Accounting Standards of Islamic Financial Institutions: Analysis of the Balance Sheet Structure
Markfield Institute of Higher Education Dr. Seif I. Tag El-Din, October, 2004

I. Introduction

The need for accounting records as means for trust building is emphasized in the Quran: “...Never get bored with recording it, however small or large, up to its maturity date, for this is seen by Allah as closer to justice, more supportive to testimony, and more resolving to doubt ..”(al-Baqara: 2 82). This verse relates primarily to the recording of deferred transactions, but it still hints for the likelihood of recording spot transactions though it was uncommon in the earlier stages :“..except when it is spot trade carried out amongst yourselves, then you are not to blame for not recoding it” (ibid). In this manner the Quranic verse provides for the fair recording of both deferred and spot transaction, which is all what accounting is about.
Banking success, in general, depends upon the extent of public trust placed in the financial strength of individual banks, most particularly the trust of depositors and investors. In addition to the paramount importance of financial strength, trust in Islamic banks relates also to the extent of adherence to Shariah, which is the identity card of Islamic banks. Therefore the major source of public confidence in Islamic banking financial statements is the quality of information issued to the investing public about banks’ ability to achieve both financial and Shariah-related objectives.

Prohibition of interest in financial dealings is the primary reason why Islamic financial accounting methods and principles have to be carefully distinguished from their conventional counterparts, but there are various other issues and fine details which make up for the case of Islamic financial accounting standards.

1/2 Scope of lecture:

Due to space and time constraints, we shall focus in this lecture on the following topics:

Key concept of an Islamic Bank - mainly as an accounting background.
Objectives of financial accounting for Islamic financial institutions
Basic assumptions and criteria for Islamic accounting
The prescribed general lay out of the balance sheet in Islamic banks.

Accounting standards for the various Islamic modes of financing are beyond the scope of this brief presentation. The present lecture is based on the Accounting and Auditing Standards for Islamic Financial Institutions, 1997, published by AAOIFI (the Accounting and Auditing Organization for Islamic Financial Institutions). Since its establishment in 1991, the Bahrain-based AAOIFI has been catering its advisory services as the professional body responsible to develop suitable accounting and auditing standards for Islamic banks. Additional help can be obtained from other references listed at the end. For a better appreciation of accounting issues, it is appropriate to highlight the basic financing and investment structure of a typical Islamic bank as adopted by the accounting standards.

I. Key concept of an Islamic bank

As a financial intermediary, the basic mechanism of the Islamic bank is to accept deposits from surplus persons on the liability side and offer financing on the assets side to the deficit persons, apart from ancillary income-generating services which do not concern us in this lecture. The idea is to activate this mechanism on acceptable Islamic modes which preclude payment or receipt of interest and conform to the jurist rules of Shariah. Formal definitions of accounting elements will be provided later, as our intention here is only to highlight the basic mechanism.

1/1 Assets & Liabilities Sides

Assets include physical and financial items in addition to a broad range of Islamic financings: Murabaha, Ijara, Istisnaa, Salam, Mudarabah and Musharakah. It will be assumed in this course that the reader is familiar with these modes of financing. The liabilities side of an Islamic bank consist of two main categories: ‘liabilities’ which are the guaranteed claims over the assets, including among other things the usual interest-free current and saving accounts, and the ‘non-guaranteed claims over the assets’, including investment accounts based on the profit-and-loss sharing principle (PLS) and owners’ equity. The PLS investment is the Islamic bank’s alternative of the interest-based term deposits which utilizes the principles of Mudarabah and Musharakah.

Investment structure:

For the purpose of the accounting standards Of Islamic financial institutions, two major categories of investment activities are defined:

Unrestricted investment accounts and their equivalents: These are funds received by the Islamic bank from investors, whereby the Islamic bank is held free to invest those funds without prior restrictions, including the mixing of these funds with the bank’s own investment. In this case, rules of unrestricted Mudarabah are adopted. The term ‘equivalent’ accounts is used in the standards to allow for similar investments like unrestricted participating bonds issued by Islamic banks at face value and share in the bank’s profits.

Restricted investments and their equivalents: The bank acts only as manager - agent or non-participating Mudarib – it is not authorized to mix its own funds with those of investors without prior permission of the investors. Hence, the rules of restricted Mudarabah are adopted here.

