Learning Objectives

Upon the completion of this chapter. the reader

should be able to:
1 Understand the definition of accounting from both conventional and
Islamic perspectives, respectively, and its significance in financial
decision-making.

2 Explain the relevance of International Financial Reporting Standards

(IFRS) in international accounting regulation.

3 Understand the basic principles of accounting.

4 Understand the basic principles of Islamic accounting.
5 Differentiate between the accrual and cash flow accounting
methods.

6 Draft the main financial statements for Islamic finance products.

Accounting is regarded as a product of the environment within which it operates.

A number of environmental factors greatly influence a country's financial
accounting system.Thesefactors include the legal, regulatory,and political
frameworks,sizeof ownership, and the nature of business being carried.
There is a strong relationship between Islamic financial principles and accounting.
Such principles have been aligned with international financial standards with a view
to establishing a formidable framework for financial accounting for Islamic banking
products without compromising an inch of the fundamental requirements of Islamic
financial transactions.To this end, this chapter examines financial accounting
for Islamic banking products. It examines the international financial reporting
stondords. basic principles of conventional accounting, and basic principles of
Islamic accounting. It further appraises the financial accounting standards of the
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI),
which, for the purpose of this book, are considered to be the general standards for
Islamic financial accounting. In order to guide the reader,the chapter also gives
comparative financial statements for Islamic financial products. There is no doubt
that the development of the Islamic banking sector requiresa standard financial
reporting framework.
 Professor Mustafa Hanefah
Dean, Research and Innovation
Universiti Sains Islam Malaysia

1 What accounting standards do you adopt In your organization?

Malaysian universities are required to adopt IFRS of the International Accounting
Standards Board, and Malaysian Financial Reporting Standards (MFRS) in their
teaching at undergraduate and postgraduate programs. SinceJanuary 1, 2012, MFRS
issued by the Malaysian Accounting Standards Board (MASB) are in congruence
with the IFRS. All corporate entities, including Islamic financial institutions (IF!s),
must adopt IFRS or MFRS in their reporting and disclosure practices. It is also
mandatory for all Malaysian IFis to adopt IASB recommended standards and
guiding principles.

2 Is there any conflict between IFRS. AAOIFIand IFSB recommendations

regarding accounting standards for Islamic financial products?
There are several major differences between IFRS and AAOIFI accounting standards.
AAOIFI standards are mainly for IFis, whereas the IFRS cover all entities. AAOIFI and
IFSB standards are based on Shari'ah principles, and full compliance with these
principles are mandatory at all times. Shari'ah-based standards differ in respect to
time value of money (money availableat this time is worth more in future as a result
of its inherent potential earning capacity),legal forms, and rule-based standards. The
IASB is more concerned with substance and principle-based accounting standards.
Time value of money or interest is not a problem for the IFRS, but is with regard to
AAOIFI and IFSB standards and guidelines. The AAOIFI and IFSB should also ensure
their standards and guiding principles can be adopted by all entities, not just Islamic
banks. Islamic banks in the Middle East adopt AAOIFI standards, but Malaysian ones
adopt IFRS as .AAOIFI standards are not mandatory. Issues of comparability and
transparency arise because of these anomalies.

3 Are the accounting standards for Islamic banks enough? Do we need

to come up with more standards?
New accounting standards are only issued when new Islamic financialinstruments
or products are made available by Islamic banks. In today's competitive business
world, Islamic banks always try to market new financial products to their
customers. This will require new standards, just like IFRS. Standards should also
cover all areas of Islamic finance and banking including corporate governance, risk
management, capital adequacy, and not only for the banks but also other IFis.

127
 Muhammad Tariq
Partner, Head of Islamic Finance. KPMG UAE

1 What accounting standards are adopted by organizationsin your

jurisdiction?
The choice of an accounting framework is almost always driven by regulatory
requirements. In the United Arab Emirates, all Islamic financial institutions (IF!s)
follow International Financial Reporting Standards {IFRS), except those !Fis which
are domiciled in Dubai International Financial Centre (an offshore jurisdiction)
and regulated by Dubai Financial ServicesAuthority (DFSA) where the accounting
framework for IF!s is Financial Accounting Standards (FAS) issued by Accounting
and Auditing Organization for Islamic Financial Institutions (AAOIFI). I am aware
that DFSA is currently reviewing its position on mandatory use of FAS and there is
a possibility that this requirement will be removed.

2 Is there any difference between IFRS, AAOIFIand IFSB

recommendations regarding accounting standards for Islamic
financial products?
It is important to understand why FAS were created in the first place. Fora very long
time Islamic finance professionals have been highlighting the inadequacies of IFRS
when it comes to dealing with Shari'ah-cornpliant products and transactions. They
believed that the true nature of Shari'ah-compliant products and transactions
was being ignored and the needs of the users of financial statements were not
being fully met. In particular, the risk-sharing nature of these products and
transactions was being lost because IFRS focuses on the 'economic substance' of
the products and transactions rather than their legal structure. Another reason for
creating FAS was to address accounting issues which are unique to Islamic finance.
For example, accounting for qard hasan, zakan, profit equalization reserves, etc.
Clearly,IFRS do have an advantage because of its global reach and long history of
robust standard-setting, which gives confidence to users of financial statements.
However, AAOIFI has been trying to gain more jurisdictions, and much effort has
gone into creating awareness of its value proposition.

3 Are the accounting standards for Islamic Banksenough?

Do we need to come up with more standards?
The clear answers to these two questions are 'probably not' and 'yes', respectively.
There are many areas which are the subject of considerable debate.and authoritative
accounting guidance is lacking. This is compounded by fast-paced growth in the
Islamic finance industry and the continuing evolution and complexity of many
Islamic finance products. In my personal opinion, AAOIFI is struggling to cope with
this and the pace of standard-setting has been relatively slow as a result. I believe
a closer coordination among standard-setters in this respect will be beneficial and
many more synergies can be achieved.

128
tLEARNING
,·, OBJECTIVE 4.1 Definition of Islamic Financial
Understand the
definition of accounting
Accounting
from both conventional The language of business is accounting. The language can only be communicated through
and Islamic perspectives, a process that may involve a number of activities such as recording the transactions and
respectively, and its
classifying them under the appropriate heading. This process is essential for the success
significance in financial
of a business. In this section, we shall be defining the terms 'accounting' and 'Islamic
decision -rnaking.
accounting' and explain the importance of accountability in Islam. Although there are
different kinds of accounting, our focus in this chapter is financial accounting.

What is Accounting?
In simple terms, accounting is a process whereby business operations and activities are
measured, and the measurements are processed into information that is made available
to decision-makers. This simple definition involves three main issues:

recognizing, recording, classifying, and summarizing business transactions

measuring, analyzing, processing, and interpreting operating results
reporting and presenting the financial position.
The financial position presented on the business transactions is specifically meant for
the decision-makers, who include both internal and external stakeholders. The internal
decision-makers include the company management while the external decision-makers
are mainly investors and customers.

American Accounting According to the American Accounting Association, accounting can be defined as "the
Association process of identifying, measuring, and communicating economic information to permit
A voluntary organizationfor
informed judgments and decisions by users of the information." The purpose of this
people interested in accounting
education and research, which process is to provide necessary information that has the potential to be useful for
was founded in 1916. economic decision-making by stakeholders in the financial industry. Accounting or
economic information is identified and measured by creating a set of accounts in which
For more information the records of business transactions are summarized.
on the American
Accounting
Association. see
http://aaahq.org
What is Islamic Accounting?
financial accounting Islamic financial accounting can be defined as "the accounting process that provides
A process where business appropriate information (not necessarily limited to financial data) to stakeholders of an
operations and activities
entity that will enable them to ensure that the entity is continuously operating within
are measured, and the
measurements are processed the bounds of the Islamic Shari'ah and delivering on its socioeconomic objectives."
into information that is made Islamic law is generally inclusive regarding issues that relate to Islamic financial
available to decision-makers. transactions, with the exception of few prohibited elements. Therefore, the general
Islamic worldview definition of financial accounting remains acceptable within the Islamic financial
The vision of reality and truth
framework provided that the underlying objective of Islamic financial accounting is an
about a phenomenon based on
Islamic ideals. Islamic worldview in compliance with the Shari'ah prescriptions. The significance of

129
 financial accounting in both frameworks is to enable stakeholders to make informed
decisions about their various options when conducting business transactions. Financial
accounting is directed at the needs of external decision-makers. Decision-makers include
the company management, the board of directors, shareholders, investors, creditors,
regulatory authorities, staff, and the general public.

The Importance of Accountability in Islam

In the Our'an, the generic word for accounting or accountability is hisab. The word hisab
or muhasabah (a word derived from hisab) refers to the individual spiritual reckoning
in Islam. It is generally used in several verses of the Our'an to emphasize the need
for accountability in every human activity. In most of the verses in the Our'an, the
word is used in its generic sense, which emphasizes the obligation on mankind to be
accountable to God in every worldly disposition. There is emphasis on the importance
of accountability in daily transactions regardless of whether they relate to financial
or administrative matters. In order to ensure transparency in commercial dealings,
there is emphasis on the accountability of parties in a partnership business. For
instance, in a trust partnership contract where a capital provider provides the capital
to an entrepreneur for investment in a commercial enterprise, known as a mudarabah
transaction, one key element in the transaction is accountability and fair dealing. The
Islamic worldview of accountability leaves its footprints in every page of the Our'an,
All legislative prescriptions on economic matters mentioned in the Our'an and clearly
explained in the Prophetic traditions are based on fair dealings and accountability.

Against this backdrop, a number of Islamic concepts underscore the significance of

accountability in Islam with particular reference to financial transactions. These
concepts include khilafah (vicegerency), taklif (responsibility), documentation of financial
dealings, Islamic law of inheritance (mawarith), calculation of obligatory alms (zakat),
and the underlying concept of tawhid (unity of God). The concept of responsibility (taklij)
in Islam typifies the duty of people towards their God. The purpose of creation in Islam
as proclaimed by God is the unparalleled worship of the Ultimate Creator. Therefore,
a person is the vicegerent of God (khalifah) and merely the trustee of all resources
provided for their benefit on earth. As a vicegerent of God, a person is accountable for
their prudent management of these resources. Each person will be held accountable for
Last Day their deeds involving the management of endowed resources in this world and the next.
The Day of Accountability · This is one reason why one of the commonest names for the Last Day, when all persons
where, according to the Islamic
and jinns (a class of spirits that are capable of appearing in animal or human forms) will
belief, human beings and jinns
will account for their worldly account for their deeds, is the Day of Accountability. This implies full accountability of
life before Almighty God. one's deeds on earth, which accordingly attracts some form of immediate recompense.

