Journal of Financial Reporting and Accounting

Profit-Sharing Investment Accounts in Islamic Banks or Mutualization , Accounting Perspective

Wasim k AlShattarat Muhannad A Atmeh
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To cite this document:
Wasim k AlShattarat Muhannad A Atmeh , (2016),"Profit-Sharing Investment Accounts in Islamic Banks or Mutualization ,
Accounting Perspective", Journal of Financial Reporting and Accounting, Vol. 14 Iss 1 pp. -
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 Profit-Sharing Investment Accounts in Islamic Banks or Mutualization ,

Accounting Perspective

1- Introduction

As interest-bearing deposits are prohibited by Islamic Shariah, Islamic banks typically mobilize

funds from depositors in the form of profit-sharing investment accounts (PSIA). PSIA are held by
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investment account holders (IAH) and comprise a major source of the Islamic banks funding

(Archer and Karim, 2009). Mudarabah contract, i.e. a partnership in profit between the provider

of labor and the providers of capital, is the main vehicle to accomplish this mission. In this type

of contract, profit is shared, by the two parties, as agreed, and losses are borne by the provider of

funds (Kamla, 2009)1. Mudarabah contract is employed by banks, where the bank acts as mudarib

(asset manager) and the IAHs as rab-al-mal (investor)2. The profits on investments financed by

the IAHs are shared between the IAHs and the bank, according to the pre-determined profit-

sharing ratio, while all losses are borne by the IAHs.

This model of deposit raising and profit sharing that was introduced by Islamic finance is still

controversial and its relevance in today’s banking environment is still debatable. While the

framework and rules of Mudarabah which were formulated by classical jurists in the 7th century

reflect the conditions that were present at that time, modern jurists performed major modifications

to Mudarabah contract to cater for complex financial transactions and different economic

conditions. These modifications may result in deviating Mudarabah from equity and justice as

prescribed in the classic framework.

1
More accurately, it is profit-sharing-and-loss-absorbing. (Abdul – Gafoor, 2006)
2
The Islamic bank may employ Mudarabah contract on both sides; the liability side (IAHs) and the asset
side. On the asset side, banks may invest part of the funds received from IAHs, or funds available from
other sources, in Mudarabah contracts. In this case, banks act as a financer to the parties who borrow these
funds and receive a share of the profit by applying a profit-sharing base. This paper is concerned in the
Mudarabah contract on the liability side which is related to the investment received from depositors.

1
 1.1 Evolving of Mudarabah contract: back to basics

Originally, Mudarabah contract was applied between two parties to conduct a business

partnership. The first party possesses a surplus fund with limited trading skills, while the second

party is traders who are in need of a fund. The classical jurists viewed Mudarabah as a

commercial contract executed in simple trading activities where the agent manager buys saleable

items from Mudarabah capital and sells them for profit. The agent-manager is required to return

the capital to the investor when the business is liquidated and anything exceeding the capital is
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considered as profit. Profit would be shared between the two parties based on a pre-agreed ratio.

All these procedures are straightforward because the classic Mudarabah was implemented in a

simple business setting. For example, the agent manager was restricted to invest the capital in

trading (retail) activities and any other complicated activities (manufacturing ,agriculture, or

complex commercial dealing) may render the Mudarabah invalid. It was viewed that activities,

other than trading, could produce inequality of the risks and rewards shared by the partners. If

Mudarabah contract is employed, for example, in a manufacturing project, the investor will

provide a huge fund to cover the costs of the fixed assets, raw material, wages, and other

expenses. On the other hand, the agent manager receives part of the profit for his management,

and any losses result from his work will be totally borne by the investor. This business model

cannot be fair for the investor considering the amount of money invested in the project

(Shaharuddin, 2010).

In classic Mudarabah, the relationship between the investor and the agent manager is considered

fair and in balance considering the rights, obligations, responsibilities, skills, rewards, etc., for

each party. Although jurists prohibited the investor from participating in Mudarabah fund

management as it is assigned to the agent manager, the empowerment given to the agent manager

is restricted and not absolute. Most jurists did not allow the agent manager to expose Mudarabah

2
 capital to risks without obtaining an explicit permission from the investor. This is because the

investor is the sole party who bears the risk. Examples of transactions that were considered risky

by classical jurists are purchase or sell on credit3 and travelling with capital4. The interpretation

offered by jurists for such restrictions is that the agent manager was asked to perform his job with

careful and vigilant consideration; credit transactions and travelling are not regarded as a vigilant

decision because they could cause loss of capital.

Another restriction imposed on the agent manager is that he is not allowed to commingle the
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entrusted capital with his own money or other investors’ money. Classical jurists consider these

transactions beyond the general scope of the agent manager’s empowerment because, in such

cases, the investor will be obliged to enter into a partnership with other parties. The agent

manager must acquire explicit permission from the investor before executing such transactions.

Additionally, jurists prevented the agent manager from acting as capitalists in another Mudarabah

agreement - playing an intermediary role- as the agent manager in this case is neither the owner

of the capital nor the worker for the business. Hence, the agent manager’s share of profit is not

justified by virtue of the fund provider or by virtue of the work performer. Moreover, the classical

rules of Mudarabah disallow the distribution of profit before the physical liquidation of the

Mudarabah business (Shaharuddin, 2010).

Modern Islamic scholars allowed the Islamic bank to conduct the previous prohibited

transactions, justifying their permission on the basis of the depositor’s consent on such

transactions. The depositor provides his consent when he signs a standard forms at the beginning

3
Purchase on credit may result in purchasing goods worth more than the Mudarabah capital, and
consequently, exposing the investor to obligation more than his investment. Credit sale is risky when the
creditworthiness of customer is doubtful.
4
There is a significant difference between travelling in the past and nowadays. In the past, travelling refers
to caravan trade where properties of Mudarabah were carried from one place to another. Hence, properties
may be exposed to robbers and other risks.

