ISSUES IN ACCOUNTING STANDRADS

Dr. Seif I. Tag El-Din,

I. Introduction
The contemporary experience of Islamic banking is hardly more than three decades
old, though it proved to be groundbreaking with far reaching impacts worldwide.
Among the major challenges faced by Islamic banking experts and Shariah Scholars
has been the idea of developing appropriate accounting and auditing standards, to
achieve financial transparency and enhance the quality of financial service to society.

Banking success, in general, depends on the extent of public trust placed in the
financial strength of individual banks, particularly the trust of depositors and
investors. In addition to the paramount importance of financial strength, trust in
Islamic banks relates also to the extent of adherence to Shariah, which, after all, is the
identity card of Islamic banks. One major source of public confidence is the quality
of information issued to the investing public about banks’ ability to achieve both
financial and Shariah-related objectives.

Hence, developing unique accounting and auditing standards for the dissemination of
such information about Islamic banks becomes a necessity. The need for accounting
records as means for trust building is emphasized in the Quran : “…Never get bored
with recording it, however small or large, up to its maturity date, for this is seen by
Allah as closer to justice, more supportive to testimony, and more resolving to doubt,
except when it is spot trade carried out amongst yourselves, then you are not to
blame for not recoding it”, (al-Baqara: 2 82). Even for spot transactions where debt
is not involved, the Quran allows an open discretion for taking records, and that is all
what accounting is about.

The reason why Islamic financial accounting methods and principles have to be
carefully distinguished from their conventional counterparts is the same reason why
Islamic banks and financial institutions has existed in the first place. Prohibition of
interest in financial dealings is the primary reason, but there are various other issues
and fine details which make up for the case of Islamic financial accounting standards.
For a better appreciation of accounting issues, it is appropriate to highlight the basic
financing and investment structure of a typical Islamic bank as adopted by the
accounting standards.

1/1 Core concept of Islamic bank
As a financial intermediary, the basic mechanism of the Islamic bank is to accept
deposits from surplus persons on the liability side and offer financing on the assets
side to the deficit persons. The basic idea is to activate this mechanism on acceptable
Islamic modes which preclude payment or receipt of interest and conform to the jurist
rules of Shariah. Formal definitions of accounting elements will be provided later, as
our intention here is only to highlight the basic mechanism.
.
Liabilities & Assets. Among other things, liabilities of an Islamic bank consist of
two main categories: the usual interest-free current accounts and saving accounts, and
investment accounts based on the profit-and-loss sharing principle (PLS) between the
bank and depositors. The latter is the Islamic alternative of term deposits in
conventional banks where the principles of Mudarabah and Musharakah are adopted
instead of the interest rate. Assets include, among other things, a broad range of
financings: Murabaha, Ijara, Istisnaa, Salam, Mudarabah and Musharakah. It will be
assumed in this course that the reader is familiar with these modes of financing.

Investment structure: For the purpose of accounting standards, two major categories
of investment activities are defined:

Unrestricted investment accounts and their equivalents: These are funds
received by the Islamic bank from investors whereby the Islamic bank is held free
to invest those funds without prior restrictions, including the mixing of these
funds with the bank’s own investment. In this case, rules of unrestricted
Mudarabah are adopted.

Restricted investments and their equivalents : The bank acts only as manager –
agent or non-participating Mudarib – not authorized to mix his own funds with
those of investors without prior permission of the investors.

Fiduciary service for funds devoted for social purposes: The financial statements
of Islamic bank must also reflect its functions as possible agent of Zakah payment,
manager of charitable funds and Qard Fund.

The above financing, investment and unique religious features have proved to reflect
far reaching implications as regards the preparation and presentation of financial
statements of Islamic banks. The accounting treatment of different Islamic modes of
financing will arouse various issues of recognition, measurement and disclosure.
Similar issues arise with respect to investments, depending on their type, where
investors are allowed to subscribe or withdraw their funds totally or partially during
the period of investment.

1/2 Common grounds with conventional banks
Apart from its detailed characteristics, Islamic accounting shares with their
conventional counterparts the same common process of recognition, measurement and
recording of transactions and fair presentation of rights and obligations Recognition
of rights and obligations must apply to a given period of time tracing all changes of
consummated transactions that may have taken place. Measurement is the
quantification of financial effects of consummated transactions and the impact of
other events during the same period of time. The recording process offers a lucid
classification scheme of financial effects together with other events, in order to show
the results of the entity’s operations and changes in its financial positions including
cash flow. Periodic reports are, then, prepared and issued by the entities to disclose
their financial records during a given period of time.

