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IBF 8211 (Accounting for Islamic Financial Institutions)

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BAYERO UNIVERSITY, KANOINTERNATIONAL INSTITUTE FOR ISLAMIC

BANKING & FINANCE (IIIBF) COURSE

: IBF 8211- Accounting for Islamic Financial Institutions

PROGRAM:

M. Sc. Islamic Banking and Finance

SESSION/SEMESTER: 2011/2012 Session - First Semester 

LECTURER: Kabir Tahir Hamid, B.Sc., M.Sc., PhD. (Acct), MBA,

FIFC, FIDRP, ATM,

A. COURSE DESCRIPTION

This course is designed to introduce students to basic

issues in Islamic Accounting, accounting for Islamic

deposits and investment accounts, accounting for Mudharabah

investment account, Islamic equity financing and Islamic

assets financing (Musharakah,  Murabaha and Ijara), accounting

for  Zakat  and auditing and Sharia supervision of Islamic

Financial Institutions (IFIs).

B. COURSE OBJECTIVES

The objectives of the course are to develop an understanding of:

I. the meaning of Islamic accounting and its

differences with conventional accounting;

II. The applicability of GAAPs and accounting standards

in IFIs;

III. Accounting for various types of deposits in Islamic

banks

IV. Islamic equity and assets financing;

V. A c c o u n t i n g f o r Zakat 

VI. Auditing and Sharia Supervision of IFIs.

C. COURSE CONTENTS1.0 INTRODUCTION TO ISLAMIC ACCOUNTING

1.1 The Concept of Islamic Banking

1.2 The Definition of Islamic Accounting

1.3 Differences between Islamic Accounting and Conventional

Accounting

1.4 Islamic Worldview of Accounting and Accountants

1.5 Objectives of Financial Accounting and Reporting for IFIs

1.6 The Need for Islamic Accounting Standards

1.7 The Development of Islamic Accounting Standards

1.8Application of GAAPs in Conventional Accounting Compared with

Islamic Accounting

1.9Qualities of Islamic Accounting Information

1.10Discussion Questions

2.0ACCOUNTING FOR ISLAMIC DEPOSITS AND INVESTMENT ACCOUNTS

2.1 Principles of Wadi’ah Deposit and Accounting Implications

2.2Principles of Mudharabah Investment Account

2.3Unrestricted Mudharabah and Restricted Mudharabah (Investment

Accounts)

2.4Discussion Exercises

3.0 ACCOUNTING FOR MUDHARABAH INVESTMENT ACCOUNT

3.1 Specific Disclosure Requirements Relating to Mudharabah

3.2 Accounting for Mudharabah Financing

3.3 Principles of Mudharabah Investment Account

3.4Mudharabah Financing –AAOIFI FAS 32.5

3.5 Discussion Exercises

4.0 ISLAMIC EQUITY FINANCING AND ISLAMIC ASSETS FINANCING

4.1 ACCOUNTING FOR  MUSHARAKAH FINANCING

4.1.1 Principles of Musharakah Financing

4.1.2 Termination of Musharakah

4.1.3 Types of Musharakah Financing

4.1.4 Accounting for Musharakah Financing - AAOIFI FAS 4

4.1.5 Discussion Exercises

4.2 ACCOUNTING FOR  MURABAHAH FINANCING

4.2.1 Bai’ Al Muajjal or Bai’ Bithaman Ajil 

4.2.2 Murabahah Financing –AAOIFI FAS 2

4.2.3 Discussion Exercises4.3 ACCOUNTING FOR IJARAH FINANCING

4.3.1 Principles of Ijarah

4.3.2  Ijarah Financing- AAOIFI FAS 84.3.3 Discussion Exercises

5.0 PRINCIPLES OF ZAKAT AND ZAKAT ACCOUNTING FOR BUSINESS WEALTH

5.1 Comparison between Zakat and Taxation

5.2 Fundamental Principles of  Zakat 

5.3 Zakat Accounting for Islamic Financial Institutions

5.3.1 Accounting Standard on Zakat for IFIs: AAOIFI FAS 9

5.3.2Valuation of Assets for  Zakat 

5.3.3 Discussion Exercises

6. 0 AUDITING AND SHARIA SUPERVISION OF IFIs

6.1 Shari`ah Supervision in Islamic Banks

6.2 Auditing of Islamic Financial Institutions

6.2.1 The Objectives of Auditing IFIs

6.2.2 The Role of Key Players in the Audit of IFIs

6.2.3 The Role of Shariah Supervisory Board in Audit of IFIs

6.2.4 External Auditor 

6.2.5 Internal Shariah Review

6.2.6 Audit and Governance Committee

6.2.7 Challenges of Audit of IFIs

D. RECOMMENDED TEXT BOOKS

1.An Introduction to Islamic Accounting: Theory and

Practice by Abdul Rahim Abdul Rahman2.Accounting,

Auditing and Governance Standards for Islamic

Financial Institutions by Accounting and Auditing

Organization For Islamic Financial Institutions (AAOIFI)3.A

Mini Guide to Accounting for Islamic Financial

Products by Syed Alwi Mohamed Sultan4 . I s l a m i c

B a n k i n g a n d i t s O p e r a t i o n s b y Z a f a r A h m a d

K h a n 5.Islamic Corporate Reporting: Between the

Desirable and the Desired by Maliah

Sulaiman6.Financial Reporting from an Islamic

Perspective by Malaysian Accounting Standards

Board7.A Statement of Basic Accounting Theory by

American Accounting Association

E. METHODOLOGY

Discussion papers, covering the theoretical aspects of each

topic, would be prepared and presented in theclass.

Discussion exercises will follow the theory on every

topic. Some of the exercises would be attempted in the

class, and the rest would be left to the students to practice on

their own.

F. GRADING FORMULA

Continuous Assessment 40%Semesters Examination 60%Aggregate

100%.The continuous assessment marks are to be absorbed through

paper presentation, assignments and tests.2

1. 0 INTRODUCTION TO ISLAMIC ACCOUNTING

1.1 The Concept of Islamic Banking

Islamic banking is banking activity that is consistent

with the principles of sharia law and its practical

application through the development of Islamic economics, which

prohibits the payment or acceptance of interest (i.e. riba or

usury) for money loans or investing in businesses that provide

goods or services that are sinful and prohibited in Islam

(haraam).As a financial intermediary, the basic mechanism of the

Islamic bank is to accept deposits from surplus units on the

liability side and offer financing on the assets side to the

deficit units. Among other things,

Liabilities of an Islamic bank consist of two main categories:

the usual interest-free current accounts and saving accounts, and

investment accounts based on the profit-and-loss sharing

principle (PLS) between the bank and depositors. The latter

is the Islamic alternative of term deposits in

conventional banks where the principles of   Mudharabah

and Musharakah are adopted instead of the interest rate.

Assetsinclude, among other things, a broad range of financings:

Murabaha, Ijara and Istisnaa. All these instruments need different

accountings due to different conditions of financial contracts of

conventional finance based on interest, as well as,

different requirements for presentations and

disclosure. The financial statements of Islamic bank must

also reflect its functions as possible agent of  Zakat 

payment,manager of charitable funds and Qard Fund. The following

are the definition of some of the major terms associated with

Islamic banking:

 Musharaka: Musharaka is a partnership or co-ownership with

profit and loss sharing. It allows each party involved to

share risk and reward to achieve a return in the form of a share

of the actual profits earned according to a predetermined ratio.

 Mudharabah: A Mudharabah transaction is an investment

partnership. In a Mudharabah arrangement, the contract is between

an investor (and financier) and an entrepreneur or investment

manager known as the mudarib. In the case of a profit, both

parties receive their agreed share of the profit. However, in the

case of a loss, the investor bears any loss of capital while the

Mudharib loses his time and effort.

 Mudharib: Entrepreneur in a  Mudharabah contract, which is

usually the bank in deposit takingtransactions.

 Murabaha: A Murabaha transaction is a sale at a stated

profit. In a Murabaha

Transaction, the bank purchases something from a third party

and sells it to the client at a stated profit on a deferred

payment basis. In this way, the client can buy something without

taking an interest-based loan.

Wakala: Wakala refers to an agency contract where the agent act on

behalf of the principal. In Wakala,the bank acts as an agent to

the client to buy the asset according to the specific terms and

conditions.

  Ijarah:An  Ijarah is an Islamic lease. The bank purchases an

asset and leases it to a client for fixedmonthly payments.

An  Ijarah may include an option for the lessee to buy the

asset at the end of the lease.

Qard-al-Hasan: Benevolent loan contract (no interest) used for

current and savings deposits in Middle Eastern Islamic Banks

 Al Wadiah: Safe custody contracts used as a basis for current and

savings account by Islamic Banks inAsia.

 Hadiah: Gift given to current and savings account holders

entirely at the discretion of the bank.

Rab ul Mal or Sahi ul Mal: Finance provider in Mudharabah contract

IRR: Investment Risk Reserve

PER: Profit equalization reserve, an amount provided

from profits before the mudharib share is deducted, in

order to smooth income and provide a stable rate of return

for  both mudharib and Rab ul mal. The mechanism is provide when

return is high and reverse provision when return is low.

1.2 The Definition of Islamic Accounting

Islamic accounting can be defined as the accounting

process which provides appropriate information (not

necessarily limited to financial data) to stakeholders of an

entity which will enable them to ensure that the entity is

continuously operating within the bounds of the Islamic

Shariah and delivering on its socio-economic

objectives. Similarly, Islamic accounting has also been

defined as “the process of identifying, measuring and

communicating economic and other relevant information, inspired

by the Islamic worldview and ethics, and complied with the

Shari’ah (Islamic law) – in order to permit informed judgments and

decisions by potential and expected users of information– to

enhance social welfare and seek the blessings of Allah”. Islamic

accounting is also a tool, which enables Muslims to evaluate

their own accountabilities to God (in respect of

inter-human/environmental transactions).The meaning of Islamic

accounting would be clearer if compared with the

definition of conventional accounting. The most generally

acceptable definition of conventional accounting is that

given by the AAA in 1966, which defined accounting as the

process of identifying, measuring and communication

economic information to permit informed judgments and decisions

by the users of the information. From the definitions above, it

can be seen that accounting is the system that measures business

activities, processes that information into reports, and

communicates these reports to decision-makers. The output of

accounting process is in the form of financial statements, which

are documents that report an entity’s financial activities in

monetary terms. The accounting process relies on

bookkeeping in the form of double entry system. The role

of accounting is to serve the accountability of the agent

(stewardship of the management) towards the principal

(shareholders and other stakeholders) of the business wealth due

to the separation of ownership from control of the

corporation. Stewardship accounting is associated with the

need of those in business to keep records of their

transactions, the manner in which they invested their

wealth and the debts owed to them and by them. From this, it can

be seen that both Islamic and conventional accounting are

concerned with the provision of information for decision

making, which is the ultimate goal of accounting.

 1.3 Differences between Islamic Accounting and Conventional

Accounting

The differences between Islamic accounting and conventional

accounting are presented on

Table1.Table 1: Differences between Islamic Accounting and

Conventional Accounting

S/No.Basis

of D i f f e r e n t i a t i o n I s l a m i c

A c c o u n t i n g C o n v e n t i o n a l

A c c o u n t i n g

1 O b j e c t i v e o f p r o v i d i n g information

D e c i s i o n r e l a t i n g t o a s s e s s m e n t o f   c o m p l i a n c e

w i t h t h e S h a r i a h i n organizational dealings and the

extent o f m e e t i n g i t s o b j e c t i v e s ( I s l a m i c

accountability). Decision relating to efficient allocation of

scarce resources mostly buy, sell or hold decisions on

their investments (Decisions usefulness).

4

 

S/No.Basis

of D i f f e r e n t i a t i o n I s l a m i c

A c c o u n t i n g C o n v e n t i o n a l

A c c o u n t i n g

2 t h e t y p e o f

t h e i n f o r m a t i o n t h a t i s i d e n t i f i e d , h o w

i t i s m e a s u r e d , r e c o r d e d and communicated Identify

socio-economic and religious events and transactions and

records them using both historical cost and current

valuation (current valuation is used at least on

accounting for Zakat ).I t a l s o

e n g a g e s i n reporting/disaggregating

items into haram and halal elements. For example, finance

income would have to be splitted in to conventional interest and

income from the various types of Shariah compliant contracts.

Concentrates on identifying economic events and transactions

and record them using historical costs (or net realizable

v a l u e , w h i c h e v e r i s l o w e r ) . Conventional

accounting has tried in the past to overcome the limitation

of historical accounting through inflation a c c o u n t i n g

a n d c u r r e n t v a l u e accounting, but the ideas were

given up due to their complexity and lack of objectivity.

3 U s e r s o f t h e information Give

f a i r l y g o o d f o c u s t o a w h o l e gamut of stakeholders

recognized by t h e c o r p o r a t e a c c o u n t i n g t o e n a b l e

them assess compliance with Shariah and enables the

assessment of whether the socio-economic objectives of

theorganization are being met ethically, w i t h o u t h a r m

t o o t h e r s a n d t h e achievement of equitable allocation

and distribution of wealth among members o f t h e s o c i e t y

e s p e c i a l l y t h e s t a k e h o l d e r s o f t h e

c o n c e r n e d corporation. F o c u s e s m o r e o n

s h a r e h o l d e r s a n d c r e d i t o r s w h o a r e f i n a n c i e r s

a n d  providers the funds.

4 . A n t e c e d e n t a n d Legislations

for Reporting I s l a m i c a c c o u n t i n g i s b a s e d u p o n ethical

law originating in the Qur’an and Sunnah. T h e s o c i o -

e c o n o m i c activities are reported using Shari’a and I s l a m i c

a c c o u n t i n g s t a n d a r d s . T h e  principles of Islamic

accounting do not s e r v e t h e i n t e r e s t o f a n y

p a r t i c u l a r   group, but to the society as a whole

w h i c h c a n m a k e c o r p o r a t i o n s accountable for

their actions and ensure they comply with Shariah principles.

