Introduction to Islamic Banking and Finance:

Principles and Practice

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

Chapter 4

Financial Accounting for

Islamic Banking Products
Learning Objectives

Upon completion of this chapter, the reader should be able to:

• Understand the definition of accounting from both conventional

and Islamic perspectives, respectively, and its significance in
financial decision-making
• Explain the relevance of International Financial Reporting
Standards (IFRS) in international accounting regulation
• Understand the basic principles of accounting
• Understand the basic principles of Islamic accounting
• Differentiate between the accrual and cash flow accounting
methods
• Draft the main financial statements for Islamic finance products
 Learning Objective 4.1
Understand the definition of
The Definition and the Significance of accounting from both
conventional and Islamic

Accounting in Financial Decision- perspectives, respectively, and

its significance in financial
decision-making
making

What is Financial Accounting?

Financial accounting is a process where business operations and

their activities are measured and measurements are processed
into information for these decision-makers:

   - Internal decision makers include the management of

the company

- External decision makers are mainly investors and

customers
 Learning Objective 4.1
Understand the definition of
The Definition and the Significance accounting from both
conventional and Islamic

of Accounting in Financial Decision- perspectives, respectively, and

its significance in financial
decision-making
making

The definition of accounting involves the following main issues:

1. Recognizing, recording, classifying and summarizing

business transactions

2. Measuring, analyzing, processing, interpreting operating

results

3. Reporting and presenting the financial position

 Learning Objective 4.1
Understand the definition of
The Definition and the Significance accounting from both
conventional and Islamic

of Accounting in Financial Decision- perspectives, respectively, and

its significance in financial
decision-making
making

What is Islamic Accounting?

… is ‘the accounting process that provides appropriate

information to stakeholders of an entity that will enable
them
to ensure that the entity is continuously operating within the
bounds of the Islamic Sharī‘ah and delivering on its
socioeconomic objectives’
 Learning Objective 4.1
Understand the definition of
The Definition and the Significance accounting from both
conventional and Islamic

of Accounting in Financial Decision- perspectives, respectively, and

its significance in financial
decision-making
making

• The general definition of financial accounting is acceptable

within the Islamic finance framework if it complies with
Islamic Sharī‘ah

• Financial accounting in both Islamic and conventional

frameworks enable stakeholders to make informed decisions

• Financial accounting fulfills the needs of external decision-

makers
 Learning Objective 4.1
Understand the definition of
The Definition and the Significance of accounting from both
conventional and Islamic

Accounting in Financial Decision- perspectives, respectively, and

its significance in financial
decision-making
making

Accountability in Islam

• The Holy Qur’an emphasizes the need and requirement of

accountability ‘hisab’ in every human activity

• Transparency and fair dealings involve a great commitment

towards accountability in financial transactions

• Muslim accountants have more responsibilities than non-

Muslim counterparts
 Learning Objective 4.1
Understand the definition of
The Significance of Accountability accounting from both
conventional and Islamic

in Islam perspectives, respectively, and

its significance in financial
decision-making

The significance of accountability with particular reference to financial

transactions is evidenced by the following Islamic concepts:

• Khilafah (vicegenrency)

• Taklif (responsibility)

• Documentation of financial dealings

• Islamic law of inheritance (mawarith)

• Calculation of obligatory alms (zakat)

• The underlying concept of tawhid (unity of God)

 
 Learning Objective 4.2
Explain the relevance of
International Financial
International Financial Reporting Reporting Standards (IFRS) in
international accounting

Standards (IFRS) regulation

• IFRS standards developed by independent, non-for-profit

organisation (International Accounting Standards Board [IASB])

• The IASB is the standard-setting body of the IFRS Foundation

• The IFRS provides globally acceptable standards for public

companies preparing and disclosing financial statements

• The IFRS contains general guidelines for financial reporting

• The IFRS is more relevant to multinational companies

• IFRS replaced the International Accounting Standards (IAS)

 
 Learning Objective 4.2
Explain the relevance of
International Financial

International Financial Reporting Reporting Standards (IFRS) in

international accounting
regulation
Standards (IFRS)

