ACCOUNTING STANDARDS IN ISLAMIC BANKS
TREVOR GAMBLING
Under the aegis of the Accounting and Auditing Organisation for Islamic Financial Institutions, the Financial Accounting Standards Board for Islamic Banks and Financial Institutions (FASBIBFI) has produced an accounting standard entitled The General Presentation and Disclosure Standard in the Financial Statements of Islamic Banks and Financial Institutions.
At the same time, it has brought out a Statement of Objectives of Financial Accounting for Islamic Banks and Financial Institutions and Statements of Concepts of Financial Accounting for Islamic Banks and Financial Institutions. It is the first document which contains the Statement of the Standard, which is a clearly-written listing of what such accounts should disclose, but provides no explanations for what is advocated therein.
The reasons for drawing up the Standard and the legal and religious considerations which underlie its contents, are summarised in the three opening sections of the Standard document, but these are set out in full in the two other documents. In short, the Statement of the Standard is in many ways the least significant of the three.
This is true of the other series of accounting standards that have been undertaken in various parts of the world. It is necessary to understand the objectives and concepts that underlie the bald statements of the Standard, to be able to apply them to the very varied situations that must arise in practice.
It might seem odd that so much philosophical material should be needed in order to apply such outwardly mundane recommendations, but accounting is not what it seems. Accounting appears to be a straightforward if tedious process of recording monetary transactions, and summarising these records in a significant fashion, as final accounts.
One would suppose that the accounts of an Islamic bank could be expected to provide a satisfactory standard of performance, in the same way that this is expected of its computer systems, or its buildings.
But financial reports are not a product or a service which is “used” in a way which permits the evaluation of the outcomes of that use, and hence the development of purely utilitarian standards of construction. To date it has been impossible to find a statistically significant relationship between the emergence of accounting information and the stock price of the entity concerned. Nor does it seem possible to describe the physiology through which human beings process financial information.
Many attempts to do these things have been made (and continue to be made) by both academics and investment analysts. Apart from any other benefits, if it were possible, the first person to work out the sums after the publication of a company’s results could make a lot of money on the Stock Exchange!
Accounting standards therefore must be normative; a matter of what is seen to be “sensible” and even “right” and ‘just”. Hence the philosophical background needed to put them into practice. The arguments against allowing a choice of alternative presentations of the entity’s affairs flow from a conviction that a financial position is an artefact to be used in some specific ways, like a computer system or a building. It would follow that to permit a multiplicity of acceptable presentations must be contrary to “the public interest”, if only because their use would not produce the expected out-turns.
Questions as to what people ought to be getting from financial reports and what should be done about them in the public interest eventually reduce to matters of moral choice – involving a view of the nature of the universe, the nature of man and the nature of justice.
An interesting monograph produced for the American Accounting Association sets out the difficulties in arriving at such choices on the basis of some idea of natural justice, as opposed to the moral teachings of revealed religion. Such approaches tend to endorse situational ethics, and hence the acceptability of alternatives.
Nevertheless, accounting is an activity that is so fundamental to the human condition that some of its standards seem matters of common sense, as opposed to deliberate cognitive choice. However, the fact that we rarely if ever consider any alternative to a standard does not prevent it being normative. I will attempt to distinguish at least four levels of normative standards in accounting, and show their relevance to the Statement of Standard which has been developed for Islamic banks by the FASBIBFI.
The Primary (intuitive) Standards of Accounting
1. The basic building blocks
For a start, we have to assume that it is possible for an entity to exist which is at once smaller than the community-at-large, and distinguishable from the individual or individuals whose transactions are the subject of the account.
The morality of this proposition might seem dubious to some Muslims, because Islam does not recognise any division between public life and private life. Is it right to account for the business transactions of an individual or a group of individuals, as a separate entity from their private transactions? (Is it even possible? British insolvency law doesn’t do so.)
However, the Sharia commends the employment of one’s wealth in trade, and the FASBIBFI “concepts” cover this issue by citing numerous instances where a fiqh specifically justifies both corporate and unincorporated trading and accounting, and even (in some circumstances) the concept of limited liability.
Again, we assume that the transactions themselves are truthfully described. An honourable accountant would not knowingly prepare misleading financial statements, or certify that they were true and fair. He or she does well to avoid these things, because they will almost certainly constitute the crime of “false accounting”.
