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Accounting

Islamic Accounting and Traditional Accounting


Some Conflicts and Their Resolutions
Dr Syed Mohammad Ather FCMA
Md Hafij Ullah

Abstract: Objectives of the Study:


Accounting is a mechanism of recording and reflecting the The main objective of the study is to provide resolutions of
real financial aspects of any person or organization. This some problems of traditional accounting in Islamic
man-made mechanism is facing some problems in view of perspective. The specific objectives of the study cover the
Islamic perspective in recording and reflecting the financial following areas:
and others aspects of the organization. But Allah (SWT) and 1. To identify and analyze the problems of traditional
His Messenger (SAW) gave directions to solve all sorts of accounting.
problems faced by mankind in the world. This article is an 2. To resolve of the identified problems according to
endeavor to give an overview of some conflicts of Traditional Islamic accounting.
Accounting with Islamic Accounting as well as the resolutions 3. To focus the advantages of Islamic accounting over the
of these conflicts. This Article also highlights the advantages traditional accounting.
of Islamic accounting over the Traditional Accounting.
Methodology of the Study:
The methodology followed in this study is mainly of library
Key Words:
work basically based on the study of the Holy Qur’an,
Islamic Accounting, Traditional Accounting, Islamic
Hadiths and related literatures of available accounting written
Shari’ah,
in traditional and Islamic perspective.

Introduction: Traditional Accounting:


Accounting is a mechanism of recording and reflecting the Traditional Accounting process aims to allow informed
real financial aspects of any person or organization. decisions whose ultimate purpose is to efficiently allocate
Accounting is the process of identifying, recording, scarce resources available to their most efficient (and
classifying, interpreting and communicating economic events profitable) uses by providing information efficiency in the
to permit users to make informed decisions (AAA, 1966). market. Therefore, the accounting systems which identifies,
Like all other disciplines of measuring, recording, and measures and records the financial aspects of an entity with a
communicating information, traditional accounting suffers true and fair view and communicates the information to the
from some problems. We know that the Al-Qur’an gives right interested users is termed as Traditional Accounting (Without
directions to all aspects of human life and Islam is a complete any compliance to Islamic Shari’ah).
code of life (Al-Qur’an, 5:3); Allah (SWT) and His Islamic Accounting:
Messenger (SAW) gave us guidelines regarding every aspect The branch of accounting which sets its goals and performs
of human life to be dealt with (Al-Qur’an, 16:89). This paper all of its activities to achieve those goals ethically and
is a humble attempt towards the resolutions of the conflicts of objectively within the limits and boundary of Islamic Shari’ah
the traditional accounting in the light of Islamic accounting is called Islamic Accounting. Therefore, the accounting
(based on Islamic Shari’ah). systems which identifies, measures, records and analyzes the

Dr. Syed Mohammad Ather FCMA, Professor, Department of Management Studies, Faculty of Business Administration, University of
Chittagong and Md. Hafij Ullah, Lecturer, Department of Business Administration, Faculty of Business Studies, International Islamic University
Chittagong.
The Bangladesh Accountant/January- March 2010 20
Accounting
financial aspects of an entity on the basis of Islamic Shari’ah collecting cash from that account which may turn into bad
(That is, Rules and Principles of Islam) is termed as Islamic (Napier, 2007). Considering the above issues, Islamic
Accounting. accounting recommends Cash basis of accounting where
operating results are determined based on actual collections
Problems in Traditional Accounting and their
of revenues and actual payment of expenses in cash.
Solutions in Islamic Accounting:
There are some conflicts between Traditional Accounting and c. Determination of Financial position:
Islamic Accounting. The following discussion focuses these One important basic criteria of an account is its relevance but
conflicts and suggests their resolution. the accounts prepared based on cost concept of traditional
accounting is not relevant at the point of time when it is
a. Determination of Zakat:
prepared because investors and other related parties are more
Muslims are compulsorily required to pay Zakat based on the
interested in what the business is actually worth today rather
value of their wealth if it crosses the ‘Nisab’ (minimum value
than what the assets cost originally (Khan, 1989). Another
of assets for charging Zakat). One of the important objectives
of Islamic financial reporting is to assist in determination of characteristic of the accounts is completeness, but the

