chp_05 the need for islamic accounting-pf2-estab of isl org
TRANSCRIPT
Chapter 5
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CCHHAAPPTTEERR 55:: TTHHEE NNEEEEDD FFOORR IISSLLAAMMIICC AACCCCOOUUNNTTIINNGG:: PPUULLLL FFAACCTTOORRSS 22-- TTHHEE EESSTTAABBLLIISSHHMMEENNTT OOFF IISSLLAAMMIICC OORRGGAANNIISSAATTIIOONNSS
55..00 IINNTTRROODDUUCCTTIIOONN In the previous chapter, the researcher attempted to argue the need for an alternative
Islamic Accounting in the form of pull factors; those factors that motivate the
development of Islamic accounting. The first category of Pull Factors, the theoretical
imperative of Islamisation of Accounting, was discussed in the previous chapter. In
this chapter, the second category of Pull Factors, the practical imperative, will be
discussed.
The practical imperative or necessity for the development of an alternative “Islamic
Accounting” is the establishment of Islamic business and not for profit organisations
which are specifically based on the Shari’ah or controlled by Muslims who may wish
to follow its precepts. These socio-economic organisations are part of the Islamic
economic and financial system, which is based on the Islamic world-view. The
researcher believes that the objectives, operations and practical accounting
requirements of these organisations need an alternative “accounting” framework in
order for their objectives to be achieved, their operations to run smoothly and their
activities accounted in a true and fair manner within the world-view in which they
operate.
This chapter is organised as follows:
In section 5.1, the principles and objectives of the Islamic economic and financial
system will be presented. As the prohibition of interest (riba) “is one of the key
elements of the Islamic Economic programme” (Ahmad,1994a, p5), the definition of
riba, some possible reasons for its prohibition and the controversies surrounding its
definition are discussed.
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In section 5.2, the main types of Islamic business and non-business organisations,
which attempt to operationalise the Islamic economic order, will be introduced. This
will include a discussion of their objectives, functions, history of establishment and
accounting implications. Due to the extensive scope of Islamic organisations, it is
difficult to cover all of them in detail in this research, as such only a brief sketch is
presented.
Although this research attempts to argue the need for Islamic Accounting in for both
business and non-business Islamic and Muslim organisations, The researcher feels
that describing the accounting needs of many types of Islamic organisations in detail
will be too broad for this research project. As such, the researcher has opted to
concentrate on one industry i.e. the Islamic Finance industry where there has been
intense development. The Islamic banking and financial institutions constituting this
industry, are examples of Islamic business organisations, which have established
themselves in the real world.
Consequently, in section 5.3, Islamic banks and financial institutions will be
discussed in some detail. This will include taxonomy of Islamic financial institutions,
their history, characteristics, differences with conventional banks and their modes of
operation. The Investment of funds mobilised by Islamic banks present both
operational and accounting problems for Islamic banks as they cannot be invested on
the basis of a predetermined fixed return on capital. The complexities of investing
through an equity-like mode are full of agency, monitoring, accounting classification
and income recognition problems. In order to appreciate these problems, a detailed
description of the Islamic financing instruments is presented in section 5.4.
In section 5.5, the accounting problems of banks, as an example of the problems of
attempting to apply conventional accounting to Islamic organisations will be
discussed. This will include the problem of using conventional accounting concepts
and the attempt to introduce standards for the accounts of Islamic banks.
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This chapter concludes with section 6.6 that will discuss the possible benefits an
Islamic accounting system for Islamic Banks would produce. Although the Islamic
banking and its problems are discussed in length in this chapter, the research does
not concern itself with Islamic Banking or even Accounting for Islamic banks. Rather,
the discussion is intended as an example of problems faced by Islamic organisations
in using conventional accounting and the need for an alternative accounting system.
55..11 TTHHEE IISSLLAAMMIICC EECCOONNOOMMIICC AANNDD FFIINNAANNCCIIAALL SSYYSSTTEEMM AANNDD TTHHEE PPRROOBBLLEEMM OOFF RRIIBBAA..
Unlike, other economic systems, the Islamic economic system aims to achieve social
justice from a religious ethical perspective. Although the Western economic systems
be they capitalist, socialist or welfare state, aim to achieve human welfare, they all
seem to have accepted interest as a fair reward for capital, although interest has
been condemned by Marx and even Fisher. The Islamic economic system is based
on its complete elimination from the economy by introducing the alternative of
participative investment as opposed to a rentier economy. The capitalist system
strives to attain human welfare through the operation of the invisible hand driven by
self-interest and a free market. The Marxist system attempted to create social welfare
by ownership and centralisation of the production function by the state (representing
the workers). However, all these systems have been ‘unsuccessful’ in achieving
social welfare for all (Chapra, 1992).
Although it is a fact that there is no complete Islamic economic system in operation,
the unique characteristics and features of the Islamic economic system are worth
discussing and modeling for future implementation especially in Islamic countries.
However, practical implementation of the Islamic banking system, which is a partial
implementation of the Islamic economic system, has overtaken academic discussion.
Hence there is an urgent need to come up with both practical devices and theoretical
models, which can be, tested in future practice.
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This section proceeds as follows; the objectives and characteristics of the Islamic
economic system are described first. In the following sub-sections riba is discussed
in detail including its definition, classification, reasons for its prohibition and
controversies surrounding its definition.
55..11..11 TThhee oobbjjeeccttiivveess aanndd cchhaarraacctteerriissttiiccss ooff tthhee IIssllaammiicc EEccoonnoommiicc SSyysstteemm
Ahmad (1994a) observes that the Islamic economic program includes a different
concept of the individual and his rights, a different concept of property and a different
approach to civil and economic contracts. Its principles of economic organisation are
also different including; how and on what basis co-operation and collaboration
between individual and society is to take place, the need for regulating the market to
attain efficiency and equity, and the role of the state in the fiscal system.
Al-Faisal & Ali (1996) sum up the principal characteristics of the Islamic Economic
System as follows:
• Although every individual has a right to seek his economic well being, Islamic
makes a clear distinction between what is lawful and what is unlawful in the
pursuit of economic activity. Broadly, Islam forbids all forms of economic
activities, which are morally or socially injurious. The particulars as to what is
considered morally or socially injurious vary from the secular capitalistic system.
• Although Islam recognises, the ownership of legitimately acquired wealth, the
individual is obligated to spend his wealth judiciously and not to hoard it, keep it
idle or squander it.
• Although an individual may retain surplus wealth, Islam seeks to reduce the
margin of this surplus for the well being of the community as a whole.
• It seeks to prevent the accumulation of this wealth in a few hands to the detriment
of the society as a whole through its law of inheritance
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• It aims at social justice without inhibiting individual enterprise beyond the point
where it becomes not only collectively injurious but also individually self-
destructive.
Chapra (1992) observes that in line with the Islamic concept of brotherhood and
justice, all resources at the disposal of human beings must be utilised to actualise the
objectives of the Shari’ah. He suggests four objectives of the Islamic economic
system:
a) Need fulfilment: the basic needs of all individuals must be satisfied and everyone
must be assured of a humane and respectable standard of living.
b) Respectable Source of Earnings: The dignity attached to man’s status, as God’s
khalifah or representative means that need fulfillment should be through the
individual’s effort. In the case of handicap or inability to earn a living, it is the
collective obligation of the Muslim community to fulfil their needs through Islamic
socioeconomic institutions such as Zakat, and charitable endowments- awqaf.
Except for Zakat, which is administered by the state, the other institutions are
voluntary but form part and parcel of the Islamic economic ethic.
c) Equitable distribution of income and wealth: Although inequalities in income and
wealth can be tolerated in proportion to skill, initiative, effort and risk, skewed
inequalities are incompatible with Islamic teachings. The elimination of interest,
the introduction of Zakat and change in consumer behaviour patterns to one
conforming to Islamic guidelines are essential to achieve this.
d) Growth and Stability: Growth and stability are essential to maintain employment
and to ensure the goal of equitable wealth distribution as the poor can reap the
fruits of economic growth thus lessening the burden of the rich to redistribute their
wealth.
Chapra (1992) proposes the following strategy to achieve the objectives:
a) Introducing a socially agreed filter mechanism: In addition to the price
mechanism, a double layer of moral filters tempers claims on resources.
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Individually, Islamic consumers should avoid wasteful expenditures because of
legal/moral precepts of the Shari’ah. In addition the Islamic financial system also
acts as moral filters in their investing and credit expansion activities.
b) A strong motivating system to induce the individual to render his best in his own
interest as well as in the interest of society. This comes from the Islamic concept
of accountability to Allah, from whom no actions can be hidden, and to whom
every action has to be accounted for in the life after death.
c) Restructuring the entire economy to realise the Shari’ah objectives in spite of
scarce resources. This is to be done by reforming all social, economic and
political institutions including public finances and financial intermediation to
minimise wasteful and unnecessary consumption and to promote investment for
need fulfillment. The Islamic structures will also support the filter and motivating
system by not allowing material possessions and conspicuous consumption to
become a source of prestige, thus killing off the economic man.
d) A positive and goal-oriented role for the government. The government would
support the raising of the moral consciousness of people, motivate and help the
private sector play its role effectively and accelerate political, social and
economic reform and provide incentives and facilities.
Ahmad (1994a) observes that, although the elimination of interest is not the be-all
and end all of Islamic economic programme, it is one of its key elements. It can thus
be seen that reforming the banking and monetary system to eliminate interest
transactions and putting them on an Islamic plane is one of the cornerstones of the
Islamic financial system.
The Islamic financial system is part of the Islamic socioeconomic system which
Muslim economists and Islamists are endeavouring to develop. The development of
an interest-free, ethical Islamic economic system is an important agenda of most
Islamic movements and some governments such as Pakistan, Iran and Sudan
(Ahmad, 1994a). Other countries, such as Malaysia and Gulf countries, allow Islamic
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economic institutions such as Islamic banks to operate in parallel with the
conventional financial system.
Social Justice is said to be the hallmark of the Islamic economic system (Ahmed et
al., 1996). In order to achieve this Islamic economy, two institutional devices “the
abolition of interest and presence of a well-functioning Zakat system (p3)” are
considered essential. As the Islamic financial system relies mostly on the former, this
aspect will be discussed in some detail. The researcher will firstly discuss the
definition, the nature and classification of riba (interest), followed by a discussion on
the possible reasons for its prohibition in Islam. This is then followed by a review of
the controversies surrounding the nature and application of riba in modern business
life.
55..11..22 DDeeffiinniittiioonn aanndd ccllaassssiiffiiccaattiioonn ooff RRiibbaa
The Qur’an and the Hadith of the Prophet (pbuh) specifically prohibits riba in
economic transactions in the sternest terms (e.g. Al-Qur’an, 2:275,278,279). ‘Riba
has been translated into English as usury or interest. However, it has in fact a much
broader meaning under the Shari’ah as suggested by its dictionary meaning of
“increase” or “gain”. Saleh (1992) has defined riba in the Shari’ah context as “an
unlawful gain derived from the quantitative inequality of the counter-values in any
transaction purporting to effect the exchange of two or more species, which belong to
the same genus and are governed by the same efficient cause” (p16). Thankfully, the
author has adopted a shortened version of this rather long technical definition as “an
unlawful advantage by way of excess or deferment” (p17).
Riba has been classified into two categories: riba al-fadl and riba al-nasi’a
(Muslehuddin, 1987). Riba al-fadl is riba by way of excess of one of the exchanged
counter-values e.g. the exchange of 2 Kg. of low quality rice for 1 Kg. of high quality
rice. Riba al-nasi’a is excess by way of deferment of completion of exchange, for
example a loan of £100 for a deferred repayment of £110 a year later. As Islamic
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banking involves the elimination of Riba al-nasi’a, further discussion on riba will be
limited to this form only.
