Financial Statement for Islamic Banks

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Conceptual Framework of Islamic Accounting

Accounting Treatment for major Islamic transitions

Disclosure methods for major Islamic transactions

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Investors (potential and existing) (lawful and equitable investment)

Creditors (potential and existing) (lawful trade assets)

Regulators (e.g. CBO)

Syari’ah Supervisory Board & Advisory Council (syari’ah compliance)

Customers (lawful goods and services)

Others who may be effected by the disclosure or non-disclosure of information

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Primary Purpose To enhance the confidence of users of the financial

statements of the IFIs

Objectives Develop accounting and auditing thought relevant to

IFIs Disseminate accounting and auditing thought relevant

to IFIs Prepare, promulgate and interpret accounting and

auditing standards for IFIs Review and amend accounting and auditing standards

for IFIs

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Present entity’s economic resources, obligations and related risks

Determine Zakat obligations

Estimate cash flow and related risk

Ensuring reasonable (or equitable) rates of returns to investors

Disclose Islamic Bank’s discharge of social responsibility (not as a constraint but as a goal)

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To ensure rights and obligations of interested

parties

To safeguard entity assets and rights of others

To contribute to enhancement of managerial

productive capacities

To provide useful information to make legitimate

decisions

Ensure Syari’ah compliance

Distinguish prohibited earnings and expenditure

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Accounting unit Separate legal entity; owners are different from

managers

Periodicity periodic reports of financial positions as of a

given date and divided into reporting periods (normally annual)

Accounting for zakat based on one year complete ownership

Going concern contracts assumed to continue until there is

evidence to the contrary when material uncertainties, those uncertainties

should be disclosed

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Matching of revenues and gains with expenses and losses that relate to that period

Measurement Attributes: acquisition cost (HC), cash equivalent value, asset’s replacement cost etc.

In the case of Zakat measurement, preference is current market value (AAOIFI FAS 9: Cash Equivalent Value)

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“Capable of generating positive cash flows

or other economic benefits in the future

either by itself or in combination with other

assets which the bank has acquired the right

to hold (rightful ownership of maal), use

of dispose (rights on manfaat) as a result

of past transactions or events” (AAOIFI)

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Asset = Capital + Liabilities

When the entity earns profit since it belongs to the owner it ahs to be added with capital.

Asset = Capital + Profit + Liabilities

Profit = Income – Expense

Asset = Capital + Income – Expense + Liabilities

Asset + Expense = Capital + Income + Liabilities

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Asset + Expense = Capital + Income + Liabilities

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Increase Dr Decrease Cr

Increase Cr Decrease Dr

Information should be presented in a way that is readily understandable

by users who have a reasonable knowledge of business and economic

activities and accounting.

Information in financial statements is relevant when it influences the

economic decisions of users. Information is material if its omission or

misstatement could influence the economic decisions of users.

Information must be provided to users within the time period in which it is

most likely to bear on their decisions.

Information in financial statements is reliable if it is free from material

error and bias and can be depended upon by users to represent events

and transactions faithfully.

Users must be able to compare the financial statements of an enterprise

over time to be able to identify trends in its financial position and

performance and to compare the financial statements of different

enterprises.

Qualitative Characteristics

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The accrual basis accounting principle is: revenue should be recognised when realised, and costs should be recognised when they occur.

The ‘realisation’ of the revenue is expressed by three conditions:

1. The institution has earned the right to receive the revenue.

2. There is an obligation on the part of the other party to remit the

revenue.

3. The amount of revenue should be known and collectible with a degree of certainty.

The same is applicable in in recognising the revenue in islamic financial statement.

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Balance sheet: a snapshot of the company’s financial position as at the company’s

accounting year end. It does not reflect the present value of the company.

Income statement: summarises the trading activities, or revenue generating transactions,

that have been undertaken by the company during its accounting period to produce a profit

or loss.

Cash flow statement: identifies how a company’s cash has been generated and how it has

been spent.

