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Relevance means the capacity of information to make a difference in a decision by helping users to form predictions about outcomes of past, present, and future events or to confirm correct prior expectations. Reliability means the quality of information that assures that information is reasonably free from error, bias and faithfully represent what its purports to represent. Conventional accounting objectives and concepts are needed to guide existing accounting practice, prescribe future accounting practice and define key terms and fundamental accounting issues. The accounting measurement is based on the cost principle that considers the acquisition cost or historical cost. The method that adopts the historical cost and conservatism concept is to ensure the repayment from capital. However, this principle is disagreeing from the Islamic point of view because it does not match with the concept in Shari'ah about fairness and justice. Islamic accounting provides appropriate information to stakeholders of an entity which allows them to govern the entity is continuously operating within the concept in Shari'ah and delivering on its socioeconomic objectives.
Furthermore, accounting concepts can be described as rules, principle, practices, postulates and assumption. Based on the concept of conservatism, we know that the basic accounting principle is use of historical cost for asset valuation. There is an issue raises that Islamic accounting whether the concept of conservatism is relevance or not. Let us refer to the principles of zakat where zakat must be based on current market value or cash equivalent value for the trade assets.The use of current prices on the due date of zakat is the best recommendation from many scholars. The use of current market value is wants to find the most accurate valuation of wealth from zakat payer to be subjected for zakat. This is because the principle of zakat design to serves the recipients and payers for justice and fair. However, the principle of conventional accounting practice is choosing lower of cost or market value. By using conventional accounting practice it may lead to understatement in the financial report of trade assets that subjected for zakat. This kind of cost concept definitely cannot be acceptable in Islam because the preparer of financial report in Islam should be aimed for justice and fairness as well.
Accounting recognition is the basic elements of recording in the financial statements. The concepts include the basic principles that when is the time to recognize revenue, expense, gain and loss in the entity's income statement. We should recognize the revenue when it is realized in conventional accounting perspectives. Realization of revenue occurs when the entity can receive the revenue with their right and the obligation on the part of another party is remit. The use of accrual basis accounting is better than the cash basis accounting in conventional practice but it is in conflict with Islamic accounting as it is claimed to misleading and may underestimate the amount of zakat.
From traditional perspective, the matching principle recognized the expense when the expense is related directly to generate revenues or when the expense is incurred in the related period. The fairness and justice to the shareholders and stakeholders must be considered during allocates expenses to related revenue according to matching principle from Islamic perspective. The measurement attributes to the financial report should be guided by the relevance, reliability, understandability and comparability of the information being use by related parties. In order to ensure the reliability and comparability of the information, it must be supported with objective, logical and relevant methods, and consistency of the use of methods and conservatism in the process.
In terms of disclosure requirements, traditional accounting perspective provides limited disclosure provision of information that subject to public interest. However, Islamic accounting perspective requires additional disclosure in the financial report in order to satisfy any reasonable demand for information in accordance with the principle of Shari'ah. Their full disclosure does not mean to disclose everything in the report but the preparer of account should disclose any information that is important to users for serving their God. The Islamic concept of social accountability encompass the accountability is ultimately to God.
The majority had point out different critique of conventional accounting about its deficiencies from their own perspective. Thus, the Islamic academics are concerns with the issues raised. There is some researchers concern with the application of conventional accounting to Islamic societies in other areas. The religious content is excluded due to the differences between Islam and the history in Western society. The researchers always highlight this point when the proposed solutions are not compatible with an Islamic.
1.2 Why the Issue under Discussion is Crucial?
We had found that the current issue under discussion is crucial because of the lack of standardized in accounting. It is hard for the investor to make their decisionwhen the financial institutions apply different standard in their financial report. For institutions offering Islamic finance products and services, the Standards applied may not offer appropriate disclosure requirements because of the differences and difficulties
1.3 Objective of Topic under Discussion
A conflict occurs between the transactions and product accord to Shari'ah compliance and conventional accounting which may lead to a clear lack of a single financial reporting framework. Thus, similar entities become difficult in make comparability across border on the financial report. This lack of consistency could be drawback due to increasing demands by investor in IFIs, who look for greater opportunity in global market. This report sets the scene for a broad project which will aim to inform the international agenda on financial reporting by IFIs and support the work of accounting and auditing standard setters in this area.
The main objective of this discussion is to determine the quality of financial report from Islamic and Conventional Accounting Perspective based on the characteristic of relevant and reliable issue. The usefulness of financial report is important to enables users make the correct judgments, predictions and economic decision. We will find out the argument of the practice and policy among the two different perspectives which could influence the quality of financial report. We will further outlines key practices in Islamic accounting distinct from those found in conventional accounting and that could lead to misrepresentations of financial information if they were accounted for using IFRS. In the discussion, our group members will express our opinion under the Islamic and Conventional accounting perspective based on the argument. Some considerations relating to the specific practices of IFIs are stated in the body of this report. We hope the findings can further encourage the development of strengthen the financial reporting of Islamic financial institutions.