Conventional accounting is claimed by some writers to be a

product of culture a n d i t i s b a s e d u p o n

m o d e r n commercial law. It is a set of beliefs and

techniques that has the ability to l i n k a c t i o n s a n d

v a l u e s s o a s t o legitimize those actions. If

there are some restrictions, they are imposed by human

beings and subject to change through democratic

legislation.

5 A c c o u n t a b i l i t y A c c o u n t a b i l i t y

i n I s l a m e n c o m p a s s e d a t w o

d i m e n s i o n a l c o n t e x t , f i r s t , horizontal

accountability to fellow h u m a n b e i n g s i . e . t h e

p u b l i c a n d stakeholders and secondly, ultimate

transcendental accountability to Allah. Personal accountability t o

t h e individuals who control resources and to some extent

other stakeholders.

6 F o u n d a t i o n R e l i g i o u s

( t h e r e i s a j u d g m e n t d a y

in the hereafter which mankind pay responsibility during

his/her life before the God and there is hell for punishment and

heaven for reward).S e c u l a r i s m ( p o w e r i s h o l d b y

mankind, no judgment day and the world is the end of life).

Admittedly, sensitivity to social responsibility is not exclusive

to Islam, and is arguably a universal concern that transcends

religious affiliation and social and environmental reporting is

advocated by many non-Islamic bodies, such as the Global

Reporting Initiative. Many entities that do not

readily identify themselves with Islam also include

social and/or environmental reporting in their financial

or annual reports. However, while these parties may be

driven by a primarily humanitarian impetus, Muslims are

compelled by their religion to be attentive to these issues. For

Muslims, such disclosure form part of their muamalat 

responsibility.

1.4 Islamic Worldview of Accounting and Accountants

The Islamic worldview of accounting are not merely

derived from cultural and philosophical elements aided

by science, but one whose original source is revelation, affirmed

by intellectual and intuitive principles. Islam literally means

‘peace’ and ‘obedience’, and the adherents to Islam have to be

‘obedient’ to God and to appreciate the purpose of their

existence in this world. God proclaimed that, “I have only created…

men that they may serve me” (Qur’an, 51:56). The nature of this

service is taken to have been spelled out clearly when God,

upon creating men, declared, “I will create a vicegerent on earth”

(Qur’an, 2:30). Muslims consider humans to be vicegerents of

God. Thus, whatever worldly possession a Muslim has is to be

held in a stewardship capacity – that is simply in trust from

God. According to Islam, Muslims are trustees (or stewards) for

God. An overriding consequence of acceptance of the faith

is that everything a Muslim does is to be in accordance

with God’s wishes as disclosed in two major sources.

First, they are prescribed by the revealed words of God,

in the Qur’an. Second, they are exemplified by the Sunnah,

the sayings of the Prophet Muhammad (SAW); and

descriptions of his conducts. These two sources are

the material sources of Islamic law (Shari’ah). These sources

is supplemented also by the Ijma (the pronouncements

representing the consensus of Islamic scholars on matters not

addressed explicitly by the Qur’an and the Sunnah).The worldview

of Islam encompasses both the worldly aspect and the religious

aspect, in which the worldly aspect must be related in a

profound and inseparable way to the religious aspect, in

which the religious aspect has ultimate and final

significance. To achieve God’s blessing, economic

activities must be morally directed. In any economic decisions,

including financial reporting upon economic activities, the

ethical values should act as a norm and economic

relationship must be regarded as moral relationship. Man is

unique and God has created him and honored him with free

will and responsibility over the universe on the basis of

truth and justice. The concept of tawhid is also directly related

with another important concept, namely khilafah

(vicegerent). This concept means that man is a trustee on

this earth, and this requires as a guardian and deputy

of God in dealing with the universe and its

environment, wealth, and other creatures. However, if man uses

his will and ability for any purpose other than those for

which they were created, he will have failed in his

responsibility, violated the h o n o r o f h i s d u t i e s , a n d

m i s s e d t h e p u r p o s e o f h i s e x i s t e n c e .

  In the Islam, the concept of accountability is ingrained in the basic creation of man as

a vicegerent of God.   In Islam, accounting should function not only as a service activity

providing financial information tothe users and to the publ i c a t large but

more impor tant l y accountants should d i scharge the i r   accountability by

providing information to enable society to follow God’s commandments. In terms o f

respons ib i l i t y , the acc ount ant in I s l am i s no t mere ly res pons ib le to

human super i ors , the management/client or shareholders. He/ she is a

servant and trustee of God in all situations, is   simultaneously responsible to God

the Owner of his very self and the resources he is utilizing and managing. To forget

or to neglect this fundamental aspect of this responsibility is tantamount to

a betrayal of divine trust with all the attending consequences in this world and in the

hereafter. The accountant in Islam is motivated to provide work and excellent

service because as a holder of  amanah (trustee of God) on earth he must search

for the bounties of God. His/ Her work is a form of amal salih (virtuous deed) which is

then the key for the attainment of blessings (true success in this world and in the

hereafter). His/her work is also a form of ibadah (servitude to God) in so far as it  is in

conformity with the divine norms and values. The accountant who is imbued

with the world-view of tawhid (oneness of God) is not anti-profit or anti-worldly gain

within the limits provided by eligion. His vision of success and failure however extends

beyond worldly existence to the life in the hereafter.

1.5 Objective of Financial Accounting and Reporting for IFIs

The following are the objectives of financial accounting and

reporting for IFIs as given by AAOIFI. To provide :

I. Information about the Islamic bank’s

compliance with the Shari’ah and its objectives

andinformation establishing the separation of

prohibited earnings and expenditures, if any, which

occurred, and the manner in which these were disposed

of.

II. Information about the Islamic bank’s economic

resources and related obligations to assist the

users in: evaluating the adequacy of the Islamic

bank’s capital to absorb losses and business risks;

assessing the risk inherent in its investments and;

evaluating the degree of liquidity of its assets and the

liquidity requirements for meeting its other

obligations.

III. Information to assist the concerned party in the

determination of Zakat on the Islamic bank’s funds

and the purpose for which it will be disbursed.

IV. Information to assist in estimating cash flows that

might be realized from dealing with the Islamic bank,

the timing of those flows and the risk associated with

their realization. The information should be

directed principally at assisting the user in

evaluating the Islamic bank’s ability to generate

income and to convert it into cash flows and the

adequacy of those cash flows for distributing profit

to equity and investment account holders.

V. I n f o r m a t i o n t o a s s i s t i n e v a l u a t i n g t h e

I s l a m i c b a n k ’ s d i s c h a r g e o f i t s f i d u c i a r y

responsibility to safeguard fund and to invest

them at reasonable rates of return, and

information about investment rates of returns on

the bank’s investments and the rate of return

accruing to equity and investment accountholders.vi.

Information about the Islamic bank’s discharge of its

social responsibilities.

VI. Information to users of these reports, to enable them

to make legitimate decisions in their dealings with

Islamic banks.

1.6 The Need for Islamic Accounting Standards

The contemporary experience of Islamic banking is hardly

more than three decades old, though it proved to be

groundbreaking with far reaching impacts worldwide. Among the

major challenges faced by Islamic banking experts and Shariah

Scholars has been the idea of developing appropriate accounting

and auditing standards, to achieve financial transparency and

enhance the quality of financial service to society. Hence,

developing unique accounting and auditing standards

to serve the special needs of Islamic banks becomes a

necessity. The need for accounting records as means for

trust building is emphasized in the Quran : “...Never get

bored with recording it, however small or large, up to its

maturity date, for this is seen by Allah as closer to

justice, more supportive to testimony, and more resolving

to doubt, except when it is spot trade carried out amongst

yourselves, then you are not to blame for not recoding it”,

(Baqara: 282). Even for spot transactions where debt is not

involved, the Quran allows an open discretion for taking records,

and that is all what accounting is about. Islamic accounting

practice takes place within the IFIs such as Islamic banks

and Zakat institutions, andit is essential to the running of these

institutions. Islamic accounting practice does not indicate that

Islamman date any particular form of accounting. However, the

manifestation of Islamic faith simply implies that there are

particular forms of accounting to suit the needs of Islamic

religious requirements. This is particularly true in the context

of accounting practices in IFIs. The prohibition of interest

(riba’) and the different forms of financing has led to modified

accounting treatments and disclosure requirements for Islamic

financial services. This is manifested by the explanations

and discussions of accounting for various Islamic financial

services and transactions. The discussions of a unique Islamic

financial system of Zakat indicates the needs for accounting

for Zakat. This is especially crucial considering Zakat is

areligious institution that involves quite a number of accounting

implications. First, it is widely accepted that the primary

objective of accounting is to provide useful information

to assist users in making economic decisions. Thus, it

can be argued that accounting is therefore, a religious

obligation. Hence, if accounting is a religious obligation, then

the rules of accountability must be purely divine. In order to do

so, appropriate accounting framework based on Shariah principles

must be in place. The motivation for the development of Islamic

accounting comes together with the emergence Islamic economic and

Islamic resurgence for the last two to three decades. The

awareness for the need for Islamic accountingng is due to

basic building blocks of conventional accounting itself

since the International Financial Reporting Standards (IFRS) are

based on interest-based elements. This is one of the elements

embedded in the conventional accounting which is already

violating the requirements of Shariah. It is necessary to have

Islamic accounting to be in place rather than conventional

accounting inorder to provide information on financial success in

Islamic organizations. The Accounting and Auditing Organization

for IFIs (AAOIFI) was formed for this reason. Second, Islamic

accounting may be more appropriate to achieve the

socio-economic and religions objectives of Islamic

institutions and Muslim users. This is because Islamic

institutions such as Islamic banks etc. are established to meet

the socio-economic objectives of the Shariah (Islamic Law)

through the implementation of an Islamic economic

system. Hence, these institutions should logically

use Islamic accounting, especially for monitoring these

institutions to achieve their objectives. However,

if conventional accounting which developed to meet the

needs of a capitalist economy is used instead in these

institutions, a problem is likely to occur, which will

lead to the institutions not meeting their Shariah socio-

economic objectives and even worse may turn these Islamic

institutions into capitalist institutions by providing

materialist profit-focused information instead of the

holistic information provided by Islamic accounting.

Nevertheless, Islam is not against profit motive that is

reasonable. There is no doubt, therefore, that Islamic accounting

would result in an ethical based accounting system which measures

not only profits but social, environmental and religious

performance. Third, with the resurgence of Islam globally,

the awareness for the need of Islamic accounting arises.

Islamic accounting as a whole is able to serve the whole

gamut of stakeholders. Its principles do not serve the

interest of any particular group, but to the society as a

whole which can make corporations accountable for their

actions and ensure they comply with Shariah principles. Fourth,

Islam as a religion embraces a comprehensive system of human

conduct, influencing all aspects of life. The uniqueness of Islam

lies in its practicalities. Islam as a religion is not merely a

belief but is a complete way of life. In fact, accounting is

embodied in Islam. This can analogically be seen from

Islamic faith whereby for every human, 2 angels

accompanied them at right and left shoulders, record every

good deeds and sins (the double-entry bookkeeping

principles?). Further, the accounting profession has been

mentioned comprehensively in Quranic verses, portrayed to

shoulder responsibility of social and economic justice. Allah has

declared in Quran; “O ye who believe! When ye deal with eachother, in

transactions involving future obligations in a fixed period of time, reduce them to

writing, let a scribeaccountant?) Write down faithfully as between the parties; let not the

scribe refuse to write; as Allah has t aught him, so let him write. Let him who incurs the

liability dictate, but let fear his Lord Allah, and not diminish aught of what he owes. If

the party liable is mentally deficient, or weak or unable himself to dictate, let his

guardian dictate faithfully. And get two witnesses, out of your own men, and if there

are not two men, then a man and two woman, such as ye choose, for witnesses, so that

if one of them errs, the other can remind him/ her. The witnesses should not

refuse when they are called on(for evidence). Disdain not to reduce to writing (your

contract) for a future period, whether it be small and more convenient to prevent

doubts among yourselves but if it be a transaction which ye carry out on8the spot

among yourse lves there i s no b lame on you i f ye reduce i t no t to

wr i t ing . But ne i ther take witnesses whenever ye make a commercial contract;

and let neither scribe nor witness suffer harm. If yes do (such harm), it would be

wickedness in you. So fear Allah; for it is Allah that teaches you. And Allah is well

acquainted with all things”(Al-Baqarah,2: 282).Fifth, the proper

development of Islamic accounting practice especially in IFIs

requires a well regulatedIslamic financial service, and one of

the key elements of regulation is accounting regulation.

Therefore, a well-regulated Islamic financial industry requires a

sound accounting and reporting requirements that, first, would

meet the requirements of Shari’ah and, second, will be relevant to

be practiced in our time.The need for a codified Islamic

accounting primarily stemmed from the need that Islamic

accounting objectives, concepts and principles developed

based on Shari’ah requirements. However, the Islamic

accounting regulation also needs to adapt to the modern

accounting regulatory environment to make it relevant to be

practiced in our time.