This is defined in the British Theft Act of 1988 as preparing or issuing misleading financial statements with intent to deceive for gain. Nevertheless, it happens. When firms of auditors are sued by clients or third parties for professional negligence (or even arraigned on criminal charges), it is usually for failing to detect (or denounce) false accounting, rather than for giving an unqualified audit report to a set of accounts which did not conform to the appropriate Financial Reporting Standards.
In a recent and typical American case, a firm of automobile repairers, who were about to sell their business, inflated its profits and assets by simply billing customers for work that had already been paid for by insurers. The auditors failed to make an adequate check of these receivables, despite the fact that the firm had paid a fine for being detected in several of those instances.
National and international financial reporting standards take it as read that the accounts have been prepared honestly, without intent to deceive, and confine themselves to those areas where honest differences of opinion need to be resolved. Accordingly, some found it odd that the exposure draft of the FASBIBFI standard used the word “misleading” in several places in its preface.
A member of the Executive Committee responsible for the draft expressed formal reservations about this usage, which he felt might lead to misunderstandings, and could be taken as an insult to the integrity of the Islamic banking community in general.
On the other hand, it may be appropriate to spell-out this assumption in the case of Islamic bank reporting, since the raison d’etre for this form of banking is the desire for an absolute standard of purity on the part of those who invest in them.
The standard of truthfulness adopted by many who consider themselves to be honourable accountants is often less than absolute: they think it sufficient to avoid making statements which are positively misleading, and otherwise to comply with the law of their country and its accounting standards. They do not consider it improper to omit information which may be relevant but which is neither required by law nor specifically asked for by the recipient.
But even non-Islamic law recognises a higher standard of truthfulness than this: the information in a contract of insurance is given ‘in utmost good faith”, and must include all relevant matters. It would follow that the appropriate objective for a Muslim accountant should be this standard of absolute transparency, rather than mere observance of the letter, or even the spirit, of such laws and standards as may be in force.
2. The Basic Techniques of Constructing Accounts
Published, cognitive accounting standards rarely if ever make specific recommendations with respect to basic concepts of accounting, such as comparability, reliability, objectivity, consistency, valuation on a going-concern basis and the like. These concepts are plausible, and are usually described as the axioms which underlie “the conceptual framework of accounting” – but as always, it is not easy demonstrate what utilitarian benefits flow from their observance.
However, they do have moral virtues. Generally, these concepts are concerned with ensuring the stability and universality of accounting statements over time and distance. Since Islam is opposed to “situational ethics” and insists that common God-given standards of behaviour must apply throughout human activity, these concepts must always be a part of the accounting standards for specifically Islamic business activity.
These first and virtually subliminal levels of “accounting standards” have been applied, if not codified, from the earliest beginnings of accounting. By contrast, those codes of financial reporting standards which are set at cognitive levels are of much more recent origin, and deal with more advanced areas of financial reporting.
The best-known series of standards, the familiar pronouncements of the British ASB, the American FASB, and the lASC do not say anything about bookkeeping or the preparation of final accounts as such. However, there are other standard-like codes which do lay down rules for the recognition of income or expenditure, prescribing what nominal ledger accounts should be maintained and how these should be presented in the final accounts.
3. Mandatory and Voluntary Standards of Practice
These are usually called accounting regulations rather than accounting standards, and are to be found in most countries. The idea of “uniform accounting” was first propounded by the French “physiocrats” in the eighteenth century of the Christian Era. The British Companies Act 1985, is the latest in a line of such legislation in this country, and now reflect the contents of the accounting directives of the European Union.
This element of uniformity in accounting is necessary in order to produce meaningful statistics for the purposes of national and regional economic planning. It is also essential where regulators, or even trade associations, are concerned with the pricing policies of organisations such as public utilities, public transport and so on. The regulations extend the axiomatic concept of comparability from being an internal matter for a single entity, to requiring comparability between entities.
The regulations also set minimum standards of record-keeping, reporting and disclosure within their jurisdictions. Those who handle other people’s money have a moral duly to account for their stewardship. The Qur’an specifically commends the keeping of formal records of business transactions, and orderly business communities can hardly function in their absence.