2.0 Main Discussion
2.1 How conventional perspective of accounting perceives or measure relevance
Recognition and measurement concept
Revenue should recognize when it is earned but not when we received the payment; expenses should be recognized when it is incurred but not when we make payment. Even when we receive income or paid expenses in advance, there are cash flow involve, such income and expenses can't be recognized until it is earned or incurred. Matching principle in conventional accounting is stated that cost incurred should link to revenue produced. Conventional accounting adopted accrual basis and matching principle in recording financial event or transaction according to GAAP. By adopting accrual basis, financial statement will provide more reliable figures in presenting company's performance, net value and their financial condition and position of that business entity. However, cash basis accounting are claimed to decrease the accuracy and relevance of reporting as it emphasis on conservatism and the prudence concept when it is used in income and expenses recognition.
Accounting disclosure is use to inform and direct the both current and potential investors' point to accounting strategies and methods as well as any events that would give impact on their respective financial statement. As increasing competitive in business world, disclosure become increasing importance as complete and accurate information can have huge and lasting impact on the stakeholder. Information are need to serve difference group of user demand on different type of information on the financial statement to make their decision, e.g. employee will need profitability information of the company to get know whether there are possibility of salary raises or bonus amount for that current year, internal management may need to use for prediction and plan for the future.
FRS 101 provides overall framework and responsibilities for the presentation of financial statements, rules for their structure and minimum requirements for the content of the financial statements. Financial statements as set out by FRS 101 are income statement, balance sheet, cash flow statement, statement of changes in equity, and notes accompanying the financial statements. For example, the contents in balance sheet such as capital which detailed information as to the authorized, different classes of share capital, par value of each share, issued capital, paid up capital, redemption date for redeemable shares (if any) are to be disclosed and dividends payable. While in income statement such as dividends paid and proposed depreciation, amortization and diminution in value of assets.
The concept defined by adage as "anticipate no profit, but anticipated all losses" (Bliss, 1924). The IASB defines prudence as "the presence of a degree of attention in the exercise of the findings needed in making the estimations required under conditions of improbability, such that assets or income are not overelaborate and liabilities or expenses are not minimalist." If there are two similar conditions arises where both having acceptable alternatives for reporting an item, the accountant are required to pick the alternate that will result in less net income or less asset amount.
The principle of conservatism leads accountants to expect or disclose losses, but it does so in action for gains. For example, potential losses from lawsuits need to be disclosed; in contrast potential gains are not be stated. Inventory may need to write down to the lower than its historical cost, but it will not write up inventory amount to be higher than its historical cost.
Criticism of conservatism claimed that it would not 'conservative' future income statements (e.g., AICPA, 1939). This is due to those downward-biased estimates of net assets lead to upwardly biased assessments of earnings in following years when those assets are expensed. Thus, conservatism produces "non-conservative" earnings in the following year. This claim slips the point of conservatism in the diminishing clarification. There are many reasons for the existing of conservatism notion, for example, it is to stop actions by managers and others that decrease the size of the pie obtainable to all claimants on the firm. Conservatism creates asset and earnings measures that maximize the actual value of the firm. Higher future year earnings because gains are deferred until there is proof that they are happen and have been earned. This seems to make them conventional. The circumstance that following earnings for a given year are higher than some Nirvana benchmark for earnings such as the alteration in the value of the shares predictable by an accountant does not make the future earnings non-conformist. Accountants are anticipated to be neutral and unprejudiced.
Business entity principle is the business that seen as a separate entity from its owners (shareholder) and management (board of director) for preparation of financial statements. In conventional accounting, we consider a business and its owners as two separate parties, means that personal transactions of owners are separate from business.
Differences of stewardship concept with conventional accounting are potential investors and creditors are not included in user categories, it is not serving as prediction model for the users and it is emphasize on what has been accomplished in the past. Accounting in conventional views is to identification, recording, classification, interpreting and communication of economic events so that the user can make use of the information to effectively and efficiently allocate their resources.
The going concern principle is the assumption that an entity will stay in business for the future. In contrary, this means the entity will not be forced to cease operations and liquidate its assets in the near term. When the entity is still in the business and using the assets effectively, the accountant is equitable in deferring the recognition of particular expenses till a later period.
The Conventional accounting which mainly uses historical cost to measure and values of assets and liabilities that bring the profession to paid attention on the unit of measurement assumption of the monetary unit's limitations because the using of current value is complex and troublesome. In communist countries, the accounting profession had never developed the conventional accounting as it did not make much economic sense. As religious truths cannot be verified hence the revelation is not reflected a source of knowledge. Dr.Shahul Hameed & Chapra (2000) argue that sciences deal with the physical universe observable by the senses while religion deals with the higher level of reality with beyond the sense of perception.
The historical cost principle used to measure the accounting quality of reliability as there is agreement on the purchase price of an asset in that time. However, the historical price is not seen as some relevant information. For example, value of land in 20 years ago may be worth and valuable much more than the balance sheet. E.g. building are recorded in balance sheet with historical cost and its does not reflect their fair value effectively as their real value may increase from time to time. Thus, when reporting financial information, many accountants and users of financial statements argued that the market price or fair value should be used.
