Conceptual Frmework For Eslamic Bank

The Nature and Rationale of a Conceptual
Framework for Financial Reporting by
Islamic Banks
Rifaat Ahmed Abdel Karim*
Abstract—Islamic banks have lo abide by the revealed doctrines in Islam in conducting their business and financial
transactions. They employ in-house religious advisers—often referred to as SharCa Supervisory Board (SSB)—who
issue a special report to inform users of financial statements whether or not the bank has adhered to the Islamic
principles. Recently, a private standard-setting body—the Financial Accounting Organization for Islamic Banks and
Financial Institutions (FAOIBFI)—has been set up to externally regulate the financial reporting by Islamic banks.
The FAOIBFI has published two statements on the objectives and concepts of financial reporting to act as a
framework in setting accounting standards for Islamic banks. This paper examines the FAOIBFI's approach for
developing objectives and concepts of financial accounting and investigates its need for such a theoretical framework.
It is argued that the FAOIBFI's objectives and concepts would not be useful in mandating accounting standards
on issues that are affected by religious ruling. This does not necessarily mean that such a framework may not be
useful in legitimating the FAOIBFI's role and in setting accounting standards for issues that are not governed by
revealed moral doctrines although it will be subject to similar limitations to those found by other standard-setting
bodies in utilising and applying their framework. However, it implies that the more the FAOIBFI sets accounting
standards that incorporate religious ruling, the less it would tend to find its own objectives and concepts useful. The
ambiguities that may arise from different interpretations of the religious rules will require resolutions primarily by
reference to religious rather than accounting authority.
Introduction
A number of accounting standard-setting bodies
have developed a theoretical framework for financial
reporting that would provide 'general utiderlying
principles which permeate and underpin any
specific transaction or chain of transactions which
exists or which may be invented at a later date',
and which would also reflect 'a whole spate of
formal proposals from various bodies and individuals
seeking to provide or move towards an allembracing
theory' (Alexander, 1990, p. 99). It is
claimed that the development of such a framework
would be a crucial aspect of professional
self-regulation highlighting a major departure from
previous low-level efforts to establish accounting
*The author is secretary-general of the Accounting and
Auditing Organization for Islamic Financial Institutions (previously
Financial and Accounting Organization For Islamic
Banks and Financial Institutions), This paper was written
before the author's appointment as secretary-general for the
AAOIFI, The views expressed in this paper are his own, and do
not necessarily represent those of either of the named institutions,
or any other organisations. He would like to acknowledge
the helpful comments of Simon Archer, Todd Johnson,
Trevor Gambling and Jason Karim on an earlier draft of this
manuscript and two anonymous referees of this journal. Correspondence
should be addressed to Dr Karim at the AAOIFI,
PO Box 1176, Manama, Bahrain,
'The FASB issued five Statements of Financial Accounting
Concepts, These are stated in footnote 17,
theory as a guide for practitioners in their individual
decision-making capacity (Archer, 1993,
p. 63).
In the US, for example, the Financial Accounting
Standards Board (FASB) (1976 and following')
has completed the basic elements of a
conceptual framework (CF), Additionally, the International
Accounting Standards Committee
(IASC) has published its Framework for the Preparation
and Presentation of Financial Statements
(1989). In the UK, the Institute of Chartered
Accountants of Scotland published Making Corporate
Reports Valuable in 1988 and the Institute
of Chartered Accountants in England and Wales
published the Solomons' Report Guidelines for
Financial Reporting Standards (1989) which was
'addressed to the Accounting Standards Committee'.
Recently, the Accounting Standards Board
(ASB) published as exposure draft The Objectives
of Financial Statements and the Qualitative Characteristics
of Financial Information (1991), a statement
of principles which seems to be the first part
of a CF. Similar efforts have also been made in
Canada and Australia.
At the same time, there has been a growing appreciation
of the moral considerations in business
and accounting. For example, ethical funds, which
attempt to introduce 'a moral as opposed to purely
financial aspect to "social" investment, . . . typically
do not invest in companies that fail to
286 ACCOUNTING AND BUSINESS RESEARCH
meet their social criteria, or they disinvest from
companies whose activities become unacceptable
. . . ' (Owen, 1990, p. 250; see also Perks et al.,
1992). And in terms of research, it is observed that
'[s]erious academic attention is only now beginning
to be paid to the ethical problems of the public
accounting profession' (Gaa, 1994, p. xii).
Such an appreciation of the importance of moral
considerations (in secular societies) tends to stem
from the view that
'what we seek in ethics is not simply to know
what the good is, but what we are to be and
to do in complex and changing situations in
order to live well, to be good and just'
(Schweiker, 1993, p. 239).
and that
'The universality of ethics in business [as well
as in accounting] operates on the fundamental
assumption that a human being has a
purpose for existing, and one ought to behave
in order to realise that (Nozick [1975]).
Thus the search for a purpose in life involves
an individual's attempt to discover a relationship
between oneself and a larger social context.
This extends to daily activities within
the work environment where an individual
strives to believe that what one is doing is
worthwhile (Graham [1986])' (Ponemon and
Gabhart, 1994, p. 3).
Hence, it is argued that
'what makes accounting an activity concerned
with how we should live . . . [is] giving
an account of our past actions and their
consequences [usually described in a number
of ways: political, economic, social, and personal],
that is, of ascribing accountability ex
post facto' (Schweiker, 1993, pp. 234, 241,
emphasis in original).
This would suggest, as Gambling and Karim
(1991, p. 2) note, that
'an amoral accounting code is neither essential
nor desirable—and is, in fact, strictly
impossible'.
'Historically, religion has played a role in enforcing
ethical behaviour by invoking an omniscient
being with the power to reward and punish behaviour'
(Noreen, 1988, p. 368). In medieval
Europe, canon law decreed that the taking and
payment of interest on loans was a major sin.
Commerce was seen as a matter of morality and
subject to divine ordinances. However, as Tawney
'Shari'a is the Islamic law of human conduct which is derived
from the Quran (The Muslim Holy Book) and the deeds and
sayings of Prophet Mohammed.
(1926) observes, the development of the outwardly
more rigorous definition of usury eventually led to
the division of worldly and spiritual affairs thereby
permitting the emergence of the modern Western
capitalist society. According to Tawney (1926,
p. xi, preface to 1936 edition):
"'Trade is one thing, religion is another":
once advanced as an audacious novelty, the
doctrine that religion and economic interests
form two separate and co-ordinate kingdoms,
of which neither, without presumption,
can encroach on the other, was
commonly accepted by the England of the
nineteenth century with an unquestioning
assurance at which its earliest exponents
would have felt some embarrassment.'
Apparently, the ethics preached by the church
and the reality of the marketplace were painfully
at odds. As commerce grew, merchants needed
more complex forms of credit and theologians
began to find ways to justify the payment of
interest. For example, in considering the practical
accounting effects of the medieval Christian
church's ban on usury, de Roover, according to
Parker (1988, p. 140), claims:
'It was argued by the merchants . . . and
accepted by most theologians, that the [bill
of] exchange transaction was not a loan but
either a commutation of moneys or a buying
and selling of foreign currency. The exchange
transaction was used to justify the credit
transaction and the speculative profits on
exchange to cloak the interest charges. There
was, it was claimed, no usury because there
was no loan.'
Such developments also seem to have shaped
the way in which social sciences (including
accounting and auditing) have come to be seen
as objective, value-free and hence as essentially
amoral disciplines in Western capitalism
(Gambling and Karim, 1991).
