Accounting and Auditing for Islamic Financial Institutions Accounting and Auditing Organization for Islamic Financial Institutions 1 st Edition, 1428/2007 PDF Page Organizer -Foxit Software

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Accounting and Auditing for Islamic Financial Institutions

Shahul Hameed Hj Mohamed Ibrahim

Accounting and Auditing Organization for Islamic Financial Institutions 1st Edition, 1428/2007


Contents

Acknowledgements Preface Chapter 1

Introduction to Islamic Accounting and Accounting for Islamic Financial Institutions

Chapter 2

Islamic Financial System

Chapter 3

Islamic Financial Transactions

Chapter 4

Objectives of Financial Accounting for Islamic Financial Institutions

Chapter 5

Concepts of Financial Accounting for Islamic Financial Institutions

Chapter 6

General Presentation and Disclosure Requirements

Chapter 7

Accounting for Murabaha/BBA

Chapter 8

Accounting for Mudaraba Financing

Chapter 9

Accounting for Musharaka Financing

Chapter 10

Accounting for Ijarah and Ijarah Muntahia Bittamleek

Chapter 11

Accounting for Salam and Parallel Salam

Chapter 12

Accounting for Istisna’a and Parallel Istisna’a

Chapter 13

Accounting for Zakah of Islamic Financial Institutions

Chapter 14

Accounting for Equity of Investment Account Holders and their Equivalent and Disclosure of Bases for Profit Allocation between Owners’ Equity and Investment Account Holders

Chapter 15

Investments

Chapter 16

Objectives and Principles of Auditing and the Auditors Report for IFIs

Chapter 17

Shari’a Supervisory Board, Shari’a Auditing and the Shari’a Report

Appendix A

AAOIFI and the CIPA examinations

Appendix B

Suggested Solutions to some questions. Glossary and Index Bibliography

AIBTable of Contents June 28


Acknowledgments

‫ﺑﺴﻢ اﷲ اﻟﺮﺣﻤﻦ اﻟﺮﺣ ﻢ‬ ‫ﻻ ﺸﻜﺮ اﷲ ﻣﻦ ﻻ ﺸﻜﺮ اﻟﻨﺎس‬ “(He) is not thankful to Allah, who is not thankful to the people” ( Hadith of Prophet saw as reported by Abi Hurairah (ra) and transmitted by Ibn Majah and Termizi- classified as sahih)

‫اﻟﺤﻤﺪ ﷲ رب اﻟﻌﺎﻟﻤ ﻦ واﻟﺼﻼة واﻟﺴﻼم ﻋﻠﻰ أﺷﺮف اﻷﻧﺒ ﺎء واﻟﻤﺮﺳﻠ ﻦ وﻋﻠﻰ آﻟ وأﺻﺤﺎﺑ‬ ‫أﺟﻤﻌ ﻦ‬ After thanking Allah swt and sending salutation on His beloved Prophet saw, I would like first to thank the Accounting and Auditing Organization for Islamic Financial Institutions, Bahrain, especially Dr Nidal AlChaar, the Secretary General and Mr. Kamal Hassan, Technical Director, without whose generous stipend and other material and moral support, this book would not have been possible. May Allah swt bless AAOIFI and its people and may it grow from strength to strength. Next, I have to thank the International Islamic University Malaysia, my employer, for giving me research leave with pay for three months during the short semester in order to enable me to complete this book as well as permission to use questions from their past end of semester examination papers in Accounting for Islamic Banks. Particular thanks goes to Prof Datuk Syed Arabi Aideed, the Rector and Professors Dr. Azmi Omar, Deputy Rector Academic and Research, and Datuk Dr Jamil Osman, the Dean of the Kulliyah of Economics and Management Sciences as well as Dr Alias Abdullah, the Director of the Bureau of Consultancy and Entrepreneurship, IIUM. Also my colleagues in the Kulliyah and Department of Accounting, who wished me well in the assignment. Associate Professor Dr. Abdul Rahim Abdul Rahman deserves special mention as some of his lecture slides and illustrations has been helpful to me in writing this book. He and Assistant Professor, Dr Noraini Ariffin should also be credited for some of the IIUM Examination Questions. I also thank the Association of International Accountants for permission to use questions from their past Professional Examination paper. Also to be thanked are the various Islamic and non-Islamic banks for permission to use their financial statements and audit and shari’a reports in the book. Next, I have to thank the wonderful staff at AAOIFI especially Br. Khairul Nizam who provide so much assistance to me during my stay in Bahrain, May Allah swt


reward him amply. Br. Herz, a wonderful Bahraini Muslim brother who made sure that I got the visas and made my office equipment arrangements but mostly his friendliness and smile which made me very comfortable to work at AAOIFI. To Sister Huma Sodher, CA, CIPA, who provided me with spiritual and intellectual support during my stay, May Allah swt. bless her. To Sister Mona who provided assistance with some of the graphical illustrations, Br. Majd and Bashar who provided assistance searching Qur’anic texts. Br. Mohammad Alaradi who ensured that I was paid promptly and Mohammad the driver who drove me to the office countless times. Also not forgetting Mr Raja, the office boy, who kept me alert with his hot tea, coffee, drinking water and conversations. Last but not least, to my family especially my mother who gave permission for me to go despite her ill health, my wife who had to become the ‘man’ in the family for three months, my sons who were happy I was not around to father them and my daughter who missed me a lot. Also my brother Dr Mohammed Rafiq and family, who kept me abreast of developments in Malaysia. May Allah swt bless them all and may He accept this book as ibadah.

Shahul Hameed bin Mohamed Ibrahim Manama, Bahrain 29 Jamadil ula, 1428/15 th July 2007

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions ‫ﻳﻦ‬ ‫ﻣﻔﺴِﺪ‬

َ‫ﻲ ﻷ‬ ‫ﺷﻴﺎ ﻫﻢ ﻻ ﺗﻌﺜﻮ ﻓ‬

‫ﻂ ﻻ ﺗﺒﺨﺴﻮ ﻟﻨﺎ‬ ‫ﺴ‬ ‫ﻴﺰ ﺑﺎﻟﻘ‬ ‫ﻜﻴﺎ ﻟﻤ‬ ‫ﻳﺎ ﻗﻮ ﻓﻮ ﻟﻤ‬ ‫ﻴﻆ‬ ‫ﻨﲔ ﻣﺎ ﻧﺎ ﻋﻠﻴﻜﻢ ﺑﺤﻔ‬ ‫ ﺧﻴﺮ ﻟﱠﻜﻢ ﻛﻨﺘﻢ ﻣﺆﻣ‬ ‫ﻴﺔ ﻟﻠﻪ‬ ‫ﺑﻘ‬

Hence, O my people, [always] give full measure and weight, with equity, and do not deprive people of what is rightfully theirs, and do not act wickedly on earth by spreading corruption. That which rests with God is best for you, if you but believe [in Him]! However, I am not your keeper." (Hud, 11:85-86)

Chapter

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CHAPTER LEARNING OBJECTIVES: At the end of this chapter, insha Allah you will be able to: (i) (ii) (iii) (iv)

1.

Define and explain the meaning of Islamic Accounting Explain the differences between the Accounting for Islamic Institutions and Islamic Accounting Elaborate the need for Islamic Accounting Appreciate the differences between conventional and Islamic Accounting.

Introduction

To professional accountants and those who have received a conventional accounting education and who have been brought-up on the idea of accounting as an ‘objective’, technical and value-free discipline, the idea of attaching a religious adjective to accounting may seem to be embarrassing and unprofessional. On the other hand, the development of Islamic banking and finance now embraced even by ardent capitalist institutions such as Citibank, HSBC and ANZ banks may interest accountants and other job seekers to the possibility of new opportunities in this new discipline. Perhaps, the Enron affair has rekindled an interest in having a more honest profession who truly care about the public interest in addition to their pockets. Whatever the interest or curiosity, we hope readers will find this chapter (and hopefully the entire book) interesting, informative, and profitable and yes we hope it may even lead to a bit of soul searching. In this chapter, what is meant by the term “Islamic accounting” is explained, together with a discussion of the main differences between Islamic and conventional accounting. Justifications for the addition of the world ‘Islamic’, to the word accounting is provided,

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions along with a prima facie case for Islamic accounting. Finally the distinction between accounting for Islamic banks and Islamic accounting, which is presently thought of by many people as synonymous, is made.

2. Meaning of Islamic Accounting Islamic accounting can be defined as the “accounting process” which provides appropriate information (not necessarily limited to financial data) to stakeholders of an entity which will enable them to ensure that the entity is continuously operating within the bounds of the Islamic Shari’a and delivering on its socioeconomic objectives. Islamic accounting is also a tool, which enables Muslims to evaluate their own accountabilities to God (in respect of inter-human/environmental transactions).

Fig 1: Islamic Accounting and Accountability The above diagram illustrates the purpose of Islamic accounting. Muslims believe in the hereafter. All business activities should be in line with the shari’a or Islamic law, including business. In life, people transact through institutions such as business. These activities are classified, recorded and summarized using a philosophic filter (shari’a and Islamic accounting standards) to produce accounting statements, which people act on. If the information produced is useful and appropriate to make economic or social decisions through a moral framework, then the users will act in ways to correct their ‘sins’ and increase good behaviour leading to God’s pleasure in the hereafter. If the accounting information system misinforms or does not provide appropriate information, the business

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions might be undertaking sinful activities, the responsibility for which will be borne by the investor as he is a participant. This may lead him to Hell. The meaning of Islamic accounting would be clearer if we compare this with the definition of “conventional” accounting. (Conventional) accounting as we know is defined to be the identification, recording, classification, interpreting and communication economic events to permit users to make informed decisions (AAA, 1966). From this, it can be seen that both Islamic and conventional accounting is in the business of providing information. The differences lie in the following: Ø The objectives of providing the information Ø What type of information is identified, and how is it measured and valued, recorded and communicated, and Ø To whom is it communicated (the users) Conventional accounting aims to permit informed decisions by users, whose ultimate purpose is to efficiently allocate scarce resources available to their most efficient (and profitable) uses by providing information efficiency in the market (FASB, 1978). Apparently this is achieved by the user making the appropriate, buy, sell or hold decisions on their investments. Islamic Accounting, on the other hand, hopes to enable users to ensure that Islamic organisations (whether business, government or NFP) abide by the principles of the Shari’a or Islamic Law in its dealings and enables the assessment of whether the objectives of the organisation are being met. At the very basic level, it can be said that Islamic organisations (whether business or otherwise) differ from their conventional counterparts by having to adhere to certain Shari’a principles and rules and also try to achieve certain socio-economic objectives encouraged by Islam. Following from the above, the type of information which Islamic accounting identifies and measures is different. Conventional accounting concentrates on identifying economic events and transactions, while Islamic accounting must identify socio-economic and religious events and transactions. Older accountants may still remember when they first learnt accounting. They had to prepare final accounts (i.e. balance sheet and profit and loss account). However, Americanization of the curriculum has popularised the term financial statements. Hence, the concentration of accounting has moved from stewardship based manorial accounts to accounting for money (accentuated by the monetary measurement concept). This is not to say that Islamic accounting is not concerned with money (especially when accounting for businesses). On the contrary due to prohibition of interest-based income or expense, profit determination is more important in Islamic accounting than conventional accounting. However, Islamic accounting must be holistic in its reporting. Hence, both financial and non-financial measures regarding the economic, social, environmental and religious events and transactions are measured and reported. Conventional accounting mainly uses historic cost (or lower) to measure and values assets and liabilities (although the new IFRS seeks to introduce fair value measurements). The profession is well aware of the limitations of the stable unit of measure assumption of

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions the monetary unit and to its credit has tried in the past in its inflation accounting initiatives. However, despite recommendation from its own research efforts (True blood committee?), the idea of using current values was given up due to its complexity and presumed lack of verifiability. From an Islamic point of view, at least for the purpose of computation of Zakat, current valuation is obligatory (see for example, Clarke et al, 1996) prompting calls for a current value Balance Sheet (Baydoun and Willet, 2000). A further difference is, Islamic accounting may require a different statement altogether to deemphasize the focus on profits by the income statement provided by conventional accounting. Baydoun and Willlet (2000) have suggested a Value Added Statement to replace the Income Statement in Islamic Corporate Reports. They argue that this shows and encourages a cooperative environment in business as opposed to a destructive competitive environment. The third category of differences is in the users of the information. Although the profession has recognised various stakeholders as users of accounting information (see for example, the Corporate Report, 1975), the users which it focuses on are shareholders and creditors (i.e. Financiers – those who provide the funds). This is obvious from the fact the FASB’s SFAC 1 dismisses a whole range of stakeholders by the term “and others”. From recent developments in finance and financial markets, accounting seems to be serving an elite group of financiers – market players and banks and other financial institutions. It has been accused of helping a group of rich people get richer (Gray et al., 1996)- a grave charge since the profession always justifies its monopoly on audit services by virtue of the public interest. Islamic accounting serves the whole gamut of stakeholders. Society as a whole can make corporations accountable for their actions and ensure they comply with Shari’a principles and do not harm others while making money ethically and achieve an equitable allocation and distribution of wealth among members of society especially the stakeholders of the concerned corporation.

3. Religion and accounting- an explosive mix? Now we come to the question, is it wise to add the adjective “Islamic” to accounting? Why not accounting for Islamic organisations or accounting from the Islamic perspective? The worry is that the addition of any religious adjective may compromise the objectivity of the discipline as religion is mostly seen as an unchanging dogma and code not subject to pragmatic or logical considerations. We will take this matter in two stages: a) Is conventional accounting value free and objective as it portrayed to be or is there a hidden adjective attached to it?

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions b) The problem of epistemology- the nature and sources of knowledge What are the implicit assumptions behind the theory and practice of conventional accounting, in other words – what is the worldview behind conventional accounting? Some years back, European and communist states adopted different systems of accounting. In a centrally planned or a socialist state, there is a lack of profit motive or not too much of it. Hence, the conventional accounting i.e. profit and loss account, balance sheet did not make much sense in that economic system. This is why the accounting profession never developed in the communist countries. It is only after liberalisation i.e. conversion to capitalism that these states are trying to catch up with the West. A little more reflection and we come to the conclusion that the conventional accounting system in which many of us were educated and work in is in fact Capitalist Accounting. The adjective ‘capitalist’ is not used before the word accounting, because it would then not appear neutral as capitalism is a philosophy and many ways a religion. Its sacred symbols are private property, the hudud (literal meaning the definitive borders) of the market and its God- wealth, for the creation of which, business and finance exists. Capitalism is not only the economic system which allows choices and opportunities but a philosophy and religion which forsakes equity for efficiency and the wants of a few for the needs of the many. It can be said to be the dominant ‘religion’ of the world (both in Muslim and Non-Muslim countries). Hence, to call a spade, a spade, accounting should be renamed capitalist accounting, economics as capitalist economics and so forth. Hence, faculty of economics in our universities should be renamed faculty of capitalist economics. However, we do not do so because it is unnecessary as it is assumed and implicit. Due to the non-explicitness of this assumption, we sometime forget that accounting is not objective, neutral and value-free as it is portrayed to be. Secondly, we discuss the problem of epistemology which is the theory of the nature and sources of knowledge. Ever since the ‘enlightenment’ period in European history, science has gained the upper hand and has replaced religion as the authority in defining what is knowledge. Modern research emphasises positivism i.e. what is. Knowledge is only what is perceptible through our senses through observation and experiment or what appears logical to our mind. Revelation is not considered a source of knowledge as religious truths cannot be verified by our senses. Accounting is considered a science (many US and UK universities use MS or MSc not MA for post graduate accounting programmes) and as such mixing religion with accounting may be considered unprofessional. However, as Chapra (2000) argues science and religion deals with different levels of reality. While sciences deal with the physical universe perceptible by the senses, religion deals with a higher level of reality which is transcendental and beyond the sense of perception. The sources of scientific knowledge are reason and its method observation and experiment. It describes and analyse ‘what is’ and tries to predict what will happen in the future (e.g. forecast earnings from models). When dealing with the physical universe, it is exact in its description and analysis and more accurate in its predictive power (e.g. in Physics or Chemistry). However, when it deals with human beings who do not behave in a

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions consistent manner, unlike the revolution of the planets above, its analysis is less precise and its predictions less accurate. The recent move by the Malaysian Securities Commission on insistence of a +/-10% accuracy level on profit forecasts reports by accountants has given a headache for accountants as forecasting market prices is not an accurate science as it deals with behaviour of human beings in the marketplace. Unlike science, religion depends on Revelation as well as reason for its knowledge. Its objective is to help transform the human condition from ‘what is’ (e.g. Enron, WorldCom) to what should be (perhaps, Johnson & Johnson under Burke). It should bring about individual and social change to conform to its worldview, values and institutions that it provides. The ultimate objective of both science and religion is to bring about the well-being of human beings. One addresses the physical and material while the other addresses the social, mental, emotional and the spiritual. Chapra (2000) further argues that if both of these are important, then both science and religion can better serve mankind by greater cooperation and coordination between them. Religion can help science by reminding it of its ultimate objectives and limitations, to use the power and mastery over the universe for well-being rather than destruction. Science can help religion by helping it realise ‘what ought to be’ by providing a better description of ‘what is’ , facilitating prediction and providing better technology for a more efficient use of all available resources. It can thus be seen that rather then becoming an explosive mix, the mixing of science and religion can be fruitful and in fact serve to stabilise society from the instability of a world dominated either by science or religion alone. Hence, we conclude that the addition of the adjective Islamic before accounting will not affect the objectivity of accounting.

4. A Prima-facie case for Islamic Accounting Accounting is a tool to achieve certain objectives. In order to be useful, it must be relevant to its purpose. The purpose of accounting has been extended by the American Accounting Association in 1975 (presumably concerned to promote the public interest responsibility of the profession) which defined the purpose of accounting thus: “to permit informed decisions which will enable scarce resources to be allocated efficiently thereby achieving social welfare”. Hence, like it or not, the accounting profession is entrusted with the responsibility of helping to achieve social welfare by providing its services. It is common sense, that one must use the right tool for the right job. If one were to use a sledgehammer to crack a nut, the end result would be paste instead of nuts! Hence, Islamic accounting may be more appropriate to achieve the socio-economic and religions objectives of Islamic institutions and Muslim users. The diagram below (Shahul, 2001) shows the situation of match and mismatch. Briefly, Islamic institutions (1) such as Islamic banks or the Lembaga Tabung Haji in Malaysia etc. are established to meet the socio-economic objectives of the Shari’a (Islamic

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions Law) through the implementation of an Islamic economic and financial system. Hence, these institutions should logically use Islamic accounting (2), especially for monitoring these institutions to achieve their objectives which are different from capitalist institutions. If such a system is used, then Muslim users (as homeo Islamicus) will make decisions in a manner congruent with Islamic values (3) and will inshaAllah achieve the socioeconomic objectives of the sharia’ (4), thereby strengthening the Islamic economic and financial system (5). However, if conventional accounting which developed to meet the needs of a capitalist economy is used instead in these institutions (2A), a mismatch is likely. This will lead to the institutions not meeting the Shari’ate socio-economic objectives and even worse may turn these Islamic institutions into capitalist institutions (4A) by providing materialist profit-focused information instead of the holistic information provided by Islamic accounting. This will lead to Muslim users making decisions incongruent with Islamic values but congruent with capitalist values (3A) and thus it is the socio-economic objectives of the capitalist system (5A) which will be achieved, not the socioeconomic objectives of the sharia’. It can thus be seen that it is not at all unscientific or objectionable, to use Islamic accounting and would in fact be more logical to use it as it would result in an ethical based accounting system which measures not only profits but social, environmental and religious performance. Finally, it must be borne in mind that accounting for Islamic banks and financial institutions is not Islamic Accounting but only a subset of it. Although the efforts of AAOFI must be commended for developing standards for Islamic Financial Institutions, not all Islamic Institutions are Financial Institutions. Islamic accounting is not the just technicalities of accounting for Islamic financial instruments employed by Islamic banks but much more requiring whole new areas of performance measurement including the social, environmental, economic and the Shari’ate.

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1. Introduction to Islamic accounting and Accounting for Islamic Financial Institutions. Institutions

5A. T HE SOCIO-ECONOMIC OBJECTIVES OF T HE SECULAR CAPIT ALIST ECONOMIC SYSTEM

4A. CAPIT ALIST ECONOMIC INSTIT UTIONS

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4 .THE SOCIO ECONOMIC OBJECTIVES OF THE SHARI’A

5. THE ISLAMIC ECONOMIC SYSTEM & FINANCIAL SYSTEM

1. ESTABLISHMENT OF ISLAMIC SOCIOECONOMIC INSTITUTIONS 2A. USE OF CONVENTIONAL ACCOUNT ING BASED ON SECULAR PHILOSOPHICAL VALUES INCONSISTENT WIT H ISLAMIC VALUES

3A. INCONSISTENT OR DEVIANT DECISION MAKING OF MUSLIM USERS (HOMEO ECONOMICUS)

2. USE OF ISLAMIC ACCOUNTING CONSISTENT WITH ISLAMIC VALUES

3. CONSISTENT DECISION MAKING IN LINE WITH ISLAMIC NORMS (HOMEO ISLAMICUS)

FIGURE 2: RESULT OF INCONGRUENCY BETWEEN ECONOMIC SYSTEM AND ACCOUNTING SYSTEM SSYSTEMSYSTEMSYSTEM(S ; , 2001)


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Accounting For Islamic Business Organizations

Accounting For Islamic Societies & Unions

Accounting For Zakat Collection & Distribution

ISLAMIC ACCOUNTING

Accounting for Islamic Banks and Financial Institutions

Accounting for Waqfs

Accounting For Islamic Government Agencies

Accounting for Takaful

Fig. 3. Components of Islamic Accounting

Question CIPA Multiple Choice Questions

1. What kind of standards are issued by the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI)? a) Accounting and Auditing. b) Accounting, Auditing and Governance. c) Accounting, Auditing, Governance and Ethics and Shari’a. d) Accounting, Auditing, Governance and Shari’a.

(CIPA July 2006)

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References and Further reading AAA(1966), A Statement of Basic Accounting Theory, US: American Accounting Association. Baydoun and Willet (2000), “The Islamic Corporate Report”, Abacus, Vol. 36, No. 1, 2000. Chapra, U (2000), The Future of Economics, An Islamic Perspective, Leicester, UK: The Islamic Foundation. Clarke F., R Craig and S. Hamid (1996), “Physical Asset Valuation and Zakat: Insights and Implications, Advances in International Accounting , vol. 9., 1996. Corporate Report (1975), The Corporate Report, London: Accounting Standards Sterring Committee. FASB (1978), Statement of Financial Accounting Concept 1:Objectives of Financial Reporting by Business Enterprises, Stamford, Connecticut: Financial Accounting Standards Board. Gray, RH, Owens K and Maunders K (1996), Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Accounting, London: Prentice Hall. Karim, RAA (1995), “The Nature and Rationale for a Conceptual Framework for Financial Reporting by Islamic Banks”, Accounting and Business Research, Vol 25, No. 100, pp285300. Shahul Hameed (2001), “Islamic Accounting – Accounting for the New Millenium?”, Paper presented at the Asia Pacific Conference 1, Kota Bahru, Kelantan, October 10-12, 2001,

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Chapter 2 . The Islamic Financial System

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O ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye are indeed believers. If ye do it not, Take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums: Deal not unjustly, and ye shall not be dealt with unjustly. (Al-Baqara,2:278-279)

Chapter

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CHAPTER LEARNING OBJECTIVES: At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv.

Understand the underlying Islamic economic principles relevant to Islamic finance. Understand the meaning and concept of riba and why it is prohibited. Be familiar with the nature and development of Islamic financial and Non Financial Institutions and their accounting implications. Explain the modus operandi of Islamic banking institutions and how they differ from conventional banking operations.



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2.1 Islamic Economic and Financial System and Riba. Unlike, other economic systems, the Islamic economic system aims to achieve social justice from a religious ethical perspective. Although the Western economic systems whether capitalist, socialist or welfare state, aim to achieve human welfare, they all seem to have accepted interest as a fair reward for capital, although interest has been condemned by Western thinkers such as Marx. The Islamic economic system is based on its complete elimination from the economy by introducing the alternative of participative investment as opposed to a rentier economy. The capitalist system strives to attain human welfare through the operation of the invisible hand driven by self-interest and a free market. The Marxist system attempted to create social welfare by ownership and centralisation of the production function by the state (representing the workers). However, all these systems have been ‘unsuccessful’ in achieving social welfare for all (Chapra, 1992).

Economic Systems

Financial System

Capitalist Financial System


Marxist Financial System

FINANCIAL SYSTEMS

Although it is a fact that there is no complete Islamic economic system in operation, the unique characteristics and features of the Islamic economic system are worth discussing in order to better understand the philosophy under which Islamic financial institutions operate.



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2.1.1 The objectives and characteristics of the Islamic Economic System Ahmad (1994a) observes that the Islamic economic program includes Ø a different concept of the individual and his rights, Ø a different concept of property and Ø a different approach to civil and economic contracts. Its principles of economic organisation are also different including; Ø how and on what basis co-operation and collaboration between individual and society is to take place, Ø the need for regulating the market to attain efficiency and equity, Ø and the role of the state in the fiscal system. Al-Faisal & Ali (1996) sum up the principal characteristics of the Islamic Economic System as follows: Ø Although every individual has a right to seek his economic well being, Islamic makes a clear distinction between what is lawful and what is unlawful in the pursuit of economic activity. Broadly, Islam forbids all forms of economic activities, which are morally or socially injurious. The particulars as to what is considered morally or socially injurious vary from the secular capitalistic system. Ø Although Islam recognises, the ownership of legitimately acquired wealth, the individual is obligated to spend his wealth judiciously and not to hoard it, keep it idle or squander it. Ø Although an individual may retain surplus wealth, Islam seeks to reduce the margin of this surplus for the well being of the community as a whole. Ø It seeks to prevent the accumulation of this wealth in a few hands to the detriment of the society as a whole through its law of inheritance Ø It aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually selfdestructive. Chapra (1992) observes that in line with the Islamic concept of brotherhood and justice, all resources at the disposal of human beings must be utilised to actualise the objectives of the Shari’a. He suggests four objectives of the Islamic economic system: Ø Need fulfilment: the basic needs of all individuals must be satisfied and everyone must be assured of a humane and respectable standard of living. Ø Respectable Source of Earnings: The dignity attached to man’s status, as God’s khalifah or representative means that need fulfillment should be through the individual’s effort. In the case of handicap or inability to earn a living, it is the collective obligation of the Muslim community to fulfil their needs through Islamic



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socioeconomic institutions such as Zakat, and charitable endowments- awqaf. Except for Zakat, which is administered by the state, the other institutions are voluntary but form part and parcel of the Islamic economic ethic. Ø Equitable distribution of income and wealth: Although inequalities in income and wealth can be tolerated in proportion to skill, initiative, effort and risk, skewed inequalities are incompatible with Islamic teachings. The elimination of interest, the introduction of Zakat and change in consumer behaviour patterns to one conforming to Islamic guidelines are essential to achieve this. Ø Growth and Stability: Growth and stability are essential to maintain employment and to ensure the goal of equitable wealth distribution as the poor can reap the fruits of economic growth thus lessening the burden of the rich to redistribute wealth.

Respectable Source of Earnings

Equitable Distribution of Wealth

Socially agreed filter mechanism

Strong Motivating System

Restructuring the Entire Economic System

Positive and Goal Growth & Stability

Oriented Government

OBJECTIVES OF THE ISLAMIC ECONOMIC SYSTEM (Chapra 1992) Chapra (1992) proposes the following strategy to achieve the objectives:

STRATEGIES TO ACHIEVE THE OBJECTIVES

Need filfilm ent



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a) Introducing a socially agreed filter mechanism: In addition to the price mechanism, a double layer of moral filters tempers claims on resources. Individually, Islamic consumers should avoid wasteful expenditures because of legal/moral precepts of the Shari’a. In addition the Islamic financial system also acts as moral filters in their investing and credit expansion activities. b) A strong motivating system to induce the individual to render his best in his own interest as well as in the interest of society. This comes from the Islamic concept of accountability to Allah, from whom no actions can be hidden, and to whom every action has to be accounted for in the life after death. c) Restructuring the entire economy to realise the Shari’a objectives in spite of scarce resources. This is to be done by reforming all social, economic and political institutions including public finances and financial intermediation to minimise wasteful and unnecessary consumption and to promote investment for need fulfillment. The Islamic structures will also support the filter and motivating system by not allowing material possessions and conspicuous consumption to become a source of prestige, thus killing off the economic man. d) A positive and goal-oriented role for the government. The government would support the raising of the moral consciousness of people, motivate and help the private sector play its role effectively and accelerate political, social and economic reform and provide incentives and facilities. According to Ahmad (1994a), although the elimination of interest is not the be-all and end all of Islamic economic system, it is one of its key elements. It can thus be seen that reforming the banking and monetary system to eliminate interest transactions and putting them on an Islamic plane is one of the cornerstones of the Islamic financial system. The Islamic financial system is part of the Islamic socioeconomic system which Muslim economists and Islamists are endeavouring to develop. The development of an interestfree, ethical Islamic economic system is an important agenda of most Islamic movements and some governments such as Pakistan, Iran and Sudan (Ahmad, 1994a). Other countries, such as Malaysia and Bahrain, allow Islamic economic institutions such as Islamic banks to operate in parallel with the conventional financial system. Social Justice is said to be the hallmark of the Islamic economic system (Ahmed et al., 1996). In order to achieve this Islamic economy, two institutional devices i.e. “the abolition of interest and presence of a well-functioning Zakat system (p3)” are considered essential. As the Islamic financial system relies mostly on the former, this aspect will be discussed in some detail. .

2.2 Riba - Definition and classification The Qur’an and the Hadith of the Prophet (pbuh) specifically prohibits riba in economic transactions in the sternest terms (e.g. Al-Qur’an, 2:275,278,279). Riba has been translated into English as usury or interest. However, it has in fact a much broader



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meaning under the Shari’a as suggested by its dictionary meaning of “increase” or “gain”. Saleh (1992) has defined riba in the Shari’a context as “an unlawful gain derived from the quantitative inequality of the counter-values in any transaction purporting to effect the exchange of two or more species, which belong to the same genus and are governed by the same efficient cause” (p16). Thankfully, the author has adopted a shortened version of this rather long technical definition as “an unlawful advantage by way of excess or deferment” (p17). Riba has been classified into two categories: riba al-fadl and riba al-nasi’a (Muslehuddin, 1987). Riba al-fadl is riba by way of excess of one of the exchanged counter-values e.g. the exchange of 2 Kg. of low quality rice for 1 Kg. of high quality rice. Riba al-nasi’a is excess by way of deferment of completion of exchange, for example a loan of £100 for a deferred repayment of £110 a year later. As Islamic banking involves the elimination of Riba al-nasi’a, further discussion on riba will be limited to this form only.

2.2.1

Reasons for the prohibition of Riba

We can thus surmise that any interest or excess above the principal sum in a deferred repayment transaction is riba. The reason given in the Qur’an for the prohibition of riba is that, a pre-determined fixed rate of return on capital lent leads to injustice because there is an uneven distribution of risk and reward in the transaction (Obiyathulla, 1995). One party bears the risk, while the other party receives a reward irrespective of the outcome of the use of the borrowed amount. Riba is also said to lead to the concentration of wealth by transferring wealth from the poor to the rich, a position not unreasonable given the current distribution of wealth and third world debt crisis (Caufield, 1998). It is also said to increase the instability of the trade cycle, causing more violent fluctuations because a high rate of interest, by increasing the cost of capital, discourages investments (Keen, 1997). An IMF economist observes that Islamic banking, based on the elimination of riba will to lead to a more stable banking system, thus: “The Islamic model of banking based on the principle of equity participation may well prove to be better suited to adjusting to shocks that result in banking crisis and disruption on the payment mechanism of the country. In an equity-based system that ...does not guarantee the nominal value of deposits, shocks to asset positions are immediately absorbed by changes in the values of the share deposits held by the public in the banks. Therefore, the real value of assets and liabilities of banks in such a system will be equal at all points in time. In the more traditional banking system since the nominal value of deposits is fixed, such shocks can cause a diversion between real assets and liabilities”. (Mohsin, 1986, p19)

2.2.2 Controversies on the prohibition of Riba In the light of modern financial practices, the elimination of interest would seem to be an unworkable plan. In fact, the elimination of interest has been thought to be irrational and a sign of a backward economy. Although usury i.e. excessive rates of interest, especially on consumption loans are regarded by some in the West as immoral,



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commercial interest is seen as a legitimate reward for the use of capital in modern economies. It is justified as reward for the “time value of money”. Indeed, some modern Muslim economists (in the early part of this century) and even some Islamic scholars have tried to restrict the definition of riba to usury and thus legitimise the institution of interest among Muslims. Among the arguments offered in favour of legitimising interest are: (a) Riba is only usury and not interest (b) Riba is compound interest and not simple interest (c) Only interest on consumption loans is prohibited, not on investment loans. (d) Islam recognises the time value of money and therefore interest should be allowed. (e) Bank interest is not prohibited because it is not exploitative. The first controversy as to whether riba is limited to usury begs the question as to what is the upper limit of the interest rate which is justified and what rate does illegitimate usury begins. Prior to 1571 in England, at least, all rates of interest above zero were considered usurious following the edict of St. Thomas Aquinas (Keen, 1997). Of course, a legal solution could be offered but the historical evidence shows, at different times, different rates were considered usurious. For example, the Sumerians considered 25% interest rate normal while the 1571 Act against Usury of England indicated that anything more than 10% was usurious. Although in a secular framework, the rate of usury may be a matter of individual conscience or to parliamentary consensus, this does not provide the specific technical, moral or any other reason why the rate below the benchmark is justified and that above is not. (Shaikh, 1987). The second controversy asserting that riba is only compound interest is based on one interpretation of the Quranic verse: “ O you who believe, do not devour riba, doubling and redoubling” (Al- Qur’an, 3:130). However, Islamic rules of interpretation state that the whole Qur’an (together with the Hadith) must be considered in interpreting any verse. Verses 275 to 279 of the second chapter of the Qur’an leave no doubt regarding what is meant as they clearly state that only the principal lent is the amount the borrower is obligated to return. Further, as Hoque (1987) observes, the distinction between compound and simple interest is apparent and not real as an overdue interest on simple interest becomes compounded. As the compulsory notification of the APR (Average percentage rate) in the UK shows that a compound interest rate can also be expressed in terms of a simple interest rate. In fact, it is just a matter of time before the interest doubles and triples the principal amount. Thus, this sophistry is not enough to deny the prohibition of riba. The secular reasoning that, interest is only injurious, if at all, in consumption loans and not in the case of commercial or investment loans as is the case in commercial bank lending, is not acceptable from an Islamic point of view. This is due to the fact, that at the time of prohibition, Arabia was a major commercial centre of the Indian – Mediterranean trade route (Chaudhuri, 1985). In fact many of the Companions of the Prophet (pbuh) received loans on an interest basis (before the Qur’anic prohibition) to invest in their trades. The Prophet (pbuh) specifically banned such interest-based loans after the Qur’anic prohibition was revealed, retrospectively. The Qur’an states that “Allah has permitted trade and prohibited riba”, in spite of the protests of the Arabs that “Trade is like riba” (Al-Qur’an, 2:275), Islam is quite clear on this. Further Islam has not prohibited



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other avenues of lawful employment of capital to generate income in the form of rent, labour-capital participation, joint venture and mark-up trading. Chapra (1985) quoting Shaykh Abu Zahrah, an eminent Muslim scholar, observes that: “There is absolutely no evidence to support the contention that the riba (prohibition)...was on consumption loans and not on development loans. In fact the loans for which a research scholar finds support in history are production loans. The circumstances of the Arabs, the position of Makkah and the trade of the Quraysh (the tribe of the Prophet (pbuh)), all lend support to the assertion that the loans were for production and not consumption purposes”. (Chapra , 1985, p 62)

One might protest that despite the historical basis on which the prohibition was based, the ruling is irrational in view of the fact the loans provide for development or investment accrue profits and it would be unreasonable for the lender not to share in it. The answer to this is that Islam does not bar the association of capital and entrepreneurship. However, it prohibits interest-based loans because the predetermined fixed return to the lender is irrespective of the fortunes of the entrepreneur. If the investor agrees to share any eventual loss, he can contract for a share of the actual profit earned by the entrepreneur. Whether Islam recognises the time value of money is more controversial. In the case of the Islamically allowable murabaha or mark-up contracts, in which a supplier contracts with a buyer to acquire a product and sell it to the buyer at a mark up on cost, the price can be deferred or paid on an instalment basis. By allowing, the extra charge for delayed payment - Islam appears to recognise the time value of money by recognising the opportunity cost foregone by the entrepreneur who might have otherwise have his capital tied up – a subtle distinction from the charging of interest (Vogel & Hayes, 1998). On the other hand, Khan (1994a) is of the opinion that discounting violates the Shari’a prohibition of interest. Khan (1994a) observes that only in the case of the poor people is it true that the current utility of money is greater than the future utility. He opines that every cent saved testifies to the fact that savers have a preference for the future utility of the money rather than current. Hence there is no need to discount future inflows. Tomkins & Karim (1987), however, observe that the objection to the use of interest rate for discounting can easily be avoided by using an expected return rate as a hurdle rate. Hence using discounting techniques is not a problem in capital budgeting and valuing assets. Finally, many scholars argue that the modern banking institution was not present at the time of the Prophet (pbuh). As it performs vital functions of financial intermediation in the modern economy and is not exploitative, bank interest should not come under the gambit of the riba prohibition. Some court ulemas especially those from the Egyptian government have in fact given legal opinions (fatawas) to this effect. However, the majority of the Islamic scholars view that bank interest is no exception because the bank in fact represents a group of individuals (the shareholders) who are in the money-lending



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business. Since the riba prohibition equally applies to individuals as well as groups, banks are not exempted (Hoque, 1987). Despite this, however, the same author observes that it is a fallacy to view the whole conventional banking process itself to be UnIslamic. A close look at the function of banks in channeling savings to productive enterprises is actually facilitating the realisation of the objectives of the Shari’a, which abhors and penalises idle savings. Only the interest mechanism used to achieve this objective is objectionable. Hence if interest is replaced by any permissible mechanics and the bank limits its activities to financing businesses approved by the Shari’a banking becomes an important Islamic institution (Hoque, 1987).

Bank Interest is NOT RIBA because NOT EXCESSIVE

INTEREST Should be Allowed because of Inflation

MISCONCEPTIONS ABOUT RIBA

RIBA is not relevant to commercial loans

Interest-based commercial transactions is NOT RIBA because it’s newly invented

RIBA should be allowed under Dharurah

Finally the Federal Shari’a Court of Pakistan’s judgement on Riba1 (Khan, 1994b) should put to rest any lingering suspicions on the nature of riba. Contrary to a normal process of

1

This ruling was appealed by the Government of Pakistan whose Appeals Court turned down the appeal in December 1999, and gave the Pakistan government one year to rid the economic system of riba consistent with the constitution of the Islamic Republic of Pakistan.



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interpretation of a constitution2, the Court sent out a questionnaire and collected evidence and cited various works of both Muslim and Non-Muslim scholars to discern the nature of riba. It concluded “ a transaction which contains excess or addition over and above the principal amount of loan, payable to the creditor constitutes riba “(p13). Therefore, any such sale, transaction or credit facility, in money or in kind, has been considered to be of riba, which is unlawful (haram) in Muslim society. Khan (1994b) observes that the court held that there was a consensus of the opinion (ijma’) of Muslim jurists upon it. Further, it did not make a difference whether the loan is for consumption or for commercial purpose, if the rate of interest is high or low, simple or compound or between Muslim and Non-Muslim or between an individual and the state. While debate might continue forever on this issue in academic circles, the matter is quite clear to Muslims that conventional interest is not acceptable from an Islamic perspective. Thus, they have no option, if they want to abide by Qur’anic principles, except to overhaul the conventional financial and banking system to an interest-free footing.

2.3 Islamic Organisations and Institutions. As part of the Islamic resurgence, Muslims have set up Islamic business and nonbusiness organisations which attempt to operationalise the Shari’a in their economic and governmental affairs (El-Ashker, 1987). In the heydays of Islamic civilisation, there were unique socio-economic Islamic Institutions, which were replaced, by foreign economic institutions, after the colonisation of Muslim lands. The two most important institutions, which will be discussed in this research, were the “Baitul-Mal” (public treasury)- which collected and disbursed Zakat – the Islamic religious levy and the Awqaf (Muslim endowment). In the private sector, businesses were conducted for the most part, according to Islamic precepts despite the claims of Rodinson (1974) that this was more in letter rather than in spirit. Muslims are attempting to revive these institutions and adapt them to

2

The litigant filed a case against the Pakistan’s government use of conventional interest based financing as against its constitution.



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Islamic Economic System Baitul Mal & Govt Agencies

Zakat Agencies


Awqaf Islamic Financial

Market

Islamic and Muslim Business Organizations

Direct Financial Market

Money market

Indirect Financial Market

Commercial Banks

Unit Trusts

Individuals Islamic Bond Market

Islamic Equity Market

Finance Companies

COMPONENTS OF THE ISLAMIC FINANCIAL SYSTEM

Takaful

Merchant Banks



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contemporary circumstances as part of the Islamic resurgence in the Muslim countries (Sivan, 1985). In the business sector, although the concept of the modern corporation was unknown, Islamic law and Muslim business practice knew the concept of separate legal person and joint stock partnership (Usmani, 1998). Muslims undertook joint ventures, especially commenda (mudharabah) and partnerships, which were based on risk-taking profit and loss sharing ventures (Udovitch, 1970). As interest was prohibited, interest bearing bonds were unknown but interest bearing commercial loans and government loans did take place, sometime in the guise of “mark-up” or buy and resell sales contracts allowed in Islam (Rodinson, 1974). Some Muslim governments, especially the late Ottoman Sultans took interest-bearing loans from Western countries, which eventually led to the downfall of the Caliphate. There were even instances of Mosque funds lent out at interest, which was prohibited under Muslim Law. However, these were always frowned at by Islamic scholars and Muslims and never accepted as legal by the majority of Muslims. Although the use of trade bills and cheques were known in Islamic History, modern banking was a Western Introduction in Muslim lands which took root after colonisation. Despite being encouraged by the governments of Muslim countries, the Muslim masses harboured much suspicion of the allowability of interest charged or given on deposits by these banks. Many strict Muslims refused to deposit their money and preferred to keep it in their homes. Others used the banks as a safe-deposit service and would not take the interest credited to their accounts or gave them away to charity. To solve this problem and give Muslims a Shari’a friendly alternative to conventional banking, Islamic banking was born and has since become established as a viable alternative, although there are many strategic, operational, regulatory and accounting problems faced by these banks (Al-Faisal & Ali, 1996). In addition to the banks, Islamic finance co-operatives and savings institutions which invest the believers’ money in Shari’a approved and ethically correct ways have been set up. The Lembaga Tabung Haji of Malaysia, established in 1962 is an example of one such successful institution, which had assets totalling 5.2billion Malaysian Ringgit (around US $2billion) in 1997. Another financial institution, which presented problems for Muslims, is the conventional insurance company. The Shar’iah prohibits conventional insurance because of its connections with interest, gambling and gharar (uncertainty). In general, a contingent insurance contract is prohibited in Islam. To overcome this problem, Islamic Insurance companies (known as Takaful) have been developed, where the contributors share in a savings scheme including a compulsory contribution to a claims pool. The Takaful Company then tries to compensate any claimant from the amount of his contribution plus earnings. Any shortfall of the indemnified amount comes from the claims pool if available. Of course, the policy premiums are invested in interest-free, Shari’a approved investments. The world-view of Islam and therefore Islamic organisations, whether in the public, private or voluntary sector, are different from those of conventional business and non-



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business organisations. The difference arises in the objectives, nature of profits, the activity or industry Muslims can undertake or invest and in the way the wealth is distributed. The charging and earning of interest, gambling, alcohol and other industries and aleatory contracts are prohibited. Further the maximising of profits or wealth as an objective is frowned upon because it conflicts with the ultimate objective of achieving falah (Islamic success/salvation in the hereafter. Although unlike Christianity (see Laughlin, 1988; Tawney, 1927), Muslims are not averse to exploiting the resources for material gain, they would have to undertake this in ways which is in accord with the Shari’a. There is a need to differentiate between Islamic and Muslim organisations. In case of businesses. Islamic business organisations as those which have been set up specifically to operate within the Shari’a as part of the strategy to develop a comprehensive Islamic Economic and Financial system. Their philosophy must be Islamic and not merely meant as a cover to introduce interest through the backdoor. On the other hand, Muslim business organisations are businesses set up by Muslims who may or may not follow the Shari’a. However, Muslim businesses, especially small and medium-scale ones may intend to gradually shift towards an Islamic business profile in their activities. Islamic accounting is needed by both types of organisations – mandatory for the former and helpful for the latter to achieve their Islamic ambitions.

2.3.1 Forms of Islamic Business Organisations Islam not only allows, but encourages trade and business. Business can be organised either as sole proprietorship, partnership and companies as in common law. Although the concept of limited liability has been frowned upon (Usmani, 1998), the company form of organisation is lawful in Islam with certain restrictions. These include the type of capital, which can be raised, the type of investments, which can be carried out, and the way profit and loss is shared. Although sole proprietorships, partnerships and joint ventures have been the most common forms of businesses in the Muslim world (El-Ashker, 1987), the company form of business organisation is increasingly used in the Muslim world both by private and public companies. The common law varieties of business organisations (sole proprietorship, the partnership and the company) are permitted in Islam. The liabilities, obligations and the rewards of ownership are pretty much the same for sole proprietorship except that the owner is not allowed to conduct business in forbidden products or services such as selling pork, liquor, gambling or interest-based money lending. The distinction between partnership and companies in not clear in Islamic law because the modern corporation was never found in Muslim countries before the adoption of European law in Muslim lands. However, the Muslim partnership law is quite comprehensive to allow for the formation of joint stock companies, the formation of which is said to be encouraged by the Prophet (pbuh) himself (Atiyah, 1992).



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2.3.2 Objectives and operations of Islamic Organisations. The objective of Islamic business organisations is to enable Muslims to undertake economic activities within the framework of the Shari’a as a means to attain falah (success in the hereafter). This means that the businesses must follow a code of Islamic ethics in relation to their activities and behaviour towards their stakeholders (Beekun, 1997). Conventional business organisations follow a profit or wealth maximisation model. This is the based on the concept of the utility maximising behaviour of conventional rational economic man. Although profit is deemed legitimate and is one of the major objectives of Islamic businesses, profit maximisation, as a prime objective is not identified in the Islamic model (El-Ashker, 1987). Even though capitalist businesses seem to be moving to wealth maximising and satisficing, the concept of maximisation is entrenched in the accounting calculus e.g. when investment appraisals are carried out. In Islam, wealth is only considered as a means to an end. As in other religions, the Muslim scholars, for example Al-Ghazali (Al-Karim, 1995), have warned their followers of the dangers of greed for wealth. Thus maximising wealth is not a priority of the Muslim. On the other hand, the economic strength of a nation or group has direct implications for political and social stability. Hence, Islam encourages the pursuance of wealth in an ethical manner. In line with this, the objective of Islamic business organisations is therefore to seek reasonable profits in line with the risk taken and any particular social consequences of high pricing policy. Survival and growth are also emphasised as important objectives in hostile environments where Islamic businesses have to compete with conventional ones. Islamic businesses have to take into account the benefits accruing to employees, society and the environment, in addition to fund providers as a matter of religious/moral obligation emanating from their Islamic beliefs. El-Ashker’s (1987) study of Islamic business enterprises in Egypt provides some evidence that Islamic businesses aim to achieve three sets of objectives related to the benefits accruing to finance providers, employees and society. He proposes a utility model for Islamic economics, consisting of secular and ritual utilities. The secular utility is the normal conventional utility consisting of profits and financial benefits whereas the ritual utility relates to employee and nonprofit oriented social objectives intending to please God and to achieve falah. Achieving profits within this constraint is said to please God and leads to a higher divine reward and hence is a source of utility for Islamic businesses. The Islamic business aims to achieve a balanced relationship between the three sets of objectives of the three interested parties in the course of maximising its utility. Thus: Maximise U = Ua(R), Ub [UaR, E, S], F(P) Subject to Y= R+E+S, where: U= Utility function Ua = secular utility function Ub = ritual utility function R=Profit E = cost of employment welfare (wages and the like)



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S = social cost (costs of social welfare) P = degree of piety Y = net value of production. Since Islamic and Muslim businesses vary in the degree of commitment to Islam, the degree of piety (P) is introduced into the equation to account for this. Thus for different organisations with different degrees of piety, the equilibrium point, E, S, and R will be achieved will be different. The researcher proposes that an additional environmental cost (N) be added to the equation. Hence Y= E+S+N+R and Ub [UaR, E,S,N], hence Islamic businesses will maximise its utility and will be in equilibrium when a proper mix depending on the degree of piety is achieved. While all this might seem theoretical and not practical, the study by El-Ashker (1987) using actual case studies of Islamic companies in Egypt indicates that this is what is done in practice by Islamic companies with a high degree of piety (P).

2.3.3 Accounting implications Both the structure and objectives of Islamic business organisations make the development of an alternative Islamic accounting an imperative. For example, debentures, bonds and even preference shares are not allowable in an Islamic company. This is because of fixed interest bearing characteristics of the former and profit sharing arrangements of the latter which are considered inequitable according to the Shari’a. New type of financial instruments such as mudharabah and muqarada bonds (Rosly & Sanusi, 1999), are needed to finance Islamic companies and used as investment instruments by Islamic banks. These instruments are hybrid instruments containing both the characteristics of debt and equity (Obiyathullah, 1995) which call for special accounting treatment. This is not only a matter of different technique but also a matter of change in the fundamental accounting assumption of substance over form, which underlies conventional accounting standards, e.g. IAS 1 (IASC, 1975) which may not be acceptable from an Islamic point of view. Further, the objective of Islamic businesses which have to balance the shareholder, employee, society and environmental interests poses serious questions on the adoption of the profit calculus (the bottom line) as the main area of concentration of conventional accounting. It cannot be denied that the importance of the bottom line is exacerbated by the prominence given to the profit and loss account as the primal financial statement in a set of conventional accounts. This has implications for the behaviour of stakeholders as accounting can itself lead to the construction of a social reality (Hines, 1988) not in line with the Islamic aspirations. To balance these non-shareholder considerations, an Islamic accounting statement might have to consider an alternative scoring system other than the financial unit.

2.3.4 Organizations for Zakat collection and distribution Zakat is one of the five ‘pillars’ of Islam. Literally, it means to purify one’s wealth. Zakat is a “religious levy by which Muslims make over part of their wealth for the benefit of



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others” (Clarke et al., 1996). It is neither a tax nor a charitable donation. A tax may be expended for any purpose while Zakat can only be paid to eight categories of beneficiaries specified in the Qur’an. Further, as opposed to a charitable donation, it is compulsory. Zakat is a wealth based levy although contemporary Islamic scholars insist that Zakat should also be payable on salaries and wages. Zakat has been levied on animals, trading profit, and agricultural produce and gold and silver and money equivalents. Scholars have extended the category of zakatable items. The rate of wealth Zakat is 2.5% but agricultural produce is subject to 5% or 10% depending on the use or non- use of irrigation respectively. The collection and disbursement of Zakat has been traditionally carried out by the Islamic State, since the time of the Prophet (pbuh) (Zaman, 1991). The Prophet (pbuh) used to appoint Zakat collectors to assess and collect Zakat from his followers. This was deposited into the Baitul Mal or the public treasury. Zakat was collected and disbursed both in cash and in kind. The Islamic State continued to perform this function until colonisation resulted in the introduction of alternative tax systems. However, Zakat continued to be paid individually, through charitable associations (as in the UK) or through the religious departments of government as in Malaysia. As part of the Islamisation of the economy, some Muslim countries have started organising their Zakat collection and distribution activities more efficiently. In Pakistan, Zakat is now deducted at source e.g. on investment deposits in banks. In Malaysia, Zakat collection is carried out by religious departments, which come under the jurisdiction of the various states. Mustapha (1991) observed that Zakat collection and administration is inefficient as for example, the administrative cost is twice the pay-out to the destitute group of beneficiaries. There have also been accusations of mismanagement and maladministration by the head of states that are ultimately responsible for it (AbdulRahim & Goddard, 1998). There have been calls in Malaysia for the proper organisation and administration of the Zakat. The Malaysian government has proposed the establishment of an agency on a national level for the administration of Zakat3. As a preliminary step, corporatized Zakat collection agencies was first established in the Federal Territory and Selangor, the two states with the largest earning population. Zakat collection has increased considerably due to the promotional activities of these agencies. Payment of individual Zakat is also given income tax rebate. However the authority and accountability structure of these organisations are far from satisfactory. In the first phase, the Zakat collected was and in some states, still is, handed over to the religious department and is only subject to the Auditor General’s inspection. Initially, in the distribution of Zakat was not transparent. At the present time, the Selangor and the Federal Territory Zakat Centres (Renamed from Zakat collection centres) are in charge of both collecting and distributing zakat. They publish a monthly magazine which incorporates an account of collections and distributions which are much detailed. However research indicates, zakat distribution is still inefficient and in some cases ineffective An interpretive study of accounting in two religious departments in Malaysia shows lack 3

In January 2000, the Malaysian Government informed the public that Zakat will be collected on a PAYE basis through the Department of Inland Revenue.



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of transparency and power conflicts to varying degrees (Abdul Rahim & Goddard, 1998). There is more professionalism and transparency to a certain level in the department situated in the more urban Federal Territory where conventionally qualified accounting personnel carry out conventional computerised accounting. In the other department located in a more rural area, there was a general lack of transparency and the researchers reported misuse of power. However, while the departments using qualified accountants showed more transparency, the introduction of a conventional accounting system has resulted in a profit-oriented thinking which has resulted in the adoption of new marketing techniques to collect Zakat. For example, the Pusat Pembayaran Zakat (Zakat collection centre) is a privatised profit-oriented entity who are remunerated on a percentage of the collections. Although, they do not have the power to collect Zakat by legal force, such a measure may have grave societal implications when Zakat becomes legally compulsory as the profit-motive in increasing Zakat collection may lead to arbitrary practices. Hence, there is a need to develop an appropriate Islamic accounting system, which will induce the proper Islamically accountable behaviour including the introduction of Islamic performance indicators.

2.3.5

Awqaf

The waqf (pl. Awqaf) is one of the Islamic institutional devices to foster voluntary spending for the poor as well as to meet several other social causes (Ziauddin, 1991). It is the setting aside of certain assets usually land, buildings etc. for the exclusive use for specific charitable/religious purposes under a legal deed. The asset so established becomes a waqf in perpetuity, and cannot be sold, inherited or expropriated by the government. Only the income form the asset is disbursed according to the wishes of the waqif - the person setting up the waqf. The waqf thus becomes a trust property, which is administered by one or more trustee who can claim reasonable administrative expenses and salary. According to Ziauddin (1991), “Waqf is thus a device for transferring private property to collective ownership (not public ownership) for socially beneficial purposes” Awqaf are said to date from the time of the Prophet (pbuh) but acquired clearer legal status under Islamic law in the first century A.H. Although the legal concept is similar to trusts and endowments under common law, it is said to predate the English Institution of Trust. Thus as (Hasanuddin, 1998) observes, “there is no evidence that such a complex system of appropriating usufruct as a life-interest to varying and successive classes of beneficiaries existed prior to Islam” However, as opposed to English Law which only recognises trusts in favour of other than the trustor and family as charitable, Islamic law recognises awqaf even if its is for the trustor’s own or his family’s benefit but with eventual succession to charitable purposes. The former type of waqf is known as waqf ahli (family endowment) whereas awqaf specifically meant for charitable purposes from the outset is known as waqf khairi (endowment for general good). On the surface, it seems the former type of waqf would not be practicable as it entails a lapse from the time such assets are endowed and the



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time it s available for public use. It would be an uphill task for the authorities or community to keep track of the asset. However, Hoexter (1998) observes that “contrary to what one might have thought, many of the assets did eventually find their way to their ultimate beneficiary” In any case, both types of awqaf have been and are very important socio-economic institutions in the Islamic world. Awqaf has been set up for various purposes e.g. the upkeep of mosques, religious schools, orphanages, hospitals, animal care centres, parks, rest-rooms, drinking water facilities and food distribution centres (Siddiqi,1996). In many cases, awqaf are set up to feed the poor in other countries especially those of the Haramain (the Holy Lands of Islam: Makkah and Medina). Hoexter (1998) has undertaken an extensive study of the development of this institution, the waqf alHaramain in Algiers (Tunisia) during Ottomon rule, from its own records. The Algerian, Waqf Al-Haramain was in fact a foundation, which managed all the individual awqaf assets dedicated to feeding the poor in the Holy Cities of Mecca and Medina (Hoexter, 1998). Later it took other awqaf into its ambit including those of other local mosques, feeding the local poor and contributing to local public projects such as the town’s water system. The local Qadis or Muslim judges were active in the development of the Islamic jurisprudence of Awqaf to adapt its principles for the needs of the times and locality. On the whole, the Haramain foundation was equitably and efficiently administered – a quality, which is not found these days e.g. in the Awqafs of India (Siddiqi, 1996; Hasanuddin, 1998). Hoexter (1998) observes that the Haramain became a “most significant vehicle for advancing the interests of the local Islamic community” as well as becoming the focal rallying point in the fostering Algerian-Islamic solidarity. Awqaf became such an important part of Islamic society, that a Ministry of Awqaf was established in 1840 by Ottoman Turkey- a tradition which has continued in many Muslim countries. Unfortunately, the loss of political and economic power by Muslims resulted in the decay of this institution as shown by the contemporary state of awqaf, which leaves much to be desired. Siddiqi (1996), for instance, observes that “we find increasing state intervention in waqf management owing to a number of causes, the chief one being widespread abuse of powers by waqf supervisors”(p146). Despite this however, the state of affairs is dismal e.g. in India. Hasanuddin (1998) observes: “But unfortunately, the Waqf institution in India, is most misunderstood and Waqf properties mismanaged. Legislative lacunae, administrative lapses, lack of political will...has given rise to the painful phenomenon that Waqf properties are the chief-attention of the land-grabbers. As against this background, colossal and gigantic Waqf buildings with tremendous commercial potential, are not even receiving the most needed repairs and maintenance, thus converting such attractive buildings into dilapidated structures and there is a general feeling that Waqf property is a cheap commodity available in the commercial market”. (Hasanuddin, 1998, p 23-24)



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Despite this however, as the author observes, Awqaf is an important Islamic institution which the Muslims have inherited in the past and “which possesses immense potential for the reconstruction of social and economic life in Muslim countries and communities” (p21). This is shown by the fact that there is estimated to be about 300,000 awqafs in India alone (Haque, 1999). Waqf is also an important wealth re-distributive mechanism of the Islamic economic system. For example, Siddiqi (1996) notes that Waqf takes property out of private ownership and vesting ownership permanently and irrevocably in Allah. With the passage of time, more private property pass into waqf sector but the reverse cannot and does not take place (if the assets are properly accounted for!). Since awqaf are normally made by wealthy people (especially Muslim rulers in the past), it serves to redistribute wealth and mitigate the ill effects of inequality in society and counter-act the tendency to concentrate wealth. It is thus essential, that an appropriate accounting and auditing system be developed to ensure this institution is properly administered and accountable to the public to ensure that it serves its function efficiently. As awqaf are not a commercial institution seeking profits, conventional accounting may not be suitable for them. An Islamic accounting system for awqaf would seek to address the following problems: • • • • • •

The tracking of family awqafs until it reaches public status. Activity accounting , both financial and non-financial accounting Accountability of the trustee, and the transparency of operations. Islamic Social audit to ensure the beneficiaries get what is entitled to them. Management audit of income and property. Promoting the establishment of more awqaf.

2.3.6 Islamic Insurance companies Together with the growth of Islamic banks, Islamic Insurance companies (called Takaful Companies) have sprouted, although not as numerous as Islamic banks. These are usually subsidiaries or associates of Islamic banks or Islamic Finance Groups (e.g. Syarikat Takaful Malaysia – a subsidiary of Bank Islam Malaysia) or conventional Insurance companies which have Islamic subsidiaries e.g. Syarikat MNI Takaful. The establishment of these organisations are due to the fact conventional insurance is prohibited by Islamic Shari’a (although there are controversies in this area). This is due to the element of gharar or uncertainty in contingent contracts as well the elements of gambling especially in relation to life insurance. In addition, the practice of investing premiums in interest-bearing securities by conventional insurance companies is also problematic (Shamsiah, 1995). Takaful operates as a co-operative savings and mutual help scheme. In the case of Takaful, any contributions (premiums) paid by the participants (i.e. policyholders) are not recorded as income of the takaful company as in conventional insurance. In the case of Family Takaful - the replacement for conventional life insurance, the premiums paid by



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the contributors are apportioned to a participator’s fund account and a claims pool. The amount apportioned to the claims pool is based on actuarial calculations. The fund is invested in Shari’a approved investments. Any profits are shared between the Takaful Company and the contributors in a pre-agreed ratio. Any losses are born by the participants – not by the Takaful Company. Any profits accruing to the claims pool is credited to it. All actuarial surpluses are credited to the participants. At the end of the policy term, a contributor gets the amount of his contributions plus any share of the profits, if any. He does not get any amount apportioned to the claims pool. If the policyholder dies before maturity of the policy, then any shortfall (the difference from the insured amount and the balance in his account representing his contributions + profit) is met from the claims pool. In the case of General Takaful – the Islamic equivalent of General Insurance, all contributions are credited into a collective claims pool fund. Any profits from the invested funds are credited to this account. After making any required provisions and making any claims payments, the profit, if any, is shared between the participants and the company in the pre-agreed ratio. Any losses are born by the claims pool fund. It can thus be seen that the Takaful concept is quite different from conventional insurance. A conventional insurance company is a risk taker while the takaful company is mainly a manager of funds. While premiums paid to Insurance companies are treated as income, takaful contributions are treated as a separate fund attributable to policyholders. The Takaful Company shares profit arising from investments and any surplus in managing claims. The operational expenses (staff and administration costs) are born by the Takaful Company. Thus three main stakeholders are accounted for in separate funds; shareholders funds, family takaful fund and general takaful fund, each having its own balance sheet, profit and loss account and cash flow statements. It can be seen that Takaful companies cannot operate under accounting standards meant for conventional insurance companies. There are several technical and philosophical accounting problems to be solved, for example: • • • • •

Valuation of investment assets; currently follows conventional valuation principles may not acceptable from an Islamic point of view Apportionment of profit share; the cash basis is currently used. This may lead to distortions in profit distributions for all the parties. The calculation of Zakat on profits; the value to be used and the avoidance of double taxation. The calculation of actuarial surpluses based on interest-based contingency tables may not be acceptable from a Shari’a point of view (see Tomkins & Karim, 1987). In line with the co-operative and participatory nature of Takaful, more qualitative information may need to be disclosed.

There is thus a need to develop an Islamic accounting system, which will deal with the above matters from an Islamic perspective.



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2.4 Islamic banks and Financial Institutions: history, nature and operations Islamic banks are perhaps the most important and developed Islamic organisations in contemporary Islamic society. Assets of Islamic banks are estimated to range from 50 to 100 billion dollars (Pomeranz, 1997). Although the principles on which it is based are not new, the institution itself is an innovation in Islam. An Islamic bank is an ethically based institution which performs conventional banking functions with an important exception, they do not receive interest from their borrowers or pay interest on the customers deposits as this is prohibited under Islamic Shari’a (Al-Faisal & Ali, 1996). This does not mean Islamic banks are charitable institutions undertaking free lending and borrowing. On the contrary, Islamic banks are businesses, which aim to make profit within the constraints of the Shari’a, by undertaking profit- sharing projects, trade financing, lease financing and providing fee-based services. Due to the importance of Islamic banking in the Muslim world, it will be discussed in some detail as an example of an Islamic organisation in practice, which makes the development of an Islamic accounting system a practical imperative. In the next two sub-sections the classification and development of Islamic banks will be discussed to provide some background to the subject. This is followed by a description of the operations and activities of the Islamic bank. As the accounting problems of Islamic banks mainly concern the asset side of Islamic banks, the Islamic financial instruments used as alternatives to conventional interestbased lending are discussed. Next, the accounting problems of Islamic banks are discussed at some length. All Islamic organisations, in the opinion of the researcher, need an alternative Accounting System. However, the accounting problems of the Islamic banks have been considered acute enough to have led to the establishment of an alternative regulatory body for the setting up of Accounting Standards for Islamic Financial Institutions (Pomeranz, 1997), which is the main concern of this book. The chapter is concluded with a discussion of the perceived benefits of an Islamic accounting system for banks and other business organisations.



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2.4.1

Classification of Islamic banks

(Ahmed, 1994b) has classified Islamic banks and financial institutions into several different types, as follows: 1. Islamic Special Purpose banks aim to achieve a specific purpose or serve a special class of clientele. This include social banks, agricultural banks, co-operative and Industrial banks. Examples include the Nasser Social Bank in Egypt and Islamic Bank of Western Sudan charged with promoting the development of Western Sudan. 2. Islamic Development Banks aim to foster the process of socio-economic development amongst its members. Its clientele are usually governments 3. Islamic Commercial Banks mainly aim to make profits but still operate within the Islamic ethical system. This class forms the bulk of Islamic banks in operation. 4. Non-banking Islamic financial institutions such as the Pilgrims Fund (LTH) of Malaysia do not perform banking functions but channel savings to productive investments and pay the depositors a bonus depending on profits.

2.4.2 Development of Islamic banks and financial institutions It is generally agreed that the first Islamic bank was established at Mit-Ghamr, Egypt in 1963 (Ahmed 1994a; Naggar 1987). Mit-Ghamr is a rural area in Egypt, where the people were mostly religious farmers and artisans. They did not put their savings in the conventional banks because of the Islamic prohibition of interest. The bank operated three types of accounts; the savings and loan fund, the investment fund and the social service fund. The first fund was like a current account. The depositor received no interest but could apply for an interest free loan for productive purposes. The investment funds were deposits received based on profit/loss participation. The funds were invested in local businesses and agricultural projects. The deposit received a proportion of the profits according to its amount and term. The social fund received Zakat and other charitable contributions from which grants were made to savers who were in financial difficulty as a result of sudden misfortune. It can thus be seen that an Islamic/social ethos prevailed in the conception and operations of the bank. One Western observer noted the significance of the experiment thus: “The majority of the population had never been dealing with the financial institutions. Because of this, capital formation had been impaired. Basically rural and religious, they tended to distrust the bankers operating in the western style. Since a substantial part of their income was not spent immediately, but put aside for social events, emergencies and the like, this idle capital could not be used for productive investment A precondition, however for any change of behaviour from hoarding and ‘real-asset saving’ to financial saving was the creating of financial institution which would not violate the religious principles of large segments of the population. Only



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then could the rest of the majority of the population be integrated in the process of capital formation”. (Wohlers-Scharf, 19834, pp79-80 as quoted in Ahmed, 1994a, p351). In the words of one of its founding executives (Naggar, 1987), the three most important principles which were applied by the bank and responsible for its success were: 1. Participation of the bank with its borrowers in their profits as well as losses. 2. Decentralisation and localisation through the operation of a community based philosophy which help in: a) the education and credit enlightenment through direct and sympathetic contacts, b) constant follow up of projects to guarantee their repayment and effective use of the money, and c) the provision of a mix of economic and social development services. 3. Consistency and integrity of the bank accounts. The bank’s success5, however, attracted the attention of the anti-Islamic, socialist regime of Nasser. In 1967, the Egyptian government took over all the nine banks and converted them to social savings bank on the conventional model. Thus the experiment came to an end, not on the basis of its economic viability but political interference and commercial opposition of the conventional banks. At the same time as the Mit-Ghamr bank was started in Egypt, the Lembaga Urusan dan Tabung Haji (LUTH)6 (Pilgrims Fund and Management Board) was established in Malaysian in 1963 as an Islamic savings institution. A Muslim economist who had noticed the wasteful nature of Malaysian Muslims selling of their property to go on the Haj (Muslim pilgrimage to Makkah) suggested that Muslims could save up the amount which would be invested in accordance to Shari’a principles. Thus LUTH was born. Until then, intending pilgrims did not put their savings in a conventional bank because it would have been tainted with interest. Money thus tainted could not be used to perform the pilgrimage, as it would not have been religiously valid. The Malaysian government initially set LUTH (Now known as Lembaga Tabung Haji) up as a savings corporation in 1963 and was incorporated in 1969. Although LUTH is not an Islamic bank, it is an Islamic financial institution. It collects the savings from would be pilgrims and invests them in real estate, trading and plantations. Recently it has gone into share trading and Islamic money markets. LUTH is an active investor both directly and through its seven subsidiary companies. LUTH in addition to its investing activities administers the whole pilgrimage programme every year, which is a mammoth undertaking involving about 40,000 pilgrims. In cooperation with other government agencies, it takes care of their transport, food, lodging, 4

Wohlers-Scharf, Traute (1983), Arab and Islamic Banks, Paris, France: OECD. Four more branches were established in the three year period 1963-66. 6 LUTH has now be renamed to Lembaga Tabung Haji(Pilgrimage Fund Board) 5



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health and emergency aid during the pilgrimage. The author having personally used its services can attest to its efficiency in organising the pilgrimage. However, in recent years, its importance as a financial intermediary has increased. The author was informed by one of its accountants in an interview that 70% of LUTH’s deposits were investment deposits, whereas previously most depositors withdrew their savings to perform their pilgrimage. Unlike the Mit-Ghamr bank, LUTH had better fortunes because of the political climate in Malaysia, which though secular, was not socialist and anti-Islamic, as was the Nasser government. From 1,281 depositors in 1963 and RM46,600 in deposits, the number of depositors increased to 2,278,121 with deposits of RM1,541 million in 1993, a period of 30 years (Zainal & Yusof, 1993). Its income has increased from RM6,573 to about RM95 million (excluding government contribution towards operating expenses) during the same period, 1990. Depending on the profits, a bonus is declared by LUTH once a year. The dividend rate had been around 8-8.5% but has since declined to around 4-5% after the recession in 1997. The first private commercial Islamic bank was the Dubai Islamic Bank in 1975. It is a public limited company with 50 million dirhams. In the same year, an international Islamic bank, the Islamic Development Bank was established in Jeddah, Saudi Arabia jointly by the 45 Muslim countries under the auspices of the Organisation of the Islamic Conference. The purpose of this bank was to foster economic development and social progress of member countries using Islamic finance financial instruments. It also grants loan and aid to Muslim organisations especially in Muslim minority countries. Thereafter Islamic banks began to be established at an increased pace in Egypt, Sudan, Jordan, Bahrain, Pakistan, Iran, UK, Malaysia, Bangladesh, African countries, Turkey, India, South Africa and the US. Two milestones in the establishment of Islamic banking were firstly, the Islamisation of the whole banking sector in Iran (1979), Pakistan (1985) and Sudan. The second milestone was the establishment of the Dar-al Mal Al-Islamic (DMI) Switzerland in 1981 by a Saudi Prince and the Dalla Al-Barakah Group in 1983. These two Islamic Finance Multinationals were responsible for setting up a spate of Islamic banks, Investment corporations, Takaful companies and other financial institutions in Egypt, Sudan , Africa and Europe. A Chronology of the Pioneering Islamic Banks Period

Institution

Mid 1940

Interest Free Bank

1950s

Local Islamic Bank

1963s

Mit Ghamr Local Savings Bank

1971

Nasser Social Bank



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1975

Islamic Development Bank (OIC Foreign Minister Conference, 1970, 1973 ,1974)

1975

Dubai Islamic Bank

1977

International Association of Islamic Banks (OIC)

1977

Faisal Islamic Bank of Egypt

1977

Faisal Islamic Bank of Sudan

1977

Kuwait Finance House

1978

Islamic Banking System International Holding (Luxemborg)

1979

Jordan Islamic Bank

1981

Bahrain Islamic Bank

1981

Dar al Mal al Islami (Switzerland)

1981

Bahrain Islamic Investment Company

1981

Islamic International Bank for Investment and Development (Egypt)

1981

Islamic Investment House (Jordan)

1982

Al Barak Investment and Development Company (Saudi Arabia)

1982

Saudi Philippine Islamic Development Bank (Saudi Arabia)

1982

Faisal Islamic Bank Kibris (Turkey)

1983

Bank Islam Malaysia Berhad

1983

Islamic Bank Bangladesh Ltd

1983

Islamic Bank International (Denmark)

1983

Tadamon Islamic Bank (Sudan)

1983

Qatar Islamic Bank

1984

Beit Ettamouil Saudi Tounsi (Tunisia)

1985

West Sudan Islamic Bank



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1985

Al Baraka Turkish Finance House (Turkey)

1985

Faisal Finance Institution (Turkey)

1985

Al Rajhi Company for Currency Exchange & Commerce (Saudi Arabia)

1985

Al-Ameen Islamic & Financial Investment Corp. Ltd. (India)

The ownership of the Islamic banks varies between 100% government ownership and 100% private ownership. Most Islamic banks have been set up as joint-stock companies. The total number of Islamic banks and financial institutions number in the thousands (if the Islamic banks in Sudan, Pakistan and Iran established by wholesale Islamic legislation are counted) but those established voluntarily number 192 (IAIB 1997). As at 2003, there were more than 300 Islamic banks and financial institutions globally with total equity of US$15billion and total assets of 174.72 billion (CIBAFI). The aggregate net profit was US2.74 billion. This compares to 133 institutions with $5 billion of paid up capital and $53.3 billion in assets in 1994. Considering that there was no wholesale Islamisation of the banking sector in any Muslim country between these dates, the increase represents about 72% increase in assets and capital over 10 years or about 23% growth rate. It would have been much higher if not for the devaluation of the Iranian currency against the dollar in 2002 when the Islamic banking assets decreased by 44% in that year. These statistics excludes assets under Islamic windows and investment funds. The industry employs around 300,000?? employees spread across 34 countries in all continents except South America. It can thus be seen that the Islamic finance sector is no longer a theoretical possibility but a practical and viable fact here to stay. However, Islamic banks face many regulatory, operational and accounting problems which prevent the further realisation of its Shari’a oriented ethical and social goals. In Malaysia for instance, the industry where non-Muslims play a major part, there is some tendency to go for the “loan mode” and to account for it as such. Recently, International Accounting Standard Board with its new International Financial Reporting Standards insists wholesale adodption of its standards may pose a problem to Islamic banks. Resisting these pressures by means of developing and supporting a set of high quality parallel Islamic accounting standards would be helpful in developing this important Islamic institution to be in accord with its own worldview rather than being derailed into the capitalistic mould.

2.4.3 Modus operandi of Islamic Banks Siddiqi (1998b) has classified the activity of Islamic banks into three activities: a) Services for which the bank charges a fee or commission. b) Investment of capital on the principle of partnership or mudharaba and c) Fee based or uncharged services.



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The services in category a) above include many of the functions performed by conventional banks on a fee basis, such as keeping accounts, clearing cheques, providing funds transfers and business advisory as well as providing financial guarantees and safety deposit lockers. The activities under b) are the major theoretical basis on which Islamic banks operate although a recent survey shows only 20% of financing of Islamic banks is done through this way (IAIB, 1997). The main activity of a conventional bank, lending and borrowing money through fixed and savings deposits is changed in an Islamic bank. The relationship in conventional banking between the bank and its deposit holders is that of a debtor-creditor relationship. This is not so in the case of Islamic banks. The relationship in an Islamic bank, depending on the type of deposits, is either trustee for deposits or a business partner. On the liability side, in the case of both current and savings accounts, conventional banks pay interest based on a pre-determined percentage of the amount deposited varying with the length of time. The Islamic bank does not pay interest but may give a gift, which is at the option of the bank. The bank guarantees the principle amount, which can be withdrawn by the customer at any time. Current and savings account deposits are based on the Islamic contract of al-wadia’ – safe keeping. In the Middle East, the qard al-hasan (benevolent loan contract or Amanah contract (trusteeship) is used. Under this contract, the depositor gives permission to the bank to use the funds in any Islamically permissible activity but he can request the money back on demand. In practice, some Islamic banks pay an amount called hibah or gift depending on the profit of the company, which is permissible. However, the depositor is not legally entitled to this as that would amount to interest. The bank, however, guarantees the principal sum. Islamic banks do not accept fixed or term deposits on which interest is paid. Instead, customers can open an investment account for a fixed period. After the period, the customer is entitled to a share of the profit (the percentage share of profits being predetermined), if the banks make a profit. If the bank makes a loss, the whole loss is borne by the customer. This contract is called mudharaba- capital/labour partnership. Under this contract, the depositor as the capitalist gives the capital to the bank who acts as the entrepreneur in managing the funds for which it is entitled to a share of the profit. The banking expenses are not charged to depositors as management expenses as in the case of a loss, it is wholly borne by the depositor. The bank is only entitled to a share of profits the ratio being pre-determined at the beginning of the agreement. What in fact happens, is all investment deposits are pooled and invested in various projects- forming portfolios with varying maturities. Sometimes the bank’s shareholders funds are also pooled to finance projects. In this case, the bank is also entitled to a share in proportion to its capital invested. Profits are allocated to the depositors in proportion to deposit amount and time for which the amount is deposited with the bank. Most Islamic banks have two types of investment accounts, unrestricted and restricted. Unrestricted investment account deposit can be invested in any sector according to the wishes of the bank, provided the investment does not contradict the Shari’a. Restricted Investment accounts allows the depositor to specify in what sector, his deposit will be invested.



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On the Assets side of the balance sheet, conventional banks usually grant credit facilities such as term-loans, overdrafts and housing mortgage loans. They also invest in the short-term money market, government securities, treasury bills, company bonds and equities in the stock exchange. In the case of Islamic banks, as all interest-bearing instruments are prohibited, these financial instruments, except for equities, are not available to it. Instead Islamic banks use Islamic financial instruments, some of which have equity features while others have features of both debt and equity (Obiyathullah, 1995) and still some others have features of debt. This will be explained in some detail in the next section. The third type of activity is unique to Islamic banks (although some conventional banks provide free overdraft to student customers). Providing interest-free loans is part of the social activity of Islamic banks although only a small portion of its total funds is allocated to this. Usually the funds come from Zakat and charity pool created by the bank from its own Zakat contributions and charitable contributions of others. In theory, Islamic banks should set aside a portion of the shareholders and depositors funds for this purpose. It is not certain how many banks actually undertake this function, as they seem to operate mostly along commercial lines. However, as we have seen in the case of Mit-Ghamr bank, this is not theoretical and has been applied in practice. In Pakistan, Islamic banks have given interest-free study loans to students.

2.4.4 The Asset side of islamic banks: Islamic Financial Instruments Since Islamic banks cannot grant loans on interest, the assets side of the balance sheet cannot have any advances (except interest free loans) as assets. Since banks cannot earn any money on interest-free loans, they have to resort to participatory finance and other Islamic financial instruments to earn an income. These Islamic financial instruments will be discussed in the next chapter.



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CIPA Multiple Choice Questions

1. To argue that “good is lawful and hence what is lawful must be good” is an example of which of the following techniques of deriving the law: a) ‘Urf. b) Qiyas. c) Maslaha. d) Istihsan. 2. How does the Murabaha contract avoid Riba’ elements: a) It is a trade-based contract and thus any increase above the cost is justified as a profit element on the sale of the asset. b) Murabaha only avoids Riba’ al-fadhl when they buy and sell non-ribawi items. c) Murabaha avoids Riba’ by combining the contract with a collateral agreement. d) Statements (b) and (c) are correct.



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Questions 3-5 refers to the following Hadith: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt – like for like, equal for equal, and hand-to-hand; if the commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand” 3. What are the two categories of goods that can be classified as ribawi goods: a) Foodstuff and clothing. b) Foodstuff and fuel. c) Jewelry and fruits. d) Foodstuff and currencies.

4. In an exchange of gold against silver, the following rules must be adhered to to avoid riba’: a) The items exchanged must be similar in quantity, weight and exchanged at the same time. b) The items must be exchanged at the similar value only. c) As long as the exchange is conducted on spot basis without any undue delay, the value can be different. d) None of the above is true. 5. In an exchange of gold of higher value with a larger quantity of gold of lower value, the following statement is true: a) The exchange is not riba’ as it is fair to get more of lower value for less of higher value. b) The exchange is riba’ because it violates the conditions mentioned in the above Hadith c) The exchange is riba’ because no market value is stipulated as a basis of exchange. d) The exchange is not riba’ because gold against gold is within the same category of ribawi items.



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Question 2-1

Discuss the main characteristics of the Islamic economic systems and compare this with the capitalist economic systems. Question 2-2 What are the objectives of the Islamic economic system as enunciated by Chapra (1992) and explain the strategies he has suggested to achieve these objectives.

Question 2-3

Explain what is riba and why it is prohibited in the Qur’an. Question 2-4 Argue against the common misconceptions and controversies on the prohibition of riba.

Question 2-5 List and explain briefly the components of an Islamic Financial system.

Question 2-6

Compare the objectives of capitalist and Islamic business organizations. Demonstrate the accounting implications of these objectives for (a) awqaf and (b) Islamic insurance (takaful) companies.

Question 2-7 Explain how the objectives and processes of Islamic bank as compared to a conventional bank necessitates the development of Islamic accounting standards such as that of AAOIFI.


Chapter 3. Islamic Financial Contracts

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O ye who believe! Eat not up your property among yourselves in vanities: But let there be amongst you Traffic and trade by mutual good-will: Nor kill (or destroy) yourselves: for verily Allah hath been to you Most Merciful! (An-Nisa 4:29)

Chapter

3

CHAPTER LEARNING OBJECTIVES: At the end of this chapter you will, insha Allah you will be able to: i. ii. iii.

Understand the various Islamic financial products used by Islamic banks Describe the characteristics of Bai al murabaha, Mudaraba, musharaka, bai assalam, istisna, al ijarah and sukuk. Demonstrate how Islamic banks use basic Islamic contracts to create Islamic financing products.

3.1 Introduction: Islamic banking principles. Conventional banks provide loans of various types and terms to customers on which they pay a pre-determined rate of return (interest) on top of the principal sum lent, based on the length of time, the customer needs the financing. This is of course, prohibited (haram) in Islam. Thus, Islamic banks will have to find alternative financing mechanisms to make their earnings halal.



In essence, Islamic banks must avoid riba (interest/usury), gharar (ambiguity), and maisir (gambling) in their contracts. We have already discussed riba’ at length, in the previous chapter.

Gharar is ambiguity which may lead to fraud or un-workability of the contract. Contingent contracts such that of conventional insurance, where the execution of the contract is dependent on the occurrence non occurrence of an event is an example of a gharar contract. Other instances of gharar are when the substance of the contract is non-existent, unspecified, too broad or too specific. Normally, futures contracts where the substance of the contract is not existent at the time of contracting are not allowed, unless assurance can be given that at the time of delivery, it will exist. An example of a gharar contract where the substance is too broad is a contract to deliver “fish in the sea” or “birds in the air”. A “too specific” type of gharar contract is for example a contract to deliver in future oranges from a particular orchard, as the particular orchard may not fruit.

Maisir refers to gambling and to any form of business activity where monetary gains are derived from mere chance, speculation and conjecture. For example uncertainty of the timing of benefits in a pure life insurance contract creates an element of maisir. Islamic banks will have to avoid any transactions with a purely speculative purpose.

The Islamic bank, must also avoid in addition to the above three elements , the following activities or commodities: ♦ Pork ♦ Pornography ♦ Interest based finance ♦ Arms or munitions (with certain exceptions)

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44

♦ Cinema ♦ Tobacco ♦ Gambling ♦ Alcoholic Liquor The above list of prohibitions is not only in direct dealings of the Islamic bank but in financing customers who undertake the activities or deal with the commodities. Scholars in Malaysia include Hotels (to avoid being involved in prostitution and illegal sexual activities). However, a contemporary broader perspective may include any customers whose activities include unacceptable damage to the environment or society.

On the liability side of the balance sheet, the Islamic bank mobilizes

funds

through the contract of mudaraba or wakala by which Islamic banks agree to manage the funds of customers (investment account holders) in return for receiving a share of the profits or fixed fee from investing the funds and investment account holders agree to bear any losses incurred from investing their funds.

For customers who wish to maintain current and savings accounts, who are not very focused on the returns but more for banking convenience and safety, Islamic banks us the contract of al wadi’a (safe custody) or amanah or Qard alhasan (benevolent loan) contract. In al wadi’a, the bank contracts with the customer to keep the money and pay it back to the customer on demand with permission given to the bank to use it any halal activities without any risk or reward to the customer. No interest is paid to the customer. However, it is not prohibited to give a hibah or gift or some reward which is not predetermined, at the end of the contract. (para 5/1, Shari’a Standard No. 19)



On the “asset” side of their balance sheet, Islamic banks cannot lend money by charging interest but have to engage in permissible investment and trading activities. This is reflected in the structure of their assets based or trade concept being different from that of conventional banks. Islamic banks use various Islamic financial instruments or tools based on Shari’a contracts to lawfully earn profits on shareholders’ and depositors’ funds. These will be discussed in detail in the next section.

3.2 Islamic financial Instruments Islamic banks enter into various contractual relationships with their customers which are allowed in Islam which are basically of three different types; a) the sale contract – al ba’i b) the rental contract – al ijarah c) partnership contract – mudaraba and musharaka

3.2.1 Murabaha

The contract of Murabaha or mark-up contract is where a customer requests an agent (the Islamic bank) to buy goods on his behalf, on the understanding that the agent will charge a mark-up on the cost of the goods which will be sold to the buyer. The marked up price can be on spot, deferred lump sum or in deferred instalments

(the later two is known as bai al muajjal) . The Islamic law of

contract allows a higher price on deferred sale. Various reasons have been give for the permissibility of this excess. Reasons include opportunity cost foregone by the agent, the risk of default and the risk of the buyer refusing to take the

45



goods after the agent has acquired to buy on his behalf. The ownership risk of the goods bought by the agent resides with the agent until delivery to the buyer. The buyer can refuse to accept the goods at any time before delivery.

The Islamic banks saw this as an opportunity in financing a purchase e.g. a house or trading stock or a fixed asset and this has become the main financing device of the Islamic bank. Any person requiring finance e.g. say a car, goes to the bank and requests the bank to buy it for him. The bank buys the car adds a mark-up, depending on the amount and term of the financing required and sells it to the customer, who pays by instalments. Once delivered, the car becomes the property of the customer although it could be collateralised.

