not judge the outcome or quality of the organisation’s process for
defining report content, or the report itself. Instead, the GRI emphasises its impartiality and
reinforces the role of stakeholders in assessing the reporting performance of the organisation
(GRI 2013a).
The G4 reporting principles cover both the report content and report quality. They are designed to
guide sustainability report preparers in their choices about what to disclose and how to present the
information, with the aim of providing high quality information that aids transparency, and enables
stakeholders to make informed assessments of sustainability performance (GRI 2013b, p. 17).
Principles for defining report content are:

• Stakeholder inclusiveness—identifying the organisation’s stakeholders and explaining how
their expectations and interests have been responded to;
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• Sustainability context—presenting the organisation’s performance in the wider context of

sustainability;
• Materiality—reporting performance in a way that reflects the organisation’s significant
economic, environmental and social impacts, or that substantively influences the assessments
and decisions of stakeholders; and
• Completeness—providing sufficient coverage of material sustainability issues in reports and
allowing assessment of the organisation’s performance (GRI 2013b).
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Materiality is a key principle governing the content of the report because its application
determines what sustainability issues the organisation chooses to report on. It has an
increased focus in G4 than in earlier guidelines, as the GRI is attempting to ensure that
sustainability reports focus on what really matters to stakeholders, rather than presenting a
shopping list of sustainability factors and forcing stakeholders to identify those that really
matter to the organisation or its stakeholders. By doing so, the guidelines help reporters by
avoiding the unnecessary burden of reporting irrelevant issues. The focus, in turn, is maintained
on the key issues in the sustainability report, which is designed to facilitate a more meaningful
dialogue between reporters and stakeholders (GRI 2013a). Material aspects are defined by the
G4 guidelines as:
… those that reflect the organization’s significant economic, environmental and social impacts;
or that substantively influence the assessments and decisions of stakeholders. To determine if
an Aspect is material, qualitative analysis, quantitative assessment and discussion are needed
(GRI 2013b, p. 92).
Principles for defining report quality are:

• Balance—presenting both positive and negative aspects of performance;
• Comparability—offering consistency in content and presentation;
• Accuracy—being sufficiently accurate to enable assessment of performance;
• Timeliness—reporting on a regular schedule and in a timely fashion;
• Clarity—presenting information in a form that is understandable; and
• Reliability—dealing with information in a way that enables it to be subject to
examination (GRI 2013b).
The report quality principles echo the principles or desired qualitative characteristics of
information in the financial reporting framework, such as comparability, understandability and
being error-free. The first principle, balance, is similar to the accounting principle of freedom
from bias, which is part of reliability, and directly refers to the issue that choice of content
and format should not inappropriately influence those who use the sustainability information.
Balance addresses a key concern of users of sustainability reports: that organisations are using
sustainability reporting as a public relations tool by presenting only positive news rather than
an unbiased accounting of the impacts of an organisation’s activities. Other mechanisms
of addressing this concern, such as obtaining independent assurance, are covered later in
this module.
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Building blocks
The content of sustainability reports prepared under the G4 guidelines is shaped by a three-level
structure comprising categories, aspects and individual indicators. Three categories are the main
focus of the guidelines:
1. economic;
2. environmental; and
3. social.
Within each category are various aspects and specific measures that shape the information to be
reported by organisations.
Table 4.9 is taken from the G4 guidelines and illustrates the structure.
Table 4.9: Categories and aspects in the guidelines
Category Economic Environmental
Aspects • Economic Performance • Materials

• Market Presence • Energy
• Indirect Economic Impacts • Water
• Procurement Practices • Biodiversity
• Emissions
• Effluents and Waste
• Products and Services
• Compliance
• Transport
• Overall
• Supplier Environmental Assessment
• Environmental Grievance Mechanisms
Category Social
Sub-Categories Labor Practices Human Rights Society Product Responsibility

and
Decent Work
Aspects • Employment • Investment • Local • Customer Health

• Labor/ • Non- Communities and Safety
Management discrimination • Anti- • Product and
Relations • Freedom of corruption Service Labeling
• Occupational Association • Public Policy • Marketing
Health and and • Anti- Communications
Safety Collective competitive • Customer Privacy
• Training and Bargaining Behavior • Compliance
Education • Child Labor • Compliance
• Diversity • Forced or • Supplier
and Equal Compulsory Assessment
Opportunity Labor for Impacts
• Equal • Security on Society
Remuneration Practices • Grievance
for Women • Indigenous Mechanisms
and Men Rights for Impacts
• Supplier • Assessment on Society
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Assessment • Supplier
for Labor Human Rights
Practices Assessment
• Labor • Human Rights
Practices Grievance
Grievance Mechanisms
Mechanisms
Source: Global Reporting Initiative (GRI) 2013b, G4 Sustainability Reporting Guidelines: Part 1
Reporting Principles and Standard Disclosures, accessed June 2015, https://www.globalreporting.org/
resourcelibrary/GRIG4-Part1-Reporting-Principles-and-Standard-Disclosures.pdf.
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Boundaries
When deciding on the content of the report, the organisation needs to determine where the
reporting boundary lies. A boundary of a topic specifies where the impacts occur: within or
outside the organisation. It is not relevant under G4 whether the organisation exerts control
or significant influence over a particular entity (GRI 2013c). The impacts that make an aspect
material can occur within or outside the organisation, or both, and the material aspects included
in a report can have different boundaries. This means that an organisation might choose to report
details of various material aspects, which differ in the range of their impacts.
The G4 implementation guidance gives examples of issues that have different reporting
boundaries for a hypothetical organisation. In the example, the organisation discloses the
following in its sustainability report:
(i) anti-corruption issues that are relevant only to the organisation and its subsidiaries;
(ii) child labour issues that are relevant only to suppliers (not the organisation itself); and
(iii) emissions issues that are relevant to both distributors (outside the organisation) and joint
ventures (within the organisational boundaries) (GRI 2013c).
Enough detail should be provided in the report so that readers can identify exactly where,
inside and outside the organisation, impacts are occurring (GRI 2013c).
General standard disclosures

Once the material aspects are identified within each category, the reporter identifies the
disclosures required. If the organisation is in certain sectors (e.g. mining) additional disclosures
might be required. The implementation manual (GRI 2013c) provides guidance on how to make
the disclosures.
General standard disclosures (GSDs) are applicable to all organisations preparing sustainability
reports. The GSDs are divided into seven parts:
• Strategy and Analysis;
• Organisational Profile;
• Identified Material Aspects and Boundaries;
• Stakeholder Engagement;
• Report Profile;
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• Governance; and
• Ethics and Integrity (GRI 2013b).
In each of these categories, there is a set of basic disclosures that an organisation is required to
make. The G4 guidelines provide 58 GSDs. If the reporter chooses to report ‘in accordance—core’,
it has to report on 34 GSDs. If the reporter choose to report ‘in accordance—comprehensive’, it has
to report on all 58 GSDs. Both options are available for an organisation of any type, size, sector or
location (GRI 2013b). The choice between the two options is driven by the organisation’s reporting
needs and, ultimately, the stakeholders’ information needs. The choice should not be driven by the
organisation’s performance (GRI 2013b). In summary, the ‘comprehensive’ GSDs are deeper and
more extensive, particularly in the areas of governance, ethics and integrity, and are likely to be
more suitable for organisations with better systems (to reduce the additional costs of disclosure)
and with greater stakeholder information needs.
For example, the GSD for strategy and analysis (G4-1) is required for both the ‘core’ and
‘comprehensive’ options. It provides a general strategic view of the organisation’s sustainability,
and context for other sections of the report, by giving insight on strategic topics. The requirements
are as follows:
a. Provide a statement from the most senior decision-maker of the organization (such as CEO,
chair, or equivalent senior position) about the relevance of sustainability to the organization
and the organization’s strategy for addressing sustainability.
The statement should present the overall vision and strategy for the short term, medium term,
and long term, particularly with regard to managing the significant economic, environmental
and social impacts that the organization causes and contributes to, or the impacts that can
be linked to its activities as a result of relationships with others (such as suppliers, people or
organizations in local communities. The statement should include:
• Strategic priorities and key topics for the short and medium term with regard to
sustainability, including respect for internationally recognized standards and how such
standards relate to long term organizational strategy and success
• Broader trends (such as macroeconomic or political) affecting the organization and
influencing sustainability priorities Key events, achievements, and failures during the
reporting period
• Views on performance with respect to targets
• Outlook on the organization’s main challenges and targets for the next year and goals
for the coming 3–5 years
• Other items pertaining to the organization’s strategic approach (GRI 2013b, p. 24).
If the organisation is reporting ‘in accordance—comprehensive’, it would make additional

disclosures for strategy and analysis under G4-2 which requires a description of key impacts,
risks and opportunities (GRI 2013b).
Example 4.9: Oz Minerals

