THE DIFFERENCES BETWEEN CONVENTIONAL AND ISLAMIC ACCOUNTING

ABSTRACT

The concern of this project paper is to explore the differences between Islamic accounting and its conventional counterpart. The distinctions need to be addressed as both accounting is presently thought of many people as synonymous. There is danger for such kind of perception because the basic building blocks for respective accounting are worlds apart. As for professional accountants who have been taught on the idea for accounting to be ‘objective’ and value-free, the idea for attaching a religion may seems to be embarrassing and unprofessional. However, with the resurgence of Islam globally, the awareness for the need of Islamic accounting arises. Islamic accounting as a whole is able to serve the whole gamut of stakeholders. Its principles do not serve the interest of any particular group, but to the society as a whole which can make corporations accountable for their actions and ensure they comply with Shariah principles.

1.0             1.0              Introduction

It is widely accepted that the primary objective of accounting is to provide useful information to assist users in making economic decisions. Thus, it can be argued that accounting is therefore, a religious obligation. Hence, if accounting is a religious obligation, then the rules of accountability must be purely divine. In order to do so, appropriate accounting framework based on Shariah principles must be in place. The motivation for the development of Islamic accounting comes together with the emergence Islamic economic and Islamic resurgence for the last two to three decades. The awareness for the need for Islamic accounting is due to basic building blocks of conventional accounting itself since the International Financial Reporting Standards (IFRS) are based on interest-based elements. Because of the interest-based requirement, the conventional accounting adopts the ‘historical cost and conservatism concept’ in order to ensure whether the capital and interest are repaid. This is one of the elements embedded in the conventional accounting which is already violating the requirements of Shariah. As an alternative accounting system, Islamic accounting is gaining more recognition, especially by Islamic countries. It is necessary to have Islamic accounting to be in place rather than conventional accounting in order to provide information on financial success in Islamic organisations. The Accounting and Auditing Organisation For Islamic Financial Institutions (AAOIFI) was formed for this reason. To this date, AAOIFI has produced a set of accounting standards that could represent a benchmark framework that draws rationales from the Shariah.

Islamic accounting can be initially defined as the “accounting process” which provides appropriate information (not necessarily limited to financial data) to stakeholders of an entity which will enable them to ensure that the entity is continuously operating within the bounds of the Islamic Shariah and delivering its socioeconomic objectives. Islamic accounting is also a tool, which enables Muslims to evaluate their own accountabilities to God (in respect of inter-human / environmental transactions). The meaning of Islamic accounting would be clearer if we compare this with the definition of ‘conventional accounting’. The conventional accounting as we know it is defined to be the identification, recording, classification, interpreting and communication of economic events to permit users to make  informed decisions (AAA, 1966). From this, it can be seen that both accounting systems set out similar objective of reporting. However, the differences lie in the following;

      The objectives of providing the information;

      The type of  information is identified;

      How the information is it  measured, valued, recorded and communicated; and

      To whom will the information be communicated (the users).

At present, AAOIFI has no legal backing. Only few countries such as Bahrain and Sudan has made AAOIFI standards mandatory to their Islamic Financial Institutions (IFIs). In the absence of legal provisions, compliance with its standards is on voluntary basis to the extent that IFIs do not comply. In so doing, how IFIs’ financial statements are to be made comparable? And when accountants of the firms encountered difficulties in regards to complex transactions, they will eventually resort to conventional accounting treatment because of lack of knowledge in Shariah.

Therefore, this project paper intends to highlight and address the important distinctions between both conventional and Islamic accounting which is presently thought of many people as synonymous. There is danger for such kind of perception because the basic building blocks for respective accounting are worlds apart. Further, such blind acceptance and adoption of conventional accounting in Islamic organisations would lead to socio-economic behaviour inconsistent with the specific Islamic objectives, the attainment of which these institutions were set up for in the first place.

