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Banking & Financing Economics Insurance zakat Accounting Legislation

Contemporary Accounting Practices and Islamic Banking

- By Muhammad Amanullah Khan

1. IntroductionThere is a widespread agreement among Islamic Economists that Musharakah and Mudarabah are the most suitabe alternatives to interest based system. The mark-up through buy-back arrangement (being widely practiced in Pakistan) has been severely criticized on Shari'ah basis. On the other hand there are apprehensions on the part of both bankers and entrepreneurs about the success of Musharakah. One major apprehension of bankers relates to manipulation of the accounting data by the businessmen to achieve a desired profit/loss figure. Data manipulation has two aspects:

  1. Through sheer dishonesty, i.e. false reporling or concealing of transactions
  2. Technical manipulation under the umbrella of generally accepted accounting principles

This paper discusses the nature and extent of the technical aspect and suggests an approach to overcome the problem involved. The question of overcoming the aspect of sheer dishonesty through administrative and other measures is not discussed here. In order to understand the nature of accounting practices or International Accounting Standards which provides guidelines for these practices, it is essential to examine their history of development.

1.1 A Historical Perspective

Accounting has an ancient history which can be traced back to the palace of Nestor. However, the origin of the double entry system is attributed to an Italian mathematician LUCE PACIOLI. His book printed in 1494 named "Summa et Arthimetica, Geometrica, Proportioni et Proportionalita" was primarily a mathematical work containing a section on double entry book-keeping. It was a mathematical model of accounting and not a conceptual work. The preliminary conceptual work started in 19th Century with the rapid growth of trade and industry. Initially it developed as a series of pragmatic techniques to satisfy the individual needs of businessmen. These techniques lacked theoretical and conceptual basis. The promulgation of personal and business law had the largest impact on the development of accountinu techniques. The collection of tax necessitated the attestation of the profit to be true by some professionally competent accountant. It provided a new business opportunity and resulted in establishment of professional accountants' bodies. The first such body to be established was the Society of Accountants in Scotland which acquired Royal Charter in 1854. The Institute of Chartered Accountants in England and Wales was established in 1880. The first such body in USA was established by the Association of Public Accountants in 1887 which is now American Institute of Certified Public Accountants.

These bodies provided assurance to tax collectors, creditors and investors about the fairness of profit figures reported by business units. The three groups got an implicit understanding that there are uniform and conceptually sound policies followed by the accountants endorsed by these bodies. It was only after the New York Stock Exchange Crash in 1929 that it proved otherwise. It became evident that there are diversified accounting practices without any coherent set of guiding principles. The dissatisfaction with financial reporting increased to the extent that the New York Stock Exchange and the American Institute of Accountants were virtually forced to cooperate in setting guidelines for achieving the target of purposive and uniform reporting. In 1930, a special committee was set up under the cooperation of the two agencies for the purpose of developing accounting principles. However, till 1933 no authoritative pronouncement regarding the standards was made. In 1933-34 The American Congress passed two major securities Acts and as a result Securities and Exchange Commission (SEC) was created. SEC was vested with .the authority to prescribe accounting practices to be followed by listed corporations in preparation of their financial statements. The American Institute of Accountants and a Committee of the New York Stock Exchange reached two agreements during 1932-34 one was for the standard wording of the independent auditor's opinion and the other on five accepted principles of accounting to which all listed companies were asked to subscribe.

The Institute of Chartered Accountants in England and Wales began to issue recommendations on accounting principles in 1942. The other principal accounting bodies in UK also started issuing accountancy recommendations. The pronouncements were intended as a general guidance to the Institute members. The Steering Committee for these Accounting Standards was established in 1970 with the cooperation of six main accounting bodies of UK. Later on, its name was changed to Accounting Standards Committee.

The professional bodies of Canada and Australia .started issuing recommendations in 1946. The Accountancy Bodies in South Africa, Mexico, Argentina and New Zealand also issued authoritative pronouncements. The recommendations issued by the Professional bodies could be interpreted in many ways and in certain instances even contrary to the their purpose and intentions. However, these pronouncements served as national accounting standards in respective countries.

