You are on page 1of 45

Accounting for IFIs

Defini&on  
Islamic accounting can be defined as the accounting process which provides
appropriate information (not necessarily limited to financial data) to
stakeholders of an entity which will enable them to ensure that the entity is
continuously operating within the bounds of the Islamic Shariah and
delivering on its socio-economic objectives.  
“the process of identifying, measuring and communicating economic and
other relevant information, inspired by the Islamic worldview and ethics,
and complied with the Shari’ah (Islamic law) – in order to permit informed
judgments and decisions by potential and expected users of information– to
enhance social welfare and seek the blessings of Allah”. Islamic accounting
is also a tool, which enables Muslims to evaluate their own accountabilities
to God (in respect of inter-human/environmental transactions).

Differences between Islamic Accounting and
Conventional Accounting  
S/
No.
1

Basis  of  
Differen&a&on
Objec've  of  
providing  
informa'on

Islamic  Accoun&ng
D e c i s i o n   r e l a ' n g   t o  
assessment   of   compliance  
w i t h   t h e   S h a r i a h   i n  
organiza'onal   dealings   and  
the   extent   of   mee'ng   its  
o b j e c ' v e s   ( I s l a m i c  
accountability).

Conven&onal  Accoun&ng
Decision  rela'ng  to  efficient  
a l l o c a ' o n   o f   s c a r c e  
resources  mostly  buy,  sell  or  
hold   decisions   on   their  
investments   (Decisions  
usefulness).

S/
No.
2

Basis  of  
Differen&a&on
the   type   of   the  
informa'on   that  
is   iden'fied,   how  
it   is   measured,  
r e c o r d e d   a n d  
communicated

Islamic  Accoun&ng
Iden'fy   socio-­‐economic   and  
r e l i g i o u s   e v e n t s   a n d  
transac'ons   and   records  
them   using   both   historical  
cost   and   current   valua'on  
(current   valua'on   is   used   at  
least   on   accoun'ng   for  
Zakat).   It   also   engages   in  
rep o r' n g/ d i s aggrega' n g  
items   into   haram   and   halal  
elements.     For   example,  
finance   income   would   have  
t o   b e   s p l i J e d   i n   t o  
conven'onal   interest   and  
income   from   the   various  
types   of   Shariah   compliant  
contracts.

Conven&onal  Accoun&ng
Concentrates   on   iden'fying  
e c o n o m i c   e v e n t s   a n d  
transac'ons  and  record  them  
using   historical   costs   (or   net  
realizable   value,   whichever   is  
l o w e r ) .   C o n v e n ' o n a l  
accoun'ng   has   tried   in   the  
p a s t   t o   o v e r c o m e   t h e  
l i m i t a ' o n   o f   h i s t o r i c a l  
accoun'ng   through   infla'on  
accoun'ng   and   current   value  
accoun'ng,   but   the   ideas  
were   given   up   due   to   their  
complexity   and   lack   of  
objec'vity.  

  .   F o c u s e s   m o r e   o n   shareholders   and   creditors   who   are   financiers   and   providers  of  funds.3 Users  of  the   informa&on Give   fairly   good   focus   to   a   w h o l e   g a m u t   o f   stakeholders   recognised   by   the   corporate   accoun&ng   to   enable   them   assess   compliance   with   Shariah   a n d   e n a b l e s   t h e   assessment  of  whether  the   socio-­‐economic   objec&ves   of   the   organiza&on   are   b e i n g   m e t   e t h i c a l l y .   without   harm   to   others   and   the   achievement   of   equitable   alloca&on   and   distribu&on   of   wealth   among   members   of   the   society   especially   the   s t a k e h o l d e r s   o f   t h e   concerned  corpora&on.

