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
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…
 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
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)
 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”
 ACCOUNTING

A PROCESS OF

Recognising,
recording,
classifying Measuring,
Analyzing, Reporting &
and summarising Presenting
business Interpreting Result
of Operation Financial Position
transaction

Documents
Profitability Financial Statement
= Income - Expenses
Vouchers
• Balance Sheet
Growth • Income Statement
Ledger
• Stmt of Changes
Liquidity In Equity
Trial Balance
• Cash Flow Statement
Productivity • Notes to Accounts
Report (Mgmt)

STAKEHOLDERS

1. Management 3. Shareholders 6. Authorities – BNM, Inland

2. Board of Directors 4. Investors Revenue, Baitulmal
5. Creditors 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)
 Neo-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
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
of what 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….”
 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”
 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”
 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)
Objectives of Financial Statements
Traditional Islamic

Income Economic Fulfilment of

Statement Performance Amanah
Balance Financial Financial
Sheet Position Trust and
Obligation

Cash Flow Cash Position Cash

Entrusted
Equity Wealth Wealth
Statement Ownership Entrusted
 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
 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
 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; Shari’ah
Committee
 Funded by founding members of IFIs,
establishment of waqf etc.
 AAOIFI: Accounting, Auditing and
Governance Standards
Statements of Financial Accounting
Financial Accounting Standards
 Musharaka Financing
 Objectives
 Profit Allocation Basis
 Concepts
 Investment Account Holders
Financial Accounting  Salam Financing
Standards  Ijarah Financing
 Presentation and  Zakah

Disclosure of Financial  Istisna’ Financing

Statements of Islamic  Provisions and Reserves
Banks  Presentation and Disclosure
 Murabaha Financing of Financial Statements of
 Mudaraba Financing Islamic Insurance Companies
 AAOIFI: Accounting, Auditing and
Governance Standards
Code of Ethics
Auditing Standards  Code of Ethics for
 Objectives and
Accountants and Auditors
Principles of Auditing of IFI
 The Auditor’s Report
New Financial
 Terms of Audit
Accounting Standards
Engagement  Investment Fund
Governance Standards  Disclosure Bases for
 Syariah Supervisory
Determining and
Board Allocating Insurance
 Syariah Review Surplus (and deficit)
 Internal Syariah New Auditing Standards
Review  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
 Syari’ah compliance
 Distinguish prohibited earnings and
expenditure
 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)
 PART 5
Accounting concepts from an
Islamic perspective
 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)
 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

 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
 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 –

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)
 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)
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
of dispose (rights on manfaat) as a result
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 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
 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
 Conclusions
Islamic accounting framework
(objectives and concepts):
1. Compliance with syari’ah 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