Accounting problems of Islamic
banks
Analysis of
The Islamic instruments
Unique accounting problems
• Islamic banks face unique accounting problems both from
a technical point of view and philosophical point of view.
Some of these accounting problems are:
• 1. The ethical accountability requirements (Gambling,
1994;Shahul & Yaya, 2003) ).
• 2. The problems of profit recognition and allocation due to
Islamic banking mechanics (Abdulgader, 1990; Karim,
1998a),
• 3. The inappropriateness of International Accounting
Standards (Hamid et al., 1993; Karim, 1999)
• 4. The hybrid nature of some Islamic financial instruments
(Obiyathullah, 1995; Karim, 1999), and
• 5 Profit sharing
• Abdulgader (1990) studied profit recognition
and allocation problems in Islamic Banks in
Sudan and Egypt.
• His study examined the practices of four
existing Islamic Banks (each of which had
many branches all over Sudan) and found that
the profit recognition and allocation practices
of the three banks were not uniform.
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In the first example, the banks separated the investment account funds from the
shareholders and other depositors’ funds.
In this case, the investment account funds were invested separately, after allowing for
reserve requirements.
This lead to a separate fund account being established for Investment account holders
and accounted for separately from the others.
Hence separate financial statements were prepared for this fund account. Further the
profit were recognised only when the projects were liquidated; implying that the
projects were short-term. After deducting the bank’s share of profits, the depositors
share of profits was distributed to individual depositors according to the amount and
period of the deposit.
In the second case, all funds whether from shareholders, current and savings accounts
and investment accounts were all pooled and invested in various projects. In this case,
the profits earned by the bank excluding those from fee paying banking services were
made proportionate to average deposit in each type of account.
The share of the current and savings account depositors went to the shareholders, as
the depositors were not entitled to any profit. (In the case of Malaysia, the banks
distribute part of this profit as a gift to savings and current account holders).
From the proportion attributable to the investment account holders, the bank’s share is
deducted and the balance distributed to the investment account holders in proportion
to deposit and period held. Except for expenses directly related to investments, all other
expenses are borne by the bank and not by the investment account holders as under the
Mudaraba contract, the bank is only entitled to its share of profits.
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In the second case it was difficult to determine each party’s share in investment and profit as all
funds are pooled. The actual amount of investments for each class of deposits as opposed to the
actual amount of deposits cannot be known.
In calculating the share of profit due to investment account holders, the bank estimates the portion
of the depositors account invested by the following steps on each months’ balance:
1) The actual deposit in each class of account (and shareholders funds available for investment) is
multiplied by the available percentage (100-reserve percent) to obtain amount available for
investment. The reserve ratio is
different for each account. Investment accounts have a lower reserve ratio than other accounts.
2) The actual invested funds for each class of account is apportioned using the amount available per
step 1 divided by total deposits available for investment multiplied by total amount invested in the
month.
3) The monthly amounts are added up for twelve months to get yearly amounts.
4) The total profit is then apportioned to the accounts on the basis of total assumed investments.
The above method, although rational and equitable on the face of it presents some difficulties.
As the investment account depositors are mainly interested in profit as they bear the risk, the above
allocation does not give any preference to this.
Since savings and current deposits in Islamic banks are not meant to earn profits, they should not have a
claim to profits on an equal basis (although in actual fact, profit attributed to these deposits goes to
the shareholders).
• Thus, as in the example from table 5-1 shows, the amount
from the investment account, assumed as invested is only
$53,070/$77228 = 68%, whereas current account deposit
invested is also assumed to be 68%.
• Since investment account holders assume that their
deposits will be invested, it is clear that their funds should
be accorded priority in the distribution of profits.
• Hence in 1985, the Shari’a Supervisory Board of the Faisal
Islamic bank recommended that all investment account
deposits less a liquidity reserve be assumed to be invested.
• Using the new formula, the investment account deposit
assumed to be invested would be £77228 x90%= £69505
(to take account of liquidity ratio of 10% as investment
account can be withdrawn on short notice although not on
demand).
