Chapter 5 Page 166

CHAPTER 5: THE NEED FOR ISLAMIC ACCOUNTING: PULL

FACTORS 2- THE ESTABLISHMENT OF ISLAMIC
ORGANISATIONS

5.0 INTRODUCTION

In the previous chapter, the researcher attempted to argue the need for an alternative

Islamic Accounting in the form of pull factors; those factors that motivate the

development of Islamic accounting. The first category of Pull Factors, the theoretical

imperative of Islamisation of Accounting, was discussed in the previous chapter. In

this chapter, the second category of Pull Factors, the practical imperative, will be

discussed.

The practical imperative or necessity for the development of an alternative “Islamic

Accounting” is the establishment of Islamic business and not for profit organisations

which are specifically based on the Shari’ah or controlled by Muslims who may wish

to follow its precepts. These socio-economic organisations are part of the Islamic

economic and financial system, which is based on the Islamic world-view. The

researcher believes that the objectives, operations and practical accounting

requirements of these organisations need an alternative “accounting” framework in

order for their objectives to be achieved, their operations to run smoothly and their

activities accounted in a true and fair manner within the world-view in which they

operate.

This chapter is organised as follows:

In section 5.1, the principles and objectives of the Islamic economic and financial

system will be presented. As the prohibition of interest (riba) “is one of the key

elements of the Islamic Economic programme” (Ahmad,1994a, p5), the definition of

riba, some possible reasons for its prohibition and the controversies surrounding its

definition are discussed.

Chapter 5 Page 167

In section 5.2, the main types of Islamic business and non-business organisations,

which attempt to operationalise the Islamic economic order, will be introduced. This

will include a discussion of their objectives, functions, history of establishment and

accounting implications. Due to the extensive scope of Islamic organisations, it is

difficult to cover all of them in detail in this research, as such only a brief sketch is

presented.

Although this research attempts to argue the need for Islamic Accounting in for both

business and non-business Islamic and Muslim organisations, The researcher feels

that describing the accounting needs of many types of Islamic organisations in detail

will be too broad for this research project. As such, the researcher has opted to

concentrate on one industry i.e. the Islamic Finance industry where there has been

intense development. The Islamic banking and financial institutions constituting this

industry, are examples of Islamic business organisations, which have established

themselves in the real world.

Consequently, in section 5.3, Islamic banks and financial institutions will be

discussed in some detail. This will include taxonomy of Islamic financial institutions,

their history, characteristics, differences with conventional banks and their modes of

operation. The Investment of funds mobilised by Islamic banks present both

operational and accounting problems for Islamic banks as they cannot be invested on

the basis of a predetermined fixed return on capital. The complexities of investing

through an equity-like mode are full of agency, monitoring, accounting classification

and income recognition problems. In order to appreciate these problems, a detailed

description of the Islamic financing instruments is presented in section 5.4.

In section 5.5, the accounting problems of banks, as an example of the problems of

attempting to apply conventional accounting to Islamic organisations will be

discussed. This will include the problem of using conventional accounting concepts

and the attempt to introduce standards for the accounts of Islamic banks.
Chapter 5 Page 168

This chapter concludes with section 6.6 that will discuss the possible benefits an

Islamic accounting system for Islamic Banks would produce. Although the Islamic

banking and its problems are discussed in length in this chapter, the research does

not concern itself with Islamic Banking or even Accounting for Islamic banks. Rather,

the discussion is intended as an example of problems faced by Islamic organisations

in using conventional accounting and the need for an alternative accounting system.

5.1 THE ISLAMIC ECONOMIC AND FINANCIAL SYSTEM AND THE

PROBLEM OF RIBA.

Unlike, other economic systems, the Islamic economic system aims to achieve social

justice from a religious ethical perspective. Although the Western economic systems

be they capitalist, socialist or welfare state, aim to achieve human welfare, they all

seem to have accepted interest as a fair reward for capital, although interest has

been condemned by Marx and even Fisher. The Islamic economic system is based

on its complete elimination from the economy by introducing the alternative of

participative investment as opposed to a rentier economy. The capitalist system

strives to attain human welfare through the operation of the invisible hand driven by

self-interest and a free market. The Marxist system attempted to create social welfare

by ownership and centralisation of the production function by the state (representing

the workers). However, all these systems have been ‘unsuccessful’ in achieving

social welfare for all (Chapra, 1992).

Although it is a fact that there is no complete Islamic economic system in operation,

the unique characteristics and features of the Islamic economic system are worth

discussing and modeling for future implementation especially in Islamic countries.

However, practical implementation of the Islamic banking system, which is a partial

implementation of the Islamic economic system, has overtaken academic discussion.

Hence there is an urgent need to come up with both practical devices and theoretical

models, which can be, tested in future practice.

Chapter 5 Page 169

This section proceeds as follows; the objectives and characteristics of the Islamic

economic system are described first. In the following sub-sections riba is discussed

in detail including its definition, classification, reasons for its prohibition and

controversies surrounding its definition.

5.1.1 The objectives and characteristics of the Islamic Economic System

Ahmad (1994a) observes that the Islamic economic program includes a different

concept of the individual and his rights, a different concept of property and a different

approach to civil and economic contracts. Its principles of economic organisation are

also different including; how and on what basis co-operation and collaboration

between individual and society is to take place, the need for regulating the market to

attain efficiency and equity, and the role of the state in the fiscal system.

Al-Faisal & Ali (1996) sum up the principal characteristics of the Islamic Economic

System as follows:

• Although every individual has a right to seek his economic well being, Islamic

makes a clear distinction between what is lawful and what is unlawful in the

pursuit of economic activity. Broadly, Islam forbids all forms of economic

activities, which are morally or socially injurious. The particulars as to what is

considered morally or socially injurious vary from the secular capitalistic system.

• Although Islam recognises, the ownership of legitimately acquired wealth, the

individual is obligated to spend his wealth judiciously and not to hoard it, keep it

idle or squander it.

• Although an individual may retain surplus wealth, Islam seeks to reduce the

margin of this surplus for the well being of the community as a whole.

• It seeks to prevent the accumulation of this wealth in a few hands to the detriment

of the society as a whole through its law of inheritance

Chapter 5 Page 170

• It aims at social justice without inhibiting individual enterprise beyond the point

where it becomes not only collectively injurious but also individually self-

destructive.

Chapra (1992) observes that in line with the Islamic concept of brotherhood and

justice, all resources at the disposal of human beings must be utilised to actualise the

objectives of the Shari’ah. He suggests four objectives of the Islamic economic

system:

a) Need fulfilment: the basic needs of all individuals must be satisfied and everyone

must be assured of a humane and respectable standard of living.

b) Respectable Source of Earnings: The dignity attached to man’s status, as God’s

khalifah or representative means that need fulfillment should be through the

individual’s effort. In the case of handicap or inability to earn a living, it is the

collective obligation of the Muslim community to fulfil their needs through Islamic

socioeconomic institutions such as Zakat, and charitable endowments- awqaf.

Except for Zakat, which is administered by the state, the other institutions are

voluntary but form part and parcel of the Islamic economic ethic.

c) Equitable distribution of income and wealth: Although inequalities in income and

wealth can be tolerated in proportion to skill, initiative, effort and risk, skewed

inequalities are incompatible with Islamic teachings. The elimination of interest,

the introduction of Zakat and change in consumer behaviour patterns to one

conforming to Islamic guidelines are essential to achieve this.

d) Growth and Stability: Growth and stability are essential to maintain employment

and to ensure the goal of equitable wealth distribution as the poor can reap the

fruits of economic growth thus lessening the burden of the rich to redistribute their

wealth.

Chapra (1992) proposes the following strategy to achieve the objectives:

a) Introducing a socially agreed filter mechanism: In addition to the price

mechanism, a double layer of moral filters tempers claims on resources.

Chapter 5 Page 171

Individually, Islamic consumers should avoid wasteful expenditures because of

legal/moral precepts of the Shari’ah. In addition the Islamic financial system also

acts as moral filters in their investing and credit expansion activities.

b) A strong motivating system to induce the individual to render his best in his own

interest as well as in the interest of society. This comes from the Islamic concept

of accountability to Allah, from whom no actions can be hidden, and to whom

every action has to be accounted for in the life after death.

c) Restructuring the entire economy to realise the Shari’ah objectives in spite of

scarce resources. This is to be done by reforming all social, economic and

political institutions including public finances and financial intermediation to

minimise wasteful and unnecessary consumption and to promote investment for

need fulfillment. The Islamic structures will also support the filter and motivating

system by not allowing material possessions and conspicuous consumption to

become a source of prestige, thus killing off the economic man.

d) A positive and goal-oriented role for the government. The government would

support the raising of the moral consciousness of people, motivate and help the

private sector play its role effectively and accelerate political, social and

economic reform and provide incentives and facilities.

Ahmad (1994a) observes that, although the elimination of interest is not the be-all

and end all of Islamic economic programme, it is one of its key elements. It can thus

be seen that reforming the banking and monetary system to eliminate interest

transactions and putting them on an Islamic plane is one of the cornerstones of the

Islamic financial system.

The Islamic financial system is part of the Islamic socioeconomic system which

Muslim economists and Islamists are endeavouring to develop. The development of

an interest-free, ethical Islamic economic system is an important agenda of most

Islamic movements and some governments such as Pakistan, Iran and Sudan

(Ahmad, 1994a). Other countries, such as Malaysia and Gulf countries, allow Islamic
Chapter 5 Page 172

economic institutions such as Islamic banks to operate in parallel with the

conventional financial system.

Social Justice is said to be the hallmark of the Islamic economic system (Ahmed et

al., 1996). In order to achieve this Islamic economy, two institutional devices “the

abolition of interest and presence of a well-functioning Zakat system (p3)” are

considered essential. As the Islamic financial system relies mostly on the former, this

aspect will be discussed in some detail. The researcher will firstly discuss the

definition, the nature and classification of riba (interest), followed by a discussion on

the possible reasons for its prohibition in Islam. This is then followed by a review of

the controversies surrounding the nature and application of riba in modern business

life.

5.1.2 Definition and classification of Riba

The Qur’an and the Hadith of the Prophet (pbuh) specifically prohibits riba in

economic transactions in the sternest terms (e.g. Al-Qur’an, 2:275,278,279). ‘Riba

has been translated into English as usury or interest. However, it has in fact a much

broader meaning under the Shari’ah as suggested by its dictionary meaning of

“increase” or “gain”. Saleh (1992) has defined riba in the Shari’ah context as “an

unlawful gain derived from the quantitative inequality of the counter-values in any

transaction purporting to effect the exchange of two or more species, which belong to

the same genus and are governed by the same efficient cause” (p16). Thankfully, the

author has adopted a shortened version of this rather long technical definition as “an

unlawful advantage by way of excess or deferment” (p17).

Riba has been classified into two categories: riba al-fadl and riba al-nasi’a

(Muslehuddin, 1987). Riba al-fadl is riba by way of excess of one of the exchanged

counter-values e.g. the exchange of 2 Kg. of low quality rice for 1 Kg. of high quality

rice. Riba al-nasi’a is excess by way of deferment of completion of exchange, for

example a loan of £100 for a deferred repayment of £110 a year later. As Islamic
Chapter 5 Page 173

banking involves the elimination of Riba al-nasi’a, further discussion on riba will be

limited to this form only.

