Chapter 4

Financial Accounting for Islamic Banking Products

Learning Objectives

1 Understand the definition of accounting from both conventional and Islamic perspectives,
respectively, and its significance in financial decision-making.
2 Explain the relevance of International Financial Reporting Standards (IFRS) in international
accounting regulation.
3 Understand the basic principles of accounting.
4 Understand the basic principles of Islamic accounting.
5 Differentiate between the accrual and cash flow accounting methods.
6 Draft the main financial statements for Islamic finance products.

Chapter Overview
Accounting is regarded as a product of the environment within which it operates. Accordingly, there are many
factors that influence a country’s accounting system. Within the context of Islamic finance, there is a strong
relationship between Islamic financial principles and accounting. This chapter explores financial accounting for
Islamic banking products. It looks at the international financial reporting standards, basic principles of
conventional accounting, and basic principles of Islamic accounting. Furthermore, it appraises the financial
accounting standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

A. Definition of Islamic Financial Accounting

● The language of business is accounting and it can only be communicated through a process that
may involve a number of activities (such as recording the transactions and classifying them
under the appropriate heading). Such activities are essential for the success of a business. In this
chapter, we shall be defining the terms ‘accounting’ and ‘Islamic accounting’ and explain the
importance of accountability in Islam (note: this chapter will focus on financial accounting).

What is Accounting?
● The process whereby business operations and activities are measured and the measurements
are processed into information that is made available to decision-makers. In simple terms,
accounting is made up of three main activities:
○ recognizing, recording, classifying, and summarizing business transactions
○ measuring, analyzing, processing, and interpreting operating results
○ reporting and presenting the financial position
 According to the American Accounting Association, accounting can be defined as “the process of
identifying, measuring, and communicating economic information to permit informed judgments and
decisions by users of the information.” The purpose of this process is to provide necessary information
that has the potential to be useful for economic decision-making by stakeholders in the financial
industry.

What is Islamic Accounting?

● Islamic financial accounting can be defined as, “the accounting process that provides
appropriate information (not necessarily limited to financial data) 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 socio-economic objectives.”
● The general definition of financial accounting remains acceptable within the Islamic financial
framework provided that the underlying objective of Islamic financial accounting is an Islamic
worldview in compliance with the Sharī‘ah prescriptions.

The Importance of Accountability in Islam

● In the Qur’an the word for accounting or accountability is hisab. The word hisab or muhasabah
(a word derived from hisab) refers to the individual spiritual reckoning in Islam.
● Several Qur’anic verses emphasize the obligation on mankind to be accountable to God in every
worldly disposition.
● An emphasis on the importance of accountability in daily transactions regardless of whether
they relate to financial or administrative matters (this is to ensure transparency in commercial
dealings).
● All legislative prescriptions on economic matters mentioned in the Qur’an and clearly explained
in the Prophetic traditions are based on fair dealings and accountability.
● A number of Islamic concepts underscore the significance of accountability (or their deeds
involving the management of endowed resources in this world and the next) in Islam with
particular reference to financial transactions. They include khilafah (vicegerency- prudent
resource management), taklif (responsibility- the duty of people towards their God),
documentation of financial dealings, Islamic law of inheritance (mawarith- inheritance),
calculation of obligatory alms (zakat), and the underlying concept of tawhid (unity of God).
● This is one of the reasons why Islamic accountants have more responsibility in their duties for
they are expected to understand the underlying religious principles of their chosen profession.

B. International Financial Reporting Standards

● Financial reporting is an element of documentation in financial dealings, which is a Qur’anic
prescription in commercial transactions in Islam.
● The general approval for financial recording within the Qur’an is summarized in Qur’an 2, verse
282 (the longest verse of the Qur’an popularly called the “verse on debt,” or ayat al-dain).
● The recording and reporting of Islamic financial products requires different techniques.
 ● The International Financial Reporting Standards (IFRS) are a set of principles-based accounting
standards developed by an independent, non-for-profit organization called the International
Accounting Standards Board (the IASB is the standard-setting body of the IFRS). Box 4.1 outlines
the principal objectives of the IFRS and IASB.
● The IFRS contains general guidelines, not industry-specific standards (for individual companies) for
financial reporting that are more relevant to larger multinational companies with subsidiaries
spread across different countries (as it allows them to adopt the same set of accounting
standards).
● Having a single set of standards of reporting creates a situation where both prospective investors
and auditors will have the same overview of the company’s finances.

Box 4.1 The IFRS Foundation and the IASB

The IFRS Foundation is an independent, not-for-profit, private sector organization working in the public
interest. Its principal objectives are:

● to develop a single set of high quality, understandable, enforceable and globally accepted
international financial reporting standards (IFRS) through its standard- setting body, the IASB
● to promote the use and rigorous application of those standards
● to take account of the financial reporting needs of emerging economies and small and medium-
sized entities (SMEs)
● to bring about convergence of national accounting standards and IFRS.

● It should be noted that people often confuse the International Accounting Standards (IAS) with
the IFRS, but these are two different accounting reporting regimes.
● The IAS are the old standards, replaced by the IFRS in 2001.
● More than 120 countries require the adoption of IFRS for public companies in financial reporting
and disclosures (see Table 4.1 on page 133 for a detailed list of countries, and their status, since
they have adopted the IFRS).

