Accounting Principles

Since GAAP is founded on the basic accounting principles and guidelines, we

can better understand GAAP if we understand those accounting principles. The
following is a list of the ten main accounting principles and guidelines together
with a highly condensed explanation of each.

1.Economic entity assumption

The accountant keeps all of the business transactions of a sole proprietorship
separate from the business owner's personal transactions. For legal purposes, a
sole proprietorship and its owner are considered to be one entity, but for
accounting purposes they are considered to be two separate entities.
2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be
expressed in U.S. dollars are recorded. Because of this basic accounting principle,
it is assumed that the dollar's purchasing power has not changed over time. As a
result accountants ignore the effect of inflation on recorded amounts. For
example, dollars from a 1960 transaction are combined (or shown) with dollars
from a 2018 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and
ongoing activities of a business in relatively short, distinct time intervals such as
the five months ended May 31, 2018, or the 5 weeks ended May 1, 2018. The
shorter the time interval, the more likely the need for the accountant to estimate
amounts relevant to that period. For example, the property tax bill is received on
December 15 of each year. On the income statement for the year ended December
31, 2017, the amount is known; but for the income statement for the three months
ended March 31, 2018, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading
of each income statement, statement of stockholders' equity, and statement of
cash flows. Labeling one of these financial statements with "December 31" is not
good enough–the reader needs to know if the statement covers the one
week ended December 31, 2018 the month ended December 31, 2018 the three
months ended December 31, 2018 or the year ended December 31, 2018.
4. Cost Principle

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From an accountant's point of view, the term "cost" refers to the amount spent
(cash or the cash equivalent) when an item was originally obtained, whether that
purchase happened last year or thirty years ago. For this reason, the amounts
shown on financial statements are referred to as historical cost amounts.
Because of this accounting principle asset amounts are not adjusted upward for
inflation. In fact, as a general rule, asset amounts are not adjusted to
reflect any type of increase in value. Hence, an asset amount does not reflect the
amount of money a company would receive if it were to sell the asset at today's
market value. (An exception is certain investments in stocks and bonds that are
actively traded on a stock exchange.) If you want to know the current value of a
company's long-term assets, you will not get this information from a company's
financial statements–you need to look elsewhere, perhaps to a third-party
appraiser.
5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial

statements, that information should be disclosed within the statement or in the
notes to the statement. It is because of this basic accounting principle that
numerous pages of "footnotes" are often attached to financial statements.

As an example, let's say a company is named in a lawsuit that demands a

significant amount of money. When the financial statements are prepared it is not
clear whether the company will be able to defend itself or whether it might lose
the lawsuit. As a result of these conditions and because of the full disclosure
principle the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its
financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long
enough to carry out its objectives and commitments and will not liquidate in the
foreseeable future. If the company's financial situation is such that the accountant
believes the company will not be able to continue on, the accountant is required
to disclose this assessment.
The going concern principle allows the company to defer some of its prepaid
expenses until future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of

accounting. The matching principle requires that expenses be matched with

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revenues. For example, sales commissions expense should be reported in the
period when the sales were made (and not reported in the period when the
commissions were paid). Wages to employees are reported as an expense in the
week when the employees worked and not in the week when the employees are
paid. If a company agrees to give its employees 1% of its 2018 revenues as a
bonus on January 15, 2019, the company should report the bonus as an expense
in 2018 and the amount unpaid at December 31, 2018 as a liability. (The expense
is occurring as the sales are occurring.)
Because we cannot measure the future economic benefit of things such as
advertisements (and thereby we cannot match the ad expense with related future
revenues), the accountant charges the ad amount to expense in the period that the
ad is run.