3
 of the contract. Hence, the consent can be viewed as an open consent rather than a transaction by

transaction consent. The question here is whether this type of consent could be considered as a

reliable consent. In reality, depositors do not have any negotiating power or influence on the

contract. Mudarabah is offered by banks as a ‘take it or leave it’ contract. Hence, the consent

provided by depositors are artificial and in form more than in substance. Besides, many of the

depositors are not aware of the contract details and in many cases, some essential information

such as the investment strategy, risks, profit calculations and other details are not stated in the

contract.
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Based on the previously mentioned, the scope of empowerment is shifted towards the agent

manager, and therefore, the bank is seen as the controlling party instead of the depositor (unlike

the traditional Mudarabah). The bank decides the investment product, stipulates conditions, and

determines the provisions of profit ratio and other matters. On the other hand, depositors who

bear the risks do not have the opportunity to change or amend any condition in the contract. This

bias in favor of the agent manager is considered one of the prime reasons for lack of Mudarabah

contract on the assets side of Islamic banks.

Some scholars claim that the current jurists were driven by market demands in modifying

Mudarabah rules to suit modern banking practices, and therefore, Islamic banks practices have

deviated from the original theory of Mudarabah and its ethical framework in order to replicate the

interest-based banking system. Besides, these modifications generate severe practical problems in

implementation. The aim of this paper is to investigate the applicability of using modern

Mudarabah by banks on a high scale.

Tahir (2007) asks the question: “Is the difference between Islamic and interest based banking

really thin on the deposit mobilization side? Or, is there something that is being missed?”

4
 Researchers in this area brought out many missing issues in Mudarabah contract and diagnosed

severe deficiencies that may hinder the use of this model.

First, the dilemma of how to determine the total profit has not been resolved yet. In practice,

Islamic banks employ continuous Mudarabah in which profits are accounted for on a periodic

basis during the Mudarabah period, but without liquidation of investment and without returning

the capital to the providers of funds. The question that arises here is: should the assets financed by

Mudarabah, at the financial statements date, be measured to their cash equivalent value or to the
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historical cost in order to reach the distributable profit?

Second, and beside the determination of total profit difficulties, profit allocation between

different types of depositors and stockholders, is another challenge. As the bank invests the IAH

funds in a commingled asset pool, together with funds from current accounts (unremunerated),

saving accounts and shareholders’ funds and then distributes the generated profits to IAH and

stockholders. Furthermore, how to calculate the profit for each depositor comprises another

concern, taking into consideration that depositors may provide or withdraw money at different

points of time. This may not match the inception or liquidation of the projects financed by

deposits received.

Third, reserves related to Mudarabah impose another threat regarding the applicability of

Mudarabah model. In a Mudarabah contract, neither deposits amounts nor returns on deposits are

guaranteed. Therefore and in order to override this issue, Accounting and Auditing Organization

for Islamic Financial Institutions (AAOIFI) stated in the Financial Accounting Standard (FAS)

No.11 that the Islamic bank may use two types of reserves; Profit equalization reserve (to

maintain a specific level of return to IAH) and investment risk reserve (to guarantee the deposits

5
 principal to IAH). Jurists legalized these reserves by relying on a donation (Tabarru)5 contract.

These reserves are used heavily by Islamic banks in order to smooth the profits payout to

investment account holders which affect the transparency of the financial statements and may

result in profit misallocation among IAH (Arshad and Ismail, 2011; Islamic Financial Services

Board, 2010; Taktak et al., 2010). Atmeh and Ramadan (2012) also questioned the

appropriateness of using donation (Tabarru) contracts in doing business with commercial

substance.
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Fourth, the classification of IAH and its related reserves is still under debate. It is argued that the

IAH funds cannot be considered as a liability because the Islamic bank is not obliged to return the

funds it has received in case of loss. Likewise, IAH are not considered as owners’ equity since the

holders of these accounts do not enjoy the powers and ownership rights, such as, the voting rights

held by owners. Hence, AAIOFI established a new category (a fourth category besides assets;

liabilities; and stockholders’ equity) for IAH accounts. However, presenting IAH in a separate

category in the financial position statement, without reclassifying the assets in the financial

position statement to reflect the assets attributable to IAH, suggests undue bias in the financial

statements. This contradicts the concepts of full disclosure and true and fair view of the financial

statements (Atmeh and Ramadan 2012).

Fifth: corporate governance structure comprises another serious issue in Mudarabah contract. The

holders of IAH are exposed to the risks of equity investors, however, they don’t have any

governance rights such as voting rights, and rights to adequate information about financial

performance (Archer and Karim, 2009; Arshad and Ismail, 2011). The agency problem is also

addressed in this regard. The bank’s management acts as an agent for the shareholders, while the

5
IAH donate part of their profit either to other IAHs in different periods that suffer a defined loss, or to a
third party in case of liquidation.

6
 bank as mudarib acts as an agent for the IAH. This may enable the bank’s management to reduce

the profit of IAH for the benefit of shareholders (Napier, 2007; Archer and Karim, 2009).

The structure of this paper proceeds as follows: Section 2 discusses and reviews the difficulties

that encounter profit measurement and allocation among different parties. A critical analysis of a

number of contradicting views in this issue is also provided; Section 3 examines the reserves

related to Mudrabah contract and its applicability; Section 4 considers the effect of Mudarabah

contract on the presentation of financial statements; Section 5 demonstrates concerns connected

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to the corporate governance structure; Section 6 introduces suggestions to substitute Mudarabah

contract by employing a mutual fund formula; and finally Section 7 summarizes this work along

with some avenues for further research .

2. Profit Determination and Allocation

Islamic banks mobilize funds on different bases from those of conventional banks because of the

prohibition of interest in Islam. Hence, the capital structure of the Islamic bank has four main

sources of funds; shareholders’ equity, current accounts, investment accounts, and saving

accounts (AL-Deehani et al., 1999). Shareholders' equity comprise the funds raised through the

sale of bank’s common shares to the public plus retained earnings and reserves attributable to

stockholders that accumulated over the years. Current accounts are mobilized on bases other than

Mudarabah contract, and not entitled to receive any profits as the depositors’ concern is safe-

keeping of funds with maximum flexibility in their withdrawal6. Investment accounts and saving

accounts are governed by Mudarabah contract, and the bank invests these accounts on the basis of

profit sharing (Archer et al., 1998).

