Islamic Accounting Standards

Islamic Accounting Standards Date:

April 08-10, 2012 

Time : 8:30 AM- 1:30 PM 

Title Location : EIBFS  – AD  Date rd 

3  Floor Classroom No.: 307  Lifetime Learning… Building Success… Towards Globalization

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Course Objective:

to familiarize the participants with broad framework of accounting and financial reporting issues in Islamic banks -to outline the Islamic Accounting Standards developed by the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) -to provide detail analysis of a number of Standards to explain how they have tackled the financial reporting issues in Islamic banks Contents : Objectives of Financial Accounting for Islamic bank -Financial Statement of an Islamic Bank -International Accounting Standards (IAS) and Islamic Banking Operations -The establishment of AAOIFI AAOIFI and the objectives and concepts of financial reporting for Islamic banks -General presentation and disclosure in the financial Statements of Islamic banks -Accounting Standards for Murabaha, ijarah, istisna’a, mudarabah, musharakah, and Investment Accounts Method:

Lecture, presentation, discussion, exercises and case studies Pre Requisites:

Bankers involved in the Accounting, Financial control and Auditing functions of Islamic banks. Audit firms professionals and regulators who supervise and inspect Islamic banks

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Course Objective:

to familiarize the participants with broad framework of accounting and financial reporting issues in Islamic banks -to outline the Islamic Accounting Standards developed by the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) -to provide detail analysis of a number of Standards to explain how they have tackled the financial reporting issues in Islamic banks Contents : Objectives of Financial Accounting for Islamic bank -Financial Statement of an Islamic Bank -International Accounting Standards (IAS) and Islamic Banking Operations -The establishment of AAOIFI AAOIFI and the objectives and concepts of financial reporting for Islamic banks -General presentation and disclosure in the financial Statements of Islamic banks -Accounting Standards for Murabaha, ijarah, istisna’a, mudarabah, musharakah, and Investment Accounts Method:

Lecture, presentation, discussion, exercises and case studies Pre Requisites:

Bankers involved in the Accounting, Financial control and Auditing functions of Islamic banks. Audit firms professionals and regulators who supervise and inspect Islamic banks

Accounting Accounting of Islamic Banks

Part 1 Development of Islamic Banking System

Definition of a Bank Banking business means: (a) The business of; (i) Receiving deposits on current account, deposit account, savings account or other similar account; (ii) Paying and collecting cheques drawn by or paid in by customers; and, (iii) Provision of finance; or (b) Such other business as the bank (BNM), with the approval of the Minister may prescribe Banking and Financial Institutions Act 1989 (BAFIA)

Definition of an Islamic Bank “Banking business whose aims and operations

do not involve any element which is not approve by the religion of Islam”

Islamic Banking Act (1983)

Need for Islamic Banking System • • • • •

Shariah Islamiyyah compliance Meet financing and investment needs of the Muslims Meet modern requirement of individual and commercial needs Encourages financial innovations but in line with Shariah In Malaysia, growing regulatory and social support

Historical Development of Islamic Banking • • • • •

The 1st. Islamic Bank – Mit-Ghamr Nasser Social Bank, Egypt (1963) Dalla Al-Baraka Group, Saudi (1969) Islamic Development Bank, Jeddah, Saudi (1975) Dar al-Maal al-Islami, Saudi (1981) BIMB (1983)

• Jordan Islamic Bank, Dubai Islamic Bank etc…

Factors Factors Affecting the Development of Islamic I slamic Banking System • • • •

Legal, political and economic changes internationally Islamization and Institutional Reform (e.g. Pakistan, Iran, Sudan, Malaysia) International Muslim organizations (OIC – IDB – etc) International response to capture capital/fund of oil rich Islamic countries (e.g. Citibank, Dresdner Kleinworth Benson, ANZ group, etc.

