Accounting & Auditing Standards for Islamic Banks

Dr. Muhammad Qattan Islamic Economics Unit Kuwait University

Need for Accounting Standards in Islamic Banking

Developments of Islamic Banking demand financial reporting framework and information that is useful for investors and stakeholders. Existing conventional financial reporting standards on conventional financial institutions do not address the information needs of Islamic financial Institutions. Nature of Islamic banking emphasizes the importance of lawful and equitable banking business requires accounting treatment of unique features of Islamic banking operations as well as its distribution mechanism.

Financial Reporting, Auditing & Governance Framework

AAOIFI
Audit Committee

Shareholders

Regulatory Authorities

Governance Committee

Islamic Financial Institution

Investment Accounts Holders

IFSB

Shari Control Committee

Other Shareholders

Determinants of Accounting, Auditing and Governance Framework

Regulatory Requirements Legislations and guidelines promulgated by Central Banks or Monetary Authorities to be enforced should addressed matters with reference to the Shariah compliance Sharia Opinions & Standards Coordinated Sharia opinion and generally accepted Sharia Standards promulgated by AAOIFI should facilitate the development of IFI towards the GOALS of Sharia.

Determinants of Accounting, Auditing and Governance Framework

Financial Reporting & Auditing Standards Internationally recognized and accepted financial reporting and auditing standards promulgated by AAOIFI that address specific information needs of users of financial statements of Islamic Financial Institution should be adopted. Governance Standards A comprehensive governance framework that addresses structure and processes of Sharia governance need to be established and employed by all IFIs to implement the relevant reporting, auditing and prudential standards

Determinants of Accounting, Auditing and Governance Framework

Prudential Guidelines/Standards Sharia Audit and governance will not complete without relevant prudential standards that address unique risk features and exposures of IFI

Establishment of AAOIFI
The Accounting and Auditing Organization for Islamic Financial Institutions is an Islamic international autonomous non-profit making corporate body that prepares accounting, auditing, governance, ethics and Shari'a standards for IFI. AAOIFI was established on 11 Ramadan 1411 corresponding to 27 March, 1991 in Bahrain.

AAOIFIs Role & Objectives

Develop accounting, auditing, governance and ethical thought relating to the activities of IFI taking into consideration the international standards and practices which comply with Shari'a rules. Disseminate the accounting, auditing, governance and ethical thoughts relating to the activities of IFI and its application through training seminars, publication of periodical newsletters, preparation of reports, research and through other means. Harmonize the accounting policies and procedures adopted by IFI through the preparation and issuance of accounting standards and the interpretations of the same to the said institutions.

AAOIFIs Role & Objectives

Improve the quality and uniformity of auditing and governance practices relating to IFI through the preparation and issuance of auditing and governance standards and the interpretation of the same to the said institutions.
Promote good ethical practices relating to IFI through the preparation and issuance of codes of ethics to these institutions.

Members of the Accounting & Auditing Standards Board (AASB)

The AASB is composed of 15 part-time members who are appointed by the Board of Trustees for a 4 year term. Members of the AASB represent the following categories:
Regulatory and supervisory authorities Islamic financial institutions Shari'a Figh scholars accounting and auditing profession that relates to the work of IFI. users of financial statements of IFI. university professors in accounting and financial studies.

The powers of the AASB include, among others, the following:

Powers & Functions of AASB

To prepare, adopt and interpret accounting, auditing and governance statements, standards and guidelines for IFI. To prepare and adopt code of ethics and educational standards related to the activities of IFI To review with the aim of making additions, deletions or amendments to any accounting standards and guidelines for IFI prepared by the AASB to meet the needs of the users of the financial statements of these institutions. To prepare and adopt the due process for the preparation of standards, as well as regulations and by-laws of the AASB.

Standard Setting Approaches

AAOIFI adopts the standard setting due process by reviewing existing Islamic banking reporting practices followed by formulation of discussion paper, exposure draft and reporting standard. Existing IAS standards are referred to where these are deemed relevant and not contravening the Sharia Principle.

AAOIFI Financial Reporting Framework

Financial Accounting Statements No. 1 & 2 Objective of Financial Accounting of Islamic Banks and Financial Institutions
Emphasizes the importance of contractual rights and obligations and Sharia compliance

Concepts of Financial Accounting for Islamic Banks and Financial Institutions

Addresses the issue of prohibited earnings & expenditures as well as ensuring reasonable rates of returns to depositors

Financial Reporting Objectives

Sharia compliance (principles, rules and opinions) Distinguish & disclose prohibited earnings & expenditures Present entitys economic resources and obligations and related risks pertaining to its assets and liabilities
Determine Zakat obligations of both depositors and shareholders Estimate cash flows & related risk of banks financing assets Ensuring reasonable rates of returns to investors Disclose IBs discharge of social responsibilities.

