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Islamic Accounting — Exclusivity, Harmonization or
Convergence?
By Arzim Naim
When the notion of Islamic economics was introduced, the argument
against its very existence was expected. Along the way, not only did
people eventually appreciate its main distinctions, it flourished and
Islamic finance principles and products were spread to the world.
These phenomena have led to the existence of Islamic accounting
principles to be used as it is more suitable in conveying the true nature
of Islamic financial instruments. The never ending debate on the
need to use Islamic accounting by the Islamic financial institutions
(IFIs) over the use of conventional accounting has pushed Islamic
accounting to a new level.
The question now is whether Islamic accounting should (i) live in its
own exclusivity, or (ii) harmonize or (iii) to converge with conventional
accounting. These three options have been highlighted by Mohammad
Faiz Azmi, chairman of the Malaysian Accounting Standards Board
(MASB).
Exclusivity means that Islamic accounting is to live side by side with
its conventional counterpart. Thus, any Islamic financial instruments
will only be recorded by way of Islamic accounting. The harmonization
concept is when the financial reporting standards (FRSs) are fine tuned
— for example, certain exemptions are allowed/disallowed or Shariah
related disclosures are allowed for any Islamic financial instruments.
The last option is convergence, or simply put, applying FRSs in every
aspect, even to Islamic financial instruments.
This article attempts to fill the gap in the literature and encourage
emancipator perspectives to the notion of Islamic accounting. In
order to do so, we need to go back to the basic building blocks of both
Islamic and conventional accounting. Are they really miles apart?
What is Islamic accounting?
Accounting is just a recording function, just a tool. An academic
definition for accounting is the “identification, recording, classification,
interpreting and communication of economics events to permit users
to make informed judgment” (American Accounting Association,
1966). It is a total value free definition without attaching any religious
dogma to it. The Islamic accounting’s definition does share the same
spirit to its conventional counterpart. However, the main difference lies
in two major categories (i) its objectivity and to whom the information
shall be communicated, and (ii) the identification, valuation and
measurement of information.
1. Objective of accounting
It is widely accepted that the primary objective of financial reporting
and accounting is to provide useful information to assist users in
making economic decisions. It is the objective of the accounting to
provide a fair information flow between the principal and agent. One
of the arguments on the basic differences between Islamic accounting
and conventional accounting falls within the ambit of the objective of
accounting itself.
Conventional accounting leans towards the term ‘decision
usefulness’ whereas Islamic accounting leans towards the context of
‘accountability’. The ‘decision usefulness’ is where the information
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disseminated will only useful to certain parties (for example, bankers,
creditors, staffs and such). On the other hand, ‘accountability based’
framework within the Islamic context is a consequence of responsibility.
In Islam, man has a covenant with God. Accordingly, this covenant
requires the man to discharge his accountability in accordance with
the responsibilities laid down by the Shariah.
Whether those arguments are real or not will depend on the perceptions
of the public. Some would say that conventional accounting has always
catered for all users of financial statements. The person preparing
financial statements will always be held accountable for the accuracy
of the financial statements. The fact that modern accounting requires
more transparency in the accounts has proven that the ‘decision
usefulness’ framework no longer prevails in its framework. In addition,
the core content of modern corporate governance will always focus
on the fair information flow to all parties particularly through financial
statements.
The ‘accountability based’ framework has now become universal
practise. However, I must say that the only distinction of the
‘accountability based’ framework espoused by Islamic accounting is
that the rule of accountability must be purely divined since financial
reporting and accounting carries religious obligations. In this sense,
Islamic accounting must not incur any form of reporting that gives way
to interest based elements.
For example, under the new requirements of the FRSs, any form of
loan given by a parent company to its subsidiaries must be discounted
back using an appropriate rate of returns/interest rate used by the
company’s panel actuary after the timing for the repayment of the
loans have been forecasted. The fact that this requirement includes
the Qard al-Hassan (benevolent loan) by the company to another party
to be discounted back using an appropriate interest rate, definitely
contravenes the Islamic precepts itself.
2. Identification, valuation and measurement
Conventional accounting in its current structure follows what is
known as generally accepted accounting principle or the fundamental
accounting concepts. This takes into account among others accrual
and matching, substance over form, going concern, prudence or
conservatism, consistency, monetary measurement, materiality and
others.
(i) Going concern and accruals
These two concepts are considered part of the bedrock of
accounting. The going concern is particularly important with regard
to measurement. As a result, the conventional accounting standards
requires that financial statements be prepared on going concern and
requires that the directors assess whether there are significant doubts
about the entity’s ability to continue as a going concern.
The accruals concept lies at the heart of the definitions of assets,
liabilities, gains, losses and changes to shareholders funds. Accruals
basis of accounting requires the non-cash effects of transactions to be
continued...
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Islamic Accounting — Exclusivity, Harmonization or Convergence? (continued)
reflected in the financial statements for the period in which they occur.
This concept is closely related to the ‘realization’ concept whereby the
firms can only allow profits that are ‘realized’ or earned by the balance
sheet date to be included in the income statements.
