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CHAPTER 5: THE NEED FOR ISLAMIC ACCOUNTING: PULL FACTORS 2- THE ESTABLISHMENT OF ISLAMIC ORGANISATIONS
In the previous chapter, the researcher attempted to argue the need for an alternative Islamic Accounting in the form of pull factors; those factors that motivate the development of Islamic accounting. The first category of Pull Factors, the theoretical imperative of Islamisation of Accounting, was discussed in the previous chapter. In this chapter, the second category of Pull Factors, the practical imperative, will be discussed. The practical imperative or necessity for the development of an alternative “Islamic Accounting” is the establishment of Islamic business and not for profit organisations which are specifically based on the Shari’ah or controlled by Muslims who may wish to follow its precepts. These socio-economic organisations are part of the Islamic economic and financial system, which is based on the Islamic world-view. The researcher believes that the objectives, operations and practical accounting requirements of these organisations need an alternative “accounting” framework in order for their objectives to be achieved, their operations to run smoothly and their activities accounted in a true and fair manner within the world-view in which they operate. This chapter is organised as follows: In section 5.1, the principles and objectives of the Islamic economic and financial system will be presented. As the prohibition of interest (riba) “is one of the key elements of the Islamic Economic programme” (Ahmad,1994a, p5), the definition of riba, some possible reasons for its prohibition and the controversies surrounding its definition are discussed.
In section 5.2, the main types of Islamic business and non-business organisations, which attempt to operationalise the Islamic economic order, will be introduced. This will include a discussion of their objectives, functions, history of establishment and accounting implications. Due to the extensive scope of Islamic organisations, it is difficult to cover all of them in detail in this research, as such only a brief sketch is presented. Although this research attempts to argue the need for Islamic Accounting in for both business and non-business Islamic and Muslim organisations, The researcher feels that describing the accounting needs of many types of Islamic organisations in detail will be too broad for this research project. As such, the researcher has opted to concentrate on one industry i.e. the Islamic Finance industry where there has been intense development. The Islamic banking and financial institutions constituting this industry, are examples of Islamic business organisations, which have established themselves in the real world. Consequently, in section 5.3, Islamic banks and financial institutions will be discussed in some detail. This will include taxonomy of Islamic financial institutions, their history, characteristics, differences with conventional banks and their modes of operation. The Investment of funds mobilised by Islamic banks present both operational and accounting problems for Islamic banks as they cannot be invested on the basis of a predetermined fixed return on capital. The complexities of investing through an equity-like mode are full of agency, monitoring, accounting classification and income recognition problems. In order to appreciate these problems, a detailed description of the Islamic financing instruments is presented in section 5.4. In section 5.5, the accounting problems of banks, as an example of the problems of attempting to apply conventional accounting to Islamic organisations will be discussed. This will include the problem of using conventional accounting concepts and the attempt to introduce standards for the accounts of Islamic banks.
This chapter concludes with section 6.6 that will discuss the possible benefits an Islamic accounting system for Islamic Banks would produce. Although the Islamic banking and its problems are discussed in length in this chapter, the research does not concern itself with Islamic Banking or even Accounting for Islamic banks. Rather, the discussion is intended as an example of problems faced by Islamic organisations in using conventional accounting and the need for an alternative accounting system.
5.1 THE ISLAMIC ECONOMIC AND FINANCIAL SYSTEM AND THE PROBLEM OF RIBA.
Unlike, other economic systems, the Islamic economic system aims to achieve social justice from a religious ethical perspective. Although the Western economic systems be they capitalist, socialist or welfare state, aim to achieve human welfare, they all seem to have accepted interest as a fair reward for capital, although interest has been condemned by Marx and even Fisher. The Islamic economic system is based on its complete elimination from the economy by introducing the alternative of participative investment as opposed to a rentier economy. The capitalist system strives to attain human welfare through the operation of the invisible hand driven by self-interest and a free market. The Marxist system attempted to create social welfare by ownership and centralisation of the production function by the state (representing the workers). However, all these systems have been ‘unsuccessful’ in achieving social welfare for all (Chapra, 1992). Although it is a fact that there is no complete Islamic economic system in operation, the unique characteristics and features of the Islamic economic system are worth discussing and modeling for future implementation especially in Islamic countries. However, practical implementation of the Islamic banking system, which is a partial implementation of the Islamic economic system, has overtaken academic discussion. Hence there is an urgent need to come up with both practical devices and theoretical models, which can be, tested in future practice.
This section proceeds as follows; the objectives and characteristics of the Islamic economic system are described first. In the following sub-sections riba is discussed in detail including its definition, classification, reasons for its prohibition and controversies surrounding its definition.
5.1.1 The objectives and characteristics of the Islamic Economic System
Ahmad (1994a) observes that the Islamic economic program includes a different concept of the individual and his rights, a different concept of property and a different approach to civil and economic contracts. Its principles of economic organisation are also different including; how and on what basis co-operation and collaboration between individual and society is to take place, the need for regulating the market to attain efficiency and equity, and the role of the state in the fiscal system. Al-Faisal & Ali (1996) sum up the principal characteristics of the Islamic Economic System as follows: • Although every individual has a right to seek his economic well being, Islamic makes a clear distinction between what is lawful and what is unlawful in the pursuit of economic activity. Broadly, Islam forbids all forms of economic activities, which are morally or socially injurious. The particulars as to what is considered morally or socially injurious vary from the secular capitalistic system. • Although Islam recognises, the ownership of legitimately acquired wealth, the individual is obligated to spend his wealth judiciously and not to hoard it, keep it idle or squander it. • Although an individual may retain surplus wealth, Islam seeks to reduce the margin of this surplus for the well being of the community as a whole. • It seeks to prevent the accumulation of this wealth in a few hands to the detriment of the society as a whole through its law of inheritance
It aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually selfdestructive.
Chapra (1992) observes that in line with the Islamic concept of brotherhood and justice, all resources at the disposal of human beings must be utilised to actualise the objectives of the Shari’ah. He suggests four objectives of the Islamic economic system: a) Need fulfilment: the basic needs of all individuals must be satisfied and everyone must be assured of a humane and respectable standard of living. b) Respectable Source of Earnings: The dignity attached to man’s status, as God’s khalifah or representative means that need fulfillment should be through the individual’s effort. In the case of handicap or inability to earn a living, it is the collective obligation of the Muslim community to fulfil their needs through Islamic socioeconomic institutions such as Zakat, and charitable endowments- awqaf. Except for Zakat, which is administered by the state, the other institutions are voluntary but form part and parcel of the Islamic economic ethic. c) Equitable distribution of income and wealth: Although inequalities in income and wealth can be tolerated in proportion to skill, initiative, effort and risk, skewed inequalities are incompatible with Islamic teachings. The elimination of interest, the introduction of Zakat and change in consumer behaviour patterns to one conforming to Islamic guidelines are essential to achieve this. d) Growth and Stability: Growth and stability are essential to maintain employment and to ensure the goal of equitable wealth distribution as the poor can reap the fruits of economic growth thus lessening the burden of the rich to redistribute their wealth. Chapra (1992) proposes the following strategy to achieve the objectives: a) Introducing a socially agreed filter mechanism: In addition to the price mechanism, a double layer of moral filters tempers claims on resources.
Individually, Islamic consumers should avoid wasteful expenditures because of legal/moral precepts of the Shari’ah. In addition the Islamic financial system also acts as moral filters in their investing and credit expansion activities. b) A strong motivating system to induce the individual to render his best in his own interest as well as in the interest of society. This comes from the Islamic concept of accountability to Allah, from whom no actions can be hidden, and to whom every action has to be accounted for in the life after death. c) Restructuring the entire economy to realise the Shari’ah objectives in spite of scarce resources. This is to be done by reforming all social, economic and political institutions including public finances and financial intermediation to minimise wasteful and unnecessary consumption and to promote investment for need fulfillment. The Islamic structures will also support the filter and motivating system by not allowing material possessions and conspicuous consumption to become a source of prestige, thus killing off the economic man. d) A positive and goal-oriented role for the government. The government would support the raising of the moral consciousness of people, motivate and help the private sector play its role effectively and accelerate political, social and economic reform and provide incentives and facilities. Ahmad (1994a) observes that, although the elimination of interest is not the be-all and end all of Islamic economic programme, it is one of its key elements. It can thus be seen that reforming the banking and monetary system to eliminate interest transactions and putting them on an Islamic plane is one of the cornerstones of the Islamic financial system. The Islamic financial system is part of the Islamic socioeconomic system which Muslim economists and Islamists are endeavouring to develop. The development of an interest-free, ethical Islamic economic system is an important agenda of most Islamic movements and some governments such as Pakistan, Iran and Sudan (Ahmad, 1994a). Other countries, such as Malaysia and Gulf countries, allow Islamic
economic institutions such as Islamic banks to operate in parallel with the conventional financial system. Social Justice is said to be the hallmark of the Islamic economic system (Ahmed et al., 1996). In order to achieve this Islamic economy, two institutional devices “the abolition of interest and presence of a well-functioning Zakat system (p3)” are considered essential. As the Islamic financial system relies mostly on the former, this aspect will be discussed in some detail. The researcher will firstly discuss the definition, the nature and classification of riba (interest), followed by a discussion on the possible reasons for its prohibition in Islam. This is then followed by a review of the controversies surrounding the nature and application of riba in modern business life.
5.1.2 Definition and classification of Riba
The Qur’an and the Hadith of the Prophet (pbuh) specifically prohibits riba in economic transactions in the sternest terms (e.g. Al-Qur’an, 2:275,278,279). ‘Riba has been translated into English as usury or interest. However, it has in fact a much broader meaning under the Shari’ah as suggested by its dictionary meaning of “increase” or “gain”. Saleh (1992) has defined riba in the Shari’ah context as “an unlawful gain derived from the quantitative inequality of the counter-values in any transaction purporting to effect the exchange of two or more species, which belong to the same genus and are governed by the same efficient cause” (p16). Thankfully, the author has adopted a shortened version of this rather long technical definition as “an unlawful advantage by way of excess or deferment” (p17). Riba has been classified into two categories: riba al-fadl and riba al-nasi’a (Muslehuddin, 1987). Riba al-fadl is riba by way of excess of one of the exchanged counter-values e.g. the exchange of 2 Kg. of low quality rice for 1 Kg. of high quality rice. Riba al-nasi’a is excess by way of deferment of completion of exchange, for
example a loan of £100 for a deferred repayment of £110 a year later. As Islamic
banking involves the elimination of Riba al-nasi’a, further discussion on riba will be limited to this form only.
