Islamic Accounting

Foundation and Development of Islamic Accounting

Md. Harashid bin Haron, Ph.D harashid@usm.my; mdharashid@gmail.com E-learning Portal: http://elearning.usm.my/

Methods arriving at IA knowledge (concept/theory)

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 Shariah, accept those that are consistent with Shariah and reject those that are not, and develop those that are unique.

Suggested Readings
MASB Pronouncements (refer to course website) Ahmed, EA (1994). Accounting postulates and principles from an Islamic perspective. Review of Islamic Economics, 13(2), 143-160 The Objectives & Characteristics of Islamic Accounting.
http://www.scribd.com/doc/9868268/chp06-Islamic-AccountingLiterature-Review If you cant get the article, it is downloadable from the e-learning courses website.

Definition and Purpose of Accounting

In 1966 the American Accounting Association defined accounting as: the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of that information In 1975 they added that the purpose of the process was: to provide information which is potentially useful for making economic decisions and which, if provided, will enhance social welfare

ACCOUNTING
Recognising, recording, classifying and summarising business transaction

A PROCESS OF
Measuring, Analyzing, Interpreting Result of Operation

Reporting & Presenting Financial Position

Philosophic filter (Shariah, and IA and non-contravention-to-Shariah Standards.

Documents Vouchers Ledger Trial Balance Report (Mgmt) Profitability = Income - Expenses Growth Liquidity Productivity Financial Statement Balance Sheet Income Statement Stmt of Changes In Equity Cash Flow Statement Notes to Accounts

STAKEHOLDERS or MAIN USERS 1. Management 2. Board of Directors 3. Shareholders 4. Investors 5. Creditors 6. Authorities BNM, Inland Revenue, Baitulmal 7. Staff 8. Public

Accountability
Your definition??? .

General Definition An account of the extent to which the objectives for which the resources were entrusted have been achieved.

Islamic Accountability
Transcendental accountability to Allah SWT (Hablumminallah) Social accountability to the society (Hablumminannass) Individuals as trustees or Khalifah (vicegerents) Success in this world and in the hereafter (Falah) Economic goals beyond purely wealth maximization or economic value added but include Tazkiyah (purification of self and wealth i.e. Zakat, Waqf) Personal accountability (Taklif) Justice (Adalah) in relationships, contracts, activities etc. Maslahah i.e. public interest is more important than personal interest.

Islamic Accounting Objectives

Al-Baqarah 282: O you who believe! When you deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing, let a scribe write down faithfully as between the parties: let not the scribe refuse to write: as God has taught him, so let him write. Let him who incurs the liability (debtor) dictate, but let him fear his Lord God, and not diminish aught of what he owes. If the party liable (debtor) is mentally deficient, or weak, or unable himself to dictate, let his guardian dictate faithfully, and get two witnesses, out of your own men, and if they are not two men, then a man and two women, so that if one of them errs, the other can remind him.

Islamic Accounting Objectives

The witnesses should not refuse when they are called on (for evidence). Disdain not to reduce to writing (your contract) for a future period, whether it be small or big: it is more just in the sight of God, more suitable as evidence, and more convenient to prevent doubts among yourselves. But if you carry out the transactions on the spot there is no blame if you reduce it not to writing. But take witness whenever you make a commercial contract, and let neither the scribe nor witness suffer harm. If you do (such harm), it would be wickedness in you. So fear God; for it is God that teaches you. And God is well acquainted with all things

Islamic Accounting Objectives: Lessons from Verse 282 Al-Baqarah

The importance of proper recording Fear God in recording transactions (Islamic true and fair view) Justice in financial transactions (e.g. the rights of debtor and creditor) Islamic materiality concept Financial transactions require trustworthy witnesses Witnesses must be independence and protected by law Proper accounting to avoid doubts and disputes among human beings

Secondary Objectives
Shariah Compliance Assessment and Distribution of Zakat Equitable distribution of wealth among stakeholders The creation of co-operative environment and solidarity

