Principles of Islamic banking and finance/PIBF202/Financial reporting/Islamic Accounting Basics

Islamic Accounting: Principles and Distinguishing Feature

The accountants have been brought up with the knowledge that accounting is a technical, value-free and objective discipline. It is hard to accept when the same idea is connected with some religious principles, such as accounting in Islam. However, religion has always exerted a profound influence on many aspects of human life and personality. Every society has a religious dimension, which it shares and expresses in all aspects of the social life of individuals: their laws, their customs and habits. More importantly, religion may be regarded as the lens through which all understanding and thinking take place, making it the foundation of all decisions and actions. As such, religious ideas and practices have always been at the centre of human activities. Religion, therefore, can reasonably be seen as a part of the overall set of cultural values of a society. Thus, if culture influences accounting, by implication, religion, particularly Islam, may also influence accounting practice. More importantly, given the rise in Islamic banking and finance throughout the world, the emergence of an Islamic accounting system seems plausible rather inevitable.

Islamic society operates under different principles and assumptions. While operating a business, the owners and managers have the role of stewardship toward society. The Shariah guidelines defines duties towards employees, customers and competitors. That is why objectives of Islamic accounting are different from those of conventional accounting. Here are the two main reasons:

1. Islamic banks and other Islamic financial and business institutions deal within a Shariah framework. As a result, the nature of their transactions is different from that of their conventional counterparts.

2. The users of the information generated by Islamic financial institutions have different needs from the users of the information published by conventional institutions.

Conventional Accounting

Conventional accounting defines accounting as the identification, recording, classification, interpreting and communication of economic events to permit users to make informed decisions (AAA, 1966). The focus here is on a narrow group of stakeholders, namely the creditors, the banks as well as the investors. Further, conventional accounting concentrates on identifying economic events and transactions, while Islamic accounting must identify with the socio-economic and religious events and transactions.

Islamic Accounting

Islamic accounting is an “accounting process” which provides appropriate information (not necessarily limited to financial data) to stakeholders of an entity enabling them to determine if the entity is continuously operating within the Sharia framework. Islamic accounting is also a tool which enables Muslims to evaluate their accountability to God. Thus Islamic accounting is broader in scope. Not only is one accountable to fellow human beings, one is ultimately accountable to God Almighty. This is the primary and most important difference between Islamic and conventional accounting.

Business organizations in an Islamic economy must undertake activities that align with the Sharia. These activities must be classified, recorded and summarized using the Sharia framework and Islamic accounting standards to produce accounting statements for users. Information that is provided must be useful, lawful and appropriate so that users may make more informed economic and social decisions. Needless to say, Islam emphasizes on the need of the community.

The Need for Islamic Accounting

Accounting is a tool to achieve certain objectives. The American Accounting Association in 1975 defines the purpose of accounting as a tool “to permit informed decisions which will enable scarce resources to be allocated efficiently thereby achieving social welfare”. Thus, in order for accounting to be useful, it must be relevant for its purpose. More specifically, since the environment in Muslim societies is culturally different in several respects from that of the developed West, it follows that the objectives of 'Islamic' accounting may also be different.

Given that Islamic institutions such as Islamic banks or the Pilgrims Fund Board of Malaysia are established to meet the socio-economic objectives of the Sharia, these institutions should logically use Islamic accounting. If such a system is used, then Muslim users will make decisions in a manner congruent with Islamic values. This will in turn achieve the socioeconomic objectives of the Sharia, thus strengthening the Islamic economic and financial system.

In contrast, if conventional accounting (which was developed to meet the needs of a capitalist economy) is used, there would likely be a mismatch. This will lead to the institutions not meeting the socio-economic objectives of the Sharia. What is even worse is that these Islamic institutions may turn into capitalist institutions, providing materialist profit-focused information instead of the holistic information provided by Islamic accounting. More importantly, using an Islamic accounting system would result in an ethical based accounting system which measures not only profits but social, environmental and religious performance.