The structure of IFRS comprises five different aspects:

● International Financial Reporting Standards (IFRS)—standards issued after 2001
● International Accounting Standards (IAS)—standards issued before 2001
● Interpretations originated from the International Financial Reporting Interpretations Committee
(IFRIC)—issued after 2001
● Standing Interpretations Committee (SIC)—issued before 2001
● Conceptual Framework for Financial Reporting (IFRS Framework) (2010).

IFRS and Islamic Banks and Financial Institutions

● Due to the fact that the IFRS are designed for conventional forms of business, their applicability
to Islamic financial institutions has been somewhat problematic (there are issues in Islamic
 finance for which many IFRS are not applicable at all -mudarabah- and others for which there
are no IFRS).
● This prompted the establishment of the Bahrain-based Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI), which has remained on the forefront in terms of
developing Islamic accounting, auditing, governance, ethic, and Sharī‘ah standards (to date, the
AAOIFI has issued more than 81).
● Currently, there is increasing demand for harmonization between the IFRS and the AAOIFI
standards. This is due to the increasing demand for a global adoption of the IFRS (see the Islamic
Finance in the News feature).

Islamic Finance in the News

IFRS to Converge with Islamic Accounting Standards (Source: Accounting Today, April 21, 2009)

The International Accounting Standards Board is also looking to extend the standards globally,
including the countries of the Middle East, claiming that about 113 different countries have either
adopted IFRS or agreed to adopt the standards. Board member and chair of the International Financial
Reporting Committee, Robert Garnett, said that the IASB would need to meet with the Middle Eastern
standard-setter, the Accounting and Auditing Organization for Islamic Financial Institutions, ‘to have a
better understanding of their concerns and how we can accommodate those with a revised IFRS’. He
plans to begin holding talks with the AAOIFI this year to try to work out the differences between IFRS
and the Islamic standards.

C. Basic Principles of Accounting

● Accounting companies partake in two main activities, distinct, yet complementary in function.
● The first is bookkeeping, which in simple terms, can be defined as the detailed recording of all
financial transactions involved in a business.
● The second is the preparation of the financial statement (showing the performance of a business),
or accounting, which may the preparation of the financial statement, or accounting.
● Regardless of the type or size of the business, the principles of accounting, and the order that they
take place (first, bookkeeping, then accounting) are the same.

Recording Financial Information

● The information recorded must reflect both the revenue and expenditure.
● The accounting record where all financial transactions of a business are originally entered is
known as a journal
● Similarly to individuals, who also keep record of their finance in order to allot their money in an
efficacious manner, proper record keeping of a business’s transactions can allow them to do so
as well.
● Another relevant item in recording financial information is the ledger (a collection of financial
accounts that uses both credits and debits), or what is generally known as the T account (format
of a ‘T’ form- credits are presented on one side and debits are presented on the opposite, hence
the name T account).
 Double-Entry Bookkeeping
A set of rules for recording financial information where every transaction or event changes at
least two different ledger accounts.
1 Debit - An increase in assets and expenses, and a decrease in liability, revenue, and
capital.
2 Credit- An increase in liability, revenue, and capital, and a decrease in assets and
expenses.

Table 4:2 Example of a Journal Entry

Date Account Name and Debit (dr) Credit (cr)

Explanation
1/12013 Cash 10,000
Capital 10,000
The owner contributes
$10,000 to start the
business

1/3/2013 Lease expense 1,200

Cash
1,200
1/6/2013 Office supplies 200
Computer 2,000
Cash 2,200

● The date column gives the actual day when each transaction was carried out.
● The account name and explanation gives the details of the transaction and the item either
purchased or acquired.
● The debit column provides for the assets of the business, which also signifies a decrease in the
revenue or capital of the business (this is recorded on the left-hand side of a ledger or “T”
account).
● The credit column provides information about the increase in assets and expenses. This is
recorded on the right-hand side of a ‘T’ account.
● In some cases a fifth column may be added to reflect the balance of the “T” account.

The Three Branches of Accounting

Accounting can be broadly divided into three main categories: (1) cost and management accounting, (2)
financial accounting, and (3) auditing.

Cost and Management Accounting

 ● Deals with the provision of relevant financial information to interested parties in the business to
assist them in planning, decision-making, management, and control.

Financial Accounting
● Deals with the provision of relevant information (concerning the performance of the business)
to interested parties (prospective investors, banks, future partners, regulatory bodies, etc.)
outside the domain of the business.
● Financial accounting allows the stakeholders in the business to make sound economic decisions
that could have an impact on the populace.

Auditing
● Key branch of accounting that determines, through verification, whether the financial
information recorded or disclosed is a true reflection of the business transactions that were
undertaken during a financial period.
● There are two forms:
○ Internal auditing (where the business itself carries out the audit).
○ External auditing (when the business engages the services of an outside company).
● The modern practice of auditing combines the two above forms.

C. Basic Principles of Islamic Accounting

● The purposes of Islamic accounting include the accurate determination of income, promotion of
efficiency and leadership, compliance with the Sharī‘ah, commitment to justice, reporting best
practices, and adapting to positive social change through corporate social responsibility.