5.1.3 Reasons for the prohibition of Riba

We can thus surmise that any interest or excess above the principal sum in a

deferred repayment transaction is riba. The reason given in the Qur’an for the

prohibition of riba is that, a pre-determined fixed rate of return on capital lent leads to

injustice because there is an uneven distribution of risk and reward in the transaction

(Obiyathulla, 1995). One party bears the risk, while the other party receives a reward

irrespective of the outcome of the use of the borrowed amount. Riba is also said to

lead to the concentration of wealth by transferring wealth from the poor to the rich, a

position not unreasonable given the current distribution of wealth and third world debt

crisis (Caufield, 1998). It is also said to increase the instability of the trade cycle,

causing more violent fluctuations because a high rate of interest, by increasing the

cost of capital, discourages investments (Keen, 1997). An IMF economist observes

that Islamic banking, based on the elimination of riba will to lead to a more stable

banking system, thus:

“The Islamic model of banking based on the principle of equity

participation may well prove to be better suited to adjusting to shocks that
result in banking crisis and disruption on the payment mechanism of the
country. In an equity-based system that ...does not guarantee the nominal
value of deposits, shocks to asset positions are immediately absorbed by
changes in the values of the share deposits held by the public in the banks.
Therefore, the real value of assets and liabilities of banks in such a system
will be equal at all points in time. In the more traditional banking system
since the nominal value of deposits is fixed, such shocks can cause a
diversion between real assets and liabilities”. (Mohsin, 1986, p19)

5.1.4 Controversies on the prohibition of Riba

In the light of modern financial practices, the elimination of interest would seem to be

an unworkable plan. In fact, the elimination of interest has been thought to be

irrational and a sign of a backward economy. Although usury i.e. excessive rates of

interest, especially on consumption loans are regarded by some in the West as

immoral, commercial interest is seen as a legitimate reward for the use of capital in
Chapter 5 Page 174

modern economies. It is justified as reward for the “time value of money”. Indeed,

some modern Muslim economists (in the early part of this century) and even some

Islamic scholars have tried to restrict the definition of riba to usury and thus legitimise

the institution of interest among Muslims. Among the arguments offered in favour of

legitimising interest are:

(a) Riba is only usury and not interest

(b) Riba is compound interest and not simple interest

(c) Only interest on consumption loans is prohibited, not on investment loans.

(d) Islam recognises the time value of money and therefore interest should be

allowed.

(e) Bank interest is not prohibited because it is not exploitative.

The first controversy as to whether riba is limited to usury begs the question as to

what is the upper limit of the interest rate which is justified and what rate does

illegitimate usury begins. Prior to 1571 in England, at least, all rates of interest above

zero were considered usurious following the edict of St. Thomas Aquinas (Keen,

1997). Of course, a legal solution could be offered but the historical evidence shows,

at different times, different rates were considered usurious. For example, the

Sumerians considered 25% interest rate normal while the 1571 Act against Usury of

England indicated that anything more than 10% was usurious. Although in a secular

framework, the rate of usury may be a matter of individual conscience or to

parliamentary consensus, this does not provide the specific technical, moral or any

other reason why the rate below the benchmark is justified and that above is not.

(Shaikh, 1987).

The second controversy asserting that riba is only compound interest is based on

one interpretation of the Quranic verse: “ O you who believe, do not devour riba,

doubling and redoubling” (Al- Qur’an, 3:130). However, Islamic rules of interpretation

state that the whole Qur’an (together with the Hadith) must be considered in

interpreting any verse. Verses 275 to 279 of the second chapter of the Qur’an leave
Chapter 5 Page 175

no doubt regarding what is meant as they clearly state that only the principal lent is

the amount the borrower is obligated to return. Further, as Hoque (1987) observes,

the distinction between compound and simple interest is apparent and not real as an

overdue interest on simple interest becomes compounded. As the compulsory

notification of the APR (Average percentage rate) in the UK shows that a compound

interest rate can also be expressed in terms of a simple interest rate. In fact, it is just

a matter of time before the interest doubles and triples the principal amount. Thus,

this sophistry is not enough to deny the prohibition of riba.

The secular reasoning that, interest is only injurious, if at all, in consumption loans

and not in the case of commercial or investment loans as is the case in commercial

bank lending, is not acceptable from an Islamic point of view. This is due to the fact,

that at the time of prohibition, Arabia was a major commercial centre of the Indian –

Mediterranean trade route (Chaudhuri, 1985). In fact many of the Companions of the

Prophet (pbuh) received loans on an interest basis (before the Qur’anic prohibition)

to invest in their trades. The Prophet (pbuh) specifically banned such interest-based

loans after the Qur’anic prohibition was revealed, retrospectively. The Qur’an states

that “Allah has permitted trade and prohibited riba”, in spite of the protests of the

Arabs that “Trade is like riba” (Al-Qur’an, 2:275), Islam is quite clear on this. Further

Islam has not prohibited other avenues of lawful employment of capital to generate

income in the form of rent, labour-capital participation, joint venture and mark-up

trading. Chapra (1985) quoting Shaykh Abu Zahrah, an eminent Muslim scholar,

observes that:

“There is absolutely no evidence to support the contention that the riba

(prohibition)...was on consumption loans and not on development loans.
In fact the loans for which a research scholar finds support in history are
production loans. The circumstances of the Arabs, the position of Makkah
and the trade of the Quraysh (the tribe of the Prophet (pbuh)), all lend
support to the assertion that the loans were for production and not
consumption purposes”. (Chapra , 1985, p 62)

One might protest that despite the historical basis on which the prohibition was

based, the ruling is irrational in view of the fact the loans provide for development or
Chapter 5 Page 176

investment accrue profits and it would be unreasonable for the lender not to share in

it. The answer to this is that Islam does not bar the association of capital and

entrepreneurship. However, it prohibits interest-based loans because the

predetermined fixed return to the lender is irrespective of the fortunes of the

entrepreneur. If the investor agrees to share any eventual loss, he can contract for a

share of the actual profit earned by the entrepreneur.

Whether Islam recognises the time value of money is more controversial. In the case

of the Islamically allowable murabaha or mark-up contracts, in which a supplier

contracts with a buyer to acquire a product and sell it to the buyer at a mark up on

cost, the price can be deferred or paid on an instalment basis. By allowing, the extra

charge for delayed payment - Islam appears to recognise the time value of money by

recognising the opportunity cost foregone by the entrepreneur who might have

otherwise have his capital tied up – a subtle distinction from the charging of interest

(Vogel & Hayes, 1998).

On the other hand, Khan (1994a) is of the opinion that discounting violates the

Shari’ah prohibition of interest. Khan (1994a) observes that only in the case of the

poor people is it true that the current utility of money is greater than the future utility.

He opines that every cent saved testifies to the fact that savers have a preference for

the future utility of the money rather than current. Hence there is no need to discount

future inflows. Tomkins & Karim (1987), however, observe that the objection to the

use of interest rate for discounting can easily be avoided by using an expected return

rate as a hurdle rate. Hence using discounting techniques is not a problem in capital

budgeting and valuing assets.

Finally, many scholars argue that the modern banking institution was not present at

the time of the Prophet (pbuh). As it performs vital functions of financial

intermediation in the modern economy and is not exploitative, bank interest should

not come under the gambit of the riba prohibition. Some court ulemas especially

those from the Egyptian government have in fact given legal opinions (fatawas) to
Chapter 5 Page 177

this effect. However, the majority of the Islamic scholars view that bank interest is no

exception because the bank in fact represents a group of individuals (the

shareholders) who are in the money-lending business. Since the riba prohibition

equally applies to individuals as well as groups, banks are not exempted (Hoque,

1987). Despite this, however, the same author observes that it is a fallacy to view the

whole conventional banking process itself to be UnIslamic. A close look at the

function of banks in channeling savings to productive enterprises is actually

facilitating the realisation of the objectives of the Shari’ah, which abhors and

penalises idle savings. Only the interest mechanism used to achieve this objective is

objectionable. Hence if interest is replaced by any permissible mechanics and the

bank limits its activities to financing businesses approved by the Shari’ah banking

becomes an important Islamic institution (Hoque, 1987).

Finally the recent Federal Shari’ah Court of Pakistan’s judgement on Riba1 (Khan,

1994b) should put to rest any lingering suspicions on the nature of riba. Contrary to a

normal process of interpretation of a constitution2, the Court sent out a questionnaire

and collected evidence and cited various works of both Muslim and Non-Muslim

scholars to discern the nature of riba. It concluded “ a transaction which contains

excess or addition over and above the principal amount of loan, payable to the

creditor constitutes riba “(p13). Therefore, any such sale, transaction or credit

facility, in money or in kind, has been considered to be of riba, which is unlawful

(haram) in Muslim society. Khan (1994b) observes that the court held that there was

a consensus of the opinion (ijma’) of Muslim jurists upon it. Further, it did not make a

difference whether the loan is for consumption or for commercial purpose, if the rate

of interest is high or low, simple or compound or between Muslim and Non-Muslim or

between an individual and the state.

1
This ruling was appealed by the Government of Pakistan whose Appeals Court has just turned down
the appeal in December 1999, and has given the Pakistan government until year to rid the economic
system of riba consistent with the constitution of the Islamic Republic of Pakistan.
2
The litigant filed a case against the Pakistan’s government use of conventional interest based
financing as against its constitution.
Chapter 5 Page 178

While debate might continue forever on this issue in academic circles, the matter is

quite clear to Muslims that conventional interest is not acceptable from an Islamic

perspective. Thus, they have no option, if they want to abide by Qur’anic principles,

except to overhaul the conventional financial and banking system to an interest-free

footing.

5.2 ISLAMIC ORGANISATIONS

As part of the Islamic resurgence, Muslims have set up Islamic business and non-

business organisations which attempt to operationalise the Shari’ah in their economic

and governmental affairs (El-Ashker, 1987). In the heydays of Islamic civilisation,

there were unique socio-economic Islamic Institutions, which were replaced, by

foreign economic institutions, after the colonisation of Muslim lands. The two most

important institutions, which will be discussed in this research, were the “Baitul-Mal”

(public treasury)- which collected and disbursed Zakat – the Islamic religious levy

and the Awqaf (Muslim endowment). In the private sector, businesses were

conducted for the most part, according to Islamic precepts despite the claims of

Rodinson (1974) that this was more in letter rather than in spirit. Muslims are

attempting to revive these institutions and adapt them to contemporary

circumstances as part of the Islamic resurgence in the Muslim countries (Sivan,

1985).

In the business sector, although the concept of the modern corporation was

unknown, Islamic law and Muslim business practice knew the concept of separate

legal person and joint stock partnership (Usmani, 1998). Muslims undertook joint

ventures, especially commenda (mudharabah) and partnerships, which were based

on risk-taking profit and loss sharing ventures (Udovitch, 1970). As interest was

prohibited, interest bearing bonds were unknown but interest bearing commercial

loans and government loans did take place, sometime in the guise of “mark-up” or

buy and resell sales contracts allowed in Islam (Rodinson, 1974). Some Muslim
Chapter 5 Page 179

governments, especially the late Ottoman Sultans took interest-bearing loans from

Western countries, which eventually led to the downfall of the Caliphate. There were

even instances of Mosque funds lent out at interest, which was prohibited under

Muslim Law. However, these were always frowned at by Islamic scholars and

Muslims and never accepted as legal by the majority of Muslims.

Although the use of trade bills and cheques were known in Islamic History, modern

banking was a Western Introduction in Muslim lands which took root after

colonisation. Despite being encouraged by the governments of Muslim countries, the

Muslim masses harboured much suspicion of the allowability of interest charged or

given on deposits by these banks. Many strict Muslims refused to deposit their

money and preferred to keep it in their homes. Others used the banks as a safe-

deposit service and would not take the interest credited to their accounts or gave

them away to charity.

