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:
- Through sheer dishonesty, i.e. false reporling or concealing of transactions
- Technical manipulation under the umbrella of generally accepted accounting principles
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
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.
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
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
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:
There was no substantial authoritative support for such treatment, or
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'.
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:
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
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.
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. 
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:
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;
work generally for the improvement and harmonization of regulations,
accounting standards, and procedures, relating to the presentation of
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.
conclusion of the discussion so far indicates that efforts to reduce
the diversity in accounting practices has been successful to a very
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:
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". 
1.3 The Auditor's Role
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:-
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".
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:
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
addition to the above, the major limitation, in my opinion, is the
undefined generally accepted principles of accounting, Thomas G.
Higgins has remarked:
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".  Although Higgins said it 30 years ago, yet it is true even today.
1.4 What Can Be Done?
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.
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.
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.
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.
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.
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
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:
Which profit is to be shared, i.e. Net Profit, Operating Profit or a profit reached through an agreement.
How to determine the profit/loss sharing ratio.
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
'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.
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.
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.
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:
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.
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.
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.
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
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.
The management would not afford to be negligent and
The management will not be tempted to use this leverage for showing lower profits.
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.
The above list is not an exhaustive one. It only demonstrates the approach to be followed.
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
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
To prepare income statements (profit and loss account) for that particular period for which the funds have been utilized.
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
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
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
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
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
Notes:'Objective and Procedures'. International Accounting Standards Committee, January, 1983.
Morison A.M.C. "The role of the Reporting Accountants Today", The Accountants Magazine (September, 70).
Higgins, "The Accounting Principles Board and Uniformity in Financial Accounting," in Twenty-fifth Annual Institute on Accounting, Proceeding 67, 71 (Ohio State University, 1963).
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