Accounting for IFIs
Transcript of Accounting for IFIs
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Accounting for IFIs
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Islamic accounting can be defined as the accounting process which provides
appropriate information (not necessarily limited to financial data) tostakeholders of an entity which will enable them to ensure that the entity is
continuously operating within the bounds of the Islamic Shariah and
delivering on its socio-economic objectives.
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“the process of identifying, measuring and communicating economic andother relevant information, inspired by the Islamic worldview and ethics,
and complied with the Shari’ah (Islamic law) – in order to permit informed
judgments and decisions by potential and expected users of information– to
enhance social welfare and seek the blessings of Allah”. Islamic accounting
is also a tool, which enables Muslims to evaluate their own accountabilitiesto God (in respect of inter-human/environmental transactions).
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Differences between Islamic Accounting and
Conventional Accounting
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Islamic Worldview of Accounting and Accountants
The Islamic worldview of accounting are not merely derived from culturaland philosophical elements aided by science, but one whose original
source is revelation, affirmed by intellectual and intuitive principles.
Islam literally means ‘peace’ and ‘obedience’, and the adherents to Islam
have to be ‘obedient’ to God and to appreciate the purpose of their
existence in this world.
In Islam, accounting should function not only as a service activity
providing financial information to the users and to the public at large but
more importantly accountants should discharge their accountability by
providing information to enable society to follow God’s commandments.
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In terms of responsibility, the accountant in Islam is not merely responsible
to human superiors, the management/client or shareholders.
He/ she is a servant and trustee of God in all situations, is simultaneously
responsible to God the Owner of his very self and the resources he is
utilizing and managing.
To forget or to neglect this fundamental aspect of this responsibility is
tantamount to a betrayal of divine trust with all the attending consequencesin this world and in the hereafter.
The accountant in Islam is motivated to provide work and excellent service
because as a holder of amanah (trustee of God) on earth he must search for
the bounties of God.
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His/ Her work is a form of amal salih (virtuous deed) which is then the key
for the attainment of blessings (true success in this world and in the
hereafter).
His/her work is also a form of ibadah (servitude to God) in so far as it is in
conformity with the divine norms and values.
The accountant who is imbued with the world-view of tawhid (oneness of
God) is not anti-profit or anti-worldly gain within the limits provided byreligion.
His vision of success and failure however extends beyond worldly existence
to the life in
the hereafter.
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Objective of Financial Accounting and Reporting for IFIs
The following are the objectives of financial accounting and reporting for IFIsas given by AAOIFI. To provide:
i. Information about the Islamic bank’s compliance with the Shari’ah
and its objectives and information establishing the separation of prohibited
earnings and expenditures, if any, which occurred, and the manner in
which these were disposed off.
ii. Information about the Islamic bank’s economic resources and related
obligations to assist the users in: 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 itsassets and the liquidity requirements for meeting its other obligations.
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iii. Information to assist the concerned party in the determination of Zakat on
the Islamic bank’s funds and the purpose for which it will be disbursed.
iv. Information to assist in estimating cash flows that might be realized from
dealing with the Islamic bank, the timing of those flows and the riskassociated with their realization. The 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 profit to equity and investment account holders.
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The Need for Islamic Accounting Standards
The need for accounting records as means for trust building is emphasized in
the Quran
: “... Never get bored with recording it, however small or large, up to its
maturity date, for this is seen by Allah as closer to justice, more supportive to
testimony, and more resolving to doubt, except when it is spot trade carried
out amongst yourselves, then you are not to blame for not recoding it”,(Baqara: 282).
Even for spot transactions where debt is not involved, the Quran allows an
open discretion for taking records, and that is all what accounting is about.
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Islamic accounting practice takes place within the IFIs such as Islamic banks
and Zakat institutions, and it is essential to the running of these institutions.
Islamic accounting practice does not indicate that Islam mandate any particularform of accounting.
However, the manifestation of Islamic faith simply implies that there are
particular forms of accounting to suit the needs of Islamic religious
requirements.