To solve this problem and give Muslims a Shari’ah friendly alternative to conventional

banking, Islamic banking was born and has since become established as a viable

alternative, although there are many strategic, operational, regulatory and accounting

problems faced by these banks (Al-Faisal & Ali, 1996). In addition to the banks,

Islamic finance co-operatives and savings institutions which invest the believers’

money in Shari’ah approved and ethically correct ways have been set up. The

Lembaga Tabung Haji of Malaysia, established in 1962 is an example of one such

successful institution, which had assets totalling 5.2billion Malaysian Ringgit (around

US $2billion) in 1997.

Another financial institution, which presented problems for Muslims, is the

conventional insurance company. The Shar’iah prohibits conventional insurance

because of its connections with interest, gambling and gharar (uncertainty). In

general, a contingent insurance contract is prohibited in Islam. To overcome this

problem, Islamic Insurance companies (known as Takaful) have been developed,

where the contributors share in a savings scheme including a compulsory

Chapter 5 Page 180

contribution to a claims pool. The Takaful Company then tries to compensate any

claimant from the amount of his contribution plus earnings. Any shortfall of the

indemnified amount comes from the claims pool if available. Of course, the policy

premiums are invested in interest-free, Shari’ah approved investments.

As discussed in chapter 2, the world-view of Islam and therefore Islamic

organisations, whether in the public, private or voluntary sector, are different from

those of conventional business and non-business organisations. The difference

arises in the objectives, nature of profits, the activity or industry Muslims can

undertake or invest and in the way the wealth is distributed. The charging and

earning of interest, gambling, alcohol and other industries and aleatory contracts are

prohibited. Further the maximising of profits or wealth as an objective is frowned

upon because it conflicts with the ultimate objective of achieving falah (Islamic

success/salvation –see chapter 6) in the hereafter. Although unlike Christianity (see

Laughlin, 1988; Tawney, 1927), Muslims are not averse to exploiting the resources

for material gain, they would have to undertake this in ways which is in accord with

the Shari’ah.

There is a need to differentiate between Islamic and Muslim organisations. In case of

businesses, the researcher defines Islamic business organisations as those which

have been set up specifically to operate within the Shari’ah as part of the strategy to

develop a comprehensive Islamic Economic and Financial system. Their philosophy

must be Islamic and not merely meant as a cover to introduce interest through the

backdoor. On the other hand, Muslim business organisations are businesses set up

by Muslims who may or may not follow the Shari’ah. However, Muslim businesses,

especially small and medium-scale ones may intend to gradually shift towards an

Islamic business profile in their activities. Islamic accounting is needed by both types

of organisations – mandatory for the former and helpful for the latter to achieve their

Islamic ambitions.
Chapter 5 Page 181

5.2.1 Islamic businesses

Islam not only allows, but encourages trade and business. Business can be

organised either as sole proprietorship, partnership and companies as in common

law. Although the concept of limited liability has been frowned upon (Usmani, 1998),

the company form of organisation is lawful in Islam with certain restrictions. These

include the type of capital, which can be raised, the type of investments, which can

be carried out, and the way profit and loss is shared.

Although sole proprietorships, partnerships and joint ventures have been the most

common forms of businesses in the Muslim world (El-Ashker, 1987), the company

form of business organisation is increasingly used in the Muslim world both by private

and public companies.

5.2.1.1 Forms of Business Organisation

The common law varieties of business organisations (sole proprietorship, the

partnership and the company) are permitted in Islam. The liabilities, obligations and

the rewards of ownership are pretty much the same for sole proprietorship except

that the owner is not allowed to conduct business in forbidden products or services

such as selling pork, liquor, gambling or interest-based money lending.

The distinction between partnership and companies in not clear in Islamic law

because the modern corporation was never found in Muslim countries before the

adoption of European law in Muslim lands. However, the Muslim partnership law is

quite comprehensive to allow for the formation of joint stock companies, the

formation of which is said to be encouraged by the Prophet (pbuh) himself (Atiyah,

1992).

5.2.1.2 Objectives and operations of Islamic Organisations.

The objective of Islamic business organisations is to enable Muslims to undertake

economic activities within the framework of the Shari’ah as a means to attain falah
Chapter 5 Page 182

(success in the hereafter). This means that the businesses must follow a code of

Islamic ethics in relation to their activities and behaviour towards their stakeholders

(Beekun, 1997).

Conventional business organisations follow a profit or wealth maximisation model.

This is the based on the concept of the utility maximising behaviour of conventional

rational economic man. Although profit is deemed legitimate and is one of the major

objectives of Islamic businesses, profit maximisation, as a prime objective is not

identified in the Islamic model (El-Ashker, 1987). Even though capitalist businesses

seem to be moving to wealth maximising and satisficing, the concept of maximisation

is entrenched in the accounting calculus e.g. when investment appraisals are carried

out.

In Islam, wealth is only considered as a means to an end. As in other religions, the

Muslim scholars, for example Al-Ghazali (Al-Karim, 1995), have warned their

followers of the dangers of greed for wealth. Thus maximising wealth is not a priority

of the Muslim. On the other hand, the economic strength of a nation or group has

direct implications for political and social stability. Hence, Islam encourages the

pursuance of wealth in an ethical manner. In line with this, the objective of Islamic

business organisations is therefore to seek reasonable profits in line with the risk

taken and any particular social consequences of high pricing policy. Survival and

growth are also emphasised as important objectives in hostile environments where

Islamic businesses have to compete with conventional ones.

Islamic businesses have to take into account the benefits accruing to employees,

society and the environment, in addition to fund providers as a matter of

religious/moral obligation emanating from their Islamic beliefs. El-Ashker’s (1987)

study of Islamic business enterprises in Egypt provides some evidence that Islamic

businesses aim to achieve three sets of objectives related to the benefits accruing to

finance providers, employees and society. He proposes a utility model for Islamic

economics, consisting of secular and ritual utilities. The secular utility is the normal
Chapter 5 Page 183

conventional utility consisting of profits and financial benefits whereas the ritual utility

relates to employee and non-profit oriented social objectives intending to please God

and to achieve falah. Achieving profits within this constraint is said to please God and

leads to a higher divine reward and hence is a source of utility for Islamic businesses.

The Islamic business aims to achieve a balanced relationship between the three sets

of objectives of the three interested parties in the course of maximising its utility.

Thus:

Maximise U = Ua(R), Ub [UaR, E, S], F(P)

Subject to Y= R+E+S, where:

U= Utility function
Ua = secular utility function
Ub = ritual utility function
R=Profit
E = cost of employment welfare (wages and the like)
S = social cost (costs of social welfare)
P = degree of piety
Y = net value of production.

Since Islamic and Muslim businesses vary in the degree of commitment to Islam, the

degree of piety (P) is introduced into the equation to account for this. Thus for

different organisations with different degrees of piety, the equilibrium point, E, S, and

R will be achieved will be different. The researcher proposes that an additional

environmental cost (N) be added to the equation. Hence Y= E+S+N+R and Ub [UaR,

E,S,N], hence Islamic businesses will maximise its utility and will be in equilibrium

when a proper mix depending on the degree of piety is achieved.

While all this might seem theoretical and not practical, the study by El-Ashker (1987)

using actual case studies of Islamic companies in Egypt indicates that this is what is

done in practice by Islamic companies with a high degree of P.

5.2.1.3 Accounting implications

Both the structure and objectives of Islamic business organisations make the

development of an alternative Islamic accounting an imperative. For example,

debentures, bonds and even preference shares are not allowable in an Islamic
Chapter 5 Page 184

company. This is because of fixed interest bearing characteristics of the former and

profit sharing arrangements of the latter which are considered inequitable according

to the Shari’ah. New type of financial instruments such as mudharabah and

muqarada bonds (Rosly & Sanusi, 1999), are needed to finance Islamic companies

and used as investment instruments by Islamic banks. These instruments are hybrid

instruments containing both the characteristics of debt and equity (Obiyathullah,

1995) which call for special accounting treatment. This is not only a matter of

different technique but also a matter of change in the fundamental accounting

assumption of substance over form, which underlies conventional accounting

standards, e.g. IAS 1 (IASC, 1975) which may not be acceptable from an Islamic

point of view.

Further, the objective of Islamic businesses which have to balance the shareholder,

employee, society and environmental interests poses serious questions on the

adoption of the profit calculus (the bottom line) as the main area of concentration of

conventional accounting. It cannot be denied that the importance of the bottom line

is exacerbated by the prominence given to the profit and loss account as the primal

financial statement in a set of conventional accounts. This has implications for the

behaviour of stakeholders as accounting can itself lead to the construction of a social

reality (Hines, 1988) not in line with the Islamic aspirations. To balance these non-

shareholder considerations, an Islamic accounting statement might have to consider

an alternative scoring system other than the financial unit.

5.2.2 Zakat collection and distribution

Zakat is one of the five ‘pillars’ of Islam. Literally, it means to purify one’s wealth.

Zakat is a “religious levy by which Muslims make over part of their wealth for the

benefit of others” (Clarke et al., 1996). It is neither a tax nor a charitable donation. A

tax may be expended for any purpose while Zakat can only be paid to eight

categories of beneficiaries specified in the Qur’an. Further, as opposed to a

Chapter 5 Page 185

charitable donation, it is compulsory. Zakat is a wealth based levy although

contemporary Islamic scholars insist that Zakat should also be payable on salaries

and wages. Zakat has been levied on animals, trading profit, and agricultural produce

and gold and silver and money equivalents. Scholars have extended the category of

zakatable items. The rate of wealth Zakat is 2.5% but agricultural produce is subject

to 5% or 10% depending on the use or non- use of irrigation respectively.

The collection and disbursement of Zakat has been traditionally carried out by the

Islamic State, since the time of the Prophet (pbuh) (Zaman, 1991). The Prophet

(pbuh) used to appoint Zakat collectors to assess and collect Zakat from his

followers. This was deposited into the Baitul Mal or the public treasury. Zakat was

collected and disbursed both in cash and in kind. The Islamic State continued to

perform this function until colonisation resulted in the introduction of alternative tax

systems. However, Zakat continued to be paid individually, through charitable

associations (as in the UK) or through the religious departments of government as in

Malaysia.

As part of the Islamisation of the economy, some Muslim countries have started

organising their Zakat collection and distribution activities more efficiently. In

Pakistan, Zakat is now deducted at source e.g. on investment deposits in banks. In

Malaysia, Zakat collection is carried out by religious departments, which come under

the jurisdiction of the various states. Mustapha (1991) observed that Zakat collection

and administration is inefficient as for example, the administrative cost is twice the

pay-out to the destitute group of beneficiaries. There have also been accusations of

mismanagement and maladministration by the head of states that are ultimately

responsible for it (AbdulRahim & Goddard, 1998). There have been calls in Malaysia

for the proper organisation and administration of the Zakat. The Malaysian

government has proposed the establishment of an agency on a national level for the
Chapter 5 Page 186

administration of Zakat3. As a preliminary step, privatised Zakat collection agencies

has been established in the Federal Territory and Selangor, the two states with the

largest earning population. Zakat collection has increased considerably due to the

promotional activities of these agencies. Payment of individual Zakat is also given

income tax rebate. However the authority and accountability structure of these

organisations are far from satisfactory. Once the Zakat is collected it is handed over

to the religious department and is only subject to the Auditor General’s inspection.