Information so reported would then assist investors to take the right decisions with
respect to their future dealings with the entity in question. It also assists the entity’s
own management to evaluate its performance and lay future plans for the entity’s
activities and financial services. Governmental agencies benefit a great deal from
such reported information in the process of supervising the banking and financial
sector and evaluating tax policies. Governmental regulatory requirements for
conventional financial institutions are also shared by Islamic entities, like the basic
provision of having adequate banking capital to provide safety for depositors’ money.
Given the provision of adequate capital, success of Islamic banks depends on
compliance with Shariah as well as the financial competence to realize rates of return
commensurate to investment risks assumed.

1/3 Scope of lecture:

Due to the time constraint, we shall focus in this lecture on the following topics:

1. Objectives of financial accounting for Islamic financial institutions
2. Basic assumptions and criteria for Islamic accounting
3. General lay out of Islamic financial statements.

Therefore, accounting standards for the various Islamic modes of financing are
beyond the scope of this brief presentation. The present lecture is based on the
Accounting and Auditing Standards For Islamic Financial Institutions, 1997,
published by AAOIFI (the Accounting and Auditing Organization for Islamic
Financial Institutions). Since its establishment in 1991, the Bahrain-based AAOIFI
has been catering its advisory services as the professional body responsible to develop
suitable accounting and auditing standards for Islamic banks. Additional help can be
obtained from other references Listed at the end.

II. Objectives of financial accounting
To achieve the desired success, accounting standards for Islamic banks should be
developed consistently in relation to the unique objectives of financial accounting for
Islamic banks and institutions. It is for this reason, as well as the need to ensure
consistency among all present and future accounting standards, that the Islamic
objectives have to be clearly specified. The setting of clear objectives for financial
accounting of Islamic banks and institutions, as opposed to their conventional
counterparts, will also assist Islamic banks, in the absence of accepted accounting
standards to make sensible judgements for choice among alternative accounting
treatments.

The objectives of financial accounting determine the type and nature of information
which should be included in the financial reports in order to assist users of these
reports in making sound decisions. Governments agencies, generally, have the power
to directly obtain the type of information that best serves their needs. This leaves
external users of information limited to the common information contained in the
Islamic banks financial reports, namely: equity holders, holders of investment
accounts, current and saving account holders, other depositors, other dealers with
Islamic banks, Zakah agencies and regulatory agencies. On this basis, the objectives
of financial accounting for Islamic banks and institutions are to achieve the following:

1. Determine the rights and obligations of all interested parties, including rights
and obligations resulting from incomplete transactions and other events, in
accordance with the principles of Shariah and its concepts of fairness, clarity
and business ethics.

2. Subscribe to the safeguarding of Islamic banks’ assets, rights of Islamic banks
and rights of others in an adequate manner.

3. Subscribe to the enhancement of management and Islamic banks’ productive
capabilities, and encourage compliance with the established goals and policies,
and above all Islamic Shariah, in all transactions and events.

4. Provide through financial reports useful information to report users, and thus
enable them to make legitimate decisions in their dealings with Islamic banks.

On the other hand, the objective of financial reports are to provide the following kinds
of information :

1. Information about the Islamic bank’s objectives and the extent of its
compliance with Shariah. And, if the bank is partly engaged in prohibited
dealings, information about the separation of such dealings and how to
dispose of them.

2. Financial information assisting users to evaluate the adequacy of the Islamic
bank’s capital, risks inherent in investment, and degree of liquidity for
meeting the outstanding obligations.

3. Information to assist in the assessment of Zakah on Islamic banks’ funds and
the targets of its dispersal.

4. Information about cash flows, their timing, and associated risks. This will help
users evaluate an Islamic bank’s ability to generate sufficient dividend income
for equity and profits for investment holders.

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

III. Basic assumptions and criteria for financial accounting :

3/1 A
ssumptions

Accounting unit : As per Resolution No. 65/17, 7th Session of the Fiqh
Academy, Jeddah, 9-14 March, it is possible in Islamic jurisprudence to form
a limited liability company. This provision allows for the treatment of the
Islamic bank as a separate accounting unit from its owners.