Islam, like medieval canon law, does not recognise
the separation between spiritual and temporal
affairs. Commerce is seen as a matter of morality
and is subject to the precepts of the Shari'a.-
However, as Ahmad (1989, p. 24) notes, 'despite
the severe condemnation of interest in Islam, the
Muslim societies were unable to keep away from
interest-based transactions when modern banks
appeared on the scene . . . [apparently because of]
the political and military subjugation of a large
part of the Muslim world by the Western colonial
powers who foisted alien financial practices on the
Muslim people'. Hence, it seems that it was not
until recently that Muslims have had the opportunity
to conduct their banking businesses in accordance
with their revealed doctrine. This was spurred
on by the revival of the Islamic faith in many
AUTUMN 1995 287
Islamic countries and one of the major financial
innovations that emerged from this resurrection is
Islamic banking.' The rapid increase in the size and
number of these religious banking organisations is
an indication of their growing significance as a new
type of financial institution.
The Sharp a forms the basic ground-rules with
which Islamic banks must comply in all their
financial transactions. For example, Islamic banks
cannot enter into any financial transaction that
would result in the payment or receipt of interest
as this is strictly prohibited by the Shari'a. However,
there are different views on the effect of the
prohibition of interest on such Western concepts as
the time value of money. Some Muslim scholars
I (e.g. Abu Saud, 1976; Khan, 1986) argue that the
i concept of time value of money is not acceptable
', in Islam. Others (e.g. al Abji, 1985; al Masri, 1986)
I believe that since a higher deferred price of an
object of sale, compared to its spot price is legiti-
I mate, it implies a recognition of the time value of
! money in Islam. Saadalla (1985) also identifies the
' acceptance of the time value of money by SharCa
scholars but only in relation to real transactions
(see also Tomkins and Karim, 1987; al-Zarqa,
1983).
From the standpoint that does not permit the
concept of time value of money, to approve of it
may be little more than another way of circumventing
the ban on riba.'* Parallels can be drawn with
the ban of usury in medieval Europe which led
merchants to invent instruments that did not appear
to charge interest directly such as bills of
exchange (which also seem to be closely linked to
the emergence of double-entry bookkeeping
(Hoskin and Macve, 1986)). Just as Christian
theologians eventually found reasons to permit the
charging of interest, so some Islamic scholars are
gradually extending the range of transactions permitted
by revealed doctrines. One of the implications
of such behaviour is that it would tend to
^See the appendix of chapter two in Gambling and Karim
(1991) for more details on the revival of Islam and modern
business activity.
'Riba is translated strictly as usury, but interpreted universally
as interest.
'This is a contract based on the combination of capital from
one or more partners and work from the other party. Profit is
shared by the two parties according to a predetermined percentage.
However, in case of loss, the capital provider bears all risks,
but not more than what has been paid, and the other party
receives no return for his work. Furthermore, the capital
provider(s) is not allowed to interfere in the management of the
enterprise in which his funds are being used, i.e. ownership is
separated from the management of the project.
'According to Accounting Principles Board Opinion No. 21,
para. 3(a), all receivables are subject to present value measurement
techniques and interest imputation, if necessary, except
for normal accounts receivable due within one year and other
specifically excluded types, for example, security deposits,
advances, transactions between parent and subsidiary, and
receivables due at some indeterminable future date.
give rise to different recognition, measurement and
reporting to transactions conducted by Islamic
banks.
With this background, this paper gives a brief
account of the self-regulation of financial reporting
by Islamic banks and examines the approach followed
by the Financial Accounting Organization
for Islamic Banks and Financial Institutions
(FAOIBFI) in developing its objectives and concepts
of financial accounting. It also investigates
the FAOIBFI's need for a theoretical framework
in the light of the current practices of Islamic
banks which, with the help of their SSB {Shari'a
Supervisory Board), set their own accounting policies
but without reference to explicit objectives
and concepts. It is argued that the FAOIBFI's
objectives and concepts would not be of use in
regulating those accounting issues governed by
Shari'a rulings. Whilst a theoretical framework
may be useful in regulating those issues not governed
by Shari'a injunctions, the more the
FAOIBFI sets accounting standards on issues that
are affected by doctrinal ruling, the less it would
tend to be able to use its own objectives and
concepts.
The next section provides an overview of the
establishment of the FAOIBFI to regulate the
financial reporting by Islamic banks. The remainder
of the paper discusses the methodology pursued
by the FAOIBFI in developing its objectives
and concepts of financial reporting and examines
the FAOIBFI's need for a CF and the difficulties
that it may encounter in using its objectives and
concepts. The concluding remarks are presented in
the final section.
Regulation of financial reporting by Islamic
banks
At present, most Islamic banks operate in semiregulated
markets. This enables them to set their
own accounting policies either on issues that
are not usually addressed in the accounting
standards promulgated by Western or international
standard-setting bodies (e.g. the use of
the Mudaraba contract^ both in the mobilisation
and uses of funds) or on issues where Western or
international standards do not comply with the
Shari'a principles (e.g. Islamic banks do not report
long-term receivables at their present value.')
The process of accounting policy-making in
Islamic banks is carried out (in most cases) with
the help of the bank's SSB. The demand for the
services of an SSB:
'indicates the perceived need to constantly
check innovations in banking practice [as
well as in accounting] against the principles
of Islamic orthodoxy' (Wilson, 1985, p. 42).
288 ACCOUNTING AND BUSINESS RESEARCH
It is not mandatory that each Islamic bank
should have its own SSB. This is because an SSB
is perceived as a control process developed voluntarily
by Islamic banks to satisfy the moral expectations
of their customers. In certain countries (e.g.
United Arab Emirates and Malaysia), however, it
is a legal requirement that has to be fulfilled by
Islamic banks if they are to be licensed. Members
of the SSB are usually appointed by a decision of
the general meeting of shareholders and although
their duties and responsibilities differ from one
bank to another, in most banks they:
1. design and approve the bank's contracts for
its basic activities and issue religious rulings
in response to requests by the staff;
2. participate with the external auditor and the
management of the bank in setting the bank's
accounting policy on issues which are either
not covered by the accounting principles enforced
in the country or are in violation of the
SharVa (Karim, 1990a);
3. 'ensure that all bank practices conform with
the letter as well as the spirit of Islamic
teaching' (Wilson, 1985, p. 42); and
4. 'prepare a religious auditing report which is
regarded as part of the annual report, [in
which it] verifies whether the bank's operations
are in conformity with the Shari'a
(El-Ashker, 1987, p. 119).
However, despite these internal self-regulations,
Islamic banks and other interested parties have
recently appreciated the need to externally selfregulate
their financial reporting. In effect, this
would replace the second duty performed by the
SSB, namely to participate in setting accounting
policies for the bank. Karim (1990b) argues that
rather than leave the matter to their regulatory
bodies, Islamic banks have been urged to take the
initiative in regulating their financial reporting,
fearing that regulatory bodies may otherwise mandate
the accounting policies of Islamic banks in
order to achieve a uniformity between them and so
improve the quality of their financial reporting.
In 1991, several parties (including practising
accountants and Shari'a scholars) helped set up
the FAOIBFI—a private-sector standard-setting
body—in Bahrain with the aim of producing international
accounting standards based on Shari'a
precepts for Islamic banks and financial institutions.'
However, it is unusual in the Middle East
for the private sector (of a certain industry) to
unilaterally take the initiative of establishing a
standard-setting body to regulate its financial reporting.
Hence, the FAOIBFI is an exception.
The Financial Accounting Standards Board (the
'See Karim (1990b) for a detailed account of the events that
led to the establishment of the FAOIBFI and the parties that
were involved in that process.
