Principles of Islamic banking and finance/PIBF202/Financial reporting/The Objectives of Islamic Accounting

1. Introduction

A conceptual framework is developed so that standards developed are consistent with one another. The section discusses the development of the conceptual framework for IFIs. Specifically, AAOIFI’s Statement of Financial Accounting 1 (SFA 1) will be discussed.

2.Developing a Theory of Islamic Accounting

There are two basic approaches to accounting theory construction: the empirical inductive approach and the deductive approach.

The Empirical Inductive Approach

This approach develops a theory based on generalising from empirical phenomenon. Thus, this rationalises ex-post, current accounting practice. According to one school of thought, accounting theory should be positive. Thus, accounting theory attempts to explain what is and help to predict future events, instead of determining what it ought to be. From an Islamic perspective, positive accounting theory cannot be a substitute for normative-deductive theorizing. This is due to the following reasons:

i. Empirical phenomenon may reflect a deviation of the normative percepts of lslam. However, positive research can be conducted to determine the gap between the actual and the normative.

ii. Islam has a Sharia framework that guides eternal ethical and behavioural principles and objectives. Thus, a purely positive approach may subordinate the normative principles of Islam.

The Normative Deductive Approach

Using this approach, theoretical accounting principles are logically derived by deduction from assumptions or axioms (first principles). Specifically, the normative deductive approach has been suggested as the approach to use in setting accounting standards for Islamic financial institutions primarily because in Islam, the Sharia is the framework with which accounting standards may be developed. This approach involves deducing the objectives of financial reporting, the postulates of accounting and the definition of accounting concepts from Sharia principles. This would then constitute the foundation for a structural framework, which would act as a reference for the development of principles for accounting.

There are two methods to develop Islamic accounting concepts:

I. Establish objectives (and concepts) based on the principles of Islam and its teachings and consider these objectives in relation to contemporary accounting thought, or

ii. Start with the objectives established in contemporary accounting thought, test them against the Islamic Sharia, accept those that are consistent with Sharia and reject those that are not, and develop those that are unique.

AAOIFI has adopted the second approach in developing Statement of Financial Accounting 1 (SFA 1). However, some authors have objected to this on the grounds that the conceptual framework of accounting currently applied in the West is based on a dichotomy between business morality and private morality. Thus it cannot be implemented in other societies that have revealed doctrines and morals that govern all social, economic and political aspects of life. Further, neither Western accounting theory nor Western accounting standards explicitly deal with the morality of the objectives of commercial accounting entities. Thus, the hybrid approach is proposed.

The steps for the hybrid approach are suggested as follows:

i.	Identify the ethical and accounting principles of the Sharia that relates to business and other activities. Compare these with the principles under which Western businesses and other organizations operate.

ii. Identify the main and subsidiary objectives of Islamic accounting based on Islamic ethical principles and consider these objectives in relation to contemporary accounting thought.

iii. Identify the theoretical foundation of Islamic accounting, that is, whether it is accountability, stewardship or decision-usefulness. This is closely linked with the objectives.

iv. Identify the users of Islamic accounting information and examine what they use the information for.

v.	Develop the characteristics of Islamic accounting, that is, the information required and the relevant valuation and disclosure principles.

vi. Seek consensus amongst scholars and accountants on these objectives and characteristics.

Despite the method chosen by AAOIFI, it is undeniably a commendable effort on the part of the organization in developing the conceptual framework and accounting standards.

3. Deriving the Islamic Accounting Objectives from Islamic Economic Objectives

Islamic economics is an ethics-based system with its principles and rules derived from the Qur’an and the Sunnah. The concept of ‘Khilafah’ or vicegerency is pertinent. Further, given that God has provided enough resources for mankind, any scarcity is not absolute but relative to the claims on those resources. More importantly, Islam categorically states that a man has the freedom to choose between alternative use of the resources. However, such resources should be utilized in an efficient and equitable manner in order to attain falah. Additionally, falah can only be achieved if resources are used with a sense of responsibility and constraint determined by the Divine Guidance and the objective (maqasid) of the Sharia. Thus, the ultimate objective of Islamic Economics is to lead man to falah. Islamic accounting is similar. Its objective is also to ensure that it leads to man’s well-being or success in this world as well as the hereafter. Accordingly, Islamic accounting should provide information to facilitate this socioeconomic process. This will facilitate the workings of a truly Islamic economic system. The Qur’anic concept of falah is important and is elaborated next.

Falah

Falah is said to have three components: baqa (survival), Ghana (freedom from want) and ‘izz (honour and power). From the microeconomic point of view, baqa encompasses biological (health), economic (i.e. means of livelihood), social (brotherhood and harmonious inter-relationships) and political survival (freedom and participation in affairs of the state). Its macroeconomic implications are a healthy environment and medical aid for all, full employment, inner social cohesion and independence and self-determination.

Ghana means that no one should live in abject poverty but also assumes self-reliance. Its macroeconomic implication includes equitable distribution of resources and intergenerational equity.

‘Izz means self-respect, civil liberties, protection of honor and life for the individual; and economic power, freedom from debts and military power to safeguard freedom and to enforce justice, for the community.

