Chapter 4 Financial Accounting for Islamic Banking Products

1. Introduction to Islamic Banking and Finance: Principles and PracticeM. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni Chapter 4 Financial Accounting for Islamic Banking Products

2. Learning Objectives Upon completion of this chapter, the reader should be able to: • Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making • Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation • Understand the basic principles of accounting • Understand the basic principles of Islamic accounting • Differentiate between the accrual and cash flow accounting methods • Draft the main financial statements for Islamic finance products

3. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making The Definition and the Significance of Accounting in Financial Decision-making What is Financial Accounting? Financial accounting is a process where business operations and their activities are measured and measurements are processed into information for these decision-makers:     - Internal decision makers include the management of the company - External decision makers are mainly investors and customers

4. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making The Definition and the Significance of Accounting in Financial Decision-making The definition of accounting involves the following main issues: 1. Recognizing, recording, classifying and summarizing business transactions 2. Measuring, analyzing, processing, interpreting operating results 3. Reporting and presenting the financial position

5. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making The Definition and the Significance of Accounting in Financial Decision-making What is Islamic Accounting? … is ‘the accounting process that provides appropriate information to stakeholders of an entity that will enable them to ensure that the entity is continuously operating within the bounds of the Islamic Sharī‘ah and delivering on its socioeconomic objectives’

6. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making The Definition and the Significance of Accounting in Financial Decision-making • The general definition of financial accounting is acceptable within the Islamic finance framework if it complies with Islamic Sharī‘ah • Financial accounting in both Islamic and conventional frameworks enable stakeholders to make informed decisions • Financial accounting fulfills the needs of external decision-makers

7. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making The Definition and the Significance of Accounting in Financial Decision-making Accountability in Islam • The Holy Qur’an emphasizes the need and requirement of accountability ‘hisab’ in every human activity • Transparency and fair dealings involve a great commitment towards accountability in financial transactions • Muslim accountants have more responsibilities than non-Muslim counterparts

8. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making The Significance of Accountability in Islam The significance of accountability with particular reference to financial transactions is evidenced by the following Islamic concepts: • Khilafah (vicegenrency) • Taklif (responsibility) • Documentation of financial dealings • Islamic law of inheritance (mawarith) • Calculation of obligatory alms (zakat) • The underlying concept of tawhid (unity of God)

9. Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation International Financial Reporting Standards (IFRS) • IFRS standards developed by independent, non-for-profit organisation (International Accounting Standards Board [IASB]) • The IASB is the standard-setting body of the IFRS Foundation • The IFRS provides globally acceptable standards for public companies preparing and disclosing financial statements • The IFRS contains general guidelines for financial reporting • The IFRS is more relevant to multinational companies • IFRS replaced the International Accounting Standards (IAS)

10. Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation International Financial Reporting Standards (IFRS) The Different Aspects of the Structure of IFRS • International Financial Reporting Standards (IFRS)—standards issued after 2001 • International Accounting Standards (IAS)—standards issued before 2001 • Interpretations originated from the International Financial Reporting Interpretations Committee (IFRIC)—issued after 2001 • Standing Interpretations Committee (SIC)—issued before 2001 • Conceptual Framework for the Preparation and Presentation of Financial Statements (2010)

11. Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation International Financial Reporting Standards (IFRS) IFRS and Islamic Banks and Financial Institutions • IFRS designed for conventional forms of business • Islamic banks have specific requirements e.g. transactions, reporting and disclosures • Therefore,the Islamic finance industry requires alternative sets of accounting and financial reporting standards • The establishment of the Bahrain-based Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1991

12. Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation International Financial Reporting Standards (IFRS) Differences between Islamic Accounting and Conventional Accounting - Financial instruments - Accounting standards - Accounting treatment - Types of information contained in financial statements - Financial reporting - Functions of commercial/financial contracts

13. Learning Objective 4.3 Understand the basic principles of accounting Basic Principles of Accounting Accounting comprises two main business activities: • Bookkeeping The detailed recording of all financial transactions in the business • The preparation of financial statements or financial accounting (periodically) Depending on the policy and the accounting standards adopted by the business

14. Learning Objective 4.3 Understand the basic principles of accounting. Basic Principles of Accounting Recording Financial Information • Records for every financial transaction must be kept • Information recorded must reflect revenue and expenditures • Journal: Accounting record where financial transactions of a business are originally entered • Account or Ledger or (T Account):Ledger account format resembling the letter T originating from process of using debits and credits