Comparative figures: from previous years to enable comparison of the company’s

performance on a year-on-year basis.

Accounting policies: are the basis on which the accounts have been prepared.

Directors’ report: outlines the company’s principal activities and how each has performed,

and also details any significant changes made to its fixed assets.

Auditors’ report: gives an opinion on whether the accounts give a true and fair view of the

company’s activities and financial position and comply with regulatory requirements.

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The buyer promises to buy the goods from Islamic Bank (IB).

The promise could be binding or not depending on the agreement

between the two parties. However, in practice, the promise is

deemed binding and the AAOIFI ruled as such in order to protect

Islamic financial institutions.

IB may ask the customer to provide a down payment in the form of

earnest money (Hamish Jeddiyah). This payment shows the

buyer’s good faith in the transaction.

Upon signing the Murabaha, the down payment becomes part of

the agreed price and thus reflects on the total price.

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Customers A/C / Cash A/C Dr

Hamish Jiddiyya A/C Cr

FAS 2 of AAOIFI states

In case of breach of promise, Hamish Jiddiyyah can be used to

recover actual damages. However it cannot be used for

recovering the Cost of Funds / Opportunity Cost.

Disclosure should be made in the notes as to whether the

promise is binding or not-binding

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Agency Agreement is not the condition of the Murabaha if the institution can make direct purchases from the supplier.

The financial institution, does not have the expertise

to identify the goods and negotiate an efficient price. The customer, however, being in the industry, can do this.

The institution therefore appoints him as its Agent

(which is also permissible), in the first step of the transaction, to identify and procure the goods on institution behalf.

This is done by execution of Agency Agreement

between the institution and the customer.

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Accounting entries for Advance paid to

customer under Master Murabaha Facility

Advance against Murabaha Dr xxx

(Asset – BS)

Cash A/C (BS) Cr xxx

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If the assets bought by the bank directly for

cash

Murabaha inventory A/C Dr

Cash A/C Cr

If the assets bought by the bank directly from

the supplier for credit

Murabaha inventory A/C Dr

Supplier A/C Cr

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If the assets bought by the bank through the customer

under agency agreement

Murabah inventory A/C Dr

Advance Against Murabaha A/C Cr

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Discounts from supplier (If any) would be passed on

to the customer at the time of Murabaha Sale by

reducing the cost of sales.

Alternatively it can be recognized as revenue if sharia

board gives permission. Usually sharia board would

allow it to be shown as in income if the promise is

non binding and the murabaha contract is general

form assets.

The institution (Bank) reserves the right to reject the

purchases if made other then agreed price.

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Asset is initially measured and recorded at historical cost, including all costs necessary to bring the asset in its present location and condition.

AAOIFI requires that if inventory is lying with the Bank, the IAS applicable to inventories shall be applied.

In case where the customer has not fulfilled his promise to purchase the inventory, the same needs to be brought down to Net Realizable Value (NRV).

If he has not defaulted, then even the market value of goods is declined, since the Bank is sure that it is able to sell the inventory at a profit (Murabaha price), it would not be required to write down the inventories.

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Profit shall be recognized at the time of

consummation of sales, if the sale is for cash

or on credit but the term does not exceed the

current financial period.

The profit on portion of Murabaha receivable

not due for payment should be recorded as

“Unearned Murabaha Income” with a

corresponding liability on the balance sheet

called “Deferred Murabaha Income”.

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As per AAOIFI Standard, profits of credit sale whose payment due after the current financial period shall be recognized using any of the following methods: ◦ Preferred method – Proportionate allocation of profits

whether or not cash is received;

◦ Allowed Alternative method – Profit may be recognized as and when the amount is received. Accrued amount of profit which is not yet received is disclosed.

Deferred profits shall be offset against (shown as a deduction from) Murabaha receivables in the statement of financial position / balance sheet.

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Records asset at full

amount of Purchase Price less discount

Rs. 10 M BANK Rs. 12 M

Murabaha Receivable is recorded at Rs. 12 M including unearned

Murabaha income and a liability of Rs. 2

M is recorded.

