Islamic Accounting

Introduction to IA: Foundation

& Development

Md. Harashid bin Haron, Ph.D

[email protected]; [email protected]
E-learning Portal: http://elearning.usm.my/
Foundation and Development of
Islamic Accounting
 Suggested Readings
MASB releases (refer to course website)

Ahmed, EA (1994). Accounting postulates and

principles from an Islamic perspective. Review
of Islamic Economics, 13(2), 143-160

Shahul Hameed. Islamic Accounting – a primer

Shahul Hameed. Objectives and

Characteristics of Islamic Accounting
 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

Recognising,
recording,
classifying Measuring,
Analyzing, Reporting &
and summarising Presenting
business Interpreting Result
of Operation Financial Position
transaction

Documents
Profitability Financial Statement
= Income - Expenses
Vouchers
• Balance Sheet
Growth • Income Statement
Ledger
• Stmt of Changes
Liquidity In Equity
Trial Balance
• Cash Flow Statement
Productivity • Notes to Accounts
Report (Mgmt)

STAKEHOLDERS or MAIN USERS

1. Management 3. Shareholders 6. Authorities – BNM, Inland

2. Board of Directors 4. Investors Revenue, Baitulmal
5. Creditors 7. Staff
8. Public
 Islamic Accountability
An account of the extent to which the
objectives for which the resources were
entrusted by both accountees have been
achieved.

This forms the primary objective in

Islamic accounting.
 Islamic Accountability
• Transcendental accountability to Allah SWT
(Hablumminallah)
• Social accountability to the society (Hablumminan-
nass)
• Individuals as trustees or Khalifah (vicegerents)
• Success in this world and in the hereafter (Falah)
• Economic goals beyond purely wealth maximization or
economic value added but include Tazkiyah
(purification of self and wealth i.e. Zakat, Waqf)
• Personal accountability (Taklif)
• Justice (Adalah) in relationships, contracts, activities
etc.
• Maslahah i.e. public interest is more important than
personal interest.
 Islamic Accounting Objectives
Al-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….”
 Islamic Accounting Objectives

“…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”
 Islamic Accounting Objectives:
Lessons from Verse 282 Al-Baqarah
 The importance of proper recording
 Fear God in recording transactions (Islamic true and
fair view)
 Justice in financial transactions (e.g. the rights of
debtor and creditor)
 Islamic materiality concept
 Financial transactions require trustworthy witnesses
 Witnesses must be independence and protected by
law
 Proper accounting to avoid doubts and disputes
among human beings
 Objectives of Financial Statements
Conventional Islamic
Statement of Financial Fulfilment of
Income Performance Amanah (Trust) of
Financial Resources
& Financial
Performance
Statement of Financial Position
Equitable Wealth
Financial Ownership and
Position Financial Obligation
(Balance Sheet)
Statement of Cash Flow & Cash Cash Entrusted
Cash Flow Management
Statement of Wealth Ownership Wealth
Equity Entrusted
 Subsidiary Objectives
• Shariah compliance
• Proper assessment and distribution of
Zakat
• Equitable and fair distribution of wealth
generated by an organisation
• Creation of a co-operative environment
and solidarity
 Features of Islamic Accounting
• No different in terms of recording (i.e. double entry system)
• Clear distinction of accounting objectives i.e. religious obligation
vs. commercial obligation (different significance of financial
statements)
• Modified accounting concepts to meet Shari’ah compliance (e.g.
prudence, historical cost vs. current value etc.)
• Different users information needs affecting financial disclosure
practices (legitimate and equitable transactions and wealth vs.
maximization of wealth and pure economic consequences)
• Compliance with the goals (Maqasid), principles and rules of
Shariah
• Different Islamic contractual relationships in financial services
(e.g. mudarabah; murabahah; ijarah etc.)
• Distinct accountability relationships affecting Muslim accountants
(to Allah SWT and Ummah)
• Determination of zakat (social responsibility of individuals and
business organizations)
 Definition of Islamic Accounting

“ The process of identifying, measuring, and

communicating economic and other relevant
information inspired by Islamic Worldview and
complied with Shari’ah Islamiyyah to permit
informed judgments and decisions by
potential and expected users information to
enhance social welfare and achieve
Mardhatillah (blessings from Allah)”
Methods/approaches in developing
IA Knowledge
(objective/concept/theory)

1. Establish objectives (and concepts/theories) based on

the principles of Islam and its teachings and consider
these objectives in relation to contemporary accounting
thought.