Board), responsible within the FAOIBFI for setting
accounting standards, consists of 22 unpaid
part-time members representing Islamic banks,
users of financial statements of these banks, practising
accountants, academics, Shari'a scholars
and regulatory bodies. The appointment of members
of the Board and the raising of funds for the
FAOIBFI are the two main duties of the Supervisory
Committee, the highest authority in the
FAOIBFI. The Supervisory Committee consists of
17 unpaid part-time members representing the
same categories as the Board and appointed by
representatives of Islamic banks. Members of the
Supervisory Committee and the Board serve for a
term of three and four years respectively and can
be re-appointed for one term only. It is worth
noting that the main reason behind having a
two-tier structure is to separate the unit responsible
for fund-raising from the unit in charge of producing
the standards in order to minimise the influence
of the former on the latter.
Given that Islamic banks were the main driving
force behind the establishment of the FAOIBFI
and that they currently finance its budget—which
may mean that the survival of the FAOIBFI
may depend on how well the standards it produces
are accepted by Islamic banks—it is arguable
that these banks could 'capture' the regulatory
process of the FAOIBFI to promote their own
self-interest. However, this seems to be unlikely
for the following reasons:
(a) Islamic banks do not dominate the Board
because they occupy only six of its seats.
(b) The discussions of the exposure drafts of the
objectives and concepts of financial accounting
have revealed that Islamic banks do not
have a unified viewpoint on major issues
(e.g. the treatment of investment accounts as
an on or off balance sheet item, as discussed
later).
(c) The parties affected by the FAOIBFI's standards
(e.g. Islamic banks, auditors and users
of financial statements) have a divergence of
interests.
(d) The views of the Shari'a scholars in the
Board are usually given significant considerations
in accounting policy deliberations.
These views may or may not match with
those of Islamic banks.
The FAOIBFI has an extensive due process of
seven phases which governs the production of its
accounting standards (FAOIBFI, 1992c). This due
process includes the vetting of the doctrinal suitability
of proposed standards by a Shari'a Committee
and also provides interested parties with the
opportunity to express their opinion on the standards
before they are finally approved by the
Board. Although the due process of the FAOIBFI
is similar in many respects to that used by Western
AUTUMN 1995 289
and international standard-setting bodies, it does
not require the issuance of a discussion memorandum
to set forth the issues to be addressed by the
standards and the alternative views without conclusion.
Furthermore, the FAOIBFI's due process
does not require the holding of a public hearing to
discuss an exposure draft. The steering committee
which drafted the due process felt that those
requirements would be impractical to implement in
a multi-national set-up.
At present the FAOIBFI has neither the consent
of regulatory bodies (e.g. central banks) nor the
power to force Islamic banks to implement its
proposed standards. Hence, in order to ensure
compliance with its standards, the FAOIBFI may
have no choice but to obtain the support of the
concerned regulatory bodies and/or to try to secure
the co-operation of at least the major Islamic
banks and their auditors. As suggested by Peasnell
(1982) with regard to the situation in Britain
during the time of the Accounting Standards Committee
(ASC), this could mean that the FAOIBFI's
accounting standards would be produced by what
is, in essence, a bargaining process. However, even
if that were to be the case, the accounting practices
emanating from such a process would still have to
be within the boundaries of what is permissible by
Shari'a precepts.
On the other hand, given that Islamic banks are
set up in many parts of the world and are therefore
subject to different requirements of regulatory
bodies and various legislation, adherence to the
FAOIBFI's standards might not be an easy task to
achieve. For example, Ahmad and Hamat (1992,
p. 53) report that in Malaysia the law stipulates
that the first priority for Islamic banks is the
Shari'a, followed by the legal requirements and,
finally, accounting standards requirements. In addition,
some Islamic banks (e.g. the Jordan Islamic
Bank) were established by special laws which include
accounting policies that have to be implemented
by the banks. Changes in these laws
would require the approval of the legislative bodies
in these countries.
Following a similar approach to that of the
FASB in the US, the FAOIBFI has decided to start
its work by developing objectives and concepts of
financial accounting for Islamic banks. In September
1992 the FAOIBFI issued two Exposure
Drafts, one on the objectives of financial accounting
and the other on the concepts of financial
accounting (FAOIBFI, 1992a; 1992b). These were
revised in April 1993 (FAOIBFI, 1993a; 1993b).
The final statements were approved by the Board
in October 1993 as Financial Accounting Statement
No. I: Objectives of Financial Accounting for Is-
"The author participated in all the sessions in which
the objectives and concepts of financial accounting were
discussed.
lamic Banks and Financial Institutions (FAOIBFI,
1993c) and Financial Accounting Statement No. 2:
Concepts of Financial Accounting for Islamic Banks
and Financial Institutions (FAOIBFI, 1993d). At
present the FAOIBFI has no plans to issue additional
statements on what may be called its
theoretical framework.
The next section discusses the methodology pursued
by the FAOIBFI in developing its objectives
and concepts of financial accounting.
FAOIBFI's methodology of developing
objectives and concepts of financial
accounting*
In regulating the financial reporting by Islamic
banks, the FAOIBFI claims:
'Financial accounting plays an important
role in providing the information which users
of the financial statements of Islamic banks
depend on in assessing the bank's compliance
with the precepts of Shari'a. However, to
perform this role effectively, accounting standards
need to be developed and complied
with by Islamic banks. The development of
such standards must be based on clear objectives
of financial accounting and agreed upon
definitions of its concepts' (FAOIBFI, 1993c,
para. 11, emphasis added).
Two options were considered by the FAOIBFI
in developing objectives of financial accounting:
1. 'Establish objectives based on the principles
of Islam and its teachings and then consider
these established objectives in relation to
contemporary accounting thought'; or
2. 'start with objectives established in contemporary
accounting thought, test them against
Islamic Shari'a, accept those that are consistent
with Shari'a and reject those that are not'
(FAOIBFI, 1993c, para. 23).
According to the first approach, the development
of objectives should start by deducing from
the Shari'a precepts what ought to be the objectives
of financial accounting. These would then be
supplemented, if necessary, by (Western) objectives
of financial accounting that do not breach Shari'a
precepts and are deemed to be appropriate for
Islamic banks.
Advocates of this approach believe that this
would help to minimise the influence of secular
contemporary accounting thought on the objectives
to be developed. In addition, it would encourage
the consultants who were in charge of this task
to look beyond purely secular methodologies.
The second approach calls for adopting the
objectives of (Western) financial accounting currently
available in contemporary accounting
thought that are appropriate for Islamic banks
ABR 25/100—E
290 ACCOUNTING AND BUSINESS RESEARCH
provided that any objective violating the SharCa
precepts is excluded. This approach would also
include those objectives implicit in the financial
reporting by Islamic banks (e.g. the disclosure of
information reflecting the bank's activities in fulfilling
its social responsibilities) as well as those
objectives that the FAOIBFI considers obligatory
to the financial accounting of Islamic banks (e.g.
the provision of information demonstrating that
the bank's transactions have been conducted in
accordance with the Shari'a precepts). The latter
would focus on the moral dimensions that are
absent in contemporary accounting thought since
it was developed on the basis of separation between
spiritual and temporal affairs.
After a lengthy process of discussions, which
involved accounting academics and practitioners,
Shari'a scholars, Islamic bankers and officials in
central banks, it was agreed that the second approach
should be adopted for the development of
objectives. According to Shari'a scholars the methodology
of this approach is acceptable from a
Shari'a perspective.' Although no justifications
were provided for the selection of the second
approach, both approaches are in compliance with
Shari'a precepts. Therefore, there was no reason to
refrain from considering what was available in
contemporary accounting thought.
A similar approach was also pursued in developing
the concepts of financial accounting which
comprised the following:
'(a) The identification of accounting concepts
which have been previously developed by
other institutions that are consistent with
the Islamic ideals of accuracy and fairness.
It is unlikely that anyone would
dispute the adoption of such concepts,
for example those relating to defining the
characteristics of useful accounting information
such as relevance and reliability.
