Islamic Accounting free essay sample

An alternative method to improve fair and just between bank and customer is proposed. 1. Introduction The growth of Islamic financial market and institution create the need for different accounting requirement. This is because Islamic Financial Institution (IFI) has distinctive features from conventional financial institution. The recording not only has to facilitate transactions happen in IFI, but also has to meet Shariah compliant. A lot of issues rose for accounting and control of IFI. One of the issues is accounting basis of income recognition. Islamic accounting can be defined as the â€Å"accounting process† which provides appropriate information to stakeholders of an entity which will enable them to ensure that the entity is continuously operating within the bounds of the Islamic Shariah and delivering on its socioeconomic objectives. Islamic accounting is also a tool, which enables Muslims to evaluate their own accountabilities to God (in respect of interhuman/environmental transactions). 1 1 Shahul Hameed, Accounting and Auditing for Islamic Financial Institution, page. 1 In conventional banks, how they recognise the income does not affect the distribution profit to the depositor. They use interest mechanism, give interest to depositor and receive interest from debtor. Unlike conventional banks, Islamic bank are not operated with interest mechanism. It is operated with buying and selling basis, profit and loss sharing or leasing. It is a financial intermediary between investors and entrepreneurs. How much the depositors will get their return depends on how good Islamic bank generate profit. Therefore, income recognition in Islamic Banks will affect their profit distribution to their depositors because different income recognition basis will give different implication for all the parties involved. Accounting recognition refers to recording the basic element of the financial statements. The concept of accounting recognition define the basic principles that determine the timing of revenue, expense, gain and loss recognition in the bank’s income statement and, in turn, the basic principles that determine the timing of assets and liabilities recognition. The concepts of accounting recognition also determine the timing of recognizing profits and losses resulting from restricted investments in the statement of changes in restricted investments. 2 Currently, there are two basis of recognition in accounting, namely cash basis and accrual basis. The characteristic of each basis will be discussed in the next section. The issue is which one that should be the basis of income recognition from Islamic perspective. 2. Accounting Principles from Islamic Perspective There are three major Islamic principles mentioned in Qur’an which related with financial dealings and contracts. These are: †¢ †¢ †¢ Realization of fairness and justice Preservation of the rights and dues of all parties Paying zakah (that necessitates having accurate and just financial statements which represent accurately and truly the financial position of the entity)3. AAOIFI, Statement of Financial Accounting No. 2 Eltegani, Accounting postulates and principles from an Islamic Perspective, Review of Islamic Economics. page. 9 3 2 2 The first two Islamic principles are emphasized by the Holy Qur’an. It is instructed that measure and weight should be given with justice and without withholding from people what is theirs (QS 6:152, 7:29, 11:85, 17:35, 55:9, 57:25). In Surah Al-Baqarah verse 282, Muslims are asked to write down faithfully and precisely when dealing in financial transactions involving further obligation (debt). â€Å"O you who believe! When you deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing† and â€Å"Let a scribe write down faithfully as between the parties† (QS 2:282) Therefore, Islam required accounting which helps to keep and record the rights and dues of all parties. The third principle, which is paying zakah is one of the pillars of Islam. Allah SWT requires Muslims with specified minimum wealth (nisab) to pay zakah. Having accurate and just financial statement is necessity to determine the amount of zakah. 3. The Concept of Accrual and Cash Basis Accounting The policy of recognizing revenue in the accounting records when it is earned and recognizing expenses when the related goods or services are used is called the accrual basis of accounting. The purpose of accrual accounting is to measure the profitability of the economic activities conducted during the accounting period. Accrual-basis accounting records financial events based on economic activity rather than financial activity. Under accrual accounting, revenue is recorded when it is earned and realized, regardless of when actual payment is received. 4 The most important concept involved in accrual accounting is the matching principle. Revenue is offset with all the expenses incurred in generating that revenue, thus providing a measure of the overall profitability of the economic activity. From Islamic 4 Jan R. Williams, et al. (2003). Financial Accounting, page. 104 3 perspective, the matching principle provides fairness and justice simultaneously to shareholders and depositors in Islamic banks. 5 An alternative for accrual basis is called cash basis accounting. Under cash basis accounting revenue is recognized when cash is collected from the customer, rather than when the company sells goods or rendered services. Expenses are recognized when payment is made, rather than when the related goods or services are used in business operations. The cash basis of accounting measures the amounts of cash received and paid out during the period, but it does not provide a good measure of the profitability of activities undertaken during the period. 6 Cash-basis accounting does not recognize promises to pay or expectations to receive money or service in the future, such as payables, receivables, and prepaid or accrued expenses. There are two types of cash-basis accounting: strict and modified. Strict cash basis records cash outflow and inflow only. Modified cash basis includes some elements from accrual basis, such as receivable and inventory. For example, the bank enter mudaraba contract with mudarib A for four years. In the first year, the mudarib declared profit but has not paid to the bank yet. In accrual basis, bank will record this share of profit as account receivable from mudarib A. In cash basis, bank would not record anything because there is not cash movement to or from the bank. If after the project finish, mudarib A still have outstanding balance, modified cash basis will recognize it as account receivable from mudarib A. Cash basis still does not record this event because there is not involve cash movement. 4. Choice of Cash or Accrual Basis Accounting Cash or accrual accounting has been the subject of discussion among Shariah jurist. Fiqh experts have determined that cash basis of accounting to be a mode of practice to account for Islamic transactions in the past. 5 Eltegani, Accounting postulates and principles from an Islamic Perspective, Review of Islamic Economics, page. 11 6 Jan R. Williams, et al. (2003). Financial Accounting, page. 104 4 The early mudaraba contract was conceived of â€Å"primarily as an instrument of singleventure commerce. It was, indeed, ideally suited for this purpose and was extensively used in this way†7. The accounting rules developed by early Islamic jurist for such single-ventures recommend a cash basis for the recognition of profit and stipulated that it should be realized and allocated between parties when the venture is terminated and the mudarib remits to the capital provider. The realization principle is considered acceptable from the Islamic viewpoint as far as recording of transactions are concerned. It is prudent to recognize revenue only when it is realized. But this convention might harm transitional investors who withdraw from investment. Depositors in some Islamic banks have the right to withdraw their funds at any time. Therefore, if some of them withdraw before the full liquidation of the project in which their funds or part of them have actually participated, they may lose all or part of the profit that might be realized in the future. 8 Mudaraba investment accounts in some Islamic banks are entitled to a part of the realized profits for the accounting period. Since these profits do include profits or loss of projects which are not yet liquidated, investors who withdraw at this stage may well not share in the profits of some of the projects in which their money have actually participated. Hence it may be argued that this conflicts with the requirement of justice and fairness. Co-mingling of funds in Mudaraba contracts, separate legal entity, going concern are concepts that cash accounting has failed to address completely but they exist in the Islamic banking business today. In Malaysia, modified cash accounting has been the basis of accounting used by Islamic bank as the Shariah council of the bank has permitted the use of modified cash accounting for the bank. 9 AAOIFI’s FAS 3 explains that realization profit is the time at which it can be established that profit is achieved in a Mudaraba.