6
Current accounts are placed under the contract of trust.

7
 In many cases, the bank invests the four sources of funds in a ‘commingled’ asset pool. If the

aggregate investment portfolio yields a profit, then the shares of profit are allocated between the

parties; saving accounts, investment accounts7, and stockholders, according to the proportionate

shares of their respective investments in the portfolio. The bank’s share of profit relates to both its

shareholders’ own funds and to current accounts funds. However, the shareholders also receive

the mudarib share (asset manager) according to predetermined rate (Archer and Karim, 2009).

While this profit allocation mechanism seems fair and straightforward, crucial and controversial

decisions should be taken to implement it. These decisions include determination of: methods of
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profit measurement, recognizable income and expenses that are applicable to IAH funds, reserves

and smoothing practices, range of weights and profit-sharing ratios applicable to various tenors of

IAH funds and comingled funds of the shareholders (Islamic Financial Services Board, 2010).

2.1 How to determine the profit (measurement issues)

Traditionally, and throughout the Islamic history, Mudarabah was a one-project, time-limited

contract and the distributed profit of Mudarabah is determined when the projects financed by

Mudarabah are liquidated8(Napier, 2007). Currently, Islamic bank employs different types of

Mudarabah. These include compound9, unrestricted10, commingled11 and continuous12

Mudarabah. Usually, the bank commingles its funds with the depositors’ funds and invests these

amounts in multiple projects; some of which are long term projects. Profits are accounted for on a

periodical basis, regardless of the liquidation of the projects. This is because it is not practical for

7
In the remaining sections of this paper, the term IAHs includes both types of saving accounts and
investment accounts.
8
Liquidation concept is known in Fiqh as Tandeed
9
Compound Mudarabah is based on a multiplicity of Mudaraba parties. The most used form of this type of
mudaraba by banks is a several providers of funds (IAH) and a single mudarib (Bank) (AAOIFI, 2008,
p.206)
10
Unrestricted Mudarabah: bank is authorized by the depositors to invest their funds in the manner which
the bank deems appropriate(AAOIFI, 2008, P.206)
11
Commingled Mudarabah: investment in the Mudarabah funds is provided by the mudarib as well as by
the depositors.
12
Continuous Mudarabah: Profits are accounted for on a periodical basis during the Mudaraba period, but
without its liquidation and without returning the capital to the providers of funds(AAOIFI, 2008, P.206)

8
 depositors to wait for the liquidation of all projects financed by the bank, which may last for

several years, in order to get their profit. In practice, scholar developed the concept of “tandeed

hukmi” (constructive tandeed or face liquidation) to accommodate contemporary banking

practices. According to tandeed hukmi, the profits generated from investments during the year are

calculated without actual liquidation of the investments, and these investments are considered as

new investments in the new financial period13.

The difficulty of this approach is how to determine the value of the investment assets at the end of
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the financial period: should it be the historical cost or the fair value (cash equivalent value)? The

cash equivalent value would be a suitable measurement base for investment assets financed by

stockholders and IAH. This is because the cash equivalent value would ensure:

“equitable allocation of the results of unrestricted investments between the holders of

unrestricted investment accounts who have provided or withdrawn funds at different

points of time during the lives of those investments, on one hand, and between such

account holders as a group and owners of the Islamic bank on the other hand” (AAOIFI,

2008, P.47, para. 92)

It is also recognized that cash equivalent value prevails over historical cost because:

“If unrestricted investments were to be measured at their acquisition (historical) cost,

inequities would occur in the distribution of investment results between holders of

investment accounts who provide or withdraw funds at different points of time during the

lives of those investments. Likewise, inequities would occur in the distribution of

unrestricted investment results between the holders of unrestricted investment accounts as

a group and owners of the Islamic bank” (AAOIFI, 2008, P.47, para. 93).

13
This approach is criticized by some Islamic scholars as it violates the basic principles of Mudarabah
(Napier, 2007).

9
 Unfortunately, and despite of the previous paragraphs, AAOIFI does not adopt the cash

equivalent value at the present time. This is because it is not evident that adequate means are

currently available to apply this concept in a manner that is likely to produce reliable information.

Unlike other financial reporting frameworks, AAOIFI implements the historical cost concept

instead of developing techniques or standards that may enhance the reliability of the fair value

determination14. In contrast, and for Zakah purposes, AAOIFI employed the cash equivalent value

to evaluate assets and liability. It is evident that cash equivalent value is in line with Shariah

principles, conventional accounting standards, fair presentation, and relevance information. Using
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historical cost for calculating Mudarabah profit may result in misallocation of profit among

different categories of fund providers, and across financial periods.

2.2 How to determine attributable profit for different parties (expenses and income

allocation)

Napier (2007) raises the following question: when the bank commingles its own funds with funds

of depositors, how does it allocate administrative expenses and revenue generated from other

banking operations? AL- Deehani et al., (1999) indicated that there are two profit sharing

methods often used by Islamic banks to handle this issue: the pooling method, in which all

sources of funds in the Islamic bank share in all revenue and expenses15, and the separation

method, in which IAH share only in the revenue and expenses related to their investment. This

means that other revenue and expenses (including administrative expenses) are borne by the

stockholders solely. Hence, each method produces different shares for each party.

14
For example, International Accounting Standards Board (IASB) issued the International Financial
Reporting Standard (IFRS) No. 13 (Fair Value Measurement) as guidance to assist professionals in
determining the fair value in a reliable manner.
15
Except for the revenue generated from subsidiaries and affiliated companies, the directors’ benefits
expenses, and external audit fees which will be allocated to stockholders (AL- Deehani et al., 1999).

10
 The pooling method is easier to apply as there is no need to determine the expenses related to

IAH investments. On the other hand, why the bank deserves the mudarib share of profit in this

formula? According to Mudarabah contract, the contribution provided by the mudarib is work,

and work in this context relates to the management of the Mudarabah (AAOIFI, 2008, P.157), so

by definition, management and administrative expenses should be charged to the mudarib solely

(his contribution) in order to be entitled to the mudarib share of profit (his reward).