  The   socio-­‐ economic   ac&vi&es   are   reported  using  Shari’a  and   I s l a m i c   a c c o u n & n g   standards.   The   principles   of   Islamic   accoun&ng   do   not   serve   the   interest   of   any   par&cular   group.   but   to   the   society   as   a   whole   w h i c h   c a n   m a k e   corpora&ons   accountable   for   their   ac&ons   and   ensure   they   comply   with   Shariah  principles.  It   is   a   set   of   beliefs   and   techniques   that   has   the   ability   to   link   ac&ons   and   values   so   as   to   legi&mise   those   ac&ons. Conven&onal  accoun&ng  is   claimed   by   some   writers   to   be   a   product   of   culture   and   it   is   based   upon   modern  commercial  law.   If   there   are   some  restric&ons.  they  are   imposed   by   human   beings   and   subject   to   change   t h r o u g h   d e m o c r a & c   legisla&on.4. . Antecedent  and   Islamic  accoun&ng  is  based   Legisla&ons  for   u p o n   e t h i c a l   l a w   Repor&ng   origina&ng   in   the   Qur’an   and   Sunnah.

  horizontal   accountability   to   fellow   human   beings   i .  first. Personal   accountability   to   t h e   i n d i v i d u a l s   w h o   control   resources   and   to   s o m e   e x t e n t   o t h e r   stakeholders.   no   judgment   day   and   the   world   is   the   end  of  life).   t h e   p u b l i c   a n d   s t a k e h o l d e r s   a n d   s e c o n d l y . e .     .         Secularism   (power   is   hold   by   mankind.5 Accountability 6 Founda'on Accountability   in   Islam   e n c o m p a s s e d   a   t w o   dimensional    context.   R e l i g i o u s   ( t h e r e   i s   a   j u d g m e n t   d a y   i n   t h e   t h e   h e r e a N e r   w h i c h   mankind   pay   responsibility   during   his/her   life   before   the   God   and   there   is   hell   for  punishment  and  heaven   for  reward).   u l & m a t e   t r a n s c e n d e n t a l   accountability  to  Allah.

Islamic Worldview of Accounting and Accountants The Islamic worldview of accounting are not merely derived from cultural and philosophical elements aided by science. Islam literally means ‘peace’ and ‘obedience’. but one whose original source is revelation. In   Islam. accounting should function not only as a service activity providing financial information to the users and to the public at large but more importantly accountants should discharge their accountability by providing information to enable society to follow God’s commandments. affirmed by intellectual and intuitive principles. . and the adherents to Islam have to be ‘obedient’ to God and to appreciate the purpose of their existence in this world.

is simultaneously responsible to God the Owner of his very self and the resources he is utilizing and managing. To forget or to neglect this fundamental aspect of this responsibility is tantamount to a betrayal of divine trust with all the attending consequences in this world and in the hereafter.In terms of responsibility.   . the management/client or shareholders. The accountant in Islam is motivated to provide work and excellent service because as a holder of amanah (trustee of God) on earth he must search for the bounties of God. the accountant in Islam is not merely responsible to human superiors. He/ she is a servant and trustee of God in all situations.

His vision of success and failure however extends beyond worldly existence to the life in the hereafter. . The accountant who is imbued with the world-view of tawhid (oneness of God) is not anti-profit or anti-worldly gain within the limits provided by religion.His/ Her work is a form of amal salih (virtuous deed) which is then the key for the attainment of blessings (true success in this world and in the hereafter). His/her work is also a form of ibadah (servitude to God) in so far as it is in conformity with the divine norms and values.

and the manner in which these were disposed off. . assessing the risk inherent in its investments and. evaluating the degree of liquidity of its assets and the liquidity requirements for meeting its other obligations.Objective of Financial Accounting and Reporting for IFIs The following are the objectives of financial accounting and reporting for IFIs as given by AAOIFI.  Information about the Islamic bank’s compliance with the Shari’ah and its objectives and information establishing the separation of prohibited earnings and expenditures.  Information about the Islamic bank’s economic resources and related obligations to assist the users in: evaluating the adequacy of the Islamic bank’s capital to absorb losses and business risks. To provide: i. ii. which occurred. if any.

