CIFP IE1002: Reporting of Islamic Financial Transactions: Assignment for online students Session: September 2012

Online Facilitator: Dr Noraini Mohd Ariffin Course Leader: Dr Shahul Hameed Mohamed Ibrahim

INCEIF
Student Name: Hani Hazaa Abdulbari Hazaa Student ID: 1200189

Question No. (1); Islamic accounting framework;

Allah (SWT) says in Surah (Al-Kafirun :6) For you is your religion, and for me is my religion.. Islamic religion yielded an Islamic society and Islamic economy which is distinct of what everything else. It is a divine moral economy, ideological, and realistic dominated by economic freedom. Its rules and origins are constant and derived from the Quran and Sunnah, but the branches are renewable in the interests of the people. Conventional accounting emerged as a result of scientific and organized research in capitalistic societies in the last century, and aiming to permit informed decisions by users, despite this, but it does still in a constant amendment process because it is a man-made, and is subject to right and wrong. As long as Islam is a divine religion which is comprehensive to all aspects of life including economic and spiritual aspects, then, Islamic accounting is a system that derives its goals, concepts, assumptions and principles from the Shariah sources (i.e. Quran, Sunnah, Ijmaa and Qiyas) to identify, record and report socio-economic events and transactions and provide full disclosure to their compliance with the Shariah and communicating them to the users. Since we could came out with a definition for the Islamic accounting, then, a framework to Islamic accounting can be placed. Through identifying the goals, concepts, assumptions and principles of the Islamic accounting, thus, a framework of Islamic accounting is done. Here is an attempt for putting headlines for making a framework to Islamic accounting; First of all; goals of Islamic accounting should be identifyed to enable us to put harmonious standards that describe the nature, functions, and determinants of Islamic accounting. To identify the goals, we should first identify the users of Islamic accounting outcomes and the required information that satisfy their needs. Since informition needed by useres of islamic accounting

outcomes increase and vary with the increase in the categories of users, so this made it impossible for Islamic accounting to satisfy each needed information by each category of users of Islamic accounting outcomes. But I think that there are joint information that could satisfy the most of information needed by those users which are financial info represented by (income and balance sheet statements), and info about their consistent with the Shariah values and principles. Financial statements of an institution should be presented according to Islamic concepts and principles which constitute the main determinants of the Islamic accounting practices. These are explained below. Secondly; we must define the essential concepts of Islamic accounting which the goals of Islamic accounting depend fully on them through guiding or directing the Islamic accounting practices. Those concepts are accurate definitions for the elements of the financial statements. Many Islamic concepts of elements of financial statements have different definitions than that of conventional definitions of financial statements elements. For example; the concept of assets; asset was defined by the (FASB) as a Resource controlled by an entity as a result of past events, and from which future economic benefits are expected to flow to the entity. While the AAOIFI defined the asset as a resource controlled by an entity, whether financed by owners or its investment accountholders, as a result of a past transaction, event or condition which provides the entity an enforceable right over the resource and gives it an economic benefit, present or future !!!. It seems that both definitions are the same since they conditioned only the control over the asset by the entity to be recognized in the financial statements of the entity, this if I did not misunderstand the definition of asset that issued by AAOIFI would open the door to entities to recognize assets which are not legally owned (according to Islamic law) by those entities e.g. Finance leases. I think it was better for AAOIFI to replace the word CONTROLLED by the

word OWNED BY so that only assets legally owned by entities recognized in the financial statements. Anyway, all financial statements elements should be defined Islamically. After that; principles for Islamic accounting should be placed. The accounting principles defined as general executive indicators to be guided through, and used in the knowledge of the general principles of accounting methodology. These principles are fixed and not variable. Dr, Zaid & Omar Abdullah [Financial Accounting in the Muslim community, First Edition, Amman, 1995] have suggested that the main and essential principle of Islamic accounting should be PRINCIPLE OF ISLAMIC LEGALITY OF TRANSACTIONS In the sense that the goal of a business is legitimate, and transactions related to the objectives of that activity legitimate, and the means used in the completion of those transactions to achieve the objectives of the business are legitimate. Putting a complete framework for Islamic accounting require great efforts to be exerted by all professional Muslims so that Islamic accounting would be the first step toward the Islamization of all aspects of life in the Islamic world.

