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The Accounting And Auditing Organization For Islamic Financial Institutions: An Important Regulatory Debut
Journal of International Accounting Auditing & Taxation, July 1997
- By Pomeranz Felix

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has made an important regulatory beginning. Bahrain-based AAOIFI seeks to support the faith of Islam by developing accounting standards for Islamic investment vehicles and by conducting related training and publicity. AAOIFI also expects to strengthen the effectiveness of Sharia committees by facilitating evaluation of emerging financing instruments and by aiding in the implementation of Islamic ethics. The agency merits close monitoring by Western bankers and their accountants, given the rapidly growing asset base of Islamic financial institutions.

Key Words: Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI); banks, Islamic; Emerging Issues Task Force; ethics, internalization; ethics,
Islamic; iman (Arabic for faith); investment vehicles, Islamic; liquidity, short term; riba (Arabic for interest); Sharia committee; stakeholder model.

INTRODUCTION

Citibank recently opened its first Islamic banking subsidiary in Bahrain. The event is expected to lead to significant cooperation, accompanied by eventual realization of substantial benefits by both Western and Islamic banks. The spread of Islamic banking during the past twenty years, propelled by the generally successful performance of these banks, has been a great, albeit largely unknown, success story.

Presently, assets of Islamic banks are estimated to range from 50 to 100 billion dollars. The annual growth rate is between 10 and 15 percent of the asset base. Moreover, rapid progress is now being made in the development of new Islamic products. Also, important forward strides are occurring in banking regulation: in external regulation, of a particularly helpful and sympathetic nature in Bahrain, and in internal regulation by religious supervisory committees, referred to as Sharia committees.

Islamic banks are poised for rapid future growth. The pool of investors has grown. In Muslim states a monied middle class has emerged, to some extent as a result of economic development; contemporaneously, the role of government appears to be diminishing as reflected in endeavors to privatize. Several constituencies stand to gain. Observant Muslims will benefit from availability of new investment and savings opportunities and Islamic banking organizations may benefit directly from privatization, especially in light of an increasing need for effective oversight by Sharia committees. Non-Muslim investors will benefit from the availability of a broadened range of Islamic investment choices. (Tangentially, it should be observed that Islamic banks generally have no restrictions on accepting deposits from non-Muslims; however, there may be U.S. prohibitions against unregistered, “offshore” investments.)

This paper defines the place of Islamic banking in mostly recent history, describes some of the competitive problems faced by these banks, and focuses on the role of Sharia committees. While such committees bear a superficial resemblance to Western audit committees, they are of transcendent importance for corporate governance in an Islamic sense. Also, information will be provided on the as yet little known, but activist agency, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). The AAOIFI’s work is of special importance to international public accounting firms which may be confronted by (a) new rules relating to both accounting and auditing, and (b) the actions of Sharia committees in regard to the observance of Islamic ethics.

OVERVIEW OF ISLAMIC BANKING

In Muslim communities, limited banking activity, such as acceptance of deposits, goes back to the time when the Prophet Muhammad (PBUH)[1] was still alive. At that time people deposited money with the Prophet or with Abu Bakr Sedique, the First Khalif of Islam. The first modem Islamic bank, Nasser’s Social Bank, was established in Egypt in 1971; the first Saudi Arabian Islamic bank began in Jeddah in 1975; the first Bahraini Islamic bank was founded in 1979. Bahrain now boasts eighteen Islamic financial institutions.

The need for Islamic banking is driven by three considerations: (a) an Islamic investor should avoid association with industries prohibited to Muslims: alcohol, gambling, pornography, meat packing (of pork), weapons production, and liquor; (b) an Islamic enterprise is to avoid interest (riba), along with gambling, and, accordingly, restrictions exist on trading in debt securities and in futures and options; (c) many Muslim investors tend to be attracted to enterprises observing Islamic ethical and moral standards (O’Sullivan 1996a).

