FN 6103
Accounting for Islamic Financial Transactions
The basic principle
 O ye who believe! Fear Allah, and give up what remains
of your demand for usury, if ye are indeed believers. If
ye do it not, Take notice of war from Allah and His
Messenger. But if ye turn back, ye shall have your
capital sums: Deal not unjustly, and ye shall not be
dealt with unjustly. (Al-Baqara,2:278-279)
Islamic Economic and Financial
System and Riba.
 The Islamic economic system aims to achieve social justice from a
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religious ethical perspective.
Although the Western economic systems whether capitalist, socialist or
welfare state, aim to achieve human welfare, they all seem to have
accepted interest as a fair reward for capital, although interest has been
condemned by Western thinkers such as Marx.
The Islamic economic system is based on its complete elimination from
the economy by introducing the alternative of participative investment
as opposed to a rentier economy.
The capitalist system strives to attain human welfare through the
operation of the invisible hand driven by self-interest and a free
market. The Marxist system attempted to create social welfare by
ownership and centralisation of the production function by the state
(representing the workers).
However, all these systems have been ‘unsuccessful’ in achieving social
welfare for all (Chapra, 1992).
There is no complete Islamic economic system in operation, the unique
characteristics and features of the Islamic economic system are worth
discussing in order to better understand the philosophy under which
Islamic financial institutions operate.
The objectives and characteristics
of the Islamic Economic System
 Ahmad (1994a) observes that the Islamic economic
program includes
 a different concept of the individual and his rights,
 a different concept of property and
 a different approach to civil and economic contracts.
 Its principles of economic organisation are also different
including;
 how and on what basis co-operation and collaboration
between individual and
 society is to take place,
 the need for regulating the market to attain efficiency and
equity,
 and the role of the state in the fiscal system.
The objectives and characteristics
of the Islamic Economic System
 Al-Faisal & Ali (1996) sum up the principal characteristics of the
Islamic Economic System as follows:
 Although every individual has a right to seek his economic well
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being, Islamic makes a clear distinction between what is lawful and
what is unlawful in the pursuit of economic activity. Broadly, Islam
forbids all forms of economic activities, which are morally or
socially injurious. The particulars as to what is considered morally
or socially injurious vary from the secular capitalistic system.
Although Islam recognises, the ownership of legitimately acquired
wealth, the individual is obligated to spend his wealth judiciously
and not to hoard it, keep it idle or squander it.
Although an individual may retain surplus wealth, Islam seeks to
reduce the margin of this surplus for the well being of the
community as a whole.
It seeks to prevent the accumulation of this wealth in a few hands to
the detriment of the society as a whole through its law of
inheritance
It aims at social justice without inhibiting individual enterprise
beyond the point where it becomes not only collectively injurious
but also individually selfdestructive.
The objectives and characteristics
of the Islamic Economic System
 Chapra (1992) observes that in line with the Islamic concept of brotherhood and
justice, all resources at the disposal of human beings must be utilised to actualise the
objectives of the Shari’a. He suggests four objectives of the Islamic economic system:
 Need fulfilment: the basic needs of all individuals must be satisfied and everyone must
be assured of a humane and respectable standard of living.
 Respectable Source of Earnings: The dignity attached to man’s status, as God’s khalifah
or representative means that need fulfillment should be through the individual’s effort.
In the case of handicap or inability to earn a living, it is the collective obligation of the
Muslim community to fulfil their needs through Islamic socioeconomic institutions
such as Zakat, and charitable endowments- awqaf.
 Except for Zakat, which is administered by the state, the other institutions are voluntary
but form part and parcel of the Islamic economic ethic.
 Equitable distribution of income and wealth: Although inequalities in income and
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wealth can be tolerated in proportion to skill, initiative, effort and risk,
skewed inequalities are incompatible with Islamic teachings. The
elimination of interest, the introduction of Zakat and change in consumer
behaviour patterns to one conforming to Islamic guidelines are essential
to achieve this.
Growth and Stability: Growth and stability are essential to maintain employment and
to ensure the goal of equitable wealth distribution as the poor can reap the
fruits of economic growth thus lessening the burden of the rich to
redistribute wealth.
OBJECTIVES OF THE ISLAMIC ECONOMIC
SYSTEM (Chapra 1992)
 a) Introducing a socially agreed filter mechanism: In addition to the price
mechanism, a double layer of moral filters tempers claims on resources.
Individually, Islamic consumers should avoid wasteful expenditures because of
legal/moral precepts of the Shari’a. In addition the Islamic financial system also acts
as moral filters in their investing and credit expansion activities.
 b) A strong motivating system to induce the individual to render his best in his own
interest as well as in the interest of society. This comes from the Islamic concept of
accountability to Allah, from whom no actions can be hidden, and to whom every
action has to be accounted for in the life after death.
 c) Restructuring the entire economy to realise the Shari’a objectives in spite of scarce
resources. This is to be done by reforming all social, economic and political
institutions including public finances and financial intermediation to minimise
wasteful and unnecessary consumption and to promote investment for need
fulfillment.
 The Islamic structures will also support the filter and motivating system by not
allowing material possessions and conspicuous consumption to become a source of
prestige, thus killing off the economic man.
 d) A positive and goal-oriented role for the government. The government would
support the raising of the moral consciousness of people, motivate and help the
private sector play its role effectively and accelerate political, social and economic
reform and provide incentives and facilities.
OBJECTIVES OF THE ISLAMIC ECONOMIC
SYSTEM
 reforming the banking and monetary system to eliminate
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interest transactions and putting them on an Islamic plane is one
of the cornerstones of the Islamic financial system.
The development of an interestfree, ethical Islamic economic
system is an important agenda of most Islamic movements and
some governments such as Pakistan, Iran and Sudan (Ahmad,
1994a).
Other countries, such as Malaysia and Bahrain, allow Islamic
economic institutions such as Islamic banks to operate in
parallel with the conventional financial system.
Social Justice is said to be the hallmark of the Islamic economic
system (Ahmed et al., 1996). In order to achieve this Islamic
economy, two institutional devices i.e. “the abolition of interest
and presence of a well-functioning Zakat system (p3)” are
considered essential.
As the Islamic financial system relies mostly on the former, this
aspect will be discussed in some detail.
Riba - Definition and classification
 The Qur’an and the Hadith of the Prophet (pbuh) specifically prohibits riba
in economic transactions in the sternest terms (e.g. Al-Qur’an,
2:275,278,279).
 Riba has been translated into English as usury or interest.
 However, it has in fact a much broader meaning under the Shari’a as
suggested by its dictionary meaning of “increase” or “gain”. Saleh (1992) has
defined riba in the Shari’a context as “an unlawful gain derived from the
quantitative inequality of the counter-values in any transaction purporting
to effect the exchange of two or more species, which belong to the same
genus and are governed by the same efficient cause” (p16).
 Thankfully, the author has adopted a shortened version of this rather long
technical definition as “an unlawful advantage by way of excess or
deferment” (p17).
 Riba has been classified into two categories: riba al-fadl and riba al-nasi’a
(Muslehuddin, 1987).
 Riba al-fadl is riba by way of excess of one of the exchanged counter-values
e.g. the exchange of 2 Kg. of low quality rice for 1 Kg. of high quality rice.
 Riba al-nasi’a is excess by way of deferment of completion of exchange, for
example a loan of £100 for a deferred repayment of £110 a year later.
 As Islamic banking involves the elimination of Riba al-nasi’a, further
discussion on riba will be limited to this form only.