Objectives of Financial Statements

Conventional
Statement of Comprehensive Income (Income Statement) Financial Performance

Islamic
Fulfilment of Amanah (Trust) of Financial Resources & Financial Performance Equitable Wealth Ownership and Financial Obligation Cash Entrusted

Statement of financial Financial Position position (Balance Sheet) Statement of cash flow (Cash Flow) Statement of Changes in Equity (Equity Statement) Cash Flow & Cash Management Wealth Ownership

Wealth Entrusted

Features of Islamic Accounting

No different in terms of recording (i.e. double entry system) Clear distinction of accounting objectives i.e. religious obligation vs. commercial obligation (different significance of financial statements) Modified accounting concepts to meet Shariah compliance (e.g. prudence, historical cost vs. current value etc.) Different users information needs affecting financial disclosure practices (legitimate and equitable transactions and wealth vs. maximization of wealth and pure economic consequences) Compliance with the goals (Maqasid), principles and rules of Shariah Different Islamic contractual relationships in financial services (e.g. mudarabah; murabahah; ijarah etc.) Distinct accountability relationships affecting Muslim accountants (to Allah SWT and Ummah) Determination of zakat (social responsibility of individuals and business organizations)

Definition of Islamic Accounting

The process of identifying, measuring, and communicating economic and other relevant information (not necessarily limited to financial data) inspired by Islamic Worldview and complied with Shariah Islamiyyah to permit informed judgments and decisions by potential and expected users information to enhance social welfare and achieve Mardhatillah (blessings from Allah)

Definition of Islamic Accounting

The process of identifying, measuring, and communicating economic and other relevant 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 Shariah and delivering its socioeconomic objectives

Islamic Accounting Practice i.e. Accounting in Islamic Financial Institutions

Development
Internationally, Islamic banking accounting and financial reporting practices are under the purview of central banks regulation in respective Muslim and non-Muslim countries In Malaysia, it is under the purview of BNM GP 8, Companies Act 1965, applicable MASB accounting standard, and International Accounting Standard (IAS) In reality, lack of Shariah consistency internationally as each bank relied on Shariah Advisors of respective banks even with the supervision of the central banks; but it is more harmonised now Needs for a comprehensive and enforceable accounting standard for Islamic financial institutions To take into consideration unique Islamic financial services and products

Development
As a result, lack of comparability and consistency on the accounting treatment on recognition, measurement and disclosure of Islamic-based transactions Lack of comparability leads to measurement and comparison of financial performance of the banks not possible Lack of sound regulation on accounting hinders the development of Islamic banking Internationally, the efforts made by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) since mid-1990s to develop accounting, auditing and governance standards for Islamic financial institutions In Malaysia, efforts by MASB with the guidance of AAOIFIs standards to develop Malaysian accounting standard for Islamic financial institutions

User Groups of Accounting Information for Islamic Banks & Their Needs
Investors (potential and existing) (lawful and equitable investment) Creditors (potential and existing) (lawful trade assets) Regulators (e.g. Bank Negara) (financial stability and soundness) Shariah Supervisory Board & Advisory Council (Shariah compliance) Customers (lawful goods and services) Others who may be effected by the disclosure or nondisclosure of information

Accounting and Auditing Organizations of Islamic Financial Institutions (AAOIFI)

Primary Purpose To enhance the confidence of users of the financial statements of the IFIs and ultimately to promote IFIs Objectives Develop accounting and auditing thought relevant to IFIs Disseminate accounting and auditing thought relevant to IFIs Prepare, promulgate and interpret accounting and auditing standards for IFIs Review and amend accounting and auditing standards for IFIs

Accounting and Auditing Organizations of Islamic Financial Institutions (AAOIFI)

History: established in 1991 agreement of association by IFIs worldwide supported by IDB Head office is in Bahrain Organizational Structure Supervisory Committee; Financial Accounting Standard Board; Executive Committee; Shariah Committee Funded by founding members of IFIs, establishment of waqf etc.