Consumer of Accounting Information on Islamic Banks

● Similar to conventional accounting, the consumers of accounting information on Islamic banks
consist of numerous stakeholders of the Islamic finance industry who require information to
make appropriate decisions.
● Financial statements are typically the most popular method of communication financial
information.
● It is important that such information focuses on the diverse needs of users.
● AAOIFI’s Statement oh Financial Accounting (SFA) No. 1, para 26 gives a list of the main
categories of users of external financial reports for Islamic banks as:
1 equity holders
2 holders of investment accounts
3 other depositors
4 current and savings account holder
5 others who transact business with the Islamic bank, who are not equity or account
6 holders
7 zakat agencies (in case there is no legal obligation for its payment
8 regulatory agencies
 ● The purpose of accounting in Islam goes beyond making informed decisions and extends to
aspects of accountability, transparency, fair dealing, and just policies.
● The information that is directed at external users should provide the information required in SFA
No. 1, paras 37–42.

An Islamic Perspective on Accounting Concepts

● The Islamic perspective on accounting concepts relates to the requirement of full disclosure, and
social and financial accountability.
● Within the context of modern accounting practice and the growing importance of IFRS, Islamic
accounting is relevant for transactions that use alternative principles of financing based on
Islamic commercial rules.
● In conventional accounting, the accounting concepts are required to guide the existing practice,
prescribe future directions, and identify certain fundamental issues.
● Islamic perspective on these concepts is the need for an Islamic bank or financial institution to
provide the relevant information on all its transactions for the users of such information to be
able to assess the level of compliance with the mandatory principles of the Sharī‘ah in its daily
activities.
● The social responsibilities specified in Islam such as obligatory charitable giving (zakat) and
voluntary charitable endowment (waqf) are to be accounted for in any financial information
prepared by Islamic banks and financial institutions.
● Several verses in the Qur’an and Prophetic precedents that emphasize accountability in
commercial transactions. One such verse is:
Qur’an 21:47: “And We shall set up balances of justice on the Day
of Resurrection, then none will be dealt with unjustly in anything.
And if there be the weight of a mustard seed, We will bring it (to
account). And sufficient are We to take account.”

The Accounting and Auditing Organization for Islamic Financial Institutions

● The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was
developed out of a need to introduce international accounting standards for Islamic financial
products.
● Established in 1990,AAOIFI is independent non-governmental organization, and is the result of
the joint efforts of leading banks and financial institutions in the Muslim world.
● Failure to fill the still-existing gaps between IFRS and the financial reporting of Islamic financial
products will not allow for the much-needed convergence and standardization of international
financial reporting standards.
● Since AAOIFI (1991) began issuing the first accounting, auditing, governance and Sharī‘ah
standards (Bahrain, Jordan, and Sudan have required Islamic financial institutions in their
respective jurisdictions to abide by the AAOIFI reporting standards), there have been a series of
relevant standards for specific Islamic finance products (box 4.2 on page 143 outlines the
background and primary purpose of the AAOIFI accounting and auditing standards).
 Box 4.2 Background to AAOIFI Accounting Standards (Source: See AAOIFI. (2010). Accounting,
Auditing and Governance Standards for Islamic Financial Institutions. Bahrain: AAOIFI.)
Islamic financial institutions have generally adopted the IFRS for lack of Islamic alternatives. With the
passage of some years and the development of more Islamic financial products in the industry,
stakeholders saw the increasing need to develop Islamic accounting standards that would address the
needs of these unique products. In 1987, various stakeholders met at an international forum to
discuss the financial reporting by Islamic financial institutions. Participants recognized that there was a
vacuum in the financial reporting of some products. The establishment of AAOIFI in 1991 was a
response to this.New Islamic financial accounting standards were adopted in October 1993. The
financial accounting standards have had far-reaching effects on the Islamic finance industry because,
for the first time, issues that relate to the calculation of zakat (obligatory alms) surfaced in financial
reporting.

AAOIFI Accounting Standards

● The objectives of financial accounting standards for Islamic banks and financial institutions as
identified by AAOIFI are:
○ To serve as a guide for the financial accounting standards boards for Islamic banks and
financial institutions when developing financial accounting standards.
○ To assist the Islamic banks, in the absence of accepted accounting standards, in making
choices among alternative accounting treatments.
○ To make available a guide and a regulator of subjective judgment made by management
when preparing the financial statements and other financial reports.
○ To increase users’ confidence and understanding of accounting information and, in turn,
their confidence in Islamic banks.
○ To develop accounting standards which are likely to be consistent with each other.
● There are two SFAs in the AAOIFI standards. SFA No. 1 is on the objectives of financial
accounting for Islamic banks and financial institutions, whereas SFA No. 2 focuses on the
concepts. Meanwhile, there are 25 AAOIFI standards that are relevant to Islamic accounting
(these are summarized in Table 4.3).
● AAOIFI has continued to issue guidelines or guidance statements to amend or revise existing FAS
in order to address any request from the key stakeholders in the Islamic finance industry.

D. Accrual and Cash Flow Accounting Methods

● One of the major initial decisions an entrepreneur will have to make at the start of a new business
is to determine the accounting method to use.
● They are required to present to the general public periodic reports that reflect their actual
financial position throughout the year.

There are two main methods of accounting: Cash flow method of accounting and accrual method of
accounting.
 Typically, when an entrepreneur extends credit to customers by allowing them to purchase items
on credit with an arrangement for deferred payment, they are incurring what is called accounts
receivable. If an account receivable is recorded when it is incurred, it is regarded as accrual
accounting.

Conversely, if the accounts receivable are recorded when the payment is received at a later date,
they are regarded as cash flow accounting.

● These principles fall under the periodicity concept, which provides for the relationship between
the income of a business and periods of time.
● Essentially, the periodicity concept, with regards to Islamic banks and financial institutions, allows
the entity to properly calculate zakat due and make the necessary deductions for its onward
disbursement to those who are entitled to it.