On-going concern: In the absence of persuasive evidence to the contrary,
financial accounting assumes the continuation of an entity as an on-going
concern. This has an important implication to Islamic banks as there is not
perceivable time horizon of assets liquidation or investment termination in
case of equity owners and owners of unrestricted investment accounts or their
equivalents. In most cases there is no specific time when actual investment
results would be known. This point will have implications for the issue of
measurement.


Periodicity: Life of the Islamic bank should be broken into reporting periods
to prepare financial reports that provide information to interested parties about
the performance of the bank.

Stability of purchasing power: Financial accounting uses monetary units as a
common denominator to express basic elements of financial statements.
However, the use of monetary units is subject to inflationary and deflationary
pressures which may significantly affect its purchasing power. For the
purpose of accounting standards such effects are completely ignored.

3/2
Qualitative Criteria of accounting information

Usefulness: Usefulness of accounting information must be evaluated in
relation to the objectives of presenting financial statements which are focused
on making their external users make the best out of them. Hence, to be useful
accounting information must target the interest of external users.

Relevance: A close relationship must exist between the financial accounting
information and the purpose for which this information is provided.
Accounting information is relevant if it helps the main users of financial
statements to evaluate the potential outcomes of maintaining, or establishing,
relationships the given Islamic bank, rather than assisting investors to choose
from alternative options. To be relevant, accounting information must satisfy
three main qualities.
o
Predictive value makes it possible for users to asses the potential
outcome of a current or a new relationship with the bank.
o
Feedback value assists users to check the accuracy of their prior
predictions, say, about net income.
o
Timeliness means information is only useful at the time when it is
needed. Optimal frequency of reporting and minimal lag between
successive reports are therefore important criteria for useful accounting
information

Reliability: This is the quality which permits users to depend on the reported
information with confidence, but reliability does not mean absolute accuracy.
It means that based on all the specific circumstances surrounding a particular
transaction or event, the method chosen to measure/disclose its effects
produces information that reflects the substance of the event or transaction.
The provision of estimates /judgements in accounting applying methods is not
inconsistent with Shariah. Most particularly, reliability should satisfy the
following properties of representational faithfulness, objectivity and
neutrality.

Comparability: Usefulness of accounting information is enhanced by
comparability of bank’s performance over time. This property requires the
adoption of similar methods of measurement/ disclosure in relation to similar
events.

Consistency: Banks should stick as much as possible to the same
measurement/disclosure methods from one period to another, unless there is
genuine call for change ( e.g changing depreciation measurement). In this
case, the new change and its effect should be appropriately disclosed.
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Understandability: Accounting information is targeted to common users not
to accountants. The nature of information, the way it is presented and the
technical background of external users are important factors in the preparation
of understandable information. Use of simple classification tools, clear
information headings, juxtaposition of data and statement of net results which
users want to know, would contribute to better understandability.
3/3 Recognition / measurement & revaluation criteria:
Accounting recognition : refers to the timely recording of the basic elements of
financial statements as they take effect, which is the reason why a clear definition of
accounting elements must precede their recognition. It is worth noting that recognition
relates to accounting flows rather than stocks since the stocks will, then, be
automatically recognized. This issue is particularly crucial as regards recognition of
assets acquired under various Islamic modes of financing , profit/loss investment
accounts, and funds ((e.g when should Murabaha profit, or Mudarabah capital, be
recognized ? when should investment profit be recognised, and how is it measured?).
The rules governing recognition and measurement must be appreciated by reference
to Shariah rules.

Accounting measurement: refers to the determination of the amounts at which
accounting elements should be recognized. Measurement of accounting flows requires
the matching of incomings with the corresponding outgoings, separately, for each
independent account during a given period of time, e,g the matching of revenues and
gains with expenses and losses to get the bank’s net income for a given period of
time.

Measurable attributes: Measurable attributes of an asset or a liability fall broadly
into two categories: cash equivalent value and historical cost. The latter stands for
the cash value expected to be realized as of the current date if an asset is sold for cash
in the normal course of business. The formers stands for the asset’s fair value at the
date of its acquisition including amounts incurred to make it usable or ready for
disposition. These two attributes invoke significant implications as regards
measurement of assets acquired under various modes of financing. They also relate to
the issue of revaluation of unrestricted investment accounts and restricted investment
accounts.

3/4 Issue of Revaluation
Measurement attributes, as defined above, provide for the possibility of adopting cash
equivalent value by the Islamic bank both as a joint investor in the unrestricted
investment accounts and as a manager as in the restricted investment accounts.

