Accounting of Islamic Banks

Introduction (Week 1 & 2)

Part 1
Development of Islamic Banking System

Definition of a Bank
Banking business means: (a) The business of; (i) Receiving deposits on current account, deposit account, savings account or other similar account; (ii) Paying and collecting cheques drawn by or paid in by customers; and, (iii) Provision of finance; or (b) Such other business as the bank (BNM), with the approval of the Minister may prescribe Banking and Financial Institutions Act 1989 (BAFIA)

Definition of an Islamic Bank

Banking business whose aims and operations do not involve any element which is not approve by the religion of Islam Islamic Banking Act (1983)

Need for Islamic Banking System

 

Shariah Islamiyyah compliance Meet financing and investment needs of the Muslims Meet modern requirement of individual and commercial needs Encourages financial innovations but in line with Shariah In Malaysia, growing regulatory and social support

Historical Development of Islamic Banking



 

  

The 1st. Islamic Bank Mit-Ghamr Nasser MitSocial Bank, Egypt (1963) Dalla Al-Baraka Group, Saudi (1969) AlIslamic Development Bank, Jeddah, Saudi (1975) Dar al-Maal al-Islami, Saudi (1981) alalBIMB (1983) Jordan Islamic Bank, Dubai Islamic Bank etc

Factors Affecting the Development of Islamic Banking System



Legal, political and economic changes internationally Islamization and Institutional Reform (e.g. Pakistan, Iran, Sudan, Malaysia) International Muslim organizations (OIC IDB etc) International response to capture capital/fund of oil rich Islamic countries (e.g. Citibank, Dresdner Kleinworth Benson, ANZ group, etc.

Malaysian Dual Banking System



In 1963, the Pilgrims and Fund Management 1963, Board provides a savings mechanism for Muslims to perform Hajj In 1983, the Islamic Banking Act (IBA) was 1983, approved and defined Islamic Banking as banking business whose aims and operations do not involve any element which is not approve by the religion of Islam. Government Investment Act (Act 275) 1983 empowers the government to issue Government Investment Certificates (GIC) with returns in the form of discretionary gift (Hibah) rather than interest In 1993, Conventional banks can operate Islamic 1993, baking and financial products known as Skim Perbankan Tanpa Faedah (SPTF)

PART 2

Traditional western (secular) accounting objectives

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 welfare

ACCOUNTING
A PROCESS OF
Recognising, recording, classifying and summarising business transaction Documents Vouchers Ledger Trial Balance Report (Mgmt)

Measuring, Analyzing, Interpreting Result of Operation

Reporting & Presenting Financial Position

Profitability = Income - Expenses Growth Liquidity Productivity

Financial Statement Balance Sheet Income Statement Stmt of Changes In Equity Cash Flow Statement Notes to Accounts

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

Traditional Model of Accounting



 

Accounting entity (Owners (principals) are different from managers (agents) Economic events (identifiable and measurable in monetary terms) Financial description Decision usefulness to a very restricted set of users (esp. those with financial involvement with the entity) NeoNeo-Classical Economics and maximization of wealth of stakeholders

Objectives of Financial Accounting and Reporting



Provide information that is useful to present and potential investors and creditors and other users in making rational decisions Information should be comprehensible to those who have reasonable understanding of economic activities and are willing to study the information Primary user groups are shareholders, investors and creditors Secondary user groups are employees, customers, and the public Accountability framework - the objective is to provide a fair system of information flow between the accountor (agent) and the accountee (principal)

PART 3
Accounting from an Islamic perspective

Accounting and Islam

AlAl-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 owes. (debtor) is mentally deficient, or weak, or unable himself to dictate, let his guardian dictate faithfully, and get two witnesses, out witnesses, 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.

Accounting and Islam

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 God, 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 harm. (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

Definition of Accounting from an Islamic Perspective

The process of identifying, measuring, and communicating economic and other relevant information inspired by Islamic Worldview and complied with Syariah Islamiyyah to permit informed judgements and decisions by potential and expected users information to enhance social welfare welfare

Islamic Accountability


 

Transcendental accountability to Allah SWT (Hablumminallah) (Hablumminallah) Social accountability to the society (Hablumminan-nass) Hablumminan-nass) Individuals as trustees or khalifah Success in this world and in the hereafter (al-falah) al-falah) Economic goals beyond purely wealth but include tazkiyah (purification of self and wealth)

