Islamic banking: Features of accounting

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Afzalul Haq in the first of his three-part article

Islamic banking: Features of accounting

Now-a-days accountancy has become an important academic and professional discipline as the lingua franca or language of business. As such in the real life industrial scenario, accounting has become the vital part of the top management.

Although it is not a language of mass people, by this time some of the accounting knowledge has become the part of general knowledge, at least as a common business language. For example, study or observation of annual report of any company is a matter of common interest for any stakeholder from any discipline. Accounting in general and particularly in Islam deals with many things including the fair presentation of rights and obligations of the parties concerned. The Quran says ”O you, who believe, when you contract a debt for a fixed period, write it down. Let a scribe write it down faithfully as between the partiesā€¦” (Sura Baqarah: 282). So we relate accounting as it is the fear of Allah that prevents the person involved in accounting or keeping record of transactions. In other dimension, it would also explicitly reveal what is permissible (halal) and what is forbidden (haram). This further indicates that financial accounting in Islam has defined objectives which the accountant should be aware of and complies with and should work with a clear understanding of these objectives. An important feature of accounting in Islamic banking is that the ethical values of Islam have been tried to be tied with the conventional accounting principles, evolved from the practice of centuries. With this perception, we draw an inference that a well designed accounting system complying with Shariah as well as Generally Accepted Accounting Principles (GAAP) and/ or any other global standard at large, is a vital issue for ensuring smooth operation of an Islamic bank. Apart from different conventional accounting standards we welcome the efforts of some of the evolving Islamic financial accounting standard setting bodies like Bahrain-based AAOFI (Accounting and Auditing Organisation for Islamic Financial Institutions), and Malaysia based IFSB (Islamic Financial Services Board). As such although there has yet not been any universally accepted accounting system, there are some features which make Islamic banking unique in recording accounts. These may be mentioned under the following subheads: Cost of fund and profit distribution module: Unlike conventional banking, cost of deposit of an Islamic bank is the output and not input. It is one of the key features of Islamic banking that cost of Mudaraba deposit is directly based on income generated from investment of that deposit. In conventional banking cost of deposit is predetermined at fixed interest rate which need not necessarily be resulting from the income earned by utilisation of the concerned fund. Adding other administrative and overhead cost thereto, the cost of fund is arrived at. In case of Islamic banking it is the ‘investment income’ which virtually determines the resultant cost of deposit as a core element of cost of fund. Summation of profit for all the individual deposit accounts makes the total cost of deposit. Such cost is generally recognised monthly, on accrual basis. Monthly accruals, in this respect are calculated as per profit sharing ratio (between the bank and the depositors) on the basis of amount of revenue earned during the concerned month. Thus it is the concerned revenue which determines the cost of deposit in Islamic banking. Under Mudaraba principle, as applied in Islamic banking, the cost of deposit would be represented as a function of its corresponding investment income Profit distribution module for arriving at the rate of profit on Mudaraba deposit has become a matter of pivotal importance because in fact the cost of fund is determined mostly through this module. Again between the two major aspects of banking i.e. Investment income and profit paid on deposit (For conventional banking these two are, interest income and interest expense), it is the latter for which more people are concerned than that for the former. In this connection it would be wise to recall that in banking, irrespective of Islamic or conventional, the number of deposit clients is always substantially more than that of the investment (loan) clients. Mass people are exposed to banking as deposit client. Consequently mass people are concerned for the rate of profit on deposit and how the rate is determined, while a few is concerned for the pricing of investment/ loan products. Again, particularly in Islamic banking, the rate of profit on Mudaraba deposit works as its pulse because operation of asset products of Islamic banking cannot, in most of the cases, transparently demonstrate the distinction of Islamic banking and the conventional one. Yes, a lot of reasons are there which make it