For the 2014 year, the mining company OZ Minerals prepared its sustainability report in accordance
with the GRI G4 Core Reporting Guidelines. Following the requirements of the GRI, the ‘statement
from the most senior decision-maker’ comes from Andrew Cole, Managing Director and CEO.
To address the ‘the overall vision and strategy‘ requirement, Oz Minerals outlines its current strategy as:
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… delivering superior shareholder returns built upon a foundation of Governance and

Zero Harm, with the following five key elements: a focus on copper, maximising current
assets, building a project pipeline, investing in exploration and exercising disciplined capital
management (OZ Minerals 2015).
The section of the Oz Minerals report outlining ‘Broader trends‘ details a new agreement with the
South Australian government to work together to facilitate the development of copper projects in
South Australia and various other initiatives aimed at:
… leveraging greater value from its collection of assets in South Australia. These initiatives
include a pre-feasibility study of rail infrastructure to transport ore to be produced at
Carrapateena to Prominent Hill for processing into concentrate, and … a demonstration plant
for a hydrometallurgical process that, based on pilot plant results, can significantly upgrade
copper concentrate, improving its value and reducing costs (OZ Minerals 2015).
Various other disclosures are included in OZ Minerals sustainability report to meet the
requirements of this GSD. The above are provided as examples of some of the disclosures.
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Specific standard disclosures

Specific standard disclosures (SSDs) are organised by the categories and aspects outlined
earlier, and need to be reported only for the material aspects identified by the organisation.
They include disclosures on management approach (DMA) and indicators of performance.
For each identified material aspect, the organisation should disclose the general DMA and
at least one indicator to meet the ‘core’ option. If the ‘comprehensive’ option is chosen,
the organisation should disclose the general DMA and all indicators related to the material
aspect (GRI 2013a). An example of an SSD with regard to water resources is outlined in
Example 4.10.
Example 4.10: S
pecific standard disclosures in the
environmental category
An organisation might identify that its use of, or effect on, water resources is significant and therefore
‘material’. As part of the overview of the use of input water, the organisation should report:
• disclosures on management approach (DMAs);
• indicators for total water withdrawal by source;
• water sources significantly affected by withdrawal of water; and
• percentage and total volume of water recycled and reused (GRI 2013c).
At least one indicator should be reported if ‘in accordance—core’ is chosen, and all indicators should
be reported if ‘in accordance—comprehensive’ is chosen. In both cases, the DMA is required; it should
explain why the water use is material and how the organisation manages its use of water and its
policies in this area.
These elements can be seen in the Oz Minerals sustainability report for 2014. In a section of their
report headed ‘Environmental performance’, the company details information about various ‘aspects’
as required under the GRI framework, such as water, energy, effluents and waste. Within each of those
aspects relevant indicators are provided. For the company, water is the most used natural resource at
the Prominent Hill site, which is in a location with a relatively low average annual rainfall of less than
200 millimetres per year. Because of this, the site depends on the supply of groundwater to sustain its
operation and draws its water from the Boorthanna Formation geological unit of the Arckaringa Basin.
As such, water input and water discharged offsite are listed as indicators of the company’s environmental
performance and impact in relation to this aspect.
This section also includes a number of indicators relating to various other environmental aspects
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including:
• energy—energy use in gigajoules;
• emissions—total greenhouse gas emissions (CO2 equivalent emissions); and
• biodiversity—land disturbance and land rehabilitated.
Review the Oz Minerals report to become more familiar with the types of information presented at:
http://www.ozminerals.com/uploads/media/oz-minerals-2014-sustainability-web-37b03826-8ed8-
4d70-8e69-00a96f89d4d4-0.pdf.
Source: OZ Minerals 2015, Sustainability Report 2014, accessed November 2015, http://www.ozminerals.
com/uploads/media/oz-minerals-2014-sustainability-web-37b03826-8ed8-4d70-8e69-00a96f89d4d4-0.pdf.
Telstra is another company that produces its sustainability report in accordance with Global Reporting
Initiative G4-Core Sustainability Reporting Guidelines. Telstra’s report can be accessed at:
http://www.telstra.com.au/aboutus/community-environment/reports/sustainability-report/.
Implications for accountants

There appear to be several types of implications of the GRI G4 guidelines for accountants.
First, the G4 guidelines are part of a process towards greater integration of financial and non
financial reporting, consistent with the IR initiative discussed earlier in this module. The GRI
acknowledges that the framework developed for IR by the IIRC created the need for greater
guidance on sustainability reporting under the GRI framework. The GRI has also attempted
to align its framework with other pronouncements, such as those issued by the OECD and
the UN covering multinational organisations and human rights. Country-specific legislation
for emissions control, environmental protection, anti-corruption and governance also
potentially affect accountants in their development of data collection and reporting systems.
Greater harmonisation of guidelines issued by the GRI, with the principles and detailed
requirements in such pronouncements, should relieve accountants at least partially from
competing pressures for data collection and information reporting. Although sustainability
reporting may be under the control of the public relations department in some organisations,
rather than in the finance function, greater integration of financial and non-financial reporting
suggests a greater involvement for accountants in the future.
Second, the GRI has recognised the increasing importance of supply chains in sustainability
reporting, as well as in risk management within organisations. It has introduced specific new
disclosures for supply chains in G4 and radically altered its approach to the boundary concept
when determining what should be included in a sustainability report. Although the boundary
concept moves away from that which is familiar to accountants from standards on business
combinations, it could be argued that it more closely reflects the realities of supply chains and
their role in modern business.
Third, the G4 guidelines continue to recognise the importance of external assurance for
sustainability reporting, although external assurance of the report is not a GRI requirement.
Accountants are not the only assurance providers for these types of reports, but many accounting
firms do offer sustainability assurance services, as well as advice on sustainability reporting and
general business and risk management. There is the potential for the development of integrated
financial and non-financial assurance to reflect the integration of sustainability and financial reports.
➤➤Question 4.15
MODULE 4
Why does the GRI believe that the GFC could have been averted, or less severe, with better
reporting?
Carbon Disclosure Project (CDP)

Regardless of whether they use the GRI guidelines, sustainability reports are generally publicly
available as part of an entity’s demonstration of its commitment to good performance on social,
governance and environmental issues. However, companies are also making other types of
disclosures about their environmental performance. One example is the disclosure of the
company’s impact on environmental and natural resources to stakeholders through the CDP.
The CDP, originally the Carbon Disclosure Project, was established to be a repository of information
about carbon emissions and other aspects of climate change that could be accessed by interested
parties (CDP 2013a). The Carbon Disclosure Project invited companies around the world to
complete its questionnaires. The information was then made available to various stakeholders,
including investor and other parties who are involved in supply chains with the companies.
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Initially, the Carbon Disclosure Project questionnaires were reasonably limited in focus, with an
emphasis on carbon emissions, energy and climate. The questionnaires are now broader in focus,
covering a wider spectrum of the earth’s natural capital, including water and forests. Consistent
with this broader focus, the organisation changed its name from the Carbon Disclosure Project to
CDP (CDP 2013a).
As a result of the broad coverage of entities and issues in its questionnaires, the CDP claims to
hold the largest global collection of self-reported climate change, water and forest-risk data
(CDP 2013a).
A special project of the CDP is the Climate Disclosure Standards Board (CDSB). The board
has developed a climate change reporting framework that is intended for use by companies
making climate change disclosures in their mainstream financial reports. It is about linking
financial and climate change-related reporting to provide policymakers and investors with clear,
reliable information for robust decision-making. It has a similar objective to the integrated
reporting initiative but with regards to a specific issue.
The CDP believes that this collection of carbon and other disclosures helps investors and other
stakeholders understand and manage the risks of investment and doing business with the
organisations that provide the information.
Companies benefit from this gathering, managing and reporting of data on climate change
because this information is becoming an increasingly important aspect of standard business
practice. According to the CDP, specific benefits of responding to the CDP questionnaire include:
• Increased transparency to shareholders, clients and the public audience.
• Identifying how the organization copes with threats arising from climate change.
• Highlighting the business opportunities available.
• Enhanced ability to increase efficiency and reduce unnecessary costs (CDP 2013b).
The information provided to the CDP by companies is increasingly being used by other parties to
develop sustainable supply chains. Due to either legislation or market lobbying, organisations are
now becoming more conscious of climate and environmental performance over their whole
supply chain. These organisations are now exchanging information with other parties to enable
a better assessment of their total climate and environmental performance. Information on
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supply chains is important for companies because disruptions to the expected flow of products,
or problems with the final end product that can be traced back to suppliers, can severely
adversely impact company profits (see Example 4.11). CDP and Accenture (2014) reported that
suppliers reporting their supply chain analysis realised USD 11.5 billion from emissions-reduction
investments in 2013. Seventy-two per cent of suppliers identified a current or future risk to their
business from climate change, while 56 per cent identified an opportunity (e.g. that consumers
are increasingly becoming more receptive to low-carbon products and services).
Example 4.11: Sustainable supply chains

