ACCOUNTING STANDARDS AND TAX LAWS
MUSTAPHA HAMAT
In Islamic banking, depositor/bank relationships differ, not only from those in conventional banking, but also between the various categories of depositors. Unlike conventional banking, where the depositor/bank relationship is that of debtor/creditor, this relationship in Islamic banking could either be that of safekeeping (Wadia) in the case of current and savings accounts, or trustee financing (Mudaraba) in the case of fixed deposits (investment accounts). As such, the most suitable accounting system for Islamic banks would be one that reflects the various bank-customer relationships.
Fund Accounting
The funds that are available for the Islamic banks to invest are managed according to the type and nature of contractual relationships.
The shareholder’s fund, which is received from the shareholders by the bank on the basis of Musharaka, is managed separately from the funds received from depositors – although when it comes to the annual financial statement, all funds are amalgamated under one heading – and so requires special accounting.
Modified Cash Basis
A substantial percentage of the deposits received by Islamic banks are structured according to the principles of Mudaraba. This principle involves the distribution of a cash profit, either periodically or at the end of the Mudaraba period.
This is because if the recognition of income earned were to be made on an accrual basis, the distribution of profit would require Islamic banks to advance cash from other sources before the liquidation of receivable accounts were made. Or if the account shows a loss, the bank has to use its own funds to recompense the depositor, and this violates one of the conditions of the Mudaraba contract, which dictates that the loss should be borne by the owners of the capital.
But, because, according to the Shafi school of law, the profit which is distributed has to be treated as a refund of capital, to avoid this problem, Islamic banks usually adopt a cash basis rather than accrual in the recognition of income.
Sharia Requirements
Obviously, any accounting system adopted by Islamic banks should reflect all Sharia requirements as closely as possible. For example, transactions conducted on the basis of the Sharia principle of Bai Bithaman Ajil consists of the following steps: the bank buys a house from the developer and pays cash; next, the bank sells the house at cost, plus a margin of profit.
The accounting entries for these transactions are: the bank buys a house from the developer and pays cash – debit cost of the house and credit amount of banker’s cheque.
When the bank sells the house to the customer on a deferred payment basis, the record is – debit Bai Bithaman Ajil Financing (cost plus profit), credit cost of house (cost) and credit unearned profit (profit margin).
As shown in the above example, the debits and credits of the cost of the house cancel each other out. However, to explain the logistics of a transaction, a set of entries relating to the cost of the house must be made.
A crucial aspect of this transaction is the Sharia principle on the categorising of assets and liabilities, based on Sharia principles such as Bai Bithaman Ajil, Murabaha and Mudaraba, amongst others.
Requirements for a Dual Accounting System
Conventional banks which mobilise deposits on the basis of the interest-free principle should manage the fund separately. All interest-free deposits should be used in interest-free or Sharia-permitted investments. As such, it is imperative that separate accounts are kept for these funds, and ideally, a separate accounting entity should be established.
At the end of the accounting period, separate statements of assets and liabilities, and profit-and-loss accounts, for each fund are prepared. Aggregation of interest-free fund accounts with conventional banking operation accounts will only be made in the annual financial statement.
If the interest-free fund is managed and accounted for in the same account as the funds from conventional banking operations, it will be very difficult for the banks to manage their investments, as they need to segregate income derived from employment of the interest-free deposits from that form the interest-based deposits.
Questions may be raised as to how the banks will allocate overhead costs, as the two systems share the premises, equipment, personnel and facilities. Strictly speaking, all these facilities need to be segregated, but issues such as practicality and cost factor should receive careful consideration. If it is either impossible or impractical to segregate, allocation on the basis of size of the operations could be considered. However, it would be best that the management of the banks refer to Sharia experts for guidance.
Applicability of Existing Accounting Standards
Some of the current practices and standards which are directly relevant to Islamic banking include:
i. disclosure of accounting policies,
ii. information to be disclosed in a financial statement,
iii. lease financing, iv provisions for potential bad debts.
Disclosure of Accounting Policies
The Disclosure of Significant Accounting Policies is an important standard, introduced by many professional bodies to help in giving a correct reading of financial statements. The adoption of different standards for certain accounting issues gives rise to different accounting effects.