So we can see that accountability and the need for proper accounting in whatever one
undertakes is part of the Islamic ideals. This is the reason why Islamic accountants have
more responsibility in their duties for they are expected to understand the underlying
religious principles of their chosen profession.

130
 LEARNING OBJECTIVE 4.2 International Financial Reporting
Explain the relevance of
International Financial
Standards
Reporting Standards Financial reporting is an element of documentation in financial dealings, which is a
(IFRS) in international Our'anic prescription in commercial transactions in Islam. The general approval and
accounting regulations.
guideline Islam provides for recording and subsequent reporting of transactions is
summarized in Our'an 2, verse 282, which is the longest verse of the Our'an, popularly
called the 'verse on debt', or ayat al-dain in Arabic.The emphasis on these issues requires
a standard framework for Islamic reporting of various commercial transactions in
Islamic law. The recording and reporting of Islamic financial products requires different
techniques. For instance, the financial reporting of mudarabah financing is different
from that of murabahoh financing, and so on.
The International Financial Reporting Standards (IFRS) are a set of principles-based
accounting standards developed by an independent, non-for-profit organization called
International Accounting the International Accounting Standards Board (IASB). The IASB is the standard-setting
Standards Board {IASB) body of the IFRS Foundation. The main goal of the IFRS is to provide globally acceptable
An independent standard-
standards for public companies in the preparation and disclosure of their financial
setting body of the IFRS
Foundation. This is the leading statements. Box 4.1 outlines the principal objectives of the IFRS and IASB. The IFRS
standard-setting body for contains general guidelines for financial reporting. It does not contain industry-specific
conventional accounting and standards for individual companies. Public companies across the world are required to
auditing practices.
adopt and adapt the global standards to suit the specifics of the industry within which
they operate. The IFRS is more relevant to multinational corporations with subsidiaries
spread across different countries as it allows them to adopt the same set of accounting
standards. This simplifiesthe accounting procedures as all subsidiaries can adopt the same
reporting language in preparing and disclosingtheir respective financial statements. Both
prospective investors and auditors will have the same overview of the company's finances
as a single set of standards of reporting has been adopted .

. ,!! •• ..,.. '.-, ·~· •

1
BOX 4.1: fTHE'IFRS FOUND. T~~N !'j;,~~·tHE IASB ),

The IFRS Foundation is an independent, not-for-profit, private sector organization

working in the public interest. Its principal objectives are:

to develop a single set of high quality, understandable, enforceable and globally

accepted international financial reporting standards (IFRS) through its standard-
setting body,the IASB
to promote the use and rigorous application of those standards
to take account of the financial reporting needs of emerging economies and small
and medium-sized entities (SMEs)
to bring about convergence of national accounting standards and IFRS.

See IFRS Foundation at www.ifrs.org.

131
 People often confuse the International Accounting Standards (IAS) with the IFRS. These
are two different accounting reporting regimes. The !AS are the old standards, which
have been replaced by those of the IFRS. Nevertheless, many standards forming part
of the IFRS are still known by their older name of !AS. The Board of the International
Accounting Standards Committee (IASC) issued !AS between 1973 and 2001. The new
IASB took over the responsibility for setting international accounting standards from
the IASC on April 1, 2001. It has, however, adopted the existing !AS and the Standing
Interpretations Committee (SIC). Since then, the IASB has continued to develop new
standards under the new name IFRS. More than 120 countries require the adoption of
IFRS for public companies in financial reporting and disclosures (see Table4.1 on page 133).
IFRS provides broad rules and dictates specifictreatments for certain aspects of financial
reporting. The structure of IFRS comprises five different aspects:
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 Financial Reporting (IFRS Framework) (2010).

IFRS and Islamic Banks and Financial Institutions

The applicability of IFRS to Islamic banks and financial institutions has created certain
problems because its standards are intended for conventional forms of business whereas
Islamic banks have their own specific requirements in terms of transactions, reporting,
and disclosure. There are issues in Islamic finance for which there are no IFRS, and a
number of the existing IFRS are not applicable to Islamic banks and financial institutions.
Therefore,the Islamic finance industry requires its own set of accounting and financial
reporting standards. This prompted the establishment of an international standard-
Accounting and Auditing setting body for Islamic financial institutions. The Bahrain-based Accounting and
Organization for Islamic Auditing Organization for Islamic Financial Institutions (AAOIFI) has issued more
Financial Institutions (AAOIFI)
than 81 accounting, auditing, governance, ethics, and Shari'ah standards. AAOIFJ's
The main international
standard-setting body for establishment was overdue considering the tremendous growth experienced in the
Islamic financial institutions. Islamic finance industry within the past 20 years. This body has spearheaded the
development of accounting, auditing, and Shari'ah standards for Islamic banks and
financial institutions across the world. AAOIFI operates in a competitive world where
there is an increasing call for the adoption of IFRS in order to achieve harmonization in
To learn more
about AAOIFI. visit its financial reporting regardless of the cultural differences between countries. The efforts
website at
www.aaoifi.com.
made towards harmonization of the AAOIFI standards with the IFRS are given in the
Islamic Finance in the News feature.

There is a world of difference between conventional financial instruments and Islamic

ones such as mudarabah between two parties where they both contribute capital
towards the joint venture. Therefore, their respective accounting treatments differ
and, furthermore, the type of information contained in the financial statements

132
 TABLE 4.1: Adoption of IFRS by Companies in Selected Countries
Country JI Status for listed companies as of December aou
·----··-
Argentina Required for fiscal years beginning on or after January 1, 2012.
Required for all private-sector reporting entities and as the basis
Australia
for public-sector reporting since 2005.
~===-_... --:==========:
Required for consolidated financial statements of banks and
Brazil listed companies from December 31,2010 and for individual
company accounts progressively since January 2008.
Required from January 1, 2011 for all listed entities and permitted
C d

~ '1 Substantially converged national standards. - I

I -
. All member states of the EU are required to use IFRS as adopted
European Uruon . .
, by the EU for listed companies smce 2005.
1
Required via EU adoption and implementation process since
France
.__ •• 2005.

Required via EU adoption and implementation process since

Germany
2005.

t.!_ndia .. India is converging with IFRS at a date to be confirmed.

IrIndonesia. Convergence process ongoing; a decision about a target date for

full compliance with IFRS was expected to be made in 2012.
=It=al======·,·,-R-e=quired via EU adoption and implementation process since

y 2005. --- ----=--=========~

Permitted from 2010 for a number of international companies;
Japan decision about mandatory adoption by 2016 expected around
2012.

I Mexico
1

1
Russia
~ired
Republic of Korea If Required from 2011.
from 2012.

Required from 2012.

=
_ _
]

j
j
bi Required for banking and insurance companies; full
,
Saudi Ara ia I convergence with IFRS currently under consideration.
South Africa 1~quired for listed entities since 2005. !
I Turkey ~~ Required for listed entities since 2005.
. d . d
Urute King om
:-111 Required via EU adoption and implementation process since
11 2005.

II Allowed for foreign issuers in the US since 2007;

US SEC
committed to global accounting standards and IFRS best placed
Unite d States I to meet that need in the US, awaiting
. . decision
. regarding use of I
-------- II IFRS for domestic companies.
-- -
Source: IFRS Foundation. Available at www.ifrs.org/Use-around-the-world/Pages/Use-
___.,
around-the-world.aspx.

133
 ...............................................................................................................................................................................................................................................

ISLAMIC FINANCE IN THE NEWS

...............................................................................................................................................................................................................................................

IFRS to Converge with Islamic Accounting Standards

April 21, 2009

E ven as the Securities and Exchange Commission

weighs the comments that were due this week on its
proposed roadmap to International Financial Reporting
'We have to embrace all financial products so we will need
to change our standards,' he said, according to Emirates
Business. He said that the IASB would need to meet with
Standards, IFRS could be on a convergence path of its the Middle Eastern standard-setter, the Accounting and
own with Islamic accounting standards. Auditing Organization for Islamic Financial Institutions,
In addition to converging IFRS with U.S. generally 'to have a better understanding of their concerns and
accepted accounting principles, the International how we can accommodate those with a revised IFRS'.
Accounting Standards Board is also looking to extend He sees only slight differences between the standards
the standards globally, claiming that about 113 different now and believes they can be reconciled with the help of
countries have either adopted IFRS or agreed to adopt the professional judgment.
standards. Now the IASB is looking to the Middle East to Garnett also chairs the International Financial Reporting
adopt the standards. Board member Robert Garnett spoke Committee and he plans to begin holding talks with
at an IFRS breakfast briefing in Dubai about the standards the AAOIFI this year to try to work out the differences
and how they could converge with Islamic accounting between IFRS and the Islamic standards.
standards.

Source: Accounting Today

also differ. Conventional accounting standards are based on a framework useful for
decision-making by stakeholders who are given the relevant information. Conversely,
Islamic accounting standards focus on accountability and a framework for Shari'ah
compliance that seeks fair dealing among all parties in a business transaction. That
does not mean that Islamic accounting standards neglect the important objective of
financial accounting, i.e. to provide useful information to the users of financial reports.
But there is a more ethical perspective towards the Islamic worldview. Financial reports
are made available to the users to enable them to make informed, legitimate decisions
in their dealings with the IFI rather than to think of how to increase their wealth in the
11:Challenge capitalist sense. In addition, the functions of Islamic commercial contracts, for which
YJhat are the similarities financial disclosure and reporting are required, are different from the functions of
of the objectives of conventional banks' financial contracts. Whereas conventional banks aim to mobilize
financial accounting in
deposits and advance loans with interest, Islamic banks focus on investment financing
both the conventional
and social services through joint venture contracts between the financial institutions
and Islamic frameworks?
and their customers.