The main distinct among these two principles are in their future usage of the asset and assumptions about its useful life. For example other professions, the particular data provide professional appraisers balance opinions and judgments.
2.2 How Islamic perspective of accounting perceives or measure relevance
From Islamic point of view, the conservatism concept is not relevant for Islamic financial reporting, because it will underestimate the computation of zakat. As Adnan and Gaffikin (1997) states that the conservatism concept go against the Qur'an and not match with Shari'ah. Gambling and Karim (1991) claim that the concept of conservatism would result in underestimate of assets that could be subject to zakat and Khan (1994) supports their view. Attiah (1989, p. 93) emphases on specific Islamic transactions and says that Islam identifies the conservatism concept on the basis that profits cannot be distributed in transactions such as mudaraba until the recovery of the capital.
We have to think more radical, conservatism sometimes go against Islamic perspective, but in other cases, it helps to maintain public welfare by limiting over-optimistic valuations and distribution of unearned revenue.
In Islamic perspective the contract fulfilment principles is not effective as it is assume the contract is the pass activity and they assume that the historical cost will disclosing of the truth and forbidding the withholding. However, we are suggest that the using of historical cost is applicable in reflects to the conservatism which will understated the valuation.
There is a general harmony in accounting that there should be fair and adequate disclosure of accounting data. It is expected that any matter of significance will be disclosed if it would affect the decision of an average investor. From an Islamic viewpoint, adequate disclosure is also one of the desired principles for fair accounting. It provides public with useful information for making financial decisions. Zakah base value and its distribution can also be accomplished as an outcome of this principle.
Disclose information is mainly for Islamic community in the first place which the disclosure is mainly to advise the Islamic community about its operation as well as use for internal management. Everything that is believed to be of importance to Islamic users for the purpose of serving God should be disclosed. AAOIFI justified its adoption of this concept by arguing that it is supported by the Islamic concept of assigning the responsibility of the cost to the recipient of benefit (AAOIFI, 1999a, p.63).
Decision usefulness is criticised on whether the information disclose in the financial reporting useful for their respective users. In Islamic perspective, information which helps to determination of zakat, support in assessing cash flows that might be recognized from trade with the Islamic bank, considering the Islamic bank's release of its fiduciary responsibility to protection of fund, discharge of their social responsibility, and etc. should be disclosed.
Islamic corporations are expected to disclose consist of any prohibited transection there had made for the year, zakat payable and their social responsibility has been done for the year, it is more detailed than conventional accounting disclosure. They suggest that Value Added Statement should be applied which have some influence on the company policy so that the company aware of their social responsibility such as bonus payment to employees.
Recognition and Measurement Concept
Zakat is important in the Islamic perspective in dealing with the measurement of timing of the assets. Muslims is encouraged to involve in zakat as to fulfil their obligations which in line with Shari'ah of Islam. The determination and accountability of zakat in the early accounting development had already provided by the accounting books and reports.
In IAS 37, the liability is requires disclosing only when these three conditions are present: i) obligation, ii) reliable measurement and iii) probability of an outflow of resources. While in Islamic standard, they only recognize when the information are available indicate an event will result in the impairment of asset.
Hamat (2000, p.404) criticises the accrual basis on the grounds that if income from mudaraba financing were to be recognised on an accruals basis, the distribution would require Islamic banks to take cash from other sources before depositors' accounts are collected. If these accounts turn bad, banks would have to use their own funds to cover losses, thus violating the condition of the mudaraba arrangement, which dictates that losses are borne by the owners of capital.
From our point of view, the significant biases created by the use of allocation procedures cast doubts on traditional accounting methods, and the only way to avoiding some of these biases is to emphasise the reporting of cash flow information.
In business entity concept it is disagree with the separate entity concept which states that the owners and the firms are separate entities and one firm is different from another firm which means, if bankruptcy occurs, the owners is not liable for the debt because in Islamic perspective they consider such assumption are unlawful and like gambling. But in my point of view, the separate of entity may affect the reliability of reporting. In normal course of business reporting, the personal transactions are not counted in the ordinary course of business transaction and will treat as withdrawal under the shareholders' equity in the balance sheet. As separate entity concept is not applied, the withdrawal of owners in the firm will be treat as expenses and hence overestimated the expenses that result in income underestimated and causing the inaccuracy of financial reporting.
2.3 Comparison of Reliability and Relevance in Financial Reporting between Islamic and Conventional Accounting Perspective
From the elaboration and explanation how each of them (Islamic and conventional perspective) in financial statement measure or perceive reliability and relevance concept, we will further look into the similarity and differences between these two accounting perspective in treatment of reliability ad relevance concept in presenting their financial statement.
