INCEIF

The Global University of Islamic finance

MSc in Islamic Finance

Fundamental Accounting Principles from Shari'ah

Perspectives _______________________________________________________________________

ACCOUNTING FOR ISLAMIC FINANCIAL TRANSACTIONS

Semester Sep 2015

Submitted to

PROFESSOR DR ZULKARNAIN MUHAMAD SORI

Submitted by

Md Akther Uddin - 1400225

Yousuf Sultan - 1400226

Mosharrof Hosen - 1500176

Nazim Ullah - 1500015

Table of Contents1. Introduction..................................................................................................................................... 1

1.1. Emergence of Islamic finance and need for Islamic accounting..............................................1

1.2. Objective of the Study.............................................................................................................. 1

2. Substance over Form...................................................................................................................... 2

2.1. Example: IjÉra......................................................................................................................... 3

2.2. The concept of substance over form from the sharī’ah point of view.....................................3

2.3. The Resolution of the Sharī’ah Advisory Council (SAC) of Bank Negara Malaysia (BNM) on the Principle of Substance over Form........................................................................................4

2.4. Literature Review..................................................................................................................... 5

2.5. Commentary............................................................................................................................. 5

3. Time value of money...................................................................................................................... 6

3.1. Interest, Time Value of Money, Discounting Factor and Its Implications...............................6

3.2. The concept of time value from the classical to contemporary jurists.....................................7

3.3. Commentary............................................................................................................................. 8

3.4. Literature Review..................................................................................................................... 8

3.4.1. Commentary...................................................................................................................... 9

3.5. Resolutions on the Time Value of Money................................................................................9

3.5.1. Commentary.................................................................................................................... 10

4. Fare value measurement................................................................................................................ 11

4.1. Classical view on fair value measurement.............................................................................11

4.2. Arguments supporting the fair value measurement................................................................12

4.3. Argument against fair value of money...................................................................................12

4.4. Interpretation.......................................................................................................................... 12

4.5. Commentary........................................................................................................................... 13

5. Application of Probability Principle.............................................................................................13

5.1. Estimation of Probability under AAOIFI and IFRS...............................................................13

5.2. Literature review.................................................................................................................... 14

5.3. Resolutions of the SAC of BNM on probability...................................................................14

5.4. Other Resolutions related to the concept of Probability.........................................................15

5.4.1. Commentary.................................................................................................................... 15

6. Do We Really Need Accounting for Islamic Financial Transactions?..........................................15

7. Conclusion.................................................................................................................................... 16

References:.................................................................................................................................... 19

1. Introduction

Accounting principles are the rules and guidelines that companies must follow when reporting financial data. Accounting principles differ across the world, and countries usually have their own, slightly different, versions of International Financial Reporting Standards (IFRS). Generally Accepted Accounting Principles (GAAP) was widely used and accepted until IFRS has emerged to harmonize accounting standards and currently IFRS standards adapted or adopted in more than 120 countries across the world set by the International Accounting Standards Board (IASB). IFRS are principles based rather than rules based (GAAP) which guide countries to formulate their own accounting standards according to their local needs, rules and regulations. The acceptance of IFRS has grown significantly not only in European countries but also in the USA, where GAAP was widely used before worldwide convergence towards IFRS. This convergence of course helps not only international acceptance and rating of sovereign but also give better comparability picture for multinational investors for whom it would be easier to compare various potential investing companies from different jurisdictions. For example, Malaysian Accounting Standard Board formulates their own accounting standards based on the IFRS principles.

1.1. Emergence of Islamic finance and need for Islamic accounting

The growth of Islamic finance, more specifically, Islamic banking in the last four decades has been phenomenal and many Muslim and non-Muslim countries have started to promote Sharī’ah based financing on the backdrop of global financial crisis, where corruption, manipulation, frictional reserve and subprime credit were rampant and many scholars have started to ask the credibility of financial institutions (Zingales, 2015). The rapid growth of Islamic banking industry in the late eighties and early nineties stimulates to establish a separate accounting standard setting organization for Islamic Financial Institutions (IFIs), consequently on the 27th March 1991, Accounting and Auditing Organization for Islamic Financial Institutions(AAOIFI) was established in Bahrain. AAOIFI has so far issued 26 accounting standards for IFIs and currently, as an independent international organization, AAOIFI is supported by institutional members (200 members from 40 countries, so far) including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry, worldwide. AAOIFI standards are followed – as part of regulatory requirement or IFIs’ internal guidelines – in jurisdictions that offer Islamic finance across Middle East, Asia Pacific, South Asia, Central Asia, Africa, Europe, and North America; and Islamic Development Bank Group (AAOIFI, 2010; AAOIFI Official Website, 2015).

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1.2. Objective of the Study

Prohibition of RibÉ, Gharar and Maysir in financial transactions is the fundamental of Islamic finance which distinguishes it from conventional finance. In addition to that, financial behavior, practice and contracts used by IFIs must be in accordance with the Sharī’ah principles. Although most of the accounting principles issued by IFRS are more or less in line with the Sharī’ah, however, there are some principles which may contradict with the core principles of Sharī’ah. As a result, many scholars propagate for separate accounting standards for IFIs. In the ISRA research paper “An Appraisal of the Principles Underlying International Financial Reporting Standards: A Sharī’ah Perspective”, researchers discuss whether the key underlying principles of IFRS are acceptable from the Sharī’ah perspective. Based on the classical fiqh literature and Sharī’ah resolutions from local and international organizations, the four key principles are: 1) substance over form, 2) time value of money, 3) fair value measurement, and 4) recognition based on probability are elaborated.