134
iARNING OBJECTIVE4.3 Basic Principles of Accounting
Understand the basic Accounting comprises two main activities that are distinct in nature but complementary
principles of accounting. in their functions. The first activity is called bookkeeping. In simple terms, bookkeeping
bookkeeping is the detailed recording of all financial transactions involved in a business. This is the
The detailed recording of all recording aspect of accounting, whereby all transactions are carefully documented. The
financial transactions involved second activity is the preparation of the financial statement, or accounting. This may
in a business.
be made periodically depending on the policy and accounting standards adopted by
the business. Periodic statements or accounts are prepared to give a summary of the
Remember that the
financial performance of a business. Users of this information can assess it for their
users of financial
information are needs. Regardless of the type or size of the business, the principles of accounting are
management,
potential investors.
the same. That is, there must be two-tier procedure for accounting, beginning with
employees. lenders. bookkeeping and ending with accounting.
suppliers and other trade
creditors, customers.
government and their
agencies, and the general
public.
Recording Financial Information
In a business, one has to monitor the progress of transactions through appropriate
records for each and every financial transaction. The information recorded must
revenue reflect both the revenue and expenditure. The accounting record where all financial
The money received from the transactions of a business are originally entered is known as a journal. However,
sale of products and services
individuals also keep records of their finances. When you receive your payslip at the
before expenses incurred are
deducted. Revenue is also end of the month, the next thing you do is plan how to use your wages. Paying the
known as 'top line'. bills and rent usually comes first from your monthly pay, then a workable budget for
expenditure consumables and your monthly upkeep. Keeping proper records allows you to know your
Amount of money or resources financial position at every point in time, enabling you to plan for other future financial
spent in a financial operation
commitments. So financial information is very important to us in our daily lives. The
or in the settlement of an
obligation.
same applies to a business, where financial information is required to make business
decisions. This information can only be derived by proper record-keeping of all the
journal
An accounting record where
business's financial transactions. The recording of financial information is formalized
all financial transactions of a in a business, as opposed to that of the individuals. The reason for keeping a financial
business are originally entered. record is that it is difficult for the entrepreneur to remember all transactions; hence, the
need to document everything. The basis of modern accounting systems, which became
an established method of recording financial transactions in the 15th century, is double-
entry bookkeeping.
T account (or ledger) Another relevant item in recording financial information is the ledger, or what is generally
The ledger account format that
known as the T account. The ledger is a collection of financial accounts that uses both
resembles the letter T, which
originates from the process of credits and debits. The format is usually in a T'form, where credits are presented on one
using debits and credits. side and debits are presented on the opposite, hence the name T account.
double-entry bookkeeping
A set of rules for recording Double-Entry Bookkeeping
financial information where
The double-entry bookkeeping system is a set of rules for recording financial information
every transaction or event
changes at least two different where every transaction or event changes at least two different ledger accounts. Every
ledger accounts. financial transaction reveals two main aspects: the debit aspect and the credit aspect.

135
 FIGURE 4.1 !".1HE'BAs1cs OF iHJ . #,.:"!
DOUBLE EN!~~S_JST·EM~"I' .
Dr Cr

Balance
Assets Liabilities
sheet

Income and
Expenses Income
expenditure

Source: Leo Isaac. Available at www.leoisaac.com/fin/fin004.htm.

debit The debit aspect is the receiving, incoming or expenses/loss aspect. Conversely, the credit
An increase in assets and aspect is the giving, outgoing or income/gain aspect, as shown in Figure 4.1. These two
expenses, and an decrease in
aspects form the basis of the double-entry system, which records them both. The basic
liability, revenue, and capital.
principle is: for every debit, there must be a corresponding credit of an equal amount and
credit
for every credit, there must be a corresponding debit of an equal amount. Therefore, the
An increase in liability, revenue,
and capital, and a decrease in accounting equation, which governs the double-entry bookkeeping, provides if revenue
assets and expenses. equals expenses, the following basic equation must be true:

assets = liabilities + owners' equity

To have a balanced account, total debits must be equal to total debits.

To give a practical example, suppose someone invests US$10,ooo in a business. They

use this capital to lease an office and buy basic office supplies to kick start the business.
According to the double-entry bookkeeping, his initial journal entries might look like
Table 42.

1/1/2013 II Cash 10,000

Capital I II 10,000
The owner contributes $10,000 to start
the business
11 Lease expense

r~;~~
1/3/2013
..__Cash-
iL200
__ Ji_ 1,200
-..r-
1/6/2013 lfoffice supplies
Computer
Cash \\ 1,100

136
 The date column gives the actual day when each transaction was carried out.

The account name and explanation gives the details of the transaction and the item
either purchased or acquired.

The debit column provides for the assets of the business, which also signifies a decrease
in the revenue or capital of the business. This is recorded on the left-hand side of a ledger
or 'T' account.

The credit column provides information about the increase in assets and expenses. This
is recorded on the right-hand side of a 'T' account.

In some cases a fifth column may be added to reflect the balance of the 'T' account.
Alternatively, a line may be drawn underneath the entries to show the net balance. This
is put in the appropriate side of the account.

Note how in the table each transaction is balanced accordingly. Any transaction entered
on the left-hand side (debit column) equals the amount on the right-hand side (credit
column). This balances the transactions and shows the double-entry system. The
entries for 1/1/2013 and 1/3/2013, respectively, are single entries for each of those days.
They represent two separate single journal entries for transactions on two different
compound accounting days. However, the entry for 1/6/2013 comprises two journal entries (office supplies and
journal entry
More than one debit or credit in
computer), where two separate accounts were credited in one single account (as cash).
a single journal entry. It is is also This is known as the compound accounting journal entry, which is considered to be
called combined journal entry. more efficient and preferable for financial accounting.

The Three Branches of Accounting

Accounting covers a range of activities and related financial issues. However, the
branches of accounting are broadly divided into three main categories-cost and
management accounting, financial accounting, and auditing (Figure 4.2).