Malaysian Dual Banking System • •

In 1963, the Pilgrims and Fund Management Board provides a savings mechanism for Muslims to perform Hajj In 1983, the Islamic Banking Act (IBA) was approved and defined Islamic Banking as “banking business whose aims and

operations do not involve any element which is not approve by the religion of Islam”. •

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Government Investment Investment Act (Act 275) 1983 empowers the government to issue Government Investment Certificates (GIC) with returns in the form of discretionary discretionary gift (Hibah) rather than interest In 1993, Conventional banks can operate Islamic baking and financial products known as Skim Perbankan Tanpa Faedah (SPTF)

PART 2

Traditional western (secular) accounting objectives

Definition and Purpose of Accounting In 1966 the American Accounting Association defined accounting as: “…the process of identifying, measuring and communicating

economic information to permit informed judgements and decisions by users of that information” In 1975 they added that the purpose of the process was: “…to provide information which is potentially useful for

making economic decisions and which, if provided, will enhance social welfare”

ACCOUNTING A PROCESS OF Recognising, recording, classifying and summarising business transaction Documents Vouchers

Measuring, Analyzing, Interpreting Result of Operation

Profitability = Income - Expenses

Reporting & Presenting Financial Position

Financial Statement •

Ledger

Growth

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Trial Balance

Liquidity •

Report (Mgmt )

Productivity

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Balance Sheet Income Statement Stmt of Changes In Equity Cash Flow Statement Notes to Accounts

STAKEHOLDERS 1. Management 2. Board of Directors

3. Shareholders 4. Investors 5. Creditors

6. Authorities – BNM, Inland Revenue, Baitulmal 7. Staff  8. Public

Traditional Model of Accounting • • • •

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Accounting entity (Owners (principals) are different from managers (agents) Economic events (identifiable and measurable in monetary terms) Financial description Decision usefulness to a very restricted set of users (esp. those with financial involvement with the entity) Neo-Classical Economics and maximization of wealth of stakeholders

Objectives of Financial Accounting and Reporting •

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• • •

Provide information that is useful to present and potential investors and creditors and other users in making rational decisions Information should be comprehensible to those who have reasonable understanding of economic activities and are willing to study the information Primary user groups are shareholders, investors and creditors Secondary user groups are employees, customers, and the public Accountability framework - the objective is to provide a fair system of information flow between the accountor (agent) and the accountee (principal)

PART 3 Accounting from an Islamic perspective

Accounting and Islam Al-Baqarah 282: “O you who believe! When you deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing, let a scribe write down faithfully as between the parties: let not the scribe refuse to write: as God has taught him, so let him write. Let him who incurs the liability (debtor) dictate, but let him fear his Lord God, and not diminish aught of what he owes. If the party liable (debtor) is mentally deficient, or weak, or unable himself to dictate, let his guardian dictate faithfully, and get two witnesses, out of your own men, and if they are not two men, then a man and two women, so that if  one of them errs, the other can remind him….”

Accounting and Islam “…The witnesses should not refuse when they are called

on (for evidence). Disdain not to reduce to writing (your contract) for a future period, whether it be small or big: it is more just in the sight of God, more suitable as evidence, and more convenient to prevent doubts among yourselves. But if you carry out the transactions on the spot there is no blame if you reduce it not to writing. But take witness whenever you make a commercial contract, and let neither the scribe nor witness suffer harm. If you do (such harm), it would be wickedness in you. So fear God; for it is God that teaches you. And God is well acquainted with all things”

Definition of Accounting from an Islamic Perspective “The process of identifying, measuring, and

communicating economic and other relevant information inspired by Islamic Worldview and complied with Syari’ah Islamiyyah to permit informed

 judgements and decisions by potential and expected users information to

enhance social welfare”

Islamic Accountability • • • • •

Transcendental accountability to Allah SWT (Hablumminallah) Social accountability to the society ( Hablumminannass) Individuals as trustees or khalifah Success in this world and in the hereafter (al-falah) Economic goals beyond purely wealth but include tazkiyah (purification of self and wealth)