• The amount allocated to current accounts and shareholders
is found as a balancing figure. Hence the profit allocated to
investment funds would be higher.
• Despite this apparent improvement, the profit attributed to investment
accounts will vary between different Islamic banks depending on the
proportion of current and savings account deposits.
• For example, if Bank A has more current and savings account deposits than
Bank B, assuming equal amount of investment deposits, Bank B will be giving
a higher share of profits to its investment account holders.
• Another problem, is although, current and savings account holders expect
no return, the shareholders are effectively using these deposits as financial
leverage in earning profits for themselves without giving anything in return
to these depositors except guarantee of capital. Perhaps, in this case, the
central bank should regulate the Islamic banks and insist on a payment of a
gift to these accounts (after building up sufficient reserves to cater for
losses). This is legal and recommended (and practised in certain countries) in
Islamic law provided they are not predetermined.
• In contrast to the above situation, some Islamic banks do not pool the funds
from investment accounts and treat them as a separate entity. In order to
provide a portfolio instead of matching each deposit to an actual
investment, the deposits are pooled into many projects.
• However, this method is more risky for the depositor because the portfolio
may not be well diversified. In certain banks, limited Mudaraba certificates
are issued which link the securities, issued in fixed denominations for a fixed
period of time, to a particular project. These certificate holders are entitled
to profits when the project is liquidated. They bear all the losses if any.
• This second type of profit allocation where the funds are not
pooled solves the problem of allocating profits between the various
types of depositors. However, it still has the problem of matching
profits because in Islam, the venture has to be realised to return
capital before profit is calculated (Udovitch, 1970).
• Hence, if a depositor withdraws his funds before project is
liquidated, then he will not beentitled to share in the profits. The
problem of capital gains and losses betweenaccounting period also
presents problems as it does in conventional historic cost
accounting. Perhaps a realisable income model (Edwards & Bell,
1961) would be more appropriate.
• Another problem posed by Islamic banks is the nature of
investment and savingsdeposits. Are investment deposit holders,
equity holders? (Karim, 1999).
• Should they have say in the administration of banks (i.e. voting
rights)? It can be seen that investment account holders are neither
a liability nor equity and to classify them as such according to
conventional accounting principles would amount to unfair
disclosure.
• Investment accounts have both the characteristics of debt and
equity.
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They are short or medium term equity holders. Equity holders have longterm
relationship with the banks. They can vote in annual general meetings and take part
in the management of the bank through their directors. By contrast the relationship
of investment account holders vary between short and medium term.
However since they share in the profits and bear all risks associated with their
investment, they should neither be treated as current and savings account holders
nor fixed deposit accounts holders. Perhaps, they should have limited voting rights
like debenture holders, especially in the case of limited Mudaraba certificate holders
to ensure that their interests are taken care of properly.
Investment accounts cannot be classified as current liability as are fixed deposit
holders in a conventional bank. Perhaps a separate balance sheet should be prepared
for them, or they should be shown between equity and current liabilities.
Another problem associated with investment projects relating to investment
accounts is whether they should be consolidated or equity accounted? Presently only
profits received from the projects are incorporated into the accounts.
This isinconsistent with the ruling that Islamic banks are not lenders but managers of
the investment account holders. Conventional banks do not manage the projects
they finance except to monitor periodic reports.
Islamic banks as managers of investment account holders and as partners in case of
Musharaka financing would have to take a more active role in appraising, monitoring
and even directing major decisions in ventures they finance. When they do this, the
problem of consolidating results and assets of financed ventures comes in.
• Karim (1999) observes that, in the application of
funds, most Islamic banks use the murabahafinancing instrument.
• Since the source of financing includes investment
accounts, the profit recognition method used will
also affect profit allocation to these accounts.
• As Karim (1999) notes, there are at least five
different methods of profit recognition used by
Islamic banks in recognising profits in murabaha
transactions where the price of the goods
financed are received in instalments which may
traverse several accounting periods.
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These include:
· Recognising profits in full when customer takes delivery.
