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IMEFM
14,2 The economic reality of Islamic
banks’ transactions: a
qualitative inquiry
286 Bassam Mohammad Maali
Department of International Accounting,
Received 18 April 2020 German Jordanian University, Amman, Jordan
Revised 25 June 2020
20 September 2020
Accepted 20 September 2020
Usama Adnan Fendi
American University of Madaba, Amman, Jordan, and
Muhannad Ahmad Atmeh
Department of International Accounting, German Jordanian University,
Amman, Jordan

Abstract
Purpose – This paper aims to investigate the economic substance of Islamic banks’ transaction as perceived by
the employees and regulators of banks and the effect of such substance on the need for special accounting standards
for Islamic banks. If there is a distinctive “Islamic economic substance”, then special accounting practices may be
necessary such as the standards of the Accounting and Auditing Organization for Islamic Financial Institutions.
Design/methodology/approach – A qualitative inquiry on one of the leading Islamic banks in the Middle
East was conducted to investigate the economic substance of the bank’s main two transactions; the deposit system
and Murabaha financing, as perceived by informants within one of the earliest Islamic banks and its regulators.
Findings – It is found that despite the belief that the transactions under examination were different from
equivalents within conventional banking, practice within the bank was not consistent with such a belief. Informants
largely perceived the economic reality of the investigated transaction as being not different from conventional
banks’ transactions, and this would affect the need for special accounting and regulatory frameworks.
Research limitations/implications – This investigation is confined to informants working within one
Islamic bank; their views and perceptions may not coincide with those working in other Islamic banks in the world.
Practical implications – The results of this investigation provide policy implications for Islamic banks,
regulators and standards setters in regard to the need for special accounting standards for Islamic banks.
Originality/value – The paper is one of the first papers that uses a qualitative inquiry on the main
transactions of Islamic banks and the related need for special accounting practices. The paper provides a new
perspective on the debate over whether Islamic banking is genuinely innovative or is merely a replicate for
conventional banking.
Keywords IFRS, Islamic Banking, Mudarabah, Substance over form,
AAOIFI accounting standards, Economic reality, Murabaha
Paper type Research paper