In addition, modern reporting standards usually contain regulation for the non-monetary content of financial reports. Some of this material comprises “notes to the accounts” on the accounting principles being adopted and so on, and additional statistics on matters like employment, export sales or contingent liabilities. But there are also requirements for purely narrative reports to supplement and explain the accounting results.
A “standard” for this last type of material is inherently problematic; the reason for requiring the narrative is basically that the monetary results are too hard-edged to convey the whole picture of the entity’s affairs. Without standards, these reports tend to be imprecise and anodyne. Attempts to specify what such a narrative should contain elicits one- or two-line paragraphs of defensive “boiler-plate” text.
Not all “standards” of this type are mandatory. Non-mandatory examples are called “Statements of Recommended Practice” (SORPs), or something like that. The FASBIBFI “Standard” is such a SORP, containing recommendations for the uniform presentation of the financial reports of an Islamic bank. It is not legally enforceable, but it is the hope of those who have prepared it that states will adopt all or part of the material as accounting regulations which are mandates for such banks within their jurisdictions.
These regulations or recommendations are rarely the subject of controversy, since they merely require the disclosure of facts about the reporting entity. Objections arise when it is thought that the requirements place too great a burden on the preparers of accounts, that the information demanded is of a confidential nature, or that its disclosure would give an unfair advantage to competitors.
Another reservation expressed by a member of the FASBIBFI Executive Committee was that other, secular, banks were not required to give some of the information set out in the Standard. Here, too, the reason for the greater disclosure may be the desire of Islamic institutions to adopt the very highest standards of transparency, even at the cost of some commercial disadvantage.
4. A true and Fair View
Finally, there is a level of financial reporting standards whose aim is to secure the presentation of “a true and fair view” of the reporting entity’s affairs, if need be, at the expense of some degree of uniformity.
These are of much more recent origin: the movement commenced about 1900 AD, with the creation of schools of business administration at various American and British universities, which sought to develop “scientific” theories of business and administrative activity. However, its principal impetus came from the crash of the NYSE in 1929 AD, which was partly, if not altogether correctly, attributed to inadequate presentation of company accounts.
The problematic nature of contemporary corporate reporting is well illustrated by a major British criminal case of 1932 AD. A company that was about to make a further issue of shares had made a trading loss. However, this was set-off against a much larger credit arising from an excessive provision for tax in earlier years, and the resulting net figure was described as “Balance on profit and loss account after adjustment for taxation.” The chairman of the board of directors and the company’s auditor were arraigned on charges of fraud.
This would be an open-and-shut case today, if such a method of presentation were still permissible – which it is not. But in 1932, defence counsels were able to call on the senior partners of most of the major firms of accountants to testify that this procedure was quite normal. It was called reserve accounting, and it was felt to be the duty of directors to “smooth” the flow of the reported profits as far as was possible.
It was believed that such presentations led to stable stock prices and that this was beneficial to both the company and its shareholders. The current view is that everybody’s best interests will be served if companies disclose the lumpy nature of their streams of income in considerable detail. Again, it is not easy to demonstrate the superiority of either view, and this explains why this type of accounting standard has been the subject of unresolved dispute for more than sixty years.
Moreover, an Islamic bank, or indeed any business, which claimed to be specifically “Islamic” would choose to ignore a secular standard which contravened the Sharia. It could conform to such standards by disclosing, by way of a note to the accounts, what would have been the result of applying them; the business would also have to accept a qualification to that effect in its auditor’s report.
Islamic Banking and Accounting Standards
The FASBIBFI standard sets out a comprehensive recommendation for the presentation of the financial reports of an Islamic bank, and has virtually nothing to say at this philosophical level of “truth and fairness”.
In many respects, it does not need to do so, because such banks already exist in environments which provide local banking regulations, uniform accounting regulations – and general accounting standards as well, if only the International Accounting Standards. In fact, this standard touches upon at least one issue of “truth and fairness” which is the subject of a (secular) accounting standard: the treatment of Restricted and Unrestricted Investment Accounts, in the light of the British FRS4 on Capital Instruments.
The curiosity is that FASBIBFI presents such issues in the same legalistic form as its straightforward regulatory material. It offers no philosophical justification for its stance on Investment Accounts, but only a theocratic one.