The working of the bureaucracy in the distribution of Zakat is not transparent. Further

the “accounts” published by the collection agencies is dismal as the amount collected

is just categorised into the eight beneficiaries as disbursement. Hence what is shown

as disbursements is not actually paid out in fact but theoretical.

An interpretive study of accounting in two religious departments in Malaysia shows

lack of transparency and power conflicts to varying degrees (Abdul Rahim &

Goddard, 1998). There is more professionalism and transparency to a certain level in

the department situated in the more urban Federal Territory where conventionally

qualified accounting personnel carry out conventional computerised accounting. In

the other department located in a more rural area, there was a general lack of

transparency and the researchers reported misuse of power. However, while the

departments using qualified accountants showed more transparency, the introduction

of a conventional accounting system has resulted in a profit-oriented thinking which

has resulted in the adoption of new marketing techniques to collect Zakat. For

example, the Pusat Pembayaran Zakat (Zakat collection centre) is a privatised profit-

oriented entity who are remunerated on a percentage of the collections. Although,

they do not have the power to collect Zakat by legal force, such a measure may have

grave societal implications when Zakat becomes legally compulsory as the profit-

motive in increasing Zakat collection may lead to arbitrary practices. Hence, there is

3
In January 2000, the Malaysian Government informed the public that Zakat will be collected on a
PAYE basis through the Department of Inland Revenue.
Chapter 5 Page 187

a need to develop an appropriate Islamic accounting system, which will induce the

proper Islamically accountable behaviour instead of introducing modern methods and

conventional accounting, which may lead to inappropriate behaviour.

5.2.3 Awqaf

The waqf (pl. Awqaf) is one of the Islamic institutional devices to foster voluntary

spending for the poor as well as to meet several other social causes (Ziauddin,

1991). It is the setting aside of certain assets usually land, buildings etc. for the

exclusive use for specific charitable/religious purposes under a legal deed. The

asset so established becomes a waqf in perpetuity, and cannot be sold, inherited or

expropriated by the government. Only the income form the asset is disbursed

according to the wishes of the waqif - the person setting up the waqf. The waqf thus

becomes a trust property, which is administered by one or more trustee who can

claim reasonable administrative expenses and salary. According to Ziauddin (1991),

“Waqf is thus a device for transferring private property to collective ownership (not

public ownership) for socially beneficial purposes” (p 43).

Awqaf are said to date from the time of the Prophet (pbuh) but acquired clearer legal

status under Islamic law in the first century A.H. Although the legal concept is similar

to trusts and endowments under common law, it is said to predate the English

Institution of Trust. Thus as (Hasanuddin, 1998) observes, “there is no evidence that

such a complex system of appropriating usufruct as a life-interest to varying and

successive classes of beneficiaries existed prior to Islam”(p29).

However, as opposed to English Law which only recognises trusts in favour of other

than the trustor and family as charitable, Islamic law recognises awqaf even if its is

for the trustor’s own or his family’s benefit but with eventual succession to charitable

purposes. The former type of waqf is known as waqf ahli (family endowment)

whereas awqaf specifically meant for charitable purposes from the outset is known

as waqf khairi (endowment for general good). On the surface, it seems the former

type of waqf would not be practicable as it entails a lapse from the time such assets
Chapter 5 Page 188

are endowed and the time it s available for public use. It would be an uphill task for

the authorities or community to keep track of the asset. However, Hoexter (1998)

observes that “contrary to what one might have thought, many of the assets did

eventually find their way to their ultimate beneficiary”(p10).

In any case, both types of awqaf have been and are very important socio-economic

institutions in the Islamic world. Awqaf has been set up for various purposes e.g. the

upkeep of mosques, religious schools, orphanages, hospitals, animal care centres,

parks, rest-rooms, drinking water facilities and food distribution centres

(Siddiqi,1996). In many cases, awqaf are set up to feed the poor in other countries

especially those of the Haramain (the Holy Lands of Islam: Makkah and Medina).

Hoexter (1998) has undertaken an extensive study of the development of this

institution, the waqf al-Haramain in Algiers (Tunisia) during Ottomon rule, from its

own records.

The Algerian, Waqf Al-Haramain was in fact a foundation, which managed all the

individual awqaf assets dedicated to feeding the poor in the Holy Cities of Mecca and

Medina (Hoexter, 1998). Later it took other awqaf into its ambit including those of

other local mosques, feeding the local poor and contributing to local public projects

such as the town’s water system. The local Qadis or Muslim judges were active in

the development of the Islamic jurisprudence of Awqaf to adapt its principles for the

needs of the times and locality. On the whole, the Haramain foundation was equitably

and efficiently administered – a quality, which is not found these days e.g. in the

Awqafs of India (Siddiqi, 1996; Hasanuddin, 1998). Hoexter (1998) observes that the

Haramain became a “most significant vehicle for advancing the interests of the local

Islamic community” as well as becoming the focal rallying point in the fostering

Algerian-Islamic solidarity. Awqaf became such an important part of Islamic society,

that a Ministry of Awqaf was established in 1840 by Ottoman Turkey- a tradition

which has continued in many Muslim countries.

Chapter 5 Page 189

Unfortunately, the loss of political and economic power by Muslims resulted in the

decay of this institution as shown by the contemporary state of awqaf, which leaves

much to be desired. Siddiqi (1996), for instance, observes that “we find increasing

state intervention in waqf management owing to a number of causes, the chief one

being widespread abuse of powers by waqf supervisors”(p146). Despite this

however, the state of affairs is dismal e.g. in India. Hasanuddin (1998) observes:

“But unfortunately, the Waqf institution in India, is most misunderstood

and Waqf properties mismanaged. Legislative lacunae, administrative
lapses, lack of political will...has given rise to the painful phenomenon that
Waqf properties are the chief-attention of the land-grabbers. As against
this background, colossal and gigantic Waqf buildings with tremendous
commercial potential, are not even receiving the most needed repairs and
maintenance, thus converting such attractive buildings into dilapidated
structures and there is a general feeling that Waqf property is a cheap
commodity available in the commercial market”.
(Hasanuddin, 1998, p 23-24)

Despite this however, as the author observes, Awqaf is an important Islamic

institution which the Muslims have inherited in the past and “which possesses

immense potential for the reconstruction of social and economic life in Muslim

countries and communities” (p21). This is shown by the fact that there is estimated to

be about 300,000 awqafs in India alone (Haque, 1999).

Waqf is also an important wealth re-distributive mechanism of the Islamic economic

system. For example, Siddiqi (1996) notes that Waqf takes property out of private

ownership and vesting ownership permanently and irrevocably in Allah. With the

passage of time, more private property pass into waqf sector but the reverse cannot

and does not take place (if the assets are properly accounted for!). Since awqaf are

normally made by wealthy people (especially Muslim rulers in the past), it serves to

redistribute wealth and mitigate the ill effects of inequality in society and counter-act

the tendency to concentrate wealth.

It is thus essential, that an appropriate accounting and auditing system be developed

to ensure this institution is properly administered and accountable to the public to

ensure that it serves its function efficiently. As awqaf are not a commercial institution
Chapter 5 Page 190

seeking profits, conventional accounting may not be suitable for them. An Islamic

accounting system for awqaf would seek to address the following problems:

• The tracking of family awqafs until it reaches public status.

• Activity accounting , both financial and non-financial accounting

• Accountability of the trustee, and the transparency of operations.

• Islamic Social audit to ensure the beneficiaries get what is entitled to them.

• Management audit of income and property.

• Promoting the establishment of more awqaf.

5.2.4 Islamic Insurance companies

Together with the growth of Islamic banks, Islamic Insurance companies (called

Takaful Companies) have sprouted, although not as numerous as Islamic banks.

These are usually subsidiaries or associates of Islamic banks or Islamic Finance

Groups (e.g. Syarikat Takaful Malaysia – a subsidiary of Bank Islam Malaysia) or

conventional Insurance companies which have Islamic subsidiaries e.g. Syarikat MNI

Takaful.

The establishment of these organisations are due to the fact conventional insurance

is prohibited by Islamic Shari’ah (although there are controversies in this area). This

is due to the element of gharar or uncertainty in contingent contracts as well the

elements of gambling especially in relation to life insurance. In addition, the practice

of investing premiums in interest-bearing securities by conventional insurance

companies is also problematic (Shamsiah, 1995).

Takaful operates as a co-operative savings and mutual help scheme. In the case of

Takaful, any contributions (premiums) paid by the participants (i.e. policyholders) are

not recorded as income of the takaful company as in conventional insurance. In the

case of Family Takaful - the replacement for conventional life insurance, the

premiums paid by the contributors are apportioned to a participator’s fund account

and a claims pool. The amount apportioned to the claims pool is based on actuarial

calculations. The fund is invested in Shari’ah approved investments. Any profits are
Chapter 5 Page 191

shared between the Takaful Company and the contributors in a pre-agreed ratio. Any

losses are born by the participants – not by the Takaful Company. Any profits

accruing to the claims pool is credited to it. All actuarial surpluses are credited to the

participants. At the end of the policy term, a contributor gets the amount of his

contributions plus any share of the profits, if any. He does not get any amount

apportioned to the claims pool. If the policyholder dies before maturity of the policy,

then any shortfall (the difference from the insured amount and the balance in his

account representing his contributions + profit) is met from the claims pool.

In the case of General Takaful – the Islamic equivalent of General Insurance, all

contributions are credited into a collective claims pool fund. Any profits from the

invested funds are credited to this account. After making any required provisions and

making any claims payments, the profit, if any, is shared between the participants

and the company in the pre-agreed ratio. Any losses are born by the claims pool

fund.

It can thus be seen that the Takaful concept is quite different from conventional

insurance. A conventional insurance company is a risk taker while the takaful

company is mainly a manager of funds. While premiums paid to Insurance

companies are treated as income, takaful contributions are treated as a separate

fund attributable to policyholders. The Takaful Company shares profit arising from

investments and any surplus in managing claims. The operational expenses (staff

and administration costs) are born by the Takaful Company. Thus three main

stakeholders are accounted for in separate funds; shareholders funds, family takaful

fund and general takaful fund, each having its own balance sheet, profit and loss

account and cash flow statements.

It can be seen that Takaful companies cannot operate under accounting standards

meant for conventional insurance companies. There are several technical and

philosophical accounting problems to be solved, for example:

Chapter 5 Page 192

• Valuation of investment assets; currently follows conventional valuation principles

may not acceptable from an Islamic point of view (see chapter 6).

• Apportionment of profit share; the cash basis is currently used. This may lead to

distortions in profit distributions for all the parties.

• The calculation of Zakat on profits; the value to be used and the avoidance of

double taxation.

• The calculation of actuarial surpluses based on interest-based contingency tables

may not be acceptable from a Shari’ah point of view (see Tomkins & Karim,

1987).

• In line with the co-operative and participatory nature of Takaful, more qualitative

information may need to be disclosed.

There is thus a need to develop an Islamic accounting system, which will deal with

the above matters from an Islamic perspective.

5.3 ISLAMIC BANKS AND FINANCIAL INSTITUTIONS: HISTORY,

NATURE AND OPERATIONS

Islamic banks are perhaps the most important and developed Islamic organisations in

contemporary Islamic society. Assets of Islamic banks are estimated to range from

50 to 100 billion dollars (Pomeranz, 1997). Although the principles on which it is

based are not new, the institution itself is an innovation in Islam. An Islamic bank is

an ethically based institution which performs conventional banking functions with an

important exception, they do not receive interest from their borrowers or pay interest

on the customers deposits as this is prohibited under Islamic Shari’ah (Al-Faisal &

Ali, 1996).

