CHAPTER 3

ADJUSTING ISLAMIC
ACCOUNTING RECORDS
AT THE CLOSE OF THE
ACCOUNTING PERIOD
 Learning Objectives
After studying this chapter, you should be able to:
1.Explain the accrual accounting system and its suitability to an Islamic business environment.
2.Make the necessary end-of-period adjustments to the accounts.
3. Journalize and post closing entries.
4.Prepare an extended trial balance, taking into account the necessary adjustments to the accounts.
5.Prepare the profit and loss account and balance sheet from the extended trial balance.
 ADJUSTING ISLAMIC ACCOUNTING RECORDS AT THE CLOSE OF THE
ACCOUNTING PERIOD
■ Trade and commerce are encouraged in Islam. Many verses in the Quran promote honest trade and business
activities.

■ People are encouraged to work toward respectful living for their families and support others less fortunate
through charitable donations.

■ The generation of profits is not done at the expense of, or through the exploitation of, others, and the welfare
of the community is promoted over the rights of the owners of the business.

■ For Zakat and other reasons, Islamic financial statements are produced annually:
 As already noted, FAS1 requires the production of a profit and loss account, which shows the revenue
generated by a business during an accounting period minus all the expenses paid to generate these revenues.

 This is a significant metric for an Islamic business but is not the only important indicator of success in an Islamic
environment, since a profitable business contributes positively not only to the owners' wealth but also to the
betterment of the community and the wider economy.

 The benefits of the economic activities of a business to society generally are seen in the calculation of value-
added.
 ADJUSTING ISLAMIC ACCOUNTING RECORDS AT THE CLOSE OF THE
ACCOUNTING PERIOD

 The system accountants use to prepare the financial statements is the accrual system of
accounting, which stands in contrast to the cash basis of accounting.

 The accrual basis allows for recognising revenues when they occur irrespective of whether
cash is received. This system also allows recognising the expenses when they take place
irrespective of the whether they are paid.

 The accrual system of accounts is the one mostly used around the world and is based on
certain accounting concepts and principles including periodicity, realization, going concern,
entity, and others.
 ACCRUAL ACCOUNTING
 The Quran requires records of indebtedness to be kept by followers. Surat Al-Baqra verse 2:282 states, ‘Believers,
when you contract a debt for a fixed period, put it in writing. Let a scribe write it down fairly… and let the
debtors dictate, not diminishing the sum he owes…’
‫فاكتبوه(ياأيها‬
‫الذين آمنوا إذا تد‬ )

 In an Islamic business, accountants are, therefore, required to record the Sharia compliant economic events,
which have financial implications.

 Accountants are required to follow accrual principles that allows for recognising revenue when it occurs
irrespective of whether cash is received and allows recognising the expenses when they take place, irrespective
of whether they are paid.

 According to the Malaysian Financial Reporting Standard i-12004, ‘Presentation of Financial Statements of
Islamic Financial Institutions’, with the exception of the cash flow statement, the financial statements must be
prepared on the basis of the accrual accounting system. Any departure from this rule must be approved by the
Sharia Advisory Council of Bank Negara Malaysia.
 Accrual accounting

 Accrual accounting provides a comprehensive picture of the results of the operations

and financial position of businesses.

 If a business earned revenue prior to the end of the accounting period without
collecting cash, using the cash-basis of accounting method, the financial statements
would not report the revenue or the related account receivable, because no collection
has occurred. This omits important information about the financial position of the
business.

 According to AAOIFI's SFA2, ‘Revenues should be recognised when realized’. Realization

of revenues is subject to the legal right that the entity is to receive the expected
revenue and the receipt of revenue is known with a reasonable degree of certainty.
 Adjusting the accounts at the accounting period end

 The Islamic Sharia requires financial statements to be prepared at the end of each accounting
period.

 The financial statements are prepared from the accounting balances of the various accounts
available on the books and summarized in the trial balance.

 Prior to the preparation of the financial statements, the trial balance will need to be adjusted for
items affecting more than one accounting period.

