Mobilisation of funds and employment of funds
Mobilisation of funds has to do with the acceptance of deposits. Islamic banks in this sense are not that
different from conventional banks. They accept depositors’ funds and the recording of those deposits
from an accounting point of does not differ that much from conventional banks. We have current
accounts, then we have savings accounts, which can be different types, A and B, depending on the time
and if they are short term or long term. Then we have investment accounts, which are going to be used
for a specific investment. Finally, we have joint accounts, where discretion is given to the bank to use
those funds wherever they want, in any type of investments.
Clearly, the recording of the accounting transaction is not that different from what we have been already
used to in conventional banking. The only difference is that Islamic banks are required to keep certain
transactions separate because there will be a problem at the end as to how to share the profit between
the shareholders and the depositors. So far this has not been a problem for the conventional banks,
because the interest rate is known. For Islamic banks it is different. We have to wait until the transaction
is completed and then decide at the end of the year how much each of the group will receive as profit.
Modaraba and musharaka
The modaraba and musharaka are not that much different from the joint ventures in conventional
banking. Musharaka means sharing the profit. These are for a certain type of operation, and it is agreed
in advance between the two parties that the bank and the customer will contribute certain capital assets
as well as technical managerial experience, but in varying proportions. They share the realised profit in
an agreed upon ratio, sometimes at the beginning and sometimes they wait until the transaction is
completed. Normally, the bank does not interfere in the management but periodically can ask for an
audit or some financial reporting details.
Profit and loss are shared on the basis of capital contribution, after allowing for the costs incurred in
running the day-to-day business. The problem with this, as well as modaraba, is that the profit could be a
short term musharaka or modaraba, which could last for a month, or it could last for a medium or long
The views of the Islamic banks are not all the same as to how they should record these transactions in
their financial statements. Some, with musharaka, will put in their financial statements only the portion
they are contributing in the musharaka. If they are going in for 10%, they will show this as part of their
investments. Others show the total amount invested by them, as well as their partners. By doing this
‘window dressing’, the balance sheet is inflated on both sides by the share of the partners.
When the profit emerges, some of the banks, in line with the Shari’a teaching, feel that the profit should only be recognised after the modaraba or musharaka is completed. If this is going to be within the same
financial period, there is no problem. The problem arises if we are talking about between one year and
two years. If it falls between two years, you might have a profit or you might have a loss.
If you have specific accounts, investment accounts that have been paying the funds for you, investors
are going to wait, and will receive their share of the profit whenever the results are announced.
However, in the case of joint accounts, there is a problem, because some of those accounts may not be
the same accounts next year, or the composition of the joint accounts may be different between one
year and the next. The profit sharing, even though all the Islamic banks are trying to keep separate
books, may not be properly reflected for each group between the depositors and the shareholders.
Turning to the supply of goods, these are the murabaha or leasing transactions. Again the problem arises
of transactions between one and two years. It may mean that one year is going to have the profit and the
other one is going to have the adjustments, which is not going to reflect the proper profit for both parties
Put another way, if nothing is paid out thus giving you a receivable, because you are talking about the
relationship between a creditor and a debtor, the transaction has already taken place and there is no
payment, we therefore have a loss. Again, the Islamic bank will be faced with the problem that they
have to pay to the depositors their total profit up front, when in reality they have not yet received their
So the problem of profit recognition is an issue that has to be resolved, and it has to be consistently
received by all Islamic banks and treated in the same way, so that we can make valid comparisons
between what each is reporting in the financial statements to their shareholders.
Leasing has not really been developed yet as much as it should be within Islamic banks. The only one
which has really been doing a lot of business in this area is the Islamic Development Bank in Jeddah. It
has used it very extensively, especially in the area of financing commodity deals between countries, for
instance in the oil sector.
We can have two types of leasing: leasing whereby the bank goes and buys the equipment for a
company, and they agree together that they are renting the equipment for a period, and there will be rent
paid. The point is, is title going to be passed or not? In most cases the bank has a problem, because if
they do not have security over the equipment, they have no come-back if repayment is not forthcoming.