Section 1: Introduction
International Journal of Islamic
The concept of economic reality has been subject to much discussion in accounting literature
and Middle Eastern Finance and and affected standard setters, and hence accounting practices (Erb and Pelger, 2015;
Management
Vol. 14 No. 2, 2021 Elkhashen and Ntim, 2018). The International Accounting Standards Board (IASB) argues
pp. 286-300
© Emerald Publishing Limited
1753-8394
DOI 10.1108/IMEFM-04-2020-0172 The authors thank Professor Christopher Napier and anonymous reviewers for their helpful comments.
that “in assessing whether an item meets the definition of an asset, liability or equity, Islamic banks’
attention needs to be given to its underlying substance and economic reality and not merely transactions
its legal form” (IASB, 2010, p. 26, emphasis added) [1]. Accounting is largely considered as a
non-problematic tool and data source recording a pre-existing economic reality (Suzuki,
2003, p. 70). Accountants and other social scientists traditionally adopted such a positivist
view that an external reality exists independently of the representations we make of it. The
mainstream accounting literature, including standard-setting bodies’ official publications,
tends to deal with accounting as independently existing economic and financial phenomena 287
(Mouck, 2004, p. 527). The literature on Islamic accounting is not an exception (Maali and
Jaara, 2014).
In total, 14 centuries after the emergence of Islam, the increase in the number of Muslims
around the world who want to conduct their business transactions according to the
principles of Islamic law, the Sharia, led to the emergence and expansion of Islamic banking.
Islamic banks provide financial services to Muslims in accordance with Islamic economic
principles. Islamic banks structure their transactions in a way that does not incorporate the
receipt or payment of interest; transactions are based on profit and loss sharing and on
mark-up arrangements.
Many Islamic bank transactions, at least in theory, differ from conventional banking
practices (Maali and Napier, 2010). The concept of Islamic banking is enshrined in Sharia
(Mohammed and Taib, 2015). The unique transactions found in Islamic banks is claimed to
have material consequences on the regulatory framework in the countries where Islamic
banks operate (Hidayat et al., 2018; Alam et al., 2019) and the accounting standards that
these banks use. To account for their transactions, Islamic banks around the world apply
different accounting standards. In some countries (e.g. Bahrain and Jordan), Islamic banks
adopt standards issued by the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI). In other countries, they simply follow the conventional accounting
standards applied in the countries where they operate. Others use an in-house standard-
setting process, making use of a “Sharia Supervisory Board” (SSB) to advise management
as to relevant accounting treatments that do not violate Sharia. Some Islamic banks use a
combination of these approaches (Hamat, 1994; Karim, 2001; Maali and Napier, 2010;
Siswantoro, 2018).
One of the main arguments for special regulatory and accounting formwork and special
accounting treatments for Islamic banks is the claim that their transactions are different
from those of conventional banks, so traditional regulatory and accounting standards
cannot deal successfully with these banks (Khan, 1994; Hamat, 1994; Karim, 2001; Sarea and
Hanefah, 2013; Siswantoro and Ibrahim, 2017). In addition, Napier (2009) argues that Islamic
accounting could be understood in a religious sense; accountability to God would affect the
accounting practices of Muslims, including Islamic banks. However, some scholars argue,
both on religious grounds (Al-Azzizi, 2000) and on empirical grounds (Kuran, 1995; Murinde
and Naser, 1998; Maali and Atmeh, 2015; Mohammed et al., 2016; Atmeh and Maali, 2017)
that some Islamic bank operations, as actually practiced, are similar to transactions
undertaken by conventional banks. The implication of such a view is that, if the transactions
of Islamic banks were similar in substance to those of conventional banks, then conventional
regulatory framework and accounting standards such as IFRS would be relevant to Islamic
banks. The debate on this issue has moved to a higher epistemological level; following Hines
(1988), researchers such as Archer and Karim (2001) argue that economic reality is part of
social reality, which is an intersubjective social construction. This may differ internationally
due to many factors including religion. Thus, religion would affect the construction of
reality of these transactions.
IMEFM However, except for Kholvadia (2017), the debate over the economic reality of Islamic
14,2 banking transactions and in effect the need for special accounting practices has largely been
conducted at a conceptual level only. In this paper, we empirically investigate the economic
substance of the most two important financial instruments undertaken by Islamic banks; the
deposit system based on Mudaraba contract and the Murabaha financing. The case study is
undertaken on one of the oldest-established Islamic banks in the Middle East, which
288 pioneered various Islamic transaction structures that have become pervasive in Islamic
banking around the world. The study is based on a series of interviews and less formal
conversations, in which an attempt was made to understand how those working in and
connected with the bank regarded the transactions and how their understanding of the
principles of Islam effects on their views about the economic substance of the transactions.
The chosen transactions are those that represent the “skeleton” of Islamic finance: the
deposit system based on Mudaraba contract which is adopted by Islamic banks and the
Murabaha financing, which is the main financing model adopted by Islamic banks and
reaches 90% of the financing provided by these banks (Miah and Suzuki, 2020). The
remainder of this paper is structured as follows: Section 2 outlines the concept of Islamic
banking and explains the accounting implications of the investment account deposits and
Murabaha financing. Section 3 develops the research questions. The research methodology
is explained in Section 4. Section 5 discusses how informants perceived the main
transactions in the bank under study. Section 6 provides an overall conclusion.

Section 2: Islamic banking and accounting implications

Islamic Sharia prohibits Muslims from dealing with Riba, which is commonly translated as
“usury”. Sharia also prohibits transactions that can be considered as Gharar (high
uncertainty of objects), which rules out a wide range of contracts involving some form of
contingency. Rather than dealing in interest, Islamic banks use forms of financial
instruments, both in mobilizing funds for their operations and in providing finance for their
clients that comply with the principles and rules of Sharia (Archer and Karim, 2001, p. 1).
For mobilizing funds from their depositors, Islamic banks use a Mudaraba contract. In its
original form, this involved one party contributing capital to a venture while the other party
contributed labor. The two parties would share the profits generated by the contract
according to pre-agreed percentages, but in case of loss, the capital provider would bear all
financial losses up to the amount invested, while the other party would receive no return for
his/her work. In its current form, depositors place their funds with the bank and the bank
invests these funds, with the profits being divided between the bank and the depositors
according to a predetermined ratio. In the case of loss, the depositors bear the losses and the
bank receives nothing for its efforts.
For financing activities, Islamic banks mainly use mark-up instruments such as
Murabaha. In its original form, Murabaha involved the sale of goods at cost to the seller plus
a mark-up agreed with the buyer. In its current form as applied by Islamic banks, the client
usually specifies the goods he/she wants to acquire, and in some cases specifies a particular
supplier, the bank purchases these goods and resells them to the client at a higher price, the
total amount usually being paid by instalments. Thus, in its current form, it represents a
financing instrument. Other modes of financing used by Islamic banks include Ijara,
Musharaka and Salam. Islamic banks undertake other activities provided by conventional
banks such as letters of credit, letters of guarantee and current accounts. To make sure that
the religious expectations of those who deal with Islamic banks have been met, Islamic
banks appoint a “religious auditor”. This may be a single advisor, usually referred to as the
Sharia consultant or more commonly takes the form of an SSB.
 To further shed light on Islamic banks’ transactions, and to discuss the arguments for the Islamic banks’
need for special accounting practices, the following subsections provide a discussion of transactions
the major two financial instruments undertaken by Islamic banks; investment deposits and
the Murabaha financing and their related accounting implications.