2.0              2.0              Religion, economy and accounting

When the conventional and Islamic accounting are compared, first and foremost, we have to look upon the root of modern accounting principles. Some years back, European and communist blocks adopted different set of accounting practice. In communist countries, there is lack of profit motive. Thus, profit and loss account and balance sheet doesn’t make sense in that economic system. This is why accounting profession never developed in Communist countries. Only after financial market liberalisation i.e. conversion to capitalism market, that these states trying to catch up with the West. We can conclude here, the modern accounting is in fact, capitalist accounting (Shahul Hameed, 2000). It is an offspring to capitalist economy. The adjective ‘capitalist’ is however, is not attached to the word ‘accounting’ because it would then appear not neutral. Furthermore, it has been proposed that capitalism owes its beginnings to the Protestant ethic which emphasises frugality and industry. Protestantism led by Calvin legalised the interest as opposed to Catholicism. The subsequent growth of trade aided by the formation of limited liability corporations and stock markets enabled the mobilisation and concentration of vast amounts of capital. These factors gave rise to the development of modern accounting and financial reporting practices based on ‘stewardship theory’ and later, on decision usefulness. Plainly put and in terms, conventional accounting is best described as formal rationalism of capitalist economy orientation so as to legitimise its action. On the other hand, conventional accounting is claimed by some writers to be a product of culture. It is a set of beliefs and techniques that has the ability to link actions and values so as to legitimise those actions. On contrary, Islamic accounting is a value-oriented activity, the development of which encompasses moral, spiritual, material and social aspects. It is governed by divine injunctions and does not separate the secular and religion and holistic in its reporting. Its principles do not serve the interest of any particular group, but to the society as a whole which can make corporations accountable for their actions and ensure they comply with Shariah principles.

Nevertheless, Islam is not against market system per se. Islam does not deny the market forces and market economy. Even the profit motive is acceptable to a reasonable extent. Private ownership is not totally negated. Yet, the basic difference capitalist and Islamic economy is that in secular capitalism, the profit motive or private ownership are given unbridled power to make economic decisions. Their liberty is not controlled by any divine injunctions. If there are some restrictions, they are imposed by human beings and subject to change through democratic legislation. When both accounting manifested according to the origins of its respective economic systems, the accounting treatments are totally different to each other.

3.0            3.0                The principles of accounting concepts and Islamic worldview

1.0          

Conventional accounting structure in its current structure follows what are known as Generally Accepted Accounting Principles (GAAP) or fundamental accounting concepts. This takes into account among others historical cost, conservatism, accrual and matching, substance over form, going concern monetary measurement, materiality and consistency. These principles nevertheless favour and follow the historical development of western civilisations. In this section, the paper shall discuss this in comparative perspective with the values of the Islamic worldview.

3.1              Going concern and accruals

These two concepts are considered part of the bedrock of accounting. Going concern is particularly important with regard to measurement. As 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 reflected in the financial statements for the period in which they occur. This concept is closely related to the ‘realisation’ concept whereby the firms can only allow profits that are ‘realised’ 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 whereby the directors should making assessment on the firms’ ability to continue as a going concern. Consequently, the financial statements must also be prepared on the basis of going concern basis unless the directors want to liquidate the firms or to cease trading or has no realistic alternative but to do so. In regards to the accruals concept, the principle do not in conflict to the requirements of Shariah. Thus, it is allowable. For example, in the case of murabahah[1] or bay’ bithaman-ajil (BBA)[2] transactions conducted by Islamic banks. If the banks treat a murabahah or BBA transaction as a financing transaction or purely as a sales transaction, it has the same effect on profit. However, Islamic banks may differ in terms of the timing of recognition of the margin: at time of sale, as cash received or as payment becomes due. If the cash basis is adopted, the profit will be recognised as and when the instalments are received. On the other hand, the accrual basis method recognises profit based on a proportionate allocation of profits whether cash is received or otherwise. However, AAOIFI rejects the first method, except where the credit period does not exceed the current financial period. Thus the preferred method would be the accrual basis. In this case, the banks have to set-up ‘Profit-In-Suspense account’ or ‘Unearned Income account’ whereby the deferred profits (unearned income) shall be offset against murabahah receivables. Consequently, for each payment made by the debtor, the profit related to the payment would realised and recorded in the Income Statement of the banks. The examples of journal entries are shown as follows:

Journal entries:

      Recognition of murabahah financing assets;

Dr       Murabahah financing

Cr       Cash (Cost of purchase)

Cr       Unearned income (Profit)

      Repayment received from customers;

Dr       Cash

Cr       Murabahah financing

      Income recognition at the end of each period;

Dr       Unearned income (Profit)

Cr       Profit and loss a/c

3.2              Prudence and consistency

These two concepts are considered desirable qualities of financial statements rather than part of bedrock of accounting. The prudence concept was closely linked to that of ‘realisation’. The concept of prudence implies that a firm 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. Circumstances that lead too uncertainties such as collectability of doubtful receivables, the probable useful life of assets and other contingencies are recognised by the disclosure of their nature and extent with a reasonable dose of prudence in the preparation of financial statements. The concept of consistency implies that a company should rarely if ever change the way in which financial information is prepared and presented. However, the comparability is regard to be more fundamental objective than consistency. In particular, any firms should not use consistency to justify an accounting policy that is no longer the most appropriate to its particular circumstances.