8.Revenue RecognitionPrinciple

Under the accrual basis of accounting (as opposed to the cash basis of
accounting), revenues are recognized as soon as a product has been sold or a
service has been performed, regardless of when the money is actually received.
Under this basic accounting principle, a company could earn and report $20,000
of revenue in its first month of operation but receive $0 in actual cash in that
month.
For example, if ABC Consulting completes its service at an agreed price of
$1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it
does not matter whether the client pays the $1,000 immediately or in 30 days. Do
not confuse revenue with a cash receipt.
9. Materiality

Because of this basic accounting principle or guideline, an accountant might be

allowed to violate another accounting principle if an amount is insignificant.
Professional judgement is needed to decide whether an amount is insignificant or
immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by

a highly profitable multi-million dollar company. Because the printer will be used
for five years, the matching principle directs the accountant to expense the cost
over the five-year period. The materiality guideline allows this company to
violate the matching principle and to expense the entire cost of $150 in the year
it is purchased. The justification is that no one would consider it misleading if
$150 is expensed in the first year instead of $30 being expensed in each of the
five years that it is used.

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Because of materiality, financial statements usually show amounts rounded to the
nearest dollar, to the nearest thousand, or to the nearest million dollars depending
on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an
item, conservatism directs the accountant to choose the alternative that will result
in less net income and/or less asset amount. Conservatism helps the accountant
to "break a tie." It does not direct accountants to be conservative. Accountants are
expected to be unbiased and objective.

Accounting in Islam is a moral and ethical code of conduct and there is no concept
of interest. There are two basic principles on which the Islamic Accounting
works. These are:

 Justice.
Under all circumstances, the justice should be maintained within the society. It
has to be assured in the banking system that everything is managed according to
the rules and regulation of Islam. In Islamic Accounting, the system is now
allowed to exploit others.

 Benevolence.
Benevolence is related to perfection and beauty in Islam. It is the one principle
that will keep us away from bitterness and undesirable things. It will make the
banking procedure manageable. It would be easier to meet the requirements of
the public.

 Reporting of accurate income information

 Promotion of efficiency and leadership
 Compliance with the Shari’ah
 Commitment to justice
 Reporting best practices and adapting to social change through corporate
social responsibility

Islamic Accounting Standards

The need of Islamic Accounting Standards is caused by the establishment of

Islamic financial institutions (which have different fundamental concepts and

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 principles from conventional institutions). In addition, this was established in
order to accommodate the accounting of Islamic financial transactions and make
them comparable.

The existing accounting standards that based on International Accounting

Standards (IASs) cannot address accounting issues, within Islamic banking
operations adequately useful in providing a structural framework for reporting,
but they are inadequate to accommodate Shari’ah precepts, which form the basis
of all Islamic transactions.

Many statements said that Islamic accounting standards are referred to what have
AAOIFI prepared. However, other scholars will comment that what AAOIFI has
done are not so called “Islamic accounting standards”. But, it is only “accounting
for Islamic financial institutions”. These both difference phrases actually do not
bother for the practitioners, but it will become a serious discussion for academics.

Islamic accounting standards can be defined as accounting standards that are

derived directly from the Islamic teaching. Unfortunately, the real Islamic
accounting standards are still on the theory and concepts. Because, there is a gap
between Islamic financial practices and theory, or there is no complete Islamic
financial implementations (Taheri, 2000).

Accounting in Islam has some important standards and some of them have been
listed below:

 Management of an information library including the industry reports, standards

and reference books.
 Delivering the reports and IKFC research to the stakeholders of the company.
 With the Islamic finance leaders conducting a survey.
 All the discussion with the policymakers and experts is shared with the member
of the team.
 To share leadership with market and clients, special magazines are published.