Supply chains are the journey from raw materials to finished product. The Council of Supply Chain
Management Professionals defines supply chain management as encompassing:
… the planning and management of all activities involved in sourcing and procurement,
conversion, and all logistics management activities. Importantly, it also includes coordination
and collaboration with channel partners, which can be suppliers, intermediaries, third party
service providers, and customers. In essence, supply chain management integrates supply
and demand management within and across companies (CSCMP 2014).
The raw material may come from an agricultural or mining process. At each stage in the supply chain,
the addition of labour and other forms of capital transform the product from one state to another. For
example, raw materials are transformed into components, which are in turn built into products (e.g.
cars, computers). In some cases, the product may be moved from one location to another without
any further processes or repackaging but as part of a service, such as from a wholesaler to a retailer.
In 2014, Unilever, a large Anglo–Dutch company that produces ‘foods … ice creams … soaps, …
shampoos and everyday household care products’ (Unilever 2014a), announced that the impact of
climate change cost the company USD 300 million a year as a result of drought and flooding. As part
of its value chain analysis and analysis of its global greenhouse gas (GHG) footprint, Unilever found
that sourcing raw materials accounts for about a quarter of its value chain impacts, while people using
their brands at home accounts for over two-thirds.
Heated water for showering and washing hair are the most material impacts in Unilever’s value chain
GHG footprint. While it concluded it was making good progress in the areas of the value chain that it
could control (e.g. manufacturing), it found the consumer use phase harder to address. It is dependent
on a wide range of external factors, such as the energy used in consumer appliances (e.g. washing
machines, hot water heaters) and the carbon intensity of the energy supplied to people’s homes,
as well as consumer behaviour (Unilever 2014b).
➤➤Question 4.16
(a) What is a supply chain?
(b) Why would a company be interested in environmental information for other parties in its
supply chain?
Water accounting
Awareness of limited water resources is increasing. Limited water resources represent a huge risk
to human life and commercial activity. As discussed in Module 2, while 70 per cent of the earth’s
surface is water, less than 1 per cent of this is fresh water suitable for human use. Water availability
is especially a risk in Australia, which is one of the driest continents on earth. Consequently, it is not
surprising that Australia leads the way in water accounting and associated assurance. Consistency
in the way that volumes and values of water allocated and traded across Australia are accounted for
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should result in beneficial economic, social and environmental outcomes.
Traditionally, entities that managed water resources, such as reservoirs, reported their water
holdings in litres (megalitres or gigalitres). Such reports showed the physical volume of the water
and were intended primarily for use by water managers and their direct customers, rather than
external users of water information. In addition, the reports were not standardised, and water
accounting or reporting was developed in an ad hoc fashion (Bureau of Meteorology 2011c).
The prolonged drought in Australia during the first decade of the 21st century created pressure
for better management of water in rivers, reservoirs and other storages. Accurate data is critical to
water allocation decisions, and the National Water Initiative (NWI) of the Australian government
provides for legislation to govern the presentation of general purpose water accounting reports
(GPWAR) by bodies responsible for water storages (Bureau of Meteorology 2011c). The Australian
government’s vision for water reporting is that there will be:
• a range of water organisations regularly producing GPWARs;
• a set of national water accounts; and
• use of the GPWAR by the water industry to make water-related decisions (Bureau of
Meteorology 2011b).
Study guide | 359
Water volumes and water ‘balance sheets’ are to be reported for each entity and, on a
consolidated basis, for the entire country. This approach to water accounting is based on a
double-entry accrual system of accounting for water, using water volume as a base unit rather
than currency. Its principles are drawn from financial reporting, using a conceptual framework
and standards to define water assets and liabilities and to state recognition and measurement
principles. As such, water accounting is a stand-alone, fully articulating system of accounting.
A Water Accounting Conceptual Framework (WACF) was released that is modelled on the
financial accounting conceptual framework (WASB 2009). In the Statement of Water Accounting
Concepts 1 Definition of the Water Reporting Entity (SWAC 1) (WASB 2009), GPWARs will be
prepared by water reporting entities, which are defined as follows:
A water reporting entity is a water entity in respect of which it is reasonable to expect the existence
of users who depend on General Purpose Water Accounting Reports for information about water,
or rights or other claims to water, which shall be useful to them for making and evaluating decisions
about the allocation of resources (SWAC 1, para. 11).
Water reporting entities:

… may be individuals, physical entities, organisations, or an organisation that has management
responsibility for a physical entity (e.g. a catchment water authority whose responsibility is for the
physical catchment) (SWAC 1, para. 20).
The WACF also defines the objective of water reporting (information for decision-making) and
elements of the reports (including water assets and liabilities). Entities are expected to provide
the following:
(a) Statement of Physical Water Flows (analogous to a statement of cash flows).
(b) Statement of Water Assets and Water Liabilities (analogous to a balance sheet).
(c) Statement of Changes in Water Assets and Water Liabilities (analogous to an
income statement).
(d) Disclosure Notes.
(e) Compliance Statement.
(f) Assurance Statement.
The water accounting framework focuses on the needs of the users of water accounting reports.
The WACF identifies a broad range of users of water accounting reports. The main categories are:
• water users—environmental, agricultural, urban, industrial and commercial;
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• investors in water-dependent organisations and related parties such as lenders, creditors,
suppliers, insurers and water traders and water brokers;
• government representatives and their advisers including water-related economic,
environmental and social policy makers;
• water industry regulators;
• water managers, including environmental water managers and water service providers,
who may be interested in not just the water entities they manage but water entities they
depend on or compare to;
• groups and associations with water-related interests;
• water industry consultants;
• academics; and
• interested citizens (Bureau of Meteorology 2012).
The WACF also discusses the information needs of various users. Users’ needs vary depending
on their circumstances and the types of decisions they are considering. However, water reporting
entities would need to provide information about:
• the water resources under their control;
• whether their water resource management objectives were being met;
• their water resource policies;
• comparisons over time of annual water allocations, extractions and returns; and
• water levels and flow, and water entitlement trading, where relevant (SWAC 1, para. 20).
After an appropriate due process involving a pilot program and exposure draft process,
the standard (Australian Water Accounting Standard 1 Preparation and Presentation of General
Purpose Water Accounting Reports (WASB 2012)) was approved in 2012. The standard focuses
on how to prepare and present a general purpose water accounting report and also specifies
how items are recognised, recorded and presented.
CPA Australia and the Institute of Chartered Accountants in Australia (now Chartered Accountants
Australia and New Zealand) decided to take a leadership role in water accounting because of
the importance of the public debate around water and the ability of accountants to make a
contribution to the development of measurement and reporting of water resources (CPA & ICAA
2012). Godfrey and Chalmers (2012) document the various approaches and systems of water
accounting and reporting already in existence around the world, primarily developed by either
hydrologists or economists. However, none of the existing systems is as complete or as rigorously
conceptually based as the WACF in its set of statements and standards (Chalmers et al. 2012).
The strengths and weaknesses of the general purpose approach have been assessed in a range
of pilot studies. One of the key issues identified is the difficulty in measuring both stocks and
flows of water. As argued:
It should, of course, be noted that General Purpose Water Accounting requires the recording,
reporting and assurance of some information that is not commonly otherwise collected and
reported to external parties. Once a system is bedded down and its importance understood, it is
likely that the imperatives of improved reporting to external stakeholders will drive a market for
better modelling and metering and inclusion of information regarding water value (Godfrey &
Chalmers 2012, p. 297).
The issues raised by the need to provide assurance of water accounting reports are addressed
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by the issuing of a joint assurance standard in 2014 by the Water Accounting Standards Board
(WASB) and the Australian Auditing and Assurance Standards Board (AUASB). The standard has
been published by the AUASB (2014c) as Australian Standard on Assurance Engagements (ASAE)
3610, and by the WASB/Bureau of Meteorology as Australian Water Accounting Standard (AWAS)
2 Assurance Engagements on General Purpose Water Accounting Reports. The standard
provides requirements and application material regarding the assurance practitioner’s
responsibilities in an assurance engagement on a general purpose water accounting report,
including both reasonable assurance and limited assurance engagements.
AWAS 2 is based on the financial reporting assurance model, with:

… rigorous and consistent processes that provide the assurance practitioner with evidence to
support the conclusion reached and the assurance provided (Bureau of Meteorology 2013).
It sits under the umbrella standard ASAE 3000 Assurance Engagements Other than Audits or
Reviews of Historical Financial Information (revised 2014) (AUASB 2014a), which applies to all
assurance engagements on non-financial information and expands on how it is to be applied for
an assurance engagement on a general purpose water accounting report (AWAS 2, para. 11).
Study guide | 361
An overview of water accounting, ‘Water accounting’ is available on the Bureau of Meteorology

website at: http://www.bom.gov.au/water/about/publications/document/InfoSheet_8.pdf.
Read this document now to become more familiar with the rationale behind the establishment of the
WASB and the institutional arrangements for water reporting. Please note that this is an optional
reading and is not examinable.
➤➤Question 4.17
(a) Who will issue water reports under the water accounting standards?
(b) Who will use water reports and for what types of decisions?
(c) Is auditing of water reports necessary? If so, who will audit water reports?
Natural capital
What is natural capital and why is it important?
Most businesses rely heavily on natural capital (the world’s stocks of natural assets including air,
water, land, soil, geology and biodiversity) for their operations and continued existence. However,
it is a finite resource, and escalating demands are being placed on an already overstretched
resource. A recent study argued that we are already ‘drawing down’ on 50 per cent more natural
capital a year than the earth can replenish (CIMA 2014).
The depletion and degradation of natural capital can represent enormous potential costs for
business. It has been estimated that 50 per cent of all existing corporate profits are at risk if
the costs associated with natural capital were to be internalised through market mechanisms,
regulation or taxation (TEEB 2012). A water shortage, for example, would have a ‘severe’ or
‘catastrophic’ impact on 40 per cent of Fortune 100 companies.
How is natural capital currently reflected in financial reporting?

