ISSUES IN ACCOUNTING STANDRADS: FOR ISLAMIC FINANCIAL INSTITUTIONS

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ISSUES IN ACCOUNTING STANDRADS FOR ISLAMIC
FINANCIAL INSTITUTIONS

• Markfield Institute of Higher Education
• Dr. Seif E. I. Tag El-Din,
• October, 2004

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Introduction

• Banking success public trust placed in
  individual banks (depositors/ investors).
• Trust in Islamic banks also relates to the
  extent of adherence to Shariah ( the identity
  card of Islamic banks).
• Source of public confidence quality of
  information both financial strength and Shariah
  adherence.

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Imperative need for Accounting Standards

• Emphasis of the Quran
• ...Never get bored with recording it, however
  small or large, up to its maturity date, for
  this is seen by Allah closer to justice, more
  supportive to testimony, and more resolving to
  doubt..

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Imperative need for Accounting Standards

• An open room for making appropriate accounting
  judgement
• except when it is spot trade carried out
  amongst yourselves, then you are not to blame
  for not recoding it, (al-Baqara 2 82).

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General Plan

• Key Concept of an Islamic Bank
• Objectives of Islamic financial accounting
• Basic Accounting assumptions and criteria
• General Layout of Islamic Accounting Financial
  Statements

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I. Key concept of Islamic bank

• Mechanism accept deposits and offer
  financings plus other banking/ investment
  services.
• Compliance to Shariah interest rate elimination
  plus alternative Islamic modes.
• PLS investment alternatives
• Unrestricted investments.
• Restricted investments.
• Fiduciary service for funds devoted to social
  purposes Zakah, Charitable funds.

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Key Concept of Islamic bank Balance Sheet

• Assets Side Physical assets plus interest-free
  financial assets Murabaha, Ijara, Istisnaa,
  Salam, Mudarabah, Musharakah etc.
• Liability side
• Liabilities interest-free demand deposits,
  interest-free saving deposits- no fixed return
  term deposits.
• Unrestricted investment accounts The Islamic
  alternative of term deposits.
• Net, worth
• minority interest

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Islamic Banks Processing of rights and
obligations

• Recognition timely recording of the basic
  elements of financial statements as they take
  effect .
• Measurement - quantification of financial effects
  
• Recording - lucid classification scheme of
  financial effects
• Presentation - periodic reports to disclose
  financial records during the given period of
  time.

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II. Objectives of financial accounting.

• Why to identify unique objectives?
• Ensure consistency with the objectives of Islamic
  accounting standards.
• Ensure internal consistency for all present and
  future standards
• Provide general guidance for choice among
  possible alternatives.

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Objectives of financial accounting.

• Determine rights and obligations of all
  interested parties in accordance with the
  principles of Shariah.
• Subscribe to the safeguarding of the Islamic
  banks assets, its rights and the rights of
  others.
• Subscribe to the enhancement of managerial and
  productive capabilities of Islamic banks.
• Report useful information to users, thus
  enabling them to make legitimate decisions in
  their dealings with Islamic banks.

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Users of Financial Reports

• Focus must be placed on non-authoritative common
  information needs.
• Appropriate Users of information are
• Equity holders
• Investment account holders
• Current and Saving Account holders
• Other dealers with Islamic banks
• Zakah Agencies
• Regulatory agencies

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Objectives of Financial Reports

• Information about Islamic banks extent of
  compliance with Shariah.
• Information about adequacy of Islamic banks
  capital, investment risks, and liquidity.
• Information about cash flows-timing/risks.
• Information about Banks policy in Zakah
  assessment and disbursal.
• Information about Banks fiduciary
  responsibilities.
• Information about discharge of other social
  responsibilities.

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II. Basic assumptions and Criteria The
assumptions

• Accounting unit treatment of an Islamic bank as
  a separate accounting entity from its owners
• On-going concern no perceivable time horizon of
  assets liquidation or equity/ unrestricted
  investment termination. Consider the far reaching
  consequences !
• Periodicity breaking life of the Islamic bank
  into reporting periods
• Stability of purchasing power. The accepted
  standard is to ignore changes in the value of
  money.