Objectives of Financial Statements Traditional

Islamic

Balance Sheet

Economic Performance Financial Position

Fulfilment of  Amanah Financial Trust and Obligation

Cash Flow

Cash Position

Equity Statement

Wealth Ownership

Cash Entrusted Wealth Entrusted

Income Statement

Features of Islamic Accounting • •

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No different in terms of recording (double entry system) Clear distinction of Accounting Objectives i.e. religious obligation vs. commercial obligation (different significance of financial statements) Different users information need (legitimate and equitable transactions and wealth vs. maximization of wealth and economic consequences)

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Compliance with the principles and rules of Syari’ah

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Different Islamic contractual relationships (mudarabah instrument; murabahah etc.) Distinct accountability relationships (to Allah SWT and Ummah)

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Determination of zakat

User Groups of Accounting Information for Islamic Banks • • •

Investors (potential and existing) (lawful and equitable investment) Creditors (potential and existing) (lawful trade assets) Regulators (e.g. Bank Negara)

• Syari’ah Supervisory Board & Advisory Council

(syari’ah compliance) • •

Customers (lawful goods and services) Others who may be effected by the disclosure or non-disclosure of information

PART 4 Introduction to AAOIFI Accounting Standards and Objectives of  Financial Accounting and Reporting

Accounting and Auditing Organizations of  Islamic Financial Institutions (AAOIFI) Primary Purpose • To enhance the confidence of users of the financial statements of the IFIs and ultimately to promote IFIs Objectives • Develop accounting and auditing thought relevant to IFIs • Disseminate accounting and auditing thought relevant to IFIs • Prepare, promulgate and interpret accounting and auditing standards for IFIs • Review and amend accounting and auditing standards for IFIs

Accounting and Auditing Organizations of Islamic Financial Institutions (AAOIFI) http://www.aaoifi.com/

History: established in 1991 – agreement of  association by IFIs worldwide supported by IDB • Head office is in Bahrain • Organizational Structure  – Supervisory Committee; Financial Accounting Standard Board; Executive Committee; Shari’ah Committee • Funded by founding members of IFIs, establishment of waqf etc. •

AAOIFI: Accounting, Auditing and Governance Standards Financial Accounting Standards • Musharaka Financing • Profit Allocation Basis • Objectives • Investment Account Holders • Concepts • Salam Financing Financial Accounting • Ijarah Financing Standards • Presentation and Disclosure • Zakah of Financial Statements of  • Istisna’ Financing • Provisions and Reserves Islamic Banks • Presentation and Disclosure of  • Murabaha Financing Financial Statements of Islamic • Mudaraba Financing Insurance Companies Statements of Financial Accounting

AAOIFI: Accounting, Auditing and Governance Standards Auditing Standards • Objectives and Principles of  Auditing • The Auditor’s Report • Terms of Audit Engagement Governance Standards • Syariah Supervisory Board • Syariah Review • Internal Syariah Review

Code of Ethics • Code of Ethics for Accountants and Auditors of IFI New Financial Accounting Standards • Investment Fund • Disclosure Bases for Determining and Allocating Insurance Surplus (and deficit) New Auditing Standards • Audit Tests for Syariah Compliance

Objectives of Islamic Financial Accounting and Reporting (AAOIFI) •

To determine rights and obligations of interested parties

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To safeguard entity assets and rights of others

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To contribute to enhancement of managerial productive capacities

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To provide useful information to make legitimate decisions

• Syari’ah compliance •

Distinguish prohibited earnings and expenditure

Objectives of Islamic Financial Accounting and Reporting (AAOIFI) • Present entity’s economic resources, obligations and • • •

related risks Determine Zakat obligations Estimate cash flow and related risk Ensuring reasonable (or equitable) rates of returns to investors

• Disclose Islamic Bank’s discharge of social

responsibility (not as a constraint but as a goal)

PART 5 Accounting concepts from an Islamic perspective

Impact of Syari’ah Contractual

Conditions Accounting concepts Existence

(Recognition of revenue and expense) Lawful (Recognition of revenue and expense) Measurable (Measurement of assets and liabilities) Deliverable (Recognition & Measurement) Equitable (Profit determination and distribution) Accountability (Disclosure & Presentation)