This does not mean Islamic banks are charitable institutions undertaking free lending

and borrowing. On the contrary, Islamic banks are businesses, which aim to make

profit within the constraints of the Shari’ah, by undertaking profit- sharing projects,

trade financing, lease financing and providing fee-based services. Due to the
Chapter 5 Page 193

importance of Islamic banking in the Muslim world, it will be discussed in some detail

as an example of an Islamic organisation in practice, which makes the development

of an Islamic accounting system a practical imperative.

In the next two sub-sections the classification and development of Islamic banks will

be discussed to provide some background to the subject. This is followed by a

description of the operations and activities of the Islamic bank in section 5.3.3.

As the accounting problems of Islamic banks mainly concern the asset side of

Islamic banks, the Islamic financial instruments used as alternatives to conventional

interest-based lending are discussed in section 5.4. In section 5.5, the accounting

problems of Islamic banks are discussed at some length. All Islamic organisations, in

the opinion of the researcher, need an alternative Accounting System. However, the

accounting problems of the Islamic banks have been considered acute enough to

have led to the establishment of an alternative regulatory body for the setting up of

Accounting Standards for Islamic Financial Institutions (Pomeranz, 1997). Thus, the

detailed discussion of these institutions in this thesis. The chapter is concluded with a

discussion of the perceived benefits of an Islamic accounting system for banks and

other business organisations.

5.3.1 Classification of Islamic banks

(Ahmed, 1994b) has classified Islamic banks and financial institutions into several

different types, as follows:

1. Islamic Special Purpose banks aim to achieve a specific purpose or serve a

special class of clientele. This include social banks, agricultural banks, co-

operative and Industrial banks. Examples include the Nasser Social Bank in

Egypt and Islamic Bank of Western Sudan charged with promoting the

development of Western Sudan.

2. Islamic Development Banks aim to foster the process of socio-economic

development amongst its members. Its clientele are usually governments

Chapter 5 Page 194

3. Islamic Commercial Banks mainly aim to make profits but still operate within the

Islamic ethical system. This class forms the bulk of Islamic banks in operation.

4. Non-banking Islamic financial institutions such as the Pilgrims Fund (LUTH) of

Malaysia do not perform banking functions but channel savings to productive

investments and pay the depositors a bonus depending on profits.

5.3.2 Development of Islamic banks and financial institutions

It is generally agreed that the first Islamic bank was established at Mit-Ghamr, Egypt

in 1963 (Ahmed 1994a; Naggar 1987). Mit-Ghamr is a rural area in Egypt, where the

people were mostly religious farmers and artisans. They did not put their savings in

the conventional banks because of the Islamic prohibition of interest. The bank

operated three types of accounts; the savings and loan fund, the investment fund and

the social service fund. The first fund was like a current account. The depositor

received no interest but could apply for an interest free loan for productive purposes.

The investment funds were deposits received based on profit/loss participation. The

funds were invested in local businesses and agricultural projects. The deposit

received a proportion of the profits according to its amount and term. The social fund

received Zakat and other charitable contributions from which grants were made to

savers who were in financial difficulty as a result of sudden misfortune.

It can thus be seen that an Islamic/social ethos prevailed in the conception and

operations of the bank. One Western observer noted the significance of the

experiment thus:

“The majority of the population had never been dealing with the financial
institutions. Because of this, capital formation had been impaired.
Basically rural and religious, they tended to distrust the bankers operating
in the western style. Since a substantial part of their income was not spent
immediately, but put aside for social events, emergencies and the like, this
idle capital could not be used for productive investment A precondition,
however for any change of behaviour from hoarding and ‘real-asset
saving’ to financial saving was the creating of financial institution which
would not violate the religious principles of large segments of the
population. Only then could the rest of the majority of the population be
integrated in the process of capital formation”.
(Wohlers-Scharf, 19834, pp79-80 as quoted in Ahmed, 1994a, p351).
Chapter 5 Page 195

In the words of one of its founding executives (Naggar, 1987), the three most

important principles which were applied by the bank and responsible for its success

were:

1. Participation of the bank with its borrowers in their profits as well as losses.

2. Decentralisation and localisation through the operation of a community based

philosophy which help in:

a) the education and credit enlightenment through direct and sympathetic

contacts,

b) constant follow up of projects to guarantee their repayment and effective use

of the money, and

c) the provision of a mix of economic and social development services.

3. Consistency and integrity of the bank accounts.

The bank’s success5, however, attracted the attention of the anti-Islamic, socialist

regime of Nasser. In 1967, the Egyptian government took over all the nine banks

and converted them to social savings bank on the conventional model. Thus the

experiment came to an end, not on the basis of its economic viability but political

interference and commercial opposition of the conventional banks.

At the same time as the Mit-Ghamr bank was started in Egypt, the Lembaga Urusan

dan Tabung Haji (LUTH) (Pilgrims Fund and Management Board) was established in

Malaysian in 1963 as an Islamic savings institution. A Muslim economist who had

noticed the wasteful nature of Malaysian Muslims selling of their property to go on the

Haj (Muslim pilgrimage to Makkah) suggested that Muslims could save up the

amount which would be invested in accordance to Shari’ah principles. Thus LUTH

was born. Until then, intending pilgrims did not put their savings in a conventional

bank because it would have been tainted with interest. Money thus tainted could not

be used to perform the pilgrimage, as it would not have been religiously valid.

4
Wohlers-Scharf, Traute (1983), Arab and Islamic Banks, Paris, France: OECD.
5
Four more branches were established in the three year period 1963-66.
Chapter 5 Page 196

The Malaysian government initially set LUTH (Now known as Lembaga Tabung Haji)

up as a savings corporation in 1963 and was incorporated in 1969. Although LUTH is

not an Islamic bank, it is an Islamic financial institution. It collects the savings from

would be pilgrims and invests them in real estate, trading and plantations. Recently it

has gone into share trading and Islamic money markets. It restricts withdrawals to

twice a year and for the purpose of performing the pilgrimage. LUTH is an active

investor both directly and through its seven subsidiary companies.

LUTH in addition to its investing activities administers the whole pilgrimage

programme every year, which is a mammoth undertaking involving about 40,000

pilgrims. In co-operation with other government agencies, it takes care of their

transport, food, lodging, health and emergency aid during the pilgrimage. The

researcher having personally used its services can attest to its efficiency in

organising the pilgrimage.

However, in recent years, its importance as a financial intermediary has increased.

The researcher was informed by one of its accountants in an interview that 70% of

LUTH’s deposits were investment deposits, whereas previously most depositors

withdrew their savings to perform their pilgrimage. Unlike the Mit-Ghamr bank, LUTH

had better fortunes because of a political climate in Malaysia, which though secular,

was not socialist and anti-Islamic, as was the Nasser government. From 1,281

depositors in 1963 and M$46,600 in deposits, the number of depositors increased to

2,278,121 with deposits of M$1,541 million in 1993, a period of 30 years (Zainal &

Yusof, 1993). Its income has increased from M$6,573 to about M$95 million

(excluding government contribution towards operating expenses) during the same

period, 1990. Depending on the profits, a bonus is declared by LUTH once a year.

The dividend rate has been around 8-8.5%

The first private commercial Islamic bank was the Dubai Islamic Bank in 1975. It is a

public limited company with 50 million dirhams. In the same year, an international

Islamic bank, the Islamic Development Bank was established in Jeddah, Saudi
Chapter 5 Page 197

Arabia jointly by the 45 Muslim countries under the auspices of the Organisation of

the Islamic Conference. The purpose of this bank was to foster economic

development and social progress of member countries using Islamic finance financial

instruments. It also grants loan and aid to Muslim organisations especially in Muslim

minority countries.

Thereafter Islamic banks began to be established at an increased pace in Egypt,

Sudan, Jordan, Bahrain, Pakistan, Iran, UK, Malaysia, Bangladesh, African countries,

Turkey, India, South Africa and the US. Two milestones in the establishment of

Islamic banking were firstly, the Islamisation of the whole banking sector in Iran

(1979), Pakistan (1985) and Sudan. The second milestone was the establishment of

the Dar-al Mal Al-Islamic (DMI) Switzerland in 1981 by a Saudi Prince and the Dalla

Al-Barakah Group in 1983. These two Islamic Finance Multinationals were

responsible for setting up a spate of Islamic banks, Investment corporations, Takaful

companies and other financial institutions in Egypt, Sudan , Africa and Europe.

The ownership of the Islamic banks varies between 100% government ownership

and 100% private ownership. Most Islamic banks have been set up as joint-stock

companies. The total number of Islamic banks and financial institutions number in the

thousands (if the Islamic banks in Sudan, Pakistan and Iran established by wholesale

Islamic legislation are counted) but those established voluntarily number 192 (IAIB

1997). Based on 166 of these institutions, Islamic financial institutions had a total of

US7.3 billion in paid up capital and total assets of US$137 billion. The aggregate net

profit was US1.7billion. This compares to 133 institutions with $5 billion of paid up

capital and $101 billion in assets in 1994. Considering that there was no wholesale

Islamisation of the banking sector in any Muslim country between these dates, the

increase represents about 40% increase in assets and capital for two years or about

20% growth rate. Long-term expansion barring wholesale Islamisation is, however,

estimated to be around 5-7% (IAIB, 1997). The industry employs around 300,000
Chapter 5 Page 198

employees spread across 34 countries in all continents except Australia and South

America.

It can thus be seen that the Islamic finance sector is no longer a theoretical possibility

but a practical and viable fact here to stay. However, Islamic banks face many

regulatory, operational and accounting problems which prevent the further realisation

of its Shari’ah oriented ethical and social goals. Further, discounting the nation- wide

Islamic banks of Pakistan, Sudan and Iran (which have government support) the

profitability of small Islamic banks in other countries seems to be in some doubt

(Timewell, 1998). The researcher is of the opinion that Islamic Accounting would be

helpful in developing this important Islamic institution to be in accord with its own

worldview rather than being derailed into the capitalistic mould.

5.3.3 Modus operandi of Islamic Banks

Siddiqi (1998b) has classified the activity of Islamic banks into three activities:

a) Services for which the bank charges a fee or commission.

b) Investment of capital on the principle of partnership or mudharaba and

c) Fee based or uncharged services.

The services in category a) above include many of the functions performed by

conventional banks on a fee basis, such as keeping accounts, clearing cheques,

providing funds transfers and business advisory as well as providing financial

guarantees and safety deposit lockers.

The activities under b) are the major theoretical basis on which Islamic banks operate

although a recent survey shows only 20% of financing of Islamic banks is done

through this way (IAIB, 1997). The main activity of a conventional bank, lending and

borrowing money through fixed and savings deposits is changed in an Islamic bank.

The relationship in conventional banking between the bank and its deposit holders is

that of a debtor-creditor relationship. This is not so in the case of Islamic banks. The

relationship in an Islamic bank, depending on the type of deposits, is either trustee

for deposits or a business partner.

Chapter 5 Page 199

On the liability side, in the case of both current and savings accounts, conventional

banks pay interest based on a pre-determined percentage of the amount deposited

varying with the length of time. The Islamic bank does not pay interest but may give a

gift, which is at the option of the bank. The bank guarantees the principle amount,

which can be withdrawn by the customer at any time. Current and savings account

deposits are based on the Islamic contract of al-wadia’ – safe keeping. Under this

contract, the depositor gives permission to the bank to use the funds in any

Islamically permissible activity but he can request the money back on demand. In

practice, some Islamic banks pay an amount called hibah or gift depending on the

profit of the company, which is permissible. However, the depositor is not legally

entitled to this as that would amount to interest. The bank, however, guarantees the

principal sum.