1.7The Development of Islamic Accounting Standards

The growth of Islamic financial markets and institutions,

culminating in the growing interest in Islamic banking, insurance

and capital market reiterates the need for different accounting

requirements. Islamic accounting is needed to serve

different principles of financial instruments that

are founded on the Islamic worldwide and Shari’ah

r e q u i r e m e n t s . S e q u e l t o t h i s , t h e A c c o u n t i n g a n d

A u d i t i n g O r g a n i z a t i o n f o r I s l a m i c F i n a n c i a l

I n s t i t u t i o n s ( A A O I F I ) w a s e s t a b l i s h e d o n 1 S a f a r ,

1 4 1 0 H corresponding to 26 February, 1990 in Algiers, and then,

registered on 11 Ramadan 1411 corresponding to 27 March, 1991

in the State of Bahrain, as an international

autonomous not-for-profit Islamic corporate body that

prepares standards for IFIs, through the support of

institutional members (200members from 45 countries, so

far) including central banks, Islamic financial

institutions, and other  participants from the international

Islamic banking and finance industry, worldwide. Explain AAOFI

issues accounting, auditing, governance, ethics and

Shari'a standards for Islamic financial institutions and the

industry. Professional qualification programs (notably CIPA, the

Shari’a Adviser and Auditor "CSAA", and the corporate compliance

program) are presented now by AAOIFI in its efforts to enhance

the industry’s human resources base and governance structures.

AAOIFI has gained assuring support for the implementation of

its standards, which are now adopted in the Kingdom of

Bahrain, Dubai International Financial Centre, Jordan, Lebanon,

Qatar, Sudan and Syria. The relevant authorities in Australia,

Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia,

and South Africa have issued g u i d e l i n e s t h a t a r e b a s e d

o n A A O I F I ’ s s t a n d a r d s a n d p r o n o u n c e m e n t s . I n t h e

m e a n t i m e , t h e globalization agenda and international

harmonization movement of Islamic accounting and financial

reporting is gaining momentum. However, the calls for

worldwide adherence to IFRSs to achieve harmonization

in financial reporting regardless of cultural differences

should not go unchallenged. Standards that have been developed

by AAOIFI as at 30th September, 2012 are as follows:

Accounting standards

 1. Objective of financial accounting for Islamic banks and

financial institution (IFIs).

2. Concept of financial accounting for IFIs.

3. General presentation and disclosure in the financial

statements of IFIs.

4. Murabaha and Murabaha to the purchase orderer.

5. Mudaraba financing.

6. Musharaka financing.

7. Disclosure of bases for profit allocation between owners’

equity and investment account holders.

8. Equity of investment account holders and their equivalent.

9. Salam and Parallel Salam.

10. Ijarah and Ijarah Muntahia Bittamleek.

11. Zakah.

12. Istisna’a and Parallel Istisna’a.

13. Provisions and Reserves.

14. General Presentation and Disclosure in the Financial

Statements of Islamic Insurance Companies.

15. Disclosure of Bases for Determining and Allocating Surplus or

Deficit in Islamic Insurance Companies.

16. Investment Funds.

17. Provisions and Reserves in Islamic Insurance Companies.

18. Foreign Currency Transactions and Foreign Operation.

19. Investments.

20. Islamic Financial Services Offered by Conventional Financial

Institutions.

21. Contributions in Islamic Insurance Companies.

22. Deferred Payment Sale

.

23. Disclosure on Transfer of Assets.

24. Segment Reporting.

25. Consolidation.

26. Investment in Associates.

Auditing Standards 

1. Objective and principles of auditing.

 

2. The Auditor’s Report.

3. Terms of Audit Engagement.

4. Testing for Compliance with Shari’a Rules and Principles by an

External Auditor.

5. The Auditor’s Responsibility to Consider Fraud and Error in an

Audit of Financial Statements.

Governance Standards

 1. Shari’a Supervisory Board: Appointment, Composition and

Report.

2. Shari’a Review.

3. Internal Shari’a Review.

4. Audit and Governance Committee for IFIs.

5. Independence of Shari’a Supervisory Board.

6. Statement on Governance Principles for IFIs.

7. Corporate Social Responsibility.

Ethics Standards

1. Code of ethics for accountants and auditors of IFIs.

2. Code of ethics for employees of IFIs.

Shari’a Standards

1. Trading in currencies.

2. Debit Card, Charge Card and Credit Card

3. Default in Payment by a Debtor.

4. Settlement of Debt by Set-Off.

5. Guarantees.

6. Conversion of a Conventional Bank to an Islamic Bank.

7. Hawala.

8. Murabaha to the Purchase Orderer.

9. Ijarah and Ijarah Muntahia Bittamleek.

10. Salam and Parallel Salam.

11. Istisna’a and Parallel Istisna’a.

12. Sharika (Musharaka) and Modern Corporations

13. Mudaraba

14. Documentary Credit.

15. Jua’la.

16. Commercial Papers.

17. Investment Sukuk.

18. Possession (Qabd).

19. Loan (Qard).

20. Commodities in Organised Markets.

21. Financial Papers (Shares and Bonds).

22. Concession Contracts.

23. Agency.

24. Syndicated Financing.

25. Combination of Contracts.

26. Islamic Insurance.

27. Indices.

28. Banking Services.

29. Ethics and stipulations for Fatwa.

30. Monetization (Tawarruq)

31. Gharar Stipulations in Financial Transactions

32. Arbitration

33. Waqf 

34. Ijarah on Labour (Individuals)

35. Zakah

36. Impact of Contingent Incidents on Commitments.

37. Credit Agreement

38. Online Financial Dealings

39. Mortgage and its Contemporary Applications.

40. Distribution of Profit in Mudarabah-based Investments

Accounts.

41. Islamic Reinsurance

42. Financial Rights and Its Disposal Management

43. Liquidity and Its Instruments44. Bankruptcy45. Capital and

Investment Protection

Standards under development include:Shari'a Standards

1.Purification of Prohibited Income

2.Promise and Bilateral Promise

3 . C r e d i t C a r d s

4 . A g r i c u l t u r e C o n t r a c t

5 . C a p i t a l P r o t e c t i o n

6 . R i s k M a n a g e m e n t

7 . F e e s a n d C o m m i s s i o n s

8.Calculation of Financial Transactions Profit

9 . C o o l i n g o f O p t i o n s

10.Safety Options

11.Sincerity & honesty options

12.Investment Agency

13.Special purpose vehicles

14.Legal reference for Agreements and contracts for IFIs

15.Bankruptcy

16.Liquidity and Its Instruments

17.Financial rights and its disposal management

18.Capital and Investment protection

AAOIFI FAS 1

AAOIFI has issued the Financial Accounting Standard No. 1 on

General Presentation and Disclosure inthe Financial Statements

of Islamic Banks and Financial Institutions in January

1996. The standard is applicable to the financial

statements published especially by Islamic banks to

meet the common information needs of the main users

of such statements. The standard makes it clear that

if the requirements of the standard contradict the bank’s

charter or the laws and regulations of the country in which it

operates a disclosure should be made on the

contradiction and the impact of promulgated standards

on the relevant elements of the financial statements .AAOIFI FAS

1 specified that the complete set of financial statements consist

of conventional statements such as a statement of

financial position (balance sheet); income statement,

cash flows statement; statement of changes in owners’

equity, or a statement of retained earnings; and notes to

the financial statements. However, the standard added three (3)

additional statements that could be useful for users of Islamic

banks and financial institutions, namely:

(i) statement of changes in restricted investment;

(ii) statement of sources and uses of funds in the

Zakat and charity fund (if the bank assumes the

responsibility for the collection and distribution

of Zakat ); and (iii) statement of sources and uses

of funds in the Qard fund. The standard also makes

it clear that Islamic banks and financial

institutions, in addition to

other conventional disclosures (Para 3/2), should

disclose two (2) very important aspects of their

unique functions i.e.

(iii) The role of the Shari’ah adviser or the Shari’ah

board in supervising the bank’s activities and

the nature of adviser’s or board’s authority in

accordance with the bank’s bye-laws and in actual

practice; and,

(iv) the bank’s responsibility towards Zakat For the

disclosure of significant accounting policies,

AAOIFI FAS 1 made a number of disclosure

requirements such as (i) disclosure of accounting

policies; (ii) disclosure of bases and methods

adopted by the bank’s management for revaluation of

assets, liabilities and restricted investments to

their cash equivalent value; (iii) disclosure of

earnings or expenditures prohibited by the

shari’ah and how the bank intends to dispose of the

assets generated by the prohibited earnings or

acquired through prohibited expenditures; (iv)

disclosure related to unrestricted and restricted

investment accounts; (v) disclosure on the

distribution of unrestricted investment accounts, by

type, in accordance with maturity (Para 3/9);

(vi)disclosure of the method used by the Islamic

bank in allocating investment profits (or

losses) between unrestricted investment account

holders or their equivalent (Para 3/18); (vii)

disclosure on returns to each type of investment

accounts and their rate of return.

AAOIFI SFA 2

AAOIFI’s Statement of Financial Accounting No. 2 on

Concepts of Financial Accounting for IslamicBanks and

Financial Institutions (FAS 2) made it very clear that the

Islamic concept of disclosurerevolved around the concept

of ‘adequate’ disclosure. Here, adequate disclosure

means that the financial statements should contain all

material information necessary to make them useful to

users. AAOIFI’s FAS 2 elaborated the concept of

adequate disclosure into two aspects namely optimal

aggregation and appropriate descriptions and

clarifications. Optimal aggregation means the financial

statements should provide sufficient details to meet the users’

need for information. However, too muchdetail can contribute to

confusion. Therefore, it needs appropriate descriptions and

clarifications to make the information provided to be useful to

users and sufficient additional notes become necessary.

1.8Application of GAAPs in Conventional Accounting Compared with

Islamic Accounting

(i) Going Concern Concept:

Basically, the going concern concept embedded in conventional

accounting is not in conflict with the requirements

of Islamic accounting whereby the directors should

make assessment on the firms’ ability to continue as

a going concern. Consequently, the financial statements

must also be prepared on the basis of going concern basis

unless the directors want to liquidate the firms or to cease

trading. In Islamic jurisprudence, there is a presumption of

continuity, or istishab. T h e p r e s u m p t i o n o f   continuity

means retaining any event or verdict experienced in the

past until evidence is found that this event or verdict

has changed. Hence if a person is known to exist, his

existence is not denied until there is evidence to the

contrary. Extending this principle to a business entity, it

may be acceptable to assume that the entity would continue in

operation in the foreseeable future unless and until there is

indication that its ability to continue as a going concern has

ceased, for example, an entity based on Mudharabah which was

meant to be inoperation only to the end of the agreed Mudharabah

period

.(ii) Accruals/Matching Concept:

The accruals concept is not in conflict to the requirements

of Shariah. Thus, it is allowable for example, in the case

of   Murabahah or bay’ bithaman-ajil  (BBA) transactions conducted

by Islamic banks. If the banks treat a  Murabahah

or BBA transaction as a financing transaction or purely as

a sales transaction, it has the same effecton profit.

However, Islamic banks may differ in terms of the timing

of recognition of the margin: at time of sale, as cash

received or as payment becomes due. From the

Islamic perspective, the matching principle which allocates

expenses to their related revenues provides fairness and justice

simultaneously to the shareholders and other stakeholders.

(iii)

The Concept of Prudence/Conservatism:

The preparers of financial statements do,however, have to

contend with the uncertainties that inevitably surround many

events and circumstances, such as the collectability of

doubtful receivables, the probable useful life of  plant

and equipment and the number of warranty claims that may occur.

Such uncertainties are recognized by the disclosure of their

nature and extent and by the exercise of prudence in the

preparation of the financial statements. Prudence is the

inclusion of a degree of caution in the exercise of the

judgements needed in making the estimates required under

conditions of uncertainty such that assets or income are not

overstated and liabilities or expenses are not understated.

However, the exercise of prudence in Islamic Accounting

does not allow, for e x a m p l e , t h e c r e a t i o n o f

h i d d e n r e s e r v e s o r e x c e s s i v e p r o v i s i o n s , t h e

d e l i b e r a t e understatement of assets or income, or the

deliberate overstatement of liabilities or expenses, because the

financial statements would not be neutral, and therefore not have

the quality of reliability.(iv)

The Concept of ‘Substance over Form’:

AAOIFI does not particularly endorse the conceptof ‘substance

over form’. In view of the primacy of contract in

transactions in Islam, the emerging reality must be

constructed or appear to be as the form. This is

evident in the t r e a t m e n t o f l e a s e d a s s e t s (   Ijarah )

a n d s a l e s b a s e d t r a n s a c t i o n s (  Murabahah) .

F o r   Murabahah contracts, the essence of the transaction is in

fact a sales transactions. Thus, theownership title will be

passed to the purchaser upon acquisition. However, the

financier or the bank can require the purchaser to pledge the

assets acquired as collateral to the financing amount. The

financier or the bank is prohibited to buy back the assets from

the purchaser

(v)

Consistency Concept:

The requirement for consistency is not in conflict with

the Islamic accounting requirement whereby the presentation and

classification of items in the financial statements should be

retained from one period to the next unless circumstances require

it tochange.

(vi)

Historical Cost Concept:

The conventional accounting measurement is based on the

cost principle that considers the acquisition cost or historical

cost as appropriate measurement basis. However, this principle is

questionable from the Islamic point of view due to its conflicts

with the concept of fairness and justice. In case of  Zakat

determination, majority of scholars recommend the use of current

prices on the due date of  Zakat . The argument for theuse of

current market value has been based on the needs for the

most accurate valuation of wealth to be subjected for 

 Zakat  in order to serve justice to both the  Zakat recipients

and Zakat payers. Adherence to the conventional accounting

cost principles may lead to the accounting practice of asset

valuation that is lower of cost or market value. This may lead to

understatement of trade assets to be subjected for  Zakat .

AAOIFI, however, recommended the use of cash equivalent value

that indicates the value that would be realized if an asset was

sold for cash in the normal course of business as at the

date of the financial statement. In order to ensure the

reliability and comparability of the cash equivalent

value, it must be supported with objective indicators;

logical and relevant valuation methods; consistency of the

use of valuation methods; expert valuation; and conservatism in

the valuation process.