Cash Flow Method of Accounting

● Based on the frequency of cash flow, no transaction is recorded until and unless there is an
actual exchange of money.
● This method gives a clear account of the cash flow of the business.

Accrual Method of Accounting

● Based on the frequency of the occurrence of a transaction regardless of whether there is
exchange of cash or not (whenever there is a transaction involving a business, a financial record
is made of it immediately, whether money has changed hands or not).
● Since it allows businesses to keep track of their assets and liabilities, it gives a clearer picture of
profitability.

E. Financial Statements in Islamic Banks and Financial Institutions

● A financial statement is a formal record of all the financial activities of a business entity.
● Any business transacted between the business entity and other corporate bodies, organizations,
or individuals, is included in its financial statement (figure 4.3 illustrates the simple flow of
activities that begins with ordinary transactions and ends in a financial statement).
● The process of bookkeeping entails records being sorted, classified, and presented in the
accounts.

According to AAOIFI FAS 1, the financial statements of an Islamic bank should consist of the following:
● a statement of financial position (balance sheet)
● an income statement
● a statement of cash flows
● a statement of changes in owners’ equity or a statement of retained earnings
● a statement of changes in restricted investment
 ● a statement of sources and uses of funds in the zakat and charity fund (when the bank assumes
responsibility for the collection and distribution of zakat)
● a statement of sources and uses of funds in the qard fund
● notes to the financial statements
● any statements, reports and other data that assist in providing information required by users of
financial statements as specified in the Statement of Objectives

Comparative Financial Statements of Islamic Financial Products

● A corporate entity’s comparative financial statements give the direction of change in the
business in at least two financial periods.
● Necessary steps are taken to either sustain performance or rectify any deficiency when changes
are noted in the performance of the business (in the current financial period as compared to the
previous financial periods).
● Comparative financial analysis, also called horizontal analysis, involves the comparison of the
figures of the current year with those of the previous year(s) performance.

The Four Basic Financial Statements

There are four basic financial statements in financial reporting.
1 Balance sheet
2 Income statement
3 Cash flow statement
4 Statement of retained earnings or shareholders’ equity

Balance Sheet
● A balance sheet is a summary of financial balances of a corporate entity (also known as the
statement of financial position).
● It can be defined as a summary of:
○ assets (which should not be offset against liabilities and liabilities should not be offset
against assets unless there is a religious or legal right and an actual expectation of
offset)
○ liabilities
○ ownership equities of a listed company (as of the end of a specific financial year)

FAS 1, paragraph 4/1 provides for balance sheets and sets out the specific details they should contain
(see box 4.3 for an Illustration of a Company’s Comparative Financial Statement).

● Assets and liabilities should be combined into groupings in accordance with their nature and
those groupings should be presented in the statement of financial position in the order of the
relative liquidity of each grouping.
● The statement of financial position should present separate totals for assets, liabilities,
unrestricted investment accounts and their equivalent, and owners’ equity.
The balance sheet should be prepared in line with the relevant paragraphs of FAS 1. Paragraph 41 of the
standard provides that the statement of financial statement should disclose the following liabilities:
current accounts, savings accounts, and other accounts, with separate disclosure of each category of
accounts, deposits of other banks, salam payables, istisna’ payables, declared but undisturbed profits,
zakat and taxes payable, and other accounts payable.

Paragraph 42 provides for the disclosure of equity of unrestricted account holders. It is a mandatory
requirement to disclose and present the unrestricted investment accounts and their equivalent in the
statement of financial position as a separate item between liabilities and owner’s equity. Furthermore,
paragraph 43 of the standard requires that the consolidated statement of financial position should
disclose the minority interest. Additionally, paragraph 44 provides disclosure of the following items,
which should be made accordingly in the statement of financial position.

● authorized, subscribed and paid-in capital

● number of authorized ownership units (shares), number of issued ownership units,
number of outstanding ownership units, par value per unit, and premiums on issued
units
● legal reserve and discretionary reserves at the beginning and end of the period and
changes therein during the period
● retained earnings at the beginning and end of the period and amount of retained earnings
resulting from the revaluation of assets and liabilities to their cash
equivalent values, where applicable, and changes therein during the period including
distribution to owners and transfers to or from reserves
● other changes in owners’ equity during the period
● any restrictions imposed on the distribution of retained earnings to owners

For an example of a balance sheet displaying a summary of assets in a consolidated statement of

financial position, see Box 4.3. Box 4.4 reproduces an example of the financial statements and
disclosures of XYZ Bank as adapted from AAOIFI FAS. Box 4.4, is to present a consolidated statement of
financial position that gives an insight into the performance of the financial institution within the most
recently concluded financial year compared to the previous year.

Income Statement (often referred to as the profit and loss statement)

● 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 (after all revenue and
expenditures have been accounted for, known as the net income, or ‘bottom line’).
● It is significant in its ability to disclose the profitability (investment revenues, expenses incurred,
gains realized, and losses incurred) of an entity during the time interval specified in its heading
(note: FAS 1, paragraph 49 requires the disclosure of estimated gains and losses from the
revaluation of assets and liabilities to their cash equivalent values).
 ● The management of the business entity must choose the period of time that the income
statement covers. The heading can vary in form.
● After the heading of the income statement, it is required, according to FAS 1, paragraph 50, that
the following information (Box 4.5 reproduces an example of the financial statements and
disclosures of Bank XYZ as adapted from AAOIFI FAS 1) is disclosed, with separate disclosures of
investment revenues, expenses, gains, and losses jointly financed by the Islamic bank and
unrestricted investment account holders, and those exclusively financed by the bank.