Zakat (Askary and Clarke, 1997). In case of business, the accounts prepared based on traditional accounting do not
trading goods (inventory or stock), cash, current receivables show the complete situation of the organization (Hye &
and marketable securities (Maliah, 2003) after deduction of Yeasmin, 2000). The assets shown on the Balance Sheet
any liabilities regarding these items are subject to Zakat don’t reveal the real financial position of the organization
(Quardawi, 2007), Zakat is not paid on fixed assets (capital (Hye & Yeasmin, 2000). Some of the assets (cash and its
assets) such as building, machineries, which are used in the equivalent) remain at market values readily at the time of
business to earn revenues (Quardawi, 2007). Computation of preparing the financial statements and some stated at their
Zakat requires determining the value of these assets at current original costs. When the units of measurement is unstable, the
market price (Maliah, 2003). Deduction of allowance for view can not be true and fair if the suitable adjustments are
doubtful accounts from gross accounts receivable is not not made in the accounts to allow for variations in the value
permissible in computation of Zakat (Clarke et al., 1996). of money (Grimsley, 1975). As per International Accounting
Reportedly the market value may be difficult to determine, Standard-2 (IAS-2), the traditional accounting may value
since it would require the accountant to keep trace of the ups inventory (stock) at lower of cost and net realizable value. As
and downs of market price (Khan, 1989). Notably the balance a result, the reduction in the realizable value of inventory
sheet, prepared as per traditional accounting, reveals the value below cost is recognized immediately but the increase in the
of assets at cost price or at cost or market which ever is lower. realizable value of inventory is not recognized until the
Therefore, valuation of assets in traditional accounting is not inventory is sold (Hye & Yeasmin, 2000). But for
suitable for determination of Zakat. Hence, Islamic computation of Zakat, inventory is required to be valued
accounting systems recommends recording of assets at always at current market price (whether it is higher or lower
current market price for the computation of Zakat. from cost). As there is no Zakat for fixed assets, therefore,
b. Determination of Operating Result: these assets are not required to be shown at current market
The operating result or net profit for a certain period is value. Further, it would not be justified to show fixed assets
determined deducting the amount of total expenses from the at current prices because these are not intended to be sold in
amount of total revenues of that period. Total revenues and near the future. If the fixed assets are stated at current value
total expenses are determined considering both the collected then unrealized profit would be recognized in the income
and accrual revenues and paid and accrued expenses as per statement and hence profit would ultimately be overstated as
accrual concept in traditional accounting respectively. The like as traditional method. On the other hand, other assets and
application of accrual concept requires subjective judgment liabilities, that is, claims of the organization to others and
which may be biased and create doubts in account (Napier, claims of others to the organization will not change due to the
2007). In accrual basis of traditional accounting, profits may change in price level and these would not be required to be
be distributed collecting cash from other sources before adjusted as per Islamic accounting. Mirza and Baydoun

