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"Objectives
of Financial Accounting for Islamic Banks and
IFIs" and "Objective and
Principles of Auditing"
Accounting encompasses several areas, generally
agreed to include financial accounting,
managerial accounting, cost accounting, and
accounting for non-for-profit organizations. We
are concerned here only with financial
accounting.
3/1 Financial accounting
Financial accounting has developed over time for
many practical considerations relating to the
need of entities to determine their financial
rights and obligations, and results of
operations, and to inform present and potential
parties concerned with the affairs of the entity
of its financial position, the results of its
operations and its cash flows. This information
is intended to assist those parties in making
suitable decisions with respect to the entity.
Thus financial accounting plays an important
role in directing economic resources in society
to different entities as a result of the
decisions made by the parties concerned with the
affairs of those entities. These decisions are
based, among other things, on information
available to them through financial accounting
which ranks as one of the important sources of
the basic information required for decision
making. During the period of its development, a
number of rules and principles have been
accumulated which specify the processes of
financial accounting, its general objectives and
limitations.
3/2 The financial accounting processes
Financial accounting consists of the following
processes:
(a) Accounting recognition of an entity’s
financial rights and obligations as of a given
date and changes in those rights and obligations
resulting from consummated transactions and
other events during a given period.
(b) Measurement of the financial effect of
consummated transactions and the impact of other
events during a given period.
(c) Classifying the financial effect of
consummated transactions and other events for
the purpose of determining the entity’s results
of operations and other changes in its financial
position including its cash flows.
(d) Preparing periodic reports about the
entity’s financial position as of a given date
and the results of its operations and cash flows
during a given period.
3/3 The general objectives of financial accounting
The main objective of financial accounting is to
provide information, through periodic reports,
about the entity’s financial position, its
results of operations and cash flows, to assist
users of such reports in making decisions. The
financial statements (statement of financial
position, income statement, the statement of
cash flows, and related notes) are the main type
of reports provided by financial accounting.
Financial accounting also provides important
information which assists the entity’s
management in directing available economic
resources. Accordingly, it facilitates
management efforts in planning, directing and
supervising the entity’s activities. It also
facilitates the roles of governmental agencies
responsible for supervising the national economy
and for collecting tax based on the financial
information which it produces.
3/4 Limitations of information provided by
financial accounting
Financial accounting does not provide all the
information required by those who need to make
decisions about the entity. This is so because
of many reasons, including those related to the
nature of the financial accounting processes,
and those related to cost and benefit
considerations. The following are some aspects
of the limitations of information produced by
financial accounting and the reasons for such
limitations.
3/5 Limitations resulting from the nature of the financial
accounting processes
(a) Financial accounting is concerned
mainly with measuring the financial effect of
transactions and other events on the entity’s
financial position, results of operations and
cash flows. Accordingly, financial accounting is
not usually able to produce information to
assist in the evaluation of the entity’s ability
to achieve objectives that are not capable of
financial measurement in an objective manner.
(b) Financial accounting does not
differentiate, through its processes, between
the entity’s performance and that of its
management. Although, management ability is one
of the important factors that affect the
entity’s performance, there are other factors
beyond management control which affect the
entity’s performance such as natural disasters
and external political and economic changes.
Accordingly, it is not currently possible for
financial accounting to provide information
which can assist in evaluating management
performance aside from the entity’s performance.
(c) The information currently provided by
financial accounting is historical in nature
which may or may not be indicative of the
future. Yet, decisions made by those who need
this information are concerned with the future
impact of alternative courses of action.
(d)
Financial
accounting relies to a very great extent on
estimates when measuring the financial effect of
transactions and other events on the entity’s
financial position and the results of
operations; for example, depreciation of fixed
assets, doubtful receivables, etc. Such
estimates are based on assumptions determined by
management which may or may not turn out to be
accurate.
3/6 Limitations resulting from cost and
benefit consideration
The information which financial
accounting produces has costs associated with
its preparation, presentation and usage.
Accordingly, cost considerations affect the
information produced by financial accounting.
One of the results of cost considerations is the
emphasis in financial accounting on the
production of general purpose financial reports
to serve the common information needs of
multiple external users.
4. The importance of establishing objectives of
financial accounting for Islamic banks and
financial institutions
4/1 The importance of establishing objectives
Human experience proved that any work
which does not have clear objectives encounters
limitations, conflicts and blurred vision in its
implementation. Financial accounting and
financial reporting are no exception to this
precept. Accounting scholars and practitioners
alike have found that the process of developing
financial accounting standards without
establishing objectives leads to inconsistent
standards which may not be suitable for the
environment in which they are expected to be
applied.