In the separate method, which expenses should be allocated to the Mudarabah fund and which to
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be borne by the bank is another challenge? This is because there are common costs (indirect

costs) that incur to support a number of bank’s activities16 and cannot be traced easily and

conveniently to these activities individually. Usually judgment is used to find the appropriate

allocation base in order to assign costs to activities. In this regard, different practices among

Islamic banks can be found, and each practice produce different share for stockholders and IAH.

In order to overcome this issue, Tahir (2007) proposes the use of segregated Mudarabah

investment pools with separate accounting records and profit distribution for each such pool. He

also criticized the approach of commingling accounts because it lacks the principle of equity and

justice and contradicts with Shariah principles.

AAOIFI addresses these problems without offering any guidelines or standardized solutions.

Instead, it requires the Islamic bank to present sufficient disclosure about the polices used.

Disclosures required by AAOIFI include: the bases applied by the Islamic bank for charging

expenses to IAH, whether the Islamic bank has included IAH in the sharing of profit resulting

from investing current accounts funds or any other funds, whether the Islamic bank has included

16
These activities may support Mudarabah investments and other bank’s functions on the same time.

11
 IAH in the sharing of revenue from banking operations, and if so, the types of such revenue and

the bases applied should be also disclosed. (AAOIFI, 2008)

Furthermore, and in cases where the Islamic bank is unable to utilize all funds available for

investing, a disclosure should be made of which of the two parties was given priority.

Ahmed (1996) presents an example of how one of these polices could affect sharply the profit

share of each part. He examined Faysal Islamic Bank of Sudan (FIBS) figures for two

consecutive years during which the Shariah Supervisory Board (SSB) of FIBS changed the profit
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allocation treatment between current account, IAHs, and stockholders accounts. In the first year,

the profit was allocated to three categories (current accounts, IAH, owners’ equity) and the

stockholders received the share of the current accounts profit plus the share of the owners’ equity

profit. Since the bank couldn’t invest all funds available from the three categories, the amount of

IAH which participated in the actual investment was significantly lower than the actual deposits

received by the bank. Subsequently, the profit related to the participated IAH is distributed to the

actual IAH received by the bank, resulting in low dividends rate for IAH. In the first year,

dividends to IAHs were 4.3%. In the second year, the bank changed its policy regarding profit

allocation and gave the priority of investment to IAH, i.e. the amount invested is financed firstly

by IAHs and any unutilized funds are considered from current accounts and owners’ equity funds.

This new policy increased the dividends rate dramatically to IAHs from 4.3% to 9.1% without

any significant change in the bank performance during the two periods. This is because the share

of IAH which participated in total investment increased at the expense of the shareholders' share.

This shocking result stresses the reliability of profit allocation techniques and also emphasises the

crucial role of the SSB and the structure of corporate governance of the bank.

2.3 Do the stockholders of the Islamic bank really play the role of mudarib to be entitled to

mudarib share?

12
 Mudarabah is a partnership between capital and work. There are two contracting parties in

Murabahah: the provider of the funds and the mudarib. Meanwhile, and in corporations structure,

the ownership is separated from management. Consequently, in the corporate Islamic banks, three

parties could be identified in the Mudarabah contract: depositor-investor as rabb-al-mal, bank’s

management which manages the depositor-investor’s money, and the bank’s stockholders who

receive the mudarib share of profit. In this formula, the party who receives the mudarib profit

(stockholders) may not provide any work (Mudarabah management) or maintain any capabilities

which are assumed in the mudarib. In contrast, the management which is responsible to provide
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the work and invest the funds may not share any profit. Furthermore, and in the classic

Mudarabah, the provider of funds must be confident of the personal qualifications and ethics of

the mudarib. This is because the provider of funds bears all losses incurred from the Mudarabah

and cannot interfere in the work as work is the exclusive right of the mudarib (AAOIFI, 2008).

In the current structure of Islamic Banks as corporations, the depositor-investor doesn’t know the

mudarib (stockholders) in order to assess his/their personal qualifications and ethics, as the

stockholders change on a daily basis and don’t participate in Mudarabah management. It is

apparent from the above that the corporation form contradicts with the mudarib rights and

responsibilities as described in the classic Mudarabah contract. Archer and Karim (2006)

suggested that this overlapping in roles is considered as an anomaly from the capital market

perspective: shareholders and IAHs share the same asset risk on the commingled fund, while

shareholders enjoy higher profit because of the mudarib share. They also wondered why IAH

would not shift their investments to common shares in order to enjoy a higher return for the same

level of risk17. Shubber and Alzafiri (2008) found that the majority of Kuwait Finance House

depositors are not satisfied with their level of return comparing with that paid to stockholders and

concluded that the shareholders enjoy a higher level of return than depositors, though the former

17
In other words, choosing between to be a stockholder or IAH is not related to the functions assumed by
each party but related to risk preferences.

13
 are exposed to higher risks. It is clear that in the corporation structure of banks, the IAH (rabb-al-

mal) can shift their investments to be stockholders (mudarib) and vice versa, without taking into

account any personal capabilities for each group. This idea overshadows the role of mudarib of

the Islamic banks and furnishes the stockholders with part of profit they do not deserve.

Abdul-Gafoor (2006) investigated the mudarib role of the Islamic banks from another angle. His

argument was as follows: the Islamic bank raises the funds from the depositors then finances

projects put forward by entrepreneurs. In this mechanism, the Islamic bank plays the role of the
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intermediary between investors and entrepreneurs, i.e. the role of the financer. However, and in

order to meet the Mudarabah concept, the Islamic bank (as mudarib) should assume the role of

trader. Abdul-Gafoor (2006) claims that Islamic banks are financers in substance and traders in

form, and this alteration from financer to trader are achieved by ‘legal’ documentation and some

self-persuasion. He proposed an approach to overcome this “split personality” problem and

suggested “let the financiers be financiers, and the traders and entrepreneurs be traders and

entrepreneurs”. He proposed that the Islamic bank, as an intermediary, should be independent of

both the investors and the entrepreneurs. The bank is responsible for identifying good projects for

financing as well as for monitoring their progress. The system proposed emphasized the features

that the intermediaries and entrepreneurs should carry.