FIGURE 4.2 :'~THrtHREEBRA

ACCOUNTl~G
cH~ 01: -~ -·~)~"'~;:~1 i
. " . .c

,:.-
••• ,
- •
. :
.
·,
,,,.
~~~

Cost and management Financial

accounting accounting Auditing

137
 Cost and Management Accounting
Cost and management accounting deals with the provision of relevant financial
information to interested parties in the business to assist them in planning, decision-
making, management, and control. The information generated must be relevant and
help managers make informed decisions in the management of the business. The
information is also useful for planning, control, and performance measurement. The cost
component of cost and management accounting appropriately allocates costs between
the costs of goods sold and inventories. This is relevant for internal and external profit
reporting on the business.

Financial Accounting
Financial accounting deals with the provision of relevant information to interested
parties outside the domain of the business. Prospective investors, banks, future partners,
regulatory bodies, government agencies, shareholders, and prospective buyers who will,
one way or another, need financial information on the performance of the business to
help them make better decisions or policies. Financial accounting allows the stakeholders
in the business to make sound economic decisions that could have an impact on the
populace. While cost and management accounting provides information for managers
to help them make better decisions to manage the business effectively, financial
accounting is directed at outsiders from the business, who are usually stakeholders in
the industry at large. These stakeholders are not involved in the day-to-day running of
the company but are considered to be interested parties.
internal auditing
This is a system designed by Auditing
an organization to examine, Auditing is a key branch of accounting that determines, through verification, whether
monitor, and analyze activities
related to its operation, the financial information recorded or disclosed is a true reflection of the business
including its business transactions that were undertaken during a financial period. There are two forms-
structure, employee behavior, internal auditing and external auditing. Internal auditing is where the business itself
and information systems. carries out the audit. External auditing is when the business engages the services of an
external auditing outside company, usually an auditing firm, to conduct the audit. The modern practice is
When an independent to combine both internal auditing and external auditing for a particular financial year.
professional or firm outside
the organization is engaged to The validity and reliability of the financial information prepared and disclosed by the
perform auditing functions. company is.ascertained through auditing.

LEARNING OBJECTIVE 4.4 Basic Principles of Islamic Accounting

Understand the basic Islamic accounting is unique in its features, objectives, and approach. Modern Islamic
principles of Islamic accounting principles evolved because of the lack of relevant standards in the available
accounting.
international financial accounting standards. The objectives of Islamic accounting are
diverse depending on the approach used. The purposes of Islamic accounting include the
accurate determination of income, promotion of efficiency and leadership, compliance
with the Shariah, commitment to justice, reporting best practices, and adapting to
positive social change through corporate social responsibility.

138
 Consumers of Accounting Information on Islamic Banks
Just as in conventional accounting, the consumers of accounting information on Islamic
banks consist of numerous stakeholders of the Islamic finance industry who require
information to make appropriate decisions. Financial information is communicated
to consumers or users through different means. The most popular method of
Statement of Financial
communicating financial information is through the use of financial statements, but
Accounting (SFA)
A statement issued by the there are other means that can be used to communicate directly or indirectly. The
Accounting and Auditing type and nature of information that should be included in the financial statements is
Organization for Islamic determined by the objectives of financial accounting. It is important for the financial
Financial Institutions that
information to focus on the information needs of diverse users. AAOIFI's Statement of
contains financial accounting
and reporting standards for Financial Accounting (SFA) No. 1, para 26 gives a list of the main categories of users of
Islamic finance products. external financial reports for Islamic banks as:
equity holders
ltf Challenge holders of investment accounts
Compare these other depositors
categories of users of current and savings account holders
financial reports with others who transact business with the Islamic bank, who are not equity or account
those of the conventional holders
financial institutions. Are
there any differences? zakat agencies (in case there is no legal obligation for its payment)
regulatory agencies.'
Providing financial information to the relevant stakeholders is one of the objectives of
Islamic accounting. Therefore, the common information needs of users, particularly the
external users, should be met by the available data in the company's financial statement.
Remember that the purpose of accounting in Islam goes beyond making informed
decisions but extends to aspects of accountability, transparency, fair dealing, and just
policies. Thus, the information that is directed at external users should provide the
following types of information as required in SFA No.1, paras 37-42:
Information about the Islamic bank's compliance with the Shari'ah and its objectives
and that establishes such compliance; and information establishing the separation
of prohibited earnings and expenditures, if any, which occurred, and of the manner
in which these were disposed.
Information about the Islamic bank's economic resources and related obligations (its
obligations to transfer economic resources to satisfy the rights of its owners or the
rights of others). and the effect of transactions, other events and circumstances on
its economic resources and related obligations. This information should be directed
principally at assisting the user to evaluate the adequacy of the Islamic bank's
capital to absorb losses and business risks,assess the risk inherent in its investments,
and evaluate the degree of liquidity of its assets and the liquidity requirements for
meeting its other obligations.
Information to assist the concerned party in determining zasat on the Islamic bank's
funds and the purpose for which it will be disbursed.

139
 Information to assist in estimating cash flows that might be realized from dealing
with the Islamic bank, the timing of those flows, and the risks associated with their
realization. This information should be directed principally at assisting the user to
evaluate the bank's ability to generate income and convert it into cash flows, and
the adequacy of those cash flows for distributing profits to equity and investment
account holders.
Information to assist in evaluating the Islamic bank's discharge of its fiduciary
responsibility to safeguard funds and to invest them at reasonable rates of return,
and information about investment rates of return on the bank's investments and
the rate of return accruing to equity and investment account holders.
Information about the Islamic bank's discharge of its social responsibilities.s

An Islamic Perspective on Accounting Concepts

The Islamic perspective on accounting concepts relates to the requirement of full
disclosure, and social and financial accountability. This is required for any information
The framework of requested by users, in accordance with the rules of Shari'ah. With a very few exceptions,
Islamic accounting
is wide and unique
most of the accounting concepts are not alien to key Islamic principles. The requirement
in its applicability to for legal documentation or recording of financial transactions, as earlier explained, is the
different transactions. There
ore different accounting principal reason for the importance of bookkeeping and accounting in Islamic financial
principles for the transactions. Within the context of modern accounting practice and the growing
calculation of the returns
on various Islamic modes importance of IFRS, Islamic accounting is relevant for transactions that use alternative
of financing. principles of financing based on Islamic commercial rules.

In conventional accounting, the accounting concepts are required to guide the existing
practice, prescribe future directions, and identify certain fundamental issues. Conversely,
the Islamic perspective on these concepts is the need for an Islamic bank or financial
institution to provide the relevant information on all its transactions for the users of such
information to be able to assess the level of compliance with the mandatory principles
of the Shari'ah in its daily activities. Those who patronize Islamic banks and financial
institutions are greatly influenced by their ethical practices, as required by Islam. The
religio-spiritual element in financial transactions is brought to bear alongside the
element of profitability, which is also important in the assessment of an Islamic bank's
performance. In addition, the social responsibilities specified in Islam such as obligatory
charitable giving (zakat) and voluntary charitable endowment (waqf) are to be accounted
for in any financial information prepared by Islamic banks and financial institutions.

There are numerous verses in the Our'an and Prophetic precedents that emphasize
accountability in commercial transactions. The strictness of the need to be accountable
in a just manner in all human endeavors is emphasized in the following verse:

Qur'an 21:47: "And We shall set up balances of justice on the Day

of Resurrection, then none will be dealt with unjustly in anything.
And if there be the weight of a mustard seed, We will bring it (to
account). And sufficient are We to take account."

140
 As we mentioned earlier. in Islam the Last Day, commonly known as the Day of
Judgment. is also referred to as the Day of Accountability. The concept of accountability
in alt dealings and the need to keep a record of accounts runs through the whole body of
Islamic commercial law. For instance, the main verse on the objectives of accounting in
commercial transactions reads:

Qur'an 2:282: "O you who believe! When you contract a debt for
a fixed period, write it down. Let a scribe write it down in justice
between you. Let not the scribe refuse to write as Allah has taught
him, so let him write. Let him (the debtor) who incurs the liability
dictate, and he must fear Allah, his Lord, and diminishes not
anything of what he owes."

Apart from encouraging fair and just transactions among contracting parties, the verse
also lays down some accounting ethics. Trustworthiness and objectivity in bookkeeping
and accounting are paramount in the principles and ethics of accountants. The allusion
to these ethical practices in the verses of the Qur'an explains the significance of
accounting concepts in Islam. Mankind is said to be accountable before God, while in
some other cases people are accountable to others. especially in transactions that involve
dealings among people alone.

The Accounting and Auditing Organization for Islamic

Financial Institutions
The need to introduce international accounting standards for Islamic financial products
led to the creation of the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI). This body is an independent non-governmental organization,
and is the result of the joint efforts of leading banks and financial institutions in the
Muslim world. AAOIFI was established in 1990 at a meeting in Algiers based on an
Agreement of Association among financial institutions from different countries. The
body was registered in 1991 in Bahrain as an international, autonomous, non-profit-
f~'iP! Challenge
~ making institution. The vacuum that was created in international accounting and
Why is it so important auditing standards with the proliferation of Islamic finance products was filled with
for AAOIFI to issue the establishment of AAOIFI and the resulting relevant standards. Despite the need to
Financial Accounting
standardize international financial reporting standards, as consistently advocated by
Standards for Islamic
Banks? the IASB, failure to fill the still-existing gaps between IFRS and the financial reporting of
Islamic financial products wilt not allow for the much-needed convergence.
Since 1991, when AAOIFI issued the first accounting, auditing, governance and Shari'ah
standards, there has been a series of relevant standards for specific Islamic finance
products. Box 4.2 on page 143 outlines the background and primary purpose of the AAOIFI
accounting and auditing standards. Many sovereign nations have adopted these standards.
Some countries such as Bahrain, Jordan, and Sudan have required Islamic financial
institutions in their respective jurisdictions to abide by the AAOIFI reporting standards,
while others allow Islamic financial institutions to adopt the standards voluntarily.

141
 -,., "i-----~ .... -. ' ..-- .o--:~---------
BOX 4.2: ~BACKGROUND O' AAOIFI:-" '
ACCOUNTING ST NDARDS • ·.;>,

As part of the regulatory framework for financial institutions in some countries, banks
and financial institutions are required to adopt a particular standard for financial
reporting. For close to two decades, Islamic financial institutions have generally
adopted the IFRS for lack of Islamic alternatives. With the passage of some years and the
development of more Islamic financial products in the industry, stakeholders saw the
increasing need to develop Islamic accounting standards that would address the needs
of these unique products. In 1987, various stakeholders met at an international forum to