 The adjustment process, which takes place prior to the preparation of end of accounting period
financial statements, allocates revenues and expenses transactions to the period in which they
occur. The assets and liability accounts will also be adjusted to reflect their accrual basis balance
at the balance sheet date.
 Prepaid and Accrued Expenses
 Prepaid and accrued expenses are adjusted in the books to ensure they are accounted for in the
correct period in which they occur, according to accrual principles.

 Prepaid Expenses arise when expenses are paid in advance. A business may have to pay for certain services
in advance—that is, prior to when the service is delivered. Such practice gives rise to an asset account
named prepaid expenses. Prepaid expenses represent payments made for expenses that are not yet
incurred.

 Examples of prepaid expenses include rent paid in advance, where the landlord requires payment at the
beginning of the month or the year. Other examples include prepaid insurance, which is typically paid in
advance for the period insured.
■ Accrued Expenses arise when expenses are incurred but not yet paid. Accrued expenses are the
counterpart of prepayments. They are expenses for services already delivered but not yet paid for.
■ Examples of accrued expenses include salaries payable or accrued salaries, which represents the salaries
due for work performed by employees not yet paid for. Adjusting entries are prepared at the end of the
accounting period to account for accrued expenses. The accountant will record each expense and its
corresponding liability prior to the preparation of the financial statements.
 Accrued and Unearned Revenues
Accrued Revenues refer to the revenue earned by the companies for which the cash has
not yet been received. The cash will be collected later.

Unearned Revenues refer to the advance payment for work not yet performed. These are
amounts collected from customers for services not yet delivered. Given that the work is
not yet performed, any advance payment represents an obligation and must appear in the
liability side under unearned revenues or deferred revenues. Revenue becomes earned
only when the work is performed or the service or product is delivered.
■According to the Application Guidance of the Malaysian FRS 132 Financial Instruments:
Disclosure and Presentation (AG11): ‘Assets (such as prepaid expenses) for which the
future economic benefit is the receipt of goods or services, rather than the right to receive
cash or another financial asset, are not “financial” assets. Similarly, items such as deferred
revenue and most warranty obligations are not “financial” liabilities because the outflow of
economic benefits associated with them is the delivery of goods and services rather than a
contractual obligation to pay cash or another financial asset’.

■These transactions therefore result in the creation of what are considered ‘non-financial’
assets and liabilities rather than ‘financial' assets and liabilities.
 Depreciation of Fixed Assets
 In an Islamic business, Fixed or noncurrent assets are assets entrusted to the business to assist
in its operations and are not intended for sales. The word entrusted is used because according
to the Islamic Sharia, the ultimate ownership of assets remains with God.

 The Quran in Al Baqarah, 2:284 specifically mentions that )whatever is in heavens and
whatever on earth belong to Allah(. ‫))هلل ما في السماوات وما في األرض‬

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

 According to the Malaysian FRS116, the costs of property, plant, and equipment are recorded
as assets if future economic benefits could be associated with the use of these assets, and
their cost can be measured reliably. All fixed assets, with the exception of land, tend to decline
in value over time. Companies create a depreciation account to capture the decline in the
value of fixed assets.
Examples
Example: Dar Alhikma pays advance rent to its landowner of $15,000 on December 31, 2017, in respect of
bookshop rent for the following year. Dar Alhikma will recognise the payment as an asset of $15,000 in
the 2017 financial statements. This will be reflected in the 2017 books of Dar Alhikma as follows:

Debit Prepaid rent $15,000

Credit Cash $15,000

In 2018, the period for which the prepaid expenses were intended, the prepaid expenses will then be
recognised as an expense related to this year. The 2018 books will reflect this as follows:
Rent expense (income
Debit $15,000
statement)
Credit Prepaid Rent $15,000
 Example: Tecom signed a contract with Tamimi law firm to provide legal services for a three-month period
from March 1, 2018, to May 31, 2018, and paid $15,000 cash in advance for this service.
This transaction will be reflected in Tecom books in the following manner:

Debit Prepaid legal services $15,000

March 1, 2018 Cash
Credit $15,000

The prepaid legal service represents an asset account.

