Accounting and Auditing Standards for Islamic Financial Institutions

Mohd Ma'Sum Billah

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000509045
• Edition: 1
• Topic: Business
• Subtopic: Contabilità finanziaria
• Index: Business

While accounting and audit functions are significantly regulated and standardized in conventional financial industries and activities, through the implementation of International Accounting Standards, and International Financial Reporting Standards, as well as other international, regional, and local regulations, this is not the case for Islamic financial organizations. Rather than having their own set of comprehensive accounting or auditing standards or policies, these are based, in some cases, on the Accounting and Auditing Organization for Islamic Financial Institutions (AAIOFI), the Islamic Financial Services Board (IFSB)'s standards and Shari'ah based local policies.

This book is a timely and comprehensive overview of accounting and auditing standards within the doctrine of Shari'ah. It offers a significant contribution to the field and a wealth of technical know-how. It analyzes Islamic accounting and auditing both in theory and practice and from a distinctly international perspective. The chapters are arranged in a systematic and logical way making it easily accessible and engaging.

The book evaluates the existing standards and widens the scope of the discourse to include Maqasid al-Shari'ah, Islamic accounting and audit models and standards, as well as, offering practical policy recommendations. The author presents a Shari'ah justified solution to Islamic Accounting and Audit and offers guidance on overcoming the challenges to implementing Islamic Accounting and Auditing Standards.

The book is a unique and exhaustive guide and, as such, will be an invaluable resource for academics, researchers, students, policymakers, as well as, practitioners in accounting and auditing firms and financial institutions.

Part I

Shari’ah standard of accounting

1

Islamic accounting system

DOI: 10.4324/9781003201878-3

Introduction

Islam is a religion of truth and comprehensive. Islamic teachings cover all aspects of human life and the universe. Islam also provides guidelines and principles to be followed by both Muslims and non-Muslims to the right path and better way. Besides fulfilling our responsibilities as slaves of Allah, we also need to accomplish our responsibilities toward other people especially when dealing with them. As stated in the holy Qur’an:

“O you who believe! When you deal with each other, in transactions involving future obligations in a fixed period, reduce them to writing.”

(al-Baqarah: 282)

As dealing with money, goods, and properties is the most common of our daily activities, it would be the reason why a proper measurement and recording system is required for fair presentation of rights and obligations. A systematic and accurate financial accounting system that had originated and applied since the time of Prophet is an effort to fulfill this requirement. This financial accounting system had been developed and improved occasionally to satisfy the users of information needs. Islamic institutions have been established to assist Muslim societies to spend money in a beneficial manner in line with Shari’ah principles. Islamic institutions such as the Islamic banks play their important roles in introducing and attracting depositors and investors to invest their properties according to the Islamic Shari’ah. Further on, the financial accounting system emphasizes on the conceptual framework and Shari’ah requirements that have been adopted by Islamic financial institutions across the world.

Accounting system

Accounting system in financial industries is a set of structured frameworks to record business transactions in a proper manner with certain rules and principles, and those transactions should be recorded in monetary term. The system is necessary especially for businesses and profit-making organizations or companies to record daily transactions and to define and classify the financial effects of consummated transactions. Besides, the system is supposed to prepare financial statements as a final report of all transactions during a period. The financial statements are to report profit or loss, cash flow and changes in equity of the company every year. The system is also expected to evaluate the organization’s performance as well as enable the Board of Directors to forecast future income and expenses for the future years. The system has also been adopted and practiced in Islamic financial institutions of Malaysia. The accounting system applied by the institutions is conventional and like what has been practiced by other non-Islamic financial institutions, but the only different aspect is that the system takes into consideration the Shari’ah requirements and other Islamic conceptual frameworks. It means the accounting system applied by the Islamic financial institutions follows the Shari’ah guidelines as well as the conceptual frameworks.