The structure of a murabaha contract is illustrated in Figure 3.1 Transfer of title to bank

Transfer of title to customer

Islamic Bank

Vendor Payment of purcha se price (P)

Customer Payment of marked u p price ( P+X)

Figure 3.1 Structure of a Murabaha contract

Although this appears as a casuistry for interest, it has some differences from pure interest based credit including:

a) The buyer can refuse to take delivery in case of Murabaha.

46



b) In case of late payment of instalments, the bank cannot add a markup on markup as a conventional bank compounds the interest on the late instalment. c) In the case of variable interest rate financing, the conventional banker varies the interest rate according to the prevailing base lending rate. In the case of murabaha, the mark-up is fixed and cannot be varied. d) Of course the produce or service financed cannot be against Shari’a injunctions e.g. one cannot buy and re-sell alcoholic products, gambling services or drugs.

In Malaysia, a kindered instrument, known as al-bai bithaman ajil is practised. This term means “sale with deferred payment of the price”. Here, the customer who needs the finance buys the goods, usually a house from the vendor or developer by paying a deposit (say 10% of the purchase price). The bank contracts with the customer through a property purchase agreement to buy this good at the cost price (which is paid directly to the developer of the house or seller of the good) and later sells it to the customer through a property sales agreement at cost plus mark-up, which is repayable through instalments. This contract is used extensively for house and commercial property purchase.

47



2 BANK

2)Bank sells assets to customer using property sales agreement at BBA

CUSTOMER

price. 4)Customer repays bank in instalments.

2)Bank buys the asset through a property purchase agreement and pays cash to owner on behalf of customer

Figure 3. 2

ASSET OWNER

11) Customer identifies asset to be purchased and pays deposit to owner and signs sale and purchase agreement with owner

Structure of the Bai Bithaman Ajil contract

There are some problems with this contract; Firstly, the bank never takes delivery of the goods nor assumes liability for it before it is handed over to the customer. Secondly, in many cases, the house which is bought is not yet completed. In a number of cases, the developer fails to complete the project and the bank’s customer is left with the marked-up price to pay for an undelivered house! This contract is not accepted by shari’a scholars in the Middle East.

48



3.2.2 Mudaraba

Mudaraba is a labour-capital partnership, wherein an investor (sahibul mal) puts up an amount of capital for a specific period of time with an entrepreneur (mudarib) who conducts business with the amount. The investor contributes the capital while the entrepreneur contributes the labour or expertise. The investor is not allowed to interfere with the management of the business. However, he can specify the type of business or investment the entrepreneur can undertake. When the entrepreneur determines the type of business or investment, the contract is a restricted mudaraba. If there is no such specification, it is an unrestricted mudaraba. The profit sharing ratio between the entrepreneur and the investor is pre-determined in advance. At the end of the period, any profits are shared in the agreed ratio. In case of losses, the investor bears the entire loss, the entrepreneur loses his labour as he is not paid a salary.

periodic profits and return of capital

Investment / trading activity

Entrepren eur (mudarib)

Islamic bank Payment of mudaraba capital

Figure 3. 3

The Structure of a Mudarabah Contract

The Islamic bank adopts a two-tier Mudaraba contract. In the case of investment accounts, the depositor is the investor while the Islamic bank is the entrepreneur or manager of the fund. The bank itself then becomes the investor when it places

49



money with the entrepreneur who runs the actual business. In case of profit the bank and the entrepreneur shares the profits. From the bank’s share of the profit, a pre-agreed share is given to the depositor. In case of loss, the bank passes on the whole loss to the depositor. The bank’s overhead expenses are not charged to the investment accounts as the bank is only entitled to a profit share and is not liable for loss.

periodic profits and return of capital

Payment of mudaraba capital

Mudarib 2 Entrepreneur

Islamic bank (mudarib 1) periodic profits and return of capital

Figure 3. 4

Depositor Payment of mudaraba capital

The Structure of a Two-tier Mudaraba Contract

This was thought to be the ideal contract for Islamic banking. However, empirical results indicated only 7% of Islamic financing was of this type in 1996 and the overall trend is negative (IAIB 97). Many reasons have been given for the lack of fervour for using this mechanism: 1) Agency costs: “Borrowers” un-Islamically tend to consume perks which reduces the profit available to the banks and depositors. Obiyathullah (1995) shows how this contract has both debt and equity characteristics. 2) The tax structures of some Islamic countries are such that no honest traders can survive. As such, traders normally keep two set of accounts, one for their use and one for tax purposes which shows lower profits to avoid tax. The second set is the one usually given to the banks. Even if the entrepreneur does not wish to cheat the Islamic bank, the fear of being found out by tax

50



authorities dissuade them from keeping and giving truthful accounts to Islamic banks. Further, while interest costs are given as tax deduction, profit shares are not allowable in most legislation, hence increasing the cost of capital of

Mudaraba financing for businesses. 3.2.3 Musharaka This is plain partnership financing. Here the bank becomes a full partner of the entrepreneur who also contributes capital. The bank shares profits of the business with the entrepreneur in a pre-agreed ratio which is not necessary in the ratio of the capital. In case of loss, the losses are shared in the ratio of the capital In case the bank does not play an active part in the business, then the entrepreneur may charge management salary or expenses to the business account. Unlike the case of Mudaraba, where the bank cannot interfere in the running of the business, the bank has full rights of administration in Musharaka contracts.

Partner (customer)

Islamic Bank

60% ownership

40% ownership Musharaka

Figure 3.5: The Structure of Musharaka contract A variant of the Musharaka contract which is used to finance the acquisition of assets is the Musharaka Mutanaqqisa or Reducing partnership contract. In this contract, initially the customer and the bank or partners. Over a period of time,

51



52

the customer gradually increases his share of ownership (and consequently, the bank’s share gets reduced until it becomes nil ) buy paying instalments which include a portion to purchase a portion of the bank’s share and a portion representing the rental payment (if the customer is using or occupying the asset. 3.2.4 Ijarah

Ijarah is renting or leasing of assets. Here the bank purchases the asset and leases it to the borrower. Although, strictly only operational leases are allowed in Islam, most ijarah contracts take the form of financial leases, which transfers the risk and rewards of ownership to the borrower. Even in the case of a financial ijarah, since the contract is a lease agreement, the ownership resides with the bank until the borrower exercises an option to buy the asset at the end of the lease. The buying option can be pre-agreed at the inception of the contract. This is known as an Ijarah wa iqtina (Lease and sell) contract. Assets leased to customer title does (not) pass at end of lease term

Transfer of title to bank Vendor

Payments of purchase price

Islamic bank

Customer (Lessee) Ijarah Instalments

Figure 3.6: Structure of a Ijara Wa Iqtina contract (Lease to own)



3.2.5 Commodity Murabaha (Money Market)

A commodity murabaha is an Islamically acceptable form of a short term interbank deposit/placement. The structure of a commodity murabaha contract is given in Figure 3.7

Broker B (5) Buyer pays on deferred

(4) Conventional bank sells as agent

payment

Conventional bank (Agent) (6) Conventional bank pays client on deferred payment date

Cash flow (2) Conventional bank buys as agent (3) Conventional bank pays the seller

Flow of commodity

Broker A

(1) Client pays Conventional bank on value date

Islamic Investor (Principal)

Cash Flow Flow of commodity

Figure 3.7: The Structure of a Commodity Murabaha contract

Examples of the responsibilities of the various parties to a commodity murabaha contract are given below: ♦ Islamic Bank instructs Conventional bank (as Agent) to invest US$ 10 million for one month ♦ Acting as Agent, the conventional bank buys a commodity from Broker A, value spot on behalf of the Islamic bank. The commodity is credited to the Conventional bank’s account with Broker A. The Conventional bank will credit

53



54

Broker A’s dollar account with $ 10 million and this account will accrue interest to build up to the deferred payment amount ♦ Value spot, conventional bank (acting as agent on behalf of the Islamic bank) sells the commodity at cost plus mark-upon a deferred payment basis (one month) to Broker B. The commodity is debited to conventional bank’s account with Broker B ♦ Broker B will sign an assignment of rights deed to assign the security interest of the funds to the Conventional bank. This will allow the Conventional bank to net off the amounts due to Broker A with amounts payable by Broker B. Similar assignment of rights will allow Broker A and Broker B to net off Conventional bank’s commodity positions with them, value spot ♦ On maturity (in one month) the Conventional bank pays to the Islamic bank profit (mark up) plus the original investment of $ 10 million ♦ Commission

will

be

payable

to

the

Conventional

bank

as

agent

(approximately 25 basis points) and to the commodity brokers (approximately $50 per $ 1 million of the commodity) on buying and selling the commodities. These will be built into the price quoted to the Islamic bank and will not be accounted for separately. 3.2.6 Salam and Parallel Salam – (Seller Finance) In the case of Murabaha, the goods to be bought must be in existence at the time of the contract and capable of delivery. This mode thus cannot be used to finance the cost of say agricultural output in advance. The salaam contract on the other hand is an advance purchase contract, where the goods, say, wheat, of a particular quality and quantity, which is not yet in existence, can be the subject of a contract. Here the buyer pays the agreed price in advance for delivery at a deferred date. Hence, this contract can be used to buy commodity futures for example. However, according to Islamic law, the bank cannot sell this until



delivery. In order to overcome this, the bank enters into another “parallel” salaam contract to sell the same quantity and quality of goods at a different price. However the second contract cannot be linked to the first. By means of parallel salaam, the bank can cover its position and make a profit. In case of delivery failure, the bank can only request the money back without any penalty or wait longer. This can become an important means of financing agricultural or fishing activities. The structure of a salam contract of given in Figure 3.8

Delivery of asset at future date

Commodity Owner


Financer

Advance payment of purchase price

Entrepreneur Payment of purchase price on delivery

Figure 3.8: The Structure of a salam contract

3.2.7 Istisna and Parallel Istisna’a: (Project Finance)

Istisna is a variation of salaam. It is the payment for commissioned manufacture. A buyer can contract to have goods manufactured and delivered at a later date, in accordance to specifications. The buyer has the option of cancelling the contract if the delivered item is not to specifications. Although the majority legal opinion is that the contract cannot be enforced until the manufactured item is delivered and accepted, the minority opinion is followed binding both parties from the start. Unlike salaam, payment is at delivery or according to manufacturing or construction progress. Thus, this instrument can be used to finance construction

55



56

or manufacturing projects. Islamic banks have also used and modified this to a “back to back” istisna where two contracts are made up; one with the manufacturer and one with the ultimate buyer. The Islamic bank uses this contract to finance the purchase of ships or airplanes. The bank contracts with the buyer to supply the item for a fixed future payment schedule. The bank contracts with the shipbuilder to supply the ship for a series of shorter progress payment. The difference between the present values of the payments under the two contracts is the bank’s compensation (Vogel & Hayes, 1998).

The structure of an Istisna contract is given in Figure 3.9


Entrepreneur


Financer

Payment of purchase price on delivery

Manufacturer

Progress payment of purchase price

Figure 3.9: Structure of an Istisna contract – (Project Finance)

3.2.8 Sukuk – (Islamic Bonds) Sukuk represent proportionate beneficial ownership. For a defined period the risk and return associated with the cash flows generated from the assets belong to the sukuk holder. The characteristics of a sukuk are similar to a conventional bond with the difference being that they are asset backed.

The structure of a sukuk contract is given in Figure 3.10



Transfer of assets Entrepreneur

Sukuks Asset SPV

57

Issued Investors

Cash

Cash

Figure 3.10: Structure of a Sukuk contract

3.3 Accounting problems of Islamic banks Islamic banks face unique accounting problems both from a technical point of view and philosophical point of view. Some of these accounting problems are: 1. The ethical accountability requirements

(Gambling, 1994;Shahul & Yaya,

2003) ). 2. The problems of profit recognition and allocation due to Islamic banking mechanics (Abdulgader, 1990; Karim, 1998a), 3. The inappropriateness of International Accounting Standards (Hamid et al., 1993; Karim, 1999) 4. The hybrid nature of some Islamic financial instruments (Obiyathullah, 1995; Karim, 1999), and 3.3.1

Profit sharing

Abdulgader (1990) studied profit recognition and allocation problems in Islamic Banks in Sudan and Egypt. His study examined the practices of four existing Islamic Banks (each of which had many branches all over Sudan) and found that the profit recognition and allocation practices of the three banks were not



uniform. In the first example, the banks separated the investment account funds from the shareholders and other depositors’ funds. In this case, the investment account funds were invested separately, after allowing for reserve requirements. This lead to a separate fund account being established for Investment account holders and accounted for separately from the others. Hence separate financial statements were prepared for this fund account. Further the profit were recognised only when the projects were liquidated; implying that the projects were short-term. After deducting the bank’s share of profits, the depositors share of profits was distributed to individual depositors according to the amount and period of the deposit. In the second case, all funds whether from shareholders, current and savings accounts and investment accounts were all pooled and invested in various projects. In this case, the profits earned by the bank excluding those from feepaying banking services were made proportionate to average deposit in each type of account. The share of the current and savings account depositors went to the shareholders, as the depositors were not entitled to any profit. (In the case of Malaysia, the banks distribute part of this profit as a gift to savings and current account holders). From the proportion attributable to the investment account holders, the bank’s share is deducted and the balance distributed to the investment account holders in proportion to deposit and period held. Except for expenses directly related to investments, all other expenses are borne by the bank and not by the investment account holders as under the Mudaraba contract, the bank is only entitled to its share of profits. In the second case it was difficult to determine each party’s share in investment and profit as all funds are pooled. The actual amount of investments for each class of deposits as opposed to the actual amount of deposits cannot be known. In calculating the share of profit due to investment account holders, the bank

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estimates the portion of the depositors account invested by the following steps on each months’ balance: 1) The actual deposit in each class of account (and shareholders funds available for investment) is multiplied by the available percentage (100-reserve percent) to obtain amount available for investment.

The reserve ratio is

different for each account. Investment accounts have a lower reserve ratio than other accounts. 2) The actual invested funds for each class of account is apportioned using the amount available per step 1 divided by total deposits available for investment multiplied by total amount invested in the month. 3) The monthly amounts are added up for twelve months to get yearly amounts. 4) The total profit is then apportioned to the accounts on the basis of total assumed investments. The above method, although rational and equitable on the face of it presents some difficulties. As the investment account depositors are mainly interested in profit as they bear the risk, the above allocation does not give any preference to this. Since savings and current deposits in Islamic banks are not meant to earn profits, they should not have a claim to profits on an equal basis (although in actual fact, profit attributed to these deposits goes to the shareholders). Thus, as in the example from table 5-1 shows, the amount from the investment account, assumed as invested is only $53,070/$77228 = 68%, whereas current account deposit invested is also assumed to be 68%. Since investment account holders assume that their deposits will be invested, it is clear that their funds should be accorded priority in the distribution of profits. Hence in 1985, the Shari’a Supervisory Board of the Faisal Islamic bank recommended that all investment account deposits less a liquidity reserve be assumed to be invested. Using the new formula, the investment account deposit assumed to be invested would be £77228 x90%= £69505 (to take account of liquidity ratio of 10% as

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60

investment account can be withdrawn on short notice although not on demand). The amount allocated to current accounts and shareholders is found as a balancing figure. Hence the profit allocated to investment funds would be higher. ACTUAL TYPE OF DEPOSIT

ACTUAL

INVESTMENT

FUNDS FOR

INVESTED

DEPOSIT

AVAILABLE %

INVESTMENT

FUNDS

(1)

(2)

(3)=(1)X(2)

(4)

JANUARY 1984 Current Deposit Investment Deposit Savings Deposit Shareholders

157,000

70%

109,926

77,228

100%

77,228

12,454

90%

11,209

58,536

100%

58,537

75,540 53,070 7,703 40,226

funds TOTAL

305218

256,900

176,539

TABLE 0-1:PROFIT DISTRIBUTION METHOD IN THE FAISAL ISLAMIC BANK OF SUDAN (SOURCE: ABDELGADER, 1990,P 176).

Despite this apparent improvement, the profit attributed to investment accounts will vary between different Islamic banks depending on the proportion of current and savings account deposits. For example, if Bank A has more current and savings account deposits than Bank B, assuming equal amount of investment deposits, Bank B will be giving a higher share of profits to its investment account holders. Another problem, is although, current and savings account holders expect no return, the shareholders are effectively using these deposits as financial leverage in earning profits for themselves without giving anything in



return to these depositors except guarantee of capital. Perhaps, in this case, the central bank should regulate the Islamic banks and insist on a payment of a gift to these accounts (after building up sufficient reserves to cater for losses). This is legal and recommended (and practised in certain countries) in Islamic law provided they are not predetermined. In contrast to the above situation, some Islamic banks do not pool the funds from investment accounts and treat them as a separate entity. In order to provide a portfolio instead of matching each deposit to an actual investment, the deposits are pooled into many projects. However, this method is more risky for the depositor because the portfolio may not be well diversified. In certain banks, limited Mudaraba certificates are issued which link the securities, issued in fixed denominations for a fixed period of time, to a particular project. These certificate holders are entitled to profits when the project is liquidated. They bear all the losses if any. This second type of profit allocation where the funds are not pooled solves the problem of allocating profits between the various types of depositors. However, it still has the problem of matching profits because in Islam, the venture has to be realised to return capital before profit is calculated (Udovitch, 1970). Hence, if a depositor withdraws his funds before project is liquidated, then he will not be entitled to share in the profits. The problem of capital gains and losses between accounting period also presents problems as it does in conventional historic cost accounting. Perhaps a realisable income model (Edwards & Bell, 1961) would be more appropriate. Another problem posed by Islamic banks is the nature of investment and savings deposits. Are investment deposit holders, equity holders? (Karim, 1999). Should they have say in the administration of banks (i.e. voting rights)? It can be seen that investment account holders are neither a liability nor equity and to classify them as such according to conventional accounting principles would amount to

61



unfair disclosure. Investment accounts have both the characteristics of debt and equity. They are short or medium term equity holders. Equity holders have longterm relationship with the banks. They can vote in annual general meetings and take part in the management of the bank through their directors. By contrast the relationship of investment account holders vary between short and medium term. However since they share in the profits and bear all risks associated with their investment, they should neither be treated as current and savings account holders nor fixed deposit accounts holders. Perhaps, they should have limited voting rights like debenture holders, especially in the case of limited Mudaraba certificate holders to ensure that their interests are taken care of properly. Investment accounts cannot be classified as current liability as are fixed deposit holders in a conventional bank. Perhaps a separate balance sheet should be prepared for them, or they should be shown between equity and current liabilities. Another problem associated with investment projects relating to investment accounts is whether they should be consolidated or equity accounted? Presently only profits received from the projects are incorporated into the accounts. This is inconsistent with the ruling that Islamic banks are not lenders but managers of the investment account holders. Conventional banks do not manage the projects they finance except to monitor periodic reports. Islamic banks as managers of investment account holders and as partners in case of Musharaka financing would have to take a more active role in appraising, monitoring and even directing major decisions in ventures they finance. When they do this, the problem of consolidating results and assets of financed ventures comes in. Karim (1999) observes that, in the application of funds, most Islamic banks use the murabaha-financing instrument. Since the source of financing includes investment accounts, the profit recognition method used will also affect profit allocation to these accounts. As Karim (1999) notes, there are at least five

62



different methods of profit recognition used by Islamic banks in recognising profits in murabaha transactions where the price of the goods financed are received in instalments which may traverse several accounting periods. These include: •

Recognising profits in full when customer takes delivery.

•

Pro-rata the profits according to due dates of instalments.

•

Pro-rata the profits according to receipt of the monthly payments.

•

At the liquidation of the transaction i.e. on the last payment date and

•

Once the capital has been recovered.

Karim (1999) notes that “the use of any of the above profit recognition methods affect the returns credited to investment account holders”(p33) as the duration of the depositors’ investment is generally different from the duration of the

murabaha contract above. In addition, there is no conventional accounting standard to prescribe the disclosure of different profit allocation bases (which has been discussed above) which Islamic banks use to allocate profits between the various account holders. Hence, applying conventional accounting standards (e.g. IAS), where they are available, to Islamic banks will result in noncomparable financial statements rather than induce comparability as there no standards which meet the specific Islamic banking requirements. This is the rationale behind the formation of the Accounting and Auditing Organisation for Islamic Financial Institutions (Pomeranz, 1997; Karim 1999) which has some accounting and auditing standards for Islamic banks and Financial Institutions 3.3.2 Capital Adequacy Ratio

As a result of the recent third world debt crisis, there have been increasing demands for more capital regulation in the banking industry. One of the most important measures facilitating this regulation is the capital adequacy ratio

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(CAR). This ratio is a measure of a bank’s risk exposure and is usually calculated by finding the percentage of capital to total balance sheet assets. The CAR of commercial banks is an important accounting measure used to assess the adequacy of the bank’s capital in relation to deposits to cover credit risk (Llewellyn, 1988).

Regulators use the CAR as an important measure of the

safety and soundness on banks as the capital of such institutions is viewed as a buffer or cushion to absorb losses (Karim, 1998b) The increasing pressure from regulators to maintain an adequate ratio has led some banks to adjust accounting measures to reflect a good ratio. Hence, accounting practices have major implications for this ratio. The Basle Accord of the Basle Committee on Banking Supervision implemented since 1992, sets out an agreed framework for measuring capital adequacy and the minimum standards to be achieved by the representative countries. The accord is intended to “strengthen the soundness and stability of the international banking system and “to be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks”. The minimum acceptable Capital Adequacy Ratio (CAR) according to the Basle Accord is 8%. The majority of countries in which Islamic banks operate have taken steps to introduce the Basle framework. However because the framework of Islamic banking is different, the Basle framework geared for conventional banking cannot be applied as it would lead to Islamic banks not meeting the requirements, although this would not imply any more credit risk than conventional banks. As Karim (1998) observes, only share capital and reserves attributable to them would be considered as capital. Islamic banks issue neither preference shares nor subordinated debt as they contravene the Shari’a. Since current account holders of Islamic banks are not entitled to any return, the revenue generated

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from them is exclusively the right of the shareholders. The investment account deposits cannot be considered as equity or liability but a unique type of Instrument which gives the depositors right to share in the profits but bear all the losses. Hence, since both deposit accounts are not paid a predetermined return, they do not constitute a financial risk to the bank as (in the case of investment accounts) all the losses can be passed on to the account holders. Although the shareholders funds would have to bear the losses of capital on investments from current account deposits, the risk of loosing the capital is much less than loosing both capital and the pre-determined interest which must be paid to conventional bank account holders. Karim (1998) illustrates this point through four possible scenarios, each depending on the way investment accounts are treated by Islamic banks and regulatory authorities: In scenario 1, Investment accounts are added to the core-capital (tier 1). This would increase the CAR and help Islamic banks follow a strategy of attracting high investment accounts and low equity capital, as Islamic banks do not share losses only profits from the investment account fund invested. If the amounts of deposit accounts were restricted in the calculation of capital, the bank would be forced to pursue a strategy of raising equity and restructuring its assets to more safe areas like Government investment certificates. Scenario 2, which allows for deduction of the investment accounts from the riskweighted assets would similarly increase CAR and compensate for assets with high-risk weightings. Here, shareholders continue to encourage investment accounts compared to savings accounts. In scenario 3, investment accounts are added to Tier 2 capital element. In this case, since tier 2 capital is restricted to 50% of the total of tier1+tier 2 capital, this would mean that when investment accounts equals equity, there is no benefit to

65



the CAR calculation. This would mean, after this threshold, Islamic banks would have to raise shareholder equity. In scenario 4, no adjustment is made to the CAR calculation in respect of investment accounts. Islamic banks with CAR below 8% would have to increase their shareholders equity as the use of investment accounts confers no advantage in the calculation of CAR. Another way out would be to restructure their assets to include lower risk weighted assets. Given the nature of Islamic financial instruments, Karim (1998) observes that the latter option would be more feasible in an Islamic bank given the nature of financial instruments used by Islamic banks. Although it is up to regulatory authorities of the various countries to adopt the appropriate rules, Central bankers of Muslim countries with their conventional economic and banking training seem not too creative in this matter. In the case of Sudan (Abdelgader, 1990), the Central Bank wrongly subjected the funds of investment accounts to their credit ceiling targets meant to control consumption credit and inflation. Investment accounts, of course, were meant to finance long term, high return investments. Since the Islamic banks could not invest most of the funds, profitably it stopped accepting investment deposits altogether, defeating the purpose for which the bank was set-up. Karim’s (1998b) analysis, although constructive and insightful, nevertheless only skimmed the surface of the implications of the Basle convention for accounting of Islamic banks. His analysis is limited to the financial strategy of shareholders in leveraging the use of investment accounts. It does not analyse the CAR standards implication for the investment strategy in terms of achieving the investment objectives of Islamic banks i.e. to substitute profit-sharing contracts for risk based contracts which would bring about the theorised objectives of Islamic banking. As already indicated, one of the problems of the Islamic banking is that Islamic banks have opted for the easy use of credit-based Islamic

66



instruments (murabaha) which do not change the basis of Islamic banks from conventional counterparts to any large degree (Abdelgader 1990; Ahmed, 1994b). An appropriate indigenous Islamic capital adequacy ratio standard could have a marked difference in increasing both investment accounts and more profit-loss financial instruments. For example, if investment accounts could be added to the core capital or deducted from total risk weighted assets, (scenario 1 and 2), this could increase the promotion of investment accounts. Further as the Islamic banks do not bear any losses arising from the loss of investment deposits (except arising from negligence), the investment account investments (not deposits) could be deducted from risk weighted assets or given a 0 or low risk weighting depending on the nature of the instrument. A reverse risk weighting score could be given. For example, musharaka and mudhraba investments would be given a lower risk-weighting then those used for murabaha or ijara investments. This would increase CAR and at the same time encourage Islamic banks to manage their portfolio carefully, as their earnings will depend on high return / high-risk investments. This is so because banks earn only a share of profits and cannot charge expenses to the investment account deposit holders except for direct expenses. Hence this is one way, an appropriate Islamic financial standard based on an accounting number could induce behaviour towards attaining Islamic objectives. Another instance would be to consolidate the investments at current costs. Since Islamic accounting seems to favour current values (Clark et al., 1996; see also this would reduce CAR. However, if the bank’s share of unrealised capital gains is added to capital and the current value of investments (from the investment account funds) were excluded from the risk weighted assets, this would boost CAR, encouraging such investments.

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A development from this would be an “Islamicity” ratio computed using an inverted risk weighted value of assets. The higher the ratio, the higher the Islamicity of financial instruments used and would give the user an indication of the extent to which the Islamic banks are using the funds in profit-sharing instruments and other social areas in which it should be used. 3.3.3 Confounding International Accounting Standards

The accounts of Bank like other business organisations are increasingly subject to both national and international accounting standards, which are increasingly being globalised in the form of International Accounting Standards. Unfortunately, recent studies on the cultural impact on national accounting systems seem to be motivated only towards removing non-European and non-American impediments in the way of international harmonisation of accounting (Hamid et al., 1993). The researchers do not contemplate that harmonisation may entail imposing Western and European accounting practices and the theories behind them upon nations whose commercial and accounting practices are based on alternative ethical or cultural paradigms. Thus: “But the focus has been more to identify what practices and underlying theories have to be changed to fit into the Western paradigm, rather than to discover whether those not conforming to it might give insights to alternative, theoretically defensible accounting processes”. (Hamid et al., 1993, p132)

This may not only distort international comparison (see for example, Choi et al., 1983) but also upset the socio-economic balance of the recipient countries.

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Hamid et al. (1993) observes that although, harmonisation is pursued under the pretext of transporting developed accounting practices to countries with lesser developed practices, such ascription of development to the West, commits the world to a dominant allegiance to Judaic-Christian influences and ignores traditions founded in Eastern philosophies. Thus, any implications of accounting being required to conform to the philosophies underlying Islam, which transgresses national boundaries, for example, are dismissed without enquiry. Islamic banking in particular only permits financial support and offers banking f acilities to Islamic compliant businesses. One could therefore reasonably presume that the prevalence of stricter Islamic banking would lead to higher business compliance with Islamic principles. This would in turn increase the need for an alternative Islamic accounting to meet the needs of these organisations. Hamid et al. (1993) further argues that the prohibition of riba, which is the cornerstone of Islamic banking has important implications for the harmonisation of accounting procedures as implementing international accounting standards entail enforcing many accounting procedures where interest based calculations are essential. For example, standards on pension benefits (SFAS 87 & 88), amortisation of long-term debt (APB 12), lease capitalisation (SFAS 12), interest on receivables and payables (APB 21) and their International Accounting Standard equivalents all invoke discount calculations based on the time value of money. Karim (1999) also point out many problems of using International Accounting Standards for Islamic banks. For example, many Islamic Banks use murabaha financial instrument. In this cost plus contract, the Shari’a imposes the condition that the bank must possess the title to the goods before delivery to customer. The purchase order made by the customer may or may not be binding on him. Hence the valuation of such stocks is a problem in the accounts. Should the bank

69



70

value at lower of cost and NRV as per current accounting standards or at current market value as per Zakat accounting requirements. IAS’s do not have any standards to deal with the status of investment accounts, as they are neither equity nor debt in the conventional sense. There are also no disclosure requirements to disclose the bases of profit allocation between shareholders and investment account holders. The use of different methods by different Islamic banks has resulted in the incomparability of their performances. Profit recognition difficulties have already been alluded to in the section 5.5.1. The adoption of IAS would not make the Islamic banks accounts comparable but might achieve the opposite effect. International Auditing Standards also do not provide for the idiosyncrasies of a Shari’a Review or audit which is required of Islamic banks. Neither do they provide guidelines on the qualifications, independence and competence of Shari’a Auditors or Shari’a supervisory board of Islamic banks. It is no wonder that Muslims have come up with their own alternative to the IASC in the form of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). This organisation

has issued two Financial Accounting Concepts

Statements, ten Financial Accounting standards and five Auditing standards for Islamic banks (Karim, 1999). The organisation has also issued exposure drafts on Shari’a Audit, and Islamic Insurance Company disclosure standards. If the current Islamic resurgence permeates Islamic businesses, then there is definitely a need for the development of Islamic accounting and an International organisation

to

develop

Islamic

Accounting

Standards

organisations. Perhaps, the AAOIFI will evolve into such a body.

for

all

Islamic



3.3.4 Non-Financial Disclosure

While, the technical problems associated with accounting for Islamic banks have been emphasised and the AAOIFI been established to deal with it, it should not be forgotten that Islamic banks are much more than institutions which avoid interest. All business and non-business Islamic organisations have Islamic ethics as their founding basis. As such these institutions must account to their owners and other stakeholders as to the extent to which they have complied with the ethical dictates. This involves non-financial as well as financial disclosure. Khan (1994a) observes that an Islamic bank would have to disclose: (i)

The avoidance of prohibited transactions.

(ii)

The extent to which their activities have contributed to the economic and social development of various poor sectors of society by offering financing and interest-free loans to for example, farmers and small traders.

(iii)

The ethical standard which they have reached in the treatment of employees and depositors and entrepreneurs.

(iv)

Segmental information on the financial instruments used and the efforts made by the bank to move away from interest-like instruments such as

murabaha. (v)

The extent to which they have safeguarded the environment and conserved energy.

(vi)

The collections and disbursement of Zakat from the bank’s operations, and

(vii)

The social and the religious contribution to local community

Conventional accounting places emphasis on financial outcomes, thus conventional accounting users (e.g. shareholders) may switch to debt financing when economic conditions make debt financing attractive. They also may switch

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to other business activities, which promises the best financial returns to them. However, as Hamid et al. (1993) notes, whether equity or debt financing promises the best financial returns to owners or managers, is not the motivating factor in Islamic commerce undertaken according to the Islamic tradition. Instead success in the hereafter by following God’s commandments in economic transactions on earth would be the foremost thought of Muslim users. Hence Islamic accounting would provide information which ensures their confidence in the integrity of Islamic banks and other organisations. It should provide assurance that the organisation has invested their money within the constraints of the Shari’a, no exploitation or injustice has been done to any quarter and their money has made a contribution to uplifting the community.

3.4 Conclusion In this chapter, the objectives of various forms of Islamic organisations, their structure, operations and framework under which they operate have been discussed. The development and operations of Islamic banks were discussed at some length to emphasise the different paradigm of Islamic business. Hence, the discussion of the accounting problems related to different financial instruments, profit sharing and the problems of imposing international banking, accounting and auditing standards on Islamic is meant as an example of the differences and difficulties Islamic organisations pose for conventional accounting. It is hoped that this has demonstrated the practical need for the development of Islamic accounting Islamic accounting as can be seen from this chapter, is not only a matter of modifying conventional accounting to fit the needs of Islamic institutions- a major overhaul is called for. It is not a matter of extrapolating the conventional accounting principles to specialised entities e.g. in the case of accounting for

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plantations,

insurance

companies

or

space

exploration.

The

73

different

philosophical assumptions underlying Islamic organisations and their different operating mechanism, some of which find no parallel in the conventional business and accounting practices, suggest a more radical accounting. Benefits of an Islamic Accounting System for Islamic banks and other organisations would include: •

Motivating employees, shareholders, managers and participants to be accountable to society and God and to take a pro-active role in ensuring ethical economic activity instead of motivating them through higher financial returns to increase their greed and material possession.

•

Ensure the accountability of Islamic organisations to their stakeholders and thereby ensuring the accountability of Muslims to God in their economic activities.

•

Ensure the specific socio-economic objectives for which Islamic organisations have been established are achieved and to disclose the reasons why they are not. The holistic nature of an Islamic accounting system would not deflect the users

from their ethical objectives as conventional

accounting, by

concentrating on the financial return, might do. •

The development of Islamic accounting and auditing standards would in time ensure comparability between different organisations which would promote the allocation of resources (financial, manpower, government support) to those organisations which better promote the interests of Islamic societies.

From the above, it can be seen, that Islamic organisations can benefit immensely from the development of an Islamic accounting system. Failure to develop one, on the other hand, may contribute to their failure




MCQ3-1 Which of the following contracts are appropriate for a home financing facility: a) Mudaraba and Ijarah. b) Ijarah and Murabaha. c) Murabaha and Mudaraba. d) All of the above.

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Chapter 4. Objectives and concepts of financial accounting for Islamic Institutions

(44:38)‫ﺒﲔ‬ ‫ﻣﺎ ﺑﻴﻨﻬﻤﺎ ﻟﺎﻋ‬ ( 44: 3 9)

‫ ﻟﺄ‬ ‫ﻣﺎ ﺧﻠﻘﻨﺎ ﻟﺴﻤﺎ‬

‫ﻦ ﻛﺜﺮﻫﻢ ﻟﺎ ﻳﻌﻠﻤﻮ‬ ‫ﻖ ﻟﻜ‬ ‫ﻣﺎ ﺧﻠﻘﻨﺎﻫﻤﺎ ﻟﱠﺎ ﺑﺎﻟﺤ‬

For [thus it is:] We have not created the heavens and the earth and all that is between them in mere idle play: none of this have We created without [an inner] truth (and objective) : but most of them understand it not. (AD-Dukhan, 44: 38-39)

Chapter

4

CHAPTER LEARNING OBJECTIVES: At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv.

v. vi.

Explain the need for and importance of Accounting Conceptual Frameworks List and explain the main components of AAOIFI’s conceptual framework Differentiate AAOIFI’s conceptual framework and conventional Conceptual Frameworks Describe the methods by which accounting standards can be developed for Islamic institutions and the method adopted by AAOIFI. Discuss the users and uses of accounting information of IFI’s Explain how the users requirements can be met

4.1 Introduction: Developing a theory of Islamic accountingmethodologies. Before, we can develop detailed accounting rules and standards for Islamic financial institutions, it is necessary to have an overall theory of Islamic

75



accounting which in practical form is known as a conceptual framework. Otherwise the resulting standards may be inconsistent with one another. I would say that accounting conceptual framework is a lower level theory on which accounting standards can be based. Developing an accounting theory is known as theory construction.

How does

one develop a theory of Islamic accounting? We can get a lesson from conventional accounting. There are two basic approaches to accounting theory construction which are; the empirical inductive approach and the deductive approach.

The Empirical Inductive Approach:

The empirical inductive approach is an attempt to develop a theory based on generalising from empirical phenomenon. It has been used to rationalise expost , current accounting practice. The development of principles and accounting standard development process of the Anglo-American professional accounting bodies such as the AICPA, and the CCAB, is one such approach; where standards are set as guidelines to regulate accounting practice. For the past two decades, the empirical-inductive theory has slipped into the realm of positive accounting theory (or PAT). The proposers of this theory, Watts & Zimmerman (1986) attempted to argue that accounting theory should be positive i.e. attempt to explain what is and help to predict future events, instead of trying to preach what ought to be. This has led to capital market research becoming mainstream in accounting. Unfortunately, the regulatory approach has also followed suit in adopting the decision-usefulness paradigm. This can be seen the conceptual framework developed by the FASB which adopted a decision usefulness (for finance providers) paradigm (FASB, 1978).

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There has been severe criticism of Positive Accounting Theory (e.g. Christenson, 1983;Tinker & Puxty, 1995). From an Islamic point of view, although what is should be taken into account in deciding strategies, it cannot be a substitute for normative-deductive theorizing because:

a) The positive situation may reflect a deviation of the normative percepts of lslam; hence it cannot be a basis for developing a theory. However, positive research can be conducted to discover the actual situation, to measure the extent of the deviation (or extent of compliance/agreement) from Islamic principles and to formulate strategies for correcting it. b) Islam has already eternal ethical and behavioural principles and objectives; hence a purely positive approach that ignores the normative principles of Islam will not lead to an Islamic society and the achievement of falah.

The Deductive Approach

In this approach, theoretical accounting principles are logically derived by deduction from assumptions or axioms/first principles (Whittington, 1986). Writers such as Tinker (1985), Gray et al. (1996) and Cooper & Sherer (1984) take sociology, democracy ethics and political economy as sources of ideas on which to deduce theory. Others suggest the “the true income model” of accounting which relates accounting income to economic income

However, we have to be cautious in deriving an Islamic accounting theory from these disciplines as these sources are secular in essence. The secular viewpoint itself is a normative position just as the positive theory also has a normative content (e.g. Tinker et al., 1982).

The denial of revelation as a

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source of knowledge leads to empiricism (whether in its positive or interpretative form) as the only source of knowledge. Although critical writers are critical of positivism, they propose a solution based on the economic determinism of Marx. This is a normative deduction of observed perception. It does not refer to any divine criteria for its critique of the system but to axiomatically arrive at theories of human conflict. These axioms or assumptions are accepted without question as if they were absolute truth. These theories are not compatible with the Islamic point of view

Gambling & Karim (1991), suggest a normative deductive approach in setting accounting standards as Muslims have to abide by the Shari’a in both the social and economic aspects of their lives. This approach according to them involves deducing the objectives of financial reporting, the postulates of accounting and the definition of accounting concepts from Shari’a principles. This would then constitute the foundation for a structural framework, which would act as a reference for the development of principles for accounting.

This is the best methodology in arriving at an Islamic accounting theory, in my opinion, as any principles and rules derived would be consistent with Islamic worldview and values.

As argued by Karim (1995), there are two methods whereby Islamic accounting concepts could be arrived at: 1)

Establish objectives (and concepts) based on the principles of Islam and its teachings and consider these objectives in relation to contemporary accounting thought.

2)

Start with the objectives established in contemporary accounting thought, test them against the Islamic Shari’a, accept those that are

78



consistent with Shari’a and reject those that are not, and develop those that are unique.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has adopted the second approach in the development of their “Statements of Financial Accounting 1” (para 24)

which they claim is

“consistent with the broader view of Islamic principles- a view which does not require that a concept be always be derived from the Shari’a”. This approach is in line with the Islamic judicial principle of ibaha or permissibility which suggests that anything is permissible unless it is prohibited clearly by the Shari’a in transactions between human beings.. Hence, the concepts of decision useful accounting information such as relevance and reliability are immediately embraced into Islamic accounting by the AAOIFI.

However, this approach has been objected to earlier by Gambling & Karim (1991) on the grounds that the conceptual framework of accounting currently applied in the West is justified in a dichotomy between business morality and private morality. Thus it cannot be implemented in other societies that have revealed doctrines and morals that govern all social, economic and political aspects of life. Further objections to this method arise because neither Western accounting theory nor Western accounting standards explicitly deal with the morality of the objectives of commercial accounting entities or even of the methods by which they are pursued (Karim, 1995).

Hence, the approach of not reinventing the wheel adopted by the AAOIFI may be indefensible. The AAOIFI has adopted this approach not because of its correctness or intellectual apathy, but due to pragmatic considerations of its survival and acceptance of its standards by Islamic Banks (Karim, 1995). Thus:

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“In order to gain the recognition and support of Islamic banks in the implementation of its standards, the [AAOIFI] might find it necessary to demonstrate to Islamic Banks that it has not completely discarded the efforts that they have exerted in setting up their own accounting policies with the help of their SSB”. (Karim, 1995, p292)

I personally favour a different approach, which is a hybrid of approaches 1 and 2 with some additions. This is as follows:

1. Identify the ethical and accounting principles of the Shari’a in relation to business

and

other

activities

which

involves

fiduciary

or

agency

relationships and then consider the implications for accounting. Compare these with the principles under which Western businesses and other organizations operate- those of capitalism. 2. Identify the main objective and subsidiary objectives of Islamic accounting based on these Islamic ethical principles and consider these objectives in relation to contemporary accounting thought. This should not be restricted to mainstream accounting thought, as “the development of (socially related) narrative and non-traditional reporting has increased to such an extent that it cannot be ignored by modern accountants” (Mathews & Perera, 1991, p 334). The comparison with contemporary accounting thought can serve two purposes: identify alternative (socially responsible) accounting techniques developed in the West which can be incorporated in Islamic accounting to achieve its purposes and identify conventional accounting principles which are not in conflict with Islamic accounting. 3. Identify the theoretical foundation of Islamic accounting, i.e. whether it is accountability, stewardship or decision-usefulness. This is closely linked with the objectives and may be inseparable from it.

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4. Identify the users of Islamic accounting information and examine what they

use the information for. To a certain extent, the uses are identifiable by considering the ethical rules of Islamic business. 5. Develop the characteristics of Islamic accounting, i.e. the information required, valuation and disclosure principles which would incorporate Islamic business ethical principles and will achieve the objectives of Islamic accounting to the extent that it is not already defined by the Islamic Shari’a. 6. Seek consensus among Scholars and Accountants on these objectives and characteristics, as this is one method of arriving at Islamic rules which do not exist in the Qur’an (Kamali, 1991). . Both disagreements and conditional agreements should be investigated to gain further insights and to establish whether the deduced principles are wrong or whether certain factors such as education and background or professional experience led to the disagreement.

Having recorded my disagreement, however, to its credit, AAOIFI has done a thorough job during the development of its conceptual framework and standards as each standard is backed by appendices on brief history on the preparation of the standard, juristic rules, reasons for the standard and basis for conclusions, a feature not present even in “world class” International Financial Reporting Standards. InshaAllah, this process, hopefully, has ridden the standards of any Western “philosophical baggage” against which Karim (1995) has cautioned.

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4.2 Deriving the Islamic Accounting objectives from Islamic economic objectives. Islamic economics offers an alternative paradigm to conventional economics (Presley & Sessions, 1994). It is an ethics-based system based on the principles and rules contained in the Qur’an and Sunnah (Al-Habshi, 1987). The Islamic economic paradigm is derived from the Qur’an and is is put succinctly by Professor Nejatullah Siddiqi as follows: “The world of nature is there for man to make a living out of it, promising sufficiency for all human beings. Man has to ensure this through his efforts for which he has freedom of ownership and enterprise (i.e. business). Justice, must , however, be ensured, if necessary, through law, Co-operation and benevolence rather than self-centredness and avarice should be the norm in economic affairs. Allah (S.W.T.) being its real owner, property has to be handled as a trust and all economic activity conducted in the framework of trusteeship. Poverty is an empirical reality, hence the rich must surrender a part of what they possess to the have-nots. Trade is lawful, but riba (interest) is prohibited. Waste is sinful and it is imperative to economize and be sufficient. Worldly wealth should be treated as a means to a good normal life leading to eternal bliss, rather than an end in itself... the motto being, utilise the resources given by Allah, including your own abilities, to live and help others live a well provisioned life conducive to moral excellence”. (Siddiqi, 1988, p166).

From the perspective of Islamic economics, therefore, the concept of ‘Khilafah’ or vicegerancy of man, assumes that God has provided enough resources for mankind. Hence, any scarcity is not absolute but relative to the claims on those resources. Chapra 1992, argues that: “The resources with which God has endowed this world are not unlimited. They are sufficient to cater for the well-being of all, if used efficiently and equitably”. (Chapra, 1992, p 203).

However, man should remember that although, he has the freedom to choose between alternative uses of the resources, he is not the only vicegerent on earth. There are millions of vicegerents like him. Thus, the efficient and equitable utilisation of the God given resources to attain the well-being (falah) of all is only possible if resources are used with a sense of responsibility and constraint determined by the Divine Guidance and the objective (maqasid) of the Shari’a (Chapra, 1991).

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The ultimate objective of Islamic Economics (and thus Islamic accounting) is to lead man to falah, i.e. well being or success in this world and the hereafter (Khan, 1985). Islamic accounting should similarly provide information to facilitate this socioeconomic process which will facilitate the working of the Islamic economic system.The Qur’anic concept of falah,

(which occurs in more than 40 verses), is seen as a multi-

dimensional concept which has implications for both individual and collective behaviour i.e. at micro and macroeconomic levels (Khan, 1985). Falah is said to have three components Khan (1985): (i) survival (Baqa) , (ii) freedom from want (ghana) and (iii) Honour and power (‘Izz) From the microeconomic point of view, ghana encompasses biological (health), economic (i.e. means of livelihood), social (brotherhood and harmonious interrelationships) and political survival (freedom and participation in affairs of the state). Its macroeconomic implications are a healthy environment and medical aid for all, full employment, inner social cohesion and independence and self-determination. The concept of Ghana means that no one should live in abject poverty but also assumes self-reliance and work rather than parasitic idleness. Its macroeconomic implication includes equitable distribution of resources and intergenerational equity. The concept of ‘Izz means self respect, civil liberties, protection of honor and life for the individual; and economic power, freedom from debts and military power to safeguard freedom and to enforce justice, for the community. Khan (1985) has categorised the conditions which lead to falah, from a perusal of the verses in the Qur’an, into spiritual, economic, cultural and political factors. The economic conditions are said to be: 1. Infaq: to spend in the way of God on the poor, needy, relations, neighbours and for the socio-ecoonomic good of the community. Infaq is not restricted to charity but includes expenditure on one’s own family. The Qur’an instructs believers to spend what is excess to their requirements. Islam recognises a right of the poor in the wealth of the rich (Al-Qur’an 70:24 & 51:19). The compulsory part of infaq is Zakat or the Islamic religious tax. According to Khan (1985) infaq assumes certain

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characteristics of man i.e. contentment and adoption of simple life. He asserts that

infaq would not be possible if these traits are not present as wants multiply very quickly if there is no contentment. The socioeconomic implication of infaq includes the collection and distribution of

Zakat and other Islamic taxes such as kharaj and the importance of the voluntary sector in Islam represented by Endowments (Waqf) and other charities. 2. Prohibition of riba (interest). Kahn notes that riba is a subtle institution which is exploitative and iniquitous. The Prophet (pbuh) took many measures to ensure that

riba, whether implicit or explicit, did not re-appear in another garb by prohibiting consumer and commercial interest-based credit, unequal barter exchange and certain contracts of land-tenure which provided a definite share for only one party. Khan rightly observes that the road to falah will remain blocked until riba is completely eliminated. The socioeconomic implication of this is the replacement of pre-determined fixed return financing instruments with profit-sharing and risk bearing instruments. These have major implications for investment, accounting and monitoring (auditing). 3. Fulfillment of Covenants (Contracts) and Trusts. Honouring commitments and fulfilling contracts is a condition for the achievement of falah (Al-Qur’an, 23:8). Some interpreters of the Qur’an

assert this also implies the fulfillment of the

implicit covenant (or the primordial covenant alluded to in the Qur’an) of meeting one’s social and religious obligations to God, oneself, family, neighbours, the ummah (community of believers), mankind and other creatures. This obligation serves as a basis for the accountability premise of Islamic accounting. 4. Avoiding Zulm (injustice, exploitation and usurpation of others’ rights). A perpetrator of Zulm cannot achieve falah (Al-Qur’an, 6:21, 6:135, 12:23, 28:37). Using unlawful means of acquiring wealth (according to Islam) implies usurping the rights of others and will lead to widespread inequalities, impaired incentives and social waste. The socioeconomic implication includes the avoidance of aleatory (ghrarar) contracts, information asymmetry, the prevention of hoarding and fairness accounting.

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5. Seeking God’s bounty: The believer is expected to show enterprise and effort to achieve falah. A parasitic existence, idleness and beggary are prohibited in Islam unless due to physical or mental disability. The socioeconomic implication is the dignity of labour and the safeguarding of labour rights, earnings from labour and fair wage practices. 6. Avoidance of Niggardliness: Withholding resources from society even from spending on oneself and one’s family deprives the community of God’s bounty. In the economic sense, this leads to low aggregate demand and a level of employment. Sanctions are imposed on such miserly practices. For example,

Zakat is payable on idle wealth (money kept at home, in the bank or in shares and stocks) and idle land can be taken away by the state from the owner and given to somebody who can utilise it. Only with generosity and sacrifice as opposed to miserliness and selfishness, can one achieve falah. All the above five elements of falah can be seen to involve accounting and taxation. Hence falah can be taken to be ultimate objective of Islamic accounting as well but a more intermediate concept and objective is needed to operationalise Islamic accounting. This intermediate objective may be served by the concept of “Islamic Accountability”.

4.3 Accountability and Islamic Accountability : the objective and premise of Islamic accounting. Since the objective of Muslims and the Islamic economic system is to achieve falah, Islamic businesses and Muslim businessmen should so conduct their business activity to achieve this falah, as business activity is part of human activity and cannot be separated from other daily activities (Beekun, 1997). Hence, the principles of profit and wealth maximisation and the incessant concern with shareholder value, on which capitalist businesses are based, are questionable from an Islamic framework. This is especially so, since Islam has comprehensive ethical principles for business. Accounting should support this activity by providing information to achieve falah.

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Since accounting cannot achieve falah directly but only by directing user behaviour towards activities (mainly in the economic arena) which will lead them to achieve falah, there needs to be an intervening variable, especially related to accounting, which Islamic accounting is based on. I propose the notion of “Islamic accountability” and not decision usefulness, which is the basis of conventional accounting, as a basis which can help operationalize falah in the socio-economic arena.

From an Islamic perspective, accountability is a basic ingrained concept in the Muslim community (Khir, 1992) and forms one of the core concepts of belief i.e the belief in the hereafter, heaven and hell, accounting and punishment. Accountability arises from the amanah or primordial trust (i.e. free- will, freedom to choose, knowledge and reason) which was given to man only (Al-Faruqi, 1992). Other creatures including angels, animals and non-living matter have no such ability. Hence angels, animals and other creation will not be accountable as they have no choice but to obey God and carry out their mission and purpose in life as He decreed. Only Man has the freedom to choose or not to choose God’s way. Further the concept of Khilafa or Man as vicegerent of God on Earth (Al-Faruqi, 1992) means that God has placed man in custody of the resources of not only this earth but the entire heavens and the earth to be exercised in accordance with his instructions to his benefit as well as all other human- beings and animals and the environment.

Besides this concept of accountability, which is common to many religions, Islam places special emphasis on accounting i.e. recording events or actions itself. The Qur’an declares that there are two angels recording every action of man. One angel records rightful actions and the rewards attributed to them (sawab) and the other records sinful actions and the sin attributed to them (ithm). The translation of actions into units of rewards and sins is unique to Islam. In fact there is a whole area of study in Islam regarding the benefits of actions (al-fadhail). This acts as a motivation and a deterrent to actions of Muslims. A good act gets up to 700 reward units depending on the intention and effort. A good intention counts as one reward unit and when it is

86



undertaken merits at least 10 reward units. A bad intention without action does not merit any debit (sin) units but when carried out gets one sin unit. Further, Islamic scholars have classified the value of all actions into five categories;

Fard (obligatory), Sunnah or Mustahab (recommended), Mubah (permitted but legally indifferent), Makruh (disapproved) and Haram (forbidden) (Doi, 1992;Kamali, 1991).

Fard acts attract reward units and leaving them out attracts sin units. Sunnah acts attract reward units but if left out do not attract sin units. Mubah acts do not attract reward or sin units. Makruh acts do not attract sin units but leaving them out attracts reward units and finally Haram acts attract sin units whereas leaving them out attracts reward units. Although neither the exact quantum of rewards or sins, nor their exact nature is revealed to Muslims; it forms part of the core belief structure. On the day of judgement, the person with more reward units will be given the book of records (which the angel had kept) in the right hand. The person with a deficiency of reward units will be given the book from the back (Al-Qur’an, 84:7-12) and they will be glad or sad depending on the situation. Finally, the units will be placed on the Mizan (measuring scale) and will be weighed. The person with more good units than bad will be sent to heaven, whereas the person with a deficiency will land in hell. In order to prevent a misfortune on the day of Judgement, the Muslim is asked by the Prophet Muhammad (pbuh) “to take account before account is taken of you”. The pious Muslim therefore makes a self-account (a sort of a confession to God) of the actions he has undertaken during the day and asks forgiveness for his sins and praises God for the good he has done. This activity serves as a sort of feed-forward control to discipline behaviour. If a sin involves other persons, then restitution is an essential pre-condition for forgiveness. It can thus be seen that for a believing Muslim, accountability and accounting is ingrained by his religion into his soul, as Khir (1992) asserts, “the concept of accountability is so ingrained in the (Muslim) community. This to me is the greatest motivation for the practical development of (Islamic) accountancy. This is due to the fact, that Muslims hold dearly to the concept of man as a trustee and not as holder of absolute power”. (Khir, 1992, p 36)

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Further, this accountability concept is not restricted to spiritual aspects but extends to social, business and contractual dealings. The Qur’an declares that “And Fulfil contract, Verily (fulfillment of) contracts will be questioned (on the day of reckoning)” (Al-Qur’an, 17:34). Hence, it is thus logical to extend this ingrained accountability and accounting (recording of actions by angels) concepts into the notion of “Islamic Accountability” which can be used as the main objective of Islamic accounting. By Islamic accountability, the researcher means, undertaking actions (and refraining from some) and giving account of the actions taken (and not taken) by an organisation or person (the accountor) in discharging its Shari’a obligations both contractual and social as an aid to self-correction and inducing behaviour of stakeholders towards

falah. This will transform accounting into a social accountability activity, as Schweiker (1993) puts it: “what makes accounting an activity concerned with how we should live.. (is) giving an account of our past actions and their consequences(usually described in a number of ways; political, economic, social and personal) that is, of ascribing accountability ex post facto”. (Schweiker, 1993, p 234- 241)

How would Islamic accounting influence the behaviour of stakeholders towards falah? From the conventional accounting literature (e.g. Hines, 1988) we know accounting can give importance to certain notions i.e. what is accounted for becomes what is important. If profit is emphasised in conventional accounting, Islamic accounting should disclose information about Shari’a compliance and non-compliance. Similarly, an alternate valuation system (in line with the Shari’a) may have to be conceived giving scores to events and actions which have social and moral values encouraged by Islam. Although these units cannot be distributed to stakeholders, they will certainly point them towards what is important.

Furthermore, the control aspect is very

important. If information users know that the entity has not followed Shari’a actions, they can demand explanations and take actions resulting in the entity complying with the Shari’a in the future, thus protecting the economic, social and spiritual future of the users. Thus: “It is very important that accounting performs as a control tool of the Sharia in respect of economic activities; that is, an Islamic accounting

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Chapter 4. Objectives and concepts of financial accounting for Islamic Institutions system must conform to the Sharia verses (in the Qur’an), while measuring , recording and reporting financial outcomes”. (Askary & Clarke, 1997, p 143)

According to Blumer (1969) when the individual internalises the values of a society (or Islam, for that matter), his covert (thinking) and overt actions will be actualised based on the perspectives of those values (Triyuwono & Gaffikin, 1996). However, an accounting system is like a mirror (surface) reflecting reality. Further, the appearance of the reality depends on the surface of the mirror because as (Dillard, 1991) argues, “different surfaces (ideological frames) reflect a different reality”. Hence for Muslims with different value sets, Islamic accountability can be attenuated by an Islamic accounting system which reflect Shari’ate values (Triyuwono & Gaffikin, 1996). Although the word, accountability is not used in the “objectives of financial accounting for Islamic banks and financial institutions” (AAOIFI, 2005), the notion of accountability is implicit. In noting the differences between objectives of financial accounting for Islamic banks and other banks, it states that: “[while] financial accounting is mainly concerned with providing information to assist users in making decisions, those who deal with Islamic banks are concerned in the first place to obeying and satisfying Allah in their financial and other dealings”. (AAOIFI , 2005 p11? ).

Further, the AAOIFI (1996) lists four objectives of financial accounting in the same statement and only the last seems to be decision-usefulness; the first three pertain to Islamic accountability. The statement lists the determination of rights and obligations of all interested parties in accordance with the principles of the Shari’a and its concepts of fairness, charity and compliance with Islamic business values (Para 6/1(a)). It also includes the encouragement of compliance with Islamic Shari’a in all transactions and events (Para 6/1 (c)). Thus the notion of Islamic accountability is implied strongly in a prominent Islamic accounting Regulatory Institution document (Pomeranz, 1997).

Adnan & Gaffikin (1997) advocate a slightly different view of accountability, basing their findings from a reading of some Qur’anic verses. They assert that the primary

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objective of (Islamic) accounting information is the provision of information to satisfy an accountability obligation to the real owner (Allah). However, they assert that the overall accountability to act within the Shari’a would be better operationalised, if the accountability is directed towards the fulfillment of the Zakat obligation (which is considered God’s share of the wealth). They argue that this emphasis on accounting for Zakat is logical because it is a prime Islamic socio-religious obligation, it will lead to avoidance of cheating and window dressing. Consequently it will lead to a discharging of societal responsibility, because Muslims believe that God always watches over them and thus is aware of any wrong doing in this respect. One could argue that God equally watches the faithful on all transactions and not only those pertaining to Zakat. However, what the authors seem to imply is that, the psychological affect of avoiding window dressing games in Zakat accounting is real because both preparers and users realise that they cannot cheat God of his share. This is a strong argument but I believes that a broader concept of accountability is better because, although Zakat is an important socio-religious obligation, it is just as important to ensure just rights of various stakeholders of large organizations, especially in this era of large corporations. If large businesses and other entities are not held Islamically accountable but only Zakat accountable, they may pay Zakat on unlawful and immoral sources of income, which is forbidden by Islam. This may create havoc for the economic, moral and spiritual health of stakeholders such as by instilling consumerism through their marketing activities.

The Islamic accountability model I propose (Fig is premised on both Islamic and Muslim organizations (through their managers), and Muslim owners /investors having dual accountabilities. The first or prime accountability arises through the concept of

khilafa in Islam whereby a man is also a trustee (khalifa) of Allah’s (God’s) resources (physical and intellectual). Under the khilafa concept, he is also accountable to Allah for the care of other human beings (specifically local community, society and employees, in the case of organizations), animals and environment. This primary accountability is transcendent, as it cannot be perceived through the senses and is therefore represented by a dotted arrow (1). However, this transcendent accountability

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is made visible (through the revelation of the Qur’an and Hadith) to both investors and managers, in the form of Islamic teachings. This is represented by the two dashed arrows (2). The secondary accountability is established by contract between the owner/investor and manager (e.g. through the Memorandum and Articles of Association of a company). The solid arrows in the model represent this (3). The secondary accountability contract between the owner/investor and manager implicitly or explicitly embeds the primary accountability stipulations of Islam. As the company performs its activities the Islamic accounting system identifies, records, measures and reports these socioeconomic activities (similar to the conventional accounting system) to the investor thus discharging the secondary accountability. This is again shown in the model by the solid arrows (4), as these are perceivable by the senses. The latter completes the secondary accountability cycle. However, the Islamic accounting system also identifies, measures and reports the socioeconomic activities pertaining to Islamic/social/economic/environmental and other issues to both the owner/investor and the manager (5 & 6). Dashed arrows show these information flows. The information thus disclosed enables both these parties to monitor the activities of the organisation and ensure their primary accountabilities (measured by Qur’anic and Hadith criteria) in their capacities as khalifas of Allah, are discharged. The Angels of course record these actions and account this to Allah according to Islamic belief. However, as these latter information flows (7) are not perceptible to the senses, they are shown as dotted arrows to indicate their metaphysical nature. These information flows complete the primary accountability cycle.

The Islamic accountability model can thus be seen to have two accountability cycles, one to God and one to men. The accountability to God is partly transcendent and is thus indicated by dotted arrows. That part of accountability relationships to God which is perceptible,

is indicated by dashed arrows. Finally, solid arrows designate the

normal physical accountability relationship between man and man.

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The Islamic accountability model can thus be seen to have two accountability cycles, one to God and one to men. The accountability to God is partly transcendent and is thus indicated by dotted arrows. That part of accountability relationships to God which is perceptible,

is indicated by dashed arrows. Finally, solid arrows designate the

normal physical accountability relationship between man and man.

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93

Figure 4.1 :The Islamic Accountability Model

ALLAH/ GOD (Primary Accountee

1

PRIMARY ACCOUNTABILITY (Angelic Records)

PRIMARY ACCOUNTABILITY (Angelic Records) PRIMARY ACCOUNTABILITY THROUGH THE QUR’AN & HADITH (Trusteeship of physical resources and creatures arising from nature of man as Khalifa)

7 2

KHALIFA (Vicegerent: Primary Accountor)

2

6

KHALIFA (Vicegerent: Primary Accountor)

6 5

4

MAN

ISLAMIC ACCOUNTING SYSTEM

4

[SECONDARY ACCOUNTABILITY]

MAN MANAGER

Managerial Contract 3

7

3



4.4 Benefits of establishing objectives of financial accounting for Islamic banks.

Accounting is a purposeful activity with certain objectives. Even the creation of man has its objective according to the Qur’an i.e. in order for man to worship Allah. Hence, in order for any activity to be fruitful, they should have objective against which progress can be measured and the activity meaningful. According to Statement of Financial Accounting: Objectives of Financial Accounting for Islamic Banks and Financial Institutions (SFA1) (para 19) , five reasons are given for establishing objectives which are: (a)

To be used as a guide by AAOIFI when developing financial accounting standards to ensure consistency in developing standards.

(b)

To assist Islamic banks, in the absence of accepted accounting standards, in making choices among alternative accounting treatments.

(c)

To act as a guide and a regulator of subjective judgment made by management when preparing the financial statements and other financial reports.

(d)

The objectives, when properly defined, should increase users’ confidence and understanding of accounting information and, in turn, their confidence in Islamic banks.

(e)

Establishing objectives should lead to the development of accounting standards which are likely to be consistent with each other. This should increase users’ confidence in the financial reports of Islamic banks.

Unlike other standard setting bodies, AAOIFI had the wisdom of hindsight to establish its conceptual framework before starting to develop standards. Other professional and standard setting bodies such as the FASB and ACCA, the standards were set first and when they realised some of them were inconsistent, they started their conceptual

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framework project. Standards are usually behind practise. In the particular instance when the standards for a particular transaction has not been set yet, the objectives together with the pronouncements of the Shari’a supervisory board could be used as a basis for management choice of a particular accounting method.

4.5 Differences in objectives of financial accounting from those of conventional banks. Although the objective of financial accounting is to provide information to make decisions, as discussed earlier, the user and the type of information is different as the objectives of the users of information of IFIs are different based on their worldview. SFA1 (para 21) rightly stresses the fact that “those who deal with Islamic banks are concerned, in the first place, with obeying and satisfying Allah in their financial and other dealings.” In particular the following differences are stressed: (a)

Islamic banks must comply with the principles and rules of Shari’a in all their financial and other dealings.

(b)

The functions of Islamic banks are significantly different from those of traditional banks who have adopted the Western model of banking.

(c)

The relationship between Islamic banks and the parties that deal with them differs from the relationship of those who deal with traditional banks. Unlike traditional banks, Islamic banks do not use interest in their investment and financing transactions, whereas traditional banks borrow and lend money on the basis of interest. Islamic banks mobilize funds through investment accounts on the basis of Mudaraba (i.e. sharing of profit between the investor who provides the funds and the bank which provides the effort) and invest these funds on the basis of Mudaraba, profit and loss sharing mechanisms, or deferred payments methods consistent with the Shari’a. (para 21)

Thus the conventional accounting standards may not be relevant to Islamic banks. However, AAOIFI may still be guided by objectives and concepts developed for conventional banks provided they are in line with shari’a precepts.

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4.6 Identifying users, their information requirements and the financial reports required After being informed of the differences between conventional and Islamic banks, AAOIFI identified the users and the elicited decision making behaviour from a shari’a point of view, which directly inputs into deciding what the objectives are. Then what information is required making those decisions is deduced and finally what financial or other reports are required to provide the information. This process is illustrated in Figure 4.2 below.

Informed by differences between conventional and Islamic banks

Informed by Islamic accountability model

1.Identify Users

2. What behaviours Need to elicited in them ?

2A.OBJECTIVES OF FINANCIAL ACCOUNTING FOR ISLAMIC FINANCIAL INSTITUIONS

3.What information do they need?

4.What financial reports are required?

Figure 4.2 The process of deriving objectives and the reports required

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4.7 The major users of financial reports of Islamic Financial Institutions. As with conventional banks, we have to consider the users of the Financial reports of Islamic financial institutions. The users include equity holders, current and savings account holders, regulatory agencies such as the Central Bank, other depositors and other who transact business with the bank. However, a special class of users of Islamic banks are investment account holders and zakat agencies. However, even though there are common user groups such as equity holders, the uses and thus type of information the users of financial accounting information of IFIs are different from those of conventional banks. .

Equity holders.

Holders of investment accounts.

Zakah Agencies

Users of Financial Accounting Information of IFIs

Regulatory Agencies.

Other Depositors.

Non owner/ depositor who transact business with the IFI

Current and saving account holders

Figure 4.3 The major users of accounting information of Islamic Financial Institutions.

As with conventional banks, we have to consider the users of the Financial reports of Islamic financial institutions. The users include equity holders, current and savings

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account holders, regulatory agencies such as the Central Bank, other depositors and other who transact business with the bank. However, a special class of users of Islamic banks are investment account holders and zakat agencies. However, eventhough there are common user groups such as equity holders, the uses and thus type of information the users of financial accounting information of IFIs are different from those of conventional banks. The users are depicted in Figure 4.3 above.

4.8 Common Information Needs of users of financial reports The different users require different types of information but there are certain type of common information such as financial position and earnings which are useful to all the categories of users. Also, normally the more information the better although in certain cases it can result in information overload. However, there is a cost consideration in addition to the practicality of providing all the required information in financial statements. In addition, certain users have the power and authority to directly obtain the types of information which best serves their interests. These include government agencies, auditors and executive directors and even potential take over partners. Thus AAOIFI, rightly concentrates in providing information which are commonly required by many categories of users who are dependent and limited to the Islamic bank’s financial reports.

AAOIFI has thus identified the common “minimum “information needs as

follows: •

Information which can assist in evaluating the bank’s compliance with the principles of Shari’a in all of its financial and other dealings.

•

Information which can assist in evaluating the bank’s ability in: o

Using the economic resources available to it in a manner that safeguards these resources while increasing their value, at reasonable rates.

o

Carrying out its social responsibilities and in particular those that have been specified by Islam, including the good use of available resources, the protection of the rights of others and the prevention of corruption on earth.

o

Providing for the economic needs of those who deal with the bank.

o

Maintaining liquidity at appropriate levels.

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Chapter 4. Objectives and concepts of financial accounting for Islamic Institutions •

Information which can assist those employed by the bank in evaluating their relationship and future with the Islamic bank, including the bank’s ability to safeguard and develop their rights and develop their managerial and productive skills and capabilities. (para 28)

Having considered the information needs, we now consider what sort of reports are needed to provide the information (step 4 in figure 4.2) We can categorise the above information needs into two groups: a)normal financial information i.e. financial position, liquidity, profitability b)specific additional financial and non financial information i.e. shari’a compliance, discharge of social responsibilities and information for employees. The first group in a) is taken care of by those that are currently produced by financial accounting in the form of financial statements and related notes. These include the balance sheet, income statement and cash flow statement. The second group b) requires new types of reports which could be both financial and non financial, which are not currently being produced. AAOIFI notes that while category (a) reports are established and supported by a host of international financial reporting standards and thus provide reasonable assurance of fairness, the second category (b) lacks a generally accepted definition and therefore there is no assurance that they would contain reliable and fair presentation. However, despite this difficulty, AAOIFI has wisely chosen these under their objectives which can be used to guide the development of standards for these reports in the future. AAOIFI goes on to list example of category (b) reports as follows: (a)

Analytical financial reports about sources of funds for Zakah and their uses. Although the financial statements of Islamic banks will disclose the liability for Zakah and the amount that has been disbursed, users of financial statements might be interested in additional analysis of sources of funds for Zakah, methods of its collection including controls to safeguard these funds and their uses.

(b)

Analytical financial reports about earnings or expenditures prohibited by the Shari’a It is our intent for the financial statements to disclose income earned by the Islamic bank from prohibited transactions or sources and expenditures prohibited by the Shari’a and how those earnings were disposed of. However, users of the financial

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statements may be interested in detailed financial reports. Such reports may include information about the causes of such earnings, their sources, how they were disposed of and procedures established to prevent entering into transactions prohibited by the Shari’a. (c)

Reports concerning the Islamic bank’s fulfillment of its social responsibilities Islam has always been concerned with the concept of social responsibility whether that responsibility be for the welfare of society or the prevention of harm. Indeed, this can be clearly observed in the Quranic verses, the sayings and deed of the Prophet (may the blessing and peace of Allah be upon him), and Islamic jurisprudence. For example, Allah said “But seek with the (wealth) which Allah has bestowed on thee, the Home of the Hereafter, nor forget thy portion in this world: but do thou good, as Allah has been good to thee and seek not (occasions for) mischief in the land; for Allah loves not those who do mischief”. (Chapter 28: verse 77). The Prophet (may the peace and blessings of Allah be upon him) said (1) “The most loved by Allah among the people are those helpful to others” . The Prophet also said “There should be neither harming nor reciprocating harm”(2). Hence, Islam prohibits the Muslim from causing harm to himself, to others, his environment or society in the pursuit of material returns. This shows that Islam spearheaded this concept which did not develop in the West except recently.

(d)

Reports about the development of the Islamic bank’s human resources Those reports may contain information about and the bank’s efforts to develop its human resources whether with respect to their knowledge of Shari’a or economics. In addition it would include the bank’s efforts in encouraging its employees to be effective and efficient. (para 32)

In certain jurisdictions, such as Malaysia and perhaps Pakistan the statement of sources and uses of Zakah is not applicable, as only certain designated agencies are allowed to collect and distribute zakah. In Malaysia, Islamic banks would just hand over their zakah to these agencies and this would only appear in their income statement. There is also another consideration in multi religious jurisdictions. In Malaysia, many Islamic banks are operated by nonMuslims and most of the islamic banks have both Muslim and Non Muslim shareholdings. Since, it is not relevant for non-Muslims to pay zakah, only that portion of earnings or wealth which belongs to Muslim shareholders and depositors are subject to zakah. In this instance, the amount of zakah payable on a $ of share should be disclosed so the Muslim shareholders and depositors can discharge their obligations, if it is not carried out by the bank. 1

() 2

()

Related by al-Tabarani in his three volumes and the Hadith includes a weak chain of authorities. Also related by Abdullah ibn Ahmad ibn Hanbal in his father’s Zawaid Kitab al-Zuhd with a weak chain of authorities, (al-Haitham, Mu’jam al Zawaid Vol.8, p.191; al-Ma’nawi, Fath al Qadeer, Vol.1, p.174) Related by Ibn Majah and ad-Daraqutni on the authority of Abu Said al-Khudri. An-Nawawi said it is a good Hadith (An-Nawawi’s Forty Hadith, No. 32).

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4.9 Objectives of financial accounting and reports for Islamic banking and financial Institutions. According to SFA1, “The objectives of financial accounting determine the type and nature of information which should be included in financial reports, in order to assist users of these reports in making decisions. Therefore, the objectives of financial accounting should focus on the common information needs of users of financial reports. In addition, the objectives should focus on the common information needs of those users who do not have the authority or ability to directly obtain the information they need, or access to such information. This focus stems from two reasons, namely the ability of other users to directly obtain from the entity the information they need to make decisions; and the need for accountants to make a choice among a variety of contending information needs of different users because of the limited nature of what could be included in financial reports. This does not mean, however, that financial reports which are focused on the common information needs of users with limited access to information will not be useful for others.” (para 25, SFA1).

AAOIFI goes on to list four objectives of financial accounting (paras 33-36) for IFI’s as follows: • To determine the rights and obligations of all interested parties, including those rights

and obligations resulting from incomplete transactions and other events, in accordance with the principles of Islamic Shari’a and its concepts of fairness, charity and compliance with Islamic business values. • To contribute to the safeguarding of the Islamic bank’s assets, its rights and the rights

of others in an adequate manner. • To contribute to the enhancement of the managerial and productive capabilities of the

Islamic bank and encourage compliance with its established goals and policies and, above all, compliance with Islamic Shari’a in all transactions and events. • To provide, through financial reports, useful information to users of these reports, to

enable them to make legitimate decisions in their dealings with Islamic banks.

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We can thus see that the objectives of financial accounting are the behaviour which we need to elicit from the users of the accounting reports of Islamic banks. However, this does not say much about “the nature and type of the information which should be included in the financial reports”. AAOIFI has left this to a second section (para 37 -42) which it titles objectives of financial reports. These are given below: Objectives of financial reports Financial reports, which are directed mainly to external users, should provide the following types of information: (a)

Information about the Islamic bank’s compliance with the Islamic Shari’a and its objectives and to establish such compliance;(3) and Information establishing the separation of prohibited earnings and expenditures, if any, which occurred, and of the manner in which these were disposed of (4). (para 37)

(b)

Information about the Islamic bank’s economic resources and related obligations (the obligations of the Islamic bank to transfer economic resources to satisfy the rights of its owners or the rights of others), and the effect of transactions, other events and circumstances on the entity’s economic resources and related obligations. This information should be directed principally at assisting the user evaluating the adequacy of the Islamic bank’s capital to absorb losses and business risks; assessing the risk inherent in its investments and; evaluating the degree of liquidity of its assets and the liquidity requirements for meeting its other obligations. (para 38)

(c)

Information to assist the concerned party in the determination of Zakah on the Islamic bank’s funds and the purpose for which it will be disbursed(5).

3

() 4

()

5

()

This objective stems from the basic idea behind the existence of Islamic banks as well as the objectives of those who transact business with them. This objective is incidental since it is assumed that earnings of an Islamic bank are from legitimate transactions and sources consistent with the Shari’a precepts. However, illegitimate earnings may occur inadvertently because of factors outside the control of management such as when the bank operates in a country that does not apply Shari’a and is asked to deposit funds with the central bank as reserves and is paid interest on those funds or because of erroneous judgment by the management of the bank. The giving of Zakah is one of the pillars of Islam and is a personal obligation of the Muslim who is financially capable towards the poor and others who are entitled to Zakah. However, some Shari’a scholars, according to the first conference on Zakah held in Kuwait in 1985, are of the opinion that the entity can fulfill the Zakah obligation either because it is a governmental requirement, a requirement in its articles of incorporation or by-laws, a decision by its general assembly or as a consequence of its owners appointing it as their agent with respect to their Zakah obligation.

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(d)

Information to assist in estimating cash flows that might be realized from dealing with the Islamic bank, the timing of those flows and the risk associated with their realization. This information should be directed principally at assisting the user in evaluating the Islamic bank’s ability to generate income and to convert it into cash flows and the adequacy of those cash flows for distributing profits to equity and investment account holders.

(e)

Information to assist in evaluating the Islamic bank’s discharge of its fiduciary responsibility to safeguard funds and to invest them at reasonable rates of return, and information about investment rates of returns on the bank’s investments and the rate of return accruing to equity and investment account holders.

(f)

Information about the Islamic bank’s discharge of its social responsibilities.

4.10 Conclusion We can see that AAOIFI has done a tremendous job in the early days (1994) in coming with a conceptual framework. However, it had to be practical to be acceptable. However, Islamic accounting theory from the academic literature would suggest perhaps we should de focus the income statement by including the Value added statement and the current value balance sheet ( Baydoun and Willet, 2000). Also there is no consideration of an integrated financial statement incorporating economic, social, environmental and religious aspects as suggested by the Global Reporting Iniatiative. Despite these limitations the SFA1 has been a strong document which has enabled AAOIFI to go to prepare 21 Accounting standards which are consistent with its conceptual framework. This is unlike its counterpart in Malaysia, the MASB, which had to buckle to industry pressures in the absence of their own conceptual framework, could not get Islamic accounting standards of the ground. Despite these achievements, AAOIFI is still to produce a single accounting standard on the category (b) of reports which we mentioned in section 4.6 i.e. regarding social, environmental and employee information. If this burdensome for Islamic banks at this stage of development, perhaps AAOIFI should come out with some Technical Releases or Statement of recommended practices on these issues and request Islamic banks to adopt them on a voluntary basis.

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Question 4-1

a. Compare the objectives of financial accounting for IB&FIs in AAOIFI’s statement of Financial Accounting 1, with the objectives of financial accounting for conventional business organizations. b. In line with these objectives of financial accounting for IFI’s, AAOFI has also recommended some additional objectives of financial reports to provide specific types of information. i. List and describe four different types of information which must be provided by the financial reports of IBs which are different from those of conventional banks. ii. For the four objectives you have listed in (b) above, list the corresponding reports which would provide the information. c. MASBi-1 has recommended the voluntary inclusion of a value added statement (VAS). What Islamic purpose would a VAS serve?

(IIUM B.Acc, semester 1, 2004/2005, Q4)

d. Identify the three most important users of the financial reporting for Islamic financial institutions and explain the ways in which their needs are different from the users of conventional financial institutions. (IIUM B.Acc, Resit semester 3, 2002/2003, Q4)

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Question 4-2

With reference to AAOIFI’s Statement of Financial Accounting no 1 (SFA 1) : Objectives and Financial Accounting for Islamic Banks and Financial Institutions : (a)

What are the two approaches to establishing objectives for accounting for Islamic banks?

(b)

In addition to the conventional financial statements such as the balance sheet and the income statement, SFA 1 has recommended 4 other financial reports to be produced by Islamic banks. List and describe briefly these 4 other financial statements. ( IIUM B.Acc, mid term sem 1 2004/2005, Q2 ) Question 4-3

AAOIFI has seen fit to issue two statements on financial accounting 1& 2 (objectives and concepts respectively). i. ii.

What was the necessity for these? Couldn’t AAOIFI have utilized the many conventional accounting frameworks such as the FASB and the IASC frameworks which define the objective of accounting as to provide information for shareholders, creditors and others on the amount, timing and certainty of cash flows to make informed decisions (whether to buy, hold or sell their investments?

iii.

(iii) What are the 4 set of financial statements which are proposed by FAS 1 which are unique to IFI’s and are they globally applicable (i.e. do they fit all local environments)? ( IIUM MBA, 2005/2006, Q1 )

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Question 4-4 MASB has in its nine years of existence have come out with one accounting standard for Islamic financial institutions (FRSi-1 on disclosure) and two technical Tri-1 and Tri-2 on zakat and ijarah. AAOIFI on the other hand has come out with 22 accounting standards in addition to many standards on auditing, shari’a auditing and governance in its 15 years of existence. i. ii.

iii.

Explain the reasons for this disparity. Does the inability of MASB to adopt AAOIFI standards a reflection of the inability for accounting standards for Islamic Financial Institutions to converge due to wide variations shari’a interpretations or simply a lack of political will or the inordinate power of the banking industry to cling on to its capitalistic banking modes? Suggest how MASB can speed up the process of developing Accounting standards for Islamic banks. ( IIUM MBA, 2005/2006, Q2)

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Chapter 5:Financial accounting Concepts for Islamic Institutions

107

‫ﻦ ﻟـﻪ ﻏﻴﺮ ﻻ ﺗﻨﻘﺼﻮ‬ ‫ﻟﻰ ﻣﺪﻳﻦ ﺧﺎﻫﻢ ﺷﻌﻴﺒﺎ ﻗﺎ ﻳﺎ ﻗﻮ ﻋﺒﺪ ﻟﻠﻪ ﻣﺎ ﻟﻜﻢ ﻣ‬ ‫ﻴﻂ‬ ‫ﻲ ﺧﺎ ﻋﻠﻴﻜﻢ ﻋﺬ ﻳﻮ ﻣﺤ‬ ‫ﻲ ﻛﻢ ﺑﺨﻴﺮ ﻧ‬ ‫ﻴﺰ ﻧ‬ ‫ﻜﻴﺎ ﻟﻤ‬ ‫ﻟﻤ‬ AND UNTO [the people of] Madyan [We sent] their brother Shu'ayb. He said: "O my people! Worship God [alone]: you have no deity other than Him; and do not give short measure and weight [in any of your dealings with men]. Behold, I see you [now] in a happy state; but, verily, I dread lest suffering befall you on a Day that will encompass [you with doom]! (Hud,11:84)

Chapter

5

CHAPTER LEARNING OBJECTIVES:

At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv. v. vi. vii. viii.

ix.

Explain and critique, the approach taken by AAOIFI in arriving at Islamic Accounting Concepts Explain the functions of Islamic Banks . Demonstrate the need for developing Islamic accounting concepts List the proposed set of financial statements of Islamic banks. Define the various elements of Financial Statements of Islamic Banks and compare this with the definition of the IASB framework. Critique conventional accounting concepts from an Islamic viewpoint as to their acceptability List and explain both accounting assumptions; and recognition and measurement concepts as defined by SFA2 List and explain qualitative characteristics of accounting information required for Islamic banks and justify them from an Islamic sharia’ point of view. Consider Materiality, cost and adequacy of disclosure in the preparation and presentation of accounting information.


Chapter 5:Financial accounting Concepts for Islamic Institutions 5.1

108

Introduction to accounting principles and concepts

Financial reports under conventional accounting are prepared according to certain concepts, which are variously referred to as postulates, principles conventions and concepts. Belkaoui (1992, p 229) defines accounting principles as general decision rules derived from the objectives and theoretical concepts of accounting, that govern the development of accounting techniques. He includes the historical cost, revenue, matching, objectivity and full-disclosure, conservatism, materiality and the uniformity and comparability concepts as principles. Belkaoui classifies the monetary measurement and entity concepts as postulates.

In the previous IAS1 and the IASB Framework for the preparation and presentation of financial statements, Some of these were termed fundamental accounting assumptions and many of these are retained under the new IFRS1.

Under IFRS1, going concern, accrual, consistency and under the framework, materiality, prudence and substance over form are mentioned. The Historical cost concept has taken a back seat in view of the emphasis on “fair value” philosophy of the new IFRS’s.

As this is not an introductory principles book, I do not intend to redefine all the concepts which should be already known to accountants and accounting students at this stage.

The important thing here is to consider whether these concepts are acceptable from a shari’a point of view. This is what AAOIFI’s SFA2 attempts to do.

SFA1 and SFA2 together is an attempt by AAOIFI to come up with a conceptual framework for Islamic accounting or accounting for Islamic financial institutions. While SFA 1 is a commendable achievement, SFA2 seems to be a mixed bag consisting of quality characteristics, elements of financial statements and concepts rolled into one statement, much like the IASB’s framework.



109

SFA2 starts out with a defence of the “ibaha” approach, where in Islamic law of transactions, everything is permissible unless specifically prohibited. This is a broader view of Islamic principles which does not require that a concept need not be directly derived from the shari’a, as long as these principles are beneficial to society and do not violate any specific shari’a precepts.

SFA2 uses three approaches in its development which are: (i)

Concepts developed elsewhere which are consistent with Islamic ideals of accuracy and fairness e.g. relevance and reliability

(ii)

Those concepts which are inconsistent with the shari’a, e.g. time value of money, historical cost

(iii)

Concepts which are unique to fiqh muamalat.

Development Approach To arrive at Islamic Accounting Concepts

ACCEPT

REJECT

DEVELOP

Concepts from conventional accounting which are consistent with shari’a ideals

Concepts which Are contrary to Shari’a

Concepts Unique to Islamic way of business transactions.

Fig 5.1 Development approach to arriving at Islamic accounting concepts.



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.Next SFA2 goes on to discuss the functions of Islamic banks as to demonstrate the need for developing concepts which are tailored for Islamic banks in line with their functions. These are section 5.2. Next financial statements required for Islamic Financial Institutions are defined and mapped to their functions discussed earlier. SFC2 goes on to discuss the basic elements of financial statements of Islamic banks are defined under each financial statement. These are discussed in section 5.4 . To make the reading interesting I have compared AAOIFI’s definitions with the respective IASB’s framework definitions in a table format pointing out some important differences. The accounting assumptions and concepts are discussed in section 5.5 followed by a discussion of the recognition and measurement concepts in section 5.6 followed by qualitative characteristics in section 5.7.



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5.2 Functions of Islamic Banks Islamic banks have to comply with the shari’a in all its operations, investment and financing activities. Unlike conventional banks they have to eschew riba or usury/interest. From an Islamic point of view money is a medium of exchange and means of discharging financial obligations. Islam does not recognize money as a commodity and insists that it has no time value aside from the value of the goods or services that are exchanged through the use of money. Hence, Islamic banks cannot pay or receive interest as cost of funds or use loans as investment vehicles.

SFA2

points

out

four

main

functions of Islamic banks which are:

Investment Through Mudaraba or Agency Contract

a) Investment Management b) Investment c) Financial services d) Social Services

Islamic

banks

may

perform

Investment Management function based

on

either

a

Mudaraba

Financial Services eg. Letter of guarantee, money transfers.

Functions of Islamic Banks

contract or an agency contract. According

to

the

Mudaraba

contract, the bank (in its capacity as a Mudarib i.e. the one who undertakes the investment of other parties’

funds)

receives

Investment Using Islamic Financial Contracts such As Ijara,

a

percentage of the returns only in

Fig 5.2 Functions of Islamic Banks

Social Services



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case of profit. However, in case of loss the bank receives no reward for its effort and the provider of funds ,(rabb-al-mal) is allocated the losses. If an agency contract is use, the bank receives either a lump sum or a percentage of the invested amount irrespective of whether or not a profit is realized. On the Asset side, Islamic banks invest funds (both owners’ equity and by account holders) using investment vehicles consistent with the Shari’a. Examples would include Murabaha contracts, leasing, joint ventures, Mudaraba contracts, Salam or Istisna’ contracts, formation of enterprises or the acquisition of controlling or other interests in existing enterprises, trading products, and investment or trading in publicly traded shares or real estate. The returns are divided between the contributors of funds after the bank receives its Mudarib share of profit which must be agreed upon between investment account holders and the bank before implementation of the contract. (para 11) Investment accounts may be divided into: •

unrestricted (i.e. unrestricted Mudaraba) , or

•

restricted (i.e. restricted Mudaraba).