We are going to discuss and argue the above mentioned four accounting principles from conventional accounting point of view and explore the classical fiqh literature and resolutions mentioned in the ISRA paper and beyond to support or argue against their views and finally give our own judgment based on the existing literature.

2. Substance over Form

Substance over form refers to the principle of recording a transaction based on its economic substance or financial reality rather than its legal form. For instance, in a sale and buy back contract, the financial reporting will record the overall effect of all contracts involved in the transaction, whereby the profit generated from the contracts will be recorded as the financing cost payable by the finance (BNM, 2010).

IFRS gives greater weight to economic substance rather than legal form for recognition and measurement purposes. For instance, in paragraph 4.6 of the IASB’s Conceptual Framework for Financial Reporting, the preference for economic substance over legal form is specifically mentioned as follows: “In assessing whether an item meets the definition of an asset, liability or equity, attention needs to be given to its underlying substance and economic reality and not merely its legal form”.

AAOIFI on the other hand, even though it did not include the ‘substance over form’ concept as an element of reliability in Statement of Financial Accounting No. 2, but it indirectly recognised this concept in its statements of concepts, although not necessarily in its standards (Napier, 2007).

The principle of substance over form in the reporting of a Sharī’ah -compliant financing transaction means that the end result or substance of the transaction is recorded. The area of

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concern regarding this concept of ‘substance over form’ is that, in applying it, the reporting of a Sharī’ah compliant transaction may render it virtually indistinguishable from an interest-bearing transaction. Thus the difference between a transaction in conventional bank and an Islamic Bank will be insignificant.

2.1. Example: Ijāra

Ijāra is a form of leasing arrangement. The pure Ijāra is essentially an operating lease and there would appear to be little conflict in accounting for this. Another form of leasing increasingly used by IFIs is the Ijāra Muntahia Bittamleek (a lease that concludes with the legal title in the leased asset passing to the lessee) or Ijāra wa Iqtina, which are similar to the hire purchase agreement popular in conventional finance.

This is treated as a finance lease under IFRS because, as with a hire purchase agreement, the risks and rewards associated with owning the asset are in substance transferred to the lessee. Thus under IAS17 the asset would be booked as such by the lessee, while the lessor (the financer) would book a receivable for the rent and related interest receivable (ACCA, 2010).

By contrast, under AAOIFI’s FAS8, the legal form of the contract is paramount, meaning that the ownership of the asset remains with the lessor, until legal title is transferred at the end of the lease period. In this case the IFI would remain the owner, and record the asset on its balance sheet in the same way as an operating lease or operating Ijāra (ACCA, 2010).

The paper argues that in case the principle of ‘form over substance’ is used for the recording of this transaction (according to IFRS), the financial statements will recognise two separate transactions:

(1) Rental is recognised throughout the ijārah period.(2) A sale is recognised when the aqd (contract) to transfer the leased item is entered into.

However, if the ‘substance-over-form’ concept is applied, the financial statements will recognise only one transaction, which is to account for the final sale similar to the case of a conventional hire-purchase agreement whereby the two contracts of lease (hire) and sale (purchase) are combined into one.

2.2. The concept of substance over form from the sharī’ah point of view

The paper argues that Sharī’ah gives importance to both the form and the substance of the transaction. However, as most Islamic financial products are designed by using a series of contracts, debates arise as to whether the effect of each contract in isolation is to be recorded, hence recognizing the ‘form’ of each contract; or whether the overall economic effect of the

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series of transactions is to be recorded, thus recognizing the ‘economic substance’ of the overall transaction.

It further argues that the principle of substance over form is in line with the legal maxims of Sharī’ah. The following two legal maxims give precedence to the substance.

األمور بمقاصدها

“Matters are determined according to intentions.”1

العبرة في العقود لأللفاظ والمعاني ال لأللفاظ و المباني

“In contracts, effect is given to intention and meaning and neither words nor forms.”2

The words maqÉsid and ma’ani refer to the intention indicated by the verbal clues found in the contract that change it to another contract. For example ×awÉlah can be contracted in the name of KafÉlah and vice versa. Similarly, Hibah can become Bay’ if an exchange is conditioned. In case of Mudarabah, if all the profit is conditioned for the Mudarib, the contract will become a qardh contract. On the other hand, if all profits are conditioned for Rabb-al-Maal, the money will be considered Amanah in the hands of Mudarib (Al-Zarqa', 1989).

The paper mentions that the principle of substance over form is supported by Sharī’ah and majority of the scholars have supported it, including the HanafÊs, MalikÊs and HanbalÊs. However, Shafi’i scholars have disagreed and favoured the form over substance.

2.3. The Resolution of the Sharī’ah Advisory Council (SAC) of Bank Negara Malaysia (BNM) on the Principle of Substance over Form

The SAC of BNM, in its 57th meeting3, has resolved that in principle, “substance” and “form” are equally important and highly taken into consideration by the Sharī’ah. In this regard, the Sharī’ah emphasises that “substance” and “form” must be consistent and shall not contradict one another. In the event of inconsistency between “substance” and “form” due to certain factors, the Sharī’ah places greater importance on “substance” rather than “form” (BNM, 2010).

SAC further states that the principle of ‘substance over form’ is in line with the legal maxims of Sharī’ah. In case the substance conflicts with the form, the substance will have the precedence.