These standards become even more important when these policies affect the position of Sharia principles. Some of the areas where accounting policies usually vary are:
i. the conversion or translation of foreign currencies, including the disposition of exchange gains or losses,
ii. overall valuation policy (such as historical cost, replacement cost etc.),
iii. leasing, hire purchase, instalment transaction and related interest or profit,
iv. depreciable assets and depreciation,
V. investment: subsidiary companies, associated companies and other investments,
vi. methods of revenue recognition,
vii). maintenance, repairs and improvements.
A survey carried out into the accounting standards of ten Islamic institutions revealed that in some developing countries where there were Islamic institutions operating, there were no accounting standards laid down by the accounting bodies. This means that the focus of financial reporting has been left to the discretion of the management of financial institutions, with the result that the emphasis given to disclosure is often minimal.
However, these findings do not apply to BIMB or other Islamic institutions operating in Malaysia, as, when reporting the results of the bank’s operations and its financial position, the bank has to observe both Sharia requirements and the Ninth Schedule of the Companies Act of 1965, which requires the profit-and-loss operating revenue be disclosed, along with the basis on which the income is determined. Also, depreciation must be shown.
The profit-and-loss account must show the amount charged for depreciation in value on fixed assets, goodwill – and the intangible assets – and investments, but it does not require the method or basis of provision to be stated. There is no direct Sharia ruling on depreciation, but for the purpose of providing prudent banking services, BIMB have adopted this standard in their financial reporting.
However, it may become clear as to how the depreciation has been charged when a customer’s deposit is accepted on the basis of the Mudaraba principle and the bank has informed the customer that operational costs can be deducted from the Mudaraba revenue, to be charged at the pre-distribution profit.
There is no Sharia ruling on goodwill either, and as far as the Sharia is concerned, whatever the banks paid is the amount recorded.
Disclosing Information
All information necessary in making a financial statement clear and understandable must be disclosed. The general standards to be observed are given, but in the case of specialised industries such as banking and insurance, the layout and groupings are allowed to vary according to the requirements of each industry and Bank Negara.
As a result, Islamic banks are allowed to vary the layout and grouping of their assets, liabilities and profit-and-loss items according to the requirements of the Sharia and the Companies and Islamic Banking Acts.
Generally, the classification and grouping of information, for the purpose of disclosure requirements are:
i. general items, such as the method of allocating provisions
ii. long-term assets
iii. current assets
iv. long-term liabilities
V. current liabilities
vi. other liabilities and provisions
vii. shareholders’ funds
viii. sales and other operating revenue
ix. depreciation
X. income from investment etc.
Mudaraba and Musharaka financing are quite similar to joint ventures usually carried out by investment banks – conventional commercial banks in Malaysia are not allowed to finance customers through joint ventures, unless approved by Bank Negara. The profit from this form of financing is not fixed, but depends on the actual profit after the account has been closed and the project completed. Neither the Malaysian Companies Act of 1965 nor the Islamic Banking Act, 1983 gives specific directions on these forms of financing. However, the accounting conventions of accrual, matching, periodicity and conservatism are expected to be observed.
Short-and-Long-Term Mudaraba
The profit portion charged by the Bank Islam Malaysia (BIMB) in its financing and investment activities is taken to be equivalent to the interest charged by other banks for income tax purposes.
The recognition of the profit portion will depend on the method used. There are a number of acceptable methods that have been used by financial institutions and banks. The most common one is the sum of digit, constant rate of return and straight-line methods. Applying any one of these methods will enable the bank to prepare the recovery of cost and profit from monthly or quarterly and semi-annual repayments received from customers.
This practice has been accepted by the revenue law in some countries and does not violate the Sharia. As far as presentation is concerned, the standards relating to the accounting conventions will apply. Therefore, the amount to be shown in the financial statement is the total receivable balance less profit portion, which is not due.
Lease Finance
Leasing is defined in Malaysian law as an agreement whereby the lessor conveys to the lessee in return for a fair rent, the right to use a specified asset for an agreed period of time. This definition includes contracts for the hire of an asset containing a provision giving the hirer an option to purchase the asset upon the fulfilment of agreed conditions, known as hire purchase contracts.