The Bangladesh Accountant/January- March 2010 21


Accounting
(2000) suggested for using both the valuation methods in be shown by the Income Statement and value of assets would
Islamic Accounting, i.e., the contractual transactions with be higher due to use of current value for some assets and
other parties should be based on cost and Zakat calculation amount of owners’ equity would reflect the more up-dated
(assets valuation) should be based on current market value. position.
d. Interest: f. Comparative Analysis:
The word ‘Interest’ originated from the Arabic word ‘Riba’ One of the important characteristics of the accounts or
which means ‘Addition’, ‘Expansion’, or, ‘Premium’. Interest accounting reports is their comparability. But the information
on loan is a fixed charge made for borrowing/investing a sum provided by the accountants will not be possible to be
of money (Oxford, 2006). Traditional accounting recognizes compared with the information provided earlier to justify the
and records interest in the books of account but as per the improvement of profitability or operating efficiency of the
directives of Islamic Shari’ah, interest is strictly prohibited firm as because the depreciation expense and cost of assets
(Qur’an-2:275). Interest is unjust (Hamid et al, 1993) and are not the real amount (Hye & Yeasmin, 2000). Under the
makes the rich people richer and poor people poorer (Shafi, cost concept of traditional accounting, generally, the revenues
1992) A fixed interest rate guarantees a profit on money are stated at current prices, some costs are also stated at
contributed, regardless of whether the borrower has made a current prices but some other costs are expressed at historical
profit or a loss. Thus it is possible that labor and hard work cost and hence the net income determined in one accounting
may go unrewarded while lending of capital. On the other
period loses its comparability with that of earlier ones. In the
hand, interest is a guaranteed remuneration which entails no
balance sheet of traditional accounting, assets are stated at
exertion or effort on the part of the lender, and the capital (or
original cost or at lower of cost and market value and
original money lent) is not eroded or reduced in value by its
therefore, the assets and liabilities of one period are
use, (Shafi, 1979). Due to the avoidance of
incomparable with that of another one. If the balance sheets
debt/bond/debenture and Preference share (which are based
were actually stated on a current value basis, this would help
on interest), the capital structure of the firm would be
us make better comparisons (Brigham & Houston, 2006).
different. As per Islamic financial system, Islamic accounting
Thus the application of Islamic accounting, which is based on
uses different modes of financing like- Mudarabah (trust
current market prices for the inventory or stocks, will make
financing), Murabaha (cost-plus trade financing), Musharaka
the income statement and balance sheet information
(Participation financing), Ijara (Rental/lease financing) all of
comparatively more comparable than that of traditional
which are based on profit and loss sharing. If any firm cannot
views.
avoid interest due to the prevailing rules and regulations, they
must give an explanation as to why it has arisen and the steps g. Reduction of Capital:
they have taken to avoid the payment of interest (Maliah, At the time of inflation, if the accrual revenues are
2003). considered, profit would be overstated and it will result
e. Ratio analysis: excess payment of dividend but due to accrual concept,
Ratio analysis is done to evaluate organizational performance sufficient amount of cash would not be available in the hand
based on which users of accounting information made of the firm to pay the dividend. But if the accrual revenues
different decisions in relation to that organization. As per turn into uncollectible then the firm will require using other
traditional accounting (based on cost and conservatism funds to recompense the depositor, which will violate the rule
concepts) profit is overstated but assets and owners’ equity, to that the loss should be borne by the investors. So, Islamic
some extent, are understated and therefore, return on assets accounting emphasizes using cash basis of accounting rather
(ROA) and return on investment (ROI) will also be than accrual basis of accounting (Hamat, 1994). At the time
overstated. These overstated ratios may mislead the intended of inflation, the dividend payout ratio tends to be low (Khan
investors to invest their money in the organizations from & Jain, 1999). But the overstatement of profit results in
where they may not earn the same returns in future. If Islamic excess payment of dividend to the stockholders; as a result of
accounting is applied then the realized accurate profit would which, the capital of the firm would ultimately be reduced.