55..11..33 RReeaassoonnss ffoorr tthhee pprroohhiibbiittiioonn ooff RRiibbaa We can thus surmise that any interest or excess above the principal sum in a
deferred repayment transaction is riba. The reason given in the Qur’an for the
prohibition of riba is that, a pre-determined fixed rate of return on capital lent leads to
injustice because there is an uneven distribution of risk and reward in the transaction
(Obiyathulla, 1995). One party bears the risk, while the other party receives a reward
irrespective of the outcome of the use of the borrowed amount. Riba is also said to
lead to the concentration of wealth by transferring wealth from the poor to the rich, a
position not unreasonable given the current distribution of wealth and third world debt
crisis (Caufield, 1998). It is also said to increase the instability of the trade cycle,
causing more violent fluctuations because a high rate of interest, by increasing the
cost of capital, discourages investments (Keen, 1997). An IMF economist observes
that Islamic banking, based on the elimination of riba will to lead to a more stable
banking system, thus:
“The Islamic model of banking based on the principle of equity participation may well prove to be better suited to adjusting to shocks that result in banking crisis and disruption on the payment mechanism of the country. In an equity-based system that ...does not guarantee the nominal value of deposits, shocks to asset positions are immediately absorbed by changes in the values of the share deposits held by the public in the banks. Therefore, the real value of assets and liabilities of banks in such a system will be equal at all points in time. In the more traditional banking system since the nominal value of deposits is fixed, such shocks can cause a diversion between real assets and liabilities”. (Mohsin, 1986, p19)
55..11..44 CCoonnttrroovveerrssiieess oonn tthhee pprroohhiibbiittiioonn ooff RRiibbaa
In the light of modern financial practices, the elimination of interest would seem to be
an unworkable plan. In fact, the elimination of interest has been thought to be
irrational and a sign of a backward economy. Although usury i.e. excessive rates of
interest, especially on consumption loans are regarded by some in the West as
immoral, commercial interest is seen as a legitimate reward for the use of capital in
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modern economies. It is justified as reward for the “time value of money”. Indeed,
some modern Muslim economists (in the early part of this century) and even some
Islamic scholars have tried to restrict the definition of riba to usury and thus legitimise
the institution of interest among Muslims. Among the arguments offered in favour of
legitimising interest are:
(a) Riba is only usury and not interest
(b) Riba is compound interest and not simple interest
(c) Only interest on consumption loans is prohibited, not on investment loans.
(d) Islam recognises the time value of money and therefore interest should be
allowed.
(e) Bank interest is not prohibited because it is not exploitative.
The first controversy as to whether riba is limited to usury begs the question as to
what is the upper limit of the interest rate which is justified and what rate does
illegitimate usury begins. Prior to 1571 in England, at least, all rates of interest above
zero were considered usurious following the edict of St. Thomas Aquinas (Keen,
1997). Of course, a legal solution could be offered but the historical evidence shows,
at different times, different rates were considered usurious. For example, the
Sumerians considered 25% interest rate normal while the 1571 Act against Usury of
England indicated that anything more than 10% was usurious. Although in a secular
framework, the rate of usury may be a matter of individual conscience or to
parliamentary consensus, this does not provide the specific technical, moral or any
other reason why the rate below the benchmark is justified and that above is not.
(Shaikh, 1987).
The second controversy asserting that riba is only compound interest is based on
one interpretation of the Quranic verse: “ O you who believe, do not devour riba,
doubling and redoubling” (Al- Qur’an, 3:130). However, Islamic rules of interpretation
state that the whole Qur’an (together with the Hadith) must be considered in
interpreting any verse. Verses 275 to 279 of the second chapter of the Qur’an leave
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no doubt regarding what is meant as they clearly state that only the principal lent is
the amount the borrower is obligated to return. Further, as Hoque (1987) observes,
the distinction between compound and simple interest is apparent and not real as an
overdue interest on simple interest becomes compounded. As the compulsory
notification of the APR (Average percentage rate) in the UK shows that a compound
interest rate can also be expressed in terms of a simple interest rate. In fact, it is just
a matter of time before the interest doubles and triples the principal amount. Thus,
this sophistry is not enough to deny the prohibition of riba.
The secular reasoning that, interest is only injurious, if at all, in consumption loans
and not in the case of commercial or investment loans as is the case in commercial
bank lending, is not acceptable from an Islamic point of view. This is due to the fact,
that at the time of prohibition, Arabia was a major commercial centre of the Indian –
Mediterranean trade route (Chaudhuri, 1985). In fact many of the Companions of the
Prophet (pbuh) received loans on an interest basis (before the Qur’anic prohibition)
to invest in their trades. The Prophet (pbuh) specifically banned such interest-based
loans after the Qur’anic prohibition was revealed, retrospectively. The Qur’an states
that “Allah has permitted trade and prohibited riba”, in spite of the protests of the
Arabs that “Trade is like riba” (Al-Qur’an, 2:275), Islam is quite clear on this. Further
Islam has not prohibited other avenues of lawful employment of capital to generate
income in the form of rent, labour-capital participation, joint venture and mark-up
trading. Chapra (1985) quoting Shaykh Abu Zahrah, an eminent Muslim scholar,
observes that:
“There is absolutely no evidence to support the contention that the riba (prohibition)...was on consumption loans and not on development loans. In fact the loans for which a research scholar finds support in history are production loans. The circumstances of the Arabs, the position of Makkah and the trade of the Quraysh (the tribe of the Prophet (pbuh)), all lend support to the assertion that the loans were for production and not consumption purposes”. (Chapra , 1985, p 62)
One might protest that despite the historical basis on which the prohibition was
based, the ruling is irrational in view of the fact the loans provide for development or
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investment accrue profits and it would be unreasonable for the lender not to share in
it. The answer to this is that Islam does not bar the association of capital and
entrepreneurship. However, it prohibits interest-based loans because the
predetermined fixed return to the lender is irrespective of the fortunes of the
entrepreneur. If the investor agrees to share any eventual loss, he can contract for a
share of the actual profit earned by the entrepreneur.
Whether Islam recognises the time value of money is more controversial. In the case
of the Islamically allowable murabaha or mark-up contracts, in which a supplier
contracts with a buyer to acquire a product and sell it to the buyer at a mark up on
cost, the price can be deferred or paid on an instalment basis. By allowing, the extra
charge for delayed payment - Islam appears to recognise the time value of money by
recognising the opportunity cost foregone by the entrepreneur who might have
otherwise have his capital tied up – a subtle distinction from the charging of interest
(Vogel & Hayes, 1998).
On the other hand, Khan (1994a) is of the opinion that discounting violates the
Shari’ah prohibition of interest. Khan (1994a) observes that only in the case of the
poor people is it true that the current utility of money is greater than the future utility.
He opines that every cent saved testifies to the fact that savers have a preference for
the future utility of the money rather than current. Hence there is no need to discount
future inflows. Tomkins & Karim (1987), however, observe that the objection to the
use of interest rate for discounting can easily be avoided by using an expected return
rate as a hurdle rate. Hence using discounting techniques is not a problem in capital
budgeting and valuing assets.
Finally, many scholars argue that the modern banking institution was not present at
the time of the Prophet (pbuh). As it performs vital functions of financial
intermediation in the modern economy and is not exploitative, bank interest should
not come under the gambit of the riba prohibition. Some court ulemas especially
those from the Egyptian government have in fact given legal opinions (fatawas) to
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this effect. However, the majority of the Islamic scholars view that bank interest is no
exception because the bank in fact represents a group of individuals (the
shareholders) who are in the money-lending business. Since the riba prohibition
equally applies to individuals as well as groups, banks are not exempted (Hoque,
1987). Despite this, however, the same author observes that it is a fallacy to view the
whole conventional banking process itself to be UnIslamic. A close look at the
function of banks in channeling savings to productive enterprises is actually
facilitating the realisation of the objectives of the Shari’ah, which abhors and
penalises idle savings. Only the interest mechanism used to achieve this objective is
objectionable. Hence if interest is replaced by any permissible mechanics and the
bank limits its activities to financing businesses approved by the Shari’ah banking
becomes an important Islamic institution (Hoque, 1987).
Finally the recent Federal Shari’ah Court of Pakistan’s judgement on Riba1 (Khan,
1994b) should put to rest any lingering suspicions on the nature of riba. Contrary to a
normal process of interpretation of a constitution2, the Court sent out a questionnaire
and collected evidence and cited various works of both Muslim and Non-Muslim
scholars to discern the nature of riba. It concluded “ a transaction which contains
excess or addition over and above the principal amount of loan, payable to the
creditor constitutes riba “(p13). Therefore, any such sale, transaction or credit
facility, in money or in kind, has been considered to be of riba, which is unlawful
(haram) in Muslim society. Khan (1994b) observes that the court held that there was
a consensus of the opinion (ijma’) of Muslim jurists upon it. Further, it did not make a
difference whether the loan is for consumption or for commercial purpose, if the rate
of interest is high or low, simple or compound or between Muslim and Non-Muslim or
between an individual and the state.
1 This ruling was appealed by the Government of Pakistan whose Appeals Court has just turned down the appeal in December 1999, and has given the Pakistan government until year to rid the economic system of riba consistent with the constitution of the Islamic Republic of Pakistan. 2 The litigant filed a case against the Pakistan’s government use of conventional interest based financing as against its constitution.
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While debate might continue forever on this issue in academic circles, the matter is
quite clear to Muslims that conventional interest is not acceptable from an Islamic
perspective. Thus, they have no option, if they want to abide by Qur’anic principles,
except to overhaul the conventional financial and banking system to an interest-free
footing.
55..22 IISSLLAAMMIICC OORRGGAANNIISSAATTIIOONNSS As part of the Islamic resurgence, Muslims have set up Islamic business and non-
business organisations which attempt to operationalise the Shari’ah in their economic
and governmental affairs (El-Ashker, 1987). In the heydays of Islamic civilisation,
there were unique socio-economic Islamic Institutions, which were replaced, by
foreign economic institutions, after the colonisation of Muslim lands. The two most
important institutions, which will be discussed in this research, were the “Baitul-Mal”
(public treasury)- which collected and disbursed Zakat – the Islamic religious levy
and the Awqaf (Muslim endowment). In the private sector, businesses were
conducted for the most part, according to Islamic precepts despite the claims of
Rodinson (1974) that this was more in letter rather than in spirit. Muslims are
attempting to revive these institutions and adapt them to contemporary
circumstances as part of the Islamic resurgence in the Muslim countries (Sivan,
1985).
In the business sector, although the concept of the modern corporation was
unknown, Islamic law and Muslim business practice knew the concept of separate
legal person and joint stock partnership (Usmani, 1998). Muslims undertook joint
ventures, especially commenda (mudharabah) and partnerships, which were based
on risk-taking profit and loss sharing ventures (Udovitch, 1970). As interest was
prohibited, interest bearing bonds were unknown but interest bearing commercial
loans and government loans did take place, sometime in the guise of “mark-up” or
buy and resell sales contracts allowed in Islam (Rodinson, 1974). Some Muslim
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governments, especially the late Ottoman Sultans took interest-bearing loans from
Western countries, which eventually led to the downfall of the Caliphate. There were
even instances of Mosque funds lent out at interest, which was prohibited under
Muslim Law. However, these were always frowned at by Islamic scholars and
Muslims and never accepted as legal by the majority of Muslims.
