islamic accounting standards

TitleTitleDateDate

Lifetime Learning… Building Success… Towards Globalization

DateDate: April 08-10: April 08-10, 2012 Time: 8:30 AM- 1:30 PMLocation: EIBFS – AD

3rd Floor Classroom No.: 307

Lifetime Learning… Building Success… Towards Globalization

Islamic Accounting Standards

• Course Objective:to familiarize the participants with broad framework of accounting and financial reporting issues in

Islamic banks-to outline the Islamic Accounting Standards developed by the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI)-to provide detail analysis of a number of Standards to explain how they have tackled the financial reporting issues in Islamic banks

Contents: Objectives of Financial Accounting for Islamic bank

-Financial Statement of an Islamic Bank-International Accounting Standards (IAS) and Islamic Banking Operations-The establishment of AAOIFI and the objectives and concepts of financial reporting for Islamic banks-General presentation and disclosure in the financial Statements of Islamic banks-Accounting Standards for Murabaha, ijarah, istisna’a, mudarabah, musharakah, and Investment Accounts

Method: Lecture, presentation, discussion, exercises and case studies Pre Requisites: Bankers involved in the Accounting, Financial control and Auditing functions of Islamic banks.

Audit firms professionals and regulators who supervise and inspect Islamic banks

Accounting of Islamic Banks

Part 1

Development of Islamic Banking System

Definition of a BankBanking business means:(a) The business of;(i) Receiving deposits on current account, deposit

account, savings account or other similar account;(ii) Paying and collecting cheques drawn by or paid in by

customers; and,(iii) Provision of finance; or(b) Such other business as the bank (BNM), with the

approval of the Minister may prescribe

Banking and Financial Institutions Act 1989 (BAFIA)

Definition of an Islamic Bank

“Banking business whose aims and operations do not involve any element which is not approve by the religion of Islam”

Islamic Banking Act (1983)

Need for Islamic Banking System

• Shariah Islamiyyah compliance• Meet financing and investment needs of the

Muslims• Meet modern requirement of individual and

commercial needs • Encourages financial innovations but in line

with Shariah• In Malaysia, growing regulatory and social

support

Historical Development of Islamic Banking

• The 1st. Islamic Bank – Mit-Ghamr Nasser Social Bank, Egypt (1963)

• Dalla Al-Baraka Group, Saudi (1969)• Islamic Development Bank, Jeddah, Saudi (1975)• Dar al-Maal al-Islami, Saudi (1981)• BIMB (1983)• Jordan Islamic Bank, Dubai Islamic Bank etc…

Factors Affecting the Development of Islamic Banking System

• Legal, political and economic changes internationally• Islamization and Institutional Reform (e.g. Pakistan,

Iran, Sudan, Malaysia)• International Muslim organizations (OIC – IDB – etc)• International response to capture capital/fund of oil

rich Islamic countries (e.g. Citibank, Dresdner Kleinworth Benson, ANZ group, etc.

Malaysian Dual Banking System• In 1963, the Pilgrims and Fund Management Board provides a

savings mechanism for Muslims to perform Hajj• In 1983, the Islamic Banking Act (IBA) was approved and

defined Islamic Banking as “banking business whose aims and operations do not involve any element which is not approve by the religion of Islam”.

• Government Investment Act (Act 275) 1983 empowers the government to issue Government Investment Certificates (GIC) with returns in the form of discretionary gift (Hibah) rather than interest

• In 1993, Conventional banks can operate Islamic baking and financial products known as Skim Perbankan Tanpa Faedah (SPTF)

PART 2

Traditional western (secular) accounting objectives

Definition and Purpose of Accounting

In 1966 the American Accounting Association defined accounting as:

“…the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of that information”

In 1975 they added that the purpose of the process was:“…to provide information which is potentially useful for

making economic decisions and which, if provided, will enhance social welfare”

ACCOUNTING

A PROCESS OF

Measuring,Analyzing,

Interpreting Resultof Operation

Recognising,recording,classifying

and summarisingbusiness

transaction

Reporting &Presenting

Financial Position

Documents

Vouchers

Ledger

Trial Balance

Report (Mgmt)

Profitability= Income - Expenses

Growth

Liquidity

Productivity

Financial Statement

• Balance Sheet• Income Statement• Stmt of Changes In Equity• Cash Flow Statement• Notes to Accounts

STAKEHOLDERS

1. Management2. Board of Directors

3. Shareholders4. Investors5. Creditors

6. Authorities – BNM, InlandRevenue, Baitulmal

7. Staff8. Public

Traditional Model of Accounting

• Accounting entity (Owners (principals) are different from managers (agents)

• Economic events (identifiable and measurable in monetary terms)

• Financial description• Decision usefulness to a very restricted set of users

(esp. those with financial involvement with the entity)

