In this part . . .
Much like their conventional counterparts, Islamic finance institutions are governed by regulatory agencies and accounting standards and must issue financial statements so regulators and investors can study their performance. I open this part with a chapter that focuses on those statements and points out how they may differ from the statements of conventional financial firms.
Next, I turn to the governance at Islamic financial institutions and how it may differ from that of a conventional firm. One key piece of the governance puzzle is supervision by a sharia board, which ensures that an Islamic institution’s operations and products comply with sharia (Islamic law). I devote Chapter 16 to explaining what this board looks like and what it does.
Finally, I dive into how Islamic financial firms manage risk — a primary function of corporate governance. In addition to all the risks that a conventional financial firm faces, Islamic institutions have particular risks related to ensuring sharia compliance. I explain those risks and how they’re mitigated in Chapter 17.
In This Chapter
Reviewing the purpose of financial statements
Comparing Islamic and conventional financial statements
Getting to know the source of Islamic accounting standards
If accounting or auditing is your thing, you’ve come to the right place. But if not, don’t skip out just yet! My purpose in this chapter isn’t to delve into detail about what each line of a corporate financial statement means or to parse specific accounting standards. Instead, I just want to explain why some financial statements issued by an Islamic financial institution may look different from those issued by its conventional counterpart. From the perspective of end users, what do those differences mean?
I start with a quick review of the key financial statements issued by most companies and then turn the spotlight on Islamic financial institutions. I offer some detailed analysis of what’s included on the balance sheet and income statement for an Islamic company that you won’t find on a conventional version of these reports, and I introduce four statements that are unique to Islamic institutions. (I don’t spend time covering the cash flow statement and statement of retained earnings or owners’ equity because these reports are largely the same for Islamic and conventional companies.)
Finally, I touch on the role of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in setting and enforcing accounting standards in the Islamic financial sector.
To keep the size of this chapter under control, I don’t attempt to cover the specific financial statements of every type of Islamic financial institution. When I discuss how the balance sheet and income statement are prepared in the Islamic finance world, I use Islamic banks as my model institution. They are, after all, the cornerstone of the Islamic finance industry (see Chapter 4). Although other Islamic financial institutions follow the same format when generating their statements, their specific product offerings and funds differ from those of an Islamic bank.
Getting a Financial Statement Refresher
Financial statements provide information about the performance of a business organization and its financial positions. In this section, I offer just the briefest refresher on financial statements: their purposes, users, and basic requirements. If you need more information on this topic, check out Financial Accounting For Dummies by Maire Loughran (Wiley).
Recognizing the most commonly issued statements
These four financial statements are generally issued by all businesses, including conventional and Islamic financial institutions:
Balance sheet: A statement of financial position or standing of the company, the balance sheet explains the sources and uses of funds.
Income statement: The best tool to use to understand the performance of a company, the income statement describes how the business has performed during the year and documents its income and expenses.
Cash flow statement: A report of how cash and cash equivalents have moved through the business during the year, the cash flow statement is crucial for monitoring a company’s fund management.
Statement of retained earnings or owners’ equity: This report helps stockholders see what happened to their investments during the year and how their equity with the business changed.
The two most important financial statements are the balance sheet and income statement because they illuminate the overall health of an organization. A company’s board of directors, managers, investors, and other stakeholders rely most heavily on these two statements to determine whether the company is moving in the right direction.
Spotting statement users
Stakeholders of a business use financial statements for various purposes. In the accounting world, the users of financial statements are generally divided in two categories:
Internal users: People inside the organization, such as employees, managers, and the board of directors, who are most interested in using the financial information to make decisions regarding business operations.
External users: People outside the organization who have an interest in its financial performance. These folks may be any of the following:
• Stockholders watching investments that fluctuate in value based on the company’s financial health
• Potential investors considering whether to put money into the organization
• Trade unions making decisions about possible union actions
• Competitors reviewing market trends and the performance of other companies in the same industry
• Governmental organizations monitoring taxation and other regulations
• Financial institutions keeping track of how their loans are being used or considering whether to extend a loan to the company
• Customers curious about the organization’s performance or its socially responsible activities
Issuing statements publicly and regularly
Generally, regulations dictate that a public corporation’s financial statements be publicly available and published in its annual report. The financial statements for private partnership businesses or sole proprietorships may or may not be published, depending on owner preference, and aren’t usually required to be made public.
