Islamic accounting: Many differences exist between conventional and Islamic accounting systems. So is it possible for the two to be reconciled? Professor Bala Shanmugam and lokesh gupta explore the issue.
When East meets West
As an activity that deals with labour, work, trade, the exchange of material objects, the production of goods and the amassing of wealth, the science of economics has been important in every civilisation.
However, from the Islamic point of view, as in other traditional civilisations, economics has never been considered as a separate discipline or distinct domain of activity. As a result, there is not even a word to describe 'economics' in classical Arabic.
As such, the term 'Iqtisad' (economic), which is a fairly recent translation of the modern term 'economics' in Arabic, has an entirely different meaning in classical Arabic. What it primarily means is moderation.
An Islamic economy is composed of three broad and basic components, which are:
the principle of multifaceted ownership
the principle of economic freedom within a defined limit
the principle of social justice
Of wealth, the Koran states: 'In their wealth there is a known right for those who ask for it and those who have a need for it.' This can be interpreted as wealth maximisation not being the sole objective of economics in Islam.
In fact, this distinction has been summed up by Crane in his article 'Islamic commercial law in contemporary economics' (Embassy Handbook, Department of State, US, 1981): 'Western economists generally cannot conceive of any measure that extends beyond the material world, whereas Muslims generally cannot conceive of any measure that does not.'
Within this context of Islamic economics, in his book On Islamic Accounting: Its Future Impact on Western Ac-counting (The Institute of Middle Eastern Studies, International University of Japan, 1989) Hayashi states: 'The traditional Western double-entry accounting technology is well-suited to an orthodox, positivist society of any kind. It is not surprising that this is proving inadequate, as people are returning to more integrated world views, whether Islamic or otherwise.'
The basic framework, then, for Islamic finance is a set of rules and laws, collectively referred to as Shariah, which is responsible for governing economic, social, political and cultural aspects of Islamic societies. Shariah originates from the rules dictated by the Koran and its practices, and explanations rendered (more commonly known as Sunnah) by the prophet Muhammad.
Further elaboration of the rules is provided by scholars in Islamic jurisprudence within the framework of the Koran and Sunnah.
An alternative framework
The major reasons for Islamic transactions to insist upon an alternative framework for reporting are due to the existence of the viewpoints expressed below.
Prohibition of Interest Riba means excess and can be interpreted as 'any unjustifiable increase of capital whether in loans or sales'. More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal (that is, guaranteed regardless of the performance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of interest as widely practised.
This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits, determined based on analysis of past performance, symbolise successful entrepreneurship and creation of additional wealth. Interest, determined based on anticipated changes or activity, is a cost that is accrued irrespective of the outcome of business operations, and may not create wealth if there are business losses.
Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion, and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.
Risk Sharing Because interest is prohibited, suppliers of funds become investors instead of creditors. The providers of financial capital and entrepreneurs share business risks in return for shares of the profits.
Money as potential capital Money is treated as potential capital that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity.
Islam recognises the time-value of money, but only when it acts as capital, not when it is potential capital.
Prohibition of speculative behaviour Islam discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling and high risks.
Sanctity of contracts Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard.
Shariah-approved activities Only those business activities that do not violate the rules of Shariah qualify for investment. For example, any investment in businesses dealing with alcohol, gambling and casinos would be prohibited.
In talking about Shariah principles in accounting it is worth mentioning some of the common terms used. In summary the terms are as follows:
Zakat: This term literally means purification and is the second-most important duty of a Muslim. Its purpose is to eradicate poverty, by redistributing wealth from the relatively well-to-do to the poor and needy. Zakat is not considered charity, but something that rightly belongs to the poor and needy. Thus zakat keeps wealth circulating in society constantly and therefore creates a society based on mutual assistance. If properly developed, it guarantees a minimum level of living for all.
Mudarabah: Described as trust financing. The bank acts as a partner, providing cash to the borrower and sharing in the net profits and net losses of the business. The loan is for an undetermined period, although the contract may be rescinded by either party.
Murabaha: Cost-plus trade financing. The bank, as a partner, provides financing for purchasing of goods, for a share in profits, once the goods are sold. The bank may or may not share any losses incurred. Repayment may either be in a lump sum or in instalments.
Musharaka: Defined as participation financing. The bank provides part of the equity and part of the working capi-tal for the business, and shares in the profits and / or losses.
Ijara: Explained as rental financing or leasing. The bank purchases a piece of equipment and rents it to the busi-ness. Alternatively, for hire-purchase contracts, the business partly purchases and partly rents the equipment.
In some ways Islamic accounting can be stated as a 'wholesome accounting process' because it provides appropriate information that is not necessarily limited to financial data to stakeholders of an entity. According to some, using an Islamic accounting system will ensure stakeholders that the entity is continuously run within the limits of the Islamic Shariah and that the entity delivers on its socioeconomic objectives. As such, Islamic accounting is considered a God-induced tool, which enables Muslims to evaluate their own accountabilities to God in relation to interhuman and environmental relations.
In essence it can be argued that an accounting system based on Islamic principles can be expected to be stable owing to the elimination of debt-financing and enhanced allocative efficiency.
Islamic accounting models tend to be more stable since the term and structure of liabilities and assets are symmetrically matched through profit-sharing arrangements; no fixed interest cost accrues, and refinancing through debt is not possible. Allocative efficiency then occurs because investment alternatives are strictly selected based on their productivity and the expected rate of return. In addition, Islamic accounting models support the growth of entrepreneurship, without greed.
The meaning of Islamic accounting becomes clearer if it is compared with the definition of conventional accounting. Conventional accounting according to the AAA (1966) definition is the identification, recording, classification, interpreting and communication of economic events to allow users to make informed decisions.