(vii)

Materiality Concept:

Information is material if its omission or misstatement could

influencethe economic decisions of users taken on the basis

of the financial statements. Materiality depends on the size

of the item or error judged in the particular circumstances of

its omission or misstatement. From an Islamic perspective,

the nature of an item may make it material, even if the size

of the item is quantitatively insignificant. A related Quranic

verse reads: “...and if there be no more than the weight

of mustard seed, we will bring it to account ...”

(Surah Al-Anbiya, verse 47). Moreover, in fiqh, there is a legal

maxim that when there is amix of the permissible and the

prohibited, the whole becomes prohibited. This would appear to

suggest that even small amounts of prohibited items may be

material. However, the maxim appears to be ihtiyat , a

precautionary measure rather than a ruling. There are

numerousexamples of and exceptions to, the maxim. For example,

the maxim is applied in the case of a m i x t u r e o f zabiha,

i.e. islamically slaughtered, and non-  Zabiha m e a t s .

T h e m i x o f   permissible and prohibited meats renders the whole

prohibited for Muslim consumption. Conversely, the prohibition

does not apply to a mixture of silk and other threads. Although

M u s l i m m e n a r e p r o h i b i t e d f r o m w e a r i n g s i l k

c l o t h i n g , a g a r m e n t m a y b e d e e m e d  permissible if it is

made of a mixture of silk and other threads such that the silk

content does not exceed a prescribed proportion. For financial

reporting purposes, an entity may not need to report some items

below a certain threshold. Conversely, there may be instances

where an entity may be required to disclose an item regardless of

the size of the item.

(viii)

Periodicity Concept:

The conventional accounting periodicity concept is also

acceptable inIslam on the basis that even in the case

of  Zakat , it is being paid once a year as a period

of measurement. The concept of haul  determined that the wealth

must be owned at least one year to qualify for the

payment of   Zakat . Thus, the periodicity concept for an

Islamic financial institution means the life of the

institution can be broken into reporting periods to prepare

financial reports to the interested parties and stakeholders.

This will assist the users to periodically evaluate the

institution’s financial performance and position. In addition,

the periodic preparation of the financial statements will be

useful to determine the financial obligations and the financial

rights of the bank and other interested parties. Thus, the life

of the Islamic bank should be broken into reporting periods

to prepare financial reports that provide information to

interested parties about the performance of the bank. One lunar

year is used for Zakat calculation.

(ix)

Realization and Accrual Concepts AAOIFI’s SFA 2 recommends that

“revenues should be recognized when realized”. Realization of

revenues shall take place when one of the three conditions is

met: (i) the entity has the right to receive the revenue; (ii)

there is an obligationon the part of another party to remit;

and (iii) the amount of revenue should be known and

collectible with reasonable degree of certainty. Accrual

basis of income recognition does meet the requirement of

Islamic objectives as it aims to measure the ‘real’ wealth

of an entity. IFIs therefore used both accrual and cash basis of

accounting.

 1.9 Qualities Islamic Accounting Information

1.9.1 Understandability

A n e s s e n t i a l q u a l i t y o f t h e i n f o r m a t i o n p r o v i d e d

i n f i n a n c i a l s t a t e m e n t s i s t h a t i t i s r e a d i l y

understandable by users. For this purpose, users are

assumed to have a reasonable knowledge of  business and

economic activities and accounting and are willingness to study

the information with reasonable diligence. However,

information about complex matters that should be included

in thefinancial statements because of its relevance to the

economic decision-making needs of users should not be excluded

merely on the grounds that it may be too difficult for certain

users to understandProphet Muhammad (peace be upon him) had

enjoined Muslims to address people according to

their ability to understand. Two sayings of the Prophet’s

companions, reinforce the principle:Ibn Mas’ud (may Allah be

pleased with him) said: “No one relates something to a people

which they donot understand, except that it puts some of

them into

  Fitnah (trial and discord).” (in the introduction to Sahih

Muslim). Ali Ibn Abu Talif (may Allah be pleased with him)

said: “Relate knowledge to people according to their level of

understanding ...” (Sahih Bukhari Vol.1 Book 3 No.129)Applying

the above sayings to financial reporting, it would appear that

the concept of understandabilitywould be consistent with

Islamic beliefs. By extension, this means that since

a number of Islamic banking customers are non-Muslim,

information should be displayed in a manner that

wouldcommensurate with non Muslims’ understanding of financial

reporting from an Islamic perspective, andalso fulfill their

information needs. Similarly, with globalisation, an

entity’s financial reports may beread by users outside its

reporting jurisdiction. Information that is commonly

understood by userswithin the jurisdiction may not be so to

those users unfamiliar with the principles and practices in

that jurisdiction. Additional information may be necessary to

enhance such users’ understanding of itemsthat may be peculiar to

an entity’s reporting jurisdiction. 

1.9.2 Relevance

To be useful, information must be relevant to the decision-making

needs of users. Information has thequality of relevance when it

influences the economic decisions of users by helping them

evaluate past, present, or future events or confirming, or

correcting, their past evaluations. Information about

financial position and past performance is frequently used as the

basis for predicting future financial position and performance

and other matters in which users are directly interested, such as

dividend and wage payments, security price movements and the

ability of the entity to meet its commitments as they falldue.

The ability to make predictions from financial statements

is enhanced, however, by the manner inwhich information on

past transactions and events is displayed. For example, the

predictive value of theincome statement is enhanced if

unusual, abnormal and infrequent items of income or

expense areseparately disclosed. However, in Islamic

reporting, relevance is subjective. Information that

mayinfluence one user group’s decisions may not influence

another’s. For example, an item described as‘finance

income’, when disaggregated into permissible and non-permissible

income, may influence theeconomic decision of a Muslim user,

while a non-Muslim user may be indifferent to the

disaggregation.Thus, what is relevant to the Muslim may be

irrelevant to the non-Muslim.15

1.9.3 Reliability

To be useful, information must also be reliable. Information has

the quality of reliability when it is freefrom material error

and bias and can be depended upon by users to represent

faithfully that which iteither purports to represent or could

reasonably be expected to represent. Information may be

relevant but so unreliable in nature or representation that its

recognition may be potentially misleading.Reliability means that

users can depend on the information presented. In some instances,

the validity or certainty of an item or amount cannot be

determined with absolute accuracy and the use of estimates

and judgements may become necessary. Shariah permits the use of

persuasive evidence in the absence of conclusive evidence.

Where persuasive evidence has been used, it may be

appropriate to includeadditional disclosure on the

assumptions underlying the estimates and judgements.

1.9.4 Faithful representation

To be reliable, information must represent faithfully the

transactions and other events it either purportsto represent or

could reasonably be expected to represent. Thus, for

example, a balance sheet shouldrepresent faithfully the

transactions and other events that result in assets,

liabilities and equity of theentity at the reporting date

which meet the recognition criteria. Faithful representation

means that thereis a close correspondence between the information

presented and the actual transactions and events thatoccurred.

Generally, this characteristic is deemed to be satisfied by

displaying the economic reality of atransaction or event.

However, in

 fiqh, one of the five foundational legal maxims is a l

u m u r b i maqasidiha which means that acts are judged by their goals

and purposes.

1.9.5 Neutrality

To be reliable, the information contained in financial statements

must be neutral, that is, free from bias.Financial statements are

not neutral if, by the selection or presentation of information,

they influence themaking of a decision or judgement in order to

achieve a predetermined result or outcome. Neutrality or lack of

bias against any group is a concept fully endorsed by

Islam. This is indicated by the followingverses from the

Quran: “O ye who believe! Stand out firmly for Allah, as

witnesses to fair dealing, andlet not the hatred of others to

you make you swerve to wrong and depart from justice. Be

just; that isnext to piety; and fear Allah, for Allah is well

acquainted with all that ye do.” Surah Al-Maidah, verse 8“O ye

who believe! Stand out firmly for justice, as witnesses to

Allah, even as against yourselves, or your parents, or

your kin, and whether it be (against) rich or poor;

for Allah can best protect both.Follow not the lusts

(of your hearts), lest ye swerve, and if ye distort

(justice) or decline to do justice,verily Allah is well-

acquainted with all that ye do.” Surah An-Nisa’, verse 135In

accordance with the principle in the above verses,

accounting information should serve theinformation needs

of its users without bias or unfair information advantage given

to one group of usersat the expense of others. Reporting

that focuses on profit may deflect attention away from the

social,economic and environmental impacts of an entity.

Neutrality may be impaired when some users havesufficient

information to make their decisions, while the focus on

‘commonality’ excludes informationcrucial to other users’

decisions. This is apparent in the insufficient display of

information that isimportant to Muslims, for example, the

Halalness of an entity’s income, and the permissibility of

itsactivities. Such information though not ‘common’ to all

users, is ‘core’ to a Muslim user.

1.9.6 Completeness

To be reliable, the information in financial statements must be

complete within the bounds of materialityand cost. An omission

can cause information to be false or misleading and thus

unreliable and deficientin terms of its relevance. Completeness

means including all information that is necessary for a faithful

representation of the transaction or event that the information

purports to represent. In this regard, it can be said that

completeness in recording Shariah compliant transactions would

include the display of information on both the economic reality

and the component contracts of a series of closely inter-related

Shariah compliant transactions.

1.9.7 Comparability

Users must be able to compare the financial statements of

an entity through time in order to identify trends in its

financial position and performance. Users must also be

able to compare the financial statements of different

entities in order to evaluate their relative financial

position, performance and changes in financial position.

Hence, the measurement and display of the financial

effect of like transactions and other events must be carried

out in a consistent way throughout an entity and over time for

that entity and in a consistent way for different entities. An

important implication of the qualitative characteristic of

comparability is that users be informed of the accounting

policies employed in the preparation of the financial

statements, any changes in those policies and the effects of such

changes. Users need to be able to identify differences

between the accounting policies for like transactions and

other events used by the same entity from period to periods and

by different entities. Because users wishto compare the financial

position, performance and changes in financial position of an

entity over time,it is important that the financial statements

show corresponding information for the preceding periods.

1.9.8Timeliness

If there is undue delay in the reporting of information it may

lose its relevance. Management may needto balance the relative

merits of timely reporting and the provision of reliable

information. To provideinformation on a timely basis it may

often be necessary to report before all aspects of a

transaction or other event are known, thus impairing

reliability. Conversely, if reporting is delayed until all

aspectsare known, the information may be highly

reliable but of little use to users who have had to

makedecisions in the interim. In achieving a balance

between relevance and reliability, the overriding

consideration is how best to satisfy the economic

decision-making needs of users. There is limited discussion

on timeliness of financial reporting from an Islamic

perspective. Nevertheless, where it is necessary to report

before all aspects of a transaction or event is known, some

degree of estimation and judgement may be used, as Shariah

principles permit the use of persuasive evidence in the absence

of conclusive evidence.

1.9.9 Balance between Benefit and Cost

The benefits derived from information should exceed the cost of

providing it. The evaluation of benefitsand costs is, however,

substantially a judgmental process. In providing information to

users, the generalrule is that the cost of providing that

information should not exceed the benefit to users. However, in

theevaluation of benefits and costs, it should be borne in mind

that from an Islamic perspective, ‘users’ isnot limited to

investors and creditors, but extends to society as a whole.

1.9.10 True and Fair View/Fair Presentation

Financial statements are frequently described as showing a true

and fair view of, or as presenting fairly,the financial

position, performance and changes in financial position of

an entity. Islam is very muchconcerned with the fair

presentation of rights and obligations as evidenced by the

following verses:“O ye who believe! Stand out firmly for

justice ...” Surah An-Nisa’, verse 135“Woe to those that deal

in fraud – those who, when they have to receive by measure

from men, exactfull measure, but when they have to give by

measure or weight to men, give less than due” Surah Al-

Muthaffifin, verses 1-317

This statement may need to be qualified because from an Islamic

perspective, the true and fair view of an entity is not achieved

by presenting only the financial position, performance, and

changes in financial position of an entity. A more holistic

presentation of an entity may extend into non-financial areas. 

Question One

What are the lessons that we can benefit from the proper

understanding of the Qur’anic verse 282 of 

Surah Al-Baqarah

especially for accounting policy making?

Suggested Answer to Question One

Al-Qur’an (

 Al-Baqarah:

282):

“O you who believe! When you deal with each other, in transactions involving

future obligations in a fixed period of time, reduce them to writing, let a scribe write

down faithfully as between the parties: let not the scribe refuse to write: as God has

taught him, so let himwrite. Let him who incurs the liability (debtor) dictate, but let him

fear his Lord God, and not diminishaught of what he owes. If the party liable

(debtor) is mentally deficient, or weak, or unable himself todictate, let his

guardian dictate faithfully, and get two witnesses, out of your own men, and

if they arenot two men, then a man and two women, so that if one of them

errs, the other can remind him. Thewitnesses should not refuse when they

are called on (for evidence). Disdain not to reduce to writing   (your contract)

for a future period, whether it is small or big: it is more just in the sight of

God, more suitable as evidence, and more convenient to prevent doubts among

yourselves. But if you carry out thetransactions on the spot there is no blame if you

reduce it not to writing. But take witness whenever youmake a commercial contract,

and let neither the scribe nor the witness suffer harm. If you do (suchharm) ,

it would be wickedness in you. So fear God; for it is God that teache s you.

And God is well  acquainted with all things”

Lessons of 

Surah Al-Baqarah

verse 282 for Islamic ccounting policy making:1.Proper,

complete and transparent recording of financial and

business transactions by responsibleaccountants are the

fundamentals of Islamic accounting.2.Written contract is the

main requirement for all significant financial and

business transactionsespecially for a debt contract. This is

due to the obligation of one party (debtor) towards

another  party (creditor), and some legal rights of the creditor

over the debtor.3.Islamic financial contracts must have at

least 2 truthful witnesses to provide a check and

balancemechanism, ensure proper accountability, and ensure

parties of the contract properly honor their financial

obligations.4.Materiality as an accounting concept in Islam

is ultimately to ensure proper recognition of thefinancial

rights and obligations of the contractual parties.5. Fear God

(Allah) for all the contractual parties including the

witnesses and the accountant toensure fairness and justice

in accounting for financial and business transactions.