5.1.3 Reasons for the prohibition of Riba
We can thus surmise that any interest or excess above the principal sum in a deferred repayment transaction is riba. The reason given in the Qur’an for the prohibition of riba is that, a pre-determined fixed rate of return on capital lent leads to injustice because there is an uneven distribution of risk and reward in the transaction (Obiyathulla, 1995). One party bears the risk, while the other party receives a reward irrespective of the outcome of the use of the borrowed amount. Riba is also said to lead to the concentration of wealth by transferring wealth from the poor to the rich, a position not unreasonable given the current distribution of wealth and third world debt crisis (Caufield, 1998). It is also said to increase the instability of the trade cycle, causing more violent fluctuations because a high rate of interest, by increasing the cost of capital, discourages investments (Keen, 1997). An IMF economist observes that Islamic banking, based on the elimination of riba will to lead to a more stable banking system, thus:
“The Islamic model of banking based on the principle of equity participation may well prove to be better suited to adjusting to shocks that result in banking crisis and disruption on the payment mechanism of the country. In an equity-based system that ...does not guarantee the nominal value of deposits, shocks to asset positions are immediately absorbed by changes in the values of the share deposits held by the public in the banks. Therefore, the real value of assets and liabilities of banks in such a system will be equal at all points in time. In the more traditional banking system since the nominal value of deposits is fixed, such shocks can cause a diversion between real assets and liabilities”. (Mohsin, 1986, p19)
5.1.4 Controversies on the prohibition of Riba
In the light of modern financial practices, the elimination of interest would seem to be an unworkable plan. In fact, the elimination of interest has been thought to be irrational and a sign of a backward economy. Although usury i.e. excessive rates of interest, especially on consumption loans are regarded by some in the West as immoral, commercial interest is seen as a legitimate reward for the use of capital in
modern economies. It is justified as reward for the “time value of money”. Indeed, some modern Muslim economists (in the early part of this century) and even some Islamic scholars have tried to restrict the definition of riba to usury and thus legitimise the institution of interest among Muslims. Among the arguments offered in favour of legitimising interest are: (a) Riba is only usury and not interest (b) Riba is compound interest and not simple interest (c) Only interest on consumption loans is prohibited, not on investment loans. (d) Islam recognises the time value of money and therefore interest should be allowed. (e) Bank interest is not prohibited because it is not exploitative. The first controversy as to whether riba is limited to usury begs the question as to what is the upper limit of the interest rate which is justified and what rate does illegitimate usury begins. Prior to 1571 in England, at least, all rates of interest above zero were considered usurious following the edict of St. Thomas Aquinas (Keen, 1997). Of course, a legal solution could be offered but the historical evidence shows, at different times, different rates were considered usurious. For example, the Sumerians considered 25% interest rate normal while the 1571 Act against Usury of England indicated that anything more than 10% was usurious. Although in a secular framework, the rate of usury may be a matter of individual conscience or to parliamentary consensus, this does not provide the specific technical, moral or any other reason why the rate below the benchmark is justified and that above is not. (Shaikh, 1987). The second controversy asserting that riba is only compound interest is based on one interpretation of the Quranic verse: “ O you who believe, do not devour riba, doubling and redoubling” (Al- Qur’an, 3:130). However, Islamic rules of interpretation state that the whole Qur’an (together with the Hadith) must be considered in interpreting any verse. Verses 275 to 279 of the second chapter of the Qur’an leave
no doubt regarding what is meant as they clearly state that only the principal lent is the amount the borrower is obligated to return. Further, as Hoque (1987) observes, the distinction between compound and simple interest is apparent and not real as an overdue interest on simple interest becomes compounded. As the compulsory notification of the APR (Average percentage rate) in the UK shows that a compound interest rate can also be expressed in terms of a simple interest rate. In fact, it is just a matter of time before the interest doubles and triples the principal amount. Thus, this sophistry is not enough to deny the prohibition of riba. The secular reasoning that, interest is only injurious, if at all, in consumption loans and not in the case of commercial or investment loans as is the case in commercial bank lending, is not acceptable from an Islamic point of view. This is due to the fact, that at the time of prohibition, Arabia was a major commercial centre of the Indian – Mediterranean trade route (Chaudhuri, 1985). In fact many of the Companions of the Prophet (pbuh) received loans on an interest basis (before the Qur’anic prohibition) to invest in their trades. The Prophet (pbuh) specifically banned such interest-based loans after the Qur’anic prohibition was revealed, retrospectively. The Qur’an states that “Allah has permitted trade and prohibited riba”, in spite of the protests of the Arabs that “Trade is like riba” (Al-Qur’an, 2:275), Islam is quite clear on this. Further Islam has not prohibited other avenues of lawful employment of capital to generate income in the form of rent, labour-capital participation, joint venture and mark-up trading. Chapra (1985) quoting Shaykh Abu Zahrah, an eminent Muslim scholar, observes that:
“There is absolutely no evidence to support the contention that the riba (prohibition)...was on consumption loans and not on development loans. In fact the loans for which a research scholar finds support in history are production loans. The circumstances of the Arabs, the position of Makkah and the trade of the Quraysh (the tribe of the Prophet (pbuh)), all lend support to the assertion that the loans were for production and not consumption purposes”. (Chapra , 1985, p 62)
One might protest that despite the historical basis on which the prohibition was based, the ruling is irrational in view of the fact the loans provide for development or
investment accrue profits and it would be unreasonable for the lender not to share in it. The answer to this is that Islam does not bar the association of capital and entrepreneurship. However, it prohibits interest-based loans because the
predetermined fixed return to the lender is irrespective of the fortunes of the entrepreneur. If the investor agrees to share any eventual loss, he can contract for a share of the actual profit earned by the entrepreneur. Whether Islam recognises the time value of money is more controversial. In the case of the Islamically allowable murabaha or mark-up contracts, in which a supplier contracts with a buyer to acquire a product and sell it to the buyer at a mark up on cost, the price can be deferred or paid on an instalment basis. By allowing, the extra charge for delayed payment - Islam appears to recognise the time value of money by recognising the opportunity cost foregone by the entrepreneur who might have otherwise have his capital tied up – a subtle distinction from the charging of interest (Vogel & Hayes, 1998). On the other hand, Khan (1994a) is of the opinion that discounting violates the Shari’ah prohibition of interest. Khan (1994a) observes that only in the case of the poor people is it true that the current utility of money is greater than the future utility. He opines that every cent saved testifies to the fact that savers have a preference for the future utility of the money rather than current. Hence there is no need to discount future inflows. Tomkins & Karim (1987), however, observe that the objection to the use of interest rate for discounting can easily be avoided by using an expected return rate as a hurdle rate. Hence using discounting techniques is not a problem in capital budgeting and valuing assets. Finally, many scholars argue that the modern banking institution was not present at the time of the Prophet (pbuh). As it performs vital functions of financial intermediation in the modern economy and is not exploitative, bank interest should not come under the gambit of the riba prohibition. Some court ulemas especially those from the Egyptian government have in fact given legal opinions (fatawas) to
this effect. However, the majority of the Islamic scholars view that bank interest is no exception because the bank in fact represents a group of individuals (the shareholders) who are in the money-lending business. Since the riba prohibition equally applies to individuals as well as groups, banks are not exempted (Hoque, 1987). Despite this, however, the same author observes that it is a fallacy to view the whole conventional banking process itself to be UnIslamic. A close look at the
function of banks in channeling savings to productive enterprises is actually facilitating the realisation of the objectives of the Shari’ah, which abhors and penalises idle savings. Only the interest mechanism used to achieve this objective is objectionable. Hence if interest is replaced by any permissible mechanics and the bank limits its activities to financing businesses approved by the Shari’ah banking becomes an important Islamic institution (Hoque, 1987). Finally the recent Federal Shari’ah Court of Pakistan’s judgement on Riba1 (Khan, 1994b) should put to rest any lingering suspicions on the nature of riba. Contrary to a normal process of interpretation of a constitution2, the Court sent out a questionnaire and collected evidence and cited various works of both Muslim and Non-Muslim scholars to discern the nature of riba. It concluded “ a transaction which contains excess or addition over and above the principal amount of loan, payable to the creditor constitutes riba “(p13). Therefore, any such sale, transaction or credit
facility, in money or in kind, has been considered to be of riba, which is unlawful (haram) in Muslim society. Khan (1994b) observes that the court held that there was a consensus of the opinion (ijma’) of Muslim jurists upon it. Further, it did not make a difference whether the loan is for consumption or for commercial purpose, if the rate of interest is high or low, simple or compound or between Muslim and Non-Muslim or between an individual and the state.
This ruling was appealed by the Government of Pakistan whose Appeals Court has just turned down the appeal in December 1999, and has given the Pakistan government until year to rid the economic system of riba consistent with the constitution of the Islamic Republic of Pakistan. 2 The litigant filed a case against the Pakistan’s government use of conventional interest based financing as against its constitution.
While debate might continue forever on this issue in academic circles, the matter is quite clear to Muslims that conventional interest is not acceptable from an Islamic perspective. Thus, they have no option, if they want to abide by Qur’anic principles, except to overhaul the conventional financial and banking system to an interest-free footing.