This is particularly true in the context of accounting practices in IFIs. The
prohibition of interest (riba’) and the different forms of financing has led to
modified accounting treatments and disclosure requirements for Islamic
financial services.
This is manifested by the explanations and discussions of accounting for
various Islamic financial services and transactions.
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The discussions of a unique Islamic financial system of Zakat , indicates
the needs for accounting for Zakat . This is especially crucial considering
Zakat is a religious institution that involves quite a number of accounting
implications.
First, it is widely accepted that the primary objective of accounting is to provide useful information to assist users in making economic decisions.
Thus, it can be argued that accounting is therefore, a religious obligation.Hence, if accounting is a religious obligation, then the rules of
accountability must be purely divine. In order to do so, appropriate
accounting framework based on Shariah principles must be in place.
The motivation for the development of Islamic accounting comes together
with the emergence Islamic economic and Islamic resurgence for the last
two to three decades.
The awareness for the need for Islamic accounting is due to basic building
blocks of conventional accounting itself since the International Financial
Reporting Standards (IFRS) are based on interest-based elements.
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This is one of the elements embedded in the conventional accounting
which is already violating the requirements of Shariah.
It is necessary to have Islamic accounting to be in place rather thanconventional accounting in order to provide information on financial
success in Islamic organisations.
The Accounting and Auditing Organisation for IFIs (AAOIFI) was
formed for this reason.
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Second, Islamic accounting may be more appropriate to achieve thesocio-economic and religions objectives of Islamic institutions and
Muslim users.
This is because Islamic institutions such as Islamic banks etc. are
established to meet the socio-economic objectives of the Shariah (Islamic
Law) through the implementation of an Islamic economic system.
Hence, these institutions should logically use Islamic accounting,
especially for monitoring these institutions to achieve their objectives.
However, if conventional accounting which developed to meet the needs
of a capitalist economy is used instead in these institutions, a problem is
likely to occur, which will lead to the institutions not meeting theirShariah socio-economic objectives and even worse may turn these Islamic
institutions into capitalist institutions by providing materialist profit-
focused information instead of the holistic information provided by
Islamic accounting.
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Nevertheless, Islam is not against profit motive that is reasonable. There is
no doubt, therefore, that Islamic accounting would result in an ethical
based accounting system which measures not only profits but social,environmental and religious performance.
Third, with the resurgence of Islam globally, the awareness for the needof Islamic accounting arises.
Islamic accounting as a whole is able to serve the whole gamut of
stakeholders. Its principles do not serve the interest of any particular
group, but to the society as a whole which can make corporations
accountable for their actions and ensure they comply with Shariah
principles.
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Fourth, Islam as a religion embraces a comprehensive system ofhuman conduct, influencing all aspects of life.
The uniqueness of Islam lies in its practicalities. Islam as a religion is
not merely a belief but is a complete way of life.
In fact, accounting is embodied in Islam. This can analogically be seen
from Islamic faith whereby for every human, 2 angels accompanied
them at right and left shoulders, record every good deeds and sins (the
double-entry bookkeeping principles?).
Further, the accounting profession has been mentioned comprehensively
in Quranic verses, portrayed to shoulder responsibility of social and
economic justice.
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. Allah has declared in Quran;
“O ye who believe! When ye deal with each other, in transactions
involving future obligations in a fixed period of time, reduce them to
writing, let a scribe (accountant ?) write down faithfully as between the parties; let not the scribe refuse to write; as Allah has taught him, so let
him write. Let him who incurs the liability dictate, but let fear his Lord
Allah, and not diminish aught of what he owes. If the party liable 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 thereare not two men, then a man and two woman, such as ye choose, for
witnesses, so that if one of them errs, the other can remind him/ her. 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 and more convenient to prevent doubts among
yourselves but if it be a transaction which ye carry out on the spot among
yourselves there is no blame on you if ye reduce it not to writing. But
neither take witnesses whenever ye make a commercial contract; and let
neither scribe nor witness suffer harm. If ye do (such harm), it would be
wickedness in you. So fear Allah; for it is Allah that teaches you. And
Allah is well acquainted with all things” ( Al-Baqarah, 2: 282).