2.0 Accounting for Islamic Deposits and Investment Accounts

Deposits and investments from depositors and investors are

the main sources of funds especially for Islamic commercial

banks. The deposits and investments collected from the surplus

unit i.e. depositorsand investors are used for financing to

economic deficit unit i.e. customers etc. This is to

ensure the proper functioning of a bank, including an Islamic

bank, as a financial intermediary. In the case of Islamic banks

there are a number of deposits and investment facilities created

using Islamic contractualarrangements. Among the categories of

Islamic bank deposits are as follows:i. Current Account (

 Al-Wadi’ah

) Depositsii. Savings Account (

 Al-Wadi’ah

) Depositsiv. Investment Account (Unrestricted

 Mudharabah

)v. Investment Account (Restricted

 Mudharabah

)18

For current and savings account, the Middle East

Islamic banks use Qard Al Hasan (non

interest benevolent loan), whereas Islamic banks in Asia

especially Malaysia use wadiah or wadiah yadaddhamana contracts

(safe keeping or safe custody or amanah), where the depositors

keep their moneyin safe custody of the bank repayable on demand.

In both instances, no interest is paid , unlike the casein

conventional banks. However, when the bank makes profit,

it sometime gives

 Hadiah( 

gift

  )

tocurrent account and savings account holders entirely

at its discretion but increasingly because

of competition with conventional banks.Since there are no

fixed deposit accounts (which is interest paying) in

Islamic banks, they haveinvestment accounts based on

 Mudharabah

, a unique labour-capital partnership, which was

thecornerstone alternative to interest based banking,

advocated by early Islamic economists. Although,Islamic

banks have failed to use this instrument widely on the asset side

for financing customers, Islamic banks uses this contract on the

liability side to attract deposits through investment accounts.

Althoughthe original

 Mudharabah

contract envisaged the capital investor as one party and

the businessman asthe party, banks use a two tier 

 Mudharabah

, where the first tier is between the depositor (as the

capitalowner) and the bank as the mudarib (businessman).However,

since the bank itself does financial intermediation only

and does not actually carry out the business, it re enters

into a another 

 Mudharabah

contract with an actual businessman or company. Thisis not a

problem under the shari’a provided the two contracts are

not linked and the depositor does not prohibit the bank from

re-

 Mudharabah

.

 Mudharabah

contract is used both on the asset and liability sideof the

balance sheet. In the asset side, the bank is the rabbul mal

providing financing while the customer is the mudharib. However ,

the mudharaba contract is used more widely on the liability or

deposit sides.The bank is the mudahrib and the depositor is the

rabbul mal.

2.1 Principles of 

Wadi’ah

Deposit and Accounting Implications

 Al-Wadi’ah

is one of the most commonly used principles in the

Islamic banks. It is used for theacceptance of deposits

in the saving and current accounts.

 Al-Wadi’ah

literally means “the thing leftwith a person who is not its

real owner for the purpose of safe-keeping”. Al wadi’ah is

considered to bea form of contract. The jurists of all

schools of Islamic law (mazahib) agree that wadi’ah is a

form of trust. Hence, the depositee i.e. the Islamic bank

is regarded as the trustee to safely keep the

deposited property in his custody. It follows that the depositee

must return the deposited property to the depositor at any time

upon the request of the latter. For both current and

savings accounts, the depositors grant permission to the

Islamic bank to mobilize the funds but at the same time guarantee

their deposits(wadi’ah yadhamanah). No return is

promised or expected but a gift (hibah) can be given

to thedepositors. In terms of accounting, no interest

expense is recorded but the deposits will be treated

asliabilities as they are guaranteed custody account.The

accounting recognition process (journal entries) are as

follows:Dr. Cash Account )Cr. Wadi’ah Deposit Account ) with

deposit received from

depositor .......................................................

.................................................................

...........................................Dr. Wadi’ah Deposit

Account )Cr. Cash Account ) with deposit repaid to

depositor .......................................................

.................................................................

...........................................Dr. Profit and Loss

account or Reserve Account )Cr. Wadi’ah Deposit Account ) with

hibah disbursed to depositor 

2.2 Principles of 

 Mudharabah

Investment Account

19

 Al-Mudharabah

 

is a form of partnership whereby the owner of capital,

rab al- mal,

gives a specifiedamount of capital to another person, termed as

the

mudharib.

In this case, the Islamic bank 

  ,

who is to actas the entrepreneur to trade with the capital. The

profit will be shared between the two parties accordingto agreed

profit sharing ratio of their agreement. On the other hand, if

there is a loss then the loss will be borne by the

rab a l - mal  

who is the financier, whilst the

mudharib

only suffers the fruitless effort.However, if the loss is due

to the willful negligence of the

mudharib

then he/she must be responsible for the loss. The liability of

the

rab al-mal 

in a

Mudharabah

is limited to the extent of his contribution tothe capital. In

Islamic banking, the bank may act as either the

rab al-mal 

or the

mudharib

. In acceptingdeposits from its customers to be invested in

fruitful business, the bank acts as a

mudharib

and thecustomers the

rab al-mal 

. On the other hand, in financing the entrepreneurs or

business projects, the bank acts as the

rab al-mal 

and the entrepreneurs become the

mudharibs

. In this case, the bank is not participating in the

management of the business financed. It could, however, exercise

adequatesupervision to ensure that the funds are being used in

accordance with the

 Mudharabah

agreement.The Islamic bank may also act as both the

rab al-mal 

and the

mudharib

. This is what is termed as thetwo-tier 

 Mudharabah

. In this type of arrangement, it involves two separate contracts

of 

 Mudharabah

; between the bank and

 

the suppliers of capital (depositors) on the one hand, and

 

 between the bank andthe users of capital (entrepreneurs)

 

on the other. Thus, there are actually two contracts

signed

 

 betweenthree parties: the suppliers of capital (

rab al-mal 

);

 

the bank as the intermediary link; and the users of capital

 

(

mudharib

). It is called two-tier 

 Mudharabah

because, one

 

tier represents the

 Mudharabah

 between the bank and

 

the suppliers of capital, and the other tier represents the

Mudharabah

between the bank and the users of capital.In this tripartite

relationship:

rab a l - mal  

; Islamic bank; and

mudharib

, the bank will have a directcontract with both the

rab al-mal 

and the

mudharib

.The bank will act as intermediary between thefinanciers and

entrepreneurs. Thus, the bank in the first hand, will have to

share any profits (as well as bear losses) on mutually agreed

terms with the entrepreneurs who obtain capital from it, and

secondly,on receiving its share of the profits will in turn

have to share it with the depositors, also on

mutuallyagreed terms.

2.3 Unrestricted

 Mudharabah

and Restricted

 Mudharabah ( 

Investment Accounts)

T h e r e a r e a t l e a s t t w o t y p e s o f I s l a m i c

i n v e s t m e n t a c c o u n t s n a m e l y R e s t r i c t e d

 Mudharabah

(

 Mudharabah mutlaqah

), and Unrestricted

 Mudharabah

(

 Mudharabah muqayaddah

). According toAAOIFI, Unrestricted Investment Account is where

the investor fully authorizes the bank to invest thefunds without

restrictions as to where, how and what purpose the funds should

be invested as long as itis deemed appropriate. Mixing of

funds from other sources is permitted and separate

disclosure in thefinancial statement is therefore required.On

the other hand, Restricted Investment Account is where the

investor restricts the manner as towhere, how and for what

purpose the funds are to be invested. No mixing of funds

is allowed fromother sources to ensure proper management and

accountability of the funds. A separate disclosure (off- balance

sheet) in the form of Statement of Restricted Investments is

required to be kept by the Islamic bank.

3.0 Accounting Issues for

 Mudharabah

Investment Account

AAOIFI FAS 6 - Equity of Investment Account Holders-

addresses the accounting rules relating tofunds received by

the Islamic bank for investment in its capacity as a mudarib at

the Islamic bank’sdiscretion, either in whatever manner

the Islamic bank deems appropriate (equity of

unrestrictedinvestment account holders) or subject to

certain restrictions (equity of restricted investment

accountholders).20

Equity of unrestricted investment account holders shall be

recognized when received by the Islamic bank. In case the

Islamic bank makes it a condition that the funds will not be

invested before a certaindate, then the funds received shall be

recorded in a current account until their date of investment is

due.Equity of unrestricted investment account holders shall

be measured by the amount received by theIslamic bank at

the time of contracting. At the end of a financial

period, equity of unrestrictedinvestment account holders

shall be measured at their book value (balance recorded in the

books of theIslamic bank). Profits of an investment jointly

financed by the Islamic bank and unrestricted investmentaccount

holders shall be allocated between them according to the

contribution of each of the two partiesin the jointly financed

investment.Loss resulting from transactions in a jointly

financed investment (that is recognized during a

periodother than that in which final settlement of the

investment account is made) should in the first instance be

deducted from any undistributed profits on the investment. Any

such loss in excess of the amount of undistributed profits should

be deducted from provisions for investment losses formed for this

purpose.The remaining loss, if any, should be deducted from the

respective equity shares in the joint investmentof the Islamic

bank and the unrestricted investment account holders,

according to each party’scontribution to the joint

investment.Loss due to misconduct or negligence on the

part of the Islamic bank, based on the opinion of the

  shari’ah

supervisory board of the Islamic bank, shall be deducted from the

Islamic bank’s share in the profits of the jointly financed

investment. In case the loss exceeds the Islamic bank’s share of

profits, thedifference should be deducted from its equity share

in the joint investment, if any, or recognized as duefrom the

Islamic bank.Assets and liabilities relating to equity of

restricted investment account holders and their

equivalentshall be treated separately from the Islamic

bank’s assets and liabilities. In the case of more than

onetype of restricted investment accounts in the form of

investment funds or portfolios, the amount of eachtype shall be

recognized separately. Equity of restricted investment

account holders shall be measured by the amount received by

the Islamic bank or by the client’s purchase price of the units

or shares bought by him at the time of contracting. At the end of

a financial period equity of restricted investmentaccount holders

shall be measured at its book value (balance recorded in the

books of the Islamic bank).In case the Islamic bank has funds

invested in restricted investment accounts whether from

its ownequity or from other funds at its disposal, the Islamic

bank shall share in the profits earned on such fundsin its

capacity as provider of funds.In terms of disclosure in the

financial statement, disclosure should be made, in the notes on

significantaccounts, of the percentage of the funds of

unrestricted investment account holders which the

Islamic bank has agreed with them to invest in order to produce

returns for them. Equity of unrestrictedinvestment account

holders shall be presented as an independent category in

the statement of financial position of the Islamic bank

between

 

the liabilities and the owners’ equity. Information on

equity of restricted investment account holders shall

be presented in the statement of changes in

restrictedinvestments and their equivalent (Off-Balance Sheet)

or at the foot of the statement of financial

position.Conventionally, banks recognise customers deposit

as liability as it is a clear cut lending activity between

depositors (lenders) and bank (borrowers). Thus, deposits are

clearly a liability to the Bank.The main contentious issue to

recognise

 Mudharabah

investment account is to consider it as a liabilityor a kind

of equity. In the case of Islamic banks,

 Mudharabah

investment account i.e. unrestrictedinvestment as Equity of

Unrestricted Investment Accounts. This is a separate line item to

distinguish thedifferent nature of contract from normal

liability such as creditors, and normal equity holders.

For restricted

 Mudharabah

it will be treated as off-balance sheet as it deals

directly and personally with21

specific investors with specific terms, for unrestricted

 Mudharabah

, it is managed by an Islamic bank attheir discretion as long

as the usage of the funds is

Shari’ah

compliant. Even though, conventionaldeposit is a credit item

to represent a liability, for unrestricted

 Mudharabah

investment account, it is acredit item but contractually

it refers to a partnership or investment contract. The

following are therecognition of and journal entries for

unrestricted

 Mudharabah

investment account:Dr. Cash Account ) with deposit received

fromCr. Equity of Unrestricted

 Mudharabah

Investment Account ) Rab ul-mal/Capital

provider ........................................................

.................................................................

..........................................Dr. Equity of

Unrestricted

 Mudharabah

Investment Account) with deposit repaid to rab ul-malCr. Cash

Account ) /capital

provider ........................................................

.................................................................

..........................................Dr. Profit and Loss

Account or Reserve Account )Cr. Equity of Unrestricted

 Mudharabah

Investment Account ) with profit disbursed to rab ul-

malInvestment account holders enter into a profit sharing

agreement with the bank and are normally issuedinvestment

certificates. Unlike fixed deposits there is no contracted

interest expense and the investmenta c c o u n t i s n o t

g u a r a n t e e d . A c c o u n t i n g w i s e , i t i s n e i t h e r a

s h a r e h o l d e r ’ s e q u i t y n o r a l i a b i l i t y (borrowing), as

the depositor/investor does not assume the rights of the equity

holders nor guaranteed asa liability. For 

 Mudharabah

investment account, the investors provide capital to

Islamic bank. TheIslamic bank as an entrepreneur will then

utilise the fund for 

  shari’ah

compliant activities. The profitgenerated will be shared by both

parties but the loss will only be borne by the investors. The

principlesof 

 Mudharabah

have created a class of depositors that can be construed as

quasi-shareholders. It is not astraightforward debtor and

creditor relationship as in conventional banking. It needs

to recognise theinherent risks from the investor-entrepreneur

relationship of the

 Mudharabah

contract.

 Mudharabah

investors are not equivalent to the shareholders as they are not

owners of the Islamic bank.They are also technically not

creditors as the contract is an investment contract.