Justice consideration: In general, the value the holder of an investment account
expects to realize from his funds is considerably dependent upon the cash equivalent
value he expects to realize if investments were re-valued, or sold, as of the current
date. Yet, the results of investments do not occur at a given point of time. Rather, such
results are earned over the life time of the investments even though the ultimate
results will become certain only at the time when the investments are liquidated.
However, if investments were to be measured at historical costs, recognition of
investment results will only take place at the time of investment liquidation. This

point arouses a strong consideration of justice between holders of investments
accounts since they are allowed to subscribe or withdraw their investments at different
times during the period of the contract. In case of unrestricted investment accounts,
justice has to be observed, not only between holders of unrestricted investments, but
also between them as a group and the equity owners of the bank as a group.

Revaluation of assets/liabilities and restricted investments: Measurement of cash
equivalents expected to be realized or paid require periodic revaluation of assets
liabilities and restricted investments. However, the currently adopted standard is that
“ historical cost shall be the basis used in measuring and recording the assets at the
time of acquisition thereof”. Nonetheless, it is permissible to do the revaluation for the
purpose of presenting supplemental information which may relevant for an existing or
a potential holder of an investment account.

3/5 Preparation and presentation criteria:


Materiality: An item is regarded material – qualitatively or quantitatively – if its
omission non-disclosure or misstatement will result in distortion of the
information being presented in the financial statements and thereby, misguidance
of users. In deciding whether an item is material, its nature and amount must be
taken into account.
o
Qualitative materiality refers to the nature of given transactions or events
whether it is usual/unusual, expected/unexpected, Shariah compliant/non-
compliant, etc.
o
Quantitative materiality refers to the relative amount of an item as for
compared with normal expectations, or relative to an appropriate base.

Cost of information: Information is a costly economic resource. Therefore, a
process of cost/benefit analysis must underlie the decision to choose the relevant
information for financial reporting.

Adequate disclosure: Basic information about the bank must be disclosed, as
well as currency used, and accounting policies adopted. More generally, financial
statements, notes accompanying them, and any additional presentations should
contain all material information necessary to make them useful to end users.
Optimum aggregation and written descriptions/clarifications are two important
considerations:
o
Highly aggregated data conceals useful detail, and highly detailed data can
be side-tracking and confusing. Optimal aggregation is the middle course
which must be adopted.
o
Heading captions and amounts must be supplemented information just
enough to clarify their meanings. Supplementary notes to financial
statement is an example.
Based on the above assumptions and criteria, the general layout of financial
statements can now be considered.

IV. General lay out of Islamic financial statements :

Islamic financial statements
Share the same broad classification of conventional financial statements as representations of stocks and flows. The stock concept is typical of the balance sheet which provides a summary of the financial position of an entity at a given point of time. The income statement, on the other hand, provides a summary of the inflow and outflows during a given period of time, as it is measured on accrual basis. The latter is
particularly relevant for assessing the operating efficiency of the entity, but not the sate of cash liquidity. It is for this reason that a cash-basis statement is needed to complement the flow concept of financial statements as opposed to the stock concept.

The set of financial statements of an Islamic financial institutions consist of the
following:


Financial statements reflecting the Islamic Bank’s function as an investor
and its rights and obligation regardless of the objective of investment
whether it is profit oriented or socially oriented. Such financial statements
include:
o
Statement of financial position
o
Statement of income
o
Statement of cash flow
o
Statement of retained earning or statement of changes in owners’
equity.

A financial statement reflecting changes in restricted investments managed
by the Islamic bank for the benefit of others, whether based on Mudarabah
contract or agency contract

Financial statements reflecting the Islamic bank’s role as a fiduciary of
funds made available for social purposes when such services are provided
through separate funds:
o
Statement of sources and uses of Zakah and Charity fund
o
Statement of sources And uses of funds in the qard fund.
4/1
Statement of financial position:
Disclosure & Definitions
Disclosure:
The date of the statement must be disclosed. The statement
should include the Islamic bank’s assets, liabilities, equity of unrestricted
investment account holders and its equivalents, and its owners’ equity. Assets
and liabilities should be combined into groupings in accordance of their
nature, and in order of their relative liquidity, but the conventional division
into current and fixed groups is not recommended. Assets should not be set-off
against liabilities unless there is a religious or legal right and an actual
expectation of set-off (e.g deferred profits in Murabaha shall be set-off against
Murabaha receivables). Separate totals for assets, liabilities, unrestricted
investment accounts and their equivalents, and owners’ equity must be
provided. Other considerations of disclosure will be added to their respective
items below.