2.3.1 Similarity of Islamic and Conventional accounting perspective of financial
statement toward reliability and relevance
Although Islamic banks and conventional banks are operate in a different way but it doesn't mean that they are absolutely different financial institutions which need different accounting. Difference accounting principles adopted by difference groups of financial institutions which their aims and objectives are also difference. Hence, all principles and procedures which keep fairness and justice are adopted in accounting for Islamic banks.
The business and the owner are to be viewed as separate entity, income derived from business is not deemed to be income of the owner but the business itself. The financial accounting information shows the activities of the business entity but not the owners.
"Khan (1994) argues that entity concept suffer from some incongruities proprietary concept is nearer to the Islamic framework since it is not clear who is the ultimate owner of the business and since zakat has to be calculated on the property of individuals."
[Christopher Napier, 2007]
The postulate is accepted in Islamic though, because the calculation of zakat is based on the property of an individuals but not based on the business. In a partnership or corporate, the business are not belongs to an individual only, so it is not fair to view the entity as the owner.
The Going Concern Postulate
According to the postulate, except the entity has face to liquidation, it will continue for an unlimited period of time. Thus, the financial statements are only part of a series of continuous reports. This assumption does not seem to reject by any of the Islamic principles.
"In Islamic jurisprudence there is a principle similar to this postulate, that is, the principle of "retaining" or "accompaniment"(Istishab). This principle means retaining any event or verdict experienced in the past, until evidence is found that this event or verdict has changed. Hence if a person is known to exist, his existence is not denied till evidence to the contrary."
[Review of Islamic Economics, Vo1.3, No.2, (1994), pp. 1-18]
This means that the entity is going concern or continues operation if there is no evidence to state that the entity is going to cease their operation or liquidation.
There is a general harmony in accounting that there should be fair and adequate disclosure of accounting data. It is expected that any matter of significance will be disclosed if it would affect the decision of an average investor. In conventional accounting, an entity whose financial statements comply with all the requirements of MASB standards must disclose openly and absolutely such compliance in the notes (FRS 101).
From an Islamic viewpoint, adequate disclosure is also one of the desired principles for fair accounting. It provides public with useful information for making financial decisions. Zakat base value and its distribution can also be accomplished as an outcome of this principle.
"In recognition to this fact the Financial Accounting Organization for Islamic Banks and Financial Institutions suggests that the financial statements of Islamic Banks and Financial Institutions include information about sources and uses of Zukah and Qard Hassan funds."
[Review of Islamic Economics, Vo1.3, No.2, (1994), pp. 1-18]
Only if the accounting principles are maintained, the usefulness of information in Islamic financial institution just can be realised.
2.3.2 Differences of Islamic and conventional accounting perspective of financial statement toward reliability and relevance
Islamic accounting provides information to an entity which enables them to ensure the business is operating continuously according the Islamic Shari'ah principle. It is governed by Al- Qur'an and Sunnah or Islamic Shari'ah. While conventional accounting provides information from efficiently use the resource available to achieve most efficient and maximum profitable in the market and to making a right decision by potential investor. It is governed by accounting and commercial law and secular ethics.
User's view of reliability and relevance from both conventional and Islamic perspective of accounting
In order to sentence a disclosure of the financial statement to be either relevance or reliability, we should understand the need and expectation of the information toward that relevant user. There are conventional and Islamic user demand different types of information in the financial statement.
Conventional investor may concern on the risk inherent, return on investment and the firm's ability to pay dividend whereas Islamic investor may concern on whether the company has compliance of their investment with Shari'ah and any permissibility of dividend can be received. Thus, the profitability shown in the income statement become less relevance to Islamic investor but is the priority for conventional investor to invest their asset in that company.
Governmental regulator may need the information disclosure in conventional financial statement to keep track on the firm's resources and activities as well as taxation policies but they may have different expectation on Islamic business's financial statement. They may concern on accounting policies adopted by Islamic company that may influence zakat calculation, monitor their operational activities and their income whether it is permissible or non-permissible. So, accrual basis is replaced by cash basis in recognition of their income and expenses and conservatism concept are not acceptable in Islamic accounting as they are seem to underestimate the amount of zakat. Fair value is encouraged to use in presentation of balance sheet rather than historical cost that adopted by FRS due to improve in accuracy and reliability of the figure in balance sheet. In suit with demand of the Islamic user, some concepts that are commonly used by conventional accounting are disagreement by Islamic researcher and become irrelevant in Islamic point of view.
Treatment of accounting theory and assumption
Recognition and measurement
Accrual basis and cash basis are two type of recognition of income and expenses and each of the bases exist for the purpose to make financial statement for meaningful and relevant to the user's need or expectation. Accrual basis adopted by conventional accounting are recognised income when it is earned and expenses when it is incurred. Both of them have no influenced by cash receipt or outflow.
IAS 37 requires disclosure of a liability when probability of an outflow of resources and reliable measurement are present.
The Islamic standard requires recognition when information becomes available indicating that an event will most probably result in the impairment of an asset. The issue of uncertainty is not addressed and the standard does not consider the recognition of a contingency.