A. The deposit system – investment accounts

The so-called “investment account” represents a major source of funds for Islamic banks, 289
and these usually take the form of Mudaraba contracts. The most common form of
investment account is the unrestricted investment deposit. At least theoretically, the Islamic
bank does not guarantee the repayment of principal or any returns on these deposits. The
structure of the deposit system has opened the door for discussion about the relevant
accounting treatment for investment deposits, as the absence of any formal obligation to
repay the principal and provide returns seems to suggest that they are not liabilities.
However, although Islamic banks consider investment deposits as not guaranteed, early
attempts to accommodate the Mudaraba contract within contemporary banking practice
suggested that they should be guaranteed (Al-Sader, 1974; Hmoud, 1982). As such
suggestions were criticized, Islamic banks operate under the non-guarantee convention, at
least in theory. This would imply that investment deposits of Islamic banks require a
different accounting treatment from deposits with conventional banks, and such a view has
been advanced by scholars (e.g Janahi,1994; Karim, 2001; Khammasi and Jedidia, 2018).
Janahi (1994) argues that Islamic banks adopted different accounting treatments for their
investment accounts, which rendered comparability of financial statements difficult if not
meaningless. Suandi (2017) examined the classification of investment accounts in 63 Islamic
banks operating in 15 countries and found high heterogeneity in reporting these accounts
across different countries. AAOIFI, in the Statement of Financial Accounting No. 2 classified
investment accounts into unrestricted and restricted accounts. AAOIFI considered
unrestricted investment accounts as an element of an Islamic bank’s financial position,
which should be reflected separately from liabilities and equities (a third category lying
between liabilities and equities).
The main supporting argument for AAOIFI treatment of investment accounts as being
non-liability is the issue of that the bank does not guarantee the deposits, nor guarantee any
profit for depositors. However, this argument has been subject to continuous challenge, as
the early beginning of Islamic banking. Siddiqi (1983) describes it as merely theoretical, both
on economic and empirical grounds. Maali and Napier (2010) found evidence that some
Islamic bankers view investment deposits as being guaranteed due to the competitive
markets in which the Islamic banks operate. Kuran (1995) and Samad and Chowdhury
(2017) provided evidence that Islamic banks’ rate of return on investment deposits is directly
related to the conventional banks’ interest rate.
This raises the question of the relevant reporting treatment for these deposits. If these
deposits are guaranteed in the practical sense, this would challenge the view that special
reporting treatments for these deposits are needed. However, such an issue needs to be
understood at the level of the perceptions of those who have undertaken the transaction; it is
suggested here that we cannot look to “the economic substance” of such a transaction in
isolation from the context in which it emerged in practice. This is because the substance of
the transaction is not an objective reality “out there” but rather an intersubjective
construction, which could differ from one culture to another, owing to many factors,
including religion.
IMEFM B. Murabaha financing
14,2 The Murabaha transaction as practiced by Muslims prior to the appearance of Islamic
banking was a pure sales transaction. Hmoud (1982) developed the transaction as the
Murabaha to purchase orderer, where the bank buys an item at to the order of the ultimate
purchaser and sells the item on at an agreed mark-up. The original form of the transaction
did not aim to provide finance or to be a lending transaction (Al-Maliqi, 2000; Al-Abadi,
290 1988). As Murabaha in its modern form covers as much as 90% of business activities in
some Islamic banks (Miah and Suzuki, 2020), the issue of revenue recognition from
Murabaha is very important for Islamic banks. In the view of Islamic scholars who have
developed the modern form of Murabaha, none of the mark-ups is interested. Thus,
traditional accounting practices for sales on deferred payment terms, which require the
identification of the profit margin and the interest charges, are inappropriate from the
Islamic perspective.
The recognition of profits from a Murabaha transaction differs across Islamic banks, and
whether the Islamic bank adopts AAOIFI standards or not. The accounting treatment for
Murabaha profit range from recognition of the profit when the customer takes delivery of
the item, pro-rata at the due dates of the monthly payments or once all the payments have
been received (Archer and Karim, 1997). AAOIFI adopted proportional allocation of the
profits over the period of the credit as the basic treatment. AAOIFI claimed that this
treatment provides reliable and relevant information and leads to matching revenues and
expenses.
The discussion of accounting for Murabaha financing has so far taken for granted that
the transaction is a sale with deferred payment. However, some commentators have argued
that this financing, as practiced by Islamic banks, is similar in some aspects to loans
provided by conventional banks (Siddiqi, 1983; Al-Abadi, 1988; Al-Azzizi, 2000; Ariff and
Rosly, 2011; Suzuki and Miah, 2016). This raises the issue of the relevance of conventional
accounting standards such as IFRS15 “revenue from contracts with customers” to account
for this transaction. According to Ahmed et al. (2016), IFRS requires that Murabaha contract
is recognized as a financing instrument and the measurement is based on amortized costs,
which apply the concept of the time value of money. This would amount to treating the
credit facility as a loan and the mark-up as interest on this loan, which is not acceptable from
the Islamic view. However, the presence of any genuine trading profit in a Murabaha
transaction is questionable. Ahroum et al. (2020) argue that Islamic contracts are impacted
by the presence of interest in the economic system, and this impact is seen mainly is the use
of interest rate (Libor, Euribor, etc.) as a benchmark for profitability, which is required by
Islamic financial institutions (p. 201). Literature (Murinde and Naser,1998; Ghauri, 2015)
found that Murabaha mark-up rate in Islamic banks is highly correlated with the interest
rate on loans provided by conventional banks.