Reasons for the prohibition of
Riba
 We can thus surmise that any interest or excess above the
principal sum in a deferred repayment transaction is riba. The
reason given in the Qur’an for the prohibition of riba is that, a
pre-determined fixed rate of return on capital lent leads to
injustice because there is an uneven distribution of risk and
reward in the transaction (Obiyathulla, 1995).
 One party bears the risk, while the other party receives a reward
irrespective of the outcome of the use of the borrowed amount.
 Riba is also said to lead to the concentration of wealth by
transferring wealth from the poor to the rich, a position not
unreasonable given the current distribution of wealth and third
world debt crisis (Caufield, 1998).
 It is also said to increase the instability of the trade cycle, causing
more violent fluctuations because a high rate of interest, by
increasing the cost of capital, discourages investments (Keen,
1997).
Comment from conventional
practitioners
 An IMF economist observes that Islamic banking, based on
the elimination of riba will to lead to a more stable banking
system, thus:
 “The Islamic model of banking based on the principle of
equity participation may well prove to be better suited
to adjusting to shocks that result in banking crisis and
disruption on the payment mechanism of the country.
In an equity-based system that ...does not guarantee the
nominal value of deposits, shocks to asset positions are
immediately absorbed by changes in the values of the
share deposits held by the public in the banks.
Therefore, the real value of assets and liabilities of
banks in such a system will be equal at all points in time.
In the more traditional banking system since the
nominal value of deposits is fixed, such shocks can
cause a diversion between real assets and liabilities”.
(Mohsin, 1986, p19)
Controversies on the prohibition
of Riba
 In the light of modern financial practices, the elimination of interest would
seem to be an unworkable plan. In fact, the elimination of interest has been
thought to be irrational and a sign of a backward economy. Although usury
i.e. excessive rates of interest, especially on consumption loans are regarded
by some in the West as immoral, commercial interest is seen as a legitimate
reward for the use of capital in modern economies.
 It is justified as reward for the “time value of money”. Indeed, some modern
Muslim economists (in the early part of this century) and even some
Islamic scholars have tried to restrict the definition of riba to usury and
thus legitimise the institution of interest among Muslims. Among the
arguments offered in favour of legitimising interest are:
 (a) Riba is only usury and not interest
 (b) Riba is compound interest and not simple interest
 (c) Only interest on consumption loans is prohibited, not on investment
loans.
 (d) Islam recognises the time value of money and therefore interest should
be allowed.
 (e) Bank interest is not prohibited because it is not exploitative.
 The first controversy as to whether riba is limited to usury begs the question as to what
is the upper limit of the interest rate which is justified and what rate does illegitimate
usury begins.
 Prior to 1571 in England, at least, all rates of interest above zero were considered
usurious following the edict of St. Thomas Aquinas (Keen, 1997).
 Of course, a legal solution could be offered but the historical evidence shows, at
different times, different rates were considered usurious.
 For example, the Sumerians considered 25% interest rate normal while the 1571 Act
against Usury of England indicated that anything more than 10% was usurious.
 Although in a secular framework, the rate of usury may be a matter of individual
conscience or to parliamentary consensus, this does not provide the specific technical,
moral or any other reason why the rate below the benchmark is justified and that above
is not. (Shaikh, 1987).
 The second controversy asserting that riba is only compound interest is based on one
interpretation of the Quranic verse: “ O you who believe, do not devour riba, doubling
and redoubling” (Al- Qur’an, 3:130).
 However, Islamic rules of interpretation state that the whole Qur’an (together with the
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Hadith) must be considered in interpreting any verse.
Verses 275 to 279 of the second chapter of the Qur’an leave no doubt regarding what is
meant as they clearly state that only the principal lent is the amount the borrower is
obligated to return.
Further, as Hoque (1987) observes, the distinction between compound and simple
interest is apparent and not real as an overdue interest on simple interest becomes
compounded.
As the compulsory notification of the APR (Average percentage rate) in the UK shows
that a compound interest rate can also be expressed in terms of a simple interest rate.
In fact, it is just a matter of time before the interest doubles and triples the principal
amount. Thus, this sophistry is not enough to deny the prohibition of riba.
Is interest a Riba’?
 The secular reasoning that, interest is only injurious, if at all, in
consumption loans and not in the case of commercial or
investment loans as is the case in commercial bank lending, is
not acceptable from an Islamic point of view. This is due to the
fact, that at the time of prohibition, Arabia was a major
commercial centre of the Indian – Mediterranean trade route
(Chaudhuri, 1985).
 In fact many of the Companions of the Prophet (pbuh) received
loans on an interest basis (before the Qur’anic prohibition) to
invest in their trades. The Prophet (pbuh) specifically banned
such interest-based loans after the Qur’anic prohibition was
revealed, retrospectively. The Qur’an states that “Allah has
permitted trade and prohibited riba”, in spite of the protests of
the Arabs that “Trade is like riba” (Al-Qur’an, 2:275), Islam is
quite clear on this. Further Islam has not prohibited other
avenues of lawful employment of capital to generate income in
the form of rent, labour-capital participation, joint venture and
mark-up trading.
Consumption loans vs
Development loans
 Chapra (1985) quoting Shaykh Abu Zahrah, an eminent Muslim scholar,
observes that:
“There is absolutely no evidence to support the contention that
the riba (prohibition)...was on consumption loans and not on
development loans. In fact the loans for which a research
scholar finds support in history are production loans. The
circumstances of the Arabs, the position of Makkah and the
trade of the Quraysh (the tribe of the Prophet (pbuh)), all lend
support to the assertion that the loans were for production and
not consumption purposes”. (Chapra , 1985, p 62).
 One might protest that despite the historical basis on which the prohibition
was based, the ruling is irrational in view of the fact the loans provide for
development or investment accrue profits and it would be unreasonable for the
lender not to share in it.
 The answer to this is that Islam does not bar the association of capital and
entrepreneurship.
 However, it prohibits interest-based loans because the predetermined fixed
return to the lender is irrespective of the fortunes of the entrepreneur. If the
investor agrees to share any eventual loss, he can contract for a share of the
actual profit earned by the entrepreneur.
Islam and the Time Value of
Money
 Whether Islam recognises the time value of money is more controversial.
 In the case of the Islamically allowable murabaha or mark-up contracts, in
which a supplier contracts with a buyer to acquire a product and sell it to the
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buyer at a mark up on cost, the price can be deferred or paid on an instalment
basis.
By allowing, the extra charge for delayed payment - Islam appears to recognise
the time value of money by recognising the opportunity cost foregone by the
entrepreneur who might have otherwise have his capital tied up – a subtle
distinction from the charging of interest (Vogel & Hayes, 1998).
On the other hand, Khan (1994a) is of the opinion that discounting violates the
Shari’a prohibition of interest. Khan (1994a) observes that only in the case of
the poor people is it true that the current utility of money is greater than the
future utility.
He opines that every cent saved testifies to the fact that savers have a preference
for the future utility of the money rather than current. Hence there is no need
to discount future inflows.
Tomkins & Karim (1987), however, observe that the objection to the use of
interest rate for discounting can easily be avoided by using an expected return
rate as a hurdle rate.
Hence using discounting techniques is not a problem in capital budgeting and
valuing assets.
Islam and the Time Value of
Money
 Finally, many scholars argue that the modern banking institution was not
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present at the time of the Prophet (pbuh).
As it performs vital functions of financial intermediation in the modern
economy and is not exploitative, bank interest should not come under the
gambit of the riba prohibition. Some court ulemas especially those from the
Egyptian government have in fact given legal opinions (fatawas) to this effect.