[Thea Vinnicombe* and David Park, CPA,2007]
Contingent liabilities and provision are needed to be disclosing in financial statement as there is a probability of an outflow of resources. This may improve the reliability and relevancy of financial statement as all potential possibility are take into account to indicate the financial position of a company. However, Islamic accounting is emphasis on the event that results in impairment of asset. We think that Islamic organization become less reliable and relevant when touching on the future event and uncertainty disclosure.
Recognition of ensuing rights and obligations must apply to a given period of time tracing all changes of consummated transactions that may have taken place. Measurement is the quantification of financial effects of consummated transactions and the impact of other events during the same period of time.
[ Dr. Seif I. Tag El-Din, October 2004]
Income and expenses recognize in conventional financial statement is based on accrual basis, in contrast, cash receipt basis are adopted by Islamic perspective of accounting. The cash basis approach are claim to improve accuracy of financial position of a company and the company will impose zakat based on their actual profit for the year but not include the income not yet receive and expenses not yet paid.
Accrued revenue (output) will reflect the actual level of the institution's activity whilst matching of accrued expenses (input) portrays its efficiency. Net income or return of investment then measures the productive capacity or net accomplishment of the institution. If cash basis is adopted, the outcome would be net operating cash flow and not income (Hicks, 1980). The net operating cash flow is useful for ascertaining the distribution policy as well as meeting other obligations (Lee, 1981).
The importance of equitable distribution in Islamic financing activities has also influenced the need for cash basis accounting. Since the basic principle of distribution in muèrabah transactions is that only income realized in cash can be distributed, profit to the investment account holder is the investment surplus.
[Syed Musa Alhabshi, 2002]
Again, degree of relevancy and reliability depend on the users' categories and their expectation against information. Both accrual and cash basis are relevant to the investor as they may need the information to evaluate the actual revenue earning and earnings for the year and determine the company's liquidity
The conservatism of conventional reporting which applies the lower of historical cost or net realizable value basis is applied to act in the interest of equity holders. In Islamic financing, the preferred scale of measure has been net realizable value or cash equivalent value, also known as the exit price (paragraph 89 in AAOIFI, SFA 2, 1997)
[Syed Musa Alhabshi, 2002]
The main difference of treatment of conservatism concept is due to zakat calculation. Islamic researcher argues that it will underprovide gain of a company and it may lead to underestimate zakat amount.
Gambling and Karim (1991), the provision of information relevant for zakah, the concept of conservatism is not relevant for Islamic financial reporting purposes, nor is the use of historical costâ€¦â€¦.all the transactions according to their effect on assets and liabilities and owners' equity, this would shift the focus of Islamic financial reporting from a revenue-expense approach to an asset-liability approach for income measurement purposes, which implies that the revenue recognition and matching principles would be become less significant.
[Christopher Napier,Aug 2007]
As the conservatism concept are claim to potentially underestimate zakat amount, the information provided using that concept are seem irrelevant to decision making of Islamic user of financial statement. Islamic researcher claimed that this concept tend to misleading user.
Belkaoui (2000, p. 179) describes it as "an exception or modifying principle in the sense that it acts as a constraint to the presentation of relevant and reliable data". He further suggests that it may result in the introduction of bias, errors, possible distortions and misleading statements. Hendriksen (1982, p. 83) describes it as "at best, a very poor method of treating the existence of uncertainty in valuation and income, and at worst, it results in a complete distortion of accounting data".
[Christopher Napier,Aug 2007]
The Islamic view of conservatism concept is totally different from conventional accounting. The formation of this concept is mainly to prevent management from bias.
Devine (1963, p.130) argued that businesspersons tend to slant their representations, and their statements are therefore often biased to favour their immediate goals; thus, conservatism is used as counter-bias.
[Christopher Napier, Aug 2007]
It is still relevant to conventional financial statement's users as by using conservatism concept to minimize earning as accountants are expected to disclose loss but not gain in uncertainty arise.
There are different meanings of "full disclosure" between conventional and Islamic perspective of accounting mainly based on their respective objective. The first perspective define full disclosure when all information subject to public interest are being disclosure whereas the latter define it as full disclosure when it is satisfy any reasonable demand for information in accordance to Shari'ah are being disclosed.
Islamic corporations are expected to disclose consist of any prohibited transaction there had made for the year, Zakat payable and their social responsibility has been done for the year, it is more detailed than conventional accounting disclosure.
Baydoun and Willett (2000) considered the historical value balance sheet should still be used because of the problems associated with current value such as â€¦..The principles of full disclosure and social accountability require Islamic businesses to issue such a statement, and current value information is also necessary for the determination of zakah.
AAOIFI justified its adoption of this concept by arguing that it is supported by the Islamic concept of assigning the responsibility of the cost to the recipient of benefit (AAOIFI, 1999a, p.63).
[Christopher Napier, 2007]
In order to compliment with Islam's objective of leading justice and equitable distribution of wealth, they suggest that Value Added Statement should be applied which have some influence on the company policy so that the company aware of their social responsibility such as bonus payment to employees. Besides that, it is also used by the public to enforce the company to be more aware of their social responsibility. However, income statement has no such tool.
