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Islamic accounting

Question - 01

What distinguishes Islamic accounting and conventional accounting? Briefly discuss the additional objectives of Islamic accounting.

Answer - 01

It could be stated that both Islamic accounting as well as conventional accounting are both in the business of providing information to end customers. The main differences lie in the following factors:

Objective of providing information

Islamic accounting enables users to ensure that Islamic organizations abide by the principles of the Shari'ah in all of its dealings and enables the assessment of whether the objectives of the organization are being met.

Type of information

The type of information which Islamic accounting identifies, measures is different. Conventional accounting concentrates on identifying economic events and transactions, while Islamic accounting must identify socio-economic and religious events and transactions. Islamic accounting is more holistic in its approach as both financial and non-financial measures regarding the economic, social, environmental and religious events and transactions are measured and reported.

Different statements

Islamic accounting requires totally different statements altogether from that of conventional accounting. This is to de-emphasize the focus on profits by the income statement provided by conventional accounting.

Users of reports

Islamic accounting recognizes that all including the society are the users of the reports. The reason being that society as a whole can make corporations accountable for their actions and ensure that they comply with Shari'ah principles and do not harm others while making money ethically and achieve a equitable allocation and distribution of wealth among members of society especially the stakeholders of the concerned corporation.

The importance of establishing objectives

Accounting scholars and practitioners alike have found that the process of developing financial accounting standards without establishing objectives leads to inconsistent standards which may not be suitable for the environment in which they are expected to be applied.

Agreement on the objectives of financial accounting for Islamic banks would achieve many benefits:

Financial accounting is mainly concerned with providing information to assist users in making decisions. Those who deal with Islamic banks are concerned, in the first place, with obeying and satisfying Allah in their financial and other dealings. It is natural, therefore, that there should be differences between objectives established for other banks and those to be established for Islamic banks. Those differences stem mainly from differences in the objectives of those who need accounting information and, therefore, in the information they need. This does not mean, however, that we should reject all the results of contemporary accounting thought in non-Islamic countries. This is so because there are common objectives between Muslim and non-Muslim users of accounting information.

In addition to the above, there are other reasons why different objectives of financial accounting should be established for Islamic banks. Those are:

Two approaches to establishing objectives have emerged through the discussion which took place at different meetings of the committees established by the Board. These are:

In order to test each approach and select an appropriate one, various efforts were put in by various Shari'ah scholars. Subsequent to all their efforts it was decided that the second approach be chosen to establish objectives of financial accounting for Islamic banks and financial institutions.

The main categories of users of external financial reports for Islamic banks whose information needs are addressed in this statement include:

  1. Current and saving account holders.
  2. Equity holders.
  3. Holders of investment accounts.
  4. Other depositors.
  5. Others who transact business with the Islamic bank, who are not equity or account holders.
  6. Regulatory agencies.
  7. Zakah agencies.

It is possible to summarize the common information needs of users as follows:

  1. Information which can assist in evaluating the bank's compliance with the principles of Shari'ah in all of its financial and other dealings.
  2. Information which can assist in evaluating the bank's ability in:
  1. Using the economic resources available to it in a manner that safeguards these resources while increasing their value, at reasonable rates.
  2. Carrying out its social responsibilities and in particular those that have been specified by Islam, including the good use of available resources, the protection of the rights of others and the prevention of corruption on earth.
  3. Providing for the economic needs of those who deal with the bank.
  4. Maintaining liquidity at appropriate levels.
  1. Information which can assist those employed by the bank in evaluating their relationship and future with the Islamic bank, including the bank's ability to safeguard and develop their rights and develop their managerial and productive skills and capabilities.
  2. It is assumed that the types of information described above represent the minimum required to satisfy the common information needs of external users of financial reports.

In conclusion, the following could be stated as the objectives of Islamic accounting:

  1. To determine the rights and obligations of all interested parties, including those rights and obligations resulting from incomplete transactions and other events, in accordance with the principles of Islamic Shari'ah and its concepts of fairness, charity and compliance with Islamic business values.
  2. To contribute to the safeguarding of the Islamic bank's assets, its rights and the rights of others in an adequate manner.
  3. To contribute to the enhancement of the managerial and productive capabilities of the Islamic bank and encourage compliance with its established goals and policies and, above all, compliance with Islamic Shari'ah in all transactions and events.
  4. To provide, through financial reports, useful information to users of these reports, to enable them to make legitimate decisions in their dealings with Islamic banks.