March 31, 2018 Debit Legal expense $5,000

Credit Prepaid legal services $5,000

April 30, 2018 Debit Legal expense $5,000

Credit Prepaid legal services $5,000

Debit Legal expense $5,000

May 31, 2018
Credit Prepaid legal services $5,000
Reducing balance Cost 20,000
Accumulated depreciation provision *8,750
Carrying amount (or net book value) 11,250
Depreciation year 1 + Depreciation year 2 *

Accrued Expenses

Example: The December 31, 2018, financial statements of Dar Alhikma showed a water and electricity account
balance of $200 accrued. The 2019 books would show a credit balance of this amount on January 1, 2019. The total
payment for water and electricity invoices for the first 11 months up to November 30, 2019, was $4,600. The books
of Dar Alhikma would show the following charges for the water and electricity account to reflect the preceding
transactions. The adjusting entry for accrued water and electricity account on December 31, 2018, would be:

Dr Electricity expense $200

Cr Accruals $200
This adjustment is to ensure that the water and electricity costs incurred up to December 31, 2018, are recognized as
an outstanding amount that remains at the end of the year. The 2019 books would show this amount at the
beginning of the following year to offset against the payment made during the year of $4,600, which included the
amount that was accrued in 2018. The payment of $4,600 does not include the water and electricity already
consumed for December 2019. The amount for this month must therefore be accrued. On the basis of the payment
of $4,600 for the 11 months of the year and the outstanding amount from last year, one can assume that the amount
due for December would be $400, i.e. ($4,600 − $200)/11, and the following entry would therefore be made in the
accounting records on December 31, 2019
Dr Electricity expense $400
Cr Accruals $400

Accrued Revenues Accrued revenues refer to the revenue earned by the companies for which the cash has not yet
been received. The cash will be collected later.
Example: On March 3, 2019, Dar Alhikma sold books to the university bookshop for $7,000 and received the payment
on March 15, 2019. This transaction will be reflected in the books as follows:
March 3, 2019 Debit Credit
Accounts receivable 7,000
Sales 7,000

Debit Credit
March 15, 2019 Cash 7,000
Accounts receivable 7,000
 Unearned Revenues :-
Example: On April 1, 2019, Tecom leased office space to Infosys and signed a one-year contract. Tecom
received $8,000 from Infosys as rent for April and May 2019 in advance.
April 1, 2019 April 30 and May 31, 2019
Cash is received. Revenue is recognised at the end of April 2019 and May 2019.
Tecom should only recognise revenue when its services are provided to Infosys. This transaction would
be reflected in the books of Tecom as follows:
April 1, 2019

Debit Credit
Cash 8,000
Unearned rent revenue 8,000

Until the services are provided by Tecom, the unearned rent revenue account represents liability in Tecom accounts.
Therefore, ‘Unearned revenue’ refers to amounts received prior to services for which the amount is received are provided
April 30, 2019 Debit Credit Debit Credit
May 31, 2019
Unearned rent revenue 4,000 Unearned rent revenue 4,000
Rent revenue 4,000 Rent revenue 4,000
Depreciation of Fixed Assets:
Example: Dugas has acquired a new machine during the year at a cost of $20,000. The machine has an expected
useful life of five years, after which time it will be sold for $5,000. If Dugas decides to use straight-line
depreciation, it will allocate the cost of the machine less salvage value equally through the life of the machine –
that is, the annual depreciation charge will be

This charge will be used every year for the five-year life of the machine. If Dugas chose to use the declining-
balance method and apply a 25% rate, the resulting depreciation charge would be as follows:

This shows that different depreciation methods lead to different charges applied in the income statement, thus
leading to different profit figures.
FRS 116 requires the depreciation method to be reviewed each financial year-end to ensure that companies reflect
any significant changes in the expected pattern of future economic benefits associated with the use of fixed assets
Accumulated Depreciation
Accumulated depreciation represents depreciation to date. That is the total depreciated amount since the asset was
first bought. It is the sum of the depreciation amounts to date. The accumulated depreciation is a contra-asset account.
That is, it will have the relevant fixed asset as its companion. While the balance of the fixed assets is always a debit
balance, its accumulated depreciation will always have a credit balance.
Using the preceding Dugas example, the journal entry in the books of Year 2 will be:
Straight line
DR Depreciation expense 3,000
CR Accumulated depreciation provision 3,000

