Principles of Islamic banking and finance/PIBF202/Financial reporting/Conceptual Framework for Accounting for Islamic Financial Institutions

1. Introduction
AAOIFI developed Statement of Financial Accounting 1 (SFA 1) on objectives of accounting for Islamic financial institutions, and Statement of Financial Accounting 2 (SFA 2) to address the conceptual framework for accounting for Islamic financial institutions. SFA1 was discussed in last section, Chapter 4. This section discusses SFA 2.

SFA2 identifies 3 approaches to developing concepts:

I. Concepts developed elsewhere which are consistent with Islamic ideals of accuracy and fairness e.g. relevance and reliability

ii. Those concepts which are inconsistent with the Sharia, e.g. time value of money, and historical cost

iii. Concepts which are unique to fiqh muamalat.

2. Functions of Islamic Banks
SFA 2 points out four main functions of Islamic banks as follows:

i.	Investment Management ii. Investment iii. Financial services iv. Social Services

Islamic banks may perform investment management based on either a Mudaraba contract or an agency contract. On the basis of a Mudaraba contract, the bank (in its capacity as a Mudarib) receives a percentage of the returns only in case of profit. However, in case of loss the bank receives no reward for its effort and the provider of funds (the rabb-al-mal) incurs the whole loss. If an agency contract is used, the bank receives either a lump sum or a percentage of the invested amount irrespective of whether or not a profit is realized.

The Assets of an Islamic bank
On the Asset side, Islamic banks invest funds (both owners’ equity and by account holders) using investment vehicles consistent with the Sharia. These include Murabaha contracts, leasing, joint ventures, Mudaraba contracts, Salam or Istisna’ contracts, formation of enterprises or the acquisition of controlling or other interests in existing enterprises, trading products, and investment or trading in publicly traded shares or real estate.

Investment accounts may be divided into:

i.	unrestricted (i.e. unrestricted Mudaraba), or ii. restricted (i.e. restricted Mudaraba).

Unrestricted Mudaraba

a) The investment account holder authorizes the Islamic bank to invest the account holder’s funds in a manner which the Islamic bank deems appropriate without laying down any restrictions as to where, how and for what purpose the funds should be invested. b) The Islamic bank can commingle the investment account holder’s funds with its own funds or with other funds the Islamic bank has the right to use c) The investment account holders and the Islamic bank generally participate in the returns on the invested funds.

Restricted Mudaraba

a.	The investment account holder imposes certain restrictions as to where, how and for what purpose his funds are to be invested. b.	The Islamic bank may be restricted from commingling its own funds with the restricted investment account funds. c.	There may also be other restrictions which investment account holders may impose.

3.	Recommended Financial Statements
SFA2 proposes the following set of financial statements for Islamic banks:

i.	Statement of Financial Position. ii. Statement of Income. iii. Statement of Cash Flows. iv. Statement of Retained Earnings or Statement of Changes in Owners’ Equity. v.	Statement of Changes in Restricted Investments. This is a financial statement reflecting changes in restricted investments managed by the Islamic bank for the benefit of others whether based on a Mudaraba contract or an agency contract. vi. Statement of Sources and Uses of Funds in the zakah and Charity Fund, and vii. Statement of Sources and Uses of Funds in the Qard Fund

The first four statements are also prepared by conventional banks while the last three are unique to Islamic banks. Additionally, the last two are financial statements reflecting the Islamic bank’s role as a fiduciary of funds made available for social services. In line with Baydoun and Willett (2000) and Sulaiman and Willett (2003), the Malaysian Accounting Standards Board suggests the voluntary adoption of other reports such as the Value Added Statement and environmental reports.