Investment Accounts

In the case of unrestricted murabaha, the investment account holder authorizes the Islamic bank to invest the account holder’s funds in a manner which the Islamic bank deems appropriate without laying down any restrictions as to

Unestricted Investment Accounts

Restricted Investment Accounts

where, how and for what purpose the funds should be invested. Under this arrangement the Islamic bank can commingle the investment account holder’s funds with its own funds or with other funds the Islamic bank has the right to use

What type? How? Where?

(e.g. current accounts). The investment account holders and the Islamic bank generally participate in the returns on the

Commingling?

invested funds. Under the Restricted murabaha investment accounts, on the other hand, the investment account holder imposes certain

Risk profile ?

Fig 5.3 Investment Account Categories



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restrictions as to where, how and for what purpose his funds are to be invested. Further, the Islamic bank may be restricted from commingling its own funds with the restricted investment account funds for purposes of investment. In addition, there may be other restrictions which investment account holders may impose. For example, investment account holders may require the Islamic bank not to invest their funds in installment sales transactions or without guarantor or collateral or require that the Islamic bank itself should carry out the investment rather than through a third party. Islamic banks also offer a variety of other financial services for a fee based on an agency contract or a rental. Examples include letter of guarantee, wire transfers, letter of credit, etc. The concept of Islamic banking requires that Islamic banks perform social services whether through the Qard (good faith loan) fund or the Zakah and charity fund consistent with Islamic teachings. Furthermore, the concept of Islamic banking also requires Islamic banks to play a role in the development of its human resources and to contribute to the protection and development of the environment.

5.3 Definition of financial statements How do we define the appropriate set of financial (and non-financial statements) that are appropriate for Islamic banks? We definetely need to consider their functions and the consequences of performing those functions on the rights and obligations of the Islamic bank and other parties. In addition, consideration should also be given to the common information needs of the users of those financial statements. Based on those considerations, SFA2 proposed the following set of financial statements for Islamic banks: • • • •

Statement of Financial Position. Statement of Income. Statement of Cash Flows. Statement Of Retained Earnings or Statement of Changes in Owners’ Equity.

These four statements as we know are the financial statements used by conventional banks. However, inshaAllah, as we shall see, some of their contents are different. In addition to the above four statements, AAOIFI recommends another three financial statements which are unique to Islamic banks. These are:



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•

Statement of Changes in Restricted Investments which is a a financial statement reflecting changes in restricted investments managed by the Islamic bank for the benefit of others whether based on a Mudaraba contract or an agency contract.

•

Statement of Sources and Uses of Funds in the Zakah and Charity Fund , and

•

Statement of Sources and Uses of Funds in the Qard Fund

.

The last two are financial statements reflecting the Islamic bank’s role as a fiduciary of funds made available for social services when such services are provided through separate funds.Fig 5.3 sums up the recommended statements.

Unestricted Investment Accounts

Investment Accounts

Restricted Investment Accounts



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Fig 5.3 AAOIFI’s Recommended Set of Financial Statements for Islamic Financial Institutions.



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One would immediately note that AAOIFI did not include the three analytical reports mentioned in SFA 1 which are: • • •

Analytical financial reports on Shari’a prohibited earnings and expenditures. Social responsibility report Human Resources Development Report

AAOIFI has also not included any of the social and enviornmental reports suggested by researchers in the Islamic, Social and Critical accounting literature such as Baydoun and Willet (2000) who suggest a Value Added Report or the various alternative reports referred to in Corporate Report (1975) and Shahul and Yaya (2003)1. The reason these are not mentioned here is I suppose is given in SFA1 which is that these reports lacks a generally accepted defintion (not true of VAS) and there would be no assurance of the reliability or fairness of the presentations. FRSi-1 (General Presentation and Disclosure in the Financial Statement of Islamic Financial Institutions) of the Malaysian Accounting Standards Board suggests the voluntary adoption of other reports such as the Value Added Statement without worrying too much about their quality. In FAS1, however AAOIFI has noted that “the complete set of financial statements that should be published by Islamic Banks” would include “Any statements, reports and other data which assist in providing information reuired by users of financial statements as specified in Statement of Objectives.” However, since AAOIFI did not define these statements, it was left to the bank to decide on these. We will discuss the contents o these financial statements in the next chapter

5.4 Definition of the basic elements of financial statements SFA 2 then proceeds to define the basic elements of the financial statements given above, under each financial statement. Figure 5.4 below lists the elements defined.. What I would like to do is to compare this defintion and give my comments. I do this in Table 5.1 While SFA2 defines elements of financial statements under each financial statement category, the IASB framework (herein refererred to as the Framework) does not take this approach. If we note that the first version of the framework was published in 1989 when the main financial statements were the balance sheet and the income statement and the statement of changes in financial position (IAS7

1

I am aware that SFA1&2 was adopted in 1993 and thus preceded some of the literature. However, value added report was mentioned in the Corporate Report 1975 and for a time was adopted voluntarily in the UK.



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issued in 1977) which took a funds approach, this is understandable. This table compares the definition of these first two financial statements and the statement of unrestricted funds.

Elements of Financial Statements

Statement of Financial Position

Income Statement

Assets

Liabilities

Expenses

Owners’ Equity

Equity of unrestricted Account Holders and their equivalents

Gains & Losses

Statement of Changes in Owners’ Equity

Cash Flow Statement

Revenues

Returns on Unrestricted Investment Accounts

Fig 5.4 Elements of Financial Statements for Islamic Financial Institutions.

In brief, we note in some cases, IASB’s framework definition appears more Islamic (unintentionallysee the definition of assets noted in blue) and better worded and thus clearer, the SFA2 is much more detailed and comprehensive and shines in not only in the definitions of its unique elements such as returns from unrestricted investment account holders but also in terms of defining elements of statement of changes in owners’ equity and cash flow statement which are not defined in the framework. However, due to direct translation from Arabic, using a classical shari’a language, there might be subtle errors which should be rectified in the upcoming revision exercise being currently undertaken by AAOIFI.



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Financial Statement

Definition as per SFAC 2

Definition as per IASB Framework

STATEMENT OF

ASSETS: An asset is anything that is capable of generating positive cash flows or other economic benefits in the future either by itself or in combination with other assets which the Islamic bank has acquired the right to as a result of past transactions or events. (a)It should be capable of financial measurement with a reasonable degree of reliability; (b)It should not be associated with a non-measurable obligation or a right to another party; (c)The Islamic bank should have acquired the right to hold, use OR dispose of the asset.

Assets: is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Several paragraphs adds further explanation such as the meaning of economic benefits. How these benefits flow to the entity, physical and non physical form, legal and non legal control, relation between expenditure and assets as well as recognition criteria of probability of expectation and reliability.

FINANCIAL POSITION:

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My Comments

Whereas IASB does not attempt to specify recognition criteria in the definition itself, AAOIFI has included the criteria in the definition. Condition (c) in SFA 2 the right to hold, use or dispose of the asset is troublesome as this has implication for asset recognition under ijarah. Tthe Arabic version of the text actually states the “right to sale of the asset. Hence, the word “or” should be replaced with the word “and”.

“The definition of an asset…identify the essential features but do not attempt to specify criteria that need to be met before they are recongised in the balance sheet.”

Presumably, if an asset is not capable of recogntion, it should be disclosed in the notes, explanatory material or supplementary schedules (see para 86: Reliabiality of measurement of IASB framework)

An important distinction in the defintion of an asset include is paragraph 57 which states that “in determining the existence of an asset, the right of ownership is NOT essential, thus for a property held on a lease is an asset if the enterprise controls the benefits….”. Also para 51, In assessing whetheran item meets the defintion of an asset…attention need to be given to its underlying substance and economic reality and not merely its legal form.

The IASB framework gives the specific example of a finance lease to demonstrate this economic reality, thus “”in case of financial leases…the lesse acquires the economic benefits of the use of the leased asset for the major part of its economic life…hence the finance lease give rise to items that satisfies the definition of asset ..and are recognised as such in the balance sheet. This concept of substance over form does not seem to be in line with the shari’a and there is not mention of it in the AAOIFI standards.



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LIABILITY A liability is a present obligation to transfer assets, extend the use of an asset or provide services to another party in the future as a result of past transaction(s) or other events(s). However, to be reflected as a liability on the Islamic bank’s statement of financial position, the obligation must have the following additional characteristics: The Islamic bank must have an obligation to another party and the Islamic bank’s obligation must not be reciprocal to an obligation of the other party to the bank. The Islamic bank’s obligation must be capable of financial measurement with a reasonable degree of reliability. The Islamic bank’s obligation must be capable of being satisfied through the transfer of one or more of the Islamic bank’s assets to another party, extending to the other party the use of the Islamic bank’s assets for a period of time, or providing services to the other party

Present obligation of the enterprise as a result of past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. An obligation is a duty or responsibility to perform in a certain way. May be legally enforcible by contract or statute. HOWEVER, OBLIGATIONS ALSO ARISE FROM NORMAL BUSINESS PRACTICE, CUSTOM AND A DESIRE TO MAINTAIN GOOD BUSINESS RELATIONS OR ACT IN AN EQUITABLE MANNER. e.g. obligations to service expired warranties. Settlement of a present obligation include: replacement of that obligation with another obligation or the conversion of the obligation to equity and can also be extinguished by a CREDITOR WAIVING OR FORFEITING ITS RIGHTS.

EQUITY OF UNRESTRICTED INVESTMENT ACCOUNT HOLDERS (UIAH) AND THEIR EQUIVALENTS Unrestricted investment accounts refer to funds received by the Islamic bank from individuals and others on the basis that the Islamic bank will have the right to use and invest those funds without restrictions including the Islamic bank’s right to commingle those invested funds with its own investment in exchange for proportionate participation in profits and losses after the Islamic bank receives its share of profit as a Mudarib. (para 24) The relationship between the Islamic bank and holders of unrestricted investment accounts and their equivalent is based on an unrestricted Mudaraba contract because the Islamic bank has the right to commingle funds received from holders of unrestricted investment accounts with owners’ equities. The Islamic bank also has the right to use those funds unconditionally and without any restrictions imposed by holders of investment accounts. Hence, unrestricted investment accounts are considered as one of the elements of the financial position of the Islamic bank. This is in conformity with the Shari’a precepts which permit the Islamic bank to commingle its own assets with those which the Islamic bank has

No Equivalent in the framework by IASB.. This is unique to Islamic financial institutions.

The notes on assets regarding recognition are applied to liabilities as well. Regarding the negative reciprocity of the obligation, perhaps this is because of the shari’a requirements not to link obligations parallel contracts?? SFA2’s definition is very legalistic coming from a technical view of the shari’a. However, IASB’s explanation of a liability, strangely incorporates the akhlaq elements of the shari’a when it notes that a liability need to be recognised when there is a moral obligation (to act in an equitable manner) or extinguishment of debt by WAIVING ITS RIGHT – which is actually a Qur’anic advice (alBaqarah 2:280).

This is actually a new unique class of items in a balance sheet of an Islamic financial institutions. It is neither a liability nor equity for the reasons given. As such, they are classified separately under the liabilities side of the balance sheet.



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the right to use or dispose of. On the other hand, restricted investment accounts and their equivalent are not considered an element of the Islamic bank’s financial position because the Islamic bank does not have unconditional right to use or dispose of these funds Equity of unrestricted investment account holders and their equivalent refers to the amount remaining, at the date of the statement of financial position, from the funds originally received by the Islamic bank from the account holders plus (minus) their share in the profits (losses) and decreased by withdrawals or transfers to other types of accounts. Unrestricted participating bonds and other accounts of similar nature are equivalent to unrestricted investment accounts. Unrestricted participating bonds have a face amount and are issued by the Islamic bank in the names of those who subscribe to them on the basis that the Islamic bank will use those funds to finance its investment activities. Profits are allocated between holders of these bonds and the Islamic bank, based on the relative amount of funds invested by each, after the bank has received its share of profits as a Mudarib. Losses are allocated between the Islamic bank and holders of these bonds based on the relative amount of funds invested by each. Equity of unrestricted investment account holders and their equivalent is not considered a liability for the purpose of financial accounting. This is because the Islamic bank is not obligated in case of loss to return the original amount of funds received from the account holders unless the loss is due to negligence or breach of contract. Likewise, equity of unrestricted investment account holders and their equivalent is not considered part of the ownership equity in the Islamic bank since the holders of these accounts and their equivalent do not enjoy the same ownership rights, for example voting rights and entitlement to profits realized from investing funds provided by current and other non investment accounts. Current accounts and other non investment account are guaranteed by owners’ equity and not by the equity of investment account holders or their equivalent. This is in accordance with the hadith of the Prophet (may the blessing and peace of Allah be upon him) which says “Profit is for that who bears risk”(2). OWNERS’ EQUITY Owners’ equity refers to the amount remaining at the date of the statement of financial position from the Islamic bank’s assets after deducting the bank’s liabilities, equity of unrestricted investment account holders and their equivalent and prohibited earnings, if any. That is why owners’ equity is sometimes referred to as the owners’ residual interest

2

()

This is a good Hadith related by a number of Hadith reporters.

EQUITY Is the residual interest in the assets of the enterprise after deducting all liabilities. Also discusses classification of equities into shareholders’ funds, retained earnings and reserves. The reason for this is that the classification may indicate legal or other restrictions on the abiity of the enterprise to distribute or otherwise apply its equity, different ownership interests in relation to dividend entitlemenents and

Since equity of UIAH is not a liabilitiy by definition neither is it owners’ equity, it has to be deducted from assets (much like minority interest in consolidations). Also unique is the deduction of prohibited earnings ( a process known as purification) to arrive at owners’ equity which is ‘purified’. It is interesting that in the case of mixed ownership of an Islamic bank by Muslims and NonMuslims, would owners’ equity need to be separated into Muslim Equity and Non-Muslim Equity or


Chapter 5:Financial accounting Concepts for Islamic Institutions INCOME STATEMENT

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121 repayment of capital. There is also a note between the market value and the book value of equity.

will the SSB require all equity holders to relinquish prohibited earnings to charity?

IASB’s framwork encompasses both revenues and gains under an INCOME category. It defines INCOME as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity other than contributions from equity participants. INCOME encompasses both revenue and gains. Revenue arises in the course of ordinary business activities whereas Gains arises either in the ordinary course of business or may not and include income from sale of non-current assets, revaluation of marketable securities and long term assets.

SFA 2’s definition is a bit akward and repititious but perhaps necessary in the light of the many classess of equities in an Islamic bank. While in a normal enterprise, revenues can be defined as increases in equity excepting those related to additional injections of capital by owners, this is difficult to do in Islamic banks as there are equity holders of the bank, restricted and unrestricted investment accounts and savings and current account holders.

REVENUES: are gross increases in assets or decreases in liabilities or a combination of both during the period covered by the income statement which result from legitimate investment, trading, rendering of services and other profit oriented activities of the Islamic bank like investment management of restricted investment accounts. To be considered revenues, the gross increases in assets or the gross decreases in liabilities should have the following characteristics: (a) The gross increases in assets or the gross decreases in liabilities should not be the result of investment by or distribution to owners, deposits or withdrawals by unrestricted investment account holders or their equivalent, deposits or withdrawals by current or other non-investment account holders or the acquisition of assets. (b) The gross increases in assets or the gross decreases in liabilities should have the same characteristics of assets and liabilities, respectively. (c) The gross increases in assets or the gross decreases in liabilities should relate to the period covered by the income statement.

EXPENSES Expenses are gross decreases in assets or increases in liabilities or a combination of both during the period covered by the income statement which result from legitimate investment, management of investments, trading and other activities of the Islamic bank, including the rendering of services. To be considered expenses, the gross decreases in assets or the gross increases in liabilities should have the following characteristics: (a) The gross decreases in assets or the gross increases in liabilities should not be the result of distribution to or investment by owners, withdrawals or deposits by unrestricted investment account holders or their equivalent, or withdrawals or deposits by current or other non-investment account holders. (b) The gross decreases in assets or the gross increases in liabilities should have the same characteristics of assets and liabilities. The gross decreases in assets or the gross increases in liabilities should relate to the period covered by the income statement.

EXPENSES Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity other than those that result in distributions to equity participants

Whereas SFA2, differentiates revenues and gains (as well as expenses and losses) , the framework of IASB does not differentiate gains and revenues as separate elements of the income statement although they are to be disclosed separately. Again the frameworks reference to the effect on equities makes the defintion much easier as compared to the unique nature of Islamic banks’ different equities which makes it more difficult to define. Thus SFA2, tries to details the source of the expenses as relating to investment and other specified activities. An important difference is once again, the framework encompasses losses as well as expenses that arise in the ordinary activities of the enterprise,



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122 whereas SFA2 differentiates between expenses and losses

GAINS AND LOSSES A gain is a net increase in net assets which results from holding assets that appreciate in value during the period covered by the income statement or from incidental legitimate reciprocal and non reciprocal transfers, except for non-reciprocal transfers with equity owners or holders of unrestricted investment accounts and their equivalent. (para 34) A loss is a net decrease in net assets which results from holding assets that depreciate in value during the period covered by the income statement, or from incidental legitimate reciprocal and non-reciprocal transfers, except for non-reciprocal transfers with equity owners or holders of unrestricted investment accounts or their equivalent. (para 35) Not all gains and losses result from the same causes. Some gains and losses result from exchanges between the Islamic bank and other entities, for example, gains and losses from the sale of fixed assets that were not acquired for sale in the normal course of business. Other gains or losses result from nonreciprocal transfers (one sided transactions), for example, donations received by the Islamic bank or penalties imposed on the bank by the central bank. In addition, the bank may incur other losses which result from involuntary conversions of assets, for example loss of assets due to theft, destruction of assets due to flood. Other gains or losses may result from holding assets while their value changes during the period covered by the income statement RETURN ON UNRESTRICTED INVESTMENT ACCOUNTS AND THEIR EQUIVALENT :

Gains are income other than revenue which may or may not be arise in the course of the ordinary activities of the enterprise. Gains represent increases in economic benefits amd as such no different in nature from revenue. Losses are expenses which may or may not arise from the ordinary activities of the enterprise. Losses represent decreases in economic benefits and as such no different in nature from other expenses and are not considere a separate element in the framework.

Not applicable

Return on unrestricted investment accounts and their equivalent is the share allocated to the holders of those accounts out of investment profits and losses as a result of their participation jointly with the Islamic bank, in the financing of investment transactions during the period covered by the income statement. The return on unrestricted investment accounts and their equivalent is not considered an expense (in case of profit) or a revenue (in case of loss). Rather, it is considered an allocation of the investment profits and losses accruing to the holders of unrestricted investment accounts from their participation in investment activities carried out jointly with the Islamic bank

NET INCOME (NET LOSS) Net income (net loss) for the period covered by the income statement is the net increase or decrease in owners’ equity resulting from revenues, expenses, gains, losses, after

Not defined in the Framework. However, intermediate measures of performance are explained under Performance (para 73) as different measures of performance having

As noted earlier, the presence of different classes of equities make the defintion in SFA 2 a bit more difficult as opposed to a direct reference to equity in the framework definition. In the framework, gains and losses are not defined as separate elements from income and expenses whereas SFA 2 defines them separately.

This is unique to IFIs. This is the result of investment management activities of the islamic bank. Whereas, a conventional bank can be said to management investment of savings or fixed deposit holders, these are not profit sharing contracts as in the case of mudaraba contracts in Islamic banks. Hence, “returns” i.e. interest to these account holders in conventional banks are considered as expenses whereas returns to investment account holders are consideres appropriations of profit and when given , as gift – expenses to savings and current account holders.


Chapter 5:Financial accounting Concepts for Islamic Institutions allocating the return on unrestricted investment accounts and their equivalent, for the period. It is the result of all ongoing profit oriented operations of the bank and other events and circumstances affecting the value of assets held by the Islamic bank during the period covered by the income statement. Net income (net loss) includes all legitimate changes in equity during the period covered by the income statement except those resulting from investments by owners and distributions to owners. (para 38) The basic elements of the income statement may be combined in different ways to obtain intermediate measures of the Islamic bank’s performance during a specific period of time. Examples of such intermediate measures are income (loss) from investments, income (loss) after return on unrestricted investment accounts, income before Zakah and Tax. Those intermediate measures are, in effect, sub-totals of net income (net loss).

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123 different degrees of inclusiveness such as Gross Margin, profit before taxation etc.

Table 5.1: A comparison between elements of financial statements as defined in SFA2 and IASB Framework



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As for the retained earnings and cash flow statement I just reproduce the unique definitions of SFAC 2: Statement of Changes in Owners’ Equity :

Investment by owners is the amount of increase in owners’ equity resulting from the transfer of assets or the performance of services to the Islamic bank or the assumption or payment by owners of an obligation of the Islamic bank for the purpose of increasing their equity in the bank. Distributions to owners is the amount of decrease in owners’ equity resulting from transfer by the Islamic bank to the owners of assets or the performance of services or the assumption or payment by the Islamic bank of an obligation of the owners for the purposes of reducing their equity in the bank. investments by owners and distribution to owners are nonreciprocal transfers (one sided transactions) between the Islamic bank and its owners as owners. This is different from reciprocal and nonreciprocal transfers between the Islamic bank and its owners as non owners. Statement of Retained Earnings Dividends are one type of distributions to owners Transfer to other owners equity accounts is a decrease in retained earnings resulting from their transfer to legal or other reserves or to the owners’ capital accounts. Statement of Cash Flows Cash and cash equivalent include local and foreign currency and deposits with central bank and other institutions which the Islamic bank can withdraw in full on demand. Cash and cash equivalent do not include gold, silver or other precious metals. This is because the purpose of this statement is to report sources and uses of cash and cash equivalent items that are available immediately as a means of transacting business. Cash flows from operations Cash flows from operations refer to cash inflows or outflows during the period as a result of transactions and other events whose effects are reflected in the Islamic bank’s statement of income as revenues, expenses, gains and losses, except for gains and losses resulting from the sale of assets acquired by the bank for its own use.



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Cash flows from investing activities Cash flows from investing activities refer to cash outflows as a result of the acquisition of assets for investment including investment for the Islamic bank’s own use and/or cash inflows as a result of the sale of assets previously acquired by the bank for investment or/and for its own use. Cash flows from financing activities Cash flows from financing activities refer to cash inflows as a result of investment by owners, deposits by holders of unrestricted investment accounts and their equivalent, and deposits by current, savings and other similar accounts and/or cash outflows resulting from distributions to owners or withdrawals by holders of unrestricted investment accounts and their equivalent, and withdrawals by current, savings and other similar accounts. A Ann iim mppoorrttaanntt ppooiinntt ttoo nnoottee:: In IAS 7, changes in current, savings and other similar account deposits and withdrawals are classified as operating cash flows (increases/decreases in operating assets) as illustrated by in its appendix B (cash flow statement for a financial Institution) , whereas these are considered as financing cash flows under SFA 2. The reason is under the shari’a cash is not a commodity to be used in earning returns by itself (this amounts to riba’. As the Islamic bank does not pay interest and not required to give hiba on its deposits, it is not operating inventory as it is in conventional banks. See figure ?? for an illustration of a conventional bank cash flow statement and that of an Islamic bank.

5.5 Definitions of elements in financial statements unique to Islamic Financial Institutions. 5.5.1 Statement of Changes in Restricted Investments and their Equivalent Restricted investments are assets acquired by funds provided by holders of restricted investment accounts and their equivalent and managed by the Islamic bank as an investment manager based on either a non-participating ?? Mudaraba contract or agency contract. Restricted investments are not assets of the Islamic bank and should not be reflected on the bank’s statement of financial position since the bank does not have the right to use or dispose of those investments except within the conditions of the contract between the Islamic bank and holders of restricted investment accounts and their equivalent. Hence, the requirement of an off-balance sheet “Statement of Changes in Restricted Investments and their Equivalent” in the annual report of the Islamic Financial Institutions. The basic elements of this statement include restricted investments as of a given date, deposits and withdrawals by holders of restricted investment accounts and their equivalent, restricted



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investment profits and losses before the investment manager share in investment profits as a Mudarib or his compensation as an investment agent, and the investment manager share in investment profits or compensation during the period ending at that date. Deposits and withdrawals by holders of restricted investment accounts and their equivalent Deposits by holders of restricted investment accounts and their equivalent are funds received by the Islamic bank, as an investment manager or agent, from holders of such accounts who agree that the Islamic bank invests their funds for a share in investment profits as a Mudarib or for a fee as an agent. Withdrawals by holders of restricted investment accounts and their equivalent are funds received by such holders out of the proceeds of restricted investments that reduce the holders’ share in restricted investments. The following transactions are equivalent to withdrawals: (a) The transfer of all or part of the balance of the holder of a restricted investment account to an unrestricted investment, a current account or any other account with the bank. (b) The transfer of all or part of the balance of the holder of a restricted investment account from one restricted investment portfolio (or a mutual fund) to another restricted investment portfolio managed by the same bank. Such transfer is considered a withdrawal from the first portfolio and a deposit in the second portfolio. (c)

The reacquisition by a mutual fund of investment units previously issued by the fund.

Restricted investment profits (losses) before the bank’s share in investment profits as a Mudarib or compensation as an agent is the amount of net increase (decrease) in restricted investments other than increases (decreases) resulting from deposits and withdrawals by holders of restricted investment accounts and their equivalent. The relationship between the bank as an investment manager and holders of restricted investment accounts and their equivalent may be based on a Mudaraba contract or an agency contract. In the first case, the bank’s compensation, as an investment manager, takes the form of a percentage of investment profits. No compensation would be due to the bank, as investment manager, in the case of investment losses when the bank’s arrangement is based on a Mudaraba contract. However, the bank’s invested funds would bear its share of investment losses. ?? this would amount to a comingling of the funds. Is this allowed in a restricted mudarab?. In the second case, the bank’s compensation, as an investment manager, takes the form of a fixed fee regardless of the investment results.



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5.5.2 Statement of Sources and Uses of Funds in the Zakah and Charity Fund When an Islamic bank establishes a Zakah and charity fund, the bank acts as a fiduciary of that fund if the bank is responsible for the collection and distribution of all or part of Zakah and charity funds. The basic elements of this financial statement include sources of funds in the Zakah and charity, uses of funds in the Zakah and charity fund during a period and the fund balance as of a given date. Zakah is a fixed religious obligation calculated by reference to net assets (including cash) that have appreciated or have the capacity to appreciate in value over a specific period of time except for assets that have been acquired for consumption or use in the production of revenues(3). Zakah is a religious obligation on wealth which every Muslim, including a child or an insane person, must meet provided his net assets are liable for Zakah. However, unlike Zakah, charitable contributions are discretionary. The first Zakah conference held in Kuwait in 1984 concluded that in the case of a company that is considered, legally, a separate entity (e.g. limited liability companies and corporations) Zakah should be determined based on the company’s net assets as if the company was subject to Zakah. The total amount of Zakah, so determined, would then be divided between owners to enable each owner to meet his religious obligation personally. However, in the following four cases the company is required to satisfy its Zakah obligation on behalf of its owners. (a)

When the law requires the company to satisfy the Zakah obligation as an entity.

(b)

When the company is required by its charter or by-laws to satisfy the Zakah obligation as an entity.

(c)

When the general assembly of shareholders passes a resolution requiring the company to satisfy the Zakah obligation as an entity.

(d)

When individual owners authorize the company to act as their agent in satisfying the Zakah obligation.

In addition, holders of investment accounts and other accounts as well as other parties may ask the Islamic bank to act as an agent in meeting the Zakah obligation on their interest in the bank. The bank may also receive charitable contributions from owners, depositors and others for distribution on their behalf. Uses of funds in the Zakah and charity fund include the eight purposes for which they are distributed as set forth in the following verse “Alms are for the poor and the needy, and those employed to administer the (funds); for those whose hearts have been 3

()

For example fixed assets of the bank or real estate owned by it.



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(recently) reconciled (to the truth); for those in bondage and in debt in the cause of Allah and the wayfarer. (Thus is it ) ordained by Allah, and Allah is full of knowledge and wisdom (Chapter 9: verse 60)”. (para 58) Fund balance in the Zakah and charity fund refers to funds in the Zakah and charity fund which have not been distributed as of a given date.

In certain countries such as Malaysia, the power to collect and distribute zakah is the prerogative of the government. It is prohibited for individuals or organizations (whether NGOs or businesses) to be involved in this. As with other developing countries, the government machinery is bureucratic and extremely inefficient. In Malaysia, the many state governments have corporatised this function to a company owned by the religious department. Research (e.g. Nazifah 2007) has shown the collection and distribution has improved over the years after the corporatization, although there are some problems to sort out. In Pakistan, several levels of committes at the national, provincial, district and village levels undertake this function. In Saudi Arabia, zakah is collected from Saudi nationals at 2.5% by the Department of Zakat and Taxation under the Ministry of Finance. Nationals are required to submit zakat returns. In Indonesia, the government has licensed certain NGOs (which are not Islamic banks) such as Dompet Duafa to collect and distribute zakah. Research (e.g. Hidayatul Ihsan 2007) has shown that some of these organizations are very transparent and accountable. The lack of reporting standards have not hindered these organizations, but standards would certain help improve accountability. It is perhaps time for AAOIFI to develop shari’a, governance, auditing, ethics and accounting standards for zakah institutions, whether public or private. Also, charity (sadaqah) and zakah, according to shari’a, have different conditions of collection and distribution. AAOIFI does not prescribe the separation of these two funds as it should be. If a joint statement is easier, it should be columnar separating zakah from charity. In fact, the charity fund if any should be joined to the Qard Hasan Fund but still separated.

5.5.3 Statement of Sources and Uses of Funds in the Qard Fund The basic elements of financial statement include, sources of funds and uses of funds during a period and the fund balance as of a given date. The fiqh definition of Qard is that it is a non-interest bearing loan intended to allow the borrower to use the loaned funds for a period of time with the understanding that the same amount of the loaned funds would be repaid at the end of the period. An Islamic bank may organize a fund for Qard as a means of achieving social objectives

Jordan Islamic Bank for Finance and Development gave Al-Qard Al-Hassan loans until the end of (2005) amounting to JD (6.7) million (US$9.45 million) from which 14,369 citizens benefited.



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Sources of funds in the Qard fund represent the gross increase in funds available for lending during the period covered by the statement. Sources of such increase may be external or internal. External sources include funds provided to the fund by the bank from current accounts at the bank, funds provided to the fund by owners of the Islamic bank and proceeds of prohibited earnings which the Islamic bank may make available to the fund on a temporary basis until such proceeds are properly disposed of. Internal sources include collections of loans during the period or funds deposited in the fund by individuals on a temporary or permanent basis. Uses of funds in the Qard fund represent the amount of gross decrease in funds available for lending during the period covered by the statement. Uses include new loans granted during the period, reimbursement of funds made available to the fund by the Islamic bank from current accounts and/or prohibited earnings, if any, and repayment of funds previously provided to the fund by individuals on a temporary basis. Fund balance in the Qard fund refers to the outstanding collectible loans and the other funds not loaned or used for other purposes. In a study undertaken by Maali et. al. (2003)4, they observe that “ despite the importance of Qard Hassan for Islam, only two (out of 29 respondent banks) banks provided detailed information and a further two banks made a brief statement about this Islamic loan. Although AAOIFI requries Islamic banks to provide statement of Qard ..as part of a full set of financial statements, none of the 11 banks claiming to follow AAOIFI standards did this.” This is indeed a sad state of affairs. After almost a quarter decade of history, Islamic banks have still far to go in meeting their social obligations.

5.6 The accounting assumptions (concepts, principles and conventions) The accounting concepts, postulates, principles and conventions under which conventional accounting financial statements are general decision rules derived from the objectives and theoretical concepts of accounting, that govern the development of accounting techniques. These includes the historical cost, revenue, matching, objectivity and full-disclosure, conservatism, materiality and the uniformity and comparability concepts, the monetary measurement and entity concepts Accounting information produced in accordance to these principles is often put forward as objective, neutral, verifiable and reliable. However, even the economic consequences produced by the accounts prepared under these principles were shown to be wanting as early as 1931 by MacNeal. These principles and concepts have been criticized both from the capitalist (e.g. Stirling, 1970) and Islamic points of view ( e.g. Adnan & Gaffikin, 1997). 4



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MacNeal (1970, [1939]), argued that accounting was ‘untruthful’ as it consisted of ‘unsound accounting principles’ which he claimed was based on ‘expediency rather than the truth’ Financial statements prepared under these principles were supposed to have misled investors because it failed to take into account current values (values in exchange) of assets and instead used historical (original) costs and justifying them in terms of a ‘going concern’ theory. According to him, the unwillingness of accountants to recognise unrealised profits leads the investor to make wrong economic decisions on lending, buying and selling securities. He further advocated that all profit and losses whether realised or otherwise should be disclosed (a position later upheld by Edwards & Bell (1961) and the Trueblood Committee (AICPA, 1973). MacNeal (1970) argued that the historic cost principle was relevant when businesses were owner managed, where the function of accounting was ‘counting’ the costs of a project or venture. As the project or venture was of short duration, historical cost sufficed to track the cost and profits accumulated to the end of the venture as no external parties relied on this information. The growth of bank credit perpetuated this principle because the bank required only a conservative estimate of the value of the net assets of the borrower to guarantee the return of loan. An under-valuation due to historic costs would be that much better and the conservatism concept would ensure that current assets were written down in value if its cost was higher than the prevailing market price. Thus, the accounting principles were acceptable for this period, as the accountant could satisfy both the interest of the banker by being conservative, and the businessman/owner would not be mislead as the latter knew the real value of his assets independent of the accountant. The accountant, left with the question of valuing non-marketable fixed assets invented his theory of the going concern so that he could justify its valuation in terms of its original cost less depreciation for maintenance and renewal. Mergers and Acquisitions led to bigger and bigger corporations controlled by non-owner management. This led to a situation where many small shareholders were entirely dependent on financial statements for information to make their investment decisions. The accounting principles led to the preparation of financial statements which according to McNeal, ‘frequently allow managers and directors of a company to enrich themselves at the expense of the stockholders in a most comfortable and legal manner’. The prudence and realisation concept is also not appropriate although a fixed asset may be carried for a long term, investors change during this period. Hence, if investors are not given the market values, this favours, the insider who can buy up the shares, knowing the real values of the assets and rake in the profit at the time of realisation, thus in effect defrauding the previous shareholder who would have sold his shares for a value less than its worth Although the accountancy profession has increased its standards of reporting, overall it has followed the latter course of redefining accounting objectives. The historical cost, realisation, going concern and prudence concepts continue to be the bedrock accounting principles, fifty years after MacNeal wrote his book. Financial scandals continue to rock the world (Briloff, 1990, Enron 2003) and the profession refuses to budge from its basic position with respect to recognition and measurement conventions despite the increasing ‘audit expectation gap’.



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The Trueblood Report (AICPA, 1973) tried to change the status quo by suggesting the use of current values. It rejected the traditional emphasis on prudence and suggest the fullest disclosure of the uncertainties involved’ (Peasnell, 1974, p38). Other proposals called for a middle position between full current value accounting and historical accounting include those by Lowe (1970) for “multiple-column reporting” alternate values and the proposal to report both realised and realisable profits by Edwards & Bell (1961). The Trueblood Committee Report was rejected because it was too revolutionary. It is only with the recent introduction of the new IFRS that the profession is finally moving, away from historical cost to towards a concept of fair value (for example in, IAS32 financial instruments, IAS 16 Property Plant and Equipment, IAS 38 Intangible assets and IAS 41 Agriculture). The IASB has recently issued a discussion paper in November 2006 on fair value measurement based on SFAS 157 of the FASB. The IASB intends to issue an exposure draft to codify the measurement of fair value. Coming back to SFA2, the standard discusses the following concepts: a) b) c) d)

the accounting unit concept (accounting entity) the going concern concept the periodicity concept the stability of the purchasing power of the monetary unit

It also discusses under the measurement concepts e) revenue recognition (realization) concept f) matching concept g) measurement attribute, the historical cost concept and other alternative measures. It does not discuss the monetary measurement concept, substance over form and prudence and accruals. However, the last concept is implied especially in the revenue recognition concept.

5.6.1 The accounting unit concept (the accounting entity concept) The accounting unit concept requires the identification of economic activities that are associated with the Islamic bank as a separate entity and can be expressed as the bank’s assets, liabilities, revenues, expenses, gains and losses, net income and net loss. From the shari’a point of view, artificial entities such as the baitul mal and the waqf has been recognized as separate legal and accounting entities. Although some scholars object to private limited liability company having a separate legal entity (e.g. Sheikh Taqu Usmani), others have extended this concept to companies. Thus an Islamic bank is considered an accounting unit separate from its owners or others who have provided the bank with funds. This separation also includes the separation of the bank’s liability from that of its owners because “There is no objection in Shari’a to setting up a company whose liability is limited to its capital for that is known to the company clientele and such awareness on their part precludes deception” according to a resolution of the Council of the Islamic Fiqh Academy, Jeddah, (1992).



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On the other hand, some activities with which the bank is associated are the activities of other accounting units and should be reflected as such. For example, the bank may

manage a restricted investment portfolio for the benefit of other parties, manage a Zakah and charity fund or manage a Qard fund. Similarly, the bank itself as an accounting unit may be part of a bigger accounting unit. In this case, in addition to the bank producing its own financial statements as an accounting entity, the preparation of financial statement reflecting the activities of the bigger accounting unit may be appropriate. 5.6.2 The going concern concept In the absence of persuasive evidence to the contrary, financial accounting assumes the continuation of an entity as a going concern. This means that in preparing the entity’s financial statements it is assumed that there is no intention or necessity to liquidate the entity. In addition, the going concern concept has an important bearing on financial accounting and the financial statements of the accounting unit. In so far as the entity is conceived of as a continuous stream of activities, it is the task of financial accounting to make the most significant measurements possible of the continuous flow of the entity activities. Under this concept, the most significant measurements possible of the continuous flow of the entity activities are those pertaining to allocating its efforts and accomplishments as between the present and future and matching those efforts and accomplishments. Mudaraba and Musharaka contracts are for specific periods, however, these are assumed to continue until one or all of the parties involved decide to terminate such contracts. Hence, investment accounts managed by an Islamic bank that are based on Mudaraba contracts are assumed to continue until they are terminated by their owners or the bank. Similarly the concept of Islamic banking is based on Mudaraba contracts, which are assumed to continue until there is evidence to the contrary. On other hand, Islamic Fuqaha divide wealth into money and goods. Goods are divided into those that are available for sale and those that are not available for sale. The latter are used for longer periods (e.g. buildings and equipment) which imply that the entity would continue in operation Breaking up these continuous streams of activities into periodic streams between the present and the future severs many real connections and tends to give an impression of high degree of certainty with respect to the figures presented in the financial statements. In reality, what the financial statements present as of a given point in time is dependent to a very great extent on the future direction of events and circumstances that affect the entity’s activities. The financial statements of a period, even under the most favourable circumstances, are tentative in character. The complete picture of the entity is never entirely discernible prior to final liquidation.



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The going concern concept has an important implication to an Islamic bank. Assumptions are made about the continuity of the bank’s activities in the future, including its investment activities. However, the relationship between the bank and owners of investment accounts may not continue until the liquidation of investments, when actual results

become known. It may, therefore, be appropriate to measure investments during the life of such investments at their cash equivalent values in order to achieve equity in determining the rights of holders of investment accounts who wish to withdraw their funds before the actual liquidation of investments.

Remember MacNeal’s argument regarding current values? This is why the shari’a, to institute fairness, insists on the current value in measuring assets for zakah. 5.6.3 The periodicity concept Islam assigns certain rights to money and wealth and associates such rights with periods of time to ensure that obligations pertaining to such rights are fulfilled on a timely basis. For example, Zakah is due on the amount of money and wealth that have reached a certain level one year after reaching that level. It is reported that the Prophet (peace be upon him) has said “No Zakah on wealth (property) until a year passes”. Consistent with this concept in Islam, there is an obligation on Islamic banks to present periodic reports reflecting their financial positions as of a given date and the results of their operations during a specific period in order to disclose the rights and obligations of the bank and those of interested parties. Hence, the periodicity concept means that life of the Islamic bank should be broken into reporting periods to prepare financial reports that provide interested parties with information or directions by which they can evaluate the performance of the accounting unit. This assumption also indicates the need to relate the activities of the accounting unit through the entirety of its life to the appropriate reporting periods as necessary. The Qur’an refers to the calculation of the year and months made easy with the orbit of the moon and the sun (rather the earth!) (Qur’an 6:5). From an Islamic point of view, a lunar year would have been more appropriate. However, due to international conventions and practical difficulties, aaoifi has not insisted on a lunar fiscal year for Islamic banks. The only stipulation is that since Zakat is based on a lunar year, if the Islamic Financial Institutions uses a solar year, then its zakat rate is adjusted to 2.5775% instead of 2.5%. 5.6.4 The stability of the purchasing power of the monetary unit



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Financial accounting uses monetary units of a given currency as a common denominator to express the basic elements of financial statements. The use of monetary units as a means of expressing the basic elements of financial statements is a prerequisite for measuring the financial position, results of operations and other changes in the financial position of an accounting entity during a specific period. The use of monetary units as a means of expressing the basic elements of financial statements may raise a question regarding the stability of the measurement unit in view of a change in its purchasing power. For example, the purchasing power of a monetary unit

decreases during a period experiencing an increase in the general price level (inflation) and increases during a period experiencing a decrease in the general price level (deflation). There are two schools of thought in Islamic Fiqh with respect to the effect of changes in the purchasing power of money on financial rights and obligations. One school of thought believes that changes in the purchasing power of money should be taken into account when settling financial rights and obligations. The other school of thought believes that changes in the purchasing power of money should be ignored when settling financial rights and obligations. For purposes of financial accounting for Islamic banks, the stability of the purchasing power of the monetary unit is assumed. As long as fiat money is being used, the problem of inflation will have consequences on the fairness in the settlement of monetary rights and obligations. It is a problem which the fuqaha has tolerated. Indexation has been rejected by the fiqh academy. In addition to the problems of inflation, the monetary measurement concept accounts only measures and reports only economic events, which are reliably measurable in monetary terms. Externalities (events and transactions which are caused by the entity but do not have a monetary impact are not accounted for. Unfortunately, SFAC2 completely avoids discussion of this important issue. Since Islamic accounting has a social accountability dimension (Baydoun & Willet, 1998), Islamic accounting cannot restrict itself to the monetary measurement concept. I propose that to the extent possible, externalities be measured in monetary terms where possible and included in the Islamic accounting report. If not, at least qualitative disclosure is required. Islamic accounting, however, should not separate social and economic events into different reports as prescribed by Chen (1975) but a holistic “Accounting” or “Accountability” report combining monetary and nonmonetary, qualitative and quantitative, social and economic events and transactions.



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5.7 Concepts related to recognition Accounting recognition refers to recording the basic elements of the financial statements. The concepts of accounting recognition define the basic principles that determine the timing of revenue, expense, gain and loss recognition in the bank’s income statement and, in turn, the basic principles that determine the timing of assets and liabilities recognition. The concepts of accounting recognition also determine the timing of recognizing profits and losses resulting from restricted investments in the statement of changes in restricted investments.

5.7.1 Revenue recognition (Realization concept) The basic principle for revenue recognition is that revenues should be recognized when realized. Realization of revenues takes place when the following conditions are met: (a)

The bank should have earned the right to receive the revenue. This means that the earning process should be complete or virtually complete. The point at which the earning process is complete may differ for different types of revenues. For

example, the earning process for revenues from services is compete when the bank delivers the service; the earnings process for revenues from the sale of goods is complete upon delivery of those goods; and the earning process for revenues from allowing others the use of the bank assets (e.g. leasing real estate) is completed through the passage of time. (b)

There should be an obligation on the part of another party to remit a fixed or a determinable amount to the bank.

(c)

The amount of revenue should be known and should be collectible with reasonable degree of certainty, if not already collected.

The basic principle for expense recognition is realization either because the expense relates directly to the earning of revenues that have been realized and recognized or because it relates to a certain period covered by the income statement. The recognition of expenses that relate directly to the earning of revenues that have been realized and recognized is founded on the Islamic concept of assigning the responsibility for the cost to the recipient of the benefit. Expenses that have no direct relationship to revenues but do have a direct relationship to the periods during which revenues are recognized fall in two categories:

(a) Expenses representing costs that provide a benefit in the current period but are not expected to provide reasonably measurable benefits in the future. Examples include management compensation and bonuses and other administrative expenses which are difficult to allocate directly to specific services performed for others by the bank or specific



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assets acquired by the bank. Accordingly, such expenses should be recognized when incurred. (the accrual concept). (b) Expenses that represent a cost incurred by the bank which is expected to benefit multiple periods. Such cost should be allocated in a rational and systematic manner to the periods expected to receive the benefit. An example of such expenses is depreciation of fixed assets which represents (c) an allocation of the cost of fixed assets to the periods that benefit from the use of such assets. The basic principle for gain and loss recognition is their realization as a result of: (a)

The completion of a reciprocal or a nonreciprocal transfer resulting in the gain or loss. An examples of reciprocal transfer is the consummation of the sale of fixed assets as a basis for the recognition of gains (losses). An example of a nonreciprocal transfer is the occurrence of an event such as a natural disaster which results in a loss.

(b)

The availability of sufficient competent evidential matter indicating reasonably measurable appreciation or depreciation in the values of recorded assets or liabilities as a result of changes in supply and demand. Such gains and losses are estimated

unrealized gains and losses resulting from revaluation of assets and liabilities, where applicable. The basic principles governing the recognition of gains and losses also govern the recognition of restricted investment profits and losses. Restricted investment profits and losses may consist of two types, namely realized profits and losses resulting from reciprocal and nonreciprocal transfers, and estimated unrealized profits and losses resulting from the revaluation of restricted investments, where applicable.

5.7.2 The matching concept The bank’s net income (net loss) for a period of time should be determined by matching revenues and gains with expenses and losses that relate to that period of time in accordance with the basic principles of accounting recognition. Likewise, restricted investments’ net profit or net loss for a period of time should be determined by matching restricted investment revenues and gains with restricted investment expenses and losses that relate to the period of time in accordance with the basic principles of accounting recognition. The matching concept is supported by the Islamic concept of assigning the responsibility of the cost to the recipient of the benefit.



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5.8 Concepts related to Measurement Accounting measurement refers to the determination of the amount at which assets, liabilities and, in turn, equity of the holders of unrestricted investment accounts and their equivalent and owners’ equity are recognized in the bank’s statement of financial position. It also refers to the amounts at which restricted investments and, in turn, equity of the holders of restricted investment accounts and their equivalent are recognized in the statement of changes in restricted investments. Accounting measurement concepts define the broad principles that determine the amount or amounts at which those elements are recognized. 5.8.1 Measurement attributes (or bases according to the IASB framework) refer to the attributes of assets and liabilities that should be measured for financial accounting purposes. For example, asset attributes that may be selected for measurement in financial accounting may include: (a)

the acquisition cost of the asset, (historical cost concept)

(b)

the net realizable or cash equivalent value of the asset as of a given date,

(c)

the asset’s replacement cost as of a given date or

(d)

any other attribute whose measurement would result in relevant information (e.g. fair value variously defined)

.

The choice of the attribute(s) that should be measured for financial accounting purposes should be guided by the relevance, reliability, understandability and comparability of the resulting information provided to users of financial statements. These include:

5.8.2 The cash equivalent value expected to be realized or paid The cash equivalent value expected to be realized is the number of monetary units that would be realized if an asset was sold for cash in the normal course of business as of the current date. The cash equivalent value expected to be paid is the number of monetary units required to settle an obligation as of the current date such as a Salam or Istisna’a obligation. When all of the conditions required for the measurement of this attribute are present (i.e. relevance, reliability and understandability of the resulting information), measurement of this



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attribute would be suitable as a basis for accounting measurement for an Islamic bank whether as: (a) an investor of the funds available to it from its owners and holders of unrestricted investment accounts on the basis of an unrestricted Mudaraba contract (b) an investment manager of restricted investment accounts either on the basis of a restricted Mudaraba or agency contract. In both cases, information resulting from the measurement of this attribute is particularly relevant to present and potential holders of unrestricted or restricted investment accounts or their equivalent. Present and potential holders of investment (restricted or unrestricted) accounts and their equivalent need information to evaluate the bank’s ability in achieving their investment objectives. In addition, holders of investment accounts and their equivalent need information to evaluate alternatives available to them whenever they can change their relationship with the bank. In both respects, the investment account holder’s evaluation needs to take into consideration, among other factors, the cash equivalent value he expects to realize from the funds he has provided or expects to provide to the bank to finance restricted or unrestricted investments. The value the holder of an investment account expects to realize from his funds is substantially dependent upon the cash equivalent value expected to be realized from investments if the investments were to be sold as of the current date. Another important factor that calls for the measurement of this attribute, is the equitable allocation of the results of unrestricted investments between the holders of unrestricted investment accounts who have provided or withdrawn funds at different points of time during the lives of those investments, on the one hand, and between such account holders as a group and owners of the Islamic bank on the other hand. Unlike owners of the Islamic bank, holders of investment accounts and their equivalent may withdraw their funds at the end of their contract. This means that if unrestricted investments were to be measured at their acquisition (historical) cost, inequities wouldoccur in the distribution of investment results between holders of investment accounts who provide or withdraw funds at different points of time during the lives of those investments. Likewise, inequities would occur in the distribution of unrestricted investment results between the holders of unrestricted investment accounts as a group and owners of the Islamic bank. This consideration is also relevant with respect to holders of restricted investment accounts or their equivalent who have provided or withdrawn funds at different points in time during the life of restricted investments. The results of investments (profits and losses) do not occur at a given point in time. Rather, such results are earned over the life of those investments even though the ultimate result is not certain until the investments are liquidated. If restricted investments were to be measured at their acquisition costs until liquidated, investment results would only be recognized during the period when the investments are liquidated. Should this be the case inequities would arise between holders of restricted investment accounts who have



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provided or withdrawn funds at different points in time during the life of those investments. It seems to me that AAOIFI has taken cash equivalent value as the primary “fair value” measurement. However, AAOIFI has not defined “fair value” despite its numerous references to fair value in its standards (see for example, FAS 4 on Musharaka Financing, para 8). According to IAS39, fair value is defined by the IASB as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction.”. The definition is simple but to arrive at the amount is difficult as many attributes and principles (as mentioned in 5.8.3) has to be taken into account. Fair value is currently the subject of the discussion paper by the IASB.

5.8.3 Revaluation of assets, liabilities and restricted investments at the end of the accounting period Measurement of the cash equivalent expected to be realized or paid require the periodic revaluation of outstanding assets, liabilities and restricted investments. However, the resulting information must be reliable and comparable. To assure reliability and comparability, it is imperative that the management of the Islamic bank adheres to all of the following broad principles during the revaluation of assets, liabilities and restricted investments: (a) (b) (c) (d) (e) (f)

To the extent available, outside indicators (such as market prices) should be used. All relevant information whether positive or negative should be utilized. Logical and relevant valuation methods should be utilized. Consistency in the use of valuation methods should be adhered to. To the extent appropriate, experts in valuation should be utilized. Conservatism in the valuation process by adhering to objectivity and neutrality in the choice of values.

5.8.4 Applicability of revaluation of assets, liabilities and restricted investments Notwithstanding the relevance of revaluing assets, liabilities and restricted investments whenever investments are financed by holders of investment accounts, this concept will not be adopted at the present time. It is not evident that adequate means are currently available to apply this concept in a manner that is likely to produce reliable information. It is permissible, however, to apply this concept for the purpose of presenting supplemental information which may be relevant to an existing or a prospective holder of an investment account. Presentation of such supplemental information does not necessarily obligate the Islamic bank to distribute unrealized investment results. Distribution of investment results and the nature of the results to be distributed is generally based on the contractual relationship between the Islamic bank and the holder of the investment account and the laws and regulations governing that relationship.



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5.8.5 Alternative measurement attribute to the cash equivalent value The historical cost of an asset refers to its fair value at the date of its acquisition including amounts incurred to make it usable or ready for disposition. Fair value at the date of acquisition refers to the price paid by the Islamic bank to purchase the asset in an arm’s length transaction. When an asset is acquired through a nonreciprocal transfer to the Islamic bank, fair value refers to the market price at which a similar asset is exchanged in an arm’s length transaction between unrelated parties at the date of the transfer. Note that this is only a partial definition of fair value in relation to assets only, not liabilities. The historical cost of a liability refers to the amount received by the Islamic bank when the liability was incurred or the amount at which the liability will be settled when it is done.

5.9 The Qualitative Characteristics Of Accounting Information 5.9.1 Meaning of the qualitative characteristics of accounting information The qualitative characteristics of accounting information refer to the qualities of useful accounting information and the basic principles that should be used to evaluate the quality of such information. Definition of these qualities should assist those responsible for setting accounting standards, as well as, those responsible for the preparation of financial statements in evaluating financial information produced by alternative accounting methods and in differentiating between necessary and unnecessary disclosures. The usefulness of accounting information must be evaluated in relation to the objectives of presenting financial statements which are focused on helping their main external users make decisions involving Islamic banks. The interest of accountants should be directed to such users and to the preparation of financial statements that aid users in decision making. The decision making objective of presenting financial statements leads to the overriding criterion by which the alternative accounting methods or disclosure choices can be evaluated. Given a choice from among alternative accounting methods or given a number of disclosure choices, the method that should be chosen or the disclosure that should be made is the one that produces the information that is most useful for decision making by the main external users of financial statements. To say that a choice from among alternative accounting methods or disclosure alternatives should be based on the usefulness of the resulting information for decision making is not sufficient guidance to those who have to make the choice. The specific characteristics that would make the information useful for decision making need to be discerned and defined.

Did AAOIFI get this right here? Given the main objectives in SFA1, this seem to be inconsistent with its main objectives of safeguarding the rights and obligations of the IFI and related parties as defined by the Shari’a



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5.9.2 Relevance Relevance refers to the existence of a close relationship between the financial accounting information and the purposes for which this information is prepared. To be useful, financial accounting information should be relevant to one or more decisions of users of that information. The main users of financial statements have many courses of action under consideration. Some of these courses of action may involve a particular Islamic bank but others do not. Financial accounting information of a particular bank can only be relevant to evaluating an outcome of the course of action that relates to that bank. Accordingly, the financial statements of the bank in which an investor has an equity interest can not be expected to provide him with information about the outcome from the immediate sale of his interest-a quotation from a willing buyer is needed for that-or information about the outcome from investing elsewhere. For this reason, the role of the financial statements of a particular bank in the evaluation of outcomes of different courses of action must be related to the evaluation of the outcome from holding an equity interest in that bank or starting a particular relationship with a specific bank. On this basis relevance may be defined as follows: Accounting information is relevant if it helps the main users of financial statements evaluate the potential outcomes of maintaining or establishing relationships with the Islamic bank provided that information meets the other criteria of useful information. Relevance of accounting information requires that the information has the following three qualities: (a)

Predictive value This means that the information should enable the user to predict the potential outcome of a current or a new relationship with the bank. For example, net income resulting from the revaluation of assets and liabilities at their cash equivalent value would provide a better basis for predicting future cash flows than their valuation at historical cost.

(b)

Feedback value This means that the information should enable the user to verify the accuracy of his prior prediction and make adjustments. For example the reporting of net income would help equity owners to confirm their earlier predictions about cash flows or to correct those predictions.

(c)

Timeliness This means that if information is not available when it is needed or becomes available only so long after the reported events then it becomes of little use in making decisions. Timeliness alone cannot make information relevant because there are other factors which also make information relevant. However, lack of timeliness reduces the value of information or detracts from it usefulness.

Timeliness of accounting information requires consideration of two aspects:



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(1)

The frequency of financial statements issued by the Islamic bank. i.e., the length of the time period for which financial statements are prepared and issued. In this respect, the longer the period for which financial statements are prepared the less useful the information contained therein. On the other hand, the shorter the period for which financial statements are prepared the less reliable the information contained therein. Information contained in financial statements prepared for a very short period of time are likely to be affected by seasonal or random factors which might cause the information to be misleading or at least not worth the user’s time. But if the reporting period is too long, the user is required to wait too long before obtaining and using the information included in the financial statements. By then it might be too late for the information to make a difference in the user’s assessments of the outcome of different courses of action under consideration.

(2)

The time-period that elapses between the end of the period for which the financial statements are prepared and the date of their issuance. The longer the period during which the financial statements are being prepared for issuance, the greater the loss of the information value contained therein. It is the responsibility of the Islamic bank to prepare its financial statements in the earliest possible time that is reasonable. Optimal frequency and minimal lag are, therefore, important criteria of useful accounting information. They apply primarily to the reporting function rather than to the accumulation and measurement of financial accounting data.

5.9.3 Reliability Users of financial accounting information prefer that such information has a high degree of reliability. Reliability is the characteristic which permits users to depend upon information with confidence. However, reliability does not mean absolute accuracy since accounting information by necessity reflects estimates and judgments. Rather, reliability means that based on all the specific circumstances surrounding a particular transaction or event, the method chosen to measure and/or disclose its effects produces information that reflects the substance of the event or transaction. Estimates and judgments in applying accounting methods are not inconsistent with Shari’a principles which permit the use of persuasive evidence in the absence of conclusive evidence. Reliable accounting information should have the following qualities: (a)

Representational faithfulness This means that the information should reflect a faithful representation of what it purports to represent. That is there is close correspondence between such information and reality. However, there is no general rule to permit the evaluation of different



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methods of accounting based on this quality of accounting information. Whether a particular method of accounting will produce information that is more

representationally faithful than information produced by another method depends on the facts and circumstances of each case.

5.9.4 Objectivity This means that the results reached by a person can be substantially duplicated by another independent person using the same measurement and/or disclosure methods. Hence, to verify financial accounting information means to substantiate the information. However, the process of measuring and disclosing financial information can never become completely scientific because its factual materials can never be determined with complete and conclusive objectivity. The Islamic bank’s business does not lend itself to scientific experiments and its activities do not follow mathematical formulae. Accordingly, accounting information is not always conclusively objective or completely verifiable. Nevertheless, the usefulness of accounting information is enhanced if it is verifiable, that is, if the measurement and/or disclosure methods used provide results that can be substantially corroborated by independent measures. To summarize, reliability means that the measurement and/or disclosure methods selected to produce and present the information are appropriate to the specific circumstances and have been applied in a manner that can be substantially replicated by independent measures. It also means that the information presented is a faithful representation of the underlying events and does not contain material errors or distortions.

5.9.5 Neutrality Neutrality to or lack of bias against any group is a concept fully endorsed by Islamic principles. Allah says “O ye who believe! Stand out firmly for Allah, as witnesses to fair dealing, and let not the hatred of others to you make you swerve to wrong and depart from justice. Be just; that is next to piety; and fear Allah. For Allah is well acquainted with all that ye do” (Chapter 5: verse 8). This means that accounting information should serve the common information needs of its users without bias or unfair information advantage given to one group of users at the expense of others. Lack of neutrality affects the reliability of accounting information. Biased information is not reliable information. Neutral financial accounting information is directed towards the common needs of external users and is independent of presumptions about particular needs of specific users of the information. Neutral financial accounting information is fair information and is free from bias towards predetermined results. Neutrality of accounting information, therefore, creates a special duty on the part of those responsible for promulgating accounting standards as well as those who prepare financial statements. In both cases, there is duty to make choices among alternative measurement



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and/or disclosure methods on the basis of achieving two objectives: relevance of the resulting information, and reliability of that information. 5.9.6 Comparability Comparable financial accounting information allows users to identify real similarities and differences in the bank’s performance in relation to its own performance over time and in relation to the performance of other banks. The usefulness of financial accounting information is, therefore, enhanced by the use of similar measurement and/or disclosure methods to similar events. While there is some overlap between comparability, reliability and relevance, the many aspects of comparability are so important in providing useful financial accounting to users that a separate consideration seems to be warranted. 5.9.10 Consistency An Islamic bank should be consistent in its application of accounting measurement and disclosure methods from one period to another. However, this does not mean that the bank should keep using the same measurement and disclosure methods for the same transaction if there is a genuine reason to use other methods. For example, the management of the bank may decide to change the depreciation method if there were justifications that warrant the use of a different method. However, the change and its effect should be disclosed in the financial statement. (para 119) 5.9.11 Understandability The Prophet (peace and blessing of Allah be upon him) has ordered Muslims to address people according to their ability to understand. Information can not be useful to users who can not understand it. Understandability depends on the nature of the Information contained in the financial statements, the way the Information is presented as well as the background and abilities of external users. It is , therefore, important for those who promulgate accounting standards and those who prepare financial statements to be aware of the abilities and limitations of those for whom accounting information is provided. This is one of the concepts that requires careful attention by those who promulgate accounting standards as well as those who prepare financial statements. The former group should realize that accounting standards are not produced only for the benefit of those who prepare financial statements. Rather, standards are prepared for users of financial statements to revaluate the outcome of alternative courses of action under consideration. Accordingly, the strengths and limitations of users of financial statements should be as important a consideration as anything else when preparing financial accounting standards. Likewise, those who prepare financial statements should realize that the statements are not produced for the benefit of other accountants. Rather, they are prepared for the benefit of external users who may have a limited knowledge, if any, of financial accounting of Islamic banks. Hence, the strengths and limitations of those users should be taken into



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consideration when designing financial statements and writing the notes accompanying them. The following should contribute to the understandability of financial accounting information: a) Use of classification that are meaningful to users of financial statements and not just to accountants b) Information headings c) Juxtaposition of related data d) presentations of net figures which the users typically want to know. One could make an argument on whether relevance and reliability from the conventional capitalist framework is consistent with the shari’a. The question is relevance to whom and for what. From the FASB conceptual framework, the information should be relevant to shareholders and interest based bank creditors to make decisions as to buy, sell or hold their shares and investments. Reliability means they can be verified by reference to international financial reporting standards. Both these are not very shari’a friendly.However, to give the benefit of the doubt, we will mean relevance and reliability according to objectives mentioned by AAOIFI in SFA1 reviewed in the last chapter

5.10

Preparation and presentation of accounting information

5.10.1 Materiality The principles of Islamic jurisprudence include rules that regulate priorities and classifications of human needs, namely daruriyat (necessities), hajiyat (needs) or tahsiniyat (commendables) matters. Among these principles is the principle of gharar (uncertainty of price quality, quantity or time of delivery in a contract) and the principle of choosing the least detrimental alternative. In preparing financial statements, the common information needs of users should always be taken into consideration with respect to the qualitative and quantitative importance of the information contained in those financial statements. Statement of Financial Accounting No.1 : Objectives of Financial Accounting for Islamic Banks and Financial Institutions defines the primary users as well as their common information needs. Information that is qualitatively or quantitatively important (material) should be presented. Conversely, information that is not material need not be presented. Materiality and adequate disclosure are interrelated and relate also to the concepts of relevance and reliability. Materiality and adequate disclosure are interrelated because if the information is material it should be disclosed and at the same time, information that

is not disclosed is presumed to be immaterial. Materiality and adequate disclosure relate to relevance and reliability because information which is not relevant to the objectives of



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financial statements or which cannot be relied upon should not be disclosed. Financial accounting as a process of measurement and communication frequently involves judgments. In making these judgments, considerations of materiality play an essential role. Materiality in financial accounting is a state of relative importance. Importance may depend on quantitative or qualitative characteristics or a combination of both.

In general, an item is regarded material if its omission, non-disclosure or misstatement would result in distortion of the information being presented in the financial statements, and thereby influence users of the statements when making evaluations or decisions. In deciding whether an item is material, its nature and its amount should both be taken into consideration, although in particular circumstances, either one may have to be recognized as the decisive factor. Qualitative materiality considerations include: (a) The inherent importance of the transaction, event or circumstance which an item reflects, e.g., whether usual or unusual, expected or unexpected, recurring or non recurring, in compliance with Shari’a or not in compliance with Shari’a, legal or illegal, etc. (b) The inherent importance of the item as an indicator of probable course of future events whether the item is indicative of new activities, represents substantive changes in current activities or changes in the bank’s practices.

Quantitative materiality considerations include: (a)

The amount of the item relative to normal expectations.

(b)

The magnitude of the item in relation to an appropriate base. For example, income statement items in relation to net income after deducting the share of unrestricted investment accounts, or the average operating income for a number of past years; or statement of financial position items in relation to total assets, total investment accounts or owners’ equity.

5.10.2 Cost of information Information, like any other commodity, has a cost either for the Islamic bank or society as a whole. The information provided by financial accounting involves a cost for its provision and use, and generally the cost of information provided should be expected not to exceed the benefits to users of financial accounting information in their decision making either at the individual level or the society level.

5.10.3 Adequate disclosure



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Adequate disclosure means that the financial statements should contain all material information necessary to make them useful to their users. This requires the disclosure of information which is expected to be useful to users of financial statements in their decision making whether that information is included in the financial statements, the notes accompanying them or in additional presentations. There are two aspects to adequate disclosure: optimal aggregation of accounting data and appropriate descriptions and clarifications. (a) With respect to optimum aggregation of accounting data, the financial statements should provide sufficient details to meet the users’ need for information about various categories of assets, liabilities, equity of holders of unrestricted investment (b) accounts and their equivalent, owners’ equity, revenues, expenses, gains, losses, cash flows, changes in owners’ equity, changes in equities of holders of restricted investments accounts and their equivalent, sources and uses of funds in the Zakah and charity fund, sources and uses of funds in Qard fund. However, too much details can contribute to confusion, especially if the user is required to study many lines of data that are not helpful in order to find the few that are needed. Furthermore, as excessive detail can cause the user to overlook the significant data, immaterial items should not be separately stated. (c)

With respect to written descriptions and clarifications, the headings, captions and amounts must be supplemented by enough additional descriptions and explanations so that their meaning is clear but not by so much information that important matters are buried in a mass of trivia. Notes accompanying the financial statements are always necessary both to provide users of financial statements with information that helps them in evaluating the bank’s performance and its management, and in explaining the limitations of the financial statements. This, however, depends partly on the ability of users of financial statements.

Whatever the circumstances, those who promulgate financial accounting standards and those who prepare financial statements must aim at adequate disclosure as a significant step towards providing useful information, particularly the information stated in the Statement of Financial Accounting No. 1: Objectives of Financial Accounting for Islamic Banks and Financial Institutions.



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MCQ5-1 Read the statements below and answer the question •

The earnings process should be completed entitling the bank to the right to receive

•

Obligations arises on the part of the customer to remit fixed or determinable obligations

•

Amount received is known and if not collected is collectible with reasonable certainty

What do the above statements reflect? a) Revenue recognition principle b) Expenses recognition principles c) Provision recognition d) Debt recognition principles.

MCQ 5-2 refers to the following statement. An asset is anything that is capable of generating positive cash flows or other economic benefits in the future either by itself or in combination with other assets which the financial institution has acquired the right to as a result of past transactions or events. Although the capacity of the financial institution to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. MCQ5-2 . Based on the above statement which of the following is true: a) The above statement reflects the definition of an asset in Islamic accounting. b) The above statement contradicts the definition of an asset in Islamic accounting. c) The above statement reflects the definition of forward sale contracts with an underlying asset in Islamic accounting. d) The above statement contradicts the definition of forward sale contracts with an underlying asset in Islamic accounting.

8



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Question 5-1

In SFA 2, AAOIFI has used what it terms as a “broad view” of Islamic principles. Explain what is meant by this “broad view” and how this approach is used to develop accounting concepts for Islamic Financial Institutions.

Question 5-2

Explain the functions of Islamic banks and how they differ from those of their conventional counterparts. How do these differences in functions lead to a need to develop different Islamic accounting concepts?

Question 5-3

Define Equity of Unrestricted Investment Account Holders and explain the difference in accounting presentation in the financial statements of the Islamic bank between these and equity of Restricted Investment Account Holders. What is the reason given for their different treatments. Question 5-4

How does the definition of Owner’s Equity of Islamic Banks differ from owners’ equity in a conventional bank? Differentiate between Gains and Revenue; and Expenses and Losses. Are returns on unrestricted investment accounts considered expenses of the Islamic Bank. Why or why not?



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Question 5-5

Where in the balance sheet of the Islamic bank do the equity of Restricted Investments and their equivalent appear?

Question 5-6 Explain the application of (i) the accounting unit concept (ii) the going concern concept (iii) the periodicity concept (iv) the stability of the monetary unit concept as applicable to the Islamic banks from a shari’a point of view.

Question 5-7

AAOIFI states that one of the conventional accounting concepts that is not shari’a compliant are measurement attribute (of historical cost). It suggests the use of cash equivalent value for many elements of the financial statements (i) (ii) (iii)

Define what is cash equivalent value (cev) What is the importance of using the cev? What elements should use cev as the basis of measurement.?

Question 5-8

(i)

Define relevance. Explain the three qualities that information must have to make it relevant?


Chapter 5:Financial accounting Concepts for Islamic Institutions (ii) (iii)

151

Discuss the two considerations for timeliness of accounting information. Give the Islamic basis of neutrality and understandability.

Question 5-9

In preparing and presenting of accounting information, Islamic banks should consider the issues of materiality, cost of information and adequate disclosure. (i) (ii) (iii)

Explain the meaning of these terms. What are the qualitative and quantitative materiality considerations Describe the two aspects of adequate disclosure.

Question 5-10 CIPA Multiple Choice Questions

Q 5-10 (i)

(ii)

What is the difference between restricted and unrestricted investment accounts? a) Right to commingle funds. b) Right to share profits. c) Right to guarantee returns. d) Right to additional equity shares. Read the statement below and answer question 5-10 (ii)

• The earning process should be completed entitling the bank to the right to receive. • Obligation arises on the part of customer to remit fixed or determinable obligation • Amount received is known and if not collected is collectable with reasonable certainty. (ii)

What do the above statements reflect: a) Revenue recognition principles. b) Expenses recognition principles. c) Provision recognition principles. d) Debt recognition principles.



Question 5-10(iii) refers to the following statement. An asset is anything that is capable of generating positive cash flows or other economic benefits in the future either by itself or in combination with other assets which the financial institution has acquired the right to as a result of past transactions or events. Although the capacity of the financial institution to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control.

Q5-10(iii) Based on the above statement which of the following is true: a) The above statement reflects the definition of an asset in Islamic accounting. b) The above statement contradicts the definition of an asset in Islamic accounting. c) The above statement reflects the definition of forward sale contracts with an underlying asset in Islamic accounting. d) The above statement contradicts the definition of forward sale contracts with an underlying asset in Islamic accounting.

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Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 152 Institutions

‫ﻞ ﺗﻜﺘﻤﻮ ﻟﺤﻖ ﻧﺘﻢ ﺗﻌﻠﻤﻮ‬ ‫ﻻ ﺗﻠﺒﺴﻮ ﻟﺤﻖ ﺑﺎﻟﺒﺎﻃ‬ “And cover not Truth with falsehood, nor conceal the Truth when you know. Al Baqarah 2:42

Chapter

6

CHAPTER LEARNING OBJECTIVES: At the end of this chapter you will, insha Allah you will be able to: (i) (ii) (iii) (iv) (v) (vi) (vii)

(viii) (ix) (x)

6.1

Discuss the Quranic/philosophical basis adopted by FAS1 compared to suggestions in the literature. List the complete set of financial statements required by FAS 1 for Islamic Financial Institutions. Prepare, Read, and analyse the complete set of financial statements required by FAS1 Describe the general principles for the presentation of information Define the information that should be disclosed in the financial statements of Islamic banks Map (iv) and (v) to the objectives of financial accounting for Islamic Financial Institutions. Explain how the presentation and disclosure requirements as enunciated by FAS1 achieves the objectives of accounting and financial reports of Islamic financial Institutions. Compare MASB FRSi-1 with FAS1 and point out the strength and weakness of each. Compare FAS1 to IAS 30: Disclosures in the Financial Statements of Banks and Similar Financial Institutions. Discuss the deficiencies of FAS1 and suggest improvements to FAS1

Introduction

AAOIFI adopted Financial Accounting Standard 1 (or FAS1) on Jumada 1 1414H (October 1993). This standard deals with the “General presentation and Disclosure in the financial statements of Islamic Banks and Financial Institutions”. It lists the complete list of financial statements required to be published by Islamic Financial Institutions. It also establishes the general principles for the presentation of information ad defines certain information that should be disclosed. Other corresponding financial standards include the Malaysian Accounting Standard



Board’s FRSi-1 and the IASB’s IAS 30: Disclosures in the Financial Statements of Banks and Similar Financial Institutions. This chapter will proceed as follows: In section 6.2 I will discuss the Quranic/philosophical basis of presentation and disclosure suggested in the literature. In section 6.3 I will map the FAS1 Financial Statements to its underlying philosophy. This will help us to understand the rationale of FAS1 and to its contents. This is followed by an illustration of an actual Islamic Bank’s Financial Statements which follow AAOIFI standards from Bahrain,. Students should study these statements carefully in conjunction with a study of the requirements of the FAS 1. This will help them to visualize the Islamic banks objectives, operations and accounting. In section 6.4 I will discuss the other disclosure requirements. In section 6.5, will make a brief comparison between FAS1 and FRSi-1 , the equivalent Malaysian standard. This is followed by an illustration of an Islamic Bank which follows Malaysia’s FRSi-1 (and the Malaysian Central Bank’s (BNM) guidelines). In section 6.6 IAS 30 is discussed in relation to Islamic banking and is followed by an illustration of a conventional bank which follows IAS 30.

6.2 The Quranic/philosophical basis of presentation and disclosure Telling the truth is a cardinal principle in all religions. Islam is no exception. The Qur’an warns: 2 :42 :‫ﺗﻌﻠﻤﻮ‬

‫ﻞ ﺗﻜﺘﻤﻮ ﻟﺤﻖ ﻧﺘﻢ‬ ‫ﻻ ﺗﻠﺒﺴﻮ ﻟﺤﻖ ﺑﺎﻟﺒﺎﻃ‬

“And cover not Truth with falsehood, nor conceal the Truth when you know. 1 6 : 9 0)

‫ﻹِﺣﺲ‬

‫ﱠ ﻟﻠﻪ ﻳﺄﻣﺮ ﺑﺎﻟﻌﺪ‬

“BEHOLD, God enjoins justice, and the doing of good, and generosity towards

[one's] fellow-men”. Hence , we can see from the above two verses, that truth and fairness (justice) and generosity (equity) is a commandment of the Qur’an. This is in line with the true and fair view reporting which the financial statements should provide. One of the difficult things, customers and investors face when dealing with businesses is information asymmetry, where one party has more advantageous information than the other. From an Islamic perspective, information asymmetry is to be avoided and it is a sin to withhold material information from other parties to a business transaction (including providing information). This is clearly spelt out in a hadith of the Prophet (pbuh) where it is related that one day, as He was



walking by the market, he noticed a man selling a pile of dates which appeared to all of very good quality at the top of the pile. The Prophet (pbuh) dug his hands into the pile and brought up a handful of wet (spoilt )dates from the bottom of the pile and asked the trader for an explanation… . The Prophet (pbuh) also prohibited a kind of sale in which a trader goes outside the city to catch hold of an incoming trader who is unaware of the price of their product in the market of the city, to buy off his goods at a lower price which amounts to defrauding the incoming trader. The Qur’an warns both the preparer and user about proper information. On the preparer’s part, he should not hide important facts and truthfully disclose all necessary information for the user to make his decision. The preparer of the accounting information will have to recognise, measure using a fair valuation unit and present and disclose truthfully. Thus:

Give full measure when ye measure, and weigh with a balance that is straight: that is better and fairer in the final determination. Q17:35 On the other hand, the user will have to be careful to ensue he is relying on verifiable, truthful information. This is stated in the following verses:

And pursue not that of which thou hast no knowledge; for every act of hearing, or of seeing or of (feeling in) the heart will be enquired into (on the Day of Reckoning). Q,17:36 and



O ye who believe! If a wicked person comes to you with any news, ascertain the truth, lest ye harm people unwittingly, and afterwards become full of repentance for what ye have done. Q 49:6 The user should verify the information (perhaps through an audit) before acting on the information and if he acts on the information which he is not sure, he has to bear the consequences of his bad decision. For example, it may infringe on someone else’s rights. Accounting and Financial Reporting is one of the most important tools to lower information asymmetry. Hence, the need to recognize, mesure, present and disclose in the proper way all economic events and transactions, undertaken by the entity including negative news. It is thus important to classiy, order and summarize the various elements in he financial statements to make them understandable and to provide full or adequate disclosure.

6.3 Mapping the FAS1 Financial Statements to their underlying philosophy and the detailed disclosure requirements in the financial statements required per FAS1. FAS 1 requires the four normal financial statements (i.e. the balance sheet, income statement, cash flow statement, statement of changes in owners’ equity) and three specific and unique new financial statements (Statement of Changes in Restricted Investments, Statements of Source and Application of Zakat and Charity Fund, Statement of Sources and Uses of Qard Funds) , notes to the accounts and “any statements, reports and other data which assist in providing information required by users of financial statement as specified in the statement of objectives”. The last statement(s) is a reference to persuade IFI’s to disclose, voluntarily perhaps, social, environmental and employee information mentioned in SFA 1.


Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 156 Institutions AAOIFI’s Recommended Set of Financial Statements

Similar to conventional to Financial Statements

Unique to Islamic Financial Institutions Notes to the Accounts

Statement of Financial Position (Balance Sheet)

Income Statement (Profit and Loss Account)

Statement of Changes In Restricted Investments

Statement of Changes in Retained Earnings

Cash Flow Statement

Any Other Useful Statements

Statement of Sources and Uses of Funds in the Zakah and Charity Fund.

Statement of Sources and Uses of Funds in the Qard


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The above recommended statements are in line with SFA1 Objectives of Financial Accounting of Islamic Financial Institutions. These can be seen from the following table where the statements are mapped to the uses (objectives) users and information required and the corresponding Balance Sheet. Objectives (Uses) To determine the rights and obligations

of

all

interested

parties, including those rights

Information Required The date of the balance sheet Assets, liabilities, equity of unrestricted investment account holders and their equivalent, and its owners’ equity.

and obligations resulting from

Assets should not be set-off against liabilities(1) and liabilities should not be set-off against assets unless other events, in accordance with there is a religious or legal right and an actual the principles of Islamic Shari’a expectation of set-off. incomplete

transactions

and

and its concepts of fairness, charity and compliance with Islamic business values.

Significant items of assets, liabilities, unrestricted investment accounts and their equivalent or owner’s equity should not be combined on the face of the statement of financial position without disclosure.

To contribute to the safeguarding of the Islamic bank’s assets, its rights and the rights of others in 1

( )

The amount of any allowance established to cover expected losses should be disclosed.

Accounting provisions are not considered as liabilities.

Financial Statements Balance Sheet

User Owners, Depositors, Customers, Authority, Employees

Zakat



Objectives (Uses) an adequate manner. To provide, through financial reports, useful information to users of these reports, to enable them

to

make

legitimate

decisions in their dealings with Islamic banks.

Information Financial Required Statements Assets and liabilities should be combined into groupings in accordance with their nature and those groupings should be presented in the statement of financial position in the order of the relative liquidity of each group. The statement of financial position should present separate totals for assets, liabilities, unrestricted investment accounts and their equivalent, and owners’ equity. Assets and liabilities should not be classified between current and non-current. Disclosure should be made on the face of the statement of financial position or the notes to the financial statements of the following assets with separate disclosures of assets jointly financed by the Islamic bank and unrestricted investment account holders and those exclusively financed by the Islamic bank: (a) Cash and cash equivalent (b)Receivables: • Murabaha receivables • Salam receivables • Istisna’a receivables (c) Investment securities (refer to chp?? For details) (d) Mudaraba financing

User

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Objectives (Uses)

Information Required (e) Musharaka financing (f) Investments in other entities (refer to chp?? For details) (g) Inventories (including goods purchased for Murabaha customers prior to consummation of Murabaha agreement (h) Investment in real estate (refer to chp?? For details) (i) Assets acquired for leasing. (j) Other investments with disclosure of their types. (k) Fixed assets with disclosure of significant types and related accumulated depreciation. (l) Other assets with disclosure of significant types Disclosure should be made of the net realizable value of an asset if such value is less than the asset’s recorded amount. However, all expected losses should be recognized when reasonably measurable. Disclosure should be made of the historical cost of assets or the historical amounts of liabilities which are reflected in the statement of financial position at

Financial Statements

User

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Objectives (Uses)

There are

Information Financial Required Statements their estimated cash equivalent values, when the revaluation of assets and liabilities to their estimated cash equivalent value is utilized.

Disclosure should be made of changes during the period in the provision for doubtful accounts receivable as follows: (a) Provision charged to income statement during the period. (b) Receivables written-off during the period. (c) Receivables collected during the period which were previously written-off. (d) The balance of the provision for doubtful receivables as of the beginning and end of the period. unique features and

associated risks of each type of

Disclosure should be made in the statement of financial position or the notes to the financial For example: Wadi’a or Qard statements of the following liabilities: contract

hasan contracts guarantee safe custody of deposits. The IFI can decide on discretionary share of income (hibah) to be paid to depositors

(a) Current accounts, saving accounts and other accounts, with separate disclosure of each category of accounts. (b) (c) (d)

Deposits of other banks. Salam payables. Istisna’ payables.

User

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Objectives (Uses) Mudarabah deposits are profit sharing deposits where the profit

Information Required (e) Declared but undistributed profits. (f) Zakah and taxes payable. (g) Other accounts payable.

paid is based on a pre-agreed sharing ratio. Their risk profiles are different. This presentation of liabilities is useful to decision makers

due

to

distinguishing features.

their

Unrestricted investment accounts and their equivalent should be disclosed and presented in the statement of financial position as a separate item between liabilities and owner’s equity. A consolidated statement of financial position should disclose the minority interest and that interest should be shown on the statement as a separate item between unrestricted investment accounts and owner’s equity. Disclosure should be made in the statement of financial position, and/or the statement of retained earnings or the statement of changes in financial position, and/or notes to the financial statements, as appropriate, of the following: (a) Authorized, subscribed and paid-in capital. (b) Number of authorized ownership units (shares), number of issued ownership units, number of outstanding ownership units, par value per unit and premiums on issued units. (c) Legal reserve and discretionary reserves at


User

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Objectives (Uses)

To

contribute

Information Financial Required Statements the beginning and end of the period and changes therein during the period. (d) Retained earnings at the beginning and end of the period and amount of retained earnings resulting from the revaluation of assets and liabilities to their cash equivalent values, where applicable, and changes therein during the period including distribution to owners and transfers to or from reserves. (e) Other changes in owners’ equity during the period. (f) Any restrictions imposed on the distribution of retained earnings to owners.

to

The rights, conditions and obligations of each type of unrestricted investment account and its equivalent and other deposit accounts shown in the statement of position should be disclosed The period covered by the income statement should Income Statement the be disclosed.

enhancement of the managerial and productive capabilities of the

Investment revenues, expenses, gains and losses should be disclosed by type.

Islamic bank and encourage compliance with its established goals and policies and, above all,

The nature of material revenues, expenses, gains and losses from other activities should be disclosed.

User

Owners, Zakah Authority, Employees, Mudaraba Depositors, Tax authorities



Objectives (Uses)

Information Financial Required Statements compliance with Islamic Shari’a Where applicable, estimated gains and losses from the revaluation of assets and liabilities to their cash in all transactions and events. equivalent values should be disclosed including the general principles used by the Islamic bank in the revaluation of assets and liabilities. To the extent applicable, the following information should be disclosed in the income statement with separate disclosures of investment revenues, expenses, gains and losses jointly financed by the Islamic bank and unrestricted investment account holders and those exclusively financed by the Islamic bank: (a) (b) (c) (d) (f) (g) (h) (i) (j)

Revenues and gains from investments. Expenses and losses from investments. Income (loss) from investments. Share of unrestricted investment account holders in income (loss) from investments before the bank’s share as a Mudarib. The Islamic bank’s share in income (loss) The Islamic bank’s share in unrestricted The Islamic bank’s share in restricted investment The Islamic bank’s fixed fee as an investment agent Other revenues, expenses, gains, and

User

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Objectives (Uses)

Information to assist concerned party in determination of Zakah on Islamic bank’s funds and purpose for which it will disbursed.

Information Financial Required Statements losses. (k) General and administrative expenses. (l) Net income (loss) before Zakah and taxes. (m) Zakah and taxes (to be separately disclosed). (n) Net income (loss). the the the the be

The Zakah base should be disclosed whenever the Islamic bank is obligated to pay such Zakah on behalf of all owners

The minority interest (pertaining to companies whose financial statements are consolidated with those of the Islamic bank) in net income (loss) should be disclosed in the consolidated statement of income as a separate item before net income (loss). The period covered by the statement should be Cash in disclosed Statement

Information to assist estimating cash flows that might be realized from dealing with the Islamic bank, the timing of those flows and the risk associated with their realization. This information should be directed principally at assisting the user in evaluating the Islamic bank’s ability to generate income and to

User

The statement of cash flows should differentiate between cash flows from operations, cash flows from investing activities and cash flows from financing activities. In addition, the statement should disclose the main components of each category of cash flows. The statement of cash flows should disclose the net

Flow

Owners, Authority, Employees, Mudaraba Depositors,

Zakat


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Objectives (Uses)

Information Financial Required Statements convert it into cash flows and increase (decrease) in cash and cash equivalent the adequacy of those cash during the period and the balance of cash and cash flows for distributing profits to equivalent at the beginning and end of the period. equity and investment account holders. Information to assist in evaluating the Islamic bank’s discharge of its fiduciary responsibility to safeguard funds and to invest them at reasonable rates of return, and information about investment rates of returns on the bank’s investments and the rate of return accruing to equity and investment account holders Information to assist in evaluating the Islamic bank’s discharge of its fiduciary responsibility to safeguard funds and to invest them at reasonable rates of return, and information about investment rates of returns on the bank’s investments and the rate of return accruing to equity

User

Transactions and other transfers that do not require the payment of or do not result in the receipt of cash and cash equivalent should be disclosed, for example bonus shares or the acquisition of assets in exchange for shares in the equity of the Islamic bank. The Islamic bank’s policy with respect to the components of cash and cash equivalent used as a basis for the preparation of the statement of cash flows should be disclosed.