Definitions:
The following definitions relate to the broad items of the
statement of financial position.

Assets: An assert is any measurable thing that is capable to generate cash
flows or other economic benefits in the future, individually or in combination
with other assets, of which the Islamic bank has acquired the right to hold, use
or dispose of, as a result of past transactions or events.
Disclosure of assets: The following breakdown of assets should be disclosed
either on the face of the financial statement of financial position or the notes to
financial statements:

1. Cash and cash equivalent
2. Receivables ( Murabaha, Salam, Istisnaa)
3. Investment securities
4. Mudarabah investment
5. Musharakah investment
6. Investment in other entities
7. Inventories (including goods purchased for Murabaha prior to
consummation of Murabaha agreement
8. Investment in real estate
9. Assets acquired for leasing
10. Other investments (disclosure of their types)
11. Fixed assets (disclosure of depreciation for significant asset types )
12. Other assets (disclosure of significant types).

Liabilities: A liability is any measurable present bank’s obligation to another
party to transfer assets, extend the use of an asset, or provide services to that
party in the future as a result of past transactions or events. The Islamic
obligation must not be a reciprocal to an obligation of the other party to the
bank.

Disclosure of liabilities: The statement of financial position or its note should
disclose the following liabilities:
1. Current accounts, saving accounts and other accounts with separate
disclosure of each category
2. Deposits of other banks
3. Salam Payable
4. Istisnaa Payable
5. Declared but undistributed profits
6. Zakah and taxes payable
7. Other accounts payable

Equity of unrestricted investment account holders and their equivalents:
At the date of the statement of financial position, equity of unrestricted
investment account holders (and their equivalents) refers to the amount of
original funds received minus withdrawals or transfers to other accounts
plus/minus shares in profits/losses. Because of they are based unrestricted
Mudarabah, unrestricted investment accounts and their equivalents are treated
as elements of the financial position. It is noteworthy that equity of
unrestricted investment account holders and their equivalents is not considered
a liability since there is no obligation on the bank to guarantee original
principals except in cases of proven neglect. Likewise, equity of unrestricted
investment account holders and their equivalents is not considered part of
ownership equity because they do no enjoy voting right or entitlement to
profits generated from the use of the bank’s current accounts.

Disclosure of unrestricted investment accounts/equivalents: The method
used to allocate investment profit/loss between the bank and the unrestricted
investment account holders and their equivalents should be disclosed, whether
the bank acts as Mudarib or agent, should be disclosed. Separate disclosures of
assets jointly financed by the Islamic bank and unrestricted investment
account holders and those exclusively financed by the bank should be
provided in supplementary notes.

Owners’ equity: It is the amount remaining at the date of the statement of
financial position, from the Islamic bank’s assets after deducting the bank’s
liabilities, equity of unrestricted investments and their equivalents and
prohibited earnings if any.

Disclosure of owners’ equity: See statement of changes in owners’ equity
4/2 Income statement :
Disclosure, definition and recognition :
Disclosure:
The period covered by the income statement should be disclosed .
To the extent applicable, the following information should be disclosed in income
statements with separate disclosures of investment revenues, expenses, gains and
losses jointly financed by the bank and unrestricted investment account holders
and their equivalents, and those exclusively financed by the bank:

Revenues and gains from investments

(-)Expenses and losses from investments

(=)Income (loss) from investments

(-)Share of unrestricted investment account holders from income (loss)
from investments before the bank’s share as Mudarib

(=)The bank’s share in income (loss) from investments

(+)The bank’s share in unrestricted investment income as Mudarib

(+) The bank’s share in restricted investment profit as Mudarib

(+)The bank’s fixed fee as an investment agent for restricted investment

(=/-) Other revenues, expenses, gains and losses

(-) General and administrative expenses

(=) Net income (loss) before Zakah and taxes

(-) Zakah and taxes ( separate disclosures)

(=) Net income (loss)
Definitions & recognition:
The following definitions and methods of
recognition relate to the broad items of the income statement.

Revenues : Gross increases in assets or decreases in liabilities or a combination
of both during the period covered by the income statement which result from
legitimate investment, trading, rendering of services, including investment
management of restricted investment accounts. This excludes increases in assets
or decreases in liabilities due to investment by, or distribution to owners, deposits
or withdrawals by unrestricted account holders or their equivalents, deposits or
withdrawals by current or non-investment account holders or the acquisition of
assets.

