CHAPTER 4

ISLAMIC FINANCIAL
STATEMENTS
Learning Objectives

■ After studying this chapter, you should be able to:

1. Prepare an accounting worksheet.
2. Complete the accounting cycle using an accounting worksheet.
3. Close the accounts of revenue, expense, and drawings.
4. Correct accounting errors.
5. Prepare a classified balance sheet.
6. Prepare basic Islamic finance statements
THE ACCOUNTING CYCLE

 The value chain from recording transactions in the journal, posting these records to the ledger, preparing the
trial balance, and finally producing the financial statements is referred to as the accounting cycle.

 The accounting cycles for the following periods start with the balances of the accounts of the preceding period.

 At the end of the accounting period, the fair values of some assets and liabilities are estimated based on market
conditions existing at the balance sheet date.

 The accounting cycle starts with journalizing the business transactions taken place during the accounting period
and ends with the preparation of the financial statements at the end of the period after adjusting and closing
the accounts and journalizing and posting the adjusted entries. The end-of-year account balances are taken
forward to the following period as starting balances for these accounts
The Worksheet

 The trial balance, which includes the debit and credit balances of all the accounts in a business, is the principal
source of data for the preparation of the end-of-period financial statements. This process of moving information
from the trial balance to the financial statement can be done using a worksheet.
 It lists the account balances from the unadjusted trial balance, helps identify the accounts that need adjustment,
and lists ending adjusted balances for all accounts.
 It is important to note that the worksheet is not part of the accounting system but is a document that facilitates
transferring information from the unadjusted trial balance to the related financial statements.
1. The first three columns of the worksheet have the title of the account and the unadjusted account balances as
debits and credits.
2. Columns four and five cover the adjustments to the trial balance accounts
3. Columns six and seven will have the adjusted account balances, which represent the combination of the
adjusted and unadjusted figures
4. Each of the balances in the adjusted trial balance is transferred to the income statement and balance sheet
according to the type of account: assets, liabilities, owners' equity, revenues, or expenses.
Completing the Accounting Cycle An important purpose of the accounting worksheet is to
summarize data to assist in the preparation of financial statements at the end of the accounting
period.

Preparing the Financial Statements The worksheet shows the total revenue and total expenses in
two different columns. The difference between the two represents the net profit or loss for the
period.
 Closing the Accounts
 Closing the account is the process of journalising and posting closing entries as well as zeroing all revenue
and expense accounts to prepare for the next period's accounts.

 Balance sheet accounts (assets, liabilities, and capital or equity accounts) are not closed but their balances
are carried forward from one period to the next. These are permanent accounts.

 The revenue and expense accounts are temporary or nominal accounts.

 Owners' drawings are considered to be a distribution (withdrawals) of capital and the drawings account is
closed at the end of the period in the same manner as expense accounts.

 The process of closing the accounts involves transferring the revenue, expenses, and owners' drawings
account balances from their respective accounts to the Capital account. This step is done by creating an
intermediate holding account called Profit and Loss Summary or, Income Summary, where the total debit for
the sum of all expenses and drawings and the total credit for the sum of all the revenue accounts for the
period are collected. The Income Summary account is balanced and the balance is transferred to the Capital
account.
Post-Closing Trial Balance
 The post-closing trial balance represents the end of the
accounting cycle.
 It lists all the ledger account balances after the closing process.
 The steps show what goes to the next period and their
balances.
 Given that all temporary accounts – revenues , expenses,
dividends, and withdrawals – are transferred to capital as per
the previous step, only balance sheet accounts, namely assets,
liabilities, and capital accounts, are reflected in the post-closing
trial balance. ( see table 4.6)
ASSETS AND LIABILITIES CLASSIFICATIONS

 The two sides of the accounting equation contain lists of assets and liabilities, respectively.

 The assets represent the resources controlled, providing the business with future economic benefits. Examples
include cash, accounts receivable, inventory, furniture, land, and buildings.