1 Ahmad al-Zarqa’, Syarh al-Qawa`id al-Fiqhiyyah, Dar al-Qalam, 1989, p. 47.2 Ahmad al-Zarqa’, Syarh al-Qawa`id al-Fiqhiyyah, Dar al-Qalam, 1989, p. 55.3 Dated 30 March 2006 and 71st meeting dated 26 - 27 October 2007

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2.4. Literature Review

Napier (2007) argues that religion has effect on the construction of reality of the transactions in Islamic Banks, so there can be difference in perception of a similar transaction in a Western context and in an Islamic context. This would render the transactions different in their Islamic substance although they might be similar to conventional bank transactions from a Western perspective (Napier, 2007).

It is argued that there are those who believe that the recognition and measurement of an Islamic financial transaction should give prominence to its legal form to differentiate it from a perceived conventional equivalent. One writer even claims that substance over form is ‘a blatant violation of Sharī’ah. Conversely, others believe that it is acceptable, and would benefit users more, to show the economic substance of an Islamic financial transaction, and information about the legal form may be relegated to the notes to the financial statements (AOSSG, 2010).

ACCA (the Association of Chartered Certified Accountants) states that the conflict between accounting based on economic substance as opposed to Sharī’ah - compliant form appears to be a recurring theme. IFRS is reliant on a strong framework of principles that emphasise the economic nature of transactions, whereas in Islamic finance the contractual aspect of the transaction is crucial for Sharī’ah compliance. Underpinning those contracts are Sharī’ah principles that give rise to products (eg mudaraba, musharaka, salam and istisna) that are unique to the industry and that have different rights and obligations associated with them (ACCA, 2010).

Maurer (2010) argues that there is not much conflict between El-Gamal and Moody’s. El-Gamal has argued persuasively for an Islamic banking that focuses on substance rather than form. For him, substance means meaningful understanding of and adherence to the prohibition of ribā. Moody’s too, put the emphasis on substance rather than form. Where El-Gamal seeks an Islamic finance that is true to the substance of Islamic fundamental principles rather than engaging in analytical or semantic tricks to achieve a “form” that appears in compliance with Islamic norms but introduces a host of inefficiencies and transaction costs, Moody’s seeks an Islamic finance that is true to the market fundamentals (Maurer, 2010).

2.5. Commentary

As mentioned above, the ISRA paper supports the principle of substance over form in financial reporting based on its literature review and sharī’ah resolutions. We agree with it; however we think that the issue doesn’t need to go much further. Substance over form in financial reporting has no conflict with the Sharī’ah in the first stance.

The verse in Al-Qur’an (2:282) which orders us to write a contract says:

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��وُه �ب اْك ُت م%ى ف##" ٍل) م'َس##" "َج##" "ى, َأ -ل د"ْي ٍن) ِإ �م ب##- "نُت د"اْي -َذ"ا َت##" وا ِإ �ِذ-ْيٍن" آم"ن## 'َه"ا ال7## ْي" "ا َأ ْي

-ال ع"د ِل- -ٌب: ب "اَت �م ْك "ُك 7ْي ن �ٌب ب "ُك ُت و"ل ْي

O you who believe! When you deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing. Let a scribe write down faithfully as between the parties. (2:282)

The word ‘writing’ denotes the writing of the contracts, rather than recording in the financial reports. The financial reports are just some records, where we can use any of the principles from substance over form or form over substance. This can be easily understood by the majority Tafseers like Ibn Katheer, Qurtubi etc. However, since the reports are means of communication between the stakeholders, therefore they should have some clarity. And thus we propose that IFRS should have some additional notes or sections that clarifies the types of contracts used in the financial reports, so that they are distinguishable from the interest based contracts.

3. Time value of money

Time value of money is the core principle of finance which explains that money available today is worth more than the same amount in the future; this is because of potential earning capacity of money in the form of interest or be invested up until the time the future dollar is received 4. In other words, money is worth more to an economic actor if it is available immediately for consumption or investment purpose. This concept applies to many contracts; for example, credit sale, and stock, project or company valuation. This concept may be thought of as a financial application of the saying, "A bird in the hand is worth two in the bush." Based on this, it is argued that since current consumption brings more satisfaction than future consumption, people (i.e. creditors) who are asked to postpone current consumption must be compensated for the pleasure foregone today. Hence, in a capitalist economy, this positive time preference—an alternative term for time value of money—lays the rationale for the payment of interest.

3.1. Interest, Time Value of Money, Discounting Factor and Its Implications

Interest is defined in IAS 39 as the consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time”. As the computation of the time value of money and the discounting technique used in calculating Net Present Value (NPV) generally involve reference to the interest rate, many Muslim jurists consider this non-permissible as it is in conflict with the outlawing of interest charges (Ribā) under the Sharī’ah (AOSSG, 2010). In other words, as conventional finance revolves around

4 Time value of money. (n.d.) Financial Glossary. (2011). Retrieved October 2 2015 from http://financial dictionary.thefreedictionary.com/Time+value+of+money

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the interest rate, time value of money is acceptable principle, however, some controversies arise in Islamic finance when we consider in credit sale the deferred price is higher than the spot price, also interest rate as a discounting factor to get the NPV of future cash flows of a stock, project, or company. Consequently, Islamic banking in its current form also appears to accept the validity of charging higher prices for future payments in comparison with prices for immediate payment, such as in the case of the murabaha (cost plus profit) contract. For example, an Islamic bank may charge a customer MYR 2 million for a house if he chooses to repay over twenty years, but only MYR 1.5 million if he pays immediately in full.