Although the use of trade bills and cheques were known in Islamic History, modern
banking was a Western Introduction in Muslim lands which took root after
colonisation. Despite being encouraged by the governments of Muslim countries, the
Muslim masses harboured much suspicion of the allowability of interest charged or
given on deposits by these banks. Many strict Muslims refused to deposit their
money and preferred to keep it in their homes. Others used the banks as a safe-
deposit service and would not take the interest credited to their accounts or gave
them away to charity.
To solve this problem and give Muslims a Shari’ah friendly alternative to conventional
banking, Islamic banking was born and has since become established as a viable
alternative, although there are many strategic, operational, regulatory and accounting
problems faced by these banks (Al-Faisal & Ali, 1996). In addition to the banks,
Islamic finance co-operatives and savings institutions which invest the believers’
money in Shari’ah approved and ethically correct ways have been set up. The
Lembaga Tabung Haji of Malaysia, established in 1962 is an example of one such
successful institution, which had assets totalling 5.2billion Malaysian Ringgit (around
US $2billion) in 1997.
Another financial institution, which presented problems for Muslims, is the
conventional insurance company. The Shar’iah prohibits conventional insurance
because of its connections with interest, gambling and gharar (uncertainty). In
general, a contingent insurance contract is prohibited in Islam. To overcome this
problem, Islamic Insurance companies (known as Takaful) have been developed,
where the contributors share in a savings scheme including a compulsory
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contribution to a claims pool. The Takaful Company then tries to compensate any
claimant from the amount of his contribution plus earnings. Any shortfall of the
indemnified amount comes from the claims pool if available. Of course, the policy
premiums are invested in interest-free, Shari’ah approved investments.
As discussed in chapter 2, the world-view of Islam and therefore Islamic
organisations, whether in the public, private or voluntary sector, are different from
those of conventional business and non-business organisations. The difference
arises in the objectives, nature of profits, the activity or industry Muslims can
undertake or invest and in the way the wealth is distributed. The charging and
earning of interest, gambling, alcohol and other industries and aleatory contracts are
prohibited. Further the maximising of profits or wealth as an objective is frowned
upon because it conflicts with the ultimate objective of achieving falah (Islamic
success/salvation –see chapter 6) in the hereafter. Although unlike Christianity (see
Laughlin, 1988; Tawney, 1927), Muslims are not averse to exploiting the resources
for material gain, they would have to undertake this in ways which is in accord with
the Shari’ah.
There is a need to differentiate between Islamic and Muslim organisations. In case of
businesses, the researcher defines Islamic business organisations as those which
have been set up specifically to operate within the Shari’ah as part of the strategy to
develop a comprehensive Islamic Economic and Financial system. Their philosophy
must be Islamic and not merely meant as a cover to introduce interest through the
backdoor. On the other hand, Muslim business organisations are businesses set up
by Muslims who may or may not follow the Shari’ah. However, Muslim businesses,
especially small and medium-scale ones may intend to gradually shift towards an
Islamic business profile in their activities. Islamic accounting is needed by both types
of organisations – mandatory for the former and helpful for the latter to achieve their
Islamic ambitions.
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55..22..11 IIssllaammiicc bbuussiinneesssseess
Islam not only allows, but encourages trade and business. Business can be
organised either as sole proprietorship, partnership and companies as in common
law. Although the concept of limited liability has been frowned upon (Usmani, 1998),
the company form of organisation is lawful in Islam with certain restrictions. These
include the type of capital, which can be raised, the type of investments, which can
be carried out, and the way profit and loss is shared.
Although sole proprietorships, partnerships and joint ventures have been the most
common forms of businesses in the Muslim world (El-Ashker, 1987), the company
form of business organisation is increasingly used in the Muslim world both by private
and public companies.
5.2.1.1 Forms of Business Organisation The common law varieties of business organisations (sole proprietorship, the
partnership and the company) are permitted in Islam. The liabilities, obligations and
the rewards of ownership are pretty much the same for sole proprietorship except
that the owner is not allowed to conduct business in forbidden products or services
such as selling pork, liquor, gambling or interest-based money lending.
The distinction between partnership and companies in not clear in Islamic law
because the modern corporation was never found in Muslim countries before the
adoption of European law in Muslim lands. However, the Muslim partnership law is
quite comprehensive to allow for the formation of joint stock companies, the
formation of which is said to be encouraged by the Prophet (pbuh) himself (Atiyah,
1992).
5.2.1.2 Objectives and operations of Islamic Organisations. The objective of Islamic business organisations is to enable Muslims to undertake
economic activities within the framework of the Shari’ah as a means to attain falah
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(success in the hereafter). This means that the businesses must follow a code of
Islamic ethics in relation to their activities and behaviour towards their stakeholders
(Beekun, 1997).
Conventional business organisations follow a profit or wealth maximisation model.
This is the based on the concept of the utility maximising behaviour of conventional
rational economic man. Although profit is deemed legitimate and is one of the major
objectives of Islamic businesses, profit maximisation, as a prime objective is not
identified in the Islamic model (El-Ashker, 1987). Even though capitalist businesses
seem to be moving to wealth maximising and satisficing, the concept of maximisation
is entrenched in the accounting calculus e.g. when investment appraisals are carried
out.
In Islam, wealth is only considered as a means to an end. As in other religions, the
Muslim scholars, for example Al-Ghazali (Al-Karim, 1995), have warned their
followers of the dangers of greed for wealth. Thus maximising wealth is not a priority
of the Muslim. On the other hand, the economic strength of a nation or group has
direct implications for political and social stability. Hence, Islam encourages the
pursuance of wealth in an ethical manner. In line with this, the objective of Islamic
business organisations is therefore to seek reasonable profits in line with the risk
taken and any particular social consequences of high pricing policy. Survival and
growth are also emphasised as important objectives in hostile environments where
Islamic businesses have to compete with conventional ones.
Islamic businesses have to take into account the benefits accruing to employees,
society and the environment, in addition to fund providers as a matter of
religious/moral obligation emanating from their Islamic beliefs. El-Ashker’s (1987)
study of Islamic business enterprises in Egypt provides some evidence that Islamic
businesses aim to achieve three sets of objectives related to the benefits accruing to
finance providers, employees and society. He proposes a utility model for Islamic
economics, consisting of secular and ritual utilities. The secular utility is the normal
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conventional utility consisting of profits and financial benefits whereas the ritual utility
relates to employee and non-profit oriented social objectives intending to please God
and to achieve falah. Achieving profits within this constraint is said to please God and
leads to a higher divine reward and hence is a source of utility for Islamic businesses.
The Islamic business aims to achieve a balanced relationship between the three sets
of objectives of the three interested parties in the course of maximising its utility.
Thus:
Maximise U = Ua(R), Ub [UaR, E, S], F(P)
Subject to Y= R+E+S, where:
U= Utility function Ua = secular utility function Ub = ritual utility function R=Profit E = cost of employment welfare (wages and the like) S = social cost (costs of social welfare) P = degree of piety Y = net value of production. Since Islamic and Muslim businesses vary in the degree of commitment to Islam, the
degree of piety (P) is introduced into the equation to account for this. Thus for
different organisations with different degrees of piety, the equilibrium point, E, S, and
R will be achieved will be different. The researcher proposes that an additional
environmental cost (N) be added to the equation. Hence Y= E+S+N+R and Ub [UaR,
E,S,N], hence Islamic businesses will maximise its utility and will be in equilibrium
when a proper mix depending on the degree of piety is achieved.
While all this might seem theoretical and not practical, the study by El-Ashker (1987)
using actual case studies of Islamic companies in Egypt indicates that this is what is
done in practice by Islamic companies with a high degree of P.
5.2.1.3 Accounting implications Both the structure and objectives of Islamic business organisations make the
development of an alternative Islamic accounting an imperative. For example,
debentures, bonds and even preference shares are not allowable in an Islamic
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company. This is because of fixed interest bearing characteristics of the former and
profit sharing arrangements of the latter which are considered inequitable according
to the Shari’ah. New type of financial instruments such as mudharabah and
muqarada bonds (Rosly & Sanusi, 1999), are needed to finance Islamic companies
and used as investment instruments by Islamic banks. These instruments are hybrid
instruments containing both the characteristics of debt and equity (Obiyathullah,
1995) which call for special accounting treatment. This is not only a matter of
different technique but also a matter of change in the fundamental accounting
assumption of substance over form, which underlies conventional accounting
standards, e.g. IAS 1 (IASC, 1975) which may not be acceptable from an Islamic
point of view.
Further, the objective of Islamic businesses which have to balance the shareholder,
employee, society and environmental interests poses serious questions on the
adoption of the profit calculus (the bottom line) as the main area of concentration of
conventional accounting. It cannot be denied that the importance of the bottom line
is exacerbated by the prominence given to the profit and loss account as the primal
financial statement in a set of conventional accounts. This has implications for the
behaviour of stakeholders as accounting can itself lead to the construction of a social
reality (Hines, 1988) not in line with the Islamic aspirations. To balance these non-
shareholder considerations, an Islamic accounting statement might have to consider
an alternative scoring system other than the financial unit.
55..22..22 ZZaakkaatt ccoolllleeccttiioonn aanndd ddiissttrriibbuuttiioonn Zakat is one of the five ‘pillars’ of Islam. Literally, it means to purify one’s wealth.
Zakat is a “religious levy by which Muslims make over part of their wealth for the
benefit of others” (Clarke et al., 1996). It is neither a tax nor a charitable donation. A
tax may be expended for any purpose while Zakat can only be paid to eight
categories of beneficiaries specified in the Qur’an. Further, as opposed to a
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charitable donation, it is compulsory. Zakat is a wealth based levy although
contemporary Islamic scholars insist that Zakat should also be payable on salaries
and wages. Zakat has been levied on animals, trading profit, and agricultural produce
and gold and silver and money equivalents. Scholars have extended the category of
zakatable items. The rate of wealth Zakat is 2.5% but agricultural produce is subject
to 5% or 10% depending on the use or non- use of irrigation respectively.
The collection and disbursement of Zakat has been traditionally carried out by the
Islamic State, since the time of the Prophet (pbuh) (Zaman, 1991). The Prophet
(pbuh) used to appoint Zakat collectors to assess and collect Zakat from his
followers. This was deposited into the Baitul Mal or the public treasury. Zakat was
collected and disbursed both in cash and in kind. The Islamic State continued to
perform this function until colonisation resulted in the introduction of alternative tax
systems. However, Zakat continued to be paid individually, through charitable
associations (as in the UK) or through the religious departments of government as in
Malaysia.
As part of the Islamisation of the economy, some Muslim countries have started
organising their Zakat collection and distribution activities more efficiently. In
Pakistan, Zakat is now deducted at source e.g. on investment deposits in banks. In
Malaysia, Zakat collection is carried out by religious departments, which come under
the jurisdiction of the various states. Mustapha (1991) observed that Zakat collection
and administration is inefficient as for example, the administrative cost is twice the
pay-out to the destitute group of beneficiaries. There have also been accusations of
mismanagement and maladministration by the head of states that are ultimately
responsible for it (AbdulRahim & Goddard, 1998). There have been calls in Malaysia
for the proper organisation and administration of the Zakat. The Malaysian
government has proposed the establishment of an agency on a national level for the
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administration of Zakat3. As a preliminary step, privatised Zakat collection agencies
has been established in the Federal Territory and Selangor, the two states with the
largest earning population. Zakat collection has increased considerably due to the
promotional activities of these agencies. Payment of individual Zakat is also given
income tax rebate. However the authority and accountability structure of these
organisations are far from satisfactory. Once the Zakat is collected it is handed over
to the religious department and is only subject to the Auditor General’s inspection.