2. Start with the objectives (and concepts/theories)

established in contemporary accounting thought, test
them against the Islamic Shariah, accept those that are
consistent with Shariah and reject those that are not,
and develop those that are unique.
 Islamic Accounting Practice
i.e. Accounting in Islamic Financial
Institutions
 Development

 Internationally, Islamic banking accounting and financial

reporting practices are under the purview of central banks’
regulation in respective Muslim and non-Muslim countries
 In Malaysia, it is under the purview of BNM GP 8,
Companies Act 1965, applicable MASB accounting
standard, and International Accounting Standard (IAS)
 In reality, lack of Shariah consistency internationally as
each bank relied on Shariah Advisors of respective banks
even with the supervision of the central banks
 Needs for a comprehensive and enforceable
accounting standard for Islamic financial institutions
 To take into consideration unique Islamic financial
services and products
 Development
 As a result, lack of comparability and consistency on the
accounting treatment on recognition, measurement and
disclosure of Islamic-based transactions
 Lack of comparability leads to measurement and
comparison of financial performance of the banks not
possible
 Lack of sound regulation on accounting hinders the
development of Islamic banking
 Internationally, the efforts made by Accounting and
Auditing Organization for Islamic Financial Institutions
(AAOIFI) since mid-1990s to develop accounting, auditing
and governance standards for Islamic financial institutions
 In Malaysia, efforts by MASB with the guidance of
AAOIFI’s standards to develop Malaysian accounting
standard for Islamic financial institutions
User Groups of Accounting Information for Islamic
Banks & Their Needs
• Investors (potential and existing) (lawful and equitable
investment)
• Creditors (potential and existing) (lawful trade assets)
• Regulators (e.g. Bank Negara) (financial stability and
soundness)
• Shari’ah Supervisory Board & Advisory Council (Shari’ah
compliance)
• Customers (lawful goods and services)
• Others who may be effected by the disclosure or non-
disclosure of information
 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 IFIs

Objectives
• 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)

• 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.
 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)
 AAOIFI’s Accounting Standards

 FAS 1: General Presentation and Disclosure in the

Financial Statements of Islamic Banks and Financial
Institutions
 FAS 2: Murabaha and Murabaha to the Purchaser
Orderer
 FAS 3: Mudaraba Financing
 FAS 4: Musharaka Financing
 FAS 5: Disclosure of Bases for Profit Allocation between
Owners’ Equity and Investment Account Holders and
Their Equivalent
 FAS 6: Equity of Investment Account Holders and Their
Equivalent
 AAOIFI’s Accounting Standards
 FAS 7: Salam and Parallel Salam
 FAS 8: Ijarah and Ijarah Muntahia Bittamleek
 FAS 9: Zakah
 FAS 10: Istisna’ and Parallel Istisna’
 FAS 11: Provisions and Reserves
 FAS 12: General Presentation and Disclosure in
Financial Statements of Islamic Insurance Companies
 FAS 13: Disclosure of Bases for Determining and
Allocating Surplus or Deficit in Islamic Insurance
Companies
 AAOIFI’s Accounting Standards

 FAS 14: Investment Funds

 FAS 15: Provisions and Reserves in Islamic Insurance
Companies
 FAS 16: Foreign Currency Transactions and Foreign
Operations
 FAS 17: Investments
 FAS 18: Islamic Financial Services offered by
Conventional Financial Institutions
 FAS 19: Contributions in Islamic Insurance Companies
 FAS 20: Deferred Payment Sale
 FAS 21: Disclosure on Transfer of Assets
 FAS 22: Segment Reporting
 FAS 23: Consolidation

Others (refer to AAOIFI website)

 Malaysian Accounting Standards for Islamic
Financial Institutions

 MASB FRSi-1: Presentation & Disclosure in Financial

Statements of Islamic Financial Institutions (repealed)
 MASB TRi-1: Accounting for Zakat on Business (TRi-1)
 MASB TRi-2: Ijarah
 MASB TRi-3: Presentation & Disclosure in Financial
Statements of Islamic Financial Institutions
 MASB TRi-3: Shariah Compliant Sale Contracts
 MASB DSOPi:
 Impact of Shari’ah Contractual Conditions on
Accounting concepts