Agreement on the objectives of
financial accounting for Islamic banks would
achieve many benefits:
(a) The objectives will be used as a guide
by the Financial Accounting Standards Board for
Islamic Banks and Financial Institutions when
developing financial accounting standards. This
should assure consistency in developing
standards.
(b) The objectives will assist Islamic
banks, in the absence of accepted accounting
standards, in making choices among alternative
accounting treatments.
(c) The objectives will be available as a
guide and a regulator of subjective judgment
made by management when preparing the financial
statements and other financial reports.
(d) The objectives, when properly defined,
should increase users’ confidence and
understanding of accounting information and, in
turn, their confidence in Islamic banks.
(e) Establishing objectives should lead to
the development of accounting standards which
are likely to be consistent with each other.
This should increase users’ confidence in the
financial reports of Islamic banks.
4/2 Differences between the objectives of financial accounting and
financial reports for Islamic banks and
objectives of financial accounting for other
banks
Financial accounting is mainly
concerned with providing information to assist
users in making decisions. Those who deal with
Islamic banks are concerned, in the first place,
with obeying and satisfying Allah in their
financial and other dealings. Allah says “O ye
people! eat of what is on earth. Lawful and
good; and do not follow the footsteps of the
Evil One, for he is to you an avowed enemy”.
(Chapter 2: verse 168). The objectives of
financial accounting for other banks have, for
the most part, been established in non-Islamic
countries. It is natural, therefore, that there
should be differences between objectives
established for other banks and those to be
established for Islamic banks. Those differences
stem mainly from differences in the objectives
of those who need accounting information and,
therefore, in the information they need. This
does not mean, however, that we should reject
all the results of contemporary accounting
thought in non-Islamic countries. This is so
because there are common objectives between
Muslim and non-Muslim users of accounting
information. For example, Muslim and non-Muslim
investors share in their desire to increase
their wealth and to realize acceptable returns
on their investments. This is a legitimate
desire which has been recognized in Shari’a
consistent with Allah’s saying “It is He Who has
made the earth manageable for you, so traverse
ye through its tracts and enjoy of the
sustenance which He furnishes” (excerpt from
chapter 67:verse 15).
In addition to the above, there are
other reasons why different objectives of
financial accounting should be established for
Islamic banks. Those are:
(a) Islamic banks must comply with the
principles and rules of Shari’a in all their
financial and other dealings.
(b) The functions of Islamic banks are
significantly different from those of
traditional banks who have adopted the Western
model of banking.
(c)
The relationship
between Islamic banks and the parties that deal
with them differs from the relationship of those
who deal with traditional banks. Unlike
traditional banks, Islamic banks do not use
interest in their investment and financing
transactions, whereas traditional banks borrow
and lend money on the basis of interest. Islamic
banks mobilize funds through investment accounts
on the basis of Mudaraba (i.e. sharing of profit
between the investor who provides the funds and
the bank which provides the effort) and invest
these funds on the basis of Mudaraba, profit and
loss sharing mechanisms, or deferred payments
methods consistent with the Shari’a.
Hence, accounting standards developed
for traditional banks may not be relevant to
Islamic banks. Nevertheless, in developing
accounting standards for Islamic banks, the
Board may be guided by clear objectives and
concepts which are appropriate for other banks
provided they are in compliance with the Shari’a
precepts.
5. The approach to establishing objectives of
financial accounting for Islamic banks and
financial institutions
Two approaches to
establishing objectives have emerged through the
discussion which took place at different
meetings of the committees established by the
Board. These are:
(a) Establish objectives
based on the principles of Islam and its
teachings and then consider these established
objectives in relation to contemporary
accounting thought.
(b) Start with objectives
established in contemporary accounting thought,
test them against Islamic Shari’a, accept those
that are consistent with Shari’a and reject
those that are not.
In order to test each approach and select an appropriate one, a
Shari’a scholar was requested to prepare a
working paper on the objectives of financial
accounting for Islamic banks consistent with the
first approach, and an accounting scholar was
requested to prepare a separate working paper
consistent with the second approach. In
addition, a joint working paper was prepared by
a Shari’a expert and an accounting expert.