Islamic Accounting will provide you complete control over your accounts, the
profit you have earned and other information related to the business. It will help
in the growth of your organization in the best possible way.
AAOIFI Proposed Set of Financial Statements for Islamic Banks
There are three major categories The first category comprises the financial
statements that are meant to reflect the position of the Islamic bank as an investor,
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such as: Statement of Financial Position Statement of Income Statement of Cash
Flows Statement of Retained Earnings or Statement of Changes in Owners’
Equity
The second category focuses on the financial reporting of restricted investments
managed by the Islamic bank for the benefit of others. Such a statement will be
referred to as “Statement of Changes in Restricted Investments “The third
category includes financial statements reflecting the Islamic bank’s role as a
fiduciary of funds made available for social services Statement of Sources and
Uses of Funds in the Zakah & Charity Fund Statement of Sources and Uses of
Funds in the Qard Fund

IMPORTANT ACCOUNTING STANDARD ISSUED BY AAOIFI

Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI) is an independent industry body dedicated to the development of
international standards applicable for Islamic financial institutions. The Bahrain-
based Organisation started producing standards as early as 1993.
AAOIFI standards have been developed in consultation with leading Sharia
scholars, with several counties adopting them. Although AAOIFI standards are
not binding on members, over the last few years the Organisation has made
significant progress in encouraging the widespread adoption of the standards.
Countries where AAOIFI standards are either mandatory or recommended
include: Bahrain, Malaysia, UAE, Saudi Arabia, Lebanon, Syria, Sudan and
Jordan. Prior to implementation of AAOIFI standards many financial institutions
in these countries were operating under a “semi-regulated market” (Al Baluchi,
2006), where accounting policies were determined with the assistance of the
bank’s Sharia Supervisory Board (SSB). In addition, over this period,
International Accounting Standards (IAS) or respective national accounting
standards were followed by Islamic banks.
AAOIFI Standards – The following standards have been developed by AAOIFI:
Accounting Standards:
AAOIFI Financial Accounting Standards Consist of 25 Standards As Following
(AAOIFI, 2010)
 FAS 1 Presentation and disclosure
 FAS 2, 3 and 4 Modes of financing (Murabahah , Mudaraba and
Musharaka)

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  FAS 5 Disclosures of bases for profit allocation between owners’ equity
and investment account holders
 FAS 6 Cover equity of investment account holders and their equivalent
 FAS 7 and 8 are about Salam and Parallel Salam Ijarah and Ijarah
transactions
 FAS 9 Zakah
 FAS 10 relates to Istisna’a
 FAS 11 Covers provisions and reserves
 FAS 12 and 13 and 15 and 19 Relates to insurance companies
 FAS 14 and 17 Covers investment funds and investments
 FAS 16 relates to foreign currency transactions
 FAS 18 Islamic Financial Services Offered by Conventional Financial
Institutions
 FAS 20 about deferred payment sale
 FAS 21 relates to transfer of assets
 FAS 22 relates to segment reporting
 FAS 23 relates to consolidated financial statements
 FAS 24 Contributions in Islamic Insurance Companies
 FAS 25 Investments in Associates.

AAOIFI Standard – Trading in Currencies

The standard was issued on 27 Safar 1421H corresponding to 31 May 2000. The
standard is applicable to issues of both actual and constructive possession of
currencies, the use of modern means of communication in currency trading,
exchange of currencies in the context of the bilateral settlement of debts owed by
the parties to the exchange, dealing in currencies in money markets, bilateral
promises to buy and sell currencies, deferment of the delivery of one of two
counter values in currency trading, and some cases practiced by the institutions.

AAOIFI Standard – Default in Payment by a Debtor

The purpose of this standard is to explain the Shari’ah rulings applicable to the
transactions of Islamic Financial Institutions relating to delay on the part of
solvent debtors in settling their debts, delay on the part of guarantors and
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contractors in fulfilling their obligations, and the ruling on the matter of penalty
clauses.

AAOIFI Standard – Debit Card, Charge Card and Credit Card

The standard is applicable to debit cards, charge cards and credit cards that are
issued by institutions to their customers to enable the latter, by using the cards,
either to withdraw cash from their accounts or to obtain credit or to pay for goods
or services purchased. The standard is issued on 27 Safar 1421, corresponding to
31 May 2000.