Among therecommendations of IFSB, before opening a

 Mudharabah

investment account, the investors should beadequately advised

of their contractual rights and risks. For example, in the

event of liquidation, theinvestors shall only bear the loss in

proportion to the asset funded by their investment. The Islamic

bank shall be liable for losses arising from their

negligence, misconduct and breach of their

investmentmandate. The Islamic Financial Services Board

(IFSB) was established in 2002, as an

international prudential standard-setting body to promulgate

international regulatory and supervisory standards for Islamic

financial industry.IFSB requires relevant disclosures to be made

in a timely and effective manner on the profit

distribution policy between the Islamic bank, the shareholders

and the

 Mudharabah

investors, as well as the assetallocation strategies.

Many Islamic banks adopted the practice of “smoothing

the returns” for theinvestors and shareholders by using

the Profit Equalization Reserve (PER) account. This

practice is justified as to enable the Islamic banks to pay a

competitive rate of return especially when the profit for certain

periods are below the market rate. It is widely known that

Islamic finance is not only about the prohibition of riba’ but

includes the prohibition of gharar and other forms of unethical

practices. Gharar is normally defined as injustice or

loss suffered by one party due to uncertainty in the

contracts,unfairness in commercial transactions, or/and

unethical business dealings.Once the Islamic bank has accumulated

the profit from operations, it need to share with the

depositors/investors according to profit sharing ratio.

There are at least two methods to distribute profit

todepositors/investors namely (i) Separate Investment Account

Method (SIAM) and (ii) Pooling Method(PM). SIAM is where the

Islamic bank will share the gross profit with

depositors/investors. The22

administrative expenses such as provisions and

overhead (indirect expenses) will be borne by

theIslamic bank. Thus, depositors/investors will not

be burdened by administrative expenses and theIslamic

bank already deserved the profit from the agreed profit sharing

ratio. While, pooling method iswhere the profit is shared at net

income rather than gross income in the case of SIAM. The

rationale of this method is the bank has the right to share

the administrative and other overhead expenses with

thedepositor/investors.

Example 1:The illustration of SIAM is as follows: N

Income from Sales, Investment & Financing 30,000,000Less: Direct

Cost of Sales, Investment & Financing 15,000,00015,000,000Less:

Distribution of Profit to Depositors/ Investors (PSR = 30%)

(4,500,000) Net Income to the Islamic Bank (PSR = 70%)

10,500,000Add: Fee Based Income 1,500,000Less: Overhead and Other

Admin. Expenses (4,000,000) Net Income to the Islamic Bank

(Before Tax &

 Zakat 

) 8,000,000

Example 2The illustration of PM is as follows: N

Income from Sales, Investment & Financing 30,000,000Less: Direct

Cost of Sales, Investment & Financing 15,000,000Less: Overhead

and Other Admin. Expenses 4,000,000 19,000,00011,000,000Add: Fee

Based Income 1,500,000 Net Income to the Islamic Bank

12,500,000Less: Distribution of Profit to Depositors/ Investors

(PSR = 30%) (3,750,000) Net Income to the Islamic Bank (Before

Tax &

 Zakat 

) 8,750,000Under normal circumstances, where overhead expenses

are much more than fee based income (indirectrevenue), the banks

may prefer to use PM as they will share higher profit. However,

if indirect revenueis more than overhead expenses then the bank

may prefer gross method. Therefore, the choice of

profitdistribution method or policy is subject to abuse by the

banks. There must be proper rules and guidancesto ensure

depositors/investors are not manipulated or deceived.The

National

Shari’ah

Advisory Council (NSAC) of Bank Negara Malaysia has made a

ruling on theissue of allocation and distribution of profit

to depositors. After reviewing the opinion of 

  fuqaha

(Islamic Jurists), they have found that most

  fuqaha

are of the opinion that distribution of profit should bemade at

gross level (i.e. SIAM). This ruling was made after

examining the underlying terms andconditions of 

 Mudharabah

principles. As a result of this decision, expenditure relating to

 Mudharabah

funds is deductible only to the extent that they are directly

attributable to the investment of those funds.Indirect overhead

expenses should not be deducted from

 Mudharabah

fund. Some fuqaha, however, areof the view that expenses,

direct or indirect, can be deducted from the

 Mudharabah

funds (i.e. PM),arguing that such decision is a managerial

decision rather than a

  shari’ah

issue. Examples of indirectexpenses that are deducted from

 Mudharabah

funds are salaries, wages and bonuses of employees,rental,

etc. Profit will then be allocated and distributed to

various categories of depositors at net rather than at gross

level.

Question One

The following are the relevant information pertaining to the

results of the business operations for Bank 

Shari’ah

for the year 2012:23

NProfit from Operations (Gross) 75,500,000Indirect Expenses

12,200,000Fee Based Income 12,500,200The above profit from

operation is prior to (before) the distribution of profit

to Mudharabah depositors.The agreed profit sharing ratio between

the Bank and Mudharabah depositors is 80:20

respectively.i.Assuming that other variables remain

constant, which profit distribution policy do you

think the bank might prefer i.e. pooling method or Separate

Investment Account method? Please show allyour workings.i i .

W h a t i s t h e o p i n i o n o f   fuqaha (Islamic Jurists)

regarding profit distribution policy for Islamic banks? What are

their justifications?

Question Two

In the year 2012, Bank Ummah Nig. PLC earned annual profit

attributable to Unrestricted

 Mudharabah

Investment Account (Mudharabah mutlaqah) before

distributing profit to the Bank, amounting to N10,

000,000. Depositor’s profit sharing ratio under Mudharabahh

deposit account is currently at 70:30 between depositors and the

Bank, respectively. The following is the information pertaining

to deposittypes, average balance, and the weights used for 

Mudharabah

deposit account in the Bank for the year 2012.

Deposit T y p e A v e r a g e

B a l a n c e W T S ≤ 6

m o n t h s 3 0 , 0 0 0 , 0 0 0 0 . 6 0 ≤

9

m o n t h s 4 0 , 0 0 0 , 0 0 0 0 . 8 0 ≤

1 2

m o n t h s 1 0 , 0 0 0 , 0 0 0 1 . 0 0 >

1 2

m o n t h s 2 0 , 0 0 0 , 0 0 0 1 . 2 0 100,000

,000(a)You are required to compute and determine:i . W e i g h t e d

a v e r a g e b a l a n c e f o r e a c h d e p o s i t

t y p e . ii.Depositor’s share of profit based on the

weighted average balance.i i i . D e p o s i t o r s r a t e o f

r e t u r n f o r e a c h d e p o s i t t y p e . (b) Based on the

depositors rate of return as computed in part (a) above,

determine the profit attributableto the following depositors in

the

 Mudharabah

General Investment Account of Bank Ummah:i . A w h o i n v e s t e d N

5 0 0 , 0 0 0 f o r t h e d u r a t i o n o f 6 m o n t h s . ii.B who

invested N 420,000 for the duration of 12

months.iii.C who invested N 230,000 from 1st January

2012 to 15 October 2012.

Question Two: Suggested Solution(a)

i . W e i g h t e d a v e r a g e b a l a n c e f o r e a c h d e p o s i t

t y p e s .

  Formular Average Bal. x Weights

(obtainedfor exampleby multiplying N30,000,000 by 0.6 = N

18,000,000).i i . D e p o s i t o r ’ s s h a r e o f p r o f i t b a s e d o n

t h e w e i g h t e d a v e r a g e b a l a n c e ( o b t a i n e d f o r

e x a m p l e b y dividing N 18,000,000 by N 84,000,000 and

multiplying it by N7,000,000= N1,500,000). 

  Formular 

Weighted Balance x Total profitTotal Weighted Balanceiii.

Depositors rate of return for each deposit types

(obtained for example by dividing N1,500,000 by N

30,000,000 and multiplying it by 100% = 5.00%).24

Formular 

Depositors’ share x 100Average Balance 1

DepositT y p e A v e r a g e

B a l a n c e W T S WeightedBalanceDepositor'sShareD

epositor'sReturn≤ 6

m o n t h s 3 0 , 0 0 0 , 0 0 0 0 . 6 0 1 8

, 0 0 0 , 0 0 0 1 , 5 0 0 , 0 0 0 5 . 0 0 %

≤ 9

m o n t h s 4 0 , 0 0 0 , 0 0 0 0 . 8 0 3 2

, 0 0 0 , 0 0 0 2 , 6 6 6 , 6 6 7 6 . 6 7 %

≤ 1 2

m o n t h s 1 0 , 0 0 0 , 0 0 0 1 . 0 0 1 0 ,

0 0 0 , 0 0 0 8 3 3 , 3 3 3 8 . 3 3 % >

1 2

m o n t h s 2 0 , 0 0 0 , 0 0 0 1 . 2 0 2 4 , 0

0 0 , 0 0 0 2 , 0 0 0 , 0 0 0 1 0 . 0 0 % 1 0 0

, 0 0 0 , 0 0 0

8 4 , 0 0 0 , 0 0 0 7 , 0 0 0 , 0 0 0 (b) Thus, the amount

of profit for each depositor can be determined as follows:A = N

500,000 x 5.00% = N 25,000B = N 420,000 x 8.33% = N 34,986C = N

230,000 x 8.33% = N 19,159The above table shows the steps in

profit allocation between an Islamic banks and their investors.

Oncethe bank has distributed profit to depositors/investors, the

bank will first determine the Monthly AverageDaily Balance (MADB)

for each category of investment. Secondly, the Bank will assign

weigths to eachcategory and determine the weightedbalance.

Investors’ share of profit is determined based on the ratioof

weighted average balance. In allocating profit,

higher investment weights are given to

thoseinvestments with longer maturity periods. Those

investors that invested longer period deserve

higher  profit rate to accommodate for the higher opportunity

cost of capital rendered by them. The weights arenormally

regulated by the Central Bank to avoid abuse and to

provide guidelines to the Islamic banks.Finally, the Bank

will apportion the profit available according to each

category according to theweighted balance. Once the

profit is allocated to each category, the bank can

determine the investor’srate of return, by taking the

ratio of investor’s share of profit over the real average

balance. Thus, anyindividual investor can then use the rate of

return to determine their profit, based on the amount of

their deposits.

Question Three

I n t h e y e a r 2 0 1 2 , I s l a m i c B a n k o f N i g . P L C e a r n e d

a n n u a l p r o f i t a t t r i b u t a b l e t o U n r e s t r i c t e d

 Mudharabah

Investment Account (

 Mudharabah

mutlaqah) before distributing profit to the

Bank,amounting to N100,000. Depositor’s profit

sharing ratio under 

 Mudharabah

h deposit account iscurrently at 72:28 between depositors

and the Bank, respectively. The following is the

information pertaining to deposit types, average balance, and

the weights used for 

 Mudharabah

deposit account inthe Bank for the year 2012.A v e r a g e

B a l a n c e W T S DepositType≤ 6

m o n t h s 1 0 0 , 0 0 0 0 .

6 ≤ 9

m o n t h s 3 0 0 , 0 0 0 0 .

9 ≤ 1 2

m o n t h s 2 5 0 , 0 0 0 1 . 0 >

1 2

m o n t h s 3 5 0 , 0 0 0 1 . 2 (a

)You are required to compute and determine:i v . W e i g h t e d

a v e r a g e b a l a n c e f o r e a c h d e p o s i t

t y p e . v.Depositor’s share of profit based on the

weighted average balance.v i . D e p o s i t o r s r a t e o f

r e t u r n f o r e a c h d e p o s i t t y p e . 25

(b) Based on the depositors rate of return as computed in part

(a) above, determine the profit attributableto the following

depositors in the

 Mudharabah

General Investment Account of Islamic Bank of Nig.PLC:i v . A

w h o i n v e s t e d N 5 0 0 , 0 0 0 f o r t h e d u r a t i o n o f 7

m o n t h s . v . B w h o i n v e s t e d N 6 2 0 , 0 0 0 f o r t h e

d u r a t i o n o f 1 1 m o n t h s . v i . C w h o i n v e s t e d N 2 3 0 , 0 0 0

f r o m 1 s t J a n u a r y 2 0 1 2 t o 3 1

st

April 2012.Suggested Answer (a)

A v e r a g e

B a l a n c e W T S WeightedBalanceDepositor'sShareDepositor'sReturnD

epositType≤ 6

m o n t h s 1 0 0 , 0 0 0

0 . 6 6 0 , 0 0 0 4 , 3 2

0 4 . 3 2 % ≤ 9

m o n t h s 3 0 0 , 0 0 0 0

. 9 2 7 0 , 0 0 0 1 9 , 4 4

0 6 . 4 8 % ≤ 1 2

m o n t h s 2 5 0 , 0 0 0 1 .

0 2 5 0 , 0 0 0 1 8 , 0 0 0 7

. 2 0 % > 1 2

m o n t h s 3 5 0 , 0 0 0 1 .