In the following section, based on the ISRA article we are going to discuss the concept of time value of money and various issues from the fiqh sources starting from the Quran, the Sunnah, classical and contemporary jurists and the fiqh scholars.

3.2. The concept of time value from the classical to contemporary jurists

The paper argues that a literature review shows that the Sharī’ah does not totally rule out the concept of the time value of money. Authors provided authentic Quranic verses (The Holy Quran, 75: 20-21; The Holy Quran, 87:16-17) to support the permissibility of the time value of money, however, some scholars tend to disagree and they argue that these verses have nothing to do with the time value of money, it is mere admonishing of people who prefer life here than life hereafter. However, we can argue that an innate human nature (fitrah) is to prefer present gratification (al-Masri; Khan FM; al-Zarqa) even though higher reward granted by Allah (SWT) for deferred gratification and some people still prefer not to spend money immediately and save it for the future consumption (Al-Muwdudi, Khan MA). Furthermore, classical and contemporary jurists of four major schools of thought like, Al-Dasuqi, Al-Kasani, Al-Sharbini, and Ibn Taymiyyah support the concept of time value of money, but no sound opposition from scholars are noted in the paper. Therefore, we can state that the time value of money concept in exchange contracts is well accepted among majority scholars but not in loan contracts as the subject matter is money rather than an underlying asset. In this manner, positive time preference has been found acceptable to Sharī’ah scholars in an exchange contract (Khan, 1991; Khaf, 1994; Ahmad and Hassan, 2004).

It is well argued in the article that Sharī’ah permissibility of Bay’ al-Salam and Bay’ al-Istisna further strengthens the support in favor of time value of money. However, we can argue that the difference in the present and future values of the same commodity cannot be considered to have been allowed just because of the pure time element involved (Khan, 1991). As Khan argues that the jurists could have allowed this difference because they recognized that supply and demand forces are different at different points of time. Refuting the idea that demand and supply in the future must have been considered to permit bay’ mu’ajjal, Kahf argues that the legitimacy of bay’ mu’ajjal and bay’ salam can be rationalized along the lines of musharakah, mudarabah, and ijārah on the basis of ownership and the distinction between money’s

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anticipated and realized time value (Kahf, 1994). According to Siddiqui, unlike Kahf’s assertion, bay’ mu’ajjal is neither similar to mudarabah or musharakah, nor could its permissibility be linked to bay’ salam.

While the paper argues that the time value of money concept is also applicable in evaluating projects under construction and higher deferred price in future is settled. But the issue of using interest rate in the discounting process, similar to the conventional practice, given that the Sharī’ah prohibits a fixed promised return on debt transactions, is a significant issue. The issue was also raised by PricewaterhouseCoopers (2010) more specifically, the question is whether the use of a discount rate benchmarked to the interest rate for calculation of fair value purposes actually poses a problem in the context of Islamic financial transactions. Khir (2012) states that there is no consensus regarding this among scholars, some argue there is no issue in using interest rate as a benchmark as they consider this a human innovations which do not contradict Sharī’ah. On the contrary, Zarqa (1983) totally rejects it although he concluded that discounting is accepted and even desirable for promoting investing efficiency, consequently he proposes to use return on equity as the appropriate discounting rate.

3.3. Commentary

Based on the research paper, we can argue that economic agents in an Islamic economy will have positive time preference and there will be indicators available in the economy to approximate the rates of their time preferences. There is no justification to assume zero rate of time preference in an lslamic economy as is done in many studies on investment behavior from lslamic perspective (Khan, 1991; Khaf, 1994; Ahmad and Hassan, 2004). In the following section, we are going to present a review of selected works on the time value of money from Sharī’ah perspective.

3.4. Literature Review

Khan (1991) states that Anas Zarqa, Rafiq al-Masri and Rauf Azhar accepts the concept of positive time preference and time value of money. By analyzing classical and contemporary fiqh scholars and jurists he also confirms that positive time preference or time value of money is acceptable as long as it is not claimed as a predetermined value. Furthermore, he proposes return paid by Islamic banks on deposits of different maturities to be considered as a close proxy for discount rates for the evaluation of projects of different maturities (Khan, 1991).

While critically analyzing Khan(1991), Kahf (1994) considered time value of money is an investment phenomenon not a phenomenon related to abstention from current consumption. Time preference is, therefore, a real factor in the mind of the income earner and provider of investible funds. He further argues that the valuation of time preference can only be affected ex-post because its nature does not allow an opportunity of knowing it ex-ante (Kahf, 1994).

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Ahmad and Hassan (2004) argue that any conditional increase in the loan’s principal in return for a deferred repayment due to an expected depreciation in the value of the money, asset, or other factors (e.g., inflation and commercial losses) is prohibited. They further state that even though there is near consensus among Islamic jurists that in a credit sale contract where repayment is deferred, a commodity’s price may be increased. However, the issue remains unresolved from an Islamic legal financial perspective (Ahmad and Hassan, 2004).

Pervez, on the other hand, argues that there are no specific Islamic theories on money’s time value, since postponing an asset’s enjoyment to a future date is, in effect, a sacrifice made by the investor; an expected depreciation of the money’s or asset’s value due to factors related to inflation, depreciation, and commercial loss (Pervez, 1997).