Apparently AAOIFI Standards are silent on the prudence principle in financial reporting. If the firms understate the potential income or assets value, the financial report would be ‘unfair’ to the stakeholders and the users of financial statements (because if the report do not show the potential income/ assets, it is in conflict to the very idea of financial reporting in Islam which focus on ‘fair reporting’ of an entity’s financial position). However, if the firms take a route to ensure in exact detail the value of each element of financial statement, this will increase the costs in the effort of ensuring the full and exact disclosure in the financial statements and this will burden the shareholders. Therefore, AAOIFI Standards are silent with regards to the concept of prudence and leaves it to the best discretion of the preparers of financial statements to comply with their local regulatory requirements or management or to any other regulations that would shape the decision in so far as employing prudence in the reporting process.

The requirement for consistency also is not in conflict with the Islamic accounting requirement whereby the presentation and classification of items in the financial statements should be retained from one period to the next unless circumstances require it to change. This is because comparability is regarded to be more fundamental objective than consistency. Should there is unexpected events occurred that require the reporting entity to change its accounting policy, and then comparability would prevail.

3.3              Definition of asset and the concept of ‘substance over form’

A major difference between conventional accounting and Islamic accounting lies in the definition of assets. AAOIFI defines asset as that which the enterprise has acquired rights to hold, use or dispose and does not recognise asset based on ability to control through other than legal ownership. An asset, in the conventional sense, is regarded as an asset when there is any future economic benefit embodied in the asset regardless of whether there is legal control by the reporting firm. In Islamic finance, to qualify as an asset, the Islamic organisations should have acquired the right to hold, use or dispose of the asset. Thus, AAOIFI does not particularly endorse the concept of ‘substance over form’. 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 is evident in the treatment of leased assets (ijarah[3]) and sales based transactions (murabahah). For murabahah contracts, the essence of the transaction is in fact a sales transactions. Thus, the ownership title will be passed to the purchaser upon acquisition. However, the financier or the bank can require the purchaser to pledge the assets acquired as collateral to the financing amount. The financier or the bank is prohibited to buy back the assets from the purchaser.

Under ijarah contract, AAOIFI recognised ijarah asset as fixed asset (incidental to legal ownership). Thus, repair and maintenance costs are the expense of the lessor (i.e. the financier or the banks) but the conventional practice, it is borne by the lessee. The examples of journal entries are shown as follows:

Journal entries:

      Cash purchase of equipment for ijarah financing;

Dr       Equipment

Cr       Cash

      Provides ijarah financing to lessee;

Dr       Ijarah financing asset

Cr       Equipment

      Repayment received from lessee & income recognition;

Dr       Cash

Cr       Profit and loss a/c

      Depreciation cost of ijarah financing asset;

Dr       Profit and loss a/c

Cr       Depreciation

3.4       Historical cost, conservatism and current value

The current convention of historic cost and conservatism arose from the needs of bankers and shareholders. This concept has been developed from the requirements of interest-based bankers who are interested not in seeing whether a proposed venture is profitable, but whether capital and interest are repaid. Thus there is need to be conservative in the valuation of assets by using historical cost but anticipating all liabilities in conservatism concepts (Shahul Hameed, 2005). It is also favourable because the cost of publishing historical cost financial statements are negligible compared with those prepared under current cost accounting. However, these concepts could be contrary to the idea of fairness and justice. For example under valuation of historical cost, zakat or Islamic tax based on historical cost valuation would yield lower receipts and consequently lower transfer payments to the beneficiaries in times of inflation or rising costs. Zakat is basically an income tax and its payment is a religious obligation. Since zakat is based on wealth, current values would satisfy Islam’s concept of justice more adequately than would historical cost. Many writers have called for the provision of a fair zakat base is the most important objective of Islamic accounting. This may be strange to conventional accountants whereby many of them make their living by giving advice on how to avoid tax.

AAOIFI has also supports the use of current value and very specific on the method of current valuation to be used in the case of Islamic banking environment. The rationale for this position is that present and potential investment account holders (e.g. Mudarabah[4] investment account holders) need information to evaluate the bank’s ability to achieve its investment objectives. Thus if investments are measured using historical costs, inequities would occur in the distribution of investment results between the holders of investment accounts. Therefore, the current values appear to be consistent with the principles of socio-economic justice advocated in Islam. However, due to practical difficulties in the implementation, AAOIFI has put its recommendation on this issue on hold.