Islamic banks

•	Statement of Financial Position. •	Statement of Income. •	Statement of Cash Flows. •	Statement of Retained Earnings or Statement of Changes in Owners’ Equity. •	Statement of Changes in Restricted Investments. This is a financial statement reflecting changes in restricted investments managed by the Islamic bank for the benefit of others whether based on a Mudaraba contract or an agency contract. •	Statement of Sources and Uses of Funds in the zakah and Charity Fund, and •	Statement of Sources and Uses of Funds in the Qard Fund •	Notes

''Conventional banks

''•	Statement of Financial Position. •	Statement of Income. •	Statement of Cash Flows. •	Statement of Retained Earnings or Statement of Changes in Owners’ Equity. •	Notes

Statement of Changes in Owners’ Equity:
The statement indicates investment by owners and the distributions made to owners.

Statement of Retained Earnings
The statement reflects the distribution of dividends to owners.

Statement of Cash Flows
The statement indicates the cash and cash equivalent inflows and outflows for the IFI. Specifically, it shows the cash flows from operations, from investing activities as well as cash flows from financing activities.

Statement of Changes in Restricted Investments and their Equivalent
The Statement of Changes in Restricted Investments and their Equivalent is an off balance sheet statement. The basic elements of this statement include restricted investments as of a given date, deposits and withdrawals by holders of restricted investment accounts and their equivalent, restricted investment profits and losses before the investment manager share in in investment returns.

Statement of Sources and Uses of Funds in the zakah and Charity Fund
The basic elements of this financial statement include sources and uses of zakah and charitable funds during the accounting period.

It is important to note that the first zakah conference held in Kuwait in 1984 concluded that a corporation can be regarded as a legal person and be subjected to zakah.

However, in the following four cases the company is required to satisfy its zakah obligation on behalf of its owners.

i.	When the law requires the company to satisfy the zakah obligation as an entity ii. When the company is required by its charter or by-laws to satisfy the zakah obligation as an entity. iii. When the general assembly of shareholders passes a resolution requiring the company to satisfy the zakah obligation as an entity. iv. When individual owners authorize the company to act as their agent in satisfying the zakah obligation.

In addition, holders of investment accounts and other accounts as well as other parties may ask the Islamic bank to act as an agent in meeting the zakah obligation on their interest in the bank.

Zakah and charity fund should be distributed to the 8 asnafs as follows:

i.	the poor ii. the needy iii. the amil (those employed to administer the funds) iv. those whose hearts have been (recently) reconciled (to the truth) v.	those in bondage vi. those in debt vii. those who fights for the cause of Allah and viii. the wayfarer

Charity (sadaqah) and zakah, according to Sharia, have different conditions of collection and distribution. However, AOIFI does not distinguish the two funds.

Statement of Sources and Uses of Funds in the Qard Fund Qard loans are loans that do not attract any returns. An Islamic bank may organize such a fund to meet its social objectives. The statement reflects the sources of funds and uses of qard funds during an accounting period.

5. The Accounting Assumptions (Concepts, Principles and Conventions)
The accounting concepts, postulates, principles and conventions underlying conventional accounting are general decision rules derived from the objectives and theoretical concepts of accounting. These include the historical cost, revenue, matching, objectivity, full-disclosure, conservatism, materiality, uniformity, comparability, the monetary measurement as well as the entity concept.

SFA 2 discusses the following concepts:

a. the accounting unit concept (accounting entity)
The Islamic bank is regarded as a separate entity, thus separating the bank’s liability from that of its owners.

b. the going concern concept
In the absence of persuasive evidence to the contrary, financial accounting assumes the continuation of an entity as a going concern.

Mudaraba and Musharaka contracts are generally for specific periods. However, these are assumed to continue until one or all of the parties involved decide to terminate such contracts. The going concern concept has an important implication to an Islamic bank. Assumptions are made about the continuity of the bank’s activities in the future, including its investment activities. However, the relationship between the bank and owners of investment accounts may not continue until the liquidation of investments, when actual resultsbecome known. It may, therefore, be appropriate to measure investments during the life of such investments at their cash equivalent values in order to achieve equity in determining the rights of holders of investment accounts who wish to withdraw their funds before the actual liquidation of investments.

c. the periodicity concept
Islam assigns certain rights to money and wealth and associates such rights with periods of time to ensure that obligations pertaining to such rights are fulfilled on a timely basis. Zakah is a good example. Thus, Islamic banks need to present periodic reports reflecting their financial position as of a given date and the results of their operations during a specific period in order to disclose the rights and obligations of the bank and those of interested parties.