Section 3: Research question

The difference in transactions undertaken by Islamic banks has been the main argument for
the need for special accounting standards for Islamic banks, and hence the main driving
force behind the calls for adopting AAOIFI standards (Khan, 1994; Hamat, 1994; Karim,
2001; Sarea and Hanefah, 2013; Siswantoro and Ibrahim, 2017; Ahmed et al., 2019). However,
this view was continuously challenged; Mohammed et al. (2019) provided evidence that
“separate Islamic accounting standard is not needed, instead the option needs to be within
the IFRS framework with the collaboration work of AAOIFI and the IASB” (p. 115).
The need for special accounting standards would emerge from the different “economic
substance” for the Islamic banks’ transactions, and not merely of what Kamla and Haque
(2019) describe as an “identity staging exercise to appear Islamic”. There has been a Islamic banks’
continuous criticism for Islamic financial institutions that their transactions are similar in transactions
the economic substance to conventional banks transactions (Al-Azzizi, 2000; Kuran, 1995;
Murinde and Naser, 1998; Mohammed et al., 2016; Atmeh and Maali, 2017). Hamour et al.
(2019) provided evidence that an economic substance gap in contemporary contracts exists
between the Sharia rules and conditions of an Islamic contract and their development and
construction in the modern practice in Islamic financial institutions.
If the transactions undertaken by Islamic financial institutions are similar in the 291
“economic substance” to those undertaken by conventional banks, then traditional
accounting frameworks such as IFRS would be relevant to Islamic banks. Hanif (2016)
analysed some of the Islamic banking transactions and concluded that “the process that
legally (legal form) contracts/products are in line with theory; however, economic substance
is not very different from conventional counterparts” (p. 277). In a study for a number of
transactions undertaken by Islamic banks in South Africa, Kholvadia (2017) found that the
economic reality of these transactions is usually significantly different from its legal form
and was found to, economically, replicate conventional banking transactions.
As the concept of the economic reality of Islamic banking transactions is still of concern,
it has been argued that accounting for the transactions of Islamic banks on the legal form
may create a financing mechanism that is not consonant with economic reality (Talip, 2000,
p. 58). However, the reality is a social construction and no single concrete social reality exists
there: multi-realities exist (Maali and Jaara, 2014). Accounting presentations are part of
social reality, and they are social constructs and construct reality (Hines, 1988). Following
Archer and Karim (2001), it is believed that economic reality is part of the social reality,
which is an intersubjective social construction. This may differ internationally due to many
factors including religion. Islamic principles influence the process of the intersubjective
construction of economic reality. Thus, what is perceived as being similar to conventional
bank transactions by one society or an individual may not hold for another society or
individual; such perceptions are affected by many cultural values, including Islam.
However, the effect of religion on the construction of reality has not been largely
investigated to any great extent in the context of accounting. For the present study, the
research question could be set as follows: “how informants (both inside and outside an
Islamic bank) perceive the economic substance of transactions undertaken by Islamic banks
and how this might affect the need for special accounting practice”?