3- Reserves

AAOIFI allows the Islamic bank to use two types of reserves related to Mudarabah contract:

profit equalisation reserve (PER) and investment risk reserve (IRR).

Profit equalisation reserve is the amount appropriated by the Islamic bank out of the Mudarabah

income, before allocating the mudarib share, in order to maintain a certain level of return on

14
 investment for the IAH. On the other hand, investment risk reserve is the amount appropriated by

the Islamic bank out of the income of IAH, after allocating the mudarib share, in order to cater

against future losses for the IAH (AAOIFI, 2008).

Although such types of reserves may undermine the main notion of Mudarabah (profit – loss

sharing)18, Islamic jurists permit the deduction of part of the profit attributable to certain

individuals (i.e., IAH) and make it available for the benefit of other IAH. Islamic jurists legalized

these reserves by relying on a donation (tabarru) 19 contract (in years of profits, IAH donate part
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of their profit to the reserve, and in years of losses, IAH receive donations from reserves). As for

the amounts which were deducted to create reserves, it is preferred that they be donated to

charitable causes when the contract is terminated, if the purpose for which they were deducted no

longer exists (AAOIFI, 2008, P.350).

Atmeh and Ramadan (2012) indicated that using profit equalization reserve could result in profit

misallocation between IAH, that is, the profit earned from investing IAH funds in a specific year

could be distributed to other IAH in a future year. In addition, these reserves may affect equity

and justice among IAH. An IAH who withdraws his funds loses his share of the accumulated

reserves and is in effect contributing to the future profits of other IAH (Islamic Financial Services

Board, 2010).

This issue is critical for several reasons. First, earnings management or income smoothing is

mentioned in conventional accounting and auditing standards as a mechanism that may result in

fraud and misstatement. Hence, the management has a responsibility to publish financial

statements that reflect the economic position of the firm and its performance in a very transparent

18
PER could be used to distribute a fixed level of return to IAH, and IRR could be used to guarantee the
principal of the IAH deposits.
19
Tabarru means a donation, charity, or gift which cannot be taken back.

15
 way rather than in the way that the management desires. Although the main goal for this reserve

is to enable the bank to distribute a certain level of profit to IAH regardless of the profit achieved,

managers and shareholders of an Islamic bank can draw benefits from a “loose” accounting

standard that provide managers with latitude in timing the reporting of income. Archer et al.,

(2010) argues that the management of the Islamic bank may engage in a range of practices that

smooth or cushion the cash returns paid to IAH, thus keeping a stable trend of income from assets

financed by those funds. This is done either to pay market-related returns to IAH or to reduce the

risk of investment accounts drawing. Asian-Oceanian Standard-Setters Group (2010) also

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addressed this issue and mentioned that Islamic banks may practice earnings management by

utilizing four main methods; a) profit equalization reserves, b) investment reserve risk, c) an

Islamic bank forgoing some portion of its share of profits, and d) an Islamic bank transfers

amounts from shareholders' current or retained profits.

These practices may be subject to potential abuse and may also include Gharar 20(Uncertainty) as

IAH share of profit does not depend fully on the performance and profit realized, but is also

affected by management discretion in determining reserves.

This treatment also raises an ethical concern on whether the AAOIFI’s accounting standards are

based on Islamic ethics in serving public interest or are they based on serving the interests of the

shareholders of the bank? It is fairer to appropriate risk reserve and profit equalization reserve out

of the shareholders’ profit than out of the IAH’ profit. This is because the ultimate objective of

these reserves is to attract deposits and to ensure sustainability of the bank, which should be the

concern of Islamic bank shareholders. Moreover, an IRR may give rise to moral hazard problems,

since the existence of an IRR in an Islamic bank may encourage the management to take

excessive risk. This is because losses can be absorbed by IRR reserve, which is built only from

the funds of IAHs and not those of shareholders (Islamic Financial Services Board, 2010).

20
Gharar is prohibited in Islamic finance.

16
 Additionally, the appropriateness of using donation (tabarru) contracts in business that has a

commercial substance is under question.

3.1 Donation Contracts

Islamic contracts can be broadly classified, in terms of consideration exchanged, into two

categories: Exchange (Muawadah) contracts where the contract entails an exchange of counter

values or reciprocal consideration, and Donation (Tabarru) contracts where the value is

transferred from one party to another without consideration but with the intention to perform
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good deed and pious.

Usually the economic activities are based on contracts with reciprocal consideration (exchange

contracts), while the charitable activities are based on the incentive to donate (donation

contracts).

Jurists established different requirements and conditions for each group of contracts, and

accordingly, different legal positions and effects emerge from each type. For example, exchange

contracts are considered as bilateral contracts which require the consent of both contracting

parties. Besides, an exact knowledge of the counter values should be identified in order to ensure

the fairness for both sides of the contracting parties. In donation contacts, such knowledge is not

required and the consent of the recipient is not necessary (unilateral contract). This is because in

a donation contract, the donor voluntarily gives up the value and the receiver obtains the value for

no consideration. Therefore, fairness issue is not raised in this situation even when the value

being transferred lacks a precise specification and identification.

17
 The current practices of Islamic banks combine donation contracts with exchange contracts in

conducting commercial transactions. This combination needs further investigation21.

As the aim of parties entering into commercial transactions is to make profit, exchange of

considerations should be present in such types of transactions. Thus, intercalating donation

contracts in commercial transactions does not seem reasonable, especially when these donations

are not directed to poor or needy parties. It results in injustice treatment among parties, since one

party receives value at no cost while the other gives up value for no return. Ironically, according

to AAOIFI, the mudarib (asset manager) is not allowed to make donations or gifts out of the
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mudarbah funds because these actions reduce the fund provider’s wealth. And at the same time,

the mudarib (Bank) has the right to deduct part of the fund provider’s profit - legitimized as

donation from the fund provider - to build IRR and PER to the level that is considered prudent

and without seeking approval from the fund provider for each amount deducted. This

contradiction casts doubt over intercalation of donation contracts into commercial transactions.