'(b) The identification of concepts which are
used in traditional financial accounting
but are inconsistent with Islamic Shari'a.
Such concepts were either rejected or
sufficiently modified to comply with the
'In addition to the approval of the Shari'a consultants who
have worked on these projects for the FAOIBFI, support of
other Shari'a scholars to this methodology was expressed in the
seminar on Objectives, Concepts and Standards of Financial
Accounting for Islamic Banks and Financial Institutions which
was held by the FAOIBFI on 12-13 December 1992 to discuss
the objectives and concepts of financial accounting for Islamic
banks.
'"This suggests that the FAOIBFI does not accept the concept
of time value of money except in relation to real transactions
as in the case of Murabaha transactions (sale of
goods at cost plus margin of profit) where it is considered
legitimate to sell an object (other than money) at a higher
deferred price compared to its spot price.
Shari'a in order to make them useful.
An example of such concepts is the
time value of money as a measurement
attribute.'"
'(c) The development of those concepts defining
certain aspects of financial accounting
for Islamic banks that are unique to
the Islamic way of transacting business.
The development of these concepts was
particularly emphasised in this Statement.
Examples include concepts developed
based on the Islamic laws defining
the risks and rewards associated with
business transactions, and the incurrence
of costs and earnings of profits'
(FAOIBFI, 1993d, para. 7).
The approach adopted by the FAOIBFI for the
development of objectives and concepts of financial
accounting is shared by those who believe that
'most of the accounting issues found in the
operation of Islamic banks fall within the
scope of existing accounting standards . ..
[and, therefore,] there is no requirement for
new standards to be formulated specifically
for Islamic banks' (Ahmad and Hamat, 1992,
p. 59).
However, others would have reservations since
'the conceptual framework of accounting
currently applied in the West finds its justification
in a dichotomy between business
morality and private morality. As such, it
cannot be implemented in other societies
which have revealed doctrines and morals
that govern all social, economic and political
aspects of life.
Islam has its own cohesive rules which
dictate how a business should be run. These
rules can be applied at any time and in any
culture. Accounting theory and practice have
to pursue these rules if they are to be of any
relevance to obedient Muslim users' (Gambling
and Karim, 1991, pp. 103^).
The latter view is further justified on the ground
that:
'Neither Western accounting theory nor
Western accounting standards explicitly deal
with the morality of the objectives of commercial
accounting entities, or even of
the methods by which they are pursued'
(Gambling et al., 1993, p. 196).
Indeed, the objectives of financial reporting
stated in the CFs developed by Western standardsetting
bodies tend to focus mainly on providing
AUTUMN 1995 291
information useful in making economic decisions.
This narrow perspective of accounting gives no
credence to such non-market considerations as
social responsibility or 'illegal acts'."'- Nonetheless,
despite its absence in Western CFs and
'measurement and integration problems, the development
of [socially related] narrative and nontraditional
reporting in the annual report has
increased to such an extent that it cannot be
ignored by modern accountants' (Mathews and
Perera, 1991, p. 334).
Furthermore, it is arguable that in borrowing
accounting CFs that are developed for specific
countries consideration should be given to 'a society's
institutional arrangements with regard to
the legal and political systems, corporate ownership,
capital market, professional associations,
education, religion and so on, which impact upon
accounting values and accounting practices'
(Mathews and Perera, 1991, p. 326). For example,
Macve (1989, pp. 26-27) claims that
'the framework set out in the Solomons
report. Guidelines for Financial Reporting
Standards, is essentially a reiteration of the
approach taken by FASB in its conceptual
framework project . . . legally-based aspects
are dismissed as 'constraints', but legal roles
of accounting are as, if not more, important
than other roles. This is the major distinction
between the US and the UK, which must be
addressed in developing implementable UK
guidelines, and makes importing FASB's
framework "as it is" inappropriate.
Solomons fails to address the British environment,
nor does he explicitly consider how far
our guidelines should harmonise with European
thinking.'
"Under UK company law, companies have to disclose
charitable donations and illegal acts such as loans to directors.
'-Gambling and Karim (1986) argue that a possible vehicle
for developing a rigorous social accounting for both East and
West may exist in some extension of the concepts behind the
Islamic system of Zakah (see footnote 14 for the definition of
Zakah).
"See Karim and Ali (1988) and Shirazi (1990) for more
details on this and other instruments.
'''Zakah is alms giving and it is a duty on all Muslims to
pay it. It is distributed to a group of eight specific classes of the
more or less relatively poor. Its amount differs according to
the type of business. For example, in trade (which includes
Islamic banks) it is levied at the rate of 2.5% while in industry
the rate is 10%.
'^This is a non-interest bearing loan which is provided by the
bank to help those who are in need to achieve a social activity
(e.g. to enable students to complete their education and craftsmen
to enhance their profession). The loan is provided for a
period of time with the understanding that it would be repaid
at the end of the period. However, should the borrower prove
to be unable to repay the loan, the bank may write-off the loan
and treat it as a charitable contribution.
Unlike the approach adopted by the FAOIBFI,
at present most Islamic banks set their own accounting
policies with the help of their SSB but
without reference to explicit objectives and concepts
of financial accounting. In the case of Islamic
banks, the SSB would tend to deal with the setting
of accounting policies in two ways which are not
mutually exclusive. These are, firstly, to prescribe
accounting policies based on an interpretation of
Shari'a precepts; and, secondly, to ensure that the
accounting policies adopted by the bank from
contemporary accounting practices do not breach
Shari'a precepts.
An example of the first approach to setting
accounting policies is the recommendation by the
SSB in some Islamic banks (e.g. Tadamon Islamic
Bank and Faisal Islamic Bank-Sudan) to recognise
revenue generated through the financing instrument
of Murabaha'^ only when the full amount is
collected, thereby favouring a cash basis treatment.
However, other Islamic banks (e.g. Faysal Islamic
Bank of Bahrain, Jordan Islamic Bank and Bank
Islam Malaysia Berhad) implement different accounting
policies for the treatment of the same
transaction. On these issues Shari'a precepts are
broad enough to accommodate more than a single
interpretation.
Furthermore, Islamic banks pursue objectives
of financial accounting that their SSB consider
ought to be fulfilled from a Shari'a perspective.
For example, as evidence of fulfilling their social
obligations, the Faisal Islamic Bank-Egypt and
Bahrain Islamic Bank disclose the payment of
Zakah"^ and al-Qardal-Hassan^^ in separate statements
in their annual report. This is similar to the
social responsibility objective proposed by the
FAOIBFI in its statement of objectives.
The position the FAOIBFI may take with regard
to the accounting policies developed by each
Islamic banks has parallels with the ASC's experience
in Britain. According to Solomons (1989,
pp. 1-2), the ASC
'did not start with a clean sheet. It inherited
a considerable body of prescriptions that had
evolved over the years. In SSAP 2 [Statement
of Standard Accounting Practice], issued in
November 1971, it recognised four fundamental
concepts as having general acceptability
. . . These concepts were part of the
accountant's mental stock-in-trade long before
the ASC came into existence or the
Council's [of the Institute of Chartered Accountants
in England and Wales] earlier
recommendations were promulgated'.
The accounting policies already set by Islamic
banks with the help of their SSB may or may not
fit in with the objectives and concepts developed by
the FAOIBFI.
292 ACCOUNTING AND BUSINESS RESEARCH
There are at least three reasons why it would be
difficult for the FAOIBFI to ignore such accounting
policies or consider not adopting some of them
when developing its accounting standards." These
reasons are:
1. The accounting policies developed with the
help of the SSB are based on the latter's
interpretation of Shari'a precepts which is the
same framework that governs the FAOIBFI
in the setting of its accounting standards. As
stated earlier, this does not mean that there
would not be differences in the interpretation
of Shari'a precepts when favouring a certain
accounting treatment. However, it would require
the FAOIBFI to produce very convincing
arguments to justify the accounting
treatment it would be proposing if it were
to persuade Islamic banks to adopt it and
abandon their existing accounting policy.