Question - 02

Discuss the Shari'ah audit issues and their importance in relation to financial statements of Islamic banks.

Answer - 02

There are various issues in a Shari'ah audit that could face an Islamic financial institution. The following discussion pertains to those issues and their high relevance to the financial statements of such institutions.

First and foremost, any Islamic bank that is found to have breached any of their fiduciary duties or have contravened the covenants of Shari'ah could be in a serious and potentially harmful situation by litigation from its investors and other third parties. Hence, to make certain Islamic banks comply properly with the requirements of Shari'ah principles as well as their performance of fiduciary duties and obligations, there should be very close cooperation between the Shari'ah Boards and the external auditors. This process will help to ensure compliance in all these respects.

The term or rather the concept now commonly known as "Shari'ah audit" is now understood that the ensuring of Shari'ah compliance, fiduciary compliance and further the assigning of the formal responsibility to ensure all such compliances are in order. The Shari'ah audit of an Islamic financial institution is not necessarily limited to the performance by an external auditor. It could be performed by the Islamic financial institution's very own Shari'ah Board or by external auditors as well. If the Shari'ah audit is being done by the Shari'ah Board, they should be capable of doing the task.

On one perspective, it should clearly be noted that when the Shari'ah audit is performed by the bank's external auditors they will undoubtedly ensure adequate independence to be maintained. Further, these auditors would most definitely require knowledge, competence and expertise to cope with Shari'ah compliance issues and fiduciary compliance issues.

On another perspective, if the Shari'ah audit is being carried out by the Shari'ah Board of the Islamic bank, they will have to ensure sufficiently or maximum independence in order to carry out a thorough and an effective audit. Like in the previous situation, the Shari'ah Board will have to have knowledge, competence and expertise to cope with and solve issues relating to accounting issues and their implications.

Some contemporary Islamic financial institutions have now a group of scholars known as "Shari'ah internal auditors". These individuals are also members of the institutions Shari'ah Board. They on a continuous basis monitor Shari'ah and fiduciary compliance and report findings to the main Shari'ah Board.

Therefore, based on the above two scenarios the Shari'ah Board as well the external auditors will require close liaising with each other on a continuous basis to ensure that all potential Shari'ah and fiduciary compliance issues, which the Islamic bank may be exposed to, are addressed and resolved on a timely and accurate basis.

Finally, in order to ensure that all Islamic banks comply with all the covenants of the Shari'ah and perform their fiduciary duties and obligations as well towards their depositors, it is highly important that there are proper rules and regulations established. These are important with regard to general and additional disclosure requirements in the Islamic banks financial statements, such as disclosure requirements of the:

Auditors are responsible for forming and expressing opinions on financial statements. It is also their responsibility for preparing and presenting financial statements in compliance with all Shari'ah rules and principles. The relevant legislation and regulations is that of the management of the financial institution.

Hence, it should clearly be understood that the audit of the financial statements does not relieve the management of the financial institution of this responsibility. Thereby, indicating the importance of Shari'ah audit issues and their importance to the preparation of financial statements of Islamic banks.

Question - 03

Why is taxation an important issue for Islamic banking products?

Answer - 03

A common misperception created in the minds of most people nowadays is the perception of unfair taxation. Islamic banks, other than in Malaysia have developed in a relatively tax free milieu. Even countries such as Pakistan, general provisions were made to exempt from taxation for Islamic finance arranged on a cross border basis, but no specific provisions were made for within the country. It was the UK government that took a lead in the west in revising its taxation law to include specific provisions for Islamic products and services.

The following is a discussion about a key taxation issue that arose in UK and how it was resolved. In fact had this issue not been properly resolved it would have derailed any plans to establish Islamic banks in the UK. The key issue relates to the tax treatment of Islamic deposit accounts that in theory paid a profit share to the depositor. Deposit accounts offered by the Islamic Bank of Britain were based on the principle of Mudharabah.

Generally, any interest payments made by banks to its depositors is deductible from gross income before tax is calculated. However, in accordance with anti-avoidance rules in UK, any "interest" payments made on deposits that were linked to the profit made by a bank was not allowed to be deducted from gross income but was considered as distribution of profit after tax. In other words, these were considered as dividend payments.