The period covered by the statement of changes in Statement of owners’ equity or the statement of retained earnings Retained Earnings should be disclosed. The statement of changes in owners’ equity should disclose the following: (a) Paid-in-capital, legal and discretionary reserves separately, and retained earnings as of the beginning of the period with separate disclosure of

Owners



Objectives (Uses)

Information Financial Required Statements the amount of estimated earnings resulting from the revaluation of assets and liabilities to their cash equivalent values, where applicable.

User

(b) Capital contribution by owners during the period. (c) Net income (loss) for the period. (d) Distributions to owners during the period. (e) Increase (decrease) in legal and discretionary reserves during the period. (f) Paid-in-capital, legal and other discretionary reserves and retained earnings as of the end of the period with separate disclosure of the estimated amount of retained earnings resulting from the revaluation of assets and liabilities to their cash equivalent values, where applicable. The statement of retained earnings should disclose the following: (a) Retained earnings at the beginning of the period with separate disclosure of the amount of estimated retained earnings resulting from the revaluation of assets and liabilities to their cash equivalent values, where applicable. (b) Net income (loss) for the period.

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Objectives (Uses)

Information Required


User

(c) Transfers to legal and discretionary reserves during the period. (d) Distribution to owners during the period. (e) Retained earnings at the end of the period with separate disclosure of the amount of estimated retained earnings resulting from the revaluation of assets and liabilities to their cash equivalent values, where applicable.

Adequate disclosure and avoid information asymmetry.

Disclosure of the currency used for accounting Notes to measurement Accounts (a) The financial statements should disclose the currency used for accounting measurement, if not otherwise evident from the contents of the financial statements. (b )The financial statements should disclose the accounting method used for translating foreign currency balances and transactions. Disclosure of significant accounting policies

the

All Stakeholders



Objectives (Uses)

Information Financial Required Statements The financial statements must contain a clear and precise description of the significant accounting policies used for the preparation and publication of the financial statements. This disclosure should include, as a minimum, the significant policies in the following circumstances: 1. The accounting policies that represent a choice among acceptable alternative accounting methods (e.g. the depreciation method used). 2. The accounting policies adopted by the management of the Islamic bank but which are not consistent with the concepts of financial accounting for Islamic banks, if any. 3. The accounting policies adopted by the management of the Islamic bank for revenue, gain and loss recognition. 4. The accounting policies adopted by the Islamic bank’s management for the recognition and determination of doubtful receivables and the polices of writing-off debts. 5.

The policies, bases and methods adopted

User

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Objectives (Uses)

Information Financial Required Statements by the bank’s management for the revaluation of assets, liabilities and restricted investments to their cash equivalent value, if applicable. 6. The use of historical cost as a basis of determining equity of owners of unrestricted investment accounts and their equivalent (or restricted investment accounts or their equivalent) if the revaluation of assets, liabilities, and reinvestments to their cash equivalent value, is not mandatory. 7. The accounting policies adopted by the Islamic bank’s management for the consolidation of the financial statements of subsidiaries, if any. Method of disclosing significant accounting policies Significant accounting policies should be disclosed in one note and should be shown as either the first or second note of the notes to the financial statements. Disclosure of unusual supervisory restrictions The financial statement should disclose any unusual supervisory restrictions imposed on the Islamic bank

User

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Objectives (Uses)

Information Financial Required Statements by any regulatory or supervisory agency after due consideration with respect to any regulations regarding the disclosure of such restrictions. A supervisory restriction should be considered unusual if it either restricts management’s ability to make decisions necessary to manage the bank, or if it prevents the bank from carrying out some of the activities it has been authorized to carry out by its charter.

Information about the Islamic bank’s compliance with the Islamic Shari’a and its objectives and to establish such compliance; and Information establishing the separation of prohibited earnings and expenditures, if any, which occurred, and of the manner in which these were disposed of.

Disclosure of earnings prohibited by Shari’a

or

expenditures

The financial statements should disclose the amount and nature of earnings that have been realized from sources or by means which are not permitted by Shari’a. Likewise, disclosures should be made of the amount and nature of expenditures for purposes not permitted by Shari’a. The Islamic bank should also disclose how it intends to dispose of the assets generated by the prohibited earnings or acquired through prohibited expenditures. Disclosures of concentrations of asset risks Disclosure

should

be

made

in

the

financial

User

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Objectives (Uses)

Information Financial Required Statements statements of the magnitude of assets invested or deposited in any of the following concentrations.

Social responsibility e.g for low cost housing, microfinancing, small and medium businesses, educational financing.

(a) An economic sector (e.g. the agriculture sector, the service sector, the manufacturing sector, the real estate sector, etc.); (b) A customer, including another bank or a financial institution without stating the customer’s name. (c)

Domestic geographical economic characteristics

area

with

unique

(d) Foreign Countries Disclosure of concentrations of sources of unrestricted investment account and their equivalent and other accounts Disclosure should be made in the financial statements of the magnitude of balances of all unrestricted investment accounts and their equivalent and other accounts by type in foreign countries. Disclosure of the distribution of unrestricted investment accounts and their equivalent and other

User

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Objectives (Uses)

Information Financial Required Statements accounts in accordance with their respective periods to maturity Disclosure should be made in the financial statements of the distribution of unrestricted investment accounts and their equivalent and other accounts, by type, in accordance with their respective periods to maturity, from the date of the Statement of Financial Position. The Islamic bank’s disclosure should differentiate between demand accounts and other accounts. With respect to nondemand accounts, the bank should use for the purpose of this disclosure, maturity periods designed to disclose liquidity requirements during the next period and liquidity requirements during the following periods. Maturity periods should be consistently used and changes in the maturity periods used by the bank should be disclosed. Disclosure of the distribution of assets in accordance with their respective periods to maturity or expected periods to cash conversion Disclosure should be made in the financial statements of the distribution of assets in accordance with their respective periods to maturity or expected periods to cash conversion from the

User

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Objectives (Uses)

Information Financial Required Statements date of the balance sheet. The Islamic bank’s disclosure should differentiate between cash and other assets. With respect to other assets, the Islamic bank should use, for the purpose of this disclosure, maturity or conversion periods designed to disclose expected sources of liquidity during the next period and the following periods from outstanding assets at the Statement of Financial Position date. Maturity or conversion periods should be used consistently and changes in the maturity or conversion periods should be disclosed. Disclosure of compensating balances Disclosure should be made in the financial statements of any amounts the Islamic bank is obligated to deposit with others as compensating balances. Disclosures of risk associated with assets and liabilities which are denominated in foreign currency Disclosure should be made in the financial statements of the net assets (net liabilities) by type of foreign currency, as of the Statement of Financial Position date, which are denominated in foreign currency.

User

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Objectives (Uses)

Information Required Disclosure should be made in the financial statements of contingencies existing as of the Statement of Financial Position date including those resulting from the issuance of letters of credit or guaranty, documentary credit and similar instruments. Disclosure of outstanding financial commitments as of the Statement of Financial Position date Disclosure should be made in the financial statements of the nature and amounts of outstanding significant financial commitments as of the Statement of Financial Position date which the Islamic bank cannot cancel without significant cost or penalty. Disclosure should be made in the financial statements of any event subsequent to the date of the Statement of Financial Position which might have a significant effect on the Islamic bank’s financial position or results of operations, including those events which may cause significant change in the bank’s activities or size, or which may restrict management’s ability to take action. Such disclosure should be made after due consideration to regulatory


User

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Objectives (Uses)

Information Required requirements imposed by the supervisory agencies.


User

Disclosure of restricted assets or assets pledged as security Disclosure should be made in the financial statements of the nature and amounts of any assets which are restricted for a particular use or used as a collateral for the Islamic bank’s obligations. Disclosure of accounting changes Disclosure should be made in the financial statements of the nature and effects of the following accounting changes: (a)

Change in an accounting policy Disclosure of a change in an accounting policy should include the following: 1. Description of the change and its justification. 2. The effect of the change on net income for the current period and prior periods presented for comparative purposes and on retained earnings as of the beginning of the first period presented for comparative purposes (b)

Change

in

a

non-routine

accounting

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Objectives (Uses)

Information Financial User Required Statements estimate) Disclosure of a change in a non-routine accounting estimate should include the following: 1. Description of the change and the reasons thereof. 2. The effect of the change on net income or profits (losses) from restricted investments for the current period. (c) Correction of an error in prior period financial statements Disclosure of a correction of an error should include the following: 1. 2.

Nature of the error and the prior period(s) affected by the error. The effect of the error correction on net income or profits (losses) from restricted investments for the period(s) affected by the error and the current period.

Disclosure of the method used by the Islamic bank to allocate investment profits (losses) between unrestricted investment account holders or their equivalent and the Islamic bank as a Mudarib or as an investment manager whether or not participating



Objectives (Uses)

Information Required in the investments with its own funds


User

Disclosure should be made in the financial statements of the method(s) used by the Islamic bank to determine the share of unrestricted investments in the profits (losses) of the period. Disclosure should also be made of the returns of each type of investment accounts and their rate of return. Disclosure of related party transactions Definition of related parties Related parties mean the following: (a) Members of the Islamic bank’s board of directors, its external auditors, Shari’a adviser or members of its Shari’a Board, its general manager and his deputies and equivalent. (b) Relatives of those mentioned in (a) above to the second degree there is vested interest between the two parties. (c) Any natural person or entity which directly or indirectly owns a percentage (to be determined by the Islamic bank) of the banks voting ownership units and relatives of the natural person to the second degree. Changes in the percentage used by the Islamic bank should be disclosed.

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Objectives (Uses)

Information Financial Required Statements (d) Any entity in which any person in (a), (b) or (c) above either directly or indirectly owns the percentage referred to in (c) above of its voting ownership units or is a member of its board of directors. (e) Subsidiaries and other affiliates of the Islamic bank. An entity is considered an affiliate of another if they are controlled by an entity that owns not less than 51 percent of the shares of each entity. (f) Any entity in which the Islamic bank directly or indirectly owns a sufficient percentage of its voting ownership units to enable the bank to influence its operations. (para 28) Contents of transactions

the

disclosure

of

related

User

party

Disclosure of related party transactions should include the following:(2) (a) The nature of the relationship between the bank and the related party. (b) The nature and amount(s) of the transaction(s) consummated with the related party during the period.

2

()

In case of executive managers, disclosure should be limited to amounts in excess of the maximum limits, if any, established by law or regulatory authorities for transactions between the bank and its executive managers.


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Objectives (Uses)

Information to assist in evaluating the Islamic bank’s discharge of its fiduciary responsibility to safeguard funds and to invest them at reasonable rates of return, and information about investment rates of returns on the bank’s investments and the rate of return accruing to investment account holders.

Information Financial Required Statements (c)Balances due from or due to the related party as of the statement of financial position date. Statement The period covered by the statement of changes in Changes restricted investments should be disclosed. Restricted The statement should segregate restricted Investments investments by source of financing (e.g. those financed by restricted investment accounts, investment units in restricted investment portfolios.) In addition, the statement should segregate investment portfolios by type. The statement of changes in restricted investments should disclose the following: (a) The balance of restricted investments at the beginning of the period with separate disclosure of the portion of the balance resulting from the revaluation of restricted investments to their cash equivalent values, where applicable. (b) The number of investment units in each of the investment portfolios and the value per unit at the beginning of the period. (c) Deposits received or investment units issued by the Islamic bank during the period. (d) Withdrawals or repurchase of investment units during the period. (e) The Islamic bank’s share in investment

User

of in

Owners



Objectives (Uses)

Information Financial Required Statements profits as a Mudarib or its fixed fee as an investment agent. (f) Allocated overhead expenses, if any, from the Islamic bank to restricted investment accounts or portfolios. (g) Restricted Investment profits (losses) during the period with separate disclosure of the amount resulting from the revaluation of restricted investments to their cash equivalent values, where applicable. (h) The balance of restricted investments at the end of the period with separate disclosure of the portion of the balance resulting from the revaluation of restricted investments to their cash equivalent values, where applicable. (i) Number of investment units in each of the investment portfolios at the end of the period and the value per unit. (para 63) Notes to the statement of changes in restricted investments should disclose the following: (a) The nature of the relationship between the Islamic bank and owners of restricted investments either as a Mudarib or investment agent. (b) The rights and obligations associated with each type of restricted investment account or investment unit.

User

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Objectives (Uses)

Information Required


Information to assist the concerned party in the determination of Zakah on the Islamic bank’s funds and the purpose for which it will be disbursed. Information about the Islamic bank’s discharge of its social responsibilities

The period covered by the statement of sources and Statement of uses of funds in the Zakah and charity fund should Source and be disclosed Applicaton of Zakat and Charity Funds Disclosure should be made of the Islamic bank’s responsibility for the payment of Zakah and whether the bank collects and pays Zakah on behalf of owners of unrestricted investment account holders.

User

Zakat agencies, Government charity regulator, NGO watchdogs

Other sources of funds in the Zakah and charity fund should be disclosed. Disclosure should be made of the funds paid by the Islamic bank from the Zakah and charity fund during the period and of funds available in the fund at the end of the period. (para 68) Information about the Islamic bank’s discharge of its social responsibilities

The period covered by the statement of sources and uses of funds in the Qard fund should be disclosed. The balances of Qard outstanding and funds available in the fund at the beginning of the period should be disclosed by type. The amounts and sources of funds contributed to the fund during the period should be disclosed by source.

Statement of Source and Applicaton of Qard Funds

Government charity regulator, NGO watchdogs


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Objectives (Uses)

Information about the Islamic bank’s compliance with the Islamic Shari’a and its objectives and to establish such compliance; and Information establishing the separation of prohibited earnings and expenditures, if any, which occurred, and of the manner in which these were disposed of.

Information Financial Required Statements The amounts and uses of funds during the period should be disclosed by type. The balances of Qard outstanding and funds available in the fund at the end of the period should be disclosed. Others

User

All stakeholders especially employees, envionmentalists, social workers, shari’a scholars.



Fig 6.3(a) Balance Sheet of Shamil Islamic Bank, Bahrain (follows AAOIFI standards)



Fig 6.3(b) Income Statement of Shamil Islamic Bank, Bahrain (AAOIFI standards)



Fig 6.3 (c) Statement of Changes of Owners’ Equity, Shamil Bank (AAOIFI)



Fig 6.3(d) Statement of Cash Flows of Shamil Bank (AAOIFI)



Fig 6.2(e) Statement of Changes in Restricted Investment Accounts Funds of Shamil Bank (AAOIFI)


Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 188 Institutions It can be summed up that on the whole, FAS1 is in line with SFA1’s objectives. However there are some glaring exceptions. SFA1, if you remember from chapter 4, also state that the following reports will also meet the relevant objectives. (i) (ii) (iiI)

Analytical financial reports about earnings or expenditures prohibited by the Shari’a Reports concerning the Islamic bank’s fulfillment of its social responsibilities Reports about the development of the Islamic bank’s human resources.

FAS 1 requires disclosure about prohibited earnings and expenditures in the notes to the accounts, not as a separate statement. The reason given, being psychological effect on users. In my opinion, unless the amounts are not substantial , they should be presented in a separate statement together with the sharia supervisory boards and directors comments regarding the progress made in eliminating them. Otherwise, both users and preparers may become complacent regarding this Further, the social responsibility and human resources reports are not required but perhaps left to the discretion of the bank under item 2/1(i) [para 2] of FAS 1 i.e. “Any statements, reports and other data which assist in providing information required by users of financial statements as specified in Statement of Objectives”. While, this is understandable as the Islamic financial services was in its infancy in 1993 when the standard was promulgated, almost 15 years has passed. To metamorphosise IFIs to more ethical and social institutions and to be in line with sustainability , green and social reporting , it is time for AAOIFI to come out with specific standards on (I) (II) (III) (IV) (V) (VI)

employee reporting environmental reporting prohibited earnings and disposal in line with sharia standard social responsibility reporting Waqf standard and separate charity fund from zakah funds. Encourage Islamic banks to set a side a percentage of their profits for charity by charter.

6.4 Other disclosure requirements. (i)

(ii) (iii) (iv)

Comparative financial statements at least of the comparable prior period. There must be adequate disclosure to enable user to distinguish actual changes and the accounting changes between the two periods. All amounts in the financial statements and notes should be rounded up to the nearest monetary unit. The form of and the classification used in the financial statements should ensure a clear presentation of their content. Assets and Liabilities should not be classified as current and non-current. Pages containing the financial statements and the related notes should be numbered consecutively. Notes to the financial statements should be given



(v)

(vi)

(vii)

clear and distinct titles and should be cross referenced to the related items in the financial statements. A warning to the reader that the notes to the accounts form an integral part of the financial statements need to be placed on every page of the financial statements, and the notes should be placed immediately after the page containing the last financial statement. The financial statements should disclose all material information that is necessary to make those financial statements adequate, relevant and reliable for their users. Basic Information about the islamic banks : (a) The name of the Islamic bank. (b) The country of incorporation. (c) Formation date and legal form. (d) Location of headquarters and number of branches in each country where the bank operates. (e) The nature of the activities the bank is authorized to carry out by its charter and the major banking services it provides. (f) The names of the bank’s subsidiaries whose financial statements are consolidated with those of the bank, the countries of their incorporation, the bank’s ownership percentage in each subsidiary and the nature of their activities. (g) The names of the bank’s subsidiaries whose financial statements are not consolidated with those of the bank’s, the countries of their incorporation, the bank’s ownership percentage in each subsidiary, the nature of their activities, and the reasons for excluding their financial statements from the consolidated financial statements of the bank. (h) The name of the holding company and the names of other affiliates. An entity is considered an affiliate of another if they are controlled by an entity that owns not less than 51 percent of the shares of each entity. (i) The role of the Shari’a adviser or the Shari’a board in supervising the bank’s activities and the nature of the adviser’s or board’s authority in accordance with the bank’s by-laws and in actual practice. (j) The agency responsible for supervising the bank’s activities and the agency responsible for supervising the .holding company (k) The bank’s responsibility towards Zakah. (l) The tax treatment in the country of incorporation and in other countries where the bank has operating branches. If the bank enjoys a tax holiday in the country of incorporation and in other countries, the period of the tax holiday and the remaining period thereof.


Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 190 Institutions 6.5 Comparison between FAS1 and FRSi-1 Islamic banking financial reporting practices in Malaysia are under the purview of the Bank Negara Malaysia (National Bank of Malaysia) which is the Central Bank, the Malaysian Companies Act 1965, applicable Malaysian Accounting Standards Board’s (MASB) accounting standards and International Accounting Standard (IAS). Initially, there was a lack of shari’a consistency as each bank relied on their own Shari’a’ advisors despite the supervision of BNM’s own Shari’a advisory council. The Malaysian Accounting Standards Board issued FRSi-1 (initially known as MASBi-1, Presentation of Financial statements of Islamic financial institutions effective 2003. This was the first Malaysian Islamic Accounting Standard issued by the MASB. At the time of issue, the Islamic Banking Industry in Malaysia was already twenty years old. The purpose this standard was issued was to due to the inability of IAS’s to address accounting issues related to the Islamic banking operations and their inadequacy to accommodate Shari’a precepts. While the MASB acknowledged in its introduction to FRSi-1, the contributions of AAOIFI, nevertheless, it felt that there was a need to have a standard to meet the specific needs of Islamic financial practices and the regulatory and economic structure in Malaysia. The fact of the matter is, the economy in Malaysia is controlled by Non-Muslims who form a significant proportion of the population. While, the government of Malaysia wanted to promote Islamic banking as a matter of religious conviction as well as political and economic expediency, it could not make the country a big player without the cooperation of non-Muslims, who of course do not need to care for shari’a precepts. Hence, while in the gulf region, the shari’a supervisory boards of Islamic banks were very strict, the Malaysian shari’a scholars were more flexible to a point of disagreement in certain basic contracts which were deemed unacceptable in Islam by the Middle East scholars. Products such as Bai Bithaman Ajil, Islamic private debt securities, bai al inah and other products and judicial concepts were frowned at by both Middle East scholars and some Malaysian academics. The Middle East scholars are catching up in their flexibility by approving premium bonds (Dubai) and tawarruq (akin to BBA) but a majority of them are still strict. The implication is some of the contracts were resembling loan contracts in substance and hence their accounting treatment by the IFI’s of Malaysia as loan advances. AAOIFI’s standards, however, are shari’a based (“the Middle East variety”) and requires to treat the form and substance of the transaction as one. Hence, the need for “Malaysian” Islamic Accounting Standards, to follow Malaysian industry practice. In its appendix A, to FRSi-1, MASB states that one of the aim of the standard was to “to bridge the gap or areas where the IAS’s and AAOIFI’s Islamic Accounting Standards have not been able to address. Hence, it would be interesting to compare the three relevant standards to know what “gaps have been bridged and what issues have been addressed The following table sets out the comparison.



GAPS BRIDGED AND ISSUES ADDRESSED Complete set of financial statements Voluntary statements

FAS 1 compared to FRSi-1 While FAS1 requires the four conventional and three unique financial statements, FRSi-1 only requires the four conventional financial statements. However, it encourages IFIs to produce outside its financial statements (i) (ii) (iii)

environmental report and value added statement zakat fund and qard fund (but no format is given a financial review by management describing and explaining the financial performance and position of the bank, mentioning principal uncertainties. This may contain:

a. Factors determining performance, including changes in the environment, its response to those changes, and investment policies aimed at maintaining and enhancing performance, including its dividend policy; b. Sources of funding, policy on gearing, and its risk management policies c. The IFI’s strengths and resources whose value is not reflected in the balance sheet. SFA1 does not name the additional reports required and even its required reports such as the Zakat Fund and Qard Fund are not produced by IFIs which are supposed to follow the AAOIFI standards. Further, AAOIFI should require the financial review as it is very useful to explain what happened to non- savy investors.

Cash vs Accrual basis for recognizing income from investments

Of course in Malaysia and other countries, the statement of changes in Zakat fund is inapplicable as Zakah is collected by government agencies and is prohibited for Banks’s to collect and distribute zakah Most Malaysian IFIs had been using cash basis of accounting for revenue from investments due to difference in shari’a rulings but more so because, it is



Allocation of Profit and Distribution to Depositors

difficult for the IFI to recover from the customer any amounts paid out, if later the actual income turns out to be less than accrued, especially if the depositor withdraws his investment before the final results become known. FRSi-1 requires the accrual method to be adopted unless the Sharia Advisory Council of the Central Banks allows the IFI to use cash basis but in this case, requires a reconciliation to reflect the financial position had accrual basis been used. Although FAS1 is silent on this, it can be assumed from SFA 2 on revenue recognition, the accrual method should be adopted (6/2/1 SFA2) to recognised revenue. This should not present a problem as the bank can only recognised revenue if there is an obligation on the part of another party to remit a fixed or determinable amount to the bank. FRSi-1 requires the disclosure of the profit distribution policy. It specifically states that when “An IFI commingles various types of deposits into a single pool of funds shall disclose the method of allocation of income among various categories of deposits.” It further states that the distribution of profits should be at the gross level after deducting only expenses that are directly to the investment of those funds. Hence, indirect expenses of the bank such as salaries, wages and bonuses of employees, rental will not be deducted by the bank unless they are clearly attributable to the investment. FRSi-1 also states the normal methods used in allocation and distributing profits between the various class of depositors and owners. Thus, Islamic banks “allocates income by using a weighted average method balances and allocates a total income to various categories of depositors Distributes profit derived from investment of depositors funds based on a pre-determined ratio in the case of Mudarabah deposits, and on a ratio determined at the discretion of the IFI’s in the case of Wadiah and other non-Mudarfabah deposits In case of specific (restricted) investment accounts, it requires the separate disclosure of profits or losses and prohibits their offset with other types of IFI’s profit or loss. Investment. FAS1 requires disclosure of the method used to allocate investment profits (losses) between the unrestricted investment account holders or their equivalent. However, FAS 5: Disclosure of profit allocation method, requires the disclosure of the basis


Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 193 Institutions of profit allocation, and investment allocation. As this is an important shari’a issue dealing with fairness, AAOIFI should come up with a separate standard on recognition of profit allocation. AAOIFI presumes that restricted investment accounts are not commingled with the bank’s or other depositors funds. This may not be true. Further, current and savings account holders should in all fairness be given Hibah (although this is not contractual, it is recommended). Hence, we can say FRSi-1 recommendation on disclosure is better that FAS1. Going Concern basis

Prohibited earnings expenditures

FRSi-1, specifically states that the accounts should be prepared under the going concern concept after management has reviewed the going concern status of the bank. Material uncertainties need to be disclosed when this come up during the management review. FAS1 is silent on this, however this is assumed from SFA2..

and

While FAS 1 makes it mandatory to disclose shari’a prohibited earnings and expenses and the methods used to dispose of these, FRSi-1, makes it voluntary. AAOIFI has to be congratulated to sticking to its principles on this one, as declared in the appendix to FAS1,it was under pressure not to make this mandatory from feedback on its exposure draft but decided this was against SFA1, the objectives.

As a summary, I do not see many gaps and issues not addressed by FAS1 being addressed by FRSi-1, except in highlighting the voluntary reports and the different contracts practised (al-wadi’a) in Malaysia. Also, making disclosure of prohibited expenses and revenues voluntary is not helpful. Perhaps, the SSB would make it compulsory but because of independence issues, I doubt they will. However, MASB is to be congratulated to require disclosure of profit allocation and distribution methods. In my estimation, I think it would have been better for MASB to have adopted FAS1 with a note of the changes required just as it adopts IFRS’s and IAS’s.

.


Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 194 Institutions Below is given the Financial Statements for 2006 of Bank Muamalat Malaysia Bhd. which follows FRSi-1:







This statement should actually be for the year ended 31st December 2005. There is a typo in the Financial Statement.





























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From a review of the Bank Muamalat Financial Statements above, it can seen that it is quite comprehensive. (not all the notes have been reproduced). However, non of the voluntary social/environmental reports are produced. Further, I have not found any notes disclosing the basis of profit allocation and distribution between the various depositors and owners’ equity although the amounts are given.

6.6 Comparison between FAS 1 and IAS 30: Disclosures in the financial statements of Banks and Similar Financial Institutions. This was issued by the IASB became effective in 1st January 1991. It was one of the few industry specific standards to be issued by the IASB other than IAS 11 Construction Contracts, IAS 41 Agriculture,, IAS 40 Investment Properties and IFRS 4, Insurance Contracts. The standard was developed in view of the importance of the banking industry for an economy and the specificity of the business in which much more than shareholders’ funds are at risk if not properly managed, controlled and accounted for. IAS 30 does not say anything on the full set of financial statements, in fact it gives guidance only on the income statement and balance sheet, it is presumed that the bank will present a cash flow statement and statement of retained earnings as required under IAS 1. IAS 30 says nothing of Islamic banks. Perhaps, in 1991, the Islamic banking industry was still nascent and thus not important in the eyes of the IASB. It however, defines banks as “all financial institutions, one of whose principal activities is to take deposits and borrow with the objective of lending and investing and which are within the scope of banking or similar legislation.” It also states that even if an entity does not have the word bank in its name, it would be covered by the standard. It is thus reasonable to assume that all Islamic Financial Institutions are covered by IAS30 as Islamic Financial Institutions take deposits and invest funds. However, it should be noted IAS30 is a disclosure standard, not a recognition standard. It covers the format and elements in the balance sheet and income statement, contingencies and commitments including off balance sheet items, maturities of assets and liabilities as well as concentrations of assets, liabilities and off balance sheet items. The latter three are important facets of a bank’s business and their disclosure is important to gauge the liquidity, solvency and risk profile of a bank. In addition, the standard covers losses on loans and advances, general banking risks, assets pledged as securities, trust activities and related party transactions. In general, I would say, IFI’s by following AAOIFI’s FAS1, would meet the requirements of IAS30 except perhaps in disclosure of trust activities, valuation of financial instruments (IAS 32 and 39) and IAS 17 on leases. The following illustrations of the United Overseas Bank Singapore gives an example of the financial statements (only the balance sheet and profit and loss accounts i.e. income


Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 214 Institutions statement is reproduced together with some notes) conventional bank following IAS30 and IFRS. Note the differences in income and balance sheet items.













Question 6-1

In harmonising the practices of Islamic financial institutions from different countries, the Accounting and Auditing Organisation of Islamic Financial Institutions have developed the Financial Accounting Standards. Financial Accounting standard No 1 addresses the General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions.

Required : Explain the rationale and need for FAS No 1 b.

The following information is extracted from the accounting records of an Islamic Financial Institution. Prepare an extract of income statement and the disclosure required in accordance to FAS 1.

$ ‘000 Murabaha financing Income

$ ‘000 10,000

Mudharaba Financing Income Revenue from banking Services Bank’s Investment income Income from Restricted Investment

20,000 5,500 (5,000) 3,500

Operational expenses Administrative expenses Distribution to unrestricted investment account holders

Additional Notes : 90% is from commingled funds including investment deposit 50% is from equity funds only 100% from equity funds

12,000 4,000 4,550

(IIUM B.Acc, semester 2, 1998/1999, Q1) Question 6-2



The following is the trial balance for Manama Islamic Bank for the year ended on 31st December 2007 :

Cash and cash equivalents Short term securities Murabaha receivable (net) Investment in Ijarah Other assets Fixed assets Equity of unrestricted investment account holders Current and saving accounts Other liabilities Minority interest Paid-up capital Reserves

$’000 180,000 91,000 360,000 404,000 52,000 13,000 600,000 70,000 50,000 20,000 335,000 25,000

Additional Information : 1.

Equity of unrestricted investment account holders balance of $600,000 has

been used to finance the following earning assets (net of provisions) :

Short term securities Murabaha receivables Investment in Ijarah

$’000 50,000 300,000 250,000

2.

Murabaha receivables balance before provisions is $402,000 of which $335,000 relates to equity of unrestricted investment account holders as at 31st December 2007

3.

Reserves balance includes legal, general reserves and retaining earnings.

Required :


Chapter 6: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial 222 Institutions Prepare the Statement of Financial position for Manama Islamic Bank as at 31st December 2007 in accordance with the provisions of FAS 1 Prepare a note to disclose the details of the Murabaha receivables account to be inserted in the Notes to Financial Statements in accordance to provisions of FAS 1 FAS 1 prescribed a long list disclosure requirements, in the notes to the financial statements, most of them are also required by International Accounting Standards (IAS). However, a few disclosure requirements are unique and do only apply in the case of Islamic Banking operations. Outline and explain three of these requirements.

Question 6-3

(a)

What are the requirements for a complete set of financial statements in accordance with the FAS 1: General Presentation and Disclosure in the Financial Statements of Islamic Financial Institutions

(b)

List any four disclosure requirements for each of the restricted and unrestricted investment accounts as required in FAS 5 : Disclosure of Bases of Profit Allocation Between Owners’ Equity and Investment account Holders.



Question 6-4

(a)

Do you think it is sufficient to measure performance of Islamic banks on a purely financial basis? Why or why not?

(b)

AAOIFI has listed the functions of Islamic banks as:Investment management, financial services and social services. Based on these functions; Explain what performance measures would you use and what accounting statements do you think the Islamic banks should produce to disclose accountability of these functions. ( IIUM MBA, 2005/2006, Q3 )


Chapter 7. Accounting for Murabahah, Murabahato the Purchase Orderer and Bai Bithaman Ajil

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‫ َﻟ ْﺲَ ﻋَﻠ ﻜﻢ ﺟﻨﺎحٌ أن ﺗﺒﺘﻐﻮا ﻓﻀﻼً ﻣﻦ رﺑﻜﻢ‬.. “It is no crime for you to seek the bounty of your lord” (Al Baqarah 2:198)

‫واﺳﺘﺪل ﻋﻠ ﺎ ﺑﺎﻟﻘ ﺎس ﻋﻠﻰ اﻟﺘﻮﻟ ﺔ ﻓﻘﺪ اﺷﺘﺮى رﺳﻮل اﷲ )ص( اﻟﻨﺎﻗﺔ ﻣﻦ أﺑﻲ ﺑﻜﺮ‬ ..‫ﺒﺘ ﺎ ﻟ ﻗﺎل ﺑﻞ ﺑﺎﻟﺜﻤﻦ‬ª ‫ﻟﻠ ﺠﺮة ﺑﺎﻟﺘﻮﻟ ﺔ ﻷﻧ ﺣ ﻦ أراد أﺑﻮ ﺑﻜﺮ‬ “The Murabaha is also analogous to a form of sale called Tawliyyah (to sell as per the purchasing price without making profit. This is because the Prophet (BBUH) purchased a she-camel from Abubaker for use as transportation means to migrate to Medina. Abubaker had wanted to give it to the prophet free of charge but the prophet refused and said: I will preferably take it at the acquisition price”.

Chapter

7


At the end of this chapter you will, insha Allah you will be able to: i.

ii. iii. iv. v. vi.

Explain the meaning of and differences between murabaha, murabaha to the purchase orderer and bai bithaman ajil and how they are used by Islamic banks to finance customers List the principles of murabaha and mtpo financing as well as the rules Journalise accounting entries for murabaha and mtpo as well as BBA financing Prepare the balance sheet and income statement extracts for murabaha transactions Apply accounting treatment for penalties Account for deposts, refundable and non-refundable.



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7.1 Introduction If you are still with me after the previous two long (and perhaps boring) chapters, you will be well rewarded. This is the first chapter where we start making accounting entries (at last!). Murabaha or cost plus markup sale is the first of asset based financing contracts employed by Islamic banks. It is the most widely used financing instrument as it somehow resembles a loan contract. Other asset based financing contracts are salam and istisna. In contrast to these, we have contract based on services i.e ijarah, ijarah muntahia bi tamlik (or ijarah thumma al bai’ (the Malaysian version) and wakalah (agency contracts). In this chapter, we will first define murabaha, murabaha to the purchase orderer and bai bithaman ajil (sale with deferred price) , the contract used by Malaysian Islamic banks. We will then discuss the rules and principles of the contracts to understand what) accounting entries are needed. We will then learn the accounting entries on contract intiation, instalment receipts, revenue recognition, recognition and measurement of assets, and the accounting treatments for termination, deposits and penalties. I will illustrate with some examples and will finally leave you to do the problems in the chapter some of which have answers at the back of the book.

7.2 Definition of Murabaha and Murabaha to the purchase orderer. When a business wants to purchase an asset, they have four choices: (i) (ii)

(iii) (iv) (v)

pay cash – difficult if it is a big ticket item, say vehicle, machinery or buildings get it on credit from the vendor, possibly through interest free credit card; you can forget about getting interest free credit from a car dealer or housing developer. Get a loan to buy the asset either from a conventional financial institution. Get an Islamic financing from an IFI. Defer or forget about the intended purchase.

In a conventional financing, the buyer usually pays a deposit to the vendor and the remaining amount is financed through a loan or hire purchase or leasing, the substance of which is he pays in installments, include interest for the time, he uses the bank’s money. If he goes to an Islamic Financial Institution, he has various financing options; murabaha, musharaka mutanaqissa, ijarah muntahi bitamlik and others (if the goods



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are not available, salam and istisna can be used). We will learn murabaha in this chapter and the rest later, inshaAllah. Definition of Murabaha and Murabaha to the Purchase Orderer. There are two types of Murabaha viz. Murabaha and Murabaha to the Puchase Orderer. We also have the controversial Malaysian Bai Bithaman Ajil. In Islam, a sale (sarf) can take place in the following ways: (i) (ii)

(iii)

on the spot exchange, where the buyer gets the goods and pays the price to the seller on the spot. Sale for deferred payment (bai al muajjal), where the seller sells the goods but the pays the agreed price at a future date in a full lump sum or in installments over a period. The buyer pays in advance for an agreed kind, quality, quantify of goods and the seller either makes it to order (istisna) or buys or produces it (salam) and delivers it to the buyer at a later agreed date.

Murabaha comes under (ii), and in its original practice, not necessarily a credit sale. FAS2 defines murabaha as follows:



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A Murabaha is defined by Fuqaha (jurists) as the sale of goods at cost plus an agreed profit mark up (1). Its characteristic is that “the seller should inform the purchaser of the price at which he purchased the product and stipulate an amount of profit in addition to this”(1). The Murabaha conditions include the following: a. The Islamic bank should make the cost or capital outlay known to the client. b. The first contract should be valid. c. The contract should be free of usury. d. The Islamic bank should disclose any fault which occurs after the purchase and should disclose all what is related to the fault. e. The Islamic bank should disclose the terms applicable to the purchase price, for example if the purchase was on credit. f. If any of the conditions in (a), (d) or (e) is not met, the purchaser shall have the option to: 1. proceed with the sale as it is; 2. have recourse to the seller for the discrepancy; or 3. cancel the contract. It is worth noting that a Murabaha sale in the above context means the selling of a product owned by the seller at the time of negotiation and contracting. (FAS 2, appendix B) It is also worth noting, that murabaha is not necessarily a sale on credit or deferred basis but to avail the experience of an expert buying agent. However, as practiced by Islamic banks, it is invariably due the need for credit that it is practiced. Under fiqh rules, the price for a murabaha sale need not be paid on spot, It can be deferred either to one lump sum in the future or paid in a series of installments. As a mode of Islamic financing product, we can redefine murabaha as a sale in which the Islamic bank informs the customer of its own cost and the profit it is taking on the



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transaction and where the sale price is paid in installments over an agreed period of time. We can depict the murabaha transaction as follows:

ISLAMIC BANK

VENDOR

(3) CUSTOMER

(1)

(2) Fig 7.1: Murabaha transaction

(1) The banks buys the goods for murabaha sale from the vendor and pays for it. (2) The Bank enters into a murabaha contract with a customer and delivers the good. (3) The customers pays the bank in installments over the contract period.

Some Islamic banks such as the Kuwait Finance House practices this model, in the case of motor car financing. The bank has warehouses, where it keeps its cars which it has bought from manufacturers or dealers. The customer wanting to purchase a car with financing goes to the warehouse and selects a car, informs the bank and signs the murabaha contract. He drives off with the car and pays for it later in installments. However, most Islamic banks do not want to do this, as it involves trading and it is risky in the sense that the bank is an owner of the bought goods (and this is reflected in the balance sheet as inventory) and is thus liable for risk of loss, damage and decline in value until the time it manages to sell it to a customer.

Hence, in most Purchase Orderer. is Muracases, bahaIslamic to theBanks purchuse ase“Murabaha orderer to is the a sale in which twoThis parties or defined as more follows:negotiate and promise each other to execute an agreement

according to which the orderer asks the purchaser to purchase an asset of which the latter will take legal possession. The orderer promises the purchaser to purchase the asset from him and give the ordered a profit thereon. The two parties would conclude a sale after the possession of the ordered to the asset (1). However, the purchase orderer may or may not be obliged to conclude the sale. (FAS 2 Appendix B1/2/1)



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We can depict the “Murabaha to the purchase orderer” as follows:

The Murabaha to the Purchase Orderer transaction can be depicted as follows:

(1) (2) VENDOR

ISLAMIC BANK

(3)

CUSTOMER

(4)

Fig 7.2: Murabaha to the Purchase orderer transaction. (1) The customer orders the bank to purchase goods , which it promises (this may be binding or non binding) to buy from the bank giving it some profit. (2) The bank buys and pays for the goods from the vendor. (3) The banks executes a murabaha contract of sale to the customer and delivers the goods. (4) The customer pays for the goods on an installment basis to the bank.

7.3 Fiqh Rules, principles and complexities in Murabaha. Besides the principles mentioned in the definition box of murabaha, we should note the following: In a murabaha to the purchase orderer, the promise to buy of the customer (the purchase orderer) may be binding or non binding. This result from different shari’a opinions. One group of scholars view that the promise is non-binding because: (a)The bank cannot sell what it does not possess (at the time of making the promise) (b) The goods may be defective, deficient or unnecessary when delivered. However, this will present problems to the Islamic banks as it incurs cost to purchase the goods and as a financing institution would not want to be left with unsold inventory.



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In order to reduce the risk of the Islamic bank, the bank may require a deposit from the orderer (potential customer) to ensure his seriousness. Under the shari’a, there are two types of deposits which the bank can demand. One is known as Hamish jiddiyah and the other urboun, each with different characteristics. These two deposits are defined by FAS2 as follows:

Definitions Hamish jiddiyyah It is the amount paid by the purchase orderer upon request of the purchaser to make sure that the orderer is serious in his order of the asset. However, if the promise is binding and the purchase orderer declines to purchase the asset, the actual loss incurred to the purchaser shall be made good from this amount. Urboun It is the amount paid by the client (orderer) to the seller (i.e., the original purchaser) when the former purchases an asset from the seller. If the customer proceeds with the sale and takes the asset, then the urboun will be part of the price; otherwise, the urboun will be for the seller.

Hamish Jiddiyayah is problematic, because, in case of a non-binding promise, the bank will have to return the deposit in full to the potential customer, even if it subsequently incurs a loss in selling the goods, which the original orderer had refused to take delivery. In case, the promise is binding and the customer declines, the bank can deduct any losses and expenses it incurs on transaction from the deposit and return the excess. If the loss is greater than the deposit, the customer becomes liable for the balance. In case of urboun deposit, this is deducted from the purchase price if the customer proceeds with the sale. If not, the customer looses his deposit, even if the deposit is more than the loss incurred by the bank. In order to make it safer for Islamic banks, it should make the contract a binding promise and then require Hamish Jiddiyah or Urboun. However, this does not solve the problem of credit risk i.e. payment default by customer. To mitigate this, the bank



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may request for a guarantee from the customer. The goods sold under murabaha can be collateral for the debt. In this case, however, the customer cannot sell the goods until the debt is repaid to the bank. In the case of late payment and procrastination by the customer, the bank normally cannot levy any penalty as this would amount to interest. If the shari’a board agree on a penalty, then this penalty cannot be recognized as revenue but given away as charity. The Islamic bank can institute legal proceedings to recover the debt and financial damage caused by procrastination (e.g. legal fees, “lost opportunity”). Unless the goods sold are collateral, the goods cannot be taken by the Islamic bank to settle outstanding debt. If the indebted owner is insolvent and fails to settle the debt, the bank should defer collection until he becomes solvent. If the bank gets a discount on the purchase price, this will belong to the bank unless it was obtained at the time of making the promise to buy (by the customer) or before the Murabaha sale was concluded. The last rule to consider is early settlement of the debt or a lump sum payment before scheduled time. Since, the transaction is a sale, the bank is under no obligation to give a discount to the customer. However, due to competitive pressures, the Islamic banks do give a discount for early settlement. This is allowed under the shari’a and is called ‘ibra. The amount must be agreed between the bank and the customer at the time of settlement or before the lump sum payment is made. Bai bithamin ajil model has been discussed in chapter ?? and will not elaborated here. However, we will do an illustration of the accounting entries for the BBA later.

7.4 Recognition and Measurement and Journal Entries. The following diagram depicts the transaction flow and the recognition (recording) of the events in the accounts.



Refusal

Order

Purchase Financing

Deposit

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Gain/Loss on disposal/deposit refund

Installmenr repayment

Early payment/ default

Cash / cash equivalent

Rebate/ Write -off

Disbursement Receivable / collateral

Fig 7.3: Transaction flow and accounting event.

No. Transactions /Events 1 Purchase of Asset by Bank 2 Murabaha sale 3 Installment receipt Recognition of profit as each 4 installment s receved 5. Termination of contract 6 Rebate for early payment

DR Equipment Murabaha Financing (cost+profit) Cash Deferred profit

CR. Cash/Creditors Equipment at cost Deferred profit with profit Murabaha Financing Profit and Loss

A/c Receivable Deferred Profit

Murahaha Financing Murabaha Financing



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7.5 Measurement of Murabah financing Assets l Upon acquisition of Assets: Ø With obligation : Assets should be measured at lower of historical cost or impaired value. (not to over value- prudence & protect the purchaser) Ø Without Obligation: Assets should be measured at cash equivalent value. (reflect current value & protect the bank/ financier) Ø A provision should reflect any decline between the acquisition cost and cash equivalent value. l Price discount if obtained after acquisition should not be treated as revenue but to reduce the cost of the relevant goods unless agreed by SSB. l Upon financing the customer: Ø Murabaha receivables should be recorded (by the bank) at face value (cash equivalent value) less provision for doubtful debts

Income recognition of Murabaha financing assets l Profits are recognized at time of contracting for cash or credit transaction not exceeding the current financial period. l If credit period > one financial period with a single or several installment , the recognition methods are: • Accrual basis method • Cash basis method l Accrual basis method recognizes profit based on a proportionate allocation of profits whether cash is received or otherwise l Cash basis method recognizes profit as and when the installments are received and requires the approval of SSB 1. Principle of matching expenses with income is applied 2. Deferral profits (unearned) shall be offset against Murabaha receivables in ths statement of financial position 3. Settlement amount is based on outstanding financial amount (accrual basis)



7.6 Accounting Illustration of Murabaha Financing Accounting Problem 7-1

w An Islamic financial institution provides a financing of $100,000 at a constant rate of return of 10% for a period –5 years and requires an annual installment payment of RM 30,000 w Prepare an extract of the Balance Sheet and income statement at the beginning and end of Year 1 w Workings: Unearned income = (5 x 30,000) – 100,000 = RM 50,000

Murabaha financing Unearned income Net receivable Murabaha Income

Year 0 150,000 (50,000) 100,000

Working : Income = 10% of RM100,000

Year 1 120,000 (40,000) 80,000 10,000

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MCQ 7-1 In a Murabaha transaction, if a client accelerates payment of one or more installments prior to the date specified for such payment, the Islamic Bank may deduct part of the profit to be agreed upon between the Islamic Bank and the client at the time of settlement. The deducted amount … a) shall be debited to the Murabaha receivables account. b) shall be treated as a liability. c) shall be excluded from the profit related to the instalments being prepaid. d) shall be credited to the Murabaha payables account. MCQ7-2 Rukyah purchased a house from Sameera through an Islamic banking facility. If the contract of the facility is based on Murabaha, which of the following scenarios would be valid: a) The Islamic bank establishes a Special Purpose Company which would collect the equal proportions of capital from both the Islamic bank and Rukyah before purchasing the house from Sameera. The title of ownership is shared by both parties until Rukyah purchases off the entire ownership. b) Rukyah pays Sameera a downpayment and gets the Islamic bank to finance the remaining amount. The title of ownership is passed to Rukyah upon making the downpayment. c) The bank purchases the house from Sameera and subsequently sells the house to Rukyah at cost plus a mark up. The title of ownership is passed to Rukyah upon concluding the sale agreement. d) The bank purchases the house from Sameera and subsequently sells the house to Rukyah at cost plus a mark up. The title of ownership is retained by the Islamic bank until full settlement.



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MCQ 7-3

MCQ 7-4 An Islamic Bank provides a Murabaha to the Purchase Orderer financing to Barakah Construction to purchase a specialized equipment to be used for Barakah Construction’s business project. Financing is for US$ 500,000 at a constant rate of return of 10% for a period of 5 years. The annual installment payment is US$ 150,000. What is the Islamic Bank’s journal entry at the start of the transaction in Year 1? a)

Dr Murabaha receivable Cash Unearned Income

b)

500,000 250,000 Dr

Murabaha receivable Cash Unearned Income

c)

Cr 750,000

Cr 500,000

500,000 -

Dr

Cr



Murabaha receivable Cash Unearned Income d) Murabaha receivable Cash Unearned Income

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500, 000 500,000 Dr 650,000

Cr 500,000 150,000

MCQ 7-5 Mr. ABC made a non-binding promise to an Islamic Bank that he would buy a van from the latter through a Murabaha transaction. Based on that promise, the Islamic Bank collected hamish jiddiyah of US$ 500 from him, and bought a van from a vendor for US$ 3,000 in cash. After the van is delivered to the Islamic Bank, Mr. ABC decided not to buy it. The Islamic Bank then sold the van to another customer, Mr. DEF, for US$ 2,800 in cash. Which of the following should apply? a) The Islamic Bank should return US$ 500 to Mr. ABC. b) The Islamic Bank should return US$ 300 to Mr. ABC. c) The Islamic Bank should not return any money to Mr. ABC. d) The Islamic Bank should not return any money to Mr. ABC but pass US$ 300 to Mr. DEF.



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Question 7-1

a. Bank Syari’ah Berhad provides a financing facility based on Bai’ Bithaman Ajil (BBA) principles to Ahmad bin Ali for the purpose of house purchase. The financing is amounting to RM300,000 at a constant rate of return 8% for a period of 5 years. At the end of the contract, Ahmad owes the bank amounting to RM32,000. As part of the normal requirements, the customers will be charged a penalty fee of 3% per month for any outstanding amount due at the end of the contract and the amount collected is normally disbursed as charity. You are required to : (i)

Prepare an extract of the balance sheet and income statement of Bank Syari’ah Berhad from the beginning till the end of the contract to show the amount of net receivable and Murabaha (BBA) income.

(ii)

Prepare journal entries to record all the above transactions in the book of Bank Syari’ah Berhad (including the treatment for penalty fee).

b. Explain the similarities and the differences between Murabaha to the Purchase Orderer and Bai’ Bithaman Ajil financing. (IIUM B.Acc, semester 1, 2004 / 2005, q1)

Question 7-2



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Kuwait Finance House (M) Bhd is a newly setup Malaysian subsidiary of a foreign Islamic bank which is in the process commencing operations in Malaysia. It started its operations by providing a BBA financing facility of RM 1 Million to Bumi Ventures (M) Bhd. to purchase its factory machinery. The terms of the contract are:

Mark – up 10 % on cost Period of financing 4 years Repayment in four equal yearly installments Early payment rebate 50 % of outstanding profit

Bumi ventures paid all the installments for the first 3 years on schedule. At the end of the 3rd year Bumi ventures informed the bank that it wanted to settle the financing immediately and asked the bank to inform it of the balance after rebate. You are required to : a) Show journal entries for the transactions for the 3 years in the books of KFH. b) Show the extract of the balance sheet and income statements of KFH in respect of the above transactions at the end of the first 3 years and the beginning of the fourth year showing clearly what the amount owing by Bumi Ventures after rebate. ( IIUM B.Acc, mid term sem 2 2004/2005, q2 )



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Question 7-3

Bank Islam Brunei provided a murabaha financing facility to purchase construction equipment for Malaysian Constructions Bhd., for RM1,000,000. The mark up was agreed at 10% per year on the initial sale price of the equipment. The murabaha sale was to be paid in equal instalments of RM300,000 over the next 5 years. It was agreed that a late penalty payment of 5% of the instalment receivable was to be made by Malaysian Constructions Bhd., should they not pay on time. The SSB of the bank has decided that the penalty should be credited to a charity account. The following events took place in the five years. (i)

(ii) (iii) (iv) (v) (vi)

Jan 1, year 1, the murabaha contract was signed and the bank purchased the equipment for RM1,000,000 which was delivered directly to the clients construction site. The bank paid for the equipment in cash. Dec 31, year 1, the client paid the bank RM 300,000 as scheduled. Dec 31, year 2, the client paid the bank RM 300,000 as scheduled. Dec 31, year 3, the client could not pay on time but subsequently paid RM 300,000 and the penalty in Feb 28, year 4. Dec 31, year 4, the client paid the bank RM 300,000 as scheduled. On Jan 31st, year 5, Malaysian constructions decided to pay off the asset in full and requested Bank Islam Brunei for a rebate. Bank Islam Brunei decided to give a 50% rebate on a pro rata basis (to the nearest month) on the balance of the profits. On the same day, Malaysian constructions settled the difference.

Required: a. b.

Show journal entries for all transactions involving the murabaha. Show extracts of the income statement balance sheet at the end of each year to year 5.



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Question 7-4

Bank Muamalat provides a Bai’ Bithaman Ajil financing facility to Dodik for the purpose of buying a shop lot. The financing is amounting to RM400,000 at a constant rate of return 10% for a period of 4 years. At the end of the contract, Ahmad owes the bank amounting to RM40,000. It is the policy of the bank to charge customers a penalty fee of 4% per month for any outstanding amount due at the end of the contract and the amount collected is disbursed as charity. You are required to: i.

Prepare an extract of the balance sheet and income statement of Bank Muamalat from the beginning till the end of the contract to show the amount of net receivable and Murabaha (BBA) income.

ii. Prepare journal entries to record all the above transactions in the book of Bank Muamalat (including the treatment for penalty fee).

Question 7-5

A customer of an Islamic Bank is interested to obtain short-term credit for his working capital financing and has approached you to seek your advice on Murabaha Financing.

Required:



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a. Explain the usefulness of Murabaha Financing and the mechanism of Murabaha to the Purchase Orderer. b. State the limitations of Murabaha Financing. (IIUM B.Acc, semester 1, 2000/2001, q3)

Question 7-6

1. Bank Muslimin Berhad provided a financing facility based on Murabaha principles to Ahmad Construction Sdn. Bhd. The financing amounted to RM1,000,000 at a constant rate of return 15% for a period of 5 years. The annual installment payment is RM350,000. You are required to prepare an extract of the balance sheet and income statement of Bank Muslimin Berhad from the beginning of the contract up to year 5 to show the amount of net receivable and Murabaha income. (IIUM B.Acc, semester 2, 2002/2003, q1b)

2. Explain the conceptual and contractual differences between Murabaha; Murabaha to the Purchase Orderer (as defined by the AAOIFI FAS 2) ; and Bai Bithaman Ajil (as practiced by Malaysian financial institutions); (IIUM B.Acc, semester 2, 2002/2003, 3a)

Question 7-7



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Bank Muamalah Berhad provides a financing facility based on the principles Murabaha to the Purchase Orderer to Barakah Construction Sdn. Bhd. to purchase a specialized equipment to be used for their business project. The financing amounted to RM500,000 at a constant rate of return of 10% for a period of 5 years. The annual installment payment is RM150,000. You are required to: i.

Prepare journal entries for Bank Muamalah Berhad only for the first year and final year of the contract. ii. Present a statement showing the amount of net receivable and murabaha income for the whole duration of the contract. (IIUM B.Acc, semester 1, 2003/2004, q1b)

Question 7-8

One of the major forms of financing offered by Islamic financial institutions is Bai Bitham Ajil Financing. Essentially this is a deferred Instalment Sale with a Mark-up Price. A customer has paid several installments amounting to RM 100,000 including RM 60,000 of profit realized by the bank. The financing amount is RM 250,000 including a mark-up of RM90,000.



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Required: a. b. c.

Discuss the relevance and importance of ‘Murabaha’ in financial reporting and disclosure. Explain the usefulness of ‘Provision of Unearned income’ in the accrual basis accounting. Based on the murabaha transaction, prepare the following extracts of banks’ financial statement. i. ii. iii.

Balance sheet extract at year end using accrual basis accounting Balance sheet extract at year end using cash basis accounting Journal entries for early settlement (IIUM B.Acc, semester 1, 1999/2000, 3)

Question 7-9

In financing the purchase of property, Islamic bank provides Bai Bithaman ajil finacing (BBA). The Islamic bank finaced a completed semi-detached house of RM500,000 at 12% per annum financing rate for 15 years. The monthly instalment is RM5,941 per month. In addition the customer has to place a two-month security deposit at the beginning of the period. Required: a. Compute the unearned income at beginning of the period and determine realized income after one year using the gross margin and constant rate of return methods. b. If the customer agrees to make early settlement after 5 years how much will the outstanding principal



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c. Show the relevant accounting entries of both (a) and (b) (IIUM B.Acc, semester 1, 1999/2000, 3)

Question 7-10 Hong Leong Islamic Bank (HLIB) gave a 5 year financing facility based on BBA to Zaitun Industries to purchase factory machinery costing RM550,000 on 1st January 2006. . Zaitun would pay a deposit of RM50,000 of the amount to the manufacturer as buying agent of Hong Leong. The bank would take a profit of 8% per annum on a constant rate of return on the financing it provided to Zaitun. Payment to be made on a semi-annual basis. A penalty charge of 5% of the outstanding amount would be made for any payments more than 30 days late. The Shariah Supervisory Board of Hong Leong Islamic Bank had declared that any penalty on contracts can be taken as revenue of the company provided that the customer has been informed about it. Otherwise no penalty could be charged. In 2008, Zaitun industries paid the instalment due on 30 June 2008, only on 30th August and was charged penalty which it disputed because it was not told about the penalty clause and the contract accidentally omitted it. It also informed Hong Leong Islamic Bank that it would like to pay the balance of the price on January 1st 2009. and requested HLIB for a rebate based on ibra’ principles. HLIB decided to give an ibra of 20% of the remaining profit. Zaitun paid off the requested amount to HLIB and ended the contract. Required: (i) Give the journal entries for year 2006, year 2008 and year 2009 in the books of HLIB together with the extract of the Balance Sheet and Income Statement for the year ended 31st December from the beginning until the end of the contract. (iii) Assuming the deposit paid by Zaitun was treated as the 1st ijarah rental and the whole contract was an Ijara muntahia bitamlik where the repayments under BBA in (a) was considered to be ijarah rental payments and all the payments were made on time to Hong Leong and Zaitun



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decided to rent the machinery until the 5 year ijarah contract expired. Give the journal entries in the books HLIB for 2006 and 2010 as well as the income statement and balance sheet for 31st December 2006 and 2010 provide HLIB follows FAS8 of AAOIFI. Depreciate the machine on a straight line basis with no residual value. (iii) From the difference in treatment of the above transactions suggest reasons why Islamic banks in Malaysia rejected the original ED on MASBi2 on Ijarah which closely followed FAS8? (IIUM B.Acc, semester 1,2006/2007, Q2)


Chapter 8. Accounting for Mudaraba Financing

247

.. ‫ وآﺧﺮون ﻀﺮﺑﻮن ﺑﺎﻷرض ﺒﺘﻐﻮن ﻣﻦ ﻓﻀﻞ اﷲ‬: “others traveling through the land, seeking Allah’s bounty” (Al Muzzamil, 73:20).

‫روي أن اﻟﻌﺒﺎس ﺑﻦ ﻋﺒﺪ اﻟﻤﻄﻠﺐ إذا دﻓﻊ ﻣﺎﻻً ﻣﻀﺎرﺑﺔ اﺷﺘﺮط ﻋﻠﻰ ﺻﺎﺣﺒ أن ﻻ ﺴﻠﻚ ﺑ ﺑﺤﺮًا‬ ‫وﻻ ﻨﺰل ﺑ واد ﺎً وﻻ ﺸﺘﺮي ﺑ ذات ﻛﺒﺪ رﻃﺒﺔ ﻓﺈن ﻓﻌﻞ ﻓ ﻮ ﺿﺎﻣﻦ ﻓﺮﻓﻊ ﺷﺮﻃ إﻟﻰ رﺳﻮل اﷲ‬ ..‫ﺻﻠﻰ اﷲ ﻋﻠ وﺳﻠﻢ ﻓﺄﺟﺎزه‬ It was reported that Al Abbas bin abd Almuttalib used to pay money for Mudaraba and to stipulate the mudarib that he should not travel by sea, pass by valleys or trade in livestock, and that the mudarib would be liable for any loses if he did so. These conditions were brought before Prophet Mohamed and he approved them.(Al Bayhaqi 6/111).

Chapter

8


At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv. v.

Explain the meaning of mudaraba and how this contract is used by Islamic banks to finance customers List the principles of mudaraba and as well as the rules explain the shari’a rules. Journalise accounting entries for mudaraba. Prepare the balance sheet and income statement extracts for mudaraba transactions Apply shari’a and accounting principles as per FAS 3 to solve accounting problems for complex events.

8. 1 Introduction In this chapter, we study mudaraba, a unique labour-capital partnership, which was the cornerstone alternative to interest based banking, advocated by early Islamic economists such as Dr Nejatullah Siddiqui. Although, Islamic banks have failed to use this instrument widely on the asset side for financing customers, Islamic banks uses this contract on the liability side to attract deposits through investment accounts. Although the original mudaraba contract envisaged the capital investor as one party and the businessman as the party, banks use a two tier mudaraba, where the first tier

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is between the depositor (as the capital owner) and the bank as the mudarib (businessman). However, since the bank itself does financial intermediation only and does not actually carry out the business, it re enters into a another mudaraba contract with an actual businessman or company. This is not a problem under the shari’a provided the two contracts are not linked and the depositor does not prohibit the bank from re-mudaraba. We shall first define mudaraba and explain how it is used by the bank for financing and deposit mobilization. Next we delve into some of the fiqh rules regarding mudaraba. This should be borne in mind when recording transactions, allocating profits and valuing assets and liabilities. We then consider recognitions issues and the associated journal entries for recording transactions and events up to the income statement and balance sheet. Finally, we illustrate with examples and then leave you to the questions.

8.2 Definition and financing model of mudaraba Mudaraba is a partnership, in which one or more parties (Rab al mal or sahibul mal) who provide the capital , contract with another party (the mudarib) who provide the labor, management expertise or entrepreneurship. This can take several forms: (i)

Bilateral mudaraba , where there is one capital provider and one entrepreneur (can be an organization such as an Islamic bank.

RAB AL MAL (CAPITAL PROVIDER)

ISLAMIC BANK (MUDARIB)

INVESTMENT

The distinguishing feature of any mudaraba is that : (i) the profit sharing ratio between the rab al mal and the mudarib (Islamic bank) is agreed beforehand. (ii) Any losses, other than those incurred due to negligence or mismanagement of the mudarib is borne by the rab al mal, the mudarib looses his labour as he is not paid any salaries or fee. This introduces agency problems to the rab al mal (Obiyatullah, 1998??)

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ILLUSTRATION 8-1: BILATERAL MUDARABA

$200,000

RM

70:30

INVESTMENT MU (70%) $24,000(30%)

$56,000(70%)/ ($80,000) (100%)

PROFIT(loss)= $80,000/( $80,000)

If Rabbul Mal (RM) invested $200, 000 with Mudarib (MU) in the profit sharing ratio of 70:30 (70% to RM and 30% to MU), then if the investment results in a profit of $80,000, then the mudarib will get 30% i.e. $24,000 (30%x $80,000) and the Rab al Mal will get $56,000 (70% x $80,000). However, if the investment resulted in a loss of $80,000 instead, then all this loss of $80,000 will be borne by the rab al mal will , unless the mudarib was negligent.

(ii)

Multilateral mudaraba, where there are at least two capital providers and one entrepreneur

RAB AL MAL 1 (CAPITAL PROVIDER)

RAB AL MAL 2 (CAPITAL PROVIDER)

ISLAMIC BANK (MUDARIB)

INVESTMENT

In this case, where there are profits, after the bank gets its share, the rabs al mal are allocated the profits in according to their capital. In the case of Islamic banks, there

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are many investment account holders (rabs al mal) and profit allocation can become complex especially when the rabs al mal do not have coterminus contracts with the bank i.e they invest for different periods of time.

ILLUSTRATION 8-2: MULTILATERAL MUDARABA

RM 1: $100,000

INVESTMENT

70:30 MU

RM 2: $100,000

24,000/ ($0) $28,000/($20,000)

PROFIT(loss)= $80,000 ( $40,000)

$28,000/($20,000)

In the chart above, two rabs al mal invest $100,000 each with mudarib (MU) who invests it. The profit sharing agreement between the rabs al almal and the mudarbib being 70:30. If the ventures returns a profit of $80,000, then the mudarib gets (30%x$80,000), $24,000 and the rabs al mal share $56,000. This amount is allotted between RM1 and RM2 in proportion to their capital investment i.e 1:1 in this case, therefore they each get $28,000 If the loss is $40,000, then RM1 bears $20,000 and RM2 bears $20,000. The mudarib looses his labour, if the mudarib has NOT been negligent.

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(iii)

251

Re mudaraba where, the entrepreneur sources and hires another mudarib under a another mudaraba contract. This is the

RAB AL MAL (CAPITAL PROVIDER)

ENTREPRENUER (MUDARIB 2)

ISLAMIC BANK (MUDARIB 1)

INVESTMENT

ILLUSTRATION 8-3: RE MUDARABA

RM =$100,000

70:30

MU 1 $9,000/($0)

60:40

MU 2

INVESTMENT

$20,000/($0)

PROFIT(loss)= $50,000/( $30,000)

$21,000/($30,000)

Rabbul Mal (RM) provides $100,000 capital to Mudarib (MU1) with PSR 70:30. This is in turn handed over to Mudarib 2 (MU2)with profit sharing ratio 60:40. If the venture earns a

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profit of $50,000, then MU2 gets 40% of $50,000= $20,000, M1 gets 30%x60%x$50,000=$9,000 and the rab al mal gets 70%x60%x$50,000=$21,000. However, if the investment results in a loss of $30,000, this loss is borne by the rab al mal.

Definitions Mudaraba It is a partnership in profit between capital and work. It may be conducted between investment account holders as providers of funds and the Islamic bank as a mudarib. The Islamic bank announces its willingness to accept the funds of investment amount holders, the sharing of profits being as agreed between the two parties, and the losses being borne by the provider of funds except if they were due to misconduct, negligence or violation of the conditions agreed upon by the Islamic bank. In the latter cases, such losses would be borne by the Islamic bank. A Mudaraba contract may also be concluded between the Islamic bank, as a provider of funds, on behalf of itself or on behalf of investment account holders, and business owners and other craftsmen, including farmers, traders etc. Mudaraba differs from what is known as speculation which includes an element of gambling in buying and selling transactions.

Unrestricted Investment Accounts(1) With this type of account, the investment account holder authorizes the Islamic bank to invest the account holder’s funds in a manner which the Islamic bank deems appropriate without laying down any restrictions as to where, how and for what purpose the funds should be invested. Under this arrangement the Islamic bank can commingle the investment account holder’s funds with its own funds or with other funds the Islamic bank has the right to use (e.g., current accounts). The investment account holders and the Islamic bank generally participate in the returns on the invested funds. (Statement of Concepts,

Restricted Investment Accounts (1) With this type of account, the investment account holder imposes certain restrictions as to where, how and for what purpose his funds are to be invested. Further, the Islamic bank may be restricted from commingling its own funds with the restricted investment account funds for purposes of investment. In addition, there may be other restrictions which investment account holders may impose. For example, investment account holders may require the Islamic bank not to invest their funds in instalment sales transactions or without guarantor or collateral or require that the Islamic bank itself should carry out the investment itself rather than through a third party.

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8.3 Mudaraba principles, rules and complexities Offer and acceptance

Capital:

As with other Islamic contracts, the mudaraba contract must be preceded by offer and acceptance Both the parties , the fund provider and the mudarib should be eligible to act as principal and agent (contracting capacity).

Specific amount and type (currency). Normally in cash but can be in inventory. In such case, the historical cost or value of such assets should be considered as mudaraba capital. Hanbalis allow nonmonetary assets. Cannot be in the form of debt as this is not readily available (even if the debt is owed by the mudarib). Capital must be paid to the mudarib. The contract can allow payment by installments.

The wording of the offer and acceptance must indicate the purpose of the contract, explicitly or implicitly. There should be no counter offer i.e. the party must accept of the same conditions as the conditions of the offer. The contract can be verbal or in writing but in practice is invariably written. It can be concluded through correspondence or by fax. Profit Sharing Ratio should be determined at the time of contracting. PSR can be adjusted subsequently. Profit is the amount earned in excess of the amount of the initial murabaha capital. No revaluation of capital is permitted.

Capital provider bears all the loss unless due to trespass or omission by the mudarib

No work interference by capital Provider (Hanbalis permit this)

The entrepreneur should comply with shari’a rules and any conditions imposed unless these contradict the mudaraba contract.

Can be limited to a period. The entrepreneur should comply with capital provider’s instructions No guarantee of recovery of fund except for betrayal guarantee. ( performance bond) or a third party guarantee.

Distribution Method: According to Maliki it is realised upon distribution between the two parties Profit can be on a realization or cash basis. (recognized when distributed or losses deducted from capital or when declared.

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8.4 Recognition of mudaraba transactions and journal entries Accounting issues on Mudaraba • • • •

Recognition of Asset and Liability Recognition of Profit/ Income or Loss/ Expense Valuation of Asset Disclosure

8.4.1 Recognition and Measurement of Mudaraba Financing FAS 3, Mudaraba Financing is a standard for the provision of mudaraba financing by the Islamic bank and does not deal with the deposit side of receiving the funds on mudaraba basis. However, in this chapter we will consider both. When the capital is paid to the mudarib or placed in his disposition (for example, credited to his account) then Mudaraba financing capital is recognized by debiting Mudaraba Financing and crediting cash. If the capital is paid in installments, each installment is recognized as capital when paid. If payment of capital is conditional of an occurrence of a future event or delayed to a future time, capital is recognized only when it is paid to the mudarib. If the capital is in the form of non-monetary assets such a plane or building then the heading of “non Monetary mudaraba asset. If capital provided by the Islamic bank is in kind (trading assets or non-monetary assets), the capital shall be valued at fair value of the assets. Any difference between fair value and book value shall be recognized as profit or loss to the bank. Expenses of contracting procedures such as feasibility studies are not considered mudaraba capital unless specifically agreed.

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ILLUSTRATION 8-5: RECOGNITION OF MUDARABA FINANCING

Bahrain Islamic Bank executes a mudaraba contract for $1,000,000 with Babul Bahrain constructions on 1 Muharram 1428. The feasibility study and legal expenses cost the bank $50,000 and was paid by the Bank. The $1,000,000 is to given to babul Bahrain constructions for their use in the mudaraba as follows: 1 Muharram 1428: $200,000 cash +$300,000 (fair value) of a crane which was used for ijarah purposes by the bank in a previous assets with a book value of $400,000. 1 Safar 1428: $200,000 fair value of construction materials which was left over from terminated istisna contract, the carrying value was $150,000. 1 Jamada I, : $300,000 in cash. Required: Journal entries in the books of Bahrain Islamic Bank for the above transactions which were executed as scheduled. ANSWER: Muharram 1

Dr Mudaraba Financing Non-Monetary Mudaraba Asset Loss on Crane (P/L account)

$200,000 $300,000 $100,000

Cr. Cash Cr Assets on Ijarah

$200,000 $400,000

Being initiation of mudaraba contract with Babul Bahrain Constructions. Safar 1

Dr. Mudaraba Financing $200,000 Cr. Istisna work in progress $150,000 Cr Profit and Loss 50,000 Being transfer of construction materials as capital to Babul Bahrain constructions at a fair value of $200,000. Jamada 1

Dr. Mudaraba Financing Cr Cash Being payment of last installment of capital.

$300,000 $300,000

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8.4.2 Measurement of Mudaraba Capital at the end of the financial year after contracting. Mudaraba capital should not be revalued subsequent to the execution of contract but should be at initial carry value except for any repayment of capital which should be de/ducted from the Mudaraba Financing Account. However, if a partial loss of the capital occurs (e.g. theft or fire) before the work on the mudaraba is started (and this is NOT caused by negligence of the mudarib., this should also be deducted from mudaraba financing account and debited to pofit and loss account. If the whole of the mudarba capital is lost, (not due to mudraibn then the Islamic bank must bear the loss, and terminate the mudarba contract. Any unpaid amounts remaining becomes a receivable of the bank from the ex mudarib.

8.4.3. Recognition of the Islamic bank’s share in the profit and losses If a mudaraba starts and finishes within the financial year of the bank, profit and losses (bank’s share) should be recognized by the bank in that financial year. If a mudraba transaftion carries on after the financial year end, the profit or losses should be recognized in the accounts for that period. To the extent that profits are distributed. The Islamic Bank’s share of losses should be recognized to the extent such losses are deducted from the Mudaraba capital. If the mudraba is terminated or settlement is made and the mudarib has not paid the profits to the bank, this will be treated as a receivable from the mudarib. Losses due to liquidation is recognized at the time of liquidation by reducing the Mudaraba capital. ANY MISCONDUCT OR NEGLIGENCE OF THE MUDARIB RESULTING IN LOSSES WILL BE BORNE BY THE MUDARIB AND IT BECOMES A RECEIVABLE DUE FROM THE MUDARBIB. Any provision made for the decline in the value of Mudaraba assets should be DISCLOSED in the notes to the accounts.

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8.4.3 Journal Entries: Summary No. 1

Transactions /Events Cash Recognition of Mudarabah Deposit (Liability) (Being deposit received from RabbulMal / Capital provider)

DR

CR. Mudaraba Deposit

Cash Withdrawal of deposit Mudarabah Deposit 2 (Being deposit repaid to Rabbul Mal/ Capital provider) Provision of Mudaraba financing Mudarabah Financing Cash 3 to Mudarib Asset Non-Monetary assets provided Non Monetary 3a on Mudaraba Mudaraba Assets

4

5. 6

Profit received from mudarib

Cash

Profit disbursed to rabul malz P & L Loss set off against rab al mal P&L Cash Repayment of mudaraba capital to the bank.

Profit and Loss Cash Mudarabah Financing Mudaraba Financing

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8.5 Asset and Liability measurement AAOIFI : presentation and disclosure of Mudarabah Financing Balance Sheet Mudaraba Financing ( Non Monetary Mudarabah Asset)* Less : Provision for decline in value of mudaraba Assets Net Mudarabah Financing

XX

(XX)

XX

*Jointly or self finance assets

Income statement Mudarabah income

XX

8.6 Accounting Problem Bank Syari’ah Malaysia Berhad contributed $2,000,000 for a four-year Mudaraba financing contract (Mudarabah Muqayaddah) at the profit sharing ratio of 2:1 between the Bank (Rabb al-Mal) and Ihsan Corporation (Mudarib) respectively. Assume that the venture incurred a loss of $150,000 in the first year; realized profit of $375,000 in the second year; incurred a loss of 250,000 in the third year; and realized profit of $350,000 in the fourth year. Required: (a)

Prepare the necessary journal entries to recognize asset and profit/loss of the above transactions, and show how profit/loss will be allocated between the Bank, and the Mudarib will appear in the respective income statements at the

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end of first, second, third and fourth year, if the profit of Mudarabah is determined at the end of: (i) each period (ii) at the end of the contract (b)

Comment on the impacts different basis of profit allocation (i.e. each period vs. end of the contract) on the income of the Bank and the Mudarib.

(c)

What are the different forms and types of Mudarabah contracts? (IIUM B.Acc, semester 2, 2004/2005, Q1)

Solution: Each period method : Year 0: Dr. Mudharabah Financing Cr. Cash

2,000,000 2,000,000

Year 1: Dr.Profit and Loss Cr. Mudharabah Financing ( loss in 1st year )

150,000

Year 2 : Dr. Cash / Receivable (2/3 x 375,000) Cr. Profit and Loss (Profit in 2nd year )

250,000

Year 3 : Dr. Profit and Loss Cr. .Mudharabah Financing ( loss in 3rd year )

250,000

Year 4 : Dr. Cash / Receivable (2/3 x 375,000) Cr. Profit and Loss (profit in 4th year )

233,333

Dr. Cash / Receivable Cr. Mudharabah Financing ( Capital repayment , year 4 )

150,000

250,000

250,000

233,333

1,600,000 1,600,000

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End of contract Method: Year 1: Dr. Mudharabah Financing Cr. Cash

2,000,000 2,000,000

Year 4 : Dr. Cash / Receivable Cr. Mudharabah Financing

2,000,000 2,000,000

Profit / Loss Year 1 Year 2 Year 3 Year 4

( 150,000) 375,000 ( 250,000) 350,000 325,000

Bank 2/3

216,667

Mudharib 1/3 108,333

Year 4 : Dr. Cash / Receivable Cr. Profit and Loss

216,667 216,667

Comparison between the different methods: Each Period Income Statement: Year 1 Year 2 Year 3 Year 4

Bank (150,000) 250,000 (250,000) 233,,333

Mudarib 0 125,000 0 116,667

Total

83,333

241,667

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End of contract :

Year 4

Bank

Mudharib

216,667

108,333

Comments Different method ( end of contract vs. Each period ) will lead to different amount of income recognized by both the Rabbul-Mal and Entrepreneur. For each period, loss during the contract will borne by Rabbul Mal, thus reduced total profit. Mudharib only earned profit not loss (protect Mudharib) may lead to moral hazard. For end of contract ,loss will be absorbed by profit, some argued not true Murbahah, some others argued that we should consider it as a project basis. Method of profit recognition must be transparent to both parties at the beginning of the contract to avoid abuse by one party over the other. Different forms of Mudharabah Mudharabah Muqayaddah (restricted Investment) vs. Mudharabah Mutlaqah (unrestricted investment )

Simple (1 tier Mudharabah) Multilateral ( 2 tiers Mudharabah ) Re-Mudharabah ( 3 parties involved )

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Question 8-1 Bank Muamalah Berhad (rabb al-mal) entered into a restricted Mudaraba contract on the 1st. of January 2003 with Jaya Sdn. Bhd. (mudarib) to provide $500,000 capital. Jaya Sdn. Bhd. is a specialist personal computer distributor in Malaysia used the whole amount of capital to purchase 250 units of computer on the 1st of February 2003. At the time of the contract, the computer has a fair value of $600,000. The mudarib sold all the 250 computers during the year 2003 for the total income of 700,000. Later in the same year, Jaya Sdn. Bhd. bought another 200 computers at $400,000 and sold it before the end of the year at $500,000. Profit sharing as agreed at the beginning of the contract between Bank Muamalah Bhd. and Jaya Sdn. Bhd. was at the ratio of 70% and 30% respectively.

You are required to: Determine the profit of the Bank Muamalah Bhd. at the end of 2003 if the mudaraba goods (i.e. computers) are valued at: i. Historical cost. ii. Fair value. (IIUM B.Acc, semester 1, 2003/2004, Q1a)

Question 8-2

In the year 2004, Bank Muslimin Berhad earned annual profit attributable to Mudaraba depositors (Mudaraba Mutlaqah) amounting to $ 950,000. Depositor’s profit sharing ratio under Mudaraba deposit account is currently at 0.7 (70:30 – Depositors:Bank). The following is the information pertaining to deposit types, average balance, and the weights used for Mudaraba deposit account in the Bank for the year 2004: 1. Deposit Types 6 months & less 9 months & less 12 months & less More than 12 months

Average Balance in Year 2004 250,000 300,000 400,000 550,000

Weights 0.5 0.75 1.0 1.25

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You are required to compute and determine: i. Weighted average balance for each deposit types; ii. Depositor’s share of profit based on the weighted average balance; and, iii. Depositors rate of return for each deposit types. 2. Bank Syari’ah Malaysia Berhad earns a gross profit for the year 2004 on Mudarabah al-Mutlaqah investment fund amounted to $1,500,000. During that year the overhead expenditure incurred was $450,000 and indirect revenue earned through the penalty fee of late payment for Islamic financing was amounted to $280,000. Which method of profit distribution policy that you think the Bank may adopt, assuming other variables remain constant? (IIUM B.Acc, Resit semester 3, 2004 / 2005, Q1 b & c) Question 8-3

A.

An Islamic bank bought goods for $100,000 and it entered into a Mudarabah contract with a client in which the goods were the mudarib capital. At the time of the contract, the goods had a fair value of $110,000. the Mudharib (client) sold the goods for $120,000 i. During the same year, the mudharib bought another consigmnet of goods at $120,000 and sold it for $130,000.

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ii.

264

Profit is allocated between the Islamic Bank and the Mudharib at the ratio of 70% to 30% respectively.

Required: Determine the profit of the Islamic Bank if the Mudharabah goods are valued at: i. ii.

Historical cost Fair value

B. An Islamic bank paid $100,000 for a two-year Mudharabah contract . Profit is shared in the ratio of 2 : 1 between the Islamic Bank and the Mudharib, respectively. Assume that the Mudharabah : i. ii.

Realised a profit of $9,000 in the first period Incurred a loss of $21,000 in the second period.

Required: Show how the profit to be allocated between the Islamic bank and the Mudharib will appear in their respective financial statements at the end of the first and second period if the profit of the Mudharabah is determined at the end of: i. Each period ii.The contract (AIA, Professional Examination II, 2002, Q 5)

Question 8-4 (a) Bank Shari’ah Malaysia Berhad contributed $2,000,000 for a fiveyear Mudaraba contract (Mudarabah Muqayaddah) for property development project to Shah Alam Sdn. Bhd. The profit sharing ratio agreed by both parties is 2:1 between the Bank (Rabb al-Mal) and Shah

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Alam Sdn. Bhd. (Mudarib) respectively. The project incurred loss of $120,000 in the first year; realized profit $375,000 in the second year; realized profit of $450,000 in the third year; incurred loss of $220,000 in the fourth year; and realized profit of $250,000 in the fifth year. Required :

(i)

Prepare the extract of necessary journal entries to recognize asset and profit/loss of the above transactions based on the income recognition method determined at the end of each period.

(ii)

Show how profit to be allocated between the Bank, and the Mudarib will appear in the respective income statements from year 1 to year 5, if the profit of Mudaraba is determined at the end of: • Each period • The contract (iii) Comment on your answer to part (ii) above. (IIUM B.Acc, semester 1, 2005/2006, Q1a) Question 8-5

Abdullah bin Ahmad has entered into a Mudaraba contract with Bank Syariah Berhad in which he provides monetary capital of $500,000 to be managed and invested by the Bank. The Bank provides Al-Mudharabah Moqayadah investment account facility to Abdullah whereby the Bank will invest in a specific project as agreed by the client. For this project there are two other investors, Hashim and Ibrahim who have invested $500,000 and $200,000 respectively. The profit sharing between four of them is 5:5:2:2 for Abdullah, Hashim, Ibrahim, and the Bank respectively. The Bank has entered into another Mudaraba contract (ReMudaraba) with Ihsan Development Berhad to undertake manufacturing project and they agreed on the profit sharing ratio of 70:30 (Bank: Ihsan). You are required to dete$ine the profit or loss to be shared at the end of the contract by the five parties involved above if: Profit $550,000 ; or

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Loss $350,000. Question 8-6 (a)

(IIUM B.Acc, semester 2, 2002/2003, Q1a)

In the year 2005, Bank Ummah earned annual profit attributable to Mudaraba depositors (Mudaraba Mutlaqah) after distributing profit to the Bank amounting to $ 9,500,000. Depositor’s profit sharing ratio under Mudaraba deposit account is currently at 0.7 (70 : 30 – Depositors : Bank). The following is the information pertaining to deposit types, average balance, and the weights used for Mudaraba deposit account in the Bank for the year 2005:

Deposit Types 6 months & less 9 months & less 12 months & less More than 12 months

Average Balance in Year 2005 25,000,000 30,000,000 40,000,000 55,000,000 150,000,000

Weights 0.50 0.75 1.0 1.25

You are required to compute and determine: i. ii. iii.

(b)

Weighted average balance for each deposit types. Depositor’s share of profit based on the weighted average balance. Depositors rate of return for each deposit types.

Based on the depositors rate of return as computed in part (a) above, determine the profit attributable to the following depositors in the Mudarabah General Investment Account of Bank Ummah: i. ii. iii.

Ahmad bin Abdullah who invested $500,000 for the duration of 5 months. Chong Kok Seng who invested $420,000 for the duration of 12 months. Sulaiman bin Muhamad who invested $230,000 from 1st. January 2005 to 15 August 2005.

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(c)

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Explain the disclosure requirements of MASB FRSi-1 on the following issues: i. Profit Distribution Policy (4 Marks) ii. Going Concern (4 Marks) iii. Earnings or Expenditure Prohibited by Syari’ah (3 Marks)

(IIUM B.Acc, semester 2, 2005/2006, Q1)

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Chapter 9 Accounting for Musharaka Financing

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‫"وإن ﻛﺜ ﺮاً ﻣﻦ اﻟﺨﻠﻄﺎء ﻟ ﺒﻐﻲ ﺑﻌﻀ ﻢ ﻋﻠﻰ ﺑﻌﺾ إﻻ اﻟﺬ ﻦ آﻣﻨﻮا وﻋﻤﻠﻮا اﻟﺼﺎﻟﺤﺎت وﻗﻠ ﻞ ﻣﺎ‬ “Verily many are the partners in business who wrong each other except those who believe and work deeds of righteousness and how few are they (Sad 38: 24)

‫ ﻓﻠﻤﺎ‬،‫ "أﻧ ﻛﺎن ﺷﺮ ﻚ اﻟﻨﺒﻲ )ص( ﻓﻲ أول اﻻﺳﻼم ﻓﻲ اﻟﺘﺠﺎرة‬:‫ ﺣﺪ ﺚ ﺑﻦ أﺑﻲ اﻟﺴﺎﺋﺐ اﻟﻤﺨﺰوﻣﻲ‬: ."‫ ﻻ ﺪاري وﻻ ﻤﺎري‬،‫ ﻣﺮﺣﺒﺎً ﺑﺄﺧﻲ وﺷﺮ ﻜﻲ‬:(‫ﻛﺎن ﻮم اﻟﻔﺘﺢ ﻗﺎل اﻟﻨﺒﻲ )ص‬ al-Sa’ib Ibn Abi al-Sa’ib al-Makhzumi who was a partner of the Prophet peace be upon him in business at the beginning of Islam. On the day when the Prophet peace be upon him conquered Mecca the Prophet said when he met Saib Welcome my brother and my partner. He jokes not (i.e. he is serious in business) and do not argue (unnecessarily) (Al Hakim, 2/61)

Chapter

9


At the end of this chapter you will, insha Allah you will be able to:

i. Explain the meaning of musharaka and how this contract is used by Islamic banks to finance customers. Ii List the principles of musharaka and as well as explain the shari’a rules. iii. Journalise accounting entries for musharaka iv Prepare the balance sheet and income statement extracts for musharaka transactions v Apply shari’a and accounting principles as per FAS 4 to solve accounting problems for complex events.

9. 1 Introduction In this chapter, we will insha Allah, study the second partnership instrument i.e. musharaka. Musharaka is a partnership between two or more persons with a number of fiqh rules to protect the interests of all parties. Although, the Muslim world never



269

developed its version of the joint stock company, the sharikah al’inan is the closest to a joint stock company. Islam leaves many of the details of the partnership to be agreed among the partner but as with all muamalat contracts, there are certain fiqh rules to be applied. Some of the distinguishing features of musharaka are: 1. At least two partners, there is no maximum 2. All partners can participate in the management , even if not to the same extent 3. Capital can be equally contributed or in different amounts 4. Proft sharing ratio is must be agreed in advance. 5. Capital cannot be guaranteed by any partner, neither is interest on capital permitted. 6. Losses are shared on the capital ratio, not in the profit sharing ratio. 7 Each partner act as the agent of the other and can by himself decide to take a decision or to undertake a partnership activity, except that he is not allowed to his personal business or expenses under the partnership umbrella. 8. Some partners, especially if they work more than others can have a profit share more than others even if they have contributed lower capital. 9. Musharaka differs from mudaraba, in that all partners must participate in the running of the business and all partners must contribute in capital (except in wujooh and ‘amal partnerships)

In contrast to the mudaraba, the bank has two advantages: 1) it has a say in the management and running of the musharaka business, this allows for control of agency costs and moral hazard problems. 2) losses are born in the capital contribution ratio, whereas in mudaraba, it is borne by the bank.as the rabbul mal. The disadvantages are: 2) as a financial intermediary the Islamic bank might not want to get involved in the management of the business due to lack of expertise or regulatory requirements. However, in many jurisdictions, some leeway is given to Islamic banks to be more commercial as opposed to being a strictly financing institution, although this is stll a problem with many bank regulators.



