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Unique accounting problems

Islamic banks face unique accounting problems both froma technical point of view and philosophical point of view.Some of these accounting problems are:

1. The ethical accountability requirements (Gambling,

1994;Shahul & Yaya, 2003) ). 2. The problems of profit recognition and allocation due to

Islamic banking mechanics (Abdulgader, 1990; Karim,1998a),

3. The inappropriateness of International Accounting

Standards (Hamid et al., 1993; Karim, 1999) 4. The hybrid nature of some Islamic financial instruments

(Obiyathullah, 1995; Karim, 1999), and

5 Profit sharing

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Abdulgader (1990) studied profit recognitionand 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 thatthe profit recognition and allocation practices

of the three banks were not uniform.

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In the second case it was difficult to determine each partys 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:

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 aboveallocation 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).

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Thus, as in the example from table 5-1 shows, the amountfrom the investment account, assumed as invested is only

$53,070/$77228 = 68%, whereas current account depositinvested is also assumed to be 68%.

Since investment account holders assume that theirdeposits will be invested, it is clear that their funds shouldbe accorded priority in the distribution of profits.

Hence in 1985, the Sharia Supervisory Board of the FaisalIslamic bank recommended that all investment accountdeposits less a liquidity reserve be assumed to be invested.

Using the new formula, the investment account depositassumed to be invested would be 77228 x90%= 69505

(to take account of liquidity ratio of 10% as investmentaccount can be withdrawn on short notice although not ondemand).

The amount allocated to current accounts and shareholdersis found as a balancing figure. Hence the profit allocated to

investment funds would be higher.

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Despite this apparent improvement, the profit attributed to investment

accounts will vary between different Islamic banks depending on theproportion 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 givinga higher share of profits to its investment account holders.

Another problem, is although, current and savings account holders expectno return, the shareholders are effectively using these deposits as financialleverage in earning profits for themselves without giving anything in returnto these depositors except guarantee of capital. Perhaps, in this case, thecentral bank should regulate the Islamic banks and insist on a payment of agift to these accounts (after building up sufficient reserves to cater forlosses). This is legal and recommended (and practised in certain countries) inIslamic law provided they are not predetermined.

In contrast to the above situation, some Islamic banks do not pool the fundsfrom investment accounts and treat them as a separate entity. In order toprovide 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 Mudaraba certificatesare issued which link the securities, issued in fixed denominations for a fixedperiod of time, to a particular project. These certificate holders are entitledto profits when the project is liquidated. They bear all the losses if any.

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This second type of profit allocation where the funds are not

pooled solves the problem of allocating profits between the varioustypes of depositors. However, it still has the problem of matchingprofits 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 beentitled to share in the profits. Theproblem of capital gains and losses betweenaccounting period alsopresents problems as it does in conventional historic costaccounting. Perhaps a realisable income model (Edwards & Bell,1961) would be more appropriate.

Another problem posed by Islamic banks is the nature ofinvestment and savingsdeposits. 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 neithera liability nor equity and to classify them as such according toconventional accounting principles would amount to unfairdisclosure.

Investment accounts have both the characteristics of debt andequity.

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They are short or medium term equity holders. Equity holders have longterm

relationship with the banks. They can vote in annual general meetings and take partin the management of the bank through their directors. By contrast the relationshipof investment account holders vary between short and medium term.

However since they share in the profits and bear all risks associated with theirinvestment, they should neither be treated as current and savings account holdersnor fixed deposit accounts holders. Perhaps, they should have limited voting rightslike debenture holders, especially in the case of limited Mudaraba certificate holdersto ensure that their interests are taken care of properly.

Investment accounts cannot be classified as current liability as are fixed depositholders in a conventional bank. Perhaps a 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 onlyprofits received from the projects are incorporated into the accounts.

This isinconsistent with the ruling that Islamic banks are not lenders but managers ofthe investment account holders. Conventional banks do not manage the projectsthey finance except to monitor periodic reports.

Islamic banks as managers of investment account holders and as partners in case ofMusharaka financing would have to take a more active role in appraising, monitoringand even directing major decisions in ventures they finance. When they do this, theproblem of consolidating results and assets of financed ventures comes in.