Any decline in value shall be reflected

at the end of financial period

Liability Rs. 2 M

Asset Rs. 12 M

Rs. 2 M recognized as income over a period of

Murabaha term

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1 Advance paid to customer under Master Murabaha

Facility

Debit Credit

Advance against Murabaha (B/S – Asset Side) 100

Customer’s current account / Cash A/C (B/S) 100

2 Item purchased by the Bank or the customer on

the Bank’s behalf

Murabaha inventory (B/S – Asset Side) 100

Advance against Murabaha (B/S) 100

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3 Murabaha sales – after purchase of items Debit Credit

Murabaha receivables (gross amount) (B/S –

Asset Side)

120

Murabaha Sales (P/L) 120

4 If inventory was recorded then this is the

additional entry required

Murabaha cost of sales (P/L) 100

Murabaha inventory (B/S – Asset Side) 100

5 Profit deferment

Unearned Murabaha income (P/L) 20

Deferred Murabaha income (B/S – Liability

Side)

20

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6 Profit recognition (each month end) Debit Credit

Deferred Murabaha income (B/S – Liability

Side)

5

Unearned Murabaha income (reversal) (P/L) 5

7 Settlement of Murabaha Receivable

Cash (B/S – Asset Side) 30

Murabaha receivables (gross amount) (B/S

– Asset Side)

30

8 Penalty received (Charity)

Cash 1

Charity fund payable 1

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ABC Islamic Bank provides a Murabaha of US$

200,000/- for a Commodity at a constant rate of

return of 10% for period of 5 Years and requires

an annual installment payment of 60,000/-

Requirement

Prepare an extract of the Balance Sheet and

income statement at the beginning and end of

Year 1.

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Workings:

Total Unearned income = (5 × 60,000) – 200,000 = $ 100,000

Income per year $ 20,000

Balance sheet Year 0 Year 1

Murabaha receivable (300,000) (240,000)

Unearned Murabaha income (100,000) (80,000)

Net receivable 200,000 160,000

Income statement

Murabaha Income 20,000

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Amount in

Rupees

Murabaha sale price 465

Purchase price (400)

65

Deferred Murabaha income

Opening balance 135

Deferred during the year 65

Recognised during the year (95)

105

Murabaha receivable

Opening balance 850

Sales during the year 465

Received during the year (730)

585 CBFS

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1. Customer (Mr.First) approaches bank with the request for salam financing

2. Full specifications of the commodity are finalized, sale price is fixed and the date of delivery is agreed upon

3. Collateral against salam finance is agreed

4. Salam agreement is signed between the bank and customer (Mr.First)

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5. Bank pays the full sales price to the customer (Mr.First)

6. Islamic Bank finalizes a second salam agreement with another customer (Mr.Second). This time the bank is the seller of the commodity.

7. Mr.First delivers the commodity to Islamic bank

8. If Mr.First fails to deliver on the due date, Islamic Bank should purchase the commodity from in Open market and honor the pledge to Mr.Second

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Salam payment to the customer is made ◦ Salam Financing (Mr.First) A/C Dr ◦ Cash A/C Cr

Commodity is delivered by the customer ◦ Salam Inventory A/C Dr ◦ Salam Financing (Mr.First) A/C Cr

Cash received from the second customer ◦ Cash A/C Dr ◦ Parrarel Salam (Mr. Second) A/C Cr

Goods delivered to the second customer ◦ Parrarel Salam (Mr. Second) A/C Dr ◦ Salam Inventory A/C Cr ◦ Income on Salam A/C Cr

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Bank signs the first salam agreement with the

customer for R.O 10000 for 100Kg of salam

goods. Banks has decided to make a profit of

15% per annum on the salam contract by

signing a parallal agreement with Mr.Second.

Bank pays Mr.First R.O 10000 on 1st january

2013 with the agreement where Mr.First is

bound to deliver the goods to Mr.Second on

31st Janury 2013.