The Bangladesh Accountant/January- March 2010 22


h. Determination of Tax Payments:
Accounting
their accountability to almighty Allah (SWT) (Shahul and
Income tax is levied by the government on the profit Yaya, 2003).
determined by the company. But overstatement of profit as k. Social Contribution and Shari’ah Compliance
per traditional accounting on accrual basis may require The traditional view of accounting is much more
paying higher amount of income tax payments. Further some materialistic. Therefore maximization of profit and wealth is
revenues (which are on account) shown in the income emphasized and there is no consideration of ‘Halal’
statement may not be realized/received in cash or may (permitted) and ‘Haram’ (forbidden) of Shari’ah. In Islamic
become bad and therefore will have to written off in future. In organization it is required to get a Shari’ah clearance from the
this context Islamic accounting suggests showing the Shari’ah board (consisting of recognized experts in Islamic
revenues that are realized in cash and hence, there will be no Shari’ah) before finalization of any financial transactions
scope of over payment or under payment of income tax. (Algaoud and Lewis, 1999). Islam encourages to give own
money to others for the sake of Allah (SWT). Allah (SWT)
i. Replacement of Fixed Assets:
said, there is a claim of the poor in the wealth of the rich
Organizations accumulate funds charging depreciation for
(Qur’an 51:19). Qard-E-Hasana (a zero return investment for
replacement of fixed assets. As the funds generated from
the betterment of the society) is encouraged by Islam (Al-
depreciation may be inadequate to replace obsolete assets, the
Qur’an 2:245 & 57:11) and these transactions are also
firms have to rely upon retained earnings as a source of funds
revealed in the statements of Islamic Accounting. As per the
to make up the short falls and hence dividend payout ratio
guidelines of The Accounting and Auditing Organization for
tends to be low (Khan & Jain, 1999). But under accrual basis
Islamic Financial Institutions (AAOIFI), Islamic accounting
of accounting overstatement of profits encourages the
requires to prepare a separate report regarding social
organization to pay more dividends to the investors and as a contribution named ‘Social Responsibility Reports’
result the retained earnings balance may be inadequate as (AAOIFI).
well as there may not be any cash fund to replace the fixed
Advantages of Islamic Accounting over Traditional
assets. But as Islamic accounting on cash basis recognizes the
Accounting:
realized profits and there would not be any excess payment of
Islamic accounting gives emphasis on truth and justice in
dividend. Moreover, there will be availability of cash funds to
recording and communicating the information regarding any
replace the fixed assets when needed.
organization. Therefore, the application of Islamic accounting
j. Disclosure of information for decision making: in any organization is expected to provide the following
Relevant and reliable information are the basis for making advantages:
any decision regarding organization. As per traditional i. Application of Islamic accounting satisfies compliance
accounting (based on cost and conservatism concepts), assets of the Islamic Shari’ah in maintaining the books of
shown in the accounts don’t indicate the current market value account by the organization.
and hence there is a common mistake by the uninformed ii. Application of Islamic accounting enables the
persons using accounting reports when they consider these organization to determine the accurate amount of Zakat
figures as akin to market value (Khan, 1989). But Islamic payable by the firm during the period.
accounting provides comparatively more reliable and relevant iii. Islamic accounting reveals the accurate realized profit
information showing some assets in current value for Zakat earned by the organization during the period as per cash
purpose and determining actually realized net profit on cash basis of accounting.
basis of accounting. Traditional accounting provides iv. Islamic accounting as compared to traditional accounting
information just related to financial aspects of the firm and it reveals comparatively the more accurate financial
provides only that information which is required by the users position of the organization to the users of the statements
of accounting information. On the other hand Islamic in terms of the current value.
accounting has to cover wider range information including v. Comparatively better ratio and comparative analyses of
social, environmental, and religious transactions as per their the information would be expected from Islamic
accountability and justice to the related parties and also as per accounting.

The Bangladesh Accountant/January- March 2010 23


Conclusion:
Accounting
vi. As per Islamic accounting the organization would be
able to maintain appropriate amount of retained earnings There are some conflicts between Islamic Accounting and
paying just dividends to the investors to cover the short Traditional Accounting . But they are not as such as cannot be
fall of accumulated fund for replacement of fixed assets resolved. With intuitive and transperent thinking they can be
in inflationary situation. reconciled. In this article a modest attempt is endeavored in
vii. Application of Islamic accounting will reveal the just this direction. The researchers view that Islamic accounting is
amount of realized profit for payment of income tax. a must for any organization ventured and run by Muslim
viii. Determination of just profit will result determination of entreprenuers. It is considered to be more objective,
right tax liability and right dividend. transperent and just for computation of Zakat and providing
ix. Unlike traditional accounting, Islamic accounting information and services to the interested persons and others.
provides an wide range of information covering And hence the contemporary traditional accounting should be
religious, social, environmental, and others aspects of gradually replaced through further research and studies in
the organization. Islamic accounting. n

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