Islamic Financial Institutions - A risk-free return? It's forbidden

Can existing IASs deal properly with all the transactions involved in Islamic finance? asks James Drummond

Mudaraba, musharaka and ijara are not normally included in the conventional accountancy syllabus. But to a small and growing body of Islamic bankers, fund managers and financial controllers, these contractual terms are the nuts and bolts of an industry. Deciding on the precise definitions and treatments of these contracts has become central to the growth of Islamic finance and to bringing order to some poorly managed economies.

Islamic banking started in Egypt in the 1960s and has since spread into the Muslim states of the Middle East, Iran, Pakistan, Malaysia and Indonesia. In three states - Iran, Pakistan and Sudan - the entire banking and financial system is run along Islamic lines. But elsewhere in the Muslim world, one or two Islamic banks, marketing themselves to the pious, typically operate alongside their conventional peers.

The industry has now also attracted global players such as Citibank, BNP-Paribas and Deutsche Bank, which operate Islamic banking windows within conventional institutions. The thinking is that although Islamic banking is in its infancy, the potential for growth is enormous.

So what does it mean to talk of a specifically Islamic institution or system?

Islamic finance is based on the Quranic injunction against riba, or usury, and on the belief that investments should be made in a socially responsible way, eschewing products that are haram or forbidden under Islam. Analysts talk of riba-based (conventional) and non-riba based (Islamic) banking systems.

There is a good deal of discussion about what constitutes usury - the Mufti of Cairo, a leading jurist, has declared that taking moderate amounts of interest is not usurious - but the modern industry has developed around the idea that taking any interest is haram.

In order to get around charging interest, a depositor, or more properly an investor, in an Islamic bank shares in the risks and rewards of the investments. Simply to earn a risk-free interest rate return is deemed to be usurious and is therefore not allowed.

Islamic banks also avoid industries involved in alcohol, gambling and rearing pigs, and they try to avoid other institutions that charge interest - such as conventional banks and (arguably) any company with a treasury function. Banks, leasing and insurance companies, project finance transactions and, in particular, fund management, can be and are managed Islamically.

Faysal Islamic Bank of Egypt

At first glance, the balance sheet of an Islamic bank is a strange beast. Take Faysal Islamic Bank of Egypt, part of the larger Dar al-Mal al-Islami based in Geneva. The bank's most recent financial statements include a balance sheet date that is the end of the Islamic year ending 1419, equivalent to 14 April 1999.

At that time, Faysal Islamic Bank of Egypt had deposits with banks and other financial institutions, but loans were noticeably absent. Instead, net of provisions, there are 'investments, participations, productive and commercial murabahat and mudarabat'. On the liability side, instead of deposits there are 'investment accounts'.

On the p&l account, there is no interest income or expense. Instead, there is income from participations, murabahat and mudarabat. Net profit is stated only after provisions and administrative expenses.

Where is the equivalent of cost of funds? Islamic banks are not capital-certain institutions but are more akin to funds, and so one has to go to the statement of distribution of profits, reflecting the fact that the investment account holders (depositors) are sharing in the business's risks and rewards, along with the bank's owners.

This treatment is increasingly rare. Nearly all Islamic banks now show net profit after a charge for cost of funds. There is another variant to watch out for. This time an Islamic bank decides to keep its equivalents of deposits as off-balance sheet liabilities. The first treatment above has the effect of artificially boosting an institution's net profit and the second the bank's net asset position.

Faysal Islamic Bank of Egypt has to comply with disclosure requirements set out by the Central Bank of Egypt. But there is another body that is trying to regularise the varied accounting practices.

The lack of thorough, comprehensive and consistent accounting standards has held up the growth of the industry out of the niche it currently occupies. It has proved difficult if not impossible to compare like with like, for Islamic institutions to trade with one another and also to estimate the real size of the industry.


The rather cumbersomely-named Accounting and Auditing Organisation for Islamic Financial Institutions, based on the island state of Bahrain in the Persian Gulf, was founded in 1993. It has to date issued 16 accounting standards covering areas such as the presentation of financial statements of Islamic banks and financial institutions, the treatment of provisions and reserves, and the treatment of the contracts such as mudaraba, musharaka, istisna and ijara (see panel).

AAOIFI has also issued statements on capital adequacy for Islamic banks and has just completed a series of exposure drafts on foreign currency transactions and foreign operations, the provisions and reserves of Islamic insurance companies and the auditing of Islamic financial institutions.

For the most part the standards are concerned with presentation and disclosure, and they seek to chime with International Accounting Standards. There are some variances, though. Most importantly, AAOIFI standards insist that if funds are earned in a non-Islamic way, say from bonds, then the proceeds have to be given to charity so that the institution is cleansed of riba.

