islamic accounting definition

1 of 20

Edib Smolo

Introduction to Islamic Accounting

26th Annual Islamic Banking Conference

2 of 20

Edib Smolo [email protected]



Outline

۞ Islamic Finance Industry – Overview

۞ Accounting Definition

۞ Islamic Accounting Definition

۞ Objectives of Islamic Accounting

۞ Why a need for Islamic Accounting?

۞ Islamic vs. Conventional Accounting

۞ Issues in Islamic Accounting

۞ Malaysia: AAOIFI vs. IFRS

۞ Some Other Issues

3 of 20




Islamic finance Industry has grown tremendously since it first emerged and continued this tendency in the past year.

- The total assets of Shari’ah - Compliant institutions rose from $1,166bn in 2012 to $1,267bn in 2013, representing 8.67% annual growth.

- To date, total global financial assets of the IFI is estimated to be around USD2tln and expected to increase by 80 percent over the next five years, reaching $3.24 trillion in value by 2020.

- The Islamic financial industry has experienced robust expansion in the past five years, recording a 17.3% Compounded Annual Growth Rate (CAGR) between 2009 and 2014.

- Number of institutions reporting Shari’ah-Compliant assets grew to 13.68%

- Total profits of standalone banks was $14.7bn

- Average return on assets for standalone banks was 1.43%

- Globally, almost 80% of the potential customer base for Islamic finance is still untapped

Region Asset growth from 2012

GCC 22,73%

Non-GCC Mena 0,48%

Mena Total 10,58%

Sub-Saharian Africa -3,43%

Asia 19,24%

Australia/Europe/America -60,33%

Global Total 8,67%

35

307

225

82

178

72 49 37

349

245

104

185

86 61

0

70

140

210

280

350

420

Number ofcountries

Number ofinstitutions reprting

Sharia-compliantassets

Number of Sharia-compliant

institutions

Number ofconventional

institutions withSharia-compliant

windows

Number ofcommercial banks

Number ofinsurancecompanies

Number of foreign-owned subsidiaries

The expansion of the Islamic Finance Industry from 2012 to 2013

2012

2013

405 487

892

11

208

55

497 490

987

10

249

22

0

200

400

600

800

1,000

1,200

2012

2013

GCC Non-GCC Mena Mena Total Sub-Saharian Africa Asia Australia/Europe/America

Total Assets $’000

Source: Various reports

4 of 20




This tendency will continue by expanding into potential new markets…

France - Passed regulation to support IFI by launching Paris Europlace

Islamic Finance Commission

UK - In 2013, British PM announced the launch of

first sovereign Sukuk and intention for London to become a global IF hub

Singapore - Introduced tax neutrality for IF - Aspiring to be centre for Islamic finance by having

issued SGD 200 million worth of Sukuk in 2009 - Launched Sharia-compliant REIT

Hong Kong - In January 2014 Hong Kong has gazette a new law

for Sukuk issuance

Malaysia - Malaysia, being a leading IF hub, will require more

innovative IF products and services to meet diverse global demands.

- The second largest Takaful market having 11 operators with a CAGR of 18.7% (2009-2012) has tremendous pant up demand for new Takaful offerings.

Dubai

- Has announced to become a global IF hub in 2013

Indonesia - Legislated establishment of IF in 2008 - Indonesia has the biggest Muslim population - 80% is unbanked. - The estimated bankable middle class by 2020 will be 141 million rising at a rate of about 9 million

annually - Only 5% are using IF services, presenting opportunity for new IFIs

North Africa - IF emerging as result of Arab

Spring

Source: Ernst & Young, BCG and MIFC reports

5 of 20




… and creating new Islamic Finance products and Regulations

- Retail banking

- Retail banking - Project finance and

syndications


syndications - Investment banking - Equity/Securities/indexes - Sukuks (Common and

hybrid) - Ijarah - Structured alternative asset - Liquidity mgmt tools - Takaful and Retakaful


syndications - Investment banking - Equity/Securities/indexes - Sukuks (Common and

hybrid) - Ijarah - Structured alternative asset

1970s 1980s 2000s 2010s

The industry has experienced a major progress since the 90’s


syndications - Investment banking - Equity /Securities/indexes - Sukuks (Common and

hybrid) - Ijarah

1990s

- Nasser Social Bank Egypt (1971)

- Bank Amanah Philippines (1973)

- Islamic Development Bank, Jeddah (1975)

- Dubai Islamic Bank, Dubai (1975)

- Faisal Islamic Bank, Sudan (1977)

- Bahrein Islamic Bank, Bahrein (1979)

- Bank Islam Malaysia Berhad, Malaysia (1983)

- Islamic Bank Bangladesh (1983)

- Al-Baraka Group in Countries (1982)

- Qatar Islamic Bank, Qatar (1983)

- Dar al-Mal al-Islamic Trust, Geneva (1984)

- AHZ Global Islamic Bank, France, UK (1989)

