The Principles Of Islamic Economic System Accounting Essay

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The main element of Islamic societies is the restriction on the use of interest. As a result, this has implication for accounting practices of a firm that complies with the requirements of the Islamic law. In this research paper, I focus the implication of interest prohibition on the firm's accounting and reporting policies.

Several studies emphasize the prohibition of interest in Islam. However, they stop short of identifying the accounting implications of prohibition on the use of interest. The prohibition of interest also means that the use of discount rate is forbidden. Because the future is in the hands of God Almighty, the followers of Islam do not predict the future. The use of discount rate essentially involves predicting the future. Islamic scholars have questioned the use of methods such as net present value in calculating the value of an asset that require predicting the future. It also means that the use of debenture and other loans with interest is not allowed. Thus, the balance sheet of an Islamic firm is likely to exclude debentures, preference shares and interest.

Abdallah (2001) says that Islam considers the use of interest as exploitation of borrowers by the lenders. The accounting system should not lead to the exploitation of one group of people by another. Therefore, the aim of accounting in Islamic community should be to conform to the prohibition of interest. Muslim managers are therefore to adopt principles that best accommodate the interests of the firm's claimants, with the minimum cost involved.

2.0 The principles of Islamic economic system.

A major principle of an Islamic economic system is the principle of God ownership of resources. In Islam God is the sole owner of wealth and people are trustees. According to Mirakhor (2007) the Islamic law specifies the meaning and the way of achieving accountability. In this respect people are individually accountable for their actions with what they have been trusted with on the Day of Judgment.

In Islam the relationship with God is defined by the concept of unity or oneness of God. This concept implies total commitment to the will of God (Mirakhor 2007). He also emphasizes the individual's role in a broader social context and the obligation not to benefit at the expense of others. Parties in business must be legitimate, just and fair and achieve a reasonable level of profit. Excessive profit is considered as tantamount to exploitation. Islam gives preference to the needs of the community over those of individuals. Whenever the needs of the God conflict with those of individuals, those of the God must come first. Firm managers in Islamic societies are likely to adopt policies that are consistent with the requirements of the law. Managers are also likely to use accounting and reporting policies which maximize the value of the firm "within the rules of the law.

This does not imply that individuals should not work for their own betterment and cannot become rich. In Islam becoming well-off is perfectly acceptable as long as the wealth is generated through complying with the requirements of the law.

Abdel (1999) says that Islam requires its followers to submit to God Almighty and live simply, but it does not suggest that individuals ignore their self-interest. In relation to the firms, Islam recommends a reasonable profit margin and not excessive. It advocates the use of practices such as treating employees well, serving the community in which the business operates, and trading in desirable, quality products. Trade in an Islamic society is conducted, as elsewhere, through contracts, implied as well as explicit. The use of interest bearing loans is avoided. The use of interest in personal or business transactions has always been a source of controversy in Muslim societies. For example, a major business arrangement that avoids the use of interest is called the Mudaraba (Abdel 1999).

According to Abdel (1999) mudaraba contract is a trustee financing contract, where one party, the financier, entrusts funds to the other party, the entrepreneur, for undertaking an activity. In mudaraba contracts the agent for example a bank receives a specified share of the profit arising from investing the funds provided while the investor bears any losses. He goes on to say that investments are considered restricted if the supplier of funds restricts the use to which the funds can be put, otherwise the investments are considered unrestricted. In a Mudaraba contract, profit is divided between the investor and the agent in a ratio agreed upon at the time the contract is negotiated.

3.0 Argument about the use of interest.

According to the Islamic law, interest is strictly forbidden because it leads to a concentration of wealth in the hands of a few. Those who benefit from interest shall be raised like those who have been driven to madness by the touch of the Devil; this is because they say: Trade is like interest while God has permitted trade and forbidden interest. Hence those who have received the admonition from their Lord and desist may have what has already passed, their case being entrusted to God; but those who revert shall be the inhabitants of the fir and abide therein forever (Abdel 1999). These suggest that the use of interest is disallowed.

According to Yue (2008) the use of interest violates the principle of social justice, which underlies all economic activities in Islam. All rewards must be the result of effort. Interest transactions lead to rewarding people without them making the effort and this is forbidden in Islam. One of the underlying concepts of the Islamic economic system is growth with equity; the use of interest clearly is in direct conflict with this concept. He goes on to say that prohibition of interest is related to Muslims' attitudes to the time value of money. Some learners have suggested that the concept is not acceptable to the Islamic law. However, this view is not shared by all Islamic learners.