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Karim (1999) observes that, in the application offunds, most Islamic banks use the murabaha-

financing instrument. Since the source of financing includes investment

accounts, the profit recognition method used willalso affect profit allocation to these accounts.

As Karim (1999) notes, there are at least fivedifferent methods of profit recognition used byIslamic banks in recognising profits in murabaha

transactions where the price of the goodsfinanced are received in instalments which maytraverse several accounting periods.

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These include:

Recognising profits in full when customer takes delivery.

Pro-rata the profits according to due dates of installments.

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 recognitionmethods

affect the returns credited to investment account holders(p33) as the

duration of the depositors investment is generally different from theduration of the murabaha contract above.

In addition, there is no conventional accounting standard to prescribe thedisclosure of different profit allocation bases (which has been discussedabove) which Islamic banks use to allocate profits between the variousaccount holders.

Hence, applying conventional accounting standards (e.g. IAS), where theyare available, to Islamic banks will result in noncomparable financialstatements rather than induce comparability as there no standards whichmeet the specific Islamic banking requirements.

This is the rationale behind the formation of the Accounting and AuditingOrganisation for Islamic Financial Institutions (Pomeranz, 1997; Karim

1999) which has some accounting and auditing standards for Islamic banksand Financial Institutions

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Capital Adequacy Ratio

As a result of the recent third world debt crisis, there have been increasingdemands for more capital regulation in the banking industry.

One of the most important measures facilitating this regulation is the capitaladequacy ratio (CAR).

This ratio is a measure of a banks risk exposure and is usually calculated by findingthe percentage of capital to total balance sheet assets. The CAR of commercial

banks is an important accounting measure used to assess the adequacy of thebanks capital in relation to deposits to cover credit risk

(Llewellyn, 1988). Regulators use the CAR as an important measure of the safetyand soundness on banks as the capital of such institutions is viewed as a buffer orcushion to absorb losses (Karim, 1998b)

The increasing pressure from regulators to maintain an adequate ratio has ledsome 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 theminimum standards to be achieved by the representative countries.

The accord is intended to strengthen the soundness and stability of theinternational banking system and to be fair and have a high degree of consistencyin its application to banks in different countries with a view to diminishing an

existing source of competitive inequality among international banks.

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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 stepsto introduce the Basle framework. However because the framework of

Islamic banking is different, the Basle framework geared for conventionalbanking cannot be applied as it would lead to Islamic banks not meetingthe requirements, although this would not imply any more credit risk thanconventional banks.

As Karim (1998) observes, only share capital and reserves attributable tothem would be considered as capital. Islamic banks issue neither

preference shares nor subordinated debt as they contravene the Sharia.Since current account holders of Islamic banks are not entitled to anyreturn, the revenue generated from them is exclusively the right of theshareholders. The investment account deposits cannot be considered asequity or liability but a unique type of Instrument which gives thedepositors right to share in the profits but bear all the losses. Hence, sinceboth deposit accounts are not paid a predetermined return, they do not

constitute a financial risk to the bank as (in the case of investmentaccounts) all the losses can be passed on to the account holders. Althoughthe

shareholders funds would have to bear the losses of capital oninvestments from current account deposits, the risk of loosing the capitalis much less than loosing both capital and the pre-determined interest

which must be paid to conventional bank account holders.

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Karim (1998) illustrates this point through four possible scenarios,

each depending on the way investment accounts are treated byIslamic 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 astrategy of attracting high investment accounts and low equitycapital, as Islamic banks do not share losses only profits from theinvestment account fund invested. If the amounts of depositaccounts were restricted in the calculation of capital, the bankwould be forced to pursue a strategy of raising equity and

restructuring its assets to more safe areas like Governmentinvestment certificates.

Scenario 2, which allows for deduction of the investment accountsfrom the risk weighted assets would similarly increase CAR andcompensate for assets with high-risk weightings. Here, shareholderscontinue to encourage investment accounts compared to savingsaccounts.

In scenario 3, investment accounts are added to Tier 2 capitalelement. In this case, since tier 2 capital is restricted to 50% of thetotal of tier1+tier 2 capital, this would mean that when investmentaccounts equals equity, there is no benefit to the CAR calculation.

This would mean, after this threshold, Islamic banks would have toraise shareholder equity.