The second type, though it may not sound very Islamic or in accordance with Shari’a law, is where
banks have been keeping the title until full payments are made. This is going to be an area of real
concern and Islamic banks should really get together and come up with a way to present murabaha and
leasing in their own financial statements. This should be in accordance with accounting principles,
recognised internationally, either by all the people who are members of the accounting committee,
which is made up of 57 bodies, or in accordance with the US or UK, depending upon who they want to
Letters of credit, investment trustee and safe-keeping
There is no problem between the Islamic banks and conventional banks in recognising this income.
There is a fee that is charged for these services and which is supposed to cover overheads plus a mark
up for providing the service. The recognition in the accounts is made at the time the service is billed to
the customers and so there are no real problems in accounting terms.
Acounting survey of 10 Islamic institutions
Ten Islamic institutions have been surveyed including one non- bank. The purpose was to assess the
accounting policies followed by these institutions and to find any disparities and check the adequacy of
the disclosure made in the audited financial statements.
At the present time, apart from local regulations, there are no accounting standards laid down by
accountancy bodies in most of the countries where Islamic banks have been incorporated. There may be
something in Denmark, but the Islamic International Bank is not included in the sample. Therefore the
focus of the financial reporting has been left to the discretion of management, with no pressure from the
users of the financial statement.
The importance given to the subject of disclosure is minimal. There is no strong pressure from the
public, nor from the shareholders. Depositors generally feel that their money is safe. There are no
organisations, such as the Securities Exchange Commission (SEC) in the US, which may claim the right
to information on corporate activities and performance. It is possible that with the evolution of the
Islamic banking concept the legislator as well as the accounting bodies may lay down standards that all
banks: will be required to adopt in most countries of the region.
The banks in the survey are as follows: The Islamic Development Bank, Jordan Islamic Bank, Dubai
Islamic Bank, Faisal Islamic Bank of Egypt, Kuwait Finance House, Bahrain Islamic Bank, Bahrain
Islamic Investment Company, Islamic Bank of Sudan, El Baraka Islamic Investment Bank and Dar
Al-Maal Al-Islami, the holding company. These banks are in Egypt, Jordan, Sudan, United Arab
Emirates, Saudi Arabia, Kuwait, Bahrain, and the Bahamas.
Of the auditors of those banks, 50% were the ‘big eight’, international accounting firms which are
known worldwide. Three of the banks, which are the Islamic Development Bank, Faisal Islamic Bank of
Egypt and Bahrain Islamic Bank, elected to report their results at the end of a hijar year. The remaining
banks use the Gregorian year.
Financial statements can be prepared using various accounting policies, which can range from ultra
conservative to highly optimistic and accordingly may result in different financial statements by banks
that are subject to the same events and conditions.
It is therefore important for a proper understanding of any financial statement that the significant
accounting policies on which the statements are based are fully and clearly disclosed. Fortunately, the
10 banks and institutions surveyed have all disclosed, in varying degree and quality, the accounting
policies adopted in drawing up their financial statements.
The international accounting standards recognise the following three fundamental concepts as not
requiring any disclosure, since their use and general acceptance are assumed. These concepts are —
1. The going concern, where the enterprise is viewed as continuing its operation into the future with no
intention of materially curtailing the scale of its activities.
2. Consistency, which assumes that the accounting policies are used consistently from one period to the
3. The accruals concept where revenues and expenses are recognised as they are earned and incurred.
Recording in the financial statement is reflected in the period to which they relate.
Any departure from those three fundamental concepts should be disclosed together with reasons.
In selecting the appropriate accounting policies, the international accounting standard recommends the
following considerations to be applied: prudence, substance of forms, and materiality. Prudence should
be exercised to recognise the uncertainties surrounding any transaction. Substance of form in recording
a transaction should look at the reality and not the legal form. With materiality, the disclosure should
focus on items which are material enough to affect evaluation or decision.
The IAS (international accounting standards) requires that all significant accounting policies should be
disclosed in a clear and concise language. This disclosure should be an integral part of the financial
statements. Changes in accounting policy should be highlighted with the reason for the changes and the
effect from one year to the other.
The following policies are the ones which are mainly used for valuation and income measurement.