· Pro-rata the profits according to due dates of installments.
· Pro-rata the profits according to receipt of the monthly payments.
· At the liquidation of the transaction i.e. on the last payment date and
· Once the capital has been recovered.
Karim (1999) notes that “the use of any of the above profit recognition
methods
affect the returns credited to investment account holders”(p33) as the
duration of the depositors’ investment is generally different from the
duration of the murabaha contract above.
In addition, there is no conventional accounting standard to prescribe the
disclosure of different profit allocation bases (which has been discussed
above) which Islamic banks use to allocate profits between the various
account holders.
Hence, applying conventional accounting standards (e.g. IAS), where they
are available, to Islamic banks will result in noncomparable financial
statements rather than induce comparability as there no standards which
meet the specific Islamic banking requirements.
This is the rationale behind the formation of the Accounting and Auditing
Organisation for Islamic Financial Institutions (Pomeranz, 1997; Karim
1999) which has some accounting and auditing standards for Islamic banks
and Financial Institutions
Capital Adequacy Ratio
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As a result of the recent third world debt crisis, there have been increasing
demands for more capital regulation in the banking industry.
One of the most important measures facilitating this regulation is the capital
adequacy ratio (CAR).
This ratio is a measure of a bank’s risk exposure and is usually calculated by finding
the percentage of capital to total balance sheet assets. The CAR of commercial
banks is an important accounting measure used to assess the adequacy of the
bank’s capital in relation to deposits to cover credit risk
(Llewellyn, 1988). Regulators use the CAR as an important measure of the safety
and soundness on banks as the capital of such institutions is viewed as a buffer or
cushion to absorb losses (Karim, 1998b)
The increasing pressure from regulators to maintain an adequate ratio has led
some banks to adjust accounting measures to reflect a good ratio. Hence,
accounting practices have major implications for this ratio.
The Basle Accord of the Basle Committee on Banking Supervision implemented
since 1992, sets out an agreed framework for measuring capital adequacy and the
minimum standards to be achieved by the representative countries.
The accord is intended to “strengthen the soundness and stability of the
international banking system and “to be fair and have a high degree of consistency
in its application to banks in different countries with a view to diminishing an
existing source of competitive inequality among international banks”.
• The minimum acceptable Capital Adequacy Ratio (CAR) according to the
Basle Accord is 8%.
• The majority of countries in which Islamic banks operate have taken steps
to introduce the Basle framework. However because the framework of
Islamic banking is different, the Basle framework geared for conventional
banking cannot be applied as it would lead to Islamic banks not meeting
the requirements, although this would not imply any more credit risk than
conventional banks.
• As Karim (1998) observes, only share capital and reserves attributable to
them would be considered as capital. Islamic banks issue neither
preference shares nor subordinated debt as they contravene the Shari’a.
Since current account holders of Islamic banks are not entitled to any
return, the revenue generated from them is exclusively the right of the
shareholders. The investment account deposits cannot be considered as
equity or liability but a unique type of Instrument which gives the
depositors right to share in the profits but bear all the losses. Hence, since
both deposit accounts are not paid a predetermined return, they do not
constitute a financial risk to the bank as (in the case of investment
accounts) all the losses can be passed on to the account holders. Although
the
• shareholders funds would have to bear the losses of capital on
investments from current account deposits, the risk of loosing the capital
is much less than loosing both capital and the pre-determined interest
which must be paid to conventional bank account holders.
• Karim (1998) illustrates this point through four possible scenarios,
each depending on the way investment accounts are treated by
Islamic banks and regulatory authorities:
• In scenario 1, Investment accounts are added to the core-capital
(tier 1). This would increase the CAR and help Islamic banks follow a
strategy of attracting high investment accounts and low equity
capital, as Islamic banks do not share losses only profits from the
investment account fund invested. If the amounts of deposit
accounts were restricted in the calculation of capital, the bank
would be forced to pursue a strategy of raising equity and
restructuring its assets to more safe areas like Government
investment certificates.