Question No. (2)

One must refrain from making a direct comparison between Islamic banking and conventional banking (apple to apple comparison). This is because they are extremely different in many ways. The key difference is that Islamic Banking is based on Shariah foundation. Thus, all dealing, transaction, business approach, product feature, investment focus, responsibility are derived from the Shariah law, which lead to the significant difference in many part of the operations with as of the conventional including accounting practices [Ust Hj Zaharuddin Hj Abd Rahman, 2007]. Since products of Islamic banks are completely different than those of conventional banks, we find that international accounting standards (IASs) and international financial reporting standards (IFRS) did not include any accounting standards regarding on how to deal with Islamic banks products, through the processes of measurement, presentation and disclosure. In addition, international accounting standards arent based on the Shariah Basis that the Islamic accounting standards are to be based on. Here we will try to prove how international financial reporting standards (IFRSs) are not applicable for recording and presentation of the Islamic banks financial statements through discussing TWO (IASs) and proving how they arent applicable to Islamic financial institutions. First, IAS No (17, Leases), we will make a comparison between the treatment of leases (recording and presentation) according to this Standard, and how Leases are recorded and presented according to Islamic accounting perspective. Next, Ill discuss why the IAS No 27 (Consolidated and Separate Financial Statements) is not applicable to IFIs however the AAOIFI had permitted to apply it through adopting the aapifi FAS No23 (Consolidation).

First; IAS 17, Leases The objective of this Standard is to prescribe, for lessees and lessors, the appropriate accounting policies and disclosure to apply in relation to leases. This standard classifies leases to two classifications, which are Financial Leases and Operating Leases. The classification of leases adopted in this Standard is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. According to this Standard, whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. A lease being classified as a finance lease if for example (the lease transfers ownership of the asset to the lessee by the end of the lease term, or if the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised, or even if the lease term is for the major part of the economic life of the asset even if title is not transferred!). The accounting treatment of Finance Leases in the financial statements of lessees according to this Standard, lessees shall recognize finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. And the discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessees incremental borrowing rate shall be used. Any initial direct costs of the lessee are added to the amount recognized as an asset.

And Lessors shall recognize assets held under a finance lease in their statements of financial position and present them as a receivable at an amount equal to the net investment in the lease. From the Islamic perspective, Leases should be judge only by their legal forms, not by their substance as it the case in conventional accounting. One of the most common structure used in Islamic finance is the Ijara a form of leasing arrangement. The pure Ijara is essentially an operating lease and there would appear to be little conflict in accounting for this (either for the lessor or the lessee) under the requirement of IAS17. Increasingly used forms of leasing by IFIs are the Ijara muntahia bittamleek, which are similar to a hire purchase agreement popular in conventional finance. This is essentially a form of financing which, under IFRS is treated as mentioned above. By contrast, the AAOIFIs FAS8, consider the legal form of the contract is paramount, meaning that the ownership of the asset remains with the lessor, until legal title is transferred at the end of the lease period. In this case the IFI would remain the owner, and record the asset on its balance sheet in the same way as an operating tease or operating Ijara. Second; IAS27, Consolidated and Separate Financial Statements, and its conflict with accounting for IFIs. According to the IAS 27, This Standard shall be applied in the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent. A Parent must consolidate its investments in subsidiaries. There is a limited exception available to some non-public entities. However, that exception does not relieve venture capital organizations, mutual funds, unit trusts and similar entities from consolidating their subsidiaries. Paragraph 4 of IAS 27 defines control as the power to govern the financial and operating policies of an entity so

as to obtain benefits from its activities. Financial statements to be prepared according to this standard is by combining the financial statements items of entity A with those of the subsidiaries, mutual transactions between Entity A and subsidiaries shall be eliminated. First of all, this standard is completely disagreeing and conflicting with the Accounting Entity Assumption which mean; a business is a separate legal entity from the owner. And only the business's financial transactions are to be recorded, recognized and presented in its financial statements. So, the consolidated financial statements of the holding (parent) company and its subsidiaries, which are prepared in accordance with IAS No27 represents an explicit violation of the Accounting Entity Assumption because these companies are shown in those consolidated financial statements as in the case of an actual merger, while this merger did not happen in reality, because subsidiaries are still retaining their legal independency. From Islamic point of view, acquisition of assets means that the owner of these acquired assets must have the absolute right to dispose. The owner should acquire the legal authority to dispose of his properties. According to this standard (IAS No27) assets are to be recognized in those consolidated financial statements regardless of the legal acquisition that authorize the owner to have the absolute right to dispose of his assets at any time and in any way. For example, if the Parent company is going through a financial hardship, but the results acquired of the financial analyzing of liquidity ratios of those Consolidated Financial Statements for the Parent Company and its Subsidiaries show that this group is able to meet its obligations as they fall due! Here we pose a question: can the Parent Company transfer cash from its subsidiaries so that it could fulfill its obligations toward its creditors without any cost? If the answer is yes, then the merger is legal and real merger. If the answer is no, then the merger isnt a real and its merely a control of management.