Recognition of revenues: Revenues should be recognized at the time when
realized. Realization of revenues pre-supposes the fulfilment of three main
conditions: First, the bank should have earned the right to receive revenue through
a completely consummated process. Second, an obligation must fall on another
party to a remit a fixed or a determinable amount to the bank (e.g share in actual
profit). Third, amount should be known and collectible, if not already collected.
Expenses : They are the reverse of revenues: gross decreases in assets or
increases in liabilities or a combination of both resulting from similar activities as
in revenues. This excludes gross decreases in assets or increases in liabilities
resulting from the same sources as defined for revenues.
Recognition of expenses: Expenses are also recognized when realized, either
because the expense relates directly to the earning of revenues that have been
realized or because indirect cost relating to a certain period covered by the income
statement. The latter costs could either be those providing a benefit in the current
period but are not expected to realize reasonable measurable benefits in the future.
Examples are management compensation, bonuses and administrative expenses
which are difficult to allocate directly to specific services performed by others to
the bank or specific assets acquired by the bank. Or, expenses that represent costs
that will benefit multiple periods, like depreciation of fixed assets. These has to be
rationally allocated to to the periods that benefit from the use of such assets.
Gains and losses: A gain is a net increase in net assets which results from holding
assets that appreciate in value during the period covered by the income statement
or from incidental legitimate reciprocal (e.g sale of assets not acquired for sale) or
no-reciprocal transfers (donations), except for non-reciprocal transfers with equity
owners or holders of unrestricted investment accounts or their equivalents. A loss
is a net decease in net assets which results from holding assets that depreciate in
value during the period covered by the income statement or from incidental
legitimate reciprocal and non-reciprocal transfers (e.g penalties by Central Bank,
or involuntary conversion of assets- theft, destruction, etc), except for non-
reciprocal transfers with equity holders or holders of unrestricted investment
accounts or their transfers.

Recognition of gains and losses: Gains/losses are recognized when realized in
one of two possible situations: completion of a reciprocal or non-reciprocal
transfer resulting in gain or loss, or sufficient evidence indicating reasonably
measurable appreciation or depreciation in values of recorded assets or liabilities.
The latter makes up for estimated unrealized gains and losses resulting from
revaluation of assets and liabilities.

Return on unrestricted investment accounts/equivalents: It is the share
allocated to the holders of these accounts out of investment profits/losses as a
result of their joint participation with the Islamic bank with the financing of
investment transactions during the period covered by the income statement – not
an expense (in case of profit) or revenue (in case of loss).

Recognition:
Net income (net loss): It is the net increase (decrease) in owners’ equity resulting
from revenues, expenses, gains, losses, after allocating the return on unrestricted
investment accounts and their equivalents, for the period. It is the result of all on-
going profit oriented operations of the bank and other events and circumstances
affecting the value of assets held by the bank during the period covered by the
income statement. All legitimate changes in equity are included except those
resulting from investment by owners and distributions to owners.

4/3 Statement of changes in owners’ equity
or statement of retained earnings:
Disclosure and definitions:

Disclosure:
The period covered by the statement of changes in owners’ equity or
the statement of retained earnings should be disclosed.

Statement of changes in owners’ equity: Basic elements are net income(loss),
investment by and distribution to owners (non-reciprocal transfers). Investment by
owners is the amount of increase in owners’ equity, while distribution to owners is
decrease in owners’ equity. The former results from the transfer of assets, or
performance of service, or the assumption, or payment by owners of an obligation of
Islamic bank for the purpose of increasing their equity in the bank. The latter results
from transfer of assets by the Islamic bank to owners , or performance of services, or
assumption or payment of the owners for the purpose of reducing their equity in the
bank (e.g dividends).
Disclosure of changes in owners’ equity: The statement of changes in owners’
equity should disclose:

Paid-in capital, legal and discretionary reserves, separately, and retained
earnings as of the beginning of the period with separate disclosure of the
amount of estimated earnings resulting from revaluation of assets and
liabilities to their cash equivalents where applicable.

Capital contribution by owners during the period

Net income (loss) during the period

Distributions to owners during the period

Increase (decrease) in legal and discretionary reserves during the period

Paid-in Capital, legal and other discretionary reserves and retained earnings as
of the end of the period with disclosure of the estimated amount of retained
earnings resulting from the revaluation of assets and liabilities to their cash
equivalents where applicable.