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Fifth, the proper development of Islamic accounting practice especially inIFIs requires a well regulated Islamic financial service, and one of the key
elements of regulation is accounting regulation.
Therefore, a well-regulated Islamic financial industry requires a sound
accounting and reporting requirements that, first, would meet the
requirements of Shari’ah, and, second, will be relevant to be practiced in
our time.
The need for a codified Islamic accounting primarily stemmed from the
need that Islamic accounting objectives, concepts and principles developed
based on Shari’ah requirements.
However, the Islamic accounting regulation also needs to adapt to themodern accounting regulatory environment to make it relevant to be
practiced in our time.
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The Development of Islamic Accounting Standards
Organization for Islamic Financial Institutions (AAOIFI) was established on1 Safar, 1410H corresponding to 26 February, 1990 in Algiers, and then,
registered on 11 Ramadan 1411 corresponding to 27 March, 1991 in the
State of Bahrain, as an international autonomous not-for-profit Islamic
corporate body that prepares standards for IFIs, through the support of
institutional members (200 members from 45 countries, so far) including
central banks, Islamic financial institutions, and other participants from the
international Islamic banking and finance industry, worldwide
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AAOFI issues accounting, auditing, governance, ethics and Shari'a standards
for Islamic financial institutions and the industry.
AAOIFI has gained assuring support for the implementation of its standards,which are now adopted in the Kingdom of Bahrain, Dubai International
Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria.
The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom
of Saudi Arabia, and South Africa have issued guidelines that are based onAAOIFI’s standards and pronouncements.
In the meantime, the globalisation agenda and international harmonisation
movement of Islamic accounting and financial reporting is gaining momentum.
However, the calls for worldwide adherence to IFRSs to achieve harmonization
in financial reporting regardless of cultural differences should not go
unchallenged.
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Standards that have been developed by AAOIFI as at 30th
September, 2012 are as follows:
Accounting standards 1. Objective of financial accounting for Islamic banks and financial institution
(IFIs).
2. Concept of financial accounting for IFIs.
3. General presentation and disclosure in the financial statements of IFIs.
4. Murabaha and Murabaha to the purchase orderer.
5. Mudaraba financing.6. Musharaka financing.
7. Disclosure of bases for profit allocation between owners’ equity and investment
account holders.
8. Equity of investment account holders and their equivalent.
9. Salam and Parallel Salam.
10. Ijarah and Ijarah Muntahia Bittamleek.
11. Zakah.
12. Istisna’a and Parallel Istisna’a.
13. Provisions and Reserves.
14. General Presentation and Disclosure in the Financial Statements of Islamic
Insurance Companies.
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15. Disclosure of Bases for Determining and Allocating Surplus or Deficit in
Islamic Insurance Companies.
16. Investment Funds.
17. Provisions and Reserves in Islamic Insurance Companies.RSA I),%-0/ K>,,%/&? T,2/42&')/4 2/. I),%-0/ "+%,2')/A
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Auditing Standards
1. Objective and principles of auditing.
2. The Auditor’s Report.
3. Terms of Audit Engagement.
4. Testing for Compliance with Shari’a Rulesand Principles by an External Auditor.
5. The Auditor’s Responsibility to Consider
Fraud and Error in an Audit of Financial
Statements.
Governance Standards 1. Shari’a Supervisory Board: Appointment,
Composition and Report.