Khir (2012) states the opponents of TVM have argued that recognizing it will lead to acceptance of Ribā, against which Islam is at war however, he concludes that Islamic acceptance of TVM should not be disregarded, particularly in financial transactions, such as deferred sales and loan contracts, in order to uphold justice. He further argues that if the Sharī’ah parameters are completely complied with, the application of TVM may result in removal of Ribā and achievement of fair economic effects in financial transactions (Khir, 2012).

3.4.1. Commentary

From the above discussion, we can conclude that the principle of time value of money (TVM) is controversial, as Sharī’ah scholars hold differing views regarding its conceptual and practical foundation in the Islamic financial system. The opponents of TVM have argued that recognizing it will lead to acceptance of Ribā, against which Islam is at war. (al Mawdudi, Khan M A). There are arguments for time value of money as time can be given a counter-value in association with real commercial activities; as a result, this concept should not be disregarded in financial transactions, such as deferred sales, in order to uphold justice, given that it must be applied in accord with the specific Sharī’ah parameters. It can be concluded that the Islamic legitimacy of TVM is established on four bases: 1) the concept of Positive Time Preference (PTP); 2) the permissibility of a different price in a cash sale as opposed to a credit sale; 3) the permissibility of bay’ al-salam and bay’al-Istisna; and 4) Islamic legal maxims.

3.5. Resolutions on the Time Value of Money

As discussed in the paper, the Sharī’ah Advisory Council (SAC) of Bank Negara Malaysia (BNM) resolved that the application of time value of money principle in Islamic financial reporting is permissible only for exchange contracts that involve deferred payment. Nevertheless, the SAC prohibits the charging of an extra sum for deferred repayment of Qard (loan). The SAC explained that the jurists had long accepted that there is an economic value to

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time and quoted various classical statements permitting an increase in value due to the lapse of time.

OIC Fiqh Academy also resolved that deferred installment sales are permissible even if the deferred price is more than the immediate price. It is also stated in the ISRA paper that the application of deferred installment sales such as the murabaha contract is unanimously permitted by other authorities such as Kuwait Finance House, Dubai Islamic Bank and al-Rajhi Bank. The contemporary Middle East Sharī’ah scholars recognize the principle of the time value of money in the sale contract—not in a lending contract—and thus allow for the

3.5.1. Commentary

By examining resolutions and guidelines regarding the application of time value of money in Islamic financial transactions, we can argue that majority scholars accept the current use of time value of money concept in murabaha financing as there is an underlying asset and higher deferred price is justified due to risk associated. However, there is no resolution so far regarding using interest rate as a discounting factor in capital budgeting technique but some scholars seem there is no issue in using interest rate as a benchmark (Karim, 2001). Therefore, we tend to agree based on the principle of permissibility in muamalat otherwise not prohibited by Sharī’ah is permissible, the time value of money is the fundamental principle of finance, and majority scholars agree that time does have economic value, therefore they approve time value of money concept in exchange contract and prohibit mere charging of interest on loan contract.

4. Fare value measurement

Fair value measurements have placed greater function in financial statements, because this information is perceived as more relevant to investors and creditors than historical cost information in making financial decision. It is the exit market price which is equal to the benchmark depending on the demand and supply in the market, customer perceived value or utility, cost of the assets and risk characteristics that would result under close-to-ideal market conditions, in a transaction between knowledgeable, independent and economically rational parties, which interact on the basis of an identical information set.

The new Standard FAS 157, Fair Value Measurements, which states in para. 5: ‘Fair value isthe price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’ The IASB framework at present has no definition of fair value, yet a uniform definition can be found on the standards level: ‘Fair value is the amount for which an asset could be exchanged, or a liability settled in difference time period, between knowledgeable, willing parties in an arm’s length transaction.’

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In a current convergence project, the IASB develops an International Financial Reporting Standard (IFRS) on fair value measurements, which is based on SFAS 157 (Hitz, 2007).

Sing et al. (2005) argues that many accounting papers or standard setters have investigated the survey on whether the investors want financial instruments to be measured based on fair value or historical cost. And the results were to use mixture of both. The investors want fair value information so as to better determine the true value of their investment. At the same time, they also wish to see the historical results that provide a measure of cash flows and indicate whether management has achieved operating results that were budgeted or predicted. This kind of thinking in other common circumstances always create a dilemma and desirous to keep all preference (Sing et al, 2005).

An investigation of fair value measurement is important because many commentators have suggested that fair value measurement would be more pervasive under IFRS than under national GAAP. Some suggested that IFRS were a ‘fair value based accounting framework with some exceptions for historical cost’ and that financial reporting under IFRS largely involved the measurement of assets and liabilities at each balance sheet date at fair value and they use it in the financial statement in four ways (Cairns et al, 2011).

4.1. Classical view on fair value measurement

Islam emphasizes fair dealing and just commercial transactions. The prohibition of several forms of sales known to the medieval Arabs, such as talaqqe al-rukban, and najash, is the clear indication of the fair value measurement. Whereas, in determining the fair value, jurists would normally refer to ‘Urf (customary practice). Based on ‘Urf, determination of fair value can be divided into two categories. The first comprises commodities whose prices are commonly known to the public. The second comprises rare commodities. But it is also realized that the fair value would be affected by certain circumstances such as shortage of supply of goods due to market manipulation, war and emergency, customer perceived value or utility, cost of the assets and risk characteristics. Therefore, Islamic law recognizes the role of experts in determining the fair value measurement. Some Sharī’ah scholars require or prefer that certain transactions such as leasing with gradual sale and zakah (poor due) be based on cash equivalent values (fair values) rather than on other measurement bases such as the lower of historical cost or net realizable value (Ibrahim, 2007).