Distinguishing Features of IFIs Financial Accounting & Reporting Objectives

Not only to attain economic objectives but also involve in fulfilling a religious obligation. Different user information needs are identified that includes assurance of legitimate transactions & wealth accumulation as well as acceptable (equitable) rates of returns

Distinguishing Features of IFIs Financial Accounting & Reporting Objectives

Compliance with the principles and rules of Sharia need to disclosed in terms of reporting accountability and decision usefulness Different contractual relationships require reporting requirements for both equity and asset based funding and financing contracts which are:
recognition principles measurement principles disclosure & presentation principles

AAOIFI Accounting Standards

1. General Presentation and Disclosure in the Financial Statements of IFI 2. Murabaha and Murabaha to the Purchase Order 3. Mudaraba Financing 4. Musharaka Financing 5. Disclosure of Bases for Profit Allocation between Owners' Equity and Investment Account Holders and Their Equivalent 6. Salam and Parallel Salam 7. Ijarah and Ijarah Muntahia Bittamleek 8. Istisna'a and Parallel Istisna'a 9. Zakat 10.Provisions and Reserves 11.General Presentation and Disclosure in Financial Statements of IFI

AAOIFI Accounting Standards

12. Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance Companies 13. Investment Funds 14. Provisions and Reserves in Islamic Insurance Companies 15. Foreign Currency Transactions and Foreign Operations 16. Investments 17. Islamic Financial Services offered by Conventional Financial Institutions 18. Contributions in Islamic Insurance Companies 19. Deferred Payment Sale 20. Disclosure on Transfer of Assets 21. Segment Reporting
70 standards on accounting, auditing, and governance, in addition to codes of ethics and Sharia standards.

AAOIFI Auditing Standards

1. 2. 3. 4. Objective and Principles of Auditing The Auditor's Report Terms of Audit Engagement Testing by an External Auditor for Compliance with Shari'a Rules and Principles by an External Auditor 5. The Auditor's Responsibility to Consider Fraud and Error in an Audit to Financial Statements.

AAOIFI Governance Standards & Code of Ethics

Governance Standards 1. Shari'a Supervisory Board: Appointment, Composition and Report 2. Shari'a Review 3. Internal Shari'a Review 4. Audit and Governance Committee for IFIs Ethics 1. Code of Ethics for Accounting and Auditors of IFI 2. Code of Ethics for the Employees of IFIs

Role of Financial Reporting & Accounting Information

FINANCIAL REPORTS

Economic Decision Usefulness

Reporting
Accountability

Relevance Economic Agent Economic Consequences

Reliability Stewardship function Representational Faithfulness

Nature of Accounting Information

Economic Decision Usefulness Relevant (Timely, Feedback, Predictive) Reliable (verifiable, faithful representation, neutral) Wealth maximization Safety, Liquidity & Profitability of IFI

Nature of Accounting Information

Legitimate Decision
Lawful Transactions
fulfilling contractual conditions and requirements

Lawful goods & Services

nature, type and purpose of goods and services

Competitive price & fair value

market mechanism and market structures

Equitable Distribution
reasonable rates of returns to shareholders and depositors

Financial Reporting Framework

User Groups

Shari Principles

Islamic Financial Institution

Financial Reporting Objectives Accounting Principles

User Groups of Accounting Information

Investors (potential & existing) [Lawful &Equitable Investments]
Includes Shareholders and Depositors with different investment horizons Investors are not only concerned with profits but also its lawfulness, legality and equity

Creditors (potential & existing) [Lawful Trade Assets]

Creditors exclude debt holders and confined to asset backed or trade assets. Not only concerned with default risk but also validity of contract and lawfulness of the asset.

User Groups of Accounting Information

Regulators
Legislation to be enforced should make reference to the Sharia compliance

Sharia Supervisory Boards & Advisory Council

Governance extends beyond audit committee to the Sharia governance

Customers [Lawful Goods &Services]

Customers are concerned about lawful products & facilities

Others
Any party that directly or indirectly make reference to the financial statement of IFI

Types of Financial Statements

Balance Sheet Income Statement Statement of Owners Equity Cash Flow Statement Statement of Restricted Investments Statement of Sources & Uses of Zakat Statement of Sources & Uses of Qard Fund

AAOIFI & IAS Standards

In interpreting and adopting AAOIFI standards there is a need to be familiar with Sharia concepts, principles & requirements as these determine the appropriate choice of accounting policies, principles and methods. AAOIFI standards complement, replace or enhance existing IAS where relevant in accordance to Sharia requirement.