The professional bodies of different countries while issuing the authoritative pronouncements and attestation of Financial Statements' used the term "Generally Accepted Accounting Principles"  (GAAP). However, nobody defined this term. The history of the "term" is that it was first used by a document entitled "Examination of Financial Statements" issued by American Institute of Accountants in 1936. The document was basically concerned with the auditing procedures. It was then used by SEC Chief Accountant in his speeches, and by other influential accountants. The Securities exchange commission of USA in its Accounting Series No. 4 explained the term by saying that it would reject a treatment if:

  1. There was no substantial authoritative support for such treatment, or
  2. The treatment was contrary to any rule, regulation or opinion of the Commission or its Chief Accountant.

The release did not elaborate as to what constituted the 'substantial authoritative support'.

The GAAP, therefore, developed and gained authority largely by precedent and tradition. As a result, to say the least, the diversity of accounting practices remained the same. The professional bodies of different countries continued to issue accounting standards at national level. The efforts of these bodies to narrow down the diversity of accounting practices were independent of and without proper coordination with each other and therefore, these standards launched impurity. To overcome the problems of multinational financial reporting and investment interest in other countries, a need to have a global uniformity was largely felt. In 1973, the accountancy bodies in USA, Canada, Australia, United Kingdom, Japan. Mexico and Netherlands entered into an agreement to constitute an International Accounting Standards committee (IASC). The Committee, while jiving the rationale of its creation, states the following:

  1. In a world where technological advances are rapidly bringing about previously undreamt of improvements in communications, the public is becoming more international in outlook and so their use of companies' financial statements in an international context has grown
  2. The use of financial statements as a medium of communication has been steadily increasing. It is now widely recognized that they are a prime source of information for investors, employee groups, Government agencies and many other bodies.
  3. Investors in international markets need to be sure that the information on which they base their assessment is compiled using accounting principles recognized in their own country and comparable with others regardless of the country of origin. Interested groups, such as employees, Government agencies and regulatory bodies, will only find financial statements acceptable if they are based on standards which are relevant, balanced and internationally comparable. [1]

It further states that the 'Role and Objectives' of IASC are to contribute to the development and adoption of accounting principles that are relevant, balanced and comparable internationally and to encourage their observance in the presentation of Financial Statements.

The. objectives as stated by the constitution of IASC are:

  1. To formulate and publish, in the public interest, accounting standards to be observed in the presentation of Financial Statements and to promote their world-wide acceptance and observance;
  2. To work generally for the improvement and harmonization of regulations, accounting standards, and procedures, relating to the presentation of financial statements.

Until now, professional accountancy bodies of about 65 countries are member of IASC, and it has issued 29 International Accounting Standards.

1.2 The Issue Of Accounting Profit

Even the International Accounting Standards do not provide for the apprehensions of the parties interested to enter into a Musharakah or Mudarabah agreement. Each standard provides more than one acceptable treatments in a particular area. In fact, these standards are a compromise formula between different vested interests and pressure groups. A lot has been said and written on the process and economics of standards' setting, a topic which is beyond the scope of this discussion.

The conclusion of the discussion so far indicates that efforts to reduce the diversity in accounting practices has been successful to a very limited extent.

The accounting profit remains a conceptual residual figure of a set of accounting assumptions and the same data may result in different profit figures under different set of assumptions. The nature of accounting profit is very appropriately defiped by A.M.C. Morison as follows:

"In accounting, the term profit has no absolute meaning. It is simply a measurement of the success or failure of a business to achieve what it has set out to achieve. The measurement is a subjective one in so far as it depends upon the view taken as to what the business has in fact set out to achieve. Thus the term profit as used by accountants can never have that absolute meaning which lawyers, economists and revenue officials seek to attribute to it". [2]

1.3 The Auditor's Role

The role of the auditor may also be understood at this stage, The objective and scope of the audit as stated by the International Auditing Guideline No. 1 issued by the International Auditing Practices Committee of the International Federation of Accountants is as follows:-

"Objective of an audit of financial statements, prepared within a framework of recognized accounting policies, is to enable an auditor to express an opinion on such financial statements. The auditor's opinion helps to establish the credibility of the financial statements. The user, however, should not assume that the auditor's opinion is an assurance as to the future viability of the entity nor an opinion as to the efficiency or effectiveness with which management has conducted the affairs of the entity".