Statement of retained earnings: Basic elements are net income (loss), dividends, and
transfers to other owners’ equity accounts. The latter is a decrease retained earnings
resulting from their transfer to legal or other reserves or to the owners’ capital
accounts.
13
Disclosure of changes in retained earnings: The statement of changes in retained
earnings should disclose:

Retailed earnings at the beginning of the period with separate disclosure of the
amount of estimated of retained earnings resulting from the revaluation of
assets and liabilities where applicable

Net income (loss) for the period

Transfer to legal and discretionary reserves during the period

Distribution of profit to owners during the period

Retained earnings at the end of the period with separate disclosure of the
amount of estimated retained earnings resulting from revaluation of assets and
liabilities to their cash equivalence where applicable.

4/4 Statement of cash flows: disclosure & definitions
Disclosure:
The period covered by the cash flow statement must be disclosed.
The statement should disclose the net increase (decrease) in cash and cash
equivalent during the given period and the balance of cash and cash equivalent at
the beginning and end of the period. As regards transactions and other transfers
that do not require payment or receipt of cash and cash equivalent should be
disclosed (e.g bonus shares, or acquisition of assets in exchange for shares in the
equity of the bank).

Cash and cash equivalent: Currency local or foreign which is available
immediately as means of transacting business (Deposits with central bank, other
institutions).
Cash flow from operations: Refers to cash inflows or outflows during the period
as a result of transactions and other events whose effects are reflected in the
income statement of the bank (revenues, expenses, gains, losses) except for gains
or losses resulting from the sale of assets acquired by the bank for its own use.
Cash flows from investing activities: refer to cash outflows as a result of the
acquisition of assets for investment including investment for the Islamic bank’s
own use, and/or cash inflows resulting from sale of assets acquired by the bank for
investment or for its own use.
Cash flows from financing activities: refer to cash inflow as a result of
investment by owners, deposits by holders of unrestricted investment accounts
and their equivalent and deposits of the usual bank accounts (current, saving) and
cash outflows resulting from distribution to owners or withdrawals by holders on
the mentioned accounts.

4/5
Statement of changes in restricted investment
and their equivalent:

Definitions & disclosure:

Restricted investment accounts and their equivalents:
Because they are
based on restricted Mudarabah, restricted investments are not assets of the
Islamic bank and should not be reflected in the bank’s statement of financial
position. The bank does not have the right to use or dispose of these
investments except within the conditions of the contract between the bank and
holders of these accounts. The statement must show deposits and withdrawals
by holders of restricted investments and their equivalent as of a given date.
14
Restricted investment profits/losses before the investment manager share
in profits (losses): It is the amount of net increase (decrease) in restricted
investments before the bank’s share as Mudarib or compensation as an
investment agent, other than the result of deposits/ withdrawals.
The investment manager share in restricted investment profits: If the
bank acts as agent, it gets a fixed percentage regardless of investment results,
but no compensation is given to the bank if it acts as Mudarib.
Recognition of restricted investment profit/loss: Restricted investments
profit/ loses are recognized in terms of realized profits/ losses resulting from
reciprocal and non-reciprocal transfers, or as estimated unrealized
profits/losses resulting from the revaluation of restricted investments.

Disclosure:
The period covered by the statement of changes in restricted investments/equivalents
should be disclosed. The statement should segregate restricted investments by source
of financing ( e.g accounts or portfolio units) and by type. Disclosure should include
the following:

Balance of restricted accounts at the beginning of the period, with separate disclosure
for the part of the balance which results from revaluation of restricted investment
accounts to their cash equivalents where applicable.

Number of investment units in each of the investment portfolios and the value per
unit at the beginning of the period

Deposits received or investment units issued during the period

Withdrawals or repurchase of units during the period

Bank’s share in investment profit as Mudarib or fixed fee as investment agent.

Allocated overhead expense, if any.

Restricted investment accounts profits/losses during the period with separate
disclosure of the part resulting from revaluation to cash equivalents where applicable

Number of investment units in each of the investment portfolios at the end of the
period and the value per unit.

Note to the statement of changes in restricted investments and their equivalents should
disclose:

1. Nature of contractual relationship between bank and owners of restricted investments
– Mudarib or agent
2. Rights and obligations associated with each type of investment account or investment
portfolio.