Important Sharia Contractual Conditions and Accounting Principles

Existence (Recognition)
The existence a valid contract is necessary before a transaction can be recognized. Thus fulfillment of the contractual conditions would determine whether transaction exist.

Lawful (Recognition)
The recognition process would also take into consideration the lawfulness of economic activities. Thus revenue is not recognized if the activity is unlawful.

Important Sharia Contractual Conditions and Accounting Principles

Measurable (Measurement) Precise measurement is an essential condition to avoid aleatory transactions. Hence the scale and basis of measurement should be reflective of the real economic condition. Deliverable (Recognition & Measurement) Deliverable goods is also an essential condition to avoid Gharar and timing of recognition and ability to measure will also take into account this condition.

Important Sharia Contractual Conditions and Accounting Principles

Equitable (Distribution) Equitable in dealings between the contracting parties include the manner of distribution between the IFI and the depositors. It involves the determination of reasonable rates of returns from the contracted profit sharing ratio Accountability (Disclosure & Presentation) An essential mechanism to attain accountability is through proper and adequate disclosure and reporting

Definitions of Assets & Liabilities

Assets : capable of generating positive cash flows or other economic benefits in the future either by itself or in combination with other assets which the bank has acquired the right to hold, use or dispose as a result of past transactions or events. Liabilities: a present obligation to transfer assets, extend the use of an asset or provide services to another party in the future as a result of past transactions/events.

Definitions of Equity & Investment Deposits

Owners Equity: the net assets or residual equity after deducting liabilities, equity of unrestricted investment account holders and their equivalent and prohibited earnings, if any
Unrestricted investment deposits and their equivalents are funds received by Islamic banks which the bank has the right to use and invest the funds without restrictions. Restricted investment deposits and their equivalents are funds restricted by purpose & commingling of funds.

Revenue & Expenses

Revenues- gross increases in assets or decreases in liabilities or a combination of both during the period covered by the income statement which result from legitimate investment and trading activities of the Islamic bank. Expenses - gross decreases in assets or increases in liabilities or a combination of both during the period covered by the income statement from the legitimate activities as per revenue.

Interest Based Financial Intermediation Process

Current Deposits (Demand) Shareholder s Funds Loans & Advances Financial Institution Investment s

Savings Deposits (Demand)

Fixed Deposits (Time)

Deposit interest rate (expense)

Lending interest rate

Interest Rate Spread (income)

Interest rate Spread

Profit Sharing Ratio - Financial Intermediation Process

Current Deposits (Demand) Shareholder s Funds

Equity Based Financing

Sales Based Financing Lease Based Financing Investment s

Savings Deposits (Demand)

Financial Institution

Investment Accounts (Time)

Dividend rate (Gift or Profit) (distribution)
Profit Rate Distribution (Profit Sharing Ratio)

Profit rate
(income)

Islamic Financing Operations

The funding contracts include:
Mudaraba deposits/bonds Musharaka equity/ bonds Parallel Salam (trade financing) Parallel Istisna (trade financing) Other trade or non-trade payables

Islamic Financing Operations

The financing contracts include:
Mudarabah financing Musharakah financing Murabahah financing Salam Financing Istisna Financing Ijarah Financing Trade and non trade financing

Presentation & Disclosure Of Income

Additional disclosure is also required on whether the revenue, expense, gain or losses are jointly financed or self financed by the Islamic bank. The Zakat base should also be disclosed.

Nature of Musharaka Financing

A partnership between the Islamic bank and its clients, where both parties, Contribute equal or varying amounts of capital to establish a new project or share in an existing one, where such capital can be on permanent or declining (capital) basis and will have his due share of profits. And partners share proportionate losses according to the capital contribution and not other wise. Is there a difference between Mudaraba & Musharaka?

Types of Musharaka Financing

Constant Musharaka :
the partners share in Musharaka capital remains (constant) throughout its period

Musharaka Diminishing to Ownership:

one party has the right to purchase a part of the other partys share which declines until one becomes the sole proprietor of all capital. In Musharaka financing there is both Profit Sharing Ratio as well as Loss Sharing Ratio

Musharaka Financing Principles

Existence of capable contracting parties, The capital should be in cash, or equivalent; realty (goods, real estates machines); or intangible rights (liens, patents) or equivalents The partner does not guarantee another partners capital or funds except in case of negligence or omission.

Musharaka Financing Principles

Any exchange or sale of capital to the other partner should not be at historical cost but at the fair value at the time of sale. Profits can vary with the agreement and capital contribution and to be distributed upon completion. Loss to be shared according to capital contribution (credit guarantee) and can be carried forward or offset.