Thus the target of the auditor is to express an "opinion" on financial statements as to whether they have been prepared within the framework of recognized accounting policies do have a potential to transfrom financial statements of a dying organization into a nice looking profit venture. This is why International Federation of Accountants has very rightly warned the readers of financial statements against assuminsz auditor's opinion as any kind of assurance for future viability of management's efficiency and effectiveness. This is probably due to the built-in limitations of the audit process.

The International Auditing Guide line No. 11 dealing with frauds and errors describe this fact as follows:

The test nature of an audit of financial information involves judgement as to the areas to be tested and the number of transactions to be examined. Furthermore, such audit evidence is persuasive rather than conclusive in nature. Therefore, the auditor's examination is subject to the inherent risk that some material misstatements ot the financial information resulting from fraud or error, if either exists, will not be detected.

In addition to the above, the major limitation, in my opinion, is the undefined generally accepted principles of accounting, Thomas G. Higgins has remarked:

"When we, independent public accountants, report that financial statements are presented in conformity with 'generally accepted accounting principles' we can not be sure of what we mean, because the impression 'generally accepted accounting principles' has never been satisfactorily defined. Those who issue the financial statements on which we report, and those who use them, do not know what we mean, either". [3] Although Higgins said it 30 years ago, yet it is true even today.

1.4 What Can Be Done?

In this situation what could be the possible solution for equity financing (i.e profit-sharing) by individuals, banks or other institutional financiers. There seems to be two options.

  1. To define generally accepted accounting principles through legislation so that there is a unique set of assumptions resulting in only one profit/loss figure to be shared by the financiers.
  2. To agree upon the basic accounting policies/practices to be followed in the Musharakah and Mudarabah agreement in advance, while remaining within the framework of International Accounting Standards.

The first option has been debated since iong in accounting literature in the name of uniformity versus flexibility. There seems to be an agreement amongst professionals that it is not possible to have a set of ricid rules which are applicable to all situations due to diversity in the nature and objective of the business organizations. The element of judgement remains the essence of the accounting discipline.

The second option is feasible and viable. The term profit can be defined for a particular contract by agreeing upon a set of assumptions i.e. accounting policies and treatment while remaining within the framework of existing International Accounting Standards. The paper does not discuss the viability of different accounting treatments approved by the International Accounting Standards from an Islamic point of view. There is no international accounting standard which provides only one solution for treating a particular item, such that any treatment which is not acceptable from Shari'ah point of view may be discarded. The legislation in almost all countries requires the disclosure of accounting policies or treatments where judged material (i.e. judgment) is critical in determining results for a financial period. The extent of disclosure is another unresolved issue of accounting discipline. The regulating authorities in almost all countries are trying to increase the scope of disclosure.

Disclosure at the end does not, however, serve the purpose of equity financing but an agreement at the beginning can be of crucial importance. The solution, therefore, is to have a detailed agreement on accounting policies and practices for Musharakah and Mudarabah contracts.

1.5 The Practical Aspects Of The Rule

Having an agreement on different accounting policies provides a basic conceptual rule. However, there are numerous problems in its practical applications. For example the rule can be efficient in case of long term investments for the new projects. But how to tackle the funds provided for short term working capital needs or for long term for the expansion of the ongoing projects. Where PLS (Profit/Loss Sharing) funds are to be provided for working capital to a new or an ongoing project, the assumption is that fixed investment and pre-production costs have already been incurred and funds are required for the operations. There are three basic questions to be answered in this case. They are:

  1. Which profit is to be shared, i.e. Net Profit, Operating Profit or a profit reached through an agreement.
  2. How to determine the profit/loss sharing ratio.
  3. As the project is ongoing and the organization is already following certain accounting policies, what could be the basis for an agreement about these or new policies.

1.6 Profit To Be Shared For Short Term Funds

The 'profit to be shared' can be defined with reference to the use of funds i.e. working capital. Broadly speaking, it must be the profit on ordinary activities or profit before extraordinary items adjusted for items not directly related to that period. That is, the revenues generated from regular activity of the business, technically known as profit oriented activities, less such current expenses which directly helped in separation of such revenues. Other incomes and expenses can also be included if they are of regular nature and can be predicted with reasonable certainty.

To make it more clear and to explain the approach, the treatment of different items in the context of this definition is discussed.

The different revenues and expenses can be grouped into three broad categories.