Fiduciary service for funds devoted for social purposes: The financial statements of Islamic bank must also reflect its functions as possible agent of Zakah payment, manager of charitable funds and Qard Fund.

The above structure, investment pattern and unique religious features have proven to reflect far reaching implications as regards the preparation and presentation of financial statements of Islamic banks. The accounting treatment of different Islamic modes of financing will evoke various issues of recognition, measurement and disclosure which will be considered briefly in this lecture. Similar accounting issues arise with respect to the treatment and presentation of the above two kinds of investment.

1/2 Comparability with conventional banks

Apart from its unique characteristics, Islamic accounting shares with their conventional counterparts the same processes of recognition, measurement and recording of transactions and fair presentation of rights and obligation, but the crux of the matter is how to apply these concepts to Islamic financing and investment instruments. Recognition of ensuing rights and obligations must apply to a given period of time tracing all changes of consummated transactions that may have taken place. Measurement is the quantification of financial effects of consummated transactions and the impact of other events during the same period of time. The recording process in intended to offer a lucid classification scheme of financial effects, together with other events, in order to show the results of the entity’s operations and changes in its financial positions including cash flow. Periodic reports are, then, prepared and issued by the entities to disclose their financial records during a given period of time. It is interesting to see how the processes of recognition, measurement and recoding of rights and obligations are handled from the viewpoint of Islamic Accounting standards.

Information so reported is intended to assist investors in taking the right decisions with respect to their future dealings with the entity in question. It also assists the entity’s own management to evaluate its performance and lay future plans for the entity’s activities and financial services. Governmental agencies in Muslim countries should benefit a great deal from such reported information in the process of supervising the banking and financial sector and evaluating tax policies. Governmental regulatory requirements for conventional financial institutions are also shared by Islamic entities, like the basic provision of having adequate banking capital to provide safety for depositors’ money. Given the provision of adequate capital, success of Islamic banks depends on compliance with Shariah as well as the financial competence to realize rates of return commensurate to investment risks assumed.


II. Objectives of financial accounting
To achieve the desired success, accounting standards for Islamic banks should be developed consistently in relation to the unique objectives of financial accounting for Islamic banks and institutions. It is for this reason, as well as the need to ensure consistency among all present and future accounting standards that the Islamic objectives have to be clearly specified. The setting of clear objectives for financial accounting of Islamic banks and institutions, as opposed to their conventional counterparts, will also assist Islamic banks, in the absence of accepted accounting standards to make sensible judgements for choice among alternative accounting treatments.

The objectives of financial accounting determine the type and nature of information which should be included in the financial reports in order to assist users of these reports in making sound decisions. Government’s agencies, generally, have the power to directly obtain the type of information that best serves their needs. This leaves external users of information limited to the common information contained in the Islamic banks financial reports, namely: equity holders, holders of investment accounts, current and saving account holders, other depositors, other dealers with Islamic banks, Zakah agencies and regulatory agencies. On this basis, the objectives of financial accounting for Islamic banks and institutions are to achieve the following:

1. Determine the rights and obligations of all interested parties, including rights and obligations resulting from incomplete transactions and other events, in accordance with the principles of Shariah and its concepts of fairness, clarity and business ethics.
2. Subscribe to the safeguarding of Islamic banks’ assets, rights of Islamic banks and rights of others in an adequate manner.
3. Subscribe to the enhancement of management and Islamic banks’ productive capabilities, and encourage compliance with the established goals and policies, and above all Islamic Shariah, in all transactions and events.
4. Provide through financial reports useful information to report users, and thus enable them to make legitimate decisions in their dealings with Islamic banks.

On the other hand, the objective of financial reports is to provide the following kinds of information:

1. Information about the Islamic bank’s compliance with Shariah and its objectives. And, if the bank is partly engaged in prohibited dealings, information about the separation of such dealings and how to dispose of them.
2. Financial information assisting users to evaluate the adequacy of the Islamic bank’s capital, risks inherent in investment, and degree of liquidity for meeting the outstanding obligations.
3. Information about cash flows, their timing, and associated risks. This will help users evaluate an Islamic bank’s ability to generate sufficient dividend income for equity and profits for investment holders.
4. Information to assist in the assessment of Zakah on Islamic banks’ funds and the targets of its dispersal.
5. Information to assist in evaluating the Islamic banks’ discharge of its fiduciary responsibility, to safeguard funds and invest them at reasonable rates of return. This includes information about investment rates of returns on the bank’s investments and the rates of return accruing to equity and investment holders.