Differences between Islamic and Conventional Accounting

Primarily, the differences between Islamic and conventional accounting are:

i. The objectives of providing the information ii. The type of information identified, how it is measured, recorded and communicated, and iii.The users

Differences in Objectives

Islamic Accounting

i. To determine if organizations abide by the principles of the Sharia ii. To determine if the socio-economic objectives are achieved

Conventional Accounting

i. To permit informed decisions by users whose ultimate purpose is to efficiently allocate scarce resources to their most efficient (and profitable) uses

Differences in Type of Information

Islamic Accounting

i. identifies socio-economic and religious events and transactions. Holistic in its reporting. ii. Use current values iii. Deemphasizes the focus on profits. iv. Value Added Statement to replace the Income Statement

Conventional Accounting

i. Identifies economic events and transactions ii. Use lower of historical cost and current values (although currently the emphasis is on fair value)

Differences in Users of information

Islamic Accounting

Serves a wider spectrum of stakeholders

i. equity holders ii. current and savings account holders iii. regulatory agencies such as the Central Bank iv. other depositors v. investment account holders vi. zakat agencies, and vii. others who transact business with the bank viii. community

Conventional Accounting

Serving an elite group

i. creditors ii. banks iii. investors

Two Important Aspects of Islamic Accounting

This section is based on the following article freely available on net. All the references mentioned here can be found in that article: Yaya, Rizal & Ibrahim, Shahul (2010) Objectives and characteristics of Islamic Accounting: Perceptions of Muslim Accounting Academicians in Yogyakarta, Indonesia.

The debates on the characteristics of Islamic accounting are focused on two aspects (1) financial measurement and (2) disclosures and presentations.

Therefore, the following section will discuss those two aspects of Islamic accounting characteristics.

Financial Measurement Aspects

Most of Islamic accounting literature takes Zakat as a cornerstone of determining measurement tools. There are, at least, three reasons for taking Zakat as the main focus of measurement issues. Firstly, Zakat is a concept in Islam that deals specifically with the measurement of assets. This can be inferred from some verses in the Qur’an and Hadith of the Prophet Muhammad (pbuh) regarding the timing and the way in which Zakat is calculated. Secondly, Zakat has been decreed in many verses directly after the ordinance of prayer and considered as one of the five pillars of Islam. This implies that Muslims are encouraged to establish instruments (including accounting instruments) in order to ensure this obligation can be fulfilled in accordance with the Shariah of Islam. Thirdly, the development of accounting in the early Muslim government are closely related with the practice of Zakat. During that time, the Islamic State had already provided accounting books and reports for the determination and accountability of Zakat. In valuing Zakat, the majority of jurists appear to have concluded that it should be based on the selling prices prevailing at the time Zakat falls due (al-Qardhawi, 1988). This implies that in accounting, Islamic business organizations should apply current cost rather than historical cost which is widely used at this time (Adnan & Gaffikin, 1997; Baydoun & Willet, 1997 & 2000; Clarke et al, 1996; and Haniffa & Hudaib, 2001). Besides that, some accounting principles related to the measurement also need to be redefined. For instance, Haniffa & Hudaib (2001) argued that what is meant in Islamic accounting by the conservatism principle is not the selection of the accounting techniques that has the least favorable impact on owners but more towards the selection of accounting techniques with the most favorable impact on society i.e. better to overestimate funds for Zakat purposes. The AAOIFI (1996) recognizes the current value concept of assets, liabilities and restricted investments in its statement of accounting concepts. However, due to the lack of adequate means, such a concept is not recommended. Instead of that, historical cost remains to be applied and the use of the current value financial statement is only regarded as supplementary information if the enterprise considers its importance for the potential investor and other users. Therefore, in practice, it is the historical cost which is applied by Islamic banks (Shihadeh, 1994). Mirza and Baydoun (2000) view this issue differently in that Islamic accounting is likely to use both historical cost and market selling prices. Therefore, an Islamic accounting system would have a dual system of asset valuation. This argument is based on the premise that an Islamic enterprise needs to adhere both to the contract and discharge its obligation on Zakat. Since contract is based on past transaction and Zakat is based on current valuation, then the measurement needs to conform to each purpose. Mirza and Baydouns assertion (2000) on the application of historical cost in all (except for Zakat purposes) accounting calculations, is based on the arguments that historical cost is a highly reliable source of information about a firm’s assets, private debts, the firms operation and cash management. In their opinion, historical cost also fits well into the concept of stewardship, which they believe is the objective of Islamic accounting. The historical cost method could highlight the fiduciary responsibility of the managers and their stewardship function. This method is most appropriate because contracts are written in historical cost numbers and this has survived over the centuries and if there were a more efficient valuation method it would have displaced the historical cost system long ago. It can be said that, unlike the current valuation method, historical cost has no Shariah basis to be applied in an Islamic enterprise. The contract fulfillment principle in Islam cannot be used as the basis for applying historical cost for measurement purposes as contract itself is a kind of past activity but for the future realization[3]. Therefore, at the time of measurement, it is the current valuation which should be used. In this case, the use of historical cost could corrupt the principles of disclosing the truth (Al-Qur’an 2:42) and forbidding withholding it (Al-Qur’an 83:7). These principles encourage every enterprise to disclose the truth as it is, with neither understatement nor overstatement. On the other hand, the historical cost reflects a type of conservatism that would lead to the understated valuation in time of inflation.