The Islamic Finance in Practice box presents the statement of income of Qatar Islamic Bank for the six-
month period ended June 30, 2011. This sheet illustrates the actual income of an Islamic bank calculated
after all the necessary deductions are made.

Cash Flow Statements (may be called a statement of cash flows or funds flow
statement)
● A financial statement that indicates how changes in the balance sheet accounts and income
statements affect cash and its equivalent.
● The purpose of the cash flow statement is to identify the sources and uses of cash during the
financial year.
● FAS 1, paragraph 54 provides that the statement of cash flows should differentiate between
cash flows from operations, cash flows from investing activities, and cash flows from financing
activities.
● Paragraph 55 requires the disclosure of the net increase (or decrease) in cash and cash
equivalent during the period and the balance of cash and cash equivalent at the beginning and
end of the period.
● Paragraph 56 provides that transactions and other transfers that do not require the payment of,
or do not result in the receipt of, cash and cash equivalent should be disclosed, for example,
bonus shares or the acquisition of assets in exchange for shares in the equity of the company.
(Box 4.6 reproduces an example of the financial statements and disclosures of XYZ Bank as
adapted from AAOIFI FAS 1).

Statements of Retained Earnings or Shareholders’ Equity

● A financial statement that explains the change in the retained earnings of a company over the
period of time being reported (in a single proprietorship, the statement of retained earnings
may also be called the equity statement or statement of owners’ equity, and in a partnership,
called a statement of partners’ equity).
● Using the following formula, OWNERS’ EQUITY = ASSETS - LIABILITY, the owners’ equity and
retained earnings may be calculated.
● Paragraph 58 of FAS 1 provides that the statement of changes in owners’ equity should disclose
specific information, which includes (1) paid-up capital, legal and discretionary reserves
separately, and retained earnings (as of the beginning of the period with separate disclosure of
the amount of estimated earnings resulting from the revaluation of assets and liabilities to their
 cash equivalent values, where applicable), (2) capital contribution by owners during the period,
(3) net income (loss) for the period, etc.

Paragraph 60 requires the statement of retained earnings to disclose, among other items, (1)
retained earnings at the beginning of the period (with separate disclosure of the amount of
estimated retained earnings resulting from the revaluation of assets and liabilities to their cash
equivalent values, where applicable) (2) net income (loss) for the period, (3), transfers to legal
and discretionary reserves during the period, etc.

Box 4.7 reproduces an example of the financial statements and disclosures of XYZ Bank as
adapted from AAOIFI FAS 1. In the statement, there is a focus on the assets and liability of the
financial institution, which gives a clearer picture of the changes in its equity over the financial
year. It also gives a true presentation of the current position of the financial institution to enable
its stakeholders to make an informed decision regarding the plans for the coming years.

AAOIFI Proposed Set of Financial Statements for Islamic Banks

● Within the Islamic banking industry, there is a need for a different set of items in the financial
statements. The Global Islamic Finance box on page 161 presents the contentious issue
concerning whether the Islamic accounting framework as represented by the AAOIFI standards
should be brought into the mainstream global accounting framework under the IASB.
● Though the majority of the examples (of financial statements) presented in this chapter are
based on the conventional framework, there is more to the accounting framework of Islamic
banks.
● Since it is not possible to detail all the accounting principles for each Islamic financial
instruments in this chapter, it suffices to observe that AAOIFI has proposed a set of financial
statements for Islamic financial institutions, split into three major categories.
● They are:
1. The financial statements discussed and illustrated above, such as the statement of
financial position, statement of income, statement of cash flows, and statement of
retained earnings or statement of changes in owners’ equity.
2. The second category focuses on the financial reporting of restricted investments,
which are managed by the Islamic bank (they require a unique financial statement
generally known as the statement of changes in restricted investments).
3. The third category emphasizes the original value proposition of Islamic financial
intermediation, which reflects the role of Islamic banks as a fiduciary of funds in
providing social services, especially in situations where such services are rendered
through specially designated funds.

Global Islamic Finance: Bringing AAOIFI Accounting Standards into the Mainstream Global
Framework (Source: Anjuli Davies. ‘Islamic finance pressured to join accounting mainstream’,
Reuters, April 5, 2012. Available at http://www.reuters.com/article/2012/04/05/us-finance-islamic-
 accounting-idUSBRE8340CA20120405).

“A recent survey conducted by Deloitte showed that 93 percent of Islamic finance leaders believe the
AAOIFI standards are sufficient to ensure transparency and best practice in financial reporting while a
negligible 7 percent believe they are not. Furthermore, some experts have also argued that most of
the standards were developed based on conventional financial reporting standards with some
modifications to suit the needs of the Islamic finance industry. In response some commentators have
asked whether there are no classical models of accounting in Islamic law. The recent approach
adopted by AAOIFI to issue the Conceptual Framework for Financial Reporting by Islamic Financial
Institutions in 2011 seems to have addressed these questions in a more proactive way.....This new
approach seems to be more convincing and also sustainable as it leaves room for the adoption of best
practices that do not contradict Islamic law and it also encourages the development of Sharī‘ah-based
principles of financial reporting. However, there is a raging controversy on the need to bring Islamic
accounting standards into the mainstream global framework. While some believe that the Sharī‘ah
scholars and other stakeholders should work harder to make the AAOIFI accounting framework
stronger in order to be considered as a serious alternative, others contend that the Islamic accounting
framework should be harmonized with the global framework spearheaded by IASB.”