the timing of those flows and the risk associated with their realization.  Informa'on  about  the  Islamic  bank’s  discharge  of  its  social   responsibili'es. iv. Information to assist in estimating cash flows that might be realized from dealing with the Islamic bank.   .  and  informa'on  about  investment  rates  of  returns  on  the   bank’s  investments  and  the  rate  of  return  accruing  to  equity  and  investment   accountholders.  to  enable  them  to  make  legi'mate   decisions  in  their  dealings  with  Islamic  banks.      vi.  Informa'on  to  assist  in  evalua'ng  the  Islamic  bank’s  discharge  of  its   fiduciary  responsibility  to  safeguard  fund  and  to  invest  them  at  reasonable   rates  of  return. The information should be directed principally at assisting the user in evaluating the Islamic bank’s ability to generate income and to convert it into cash flows and the adequacy of those cash flows for distributing profit to equity and investment account holders.iii.  v. Information to assist the concerned party in the determination of Zakat on the Islamic bank’s funds and the purpose for which it will be disbursed.  Informa'on  to  users  of  these  reports.               vii.

however small or large. Even for spot transactions where debt is not involved.Never get bored with recording it.. up to its maturity date. for this is seen by Allah as closer to justice.   . then you are not to blame for not recoding it”. except when it is spot trade carried out amongst yourselves. (Baqara: 282). and that is all what accounting is about..The Need for Islamic Accounting Standards The need for accounting records as means for trust building is emphasized in the Quran : “. the Quran allows an open discretion for taking records. more supportive to testimony. and more resolving to doubt.

This is particularly true in the context of accounting practices in IFIs. the manifestation of Islamic faith simply implies that there are particular forms of accounting to suit the needs of Islamic religious requirements. and it is essential to the running of these institutions. This is manifested by the explanations and discussions of accounting for various Islamic financial services and transactions.Islamic accounting practice takes place within the IFIs such as Islamic banks and Zakat institutions. Islamic accounting practice does not indicate that Islam mandate any particular form of accounting. The prohibition of interest (riba’) and the different forms of financing has led to modified accounting treatments and disclosure requirements for Islamic financial services. . However.

The motivation for the development of Islamic accounting comes together with the emergence Islamic economic and Islamic resurgence for the last two to three decades. The awareness for the need for Islamic accounting is due to basic building blocks of conventional accounting itself since the International Financial Reporting Standards (IFRS) are based on interest-based elements. it is widely accepted that the primary objective of accounting is to provide useful information to assist users in making economic decisions.The discussions of a unique Islamic financial system of Zakat. appropriate accounting framework based on Shariah principles must be in place. a religious obligation. This is especially crucial considering Zakat is a religious institution that involves quite a number of accounting implications. then the rules of accountability must be purely divine. indicates the needs for accounting for Zakat.   First. . Thus. it can be argued that accounting is therefore. Hence. if accounting is a religious obligation. In order to do so.

This is one of the elements embedded in the conventional accounting which is already violating the requirements of Shariah. The Accounting and Auditing Organisation for IFIs (AAOIFI) was formed for this reason. It is necessary to have Islamic accounting to be in place rather than conventional accounting in order to provide information on financial success in Islamic organisations. .

Second. This is because Islamic institutions such as Islamic banks etc. a problem is likely to occur. However. if conventional accounting which developed to meet the needs of a capitalist economy is used instead in these institutions. Hence. Islamic accounting may be more appropriate to achieve the socio-economic and religions objectives of Islamic institutions and Muslim users. these institutions should logically use Islamic accounting. are established to meet the socio-economic objectives of the Shariah (Islamic Law) through the implementation of an Islamic economic system.   . especially for monitoring these institutions to achieve their objectives. which will lead to the institutions not meeting their Shariah socio-economic objectives and even worse may turn these Islamic institutions into capitalist institutions by providing materialist profitfocused information instead of the holistic information provided by Islamic accounting.

Islam is not against profit motive that is reasonable. . with the resurgence of Islam globally. therefore. environmental and religious performance. Islamic accounting as a whole is able to serve the whole gamut of stakeholders. but to the society as a whole which can make corporations accountable for their actions and ensure they comply with Shariah principles.Nevertheless. There is no doubt. the awareness for the need of Islamic accounting arises.   Third. that Islamic accounting would result in an ethical based accounting system which measures not only profits but social. Its principles do not serve the interest of any particular group.

This can analogically be seen from Islamic faith whereby for every human. 2 angels accompanied them at right and left shoulders. the accounting profession has been mentioned comprehensively in Quranic verses. Islam as a religion embraces a comprehensive system of human conduct. influencing all aspects of life. Further.   . record every good deeds and sins (the double-entry bookkeeping principles?).Fourth. portrayed to shoulder responsibility of social and economic justice. In fact. Islam as a religion is not merely a belief but is a complete way of life. The uniqueness of Islam lies in its practicalities. accounting is embodied in Islam.