4/6 Statement of sources and uses of funds in the Zakah
and Charity Fund:

Disclosure & definitions:

Disclosure
The period covered by the statement of sources and uses of funds in the Zakah and
Charity Fund should be disclosed. Disclosure should be made of the bank’s
responsibility for the payment of Zakah on behalf of owners of unrestricted
investment accounts and their equivalents. Disclosure should be made of payments
and uses of funds during the period and available funds at the end of the period.
Sources of funds in the Zakah and Charity fund: Zakah is a fixed obligation
calculated by reference to net assets that have appreciated or have the capacity to
appreciate in value over a specific period of time except for assets acquired for
consumption or used in production. In the case of a limited liability company, Zakah
should be based on the company’s net assets, and the total amount be divided between
owners who should then their Zakah obligations personally. Otherwise, the company
should pay out Zakah on behalf of its owners, if it is so authorized. The bank may
also act as an agent of Zakah or other charitable contributions for its various
accounts’ holders and other parties.
Uses of funds in the Zakah and charity fund: These are the eight categories stated
in the Quran ( al-Tawaba: 56)
Fund balance in Zakah and Charity fund: Refers to outstanding funds which have
not been distributed as of a given date.

4/7 Statement of sources and uses of funds in the Qard Fund:

Definitions:
Qard is a non-interest bearing loan allowing borrower to use the loaned funds for a
specific period of time such that the same amount of loan should be returned to lender
at the end of the period – a means of achieving social objectives.
Sources of funds in the Qard fund: Represent gross increase in funds available from
both external and internal sources for lending during the period covered by the
statement.
Uses of funds in the Qard fund: Represent the amount of gross decrease in funds
available for lending during the period covered. It includes new loans granted,
repayments of funds previously provided to the fund by individuals on a temporary
basis, and reimbursements of funds made available to the funds by the Islamic bank
from current accounts or prohibited earnings.
Fund balance in the Qard fund: The outstanding collectible loans and the other
funds not loaned or used for other purposes.

Disclosure:
The period covered by the statement of sources and uses of funds in Qard Fund
should be disclosed. The above define items should all be disclosed.

REFERENCES:

AAOIFI (Accounting and Auditing Organization for Islamic Financial
Institutions), Accounting and Auditing Standards For Islamic Financial
Institutions, Manama, Bahrain, 1997.

___________Accounting Auditing and Governance Standards for Islamic
Financial Institutions, Manama, Bahrain, 2002

Ahmed, Eltigani Abdulqadir, Accounting Postulates and Principles from an
Islamic Perspectives, Review of Islamic Economics, Vol. 3 , No.2, 1994, pp1-
18.

Bahjatt, Muhammed F., Towards Standards for Religious Audit in Islamic
Banks, Review of Islamic Economics, Vol. 3 , No.2, 1994, Arabic section, 1-
60.

Chapra, Umar and Ahmed, Habib, Corporate Governance in Islamic
Financial Institutions, Islamic Development Bank, IRTI, 2002

Hamoud, Sami, Standards of Profit Accounting in Islamic Banks, Islamic
Economics Studies, (Arabic)Vol. 3, No. 2, 1996, pp 83-112.

Khan, M. Aamnullah , Contemporary Accounting Practices and Islamic
Banking, Review of Islamic Economics, Vol. 3, No. 1, 1994, pp 51-61

Khan, Abdul Jabbar, Comment on Paper “contemporary accounting practices
and Islamic banking” by M.A. Khan, Review of Islamic Economics, Vol. 3,
No. 2, 1994, 29-30.

Khan, M. Fahim, Time Value of Money and Discounting, Review of Islamic
Economics, Vol. 1, No. 2, 1991 pp35-54

Kahf, Munzir, Time Value of Money and Discounting in Islamic Perspective:
Revisited, Review of Islamic Economics, Vol. 3, No. 2, 1994

____________Profit Distribution in Islamic Banks, Islamic Economic Studies,
Vol. 3, No. 2, 1996, pp113-137.

Umar, Muhammed Abdul Halim, Shariah, Economic and Accounting
Framework of Bay’Al-Salam in the Light of Contemporary Application,
Islamic Development Bank, IRTI, Jeddah, KSA, . 1995.

Tag El-Din, Balance Sheet Analysis : Case Study of Faysal Bank-Bahrain,
presented in “Intensive Orientation Seminars on Islamic Economics, Banking
& Finance”, Islamic Foundation , IDB and Loughborough University, 23- 27
Sep. 1999.

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