Reducing balance
DR Depreciation expense 3,750
CR Accumulated depreciation provision 3,750

Carrying Amount
Fixed assets are shown in the balance sheet on the asset side at their carrying amount. This is their original cost or
valuation minus accumulated depreciation and any accumulated impairment losses. The carrying amount is also
referred to as the asset net book value. The assets side of the balance sheet shows fixed assets as per the following
example. The respective carrying values appearing in Year 2 balance sheet under each method would be as follows:
Straight line Cost 20,000
Accumulated depreciation provision *6,000
Carrying amount (or net book value) 14,000
Depreciation year 1 + Depreciation year 2 *
Comprehensive Example:
The ledger accounts of Afaaq show the following balances as of December 31, 2019:

a. Prepaid insurance $4,000

b. Equipment $10,000
c. Service income $1,500
d. Unearned income $3,000

Additional Information:
• The $4,000 prepaid insurance represents the cost of an insurance policy covering two years, effective from
January 01, 2019.
• The depreciation rate on the equipment is 20%. The estimated residual value is zero.
• Services provided but not billed at December 31, 2019, are valued at $500.
• Half of the unearned income has been earned during the year.
Requirements: Prepare the adjusting entries for the year to December 31, 2019.

Solution:
Adjusting Entries

Credi
Date Account Title and Explanation Ref. Debit
t

Dec. 31, Dr. Insurance expense Cr. PrepaidInsurance

2,000 2,000
2019 expense expired for the year.

Dr. Depreciation expense Cr. Accumulated

Dec. 31,
dep. – Equip. 2,000 2,000
2019
Yearly depreciation charged.

Dr. Accounts receivable

Dec. 31,
Cr. Service income 500 500
2019
Income accrued for services realized.

Dr. Unearned income

Dec. 31,
Cr. Service income 1,500 1,500
2019
Unearned income realized.

The Extended or Adjusted Trial Balance

The balances of all accounts in the ledger are listed in the trial balance. Adjustments are required to produce the
adjusted trial balance from which the financial statements will be prepared. We complete this process for the Al
Madani Group below. The company trial balance as of December 31, 2019, is shown in Table 3.1.
TABLE 3.1 Al Madani Group Trial Balance as on December 31, 2019
Account Title Trial Balance
Dr. Cr.
Cash 31,950
Accounts receivable 19,200
Supplies on hand 4,200
Prepaid insurance 7,200
Prepaid rent 56,550
Account payable 9,390
Fixed assets 63,450
Sales received in advance 13,500
Capital 150,000
Dividends 9,000
Sales 32,100
Advertising expenses 150
Gas and oil expenses 2,040
Salaries expenses 10,800
Utilities expenses 450
Total 204,990 204,990

Assume the insurance expense for the month of December was $600, rent expense for the same month was
$1,200, supplies used during the month amounted to $1,500, and the depreciation allowance for December was
$2,250. Fixed assets consist of property, plant, and equipment purchased on December 31, 2018. Also, assume
$6,300 of the sales received in advance account has been earned by December 31, unbilled sales were $3,000,
and salaries not yet paid at year-end were $540.
Recording the Adjusting Entries
The worksheet provides information that assists in identifying the accounts that need adjustment. Data used to record
adjusting entries in the journal and post these entries to the ledgers. The adjusting entries from the preceding Al
Madani group worksheet will be as follows:
Dec. 31 Dr. Insurance expenses……………………………600

Cr. Prepaid insurance…………………………… 600

Dec. 31 Dr. Rent expenses………………………………….1200

Cr. Prepaid rent………………………………………. 1200

Dec. 31 Dr. Supplies expense……………………………….1500

Cr. Supplies………………………………………. 1500

Dec. 31 Dr. Depreciation………………………………….2250

Cr. Accumulated
2250
depreciation………………………………….