5.2 ISLAMIC ORGANISATIONS
As part of the Islamic resurgence, Muslims have set up Islamic business and nonbusiness organisations which attempt to operationalise the Shari’ah in their economic and governmental affairs (El-Ashker, 1987). In the heydays of Islamic civilisation, there were unique socio-economic Islamic Institutions, which were replaced, by foreign economic institutions, after the colonisation of Muslim lands. The two most important institutions, which will be discussed in this research, were the “Baitul-Mal” (public treasury)- which collected and disbursed Zakat – the Islamic religious levy and the Awqaf (Muslim endowment). In the private sector, businesses were
conducted for the most part, according to Islamic precepts despite the claims of Rodinson (1974) that this was more in letter rather than in spirit. attempting to revive these institutions and adapt them to Muslims are contemporary
circumstances as part of the Islamic resurgence in the Muslim countries (Sivan, 1985). In the business sector, although the concept of the modern corporation was unknown, Islamic law and Muslim business practice knew the concept of separate legal person and joint stock partnership (Usmani, 1998). Muslims undertook joint ventures, especially commenda (mudharabah) and partnerships, which were based on risk-taking profit and loss sharing ventures (Udovitch, 1970). As interest was prohibited, interest bearing bonds were unknown but interest bearing commercial loans and government loans did take place, sometime in the guise of “mark-up” or buy and resell sales contracts allowed in Islam (Rodinson, 1974). Some Muslim
governments, especially the late Ottoman Sultans took interest-bearing loans from Western countries, which eventually led to the downfall of the Caliphate. There were even instances of Mosque funds lent out at interest, which was prohibited under Muslim Law. However, these were always frowned at by Islamic scholars and Muslims and never accepted as legal by the majority of Muslims. Although the use of trade bills and cheques were known in Islamic History, modern banking was a Western Introduction in Muslim lands which took root after colonisation. Despite being encouraged by the governments of Muslim countries, the Muslim masses harboured much suspicion of the allowability of interest charged or given on deposits by these banks. Many strict Muslims refused to deposit their money and preferred to keep it in their homes. Others used the banks as a safedeposit service and would not take the interest credited to their accounts or gave them away to charity. To solve this problem and give Muslims a Shari’ah friendly alternative to conventional banking, Islamic banking was born and has since become established as a viable alternative, although there are many strategic, operational, regulatory and accounting problems faced by these banks (Al-Faisal & Ali, 1996). In addition to the banks, Islamic finance co-operatives and savings institutions which invest the believers’ money in Shari’ah approved and ethically correct ways have been set up. The Lembaga Tabung Haji of Malaysia, established in 1962 is an example of one such successful institution, which had assets totalling 5.2billion Malaysian Ringgit (around US $2billion) in 1997. Another financial institution, which presented problems for Muslims, is the conventional insurance company. The Shar’iah prohibits conventional insurance because of its connections with interest, gambling and gharar (uncertainty). In general, a contingent insurance contract is prohibited in Islam. To overcome this problem, Islamic Insurance companies (known as Takaful) have been developed, where the contributors share in a savings scheme including a compulsory
contribution to a claims pool. The Takaful Company then tries to compensate any claimant from the amount of his contribution plus earnings. Any shortfall of the indemnified amount comes from the claims pool if available. Of course, the policy premiums are invested in interest-free, Shari’ah approved investments. As discussed in chapter 2, the world-view of Islam and therefore Islamic organisations, whether in the public, private or voluntary sector, are different from those of conventional business and non-business organisations. The difference arises in the objectives, nature of profits, the activity or industry Muslims can undertake or invest and in the way the wealth is distributed. The charging and earning of interest, gambling, alcohol and other industries and aleatory contracts are prohibited. Further the maximising of profits or wealth as an objective is frowned upon because it conflicts with the ultimate objective of achieving falah (Islamic success/salvation –see chapter 6) in the hereafter. Although unlike Christianity (see Laughlin, 1988; Tawney, 1927), Muslims are not averse to exploiting the resources for material gain, they would have to undertake this in ways which is in accord with the Shari’ah. There is a need to differentiate between Islamic and Muslim organisations. In case of businesses, the researcher defines Islamic business organisations as those which have been set up specifically to operate within the Shari’ah as part of the strategy to develop a comprehensive Islamic Economic and Financial system. Their philosophy must be Islamic and not merely meant as a cover to introduce interest through the backdoor. On the other hand, Muslim business organisations are businesses set up by Muslims who may or may not follow the Shari’ah. However, Muslim businesses, especially small and medium-scale ones may intend to gradually shift towards an Islamic business profile in their activities. Islamic accounting is needed by both types of organisations – mandatory for the former and helpful for the latter to achieve their Islamic ambitions.
Chapter 5 5.2.1 Islamic businesses
Islam not only allows, but encourages trade and business. Business can be organised either as sole proprietorship, partnership and companies as in common law. Although the concept of limited liability has been frowned upon (Usmani, 1998), the company form of organisation is lawful in Islam with certain restrictions. These include the type of capital, which can be raised, the type of investments, which can be carried out, and the way profit and loss is shared. Although sole proprietorships, partnerships and joint ventures have been the most common forms of businesses in the Muslim world (El-Ashker, 1987), the company form of business organisation is increasingly used in the Muslim world both by private and public companies.
18.104.22.168 Forms of Business Organisation
The common law varieties of business organisations (sole proprietorship, the partnership and the company) are permitted in Islam. The liabilities, obligations and the rewards of ownership are pretty much the same for sole proprietorship except that the owner is not allowed to conduct business in forbidden products or services such as selling pork, liquor, gambling or interest-based money lending. The distinction between partnership and companies in not clear in Islamic law because the modern corporation was never found in Muslim countries before the adoption of European law in Muslim lands. However, the Muslim partnership law is quite comprehensive to allow for the formation of joint stock companies, the formation of which is said to be encouraged by the Prophet (pbuh) himself (Atiyah, 1992).
22.214.171.124 Objectives and operations of Islamic Organisations.
The objective of Islamic business organisations is to enable Muslims to undertake economic activities within the framework of the Shari’ah as a means to attain falah
(success in the hereafter). This means that the businesses must follow a code of Islamic ethics in relation to their activities and behaviour towards their stakeholders (Beekun, 1997). Conventional business organisations follow a profit or wealth maximisation model. This is the based on the concept of the utility maximising behaviour of conventional rational economic man. Although profit is deemed legitimate and is one of the major objectives of Islamic businesses, profit maximisation, as a prime objective is not identified in the Islamic model (El-Ashker, 1987). Even though capitalist businesses seem to be moving to wealth maximising and satisficing, the concept of maximisation is entrenched in the accounting calculus e.g. when investment appraisals are carried out. In Islam, wealth is only considered as a means to an end. As in other religions, the Muslim scholars, for example Al-Ghazali (Al-Karim, 1995), have warned their followers of the dangers of greed for wealth. Thus maximising wealth is not a priority of the Muslim. On the other hand, the economic strength of a nation or group has direct implications for political and social stability. Hence, Islam encourages the pursuance of wealth in an ethical manner. In line with this, the objective of Islamic business organisations is therefore to seek reasonable profits in line with the risk taken and any particular social consequences of high pricing policy. Survival and growth are also emphasised as important objectives in hostile environments where Islamic businesses have to compete with conventional ones. Islamic businesses have to take into account the benefits accruing to employees, society and the environment, in addition to fund providers as a matter of religious/moral obligation emanating from their Islamic beliefs. El-Ashker’s (1987) study of Islamic business enterprises in Egypt provides some evidence that Islamic businesses aim to achieve three sets of objectives related to the benefits accruing to finance providers, employees and society. He proposes a utility model for Islamic economics, consisting of secular and ritual utilities. The secular utility is the normal
conventional utility consisting of profits and financial benefits whereas the ritual utility relates to employee and non-profit oriented social objectives intending to please God and to achieve falah. Achieving profits within this constraint is said to please God and leads to a higher divine reward and hence is a source of utility for Islamic businesses. The Islamic business aims to achieve a balanced relationship between the three sets of objectives of the three interested parties in the course of maximising its utility. Thus: Maximise U = Ua(R), Ub [UaR, E, S], F(P) Subject to Y= R+E+S, where: U= Utility function Ua = secular utility function Ub = ritual utility function R=Profit E = cost of employment welfare (wages and the like) S = social cost (costs of social welfare) P = degree of piety Y = net value of production. Since Islamic and Muslim businesses vary in the degree of commitment to Islam, the degree of piety (P) is introduced into the equation to account for this. Thus for different organisations with different degrees of piety, the equilibrium point, E, S, and R will be achieved will be different. The researcher proposes that an additional environmental cost (N) be added to the equation. Hence Y= E+S+N+R and Ub [UaR, E,S,N], hence Islamic businesses will maximise its utility and will be in equilibrium when a proper mix depending on the degree of piety is achieved. While all this might seem theoretical and not practical, the study by El-Ashker (1987) using actual case studies of Islamic companies in Egypt indicates that this is what is done in practice by Islamic companies with a high degree of P.
126.96.36.199 Accounting implications
Both the structure and objectives of Islamic business organisations make the development of an alternative Islamic accounting an imperative. For example, debentures, bonds and even preference shares are not allowable in an Islamic
company. This is because of fixed interest bearing characteristics of the former and profit sharing arrangements of the latter which are considered inequitable according to the Shari’ah. New type of financial instruments such as mudharabah and muqarada bonds (Rosly & Sanusi, 1999), are needed to finance Islamic companies and used as investment instruments by Islamic banks. These instruments are hybrid instruments containing both the characteristics of debt and equity 1995) which call for special accounting treatment. (Obiyathullah,
This is not only a matter of
different technique but also a matter of change in the fundamental accounting assumption of substance over form, which underlies conventional accounting standards, e.g. IAS 1 (IASC, 1975) which may not be acceptable from an Islamic point of view. Further, the objective of Islamic businesses which have to balance the shareholder, employee, society and environmental interests poses serious questions on the adoption of the profit calculus (the bottom line) as the main area of concentration of conventional accounting. It cannot be denied that the importance of the bottom line
is exacerbated by the prominence given to the profit and loss account as the primal financial statement in a set of conventional accounts. This has implications for the behaviour of stakeholders as accounting can itself lead to the construction of a social reality (Hines, 1988) not in line with the Islamic aspirations. To balance these nonshareholder considerations, an Islamic accounting statement might have to consider an alternative scoring system other than the financial unit.
5.2.2 Zakat collection and distribution
Zakat is one of the five ‘pillars’ of Islam. Literally, it means to purify one’s wealth. Zakat is a “religious levy by which Muslims make over part of their wealth for the benefit of others” (Clarke et al., 1996). It is neither a tax nor a charitable donation. A tax may be expended for any purpose while Zakat can only be paid to eight categories of beneficiaries specified in the Qur’an. Further, as opposed to a
charitable donation, it is compulsory.
Zakat is a wealth based levy although
contemporary Islamic scholars insist that Zakat should also be payable on salaries and wages. Zakat has been levied on animals, trading profit, and agricultural produce and gold and silver and money equivalents. Scholars have extended the category of zakatable items. The rate of wealth Zakat is 2.5% but agricultural produce is subject to 5% or 10% depending on the use or non- use of irrigation respectively. The collection and disbursement of Zakat has been traditionally carried out by the Islamic State, since the time of the Prophet (pbuh) (Zaman, 1991). The Prophet (pbuh) used to appoint Zakat collectors to assess and collect Zakat from his followers. This was deposited into the Baitul Mal or the public treasury. Zakat was collected and disbursed both in cash and in kind. The Islamic State continued to perform this function until colonisation resulted in the introduction of alternative tax systems. However, Zakat continued to be paid individually, through charitable
associations (as in the UK) or through the religious departments of government as in Malaysia. As part of the Islamisation of the economy, some Muslim countries have started organising their Zakat collection and distribution activities more efficiently. In Pakistan, Zakat is now deducted at source e.g. on investment deposits in banks. In Malaysia, Zakat collection is carried out by religious departments, which come under the jurisdiction of the various states. Mustapha (1991) observed that Zakat collection and administration is inefficient as for example, the administrative cost is twice the pay-out to the destitute group of beneficiaries. There have also been accusations of mismanagement and maladministration by the head of states that are ultimately responsible for it (AbdulRahim & Goddard, 1998). There have been calls in Malaysia for the proper organisation and administration of the Zakat. The Malaysian government has proposed the establishment of an agency on a national level for the
administration of Zakat3. As a preliminary step, privatised Zakat collection agencies has been established in the Federal Territory and Selangor, the two states with the largest earning population. Zakat collection has increased considerably due to the promotional activities of these agencies. Payment of individual Zakat is also given income tax rebate. However the authority and accountability structure of these organisations are far from satisfactory. Once the Zakat is collected it is handed over to the religious department and is only subject to the Auditor General’s inspection. The working of the bureaucracy in the distribution of Zakat is not transparent. Further the “accounts” published by the collection agencies is dismal as the amount collected is just categorised into the eight beneficiaries as disbursement. Hence what is shown as disbursements is not actually paid out in fact but theoretical. An interpretive study of accounting in two religious departments in Malaysia shows lack of transparency and power conflicts to varying degrees (Abdul Rahim & Goddard, 1998). There is more professionalism and transparency to a certain level in the department situated in the more urban Federal Territory where conventionally qualified accounting personnel carry out conventional computerised accounting. In the other department located in a more rural area, there was a general lack of transparency and the researchers reported misuse of power. However, while the departments using qualified accountants showed more transparency, the introduction of a conventional accounting system has resulted in a profit-oriented thinking which has resulted in the adoption of new marketing techniques to collect Zakat. For example, the Pusat Pembayaran Zakat (Zakat collection centre) is a privatised profitoriented entity who are remunerated on a percentage of the collections. Although, they do not have the power to collect Zakat by legal force, such a measure may have grave societal implications when Zakat becomes legally compulsory as the profitmotive in increasing Zakat collection may lead to arbitrary practices. Hence, there is
In January 2000, the Malaysian Government informed the public that Zakat will be collected on a PAYE basis through the Department of Inland Revenue.
a need to develop an appropriate Islamic accounting system, which will induce the proper Islamically accountable behaviour instead of introducing modern methods and conventional accounting, which may lead to inappropriate behaviour.