 Liabilities are the claims on the assets; they represent the obligations the business will have to pay in the
future. Examples include creditors and long-term loans.

 The residual interest for the owners in the business is referred to as the owners' equity or capital.
 Financial Accounting Disclosure in Islamic Business Environments
 Financial Accounting Standard No.1, published by AAOIFI, lists the following financial statements
required by Islamic financial Institutions: A balance sheet, a statement of income, a statement of cash
flow, changes in owners' equity, or a statement of retained earnings and the notes to the annual
reports.
 The standard lists the following three additional statements that could be useful to users of Islamic
financial institutions' financial reports: Changes in restricted accounts, sources and uses of zakat and
charity funds, and sources and uses of qard funds statements. Specific disclosure requirements stated
by the standard include:
 The role of the Sharia Supervisory Board in overseeing the bank's Islamic finance activities
 The bank's responsibility toward zakat
 Disclosure of activities prohibited by the Sharia and how the bank intends to dispose of assets
generated by these activities.
 Unrestricted and restricted account information
 Information on the distribution of unrestricted accounts
 Investment profits allocation methods
 Information on returns and the rate of return for each type of investment
 Financial Accounting Disclosure in Islamic Business Environments

■ Islamic corporate reports should comply with Islamic Sharia social accountability and full disclosure
requirements. Such reports require additional information beyond what is currently provided in financial
statements.
■ Current values should be the basis of the balance sheet because zakat is computed on the basis of the
current value of assets, and current value information is needed for the calculation of shares in mudaraba
contracts.
Balance Sheet
 The balance sheet represents the financial position of the entity at a
particular point of time, so it is like a snapshot of the entity at that
point in time.

 In the case of Islamic banks, AAOIFI, FAS1 requires the balance sheet
to include the assets, liabilities, and equity of their unrestricted
investment accountholders (para. 31).

 The following assets must be disclosed in the body of the balance

sheet or in the notes to the financial statements (para. 37):
• Cash and cash equivalent
• Accounts receivable
• Investment in securities
• Mudaraba financing
• Musharaka financing
• Investment in other entities
• Inventories
• Real estate investment
• Assets acquired for leasing
• Other investments
• Fixed assets
• Other assets
Assets are divided in the balance sheet into two categories: Current assets and fixed assets.

 Current Assets
 Current assets are those assets that are mostly expected to be converted into cash within the current operating
cycle.

 Examples of current assets include cash at bank, accounts receivable, and prepaid expenses.

 Fixed or Noncurrent Assets

 In an Islamic business, fixed or noncurrent assets refer to assets that are entrusted to businesses by God and
used to perform their operations.

 They are not intended to be sold.

 Examples include machines and equipment, building, land, and furniture.

 According to the Malaysian FRS116, ‘The cost of an item of property, plant and equipment shall be recognized as
an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the
entity; and (b) the cost of the item can be measured reliably’.
 With regard to the liability side of the balance sheet of Islamic banks, FAS1 requires the following items
to be disclosed (para. 41 to 44):
• Current, savings, and other accounts
• Deposits of other banks
• Profits not distributed
• Zakat and taxes payable
• Other accounts payable
 Liabilities
are classified into short-term liabilities and long-term liabilities.
 Current Liabilities
Current liabilities are mostly short-term obligations that are expected to be paid within one year after
the end of the accounting period. Examples include accounts payable, salary payable, and unearned revenue.
 Long-Term Liabilities
Long-term liabilities are mostly obligations expected to be paid more than one year after the end of the
current accounting period. Examples of long-term liabilities include Islamic bonds (sukuk).