There are two types of lease arrangements: finance lease and operating lease. Paragraph 49 of the Malaysian law IAS 17 requires the recognition of income under a finance lease to be based on a pattern reflecting a consistent periodic rate of return on the lessor’s net investment outstanding, and the method should be applied consistently.
In the case of an operational lease, rental income should be recognised on a straightline basis over the lease term, unless another systematic basis is more representative.
There is no Sharia complication as far as the straightforward leasing arrangement is concerned. However, if the profit margin is tied to the interest rate, this is not permitted as it creates uncertainties. The lessees’ total rental payable or the banks’ total rental income now varies according to changes in the interest rate. There is no Sharia restriction with regard to income recognition, or presentation.
However, according to existing accounting standards, with financed leases, BIMB does not record the lease asset as a fixed asset on the balance sheet, but it will be recorded as lease receivable, less the profit margin which is not received.
In the case of an operating lease, the lease assets should be recorded as fixed assets in the balance sheet of the lessor. As such, depreciation for these assets is provided periodically.
Accounting for Foreign Currency Transactions
Reporting transactions conducted, or assets and liabilities stated in currencies, is subject to a number of variations. BIMB translates its foreign currency transactions into the Malaysian Ringgit at the current rate of exchange on the dates of the realisation of the transactions.
However, the assets and liabilities on the balance sheet date are stated at the rate of exchange on the dates of transactions. Gains or losses resulting from these transactions are only recognised when realised, in accordance with the cash basis of accounting. Kuwait Finance House (KFH), Bahrain Islamic Bank (BIB) and the Albaraka Investment Bank (AIB) have adopted the same method for translating transactions into foreign currencies.
In the case of assets and liabilities and the treatment of gains or losses arising from the transactions, the exchange rate current at the year-end date, or the date of the balance sheet is used. Gains or losses are transferred to the profit or loss account. However, some Islamic banks, such as the Faisal Islamic Bank, do not disclose the method at all.
Essentially, the questions to be asked are whether the transactions or assets and liabilities belong to the shareholders’ fund or customer deposits, and if the latter is the case assuming that the deposit is accepted on the Mudaraba principles, the method chosen for translating foreign currencies must reflect the terms and conditions of the contract. For example, using the exchange rate current on the date of realisation for Mudaraba transactions utilising Mudaraba funds, reflects more the terms and conditions of the contract with the depositors.
The gains from the foreign currency translation can be distributed to the depositors as they arise from realised transactions. According to the Shafi school, profit distributed to the owner of capital while the capital is still tied up is not acceptable. Therefore, only related foreign exchange gains can be distributed. As such, the method adopted by BIMB is closer to this view, but this does not mean that other methods cannot be used, in fact, KFH have acceptable Sharia arguments for adopting a different method.
However, the main issue in this case is the fact that the existing standards are not adequate in informing a reader of the Sharia aspects and of their influence on the profit and loss of the balance sheet.
For this reason, new accounting standards may need to be formulated. Any proposed standard must outline the disclosure requirement with regard to the foreign exchange translation, the underlying Sharia principle and the method adopted for the translation.
Provision for Bad Accounts
Prudent and conservative management of the bank’s assets and liabilities is not contrary to the Sharia, so long as the Islamic banks try to be just in their dealing with all depositors.
In the case of bad accounts, however, the bank may have to re-value the account to determine the extent of the loss to be specifically provided for. In line with the real nature of the loss as dictated by the Sharia principle of Mudaraba, and in order to be fair to the bank’s present and future depositors, the valuation is based on the gross realisable value for the account, that is the amount remaining from the outstanding cost of financing, plus the profit expected to be generated from this amount.
The procedure of realising income from monthly or quarterly instalments of the subsequent financing arrangements should be abandoned. Instead, all payments received will be treated in full as recovery of outstanding cost of financing plus all incidental expenses until this amount is fully recovered. Afterwards, all of this income will be credited in full to the profit account.
There is no accounting standard that deals totally with this issue. As it is directly related to the terms and conditions of the Mudaraba contract, it is felt that any existing standard is inadequate to deal with the problem. Thus a new standard encompassing the Sharia as well as the accounting aspect should be formulated, in order to – as with the other recommendations outlined above – to make the Islamic banks’ financial statements more informative and meaningful.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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