Several joint meetings were held to present and
discuss those working papers. It was agreed that
one of the Shari’a scholars, who attended the
meetings, prepare a paper summarizing the
results of those discussions and the views
presented in the working papers. This last paper
was presented and discussed at a meeting of the
Committee attended by several Shari’a and
accounting scholars. Based on the results of
those efforts, it was agreed that the second
approach, described above, should be adopted to
establish objectives of financial accounting for
Islamic banks and financial institutions.
5/1 The major users of financial reports
Financial reports include not only
financial statements but also other means of
communicating information that relates, directly
or indirectly, to the information provided by
financial accounting.
The objectives of financial accounting
determine the type and nature of information
which should be included in financial reports,
in order to assist users of these reports in
making decisions. Therefore, the objectives of
financial accounting should focus on the common
information needs of users of financial reports.
In addition, the objectives should focus on the
common information needs of those users who do
not have the authority or ability to directly
obtain the information they need, or access to
such information. This focus stems from two
reasons, namely the ability of other users to
directly obtain from the entity the information
they need to make decisions; and the need for
accountants to make a choice among a variety of
contending information needs of different users
because of the limited nature of what could be
included in financial reports. This does not
mean, however, that financial reports which are
focused on the common information needs of users
with limited access to information will not be
useful for others.
The main categories of users of
external financial reports for Islamic banks
whose information needs are addressed in this
statement include:
a) Equity holders.
b) Holders of investment accounts.
c) Other depositors.
d) Current and saving account holders.
e) Others who transact business with the
Islamic bank, who are not equity or account
holders.
f) Zakah agencies (in case there is no legal
obligation for its payment).
g) Regulatory agencies.
5/2 Common information needs of users of financial reports who do
not have the authority or ability to obtain
additional information from the Islamic bank
The information needs of users of
financial reports increase and vary with the
increase in the categories of users for example
investors including equity and investment
account holders, creditors including current
depositors, savings depositors, debtors,
employees of the Islamic bank, other financial
and banking institutions, and those who deal
with the Islamic banks in any other manner.
Government agencies have the power and
authority to directly obtain the types of
information that best serve their needs. On the
other hand, other external users are limited to
the information contained in the Islamic bank’s
financial reports. Accordingly, it is essential
that the common information needs of these
categories of users be the focus of financial
reports. It should be emphasized, however, that
financial reports, because of cost
considerations, cannot be expected to provide
for every possible information need of these
categories of users, particularly those needs
that are not common to all users.
It is possible to summarize the common
information needs of users as follows:
(a) Information which can assist in
evaluating the bank’s compliance with the
principles of Shari’a in all of its financial
and other dealings.
(b) Information which can assist in
evaluating the bank’s ability in:
1. Using the economic resources available to
it in a manner that safeguards these resources
while increasing their value, at reasonable
rates.
2. Carrying out its social responsibilities
and in particular those that have been specified
by Islam, including the good use of available
resources, the protection of the rights of
others and the prevention of corruption on
earth.
3. Providing for the economic needs of those
who deal with the bank.
4. Maintaining liquidity at appropriate
levels.
(c) Information which can assist those
employed by the bank in evaluating their
relationship and future with the Islamic bank,
including the bank’s ability to safeguard and
develop their rights and develop their
managerial and productive skills and
capabilities.
(d) It is assumed that the types of
information described above represent the
minimum required to satisfy the common
information needs of external users of financial
reports.
5/3 Other financial reports
Financial reports which are intended to
provide for the common information needs of
external users have been divided into the
following categories:
(a) Those that are currently produced by
financial accounting in the form of financial
statements and related notes.
(b)
Those that could
be produced by financial accounting or other
information systems of Islamic banks in the form
of other financial reports, which are not
currently being produced.
The distinction between these two
categories of reports is essential at this stage
of the Board’s efforts for the following
reasons:
1. The first category of reports, i.e. the
financial statements and related notes, is the
main output of financial accounting. In
addition, they are generally known and are
prepared in accordance with standards that
provide reasonable assurance of fairness in the
presentation of the financial position, results
of operations and cash flows.
2. The second category of reports lacks a
generally accepted definition and there is no
assurance that they would contain reliable and
fair presentations of information required by
those who deal with Islamic banks for a variety
of reasons, including the limitations of the
financial accounting processes.
Notwithstanding the above, objectives
will be established for all financial reports as
a group to guide the development of accounting
standards for Islamic banks. The future plans of
the Board will address the specific objective(s)
of each report and its concept and develop the
standards for its preparation to assure its
accuracy.
Examples of these types of other
financial reports for Islamic banks include:
(a) Analytical financial reports about
sources of funds for Zakah and their uses.