2. The accounting policies of such Islamic banks
as Jordan Islamic Bank (which are based on
certain Shari'a precepts) are incorporated in
the articles and memorandum of association
of the bank. These would form the starting
point for the survey to be conducted by the
FAOIBFI when preparing accounting standards
as stated in its due process (FAOIBFI,
1992b). However, such accounting policies
could hinder the implementation of the standards
promulgated by the FAOIBFI if these
standards recommend a different treatment
than the one currently implemented by the
bank.
3. In order to gain the recognition and support
of Islamic banks in the implementation of its
standards, and given that it currently lacks
the power to enforce the standards it will
produce, the FAOIBFI might find it necessary
to demonstrate to Islamic banks that it
has not completely discarded the efforts that
they have exerted in setting up their own
accounting policies with the help of their
SSB. Yet, the differences in the accounting
practices of Islamic banks mean that it is
likely that the resulting standards would be
derived from mutual bargaining.
"However, this does not necessarily mean that the FAOIBFI
would confine its choice only to the existing practices of Islamic
banks.
"The first Statements of Financial Accounting Concepts are:
No. 1, Objectives of Financial Reporting by Business Enterprises
(FASB, 1978); No. 2, Qualitative Characteristics of Accounting
Information (FASB, 1980a); No. 3. Elements of Financial Statements
of Business Enterprises (FASB, 1980b); No. 5, Recognition
and Measurement in Financial Statements of Business
Enterprises (FASB, 1984); No. 6, Elements of Financial Statements
(FASB, 1985). (Statement No. 6 supersedes Statement
No. 3 as well as paragraph 4 and footnote 2 of Statement
No. 2).
The theme emerging from the preceding analysis
advances the view that whereas both the
FAOIBFI and Islamic banks are mandated by
the Shari'a principles in the setting of their accounting
policies, they differ in the approach by
which such a process is carried out. However,
(a) given that the policies governing financial
accounting of Islamic banks in both regulated
and unregulated markets are necessarily deduced
from and/or justified with reference to Shari'a
precepts, regardless of the existence of explicit
objectives and concepts of financial accounting;
and (b) since the FAOIBFI is unlikely to ignore
the existing accounting policies of Islamic banks
which may or may not fit in with its objectives
and concepts of financial accounting, then why
is a theoretical framework needed?
The FAOIBFI's need for a conceptual
framework
The need for a theoretical foundation to address
emerging accounting issues and to provide justification
for the standards to be selected has long
been appreciated by standard-setting bodies in the
West. In the US, the FASB has developed a CF
which consists of a set of general principles, claims
and concepts regarding financial accounting and
reporting. These are spelled out in five Statements
of Financial Accounting Concepts relating to
profit-oriented businesses." In the UK, the ASC
started in 1989 to make use of the lASC's Framework
for the Preparation and Presentation of Financial
Statements and Solomons' Guidelines for
Financial Reporting Standards (Nobes and Parker,
1991, p. 138), and in 1991 the ASB published as
exposure draft Statement of Principles which seems
to be the first part of a CF.
The development of the FASB's CF was apparently
designed to overcome some of the shortcomings
of the approach of its predecessor the
Accounting Principles Board which
'proceeded to face each issue on an ad hoc
basis, without a body of fundamental theory
to guide it' (Zeff and Keller, 1985, p. 77),
and which was also
'criticised for not having made adequate
progress toward developing a normative
set of objectives and concepts for corporate
financial reporting' (Pacter, 1985, p. 87).
The FASB defines its CF as
'a constitution' a coherent system of interrelated
objectives and fundamentals that can
lead to consistent standards and that preAUTUMN
1995 293
scribes the nature, function and limits of
financial accounting and financial statements...'
(FASB, 1976, p. 2, emphasis in
original).
According to this view a CF
'serves as a sort of constitution governing the
standard-setter's action . . . [or] as a theory of
some sort "guiding" rather than constraining
the FASB in its decision-making' (Gaa, 1988,
p. 146).
However, others (e.g. Macve, 1981; Peasnell, 1982)
have expressed concern about the rationale of CF
projects, despite those who claim that 'it is doubtful
whether, without a conceptual framework that
commands widespread respect and support, a private
sector standard-setting body can long survive'
(Solomons, 1983, p. 115). In the UK, the study by
Macve (1981), which was commissioned by the
ASC, argued that while it would be possible to
agree on broad statements, there was little prospect
of reaching agreement on more detailed objectives
for accounts and how they should be pursued, due
to the variety of users' needs, conflicts of interest
and disagreement about what is 'good' accounting
practice. Such a sceptical view is shared by Peasnell
(1982, p. 250) who argues that
'a CF is largely irrelevant to the needs of the
ASC as presently constituted. In a system
highly dependent on the cooperation and goodwill
of reporting companies, the ASC needs to
preserve its freedom to bargain and hence to
obfuscate points in dispute. Viewed from the
ASCs perspective, a CF might be more of a
hindrance than a help. Flexibility is all important,
but flexibility seems to be what a CF is
intended to eliminate' (emphasis in original).
As an alternative, Peasnell suggests:
'Rather than providing a framework or platform
for the standards programme, the CF
could be intended to do no more than
provide very broad general objectives for
financial reporting to which no one could
take serious objection; the aim would be to
"raise the moral tone" of the profession'
(p. 255).
At the international level, the IASC's CF was
published to assist in 'promoting harmonisation
of regulations, accounting standards and procedures
relating to the presentation of financial
'"There are two main Muslim sects, the Sunni and the Shi'ite.
The four schools offiqh belong to the former sect. The Shi'ite
sect has its own fiqh and is not considered by the FAOIBFI
because all Islamic banks, other than those in Iran, follow the
Sunni fiqh.
"For more details on the Shari'a implications of these issues
see Ahmad and Hamat (1992).
Statements' (IASC, 1989, para. 1). However, cultural
difl"erences which underlie social, economic,
legal and religious differences between countries
are likely to challenge the benefits to be obtained
from such a CF. For example, Goeltz (1991, p. 86)
observes:
'Too many different national groups have
vested interests in maintaining their own
standards and practices which have developed
from widely different perspectives and
histories. There is not a single, powerful
champion of the proposal for harmonisation.'
Unlike Western and international accounting
standard-setting bodies, the FAOIBFI must operate
within a revealed ideological foundation to
which it has to adhere in setting accounting standards
if the latter were to be perceived as credible.
However, in addition to the Shari'a framework the
FAOIBFI has opted to develop a theoretical foundation
for the financial accounting and reporting
of Islamic banks which must not breach the
revealed injunctions.
The Shari'a doctrines are general in nature and
are meant to act as basic values and fundamental
principles that provide guidance to Muslims in all
aspects of their life at all times. Their nature is
ahistorical. It is on the basis of these foundations
that inferences have to be drawn or justifications
provided for specific (accounting) applications.
Fiqh (Islamic jurisprudence) refers to human
understanding of the Shari'a injunctions. It is
subject to change with the changes in time and
place. The nature of Fiqh is human and not Divine,
although its rulings are derived from the Shari'a.
However, despite the fact that the derivation of the
rulings from the Shari'a is done according to Usul
al Fiqh (Principles of Islamic Jurisprudence) there
is still some scope for different acceptable interpretations.
These differences have evolved into
four principal schools offiqh.'^ It should be noted,
however, that in certain matters, the Shari'a includes
specific and definitive rulings about basic
concepts and fundamental principles (e.g. the prohibition
of gambling and hoarding) which are not
subject to different interpretations.