9.2 Definition, types and financing model of musharaka FAS 4, defines musharaka as follows:

Definitions 8.2.1 Definition Musharaka

Musharaka has been defined by AAOIFI as per FAS4 as follows:

A form of partnership between the Islamic bank and its clients whereby each party contributes to the capital of partnership in equal or varying degrees to establish a new project or share in an existing one, and whereby each of the parties becomes an owner of the capital on a permanent or declining basis and shall have his due share of profits. However, losses are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise. Constant Musharaka It is a Musharaka in which the partners’ shares in the capital remain constant throughout the period as specified in the contract. Diminishing Musharaka It is a Musharaka in which the Islamic bank agrees to transfer gradually to the other partner its (the Islamic bank’s) share in the Musharaka, so that the Islamic bank’s share declines and the other partner’s share increases until the latter becomes the sole proprietor of the venture. Participation It is a Musharaka in which the Islamic bank owns shares or units representing an equity stake in another firm’s capital.

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271

Types of Musharaka There are various types of Musharaka viz: 1) Musharaka ‘inan (equivalent to joint stock) 2) Musharaka mufawada (flexible partnership) 3)Musharaka ‘amal (based on work done jointly) 4)Musharaka Al-Wujooh(reputation based credit partnership)

TYPES OF MUSARAKA

inan

mufawada

Fig 9.1 Types of Musharaka

‘amal

wujooh



According FAS4 , the characteristics of the different types of partnerships under Islam are as follows;

‘Inan partnership It is a contract between two or more persons. Each of the parties contributes a portion of the overall fund and participates in work. Both parties share in profit or loss as agreed between them, but equality is not required either in the contribution to the fund or in work or in sharing of profit (these being subject to agreement between the parties). This type of partnership is approved by all Fuqaha. Hanafis and Hanbalis allow any of the followings. Profits of the two parties to be divided in proportion to their contributed funds; profits may be divided equally but contributed funds may be different; and profits may be unequally divided, but contributed funds are equal. Ibn Qudamah said: “preference in profit is permissible with the existence of work, as one of them may be more knowledgeable in trade than the other and he may be stronger than the other in doing the work, and thus he is allowed to make an increase in his profit share a condition of his work”. Malikis and Shafis make the acceptance of this type of partnership conditional on profits and losses being proportionate to the size of contributions to the overall fund because (according to them) profit in this type of partnership is considered to be return on capital(1). Mufawada partnership It is a contract between two or more persons. Each of the two parties contributes a portion of the overall fund and participates in work. Both parties equally divide profit or loss. It is a condition of this type of partnership that contributed funds, work, mutual responsibility and liability for debts be equally shared by the parties. Both Hanafis and Malikis have permitted this type of partnership but have stipulated many restrictions for it(2).

1

() 2

()

Sayed Sabeq, Fiqh Assunah, part 3, p. 296; Abdel Aziz Al-Khaiyaat, op. cit., part 2, pp. 30-31; Al-Kasani, Badaie’ as Sanaie’ fi Tarteeb Asharaie’, Vol. 6, p.57. Kasani, op. cit., p. 56; Ibn Qudamah Al-Mughnee, Vol. 6, p. 30.

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A’mal partnership It is a contract between two persons who agree to accept work jointly and to share the profit from such work. For example, two persons of the same profession or craft may agree to work together and to divide the profit arising from such work on an agreed basis. It is sometimes called abdan or sanaie’ partnership. An a’maal partnership is considered permissible by Hanafis, Malikis, Hanbalis(3). It is considered valid within the same profession or otherwise. Its permissibility is based on much evidences including explicit approval thereon by the Prophet, prayers and peace be on him. In addition, it is based on agency which is permissible. This type of partnership has been used throughout without being disapproved of (4). Al-Wujooh partnership It is a contract between two or more persons who have good reputation and prestige and who are expert in trading. Parties to the contract purchase goods on credit from firms, depending for that on their reputation, and sell the goods for cash. They share profit or loss according to the guarantee to suppliers provided by each partner. Accordingly, this type of partnership does not require capital since it is based on credit backed by guarantee. Hence, it is sometimes called a “receivables partnership”.

3

() 4

()

Ahmed Ali Abdulla, Legal Entity in Islamic Fiqh, (Sudanese Printing Press House, Khartoum, undated), p. 217 and after. Abdel Aziz Al-Khaiyaat, part 2, op. cit., p. 37;. Ibn Qudamah, Al-Mughnee, op. cit. Vol. 5, p.6; Sayed Sabeq, Fiqh Assunah, op. cit., p. 297.

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274

Musharaka financing model The Islamic bank provides capital along with the customer in a joint venture of an already existing project or a new project. The profit sharing ratio (PSR) is agreed beforehand in terms of percentage of the profits (and never on capital). Losses are shared on the ratio of capital contributed. However, it is permissible to defer the allocation of losses so that in order to be compensated by profits of subsequent periods. This is illustrated in the following illustration 9-1:

ILLUSTRATION 9-1: MUSHARAKA FINANCING PROFIT AND LOSS SHARING

MUSHARIK 1:

ISLAMIC BANK MUSHARIK 2

$100,000

$200,000

$30,000

INVESTMENT PSR 50:50

LOSS ($40,000)

LOSS ($20,000)

LOSS ($60,000)

PROFITS $60,000

$30,000



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Here the Islamic Bank (Musharik 2) contributes $200,000 to the project, while the other partner (musharik 1) contributes $100, 000. The Profit sharing ratio (PSR) is 50:50 although the capital ratio is 2:1.If the venture makes a profit of $60,000, each partner takes $30,000. However, if the venture makes a loss of $60,000, Musharik 1 bears only (1/3) of the loss, hence 1/3x$60,000=($20,000) while the Bank bears 2/3 of the loss which is (2/3x$60,000) =($40,000) Those of you who have studied partnership accounting will notice, that in English law, the partnership can enter into a Profit AND loss sharing agreed ratio, whereas in a Musharaka, you cannot enter into a loss sharing agreement ratio. It is always in relation to the capital contributed. Under English law, the same rule is applied using the legal rule in Garner Vs Murray , in the case of partnership dissolution and one of the partners is insolvent.

9.3 Musharaka fiqh principles, rules and complexities Contracting Parties It is a requirement that the partner should be competent to give or be given power of attorney. Work Participation of partners in the work of a Musharaka is a basic rule and it is not permissible for one of the partners to stipulate the non-participation of the other partner. However, equality of work is not a requirement. It is permissible that one of the partners exert more work than the other, and in that case he may require an additional share of profit for himself.

Work rules In a partnership with a contributed capital, the partners shall provide both funds and work and each partner shall undertake work as an agent of the partnership subject to the partnership contract. This is regulated by a number of

Subject Matter of the Contract: (Funding and Work) Capital contributed shall be in cash, gold, silver or their equivalent in value• Capital may consist of trading assets such as goods, property and equipment, etc. It may also be in the form of intangible rights, such as liens, patents and suchlike. It is considered permissible by some Fuqaha that the capital of a company can be contributed in the form of these types of assets provided they are valued at their cash equivalent according to what the partners agree upon.

Power of attorney and disposition of funds

Any partner has the right to dispose of the partnership’s assets in the normal course of business. A partnership with a contributed capital (e.g., alanan) constitutes an entity and once the



juristic rules, the most significant of which are: Agency in the work Each partner carries out work in the partnership on behalf of himself and as an agent for his partner. This is governed by the general rules of agency contract in Islamic jurisprudence. Some of these rules are related to the principal and others are related to the agent and some are related to the things which are the subject of agency. All these matters should be made clear in the Musharaka contract(5). Scope of the work This relates to the specification of the scope of each partner’s work in the partnership in relation to the latter’s objectives and activities. The partner should perform the agreed work without negligence or misconduct. Partnership work includes management of the business (e.g., planning, policy making, development of executive programs, follow-up, supervision, performance appraisal and decision-making). A partner who undertakes work outside his agreed scope of duties is entitled to employ workers to perform the said work, and if he performs such work himself, he shall be entitled to receive remuneration similar to that paid for similar work. However, it is considered permissible by some Fuqaha that one partner may delegate full authority to another to carry out the business of the partnership if this is the most satisfactory arrangement for the partnership. Appointment of workers The partners may appoint workers to perform

5

()

276

capital has been contributed it comprises a single fund. Each partner empowers his other partner(s) to dispose of the assets and he is thus considered to be authorised to employ them in the activity of the Musharaka provided he does so with due care to the interests of his partner(s) and without misconduct or negligence. A partner is not allowed to disburse or invest the funds for his personal purposes.

Non-guarantee of capital

Neither partner can guarantee the other partner’s c (c) It is not permissible to agree in a Musharaka contract that the transfer of the Islamic bank’s portion to the other partner or vice versa should be at historical cost. Normally, the transfer should take place on the basis of fair value at the time of transfer

Rules of profit Profit should be quantifiable. If it is not, this will undermine the contractual basis of the partnership through leading to differences and disputes at the time of profit allocation or liquidation of the partnership. If the partners say that the “profit will be between us”, profit will in this case be allocated according to the share of each of them in the capital. Each partner’s profit must be a proportionate share of the whole partnership profit. No predetermined amount may be assigned to one of the partners, as in this case profit sharing will not take place and the legal basis of the partnership will be undermined.

Ibn Qudamah, Al-Mughnee, Vol. 5, Kitab Al-Wakalah, p.88 and after, Sayed Sabeq, Fiqh Assunah, Vol. 3, (Agency Chapter), p. 226.



the tasks which are not within the scope of their individual work, and the cost of such work will be borne by the partnership. However, if a partner employs a worker to do some of the tasks which were originally assigned to him, the resulting costs will be borne by him since the partnership contract is based on both funds and work, and the earned profits are the outcome of both these elements(6). Appointment of workers is conditional upon a genuine requirement for their services and that they should receive remuneration in accordance with this. d.Borrowing, lending, grants and charitable donations The partner may not borrow money on account of the partnership or lend money to a third party from the funds of the partnership, donate or grant money(7) except after securing the agreement of other partners. Rules of Musharaka termination In general, the partnership shall be terminated if one of the partners terminates the contract, or dies, if his legal competency ceases or if the partnership capital is lost. The majority of Fuqaha, except for Malikis, are of the opinion that as partnership is one of the permissible forms of contract, each of the partners is entitled to terminate it whenever he wishes, as is the case with agency contracts. The partnership is based on agency and probity. Each of the partners is a proxy for the others and a principal at the same time. He acts in respect of his share as a principal and in 6

277

It is permissible for one of the partners to propose that if profits exceed a certain amount, such excess or a percentage of it will be credited to him. It is stated in Al-Bahr AlZukhar Al-Gami lemathahib Ulamma’ AlAbsar that “if one of them (partners) says that I will have ten if we gain more than that then this will be valid and the condition will be binding as there is no exigency of revocation”(10). Rules of allocating profits among partners Fuqaha differ on the issue of allocating profits among the partners. Hereunder is a brief outline of their opinions: First opinion Profit should be divided among the partners in proportion to their contributed capital, whether the amount of work done by the partners is equal or not. This is the opinion of Malikis and Shafis and their argument is based on the grounds that profit is the return on capital, hence it must be proportional thereto. Preferential treatment in profit sharing combined with equality of capital contribution leads to a return on an amount that has not been committed. Second opinion Profit may vary between the partners if they make this a condition of the contract. This is the opinion of Hanafis and Hanbalis, and their argument is based on the proposition that profit is the

( ) Al-Zailaei’, Tabieen Al-Haqaiq Sharh Kanz Alhaqaiq, part 5, p.30. 7 ( ) Ibn Qudamah, Al-Mughnee, Vol. 5, p. 22. 10 ( ) Refer to: Ali Al-Khafeef, Companies in Islamic Jurisprudence, pp. 29,30; Al-Bahr Al-Zukhar Al-Gami’ Lemathahib Ulamma’ al Absar, part 4, p.82.



respect of his partners’ shares as a proxy, i.e., as an agent. In principle, agency is one of the unanimously permissible contracts and no one party is forced to proceed with it against his will. The partnership, too, should start with an agency relationship between the partners, and this relationship provides the basis for its continuity. If the agency relationship is severed by termination on the part of one of the partners, the legal basis upon which they acted in respect of each other’s funds will be eliminated(8). In the case of death, one of the heirs, if he is of sound mind, may replace the deceased provided that the other heirs and the other partners agree to that. This shall also be applicable in case one of the partners loses competency.

Rules of loss Fuqaha agree that loss should be divided between the partners in proportion to their respective shares in the capital. Fuqaha call this “wadhee’ah” (loss). They support this opinion by the following saying of Ali bin Abi Talib (may Allah be pleased with him): “Profit should be according to what they (partners) stipulated, and the loss should be proportionate to both funds”. Ibn Qudamah says “we know not of any difference in this matter among the scholars”(9). In the case of on-going concerns, it is permissible to defer the allocation of loss in order to be compensated 8

()

fruit of the interaction of funds and work. This is because one of the partners may be more experienced, tactful and discrete than the other, and hence it is permissible for him to require for himself an additional share of profit in return for his extra work contribution. The Hanafis and Hanbalis support this argument by following the saying of Ali bin Abi Talib (may Allah be pleased with him): “Profit should be according to what they (partners) stipulated, and the loss should be proportionate to both funds.” This opinion assists in considering the role of experience, tactfulness, courtesy and efficiency in achieving profit”(11). Based on the second opinion the net realized profits can be divided into two parts: a.profit is to be allocated according to the efforts of partners in doing the work. b.profit is it is to be allocated according to the share of each partner in the capital. It is also permissible to allocate a common share of profit to a third party whenever the partners agree to that, e.g., a share for the poor and the needy or to charitable organizations. It is also permissible to allocate part of profits as a reserve to support the future position of the partnership. 1/3/4

Ali Al-Khafeef, Companies in Islamic Jurisprudence, op. cit., p548.

9

( ) Al-Ainy, Al-Benaiyah Fi Sharh Al-Hedaiyah, op. cit., part 6, p.108; Ibn Qudamah, Al-Mughnee, part 5, p.37 (The case of : Wadi’ah should be proportionate to the amount of fund). 11

278

( ) Refer to: Ibn Rushd, Bidayat al Mujtahid wa Nihayat al Muqtasid, part 2, p. 253; Al-Khateeb, Mughni Al-Mohtaj Sharh Al-Manhaj, (Dar Ehia’ Al-Turath Al-Arabi, Beirut), part 2, p. 215; Ibn Qudamah, Al-Mughnee, part 5, pp. 30,31.; Mahmoud Bin Ahmed Al-Ainy al Benaiyah Fi Sharh Al-Hedaiyah, part 6, p. 108.



by the profits of subsequent periods.

9.4 Recognition of musharaka transactions and journal entries 9.4.1.Recognition of the Islamic bank’s share in Musharaka capital at the time of contracting The Accounting rules for recognition and measurement for Musharaka capital is similar to those of mudaraba except for losses. The following are some of the rules. (1) The Islamic bank’s share in Musharaka capital (cash or kind) is recognized when it is handed over to the partner or made available to the partnership under the title “Musharaka financing” in the balance sheet. (2)If the bank’s share is in the form of trading or non-monetary assets, it should be valued at fair value and any difference between the carrying amount of the assets in the bank’s books and the fair value is recognized as profit and loss in the income statement. (3) Normally, contracting expenses ( e.g. feasibility studies, legal expenses) are not recognized as part of the capital unless agreed by both parties.

8.4.2 Measurement of the Islamic bank’s share in Musharaka capital after contracting at the end of a financial period (4) In the case of constant musharaka the Islamic bank’s share in the constant Musharaka capital should be measured at the end of the financial period at historical cost (the amount which was paid or at which the asset was valued at the time of contracting). (5) However, if the musharaka is a diminishing (musharaka mutanaqqisa), then the he Islamic bank’s share in the diminishing Musharaka should be measured at the end of a financial period at historical cost after deducting the historical cost of any share transferred to the partner (such transfer being by means of a sale at fair value). Any difference between historical cost and fair value of the

279



portion of share sold shold be recognized as profit or loss in the Islamic bank’s income statement. (6) If the diminishing Musharaka is liquidated before complete transfer is made to the partner, the amount recovered in respect of the Islamic bank’s share shall be credited to the Islamic bank’s Musharaka financing account and any resulting profit or loss, namely the difference between the book value and the recovered amount, shall be recognized in the Islamic bank’s income statement. (7) If the Musharaka is terminated or liquidated and the Islamic bank’s due share of the Musharaka capital (taking account of any profits or losses) remains unpaid when a settlement of account is made, the Islamic bank’s share shall be recognized as a receivable due from the partner.

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IN CASH ISLAMIC BANK CONTRIBUTES CAPITAL EITHER OR IN KIND: TRADING OR NON MONETARY ASSETS

- Foxit Software

281

VALUED AT HISTORICAL COST

“MUSHARAKA APPEARS AS FINANCING” IN THE BALANCE SHEET

VALUED AT FAIR VALUE

INCOME STATEMENT PROFIT/LOSS FROM MUSHARAKA

X

ADD/(LESS) GAIN/LOSS FROM SALE OF MUSHARA SHARE AT FAIR VALUE

X

CONSTANT MUSHARAK A

MUSHARAKA FINANCING AT HISTORICAL COST X LESS ALLOWANCES FOR DOUBTFUL FINANCING (X) NET X

DIMINISHING MUSHARAKA

MUSHARAKA FINANCING AT HISTORICAL COST x LESS HISTORICAL COST OF SHARE SOLD TO PARTNER (X) LESS ALLOWANCES FOR DOUBTFUL FINANCING (X) NET X



9.4.3 Recognition of the Islamic bank’s share in Musharaka profits or losses (8)

Profits or losses in respect of the Islamic bank’s share in Musharaka financing transactions that commence and end during a financial period shall be recognized in the Islamic bank’s accounts at the time of liquidation.

(9)

In the case of a constant Musharaka that continues for more than one financial period, the Islamic bank’s share of profits for any period, resulting from partial or final settlement between the Islamic bank and the partner, shall be recognized in its accounts for that period when the profits are distributed; the Islamic bank’s share of losses for any period shall be recognized in its accounts for that period to the extent that such losses are being deducted from its share of the Musharaka capital.

(10)

The same as in (9) above applies to a diminishing Musharaka which continues for more than one financial period, after taking into consideration the decline in the Islamic bank’s share in Musharaka capital and its profits or losses.

(11)

If the partner does not pay the Islamic bank its due share of profits after liquidation or settlement of account is made, the due share of profits shall be recognized as a receivable due from the partner

(12)

If losses are incurred in a Musharaka due to the partner’s misconduct or negligence, the partner shall bear the Islamic bank’s share of such losses. Such losses shall be recognized as a receivable due from the partner.

(13)

The Islamic bank’s unpaid share of the proceeds as mentioned above shall be recorded in a Musharaka receivables account. A provision shall be made for these receivables if they are doubtful.

9.4.4 Disclosure requirements FAS 4, requires disclosure in the notes to the financial statements if the Islamic bank has made during that period a provision for a loss of its capital in Musharaka financing transactions. In practise, however, the banks provides for this in the balance sheet itself and this is more in line with international standards on asset impairment.

The following are the journal entries for Musahraka in the books of the Bank.

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No. 1

Transactions /Events DR Musharaka Financing Financing for Customers and Partners provided.

2

Termination or repayment Cash of capital by partner

3 Profit received from Musharaka 4 Loss on Musharaka Profit on sale of banks share in a 5 diminsing musahraka Amount outstanding from 6 partner at settlement

283

CR. Cash

Musharaka financing

Cash Profit and Loss Cash

Profit & Los Acc Musharaka Financing Musharak Financing Profit and loss acc.

Account Receivable

Musharaka Financing

9.5 Asset and Liability and income measurement Presentation and Disclosure of Musharaka Financing Balance Sheet Musharaka Financing* Less: Provision for loss in Musharaka Financing Net Musharaka Financing * Jointly or Self finance Assets INCOME STATEMENT Musharaka income

XX (XX) XX

XX



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9.6 Accounting Illustration Accounting Problem 8-1 Bank Syari’ah Malaysia Berhad has provided working capital to Tijarah Construction Sdn. Bhd. based on the principle of Musyarakah Mutanaqisah amounting to $400,000. Profit and loss sharing ratio as agreed by both parties is similar to the ratio of capital contribution which is 30:70 (Bank: Customer) at the beginning of the contract. The repayment shall be equal throughout the contract period of four years. However, Tijarah Construction had financial difficulties during year 2 and thus only managed to pay 50% of the agreed repayment amount. Half of the amount outstanding in year 2 has been paid in year 3 and another half was paid in year 4. Tijarah Construction also experienced financial difficulties in year 4 whereby the scheduled repayment outstanding at the end of the year was amounting to $35,000. The profit and loss for the above project is as follows: Year 1 Year 2 Year 3 Year 4

Profit Loss Profit Loss

RM 180,000 RM 150,000 RM 220,000 RM 80,000

Required: Prepare extract of journal entries from the beginning until the end of the contract to record the recognition of asset and profit/loss of Musyarakah Mutanaqisah financing provided by Bank Syari’ah Malaysia Berhad based on the following recognition methods: (i)Cash basis (ii) Accrual basis Comment on your answer in part (a) above. (IIUM B.Acc, semester 2, 2004/2005, Q2)



Solution 8-1

a. Cash basis Year 1 Dr. Musyarakah mutanaqisah Financing Cr. Cash

400,000 400,000

Dr. Cash Cr. Musyarakah mutanaqisah Financing

100,000

Dr. Cash Cr. Profit and loss

54,000

100,000

54,000

Year 2 Dr. Cash Cr. Musyarakah mutanaqisah Financing

50,000

Year 3 Dr. Cash (100,000 + 8,125) Cr. Musyarakah mutanaqisah Financing

108,125

50,000

108,125

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Accrual basis Year 1 Dr. Musyarakah mutanaqisah Financing Cr. Cash

400,000 400,000

Dr. Cash Cr. Musyarakah mutanaqisah Financing

100,000


54,000

100,000

54,000

Year 2 Dr.Cash (1/2 agreed repayment ) Dr. Profit and loss ( 150,000 x 0.225) Dr. Receivable Cr. Musyarakah mutanaqisah Financing

50,000 33,750 16,250 100,000

Year 3 Dr. Cash ( 100,000 + 8,125) Cr. Musyarakah mutanaqisah Financing Cr. Receivable

108,125


33,000

Year 4 Dr. Profit and loss Dr. Cash Dr.Receivable ( 35,000 – 6,000) Cr. Musyarakah mutanaqisah Financing

Dr. Cash Cr. Receivable

100,000 8,125

33,000

6,000 65,000 29,000 100,000

8,125 8,125

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Comments: (i)Different basis of recognition ( i.e cash vs. accrual ) will lead to different amount of profit recognized. (ii)Accrual basis will lead to more complex recognition of profit / income . (iii) When there is a loss, it needs to be set-off against the amount due to the financing repayment. (iivWhen the partner faced financial problem and did not pay as scheduled, accrual basis require allocation of repayment after taking into account profit and loss for that year. (V)Accrual basis would provide true and fair reflection of profit /loss than cash basis.


MCQ 9-1

287



Question 9-1

In July 2001 Mandiri Agricultural Bank (an Islamic bank) signed a diminishing Musharakah contract with Sahid agricultural corporation. Total capital for the transaction was RM80,000 provided by the partners in the following proportions: Capital Contributions: Mandiri Agricultural Bank Sahid Agricultural Corporation

70% 30%

Bank contribution was paid at the time of contracting as follows: Cash (credited to customer A/C) RM25,000 Agricultural Machinery (physically delivered to customer)

RM31,000 (book value RM35,000) The bank and the customer agreed to share profits (or losses) as follows: In case of profits:

Customer share (for managing the transaction)

10%

Customer (for capital contribution)

30% (of the balance of profits)

Bank (for capital contribution)

70% (of the balance of profits)

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In the case of losses it was agreed that the bank and the customer would share them 70% and 30% respectively. It was also agreed that the customer would gradually buy the bank share in the joint venture. At the end of year 2001 operating profits generated by the transaction were $19000. The bank share of profit was still outstanding by the end of 200 1. The customer settled this amount on the 15th of February 2002. In addition to this payment the customer paid $18000 in cash as a price for 25% of the bank share in the venture. Year 2002 was a bad one. Due to rain short-fall and other reasons Sahid Agricultural Corporation suffered a lot. The operating result for the year ending 31 st of December 2002 was a loss of $10,000. The bank share in this loss was immediately credited to its Musharakah financing asset account. Moreover, the bank agreed to sell 25% of its remaining share in the venture to the customer for $8,000. The customer immediately settled this amount in cash. Due to the apparent risks the bank was facing a provision equal to 50% of the balance of the Musharakah financing account was created for the purpose of the fmancial reports at the end of the year. Required: 1. Calculate the profit sharing results at the end of200l and 2002. 2. Record the Journal entries for the Musharakah in the books of the bank for the year 2001 and 2002. 3. Show the effects of the Musharakah transaction on the Financial Statements of the bank (Income Statement and Statement of Financial Position) at the end of2001 and 2002. ( AIA, Professional Examination II, 2004,Q 2)

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Question 9-2

Bank Muamalat Bhd. Entered into a Musharakah agreement with Ali, a Muslim entrepreneur providing capital of RM400,000 on 1st of Muharram 1422. Ali provided a capital of RM600,000. Since Ali was the managing partner, it was decided that the profit sharing ratio of the Musharakah venture was 30:70 (30 for the bank).The financial year was to follow the Hijra calendar year. The profit and loss for the above venture was as follows: Year 1 Profit of RM100,000 Year 2 Loss of RM50,000 Year 3 Profit of RM 120,000 Year 4 Loss of RM60,000 Year 5 Loss of RM 200,000 The bank’s share of the profits in year 1 and year 3 was duly paid to the bank at the last day of the financial year. At the end of year 5, the bank decided to terminate the agreement and it was agreed that the loss of RM100,000 of the RM200,000 in year 5 was due to the negligence of Ali. At the end of the year 5, Ali had still not paid the balance due from him. Zakat at 2.5% was to be paid on the profits by each partner on his share of the profits by himself. Required: (i)

Prepare an extract of the income statements and the balance sheets of bank muamalat for the above 5 years. (include zakat)



(ii)

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If the venture was a mudharaba (the bank being rabbul maal) and the profit sharing ratio was 60:40 for bank and Ali respectively with the capital of the bank still at Rm400,000. Ali commingled the RM400,000 and his own capital (RM600,000). Mudharaba venture profits or losses to be apportioned in proportion to capital contributed, prepare journal entries for the above transactions (excluding zakat ) for the above 5 years.

Question 9-3

Ali entered into a mudaraba agreement with Bank Mualamat Bhd who agreed to provide RM300,000 financing. Profit sharing ratio between Ali and the bank in the ratio 4:6 respectively. Profits and losses for the first 4 years of the agreement were as follows: Year 1 Year 2 Year 3 Year 4

Loss Profit Profit Profit

RM100,000 RM 50,000 RM80,000 RM100,000

The banks share of profit in any year was paid to the bank in the subsequent year. At the end of year 4 It was agreed to convert the Mudharabah to a Musharakah with Ali putting in RM100,000 as capital. The banks share of profits for year 4 was not remitted to the bank but was ploughed back to the new musharaka in addition to the balance of the bank mudharaba capital at end of year 4. The new profit sharing ratio was Ali 60%, Bank 40%. The results of the musharaka venture was as follows:

Year 5 Year 6 Year 7 Year 8 Year 9

Profit Profit Loss Profit Loss

RM150, 000 (1st year of musharaka) RM100, 000 RM 50, 000 RM 30, 000 RM150, 000



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The bank decided to terminated the musharaka agreement at the end of year 9 (5th year of of musharaka). It was agreed RM50,000 of the RM150,000 loss was due to the negligence of Ali and should be compensated to the bank. One year later Ali had still not returned the remaining capital to the bank. The management of the bank is of the opinion that the recovery of the capital is doubtful. You are required to: a. Provide Ledger T for all the relevant accounts for the transactions up to year 10 b. An extract of the balance sheet and income statement up to year 10. ( IIUM B.Acc, mid term sem 2 2004/2005, Q3 )


Chapter 10.Accounting for Ijarah

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Said one of the (damsels): "O my (dear) father! engage him on wages: truly the best of men for thee to employ is the (man) who is strong and trusty".... Al-Qasas (The Narration) [28:26]

..‫ ﻗﺎل ﻟﻮ ﺷﺌﺖ ﻟﺘﺨﺬت ﻋﻠ أﺟﺮا‬، ‫ﻓﻮﺟﺪا ﻓ ﺎ ﺟﺪاراً ﺮ ﺪ أن ﻨﻘﺾ ﻓﺄﻗﺎﻣ‬... They found there a wall on the point of falling down, but he set it up straight. (Moses) said: "If thou hadst wished, surely thou couldst have exacted some recompense for it!" Al-Kahf (The Cave) [18:77]

Chapter

10

CHAPTER LEARNING OBJECTIVES: At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv. v.

Explain the meaning of ijarah and how this contract is used by Islamic banks to finance customers List the principles of ijarah and as well as explain the shari’a rules. Journalize accounting entries for ijarah. Prepare the balance sheet and income statement extracts for ijarah transactions Apply shari’a and accounting principles as per FAS 8 to solve accounting problems for complex events.


Chapter 10.Accounting for Ijarah 10. 1 Introduction The word al ijarah or simply ijarah comes from the word ajr meaning reward or wages for word done or services rendered. The technical meaning in fiqh means a contract for hire of persons or services or “usufruct” of a property. From the Islamic banking point of view, al ijarah usually refers to a Islamic leasing contract of land, property or equipment which are leased to a client for a stream of rental payments.

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u·su·fruct : the legal right to use and enjoy the advantages or profits of another person's property

There are two types (rather three) types of ijarah contacts in use: (i) al ijarah (tashghiliyah) - operating ijarah (ii) al ijarah muntahia bitamleek – ijarah with option to transfer ownership of asset to lessee, and in Malaysia, (iii) a composite contract; Al ijarah thumma al-bai’ (ijarah followed by sale) is practiced. From a conventional banking point of view, the finance lease is preferred by banks who want to concentrate on the financing and not on the operational complexities of leasing, hence, they transfer substantially all the risks and rewards of ownership of the leased asset to the client. Following the substance over form convention (on which we have noted AAOIFI’s silence), the asset is booked in the clients books and not the banks who treat the financing as receivable. From a shari’a point of view, there is no such thing as a finance lease. Anything which separates the physical transaction from its financial aspect, making the transaction a loan is treated as ribawi and thus prohibited. Further it is normally not possible to transfer all the risks and rewards of ownership of the asset, although some fuqaha allow this. Hence, the leased asset should be recognized and depreciated as asset owned by the Islamic bank and the rentals receivable treated as income. Thus, this proves to be major problem for Islamic banks who want to follow IFRS, IAS17, which requires all financial leases to be treated as a receivable with the principal and interest portion separated.



10.2 Definition and financing model of Ijarah

Definitions Ijarah Ijarah is the transfer of ownership of a service for an agreed upon consideration. According to fuqaha, it has three major elements: • a form, which includes an offer and a consent. • two parties: a lessor (the owner of the leased asset), and a lessee (the party who reaps the services of the leased asset) • the object of the (Ijarah) contract, which includes the rental amount and the service (transferred to the lessee). Operating Ijarah Ijarah contracts that do not end up with the transfer of ownership of leased assets to the lessee. Ijarah Muntahia Bittamleek Ijarah contracts that end up with the transfer of ownership of leased assets to the lessee. Ijarah Muntahia Bittamleek may take one of the following forms: a) Ijarah Muntahia Bittamleek that transfers the ownership of leased assets to the lessee – if the lessee so desires – for a price represented by the rental payments made by the lessee over the lease term. At the end of the lease term and after the last instalment is paid, legal title of leased assets passes automatically to the lessee on the basis of a new contract. b) Ijarah Muntahia Bittamleek that gives the lessee the right of ownership of leased assets at the end of the lease term on the basis of a new contract for a specified price, which may be a token price. c) Ijarah agreements that gives the lessee one of three options that he may exercise at the end of the lease term: • purchasing the leased asset for a price that is determined based on rental payments made by the lessee, • renewal of Ijarah for another term, or • returning the leased asset to the lessor (owner).

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Fair value of leased assets Fair value is the amount for which an asset could be exchanged between well informed, willing parties (seller and buyer) in an arm’s length transaction. Useful (service) life Useful (service) life of leased assets is (a) either the time period over which these assets are expected to render services, or (b) the number of output units expected to be obtained from these assets. Residual value Residual value of leased assets is the amount which is expected to be obtained for these assets at the end of their useful (service) life, net of the expected cost of disposal. Residual value of leased assets is to be estimated at the inception of the lease

1

4

2 3

Fig. 10.1 Ijarah Transaction The above diagram shows a normal ijarah transaction. The bank (in the middle) pays (1)the manufacturer or vendor the price of the product (in this case , a car) to be leased. The vendor normally delivers the car ( 2 and 3)straight to the bank’s ijarah customer. The customer then makes a series of rental payments over the term of the ijarah contract (4). If its is ijarah muntahia bitamleek, the bank sells the car to the



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customer at the end of the ijarah term. If not, the car is returned to the bank to be released or disposed. Some banks such as the Kuwait Finance House, have warehouses where they buy the cars and store them.(They are already assets on the bank’s balance sheet). The customer goes to the warehouses and chooses a car and the financing package. Once the legal formalities are carried out and the initial deposits, installments are paid, the customer gets possession of the car. However, the normal financing transaction done by the bank is ijarah muntahia bitamleek where the ownership of the assets is subsequently transferred to the customer by the end of the ijarah. These can be done in a number of ways according to the shari’a. Please see the following figure (10.2).



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Ijarah Muntahia Bitt Tamleek

Gift At the end Of period

Token sale consideration At the end Of period

Sale at specified amount

Sale during the lease period for the remaining installments

Gradual transfer during lease period

Fig 10.2 Different types of Ijarah muntahi bi tamleek In Ijarah Muntahia bittamleek , the ownership of the asset can be transferred to the lessee by means of: (i) Gift at the end of the period of the ijarah. This means the ownership of the asset is transferred to the lessee for no consideration by entering into a gift contract in fulfilment of a prior binding promise (made at the inception of the ijarah contract), upon the settlement of the last lease rental payment. The title can also be transferred through a gift deed which is conditional1 on the completion of all ijarah rental payments (i.e. installments). (ii) Sale for a token consideration at the end of the ijarah contract. In this case, initially there is a ijarah contract and a promise to sell by the lessor if the lessee wishes at a token consideration. The consideration can be any agreed amount between the parties. Note: In cases (i) and (ii), in substance, the ijarah rentals would include a portion of the capital cost of the asset which wil result in higher rentals as opposed to an operating ijarah. In this case, if the asset is not transferred at the end of the ijarah, and the asset is not impaired and the lessee has fulfilled his other obligations, the fuqaha agrees that the rent should be adjusted to a fair amount and the balance refunded to the lessee. 1

There is a difference of opinion whether a gift contract can be conditional. Only the Maliki school and the Abadeiyah sect.



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(iii) Sale at the end of the lease for an amount specifed in the lease. This is done through an ijarah contract together with a promise to enter into a sale contract. The sale contract will include the amount to be paid after the expiry of the ijarah period. (iv)Sale of the asset at any time during the period of the lease for an amount equal to the remaining installments. In this case, an ijarah contract is executed together with a promise to sell the the asset to the lessee, whenever he wishes to buy the asset during the period of the lease for a price equal to the remaining installments.. When the lessee exercises the option to buy, the bank will execute a sale contract. (v)Sale through gradual transfer of title. This is executed through an ijarah contract with a promise to gradually transfer the title of the asset to the lessee until the asset is fully transferred. In this case, the price need to be determined so that a proportionate share is tranferred at every period. There needs to be a sale contract for each transfer and a reduction in lease rental as the ownership of the bank decreases. In case the ijarah contract is revoked prior to complete transfer, the property will be jointly owned by the bank and the ex lessee. Sale and Leaseback: This is a common practice. From a shari’a perspective, it is not prohibited provided that the two contracts are not conditional upon on another. However, one of the parties may make a promise to lease to or from the other.

10.3 Ijarah fiqh principles, rules and complexities 10.3.1

Elements of Ijarah According to the majority of fuqaha, there are three general and six detailed elements of Ijarah: • The wording: This includes offer and acceptance. • Contracting parties: This includes a lessor, the owner of the asset, and a lessee, the party that benefits from the use of the asset. • Subject matter of the contract: This includes the consideration (rent) and the benefit from the use of the asset. It should be noted that the benefit from use of the asset is the subject matter of the contract, because it is the element to be satisfied in return for the rent. Hence, it is the benefit of using the asset which is guaranteed rather than the asset itself. The latter is not the subject matter of the contract, although the Ijarah contract treats it sometimes as a subject matter and a



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source of the benefit. (2)

For example, it is commonly stated: “I hereby rent out this car to you” . 10.3.2 Execution of Ijarah The basic rule of the Ijarah is that it should be executable. If the commencement of the contract is not stipulated, then the Ijarah will start from the time of the contract and will be executed as from that time. An Ijarah contract according to which execution of the contract is deferred to a future date is valid.. However, such a case is considered by the Hanafis as a non-binding contract, , it is considered permissible to enter into an Ijarah contract to lease an asset for a second year to the same lessee as the first year before the expiry of the first year’s (3) contract . Making Ijarah contingent on a future event or a condition The majority of fuqaha have agreed that Ijarah, like sale, cannot be made contingent on a future event or a condition. But Ibn-Taimeyah and Ibn Al-Jawzeiyah are of the opinion that making Ijarah contingent on any future event or condition is (4) considered permissible . Contracting Parties To enter into a contract, both contracting parties should be of sound mind and judgement. There is agreement that Ijarah cannot become valid unless the contracting party is a competent person who is qualified to dispose of funds. For a contract to be valid, it should have the mutual consent of both contracting parties. For the purpose of enforceability, the contracting party to whom the offer is made should have the authority to act in order to create a contract. This is according to both Hanafis and Malikis who are of the opinion that the authority to act is a condition for enforceability. Subject matter The subject matter of Ijarah is the benefit (the use of the asset) and the rent. These are discussed below.

Benefit: It consists of two parts 2

al Jazaire, al Fiqh ala al Mathahib al Arba’a, Vol.2, p.98.

3

Nawawi, Manhaj at Talibeen, p.67; al Fatawa al Hindia by a number of Indian fuqaha, Vol. 4, p.410; al Dardeer, al Sharah al Saqueer, Vol.4, p.30; al Bahwati, Kashaf al Qana’, Vol.4, p3. Gadi Zada, Nata’ej al Afkar, Vol.7, p.210; Rejabati, Matalib Oli Annoha, Vol.3, p77; Ramli, Nehaiat al Muhtaj, Vol.5, p.295, p.260; Ibn Rusd, Bidayat al Mujtahid, Vol. 2, p.135; Ibn Qudamah, al-Mughnee, Vol.5, p.375.

() () 4

()



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a) The contract should include the use of a benefit of a specified asset, for example, one person says to another: “I hereby lease you this house”, or the use of a benefit of an asset whose specification is accepted based on the lessor’s description, for example, “I hereby lease you a house the specification of which is so and so”. (5)

b) The contract should include a known act . Conditions of the Benefit Benefit should fulfil the following conditions: a) The benefit of using the asset, not the use of it as such, should be the subject matter of the Ijarah. This is a matter of agreement between the fuqaha. b) The benefit should be subject to valuation and intended to be fulfilled in the contract because no agreement can be concluded on what is considered permissible but does not have a price. Spending money in such a way is considered profligacy. c) The fulfillment of the benefit should be of a permissible nature. d) Ability to fulfil the benefit should be real and in accordance with Shari’a. e) The benefit should be identified in such a way as to remove lack of knowledge (6) (Jahala) which leads to dispute . Fuqaha are in agreement that lack of knowledge (7) which leads to dispute nullifies the contract . Specification of the benefit The benefit is specified by stating the subject matter or the duration. It may also be identified by specification or physical identification. The condition of specifying the subject of benefit has led to the division of Ijarah into (a) Ijarah of assets whereby the benefit is fulfilled from a particular asset. In this type of Ijarah if the asset is impaired, then the Ijarah becomes nullified, for example, the leasing of a particular house to live in. (b) Ijarah whose specification is accepted based on the lessor’s description. In this type of Ijarah the benefit is fulfilled from what is specified by description. If the benefit of the asset is impaired after it has been specified and used for some time after the contract became effective, the lessor will provide a replacement. Rent

5

() 6 () 7 ()

al Jazaire, al Fiqh ala al Mathahib al Arba’a, Vol. 2, p.99. Ibn Rushd, Bidayat al Mujtahid, Vol. 2, pp.180-223. al Fatawa al Hindiyah, Vol.4, p.41; al Kasani, Badaie’ as Sanaie, Vol.4, p.180; al Mirghinani, Hidayah, Vol.3, p.232; Ibn Rushd, Bidayat al Mujtahid, Vol.2, p.80; Sherazi, al Muhathab, Vol.1, p.398; Ibn Qudamah, Al Mughnee, Vol. 5, pp.375-368, 1389H. edition.



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Rent is what the lessee is committed to pay as a consideration for the benefit enjoyed by him. Everything that is suitable to be considered a price in a sale can be suitable to be considered as a rent in an Ijarah. The majority of fuqaha have said: “the conditions (8) applicable to price are also applicable to rent” . Rent should be known. This is in compliance with the saying of the Prophet, (Allah’s blessings and peace be upon him): (9) “he who hires a worker should inform him of his wage” . If the benefit is fulfilled and (10) the rent was not determined, the rent for a similar benefit should be paid . Paying the rent in the form of services (another benefit) The majority of fuqaha have permitted the payment of rent in the form of a benefit of the same kind of the subject of the contract. Flexibility in determining the rent Rent can be determined in terms of time, place and distance. For example, one person says to another: “if you sew me this dress on this day, its charge will be one dirham and if you sew it tomorrow, the charge will be half dirham, and if you live in this house as a blacksmith you will be charged ten and if you live as a (11) perfumer, you will be charged five, and so on” . Entitlement of the rent and its due time The Hanafis and Malikis are of the opinion that entitlement to the rent does not become a right as per the contract itself. Rather, entitlement to the rent becomes a right by fulfilling the condition in the contract or by fulfilling the subject matter of the contract. The Hanafis added the condition of accelerating the actual payment of the rent by the lessee. Shari’a characterisation of the advance payment of rent Receipt of an advance payment is not prohibited in Shari’a, but only on the basis that it is an advance payment on account from the amount of the rent. It should not, however, be considered (in terms of the relationship with the lessee) as a profit on the lease, as this is an internal affair of the lessor. This is because, from the Shari’a point of view, the rent consideration is an indivisible amount which should not be divided into a principal and a profit. From a Shari’a perspective, profit is only viewed as the 8

al Dardeer, as Sharh as Sagheer, Vol. 4, p.59; Ramli, Nehaiat al Muhtaj, Vol. 5, p.322, Ibn Qudamah, Al Mughni, Vol. 5, p.327; al Fatawa al Hindiyah, Vol. 4, p.42; AlMusali; Al Ekhtiar, Vol. 2, p.5, al-Halabi edition. ( ) Narrated by Al-Baihaqi from Abi Huraira. 10 ( ) al Fatawa al Hindiyah, Vol. 4, p.42; al Musali, al Ekhtiar, Vol. 2, p.507, al Halabi edition. 11 ( ) al Jazaire, al Fiqh ala al Mathahib al Arba’a, Vol. 2, p.120; al Qabawi, Rafeeq al Asfar (abstract of Hashiat ibn Abdeen), 224. al Jazaire, al Fiqh ala al Mathahib al Arba’a, Vol. 2, p.120; al Qabawi, Rafeeq al Asfar (Abstract of Hashiat Ibn Abdeen), 224. () 9



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result of a transaction of purchase and sale of a commodity for an amount in excess of its cost. In Ijarah, however, the whole consideration is a rent which can be accelerated or deferred in whole or in part (provided that it is a portion of the whole rent). It can also be paid in instalments or deferred until after consuming the benefit from the leased asset.

Lessor’s obligations a) Making the leased asset available The lessor is obliged to enable the lessee to benefit from the leased asset by making it available throughout the duration of the lease. Making the asset available includes equipping and preparing the asset in the manner which – according to normal practice – is considered necessary in order for the specified benefit to be enjoyed. Making the asset available also entails enabling the lessee to enjoy the benefit of the leased asset. However, if anything happens during the period of the lease that prevents the lessee from enjoying the benefit of the leased asset, for a reason not attributable to the lessee, then the lessor is obliged to rectify the situation. For example, repairing the leased house or removing all matters leading to inconvenient housing. b) Guarantee in respect of defects In Ijarah, the option of defect is treated as in sale. The defect which entitles a lessee to an option is one which causes an impairment in the benefits which are the subject of the contract. The same applies if the defect occurs before fulfillment of the benefit but after the contract is concluded. In either case, the lessee shall have the option of revoking the contract or accepting the impaired benefit while being obliged to (12) pay the full rent . However, there are some fuqaha who are of the opinion that a portion of the rent should be deducted for the defect. c) Maintenance of the leased asset (see 1/6) Lessee’s obligations Utilisation of the leased asset is determined according to the conditions of the contract

12

( ) Mula Khasro, Sharh Addor, Vol. 3, pp.78-279; al Mahbobi, Kashf al Haqaeq wa Sharh al Weqaiah, Vol. 2, p.65; Sherazi, al Muhathab Vol. 2, p.405.



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or according to practice. The lessee is also responsible for keeping the leased asset (13) intact and for payment of the rent . Fuqaha agree that the leased asset is a trust in the hands of the lessee. However, if the leased asset is impaired without omission, violation of what is permitted, or negligence in keeping it intact on the part of the lessee, then he is not to be liable for such impairment because whilst the lessee is permitted by the lessor to enjoy the benefit of the leased asset, he is not to be held as a guarantor for the leased asset. Maintenance of the leased asset In principle, it is not considered permissible to stipulate in the contract that the maintenance of the leased asset is to be carried out by the lessee because this would lead to the lessee paying a rent that includes an unknown element. According to the schools of fiqh, this condition renders the Ijarah contract void. If the maintenance condition is included in the contract and the lessee has benefited from the leased asset, he should pay the fair rental amount and be reimbursed for what he spends on maintaining the building. In addition, the lessee is entitled to be paid the equivalent fair wage and expenses incurred in carrying out the work of maintenance if that was done by permission of the lessor. If he does the work without the lessor’s permission, then this will be considered to a be a gift on his part and he cannot claim any (14) reimbursement . The lessor should also maintain the asset and carry out all repairs that would make it suitable for use. If he refuses to do so, according to the opinion of the majority of fuqaha, the lessee shall be entitled to revoke the contract unless he leased subject to (15) that condition . However, the lessee can be asked to carry out the maintenance based on the following: a) To carry out the operating maintenance which is required as a result of using the leased asset and is needed in order to ensure its continuous utilisation (for example, oils needed for machines and equipment). b) Periodic maintenance which is required to enable the asset to continue providing the benefit. c) Maintenance that is specified in description and amount in the contract or according to practice whether such maintenance is merely work or involves the use of known materials or spare parts because this type of work is considered as rent taken 13

( ) al Fatawa al Hindiyah, Vol. 4, p.470. 14 ( ) al Fatawa al Hindiyah, Vol. 4, p.443; al Bahwati, Kashaf al Qena’, Vol.4, p.16; Ramli, Nehaiat al Muhtaj, Vol. 5, p.264265; Hashiat ad Dasouqi, Vol. 4, p.47; Sharh Al Kharshi, Vol.7, p.47; al Dardeer, as Sharh as Sagheer, Vol. 4, p.63. 15 ( ) Mula Khasro, Sharh Addor, Vol. 2, p.300; Hashiat Ibn Abidin, Vol. 5, p.66; Sherazi, al Muhathab, Vol. 1, p.401.



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into consideration. Revocation of Ijarah for a justifiable reason Hanafis are of the opinion that it is considered permissible to revoke an Ijarah contract unilaterally for a reason relating either to a contracting party or to the asset itself, without the contract remaining binding. In this case, revocation is valid because it becomes necessary when there is a reason, otherwise if the contract remains binding, the party having the reason will be disadvantaged by something he did not agree to in the contract. Hence, permitting revocation of the contract in such cases is meant to prevent any one of the two parties from being forced to suffer a damage to which he did not agree. 2. Ijarah Muntahia Bittamleek

(16)

Forms of Ijarah Muntahia Bittamleek

(17)

Ijarah Muntahia Bittamleek has many forms that focus on what the two contracting parties have agreed upon and what they have intended to achieve from such contracting, for example, lease or sale, Ijarah and a promise to sell, the rent they have specified in the Ijarah, the cost of the goods in the sale transaction, and the time at which the legal title is transferred.

16

( ) Meeting of Investment Managers (Ijarah), a paper presented by the Islamic Bank of Jordan. 17 ( ) Paper of the Islamic Bank of Jordan, Meeting of Investment Managers (Ijarah) Amman.



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10.4 Recognition of Ijarah transactions and journal entries Accounting issues on Ijarah and Ijarah muntahia bitamleek • Recognition of Asset and Liability in the books of lessor and lessee. • Recognition of Profit/ Income or Loss/ Expense • Valuation of Asset • Disclosure

10.4.1 Recognition and Measurement of Ijarah Financial Accounting Standard No. 8 (FAS 8) sets out the accounting rules for recognizing, measuring, presenting and disclosing ijarah and ijarah muntahia bittamleek transactions of Islamic Financial Institutions. The standard covers acquisition of ijarah assets, leasing of the assets, ijarah expenses and revenues, gains and losses including Balance Sheet presentation.

3a initial expenses

1. Acquisition of Assets

2. leasing of assets

3.Expenses & Revenues

4. Disposal Gains /losses

Fig 10.3 Accounting Processes in Ijarah (as Lessor)

3a Depreciation & Maintenance

3c Ijarah Revenue



No.

Transactions /Events Purchase of Ijarah Assets

DR Equipment

Leasing of Ijarah Assets

Investments in Ijarah Assets

CR. Cash

1

2 3

Expenses incurred by lessor

4 Depreciation of Ijarah Assets 5

Ijarah Rental received

Cash Ijarah Expenses Depreciation Expense Accumulated Depreciation Profit and Loss Cash Cash

6 5. 6

Disposal or sale of ijarah assets Immaterial direct costs Material Direct Costs

Equipment

Expense Deferred Cost Profit and Loss

Investment in Ijarah Assets Profit and Loss (if gain) cash Cash Deferred Cost

Operating ijarah In the books of the lessor: (1) Assets acquired for Ijarah Assets acquired is recognized at historical cost. This includes net purchasing price + all expenses necessary to bring the asset to bring the asset to intended use. Examples of expenses are custome duties, teaxes, freight, insurance, installation, testing. If there is a permanent reduction in the estimated residual value, this reduction is recognized as a loss in the respective financial period. Leased assets is depreciated on a basis consistent with lessor’s normal depreciation policy for similar assets.(This requirement is currently being reviewed as a result of feedback from industry who wants the depreciation term to be the economic life of the asset i.e. the lease term. Leased assets in the financial statements as Investments in Ijarah assets.

307



308

(2) Ijarah Revenue Ijarah revenue should be allocated propotionately to the financial period of the lease term. Ijarah revenue is presented in the income statement as ijarah revenue. (3) Direct initial cost If material, should be written off as incurred. If material,shold be allocated over the lease period consistent with lease revenue pattern. (4) Repairs of leased assets Repairs necessary to secure the services of the leased assets, if immaterial, should be written off in the period, while if repairs are material and varied, a provision is set up by regular charges to income. If lessee undertakes repairs with lessor’s consent and they are chargeable to lessor, then it shall be expenses in the financlal period and a payable set up for amount owed to lessee. (5) At the end of the financial period Amotization of initial material direct costs, cost of repairs to be charged against provision, depreciate assets, ijarah installments receivable to be at cash eqivalent.

Accounting Problem 10-1 Operating Ijarah in the books of the lessor

On 20thth June, 2007, Shumul Bank of Bahrain BSC, brought 10 proton Gen 2 cars from the Malaysian manufacturer at a cost of $10,000 each. The freight costs from Malaysia to Bahrain was $20,000 and loal handling and transport costs to the Bank’s warehouse $3,000 with another $2,000 registration costs for the cars. Shumul Bank will lease the cars on various terms to its customers. At the end of the year, due to newer comparable models of cars coming from mitsubishi, the value of the cars dropped by 20%.of its original cost.



During the year, shumul bank managed to lease all its cars on operational ijarah contract for two years with monthly rental of US$500 per car to Bahrain Islamic bank BSC payable ½ yearly in advance, starting 1 July 2007. During the year it received two payments on account, the second one on 31st December 2007. The legal costs of the ijarah amounted to $5,000 which Shumul and the customer agreed to share equally. The bank considered considered the legal costs immaterial. Under the terms of the ijarah, Shumul Bank will be responsible for takaful premiums on the car (theft, fire and collision damage) which amount US$200 per year per unit, while the customer was responsible for 3rd party damage takaful, regular maintenance and fuel. The takaful premium for a whole yea on theft etc was paid by the bank on 1st July, 2007. On 1st of October, the manufacturer recalled the cars for some major repairs to be undertaken on proton gen 2 cars. Shumul Bank requested the customer to send in all the cars to the manufactuer for repairs. The cars were handed back to the customer on 31st October. Shumul Bank depreciates its Motor vehicles on a straight line basis over five years with nil residual value and its financial year end is on 31st December. Assets held for less than ½ month are not depreciated for the month. Required in the books of the Shumul Bank. (i) Journalize the necessary entries. (ii) Prepare an extract of the balance sheet and income statement of Shumul bank at 31st December 2007 related to the above transactions. (iii) Comment on the profitability of the ijarah contract.

Answer: Shumul Bank BSC Journal Entries Dr Motor Vehicles for Ijarah (10000*10)+20000+3000+2000 Cr Cash

125000 125000

309


Chapter 10.Accounting for Ijarah Purchase of 10 units of proton gen 2 for ijarah. Dr Investments in Ijarah Assets Cr Motor Vehicles for Ijarah Motor vehicles leased to Bahrain rent a car

125000 125,000

Dr Legal Expenses Cr Cash (being legal expenses on ijarah 1/2 of $5000)

2500

Dr Takaful expenses Dr Prepaid Takaful Cr. Cash

1000 1000

2500

Cash

Dr Cash Cr. Ijarah Revenue rental received on 1st july

2000 30000

Dr Cash 30000 Advance Ijarah Rentals Ijarah rentals for the next fiscal year in advance. Dr, Profit and Loss 25000 Investments in Ijarah Assets Asset impairment, loss in value of cars. (125000 x 20%) Dr. Depreciation 10000 Acc. Depreciation Depreciaton on impaired value of ijarah assets for 6 months.

30000

30000

25000

10000

Dr Rebate on Ijarah Rental 5000 Cr Cash 5000 Refund of rental for one month to customer for denial of usufruct per fiqh rules.($500x10units)

Shumul Bank BSC balance Sheet as at 31st December 2007 Investments in Ijarah Assets Less impairment on assets Gross Asset value Less Depreciation

125000 (25000) 100000 (10000) 90000

310



Prepaid Takaful

1000

Liabilities Ijarah Revenue in Advance

30000

Income Statement for the year ended 31st December 2007 Ijarah Revenue less asset impairment takaful premium legal expenses depreciation Rebate on ijarah rental Loss on ijarah

30000 25000 1000 2500 10000 5000 43500 (13500)

(iii) Although the ijarah contract shows a loss of $13500 in the first six months, this was due to unexpected impairment of $25000 and initial expenses of $2500 and the rebate due to the product defect problems. InshaAllah, if this misfortunes do not occur in the next financial period, the bank should make a profit of $60,000$20000(dep)-2000(takaful premium)=$38000. In the books of the bank as lessee. In the books of the lessee, the ijarah installments are recognized as an expense under the accrual concept over the term of the ijarah and presented as ijarah expenses. intial direct costs , if material, may be allocated over the lease period, otherwise they are written off. Accounting Problem 10-2 Operating Ijarah in the books of the lessee

Facts are same as in illustration 10-1, except that the initial direct costs are treated as material by Bahrain Islamic Bank (BIB)and the BIB paid $100 per car per year on third party takaful and $600 in 2007 and $1000 in 2008 for maintenance of the cars. Journalize the required entries and show the financial statements extracts for the year ended 31st December 2007 and 2008.

311



312

Bahrain Islamic bank Journal Entries for 2007 and 2008 2007 Jul-01

- Foxit Software

2007

2008

Balance Sheet for Bahrain Islamic Bank BSC Dr Ijarah Expenses

30000

Cr Cash

Dr Deferred Legal Expense Cr Cash

30000

2500

Deferred Legal Expense Deferred Ijarah Expense Prepaid Takaful Expense

1875

625

30000

30000

500

500

2500 Income statement for Bahrain Islamic bank BSC

Dr. Takaful Expenses Dr. Prepaid Takaful Cr Cash Dec-31

2007 2008

500 500 1000

Dr Prepaid Ijarah Expenses 30000 Cr Cash Ijarah rental paid in advance to shumul bank Dr Motor Vehicle mainteance Expenses Cr Cash Motor vehicle maintenance expenses Dr. Legal Expenses Cr Deferred Legal Expenses Dr. Cash Cr Ijarah Expense Dr

30000

600 600 625 625 5000 5000

Ijarah Expenses less rebate Net Ijarah rental legal exp on ijarah motor car maintenance

30000 (5000) 25000 625 600

60000

1250 1000


Chapter 10.Accounting for Ijarah Jul-01

Dec-31

Dr Ijarah Expenses Cr. Cash

30000 30000

Ijarah rental 1st installment Dr Takaful Expenses 500 Dr Prepaid Takaful 500 Cr Cash $100 per car 3rd party takaful payment Dr Prepaid Ijarah Expenses 30000 Cr. Cash 2nd installment paid to shamil in advance Dr Motor Vehicle Maintenance Exp 1000 Cr Cash Dr legal expenses Cr prepaid legal expenses Deferred initial cost expensed

1250

Dr Takaful Expenses Cr Prepaid Takaful 2007 takaful prepaid expensed

500

Dr Ijarah Expense Cr Prepaid Ijarah Expense 2007 instalment expensed

30000

Profit and Loss ac Cr Ijarah Expense

60000

1000

30000

1000

1250

500

30000

60000

313

- Foxit Software



- Foxit Software

314

Ijarah Muntahia bittamleek (IMBT) in the books of the lessor bank.

As there are four permutations to this, the accounting rules will be displayed on a table corresponding to the four types of IMBT.

Through Gift

Sale for token consideration

Sale for remaining installments

Gradual sale

At historical cost + all incidental expenses to bring asset to current location and use.




Assets presented as Investment in Ijarah Muntahia Bittamleek assets and measured at book value

Assets presented as Investment in Ijarah Muntahia Bittamleek assets and measured at book value

Initial direct costs , expensed if immaterial, deferred and amortised over term if material Ijarah revenue prior to sale. Allocated proportionately over the term of the lease. Presented in the income statement as ijarah revenue

Initial direct costs , expensed if immaterial, deferred and amortised over term if material Recognized in period in which it is due. Progressively decline in proportion to lessees increased share in property.

Transactions

Assets acquired for Ijarah

Contracting and beginning of ijarah

Ijarah revenue

Assets presented as Investment in Ijarah Muntahia Bittamleek assets and measured at book value. Initial direct costs , expensed if immaterial, deferred and amortised over term if material

Allocated proportionately over the term of the lease. Presented in the income statement as ijarah revenue

Assets presented as Investment in Ijarah Muntahia Bittamleek assets and measured at book value. Initial direct costs , expensed if immaterial, deferred and amortised over term if material Allocated proportionately over the term of the lease. Presented in the income statement as ijarah revenue



Through Gift

315


Transactions

Repairs of leased assets

End of financial year

Expensed if immaterial, provision for repair established by regular charges to income if material and varies from year to year. If lessee undertakes the repair with consent and chargeable to lessor, lessor to recognize expense in the fin period in which it is incurred Amortisation of initial direct cost, if material Cost of repairs charged against provision if it exists Depreciation to be consistent with dep policy of similar assets. However, residual value of asset should be nil in calculating depreciable amount Ijarah installments receivable to be recognised at cash equivalent value

- Foxit Software

Expensed if immaterial, provision for repair established by regular charges to income if material and varies from year to year. If lessee undertakes the repair with consent and chargeable to lessor, lessor to recognize expense in the fin period in which it is incurred Amortisation of initial direct cost, if material Cost of repairs charged against provision if it exists Depreciation to be consistent with dep policy of similar assets. However, residual value of asset should be token sale amount in calculating depreciable amount Ijarah installments receivable to be recognised at cash equivalent value


Expensed if immaterial, provision for repair established by regular charges to income if material and varies from year to year. If lessee undertakes the repair with consent and chargeable to lessor, lessor to recognize expense in the fin period in which it is incurred

Amortisation of initial direct cost, if material Cost of repairs charged against provision if it exists Depreciation to be consistent with dep policy of similar assets. Ijarah installments receivable to be recognised at cash equivalent value.

Gradual sale

Expensed if immaterial, provision for repair established by regular charges to income if material and varies from year to year. If lessee undertakes the repair with consent and chargeable to lessor, lessor to recognize expense in the fin period in which it is incurred Repair costs should be borne by both parties in proportion to ownership Amortisation of initial direct cost, if material Cost of repairs charged against provision if it exists Depreciation to be consistent with dep policy of similar assets. The sold portion of the leased asset is removed the leased asset account and any difference between book value and sale price of sold portion must be recognized in the



Through Gift

- Foxit Software

316


Transactions


Gradual sale

income statement. Ijarah installments receivable to be recognised at cash equivalent value. If the lessee refuses to buy the shae of the assets at the end of the financial period, then depending on if the promise is binding or not, then the differnce between the carrying value and the cash equivalent value shall either be reunded or charged to the lessee.

End of Ijarah term

Legal title passes to lessee and any book value should be written off.

Legal title passes to lessee provided all insallments are paid and lessee purchases the asset. If lessee declines to purchase, then shall be recognized as assets acquired for Ijarah and valued at lower of cash equivalent value or book value. Any difference to be written off. In case of a binding promise of lessee, and failure to buy, then any loss resulting from the difference

ifference

When all the installments and the price of the purchased portions of the leased assets are paid, all accounts are closed.



Through Gift

317


Transactions

Permanent impairment of leased asset before title passes to lessee

Sale of leased assets.

If asset is permanently impaired before title passes to the lessee which is not the fault of the lessee, the excess of the fair value of the rental over the installments paid is recognized as a liability due to lesse and charged to income statement.

- Foxit Software


in cev and book value will be receivable from lessee. If asset is permanently impaired before title passes to the lessee which is not the fault of the lessee, the excess of the fair value of the rental over the installments paid is recognized as a liability due to lesse and charged to income statement. Legal title passes to lessee when he buys. Lessor must recognise any gain or loss between selling price and net book value.

Gradual sale



318

Accounting Problem 10-3 Ijarah Muntahia Bittamleek in the books of the lessor

On 1st January, 2007, Bank Islam Pakistan Ltd arranged an Ijarah muntahia bittamleek financing for Pakistan Renta a car for a 4 year period. The package was for 10 proton Gen 2 cars from the Malaysian manufacturer at a cost of $100,000 (total cost) at a yearly rental of $37,500. The bank entered into a maintenance contract with Proton for major service at a yearly cost of $500 per car. If the cars were sold to the customer at an earlier date, the customer to bear the proportionate cost. Depreciation is to be booked on a straight line over the lease period. The rentals to be paid in ½ yearly installments over the four years in advance During discussion with Pakistan Renta a car, the bank considered the following options: Option A: The bank promises to give the cars as a gift at the end of the contract. Option B: Pakistan Renta car to undertake a binding promise to buy the cars at $2,000 per car at the end of the ijrarah period. However, in this case, the ijarah rentals to be $35,000 per year payable ½ yearly. Option C: The bank makes a binding promise to sell the cars to Pakistan Renta Car for the remaining installments, provided all installments are paid on time, with a rebate of 10% on the outstanding installments. Option D: The bank makes a promise to sell 2 cars at the end of the first year at $10,000 per car., 4 cars at the end of the second year for $6,000 per car, 2 cars at the end of the 3rd year for $4,000 per car and the last 2 cars at the end of the ijarah term for $2,000 per car. The installment of $37,500 to be reduced proportionately to ownerhsip.



319

Required: (i) Work out the profits for the bank in each case and advise the customer which is the best option for them in terms of cost. Assume that in case of option C, assume that the customer exercised the option to buy at the end of the 2nd year. (ii) Give the journal entries under option D (in columnar form with years as columns). (iii) provide in columnar form, the balance sheet and the income statement extracts from inception until the expiry of the lease for options A and B only. (iv) For options C only, where the customer exercised the option to buy at the end of the 2nd year, give the journal entries in the books of Pakistan Renta a car as lessee, yearly until 2010. Pakistan Renta a car has a straight line depreciation policy over the economic life of the car with a maxium of 4 years. At the point of purchase, the cars had a cash equivalent value of $78,000 with an economic life of 3 years. Answer: (I) without considering the time value of money Total installments under option sale price total revenue less cost of car maintenance cost borne by bank total cost profit to the bank

OPTION A

OPTION B

OPTION C

OPTION D

150000

140000

75000

90000

0 150000

20000 160000

67500 142500

56000 146000

100000 20000

100000 20000

100000 10000

10000 12000

120000

120000

110000

22000

30000

40000

32500

124000

Since the most profitable option for the customer is the one which gives the least profit to the bank. Option A is the most profitable course of action for the customer.



320

workings options D yr 1 revenue

ijarah installments sale of car 2x10,000

37500 20000

yr 2 revenue

ijarah installments(8/10x37500) sale of 4 cars at $6000

30000 24000

yr 3 revenue

ijarah installments(4/10x37500) sale

15000 8000

yr 4 revenue

ijarah installments (2/10x37500) sale 2 cars x2,000)

7500 4000

57500

54000

23000

11500

option D (ii) Journal entries under option D dr investments in ijarah assets cr cash dr assets for ijarah

total revenue and maint cost

year 1 100000

year 2

total maintenance cost year 3

146000

year 4

100000

dr cash cr ijarah rental 1st installment

18750

dr cash cr ijarah rental 2nd installments

18750

dr maintenance cr cash

5000

15000 18750

15000 18750

25000

dr cash dr acc depreciation cr investment in ijarah assets gain on disposal

20000 5000

7500

4000

1000

10000

1000 5000

10000

8000 15000 40000 4000

3750

2000

20000

24000 20000 20000 5000

3750

2000

20000

3750

7500

4000

25000

3750 7500

15000

5000

dr depreciation cr acc depreciation

7500 15000

5000

4000 20000 20000 3000

20000 4000



iii

321

Balance Sheet and Income Statement for option A Balance sheet as at 31.12. Investment in Ijarah Assets Less Acc Depreciation Net Book Value Income Statement For year ended 31st December Ijarah Rental Less Depreciation Less Maintenance total direct cost Net profit on ijarah

2007

2008

2009

2010

100000 25000

100000 50000

100000 75000

100000 100000

75000

50000

25000

0

2007 37500 25000 5000 30000 7500

2008 37500 25000 5000 30000 7500

2009 37500 25000 5000 30000 7500

2010 37500 25000 5000 30000 7500

2007

2008

2009

2010

100000 20000 80000

100000 40000 60000

100000 60000 40000

0 0 0

2007

2008

2009

2010

35000 20000 5000 25000 10000

35000 20000 5000 25000 10000

35000 20000 5000 25000 10000

35000 20000 5000 25000 10000

Balance Sheet and Income Statement for option A Balance sheet as at 31.12. Investment in Ijarah Assets Less Acc Depreciation Income statement for the year ended 31st December Ijarah Rental Less Depreciation Less Maintenance total direct cost Net profit on ijarah



(IV) In the books of the lessee option C. Option C exercised at end of 2nd year 2007 Dr Ijarah Expenses 18750 cr cash 18750 ist instalment of ijarah rental Dr Ijarah Expenses 18750 Cr Cash 18750 2nd instalment of ijarah rental

2008 18750

2009

2010

18750 18750 18750

Dr Motor Vehicles Cr Cash Cr Profit and Loss account Acquisition of previously leased assets at 10%rebate of remaining instalments with cash equivalent value of $78000

78000 67500 10500

Dr Maintenance Expenses Cr Bank Islam pakistan

5000

Dr Bank Islam Pakistan Cr Cash Payment of maintenance expenses for cars paid on behalf by Bank Islam Pakistan

5000

Dr Depeciation of Motor vehicles Acc Depreciation depreciation at 1/3 cev of 78000

322

5000 5000

5000 5000

5000

26000

5000

26000 26000

26000



323

10.5 Asset and Liability measurement In the case of IMBT assets, the balance sheet and Income Statement presentation is as shown: Balance Sheet Ijarah or Ijarah Muntahia Bittamleek Assets

XX

Less : Accumulated Depreciation

(XX)

Net Book value of IMBT Assets

XX


Income Statement Ijarah Revenue

XX

Less : Depeciation on Ijarah Assets

(XX)

Less: maintenance and other costs

XX

Less : Direct costs amortized.

In the case of operating Ijarah assets, the balance sheet presentation is as shown Balance Sheet Investment in Ijarah Assets Less : Accumulated Depreciation Net Book value

XX (XX) XX


The income statement presentation is similar to the IMBT Income statement.




MCQ10-1 Mr. ABC leases a car, for 5 years, from an Islamic Bank in a transaction of Ijarah Muntahia Bittamleek through sale for a token consideration. At the end of the Ijarah term, the cash equivalent value of the car is US$ 1,000 while the net book value is US$ 1,500. Mr. ABC is not obliged to purchase the car, and at the end of the Ijarah term, he decides not to purchase it. Therefore, the Islamic Bank should do the following: a) The car is recognized as Assets Acquired for Ijarah at US$ 1,500 and loss is recognized at US$ 500. b) The car is recognized as Assets Acquired for Ijarah at US$ 1,000 and loss is recognized at US$ 500. c) The car is recognized as Fixed Assets at US$ 1,500 and loss is recognized at US$ 500. d) The car is recognized as Fixed Assets at US$ 1,000 and loss is recognized at US$ 500.

324


Chapter 10.Accounting for Ijarah MCQ 7-4 Mr. ABC leases a car, for 5 years, from an Islamic Bank in a transaction of Ijarah Muntahia Bittamleek through sale for a token consideration. At the end of the Ijarah term, the cash equivalent value of the car is US$ 1,000 while the net book value is US$ 1,500. Mr. ABC is not obliged to purchase the car, and at the end of the Ijarah term, he decides not to purchase it. Therefore, the Islamic Bank should do the following: e) The car is recognized as Assets Acquired for Ijarah at US$ 1,500 and loss is recognized at US$ 500. f) The car is recognized as Assets Acquired for Ijarah at US$ 1,000 and loss is recognized at US$ 500. g) The car is recognized as Fixed Assets at US$ 1,500 and loss is recognized at US$ 500. h) The car is recognized as Fixed Assets at US$ 1,000 and loss is recognized at US$ 500.

325



326

Question 10-1

a) How does the practice of AITAB in Malaysia differ conceptually and in accounting aspects from al-ijarah muntahia bit tamleek according to FAS 8 of AAOFI b) Bank Mualamalat entered into a ijarah muntahia bitamleek agreement with Ali & Co. to finance the purchase of factory machinery which runs on gas at $400,000. The terms are as follows: Ali & Co. to pay a deposit of 10% of the price to the bank on the signing of the ijarah contract. They are to pay Bank Muamalat ijarah rental of $50,000 every 6 months for 5 years. At the end of 5 years, the salvage value of the machine would be $ 50,000. The bank will transfer the ownership of the machine to Ali& Co for $20,000.

During the ijarah period Ali & Co. paid the following expenses with respect to the machine: Every year : routine greasing and gas fuel related to use of machinery $10,000 Year 3 and 4, Takaful on the machine against fire, explosion and theft, $4000 and $6,000 respectively for years 3 and 4. In the early part of year 5, the machine broke down for 6 months and had to be repaired at $25,000 before it became usable again. It paid all the rentals due according to fiqh muamalat principles envisaged in the contract. Bank Muamalat had to pay legal expenses of $10,000 before it signed the ijarah contract which it considers material. It also paid Takaful expenses against fire, explosion and theft on the machinery in year 1,2 and 5 for $3,000 per year. Required: (i)

Journal entries in the books of Bank Muamalat for the 5 years period of the ijarah.


Chapter 10.Accounting for Ijarah (ii)

327

Extract of the balance sheet and income statement for the same period. (IIUM B.Acc, semester 2, 2004/2005, Q4)

Question 10-2

Bank Syari’ah Berhad entered into an Ijarah contract with Mahabbah Sdn. Bhd. to lease an equipment for a period of 3 years. The Bank purchased an equipment from a local trader on the 1st of January 2000 for $160,000. The Bank also incurred legal fees of $1500 relating to the Ijarah contract, which the bank considered to be material. Other details about the Ijarah are as follows: Fair value of equipment: At the beginning of 2000 At the end of the lease i.e. 31 December 2002 Number of installments on bi-monthly basis Rentals at the end of every two months Estimated useful life Estimated residual value at the end of useful life Estimated expenditure incurred in the second year

$160,000 $ 20,000 18 $12,000 3 years $16,000 $12000

Required: a. Prepare journal entries to record the above Ijarah contract in the books of Bank Syari’ah Berhad assuming the lease was treated as: i.

ii.

Ijarah Muntahia Bitamleek through sale for a token consideration (agreed to be equivalent to 50% of the estimated residual value at the end of useful life) Al-Ijarah Thumma al-bay’ (AITAB)



328

The journal entries should cover the following periods: At the beginning of Ijarah; On receipt of first rental; At the end of second year; and, At the end of Ijarah term. b. Explain the differences between Operating Ijarah and Financing Ijarah. (IIUM B.Acc, semester 1, 2004/2005, Q2)

Question 10-3

Bank Islam entered into an Ijarah contract with Tamrin Bhd. to lease an equipment for a period of 4 years. The Bank purchased an equipment from a local trader on the 1st of January 2003 for $260,000. The Bank also incurred legal fees of $3000 relating to the Ijarah contract, which the bank considered to be material. Other details about the Ijarah are as follows: Fair value of equipment: At the beginning of 2003 At the end of the lease i.e. 31 December 2006 Number of installments on bi-monthly basis Rentals at the end of every two months Estimated useful life Estimated residual value at the end of useful life Estimated expenditure incurred in the second year

$260,000 $ 30,000 24 $15,000 4 years $20,000 $15,000

Required: Prepare journal entries to record the above Ijarah contract in the books of Bank Islam assuming the lease was treated as:


Chapter 10.Accounting for Ijarah i.

ii.

329

Ijarah Muntahia Bitamleek through sale for a token consideration (agreed to be equivalent to 50% of the estimated residual value at the end of useful life) Al-Ijarah Thumma al-bay’ (AITAB) The journal entries should cover the following periods: At the beginning of Ijarah; On receipt of first rental; At the end of second year; and, At the end of Ijarah term.

Question 10-4 Malaysian Ijarah House provide a lease finance to STM Bhd for assets worth $10 million for a period of 15 years. The rental revenue is 3% higher than market operating lease rate of 10% of the financing amount. Required: a. Distinguish between operating Ijarah and Ijarah Muntahia Biltamleek. b. Explain why Ijarah Muntahia Biltamleek is not finance lease. c. If STM Bhd decides to acquire the asset at end of period, what is your advice on the accounting policy. (IIUM B.Acc, semester 1, 2000/2001, Q2)

Question 10-5

Islamic leasing or Ijarah is a flexible mode of financing. However not all assets are suitable for leasing. An industrial equipment worth $ 50,000 with a useful life of 10 years was purchased by an Islamic bank and leased to an enterprise 2 years ago for



330

a period of 5 years. At the end of year 3 the client decided not to continue with the lease and returned the asset to the bank. Required: a. Distinguish the characteristics of Ijarah and finance lease. b. State the journal entries that will be recorded for the purchase, lease and the recovery of the asset in accordance to AAOIFI FAS No.8. (IIUM B.Acc, semester 2, 1999/2000, Q4)

Question 10-6

Bank Syariah Berhad entered into an Ijarah contract with Takaful Berhad to lease equipment for a period of 3 years. Bank Syariah Berhad purchased an equipment from a local trader on 1st of January 2000 for $60,000. The Bank also incurred legal fees of $500 relating to the Ijarah contract, which the bank considered to be material. Other details about the Ijarah are as follows: Fair value of equipment: At the beginning of 2000 At the end of the lease i.e. 31 December 2002 Number of installments on quarterly basis Rentals at the end of each quarter Estimated useful life Estimated residual value at the end of useful life Estimated expenditure incurred in the second year

$60,000 $2,000 12 $6,000 3 years $4,000 $1,200

Required: a) Prepare journal entries to record the above Ijarah contract in the books of Bank Syariah Berhad assuming the lease was treated as Ijarah Muntahia Bitamleek through sale for a token consideration (agreed to be equivalent to



331

50% of the estimated residual value at the end of useful life) for the following periods: At the beginning of Ijarah; On receipt of first rental; At the end of first year; and, At the end of Ijarah term. b) Explain the differences between Ijarah Muntahia Bitamleek (as defined by the AAOIFI FAS 8) and Al-Ijarah Thumma Al-Bay’ (AITAB) as practiced by Malaysian financial institutions; c) Outline the contractual conditions of Ijarah financing as prescribed by the Syari’ah. (IIUM B.Acc, semester 2, 2002/2003, Q2)

Question 10-7

Bank Mukminin Berhad entered into an Ijarah contract with Barakah Sdn. Bhd. to lease an equipment for a period of 5 years. Bank Mukminin Berhad purchased the equipment from a local trader on the 1st of January 2000 for $100,000. The Bank also incurred legal fees of $1,000 relating to the Ijarah contract, which the bank considered to be material. Other details about the Ijarah are as follows: Fair value of equipment: At the beginning of 2000

$100,000


Chapter 10.Accounting for Ijarah At the end of the lease i.e. 31 December 2004 Number of installments on quarterly basis Rentals at the end of each quarter Estimated useful life Estimated residual value at the end of useful life Estimated expenditure incurred in the fourth year

332

$6,000 20 $6,000 5 years $3,000 $1,200

Required: a) Prepare journal entries to record the above Ijarah contract in the books of Bank Mukminin Berhad assuming the lease was treated as Ijarah Muntahia Bitamleek through pre-determined value (agreed to be equivalent to the lower of the fair value at the end of the year or $4000) for the following periods: At the beginning of Ijarah; On receipt of first rental; At the end of first year; At the end of fourth year; and, At the end of Ijarah term. b) Explain the similarities and differences between the Islamic concept of Ijarah and the conventional concept of leasing. (IIUM B.Acc, semester 1, 2003/2004, Q2)

Question 10-8

Bank Shari’ah Malaysia Berhad has entered into an Ijarah contract with Ummah Sdn. Bhd. to lease an equipment for a period of 5 years. Bank Shari’ah purchased an equipment from a foreign trader on the 1st of January 2000 for $180,000 and incurred custom duty of $20,000. The Bank also incurred legal fee of $5,000 relating to the Ijarah contract, which the bank considered to be material.

Both parties have agreed that the installments should be paid every quarter. The rental payment was agreed $5,000 per month. The net realizable value of the equipment is expected to be $20,000 at the end of the useful life of the asset.



333

In year 1, Ummah Sdn. Bhd. has found technical default in the equipment and incurred $10,000 to repair the equipment necessary to retain its full working order. Every year, Ummah Sd. Bhd. incurred routine maintenance costs due to wear and tear amounting to $500 per year. Required: (a) Prepare journal entries to record the above Ijarah contract in the books of Bank Shari’ah as Ijarah Muntahia Bitamleek through sale for a token consideration (agreed to be equivalent to 50% of the estimated residual value at the end of useful life) for the following periods: • At the beginning of Ijarah • On receipt of first rental • At the end of first year and, • At the end of Ijarah term. (b)

Determine the profit on Ijarah financing from year 1 to year 5.

(c) Prepare journal entries to record the above Ijarah information as required in part (a) according to Al-Ijarah Thumma Al-Bay’ (AITAB) financing as practiced by most Malaysian financial institutions. (d) Explain how the conventional accounting concept of Substance over Form influenced the asset recognition policy on Ijarah financing. (IIUM B.Acc, semester 1, 2005/2006, Q2) Question 10-9

Leasing ending with ownership (Ijarah Al Muntahia Biltamleek) is a category of financing where the lessee expects to own the asset through purchase or other forms of transfer. Required:



334

a. Briefly explain the types of Ijarah Al Muntahia Biltamleek and why it is not a finance lease. b. An equipment that cost $ 480,000 is leased for 10 years for a construction project. It has a useful life of 12 years with no residual value. Under a no$al operating lease a lease payment of $ 60,000 per annum is received. The maintenance cost is $ 10,000 per annum. Compute the following: i. Total rental net income from the operating lease for a 10 year lease period. ii. Estimated Selling price if the asset is purchased at the end of the lease period. iii. If the lease payment is $ 80,000 as the lessee intends to take ownership, determine the fair rental amount and recovery amount if the lease equipment is impaired after 5 years. c. Show the relevant journal entries for both Operating Ijarah and Ijarah Al Muntahia Biltamleek when the equipment is leased by the lessor. (IIUM B.Acc, semester 1, 1999/2000, Q4)



335

Question 10-10

An International Equipment Leasing Company has provided both finance and operating lease to developers and manufacturers that require specialized leasing equipment to conduct their operating activities. The company is exploring the possibility of adopting Islamic Leasing arrangement for some of its equipment. The management has provided the following information : Lease Equipment : Cost or fair market value Estimated useful life Estimated residual value:

At the end of year 2 At the end of year 3 At the end of year 4 At the end of year 5

RM550,000 5 years

Estimated residual value (RM’000) 425 319 240 150

The company is proposing two leasing plans : Plan A Lease term of 3 years Lease payments of RM200,000 per annum No purchase or renewal option Plan B Lease terms of 4 years Lease payments of RM150,000 per annum Purchase potion at an exercise price of RM250,000 at the end of year 4 Lessee guarantees the residual value at the end of year 4 Renewable option is a lease payment of RM100,000, for every additional year. Required:



336

(i)

What would you advise the company on plans A and B ?

(ii)

Prepare extracts of balance sheet at the end of the lease period for both plans and indicate the implications of the exercise of the purchase option. (IIUM B.Acc, semester 1, 1998/1999, Q2) Question 10-11

Bank Mualamalat entered into a ijarah muntahia bitamleek agreement with Ali & Co. to finance the purchase of factory machinery which runs on gas at RM400,000. The terms are as follows: Ali & Co. to pay a deposit of 10% of the price to the bank on the signing of the ijarah contract. They are to pay Bank Muamalat ijarah rental of RM50,000 every 6 months for 5 years. At the end of 5 years, the salvage value of the machine would be RM 50,000. The bank will transfer the ownership of the machine to Ali& Co for RM20,000. During the ijarah period Ali & Co. paid the following expenses with respect to the machine: Every year : routine greasing and gas fuel related to use of machinery RM10,000 Year 3 and 4, Takaful on the machine against fire, explosion and theft, RM4000 and RM6,000 respectively for years 3 and 4. In the early part of year 5, the machine broke down for 6 months and had to be repaired at RM25,000 before it became usable again. It paid all the rentals due according to fiqh muamalat principles envisaged in the contract.

Bank Muamalat had to pay legal expenses of Rm10,000 before it signed the ijarah contract which it considers material. It also paid Takaful expenses against fire, explosion and theft on the machinery in year 1,2 and 5 of RM3,000 per year.



337

Required: i. Journal entries in the books of Bank Muamalat for the 5 years period of the ijarah. ii. Extract of the balance sheet and income statement for the same period. ( IIUM MBA, 2005/2006, Q6)

Question 10-12

Bank Islamic Malaysia Berhad has entered into an Ijarah contract with Amal Sdn. Bhd. to lease an equipment for a period of 3 years. The Bank purchased a specialised equipment from a local trader on the 1st of January 2004 for RM1,500,000 and incurred transportation cost of RM50,000. The Bank also incurred legal fee of RM15,000 relating to the Ijarah contract, which the bank considered to be material. Both parties have agreed that the installments should be paid every quarter. The rental payment was agreed RM60,000 per month. The fair value of the equipment in 3 years time is expected to be RM100,000 based on the estimate of certified valuer. At the beginning of the year 2004, Amal Sdn. Bhd. incurred repair cost of RM50,000 to enable the equipment to be used properly. In the same year, Amal also found technical default in the equipment and incurred RM30,000 to repair the equipment necessary to retain its full working order. Every year, Amal Sdn. Bhd. incurred routine maintenance costs due to wear and tear amounting to RM1,500 per year. Required: (a) Prepare journal entries to record the above Ijarah contract in the books of Bank Shari’ah as Ijarah Muntahia Bitamleek through equivalent value method as prescribed by AAOIFI FAS 8 for the following periods: • At the beginning of Ijarah


Chapter 10.Accounting for Ijarah • • • •

338

On receipt of first rental At the end of first year, At the end of second year, and, At the end of Ijarah term.

(b) Determine the profit on Ijarah financing from year 1 to year 3. (c) Prepare journal entries to record the above Ijarah information as required in part (a) according to Al-Ijarah Thumma Al-Bay’ (AITAB) financing as practiced by most Malaysian financial institutions. (d)

Explain in what ways and why the accounting treatments on AITAB financing are similar to accounting treatments on Bai’ Bithaman Ajil financing. (IIUM B.Acc, semester 2, 2005/2006, Q2) Question 10-13

On 1 February 2006, Al-Barakah Islamic Bank (AIB) agreed to finance the purchase of factory machinery with Sime Larby Limited (SLL) based on Ijarah Muntahia Bil Tamleek (IMBT). The purchase price of the machinery is RM200,000. The details about the transactions are as follows: i.

ii.

iii.