Despite the importance of natural capital to human wellbeing and economic prosperity, it rarely
features in current financial reporting. However, there are some disclosure requirements relevant
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for natural capital that organisations listed on the Australian Stock Exchange (ASX) must meet.
Most of these are very recent, reflecting the increased desire for greater disclosure of the risks
related to natural capital.
The directors’ report, while outside the financial report, must provide details of an entity’s
performance in relation to environmental regulations ‘if the entity’s operations are subject to
any particular and significant environmental regulation under a law of the Commonwealth or
of a State or Territory’ (Corporations Act, s. 299(1)(f)). However, this section does not require
corporations to disclose the financial impacts of non-compliance with environmental regulations.
Also, normally contained in the directors’ report, the operating and financial review (OFR)
requires a discussion of environmental and other sustainability risks where those risks could
affect the entity’s achievement of its financial performance or outcomes disclosed, taking into
account the nature and business of the entity and its business strategy.
There have been recent developments in corporate governance reporting related to natural
capital. In March 2014, the ASX Corporate Governance Council updated its Corporate
Governance Principles and Recommendations (ASX Corporate Governance Council 2014)
to include a new Recommendation 7.4 which states that an:
… entity should disclose whether it has any material exposure to economic, environmental and
social sustainability risks and, if it does, how it manages or intends to manage those risks.
The inclusion of this recommendation reflects growing recognition of the importance of

sustainability risks to investors’ medium- and long-term decisions.
Outside of traditional financial reporting, there has been increased emphasis on the reporting of
natural capital, which is a major component of the sustainability reports that are being produced.
The major reporting framework in place is the Global Reporting Initiative (GRI) (discussed earlier),
which covers aspects of natural capital for which both quantitative and qualitative reporting are
commonly included in sustainability reports. Examples of natural capital reporting, under the
CDP and water accounting, have also been discussed earlier in this module.
➤➤Question 4.18
Access the GRI G4 Sustainability Reporting Guidelines at: https://www.globalreporting.org/
List at least four natural capital elements that are provided for in the guidelines.
Within the new corporate reporting approach of IR discussed earlier, natural capital is one of the
six capitals that are required to be reported on, if material to the organisation. Where material,
the associated risks and opportunities and the increased emphasis to report on these (either by
producing an integrated report, a sustainability report or other reporting mechanisms such as
CDP or water accounting) means that it is necessary to have a natural capital reporting system
in place. An example of an organisation (Rio Tinto) considering the effect of aspects of natural
capital on its operations is outlined in Example 4.12. It can be seen that to substantiate these
claims, a sophisticated natural capital reporting system must be in place.
Example 4.12: Rio Tinto—net positive impact on biodiversity

Rio Tinto, an Australian-listed metals and minerals company, recognises the high-impact nature of its
operations on biodiversity and uses a concept of ‘net positive impact’ to plan how it can minimise
its impacts and contribute to healthy ecosystems at the project or site level.
The company ‘aims to ensure that actions undertaken at [its] sites are designed to outweigh the
inevitable disturbances and impacts associated with mining and mineral processing’, and aims to
achieve this by:
• Avoiding unacceptable impacts to biodiversity;
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• Reducing the impacts that may occur;

• Restoring impacted ecosystems;
• Compensating for residual impacts through offsets; and
• Seeking additional opportunities to contribute to local conservation.
Rio Tinto refers to this approach as the ‘mitigation hierarchy’.
Since 2007, the company has used an ‘assessment protocol’ to assess the biodiversity of its
landholdings and surrounding areas. Areas are categorised as having ‘low’, ‘medium’, ‘high’ or ‘very
high’ biodiversity values.
This helps the company ‘prioritise actions and channel resources to the very high and high value sites’.
These sites must then develop and implement a ‘Biodiversity Action Plan’, which involves understanding
‘the impacts and risks that their activities might have’ and implementing ‘a plan to avoid, mitigate,
restore and offset those impacts’.
In its 2014 sustainability report, the company provides an example of its activities regarding biodiversity
in relation to the planned open-cut coal mine as part of the Mount Pleasant project in Australia’s Hunter
Valley, New South Wales. The project is located within the Brigalow Belt South bioregion and contains
the ecological communities known as Box Gum Grassy Woodlands and Derived Native Grassland.
According to the company, both are considered to be of high conservation value and endangered
on a regional scale; both have a number species of high conservation value within the project area,
including the swift parrot, the regent honeyeater and the greater long-eared bat.
Study guide | 363
A key challenge for the company in undertaking the project is balancing the economic and social
benefits it would bring with helping to ensure long-term protection of the biodiversity in the area.
Approval has been granted to clear a maximum of 2591 hectares of native vegetation, comprising
572 hectares of woodland and 2019 hectares of grassland. There are limited opportunities to apply
the avoidance element of Rio Tinto’s mitigation hierarchy because the bulk of the concession and
coal deposit is covered by the high-value ecological communities. As such, the company’s focus is
on reducing impacts and generating a net gain through a combination of minimisation, restoration
and offsetting measures.
To offset predicted residual impacts, three offset sites have been selected, totalling more than
15 500 hectares. The offset sites will provide Australia’s largest protected area of Box Gum Grassy
Woodlands (>12 875 hectares) and will also protect more than 8475 hectares of verifiable habitat for
the swift parrot, the regent honeyeater, and the greater long-eared bat. Key management activities
for these offset sites have been identified, based on the condition of the habitats and the threats
faced. In addition, 677 hectares have been identified for revegetation, in order to increase habitat
connectivity (Rio Tinto 2014).
Sources: Rio Tinto 2014 ‘Sustainable Development: Creating mutual value for the long term’,
accessed August 2015, http://www.riotinto.com/sd2014/pdfs/00_sd2014_full.pdf;
Rio Tinto 2014, ‘Understanding biodiversity impacts’, accessed July 2015,
http://www.riotinto.com/sustainabledevelopment2013/environment/biodiversity.html.
© 2015 Rio Tinto. Reproduced with permission.
If it is so important, why aren’t we currently reporting on it?

Our economic and financial systems currently continue to emphasise the return on financial
capital. Natural capital and our dependence on it are largely currently invisible in corporate
accounts and decision-making. There are a number of systemic reasons for this:
1. Our entire economic and financial system is based on flawed assumptions of infinite
resources and perpetual equilibrium in the natural ecosystem.
2. Our thinking and behaviour are overly dominated by purely financial measures of progress
and ‘success’ such as gross domestic product (GDP), revenues, profit, cash-flows and
earnings per share.
3. The structures of modern accountancy are derived historically from societies and economies
that assumed that nature’s abundance would last indefinitely.
4. Our business models and practices do not reflect how business is an integral part of a wider,
complex system.
5. The focus of the vast majority of businesses is on short-term financial performance and
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annual returns.
6. Perhaps, most importantly, we lack the frameworks and systems needed to account for the
relationship between natural capital and business strategy and performance.
The future of reporting and the Natural Capital Coalition