2 4 2 0 , 0 0 0 3 0 , 2 4 0 8

. 6 4 % 1 , 0 0 0 , 0 0 0

1 , 0 0 0 , 0 0 0 7 2 , 0 0 0 (b) profit

attributable to the following depositors in the

 Mudharabah

General Investment AccountIslamic Bank of Nig. PLCi . A N

5 0 0 , 0 0 0 X 6 . 4 8 % = N 3 2 , 4 0 0 i i . B N 6 2 0 , 0 0 0 X

7 . 2 0 % = N 4 4 , 6 4 0 i i i . C N 2 3 0 , 0 0 0 X 4 . 3 2 % = N

9 , 9 3 6

Question Four

In the year 2012, MSS Bank Nig. PLC earned annual profit

attributable to Unrestricted

 Mudharabah

Investment Account (

 Mudharabah

 

mutlaqah

) a f t e r d i s t r i b u t i n g p r o f i t t o t h e B a n k ,

a m o u n t i n g t o  N10,000,000. Depositor’s profit sharing ratio

under 

 Mudharabah

h deposit account is currently at 70:30 between depositors and

the Bank, respectively. The following is the information

pertaining to deposittypes, average balance, and the weights

used for 

 Mudharabah

deposit account in the Bank for the

year 2012.DepositT y p e A v e r a g e

B a l a n c e W T S ≤ 6

m o n t h s 3 , 0 0 0 , 0 0 0 0 . 5 0

≤ 9

m o n t h s 4 , 0 0 0 , 0 0 0 0 . 7 5

≤ 1 2

m o n t h s 1 , 0 0 0 , 0 0 0 1 . 0 0 > 1

2

m o n t h s 2 , 0 0 0 , 0 0 0 1 . 2 5 10,0

00,00026

(a)You are required to compute and determine:i.Weighted

average balance for each deposit type.ii.Depositor’s

share of profit based on the weighted average

balance.iii.Depositors rate of return for each deposit

type.(b) Based on the depositors rate of return as computed in

part (a) above, determine the profit attributableto the following

depositors in the

 Mudharabah

General Investment Account of MSS Bank Nig. PLC:i.A who

invested N 120,000 for the duration of 6 months.ii.B

who invested N 70,000 for the duration of 12 months.iii.C

who invested N 185,000 from 1st January 2012 to 31

st

December, 2012.(c) Why should

 Mudharabah

deposit not to be treated as a liability in the case of Islamic

banks? Whatis the alternative treatment recommended by AAOIFI?

3.1 Specific Disclosure Requirements Relating to

 Mudharabah

According to AAOIFI, there are a number of disclosure

requirements in the financial statements of anIslamic bank

on the

 Mudharabah

investment accounts. The rationale of the disclosures is

to providenecessary information to stakeholders especially the

existing investors and potential investors on themanagement of

the

 Mudharabah

investment fund. The transparency in managing the investment

funds iscrucial to ensure the investors to make sound

investment decision. It is also a

  shari’ah

requirement tomake all the necessary disclosures to ensure

Shari’ah

compliance on the practices of Islamic depositsand

investments accounts. This is due to contractual requirements of 

 Mudharabah

that those information be provided to the investors and

depositors. There is a need for the investors to make sound

investmentdecision, given the various opportunities offered by

many available Islamic banks currently. Among thedisclosure

requirements are:i . T h e r e s h o u l d b e d i s c l o s u r e s

p e r t a i n i n g t h e n a t u r e o f  

 Mudharabah

investment funds i.e. whether restricted or unrestricted, and as

well as the amount that they manage at the end of the year.

Thiswill provide reasonable information on the size of the

funds, as well as the return of the fundsmanaged by the

Islamic bank.ii. The profit sharing ratio as adopted by

the bank and agreed with the investors/depositors for

thefinancial year also need to be disclosed. This will

assist investors/ depositors to compare theratio with other

investment alternatives. This is due to the information about

profit sharing ratiois a contractual requirement particularly

for 

 Mudharabah

contracts.i i i . S i n c e , p r o f i t i s a l l o c a t e d t o v a r i o u s

c a t e g o r i e s o f i n v e s t o r s a c c o r d i n g t o d u r a t i o n o r

m a t u r i t y  period, and the weights used to allocate the profits,

it is imperative that disclosure of the weightsattached to

various categories of investors are properly disclosed. The

disclosure is important tothe to various categories of

investors as it directly affects the economic

welfare, and theregulatory agency such as the Central bank to

monitor the practices as to avoid and monitor the possible

tendency such as indiscriminate change in the weights used to

creatively manage theearnings of the bank.iv.Disclosure about

the profit distribution policy is also considered

necessary as the investors needto be well informed of

whether bank or the investors bear the indirect expenses such

provisionsand administrative expenses. This gives rise to the

need to disclose the profit distribution policythat the bank’s

adopted i.e. whether SIAM or PM.

3.2 Accounting for

 Mudharabah

Financing

 Mudharabah

is a concept where the capital provider or the Islamic

bank (rab al-mal ) and the smallentrepreneur (

mudharib)become a partner. The profits from the project are

shared between capital27

 provider and entrepreneur, but the financial loss will be borne

entirely by the capital provider. This isdue to the premise that

a mudharib invests the

 Mudharabahcapital on a trust basis; hence it is not liablefor

losses except in cases of misconduct. Negligence and breachofthe

terms of  Mudharabahcontract,themudharibbecomes liable for the

amount of capital.There are three fundamentals for Mudharabah

financing,

namely:i . T h e t w o c o n t r a c t i n g p a r t i e s , i . e .

rab al-mal 

(capital provider) and

mudharib

(entrepreneur)i i . T h e s u b j e c t m a t t e r o f t h e

 Mudharabah,

i.e. capital, labour and profit; andi i i . T h e o f f e r a n d

a c c e p t a n c e . The conditions of 

 Mudharabah

 pertain to three of the fundamental elements of 

 Mudharabah,

i.e. the twocontracting parties, the capital and the profit.

With regards to the conditions for the two

contracting parties, i.e.

rab ul-

 

mal 

and

mudharib

, both of them must have the capacity to enter into a

contract of agency (

Wakalah

). This is because, the authorisation by the

rab ul-mal 

or 

  sahibul mal 

to the

mudharib

is considered to be a form of agency, whereby, the

rab ul-mal 

is the principal and the

mudharib

is theagent. Islam is not a condition for both contracting

parties.

 Mudharabah

is a partnership, in which one or more parties (

 Rab ul Mal 

or sahibul mal) who provide thecapital , contract with

another party (the mudharib) who provide the labor,

management expertise or entrepreneurship. This can take

several forms: Bilateral

 Mudharabah

h , where there is one capital provider and one

entrepreneur (can be an organization such as an Islamic bank.

Figure 1: Bilateral

 Mudharabah

 

The distinguishing feature of any

 Mudharabah

is that the profit sharing ratio between the

 Rab ul Mal 

and the mudarib (Islamic bank) is agreed beforehand, and

the profit allocation ratio must be clearlys t a t e d a n d

m u s t b e o n t h e b a s i s o f a n a g r e e d p e r c e n t a g e .

P r o f i t c a n o n l y b e c l a i m e d w h e n t h e

 Mudharabah

operations make a profit. Any losses, other than

those incurred due to negligence or mismanagement of

the mudarib is borne by the Rab ul mal, the mudarib looses

his labour as he is not paid any salaries or fee. This

introduces agency problems to the Rab ul mal. If Rabbul Mal

(RM)invested N200, 000 with Mudarib (MU) in the profit

sharing ratio of 70:30 (70% to RM and 30% toMU), then if the

investment results in a profit of N 80,000, then the mudarib will

get 30% i.e. N 24,000(30%x N 80,000) and the

 Rab ul Mal 

will get N 56,000 (70% x N 80,000). However, if the

investmentresulted in a loss of N 80,000 instead, then all this

loss of N 80,000 will be borne by the

 Rab ul Mal 

will, unless the mudarib was negligent.

Figure II:

Multilateral

 Mudharabah

, where there are at least two capital providers and one

entrepreneur 28

Rab ul Mal(Capital Provider)InvestmentIslamic Bank (Mudharib)Rab

al Mal 1(CapitalProvider 1)InvestmentIslamic Bank (Mudharib)Rab

al Mal 2(CapitalProvider 2)

In this case, where there are profits, after the bank gets its

share, the rabs al mal are allocated the profitsin according to

their capital. In the case of Islamic banks, there are

many investment account holders(rabs al mal) and profit

allocation can become complex especially when the rabs al

mal do not havecoterminus contracts with the bank i.e they

invest for different periods of time. For example, if two rabsal

mal invest N 100,000 each with mudarib (MU) who invests it. The

profit sharing agreement betweenthe rabs al almal and the

mudarbib being 70:30. If the ventures returns a profit of

N 80,000, then themudarib gets (30%x N 80,000), N 24,000

and the rabs al mal share N 56,000. This amount is

allotted between RM1 and RM2 in proportion to their capital

investment i.e 1:1 in this case, therefore they eachget N 28,000.

If the loss is N 40,000, then RM1 bears N 20,000 and RM2 bears N

20,000. The mudaribloses his labour, if the mudarib has NOT been

negligent.

Figure III:

Re

 Mudharabah

where, the entrepreneur sources and hires another mudarib under a

another 

 Mudharabah

contract.For example if Rabbul Mal (RM) provides N 100,000

capital to Mudarib (MU1) with PSR 70:30. Thisis in turn handed

over to Mudarib 2 (MU2)with profit sharing ratio 60:40. If the

venture earns a profitof N 50,000, then MU2 gets 40% of N

50,000= N 20,000, M1 gets 30%x60%xN 50,000=N 9,000 andthe

 Rab ul Mal 

gets 70%x60%xN 50,000=N 21,000. However, if the investment

results in a loss of  N30,000, this loss is borne by the Rab

ul mal. The mudaribs loses their labour, if they have NOT

beennegligent.

3.3 Principles of 

 Mudharabah

Investment Account

An Islamic bank normally accumulates deposit and

investment from customers through variouschannels.

Islamic bank can offer customers to deposit their money in

various types of accounts such assavings, current or investment

accounts. The major difference with conventional banks is that

they offer interest and the customers’ relationships are merely

lending. In the case of Islamic banks they may offer Islamic

deposit or investment accounts normally based on

wadi’ah

or 

 Mudharabah

contracts.

 Mudharabah

i s a p a r t n e r s h i p i n p r o f i t b e t w e e n c a p i t a l a n d

w o r k . I t m a y b e c o n d u c t e d b e t w e e n investment account

holders as providers of funds and the Islamic bank as a mudarib.

The Islamic bank announces its willingness to accept the funds of

investment amount holders, the sharing of profits beingas agreed

between the two parties, and the losses being borne by the

provider of funds except if theywere due to misconduct,

negligence or violation of the conditions agreed upon by

the Islamic bank. Inthe latter cases, such losses would be

borne by the Islamic bank. A

 Mudharabah

contract may also beconcluded between the Islamic bank,

as a provider of funds, on behalf of itself or on

behalf of investment account holders, and business owners and

other craftsmen, including farmers, traders etc.The liability of

the

rab ul-mal 

in a

Mudharabah

is limited to the extent of his contribution to the capital.In

Islamic banking, the bank may act as either the

rab ul-mal 

or the

mudharib

. In accepting depositsfrom its customers to be invested in

fruitful business, the bank acts as a

mudharib

and the customers the

rab ul-mal 

. On the other hand, in financing the entrepreneurs or

business projects, the bank acts as the

rab ul-mal 

and the entrepreneurs become the

mudharibs

. In this case, the bank is not participating in themanagement

of the business financed. It could, however, exercise

adequate supervision to ensure thatthe funds are being used

in accordance with the

 Mudharabah

agreement.29

Rab al Mal(Capital

Provider)InvestmentIslamicBank (Mudhari1)Enterprenuer (Mudharib2)

T h e r e a r e a t l e a s t t w o t y p e s o f I s l a m i c

i n v e s t m e n t a c c o u n t s n a m e l y R e s t r i c t e d

 Mudharabah

(

 Mudharabah mutlaqah

), and Unrestricted

 Mudharabah

(

 Mudharabah muqayaddah

). According toAAOIFI, Unrestricted Investment Account is

where the investor fully authorizes the bank to invest thefunds

without restrictions as to where, how and what purpose the funds

should be invested as long as itis deemed appropriate. Comingling

of funds from other sources is permitted and separate disclosure

inthe financial statement is therefore required.On the other

hand, Restricted Investment Account is where the investor

restricts the manner as towhere, how and for what purpose the

funds are to be invested. No comingling of funds is required

fromother sources to ensure proper management and accountability

of the funds. A separate disclosure (off- balance sheet) in the

form of Statement of Restricted Investments is required to be

kept by the Islamic bank.

3.4

 Mudharabah

Financing –AAOIFI FAS 3

Conventionally, banks recognise customers deposit as

liability as it is a clear cut lending activity between

depositors (lenders) and bank (borrowers). Thus, depositors are

clearly a liability to the Bank.The main contentious issue to

recognise

 Mudharabah

investment account is to consider it as a liabilityor a kind of

equity.In the case of Islamic banks,

 Mudharabah

investment account i.e. unrestricted investment as Equity

of Unrestricted Investment Accounts. This is a separate

line item to distinguish the different nature of contract

from normal liability such as creditors, and normal equity

holders. For restricted

 Mudharabah

itwill be treated as off-balance sheet as it deals

directly and personally with specific investors

withspecific terms, for unrestricted

 Mudharabah

, it is managed by an Islamic bank at their discretion as longas

the usage of the funds is

Shari’ah

compliant. Even though, conventional deposit is a credit

item torepresent a liability, for unrestricted

 Mudharabah

investment account, it is a credit item but contractuallyit

refers to a partnership or investment contract.When a depositor

deposits money in a mudharaba investment account, the bank debits

cash and creditsmudharba deposits. (in the balance sheet this is

summarized in the Investment account holder deposits.The

reverse entry is made when the depositor withdraws

his money (Dr. Mudharaba InvestmentAccount , cr cash).

The depositor’s share of profits (as rabbul maal) is credited the

investment account,after any deduction is made for reserves (see

PER and IRR later). In case of losses, the correct entry is

todebit the Investment account and credit P/L. However, if there

is any balance in the IRR, then the IRR is debited and the

investment account credited to offset the loss,if

possible. The following are therecognition of and journal

entries for 

 Mudharabah

transactions.