Value Added Statement (VAS) should be applied. This is because the distributional characteristics of the VAS would support accountability in Islam (Baydoun and Willet, 1994)
The problem in the VAS is that, it does not provide a space for such consideration as it is only concerned with the distributional aspects of the sources. Therefore, in the writer's opinion, it can be said that the VAS is insufficient in meeting the Islamic requirements for information
[Rizal Yalya, 2004]
The function of VAS is still a question mark as it is an ex-post report and it has no affect current year performance. VAS is an additional disclosure compare to conventional accounting. It may serve as an obvious difference between these two perspectives under our discussion. But the relevancies are still limit to Muslim user of account and seem not relevance for conventional users
Muslims have to devote themselves to God as the fundamental aspect of their behaviour. Baydoun and Willett (1997, p.6) suggest that this concept gives rise to a broader concept of accountability than that present in Western societies
In the Islamic framework, all people are accountable to God on the Day of Judgement for their actions during their lives.
[Christopher Napier, 2007]
From these sentences, we can get to know Islamic accounting are basically following Shari'ah law which believe to be God's rule and guideline to His believer. Thus, the definition of reliability and relevance toward full disclosure may also difference between these two accounting perspective. The differences between Islamic and conventional accounting are their objective of providing the information, the type of information to be disclosed, and measurement and value the information and the users group of that information.
Islamic scholars disagree â€¦. obligations are separate from its owners is consistent with Islamic principles. Gambling and Karim (1991, p. 36) note that Islam has been slow to acknowledge the idea of businesses as separate legal entities, while Khan (1994, p. 9) notes that there is an ethical problem associated with dealing with a company as a separate entity, as the owners are not liable for the company's debts in the event of insolvency, but have the rights to residual profits.
[Christopher Napier, 2007]
The purpose of stewardship is to avoid or prevent owner take whatever their want from the business, e.g. if the owner use the business's money for personal usage, the ledger should be entries with "withdrawal" but not "expenses". This separation may help tax authorities to identify the nature of expenses whether allowable or non-allowable. Islamic accounting rejected entity concept due to the narrative of "no one can possess wealth in earth as all things are belong to God, human is just the representative of God in implement and execute responsibility on land". If there is no entity theory, the process of accounting may be confusing the user of financial statement whether such transaction is make by owner itself or the company. In other word, the information provided in the financial statement is not reliable and relevance by the users. For example, if the owner borrow money from bank and invest it in the company, the book recording will show in 'shareholder equity' with entity theory. Without entity theory, the entry will be just "borrowing". There are significant differences in recognized these two terms in conventional accounting. We think that personal transaction should not be included in financial statement as it is not an ordinary course of business.
Both historical cost and current cost are used to measure the accounting quality of reliability as there are agreements on the purchase price of an asset in that time. We can conclude that current cost valuation used in Islamic accounting because they believe that historical cost will underestimated in balance sheet.
Current cost valuation are acceptable in Islamic accounting practice as they claim that historical cost seem to underestimated the asset of a company. Zakat is calculated based on current valuation but argument arising saying that historical cost calculation may be provide highly reliable source of information about the financial position of a company. The other researcher oppose the former statement by saying that use of historical cost could dishonest the principles of disclosing the truth (Al-Qur'an 2:42).
[Malaysian accounting review. Shahul Hameed Mohd. Ibrahim, July 2005]
In summary, we think that current cost is better reflect current financial position of an company. This is because it can improve the accuracy and reliability of financial information. While, sometimes historical cost have been used if stewardship is concerned. Historical cost reflects asset values at the time of acquisition and the contracts are written in historical cost numbers. The advantages using historical cost are less costly and simple to understand and use. Thus, both historical cost and market selling prices are also used in Islamic accounting.
Based on the Mirza and Baydoun argument, the historical cost for asset, debts, firm operations and cash management is a reliable source, they also believe that concept of stewardship in Islamic accounting is well based on historical cost. But based on the Shari'ah, the historical cost will not be applied as it focuses on the current valuation method.
[Would the Objectives and Characteristics of Islamic Accounting for Islamic Business. Rizal Yaya, Disember 2004]
The going concern concept in conventional accounting is not oppose with the requirements of islamic accounting. The main things is the director should make assessment on the firm's ability to continue as going concern. All financial statement have to prepared according the rules of going concern. But if the directors want to liquidate or cease the firms, it can be avoided. In Islamic view, business continues not forever but depends on contractual agreement between parties. The entity may continues in the future until the ability of going concern has ceased. E.g. an entity which based on Mudharabah have to be in operation only to the end of agreed Mudharabah period in the agreements.
According to the postulate, except the entity has face to liquidation, it will continue for an unlimited period of time. Thus, the financial statements are only part of a series of continuous reports. However, many accountants disagreed and argued about this postulate as an unreasoning and ridiculous assumption. This assumption does not seem to reject by any of the Islamic principles because there is a principle similar to this postulate, the principle of "retaining" or "accompaniment" in Islamic jurisprudence.