• Neo-Classical Economics and maximization of wealth of stakeholders

Objectives of Financial Accounting and Reporting

• Provide information that is useful to present and potential investors and creditors and other users in making rational decisions

• Information should be comprehensible to those who have reasonable understanding of economic activities and are willing to study the information

• Primary user groups are shareholders, investors and creditors

• Secondary user groups are employees, customers, and the public

• Accountability framework - the objective is to provide a fair system of information flow between the accountor (agent) and the accountee (principal)

PART 3

Accounting from an Islamic perspective

Accounting and IslamAl-Baqarah 282: “O you who believe! When you 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 God has taught him, so let him write. Let him who incurs the liability (debtor) dictate, but let him fear his Lord God, and not diminish aught of what he owes. If the party liable (debtor) 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 they are not two men, then a man and two women, so that if one of them errs, the other can remind him….”

Accounting and Islam“…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 more just in the sight of God, more suitable as evidence, and more convenient to prevent doubts among yourselves. But if you carry out the transactions on the spot there is no blame if you reduce it not to writing. But take witness whenever you make a commercial contract, and let neither the scribe nor witness suffer harm. If you do (such harm), it would be wickedness in you. So fear God; for it is God that teaches you. And God is well acquainted with all things”

Definition of Accounting from an Islamic Perspective

“The process of identifying, measuring, andcommunicating economic and otherrelevant information inspired by IslamicWorldview and complied with Syari’ahIslamiyyah to permit informedjudgements and decisions by potentialand expected users information toenhance social welfare”

Islamic Accountability

• Transcendental accountability to Allah SWT (Hablumminallah)

• Social accountability to the society (Hablumminan-nass)

• Individuals as trustees or khalifah• Success in this world and in the hereafter (al-falah)• Economic goals beyond purely wealth but include

tazkiyah (purification of self and wealth)

Objectives of Financial StatementsTraditionalTraditional IslamicIslamic

Income Income StatementStatement

Economic Economic PerformancePerformance

Fulfilment of Fulfilment of AmanahAmanah

Balance Balance SheetSheet

Financial Financial PositionPosition

Financial Financial Trust and Trust and Obligation Obligation

Cash FlowCash Flow Cash PositionCash Position Cash Cash EntrustedEntrusted

Equity Equity StatementStatement

Wealth Wealth OwnershipOwnership

WealthWealth

EntrustedEntrusted

Features of Islamic Accounting• No different in terms of recording (double entry system)• Clear distinction of Accounting Objectives i.e. religious obligation

vs. commercial obligation (different significance of financial statements)

• Different users information need (legitimate and equitable transactions and wealth vs. maximization of wealth and economic consequences)

• Compliance with the principles and rules of Syari’ah• Different Islamic contractual relationships (mudarabah

instrument; murabahah etc.) • Distinct accountability relationships (to Allah SWT and Ummah)• Determination of zakat

User Groups of Accounting Information for Islamic Banks

• Investors (potential and existing) (lawful and equitable investment)

• Creditors (potential and existing) (lawful trade assets)

• Regulators (e.g. Bank Negara)• Syari’ah Supervisory Board & Advisory Council

(syari’ah compliance)• Customers (lawful goods and services)• Others who may be effected by the disclosure or

non-disclosure of information

PART 4

Introduction to AAOIFI Accounting Standards and Objectives of

Financial Accounting and Reporting

Accounting and Auditing Organizations of Islamic Financial Institutions (AAOIFI)

Primary Purpose• To enhance the confidence of users of the financial

statements of the IFIs and ultimately to promote IFIsObjectives• Develop accounting and auditing thought relevant to IFIs• Disseminate accounting and auditing thought relevant to

IFIs• Prepare, promulgate and interpret accounting and

auditing standards for IFIs• Review and amend accounting and auditing standards

for IFIs

Accounting and Auditing Organizations of Islamic Financial Institutions (AAOIFI)

http://www.aaoifi.com/

• History: established in 1991 – agreement of association by IFIs worldwide supported by IDB

• Head office is in Bahrain• Organizational Structure – Supervisory Committee;

Financial Accounting Standard Board; Executive Committee; Shari’ah Committee

• Funded by founding members of IFIs, establishment of waqf etc.