The waqf (pl. Awqaf) is one of the Islamic institutional devices to foster voluntary spending for the poor as well as to meet several other social causes (Ziauddin, 1991). It is the setting aside of certain assets usually land, buildings etc. for the exclusive use for specific charitable/religious purposes under a legal deed. The
asset so established becomes a waqf in perpetuity, and cannot be sold, inherited or expropriated by the government. Only the income form the asset is disbursed
according to the wishes of the waqif - the person setting up the waqf. The waqf thus becomes a trust property, which is administered by one or more trustee who can claim reasonable administrative expenses and salary. According to Ziauddin (1991), “Waqf is thus a device for transferring private property to collective ownership (not public ownership) for socially beneficial purposes” (p 43). Awqaf are said to date from the time of the Prophet (pbuh) but acquired clearer legal status under Islamic law in the first century A.H. Although the legal concept is similar to trusts and endowments under common law, it is said to predate the English Institution of Trust. Thus as (Hasanuddin, 1998) observes, “there is no evidence that such a complex system of appropriating usufruct as a life-interest to varying and successive classes of beneficiaries existed prior to Islam”(p29). However, as opposed to English Law which only recognises trusts in favour of other than the trustor and family as charitable, Islamic law recognises awqaf even if its is for the trustor’s own or his family’s benefit but with eventual succession to charitable purposes. The former type of waqf is known as waqf ahli (family endowment)
whereas awqaf specifically meant for charitable purposes from the outset is known as waqf khairi (endowment for general good). On the surface, it seems the former type of waqf would not be practicable as it entails a lapse from the time such assets
are endowed and the time it s available for public use. It would be an uphill task for the authorities or community to keep track of the asset. However, Hoexter (1998) observes that “contrary to what one might have thought, many of the assets did eventually find their way to their ultimate beneficiary”(p10). In any case, both types of awqaf have been and are very important socio-economic institutions in the Islamic world. Awqaf has been set up for various purposes e.g. the upkeep of mosques, religious schools, orphanages, hospitals, animal care centres, parks, rest-rooms, drinking water facilities and food distribution centres
(Siddiqi,1996). In many cases, awqaf are set up to feed the poor in other countries especially those of the Haramain (the Holy Lands of Islam: Makkah and Medina). Hoexter (1998) has undertaken an extensive study of the development of this institution, the waqf al-Haramain in Algiers (Tunisia) during Ottomon rule, from its own records. The Algerian, Waqf Al-Haramain was in fact a foundation, which managed all the individual awqaf assets dedicated to feeding the poor in the Holy Cities of Mecca and Medina (Hoexter, 1998). Later it took other awqaf into its ambit including those of other local mosques, feeding the local poor and contributing to local public projects such as the town’s water system. The local Qadis or Muslim judges were active in the development of the Islamic jurisprudence of Awqaf to adapt its principles for the needs of the times and locality. On the whole, the Haramain foundation was equitably and efficiently administered – a quality, which is not found these days e.g. in the Awqafs of India (Siddiqi, 1996; Hasanuddin, 1998). Hoexter (1998) observes that the Haramain became a “most significant vehicle for advancing the interests of the local Islamic community” as well as becoming the focal rallying point in the fostering Algerian-Islamic solidarity. Awqaf became such an important part of Islamic society, that a Ministry of Awqaf was established in 1840 by Ottoman Turkey- a tradition which has continued in many Muslim countries.
Unfortunately, the loss of political and economic power by Muslims resulted in the decay of this institution as shown by the contemporary state of awqaf, which leaves much to be desired. Siddiqi (1996), for instance, observes that “we find increasing state intervention in waqf management owing to a number of causes, the chief one being widespread abuse of powers by waqf supervisors”(p146). Despite this however, the state of affairs is dismal e.g. in India. Hasanuddin (1998) observes:
“But unfortunately, the Waqf institution in India, is most misunderstood and Waqf properties mismanaged. Legislative lacunae, administrative lapses, lack of political will...has given rise to the painful phenomenon that Waqf properties are the chief-attention of the land-grabbers. As against this background, colossal and gigantic Waqf buildings with tremendous commercial potential, are not even receiving the most needed repairs and maintenance, thus converting such attractive buildings into dilapidated structures and there is a general feeling that Waqf property is a cheap commodity available in the commercial market”. (Hasanuddin, 1998, p 23-24)
Despite this however, as the author observes, Awqaf is an important Islamic institution which the Muslims have inherited in the past and “which possesses immense potential for the reconstruction of social and economic life in Muslim countries and communities” (p21). This is shown by the fact that there is estimated to be about 300,000 awqafs in India alone (Haque, 1999). Waqf is also an important wealth re-distributive mechanism of the Islamic economic system. For example, Siddiqi (1996) notes that Waqf takes property out of private ownership and vesting ownership permanently and irrevocably in Allah. With the passage of time, more private property pass into waqf sector but the reverse cannot and does not take place (if the assets are properly accounted for!). Since awqaf are normally made by wealthy people (especially Muslim rulers in the past), it serves to redistribute wealth and mitigate the ill effects of inequality in society and counter-act the tendency to concentrate wealth. It is thus essential, that an appropriate accounting and auditing system be developed to ensure this institution is properly administered and accountable to the public to ensure that it serves its function efficiently. As awqaf are not a commercial institution
seeking profits, conventional accounting may not be suitable for them. An Islamic accounting system for awqaf would seek to address the following problems: • • • • • • The tracking of family awqafs until it reaches public status. Activity accounting , both financial and non-financial accounting Accountability of the trustee, and the transparency of operations. Islamic Social audit to ensure the beneficiaries get what is entitled to them. Management audit of income and property. Promoting the establishment of more awqaf.
5.2.4 Islamic Insurance companies
Together with the growth of Islamic banks, Islamic Insurance companies (called Takaful Companies) have sprouted, although not as numerous as Islamic banks. These are usually subsidiaries or associates of Islamic banks or Islamic Finance Groups (e.g. Syarikat Takaful Malaysia – a subsidiary of Bank Islam Malaysia) or conventional Insurance companies which have Islamic subsidiaries e.g. Syarikat MNI Takaful. The establishment of these organisations are due to the fact conventional insurance is prohibited by Islamic Shari’ah (although there are controversies in this area). This is due to the element of gharar or uncertainty in contingent contracts as well the elements of gambling especially in relation to life insurance. In addition, the practice of investing premiums in interest-bearing securities by conventional insurance companies is also problematic (Shamsiah, 1995). Takaful operates as a co-operative savings and mutual help scheme. In the case of Takaful, any contributions (premiums) paid by the participants (i.e. policyholders) are not recorded as income of the takaful company as in conventional insurance. In the case of Family Takaful - the replacement for conventional life insurance, the premiums paid by the contributors are apportioned to a participator’s fund account and a claims pool. The amount apportioned to the claims pool is based on actuarial calculations. The fund is invested in Shari’ah approved investments. Any profits are
shared between the Takaful Company and the contributors in a pre-agreed ratio. Any losses are born by the participants – not by the Takaful Company. Any profits
accruing to the claims pool is credited to it. All actuarial surpluses are credited to the participants. At the end of the policy term, a contributor gets the amount of his contributions plus any share of the profits, if any. He does not get any amount apportioned to the claims pool. If the policyholder dies before maturity of the policy, then any shortfall (the difference from the insured amount and the balance in his account representing his contributions + profit) is met from the claims pool. In the case of General Takaful – the Islamic equivalent of General Insurance, all contributions are credited into a collective claims pool fund. Any profits from the invested funds are credited to this account. After making any required provisions and making any claims payments, the profit, if any, is shared between the participants and the company in the pre-agreed ratio. Any losses are born by the claims pool fund. It can thus be seen that the Takaful concept is quite different from conventional insurance. A conventional insurance company is a risk taker while the takaful company is mainly a manager of funds. While premiums paid to Insurance companies are treated as income, takaful contributions are treated as a separate fund attributable to policyholders. The Takaful Company shares profit arising from investments and any surplus in managing claims. The operational expenses (staff and administration costs) are born by the Takaful Company. Thus three main
stakeholders are accounted for in separate funds; shareholders funds, family takaful fund and general takaful fund, each having its own balance sheet, profit and loss account and cash flow statements. It can be seen that Takaful companies cannot operate under accounting standards meant for conventional insurance companies. There are several technical and philosophical accounting problems to be solved, for example:
Valuation of investment assets; currently follows conventional valuation principles may not acceptable from an Islamic point of view (see chapter 6).
Apportionment of profit share; the cash basis is currently used. This may lead to distortions in profit distributions for all the parties.
The calculation of Zakat on profits; the value to be used and the avoidance of double taxation.
The calculation of actuarial surpluses based on interest-based contingency tables may not be acceptable from a Shari’ah point of view (see Tomkins & Karim, 1987).
In line with the co-operative and participatory nature of Takaful, more qualitative information may need to be disclosed.
There is thus a need to develop an Islamic accounting system, which will deal with the above matters from an Islamic perspective.