The working of the bureaucracy in the distribution of Zakat is not transparent. Further
the “accounts” published by the collection agencies is dismal as the amount collected
is just categorised into the eight beneficiaries as disbursement. Hence what is shown
as disbursements is not actually paid out in fact but theoretical.
An interpretive study of accounting in two religious departments in Malaysia shows
lack of transparency and power conflicts to varying degrees (Abdul Rahim &
Goddard, 1998). There is more professionalism and transparency to a certain level in
the department situated in the more urban Federal Territory where conventionally
qualified accounting personnel carry out conventional computerised accounting. In
the other department located in a more rural area, there was a general lack of
transparency and the researchers reported misuse of power. However, while the
departments using qualified accountants showed more transparency, the introduction
of a conventional accounting system has resulted in a profit-oriented thinking which
has resulted in the adoption of new marketing techniques to collect Zakat. For
example, the Pusat Pembayaran Zakat (Zakat collection centre) is a privatised profit-
oriented entity who are remunerated on a percentage of the collections. Although,
they do not have the power to collect Zakat by legal force, such a measure may have
grave societal implications when Zakat becomes legally compulsory as the profit-
motive in increasing Zakat collection may lead to arbitrary practices. Hence, there is
3 In January 2000, the Malaysian Government informed the public that Zakat will be collected on a PAYE basis through the Department of Inland Revenue.
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a need to develop an appropriate Islamic accounting system, which will induce the
proper Islamically accountable behaviour instead of introducing modern methods and
conventional accounting, which may lead to inappropriate behaviour.
55..22..33 AAwwqqaaff The waqf (pl. Awqaf) is one of the Islamic institutional devices to foster voluntary
spending for the poor as well as to meet several other social causes (Ziauddin,
1991). It is the setting aside of certain assets usually land, buildings etc. for the
exclusive use for specific charitable/religious purposes under a legal deed. The
asset so established becomes a waqf in perpetuity, and cannot be sold, inherited or
expropriated by the government. Only the income form the asset is disbursed
according to the wishes of the waqif - the person setting up the waqf. The waqf thus
becomes a trust property, which is administered by one or more trustee who can
claim reasonable administrative expenses and salary. According to Ziauddin (1991),
“Waqf is thus a device for transferring private property to collective ownership (not
public ownership) for socially beneficial purposes” (p 43).
Awqaf are said to date from the time of the Prophet (pbuh) but acquired clearer legal
status under Islamic law in the first century A.H. Although the legal concept is similar
to trusts and endowments under common law, it is said to predate the English
Institution of Trust. Thus as (Hasanuddin, 1998) observes, “there is no evidence that
such a complex system of appropriating usufruct as a life-interest to varying and
successive classes of beneficiaries existed prior to Islam”(p29).
However, as opposed to English Law which only recognises trusts in favour of other
than the trustor and family as charitable, Islamic law recognises awqaf even if its is
for the trustor’s own or his family’s benefit but with eventual succession to charitable
purposes. The former type of waqf is known as waqf ahli (family endowment)
whereas awqaf specifically meant for charitable purposes from the outset is known
as waqf khairi (endowment for general good). On the surface, it seems the former
type of waqf would not be practicable as it entails a lapse from the time such assets
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are endowed and the time it s available for public use. It would be an uphill task for
the authorities or community to keep track of the asset. However, Hoexter (1998)
observes that “contrary to what one might have thought, many of the assets did
eventually find their way to their ultimate beneficiary”(p10).
In any case, both types of awqaf have been and are very important socio-economic
institutions in the Islamic world. Awqaf has been set up for various purposes e.g. the
upkeep of mosques, religious schools, orphanages, hospitals, animal care centres,
parks, rest-rooms, drinking water facilities and food distribution centres
(Siddiqi,1996). In many cases, awqaf are set up to feed the poor in other countries
especially those of the Haramain (the Holy Lands of Islam: Makkah and Medina).
Hoexter (1998) has undertaken an extensive study of the development of this
institution, the waqf al-Haramain in Algiers (Tunisia) during Ottomon rule, from its
own records.
The Algerian, Waqf Al-Haramain was in fact a foundation, which managed all the
individual awqaf assets dedicated to feeding the poor in the Holy Cities of Mecca and
Medina (Hoexter, 1998). Later it took other awqaf into its ambit including those of
other local mosques, feeding the local poor and contributing to local public projects
such as the town’s water system. The local Qadis or Muslim judges were active in
the development of the Islamic jurisprudence of Awqaf to adapt its principles for the
needs of the times and locality. On the whole, the Haramain foundation was equitably
and efficiently administered – a quality, which is not found these days e.g. in the
Awqafs of India (Siddiqi, 1996; Hasanuddin, 1998). Hoexter (1998) observes that the
Haramain became a “most significant vehicle for advancing the interests of the local
Islamic community” as well as becoming the focal rallying point in the fostering
Algerian-Islamic solidarity. Awqaf became such an important part of Islamic society,
that a Ministry of Awqaf was established in 1840 by Ottoman Turkey- a tradition
which has continued in many Muslim countries.
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Unfortunately, the loss of political and economic power by Muslims resulted in the
decay of this institution as shown by the contemporary state of awqaf, which leaves
much to be desired. Siddiqi (1996), for instance, observes that “we find increasing
state intervention in waqf management owing to a number of causes, the chief one
being widespread abuse of powers by waqf supervisors”(p146). Despite this
however, the state of affairs is dismal e.g. in India. Hasanuddin (1998) observes:
“But unfortunately, the Waqf institution in India, is most misunderstood and Waqf properties mismanaged. Legislative lacunae, administrative lapses, lack of political will...has given rise to the painful phenomenon that Waqf properties are the chief-attention of the land-grabbers. As against this background, colossal and gigantic Waqf buildings with tremendous commercial potential, are not even receiving the most needed repairs and maintenance, thus converting such attractive buildings into dilapidated structures and there is a general feeling that Waqf property is a cheap commodity available in the commercial market”. (Hasanuddin, 1998, p 23-24)
Despite this however, as the author observes, Awqaf is an important Islamic
institution which the Muslims have inherited in the past and “which possesses
immense potential for the reconstruction of social and economic life in Muslim
countries and communities” (p21). This is shown by the fact that there is estimated to
be about 300,000 awqafs in India alone (Haque, 1999).
Waqf is also an important wealth re-distributive mechanism of the Islamic economic
system. For example, Siddiqi (1996) notes that Waqf takes property out of private
ownership and vesting ownership permanently and irrevocably in Allah. With the
passage of time, more private property pass into waqf sector but the reverse cannot
and does not take place (if the assets are properly accounted for!). Since awqaf are
normally made by wealthy people (especially Muslim rulers in the past), it serves to
redistribute wealth and mitigate the ill effects of inequality in society and counter-act
the tendency to concentrate wealth.
It is thus essential, that an appropriate accounting and auditing system be developed
to ensure this institution is properly administered and accountable to the public to
ensure that it serves its function efficiently. As awqaf are not a commercial institution
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seeking profits, conventional accounting may not be suitable for them. An Islamic
accounting system for awqaf would seek to address the following problems:
• The tracking of family awqafs until it reaches public status.
• Activity accounting , both financial and non-financial accounting
• Accountability of the trustee, and the transparency of operations.
• Islamic Social audit to ensure the beneficiaries get what is entitled to them.
• Management audit of income and property.
• Promoting the establishment of more awqaf.
55..22..44 IIssllaammiicc IInnssuurraannccee ccoommppaanniieess Together with the growth of Islamic banks, Islamic Insurance companies (called
Takaful Companies) have sprouted, although not as numerous as Islamic banks.
These are usually subsidiaries or associates of Islamic banks or Islamic Finance
Groups (e.g. Syarikat Takaful Malaysia – a subsidiary of Bank Islam Malaysia) or
conventional Insurance companies which have Islamic subsidiaries e.g. Syarikat MNI
Takaful.
The establishment of these organisations are due to the fact conventional insurance
is prohibited by Islamic Shari’ah (although there are controversies in this area). This
is due to the element of gharar or uncertainty in contingent contracts as well the
elements of gambling especially in relation to life insurance. In addition, the practice
of investing premiums in interest-bearing securities by conventional insurance
companies is also problematic (Shamsiah, 1995).
Takaful operates as a co-operative savings and mutual help scheme. In the case of
Takaful, any contributions (premiums) paid by the participants (i.e. policyholders) are
not recorded as income of the takaful company as in conventional insurance. In the
case of Family Takaful - the replacement for conventional life insurance, the
premiums paid by the contributors are apportioned to a participator’s fund account
and a claims pool. The amount apportioned to the claims pool is based on actuarial
calculations. The fund is invested in Shari’ah approved investments. Any profits are
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shared between the Takaful Company and the contributors in a pre-agreed ratio. Any
losses are born by the participants – not by the Takaful Company. Any profits
accruing to the claims pool is credited to it. All actuarial surpluses are credited to the
participants. At the end of the policy term, a contributor gets the amount of his
contributions plus any share of the profits, if any. He does not get any amount
apportioned to the claims pool. If the policyholder dies before maturity of the policy,
then any shortfall (the difference from the insured amount and the balance in his
account representing his contributions + profit) is met from the claims pool.
In the case of General Takaful – the Islamic equivalent of General Insurance, all
contributions are credited into a collective claims pool fund. Any profits from the
invested funds are credited to this account. After making any required provisions and
making any claims payments, the profit, if any, is shared between the participants
and the company in the pre-agreed ratio. Any losses are born by the claims pool
fund.
It can thus be seen that the Takaful concept is quite different from conventional
insurance. A conventional insurance company is a risk taker while the takaful
company is mainly a manager of funds. While premiums paid to Insurance
companies are treated as income, takaful contributions are treated as a separate
fund attributable to policyholders. The Takaful Company shares profit arising from
investments and any surplus in managing claims. The operational expenses (staff
and administration costs) are born by the Takaful Company. Thus three main
stakeholders are accounted for in separate funds; shareholders funds, family takaful
fund and general takaful fund, each having its own balance sheet, profit and loss
account and cash flow statements.
It can be seen that Takaful companies cannot operate under accounting standards
meant for conventional insurance companies. There are several technical and
philosophical accounting problems to be solved, for example:
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• Valuation of investment assets; currently follows conventional valuation principles
may not acceptable from an Islamic point of view (see chapter 6).
• Apportionment of profit share; the cash basis is currently used. This may lead to
distortions in profit distributions for all the parties.
• The calculation of Zakat on profits; the value to be used and the avoidance of
double taxation.
• The calculation of actuarial surpluses based on interest-based contingency tables
may not be acceptable from a Shari’ah point of view (see Tomkins & Karim,
1987).
• In line with the co-operative and participatory nature of Takaful, more qualitative
information may need to be disclosed.
There is thus a need to develop an Islamic accounting system, which will deal with
the above matters from an Islamic perspective.
55..33 IISSLLAAMMIICC BBAANNKKSS AANNDD FFIINNAANNCCIIAALL IINNSSTTIITTUUTTIIOONNSS:: HHIISSTTOORRYY,, NNAATTUURREE AANNDD OOPPEERRAATTIIOONNSS
Islamic banks are perhaps the most important and developed Islamic organisations in
contemporary Islamic society. Assets of Islamic banks are estimated to range from
50 to 100 billion dollars (Pomeranz, 1997). Although the principles on which it is
based are not new, the institution itself is an innovation in Islam. An Islamic bank is
an ethically based institution which performs conventional banking functions with an
important exception, they do not receive interest from their borrowers or pay interest
on the customers deposits as this is prohibited under Islamic Shari’ah (Al-Faisal &
Ali, 1996).