  1. The items which are treated as revenues and expenses under the prevalent accounting practices and they are very rightly so as far as accounting treatment is concerned, but must not be included in the calculation of 'Profit to be Shared' for PLS agreement.
  2. The items which are treated as revenues and expenses and would continue to be so under PLS agreement but involve element of judgement and hence require the consensus of parties for accounting treatment.
  3. The items which are clear enough and do not involve the element of judgement and thus do not require any agreement or special treatment.

The examples of the items of the first category may include:

  • Amortisation of pre-production costs: In my opinion it must not be included in the calculation of 'Profit to be shared'. The costs contribute in the generation of current income directly. There is a wide range of practices and recommendations of authorities in the profession for the treatment of such costs. The range is from immediate recognition as expense to capitalization and permanent retention in an asset category. However, capitalization and speedy write-off is most widely accepted. There is a considerable element of judgement involved in their treatment. Furthermore, those providing PLS funds during the period of amortization will have to share lower profits and those providing funds after such a period will share higher profits.
  • Amortization of other intangible assets like good will, patents, trade marks etc. My opinion here is the same as expressed in the case of pre-production costs except for those intangible assets which have a definite life e.g. patent rights. In such a case the amortization can be calculated on objective basis. And also such rights do help in generation of current income directly.
  • Research and Development Expenses: Two examples may be cited before reaching a conclusion for the treatment of research and development expenses. While it was writing oil heavy development expenses for its DC-8 jets in 1960 and 1961, Douglas Aircraft reported miserable earnings even though the company was in relatively good shape. In the three years that followed, when most of these expenses had been charged off. the company reported profits which were sharply higher on lower sales.

Much She same was true at Xerox in the late Fifties. The company was reporting almost no profit at all as it spent heavily to prepare its 914 copier for market. No one but those inside Xerox had any hint of the tremendous profit surge that followed the 914's introduction in 1960".

Thus it is clear that Research and Development expense can have a tremendous impact on the profits in a short run. Research and Development cannot be treated as an item of working capital. Although, during such periods the organization would require more working capital funds because a chunk of its own funds would be diverted to research and development, yet it would not be sharing profits with such funds as the benefits would accrue in the future dates. In the period of such benefits, the organization would not require much of working capital funds. It can be argued that during benefit periods more working capital would be required for investment to inventories, accounts receivable etc. Even if it is so, the benefit would be shared by some one else until and unless the bank provides Musarakah funds for such a long period as to reap the benefits of research. Therefore, research and development expenses must not be included in the calculation of 'Profit to be Shared' except for those research expenses which becomes beneficial during the contract. Such expenses must be capitalised and amortised at a late acceptable to both parties.

  • Other and extraordinary items:
    Other items: These items are included in the income statement after the calculation of operating profits under the head of 'Other Incomes and Expenses'. These items do not relate with the regular activity of the business. A typical example of such items is gain or loss on disposal of fixed assets. For PLS agreement the historical trend and nature of other items are to be analyzed. Incase of a predictable trend a formula can be developed for sharing such items. In case of unpredictable trend such items must be excluded from the calculations. Extraordinary items: By definition the happening of such items is very infrequent and highly unpredictable. These items must not be included in the calculation until and unless a strong justification for doing so is there. There would be two major benefits which will accrtie from sucii a step:
  1. The management would not afford to be negligent and
  2. The management will not be tempted to use this leverage for showing lower profits.

It can be argued that inventory loss by fire, and such other items, do deserve the sharing of loss by the bank. My opinion is that extraordinary losses and benelits could be associated with long term funds and not with short term funds.

  • Prior Periods Adjustments: Adjustments relating to the period prior to the Musharakah agreement must not be included in the calculation. on the other hand any adjustment relating to the agreement period and arising after the termination of the agreement must be shared at that time.

The above list is not an exhaustive one. It only demonstrates the approach to be followed.

The items of second category would include all such items involving element of judgement. This category will virtually include all areas of accounting. The PLS agreement must very clearly specify accounting policy and treatment to be followed for each item. The examples are. Valuation of inventories, Investments, Revenue recognition. Receivables, Depreciation etc.

1.7 Determination Of Profit/Loss Sharing Ratios

The profit and loss will be shared in the ratio of the capital invested i.e. the rate of return on the total capital employed will be applicable to Musharakah funds. The basis is applicable to both long term redeemable and non-redeemable Musharakah's funds. However if agreed between the parties a weight can be assigned to the profit/loss to be shared by such funds. For example the average rate of return during the year may be 20%' but the working capital may claim 25% or 1.25 times of ROR on capital.