Dec. 31 Dr. Sales received in advance…………………6300

Cr. Sales………………………………………………… 6300

Dr. Unbilled
Dec. 31
sales……………………………………………….3000

Cr.
3000
Sales…………………………………………………….

Dr. Salaries
Dec. 31
expense…………………………………………540

Cr. Accrued salaries…………………………………… 540

Posting the preceding entries to the ledgers is as follows:

Supplies Expense Insurance Expense Rent Expense

1,500 600 1,200

Supplies on hand Prepaid Insurance Prepaid Rent

4,200 1,500 7,200 600 56,550 1,200

Depreciation Sales Received in Advance Unbilled Sales

2,250 3,000
6,300 13,500

Accumulated Depreciation Salaries Expenses

Sales
2,250 10,800
32,100
540
6,300

3,000 Accrued Salaries

Balance 41,400 540
The Financial Statements
The adjusted trial balance shown in Table 3.2 can be used to prepare the financial statement for the Al Madani Group.
The accounts listed in the adjusted trial balance are allocated to their relevant financial statements. The income
statement lists all the revenues generated by the company and the expenses paid to generate these revenues. The assets,
liabilities, and owners' equity accounts are taken to prepare the balance sheet. The income statement for Al Madani
Group is shown in Table 3.3.
TABLE 3.2 Al Madani Group Adjusted Trial Balance as on December 31
Account Title Trial Balance Adjustments Adjusted Trial Balance
Dr. Cr. Dr. Cr. Dr. Cr.
Cash 31,950 31,950
Account receivable 19,200 19,200
Supplies on hand 4,200 1,500 2,700
Prepaid insurance 7,200 600 6,600
Prepaid rent 56,550 1,200 55,350
Account payable 9,390 9,390
Fixed assets 63,450 63,450

Accumulated depreciation 2,250 2,250

Sales received in advance 13,500 6,300 7,200

Capital 150,000 150,000

Dividends 9,000 9,000

Sales 32,100 9,300 41,400
Advertising expenses 150 150
Gas and oil expenses 2,040 2,040
Salaries expenses 10,800 540 11,340
Utilities expenses 450 450
Insurance expense 600 600
Rent expense 1,200 1,200
Supplies expense 1,500 1,500
Depreciation 2,250 2,250
Interest revenue
Salaries payable 540 540
Unbilled Sales 3,000 3,000

Total 204,990 204,990 15,390 15,390 210,780 210,780

TABLE 3.3 Al Madani Group Income Statement for the Year Ending December 31, 20X4

Revenue
Sales 41,400
Expenses
Advertising expenses 150
Gas and oil expenses 2,040
Salaries expenses 11,340
Utilities expenses 450
Insurance expense 600
Rent expense 1,200
Supplies expense 1,500
Depreciation 2,250
Total Expenses 19,530
Net Profit 21,870
The statement of changes in owners' equity, which represents the movement in the owners' equity of Al Madani, is
shown in Table 3.4.
TABLE 3.4 Al Madani Group Statement of changes in Owners' Equity for the Year Ended December, 31, 20X4

Capital at the beginning of period 150,000

Add: Net Profit 21,870
171,870
Less: Dividend 9,000

Capital as at end of period 162,870

The balance sheet of Al Madani as of December 31, 20X4, should be as shown in Table 3.5.
TABLE 3.5 Al Madani Group Balance Sheet as of December, 31, 20X4

Assets Liabilities
Cash 31,950 Account payable 9,390
Account receivable 19,200 Salaries payable 540

Unbilled sales 3,000 Sales received in advance 7,200

Supplies on hand 2,700 Total Liabilities 17,130

Prepaid insurance 6,600 Owners' Equity 162,870
Prepaid rent 55,350
Fixed assets 63,450
Less: Accumulated
2,250
depreciation
Fixed assets net 61,200

Total Assets 180,000 Total Liabilities and Owners' Equity 180,000