Structure of Financial Statements of Islamic Banks

Structure of Financial Statements of Islamic Banks

For Islamic financial institutions, the nature of financial intermediation, including the function of banking, is different from that of conventional financial institutions. This difference is key to understanding the difference in the nature of risks in conventional and Islamic banking. For Islamic banks, themudarabah contract is the cornerstone of financial intermediation and thus of banking. In a mudarabah contract, the owner of the capital forms a partnership with the entrepreneur or a manager who has certain business skills and both agree to share the profit and loss of a venture undertaken. Such a structure can be applied by an Islamic bank to raise funds in the form of deposits as well as to deploy funds on the asset side.

The basic concept is that both the mobilisation and (in theory) the use of funds are based on some form of profit sharing, among depositors, the banks and entrepreneurs (users of funds). A typical Islamic bank performs the functions of financial intermediation by screening profitable projects and monitoring the performance of projects on behalf of the investors who deposit their funds with the bank.

Liabilities

The liabilities side of the balance sheet is based on the “two-window” theoretical model of an Islamic bank. In addition to equity capital, this model divides the liability or funding side of the bank balance sheet into two windows, one for demand deposits and the other for investment or special investment accounts. The choice of the window is left to the depositors. Unlike conventional commercial banks, the investment accounts of an Islamic bank are not liabilities in the strictest sense because depositors in a conventional bank create immediate claims on the bank, whereas investors-depositors in Islamic banks are like partners.

In addition, special or restricted investment accounts are often shown as off-balance sheet funds under management. A 100 percent reserve is required for demand deposits (but no reserve is stipulated for the second window). This 100 percent requirement is based on the presumption that the money deposited as demand  deposits is placed as amanah (trust): they yield no returns and are repayable on demand and at par value.

Money deposited in investment accounts, in contrast, is placed with the depositors’ full knowledge that their deposits will be deposited in risk-bearing projects; no guarantee is needed or justified. Investment account holders are investors or depositors who enter into a mudarabah contract with the bank, where investors act as supplier of funds (rab al mal) to be invested by the bank on their behalf, as agent or manager of the funds (mudarib). The investors share in the profit accruing to the bank’s investments on the asset side. Therefore, such profit-sharing investments are not guaranteed, and they incur losses if the bank does. Some Islamic banks also offer special-investment accounts developed on the basis of a special-purpose or restricted mudarabah or on profit and loss sharing (musharakah). These special investment accounts, which are similar to closed-end mutual funds, are highly customized and targeted towards high-net-worth individuals.

Assets

On the asset side Islamic banks have more choice of instruments with different maturities and risk-return profiles. For short-term trade financing or financial claims resulting from a sales contract – that is murabaha, salam, and so forth – are available. For medium term investments, leasing (ijarah), manufacturing (istisna’a), and various partnerships are possible; for long-term investments, partnerships in the form of musharakah can be undertaken. An Islamic financial intermediary may also engage an external entrepreneur – on amudarabah basis in which the bank acts as principal and the entrepreneur (user of funds) acts as agent. In this capacity, an Islamic bank can form a syndicate with other financial institutions or non-financial institutions to provide entrepreneurs with medium-to long-term capital. Finally, like conventional banks, Islamic banks also provide customized services, guarantees, and underwriting services for a fee.

Disclosure and Transparency

Public disclosure through the publication of financial statements has long been the source of information on business performance of financial institutions. In recent years, however, financial institutions, under pressure from market forces, have started focusing on the disclosure of a wide range of information, including management policies, risk exposures and risk management practices. Given that disclosure disciplines management of financial institutions and helps to enhance the efficiency and transparency of the markets, it has acquired great significance in promoting the stability of financial system.

Moreover, its importance in enabling investors and parties to assess risks and returns of investing in, or dealing with, a particular institution has grown due to the increasing number of risks that financial institutions now take. The expansion in the role of disclosure also encouraged regulatory authorities in various jurisdictions to make it legally binding on financial institutions to follow a set of certain minimum disclosures in their annual reports.

Like conventional banks/financial institutions, Islamic banks and financial institutions are engaged in the business of dealing in money (collection of deposits and lending and investing). However, the fact, which distinguishes them, is that their dealings with depositors are based on profit and loss sharing rather than a fixed predetermined interest. This signifies an Islamic bank’s fiduciary role where it is considered to be dealing in trust money. Thus depositors’ / investment account holders’ trust in an Islamic bank’s ability to achieve investment goals (to record profit) and make a fair distribution of the revenues between itself and the investment account holders (according to the mudarabah agreement) become paramount in the continuity of the Islamic bank’s business.

Given this importance, Islamic banks are obliged to be transparent by making adequate disclosures to their investment account holders, not only with regard to their own financial condition as is the case with conventional banks but also in respect of the management of trust money. This is the area, going beyond  disclosure, where topics such as participation of stakeholders in the corporate governance of Islamic banks and developing effective control and accountability mechanisms to enhance fiduciary relationships in Islamic banks become relevant.

Qualitative characteristics of accounting information

Conventional accounting theory discusses the qualities of relevance, reliability, comparability and understandability essential for accounting information, although these characteristics are quite general they are equally applicable to the Islamic accounting framework.

Income statement 

The basic elements of the statement include revenues, expenses, gains, losses, return (profit or loss) on unrestricted investment accounts and their equivalent and net income or net loss.

Information to be disclosed in financial statement

The basic principle is that all information that helps to make the financial statement understandable should be disclosed. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has issued standards on disclosure of information desirable in the Islamic financial institutions financial statements.

Accounting definitions for Islamic banks

The following definitions set out a general conceptual framework for the financial statements of Islamic banks.