AIB purchased the machinery from London-based supplier on 1 May 2006. The transportation cost, custom duties and legal documentation are RM30,000, RM20,000 and RM1,000 respectively. The legal fee is considered immaterial whereas other costs are regarded material. On 1 July 2006, AIB officially signed the IMBT financing contract with SLL to lease the machinery for a period of 5 years. The monthly rental instalment agreed to be paid by SLL is RM6,500. The machinery was estimated to have a useful life of 5 years and the estimated residual value at the end of useful life is RM20,000. SLL could not pay on time for the last instalment in the year 2007, but subsequently paid the amount plus a 1% penalty stipulated by



iv. v.

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Bank Negara Malaysia (Central Bank) in the first month of the year 2008. In the year 2008, the machine broke down for 6 months and had to be repaired by SLL at RM30,000 before it became usable again. On 31 December 2010, SLL opts for early settlement, which means SLL wants to get ownership of the machinery before the actual contractual date of completion. It is the policy of AIB to give 20% rebate at pro rata basis on the remaining instalments if an instalment or more has been paid in earlier than the date it has been scheduled.

Required: a. Journal entries in the books of Al-Barakah Islamic Bank (AIB) for the 3 years period (2006 to 2008). b. Journal entries and calculations for the early arrangement between AIB and SLL in the year 2010.

settlement

c. Extract of the Balance Sheet and Income Statement for the period of 2006, 2007, 2008 and 2010. d. What would happen to the books of Al-Barakah Islamic Bank (AIB) if the above arrangements is Al-Ijarah Thumma Al Bai’ (AITAB)? (IIUM B.Acc, semester 2, 2008/2007, Q3)


Chapter 11. Accounting for Salam and Parallel Salam

338

‫ﺎ أ ﺎ اﻟﺬ ﻦ آﻣﻨﻮا إذا ﺗﺪا ﻨﺘﻢ ﺑﺪ ﻦ إﻟﻰ أﺟﻞ ﻣﺴﻤﻰ ﻓﺎﻛﺘﺒﻮه‬ O ye who believe! When you deal with each other, in transactions involving future obligations in a fixed period time, reduce them to writing (Baqara 2:282)

‫ ﻗﺪم رﺳﻮل اﷲ )ص( اﻟﻤﺪ ﻨﺔ واﻟﻨﺎس ﺴﻠﻔﻮن ﻓﻲ اﻟﺘﻤﺮ اﻟﻌﺎم واﻟﻌﺎﻣ ﻦ‬:‫ ﻋﻦ اﺑﻦ ﻋﺒﺎس )رض( ﻗﺎل‬: ‫ ﻣﻦ أﺳﻠﻒ ﻓﻲ‬:‫ وﻓﻲ روا ﺔ‬.‫ ﻣﻦ ﺳﻠﻒ ﻓﻲ ﺗﻤﺮ ﻓﻠ ﺴﻠﻒ ﻓﻲ ﻛ ﻞ ﻣﻌﻠﻮم ووزن ﻣﻌﻠﻮم‬:(‫ﻓﻘﺎل اﻟﻨﺒﻲ )ص‬ .‫ﺷﻲء ﻓﻔﻲ ﻛ ﻞ ﻣﻌﻠﻮم ووزن ﻣﻌﻠﻮم إﻟﻰ أﺟﻞ ﻣﻌﻠﻮم‬ Ibn Abbas is reported to have said: the Prophet peace be upon him has came to Medina and found that people were selling dates for deferred delivery after a duration of one or two years on a Salam basis. The Prophet peace be upon him said: whoever pays for dates on a deferred delivery basis (salam) should do so on the basis of a specified scale and weight. In another version of the hadith whoever pays on a deferred delivery basis should do so on the basis of a specified scale, weight and date of delivery(Sahih Al Bukhari, 2/781)

Chapter 11 CHAPTER LEARNING OBJECTIVES:

At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv. v.

Explain the meaning of salam and parallel salam and how this contract is used by Islamic banks to finance customers List the principles of salam and parallel salam and as well as the s explain the shari’a rules. Journalize accounting entries for salam and parallel salam. Prepare the balance sheet and income statement extracts for salam and parallel salam transactions Apply shari’a and accounting principles as per FAS 7 to solve accounting problems for complex events.



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11.1 Introduction Normal fiqh rules insist that goods for sale must exist, owned by the seller and deliverable, for the validity of a sales contract. This is to prevent gharar and fraud regarding the quality and existence of the subject matter of the contract. However, Islam is practical in that it allows flexibility in the rules to allow for the needs of the community to transact legitimately. For example, if the above conditions are insisted upon, then tailoring, manufacturing to order and food catering have to close shop, because the goods (tailored shirt to fit irregularly shaped people), aero planes, buildings and catered food are not available at the time of ordering or sale. It will only be available in the future. Certain industries especially in agriculture and construction have a long lead time which involves time, effort and substantial costs. For example, in growing crops, the farmer has to plough the land, seed the land and add fertilizer, irrigate and weed and protect it from animals, weather and people. This requires a lot of money. The traditional non-Islamic way has been and in many countries, still is to usurious loan which is ruinous to the farmer and his family and has resulted in wealth transfer to the money lending class. The salam contracts helps to prevent this. Salam and Istisna are the two main contracts allowed in Islam, which allows the sale of something which does not exist at the time of sale. However, as with all Islamic contract fiqh rules, these contracts come with conditions to protect the buyer and seller and diminish the gharar aspects of this type of transaction. Salam is a contract where a buyer purchases a commodity for future delivery in exchange for immediate payment. Istisna is similar; however the seller in istisna manufactures the goods to specification before delivery, whereas in a salam, he either grows it or buys it from the market to deliver at the promised time. From an accounting perspective, the payment made is an asset in the books of the buyer and a liability in the books of the seller until the goods are delivered. In istisna however, we have to track costs and value work in progress and accounting for billings in case of progressive payments, which makes it much more complex as construction accounting contracts. We shall explore salam in this chapter and istisna in the next.



340

11.2 Definition and financing model of Salam and Parallel Salam.

Definitions Salam Purchase of a commodity for deferred delivery in exchange for immediate payment according to specified conditions or sale of a commodity for deferred delivery in exchange for immediate payment. al-Muslam fihi :

The commodity to be delivered

al-Muslam ileihi :

The seller

al-Muslam :

The purchaser

Ras-almal Capital (cost) paid (in cash, kind or benefit) in a Salam contract, i.e. price. Parallel Salam A Salam contract whereby al-muslam ileihi depends, for executing his obligation, on receiving what is due to him – in his capacity as al-muslam – from a sale in a previous Salam contract, without making the execution of the second Salam contract dependent on the execution of the first one.

How does the Islamic bank use the salam contract to make profits? The following diagrams two ways in which it can be done. (i) use a selling agency. When the time specifed in the salam contract arrives, the bank can instruct the al muslam ileihi to deliver the commodity to a selling agency of the bank. The agent will then sell the commodity for a fee and deliver the net proceeds to the bank.



341

3

AGENT 2 5 AL MUSLAM ILEIHI (THE SELLER 1

4

ISLAMIC BANK (SALAM)

ULTIMATE BUYER

Fig 11.1 Salam financing using a selling agency 1

Islamic Bank pays advance to the seller for future delivery

2

The seller delivers per instruction of the bank to the agent

3

The agent sells the commodity to the ultimate buyer

4

The ultimate buyer pays the agent.

5

The agent pays the bank less his commission.

However, the normal method of use of the salam contract in IFI’s is through the use of a parallel salam contract As noted in the definitions box, a parallel salam is a contract to sell , what the bank will get as a buyer in another salam contract, to a buyer who pays the bank in advance. The difference in price between the parallel salam and the salam contract is the profit to the bank. This is illustrated in figure 11.2 The Islamic bank pays the al muslam ileihi in the salam contract. The Islamic bank receives a payment from the buyer in a parallel salam contract . The muslam ileihi in the salam contract delivers the goods to the bank at the agreed time The bank delivers the commodity to the al muslam in the parallel salam contract.



342

4 AL MUSLAM ILEIHI (THE SELLER

3 ISLAMIC 5 BANK 1

2

Bank’s customer AL MUSLAM in the parallel salam contract

Fig 11.2 Salam with parallel salam financing 1 2

3 4

The Islamic bank pays the al muslam ileihi in the salam contract. The Islamic bank receives a payment from the buyer in a parallel salam contract with the bank’s customer. The muslam ileihi in the salam contract delivers the goods to the bank at the agreed time.

The bank delivers the commodity to the al muslam in the parallel salam contract.

In actual fact, the bank may request the muslam ileihi to deliver the goods direct to the bank’s customer. Further the bank may enter into the salam

contract with the customer first or at the same time in order to be a bit more certain of the profits. Besides the financing of agriculture, salam can alsobe used to finance trade inventory, where the Islamic bank pays an advance for the customer to purchase inventory from a wholesaler and deliver to the bank which the bank can either resell to the customer at a higher price through a parallel salam contract or to a third party.



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11.3 Salam & Parallel Salam principles, rules and complexities 1

Legitimacy

2

Salam has its legitimacy in the Qur’an (2:282) and Sunnah and Ijma (consensus). On the wisdom of its legitimacy, Ibn Qudamah said “Because people had a need for [Salam] and because farmers, market gardeners and tradesmen needed money for their living expenses and to spend on their businesses to bring them to fruition, and so faced financial need, Salam was made permissible so that they could benefit from it as well as al-muslam having the benefit of its (1) permissibility .

The payment should be in cash. However ,the standard takes the view of some other fuqaha who permit payment in trading assets. According to Malikis, payment can be in benefit . However, it is agreed that it cannot be in the form of a cancellation of a debt due from the seller. (almuslam ileihi) as a precaution against riba. The payment needs to be paid at the time of contract execution to prevent introduction of debt by al muslam. However, a short delay is permitted my Malikis.

Hence, is legitimacy is from the strongest sources of the shari’a.

3

Al Muslam fihi (the subject matter 4 of the contract)

Place of delivery Parties to the contract can designate

1

()

Al Mughnee, Vol. 4, p.305.

Delivery date. Delivery should be deferred to a future date although shafiis allow prompt delivery. Specifying future date is permissible, eg. Last day of October and should not be contingent. Fuqahas equire a degree of specificity on the delivery date and so a range of delivery dates is acceptable.

The commodity to be supplied should be known as to kind (wheat or cotton, type (e.g. Syrian wheat, quality (superior, medium or inferior Syrian wheat) and amount. (qty in kg. or bushels). Specification to be based on description given by al muslam ileihi. And should not be confined to be made from a specific source such as a particular farm or production from a specific country.

5

Capital

The future delivery date should be matched to the time when muslam fihi would most likely be commonly available to prevent gharar (e.g next harvest season) to enable the seller to discharge the contract.

6

Sale of subject matter before delivery


Chapter 11. Accounting for Salam and Parallel Salam place of delivery, if not determined in contract, then according to custom.

344

This is prohibited, if commodity is food or movable item. If it is non-food, sale is permissible if; Sale back to muslam ileihi at the contract price or lower.or In case of sale to third party, at the contract price or lower or higher (if the quality is different)

6

Replacement of subject matter:

7

Normally replacement of subject matter is prohibited (especially if it is food, unless it is similar goods. Of same or less quantity and regarded as suitable to the muslam fihi in the salam contract..

The Shari’a supervisory board of Rajhi Banking and Investment Corporation issued a fatwa permitting the practice of parallel Salam on condition that the execution of the second Salam contract is not made dependent on the execution of the first one(2).

Classical scholars only allow for the substituition if it is not food and: Substitute is similar to muslam fihi or lower quality to negate riba Should take delivery of substitute in order not to replace debt with debt and The relation between substitute and price should be free of riba.

7

Nullification or cancellation of contract Complete nullification is permissible if the Salam capital is repaid to the Muslam. Partial cancellation of delivery with partial corresponding repayment is also allowed. In case, al muslam fihi is not fully or only partly availabe on the due date, the al muslam can either Cancel the contract and have his payment refunded or Wait until al muslam fihi is availabe.

2

()

Parallel Salam

Although some contemporary fuqaha have prohibited parallel Salam, particularly if it for the purpose of trading. And such a transaction becomes recurrent, as this may involve riba.

8

Delivery of different specification on its due date or before due date. Al muslam ileihi shold deliver the al muslam fihi on its due date and according to agreed quality, quantity and al muslam should accept it. In case a superior quality is delivered, the al muslam ileihi cannot ask for a higher price If an inferior quality is delivered, then al muslam ileihi has the option to reject the delivery or accept the lower quality

Rajhi Banking and Investment Corporation, Shari’a supervisory board, Fatwa No. 41, (paraphrased).



345

without asking for a lower price. There is difference of opinion of delivery a different type of al muslam fihi then the one agreed upon. IF DELIVERY IS BEFORE DUE DATE Al muslam can accept if it is of the same quality and quantity as agreed. Al muslam fihi cannot be of superior quality nor in greater quantity Al muslam fihi cannot be of inferior quality or in lesser quantity (as this would be riba)

/////////////////////// 9

Pledge/Guarantee of al muslam fihi Al muslami fihi can be transferred or pledged or used as guarantee..

11.4 Recognition of Salam & Parallel Salam transactions and journal entries 11.4.1 Recognition and Measurement of Salam and Parallel Salam Financing FAS No. 7: Salam and Parallel Salam is a standard for the provision of salam and parallel salam financing and deposit taking by the Islamic bank. Contract execution When the capital is paid to the muslam ileihi placed in his disposition (for example, credited to his account) then Salam Financing is recognized as an asset by debiting Salam Financing and crediting cash. If the capital is in the form of kind or benefit, the amount shall be recognized at fair value of the asset or benefit provided (in effect, the amount agreed between the bank and the client). For parallel salam, it is recognized when the amount is received. At the end of the financial year Capital is measured at the initial cost or fair value of the benefit or kind agreed at the initial execution of the contract. However, if it is probable that the al-muslam ileihi will not deliver



346

al muslam fihi in part or in full, and it is probable that the value of the al muslam fihi will decline, a provision for the deficit is made. If the muslam fihi is received but not disposed off at the financial year end, it shall be measured at the lower of historical cost and cash equivalent value and the if the cev is lower, the difference is treated as a loss for the financial year

Salam financing is presented in the Bank’s Balance Sheet as Salam Financing whereas parallel salam is recognized as a liability and presented as Parallel Salam. When the bank delivers the al muslam fihi, the difference between the amount paid by the client and the cost of the al muslam fihi is taken as the profit or loss during the year. Receipt of al muslam fi hi. Assets received in a salam contract is recognized at historical cost. In case the muslam fi hi is similar in kind but different quality: (i)if the maket or fair value of the received al muslam fi hi is equal to the contracted muslam fihi, then al muslam fi his is recorded at book value. (ii)however, if the market or fair value is lower, the muslam fihi is recorded at the market or fair value and the different recognized as a loss. In case of delivery failure: (a), if the delivery date is extended, the book value is maintained (b) if the financing is completely or partially cancelled and the amount is unpaid, then the amount is recognized as a receivable from the client.

Failure due to client’s misconduct or negligence. In this case, when there is partial o complete failure, the amount shall be recognized as a receivable. Where securities has been pledged by the customer, the proceeds from the sale of the security is less than book value, the difference will be receivable from the client. The bank may charge the client any additional amounts which are established in favour of the bank. In case of substitution of another kind of goods, the same treatment as discussed above under delivery is used. No.

Transactions /Events

DR

CR.


Chapter 11. Accounting for Salam and Parallel Salam 1

2 3

4

5

6

6

7

347

Salam Financing

Cash

Cash

Parallel Salam

Reduction in value of al muslam fi hi yet to be delivered

Profit and Loss

Provison in loss in value of al muslam fihi

Normal contract conclusion

Dr Inventory (historical Salam Financing cost)

Delivery of inventory to buyer

Parallel Salam

Inventory

Profit from sale When the inventory is delivered direct to the customer, a composite journal entry can be made without going through inventory

Parallel salam

Profit and Loss

End of year inventory decline

Dr Profit and loss

Inventory

Termination of salam due to non delivery and delivery date not extended

A/receivable

Salam Financing

In case of sale of securities for less than salam contract value

Dr Cash Salam Financing Dr A/Receivable with difference between cash proceeds and contract value Cr Salam financing Dr Cash Cr accounts payable (with excess of proceeds) 8

Recognition of Salam on payment (Being capital paid to almuslam ileihi) On receipt of payment from customer

If at the end of the fiscal year, the cev of inventory acquired through salam financing is lower than the acquisition cost

In case of sale of securities for more than salam contract value



348

11.5 Asset and Liability measurement AAOIFI : presentation and disclosure of Salam & Parallel Salam Financing Balance Sheet Salam Financing Less : Provision for decline in value of muslam fi hi Net Salam Financing

XX (XX)

XX


Income statement Profit on sale of commodity in a parallel salam

XX

Accounting Problem 11-1– Salam and parallel Salam

On 1st February, 2007, Bank Syari’ah Malaysia Berhad entered into a salam financing contract with Perak Islamic Rubber Growers Cooperative to supply 100 metric tons of RSS1 (superior grade) rubber on the 1st week of June 2007 at @$1,000 a metric ton. As security, the Cooperative’s clubhouse was pledged to the bank. The amount was paid to the muslam ileihi on the same day. On 25th of May, 2007, the bank entered into a parallel salam contract to supply the same to Bata shoe Malaysia bhd. @ $1200 a metric ton on 1st week of June 2007. On the 1st week of june 2007, the cooperative only delivered only half the promised quantity of RSS1 rubber. It also delivered 25 tons of RSS2 (lower grade) rubber which the bank accepted to take. The cooperative informed that since it is insolvent, it cannot afford to pay the difference to the bank. Meanwhile, Bata refused to take delivery of the RSS2 rubber. The bank was forced to buy RSS1 from the market at $1150 per metric ton to deliver to fulfil its commitment to Bata. RSS2 rubber had a cash equivalent value of $950 per metric ton at the end of the year on 31st December 2007. In August 2007, the security pledged by the cooperative was sold for $50,000 and the appropriate amount refunded to the cooperative.



349

Required: (i) Show the journal entries in the books of Bank Syari’ah for all the above entries. (ii) Show extracts of the income statement and the balance sheet of bank syari’ah for the year ended and as at 31.12.2007.

Solution: salam accounting problem (i) bank syari'ah bhd journal entries feb 1 07 Dr Salam Financing 100000 Cr. Cash 100000 cash payment for salam to perak islamic cooperative May 25 '07 Dr Cash 120000 Parallel Salam 120000 cash received for 100 metric tons of RSS1 from Bata Jun-07

Jun-07

Dr Parallel Salam 50000 Dr Inventory RSS2 rubber 25000 Dr Accounts receivable - perak 25000 Cr Salam Financing 100000 delivery of 50 tons to bata and 25 tons of rss2 to inventory and the rest charged to cooperative Dr Parallel Salam 70000 Cr. Cash 57500 Profit on parallel salam- p &loss ac 12500 purchase of 50mt of RSS1 to fullfill parallel salam contract and profit and net profit on parallel salam

Aug-07 dr cash 50000 cr a/c receivable 25000 cash 25000 proceeds from sale of security set off against amount owing and balance refunded Dec-31

Dr Profit and Loss 1250 Inventory RSS2 Reduction of inventory to cev (1000-950)x25tons income statement 31.12.07

1250


Chapter 11. Accounting for Salam and Parallel Salam II

profit from parallel salam loss from devaluation of inventory

350

12500 1250

the loss cannot be claimed from perak coop because the the bank accept the lower quality


MCQ 11-1 Which of the following statements is true? a) Salam requires full payment upfront while in Istisna’ the repayment must be gradual. b) Salam is a contract to purchase goods for later delivery while Istisna’ is a contract to purchase goods for future payment. c) Salam is a contract to produce goods that may be weighed, measured or counted while Istisna’ is a contract to transform a raw material into their natural state through the process of manufacturing. d) All of the above is true. MCQ11-2 Which of the following is incorrect for Salam financing: a) Salam assets (al-muslam fihi) received by an Islamic bank shall be recorded, upon receipt, at historical cost if the assets are in accordance with the contract. b) At the time of contracting, Salam capital shall be provided only in kind. c) Salam capital provided in kind shall be measured at a value agreed between an Islamic bank and its client. d) None of the above. MCQ11-3: Which of the following is incorrect for replacement of Salam assets (almuslam fihi) by substituting another kind of goods: a) Most Islamic jurists (fuqaha) have prohibited the replacement of al-muslam fihi before it is received except by substituting another kind of similar goods. b) Some fuqaha are of the view that the substitute goods should not consist of higher quantity than the intended al-muslam fihi so that the purchaser does not obtain additional profit. c) Some fuqaha are of the view that the substitute goods should be similar to almuslam fihi or of a lower quality.



351

d) Some fuqaha are of the view that the substitute goods should not be similar to almuslam fihi.

2. MCQ 11-4: The general rules regarding delivery of Salam assets (al-muslam fihi) before or on its due date include the following, except: a) If a superior quality of al-muslam fihi is delivered, the purchaser (al-muslam) may accept it on the condition that the seller (al-muslam ileihi) does not ask for a higher price. b) If an inferior quality of al-muslam fihi is delivered, al-muslam may accept or reject it. c) If al-muslam fihi is delivered on its due date and according to the agreed quality and quantity, al-muslam must accept it. d) Regardless of any conditions being met, it is impermissible to deliver almuslam fihi before its due date.

Question 11-1

Explain from your knowledge on fiqh rules on salam, how the fuqah attempt to avoid gharar and riba on salam contracts.

Question 11-2

The validity of a Salam contract is dependent on satisfying certain terms and conditions relating to al- muslam fihi. Specify any 5 terms and conditions of a typical Salam contract, which are considered necessary for the validity of the contract. (A.I.A, Professional Examination II, 2002, Q 4a)

Question 11.3



352

1. Explain with the aid of a diagram how an Islamic bank can profit from a salam and a related parallel salam contract. The diagram should show entities, cash flows and goods flows. If an Islamic bank is allowed to form trading subsidies, how does this enable the bank to profit from a salam contract without entering into a parallel salam contract?

Question 11-4

On the 1 st of March 2003 Gulf Finance House (an Islamic Bank) bought 25 tons of aluminum from Alba- a local Aluminum producing company- on the basis of Bai-asalam (Salam) contract. The purchase price of this quantity of aluminum was $25,000 ($10,000 per ton) paid in full to Alba on the day the contract was signed. It was agreed that Alba would deliver the commodity in two shipments as follows: First shipment on June 15th, 2003 for the delivery of 10 tons. Second shipment on July 30th, for delivery of 15 tons.

On April the 5th 2003 the bank entered into a parallel Salam contract with a trading company based in Kuwait to sell them 25 tons of aluminum for total value of $275,000 ($11,000 per ton). The bank signed-up to deliver the commodity in two shipments as lows: First shipment on the 20th of June 2003 for delivery of 10 tons. Second shipment on the 5th of August 2003 for delivery of 15 tons Required:

1. Record the journal entries for the Salam and Parrallel Salam transactions in the books of the bank if deliveries, in both transactions, were made as contracted.



353

2. If Alba defaulted on the second delivery and the bank had to buy equal quantity of commodity from another company for $170,000 and delivered it to the trading company in Kuwait, how will this case affect the bank's books of accounts? 3. Outline the basic features of the Salam contract showing its potentials for the Islamic banking business. (A.I.A, Professional Examination II,2004,Q 3)

Question 11-5 The Farmers Association approached Meezan Muamalat Bank, which is actively involved in agricultural financing to finance the wheat crop of its members, that is expected to be harvested in the year 2006 using Salam contract. On 30 September 2005, Meezan Muamalat Bank entered into a Salam contract whereby it bought from Farmers Association 100,000 metric tons of wheat (the specifications of which are detailed in the contract) for $200 million. It was agreed that Farmers Association would deliver the wheat after 6 months from the date of signing the contract. On 5 October 2005, Meezan Muamalat Bank paid the full amount of the contract into the account of Farmers Association. On 31 October 2005, Meezan Muamalat Bank entered into a separate parallel Salam contract with K Company whereby it was agreed that the former sell to K Company 100,000 metric tons of wheat for $250 million. The specifications of the wheat are identical to those that will be supplied by Farmers Association and it was agreed by the two parties that Meezan Muamalat Bank would deliver the wheat after 5 months from the date of signing the contract. On 5 November 2005, K Company paid half of the amount of the contract to Meezan Muamalat Bank.

On 31 March 2006, Farmers Association delivered 100,000 metric tons of wheat to Meezan Muamalat Bank and the bank delivered the wheat to K Company. K Company paid the remaining amount of the wheat on the same date. Required: a. Prepare the necessary journal entries in the books of Meezan Muamalat Bank to record the Salam and parallel Salam contracts;



354

b.Show how the necessary transactions should be presented in the financial statements of Meezan Muamalat Bank at the end of the year 2005 assuming that the value of al-muslam fihi has declined by 20%. Should Meezan Muamalat Bank recognise any earnings at the end of the year? c.

Assume that Farmers Association was not able to deliver the wheat on the agreed date and only able to deliver after 7 months from the date of signing the contract. Meezan Muamalat Bank has to buy the wheat from other supplier for $260 million. Show journal entries to record this transaction.

d.

‘The validity of a Salam contract is dependent on satisfying certain terms and conditions relating to al-muslam fihi’. Specify any 5 terms and conditions of a typical Salam contract, which are considered necessary for the validity of the contract.

(IIUM B.Acc, semester 2, 2006/2007, Q1)+


Chapter 12 Accounting for Istisna’ and Parallel Istisna’ ‫اﻟﻤﻌﺎﻟﺠﺔ اﻟﺤﺴﺎﺑ ﺔ ﻟﻤﻌ ﺎر اﻷﺳﺘﺼﻨﺎع واﻷﺳﺘﺼﻨﺎع اﻟﻤﻮازي‬

‫ﻴﺎ‬ ‫ﻗﺪ ﺳ‬

‫ﻴﻞ ﺟﻔﺎ ﻛﺎﻟﺠﻮ‬ ‫ﻦ ﻣﺤﺎ ﻳﺐ ﺗﻤﺎﺛ‬ ‫ﻳﻌﻤﻠﻮ ﻟﻪ ﻣﺎ ﻳﺸﺎ ﻣ‬ ‫ ﻟﺸﻜﻮ‬ ‫ﺒﺎ‬ ‫ﻦ ﻋ‬ ‫ﻴﻞ ﻣ‬ ‫ﺷﻜﺮ ﻗﻠ‬ ‫ﻋﻤﻠﻮ‬

They made for him whatever he wished of sanctuaries, and statues, and basins as [large as] great watering - troughs, and cauldrons firmly anchored. [And We said:] “Labour, O David’s people, in gratitude [towards Me] and [remember that] few are the truly grateful [even] among My servants!”

‫ﺛﺒﺘﺖ ﻣﺸﺮوﻋ ﺔ اﻻﺳﺘﺼﻨﺎع ﺑﺎﺳﺘﺼﻨﺎع اﻟﻨﺒﻲ )ص( اﻟﺨﺎﺗﻢ واﻟﻤﻨﺒﺮ وﺑﺎﻻﺳﺘﺤﺴﺎن واﻟﻘﻮاﻋﺪ اﻟﻌﺎﻣﺔ‬ .‫ﻓﻲ اﻟﻌﻘﻮد واﻟﺘﺼﺮﻓﺎت واﻟﻤﻘﺎﺻﺪ اﻟﺸﺮﻋ ﺔ‬ The legitimacy of Istisna’a is based on the request of the Prophet, peace be upon him, that a pulpit (a platform) for preaching and a finger ring be manufactured for him. An Istisna’a contract is also permissible on the basis of the principle of istihsan (public interest or good), the general principles of contracts and transactions and the objectives of Shari’a.

Chapter

12


Explain the meaning of Istisna’a’ and parallel istisna’a’ and how these contracts are used by Islamic banks to finance customers List the principles of istisna’a’ and as well as explain the shari’a rules. Journalise accounting entries for istisna’a’ and parallel istisna’a’. Prepare the balance sheet and income statement extracts for istisna’a’ and parallel istisna’a’ transactions Apply shari’a and accounting principles as per FAS 10 to solve accounting problems for complex events.



12. 1 Introduction Besides salam, istisna’a’ is the other contract where a sale can be made without the subject matter of the contract being in existence at the time of contracting. Whereas salam is a contract for delivery of a commodity, which might be grown or bought by the muslaim ileihi to be delivered to the muslam at a future date, istisna’a’ is a contract to manufacture the goods to specification and deliver the manufactured goods to the buyer at a future agreed date, the payment being in advance or deferred or in installments. Islamic banks have used this contract to finance infrastructure projects such as power plants, planes, highways etc. How do the Islamic banks do this when they are not construction contractors, airplane manufacturers or highway experts? These they do by means of a parallel istisna’a contracts where the manufacturer is commissioned to manufacture and deliver to the Islamic bank (actually their customer – imagine a plane is parked next to a Islamic bank building!) which in turn is delivered to the bank’s customer.

From an accounting point of view, istisna’a is complex to account for as the costs of construction has to be accumulated and progress payments billed and tracked as in construction contract accounting IAS 11. Further the most important event is the recognition of profits using the percentage of completion method which is now the standard practice under IAS 11, when the outcome of a contract can be estimated reliably. FAS 10, however, allows the completed contracts method, where no profits are recognized but costs are accumulated to the amount they are expected to be recoverable. Following the prudence concept, if any time during the istisna’a’ contract, there is a expected loss or the cash equivalent value of the work in progress is less then the contract amount receivable, then the work in progress will have to be written down to the cash equivalent value.

12.2 Definition and financing model of istisna’a’ and parallel istisna’a’

Definitions Istisna’a and Parallel Istisna’a Istisna’a It is a sale contract between al-mustasni’ (the ultimate purchaser) and al-sani’, (seller) whereby al-sani’ - based on an order from the al-mustasni’- undertakes to have manufactured or otherwise acquire al-masnoo’ (subject matter of the contract) according to specification and sell it to al-mustasni’ for an agreed



Definitions Istisna’a work-in-progress account An asset account in which the Istisna’a contract costs are accumulated. When the percentage-of-completion method is used, a portion of Istisna’a profit commensurate with the work completed during a financial period is also debited to this account. Istisna’a costs account This is an asset account used when a parallel Istisna’a exists. It accumulates progress billings made by the subcontractor. A portion of the Istisna’a profit commensurate with the work completed during a financial period is also debited to this account. Percentage-of-completion method An accounting method that recognizes the revenues and profits of Istisna’a contracts as work progresses. Completed-contract method An accounting method that recognizes Istisna’a costs and revenues only in the financial period in which the contract is completed. Contract losses



Losses expected to happen when the sum of the costs accumulated in the for the completion of the contract exceed the price fixed in the Istisna’a contract.

Manufacturer

3

Al Sani in the parallel istisna 2

ISLAMIC BANK (al sani in the istisna’ contract and al mustasni in The parallel istisna contract)

4

1

Bank’s customer Al mustasni in the istisna’ contract

Fig 12.1 Istisna’a’ with parallel istisna’a’ financing 1

2

The customer executes a contract with the Islamic bank to manufacture and deliver goods to specification. Usually paying a deposit. The customer pays a series of progress payment to the bank on being billed The bank enters into an agreement with the manufacturer to manufacture and deliver the goods to the bank at an agreed future date. Normally a deposit and a series of progress payments are made when the manufacturer bills the bank.

3

The manufacturer manufactures and bills the bank periodically and delivers the goods to the bank (actually the customer) at the end of the contract.

4

The Islamic bank makes a series of billings to the customer based on istisna’a contract price and delivers the manufactured goods to the customer on completion.

12.3 Istisna’a’ and Parallel Istisna’a’ fiqh principles, rules and complexities.



1

Legitimacy Istisna’a is considered a special case of salam. It grew out out of the Salam contract and has similar provisions and rules. It arose out of jurisprudential engineering of the Hanafi school which approved its validity based on istihsan (equity). Istisna’a is valid also based on ibaha (permissibility if not contrary to scriptural text). Hence, we can say Istisna’a is valid from the consensus (ijma) of islamic scholars.

2

Conditions for validity: Al Masnoo

3

Conditions for validity: Date of Delivery. Initially, hanafis did not allow fixing of delivery date, however, AAOIFI scholars have agreed to all the fixation of future delivery date in order to avoid gharar in line with resolution of the fiqh academy

4

Price The price should be known to the extent of removing lack of knowledge (fixed?) It cannot be increased or decreased on account of the normal increase or decrease in commodity prices of labour or cost of labour. Similarly, if the bank gets a discount from the manufacturer or if the actual costs are substantially less then expected, the ultimate purchaser is not entitled to any discount. According to the shari’a standard, a cost plus istisna’a contract is NOT allowed

(Subject Matter) The subject matter be known and specified to the extent to remove gharar. Specifications to include: (i) kind e.g car, aeroplane or house (ii) type e.g. Toyota car, boeing aeroplane, low cost house (iii)quality; according to table of specifications.

A price change is allowed if the specifications of al masnoo are modified by the contracting parties subject to mutual agreement or due to unforeseen contingencies. 5

Binding nature of contract There is a difference of opinion whether the istisna’a contract is binding although its



validity has never been questioned. If the contract is not binding, then the mustasni or al sani can rescind the contract at the time of delivery. However, the Islamic Fiqh Academy has decreed that the Istisna’a contract is binding provided that certain conditions are fulfilled. However, if the al masnoo is not according to specification, al mustasni has the option to revoke the contract.

6

Legal consequences of istisna’a It transfers reciprocally, the title of ownership between al mustasni and al sani and entitles the al sani to the contract price.

7

Guarantee and Penalty Al mustasni has a right to get collateral for the amount he has paid. He also the right to get collateral for delivery in accordance wth specification and on time Further, al sani has the right to secure collateral to guarantee that the price is payable on time. Al mustasni can insert a penalty clause in the contract against unfullfillment of obligations .

8

Termination of contract The contract of Istisna’a’a may be terminated under the following conditions: (a) Normal fulfillment of obligations by both parties. (b) Mutual consent of both parties. (c) Judicial rescission of the contract. This is if a reasonable cause arises to prevent the execution of the contract or its completion, and each party may sue for its rescission(1).

9

Options on Non-compliance If al-musnoo’ is not in conformity with specification, al-mustasni’ has the following options: (a) reject al-masnoo’ or

1

()

See Recent Civil Islamic Legislations; Abdallah, A.A., op. cit, pp. 61-62.



(b) accept it without seeking damages. 9

Parallel Istisna’a If al-mustasni’a (the ultimate purchaser) did not stipulate in the contract that al-sani’ (seller) should manufacture the al-masnoo’ by himself, then al-sani’ may enter into a second Istisna’a’a contract in order to fulfil his contractual obligations in the first contract. This new contract is known as parallel Istisna’a’a, which is in essence a subcontract whereby the obligation of al-sani’ in the first contract are carried out. Nevertheless, (a) The Islamic bank as al-sani’ in the first contract will remain solely responsible for the execution of his obligations as if the parallel contract is non-existent. Hence, al-sani’ in the first contract would remain liable for any default, negligence or breach of contract ensuing from the parallel contract. (b) Al-sani’ in the parallel Istisna’a’a is accountable to al-mustasni’ (Islamic bank) in the way and manner by which he performs his obligations. He has no direct legal relationship with al-mustasni’ in the first contract. The second Istisna’a’a is a parallel contract, but not a contingent transaction on the first contract. Legally speaking they are different contracts with respect to rights and obligations. (c)

The Islamic bank as al-sani’ is liable to al-mustasni’ with regard to any mal-execution of the subcontractor and any guarantees arising therefrom. It is this very liability that justifies the validity of the parallel Istisna’a’a and which also justifies the charging of profit by the Islamic bank, if any (2).

Similarities and Differences between Salam and Istisna’a’ Subject 1. Subject matter of the 2

()

Salam Al-muslam fihi

Abdallah, A.A., op. cit., pp. 62-66.

Istisna’a’ Al-masnoo’

Rules and comments Deferred goods, specification.

known

by


Chapter 12 Accounting for Istisna’ and Parallel Istisna’ ‫اﻟﻤﻌﺎﻟﺠﺔ اﻟﺤﺴﺎﺑ ﺔ ﻟﻤﻌ ﺎر اﻷﺳﺘﺼﻨﺎع واﻷﺳﺘﺼﻨﺎع اﻟﻤﻮازي‬ contract. 2. Price.

Paid at time of contracting.

It is permissible to: One. ay it at time of contracting;

The means of settlement (in advance, deferred, or instalments) constitutes the main difference between Salam and Istisna’a.

Two. efer it; or Three. ay it in instalments. 3. Nature of contract

Binding

Binding

4. Parallel contract.

Parallel Salam

Parallel Istisna’a

Salam is originally binding on its parties, However, Istisna’a is considered binding based on the views of some fuqaha for the sake of maslaha and for not contravening any Shari’a rule. Both parallel Salam and parallel Istisna’a are valid provided that: § the two contracts are legally separated; § the legal relationship between the parties to each contract is separate; and § the rights and obligations of each contract are separate.

12.4 Recognition of Istisna’a’a transactions and journal entries. FAS 10, Istisna’a’ Financing is a standard which addresses the accounting rules of istisna’a and parallel istisna’a contracts in the financial statements of Islamic financial institutions.. These include measuring and recognizing the costs and revenue from both these contracts and gains and losses arising there from as well as the presentation and disclosure in the financial statements. The main transactions and their treatments are as follows.

12.4.1 Accounting treatment in the books of the Islamic bank as the seller (al sani’). DR Direct Istisna costs eg. Materials, labour costs of producing al masnoo

CR

CASH



Indirect Istisna Costs which can be allocated on an objective basis to the istisna contract

Istisna work in progress account CASH

PROFIT & LOSS ACCOUNT

Portion of profit margin recognized in the financial period

Pre operating Costs

(before contracting, when incurred)

Deferred costs account

Pre operating Costs

After contracting

Istisna work in progress account

Progress payment billings to al mustasni

Receipts on Account

ISTISNA’ ACCOUNTS RECEIVABLE

CASH

CASH

Deferred costs account

ISTISNA BILLINGS ACCOUNT

ISTISNA ACCOUNTS RECEIVABLE

Pre operating Costs

ISTISNA REVENUE


Chapter 12 Accounting for Istisna’ and Parallel Istisna’ ‫اﻟﻤﻌﺎﻟﺠﺔ اﻟﺤﺴﺎﺑ ﺔ ﻟﻤﻌ ﺎر اﻷﺳﺘﺼﻨﺎع واﻷﺳﺘﺼﻨﺎع اﻟﻤﻮازي‬ At year end profit recognition using percentage of completion method: ISTISNA REVENUE

Proportion of revenue recognized = cumulative cost incurred x contract price total expected cost

cumulative cost incurred

Profit recognized for the period = cumulative cost incurred x[ contract price-total total expected cost expected cost]

COST OF ISTISNA’ REVENUE

ISTISNA’ WORK IN PROGRESS

As can be seen from the above illustration, the following are the main transactions and their treatment. (i) all direct and indirect istisna’a costs are debited to a istisna’a works in progress account. Direct costs are those such as material and labour incurred the manufacture of al masnoo’. Indirect costs relating to the contract which can be allocated on an objective basis are also debited to this account. However general administration, selling, research and development costs should not be included under istisna’a contract costs. (ii) all pre-operating contract expenses are debited to a deferred costs before the execution of the contract and upon execution of the contract transferred to the Istisna’a work in progress account. (iii) Amounts billed to al-mustasni’ will be debited to istisna’a accounts receivable account and credited to istisna billings account. (iv)if the percentage of completion method is used , then a part of the contract price commensurate with the work completed is recognized in an istisna revenue account using the formula: ISTISNA REVENUE = ACCUMULATED COST TODATE X CONTRACT PRICE TOTAL EXPECTED CONTRACT COST



and the portion of the profit recognized is debited to istisna’a work in progress account using the formula below: PROFIT FOR THE ACCOUNTING PERIOD = ACCUMULATED COST TODATE X [CONTRACT PRICE- TOTAL EXPECTED CONTRACT COST] TOTAL EXPECTED CONTRACT COST

(v) Completed contract method. This method is used when both the percentage of completion and the expected cost to complete the contract cannot be reasonably estimated, no contract revenue or profit is recognized until the completion of the contract. In this case, the accumulated costs will be carried forward in the istisna’a work in progress account. (vi) Deferred profits Unlike a salam contract, where the payment must be made in advance, in an istisna’a contract, the price is can be paid in advance, in installments or deferred. The normal practice is the payment is made in installments. For Islamic bank customers, the financing motive means that the installments period will often run after the contract is completed and the al masnoo delivered. In this case, all the profits cannot be recognized in the accounts before the time the al-masnoo’ is delivered. A portion of the profits pertaining to the unpaid installments should be deferred. The deferred profit must be deducted from the Istisna’a Accounts Receivable in the Balance Sheet. The standard requires that the preferred method of allocation of deferred profits is by proportionate allocation of deferred profit over the future financial period of credit, whereby each financial period will carry its portion of profit, whether or not, cash is received. This statement is not clear, it could mean the bank can allocate the deferred profit by equally over the remaining credit period (similar to straight line depreciation) or in proportion to the amounts receivable per payment schedule. The latter appears as a better interpretation. However, if the bank’s SSB or regulatory authorities approve, then the deferred profit is allocated in proportion to the installments received. There seem to be an error in the English version of the standard FAS10,, para 11 (2/3/2). The English version defines the deferred profit as the difference between the contract price and the installments paid during the contract term. This is actually the accounts receivable. Netting this amount against the Istisna’a Accounts Receivable will make it nil. In the Arabic version of the standard, no such definition is


Chapter 12 Accounting for Istisna’ and Parallel Istisna’ ‫اﻟﻤﻌﺎﻟﺠﺔ اﻟﺤﺴﺎﺑ ﺔ ﻟﻤﻌ ﺎر اﻷﺳﺘﺼﻨﺎع واﻷﺳﺘﺼﻨﺎع اﻟﻤﻮازي‬ given. Since the Arabic version of the standards are to be followed in case of conflict, this definition is ignored in this book. (vii) Advance payment by al mustasni. The Islamic Bank may (not must) waive a part of its profit in case of advance payment and this rebate will be deducted from Istisna’a accounts receivable and deferred profits (Dr. Deferred profits , Cr Istisna Accounts Receivable) The same treatment is effected if the al mustasni paid the whole amount and the bank refund the rebate to the customer. (viii) Change orders and additional claims If the al mustasni requests for a change in the specifications in the al masnoo or additional work, and the al sani agrees to this, the value and cost of the change orders must be added to the istina’a costs and revenues respectively. Additional claims made by al sani in excess of the contract price for delays, errors in specifications and designs or other causes of unanticipated costs caused by al mustasni’, an additional amount of revenue equal to the additional costs should be recognized provided, there is a legal basis supported by verifiable evidence (see definition below for further conditions). If the conditions for recognition of additional claims are not satisfied, then an estimated value of these claims should be disclosed in the notes to the financial statements.

Definitions Change orders Approved modifications in specifications, quantities, design, or other attributes defined in the original Istisna’a contract the implementation of which affects contract costs. Additional claims Amounts in excess of the agreed Istisna’a contract price which are claimed by al-sani’ for delays, errors in specifications and designs or other causes of unanticipated costs caused by al-mustasni’. Recognition of these claims by al-sani’ requires the satisfaction of the following conditions: (a)

The existence of a legal basis for the additional claim supported by objective and verifiable evidence.

(b)

Claims must be due to circumstances that were unforeseeable at the contract date and are not the result of the deficiencies, fault or negligence of al-sani’.



(c)

Costs associated with the additional claim are identifiable and reliably estimable.

(ix) Maintenance and Warranty costs. These costs should be accounted for on an accrual basis. These costs should be estimated and matched with istisna’a revenue. Actual maintenance and warranty expenses should be charged against an Allowance for Maintenance and Warranty Account, when carried out by the Islamic bank. In case of a parallel istisna’a, the maintenance and warranty costs should be charged as incurred to expense accounts.


Chapter 12 Accounting for Istisna’ and Parallel Istisna’ ‫اﻟﻤﻌﺎﻟﺠﺔ اﻟﺤﺴﺎﺑ ﺔ ﻟﻤﻌ ﺎر اﻷﺳﺘﺼﻨﺎع واﻷﺳﺘﺼﻨﺎع اﻟﻤﻮازي‬ Summary of Journal Entries for Istisna in the books of the bank

No. 1 2

Transactions /Events Pre contracting costs Recognition of direct and indirect expenses on contract

On execution of contract, 3 precontract deferred costs transferred

4

5

Completed contract method Portion of profit and revenue recognized

Progress Payment billings to al mustasni

6 Receipts of Billings If part of progress payments falls after al masnoo’ is delivered. Deferred profits 7 are set up and amortized in proportion to installments receivable Deferred profits recognized in proportion 8 to installments receivable

DR Deferred costs Istisna’a Work in Progress

CR. cash Cash

Istisna’a Work in Progress

Deferred costs

Istisna’a Work in Progress (with profit recognized)

Istisna Revenue (with revenue recognized)

Cost of Istisna’a Revenue (with difference between revenue and profit) Istisna Accounts Receivable Cash

Istisna Billings account Istisna’a Accounts Receivable

Istisna Revenue Deferred Profits (if profits recognized exceed the proportion of installments receivable) Dr Deferred profit Profit and Loss account



10

11

12

Early Settlement of installments by al mustasni and the bank gives rebate. Contract losses or reduction in value of istisna work in progress below cash equivalent value change orders and additional claims and requisite conditions are met. When additional costs are incurred

13

Maintenance warranty costs

and

14

Expenses on maintenance and warranty Al mustasni refuses to take delivery of al masnoo

Deferred Profits

Istisna’ Accounts Receivable

Dr Profit and Loss

Istisna work in progress

Dr Istisna work in progress

Cash

Dr Istisna’a Accounts Receivable Profit and Loss

Allowance for maintenance and warranty Istisna Asset account Profit and Loss

15 Disposal of refused al masnoo.

Cash

Istisna Revenue

Allowance for maintenance and warranty Cash

Istisna work in progress Istisna asset account (any loss due to cev less than carrying value Istisna Asset account



12.4.2 Accounting treatment in the books of the Islamic bank as the buyer(al mustasni) – parallel istisna’a contract. (i) Only the completed contracts method is recognized in the case of parallel istisna’a because both the revenues and costs (being billed to the bank by al sani) are known with reasonable certainty. (ii) The costs billed by the contractor to the Islamic bank are accumulated in a Istisna’a costs account (as opposed to an Istisna’a work in progress account in istisna’a contract). The credit entry is to an Istisna’a accounts payable. The recognized portion of profit for a financial period is added to the Istisna’a cost account.

Progress Billings of subcontractor to the bank

Portion of profit margin recognized in the financial period

Al Masnoo received not to specification and cev lower than carrying value; difference between cev and carrying value

ISTISNA’ COSTS ACCOUNT


PROFIT AND LOSS ACCOUNT

ISTISNA ACCOUNTS PAYABLE

PROFIT AND LOSS ACCOUNT


(iii) Receipt of al-masnoo’ When the contractor delivers al masnoo to the bank, in conformity to specifications and schedules., the bank should record the asset at historical cost (i.e. book value) of the Istisna’a cost account. The balance of the Istisna’a costs should be transferred to an asset account reflects the nature of the asset. E.g. fixed asset or investment in ijarah assets or istisna assets.


Chapter 12 Accounting for Istisna’ and Parallel Istisna’ ‫اﻟﻤﻌﺎﻟﺠﺔ اﻟﺤﺴﺎﺑ ﺔ ﻟﻤﻌ ﺎر اﻷﺳﺘﺼﻨﺎع واﻷﺳﺘﺼﻨﺎع اﻟﻤﻮازي‬ (iv) Late delivery of al masnoo’ IN case delay is due to negligence or fault of al sani and the Islamic bank is entitled to compensation for damages resulting from the delay, this should be first deducted from performance bonds. If insufficient, the deficit is an Istisna’a accounts receivable from al sani’ subject to allowance for doubtful debts. (vI) Al Masnoo’ not conforming to specifications If the bank declines to accept it, and it does not recover all its payents to the al sani’, the un-recovered balance becomes a receivable subject to allowance for doubtful debts. If the bank accepts al masnoo’ it will be measured at the lower of the cash equivalent value or historical cost. Any resulting uncompensated loss should be written off for the current accounting period. (vii)if al Mustasni (client) refuses to receive al-masnoo’ The masnoo will be carried at lower of cash equivalent value or historical cost. Any resulting loss will be written off in the accounting year in which it is realized. Summary of journal entries in the books of the bank as buyer (al mustasni)

No. 1

2

3

Transactions /Events Pre contracting costs On execution of contract, precontract deferred costs transferred Billings received from contractor

4 Payments to contractor

DR CR. Deferred costs cash Istisna’a Costs account Deferred Costs

Istisna’a Costs account Istisna’a Accounts Payable Istisna’a Accounts Cash Payable



At end of year, istisna’a profits recognized using 5 percentage of completion method

Istisna costs account Istisna Revenue Costs of Istisna account

Receipt of al masnoo in 6 conformity with specifications and schedule Receipt of al masnoo not in conformity to 7 specifications, value reduced to cash equivalent value Islamic bank does not 8 accept al masnoo which is not due to specs When installments are due to al sani (subcontractor) after al masnoo is delivered. Profit applicable to undue installments deferred

Istisna Asset account

Istisna costs account

Dr Profit and Loss Dr Istisna Asset

Istisna costs

Dr Istisna accounts receivable

Istisna costs

Istisna Revenue

Deferred profit

12.5 Asset and Liability measurement AAOIFI : presentation and disclosure of Istisna’a Balance Sheet Istisna Work in Progress (including profits recognized) (in case of parallel istsna – Istisna costs

XX

Less Istisna Billings

(XX)

Less loss recognized/reduction to cev

(XX)

Less Allowance for maintenance costs

(XX)

Net Istisna work in progress

XX



Balance Sheet (continued) Istisna Accounts receivables Less deferred profits Less allowance for doubtful debts Net Istisna’a Accounts Receivable

XX (XX) (XX) XX

Balance Sheet (Liability side) Istisna Accounts Payable

XX

Income Statement Istisna’a Revenue Less costs of istisn’a Revenue Less Deferred profits in future installments Less losses on istisna/reduction to cev Add reversal of deferred profit

XX (XX) (XX) (XX) XX

12.6 Accounting Illustration 12.6 Accounting Problem XYZ Islamic Bank entered into a two-year Istisna’ contract to construct a diesel power generator for a total price of $600,000 commencing ! January 2002. The following costs were estimated at the time of concluding the contract.

Materials Wages Total

31 December 2002 120,000 180,000 300,000

31 December 2003 60,000 120,000 180,000

Billings were made in tear 2002 for $225,000 and the remaining balance was billed at the end of year 2003.



Following is the payment schedule that was agreed with the client of XYZ Islamic Bank :

Year 2002 2003 2004 2005 2006

% of total price 10% 10% 20% 30% 30%

The XYZ Islamic Bank incurred general and administration expenses totalling $5,000 during 2002. Substantial increase in material cost occurred in 2003 due to the liquidation of a major supplier for the said material. Accordingly, the bank revised its cost estimate for material to be $60,000 higher than previous planned. The Bank recognises revenue based on the percentage of completion method. Required : Prepare all necessary journal entries for the years 2002 to 2006 to record the above transactions in the books of XYZ Islamic Bank . Prepare the statement of financial position and income statement of the XYZ Islamic Bank for the year 2002 and 2003 to present the transactions relating to the contract. (A.I.A, Professional Examination II,2002,Q 1) udarib. Solution: Journal entries for 2002 Dr. Istisna work in progress 300,000 Cr. Accounts payable / cash (On account of materials 120,000 and wages 180,000)

300,000



Dr. General & admin. Expenses Cr. Accounts payable / cash

5,000

Dr.Istisna account receivable Cr. Istisna billings

225,000

Dr.Cash Cr. Istisna accounts receivable

60,000

Dr. Cost of istisna revenue Dr. Istisna work in progress Cr. Istisna revenue

300,000 75,000

5,000

225,000

60,000

375,000

Journal entries for 2003 Dr. Istisna work in progress 240,000 Cr. Accounts payable / cash ( On account of materials 120,000 and wages 120,000)

Dr.Istisna account receivable Cr. Istisna billings

375,000

Dr.Cash Cr. Istisna accounts receivable

60,000

Dr. Cost of istisna revenue Cr. Istisna work in progress Cr. Istisna revenue

240,000

375,000

60,000

15,000 225,000

Journal entries for 2004 Dr.Cash

240,000

12,000



Cr. Istisna accounts receivable

12,000

Journal entries for 2005 Dr.Cash Cr. Istisna accounts receivable

180,000 180,000

Journal entries for 2006 Dr.Cash Cr. Istisna accounts receivable

180,000 180,000

b. XYZ Islamic Bank Statement of financial position as at 2002 2002 Istisna work in progress Less istisna billings

375,000 225,000 150,000 165,000

Istisna accounts receivable XYZ Islamic Bank Statement of financial position as at 2003 2003 Istisna work in progress Less istisna billings

600,000 600,000 -

Istisna accounts receivable

480,000

XYZ Islamic Bank Income statement for the year ended 2002 2002



Istisna revenue Istisna cost

375,000 300,000 75,000 5,000 70,000

General & admin expenses Net profit

XYZ Islamic Bank Income statement for the year ended 2003 2003 Istisna revenue istisna cost

225,000 240,000 (15,000)

Net Loss




MCQ12-1 . Zain Islamic Bank agreed to construct on an Istisna’ contract term, 25 semi-detached luxury villas in the Topkapi Hillview estate for their client, Aksaray Construction Company. Which statement identifies the correct parties to this Istisna’ contract: a) Topkapi Hillview estate is the seller (al-sani’) and Zain Islamic bank is the agent of the purchaser (al-mustasni’). b) The 25 semi detached villas is the asset (al-masnoo’) and Aksaray Construction Company is the seller (al-sani’). c) Topkapi Hillview estate is the purchaser (al-mustasni’) and Zain Islamic bank is the agent of the seller (al-sani’). d) Zain Islamic bank is the seller (al-sani’) and the Aksaray Construction Company is the purchaser (al-mustasni’). MCQ12-2 An Islamic Bank has agreed to construct a manufacturing facility for

its customer through an Istisna’ contract. The total contract price is US$ 1,700,000 while the contract cost is estimated at US$ 800,000. Construction is estimated to be completed in 2 years. By end of Year 1, the cumulative costs incurred were US$ 300,000 including pre-contract costs of US$ 45,000. Assuming all these costs were paid off by cash, which of the following journal entries are correct for Year 1: a) Dr Istisna’ Work in progress

Cr

345,000

Cash

300,000

Deferred cost

45,000


Chapter 12 Accounting for Istisna’ and Parallel Istisna’ ‫اﻟﻤﻌﺎﻟﺠﺔ اﻟﺤﺴﺎﺑ ﺔ ﻟﻤﻌ ﺎر اﻷﺳﺘﺼﻨﺎع واﻷﺳﺘﺼﻨﺎع اﻟﻤﻮازي‬ b) Dr Istisna’ Work in progress

Cr

300,000

Cash

255,000

Deferred cost

45,000

c) Dr Istisna’ accounts receivable

Cr

300,000

Istisna’ work in progress

300,000

d) Dr Cash

M

Cr

345,000

Istisna’ Work in progress

300,000

Deferred cost

45,000




Chapter 12: Accounting for Istisna’ and Parallel Istisna’

Question 12-1

Discuss the applicability and limitations of Salam and Istisna’a’ financing in adapting into a modern financial environment. (IIUM B.Acc, semester 2, 2002/2003, Q3b) Question 12-2 a. Compare and contrast the similarities and differences betweem salam financing and istisna’a’ financing; b. Explain the possible reasons why salam and istisna’a’ financing are not widely practiced by financial institutions in Malaysia; and, c.

Illustrate with a simple example the parallel istisna’a’ financing and show how istisna’a’ revenue and profit is recognized as recommended by AAOIFI’s Financial Accounting Standard No.10. (IIUM B.Acc, Resit semester 3, 2002/2003, Q3) Question 12-3

i. RHB Islamic Bank Islamic entered into a 4 year Istisna’a contract with the Malaysian government to build a bridge over the PutraJaya river at $100 million and payable by the Malaysian government as follows: On signing of contract End of 1st year End of 2nd year End of 3rd year

10% 20% 20% 30%



End of 4th year

20%

The bank billed the Malaysian government on schedule and the government paid promptly. The istisna’a contract stipulated any increase in costs will be borne by the bank and will not be passed on to the government. However, the government would not charge any penalty for late completion of up to a year. At the same time, RHB Islamic Bank entered into a parallel Istisna’a contract worth $80 million with Islamic Engineers Malaysia to build, test and hand over the bridge over a two year period. Islamic Engineers did not agree to bear any additional cost over run. The bank agreed to pay Islamic Engineers a 10% initial payment on the signing of the contract. Subsequent payments by the bank would be in 30 days after each progress billing was made to the bank. In the first year, Islamic engineers billed $32 million to the bank. In the second year however, costs escalated and Islamic Engineers informed the bank that it would cost an additional $ 25 million to complete the bridge and required an extension of 6 months. They billed the bank another $50million during the second year. In the third year, Islamic engineers completed the bridge. However, the actual costs had only gone up by $20 million and Islamic Engineers agreed to pay a penalty of $ 5 million according to the istisna’a contract for late completion. The SSB of RHB Islamic had established that any late payments by sub contractors was not considered as riba and to be taken as revenue of the bank. Islamic Engineers billed the bank the remaining amount during the third year and was paid accordingly in the same year. Required: Journal entries in the books of RHB Islamic Bank for the above transactions from year 1 to 4 if profits are recognized on an (a) accrual basis and (b) end of contract basis. ( IIUM MBA, 2005/2006, Q5b )



Question 12-4

A. Dubai Investment House (DIH) , an Islamic bank signed an Istisna’a contract with Malaysian Nuclear Agency (MNA) on 1 Jan 2006 to build and deliver a nuclear reactor for $300 Million on 31st December 2007. MNA would pay 10% of the contract price on the signing of the contract to DIH and DIH would bill MNA for the remaining amount of the contract as per the following schedule: 31 /12/2006 31/12/2007 31/12/2008 31/12/2009

20% 30% 20% 20%

MNA would not accept any cost escalation but would not charge DIH any penalty if the reactor was delayed NOT beyond 1 year from the schedule delivery date of 31st December 2007. DIH billed MNA per the above schedule and was paid on 31st January in the year following the billing date. At the same date(1/1/2006) , Dubai Investment House signed a parallel istisna’a contract with Nucleon, a engineering firm in France who specialized in building nuclear reactors for $200M with the following terms of payment: On signing the contract 10% of contract price Further amounts to be paid on billings by Nucleon. Nucleon agreed to deliver the reactor on 31st December 2007 failing which DIH would charge Nucleon a penalty of 10% per annum of the contract price on a prorata basis based on time. Nucleon refused to bear any cost escalation. It would simply pass on the costs to DIH. The following billings were made by Nucleon to DIH and DIH paid Nucleon in 60 days after the billing date



30th November 2006

$80M

In February 2007, Nucleon informed DIH that the cost of the reactor had escalated and it would now cost $320 Million and delivery would be delayed until 30 Jun 2008. It billed DIH another $200M on 1st November 2007, which DIH paid in 31st January 2008. In Jun 2008, Nucleon delivered the completed reactor. Nucleon billed the remaining costs of the contract less the penalty it had to pay on 30 Jun 2008 and was paid by DIH 60 days thereafter.

(i)

(ii)

Required: Provide the necessary T accounts (NOT journal entries) in the books of DIH for the contract from 1st January 2006 until the final payment was settled by MNA assuming DIH uses the percentage of completion method to calculate profits. An extract of the Income statements and Balance Sheet for the necessary years. (IIUM B.Acc, semester 1, 2006/2007, Q1a)

B. Would you prefer a BBA or a Istisna’a contract from an Islamic bank to finance an unfinished home? Why? Explain another Islamic contract that can be used to finance a house other than murabaha with ultimate ownership transferred to you? (IIUM B.Acc, semester 1, 2006/2007, Q1c)



Question 12-5

AmBank Islamic entered into a 4 year Istisna’a contract with the Malaysian government to build a bridge over the Kelang river at $100 million and payable by the Malaysian government as follows: On signing of contract End of 1st year 2nd year End of 3rd year End of 4th year

10% 20% 20% 30% 20%

The bank billed the Malaysian government on schedule and the government paid promptly. The istisna’a contract stipulated any increase in costs will be borne by the bank and will not be passed on to the government. However, the government would not charge any penalty for late completion of up to a year. At the same time, AmBank Islamic entered into a parallel Istisna’a contract worth $80 million with United Engineers Malaysia to build, test and hand over the bridge over a two year period. United Engineers did not agree to bear any additional cost over run. The bank agreed to pay United Engineers a 10% initial payment on the signing of the contract. Subsequent payments by the bank would be in 30 days after each progress billing was made to the bank. In the first year, United engineers billed $32 million to the bank. In the second year however, costs escalated and United Engineers informed the bank that it would cost an additional $ 25 million to complete the bridge and required an extension of 6 months. They billed the bank another $50million during the second year. In the third year, united engineers completed the bridge. However, the actual costs had only gone up by $20 million and United Engineers agreed



to pay a penalty of $ 5 million according to the istisna’a contract for late completion. The SSB of AmBank Islamic had established that any late payments by sub contractors was not considered as riba and to be taken as revenue of the bank. UEM billed the bank the remaining amount during the third year and was paid accordingly in the same year.

Required: Journal entries in the books of AmBank Islamic for the above transactions from year 1 to 4 if profits are recognized on an (i) accrual basis and (ii) end of contract basis. (IIUM B.Acc, semester 2, 2005/2006, Q6c)

Question 12-6

In the year 2006, the Islamic Development Bank of Brunei (IDBB) entered into an Istisna’a’a contract with Malaysian government to build and deliver a highway project at $15 million in three years time, to be delivered at the end of year 2008. The bank billed Malaysian government as follows:

On signing of contract End of year 2006 End of year 2007 End of year 2008 End of year 2009

10% 30% 20% 20% 20%

The government paid the bank one month after the billing date. The Istisna’a’a contract clearly indicated that any increase in costs will be borne by the bank and will not be paid by the government. However, the



government agreed not to charge any penalty if the bank is able to deliver within 6 months after the due delivery date. The bank immediately entered into parallel Istisna’a’a contract at $12 million with Plus Berhad to build the highway project according to the Malaysian government’s specifications. Plus Berhad did not agree to bear any additional cost over run. However, if Plus Berhad did not deliver the project on the due date, it was agreed that the bank will charge a penalty of 5% of the total costs at pro rata basis and the penalty was paid to the charity. The bank agreed to pay Plus Berhad a 10% initial payment on the signing of the contract. Subsequent payments by the bank would be two months after each billing was made to the bank. The payments made by Plus Berhad during the first two years are as follows: Year 2006 Year 2007

$4.5 million $4.0 million

In year 2008, the total costs were anticipated to increase to $16 million and Plus Berhad informed the bank that they required an extension of six months. They billed the bank $4 million during the year 2008. In July 2009, Plus Berhad completed the highway. However, the actual costs has only increased to $14 million. Plus Berhad billed the bank the remaining amount during year 2009 and was paid accordingly in the same year. Required: a. Ledger entries in the books of Islamic Development Bank of Brunei for the above transactions from year 2006 to year 2009 if profits are recognised based on percentage of completion method. b. An extract of the income statement and Balance Sheet for the necessary years. (IIUM B.Acc, semester 2, 2006/2007, Q2)



Question 12-7

1. Copy the table below to your answer book and complete the table showing the similarities and differences between salam and istisna’a contracts.

2. Bank Salim Bhd. Entered into a contract with Selangor Airlines to manufacture and deliver 2 state of the art passenger jet aircraft for $100 Million over the next two years. Subject

Salam

Istisna’a

Rules and Comments

Seller Buyer Subject Matter of the contract When Price is paid

Parallel Contract The contract called for billings and payments to be made by the end of the each financial year which coincided with the contract. At the same time Bank Salim entered into a parallel istisna’a agreement with Malaysian Airperahu Industries to buy the two aircraft for $80 million deliverable in the two years. The other details of the transactions are as follows: Transaction Billings by Bank Salim to Selangor Airlines

Year 1 $40m

Year 2 $60M

Billings by AirPerahu to Bank Salim

$30M

$50M



Payments to Malaysian Airperahu Collections from Selangor Airlines

$25M $ 35M

$55M $65M

Assuming the bank used the percentage of completion method, prepare journal entries for the above as well as show the extracts of the income statements and the balance sheets for year 1 and year 2 in the books of the Bank Salim Bhd (IIUM B.Acc, semester 2, 2004/2005, Q5 b & c)


Chapter 13: Zakat for Islamic Financial Institutions َ‫وَأَﻗِ ﻤُﻮا اﻟﺼﱠﻼةَ وَآﺗُﻮا اﻟ ﱠﺰﻛَﺎةَ وَارْﻛَﻌُﻮا ﻣَﻊَ اﻟﺮﱠاﻛِﻌِ ﻦ‬ And establish prayer and give zakah and bow with those who bow (in prayer) (Al Baqarah- The Cow 2:43)

‫ ﻣﻦ آﺗﺎه اﷲ ﻣﺎﻻً ﻓﻠﻢ ﺆد زﻛﺎﺗ ﻣُﺜﻞ ﻟ ﺷﺠﺎﻋﺎً أﻗﺮع ﻟ زﺑ ﺒﺘﺎن‬:(‫ﻗﺎل رﺳﻮل اﷲ )ص‬ ، " ‫ أﻧﺎ ﻛﻨﺰك‬، ‫ أﻧﺎ ﻣﺎﻟﻚ‬: ‫ ﺛﻢ ﻘﻮل‬- ‫ ﺷﺪﻗ‬: ‫ ﻌﻨﻰ‬- ‫ ﺛﻢ ﺄﺧﺬ ﺑﻠ ﺰﻣﺘ‬، ‫ﻄﻮﻗ ﻮم اﻟﻘ ﺎﻣﺔ‬ ‫ﻢ اﷲ ﻣﻦ‬ª‫ وﻻ ﺤﺴﺒﻦ اﻟﺬ ﻦ ﺒﺨﻠﻮن ﺑﻤﺎ ءاﺗﺎ‬: ‫ﺛﻢ ﺗﻼ اﻟﻨﺒﻲ ﺻﻠﻰ اﷲ ﻋﻠ وﺳﻠﻢ ﻗﻮﻟ ﺗﻌﺎﻟﻰ‬ ( ‫ﻮ ﺷﺮٌ ﻟ ﻢ ﺳ ﻄﻮﻗﻮن ﻣﺎ ﺑﺨﻠﻮا ﺑ ﻮم اﻟﻘ ﺎﻣﺔ )ﺳﻮرة‬ª ‫ﻮ ﺧ ﺮاً ﻟ ﻢ ﺑﻞ‬ª ‫ﻓﻀﻠ‬ Those who Allah bestowed upon them wealth (or money) and have not given out Zakah thereon, their portion will be a ferocious snake that embraces them on the Day of Judgment, grabbing their cheeks and saying: I am your money, I am your treasures. Then the Prophet recited: “those who are tight-handed as with the bounties Allah provided them, shall not consider it better for them, in contrast it is devil on them, with which they will be wrapped up on the Day of Judgment.

Chapter

13

CHAPTER LEARNING OBJECTIVES: At the end of this chapter you will, insha Allah you will be able to: i. ii. iii.

iv. v. vi. vii. viii.

Explain the meaning of zakah and the relationship of zakah to Islamic banks and their stakeholders. Demonstrate a knowledge of the basic fiqh rules on zakah. Determine the zakah base using the both the Net assets method and Net Invested Funds method and appropriate valuation rules for the financial statement elements. Compute zakah on the basis of lunar and solar months Journalize zakah entries and prepare the source and application of zakah and charity funds. Show how zakah is presented in the financial statements of Islamic banks. State the disclosure related to zakah in the notes to the accounts. Discuss some country variation in zakah legislation and their impact on Islamic bank practices. 1


Chapter 13: Zakat for Islamic Financial Institutions 8. 1 Introduction to zakah and its importance Zakah (or zakat)is one of the five pillars of Islam. This signifies its importance for the Muslim community. It is an act of workship (ibadat) to Allah swt. However, this is one of the acts of worship in Islam which has economic and social ramifications. Zakah is difficult to translate into English. The literal meaning of the word means “blessing, purification, growth and increase, cleansing.” The technical definition of zakah is a specified amount on specified wealth and income which is collected from Muslims who are liable and to be distributed to the eight categories (asnaf) of people mentioned in the Qur’an.

Definitions Zakah Literary, Zakah means blessing, purification, increase and cultivation of good deeds. It is called Zakah because it blesses the wealth from which it is paid and protects it. In Shari’a, Zakah is an obligation in respect of funds paid for a specified type of purpose and for specified categories. It is a specified amount prescribed by Allah the Almighty for those who are entitled to Zakah as specified in the Qur’an. The word Zakah is also used to indicate the amount paid from the funds that are subject to Zakah. Cash and cash equivalent Cash and cash equivalent include local and foreign currency and deposits with the central bank and other Institutions which the Islamic bank can withdraw in full on demand. For Zakah purposes cash and cash equivalent includes, in addition to the above, gold or silver in the form of currencies, bullion or other.

Zakah is not religious charity, which is termed sadaqah (although sadaqah is sometime used in the Qur’an to mean zakah). Charity is a voluntary affair, whereas Zakah is a compulsory levy on wealth and income, once it exceeds a certain amount termed nisab. According the Qur’an it is a right of the poor on the wealth and income of the rich, thus

2


Chapter 13: Zakat for Islamic Financial Institutions

And in their wealth and possessions (was remembered) the right of the (needy,) him who asked, and him who (for some reason) was prevented (from asking). Az-Zariyat 51:19 In the Prophet’s (saw) time and during the time of his successors, zakah was collected and distributed by the Islamic state as per the instructions of the Qur’an thus:

Of their goods, take alms, that so thou mightest purify and sanctify them; and pray on their behalf. Verily thy prayers are a source of security for them: And Allah is One Who heareth and knoweth At-Tauba (The Repentance) (9:103)

The Prophet saw himself appointed and sent collectors to assess zakah and even distribute it at the place of collection while the surplus was remitted to the Baitul Mal (treasury). After colonization, zakah administration by the state stopped. However, in the last 20 years, various new models of zakat administration and are being tried in various Muslim countries such as Pakistan, Malaysia and Indonesia.

In Pakistan, the government has legislated the collection and distribution of zakah. E.g. banks are asked to deduct zakah from the depositors and shareholders and remit them to government zakah agencies. In Malaysia, zakah is collected and distributed by privatized zakah agencies in many states. The Islamic banks remit their zakah to these agencies. In Indonesia, NGO’s approved by government collect and distribute zakah. The issues which will be discussed in this text are: 1. 2. 3. 4. 5. 6.

What are the different types of zakah? To whom are the zakah distributed? On what items are zakah levied? The zakah period (haul) and nisaab (exemption limit) The computation of the zakah base The measurement/valuation of items include in the zakah base

3


Chapter 13: Zakat for Islamic Financial Institutions 7. The calculation of zakah. 8. Do the Islamic banks as artificial legal persons need to pay zakah? 9. How is zakah administered by the Islamic bank and reported? However, justice cannot be done to the zakah in this book as it is a very broad subject which takes volumes by itself. Interested readers are referred to Fiqhuz Zakah by Sheikh Yusuf Qaradhawi, the magnum opus on zakah in the 20th century which is translated into English by Dr. Monzer Kahf. The calculation and payment of zakah has been argued to be the principal or one of the main objectives of Islamic accounting (Adnan and Gaffikin ) and Shahul and Yaya (2005). Hence, our concern here is to get some basic understanding of zakah, its fiqh rules and its computation and reporting in the financial statements of Islamic banks.

8.2 The fiqh of zakah – a summary The sources of zakah Zakah is levied on gold and silver (or money, bank account balances, financial papers) , livestock (cattle, sheep/goats, camels), agricultural produce of staple crops (wheat, rice), business working capital (inventory, receivables, cash and cash equivalents),

AGRICULTURE

SOURCES OF ZAKAH

GOLD, CASH

4



INVENTORY

LIVESTOCK

Under each sources, there are further detailed fiqh rules which vary among the schools of thought. For example, the shafi scholars only levy zakah on staple crops and not cash crops such as rubber, cocoa, palm oil, vegetables and fruits etc, although the latter are more important source of income and are grown by the rich plantations. Livestock only cattle, sheep and goats and camels come under zakah while chickens, ostrich, rabbits are not zakatable (unless they form part of business inventory). During the time of the Prophet saw, these were the main sources of income and wealth, where the state was in the primary stage of economic development. However, for our knowledge, services and industrial (or financial) economies, the fuqahas are reinterpreting and carrying out ijtihad to make the fiqh relevant todays society. FAS no. 9 and the forthcoming shari’a standard on zakah,Sheikh Yusuf Qaradhawi’s seminal work mentioned earlier and the Fatawa of the Islamic Fiqh Academy of the OIC are all making the rules of Zakah more relevant today’s economy. Islamic financial institutions are businesses and therefore have to pay business zakah. We will study what items in the balance sheet are zakatable later on in this chapter.

Conditions for liability to Zakah Zakah is payable under the following conditions: Unencumbered possession The possession or ownership must be complete. In other words, the owner must have control over the property especially power of disposal. Similarly, there is no Zakah on public funds, or funds held for waqf (endowment) for charitable purposes and the funds of charitable organizations and property of NGO’s., because they do not have a specific owner, and are designated for spending it on causes which benefit society in general. However, waqf ahli or family waqf is subject to zakah. The asset must be capable of growing or increasing. The growth can be in real terms by reproduction (livestock) or by potentiality e.g. stock which is intended to be traded. Growth by estimation may take place if the

5


Chapter 13: Zakat for Islamic Financial Institutions asset has the potential to yield a surplus and this includes cash and cash equivalent including gold and silver, even if they are not invested. However, assets held as part of fixed or non-circulating capital (notably fixed assets) are not subject to Zakah. Nisab Nisab is the amount exceeding which zakah becomes payable. If the zakatable base amounts to less then the nisab amount, zakah is not payable. The nisab differs for different sources of zakah. For gold, silver, cash and business working capital, the nisab is the monetary equivalent of 85 grams of gold or 595 grams of silver for each individual. In case of agriculture and livestock, the nisab for these categories are prescribed in the Shari’a. In the case of partnerships and corporations the nisab is calculated on the combined wealth of the owners. For agricultural crops and livestock, it is in terms of quantity of output and number of animals of each type.

6



Hawl and Zakah rates. Hawl is the fiscal period of zakah. It is one lunar year. Although the start and ending month is not fixed, normally Muslims pay their zakah in Ramadhan, the fasting month to obtain additional rewards from Allah. Businesses such as Islamic financial institutions, however, follow the Gregorian calendar which follows the solar year which is longer (365 or 366 days as compared to the lunar year which has 354 days.

Solar or Lunar?

Although it would be good for Islamic identity to follow the Islamic year, it is not prohibited. However, zakah must be paid once every lunar year except in the case of agriculture where the zakah is payable on the day of harvest at 5 or 10%.

7



It is He Who produceth gardens, with trellises and without, and dates, and tilth with produce of all kinds, and olives and pomegranates, similar (in kind) and different (in variety): eat of their fruit in their season, but render the dues that are proper on the day that the harvest is gathered. But waste not by excess: for Allah loveth not the wasters. Al-An'am (The Cattle) 6:141) For business working capital, gold and cash, the rate is 2.5% per lunar year. If the Islamic banks follows the Gregorian solar year, then this rate is uplifted by 365/354x2/5%= 2.5775% per solar year. Duplication of Zakah Zakah is payable only once every lunar year. It cannot be payable twice during the same lunar year. However, if an asset forming part of working capital (e.g. agricultural produce or livestock) is sold during the year and replaced by another asset of a similar or different kind (e.g. cash), then a further Zakah is payable. Tax The payment of tax does not the discharge the duty to pay zakah.. Moreover, tax is not deducted from the amount of Zakah due. However, the current tax payable (not deferred tax can be deducted before arriving at the zakah base, since it is an account payable. In some jurisdictions such as Malaysia, the amount of zakah paid can be claimed as a tax deductible expense. For personal taxation, any amount of zakah paid to authorized collections centres can be deducted as a rebate from the income tax payable.

8



Zakah on unlawful or suspect funds If the income cannot be returned, then zakah has to be paid and the balance must be given to charity. The charity payment cannot be considered zakah. Conditions of Zakah on trading assets Most of the funds held by Islamic banks, including cash, are subject to the Zakah due on trading assets. The latter include items bought for resale and raw material purchased for manufacturing and subsequent resale. For Zakah to be due on trading assets, the following conditions must be fulfilled in addition to the general conditions mentioned earlier: (a) Business activity In general, trading assets are acquired by way of purchase or exchange, or by way of discharge of a debt. Assets acquired by way of inheritance or donation would not be considered as trading assets. Such assets when sold for cash will give rise to a liability to Zakah on the cash proceeds. (b) Intention to trade This means an intention to trade in the assets once they are acquired. The intention that matters is that the trading assets should become part of the assets held by the business. Items acquired for use as fixed assets are not subject to the Zakah due on trading assets. However, if a fixed asset is subsequently sold in trading, Zakah becomes due on the cash proceeds only if the nisab is attained and the cash proceeds are still on hand at the end of hawl (the relevant financial year). On the other hand, an asset acquired for trading but subsequently converted to use as a fixed asset is no longer counted as a trading asset.

(c)

Valuation of trading assets

Trading assets should be valued for Zakah purposes at their market selling price (cash equivalent value), and not at historical cost. This is in order for the Zakah base to include the historical cost and any holding gains (losses). (d) Payment of Zakah from the same goods or from their value Normally, zakah on business assets is paid in cash. However, it is permissible to pay in trade goods especially in times of recession or lack of liquidity or if it can benefit the zakah beneficiary.

9



Zakah on debts owed by third parties (accounts receivable) Zakah is obligatory on accounts receivable which are acknowledged by debtors who are able to pay them. It is also obligatory if the debtors refuse to acknowledge the account receivable but there is evidence that they are due and they are collectible. In these cases, Zakah is due on such account receivable together with other items of working capital and cash. In the case of debts the collectability of which is doubtful, either because the debtor refuses to acknowledge them and there is insufficient evidence to prove their existence, or because the debtor is insolvent or a procrastinator, Zakah is payable only on the amount of the debt recovered when it is recovered. Moreover, Zakah is only payable once at the time of recovery and not during the years during which the amount may have remained outstanding.

Debt (liabilities) According to the majority of fuqaha, debt that is payable during the current or future financial periods should be deducted from assets subject to Zakah. However, the Shafi are of the view that any debt payable whether now or in future should not be deducted from assets subject to Zakah. In this standard, we have adopted the view of the Shafi school with respect to medium and long term debt, i.e., they should not be deducted from assets subject to Zakah. This means that only debt due to be payable during the year following the date of the statement of financial position should be deducted. Zakah on other types of assets The First Conference on Zakah and the Islamic Fiqh Academy concluded that banks should calculate their funds using the manner of calculation used by a natural person. In other words, funds subject to Zakah are recognized and measured by calculation of nisab, according to the nature and type of these funds, whether cash, livestock, agricultural and horticultural produce, trading goods, or otherwise. Zakah on livestock Zakah on camels, cows, sheep and goats is obligatory, provided that the prescribed nisab for each of them is attained, that a hawl has elapsed, and that they should not be used as work-animals (e.g., for ploughing or as draught animals). However, the majority of jurists have stipulated the condition that animals liable to Zakah should be freely grazing for most of the year, without being fed fodder. The Malikis, however, did not stipulate this condition. There are tables of numbers which are provided in Shari’a texts concerning the Zakah due on every category of livestock.

10



Zakah on agricultural and horticultural produce

‫ﻻ‬

َ‫ﻦ ﻷ‬ ‫ﻤﺎ ﺧﺮﺟﻨﺎ ﻟﻜﻢ ﻣ‬ ‫ ﻣﺎ ﻛﺴﺒﺘﻢ ﻣ‬‫ﺒﺎ‬ ‫ﻦ ﻃﻴ‬ ‫ﻘﻮ ﻣ‬ ‫ﻳﻦ ﻣﻨﻮ ﻧﻔ‬ ‫ﻳﺎ ﻳﻬﺎ ﻟﱠﺬ‬

‫ﻪ ﻋﻠﻤﻮ ﱠ ﻟﻠﻪ ﻏﻨﻲ‬  ‫ﻴ‬ ‫ﻀﻮ ﻓ‬ ‫ ﻻﱠ ﺗﻐﻤ‬ ‫ﻳﻪ‬ ‫ﺬ‬ ‫ﻟﺴﺘﻢ ﺑﺂﺧ‬

‫ﻘﻮ‬ ‫ﻨﻪ ﺗﻨﻔ‬ ‫ﺗﻴﻤﻤﻮ ﻟﺨﺒﻴﺚ ﻣ‬ ( 2 : 2 6 7 )‫ﻴﺪ‬ ‫ﺣﻤ‬

2:267 O you who have attained to faith! Spend on others out of the good things which you have earned, and out of that which We bring forth for you from the earth; and choose not for your spending the bad things which you yourselves would not accept without averting your eyes in disdain. And know that God is self-sufficient, ever to be praised.

According to the Hanafis, Zakah is payable on all crops that grow on land, and items grown for purposes other than the production of a crop are excluded. The Prophet, peace be upon him, also says: “On what has grown by water, rainfall and natural springs, or water that is drunk freely one tenth (tithe) is due, and that which has been irrigated by machinery one half of a tenth (half-tithe) is due.”(1) Other schools of fiqh have their own details and conditions on what is subject to Zakah from agricultural and horticultural produce(2). The nisab for agricultural and horticultural produce is five awsuq (bushel equivalent to 653 kg of wheat and the like). The obligatory Zakah due in cases of irrigation by natural rainwater is one tenth (10%), and in cases where irrigation is by way of machinery is half of one tenth (5%). In cases where irrigation combines both methods, Zakah is three quarters of one tenth (7.5%)(3). Gains Zakah is payable on the balance of each type of working capital at the end of hawl, including any gains from employing that type of working capital, such as business profits or increase of livestock. This is the opinion of the Hanafis, and this is a safe way as a compromise between the divergent views as to the different times when Zakah is due on gains(4).

1

() 2 () 3

() 4 ()

Narrated by Imam al Bukhary in al Bukhary, Vol. 2, p. 122, Bolaq Printing Press. Ibn Abidin, Hashiat ala al-dlur al-Mukhtar, Vol.2, p.49; al Dessougi, al Qulubii, op. cit., Vol. 2, p. 16; Ibn Qudamah, Al Mughnee, op. cit., Vol. 2, p. 690. Ibid. Ibn Al-Hammam, Fath al Qadeer, Vol. 1, p. 510; Ibn Abidin, op. cit., Vol. 2, p. 8.

op.

cit.,

Vol.1,

p.447;

11


Chapter 13: Zakat for Islamic Financial Institutions 8.3 Methods of determination of the Zakah base The method prescribed by fuqaha is the net assets method, whereas the method used by some government organizations in the calculation of Zakah is the net invested funds method. However, both methods produce the same results due to the equivalence of the assets and the liabilities side of the balance sheet. Given that either one of the two methods would give the same numerical result, provided each item in the statement of financial position is classified using the appropriate method and valued accordingly (for example, the use of the cash equivalent value in measuring assets acquired for trading and forming a revaluation reserve for the difference between the book value and the cash equivalent value), the Accounting and Auditing Standards Board of AAOIFI has decided to give the Islamic bank the option to choose the method that it considers appropriate for the bank, and that disclosure should be made of the method that has been adopted.

METHODS OF DETERMING ZAKAH BASE

NET ASSETS METHOD

NET INVESTED FUNDS METHOD

In the net assets method, the asset side of the balance sheet is used to compute the zakah base. We exclude fixed assets in the calculation as these are not zakatable. We first add the current assets which are zakatable, taking care to value some of these at cash equivalent values as opposed to historical cost shown in the balance sheet. The standard requires that assets acquired for trading should be measured at the cash

12


Chapter 13: Zakat for Islamic Financial Institutions equivalent value (market selling price) on the Zakah date.We then we deduct current liabilities which are payable within a year. From this sub total we deduct that part of equity which belongs to minority interest, unrestricted investment account holders (these two groups are asked pay by themselves). We also deduct that part of the equity belonging to the government, waqfs, endowments, charities and NGOs unless they are privately owned. This last group of items is not zakatable. In the net invested fund method, we start on the liability side (the funds side) and add up all the components which make up the shareholder’s funds and then we add the long term liabiities (zakatable) and then we deduct the fixed assets and nvestments not acquired for trading as these are not zakatable. We ignore the Investment Account Holders funds, minority interest and equities of other than shareholders. That these two methods results in the same amount can be proven by algebraic expression

a simple

Let FA = Fixed Assets, CA= Current Assets , CL= Current liabilities, SF= Shareholders funds, IAH and MI = investment account holders and minority interest equity and LTL= long term liabilities. Assume there are no govt, endowment or ngo equity. The asset side of the balance sheet is: FA+CA-CL

……………………(i)

= the liability side of the balance sheet; SF+ IAH +MI+LTL…………… ..(ii) Now using Net Assets method, we take CA-CL-IAH-MI as the zakah base (iii) Using Net Invested fund method we use SF +LTL-FA as the zakah base (iv)

But FA+CA-CL=SF+IAH+MI+LTL

(i)=(ii) balance sheet equation, A=L+E

Rearranging this, we get CA-CL-IAH-MI=SF+LTL_FA

Therefore, (iii)=(iv)

13



NET ASSETS METHOD

$ CASH AND CASH EQUIVALENTS

XX

NET RECEIVABLES

XX

INVENTORY

XX

MARKETABLE SECURITIES

XX

IJARAH INVESTMENTS

XX

FINANCING ASSETS (MUSHARAKA, MUDARABA, SALAM AND ISTISNA RECEIVABLES

XX

DEPOSITS WITH OTHER BANKS AND CENTRAL BANKS

XX

ASSETS SUBJECT TO ZAKAH

XXXX

LESS : CURRENT LIABILITIES

XX

EQUITY OF UNRESTRICTED INVESTEMENT ACCOUNTS

XX

MINORITY INTERESTS

XX

EQUITY OWNED BY GOVERMENT

XX

EQUITY OWNED BY PUBLIC ENDOWMENT FUNDS

XX

EQUITY OWNED BY CHARITIES AND NGO’S

XX

ZAKATABLE BASE

A

XXXX

14



NET INVESTED FUNDS METHOD

$

PAID UP CAPITAL

XX

RESERVES

XX

PROVISIONS NOT DEDUCTED FROM ASSETS

XX

RETAINED EARNINGS

XX

NET INCOME

XX

LIABILITIES NOT DUE IN THE COMING YEAR

XX

XXXX

TOTAL INVESTED FUNDS

XX

LESS : NET FIXED ASSETS

XX

INVESTMENTS NOT ACQUIRED FOR TRADING e.g. REAL ESTATE FOR RENT

ZAKATABLE BASE

B

XXXX

A=B

provided that items ae classified and value consistently with due consideration to the different valuation bases.