Islamic banks do not accept fixed or term deposits on which interest is paid. Instead,

customers can open an investment account for a fixed period. After the period, the

customer is entitled to a share of the profit (the percentage share of profits being

pre-determined), if the banks make a profit. If the bank makes a loss, the whole loss

is borne by the customer. This contract is called mudharaba- capital/labour

partnership. Under this contract, the depositor as the capitalist gives the capital to

the bank who acts as the entrepreneur in managing the funds for which it is entitled

to a share of the profit. The banking expenses are not charged to depositors as

management expenses as in the case of a loss, it is wholly borne by the depositor.

The bank is only entitled to a share of profits the ratio being pre-determined at the

beginning of the agreement.

What in fact happens, is all investment deposits are pooled and invested in various

projects- forming portfolios with varying maturities. Sometimes the bank’s

shareholders funds are also pooled to finance projects. In this case, the bank is also

entitled to a share in proportion to its capital invested. Profits are allocated to the
Chapter 5 Page 200

depositors in proportion to deposit amount and time for which the amount is

deposited with the bank.

Most Islamic banks have two types of investment accounts, unrestricted and

restricted. Unrestricted investment account deposit can be invested in any sector

according to the wishes of the bank, provided the investment does not contradict the

Shari’ah. Restricted Investment accounts allows the depositor to specify in what

sector, his deposit will be invested.

On the Assets side of the balance sheet, conventional banks usually grant credit

facilities such as term-loans, overdrafts and housing mortgage loans. They also

invest in the short-term money market, government securities, treasury bills,

company bonds and equities in the stock exchange. In the case of Islamic banks, as

all interest-bearing instruments are prohibited, these financial instruments, except for

equities, are not available to it. Instead Islamic banks use Islamic financial

instruments, some of which have equity features while others have features of both

debt and equity (Obiyathullah, 1995) and still some others have features of debt. This

will be explained in some detail in the next section.

The third type of activity is unique to Islamic banks (although some conventional

banks provide free overdraft to student customers). Providing interest-free loans is

part of the social activity of Islamic banks although only a small portion of its total

funds is allocated to this. Usually the funds come from Zakat and charity pool created

by the bank from its own Zakat contributions and charitable contributions of others. In

theory, Islamic banks should set aside a portion of the shareholders and depositors

funds for this purpose. It is not certain how many banks actually undertake this

function, as they seem to operate mostly along commercial lines. However, as we

have seen in the case of Mit-Ghamr bank, this is not theoretical and has been

applied in practice. In Pakistan, Islamic banks have given interest-free study loans to

students.
Chapter 5 Page 201

5.4 THE ASSET SIDE OF ISLAMIC BANKS: ISLAMIC FINANCIAL

INSTRUMENTS:

Since Islamic banks cannot grant loans on interest, the assets side of the balance

sheet cannot have any advances (except interest free loans) as assets. Since banks

cannot earn any money on interest-free loans, they have to resort to participatory

finance and other Islamic financial instruments to earn an income. The researcher

will discuss these Islamic financing instruments below:

5.4.1 Murabaha and Bai al-Mu’ajjal

The contract of Murabaha or mark-up originated in the deferred sale (bai almu’ajjal)

contract. In this contract, a buyer of goods requests an agent to do it for him, on the

understanding that the agent will charge a mark-up on the cost of the goods which

will be sold to the buyer. The price was usually deferred and hence the agent usually

quoted two prices, one for spot and a higher price for deferred sales. The Islamic law

of contract allows this higher price on the deferred sale. Various reasons have been

give for the permissibility of this excess, which is akin to interest. Reasons include

opportunity cost foregone by the agent, the risk of default and the risk of the buyer

refusing to take the goods after the agent has acquired to buy on his behalf. The

ownership risk of the goods bought by the agent resides with the agent until delivery

to the buyer. The buyer can refuse to accept the goods at any time before delivery.

The Islamic banks saw this as an opportunity in financing a purchase e.g. a house or

trading stock or a fixed asset and this has become the main financing device of the

Islamic bank. Any person requiring finance e.g. say a car, goes to the bank and

requests the bank to buy it for him. The bank theoretically buys the car adds a mark-

up, depending on the amount and term of the financing required and sells it to the

customer, who pays by instalments. Once delivered, the car becomes the property of

the customer although it could be collateralised. Although this appears as a casuistry

for interest, it has some differences from pure interest based credit including:
Chapter 5 Page 202

1) The buyer can refuse to take delivery in case of Murabaha.

2) In case of late payment of instalments, the bank cannot add a markup on markup

as a conventional bank compounds the interest on the late instalment.

3) In the case of variable interest rate financing, the conventional banker varies the

interest rate according to the prevailing base lending rate. In the case of

murabaha, the mark-up is fixed and cannot be varied.

4) Of course the produce or service financed cannot be against Shari’ah injunctions

e.g. one cannot buy and re-sell alcoholic products, gambling services or drugs.

Although this instrument constitutes about 50% of financing undertaken by Islamic

banks, it has been frowned up as a back door to interest. Scholars have suggested

minimising or discontinuing this practice. However, the survey by the International

Association of Islamic Banks (IAIB, 1997) shows an upward trend.

5.4.2 Mudharaba

Mudharaba is a labour-capital partnership, wherein an investor puts up an amount of

capital for a specific period of time with an entrepreneur who conducts business with

the amount. The profit sharing ratio between the entrepreneur and the investor is pre-

determined in advance. At the end of the period, any profits are shared in the agreed

ratio. In case of losses, the investor bears the entire loss, the entrepreneur loses his

labour as he is not paid a salary.

The Islamic bank adopts a two-tier mudharaba contract. In the case of investment

accounts, the depositor is the investor and the Islamic bank, the entrepreneur or

manager of the fund. The bank itself then becomes the investor when it places

money with the actual user of the fund who runs the actual business. In case of profit

the bank and the entrepreneur shares the profits. From the bank’s share of the profit,

a pre-agreed share is given to the depositor. In case of loss, the bank passes on the

whole loss to the depositor. The bank’s overhead expenses are not charged to the

investment accounts as the bank is only entitled to a profit share and is not liable for

loss.
Chapter 5 Page 203

This was thought to be the ideal contract for Islamic banking. However, empirical

results indicated only 7% of Islamic financing was of this type in 1996 and the overall

trend is negative (IAIB 97). Many reasons have been given for the lack of fervour for

using this mechanism:

1) Agency costs: Borrowers un-Islamically tend to consume perks which reduces

the profit available to the banks and depositors. Obiyathullah (1995) shows how

this contract has both debt and equity characteristics.

2) The tax structures of some Islamic countries are such that no honest traders can

survive. As such, traders normally keep two set of accounts, one for their use and

one for tax purposes which shows lower profits to avoid tax. The second set is

the one usually given to the banks. Even if the entrepreneur does not wish to

cheat the Islamic bank, the fear of being found out by tax authorities dissuade

them from keeping and giving truthful accounts to Islamic banks. Further, while

interest costs are given as tax deduction, profit shares are not allowable in most

legislation, hence increasing the cost of capital of mudharaba financing for

businesses.

5.4.3 Musharaka

This is plain partnership financing. Here the bank becomes a full partner of the

entrepreneur who also contributes capital. The bank shares profits and losses of the

business with the entrepreneur in a pre-agreed ratio. In case the bank does not play

an active part in the business, then the entrepreneur may charge management salary

or expenses to the business account. Unlike the case of mudharaba, where the bank

cannot interfere in the running of the business, the bank has full rights of

administration in Musharaka contracts.

Chapter 5 Page 204

5.4.4 Ijara

Ijara is rent or leasing of assets. Here the bank purchases the asset and leases it to

the borrower. Although, strictly only operational leases are allowed in Islam, most

ijara contracts take the form of financial leases, which transfers the risk and rewards

of ownership to the borrower. Even in the case of a financial lease, since the contract

is a lease agreement, the ownership resides with the bank until the borrower

exercises an option to buy the asset at the end of the lease. The buying option can

be pre-agreed at the inception of the contract. This is known as an Ijara wa iqtina

(Lease and sell) contract.

5.4.5 Salaam

In the case of Murabaha, the goods to be bought must be in existence at the time of

the contract and capable of delivery. This mode thus cannot be used to finance the

cost of say agricultural output in advance. The salaam contract on the other hand is

an advance purchase contract, where the goods say wheat, of a particular quality

and quantity, which is not yet in existence, can be the subject of a contract. Here the

buyer pays the agreed price in advance for delivery at a certain date. Hence, this

contract can be used to buy commodity futures for example. However, according to

Islamic law, the bank cannot sell this until delivery. In order to overcome this, the

bank enters into another “parallel” salaam contract to sell the same quantity and

quality of goods at a different price. However the second contract cannot be linked to

the first. By means of parallel salaam, the bank can cover its position and make a

profit. In case of delivery failure, the bank can only request the money back without

any penalty or wait longer. This can become an important means of financing

agricultural or fishing activities.

5.4.6 Istisna

Istisna is a variation of salaam. It is the payment for commissioned manufacture. A

buyer can contract to have goods manufactured and delivered at a later date, in

accordance to specifications. The buyer has the option of cancelling the contract if
Chapter 5 Page 205

the delivered item is not to specifications. Although the majority legal opinion is that

the contract cannot be enforced until the manufactured item is delivered and

accepted, the minority opinion is followed binding both parties from the start. Unlike

salaam, payment is at delivery or according to manufacturing or construction

progress. Thus, this instrument can be used to finance construction or

manufacturing projects. Islamic banks have also used and modified this to a “back to

back” istisna where two contracts are made up; one with the manufacturer and one

with the ultimate buyer. The Islamic bank uses this contract to finance the purchase

of ships or airplanes. The bank contracts with the buyer to supply the item for a fixed

future payment schedule. The bank contracts with the shipbuilder to supply the ship

for a series of shorter progress payment. The difference between the present values

of the payments under the two contracts is the bank’s compensation (Vogel & Hayes,

1998).

5.5 ACCOUNTING PROBLEMS OF ISLAMIC BANKS

Islamic banks face unique accounting problems both from a technical point of view

and philosophical point of view. Some of these accounting problems are:

1. The problems of profit recognition and allocation due to Islamic banking

mechanics (Abdulgader, 1990; Karim, 1998a),

2. The inappropriateness of International Accounting Standards (Hamid et al.,

1993; Karim, 1999)

3. The hybrid nature of some Islamic financial instruments (Obiyathullah, 1995;

Karim, 1999), and

4. The ethical accountability requirements (Gambling, 1994 ).

5.5.1 Profit sharing

Abdulgader (1990) studied profit recognition and allocation problems in Islamic

Banks in Sudan and Egypt. His study examined the practices of four existing Islamic

Banks (each of which had many branches all over Sudan) and found that the profit
Chapter 5 Page 206

recognition and allocation practices of the three banks were not uniform.

In the first example, the banks separated the investment account funds from the

shareholders and other depositors’ funds. In this case, the investment account funds

were invested separately, after allowing for reserve requirements. This lead to a

separate fund account being established for Investment account holders and

accounted for separately from the others. Hence separate financial statements were

prepared for this fund account. Further the profit were recognised only when the

projects were liquidated; implying that the projects were short-term. After deducting

the bank’s share of profits, the depositors share of profits was distributed to individual

depositors according to the amount and period of the deposit.