Key Terms and Concepts

Accounting and Auditing Organization for horizontal analysis (p. 147)
Islamic Financial Institutions (AAOIFI) (p. 132) income statement (p. 151)
account receivable (p. 145) internal auditing (p. 138)
accrual method (p. 146) International Accounting Standards
American Accounting Association (p. 129) Board (IASB) (p. 131)
balance sheet (p. 149) Islamic worldview (p. 129)
bookkeeping (p. 135) journal (p. 135)
cash flow method (p. 146) last day (p. 130)
cash flow statement (p. 154) net income (p. 151)
compound accounting journal entry (p. 137) periodicity concept (p. 145)
credit (p. 136) qard fund (p. 147)
debit (p. 136) revenue (p. 135)
deferred payment (p. 145) statement of changes in restricted
double-entry bookkeeping (p. 135) investments (p. 160)
equity of unrestricted account holders (p.151) Statement of Financial Accounting (SFA)
expenditure (p. 135) (p. 139)
external auditing (p. 138) statement of retained earnings (p. 156)
financial accounting (p. 129) T account (or ledger) (p. 135)

Summary
1 The definition of accounting from the Islamic perspective reflects the ethical perspective of
financial transactions. The just and equitable principles of fair dealings, transparency, and
 accountability are significant for the users of information. These are relevant in financial decision-
making.
2 The International Financial Reporting Standards (IFRS) issued by the International Accounting
Standards Board play a significant role in international accounting regulation. The Islamic banks
and financial institutions adopted the standards some years ago but there has been a paradigm
shift to the AAOIFI accounting standards because of the particular needs in accounting for each
Islamic finance product.
3 The basic principles of accounting are similar to the requirements for transparency and
accountability in Islamic commercial law. Accounting comprises two main activities—bookkeeping
and accounting (preparation of financial statements). Recording financial information is crucial to
the success of any business undertaking. There are three branches of accounting: cost and
management accounting, financial accounting, and auditing. This chapter provided a general
introduction to financial accounting.
4 The framework and principles of Islamic financial accounting are based on certain fundamental
concepts in Islam such as khilafah (vicegenerecy), taklif (responsibility), documentation of
financial dealings, Islamic law of inheritance (mawarith), calculation of obligatory alms (zakat), and
the underlying concept of tawhid (unity of God). Compliance with the precepts of the Sharī‘ah in
all financial dealings must be reflected in the financial information to be communicated to the
users of such information.
5 The accounting techniques and methods adopted by modern Islamic banks and financial
institutions to report Islamic financial activities are based on the AAOIFI Financial Accounting
Standards. The AAOIFI standards contain exclusive provisions for the financial reporting of Islamic
finance products.
6 The main financial statements for Islamic finance products include a statement of financial
position (balance sheet), an income statement, a statement of cash flows, a statement of changes
in owners’ equity or a statement of retained earnings, a statement of sources and uses of funds in
the zakat and charity fund (when the bank assumes the responsibility for the collection and
distribution of zakat), a statement of sources and uses of funds in the qard fund, notes to the
financial statements, and any statements, reports, and other data that assist in providing
information required by users of financial statements as specified in the statement of objectives.

Practice Questions

1. Explain some underlying principles of Islamic accounting with special reference to Islamic
perspectives on accounting.

The underlying principles of Islamic accounting are compliance with the Sharī‘ah, commitment to justice,
reporting best practices, and adapting to positive social change through corporate social responsibility, a
principal tenet of Islamic law. ethical practices, as required by Islam. The religio-spiritual element
embedded within Islamic financial transactions is brought to bear alongside the element of profitability,
which is also important in the assessment of an Islamic bank’s performance. Additionally, the social
responsibilities specified in Islam such as obligatory charitable giving (zakat) and voluntary charitable
endowment (waqf) are to be accounted for in any financial information prepared by Islamic banks and
financial institutions. The strictness of the need to be accountable in a just manner in all human
endeavors is emphasized in many Qur’anic verses.

2. Distinguish between the definitions of accounting as generally understood in the conventional

practice of financial reporting and Islamic accounting.

This simple definition involves three main issues, which are recognizing, recording, classifying, and
summarizing business transactions measuring, analyzing, processing, and interpreting operating results
reporting, and presenting the financial position. Islamic financial accounting can be defined as “the
accounting process that provides appropriate information (not necessarily limited to financial data) 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.” Essentially, Islamic
financial accounting entails the same three issues as conventional accounting with the added elements
of accountability with regards to the Sharī‘ah (any financial information prepared by Islamic banks and
financial institutions, such as zakat, obligatory charitable giving, and voluntary charitable endowment,
also called waqf).

3. Explain the objectives of the International Financial Reporting Standards in international financial
regulation.

Its principal objectives are to:

1 develop a single set of high quality, understandable, enforceable and globally accepted
international financial reporting standards (IFRS) through its standard- setting body, the IASB.
2 promotes the use and rigorous application of those standards
3 take account of the financial reporting needs of emerging economies and small and medium-
sized entities (SMEs)
4 to bring about convergence of national accounting standards and IFRS.