Although the financial statements of
Islamic banks will disclose the liability for
Zakah and the amount that has been disbursed,
users of financial statements might be
interested in additional analysis of sources of
funds for Zakah, methods of its collection
including controls to safeguard these funds and
their uses.
(b) Analytical financial reports about
earnings or expenditures prohibited by the
Shari’a
It is our intent for the financial
statements to disclose income earned by the
Islamic bank from prohibited transactions or
sources and expenditures prohibited by the
Shari’a and how those earnings were disposed of.
However, users of the financial statements may
be interested in detailed financial reports.
Such reports may include information about the
causes of such earnings, their sources, how they
were disposed of and procedures established to
prevent entering into transactions prohibited by
the Shari’a.
(c) Reports concerning the Islamic bank’s
fulfillment of its social responsibilities
Islam has always been concerned with
the concept of social responsibility whether
that responsibility be for the welfare of
society or the prevention of harm. Indeed, this
can be clearly observed in the Quranic verses,
the sayings and deed of the Prophet (may the
blessing and peace of Allah be upon him), and
Islamic jurisprudence. For example, Allah said
“But seek with the (wealth) which Allah has
bestowed on thee, the Home of the Hereafter, nor
forget thy portion in this world: but do thou
good, as Allah has been good to thee and seek
not (occasions for) mischief in the land; for
Allah loves not those who do mischief”. (Chapter
28: verse 77). The Prophet (may the peace and
blessings of Allah be upon him) said “The most
loved by Allah among the people are those
helpful to others”. The Prophet also said “There
should be neither harming nor reciprocating
harm”. Hence, Islam prohibits the Muslim from
causing harm to himself, to others, his
environment or society in the pursuit of
material returns. This shows that Islam
spearheaded this concept which did not develop
in the West except recently.
(d) Reports about the development of the
Islamic bank’s human resources
Those reports may contain information
about and the bank’s efforts to develop its
human resources whether with respect to their
knowledge of Shari’a or economics. In addition
it would include the bank’s efforts in
encouraging its employees to be effective and
efficient.
6. Objectives of financial accounting and
financial reports for Islamic banks and
financial institutions
6/1 Objectives of financial accounting
(a) To determine the rights and obligations of all interested
parties, including those rights and obligations
resulting from incomplete transactions and other
events, in accordance with the principles of
Islamic Shari’a and its concepts of fairness,
charity and compliance with Islamic business
values.
(b) To contribute to the safeguarding of the Islamic bank’s
assets, its rights and the rights of others in
an adequate manner.
(c) To contribute to the enhancement of the managerial and
productive capabilities of the Islamic bank and
encourage compliance with its established goals
and policies and, above all, compliance with
Islamic Shari’a in all transactions and events.
(d) To provide, through financial reports, useful information
to users of these reports, to enable them to
make legitimate decisions in their dealings with
Islamic banks.
6/2 Objectives of financial reports
Financial reports, which are directed mainly to
external users, should provide the following
types of information:
(a) Information about the Islamic bank’s compliance with the
Islamic Shari’a and its objectives and to
establish such compliance; and Information
establishing the separation of prohibited
earnings and expenditures, if any, which
occurred, and of the manner in which these were
disposed of.
(b) Information about the Islamic bank’s economic resources
and related obligations (the obligations of the
Islamic bank to transfer economic resources to
satisfy the rights of its owners or the rights
of others), and the effect of transactions,
other events and circumstances on the entity’s
economic resources and related obligations. This
information should be directed principally at
assisting the user evaluating the adequacy of
the Islamic bank’s capital to absorb losses and
business risks; assessing the risk inherent in
its investments and; evaluating the degree of
liquidity of its assets and the liquidity
requirements for meeting its other obligations.
(c) Information to assist the concerned party in the
determination of Zakah on the Islamic bank’s
funds and the purpose for which it will be
disbursed.
(d) Information to assist in estimating cash flows that might
be realized from dealing with the Islamic bank,
the timing of those flows and the risk
associated with their realization. This
information should be directed principally at
assisting the user in evaluating the Islamic
bank’s ability to generate income and to convert
it into cash flows and the adequacy of those
cash flows for distributing profits to equity
and investment account holders.
(e) Information to assist in evaluating the Islamic bank’s
discharge of its fiduciary responsibility to
safeguard funds and to invest them at reasonable
rates of return, and information about
investment rates of returns on the bank’s
investments and the rate of return accruing to
equity and investment account holders.