AAOIFI Standard – Settlement of Debt by Set-off

The aim of this standard is to outline rules governing the use of set-off in settling
debts, the Shari’a requirements and conditions applicable to set-off, what is
permissible or not permissible in this procedure and the most significant practices
of Islamic financial institutions (institution/institutions) in this regard.

AAOIFI Standard– Guarantees

This standard deals with guarantees that are intended to secure obligations and
protect amount of debts, either from being uncollectible or from being in default.
Such guarantees may take the form of written documents, attestations, personal
guarantees, pledges, cheques and promissory notes.

AAOIFI Standard– Bank Conversion to an Islamic Bank

This standard discusses fundamental mechanisms for converting a conventional

bank to a bank that comply with Shari’a rules and principles right after the
decision to undertake immediate comprehensive conversion within a particular
designated period that is announced, whether such a decision comes from within
the bank or from outside the bank to be converted by outside parties interested in
convert.

AAOIFI Standard– Hawala

This standard is issued on Rabii 1 1423 H corresponding to 16 May 2002. This

standard deals with hawala transactions that involve a change of debtor, i.e.
transfer of debt. The scope of this standard shall not include banking remittances
except the remittances that take the form of hawala (transfer of debt).

AAOIFI Financial Accounting Standard 27 (FAS 27) “Investment Accounts”

and PSIFIs FAS 27 issued in 2014 makes important changes in treatment of
PSIAs that should be reflected in the Compilation Guide. The standard changes

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the accounting treatment of on-balance-sheet and off-balance sheet accounts,
specifically PSIAs.
MURABAHAH FINANCING: FAS 2
THIS standard shall apply to the assets available for sale murabahah and
murabahah to purchase order, the revenue, expenses, gain and losses attributable
to such an asset as well as murabahah receivables.

FAS 28- Murabaha and other deferred payment sales

The objective of this standard is to prescribe the appropriate accounting and

reporting principles for recognition, measurement and disclosure to apply in
relation to murabahah and other deferred payment sales transactions.

Scope

1. This standard applies to accounting for murabahah and other deferred

payment sales transaction carried out under shari’ ah principles, excluding
tawarruq and commodity murabahah transactions.
2. This standard shall not apply to investment. That is investment instruments.
E.g equity instruments or sukuk

FAS 30 -Impairment, Credit Losses

The new standard FAS 30 Impairment, Credit Losses and Onerous Commitments
is not converged with the corresponding requirements in IFRS 9 Financial
Instruments as it was concluded that "the impairment and credit losses approaches
taken by the generally accepted accounting principles recently set by various
accounting standard setters and regulatory standard setters, as well as, the
regulators, cannot be applicable on Islamic finance transactions in a similar
manner".

FAS 33 -Investments in Sukuk, Shares and Similar Instruments

FAS 33, which supersedes FAS 25, sets out improved principles for
classification, recognition, measurement, presentation and disclosure of
investment in Sukuk, shares and other similar instruments of investments made
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by Islamic financial institutions in line with Sharia’a principles. It defines the key
types of instruments of Sharia’a compliant investments and defines the primary
accounting treatments commensurate to the characteristics and business model of
the institution under which the investments are made, managed and held.

FAS 34 -Financial Reporting for Sukuk-holders

FAS 34 aims to establish the principles of accounting and financial reporting for
assets and businesses underlying the Sukuk to ensure transparent and fair
reporting to all relevant stakeholders, particularly including Sukuk-holders.

FAS 35 -risk reserves

The standard defines the accounting principles for risk reserves in line with the
best practices of financial reporting and risk management. The standard
encourages but does not require maintaining adequate risk reserves to
safeguarding the interest of profit and loss stakeholders particularly against
various risks including credit, market, equity investment risks, as well as, the rate
of return risk. Together with FAS 30 Impairment, Credit Losses and Onerous
Commitments, FAS 35 supersedes the earlier FAS 11 Provisions and Reserves
and is effective for the financial periods beginning on or after 1 January 2021
with earlier adoption permitted.