III. Basic assumptions and criteria for financial accounting:

3/1 Assumptions

Accounting unit: As per Resolution No. 65/17, 7th Session of the Fiqh Academy, Jeddah, 9-14 May, 1992, it is possible in Islamic jurisprudence to form a limited liability company. This provision allows for the treatment of the Islamic bank as a separate accounting unit from its owners.
On-going concern: In the absence of persuasive evidence to the contrary, financial accounting assumes the continuation of an entity as an on-going concern. This has very important consequences to Islamic banks as there is no perceivable time horizon of assets liquidation or investment termination in case of equity owners and owners of unrestricted investment accounts or their equivalents. Contrary to the case of traditional mudarabah and musharakah contracts, there is no specific time when the actual results of unrestricted investments would be known. This point will have significant implications for the issue of measurement.
Periodicity: Life of the Islamic bank should be broken into reporting periods to prepare financial reports that provide information to interested parties about the performance of the bank. Naturally, in a rapidly changing financial environment, end users would always seek to update their information about the banking system.
Stability of purchasing power: Financial accounting uses monetary units as a common denominator to express basic elements of financial statements. However, the use of monetary units is subject to inflationary and deflationary pressures which may significantly affect its purchasing power. Yet, for the purpose of the current accounting standards such effects are completely ignored.

3/2 Qualitative Criteria of accounting information

Usefulness: Usefulness of accounting information must be evaluated in relation to the objectives of presenting financial statements which are focused on making their external users make the best out of them. To be useful accounting information must target the interest of external users, which entails another set of criteria as below.
Relevance: A close relationship must exist between the financial accounting information and the purpose for which this information is provided. Accounting information is relevant if it helps the main users of financial statements to evaluate the potential outcomes of maintaining, or establishing, relationships the given Islamic bank, rather than assisting investors to choose from alternative options. To be relevant, accounting information must satisfy three main qualities.

Predictive value makes it possible for users to asses the potential outcome of a current or a new relationship with the bank.
Feedback value assists users to check the accuracy of their prior predictions, say, about net income.
Timeliness means information is only useful at the time when it is needed. Optimal frequency of reporting and minimal lag between successive reports are therefore important criteria for useful accounting information

Reliability: This is the quality which permits users to depend on the reported information with confidence, but reliability does not mean absolute accuracy. It means that based on all the specific circumstances surrounding a particular transaction or event, the method chosen to measure/disclose its effects produces information that reflects the substance of the event or transaction. The provision of estimates /judgements in accounting applying methods is not inconsistent with Shariah. Most particularly, reliability should satisfy the following properties of representational faithfulness, objectivity and neutrality.
Comparability: Usefulness of accounting information is enhanced by comparability of bank’s performance over time. This property requires the adoption of similar methods of measurement/ disclosure in relation to similar events.
Consistency: Banks should stick as much as possible to the same measurement/disclosure methods from one period to another, unless there is genuine call for change (e.g changing depreciation measurement). In this case, the new change and its effect should be appropriately disclosed.
Understandability: Accounting information is targeted to common users not to accountants. The nature of information, the way it is presented and the technical background of external users are important factors in the preparation of understandable information. Use of simple classification tools, clear information headings, juxtaposition of data and statement of net results which users want to know, would contribute to better understandability.