It is often argued in business that we can’t manage what we can’t measure. Most companies do
not understand the complexities of natural capital, nor do they have the approaches or tools
for accounting for the natural capital that their business draws upon. However, this is changing,
with some organisations developing their own approach to quantify, price or otherwise account
for natural capital externalities. This enables them to deal with these externalities strategically.
The multinational footwear and sportswear producer PUMA, for example, is well known for its
leadership in accounting for natural capital. In 2011, PUMA released its first Environmental Profit
and Loss Account, in which it quantified a wide range of environmental impacts including water
use, greenhouse gas emissions, land use and waste associated with its supply chain, transport
networks, operations and manufacturing, particularly those associated with the leather and
cotton used in the manufacture of its products (PUMA 2011).
At the time of writing, there are a number of companies that either prepare an Environmental Profit
and Loss Statement or are considering doing so, including the Danish pharmaceutical company
Novo Nordisk (http://www2.mst.dk/Udgiv/publications/2014/02/978-87-93178-02-1.pdf) and the
global apparel and accessories company Kering (http://www.kering.com/en/sustainability).
Other, similarly focused initiatives are underway, such as ‘the B team’—co-founded by former PUMA
leader Jochen Zeitz and Virgin’s Richard Branson as part of their ‘future bottom line’ challenge.
This challenge seeks to expand corporate accountability beyond financial gains to include negative
and positive contributions to the economy, environment and society (B Team 2015).
While such individual initiatives are to be applauded, there are advantages in developing
standardised approaches. Developing a standardised approach means that each organisation
need not bear the costs of developing its own reporting methodology. In addition, a standardised
approach becomes widely known and assists with comparisons between companies.
Initiatives like the Natural Capital Coalition (NCC 2014) are developing standardised
methodologies for quantifying or pricing natural capital in ways that can be easily integrated
into existing organisational practices and decision-making. It is expected that this harmonised
evaluation framework, the Natural Capital Protocol, should be released in late 2015 or early
2016. Our ability to account for natural capital remains variable at this stage, but thinking is
advancing rapidly. Accountants are playing a critical role in the development of these methods.
Verification and assurance of non-financial

reporting disclosures
Whether an organisation adopts the GRI principles or another set of guidelines in its sustainability
reports, or the new requirements for IR or water accounting, the question of verification and
assurance of its disclosures arises. So far, this module has outlined a range of reporting
frameworks that can be used for the preparation of, for example, an integrated report
(the International IR Framework), a sustainability report (GRI G4), a carbon emission report
(CDSB framework) or a water usage report (AWAS 1). The role of assurance (which is not
mandated, but is identified as beneficial under these frameworks) is to determine whether a
report has been prepared in accordance with the framework. In other words, its purpose is to
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provide assurance that there have been no material departures from the reporting framework.
The demand for assurance of any report depends on the benefits that assurance brings to
the preparers and users of the report. Positive accounting theory suggests that the demand
for auditing of financial reports arises from the separation of management and ownership.
Managers are willing to pay auditing costs if the cost of auditing is less than the benefits
from increases in the share price of the company. Auditing provides benefits by increasing
the credibility of management-prepared financial statements and improving the quality of
an entity’s accounting system through the audit process. Assurance of sustainability reports,
in this theory, is undertaken when companies have something to gain from increasing the
credibility of their reports (Gay & Simnett 2012).
A summary of the GRI’s discussion of the benefits of assurance is as follows:

• Increased recognition, trust and credibility—stakeholders have a greater sense of confidence
in disclosures that have been assured.
• Reduced risk and increased value—assurance can increase the quality of data and reduce the
risk that the data will have to be restated at a later date.
• Improved board and CEO level engagement—sustainability data is being used at higher
levels in organisations, and this is more likely when the data is assured.
Study guide | 365
• Strengthened international reporting and management systems—external assurance reviews

internal systems and helps them improve through auditors’ recommendations.
• Improved stakeholder communication—reporting and assurance can be part of ongoing
dialogue with stakeholders (GRI 2013d).
The GRI also states that 95 per cent of the world’s largest corporations publish some form of
sustainability report, and 46 per cent of reports listed on the GRI’s Sustainability Disclosure
Database indicated some form of external assurance (GRI 2013d).
The development of standards covering the assurance of sustainability reports has lagged behind
those for financial reports. However, substantial work has been done to rectify this situation.
In June 2012 (revised June 2014), the AUASB (2014b) issued the new standard ASAE 3410
Assurance Engagements on Greenhouse Gas Statements. ASAE 3410 conforms to ISAE 3410 of
the same name issued by the International Auditing and Assurance Standards Board (IAASB) in
2012. The standard covers the assurance practitioner’s responsibilities when providing reasonable
or limited assurance on a greenhouse gas statement. Greenhouse gas statements are primarily
issued to report on emissions, energy consumption and energy production under the NGER Act.
As outlined earlier, an assurance standard was jointly issued in early 2014 by the AUASB (2014c)
as Australian Standard on Assurance Engagements (ASAE) 3610 and the WASB and Bureau of
Meteorology as the AWAS 2. The standard covers the assurance practitioner’s responsibilities
when providing reasonable or limited assurance on a general purpose water accounting report.
More generally, ASAE 3000 Assurance Engagements Other than Audits or Reviews of Historical
Financial Information (revised 2014) (AUASB 2014a) and ISAE 3000 of the same name provide
guidance for auditors undertaking an assurance engagement on sustainability reports.
CPA Australia has published a guide for auditors conducting assurance engagements for small-
and medium-sized enterprises’ sustainability reports. The guide recognises that stakeholders
in these businesses increasingly need a broader suite of information than in the past, as well
as information that encompasses social, economic, environmental and governance aspects.
Assurance of these reports provides greater confidence to the users of the sustainability reports
and facilitates decision-making by stakeholders in SMEs (CPA Australia 2012, Foreword).
Another authoritative assurance standard for sustainability disclosures is the AccountAbility AA1000
Assurance Standard (AA1000AS) (AccountAbility 2008). AccountAbility is a global organisation
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with a mission of providing advice and resources to corporations, non-profit organisations and
governments in the area of corporate responsibility and sustainable development.
AccountAbility argues that its standard differs from statements by the IAASB because:
… it requires the assurance provider to evaluate the extent of adherence to a set of principles
rather than simply assessing the reliability of the data. The AA1000AS (2008) requires the assurance
provider to look at underlying management approaches, systems and processes and how
stakeholders have participated (AccountAbility 2008).
This means that assurance practitioners applying AA1000AS are more likely to consider an
organisation’s sustainability performance and recommend improvements rather than to certify
or provide an opinion on the appropriateness of the data and reports, given the underlying
data and systems.
There is a growing role for accountants in helping businesses deal with the direct effects of
legislation and with broader sustainability issues. Example 4.13 highlights the experiences
of three CPA firms in providing green accounting services to their clients.
Example 4.13: Green accounting

The link at the end of this example is for the environmental accounting page in the CPA Australia
toolkit. This page provides access to three interviews conducted with members in public practice who
are involved in the area of sustainability and environmental accounting: Mr Malcolm Borgeaud FCPA,
Mr Reg Williams CPA and Mr Jude Lau CPA.
These interviews address some of the challenges and, more significantly, the opportunities for public
practitioners to both service and shape the needs of clients who operate in a complex and rapidly
changing environment.
The practitioners are involved in emissions measurement, carbon footprint, environmental audits and
training presentations on environmental legislation.
The list of the videos can be accessed at: cpaaustralia.com.au/professional-resources/public-practice/

toolkit/environmental-accounting.
➤➤Question 4.19
Based on the green accounting video interviews, consider the following questions.
(a) Compare current green accounting opportunities for the accounting profession with those
in the financial services area 10 years ago.
(b) How can understanding a product’s or business’s carbon footprint help management?
(c) In what way is green accounting a multidisciplinary service?
(d) Is green accounting a business or environmental issue?
(e) What skills and attributes are required for success in green accounting?
Reading 4.6 provides further information about how sustainability affects the daily lives of
accountants. When making capital investment decisions, accountants are now being forced
to consider sustainability issues in addition to the financial factors.
Reading 4.6 is an article that summarises a survey of practices relating to the integration
of sustainability issues in investment decisions. It also highlights key areas of concern for
subsequent research. The survey was undertaken by CPA Australia in 2012 in collaboration
with the International Federation of Accountants and HRH The Prince of Wales’ Accounting
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for Sustainability Project (CPA Australia 2013). The findings highlight that organisations
are still developing systems and expertise in this area; only 16 per cent of respondents
reported having systems in place to flag when sustainability-related data is required to help
with decision-making. Further, only about one-third of respondents specifically tracked the
financial effects of sustainability initiatives, reflecting how sustainability-related issues are often
viewed as a corporate-level responsibility rather than an individual project-level responsibility.
Measurement difficulties were identified as the major hurdle to including sustainability-related
impacts in capital appraisal; other challenges include the lack of available data, the cost of
external expertise and the cost of data collection (Purcell 2013). These findings were also
supported and re-enforced by Vesty et al. (2015).
Accountants are becoming more aware of sustainability issues and their potential impact on
capital investment decisions. They are taking sustainability issues into account because of the
risk that these issues could affect a particular investment, the business’s name and its reputation
if investments have negative sustainability effects. However, as identified by Purcell (2013),
the consideration of sustainability issues is not universal. It seems that some organisations are
leading others, and some investments are more likely to explicitly involve consideration of their
sustainability effects.
Study guide | 367
Now read Reading 4.6. CPA Australia, referenced by the Global Accounting Alliance, has released
guidance on capital investment appraisal by Purcell (2013) ‘Building sustainability into capital
investment decisions’.
Summary
This part considered some of the issues associated with the growth in non-financial reporting,
which is now becoming standard business practice worldwide. The review first included a
discussion of the most commonly used general reporting framework for non-financial reporting,
GRI, which was significantly updated in 2013. It then explored non-financial reporting frameworks
specific to types of non-financial information. This included information reported by companies
about their carbon emissions in accordance with the reporting requirements developed by the
Carbon Disclosure Project (CDP). Water accounting is also providing users with information about
water assets and liabilities, and water flows. The Water Accounting Standards Board (WASB)
has established a standard for water accounting, and an exposure draft for assurance of water
accounting has been issued. The Natural Capital Coalition is developing a harmonised evaluation
framework (including measurement, management, reporting and disclosure aspects) to enable the
development of aggregated measures of natural capital (akin to GDP for economic measures).
In general, assurance of non-financial reports enhances the credibility of the reports in the same
way as it does for financial reports. Various standards are being developed to help assurance
practitioners conduct these types of assurance engagements. While their role with financial
information is understood, accountants also have a significant role to play in ensuring that the
increasing demands from society for relevant and reliable non-financial information are met.
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Review
This module has addressed issues beyond traditional financial reporting. It began with a
brief review of the major financial reporting requirements for different types of companies,
including IFRSs. International developments in both accounting standards and banking
regulations were discussed. The issues of liquidity risk and the eurozone sovereign debt crisis
were discussed in detail. Ethical banking, particularly Islamic banking, was addressed.
This module included a review of current pressures on reporting, such as the actions taken
by the G20 in the wake of the GFC, and responses of world leaders who are trying to balance
domestic concerns with global reforms. These changes are being felt in both accounting
standard convergence (between the IASB, FASB and standard-setters of other countries) and
the new banking regulations known as Basel III.
In the later sections, the module reviewed the reasons for an increased demand for integrated
reporting and non-financial reporting activities. It also discussed new developments in
sustainability reporting frameworks. These included the GRI G4 guidelines and the integrated
reporting framework. Integrated reporting is an attempt to bring together the financial and
non-financial aspects of reporting in a structured way that reflects real organisational change.
A discussion followed of other forms of non-financial disclosures being developed around the
world: carbon and natural resources information reported to the CDP and water accounting,
which is a new type of non financial reporting for general purpose water reports.
Non-financial reporting is a growing area currently experiencing significant change, including