This may be because Islam has no theology as it is understood in other religious faiths: it is seen to be pointless to attempt an anthropocentric rationalisation of the Will of God. What Man has to do is to obey God’s Laws as revealed to him in general terms in the Qur’an, as expounded by the Prophet.
The normal processes of legal argument are then deployed to apply those general principles to particular issues – such as how to present the financial statements of a bank. Hence Islamic accounting standards can only enjoin obedience to whatever the Sharia directs with respect to the activity in hand, and total transparency in reporting to the public on what has been done.
It will be useful to list those features of Islamic banking which distinguish it from secular banking, and then see how these applications of revealed Truth (or dogma) are reflected in the detailed prescriptions of the Standard.
Accounting for the operations of a secular bank is a comparatively easy matter. The bank assembles a fund of cash from its own shareholders, accumulated profit and loans from depositors in the bank. These depositors are creditors of the bank, whose claims have priority over any repayment of capital to the bank’s shareholders; they are rewarded partly by being allowed subsidised banking facilities, but also by payments of interest, which are, of course, part of the bank’s expenses.
This fund of cash is advanced to borrowers through much the same products as those of Islamic banks, with the important exception that a secular bank’s charges to its borrowers almost always include the payment of some element of interest.
It follows that the question of which depositor’s money goes to which borrower is never a matter of concern, because both the reward of one and the charges of the other are largely in the form of fixed rates of interest and so independent of each other.
For the same reason, there is no problem should either choose to reduce their financial involvement in the bank or terminate it altogether; their interest charges reflect what was outstanding over the relevant period of time.
Finally, a major objective of the regulation of secular banks (and all banking regulations follow the secular model) is to ensure the total security of their depositors’ funds. This involves limits on the gearing or leverage of banks, which is to say the relative amounts of their shareholders’ equities and the depositors’ accounts. There are also required profiles for the liquidity of the bank’s assets.
Things are ordered very differently under an Islamic system in a number of ways.
a) An Islamic bank is financed by its share capital and accumulated profits, but its depositors are not creditors of the bank. Their claims are to be shown as equity capital – but distinct from the equity capital of the bank itself. Their equity is in the various advances made by the bank, in which the bank may or may not have ventured its own shareholders’ capital and reserves.
It would be hard to accommodate such arrangements with other accounting standards such as the British FSR4, which seeks to analyse capital instruments between shareholders’ funds, minority interests and liabilities.
The recommended accounting treatment in the FASBIBFI Standard for Unrestricted Accounts is akin to that of group accounts, where the depositors are the “minority”, and there is no “group of companies”, but just a bank, its depositors and its borrowers – in a relationship which lies outside non-Muslim experience. Nor would what happens here square too well with the increasingly involved requirements for group accounting.
(It would not be acceptable for depositors to make Islamic loans to the bank in return for a share of the bank’s overall profit or loss, which would then lend them on as Islamic loans to its borrowers. This would contravene the doctrine of Khalifa, whereby people are held accountable as God’s Regents on Earth for what is actually done with their wealth.
This Islamic view of personal responsibility and the need to accept one’s share of life’s risks was formerly general to Muslim, Christians and Jews alike. “The rise of Capitalism” led to its abandonment in favour of arbitrary methods of engineering the allocation of risk between the providers and the users of capital.
In recent years, this process has generated some very extreme forms of financial instrument, of which derivative securities are one example. One must wonder whether some re-assessment of the concept of equity investment might resolve the difficulties which arise from such instrument, in accounting and elsewhere.)
b) Th e situation is complicated by the possibility for depositors in Islamic banks to restrict the range of customers to whom their funds are to be advanced, and restrict or completely inhibit the mixing of the bank’s funds with their own. The effect is much the same as with accounting for charities, and requires the establishment of a general fund and number of additional restricted funds, all requiring separate treatment.
c) Moreover, the extent to which the bank has no financial interest in the advances, or only a minority interest, weakens the analogy with group accounting; the depositors clearly form a syndicate, in which the bank has at most a minority interest.