3/3 Preparation and presentation criteria:

Materiality: An item is regarded material – qualitatively or quantitatively - if its omission non-disclosure or misstatement will result in distortion of the information being presented in the financial statements and thereby, misguidance of users. In deciding whether an item is material, its nature and relative amount must be taken into account.
o Qualitative materiality refers to the nature of given transactions or events whether it is

usual/unusual, expected/unexpected, Shariah compliant/non-compliant, etc.
o Quantitative materiality refers to the relative amount of an item as for compared with

normal expectations, or relative to an appropriate base.
Cost of information: Information is a costly economic resource. Therefore, a process of cost/benefit analysis must underlie the decision to choose the relevant information for financial reporting.
Adequate disclosure: Basic information about the bank must be disclosed, as well as currency used, and accounting policies adopted. More generally, financial statements, notes accompanying them, and any additional presentations should contain all material information necessary to make them useful to end users. Optimum aggregation and written descriptions/clarifications are two important considerations:

o Highly aggregated data conceals useful detail, and highly detailed data can be side-tracking

and confusing. Optimal aggregation is the middle course which must be adopted.
o Heading captions and amounts must be supplemented information just enough to clarify

their meanings. Supplementary notes to financial statement are an example.

3/4 Accounting recognition & measurement
Accounting recognition: refers to the timely recording of the basic elements of financial statements as they take effect, which is the reason why a clear definition of accounting elements must precede their recognition. It is worth noting that recognition relates to accounting flows rather than stocks since the stocks will, then, be automatically recognized. This issue is particularly crucial as regards recognition of assets acquired under various Islamic modes of financing, profit/loss investment accounts, and funds ((e.g when should Murabaha profit, or Mudarabah capital, be recognized ? when should investment profit be recognised, and how is it measured?). The rules governing recognition and measurement must be appreciated by reference to Shariah rules.

Accounting measurement: refers to the determination of the amounts at which accounting elements should be recognized. Measurement of accounting flows requires the matching of incomings with the corresponding outgoings, separately, for each independent account during a given period of time, e.g the matching of revenues and gains with expenses and losses to get the bank’s net income for a given period of time.

Measurable attributes: Measurable attributes of an asset or a liability fall broadly into two categories: cash equivalent value and historical cost. The latter stands for the cash value expected to be realized as of the current date if an asset is sold for cash in the normal course of business. The formers stands for the asset’s fair value at the date of its acquisition including amounts incurred to make it usable or ready for disposition. These two attributes invoke significant implications as regards measurement of assets acquired under various modes of financing. They also relate to the issue of revaluation of unrestricted investment accounts and restricted investment accounts.

3/5 the Issue of Revaluation
Measurement attributes, as defined above, provide for the possibility of adopting cash equivalent value by the Islamic bank both as a joint investor in the unrestricted investment accounts and as a manager as in the restricted investment accounts.

Justice consideration: In general, the value the holder of an investment account expects to realize from his funds is considerably dependent upon the cash equivalent value he expects to realize if investments were re-valued, or sold, as of the current date. Yet, the results of investments do not occur at a given point of time. Rather, such results are earned over the life time of the investments even though the ultimate results will become certain only at the time when the investments are liquidated. However, if investments were to be measured at historical costs, recognition of investment results will only take place at the time of investment liquidation. This point arouses a strong consideration of justice between holders of investments accounts since they are allowed to subscribe or withdraw their investments at different times during the period of the contract. In case of unrestricted investment accounts, justice has to be observed, not only between holders of unrestricted investments, but also between them as a group and the equity owners of the bank as a group.

Revaluation of assets/liabilities: Measurement of cash equivalents expected to be realized or paid requires periodic revaluation of assets liabilities and restricted investments. However, the currently adopted standard is that “historical cost shall be the basis used in measuring and recording the assets at the time of acquisition thereof”. Nonetheless, it is permissible to do the revaluation for the purpose of presenting supplemental information which may relevant for an existing or a potential holder of an investment account.

Based on the above assumptions and criteria, the general layout of financial statements can now be considered. Islamic financial statements share the same broad classification of conventional financial statements as representations of stocks and flows. The stock concept is typical of the balance sheet which provides a summary of the financial position of an entity at a given point of time. In addition to the balance sheet, the income statement provides a summary of the inflow and outflows during a given period of time, as it is measured on accrual basis. The latter is particularly relevant for assessing the operating efficiency of the entity, but not the sate of cash liquidity. It is for this reason that a cash-basis statement is needed to complement the flow concept of financial statements as opposed to the stock concept.

The set of financial statements of Islamic financial institutions consist of the following:

· Financial statements reflecting the Islamic Bank’s function as an investor and its rights and obligation regardless of the objective of investment whether it is profit oriented or socially oriented. Such financial statements include:

o Balance Sheet (Statement of financial position)
o Statement of income
o Statement of cash flow
o Statement of retained earning or statement of changes in owners’ equity.

