Accounting of Islamic Banks

1. Accounting of Islamic Banks Introduction (Week 1 & 2)

2. Part 1 Development of Islamic Banking System

3. Definition of a Bank Banking business means: (a) The business of; • Receiving deposits on current account, deposit account, savings account or other similar account; • Paying and collecting cheques drawn by or paid in by customers; and, • 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)

4. 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)

5. 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

6. Historical Development of Islamic Banking • The 1st. Islamic Bank – Mit-Ghamr Nasser Social Bank, Egypt (1963) • Dalla Al-Baraka Group, Saudi (1969) • Islamic Development Bank, Jeddah, Saudi (1975) • Dar al-Maal al-Islami, Saudi (1981) • BIMB (1983) • Jordan Islamic Bank, Dubai Islamic Bank etc…

7. 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.

8. Malaysian Dual Banking System • In 1963, the Pilgrims and Fund Management Board provides a savings mechanism for Muslims to perform Hajj • In 1983, the Islamic Banking Act (IBA) was 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 baking and financial products known as Skim Perbankan Tanpa Faedah (SPTF)

9. PART 2 Traditional western (secular) accounting objectives

10. 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”

11. ACCOUNTING A PROCESS OF Recognising, recording, classifying and summarising business transaction Measuring, Analyzing, Interpreting Result of Operation Reporting & Presenting Financial Position Documents Vouchers Ledger Trial Balance Report (Mgmt) Profitability = Income - Expenses Growth Liquidity Productivity • Financial Statement • Balance Sheet • Income Statement • Stmt of Changes • In Equity • Cash Flow Statement • Notes to Accounts STAKEHOLDERS • Authorities – BNM, Inland • Revenue, Baitulmal • Staff • Public • Management • Board of Directors • Shareholders • Investors • Creditors

12. 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) • Neo-Classical Economics and maximization of wealth of stakeholders

13. 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 • Informationshould 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)

14. PART 3 Accounting from an Islamic perspective

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

16. 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 evidence, and more convenient to prevent doubts among yourselves. But if you carry out the transactions on the spot there is no blame if you reduce it not to writing. But take witness whenever you make a commercial contract, and let neither the scribe nor witness suffer harm. If you do (such harm), it would be wickedness in you. So fear God; for it is God that teaches you. And God is well acquainted with all things”

17. 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 Syari’ah Islamiyyah to permit informed judgements and decisions by potential and expected users information to enhance social welfare”

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

19. Objectives of Financial Statements

20. 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 Syari’ah • Different Islamic contractual relationships (mudarabah instrument; murabahah etc.) • Distinct accountability relationships (to Allah SWT and Ummah) • Determination of zakat

21. 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) • Syari’ah Supervisory Board & Advisory Council (syari’ah compliance) • Customers (lawful goods and services) • Others who may be effected by the disclosure or non-disclosure of information

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

23. 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

24. 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; Shari’ah Committee • Funded by founding members of IFIs, establishment of waqf etc.

25. Statements of Financial Accounting Objectives Concepts Financial Accounting Standards Presentation and Disclosure of Financial Statements of Islamic Banks Murabaha Financing Mudaraba Financing Financial Accounting Standards Musharaka Financing Profit Allocation Basis Investment Account Holders Salam Financing Ijarah Financing Zakah Istisna’ Financing Provisions and Reserves Presentation and Disclosure of Financial Statements of Islamic Insurance Companies AAOIFI: Accounting, Auditing and Governance Standards

26. Auditing Standards Objectives and Principles of Auditing The Auditor’s 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 AAOIFI: Accounting, Auditing and Governance Standards

27. 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 • Syari’ah compliance • Distinguish prohibited earnings and expenditure

28. Objectives of Islamic Financial Accounting and Reporting (AAOIFI) • Present entity’s 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 Bank’s discharge of social responsibility (not as a constraint but as a goal)

29. PART 5 Accounting concepts from an Islamic perspective

30. Impact of Syari’ah 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)

31. 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 syari’ah as to the rights and obligations

32. 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 uncertainties, those uncertainties should be disclosed

33. 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)

34. 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

35. 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 – MASBi-1 para 22; AAOIFI) e.g. when a bank 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)

36. 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, asset’s replacement cost etc. • In the case of Zakat measurement, preference is current market value (AAOIFI FAS 9: Cash Equivalent Value)

37. 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

38. 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 of dispose (rights on manfaat) as a result of past transactions or events” (AAOIFI)

39. 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)

40. 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)

41. Desirable Characteristics of Accounting Information 3. Comparability • Able to make comparison of the bank’s 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

42. 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 misstatement results in distortion of the financial statements

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