The faith of Islam represents an all encompassing way of life rooted in four aspects of the faith: the Holy Qur’an, the deeds and sayings of the Prophet, scholarly interpretations of the laws and rules, and the consciences of individual Muslims. Sharia committees have the crucial task of reviewing banking products and activities to ensure compliance with Islam, as it relates to the matters mentioned in the preceding paragraph. Each issue will be considered briefly in order to clarify the responsibilities of Sharia committee members.

PROILIBITED ACTIVITIES

Given the popularity of computer programs that serve as “screens” for investment selection, the task of eliminating companies engaged in prohibited activities from investment consideration would seem to be doable; however, the selection process can become difficult with respect to such issues as conglomerates engaged in a “portfolio” of businesses through affiliates, subsidiaries, and operating divisions. Further, Sharia committees will find it difficult to evaluate the impact of prohibited businesses because of inadequate disclosure requirements and confusing industry codes used in the United States, especially Standard Industrial Classification codes (SICs).
The challenge becomes apparent when one considers a study at the Al -Baraka Islamic Bank which identified a mere 560 companies as Islamically qualified from a universe of 19,000 companies (O’Sullivan 1996b).

Islam’s posture against interest is likely to eliminate many potential investments. Decisions are further complicated by reported differences among Sharia committee members as to whether investments should qualify on the basis of (a) having no interest transactions at all, (b) seeing that an organization is purified of interest (more easily done with interest income than interest expense) and (c) disregarding interest as an earnings component on the theory that only the act of borrowing (and not the subsequent interest) is prohibited (O’Sullivan 1996b). The very definition of “usury” is highly controversial. Thus, at each Islamic institution there is need for a mix of Sharia committee members who bear impeccable credentials: knowledge of Islamic law, pervasive and abiding faith (iman), and some knowledge of business transactions.

The issue of Islamic ethics is as significant as that of riba. Investors in Islamic businesses are expected to be active and involved with enterprise activities, while harboring caring feelings for their employees and the environment. Indeed, the Holy Qur'an and the words and deeds of the Prophet Muhammad mandate a positive social outlook. In some respects Islamic ethics resemble the well-known Western (Kantian) rights-driven or stakeholder model which assumes that every person has basic rights in a moral universe.

Islamic practice diverges widely from such creations as the “conceptual framework” of the U.S. Financial Accounting Standards Board (FASB). The FASB has sought to provide “decision usefulness” primarily to investors and creditors, with little attention to other “stakeholders.” At the time of its formulation, this focus was supported by only about one third of commentators to the FASB. Ironically, U.S. style decision usefulness appears to be a concept in search of an application: in today’s world 80 percent of U.S. securities trading involves well informed institutional investors. (The endeavor to cater to investors and creditors, together with its progeny of financial accounting, appears to be substantially limited to the United States. Moreover, many believe that the two favored groups, i.e., investors and creditors, require quite different decision making information.) In any event, decision usefulness from the point of view of a Muslim will require enrichment through the addition of Islamic ethical imperatives; thus Sharia committees will be confronted with a great challenge to make rules that are in accord with Islamic ethics.

The Sharia committees will also encounter obstacles when they attempt to search for precedents and for comparable issues resolved earlier and/or by another Sharia committee. Databases concerning committee decisions would appear to be nonexistent or rudimentary. Thus, AAOIFI seems urgently needed; the agency would fit into a natural role of serving as a clearing house for information that may facilitate Sharia committee decisions.

ACCEPTABLE INVESTMENTS

Muslims have developed a series of time honored investment vehicles considered to be acceptable. The investments are shown in Table 1. Other permissible investment activities include commodities trading. New opportunities are also emerging which may involve either traditional investments or entirely new instruments. For example, the financing of national development projects is expected to grow into an important new arena for Islamic banking.

PROBLEMS OF ISLAMIC BANKING

Some commentators have reported structural problems with Islamic banking (“Special report: Islamic banking,” 1996). They have identified the absence of interest as an endemic problem which impairs liquidity. Most Islamic deposits are said to be short term, resulting in a mismatch with long term investments. The condition may be exacerbated by (a) an absence of a sufficient number of wealthy depositors, (b) depositors’ increasing earnings expectations, and (c) inability to borrow in inter bank markets.