Table 1: Journal Entries of 

 Mudharabah

Transactions

S /

N o . T r a n s a c t i o n s

/ E v e n t s D r . C r . 1

D e p o s i t i n c u r r e n t o r

s a v i n g s accountC a s h

A / C C u r r e n t / S a v i n g s

A / C 2 W i t h d r a w a l f r o m

c u r r e n t o r   savings accountC u r r e n t / S a v i n g s

A / C C a s h A / C 3

 Hadiah

given by the bank toc u r r e n t o r s a v i n g s

a c c o u n t holdersP / L A / C (

 Hadiah

expenses)Current/Savings A/C4 R e c o g n i t i o n

o f  

 Mudharabah

hD e p o s i t ( B e i n g d e p o s i t r e c e i v e d f r o m

R a b b u l M a l / Capital provider)Cash

 Mudharabah

Deposit or Investment A/C30

5 W i t h d r a w a l o f d e p o s i t

( B e i n g deposit repaid to Rabbul Mal/Capital provider)

 Mudharabah

Depositor Investment A/CCash6 P E R p r o v i d e d

f r o m p r o f i t s sourced from IAH depositsP/L

Account PER (IAH portion) andPER (equity

portion)7 P r o f i t s h a r e o f

m u d h a r i b P / L A c c o u n t

E q u i t y

( R e t a i n e d earnings)8 I n v e s t m e n t

R i s k R e s e r v e  provisionP / L A c c o u n t

I R R ( s h o w n b e l o w e q u i t y o f I A H i n t h e  balance

sheet)9 D e p o s i t o r ’ s p r o f i t

s h a r e P / L A c c o u n t I n v e s t m e n t

A c c o u n t 1 0 S e t - o f f  

 Mudharabah

loss borne by rab al-mal

 Mudharabah

Depositor Investment A/CP/L AccountTable 3: Presentation in the

Balance Sheet

Liabilities side of Balance Sheet

 NEquity of Unrestricted Investment Account

HoldersXxProfit Equalization Reserve (portion belonging

toI A

H )

X x

I n v e s t m e n t

R i s k

R e s e r v e X x XxInvestmen

t account holders enter into a profit sharing agreement with the

bank and are normally issuedinvestment certificates. Unlike fixed

deposits there is no contracted interest expense and the

investmentaccount is not guaranteed. Accounting wise, it is

neither depositor/investor does not assume the rights of the

equity holders nor guaranteed as a liability.Profit sharing

between rab al-mal and

mudharib

will depend on the forms of 

 Mudharabah

transactions.At least there are 3 forms of 

 Mudharabah

financing:

i.

Bilateral

 Mudharabah

(Simple

 Mudharabah

): One party of capital provider and another party

of entrepreneur.

ii.

Multilateral

 Mudharabah

: Several parties of capital

iii.

Re-

 Mudharabah

(Two Tier 

 Mudharabah

): Three parties that includes capital

provider,intermediate

mudharib

(entrepreneur) and final

mudharib

(entrepreneur).

Example Three: Bilateral

 Mudharabah

If Capital Provider (C1) provides N200,000 to Entrepreneur 1 (E1)

(i.e. the Islamic Bank) and agreedon Profit Sharing Ratio (PSR)

of 70 : 30 respectively. Let say the profit from the business

venture is N80,000, then C1 will recover back the initial

capital of N 200,000 capital and shares N 56,000

profit(80,000 x 0.7). E1 shares N 24,000 profit (80,000 x 0.3).

If there is a loss, let say N 50,000, C1 will bear the full loss

of N 50,000 and will only recover N 150,000 of the original

capital

Example Four: Multi-lateral

 Mudharabah

31

If a bank has 2 capital providers i.e. C1 and C2 where C1

provides N 100,000 & C2 provides another N100,000. They agreed

on a PSR of 70:30, then if profit is N 80,000: C1 will

recover N100,000 capitaland shares N 28,000 profit (80,000

x 0.7 x 0.5) and C2 will also recover N100,000 capital and

alsoshares N 28,000 profit. On the other hand, E1 will

share N 24,000 profit. If there is loss of let say N50,000,

 

C1 will bear the loss of N 25,000 and recover only N 75,000

capital. C2 will then bear the lossof another half i.e. N 25,000

and recover N 75,000 capital as well.

Example Five: Re-

 Mudharabah

Let say there is one capital provider (C1) who

provides N1,000,000 to an Islamic Bank as

anintermediary and shares profit at the ratio of 70:30

respectively. Then, the Islamic bank entered intoanother 

 Mudharabah

contract (restricted

 Mudharabah

) with an entrepreneur E1 and share profit at aratio of

60:40 respectively. If profit from the business venture is

N 400,000: E1 will share a profit of  N160,000 (400,000 x

0.4). The Islamic bank will share N72,000 (400,000 x 0.6 x 0.3)

profit. C1shares N168,000 (400,000 x 0.6 x 0.7) profit. If

loss is N 200,000, C1 bears the loss of N200,000 andrecover

only N 800,000 of his/her initial capital. Islamic bank and E1

will loose their efforts, time etc.According to AAOIFI FAS 3,

there are at least 2 types of loss. First,

 

capital loss arises if there is a partial loss of the

 Mudharabah

fund prior to the inception of the activity. The

implication is that the profit sharing arrangement need to be

reviewed. Capital loss will reduce

 Mudharabah

financing amount.The second type of loss is normal or

ordinary business loss arises if there is partial

loss after theinception of activity. Continuous

 Mudharabah

losses can be dealt with in the following manner:

i.

offset against prior period undistributed profits;

ii.

carry forward to next year as provision; and

iii.

offset against profits distributed (recovered).In the case of 

 Mudharabah

financing that continues for more than one financial

period, the Islamic bank’s share of profits for any period,

resulting from partial or final settlement between the Islamic

bank and the

mudharib

, shall be recognized in its accounts for that period to

the extent that the profits are being distributed; the

Islamic bank’s share of losses for any period shall be recognized

in its account for that period to the extent that such losses are

being deducted from the

 Mudharabah

capital. 

Question Five

C o m p a n y A h a s e n t e r e d i n t o a

 Mudharabah

contract with Bank 

Shari’ah

in which the company provides monetary capital of N2,000,000

to be managed and invested by the Bank. The Bank provides

 Mudharabah

Al-Muqayadah investment account facility whereby the Bank

will invest in a specific project as agreed by the client. For

this project there is another investor, Company B who had agreed

toinvest N 1,000,000. The profit sharing between three of them is

2:1:1 for Company A, Company B andthe Bank respectively.Bank 

Shari’ah

then entered into another 

 Mudharabah

contract (Re-

 Mudharabah

) with Company C toundertake a housing development project and

they had agreed on the profit sharing ratio of 80 : 20(Bank:

Company C). Bank 

Shari’ah

had agreed to contribute the N 3,000,000 as monetary capital

basedon a three-year 

 Mudharabah

financing contract (

 Mudharabah

muqayaddah). Assumethe following results of the venture:

Year Profit / (Loss) 

 N32

1 (750,000)2 700,0003 1,500,000

You are required to:

Determine the profit/loss of the above transactions. Show how

profit/loss will be allocated for all partiesinvolved based on

(i) Each Period method and (ii) End of Contract method of profit

recognition.

Question Five: Suggested Solution

According to AAOIFI there are at least two methods to

recognize profit for multi-period

 Mudharabah

financing i.e. Each Period method and End of Contract method.

Each period method is where; profit isrecognized gradually

throughout the contract period. This is in line with matching

accounting principleand accrual method of income

recognition. Income will be matched against the loss

according to the period that it realized. Accrual basis is

where income is recognized when realized i.e. when we have

thecontractual rights of the income rather than when cash

received (cash basis).End of Contract method is where income is

only realized at the end of the contract or project. Income

isonly recognized when the contract or project has been

completed. This is akin to cash basis of incomerecognition.

Share of Profit Using Each Period Profit Method

Y e a r 1 Y e a r

2 Y e a r 3

T o t a l B a n k 0 1 4

0 , 0 0 0 3 0 0 , 0 0

0 440000C A -

5 0 0 , 0 0 0 2 8 0 0 0 0 6

0 0 0 0 0 380000C B -

2 5 0 , 0 0 0 1 4 0 0 0 0 3 0

0 , 0 0 0 190000C c 0 1 4

0 , 0 0 0 3 0 0 ,

0 0 0 440000T o t a l -

7 5 0 , 0 0 0 7 0 0 , 0 0 0 1 , 5 0 0 ,

0 0 0 1450000

YEAR 1:

Bank = 0Company A = (750,000) x 2 / 3 = (500,000)Company B =

(750,000) x 1/3 = (250,000)

Total (750,000)YEAR 2:

Bank = 700,000 x 0.80 x 1/4 = 140,000Company A = 700,000 x 0.80 x

2/4 = 280,000Company B = 700,000 x 0.80 x 1/4 = 140,000Company C

= 700,000 x 0.20 = 140,000

Total 700,000YEAR 3:

Bank = 1,500,000 x 0.80 x 1/4 = 300,000Company A = 1,500,000 x

0.80 x 2/4 = 600,000Company B = 1,500,000 x 0.80 x 1/4 =

300,000Company C = 1,500,000 x 0.20 = 300,000

Total 1,500,000Total:

Bank = 440,000Company A = 380,000Company B = 190,000Company C =

440,000

End of Contract Method:

Total Profit-Loss

33

B a n k 2 9 0 , 0 0 0 C

A 5 8 0 0 0 0 C

B 2 9 0 , 0 0 0 C

c 2 9 0 , 0 0 0 T

o t a l 1 , 4 5 0 , 0 0 0

End of Year 3:

Company C = 1,450,000 x 0.2 = 290,000Bank = 1,450,000 x 0.8 x

1 /4 = 290,000Company A = 1,450,000 x 0.8 x 2 / 4 =

580,000Company B = 1,450,000 x 0.8 x 1 / 4 = 290,000Based on

the above, the adoption of either one of the two methods

may lead to different amounts of  profit being recognized. In

this case, Company C i.e. the real entrepreneur and the Islamic

Bank (intermediate entrepreneur) will be getting more profits if

Each Period method is used since the net gross profit and loss is

being shared. From the capital providers, point of view, where in

the first year, the project is making a loss, Company A and B

will share higher profits.

Question Six

The following financial data pertains to the results of Tauhid

Bank Nigeria Limited at the end of 2012:Average account

balances:Current account

 N

15,000,000Unrestricted Investment accounts

 N

60,000,000Bank Equity

 N

40,000,000Portion of Equity already absorbed infunding fixed

assets and bank subsidiaries

 N

30,000,000 Net revenue (net of expenses) generated by the above

funds

 N

8,600,000Bank policy regarding percentage of fund actually

invested:Current accounts 40%Unrestricted Investment accounts

90%Equity Available for Investments 100%The Bank has a policy to

deduct 5% of the

 Mudharabah

h net revenue as profit equalization reserve and 5% of the

investors’ share of profit as Investment risk reserve. The profit

sharing as per the

 Mudharabah

h contract is75% for investors, 25% for bank.

Required:

i.

Allocate

 Mudharabah

h net revenue between investment account holders and equity

holders.ii.Calculate each of the profit equalization

reserve and the Investment risk reserve and the

distributableshare of the investor account holders’ profits.

Question Six: Suggested Solution(a) The proportion of the funds

are actually invested

34

Avg balance% of fundsi n v e s t e d a m o u n t

i n v e s t e d W e i g h t i n g  Current A/cs 15,000,000 40.00%

6,000,000 0.085714286UIAH 60,000,000 90.00% 54,000,000

0.771428571Bank Equity* 10,000,000 100.00% 10,000,000

0.14285714370,000,000 1.00*Bank equity available for investment

:average balance 40,000,000less financing fixed assets and sub

30,000,000available for investment 10,000,000Allocation of

profits N 8,600,000C u r r e n t A / c s

0 . 0 8 5 7 1 4 2 8 6 N

7 3 7 , 0 0 0 U I A H

0 . 7 7 1 4 2 8 5 7 1 N

6 , 6 3 4 , 0 0 0 B a n k

E q u i t y 0 . 1 4 2 8 5 7 1 4 3 N

1 , 2 2 9 , 0 0 0

(b) Calculation of the PER the IRR 

M u d h a r a b a

p r o f i t s N

6 , 6 3 4 , 0 0 0

L e s s P r o f i t

E q u a l i z a t i o n

R e s e r v e 5 % N

3 3 1 , 7 0 0 P r o f i

t s a f t e r

P E R N

6 , 3 0 2 , 3 0

0 Less Islamic Bank's share of 

 Mudharabah

2 5 % N

1 , 5 7 5 , 5 7 5

Investors share of profits N 4,726,725Less Investment Risk

Reserve 5% N 236,336Share of profits distributed to mudharaba

investors N 4,490,389

4.0 Islamic Equity Financing and Islamic Assets Financing4.1

Accounting for

 

 Musharakah

Financing

 Musharakah

financing is where an Islamic bank enters into a partnership with

entrepreneur(s) to investin a feasible business project. If there

is profit, it will be shared based on pre-agreed ratio, and if

there is l o s s , i t w i l l t h e n b e s h a r e d a c c o r d i n g t o

c a p i t a l c o n t r i b u t i o n r a t i o . I n t h e c a s e

o f  Musharakah mutanaqisah, capital is not permanent and every

repayment of capital by the entrepreneur will diminishthe total

capital ratio for the capital provider. This will increase the

total capital ratio for the entrepreneur until the entrepreneur

becomes the sole proprietor for the business. The repayment

period is dependent upon the pre-agreed period. This scheme

is more suitable for the existing business that need new

or additional capital for expansion. The salient feature

of Musharakah is on the profit and loss sharing arrangement which

is based on fair distribution of risks and efforts. The need

for proper accounting to measure the capital contribution

is very important in the case diminishing Musharakah

(Musharakah mutanaqisah). This is due to the Shari’ah

requirement as in the case of loss, the loss must be

fairly distributed based on capital contribution ratio.

The Musharakah financing is an equitable concept that reflects

the rights of the partners. The profit and loss sharing

concept encourage partners to effectively contribute

in the business. The accounting implications indicate that

Musharakah financing needs proper accounting recognition,

measurement.

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