Section 4: Research methodology

As the authors are interested in studying the beliefs, opinions, attitudes and understandings
of people working within the Islamic banking sector with regard to the economic substance
of transactions, we chose to undertake a study based in a single Islamic bank to which we
had been able to secure access. We recognize that views of those working for a single bank
located in this bank are not necessarily representative of those in other banks located in
other regions, but as the bank in question has been significant in the development of modern
Islamic financial transactions and was one of the first to address how to account for these
transactions. The bank officially started operations in the late seventies of the past century
in the Middle East, following the passing of a special law enabling its existence.

Data collection
The main data collection method in this research was interviewing. It is one of the most used
data collection methods in the social sciences, and an essential source of case study evidence
(Yin, 2014) and largely used in Islamic finance and accounting studies (Kholvadia, 2017;
IMEFM Wei and Thaker, 2017). In total, 15 semi-structured interviews were conducted with an
14,2 average duration of 1 h and a half. In total, 12 of the interviews were with executives,
administrators, accountants and SSB members in the bank and three interviews were with
employees from the central bank where the bank operates. The interviews were tape-
recorded whenever possible; otherwise, extensive notes were taken. Interviewees were asked
permission at the beginning of each interview regarding the taping. The questions asked
292 differed from one informant to another, depending on his position and background
knowledge. The bank under investigation and interviewees were promised anonymity.
It is recognized that interviewing has its shortcomings such as researcher bias, poor
recall and inaccurate articulation (Yin, 2014). In addition, there are problems with
respondents, perhaps, seeking to mislead the researcher or forgetting to mention issues
(Silverman, 1985, p. 163). The above-mentioned limitations represent a threat to the validity
and reliability of the study. Measures to reduce such a threat were taken, including
triangulation against data collected through other methods, including observation and
examination of annual reports and other documents.

Data analysis
To analyse the data, the Qualitative Data Analysis Protocol (QDAP) was used; it represents
a qualitative data analysis technique suggested by Miles et al. (2014), which represents a set
of systematic and structured data reduction, summarization, classification and
interpretation techniques. In QDAP, the analysis process is a continuous iterative process
involving data collection, data reduction, data display, conclusion drawing and verification
(Hughes and Berry, 2000, p. 162). The benefit of using the approach is that it allows for the
construction of a chain of evidence, and maintains an audit trail to ensure closeness between
interpretation and the original data (Perren and Grant, 2000, p. 399).

Section 5: Discussion of how Islamic banking transactions are perceived

In this section, the view of Islamic bank transactions as perceived by the informants will be
discussed. The discussion will include only two financial instruments applied used by the
bank, Murabaha financing and the deposit system based on Muradarba. This analysis is
based on the belief that reality is socially constructed. It tries to highlight the problem of the
economic substance of Islamic bank transactions through extensive inspection of the
transactions undertaken by the bank and how AAOIFI standards treat these transactions.