Foreign currency transactions
The first one is foreign currency transactions. This subject has long been under extensive study by the
various bodies in numerous countries. However, disagreement exists about how to deal with the
following problems —
1. The selection of a method for translating the foreign assets and liabilities into the reporting currency
of the holding company.
2. The treatment of the differences arising from such transactions.
3. The selection of a method for the translation of profit and loss account items and
4. The treatment of foreign trade operations and in particular the treatment of forward transactions and
Islamic banks as we know, are confined to the spot market in foreign currency transactions.
Basically, there are two methods of translating foreign currency transactions, the monetary and
non-monetary methods. Monetary assets and liabilities are translated at the closing current exchange
rate. Non-monetary items are translated at historical rates.
In 1985 the US came up with what we call the FABSE or the Financial Accounting Board Standard No.
8. However, this standard created considerable debate and has been subjected to much criticism,
following which the Financial Accounting Board issued the FABSE No. 52. It recommends that the
closing rate method is used.
In the UK, the accounting standard committee has issued an accounting standard on accounting for
foreign currency translations, which is known as SSAP 20. There are also the international accounting
standards, in particular Standard No. 21, which recommends the use of either the historical or closing
method. There are no other specific requirements in any of the countries where Islamic banks have been
In the survey, except for the Jordan Islamic Bank, where no disclosure is made, all the other banks have
referred to their policy on foreign exchange translations. The translation they mostly use is the rate of
exchange prevailing at the time of the transaction, recorded during the year. Assets and liabilities at the
end of the year are translated at the rate of exchange at the end of the year. Any difference due to the
exchange rate is picked up in the profit and loss account of the bank.
The Islamic Development Bank had the following policy in its financial statement: the value of assets
and liabilities are translated from various currencies on the rates declared by the international monetary
fund, on the date of the balance sheet. The Islamic Development Bank publishes its accounts in Islamic
Dinars which are very close to the IMF, ‘SDR’. The net difference resulting from the translation of
currency into Islamic Dinars is carried in a special reserve account. So it is not even picked up in the
profit and loss account.
The financial statement of the Tadamun Islamic Bank of Sudan discloses in its financial statement that
the capital contribution of the shareholders, because some of the shareholders are foreign, is translated
at the historical rate, i.e. 1.3 Sudanese £ to the $. There are also deposits made in foreign currency and
those are translated at the specified rate, 2.09 Sudanese £ to the dollar. Then we have the balance in
foreign currency with affiliated companies, which is again translated at a different rate, this being the
rate at the time of the transaction.
In the survey it was clear that in many cases we do not have in the financial statements all the
information we would wish to have about how investments have been recorded particularly where
investments in subsidiaries, new companies and investments in real estate are concerned.
The Dubai Islamic Bank in 1984 referred to the investments in the various Islamic institutions or
companies, in the Emirates or outside, and disclosed the following accounting policy: revenues from
securities and outside investments are recorded based on the profit realised by these companies and
institutions in 1983, the year before, or by the dividend collected in 1984, if they collected dividends, or
whatever information came to the bank’s attention.
Bahrain Islamic Bank has some investment in land. What they have done is to record the investment in
land at cost, with a provision for a possible fall in value. The Kuwait Finance House, which also has a lot
of property, values it at the lower cost, or directors’ estimate of market value on an aggregate basis after
taking into account the prevailing circumstances and ordinary and extraordinary provisions for
contingencies. Those are the properties they have purchased with their depositors who are sharing with
them in a modaraba or in a murabaha and at the end of the day they are recording those activities at the
lower cost or what directors estimate to be the market value.
Faisal Islamic Bank of Egypt unfortunately did not disclose any accounting policy regarding their
investment policies. Again, this is a very conservative approach, and does not really give us what we will
call generally accepted accounting principles, so that we can make the comparison between Islamic and
non-Islamic banks’ financial statements.
Al Baraka Islamic Investment Bank recognised profit on the finalization of the bank’s sale to a
purchaser. In the case of a credit sale known as a deferred contract, they recognise the profit as and
when the repayment of the installments are made, on a pro rata basis. Now this is also a very
conservative approach but it does give you the profit over the contract period.