5.3 ISLAMIC BANKS AND FINANCIAL INSTITUTIONS: HISTORY, NATURE AND OPERATIONS
Islamic banks are perhaps the most important and developed Islamic organisations in contemporary Islamic society. Assets of Islamic banks are estimated to range from 50 to 100 billion dollars (Pomeranz, 1997). Although the principles on which it is based are not new, the institution itself is an innovation in Islam. An Islamic bank is an ethically based institution which performs conventional banking functions with an important exception, they do not receive interest from their borrowers or pay interest on the customers deposits as this is prohibited under Islamic Shari’ah (Al-Faisal & Ali, 1996). This does not mean Islamic banks are charitable institutions undertaking free lending and borrowing. On the contrary, Islamic banks are businesses, which aim to make profit within the constraints of the Shari’ah, by undertaking profit- sharing projects, trade financing, lease financing and providing fee-based services. Due to the
importance of Islamic banking in the Muslim world, it will be discussed in some detail as an example of an Islamic organisation in practice, which makes the development of an Islamic accounting system a practical imperative. In the next two sub-sections the classification and development of Islamic banks will be discussed to provide some background to the subject. This is followed by a description of the operations and activities of the Islamic bank in section 5.3.3. As the accounting problems of Islamic banks mainly concern the asset side of Islamic banks, the Islamic financial instruments used as alternatives to conventional interest-based lending are discussed in section 5.4. In section 5.5, the accounting problems of Islamic banks are discussed at some length. All Islamic organisations, in the opinion of the researcher, need an alternative Accounting System. However, the accounting problems of the Islamic banks have been considered acute enough to have led to the establishment of an alternative regulatory body for the setting up of Accounting Standards for Islamic Financial Institutions (Pomeranz, 1997). Thus, the detailed discussion of these institutions in this thesis. The chapter is concluded with a discussion of the perceived benefits of an Islamic accounting system for banks and other business organisations.
5.3.1 Classification of Islamic banks
(Ahmed, 1994b) has classified Islamic banks and financial institutions into several different types, as follows: 1. Islamic Special Purpose banks aim to achieve a specific purpose or serve a special class of clientele. This include social banks, agricultural banks, cooperative and Industrial banks. Examples include the Nasser Social Bank in Egypt and Islamic Bank of Western Sudan charged with promoting the development of Western Sudan. 2. Islamic Development Banks aim to foster the process of socio-economic development amongst its members. Its clientele are usually governments
3. Islamic Commercial Banks mainly aim to make profits but still operate within the Islamic ethical system. This class forms the bulk of Islamic banks in operation. 4. Non-banking Islamic financial institutions such as the Pilgrims Fund (LUTH) of Malaysia do not perform banking functions but channel savings to productive investments and pay the depositors a bonus depending on profits.
5.3.2 Development of Islamic banks and financial institutions
It is generally agreed that the first Islamic bank was established at Mit-Ghamr, Egypt in 1963 (Ahmed 1994a; Naggar 1987). Mit-Ghamr is a rural area in Egypt, where the people were mostly religious farmers and artisans. They did not put their savings in the conventional banks because of the Islamic prohibition of interest. The bank operated three types of accounts; the savings and loan fund, the investment fund and the social service fund. The first fund was like a current account. The depositor received no interest but could apply for an interest free loan for productive purposes. The investment funds were deposits received based on profit/loss participation. The funds were invested in local businesses and agricultural projects. The deposit received a proportion of the profits according to its amount and term. The social fund received Zakat and other charitable contributions from which grants were made to savers who were in financial difficulty as a result of sudden misfortune. It can thus be seen that an Islamic/social ethos prevailed in the conception and operations of the bank. One Western observer noted the significance of the experiment thus:
“The majority of the population had never been dealing with the financial institutions. Because of this, capital formation had been impaired. Basically rural and religious, they tended to distrust the bankers operating in the western style. Since a substantial part of their income was not spent immediately, but put aside for social events, emergencies and the like, this idle capital could not be used for productive investment A precondition, however for any change of behaviour from hoarding and ‘real-asset saving’ to financial saving was the creating of financial institution which would not violate the religious principles of large segments of the population. Only then could the rest of the majority of the population be integrated in the process of capital formation”. (Wohlers-Scharf, 19834, pp79-80 as quoted in Ahmed, 1994a, p351).
In the words of one of its founding executives (Naggar, 1987), the three most important principles which were applied by the bank and responsible for its success were: 1. Participation of the bank with its borrowers in their profits as well as losses. 2. Decentralisation and localisation through the operation of a community based philosophy which help in: a) the education and credit enlightenment through direct and sympathetic contacts, b) constant follow up of projects to guarantee their repayment and effective use of the money, and c) the provision of a mix of economic and social development services.
3. Consistency and integrity of the bank accounts. The bank’s success5, however, attracted the attention of the anti-Islamic, socialist regime of Nasser. In 1967, the Egyptian government took over all the nine banks and converted them to social savings bank on the conventional model. Thus the experiment came to an end, not on the basis of its economic viability but political interference and commercial opposition of the conventional banks. At the same time as the Mit-Ghamr bank was started in Egypt, the Lembaga Urusan dan Tabung Haji (LUTH) (Pilgrims Fund and Management Board) was established in Malaysian in 1963 as an Islamic savings institution. A Muslim economist who had noticed the wasteful nature of Malaysian Muslims selling of their property to go on the Haj (Muslim pilgrimage to Makkah) suggested that Muslims could save up the amount which would be invested in accordance to Shari’ah principles. Thus LUTH was born. Until then, intending pilgrims did not put their savings in a conventional bank because it would have been tainted with interest. Money thus tainted could not be used to perform the pilgrimage, as it would not have been religiously valid.
Wohlers-Scharf, Traute (1983), Arab and Islamic Banks, Paris, France: OECD. Four more branches were established in the three year period 1963-66.
The Malaysian government initially set LUTH (Now known as Lembaga Tabung Haji) up as a savings corporation in 1963 and was incorporated in 1969. Although LUTH is not an Islamic bank, it is an Islamic financial institution. It collects the savings from would be pilgrims and invests them in real estate, trading and plantations. Recently it has gone into share trading and Islamic money markets. It restricts withdrawals to twice a year and for the purpose of performing the pilgrimage. LUTH is an active investor both directly and through its seven subsidiary companies. LUTH in addition to its investing activities administers the whole pilgrimage programme every year, which is a mammoth undertaking involving about 40,000 pilgrims. In co-operation with other government agencies, it takes care of their transport, food, lodging, health and emergency aid during the pilgrimage. The researcher having personally used its services can attest to its efficiency in organising the pilgrimage. However, in recent years, its importance as a financial intermediary has increased. The researcher was informed by one of its accountants in an interview that 70% of LUTH’s deposits were investment deposits, whereas previously most depositors withdrew their savings to perform their pilgrimage. Unlike the Mit-Ghamr bank, LUTH had better fortunes because of a political climate in Malaysia, which though secular, was not socialist and anti-Islamic, as was the Nasser government. From 1,281 depositors in 1963 and M$46,600 in deposits, the number of depositors increased to 2,278,121 with deposits of M$1,541 million in 1993, a period of 30 years (Zainal & Yusof, 1993). Its income has increased from M$6,573 to about M$95 million (excluding government contribution towards operating expenses) during the same period, 1990. Depending on the profits, a bonus is declared by LUTH once a year. The dividend rate has been around 8-8.5% The first private commercial Islamic bank was the Dubai Islamic Bank in 1975. It is a public limited company with 50 million dirhams. In the same year, an international Islamic bank, the Islamic Development Bank was established in Jeddah, Saudi
Arabia jointly by the 45 Muslim countries under the auspices of the Organisation of the Islamic Conference. The purpose of this bank was to foster economic
development and social progress of member countries using Islamic finance financial instruments. It also grants loan and aid to Muslim organisations especially in Muslim minority countries. Thereafter Islamic banks began to be established at an increased pace in Egypt, Sudan, Jordan, Bahrain, Pakistan, Iran, UK, Malaysia, Bangladesh, African countries, Turkey, India, South Africa and the US. Two milestones in the establishment of Islamic banking were firstly, the Islamisation of the whole banking sector in Iran (1979), Pakistan (1985) and Sudan. The second milestone was the establishment of the Dar-al Mal Al-Islamic (DMI) Switzerland in 1981 by a Saudi Prince and the Dalla Al-Barakah Group in 1983. These two Islamic Finance Multinationals were responsible for setting up a spate of Islamic banks, Investment corporations, Takaful companies and other financial institutions in Egypt, Sudan , Africa and Europe. The ownership of the Islamic banks varies between 100% government ownership and 100% private ownership. Most Islamic banks have been set up as joint-stock companies. The total number of Islamic banks and financial institutions number in the thousands (if the Islamic banks in Sudan, Pakistan and Iran established by wholesale Islamic legislation are counted) but those established voluntarily number 192 (IAIB 1997). Based on 166 of these institutions, Islamic financial institutions had a total of US7.3 billion in paid up capital and total assets of US$137 billion. The aggregate net profit was US1.7billion. This compares to 133 institutions with $5 billion of paid up capital and $101 billion in assets in 1994. Considering that there was no wholesale Islamisation of the banking sector in any Muslim country between these dates, the increase represents about 40% increase in assets and capital for two years or about 20% growth rate. Long-term expansion barring wholesale Islamisation is, however, estimated to be around 5-7% (IAIB, 1997). The industry employs around 300,000
employees spread across 34 countries in all continents except Australia and South America. It can thus be seen that the Islamic finance sector is no longer a theoretical possibility but a practical and viable fact here to stay. However, Islamic banks face many regulatory, operational and accounting problems which prevent the further realisation of its Shari’ah oriented ethical and social goals. Further, discounting the nation- wide Islamic banks of Pakistan, Sudan and Iran (which have government support) the profitability of small Islamic banks in other countries seems to be in some doubt (Timewell, 1998). The researcher is of the opinion that Islamic Accounting would be helpful in developing this important Islamic institution to be in accord with its own worldview rather than being derailed into the capitalistic mould.
5.3.3 Modus operandi of Islamic Banks
Siddiqi (1998b) has classified the activity of Islamic banks into three activities: a) Services for which the bank charges a fee or commission. b) Investment of capital on the principle of partnership or mudharaba and c) Fee based or uncharged services. The services in category a) above include many of the functions performed by conventional banks on a fee basis, such as keeping accounts, clearing cheques, providing funds transfers and business advisory as well as providing financial guarantees and safety deposit lockers. The activities under b) are the major theoretical basis on which Islamic banks operate although a recent survey shows only 20% of financing of Islamic banks is done through this way (IAIB, 1997). The main activity of a conventional bank, lending and borrowing money through fixed and savings deposits is changed in an Islamic bank. The relationship in conventional banking between the bank and its deposit holders is that of a debtor-creditor relationship. This is not so in the case of Islamic banks. The relationship in an Islamic bank, depending on the type of deposits, is either trustee for deposits or a business partner.