However, the majority of the Islamic scholars view that bank interest is no
exception because the bank in fact represents a group of individuals (the
shareholders) who are in the money-lending business.
Since the riba prohibition equally applies to individuals as well as groups, banks
are not exempted (Hoque, 1987).
Despite this, however, the same author observes that it is a fallacy to view the
whole conventional banking process itself to be UnIslamic.
A close look at the function of banks in channeling savings to productive
enterprises is actually facilitating the realisation of the objectives of the Shari’a,
which abhors and penalises idle savings.
Only the interest mechanism used to achieve this objective is objectionable.
Hence if interest is replaced by any permissible mechanics and the bank limits
its activities to financing businesses approved by the Shari’a banking becomes
an important Islamic institution (Hoque, 1987).
Islam and the Time Value of
Money
 Finally the Federal Shari’a Court of Pakistan’s judgement on Riba1 (Khan,
1994b) should put to rest any lingering suspicions on the nature of riba.
Contrary to a normal process of interpretation of a constitution2, the
Court sent out a questionnaire and collected evidence and cited various
works of both Muslim and Non-Muslim scholars to discern the nature of
riba.
 It concluded “ a transaction which contains excess or addition over and
above the principal amount of loan, payable to the creditor constitutes riba
“(p13).
 Therefore, any such sale, transaction or credit facility, in money or in kind,
has been considered to be of riba, which is unlawful (haram) in Muslim
society. Khan (1994b) observes that the court held that there was a
consensus of the opinion (ijma’) of Muslim jurists upon it. Further, it did
not make a difference whether the loan is for consumption or for
commercial purpose, if the rate of interest is high or low, simple or
compound or between Muslim and Non-Muslim or between an individual
and the state.
 This ruling was appealed by the Government of Pakistan whose Appeals
Court turned down the appeal in December 1999, and gave the Pakistan
government one year to rid the economic system of riba consistent with
the constitution of the Islamic Republic of Pakistan
Islamic Organisations and
Institutions
 Conventional interest is not acceptable from an Islamic perspective.
 Thus, they have no option, if they want to abide by Qur’anic principles,
except to overhaul the conventional financial and banking system to an
interest-free footing.
 Muslims have set up Islamic business and nonbusiness organisations
which attempt to operationalise the Shari’a in their economic and
governmental affairs (El-Ashker, 1987). In the heydays of Islamic
civilisation, there were unique socio-economic Islamic Institutions,
which were replaced, by foreign economic institutions, after the
olonisation of Muslim lands. The two most important institutions,
which will be discussed in this research, were the “Baitul-Mal” (public
treasury)- which collected and disbursed Zakat – the Islamic religious
levy and the Awqaf (Muslim endowment). In the private sector,
businesses were conducted for the most part, according to Islamic
precepts despite the claims of Rodinson (1974) that this was more
 in letter rather than in spirit.
 Muslims are attempting to revive these institutions and adapt them to
contemporary circumstances as part of the Islamic resurgence in the
Muslim countries (Sivan, 1985).
Islamic Organisations and
Institutions
 In the business sector, although the concept of the modern corporation
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was unknown, Islamic law and Muslim business practice knew the
concept of separate legal person and joint stock partnership (Usmani,
1998).
Muslims undertook joint ventures, especially commenda
(mudharabah) and partnerships, which were based on risk-taking profit
and loss sharing ventures (Udovitch, 1970).
As interest was prohibited, interest bearing bonds were unknown but
interest bearing commercial loans and government loans did take
place, sometime in the guise of “mark-up” or buy and resell sales
contracts allowed in Islam (Rodinson, 1974).
Some Muslim governments, especially the late Ottoman Sultans took
interest-bearing loans from Western countries, which eventually led to
the downfall of the Caliphate.
There were even instances of Mosque funds lent out at interest, which
was prohibited under Muslim Law.
However, these were always frowned at by Islamic scholars and
Muslims and never accepted as legal by the majority of Muslims.
The development of Islamic Banks
 Although the use of trade bills and cheques were known in Islamic
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History, modern banking was a Western Introduction in Muslim lands
which took root after colonisation.
Despite being encouraged by the governments of Muslim countries, the
Muslim masses harboured much suspicion of the allowability of
interest charged or given on deposits by these banks.
Many strict Muslims refused to deposit their money and preferred to
keep it in their homes.
Others used the banks as a safe-deposit service and would not take the
interest credited to their accounts or gave them away to charity.
To solve this problem and give Muslims a Shari’a friendly alternative to
conventional banking, Islamic banking was born and has since become
established as a viable alternative, although there are many strategic,
operational, regulatory and accounting problems faced by these banks
(Al-Faisal & Ali, 1996).
In addition to the banks, Islamic finance co-operatives and savings
institutions which invest the believers’ money in Shari’a approved and
ethically correct ways have been set up. The Lembaga Tabung Haji of
Malaysia, established in 1962 is an example of one such successful
institution, which had assets totalling 5.2billion Malaysian Ringgit
(around US $2billion) in 1997.
Islamic Banking development in
Malaysia
 Another financial institution, which presented problems for
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Muslims, is the conventional insurance company.
The Shar’iah prohibits conventional insurance because of its
connections with interest, gambling and gharar (uncertainty).
In general, a contingent insurance contract is prohibited in
Islam. To overcome this problem, Islamic Insurance companies
(known as Takaful) have been developed, where the contributors
share in a savings scheme including a compulsory contribution
to a claims pool.
The Takaful Company then tries to compensate any claimant
from the amount of his contribution plus earnings.
Any shortfall of the indemnified amount comes from the claims
pool if available. Of course, the policy premiums are invested in
interest-free, Shari’a approved investments.
The world-view of Islam and therefore Islamic organisations,
whether in the public, private or voluntary sector, are different
from those of conventional business and non-business
organisations.
Islamic Banking development in
Malaysia
 The difference arises in the objectives, nature of profits, the activity or industry Muslims
can undertake or invest and in the way the wealth is distributed.
 The charging and earning of interest, gambling, alcohol and other industries and
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aleatory contracts are prohibited.
Further the maximising of profits or wealth as an objective is frowned upon because it
conflicts with the ultimate objective of achieving falah (Islamic success/salvation in the
hereafter. Although unlike Christianity (see Laughlin, 1988; Tawney, 1927), Muslims are
not averse to exploiting the resources for material gain, they would have to undertake
this in ways which is in accord with the Shari’a.
There is a need to differentiate between Islamic and Muslim organisations. In case of
businesses. Islamic business organisations as those which have been set up specifically to
operate within the Shari’a as part of the strategy to develop a comprehensive Islamic
Economic and Financial system.
Their philosophy must be Islamic and not merely meant as a cover to introduce interest
through the backdoor. On the other hand, Muslim business organisations are businesses
set up by Muslims who may or may not follow the Shari’a. However, Muslim businesses,
especially small and medium-scale ones may intend to gradually shift towards an Islamic
business profile in their activities.
Islamic accounting is needed by both types of organisations – mandatory for the former
and helpful for the latter to achieve their Islamic ambitions.
Forms of Islamic Business
Organisations
 Islam not only allows, but encourages trade and business. Business can be organised
either as sole proprietorship, partnership and companies as in common law.
 Although the concept of limited liability has been frowned upon (Usmani, 1998), the
company form of organisation is lawful in Islam with certain restrictions.
 These include the type of capital, which can be raised, the type of investments, which
can be carried out, and the way profit and loss is shared.
 Although sole proprietorships, partnerships and joint ventures have been the most
common forms of businesses in the Muslim world (El-Ashker, 1987), the company
form of business organisation is increasingly used in the Muslim world both by
private and public companies.