increased mandatory and voluntary reporting. The accounting profession is well placed to play a
leading role in these developments and to ensure that the information needs of stakeholders are
appropriately met.
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Reading 4.1 | 369
Readings
Readings
Reading 4.1
The socio-economic impacts of the adoption of IFRS:
A comparative study between the ASEAN countries of
Singapore, Malaysia and Indonesia
Diane Kraal, Prem Yapa and Mahesh Joshi1
Note: This reading is not in the printed study material. It is available via My Online Learning.
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1
Dr Diane Kraal is a lecturer with Monash University; Associate Professor Prem Yapa and Dr Mahesh Joshi
are lecturers at RMIT University.
Reading 4.2
International accounting standards essential for growth
T. Ochi
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Reading 4.3 | 371
Reading 4.3
State-owned assets—setting out the store
T. Ball
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Reading 4.4
Background information about banking
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Reading 4.5 | 373
Reading 4.5
Background to the eurozone sovereign debt crisis
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Reading 4.6
Building sustainability into investment decisions
J. Purcell
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Suggested answers | 375
Suggested answers
Suggested answers
Question 4.1
Currently, accounting for state-owned asset sees many governments recognising these assets
at historical cost. Further, many governments make do with cash accounting rather than
accrual accounting.
Accounting for state-owned assets at historical cost has implications for the decision usefulness
of the balance sheet. This is because the historical cost of assets is merely a historical record of
the financial sacrifice made to acquire them. The historical cost, particularly if incurred long ago,
is not a relevant measure of the future economic benefits expected to be derived from using the
asset. In addition, it may not require the recognition of other assets controlled by governments—
for example, land under roads or mineral resources.
Using historical cost for state-owned assets may reduce the comparability of financial statements
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where the statements include costs relating to assets acquired at different points in time.
Also, ratios would be distorted by the comparison of current income with a historical cost,
in light of changes in the purchasing power. In this regard, historical cost has been criticised on
the grounds that it aggregates costs incurred at different times as though they are equivalent
in economic terms. However, allowing for the time value of money, the presumption is open
to criticism.
The impact of cash accounting is that obligations are only accounted for when the bill is received
rather than when the obligation is incurred. This helps to disguise weak finances and also has
implications for the decision usefulness of the financial statements.
Question 4.2
(a) Special purpose entities (SPEs) are legal or accounting entities that are treated as
separate from the reporting entity. For example, if a company establishes a limited
partnership to conduct part of its business and accounts for the partnership separately
from the company, then the partnership is an SPE. The business conducted through an
SPE usually has a different nature from the business of the main company. It is usually
narrow in focus. For example, a company might use a partnership to own an asset and
borrow money against that asset.
(b) If the assets and liabilities of the SPE are not included in the company’s consolidated
financial statements, it is ‘off-balance sheet’. If the assets owned by the SPE fell in value,
the decline would not be disclosed in the company’s financial statements. This lack of
disclosure is one advantage of SPEs for those who do not want others to know about a
fall in asset values or the existence of a liability.
(c) IFRS 10 Consolidated Financial Statements has a revised definition of control. Applying
the new definition requires significantly more judgment to determine whether an entity
should be consolidated. An entity needs to consider whether control exists, particularly
when the ownership interest is less than 50 per cent.
Further, it needs to assess whether the investor has the power to direct the activities of
the investee company in a way that significantly affects the financial returns generated.
Under the previous IAS 27 Consolidated and Separate Financial Statements the primary
test was whether the investor had the power to govern the financial and operating
policies of the investee.
The new requirements create a greater need to consider the entity’s holdings and rights
and other shareholders’ holdings and rights to determine whether the entity has the
necessary control.
Question 4.3
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A mismatch between the duration of deposits and loans gives rise to liquidity risk.
A substantial proportion of customer deposits are ‘at call’, which means that depositors may
withdraw their funds at any time without penalty. Loans are provided for a much longer duration;
for example, a mortgage may be advanced for 25 years or longer.
Liquidity risk is inherent in the banking business model, and managing this risk well is central to
the business of banking.
Question 4.4
There are a number of possible techniques for managing the liquidity risk, but the most
important two are:
• maintaining the trust that depositors have in the banking system in general and in
a given bank, so as to minimise the probability of a ‘bank run’ occurring. This requires
prudent management; and
• maintaining a sufficient base of available liquid funds to meet the daily obligations of the
bank. This level will vary, and banks estimate the level of reserve funds required based on
their particular circumstances.
Question 4.5
There were several key causes of the liquidity crisis in 2008, which, in hindsight, can be identified
as building up during the preceding decade. These causes can be broadly grouped into the
following categories:
1. Dramatic loan growth beyond available core deposit funding, making the banking
system more vulnerable to shocks, that resulted from the following processes:
–– There was significant growth in demand for lending products, including among US
sub‑prime borrowers.
–– A significant proportion of bank funding was sourced via ‘nervous’ wholesale funding.
–– Banks engaged in the trade of complex structured products, which allowed them to
further expand their balance sheets and take on higher risks.
–– The perception existed that banks’ assets, such as securitised mortgages, were liquid
and that high-quality assets were reinforced by robust credit ratings (which later proved
to be overly optimistic).
2. Financial institutions holding insufficient capital and inadequate liquidity buffers:

–– This became apparent with the benefit of hindsight.
3. Inadequate risk management practices:

–– Corporate governance, market transparency and quality of supervision were found to be
lacking, in hindsight.
–– In particular, the focus of risk management had been firm-specific, and there was a lack of
appreciation of how a system-wide shock would play out under stress.
Question 4.6
The eurozone sovereign debt crisis was caused by significant ongoing budget deficits and a
build-up of very high debt levels by a number of governments in the eurozone.
The average level of debt as a percentage of GDP in the eurozone reached 79 per cent in 2009.
Even before the Global Financial Crisis, debt levels were already high, with the average level of
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debt as a percentage of GDP in the eurozone at 68 per cent, which is 8 per cent higher than the
maximum level of 60 per cent stipulated by the EU agreement.
No actions were taken against EU member states that breached agreed debt ceilings, and a
number of EU member states took advantage of this to finance their ongoing expenditure with
debt, which was relatively cheap at the time.
The build-up of high debt levels was caused by consistent budget deficits (the difference
between a government’s tax receipts and its spending). This meant that should a government
lose access to cheap debt, it would need to take drastic measures to cut its expenditure,
or increase taxes, to be able to balance its budget.
A number of EU members became very vulnerable to financial shocks. The high debt levels
and high budget deficits meant that a sudden increase in interest costs would place significant
additional burden on those countries, and loss of access to reasonably priced debt would
expose governments to bankruptcy risk (i.e. an inability to meet their payment obligations).
This is what happened to Greece and a number of other countries in the eurozone.
Question 4.7
While there is no one correct answer to this question, the following is a reasonable hypothesis:
• Greece was the EU country most vulnerable to financial shocks, as it had the highest
level of debt as a percentage of GDP and consistently ran very high current account and
budget deficits.
• When Greece revised its budget deficit estimate for 2009 from 6 per cent to 12.7 per cent,
it undermined the credibility of Greek economic forecasting and reduced investor confidence
in the Greek economy. Investors started to question whether Greece’s budget deficit was
likely to be revised up again later, whether Greece’s debt-funding model was sustainable
and whether other countries would also revise their budget deficits and experience debt
refinancing issues.
• Risk premiums on Greek and other European government bonds increased, increasing the
likelihood of Greece and a number of other EU members defaulting on their debt and
creating a vicious cycle.
Question 4.8
‘Contagion’ in the context of the eurozone sovereign debt crisis refers to the financial shocks that
initially affected Greece and then proceeded to affect other economies in one or more of the
following ways:
• increase in the perceived likelihood of a financial crisis
• correlated increase in asset-price volatility
• correlations in asset-price movements that were not driven by fundamentals, but rather by
perception of risk and changes in risk.
Question 4.9
Regulations relating to banking and accounting could disadvantage less-developed countries
because their financial institutions and companies are less able to meet the international
standards. For example, less-developed countries could have smaller economies as well as
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a smaller proportion of their economies run by large businesses. Smaller businesses are less
likely to issue shares to the public, and therefore, share markets are smaller and less developed.
In addition, less developed countries are unlikely to have laws that offer much protection
for investors if a company in which they invested does not abide by the disclosure rules in
accounting standards.
In addition, economies in less-developed countries could be more adversely affected when

companies in other countries take action to meet the new regulations (e.g. by selling assets
in the poorer countries or withdrawing their investments from companies in those countries).
Question 4.10
Ethical finance refers to any financing structure that is based upon non-financial criteria that
incorporate a social or a religious dimension. Conventional ethical finance mainly focuses
on excluding investments in ‘harmful’ industries (e.g. tobacco, weapons and environment-
polluting industries). It also promotes the proactive search for welfare-enhancing investments.
(See, for example: https://www.australianethical.com.au/what-is-ethical-investment/.) As a matter
of principle, Islam also bans investment in industries that might harm a society, as discussed in
‘A ban on investing in harmful business activities’ in the ‘What is Islamic banking?’ section.
This is where Islamic finance shares space with other ethical finance. Islamic finance, however,
differs from other ethical alternatives in that:
(i) Islam’s universe of banned industries is relatively larger than other forms of ethical finance;
it includes industries, such as the entertainment industry, that might not be considered
harmful by other ethical alternatives; and
(ii) Islam’s ethical concerns extend to contractual relationships underlying business exchanges,
as evident from the prohibition of riba and gharar (as discussed in ‘What is Islamic banking?’).
Question 4.11
(a) The ownership of the asset in an operating lease remains with the lessor (bank), and at the
end of the lease period the bank may then lease the asset to another customer or sell it in a
secondary market. It might be difficult to do so when the asset is not in good shape or when
there is no active secondary market for certain specialised equipment. One way to deal with
the problem is to set the lease period equal to the economic life of the asset. The asset
in this case is given to the lessee as a gift or sold at a minimal price at maturity, as in the
contract of ijara muntahia bitamleek or AITAB. Another sharia-compliant alternative is to use
the diminishing musharaka structure where the lessee gradually purchases units of the assets
until she or he completely owns the asset.
(b) Asset-based financing is by nature different from interest or debt-based financing, as it

underlies a different risk structure. This obviously implies that, from an accounting point of
view, assets and liabilities need to be treated differently. Islamic banks, for example, do not
guarantee safe return of the principal amount, as holders of these accounts share in the profit
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or loss. Conventional banks on the other hand guarantee the principal amount along with
interest payment. Similarly, conventional home financing is simply an interest-based loan,
whereas Islamic home financing on a diminishing partnership basis, for example, represents
diminishing ownership in the asset, which is subject to price risk. These differences in risk
structures therefore require different accounting treatments.
There is agreement among advocates and practitioners of Islamic finance that it is not
appropriate to use accounting standards and guidelines issued by conventional bodies,
such as the IASB, for Islamic finance products without appropriate adjustments. This is seen as
an important step towards adequate comparability and transparency of financial statements,
and proper presentation and disclosure to reflect the true nature of how Islamic financial
institutions (IFIs) operate. These adjustments are done by the Accounting and Auditing
Organisation for Islamic Financial Institutions (AAOIFI), which was established in 1991 with a
mandate to issue sharia accounting and auditing standards that are voluntarily adopted by IFIs.
Question 4.12
Disclosures in the integrated report show the flow and transformation of capitals through the
organisation. Every organisation requires one or more of the capitals as inputs to its business
model. These capitals are then consumed or transformed by activities that produce a range
of outputs. Whether these outputs create or destroy value depends upon the outcomes they
generate. For instance, manufacturing a product that appeals to customers will create demand
and generate revenue; whether that demand is profitable depends on the market price that
the product can command and the cost structure in the entire supply chain. In the longer term,
factors such as customer satisfaction, innovation, organisational reputation, ethical business
activities and environmental impact are all likely to affect aspects such as brand loyalty and the
value-creating proposition of the organisation.
Question 4.13
The difference between sustainability reports and integrated reports is their scope. An integrated
report attempts to link an organisation’s sustainability report with its financial report and,
therefore, has a greater scope than a sustainability report.
Some organisations publish only financial reports (as required by the relevant regulations in their
jurisdiction), while others publish a financial report plus a sustainability report. Sustainability
reports show an organisation’s economic, environmental and social impacts.
Sustainability reports can be prepared by organisations according to any set of principles