AAOIFI: Accounting, Auditing and Governance Standards

Statements of Financial Accounting

• Objectives• ConceptsFinancial Accounting

Standards• Presentation and Disclosure

of Financial Statements of Islamic Banks

• Murabaha Financing• Mudaraba Financing

Financial Accounting Standards• Musharaka Financing• Profit Allocation Basis• Investment Account Holders• Salam Financing• Ijarah Financing• Zakah• Istisna’ Financing• Provisions and Reserves• Presentation and Disclosure of

Financial Statements of Islamic Insurance Companies

AAOIFI: Accounting, Auditing and Governance Standards

Auditing Standards• Objectives and Principles of

Auditing• The Auditor’s Report• Terms of Audit EngagementGovernance Standards• Syariah Supervisory Board• Syariah Review• Internal Syariah Review

Code of Ethics• Code of Ethics for Accountants

and Auditors of IFINew Financial Accounting

Standards• Investment Fund• Disclosure Bases for

Determining and Allocating Insurance Surplus (and deficit)

New Auditing Standards• Audit Tests for Syariah

Compliance

Objectives of Islamic Financial Accounting and Reporting (AAOIFI)

• To determine rights and obligations of interested parties

• To safeguard entity assets and rights of others• To contribute to enhancement of managerial

productive capacities• To provide useful information to make legitimate

decisions • Syari’ah compliance• Distinguish prohibited earnings and expenditure

Objectives of Islamic Financial Accounting and Reporting (AAOIFI)

• Present entity’s economic resources, obligations and related risks

• Determine Zakat obligations • Estimate cash flow and related risk• Ensuring reasonable (or equitable) rates of returns to

investors• Disclose Islamic Bank’s discharge of social

responsibility (not as a constraint but as a goal)

PART 5

Accounting concepts from an Islamic perspective

Impact of Syari’ah Contractual Conditions Accounting concepts

Existence (Recognition of revenue and expense)Lawful (Recognition of revenue and expense)Measurable (Measurement of assets and liabilities)Deliverable (Recognition & Measurement)Equitable (Profit determination and distribution)Accountability (Disclosure & Presentation)

Accounting Concepts: An Islamic Perspective

Accounting unit • Separate legal entity; limited liability; owners are

different from managers• Similar to the concept of “juridical person” in the case

Waqf & Baitulmal• Almost similar to Mudarabah as far as the purpose and

principles• Liabilities limited to the capital contribution & may be

injurious to the creditors in the case of liquidation• To be constrained by the syari’ah as to the rights and

obligations


Periodicity• periodic reports of financial positions as of a given

date and divided into reporting periods (normally annual)

• Accounting for zakat based on “haul” (one year complete ownership)

Going concern • contracts assumed to continue until there is evidence

to the contrary• Para 21 MASBi-1 when material uncertainties, those

uncertainties should be disclosed


Monetary and stability of unit measurement • currency as common denominator • Impact of inflation & purchasing power on reporting?

Prudence & Conservatism • Generally, not to overstate assets and incomes, and

not to understate liabilities and expenses• As long as can be determined with certainty

(objectivity)

Accounting Recognition and Measurement Concepts

Recognition• Define the basic principles that determine the timing

of revenue, expense, gain and loss

Measurement• Define the broad principles that determine the

amount at which assets, liabilities, owners equity etc. are recognized

Islamic Perspective of Accounting Recognition

Revenue Recognition• Recognized when realized• The right to receive not necessarily when the payment is

received (i.e. accrual basis – MASBi-1 para 22; AAOIFI) e.g. when a bank delivers the service

• Syariah Requirement: the amount of revenue should be known and collectible

Expense Recognition• Realization either because the expense relates to the

earning of revenue (e.g. transportation cost for services), or because it relates to the period of income statement (e.g. bonus)

Islamic Perspective of Accounting Measurement

Matching Concept• Matching of revenues and gains with expenses and

losses that relate to that period• Measurement Attributes: acquisition cost (HC), cash

equivalent value, asset’s replacement cost etc.• In the case of Zakat measurement, preference is

current market value (AAOIFI FAS 9: Cash Equivalent Value)

Islamic Perspective of Accounting Measurement

• Historical Value vs. Current Value• Cash Equivalent Value (most preferred if the

following are available):• availability of objective indicator;• relevant information;• logical and relevant valuation• consistency of valuation methods• experts valuation• conservatism in the valuation process

Definition of Assets

“Capable of generating positive cash flows or other economic benefits in the future either by itself or in combination with other assets which the bank has acquired the right to hold (rightful ownership of maal), use of dispose (rights on manfaat) as a result of past transactions or events” (AAOIFI)

Desirable Characteristics of Accounting Information

1. Relevance• Predictive Value (ability to predict potential

outcome)• Feedback Value (ability to verify the accuracy of

prior prediction)• Timeliness (available as soon as after the reported

events)


2. Reliability• Representational faithfulness (information reflect

what it purports to present)• Objectivity (measurement and disclosure

appropriately used and if replicated by independent person gives the same result)

• Neutrality (accounting information directed towards common needs of users and not needs of particular group of users)