 The common law varieties of business organisations (sole proprietorship, the
partnership and the company) are permitted in Islam. The liabilities, obligations and
the rewards of ownership are pretty much the same for sole proprietorship except
that the owner is not allowed to conduct business in forbidden products or services
such as selling pork, liquor, gambling or interest-based money lending.
 The distinction between partnership and companies in not clear in Islamic law
because the modern corporation was never found in Muslim countries before the
adoption of European law in Muslim lands. However, the Muslim partnership law is
quite comprehensive to allow for the formation of joint stock companies, the
formation of which is said to be encouraged by the Prophet (pbuh) himself (Atiyah,
1992).
Objectives and operations of
Islamic Organisations
 The objective of Islamic business organisations is to enable Muslims to undertake economic
activities within the framework of the Shari’a as a means to attain falah (success in the
hereafter). This means that the businesses must follow a code of Islamic ethics in relation to
their activities and behaviour towards their stakeholders (Beekun, 1997).
 Conventional business organisations follow a profit or wealth maximisation model.
 This is the based on the concept of the utility maximising behaviour of conventional rational
economic man. Although profit is deemed legitimate and is one of the major objectives of
Islamic businesses, profit maximisation, as a prime objective is not identified in the Islamic
model (El-Ashker, 1987).
 Even though capitalist businesses seem to be moving to wealth maximising and satisficing, the
concept of maximisation is entrenched in the accounting calculus e.g. when investment
appraisals are carried out.
 In Islam, wealth is only considered as a means to an end. As in other religions, the Muslim
scholars, for example Al-Ghazali (Al-Karim, 1995), have warned their followers of the dangers
of greed for wealth.
 Thus maximising wealth is not a priority of the Muslim.
 On the other hand, the economic strength of a nation or group has direct implications for
political and social stability. Hence, Islam encourages the pursuance of wealth in an ethical
manner.
 In line with this, the objective of Islamic business organisations is therefore to seek reasonable
profits in line with the risk taken and any particular social consequences of high pricing policy.
Survival and growth are also emphasised as important objectives in hostile environments where
Islamic businesses have to compete with conventional ones.
Objectives and operations of
Islamic Organisations
 Islamic businesses have to take into account the benefits accruing to employees, society and the
environment, in addition to fund providers as a matter of religious/moral obligation emanating
from their Islamic beliefs. El-Ashker’s (1987) study of Islamic business enterprises in Egypt
provides some evidence that Islamic businesses aim to achieve three sets of objectives related to
the benefits accruing to finance providers, employees and society. He proposes a utility model for
Islamic economics, consisting of secular and ritual utilities.
 The secular utility is the normal conventional utility consisting of profits and financial benefits
whereas the ritual utility relates to employee and nonprofit oriented social objectives intending
to please God and to achieve falah. Achieving profits within this constraint is said to please God
and leads to a higher divine reward and hence is a source of utility for Islamic businesses.
 The Islamic business aims to achieve a balanced relationship between the three sets of objectives
of the three interested parties in the course of maximising its utility.
 Thus:
Maximise U = Ua(R), Ub [UaR, E, S], F(P)
Subject to Y= R+E+S, where:
U= Utility function
Ua = secular utility function
Ub = ritual utility function
R=Profit
E = cost of employment welfare (wages and the like)
 S = social cost (costs of social welfare)
 P = degree of piety
 Y = net value of production.
Objectives and operations of
Islamic Organisations
 Since Islamic and Muslim businesses vary in the degree of
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commitment to Islam, the degree of piety (P) is introduced into
the equation to account for this.
Thus for different organisations with different degrees of piety,
the equilibrium point, E, S, and R will be achieved will be
different.
The researcher proposes that an additional environmental cost
(N) be added to the equation.
Hence Y= E+S+N+R and Ub [UaR, E,S,N], hence Islamic
businesses will maximise its utility and will be in equilibrium
when a proper mix depending on the degree of piety is achieved.
While all this might seem theoretical and not practical, the study
by El-Ashker (1987) using actual case studies of Islamic
companies in Egypt indicates that this is what is done in practice
by Islamic companies with a high degree of piety (P).
Accounting implications
 Both the structure and objectives of Islamic business organisations make the
development of an alternative Islamic accounting an imperative.
 For example, debentures, bonds and even preference shares are not allowable in an
Islamic company. This is because of fixed interest bearing characteristics of the former
and profit sharing arrangements of the latter which are considered inequitable according
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to the Shari’a.
New type of financial instruments such as mudharabah and muqarada bonds (Rosly &
Sanusi, 1999), are needed to finance Islamic companies and used as investment
instruments by Islamic banks.
These instruments are hybrid instruments containing both the characteristics of debt
and equity (Obiyathullah, 1995) which call for special accounting treatment.
This is not only a matter of different technique but also a matter of change in the
fundamental accounting assumption of substance over form, which underlies
conventional accounting standards, e.g. IAS 1 (IASC, 1975) which may not be acceptable
from an Islamic point of view.
Further, the objective of Islamic businesses which have to balance the shareholder,
employee, society and environmental interests poses serious questions on the adoption
of the profit calculus (the bottom line) as the main area of concentration of conventional
accounting. It cannot be denied that the importance of the bottom line is exacerbated by
the prominence given to the profit and loss account as the primal financial statement in
a set of conventional accounts.
This has implications for the behaviour of stakeholders as accounting can itself lead to
the construction of a social reality (Hines, 1988) not in line with the Islamic aspirations.
To balance these non-shareholder considerations, an Islamic accounting statement
might have to consider an alternative scoring system other than the financial unit.
Organizations for Zakat collection
and distribution
 Zakat is one of the five ‘pillars’ of Islam. Literally, it means to purify one’s wealth.
 Zakat is a “religious levy by which Muslims make over part of their wealth for the
benefit of others” (Clarke et al., 1996). It is neither a tax nor a charitable donation.
 A tax may be expended for any purpose while Zakat can only be paid to eight
categories of beneficiaries specified in the Qur’an. Further, as opposed to a
charitable donation, it is compulsory.
 Zakat is a wealth based levy although contemporary Islamic scholars insist that
Zakat should also be payable on salaries and wages. Zakat has been levied on
animals, trading profit, and agricultural produce and gold and silver and money
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equivalents.
Scholars have extended the category of zakatable items. The rate of wealth Zakat is
2.5% but agricultural produce is subject to 5% or 10% depending on the use or nonuse of irrigation respectively.
The collection and disbursement of Zakat has been traditionally carried out by the
Islamic State, since the time of the Prophet (pbuh) (Zaman, 1991).
The Prophet (pbuh) used to appoint Zakat collectors to assess and collect Zakat from
his followers. This was deposited into the Baitul Mal or the public treasury. Zakat
was collected and disbursed both in cash and in kind.
The Islamic State continued to perform this function until colonisation resulted in
the introduction of alternative tax systems.
However, Zakat continued to be paid individually, through charitable associations
(as in the UK) or through the religious departments of government as in Malaysia.
 As part of the Islamisation of the economy, some Muslim countries have started organising their
Zakat collection and distribution activities more efficiently. I
 In Pakistan, Zakat is now deducted at source e.g. on investment deposits in banks.
 In Malaysia, Zakat collection is carried out by religious departments, which come under the
 jurisdiction of the various states.
 Mustapha (1991) observed that Zakat collection and administration is inefficient as for example,
the administrative cost is twice the pay-out to the destitute group of beneficiaries.