2. Shari’a Review.
3. Internal Shari’a Review.
4. Audit and Governance Committee for IFIs.
5. Independence of Shari’a Supervisory Board.
6. Statement on Governance Principles for IFIs.
7. Corporate Social Responsibility.
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Ethics Standards
1. Code of ethics for accountants and auditors of IFIs.
2. Code of ethics for employees of IFIs.
Shari’a Standards
1. Trading in currencies.2. Debit Card, Charge Card and Credit Card
3. Default in Payment by a Debtor.
4. Settlement of Debt by Set-Off.
5. Guarantees.
6. Conversion of a Conventional Bank to an Islamic Bank.
7. Hawala.
8. Murabaha to the Purchase Orderer.
9. Ijarah and Ijarah Muntahia Bittamleek.
10. Salam and Parallel Salam.
11. Istisna’a and Parallel Istisna’a.
12. Sharika (Musharaka) and Modern Corporations.
13. Mudaraba.
14. Documentary Credit.
15. Jua’la.
16. Commercial Papers.
17. Investment Sukuk.
18. Possession (Qabd).19. Loan (Qard).
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Application of GAAPs in Conventional Accounting
Compared with Islamic Accounting
Going Concern Concept:
Basically, the going concern concept embedded in conventional
accounting is not in conflict with the requirements of Islamic
accounting whereby the directors should make assessment on the
firms’ ability to continue as a going concern.
Consequently, the financial statements must also be prepared on the
basis of going concern basis unless the directors want to liquidate the
firms or to cease trading. In Islamic jurisprudence, there is a
presumption of continuity, or istishab.
The presumption of continuity means retaining any event or verdict
experienced in the past until evidence is found that this event or verdict
has changed. Hence if a person is known to exist, his existence is not
denied until there is evidence to the contrary.
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Extending this principle to a business entity, it may be acceptable to
assume that the entity would continue in operation in the foreseeable future
unless and until there is indication that its ability to continue as a goingconcern has ceased, for example, an entity based on Mudharabah which
was meant to be in operation only to the end of the agreed Mudharabah
period.
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Accruals/Matching Concept:
The accruals concept is not in conflict to the requirements of Shariah. Thus,
it is allowable for example, in the case of Murabahah or bay’ bithaman-ajil (BBA) transactions conducted by Islamic banks.
If the banks treat a Murabahah or BBA transaction as a financing
transaction or purely as a sales transaction, it has the same effect on profit.
However, Islamic banks may differ in terms of the timing of recognition ofthe margin: at time of sale, as cash received or as payment becomes due.
From the Islamic perspective, the matching principle which allocates
expenses to their related revenues provides fairness and justice
simultaneously to the shareholders and other stakeholders.
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The Concept of Prudence/Conservatism:
The preparers of financial statements do, however, have to contend with
the uncertainties that inevitably surround many events and circumstances,
such as the collectability of doubtful receivables, the probable useful life
of plant and equipment and the number of warranty claims that may occur.
Such uncertainties are recognized by the disclosure of their nature and
extent and by the exercise of prudence in the preparation of the financialstatements.
Prudence is the inclusion of a degree of caution in the exercise of the
judgements needed in making the estimates required under conditions of
uncertainty such that assets or income are not overstated and liabilities orexpenses are not understated.
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However, the exercise of prudence in Islamic Accounting does not
allow, for example, the creation of hidden reserves or excessive
provisions, the deliberate understatement of assets or income, or the
deliberate overstatement of liabilities or expenses, because the financial
statements would not be neutral, and therefore not have the quality of
reliability.
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The Concept of ‘Substance over Form’:
AAOIFI does not particularly endorse the concept of ‘substance over form’.
In view of the primacy of contract in transactions in Islam, the emergingreality must be constructed or appear to be as the form.
This is evident in the treatment of leased assets ( Ijarah) and sales based
transactions ( Murabahah). For Murabahah contracts, the essence of the
transaction is in fact a sales transactions.
Thus, the ownership title will be passed to the purchaser upon acquisition.
However, the financier or the bank can require the purchaser to pledge the
assets acquired as collateral to the financing amount.
The financier or the bank is prohibited to buy back the assets from the purchaser.