4.0 The accounting implications of interest prohibition

Chalmers (2007) say that there is a need for developing a set of standards for Islamic accounting and reporting. The need for accounting standards is not very different from the need for any other kind of standards, whether it is standards for weights and measures, or standards for clothing sizes, grades of beef, or baseball statistics. In financial accounting sometimes we tend to think only in terms of investment decisions, but those are not the only decisions for which financial information may be useful, if not critical.

The need for developing accounting and reporting standards becomes urgent for firms in the Islamic societies as the Islamic world attempts to revive the Islamic ideology. Furthermore, if a consensus is achieved on the standards, then the overall bookkeeping costs of the firms are likely to be minimized. The issue that is still being debated in the literature is how to develop an Islamic accounting system. Is it on the basis of the international accounting standards, or other standards, is it on the basis of what is being practiced by Islamic firms, is it on the basis of the Islamic law or is it on the basis of a Combination of any of the above?

In recent years, a branch of accounting literature has developed that high lights the differences between Western and Muslim business environments. Starting from the assumption that Islam disallows the use of interest in any shape or form, it is suggested that a separate and distinct system of accounting and reporting needs to be developed. The main differences compared to Western financial statements are likely to be in the treatment of certain items in the balance sheet. A major conceptual difference is in the special treatment of unrestricted mudaraba and other investments as a separately identifiable category of assets and fund accounts, which have partly the characteristics of equity and partly that of liabilities.

The notes to the accounts are also likely to contain details of financial expenditure discharging the firms' social obligations. Firms exist because it is costly to use the price system to coordinate economic activities. In comparison to the firms, individual consumers, as infrequent purchasers of factors, incur relatively high contracting costs. Firms are able to offer cost advantages over markets by capturing economies of scale in repetitive contracting. Firms in an Islamic society generally are no different from their Western counterparts.

A firm can be viewed as a nexus of contracts; that is, its organization can be largely described by the set of contracts it enters into. Contractual relations are the essence of firms, not only with employees but also with suppliers, customers, creditors and other parties. The firms are likely to minimize the costs associated with contracts, such as costs of negotiation, monitoring, possible renegotiation, and expected costs of bankruptcy or other failures. Their accounting and reporting policies are likely to be chosen with a view to minimizing contracting costs, so as to attain efficient corporate governance. This choice makes important differences in managing contracts and reducing political costs.

In addition, managers disclose unfavorable information due to the fear of legal liability and reputation considerations. Managers expand disclosure because they perceive their firms to be undervalued by investors, and view undervaluation. The increase in disclosure helps in both redressing the undervaluation and reducing costs of financial intermediation for the firm's shares. Therefore, managers are likely to disclose information about which they are confident and withhold that they consider uncertain.

Firms in an Islamic society are no different. They are expected to operate within the given legal and political environments. As contracts are often written in accounting numbers, one of the problems the firms need to address is whether the underlying rationale for assigning values to assets is consistent with the Islamic ethical position. Historic cost data is likely to be the basis for all accounting calculations. The essential character of the historical cost accounting is that it is firm specific. It is a highly reliable source of information about the firm's assets, private debts, the operating performance of the firm and its cash management. It sits well with the Islamic concept of stewardship (Zartman 2001). The stewardship objective of historical cost accounting highlights the contractual relationship between a firm and those who provide resources to it. The Prophet Mohammed (Peace be Upon Him) himself was known to be called The Ameen. A system that allows the manager to discharge this fiduciary responsibility may include some aspects of historical cost accounting (Zartman 2001).

Furthermore, compared to current value methods that require making predictions about the future, the historical cost method is less costly and quite simple to understand and use. Of course, there are weaknesses in the historical cost system, such as the allocation problem and conservatism. However, the weaknesses of the system are unlikely to render it totally irrelevant (Zartman 2001).

Corporation reports should rest upon the assumption that a fiduciary management is reporting to absentee investors who have no independent means of learning how their representatives are discharging their stewardship. From an Islamic perspective, the measurement of assets for determining the amount of zakat to be given is an important issue. To calculate the amount of zakat, assets need to be measured in contemporary terms, not in historical cost. For the purpose of zakat, firms need to be encouraged to re-value their major assets occasionally. Therefore, an Islamic accounting system is likely to use both historical cost and market selling prices. The dual system of asset valuation is likely to enable firms to accommodate contracts and to discharge their social obligations.

The argument of the need for greater awareness of the social impact of firm activities in Islam seems to favors a value added statement, in addition to the balance sheet and profit and loss statement. A value-added statement involves a recasting of the data contained in the profit and loss statement.

Value added is the wealth the reporting entity has been able to create by its own and its employees' efforts. This statement should show how value added has been used to pay those contributing to its creation. It usefully elaborates on the profit and loss account and, in time, may come to be regarded as a preferable way of describing performance (Chalmers 2007).