Presentation and Disclosure of Musharaka Financing

Balance Sheet
Musharaka Financing * Less: Provision for loss in Musharaka Financing Net Musharaka Financing *Jointly or Self Finance Assets XX (XX) XX

Income Statement
Musharaka Income XX

Classification of Trade Contracts

Various features have been identified in classifying contracts as follows:
Price
Mark up price with disclosure (Murabaha) / Negotiated price (Musawamma)/Discounted Price (Wadhi)

Payment
Cash Payment/ Deferred Payment (Muajjal)

Delivery
Immediate delivery/Deferred delivery (Salam) /Piecemeal Delivery (Istisnaa)

Nature of Murabaha Financing

A Murabaha is defined as the sale of goods at cost plus mark up. The purchaser should be informed of his cost of purchase and the profit amount.

Murabaha Financing

Mark-up

SELLER

BUYER

PRICE = COST + PRE-DETERMINED MARK-UP US$ 150,000 = US$ 100,000 + US$ 50,000

Nature of Murabaha To the Purchase Order

Murabaha to the Purchase Order involves three parties, namely, the Customer, the purchaser (Financial Institution) and the seller (Supplier/Developer). Involves intermediary due to lack of expertise or need for credit facility.

Murabaha To The Purchase Order

MARK-UP CREDIT PRICE FINANCIER CUSTOMER

CASH PRICE

SUPPLIER/ DEVELOPER

S& P AGREEMENT

Principles of Murabaha Financing

Cost of capital/financing should be disclosed Usury free activities Transparency of facilities Right of customer to have recourse to seller or cancel the contract Advance payment or deposit is allowed.

Principles of Murabaha Financing

Murabaha with obligation to purchase customer bears risk for non-receipt of goods (delivery) Murabaha without obligation to purchase total risk born by the bank for non delivery

General Rules of Murabaha Financing

The assets can be a collateral to the financing amount. Any form of procrastination by a solvent debtor such as the customer can be liable for legal actions. Provides ease of payment to insolvent debtor. Any price discount obtained by the bank could benefit the customer.

Murabaha Financing Assets

Upon Acquisition of Assets: With obligation: Assets should be measured at lower of historical cost or impaired value. Without Obligation: Assets should be measured at cash equivalent value. A provision should reflect any decline between the acquisition cost and cash equivalent value.

Murabaha Financing Assets

Price discount if obtained after acquisition should not be treated as revenue but to reduce the cost of the relevant goods unless agreed by SSB. Upon Financing the customer:
Murabaha receivables should be recorded at face value (cash equivalent value) less provision for doubtful debts.

Income Recognition of Murabaha Financing Assets

Profits are recognized at time of contracting for cash or credit transaction not exceeding the current financial period. If credit period > one financial period with a single or several installment payments, the recognition methods are:
Accrual Basis Method Cash Basis Method

Income Recognition of Murabaha Financing Assets

Accrual Basis Method recognizes profit based on a proportionate allocation of profits whether cash is received or otherwise. Cash Basis method recognizes profit as and when the installments are received and requires the approval of SSB.

Policies on Expenses, Profits & Penalty

Matching principle of expenses with income is applied. Deferral profits (unearned) shall be offset against Murabaha receivables in the statement of financial position. Settlement amount is based on outstanding financial amount (accrual basis).

Policies on Expenses, Profits & Penalty

Penalty imposed on any procrastination in payment (mutual agreement or court action) is a form of revenue or allocation to charitable fund (except in the case of insolvency). Additional disclosure requirement relates particularly to whether the promise is obligatory or otherwise.

Nature of Ijara Financing

Ijara is the ownership of the right to the benefit of using an asset in return for consideration. Transfer of ownership of a service for an agreed upon consideration (operational)
Examples:
Rental of fixed assets Rental of a package of services

Nature of Ijara Financing

Elements: Offer & Acceptance, Lessor, Lessee & object of the contract ( rental amount and service) Asset Specification? Particular asset or based on description (replaceable) Asset Impairment: Termination or Perpetual?

Nature of Ijara Financing

Rent should be contracted (similar to price)
Rental payment can be non-monetary and of the same kind of benefit. Flexibility of rental consideration subject to time, place, distance and usage. Rental is due upon fulfilling the condition in the contract Prepayment and unearned rent is acceptable No profit in rent (non-divisible)

Types of Ijara

Operating Ijara
Ijara where the title of assets are not transferred to the lessee.

Ijara Muntahia Biltamleek

Ijara where title of assets are transferred to the lessee by way of gift, token price, pre-determined price, equivalent price & gradual transfer of share holding.