15. Learning Objective 4.3 Understand the basic principles of accounting. Basic Principles of Accounting Double Entry Bookkeeping • Every financial transaction has two main aspects: 1- Debit aspect:the receiving, incoming or expenses/loss aspect of financial transactions 2- Credit aspect:the giving, outgoing or income/gain aspect of financial transactions • For every debit, there must be a corresponding credit of an equal amount • For every credit, there must be a corresponding debit of an equal amount • In a balanced account, total debits must equal total debits

16. Learning Objective 4.3 Understand the basic principles of accounting Basic Principles of Accounting Figure 4.1: The Basics of the Double Entry System

17. Learning Objective 4.3 Understand the basic principles of accounting Basic Principles of Accounting The Branches of Accounting • Cost and management accounting • Financial accounting • Auditing Figure 4.2: The Three Branches of Accounting

18. Learning Objective 4.3 Understand the basic principles of accounting Basic Principles of Accounting Cost and Management Accounting The information generated in cost and management accounting - Provides relevant information helping managers make informed decisions in managing the business -Is useful in planning, controlling and the measurement of performance

19. Learning Objective 4.3 Understand the basic principles of accounting Basic Principles of Accounting Financial Accounting • Provides relevant information to interested parties (stakeholders) outside the domain of the business such as investors, banks, future partners, regulatory bodies, government agencies, stockholders, prospective buyers • Allows stakeholders in the industry to make sound economic decisions that could have an impact on the populace

20. Learning Objective 4.3 Understand the basic principles of accounting Basic Principles of Accounting Auditing • Determines the authenticity, validity and reliability of the financial information recorded or disclosed during a financial period • Forms of auditing: -Internal auditing where the business carries out auditing - External auditing when the business engages an outside company, usually an auditing firm, to conduct auditing • Modern practices combine internal and external auditing for a particular financial year

21. Learning Objective 4.4 Understand the basic principles of Islamic accounting Basic Principles of Islamic Accounting • The objectives of Islamic accountingare diverse depending on the approach used • The purposes of Islamic accountinginclude: - reporting of accurate income information - promotion of efficiency and leadership - compliance with the Sharī'ah - commitment to justice - reporting best practices and adapting to social change through corporate social responsibility

22. Learning Objective 4.4 Understand the basic principles of Islamic accounting Basic Principles of Islamic Accounting • Consumers of Accounting Information for Islamic Banks The most popular method of communicating financial information to consumers or users is through the use of financial statements

23. Learning Objective 4.4 Understand the basic principles of Islamic accounting Basic Principles of Islamic Accounting Consumers of Accounting Information for Islamic Banks • Equity holders • Holders of investment accounts • Other deposits • Current and saving account holders • Others who transact business with the Islamic bank, who are not equity or account holders • Zakah agencies (if there is no legal obligation for payment) • Regulatory agencies (AAOIFI Statement of Financial Accounting (SFA) No. 1, para 26)

24. Learning Objective 4.4 Understand the basic principles of Islamic accounting Basic Principles of Islamic Accounting (SFA No. 1) requires information intended for external users: • Information about the bank’s compliance with Sharī'ah and its objectives to establish such compliance • Information about the Islamic bank’s economic resources and related obligations • To assist in the determination of Zakah on the Islamic bank’s funds • To assist in estimating cash flows from dealing with the bank • To assist in evaluating the bank’s discharge of fiduciary responsibility • Information about the Islamic bank’s social responsibilities

25. Learning Objective 4.4 Understand the basic principles of Islamic accounting Basic Principles of Islamic Accounting An Islamic Perspective of Accounting Concepts • The Qur’an and prophetic precedents emphasise accountability in commercial transactions • Full disclosure, social and financial accountability • Ethics for accountant entails trustworthiness and objectivity • The Islamic financial institution needs to provide relevant information on all transactions for the user. The Islamic bank needs to account for social responsibilities • The religious-spiritual element in financial transactions is as important as the element of profitability

26. Learning Objective 4.4 Understand the basic principles of Islamic accounting Basic Principles of Islamic Accounting Accounting and Auditing Organization for Islamic Financial Institutions Standards • (AAOIFI): Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) established in Algiers in 1990 as an independent non-governmental organization based on Agreement of Association among financial institutions from different Muslim countries • AAOIFI issued the first accounting auditing, governance and Sharī'ah standards in 1991 followed by a series of relevant standards for specific Islamic finance products • Many countries have adopted AAOIFI accounting standards