This does not mean Islamic banks are charitable institutions undertaking free lending
and borrowing. On the contrary, Islamic banks are businesses, which aim to make
profit within the constraints of the Shari’ah, by undertaking profit- sharing projects,
trade financing, lease financing and providing fee-based services. Due to the
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importance of Islamic banking in the Muslim world, it will be discussed in some detail
as an example of an Islamic organisation in practice, which makes the development
of an Islamic accounting system a practical imperative.
In the next two sub-sections the classification and development of Islamic banks will
be discussed to provide some background to the subject. This is followed by a
description of the operations and activities of the Islamic bank in section 5.3.3.
As the accounting problems of Islamic banks mainly concern the asset side of
Islamic banks, the Islamic financial instruments used as alternatives to conventional
interest-based lending are discussed in section 5.4. In section 5.5, the accounting
problems of Islamic banks are discussed at some length. All Islamic organisations, in
the opinion of the researcher, need an alternative Accounting System. However, the
accounting problems of the Islamic banks have been considered acute enough to
have led to the establishment of an alternative regulatory body for the setting up of
Accounting Standards for Islamic Financial Institutions (Pomeranz, 1997). Thus, the
detailed discussion of these institutions in this thesis. The chapter is concluded with a
discussion of the perceived benefits of an Islamic accounting system for banks and
other business organisations.
55..33..11 CCllaassssiiffiiccaattiioonn ooff IIssllaammiicc bbaannkkss (Ahmed, 1994b) has classified Islamic banks and financial institutions into several
different types, as follows:
1. Islamic Special Purpose banks aim to achieve a specific purpose or serve a
special class of clientele. This include social banks, agricultural banks, co-
operative and Industrial banks. Examples include the Nasser Social Bank in
Egypt and Islamic Bank of Western Sudan charged with promoting the
development of Western Sudan.
2. Islamic Development Banks aim to foster the process of socio-economic
development amongst its members. Its clientele are usually governments
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3. Islamic Commercial Banks mainly aim to make profits but still operate within the
Islamic ethical system. This class forms the bulk of Islamic banks in operation.
4. Non-banking Islamic financial institutions such as the Pilgrims Fund (LUTH) of
Malaysia do not perform banking functions but channel savings to productive
investments and pay the depositors a bonus depending on profits.
55..33..22 DDeevveellooppmmeenntt ooff IIssllaammiicc bbaannkkss aanndd ffiinnaanncciiaall iinnssttiittuuttiioonnss It is generally agreed that the first Islamic bank was established at Mit-Ghamr, Egypt
in 1963 (Ahmed 1994a; Naggar 1987). Mit-Ghamr is a rural area in Egypt, where the
people were mostly religious farmers and artisans. They did not put their savings in
the conventional banks because of the Islamic prohibition of interest. The bank
operated three types of accounts; the savings and loan fund, the investment fund and
the social service fund. The first fund was like a current account. The depositor
received no interest but could apply for an interest free loan for productive purposes.
The investment funds were deposits received based on profit/loss participation. The
funds were invested in local businesses and agricultural projects. The deposit
received a proportion of the profits according to its amount and term. The social fund
received Zakat and other charitable contributions from which grants were made to
savers who were in financial difficulty as a result of sudden misfortune.
It can thus be seen that an Islamic/social ethos prevailed in the conception and
operations of the bank. One Western observer noted the significance of the
experiment thus:
“The majority of the population had never been dealing with the financial institutions. Because of this, capital formation had been impaired. Basically rural and religious, they tended to distrust the bankers operating in the western style. Since a substantial part of their income was not spent immediately, but put aside for social events, emergencies and the like, this idle capital could not be used for productive investment A precondition, however for any change of behaviour from hoarding and ‘real-asset saving’ to financial saving was the creating of financial institution which would not violate the religious principles of large segments of the population. Only then could the rest of the majority of the population be integrated in the process of capital formation”. (Wohlers-Scharf, 19834, pp79-80 as quoted in Ahmed, 1994a, p351).
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In the words of one of its founding executives (Naggar, 1987), the three most
important principles which were applied by the bank and responsible for its success
were:
1. Participation of the bank with its borrowers in their profits as well as losses.
2. Decentralisation and localisation through the operation of a community based
philosophy which help in:
a) the education and credit enlightenment through direct and sympathetic
contacts,
b) constant follow up of projects to guarantee their repayment and effective use
of the money, and
c) the provision of a mix of economic and social development services.
3. Consistency and integrity of the bank accounts.
The bank’s success5, however, attracted the attention of the anti-Islamic, socialist
regime of Nasser. In 1967, the Egyptian government took over all the nine banks
and converted them to social savings bank on the conventional model. Thus the
experiment came to an end, not on the basis of its economic viability but political
interference and commercial opposition of the conventional banks.
At the same time as the Mit-Ghamr bank was started in Egypt, the Lembaga Urusan
dan Tabung Haji (LUTH) (Pilgrims Fund and Management Board) was established in
Malaysian in 1963 as an Islamic savings institution. A Muslim economist who had
noticed the wasteful nature of Malaysian Muslims selling of their property to go on the
Haj (Muslim pilgrimage to Makkah) suggested that Muslims could save up the
amount which would be invested in accordance to Shari’ah principles. Thus LUTH
was born. Until then, intending pilgrims did not put their savings in a conventional
bank because it would have been tainted with interest. Money thus tainted could not
be used to perform the pilgrimage, as it would not have been religiously valid.
4 Wohlers-Scharf, Traute (1983), Arab and Islamic Banks, Paris, France: OECD. 5 Four more branches were established in the three year period 1963-66.
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The Malaysian government initially set LUTH (Now known as Lembaga Tabung Haji)
up as a savings corporation in 1963 and was incorporated in 1969. Although LUTH is
not an Islamic bank, it is an Islamic financial institution. It collects the savings from
would be pilgrims and invests them in real estate, trading and plantations. Recently it
has gone into share trading and Islamic money markets. It restricts withdrawals to
twice a year and for the purpose of performing the pilgrimage. LUTH is an active
investor both directly and through its seven subsidiary companies.
LUTH in addition to its investing activities administers the whole pilgrimage
programme every year, which is a mammoth undertaking involving about 40,000
pilgrims. In co-operation with other government agencies, it takes care of their
transport, food, lodging, health and emergency aid during the pilgrimage. The
researcher having personally used its services can attest to its efficiency in
organising the pilgrimage.
However, in recent years, its importance as a financial intermediary has increased.
The researcher was informed by one of its accountants in an interview that 70% of
LUTH’s deposits were investment deposits, whereas previously most depositors
withdrew their savings to perform their pilgrimage. Unlike the Mit-Ghamr bank, LUTH
had better fortunes because of a political climate in Malaysia, which though secular,
was not socialist and anti-Islamic, as was the Nasser government. From 1,281
depositors in 1963 and M$46,600 in deposits, the number of depositors increased to
2,278,121 with deposits of M$1,541 million in 1993, a period of 30 years (Zainal &
Yusof, 1993). Its income has increased from M$6,573 to about M$95 million
(excluding government contribution towards operating expenses) during the same
period, 1990. Depending on the profits, a bonus is declared by LUTH once a year.
The dividend rate has been around 8-8.5%
The first private commercial Islamic bank was the Dubai Islamic Bank in 1975. It is a
public limited company with 50 million dirhams. In the same year, an international
Islamic bank, the Islamic Development Bank was established in Jeddah, Saudi
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Arabia jointly by the 45 Muslim countries under the auspices of the Organisation of
the Islamic Conference. The purpose of this bank was to foster economic
development and social progress of member countries using Islamic finance financial
instruments. It also grants loan and aid to Muslim organisations especially in Muslim
minority countries.
Thereafter Islamic banks began to be established at an increased pace in Egypt,
Sudan, Jordan, Bahrain, Pakistan, Iran, UK, Malaysia, Bangladesh, African countries,
Turkey, India, South Africa and the US. Two milestones in the establishment of
Islamic banking were firstly, the Islamisation of the whole banking sector in Iran
(1979), Pakistan (1985) and Sudan. The second milestone was the establishment of
the Dar-al Mal Al-Islamic (DMI) Switzerland in 1981 by a Saudi Prince and the Dalla
Al-Barakah Group in 1983. These two Islamic Finance Multinationals were
responsible for setting up a spate of Islamic banks, Investment corporations, Takaful
companies and other financial institutions in Egypt, Sudan , Africa and Europe.
The ownership of the Islamic banks varies between 100% government ownership
and 100% private ownership. Most Islamic banks have been set up as joint-stock
companies. The total number of Islamic banks and financial institutions number in the
thousands (if the Islamic banks in Sudan, Pakistan and Iran established by wholesale
Islamic legislation are counted) but those established voluntarily number 192 (IAIB
1997). Based on 166 of these institutions, Islamic financial institutions had a total of
US7.3 billion in paid up capital and total assets of US$137 billion. The aggregate net
profit was US1.7billion. This compares to 133 institutions with $5 billion of paid up
capital and $101 billion in assets in 1994. Considering that there was no wholesale
Islamisation of the banking sector in any Muslim country between these dates, the
increase represents about 40% increase in assets and capital for two years or about
20% growth rate. Long-term expansion barring wholesale Islamisation is, however,
estimated to be around 5-7% (IAIB, 1997). The industry employs around 300,000
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employees spread across 34 countries in all continents except Australia and South
America.
It can thus be seen that the Islamic finance sector is no longer a theoretical possibility
but a practical and viable fact here to stay. However, Islamic banks face many
regulatory, operational and accounting problems which prevent the further realisation
of its Shari’ah oriented ethical and social goals. Further, discounting the nation- wide
Islamic banks of Pakistan, Sudan and Iran (which have government support) the
profitability of small Islamic banks in other countries seems to be in some doubt
(Timewell, 1998). The researcher is of the opinion that Islamic Accounting would be
helpful in developing this important Islamic institution to be in accord with its own
worldview rather than being derailed into the capitalistic mould.
55..33..33 MMoodduuss ooppeerraannddii ooff IIssllaammiicc BBaannkkss Siddiqi (1998b) has classified the activity of Islamic banks into three activities:
a) Services for which the bank charges a fee or commission.
b) Investment of capital on the principle of partnership or mudharaba and
c) Fee based or uncharged services.
The services in category a) above include many of the functions performed by
conventional banks on a fee basis, such as keeping accounts, clearing cheques,
providing funds transfers and business advisory as well as providing financial
guarantees and safety deposit lockers.
The activities under b) are the major theoretical basis on which Islamic banks operate
although a recent survey shows only 20% of financing of Islamic banks is done
through this way (IAIB, 1997). The main activity of a conventional bank, lending and
borrowing money through fixed and savings deposits is changed in an Islamic bank.
The relationship in conventional banking between the bank and its deposit holders is
that of a debtor-creditor relationship. This is not so in the case of Islamic banks. The
relationship in an Islamic bank, depending on the type of deposits, is either trustee
for deposits or a business partner.
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On the liability side, in the case of both current and savings accounts, conventional
banks pay interest based on a pre-determined percentage of the amount deposited
varying with the length of time. The Islamic bank does not pay interest but may give a
gift, which is at the option of the bank. The bank guarantees the principle amount,
which can be withdrawn by the customer at any time. Current and savings account
deposits are based on the Islamic contract of al-wadia’ – safe keeping. Under this
contract, the depositor gives permission to the bank to use the funds in any
Islamically permissible activity but he can request the money back on demand. In
practice, some Islamic banks pay an amount called hibah or gift depending on the
profit of the company, which is permissible. However, the depositor is not legally
entitled to this as that would amount to interest. The bank, however, guarantees the
principal sum.