15


Chapter 13: Zakat for Islamic Financial Institutions 8.4 Treatment of Zakah in the financial statements The Islamic bank being an artificial entity need not pay zakah as it is a natural person. Hence, it is only obliged to pay Zakah in the following cases: (a) When the law requires the Islamic bank to satisfy the Zakah obligation. (b)

When the Islamic bank is required by its charter or by-laws to satisfy the Zakah obligation.

(c)

When the general assembly of shareholders has passed a resolution requiring the Islamic bank to satisfy the Zakah obligation.

In the above cases, Zakah is treated as a (non-operating) expense of the Islamic bank and is included in the determination of net income in the income statement. Any unpaid zakah is treated as a liability and presented in the liabilities section of the balance sheet. In the first case in which the payment of Zakah is considered obligatory on the Islamic bank, Zakah is treated as an expense recognized in the income statement of the Islamic bank. This treatment complies with what is stated in the Statement of Concepts (para 33) concerning the definition of an expense as the gross decrease in assets or increase in liabilities or a combination of both, provided such a decrease in assets and increase in liabilities should not be the result of distribution to or investment by shareholders. However, since the intention to trade is a prerequisite condition for the validity of Zakah, then one alternative to fulfill this condition is for the authority passing the law of Zakah to exercise its jurisdiction by making the payment of Zakah mandatory. Secondly, the intention to trade can be expressed implicitly by stipulating in the charter or by-laws of the Islamic bank that it should pay its Zakah dues. The third alternative is through the passing of a resolution by the Islamic bank’s general assembly to pay the Zakah dues. The Islamic bank is not obliged to pay zakah as a corporate entity when non of the three conditions above have been fulfilled. However,

(a)

In case some or all of the shareholders ask the Islamic bank to act as agent in meeting the Zakah obligation relating to their investment in the Islamic bank from their share of distributable profits, then the Islamic bank must deduct Zakah from the shareholders’ share of distributable profits.

(b)

In the above case, if there are insufficient distributable profits to meet the shareholders’ obligations, the amount paid by the Islamic banks shall be recorded as a receivable due from these shareholders.

FAS 9 requires that the Zakah due from the Islamic bank as well as amounts of Zakah received from other sources of funds be presented in the statement of sources and uses of funds in the Zakah and charity fund. However, in jurisdictions such as Malaysia and Pakistan, where the state is in charge of Zakah administration, the amounts must be handed over to the zakah authorities.

16


Chapter 13: Zakat for Islamic Financial Institutions Disclosure requirements In the notes accompanying the financial statements, the following must be disclosed as per the requirements of FAS 9; (a) the method used for determining the Zakah base and the items included in this base. (b) the ruling of the Shari’a supervisory board of the Islamic bank on the issues related to Zakah that are not included in this standard. (c) whether or not the Islamic bank as a holding company pays its share of Zakah obligations in its subsidiaries. (d) In case the Islamic bank does not pay Zakah, the amount of Zakah that is due from each share. (e) the amount of Zakah that is due from the equity of investment account holders. (f)

whether or not the Islamic bank collects and pays Zakah on behalf of holders of investment accounts and other accounts.

(g) the restrictions imposed by the Shari’a supervisory board of the Islamic bank in determining the Zakah base. An example of such a restriction is: in the net invested funds method, the total of net fixed assets and investments not acquired for trading should not exceed the total of paid up capital and reserves.

17


Chapter 13: Zakat for Islamic Financial Institutions 8.5 Zakah Distribution The Qur’an directs that the zakah proceeds be spent on eight categories thus:

Alms (zakah) are for the poor and the needy, and those employed to administer the (funds); for those whose hearts have been (recently) reconciled (to Truth); for those in bondage and in debt; in the cause of Allah. and for the wayfarer: (thus is it) ordained by Allah, and Allah is full of knowledge and wisdom. At-Tauba 9:60 STRANDED TRAVELLER

DESTITUTE

IN THE PATH OF ALLAH (eg Madrasa)

POOR

ZAKAT COLLECTOR BANKRUPT

FREEING OF SLAVES

NEW CONVERTS 18



There are several issues as regards distribution. (i) How does one define destitute (faqir)- a simple definition is a person without any property or employable skills or an incapacitated person due to age or physical infirmity. (ii) Similarly what is poor differs widely throughout the world. Since the zakah funds must first be distributed in the neighborhood in which they are collected, the relative poverty in the area as well as cost of basic need to be taken into account. (iii) The zakah collector also include zakah collection and distribution management and governance expenses. In Malaysia, a group of Muslim accounting firms have been appointed by the state zakah collection agencies as zakah assessors. The accountants would compute the zakah for their clients and submit the returns and the zakah payable to the agency for a percentage of the collection from the amil portion. The expenses of the zakah centres which have been privatized in Malaysia also take a chunk of the amount collected as amil portion. An analysis of their accounts reveal a concern that they may be taking too much (as statistics show as much as 25% of collections). Although, there are no strict guidelines on the maximum an amil might take, scholars have suggested each category of zakah beneficiaries should not take more than 1/8 or 12.5% (to equalize distribution to all eight categories). However, scholars such as Qaradhawi belief that the circumstances must be taken into account and the destitute and poor being given priority. If the Islamic bank manages the collection and distribution of the zakah, the Islamic bank could itself take a percentage from the amil’s portion. (iv) muallaf – new converts to Islam. This money is given to new converts to Islam for them to learn about Islam and to take care of their initial difficulties, perhaps a half way house if they are thrown out by their familites. (v) To free slaves. Since, this category does not technically exist anymore; scholars have opined that the money can be given to oppressed Muslims in countries who are trying to liberate themselves from oppression. (vi) Insolvent and bankrupt. Some scholars say the insolvency or bankruptcy should be due to perhaps guaranteeing loans for good causes such as building masjids or due to halal business failures. Zakah money can be used to pay back the debts owed by the bankrupt businessmen. (vii) in the way of Allah. Some scholars especially the Hanafi school has restricted the scope of this category to the poor to perform Haj and military expenditure for jihad. However, contemporary scholars, especially in Malaysia has interpreted this widely to include almost anything, e.g. setting up vocational and professional teaching institutions, hospitals, scholarship for poor school and university students, publishing dawah material and holding Islamic conferences.

19


Chapter 13: Zakat for Islamic Financial Institutions (viii) The stranded wayfarer. If while traveling, the traveler runs out of money or is more likely these days, he gets robbed or he looses his baggage and wallet along with his credit cards, this person is entitled to zakah. However, the authorities are reluctant to give under this category as they say, he can contact his people and in these days of wire transfers, money can reach far away places within minutes. However, these days, many unskilled workers are cheated by employment agencies and are left penniless in foreign lands. Zakah disbursement agencies should be more active in helping these people. Before we leave this topic, there is one issue which need to be discussed i.e the Islamic banks management and accounting of zakah. AAOIFI SFA 2 prescribes the preparation and presentation of a Statement of sources and uses of Funds in the Zakah and Charity Fund by Islamic banks when it establishes a Zakah and charity fund. These statements, an actual example of Bahrain Islamic Bank is reproduced below shows the source, uses and the fund balance for the accounting period.

20



Although AAOIFI’s standard is a good beginning, it is inadequate. Firstly, we know that zakah has its own sources and categories of distribution and is mandatory. Hence, it is unsatisfactory to mix it with other charity funds and prohibited earnings, the distribution of which is much more flexible than zakah. As such, one recommendation to AAOIFI is that if only one statement needs to be presented, at least the zakah amounts should be separated in a difference column and the distribution to the eight categories should be given if not in the main statement, as a note to the accounts. This is to ensure that there is more accountability in the distribution of zakah. Further, if there is no government monitoring, perhaps a separate report should disclose in detail the amounts collected and spent.

8.6 ACCOUNTING ILLUSTRATION 13.6 Accounting: Determination of zakah base and Zakah

Computation

Selehor Islamic Bank Berhad Balance Sheet as at 31 December 2007 $ ‘000 ASSETS Cash and balances with banks and agents Deposits and placements with financial institutions Dealing Securities Investment Securities Statutory deposits with Bank Negara Malaysia

$ ‘000 149,834 2,035,500 1,423,615 494,546 212,460 21


Chapter 13: Zakat for Islamic Financial Institutions Other assets Financing of customers Bills Receivable Fixed assets Subsidiaries Due from related companies TOTAL ASSETS LIABILITIES Deposits from customers Deposits and placement of banks and other financial institutions Bills payable Other liabilities TOTAL LIABILITIES SHAREHOLDERS FUNDS Share capital Reserves

127,229 3,886,903 9,052 127,686 25,223 258 8,492,306

7,295,364 55,133 56,978 106,378 7,513,853

500,000 478,453 978,453

TOTAL LIABILITIES AND SHAREHOLDERS’ FUNDS

8,492,306

Additional information: Assume all assets were valued based on cash equivalent value. An amount of $150,000 of bank’s bills receivable and $350,000 of bank’s bills payable are non-tradable. On 1 January 2007 bank purchases machinery worth $1.5 million on behalf of its customers for Murabahah financing purposes. The Murabahah financing contracts are expected to be signed during the first quarter of 2008. This machinery has been included in the Fixed Assets in the above Balance Sheet. Required: a. Calculate zakah due to be paid by Selehor Islamic Banks Berhad for the year ended 31 December 2007 as recommended by AAOIFI’s FAS 9 based on: Net Assets Method Net Invested Funds Method

22



b.

Discuss the limitations of the conventional corporate financial statement for the purpose of zakah measurement and computation. (IIUM B.Acc, semester 2, 2006/2007, Q4)

SOLUTION: NET ASSETS METHOD Current Assets Cash and balance with bank and agents Deposits and placements with Financial insts. Dealing securities Investments securities Other assets Financing of Customers Bills receivable Total Current Assets

Less : Current Liabilities Deposits from customers Deposits and placements of banks & other FI Bills payable (56978-350) Other liabilities Total Current Liabilities Zakatable Amount (TA-TL) Zakat Due (2.5775% x 614526)

$‘000 149834 2035500 1423615 494546 127229 3888403 (3886903+15 00) (9052-150) 8902 8128029 + 258

7295364 55133 56628 106378 7513503 614526 15839.40765

614784 15846

23


Chapter 13: Zakat for Islamic Financial Institutions NET INVESTED FUNDS METHOD

Share Capital Reserves Bill Payable Total Shareholders Funds Less: Deposit with BNM

$ ‘000 500000 478453 350 978803 212460 766343

Less: Fixed Assets Bill Receivable Subsidiaries Due from related companies

126186 150 25223 258

Total Fixed Assets and others

151817

Zakatable Ammount Zakat Due (2.5775%)

614526 15839.40765

b. Limitations of the conventional corporate financial statement for the purpose of zakah measurement and computation: 1. No differentiation between trading and non - trading 2. Historical cost 3. Interest

24



Question 13-1 Bank Syari’ah Berhad Balance Sheet as at 30 June 2004 Assets Cash and balances with banks and agents Deposits and placements with financial institutions Dealing securities Investment securities Statutory deposits with Bank Negara Malaysia Financing of customers Tax recoverable Bills receivable Fixed Assets Liabilities Deposit from customers Deposits and placements of banks and other financial institutions Bills payable Shareholders’ Funds Share capital Reserves

$ 155,000,000 2,010,500,000 1,420,500,000 490,200,000 250,500,000 3,800,300,000 9,200,000 127,300,000 350,000,000 8,613,500,000 7,350,000,000 50,500,000 65,500,000

500,000,000 647,500,000 8,613,500,000

Additional Information at the end of the year: It is found that 10% of the bills receivable is non-recoverable and need to be written off. This provision has not been provided in the above Balance Sheet. A total of $400,000,000 value of investment securities of M Berhad has been treated as a long term investment where the bank has no intention to liquidate and the bank intends to become the major shareholder of M Berhad.

25


Chapter 13: Zakat for Islamic Financial Institutions Determine the amount of zakah payable by Bank Syari’ah Berhad for the financial year ended 30 June 2004 based on the two recommended methods of AAOIFI’s FAS 9. (a) Explain recommendations (other than the methods of measurement of wealth subjected to zakah as in part (a) above) made by AAOIFI FAS 9 and discuss the relevance of the recommendations in the context of Malaysian corporate and banking regulatory environment. (IIUM B.Acc, semester 1, 2004/2005, Q3)

Question 13-2

(a) As pointed out by Abdul Gader Ahmad El-Tegani (undated) in his article “Accounting Postulates and Principles from an Islamic Perspective” that accounting principles which govern financial dealings and contracts should fulfill three main criteria i.e. (i) realization of fairness and justice; (ii) preservation of the rights and dues of all parties; and (iii) paying Zakah. (b) Discuss the accounting principles of objectivity; matching; consistency; comparability; materiality; and disclosure requirements, that may fulfill the above three criteria. (c) AAOIFI has developed Financial Accounting Standard No. 9 on Zakah to be adopted by Islamic banks and provides guidelines pertaining to measurement, valuation and disclosure of financial information pertaining to Zakah. (d) Discuss the need for Islamic bank to pay Zakah and follow a specific accounting standard on Zakah; and, Briefly explain the requirements of and recommendations made by the AAOIFI FAS 9. ( IIUM B.Acc, semester 2, 2002/2003, Q5)

26



Question 13-3

(a) Determine the amount of Zakah payable by Bank Shari’ah Malaysia Berhad for the financial year 2005 based on the AAOIFI’s FAS 9 recommended methods. Bank Shari’ah Malaysia Berhad Statement of Financial Position as at the 31st. December 2005 Assets ($) `000 Cash and balances with banks and agents 150,500 Deposits and placements with financial 1,800,000 institutions Dealing securities 1,200,500 Investment securities 300,000 Statutory deposits with Bank Negara Malaysia 250,500 Financing of customers 4,500,000 Bills receivable 250,500 Fixed Assets 400,500 8,852,500 Liabilities Deposit from customers 7,000,500 Deposits and placements of banks and other 40,500 financial institutions Bills payable 85,000 Shareholders’ Funds Share capital Reserves

500,000 1,226,500 8,852,500

Note: • Some of the bills receivable and bills payable are non-trade by nature. The amounts are $200,000 and $300,000 respectively.

27



(b) Why did AAOIFI FAS 9 require the assets to be subjected to Zakah need to be valued on cash equivalent value? Identify two (2) most important zakahable assets of the Islamic banks that should be valued on cash equivalent value. (c) Bank Islam Malaysia Berhad announced recently its first-ever annual loss for the year end June 2005. The reported loss before zakah and tax was amounted to $480 million. The main reason for the loss was due to a provision of $774 million, most of it money set aside for loans that it may not be able to recover. Discuss the above issues in the light of accounting policy on provision for bank’s non-performing loans. (IIUM B.Acc, semester 1, 2005/2006, Q3)

Question 13-4

AAOIFI has developed Financial Accounting Standard No. 9 on Zakah and recommended rules and guidelines pertaining to measurement, valuation and disclosure of financial information pertaining to Zakah for Islamic Financial Institutions. a) Discuss why Islamic banks are obliged to pay Zakah and explain the main recommendations made by AAOIFI FAS 9. b) What are the requirements of MASBi-1 on the disclosure of Syari’ah Advisor or Syari’ah Board and Zakah obligations? (IIUM B.Acc, semester 2, 2004/2005, Q3b &c)

Question 13-5

28



Bank Shari’ah Berhad Balance Sheet as at 30 June 2004 $’000 1,410 79 1,721 1,429 7,800 12 373 65 2 90 12,981

2003 $’000 2,308 21 2,369 1,448 6,950 9 390 65 115 13,675

Liabilities and shareholders’ funds Deposits from customers Deposits and placements of banks Bills payable Other payables Deferred tax liabilities Provision for contingent liabilities Total liabilities Equity of unrestricted investment account holders

6,500 350 80 81 7 32 7,050 4,768

6,185 32 74 83 8 6,382 6,180

Share capital Reserves Total owners’ equity

500 663 1,163

500 613 1,113

12,981

13,675

Assets Cash and short term funds Deposits and placements with banks Dealing securities (Note 1) Investment securities (Note 2) Other assets Bills receivable (Note 3) Statutory deposits with Bank Negara Malaysia Investment in subsidiary companies Investment in associated companies Property, plant and equipment TOTAL ASSETS

TOTAL LIABILITIES, EQUITY OF UNRESTRICTED INVESTMENT ACCOUNT HOLDERS AND OWNERS’ EQUITY Additional information:

29


Chapter 13: Zakat for Islamic Financial Institutions 1. Dealing securities for the year 2004 include quoted securities of $21,000 and unquoted securities of $1,700,000. The market value of quoted securities for the year 2004 is $22,500. 2. Investment securities for the year 2004 include quoted securities of $19,000 and unquoted securities of $1,410,000. The market value of quoted securities for the year 2004 is $23,000. 3. It is discovered that 5% of the bill receivable is non-recoverable and need to be written off. This provision has not been provided for. 4. Included in the owners’ equity is the equity owned by charity organizations amounted to $15,000.

Required: (i)

Determine the amount of zakah payable by Bank Shari’ah Berhad for the financial year ended 30 June 2004 based on the two methods recommended by AAOIFI’s FAS 9.

(ii)

According to AAOIFI’s FAS 9, when should Zakah be treated as (i) expenses; and (ii) appropriation of income.

(iii)

Critique MASB Tr-i 1 as compared to AAOIFI’s FAS 9. (IIUM B.Acc, semester 1, 2006/2007, Q3)

Question 13-6

Bank Syari’ah Berhad Statement of Financial Position at 31 December Assets Cash and balances with banks and agents Deposits and placements with financial institutions Dealing securities Investment securities

2004 ($) 2005 ($) 155,000,000 150,500,000 2,010,500,000 1,800,000,000 1,420,500,000 1,200,500,000 490,200,000 300,000,000

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Chapter 13: Zakat for Islamic Financial Institutions Statutory deposits with Bank Negara Malaysia Financing of customers Tax recoverable Bills receivable Fixed Assets Liabilities Deposit from customers Deposits and placements of banks and other financial institutions Bills payable Shareholders’ Funds Share capital Reserves

250,500,000 250,500,000 3,800,300,000 4,500,000,000 9,200,000 0 127,300,000 250,500,000 350,000,000 400,500,000 8,613,500,000 8,852,500,000 7,350,000,000 7,000,500,000 50,500,000 40,500,000 65,500,000

85,000,000

500,000,000 500,000,000 647,500,000 1,226,500,000 8,613,500,000 8,852,500,000

Profit for the year 2004 and 2005 are $120,500,000 and $160,800,000 respectively. (a)

Determine the amount of zakah payable by Bank Syari’ah Berhad for the financial year 2004 and 2005 based on the AAOIFI’s FAS 9 two recommended methods.

(b)

Why is the amount of zakah as determined by the 2 methods prescribed by AAOIFI FAS 9 should be the same? Why is it important for the Islamic banks to pay zakah? What information about zakah should the Islamic banks disclosed in the financial statement for the benefits of the shareholders and depositors? (IIUM B.Acc, semester 2, 2005/2006, Q3)

(c) (a)

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Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH.

Chapter

14


Explain how Investment Account Holders in an Islamic bank differ from conventional bank depositors Explain the issues involved in profit allocation between IAH and Owners’ Equity. Explain the reasons for and the nature of provisions generally and reserves needed in relation to the IAH and Owners’ Equity Compute and prepare journal entries for reserving and provisioning and investment account holders equity transactions. Prepare the Statement of sources and uses of Restricted Investment Funds.

14. 1 Introduction As mentioned earlier in the text, a unique characteristic of Islamic banking is the relationship between depositors and the Islamic bank. Whereas, this is a debtor to creditor relationship in a conventional bank, the relationship in an Islamic bank depends on the type of contract. In this chapter, the issues regarding investment account holders (IAH) whether restricted or unrestricted, will be discussed. Investment account holders deposit their money in the bank mostly on a mudaraba basis where the bank invests their money either directly or indirectly and the profits arising there from is shared between the bank and the IAH in a predetermined profit sharing ratio agreed at the time of the execution of the deposit contract. However, in case of losses, unless it is due to the bank’s negligence, the losses are passed on completely to the depositor. This contrasts with the case of an interest bearing fixed deposit in a conventional bank, where the bank is responsible for both the capital deposit and a fixed return, no matter what the bank does with the deposit or whether it makes any returns on it.

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Current accounts and their equivalent (for example, cash margin funds) as well as all other funds received by the Islamic bank on a basis other than the Mudaraba contract and commingled with the Islamic bank’s own funds, and whose principal the Islamic bank is committed to guarantee, are characterised from the Shari’a perspective as a loan from holders of these accounts to the Islamic bank. As such, there is no financial relationship between holders of these accounts and investment account holders, nor are holders of the former accounts entitled to any revenue realised by the Islamic bank from investing their funds. Several risk issues arise which is characteristic of a mudaraba contract which does not arise in a conventional interest bearing deposit contract. Obiyathullah (1995?) for example, demonstrates that mudaraba has the characteristics of both equity and debt and results in agency costs to the depositor. If the bank consumes perks and charges these to the mudaraba, then the IAHs loose. Further, there is a moral hazard problem. If there are limited investment opportunities, the bank may give precedence to investing its own equity as opposed to IAH resulting in losses to the IAH. Another moral hazard problem is given a set of investment opportunities, the bank may choose the more profitable investments for funding by its own equity as opposed to using the IAH. Accounting issues include the basis of allocation of profits. As described earlier, the banks returns are funded by various sources of funds; its equity, IAH, savings account and current account. Some of the bank’s fee paying operations do not use IAH funds and therefore IAH’s are not entitled to share in the profits from these activities. The allocation of profits and investments are therefore an essential matter which affects the ethics and fairness of the Islamic bank to the IAHs. This is among the reasons for the issue of FAS 5: Disclosure of bases of profit allocation between owner’s equity and investment account holders, According to AAOIFI, “the importance of the issue of profit allocation between owners’ equity and investment account holders because it deals with a fundamental and ethical issue relating to the core concept of fairness in the Islamic alternative that Islamic banks offer, as opposed to what usury-based banks adopt. In addition, this subject affects the allocation of wealth in the society among individuals who deal with Islamic banks” (AAOIFI, FAS 5, Appendix B) Besides the issue of fairness and transparency in profit allocation, the other issue is the practice of trying to ensure a constant stream of income for the IAHs, as opposed to an erratic earnings pattern. In conventional accounting, the devise of using provisions such the dividend equalization reserve, where in good times, the profits earned are transferred to this reserve and in bad times, the profits are transferred from the reserve to be distributed as dividends to the shareholder.

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Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. Similarly, Islamic banks practice provisioning using two reserves namely the Investment Risk Reserve and Profit Equalization reserve. These reserves have again implications for the fairness between equity and IAH. To increase transparency and consistency, AAOIFI has come out with FAS 11: Provisions and Reserves. Lastly, FAS6: Equity of Investment Account Holders and Their Equivalent deals with the accounting issues peculiar to IAH to ensure that there is consistency between banks and transparency and fairness in dealing with the IAHs. There is also another standard concerned with the protection of IAH, ie. FAS No. 17 on Investment Funds which is off balance sheet. This will not be discussed here in this chapter. One would ask why is there so many standards for IAH’s?. One reason is the corporate governance issue discussed by Chapra and Ahmed (2002), which concerns the inability of the IAH to vote in the annual general meeting, although IAH has the characteristic of equity, but have no voting rights. Hence, they cannot change management, if they do not agree with the policies taken by the Islamic bank as concerns them. Hence, the only option for them is to walk out and invest their money somewhere else. This needs accounting standards which disclose what the Islamic Bank is doing with their money, hence the need for accounting standards to protect the interests of IAHs. In addition, some of the authors have suggested that IAHs should have a representation in the board of directors or have voting rights as far as their affairs are concerned.

14.2 Issues on Profit Allocation Before we discuss the issues in profit allocation, let us review the deposit contract of IAHs i.e. mudaraba and investment account holders.

Definitions Restricted Investment Accounts With this type of account, the investment account holder imposes certain restrictions as to where, how and for what purpose his funds are to be invested. Further, the Islamic bank may be restricted from commingling its own funds with the restricted investment account funds for purposes of investment. In addition, there may be other restrictions which investment account holders may impose. For example, investment account holders may require the Islamic bank not to invest their funds in instalment sales transactions or without guarantor or collateral or require that the Islamic bank itself should carry out the investment itself rather than through a third party (Statement of Concepts, para 13)

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4

Definitions Mudaraba It is a partnership in profit between capital and work. It may be conducted between investment account holders as providers of funds and the Islamic bank as a mudarib. The Islamic bank announces its willingness to accept the funds of investment amount holders, the sharing of profits being as agreed between the two parties, and the losses being borne by the provider of funds except if they were due to misconduct, negligence or violation of the conditions agreed upon by the Islamic bank. In the latter cases, such losses would be borne by the Islamic bank. A Mudaraba contract may also be concluded between the Islamic bank, as a provider of funds, on behalf of itself or on behalf of investment account holders, and business owners and other craftsmen, including farmers, traders etc. Mudaraba differs from what is known as speculation which includes an element of gambling in buying and selling transactions. (This standard does not apply to the latter.)

Unrestricted Investment Accounts With this type of account, the investment account holder authorizes the Islamic bank to invest the account holder’s funds in a manner which the Islamic bank deems appropriate without laying down any restrictions as to where, how and for what purpose the funds should be invested. Under this arrangement the Islamic bank can commingle the investment account holder’s funds with its own funds or with other funds the Islamic bank has the right to use (e.g., current accounts). The investment account holders and the Islamic bank generally participate in the returns on the invested funds. (Statement of Concepts, para 12)

Features of Mudaraba Investment Accounts: • •

An individual depositor places funds with an Islamic Bank. In this process, he signs a contract, where the bank promises to invest his funds (without any restriction in the case of unrestricted investment accounts) or with restrictions in the case of restricted investment accounts.

•

If it is a restricted investment account, the restriction might pertain to: o Type of investment; eg. Real estate, stock market or financing. o Specific projects


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. o o o

5

Whether the depositors allows his deposit to be commingled with the banks other funds when they are invested. Not to invest in certain types of financing such as murabaha To insist on the bank getting collateral or guarantee when undertaking financing.

•

The contract specifies the profit sharing ratio between the bank and the depositor e.g. 60% for depositor, 40% for the bank. Changes to this ratio can be effected provided there is agreement between the bank and the depositor.

•

There might be a contingency provision, such as in the case of investment funds, the deposit will not be invested until the funds reached a specified amount. For additional investments to the Mudaraba fund, participation in profit sharing may be deferred to a future date. Some banks insist that the funds deposited in an investment account will only be invested in the following month or the first working day of the week. These contingent conditions are imposed as it is difficult to match investments to deposits on a continuous basis. Such deposits will be treated as deposits in current account (qardan hasan or wadi’a) until they are invested. In the meantime, they are guaranteed by the bank and are neither eligible for profits nor subject to losses.

Profit allocation issues If the funds from the investment account holders (especially the restricted account holders) are separated from the other funds, the profit allocation is easier. In a mudaraba, since the bank is providing the labour, it should not charge any of its administration such as staff salaries to expenses to the mudaraba. However, in case of direct expenses, they can be charged. FAS5 requires the disclosure of the policies and bases of expenses whether direct or administrative to the mudaraba as well as the total expenses charged broken down by material components. The problem gets more difficult when the funds from the IAH is commingled the funds of the owners’ equity, current account and savings account depositors etc. In this case, a weighted average balance is used to apportion profits to the various fund owners. A mudaraba deposit may be limited to a certain period, one month, 3 months, 6 months, 12 months and 2-5 years. However, normally, the depositor has a right to withdraw anytime but might loose the profits for the period. Also, there might be a continuous mudaraba where profits are accounted for on a periodical basis and without returning the capital to the depositor until he withdraws. Usually, the longer the deposit period, the more weight is given to the depositor in profit allocation. The diagram and the illustration below demonstrates this: Deposits from investment account holders, shareholders and current and savings account holders is commingled (except in case of restricted investment accounts with the proviso not to commingle), and then this invested in various financing contracts and then profit is



6

then re-allocated to depositors and owners as depicted in proportion to average balance outstanding per period.

Current & saving deposit

Investment deposit

Sharehol ders funds

Pool of Funds

Sales

Financing

Investments

Fig 14.1 Pooling of Funds

ILLUSTRATION 14-1: PROFIT DISTRIBUTION BETWEEN VARIOUS DEPOSITORS AND SHAREHOLDERS

Say, the annual profit from investments is $90,000 and the depositors’ Profit sharing ratio is 80:20 (20% for the bank). This is first shared between the bank and depositors. The bank takes 20% of $90,000 =$18,000 and the depositors in total get $72,000. The profit distribution to the various depositors (who may have deposited for various periods of time, say 6 months, 9 months, 12 months or more) is based on the average balance of each class of depositors and on weighting given to each class (generally the longer the maturity period , the more the weight). In the following table, total deposits of $1,000,000 are classified by type of deposits (length of maturity) and their average balance calculated. Weights are then assigned to each category. The weighted balance is then computed. The total profit to the depositors of $72,000 is then assigned to each category using the weighted average balance of each category of depoistors. The return to each category of depositors can then be computers by taking their share divided by their unweighted average balance. Hence, a particular depositor who says deposits for 9 months an amount of $50,000 would get a return of 6.48%X $50,000 = $3,240



Deposit Types

Average Balance

WTS

Weighted Balance

Depsitor;s Share

Depositor’s Return

<=6 months

100,000

0.6

60,000

4,320

4.32%

<= 9 months

300,000

0.9

270,000

19,440

6.48%

<= 12 months

250,000

1.0

250,000

18,000

7.2%

> 12 months

350,000

1.2

420,000

30,240

8.64%

1,000,000

72,000

1,000,000

14.3 Reserves for Investment Accounts Before the profits are allocated between Owner’s equity and IAH and among themselves, Islamic bank make certain provisions and reserves. Provisions are made to ensure that the financing investments are at cash equivalent values. This is similar to the rules in conventional accounting. However, two special reserves, namely the Profit equalization reserve and Investment Risk Reserve involve the IAHs in Islamic Banking.These reserves covered by FAs are of a type that is unique to Islamic banks and has no equivalent in conventional banks.

The objective of creating these reserves is to smooth income distributions to IAHs and well as provide for future losses, just in case. According to FAS 11, “A reserve is a component of equity (of either investment account holders and/or shareholders) and is constituted by appropriations made out of income”as exemplified in the Profit equalization reserve and the Investment risk reserve as defined earlier. Both reserves require the approval of the investment account holders and are recognized when the management of the Islamic bank decides to set up the reserves.

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8

Definitions Reserves A reserve is a component of equity (of either investment account holders and/or shareholders) and is constituted by appropriations made out of income. Profit equalisation reserve Profit equalisation reserve is the amount appropriated by the Islamic bank out of the mudaraba income, before allocating the mudarib share, in order to maintain a certain level of return on investment for investment account holders and increase owners’ equity. Investment risk reserve Investment risk reserve is the amount appropriated by the Islamic bank out of the income of investment account holders, after allocating the mudarib share, in order to cater against future losses for investment account holders

The profit equalisation reserve shall be measured as the amount deemed prudent by the management of the Islamic bank in order to achieve the objectives stated above. At the end of the financial period, the amount needed to bring the balance of the reserve to the required level shall be treated as an appropriation of income before allocating the mudarib share. If the balance exceeds the amount considered prudent then the excess amount shall be credited as a release from reserve to the relevant party’s share of income for that financial period before allocating the mudarib share. The investment risk reserve shall be measured as the amount deemed prudent by the management of the Islamic bank in order to achieve the objectives of creating the provisions.. At the end of the financial period, the amount needed to bring the balance of the reserve to the required level shall be treated as an appropriation of income after allocating the mudarib share. If the balance exceeds the amount considered prudent then the excess amount shall be credited as a release from reserve to unrestricted investment account holders share of income for that financial period after allocating the mudarib share.



9

To clarify the differences between the two, the following diagram might help the reader. To remember which reserve comes first, here is a mnemonic Profit equalization reserve. Just remember that equalization between the two groups IAH and owners’ equity. This reserve is meant for both groups therefore, reserve is BEFORE mudarib’s share; hence investment risk reserve comes after the mudarib’s share is deducted. Juristic rules for provisions and reserves A number of fatwas have been issued by the Shari’a bodies …respect of the amounts which Islamic banks deduct from profits, regardless of whether these amounts are deducted before or after the determination of profits. The fatwas used the terms “provision” and “reserve” ….without passing judgement on the appropriate use of either of the two terms i.e., in accordance with the accounting distinction made between them. There are three matters discussed in these fatwas: • •

•

The purpose of forming the provision or reserves i.e. which party benefits from the amount deducted. The source from which the provisions or reserves were established. The party to whom the reserve or provision reverts.

The standard mentioned certain conditions and restrictions regarding the amounts of the provisions and reserves at the time of their formulation but does not explain what type of conditions and restrictions are meant. Although, the common practice in Islamic banking applications is that such restrictions are not mentioned. However, in keeping with practice sometimes these restrictions are applied although they are not stated. I believe, the restriction relates to the amount should be a maximum as for example too large a provision will really affect the equities between investment account holders as shown by the illustration below. There is a relationship between the purpose for which the amount deducted is formed and its source. For example, if the purpose is to benefit the two parties to the investment transaction: the capital provider and the mudarib or investment agent, i.e., investment account holders and the bank (mudarib), then the deduction should take place from the profits before allocating the mudarib share. Some shari’a guidelines included in the fatwas include: a)

Not charging to the Islamic bank (mudarib) any part of a loss attributable to investment account holders, if the deduction is made from the profit before allocating the mudarib share. This is because such a practice is a breach of the Shari’a rules of Mudaraba, which stipulate that any loss should be borne by the


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. capital provider in case there was no misconduct or negligence committed by the mudarib.

PROFITS FROM INVESTMENTS OF IAH’S FUNDS

PROFIT EQUALIZATION RESERVE

MUDARIB’S SHARE INVESTMENT RISK RESERVE

INVESTMENT ACCOUNT HOLDERS’ SHARE Fig 14.2 PER and IRR

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Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. b)

11

Avoiding the detriment to investment account holders resulting from the crediting to shareholder’s equity only of the remaining balance of the amount deducted from the profit before allocating the mudarib share.

Although the fuqaha and AAOIFI standards allow reserves , they really have to be monitored and controlled closely as otherwise it may result in unfair wealth transfers between Investment account Holders between themselves and , IAHs and owners’ equity. To illustrate, let us take an example. Ahmad deposits $10,000 in a mudaraba unrestricted investment account on July 1, 2007 for a period of six months to 31st December, 2007. During the year ended 31st December 2007, the Bank declares 8% return to the mudarib after deducting 2% for transfer to Investment Risk Reserve. Ahmad should have received (8+2)=10% of $10,000=$1,000. However, due to transfer to IRR, he gets only $800. To continue the story, At the end of the year Ahmad withdraws his deposit on the maturity date. In January 2008 Abdullah deposits $10,000 in the unrestricted investment account for a period of 6 months to July 31, 2008. The bank made profits amounting to 2% of the capital during the 6 months ended July. Since the market rate of return was around 6%, the Directors decided to transfer 2% from Investment Risk Reserve to the equity of IAH, to shore up the returns of the IAHs. Abdullah should receive 2% of $10,000= $200. . However, because of the transfer of $200 from Investment Risk Reserve, he gets $400. This additional $200 should have been Ahmad’s not Abdullah. Here, because of changes in the IAHs., there is a transfer of wealth between IAHs. However, AAOIFI’s FAS 11 in the appendix on Juristic rules states that:

It is considered an acceptable practice to deduct part of the profit attributable to certain individuals (i.e., investment account holders) and make it available for the benefit of other investment account holders. This is because profit may be shared by consent, whereas loss should only be borne by the providers of capital in proportion to their shares of capital. However, it is necessary to secure the consent of the party whose share of profit will be reduced by the deduction either during the contractual duration of the Mudaraba or Musharaka, or when it is terminated. As for the amounts which where deducted, it is preferred that


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. they be donated to charitable causes when the contract is terminated, if the purpose for which they were deducted no longer exists. (3) It must be remembered; however, the approval of the IAH is usually written into their contract and not requested individually. The standard is not clear on whether individual Investment Account Holders can individually refuse permission.

14. 4 Disclosure in financial statements of IFIs on the bases for profit allocation between Owner’s Equity and Investment Account Holders and Equity of IAH. FAS 5 prescribes the following:

Unrestricted investment accounts Disclosure should be made in the note on significant accounting policies a) the bases applied by the Islamic bank in the allocation of profits between owners’ equity and unrestricted investment account holders. b)

of the bases applied by the Islamic bank for charging expenses to unrestricted investment accounts.

c)

the bases applied by the Islamic bank for charging provisions, and the parties to whom they revert once they are no longer required.

Disclosure should be made in the notes accompanying the accounts of d)

of the total administrative expenses charged to unrestricted investment accounts along with a brief description of their major components based on the material significance of the amounts.

e)

the percentages for profit allocation between owner’s equity and various unrestricted investment account holders which the Islamic bank has applied in the current financial period. When the Islamic bank has a number of different types of unrestricted investment accounts involving different contractual conditions, the required disclosure applies to such type of accounts only when the total amount by type of account is of material significance.

f) The increase in the Islamic bank’s percentage of profits as a mudarib, after fulfilling the necessary Shari’a requirements, during the financial period., if any.

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Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. g) whether the Islamic bank has included unrestricted investment accounts in the sharing of profit resulting from investing current accounts funds or any other funds (which the Islamic bank did not receive on the basis of a Mudaraba contract). Disclosure should also be made of the bases that have been applied. h) Whether the Islamic bank has included unrestricted investment accounts in the sharing of revenue from banking operations. If so, the types of such revenue and the bases applied should be disclosed. i)

of which of the two parties (owners’ equity or investment account holders) was given priority, in cases where the Islamic bank is unable to utilise all funds available for investing,

Restricted investment accounts Disclosure should be made in the note on significant accounting policies, of a) the bases applied by the Islamic bank in the allocation of profits between owners’ equity and restricted investment account holders. b)

the bases applied by the Islamic bank for charging provisions, and the parties to whom they revert once they are no longer required.

Disclosure should be made in the notes accompanying the financial statements, of c)

the percentages of profit allocation between owners’ equity and restricted investment account holders. When the Islamic bank has a number of different types of restricted investment accounts involving different contractual conditions, the required disclosure applies to such type of accounts only when the total amount by type of account is of material significance.

d)

bases applied by the Islamic bank for determining the incentive profits which it receives from the profits of both unrestricted and restricted investment accounts if such profits are of material significance.

e)

In the case of agency based investment, disclosure should be made of the bases applied for allocating incentive profits if such profits are of material significance.

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- Foxit Software

14

DISCLOSURE BASES OF PROFIT ALLOCATION BETWEEN IAH AND OE UNRESTRICT ED INVESTMENT ACCOUNTS

BASES OF PROFIT ALLOCAT ION

BASES OF CHARGING EXPENSES

BASES OF PROVISIONS AND WHOM THEY REVERT

TOTAL ADMIN EXPENSES CHARGED TO IAH AND MATERIAL COMPONEN TS

Percentage of profit allocation to OE and IAH and each material class of IAH

Increase in Islamic bank’s percentage share in mudaraba, if any.

Whether IAH share d profits from (A) current accounts (b) banking operations

Fig 14.3 Required Disclosures for Unresticted Investment Account Holders

Who was given priority in investment of funds


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. DISCLOSURE BASES OF PROFIT ALLOCATION BETWEEN OE and RESTRICTED INVESTMENT

BASES OF PROFIT ALLOCATION

BASES OF PROVISIONS AND WHOM THEY REVERT

Percentage of profit allocation to OE and IAH and % for each material class of IAH

Fig 14.4 Required Disclosures for Resticted Investment Account Holders Figures 14.5 and 14.6 below shows an example of an actual disclosure regarding Investment Account Holders taken from Bahrain Islamic Bank’s Annual Report for 2006:

Fig 14.5 Example of Disclosure for IAH in Bahrain Islamic Bank’s annual report.

15



Fig 14.6 Example of Disclosure for IAH in Bahrain Islamic Bank’s annual report.

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Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. Definitions Agency based contract for investments and incentive profits Holders of investment accounts appoint the Islamic bank to invest their funds on the basis of an agency contract in return for a specified fee or a specified fee and share of the profit if the realised profit exceeds a certain level, the latter being an incentive for the Islamic bank to achieve a return higher than expected

Disclosure regarding Incentive Profits The bases applied by the Islamic bank to determine the incentive profits which it receives from the profits of both the unrestricted investment account holders (UIAH) and restricted investment account holders , if such profits are material have to be disclosed. In addition, if the Islamic bank undertakes the investment on an agency basis, disclosure of the bases applied for allocating incentive profits , if material should be made.

DISCLOSURE OF INCENTIVE PROFITS

BASES APPLIED BY IB FOR DETERMINING MATERIAL INCENTIVE PROFITS RECEIVED FROM BOTH RIAH AND UIAH

IN CASE OF AGENCY BASED INVESTMENT, BASES APPLIED FOR ALLOCATION OF INCENTIVE PROFITS, IF MATERIAL

Fig 14.7 Disclosure of Incentive profits

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18

14.5 Account rules and issues related to equity of investment account holders. FAS No. 6: Equity of Investment Account Holders and their Equivalent sets out the accounting rules relating to funds received by the Islamic bank for investment in its capacity as a mudarib at the Islamic bank’s discretion, either in whatever manner the Islamic bank deems (1) appropriate (equity of unrestricted investment account holders) or subject to certain (2) restrictions (equity of restricted investment account holders) . 14.4.1 Accounting treatment of equity of unrestricted investment account holders and their equivalent •

Equity of unrestricted investment account holders is recognized when received by the Islamic bank and is measured at the amount received by the Islamic bank, at the time of contracting.

•

Equity of unrestricted investment account holders is presented as an independent category in the statement of financial position of the Islamic bank between liabilities and owners’ equity. (See Shamil Bank’s statement of financial position in Figure 14.9)

•

However, in case the Islamic bank makes it a condition that the funds will not be invested before a certain date, then the funds received shall be recorded in a current account until their date of investment is due.

•

At the end of a financial period, equity of unrestricted investment account holders is measured at their book value (balance recorded in the books of the Islamic bank).

•

Profits of an investment jointly financed by the Islamic bank and unrestricted investment account holders is allocated between them according to the contribution of each of the two parties in the jointly financed investment.

In case of jointly financed investments •

(1) (2)

Loss resulting from transactions in a jointly financed investment (that is recognized during a period other than that in which final settlement of the investment account is made) should in the first instance be deducted from any undistributed profits on the investment. Any such loss in excess of the amount of undistributed profits should be deducted from provisions for investment losses formed for this purpose. The remaining loss, if any, should be deducted from the respective equity shares in the joint investment of the Islamic bank and the

Unrestricted participating investment bonds and any other accounts that are of similar nature are equivalent to unrestricted investment accounts. Restricted participating investment bonds and restricted participating investment units in mutual funds formed by the Islamic bank and any other accounts that are of similar nature are equivalent to restricted investment accounts.


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. unrestricted investment account holders, according to each party’s contribution to the joint investment. •

Loss due to misconduct or negligence on the part of the Islamic bank, based on the opinion of the Shari’a supervisory board of the Islamic bank, shall be deducted from the Islamic bank’s share in the profits of the jointly financed investment. In case the loss exceeds the Islamic bank’s share of profits, the difference should be deducted from its equity share in the joint investment, if any, or recognized as due from the Islamic bank.

Equity of restricted investment account holders •

Assets and liabilities relating to equity of restricted investment account holders and their equivalent is treated off balance sheet, separately from the Islamic bank’s assets and liabilities.

•

Same treatement on receipt as for UIAH..

•

In the case of more than one type of restricted investment accounts in the form of investment funds or portfolios, the amount of each type is recognized separately.

•

Equity of restricted investment account holders is measured by the amount received by the Islamic bank or by the client’s purchase price of the units or shares bought by him at the time of contracting.

•

At the end of a financial period, equity of restricted investment account holders is measured at its book value (balance recorded in the books of the Islamic bank

•

In case the Islamic bank has funds invested in restricted investment accounts whether from its own equity or from other funds at its disposal, the Islamic bank shall share in the profits earned on such funds in its capacity as provider of funds.

Presentation and disclosure requirements Disclosure should be made, in the notes on significant accounting policies, of the percentage of the funds of unrestricted investment account holders which the Islamic bank has agreed with them to invest in order to produce returns for them. Information on equity of restricted investment account holders is presented in the statement of changes in restricted investments and their equivalent(see example in fig 14.10 from Shamil Bank) or at the foot of the statement of financial position

19



20

Receipt of equity from unrestricted investment account holders

Invest after a certain date?

Unrestricteed Investment Account

Owners’ Equity

Joint Investment

Joint Investment

Deduct from IB’s share of profit

Y

On agreed investment date

Owners’ Equity

Profit

Loss

Misconduc t or negligence of Bank?

Current account (liability)

N

Deduct from Undistributed profits

Unrestricted Investment Account

Deduct from Reserves

Fig 14.8 Accounting treatment of investment accounts

At year end Balance is At book value



21

.

14.9 Shameel bank’s statement of financial position showing presentation of Unrestricted Investment Accounts



Fig 14.10 Statement of changes in Restricted Investment Account: Shamil Bank

22



Fig 14.11 Example of Disclosure on Unrestricted Investment Accounts

23


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. 14.6 Provisions FAS 11: Provisions and reserves has two objectives viz: a) set out the accounting rules for recognizing, measuring, presenting and disclosing the provisions made by Islamic banks to revalue their receivables, financing and investment assets. This is what we are going to discuss in this section b) setting out the accounting rules for reserves from mudaraba income which concerns both the bank and the investment account holders. This part we have covered earlier in section 14.3 To reiterate, the provisions discussed here are those regarding receivables, financing and investment assets

PROVISIONS DISCUSSED IN FAS 11

RECEIVABLES

FINANCING ASSETS

INVESTMENT ASSETS

FAS 11 does not cover statutory reserves nor depreciation provisions. It gives the following reasons for the standard which are self explanatory: Provisions are one of the most important issues in the banking business. The forming of provisions is a means by which conventional banks manage their credit risk to offset losses resulting from these risks so that the bank’s income generating assets are measured at their cash equivalent value. Islamic banks, like conventional banks, face various risks that require to be managed. Islamic banks also need to make adequate provisions to offset the expected losses resulting from these risks. Due to the major differences between the financing and investment methods of the Islamic banking system compared to those of the conventional banking system, different methods may be used for the recognition, measurement, presentation and disclosure of provisions. Such differences justify the development of a standard for provisions for Islamic banks.

24



25

From the above, we note that provisions are a means to manage credit risk and to measure the income generating assets of the bank at its cash equivalent value. However, the Islamic banks, due to their operating differences, used different methods in recognizing, measuring, presenting and disclosing provisions from conventional banks. Further, a survey conducted by AAOIFI before the development of the standard revealed: •

Different methods of provisioning undertaken by Islamic banks making their financial statements non comparable.

•

The terms ‘reserves’ and ‘provisions’ were used interchangeably. They set aside specific amounts from their own profits and/or the profits of investment account holders for specific purposes and call these amounts ‘provisions’.

•

Many Islamic banks set aside only either specific or general provision while others made both types of provisions.

•

Some Islamic banks presented the provisions as liabilities in the statement of financial position, while others present provisions as an asset valuation item (contra-asset).

•

Most Islamic banks did not disclose the methods they used to form provisions. Other Islamic banks did not give adequate disclosure on the changes that occur in the balance of provisions.

These differences led to difficulties in comparability especially in profits or returns making the financial statements less useful. It also may have led to the use of unfair bases of profit allocation defeating the shari’a objectives of protecting the rights and obligations of all parties. The box on the next page gives the FAS11 definitions of provisions and the three assets namely; receivables, investment and financing assets for which FAS 11 require provisions. It must be remembered that provisions are judgmental and are estimates which are not definitive. The management together with the concurrence of the Shari’a Supervisory Board, determine the amount to be provided for. The standard requires the bank to recognize a provision when information becomes available to it indicating that an event has occurred that results in or probably will result in the impairment of the value of an asset.



Definitions Provisions A provision is a contra-asset, and is constituted by charges made as expenses against income. Specific Provision The specific provision is an amount set aside to reflect an estimate impairment of value of a specific type of asset. In the case of receivables, the amount is that required to write down the asset to its cash equivalent value, namely the amount expected to be collected. In the cases of financing and investment assets, it is the amount needed to write the assets down to cash equivalent value if this is lower than cost. General Provision The general provision is an amount set aside to reflect a potential loss that may occur as a result of currently unidentifiable risks in relation to receivables, financing or investment assets. The amount reflects estimated losses affecting these assets attributable to events that have already occurred at the date of the statement of financial position, and not estimated losses attributable to future events. . Receivables Receivables are the amounts due from clients as a result of sale transactions through Islamic financial instruments of Murabaha, Salam or Istisna’a. Financing assets Financing assets are assets that arise from providing finance to clients using Islamic financial instruments; for example, Musharaka and Mudaraba contracts.

Investment assets Investment assets are assets that are acquired for investments using Islamic financial instruments; for example, investment in real estate, marketable securities that are in compliance with Shari’a rules and principles.

26


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. Measurement of provisions A specific provision is measured as the amount needed to write the asset down to its estimated cash equivalent value in the case of receivables, and in case of financing and investment assets to the estimated cash equivalent value if lower than cost. At the end of the financial period, the amount needed to bring the balance of the specific provision in respect of such assets, financed by unrestricted account holders’ funds and/or shareholders’ funds, to the required level shall be charged to the income statement. If the balance of the provision exceeds the required level, the amount needed to reduce it to the required level shall be credited to income of the relevant party. A general provision is measured as the amount estimated to be needed to cover a potential loss that may occur as a result of currently unspecified risk in respect of receivables, financing and investment assets. At the end of the financial period, the amount needed to bring the balance of the general provision in respect of such assets, financed by unrestricted account holders’ funds and/or shareholders’ funds, to the estimated required level shall be charged to the income statement. If the balance of the provision exceeds the required level, the amount needed to reduce it to the required level shall be credited to income of the relevant party. Presentation requirements The specific provision shall be deducted from its related receivable assets so that these assets are reported in the statement of financial position at their cash equivalent value, and the specific provision related to each of financing and investment assets shall be deducted from these assets so that they are reported in the statement of financial position at the lower of cost and cash equivalent value. The general provision shall be deducted from the total value of receivables, financing and investment assets. Disclosure requirements The Islamic bank shall disclose in the notes to the financial statements the total amount of the specific provision related to receivables, financing and investment assets. The note shall indicate the balance of the provision at the beginning of the financial period, additions, uses and recoveries during the financial period, and the balance at the end of the financial period. The disclosure shall also include the provisions that are recovered either partially or fully, if material. The Islamic bank shall disclose in the notes to the financial statements the total amount of general provision. The note shall indicate the balance of the provision at the beginning of the financial period, additions, uses and recoveries during the financial period, and the balance at the end of the financial period. The Islamic bank shall disclose in the notes to the financial statements the method applied in determining the amount of each type of provisions.

27


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. Below are some examples of presentation and disclosure from actual financial statements of Meezan Bank of Pakistan. Receivables from Murabaha, Salam etc has been included under financing. Pay attention particularly to Notes 11.3 and 12.7 .

28



29



30



31

Implications of the amount of provisions Provisioning is obviously undertaken in line with the prudence concept. “How conservative should the management be at the end of the end of the year in setting aside these provisions?” 3 It is a good practice to smooth earnings especially investors who expect a steady income flow. However, over-provisioning can lead to problems of truth and fairness which may concern the auditor, investors, shareholders and the regulators: For the auditor, the presentation of the asset after deduction overstated provision will not be fair (True & Fair view?). For the shareholders, the equity shown in the financial statements does not indicate the strength of the bank. For the investors, his profit will be understated because of overstated provision or his profit will be overstated due to understated provision. Although, the general principle that disclosure does not excuse a wrong accounting treatment, since provisions are estimates, the disclosure requirements of FAS11 and FAS 5,makes provisioning more transparent to users in order to prevent abuse by management.

3

This question and concerns were posed by Dr Abdul Rahim Abdul Rahman, Associate Professor, IIUM during his lectures.


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. Accounting Problem 14-1 Islamic banks form two types of prudential reserves, distinct and different from equity reserves. Financial Accounting Standard No. 11 defined these reserves and set out their accounting rules. The following financial data pertains to the results of Saddiq Bank Limited at the end of 2005: Average account balances: Current account Unrestricted Investment accounts Bank Equity

$15,000,000 $60,000,000 $40,000,000

Portion of Equity already absorbed in funding fixed assets and bank subsidiaries Net revenue (net of expenses) generated by the above funds

$30,000,000 $8,600,000

Bank policy regarding percentage of fund actually invested: Current accounts 40% Unrestricted Investment accounts 90% Equity Available for Investments

100%

Saddiq Bank Limited has a policy to deduct 5% of the Mudarabah net revenue as profit equalization reserve and 5% of the investors’ share of profit as Investment risk reserve. The profit sharing as per the Mudarabah contract is 75% for investors, 25% for bank. Required: (a) Allocate Mudarabah net revenue between investment account holders and equity holders. (b) Calculate each of the profit equalization reserve and the Investment risk reserve and the distributable share of the investor account holders’ profits.

32



33

SOLUTION TO ACCOUNTING PROBLEM 14-1 (a) Allocation of Mudaraba revenue between investment account holders and equity holders Before we can do this we need to what proportion of the funds are actually invested % of funds amount Avg balance invested invested 15000000 40.00% 6000000 Current A/cs 60000000 90.00% 54000000 UIAH 10000000 100.00% 10000000 Bank Equity*

Weighting 0.085714286 0.771428571 0.142857143

70000000

100

*Bank equity available for investment = average balance less financing fixed assets and sub available for investment

40000000 less fixed assets and sub

30000000 10000000 $8,600,000

Allocation of profits Current A/cs UIAH Bank Equity

0.085714286 0.771428571 0.142857143

$737,000 $6,634,000 $1,229,000

(b) Calculation of the PER and the IRR Mudaraba profits Less Profit Equalization Reserve 5% Less Islamic Bank's share of mudaraba 25% Investors share of profits Less Investment Risk Reserve 5% Investors' Distributable share of profits

$6,634,000 $331,700 $6,302,300 $1,575,575 $4,726,725 $236,336 $4,490,389


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. Question 14-1

The following information is extracted from the financial statements of an Islamic Bank:

Note

Shareholders Funds Paid- up capital Retained Earnings

2000 $ ‘000

300,000 100,000

Investment deposits Savings deposits Current Account Deposits Total Funds Assets Jointly financed Assets Self finance Assets Other assets Total

(a) (b) (b)

1,000,000 300,000 300,000 2,000,000

(c)

1,000,000 400,000 600,000 2,000,000

The composition of investment accounts include: Investment period

Weights

$

Less than one year 1-5 years More than 5 years

0.7 1.3 1.5

350,000,000 450,000,000 200,000,000

The profit for the year 2000 is $ 140,000,000 from both joint and selffinance assets. The profit sharing ratio between depositors and bank is 70:30 respectively.

34



35

Required: a. b.

Compute the return for each class of investment deposit. Discuss the implications of adopting the pooling or separate investment account method in profit distribution. Explain why restricted investment account is off-balance sheet.

c.

(IIUM B.Acc, semester 1, 2000/2001, Q4) Question 14-2 The following are extracts of an Islamic Bank Account Balances for the month end December 31, 1998: December 31, 1998 $ Share Capital & Reserves

40,500,000

Current Accounts

35,000,000

Savings Accounts

22,500,000

Investment Accounts

85,000,000 Profit Sharing ratio is 70:30

Net Murabaha Income

2,000,000 40% funding from investment accounts

Ijarah Income

1,000,000 20% funding from investment accounts

Mudarabah Income

3,000,000

Agency Fees

1,500,000

Expenditures

1,500,000


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. Notes:

Net Murabaha Income is determined after deducting cost of financing and provision for doubtful debts. Net Ijarah Income is determined after deducting depreciation and maintenance expenses. Investment Accounts can be further categorized as follows:

$

Weights

Less than one year deposits

10,000,000

0.7

One to less than three year deposits

38,000,000

1.0

Three to less than five year deposits

15,000,000

1.3

Five year or more deposits

22,000,000

1.5

Expenditures include administrative overhead expenses. Required: a. b.

Explain the difference between separate investment account method as compared to the pooling method. Based on the above information and using separate investment account method compute the following: i. Jointly financed income of the depositors and the bank ii. Total distribution to the depositors iii. Dividend rate of three to less than five year class of deposits.

36



Question 14-3

Outlines some of the distinctive provisions (at least 5 provisions) made by Malaysian Accounting Standards Board (MASBi-1) to enhance the usefulness of presentation and disclosure of financial statement and accounting related information by Islamic banks and conventional banks that are involved in Islamic Banking Scheme in Malaysia. (IIUM B.Acc, semester 1, 2003/2004, Q4b) Question 14-4

In financing activities, the cost of capital or the cost of fund is important as a financial benchmark to determine the economic viability of a project or venture. Islamic financial institution assumes this implicit cost in determining its profitability. Required: a. b.

c.

Briefly describe the components of the cost of fund as required by Bank Negara Malaysia. An Islamic Bank would like to ensure that a minimum target return of 10% is paid to its depositors. Currently 60% of its deposits comprise of investment accounts. It has to fulfil a liquidity requirement of 10% liquidity deposit from current and savings accounts and 5% liquidity deposit from investment accounts. The liquidity deposits yield 4%. A recently revised statutory deposit requirement is 6%. Compute the Islamic bank’s cost of fund. If the statutory deposit requirement is reduced to 4% and only the investment deposits will be paid the target return, what is the minimum cost of fund? (IIUM B.Acc, semester 1, 1999/2000, 2)

37



Question 14-5

Describe the two types of reserves that are permitted under FAS 11 that are set aside by an Islamic bank. Also give 3 disclosure requirements for these reserves (A.I.A, Professional Examination II, 2002, Q 4b)

Question 14-6

Bank Shari’ah earned a gross profit for the year 2004 on Mudarabah al-Mutlaqah investment fund amounted to $1,500,000. During that year the overhead expenditure incurred was $450,000 and indirect revenue earned through the penalty fee of late payment for Islamic financing was amounted to $280,000. You are required to: i. Explain the two (2) common methods of profit distribution policy. ii. Based on the above case, which method of profit distribution policy do you think the Bank may adopt? (IIUM B.Acc, semester 1, 2005/2006, Q1b)

38



Question 14-7

(i)

Define profit equalization reserve and investment risk reserve as provided by FAS No. 11. What is the importance of these reserves for Islamic banking practice?

(ii)

Outline the Presentation and Disclosure requirements of these reserves as provided by FAS No. 11. (IIUM B.Acc, semester 1, 2006/2007, Q4)

Question 14-8

a.

Describe the two types of reserves that are permitted under FAS 11 that are set aside by an Islamic bank. Also give 3 disclosure requirements for these reserves.

b.

Mudarabah and Musyarakah contracts, as instruments of financing, were the earliest to be proposed in the literature on Islamic banking. Many scholars concur that mudarabah and musyarakah should be the principal alternatives for replacing interest-bearing transactions. They are in fact regarded as the most ideal modes of financing that can be applied in the current Islamic banking business.

(b)

(a) Explain the differences between Mudarabah contract and Musyarakah contract. In practice, most of the Islamic banks prefer to use non-profit sharing arrangements, in particular Murabaha and Ijarah as compared to Mudarabah and Musharakah contracts. In your opinion, what do you think the main reasons?

39


Chapter 14: Accounting for Equity of Investment Account Holders (IAH), Provision and Reserves and Profit Allocation between Owners’ Equity and IAH. c.

List down three potential risk exposures to Islamic banks in offering Murabahah to the Purchase Orderer and briefly explain how Islamic bank can mitigate such risk.

d.

In the light of AAOIFI standard, briefly explain the difference between urboun and hamish jiddiyyah and the treatment of urboun and hamish jiddiyyah both in the case of a binding and non-binding promise.

40


Chapter 15: Investments

‫ﻴﻬﺎ ﻛﺴﻮﻫﻢ ﻗﻮﻟﻮ ﻟﻬﻢ‬ ‫ﻗﻮﻫﻢ ﻓ‬

‫ﻴﺎﻣﺎ‬ ‫ﻲ ﺟﻌﻞ ﻟﻠﻪ ﻟﻜﻢ ﻗ‬ ‫ﻻ ﺗﺆﺗﻮ ﻟﺴﻔﻬﺎ ﻣﻮ ﻟﻜﻢ ﻟﱠﺘ‬ ‫ﻗﻮﻻ ﻣﻌﺮ ﻓﺎ‬

And do not entrust to those who are weak of judgment the possessions which God has placed in your charge for [their] support; but let them have their sustenance therefrom, and clothe them, and speak unto them in a kindly way. (An-Nisa: 5)

‫ﻦ ﻣﺎﻧﺘﻪ ﻟﻴﺘﻖ ﻟﻠﻪ ﺑﻪ‬ ‫ ﺗﻤ‬ ‫ ﱠﻟﺬ‬ ‫ﻓﻠﻴﺆ‬. . . . “then let him who is trusted fulfill his trust, and let him be conscious of God, his Sustainer. (Al Baqarah 2:283 )

Chapter

15


At the end of this chapter you will, insha Allah you will be able to:

i. ii. iii. iv. v. vi.

Explain the meaning of sukuk, shares and real estate investments Classify the investments into held for trading, to maturity or available for sale Recognize and measure investments at acquisition and at year end along with the appropriate adjustments for fair value Present investments in the balance sheet and disclose the requirement matters per FAS 17 in the notes to the accounts. Present the various items in the income statement including appropriate adjustments to reserves. Advise management on investment accounting policies.



15. 1 Introduction In the previous chapter, we studied the accounting issues related to profit allocation between owners’ equity, reserves and provisions and disclosures related to these. These are in the liabilities side of the Balance Sheet, which are unique to Islamic Financial Institutions. In this chapter, we go to the Asset side of the Balance sheet. In contrast to conventional banks whose main income producing assets are interestbased advances to customers, the Islamic bank makes its money from a variety of instruments and assets approved by the shari’a. These can be roughly classified into: a) Receivables from sale based transactions such as murabaha, istisna and salam. b) Financings from partnership based transactions such as mudaraba and musharaka, c) Investment in Ijarah Assets which are property for rental, and d) Financial assets such as sukuk and shares, e) Real Estate Investments We have dealt with the first three assets earlier in this book and now we will consider the last two. Islamic Financial Institutions and especially Islamic Investment Banks such as ARCapita, increasingly use financial and real assets to derive a major component of their income (for example, see figure 15.1 Income Statement for ARCapita below). These also constitute a major component of their assets in their balance sheet (see figure 15.2).. One development of the last few years in Islamic finance is the development of the sukuk or Islamic bonds which are asset based and produce a stable stream of income comparable to conventional bonds. The sukuk, when a bank buys it as an investment, is a financial paper like shares and is reported as an asset. In recent years, due to the growth the complex financial instruments including derivatives and the Enron scandal which was partly due to inappropriate accounting of financial instruments, the IASB has come out with a various accounting standards including IAS 32, IAS 39 and recently IFRS 7 on recognition and measurement of financial instruments which is converging towards fair value measurement. There is also IAS 40 on investment property which classifies investments in various categories, prescribing various treatments depending on whether the investment is intended for trading, “available for sale” or held to maturity. The valuation bases depend on their classification. AAOIFI has adopted FAS 17 on Investments in 2002. The reasons given for the standard includes the following:



(a) The importance of investment items in the statement of financial position of the institutions in size as compared to the other types of asset items. (b) Differences in the basis applied by institutions in the treatment of investments either financed from the own funds of the institution or financed by commingling own funds and the funds of unrestricted or restricted investment account holders. (c) The need for standardised policies which show the treatment of realised and unrealised gains or losses resulting from investments which may affect the allocation of investment operation results (gains or losses) between investment account holders and owners’ equity. (d) Differences in the basis applied in treating investments in real estate.



Figure 15.1 Consolidated Income Statement of ARCapita 2005.



Figure 15.2 Extract of Balance Sheet of ARCapita as at 31.12 2005. The scope of FAS5, includes direct investments, investment funds or investment portfolios, sukuk, shares and real estate, whether funded from its own equity, jointly with UIAH or RIAH. However, it excludes associates and subsidiaries and investments through mudaraba ,musharaka, Salam and Istisn’a’

15.2 Definition and Classifications of Investments FAS 11, classifies investments into 3 broad categories of : • • •

sukuk, shares, and real estate

Under each category, a sub classification by intention of holding the assets is made i.e whether the asset is (a) held for trading purposes, (b) available for sale, (c) held to maturity (in case of sukuk only) and in the case of real estate investments, by whether it is held to earn periodical consideration (rental) or held for capital appreciation.



FAS 17 Classification of Investments

Investment in Sukuk

For Trading Purposes

Held to Maturity

Available For Sale

Investments in Shares

Real Estate Investments

For Trading Purposes

Held to Earn Periodical Returns

Available For Sale

Held for Capital Appreciation

Fig 15.3 Classification of Investments

The three classifications of investments into (a) for trading purposes, (b) available for sale and (c) held to maturity have some similarity to the well-known Shari’a classification of trade commodities for the purpose of Zakah. The jurists of the Maliki School have classified trading assets into the following: (a) assets that are meant for buying and selling and the person doing business in this way is called trader or short term investor; (b) assets that are held for sale in the expectation of making profits



through price appreciation in the future and the person trading in this way is called a medium term investor (this type of traded is different from the prohibited type which is practiced for monopoly where the assets are hoarded in order to control prices). There is a third classification that falls between the first two, which can be inferred from juristic principles, although not mentioned specifically by the jurists. This is the trader who acquires the assets not for trade, but for personal use or consumption with the aim that they will be sold if a better deal comes along. Sukuks are Islamic bonds. “It is a document or certificate that represents the value of an asset (Rosly, 2005)”. It resembles a conventional bond in that it offers a series of periodical fixed returns. What makes it Islamic, is that for a sukuk, there is an underlying assets which generates income which are used to pay the returns to the sukuk holders. The underlying asset which produces the stream of returns has an embedded Islamic contract e.g. ijarah, mudaraba, musharaka, salam or istisna. Hence, the type of sukuk is described by this embedded contract e.g ijarah sukuk, mudaraba sukuk etc. (see definitions in the box below). Except in the case of salam or istisna’a sukuk issued by the seller or buyer, the sukuks are tradable and this helps to develop a secondary market in sukuk.

Definitions Sukuk (a) Mudaraba (Muqaradah) sukuk (bonds) These are investment sukuk that represent ownership of units of equal value in the Moradabad equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of share. The owners of such sukuk are the rabbul-mal. (b) Musharaka sukuk These are investment sukuk that represent ownership of Musharaka equity. It does not differ from the Mudaraba sukuk except in the organization of the relationship between the party issuing such sukuk and holders of these sukuk, whereby the party issuing sukuk forms a committee from the holders of the sukuk who can be referred to in investment decisions.

(c )

Ijarah sukuk

These are sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the real estate. These sukuk give their owners the right to own the real estate, receive the rent and dispose of their sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such sukuk bear all cost of maintenance of and damage to the real estate.

Salam or Istisna’a sukuk (d) These are sukuk that represent a sale of a commodity on the basis of deferred delivery against immediate payment. The deferred commodity is a debt in-kind against the supplier because it refers to a commodity which is accepted based on the description



of the seller. The Istisna’a sukuk are similar to Salam sukuk, except that it is permissible to defer payment in an Istisna’a transaction, but not in a Salam. In both Salam and Istisna’a, the subject matter of the sale is an obligation on the manufacturer or builder in the case of Istisna’a and the seller in the case of Salam. Hence, both instruments can neither be sold nor traded before their maturity date if either the buyer or the seller of the commodity issues them. Accordingly, these sukuk are treated as investments held to maturity.

Investment in Shares These are investments in shares that represent ownership of units of equal value in the equity of the institution in which they invest, and are registered in the names of their holders on the basis of undivided ownership in the equity and its returns according to the percentage of ownership of share.

An example of the process of sukuk al ijarah (an actual case) is presented here to clarify the concept.

Government Transaction

1

2

5

6

8

Cash Flow

9

3

Special Purpose Vehicle (SPV)Malaysian Global Sukuk Incorporated

4

Investor

7 10

1

Government Sells land parcels and other assets for $600m to SPV

6

2

SPV pays cash to government for the land and assets

7

3

SPV issues sukuk to investors

8

SPV resells assets for $600m to Government

4

Investors pay for the sukuk to SPV

9

Government pays $600m to SPV

5

SPV leases assets to government

10

Government pays rentals to SPV

Rentals paid by SPV to investors (return on investment)

SPV pays $600m to investors and redeems sukuk

Fig. 14.4 Malaysian Global Sukuk Ijarah( modified from Rosly 2005 p475)



Since the accounting treatment depends on the intention to trade, hold or make available for sale, let us look at the definition of these terms first.

Definitions Investments held for trading purposes An investment is held for trading if acquired or originated principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. Any investments that form part of a portfolio where there is an actual pattern of profit taking are also classified as ‘held for trading’. Investments available for sale These investments are those that are not held for trading, originated or held to maturity investments. Investments held to maturity These are investments that an institution has the positive intent and ability to hold to maturity. In the case of sukuk, all three of the above classifications apply as there is a redemption of the capital i.e. maturity date for sukuk. In the case of investment in shares, only two sub classifications apply i.e. shares held for trading purposes and shares available for sale.

15.3 Accounting Treatment of Shares and Sukuk The accounting treatments for investments in shares and sukuk are similar and thus they are dealt with together. (i) Investments in sukuk and shares are recognized on the acquisition date and is measured at cost. Cost shall include the value of acquiring such investments or the fair value of any consideration in-kind as well as any other direct expenses related to the acquisition. (ii) At the end of the financial period, investments in sukuk and shares held for trading purposes and available for sale are re-measured at their fair value. The resultant re-measurement gain or loss, if any, will be the



difference between the book value (or carrying amount) and the fair value. How this re-measurement difference is treated depend on whether the investment is for trading purposes or for sale. a) investment held for trading purposes: recognized in the income statement under “Unrealised re-measurement gains or losses on investments”, taking into consideration the split between the portion related to owners’ equity and the portion related to the equity of unrestricted investment account holders. b) investments available for sale: the unrealised gains or losses resulting from the re-measurement at fair value of investments is recognized in the statement of financial position under “Investments fair value reserve”, taking into consideration the split between the portion related to owners’ equity and the portion related to the equity of unrestricted investment account holders. (iii) However, sukuk held to maturity is NOT re- measured at fair value at the end of the financial year, but measured at historical cost, unless there is an permanent impairment of value, in which case, they are measured at their fair value. The difference is recognized in the income statement, taking into consideration the split between the portion related to owners’ equity and the portion related to the equity of unrestricted investment account holders. If the sukuk is measured at historical cost when there is no permanent impairment ,the fair value of such investments is disclosed in the notes to the financial statements. (iv)

Any unrealised losses resulting from re-measurement at fair value of investments in sukuk and shares available for sale shall be recognized in the statement of financial position under “Investments fair value reserve” to the extent of the available balance of this reserve. In case such losses exceed the available balance, the unrealised losses shall be recognized in the income statement under “Unrealised re-measurement gains or losses on investments”. In case there are unrealised losses that have been recognized in the income statement in a previous financial period, the unrealised gains related to the current financial period shall be recognized to the extent of crediting back such previous losses in the income statement. Any excess of such gains over such prior-period losses shall be added to the “Investments fair value reserve” in the statement of financial position.

(v)

In case the institution has reserves that created by appropriations out of the profits of previous financial periods to meet future investment risks, and the institution had not determined the portion related to shareholders and unrestricted investment account holders in these reserves, any unrealised losses resulting from re-measurement at fair value of investments in the current financial period shall be deducted from these reserves. Any losses in excess of the available balance on these



reserves shall be deducted from the “Investments fair value reserve” in which the portion of shareholders is separated from that of unrestricted investment account holders – see 3.4 above. (vi)

The realised profits or losses resulting from the sale of any investment shall be measured at the difference between the book value (or carrying amount) and the net cash proceed from the sale for each classification of investment separately. The resulting profit or loss together with the available balance on the “Investments fair value reserve” account shall be recognized in the income statement for the current financial period, taking into consideration the split between the portion related to owners’ equity and the portion related to unrestricted investment account holders.

(vii) At the maturity date of the investments in sukuk, the difference between the book value (or carrying amount) and the recovered amount shall be recognized in the income statement taking into consideration the split between the portion related to owners’ equity and the portion related to unrestricted investment account holders. (viii) Dividend proceeds from investments in shares and sukuk shall be recognized in the income statement according to their declaration date i, taking into consideration the split between the portion related to owners’ equity and the portion related to unrestricted investment account holders.

The following flowcharts, will hopefully clarify the above:



Recognized at acquisition date

Acquistion of shares or sukuk

Measured at cost including any direct expenses of acquisition. If paid in kind, measured at fair value + expenses of acquisition

1

At the end of the year

Held for trading purposes OR Available for sale

Re-measure at Fair Value

P&L Gain/Loss charged to income statement under Unrealized remeasurement gains or losses on investments split between OE and IAH

Y

Held for Trading?

N B/S Gain/Loss recognized in balance sheet under Investments fair value reserves split between OE and IAH

Sukuk Held to maturity

Y

Permanent impairment of value?

Disclose fair value in the notes

Available for sale

No

Measure at Historical cost at year end

P&L Measure at Fair value at year end At Maturity Date

Y

Difference in fair value and book value charged/credited to Income statement split between OE and IAH

P&L Difference between carrying amount (book value) and recovered amount charged/credited to Income statement split between OE and IAH



1

P&L Sukuk and Shares Held for trading purposes OR Available for sale

Income recognized at declaration date and credit to P/L taking into consideration portion related to OE and IAH

Dividends declared

Sale of Shares

Realized profits/losses = Book value- net cash roceeds for each classification (held for trading or available for sale)

+available balance in Investment Fair value reserve

Sale of Sukuk

Realized profits/losses = Book value- net cash proceeds for each classification (held for trading or available for sale or held to maturity)

+available balance in Investment Fair value reserve

P&L

P&L

Income recognized and credit to P/L taking into consideration portion related to OE and IAH

Income recognized and credit to P/L taking into consideration portion related to OE and IAH



Accounting Problem – 15.1 Investments

Gulf Investment Corporation, an Islamic Investment bank purchased a trench of Malaysian Global Ijarah sukuk with face value of $1,000 amounting to $1,000,000. on 1st January 2005, the date of the issue. The sukuk a carried an expected profit rate of 5% of the face value and is redeemable at par on 31st December 2010. The rentals are paid every 6 months to the investor. The investment was funded 70% by Investment account holders and 30% by bank’s equity. Gulf Investment Corporation raises investment account holder equity based on mudaraba with profit sharing ratio of 20:80 (20% for the bank) Initially, as there was not secondary market for the sukuk, the bank intended to hold the investment to maturity. During the year 2005, the issuer declared 4% and 5% rental for the interim and final rental payout, after expenses. In the year 2006, the sukuk started trading in the Dubai Islamic Financial Market and at the end of the year was quoted at $960. In 2006 the rentals declared were 4% and 4% for interim and final payout. The Bank bought another $1,000,000 (face value) of sukuk ,wholly out of unrestricted investment account holder’s funds, at the end of the year at $960 cum div. The decline in value was not considered permanent by the Directors and the auditors concurred. In the year 2007, due to a fall in interest rates, the price of the sukuk went up to $1100 in July 2007 and kept rising steadily up to November 2007, when the sukuk price shot up to $1300 and this price was maintained throughout the year. The issuer declared 5% interim and 6% final rental profits. In July, the Bank decided to reclassify the sukuk as available for sale, and sold $1,000,000 worth of sukuk at a price of $1300. The bank used the FIFO method of cost allocation on the sale. In the year 2008, the following transactions took place, February 2008, July 2008,

sold $250,000 face value of sukuk for at $1,300 sold another $750,000 face value of sukuk for $1400, and bought $1,000,000 face value sukuk for $1400 wholly out of shareholders funds. The issuers declared a 4% return for interim and 3% for final due to increased maintenance costs of the underlying asset. At the end of the year, due to increasing market interest rate and lower ijarah returns, the sukuk market value plummeted to $900. The directors decided to reclassify the investment in sukuk as “held to maturity” and prepared the accounts for the year ended 31st December 2008, on that basis. However, the auditors insisted that the



directors must classify the investment as held for trading and prepared the adjusting journal entries to rectify the accounts. Assume all realized profits on Investment account holders equity is distributed in the beginning of the subsequent year and zakat is not paid by the bank. Required, (i) Prepare the Income statement and Balance Sheet for the financial year 31st December, 2005- 2007 including relevant notes to the accounts. (ii) For the year 2008, (a) Show the Income Statement and Balance Sheet extract on Investment as prepared by the Directors. (b) Show the adjusting journal entries of the auditor. (c) Why do you think the directors decided to classify the investments as held to maturity? (d) Why did the auditor argue as they did and who is correct?

Gulf Investment Corporation Income Statement for the year ended 31st Dec Wkg Profit from sukuk investment - interim - final total gross income from sukuk Less Attributable to shareholders

1

Attributable to IAH (according to proportion of funding)

Rabbal al mals share to IAH Mudarib's share of profit 20% Total Income from Sukuk (shareholders equity) Gain/(loss) on sale of sukuk Less attributable to IAH attributable to equity add mudarib's share of profit total gain for owners equity

2

2005 $ 40000 50000 90000 27000 63000 50400

2006

2007

director 2008

auditor

40000 80000 120000 24000 96000 76800

100000 60000 160000 15000 145000 116000

30000 30000 60000 30000 30000 24000

30000 30000 60000 30000 30000 24000

12600 39600

19200 43200

29000 44000 300000 210000 90000 42000 132000

6000 36000 75000 75000 0 15000 51000

6000 36000 75000 75000 0 15000 51000



Balance Sheet as at 31st December Assets Investments in sukuk held to maturity (at cost) Investments in sukuk - available for sale at fair value investments in sukuk held for trading cash Dividend received/receivable

Note

2005

2006

$ 1000000

1960000

2007

director 2008

auditor

1400000 1300000 1300000 160000 2760000

2675000 60000 4135000

900000 2675000 60000 3635000

90000 1090000

120000 2080000

700000 50400

1660000 76800

1660000 284000 272000

1660000 296000 0

1660000

shareholders' equity 300000 add accumulated profit 39600 fair value reserve attributable to equity (20% mudarib's share)

300000 43200

300000 176000 68000

2000000 119000

2000000 87000 -500000

1090000

2080000

2760000

4075000

3247000

1000000

1920000

dr 900000 500000 0

cr

Liabilities: Unrestricted Investment accounts add profits less losses Investment fair value reserve(attributable to UIAH)

Notes to the accounts Fair value of investments

dr investments in sukuk held for trading at fair value dr profit and loss owners equity cr investments in sukuk- held to maturity

1400000

950000



working 1 Profit from sukuk investment interim - final total gross income from sukuk

40000 50000 90000

40000 80000 120000

100000 60000 160000

30000 30000 60000

30000 30000 60000

working 2 calcualtion of fair value and remeasurement gain and loss 2007

Working 3 gain on sale of investments 2007

fair value of sukuk at year end. fair value of sukuk $1,000,000 face value @$1300 less cost @960 Unrealized Gain on revaluation of sukuk less mudarib's share 20% on profit remeasurement gain attributable to IAH

1300000 960000 340000 68000 272000

# IAH sales proceeds 1m @1300 less cost of sale Gain on sale of sukuk Less attributable to IAH (70%) attributable to equity add mudarib's share of profit (20%*210000) total gain for owners equity/IAH

1300000 1000000 300000 210000 90000 42000 132000

working 4 2008 Feb: sales proceeds 250000 @$1300 cost: fair value of $250000 at $1300 profit profit in fair value reserve transferred to acc profit of iah transferred to IAH from remeasurement reserve

feb OE 325000 325000 0 68000/4 272000/4

210000 -42000 168000

IAH

17000 68000



July: sales of $750,000 face value sukuk at $1400 cost at fair value @1300 gross profit less mudaribs share 20% profit to IAH fai value reserve released to P/L total profit released to P/L - IAH shae total reserves released to p/L iah shre total reserves released to p?L

1050000 975000 75000 15000 60000 68000x3/4 272000x3/4

July purchased using OE $1000000 face value at $1400 if classified as held to maturity ; value at cost

51000 204000 68000

272000

1400000 1400000

total profits to IAH sukuk dividend net of mudaribs share profit from sale of sukuk net of mudarib's share profits released from investment fair value reserve

24000 60000 272000 356000

if investments are classified as held for trading, the sukuk must be valued at fair value fair value of sukuk at $900 cost of acquistion unrealized remeasurement loss - p/l since the investment is funded from Owners Equity, the shareholders bear all the losss This is why the directors want to classify the investments as held to maturity so that this loss is not reflected in the accounts for the year. However, the auditors are correct because FAS 17 provides, that when there is a past pattern of trading of investments, the investments should be classified as held for trading, not held to maturity or available for sale.

900000 1400000 -500000



15.4 Accounting Treatment for Investments in Real Estate.

Definitions Investment in real Estate Investments in real estate are properties, lands or part of them acquired for the purpose of earning periodical income or held for future capital appreciation or both. Expected cash equivalent value This is the monetary value of the number of units that would be realised if an asset were converted to cash. Fair value Fair value is the amount for which an asset could be exchanged or an obligation settled between well informed, willing parties (seller and buyer) in an arm’s length transaction. Explanation of the definition of fair value Underlying the definition of fair value is a presumption that an institution is a going concern without any intention or need to liquidate, curtail materially the scale of its operations or undertake a transaction on adverse terms. Fair value is not, therefore, the amount that an institution would receive or pay in a forced transaction, involuntary liquidation or distress sale. When a financial instrument is traded in an active and liquid market, its quoted market price provides the best evidence of fair value. When current bid and offer prices are unavailable, the price of the most recent transaction may provide evidence of the current fair value provided that there has not been a significant change in economic circumstances between the transaction date and the reporting date. When there is infrequent activity in a market, the market is not well established or small volumes are traded relative to the number of trading units of a financial instrument to be valued, quoted market prices may not be indicative of the fair value of the instrument. In these circumstances, as well as when a quoted price is not available, estimation techniques may



be used to determine fair value with sufficient reliability to satisfy the requirements of this standard. Techniques that are well established in financial markets include reference to the current market value of another instrument that is substantially the same. In determining the fair value, the institution should take into account the cost which will be incurred in exchanging or settling a financial instrument. When it is not practicable to determine a single amount representing the fair value, the institution should disclose a range of values within which the fair value is believed to be. When disclosure of fair value information is omitted because it is not practicable to determine fair value with sufficient reliability, the institution should disclose all relevant information to assist the financial information users in making their own judgments about the extent of possible differences between the carrying amounts of the related assets and their fair values.

(i)

Investments in real estate are treated as a portfolio and measured using one of the following two methods: ( a) Fair value method According to this method, investments in real estate shall be measured at their fair value in the statement of financial position. Any subsequent change in the fair value shall be accounted for as in 15.3 (a) and (b). (b) Cost method According to this method, investments in real estate shall be treated as a fixed asset in the statement of financial position and measured at cost less depreciation and any provision for other than temporary impairment of its value. In this case, the fair value of such investments is disclosed in the notes.

(ii)

Investments in real estate leased on the basis of Ijarah Muntahia Bittamleek shall be measured at historical cost as per Financial Accounting Standard No (8) Ijarah and Ijarah Muntahia Bittamleek.

(iii)

Investments in real estate held to earn periodical consideration, which is defined in Financial Accounting Standard No. (8) as operating Ijarah, is measured using one of the two methods mentioned in item 15.4(i) above.



Once adopted, the method chosen must be consistently applied in future financial periods. (iv) Investments in real estate held for capital appreciation shall be measured at fair value. (v)

The income from investments in real estate is recognized in the income statement when it is due, taking into consideration the split between the portion related to owners’ equity and the portion related to unrestricted investment account holders.

(vi) Major expenditure incurred by the institution related to additions to and improvements in real estate subsequent to its acquisition is added to the carrying amount of investments in real estate in the statement of financial position, provided that the institution expects that such expenditure will increase the future economic benefits to the institution from the real estate. However, if such economic benefits are not expected to take place, the institution shall recognize this expenditure in the income statement in the financial period in which it is incurred, taking into consideration the split between the portions related to owners’ equity and the portion related to unrestricted investment account holders.







The accounting treatment of different types of investments The measuring of investments at cost when they are acquired is an acceptable basis because it represents the amount paid in exchange for acquiring the asset together with any other expenses related to acquiring the assets. This is in similar to what constitutes cost in Islamic jurisprudence as practiced in Murabaha transactions. The re-measurement of assets at their fair value at the end of the financial periods is also in accordance with the Shari’a principles of revaluation that are applied to determine the value of impaired property or the calculation of Zakah dues. The separation of the portion relating to owners’ equity from that which relates to the equity of unrestricted investment account holders with regard to the result of valuing investments at their fair value is due to several reasons, namely (a) the difference in the nature of ownership of each party; (b) to avoid mixing the rights and liabilities of each party; (c) to achieve equity and fairness; and (d) to avoid the shareholders guaranteeing the returns of the investment account holders, which is prohibited by the Shari’a. The matching of unrealised losses incurred in the current financial period with the unrealised gains from previous financial periods stems from the Shari’a concept of netting losses from gains in the transactions that are based on Musharaka or Mudaraba before assets are revalued. This is applicable regardless to whether investments are in the form of sukuk, shares or real estate.

It is worth noting that investments in sukuk do not include interest-based debts because receivables cannot be traded. This is because debts are payable in their equivalent counter-value. Therefore, it is not permissible to buy and sell debt assets at a discount or a premium to their face value. However, receivables such as those of Murabaha should be accounted for according to Financial Accounting Standards No. (2) Murabaha and Murabaha to Purchase Order and Financial Accounting Standards No. (11) Provisions and Reserves.

15.5 Presentation and Disclosure requirements for Investments (i)

At the end of the financial period, all types of investments is presented separately under “Investments” on the assets side of the statement of financial position. Significant components of each type of investments should be disclosed either on the face of the statement of financial position or in the notes to the financial statements.