2: 282). And Allah is well acquainted with all things” (Al-Baqarah. Allah has declared in Quran. such as ye choose. and not diminish aught of what he owes.   . If ye do (such harm). whether it be small and more convenient to prevent doubts among yourselves but if it be a transaction which ye carry out on the spot among yourselves there is no blame on you if ye reduce it not to writing. If the party liable is mentally deficient. And get two witnesses. let his guardian dictate faithfully. but let fear his Lord Allah. “O ye who believe! When ye deal with each other.. so that if one of them errs. it would be wickedness in you. then a man and two woman. So fear Allah. The witnesses should not refuse when they are called on (for evidence). let not the scribe refuse to write. out of your own men. for it is Allah that teaches you. But neither take witnesses whenever ye make a commercial contract. in transactions involving future obligations in a fixed period of time. so let him write. for witnesses. or weak or unable himself to dictate. Disdain not to reduce to writing (your contract) for a future period. Let him who incurs the liability dictate. the other can remind him/ her. and let neither scribe nor witness suffer harm. as Allah has taught him. reduce them to writing. let a scribe (accountant ?) write down faithfully as between the parties. and if there are not two men.

Fifth. Therefore. . However. will be relevant to be practiced in our time. and. the proper development of Islamic accounting practice especially in IFIs requires a well regulated Islamic financial service. the Islamic accounting regulation also needs to adapt to the modern accounting regulatory environment to make it relevant to be practiced in our time. and one of the key elements of regulation is accounting regulation. would meet the requirements of Shari’ah. second. first. The need for a codified Islamic accounting primarily stemmed from the need that Islamic accounting objectives. concepts and principles developed based on Shari’ah requirements. a well-regulated Islamic financial industry requires a sound accounting and reporting requirements that.

as an international autonomous not-for-profit Islamic corporate body that prepares standards for IFIs. through the support of institutional members (200 members from 45 countries.The Development of Islamic Accounting Standards   Organization for Islamic Financial Institutions (AAOIFI) was established on 1 Safar. Islamic financial institutions. 1990 in Algiers. and then. 1991 in the State of Bahrain. registered on 11 Ramadan 1411 corresponding to 27 March. 1410H corresponding to 26 February. so far) including central banks. and other participants from the international Islamic banking and finance industry. worldwide   .

the globalisation agenda and international harmonisation movement of Islamic accounting and financial reporting is gaining momentum. Qatar. Malaysia. The relevant authorities in Australia. Pakistan. which are now adopted in the Kingdom of Bahrain. and South Africa have issued guidelines that are based on AAOIFI’s standards and pronouncements. Lebanon.AAOFI issues accounting. Kingdom of Saudi Arabia. AAOIFI has gained assuring support for the implementation of its standards. However. Sudan and Syria. ethics and Shari'a standards for Islamic financial institutions and the industry. Jordan. Dubai International Financial Centre. auditing. governance. . Indonesia. In the meantime. the calls for worldwide adherence to IFRSs to achieve harmonization in financial reporting regardless of cultural differences should not go unchallenged.

Istisna’a and Parallel Istisna’a. 9. 7. Objective of financial accounting for Islamic banks and financial institution (IFIs). Salam and Parallel Salam. . Disclosure of bases for profit allocation between owners’ equity and investment account holders. 2012 are as follows: Accounting standards 1. Musharaka financing. Equity of investment account holders and their equivalent. Ijarah and Ijarah Muntahia Bittamleek. Zakah. 8. General Presentation and Disclosure in the Financial Statements of Islamic Insurance Companies. 4. 3. 13. Mudaraba financing. Murabaha and Murabaha to the purchase orderer. 11. Provisions and Reserves. 2. 10. 6. 5. 12. Concept of financial accounting for IFIs.Standards that have been developed by AAOIFI as at 30th September. 14. General presentation and disclosure in the financial statements of IFIs.