The Different Aspects of the Structure of IFRS

• 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 the Preparation and Presentation
of Financial Statements (2010)
 Learning Objective 4.2 Explain
the relevance of International

International Financial Reporting Financial Reporting Standards

(IFRS) in international
accounting regulation
Standards (IFRS)

IFRS and Islamic Banks and Financial Institutions

• IFRS designed for conventional forms of business

• Islamic banks have specific requirements e.g. transactions,

reporting and disclosures

• Therefore, the Islamic finance industry requires alternative

sets of accounting and financial reporting standards

• The establishment of the Bahrain-based Accounting &

Auditing Organization for Islamic Financial Institutions
(AAOIFI) in 1991
 Learning Objective 4.2 Explain
the relevance of International
Financial Reporting Standards

International Financial Reporting (IFRS) in international

accounting regulation

Standards (IFRS)

Differences between Islamic Accounting and Conventional

Accounting
- Financial instruments
- Accounting standards
- Accounting treatment
- Types of information contained in financial
statements
- Financial reporting
- Functions of commercial/financial contracts
 Learning Objective 4.3
Understand the basic principles
of accounting
Basic Principles of Accounting

Accounting comprises two main business activities:

• Bookkeeping The detailed recording of all financial

transactions in the business
 
• The preparation of financial statements or financial
accounting (periodically) Depending on the policy and
the accounting standards adopted by the business
 Learning Objective 4.3
Understand the basic principles
of accounting.
Basic Principles of Accounting

Recording Financial Information

• Records for every financial transaction must be kept

• Information recorded must reflect revenue and

expenditures

• Journal: Accounting record where financial transactions of

a business are originally entered

• Account or Ledger or (T Account): Ledger account

format resembling the letter T originating from process of
using debits and credits
 Learning Objective 4.3
Understand the basic principles
of accounting.
Basic Principles of Accounting

Double Entry Bookkeeping

• Every financial transaction has two main aspects:

1- Debit aspect: the receiving, incoming or expenses/loss

aspect of financial transactions

2- Credit aspect: the giving, outgoing or

income/gain aspect of financial
transactions

• For every debit, there must be a corresponding credit of an equal

amount
• For every credit, there must be a corresponding debit of an equal
amount
• In a balanced account, total debits must equal total debits
 Learning Objective 4.3
Understand the basic principles
of accounting
Basic Principles of Accounting
Figure 4.1: The Basics of the Double Entry System
 Learning Objective 4.3
Understand the basic principles
of accounting
Basic Principles of Accounting
The Branches of Accounting

• Cost and management accounting

• Financial accounting

• Auditing

Figure 4.2: The

Three Branches
of Accounting
 Learning Objective 4.3
Understand the basic principles
of accounting

Basic Principles of Accounting

Cost and Management Accounting

 
The information generated in cost and management
accounting

- Provides relevant information helping managers make

informed decisions in managing the
business

  - Is useful in planning, controlling and the measurement of

performance
 Learning Objective 4.3
Understand the basic principles
of accounting

Basic Principles of Accounting

Financial Accounting

• Provides relevant information to interested parties

(stakeholders) outside the domain of the business such as
investors, banks, future partners, regulatory bodies,
government agencies, stockholders, prospective buyers

• Allows stakeholders in the industry to make sound economic

decisions that could have an impact on the public.
 Learning Objective 4.3
Understand the basic principles
of accounting

Basic Principles of Accounting

Auditing
• Determines the authenticity, validity and reliability of the
financial information recorded or disclosed during a financial
period

• Forms of auditing:
- Internal auditing where the business carries out auditing
- External auditing when the business engages an outside
company, usually an auditing firm, to conduct auditing

• Modern practices combine internal and external auditing for

a particular financial year
 Learning Objective 4.4
Understand the basic principles
of Islamic accounting
Basic Principles of Islamic
Accounting

• The objectives of Islamic accounting are diverse

depending on the approach used

• The purposes of Islamic accounting include:

- reporting of accurate income information

- promotion of efficiency and leadership
- compliance with the Sharī'ah
- commitment to justice
- reporting best practices and adapting to social change
through corporate social responsibility  
 Learning Objective 4.4
Understand the basic principles
of Islamic accounting

Basic Principles of Islamic

Accounting

• Consumers of Accounting Information for Islamic

Banks
The most popular method of communicating financial
information to consumers or users is through the use of
financial statements
 Learning Objective 4.4
Understand the basic principles
of Islamic accounting

Basic Principles of Islamic

Accounting
Consumers of Accounting Information for Islamic Banks

• Equity holders
• Holders of investment accounts
• Other deposits
• Current and saving account holders
• Others who transact business with the Islamic bank, who
are not equity or account holders
• Zakah agencies (if there is no legal obligation for payment)
• Regulatory agencies
(AAOIFI Statement of Financial Accounting (SFA) No. 1, para 26)
 Learning Objective 4.4

Basic Principles of Islamic Understand the basic principles

of Islamic accounting

Accounting
(SFA No. 1) requires information intended for external users:

• Information about the bank’s compliance with Sharī'ah and

its objectives to establish such compliance
• Information about the Islamic bank’s economic resources
and related obligations
• To assist in the determination of Zakah on the Islamic bank’s
funds
• To assist in estimating cash flows from dealing with the bank
• To assist in evaluating the bank’s discharge of fiduciary
responsibility
• Information about the Islamic bank’s social responsibilities
 Learning Objective 4.4
Understand the basic principles
Basic Principles of Islamic of Islamic accounting

Accounting
 An Islamic Perspective of Accounting Concepts

• The Qur’an and prophetic precedents emphasise

accountability in commercial transactions

• Full disclosure, social and financial accountability

• Ethics for accountant entails trustworthiness and objectivity

• The Islamic financial institution needs to provide relevant

information on all transactions for the user. The Islamic
bank needs to account for social responsibilities

• The religious-spiritual element in financial transactions is as

important as the element of profitability
 Learning Objective 4.4
Understand the basic principles
of Islamic accounting
Basic Principles of Islamic
Accounting
Accounting and Auditing Organization for Islamic Financial Institutions
Standards

• (AAOIFI): Accounting and Auditing Organization for Islamic

Financial Institutions (AAOIFI) established in Algiers in 1990 as an
independent non-governmental organization based on Agreement
of Association among financial institutions from different Muslim
countries

• AAOIFI issued the first accounting auditing, governance and

Sharī'ah standards in 1991 followed by a series of relevant
standards for specific Islamic finance products

• Many countries have adopted AAOIFI accounting standards

 Learning Objective 4.4
Understand the basic principles
of Islamic accounting
Basic Principles of Islamic
Accounting

• Some countries like Bahrain, Jordan and Sudan have

required Islamic financial institutions in their respective
jurisdictions to abide by the AAOIFI reporting standards
 
• Others allow such Islamic financial institutions to adopt the
standards voluntarily
 Learning Objective 4.5
Differentiate between the accrual
and cash flow accounting
Accrual and Cash flow Accounting methods

Methods

Accrual and Cash flow Accounting Method

The cash flow accounting method - based on frequency of .1

cash flow (requires an actual exchange of cash)

The accrual accounting method - based on the .2

occurrence of a transaction regardless of whether there is
exchange of cash
 Learning Objective 4.6 Draft
the main financial statements for

Financial Statements in Islamic Islamic finance products

Banks and Financial Institutions

•Financial statement is the formal record of the financial

activities (transactions) of a business entity

•Transactions are duly sorted, classified and presented in

accordance with principles of bookkeeping

•The transactions being recorded comprise any business

transacted between the business entity and other corporate
bodies, organisations or individuals

•The end product of all financial transactions is the financial

statement
 Learning Objective 4.6 Draft
the main financial statements for
Islamic finance products
Financial Statements in Islamic
Banks and Financial Institutions

Figure 4.3:
Flow of Financial Transactions
 Learning Objective 4.6 Draft
the main financial statements for
Islamic finance products
Financial Statements in Islamic
Banks and Financial Institutions