 There have also been accusations of mismanagement and maladministration by the head of states
that are ultimately responsible for it (AbdulRahim & Goddard, 1998). There have been calls in
Malaysia for the proper organisation and administration of the Zakat.
 The Malaysian government has proposed the establishment of an agency on a national level for
the administration of Zakat3. As a preliminary step, corporatized Zakat collection agencies was
first established in the Federal Territory and Selangor, the two states with the largest earning
population. Zakat collection has increased considerably due to the promotional activities of these
agencies. Payment of individual Zakat is also given income tax rebate.
 However the authority and accountability structure of these organisations are far from
satisfactory.
 In the first phase, the Zakat collected was and in some states, still is, handed over to the religious
department and is only subject to the Auditor General’s inspection.
 Initially, in the distribution of Zakat was not transparent. At the present time, the Selangor and
the Federal Territory Zakat Centres (Renamed from Zakat collection centres) are in charge of both
collecting and distributing zakat. They publish a monthly magazine which incorporates an
account of collections and distributions which are much detailed.
 However research indicates, zakat distribution is still inefficient and in some cases ineffective
 An interpretive study of accounting in two religious departments in
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Malaysia shows lack of transparency and power conflicts to varying
degrees (Abdul Rahim & Goddard, 1998).
There is more professionalism and transparency to a certain level in the
department situated in the more urban Federal Territory where
conventionally qualified accounting personnel carry out conventional
computerised accounting.
In the other department located in a more rural area, there was a general
lack of transparency and the researchers reported misuse of power.
However, while the departments using qualified accountants showed
more transparency, the introduction of a conventional accounting system
has resulted in a profit-oriented thinking which has resulted in the
adoption of new marketing techniques to collect Zakat.
For example, the Pusat Pembayaran Zakat (Zakat collection centre) is a
privatised profit-oriented entity who are remunerated on a percentage of
the collections. Although, they do not have the power to collect Zakat by
legal force, such a measure may have grave societal implications when
Zakat becomes legally compulsory as the profit-motive in increasing
Zakat collection may lead to arbitrary practices.
Hence, there is a need to develop an appropriate Islamic accounting
system, which will induce the proper Islamically accountable behaviour
including the introduction of Islamic performance indicators.
Awqaf
 The waqf (pl. Awqaf) is one of the Islamic institutional devices to foster voluntary spending for
the poor as well as to meet several other social causes (Ziauddin, 1991).
 It is the setting aside of certain assets usually land, buildings etc. for the exclusive use for
specific charitable/religious purposes under a legal deed.
 The asset so established becomes a waqf in perpetuity, and cannot be sold, inherited or
expropriated by the government. Only the income form the asset is disbursed according to the
wishes of the waqif - the person setting up the waqf.
 The waqf thus becomes a trust property, which is administered by one or more trustee who can
claim reasonable administrative expenses and salary. According to Ziauddin (1991), “Waqf is
thus a device for transferring private property to collective ownership (not public ownership)
for socially beneficial purposes” Awqaf are said to date from the time of the Prophet (pbuh)
but acquired clearer legal status under Islamic law in the first century A.H.
 Although the legal concept is similar to trusts and endowments under common law, it is said
to predate the English Institution of Trust. Thus as (Hasanuddin, 1998) observes, “there is no
evidence that such a complex system of appropriating usufruct as a life-interest to varying and
successive classes of beneficiaries existed prior to Islam”
 However, as opposed to English Law which only recognises trusts in favour of other than the
trustor and family as charitable, Islamic law recognises awqaf even if its is for the trustor’s own
or his family’s benefit but with eventual succession to charitable purposes.
 The former type of waqf is known as waqf ahli (family endowment) whereas awqaf specifically
meant for charitable purposes from the outset is known as waqf khairi (endowment for general
good).
 On the surface, it seems the former type of waqf would not be practicable as it entails a lapse
from the time such assets are endowed and the time it s available for public use. It would be an
uphill task for the authorities or community to keep track of the asset.
 However, Hoexter (1998) observes that “contrary to what one might have thought, many of the
assets did eventually find their way to their ultimate beneficiary”
 In any case, both types of awqaf have been and are very important socio-economic
institutions in the Islamic world. Awqaf has been set up for various purposes e.g. the
upkeep of mosques, religious schools, orphanages, hospitals, animal care centres, parks,
rest-rooms, drinking water facilities and food distribution centres (Siddiqi,1996).
 In many cases, awqaf are set up to feed the poor in other countries especially those of the
Haramain (the Holy Lands of Islam: Makkah and Medina).
 Hoexter (1998) has undertaken an extensive study of the development of this institution,
the waqf al-Haramain in Algiers (Tunisia) during Ottomon rule, from its own records.
 The Algerian, Waqf Al-Haramain was in fact a foundation, which managed all the
individual awqaf assets dedicated to feeding the poor in the Holy Cities of Mecca and
Medina (Hoexter, 1998).
 Later it took other awqaf into its ambit including those of other local mosques, feeding
the local poor and contributing to local public projects such as the town’s water system.
 The local Qadis or Muslim judges were active in the development of the Islamic
jurisprudence of Awqaf to adapt its principles for the needs of the times and locality. On
the whole, the Haramain foundation was equitably and efficiently administered – a
quality, which is not found these days e.g. in the Awqafs of India (Siddiqi, 1996;
Hasanuddin, 1998).
 Hoexter (1998) observes that the Haramain became a “most significant vehicle for
advancing the interests of the local Islamic community” as well as becoming the focal
rallying point in the fostering Algerian-Islamic solidarity.
 Awqaf became such an important part of Islamic society, that a Ministry of Awqaf was
established in 1840 by Ottoman Turkey- a tradition which has continued in many Muslim
countries.
 Unfortunately, the loss of political and economic power by
Muslims resulted in the decay of this institution as shown by the
contemporary state of awqaf, which leaves much to be desired.
Siddiqi (1996), for instance, observes that “we find increasing
state intervention in waqf management owing to a number of
causes, the chief one being widespread abuse of powers by waqf
supervisors”(p146). Despite this however, the state of affairs is
dismal e.g. in India. Hasanuddin (1998) observes:
 “But unfortunately, the Waqf institution in India, is most
misunderstood and Waqf properties mismanaged.
Legislative lacunae, administrative lapses, lack of political
will...has given rise to the painful phenomenon that Waqf
properties are the chief-attention of the land-grabbers. As
against this background, colossal and gigantic Waqf
buildings with tremendous commercial potential, are not
even receiving the most needed repairs and maintenance,
thus converting such attractive buildings into dilapidated
structures and there is a general feeling that Waqf property
is a cheap commodity available in the commercial market”.
(Hasanuddin, 1998, p 23-24)
 Despite this however, as the author observes, Awqaf is an important Islamic institution
which the Muslims have inherited in the past and “which possesses immense
potential for the reconstruction of social and economic life in Muslim countries and
communities” (p21).
 This is shown by the fact that there is estimated to be about 300,000 awqafs in India
alone (Haque, 1999).
 Waqf is also an important wealth re-distributive mechanism of the Islamic economic
system. For example, Siddiqi (1996) notes that Waqf takes property out of private
ownership and vesting ownership permanently and irrevocably in Allah.
 With the passage of time, more private property pass into waqf sector but the reverse
cannot and does not take place (if the assets are properly accounted for!). Since awqaf
are normally made by wealthy people (especially Muslim rulers in the past), it serves
to redistribute wealth and mitigate the ill effects of inequality in society and counteract the tendency to concentrate wealth. ensure this institution is properly
administered and accountable to the public to ensure that it serves its function
efficiently. As awqaf are not a commercial institution seeking profits, conventional
accounting may not be suitable for them. An Islamic accounting system for awqaf
would seek to address the following problems:
· The tracking of family awqafs until it reaches public status.