It also appears that the principle of fair value is already being applied within the practice of Islamic finance. For instance, fair value is recognized by all authorities in murabaha financing, especially in the event of customer default. When a customer cannot afford to pay the installments, the Islamic bank will usually sell the asset based on the market value rather than the historical value.

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4.2. Arguments supporting the fair value measurement

Fair value proponents argue that such values are useful to investors in their decision making. Such values stress current cash flow expectations for financial assets as opposed to historical cost and amortized historical cost. Historical cost figures serve to manipulate income as decisions on when to sell the assets can be timed to reflect higher gains or losses (Webinger et al, 2013). Whereas Barth (1994) observes that the fair value of a bank’s investment securities has incremental explanatory power beyond historical cost, but that historical cost measurement has no incremental explanatory power beyond fair value.

4.3. Argument against fair value of money

To the best of our knowledge, the fatwa-issuing authorities in Islamic finance, such as the OIC International Islamic Fiqh Academy and the SACs of BNM, Kuwait Finance House, Dubai Islamic Bank and al-Rajhi Bank have not yet issued specific fatwas relating to the principle of fair value, the issue of discounting, the use of an interest rate for discounting or in valuation techniques for determining fair value. Many banks and other financial institutions criticized this standard due to unrealized losses stemming from their financial assets, contending that FAS 157 aggravated the financial crisis.

Specifically, opponents of FAS 157 asserted that illiquid markets in bank financial assets do not provide realistic long-term asset values that reflect true cash flows and also added that Fair valuation is inherently subjective when contrasted to historical cost, yet few financial statement items are strictly based on historical costs; even plant and equipment are subjected to depreciation and impairments. Applying fair values, in view of their questionable reliability in such constricted markets, has the potential to increase income volatility, reflecting a gulf between accounting income and cash flows (Webinger et al, 2013).

4.4. Interpretation

Seng and Mean (2005) argued that both true value and historical value are important in the organization. True value is needed to determine the investment and historical value is needed for the real cash flow and indicate whether management has achieved operating results that were budgeted or predicted.

According to Azmi (2010), while both AAOIFI and IFRS rely on the concept of fair value, their views apparently differ when there is no active market, which makes assessment of fair value more difficult. The IFRS’ view is that measurement of fair value may require the use of valuation techniques––which often make use of discount rates––rather than relying on quoted market prices. AAOIFI’s (2010) FAS 25, Investment in Sukuk, Shares and Similar Instruments, mentions the use of “estimation techniques” to derive fair value when quoted prices may not be indicative of fair value, but it does not elaborate further regarding the permissibility of using

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discount rates in determining fair value. Finally, AAOIFI and IFRS should be harmonized so that to resolve the differences in the accounting treatment and disclosures of the financial Islamic transaction.

4.5. Commentary

According to our opinion after analyzing ISRA paper and other related papers both fair value and the historical cost are very significant for the institution, since fair value estimation will help the institution for taking investment decision whereas historical cost will help it finding actual cash flow estimation.

5. Application of Probability Principle

The principle of probability refers to the practice of recording transaction although the contract has not yet been completely concluded. In this regard, assets will be recorded once there is a probability of economic resources inflow whilst liability will be recorded once there is a probability of economic resources outflow due to current obligation and its amount can be estimated with certainty. Instances of item recorded based on the principle of probability is wa’d (whether it is a binding promise or non-binding promise) and provision for impairment. Nevertheless, such practice is not meant to equalise promise and contract (aqd). Instead, it is aimed at notifying on the economic effect upon the execution of the arrangement.

5.1. Estimation of Probability under AAOIFI and IFRS

IFRS calculates profit under the IASB’s proposed impairment model, impairment would be recognised (that is, an expense would be deducted from profit) when impairment is expected. It is thus argued whether the use of the impairment model that recognises expected but unrealized expenses is acceptable from the Sharī’ah point of view. In contrast, AAOIFI only caters for the actual profit or loss calculation of an Islamic bank’s share in mudarabah profits or losses, which is required to be recognised only at the time of liquidation, in case the financing transaction is within a one-year period. In case of mudarabah financing that continues for more than one financial period, the Islamic bank’s share of profits for any period, resulting from partial or final settlement between the Islamic bank and the mudarib, shall be recognised in its account for that period to the extent that the profits are being distributed; the Islamic bank’s share of losses for any period shall be recognised in its account for that period to the extent that such losses are being deducted from the mudarabah capital (AAOIFI, 2010, FAS No. 3, Paragraph 2.4).

In the case of ijārah muntahiyah bi al-tamlik, there is a lease with a wa’d to transfer ownership of the leased asset. Under IFRS, if it is demonstrated that it is probable that the transfer of ownership will occur and the value of the transferred item can be measured reliably, then the

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transfer transaction should be recognised, leading to a finance lease treatment. This treatment is different from AAOIFI, which would require the separation of the lease and transfer transactions.

Based on the above discussion we can conclude that, AAOIFI favors recognition of actual profit or loss calculation in deriving the banks’ share in mudarabah profit or losses. Further, it is silent on accepting expected losses used in the impairment model espoused by the IFRS exposure draft.