• Comparative financial statements of a corporate entity

• Gives direction of business change in at least two financial
periods
• Provides top management with information for decisions
• Comparative financial statements analysis (Horizontal
analysis)
• Determines the performance of the business
• Provides necessary information about sustained performance
or poor performance
• Islamic banks and financial institutions are required to
publish comparative financial statements
 Learning Objective 4.6 Draft
the main financial statements for
Islamic finance products
Financial Statements in Islamic
Banks and Financial Institutions

Four Basic Financial Statements

• Balance sheets

• Income statements

• Cash flow statements

• Statement of retained earnings or shareholders’ equity

 Learning Objective 4.6 Draft
the main financial statements for
Islamic finance products

Financial Statements in Islamic Banks

and Financial Institutions
Balance Sheets also known as the Statement of Financial
Position): a summary of financial balances of a company

Income Statements 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 net income

The income statement may also be referred to as

i) The Profit and Loss Statement
ii) Statement of Operations
iii) Statement of Income
 Learning Objective 4.6 Draft
the main financial statements for

Financial Statements in Islamic Banks Islamic finance products

and Financial Institutions

Cash Flow Statements 

• Also called statement of cash flow or funds flow statement

• Indicates how changes in the balance sheet accounts and

income statements affect cash and its equivalent

• Purpose is for identification of the sources and uses of cash

during the financial year in question

• FAS 1, para 54 states the statement of cash flows should

differentiate between cash flows from operations, from
investing activities and from financing activates
 Learning Objective 4.6 Draft
the main financial statements for
Financial Statements in Islamic Islamic finance products

Banks and Financial Institutions

Statement of Retained Earnings or Shareholders’ Equity

• A financial statement explaining changes in retained earnings of a

company over a period of time

• The statement of retained earnings may also be called:

- Statement of owner’s equity (in a single proprietorship)

- Statement of partners’ equity (in a partnership)

- Statement of retained earnings and stockholders'

equity (for corporations)
 Learning Objective 4.6 Draft
the main financial statements for
Islamic finance products

Financial Statements in Islamic Banks

and Financial Institutions

Statement of Retained Earnings or Shareholders’ Equity

The owners’ equity and retained earnings may be calculated

using the following formulae:

Owners’ equity = Assets – Liability

 Learning Objective 4.6 Draft
the main financial statements for
Islamic finance products

Financial Statements in Islamic Banks

and Financial Institutions
AAOIFI Proposed Set of Financial Statements for Islamic Banks

•  There are three major categories

The first category comprises the financial statements that

are meant to reflect the position of the Islamic bank as an
investor, such as:

Statement of Financial Position

Statement of Income
Statement of Cash Flows
Statement of Retained Earnings or Statement of Changes in
Owners’ Equity
 Learning Objective 4.6 Draft
the main financial statements for
Islamic finance products

Financial Statements in Islamic Banks

and Financial Institutions

AAOIFI Proposed Set of Financial Statements for Islamic Banks

• The second category focuses on the financial reporting of
restricted investments managed by the Islamic bank for the
benefit of others. Such a statement will be referred to as
“Statement of Changes in Restricted Investments”

• The third category includes financial statements reflecting

the Islamic bank’s role as a fiduciary of funds made available
for social services
Statement of Sources and Uses of Funds in the Zakah and
Charity Fund
Statement of Sources and Uses of Funds in the Qard
Fund
Key Terms and Concepts

• AAOIFI • Double entry bookkeeping

• Account receivable • Credit
• Accrual method of • Debt
accounting
• Deferred payment
• American Accounting
• Equity of unrestricted
Association
account holders
• Bookkeeping
• Expenditure
• Cash flow method of
• External auditing
accounting
• Financial accounting
• Cash flow statement
• Horizontal analysis
• Compound accounting
Key Terms and Concepts

• Income statement • Statement of retained

earnings
• Internal auditing
• T account or ledger
• Islamic worldview
• Waqf
• Journal
• Zakah
• Journal entry
• Last Day
• Net income
• Periodicity concept
• Qard Fund
• Revenue