In the first of a two part series, Mustapha Hamat discusses the relevance of tax laws and accounting standards to Islamic banking, arguing that given the distinctive nature of Islamic finance, established laws all too often fall short of its requirements. 

In Islamic banking, depositor-bank relationships differ-not only from those in the conventional banking - but also between the various categories of depositors. 

Unlike conventional banking where the depositor-bank relationship is that of a debtor-creditor relationship, this relationship in Islamic banking could either be that of safekeeping (al-Wadiah) in the case of current and savings accounts or, trustee financing (al-Mudarabah) in the case of fixed deposit (investment accounts). As such, the most suitable accounting system for Islamic banks would be one which reflects the various bank-customer relationships. 

Fund Accounting

The funds that are available for the Islamic banks to invest are managed according to the type and nature of contractual relationships. 

In Islamic banking, depositor bank relationships differ - not only from those in the conventional banking - but also between the various categories of depositors. 

The shareholders' fund which is received from the shareholders by the bank on the basis of al-Musharakah is managed separately from the funds received from depositors- although when it comes to the annual financial statement, all funds are amalgamated under one heading - and so requires special accounting. 

Modified Cash Basis

A substantial percentage of the deposits received by Islamic banks are structured according to the principle of al-Mudarabah. This principle involves the distribution of a cash profit, either periodically or at the end of the Mudarabah period. This is because if the recognition of income earned were to be made on an accrual basis, the distribution of profit would require Islamic banks to advance cash from other sources before the liquidisation of receivable accounts is made. Or if the account shows a loss, the bank has to use its own funds to recompense the depositor, and as such it violates one of the conditions of the Mudarabah contract, which dictates that the loss should be borne by the owners of the capital. 

But, because according to the Shafi school of law, the profit that was distributed has to be treated as a refund of capital, to avoid this problem. Islamic banks usually adopt a cash basis rather than accrual in the recognition of income. 

Shariah Requirements

Obviously, any accounting system adopted by Islamic banks should reflect all Shariah requirements as closely as possible. For example, transactions conducted on the basis of the Shariah principle of al-Bai Bithaman Ajil consists of the following steps; the bank buys a house from the developer and pays cash; next, the bank sells the house at cost, plus a margin of profit. The accounting entries for these transactions are; the bank buys a house from the developer and pays cash; Dr. cost of the house; and Cr. amount in bankers-cheque. 

Conventional banks - which mobilize deposits on the basis of the interest-free principle should manage the fund separately. All interest-free deposits should be used in interest-free or Shariah permitted investments.

When the bank sells the house to the customer on a deferred payment basis the record is -Dr. Bai Bithaman Ajil Financing (cost plus profit) Cr. Cost of house (cost) and Cr. Unearned profit (profit margin) As shown in the above example, the debits and credits of the cost of the house cancel each other out. However to explain the logistics of a transaction, a set of entries relating to the cost of the house must be made.

 

A crucial aspect of this transaction is the Shariah principle on the categorising of assets and liabilities, based on Shariah principles such as al-Bai Bithaman Ajil., al-Murabahah, and al-Mudarabah, amongst others.

 

Requirements for a Dual Accounting System

 

Conventional banks - which mobilize deposits on the basis of the interest-free principle - should manage the fund separately. All interest-free deposits should be used in interest-free or Shariah permitted investments. As such it is imperative that separate accounts are kept for these funds, and ideally ,a separate accounting entity should be established. 

There is no direct Shariah ruling on depreciation, but for the purpose of providing prudent banking services, BIMB have adopted this standard in their financial reporting. 

At the end of the accounting period, separate statements of assets and liabilities, and profit and loss accounts for each fund t are prepared. Aggregation of interest-free fund accounts with the conventional banking operation accounts will only be made in the annual financial statement. If the interest-free fund is managed and accounted for in the same account as the funds from conventional banking operations, it will be very difficult for the banks to manage their investments, as they need to segregate income derived from employment of the interest-free deposits from the interest-based deposits. In some cases it could run the risk of interest-free funds being used for investment in non-Islamically acceptable assets. 