3. Comparability• Able to make comparison of the bank’s performance

and position over time and with other banks

4. Consistency• Consistent in applying accounting measurement,

valuation and disclosure methods from one period to another


5. Understandability• Aware of the abilities and limitations of those for

whom accounting information is provided

6. Materiality• Accounting information is regarded material if its

omission, non-disclosure or misstatement results in distortion of the financial statements

ConclusionsIslamic accounting framework (objectives and concepts):1. Compliance with syari’ah and, achievement of

Islamic goals, on financial activities (financing schemes and financial instruments)

2. Equitable and fair recognition, measurement, valuation and disclosure of financial information

3. Achievement of both economic and spiritual well being of the society

ISLAMIC FINANCIAL INDUSTRY Challenges and Opportunities

Manifestations of Islamic Finance

1. Islamic banking at economy wide level2. Islamic banking in the private corporate

sector3. Islamic Financial institutions other than the4. Islamic Financial activities undertaken by

conventional banks and non-banking financial institutions

Distinguishing Features of Islamic Finance

• Risk Sharing: Risks are shared between provider and user of funds

• More emphasis on Productivity than on credit worthiness.

• Moral Suasion: All agents in the financial markets have to work within the boundaries of moral values of Islam.

Islamic banking in practice

• Brief history: Mit Ghamr (1963), unsuccessful experiments, Dubai Islamic Bank and Islamic Development Bank (1975)

• No looking back since the. • Two approaches: Pakistani and Malaysian

Models• Iranian banks are in public sector, Gulf banks

are in the private sector.

Present State of Islamic Finance

• In terms of number of institutions: South and SE Asia 42% GCC 22% Other ME 15% Africa 10% Europe and America 9%

Present State of Islamic finance

0102030405060708090

Number ofInstitutions

4th Qtr

South and SEAsiaGCC

Other MiddleEastAfrica

Europe andAmericaTOTAL

Present State of Islamic finance

• In terms of funds managed by Islamic banks, 64% of funds are managed by

the instructions in GCC, 20% in South and SE Asia, the rest is distributed between Other ME countries, Africa, Europe and America.

• Main activity of Islamic finance is concentrated in the Gulf and South and Southeast Asian countries.

Size of the Industry

• A few years ago, an IDB study estimated the total size of the industry to be about 3 billion dollars. The industry pundits put the current figure between 7-8 billion dollars. The industry is said to be growing at the rate of 15 percent per annum.

Size of Firms in the Industry

Assets (in Million $) Frequency Distribution

0-5 39

51-100 13

101-200 4

201-300 3

301-400 8

401-500 1

500-1000 3

> -1000 7

TOTAL 78

Size of Firms in the Industry

• Optimal size of a banking firm in the US 500million $.

• Large size enables firms to save on infrastructure

• Most of Islamic banks are below this optimal size.

• Small size of Islamic banks is a major hurdle in minimizing risk through port folio diversification.

Modes of Financing :Data

Financing Technique Simple average

Weighted average

Murabaha 70.19 65.66

Musharakah 11.20 12.61

Mudarabah 7.29 8.17

Ijarah 4.84 3.73

Other 6.49 9.83

Modes of Financing: Analysis

• Murabaha accounts for about 70 percent of total financing. If Ijarah is added, the share of fixed return techniques goes up to 75 percent.

• The PLS techniques account only for 14 percent of total financing.

Where Finance is going? Sectoral Distribution

Sector Simple average

Weighted average

Trade 42.4 34.1

Agriculture 12.9 14.8

Industry 11.9 9.2

Services 19.1 19.7

Real Estate 12.9 19.5

Others 2.4 2.7

Sectoral Financing: Findings

• Lion’s share of financing is claimed by the Trade sector, followed by the real estate sector. Other studies have also reported similar findings.

• Commodity sector (agriculture and industry) appears to have received less financing.

CHALLENGES AND OPPORTUNITIES

INSTITUTIONAL ASPECTS

1. Institutional Framework2. Appropriate Legal Framework and

Institutions3. Islamic banking laws4. Laws for non banking financial institutions5. Supervisory Framework

SUPERVISORY FRAMEWORK

•Supervisory Framework is required to increase:–Transparency–Soundness and Prudence–Shari'ah Compatibility–A supervisory framework ensures confidence of the public in the banking system.

Need for Regulation and Control

1. No return from the central banks on deposits.2. Lender of last resort: Separate system required. 3. Legal Reserve Requirement also needs special

treatment4. Open market operations not available. 5. Musharakah and Mudarabah are on going activities.

Accounting not possible unless business is liquidate.

Accounting Standards

• Accounting standards of conventional banks are rigorously defined and universally applied. Makes comparison and control easy. Not so with the Islamic banks.

• Accounting and Auditing Organization for Islamic Financial Organization (AAOIFI): Voluntary Organization