1. Existence (recognition of revenue and asset e.g. cash

vs. accrual basis)
2. Lawful (recognition revenue and asset e.g. leasing vs.
ijarah)
3. Measurable (measurement of assets and liabilities e.g.
historical vs. current value)
4. Deliverable (recognition & measurement)
5. Equitable (profit determination and distribution e.g.
pooling method vs. separate investment account
method)
6. Accountability (disclosure & presentation e.g. halal vs.
non-halal income and assets)
 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
 Accounting Concepts:
An Islamic Perspective
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
 Accounting Concepts:
An Islamic Perspective

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

AAOIFI: Cash Equivalent Value (most preferred in the case
of Zakat valuation 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/usurfruct) as a
result of past transactions or events” (AAOIFI)
 Issue 1: Para 73 MASB TRi-3 on Voluntary
Disclosure of Earnings or Expenditure Prohibited
by Shariah

An IFI is encouraged to disclose:

• The amount and nature of earnings realised from
sources or means which are not permitted by Shariah;
• The amount and nature of expenses not permitted by
Shariah; and
• The manner of disposal of prohibited earnings.
 Issue 2: MASB TRi-3 Para 80-83 on Profit
Distribution Policy
• An IFI that co-mingles various types of deposits into a
single pool of funds should disclose the method of
allocation of income among various categories of
deposits.
• Discloses the distribution of profit derived from
investment of depositors’ funds at gross level after
deducting expenditure to the extent that they are directly
attributable to the investment of those funds.
• Allocates income by using a weighted average method
balances and allocates a total income to various
categories of depositors.
• Distributes profit derived from investment of depositors’
funds based on a pre-determined ratio in the case of
Mudarabah deposits, and on a ratio determined at the
discretion of the IFIs in the case of Wadiah and other
non-Mudarabah deposits
Issue 3: Is Islamic Deposit a Liability or an Equity?

• Wadiah deposit is clear cut liability because of safe

keeping contract.
• Mudarabah deposit as a profit sharing partnership or
investment is neither a liability nor equity.
• AAOIFI prescribed a separate line item in the Balance
Sheet and recognised it as Equity of Unrestricted
Investment Account Holders.
Issue 4: Basis for Income Recognition - Cash vs.
Accrual
• Cash basis recognizes actual income received in cash for
profit distribution to depositors and shareholders
• Many Shariah scholars considers cash basis as the best
since it possesses high level of certainty and ownership
in profit for distribution
• Accrual basis recognizes when realized i.e. the right to
receive rather than actual cash received
• Some Shari’ah scholars approved accrual basis as it
represents the contractual rights as sufficient to
recognize profit for distribution
• MASB TRi-3 prescribed accrual basis with the premises
to achieve harmonisation with other business entities and
banks.
Issue 5: Substance vs. Form: Ijarah Asset - Fixed
Asset or Receivable?

• International Accounting Standard considers

conventional finance lease as receivable
• Current practice for Islamic Hire Purchase (AITAB
financing) is similar to conventional finance lease
• If Substance over Form then Ijarah is receivable as
economic substance is `lending’ regardless of legal form
• AAOIFI considers Islamic finance lease (based on Ijarah
Muntahia Bitamleek) as Fixed Asset
• The Legal Form that the Asset belong to the Bank or
Financial Institution, and the lease to lessee
• According to AAOIFI Legal Form must be reflected
rather than economic substance to represent the legal
ownership of the lessor.
 Conclusions:
Objectives of Islamic Accounting

1. Islamic accountability, compliance with Shari’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
 Tutorial Task.

In your own words (individual), summarize

(one-paged summary) what have you
understood from the lecturing slides.

Note: The individual summary will be

attached together with the tutorial
solutions.
 Tutorial
1 Name and briefly discuss the approach(es)
pursued in developing Islamic Accounting.

2 Which approach is more Islamic and why?

3 How do you view them, complementary and/or

exclusive. Why they are so?

4 Which of the approaches is more dominant

today? Do you agree with it? Which approach
you prefer and why?
Terima Kasih

Thank You