Basically, the going concern concept embedded in conventional
accounting is not in conflict with the requirements of Islamic
accounting. The directors should assess the firms’ ability to continue
as a going concern. Consequently, financial statements must also be
prepared on the basis of going concern unless otherwise, alternative
valuations of assets and liabilities are used.
The principle of accruals concept does not in conflict to the
requirements of Shariah. It is permissible under the purview of
Shariah. This is evidenced from the treatments of Murabahah (sale
with deferred payment) transactions conducted by Islamic banks.
The accrual basis method recognises profit based on a proportionate
allocation of profits whether cash is received or otherwise. IFIs had
once used the cash accounting method. This was due to the religious
dogma that the income/profit will be recognized as and when money
is received, and vice versa.
The Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI), the body that promulgated Islamic accounting
standards and MASB have rejected the applications of the cash basis
accounting on the grounds that the accruals concept appears to be
more conclusive in reporting.
(ii) Consistency and prudence (conservatism)
These two concepts are considered desirable qualities of financial
statements. Consistency implies that a company should rarely change
the way in which financial information is prepared and presented. The
consistency requirement is not in conflict with the Islamic accounting
requirement. However, the comparability is regarded to be a more
fundamental objective than consistency. In particular, IFIs should not
use consistency to justify an accounting policy that is no longer the
most appropriate to its particular circumstances.
The prudence concept was closely linked to that of ‘realization’. The
concept of prudence implies that IFIs should take a very pessimistic
outlook in estimating income, expenses, assets and liabilities and
promotes the need to be cautious in overstating assets or profits
especially in the face of inevitable uncertainties in the business world
with a reasonable dose in the preparation of financial statements.
Apparently AAOIFI is silent on the prudence principle in financial
reporting. If IFIs understate the potential income or assets value, the
financial report would be ‘unfair’ to the stakeholders and the users
of financial statements. AAOIFI leaves it to the best discretion of the
preparers of financial statements.
(iii) Assets and the ‘substance over form’ principle
A major difference between conventional accounting and Islamic
accounting lies in the definition of assets. In a conventional sense, any
tangible or intangible is regarded as an asset when there is any future
economic benefit embodied in it regardless of whether there is legal
control by the reporting firm. From Islamic perspectives, to qualify as
an asset, the reporting firm should have acquired the right to hold, use
or dispose of the asset. Thus, Islamic accounting does not particularly
endorse the concept of ‘substance over form’.
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In view of the primacy of contract in transactions in Islam, the emerging
reality must be constructed or appear to be as the form. This view is
espoused by AAOIFI. This stand is backed by many Shariah scholars on
the need to recognize ‘substance’ together with the ‘form’ in financial
transactions or at least meet the ‘form over substance’ principle. Thus,
there shall be no such recognition such as quasi-subsidiary for that
matter.
Some may argue ‘substance over form’ in a way is closer to Shariah
because this principle is putting the ‘intention’ or the ‘substance’ as
the utmost requirement no matter what legal structure or the ‘form’
the financial transaction wants to pose. It is the ‘substance’ that is
matter. Most of the Sunni schools such as Maliki uphold that the
‘intention’ or the ‘niyyah’ will be the determination in deriving to the
rules due to certain acts.
(iv) Historical cost and market valuation
Historical cost concept only provides input to the ‘satisfying’ notion.
Some decision makers do not seek to optimize but ‘satisfy’. It is easy
and very cost favorable to the reporting firm. The Para 135, Statement
of Financial Accounting No 2 of AAOIFI is taken as proof pertaining
to the endorsement of historical cost technique. On the other hand,
the new FRS advocates the use of the ‘mark-to-market’ valuation. It is
expensive and undesirable. However, the ‘mark-to-market’ valuation
is really Islamic in a way that it will lead to the fair value of Zakat
computation which is so central to the Islamic faith, thus, should be
given a prominent place in accounting.
Conclusion
From the analysis we can safely say that in basic principles, FRS is
closer to the Islamic precepts. To answer the question of whether
Islamic accounting is to be in exclusivity or to harmonize or to converge,
will depend on the perceptions of the standards setters.
In my opinion, it is not an option to let the Islamic accounting remain
in exclusivity. Such treatment will lead to undesirable accounting
arbitrage. On the other hand, to converge with FRS will be a better
option except that the ‘discounted’ valuation technique for some
Islamic financial instruments for example the benevolent loan is
undesirable. Thus, the only option left is to harmonize both accounting
schools. This means, the FRS has to be finetuned to accommodate
Shariah principles. The new FRS could probably be issued for use
only in IFIs. This has to be resolved as soon as possible in order
to eliminate any hindrance that limits the progress Islamic finance
developments.
Muhammad Arzim Naim
Principal consultant
Arzim Associates Chartered Accountants
Accounting and auditing lecturer for National University of Malaysia
Email: arzim@arzim.org
Arzim is an Islamic financial accountant consultant, a practising
member of the Association of Chartered Islamic Finance
Professionals and the Malaysian Institute of Accountants, member of
the Association of Chartered Certified Accountants and is currently a
PhD candidate in Islamic finance at International Centre for Education
in Islamic Finance.
25th August 2010