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Qualitative Criteria of accounting information

• Usefulness in relation to given financial
  reporting objectives .
• Relevance Predictive value, Feedback value and
  Timeliness
• Reliability reflect the substance of the event
  or transaction.
• Comparability similar methods of measurement/
  disclosure in relation to similar events.
• Consistency same measurement/disclosure methods
  from one period to another.
• Understandability simple classification tools,
  clear information headings, juxtaposition of data
  and statement of net results which users want to
  know,

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Preparation and presentation criteria

• Materiality Qualitative as opposed to
  Quantitative materiality
• Cost of information Information is a costly
  economic resource.
• Adequate disclosure Optimum aggregation and
  written descriptions/ clarifications

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Measurement and Revaluation

• Accounting measurement the determination of the
  amounts at which accounting elements should be
  recognized matching.
• Measurable attributes fall into two categories
  cash equivalent value and historical cost.
• Justice consideration value of an investment
  account is dependent upon its expected cash
  equivalent value.

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Issue of Revaluation

• Revaluation of assets/liabilities Measurement
  at cash equivalents require periodic revaluation
  of assets liabilities and restricted investments.
  
• Currently adopted standard historical cost
  shall be the basis used in measuring and
  recording the assets at the time of acquisition
  thereof.

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General lay out of Islamic financial statements

• Basic classification as of conventional
  statements stocks and flows.
• Balance sheet snap shot of stocks at a given
  point of time financial position.
• Income statement moving film summary of inflow
  and outflows during a given period of time -
  accrual basis.
• Cash-flow statement moving film cash-basis
  statement of inflows and outflows. .

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Main categories of Islamic financial statements

• Financial statements reflecting the Islamic
  Banks function as an investor .
• A financial statement reflecting changes in
  restricted investments managed by the Islamic
  bank Mudarib /Agent.
• Financial statements reflecting the Islamic
  banks role as a fiduciary of funds for social
  purposes.

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Islamic Banks function as an investor

• Statement of financial position
• Statement of income.
• Statement of cash flow.
• Statement of retained earning / or statement of
  changes in owners equity.

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Statement of financial position
Disclosure

• Date of the statement
• Grouping of Assets and Liabilities in accordance
  of their nature, and in order of their relative
  liquidity.
• No current/ fixed groupings.
• Separate totals for Assets, Liabilities,
  Unrestricted Investment Accounts and their
  equivalents, and Owners Equity.

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Statement of financial position
Definitions

• Assets
• an asset is a measurable thing capable to
  generate cash flows or other economic benefits in
  the future, individually or in combination with
  other assets.
• Islamic bank must have acquired the right to
  hold, use or dispose of, as a result of past
  transactions or events.

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Statement of financial position
Definitions

• Liabilities
• A liability is a measurable present banks
  obligation to another party to transfer assets,
  extend the use of an asset, or provide services
  to that party in the future as a result of past
  transactions or events.
• Islamic banks obligation must not be a
  reciprocal to an obligation of the other party to
  the bank.

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Statement of financial position Definitions

• Unrestricted Investments and their equivalents
  (Unrest. part. bonds)
• Treated as elements of financial position,
  because they are based on unrestricted Mudarabah.
  
• Not considered a liability. Why ?
• not considered part of ownership equity because
  they do no enjoy ownership rights
  (e.g voting right)

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Statement of financial position Definitions

• Owners equity
• It is the amount remaining at the date of the
  statement of financial position, from the Islamic
  banks assets after deducting the banks
  liabilities, equity of unrestricted investments
  and their equivalents
• Prohibited earnings if any, must also be
  deducted.

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Statement of financial position
Assets Disclosure

• Cash and cash equivalent
• Receivables ( Murabaha, Salam, Istisnaa)
• Investment securities
• Mudarabah investment
• Musharakah investment
• Investment in other entities

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Statement of financial position
Cont. Assets Disclosure

• Inventories.
• Investment in real estate
• Assets acquired for leasing
• Other investments (disclosure of their types)
• Fixed assets (disclosure of depreciation for
  significant asset types )
• Other assets (disclosure of significant types).