discuss the financial reporting by Islamic financial institutions. Participants recognized
that there was a vacuum in the financial reporting of some products. The establishment
of AAOIFI in 1991 was a response to this.
The objectives of financial accounting for Islamic banks and financial institutions
include the need to promote consistency in financial reporting, provide a guide to
the management of these institutions in making informed decisions, increase users'
confidence in the institutions through proper understanding of the accounting
information, and develop a new framework for international financial reporting based
on the objectives of Islamic law.
Investors need to have confidence and trust in Islamic banks and financial institutions
in a competitive world. This is necessary to realize the investment objectives of these
institutions. So, in order to achieve this, stakeholders in the Islamic finance industry
established AAOIFI, which within two years issued Islamic financial accounting
standards. The new standards were adopted in October 1993-
The financial accounting standards have had far-reaching effects on the Islamic finance
industry because,for the first time, issues that relate to the calculation of zakat (obligatory
alms) surfaced in financial reporting. In addition, the role of Islamic banks and financial
institutions in discharging their corporate social responsibilities was emphasized, as
it is tied to the institutions' zakat obligations. Financial accounting, calculation, and
transparent reporting is highly required in calculating the amount of zakat that must be
paid by a bank on behalf of its shareholders or by individual shareholders.
Source: See AAOIFI. (2010). Accounting, Auditing and Governance Standards for Islamic
Financial Institutions. Bahrain: AAOIFI.

142
 AAOIFI Accounting Standards
AAOIFI has issued a number of Financial Accounting Standards (FAS), which constitute
a large percentage of its standards. This is due to the importance of financial
documentation and reporting of commercial transactions carried out by Islamic banks
and financial institutions. The objectives of financial accounting standards for Islamic
banks and financial institutions as identified by AAOIFI are:

To serve as a guide for the financial accounting standards boards for Islamic banks
and financial institutions when developing financial accounting standards. This
should ensure consistency in developing standards.
To assist the Islamic banks, in the absence of accepted accounting standards, in
making choices among alternative accounting treatments.
To make available a guide and a regulator of subjective judgment made by
management when preparing the financial statements and other financial reports.
To increase users' confidence and understanding of accounting information and, in
turn, their confidence in Islamic banks.
To develop accounting standards which are likely to be consistent with each other.
This should increase users' confidence in the financial reports ofislamic banks.'

There are two SFAs in the AAOIFI standards. SFA No. 1 is on the objectives of financial
accounting for Islamic banks and financial institutions, whereas SFA No. 2 focuses on
the concepts. Meanwhile, there are 25 AAOIFI standards that are relevant to Islamic
accounting. These are summarized in Table 4.3-

Table 4.3 is a quick reference to the FAS. Each contains a number of paragraphs explaining
the standard. For a better understanding of AAOIFI's FAS, you may need to obtain the full
text of their latest standards. The uniqueness of these FAS derives from the extensive
coverage of Islamic finance products, services, and issues that are not covered in IFRS.
There is no doubt that Islamic banks and financial institutions and conventional banks
The list of the latest offering Islamic financial services require specific standards for their financial reporting.
AAOIFI accounting
AAOIFI has continued to issue guidelines or guidance statements to amend or revise
standards and their
release dates is existing FAS in order to address any request from the key stakeholders in the Islamic
available at www.aaoift.
finance industry and provide a just and level playing field for financial reporting and
com/aaoifi/Publications/
KeyPublications/tabid/88/ disclosure. Therefore, in the application of the relevant FAS, any guidelines or guidance
language/en-US/Default.
aspx. statements subsequently released by AAOIFI is effectively considered part of the
standards.

143
 TABLE 4.3: AAOIFI Financial Accounting Standards

PAS II Description
FAS 1 General Presentation and Disclosure in the Financial Statements of
Islamic Banks and Financial Institutions

FAS 2 Murabahah and Murabahah to the Purchase Orderer

FAS 4 Musharakah Financing

;;; -~"""::;;;:.:---"" """""=======-
FAS 5 Disclosure of Bases for Profit Allocation Between Owners' Equity and
Investment Account Holders

FAS 6 Equity of Inves5m~~nt Holde!! ~ir Eq__u_i..•v__

al_e_n••t--====~
FAS7 Salam and Parallel Salam

FAS 8 Ijarah (Lease) and Ijaran Muntahia Bittamlik (Financial Lease Ending
with a Title Deed)
~:===~~=:::=::===~;;;;:==:::=::;;;;;;:;;;:::::::::::::==:
:;:;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;::::::!'-----
FASg Zakat

FAS10 Istisna' (Manufacturing Contract) and Parallel lsiisna'

FAS 11 Provisions and Reserves

FAS 12

FAS 13 Disclosure of Bases for Determining and Allocating Surplus or Deficit

in Islamic Insurance Companies

FAS14 Investment Funds

FAS 15 Provisions and Reserves in Islamic Insurance Companies

=:;:;::;:;:;;:;::;:;:;;:;::;:;:;;:;::;:;:;:.;;;;:;::;:;:;:::-:;

FAS16 Foreign Currency Transactions and Foreign Operations

FAS 17
- --
--

Investments
- -

FAS18 Islamic Financial Services offered by Conventional Financial

Institutions

FAS 21 Disclosure on Transfer of Assets

FAS 22 Segment Reporting

-=="'"""=;:;::;:;:;==:::=;:;::;:;:;;,,:,,,"=;:;::;:;:;;:;::;:;:;==:;:;;;;;;:;::;:;:;;:;::;:;:;=;;;:;::;:;:;;;==::~

144
/LEARNING
~~· OBJECTIVE 4.5 Accrual and Cash Flow Accounting
Differentiate between
the accrual and cash flow
Methods
accounting methods. One of the major initial decisions an entrepreneur will have to make at the start of a
new business is to determine the accounting method to use. That is, the entrepreneur
must decide how the financial transactions will be recorded. This is an obligation on
all corporate entities, particularly Islamic banks and financial institutions. They have to
present to the general public periodic reports that reflect their actual financial position
as of a given date, including the results of their operations during the financial year. This
enables the investing public and other interested parties to ascertain the rights and
obligations of the corporate entity.

There are two main methods of accounting. The entrepreneur may either choose the cash
deferred payment
A debt that has been incurred flow method of accounting or the accrual method of accounting, depending on a number
on the understanding that it of factors. Normally, when an entrepreneur extends credit to customers by allowing
will be paid back at some time them to purchase items on credit with an arrangement for deferred payment, they are
in the future.
incurring what is called accounts receivable. If an account receivable is recorded when
account receivable it is incurred, it is regarded as accrual accounting. Conversely, if the accounts receivable
Money owed to a company by
are recorded when the payment is received at a later date, they are regarded as cash flow
a customer for products and
services provided on credit. accounting.

periodicity concept These principles fall under the periodicity concept. The periodicity concept in financial
The concept that recognizes accounting provides for the relationship between the income of a business and periods
that each accounting period
of time. As Islamic banks and financial institutions are required to issue periodic
has an economic activity
associated with it, which can reports that reflect their financial position, the periodicity concept requires proper
be measured, accounted for, documentation of transactions within a given period of time. The AAOIFI describes the
and reported on. periodicity concept as follows:

The periodicity concept means that the life of the Islamic bank
should be broken into reporting periods to prepare financial
reports that provide interested parties with information or
directions by which they can evaluate the performance of the
accounting unit. This assumption also indicates the need to
relate the activities of the accounting unit through the entirety of
its life to the appropriate reporting periods as necessary.6

The periodicity concept allows the entity to properly calculate the zakat due and make
the necessary deductions for its onward disbursement to those who are entitled to
it. This is part of the obligations of the Islamic banks and financial institutions and is
considered as part of their social service or corporate social responsibility.

145
 Cash Flow Method of Accounting
cash flow method The cash flow method of accounting is based on the frequency of cash flow. No
A method of accounting transaction is recorded until and unless there is an actual exchange of cash, whether the
whereby the records are based
on the flow of cash into and out
business receives it by cash, credit card or check. For instance, when a business company
of the business. supplies goods to a customer in October 2011 but payment for those goods is made
in December 2011, the income will not be recorded under the cash flow method until
December 2011 when the payment is made. This method gives a clear account of the cash
flow of the business. This cash basis of accounting is relevant in certain situations, such
as upon liquidation or impending liquidation of the corporate entity.

Accrual Method of Accounting

accrual method The accrual method of accounting is based on the occurrence of a transaction regardless
A method of accounting of whether there is exchange of cash or not. Whenever there is a transaction involving
whereby the records are
based on the occurrence of
the business, a financial record is made of it immediately, whether money has changed
a transaction regardless of hands or not. For example, when a business company supplies goods to a customer in
whether there is exchange of October 2011 but payment for those goods is delayed until December 2011,the income is
cash or not.
reported in October 2011 under the accrual method. This method specificallyrequires the
use of double-entry bookkeeping. It allows the business to keep track of its assets and
liabilities, even though some of its clients have yet to pay their invoices, and it gives a
clear picture of the profitability of the business.

LEARNING OBJECTIVE 4.6 Financial Statements in Islamic Banks

Draft the main financial
statements for Islamic
and Financial Institutions
finance products. A financial statement is the formal record of all the financial activities of a business
entity. The end product of all financial transactions is a financial statement. The
transactions recorded in the financial statements comprise any business transacted
between the business entity and other corporate bodies, organizations, or individuals.
This may include the receipt of a common sale contract where the price is paid in full on
the spot, or a receipt of cash for goods sold on the basis of a deferred sale. All transactions
are duly sorted, classified, and presented in accordance with principles of bookkeeping
explained earlier.At the end of the financial year, a summary of the detailed bookkeeping
is presented as the financial statement of the business entity. Figure 4.3 illustrates the
simple flow of activities that begins with ordinary transactions and ends in a financial
statement.
Once a transaction is concluded, the records are sorted, classified, and presented in the
accounts. As we saw earlier, this procedure is known as bookkeeping. The accounts of a
particular financial period are then summarized in the financial statements.

146
 1
FIGURE 4.3 ~FLOW OF FINA Cl,AL TRANSACTIONS
~ . ' •..... ~--
·-' .. --·
.

Bookkeeping of
the transactions

Transactions
Statements Financial Statement

Accordingto AAOIFI FAS 1, the financial statements of an Islamic bank should consist of
the following:
a statement of financial position (balance sheet)
an income statement
a statement of cash flows
a statement of changes in owners' equity or a statement of retained earnings
a statement of changes in restricted investment
a statement of sources and uses of funds in the zakat and charity fund (when the
bank assumes responsibility for the collection and distribution of zakat)
qardfund a statement of sources and uses of funds in the qard fund
Interest-freebenevolentloans notes to the financial statements
given by Islamic banksand
financialinstitutions. any statements, reports and other data that assist in providing information required
by users of financial statements as specified in the Statement of objectives?
In practice, a corporate entity often provides further details of its accounting policies in
its annual report. Detailed notes and further explanations of the figures and captions
presented in the financial statements provide the users of the financial statements with
relevant supplementary information.

Comparative Financial Statements of Islamic Financial

Products
A corporate entity's comparative financial statements give the direction of change in the
business in at least two financial periods. When changes are noted in the performance
of the business in the current financial period as compared to the previous financial
periods, necessary steps are taken to either sustain performance or rectify any deficiency.
Comparative financial analysis involves the comparison of the figures of the current
year with those of the previous year(s) to determine performance. Top management
horizontal analysis
will review the major improvements or weaknesses to enable them to make informed
A comparativeanalysis of