5.2. Literature review

Certainty is the highest level of confidence in Islam. Whenever possible, Muslims are required to make decisions base on full assurance and certitude. The legal rule which allows the use of probability concept is, Certainty is not overcome by doubt (al-yaqin la yuzalu bi al-shakk). This rule has many corollaries that indicate reliance on certainty. The rule for something is not confirmed before its existence (Al-Din, 1991: 97). That which is expected to occur cannot be treated like that which has occurred (Al-Zarkashi, 1985:161). The presumptive rule is that transitory attributes do not exist (Al-Zarqa, 1989: 107). Despite the emphasis on certainty, Islam also recognizes uncertain circumstances. This is because, in reality, Muslims are faced with many probable occurrences. Hence, the use of the probability concept is not alien to the fiqh literature, and jurists have accepted its use under certain circumstances. There is a legal maxim which states, Acquisition is given the same ruling as present property (Al-Suyuti, 1990: 180).

In the case of a person performing prayer who form the intention to exit the prayer during the next rakah. Is the prayer considered void immediately upon his intention, or is the prayer still considered valid, only becoming void when he actually enters the next rakah? Some scholars opine that the prayer is considered void immediately from the point of such intention, based on these legal maxims. From these legal maxims, it can be deduced that the concept of probability is accepted in arriving at certain fiqh rulings. However, the jurists emphasize the concept of ‘valid probability’, which is defined as events yet to occur that do not contradict injunctions from the Qur’an and Sunnah.

5.3. Resolutions of the SAC of BNM on probability

In this regard, the SAC of BNM was asked whether the principle of probability in Islamic financial reporting is Permissible. The SAC, in its 71st meeting dated 26 - 27 October 2007, has resolved that the application of probability principle in Islamic financial reporting is permissible as it does not contradict the general fiqh principles.

Regarding the basis of ruling, SAC states that some scholars opine that strong presumption (al-zann al-ghalib) may be taken into consideration in ascertaining a ruling. This has been

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discussed by a number of scholars such as al-Amidi (1983), al-Ghazali (1992) and al-Zarqa (1989). In addition, the permissibility of applying the principle of probability in Islamic financial reporting is based on the following legal maxims: Consideration is given to the predominant and widespread, not to the rare (Al-Zarqa, 1989). The original state of thing is permissible. Consideration is based on the prevailing practice and not on the isolated cases. Presumption must be followed (Al-Amidi, 1983).

5.4. Other Resolutions related to the concept of Probability

The OIC Islamic Fiqh Academy resolved that the original ruling of a promise is that it is morally binding. It is considered legally binding as well if the promise is made conditional upon the fulfillment of an obligation and the promisee has already incurred expenses on the basis of the promise. Dallah Al-Barakah issued a similar resolution Research Paper No. 54/2013 (Majma’at al-Barakah al-Masrafiyah, 2007, Resolution No. 2/22: 47, Resolution No. 2/10: 40 and Resolution No. 2/34: 60).

5.4.1. Commentary

There is no specific sharī’ah resolution on the concept of probability in reporting Islamic financial transactions has. From resolutions on the issue of wa’d (whether it is a binding or non-binding promise), we can safely presume that the Sharī’ah scholars don’t have any objection to adopting this concept. This is because all fatwa-issuing bodies agree that a promise is binding on the promisor. If the promisor reneges on his promise, compensation must be paid for damages caused as a result of its non-fulfillment without a justified excuse. Moreover, AAOIFI (2008), in its Sharī’ah Standard No. 8/2/3 (pp. 116-117) and its basis of the Sharī’ah rulings (p. 129), argued that the customer may be forced to fulfill his obligation based on the general sources of the Qur’an and the Sunnah that require fulfillment of obligations and undertakings. Dallah Al-Barakah does not mention clearly the Sharī’ah justification of its resolutions. In this regard, the principle of probability in Islamic financial reporting is permissible.

6. Do We Really Need Accounting for Islamic Financial Transactions?

There are opinions for and against the need of separate Islamic accounting. Many scholars opine that accounting is a process of recording, storing, analyzing and presenting financial information to management and stakeholders in order to help their decision making. Consequently they argue that there is no need for separate Islamic accounting.

On the other hand, many Islamic scholars and jurists argue that conventional accounting principles are based on considering the interest rate, and money is considered as commodity. Hence a creditor expects fixed increase in value of money over certain time period, and

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therefore there is need for separate accounting standards for IFIs (Napier, 2007; Sarea & Hanefah, 2013).

Interest rate is greatly interconnected with the key accounting concepts like time value of money and fair value estimation technique, where interest rate is used as a discounting factor for present value calculation of future stream of cash flows. After analyzing four key accounting principles from Islamic Sharī’ah perspectives, the original sources (the Holy Quran and the Sunnah of the Prophet (PBUH)), classical and contemporary juristic opinions and resolutions from various Sharī’ah Advisory Councils, it is more than evident that there are mix of opinions among Sharī’ah scholars regarding these principles.

We can argue that accounting is above all ‘accounting’ and it is considered as human innovation, where there are very little or no Sharī’ah issues involved (Khir, 2012) as our analysis also support that. Majority scholars didn’t find any contradiction in using such accounting concepts of substance over form, time value of money, fair value estimation and probability.