Donation contracts employed by Islamic banks can be perceived as a technique to accommodate

conventional banking practices in Islamic structure22. When a traditional product is modified to

meet Shariah principles, legal effects (legal positions, rights, obligations, risks...) between the

contracting parties are changed accordingly. At that time a donation contract is employed to

redeploy legal effects between the contracting parties so as to replicate the traditional product

substance. This is because in donation contract rights, obligations, money, risks and other effects

can be transferred from one party to another with no consideration. This procedure fulfils the

21
From shariah point of view, some Islamic jurists do not allow the amalgamation between Muawadah and
Tabarru types of contract because Tabarru may be done to facilitate transaction in a Muawadhah way and
not solely done voluntarily.
22
There is also another type of donation contract attached to Mudarabah contract: Ibra’ contract (partial
surrender of rights). Ibra’ refers to the act of surrendering one’s claims and rights, such as a creditor writing
off the debts of a debtor. This contract is utilized when the depositor withdraws his deposit before the
mudarabah term. In this case, the bank repays the principle of the deposit without adding (subtracting) the
profit (loss) resulting from investing this deposit for the period that the deposit stayed in the bank. This
action is legitimized under the Ibra clause.

18
 legal Shariah requirements though it produces, in substance, identical products to those of

interest-based banking. The legitimate question here is: is it enough to change terminologies to

claim that the contract is Shariah compliant while the objectives, justice and ethical requirements

of Shariah are neglected? One of the main persisting challenges facing Islamic finance is whether

consideration should be given to substance or form.

4 Presentations of the Financial Statements

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The AAOIFI Statement of Financial Accounting No.2: Concepts of Financial Accounting for

Islamic Banking and Financial Institutions adds a new category in the statement of financial

position between liabilities and owners’ equity to present the equity of IAH and their related

reserves.

It is argued that the equity of IAH cannot be considered as a liability since the Islamic bank is not

obliged to return the funds it has received in case of loss. Likewise, the equity of IAH cannot be

considered as owners’ equity as the holders of these accounts do not enjoy powers and ownership

rights, such as the voting rights held by owners.

On the other hand, other studies classified IAH as liabilities23. Archer and Karim (2009), based

on the International Accounting Standards (IAS) 32, classify IAH as a puttable instrument in the

Islamic banks’ capital structure. IAS 32 defines a financial instrument as a puttable instrument

when it gives the holder the right to put the instrument back to the issuer for cash or any other

financial asset. Hence, the right of withdrawal from IAH by investors at any time meets the

definition of a puttable instrument.. However, IAS 32 states that such an instrument should be

23
Islamic banks in Malaysia have classified unrestricted investment deposits as liabilities which is not in
line with standards established by AAOIFI (Abd Rahman and Zainuddin, 2009).

19
 considered a financial liability in the issuer’s books, even when the amount of cash or other

financial assets is determined on the basis of an index or another item that has the potential to

increase or decrease, or when the puttable instrument gives the holder the right to a residual

interest in the assets of an issuer24.

Moreover, Atmeh and Ramadan (2012) suggest that the AAOIFI’s definition of equity of IAH is

inconsistent with the definition of the owners’ equity and could be misleading. Equity of IAH is

defined as the amount remaining from the fund originally received from IAH plus (minus) their
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share in profit (loss) and decreased by withdrawals from, or transfers to other types of accounts.

While owner’s equity is defined as the remaining amount from the Islamic bank assets after
25
deducting the bank’s liabilities and equity of unrestricted IAH . It is inferred from these two

definitions that any change in assets value would be attributable to the owners only and IAH is

considered as a monetary item (fixed amount). While in reality, assets are financed by the owners

and the IAH. Hence, the risks and rewards of assets’ ownership are shared by both parties

according to their proportionate in financing assets.

Atmeh and Ramadan (2012) proposed to classify assets into two subcategories (assets

attributable to shareholders and assets attributable to unrestricted IAH) in the statement of

financial position. This would match the classification used on the other side of the statement of

financial position where two classes of equity are presented (equity of IAH and owners’ equity).

The balance of the IAH depends on the value of the assets financed by IAH accounts, and hence,
24
The current distinction between liabilities and equity in IFRS is based on the nonexistence of an
obligation, so puttable instrument in this approach is classified as liabilities since it represents an
obligation. However, other approached have been suggested to distinguish between liabilities and equity.
One of these approaches is the Loss Absorption Approach where the distinction between equity (risk
capital) and liabilities is based exclusively on the ability or inability of capital to absorb losses incurred by
the entity (Deloitte IFRS website). According to this approach IAH funds could be classified as equity as
IAH may absorb l incurred losses.
25
The IASB Framework defines equity as the residual interest in the assets of the entity after deducting all
its liabilities. This approach should be used to identify IAH equity by determining the related assets and
liabilities.

20
 these assets must be presented separately with sufficient disclosure regarding their values and

risks26.

5- Corporate Governance

As mentioned in the previous section, IAH in Islamic banks are considered as equity investors

rather than a liability. This is because the Islamic bank is not obliged to return the funds it has

received in case of loss. However, the holders of these accounts do not enjoy the powers and

ownership rights like the voting rights held by owners. Hence, IAH accounts do not obtain the
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governance rights of either creditors or shareholders, which raises a major problem of governance

and supervision. For example, IAH do not have any power to appoint the management, the SSB

or the external auditor. Besides they do not have control over the management and they are not in

position to enforce monitoring measures.

Archer et al., (1998) perceived the form of Mudarabah contract as a complex agency problem.

The bank’s management operates as an agent for the shareholders, while the bank as mudarib

operates as an agent for the investment account holders. This relationship may create conflict of

interests between the two categories of investors (shareholder and IAH).