(ii)

Income from all types of investments is presented in the income statement under “Income from investments” taking into consideration the split between the portion related to owners’ equity and the portion related to unrestricted



investment account holders. If material, the main components of income from different types of investments needs to be disclosed in the notes. (iii)

Profits or losses resulting from the sale of investments is presented in the income statement under “profits or losses from sale of investments”, taking into consideration the split between the portion related to owners’ equity and the portion related to unrestricted investment account holders. If material, disclosure must be made of the main components of profits or losses for each type of investment separately in the notes to the financial statements.

Disclosure requirements in the notes to the financial statements The following items need to be disclosed:

(i)

The accounting policies adopted in the treatment of investments.

(ii)

Investments available for sale and investments held to maturity must be disclosed, indicating the balance at the beginning of the financial period, changes during the period and the balance at the end of the financial period.

(iii)

The investments that are financed from shareholders’ funds, and investment account holders’ funds or from both sources, should be disclosed separately.

(iv)

Th movements in the “Investments fair value reserve” indicating the balance at the beginning of the financial period, changes during the period and the balance at the end of the financial period should be disclosed.

(v)

When the investments are NOT carried at fair values, disclosure must made of the fair value of investments held for trading purposes and the reasons for not using fair value as the measurement basis should be disclosed.

(vi)

Disclosure shall be made of any restrictions on investments, their profits or sale, if any.

Special requirements Investments in sukuk (i)

Disclosure shall be made of (a) the issuer of sukuk, (b) the face value of sukuk, (c) the percentage of sukuk acquired from each party issuing the sukuk, (d) and each type of sukuk, if material.



(e) The party guaranteeing the sukuk and the nature of the guarantee, if available. (f) Disclosure shall be made of the contractual relationship between the issuer and/or manager of sukuk and the holders of such sukuk. (g) Disclosure shall be made of the classification of investments in sukuk according to their maturities. Investments in shares Disclosure shall be made of the entities in whose shares the institution has invested and the resulting percentage of equity held, if material. Disclosure shall also be made of the nature of the main activities of the investees Investments in real estate Disclosure shall be made of the fair value of investments in real estate if the institution has adopted the cost method. Reclassification of investments In cases where the institution changes its intention relating to the holding of one or a group of investments, for example from held for trading purposes to held to maturity or visa versa, the institution shall: a) Measure the investments that have been reclassified from one category to the other at fair value. In subsequent financial periods, the institution shall apply the accounting policy relating to the category to which the investments were reclassified. b) Recognize the difference between the book value (or carrying amount) and the fair value as follows: c) If the book value is greater than the fair value then the resulting remeasurement loss shall be recognized in the income statement for the current financial period. d) If the book value is less than the fair value then the resulting re-measurement gain shall be added to the “Investment fair value reserve” account. e) Disclosure shall be made of the reclassified investments in the current financial period as well as of the difference between the value of these investments before and after their reclassification. Restricted investment accounts All above items shall apply to restricted investment accounts.




MCQ 15-1 Which of the following is incorrect? a) Classifications for investments in sukuk include ‘for trading purposes’ and ‘held to maturity’. b) Classifications for investments in shares include ‘available for sale’ and ‘for trading purposes’. c) Classifications for investments in real estate include ‘held for capital appreciation’ and ‘available for sale’. d) Investments in sukuk that are reclassified from ‘held to maturity’ to ‘available for sale’ shall be measured at fair value. MCQ 15-2 Which of the following statements is false: a) Sukuk represent certificates of equal value representing undivided shares in ownership of tangible assets. b) Sukuk is issued in the name of the owner to establish the claim of the certificate owner over the financial rights and obligations represented by the certificate. c) All Sukuk cannot be tradable.

d) None of the above



Question 15-1

(i) How does sukuk differ from conventional bonds? (ii) Describe the various contracts that can underlie a sukuk

Question 15-2

The Bahraini government made an international tender offer to construct, operate and transfer a causeway between Bahrain and Qatar costing $50 billion, for a period of 30 years. A consortium of Islamic Banks bid for the project and was awarded the contract. You are requested to draw a diagram showing how a sukuk can be structured for this project.

Question 15-3

What is the difference between investments held for trading, available for sale and held to maturity. Can investments in shares be held to maturity? Why or why not? Narrate the accounting treatment for the above assuming the investment is a share. From acquisition to disposal. Question 15-4

FAS 15 allows investment in real estate to be valued either using the cost model or the fair value model. Explain the meaning of this and show by way of a hypothetical example of how this is implemented. Which model should Assets on Operating Ijrarah follow? Which model should Assets on Ijarah muntahia bitamleek follow? Question 15-5



On 1st January 2005, Jordan Islamic Investment Bank (JIIB) bought an apartment in Amman for $25 million. The land and buildings were freehold. The legal costs involved in completing the transfer of title to the bank cost $1mllion. The bank hired Ascot Inc, a real estate management company to hire the apartments for rental. Ascot will paid 10% or rental income for managing the apartment. All maintenance expenses will be charged to the bank. During the year Ascot managed a 60% occupancy rate and made a gross rental income of $3 million. It incurred maintenance expenses of $300,000 which it claimed from the bank. After deducting its management commission, it remitted the balance to JIIB. At the end of the year, the fair value of the apartments was valued to be $20 million. JIIB depreciates investment in real estate at 10%. Straight line for other similar properties. Towards the end of the year Ascot advised the bank to make some renovations to increase rentals. Renovations were started and the bank incurred $5m in 2005 and $3m in 2006. In 2006 occupancy increased to 90% and the rentals before management commissions was $5m . There were no maintenance expenses, but Ascot paid for and claimed property taxes for 2006 was $500,000. The fair value of the building increased to $30m at the end of 2006 and $35m at end of 2007 due to a property boom which was expected to continue until 2010. In 2006, the directors decided to classify the investment as held for capital appreciation. (i) give the journal entries for 2005 and 2006 and (ii) give an extract of the income statement and balance sheet for the two years.


Chapter 16:Objectives and Principles of Auditing for Islamic Financial Institutions.

Chapter

16

• Al-Hujurat (The Dwellings) [49:6] O ye who believe! If a wicked person comes to you with any news, ascertain the truth, lest ye harm people un wittingly, and afterwards become full of repentance for what ye have done.


At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv.

State the objectives of auditing of an IFI Explain the general principles and scope of audit for IFIs Discuss the differences between auditing, sharia’a review and shari’a auditing Critically input into a discussion of the emerging issues in auditing for IFIs including shari’a auditing.

16. 1 Introduction Not too long ago, AAOIFI had a series of auditing standards which included shari’a supervisory board governance issues, shari’a review and auditing together in one set of standards. Beginning from the ?? edition of the standards, the SSB governance and shari’a review standards were separated from the auditing standards into a separate set of “Governance Standards for Islamic Financial Institutions”. This measure illustrates both



the evolution and confusion of the relationship between shari’a auditing and conventional auditing. Perhaps, the shari’a audit and conventional audit was getting too close for comfort. There are several issues and questions which need to be researched and answered before the dust settles. This includes: (i) What is the definition of shari’a audit or should it be a shari’a review only? (ii)What is the scope of the shari’a audit ? (iii) What is the difference between shari’a audit and conventional audit? Should we have two separate audits or one combine one? (iv) Who should perform the shari’a audit and who should regulate its performance? (v) What is the current practice before a shari’a report is issued i.e. what work is performed, evidence gathered and who performs it. (vI) What are competence and qualifications requirements for a shari’a audit? (vii) Is there a need for a new profession of shari’a auditors? (viii) What are the independence requirements and should shari’a compliance be ranked? Currently, auditing of IFI’s and shari’a governance and review are classified differently implying that these functions should be separated and carried out by different groups of people. After introducing you to the problems and issues related to this evolving area, let us have a look at the standards in force and I will have commenting as we go along. As stated earlier, the standards for auditing and shari’a review and governance have been reclassified, but for our purposes, this section of the book (the last two chapters) will be treated as one as there are many issues which need to be discussed together. Hence, I will be iterating between the auditing and shari’a review.

16.2 Definition, objectives and principles of auditing of IFI’s. According to Auditing Standard for Islamic Financial Institutions No. 1 (ASIFI 1), “The objective of an audit of financial statements is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with the Shari’a Rules and Principles, the accounting standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and relevant national accounting standards and practices in the country in which the financial institution operates. The phrase used to express the auditor’s opinion is “give a true and fair view”. Firstly, we see that the definition is very narrowly constructed as an expression of an opinion on the truth and fairness of financial statements. From a shari’a perspective, not only should the financial statements be subject to audit but the whole institution,



objectives, processes, personnel, financial and non financial performance should be subject to an audit from an Islamic perspective. Secondly, the unique feature of audits of IFI’s is adherence of the IFI’s financial statements to Shari’a rules and principles AND accounting standards of AAOIFI in addition to national (or presumably international accounting standards). While the uniqueness of adhering to shari’a rules and principles is understandable and necessary, the necessity to comply with two sets of criteria (AAOIFI and national ) might lead to conflict because when national jurisdiction require banks to follow International Financial Reporting Standards, then as IFRS does not allow mutual existence and tolerance of other standards.

A broader definition as an assurance engagements may have been more appropriate in the case of IFI’s especially with a view to integrating the shari’a and conventional audits. The International Framework for Assurance Engagements, effective January,2005 defines an assurance engagements as an engagement in which a practitioner (the auditor) expresses a conclusion designed to enhance the degree of confidence of the intended users…about the outcome of the evaluation or measurement of a subject matter against criteria. It outlines 5 elements of an assurance engagements (auditing is an assurance engagement) which are shown in figure 16.1 below: The following table below compares each of the five dimension from a conventional and an Islamic perspective; Element 3 party relationship

Conventional Audit Entity, auditor, user

Appropriate subject matter

Financial statement assertions

Suitable criteria

IFRS

Sufficient appropriate evidence

Sufficient and appropriate evidence

Written assurance report

Standard audit report prepared by auditor

Islamic Auditing Entity, auditor and broader range of users Processes, contracts, personnel, systems, performance, financial statements Shari’a principles and rules, aaoifi standards and appropriate parts of IFRS SSB rulings, fatwas of international and national fiqh boards, plus all other conventional evidence A more detailed report prepared by a shari’a auditor

Table 16.1 Comparison table between Islamic auditing and conventional auditing



3 party relationship: User, practioner and responsible party

A written assurance report either reasonable assurance or limited

Sufficient appropriate evidence

Elements of An Assurance Engagement

Appropriate Subject Matter (e.g financial statement assertions

Suitable criteria (e.g. IFRS, AAOIFI standards

Fig 16.1 Elements of assurance engagement (source: IAASB’s International framework forassurance engagements)



The Assurance framework notes that two types of assurances can be given, ie. Reasonable assurance engagement and limited assurance engagement.

ASSURANCES

REASONABLE ASSURANCE ENGAGEMENT (RAE) (E.g. AUDIT)

LIMITED ASSURANCE ENGAGEMENT (E.g. REVIEW)

(EG AUDIT)

(E.G. REVIEW)

REDUCTION IN ENGAGEMENT RISK TO A SUBSTANTIALLY LOW LEVEL IN THE CIRCUMSTANCE OF

REDUCTION IN ENGAGEMENT RISK TO AN ACCEPTABLE LEVEL (BUT AT A HIGHER LEVEL THAN RAE) IN THE CIRCUMSTANCE OF THE ENGAGEMENT

THE ENGAGEMENT

POSTIVE FORM OF EXPRESSION OF THE CONCLUSION

NEGATIVE FORM OF EXPRESSION

Fig. 16.2 Types of assurances (source: IAASB’s International framework forassurance engagements) AAOIFI’s auditing standards as with IAASB’s audit is a reasonable assurance engagement whereas the shari’a review is a limited assurance engagement. In practise, however, the shari’a review gives a positive form of conclusion (see next chapter) than a negative one.



Even, if a reasonable assurance form of opinion is expressed, it must be remembered that the opinion is not a 100% guarantee but only a reasonable assurance . This due to its sampling nature of evidence collection as well as its limitation in scope. This last feature of an audit is reiterated in the ASIFI 1 as follows:

“ Although the auditor’s opinion enhances the credibility of the financial statements, the user cannot assume that the opinion is an assurance as to the future viability of the financial institution or as to the efficiency or effectiveness with which management has conducted the affairs of the financial institution”.

16.2 General Principles of an Audit 16.2.1 Compliance with code of ethics ASIFI requires the auditor should comply with the “Code of Ethics for Professional Accountants” issued by the AAOIFI, and the International Federation of Accountants which do not contravene Islamic Rules and Principles. Ethical principles governing the auditor’s professional responsibilities include: (a) righteousness (b) integrity (c)

trustworthiness

(d) fairness (e) honesty (f)

independence

(g) objectivity (h) professional competence (i)

due care

(j)

confidentiality

(k)

professional behaviour

(l)

technical standards

The ethics code is similar to IFACs new principle based code of ethics. Howver, AAOIFI has come with 4 of its own principles derived from the shari’a i.e. righteousness,



trustworthiness, fairness and honesty which are also universal valus. The term independence seem to be left out in IFAC’s new code of ethics but is covered under objectivity. AAOIFIs’ additions are welcome and hopefully positively contribute to the mindset of Islamic accountant. Perhaps another useful addtion could be knowledge and wisdom, as professional competence does not equal wisdom.

16.2.2 Auditor should follow audting standards in the conduct of the audit. Over the past 50 years, the accounting profession has introduced as many auditing standards as accounting standards. This was a result of various experiences of management fraud and court cases which increased standard of work required of auditors way beyond the Kingston cotton mill case where it was decided that the auditor was a watchdog but not a bloodhound. In today’s auditing environment, the auditor is somewhat a bloodhound. The International Auditing and Assurance Standards Board and its predecessor the IFAC’s International Auditing Practices Committee has developed over 54 International Standards on Auditing and International Auditing practising statements compared to 9 ASIFIs and GSIFIs (Governance standards of IFI’s). These standards cover various areas of auditing such as materiality, audit evidence in various areas, audit reports and so on. When performing audits the auditor must conduct the audit in accordance with these standards an record the procedures he has conducted. Thus, “The auditor should conduct an audit in accordance with ASIFIs, which are auditing standards approved by the Accounting and Auditing Organization for Islamic Financial Institutions. These contain basic principles and essential procedures together with related guidance in the form of explanatory and other material.” This may be needed to defend himself if there is a legal suit disputing the competency of the auditor or adequacy of his work. The unique ASIFI with regard to this ASIFI 4: Testing for compliance with Shari’a rules and Principles by an External Auditor, whereas all the Governance Standards are unique contributions by AAOIFI. It serves no purposes for AAOIFI in reinventing the auditing standards but a review should be undertaken to ensure there is not standards which contravenes the shari’a and well as to identify further unique areas for development of ASIFI’s and GSIFI’s.

16.2.3 Professional competence and due care in the conduct of the audit. Auditing is an assurance assignment in which the audit risk must be brought down to a sufficiently low level in order to give a positive assurance on the financial statements of IFI’s. This means that the auditor should probabilistically discount the possibility of material misstatements in the financial statements. He should therefore,” plan and perform the audit with professional competence and due care recognizing that circumstances may exist which



cause the financial statements to be materially misstated. For example, the auditor would usually expect to find evidence to support management representations and not automatically assume that they are necessarily correct.” In addition to the risk of material misstatements, the auditor is also responsible to ensure that he has a reasonable chance of detecting material fraud in the financial statements by infusing a dose of healthy professional scepticism in the conduct of his audit and when there are any suspicions, he should follow up until he has investigated the matter to his satisfaction. In addition to the normal auditing competencies, the auditor of IFI’s need to ensure that the financial statements are in accordance to shari’a rules and principles and follow AAOIFI’s accounting standards where they have jurisdiction. A brave auditor may even insist on management following aaoifi’s standards to ensure truth and fairness of the financial statements where no corresponding IFRS exist or where the IFRS is inappropriate. This requires additional competencies and qualities and moral courage on the part of the auditor. He requires a basic knowledge of fiqh muamalat principles, Islamic banking products, a knowledge of AAOIFI’s shari’a, accounting and auditing standards and the ability to review the fatawas of the Shari’a supervisory board of the bank and other national SSBs if any. Currently most of the auditors of Islamic bank come from the conventional big four accounting firms (see for example Table 16.2 below). I suppose they acquire these competencies through in house courses and CPE courses and on the job experience. The CIPA examination is perhaps the first attempt to certify competency in this area although it has a long way to go before becoming a full fledged professional examination system.

Country

Name of Bank

Auditor

Saudi Arabia

Al Baraka Islamic Bank Bahrain Islamic Bank Shamil Bank Kuwait Finance House ARCapita Investment Bank Al Baraka banking group

PWC EY EY EY EY EY

Pakistan

Meezan Bank Limited

A.F. Ferguson & Co(Associate of PWC)

Malaysia

Bank Islam Malaysia Berhad

KPMG Desa Megat & Co

Bahrain



Table 16.2 Auditors of Islamic banks 16.2.4 Audit Scope, Reasonable Assurance and Shari’a Responsibility Audit Scope refers to the “audit procedures deemed necessary by the auditor in the circumstances to achieve the objective of the audit. The procedures required to conduct an audit in accordance with ASIFIs should be determined by the auditor having regard to the requirements of appropriate Islamic Rules and Principles, ASIFIs, relevant professional bodies, legislation, regulations which do not contravene Islamic Rules and Principles, and, where appropriate, the terms of the audit engagement and reporting requirements. International Standards on Auditing (ISAs) shall apply in respect of matters not covered in detail by ASIFIs providing these do not contravene Islamic Rules and Principles.”

Now, an audit is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process. Reasonable assurance also means that the auditor has satisfied himself that the transactions he examined during his audit comply with Islamic Shari’a Rules and Principles as determined by the Shari’a Board of the financial institution. Now this is a very unique responsibility of the auditors of an IFI. AAOIFI has developed ASIFI 4, “Tests for compliance with Shari’a rules and Principles by an External Auditor” which provides some guidance on this issue. The additional management assertion apart from the normal ones of cost, authorization, value, beneficial ownership, and presentation is that all the transactions which have been entered into which has resulted in the financial statements and the operation summary (the income statement) has complied with the Shari’a principles and rules as determined by the Shari’a board of the institution. The auditor cannot get a 100% assurance on this as, there are inherent limitations in an audit that affect the auditor’s ability to detect material misstatements. These limitations result from factors such as: (a) the use of sampling while testing transactions and balances (b) the inherent limitations of any accounting and internal control system (including, for example, the possibility of collusion) (c) the fact that most audit evidence is persuasive rather than conclusive



Also the work undertaken by the auditor to form an opinion is based on judgement, regarding in particular: (a) the gathering of audit evidence, for example, in deciding the nature, timing and extent of audit procedures, and (b) the drawing of conclusions based on the audit evidence gathered, for example, assessing the reasonableness of the estimates made by management in preparing the financial statements. Further, other limitations may affect the persuasiveness of audit evidence available from which to draw conclusions on aspects of the financial statements (for example, transactions between related parties). In these cases certain ASIFIs identify specified procedures which may, because of the nature of these aspects, provide sufficient appropriate audit evidence in the absence of: (a) unusual circumstances which increase the risk of material misstatement beyond that which would ordinarily be expected, or (b) any indication that material misstatement exists. Hence, the auditor is only required to obtain reasonable assurance that the “IFI has complied with the Islamic Shari’a rules and principles. In order to be able to do this, the auditor must bear in mind that:

(i) it is the responsibility of management ,not the auditor, to produce financial statements which ensure that the IFI’s financial statements and the IFI’s activities comply with the Shari’a rules and principles as determined by its SSB. (ii) The auditor is not responsible for the interpretation of the rules and principles of the shari’a. This is the responsibility of the SSB. (iii)The auditor must have knowledge of Islamic shari’a rules and principles but not to the level of the SSB members. (iv) The Fatwas, rulings and guidance issued by the SSB form the basis on which the auditors considers whether the IFI’s have complied with the Islamic shari’a rules and principles and as a basis for his conclusion on shari’a compliance of the IFI.Hence, he need not refer to original sources of the shari’a such as the Qur’an and sunnah.The responsibility of the auditor is to form an opinion on whether the transactions of the IFI are in compliance with the fatwas, rulings and guidance issued by the SSB of the IFI. (v) The auditor shall have no responsibility for assessing the competence of the members of the SSB.



(vi) The auditor shall satisfy himself that the IFI’s process for introducing new products or modifying existing products includes appropriate procedures for ensuring compliance with Islamic Shari’a Rules and Principles including reviews by IFI management, internal audit and the SSB. (vii) The auditor shall include procedures in his examination to ensure that all new fatwas, rulings and guidance, and modifications to existing fatwas, rulings and guidance are identified and reviewed for each period under examination. (viii) As part of his own scope of work, the auditor shall review available documents to ensure that all types of products offered by the IFI have been subject to a review by the SSB in accordance with GSIFI No. (2), and shall satisfy himself that the SSB has found these products to be in compliance with Islamic Shari’a Rules and Principles. The documents to be reviewed shall include the reports issued by the SSB to the IFI concerning the Shari’a compliance as well as the SSB’s minutes of meetings. The auditor shall give consideration to the matters contained in these documents and their effect on the work to be carried out by him. (ix) The auditor shall also verify that the transactions entered into by the IFI are consistent with the fatwas, rulings and guidelines of the SSB. This verification shall be carried out by the auditor on a test basis. The nature and extent of the testing is subject to the individual circumstances of the IFI and shall be determined by the auditor after careful consideration of these circumstances. (x) The auditor shall also review the findings of all internal reviews carried out by the IFI management, the internal audit, and as set out in GSIFI No. (3), by an internal Shari’a review. Consideration shall be given to the findings of these reviews and whether these findings effect the nature, timing or extent of the work carried out by the auditor during his examination. (xi) The auditor shall make available the auditor’s report only after he has taken note of the SSB’s draft report on the IFI’s compliance with Islamic Shari’a Rules and Principles. If the SSB’s draft report indicates that compliance with Islamic Shari’a Rules and Principles is lacking, and the auditor decides, based on the SSB’s draft report, to modify his draft report, he shall provide an adequate explanation of the nature of and reasons for the modification. (xii) Prior to issuance of the final report of the SSB, the auditor shall make available to the SSB his draft report and conclusions related to Shari’a.

16.2.5 Auditing and Shari’a review Audit Report and Shari’a Opinion From the above, we can see that the auditor complements the shari’a supervisor board of the IFI’s. The SSB issues a Shari’a Report which pertain to Contracts, transactions and dealing,Equitable allocation of profit and losses,Earnings (lawful/prohibited) and



Zakah. It is concerned with the activities and operations of the IFI as a whole as well as its contracts. Whereas the auditor is mainly concerned with the IFI’s financial statements. They use Independent samples and tests conducted Audit opinion is expressed on or after Shari’a opinion is obtained. The evidence for either is obtained separately. The Audit opinion refers to Shari’a rules opinions and principles


- Foxit Software


Auditor must comply with AAOIFI’s code of Ethics for Professional accountants and IFAC’s code of ethics True and fair accounts prepared in accordance with shari’a rules and principles are Management’s NOT auditor’s responsibility

Audit should be conducted in accordance with AAOIFI’s auditing standards

General Principles of Auditing of Islamic Financial Institutions

Reasonable assurance not gurantee due to use of sampling, limitations of internal control and evidence is persuasive, not conslusive

Planning and performance of audit with due care and professional competence (professional skepticism Audit scope to be determined by Islamic rules, principles, ASIFIs, legislation, non contravening regulations, ISA where ASIFIs don’t exist.

Fig 16.3 General Principles governing an audit of an Islamic financial Institution



16.4 Some Examples of Auditors’ Reports of Islamic banks









Question 16-1

a) How does the auditing of IB&FI’s differ from the auditing of conventional Financial Institutions? b) What are the differences between the auditors report for a conventional financial institution and a. auditors’ report of an IB&FI b. Shariah Supervisory Board Report of an IB&FI. c) Why is it that the Auditors report for an IB&FI cannot be issued before the SSB report? d) Explain briefly three qualities, according to AAOIFI’s code of ethics, which the auditor of an IB&FI should possess, which are not normally mentioned by conventional auditors’ professional code of ethics. e) Do you think a conventionally qualified auditor is competent to audit the accounts of an Islamic Financial Institution, given the objectives of financial accounting and financial reports as recommended by AAOIFI? (IIUM B.Acc, semester 1, 2004/2005, Q5)



Question 16-2

Extract of the external auditor report is provided as follows: ‘In our opinion, the financial statements give a true and fair view of the financial statements of Bank Tijarah Berhad as of December 31, 1999 ..in accordance with Malaysian Accounting Standards, AAOIFI Accounting Standards, the Statutory requirements and the Shari’a Rules and Principles…’ Required: a.

b.

State the objectives of auditing an Islamic bank in accordance to Auditing Standards for Islamic Financial Institution No. 1 (ASIFI 1). Briefly describe the Sharia’a review process. (IIUM B.Acc, semester 2, 1999/2000, Q1)

Question 16-3

a. How does the auditing of Islamic banks and Financial Institutions differ from the auditing of conventional Financial Institutions?



b. What are the differences between the auditors report for a conventional financial institution and : i. Auditors report of an IB and FI ii. Shariah supervisory board report of an Islamic Bank c.

Why is it that the Auditors report for an IB and FI can not be issued before the Shariah Supervisory Board report ? d. Explain briefly three ethical principles governing the auditors professional responsibilities, according to AAOIFI’s code of ethics, which are not normally mentioned by conventional auditors professional code of ethics. e. Do you think a conventionally qualified auditor is competent to audit the accounts of an Islamic Financial Institution, given the objectives of financial accounting and financial reports as recommended by AAOIFI.


Chapter 17: Shari’a Auditing, the Shari’a Supervisory Board and the Shari’a Report

They will present their excuses to you when ye return to them. Say thou: "Present no excuses: we shall not believe you: Allah hath already informed us of the true state of matters concerning you: It is your actions that Allah and His Messenger will observe: in the end will ye be brought back to Him Who knoweth what is hidden and what is open: then will He show you the truth of all that ye did." (At Tauba; 9:94)

Chapter

17

CHAPTER LEARNING OBJECTIVES: At the end of this chapter you will, insha Allah you will be able to: i. ii. iii. iv. v. vi.

Define and explain the meaning of shari’a auditing and shari’a review Discuss the role and functions of the Shari’a supervisory board Critically assess the regulatory and governance standards on SSB Demonstrate how a shari’a review is performed Discuss the dimensions of shari’a auditing and review Synthesize and evaluate current practice and suggest possible future scenarios.

17. 1 Introduction In the previous chapter, in table 16.1, I used the IFAC’s assurance engagement framework elements to demonstrate the difference between Islamic Auditing (or shari’a auditing) and conventional auditing in terms of the relationships, subject matter, criteria,



evidence and reporting. Shari’a auditing is an evolving area which is only being researched although conventional accounting firms, have already seen business opportunities (see fig 17.1) and are already providing consultancy services although the knowledge base, standards and methodology have not been well established.



Fig. 17.1 Advertisement for Shari’a Audit Services from Big Four Accounting Firm



In this chapter, let me define in my own words the term “shari’a auditing” and compare it with AAOIFI’s review. I use the term Islamic auditing and sharia auditing interchangeably. Shari’a review, currently is being undertaken by various parties mainly the shari’a supervisory board, the internal audit department of the bank, sometimes a separate unit called the shari’a compliance unit with its own shari’a compliance officer (e.g Bank Muamalat Malaysia Bhd.), and independent consultants who are mainly the external auditors. I am not aware of the central bank of any country constituting a shari’a compliance unit to conduct shari’a compliance investigations just as it conducts investigations and regular inspections to ensure the bank complies with the country’s banking legislation. AAOIFI’s GSIFI No. 2 gives the power of conducting shari’a reviews to the Shari’a supervisory board. Hence, we need to look at the roles and functions of this board as well as its constitution. We will then enter into a discussion on the nature and methodology of shari’a review, internal shari’a review. This will be followed by a debate on the merits and demerits of current practise and standards and finally a discussion of possible future scenarios.

17.2 Shari’a auditing and shari’a review and internal shari’a control system. Shari’a Auditing or Islamic Auditing can be defined as a systematic process of obtaining sufficient and appropriate evidence to form an opinion as to whether the subject matter (processes, personnel, financial and non-financial performance, financial position, systems, marketing, products, transactions, contracts etc) corresponds with the criteria (the shari’a rules and principles) which is broadly accepted by the Islamic community and to report to stakeholders thereon. Some of the things to note from the above definition : (i) shari’a auditing is a process i.e. a series of steps or work. (ii)sufficient and appropriate (reliable and good quality) evidence needs to be collected. (iiI)the subject matter of the shari’a audit should be wider than a financial statement audit. In line with the broader ambit of the shari’a including akhlaq, not only should the financial statements, but the banks internal processes, personnel, financial and nonfinancial performance, financial position, information and IT systems, marketing of the bank’s product and of course, the financial contracts employed by the bank.. This has implications for cost and time. However, this can be agreed with the client in case of



agreed upon procedures based assignment. However, a minimum scope needs to be decided upon for regulatory shari’a auditing. (iv) The criteria normally are the shari’a principles and rules developed by the Shari’a Supervisory Board. However, due to reasons we will consider later, I suggest shari’a principles broadly accepted by the Islamic community to avoid banks from fatwa shopping. Shari’a audit is not defined anywhere by AAOIFI. However, GSIFI No. 2 defines shari’a review as “an examination of the extent of an IFI’s compliance, in all its activities, with the Shari’a. This examination includes contracts, agreements, policies, products, transactions, memorandum and articles of association, financial statements, reports (especially internal audit and central bank inspection), circulars, etc. GSIFI further states that “The objective of a Shari’a review is to ensure that the activities carried out by an IFI do not contravene the Shari’a. And in order to achieve this objective unencumbered, GSIFI requires the SSB to have “complete and unhindered access to all records, transactions, and information from all sources including professional advisers and the IFI employees.” It can be seen that the scope of activities is very wide, i.e. shari’a compliance must be in “all its activities”, not just products and contracts. The list of subject matter to be examined is very wide ranging from products to transactions and financial statements.” In paragraph 1 to the standard, the responsibility of the review is placed by GSIFI on the Shari’a Supervisory Board. Paragraph 2 notes the relationship between the external audit of financial statements and the shari’a review by insisting that “this standard should be read in conjunction with ASIFI No.1: Objective and Principles of Auditing with particular reference to paragraph 7, and ASIFI No.2: The Auditor’s Report with particular reference to paragraph 17. It follows that the objective of this standard as well as those of ASIFIs No.1 and No.2 requires close coordination between the SSB and the external auditor. GSIFI No. 2 places the responsibility for shari’a compliance squarely on the management of the IFI. However, unlike the role of the external auditor, the SSB is supposed to play a role in advising, providing guidance and training the management of IFI to ensure shari’a compliance. The management is also required to provide all information relating to the IFI’s compliance with the shari’a. To ensure a measure of independence, the scope of work of shari’a review cannot be restricted. And if such restrictions are imposed by the IFI on the SSB, such will be reported to the shareholders. Looking at the scope of the shari’a review, I do not think it is a limited assurance engagement where a negative assurance can be given. Looking at the shari’a reports



provided by SSB’s, they are worded positively. Hence, perhaps shari’a review is actually a shari’a audit or assurance. Compared to the shari’a review, the internal shari’a review is conducted to “to examine and evaluate the extent of compliance with Islamic Shari’a rules and principles, fatwas, guidelines, and instructions issued by the IFI’s Shari’a supervisory board (SSB), hereafter referred to as Shari’a rules and principles” according to GSIFI 3, Internal Shari’a Review. Whereas, the responsibility for the shari’a review is placed on the Shari’a supervisory Board, the internal shari’a review should “be carried out by an independent division/department or part of the internal audit department, depending on the size of an Islamic financial institution (IFI). It shall be established within an IFI.” It can thus be seen that the internal shari’a review is an internal auditing activity of the IFI management forming part of what GSIFI 3 terms as “ internal shari’a control system designed to ensure that “that the management of an IFI discharge their responsibilities in relation to the implementation of the Shari’a rules and principles as determined by the IFI’s SSB.

GSIFI 3, goes on to define the elements of this “internal shari’a control system as: (i) Employees An IFI shall have a system in place which ensures that only qualified, experienced, and committed employees are recruited and retained. The system shall ensure that employees are continuously trained and developed in related disciplines, especially fiqh al-muamalat. Their performance shall be regularly assessed and appropriate action shall be taken. Employees shall be honest and loyal to their IFI. In all cases, prior consent of the IFI’s SSB shall be secured before any employee is appointed in the internal Shari’a review (in accordance with the by-laws of the IFI) in order to ascertain the employee’s positive attitude towards compliance with Shari’a rules and principles. (ii) Segregation of duties The internal Shari’a reviewers shall not undertake any operational activities of the IFI. and (iii) control procedures An IFI’s management shall establish controls, policies and procedures, to achieve the IFI’s objective of compliance with Shari’a rules and principles.



Elements of Internal Shari’a Control System

Employee

Segregation & Duties

Control Procedure

Fig. 17.2 Elements of the Internal Control Systems.

17.3 The role, functions and composition of the Shari’a Supervisory Board A unique corporate governance mechanism of Islamic financial Institutions is the shari’a supervisory board (SSB) which is theoretically an independent external body akin to external auditors. Consisting of at least 3 scholars in fiqh muamalat, who may be supported by experts in Islamic banking with knowledge of fiqh muamalat, the board play multifarious roles which are sometime inconsistent for an independent body ( I will have more to say on this in section 17.5). The board is supposed to direct, supervise and review the activities of the Islamic Financial Institution to ensure shari’a compliance in all its activities. The SSB is known under various names. In Malaysia, Bank Negara calls it shari’a committee, although Bank Islam Malaysia Bhd., uses the term Shariah Supervisory Council, whereas Meezan Bank of Pakistan has both a Shari’a Advisor (who issued the Shari’a Report) and a SSB, Shamil Bank of Bahrain uses Religious Supervisory Board, and al Baraka Bank uses the term Shari’a Board.



Bank Islam Malaysia Shariah Supervisory Council

Bank Negara Malaysia Shari’a Committee

Meezan Bank Pakistan Shari’a Advisor

Al Baraka Bank Bahrain Shari’a Board

Shamil Bank Bahrain Religious Supervisory Board

Fig. 17.3 Confusion in SSB Nomenclature? I think the confusion in terminology is perhaps due to the different and evolving perceived roles of the SSB. To me, AAOIFI’s definition is the best and most appropriate to give it a high enough status and role. The word Board rhymes with the Board of Directors (implying that the SSB should be as powerful in status and authority as the board of directors). The word supervisory defines its management and review role as opposed to a consultant/advisor whose advice may not be heeded. Of course the word shari’a as opposed to religious is better as the word shari’a is now synonymous with the Islamic shari’a not another religion’s shari’. Supervisory means that the board has power to direct and implement its decisions. The term Shariah advisor or advisory committee looks too timid and restricted in its role. BNM’s definition of Shariah committee is not too good as a committee’s advice need not be followed, although GPS1 insists that the IFI must follow the SC’s advice.



The SSB normally consist of renowned and learned Islamic scholars who are well known and trusted in their communities and they add credibility to the word Islamic in the IFI. Recently, in some cases, in their zest to mobilize more funds and provide more investment opportunities, some Islamic banks have gone fatwa shopping employing some dubious Islamic scholars who may hurt the reputation of the bank and the industry in the long run. These scholars are not careful in giving fatwas which the collective ummatic consciousness would not accept. Examples include some fatwas permitting tawarruq, bai bithamin ajil, premium saving bonds, and also passing contracts where some conditions lead to zulm on the part of the bank’s customers. The two standards available in this area are; (a) AAOIFI’s GSIFI 1: Shari’a Supervisory Board Appointment, Composition and Report issued originally as an auditing standard in June 1997 and reclassified later as a governance standard and (b) Bank Negara Malaysia’s GPS1 (Garis Panduan Shariah – Shari’a guidelines) Guidelines on the Governance of Shariah Committee for the Islamic Financial Institutions, issued in September 2004. There are some differences between the two standards which is highlighted below (AAOIFI’s standard is presented in green italics whereas BNM’s guideline notes are written in blue The Malaysian Guideline does not deal with the Shari’a report at all in contrast to AAOIFI’s standard.

Definition Definition of Shari’a Supervisory Board A Shari’a supervisory board is an independent body of specialised jurists in fiqh almua’malat (Islamic commercial jurisprudence). However, the Shari’a supervisory board may include a member other than those specialised in fiqh almua’malat, but who should be an expert in the field of Islamic financial institutions and with knowledge of fiqh almua’malat. The Shari’a supervisory board is entrusted with the duty of directing, reviewing and supervising the activities of the Islamic financial institution in order to ensure that they are in compliance with Islamic Shari’a Rules and Principles. The fatwas, and rulings of the Shari’a supervisory board shall be binding on the Islamic financial institution. (GSIFI 1)



17.3.1 Appointment of Shari’a Supervisory Board and Fixing of its Remuneration According to GSIFI 1, (1) Every Islamic financial institution shall have a Shari’a supervisory board to be appointed by the shareholders in their annual general meeting upon the recommendation of the board of directors taking into consideration the local legislation and regulations. Shareholders may authorise the board of directors to fix the remuneration of the Shari’a supervisory board. GPS 1 also requires every IFI to establish a Shariah Committee. However, the appointment is by the Board of Directors upon recommendation of the nomination committee but with prior written approval (application for approval to be submitted 60 days before appointment) of Bank Negara Malaysia (BNM) and appointment for a renewable term of two years. BNM can impose other conditions which has to be followed by IFIs. A SC member must be a natural person. Although GSIFI 1 does not mention the qualifications of the SSB separately, in its definition, it notes that the SSB is a body of specialised jurists in fiqh almua’malat (Islamic commercial jurisprudence). GPS1 insists on qualification or necessary knowledge, experience and expertise in either fiqh muamalat or usul al-Fiqh (Islamic jurisprudence). Although it does not insist on paper qualifications as long as the candidate has the necessary expertise or experience.

(2) The Shari’a supervisory board and the Islamic financial institution should agree on the terms of the engagement. The agreed terms would need to be recorded in an appointment letter. (3) The Shari’a supervisory board should ensure that the Islamic financial institution documents and confirms the Shari’a supervisory board’s acceptance of appointment. The letter of appointment of Shari’a supervisory boards should generally include reference to the compliance of the Islamic financial institution with Islamic Shari’a Rules and Principles. GPS 1 is silent on the terms of engagement, engagement letter or documentation and confirmation of the engagement. (4) The Shari’a supervisory board shall appoint from among its members or any other person a supervisor(s) to help it in performing its duties. GPS1 requires the appointment of an officer with knowledge in shari’a to act as secretary to the SC.



Composition, Selection and Dismissal of Shari’a Supervisory Board (5) The Shari’a supervisory board shall consist of at least three members. The Shari’a supervisory board may seek the service of consultants who have expertise in business, economics, law, accounting and/or others. The Shari’a supervisory board should not include directors or significant shareholders of the Islamic financial institution. GPS1 follows AAOIFI’s recommendation of a minimum of 3 members in the SC. However, it makes the IFI responsible to provide sufficient resources including independent expert consultation, reference materials and even training. There is no mention of exclusion of the Directors/shareholders. However, the reporting structure mentions that the SC is an independent body of the IFI. Further, BNM must approve the appointment of SC committee members.

(6) The dismissal of a member of the Shari’a supervisory board shall require a recommendation by the board of directors and be subject to the approval of the shareholders in a general meeting. GPS1 allows the IFI (presumably the directors) to terminate a member of the SC on the grounds of disqualification which includes, a number of breaches of corporate governance such as misbehaviour, failure to attend a least 75% of the meetings without reasonable excuse, bankruptcy, commission of serious criminal offence, subject to detention, supervision or residence restriction or banishment order by the authorities. While this elaboration of the grounds for dismissal is welcome, the ability presumably of the directors (who appoint the SC) to dismiss without reference to shareholders or the absence of the rights of the SC to make a representation in the AGM diminishes the independence of the SC, except perhaps the requirement to notify Bank Negara Malaysia of termination or resignation of the SC may dent the ability of the directors to simply fire SC members if the BNM is watchful. However, GPS1 does provide for restriction of appointment to avoid conflict of interest and to preserve confidentiality, provision which is missing in GSIFI 1. GPS1 does not allow the appointment of a member of the Shariah Advisory Council of BNM to be appointed as a member of the SC of the IFI. Further, A SC member may hold only one appointment as a SC member in the Banking Industry excluding takaful or fund management companies.

In addition to the above, GPS1 elaborates in detail both the responsibilities of the SC as well as the management of the IFI to the SC, whereas GSIFI 1 sets a broad parameter i.e. to direct, supervise and review the activities.



The responsibility of the Shari’a Commitee includes (i) participate and actively engage in deliberating Shariah issues put before them. (ii) advise the BOD on Shariah matters in its business operation. (iii) Endorse Shari’a Compliance Manuals which specify the manner in which a submission or request for advice is to be made to the SC, the conduct of SC meetings, and the manner of compliance with any shari’a decision. (iv) endorse and validate relevant documentations such as contracts, agreemnts, product manual, marketing, advertisements, sales illustrations and brochures used to describe the product. for shari’a compliance. (v) To assist related parties such as the IFI’s legal counsel, auditor, or consultant, on shari’a matters for advice upon request. (vi) To advise on matters which have not been endorsed or resolved to the Shariah Advisory Concil of BNM. (v) To provide written shari’a opinions where the IFI requests advice and on applications for product approvales to the BNM and to assist the SAC on reference for advice e.g by explaining shari’a issues involved and references to jurisprudential literature. And established sources. On the other hand, the IFI’s responsibilities to the SC are: (i) refer all shari’a issues to the SC (ii) adopt and implement the SC’s advice. (iii) ensure all product documentations are validated (iv) have a shari’a compliance manual (v) to provide access to relevant documents. (vi) to provide sufficient resources including budget, reference materials, training.and familirize the SC on its operations and business. (vii) to remunarate the members o fthe SC. GPS1 does not cover reporting of the SC to the IFI.

17.4 The Shari’ah review The Shari’a review as defined earlier is an examination of the IFI’s transactions, processes, products, financial statements etc. to ensure that all its activities comply with the Shari’a. At present this review is undertaken by the Shari’a supervisory board. GSIFI No. 2, outlines the broad procedures for review. This can be depicted by the figure 17.3 below:



Planning Review

Documenting Conclusions & Reporting to shareholders

rocedures

SHARI’A REVIEW CYCLE

Executing Review Procedures & preparing working papers

Fig 17.4 The Shari’a Review Cycle The Shari’a review can be carried out broadly in 3 phases which are: • • •

Planning review procedures. Executing review procedures and preparation and review of working papers. Documenting conclusions and report.

These stages are explained in GSIFI No. 2 as below:

1. Planning and designing Shari’a review procedures •

The Shari’a review procedures shall be planned so that it is completed in an effective and efficient manner. The plan shall be adequately developed to include a complete understanding about the IFI’s operations in terms of products, size of operation, locations, branches, subsidiaries and divisions. The planning shall include obtaining a list of all fatwas, rulings and guidelines issued by the SSB.



•

Understanding the activities, products and management’s awareness and attitude towards compliance with the Shari’a is essential. This will have a direct effect on the nature, extent and timing of the Shari’a review procedures.

•

The plan shall be properly documented including the sample selection criteria and sizes, taking into consideration complexity, and frequency of transactions.

•

The review procedures shall be designed based on the above input. The review procedures shall cover all activities, products and locations. These procedures shall ascertain whether the SSB approved transactions and products have been undertaken and all related conditions have been met.

2. Executing Shari’a review procedures and preparation and review of working papers At this stage all the planned review procedures are executed. The SSB review procedures shall normally include: • obtaining an understanding of the management’s awareness, commitment and compliance control procedures for adherence to the Shari’a; • reviewing of contracts, agreements, etc.; • ascertaining whether transactions entered into during the year were for products authorised by the SSB; • reviewing other information and reports such as circulars, minutes, operating and financial reports, policies and procedures, etc.; • consultation/co-ordination with advisors such as external auditors; and • discussing findings with an IFI’s management. The execution of the above review procedures shall be documented in work papers which shall be complete, neat and cross referenced to review procedures. 3. Documenting conclusions and report The SSB shall document their conclusions and prepare their report to the shareholders based on the work done and discussions held. The SSB report shall be read at the annual general meeting of the IFI. A detailed report, when warranted, shall also be issued to an IFI’s management. Quality assurance



The SSB shall implement adequate quality control policies and procedures to ensure that the review is conducted in accordance with this standard. Quality control procedures may include review of all work papers to ensure that review procedures were properly understood and executed. Additional discussions may be held with the IFI’s management, if required, to ensure that all significant matters were covered during the review. Report The SSB report to the shareholders of an IFI shall be based on GSIFI No. 1 Shari’a Supervisory Board: Appointment, Composition and Report. The Shari’a review procedures shall be planned so that it is completed in an effective and efficient manner. The plan shall be adequately developed to include a complete understanding about the IFI’s operations in terms of products, size of operation, locations, branches, subsidiaries and divisions. The planning shall include obtaining a list of all fatwas, rulings and guidelines issued by the SSB. Understanding the activities, products and management’s awareness and attitude towards compliance with the Shari’a is essential. This will have a direct effect on the nature, extent and timing of the Shari’a review procedures. The plan shall be properly documented including the sample selection criteria and sizes, taking into consideration complexity, and frequency of transactions. The review procedures shall be designed based on the above input. The review procedures shall cover all activities, products and locations. These procedures shall ascertain whether the SSB approved transactions and products have been undertaken and all related conditions have been met.

17.5 Internal Shari’a Review In addition to the shari’a review, the IFI is also required to conduct an internal shari’a review by a special shari’a compliance unit or department or a branch of the internal audit department depending on the size of the bank. This is just like the internal audit and external audit which complement each other. It is plainly impossible for the SSB to carry out a vouching audit to verify the shari’ah compliance of an IFI. Therefore, it has to rely on its internal control systems, part of which is the internal shari’a review.



Internal Shari’a review The internal Shari’a review is an integral part of the organs of governance of the IFI and operates under the policies established by the IFI. It shall have a statement of purpose, authority, and responsibility (charter). The charter shall be prepared by management and shall be consistent with Islamic Shari’a rules and principles. The charter shall be approved by the SSB of the IFI and issued by the board of directors. The charter shall be regularly reviewed. The charter shall make clear that internal Shari’a reviewers are to have no executive authority or responsibility for the activities they review. The internal Shari’a review may be carried out by the internal audit department/internal control department if properly qualified and independent. However, if separate unit is set up it shall have authority equivalent to the authority of the internal audit department/internal control department.


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ELEMENTS OF INTERNAL SHARI’A REVIEW

CHARTER AND OBJECTIVES

INDEPENDENCE & OBJECTIVITY

PROFESSIONAL PROFICIENCY

SCOPE OF WORK

STAFFING AND SUPERVISION

COMPLIANCE WITH CODE OF ETHICS

KNOWLEDGE, SKILLS AND DISCIPLINES

CONTINUOS EDUCATION AND TRAINING

PERFORMANCE

DUE PROFESSIONAL CARE

MANAGEMENT OF THE INTERNAL SHARI’A REVIEW

ELEMENTS OF EFFECTIVE INTERNAL SHARI’A REVEWI CONTROL

PLANNING AND DESIGN OF INTERNAL SHARI’A REVIEW

EMPLOYEES

EXAMINING AND EVALUATING INTERNAL SHARI’A REVIEW

SEGREGATION OF DUTIES

REPORTING

CONTROL PROCEDUES

FOLLOW UP

Fig 17.5 Elements Of Internal Shari’a Review

QUALITY ASSURANCE OF SHARI’A REVIEW



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Independence and objectivity The organizational status of the internal Shari’a review shall be sufficient to accomplish its responsibilities. The organizational status of the internal Shari’a review shall not be lower than that of the internal audit department/internal control department. The internal Shari’a reviewers shall have full and continuous support of the management and the board of directors. They shall have direct and regular communications with all levels of management, SSB and external auditors, which shall enhance the organizational status of the internal Shari’a reviewers. No scope limitation and restriction of access to documents, reports, etc., shall be placed on the internal Shari’a reviewers. The head of the internal Shari’a review shall be responsible to the board of directors. He shall ensure full Shari’a review coverage, adequate consideration of the internal Shari’a review reports, and appropriate action on the internal Shari’a review recommendations. The internal Shari’a reviewers shall be objective in performing their internal Shari’a review. Objectivity includes independent attitude, which the internal Shari’a reviewers shall maintain in performing the internal Shari’a reviews. The internal Shari’a reviewers shall reach objective conclusions based on work performed and its results thereof. Professional proficiency Staffing and supervision The staff of the internal Shari’a review shall be proficient and shall have appropriate educational background and training relevant to internal Shari’a review. The head of the internal Shari’a review shall establish suitable criteria to meet the above. Supervision is a continuous process, beginning with planning and ending with the conclusion of the internal Shari’a review assignment. The head of the internal Shari’a review shall be responsible for providing appropriate internal Shari’a review supervision and he shall ensure that internal Shari’a reviews are properly supervised. Appropriate evidence of supervision shall be documented and retained.



Compliance with code of ethics The internal Shari’a reviewers shall comply with the Code of Ethics for Accountants and Auditors of Islamic Financial Institutions issued by the Accounting and Auditing Organization for Islamic Financial Institutions.

Knowledge, skills and disciplines The internal Shari’a reviewers shall possess the disciplines, knowledge and skills essential to the performance of internal Shari’a reviews. Proficiency in Islamic Shari’a rules and principles in general, and fiqh al-muamalat in particular, is required in performing internal Shari’a reviews. Continuing education and training The internal Shari’a reviewers shall maintain their technical competence through continuing education. The internal Shari’a reviewers are responsible for continuing their education in order to maintain their proficiency and keep informed about improvements and current developments. The internal Shari’a reviewers shall participate in training their IFI’s employees and other interested members of the public by holding regular meetings, courses and seminars. They may also disseminate knowledge by publishing and distributing pamphlets, brochures, etc., explaining principles of fiqh al-muamalat in general, and in particular the fatwas, guidelines and instructions issued by SSB about the products and services offered by their IFI. Due professional care Internal Shari’a reviewers shall exercise due professional care in performing internal Shari’a reviews. Professional care shall be appropriate to the complexities of the internal Shari’a review being performed. In exercising due professional care, internal Shari’a reviewers shall be alert to the possibility of intentional wrongdoing.



Scope of Work The scope of work of the internal Shari’a review shall encompass the examination and evaluation of the adequacy and effectiveness of the IFI’s system of internal Shari’a control and the quality of performance in carrying out assigned responsibilities. Shari’a rules and principles provide the direction as to the scope of work and the activities to be reviewed. The purpose of the examination of the adequacy of the system of internal Shari’a control is to ascertain whether the established system provides reasonable assurance that the IFI objectives of compliance with the Shari’a rules and principles will be met efficiently and effectively. Also, the purpose of the examination for effectiveness of the system of Shari’a internal control is to ascertain whether the system was functioning as intended. The internal Shari’a reviewers are responsible for planning, organising and directing processes to determine whether reasonable assurance exists that Shari’a compliance objective as well as other objectives and goals are being achieved. Performance of the internal Shari’a review work General The internal Shari’a reviewers shall plan each internal Shari’a review assignment. Planning documentation shall include, but not limited to, the following: • • • • • •

Obtaining background information about the activities to be reviewed, such as locations, products/services, branches, divisions, etc. Establishing internal Shari’a review objectives and scope of work. Obtaining SSB fatwas, guidelines, instructions, prior year internal and external Shari’a review results, relevant correspondence including supervisory and regulatory agencies. Determining the resources necessary to perform the internal Shari’a review. Communicating with all individuals in the IFI who need to know about the internal Shari’a review. Performing, as appropriate, a survey to become familiar with activities, risks, and controls to identify areas of the internal Shari’a review emphasis, and to invite reviewees’ comments and suggestions.



• • •

Writing the internal Shari’a review programmes. Determining how and when the internal Shari’a review results shall be communicated. Obtaining approval of the internal Shari’a review work plan from the concerned authorities including the SSB of the IFI.

Examining and evaluating internal Shari’a review information The internal Shari’a reviewers shall collect, analyse, interpret and document information to support their internal Shari’a review results. Information shall be collected on all matters related to the internal Shari’a review objectives and scope of work. Information collection shall include examination of documentation, analytical reviews, inquiries, discussions with management, and observations. Information shall be sufficient, reliable, relevant and useful to provide a sound basis for internal Shari’a review findings and recommendations. Working papers that document the internal Shari’a review shall be prepared by the internal Shari’a reviewer and reviewed by the head of internal Shari’a review. These working papers shall support the internal Shari’a review findings and recommendations. Working papers shall be appropriately prepared, completed, organised, reviewed and retained. Reporting The head of the internal Shari’a review shall discuss conclusions and recommendations with appropriate levels of management before issuing final written report. On completion of the internal Shari’a review, at least a quarterly written report shall be prepared which must be signed by the head of the internal Shari’a review, addressed to the board of directors and copied to the SSB and management. The report shall be objective, clear, constructive and timely. The report shall present the purpose, scope and results of the internal Shari’a review, and it shall contain an expression of the internal Shari’a reviewer’s opinion. The report shall also include recommendations for potential improvements and corrective action, and acknowledge satisfactory performance, when appropriate. The reviewees’ views about the internal Shari’a review conclusions or recommendations shall be included in the internal Shari’a review report. All disputes between management and internal Shari’a reviewers on matters relating to Shari’a interpretation shall be referred to the SSB for ruling.



Follow Up 22. The internal Shari’a reviewers shall follow up to ascertain that appropriate action is taken on their reported internal Shari’a review findings. In addition any other recommendations relating to Shari’a matters made by the SSB, external auditors, and regulatory agencies shall also be followed up. The management is responsible for rectification of non-compliance, prevention of non-recurrence of non-compliances, and ensuring that the agreed upon actions were carried out including their timing and extent of follow up. Management of the internal Shari’a review 23. The head of the internal Shari’a review shall properly manage the internal Shari’a review. He shall also perform the following: • • • •

establish plans to carry out the responsibilities of the internal Shari’a review; provide written policies and procedures to guide the staff of the internal Shari’a review; and establish a programme for selecting and developing the performance of the internal Shari’a review staff. The head of the internal Shari’a review shall ensure that the internal and external Shari’a review efforts are properly co-ordinated to ensure adequate Shari’a review coverage and to avoid duplicate efforts.

Quality assurance of Shari’a review The head of the internal Shari’a review shall establish and maintain an effective and efficient quality assurance programme to evaluate the operations of the internal Shari’a review.



17.6 The Shari’a Report GSIFI No.1 outlines the basic Elements which must be contained in the Shari’a Supervisory Board’s Report this includes: a)

title;

b)

addressee;

c)

opening or introductory paragraph;

d)

scope paragraph describing the nature of the work performed;

e)

opinion paragraph containing an expression of opinion on the compliance of the Islamic financial institution with Islamic Shari’a Rules and Principles;

f)

date of report; and

g)

Signature of the members of Shari’a supervisory board.

Title Of Report Signatures of the members of the SSB

Addressee

Elements of An SSB Report

Date Of Report

Opinion paragraph on the compliance of the IFI with Shari’a

Opening or Introductory Paragraph

Scope paragraph indicating nature of work performed

Fig 17.6 Elements of an SSB Report as per GSIFI No. 1’s requirements



The above elements are to ensure a measure of uniformity in the form and content of the Shari’a supervisory board’s report to help the reader’s understanding and to make it easir to identify unusual circumstances when they occur. 1. Title

The standard suggests an appropriate title. but strangely enough it does not have a title in the example report given in its appendix! Mercifully, all the actual reports I have seen have a title usually followed by praise to Allah and salutations to his Prophet saw.1

In the name of Allah, The Beneficent, The Merciful To the Shareholders of The Example Islamic Financial Institution Assalam Alaikum Wa Rahmat Allah Wa Barakatuh In compliance with the letter of appointment, we are required to submit the following report: We have reviewed the principles and the contracts relating to the transactions and applications introduced by the Example Islamic Financial Institution during the period ended. We have also conducted our review to form an opinion as to whether the Example Islamic Financial Institution has complied with Shari’a Rules and Principles and also with the specific fatwas, rulings and guidelines issued by us. The Example Islamic Financial Institution’s management is responsible for ensuring that the financial institution conducts its business in accordance with Islamic Shari’a Rules and Principles. It is our responsibility to form an independent opinion, based on our review of the operations of the Example Islamic Financial Institution, and to report to you. We conducted our review which included examining, on a test basis of each type of transaction, the relevant documentation and procedures adopted by the Example Islamic Financial Institution We planned and performed our review so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the Example Islamic Financial Institution has not violated Islamic Shari’a Rules and Principles. In our opinion: a)

the contracts, transactions and dealings entered into by the Example Islamic Financial Institution during the year ended ... that we have reviewed are in compliance with the Islamic Shari’a Rules and Principles;

b)

the allocation of profit and charging of losses relating to investment accounts conform to the basis that had been approved by us in accordance with Islamic Shari’a Rules and Principles;

(where appropriate, the opinion paragraph shall also include the following matters:) c)

all earnings that have been realized from sources or by means prohibited by Islamic Shari’a Rules and Principles have been disposed of to charitable causes; and

d)

the calculation of Zakah is in compliance with Islamic Shari’a Rules and Principles.

We beg Allah the Almighty to grant us all the success and straight-forwardness. Wassalam Alaikum Wa Rahmat Allah Wa Barakatuh (Names and signature of the members of the Shari’a supervisory board) Place and Date

1

Islamic salutations are noticeably missing from the Malaysian Reports. Perhaps they deem it unprofessional or maybe inappropriate in the multi racial multi religious shareholding/depositors environment of Malaysia.



2. The Addressee of the Shari’a Supervisory Board’s Report The Shari’a supervisory board’s report should be appropriately addressed as required by the circumstances of the engagement and local laws and regulations. 3.

Opening or Introductory Paragraph

The Shari’a supervisory board’s report should identify the purpose of the engagement. Illustrative wording for an opening (introductory) paragraph is shown below: “In compliance with the letter of appointment, we are required to submit the following report: 4.

A scope paragraph should describe the nature of the work performed.

Illustrative wording for a scope paragraph is shown below: “We have reviewed the principles and the contracts relating to the transactions and applications introduced by the Example Islamic Financial Institution during the period ended. We have also conducted our review to form an opinion as to whether the Example Islamic Financial Institution has complied with Shari’a Rules and Principles and also with the specific fatwas, rulings and guidelines issued by us.” 5.

Management’s Responsibility

A clear statement that the management of the Islamic financial institution is responsible for properly complying with Islamic Shari’a Rules and Principles. Illustrative wording for Shari’a statement is shown below: “The Example Islamic Financial Institution’s management is responsible for ensuring that the financial institution conducts its business in accordance with Islamic Shari’a Rules and Principles. It is our responsibility to form an independent opinion, based on our review of the operations of the Example Islamic Financial Institution, and to report to you.” 6. Scope Paragraph Confirmation that the Shari’a supervisory board has performed appropriate tests, procedures and review work as appropriate.



Where appropriate, examining, on a test basis of each type of transaction, evidence to support that the transaction and dealings entered into by the respective Islamic financial institution are in compliance with the Islamic Shari’a Rules and Principles. Illustrative wording to explain the review process is shown below: “We conducted our review which included examining, on a test basis of each type of transaction, the relevant documentation and procedures adopted by the Example Islamic Financial Institution. We planned and performed our review so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the Example Islamic Financial Institution has not violated Islamic Shari’a Rules and Principles.” Where appropriate, the report of the Shari’a supervisory board should include a clear statement that the financial statements have been examined for the appropriateness of the Shari’a basis of allocation of profit between the equity holders and the investment account holders. Where appropriate, the report of the Shari’a supervisory board should include a clear statement that all earnings that have been realized from sources or by means prohibited by Islamic Shari’a Rules and Principles have been disposed of to charitable causes. Where an Islamic financial institution prepares a Statement of Sources and Uses of Zakah and Charity Funds, the Shari’a supervisory board’s report should state whether the calculation of the Zakah is in compliance with Islamic Shari’a Rules and Principles. 7. Opinion Paragraph The Shari’a supervisory board’s report should state whether the Islamic Financial Institution’s contracts and related documentation are in compliance with the Islamic Shari’a Rules and Principles. An illustration of these matters in the opinion paragraph is shown below: In our opinion,: a)the contracts, transactions and dealings entered into by the Example Islamic Financial Institution during the year ended ... that we have reviewed are in compliance with the Islamic Shari’a Rules and Principles;



b)the allocation of profit and charging of losses relating to investment accounts conform to the basis that had been approved by us in accordance with Islamic Shari’a Rules and Principles; (where appropriate, the opinion paragraph shall also include the following matters:) c)all earnings that have been realized from sources or by means prohibited by Islamic Shari’a Rules and Principles have been disposed of to charitable causes; and d)the calculation of Zakah is in compliance with Islamic Shari’a Rules and Principles. If the Shari’a supervisory board has ascertained that the management of the Islamic financial institution has violated Islamic Shari’a Rules and Principles or the fatwas, ruling and guidelines issued by its Shari’a supervisory board, then the Shari’a supervisory board has to report the violations in the opinion paragraph of its report. 8. Date of Report The Shari’a supervisory board should state the period covered by its report and date the report as of the completion date of the review. The Shari’a supervisory board should not date the report earlier than the date on which the financial statements are signed or approved by management. 9. Shari’a Supervisory Board’s Signature The Shari’a supervisory board’s report should be signed by all members of the Board. The standard also requires the publication of the SSB report in the Annual Report of the IFI. It encourages the publication (separately, presumably) of all fatwas, rulings and guidelines issued by the SSB during the year. I end this section with some examples of actual shari’a reports. Readers should scan these reports and compare them with how they fare in relation to the standard. For example Meezan bank is very comprehensive while the Malaysian reports leaves a lot to be desired. Perhaps the BNM should come up with GPS 2 on shari’a reports, better make AAOIFI standards compulsory!











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17.7 Comments, conclusions and the way forward 17.7.1 The shari’a reports – a discussion. Let me start My Comments on the SSB Report standard (GSIFI No. 1) and actual practice and the go on to governance of IFI as a whole. GSIFI No. 1 combined two subjects in one i.e. the role and composition of the shari’a supervsiory board and the SSB report. This should be at least two separate standards one of the role and composition of the SSB (something like GPS1 of BNM) and another 2 standards on sharia reports (one for unqualified and one for qualified). The standards does very well on the appointment, composition, selection and disposal and also on the report format. However, it does dismally on the roles and responsibilities of the SSB (where BNM’s GPS1 excels – except on the reporting responsibility) and the contents of the appointment or engagement letter. The reporting part of the standard seems to follow the general format of the conventional audit report of the IAASB with some modifications for the nature of the audit performed by the SSB. a. On the title, perhaps it is best to have more uniformity in the title. In the example report of the standard, the basmallah is added as an indication and most IFI have followed with some form of Islamic salutation except in Malaysia. Maybe they think it is the substance not the form which is important but then this is one of the most important differences in the philosophy of the Islamic bank. So Shari’a Committee members of Malaysian IFI’s please be brave enough to mention Allah. Da’wa need not be sensitive. Islamic incantations are not mere rituals. On the contrary, they should remind the SSB members to fear Allah before they ink their signatures (sometime all too easily) on the report. b.. As far as Addressee is concerned, usually, the report is addressed to the shareholders of the IFI, following the conventional audit report, however many reports simply do not have an addressee. From an Islamic point of view, an IFI is not a capitalist institution, as such perhaps it would be advisable to report to the stakeholders of the IFI to impress upon the society that the IFI is a socio-economic institution with a socioeconomic as opposed to just an economic agenda and mission. c. The opening/introductory paragraph is supposed to identify the purpose of the engagement as well as have an introductory “scope paragraph’ describing the



nature of the work performed. This raises a few questions. Is the shari’a review or audit which is the SSB is reporting on a standard assurance engagement, a review or engagement to perform agreed upon procedure (using the definitions of the IAASB) AAOIFI should give a name to the engagement. GSIFI 2 term uses the term shari’a review but the wordings in the report is not that of a limited assurange engagement where only a negative assurance needs to be given. The illustrative words in the standards “ in compliance with the letter of engagement” seem to indicate that the assignement is an agreed upon procedure rather than an assurance engagement. As the state of knowledge is ill defined as are the procedures (both subject matter and criteria is ill defined) it is perhaps better to start with a standard requiring a review engagement rather than an assurance engagement. In the future, insha Allah, when these matters are sorted out and when qualified and skilled expertise exist, then a full shari’a audit (assurance engagement) can be made mandatory. There seems to be some confusion as to where the scope paragraph begins and ends. From a glance at the standard and the specimen report, there seem to be two scope paragraphs one as part of the opening paragraph i.e. “we have reviewed the contracts and principles…” interspersed with the management responsibility for shari’a compliance and a broader scope paragraph confirming that the SSB has conducted the appropriate tests... I think a single scope paragaph after the responsibilities paragraph should be clearer. Further, the standard seem to confuse opinion and scope on appropriateness of profit allocation, disposal of prohibited earnings and calculation of zakah. These three are mentioned in both the scope and the opinion paragraph. I think these three items can be left to the opinion paragraph alone. d.On the scope paragraph, the standard emphasizes four matters; Contracts and related documentations in compliance with Islamic shari’a rules and principles. The illustration includes transactions and dealings.The allocation of profit and losses related to investment accounts, disposal of prohibited earnings and calculation of zakah, the last two if applicable. All these matters are important and is right for aaoifi to emphasize this. One strange ommission are the financial statements. If you remember, the shari’a review standard GSIFI No. 2 included “financial statements’ in its scope of review but strangely the opinion paragraph makes no mention of it. Since the audit standards places the responsibility to review the financial statements for shari’a compliance and is included in the conventional auditors report, perhaps AAOIFI could remove the financial statements from the orbit of the shari’a review. Otherwise, the



opinion paragraph should state its conclusions from the review of the financial statements. From a broad shari’a perspective, these four or five matters although are very important, are not the only ones. Taking a cue from the SFA 1 (the objectives), the environmental, social and employee matters are equally important and should be subject to shari’a review. However, this requires AAOIFI to come up with accounting standards on these matters (perhaps initially requiring them on a voluntary basis) and then issuing auditing and shari’a review standards on these. Paragraph 21 of GSIFI no. 1 is the qualification paragraph and is worded thus: If the Shari’a supervisory board has ascertained that the management of the Islamic financial institution has violated Islamic Shari’a Rules and Principles or the fatwas, ruling and guidelines issued by its Shari’a supervisory board, then the Shari’a supervisory board has to report the violations in the opinion paragraph of its report. This is the only statement on qualifications. Firstly, this should be reworded more generally to state, that if there has been any violations of the shari’a by the IFI (not the management only – how about employees, customers, suppliers) than the violation should be reported and assessed on the basis of the operation of the IFI as a whole to see the seriousness of it. Secondly, I would suggest that AAOIFI comes up with a standard on qualifications in SSB reports to standardize the wording of the qualifications. As regard the date, perhaps, AAOIFI could insist on the Islamic date in addition to the Chrisitan date which we are using. Finally, the insistence of AAOIFI that all the SSB members must sign the report is to be commended as hopefully, this will motivate to share responsibility and to avoid free riders.



17.7.2 Some comments on corporate governance and shari’a auditing

ISLAMIC FINANCIAL INSTITUTION AAOIFI & IASB, IAASB

Central Bank Shareholders NSAC

External Auditors

BOD

IFSB

SSB AGC

Prudential Standards

Internal Audit/Shari’a compliance

AAOIFI (shari’a and accounting standards

The above diagram shows the corporate governance framework for Islamic financial Institutions in many countries. The boad of directors report to the AGM of the shareholders. The Board of Directors have several organs including the Auditing and Governance Committee, composing non-executive directors to which the External Auditors and the SSB liaise. The internal audit and shari’a compliance department



should normally report to the Audit and Governance Committee (AGC)2 or the CEO of the company. Islamic banks are also regulated by the country’s Central Bank which normally screens the appointment of external auditors (through an approved list) and in Malaysia, the SSB members (through prior application and approval). The external auditors in turn are regulated by their professional bodies’ code of ethics as well as by the accounting and auditing standards issued nationally or by the IASB and the IAASB and perhaps by standards issued by AAOIFI in certain jurisdiction such as Bahrain and Sudan. The SSB perhaps are influenced by the Shari’a standards of AAOIFI and the National Shari’a Advisory Council (in the case of Malaysia and Indonesia) or the courts. The International Financial Services Board is a prudential standard setter for Islamic Banks equivalent to Basle II standards of the IMF?? They set risk management and other standards. The questions to ask and answer are: (i) what is the nature of the shari’a audit review in practise? Is it as extensive as a statutory audit? If so are the SSB members who are fiqh scholars have the competence to do an audit or even a review. (ii) Following the IFAC code of ethics, an auditor should watch out for threats to independence including self review and advocacy threats. Now we know that the SSB also advices on the product compliance with the shari’a. They are also supposed to direct and supervise the IFI to ensure shari’a compliance. I feel that this is an uncomfortable position. The SSB is both judge and jury. Their evaluation and advisory roles should be separated. (iii) What is the responsibility of external auditors for shari’a compliance. The standard is rather vague. It puts the burden mostly on the SSB who may not be in a position to verify shari’a compliance, and yet they are expected to report on the Further are the responsibilities in this area include activities not relating to or impinging on the financial statements? (iii) Who monitors the shari’a supervisory board. They do not belong to any professional organization or registered government body who have their code of professional ethics or standards of practice. (iv)AAOIFI has also issued a code of ethics for employees of IFI’s. How is this implemented? In case of accountants who work for IFI’s they can be controlled through their professional accounting organizations(excluding the islamic part) but employees do 2

The GSIFI standard No. 4: The AGC for IFI’s is reproduced at the appendix to this chapter.



not normally belong to professional bodies. Perhaps, all IFI employees should be given the code as an attachement to their employment contracts and given trainining on ethics during in their induction in the IFI. (v) The audit procedures and evidence need to be worked out in more depth for different type of events. Compared to the IAASB which has more than 12 standards on audit evidence alone and 10 internatonal audit practice statements and given the broader range of shari’a issues, standard setting for islamic auditing has a long way to go. (vi) The IAASB has issued 1006 Auditing of the financial statements of banks, which is a 78 page document which covers a myriad of issues such as internal control in banks, risks and issues in respect of fraud and illegal acts, ratio analysis, risk and issues in securities underwriting and brokerage and risks and issues in private banking and asset management, which are not considered adequately from the perspective of the shari’a. The industry and regulators will have to face this issues especially risk management and derivative instruments used in hedging their disclosure and valuation and their shari’a acceptability. I suggest a new profession of Islamic accountants with a separate professional accountancy cum shari’a qualifications. The SSB’s fiqh scholars should be concerned with product development and shari’a advice. They should give a sharia advisor report on the products which they have approved but they should not be responsible for shari’a review or compliance of the activities of the bank other than as an advisor. The islamic accountants would do a single composite audit including the financial statements and shari’a compliance. AAOIFI should stick to the role of a standard setter and it is the responsibility of international Muslim organizations and governments and not only the industry, to fund aaoifi adequately to do its job and be on par in terms of quality with its western counterparts. A new Islamic accountants body should be set up by the islamic countries, this could be cipa well organised with a solid, rigorous range of examinations which will evaluate the skills, attitudes and values of would be islamic accountants. The qualification should be post graduate level but with substantial exemptions to degree holders and professionals of other accounting bodies who have undergone sufficient courses in arabic, fiqh muamalat, islamic economics, finance and accounting in addition to the conventional courses. CIPA and Inceifs, CIFP is a good beginning. However, a professional body needs to be independent from an training or standard setting institute. Since both AAOIFI and INCEIF has spent much money in the course and examination development, they should perhaps cooperate to form an independent professional body which will pay a royalty to both them especially aaoifi to partly fund its standards setting agenda.







Question 17-1

(a) Compare and contrast the shari’a review and the internal shari’a review. (b) What are the elements of internal shari’a control? (c) Elucidate the procedures for the shari’a review and illustrate by the use of a diagram.

Question 17-2

In an assurance engagement, the auditor obtains sufficient and relevant evidence to support his opinion of his evaluation of the subject matter against criteria. Further, the audit risk must be lowered to a sufficiently low level to give a positive assurance (unlike a limited assurance review) (a) In relation to a shari’a review, in your opinion is it an assurance engagement or a limited review engagement. Why? (b) In an financial statement audit, the subject matter are the financial statements and the criteria are the IFRS. What are the corresponding subject matter and criteria in a shari’a review? (c) List some of the evidential material the SSB can obtain/review to ascertain that the activities of the IFI are in compliance with the shari’a.

Question 17-3

i. Differentiate between the shariah audit and the conventional external audit. ii. Do you think that the two audits could or should be combined? iii. The SSB report on the next page is from Bank Islam Malaysia Berhad’s Annual Report 2004. Critique it , having regarding to the



recommendations of AAOIFI regarding SSB Reports. (assume SSB is the same as SSC)

REPORT OF THE SHARIAH SUPERVISORY COUNCIL We, Mohd Bakir Haji Mansor and Dato’ Md Hashim Haji Yahya, being two of the members of Shariah Supervisory Council of Bank Islam Malaysia Berhad, do hereby confirm on behalf of the members of the Council, that in our opinion, the operations of the Bank for the year ended 30 June 2004 have been conducted in conformity with the Shariah principles. On behalf of the Council: ………………………………… MOHD BAKIR HAJI MANSOR ………………………………… DATO’ MD HASHIM HAJI YAHYA Kuala Lumpur, Date: 27 September 2004

( IIUM MBA, 2005/2006, Q3 )



APPENDIX TO CHAPTER 17 ACCOUNTING AND AUDITING ORGANIZATION FOR ISLAMIC FINANCIAL INSTITUTIONS.

Governance Standard for Islamic Financial Institutions No. (4)

Audit & Governance Committee for Islamic Financial Institutions Contents Paragraph

Page Number

Introduction

1

33

Importance of AGC

2

33

Functions of AGC

3

33

4-9

33

10-13

36

Reporting

14

37

Effective date

15

37

Responsibities of AGC Establishing the AGC

Adoption of the standard

38

Appendix Specimen Terms of Reference

39



Introduction 1. The purpose of this Governance Standard for Islamic Financial Institutions (GSIFI) is to define the role and responsibilities of an Audit & Governance Committee (AGC) for an Islamic financial institution (IFI). The standard also highlights the requirements for establishing such a committee for an IFI and specifies the pre-requisites for an effective AGC. Importance of AGC

2. The importance of the AGC (known internationally as the Audit Committee) for an IFI emanates from its role in: (a)

achieving the fundamental objectives of an IFI, by enhancing greater transparency and disclosure in financial reporting; and

(b)

enhancing the public’s confidence of the IFI as genuine in its application of Shari’a rules and principles.

Functions of AGC 3. The AGC has gained widespread acceptance as a prerequisite for organisations seeking to demonstrate a commitment to higher standards of corporate governance. The AGC assists the board of directors in exercising independent and objective monitoring through the following functions: (a) Preserving the integrity of the financial reporting process. (b) Safeguarding the interests of shareholders, investors and other corporate stakeholders. (c) Providing additional assurance on the reliability of financial information presented to the board of directors, if the AGC is to be considered effective. (d) Acting as an independent link between the IFI’s management and its stakeholders. Responsibilities of AGC The responsibilities of the AGC shall comprise the following: Review of internal controls (including internal audit) 4. The AGC’s role with regard to internal controls is to ensure that the IFI has the appropriate controls in place and that these controls are functioning properly, as well as to monitor the implementation of management’s strategy. The AGC shall have a sufficient understanding of the IFI’s business and its control environment to make pertinent inquiries concerning systems of internal control. Implicit in such a function



is extensive interaction with the IFI’s management, its internal and external auditors and the ability to gauge the significance of problems and issues raised by these parties. The specific responsibilities associated with this function include: (a) (b)

(c) (d) (e) (f)

(g)

(h) (i)

(j)

comprehending the major risks to which the business is exposed. monitoring management’s control consciousness as it relates to the significance attached to controlling the IFI’s policies, procedures, methods, and organisational structure. reviewing the pressures on management to achieve results (eg, remuneration arrangements, and market expectations). monitoring the adequacy of management reporting processes. reviewing resources and skills, scope of responsibilities, overall work programme and reporting lines of internal audit. reviewing the effectiveness of internal control systems, particularly focussing on major findings of internal audit, the external auditor’s management letters and of any other reports from regulatory bodies together with management responses. reviewing the findings of central bank inspections and other regulatory bodies together with management responses and ensuring that appropriate actions have been taken to comply with the central bank inspectors’ requirements. reviewing the IFI code of ethics and the effectiveness with which it is implemented. reviewing the effectiveness of the IFI’s system for monitoring compliance with Shari’a rules and principles and legal requirements as well as considering the adequacy of controls over significant areas where loss or embarrassment could be caused to the IFI. ensuring that the management of IFI has implemented the procedures that govern its relationship with the related parties.

Review of accounting practices and audit plan 5. Financial reporting of transactions, projects and other activities in progress at a particular point in time includes recognition, measurement and disclosure of such activities. The outcome of such activities is subject to uncertainty and their measurement involves the use of accounting assumptions and judgement. The specific responsibilities associated with this function include:



(a)

(b)

(c) (d)

(e)

understanding areas in the IFI exposed to high degrees of risk and uncertainty, with particular reference to judgemental areas involving estimates, contingent liabilities and significant claims. reviewing the IFI’s accounting policies and practices and reporting requirements, with particular emphasis on the implications of new accounting standards and proposed changes in the IFI’s accounting policies and on areas in which choices exist between accounting methods or policies. reviewing the nature and scope of the audit with particular reference to high risk areas or locations and the resources and skills of the auditors. ensuring coordination between internal and external auditors and ensuring that the independence and professional integrity of auditors is not compromised. considering any issues related to the appointment, resignation or dismissal of members of the Shari’a supervisory board (SSB), chief internal auditor and/or the external auditors and reviewing proposals to appoint new members of the SSB, external auditors and/or chief internal auditor.

Review of interim and annual accounts and financial reports (inclusive of matters arising from the audit) 6. The over-riding principle with respect to the AGC’s review of all the abovementioned reports is to ensure their completeness, fairness and accuracy. The AGC shall review these reports (interim and annual accounts and financial reports) before their submission to the IFI’s board of directors. The review shall satisfy the AGC as to the fair presentation of reported earnings and the completeness of disclosures in the annual report and accounts. In addition, the AGC shall be briefed by the management on the latter’s methodology with respect to developing and summarising interim financial information. Also, the AGC shall be aware of any review procedures performed by the external auditors on interim financial statements. The specific responsibilities associated with this function include: (a) (b)

(c)

ensuring compliance with Shari’a, legal and regulatory requirements. ensuring compliance with all Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards and determining the appropriateness and effect of any changes in accounting policies and practices. reviewing the treatment of significant areas of judgement, accounting



(d) (e)

(f)

estimates and unusual transactions. reviewing significant adjustments arising from the audit. determining the appropriateness of the going concern assumption as the basis on which the accounts are prepared and if applicable, of the proposed statement by the directors that the company is a going concern. presenting a balanced and comprehensible assessment of the company’s position that relate to the responsibilities of the AGC.

Ethics 7. The fundamental principles governing the operation of an IFI have been enunciated in AAOIFI’s Code of Ethics for Accountants and Auditors of Islamic Financial Institutions (3). The AGC shall be governed by the principles listed below and shall endeavour to ensure that the IFI adheres to the same set of ethical values: (a) (b) (c) (d) (e) (f)

Faith-driven conduct Professional competence and diligence Trustworthiness Religious legitimacy Objectivity Professional conduct and technical standards

In order to ensure adherence to these fundamental values, it is imperative that the AGC of an IFI should work to facilitate Shari’a reviews by the SSB and the internal audit function of the IFI. Reviewing the Compliance with Shari’a rules and principles 8. The duties of the AGC also include the review of the reports produced by the internal Shari’a review and the SSB to ensure that appropriate actions have been taken. The AGC may invite a member of the IFI’s SSB to attend its meeting, as and when required.

(3 )

AAOIFI’s Code of Ethics for Accountants and Auditors of Islamic Financial Institutions, Sections 2 &3.



Reviewing the Use of Restricted Investment Accounts’ funds 9. In the case of Islamic banks, funds are mobilised from investors on the basis of the Mudaraba contract or Agency for both unrestricted and restricted investment accounts. The latter represent off balance sheet accounts, and this places a greater responsibility on the Islamic bank’s management to ensure that the funds are invested in accordance with the terms of the agreement and that profits are allocated according to the agreed terms between the Islamic bank and holders of investment accounts which should be in compliance with Shari’a rules and principles. Co-ordination between the AGC, internal Shari’a reviewers and external auditors is imperative for the effective monitoring of restricted investment accounts.

Establishing the AGC 10.The specific structure of the AGC shall vary according to the IFI and the country in which it is established. However, certain features in terms of establishing the AGC and practicing its responsibilities:

11. Constitution (a) The AGC shall be formally established by the board of directors from its non-executive members. The board of directors shall also appoint the chairman of the AGC. The AGC shall be vested with sufficient authority to carry out its responsibilities with independence and integrity. (b) The terms of reference (TOR) of the AGC shall be set out in writing and state clearly the AGC’s powers and responsibilities and empower it to investigate any matters within its jurisdiction. (c) The TOR will be used by the board of directors, AGC members, management, outside legal counsel, SSB, internal Shari’a reviewers and external auditors. The Standard provides a sample TOR of the AGC applicable to an IFI as an Appendix.



12. Membership (a) Attributes AGC members shall be knowledgeable about the business of the institution and applicable regulations and laws to deal adequately with the accounting and auditing matters the AGC will face. They shall understand the related Shari’a rules and principles and their application to various products and services offered by the IFI and have sufficient knowledge of AAOIFI’s standards. (b) Term of office and size The term of office of an AGC shall match the term of the members of the board of directors. The AGC shall not have less than three members, and these should represent a balance of views and experience. (c) Remuneration the AGC members’ remuneration may be based on a recommendation by the board of directors to the general assembly meeting or on the prevailing laws and regulations applicable in the country.

13. AGC planning and meetings

The AGC shall – with the consent of the board of directors – prepare internal by-laws to govern the AGC meetings and who should attend the meetings without the right to vote. 14. Reporting The reports of the AGC shall be submitted to the board of directors through the chairman of the board and copied at the same time to the chief executive officer. The names of the AGC may be mentioned in the annual reports. It is also recommended that the AGC’s chairman shall report to the chairman of the board of directors any significant matters of concern that arose at the last meeting to the AGC. The board of directors shall also discuss the work of the AGC based on its quarterly report.



Effective Date 15.

This standard shall be effective for financial periods beginning 1 Muharram 1423H or 1 January 2002.

Adoption of the standard The standard of the Audit and Governance Committee for Islamic Financial Institutions was adopted by the Accounting and Auditing Standards Board in its meeting No. (21) held on 8 Safar 1422H corresponding to 2 May 2001. Members of the Board 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

Abdul Malik Yousef Al Hamar Chairman Noor ur Rahman Abid Deputy Chairman Ibrahim Adam Habib Anwar Khalifa Sadah Jamil Ismail Darras Dr. Khalid Mohammed Boudi Dr. Sayed Musa Al Habshi Dr. Abdul Sattar Abughoddah Abdul Hamid Abu Mousa Dr. Abdul Samad Bin Hj. Alias Mohammed Alawi Thiban Musa Abdel Aziz Shehadeh Dr. Yousif Mohammed Mahmood Qassim



APPENDIX Specimen Terms of Reference Constitution The board of directors hereby resolves to establish a committee of the board to be known as the Audit and Governance Committee (AGC).

Membership The board of directors shall appoint the AGC members from the non-executive members of the board. The AGC shall not have less than three members. A quorum shall consist of a majority of the members. The chairman of the AGC shall be appointed by the board of directors. (All other requirements with respect to membership of the AGC are explained in more detail in item 12 (a-c) of the Standard.)

Attendance at meetings The Terms Of Reference (TOR) shall state the persons who shall be invited to attend the meetings of AGC; for example, the finance director, the head of internal audit and representatives from other technical departments, external auditor, representative from the SSB and the internal Shari’a review. It shall also be stated whether the AGC shall meet at least once a year with the external auditors in the absence of any management executive. The head of internal audit shall be the secretary of the committee.

Frequency of meetings The TOR shall state the number of meetings which must be held by the AGC annually. Authority The AGC is authorised by the board of directors to investigate any activity within its terms of reference. It is authorised to seek any information it requires from any employee and all employees are directed to cooperate with any request by the AGC.



The AGC is authorised by the board of directors to obtain outside legal or other independent professional advice and to secure the attendance of outsiders with relevant experience and expertise if it considers this necessary.

Responsibilities The responsibilities of the AGC shall be: (a) to consider the appointment of the Shari’a supervisory board, external auditor, and/or the chief internal auditor, the audit fee, and any questions of resignation or dismissal. This will include reviewing skills and resources of the external auditor. (b) to discuss with the external auditors before the audit commences the nature and scope of the audit, and ensure co-ordination where more than one audit firm is involved (c) to review the interim and annual financial statements before submission to the board of directors, focusing particularly on: § § § § § § §

any changes in accounting policies and practices major judgmental areas significant accounting adjustments resulting from the audit the going concern assumption compliance with the accounting standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions compliance with regulatory bodies, stock exchange and legal requirements compliance with the procedures that govern the relationship between management and related parties

(d) to discuss problems and concerns arising from the external and internal audits, and any matters the external and internal auditors may wish to discuss (in the absence of management where necessary) (e) to review the reports of regulatory bodies together with management responses (f)

to review the internal audit programme, consider the major findings of internal audit investigations and management’s response, and ensure co-ordination between the external and internal auditors

(g) to keep under review the effectiveness of internal control systems, and in particular to review the external auditor’s management letter and management’s response (h) to ensure compliance with Shari’a rules and principles by implementing recommendations contained in reports produced by the SSB and the internal Shari’a reviewers



(i)

co-ordinate with the internal Shari’a reviewers, internal and external auditors to ensure that restricted investment accounts are managed according to Shari’a rules and principles

(j)

to consider other topics, as defined by the board of directors

Reporting procedures The secretary shall circulate the minutes of meetings of the AGC to the board of directors.

Accounting and Auditing for Islamic Financial Institutions Accounting and Auditing Organization for Islamic Financial Institutions 1 st Edition, 1428/2007 PDF Page Organizer -Foxit Software

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