The different interpretations of Shari'a injunctions
by the four schools of fiqh would give rise to
variations in the accounting treatment of issues
affected by Shari'a rulings (e.g. revenue recognition,
revaluation of investments, foreign exchange
transactions, provision for doubtful
debts)." Given the moral nature of these differences,
it is unlikely that the regulation of the
accounting treatments of these issues can be
achieved by reference to a theoretical foundation
which draws from secular accounting knowledge
even if the latter does not violate the Shari'a
principles. This is similar to the accounting rules
294 ACCOUNTING AND BUSINESS RESEARCH
that have legal force (as in Germany and the
UK) and thus do not require the guidance and
justification or 'the authority and legitimacy of
an image of a coherent theoretical foundation'
(Hines, 1989, p. 86).
One possible alternative available for the
FAOIBFI is to rely on its SharTa Committee to
agree upon an interpretation of the underlying
Shari'a injunction and the accounting treatment
and measurement method that is compatible with
it which may or may not fit in with the FAOIBFI's
objectives and concepts of financial accounting.
However, if the Shari'a Committee fails to favour
a particular treatment over the others, the
FAOIBFI would have no option but to allow a
number of acceptable accounting treatments for
the same transaction based on different interpretations.-"
This should take place 'without any endorsement
of controversial interpretations of the
Shari'a ... [because] [\]deological standard-setting
is neither practical nor desirable, from either the
banking or the religious point of view' (Gambling
et al., 1993, p. 201, emphasis in original). However,
allowing a number of accounting treatments
for the same transaction would undermine
one of the main reasons behind the establishment
of the FAOIBFI which is to achieve a high degree
of comparability between the accounting policies
of Islamic banks in order to improve the
quality of their financial reporting.
The preceding analysis implies that the usefulness
of the FAOIBFI's objectives and concepts
in setting accounting standards would be mainly
confined to those issues unaffected by Shari'a
ruling. It also implies that the more the FAOIBFI
considers setting accounting standards that are
affected by doctrinal ruling, the less likely it is that
it will use its own objectives and concepts.
On the other hand, the general nature of the
Shari'a means that it does not cover all the issues
and details for which an accounting policy would
be required (e.g. related party disclosures). This
suggests that such issues can be treated by borrowing
from contemporary accounting practices provided
they do not involve a violation of Shari'a
injunctions. Perhaps it is for standards which need
to be set for this type of issue that the objectives
and concepts developed by the FAOIBFI could be
appropriate. In addition, given the lack of accounting
details in Shari'a injunctions, the FAOIBFI's
objectives and concepts may be of help in the
option has also been used by Western standard-setting
bodies. The set of standards produced by the IASC allowed
alternative treatments in a considerable number of cases. More
recently, following its E32 in 1989, the IASC has proposed to
reduce substantially the number of alternative treatments allowed
by the IASs, eliminating some and 'demoting' others to
the status of 'less preferred methods'.
disclosure and presentation of information pertaining
to the issues that have Shari'a implications.
The relationship between Shari'a precepts and
the FAOIBFI's theoretical foundation has parallels
to the concept of the 'true and fair view' in
accounting. Like the Shari'a doctrines which override
accounting theoretical foundation for Islamic
business organisations, the UK companies legislation
and the EC Fourth Directive give the true
and fair view concept overriding consideration
relative to other criteria for choice of accounting
method. The position of the 1989 UK Companies
Act
'appears to be that, if compliance with the
detailed requirements is not sufficient to give
a true and fair view, the remedy is to give
additional information. If compliance with
the detailed requirements is inconsistent with
giving a true and fair view, the directors must
depart from the rules to the extent necessary
to give a true and fair view' (Macve and
Jackson, 1991, p. 59).
With regard to the EC Fourth Directive,
Chopping and Skerratt (1994, p. 29) note that
the true and fair view has two implications:
'If following the provisions of the directive
would not lead the financial statements to
give a true and fair view then additional
disclosure should be given, and in certain
cases true and fair may mean that departures
will need to be made from the individual
provisions of the directive. In the
second case, member states have been given
the right to draw up definitions of when
a case is sufficiently exceptional that the
need to give a true and fair view should
override the requirement to comply with
the detailed treatment (measurement) rules
of the directive'.
However, whereas the SSB in Islamic banks and
the FAOIBFI's Shari'a Committee have a duty to
pass judgment (which is usually adhered to) as to
whether an accounting treatment and measurement
method is in consonance with Shari'a precepts,
it is arguable whether the true and fair view
requirement is a matter of law rather than a matter
purely for accountants (McGee, 1991). For
example, in the UK, opinion as to when departure
could be allowed has varied between the Law
Society and members of the accounting profession
(Tweedie and Kellas, 1987). Nevertheless, it has
been generally held that compliance with SSAPs,
Financial Reporting Standards (FRSs) and abstracts
of the Urgent Issues Task Force (UITF) is
necessary to give a true and fair view and that
financial statements not prepared in accordance
with SSAPs, FRSs and abstracts of the UITF are
AUTUMN 1995 295
less likely to be regarded by the courts as true and
fair (Arden, 1993).
Furthermore, it is observed that if and when
the combination of statutory requirements and
applicable/approved accounting standards covers
all important aspects of financial reporting
'it could be argued that there will be no place
for the concept of a true and fair view since
the emphasis will then have tilted overwhelmingly
towards compliance rather than legitimating
the exercise of individual professional
judgment . . . [However], the British accountancy
profession seems insistent on retaining
an overall true and fair criterion for accounts,
perhaps in part as a defence against
creative accounting . . . and the perceived
incursions of lawyers into accounting "territory"
(Tweedie, 1983)' (Nobes and Parker,
1991, pp. 140-41).
This is highly unlikely to be the case with regard
to the compliance of financial reporting by Islamic
banks with Shari'a injunctions.
The next section casts light on some of the issues
that highlight the difficulties the FAOIBFI may
encounter in using its objectives and concepts for
standard setting.
Difficulties of implementing the FAOIBFI
conceptual framework
Although the FAOIBFI does not label its objectives
and concepts as a CF, the functional benefits
mentioned in support of determining objectives of
financial accounting for Islamic banks are almost
identical to those cited by the FASB (1976) in
favour of having a CF. This seems to be in line with
the FAOIBFFs methodology of adopting from
contemporary accounting thought those parts
which do not breach Shari'a precepts.
For the FAOIBFI, the development of objectives
of financial accounting is necessary because
they would:
(a) ' . . . be used as a guide . . . when developing
financial accounting standards. This
should assure consistency in developing
standards';
^'The relationship between holders of unrestricted investment
accounts and the bank is based on the Mudaraba contract (see
footnote 5). Holders of these accounts deposit their funds with
the bank to be invested on their behalf. They are not guaranteed
any predetermined rate of return or given first claim on the
bank's earnings (e.g. in 1984, Kuwait Finance House, one of the
largest commercial Islamic banks, did not distribute any profits
to holders of these accounts or to its shareholders). Rather, they
share with the bank in the profits pertaining to their investments
and bear the full risks in case of loss. Unlike shareholders,
investment account holders do not have control over the
management of the bank.
( b ) ' . . . assist Islamic banks, in the absence
of accepted accounting standards, in
making choices among alternative accounting
treatments';
(c) ' . . . be available as a guide and a regulator
of subjective judgment made by management
when preparing the financial
statements and other financial reports';
( d ) ' . . . increase users' confidence and understanding
of accounting information and,
in turn, their confidence in Islamic banks';
and
(e) ' . . . lead to the development of accounting
standards which are likely to be consistent
with each other. This should
increase users' confidence in the financial
reports of Islamic banks' (FAOIBFI,
1993c, para. 19).