Financial statements are most often prepared annually, but they may be prepared at other intervals (semiannually, quarterly, or even monthly) depending on a company’s internal controls (a subject I cover in Chapter 15).
Focusing on statements for financial institutions
The financial statements for financial institutions (both conventional and Islamic) differ from those for manufacturing, merchandising, and service businesses. Financial institutions — intermediaries for savings, investment, and borrowing — have unique features that include risk and leverage. Thus, their statements are unique and tend to receive much closer inspection from government regulators than those of businesses in other industries.
Why the extra attention? Individuals, corporations, and governments all deposit money in financial firms. If this money is lost, the impact is serious.
Consider the Bernie Madoff case: the largest financial fraud in U.S. history. Investors relied on the information in financial statements for Madoff’s company (which were audited, by the way) as they made decisions about how to invest their money. Clearly, this case illustrates that a financial institution that conducts its affairs fraudulently can have a tremendous, wide-reaching impact; in many cases, this impact is much greater than any other type of business can have. That’s why regulators pay so much attention to the statements generated by financial institutions (and why the ability of someone like Madoff to buck the system is so disconcerting).
In the United States, financial institutions are regulated by federal and state government entities, including the U.S. Securities and Exchange Commission. Their accounting and auditing procedures are spelled out by entities such as the Public Company Accounting Oversight Board (which was created by the Sarbanes-Oxley Act of 2002) and the Financial Accounting Standards Board (which establishes GAAP, or generally accepted accounting principles).
Other countries have their own accounting standards, and the International Accounting Standards Board (IASB) provides separate standards on disclosure requirements for financial institutions that operate across borders.
Walking through the Balance Sheet
No matter what kind of company you’re talking about, the balance sheet explains its financial position. This statement discloses the size of the business’ assets, liabilities, and owners’ equity. The company’s assets represent the organization’s resources, which must be equal to its liabilities (what it owes to outsiders) plus the owners’ investments. In other words
assets = liabilities + owners’ equity
The balance sheet of a financial institution is somewhat different from those issued by companies in other industries because a financial institution is essentially a financial intermediary. For example, the liabilities section of a bank’s balance sheet shows the sources of funds, and the list of assets represents the uses of funds.
For an Islamic bank, the balance sheet is further distinguished from that of its conventional counterpart. In a conventional bank, liabilities represent debts that must be paid back to an outside entity. Because Islamic banks are equity-based institutions, their liabilities don’t represent the same types of debt that exist in conventional banks. Also, an Islamic bank’s assets may look quite different from those held by a conventional bank because they include, for example, equity investment partnerships and financial assets that are based on sharia-compliant contracts.
To illustrate what I mean, I explain what types of entries you’re likely to find on a balance sheet for an Islamic financial institution under the categories of assets and liabilities.
Why am I slighting owners’ equity here? That section of the balance sheet — which reflects holdings of the business’ equity owners, retained earnings (profits not distributed among equity holders), and reserves — is the same for conventional and Islamic financial institutions. I’m focusing here on elements that differ between the two financial systems.
In the balance sheet for an Islamic financial institution, you may find entries for liquid, investment, financing, and fixed assets. Although you find similar categories of assets on a conventional financial institution’s balance sheet, many of the specific entries listed on an Islamic balance sheet would never make an appearance on its conventional counterpart.
Financial institutions, like all companies, need to have liquid assets in order to meet unexpected fluctuations in business or demand from the sources of funds. The liquid assets category (for both conventional and Islamic institutions) includes the following elements:
Deposits with the national central bank for reserve requirements
Balances held with other banks
The development of capital markets and the availability of short-term funds have enabled conventional companies to maintain lesser amounts of liquid assets than they previously required. But because the Islamic finance industry is still fairly young and its capital market is even younger (see Chapter 3 for some perspective on the industry’s age), Islamic financial institutions may require larger liquid asset reserves than their contemporary counterparts. How large an Islamic bank’s liquid assets should be depends on the Islamic financial market of the particular region or country in which it operates.