financialstatementsof different decisions that increase or sustain performance. Comparative financial analysis is also
periods or financialyears. called horizontal analysis.

147
 To ensure compliance with relevant standards and policies,Islamic banks and financial
institutions are required to publish comparative financial statements. This enables a user
to compare the bank's current financial position with the previous year. The minimum
requirement for comparative financial statements of Islamic financial products is that
of the comparable prior period. FAS 1, clause 2/2 states, "the presentation methods and
disclosures in published financial statements should enable the user to differentiate
between actual changes in the Islamic bank's financial position, its results of operations,
its cash flows,the restricted investments managed by the bank, the sources and uses of
funds in the zakat and charity fund, and the sources and uses of funds in the qard fund,
from accounting changes during the periods covered by the financial statements."
Comparative financial statements provide necessary information about an entity's
sustained or poor business performance. Changes in performance can only be
determined through the availability of comparative financial figures from different
periods. Box 4.3 has an example of the financial statements and disclosures of XYZ Bank
as adapted from AAOIFI FAS 1. We can see that two distinct financial statements for two
different financial years are compared under each item of the report. The changes in the
two periods are easily noticeable when they are presented in this form side by side. The
user of the information can easily identify changes in this bank's financial performance.
It will also assist the bank in the decision-making process as it considers products for the
next financial year.

The Four Basic Financial Statements

There are four basic financial statements in financial reporting.
1 Balance sheet
2 Income statement
3 Cash flow statement
4 Statement of retained earnings or shareholders' equity.
The four types of financial statement are explained in AAOIFJ's FAS 1.

Balance Sheet
balance sheet A balance sheet is a summary of financial balances of a corporate entity and is also
A summaryof the financial
known as the statement of financial position. It can be defined as a summary of the
balancesof a companyor
businessentity. assets, liabilities, and ownership equities of a listed company as of the end of a specific
financial year. FAS 1, paragraph 4/1 provides for balance sheets and sets out the specific
details they should contain. The date of the statement of financial position should be
disclosed. The statement of financial position should include the assets, its equivalent
(prepaid, deferred and intangible assets), and owners' equity. Assets should not be offset
against liabilities and liabilities should not be offset against assets unless there is a
religious or legal right and an actual expectation of offset. Significant items of assets,
liabilities, unrestricted investment accounts and their equivalent, and owners' equity
should not be combined on the statement of financial position without disclosure. The

148
BOX 4.3: .l1LLUSTRATION OF1A COMPANY'S
: COMPARATIV ~F.INANCIAL'STATEMENT9
.,
. --
XYZ Bank
"~--
. ..:.,

Consolidated Statement of Financial Position

As at 2011and 2010

Note 2011 2010

$ $
-- ---
Assets
Cash and cash equivalent 8 95,041,890 51,281,906

Sales receivables 9 3,804,889 875,556

Investments:
Investment securities 10 14,850,000 15,000,000

Mudarabah financing 11 10,000,000 1,500,000

Musharakah investments 12 5,000,000

Participations 13 102,500,000 102,500,000

Inventories 14 - 2,000,000

Investment in real estate 15 58,500,000 71,750,000

Assets for rent 16 89,000,000 94,500,000

lstisna' 17 - 1,000,000

Other investments

Total investments 18 274,850,000 293,250,000

Other assets 19 322,000 15,510,000

Fixed assets (net) 20 24,870,500 26,070,000

Total assets 398,889,279

The accompanying notes form an integral part of the financial statements.

amount of any allowance established to cover expected losses should be disclosed. Assets
and liabilities should be combined into groupings in accordance with their nature and
those groupings should be presented in the statement of financial position in the order
of the relative liquidity of each grouping. The statement of financial position should
present separate totals for assets, liabilities, unrestricted investment accounts and their
equivalent, and owners' equity."

The balance sheet should be prepared in line with the relevant paragraphs of FAS 1. The
text of this standard serves to explain each and every item to be included. For instance,
paragraph 41 of the standard provides that the statement of financial statement should

149
 disclose the following liabilities:
current accounts, savings accounts, and other accounts, with separate disclosure of
each category of accounts
deposits of other banks
salam payables
istisna' payables
declared but undisturbed profits
zakat and taxes payable
other accounts payable.
equity of unrestricted account Moreover, paragraph 42 provides for the disclosure of equity of unrestricted account
holders holders. It is a mandatory requirement to disclose and present the unrestricted
Funds received by the Islamic
investment accounts and their equivalent in the statement of financial position as a
bank from depositors on the
basis that the bank will have separate item between liabilities and owner's equity. Furthermore, paragraph 43 of the
the right to use those funds standard requires that the consolidated statement of financial position should disclose
without restriction to finance the minority interest. Such interest must be shown on the statement as a separate item
its investments within the
Shari'ah framework.
between unrestricted investment accounts and owner's equity. In addition, paragraph
44 provides that disclosure of the following items should be made accordingly in the
statement of financial position:
authorized, subscribed and paid-in capital
number of authorized ownership units (shares), number of issued ownership units,
number of outstanding ownership units, par value per unit, and premiums on issued
units
legal reserve and discretionary reserves at the beginning and end of the period and
changes therein during the period
retained earnings at the beginning and end of the period and amount of retained
earnings resulting from the revaluation of assets and liabilities to their cash
equivalent values, where applicable,and changes therein during the period including
distribution to owners and transfers to or from reserves
other changes in owners' equity during the period
any restrictions imposed on the distribution of retained earnings to owners."
For an example of a balance sheet displaying a summary of assets in a consolidated
statement of financial position, see Box 4.3. Box 4.4 reproduces an example of the
financial statements and disclosures of X'iZ Bank as adapted from AAOIFI FAS 1. The
figure shows us that the balance sheet should also include all the bank's liabilities,
unrestricted investment accounts, minority interest, and owners' equity. The usual
practice, as shown in Box4-4, is to present a consolidated statement of financial position
that gives an insight into the performance of the financial institution within the most
recently concluded financial year compared to the previous year. The middle column,
'Note', gives number references to detailed explanations of each item on the balance
sheet. The accompanying notes form an integral part of the balance sheet as clearly
shown at the foot of Box4-4. Transparency demands the full disclosure of all these items
in the balance sheet to enable users of the information such as the shareholders and
even prospective investors to make informed decisions on the bank. As a bank is regarded

150
 BOX 4.4: ILLUSTRATION OF STATEMENT OF FINANCIAL'POSITION
..,. OF A COMPANY ~- . . . . .
; ~
XYZBank
Consolidated Statement of Financial Position
As at 2011 and 2010
Note 2011 2010
$ $
Liabilities, unrestricted investment accounts,
Minority interest and owners' equity
Liabilities:
Current accounts and savings accounts 21 18,550,000 15,400,000
Current accounts for banks and financial institutions 1,200,000 1,200,000
Payables 22 936,112 133,611
Proposed dividends 5,000,000 5,000,000
Other liabilities 23 5,069,750 2,192,321

Total liabilities 30,755,862 23,925,932

Equity of unrestricted investment account holders 24, 34 7,838,500 6,572,000
Minority interest 3,450,600 3,240,550
Total liabilities, unrestricted investment accounts and minority interest 42,044,962 33,738,482
Owners' equity
Paid-up capital 25 350,000,000 350,000,000
Reserves 26 3,368,864 1,649,796
Retained earnings 3,475,453 1,599,184
Total owners' equity 356,844,317 353,248,980
Total liabilities, unrestricted investment accounts, minority interest and
owners' equity 398,889,279 386,987,462

(paragraphs 41 to 44 of FAS 1)

The accompanying notes form an integral part of the financial statements.

Source: AAOIFI. (2010). Accounting, Auditing and Governance Standards for Islamic Financial Institutions. Bahrain: AAOIFI.

income statement as a corporate entity with a separate juristic personality, these periodic disclosures are
A financial statement that necessary to ascertain the actual position of the bank at every material time.
measures the financial
performance of a company
over a specific period of time, Income Statement
indicating how the revenue is
transformed into net income. The income statement is a financial statement that measures the financial performance
net income of a company over a specific period of time, indicating how the revenue is transformed
The result after all revenues into the result, after all revenue and expenditures have been accounted for, known as the
and expenses have been
net income (or 'bottom line'). The income statement may also be referred to as the profit
accounted for. This is also
called the 'bottom line'. and loss statement, statement of operations, or statement of income. The significance

5
 of the income statement is its ability to disclose the profitability of an entity during
the time interval specified in its heading. This kind of financial statement discloses the
investment revenues, expenses incurred, gains realized, and losses incurred in all the
entity's business activities. Note that an income statement does not show cash receipts
or cash disbursement FAS 1, paragraph 49 requires the disclosure of estimated gains
and losses from the revaluation of assets and liabilities to their cash equivalent values,
including the general principles used by the Islamic bank or financial institution in their
revaluation.

It is the responsibility of the management of the business entity to choose the period of
time that the income statement covers. This varies from one company to another but the
heading of the income statement must denote the period. The heading may look like any
of the following options:

for the Three Months Ended December 31, 2011 (the period of October 1 to December 31,
2011)
the Four Weeks Ended December 31, 2011 (the period of December 3 to December 31,
2011)
the Fiscal Year Ended January 31, 2012 (the period of February 1, 2011 to January 31,

2012).

After the heading of the income statement, it is required, according to FAS 1, paragraph
50, that the following information is disclosed, with separate disclosures of investment
revenues, expenses, gains, and losses j ointlyfinanced by the Islamic bank and unrestricted
investment account holders, and those exclusively financed by the bank:

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 a mudarib (investment manager)
the bank's share in income (loss) from investments
the bank's share in unrestricted investment income as a mudarib
the bank's share in restricted investment profits as a mudarib
the Islamic bank's fixed fee as an investment agent for restricted investments
other revenues, expenses, gains, and losses
general and administrative expenses
net income (loss) before zakat and taxes
zakat and taxes (to be separately disclosed)
net income (loss).

Box 4.5 reproduces an example of the financial statements and disclosures of Bank XYZ
as adapted from AAOIFI FAS 1. We can see that all the revenues of the bank within a
particular financial year are collated to determine its financial performance. More
importantly, one thing that is also considered is how the revenue is transformed into
net income. This can only be done when all expenses and losses are deducted from
the revenue for the period under review. Taxes, zakat, and the usual administrative

152
 • ". , ,.._t.;,""· ' t. ~,.j;;,..

BOX 4.5: ILLUSTRATIONOF THE •INCOME STATEMENT

~- OF A COMPANY
~"ii,"- ,,

XYZBank
Income Statement
for the year ended 2011
Note 2011 2010
$ $
Income
Deferred sales (29A) 97,500 36,389
Investments (29B) 5,120,000 4,168,000
28,29 5,217,500 4,168,000
Less
Return on unrestricted investment accounts before
The bank's share as a mudarib 551,480 455,673
Bank's share as a mudarib (110,296) (91,135)
Return on unrestricted investment accounts before zakat (441,184) (364,538)
--
Bank's share in income from investment
(As a mudarib and as fund owner) 4,776,316 3,839,851
Bank's income from its own investments 29B 12,000,000 10,000,000
Bank's share in restricted investment profit as a mudarib 158,000 140,000
Bank's fees as an investment agent for restricted investments 528,000 400,000
Revenue from banking services 2,000 1,000
Other revenues 303,000 2,000
Total bank revenue 17,467,316 14,382,851
Administrative and general expenditure (3,890,000) (2,468,000)
Depreciation (2,089,500) (2,030,000)
Net income (loss) before zakat and tax 11,487,816 9,884,851
Provision for zakat (2,887,479) (1,632,871)
Net income (loss) before minority interest 8,600,337 8,251,980
Minority interest (5,000) (3,000)
Net income 8,595,337 8,248,980
(Paragraphs 41 to 44 of FAS 1)

The accompanying notes form an integral part of the financial statements.