Auditing Standards:
1. Objective and principles of auditing.
2. The Auditor’s Report.
3. Terms of Audit Engagement.
4. Testing for Compliance with Shariaa Rules and Principles by an External
Auditor.
5. The Auditor’s Responsibility to Consider Fraud and Error in an Audit of
Financial Statements.
Governance Standards:
1. Sharia Supervisory Board: Appointment, Composition and Report.
2. Sharia Review.
3. Internal Sharia Review.
4. Audit and Governance Committee for IFIs.
5. Independence of Sharia Supervisory Board.
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6. Statement on Governance Principles for IFIs.
7. Corporate Social Responsibility.
Ethics Standards:
1. Code of ethics for accountants and auditors of IFIs.
2. Code of ethics for employees of IFIs.
Sharia Standards:
1. Trading in currencies.
2. Debit Card, Charge Card and Credit Card
3. Default in Payment by a Debtor.
4. Settlement of Debt by Set-Off.
5. Guarantees.
6. Conversion of a Conventional Bank to an Islamic Bank.
7. Hawala.
8. Murabaha to the Purchase Orderer.
9. Ijarah and Ijarah Muntahia Bittamleek.
10. Salam and Parallel Salam.
11. Istisna’a and Parallel Istisna’a.
12. Sharika (Musharaka) and Modern Corporations.
13. Mudaraba.
14. Documentary Credit.
15. Jua’la.
16. Commercial Papers.
17. Investment Sukuk.
18. Possession (Qabd).
19. Loan (Qard).
20. Commodities in Organised Markets.
21. Financial Papers (Shares and Bonds).
22. Concession Contracts.
23. Agency.

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24. Syndicated Financing.
25. Combination of Contracts.
26. Islamic Insurance.
27. Indices.
28. Banking Services.
29. Ethics and stipulations for Fatwa.
30. Monetization (Tawarruq)
31. Gharar Stipulations in Financial Transactions
32. Arbitration
33. Waqf
34. Ijarah on Labour (Individuals)
35. Zakah
36. Impact of Contingent Incidents on Commitments.
37. Credit Agreement
38. Online Financial Dealings
39. Mortgage and its Contemporary Applications.
40. Distribution of Profit in Mudarabah-based Investments Accounts.
41. Islamic Reinsurance
42. Financial Rights and Its Disposal Management
43. Liquidity and Its Instruments
44. Bankruptcy
45. Capital and Investment Protection
DISCLOSURE IN FINANCIAL STATEMENTS
1. Risks to disclose in financial statements
 Shari’ah compliance risk that should absolutely be taken into account
IFIs, other types of risks should be included into their financial
statements. In that sense, the AAOIFI has issued guidelines for
accounting standards taking into consideration prudential rules to
reflect the specific risk characteristics of Islamic financial contracts.
 The AAOIFI has also clarified the assessment of disclosures with regard
to credit, market and liquidity.