· Activity accounting , both financial and non-financial accounting
· Accountability of the trustee, and the transparency of operations.
· Islamic Social audit to ensure the beneficiaries get what is entitled to them.
· Management audit of income and property.
· Promoting the establishment of more awqaf.
Islamic Insurance companies
 Together with the growth of Islamic banks, Islamic Insurance companies (called Takaful
Companies) have sprouted, although not as numerous as Islamic banks. These are usually
subsidiaries or associates of Islamic banks or Islamic Finance Groups (e.g. Syarikat Takaful
Malaysia – a subsidiary of Bank Islam Malaysia) or conventional Insurance companies which
have Islamic subsidiaries e.g. Syarikat MNI Takaful.
 The establishment of these organisations are due to the fact conventional insurance is
prohibited by Islamic Shari’a (although there are controversies in this area). This is due to the
element of gharar or uncertainty in contingent contracts as well the elements of gambling
especially in relation to life insurance.
 In addition, the practice of investing premiums in interest-bearing securities by conventional
insurance companies is also problematic (Shamsiah, 1995).
 Takaful operates as a co-operative savings and mutual help scheme. In the case of Takaful, any
contributions (premiums) paid by the participants (i.e. policyholders) are not recorded as
income of the takaful company as in conventional insurance.
 n the case of Family Takaful - the replacement for conventional life insurance, the premiums
paid by the contributors are apportioned to a participator’s fund account and a claims pool. The
amount apportioned to the claims pool is based on actuarial calculations.
 The fund is invested in Shari’a approved investments. Any profits are shared between the
Takaful Company and the contributors in a pre-agreed ratio. Any losses are born by the
participants – not by the Takaful Company. Any profits accruing to the claims pool is credited
to it. All actuarial surpluses are credited to the participants.
 At the end of the policy term, a contributor gets the amount of his contributions plus any share
of the profits, if any. He does not get any amount apportioned to the claims pool. If the
policyholder dies before maturity of the policy, then any shortfall (the difference from the
insured amount and the balance in his account representing his contributions + profit) is met
from the claims pool.
 In the case of General Takaful – the Islamic equivalent of General Insurance,
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all contributions are credited into a collective claims pool fund. Any profits
from the invested funds are credited to this account.
After making any required provisions and making any claims payments, the
profit, if any, is shared between the participants and the company in the
pre-agreed ratio. Any losses are born by the claims pool fund.
It can thus be seen that the Takaful concept is quite different from
conventional insurance.
A conventional insurance company is a risk taker while the takaful company
is mainly a manager of funds. While premiums paid to Insurance companies
are treated as income, takaful contributions are treated as a separate fund
attributable to policyholders.
The Takaful Company shares profit arising from investments and any
surplus in managing claims. The operational expenses (staff and
administration costs) are born by the Takaful Company.
Thus three main stakeholders are accounted for in separate funds;
shareholders funds, family takaful fund and general takaful fund, each
having its own balance sheet, profit and loss account and cash flow
statements.
It can be seen that Takaful companies cannot operate under accounting
standards meant for conventional insurance companies. There are several
technical and philosophical accounting problems to be solved, for example
Islamic Insurance companies
 Valuation of investment assets; currently follows conventional
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valuation principles may not acceptable from an Islamic point of
view · Apportionment of profit share; the cash basis is currently
used.
This may lead to distortions in profit distributions for all the
parties.
· The calculation of Zakat on profits; the value to be used and the
avoidance of double taxation.
· The calculation of actuarial surpluses based on interest-based
contingency tables may not be acceptable from a Shari’a point of
view (see Tomkins & Karim, 1987).
· In line with the co-operative and participatory nature of
Takaful, more qualitative information may need to be disclosed.
There is thus a need to develop an Islamic accounting system,
which will deal with the above matters from an Islamic
perspective.
Islamic banks and Financial Institutions: history,
nature and operations
 Islamic banks are perhaps the most important and developed Islamic organisations in
contemporary Islamic society.
 Assets of Islamic banks are estimated to range from 50 to 100 billion dollars (Pomeranz, 1997).
 Although the principles on which it is based are not new, the institution itself is an innovation in
Islam. An Islamic bank is an ethically based institution which performs conventional banking
functions with an important exception, they do not receive interest from their borrowers or pay
interest on the customers deposits as this is prohibited under Islamic Shari’a (Al-Faisal & Ali,
1996).
 This does not mean Islamic banks are charitable institutions undertaking free lending and
borrowing.
 On the contrary, Islamic banks are businesses, which aim to make profit within the constraints of
the Shari’a, by undertaking profit- sharing projects, trade financing, lease financing and
providing fee-based services.
 Due to the importance of Islamic banking in the Muslim world, it will be discussed in some
detail as an example of an Islamic organisation in practice, which makes the development of an
Islamic accounting system a practical imperative.
 As the accounting problems of Islamic banks mainly concern the asset side of Islamic banks, the
Islamic financial instruments used as alternatives to conventional interestbased lending are
discussed. Next, the accounting problems of Islamic banks are discussed at some length. All
Islamic organisations, in the opinion of the researcher, need an alternative Accounting System.
 However, the accounting problems of the Islamic banks have been considered acute enough to
have led to the establishment of an alternative regulatory body for the setting up of Accounting
Standards for Islamic Financial Institutions (Pomeranz, 1997), which is the main concern of this
book.
 The chapter is concluded with a discussion of the perceived benefits of an Islamic accounting
system for banks and other business organisations
Classification of Islamic banks
 (Ahmed, 1994b) has classified Islamic banks and financial
institutions into several different types, as follows:
 1. Islamic Special Purpose banks aim to achieve a specific
purpose or serve a special class of clientele. This include social
banks, agricultural banks, co-operative and Industrial banks.
Examples include the Nasser Social Bank in Egypt and Islamic
Bank of Western Sudan charged with promoting the
development of Western Sudan.
 2. Islamic Development Banks aim to foster the process of
socio-economic development amongst its members. Its
clientele are usually governments
 3. Islamic Commercial Banks mainly aim to make profits but
still operate within the Islamic ethical system. This class
forms the bulk of Islamic banks in operation.
 4. Non-banking Islamic financial institutions such as the
Pilgrims Fund (LTH) of Malaysia do not perform banking
functions but channel savings to productive investments and
pay the depositors a bonus depending on profits.
Development of Islamic banks and
financial institutions
 It is generally agreed that the first Islamic bank was established at Mit-Ghamr, Egypt in 1963
(Ahmed 1994a; Naggar 1987). Mit-Ghamr is a rural area in Egypt, where the people were mostly
religious farmers and artisans. They did not put their savings in the conventional banks because
of the Islamic prohibition of interest.
 The bank operated three types of accounts; the savings and loan fund, the investment fund and
the social service fund. The first fund was like a current account.
 The depositor received no interest but could apply for an interest free loan for productive
purposes. The investment funds were deposits received based on profit/loss participation. The
funds were invested in local businesses and agricultural projects. The deposit received a
proportion of the profits according to its amount and term. The social fund received Zakat and
other charitable contributions from which grants were made to savers who were in financial
difficulty as a result of sudden misfortune.