- Creation of the International Islamic Liquidity Management Corporation (IILM) - (2010)

- Islamic Financial Stability Forum 2010 (each year different country)

- International Islamic Financial Market Bahrein (2002)

- Islamic Financial Services Board, Malaysia (2002)

- first global sukuk: the Malaysian sovereign sukuk issued (2002)

- The entry into Malaysia of the first foreign Islamic bank Kuwait Finance House (2005)

- Islamic Bank of Brunei - Islamic Intern Banks Money

Market , Malayisia (1994) - Accounting & Auditing

Organization for Islamic Financial Institution, Bahrein (1994)

- Bank Muamalat Malaysia Berhad, Malayisia (1999)

6 of 20

Introduction to Islamic Accounting Edib Smolo

[email protected]


Accounting Definition

The American Accounting Association define accounting as follows:

"the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information!”

Source: American Accounting Association (AAA). 1966. Committee to prepare a statement of basic accounting theory. A Statement of Basic Accounting Theory. Illinois. USA.

7 of 20




Islamic Accounting Definition

៚Islamic accounting can be defined as the “accounting process” which provides appropriate information (not necessarily limited to financial data) to stakeholders of an entity which will enable them to ensure that the entity is continuously operating within the bounds of the Shari’ah and delivering its socioeconomic objectives.

៚Islamic accounting has also been defined as “the process of identifying, measuring and communicating economic and other relevant information, inspired by the Islamic worldview and ethics, and complied with the Shari’ah (Islamic law) – in order to permit informed judgments and decisions by potential and expected users of information– to enhance social welfare and seek the blessings of Allah”.

៚Islamic accounting is also a tool, which enables Muslims to evaluate their own accountabilities to God (in respect of inter-human / environmental transactions).

8 of 20




Islamic Accounting Definition

៚Looking from purely definition perspective, it can be seen that both accounting systems set out similar objective of reporting.

៚However, the differences lie in the following;

a) Objectives of providing the information;

b) Type of information is identified;

c) How the information is measured, valued, recorded and

communicated; and

d) To whom will the information be communicated (the users).

9 of 20




Qur’anic Verse on Accounting

O ye who believe! when ye deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing. Let a scribe write: down faithfully as between the parties: let not the scribe refuse to write as Allah has taught him, so let him write. Let him who incurs the liability dictate, but let him fear Allah, his Lord Allah and not diminish aught of what he owes. If the party liable is mentally deficient, or weak, or unable himself to dictate, let his guardian dictate faithfully. And get two witnesses, out of your own men And if there are not two men, then a man and two women, such as ye choose, for witnesses, so that if one of them errs, the other can remind her. The witnesses should not refuse when they are called on (for evidence). Disdain not to reduce to writing (your contract) for a future period, whether it be small or big: it is juster in the sight of Allah, more suitable as evidence, and more convenient to prevent doubts among yourselves; but if it be a transaction which ye carry out on the spot among yourselves, there is no blame on you if ye reduce it not to writing. But take witnesses whenever ye make a commercial contract; and let neither scribe nor witness suffer harm. If ye do (such harm) it would be wickedness in you. So fear Allah; for it is Allah that teaches you. And Allah is well acquainted with all things. (Surah Al-Baqarah, 2:282)

10 of 20




Objectives of Islamic Accounting

۞Financial accounting is mainly concerned with providing information to assist users in making decisions. There are differences in objectives of those who need accounting information.

۞Furthermore, there are other different objectives:

a) Islamic banks must comply with the principles and rules of Shari’ah in all their financial and other dealings.

b) The functions of Islamic banks are significantly different from those of traditional banks who have adopted the Western mode of banking.

c) The relationship between Islamic banks and the parties that deal with them differs from the relationship of those who deal with traditional banks. Unlike traditional banks, Islamic banks do not use interest in their investment and financial transactions, rather they raise funds through investment accounts on the basis of Mudarabah and invest these funds on the basis of Mudarabah, or deferred payments method consistent with the Shari’ah. Source: AAOIFI, Accounting Standards (para 21)

11 of 20




Why a need for Islamic Accounting?

Islamic financial institutions, wherever they operate, do so within the same global financial system as their conventional counterparts and users of their financial reports need to make similar decisions to those of conventional banks. Thus for competitive reasons or rating purposes, it is not surprising that some Islamic financial institutions would prefer to report in the global accounting language of choice, IFRS. Nonetheless, Islamic finance by definition is distinct from conventional finance. Because of the nuances inherent within it, many countries require their Islamic banks to apply accounting standards that take into account those differences, rather than simply applying the more neutral IFRS suite of standards. (ACCA, 2010)

12 of 20





៚While the reasons and rationale differ from writer to writer, in general the contrasting views can be largely attributed to differences of opinion on the following overarching points of contention:

(a) Time value of money ๔ There are those who believe that it would be inappropriate to reflect

a time value of money in reporting an Islamic financial transaction, when no overt interest is charged or incurred in such transactions. Some go so far as to refute that there is such a concept as time value of money.