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Salam payment to the customer is made ◦ Salam Financing (Mr.First) A/C Dr 10000 ◦ Cash A/C Cr 10000

Commodity is delivered by the customer ◦ Salam Inventory A/C Dr 10000 ◦ Salam Financing (Mr.First) A/C Cr 10000

Cash received from the second customer ◦ Cash A/C Dr 10125 ◦ Parrarel Salam (Mr. Second) A/C Cr 10125

Goods delivered to the second customer ◦ Parrarel Salam (Mr. Second) A/ Dr 10125 ◦ Salam Inventory A/C Cr 10000 ◦ Income on Salam A/C Cr 125

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Salam payment to the customer is made

◦ Salam Financing (Mr.First) A/C Dr 10000

◦ Cash A/C Cr 10000

Transfer customer advance to receivable or bad debt account

◦ Receivable or bad debt A/C Dr 10000

◦ Salam Financing (Mr.First) A/C Cr 10000

Buy the goods in open market

◦ Salam Inventory A/C Dr 10500

◦ Cash A/C Cr 10500

Cash received from the second customer

◦ Cash A/C Dr 10125

◦ Parrarel Salam (Mr. Second) A/C Cr 10125

Goods delivered to the second customer

◦ Parrarel Salam (Mr. Second) A/C Dr 10125

◦ Loss on Salam A/C Dr 125

◦ Salam Inventory A/C Cr 10500

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Operating Ijarah is a lease that does not

include a promise that the legal title in the

leased asset will pass to the lessee at the end

of the lease

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It is a lease that concludes with the legal title in the

asset passing to the lessee after Ijarah. Ijarah

Muntahia Bittamleek includes:

Ijarah & transfer of legal title at the end of the lease for

a token consideration or other amount as specified in

the lease

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1. The customer approaches the Bank with the request for Ijarah financing and enters into a promise to lease agreement.

2. The Bank purchases the item required for leasing and receives title of ownership from the vendor

3. The Bank makes payment to the vendor

4. The Bank leases the asset to the customer after execution of lease agreement.

5. The customer makes periodic payments as per the contract.

6. At the end of the tenure customer can purchase the asset from the bank with the help of separate Sale agreement.

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1) Ijarah assets are recorded at cost less accumulated depreciation and impairment.

2) Rental from Ijarah is recognized as income on accrual basis.

3) Costs, including depreciation is charged to income statement.

4) Assets leased out should be classified according to it nature, distinguished from the assets in own use. (i.e. Plant & Machinery, Vehicle etc.)

5) Lessor should make an impairment testing for the asset on a regular basis. Any impairment should be dealt in according to the requirements of IAS 36 “ Impairment of assets.”

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Accounting Policy for Ijarah

Ijarah Asset Recognition

• All Ijarah transactions are to be recorded as “Asset Acquired for Ijarah”

at sum of all Cost incurred by the bank in acquiring the asset..

• Assets are to be stated at their cost less accumulated depreciation

and impairment if any.

• Depreciation is to be charged to income applying the method which

reflects the pattern in which the asset’s future economic benefits are

expected to be consumed by the bank.

• In respect of addition and disposal of assets, depreciation will be

charged from the month of acquisition till the month of disposal.

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Accounting Policy for Ijarah

Revenue Recognition.

Ijarah rentals are to be recognized as income on accrual

basis in a systematic manner over the lease period

Expense Recognition

Carrying costs, including depreciation, incurred in earning

the Ijarah income are recognized as an expense in the

Income statement.