Disclosure and Presentation Aspects

Haniffa & Hudaib (2001) propose that the importance of disclosure and presentation is to fulfill the duties and obligations according to the Islamic Shariah. To achieve this purpose, an Islamic enterprise is expected to disclose at least: (1) any prohibited transactions they made; (2) Zakat obligation they have to pay and have already paid; and (3) social responsibility. Social responsibility would include charities, wages to employees, and environmental protection. This means that financial reporting in an Islamic society is likely to be more detailed than what is currently prevalent in Western societies. Baydoun and Willet (2000) view that social accountability and full disclosures are the basis of Islamic corporate reports. They suggest the current value balance sheet be included as part of the reporting requirements of firms operating in an Islamic economy. Meanwhile, the income statement should be relegated to the notes because of its corruptive influence in directing people to become highly profit oriented. Instead of that, from an Islamic perspective, a Value Added Statement (VAS) should be applied. This is because the distributional characteristics of the VAS would support accountability in Islam through co-operative enterprise as opposed to destructive competition (Baydoun and Willet, 1997). The VAS, however, is basically a rearrangement of the income statement. Therefore, the existence of the VAS to provide a significant difference from an income statement is questionable. Just like the income statement, the VAS is also an ex-post report which would have no influential control on the enterprise's social aspect for the current year. But to some extent it can still be used by workers to influence the enterprise on policy following the issuance of the VAS in aspects such as bonus payment. Besides, community at large could also use it to enforce the enterprise to be more aware of their social responsibility whereas an income statement has no such specific tools. From an Islamic perspective, growth should lead to social justice and a more equitable distribution of power and wealth. Meanwhile, the VAS could provide information on wealth distribution between the different sectors of society and is likely to facilitate focusing a firm's performance from the stakeholders' point of view (Mirza & Baydoun, 2000). Hence it would promote a conscious policy of redistribution and resource transfers among various groups of society (Sulaiman, 1997). However, besides the distributional aspect of sources, Islam is also concerned about the acquisition of those sources. Islam requires that the sources acquired should meet the category of halal (permitted). To achieve this category, those sources should be permissible (halal) in nature and also permissible in the process of acquisition. The problem in the VAS is that, it does not provide a space for such consideration as it is only concerned with the distributional aspects of the sources. Therefore, in our opinion, it can be said that the VAS is insufficient in meeting the Islamic requirements for information. Pertaining to the disclosure presentation issue, Mirza & Baydoun (2000) suggested that the Islamic financial statements require an emphasis on transparency and avoidance of manipulation, which is manifested by the full disclosure principle of Islamic corporate reports. However, Khan (1994) is pessimistic about this principle especially on firms disclosing negative information about themselves i.e. unfair treatment of employees, environmental pollution, cheating income tax calculation. Firms will think that they will be in the grip of the law if they disclose all these matters. Therefore, Khan (1994) suggests that it is only certain transactions, which are lawful in the capitalist framework but unlawful in the Islamic framework (e.g. interest income, interest paid, investment on mark-up without taking any risk and other riba type transactions) that should be adequately disclosed in the financial statements of Islamic business firms. To be adequate, disclosure of unlawful transactions should involve amounts, sources and circumstances which force the firm to engage in such transactions, and the method by which such incomes or assets will be disposed of (Khan, 1994).