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 Due to the high proportion of investments in equities in the financial
position of Islamic Financial institutions, AAOIFI standard gives a
particular attention to the disclosure of Investment / Market Risk by
including in the financial statements of IFIs various information
regarding the classification of securities, their market value and the
movement in provisions for these securities.
 In the case of Mudharabah, disclosure may include an explanation of
the reason for not giving fair value, principal characteristics of the
investment, and information about the market for such investment.
 Regarding credit risk, AAOIFI standard require that general disclosure
in the financial statements of IFIs cover information on concentration
of assets risks by economic sectors and geographical areas, distribution
of assets in accordance with their maturity and disclosure of related
party transactions.
 Disclosure regarding Murabahah sales receivables focuses on the
maturity profile of assets and liabilities, by separating the bank’s own
assets from the assets managed for investment account holders.
 This would facilitate the identification of maturity mismatches, and thus
the estimation of liquidity risk taken by the financial institution.
 The disclosure with regard to Liquidity Risk is another important point
despite the fact that liquidity of IFIs is generally good because of the
concentration of their financing operations in self-liquidating short-
term Murabahah financing and commodity backed placements with
banks (Regulation and Supervision, Corporate Governance and
Financial Accounting of Islamic Banks; IIBI; 2009).
 And despite some concerns regarding their macro level liquidity in the
event of financial distress due to their refusal of interest, most Islamic
banks are keeping compensating balances with other commercial or
central banks, to meet urgent liquidity needs of the respective
counterparties.
 Furthermore, Islamic banks are subject to operational risk due to the
particularities of their contracts and the general legal environment
where they operate.
 In fact, there are also potential difficulties in enforcing Islamic contracts
in a broader legal environment and potential costs and risks of
monitoring equity-type contracts and the associated legal risks. For
example, there is a cancellation risk in the non-binding Mudarabah and
Istisna’a contracts. There is also a risk due to the need to maintain and
manage commodity inventories often in illiquid markets.

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  And any failure of the internal control system to detect and manage
potential problems in the operational processes and back-office
functions could affect the banks activity.
2. General Provision
General Provision on general presentation and disclosure in the financial
statements require a complete setoff statements which include seven statements,
notes require for these statements, how to present these statements and specific
form and classification used therein to ensure clear and adequate
information presentation for users of these statements.
3. General Disclosure
General disclosure in the financial statements require the disclosure of
information about the bank, its activity, Shari`ah board, its subsidiaries and
affiliates, policies use for disclosing, effect of changes in
the policies, investment mode etc. The objective of general disclosure is to ensu
re that the statements are providing enough information about itself, its activities
and its policies.
4. Disclosure in Statement of Financial Position
Statement of Financial Position is prepared to disclose full financial position by
providing information about assets, liabilities, equities. AAOIFI classified assets,
liabilities and equities to present with adding essential Islamic values to its users.
These disclosures represent sector-wise investments of the banks which ensure
banks’ profit orientation than interest.
5. Disclosure in Income Statement
Income statement required in AAOIFI Financial Accounting Standard No. 1
represents the profit or loss with source of income and nature of expenses. From
this statement user can identify the level of Halal or Haram because all revenue
and expenses are disclosed with the nature and source.
6. Disclosure in Statement of cash flows
Cash flows statement discloses the cash inflows and outflows. According to
AAOIFI guidelines on General Presentation and Disclosure in the Financial
Statements, cash flows should be disclosing activity group wise and also disclose
those transactions which do not result in cash to inform about banks
involvement activities.
7. Disclosure in Statement of Changes in Owner’s Equity

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The purpose of Statement of Changes in Owner’s Equity to disclose the equity,
distribution against equity, retained earnings etc. to inform the level of owners’
equity.

8. Non-compliance Classes
None of these Islamic banks complied with disclosure requirements
in Statement of changes in restricted investments, statement of sources and uses
of funds in the Zakah and charity fund, statement of sources and uses of funds in
the Qard fund, treatment of changes in accounting policies, treatment of changes
in non-routine accounting estimates.
9. Formats of Financial Statements
AAOIFI suggested some formats as guideline for preparing financial statements
to disclose general information of Islamic banks activities and position. These
formats disclose all information with Islamic rules.
10. Notes to the Financial Statements
Notes to the financial statements are required to enrich the financial statements.
Notes mean detail of those which are shortly presented in the statements. Notes
serve sufficient information to the users of the statements.
11. Total General Disclosure
General disclosure in financial statements required in AAOIFI Financial
Accounting Standard No. 1 provides guideline to Islamic banks for disclosing
their general information to the users. Total 203 items of general disclosure
in financial statements required in AAOIFI considered for the study. These items
can reflect the total scenario of the bank including its financial position, income
and expenses and transaction acceptability in Islam.

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