Objectives of Islamic Financial Accounting and Reporting (AAOIFI)

To determine rights and obligations of interested parties To safeguard entity assets and rights of others To contribute to enhancement of managerial productive capacities To provide useful information to make legitimate decisions Syariah compliance Distinguish prohibited earnings and expenditure

Objectives of Islamic Financial Accounting and Reporting (AAOIFI)

Present entitys economic resources, obligations and related risks Determine Zakat obligations Estimate cash flow and related risk Ensuring reasonable (or equitable) rates of returns to investors Disclose Islamic Banks discharge of social responsibility (not as a constraint but as a goal)

AAOIFIs Accounting Standards

FAS 1: General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions FAS 2: Murabaha and Murabaha to the Purchaser Orderer FAS 3: Mudaraba Financing FAS 4: Musharaka Financing FAS 5: Disclosure of Bases for Profit Allocation between Owners Equity and Investment Account Holders and Their Equivalent FAS 6: Equity of Investment Account Holders and Their Equivalent

AAOIFIs Accounting Standards

FAS 7: Salam and Parallel Salam FAS 8: Ijarah and Ijarah Muntahia Bittamleek FAS 9: Zakah FAS 10: Istisna and Parallel Istisna FAS 11: Provisions and Reserves FAS 12: General Presentation and Disclosure in Financial Statements of Islamic Insurance Companies FAS 13: Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance Companies

AAOIFIs Accounting Standards

FAS 14: Investment Funds FAS 15: Provisions and Reserves in Islamic Insurance Companies FAS 16: Foreign Currency Transactions and Foreign Operations FAS 17: Investments FAS 18: Islamic Financial Services offered by Conventional Financial Institutions FAS 19: Contributions in Islamic Insurance Companies FAS 20: Deferred Payment Sale FAS 21: Disclosure on Transfer of Assets FAS 22: Segment Reporting FAS 23: Consolidation Others (refer to AAOIFI website
http://www.aaoifi.com/aaoifi/Publications/KeyPublications/tabid/88/language/en-US/Default.aspx )

Malaysian Accounting Pronouncements for Islamic Financial Institutions

MASB FRSi-1: Presentation of Financial Statements of Islamic Financial Institutions (withdrewn/repealed) MASB TRi-1: Accounting for Zakat on Business (TRi-1) MASB TRi-2: Ijarah MASB SOPi: Financial Reporting from an Islamic Perspective MASB TRi-3: Presentation of Financial Statements of Islamic Financial Institutions MASB TRi-4: Shariah Compliant Sale Contracts

Impact of Shariah Contractual Conditions on Accounting concepts

1. 2. 3. 4. 5. Existence (recognition of revenue and asset e.g. cash vs. accrual basis) Lawful (recognition revenue and asset e.g. leasing vs. ijarah) Measurable (measurement of assets and liabilities e.g. historical vs. current value) Deliverable (recognition & measurement) Equitable (profit determination and distribution e.g. pooling method vs. separate investment account method) Accountability (disclosure & presentation e.g. halal vs. non-halal income and assets)

6.

Accounting Concepts: An Islamic Perspective

Accounting unit Separate legal entity; limited liability; owners are different from managers Similar to the concept of juridical person in the case Waqf & Baitulmal Almost similar to Mudarabah as far as the purpose and principles Liabilities limited to the capital contribution & may be injurious to the creditors in the case of liquidation To be constrained by the syariah as to the rights and obligations

Accounting Concepts: An Islamic Perspective

Periodicity periodic reports of financial positions as of a given date and divided into reporting periods (normally annual) Accounting for zakat based on haul (one year complete ownership) Going concern contracts assumed to continue until there is evidence to the contrary In consistent with Islamic principles of jurisprudence, istishab (presumption of continuity)

Accounting Concepts: An Islamic Perspective

Monetary and stability of unit measurement currency as common denominator Impact of inflation & purchasing power on reporting? Prudence & Conservatism Generally, not to overstate assets and incomes, and not to understate liabilities and expenses As long as can be determined with certainty (objectivity)