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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 ofinvestment accounts confers no advantage in the calculation of

CAR. Another way out would be to restructure their assets toinclude lower risk weighted assets. Given the nature of Islamicfinancial instruments, Karim (1998) observes that the latter optionwould be more feasible in an Islamic bank given the nature offinancial instruments used by Islamic banks.

Although it is up to regulatory authorities of the various countriesto adopt the appropriate rules, Central bankers of Muslim countrieswith their conventional economic and banking training seem nottoo creative in this matter.

In the case of Sudan (Abdelgader, 1990), the Central Bank wronglysubjected 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 investmost of the funds, profitably it stopped accepting investmentdeposits altogether, defeating the purpose for which the bank wasset-up.

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Karims (1998b) analysis, although constructive and insightful,

nevertheless only skimmed the surface of the implications of theBasle convention for accounting of Islamic banks. His analysis islimited 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 objectivesof Islamic banks i.e. to substitute profit-sharing contracts for riskbased contracts which would bring about the theorised objectivesof Islamic banking.

As already indicated, one of the problems of the Islamic banking isthat Islamic banks have opted for the easy use of credit-basedIslamic instruments (murabaha) which do not change the basis ofIslamic banks from conventional counterparts to any large degree(Abdelgader 1990; Ahmed, 1994b). An appropriate indigenousIslamic capital adequacy ratio standard could have a markeddifference in increasing both investment accounts and more profit-loss financial instruments.

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For example, if investment accounts could be added to the core capital or

deducted from total risk weighted assets, (scenario 1 and 2), this couldincrease the promotion of investment accounts. Further as the Islamicbanks do not bear any losses arising from the loss of investment deposits(except arising from negligence), the investment account investments (notdeposits) could be deducted from risk weighted assets or given a 0 or lowrisk weighting depending on the nature of the instrument. A reverse riskweighting score could be given.

For example, musharaka and mudhraba investments would be given alower 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 highreturn / high-risk investments. This is so because banks earn only a shareof profits and cannot charge expenses to the investment account depositholders except for direct expenses. Hence this is one way, an appropriateIslamic financial standard based on an accounting number could inducebehaviour towards attaining Islamic objectives.

Another instance would be to consolidate the investments at currentcosts. Since Islamic accounting seems to favour current values (Clark et al.,1996; see also this would reduce CAR. However, if the banks share ofunrealised capital gains is added to capital and the current value ofinvestments (from the investment account funds) were excluded from therisk weighted assets, this would boost CAR, encouraging such investments.

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A development from this would be anIslamicity 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.

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Confounding International Accounting

Standards The accounts of Bank like other business organisations are increasingly

subject to both national and international accounting standards, which areincreasingly being globalised in the form of International AccountingStandards. Unfortunately, recent studies on the cultural impact onnational accounting systems seem to be motivated only towards removingnon-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 theoriesbehind them upon nations whose commercial and accounting practicesare 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 Westernparadigm, rather than to discover whether those not

conforming to it might give insights to alternative, theoreticallydefensible accounting processes.

(Hamid et al., 1993, p132)

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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.

Hamid et al. (1993) observes that although, harmonisation is pursued under thepretext of transporting developed accounting practices to countries with lesserdeveloped practices, such ascription of development to the West, commits

theworld to a dominant allegiance to Judaic-Christian influences and ignorestraditions founded in Eastern philosophies.

Thus, any implications of accounting being required to conform to thephilosophies underlying Islam, which transgresses national boundaries, forexample, are dismissed without enquiry. Islamic banking in particular onlypermits financial support and offers banking facilities to Islamic compliant

businesses. One could therefore reasonably presume that the prevalence ofstricter Islamic banking would lead to higher business compliance with Islamicprinciples. This would in turn increase the need for an alternative Islamicaccounting to meet the needs of these organisations.

Hamid et al. (1993) further argues that the prohibition of riba, which is thecornerstone of Islamic banking has important implications for theharmonisation of accounting procedures as implementing internationalaccounting standards entail enforcing many accounting procedures whereinterest based calculations are essential.

For example, standards on pension benefits (SFAS 87 & 88), amortisation oflong-term debt (APB 12), lease capitalisation (SFAS 12), interest on receivablesand payables (APB 21) and their International Accounting Standard equivalentsall invoke discount calculations based on the time value of money.