• Scenario 2, which allows for deduction of the investment accounts
from the risk weighted assets would similarly increase CAR and
compensate for assets with high-risk weightings. Here, shareholders
continue to encourage investment accounts compared to savings
accounts.
• In scenario 3, investment accounts are added to Tier 2 capital
element. In this case, since tier 2 capital is restricted to 50% of the
total of tier1+tier 2 capital, this would mean that when investment
accounts equals equity, there is no benefit to the CAR calculation.
This would mean, after this threshold, Islamic banks would have to
raise shareholder equity.
• In scenario 4, no adjustment is made to the CAR calculation in
respect of investment accounts. Islamic banks with CAR below 8%
would have to increase their shareholders equity as the use of
investment accounts confers no advantage in the calculation of
CAR. Another way out would be to restructure their assets to
include lower risk weighted assets. Given the nature of Islamic
financial instruments, Karim (1998) observes that the latter option
would be more feasible in an Islamic bank given the nature of
financial instruments used by Islamic banks.
• Although it is up to regulatory authorities of the various countries
to adopt the appropriate rules, Central bankers of Muslim countries
with their conventional economic and banking training seem not
too creative in this matter.
• In the case of Sudan (Abdelgader, 1990), the Central Bank wrongly
subjected the funds of investment accounts to their credit ceiling
targets meant to control consumption credit and inflation.
Investment accounts, of course, were meant to finance long term,
high return investments. Since the Islamic banks could not invest
most of the funds, profitably it stopped accepting investment
deposits altogether, defeating the purpose for which the bank was
set-up.
• Karim’s (1998b) analysis, although constructive and insightful,
nevertheless only skimmed the surface of the implications of the
Basle convention for accounting of Islamic banks. His analysis is
limited to the financial strategy of shareholders in leveraging the
use of investment accounts.
• It does not analyse the CAR standards implication for the
investment strategy in terms of achieving the investment objectives
of Islamic banks i.e. to substitute profit-sharing contracts for risk
based contracts which would bring about the theorised objectives
of Islamic banking.
• As already indicated, one of the problems of the Islamic banking is
that Islamic banks have opted for the easy use of credit-based
Islamic instruments (murabaha) which do not change the basis of
Islamic banks from conventional counterparts to any large degree
(Abdelgader 1990; Ahmed, 1994b). An appropriate indigenous
Islamic capital adequacy ratio standard could have a marked
difference in increasing both investment accounts and more profitloss financial instruments.
• For example, if investment accounts could be added to the core capital or
deducted from total risk weighted assets, (scenario 1 and 2), this could
increase the promotion of investment accounts. Further as the Islamic
banks do not bear any losses arising from the loss of investment deposits
(except arising from negligence), the investment account investments (not
deposits) could be deducted from risk weighted assets or given a 0 or low
risk weighting depending on the nature of the instrument. A reverse risk
weighting score could be given.
• For example, musharaka and mudhraba investments would be given a
lower risk-weighting then those used for murabaha or ijara investments.
This would increase CAR and at the same time encourage Islamic banks to
manage their portfolio carefully, as their earnings will depend on high
return / high-risk investments. This is so because banks earn only a share
of profits and cannot charge expenses to the investment account deposit
holders except for direct expenses. Hence this is one way, an appropriate
Islamic financial standard based on an accounting number could induce
behaviour towards attaining Islamic objectives.
• Another instance would be to consolidate the investments at current
costs. Since Islamic accounting seems to favour current values (Clark et al.,
1996; see also this would reduce CAR. However, if the bank’s share of
unrealised capital gains is added to capital and the current value of
investments (from the investment account funds) were excluded from the
risk weighted assets, this would boost CAR, encouraging such investments.
• A development from this would be an
Islamicity” ratio computed using an inverted
risk weighted value of assets.
• The higher the ratio, the higher the Islamicity
of financial instruments used and would give
the user an indication of the extent to which
the Islamic banks are using the funds in profitsharing instruments and other social areas in
which it should be used.
