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Sunday, February 13, 2011

Islamic Accounting — Exclusivity, Harmonization or Convergence?

Islamic Accounting — Exclusivity, Harmonization or Convergence?

By Arzim Naim CA(M). FCCA . CIFP

(This article has appeared in the Islamic Finance News magazine on 25 August 2010)

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. 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 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 (Islamic law).

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 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’ 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 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 AAOIFI 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’. 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. Thus, there shall be no such recognition for the quasi-subsidiary for that matter.

Some may argue ‘form over substance’ is closer to Shariah because this principle is putting the intention 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’ 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 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.

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