Example: Suppose a bank paid £100 on normal deposit accounts. This amount was deducted from its gross income, say £300. Hence, tax paid on the net amount of £200. If on the other hand, the £100 payment was linked to profit made by the bank, tax would be deducted on the gross income of £300 and the £100 was considered as distribution after tax. This of course results in much higher tax charge for the bank. The profit payment on the Islamic deposit accounts was at first considered to be linked to the profit made by the Islamic Bank of Britain and therefore was not allowed to be deducted as an expense against gross income. This high incidence of tax charge made the Bank economically unviable.

To overcome the above issue, the UK government established a special Inland Revenue task force to review the taxation of Islamic products so as to ensure that there was a "level playing field" with the conventional market.

In the government paper, "Regulatory Impact Assessment for Shari'ah Compliant Products" that accompanied the Budget for 2005 it was stated that the key policy objective for taxation of Shari'ah compliant products is to ensure that such products are:

"..taxed in a way that is neither more nor less advantageous than equivalent banking products. The intended effect of the proposals is to allow providers to offer Shari'ah compliant products without facing commercial disadvantage and to enable customers to take up these products without encountering uncertainty or disadvantage over tax treatment".

The solution that emerged from the task force and included in the Finance Act 2005 was to define Islamic products as "Alternative Financial Arrangements" and to set out the key structures of the arrangements in the legislation. The profit payment on the deposits was termed as "Profit Share Return". Islamic products are not specially mentioned in the Finance Act but only in the explanatory notes. Furthermore, the Act is concerned not with principles but the specific structures of the products. This was done to mitigate the risk of these structures being used to avoid taxation. In the explanatory notes it was clearly stated that the relevant legislative clauses relate to arrangements:

"that involves profits and losses on sales of assets or profit share agreements that are economically equivalent to conventional banking products, but are not interest or speculative returns. The measure ensures that such arrangements are taxed no more or less favourably than equivalent finance arrangements involving interest".

In other words, profit payments made for Islamic deposits that conformed to those arrangements were "deemed" to be interest and hence treated for tax purposes as any interest payments. This ensured that Islamic deposits were taxed on the same basis as conventional deposits. In our above example, Islamic banks paid tax on the net £200 rather than the gross amount.

For sake of clarity, in case of Islamic deposit the Finance Act defines the following arrangements that give rise to profit share return:

  1. The depositor deposits money with a financial institution.
  2. The money, together with money deposited with the institution by other persons, is used by the institution with a view to producing a profit.
  3. From time to time the institution makes or credits a payment to the depositor, in proportion to the amount deposited by him, out of any profit resulting from the use of the money.
  4. The payments made or credited by the institution equate, in substance, to the return on an investment of money at interest.

Other than (d) above, the structure described is a Mudharabah. Similarly the Finance Act 2005 also defined an Islamic finance arrangement based on Murabahah principle and termed the equivalent profit amount charged to customers as "Alternative Finance Return".

Prior to 2005, the government had already resolved the issue of double incidence of Stamp Duty on property financed using Islamic structures. Normally whenever property is purchased, the buyer has to pay a Stamp Duty. In case of Islamic finance where banks buy the property and then sell to the customer, there were two Stamp Duties payable, first by the bank and then by the customer. In 2003, the government had amended the Stamp Duty rules to charge only one Stamp Duty on such finance arrangements.

These rules were further refined in the Finance Act 2005. Since 2005, UK government has continued to add to the tax legislation for Islamic products. Islamic mortgages using Diminishing Musharakah arrangements, Islamic agency accounts and recently in the Finance Bill 2006, Islamic bonds (Sukuks) have been covered.

The other issue relating to tax was VAT. This has been more difficult to resolve since VAT is a European wide legislation and requires any major change at the European level. Despite this, the UK government has issued guidelines on the application of VAT to Islamic products. These guidelines have ensured that Islamic products are treated in the same way as conventional products.

It is important to emphasize that the significant development outlined above in respect of taxation of Islamic products could not have been achieved had there not been commitment from Chancellor and his Treasury ministers. Importance has continued to be given to the success of Islamic finance in the UK and concerns that hinder a level playing field for the Islamic finance market are being carefully reviewed and resolved. The lead taken by UK authorities to tax Islamic products is now being considered by other authorities as possible solution to help the Islamic markets to flourish.

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