Chapter 4 Financial Accounting for Islamic Banking Products Basic Principles of Accounting. Basic Principles of Islamic Accounting. Accrual and Cash flow Accounting Methods. Financial Statements in Islamic Banks and Financial Institutions Remember IRR NPV, we needed cash flows to compute them. Here we learn about these cash flow estimation An important step in any investment to determine its return. Take Chanel for example. When it decided to open up another store. It would start with it’s current Salhiya store sales. There are risks: a) sale might not be at the same level. B) Cannibalize the Salhiya store. What can it do to stop that? What we will learn here is how to estimate the cash flows and the risk of these cash flows that are used extensively in the industry

The Definition and the Significance of Accounting in Financial Decision-making What is Financial Accounting? Financial accounting is a process where business operations and their activities are measured and measurements are processed into information for these decision-makers:   Internal decision makers include the management of the company External decision makers are mainly investors & customers

The Definition and the Significance of Accounting in Financial Decision-making What is Islamic Accounting? … is ‘the accounting process that provides appropriate information to stakeholders of an entity that will enable them to ensure that the entity is continuously operating within the bounds of the Islamic Sharī‘ah and delivering on its socioeconomic objectives’

Accountability in Islam The Holy Qur’an emphasizes the need and requirement of accountability ‘حساب ’ in every human activity Transparency and fair dealings involve a great commitment towards accountability in financial transactions Muslim accountants have more responsibilities than non-Muslim counterparts

An Islamic Perspective of Accounting Concepts The Qur’an & prophetic precedents emphasise accountability in commercial transactions Full disclosure, social and financial accountability Ethics for accountant entails trustworthiness and objectivity The Islamic financial institution needs to provide relevant information on all transactions for the user. The Islamic bank needs to account for social responsibilities The religious-spiritual element in financial transactions is as important as the element of profitability

The Significance of Accountability in Islam The significance of accountability with particular reference to financial transactions is evidenced by the following Islamic concepts: Khilafah (vicegenrency خليفة ) Taklif (responsibility تكليف ) Documentation of financial dealings Islamic law of inheritance (مواريث ) Calculation of obligatory alms (zakat زكاة ) The underlying concept of tawhid (unity of God التوحيد )

International Financial Reporting Standards (IFRS) Differences between Islamic Accounting and Conventional Accounting Financial instruments Accounting standards Accounting treatment Types of information contained in financial statements Financial reporting Functions of commercial/financial contracts

Basic Principles of Islamic Accounting The purposes of Islamic accounting include: Reporting of accurate income information Promotion of efficiency and leadership Compliance with the Sharī'ah Commitment to justice Reporting best practices and adapting to social change through corporate social responsibility  

International Financial Reporting Standards (IFRS) IFRS and Islamic Banks and Financial Institutions IFRS designed for conventional forms of business Islamic banks have specific requirements e.g. transactions, reporting and disclosures Therefore, the Islamic finance industry requires alternative sets of accounting and financial reporting standards The establishment of the Bahrain-based Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1991

AAOIFI الأيوفي Accounting & Auditing Organization for Islamic Financial Institutions Established in Algiers in 1990 and based in Bahrain as an independent non-governmental organization based on Agreement of Association among financial institutions from different Muslim countries AAOIFI issued the first accounting auditing, governance and Sharī'ah standards in 1991 followed by a series of relevant standards for specific Islamic finance products

Basic Principles of Islamic Accounting Many countries have adopted AAOIFI accounting standards Some countries like Bahrain, Jordan and Sudan have required Islamic financial institutions in their respective jurisdictions to abide by the AAOIFI reporting standards Others allow such Islamic financial institutions to adopt the standards voluntarily

Consumers of Accounting Information for Islamic Banks Equity holders, Holders of investment accounts & Other deposits Current and saving account holders Others who transact business with the Islamic bank, who are not equity or account holders Zakah agencies (if there is no legal obligation for payment) Regulatory agencies (AAOIFI Statement of Financial Accounting (SFA) No. 1, para 26)

(SFA No. 1) Requires Information Intended For External Users Information about the bank’s compliance with Sharī'ah and its objectives to establish such compliance Information about the Islamic bank’s economic resources and related obligations To assist in the determination of Zakah on the Islamic bank’s funds To assist in estimating cash flows from dealing with the bank To assist in evaluating the bank’s discharge of fiduciary responsibility Information about the Islamic bank’s social responsibilities

Accrual and Cash flow Accounting Methods The cash flow accounting method - based on frequency of cash flow (requires an actual exchange of cash) The accrual accounting method - based on the occurrence of a transaction regardless of whether there is exchange of cash

Financial Statements in Islamic Banks & Financial Institutions Financial statement is the formal record of the financial activities (transactions) of a business entity Transactions are duly sorted, classified and presented in accordance with principles of bookkeeping The transactions being recorded comprise any business transacted between the business entity and other corporate bodies, organisations or individuals The end product of all financial transactions is the financial statement

Financial Statements in Islamic Banks & Financial Institutions Comparative financial statements of a corporate entity Gives direction of business change in at least two financial periods Provides top management with information for decisions Comparative financial statements analysis (Horizontal analysis) Determines the performance of the business Provides necessary information about sustained performance or poor performance Islamic banks & financial institutions are required to publish comparative financial statements

Basic Principles of Accounting Accounting comprises two main business activities: Bookkeeping The detailed recording of all financial transactions in the business The preparation of financial statements or financial accounting (periodically) Depending on the policy and the accounting standards adopted by the business

Four Basic Financial Statements Balance sheets Income statements Cash flow statements Statement of retained earnings or shareholders’ equity

Balance sheets& Income statements Balance Sheets (also known as the Statement of Financial Position): a summary of financial balances of a company Income Statements is a financial statement that measures the financial performance of a company over a specific period of time indicating how the revenue is transformed into net income The income statement may also be referred to as The Profit and Loss Statement Statement of Operations Statement of Income

Cash Flow Statements  Also called statement of cash flow or funds flow statement Indicates how changes in the balance sheet accounts and income statements affect cash and its equivalent Purpose is for identification of the sources and uses of cash during the financial year in question FAS 1, para 54 states the statement of cash flows should differentiate between cash flows from operations, from investing activities and from financing activates

Statement of Retained Earnings or Shareholders’ Equity A financial statement explaining changes in retained earnings of a company over a period of time The statement of retained earnings may also be called: - Statement of owner’s equity (in a single proprietorship) - Statement of partners’ equity (in a partnership) - Statement of retained earnings & stockholders' equity (for corporations) The owners’ equity and retained earnings may be calculated using the following formulae: Owners’ equity = Assets – Liability

AAOIFI Proposed Set of Financial Statements for Islamic Banks There are three major categories The first category comprises the financial statements that are meant to reflect the position of the Islamic bank as an investor, such as: Statement of Financial Position Statement of Income Statement of Cash Flows Statement of Retained Earnings or Statement of Changes in Owners’ Equity

AAOIFI Proposed Set of Financial Statements for Islamic Banks The second category focuses on the financial reporting of restricted investments managed by the Islamic bank for the benefit of others. Such a statement will be referred to as “Statement of Changes in Restricted Investments” The third category includes financial statements reflecting the Islamic bank’s role as a fiduciary of funds made available for social services Statement of Sources and Uses of Funds in the Zakah & Charity Fund Statement of Sources and Uses of Funds in the Qard Fund