A. Investment deposits based on Mudaraba

As discussed earlier, the Mudaraba contract is the basis upon which Islamic banks mobilize
funds. Those who developed the Mudaraba contract in its current form (Al-Sader, 1974;
Hmoud, 1982) relaxed many of the conditions of the original contract to fit with current
banking practice. The issue of the right to repayment of principal (deposit guarantee) is the
major difference between deposits in conventional banks and Islamic bank deposits. It is
usually one of the main rationales advocated by scholars of Islamic accounting (Karim, 2001;
Archer and Karim, 2001; Janahi, 1994) for having special reporting standards for Islamic
banks.
When the bank was established, the founder of the bank advocated the guarantee of
deposits. While the founder was able to present religious grounds for his proposals, these
were also affected by pragmatic considerations: the founder wanted to have a deposit
system that could operate in an environment dominated by conventional banking (Maali
and Napier, 2010). At the inception of the bank, the central bank treated the deposits of the
bank in a similar way to the deposits of other banks for reserve and capital adequacy ratio Islamic banks’
requirements. A central banker commented: transactions
At that time, a percentage of the deposits of any bank should be deposited with the central bank,
no preference to any bank, conventional or Islamic. This reserve is the first defence line, which
protects the depositors. We could not give preference to one bank over another; this is not just, all
are the same.
Another central banker commented: 293
By contractual relations between the bank and the depositors, there are no guaranteed deposits (in
Islamic banks), but as a central bank, we do not allow depositors to lose, especially after the other
banks’ crisis.
As the establishment of the bank, the central bank largely looked at investment account
deposits in the same way as normal deposits in other banks. Informants believed that these
deposits were guaranteed, and the bank itself worked to provide the necessary assurance for
depositors that their funds were safe. The bank is also subject to the deposit insurance
system, in which a public corporation guarantees the deposits of all banks in the country
(Fendi, 2020).
For the employees and officials of the bank, the difference between Mudaraba deposits
and deposits found in conventional banks is twofold: the absence of a guarantee of
repayment of principal and the absence of a fixed rate of return on deposits. Some employees
argued that the contractual relationship between the bank and the depositor necessitated the
non-guarantee of deposits. For example, an informant stated:
Because of the contract between the bank and the holders of investment accounts, they know that
their money is not guaranteed, but if you ask me about my opinion in this matter, I would say that
these funds are guaranteed; the reputation of the bank would prevent us from saying to
depositors that you have lost your money.
Another informant commented:
The relation between the bank and its depositors is Mudaraba; they both incur profit and losses,
but the bank has the investment risk provision, [. . .] so it is difficult that at any time the
depositors will lose.
An executive pointed out:
The bank is not liable to return the deposits although it works on the basis that it is liable, in
terms of choosing its investments.
Although employees acknowledge that the bank, under the terms of the Mudaraba contract,
is not liable to repay the deposits, they perceive that the bank in actual practice is liable.
Some argue that the bank, is liable in substance because of competitive pressure, while
others suggest that the existence of provisions for investment losses effectively mitigates
the risk that deposits will not be repaid. Another view widely held by informants is that the
bank, by concentrating on a few kinds of relatively safe investments such as Murabaha,
which provides consistent cash flow and is almost risk-free in the form practiced by the
bank, effectively protects depositors’ funds. Whatever the reason provided, a commonly
perceived view, although not expressed explicitly, is that these deposits are guaranteed in
substance, without violation of Islamic Sharia, which would require depositors to face a
genuine risk of loss.
The above would represent a challenge for those arguments that Mudaraba deposits in
Islamic banks cannot be reported as liabilities in the balance sheet, as the bank’s own
IMEFM practices and informants’ perceptions reflect a belief that the deposits are guaranteed in
14,2 substance. This also shows how religion affects the construction of reality (Archer and
Karim, 2001) in that the perceived view of a transaction is that it differs from a conventional
bank transaction because of religious compliance, although this might not necessitate
different reporting treatment.
The question here is the relevance of conventional accounting standards such as IFRS for
294 the reporting of these deposits. The IASB framework defines a liability as a present
obligation of the enterprise arising from past events (IASB, 2018). The discussion above
reveals that in the bank under investigation, depositors’ funds are perceived to be an
obligation of the bank, thus meeting the liability definition in the IASB framework. The
economic substance of the deposits, as perceived in the bank, although not reflected directly,
is a liability, even though the legal form does not reflect such a substance. However, it is
recognized that being subject to Sharia rules affects the intersubjective construction of the
substance of such a deposit system, but again, for those practicing the transaction, they
perceive many aspects of the Mudaraba deposit system to be different from those in
conventional banks, apart from the issue of guarantee, which is perceived as not being
different than that in conventional banks.
AAOIFI required unrestricted deposits to be reported in the balance sheet in a third
category between liability and equity. It justified excluding them from liability on the basis
that “the Islamic bank is not obligated in case of loss to return the original amount of funds
[. . .]” (AAOIFI, 2015). However, the discussion of the bank’s practice above reveals a
different perceived view of obligation. AAOIFI itself argues that it is a “liability” in another
document: in its Statement on the Purpose and Calculation of the Capital Adequacy Ratio for
Islamic Banks (1999) it argues:
The Islamic bank is liable to find itself under commercial pressure to pay a rate of return to its
profit-sharing investment accounts holders which is sufficient to induce those investors to
maintain their funds with the bank, rather than withdrawing them (AAOIFI, 1999, p. 7).

