ISSUES IN ACCOUNTING STANDRADS: FOR ISLAMIC FINANCIAL INSTITUTIONS

1. ISSUES IN ACCOUNTING STANDRADS: FOR ISLAMIC FINANCIAL INSTITUTIONS Markfield Institute of Higher Education Dr. Seif E. I. Tag El-Din, October, 2004

2. 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.

3. 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..”

4. 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).

5. 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

6. I. Key concept of Islamic bank • Mechanism:accept ‘deposits’ and offer ‘financings’ plus other banking/ investment services. • Compliance to Shariah: interest rate elimination plus alternativeIslamic modes. • PLS investment alternatives: • Unrestricted investments. • Restricted investments. • Fiduciary service for funds devoted to social purposes : Zakah, Charitable funds.

7. 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

8. 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.

9. 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.

10. 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 bank’s 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.

11. 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

12. Objectives of Financial Reports: • Information about Islamic bank’s extent of compliance with Shariah. • Information about adequacy of Islamic bank’s capital, investment risks, and liquidity. • Information about cash flows-timing/risks. • Information about Bank’s policy in Zakah assessment and disbursal. • Information about Bank’s fiduciary responsibilities. • Information about discharge of other social responsibilities.

13. 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.

14. 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,

15. 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 :

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

17. 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”.

18. 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 givenperiod of time - accrual basis. • Cash-flow statement : moving film;cash-basis statement of inflows and outflows. .

19. Main categories of Islamic financial statements : • Financial statements reflecting the Islamic Bank’s function as an investor . • A financial statement reflecting changes in restricted investments managed by the Islamic bank – Mudarib /Agent. • Financial statements reflecting the Islamic bank’s role as a fiduciary of funds for social purposes.

20. Islamic Bank’s 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.

21. 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.

22. 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.

23. Statement of financial position:Definitions: • Liabilities: • A liability is a 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. • Islamic bank’s obligation must not be a reciprocal to an obligation of the other party to the bank.

24. 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)

25. Statement of financial position:Definitions • 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 • Prohibited earnings if any, must also be deducted.

26. Statement of financial position:Assets Disclosure : • Cash and cash equivalent • Receivables ( Murabaha, Salam, Istisnaa) • Investment securities • Mudarabah investment • Musharakah investment • Investment in other entities

27. 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).

28. Statement of financial position:‘Liability Side’ • Liabilities • Equity of unrestricted investment account holders and their equivalents. • Owners’ equity:

29. 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

30. 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 .

31. 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

32. 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.

33. 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 !)

34. Income statement : Definitions/Recognition • Gains/losses arerecognized 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.

35. 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.

36. 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 bank’s share as Mudarib • (=)The bank’s share in income (loss) from investments

37. Income statement : con. Disclosure: • (+)The bank’s share in unrestricted investment income as Mudarib • (+) The bank’s share in restricted investment profit as Mudarib • (+)The bank’s 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)

38. Financial statement for changesin restricted investments • Restricted investments are not assets of the Islamic bankand should not be reflected in the bank’s 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.

39. 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.

40. 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 company’s net assets, and the total amount be divided between owners. • Bank as an agent of Zakah

41. Statement of sources and uses of funds in the Zakah and Charity Fund: • Disclosure • The period covered by the statement • Bank’s 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.

42. CONCLUSIONS THANK YOU