d. the stability of the purchasing power of the monetary unit
The use of monetary units as a means of expressing the basic elements of financial statements is a prerequisite for measuring the financial position, results of operations and other changes in the financial position of an accounting entity during a specific period. This raises one pertinent question that of the stability of the measurement unit in view of a change in its purchasing power. SFAC2 did not include a discussion on this important issue. For purposes of financial accounting for Islamic banks, the stability of the purchasing power of the monetary unit is assumed.

SFA 2 also discusses, under the measurement concepts, the following:

e. revenue recognition (realization) concept
Recognition defines the basic principles that determine the timing of revenue, expense, gain and loss as well as assets and liabilities.

Revenue recognition (Realization concept)

Revenues should be recognized when realized. Realization of revenues takes place when the following conditions are met:

i.	The bank should have earned the right to receive the revenue. ii. There should be an obligation on the part of another party to remit a fixed or a determinable amount to the bank. iii. The amount of revenue should be known and should be collectible with reasonable degree of certainty, if not already collected.

f. matching
The bank’s net income (net loss) for a period of time should be determined by matching revenues and gains with expenses and losses that relate to that period of time in accordance with the basic principles of accounting recognition.

g. measurement attribute (the historical cost concept and other alternative measures)
This refers to the determination of the amount at which assets, liabilities and, in turn, equity of the holders of unrestricted investment accounts and their equivalent and owners’ equity are recognized in the bank’s statement of financial position. The same applies to restricted investments.

Measurement attribute may include the following:

i.	the acquisition cost of the asset, (historical cost concept) ii. the net realizable or cash equivalent value of the asset as of a given date, iii. the asset’s replacement cost as of a given date or iv. any other attribute whose measurement would result in relevant information

However, SFA 2 does not discuss the monetary measurement concept, substance over form and prudence and accruals. The choice of the above should be guided by the relevance, reliability, understandability and comparability of the resulting information provided to users of financial statements.

6. The Cash Equivalent Value
This refers to the number of monetary units that would be realized (or paid) if an asset was sold (or purchased) for cash in the normal course of business as at a particular date.

i.	The cash equivalent value is suitable as a basis for accounting measurement for an Islamic bank for both present and potential holders of investment (restricted or unrestricted) accounts. The investment account holder’s evaluation needs to take into consideration, among other factors, the cash equivalent value he expects to realize from the funds he has provided or expects to provide to the bank to finance restricted or unrestricted investments.

ii. The cash equivalent value is important for the equitable allocation of the results of unrestricted investments between the holders of unrestricted investment accounts who have provided or withdrawn funds at different points of time during the duration of the investments.

iii. Similarly, equitable allocation is also needed between unrestricted investment account holders and the bank. Unlike owners of the Islamic bank, holders of investment accounts may withdraw their funds at the end of their contract. This means that if unrestricted investments were to be measured at their acquisition (historical) cost, inequities would occur in the distribution of investment results.

The cash equivalent value is also relevant with respect to holders of restricted investment accounts. It would appear that the cash equivalent value aligns with IASB’s “fair value” measurement.

7. The Qualitative Characteristics of Accounting Information
The usefulness of accounting information must be evaluated in relation to the objectives of presenting financial statements. Accounting information is provided to external users to make more informed decisions. Thus, information must be relevant and reliable.

a. Relevance
Accounting information is relevant if it helps the main users of financial statements evaluate the potential outcomes of maintaining or establishing relationships with the Islamic bank.