The IFRS is more relevant to multinational corporations with subsidiaries spread across different
countries as it allows them to adopt the same set of accounting standards. If all subsidiaries can adopt
the same reporting language, the accounting procedures for all pertinent entities is simplified.

4. Are the International Financial Reporting Standards (IFRS) applicable to Islamic banks and financial
institutions? Give appropriate reasons to justify your viewpoint.

Primarily due to the fact that there are a number of the existing IFRS that are not applicable to Islamic
banks and financial institutions, there are issues concerning the application of the IFRS on Islamic banks
and financial institutions. These issues prompted the establishment of an international standard-setting
body for Islamic financial institutions, the Bahrain-based Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI). Since its inception, the organization has issued more than 81
accounting, auditing, governance, ethics, and Sharī‘ah standards. This body has spearheaded the
development of accounting, auditing, and Sharī‘ah standards for Islamic banks and financial institutions
across the world. As we move forward, the need for harmonization of the AAOIFI standards with the
IFRS has become increasingly important.

5. What are the basic principles for recording financial information? Illustrate your answer with a
simple journal entry.
The information recorded must reflect both revenue (the money received from the sale of products and
services before expenses incurred are deducted) and expenditure (the amount of money or resources
spent in a financial operation or in the settlement of an obligation). The accounting record where all
financial transactions of a business are originally entered is known as a journal. Another important item
in recording financial information is the ledger, or what is generally known as the T account e.g. the
double-entry bookkeeping system, the set of rules for recording financial information (where every
transaction or event changes at least two different ledger accounts). This system has two main aspects,
debit, the increase in assets and expenses and decrease in liability, revenue, and capital, and credit, an
increase in liability, revenue, and capital, and a decrease in assets and expenses. For illustration see
Table 4.2.

6. What are the three branches of accounting and how are they related to the business of a typical
Islamic bank?

The three branches of accounting are cost and management accounting, financial accounting, and
auditing.

Cost and management accounting - the provision of relevant financial information to interested
parties in the business to assist them in planning, decision- making, management, and control.
Financial accounting - the provision of relevant information to interested parties outside the
domain of the business. Prospective investors, banks, future partners, regulatory bodies,
government agencies, shareholders, and prospective buyers who will, one way or another, need
financial information on the performance of the business to help them make better decisions or
policies.
Auditing - is a key branch of accounting that determines, through verification, whether the
financial information recorded or disclosed is a true reflection of the business transactions that
were undertaken during a financial period.

Since the purpose of accounting in Islam goes beyond making informed decisions, the three branches of
conventional accounting must extend to aspects of accountability, transparency, fair dealing, and just
policies. However, the common information needs of users, particularly the external users, should
always be met by the available data in the company’s financial statement.

7. What are the identifiable differences between the users of financial information in the conventional
practice of accounting and Islamic accounting?
As discussed in previous questions, the most identifiable differences between the two accounting
practices deals with the additional elements required by the Islamic accounting process. For example, an
Islamic accounting statement must include the following liabilities: (1) current accounts, (2) savings
accounts, and other accounts, with separate disclosure of each category of accounts, (3) deposits of
other banks, (4) salam payables, (5) istisna’ payables, (6) declared but undisturbed profits, (7) zakat
and taxes payable, and (8) other accounts payable. Essentially, the users of financial information in the
conventional practice of accounting would not be concerned with salam payables, istisna’ payables, or
zakat and taxes payable, simply because such financial information would (in most circumstances) be
ascertainable from the business transactions of the conventional investor.

8. Explain the Islamic concept of accounting and list five Financial Accounting Standards issued by
AAOIFI.

The Islamic concept of accounting deals with the requirement of full disclosure, and social and financial
accountability. This is required for any information requested by users, in accordance with the rules of
Sharī‘ah. Accordingly, the bookkeeping and accounting of Islamic financial transaction are very
important. Five Financial Accounting Standards issued by AAOIFI (found in Table 4.3) are (FAS 1) General
Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions, (FAS
2) Murabahah and Murabahah to the Purchase Orderer, (FAS 3) Mudarabah Financing, (FAS 4)
Musharakah Financing, and (FAS 5) Disclosure of Bases for Profit Allocation Between Owners’ Equity and
Investment Account Holders.

9. Differentiate between the accrual and cash flow methods of accounting. Support your answer with
a relevant example.

If an account receivable is recorded when it is incurred, it is regarded as accrual accounting. For

example, when an entrepreneur extends credit to customers by allowing them to purchase items on
credit with an arrangement for deferred payment, they are incurring what is called accounts receivable
accounting. On the other hand, if the accounts receivable are recorded when the payment is received at
a later date, they are regarded as cash flow accounting.

10. Define the periodicity concept and explain how it is relevant to the accounting model of Islamic
banks.

The periodicity concept in financial accounting provides for the relationship between the income of a
business and periods of time. As Islamic banks and financial institutions are required to issue periodic
reports that reflect their financial position, the periodicity concept requires proper documentation of
transactions within a given period of time.
11. With the aid of the relevant AAOIFI Financial Accounting Standards, briefly explain the following
four main financial statements: balance sheets, income statements, cash flow statements, statement
of retained earnings or shareholders’ equity.
A balance sheet is a summary of financial balances of a corporate entity and is also known as the
statement of financial position. The income statement 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 the result, after all revenue and expenditures have been accounted for, known as the
net income (or ‘bottom line’). The cash flow statement is a financial statement that indicates how
changes in the balance sheet accounts and income statements affect cash and its equivalent; the
analysis is broken down into operating, investing, and financing activities. The statement of retained
earnings is a financial statement that explains the changes in the retained earnings of a company over
the period of time being reported.