Islamic banks do not accept fixed or term deposits on which interest is paid. Instead,
customers can open an investment account for a fixed period. After the period, the
customer is entitled to a share of the profit (the percentage share of profits being
pre-determined), if the banks make a profit. If the bank makes a loss, the whole loss
is borne by the customer. This contract is called mudharaba- capital/labour
partnership. Under this contract, the depositor as the capitalist gives the capital to
the bank who acts as the entrepreneur in managing the funds for which it is entitled
to a share of the profit. The banking expenses are not charged to depositors as
management expenses as in the case of a loss, it is wholly borne by the depositor.
The bank is only entitled to a share of profits the ratio being pre-determined at the
beginning of the agreement.
What in fact happens, is all investment deposits are pooled and invested in various
projects- forming portfolios with varying maturities. Sometimes the bank’s
shareholders funds are also pooled to finance projects. In this case, the bank is also
entitled to a share in proportion to its capital invested. Profits are allocated to the
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depositors in proportion to deposit amount and time for which the amount is
deposited with the bank.
Most Islamic banks have two types of investment accounts, unrestricted and
restricted. Unrestricted investment account deposit can be invested in any sector
according to the wishes of the bank, provided the investment does not contradict the
Shari’ah. Restricted Investment accounts allows the depositor to specify in what
sector, his deposit will be invested.
On the Assets side of the balance sheet, conventional banks usually grant credit
facilities such as term-loans, overdrafts and housing mortgage loans. They also
invest in the short-term money market, government securities, treasury bills,
company bonds and equities in the stock exchange. In the case of Islamic banks, as
all interest-bearing instruments are prohibited, these financial instruments, except for
equities, are not available to it. Instead Islamic banks use Islamic financial
instruments, some of which have equity features while others have features of both
debt and equity (Obiyathullah, 1995) and still some others have features of debt. This
will be explained in some detail in the next section.
The third type of activity is unique to Islamic banks (although some conventional
banks provide free overdraft to student customers). Providing interest-free loans is
part of the social activity of Islamic banks although only a small portion of its total
funds is allocated to this. Usually the funds come from Zakat and charity pool created
by the bank from its own Zakat contributions and charitable contributions of others. In
theory, Islamic banks should set aside a portion of the shareholders and depositors
funds for this purpose. It is not certain how many banks actually undertake this
function, as they seem to operate mostly along commercial lines. However, as we
have seen in the case of Mit-Ghamr bank, this is not theoretical and has been
applied in practice. In Pakistan, Islamic banks have given interest-free study loans to
students.
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55..44 TTHHEE AASSSSEETT SSIIDDEE OOFF IISSLLAAMMIICC BBAANNKKSS:: IISSLLAAMMIICC FFIINNAANNCCIIAALL IINNSSTTRRUUMMEENNTTSS::
Since Islamic banks cannot grant loans on interest, the assets side of the balance
sheet cannot have any advances (except interest free loans) as assets. Since banks
cannot earn any money on interest-free loans, they have to resort to participatory
finance and other Islamic financial instruments to earn an income. The researcher
will discuss these Islamic financing instruments below:
55..44..11 MMuurraabbaahhaa aanndd BBaaii aall--MMuu’’aajjjjaall The contract of Murabaha or mark-up originated in the deferred sale (bai almu’ajjal)
contract. In this contract, a buyer of goods requests an agent to do it for him, on the
understanding that the agent will charge a mark-up on the cost of the goods which
will be sold to the buyer. The price was usually deferred and hence the agent usually
quoted two prices, one for spot and a higher price for deferred sales. The Islamic law
of contract allows this higher price on the deferred sale. Various reasons have been
give for the permissibility of this excess, which is akin to interest. Reasons include
opportunity cost foregone by the agent, the risk of default and the risk of the buyer
refusing to take the goods after the agent has acquired to buy on his behalf. The
ownership risk of the goods bought by the agent resides with the agent until delivery
to the buyer. The buyer can refuse to accept the goods at any time before delivery.
The Islamic banks saw this as an opportunity in financing a purchase e.g. a house or
trading stock or a fixed asset and this has become the main financing device of the
Islamic bank. Any person requiring finance e.g. say a car, goes to the bank and
requests the bank to buy it for him. The bank theoretically buys the car adds a mark-
up, depending on the amount and term of the financing required and sells it to the
customer, who pays by instalments. Once delivered, the car becomes the property of
the customer although it could be collateralised. Although this appears as a casuistry
for interest, it has some differences from pure interest based credit including:
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1) The buyer can refuse to take delivery in case of Murabaha.
2) In case of late payment of instalments, the bank cannot add a markup on markup
as a conventional bank compounds the interest on the late instalment.
3) In the case of variable interest rate financing, the conventional banker varies the
interest rate according to the prevailing base lending rate. In the case of
murabaha, the mark-up is fixed and cannot be varied.
4) Of course the produce or service financed cannot be against Shari’ah injunctions
e.g. one cannot buy and re-sell alcoholic products, gambling services or drugs.
Although this instrument constitutes about 50% of financing undertaken by Islamic
banks, it has been frowned up as a back door to interest. Scholars have suggested
minimising or discontinuing this practice. However, the survey by the International
Association of Islamic Banks (IAIB, 1997) shows an upward trend.
55..44..22 MMuuddhhaarraabbaa Mudharaba is a labour-capital partnership, wherein an investor puts up an amount of
capital for a specific period of time with an entrepreneur who conducts business with
the amount. The profit sharing ratio between the entrepreneur and the investor is pre-
determined in advance. At the end of the period, any profits are shared in the agreed
ratio. In case of losses, the investor bears the entire loss, the entrepreneur loses his
labour as he is not paid a salary.
The Islamic bank adopts a two-tier mudharaba contract. In the case of investment
accounts, the depositor is the investor and the Islamic bank, the entrepreneur or
manager of the fund. The bank itself then becomes the investor when it places
money with the actual user of the fund who runs the actual business. In case of profit
the bank and the entrepreneur shares the profits. From the bank’s share of the profit,
a pre-agreed share is given to the depositor. In case of loss, the bank passes on the
whole loss to the depositor. The bank’s overhead expenses are not charged to the
investment accounts as the bank is only entitled to a profit share and is not liable for
loss.
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This was thought to be the ideal contract for Islamic banking. However, empirical
results indicated only 7% of Islamic financing was of this type in 1996 and the overall
trend is negative (IAIB 97). Many reasons have been given for the lack of fervour for
using this mechanism:
1) Agency costs: Borrowers un-Islamically tend to consume perks which reduces
the profit available to the banks and depositors. Obiyathullah (1995) shows how
this contract has both debt and equity characteristics.
2) The tax structures of some Islamic countries are such that no honest traders can
survive. As such, traders normally keep two set of accounts, one for their use and
one for tax purposes which shows lower profits to avoid tax. The second set is
the one usually given to the banks. Even if the entrepreneur does not wish to
cheat the Islamic bank, the fear of being found out by tax authorities dissuade
them from keeping and giving truthful accounts to Islamic banks. Further, while
interest costs are given as tax deduction, profit shares are not allowable in most
legislation, hence increasing the cost of capital of mudharaba financing for
businesses.
55..44..33 MMuusshhaarraakkaa
This is plain partnership financing. Here the bank becomes a full partner of the
entrepreneur who also contributes capital. The bank shares profits and losses of the
business with the entrepreneur in a pre-agreed ratio. In case the bank does not play
an active part in the business, then the entrepreneur may charge management salary
or expenses to the business account. Unlike the case of mudharaba, where the bank
cannot interfere in the running of the business, the bank has full rights of
administration in Musharaka contracts.
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55..44..44 IIjjaarraa Ijara is rent or leasing of assets. Here the bank purchases the asset and leases it to
the borrower. Although, strictly only operational leases are allowed in Islam, most
ijara contracts take the form of financial leases, which transfers the risk and rewards
of ownership to the borrower. Even in the case of a financial lease, since the contract
is a lease agreement, the ownership resides with the bank until the borrower
exercises an option to buy the asset at the end of the lease. The buying option can
be pre-agreed at the inception of the contract. This is known as an Ijara wa iqtina
(Lease and sell) contract.
55..44..55 SSaallaaaamm In the case of Murabaha, the goods to be bought must be in existence at the time of
the contract and capable of delivery. This mode thus cannot be used to finance the
cost of say agricultural output in advance. The salaam contract on the other hand is
an advance purchase contract, where the goods say wheat, of a particular quality
and quantity, which is not yet in existence, can be the subject of a contract. Here the
buyer pays the agreed price in advance for delivery at a certain date. Hence, this
contract can be used to buy commodity futures for example. However, according to
Islamic law, the bank cannot sell this until delivery. In order to overcome this, the
bank enters into another “parallel” salaam contract to sell the same quantity and
quality of goods at a different price. However the second contract cannot be linked to
the first. By means of parallel salaam, the bank can cover its position and make a
profit. In case of delivery failure, the bank can only request the money back without
any penalty or wait longer. This can become an important means of financing
agricultural or fishing activities.
55..44..66 IIssttiissnnaa Istisna is a variation of salaam. It is the payment for commissioned manufacture. A
buyer can contract to have goods manufactured and delivered at a later date, in
accordance to specifications. The buyer has the option of cancelling the contract if
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the delivered item is not to specifications. Although the majority legal opinion is that
the contract cannot be enforced until the manufactured item is delivered and
accepted, the minority opinion is followed binding both parties from the start. Unlike
salaam, payment is at delivery or according to manufacturing or construction
progress. Thus, this instrument can be used to finance construction or
manufacturing projects. Islamic banks have also used and modified this to a “back to
back” istisna where two contracts are made up; one with the manufacturer and one
with the ultimate buyer. The Islamic bank uses this contract to finance the purchase
of ships or airplanes. The bank contracts with the buyer to supply the item for a fixed
future payment schedule. The bank contracts with the shipbuilder to supply the ship
for a series of shorter progress payment. The difference between the present values
of the payments under the two contracts is the bank’s compensation (Vogel & Hayes,
1998).
55..55 AACCCCOOUUNNTTIINNGG PPRROOBBLLEEMMSS OOFF IISSLLAAMMIICC BBAANNKKSS Islamic banks face unique accounting problems both from a technical point of view
and philosophical point of view. Some of these accounting problems are:
1. The problems of profit recognition and allocation due to Islamic banking
mechanics (Abdulgader, 1990; Karim, 1998a),
2. The inappropriateness of International Accounting Standards (Hamid et al.,
1993; Karim, 1999)
3. The hybrid nature of some Islamic financial instruments (Obiyathullah, 1995;
Karim, 1999), and
4. The ethical accountability requirements (Gambling, 1994 ).
55..55..11 PPrrooffiitt sshhaarriinngg Abdulgader (1990) studied profit recognition and allocation problems in Islamic
Banks in Sudan and Egypt. His study examined the practices of four existing Islamic
Banks (each of which had many branches all over Sudan) and found that the profit
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recognition and allocation practices of the three banks were not uniform.
In the first example, the banks separated the investment account funds from the
shareholders and other depositors’ funds. In this case, the investment account funds
were invested separately, after allowing for reserve requirements. This lead to a
separate fund account being established for Investment account holders and
accounted for separately from the others. Hence separate financial statements were
prepared for this fund account. Further the profit were recognised only when the
projects were liquidated; implying that the projects were short-term. After deducting
the bank’s share of profits, the depositors share of profits was distributed to individual
depositors according to the amount and period of the deposit.