 It can thus be seen that an Islamic/social ethos prevailed in the conception and operations of the
bank. One Western observer noted the significance of the experiment thus:

“The majority of the population had never been dealing with the financial
institutions. Because of this, capital formation had been impaired. Basically rural and
religious, they tended to distrust the bankers operating in the western style. Since a
substantial part of their income was not spent immediately, but put aside for social
events, emergencies and the like, this idle capital could not be used for productive
investment A precondition, however for any change of behaviour from hoarding and
‘real-asset saving’ to financial saving was the creating of financial institution which
would not violate the religious principles of large segments of the population. Only then
could the rest of the majority of the population be integrated in the process of capital
formation”.
(Wohlers-Scharf, 19834, pp79-80 as quoted in Ahmed, 1994a, p351).
 In the words of one of its founding executives (Naggar, 1987), the three most important
principles which were applied by the bank and responsible for its success were:
1. Participation of the bank with its borrowers in their profits as well as losses.
2. Decentralisation and localisation through the operation of a community based
philosophy which help in:
a) the education and credit enlightenment through direct and sympathetic contacts,
b) constant follow up of projects to guarantee their repayment and effective use of
the money, and
c) the provision of a mix of economic and social development servicesIn the ords
of one of its founding executives (Naggar, 1987), the three most important
principles which were applied by the bank and responsible for its success were:
1. Participation of the bank with its borrowers in their profits as well as
losses.
2. Decentralisation and localisation through the operation of a
community based philosophy which help in:
a) the education and credit enlightenment through direct
and sympathetic contacts,
b) constant follow up of projects to guarantee their
repayment and effective use of the money, and
c) the provision of a mix of economic and social
development services
Consistency and integrity of the
bank accounts.
 The bank’s success5, however, attracted the attention of the anti-Islamic, socialist
regime of Nasser. In 1967, the Egyptian government took over all the nine banks and
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converted them to social savings bank on the conventional model. Thus the
experiment came to an end, not on the basis of its economic viability but political
interference and commercial opposition of the conventional banks.
At the same time as the Mit-Ghamr bank was started in Egypt, the Lembaga Urusan
dan Tabung Haji (LUTH)6 (Pilgrims Fund and Management Board) was established
in Malaysian in 1963 as an Islamic savings institution. A Muslim economist who had
noticed the wasteful nature of Malaysian Muslims selling of their property to go on
the Haj (Muslim pilgrimage to Makkah) suggested that Muslims could save up the
amount which would be invested in accordance to Shari’a principles.
Thus LUTH was born. Until then, intending pilgrims did not put their savings in a
conventional bank because it would have been tainted with interest. Money thus
tainted could not be used to perform the pilgrimage, as it would not have been
religiously valid.
The Malaysian government initially set LUTH (Now known as Lembaga Tabung Haji)
up as a savings corporation in 1963 and was incorporated in 1969.
Although LUTH is not an Islamic bank, it is an Islamic financial institution. It
collects the savings from would be pilgrims and invests them in real estate, trading
and plantations.
Recently it has gone into share trading and Islamic money markets. LUTH is an
active investor both directly and through its seven subsidiary companies.
 LUTH in addition to its investing activities administers the whole pilgrimage
programme every year, which is a mammoth undertaking involving about 40,000
ilgrims. In cooperation with other government agencies, it takes care of their transport,
food, lodging, health and emergency aid during the pilgrimage. The author having
personally used its services can attest to its efficiency in organising the pilgrimage.
 However, in recent years, its importance as a financial intermediary has increased. The
author was informed by one of its accountants in an interview that 70% of LUTH’s
deposits were investment deposits, whereas previously most depositors withdrew their
savings to perform their pilgrimage. Unlike the Mit-Ghamr bank, LUTH had better
fortunes because of the political climate in Malaysia, which though secular, was not
socialist and anti-Islamic, as was the Nasser government. From 1,281 depositors in 1963
and RM46,600 in deposits, the number of depositors increased to 2,278,121 with deposits
of RM1,541 million in 1993, a period of 30 years (Zainal & Yusof, 1993).
 Its income has increased from RM6,573 to about RM95 million (excluding government
contribution towards operating expenses) during the same period, 1990. Depending on
the profits, a bonus is declared by LUTH once a year. The dividend rate had been around
8-8.5% but has since declined to around 4-5% after the recession in 1997.
 The first private commercial Islamic bank was the Dubai Islamic Bank in 1975. It is a
public limited company with 50 million dirhams. In the same year, an international
Islamic bank, the Islamic Development Bank was established in Jeddah, Saudi Arabia
jointly by the 45 Muslim countries under the auspices of the Organisation of the Islamic
Conference.
 The purpose of this bank was to foster economic development and social progress of
member countries using Islamic finance financial instruments. It also grants loan and
aid to Muslim organisations especially in Muslim minority countries.
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Thereafter Islamic banks began to be established at an increased pace in Egypt, Sudan, Jordan, Bahrain,
Pakistan, Iran, UK, Malaysia, Bangladesh, African countries, Turkey, India, South Africa and the US.
Two milestones in the establishment of Islamic banking were firstly, the Islamisation of the whole banking
sector in Iran (1979), Pakistan (1985) and Sudan. The second milestone was the establishment of the Dar-al
Mal Al-Islamic (DMI) Switzerland in 1981 by a Saudi Prince and the Dalla Al-Barakah Group in 1983.
These two Islamic Finance Multinationals were responsible for setting up a spate of Islamic banks,
Investment corporations, Takaful companies and other financial institutions in Egypt, Sudan , Africa and
Europe.
A Chronology of the Pioneering Islamic Banks
Period
Institution
Mid 1940
1950s
1963s
1971
1975
Interest Free Bank
Local Islamic Bank
Mit Ghamr Local Savings Bank
Nasser Social Bank
Islamic Development Bank
(OIC Foreign Minister Conference, 1970, 1973 ,1974)
Dubai Islamic Bank 1977 International Association
of Islamic Banks (OIC)
Faisal Islamic Bank of Egypt
Faisal Islamic Bank of Sudan
Kuwait Finance House
Islamic Banking System International Holding
Luxemborg)
1975
1977
1977
1977
1978
1979
1981
1981
1981
1981
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1981
1982
(Saudi
1982
Arabia)
1982
1983
1983
1983
1983
1983
1984
1985
1985
1985
1985
(Saudi Arabia)
1985
(India)
Jordan Islamic Bank
Bahrain Islamic Bank
Dar al Mal al Islami (Switzerland)
Bahrain Islamic Investment Company
Islamic International Bank for Investment and
Development (Egypt)
Islamic Investment House (Jordan)
Al Barak Investment and Development Company
Arabia)
Saudi Philippine Islamic Development Bank (Saudi
Faisal Islamic Bank Kibris (Turkey)
Bank Islam Malaysia Berhad
Islamic Bank Bangladesh Ltd
Islamic Bank International (Denmark)
Tadamon Islamic Bank (Sudan)
Qatar Islamic Bank
Beit Ettamouil Saudi Tounsi (Tunisia)
West Sudan Islamic Bank
Al Baraka Turkish Finance House (Turkey)
Faisal Finance Institution (Turkey)
Al Rajhi Company for Currency Exchange & Commerce
Al-Ameen Islamic & Financial Investment Corp. Ltd.
 The ownership of the Islamic banks varies between 100% government ownership and 100%
private ownership. Most Islamic banks have been set up as joint-stock companies.
 The total number of Islamic banks and financial institutions number in the thousands (if the
Islamic banks in Sudan, Pakistan and Iran established by wholesale Islamic legislation are
counted) but those established voluntarily number 192 (IAIB 1997).
 As at 2003, there were more than 300 Islamic banks and financial institutions globally with total
equity of US$15billion and total assets of 174.72 billion (CIBAFI).