Take leasing, or ijara as it is known in Arabic. Leasing should, on the face of it, be one area where there is no contradiction between conventional and Islamic accounting standards.

But the sharia says that a lessor is duty bound to carry out repairs to a leased asset. The risks and rewards of ownership cannot therefore be transferred to the lessee, and therefore Islamic accounting principles militate against finance leases.

More importantly, AAOIFI is also seeking to regularise sharia treatments - the rules that state which contracts are legal and which are not. This has traditionally been the preserve of each Islamic bank's sharia board, the body of scholars who oversee whether the bank's operations comply with Islamic law. The sunna, unlike the Quran, is open to interpretation, and the only people who can carry out that interpretation are sharia scholars or 'ulama. AAOIFI's writing of sharia standards therefore impinges on the power of the various sharia boards, but is probably necessary if some consistency is to be achieved.

Are Islamic accounting standards needed?

One other issue needs to be addressed - whether or not existing International Accounting Standards can cover all the transactions involved in Islamic finance. Other banks offer cost-plus transactions - Islamic banks call them murabahat - and disclose them satisfactorily enough under IAS. Islamic banks, say the sceptics, can account for their ijarat as operating leases. Tax charges are just that - Islamic banks can call them zakat. Creating a separate body of rules just when the international economy is getting to grips with a consistent body of disclosure rules is fundamentally unhelpful.

The sceptics though are missing the point.

'Arguments that Islamic finance can be accommodated within global regulatory and accounting architecture are sound but they miss the point,' says Andrew Cunningham, an expert on Islamic finance and a senior credit officer at Moody's, the credit rating agency. 'For a significant constituency of Islamic financiers, the “otherness” of Islamic finance is one of its defining qualities, far too important to be traded for any advantages which might be gained from consistency with global architecture.'

AAOIFI has some important backers - the International Monetary Fund among them. The Fund backed a recent AAOIFI trip to Iran in the hope that representations to Iranian financial institutions to produce better accounts come better from an avowedly Islamic body than they do from an international body. And AAOIFI standards are significant improvements on other local accounting treatments. Investment accounts are kept firmly on balance sheet, and the cost of funds is stated well before a 'net profit' is given.

Central role for Bahrain?

Bahrain has set out to invent itself as the centre of the Islamic banking industry. Already the leading banking centre of the Gulf region, the island hosts 16 small offshore Islamic banks and two onshore. As a central part of its efforts to gain acceptance as the centre for Islamic banking, the highly-regarded Bahrain Monetary Agency has backed AAOIFI's efforts and its development of accounting standards.

Bahrain's problem, familiar to accountants and bankers, is that obtaining that consistency means treading on the toes of jealous regulatory authorities around the Islamic world. So far, AAOIFI's standards are only mandatory in Bahrain, Sudan and Malaysia's Labuan island, which is seeking to market itself as an offshore financial centre. Elsewhere, notably in Saudi Arabia, Islamic banks have to report using conventional accounting treatments and terminology. AAOIFI is hoping to persuade Islamic banks in jurisdictions that are not eager to allow exceptions from a conventional rule to publish supplementary information to demonstrate to investors that the institution is indeed being run along Islamic lines.

James Drummond is a Financial Times correspondent based in Cairo.

Islamic terms explained

Alim (pl 'ulama): an Islamic scholar.

Haram: forbidden under Islamic law.

Ijara: leasing. The lessor pays a specified sum to the owner to use a specified asset for an agreed period. Hire-purchase is also generally licit and is known as ijara wa iqtina.

Istisna: akin to leasing and often used for medium-term working capital financing in which funds are paid over in accordance with agreed levels of completion.

Mudaraba: one of the most common types of transaction both on the asset and liability side of an Islamic institution's balance sheet. The investor places funds with a bank or fund as an intermediary. The bank then invests in a business as sole investor and the investor shares the resulting profits or losses. An investor can place money with a bank and share in the overall profits of the institution or in those of a specific project. The investor's rate of return is determined retrospectively.

Murabaha: an investor places money in a project for an agreed period to earn an agreed mark-up. This is the contract Islamic banks use to manage their short-term liquidity requirements - usually by wrapping the transaction up in a commodities transaction.

Musharaka: the bank is not the sole equity participant in the project. Profits and losses are shared according to the proportions of equity invested.

Qard Hassan: interest free loans encouraged by the Quran. Borrowers may be charged a service fee as long as this is not related to the term or size of the loan.

Riba: usury.

Ribh (pl Arbah): profit(s).

Sharia: Islamic law derived from the Quran and the hadith or sayings of the Prophet, which together form the sunna or correct practice to be observed.

Takaful: mutual insurance.

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