Source: AAOIFI. (2010). Accounting.Auditing and Governance Standards for Islamic Financial Institutions. Bahrain: AAOIFI.

153
Qatar Islamic Bank (QIB)
uses Shari'ah-compliant
instruments for its business
activities, and generally
adopts the AAOIFI
Financial Accounting
Standards, but it also relies
on the IFRS for matters not
covered by AAOIFI.

, expenses must also be deducted from the revenue before you arrive at the net income.
For instance, the total bank revenue for the financial year 2011 is US$17,467,316. But after
making all necessary deductions such as administrative and general expenditure costs,
and depreciation, the net income is reduced to US$11,487,816. And after deducting zakat,
tax and minority interest, the total net income is now put at US$8,595,337.
The Islamic Finance in Practice box presents the statement of income of Qatar Islamic
Bank for the six-month period ended June 30, 2011. This gives an idea of how the actual
income of an Islamic bank is calculated after all the necessary deductions are made.
A brief overview of the statement of income in the Islamic Finance in Practice panel
reveals that the expenses and impairment losses are deducted from the net operating
income in order to arrive at the net profit before taxes. After the further deduction of the
income taxes, the net profit for the period under review is arrived at. However, further
deductions are presented. This includes the returns on equity of investment account
holders, share of profits distributed to sukuk holders, etc. Therefore, once these are
deducted, the net profit for the period attributable to the shareholders is arrived at. An
additional item displayed in the statement of income is the earnings per share, which
gives shareholders a clear indication as to the performance of their investments.

154
Qatar Islamic Bank's Income Statement
The Qatar Islamic Bank (QIB) Qatar Islamic Bank (S.A.Q) Interim
consolidated statement of income for
uses Shari'ah-compliant the six month period ended 30 June 2011 (Amountsexpressed in thousandsof Qatari Riyal unless
otherwisestated)
instruments for its business
Note Three Three Six Six
activities. These comprise month month period month period
month
period ended ended 30
period ended ended 30
banking, investment and June 2011 30 June 2010 June 2011 June 2010
(Unaudited) (Unaudited) (Unaudited) (Unaudited)
financing activities carried Income
out through murabohan, Income from financing activities, net 405,935 485,404 863,256 906,409
Income from investing activities, net 186,959 37,706 311,250 47,849
mudarabah, musharaeah,
musawamah and isiisna' on Total income from financing and
investing activities, net 592,894 523,110 1,174,506 954,258
its own behalf or on behalf of --- --- --- ---
Commission and fees income 9 60,828 102,734 125,354 186,322
its customers and/or account Commission and fees expenses (5,240) (5,653) (10,764) (10,531)
--- --- --- ---
holders depending on the Net commission and fees income 55,588 97,081 114,590 175,791
--- --- --- ---
nature of the instrument Foreign exchange gain 5,654 7,505 13,361 13,390
--- --- --- ---
used. Based on the rulings Net operating income 654,136 627,696 1,302,457 1,143,439
and recommendations of Expenses and impairment losses
General and administrative expenses (168,091) (101.738) (293,988) (191,399)
the Shari'ah Board of QIB, all Depreciation (12,109) (10,803) (23,147) (20,524)
its activities are pursued in Impairment losses on receivable from
financing activities (net) 7,480 (71,809) (20,518) (71,809)
accordance with the principles Impairment losses on financial investments (21,000) (17,008)
--- --- --- ---
oflslamic law, including its Net profit from continuing operations 481,416 443,346 943,804 842,699
Profit from discontinued operations
financial reporting. Wh~le 3,297 3,297

QIB generally adopts the

AAOIFI Financial Accounting I Net profit before taxes 484,713 443,346 947,101 842,699

Income taxes (4,459) (4,459)

Standards, it also relies on the
IFRS for matters not covered Net profit for the period 480,254 443,346 942,642 842,699
by AAOIFI. In order to illustrate
Less:
the practice of Islamic finance, Return on equity of investment
accountholders (74,786) (137,341) (188,450) (236,355)
the statement here shows the Minority interest 3,321 1,724 (4,782)
consolidated statement of Sukuk holders' share of profit (26,317) (4,546) (52,634)
--- --- ---
QIB's income for the six-month Net profit for the period attributable to
shareholders 382,472 301,459 703,282 601,562
period ended June 30, 2011. --- --- --- ---
Earnings per share
This is just one in the list of the Basic and diluted earnings per share 1,67 1,39 3,08 2,82

financial statements presented

in its financial report. I The accompanying notes from 1 to 15 form an integral part of these interim condensed consolidated financial statements

Source:Qatar Islamic Bank. Unaudited Interim Condensed Consolidated Financial Statements June 30. 2011. p. 9.
Available at ae.zawya.com/cm/financials/5319_20l 10630_6_R_C.pdf.

155
 Cash Flow Statements
cash flow statement The cash flow statement is a financial statement that indicates how changes in the
A financial statement that balance sheet accounts and income statements affect cash and its equivalent; the
indicates how changes in the
balance sheet accounts and
analysis is broken down into operating, investing, and financing activities. The cash flow
income statements affect cash statement may also be called a statement of cash flows or funds flow statement. The
and its equivalent. purpose of the cash flow statement is to identify the sources and uses of cash during the
financial year in question. The cash flow statement derives its data from the changes
in all other balance sheet items. FAS 1, paragraph 54 provides that the statement of
cash flows should differentiate between cash flows from operations, cash flows from
investing activities, and cash flows from financing activities. The statement should also
disclose the main components of each of the three categories of cash flow. Paragraph
55 requires the disclosure of the net increase (or decrease) in cash and cash equivalent
during the period and the balance of cash and cash equivalent at the beginning and
end of the period. Paragraph 56 provides that transactions and other transfers that do
not require the payment of, or do not result in the receipt of, cash and cash equivalent
should be disclosed,for example, bonus shares or the acquisition of assets in exchange
for shares in the equity of the company.
Box 4.6 reproduces an example of the financial statements and disclosures of XYZ Bank
as adapted from AAOIFI FAS 1. We can see that the flow of funds here is derived from the
previous balance sheet and income statement. The net income we saw on the income
statement {US$8,595,337) in Box 4.5 for 2011 is the first item on the cash flow statement
upon which the funds flow is considered. There is emphasis on the cash generated
within the fiscal year under review. How this cash was used in operating, investment,
and financing activities, respectively,is clearly shown in Box 4.6 on pages 157-158.

·statement of Retained Earnings or Shareholders' Equity

statement of retained The statement of retained earnings is a financial statement that explains the changes
earnings in the retained earnings of a company over the period of time being reported. In a single
A financial statement that
explains the changes in the
proprietorship,the statement of retained earnings may also be calledthe equity statement
retained earnings of a company or statement of owners' equity.In a partnership, it is calledthe statement of partners' equity.
over a period. For corporations,it is called a statement of retained earnings and shareholders' equity.The
changes in the owners' interest in the entity as well as the application of retained profit
or surplus from one financial period to another are broken down. The owners' equity and
retained earnings may be calculated using the following formula:

Owners' equity = Assets - Liability

156
 As with other financial statements, the statement of changes in owners' equity or
statement of retained earnings must disclose the period covered. There are specific
disclosures required in the statement of changes in owners' equity and statement
of retained earnings respectively.

BOX 4.6: }ILLUSTRATION OF.iHE STATE~ijyi"c,{·

CASH FLOW,S ' x~z:e~K:
•• - • _:!_

XYZBank
Statement of Cash Flows
for the year ended 2011

Note 2011 2010

$ $
Cash flows from operations
Net income (loss) 8,595,337

Adjustment to reconcile net income

Net cash provided by operating activates
Depreciation 2,089,500
Provisions of doubtful accounts 10,000
Provision for zakat 2,887,479
Provision for taxes
Zakat paid 200,000
Taxes paid
Return on unrestricted investment accounts
Gain on sale for fixed assets
Depreciation of leased assets 8,750,000
Provision for decline in value of investment securities 150,000

Bad debts {6,000)

Purchase of fixed assets (890,000)

Net cash flows provided by operations 21,827,500

Cash flows from investing activities

Sale of rental real estate
Purchase of rental real estate
Sale of real estate 15,000,000
Acquisition of investment securities
Increase in mudarabah investments (8,500,000)
Sale of inventory 2,000,000
Sale of isiisna' 1,000,000
Net increase in receivables (2,933,333)

Net cash flows from (used in) investing activities 6,566,667

157
 BOX 4.6: (continued)

Note 2011 2010

$ $
-- --
Cash flows from financing activities
Net increase in unrestricted investment accounts 825,316
Net increase in current accounts 3,150,000
Dividend paid 4,800,000
Increase in credit balances and expenses 805,501
(Decrease)in accrued expenses (10,050)
Increase in minority interest 210,050
Decrease in other assets 15,188,000
Net cash flows provided by financing activities 15,365,817
Increase (decrease) in cash and cash equivalent 43,759,984
Cash and cash equivalent at beginning of year (37) 51,281,906
Cash and cash equivalent at end of year 95,041,890

The accompanying notes form an integral part of the financial statements.

Source: AAOIFI. (2010). Accounting, Auditing and Governance Standards for Islamic
Financial Institutions. Bahrain: AAOIFI.

Paragraph 58 of FAS 1 provides that the statement of changes in owners' equity should
disclose the following information.
Paid-up capital, legal and discretionary reserves separately, and retained earnings as
of the beginning of the period with separate disclosure of the amount of estimated
earnings resulting from the revaluation of assets and liabilities to their cash
equivalent values, where applicable.
Capital contribution by owners during the period.
Net income (loss)for the period.
Distribution to owners during the period.
Increase (decrease) in legal and discretionary reserves during the period.
Paid-in-capital, legal and other discretionary reserves, and retained earnings as of
the end of the period with separate disclosure of the estimated amount of retained
earnings resulting from the revaluation of assets and liabilities to their cash
equivalent values, where applicable.12
Paragraph 60 requires the statement of retained earnings to disclose the following
information.
Retained earnings at the beginning of the period with separate disclosure of the
amount of estimated retained earnings resulting from the revaluation of assets and
liabilities to their cash equivalent values, where applicable.

158
 Net income (loss) for the period.
Transfers to legal and discretionary reserves during the period.
Distribution to owners during the period.
Retained earnings at the end of the period with separate disclosure of the amount of
estimated retained earnings resulting from the revaluation of assets and liabilities
to their cash equivalent values, where applicable.

Box 4.7 reproduces an example of the financial statements and disclosures ofXYZ Bank as
adapted from AAOIFI FAS 1. In this case, there is a focus on the assets and liability of the
financial institution, which gives a true picture of the changes in its equity over the past
financial year. Thus it also gives a true presentation of the current position of the financial
institution to enable its stakeholders to make an informed decision regarding the plans
for the coming financial year. This is usually the last portion of the balance sheet, which
details the changes in shareholders' equity since the previous financial year. To calculate
this, liabilities are deducted from assets to ascertain the financial position of the bank.
The statement also tracks what was paid out as dividends and distributed profits.

BOX 4.7: ~fujsi'RATION OF STATEMENT OF c~~N~E$'1l~.J>WNERS'

.;. EQUITY Of A COM / . .. . · >·
I -·· .. . . ·-~ ~:

XY2Bank
Statement of Changes in Owners' Equity
for the year ended 2011
Description Paid-up Reserves Retained Total
Capital (NOTE25) Earnings
Monetary Legal Monetary General Monetary
unit unit Monetary unit

Balance as at 2011 350,000,000 - - 350,000,000

Issue of () shares
Net income 8,248,980 8,248,980

Distributed profits (5,000,000) (5,000,000)

Transfer to reserves 824,898 824,898 (1,649,796)

Balance as at 2011 350,000,000 824,898 824,898 1,599,184 353,248,980

Net income 8,595,337 8,595,337

Distributed profits (5,000,000) (5,000,000)

Transfer to reserves 859,534 859,534 1,719,068

--
Balance as at 2011 350,000,000 1,684,432 1,684,432 3,475,453 356,844,317

The accompanying notes form an integral part of the financial statements.

Source: AAOIFI. (2010). Accounting, Auditing and Governance Standards tor Islamic Financial Institutions.
Bahrain: AAOIFI.

159
 AAOIFI Proposed Set of Financial Statements for
Islamic Banks
Normally,an Islamic bank would have some unique financial statements owing to the
nature of businesses it undertakes as well as specific requirements that require the
Even though Islamic computation of funds such as zakat, wacf, and qard hasan, which are not necessarily
finance claims to have
part of the conventional framework of accounting. Besides, the way Islamic banks
unique items that should
mobilize funds and use them, as discussed in Chapter 3, is different from conventional