Conceptual framework

Conceptual framework is defined by FASB (1976) as “A constitution, a coherent of inter-related objectives and fundamentals that can lead to consistent standards and that prescribe that nature, function and limits of financial accounting and financial statement.” Conceptual frameworks can be considered as the basic guidelines, and they are meant to assist the development of accounting standards and principles. There are some groups of authorities involved in developing accounting standards and principles like Financial Accounting Standards Board (FASB), Accounting Principles Board (APB), and the “Trueblood Committee” under AICPA. These authorities mainly focus on the formulation of objectives of financial statements. The most important purpose of financial statements is to provide a true and fair view on the business financial positions. Besides, the statements also report the performance of the company in order to estimate the earning potential as well as to show the changes in the financial resources of the company. The conceptual frameworks take into consideration the reliability, accuracy, going concern standard, verifiability, and other qualitative objectives of financial accounting system. The frameworks that have been adopted by Islamic financial institutions follow the basic concepts of asset valuations, liabilities, equity, earning, gain and losses, financial maintenance, and physical maintenance, which have been proposed by the conventional accounting system.

Shari’ah requirement

Shari’ah requirements are the Islamic principles and guidelines generally stated in the Holy Qur’an. The Shari’ah requirements are compulsory for every Muslim to follow. In the case of the Islamic financial institutions, they need to take into consideration the Shari’ah requirements and conceptual frameworks to be applied in conjunction with the conventional accounting system. The Shari’ah principles are the main reference in the operations of the Islamic financial institutions to ensure lawful transactions and avoid unlawful transactions. Islamic Shari’ah has highlighted the guidelines and principles due to several reasons, which are to ensure just and fair treatment to all parties involved in the transactions with the institutions and to protect the rights and interests of the parties. These facts prove that the Shari’ah requirements are essential to be obeyed to ensure the blessing and mercy from Allah. Shari’ah principles were explained in general in the holy Qur’an. Among the requirements and principles highlighted is the prohibition of Riba’ (interests). Interests are to be considered as unjust income generated in which it does not involve risks, while the risk is essential in any business contract in order for the income to be considered as lawful. Rifaat Ahmed Abdel Karim (1990) stated in his article that:

As an alternative to interest, Islamic banks use various mechanisms in their mobilization and uses of funds. Two of these mechanisms (Al-Musharakah and Al-Mudharabah) are based on the concept of profit and loss sharing while the others are similar to cost plus margin of profit (Al-Murabaha), leasing financing (Al-Ijarah) and hire-purchase financing (Al-Ijarah-wa-igtina).

Underlying principles

The financial accounting system that is adopted by the Islamic financial institutions follows the Shari’ah requirements highlighted in the Qur’an. The Islamic banks, Takaful companies, and Zakat institutions are the examples of the Islamic financial institutions, which conduct their daily activities according to the Shari’ah requirements as well as the conceptual frameworks. Among those practices are explained as follows.

Al-Murabahah (sale by deferred payment)

Al-Murabahah is a financing instrument, which involves the exchange of goods. It is a sale of goods with an agreed mark-up price on cost as ruled by the Financial Accounting Standards (FAS) 2. Islamic bank buys goods from a seller and sells them back to the customer. There are terms and conditions to be followed in which the Islamic banks should disclose the cost of the goods to the customer, the contract should be valid, and the contract must be free from interest and the need to disclose any fault or destruction of the goods to client.

Al-Mudharabah (co-partnership)

Al-Mudharabah is a contract in which one party provides capital (rabbul mal), and the other party provides work or efforts (Mudharib) (FAS3). Normally, the Islamic bank enrolls as Mudharib while the investors are considered as the contributors of funds or the rabbul mal. The Islamic banks receive the capital or deposits from the depositors, or the capital providers and the funds are to be managed or invested in businesses or projects. The profits are shared between the two parties based on the profit-sharing ratio agreed in the contract, but the losses are borne by the capital providers unless there is misconduct or violation on agreement on the part of the Islamic bank. The practice follows the Shari’ah guideline in which Islam emphasizes that a contract (‘aqd) must have the “offer and acceptance” (‘aqd). The (‘aqd) must exist and should be agreed between the two parties. Another Shari’ah principle applied is that the concept of truthfulness. It is considered relevance since the bank must disclose the cost and the mark-up price to the customer. The disclosure should not defeat the customer, and this shows how the bank follows the guideline of the Shari’ah principles.

Al-Musharakah (partnership)

Al-Musharakah is a form of partnership between the Islamic bank and its clients in which the two parties are supposed to contribute capital of either cash or kind. The parties are the owner of the capital on a permanent or declining basis (FAS4). The profits are shared based on the profit-sharing ratio as agreed during the contract while the losses are shared according to the capi...