Forms of Ijara Muntahia Biltamleek

End of Period Transfer with No Consideration (Gift) and it may be conditional End of Period Sale with token Consideration End of Period Sale for an Agreed Price Prior to End of Period Sale at price equivalent to the remaining Ijara Installments Gradual Transfer of Title to lessee.

Cancel the contract

Contractual requirements for Ijara Muntahia Biltamleek

Gift

Sale on nominal price

Sale on agreed price

Sale at price equivalent to the remaining period

Ijara

Gift

Ijara

Sale

Ijara

Sale

Ijara

Sale

Duties of Lessor/Lessee
Lessors Obligations
Making the leased asset available Maintenance of the Leased Asset

Lessees obligations
Utilization of leased asset according to contractual conditions Rental payment and safeguard asset

Ijara Muntahia Biltamleek IMB Asset reported in the lessors books & depreciated Maintenance costs borne by the lessor Ijara Revenue is not divisible Fair rental amount is considered if transfer is not effected Ijarah rate is reflective of the market rental rate

Finance Lease Finance lease is reported as receivable No depreciation & maintenance costs is borne by the lessee. Interest income accrues and accounted for separately Cost of Financing is not related to rental rates

Definition of Salam Financing

Purchase of a commodity for deferred delivery in exchange for immediate payment according to specified conditions or, Sale of a commodity for deferred delivery in exchange for immediate payment.
Al Muslam Fihi : The commodity to be delivered Al Muslam Ileihi: The seller Al Muslam: The purchaser Ras-almal: Price of commodity in cash, kind or benefit

Definition of Parallel Salam

A Salam contract whereby the seller depends, for executing his obligation, on receiving what is due to him - in his capacity as a purchaser - from a sale in a previous Salam contract. Buys and sells on Salam contracts.

Parallel Salam

Al Muslam

seller 1 2 IFI
EXPORTER

IMPORTER

Al Muslam

seller

Comparative Contract Analysis

Spot Forward Contract Contract Payment Immediate Deferred Delivery Immediate Deferred Murabaha (Deferred)
Deferred Immediate

Salam Contract
Immediate Deferred

Legal Nature of Salam

Some essential conditions:

Consideration or Price should be known as to kind type, quantity and amount. Receipt of Salam payment at place of contract to avoid debt. Involves future delivery Permissibility of specifying future delivery date limits to identified period. Delivery date should match with availability of the commodity that should be known.

Issues in Salam Contract

Quality mismatch and substitutions of goods Delayed or Earlier delivery of goods Sale of commodity prior to receipt

Accounting treatment of Salam financing and Parallel Salam transactions Recognise Salam financing capital when it is paid or made available (as a facility).
Parallel Salam transaction is recognized when the Islamic bank receives the capital of Salam (cash, kind or benefit).

Measurement of Salam Financing

Measurement of capital at time of contract is by amount paid or fair value of capital in kind. Measurement of capital at end of financial period is similar to at time of contract. However if a decline in value of the commodity is anticipated a provision for the estimated deficit is made (due to non delivery in full or part of commodity).

Classification of Salam Financing

Salam Financing transaction shall be presented as assets in the financial statement as Salam Financing. Salam Deposits from Customers based on parallel Salam transactions are presented as Parallel Salam.

Possible Outcomes of the Commodity

Received in accordance to contract ?
Received in different quality or substitute at lower quality

Asset reported at historical cost/ face value Asset reported at lower of cost or market value Asset reported at historical cost Asset to be reported as receivable

Delayed but extended delivery date

Cancelled Salam contract

Similarities & Differences Between Salam and Istisnaa

Subject
Subject matter of contract Price

Salam
The commodity

Istinaa
Al Masnoo

Rules & Comments

Deferred Goods known by specification

Nature of Contract Parallel Contract

Paid at time Payment: More flexible mode of of contracting Time of payments contracting Deferred Installment Binding Binding Istisnaa is binding based on the views of fuqaha (Maslaha) Parallel Parallel Valid contracts if these are Salam Istisnaa legally separated

An Eclectic Approach to Accounting, Audit & Governance of IFI

Multi-Disciplinary Perspectives on Role of Sharia Audit, Audit & Governance

Financial, statements, reports and other useful information required by AAOIFI & relevant international financial reporting, auditing & governance standards

Sharia goals, opinions & rulings propounded by Sharia scholars

SHARIA
COMPLIANCE

AUDIT

Regulatory requirements by central banks, monetary authorities or supervisory agencies

Prudential guidelines & standards promulgated by IFSB to ensure risk management & disclosure framework related to capital adequacy, corporate governance & market discipline