Accounting Policy Choice in an Interest-Free Environment

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Use of interest in Islamic societies is prohibited and this has brought an effect on firm's accounting practices that comply with Islamic Shari'a requirements. Islam believes that the use of interest is lenders exploitation on borrowers. Interest prohibition also means that discount rate is prohibited to use. Using discount rate involving predicting the future and Islam follower cannot do so as the future is in God Almighty hands. This also means that loans with interest and debentures are not allowed. Therefore, the main objective of this paper is to discuss the effect of interest prohibition on the firm's accounting practices.


In Islam, all wealth and earnings are owned by God, and people are merely His trustees, which mean that everyone is created to fulfill a certain responsibility on this earth. Real ownership of everything belongs to Allah, and man holds property in trust (amanah) for which he is accountable to Him. This is a new accountability concept for western system. The Islamic Shari'a explains the meaning and how to achieve this accountability.

Tawheed defines Man-God relationship that means Oneness of God. It holds God is one and unique. This concept focuses on the role of a person to the Allah. Islam prohibits some people are live in life of luxury while some people are live in the life of hunger. It was interpreted to mean 'equality' of all people in society. Islam permits making reasonable profit and all business transaction must be legitimate, fair and just. Surplus value of profit is considered as exploitation which is conflict with the view of profit in western world, where higher profit means greater efficiency in using resources.

Islam gives more focus on the need of the Ummah (the community) compared to the needs of the individual. Individual is allowed to work for their enrichment as long as the wealth is reasonable and does not conflict with the requirement of Shari'a.

In Islam, socially responsible behavior is important. It also encourages the use of practices which are focusing on the side of employees, community and products. Islam requires people to exercise ethical behavior in their dealing with each other and with the resources available to them.

In Islamic society, trade is conducted through contracts and a contract that avoids using of interest is called Mudaraba. A mudaraba contract is a contract whereby the investor contributes money for the manager to perform work. The manager receives a specified profit share arising from funds investing while the investor will bear any losses. Investments can be either restricted or unrestricted. In a Mudaraba contract, profit distributions must be made in accordance to predetermined ratios.


Interest referred to the increase on loans, and 'riba' literally means addition, increase, expansion or growth. In this sense interest obviously means 'riba'. In Islamic Shari'a, 'riba' is prohibited because it will lead to wealth concentration in a few hands. Interest has the same meaning as 'riba' and so it is prohibited.

The use of interest is strictly prohibited because it is a violation of justice. How many effort a person put must be equal to rewards he or she gets. It is all about fairness to all parties. The use of interest made people work less or even without any effort because of their guaranteed return and so, it is prohibited in Islam. Growth with equity is one of the most significant characteristics of the Islamic economic system; obviously it is conflict with the use of interest.


Since the Islamic societies hold certain unique principles, there is need for developing a specific set of standards for Islamic accounting practices. The reasons for this need are to correlate with the desire of Islamic countries to revive the Islamic ideology and minimize the cost of accounting and recording.

The differences of Islamic and Western business environments caused the different of Islamic and Western in accounting and reporting. These differences included the treatment for certain items such as mudaraba in the balance sheet and the special detailed statements of zakat and qard funds.

In Islamic context, a firm said to have contracts relation with its stakeholders. Therefore, it is important to keep the contracting costs at the minimum in Islamism's financial accounting policies. Generally, the managers of Islamic businesses tend to increase disclosure of information that they are confident. This is because such disclosure helps in rectifying the undervaluation of firms by investors and decreasing costs of any financial intermediation.

In addition, Islamic business prefers to use historical cost accounting than current value methods in valuation of assets. It is said that historical cost accounting well-suit with the stewardship theory of Islamic. It will be difficult to ensure the fundamental rationale for valuation of assets consistent with the Islamic ethical perspective. This stewardship function is similar to the concept of Amaanah in Islamic business. Furthermore, the historical cost accounting is easier to understand and less costly.

The determination of amount of zakat based on the measurement of assets is other issue in Islamic accounting. The assets will be measured at current values when use as a basic to compute zakat. Therefore, there is a dual system of asset valuation for Islamic businesses to take care of contracts and escape from social obligations.

The other argument on Islamic accounting is the preparation of an extra value-added statement. This value-added statement provides information mainly in the view of stakeholders. This statement focuses on the co-operative relationship within a business which consistent with Islamic principles.

The corporate social responsibility issue also being debated in Islamic perspective. The business should not focus only on profit in Islamic context. It should pay focus on its social contracts too. Therefore, social reporting that disclose social information is important. Islamic accounting always advocates moderation that promotes reasonable profit.


According to Islamic Shari'a, use of interest, net present value and prediction of future are disallowed in all business practices because the future is decided by God Almighty. Thus, reporting and accounting practices in Islamic societies will reflect the Islamic business practices. Partnerships and joint ventures are emphasis in Islamic society, so any interests gained from company's operations are prohibited.

Historical cost accounting is used because it emphasized the responsibility and function of the managers, exhibit asset values during acquisition and contracts are prepared in historical cost numbers. In Islamic society, market selling prices are supplement to historical cost because it does not require to predict the future and net realizable values can be presume when business transferred and asset been replaced.

Financial reporting in Islamic society is more detailed compared with in Western society. Other than ordinary financial statements, there is a value added statement to reveal the performance of the firm which transparency in financial reports is stressed on. The Rule of Islamic Shari'a affects the forming of accounting standards and policies. When generate accounting information, cost should not exceed the expected benefit.


In the perspective of Islam, the use of interest is disallowed in Islamic accounting reporting. Islam knows that the God Almighty will determine their future and the managers of firms will be trustees to control and manage the firms. Mudaraba contract in Islam is to help advocate the restriction of using of interest in accounting and reporting policies. Qard and zakat accounts, mudaraba and musharaka contracts, the ummah and all policies should comply with the Shari'a in the operation of the firms. Instead of balance sheet report and profit and loss statement, additional reporting such as zakat, charitable contribution will also help to add value on the firms' annual report. Thus, accounting regulation in Islamic is required to be impartial and universal to all so that it will be more successful implementation.