Accounting Concepts: An Islamic Perspective Accounting unit • Separate legal entity; limited liability; owners are different from managers • Similar to the concept of “juridical person” in the case Waqf & Baitulmal • Almost similar to Mudarabah as far as the purpose and principles • Liabilities limited to the capital contribution & may be injurious to the creditors in the case of liquidation • To be constrained by the syari’ah as to the rights and obligations

Accounting Concepts: An Islamic Perspective Periodicity • periodic reports of financial positions as of a given date and divided into reporting periods (normally annual) • Accounting for zakat based on “haul” (one year complete ownership) Going concern • contracts assumed to continue until there is evidence to the contrary • Para 21 MASBi-1 when material uncertainties, those uncertainties should be disclosed

Accounting Concepts: An Islamic Perspective Monetary and stability of unit measurement • currency as common denominator • Impact of inflation & purchasing power on reporting? Prudence & Conservatism • Generally, not to overstate assets and incomes, and not to understate liabilities and expenses • As long as can be determined with certainty (objectivity)

Accounting Recognition and Measurement Concepts Recognition • Define the basic principles that determine the timing of revenue, expense, gain and loss Measurement • Define the broad principles that determine the amount at which assets, liabilities, owners equity etc. are recognized

Islamic Perspective of Accounting Recognition Revenue Recognition •

Recognized when realized

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The right to receive not necessarily when the payment is received (i.e. accrual basis – MASBi-1 para 22; AAOIFI) e.g. when a bank delivers the service

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Syariah Requirement: the amount of revenue should be known and collectible

Expense Recognition •

Realization either because the expense relates to the earning of revenue (e.g. transportation cost for services), or because it relates to the period of income statement (e.g. bonus)

Islamic Perspective of Accounting Measurement Matching Concept •

Matching of revenues and gains with expenses and losses that relate to that period

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Measurement Attributes: acquisition cost (HC), cash equivalent value, asset’s replacement cost etc.

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In the case of Zakat measurement, preference is current market value (AAOIFI FAS 9: Cash Equivalent Value)

Islamic Perspective of Accounting Measurement • • • • • • • •

Historical Value vs. Current Value Cash Equivalent Value (most preferred if the following are available): availability of objective indicator; relevant information; logical and relevant valuation consistency of valuation methods experts valuation conservatism in the valuation process

Definition of Assets “Capable of generating positive cash flows

or other economic benefits in the future either by itself or in combination with other assets which the bank has acquired the right to hold (rightful ownership of maal), use of dispose (rights on manfaat) as a result of past transactions or events” (AAOIFI)

Desirable Characteristics of Accounting Information 1. Relevance •

Predictive Value (ability to predict potential outcome)

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Feedback Value (ability to verify the accuracy of prior prediction)

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Timeliness (available as soon as after the reported events)

Desirable Characteristics of Accounting Information 2. Reliability • Representational faithfulness (information reflect what it purports to present) • Objectivity (measurement and disclosure appropriately used and if replicated by independent person gives the same result) • Neutrality (accounting information directed towards common needs of users and not needs of particular group of users)

Desirable Characteristics of Accounting Information 3. Comparability • Able to make comparison of the bank’s performance

and position over time and with other banks 4. Consistency •

Consistent in applying accounting measurement, valuation and disclosure methods from one period to another

Desirable Characteristics of Accounting Information 5. Understandability • Aware of the abilities and limitations of those for whom accounting information is provided 6. Materiality • Accounting information is regarded material if its omission, non-disclosure or misstatement results in distortion of the financial statements

Conclusions Islamic accounting framework (objectives and concepts):

1.

Compliance with syari’ah and, achievement of 

Islamic goals, on financial activities (financing schemes and financial instruments) 2.