 Contribu'ons  in  Islamic  Insurance  Companies.  Deferred  Payment  Sale  .15.     21. 17. 18. Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance Companies.     24.  Investments. 16. Investment Funds.  Disclosure  on  Transfer  of  Assets.   .     19.  Foreign  Currency  Transac'ons  and  Foreign  Opera'on.     23.  Islamic  Financial  Services  Offered  by  Conven'onal  Financial  Ins'tu'ons.     25.  Consolida'on.     20.  Investment  in  Associates.     22. Provisions and Reserves in Islamic Insurance Companies.  Segment  Repor'ng.     26.

5. Independence of Shari’a Supervisory Board. Shari’a Supervisory Board: Appointment. 7. 4. 3. 3. Terms of Audit Engagement. Audit and Governance Committee for IFIs. The Auditor’s Report. Internal Shari’a Review. . Testing for Compliance with Shari’a Rules and Principles by an External Auditor. 2. Statement on Governance Principles for IFIs. Governance Standards 1. Objective and principles of auditing. Composition and Report. Shari’a Review. 4. The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements. 5. Corporate Social Responsibility. 2. 6.Auditing Standards 1.

Ijarah and Ijarah Muntahia Bittamleek. 14. Hawala. Possession (Qabd). 18. Investment Sukuk. . 9. Mudaraba. Shari’a Standards 1. Trading in currencies. Debit Card. 4. Charge Card and Credit Card 3. 7. 2. Commercial Papers. 6. Settlement of Debt by Set-Off. Istisna’a and Parallel Istisna’a. 5. 13. Code of ethics for employees of IFIs. 2. Default in Payment by a Debtor. Sharika (Musharaka) and Modern Corporations. Conversion of a Conventional Bank to an Islamic Bank. Code of ethics for accountants and auditors of IFIs. 11. 16.Ethics Standards 1. Murabaha to the Purchase Orderer. Salam and Parallel Salam. 10. Guarantees. 17. Loan (Qard). 12. Jua’la. Documentary Credit. 8. 15. 19.

the going concern concept embedded in conventional accounting is not in conflict with the requirements of Islamic accounting whereby the directors should make assessment on the firms’ ability to continue as a going concern. Hence if a person is known to exist.   . the financial statements must also be prepared on the basis of going concern basis unless the directors want to liquidate the firms or to cease trading.Application of GAAPs in Conventional Accounting Compared with Islamic Accounting Going Concern Concept: Basically. his existence is not denied until there is evidence to the contrary. The presumption of continuity means retaining any event or verdict experienced in the past until evidence is found that this event or verdict has changed. there is a presumption of continuity. In Islamic jurisprudence. or istishab. Consequently.

Extending this principle to a business entity. it may be acceptable to assume that the entity would continue in operation in the foreseeable future unless and until there is indication that its ability to continue as a going concern has ceased.   . an entity based on Mudharabah which was meant to be in operation only to the end of the agreed Mudharabah period. for example.

in the case of Murabahah or bay’ bithaman-ajil (BBA) transactions conducted by Islamic banks.Accruals/Matching Concept: The accruals concept is not in conflict to the requirements of Shariah. However. it is allowable for example. Islamic banks may differ in terms of the timing of recognition of the margin: at time of sale. as cash received or as payment becomes due. it has the same effect on profit.   . From the Islamic perspective. If the banks treat a Murabahah or BBA transaction as a financing transaction or purely as a sales transaction. Thus. the matching principle which allocates expenses to their related revenues provides fairness and justice simultaneously to the shareholders and other stakeholders.

have to contend with the uncertainties that inevitably surround many events and circumstances. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty such that assets or income are not overstated and liabilities or expenses are not understated. such as the collectability of doubtful receivables. . the probable useful life of plant and equipment and the number of warranty claims that may occur.The Concept of Prudence/Conservatism: The preparers of financial statements do. Such uncertainties are recognized by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the financial statements. however.

the deliberate understatement of assets or income. the exercise of prudence in Islamic Accounting does not allow. for example.However. . or the deliberate overstatement of liabilities or expenses. the creation of hidden reserves or excessive provisions. because the financial statements would not be neutral. and therefore not have the quality of reliability.

the essence of the transaction is in fact a sales transactions. However. The financier or the bank is prohibited to buy back the assets from the purchaser. the financier or the bank can require the purchaser to pledge the assets acquired as collateral to the financing amount.   . This is evident in the treatment of leased assets (Ijarah) and sales based transactions (Murabahah). Thus. the emerging reality must be constructed or appear to be as the form.The Concept of ‘Substance over Form’: AAOIFI does not particularly endorse the concept of ‘substance over form’. In view of the primacy of contract in transactions in Islam. the ownership title will be passed to the purchaser upon acquisition. For Murabahah contracts.