Confounding International Accounting
Standards
• The accounts of Bank like other business organisations are increasingly
subject to both national and international accounting standards, which are
increasingly being globalised in the form of International Accounting
Standards. Unfortunately, recent studies on the cultural impact on
national accounting systems seem to be motivated only towards removing
non-European and non-American impediments in the way of international
harmonisation of accounting (Hamid et al., 1993).
• The researchers do not contemplate that harmonisation may entail
imposing Western and European accounting practices and the theories
behind them upon nations whose commercial and accounting practices
are based on alternative ethical or cultural paradigms. Thus:
“But the focus has been more to identify what practices and
underlying theories have to be changed to fit into the Western
paradigm, rather than to discover whether those not
conforming to it might give insights to alternative, theoretically
defensible accounting processes”.
(Hamid et al., 1993, p132)
• This may not only distort international comparison (see for example, Choi et al.,
1983) but also upset the socio-economic balance of the recipient countries.
• Hamid et al. (1993) observes that although, harmonisation is pursued under the
pretext of transporting developed accounting practices to countries with lesser
developed practices, such ascription of development to the West, commits
theworld to a dominant allegiance to Judaic-Christian influences and ignores
traditions founded in Eastern philosophies.
• Thus, any implications of accounting being required to conform to the
philosophies underlying Islam, which transgresses national boundaries, for
example, are dismissed without enquiry. Islamic banking in particular only
permits financial support and offers banking facilities to Islamic compliant
businesses. One could therefore reasonably presume that the prevalence of
stricter Islamic banking would lead to higher business compliance with Islamic
principles. This would in turn increase the need for an alternative Islamic
accounting to meet the needs of these organisations.
• Hamid et al. (1993) further argues that the prohibition of riba, which is the
cornerstone of Islamic banking has important implications for the
harmonisation of accounting procedures as implementing international
accounting standards entail enforcing many accounting procedures where
interest based calculations are essential.
• For example, standards on pension benefits (SFAS 87 & 88), amortisation of
long-term debt (APB 12), lease capitalisation (SFAS 12), interest on receivables
and payables (APB 21) and their International Accounting Standard equivalents
all invoke discount calculations based on the time value of money.
• Karim (1999) also point out many problems of using International
Accounting Standards for Islamic banks. For example, many Islamic
Banks use murabaha financial instrument. In this cost plus contract,
the Shari’a imposes the condition that the bank must possess the
title to the goods before delivery to customer.
• The purchase order made by the customer may or may not be
binding on him.
• Hence the valuation of such stocks is a problem in the accounts.
Should the bank value at lower of cost and NRV as per current
accounting standards or at current market value as per Zakat
accounting requirements.
• IAS’s do not have any standards to deal with the status of
investment accounts, as they are neither equity nor debt in the
conventional sense. There are also no disclosure requirements to
disclose the bases of profit allocation between shareholders and
investment account holders. The use of different methods by
different Islamic banks has resulted in the incomparability of their
performances.
• Profit recognition difficulties have already been alluded to in the
section 5.5.1. The adoption of IAS would not make the Islamic
banks accounts comparable but might achieve the opposite effect.
• International Auditing Standards also do not provide for the
idiosyncrasies of a Shari’a Review or audit which is required of
Islamic banks. Neither do they provide guidelines on the
qualifications, independence and competence of Shari’a Auditors or
Shari’a supervisory board of Islamic banks. It is no wonder that
Muslims have come up with their own alternative to the IASC in the
form of the Accounting and Auditing Organisation for Islamic
Financial Institutions (AAOIFI).
• This organisation has issued two Financial Accounting Concepts
Statements, ten Financial Accounting standards and five Auditing
standards for Islamic banks (Karim, 1999).
• The organisation has also issued exposure drafts on Shari’a Audit,
and Islamic Insurance Company disclosure standards.
• If the current Islamic resurgence permeates Islamic businesses,
then there is definitely a need for the development of Islamic
accounting and an International organisation to develop Islamic
Accounting Standards for all Islamic organisations. Perhaps, the
AAOIFI will evolve into such a body.