In the second case, all funds whether from shareholders, current and savings

accounts and investment accounts were all pooled and invested in various projects.

In this case, the profits earned by the bank excluding those from fee-paying banking

services were made proportionate to average deposit in each type of account. The

share of the current and savings account depositors went to the shareholders, as the

depositors were not entitled to any profit. (In the case of Malaysia, the banks

distribute part of this profit as a gift to savings and current account holders). From the

proportion attributable to the investment account holders, the bank’s share is

deducted and the balance distributed to the investment account holders in proportion

to deposit and period held. Except for expenses directly related to investments, all

other expenses are borne by the bank and not by the investment account holders as

under the mudharaba contract, the bank is only entitled to its share of profits.

In the second case it was difficult to determine each party’s share in investment and

profit as all funds are pooled. The actual amount of investments for each class of

deposits as opposed to the actual amount of deposits cannot be known. In

calculating the share of profit due to investment account holders, the bank estimates

the portion of the depositors account invested by the following steps on each months’

balance:
Chapter 5 Page 207

1) The actual deposit in each class of account (and shareholders funds available for

investment) is multiplied by the available percentage (100-reserve percent) to

obtain amount available for investment. The reserve ratio is different for each

account. Investment accounts have a lower reserve ratio than other accounts.

2) The actual invested funds for each class of account is apportioned using the

amount available per step 1 divided by total deposits available for investment

multiplied by total amount invested in the month.

3) The monthly amounts are added up for twelve months to get yearly amounts.

4) The total profit is then apportioned to the accounts on the basis of total assumed

investments.

The above method, although rational and equitable on the face of it presents some

difficulties. As the investment account depositors are mainly interested in profit as

they bear the risk, the above allocation does not give any preference to this. Since

savings and current deposits in Islamic banks are not meant to earn profits, they

should not have a claim to profits on an equal basis (although in actual fact, profit

attributed to these deposits goes to the shareholders).

Thus, as in the example from table 5-1 shows, the amount from the investment

account, assumed as invested is only $53,070/$77228 = 68%, whereas current

account deposit invested is also assumed to be 68%. Since investment account

holders assume that their deposits will be invested, it is clear that their funds should

be accorded priority in the distribution of profits. Hence in 1985, the Shari’ah

Supervisory Board of the Faisal Islamic bank recommended that all investment

account deposits less a liquidity reserve be assumed to be invested. Using the new

formula, the investment account deposit assumed to be invested would be £77228

x90%= £69505 (to take account of liquidity ratio of 10% as investment account can

be withdrawn on short notice although not on demand). The amount allocated to

current accounts and shareholders is found as a balancing figure. Hence the profit

allocated to investment funds would be higher.

Chapter 5 Page 208

ACTUAL INVESTMENT ACTUAL

TYPE OF DEPOSIT AVAILABLE FUNDS FOR INVESTED
DEPOSIT INVESTMENT FUNDS
%
(1) (2) (3)=(1)X(2) (4)
JANUARY 1984
Current Deposit 157,000 70% 109,926 75,540
Investment Deposit 77,228 100% 77,228 53,070
Savings Deposit 12,454 90% 11,209 7,703
Shareholders funds 58,536 100% 58,537 40,226

TOTAL 305218 256,900 176,539

TABLE 5-1:PROFIT DISTRIBUTION METHOD IN THE FAISAL ISLAMIC BANK OF SUDAN

(SOURCE: ABDELGADER, 1990,P 176).

Despite this apparent improvement, the profit attributed to investment accounts will

vary between different Islamic banks depending on the proportion of current and

savings account deposits. For example, if Bank A has more current and savings

account deposits than Bank B, assuming equal amount of investment deposits, Bank

B will be giving a higher share of profits to its investment account holders. Another

problem, is although, current and savings account holders expect no return, the

shareholders are effectively using these deposits as financial leverage in earning

profits for themselves without giving anything in return to these depositors except

guarantee of capital. Perhaps, in this case, the central bank should regulate the

Islamic banks and insist on a payment of a gift to these accounts (after building up

sufficient reserves to cater for losses). This is legal and recommended (and practised

in certain countries) in Islamic law provided they are not predetermined.

In contrast to the above situation, some Islamic banks do not pool the funds from

investment accounts and treat them as a separate entity. In order to provide a

portfolio instead of matching each deposit to an actual investment, the deposits are

pooled into many projects. However, this method is more risky for the depositor

because the portfolio may not be well diversified. In certain banks, limited

mudharaba certificates are issued which link the securities, issued in fixed
Chapter 5 Page 209

denominations for a fixed period of time, to a particular project. These certificate

holders are entitled to profits when the project is liquidated. They bear all the losses if

any.

This second type of profit allocation where the funds are not pooled solves the

problem of allocating profits between the various types of depositors. However, it still

has the problem of matching profits because in Islam, the venture has to be realised

to return capital before profit is calculated (Udovitch, 1970). Hence, if a depositor

withdraws his funds before project is liquidated, then he will not be entitled to share in

the profits. The problem of capital gains and losses between accounting period also

presents problems as it does in conventional historic cost accounting. Perhaps a

realisable income model (Edwards & Bell, 1961) would be more appropriate.

Another problem posed by Islamic banks is the nature of investment and savings

deposits. Are investment deposit holders, equity holders? (Karim, 1999). Should

they have say in the administration of banks (i.e. voting rights)? It can be seen that

investment account holders are neither a liability nor equity and to classify them as

such according to conventional accounting principles would amount to unfair

disclosure. Investment accounts have both the characteristics of debt and equity.

They are short or medium term equity holders. Equity holders have long-term

relationship with the banks. They can vote in annual general meetings and take part

in the management of the bank through their directors. By contrast the relationship of

investment account holders vary between short and medium term. However since

they share in the profits and bear all risks associated with their investment, they

should neither be treated as current and savings account holders nor fixed deposit

accounts holders. Perhaps, they should have limited voting rights like debenture

holders, especially in the case of limited mudharaba certificate holders to ensure that

their interests are taken care of properly. Investment accounts cannot be classified

as current liability as are fixed deposit holders in a conventional bank. Perhaps a

Chapter 5 Page 210

separate balance sheet should be prepared for them, or they should be shown

between equity and current liabilities.

Another problem associated with investment projects relating to investment accounts

is whether they should be consolidated or equity accounted? Presently only profits

received from the projects are incorporated into the accounts. This is inconsistent

with the ruling that Islamic banks are not lenders but managers of the investment

account holders. Conventional banks do not manage the projects they finance except

to monitor periodic reports. Islamic banks as managers of investment account

holders and as partners in case of Musharaka financing would have to take a more

active role in appraising, monitoring and even directing major decisions in ventures

they finance. When they do this, the problem of consolidating results and assets of

financed ventures comes in.

Karim (1999) observes that, in the application of funds, most Islamic banks use the

murabaha-financing instrument. Since the source of financing includes investment

accounts, the profit recognition method used will also affect profit allocation to these

accounts. As Karim (1999) notes, there are at least five different methods of profit

recognition used by Islamic banks in recognising profits in murabaha transactions

where the price of the goods financed are received in instalments which may traverse

several accounting periods. These include:

• Recognising profits in full when customer takes delivery.

• Pro-rata the profits according to due dates of instalments.

• Pro-rata the profits according to receipt of the monthly payments.

• At the liquidation of the transaction i.e. on the last payment date and

• Once the capital has been recovered.

Karim (1999) notes that “the use of any of the above profit recognition methods affect

the returns credited to investment account holders”(p33) as the duration of the

depositors’ investment is generally different from the duration of the murabaha

contract above. In addition, there is no conventional accounting standard to prescribe

Chapter 5 Page 211

the disclosure of different profit allocation bases (which has been discussed above)

which Islamic banks use to allocate profits between the various account holders.

Hence, applying conventional accounting standards (e.g. IAS), where they are

available, to Islamic banks will result in non-comparable financial statements rather

than induce comparability as there no standards which meet the specific Islamic

banking requirements. This is the rationale behind the formation of the Accounting

and Auditing Organisation for Islamic Financial Institutions (Pomeranz, 1997; Karim

1999) which has some accounting and auditing standards for Islamic banks and

Financial Institutions

5.5.2 Capital Adequacy Ratio

As a result of the recent third world debt crisis, there have been increasing demands

for more capital regulation in the banking industry. One of the most important

measures facilitating this regulation is the capital adequacy ratio (CAR). This ratio is

a measure of a bank’s risk exposure and is usually calculated by finding the

percentage of capital to total balance sheet assets. The CAR of commercial banks is

an important accounting measure used to assess the adequacy of the bank’s capital

in relation to deposits to cover credit risk (Llewellyn, 1988). Regulators use the CAR

as an important measure of the safety and soundness on banks as the capital of

such institutions is viewed as a buffer or cushion to absorb losses (Karim, 1998b)

The increasing pressure from regulators to maintain an adequate ratio has led some

banks to adjust accounting measures to reflect a good ratio. Hence, accounting

practices have major implications for this ratio.

The Basle Accord of the Basle Committee on Banking Supervision implemented

since 1992, sets out an agreed framework for measuring capital adequacy and the

minimum standards to be achieved by the representative countries. The accord is

intended to “strengthen the soundness and stability of the international banking

system and “to be fair and have a high degree of consistency in its application to
Chapter 5 Page 212

banks in different countries with a view to diminishing an existing source of

competitive inequality among international banks”.

The minimum acceptable Capital Adequacy Ratio (CAR) according to the Basle

Accord is 8%. The majority of countries in which Islamic banks operate have taken

steps to introduce the Basle framework. However because the framework of Islamic

banking is different, the Basle framework geared for conventional banking cannot be

applied as it would lead to Islamic banks not meeting the requirements, although this

would not imply any more credit risk than conventional banks.

As Karim (1998) observes, only share capital and reserves attributable to them would

be considered as capital. Islamic banks issue neither preference shares nor

subordinated debt as they contravene the Shari’ah. Since current account holders of

Islamic banks are not entitled to any return, the revenue generated from them is

exclusively the right of the shareholders. The investment account deposits cannot be

considered as equity or liability but a unique type of Instrument which gives the

depositors right to share in the profits but bear all the losses. Hence, since both

deposit accounts are not paid a predetermined return, they do not constitute a

financial risk to the bank as (in the case of investment accounts) all the losses can be

passed on to the account holders. Although the shareholders funds would have to

bear the losses of capital on investments from current account deposits, the risk of

loosing the capital is much less than loosing both capital and the pre-determined

interest which must be paid to conventional bank account holders.

Karim (1998) illustrates this point through four possible scenarios, each depending

on the way investment accounts are treated by Islamic banks and regulatory

authorities:

In scenario 1, Investment accounts are added to the core-capital (tier 1). This would

increase the CAR and help Islamic banks follow a strategy of attracting high

investment accounts and low equity capital, as Islamic banks do not share losses

only profits from the investment account fund invested. If the amounts of deposit
Chapter 5 Page 213

accounts were restricted in the calculation of capital, the bank would be forced to

pursue a strategy of raising equity and restructuring its assets to more safe areas like

Government investment certificates.

Scenario 2, which allows for deduction of the investment accounts from the risk-

weighted assets would similarly increase CAR and compensate for assets with high-

risk weightings. Here, shareholders continue to encourage investment accounts

compared to savings accounts.

In scenario 3, investment accounts are added to Tier 2 capital element. In this case,

since tier 2 capital is restricted to 50% of the total of tier1+tier 2 capital, this would

mean that when investment accounts equals equity, there is no benefit to the CAR

calculation. This would mean, after this threshold, Islamic banks would have to raise

shareholder equity.