· A financial statement reflecting changes in restricted investments managed by the Islamic bank for the benefit of others, whether based on Mudarabah contract or agency contract
· Financial statements reflecting the Islamic bank’s role as a fiduciary of funds made available for social purposes when such services are provided through separate funds:
o Statement of sources and uses of Zakah and Charity fund
o Statement of sources and uses of funds in the qard fund.

IV. General lay out of Balance Sheet:

Disclosure: The date of the statement must be disclosed. The statement should include the Islamic bank’s assets, liabilities, equity of unrestricted investment account holders and its equivalents, and its owners’ equity. Assets and liabilities should be combined into groupings in accordance of their nature, and in order of their relative liquidity, but the conventional division into current and fixed groups is not recommended. Assets should not be set-off against liabilities unless there is a religious or legal right and an actual expectation of set-off (e.g deferred profits in Murabaha shall be set-off against Murabaha receivables). Separate totals for assets, liabilities, unrestricted investment accounts and their equivalents, and owners’ equity must be provided. Other considerations of disclosure will be added to their respective items below.

Definitions: The following definitions relate to the broad items of the statement of financial position.

Assets: An assert is any measurable thing that is capable to generate cash flows or other economic benefits in the future, individually or in combination with other assets, of which the Islamic bank has acquired the right to hold, use or dispose of, as a result of past transactions or events.
Disclosure of assets: The following breakdown of assets should be disclosed either on the face of the financial statement of financial position or the notes to financial statements:

1. Cash and cash equivalent
2. Receivables ( Murabaha, Salam, Istisnaa)
3. Investment securities
4. Mudarabah investment
5. Musharakah investment
6. Investment in other entities
7. Inventories (including goods purchased for Murabaha prior to consummation of Murabaha

agreement
8. Investment in real estate
9. Assets acquired for leasing
10. Other investments (disclosure of their types)
11. Fixed assets (disclosure of depreciation for significant asset types )
12. Other assets (disclosure of significant types).

Liabilities: A liability is any measurable present bank’s 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. The Islamic bank’s obligation must not be a reciprocal to an obligation of the other party to the bank.

Disclosure of liabilities: The statement of financial position or its note should disclose the following liabilities:
1. Current accounts, saving accounts and other accounts with separate disclosure of each

category
2. Deposits of other banks
3. Salam Payable
4. Istisnaa Payable
5. Declared but undistributed profits
6. Zakah and taxes payable
7. Other accounts payable

Equity of unrestricted investment account holders and their equivalents: At the date of the statement of financial position, equity of unrestricted investment account holders (and their equivalents) refers to the amount of original funds received minus withdrawals or transfers to other accounts plus/minus shares in profits/losses. Because they are based on unrestricted Mudarabah, unrestricted investment accounts and their equivalents are treated as elements of the financial position.

It is noteworthy that equity of unrestricted investment account holders and their equivalents is not considered a liability since there is no obligation on the bank to guarantee original principals except in cases of proven neglect. Likewise, equity of unrestricted investment account holders and their equivalents is not considered part of ownership equity because they do no enjoy voting right or entitlement to profits generated from the use of the bank’s current accounts.

Disclosure of unrestricted investment accounts/equivalents: The method used to allocate investment profit/loss between the bank and the unrestricted investment account holders and their equivalents should be disclosed, whether the bank acts as Mudarib or agent, should be disclosed. Separate disclosures of assets jointly financed by the Islamic bank and unrestricted investment account holders and those exclusively financed by the bank should be provided in supplementary notes.

Owners’ equity: It is the amount remaining at the date of the statement of financial position, from the Islamic bank’s assets after deducting the bank’s liabilities, equity of unrestricted investments and their equivalents and prohibited earnings if any.
Disclosure of owners’ equity: See statement of changes in owners’ equity

REFERENCES:

AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions), Accounting and Auditing Standards for Islamic Financial Institutions, Manama, Bahrain, 1997.

Accounting Auditing and Governance Standards for Islamic Financial Institutions, Manama, Bahrain, 2002
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