From the Islamic perspective, assets to be recognized in financial statements of an entity, should be legally owned by that entity, this ownership entitle the owner a full control of this asset and easily use and benefit from it. This mean that if entity A (the Parent Entity) must combine its balance sheet elements with Entity Bs (the Subsidiary) balance sheet elements without a contractual agreement of merger that would lead to whether A+B=A or A+B=C, this clearly will lead to recognizing assets which are not owned by the Parent Entity (A) and obligations which are not enforceable against this entity. This Standard is explicitly inconsistent with the Islamic concept of Property. But what is strange is that the AAOIFI had also adopted the same standard in accounting for subsidiaries in consolidated financial statements! Here I pose a question: What is the legitimate rule invoked by the AAOIFI that enforced it to issue its FAS No23 (consolidation)?

Question No. (3)

A) The Tasks the SSB/ Shariah Committee is Required to Perform; SSB or in some Islamic financial institutions is known as Shariah Committee, is one of the most important governance mechanism of an IFI to ensure compliance with Shariah. Compliance with Shariah is the distinctive characteristic of an IFI as compared to conventional financial institution. Acknowledging this importance, the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) had provided standards on SSB, Shariah Review and Internal Shariah review under its Governance Standard (AAIOIFI, 1999). The Shariah Supervisory Board is required to perform the tasks of directing, supervising and reviewing the activities of the Islamic Financial Institution to ensure Shariah compliance in all its activities.

B) The Procedures Involved in a Shariah Review Conducted By SSB; The Shariah Review is defined as an examination of the IFIs transactions, processes, products, financial statements etc. to insure that all its activities comply with the Shariah. GSIFI No. 2, outlines the the procedures of review which can be carried out broadly in 3 phases which are; 1- Planning review procedures. The Shariah review procedures shall be planned so that it is completed in an effective and efficient manner, this require the SSB to understand the activities, products and managements awareness and attitude towards compliance with the Shariah, so that the reviewing procedures are designed based on the above inputs. 2- Executing review procedures and preparation and review of working papers. At this stage all the planned review procedures are executed. 3- Documenting conclusions and reports. The SSB shall document their conclusion and prepare their report to the shareholders based on the work done and discussion held.

Question No. (4);

The major concern of Islamic banking institutions is to conduct their business in accordance to the principles of shariah. In order to ensure that all their products and services comply with the principles, most of the Islamic banks have set up Shariah supervisory Board. The boards consist of experts in Islamic commercial law (fiqh muamalat), the board also may include members other than those specialized in fiqh almuamalat, but who should be an expert in the field of Islamic financial institutions and with knowledge with fiqh almuamalat. The Board is entrusted with the duty of directing, reviewing and supervising the activities of the IFI in order to ensure that they are in compliance with the Shariah rules and principles.

In Malaysia, Bank Negara Malaysia (the Bank) places great importance in ensuring that the overall Islamic financial system operates in accordance with Shariah principles. Toward achieving this, the Shariah Governance Framework recently issued by BNM says It is the duty and responsibility of an IFI (Represented by the board of directors) to establish a sound and robust Shariah governance framework with emphasis placed on the roles o f key functionalities in ensuring effective implementation of the Shariah governance framework. Since the board is the ultimately responsible for the establishment of an appropriate Shariah governance framework of an IFI, In my consideration, this Governance Framework enterusted the Board of Directors with functions which placed the Board in a position where conflict of interests are unavoidable. In general, the main duty and responsibility of the Shariah Committee is to assure that the business operations in Islamic banks comply with shariah principles at all times. According to the Shariah Governance Framework issued by BNM the Shariah Committee members shall be appointed by the board upon the recommendation of its Nomination Committee. Normally the appointment is for a renewable term of two years. The shariah committee members should have vast knowledge in Islamic law, either in Islamic legal methodology (usul fiqh) or Islamic commercial transactions (fiqh al-muamalat) (BNM, 2004). A part from individual who posses shariah background, Islamic banks are allowed to appoint other professional such as lawyers, accountants and economists to provide assistance to the committee, especially on matters regarding law and finance. Such flexibility is appropriate as it will support the depth and breadth of the shariah deliberations. The issue of independency is given great attention. Since the shariah committee members are appointed and their allowances are paid by the banks, it is argued that the banks management may influence them in making proposed products legal. Despite all efforts in enhancing the shariah governance framework, some people still not convinced that the

shariah committee members has full freedom in expressing their opinions and is fully independent. Despite BNM stresses that Islamic banks must ensure that the shariah committees are free from any undue influence that would hamper them from making objective judgment. In relation to this, re-appointment, resignation and removal of the shariah committees cannot be decided at the banks level, it is must be approved by the National Shariah Advisory Council (NSAC) formed by Central Bank of Malaysia (BNM). But I think those procedures still an adequate to protect the independency of the committee since the appointment of members and allowance paid are done by the bank.

References; 1- IE1002 Reporting of Islamic Financial Transactions, Enhanced Edition of CIFP Module 2012. 2- [Amir Shaharuddin, Shariah Governance Framework for Islamic Financial Institutions 2011] 3- AAOIFI Financial Accounting Standard No23 (Consolidation). 4- IAS 27 Consolidated and Separate Financial Statements.
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