๔ In contrast, others believe that although charging interest on a loan is prohibited, showing the financing effect of a transaction would not be so, and would provide information that would benefit users.

13 of 20





(b) Substance over form

๔ There are those who believe that the recognition and measurement of an Islamic financial transaction should give prominence to its legal form to differentiate it from a perceived conventional equivalent. One writer even claims that substance over form is ‘a blatant violation of Shari’ah’.

๔ Conversely, others believe that it is acceptable, and would benefit users more, to show the economic substance of an Islamic financial transaction, and information about the legal form may be relegated to the notes to the financial statements.

14 of 20




Islamic vs. Conventional Accounting

No. Conventional Accounting Islamic Accounting

1. Based upon modern commercial law –permissive rather than ethical

Based upon ethical law originating in the Qur’an (Islamic law, As-Sunnah)

2. Limited disclosure (provision of information subject to public interest)

Full disclosure (to satisfy any reasonable demand for information in accordance with the Shari’ah)

3. Personal accountability (focus on individuals who control resources)

Public accountability (focus on the community who participate in exploiting resources)

4. Individuality oriented – Focus on individuality aspect without consider any social aspects

Society oriented – Focus on society aspect

5. Sources of reference - Accounting Law and Ethics

Sources of reference – Al-Qur’an & As-Sunnah (Shari’ah)

6. Secular Religious (responsibility to God at the Judgment Day)

15 of 20




Issues in Islamic Accounting

៚Historical Cost vs. Current Market Value ៚ Current value is consistent with the principles of socio-economic

justice

៚ AAOIFI accepts historical cost due to difficult implementation of current value. Recommended cash equivalent value that is supported by: a) Availability of objective indicator

b) Relevant information c) Logical and relevant valuation d) Consistency of valuation methods

e) Expert valuation f) Conservatism in the valuation process

16 of 20





៚Substance Over Form

៚ In determining the ownership of assets, one should have acquired the right to hold, use or dispose the assets. Hence,

Form over substance = Legal ownership over control

៚ AAOIFI does not endorse the concept of ‘substance over form’ in view of the primacy of contract in transactions in Islam.

៚ The staff of the Institute of Chartered Accountants of Pakistan (“ICAP”) are resistant to reporting the financing effect arising from a trade-based transaction, and have even suggested that a financing effect does not even arise.

17 of 20





៚ Substance Over Form in Case of Ijarah: An Example

๔ One of the most common structures used in Islamic finance is the Ijarah – a form of leasing arrangement. The pure Ijarah is essentially an operating lease and there would appear to be little conflict in accounting for this (either for the lessor or the lessee) under the requirements of IAS17.

๔ Increasingly used forms of leasing by IFIs are the ijarah muntahiyah bittamleek or ijarah wa iqtina’, which are similar to a hire purchase agreement popular in conventional finance. This is essentially a form of financing which, under IFRS, is treated as a finance lease because, as with a hire purchase agreement, the risks and rewards associated with owning the asset are in substance transferred to the lessee. Thus under IAS17 the asset would be booked as such by the lessee, while the lessor (the financer) would book a receivable for the rent and related interest receivable. (ACCA 2010)

๔ By contrast, under both IFAS2, Ijarah (as issued by the Institute of Chartered Accountants of Pakistan) and AAOIFI’s FAS8, the legal form of the contract is paramount, meaning that the ownership of the asset remains with the lessor, until legal title is transferred at the end of the lease period. In this case the IFI would remain the owner, and record the asset on its balance sheet in the same way as an operating lease or operating Ijarah.

18 of 20




Malaysia: AAOIFI vs. IFRS

๕ AAOIFI at its founding did not set out to establish a separate set of Islamic accounting standards but to leverage on those standards already in existence.

๕ In the preface to AAOIFI’s 1994 volume, it states that the approach adopted by its Board was to “review the standards which have been developed by prevailing accounting thought, test them against Shari’a, then adopt those which are consistent with the Shari’a and exclude those which are not”.

๕ The Malaysian Accounting Standards Board (“MASB”) has concluded that:

a) the financial reporting principles in the IFRS do not conflict with Shari’ah; and that

b) financial reporting is a recording function that would neither sanctify nor nullify the Shari’ah validity of a transaction.

๕ The MASB also concluded that the primary difference between the financial reporting of Islamic financial transactions and their conventional counterparties was not that of recognition and measurement, but the extent of information that needed to be provided to users.

19 of 20




Some Other Issues

A number of other issues arise when comparing conventional and Islamic finance, namely: Regulatory differences

Incentives for IFIs – Creating a level playing field

Issue of customer defaults

Risk-weighting of asset/liabilities

20 of 20

Wassalam &

Thank You Edib Smolo

islamic accounting definition

Documents