In the second case, all funds whether from shareholders, current and savings
accounts and investment accounts were all pooled and invested in various projects.
In this case, the profits earned by the bank excluding those from fee-paying banking
services were made proportionate to average deposit in each type of account. The
share of the current and savings account depositors went to the shareholders, as the
depositors were not entitled to any profit. (In the case of Malaysia, the banks
distribute part of this profit as a gift to savings and current account holders). From the
proportion attributable to the investment account holders, the bank’s share is
deducted and the balance distributed to the investment account holders in proportion
to deposit and period held. Except for expenses directly related to investments, all
other expenses are borne by the bank and not by the investment account holders as
under the mudharaba contract, the bank is only entitled to its share of profits.
In the second case it was difficult to determine each party’s share in investment and
profit as all funds are pooled. The actual amount of investments for each class of
deposits as opposed to the actual amount of deposits cannot be known. In
calculating the share of profit due to investment account holders, the bank estimates
the portion of the depositors account invested by the following steps on each months’
balance:
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1) The actual deposit in each class of account (and shareholders funds available for
investment) is multiplied by the available percentage (100-reserve percent) to
obtain amount available for investment. The reserve ratio is different for each
account. Investment accounts have a lower reserve ratio than other accounts.
2) The actual invested funds for each class of account is apportioned using the
amount available per step 1 divided by total deposits available for investment
multiplied by total amount invested in the month.
3) The monthly amounts are added up for twelve months to get yearly amounts.
4) The total profit is then apportioned to the accounts on the basis of total assumed
investments.
The above method, although rational and equitable on the face of it presents some
difficulties. As the investment account depositors are mainly interested in profit as
they bear the risk, the above allocation does not give any preference to this. Since
savings and current deposits in Islamic banks are not meant to earn profits, they
should not have a claim to profits on an equal basis (although in actual fact, profit
attributed to these deposits goes to the shareholders).
Thus, as in the example from table 5-1 shows, the amount from the investment
account, assumed as invested is only $53,070/$77228 = 68%, whereas current
account deposit invested is also assumed to be 68%. Since investment account
holders assume that their deposits will be invested, it is clear that their funds should
be accorded priority in the distribution of profits. Hence in 1985, the Shari’ah
Supervisory Board of the Faisal Islamic bank recommended that all investment
account deposits less a liquidity reserve be assumed to be invested. Using the new
formula, the investment account deposit assumed to be invested would be £77228
x90%= £69505 (to take account of liquidity ratio of 10% as investment account can
be withdrawn on short notice although not on demand). The amount allocated to
current accounts and shareholders is found as a balancing figure. Hence the profit
allocated to investment funds would be higher.
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TYPE OF DEPOSIT
ACTUAL
DEPOSIT (1)
INVESTMENT AVAILABLE
% (2)
FUNDS FOR INVESTMENT (3)=(1)X(2)
ACTUAL INVESTED
FUNDS (4)
JANUARY 1984 Current Deposit Investment Deposit Savings Deposit Shareholders funds
157,000 77,228 12,454 58,536
70% 100% 90% 100%
109,926 77,228 11,209 58,537
75,54053,070 7,703 40,226
TOTAL 305218 256,900 176,539
TABLE 5-1:PROFIT DISTRIBUTION METHOD IN THE FAISAL ISLAMIC BANK OF SUDAN (SOURCE: ABDELGADER, 1990,P 176).
Despite this apparent improvement, the profit attributed to investment accounts will
vary between different Islamic banks depending on the proportion of current and
savings account deposits. For example, if Bank A has more current and savings
account deposits than Bank B, assuming equal amount of investment deposits, Bank
B will be giving a higher share of profits to its investment account holders. Another
problem, is although, current and savings account holders expect no return, the
shareholders are effectively using these deposits as financial leverage in earning
profits for themselves without giving anything in return to these depositors except
guarantee of capital. Perhaps, in this case, the central bank should regulate the
Islamic banks and insist on a payment of a gift to these accounts (after building up
sufficient reserves to cater for losses). This is legal and recommended (and practised
in certain countries) in Islamic law provided they are not predetermined.
In contrast to the above situation, some Islamic banks do not pool the funds from
investment accounts and treat them as a separate entity. In order to provide a
portfolio instead of matching each deposit to an actual investment, the deposits are
pooled into many projects. However, this method is more risky for the depositor
because the portfolio may not be well diversified. In certain banks, limited
mudharaba certificates are issued which link the securities, issued in fixed
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denominations for a fixed period of time, to a particular project. These certificate
holders are entitled to profits when the project is liquidated. They bear all the losses if
any.
This second type of profit allocation where the funds are not pooled solves the
problem of allocating profits between the various types of depositors. However, it still
has the problem of matching profits because in Islam, the venture has to be realised
to return capital before profit is calculated (Udovitch, 1970). Hence, if a depositor
withdraws his funds before project is liquidated, then he will not be entitled to share in
the profits. The problem of capital gains and losses between accounting period also
presents problems as it does in conventional historic cost accounting. Perhaps a
realisable income model (Edwards & Bell, 1961) would be more appropriate.
Another problem posed by Islamic banks is the nature of investment and savings
deposits. Are investment deposit holders, equity holders? (Karim, 1999). Should
they have say in the administration of banks (i.e. voting rights)? It can be seen that
investment account holders are neither a liability nor equity and to classify them as
such according to conventional accounting principles would amount to unfair
disclosure. Investment accounts have both the characteristics of debt and equity.
They are short or medium term equity holders. Equity holders have long-term
relationship with the banks. They can vote in annual general meetings and take part
in the management of the bank through their directors. By contrast the relationship of
investment account holders vary between short and medium term. However since
they share in the profits and bear all risks associated with their investment, they
should neither be treated as current and savings account holders nor fixed deposit
accounts holders. Perhaps, they should have limited voting rights like debenture
holders, especially in the case of limited mudharaba certificate holders to ensure that
their interests are taken care of properly. Investment accounts cannot be classified
as current liability as are fixed deposit holders in a conventional bank. Perhaps a
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separate balance sheet should be prepared for them, or they should be shown
between equity and current liabilities.
Another problem associated with investment projects relating to investment accounts
is whether they should be consolidated or equity accounted? Presently only profits
received from the projects are incorporated into the accounts. This is inconsistent
with the ruling that Islamic banks are not lenders but managers of the investment
account holders. Conventional banks do not manage the projects they finance except
to monitor periodic reports. Islamic banks as managers of investment account
holders and as partners in case of Musharaka financing would have to take a more
active role in appraising, monitoring and even directing major decisions in ventures
they finance. When they do this, the problem of consolidating results and assets of
financed ventures comes in.
Karim (1999) observes that, in the application of funds, most Islamic banks use the
murabaha-financing instrument. Since the source of financing includes investment
accounts, the profit recognition method used will also affect profit allocation to these
accounts. As Karim (1999) notes, there are at least five different methods of profit
recognition used by Islamic banks in recognising profits in murabaha transactions
where the price of the goods financed are received in instalments which may traverse
several accounting periods. These include:
• Recognising profits in full when customer takes delivery.
• Pro-rata the profits according to due dates of instalments.
• Pro-rata the profits according to receipt of the monthly payments.
• At the liquidation of the transaction i.e. on the last payment date and
• Once the capital has been recovered.
Karim (1999) notes that “the use of any of the above profit recognition methods affect
the returns credited to investment account holders”(p33) as the duration of the
depositors’ investment is generally different from the duration of the murabaha
contract above. In addition, there is no conventional accounting standard to prescribe
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the disclosure of different profit allocation bases (which has been discussed above)
which Islamic banks use to allocate profits between the various account holders.
Hence, applying conventional accounting standards (e.g. IAS), where they are
available, to Islamic banks will result in non-comparable financial statements rather
than induce comparability as there no standards which meet the specific Islamic
banking requirements. This is the rationale behind the formation of the Accounting
and Auditing Organisation for Islamic Financial Institutions (Pomeranz, 1997; Karim
1999) which has some accounting and auditing standards for Islamic banks and
Financial Institutions
55..55..22 CCaappiittaall AAddeeqquuaaccyy RRaattiioo As a result of the recent third world debt crisis, there have been increasing demands
for more capital regulation in the banking industry. One of the most important
measures facilitating this regulation is the capital adequacy ratio (CAR). This ratio is
a measure of a bank’s risk exposure and is usually calculated by finding the
percentage of capital to total balance sheet assets. The CAR of commercial banks is
an important accounting measure used to assess the adequacy of the bank’s capital
in relation to deposits to cover credit risk (Llewellyn, 1988). Regulators use the CAR
as an important measure of the safety and soundness on banks as the capital of
such institutions is viewed as a buffer or cushion to absorb losses (Karim, 1998b)
The increasing pressure from regulators to maintain an adequate ratio has led some
banks to adjust accounting measures to reflect a good ratio. Hence, accounting
practices have major implications for this ratio.
The Basle Accord of the Basle Committee on Banking Supervision implemented
since 1992, sets out an agreed framework for measuring capital adequacy and the
minimum standards to be achieved by the representative countries. The accord is
intended to “strengthen the soundness and stability of the international banking
system and “to be fair and have a high degree of consistency in its application to
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banks in different countries with a view to diminishing an existing source of
competitive inequality among international banks”.
The minimum acceptable Capital Adequacy Ratio (CAR) according to the Basle
Accord is 8%. The majority of countries in which Islamic banks operate have taken
steps to introduce the Basle framework. However because the framework of Islamic
banking is different, the Basle framework geared for conventional banking cannot be
applied as it would lead to Islamic banks not meeting the requirements, although this
would not imply any more credit risk than conventional banks.
As Karim (1998) observes, only share capital and reserves attributable to them would
be considered as capital. Islamic banks issue neither preference shares nor
subordinated debt as they contravene the Shari’ah. Since current account holders of
Islamic banks are not entitled to any return, the revenue generated from them is
exclusively the right of the shareholders. The investment account deposits cannot be
considered as equity or liability but a unique type of Instrument which gives the
depositors right to share in the profits but bear all the losses. Hence, since both
deposit accounts are not paid a predetermined return, they do not constitute a
financial risk to the bank as (in the case of investment accounts) all the losses can be
passed on to the account holders. Although the shareholders funds would have to
bear the losses of capital on investments from current account deposits, the risk of
loosing the capital is much less than loosing both capital and the pre-determined
interest which must be paid to conventional bank account holders.
Karim (1998) illustrates this point through four possible scenarios, each depending
on the way investment accounts are treated by Islamic banks and regulatory
authorities:
In scenario 1, Investment accounts are added to the core-capital (tier 1). This would
increase the CAR and help Islamic banks follow a strategy of attracting high
investment accounts and low equity capital, as Islamic banks do not share losses
only profits from the investment account fund invested. If the amounts of deposit
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accounts were restricted in the calculation of capital, the bank would be forced to
pursue a strategy of raising equity and restructuring its assets to more safe areas like
Government investment certificates.
Scenario 2, which allows for deduction of the investment accounts from the risk-
weighted assets would similarly increase CAR and compensate for assets with high-
risk weightings. Here, shareholders continue to encourage investment accounts
compared to savings accounts.
In scenario 3, investment accounts are added to Tier 2 capital element. In this case,
since tier 2 capital is restricted to 50% of the total of tier1+tier 2 capital, this would
mean that when investment accounts equals equity, there is no benefit to the CAR
calculation. This would mean, after this threshold, Islamic banks would have to raise
shareholder equity.