 The aggregate net profit was US2.74 billion. This compares to 133 institutions with $5 billion of
paid up capital and $53.3 billion in assets in 1994. Considering that there was no wholesale
Islamisation of the banking sector in any Muslim country between these dates, the increase
represents about 72% increase in assets and capital over 10 years or about 23% growth rate.
 It would have been much higher if not for the devaluation of the Iranian currency against the
dollar in 2002 when the Islamic banking assets decreased by 44% in that year. These statistics
excludes assets under Islamic windows and investment funds. The industry employs around
300,000?? employees spread across 34 countries in all continents except South America .
 It can thus be seen that the Islamic finance sector is no longer a theoretical possibility but a
practical and viable fact here to stay. However, Islamic banks face many regulatory, operational
and accounting problems which prevent the further realisation of its Shari’a oriented ethical and
social goals. In Malaysia for instance, the industry where non-Muslims play a major part, there is
some tendency to go for the “loan mode” and to account for it as such.
 Recently, International Accounting Standard Board with its new International Financial
Reporting Standards insists wholesale adodption of its standards may pose a problem to Islamic
banks. Resisting these pressures by means of developing and supporting a set of high quality
parallel Islamic accounting standards would be helpful in developing this important Islamic
institution to be in accord with its own worldview rather than being derailed into the capitalistic
mould.
Modus operandi of Islamic Banks
 Siddiqi (1998b) has classified the activity of Islamic banks into three activities:
a) Services for which the bank charges a fee or commission.
b) Investment of capital on the principle of partnership or mudharaba and
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c) Fee based or uncharged services
The services in category a) above include many of the functions performed by
conventional banks on a fee basis, such as keeping accounts, clearing cheques,
providing funds transfers and business advisory as well as providing financial
guarantees and safety deposit lockers.
The activities under b) are the major theoretical basis on which Islamic banks
operate although a recent survey shows only 20% of financing of Islamic banks
is done through this way (IAIB, 1997).
The main activity of a conventional bank, lending and borrowing money
through fixed and savings deposits is changed in an Islamic bank.
The relationship in conventional banking between the bank and its deposit
holders is that of a debtor-creditor relationship. This is not so in the case of
Islamic banks. The relationship in an Islamic bank, depending on the type of
deposits, is either trustee for deposits or a business partner.
 On the liability side, in the case of both current and savings accounts, conventional
banks pay interest based on a pre-determined percentage of the amount deposited
varying with the length of time. The Islamic bank does not pay interest but may give a
gift, which is at the option of the bank.
 The bank guarantees the principle amount, which can be withdrawn by the customer
at any time. Current and savings account deposits are based on the Islamic contract of
al-wadia’ – safe keeping. In the Middle East, the qard al-hasan (benevolent loan
contract or Amanah contract (trusteeship) is used.
 Under this contract, the depositor gives permission to the bank to use the funds in
any Islamically permissible activity but he can request the money back on demand.
 In practice, some Islamic banks pay an amount called hibah or gift depending on the
profit of the company, which is permissible. However, the depositor is not legally
entitled to this as that would amount to interest. The bank, however, guarantees the
principal sum. Islamic banks do not accept fixed or term deposits on which interest is
paid.
 Instead, customers can open an investment account for a fixed period. After the
period, the customer is entitled to a share of the profit (the percentage share of
profits being predetermined), if the banks make a profit. If the bank makes a loss, the
whole loss is borne by the customer.
 This contract is called mudharaba- capital/labour partnership. Under this contract,
the depositor as the capitalist gives the capital to the bank who acts as the
entrepreneur in managing the funds for which it is entitled to a share of the profit.
The banking expenses are not charged to depositors as management expenses as in
the case of a loss, it is wholly borne by the depositor. The bank is only entitled to a
share of profits the ratio being pre-determined at the beginning of the agreement.
 What in fact happens, is all investment deposits are pooled and invested in various projectsforming portfolios with varying maturities. Sometimes the bank’s shareholders funds are also
pooled to finance projects. In this case, the bank is also entitled to a share in proportion to its
capital invested. Profits are allocated to the depositors in proportion to deposit amount and time for
which the amount is deposited with the bank.
 Most Islamic banks have two types of investment accounts, unrestricted and restricted.
 Unrestricted investment account deposit can be invested in any sector according to the wishes of
the bank, provided the investment does not contradict the Shari’a.
 Restricted Investment accounts allows the depositor to specify in what sector, his deposit will be
invested.
 On the Assets side of the balance sheet, conventional banks usually grant credit facilities such as
term-loans, overdrafts and housing mortgage loans.
 They also invest in the short-term money market, government securities, treasury bills, company
bonds and equities in the stock exchange. In the case of Islamic banks, as all interest-bearing
instruments are prohibited, these financial instruments, except for equities, are not available to it.
 Instead Islamic banks use Islamic financial instruments, some of which have equity features while
others have features of both debt and equity (Obiyathullah, 1995) and still some others have
features of debt. This will be explained in some detail in the next section.
 The third type of activity is unique to Islamic banks (although some conventional banks provide
free overdraft to student customers).
 Providing interest-free loans is part of the social activity of Islamic banks although only a small
portion of its total funds is allocated to this. Usually the funds come from Zakat and charity pool
created by the bank from its own Zakat contributions and charitable contributions of others.
 In theory, Islamic banks should set aside a portion of the shareholders and depositors funds for this
purpose. It is not certain how many banks actually undertake this function, as they seem to operate
mostly along commercial lines. However, as we have seen in the case of Mit-Ghamr bank, this is not
theoretical and has been applied in practice. In Pakistan, Islamic banks have given interest-free
study loans to students.
The Asset side of islamic banks: Islamic
Financial Instruments
 Since Islamic banks cannot grant loans on interest, the assets side of the balance sheet
cannot have any advances (except interest free loans) as assets.
 Since banks cannot earn any money on interest-free loans, they have to resort to
participatory finance and other Islamic financial instruments to earn an income.
Questions
 1. To argue that “good is lawful and hence what is lawful must be good” is an
example of which of the following techniques of deriving the law:
a) ‘Urf.
b) Qiyas.
c) Maslaha.
d) Istihsan.
 2. How does the Murabaha contract avoid Riba’ elements:
a) It is a trade-based contract and thus any increase above the cost is justified as a
profit element on the sale of the asset.
b) Murabaha only avoids Riba’ al-fadhl when they buy and sell non-ribawi items.
c) Murabaha avoids Riba’ by combining the contract with a collateral agreement.
d) Statements (b) and (c) are correct.
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Questions 3-5 refers to the following Hadith:
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“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt – like
for like, equal for equal, and hand-to-hand; if the commodities differ, then you may sell as you wish,
provided that the exchange is hand-to-hand”
3. What are the two categories of goods that can be classified as ribawi goods:
a) Foodstuff and clothing.
b) Foodstuff and fuel.
c) Jewelry and fruits.
d) Foodstuff and currencies.
4. In an exchange of gold against silver, the following rules must be adhered to to avoid riba’:
a) The items exchanged must be similar in quantity, weight and exchanged at the same
time.
b) The items must be exchanged at the similar value only.
c) As long as the exchange is conducted on spot basis without any undue delay, the value can
be different.
d) None of the above is true.
5. In an exchange of gold of higher value with a larger quantity of gold of lower value, the
following statement is true:
a) The exchange is not riba’ as it is fair to get more of lower value for less of higher
value.
b) The exchange is riba’ because it violates the conditions mentioned in the above
Hadith
c) The exchange is riba’ because no market value is stipulated as a basis of exchange.
d) The exchange is not riba’ because gold against gold is within the same category of ribawi
items.
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