4.0            4.0              Conclusion

Islam as a religion embraces a comprehensive system of human conduct, influencing all aspects of life. The uniqueness of Islam lies in its practicalities. Islam as a religion is not merely a belief but is a complete way of life. In fact, accounting is embodied in Islam. This can be analogically be seen from Islamic faith whereby for every human, 2 angels accompanied them at right and left shoulders, record every good deeds and sins (the double-entry bookkeeping principles?). Further, the accounting profession has been mentioned comprehensively in Quranic verses, portrayed to shoulder responsibility of social and economic justice. Allah has declared in Quran; “O ye who believe! When ye deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing, let a scribe (accountant ?) write down faithfully as between the parties; let not the scribe refuse to write; as Allah has taught him, so let him write. Let him who incurs the liability dictate, but let fear his Lord Allah, and not diminish aught of what he owes. If the party liable is mentally deficient, or weak or unable himself to dictate, let his guardian dictate faithfully. And get two witnesses, out of your own men, and if there are not two men, then a man and two woman, such as ye choose, for witnesses, so that if one of them errs, the other can remind him/ her. The witnesses should not refuse when they are called on (for evidence). Disdain not to reduce to writing (your contract) for a future period, whether it be small and more convenient to prevent doubts among yourselves but if it be a transaction which ye carry out on the spot among yourselves there is no blame on you if ye reduce it not to writing. But neither take witnesses whenever ye make a commercial contract; and let neither scribe nor witness suffer harm. If ye do (such harm), it would be wickedness in you. So fear Allah; for it is Allah that teaches you. And Allah is well acquainted with all things” (Al-Baqarah, 2: 282).

In recent years however, it has been recognised that conventional accounting suffers from the lack of desirable information. This leads the way for the Islamic accounting concepts to rise in recognition. The objectives of Islamic accounting would seem to be the avoidance of doubts and consequently to ensure fairness between all relevant parties and equitable transfer and distribution transfer and distribution of property rights and wealth. The Islamic accounting is on its way to be the de facto standards in every Islamic organisation or probably in every organisation in the world, if only the major distinctions between conventional accounting are fully appreciated. Further, such blind acceptance and adoption of conventional accounting in Islamic organisations would lead to socio-economic behaviour inconsistent with the specific Islamic objectives, the attainment of which these institutions were set up for in the first place.

References 

Accounting and Auditing Organization For Islamic Financial Institutions (AAOIFI). Jumada 1425H / June 2004. “Accounting, Auditing and Governance Standards For Islamic Financial Institutions”. Manama, Bahrain.

Dr. Hamzah Ismail and Radziah Abdul Latiff. 2000. “Financial Reporting of Islamic

Banks : Research Highlights”. Akauntan Nasional. Vol. 13 No.10. Pp14-18.

Syed Alwi Mohamed Sultan. 2006. A Mini Guide To Accounting For Islamic

Financial Products – A Primer. Kuala Lumpur. CERT Publications.

Paul Robins. 2001. “FRS 18 : Accounting Policies”. Student Accountant. ACCA Monthly Journal. October 2001. Pp22-24.

Bala Shanmugam & Vignesan Perumal. 2005. “The Need for Islamic Accounting”. Issues In Islamic Accounting. Kuala Lumpur. UPM Press.

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Shahul Hameed Mohamed Ibrahim. 2000. “ Islamic Accounting – A Primer”. Available online at : http://www.iiu.edu.my/iaw/Articles/ISLAMIC ACCOUNTING a primer.htm

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MASB Technical Release TR i-2 : Ijarah. 2006. Malaysian Accounting Standards Board (MASB).

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http : //www.emeraldinsight.com/0951-3574.htm

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[1] Murabahah : The sale of goods at cost plus an agreed profit mark-up. Murabahah receivables are measured at the end of the financial period at their cash equivalent value (i.e. the amount of debt due from the customers at the end of the financial period less any provision for doubtful debts).

[2] Bay’ Bithaman-Ajil or BBA : Price-deferred sale. A variation of Murabahah but the payment for sale is deferred, may be by instalments.

[3] Ijarah : Contract of hiring/ leasing.

[4] Mudarabah : A profit and loss sharing contract in which one party provides the financial capital (account holder) and the other (banker) manages the enterprise. While profit is shared, loss is borne by the financier.