Accounting Recognition and Measurement Concepts

Recognition Define the basic principles that determine the timing of revenue, expense, gain and loss Measurement Define the broad principles that determine the amount at which assets, liabilities, owners equity etc. are recognized

Islamic Perspective of Accounting Recognition

Revenue Recognition Recognized when realized The right to receive not necessarily when the payment is received (i.e. accrual basis MASB SOPi-1 para B17; AAOIFI) e.g. when a bank delivers the service Shariah Requirement: the amount of revenue should be known and collectible Expense Recognition Realization either because the expense relates to the earning of revenue (e.g. transportation cost for services), or because it relates to the period of income statement (e.g. bonus)

Islamic Perspective of Accounting Measurement

Matching Concept Matching of revenues and gains with expenses and losses that relate to that period Measurement Attributes: acquisition cost (HC), cash equivalent value, assets replacement cost etc. In the case of Zakat measurement, preference is current market value (AAOIFI FAS 9: Cash Equivalent Value)

Islamic Perspective of Accounting Measurement

Historical Value vs. Current Value AAOIFI: Cash Equivalent Value (most preferred in the case of Zakat valuation if the following are available): availability of objective indicator; relevant information; logical and relevant valuation consistency of valuation methods experts valuation conservatism in the valuation process

Issue 1: Para 36 MASB TRi-3 on Voluntary Disclosure of Earnings or Expenditure Prohibited by Shariah
An IFI is encouraged to disclose: The amount and nature of earnings realised from sources or means which are not permitted by Shariah; The amount and nature of expenses not permitted by Shariah; and The manner of disposal of prohibited earnings.

Issue 2: MASB TRi-3 Para 43-46 on Profit Distribution Policy

An IFI that co-mingles various types of deposits into a single pool of funds should disclose the method of allocation of income among various categories of deposits. Discloses the distribution of profit derived from investment of depositors funds at gross level after deducting expenditure to the extent that they are directly attributable to the investment of those funds. 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 IFIs in the case of Wadiah and other non-Mudarabah deposits

Issue 3: Is Islamic Deposit a Liability or an Equity?

Wadiah deposit is clear cut liability because of safe keeping contract. Mudarabah deposit as a profit sharing partnership or investment is neither a liability nor equity. AAOIFI prescribed a separate line item in the Balance Sheet and recognised it as Equity of Unrestricted Investment Account Holders.

Issue 4: Basis for Income Recognition - Cash vs. Accrual

Cash basis recognizes actual income received in cash for profit distribution to depositors and shareholders Many Shariah scholars considers cash basis as the best since it possesses high level of certainty and ownership in profit for distribution Accrual basis recognizes when realized i.e. the right to receive rather than actual cash received Some Shariah scholars approved accrual basis as it represents the contractual rights as sufficient to recognize profit for distribution MASB SOPi-1 prescribed accrual basis with the premises to achieve harmonisation with other business entities and banks.

Issue 5: Substance vs. Form: Ijarah Asset - Fixed Asset or Receivable?

International Accounting Standard considers conventional finance lease as receivable Current practice for Islamic Hire Purchase (AITAB financing) is similar to conventional finance lease If Substance over Form then Ijarah is receivable as economic substance is `lending regardless of legal form AAOIFI considers Islamic finance lease (based on Ijarah Muntahia Bitamleek) as Fixed Asset The Legal Form that the Asset belong to the Bank or Financial Institution, and the lease to lessee According to AAOIFI Legal Form must be reflected rather than economic substance to represent the legal ownership of the lessor.

Conclusions:
1. 2. 3. 4. Two methods arriving at Islamic Accounting concepts, including postulates and principles. Most of the conventional postulates and principles are acceptable, thus compliant to Shariah Accountability is the primary objective Compliance with Shariah and, achievement of Islamic goals, on financial activities (financing schemes and financial instruments) Equitable and fair recognition, measurement, valuation and disclosure of financial information Achievement of both economic and spiritual well being of the society

5. 6.

Terima Kasih Thank You