Until recently, Islamic banking problems included a lack of standardized accounting and auditing rules. Historically, uncertainty in accounting principles involved revenue realization, disclosures of accounting information, accounting bases, valuation, revenue and expense matching, etc. Almost a decade ago, the Afghani economist Abdul Haqiqi coauthored recommendations for (a) establishment of Islamic bank accounting standards, (b) a focus on auditing,[2] possibly before tackling accounting, (c) conformity of new rules to Islamic and Arab social and religious objectives, and (d) a coordinated and unified approach to the interpretation of pertinent Islamic law (Haqiqi and Pomeranz 1987).
Not surprisingly, Sharia committees have continued to proliferate; the number of members and the advice dispensed by them has been diverse, as have been the acceptable accounting treatments. For example, five ways of accounting for Murabaha have made more difficult the comparability of one institution or product with another (O’Sullivan 1996b). This inability to compare has grown into a major problem (“Accounting standards: key to boosting Islamic banking,” 1995).

ENTER AAOIFI

AAOIFI was set up in 1991 by Islamic banks and has a board which includes three central bank governors. Its chairman is the undersecretary at the Bahraini Finance Ministry and its general secretary is Rifaat Ahrned Abdul-Karim, an academic from Sudan. Abdul-Karim has observed that “the government of Bahrain has been very keen to pursue a strategy that helps in providing the necessary infrastructure for an Islamic financial center.” He added that Bahrain had also furnished a platform for hosting conferences and seminars on topical issues related to the Islamic banking industry, and that Bahrain is also expected to cater to the training requirements of the industry (Noor 1996). Abdul-Karim stressed the growing need for accounting standards and indicated that AAOIFI’ s regulatory effort has been focusing on certain of the Islamic investment vehicles listed in Table 1. AAOIFI seeks implementation of its rules partly by getting central banks to adopt them and partly by trying to persuade Islamic institutions of their usefulness (O’Sullivan 1996b).

NEW DEVELOPMENTS

Growth in Islamic Investment Banking
Islamic securities markets have become stronger in terms of the quantity and quality of traded equities. These markets are supported by distribution networks which promote individual securities on the twin bases of investment return and Sharia compliance. Islamic banks have begun searches for companies that do not use interest-bearing loans in order to establish equity funds (Thompson 1994). The greater availability of securities for investment for any desired holding period, is likely to ease the previously mentioned liquidity problem of Islamic banks. Ultimately, one may hope for the realization of the ideal of a Muslim common market, operated on Islamic principles.

Project Financing

Copyright of Journal of International Accounting Auditing & Taxation is the property of JAI Press, Inc. and its content may not be copied without the copyright holder’s express written permission except for the print or download capabilities of the retrieval software used for access. This content is intended solely for the use of the individual user.
Source: Journal of International Accounting Auditing & Taxation, 1997, Vol. 6 Issue 1, p123, 8p, 1 chart.
Item Number: 9709250733
Project financing supports economic development (Barraclough 1995), and enables financial institutions to monitor both project planning and project execution. An Islamic enterprise, together with its Sharia committee, could ensure that planning proceeds in full accord with Islamic principles bearing on the ethical environment, the physical environment, and employee welfare. The lender could exercise proactive control, ensuring that external controls are built into the project systems design. Further, the project could be administered by executives who have themselves internalized Islamic principles.[3]

The Emergence of New Instruments

Although the traditional Mudharaba style of asset management is likely to continue to predominate, new securities and derivative instruments have been emerging at an increasing rate. These new instruments could pose both religious and economic perils to banks and their depositors. A decade ago, Indonesian Finance Minister Prawiro attributed failures in his nation’s system of financial governance to rapid growth, technological obsolescence, and the appearance of unforeseen financing techniques. Contemporaneously, scandals occurred in Egyptian institutions, marked by the disappearance of some “bankers.” In the United States, the pace of creation of new investments led the FASB to empanel an Emerging Issues Task Force (EITF) charged with reaching accounting firm consensus on accounting treatments. The highly respected EITF has now become a source for the creation of Generally Accepted Accounting Principles (GAAP). The EITF could serve as a role model for the creation of a similar AAOIFI body.