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Karim (1999) also point out many problems of using International

Accounting Standards for Islamic banks. For example, many IslamicBanks use murabaha financial instrument. In this cost plus contract,the Sharia 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 Zakataccounting requirements.

IASs do not have any standards to deal with the status ofinvestment accounts, as they are neither equity nor debt in theconventional sense. There are also no disclosure requirements todisclose the bases of profit allocation between shareholders and

investment account holders. The use of different methods bydifferent Islamic banks has resulted in the incomparability of theirperformances.

Profit recognition difficulties have already been alluded to in thesection 5.5.1. The adoption of IAS would not make the Islamicbanks accounts comparable but might achieve the opposite effect.

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International Auditing Standards also do not provide for theidiosyncrasies of a Sharia Review or audit which is required ofIslamic banks. Neither do they provide guidelines on the

qualifications, independence and competence ofSharia Auditors orSharia supervisory board of Islamic banks. It is no wonder thatMuslims have come up with their own alternative to the IASC in theform of the Accounting and Auditing Organisation for IslamicFinancial Institutions (AAOIFI).

This organisation has issued two Financial Accounting ConceptsStatements, ten Financial Accounting standards and five Auditingstandards for Islamic banks (Karim, 1999).

The organisation has also issued exposure drafts on Sharia 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 Islamicaccounting and an International organisation to develop IslamicAccounting Standards for all Islamic organisations. Perhaps, theAAOIFI will evolve into such a body.

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Non-Financial Disclosure

While, the technical problems associated withaccounting for Islamic banks have been emphasisedand the AAOIFI been established to deal with it, itshould 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 stakeholders as to the extent to which theyhave complied with the ethical dictates.

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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 economicand

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 theefforts

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 banks operations,

and

(vii) The social and the religious contribution to local community

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Conventional accounting places emphasis on financial outcomes,

thus conventional accounting users (e.g. shareholders) may switchto debt financing when economic conditions make debt financingattractive.

They also may switch to other business activities, which promisesthe best financial returns to them.

However, as Hamid et al. (1993) notes, whether equity or debtfinancing promises the best financial returns to owners ormanagers, is not the motivating factor in Islamic commerce

undertaken according to the Islamic tradition. Instead success in the hereafter by following Gods commandments

in economic transactions on earth would be the foremost thoughtof Muslim users.

Hence Islamic accounting would provide information which ensurestheir confidence in the integrity of Islamic banks and other

organisations. It should provide assurance that the organisation hasinvested their money within the constraints of the Sharia, noexploitation or injustice has been done to any quarter and theirmoney has made a contribution to uplifting the community.

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Conclusion

In this chapter, the objectives of various forms of Islamic organisations,their discussed. The development and operations of Islamic banks werediscussed at some length to emphasise the different paradigm of Islamicbusiness.

Hence, the discussion of the accounting problems related to differentfinancial instruments, profit sharing and the problems of imposing

international banking, accounting and auditing standards on Islamic ismeant as an example of the differences and difficulties Islamicorganisations pose for conventional accounting.

It is hoped that this has demonstrated the practical need for thedevelopment of Islamic Accounting Islamic accounting as can be seen fromthis 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 organisationsand their different operating mechanism, some of which find no parallel in

the conventional business and accounting practices, suggest a moreradical accounting

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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 higherfinancial returns to increase their greed and material possession.

Ensure the accountability of Islamic organisations to their stakeholders andthereby ensuring the accountability of Muslims to God in their economicactivities.

Ensure the specific socio-economic objectives for which Islamic

organisations have been established are achieved and to disclose thereasons why they are not. The holistic nature of an Islamic accountingsystem would not deflect the users from their ethical objectives asconventional accounting, by concentrating on the financial return, might do.

The development of Islamic accounting and auditing standards would intime ensure comparability between different organisations which wouldpromote the allocation of resources (financial, manpower, governmentsupport) to those organisations which better promote the interests ofIslamic societies.

From the above, it can be seen, that Islamic organisations can benefitimmensely from the development of an Islamic accounting system. Failure todevelop one, on the other hand, may contribute to their failure