The conditions which lead to falah can be categorized into spiritual, economic, cultural and political factors. The economic factors are:

i.	Infaq

This is to spend in the way of God on the poor, needy, relations, neighbours and for the socio-ecoonomic good of the community.

ii. Prohibition of riba (interest)

Riba is a subtle institution which is exploitative and iniquitous. The socioeconomic implication of this is the replacement of pre-determined fixed return financing instruments with profit-sharing and risk bearing instruments.

iii. Fulfillment of Covenants (Contracts) and Trusts.

Honouring commitments and fulfilling contracts is a condition for the achievement of falah. This implies the fulfillment of the implicit covenant (or the primordial covenant alluded to in the Qur’an) of meeting one’s social and religious obligations to God, oneself, family, neighbours, the ummah (community of believers), mankind and other creatures.

iv. Avoiding Zulm (injustice, exploitation and usurpation of others’ rights).

Using unlawful means to acquire wealth implies usurping the rights of others and will lead to widespread inequalities, impaired incentives and social waste. The socioeconomic implication includes the avoidance of aleatory (ghrarar) contracts, information asymmetry, the prevention of hoarding and truth and fairness accounting.

v.	Seeking God’s bounty

The believer is expected to show enterprise and effort to achieve falah. The socioeconomic implication is the dignity of labour and the safeguarding of labour rights, earnings from labour and fair wage practices.

vi. Avoidance of Niggardliness

Withholding resources from society even from spending on oneself and one’s family deprives the community of God’s bounty. In the economic sense, this leads to low aggregate demand and a level of employment. Sanctions are imposed on such miserly practices. For example, Zakah is payable on idle wealth (money kept at home, in the bank or in shares and stocks) and idle land can be taken away by the state from the owner and given to somebody who can utilise it. Only with generosity and sacrifice as opposed to miserliness and selfishness, can one achieve falah. The above will have an impact on how accounting and taxation for Islamic financial institutions would be developed. Most importantly, the concept of falah can be taken to be the ultimate objective of Islamic accounting. However, the intermediate objective may be served by the concept of “Islamic Accountability”.

4. The Concept of Accountability in Islam and Islamic Accounting

The concept of “Islamic accountability” and not decision usefulness (which is the basis of conventional accounting) may provide the basis on which falah can be operationalized. From an Islamic perspective, accountability is a basic concept ingrained in the Muslim community. More importantly, accountability forms one of the core concepts of belief---the belief in the hereafter, heaven and hell, accounting and punishment. Islam also puts special emphasis on accounting, that is, on the recording of events and actions. The Qur’an categorically states that there are two angels recording every action of man. One angel records rightful actions and the rewards attributed to them (sawab) and the other records sinful actions and the sin attributed to them (ithm). Islamic scholars have classified the value of all actions into five categories:

i.	Fard (obligatory) ii. Sunnah or Mustahab (recommended) iii. Mubah (permitted but legally indifferent) iv. Makruh (disapproved) and v.	Haram (forbidden)

It can thus be seen that for a believing Muslim, accountability and accounting is ingrained by his religion into his soul. This concept of accountability is not restricted to the spiritual aspects but it also extends to social, business and contractual dealings.

Islamic accountability is undertaking actions and giving account of the actions taken by an organisation or person (the accountor) in discharging its Sharia obligations both contractual and social as an aid to self-correction and inducing behaviour of stakeholders towards falah. Accordingly, this will transform accounting into a social accountability activity.

How would Islamic accounting influence the behaviour of stakeholders towards falah? It is important to note that what is accounted for becomes what is important. In conventional accounting, it is profit that is emphasized. In contrast, in Islamic accounting, the extent an organization complies with the Sharia is important. Hence disclosure should emphasize on that.

Similarly, an alternate valuation system (in line with the Sharia) may have to be conceived giving scores to events and actions which have social and moral values encouraged by Islam.

The control aspect in Islamic accounting is imperative. If information users know that the entity has not followed the dictates of the Sharia, they can demand explanations and take actions resulting in the entity complying with the Sharia in the future. Such an action will protect the economic, social and spiritual future of the users.

Although the word “accountability” is not used by AAOIFI in Statement of Financial Accounting 2 (Objectives of financial accounting for Islamic banks and financial institutions) the notion of accountability is implicit. In noting the differences between objectives of financial accounting for Islamic banks and other banks, AAOIFI states that:

[while] financial accounting is mainly concerned with providing information to assist users in making decisions, those who deal with Islamic banks are concerned in the first place  to obeying and satisfying Allah in their financial and other dealings (AAOIFI, 2005).

5. Benefits of Establishing Objectives of Financial Accounting for Islamic Banks

Accounting is a purposeful activity with certain objectives. AAOIFI’s Statement of Financial Accounting 1: Objectives of Financial Accounting for Islamic Banks and Financial Institutions indicates the importance of establishing objectives as follows:

i.	To be used as a guide by AAOIFI when developing financial accounting standards to ensure consistency in developing standards.

ii. To assist Islamic banks, in the absence of accepted accounting standards, in making choices among alternative accounting treatments.

iii. To act as a guide and a regulator of subjective judgment made by management when preparing the financial statements and other financial reports.

iv. The objectives, when properly defined, should increase users’ confidence and understanding of accounting information and, in turn, their confidence in Islamic banks.

v.	Establishing objectives should lead to the development of accounting standards which are likely to be consistent with each other. This should increase users’ confidence in the financial reports of Islamic banks.