On the other hand, it can be argued that Islamic accounting is an absolute necessity for IFIs as their ultimate goal is not only to maximize shareholders wealth but to maximize the welfare of stakeholders and uplift maqasid al-Sharī’ah. As accounting information plays a vital role for management, board of directors, regulators, government agencies, existing and potential investors, the presentation of each and every transactions in IFIs must be in accordance to Sharī’ah, so that all stakeholders can make rational and informative decision and minimize asymmetry of information which exist in conventional accounting practices, like sophisticated manipulation and double accounting i.e. accounting for internal use and external reporting in order to get unfair advantages.

Therefore, in order to upheld the principles of Sharī’ah let alone establish an interest free economy, just, fair and ethical accounting practices is necessary, consequently, it can be argued that Islamic accounting can fulfill the vacuum exist in conventional accounting practices.

7. Conclusion

Accounting for Islamic financial transactions has been evolving as a separate discipline from mere intellectual discourses among academia. The development of Islamic finance, namely, Islamic banking has stimulated the need for separate accounting frameworks for financial institutions which run on the principles of Islamic Sharī’ah. Hence many proponents argue that it is high time to develop unique standards in order to be distinct from conventional financial system. Consequently AAOIFI has been established exclusively for developing accounting standards of IFIs but the acceptability of its standards is not overwhelming and only confined with few gulf and African countries. On the contrary, many argue that IFIs can easily

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accommodate existing accounting standards issued by IFRS to comply with Sharī’ah with minimum modification, therefore, propose greater convergence towards IFRS like in Malaysia. In doing so, scholars try to find controversial accounting principles that exist in IFRS accounting standards which may contradict with Sharī’ah principles and subsequently identify four accounting principles: substance over form, the time value of money, fair value measurement and probability.

The principle of substance over form in the reporting of a Sharī’ah compliant financing transaction means that the end result or substance of the transaction is recorded. The area of concern regarding this concept of ‘substance over form’ is that, in applying it, the reporting of a Sharī’ah compliant transaction may render it virtually indistinguishable from an interest-bearing transaction. Thus, the difference between a transaction in conventional bank and an Islamic Bank will be insignificant. As a result, we tend to argue that the issue doesn’t need to go much further as substance over form in financial reporting has no conflict with the Sharī’ah in the first stance. The financial reports are just some records, where we can use any of the principles from substance over form or form over substance. This can be easily understood by the majority Tafseers like Ibn Katheer, Qurtubi, etc. However, since the reports are means of communication between management and the stakeholders, therefore they should have some clarity. Therefore, we propose that IFRS should have some additional notes or sections that clarify the types of contracts used in the financial reports, so that they are distinguishable from the interest based contracts.

Time value of money is a fundamental concept in not only conventional finance but also in Islamic finance as Sharī’ah does not totally rule out this principle. Majority of scholars tend to agree that time has economic value therefore it is necessary to take into consideration with higher deferred price in credit sales, where payment will be made in the future and there might be risk and uncertainty associated with it, subsequently to upheld justice for both parties in the contract. It can be concluded that the Islamic legitimacy of TVM is established on four bases: 1) the concept of Positive Time Preference (PTP); 2) the permissibility of a different price in a cash sale as opposed to a credit sale; 3) the permissibility of bay’al-Salam and bay’al-Istisna; and 4) Islamic legal maxims. Although, there is no resolution so far regarding using interest rate as a discounting factor in capital budgeting technique but some scholars consider there is no issue in using interest rate as a benchmark (Karim, 2001). Therefore, we tend to agree based on the principle of permissibility in muamalat otherwise not prohibited by Sharī’ah is permissible, consequently, time value of money concept is acceptable in exchange contract and prohibit mere charging of interest on loan contract.

Fair value measurements have placed greater function in financial statements, because this information is perceived as more relevant to investors and creditors than historical cost information in making financial decision. Proponents of this concept tend to argue that such values are useful to investors in their decision making. Such values stress current cash flow

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expectations for financial assets as opposed to historical cost and amortized historical cost. According to our opinion after analyzing ISRA paper and other related literature on both fair value and the historical cost are very significant for the financial institution and scholars consider the role of experts and the use of estimation techniques in determining the fair value when there is no clear market price for a commodity. However, the issue of using interest rate as a discounting factor in an estimation technique is still to be resolved.

The principle of probability refers to the practice of recording transaction although the contract has not yet been completely concluded. In this regard, assets will be recorded once there is a probability of economic resources inflow whilst liability will be recorded once there is a probability of economic resources outflow due to current obligation and its amount can be estimated with certainty. Even though the paper states that certainty is the highest level of confidence in Islam but at present there is no specific sharī’ah resolution except the SAC of BNMon the concept of probability in reporting Islamic financial transactions. From resolutions on the issue of wa’d (whether it is a binding or non-binding promise), we can safely presume that the Sharī’ah scholars don’t have any objection to adopting this concept. This is because all fatwa-issuing bodies agree that a promise is binding on the promisor. If the promisor reneges on his promise, compensation must be paid for damages caused as a result of its non-fulfillment without a justified excuse. As a result, we can argue that the principle of probability in Islamic financial reporting is permissible.

Finally, we can confirm that four fundamental accounting principles are more often than not in line with sharī’ah principles based on opinions of classical and contemporary fiqh scholars which are also supported by resolutions from various SAC in different countries. Although, there is no specific sharī’ah objection on these principles, there exist strong arguments for the separate accounting principles for IFIs in order to be distinctive from conventional financial system and ultimately fulfill the goal of Maqasid al- sharī’ah.

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