CHAPTER 2

RECORDING
TRANSACTIONS AND
MARKET VALUES IN
ISLAM
Learning Objectives
After studying this chapter, you should be able to:
 Explain the main accounting concepts and their compliance with the Islamic
Sharia.
 Describe the importance of market values to the Islamic accounting system.
 Explain transactions analysis using the accounting equation.
 Record, post, and analyze transactions using an accounting system.
 Prepare a trial balance
 Prepare a chart of accounts.
 Prepare a simple set of Islamic financial statements.
 Use accounting information to make decisions in an Islamic business environment.
ACCOUNTING CONCEPTS AND THE ISLAMIC
SHARIA
■ Islamic accounting shares many of the accounting principles that make the building blocks of conventional accounting. However,

in Islamic accounting, these principles also have to comply with the Islamic Sharia.

The Accounting Entity Concept :-

 It requires the preparers of accounts to treat the organization as a separate entity from that of the owners and principals.

 Boundaries are established between the organization, and its owners, so that only the impact of economic events related to the
organization is reflected in the organization's accounts.

 Islamic State; mosques, bayt al mal (treasury) and Awqaf (endowment), and other institutions were considered separate and
independent financial and legal entities.

 The entity concept was accepted by AAOIFI in its Financial Accounting Standard No. 1 (FAS1) issued in January 1996. This implies
that limited liability is accepted.
The Time Period Concept :-
 The life of the business is divided into periods called accounting periods.

 For each of these periods, sets of Islamic financial statements are prepared for the
transactions related to these specific periods.

 Generally, one calendar year is used for each period. Accounts for shorter periods than
one year are sometimes prepared, called interim periods.

 For example, the budget for Bayt Al-Mal (treasury), the institution that handled the
finance of the Islamic State, was prepared on an annual basis.

 The time period concept facilitates the payment of zakat, the assessment of which is
computed annually. That is, Muslims are required to compute their zakatable wealth
every year, as per Prophet Mohammad's Hadith, ‘No zakat is payable on property till a
year passes on it’.
The Cost Principle :-
 Accountin transactions for the economic events taking place within the organization are reflected in Islamic financial
statements at their actual cost.
 The main characteristics of the cost principle are its objectivity and reliability.
 Invoices document the cost
 This ensures that Islamic financial statements are not based on just the subjective opinions of individuals.
 However, there are calls for the assets in Islamic financial statements to be shown in the balance sheet at their
market values. However, estimating market values may take place at the expense of both objectivity and reliability.
 AAOIFI adopted the cost concept in its conceptual framework, on the basis that it is the method that produces the
most reliable information. However, given that zakat is one of the five pillars of Islam, accounting should play an
important role in enabling Muslims to pay zakat. Historical cost can be misleading both as indicative of values and in
the computation of zakat.
 Accounting information should help in computing the zakat payment, thus requiring the use of market values. The
difference between historical cost and market values is subject to zakat but is not distributable to owners.
 The Matching Principle
 According to the matching principle, expense items are matched against revenue items that they generate.
 AAOIFI adopted the matching concept to ensure that the responsibility of the cost is assigned to the recipient of
benefit.
 The matching concept helps to compute the actual wealth subject to zakat.

The Profit Recognition Principle

 Profit is the outcome of the operations of a business over a period of time. It is computed as the difference
between the revenue and expenses incurred to generate this revenue.
 One issue in computing the profit is whether a cash-based method or accrual-based method should be used.
 The Islamic Sharia permits both cash and accrual methods in recognizing revenues. The accrual method is
consistent with the Sharia, which requires credit transactions to be properly recorded.
 The Conservatism Principle :
 According to the conservatism principle, accountants are required to avoid anticipating profit but should ensure
losses and expenses are anticipated and accounted for.
 This principle counters the general optimism of managers in overestimating and anticipating uncertain future
revenues.
 It also ensures that the Islamic reality of the organisation is better reflected and that stakeholders such as creditors
are better protected.
 The application of the conservatism principles requires the reporting of the lowest value of assets and revenues,
which may result in an understatement of assets that are subject to zakat.
 Conservatism thus may contradict zakat computation principles.
 On the other hand, companies have to avoid an overoptimistic valuation of assets and revenues, which may lead to
distribution of unearned profits. Therefore, conservatism is important in measuring profits to be distributed amongst
partners, although it may be adjusted in order to calculate zakat.
 AAOIFI was silent on the Conservatism Concept in its Financial Accounting Standard No. 1 (FAS1).
 The Going Concern Principle

 The going concern principle reflects an assumption that the business for which Islamic
financial statements are prepared will continue to operate into the future.

 Islam recognises continuity as the basis of human life. The requirement to pay zakat on
an annual basis emphasises the continuity of business activity.

 AAOIFI (1999a) adopted the going concern concept in its Statement of Financial
Accounting No. 2 on the basis that Mudaraba contracts associated with a specific
period of time continue operating until one of the parties to the contract decides to
terminate the contract.
Social Accountability and Full Disclosure :

 The tenet of social accountability in Islam motivates businesspeople to act for the benefit of the Ummah in their
day-to-day activities.

 This necessitates consultation and consensus and implies a principle of full disclosure, which is a strict form of
transparency.

 The concept of full disclosure ensures that any and all information of substance or interest to users, to which
they are morally entitled under the Sharia, is provided to assist them in decision making.

 For instance, information disclosed about companies' activities and their impact on society at large should be
accurate, complete, reliable, and free of bias and reflect equitable treatment of the parties involved.
 MARKET VALUE
 Central to Islamic accounting is the use of current values instead of historic costs for the correct computation of
zakat.

 Current values, when measured accurately, contain more information than actual costs about risk and have the
incidental advantage that they are consistent with international financial reporting standards and the
pronouncement of the main Islamic standard setters.

 The principle of Tandeed in Islam requires companies not to distribute any profit resulting from business
transactions until the invested capital is recovered.

 While some scholars believe that the initial capital invested should be maintained prior to any distribution of
profit, others argue that this principle requires the real capital or economic value to be maintained as opposed to
nominal capital. This favors the use of current values.

 However, pragmatic difficulties associated with the implementation of market values may necessitate the use of
historic cost as estimates of market values in many cases. Some writers have argued for two balance sheets in
Islamic financial reports, one prepared on historical cost figures and another using market values.