The same rule can be applied to short term Musharakah's funds i.e. working capital funds, provided for period of less than one year. The problem faced is how to calculate 'the profit to be shared' for the period. There could be two answers.

  1. To prepare income statements (profit and loss account) for that particular period for which the funds have been utilized.
  2. To assume that the funds have contributed to the generation of the profit/loss during the entire year and therefore share the yearly profit/loss on the proportionate basis as suggested above for the period the funds were used. For example if Rs. 100 were provided as working capital for three months and the ROR at the year end is 20%, these funds would claim Rs. 5.00 i.e. 20/4 (yearly return/Proportion of time).

The first one is not possible as financial statements cannot be prepared frequently and furthermore there can be more than one financier with different time periods. The problem in the second approach is that the financier will have to wait till the end of the year. This can be overcome by applying a tentative rate at the time of recovery and then adjusting it at the end of the year. The assumption is that the relationship between the financier and the business will be of a permanent nature and there would be many transactions during the year. A method like daily product being utilized by the banks (in Pakistan particularly) can easily be evolved. A question may arise that if the short term funds would cost the same rate of return to the entrepreneur, then why should he not prefer the long term funds. The answer is that in the first instance he will have to pay only for the period he has utilized the funds. Secondly a weight less than one can be assigned for the Bank's share in Ihis case.

1.8 The Basis For Agreement on Accounting Policies

In the case of ongoing projects the accounting policies being, followed by the organization should form the basis of agreement. The policies which are being followed consistently for the last five years should be accepted as such unless there is a strong reason to change any one of them. The policies which have been changed during the last five years may be analyzed to see their impact on the bottom line to make a decision for acceptance or change. Anyhow, it would be based on mutual agreement and would require an expert financial analysis from the side of both parties.

1.9 The Long Term Implications

Under Mushurakah the funds would be channelized to the profitable organizations providing maximum returns to the financiers. What would happen to the sick industry or ihe organization in a temporary phase of difficulty? The solution of such an organization does not He in providing short term fixed charge capital. It raiher increases the financial risk of the organization and increases the losses. As the ROR on capital is negative in such organizations, the induction of fixed charge capital with a cost higher than the ROR adversely effects the loss per share of the equity holders. If deemed feasible and viable in future after a thorough analysis, the financial institutions must provide long term funds on Profit/Loss Sharing basis. The organization may however be provided an option to redeem these long term funds only after an acceptable return has been acquired over a reasonable period. It will help the channelization of funds to their best use. The project deemed not viable will automatically be competed out. The essential projects which are not financially viable need a separate analysis. Here it may suffice to say that such projects are not the responsibility of financial institutions.

2. CONCLUSIONIn sum, we may say that in spite of various accounting difficulties involved in managing the profit/loss sharing system there are sound practical approaches to overcome them within the available accounting knowledge.

Notes:'Objective and Procedures'. International Accounting Standards Committee, January, 1983.

  1. Morison A.M.C. "The role of the Reporting Accountants Today", The Accountants Magazine (September, 70).
  2. Higgins, "The Accounting Principles Board and Uniformity in Financial Accounting," in Twenty-fifth Annual Institute on Accounting, Proceeding 67, 71 (Ohio State University, 1963).

ReferencesRichard P. Brief, "Corporate Financial Reporting at the Turn of Century", Journal of Accountancy, May. 1987.

  1. Sidney Davidson and George D. Anerson, "The Development of Accounting and Auditing Standards", Journal of Accountancy, May, 1987.
  2. Zeff E. Keller, Financial Accounting Theory l: Issues and Controversies, McGraw Hill, 1973.
  3. Zeff E. Keller, Financial Accounting Theory, McGraw Hill, 1987.
  4. Tinker Tony, Paper Prophets, A Social Critique of Accounting, Holt Rinehort and Winston, (1985).
  5. Bram which Michad, The Economics of Accounting Standard Setting, Prentice Hall (1985). International Accounting Standards, International Accounting Standards Committee. International Auditing Guidelines, International Federation of Accountants. Objectives and Procedures, International Accounting Standards Committee, London, (1983).

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