12. Prepare a simple balance sheet for an Islamic bank that reflects some unique features of the types
of business carried out by Islamic banks, based on the AAOIFI models explained to you in class.

Students must prepare a balance sheet.

Activities

1. Prepare a chart on the main differences between conventional accounting concepts and the Islamic
accounting paradigm.

Students should highlight the Islamic (accountability) requirements and how, in addition to the
conventional accounting structures, such requirements are requisite of Islamic accounting documents.
They should mention the underlying principles of Sharī‘ah, such as social responsibility, charitable alms,
etc., that warrant Islamic accounting concepts to include additional elements.

2. Read the text of AAOIFI’s Financial Accounting Standards and prepare a summary of them for a 15-
minute class presentation.

The students’ presentation should illustrate a depthful understanding of the AAOIFI standards and the
reason why they are well-suited for Islamic accounting. Students should discuss specifically many of the
standards that are unique to AAOIFI’s FAS, focusing on their applicability to Islamic financial
transactions. Since there are many FAS that students could discuss, their presentations should be
evaluated on the basis of their theoretical and conceptual understanding of the FAS, not on how
expansive their presentation is (in terms of how many standards they discuss).

3. Find two copies each of a statement of financial position (balance sheet), an income statement, a
statement of cash flows, a statement of changes in owners’ equity or a statement of retained earnings
for any Islamic bank or financial institution.
Students should bring the documents to class, where they will share their findings with other
classmates. Students should compare their copies to those of other students. This will allow them to see
firsthand several key accounting documents.

Margin challenges

1. What are the similarities of the objectives of financial accounting in both the conventional and
Islamic frameworks?
Conventional accounting standards are based on a framework useful for decision-making by
stakeholders who are given the relevant information. Islamic accounting standards, on the other hand,
focus on accountability and a framework for Sharī‘ah compliance that seeks fair dealing among all
parties in a business transaction. However, that does not mean that Islamic accounting standards
neglect the important objective of financial accounting, i.e. to provide useful information to the users of
financial reports. Though Islamic financial accounting is characterized by an ethical premise and
compliant outlook, financial reports, like those within the conventional framework, are made available
to the users. It should be noted that these reports in the Islamic finance framework are meant more to
enable users to make informed, legitimate decisions in their dealings with the IFI rather than to think of
how to increase their wealth in the capitalist sense (like in the conventional space). Both Islamic and
conventional accounting is comprised of two main activities—bookkeeping and accounting (preparation
of financial statements). Recording financial information is crucial to the success of any business
undertaking, regardless of whether or not that business endeavor is compliant. In conclusion, despite
the fact that the underlying goals of the two kinds of accounting are somewhat different, the
frameworks of both Islamic and conventional accounting aim to produce reliable and transparent
financial reports.
2. Compare these categories of users of financial reports with those of the conventional financial
institutions. Are there any differences?
The main categories of users of financial reports in the Islamic accounting framework are:
●equity holders
●holders of investment accounts
●other depositors
●current and savings account holders
●others who transact business with the Islamic bank, who are not equity or account holders
●zakat agencies (in case there is no legal obligation for its payment)
●regulatory agencies
The purpose of the conventional process is to provide necessary information that has the potential to be
useful for economic decision-making by stakeholders in the financial industry. Such information, with
the addition of some non-economic data, is utilized by Islamic accounting agencies in order to provide
users with the necessary information to advance the socioeconomic objectives of Islamic financial
institutions. Though the information given to the users of financial reports in the Islamic and
conventional framework is somewhat different, the users of the reports are (with the exception of the
zakat agency) the same.
3. Why is it so important for the AAOIFI to issue financial accounting standards for Islamic banks?
There are many objectives of financial accounting for Islamic banks and financial institutions. They
include, most significantly: the need to promote consistency in financial reporting, to provide a guide to
the management of these institutions in making informed decisions, to increase users’ confidence in the
institutions, and to develop a new framework for international financial reporting based on the
objectives of Islamic law. At its most basic level, the importance of the AAOIFI’s issuance of Financial
Accounting Standards for Islamic Banks is the same as the general reason for the development of the
AAOIFI in the first place, which is to create a harmonious regulatory framework and set of standards for
the industry. Transparent and reliable financial documentation and reporting should be an important
aspect of any industry. In the Islamic finance sector, it is absolutely critical. Consistent accounting
standards, like those issued by the AAOIFI, attempt to increase users’ confidence in the financial reports
of Islamic banks. In an industry that is still growing and competing with the conventional financial
industry, user confidence is a necessary component to future growth.

4. Even though Islamic finance claims to have unique items that should appear on financial
statements, what are the equivalent items for non-Islamic financial institutions, and how do you think
issues such as corporate social responsibility (CSR) are reported in financial statements?
There are many ways in which students can answer this question. Besides answering the
question by naming what they think might be potential equivalent items for non-Islamic financial
institutions (which could include charitable donations, employee volunteer work, etc.), they could
reasonably claim that no such items exist. As for their answers regarding how corporate social
responsibility (CSR) are reported in financial statements, their answers should include that CSR
is measured using a wide range of methods. Potential reporting methods may include: energy
usage indicators, violations with regards to human rights, gender discrimination, and health and
safety, as well as surveys that measure the status of companies in the community.