On the liability side, in the case of both current and savings accounts, conventional banks pay interest based on a pre-determined percentage of the amount deposited varying with the length of time. The Islamic bank does not pay interest but may give a gift, which is at the option of the bank. The bank guarantees the principle amount, which can be withdrawn by the customer at any time. Current and savings account deposits are based on the Islamic contract of al-wadia’ – safe keeping. Under this contract, the depositor gives permission to the bank to use the funds in any Islamically permissible activity but he can request the money back on demand. In practice, some Islamic banks pay an amount called hibah or gift depending on the profit of the company, which is permissible. However, the depositor is not legally entitled to this as that would amount to interest. The bank, however, guarantees the principal sum. Islamic banks do not accept fixed or term deposits on which interest is paid. Instead, customers can open an investment account for a fixed period. After the period, the customer is entitled to a share of the profit (the percentage share of profits being pre-determined), if the banks make a profit. If the bank makes a loss, the whole loss is borne by the customer. This contract is called mudharaba- capital/labour
partnership. Under this contract, the depositor as the capitalist gives the capital to the bank who acts as the entrepreneur in managing the funds for which it is entitled to a share of the profit. The banking expenses are not charged to depositors as management expenses as in the case of a loss, it is wholly borne by the depositor. The bank is only entitled to a share of profits the ratio being pre-determined at the beginning of the agreement. What in fact happens, is all investment deposits are pooled and invested in various projects- forming portfolios with varying maturities. Sometimes the bank’s shareholders funds are also pooled to finance projects. In this case, the bank is also entitled to a share in proportion to its capital invested. Profits are allocated to the
depositors in proportion to deposit amount and time for which the amount is deposited with the bank. Most Islamic banks have two types of investment accounts, unrestricted and restricted. Unrestricted investment account deposit can be invested in any sector according to the wishes of the bank, provided the investment does not contradict the Shari’ah. Restricted Investment accounts allows the depositor to specify in what sector, his deposit will be invested. On the Assets side of the balance sheet, conventional banks usually grant credit facilities such as term-loans, overdrafts and housing mortgage loans. They also invest in the short-term money market, government securities, treasury bills, company bonds and equities in the stock exchange. In the case of Islamic banks, as all interest-bearing instruments are prohibited, these financial instruments, except for equities, are not available to it. Instead Islamic banks use Islamic financial instruments, some of which have equity features while others have features of both debt and equity (Obiyathullah, 1995) and still some others have features of debt. This will be explained in some detail in the next section. The third type of activity is unique to Islamic banks (although some conventional banks provide free overdraft to student customers). Providing interest-free loans is part of the social activity of Islamic banks although only a small portion of its total funds is allocated to this. Usually the funds come from Zakat and charity pool created by the bank from its own Zakat contributions and charitable contributions of others. In theory, Islamic banks should set aside a portion of the shareholders and depositors funds for this purpose. It is not certain how many banks actually undertake this function, as they seem to operate mostly along commercial lines. However, as we have seen in the case of Mit-Ghamr bank, this is not theoretical and has been applied in practice. In Pakistan, Islamic banks have given interest-free study loans to students.
5.4 THE ASSET SIDE OF ISLAMIC BANKS: ISLAMIC FINANCIAL INSTRUMENTS:
Since Islamic banks cannot grant loans on interest, the assets side of the balance sheet cannot have any advances (except interest free loans) as assets. Since banks cannot earn any money on interest-free loans, they have to resort to participatory finance and other Islamic financial instruments to earn an income. The researcher will discuss these Islamic financing instruments below:
5.4.1 Murabaha and Bai al-Mu’ajjal
The contract of Murabaha or mark-up originated in the deferred sale (bai almu’ajjal) contract. In this contract, a buyer of goods requests an agent to do it for him, on the understanding that the agent will charge a mark-up on the cost of the goods which will be sold to the buyer. The price was usually deferred and hence the agent usually quoted two prices, one for spot and a higher price for deferred sales. The Islamic law of contract allows this higher price on the deferred sale. Various reasons have been give for the permissibility of this excess, which is akin to interest. Reasons include opportunity cost foregone by the agent, the risk of default and the risk of the buyer refusing to take the goods after the agent has acquired to buy on his behalf. The ownership risk of the goods bought by the agent resides with the agent until delivery to the buyer. The buyer can refuse to accept the goods at any time before delivery. The Islamic banks saw this as an opportunity in financing a purchase e.g. a house or trading stock or a fixed asset and this has become the main financing device of the Islamic bank. Any person requiring finance e.g. say a car, goes to the bank and requests the bank to buy it for him. The bank theoretically buys the car adds a markup, depending on the amount and term of the financing required and sells it to the customer, who pays by instalments. Once delivered, the car becomes the property of the customer although it could be collateralised. Although this appears as a casuistry for interest, it has some differences from pure interest based credit including:
1) The buyer can refuse to take delivery in case of Murabaha.
2) In case of late payment of instalments, the bank cannot add a markup on markup as a conventional bank compounds the interest on the late instalment. 3) In the case of variable interest rate financing, the conventional banker varies the interest rate according to the prevailing base lending rate. In the case of murabaha, the mark-up is fixed and cannot be varied. 4) Of course the produce or service financed cannot be against Shari’ah injunctions e.g. one cannot buy and re-sell alcoholic products, gambling services or drugs. Although this instrument constitutes about 50% of financing undertaken by Islamic banks, it has been frowned up as a back door to interest. Scholars have suggested minimising or discontinuing this practice. However, the survey by the International Association of Islamic Banks (IAIB, 1997) shows an upward trend.
Mudharaba is a labour-capital partnership, wherein an investor puts up an amount of capital for a specific period of time with an entrepreneur who conducts business with the amount. The profit sharing ratio between the entrepreneur and the investor is predetermined in advance. At the end of the period, any profits are shared in the agreed ratio. In case of losses, the investor bears the entire loss, the entrepreneur loses his labour as he is not paid a salary. The Islamic bank adopts a two-tier mudharaba contract. In the case of investment accounts, the depositor is the investor and the Islamic bank, the entrepreneur or manager of the fund. The bank itself then becomes the investor when it places money with the actual user of the fund who runs the actual business. In case of profit the bank and the entrepreneur shares the profits. From the bank’s share of the profit, a pre-agreed share is given to the depositor. In case of loss, the bank passes on the whole loss to the depositor. The bank’s overhead expenses are not charged to the investment accounts as the bank is only entitled to a profit share and is not liable for loss.
This was thought to be the ideal contract for Islamic banking. However, empirical results indicated only 7% of Islamic financing was of this type in 1996 and the overall trend is negative (IAIB 97). Many reasons have been given for the lack of fervour for using this mechanism: 1) Agency costs: Borrowers un-Islamically tend to consume perks which reduces the profit available to the banks and depositors. Obiyathullah (1995) shows how this contract has both debt and equity characteristics. 2) The tax structures of some Islamic countries are such that no honest traders can survive. As such, traders normally keep two set of accounts, one for their use and one for tax purposes which shows lower profits to avoid tax. The second set is the one usually given to the banks. Even if the entrepreneur does not wish to cheat the Islamic bank, the fear of being found out by tax authorities dissuade them from keeping and giving truthful accounts to Islamic banks. Further, while interest costs are given as tax deduction, profit shares are not allowable in most legislation, hence increasing the cost of capital of mudharaba financing for businesses.
This is plain partnership financing. Here the bank becomes a full partner of the entrepreneur who also contributes capital. The bank shares profits and losses of the business with the entrepreneur in a pre-agreed ratio. In case the bank does not play an active part in the business, then the entrepreneur may charge management salary or expenses to the business account. Unlike the case of mudharaba, where the bank cannot interfere in the running of the business, the bank has full rights of administration in Musharaka contracts.
Chapter 5 5.4.4 Ijara
Ijara is rent or leasing of assets. Here the bank purchases the asset and leases it to the borrower. Although, strictly only operational leases are allowed in Islam, most ijara contracts take the form of financial leases, which transfers the risk and rewards of ownership to the borrower. Even in the case of a financial lease, since the contract is a lease agreement, the ownership resides with the bank until the borrower exercises an option to buy the asset at the end of the lease. The buying option can be pre-agreed at the inception of the contract. This is known as an Ijara wa iqtina (Lease and sell) contract.
In the case of Murabaha, the goods to be bought must be in existence at the time of the contract and capable of delivery. This mode thus cannot be used to finance the cost of say agricultural output in advance. The salaam contract on the other hand is an advance purchase contract, where the goods say wheat, of a particular quality and quantity, which is not yet in existence, can be the subject of a contract. Here the buyer pays the agreed price in advance for delivery at a certain date. Hence, this contract can be used to buy commodity futures for example. However, according to Islamic law, the bank cannot sell this until delivery. In order to overcome this, the bank enters into another “parallel” salaam contract to sell the same quantity and quality of goods at a different price. However the second contract cannot be linked to the first. By means of parallel salaam, the bank can cover its position and make a profit. In case of delivery failure, the bank can only request the money back without any penalty or wait longer. This can become an important means of financing agricultural or fishing activities.
Istisna is a variation of salaam. It is the payment for commissioned manufacture. A buyer can contract to have goods manufactured and delivered at a later date, in accordance to specifications. The buyer has the option of cancelling the contract if
the delivered item is not to specifications. Although the majority legal opinion is that the contract cannot be enforced until the manufactured item is delivered and accepted, the minority opinion is followed binding both parties from the start. Unlike salaam, payment is at delivery or according to manufacturing or construction progress. Thus, this instrument can be used to finance construction or
manufacturing projects. Islamic banks have also used and modified this to a “back to back” istisna where two contracts are made up; one with the manufacturer and one with the ultimate buyer. The Islamic bank uses this contract to finance the purchase of ships or airplanes. The bank contracts with the buyer to supply the item for a fixed future payment schedule. The bank contracts with the shipbuilder to supply the ship for a series of shorter progress payment. The difference between the present values of the payments under the two contracts is the bank’s compensation (Vogel & Hayes, 1998).
5.5 ACCOUNTING PROBLEMS OF ISLAMIC BANKS
Islamic banks face unique accounting problems both from a technical point of view and philosophical point of view. Some of these accounting problems are: 1. The problems of profit recognition and allocation due to Islamic banking mechanics (Abdulgader, 1990; Karim, 1998a), 2. The inappropriateness of International Accounting Standards (Hamid et al., 1993; Karim, 1999) 3. The hybrid nature of some Islamic financial instruments (Obiyathullah, 1995; Karim, 1999), and 4. The ethical accountability requirements (Gambling, 1994 ).
5.5.1 Profit sharing
Abdulgader (1990) studied profit recognition and allocation problems in Islamic Banks in Sudan and Egypt. His study examined the practices of four existing Islamic Banks (each of which had many branches all over Sudan) and found that the profit
recognition and allocation practices of the three banks were not uniform.