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Statement of financial position Liability
Side

• Liabilities
• Equity of unrestricted investment account holders
  and their equivalents.
• Owners equity

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Statement of financial position Liability
Disclosure

• Current accounts, saving accounts and other
  accounts with separate disclosure of each
  category
• Deposits of other banks
• Salam Payable
• Istisnaa Payable
• Declared but undistributed profits
• Zakah and taxes payable
• Other accounts payable

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Statement of financial position Unrestricted
investment accounts Disclosure

• Method used to allocate profit/loss between the
  bank and unrestricted investment account
  holders.
• Assets jointly financed by the Islamic bank and
  unrestricted investment account holders and those
  exclusively financed by the bank .

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Income statement Definitions/Recognition

• Revenues Gross increases in assets or decreases
  in liabilities, or a combination of both,
  resulting from legitimate investment, trading,
  rendering of services, including investment
  management of restricted investment accounts.
  (exclusions !).
• Recognition
• Bank should have earned the right to receive
  revenue through a completely consummated process.
  
• An obligation must fall on another party to a
  remit a fixed or a determinable amount to the
  bank .
• Amount should be known and collectible, if not
  already collected

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Income statement Definitions/Recognition

• Expenses The simple reverse of revenues.
• Recognition Also recognized when realized,
  either
• because the expense relates directly to the
  earning of revenues that have been realized, or
• indirect costs relating to a certain period
  covered by the income statement.

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Income statement Definitions/Recognition

• Gains (losses ) A gain is a net increase in net
  assets resulting from
• Holding assets that appreciate in value during
  the period covered by the income statement
• Or from incidental legitimate reciprocal (e.g
  sale of assets not acquired for sale)
• Or non-reciprocal transfers (donations)
  (exceptions !)

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Income statement Definitions/Recognition

• Gains/losses are recognized when realized in one
  of two possible situations
• completion of a reciprocal or non-reciprocal
  transfer resulting in gain or loss,
• or sufficient evidence indicating reasonably
  measurable appreciation or depreciation in
  values of recorded assets or liabilities.

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Income statement Definitions/Recognition

• Net income (net loss)
• The net increase (decrease) in owners equity
• Results from revenues, expenses, gains, losses,
  after allocating the return on unrestricted
  investment accounts and their equivalents, for
  the period.
• It is the result of all on-going profit oriented
  operations of the bank and other events and
  circumstances.

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Income statement Disclosure

• Period covered by the income statement.
• Revenues and gains from investments
• (-)Expenses and losses from investments
• () Income (loss) from investments
• (-) Share of unrestricted investment account
  holders in income (loss) from investments before
  the banks share as Mudarib
• ()The banks share in income (loss) from
  investments

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Income statement con. Disclosure

• ()The banks share in unrestricted investment
  income as Mudarib
• () The banks share in restricted investment
  profit as Mudarib
• ()The banks fixed fee as an investment agent
  for restricted investment
• (/-) Other revenues, expenses, gains and losses
• (-) General and administrative expenses
• () Net income (loss) before Zakah and taxes
• (-) Zakah and taxes ( separate disclosures)
• () Net income (loss)

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Financial statement for changesin restricted
investments

• Restricted investments are not assets of the
  Islamic bank and should not be reflected in the
  banks statement of financial position.
• The bank does not have the right to use or
  dispose of these investments except within the
  conditions of the contract between the bank and
  holders of these accounts.
• The statement must show deposits and withdrawals
  by holders of restricted investments and their
  equivalent as of a given date.

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Financial statement for changesin restricted
investments

• Disclosure
• The period covered by the statement should be
  disclosed.
• The statement should segregate restricted
  investments by source of financing ( e.g accounts
  or portfolio units) and by type.
• Nature of contractual relationship between bank
  and owners of restricted investments Mudarib /
  agent
• Rights and obligations associated with each type
  of investment account or investment portfolio.

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Statement of sources and uses of funds in the
Zakah and Charity Fund

• Zakah A fixed obligation calculated by reference
  to net assets that have appreciated or have the
  capacity to appreciate over a specific period of
  time except for assets acquired for consumption
  or used in production.
• For Limited liability Company Zakah should be
  based on the companys net assets, and the total
  amount be divided between owners.
• Bank as an agent of Zakah

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Statement of sources and uses of funds in the
Zakah and Charity Fund

• Disclosure
• The period covered by the statement
• Banks responsibility for the payment of Zakah on
  behalf of owners of unrestricted investment
  accounts and their equivalents.
• Payments and uses of funds during the period and
  available funds at the end of the period.

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CONCLUSIONS

• THANK YOU