appear on financial
statements, what are practice. Thus, there is a need for a different set of items in the financial statements.
the equivalent items for The Global Islamic Finance box on page 161 presents the raging controversy on whether
non-Islamic financial the Islamic accounting framework as represented by the AAOIFI standards should
institutions, and how be brought into the mainstream global accounting framework under the IASB. One
do you think issues cannot shy away from the fact that Islamic banks have unique accounting needs. This is
such as corporate social
acknowledged by all, but the controversy over who should provide the framework and
responsibility {CSR) are
reported in financial what process they should follow in coming up with an Islamic accounting framework
statements? continues.
Most of the examples of financial statements presented in this chapter are based
on the conventional framework but there is more to the accounting framework of
Islamic banks. While it is not possible to detail all the accounting principles for each
Islamic financial instrument here, as this chapter is a general introduction to Islamic
accounting, it suffices to observe that AAOIFI has proposed a set of financial statements
for Islamic banks and financial institutions, split into three major categories. The first
category comprises the financial statements discussed and illustrated above, such
as the statement of financial position, statement of income, statement of cash flows,
and statement of retained earnings or statement of changes in owners' equity. These
are meant to reflect the position of the Islamic bank for an investor, with the aim of
recording its financial performance based on the Shari'ah-compliant investments it
undertook within a given period of time.
The second category focuses on the financial reporting of restricted investments, which
are managed by the Islamic bank. In most cases, the restricted investments are carried
out through the facility of mudarabah (trust investment financing) or wakalah (agency)
contracts, and they require a unique financial statement generally known as the
statement of changes in statement of changes in restricted investments. Finally,the third category emphasizes
restricted investments
the original value proposition of Islamic financial intermediation, which reflects the
A unique financial statement
that shows the performance role of Islamic banks as a fiduciary of funds in providing social services, especially
of investments specifically in situations where such services are rendered through specially designated funds.
restricted or limited by the Depending on the nature of the business and the type of social services provided, the
investors, such as the restricted
financial statements of the Islamic bank must therefore contain a statement of sources
trust financing investment.
and uses of funds in the zakat and charity fund, and statement of sources and uses of
funds in the qard fund."

160
 GLOBAL ISLAMIC FINANCE
Bringing AAOIFI Accounting Standards into the
Mainstream Global Framework
Before the AAOIFI accounting standards were issued, in IFis. Examples include funds mobilized by IFis
Islamic banks and financial institutions used IFRS. But under the mudarabah model.
with the availability of relevant standards that cater for The identification of the major users, particularly
the specificfinancial reporting needs of Islamic finance those who do not have the authority or ability
products. most banks around the world have embraced to obtain access to information not included in
the AAOIFI standards. One question that keeps bothering general purpose financial reports.
some experts is whether the available standards are The determination of the information needs of the
sufficient to ensure best practice and transparency users of financial reports that require addressing.s
in financial reporting. A recent survey conducted by This new approach seems to be more convincing and
Deloitte showed that 93 percent of Islamic finance also sustainable as it leaves room for the adoption
leaders believe the AAOIFI standards are sufficient of best practices that do not contradict Islamic law
to ensure transparency and best practice in financial and it also encourages the development of Shari'ah-
reporting while a negligible7 percent believethey are not. based principles of financial reporting. However, there
Furthermore, some experts have also argued that most is a raging controversy on the need to bring Islamic
of the standards were developed based on conventional accounting standards into the mainstream global
financial reporting standards with some modificationsto framework. While some believe that the Shari'ah
suit the needs of the Islamicfinance industry.In response scholars and other stakeholders should work harder
some commentators have asked whether there are no to make the AAOIFI accounting framework stronger in
classicalmodels of accounting in Islamic law. The recent order to be considered as a serious alternative, others
approach adopted by AAOIFI to issue the Conceptual contend that the Islamic accounting framework should
Framework for Financial Reporting by Islamic Financial be harmonized with the global framework spearheaded
Institutions in 2011 seems to have addressed these by IASB. Regardless of the position of each of these
questions in a more proactiveway.The approach adopted groups within the Islamic finance industry, there is
in developing the conceptual framework for financial ongoing pressure on the Islamic finance industry to
reporting comprisesthe following: enter the global accounting mainstream. Since the
The identification of accounting concepts that were International Accounting Standards Board (IASB) is
previously developed by other standard-setting the main global body setting the tone for financial
bodies and that are consistent with the Islamic reporting in conventional finance, the Islamic finance
principles and ideals of accuracy and fairness. industry is under pressure to harmonize its principles
The identification of aspects that require disclosure under the general framework.
and greater transparency to abide by the principles While it is easy to suggest that IASB introduces tailor-
and ideals of Shari'ah, made guidelines exclusively for Islamic finance, only
The identificationof conceptsused by other standard- time will tell how viable such a process would be in
setting bodies that conflict with the Shari'ah and harmonizing the global financial reporting guidelines
the development of new relevant concepts for the for both Islamic and conventional financial reporting.
purpose of financial reporting by IFis. A uniform approach may or may not be the answer
The development of concepts to address the unique but what is required is the avoidance of the rivalry that
nature of certain transactions, events or conditions already exists with other organizations such as AAOIFI.

Source: Anjuli Davies. 'Islamic finance pressured to join accounting mainstream', Reuters. April 5, 2012.
Available at http:/ /www.reuters.com/article/20l 2/04/05/us-finance-islamic-accounting-idUSBRE8340CA20l 20405.

161
 These are items that are unique to the business oflslamic banks and :financial institutions.
The social services they carry out should also be disclosed to ensure transparency and
accountability to shareholders. Thus, going beyond the provisions of zakat or any other
social services in any of the above :financialstatements, a full disclosure in the form of
a statement of sources and use of funds in zakat and charity funds may be necessary
to sustain investors' confidence. This is why AAOIFI introduced the proposed set of
:financialstatements.

162
 Key Terms and Concepts
Accounting and Auditing Organization for horizontal analysis (p. 147)
Islamic Financial Institutions (AAOIFI) income statement {p.151)
(p.132) internal auditing {p. 138)
account receivable (p. 145) International Accounting Standards
accrual method {p. 146) Board {IASB) {p. 131)
American Accounting Association {p. 129) Islamic worldview {p.129)
balance sheet (p. 149) journal (p. 135)
bookkeeping {p. 135) Last Day {p. 130)
cash flow method {p.146) net income {p. 151)
cash flow statement (p. 154) periodicity concept {p. 145)
compound accounting journal entry {p. 137) qard fund (p.147)
credit (p. 136) revenue (p. 135)
debit (p.136) statement of changes in restricted
deferred payment (p. 145) investments {p.160)
double-entry bookkeeping (p. 135) Statement of Financial Accounting
equity of unrestricted account holders (p.151) {SFA) (p. 139)
expenditure {p. 135) statement of retained earnings
external auditing (p.138) {p.156)
financial Accounting {p.129) T account (or ledger) {p. 135)

Summary
1. The definition of accounting from the Islamic perspective reflects the ethical perspective
Learning Objective 4.1
of financial transactions. The just and equitable principles of fair dealings, transparency,
and accountability are significant for the users of information. These are relevant in
financial decision-making.

2. The International Financial Reporting Standards {IFRS) issued by the International

Learning Objective 4.2
Accounting Standards Board play a significant role in international accounting regulation.
The Islamic banks and financial institutions adopted the standards some years ago but
there has been a paradigm shift to the AAOIFI accounting standards because of the
particular needs in accounting for each Islamic finance product.

3. The basic principles of accounting are similar to the requirements for transparency and
Learning Objective 4.3
accountability in Islamic commercial law. Accounting comprises two main activities-
bookkeeping and accounting (preparation of financial statements). Recording financial
information is crucial to the success of any business undertaking. There are three
branches of accounting: cost and management accounting, financial accounting, and
auditing. This chapter provided a general introduction to financial accounting.

163
 4. The framework and principles of Islamic financial accounting are based on certain
Learning Objective 4.4
fundamental concepts in Islam such as khilafah (vicegenerecy). taklif (responsibility),
documentation of financial dealings, Islamic law of inheritance (mawarith). calculation
of obligatory alms (zakat), and the underlying concept of tawhid (unity of God).
Compliance with the precepts of the Shari'ah in all financial dealings must be reflected
in the financial information to be communicated to the users of such information.
5. The accounting techniques and methods adopted by modern Islamic banks and
Learning Objective 4.5
financial institutions to report Islamic financial activities are based on the AAOIFI
Financial Accounting Standards. The AAOIFI standards contain exclusive provisions for
the financial reporting of Islamic finance products.
6. The main financial statements for Islamic finance products include a statement of
Learning Objective 4.6
financial position (balance sheet), an income statement, a statement of cash flows, a
statement of changes in owners' equity or a statement of retained earnings, a statement
of sources and uses of funds in the zakat and charity fund (when the bank assumes the
responsibility for the collection and distribution of zakat), a statement of sources and
uses of funds in the qard fund, notes to the financial statements. and any statements,
reports, and other data that assist in providing information required by users of financial
statements as specified in the statement of objectives.

Practice Questions and Activities

Practice Questions
1. Explain some underlying principles of Islamic accounting with special reference to
Islamic perspectives on accounting.
2. Distinguish between the definitions of accounting as generally understood in the
conventional practice of financial reporting and Islamic accounting.
3. Explainthe objectives of the International Financial Reporting Standards in international
financial regulation.
4. Are the International Financial Reporting Standards (IFRS) applicable to Islamic banks
and financial institutions? Give appropriate reasons to justify your viewpoint.
5. What are the basic principles for recording financial information? Illustrate your answer
with a simple journal entry.
6. -What are the three branches of accounting and how are they related to the business of a
typical Islamic bank?
7. What are the identifiable differences between the users of financial information in the
conventional practice of accounting and Islamic accounting?
8. Explain the Islamic concept of accounting and list five Financial Accounting Standards
issued by AAOIFI.
9. Differentiate between the accrual and cash flow methods of accounting. Support your
answer with a relevant example.

164
10. Define the periodicity concept and explain how it is relevant to the accounting model of
Islamic banks.
11. With the aid of the relevant AAOIFI Financial Accounting Standards, briefly explain the
following four main financial statements: balance sheets, income statements, cash flow
statements, statement of retained earnings or shareholders' equity.

12. Prepare a simple balance sheet for an Islamic bank that reflects some unique features of
the types of business carried out by Islamic banks, based on the AAOIFI models explained
to you in class.

Activities
1. Prepare a chart on the main differences between conventional accounting concepts and
the Islamic accounting paradigm.

2. Read the text of AAOIFI's Financial Accounting Standards and prepare a summary of
them for a 15-minute class presentation.

3. Find two copies each of a statement of financial position (balance sheet), an income
statement, a statement of cash flows, a statement of changes in owners' equity or a
statement of retained earnings for any Islamic bank or financial institution.

Further Reading
AAOIFI. (2010). Accounting, Auditing and Governance Standards for Islamic Financial
Institutions. Bahrain: AAOIFI.

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