difficult for Islamic banking to often explicitly demonstrate its distinction. Out of many such reasons, dominance of fixed return-based methods (Murabaha and Hire Purchase/ Leasing) over partnering (profit sharing Mudaraba and Musharaka) methods is the most important one. Fixed return based Islamic banking modes of investment make confusion among the stakeholders and as such the question of alikeness of profit and interest is raised by different quarters. Whereas profit sharing methods, by virtue of variable return, find its way to transparently show the difference and the inherent beauty of Islamic banking as opposed to the predetermined fixed rate of conventional banking. As such, a single characteristic of the rate of profit on Mudaraba deposit, being a function of investment income can be treated as the ‘radar’ and ‘acid test’ of authenticity of Islamic banking, as far as the word Islamic is concerned. It is very relevant to mention here that at present in our country there are two basic frameworks for distribution of profit to the Mudaraba depositors of Islamic banking operations. These are known in short as i) Weightage System and ii) ISR System. Weightage based framework for distribution of profit on Mudaraba deposits: This framework provides uniform/fixed management fee for the bank against all groups of Mudaraba depositors collectively, whereas each group of depositors has different sharing ratio in the name of Weightage. In fact it has got two tier distribution phases. The first one is the phase of distribution between the bank on one side and all the Mudaraba depositors collectively on the other side. Amount due to the latter, as worked out through the first phase distribution process, is thereafter processed through the second phase distribution. Thus the collective amount due to the Mudaraba depositors as a whole is distributed to the individual groups of Mudaraba depositors, such as Mudaraba Savings, Mudaraba Term Deposit, Mudaraba Special Notice Deposit etc. This second phase distribution is accomplished according to the predetermined Weightage such as 0.5, 0.6, 0.8, 0.9, and 0.97 and so on. Some groups may also have Weightage of more than 1.0; such as 1.05, 1.25 and so on. Under this mechanism, month-wise expense of profit paid on deposits (PPD) is charged on accrual basis at the provisional rate of profit declared by the Islamic Bank. The final rate is however adjusted at the end of the year as per the actual amount attained through calculation process of both the tiers as stated. ISR based Module for distribution of profit to Mudaraba Depositors: The ISR (Income Sharing Ratio) based module enters into separate ISR contract with different types of depositors. It is unlike the Weightage, which is applied on a residual portion of Income, after Tier 1 deduction of Bank’s share there from. Under this module the ratio of distribution of investment income for each group of Mudaraba depositor and the bank is declared separately and applied independently such as: So in contrast to fixed or uniform management fee as applied under Weightage system, variable or different management fee for each group of Mudaraba depositors is applied under the ISR module. Under this system, however, alike Weightage, PPD is charged every month on accrual basis. But difference is that under ISR, the amount of PPD per month is emerged at accrual unlike the Weightage, where provisional rate is applied Recognition of other costs: Other costs, in case of Islamic banking, are also recognised on the accrual basis following the matc
hing concept of accounting. For example, provision for unpaid utilities like electricity and/or phone bills etc are to be accounted for periodically irrespective of the status of actual payment of the bills i.e. be it paid or not. Matching here means matching of revenue and cost. Revenue/ income recognition: The lion’s share of revenue of an Islamic bank is earned from Investment Income. Income from Investment is accounted for on accrual basis; except for investment under Musharaka, Murabaha and Bai-Salam, against which income is recognised on realisation basis. Other income from various sources such as service charges, fees, commission and exchange-gains etc are recognised when earned/ realised. There, of course, might be special cases where such income may need to be spread over a period of time. Any unexpired / unearned income i.e. income realised in advance is shown as liability instead of income. It is, however, very important to note that all accrual income is subject to prevailing classification and provisioning rules of Bangladesh Bank which may impose condition of realisation (instead of mere accrual) to recognise an income. The writer is Head of Islamic Banking of Bank Asia Limited, and can be reached at email: [email protected] . Opinions expressed in the article are exclusively of the writer himself and not necessarily of the organisation he is serving

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