However, doubts have been expressed about
previous attempts to develop CF projects with
similar benefits. In the case of the FASB, several
authors (e.g. Dopuch and Sunder, 1985; Agrawal,
1987; Kripke, 1989; Archer, 1993) have expressed
concern as to whether such functional benefits can
be realised. For example, examining the first two
benefits stated by the FASB namely, guidance for
establishing standards and resolution of accounting
questions in the absence of standards, Dopuch
and Sunder (1985, p. 105) argue that
'the results of the FASB's effort to write
objectives and definitions are hardly different
from previous attempts of this nature
and, as such, are unlikely to help resolve
major accounting issues or to set standards
of financial reporting as the FASB had
expected'.
Dopuch and Sunder are also sceptical of the
validity of the last three benefits. They assert that
the empirical and analytical contents of these
benefits are not clear.
Other commentators have raised the problem of
the social-choice aspect of accounting standardsetting.
According to Demski (1973), it is impossible
to develop a single model of accounting that
can be applied to accounting alternatives in a way
that will satisfy everybody. Cushing (1977), however,
does not share this view and suggests a
partial, piecemeal approach as a way of addressing
accounting standards. Bromwich (1980) argues
that the conditions for the successful use of the
partial approach are fairly restrictive but, when
applicable, they substantially reduce the problems
facing accounting standard-setting bodies.
The FAOIBFI's CF is no exception. One of the
main sources through which Islamic banks mobilise
funds is unrestricted investment accounts.-'
At present, Islamic banks are divided on the
accounting treatment of this source of funds.
Based on their SSB interpretation of the Shari'a,
296 ACCOUNTING AND BUSINESS RESEARCH
some banks (e.g. Kuwait Finance House, Jordan
Islamic Bank and Faisal Islamic Bank in Egypt
and Sudan) treat investment accounts as an on-balance
sheet item while others (e.g. Faysal Islamic
Bank of Bahrain) treat them as an off-balance
sheet item. In addition, the former group of banks
treats the applications of funds deposited in investment
accounts as assets and considers the source of
funds of these accounts as a liability.
The FAOIBFI distinguishes between restricted
and unrestricted investment accounts and treats
them as off and on-balance sheet items, respectively.
Furthermore, the FAOIBFI treats the
application of funds deposited in unrestricted
investment accounts and their equivalents as
assets, but does not consider the source of these
funds as
'a liability for the purpose of financial accounting.
This is because the Islamic bank is
not obligated in case of loss to return the
original amount of funds received from the
account holders unless the loss is due to
negligence or breach of contract. Likewise,
equity of unrestricted investment account
holders and their equivalent is not part of the
ownership equity in the Islamic bank since
the holders of these accounts and their equivalent
do not enjoy the same ownership
rights . . . ' (FAOIBFI, 1993d, para. 29).
Rather, the FAOIBFI considers unrestricted investment
accounts as an additional element of the
statement of financial position of Islamic banks
(FAOIBFI, 1993d, para. 25).
The FAOIBFI's treatment of unrestricted investment
accounts, which is approved by its
Shari'a members of the Board, has major accounting
implications as well as implications for the
capital adequacy ratio regulation which is used by
regulatory bodies to measure Islamic banks' credit
risk. Hence, whether the concerned accounting
professional bodies and regulatory authorities
would accept use of the FAOIBFI's definition
remains to be seen.
The difficulties arising from reporting certain
kinds of financing as on or off-balance sheet items
are also faced by the CFs of the FASB, IASC and
ASB. These problems tend to centre around the
definition of the scope and nature of the reporting
entity (e.g. the determination of which assets and
liabilities are to be regarded as attributable to the
group of companies) and the definition of assets.
"According to Macve and Gwilliam (1993), in a Lloyd's
syndicate, where there is a "sale' of the business from one year's
syndicate to the next, the majority of assets are valued at the
amount receivable or current market value.
-'Similarly, the IASC stated in its Framework for the Preparation
and Presentation of Financial Statements (1989) that in
case of conflict between the framework and a standard, the
requirements of the latter should prevail.
liabilities and equity (e.g. the distinction between a
finance lease and an operating lease) (see Peasnell
and Yaansah, 1988; Rutherford, 1988; Tweedie
and Whittington, 1990).
Another controversial issue is the revaluation of
assets and liabilities at their cash equivalent value
which was initially proposed by the FAOIBFI in
the first exposure draft of the statement of concepts
(FAOIBFI, 1992b)." It is claimed that the use of
this accounting measurement would ensure
'equitable allocation of the results of unrestricted
investments between the holders of
unrestricted investment accounts who have
provided or withdrawn funds at different
points of time during the lives of those
investments, on the one hand, and between
such account holders as a group and owners
of the Islamic bank on the other hand'
(FAOIBFI, 1993d, para. 92) . . . 'if unrestricted
investments were to be measured at
their acquisition (historical) cost, inequities
would occur in the distribution of investment
results between holders of investment accounts
who provide or withdraw funds at
different points of time during the lives of
those investments. Likewise, inequities would
occur in the distribution of unrestricted investment
results between the holders of unrestricted
investment accounts as a group and
owners of the Islamic bank' (para. 93).
In the first exposure draft, the FAOIBFI was of
the opinion that the use of the cash equivalent
value expected to be realised or paid 'is an attribute
which should be measured in financial accounting
for Islamic banks' (FAOIBFI, 1992b, p. 19) and if
the bank cannot reasonably measure the cash
equivalent value, the FAOIBFI recommended the
use of historical cost (p. 20). The fact that the
FAOIBFI proposed the use of two measurements
for the same purpose is an indication of the limited
usefulness of its CF as a guide in resolving controversial
issues and also a reflection of its inability to
enforce its pronouncements.'^^
The revaluation of assets at their cash equivalent
value means that the estimated profits resulting
from the revaluation should either be distributed to
holders of investment accounts if the revaluation
process results in unrealised holding gains, or be
kept in a special capital reserve account. However,
the latter would deprive holders of unrestricted
investment accounts who terminate their contractual
relationship with the bank, from the benefits
for which the FAOIBFI has justified the use of the
cash equivalent value.
Islamic banks are also divided on this issue.
While some Islamic banks (e.g. Faysal Islamic
Bank in Bahrain) do revalue assets and liabilities
at their cash equivalent to determine the results
of unrestricted investment account holders, other
AUTUMN 1995 297
Islamic banks (e.g. Jordan Islamic Bank) cannot
use the cash equivalent value because their articles
and memorandum of association specify that assets
cannot be valued other than on the basis of
historical cost.
The position of the FAOIBFI on this issue in the
first exposure draft, that assets and liabilities
should be revalued at their cash equivalent value,
has attracted strong resistance, particularly from
some eminent Shari'a scholars^" who firmly believe
that the distribution of unrealised holding gains
violate Shari'a principles. Other Shari'a scholars,
however, are of the opinion that the FAOIBFI
should use the cash equivalent value because it
would lead to fair distribution of results between
the concerned parties. The FAOIBFI has changed
its position and the Financial Accounting Statement
No. 2: Concepts of Financial Accounting for Islamic
Banks and Financial Institutions (1993) no longer
makes it mandatory on Islamic banks to revalue
assets and liabilities at their cash equivalent value.
Rather, it requires Islamic banks to adhere to
historical cost accounting. According to the
FAOIBFI (1993d);
'Notwithstanding the relevance of revaluing
assets, liabilities and restricted investments
whenever investments are financed by holders
of investment accounts, this concept will
not be adopted at the present time. It is not
evident that adequate means are currently
available to apply this concept in a manner
that is likely to produce reliable information
(para. 96).
It is permissible, however, to apply this
concept for the purpose of presenting supplemental
information which may be relevant
to an existing or a prospective holder of an
investment account .. . (para. 97).