because there are no mandated standards such as those that govern financial reporting.
However, sustainability reports based on the GRI reporting framework (the most commonly
used reporting framework for sustainability reports) disclose outcomes and results according to
a set of principles governing the content of the report.
A third way of reporting adopted by some organisations is to integrate both the financial
and sustainability reports through the organisation’s business strategy and model. This helps
organisations more fully explain the risks and opportunities they face and how they are planning to
deal with those risks and opportunities. The IIRC’s IR framework (discussed in this module) provides
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details on some of the pathways that an organisation can use to prepare integrated reports.
Question 4.14
It is argued that a business’s credibility on sustainability issues increases its ability to win and
retain customers. In addition to any direct effect of marketing a business’s green performance,
it is possible that a focus on sustainability could help a business increase its competitive
advantage through better risk identification and by recognising opportunities associated with
innovation and new environmentally friendly products. Although such product development
could be costly, increasing sales is also likely to increase profits. In turn, increasing profits could
help the business borrow at cheaper rates.
It is also possible that the business’s efforts to improve its sustainability performance will help it
to attract, motivate and retain staff.
Assessing risks and opportunities associated with sustainability issues could further lead to better
cost control through operational efficiencies and by avoiding waste, travel and regulatory costs.
Question 4.15
The GRI believes that the causes of the GFC related to poor reporting by corporations.
The existing reporting system at the time was not transparent, which meant that external
stakeholders were unable to get a full and fair picture of a corporation’s performance beyond
that reported according to financial accounting rules. For example, the financial profit did not
give a full account of the organisation’s impact on the environment or society.
In addition, financial reports did not have a long-term perspective. Financial reports were
(and still are) based on historical performance. Although financial reports are usually
supplemented with a management discussion of the results, including some guide as to the
organisation’s future plans, this review is limited in scope and does not explain the expected
long-term impact on key indicators. As a result, financial reports were not seen to discharge
the organisation’s accountability to a broad group of stakeholders (beyond shareholders).
In addition, the GRI believes that the current system of voluntary sustainability reporting is not
sufficient because some of the organisations with the greatest impacts choose not to issue
sustainability reports. The GRI has called for integration of sustainability reporting with the global
financial regulatory framework, as evidenced by its support for the integrated reporting initiative.
Question 4.16
(a) A supply chain extends from a natural resource, through its extraction and activities of all
suppliers, various phases of production and combination (including assembly) and through
storage in various geographical locations. It ends when the product or service is in the hands
of the consumer.
(b) Supply chains naturally connect different organisations that are involved at different phases
of the journey from raw material to consumer. The different organisations are connected
through the supply chain, but all are seeking to maximise their own performance and not
expose themselves to unnecessary risks. Organisations at the various phases of the supply
chain place demands upon one another and, therefore, seek information about each other’s
performance as it affects the relevant supply chain. If one organisation has the potential
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to expose another organisation to environmental risks, the first organisation will seek
information about the other’s environmental performance. For example, if a miner is involved
in the extraction of the raw material used by a processor, the processor will be concerned
about any disruption to supply caused by changing legislation, environmental protests
or variable weather conditions. The processor could seek information about the miner’s
compliance with relevant legislation covering waste, for example. Further along the supply
chain, a retailer could be concerned about environmental information about food production.
Question 4.17
(a) Water reports will be issued by water reporting entities. In particular the Statement of
Water Accounting Concept (SWAC) 1, para. 20, states that water reporting entities ‘may be
individuals, physical entities, organisations, or an organisation that has management
responsibility for a physical entity (e.g. a catchment water authority whose responsibility is
for the physical catchment)’. See also the discussion in paragraph 11 of SWAC 1.
(b) AWAS 1 states that water accounting should assist informed decision-making about the
allocation of resources. According to the Bureau of Meteorology.
The reports [GPWAR] will usually be prepared by water managers and will address the general
information needs of water users, water market investors, traders and brokers, environmental
organisations, auditors, financiers, local governments, researchers, planners and policy
formulators—who cannot normally gain this information directly from the organisations that
hold it.
GPWAR are designed to:
• provide information that is relevant, reliable, comparable and understandable
• inform users about how water resources have been sourced, managed, shared and used
during the reporting period
• enhance users’ confidence in their water-related investment decisions (Bureau of
Meteorology 2011a, p. 3).
Benefits to GPWAR preparers include:
• the opportunity to demonstrate stewardship of a public good
• meeting several reporting obligations in a single report
• potential to share reliable, assured information on water resources with stakeholders
(Bureau of Meteorology 2011a, p. 3).
Benefits to users of GPWAR include:
• access to information important to core business such as water rights, other claims to water
and obligations against that water
• enhanced relevance and comparability of information, through use of a standard
• reliability of information underpinned by an assurance process (Bureau of Meteorology
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2011a, p. 3).
Therefore, users will use the information about water assets and liabilities, as well as inflows and
outflows, to assess water availability and the reliability of future supply for the following reasons:
–– to provide input to water trading models;
–– to judge the stewardship of water managers;
–– to monitor water resources and to formulate public policy or plan action to lobby
for change;
–– to study the effects of climate change; and
–– to inform government actions.
(c) Assurance of the water accounting reports is designed to add credibility to the reports and
give confidence to users. The Australian Auditing and Assurance Standards Board (AUASB)
and the WASB jointly issued the standards for assurance of water reports in 2014 (ISAE 3610/
AWAS 2).
It is possible for assurance engagements on GPWAR to be undertaken by practitioners from the
following backgrounds:
(a) There are professional accountants with specialist knowledge, training and experience in
assurance practices, particularly those who undertake financial report audits, who are capable
of performing engagements dealing with subject matters other than historical financial
information (such as engagements to provide assurance on GPWAR). When necessary,
professional accountants specialising in assurance can engage subject matter experts to assist
in parts of an engagement—, for example, to assist in verifying the appropriate application and
results of models. Standards exist to govern the use of experts by assurance practitioners.
(b) Alternatively, there are subject matter experts, including scientists, engineers, hydrologists
and professionals from backgrounds other than financial reporting, auditing and assurance,
who have expertise in the quantification of water volumes and water accounting. These
professionals could then, if necessary, acquire knowledge, skills and experience in assurance
processes, and engage appropriately skilled experts, to enable them to perform assurance
engagements on GPWAR.
Whatever their background, the lead assurance practitioners for engagements on GPWAR will
require skills in both assurance and water quantification and accounting or have access to expert
assistance, where necessary (AWAS 2, para. 17).
Question 4.18
Under the environmental sustainability category of GRI G4, there are guidelines for the reporting
of the following items that relate to natural capital:
• materials;
• energy;
• water;
• biodiversity;
• emissions; and
• effluents and waste.
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(It is also arguable that other items under the environmental sustainability category of the GRI G4
guidelines can be included, but the ones listed here are the most direct.)
Question 4.19
(a) The practitioners in the green accounting video interviews compare the current green
accounting opportunities to those facing the accounting profession 10 years ago, in the area
of financial services. They suggest that, 10 years ago, accountants failed to act in a timely
manner to ensure that financial services remained an exclusive service area for members
of the profession. In the current environment, there appears to be other professionals
(and non-professionals) who wish to enter the area of providing advice and assurance in
green accounting. Both reporting and assurance are traditional accounting functions in
which accountants have expertise and credibility. However, if the profession again reacts
slowly, accountants will see opportunities being taken by others. Not only will this mean
less business for accountants, but it could lead to a lower level of service. (For example,
witness the difficulties in the financial services area as unscrupulous billing practices and a
failure to provide impartial advice have dragged down the reputation of financial advisers.)
Accountants need to skill up to meet the demand for their services at the necessary level of
quality. Client retention is improved if accountants can provide these new services.
(b) Accountants should help clients understand their carbon footprint so they can see
opportunities to reduce waste and costs and to improve revenue. It could be argued that
in the future most businesses will have to account for their carbon in some way, regardless
of present legal obligations. Individually, accountants can help businesses reduce their
carbon footprint, as well as their fear and apathy about acting now. If people do not fully
understand their business and its costs, they cannot maximise profits.
(c) It is important to have the right people in a carbon assurance team, as well as auditors.
The audit team should include people who understand the greenhouse gas (GHG) emission
reporting regime and the industrial processes that generate emissions and consume energy.
Engineers and scientists, as well as legal expertise, are required. Difficult questions might
include whether reporting needs to be done on an entity or site basis. There is a need to
include more outside experts than for a usual financial engagement.
(d) Green accounting is not just an environmental issue—it has a business impact. Accountants
can help their clients understand how environmental issues will affect their business, deal with
the accompanying threats and grow their business. There are major strategic challenges.
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(e) Required skills and attributes for green accounting include knowledge of the client’s business
and industry and knowledge of legislation and its impact on each client. Clients are looking
for services in carbon accounting, costing, carbon footprint calculation, systems to capture
and record emissions data, and verification. Engagement is usually run most successfully as
a collaborative approach between client management and auditors. Success is more likely
if a senior person in the practice is very interested in green accounting and auditing, and is
willing to drive the systems. The skill set in the practice must include audit experience,
including sampling and materiality, understanding of the nature of procedures required to
gain assurance and expertise in greenhouse gas emissions. Someone wanting to work in this
area should consider a course in carbon or green accounting.
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MODULE 4
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References | 397
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Optional reading
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CPA PROGRAM

Edited and designed by DeakinPrime

ISBN 978 0 7300 0036 5

Part A: Developments in financial reporting and

Islamic finance in Australia

Part B: Integrated reporting 337

Part C: Non-financial reporting frameworks 346

Suggested answers 375

In the final sections of Part A, we review an alternative to traditional banking—Islamic banking—

In Part B, we investigate integrated reporting, an approach to reporting that allows an organisation

‘Background to the eurozone sovereign debt crisis’

Part A: Developments in financial

International Financial Reporting Standards

Figure 4.1: The process of developing an IFRS

Current IASB projects

Public sector accounting standards

The IPSASB is an independent accounting standing-setting board supported by the International

Development of International Public Sector Accounting

International Public Sector Accounting Standards in Australia

Impact of the Global Financial Crisis on

For further information regarding IFRS 9, see: http://www.ifrs.org/current-projects/iasb-projects/

We now consider two key types of liquidity risk:

1. Funding liquidity risk at specific institutions

its regular daily operations or its financial performance.

An orderly banking system is critical to a well-functioning economy. Governments in most

Figure 4.2: Mutually reinforcing feedback process

Confidence of a large number of market participants

Uncertainty about asset values and financial strength

Liquidity problems for individuals and institutions

Perception of increased counter-party credit risk

Source: CPA Australia 2015.

Global liquidity risk position before the GFC

and types of insurance claims expected to occur in a large population.

Role of trust in the banking system

Funding liquidity position of the global banking system pre-2007

A number of factors contributed to this:

Nature of wholesale funding

In February 2012, the funding of major Australian banks was:

Growth of complex structured products

Example 4.2: The funding crisis at Northern Rock

Table 4.1: Northern Rock’s financial position

GBP billion 31.12.2002 30.06.2007 Growth

Customer loans 24.8 96.7 290%

Assets 32.5 113.5 249%

Retail deposits 16 30.1 88%

Equity 1.2 2.3 92%

Deposits/assets (%) 49 27 (44%)

Loans/deposits (%) 155 321 107%

Evolution of the Global Financial Crisis

Rising sub-prime losses

Investors, in search of extraordinary returns, turned to increasingly complex higher-yielding

Figure 4.3: European and US structured finance issuance (USD billion)

Source: International Monetary Fund 2008, Global Financial Stability Report:

Figure 4.4: Origination of structured finance products

Sub-prime mortgage loans

Sub-prime mortgage bonds

High-grade structured finance CDOs Mezzanine structured-finance CDOs

Ultimate holder of securities: removed from

Source: CPA Australia 2015.

Worsening of the banking crisis

Bankruptcies, mergers and government-led bailouts of financial institutions in many countries

Date Financial institutions affected Events

15.09.2008 Lehman Brothers Bankruptcy