B. Murabaha financing
As the bank started operations, as in other Islamic banks in the world, Murabaha dominated
its financing. Maali and Napier (2010) argue that the bank’s founder viewed Murabaha is a
sales transaction, in which the bank acquires goods required by the customer and re-sells
them to the customer at a higher price. The difference is seen as the profit from a sales
transaction and should be recognized when the sale to the customer is concluded through
the delivery of the goods. However, when the bank started operations, practical issues that
had an effect on perceptions of Murabaha transactions and their accounting treatment had
emerged; according to Maali (2005), when the bank started financing the purchase of goods,
the bank faced a problem of getting what it calls the “Murabaha price”, which is the
difference between the cost of acquiring the goods and the price of selling them to the
customer. The management of the bank decided to adopt other banks’ financing prices, that
is, the interest rate. The bank founder and its first managers considered interest rate as a
benchmark for the “Murabaha price”, and this was largely reflected in the bank practices
(Maali, 2005).
Another issue noted in the bank’s practices related to Murabaha is the increase of
Murabaha profit in proportion to the increase in the period of financing. If the transaction is
seen as a pure sales transaction and not a financing transaction, then the Murabaha price
would be the same, however long the customer could defer payment; the time value of
money should not be considered. However, when the bank started its Murabaha
transactions, it used a single “Murabaha price”, as no contracts exceeded one year. Market Islamic banks’
pressure eventually led the bank to offer to finance for longer terms, and the issue of price transactions
increases with time came to the top of the management’s agenda. Management considered
an increase in price with time because of what one of the previous managers of the bank, in
an interview, referred to as “the opportunity cost of the capital used”.
Regarding current practice, the informants in the bank argued that Murabaha is different
from interest-bearing loans in many aspects, including that no cash is given to the client and
that two contracts are signed in the transaction, a purchase contract and a sales contract. 295
These make Murabaha as a sales transaction in substance. However, how far did this view
is valid? Informants acknowledged that interest rates are used to set the Murabaha price.
The rationales given by them reflect a perceived view of Murabaha as a financing
transaction rather than a sales transaction, and a perceived view that this transaction is not
significantly different from direct loans given by conventional banks or instalment sales
transactions.
A senior executive, when asked about how the bank set the “Murabaha price” answered:
Close to market interest rate, let us not say interest rate because people may accuse us of being
non-Islamic, let us say it is the market’s rate of return, not the interest rate.
Another senior executive justified this practice by arguing:
We are in a competitive position with conventional banks, if we set the Murabaha price above
[market] rate, no one will borrow from us. If less than [market] rate, we will be unjust to our
depositors. It is no shame to take the interest rate as an indicator.
A central banker commented:
You did interviews in the bank and I am sure you know that they use the market interest rate as a
benchmark to determine the profit in Murabaha financing, this is logical; how can an Islamic
bank set 10% on Murabaha while other banks lend at 5% or 15%? The Islamic bank is forced to
do that and cannot ask for more than conventional banks as the cost of financing.
The above examples reveal a perceived view that the Murabaha transaction, as perceived by
informants has many similarities with loans advanced by conventional banks. Firstly, the
bank uses the interest rate to set the “Murabaha price”. Secondly, the perceived view is that
Murabaha is a “competitive transaction” to interest-bearing loans. Thirdly, the informants
refer to the transaction as a financing transaction, and the Murabaha price is a “financing
cost”. In most cases, the informants referred to this transaction as “Murabaha financing”
and not a “Murabaha sale”. Furthermore, some informants justified the increase in the
Murabaha price with time by implicitly arguing for the opportunity cost of capital, which is
one of the first rationales for interest.
If the transaction is perceived as a sales transaction and not a financing transaction, this
implies that IFRS15 would be relevant to Islamic banks, which is not the case. However, the
accounting treatment suggested by IFRS for sale transactions is not suitable for Islamic
banks, Archer and Karim (2001) argue because, in a Murabaha contract, the mark-up is not
divisible into trading profits and separate charges for credit. However, as argued above,
there does not seem to be any trading profit in a modern Murabaha transaction: the whole
amount of profit is a financing charge. This is in line with the British Financial Reporting
Standard 5, “reporting the substance of transactions”, which indicated that where one party
to the transaction receives a lender’s return but no more (comprising interest on its
investment, perhaps, together with a relatively small fee), then the substance of the
transaction is that of financing. This is because the party that receives a lender’s return is
not compensated for assuming any significant exposure to loss other than that associated
IMEFM with the creditworthiness of the other party, nor is the other party compensated for giving
14,2 up any significant potential for gain (Atmeh and Maali, 2017). This implies that IFRS9,
Financial Instruments, is relevant to account for Murabaha contract as practiced and
perceived by informants. As their implicit view is that money has a time value, nothing
prevents the use of the imputed rate of the “Murabaha price” to discount future cash flows.
Thus, it is suggested here that IFRS standards are relevant to deal with Murabaha as
296 practiced and perceived in the bank.