Archer and Karim (2009) mentioned that the capital of IAH is at risk. For instance, IAH have no

choice in deciding the types and risk-return characteristics of the assets in which their funds are

invested as the IAH. (IAHs) does not have the right to interfere in the management of their funds

which is the sole responsibility of the mudarib, i.e. the Islamic Bank.
26
Tahir (2007) criticized the Islamic banks for reporting all deposits as their liabilities, and all their
advances (bank “investments”) as assets in their balance sheets. This is because the ownership of funds
under Mudarabah rests with the depositors and the bank control these funds for operational purposes. He
suggested that the investment deposits and financing from them should be off-balance sheet items for
Islamic banks. He argues that the present method used by Islamic banks, of pooling all types of deposits for
investment and then distributing the generated profits to deposit holders is Shariah incompatible and
violates the principle of equity and justice enshrined in the rules of Mudarabah.

21
 Islamic Financial Services Board (2010) indicated that management may seek profit smoothing

by using reserves for the benefit of the shareholders compromising the benefits of the IAH, as

IAH lack the right to influence the use of reserves. Moreover, it pointed out that the rate of return

on investment accounts, in some cases, is uncorrelated with the net rate of return on assets.

Ghayad (2008) suggested that effort should be done to strengthen the role of IAH. This can be

achieved by appointing a representative of IAH to join the corporate bodies in the bank. He also
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identified that the SSB members are another flaw in the corporate governance structure in the

banks. This is due mainly to the qualifications of SSB members. He claimed that the members of

the SSB were not very specialized in the fields other than Shariah. Hence, they may hinder the

performance of the directors of the Islamic banks.

6- Suggestions

It is obvious from the previous sections that the Mudarabah contract employed by Islamic banks

involves serious flaws when it is used as a mechanism for mobilizing funds. Traditionally, this

contract was used for a one limited- time project and ended by liquidation of the project. Relying

on this contract to collect funds from several investors and commingle these funds with funds

provided from the stock holders and current accounts, then to invest these funds in several

projects with different risks and maturities may take this contract out of its context.

Different suggestions have been provided to overcome these issues. Tahir (2007) proposed

segregated Mudarabah investment pools with separate accounting and profit distribution for each

pool in order to avoid inappropriate asset transfer between current and future investment

depositors as well as between various categories of depositors and the bank. However, this

22
 approach imposes additional accounting and investment costs. Archer and Karim (2009) proposed

that the activities performed by Islamic banks may be conducted through separate legal entities.

Thus, retail bank entity and fund Management Company as a subsidiary could replace the current

Islamic bank structure. The retail bank would take current accounts, issue letters of credit, offer

chequebook facilities, invest the current accounts in short-maturity assets and placing any surplus

funds with the fund management company. The fund management company would take IAH

from the public, and could use Mudarabah or Wakalah contracts for this purpose27. These funds

could be invested in longer maturity assets. Archer and Karim reached to this suggestion by
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comparing the Islamic bank with the conventional ‘universal’ banks. The conventional

‘universal’ banks combine retail banking (including deposit taking), investment banking and fund

management in the same banking group. However, , the banking groups in question conduct fund

management activities and retail banking through separate subsidiaries.

By using separate entities approach, various problems emerged from Mudarabah contractual

structure would be resolved; the corporate governance and supervision problems, other regulatory

problems such as assessing capital adequacy28 for Islamic banks, and the market perception of

IAH as close substitutes for conventional deposits29.

El-Gamal (2005, 2006) noticed that Mudarabah contract bears many of the features apparent in

mutual funds, and he came up with the mutuality owned bank solution. Under this model,

shareholders and depositors are one and the same, and will be provided the same corporate

27
The fund management company would receive funds from the public in the form of either IAH or Islamic
mutual funds.
28
The presence of IAH in the capital structure of Islamic banks imposes complications in assessing capital
adequacy for the banks. IAH do not meet the legal definition of deposits, and they are essentially
investment products. Therefore, Islamic banks cannot be considered as depositary institutions as required
by banking regulations in the majority of countries.
29
In practice, many banks avoid to pass losses to IAH, and this is could be done by using reserves. Such
practices may give the implication that the deposit principal of IAH is guaranteed.

23
 governance protections. The two separate profit-oriented groups (IAH equity and stockholders

equity) are eliminated from the formula and replaced by the unit holders in a mutual fund

structure. In this structure, many of Mudarabah imperfections in Islamic banking are resolved.

For example, the different risk preference between IAH and stockholders is considered one of the

main concerns in this context. Islamic bank managers usually respond to stockholders, whose risk

preferences (associated with equity investment) are typically quite different from those of IAHs

(low risk and low return). This problem is intensified by IAH’ lack of control over bank

decisions, which exposes them to a substantial moral hazard compared to bank shareholders. By
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mutuality structure, managers’ incentive for excessive risk is largely reduced; resulting in lower

risk-taking that reflects IAH’ preferences, or different funds could be initiated with a variety

levels of risks. Additionally, other problems like profit smoothing and reserves, governance and

supervision, and conflict of interests will be eliminated.

Bulut (2005) indicated that IAH could be operated as an open-end or closed-end mutual funds

depending upon whether account holders have a right to withdraw. He stated that with minor

adjustments to the investment management agreement, a mutual fund structure can easily replace

the Mudarabah contract. In this model, a separate entity for mutual fund is initiated and transacted

in the primary and the secondary markets as is the case for any publicly held corporation.

Different investment strategies and purposes can be adopted by this entity in order to meet the

different risk preferences and maturities of the investors. Some of these funds may follow a

specialization approach based on certain stages of ventures and certain sectors/industries, while

others will follow a portfolio approach in their investment strategies.

It is obvious from the previous suggestions that the mutual fund formula outperforms the current

Mudarabah contract implemented by Islamic banks. However, these studies focused on corporate

governance and regulatory aspects. The remainder of this section will extend the debate to cover

24
 other accounting aspects. Let us assume that banks establish separate fund management entities,

in a form of mutual fund, to handle IAH funds. The IAH can choose between these entities

according to his risk preference, as investment strategies and purposes of each fund will be

written and published. The Islamic bank may invest part of its current accounts or stockholders

equity in such funds. The management of the mutual fund provides the management expertise,

while the IAH puts in the money. The compensation of the mutual fund management may be

considered as a percentage of the profit realized (Mudarabah) or a specific amount of money

(Wakalah).
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In this mechanism, the accounting records for the mutual fund are completely separated from the

bank’s records. Hence, the commingling problems resulting from using Mudarabah contract by

banks will disappear. This means that there is no need to allocate profits between different types

of depositors and stockholders because we have only one type of investor (unit holders). There is

no need to determine how the bank allocates administrative expenses and revenue generated from

other banking operations, as the revenue and expenses related to the mutual fund are separated.