Questions may also be raised as to how the banks will allocate overhead costs; as the two systems share the premises, equipment, personnel and facilities. Strictly speaking, all these facilities need to be segregated, but the issue such as practicality and cost factor should receive careful consideration. If it is either impossible or impractical to segregate, allocation on the basis of size of the operations could be considered. However it would be best that the management of the banks refer to Shariah experts for guidance. 

Applicability of Existing Accountancy Standards Some of the current practices and standards which are directly relevant to Islamic banking include: 

i. disclosure of accounting policies,

ii. information to be disclosed in a financial statement,

iii. lease financing,

iv. provisions for potential bad debts.

Disclosure of Accounting Policies

 

The Disclosure of Significant Accounting Policies is an important standard, introduced by many professional bodies to help in giving a correct reading of financial statement. The adoption of different standards for certain accounting issues gives rise to different accounting effects. 

These standards become even more important when these policies affect the position of Shariah principles. Some of the areas where accounting policies usually the areas where accounting policies usually vary are 

i. the conversion or translation of foreign currencies including the disposition of exchange gains or losses, 

ii. overall valuation policy (such as historical cost, replacement cost etc.), 

iii. leasing, hire purchase, installment transaction and related interest or profit,

iv. depreciable assets and depreciation. 

v. investment: subsidiary companies, associated companies and other investments. 

vi. methods of revenue recognition, 

vii. maintenance, repairs and improvements.  

A survey carried out into the accounting standards of ten Islamic institutions revealed that in some developing countries where there were Islamic institutions operating there were no accounting standards laid down by the accounting bodies. This means that the focus of financial reporting has been left to the discretion of the management of financial institutions, with the result that the emphasis given to disclosure is often minimal. 

However, these findings do not apply to BIMB or other Islamic institutions operating in Malaysia, as when reporting the results of the bank's operations and its financial position, the bank has to observe both the Shariah requirements and the Ninth Schedule of the Companies Act of 1965, which requires the profit and loss operating revenue be disclosed a long with the basis on which the income is determined. Also, depreciation must be shown. 

The focus of financial reporting has been left to the discretion of the management of financial institutions, with the result that the emphasis given to disclosure is often minimal. 

The profit and loss account must show the amount charged for depreciation in value on fixed assets, goodwill -and other intangible assets-and investments, but it does not require the method or basis of provision to be stated. There is no direct Shariah ruling on deprecation, but for the purpose of providing prudent banking services, BIMB have adopted this standard in their financial reporting. 

However, it may become clear as to how the depreciation has been charged when a customer's deposit is accepted on the basis of the Mudharabah principle and the bank has informed the customer that operational costs can be deducted from the Mudarabah revenue, to be charged at the predistribution profit.

There is no Shariah ruling on goodwill either, and as far as the Shariah is concerned, whatever the banks paid, is the amount recorded. 

Disclosing Information

All information - necessary in making a financial statement clear and understandable - must be disclosed. The general standards to be observed are given, but in the case of specialised industries such as banking and insurance, the layout and groupings are allowed to vary according to the requirement of each industry and Bank Negara.

As a result, Islamic banks are allowed to vary the layout and grouping of their assets, liabilities and profit and loss items according to the requirements of the Shariah, Companies and Islamic Banking Acts.

 

Generally, the classification and grouping of information, for the purpose of disclosure requirements are:

 

i. general items such as the method of allocating provisions

 

ii. long term assets

iii. current assets

iv. long-term liabilities

v. current liabilities

vi. other liabilities and provisions

vii. shareholders' funds

viii. sales and other operating revenue

ix. depreciation

x. income from investment etc.

To be continued in next month's issue. This paper was originally presented at the Interest-free Banking/Islamic Financial System Conference organised by the Centre for Management Technology and held in January of this year.