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Case Study for Ijarah

Below is the case study for the understanding of suggested

Ijarah accounting:

Example Amount in Rs./%

Asset Price 100,000

Monthly rentals 5,000

Tenure 3 years

Security Deposit 10,000

Delivery Time 1 month

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Recording Procedures and Disclosure requirements

Feb 28, 07

3) Accrual of income when it is due (Ijarah rentals are considered as income)

Dr Rental receivable 5,000

Cr Rental Income 5,000

Feb 28, 07

4) Recording of depreciation on Ijarah Asset

Dr Depreciation expense 2,500

Cr Accumulated depreciation 2,500

{(100,000-10000)/36}

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Disclosure in Balance Sheet at month end (Feb 28,07)

Assets at cost 100,000

Less:

Accumulated Depreciation (2,500)

Provision for Impairment ( )

Net book value 97,500

5) At the time of receiving of Rental following entry would be passed:

Dr Cash/ Customer Current A/c 5,000

Cr Ijarah rental receivable 5,000

6) At the time of maturity of Ijarah Contract

Dr Security Deposit 10,000

Cr Cash/Customer Current A/c 10,000

Dr Cash/ Customer Current A/c 10,000

Cr Asset acquired for Ijarah at wdv 10,000

Recording Procedures and Disclosure requirements-continued

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7) In case of default in payment of rental

Dr Provision for doubtful debt (expense) XXX

Cr Provision for doubtful debt (accumulated XXX

(with the amount of rental receivable previously accrued and taken to

income)

8) Provision for Impairment of Ijarah assets

Dr Provision for impairment (expense) XXX

Cr Provision for impairment (accumulated) XXX

Recording Procedures and Disclosure requirements-continued

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Disclosure in Balance Sheet at period end

Assets at cost XXX

Less:

Accumulated Depreciation (XXX)

Provision for Impairment (XXX)

Net book value XXXX

Rental Receivable

Rental receivable XXXX

Less:

Provision for doubtful debt (XXX)

Net rental receivable XXXX

Recording Procedures and Disclosure requirements-continued

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The Mudaraba contract is a partnership contract. Mudaraba is the technical term for a ‘managed partnership’ (a partnership between work – a manager or entrepreneur, and capital – one or more investors).

The Mudarib generally does not invest capital, but provides (or invests) skill and effort.

Rab Al Mal – Capital Provider

55

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Islamic Bank provide capital to the Client account (A)

Mudharaba Financing – Client A A/C Dr Cash A/C Cr Fund perform better and earns profit Mudarib receivable A/C Dr Mudaraba Income A/C Cr

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Due to bad economic conditions funds makes losses

Loss on Mudaraba A/C Dr

Mudarib receivable A/C Cr

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Musharaka literally means 'sharing’. The Musharaka contracts are based on a partnership process in which several parties contribute to the financing and the management of a Sharia’a-compliant project. There are two types of Musharaka contracts

Permanent Musharaka

Diminishing Musharaka

60

IB investing its share in the partnership

Musharaka Financing A/C Dr

Cash A/C Cr

The client purchases the shares in installment at a premium

Cash A/C Dr

Musharaka Financing Cr

Income on Musharaka – Capital Gain Cr

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The client purchases the shares in installment at a discount

Cash A/C Dr

Loss on Musharaka – Capital Loss Dr

Musharaka Financing Cr

Partnership releases the profit

Cash A/C/musharaka receivable A/C Dr

Income on Musharaka – Rent A/C Cr

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Persons possessing more than a specified minimum

level of wealth have to purify it by paying Zakat, an

obligatory charitable tax. Zakat is calculated as 2.5%

(lunar calendar) or 2.5775% (solar calendar) of

wealth (the Zakat base).

Two methods can be used for the calculation of the

Zakat base: the Net Asset Method

and the Net Invested Method

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Zakat base = Asset subject to Zakat (minus liabilities to be paid during the year ended on the date of the financial statements:

Equity of UIA Minority Interests Equity owned by governments Equity owned by endowment funds Equity owned by charities Equity of non-profit organisations, excluding

those owned by individuals)

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Zakat base = Paid-up Capital +

Reserves Provisions not deducted from assets Retained Earnings Net Income Liabilities not due to be paid during the year

minus

(Net fixed assets + Investments not acquired for trading + Accumulated losses).

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