The FAOIBFI's position has parallels with
Western accounting practices. As early as 1939
MacNeal showed how by using historical cost
accounting and not taking into consideration the
changes in value of a firm's assets;
'Contemporary financial statements, as now
prepared, frequently allow the managers and
directors of a company to enrich themselves
at the expense of stockholders, and to do so
in the most comfortable and legal mannner'
(1977, p. 176).
Recently, the FASB (1993) has issued Statement
of Financial Accounting Standards No. 115 which
requires the recording of securities held for trading
or available-for-sale at their fair value and those
held-to-maturity at their amortised cost. In the
UK, Macve and Jackson (1991) discuss the legal
-''These views were expressed in the seminar in which the
proposed objectives and concepts statements were discussed.
difficulties facing firms other than banks that wish
to use market value accounting in the revaluation
of securities. They note;
'Firms appear to face a dilemma; either they
have to depart from the balance sheet provisions
of Sch. 4 by marking to market, but
can rely on the [Companies Act] s. 262(3)
definition of realised profits as the justification
for including the gains and losses in the
profit and loss account. Or, they make use of
the alternative accounting rules to justify the
balance sheet treatment, and again make use
of s. 262(3) to justify inclusion of the gains
and losses in the profit and loss account, but
now have to depart from the provisions in
Sch. 4 requiring those gains and losses to pass
through revaluation reserve' (p. 54).
In their interviews with organisations in and
connected with the securities industry, which generally
favoured the use of marking to market,
Macve and Jackson were nevertheless not able to
find any strong support for the development of an
accounting standard requiring marking to market.
If guidance is needed a SORP would probably be
regarded as preferable, and in line with the approach
now adopted in relation to banks for whom
a SORP on accounting for securities was issued by
the British Bankers' Association in 1990 (BBA,
1990).
A further problem with the FAOIBFI's CF,
which has a Shari'a implication, is that of revenue
recognition. According to the FAOIBFI (1993d,
para. 83);
'The basic principle for revenue recognition is
that revenues should be recognised when
realised. Realisation of revenues takes place
when the following conditions are met;
(a) The bank should have earned the right
to receive the revenues...
(b) There should be an obligation on the
part of another party to remit a fixed
or a determinable amount to the bank.
(c) The amount of revenue should be
known and should be collectible with
reasonable degree of certainty, if not
already collected.'
According to this definition revenue can be
recognised on an accrual basis. However, this
would have an impact on the distributable profit
between equity holders and investment account
holders. The latter relationship is based on the
Mudaraba contract, which
'involves the distribution of cash profits,
either periodically or at the end of the Mudaraba
period. If recognition of income were
to be made on the accrual basis, the distribution
will require the Islamic banks to ad298
ACCOUNTING AND BUSINESS RESEARCH
vance cash from other sources before collection
of debtors account is made. If these
accounts turn bad, the banks will have to use
their own funds to make good for the loss. As
such it will violate the conditions of al-Mudarahah
arrangement where the loss should
be borne by owners of capital [i.e. holders of
investment account]. ... in this case the
profit which has already been distributed will
have to be treated as a refund of capital . ..
Therefore, it is more appropriate for Islamic
banks to adopt the cash rather than the
accrual basis of accounting' (Ahmad and
Hamat, 1992, p. 60, emphasis in original).
One of the implications of the above argument
is that the recognition of income from a bank's
investments which are financed from the pooled
funds of investment account holders and equity
holders should be recognised on the cash basis
whereas this would not necessarily apply if the
same investments were financed exclusively by
equity holders.
Western CFs also suffer from similar problems.
Noke and Weetman (1992) examined some of the
more complex and controversial areas of recognition
practices which they claim would pose potential
problems for any conceptual framework of
principles. Their analysis demonstrates that a CF
'such as that of the IASC is adequate as an outline
of principle, but is not sufficiently precise on each
point of principle to be of use when controversal
issues are addressed' (p. 31).
Despite its flaws, the FAOIBFI's CF may still be
necessary to provide a basis that would achieve a
high degree of standardisation in the accounting
treatments of transactions that are not affected by
Shari'a injunctions. It would also enhance the
value of the financial statements of the banks
by increasing their comparability. Furthermore,
given that Islamic banks are relatively new organisations,
a CF can help to unravel the theoretical
underpinnings of their accounting practices, particularly
since there is a severe dearth of literature
on the financial accounting of these financial
institutions.
On the other hand, both the FAOIBFI and
Islamic banks would have a vested interest to see
to it that the regulatory bodies in the countries in
which Islamic banks operate agree to allow the
latter to implement accounting standards that do
not violate their revealed ideological doctrines and
at the same time are relevant to their operations.
One possible strategy by which the FAOIBFI and
Islamic banks can convince the concerned regulatory
bodies is to argue that the development of a CF
helps to ensure that the accounting standards
produced by the FAOIBFI are not set on an ad hoc
basis. Indeed, they can buttress their position by
highlighting the fact that an approach similar to
that of other recognised standard-setting bodies
(such as the FASB, ASB and the IASC, whose
accounting standards may have been adopted by
the countries in which Islamic banks operate) has
been pursued in setting accounting standards.
Such a strategy is not new to standard-setting
bodies. Based on an historical analysis over a
number of countries and centuries, Hines (1989)
suggests that despite the apparent technical failure
of CF projects, self-regulatory bodies still continue
to show interest in their availability in order
'to assist in socially constructing the appearance
of a coherent differentiated knowledge
base for accounting standards, thus legitimising
standards and the power, authority and
self-regulation of the accounting profession
. . . and at times of threat to their legitimacy,
and/or during times of possible intervention
by government, or at times of competition
from other (including accounting) groups'
(pp. 85-86, emphases in original).
A similar argument is also voiced by Dopuch
and Sunder (1985) and Watts and Zimmerman
(1979; 1986). According to Dopuch and Sunder:
'Being largely an offspring of the accounting
profession, the FASB has (as did the APB)
little defence against the criticism that it does
not have legitimate authority to make decisions
which affect wealth transfers among
members of society. Thus, a body like the
FASB needs a conceptual framework simply
to boost its public standing' (p. 115).
Concluding remarks
Islamic banks must abide by the Shari'a precepts
in their business and financial transactions. SSBs
form one of the internal control processes by which
Islamic banks assure users of their financial reporting
that the transactions conducted by the bank do
not breach the Shari'a injunctions. However, Islamic
banks have recently set up the FAOIBFI to
externally regulate their financial reporting. The
latter has published objectives and concepts of
financial accounting that would act as a theoretical
framework for the setting of accounting standards
for Islamic banks.
This paper has discussed the FAOIBFI's approach
for developing objectives and concepts of
financial accounting and investigated the need for
such a theoretical framework in the light of the
current practices of Islamic banks in developing
their own accounting policies with the help of their
SSBs. It has been argued that the FAOIBFI may
require objectives and concepts both for legitimating
its own role and in mandating accounting
standards for those issues which are not affected by
Shari'a rulings, but this will be subject to the
AUTUMN 1995 299
limitations faced by all standard-setting bodies in
utilising their conceptual frameworks. Moreover,
the more the FAOIBFT sets accounting standards
that incorporate doctrinal (Shari'a) ruling, the less
it would tend to find its own theoretical framework
useful.
The ambiguities that may arise from different
interpretations of the religious rules will require
resolutions primarily by reference to religious
rather than accounting authority. This raises the
interesting question of what the international objective
of the FAOIBFI is—is it to promote a
'Western' image of Islamic banks (hence creating
difficulties with religious image at home) or to
defend the Islamic uniqueness of the banks in the
face of a secular 'Western' world (hence causing
difficulties in fitting with international standards)?
However, although these questions are worthy of
further investigation, they are beyond the scope of
this paper.
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