[Accounting postulates and principles from an Islamic perspective. Eltegani Abudslgader Ahmed, 1994]
2.4 Critical Argument on Comparability of Reliability and Relevance in financial reporting from Islamic and Conventional Accounting Perspective.
The issue of reliability and relevance of information being disclose in the Islamic and conventional reporting being discuss in our assignment. Conventional accounting practice has develop a standard international set of accounting practice which have been widely adopted by various country but the problem arising for Islamic country. Islamic countries are relying on Shari'ah law in developing objective of falah which mean to the success in the world and hereafter. Many concept explain above that propose and implemented by the conventional accounting are found not appropriate for Islamic accounting due to the prohibition of interest, involve in stock exchange which serve as gambling in Islam and also speculation. Besides that, there are difference between objective of conventional business and Islamic business.
Normally, profit maximization are the main objective of non-Muslim organization, whereas such objective of Islamic organization are mainly social oriented which mean that profit is their secondary profit and social responsibility is their primary objective. A firm to be recognizing as success from Islamic perspective is view from amount of social activities had been done for the year rather than amount of profit has been earned. Islamic accounting assumes that all people are act honestly and faithfully as they are believed in Allah has watching their act. Zakat is the main concern in Islamic accounting which is a tool to establish objective of equally distribution of wealth in Islamic religious. Some concepts in conventional accounting are argue and disagreement by Islamic research mainly from the view of Zakat. For example, conservatism theories are saying to mislead the financial position of a company and thus lead to underestimate the amount of Zakat.
From our group's point of view, Islamic accounting may not effectively show their reliability and relevant in their way of presenting their financial statement as we are disagree some conceptual framework proposed by Islamic accounting. Although they argue that the information prepare are not mainly for the investor or even their creditor but provide mainly for computation of Zakat. We think that this may not fair to other user of the statement especially for the investor that heavily rely on the financial statement in making decision. We can't assume all investor of Islamic company are Muslim! E.g. If a country didn't open their trade to the world, they will stay in their border forever and can't even move on to better life! We think that in order to ensure better economic which lead to better social life, Islamic organizations should open their arm to the world and follow the step of the world. This would make an improvement to countries economic and increase the employment rate. If people get job, they can enjoy better life. Remember that God won't blame you to make good life for others! We think that by doing so, Islamic company can even perfectly execute their responsibility toward social or poor people.
In term of argument for historical cost and current cost, we are agree with Islamic accounting perspective as we think that current cost are better reflect current financial position of an company. This is improving the accuracy and reliability of financial information which using current cost valuation. We also assent the view of Islamic scholar on money measurement concept. Event recorded in accounting are measure in term of money which standardize a common denominator but in fact it is insufficient to reflect a company financial position effectively. Inflationary environment affect purchasing power of money and further affect future financial right obligation. Money is unable to serve just and honest unit of account only. But even today, research still can't found suitable substitute of money term.
Disagreement arising on the entity concept due to the shareholder has limited their liability on the bankruptcy of a company but they can enjoy the residual profits which seem to unlawful in Islamic. Limited liability is mean by the shareholder has protected to limited their debt within their investment in such respective company but not over their personal property. Islamic accounting propose that if the owners become bankrupt, then the liabilities may be distributed to their successors or legal inheritors, and, it will be better for the owners because he will be asked for it in hereafter [Al-Qur'an, 23:115].We think that everyone have to bear on the consequence they had brought in themselves but not implicate their posterity to undertake their debts. In the same place, God had gift us an independent body and mind so we can take up decision ourselves but not by rule. If the concept proposed by Islamic accounting had become official concept in Islamic perspective, it becomes a "must". We think that posterity "should" bear their parent debt in the ethical sense but not a "must".
Islamic perspective of disclosure required additional disclosure over conventional accounting which is social accountability. Stakeholder interest is the main concern of Islamic perspective of disclosure. Islamic Social Reporting (ISR) is serving as a way to fulfil the need of disclosure in Islamic accounting. In IFRS, the purpose of accounting is to provide relevant and reliability of information for the user to making decision. All information relating to the organization should be disclosed objectively and completely in financial statement. However, Islamic accounting concern on ethical disclosure as the accountability to the nation, because Allah [SWTA] knows everything what we conceal and disclose [Al Qur'an, 14:38].Will the firm disclosing negative information to the public about their organization such as unfair treatment of employees, environmental pollution, cheating income tax calculation, etc? Islamic accounting did not generate a standard calculation or characteristic on how to regard such company are fair treatment to their employee, environment pollution or achieving fair social responsibility. Profit can show us an amount but social oriented accounting can't even show us a figure to justify a good company.
On the other hands, our group might not agree with Islamic accounting perspective in argument of going concern concept and entity concept. In Islamic context, going concern concept and entity theory are disagree by Islamic researcher in the explanation of "no one else can live forever except Allah" and "no one can own wealth or properties in the world except Allah". If we do not assume that the entity is going concern, this would be misleading to financial statement user. Without going concern theory, all transaction should be complete in that year and no continuous effect should be carried forward to the next year. Provisions for estimate liability such as doubtful debt and warranty cost are also prohibited as Islamic accounting is only concern only current year.