 Unrestricted investment accounts are disclosed as a separate item between liabilities and owners' equity.
 Minority interests are disclosed in the consolidated balance sheet as a separate item between unrestricted
investment accounts and owners' equity.
 The equity side of the balance sheet should include:
• Capital
• Reserve
• Retained earnings
Income Statement
The income statement shows the results of operations over a period. It lists the revenue generated
during this period and the expenses incurred in order to generate this revenue. FAS1 requires the
following items to be disclosed in the income statement of an Islamic bank (para. 50):
• Revenue
• Other revenue
• Expenses Income (loss) from investment
• Share of unrestricted investment accountholder income (loss) from investment before bank's
share as mudarib Islamic bank share income (loss) from investment
• Islamic bank share in unrestricted investment income as mudarib
• Islamic bank share in restricted investment income as mudarib
• Islamic bank fees for restricted investment agency
• Other expenses
• Administrative expenses
• Net income (loss) before zakat and taxes
• Zakat
• Taxes
• Net income (loss)
If the Islamic bank is paying the zakat on behalf of its owners, the zakat base should be disclosed.
Cash Flow Statement
 The cash flow statement shows the movement of cash during an accounting period, reconciling the
opening and closing cash balances shown in the balance sheet. Cash flows are categorized into
cash flow from operating activities, financing activities, and investing activities.

Statement of Changes in Owners' Equity

 This statement shows the changes in the owners' equity over a period. It typically shows
contributions to capital during the period, the income or loss for the period, and distributions to
owners during the period, reconciling these to the opening and closing balances on each of these
equity accounts. FAS1 requires the following items to be disclosed in the statement of changes in
owners' equity (para. 60):
• Retained earnings at the beginning of the accounting period
• Net income (loss) for the period Transfers to and from reserves
• Distributions to owners during the period
• Retained earnings at the end of the accounting period
Statement of Sources and Uses of Zakat and Charity
Funds
■ The sources and uses of the Zakat funds statement is prepared by companies
authorised to collect Zakat and distribute these funds as per the Sharia
requirements.
■ This statement includes sources of Zakat and charity funds and the application of
these funds during a particular period of time and the fund balance as the end of
the period. Muslims pay Zakat based on a percentage of the amount their net
assets have appreciated in value over time. Assets that have been purchased for
consumption purposes or are used in production are exempt.
■ In the case where Zakat is directly borne by the owner, the company should
indicate this in the notes to the accounts as per AAOIFI recommendation in the
case of an Islamic financial institution.
■ Charity funds are funds donated directly by customers, or funds that arise from
certain transactions, including those that a company cannot recognize as income,
such as penalties on loan default payment.
■ While Zakat is an obligation, charitable donations are discretionary. The use of
charity funds can be made in the form of contributions to fund, for example,
education initiatives for the needy, support for the poor, and supplementary
interest-freeloans.
Statement of Sources and Uses
of Qard Funds

 AAOIFI requires Islamic financial institutions

to prepare statement of qard funds.

 Funds available for lending as a non–

interest-bearing loan in accordance with the
Sharia are referred to as qard funds.

 Transactions affecting qard funds during a

period of time are reflected in the qard fund
statement, including the sources and uses
of funds during a period and the fund
balance at a given date.
■ Statement of Changes in Restricted Investments
 Islamic Banks must keep the use of restricted investment accounts within the conditions
imposed by their holders.
 Restricted investment assets are not included in the assets category of the bank's
financial statements. The statement of changes in restricted investments shows the
movement in these investments over a period of time and their balance at a given date.
This includes restricted investments deposits and withdrawals, profits or losses on
restricted accounts, and the bank's share of profits from the investments. FAS1 requires
the following to be disclosed in the statement of changes in restricted investments:
• Restricted investments at the beginning of the period
• The number of investment shares in each of the investment portfolio, and the value
per share at the beginning of the period
• Deposits received or investment shares issued during the period
• Withdrawals or shares repurchased during the period Islamic bank's share of profit
as a mudarib or fee as agent Allocated overhead expenses to restricted investment
profit (loss) during the period
• Restricted investments at the end of the period
• Number of investment shares at the end of the period and the value per share