6. Differences in Objectives of Financial Accounting for IFIs from Conventional Banks

i.	Islamic banks must comply with the principles and rules of Sharia in all their financial and other dealings.

ii. The functions of Islamic banks are significantly different from those of conventional banks.

iii. The relationship between Islamic banks and the parties that deal with them differs from the relationship of those who deal with conventional banks.

a.	Islamic banks do not use interest in their investment and financing transactions.

b.	Islamic banks mobilize funds through investment accounts on the basis of Mudaraba and invest these funds on the basis of Mudaraba, profit and loss sharing mechanisms, or deferred payments methods consistent with the Sharia.

On the basis of the above differences, conventional accounting standards may not be relevant to Islamic banks.

7. Major Users of Financial Reports of Islamic Financial Institutions

The users of the financial reports of Islamic financial institutions are:

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. zakah agencies, and vii. others who transact business with the bank

It is important to note that the uses and the type of information the users of financial accounting information of IFIs require are different from those of conventional banks.

8. Common Information Needs of Users of Financial Reports

AAAOIFI identifies the “minimum “information needs of users as follows:

i.	Information which can assist in evaluating the bank’s compliance with the principles of Sharia in all of its financial and other dealings.

ii. Information which can assist in evaluating the bank’s ability in: a.	Using the economic resources available to it in a manner that safeguards these resources while increasing their value, at reasonable rates. b.	Carrying out its social responsibilities and in particular those that have been specified by Islam, including the good use of available resources, the protection of the rights of others and the prevention of corruption on earth. c.	Providing for the economic needs of those who deal with the bank. d.	Maintaining liquidity at appropriate levels.

iii. Information which can assist those employed by the bank in evaluating their relationship and future with the Islamic bank, including the bank’s ability to safeguard and develop their rights and develops their managerial and productive skills and capabilities.

9. The Type of Reports that Users Need

The types of reports can be categorized into:

i.	normal financial information as in financial position, liquidity, profitability

ii. specific additional financial and non-financial information to accord with the dictates of th Sharia particularly on the discharge of social responsibilities and information for employees.

The information in (i) above is currently produced by financial accounting in the form of financial statements and related notes. These include the balance sheet, income statement and cash flow statement.

The information in (ii) above, requires new types of reports which could be both financial and non-financial, which are not currently being produced. AAOIFI recommends the following statements:

i.	Analytical financial reports about sources of funds for Zakah and their uses.

ii. Analytical financial reports about earnings or expenditures prohibited by the Sharia

iii. Reports concerning the Islamic bank’s fulfillment of its social responsibilities

iv. Reports about the development of the Islamic bank’s human resources

10. Objectives of Financial Accounting and Reports for Islamic Banking and Financial Institutions

SFA1 states that the objectives of financial accounting determine the type and nature of information which should be included in financial reports. Essentially, the objectives of financial accounting should focus on the common information needs of users of financial reports.

AAOIFI goes on to list four objectives of financial accounting for IFI’s as follows:

i.	To determine the rights and obligations of all interested parties

ii. To contribute to the safeguarding of the Islamic bank’s assets, its rights and the rights of others in an adequate manner.

iii. To contribute to the enhancement of the managerial and productive capabilities of the Islamic bank

iv. To provide, through financial reports, useful information to users of these reports, to enable them to make legitimate decisions in their dealings with Islamic banks.

In addition, SFA1 indicates that financial reports which are directed mainly to external users, should provide the following types of information:

i.	Information about the Islamic bank’s compliance with the Islamic Sharia and the manner any prohibited earnings and expenditures were disposed of,

ii. Information about the Islamic bank’s economic resources and related obligations. Such information should assist the user to evaluating the adequacy of the Islamic bank’s capital to absorb losses and business risks; assessing the risk inherent in its investments and; evaluating the degree of liquidity of its assets and the liquidity requirements for meeting its other obligations,

iii. Information to assist the concerned party in the determination of Zakah,

iv. Information to assist in estimating cash flows,

v.	Information to assist in evaluating the Islamic bank’s discharge of its fiduciary responsibility to safeguard funds and to invest them at reasonable rates of return, and information about investment rates of returns on the bank’s investments and the rate of return accruing to equity and investment account holders.

vi. Information about the Islamic bank’s discharge of its social responsibilities.

11. Summary

The section discusses the need for and importance of developing the the accounting conceptual framework and elaborated on the main components of AAOIFI’s conceptual framework. The methods with which accounting standards can be developed for Islamic institutions and the method adopted by AAOIFI is also elaborated. Finally, the users and uses of accounting information of IFI’s is also discussed.

12. Related Articles

1. Akram Khan, M (1994). Accounting Issues and Concepts for Islamic Banks 2. El-Tegani, A.A (1994). “Accounting Postulates and Principles from an Islamic Perspective”, Review of Islamic Economics.