In the first example, the banks separated the investment account funds from the shareholders and other depositors’ funds. In this case, the investment account funds were invested separately, after allowing for reserve requirements. This lead to a separate fund account being established for Investment account holders and accounted for separately from the others. Hence separate financial statements were prepared for this fund account. Further the profit were recognised only when the projects were liquidated; implying that the projects were short-term. After deducting the bank’s share of profits, the depositors share of profits was distributed to individual depositors according to the amount and period of the deposit. In the second case, all funds whether from shareholders, current and savings accounts and investment accounts were all pooled and invested in various projects. In this case, the profits earned by the bank excluding those from fee-paying banking services were made proportionate to average deposit in each type of account. The share of the current and savings account depositors went to the shareholders, as the depositors were not entitled to any profit. (In the case of Malaysia, the banks distribute part of this profit as a gift to savings and current account holders). From the proportion attributable to the investment account holders, the bank’s share is deducted and the balance distributed to the investment account holders in proportion to deposit and period held. Except for expenses directly related to investments, all other expenses are borne by the bank and not by the investment account holders as under the mudharaba contract, the bank is only entitled to its share of profits. In the second case it was difficult to determine each party’s share in investment and profit as all funds are pooled. The actual amount of investments for each class of deposits as opposed to the actual amount of deposits cannot be known. In calculating the share of profit due to investment account holders, the bank estimates the portion of the depositors account invested by the following steps on each months’ balance:
1) The actual deposit in each class of account (and shareholders funds available for investment) is multiplied by the available percentage (100-reserve percent) to obtain amount available for investment. The reserve ratio is different for each account. Investment accounts have a lower reserve ratio than other accounts. 2) The actual invested funds for each class of account is apportioned using the amount available per step 1 divided by total deposits available for investment multiplied by total amount invested in the month. 3) The monthly amounts are added up for twelve months to get yearly amounts. 4) The total profit is then apportioned to the accounts on the basis of total assumed investments. The above method, although rational and equitable on the face of it presents some difficulties. As the investment account depositors are mainly interested in profit as they bear the risk, the above allocation does not give any preference to this. Since savings and current deposits in Islamic banks are not meant to earn profits, they should not have a claim to profits on an equal basis (although in actual fact, profit attributed to these deposits goes to the shareholders). Thus, as in the example from table 5-1 shows, the amount from the investment account, assumed as invested is only $53,070/$77228 = 68%, whereas current
account deposit invested is also assumed to be 68%. Since investment account holders assume that their deposits will be invested, it is clear that their funds should be accorded priority in the distribution of profits. Hence in 1985, the Shari’ah Supervisory Board of the Faisal Islamic bank recommended that all investment account deposits less a liquidity reserve be assumed to be invested. Using the new formula, the investment account deposit assumed to be invested would be £77228 x90%= £69505 (to take account of liquidity ratio of 10% as investment account can be withdrawn on short notice although not on demand). The amount allocated to current accounts and shareholders is found as a balancing figure. Hence the profit allocated to investment funds would be higher.
Chapter 5 ACTUAL TYPE OF DEPOSIT DEPOSIT (1) JANUARY 1984 Current Deposit Investment Deposit Savings Deposit Shareholders funds TOTAL 157,000 77,228 12,454 58,536 305218 70% 100% 90% 100% 109,926 77,228 11,209 58,537 256,900 INVESTMENT AVAILABLE % (2) FUNDS FOR INVESTMENT (3)=(1)X(2)
Page 208 ACTUAL INVESTED FUNDS (4) 75,540 53,070 7,703 40,226 176,539
TABLE 5-1:PROFIT DISTRIBUTION METHOD IN THE FAISAL ISLAMIC BANK OF SUDAN (SOURCE: ABDELGADER, 1990,P 176).
Despite this apparent improvement, the profit attributed to investment accounts will vary between different Islamic banks depending on the proportion of current and savings account deposits. For example, if Bank A has more current and savings account deposits than Bank B, assuming equal amount of investment deposits, Bank B will be giving a higher share of profits to its investment account holders. Another problem, is although, current and savings account holders expect no return, the shareholders are effectively using these deposits as financial leverage in earning profits for themselves without giving anything in return to these depositors except guarantee of capital. Perhaps, in this case, the central bank should regulate the Islamic banks and insist on a payment of a gift to these accounts (after building up sufficient reserves to cater for losses). This is legal and recommended (and practised in certain countries) in Islamic law provided they are not predetermined. In contrast to the above situation, some Islamic banks do not pool the funds from investment accounts and treat them as a separate entity. In order to provide a portfolio instead of matching each deposit to an actual investment, the deposits are pooled into many projects. However, this method is more risky for the depositor because the portfolio may not be well diversified. In certain banks, limited
mudharaba certificates are issued which link the securities, issued in fixed
denominations for a fixed period of time, to a particular project. These certificate holders are entitled to profits when the project is liquidated. They bear all the losses if any. This second type of profit allocation where the funds are not pooled solves the problem of allocating profits between the various types of depositors. However, it still has the problem of matching profits because in Islam, the venture has to be realised to return capital before profit is calculated (Udovitch, 1970). Hence, if a depositor withdraws his funds before project is liquidated, then he will not be entitled to share in the profits. The problem of capital gains and losses between accounting period also presents problems as it does in conventional historic cost accounting. Perhaps a realisable income model (Edwards & Bell, 1961) would be more appropriate. Another problem posed by Islamic banks is the nature of investment and savings deposits. Are investment deposit holders, equity holders? (Karim, 1999). Should they have say in the administration of banks (i.e. voting rights)? It can be seen that investment account holders are neither a liability nor equity and to classify them as such according to conventional accounting principles would amount to unfair disclosure. Investment accounts have both the characteristics of debt and equity. They are short or medium term equity holders. Equity holders have long-term relationship with the banks. They can vote in annual general meetings and take part in the management of the bank through their directors. By contrast the relationship of investment account holders vary between short and medium term. However since they share in the profits and bear all risks associated with their investment, they should neither be treated as current and savings account holders nor fixed deposit accounts holders. Perhaps, they should have limited voting rights like debenture holders, especially in the case of limited mudharaba certificate holders to ensure that their interests are taken care of properly. Investment accounts cannot be classified as current liability as are fixed deposit holders in a conventional bank. Perhaps a
separate balance sheet should be prepared for them, or they should be shown between equity and current liabilities. Another problem associated with investment projects relating to investment accounts is whether they should be consolidated or equity accounted? Presently only profits received from the projects are incorporated into the accounts. This is inconsistent with the ruling that Islamic banks are not lenders but managers of the investment account holders. Conventional banks do not manage the projects they finance except to monitor periodic reports. Islamic banks as managers of investment account holders and as partners in case of Musharaka financing would have to take a more active role in appraising, monitoring and even directing major decisions in ventures they finance. When they do this, the problem of consolidating results and assets of financed ventures comes in. Karim (1999) observes that, in the application of funds, most Islamic banks use the murabaha-financing instrument. Since the source of financing includes investment accounts, the profit recognition method used will also affect profit allocation to these accounts. As Karim (1999) notes, there are at least five different methods of profit recognition used by Islamic banks in recognising profits in murabaha transactions where the price of the goods financed are received in instalments which may traverse several accounting periods. These include: • • • • • Recognising profits in full when customer takes delivery. Pro-rata the profits according to due dates of instalments. Pro-rata the profits according to receipt of the monthly payments. At the liquidation of the transaction i.e. on the last payment date and Once the capital has been recovered.
Karim (1999) notes that “the use of any of the above profit recognition methods affect the returns credited to investment account holders”(p33) as the duration of the depositors’ investment is generally different from the duration of the murabaha contract above. In addition, there is no conventional accounting standard to prescribe
the disclosure of different profit allocation bases (which has been discussed above) which Islamic banks use to allocate profits between the various account holders. Hence, applying conventional accounting standards (e.g. IAS), where they are available, to Islamic banks will result in non-comparable financial statements rather than induce comparability as there no standards which meet the specific Islamic banking requirements. This is the rationale behind the formation of the Accounting and Auditing Organisation for Islamic Financial Institutions (Pomeranz, 1997; Karim 1999) which has some accounting and auditing standards for Islamic banks and Financial Institutions
5.5.2 Capital Adequacy Ratio
As a result of the recent third world debt crisis, there have been increasing demands for more capital regulation in the banking industry. One of the most important measures facilitating this regulation is the capital adequacy ratio (CAR). This ratio is a measure of a bank’s risk exposure and is usually calculated by finding the percentage of capital to total balance sheet assets. The CAR of commercial banks is an important accounting measure used to assess the adequacy of the bank’s capital in relation to deposits to cover credit risk (Llewellyn, 1988). Regulators use the CAR as an important measure of the safety and soundness on banks as the capital of such institutions is viewed as a buffer or cushion to absorb losses (Karim, 1998b) The increasing pressure from regulators to maintain an adequate ratio has led some banks to adjust accounting measures to reflect a good ratio. Hence, accounting practices have major implications for this ratio. The Basle Accord of the Basle Committee on Banking Supervision implemented since 1992, sets out an agreed framework for measuring capital adequacy and the minimum standards to be achieved by the representative countries. The accord is intended to “strengthen the soundness and stability of the international banking system and “to be fair and have a high degree of consistency in its application to
banks in different countries with a view to diminishing an existing source of competitive inequality among international banks”. The minimum acceptable Capital Adequacy Ratio (CAR) according to the Basle Accord is 8%. The majority of countries in which Islamic banks operate have taken steps to introduce the Basle framework. However because the framework of Islamic banking is different, the Basle framework geared for conventional banking cannot be applied as it would lead to Islamic banks not meeting the requirements, although this would not imply any more credit risk than conventional banks. As Karim (1998) observes, only share capital and reserves attributable to them would be considered as capital. Islamic banks issue neither preference shares nor subordinated debt as they contravene the Shari’ah. Since current account holders of Islamic banks are not entitled to any return, the revenue generated from them is exclusively the right of the shareholders. The investment account deposits cannot be considered as equity or liability but a unique type of Instrument which gives the depositors right to share in the profits but bear all the losses. Hence, since both deposit accounts are not paid a predetermined return, they do not constitute a financial risk to the bank as (in the case of investment accounts) all the losses can be passed on to the account holders. Although the shareholders funds would have to bear the losses of capital on investments from current account deposits, the risk of loosing the capital is much less than loosing both capital and the pre-determined interest which must be paid to conventional bank account holders. Karim (1998) illustrates this point through four possible scenarios, each depending on the way investment accounts are treated by Islamic banks and regulatory authorities: In scenario 1, Investment accounts are added to the core-capital (tier 1). This would increase the CAR and help Islamic banks follow a strategy of attracting high investment accounts and low equity capital, as Islamic banks do not share losses only profits from the investment account fund invested. If the amounts of deposit
accounts were restricted in the calculation of capital, the bank would be forced to pursue a strategy of raising equity and restructuring its assets to more safe areas like Government investment certificates. Scenario 2, which allows for deduction of the investment accounts from the riskweighted assets would similarly increase CAR and compensate for assets with highrisk weightings. Here, shareholders continue to encourage investment accounts compared to savings accounts. In scenario 3, investment accounts are added to Tier 2 capital element. In this case, since tier 2 capital is restricted to 50% of the total of tier1+tier 2 capital, this would mean that when investment accounts equals equity, there is no benefit to the CAR calculation. This would mean, after this threshold, Islamic banks would have to raise shareholder equity. In scenario 4, no adjustment is made to the CAR calculation in respect of investment accounts. Islamic banks with CAR below 8% would have to increase their shareholders equity as the use of investment accounts confers no advantage in the calculation of CAR. Another way out would be to restructure their assets to include lower risk weighted assets. Given the nature of Islamic financial instruments, Karim (1998) observes that the latter option would be more feasible in an Islamic bank given the nature of financial instruments used by Islamic banks. Although it is up to regulatory authorities of the various countries to adopt the appropriate rules, Central bankers of Muslim countries with their conventional economic and banking training seem not too creative in this matter. In the case of Sudan (Abdelgader, 1990), the Central Bank wrongly subjected the funds of investment accounts to their credit ceiling targets meant to control consumption credit and inflation. Investment accounts, of course, were meant to finance long term, high return investments. Since the Islamic banks could not invest most of the funds, profitably it stopped accepting investment deposits altogether, defeating the purpose for which the bank was set-up.