(f) Information about the Islamic bank’s discharge of its
social responsibilities.
* * *
Objective of an Audit
2. The objective of an audit of financial
statements is to enable the auditor to express
an opinion as to whether the financial
statements are prepared, in all material
respects, in accordance with the Shari’a Rules
and Principles, the accounting standards of the
Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) and relevant
national accounting standards and practices in
the country in which the financial institution
operates. The phrase used to express the
auditor’s opinion is “give a true and fair
view”.
3. Although the auditor’s opinion enhances
the credibility of the financial statements, the
user cannot assume that the opinion is an
assurance as to the future viability of the
financial institution or as to the efficiency or
effectiveness with which management has
conducted the affairs of the financial
institution.
General Principles of an Audit
4. The auditor should comply with the “Code
of Ethics for Professional Accountants” issued
by the AAOIFI, and the International Federation
of Accountants which do not contravene Islamic
Rules and Principles. Ethical principles
governing the auditor’s professional
responsibilities include:
(a) righteousness
(b) integrity
(c) trustworthiness
(d) fairness
(e) honesty
(f) independence
(g) objectivity
(h) professional competence
(i) due care
(j) confidentiality
(k) professional behaviour
(l) technical standards
5. The auditor should conduct an audit in
accordance with ASIFIs, which are auditing
standards approved by the Accounting and
Auditing Organization for Islamic Financial
Institutions. These contain basic principles and
essential procedures together with related
guidance in the form of explanatory and other
material.
6. The auditor should plan and perform the
audit with professional competence and due care
recognizing that circumstances may exist which
cause the financial statements to be materially
misstated. For example, the auditor would
usually expect to find evidence to support
management representations and not automatically
assume that they are necessarily correct.
Scope of an Audit
7. The term “scope of an audit” refers to
the audit procedures deemed necessary by the
auditor in the circumstances to achieve the
objective of the audit. The procedures required
to conduct an audit in accordance with ASIFIs
should be determined by the auditor having
regard to the requirements of appropriate
Islamic Rules and Principles, ASIFIs, relevant
professional bodies, legislation, regulations
which do not contravene Islamic Rules and
Principles, and, where appropriate, the terms of
the audit engagement and reporting requirements.
International Standards on Auditing (ISAs) shall
apply in respect of matters not covered in
detail by ASIFIs providing these do not
contravene Islamic Rules and Principles.
Reasonable Assurance
8. An audit is designed to provide
reasonable assurance that the financial
statements taken as a whole are free from
material misstatement. Reasonable assurance is a
concept relating to the accumulation of the
audit evidence necessary for the auditor to
conclude that there are no material
misstatements in the financial statements taken
as a whole. Reasonable assurance relates to the
whole audit process.
9. Reasonable assurance also means that the
auditor has satisfied himself that the
transactions he examined during his audit comply
with Islamic Shari’a Rules and Principles as
determined by the Shari’a Board of the financial
institution.
10. However, there are inherent limitations
in an audit that affect the auditor’s ability to
detect material misstatements. These limitations
result from factors such as:
(a) the use of sampling while testing
transactions and balances
(b) the inherent limitations of any accounting
and internal control system (including,
for example, the possibility of collusion)
(c) the fact that most audit evidence is
persuasive rather than conclusive
11. Also the work undertaken by the auditor
to form an opinion is based on judgement,
regarding in particular:
(a) the gathering of audit evidence, for example, in deciding
the nature, timing and extent of audit
procedures, and
(b) the drawing of conclusions based on the audit evidence
gathered, for example, assessing the
reasonableness of the estimates made by
management in preparing the financial statements
12. Further, other limitations may affect the
persuasiveness of audit evidence available from
which to draw conclusions on aspects of the
financial statements (for example, transactions
between related parties). In these cases certain
ASIFIs identify specified procedures which may,
because of the nature of these aspects, provide
sufficient appropriate audit evidence in the
absence of:
(a) unusual circumstances which increase the risk of material
misstatement beyond that which would ordinarily
be expected, or
(b) any indication that material misstatement exists
Responsibility for the Financial Statements
13. While the auditor is responsible for
forming and expressing an opinion on the
financial statements, the responsibility for
preparing and presenting the financial
statements in compliance with Islamic Shari’a
Rules and Principles and relevant legislation
and regulations is that of the management of the
financial institution. (Consideration should be
given to the definition of management in
relevant national legislation and regulations.)
The audit of the financial statements does not
relieve the management of the financial
institution of this responsibility.
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