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Consistency Concept:
The requirement for consistency is not in conflict with the Islamic
accounting requirement whereby the presentation and classification ofitems in the financial statements should be retained from one period to the
next unless circumstances require it to change.
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Historical Cost Concept:
The conventional accounting measurement is based on the cost principle that
considers the acquisition cost or historical cost as appropriate measurement basis.
However, this principle is questionable from the Islamic point of view due to its
conflicts with the concept of fairness and justice.
In case of Zakat determination, majority of scholars recommend the use of
current prices on the due date of Zakat . The argument for the use of current
market value has been based on the needs for the most accurate valuation ofwealth to be subjected for Zakat in order to serve justice to both the Zakat
recipients and Zakat payers.
Adherence to the conventional accounting cost principles may lead to the
accounting practice of asset valuation that is lower of cost or market value. Thismay lead to understatement of trade assets to be subjected for Zakat .
AAOIFI, however, recommended the use of cash equivalent value that indicates
the value that would be realized if an asset was sold for cash in the normal course
of business as at the date of the financial statement.
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In order to ensure the reliability and comparability of the cash equivalent
value, it must be supported with objective indicators; logical and relevant
valuation methods; consistency of the use of valuation methods; expertvaluation; and conservatism in the valuation process.
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Materiality Concept:
Information is material if its omission or misstatement could influence
the economic decisions of users taken on the basis of the financial
statements. Materiality depends on the size of the item or error judged in
the particular circumstances of its omission or misstatement.
From an Islamic perspective, the nature of an item may make it material,
even if the size of the item is quantitatively insignificant. A related
Quranic verse reads: “... and if there be no more than the weight ofmustard seed, we will bring it to account ...” (Surah Al-Anbiya, verse
47).
Moreover, in fiqh, there is a legal maxim that when there is a mix of the
permissible and the prohibited, the whole becomes prohibited.
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This would appear to suggest that even small amounts of prohibited
items may be material. However, the maxim appears to be ihtiyat , a
precautionary measure rather than a ruling. There are numerous
examples of and exceptions to, the maxim.
For example, the maxim is applied in the case of a mixture of zabiha, i.e.
Islamically slaughtered, and non- zabiha meats. The mix of permissible
and prohibited meats renders the whole prohibited for Muslim
consumption. Conversely, the prohibition does not apply to a mixture ofsilk and other threads.
Although Muslim men are prohibited from wearing silk clothing, a
garment may be deemed permissible if it is made of a mixture of silk and
other threads such that the silk content does not exceed a prescribed
proportion. For financial reporting purposes, an entity may not need to
report some items below a certain threshold. Conversely, there may be
instances where an entity may be required to disclose an item regardless
of the size of the item.
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Periodicity Concept:
The conventional accounting periodicity concept is also acceptable in Islam
on the basis that even in the case of Zakat , it is being paid once a year as a
period of measurement. The concept of haul determined that the wealth
must be owned at least one year to qualify for the payment of Zakat .
Thus, the periodicity concept for an Islamic financial institution means the
life of the institution can be broken into reporting periods to preparefinancial reports to the interested parties and stakeholders.
This will assist the users to periodically evaluate the institution’s financial
performance and position. In addition, the periodic preparation of the
financial statements will be useful to determine the financial obligations andthe financial rights of the bank and other interested parties.
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Thus, the life of the Islamic bank should be broken into reporting periods
to prepare financial reports that provide information to interested parties
about the performance of the bank. One lunar year is used for Zakat calculation.
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Realization and Accrual Concepts:
AAOIFI’s SFA 2 recommends that “revenues should be recognized when
realized”. Realization of revenues shall take place when one of the threeconditions is met:
(i) the entity has the right to receive the revenue;
(ii) there is an obligation on the part of another party to remit; and
(iii) the amount of revenue should be known and collectible with
reasonable degree of certainty. Accrual basis of income recognition
does meet the requirement of Islamic objectives as it aims to measure
the ‘real’ wealth of an entity. IFIs therefore used both accrual and
cash basis of accounting.
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