Further, AAOIFI might consider the development of a database to permit recapture of the facts and reasoning behind the worldwide decisions of Sharia committees. The ability to recall precedents would enhance the recommendations of AAOIFI toward seeing that emerging instruments and transactions meet Islamic requirements. Ultimately, such a database could become a clearing house for Sharia committee opinions, leading to the compilation of a list of financial instruments accepted by every branch of Islam. And, some examples of guidelines for the activities of Sharia committees appear in Table 2.

CALL TO ACTION

Increased communication between the West and the nations of Islam will help mankind to follow the ethical and moral precepts of the revealed religions. Protection of the weak from the strong is a desideratum shared by Judaism, Christianity, and Islam. Communication would seem to be especially critical for teams of regulators in various locales. Regulators need to know what works and what does not and to build on regulatory successes. They need to follow through on the correction of deficiencies and to take advantage of technology to spread information, especially in regard to identities and techniques of evildoers. Finally, they need to know how to teach ethics and morals to new generations of accountants and auditors. The Pakistani philosopher Muhammad Iqbal put it well when he suggested “action as the best form of contemplation.”

NOTES
1. Peace Be Upon Him. Muslim blessing invoked at the mention of the name of the Prophet.
2. Auditing has a rich history in the nations of Islam. Audit departments (diwans), and even the position of Chief Auditor, were introduced during the reigns of the first four, rightly guided, Khalifs.
3. The Holy Qur’an enters a far ranging and explicit prohibition against fraud: “Woe to those that deal in fraud” (83:1).
TABLE 1
Islam Investment Vehicles

Mudharaba
An Islamic bank, as a limited partner, provides cash to a borrower who uses the funds, usually on a basis not limited in time, to pursue partnership goals. Profit and loss sharing percentages will be established contractually.

Musharaka
An Islamic bank provides part of the equity plus working capital of a project and shares in profits and/or losses. The bank provides the funds and the partner the management. Murabaha
An Islamic bank finances the purchase of goods or commodities in return for a share in the profits realized. Specifications are provided by the purchaser.

Ijara
The Islamic bank purchases a piece of equipment selected by the entrepreneur and then leases it back to him; he pays a fixed fee.

Ijara wa iktina
The transaction resembles ijara, except that the client is committed to purchase the equipment at the end of the rental period.

Bai al salam
A contract for sale of goods where the price is paid in advance and the goods delivered in the future.

Istisna
A contract to acquire goods on behalf of a third party where the price is paid to the manufacturer in advance and the goods are produced and delivered at a later date.

Some Possible Guidelines for Sharia Committees
1. Each committee should identify specific tasks to be accomplished within its area of responsibility. Each task should be scheduled, budgeted, and assigned to a specific committee member, based on that member’s skills and availability.
2. Management should enter into commitments for timely action on committee recommendations. The internal auditors should follow up on committee recommendations. Open matters, that is, noncompliance, should be regularly and systematically reported to the committee.
3. Within its areas of expertise, the committee should determine whether top management is setting an appropriate Islamic ethical tone. The internal auditors should be assigned the task of monitoring compliance with ethics related policies.
4. Committee members may examine “surrogate” measures relative to compliance with Islamic ethics. These include violations noted by regulatory bodies, and legal actions brought against the institution.


REFERENCES
Accounting standards: key to boosting Islamic banking. 1995. Gulf Daily News (December 8).
Barraclough, Colin. 1995. Middle East: tough choices for Islamic banking. Institutional Investor (July) 141.
Haqiqi, A.W., and F. Pomeranz. 1987. Accounting needs of Islamic banking. Advances in International Accounting, ed. Kenneth Most, 153-167. Greenwich, CT: JAI Press.

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