In scenario 4, no adjustment is made to the CAR calculation in respect of investment
accounts. Islamic banks with CAR below 8% would have to increase their
shareholders equity as the use of investment accounts confers no advantage in the
calculation of CAR. Another way out would be to restructure their assets to include
lower risk weighted assets. Given the nature of Islamic financial instruments, Karim
(1998) observes that the latter option would be more feasible in an Islamic bank
given the nature of financial instruments used by Islamic banks.
Although it is up to regulatory authorities of the various countries to adopt the
appropriate rules, Central bankers of Muslim countries with their conventional
economic and banking training seem not too creative in this matter. In the case of
Sudan (Abdelgader, 1990), the Central Bank wrongly subjected the funds of
investment accounts to their credit ceiling targets meant to control consumption credit
and inflation. Investment accounts, of course, were meant to finance long term, high
return investments. Since the Islamic banks could not invest most of the funds,
profitably it stopped accepting investment deposits altogether, defeating the purpose
for which the bank was set-up.
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Karim’s (1998b) analysis, although constructive and insightful, nevertheless only
skimmed the surface of the implications of the Basle convention for accounting of
Islamic banks. His analysis is limited to the financial strategy of shareholders in
leveraging the use of investment accounts. It does not analyse the CAR standards
implication for the investment strategy in terms of achieving the investment objectives
of Islamic banks i.e. to substitute profit-sharing contracts for risk based contracts
which would bring about the theorised objectives of Islamic banking. As already
indicated, one of the problems of the Islamic banking is that Islamic banks have
opted for the easy use of credit-based Islamic instruments (murabaha) which do not
change the basis of Islamic banks from conventional counterparts to any large
degree (Abdelgader 1990; Ahmed, 1994b). An appropriate indigenous Islamic
capital adequacy ratio standard could have a marked difference in increasing both
investment accounts and more profit-loss financial instruments.
For example, if investment accounts could be added to the core capital or deducted
from total risk weighted assets, (scenario 1 and 2), this could increase the promotion
of investment accounts. Further as the Islamic banks do not bear any losses arising
from the loss of investment deposits (except arising from negligence), the investment
account investments (not deposits) could be deducted from risk weighted assets or
given a 0 or low risk weighting depending on the nature of the instrument. A reverse
risk weighting score could be given. For example, musharaka and mudhraba
investments would be given a lower risk-weighting then those used for murabaha or
ijara investments. This would increase CAR and at the same time encourage Islamic
banks to manage their portfolio carefully, as their earnings will depend on high return
/ high-risk investments. This is so because banks earn only a share of profits and
cannot charge expenses to the investment account deposit holders except for direct
expenses. Hence this is one way, an appropriate Islamic financial standard based on
an accounting number could induce behaviour towards attaining Islamic objectives.
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Another instance would be to consolidate the investments at current costs. Since
Islamic accounting seems to favour current values (Clark et al., 1996; see also
chapter 6), this would reduce CAR. However, if the bank’s share of unrealised capital
gains is added to capital and the current value of investments (from the investment
account funds) were excluded from the risk weighted assets, this would boost CAR,
encouraging such investments.
A development from this would be an “Islamicity” ratio computed using an inverted
risk weighted value of assets. The higher the ratio, the higher the Islamicity of
financial instruments used and would give the user an indication of the extent to
which the Islamic banks are using the funds in profit-sharing instruments and other
social areas in which it should be used.
55..55..33 CCoonnffoouunnddiinngg IInntteerrnnaattiioonnaall AAccccoouunnttiinngg SSttaannddaarrddss
The accounts of Bank like other business organisations are increasingly subject to
both national and international accounting standards, which are increasingly being
globalised in the form of International Accounting Standards. Unfortunately, recent
studies on the cultural impact on national accounting systems seem to be motivated
only towards removing non-European and non-American impediments in the way of
international harmonisation of accounting (Hamid et al., 1993). The researchers do
not contemplate that harmonisation may entail imposing Western and European
accounting practices and the theories behind them upon nations whose commercial
and accounting practices are based on alternative ethical or cultural paradigms.
Thus:
“But the focus has been more to identify what practices and underlying theories have to be changed to fit into the Western paradigm, rather than to discover whether those not conforming to it might give insights to alternative, theoretically defensible accounting processes”. (Hamid et al., 1993, p132)
This may not only distort international comparison (see for example, Choi et al.,
1983) but also upset the socio-economic balance of the recipient countries.
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Hamid et al. (1993) observes that although, harmonisation is pursued under the
pretext of transporting developed accounting practices to countries with lesser
developed practices, such ascription of development to the West, commits the world
to a dominant allegiance to Judaic-Christian influences and ignores traditions
founded in Eastern philosophies. Thus, any implications of accounting being required
to conform to the philosophies underlying Islam, which transgresses national
boundaries, for example, are dismissed without enquiry.
Islamic banking in particular only permits financial support and offers banking
facilities to Islamic compliant businesses. One could therefore reasonably presume
that the prevalence of stricter Islamic banking would lead to higher business
compliance with Islamic principles. This would in turn increase the need for an
alternative Islamic accounting to meet the needs of these organisations.
Hamid et al. (1993) further argues that the prohibition of riba, which is the
cornerstone of Islamic banking has important implications for the harmonisation of
accounting procedures as implementing international accounting standards entail
enforcing many accounting procedures where interest based calculations are
essential. For example, standards on pension benefits (SFAS 87 & 88), amortisation
of long-term debt (APB 12), lease capitalisation (SFAS 12), interest on receivables
and payables (APB 21) and their International Accounting Standard equivalents all
invoke discount calculations based on the time value of money.
Karim (1999) also point out many problems of using International Accounting
Standards for Islamic banks. For example, many Islamic Banks use murabaha
financial instrument. In this cost plus contract, the Shari’ah imposes the condition that
the bank must possess the title to the goods before delivery to customer. The
purchase order made by the customer may or may not be binding on him. Hence the
valuation of such stocks is a problem in the accounts. Should the bank value at lower
of cost and NRV as per current accounting standards or at current market value as
per Zakat accounting requirements.
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IAS’s do not have any standards to deal with the status of investment accounts, as
they are neither equity nor debt in the conventional sense. There are also no
disclosure requirements to disclose the bases of profit allocation between
shareholders and investment account holders. The use of different methods by
different Islamic banks has resulted in the incomparability of their performances.
Profit recognition difficulties have already been alluded to in the section 5.5.1. The
adoption of IAS would not make the Islamic banks accounts comparable but might
achieve the opposite effect.
International Auditing Standards also do not provide for the idiosyncrasies of a
Shari’ah Review or audit which is required of Islamic banks. Neither do they provide
guidelines on the qualifications, independence and competence of Shari’ah Auditors
or Shari’ah supervisory board of Islamic banks. It is no wonder that Muslims have
come up with their own alternative to the IASC in the form of the Accounting and
Auditing Organisation for Islamic Financial Institutions (AAOIFI). This organisation
has issued two Financial Accounting Concepts Statements, ten Financial Accounting
standards and five Auditing standards for Islamic banks (Karim, 1999). The
organisation has also issued exposure drafts on Shari’ah Audit, and Islamic
Insurance Company disclosure standards.
If the current Islamic resurgence permeates Islamic businesses, then there is
definitely a need for the development of Islamic accounting and an International
organisation to develop Islamic Accounting Standards for all Islamic organisations.
Perhaps, the AAOIFI will evolve into such a body.
55..55..44 NNoonn--FFiinnaanncciiaall DDiisscclloossuurree While, the technical problems associated with accounting for Islamic banks have
been emphasised and the AAOIFI been established to deal with it, it should not be
forgotten that Islamic banks are much more than institutions which avoid interest. All
business and non-business Islamic organisations have Islamic ethics as their
founding basis. As such these institutions must account to their owners and other
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stakeholders as to the extent to which they have complied with the ethical dictates.
This involves non-financial as well as financial disclosure. Khan (1994a) observes
that an Islamic bank would have to disclose:
(i) The avoidance of prohibited transactions.
(ii) The extent to which their activities have contributed to the economic and
social development of various poor sectors of society by offering financing
and interest-free loans to for example, farmers and small traders.
(iii) The ethical standard which they have reached in the treatment of employees
and depositors and entrepreneurs.
(iv) Segmental information on the financial instruments used and the efforts
made by the bank to move away from interest-like instruments such as
murabaha.
(v) The extent to which they have safeguarded the environment and conserved
energy.
(vi) The collections and disbursement of Zakat from the bank’s operations, and
(vii) The social and the religious contribution to local community
Conventional accounting places emphasis on financial outcomes, thus conventional
accounting users (e.g. shareholders) may switch to debt financing when economic
conditions make debt financing attractive. They also may switch to other business
activities, which promises the best financial returns to them. However, as Hamid et
al. (1993) notes, whether equity or debt financing promises the best financial returns
to owners or managers, is not the motivating factor in Islamic commerce undertaken
according to the Islamic tradition. Instead success in the hereafter by following God’s
commandments in economic transactions on earth would be the foremost thought of
Muslim users. Hence Islamic accounting would provide information which ensures
their confidence in the integrity of Islamic banks and other organisations. It should
provide assurance that the organisation has invested their money within the
constraints of the Shari’ah, no exploitation or injustice has been done to any quarter
and their money has made a contribution to uplifting the community.
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55..66 CCOONNCCLLUUSSIIOONN In this chapter, the objectives of various forms of Islamic organisations, their
structure, operations and framework under which they operate have been discussed.
The development and operations of Islamic banks were discussed at some length to
emphasise the different paradigm of Islamic business. Hence, the discussion of the
accounting problems related to different financial instruments, profit sharing and the
problems of imposing international banking, accounting and auditing standards on
Islamic is meant as an example of the differences and difficulties Islamic
organisations pose for conventional accounting. It is hoped that this has
demonstrated the practical need for the development of Islamic accounting
Islamic accounting as can be seen from this chapter, is not only a matter of
modifying conventional accounting to fit the needs of Islamic institutions- a major
overhaul is called for. It is not a matter of extrapolating the conventional accounting
principles to specialised entities e.g. in the case of accounting for plantations,
insurance companies or space exploration. The different philosophical assumptions
underlying Islamic organisations and their different operating mechanism, some of
which find no parallel in the conventional business and accounting practices, suggest
a more radical accounting.
Benefits of an Islamic Accounting System for Islamic banks and other organisations
would include:
• Motivating employees, shareholders, managers and participants to be
accountable to society and God and to take a pro-active role in ensuring ethical
economic activity instead of motivating them through higher financial returns to
increase their greed and material possession.
• Ensure the accountability of Islamic organisations to their stakeholders and
thereby ensuring the accountability of Muslims to God in their economic activities.
• Ensure the specific socio-economic objectives for which Islamic organisations
have been established are achieved and to disclose the reasons why they are
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not. The holistic nature of an Islamic accounting system would not deflect the
users from their ethical objectives as conventional accounting, by concentrating
on the financial return, might do.
• The development of Islamic accounting and auditing standards would in time
ensure comparability between different organisations which would promote the
allocation of resources (financial, manpower, government support) to those
organisations which better promote the interests of Islamic societies.
From the above, it can be seen, that Islamic organisations can benefit immensely
from the development of an Islamic accounting system. Failure to develop one, on
the other hand, may contribute to their failure. In the next chapter (chapter 6), the
researcher will discuss the objectives, theoretical framework and the characteristics
of Islamic accounting which is hoped will meet the requirements of the Islamic
organisations discussed in this chapter.