Non-Financial Disclosure
• While, the technical problems associated with
accounting for Islamic banks have been emphasised
and the AAOIFI been established to deal with it, it
should not be forgotten that Islamic banks are much
more than institutions which avoid interest.
• All business and non-business Islamic organisations
have Islamic ethics as their founding basis.
• As such these institutions must account to their owners
and other stakeholders as to the extent to which they
have complied with the ethical dictates.
• This involves non-financial as well as financial disclosure. Khan (1994a)
observes that an Islamic bank would have to disclose:
• (i) The avoidance of prohibited transactions.
• (ii) The extent to which their activities have contributed to the economic
and
• social development of various poor sectors of society by offering financing
• and interest-free loans to for example, farmers and small traders.
• (iii) The ethical standard which they have reached in the treatment of
• employees and depositors and entrepreneurs.
• (iv) Segmental information on the financial instruments used and the
efforts
• made by the bank to move away from interest-like instruments such as
• murabaha.
• (v) The extent to which they have safeguarded the environment and
• conserved energy.
• (vi) The collections and disbursement of Zakat from the bank’s operations,
• and
• (vii) The social and the religious contribution to local community
• Conventional accounting places emphasis on financial outcomes,
thus conventional accounting users (e.g. shareholders) may switch
to debt financing when economic conditions make debt financing
attractive.
• They also may switch to other business activities, which promises
the best financial returns to them.
• However, as Hamid et al. (1993) notes, whether equity or debt
financing promises the best financial returns to owners or
managers, is not the motivating factor in Islamic commerce
undertaken according to the Islamic tradition.
• Instead success in the hereafter by following God’s commandments
in economic transactions on earth would be the foremost thought
of Muslim users.
• Hence Islamic accounting would provide information which ensures
their confidence in the integrity of Islamic banks and other
organisations. It should provide assurance that the organisation has
invested their money within the constraints of the Shari’a, no
exploitation or injustice has been done to any quarter and their
money has made a contribution to uplifting the community.
Conclusion
• In this chapter, the objectives of various forms of Islamic organisations,
their discussed. The development and operations of Islamic banks were
discussed at some length to emphasise the different paradigm of Islamic
business.
• Hence, the discussion of the accounting problems related to different
financial instruments, profit sharing and the problems of imposing
international banking, accounting and auditing standards on Islamic is
meant as an example of the differences and difficulties Islamic
organisations pose for conventional accounting.
• It is hoped that this has demonstrated the practical need for the
development of Islamic Accounting Islamic accounting as can be seen from
this chapter, is not only a matter of modifying conventional accounting to
fit the needs of Islamic institutions- a major overhaul is called for.
• It is not a matter of extrapolating the conventional accounting principles
to specialised entities e.g. in the case of accounting for plantations,
insurance companies or space exploration.
• The different philosophical assumptions underlying Islamic organisations
and their different operating mechanism, some of which find no parallel in
the conventional business and accounting practices, suggest a more
radical accounting
• Benefits of an Islamic Accounting System for Islamic banks and other
organisations would include:
• · Motivating employees, shareholders, managers and participants to be
• accountable to society and God and to take a pro-active role in ensuring
ethical economic activity instead of motivating them through higher
financial returns to increase their greed and material possession.
• · Ensure the accountability of Islamic organisations to their stakeholders and
thereby ensuring the accountability of Muslims to God in their economic
activities.
• · Ensure the specific socio-economic objectives for which Islamic
organisations have been established are achieved and to disclose the
reasons why they are not. The holistic nature of an Islamic accounting
system would not deflect the users from their ethical objectives as
conventional accounting, by concentrating on the financial return, might do.
• · The development of Islamic accounting and auditing standards would in
time ensure comparability between different organisations which would
promote the allocation of resources (financial, manpower, government
support) to those organisations which better promote the interests of
Islamic societies.
• From the above, it can be seen, that Islamic organisations can benefit
immensely from the development of an Islamic accounting system. Failure to
develop one, on the other hand, may contribute to their failure