In scenario 4, no adjustment is made to the CAR calculation in respect of investment

accounts. Islamic banks with CAR below 8% would have to increase their

shareholders equity as the use of investment accounts confers no advantage in the

calculation of CAR. Another way out would be to restructure their assets to include

lower risk weighted assets. Given the nature of Islamic financial instruments, Karim

(1998) observes that the latter option would be more feasible in an Islamic bank

given the nature of financial instruments used by Islamic banks.

Although it is up to regulatory authorities of the various countries to adopt the

appropriate rules, Central bankers of Muslim countries with their conventional

economic and banking training seem not too creative in this matter. In the case of

Sudan (Abdelgader, 1990), the Central Bank wrongly subjected the funds of

investment accounts to their credit ceiling targets meant to control consumption credit

and inflation. Investment accounts, of course, were meant to finance long term, high

return investments. Since the Islamic banks could not invest most of the funds,

profitably it stopped accepting investment deposits altogether, defeating the purpose

for which the bank was set-up.

Chapter 5 Page 214

Karim’s (1998b) analysis, although constructive and insightful, nevertheless only

skimmed the surface of the implications of the Basle convention for accounting of

Islamic banks. His analysis is limited to the financial strategy of shareholders in

leveraging the use of investment accounts. It does not analyse the CAR standards

implication for the investment strategy in terms of achieving the investment objectives

of Islamic banks i.e. to substitute profit-sharing contracts for risk based contracts

which would bring about the theorised objectives of Islamic banking. As already

indicated, one of the problems of the Islamic banking is that Islamic banks have

opted for the easy use of credit-based Islamic instruments (murabaha) which do not

change the basis of Islamic banks from conventional counterparts to any large

degree (Abdelgader 1990; Ahmed, 1994b). An appropriate indigenous Islamic

capital adequacy ratio standard could have a marked difference in increasing both

investment accounts and more profit-loss financial instruments.

For example, if investment accounts could be added to the core capital or deducted

from total risk weighted assets, (scenario 1 and 2), this could increase the promotion

of investment accounts. Further as the Islamic banks do not bear any losses arising

from the loss of investment deposits (except arising from negligence), the investment

account investments (not deposits) could be deducted from risk weighted assets or

given a 0 or low risk weighting depending on the nature of the instrument. A reverse

risk weighting score could be given. For example, musharaka and mudhraba

investments would be given a lower risk-weighting then those used for murabaha or

ijara investments. This would increase CAR and at the same time encourage Islamic

banks to manage their portfolio carefully, as their earnings will depend on high return

/ high-risk investments. This is so because banks earn only a share of profits and

cannot charge expenses to the investment account deposit holders except for direct

expenses. Hence this is one way, an appropriate Islamic financial standard based on

an accounting number could induce behaviour towards attaining Islamic objectives.

Chapter 5 Page 215

Another instance would be to consolidate the investments at current costs. Since

Islamic accounting seems to favour current values (Clark et al., 1996; see also

chapter 6), this would reduce CAR. However, if the bank’s share of unrealised capital

gains is added to capital and the current value of investments (from the investment

account funds) were excluded from the risk weighted assets, this would boost CAR,

encouraging such investments.

A development from this would be an “Islamicity” ratio computed using an inverted

risk weighted value of assets. The higher the ratio, the higher the Islamicity of

financial instruments used and would give the user an indication of the extent to

which the Islamic banks are using the funds in profit-sharing instruments and other

social areas in which it should be used.

5.5.3 Confounding International Accounting Standards

The accounts of Bank like other business organisations are increasingly subject to

both national and international accounting standards, which are increasingly being

globalised in the form of International Accounting Standards. Unfortunately, recent

studies on the cultural impact on national accounting systems seem to be motivated

only towards removing non-European and non-American impediments in the way of

international harmonisation of accounting (Hamid et al., 1993). The researchers do

not contemplate that harmonisation may entail imposing Western and European

accounting practices and the theories behind them upon nations whose commercial

and accounting practices are based on alternative ethical or cultural paradigms.

Thus:

“But the focus has been more to identify what practices and underlying
theories have to be changed to fit into the Western paradigm, rather than
to discover whether those not conforming to it might give insights to
alternative, theoretically defensible accounting processes”.
(Hamid et al., 1993, p132)

This may not only distort international comparison (see for example, Choi et al.,

1983) but also upset the socio-economic balance of the recipient countries.
Chapter 5 Page 216

Hamid et al. (1993) observes that although, harmonisation is pursued under the

pretext of transporting developed accounting practices to countries with lesser

developed practices, such ascription of development to the West, commits the world

to a dominant allegiance to Judaic-Christian influences and ignores traditions

founded in Eastern philosophies. Thus, any implications of accounting being required

to conform to the philosophies underlying Islam, which transgresses national

boundaries, for example, are dismissed without enquiry.

Islamic banking in particular only permits financial support and offers banking

facilities to Islamic compliant businesses. One could therefore reasonably presume

that the prevalence of stricter Islamic banking would lead to higher business

compliance with Islamic principles. This would in turn increase the need for an

alternative Islamic accounting to meet the needs of these organisations.

Hamid et al. (1993) further argues that the prohibition of riba, which is the

cornerstone of Islamic banking has important implications for the harmonisation of

accounting procedures as implementing international accounting standards entail

enforcing many accounting procedures where interest based calculations are

essential. For example, standards on pension benefits (SFAS 87 & 88), amortisation

of long-term debt (APB 12), lease capitalisation (SFAS 12), interest on receivables

and payables (APB 21) and their International Accounting Standard equivalents all

invoke discount calculations based on the time value of money.

Karim (1999) also point out many problems of using International Accounting

Standards for Islamic banks. For example, many Islamic Banks use murabaha

financial instrument. In this cost plus contract, the Shari’ah imposes the condition that

the bank must possess the title to the goods before delivery to customer. The

purchase order made by the customer may or may not be binding on him. Hence the

valuation of such stocks is a problem in the accounts. Should the bank value at lower

of cost and NRV as per current accounting standards or at current market value as

per Zakat accounting requirements.

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IAS’s do not have any standards to deal with the status of investment accounts, as

they are neither equity nor debt in the conventional sense. There are also no

disclosure requirements to disclose the bases of profit allocation between

shareholders and investment account holders. The use of different methods by

different Islamic banks has resulted in the incomparability of their performances.

Profit recognition difficulties have already been alluded to in the section 5.5.1. The

adoption of IAS would not make the Islamic banks accounts comparable but might

achieve the opposite effect.

International Auditing Standards also do not provide for the idiosyncrasies of a

Shari’ah Review or audit which is required of Islamic banks. Neither do they provide

guidelines on the qualifications, independence and competence of Shari’ah Auditors

or Shari’ah supervisory board of Islamic banks. It is no wonder that Muslims have

come up with their own alternative to the IASC in the form of the Accounting and

Auditing Organisation for Islamic Financial Institutions (AAOIFI). This organisation

has issued two Financial Accounting Concepts Statements, ten Financial Accounting

standards and five Auditing standards for Islamic banks (Karim, 1999). The

organisation has also issued exposure drafts on Shari’ah Audit, and Islamic

Insurance Company disclosure standards.

If the current Islamic resurgence permeates Islamic businesses, then there is

definitely a need for the development of Islamic accounting and an International

organisation to develop Islamic Accounting Standards for all Islamic organisations.

Perhaps, the AAOIFI will evolve into such a body.

5.5.4 Non-Financial Disclosure

While, the technical problems associated with accounting for Islamic banks have

been emphasised and the AAOIFI been established to deal with it, it should not be

forgotten that Islamic banks are much more than institutions which avoid interest. All

business and non-business Islamic organisations have Islamic ethics as their

founding basis. As such these institutions must account to their owners and other
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stakeholders as to the extent to which they have complied with the ethical dictates.

This involves non-financial as well as financial disclosure. Khan (1994a) observes

that an Islamic bank would have to disclose:

(i) The avoidance of prohibited transactions.

(ii) The extent to which their activities have contributed to the economic and
social development of various poor sectors of society by offering financing
and interest-free loans to for example, farmers and small traders.
(iii) The ethical standard which they have reached in the treatment of employees
and depositors and entrepreneurs.
(iv) Segmental information on the financial instruments used and the efforts
made by the bank to move away from interest-like instruments such as
murabaha.
(v) The extent to which they have safeguarded the environment and conserved
energy.
(vi) The collections and disbursement of Zakat from the bank’s operations, and
(vii) The social and the religious contribution to local community

Conventional accounting places emphasis on financial outcomes, thus conventional

accounting users (e.g. shareholders) may switch to debt financing when economic

conditions make debt financing attractive. They also may switch to other business

activities, which promises the best financial returns to them. However, as Hamid et

al. (1993) notes, whether equity or debt financing promises the best financial returns

to owners or managers, is not the motivating factor in Islamic commerce undertaken

according to the Islamic tradition. Instead success in the hereafter by following God’s

commandments in economic transactions on earth would be the foremost thought of

Muslim users. Hence Islamic accounting would provide information which ensures

their confidence in the integrity of Islamic banks and other organisations. It should

provide assurance that the organisation has invested their money within the

constraints of the Shari’ah, no exploitation or injustice has been done to any quarter

and their money has made a contribution to uplifting the community.

Chapter 5 Page 219

5.6 CONCLUSION

In this chapter, the objectives of various forms of Islamic organisations, their

structure, operations and framework under which they operate have been discussed.

The development and operations of Islamic banks were discussed at some length to

emphasise the different paradigm of Islamic business. Hence, the discussion of the

accounting problems related to different financial instruments, profit sharing and the

problems of imposing international banking, accounting and auditing standards on

Islamic is meant as an example of the differences and difficulties Islamic

organisations pose for conventional accounting. It is hoped that this has

demonstrated the practical need for the development of Islamic accounting

Islamic accounting as can be seen from this chapter, is not only a matter of

modifying conventional accounting to fit the needs of Islamic institutions- a major

overhaul is called for. It is not a matter of extrapolating the conventional accounting

principles to specialised entities e.g. in the case of accounting for plantations,

insurance companies or space exploration. The different philosophical assumptions

underlying Islamic organisations and their different operating mechanism, some of

which find no parallel in the conventional business and accounting practices, suggest

a more radical accounting.

Benefits of an Islamic Accounting System for Islamic banks and other organisations

would include:

• Motivating employees, shareholders, managers and participants to be

accountable to society and God and to take a pro-active role in ensuring ethical

economic activity instead of motivating them through higher financial returns to

increase their greed and material possession.

• Ensure the accountability of Islamic organisations to their stakeholders and

thereby ensuring the accountability of Muslims to God in their economic activities.

• Ensure the specific socio-economic objectives for which Islamic organisations

have been established are achieved and to disclose the reasons why they are
Chapter 5 Page 220

not. The holistic nature of an Islamic accounting system would not deflect the

users from their ethical objectives as conventional accounting, by concentrating

on the financial return, might do.

• The development of Islamic accounting and auditing standards would in time

ensure comparability between different organisations which would promote the

allocation of resources (financial, manpower, government support) to those

organisations which better promote the interests of Islamic societies.

From the above, it can be seen, that Islamic organisations can benefit immensely

from the development of an Islamic accounting system. Failure to develop one, on

the other hand, may contribute to their failure. In the next chapter (chapter 6), the

researcher will discuss the objectives, theoretical framework and the characteristics

of Islamic accounting which is hoped will meet the requirements of the Islamic

organisations discussed in this chapter.