Relevance requires that the information has the following three qualities:

I. Predictive value Information should enable the user to predict the potential outcome of a current or a new relationship with the bank.

ii. Feedback value This means that the information should enable the user to verify the accuracy of his prior prediction and make adjustments.

iii. Timeliness Information should be available when it is needed. Lack of timeliness reduces the value of information or detracts from its usefulness.

b. Reliability
This refers to information that permits users to depend on with confidence. Reliable accounting information should have the following qualities:

a.	Representational faithfulness Information should have a close correspondence with reality. b.	Objectivity

This means that the results reached by a person can be substantially duplicated by another independent person using the same measurement and/or disclosure methods.

c. Neutrality
This means that accounting information should serve the common information needs of its users without bias or unfair information advantage given to one group of users at the expense of others.

d. Comparability
Information provided should enable users to identify real similarities and differences in the bank’s performance in relation to its own performance over time and in relation to the performance of other banks.

e. Consistency
An Islamic bank should be consistent in its application of accounting measurement and disclosure methods from one period to another.

f. Understandability
Understandability depends on the nature of the Information contained in the financial statements, the way the Information is presented as well as the background and abilities of external users.

8. Preparation and Presentation of Accounting Information
The principles of Islamic jurisprudence include rules that regulate priorities and classifications of human needs, namely daruriyat (necessities), hajiyat (needs) or tahsiniyat (commendables). Among these principles is the principle of gharar (uncertainty of price quality, quantity or time of delivery in a contract) and the principle of choosing the least detrimental alternative.

Materiality
Information that is qualitatively or quantitatively important (material) should be presented. Materiality and adequate disclosure are interrelated and these are also related to the concepts of relevance and reliability. Materiality in financial accounting is a state of relative importance. Importance may depend on quantitative or qualitative characteristics or a combination of both.

Information is material if its omission, non-disclosure or misstatement would result in distortion of the information being presented in the financial statements. In deciding whether a particular information is material, its nature and amount be taken into consideration.

Qualitative materiality considerations include:

i.	The inherent importance of the transaction, event or circumstance which an item reflects. These include whether the item is usual (or unusual), expected, recurring (or non-recurring), in compliance with Sharia (or not) legal (or illegal), etc. ii. The inherent importance of the item as an indicator of probable course of future events (that is whether the item is indicative of new activities, represents substantive changes in current activities or changes in the bank’s practices). Quantitative materiality considerations include:

i.	The amount of the item relative to normal expectations. ii. The magnitude of the item in relation to an appropriate base. For example, income statement items in relation to net income after deducting the share of unrestricted investment accounts, or the average operating income for a number of past years; or statement of financial position items in relation to total assets, total investment accounts or owners’ equity.

Cost of information
Generally the cost of information provided should be expected not to exceed the benefits to users of financial accounting information in their decision making either at the individual level or the societal level.

Adequate disclosure
Adequate disclosure means that the financial statements should contain all material information that will enable users to make more informed decisions.

There are two aspects to adequate disclosure: optimal aggregation of accounting data and appropriate descriptions and clarifications.

i. financial statements should provide sufficient details to meet the users’ need for information about various categories of assets, liabilities, equity of holders of unrestricted investmentaccounts and their equivalent, owners’ equity, revenues, expenses, gains, losses, cash flows, changes in owners’ equity, changes in equities of holders of restricted investments accounts and their equivalent, sources and uses of funds in the zakah and charity fund, sources and uses of funds in Qard fund.

ii. headings, captions and amounts must be supplemented by enough additional descriptions and explanations so that their meaning is clear.

9. Summary
The chapter discusses the approach taken by AAOIFI in arriving at the accounting concepts of Islamic financial institutions. Additionally, the various elements of financial statements of Islamic banks are examined, accounting assumptions, recognition and measurement concepts as defined by SFA2 explained and the qualitative characteristics of accounting information required for Islamic banks deliberated. Finally, the chapter discusses the issue of materiality, cost and adequacy of disclosure in the preparation and presentation of accounting information for Islamic financial institutions

10. Related Articles

1.	Karim, RAA (1995), “The Nature and Rationale for a Conceptual Framework for Financial Reporting by Islamic Banks”, Accounting and Business Research, Vol 25, No. 100, pp285-300. 2.	Shahul,H.M.I. and Yaya, R. (2005). The Emerging Issues on the Objectives and Characteristics of Islamic Accounting for Islamic Business Organizations