In these circumstances, the bank is merely acting as a broker or agent, who sets up and administers the syndicate for a fee, and it is thought inappropriate to carry either the deposits or the corresponding assets in the balance sheet of the bank itself Instead a Statement of Changes in Restricted Investments is to be given as a separate item in the financial report of the bank.
d) The withdrawal of deposits and the closure of accounts is also a problem for Islamic banks. The depositor’s profit (or loss) is determined by the outcome of ongoing lending transactions and cannot be known until some future date. Strictly, one would need to determine the currently outstanding advances whenever such a reduction or closure occurred, and pay or demand adjustments over the remainder of their terms. The Standards requires a statement setting out the methods used.
e) The giving of alms is one of the Pillars of Islam, and while this duty is incumbent upon the individual shareholders and depositors of the bank, the rather difficult and technical natures of their holdings may make it preferable for the bank itself to work out what is appropriate, deduct it from their accounts, and disburse it.
The laws of the country in which it operates, or its own internal regulations may require a bank to maintain a Zakat account to handle the mandatory wealth tax due on certain parts of Muslims’ assets. This is to be applied to the relief of poverty.
f) In addition, Muslims have a duty to improve their social and physical environment, and the bank may establish a Qard fund for that purpose. This is used to give loans, etc., on beneficial terms to worthy objects.
g) An essential feature of an Islamic bank is the appointment of a religious Sharia Supervisory Board or a Sharia Supervisor, to ensure that the bank’s products conform to Islamic law. The nature of these arrangements is among the basic administrative information which must be included in the bank’s financial reports.
h) A further problem for Islamic banks is what to do with any commissions or profits which it may receive or expenditures it may make as a result of inadvertently investing in activities which are forbidden by the Sharia, such as trading in pork products. These receipts, etc., are themselves unclean, and Muslim depositors want to be reassured as to how they have been disposed of. A note of such items has to be appended to the accounts.
i) Finally, the depositors’ capital in an Islamic bank is not secured as against the shareholders of the bank. The appropriate proportions of any losses are charges against the relevant deposits. The need to conform to regulations designed to safeguard depositors in secular banks commonly requires Islamic banks to maintain larger shareholders’ equities and higher levels of liquidity than they may need, without enhancing the security of their depositors’ accounts.
The Standard requires considerable amounts of detail about the terms and maturity of the Investment Accounts and assets of the bank to be shown by way of notes to the accounts. They are also required to set restrictions which regulators may impose on the types of business that the bank may undertake.
(This lack of security for depositors rather subverts a major objective of conventional banking regulation, and induces some regulators [such as the Bundesbank] to claim that such Islamic banks cannot be “real” banks at all, but rather a form of investment trust company.)
Conclusion
It can be seen that axiomatic accounting and normative accounting regulations fit rather well with the general Islamic ethos of a universal law that is applicable under all circumstances. Truth and fairness in accounting are equally acceptable, although Muslims will find it impossible to conceive how this could be achieved outside the Law.
Although the Sharia rules on morality were largely identical with those of Christian Canon Law and the Laws of Moses, until well into the Middle Ages, they have now grown apart. This is especially so in matters of business morality, where only Muslims still try to observe the old requirements for personal responsibility, personal involvement and an equitable sharing of risk.
Both accounting legislation and quasi-legislation, and accounting theory have developed to accord with secular ideas of business practice. An Islamic financial institution is unlikely to be able to conform to their requirements in at least one respect: the possibility that a “customer” could actually have an equity interest with full exposure to commercial risks, but in respect of a part only of the institution’s undertaking.
Secular thinking would wonder how it could be possible for someone exposed to equity risks not to have voting rights of some kind in the organisation. In fact, they must rely on the basic Islamic ideas about Shura (consultation); the management of an Islamic bank will take very full account of its depositor’s comments and suggestions.
Current European ideas about supervisory boards could perhaps be extended and strengthened to accommodate Shura, and also the authority of the Sharia Supervisory Boards as well. A lesser problem might be that British company law at least does not permit the redemption of ordinary shares, except on winding-up or by order of the Court. A solution might be to permit such redemptions, so long as there is one class of ordinary share, controlling the whole of the company’s undertaking, which cannot be redeemed in the ordinary way.
As current possibilities for risk-sharing become more and more exotic, it may be that the solution to their control lies in a better appreciation of the nuances of the earlier ideas about equity interests in business activity, and how they might be incorporated into current thinking and legislation.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
Comments
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.