The problem of which of the two parties (owners’ equity or investment account holders) should

be given priority in case of idle unutilized funds would also be removed since the IAH funds are

isolated from stockholders’ equity funds. The classification issue (liabilities or equity and how to

disclose assets related to Mudarabah fund) will not be valid after using two separate entities.

Besides, the confusion in roles (shareholders receive the mudarib share of profit, while the

management perform the tasks of mudarib) would be resolved because the mutual fund will be

managed by distinct management other than the bank management. This could also end the gap

between IAH and shareholders profits, as shareholders of Islamic banks currently enjoy higher

profit because of the mudarib share.

25
 For reserves issue, mutual funds will not use PER and IRR reserves. This will end several

concerns like income smoothing, profit misallocation between IAH, transparency, accounting

judgments and estimates, moral hazard problems, and the appropriateness in using donation

contract to build such reserves.

As mentioned previously, reserves are used by Islamic banks to replicate conventional deposits

(fixed return, capital certain). Therefore, depositors may perceive IAH as conventional deposits.

In the mutual fund formula, this misperception will disappear as the investor is subject to variable
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return and bears the risk of losses in underlying investments, which is more in line with Islamic

principles.

Mutual funds may also mitigate the issue of equity of treatment between IAH, who provide or

withdraw funds at different points of time during the financial period, in addition to the equity of

treatment between the IAH and shareholders over time. In the current practice of Mudarabah, an

IAH who withdraws his funds before the end of the term of the contract forfeits his share of any

profits earned but not declared for the period up to withdrawal and also will not be able to

withdraw any share of the PER or IRR attributable to his investment (Archer and Karim 2006).

While in mutual funds formula, ownership is divided into equal transferable units, the current

value of these units can be inferred from the net asset value of the fund30. Thus, this value

reflects the fund's performance. Furthermore, using current value in accounting and financial

reporting improves the fair presentation of the financial statements and ends up the deficiencies of

historical cost basis.

30
In order to determine the fair value of mutual funds, different financial reporting frameworks (such as
IFRS and US GAAP) could be exploited. These frameworks had established reliable standards and
guidelines to handle this issue.

26
 7- Conclusion and remarks

One of the most dominant financing contracts exploited by Islamic banks to mobilize funds is the

Mudarabah contract, where the bank acts as mudarib (entrepreneur or asset manager) and the IAH

as rab-al-mal (investor). This contract replaces the interest-bearing deposits in conventional

banks.

In practice, severe complications emerged from employing Mudarabah contract on such a high
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scale. These complications put the applicability of using Mudarabah by Islamic banks under

question and the paper demonstrates that this contract may be taken out of its context.

Traditionally, Mudarabah was a one-project, time-limited, fixed-parties contract and the

distributed profit of Mudarabah is determined when the projects financed by Mudarabah are

liquidated. However, Islamic banks use different types of Mudarabah such as; compound,

unrestricted, commingled and continuous Mudarabah. These types of Mudarabah impose several

challenges concerning the determination of total profit resulted from Mudaraba and how to

allocate this profit to multiple parties involved in Mudarabah taking into consideration that parties

may provide or withdraw money at different points of time which may not match the inception or

liquidation of the projects.

Another criticism for the existing Mudarabah is reserves. Reserves are designed to cater against

future losses for IAH and to stabilize rewards attributed to them. In substance, reserves

undermine the concept of PLS and can be used to achieve income smoothing, thereby, affecting

the transparency and reliability of the financial statement.

Mudarabah may also lessen the fair presentation of financial reporting. Investment assets

financed by Mudarabah funds are presented in the balance sheet under one category, while these

27
 assets could be financed either by IAH or stockholders. These assets should be reclassified into

two subcategories: assets attributable to shareholders and assets attributable to IAH.

Corporate governance raises a major problem in Mudarabah contract. The IAH are exposed to the

risks of equity investors, but have no governance rights, no choice in deciding the types and risk-

return characteristics, and no power to appoint the management, the SSB or the external auditor.

IAH cannot influence earning management practices or affect the provisions and reserves

deducted from their share of profits.

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From the above persistent flaws in Mudarabah contract, a new model for investing IAH is

proposed, i.e. mutual fund. In this formula, shareholders and investment account holders will be

put on par, and all accounting and corporate governance problems will be removed.

Further research can be conducted in order to develop different models of mutual funds that suit

Islamic principles, in order to be used to finance Early-Stage and Later-Stage projects. These

models may utilize the wide spectrum of mutual funds (open end, closed-end, and intervals). For

accounting technical issues, other financial reporting frameworks could be exploited in

determining the fair value of these mutual funds.

28
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Biographical Details (if applicable):

[Author 1 bio]

Wasim Khalil Al-Shattarat

Wasim Khalil Al-Shattarat is an Assistant Professor of Accounting at Gulf

University for Science and Technology (GUST), Kuwait. He received his PhD

in Accounting from Queen’s University of Belfast, UK. His research interests

are accounting information, corporate governance, dividend policy, cost of

capital and disclosure.

30
 [Author 2 bio]

Muhannad Ahmad Atmeh

Dr. Atmeh is an assistant professor of accounting at the German-Jordanian University. Before

entering the academic field, he was an auditor with Deloitte –Jordan. Dr. Atmeh is currently a
member of the board of directors of the Jordanian Association of Certified Public Accountants.
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He received his PhD from Newcastle University/UK, his MBA from University of Jordan, and his
BS from Kuwait University. Dr. Atmeh conducts research in Islamic accounting and auditing

31