Karim’s (1998b) analysis, although constructive and insightful, nevertheless only skimmed the surface of the implications of the Basle convention for accounting of Islamic banks. His analysis is limited to the financial strategy of shareholders in leveraging the use of investment accounts. It does not analyse the CAR standards implication for the investment strategy in terms of achieving the investment objectives of Islamic banks i.e. to substitute profit-sharing contracts for risk based contracts which would bring about the theorised objectives of Islamic banking. As already indicated, one of the problems of the Islamic banking is that Islamic banks have opted for the easy use of credit-based Islamic instruments (murabaha) which do not change the basis of Islamic banks from conventional counterparts to any large degree (Abdelgader 1990; Ahmed, 1994b). An appropriate indigenous Islamic
capital adequacy ratio standard could have a marked difference in increasing both investment accounts and more profit-loss financial instruments. For example, if investment accounts could be added to the core capital or deducted from total risk weighted assets, (scenario 1 and 2), this could increase the promotion of investment accounts. Further as the Islamic banks do not bear any losses arising from the loss of investment deposits (except arising from negligence), the investment account investments (not deposits) could be deducted from risk weighted assets or given a 0 or low risk weighting depending on the nature of the instrument. A reverse risk weighting score could be given. For example, musharaka and mudhraba investments would be given a lower risk-weighting then those used for murabaha or ijara investments. This would increase CAR and at the same time encourage Islamic banks to manage their portfolio carefully, as their earnings will depend on high return / high-risk investments. This is so because banks earn only a share of profits and cannot charge expenses to the investment account deposit holders except for direct expenses. Hence this is one way, an appropriate Islamic financial standard based on an accounting number could induce behaviour towards attaining Islamic objectives.
Another instance would be to consolidate the investments at current costs. Since Islamic accounting seems to favour current values (Clark et al., 1996; see also chapter 6), this would reduce CAR. However, if the bank’s share of unrealised capital gains is added to capital and the current value of investments (from the investment account funds) were excluded from the risk weighted assets, this would boost CAR, encouraging such investments. A development from this would be an “Islamicity” ratio computed using an inverted risk weighted value of assets. The higher the ratio, the higher the Islamicity of financial instruments used and would give the user an indication of the extent to which the Islamic banks are using the funds in profit-sharing instruments and other social areas in which it should be used.
5.5.3 Confounding International Accounting Standards
The accounts of Bank like other business organisations are increasingly subject to both national and international accounting standards, which are increasingly being globalised in the form of International Accounting Standards. Unfortunately, recent studies on the cultural impact on national accounting systems seem to be motivated only towards removing non-European and non-American impediments in the way of international harmonisation of accounting (Hamid et al., 1993). The researchers do not contemplate that harmonisation may entail imposing Western and European accounting practices and the theories behind them upon nations whose commercial and accounting practices are based on alternative ethical or cultural paradigms. Thus:
“But the focus has been more to identify what practices and underlying theories have to be changed to fit into the Western paradigm, rather than to discover whether those not conforming to it might give insights to alternative, theoretically defensible accounting processes”. (Hamid et al., 1993, p132)
This may not only distort international comparison (see for example, Choi et al., 1983) but also upset the socio-economic balance of the recipient countries.
Hamid et al. (1993) observes that although, harmonisation is pursued under the pretext of transporting developed accounting practices to countries with lesser developed practices, such ascription of development to the West, commits the world to a dominant allegiance to Judaic-Christian influences and ignores traditions founded in Eastern philosophies. Thus, any implications of accounting being required to conform to the philosophies underlying Islam, which transgresses national boundaries, for example, are dismissed without enquiry. Islamic banking in particular only permits financial support and offers banking facilities to Islamic compliant businesses. One could therefore reasonably presume that the prevalence of stricter Islamic banking would lead to higher business compliance with Islamic principles. This would in turn increase the need for an alternative Islamic accounting to meet the needs of these organisations. Hamid et al. (1993) further argues that the prohibition of riba, which is the cornerstone of Islamic banking has important implications for the harmonisation of accounting procedures as implementing international accounting standards entail enforcing many accounting procedures where interest based calculations are essential. For example, standards on pension benefits (SFAS 87 & 88), amortisation of long-term debt (APB 12), lease capitalisation (SFAS 12), interest on receivables and payables (APB 21) and their International Accounting Standard equivalents all invoke discount calculations based on the time value of money. Karim (1999) also point out many problems of using International Accounting Standards for Islamic banks. For example, many Islamic Banks use murabaha financial instrument. In this cost plus contract, the Shari’ah imposes the condition that the bank must possess the title to the goods before delivery to customer. The purchase order made by the customer may or may not be binding on him. Hence the valuation of such stocks is a problem in the accounts. Should the bank value at lower of cost and NRV as per current accounting standards or at current market value as per Zakat accounting requirements.
IAS’s do not have any standards to deal with the status of investment accounts, as they are neither equity nor debt in the conventional sense. There are also no disclosure requirements to disclose the bases of profit allocation between shareholders and investment account holders. The use of different methods by different Islamic banks has resulted in the incomparability of their performances. Profit recognition difficulties have already been alluded to in the section 5.5.1. The adoption of IAS would not make the Islamic banks accounts comparable but might achieve the opposite effect. International Auditing Standards also do not provide for the idiosyncrasies of a Shari’ah Review or audit which is required of Islamic banks. Neither do they provide guidelines on the qualifications, independence and competence of Shari’ah Auditors or Shari’ah supervisory board of Islamic banks. It is no wonder that Muslims have come up with their own alternative to the IASC in the form of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). This organisation has issued two Financial Accounting Concepts Statements, ten Financial Accounting standards and five Auditing standards for Islamic banks (Karim, 1999). The organisation has also issued exposure drafts on Shari’ah Audit, and Islamic Insurance Company disclosure standards. If the current Islamic resurgence permeates Islamic businesses, then there is definitely a need for the development of Islamic accounting and an International organisation to develop Islamic Accounting Standards for all Islamic organisations. Perhaps, the AAOIFI will evolve into such a body.
5.5.4 Non-Financial Disclosure
While, the technical problems associated with accounting for Islamic banks have been emphasised and the AAOIFI been established to deal with it, it should not be forgotten that Islamic banks are much more than institutions which avoid interest. All business and non-business Islamic organisations have Islamic ethics as their founding basis. As such these institutions must account to their owners and other
stakeholders as to the extent to which they have complied with the ethical dictates. This involves non-financial as well as financial disclosure. Khan (1994a) observes that an Islamic bank would have to disclose: (i) (ii) The avoidance of prohibited transactions. The extent to which their activities have contributed to the economic and social development of various poor sectors of society by offering financing and interest-free loans to for example, farmers and small traders. (iii) The ethical standard which they have reached in the treatment of employees and depositors and entrepreneurs. (iv) Segmental information on the financial instruments used and the efforts made by the bank to move away from interest-like instruments such as murabaha. (v) The extent to which they have safeguarded the environment and conserved energy. (vi) (vii) The collections and disbursement of Zakat from the bank’s operations, and The social and the religious contribution to local community
Conventional accounting places emphasis on financial outcomes, thus conventional accounting users (e.g. shareholders) may switch to debt financing when economic conditions make debt financing attractive. They also may switch to other business activities, which promises the best financial returns to them. However, as Hamid et al. (1993) notes, whether equity or debt financing promises the best financial returns to owners or managers, is not the motivating factor in Islamic commerce undertaken according to the Islamic tradition. Instead success in the hereafter by following God’s commandments in economic transactions on earth would be the foremost thought of Muslim users. Hence Islamic accounting would provide information which ensures their confidence in the integrity of Islamic banks and other organisations. It should provide assurance that the organisation has invested their money within the constraints of the Shari’ah, no exploitation or injustice has been done to any quarter and their money has made a contribution to uplifting the community.
Chapter 5 5.6 CONCLUSION
In this chapter, the objectives of various forms of Islamic organisations, their structure, operations and framework under which they operate have been discussed. The development and operations of Islamic banks were discussed at some length to emphasise the different paradigm of Islamic business. Hence, the discussion of the accounting problems related to different financial instruments, profit sharing and the problems of imposing international banking, accounting and auditing standards on Islamic is meant as an example of the differences and difficulties Islamic organisations pose for conventional accounting. It is hoped that this has demonstrated the practical need for the development of Islamic accounting Islamic accounting as can be seen from this chapter, is not only a matter of modifying conventional accounting to fit the needs of Islamic institutions- a major overhaul is called for. It is not a matter of extrapolating the conventional accounting principles to specialised entities e.g. in the case of accounting for plantations, insurance companies or space exploration. The different philosophical assumptions underlying Islamic organisations and their different operating mechanism, some of which find no parallel in the conventional business and accounting practices, suggest a more radical accounting. Benefits of an Islamic Accounting System for Islamic banks and other organisations would include: • Motivating employees, shareholders, managers and participants to be
accountable to society and God and to take a pro-active role in ensuring ethical economic activity instead of motivating them through higher financial returns to increase their greed and material possession. • Ensure the accountability of Islamic organisations to their stakeholders and thereby ensuring the accountability of Muslims to God in their economic activities. • Ensure the specific socio-economic objectives for which Islamic organisations have been established are achieved and to disclose the reasons why they are
not. The holistic nature of an Islamic accounting system would not deflect the users from their ethical objectives as conventional accounting, by concentrating on the financial return, might do. • The development of Islamic accounting and auditing standards would in time ensure comparability between different organisations which would promote the allocation of resources (financial, manpower, government support) to those organisations which better promote the interests of Islamic societies. From the above, it can be seen, that Islamic organisations can benefit immensely from the development of an Islamic accounting system. Failure to develop one, on the other hand, may contribute to their failure. In the next chapter (chapter 6), the researcher will discuss the objectives, theoretical framework and the characteristics of Islamic accounting which is hoped will meet the requirements of the Islamic organisations discussed in this chapter.
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