1. Assets

An asset is anything that is capable of generating positive cash flows or other economic benefits, either itself or in combination with other assets. However, to be recognised as an asset in the balance sheet, it should have the following additional characteristics:

a) It should be recognized as valid from the Shari’ah point of view. It means such “assets” as interest receivable in the conventional banks’ balance sheet will not treated as asset in the balance sheet of Islamic banks.

b) It should be capable of financial measurement with a reasonable degree of reliability.

c) The bank must be able to obtain benefit from it and control the access of others to it.

d) It should not be associated with an obligation or a right to another party.

2. Liabilities

Liability is an obligation arising from a transaction or other event that has already occurred and that involves the Islamic bank in a probable future transfer of cash, goods or services, or the forgoing of a future cash receipt, the date of which and the settlement of which are measurable with reasonable accuracy.

Generally, a liability should be enforceable under the Shari’ah rules. But if an Islamic bank incurs an obligation which is not valid under the Shari’ah it will still have to be recognised as a liability, although disclosed distinctly as such. 

3. Equity of unrestricted account holders

The equity of unrestricted account holders refers to funds received by the Islamic bank from depositors on the basis that the bank will have the right to use those funds without restrictions to finance the bank’s investments within the Shari’ah framework. The value of the equity of unrestricted account holders in the balance sheet is equal to the amounts deposited plus any profit or minus any loss or withdrawals.

The equity holders of unrestricted investment accounts are not the owners of the bank. Therefore, they are not liable to pay any liabilities of the bank, nor do they have any voting rights.

4. Ownership Equity

Ownership equity refers to the amount remaining on the balance sheet date from the bank’s assets after deducting the bank’s liabilities, the equity of restricted and unrestricted investment account holders and any impure earnings.

5. Revenues

Revenues are gross increases in assets or decreases in liabilities during the period covered by the income statement, which result from legitimate investment, trading and other profit-oriented activities of the Islamic bank, including delivery of services.

The gross increase in assets and decrease in liabilities should have the following characteristics:

a) It should not be the result of investment by owners, deposits by investment account holders, deposits by current account holders or the disposal of assets.

b) The gross increase in assets or decrease in liabilities should belong to the period covered by the income statement.

6. Expenses

Expenses are gross decreases in assets or increases in liabilities during the period covered by the income statement, which result from legitimate investment, trading and other activities of the bank, including delivery of services. The gross decrease in assets or increase in liabilities should have the flowing additional characteristics:

a) It should not be the result of distribution of dividend to owners, withdrawals by current account holders, withdrawals by owners or investment account holders or acquisition of assets.

b) The gross decrease in assets or increase in liabilities should belong to the period covered by the income statement.

7. Net income (net loss)

Net income (net loss) for the period covered by the income statement is the net increase (or decrease) in owners’ equity resulting from revenues (expenses), gains (losses), after allocating the return on investment accounts and their equivalent, for the period. It is the result of all ongoing profit oriented operations of the bank and other events and circumstances affecting the value of assets held by the Islamic bank during the period covered by the income statement. 

8. Return on Investment accounts

The return on restricted or unrestricted accounts is the share of those account holders in investment profits and losses which they participated in financing with the bank during the period covered by the income statement. The return on investment accounts is not an expense (in the case ) of profit or revenue (in the case of loss) of the bank. It is an allocation of the bank’s income or loss.

9.      Investment by owners

The investment by owners is the amount of increase in owners’ equity resulting from the non-reciprocal transfer by owners to the Islamic bank of assets or services, the assumption or payment by owners of an obligation of the bank for the purpose of increasing their equity in the bank or accrual of any profit to owners from the bank’s operations.

10. Distribution to owners

The distribution to owners is the amount of decrease in owners’ equity resulting from nonreciprocal transfer by the bank to the owners of the assets or services; or by assumption or payment by the bank of an obligation of the owners for the purposes of reducing their equity in the bank.

11. Cash and cash equivalent

The cash and cash equivalent include local and foreign currency and demand deposits at other institutions.

12. Restricted investments

Restricted investment refers to assets acquired by funds provided by holders of restricted investment accounts. The Islamic bank does not own these assets. The bank only manages them either for a fixed fee or, in a mudarabah contract, for profit. In the former case, the bank gets the fee anyway, but in the case of mudarabah, it  receives a share if there is a profit. In the case of loss, the bank does not get anything. Its services are included in the income statement as an expense.

14. Zakat Fund

Zakatis an obligatory payment on certain types of wealth and income. It has been prescribed in the Qur’an and Sunnah. The Islamic banks have a dual role with regard to this obligation. They collect zakat from the owners, account holders, employees and any body else who wishes to pay it through the Islamic banks. The banks can charge a fee for managing this fund. The fee will be the bank’s income. The second role of the bank is to calculate thezakat liability of the owners and pay it into a zakat fund. The zakat of the owners is payable @ 2.5% on current cash equivalents of the assets of the banks except on fixed assets such as land or building or the equipment of the bank. Any property of the bank not used for its own operations will also be assessed forzakat. But assets which have been leased out will payzakat @ 10% on the lease income after deducting any direct expenses or direct taxes.

15. Qard Hasan Fund

The Qard Hasan fund consists of revolving funds for extending interest-free loans for a period of time. In some cases, the loans may be forgiven. Sources of this fund could be a part of current account deposits, contributions by the owners for this purpose, or any impure earnings of the bank derived from prohibited activities (until they are properly disposes of).

We are Fathers. We are Mothers. We are Sisters. We are Brothers. We are Aunts. We are Uncles. It’s time to fight back Follow www.Twitter.com

Find More Financial Time Articles

Tags: , , , ,