According to Chalmers (2007) value-added statement is likely to facilitate focusing on a firm's performance from the stakeholders' point of view. For example, the statement can lead to calculation of new ratios such as wages and salaries to value added and taxation to value added. It is likely to place a greater emphasis upon the co-operative nature of economic activity and less on its competitive aspects. This is consistent with the religious principle of fair and considerate trading contained in the law.

The debate over corporate social responsibility and accountability has long passed the stage when it was argued that the only social responsibility of business was to increase its profit within the 'rules of the game' (Chalmers 2007). The advocates of social responsibility claim that profit should not be the sole criteria for judging corporate performance.

Because corporate behavior is so critical to the realization of social goals such as equal opportunity, worker safety and health, and environmental protection, a social dimension is added to corporate performance. To view the modern corporation in a strict economic sense is to ignore reality, and to suggest that its responsibilities include only economic obligations is myopic.

Social reporting is the process of identifying, recording and communicating information about an entity's performance in the social sphere (Chalmers 2007). It includes reporting on the entity's contribution to employee well-being, product quality and safety, community-related activities, public health and safety, environment protection, energy conservation, affirmative action and other related social aspects.

This notion is highly relevant to business in an Islamic society. Islam preaches moderation. It teaches making a reasonable profit. In the western world, it is called a normal profit. Islam teaches to treat the employees well, to sell products that are clean and pure, to weigh correctly, to serve the community, and to protect the environment.

5. Accounting and reporting policies for firms in Islamic societies

Under the Islamic law, all business practices that involve the use of interest are disallowed. They are being taken as exploitation of some group of people by another group. Similarly, practices that use predictions of future are also disallowed as it is being believed future belong to God. It is expected that parties to business transactions would draw up contracts that conform to the law McGee (2004). Accounting in a society exists to reflect the business practices of that society; it has little use otherwise. Thus, it follows that accounting and reporting practices of firms in Islamic societies are likely to reflect the Islamic business contracts and business practices.

Price (1999) says that In an Islamic society, there is likely to be more emphasis on accounting for partnerships and joint ventures. The use of interest-bearing bonds and preference shares would be prohibited. So would the use of interest in leasing transactions, notes receivable and notes payable. Because the future is in the hands of God Almighty, predictions and the use of net present value is likely to be disallowed. So would hedge against currency fluctuations.

The use of historical cost accounting is likely to continue. There are several reasons for this assertion. For a start, historical cost model highlights the fiduciary responsibility of the managers and their stewardship function. Apart from this, the model objectively reflects asset values at the time of acquisition. The model is most appropriate because contracts are written in historical cost numbers. Above all, historical cost is an efficient technology. It has withstood the test of the time and its use has survived over centuries. If there were a more efficient valuation method than historical cost it would have displaced the historical cost system long ago.

The use of selling prices is likely to supplement the historical cost system in an Islamic society. There are two reasons for this possibility. First, the market selling prices do not involve predicting the future. The use of net realizable values can be expected when a business is being bought, sold, or liquidated. The method is also likely to be used when a major asset is being replaced or the current market price of the asset becomes substantially different from its historical cost (McGee 2004).

Apart from the emphasis on the profit and loss statement, balance sheet, and cash flow statement, a considerable amount of further information would be provided. This would include a value-added statement and disclosure about social performance activities of the firm. The above are but a few examples of accounting and reporting practices that are likely to be relevant to firms in Islamic societies. An in-depth study needs to be conducted to develop an inventory of accounting standards that are consistent with the law. Finally, a major criterion for producing accounting information, of course, must be that the cost does not exceed the expected benefit.

6. Conclusion.

In Islam, the use of interest is prohibited; the future is considered to be in the hands of God Almighty; and the monetary and physical resources of the firm are in trust of managers. What accounting and reporting policies are likely to be in use in an Islamic society? Clearly, contracts and financial instruments that involve the use of interest and prediction of future are likely to be avoided examples of these are discounting factors which involves predicting future value of money.

Firm managers in Islamic societies are likely to adopt policies that are consistent with the requirements of the law. Managers are also likely to use accounting and reporting policies which maximize the value of the firm "within the rules of the law.

I argue that the reports of firms in Islamic societies are likely to contain a balance sheet, a profit and loss statement, a cash flow statement and a value added statement. Items involving the use of interest will be excluded and those that are specific to Islamic business included. Accounting regulation in an Islamic society needs to be fairly general and flexible. Detailed and complex regulation is likely to impose costs on the firms and ultimately on the society that it requires to serve. A combination of both prescriptive and descriptive approaches to developing Islamic accounting and reporting standards is likely to bear fruit.