Objectives of Financial Statements

Traditional Income Statement Balance Sheet Economic Performance Financial Position Islamic Fulfilment of Amanah Financial Trust and Obligation Cash Entrusted Wealth Entrusted

Cash Flow Equity Statement

Cash Position Wealth Ownership

Features of Islamic Accounting



 

No different in terms of recording (double entry system) Clear distinction of Accounting Objectives i.e. religious obligation vs. commercial obligation (different significance of financial statements) Different users information need (legitimate and equitable transactions and wealth vs. maximization of wealth and economic consequences) Compliance with the principles and rules of Syariah Different Islamic contractual relationships (mudarabah instrument; murabahah etc.) Distinct accountability relationships (to Allah SWT and Ummah) Determination of zakat

User Groups of Accounting Information for Islamic Banks



 

 

Investors (potential and existing) (lawful and equitable investment) Creditors (potential and existing) (lawful trade assets) Regulators (e.g. Bank Negara) Syariah Supervisory Board & Advisory Council (syariah compliance) Customers (lawful goods and services) Others who may be effected by the disclosure or non-disclosure of information non-

PART 4
Introduction to AAOIFI Accounting Standards and Objectives of Financial Accounting and Reporting

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) http://www.aaoifi.com/



 

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.

AAOIFI: Accounting, Auditing and Governance Standards

Financial Accounting Statements of Standards Financial  Musharaka Financing Accounting  Profit Allocation Basis  Objectives  Investment Account  Concepts Holders Financial Accounting  Salam Financing Standards  Ijarah Financing  Presentation and  Zakah Disclosure of Financial Statements of Islamic  Istisna Financing  Provisions and Reserves Banks  Presentation and Disclosure  Murabaha Financing of Financial Statements of  Mudaraba Financing Islamic Insurance Companies

AAOIFI: Accounting, Auditing and Governance Standards

Auditing Standards  Objectives and Principles of Auditing  The Auditors Report  Terms of Audit Engagement Governance Standards  Syariah Supervisory Board  Syariah Review  Internal Syariah Review Code of Ethics  Code of Ethics for Accountants and Auditors of IFI New Financial Accounting Standards  Investment Fund  Disclosure Bases for Determining and Allocating Insurance Surplus (and deficit) New Auditing Standards  Audit Tests for Syariah Compliance

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)

PART 5
Accounting concepts from an Islamic perspective

Impact of Syariah Contractual Conditions Accounting concepts

Existence (Recognition of revenue and expense) Lawful (Recognition of revenue and expense) Measurable (Measurement of assets and liabilities) Deliverable (Recognition & Measurement) Equitable (Profit determination and distribution) Accountability (Disclosure & Presentation)


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  Para 21 MASBi-1 when material MASBiuncertainties, those uncertainties should be disclosed

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 MASBiMASBi-1 para 22; AAOIFI) e.g. when a bank 22; delivers the service  Syariah 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) Value)

Islamic Perspective of Accounting Measurement

 

     

Historical Value vs. Current Value Cash Equivalent Value (most preferred 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

Definition of Assets
Capable of generating positive cash flows or other economic benefits in the future either by itself or in combination with other assets which the bank has acquired the right to hold (rightful ownership of maal), use (rightful maal), of dispose (rights on manfaat) as a result (rights manfaat) of past transactions or events (AAOIFI)

Desirable Characteristics of Accounting Information

1. Relevance  Predictive Value (ability to predict potential outcome)  Feedback Value (ability to verify the accuracy of prior prediction)  Timeliness (available as soon as after the reported events)

Desirable Characteristics of Accounting Information

2. Reliability  Representational faithfulness (information reflect what it purports to present)  Objectivity (measurement and disclosure appropriately used and if replicated by independent person gives the same result)  Neutrality (accounting information directed towards common needs of users and not needs of particular group of users)

Desirable Characteristics of Accounting Information

3. Comparability  Able to make comparison of the banks performance and position over time and with other banks 4. Consistency  Consistent in applying accounting measurement, valuation and disclosure methods from one period to another

Desirable Characteristics of Accounting Information

5. Understandability  Aware of the abilities and limitations of those for whom accounting information is provided 6. Materiality  Accounting information is regarded material if its omission, non-disclosure or nonmisstatement results in distortion of the financial statements

Conclusions
Islamic accounting framework (objectives and concepts): 1. Compliance with syariah and, achievement of Islamic goals, on financial activities (financing schemes and financial instruments) 2. Equitable and fair recognition, measurement, valuation and disclosure of financial information 3. Achievement of both economic and spiritual well being of the society