Consistency Concept: The requirement for consistency is not in conflict with the Islamic accounting requirement whereby the presentation and classification of items in the financial statements should be retained from one period to the next unless circumstances require it to change.   .

However. this principle is questionable from the Islamic point of view due to its conflicts with the concept of fairness and justice.Historical Cost Concept: The conventional accounting measurement is based on the cost principle that considers the acquisition cost or historical cost as appropriate measurement basis. The argument for the use of current market value has been based on the needs for the most accurate valuation of wealth to be subjected for Zakat in order to serve justice to both the Zakat recipients and Zakat payers. This may lead to understatement of trade assets to be subjected for Zakat. AAOIFI. Adherence to the conventional accounting cost principles may lead to the accounting practice of asset valuation that is lower of cost or market value. majority of scholars recommend the use of current prices on the due date of Zakat. In case of Zakat determination. however. recommended the use of cash equivalent value that indicates the value that would be realized if an asset was sold for cash in the normal course of business as at the date of the financial statement. .

it must be supported with objective indicators. consistency of the use of valuation methods. . logical and relevant valuation methods. and conservatism in the valuation process. expert valuation.In order to ensure the reliability and comparability of the cash equivalent value.

there is a legal maxim that when there is a mix of the permissible and the prohibited.. in fiqh.” (Surah Al-Anbiya. From an Islamic perspective. the nature of an item may make it material. verse 47). Moreover.. A related Quranic verse reads: “..   .Materiality Concept: Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. and if there be no more than the weight of mustard seed.. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. even if the size of the item is quantitatively insignificant. we will bring it to account . the whole becomes prohibited.

Islamically slaughtered. the maxim. the maxim appears to be ihtiyat. the prohibition does not apply to a mixture of silk and other threads. For example. there may be instances where an entity may be required to disclose an item regardless of the size of the item. The mix of permissible and prohibited meats renders the whole prohibited for Muslim consumption. Conversely. For financial reporting purposes. and non-zabiha meats. However. a garment may be deemed permissible if it is made of a mixture of silk and other threads such that the silk content does not exceed a prescribed proportion. a precautionary measure rather than a ruling. the maxim is applied in the case of a mixture of zabiha. an entity may not need to report some items below a certain threshold. There are numerous examples of and exceptions to. Conversely.This would appear to suggest that even small amounts of prohibited items may be material.e.   . i. Although Muslim men are prohibited from wearing silk clothing.

Thus. The concept of haul determined that the wealth must be owned at least one year to qualify for the payment of Zakat. . In addition. This will assist the users to periodically evaluate the institution’s financial performance and position. the periodic preparation of the financial statements will be useful to determine the financial obligations and the financial rights of the bank and other interested parties.Periodicity Concept: The conventional accounting periodicity concept is also acceptable in Islam on the basis that even in the case of Zakat. it is being paid once a year as a period of measurement. the periodicity concept for an Islamic financial institution means the life of the institution can be broken into reporting periods to prepare financial reports to the interested parties and stakeholders.

Thus.   . the life of the Islamic bank should be broken into reporting periods to prepare financial reports that provide information to interested parties about the performance of the bank. One lunar year is used for Zakat calculation.

IFIs therefore used both accrual and cash basis of accounting. (ii)  there is an obligation on the part of another party to remit. . and (iii) the amount of revenue should be known and collectible with reasonable degree of certainty. Accrual basis of income recognition does meet the requirement of Islamic objectives as it aims to measure the ‘real’ wealth of an entity. Realization of revenues shall take place when one of the three conditions is met: (i)  the entity has the right to receive the revenue.Realization and Accrual Concepts: AAOIFI’s SFA 2 recommends that “revenues should be recognized when realized”.