While the prohibition of partaking in interest based transactions is clearly fundamental to Islamic finance, it must be noted that the use of discounted cash flows is merely to derive an approximation of a market value. It does not result in an interest charge. Does this therefore necessarily cause a conflict with Shari'ah? Many Islamic financial institutions explicitly refer to using discounted cash flows when calculating value in use for impairment testing and valuation techniques for their financial instruments measured at fair value. We think that the first step for Islamic researcher to investigate deeply in Islamic context for the meaning of "interest" that being prohibited but not ban all word with "interest".
Although we found that there are problems in Islamic perspective of accounting but due to the increasing demand on the Muslim user of financial statement, we think that we should look into the problem and find the solution or recommendation(as below) for the relevant parties to make improvement on these issues.
Principle of Conventional accounting stated that cost incurred should link with the revenue were produced, Conventional accounting also adopted accrual basis and matching principle when performing recording financial event or transaction according to GAAP. By adopting accrual basis, financial able to provide a more reliable amount or figure in presenting financial report of the company, not only financial report and also net value, their financial position and condition of the business entity. Cash basis accounting is not that accuracy and relevance of reporting as it emphasis on conservatism and the prudence concept when it used in income and expenses recognition. Principle of conservatism will lead accountant to disclose losses, but it does so in action for gain. Historical cost principle is used to measure the valuation of asset and liability, it will improve the accounting quality of reliability as there are agreements on the purchases price of asset, but historical cost principle is not seen as some relevant information, it will ignore the depreciation or appreciation or the asset. Many of accounting professional argues that, in presenting financial statement market price or fair value should be used.
For Islamic accounting, conservation concept is not relevant with Islamic financial reporting; it is because of it will underestimate Zakat. Conservation sometimes goes against Islamic perspective; it helps to maintain public welfare by limiting over-optimistic valuation and distribution of unearned revenue. From Islamic view of point, adequate disclosure is one of the desired principle for fair accounting, it provide public with useful information. Zakah base value and its distribution can also be accomplished as an outcome of this principle. Zakat is important in the Islamic accounting principle in dealing with the measurement of timing of its asset, to fulfill their obligation which in line with Shari'ah of Islam. The objective of Islamic perspective is to ensure the entity is according to the Shari'ah and its concept of fairness, priorities to society and compliance with business value. Islamic accounting principle used historical cost valuation for asset valuation to satisfy the stewardship objective and market selling price is used to calculate Zakat. Monetary is incredible from Islamic perspective in an inflationary environment. In Islamic perspective, the accounting information is to giving satisfaction of the accountability to god and to seek Allah's pleasure and not only focus on material only. It is not reliable to individual shareholder and creditor to make decision.
Conventional accounting using historical cost to measure the valuation of asset and liabilities, and it is insufficient for the evaluation of business decision. Historical cost is not relevant to the decision making. Conventional accounting focus on the stewardship function of accounting, but user of accounting information will not only interested in the stewardship function. They are more interested in increases or decreases in the value of they invested and it also presented on the net asset of the company. In our recommendation, we suggested using market price or fair value to measure the asset cost. The main advantage of this is increase the relevant for decision making. The market value provided a better present on the economic reality of transaction. Because of this, its tend to provide a more useful and relevant information on financial report to user. Other than that current cost also gives a better measurement toward the efficiency of the entity.
Implement event accounting is useful to improve relevant of conventional accounting. The business transaction or activity treated as an event. The data maintained real-time in the database, and it able to direct accessed by user when they are needed. This not only record transaction change of asset and liabilities, but it also included plan, control and also estimated and forecasting. Event accounting able to improve the relevant of accounting report, it is because it analysis from perspective of important qualitative characteristic. This approached able meet the test of safeguarding accounting information integrity.
For Islamic accounting principle, Monetary is incredible from Islamic perspective in an inflationary environment. In Islamic perspective, the accounting information is to giving satisfaction of the accountability to god and to seek Allah's pleasure and not only focus on material only, due to this, the reliable on Islamic accounting report will be decreased. We strongly recommended that Islamic accounting should use monetary for present their financial status or condition. It able to sustainable the level economic output and foster a more stable price system. Mean it able to keeping the inflation at a lower rate. So the individual can base on the information to make decision since the information is much more reliable.
We also suggest that, IASB should corporate with the AAOIFI, it also might work together with other Islamic financial regulatory or standard. This action is to establish the gap between conventional accounting and Islamic accounting to achieve the needed buy user, such as making the information present in accounting report more relevant and more reliable. This also should include the review terminology in IRFS. The main purpose of this formation is make improvement on each principle, it allow them to exchange idea and knowledge on accounting issue, it able to help up improvement on reliable and relevant of accounting information. Its will play a very important role for future improvement of accounting reporting.