Equitable and fair recognition, measurement, valuation and disclosure of financial information

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Achievement of both economic and spiritual well being of the society

ISLAMIC FINANCIAL INDUSTRY Challenges and Opportunities

Manifestations of Islamic Finance 1. Islamic banking at economy wide level 2. Islamic banking in the private corporate sector 3. Islamic Financial institutions other than the 4. Islamic Financial activities undertaken by conventional banks and non-banking financial institutions

Distinguishing Features of Islamic Finance •

Risk Sharing: Risks are shared between provider and user of funds

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More emphasis on Productivity than on credit worthiness.

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Moral Suasion: All agents in the financial markets have to work within the boundaries of moral values of Islam.

Islamic banking in practice Brief history: Mit Ghamr (1963), unsuccessful experiments, Dubai Islamic Bank and Islamic Development Bank (1975) • No looking back since the. • Two approaches: Pakistani and Malaysian Models • Iranian banks are in public sector, Gulf banks are in the private sector. •

Present State of Islamic Finance •

In terms of number of institutions:

South and SE Asia

42%

GCC

22%

Other ME

15%

Africa

10%

Europe and America

9%

Present State of Islamic finance 90 80 70 60 50 40 30 20 10 0 Number of  Institutions

South and SE Asia GCC Other Middle East Africa

4th Qtr

Europe and America TOTAL

Present State of Islamic finance •

In terms of funds managed by Islamic banks, 64% of  funds are managed by the instructions in GCC, 20% in South and SE Asia, the rest is distributed between Other ME countries, Africa, Europe and America.

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Main activity of Islamic finance is concentrated in the Gulf and South and Southeast Asian countries.

Size of the Industry •

A few years ago, an IDB study estimated the total size of the industry to be about 3 billion dollars. The industry pundits put the current figure between 7-8 billion dollars. The industry is said to be growing at the rate of 15 percent per annum.

Size of Firms in the Industry Assets (in Million $) 0-5

Frequency Distribution 39

51-100 101-200

13 4

201-300

3

301-400 401-500

8 1

500-1000 > -1000

3 7

TOTAL

78

Size of Firms in the Industry Optimal size of a banking firm in the US 500million $. • Large size enables firms to save on infrastructure • Most of Islamic banks are below this optimal size. • Small size of Islamic banks is a major hurdle in minimizing risk through port folio diversification. •

Modes of Financing :Data Financing Technique

Simple average

Weighted average

Murabaha

70.19

65.66

Musharakah

11.20

12.61

Mudarabah

7.29

8.17

Ijarah

4.84

3.73

Other

6.49

9.83

Modes of Financing: Analysis accounts for about 70 percent of  total financing. If Ijarah is added, the share of  fixed return techniques goes up to 75 percent.

• Murabaha

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The PLS techniques account only for 14 percent of total financing.

Where Finance is going? Sectoral Distribution Sector

Simple average

Weighted average

Trade

42.4

34.1

Agriculture

12.9

14.8

Industry

11.9

9.2

Services

19.1

19.7

Real Estate

12.9

19.5

2.4

2.7

Others

Sectoral Financing: Findings • Lion’s share of financing is claimed by the

Trade sector, followed by the real estate sector. Other studies have also reported similar findings. •

Commodity sector (agriculture and industry) appears to have received less financing.

CHALLENGES AND OPPORTUNITIES

INSTITUTIONAL ASPECTS 1. Institutional Framework

2. Appropriate Legal Framework and Institutions 3. Islamic banking laws 4. Laws for non banking financial institutions 5. Supervisory Framework

SUPERVISORY FRAMEWORK •Supervisory Framework is required to increase:  –Transparency  –Soundness and Prudence  –Shari'ah  –A

Compatibility

supervisory framework ensures confidence of  the public in the banking system.

Need for Regulation and Control 1. 2. 3. 4. 5.

No return from the central banks on deposits. Lender of last resort: Separate system required. Legal Reserve Requirement also needs special treatment Open market operations not available. Musharakah and Mudarabah are on going activities. Accounting not possible unless business is liquidate.