Section 6: Conclusions
The issue of the economic substance of Islamic bank transactions was raised in the
committee preceding the establishment of AAOIFI in the 1980s. In a paper written for this
committee, Heakal (1989) argued:
There should not be disagreement that the economic substance of Islamic banking transactions is
significantly different from the economic substance of western commercial banking transactions
(Heakal, 1989, p. 386).
However, Heakal (1989) went on to observe: “this statement assumes that Islamic banking
transactions are carried out in conformity with Sharia” (p. 386). When AAOIFI published its
Statement of Financial Accounting No. 2, it did not include the substance over form concept
specifically as an element of reliability. Some Islamic finance scholars argue that the
application of the economic substance principle would lead to that Islamic banks reporting
would be “providing confusing information to users of financial reporting and causes the
transactions to be incompatible with Islamic principles because the economic substance is
not in accordance with its legal form” (Suprayogi, 2017, p. 353).
For the bank’s main two transactions, it has been shown that for a deposit system based
on the Mudaraba contract and for major investment activity – Murabaha – the bank
practice and the informants’ perceptions reflect a view that is affected by Islamic Sharia.
However, this view does not necessitate a different accounting treatment because, for issues
affecting the need for special accounting treatments, there seem to be similar perceptions of
these transactions with those of conventional banks. For example, Mudaraba deposits are
seen as guaranteed, the bank uses interest rates to set the Murabaha price and the increase
in Murabaha profits with time is seen as compensation for the time value of money, the
Murabaha profit is seen as a financing cost and Murabaha is expressed as a financing rather
than a sales transaction.
It is argued that for the above transactions, as practiced and perceived, they do not need
special accounting treatment. Conventional accounting standards would be relevant to deal
with these transactions as practiced and perceived in the case study. However, this is not to
rule out the need for special accounting standards for other Islamic banks; perhaps, as
Velayutham (2014) pointed out, Islamic accounting not meeting the needs of users rather
than acculturation or economic dependency.
Islamic banking has been continuously criticized for mirroring conventional banking
(Murinde and Naser, 1998; Maali and Atmeh, 2015; Mohammed et al., 2016). Kamla (2009)
pointed it that “Islamic banking and accounting fail to substantially challenge or depart
from conventional banking and accounting” (p. 927). El-Gamal (2006) has described Islamic
finance as Sharia arbitrage, he noted that:
The form-above-substance juristic approach to Sharia arbitrage has also been shown to squander
the prudential regulatory content of premodern Islamic jurisprudence, while reducing economic
efficiency for customers through spurious transactions, not to mention legal and juristic fees. In
 addition, [. . .] competitive pressures force the industry to undercut its own grounds for Islamic Islamic banks’
legitimacy (El-Gamal, 2006, p. 190).
transactions
The evidence in this paper suggests that, despite the desire to organize banking transactions
in a way that complies with the spirit, as well as the letter of Sharia, competitive pressures
are difficult to avoid and the economic substance of Islamic banking transactions is
recognized by bankers and customers alike as more like conventional transactions than their
documented form (Maali and Napier, 2009). A risk and profit-sharing investment, thus, 297
becomes a guaranteed deposit promising a fixed return in substance and a sale on deferred
terms becomes a fixed rate-bearing loan in substance. Mudaraba and Murabaha
transactions as practiced by the bank under investigation, are tools to those wanting to save
and those wanting to acquire goods a way of achieving their aims in a Sharia-compliant
way, but they are also much similar in substance to interest-bearing transactions. It is
difficult to identify any distinctive “Islamic economic substance” surviving, which makes it
hard to defend the case that Islamic financial institutions require distinctive accounting
standards. However, and consistent with Hassan (2013) argument, the ethical principles of
Islamic banks can not be compromised in view of their divine origin.

Note
1. Despite that this paragraph was not included in current conceptual framework issued in 2018,
however, a similar argument with different wording was provided in section BC3.26 of the 2018’s
framework (IASB, 2018).

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Corresponding author
Bassam Mohammad Maali can be contacted at: bassam.maali@gju.edu.jo

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