The Islamic Development Bank is also conducting transactions with financial institutions operating in
the international finance markets and is receiving some return on its investments. The board of
governors has decided to exclude this revenue from the profit and loss accounts and to appropriate them
on a fifty/fifty basis to a special assistance account. The special assistance account is formed to finance
training, research, relief to Islamic communities, and promotion of Islamic causes and technical
assistance grants. Again, this is income which is not appearing in the financial statement, or the P & L, it
is coming straight to the balance sheet.
With the Jordan Islamic Bank, section 19 of the articles of association confirm that the management
may not adopt a method of accounting which takes into account estimates, but should rather confine
itself to profit realised from the operation which the bank finances. This implies that the bank has the
possibility to use different accounting methods for recording its own operations. So in other words there
are two methods they can use, one for their own funds and one whenever they are using the funds of
There are some banks which do not appear to use conservative accounting policies, for instance the
Bahrain Islamic Bank and the Bahrain Islamic Investment Company. They recognise the profit or the
loss as a result of trading, whether cash or credit, on the basis of murabaha or musharaka, as soon as the
contract is signed. If that period of the contract can extend to a year or more, you are picking up the
profit immediately and you are paying it to your shareholders as well as your depositors without
knowing too much about what will happen in the future.
Financial statements and the presentation of the balance sheet
A basic picture of banking to a corporation is the holding of liquid assets that can be readily converted
into cash. In order to prove to their customers their liquidity and solvency, banks are required to
maintain a delicate balance between holding cash on the one hand and having enough assets that can be
readily converted into cash. Therefore it is desirable that a consistent approach in the classification of
liquid assets should be adopted by all Islamic banks.
The IAS has not come up with any standards for the presentation of financial statements, but they have
come up with a discussion paper and they are asking for useful disclosures. These include classifying
assets and liabilities in the balance sheet by grouping them in the nature and in approximate order of
their liquidity that equates broadly to their maturities. At the present time Islamic banks list their assets
under one of the following headings: modaraba, musharaka or murabaha investments. Unfortunately
they did not give us too many disclosures. Liquidity is not yet a problem for them. As a temporary
measure some of the Islamic banks are directing their short term funds into the commodity markets, but
the fact that we cannot really get out of the balance sheet what is current and non-current is not coming
across in the financial statements.
Deposits are classified in various ways by Islamic banks in the survey. A few classify on the basis of
depositors. Some classify Islamic deposits with other banks, corporations or individuals. Some have been
showing the deposits either in local currency or in foreign currency. Another method of classification
which has been used by some is based on current accounts, demand accounts, short notice deposit and
term deposits. But in no way was there any consistency between financial statements. Since depositors
share with the bank the profit and losses resulting from their placement, classifying by current account,
saving account, or investments account would seem to be the best way. It shows how liquid the deposit
is and also if the returns at the end of the year conform to that received during the year.
Another item in the balance sheet of one of the Islamic banks was inventories. Normally banks would
not have any inventories, but the Kuwait Finance House has an inventory which is carried as part of a
trading activity. The inventory was valued at the lower of cost and net realisable value, after making
allowance for any losses for obsolescence or slow moving items.
This policy is in agreement with general practice in the accounting profession. They also have some
motor vehicles and for those they were using a specific identification method on the basis of first in, first
Normally fixed assets on the balance sheet of a bank are not very important or not material, but in most
of the 1.0 Islamic institution the accounting policies which have been made were in agreement with
normal practice. They are almost all valued at cost, and are depreciated over the useful life of each
asset. They are depreciated at predetermined rates and in some of the banks, like the Bahrain Islamic
Investment Company, they stated that they depreciated fixed assets in the year of acquisition. However,
for that particular institution fixed assets were not really of any importance.
Because the Dubai Islamic Bank and the Islamic Development Bank received a donation from their
governments, either in Dubai from the Emirates or by the Saudi government, they showed in the balance
sheet a capital reserve which accounts for the donation. It is shown on one side as an asset and on the
other side they are showing it as a capital reserve, which is not for distribution.