27. Learning Objective 4.4 Understand the basic principles of Islamic accounting Basic Principles of Islamic Accounting • Some countries like Bahrain, Jordan and Sudan have required Islamic financial institutions in their respective jurisdictions to abide by the AAOIFI reporting standards • Others allow such Islamic financial institutions to adopt the standards voluntarily

28. Learning Objective 4.5 Differentiate between the accrual and cash flow accounting methods Accrual and Cash flow Accounting Methods Accrual and Cash flow Accounting Method 1. The cash flow accounting method - based on frequency of cash flow (requires an actual exchange of cash) 2. The accrual accounting method - based on the occurrence of a transaction regardless of whether there is exchange of cash

29. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions • Financial statement is the formal record of the financial activities (transactions) of a business entity • Transactions are duly sorted, classified and presented in accordance with principles of bookkeeping • The transactions being recorded comprise any business transacted between the business entity and other corporate bodies, organisations or individuals • The end product of all financial transactions is the financial statement

30. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions Figure 4.3: Flow of Financial Transactions

31. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions • Comparative financial statements of a corporate entity • Gives direction of business change in at least two financial periods • Provides top management with information for decisions • Comparative financial statements analysis (Horizontal analysis) • Determines the performance of the business • Provides necessary information about sustained performance or poor performance • Islamic banks and financial institutions are required to publish comparative financial statements

32. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions Four Basic Financial Statements • Balance sheets • Income statements • Cash flow statements • Statement of retained earnings or shareholders’ equity

33. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions Balance Sheets also known as the Statement of Financial Position): a summary of financial balances of a company Income StatementsThe income statement is a financial statement that measures the financial performance of a company over a specific period of time indicating how the revenue is transformed into net income The income statement may also be referred to as i) The Profit and Loss Statement ii) Statement of Operations iii) Statement of Income

34. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions • Cash Flow Statements  • Also called statement of cash flow or funds flow statement • Indicates how changes in the balance sheet accounts and income statements affect cash and its equivalent • Purpose is for identification of the sources and uses of cash during the financial year in question • FAS 1, para 54 states the statement of cash flows should differentiate between cash flows from operations, from investing activities and from financing activates

35. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions Statement of Retained Earnings or Shareholders’ Equity • A financial statement explaining changes in retained earnings of a company over a period of time • The statement of retained earnings may also be called: - Statement of owner’s equity (in a single proprietorship) - Statement of partners’ equity (in a partnership) - Statement of retained earnings and stockholders' equity (for corporations)

36. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions Statement of Retained Earnings or Shareholders’ Equity The owners’ equity and retained earnings may be calculated using the following formulae: Owners’ equity = Assets – Liability

37. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions AAOIFI Proposed Set of Financial Statements for Islamic Banks • There are three major categories The first category comprises the financial statements that are meant to reflect the position of the Islamic bank as an investor, such as: Statement of Financial Position Statement of Income Statement of Cash Flows Statement of Retained Earnings or Statement of Changes in Owners’ Equity

38. Learning Objective 4.6 Draft the main financial statements for Islamic finance products Financial Statements in Islamic Banks and Financial Institutions AAOIFI Proposed Set of Financial Statements for Islamic Banks • The second category focuses on the financial reporting of restricted investments managed by the Islamic bank for the benefit of others. Such a statement will be referred to as “Statement of Changes in Restricted Investments” • The third category includes financial statements reflecting the Islamic bank’s role as a fiduciary of funds made available for social services Statement of Sources and Uses of Funds in the Zakah and Charity Fund Statement of Sources and Uses of Funds in the Qard Fund

39. Key Terms and Concepts • AAOIFI • Account receivable • Accrual method of accounting • American Accounting Association • Bookkeeping • Cash flow method of accounting • Cash flow statement • Compound accounting • Double entry bookkeeping • Credit • Debt • Deferred payment • Equity of unrestricted account holders • Expenditure • External auditing • Financial accounting • Horizontal analysis

40. Key Terms and Concepts • Income statement • Internal auditing • Islamic worldview • Journal • Journal entry • Last Day • Net income • Periodicity concept • Qard Fund • Revenue • Statement of retained earnings • T account or ledger • Waqf • Zakah