Accounting problems of Islamic banks

1. Accounting problems of Islamic banks Analysis of The Islamic instruments

2. Unique accounting problems • 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 • 5 Profit sharing

3. 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.

4. 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 recognisedonly 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 fee paying 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.

5. 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 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).

6. 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’aSupervisory 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 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.

7. 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.

8. 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 realisedto return capital before profit is calculated (Udovitch, 1970). • Hence, if a depositor withdraws his funds before project is liquidated, then he will not beentitledto share in the profits. The problem of capital gains and losses betweenaccountingperiod 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 savingsdeposits. 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 unfair disclosure. • Investment accounts have both the characteristics of debt and equity.

9. 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 isinconsistentwith 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 Musharakafinancing 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.

10. 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 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.

11. These include: • · Recognising profits in full when customer takes delivery. • · Pro-rata the profits according to due dates of installments. • · 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 murabahacontract 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 Organisationfor Islamic Financial Institutions (Pomeranz, 1997; Karim 1999) which has some accounting and auditing standards for Islamic banks and Financial Institutions

12. 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 (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”.

13. 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 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.

14. 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 risk weighted 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 the CAR calculation. This would mean, after this threshold, Islamic banks would have to raise shareholder equity.

15. 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.

16. 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 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.

17. 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.

18. 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 Islamicityof 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.

19. 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)

20. 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. • 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 theworldto 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 facilities 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), amortisationof 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.

21. 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 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.

22. International Auditing Standards also do not provide for the idiosyncrasies of a Shari’aReview or audit which is required of Islamic banks. Neither do they provide guidelines on the qualifications, independence and competence of Shari’aAuditors 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 organisationto develop Islamic Accounting Standards for all Islamic organisations. Perhaps, the AAOIFI will evolve into such a body.

23. 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.

24. 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

25. 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 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.

26. Conclusion • In this chapter, the objectives of various forms of Islamic organisations, their 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 plantations, insurance companies or space exploration. • The 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

27. Benefits of an Islamic Accounting System for Islamic banks and other organisationswould 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