By their very nature banks enter every day into many forms of activities that give rise to financial
contingencies and commitments. All the banks surveyed showed some kind of contra accounts in the
balance sheet. They disclosed at least a figure which will give rise to a letter of credit, standby letter of
guarantee, indemnities, or any other obligations. There were only two banks, the Bahrain Investment
Company and Kuwait Finance Bank, who have given a disclosure in their financial statements about
Turning to losses, by the prudence concept, we have to provide for any losses as soon as they are
recognised, incurred, or projected. Most Islamic banks found that they had been providing for certain things, but unfortunately there was no disclosure about how they came up with their provisions and what
those provisions relate to. Faisal Islamic Bank of Egypt has listed as part of its balance sheet a provision
for a risk of investment operation, but we do not know exactly what kind of investment operation they
are referring to. Kuwait Finance House has created various provisions to offset a loss on one of their
subsidiaries and also something they call an extraordinary provision for contingencies.
Again, more disclosure is required in this area to find out why those provisions were made and also, in
the future, the movements of those provisions, if they have been used and for what.
To sum up, the last thing about the presentation on financial statements to be discussed is zakat, which is
something that you will not find in any conventional bank. It is a religious levy that all Muslims have to
pay on their wealth. Now as far as Islamic banks are concerned, you will find that some of them have
accepted the fact that the bank is responsible for taking the zakat from the depositors’ and the
shareholders’ dividends and to make sure that this zakat is going to be used for something which will
basically share the wealth. The problem from an accounting point of view is that some of those banks
are taking zakat as an expense in their P & L, while others are considering it as an appropriation of
profit. Again, for those readers of the financial statement who are making comparisons, they have to
make sure they understand that if it is outside the P & L, and it is shown as being a distribution of profit,
this element is taken into consideration.
The report of the religious supervisory board is a new form of reporting. This report confirms that the
bank in its transactions has followed the strict Islamic Shari’a doctrine. It is interesting to see that most
of the Islamic banks are putting this as part of their financial statements. In one case, the Faisal Islamic
Bank of Egypt, the accountant’s reports referred to the fact that all transactions taking place were in
accordance with Islamic Shari’a doctrine. In other words, there is a great deal of responsibility placed on
the accountant who declares that everything is according to Shari’a.
What we have to do now is decide how to harmonise the accounting policies as well as the reporting that
all Islamic banks should follow so that not only the public at large will understand what they are doing,
but the regulators, depositors and the shareholders. It is not going to be an easy task. The European
community took years to come up with a directive for the banking community to follow and comply
with. It is only now that all the European banks are following this standardised system of reporting. Now
the Islamic banks need to think about how to prove that they operate under a standardised system.
Why should we have harmonisation of financial reporting? Well, we have a much greater responsibility
in Islamic banking because of the depositors. Those depositors have up to now, if they were not
depositing their funds with an Islamic bank, held onto them because they felt that the system around the
world or around them in their own country was not really complying with their own beliefs, or faith.
They are now very enthusiastic about putting their funds in Islamic banks. More and more you will find
that depositors are becoming increasingly sophisticated and will need to know where and what is
happening with their funds. They will request banks to give more information about the projects in
which their funds are used. Islamic banks will be required to give more information when they advertise
new projects, and wish to receive funds.
In the US, when a mutual fund wishes to attract more cash, it issues a prospectus. Islamic banks will be
required in the future to prepare a prospectus about a specific contract, and forward this prospectus to
depositors, informing them that a fund is available, that these are the projections for the next five years
for this project, and this is the study that we have completed. This is something that sooner or later
Islamic banks must think about.
Auditors of Islamic banks may soon also be requested to issue special reports to the depositors
confirming that the profit distribution was prepared in accordance with contractual terms and that the
profit of a specific project is fairly stated. At the moment one of the methods of distribution is that the board of directors of the Islamic banks decides the percentage to be paid to the various types of
depositors. As depositors become more sophisticated they will want to know if the distribution from the
board is correct and if there are any problems with the management of the bank.
These are the things that we have to think about as Islamic banks. For new potential investment, and in
order to attract more funds, Islamic banks should be encouraged to publish a prospectus, and they
should at the end of the day disclose information themselves rather than waiting for someone to ask for
information. They should do it now and not wait to be pushed into it.
On a closing note, Islamic banks present a new challenge to the existing financial institutions, yet are
themselves presented with a challenge by their shareholders, depositors and customers. It is not enough
to be on a par with the commercial banks and other institutions, they are required to be better.