As it can be seen from this there is a common element in both definitions, which in essence is in the provision of giving information. However, this is only at the surface level, and there are numerous differences. For instance, answers to the following questions will be different for conventional and Islamic accounting: What are the objectives of providing the information?
What is the type of information that has been identified? How is the information measured, valued, recorded and communicated? To whom will the information be communicated (who are the users)?
As we know, conventional accounting seeks to allow informed decisions whose ultimate purpose is to efficiently allocate scarce resources available to their most efficient (and profitable) users by providing information in the market (FASB, 1978). However, in meeting with this objective the end result is a profit motive, as users make either a buy, sell or hold decision on their investments.
On the other hand, Islamic accounting attempts to answer the above questions differently. The aim here is to enable users to ensure that organisations (business, government or non-profit organisations) abide by the principles of the Shariah in their dealings. By so doing it enables the assessment of whether an organisation's objectives are being met. At the simplest level, Islamic organisations (whether business or otherwise) differ from their conventional counterparts by having to adhere to certain Shariah principles and rules, and also by trying to achieve certain socioeconomic objectives encouraged by Islam.
But this does not mean Islamic accounting is not concerned with money or profit. On the contrary, due to the prohibition of interest-based income, profit determination is more important in Islamic accounting than conventional accounting. There is a difference, however, as Islamic accounting is holistic in its reporting. Therefore its reporting includes both financial and non-financial measures with regards to economic, social, environmental and religious transactions.
Another salient point in conventional accounting is it uses mainly historic cost (or lower) to measure values, assets and liabilities. By now the accounting profession is quite aware of the limitations of using such an assumption. Yet despite recommendations for using current values (rather than historic costs), this initiative was given up due to its complexity and presumed lack of objectivity.
Nevertheless, this measure can be used in Islamic accounting, at least for the computation of zakat, where current valuation is obligatory. For instance, the accounting period for zakat purposes is different from the conventional accounting period as there is a need to follow the Hijrah year and not the Gregorian year. The reason is that zakat is payable for the former year and not the latter.
Another difference is that Islamic accounting may require a different statement altogether, mainly to de-emphasise its focus on profits via the income statement, as measured by conventional accounting standards. In fact, in their paper 'Islamic Accounting Theory,' presented at the AAANZ annual conference in 1994, Baydoun and Willet even suggested a value-added statement (VAS) to replace the income statement in Islamic corporate reporting. They argue that using the VAS encourages a cooperative environment in business (sidelining the greed motive) as opposed to a destructive competitive environment.
As for the users of the information, even though the accounting profession has recognised various stakeholders, it considers that the main users are a company's shareholders and creditors. This is based on the FASB's definition, which dismisses a whole range of stakeholders by including the term and others.
In examining current practices in global financial markets, some authors believe conventional accounting seems to be serving a select group of financiers consisting of wealthy individuals, banks and other financial institutions. Current accounting practices have been accused of helping a group of rich people get richer - a critical view indeed, as the profession more often than not justifies its monopoly on audit services by virtue of its practice of safeguarding public interest.
Islamic accounting as a whole is able to serve the whole gamut of stakeholders. Its principles also seem to suggest it does not serve the interest of any particular group, but society as a whole, which can make corporations accountable for their actions and ensure they comply with Shariah principles. As a result it does not harm others while making money ethically, and while achieving equitable allocation and distribution of wealth.
Improving relations
Having noted the differences present in conventional and Islamic accounting systems, one wonders if there is a need then to prepare two sets of accounts reflecting both calendar years and their respective principles. Shariah-compliant financial instruments simply cannot be used in conventional systems, since the IFRS are centred on interest-based elements.
Still, answering the question can be a difficult task. Conventional accounting is still widely used in Western countries where Islamic banks and businesses operate, and to have a separate accounting systems would be an immense task. Rather, as an alternative, some argue that the requirement be seen as complementary.
In this regard it is fortunate that the Financial Accounting Organisation for Islamic Banks and Financial Institutions (FAOIBFI) was institutionalised in 1991. FAOIBFI was later renamed AAOIFI (Accounting and Auditing Organisation for Islamic Financial Insitutions) to reflect accounting standards that were indeed based on Islamic Shariah. AAOIFI's objective is to develop guidelines that cater for the specifics of Shariah contracts, which complement transactions carried out by Islamic institutions.
In addition, AAOIFI has also taken the lead where there is no IFRS available. For example, AAOIFI spearheaded the development of four accounting standards for Islamic insurance companies.
Shariah principles
There is little doubt that the use of conventional accounting systems in Islamic countries based on the Anglo-American model is only suitable in a narrow context.
As Taheri argues, there is a need to study both values and norms from Islam's point of view and their effects on accounting practices before implementing reporting standards. In reality, it must be noted that without the application of Shariah principles, implementing Islamic accounting is almost impossible. Factors that need to be considered include Islamic economic items, of which social justice elements such as riba, zakat and Islamic ethics are considered important.
Critics argue that although AAOIFI's standards would complement the financial statements of institutions that use IFRS, they would also disadvantage these institutions at the international level. They argue that IFRS is becoming the lingua franca of financial reporting, and thus institutions that adopt AAOIFI's standards would need to prepare two sets of accounts. This will be a costly affair for the institutions, which may unfortunately lead to the demise of Islamic accounting.
Professor Bala Shanmugam FCPA is the chair of accounting and finance and also director of banking and finance at the school of business at Monash University Malaysia.
Lokesh Gupta, a senior business consultant, is currently pursuing his M.Phil in Islamic banking at Monash University Malaysia.