Islamic banks can’t yet maximize their profits the same way conventional banks do because the Islamic capital market is less developed. But some Islamic interbanking instruments are in operation in Malaysia and Bahrain, and this aspect of the industry will certainly continue to grow.
Conventional banks offer loans to corporations and individuals who need funding for a project or business or for purchasing an asset. Islamic banks don’t offer interest-based loans; instead, as I explain in detail in Chapter 10, they have equity partnerships with customers to support projects, businesses, or the purchase of assets. These partnerships, as well as sukuk and general investments, are listed on the balance sheet of an Islamic bank as part of its investment assets. Here’s a brief rundown of items you often see on an Islamic bank’s balance sheet in this category:
Mudaraba investments: This class of assets represents partnerships between the bank and its customers in which the bank acts as the investor (rab al mal), and the customer is the working partner (mudarib).
Musharaka investments: This class of assets represents partnerships or joint ventures in which the bank and customer are both working partners; they each provide capital and expertise or entrepreneurship skills.
Sukuk: As I explain in Chapter 12, during the years before the development of the Islamic capital market, Islamic banks had excess money and few sharia-compliant ways to invest it. As the capital market developed, sukuk — the Islamic alternative to bonds that I describe in Chapter 13 — became one of the most common modes of investment for Islamic banks.
General investments: An Islamic bank makes sharia-compliant investments, using depositors’ funds to earn income for its customers and itself. The general investments listed on an Islamic bank’s balance sheet may include investments in sharia-compliant equity funds, mutual funds, and money market instruments, for example (see Chapter 11 for info on the Islamic capital market). They may also include the purchase of assets for resale, such as real estate, vehicles, and machinery.
Islamic banks don’t offer interest-based loans to their customers, but they do offer asset-based financing based on various Islamic contracts such as murabaha, ijara, istisna, and salam. The assets involved in these contracts are considered the bank’s property until ownership is transferred to the customer when the loan is paid. Briefly, here’s how these products work (you can find more detail on these contracts in Chapter 10):
Murabaha assets: The Islamic bank purchases the asset and sells it to the customer, using deferred payments based on a cost plus profit basis. The cost and profit are known in advance by the bank and the customer. The murabaha asset, which may be a vehicle, a house, a commodity, or real estate, is reflected on the bank’s balance sheet until the contract is complete and ownership transfers to the customer.
Ijara assets: The Islamic bank purchases an asset and leases it to the customer, who may own the asset at the end of the contract period. For the duration of the contract, the bank maintains ownership of the asset, and the balance sheet reflects this ownership.
Istisna assets: On behalf of a customer, the Islamic bank finances a construction project based on the istisna contract. The construction project is delivered to the bank at the end of the contract. Until the customer takes possession, the asset appears on the bank’s balance sheet.
Salam assets: A bank most often uses parallel salam contracts: It enters one contract with a seller for a certain product and makes the full payment in advance for a specified future delivery; it enters another contract with a purchaser for the same good (after it’s delivered) for a higher price. After the asset is delivered to the bank, it becomes an asset on the bank’s balance sheet. The bank then delivers it to the purchaser.
Islamic banks also give interest-free loans (qard hasan) to people in need in order to fulfill the bank’s social responsibility. Although such loans don’t generate income for the bank, they’re still considered receivables and must appear on the bank’s balance sheet in the financial assets category.
In practice, banks offer many innovative products to suit their customers’ needs, so the items listed in the financing assets category differ greatly from bank to bank. For example
Sharjah Islamic Bank in United Arab Emirates lists the following financing receivables: qard hasan, murabaha, Visa (receivables from Visa credit cards), and istisna.
The Islamic Bank of Britain lists commodity murabaha and wakala receivables. (Wakala is a contract in which one entity works as an agent for another. In the effort to manage its liquidity, for example, one bank deposits funds in another bank, and the second bank invests them in a sharia-compliant manner.)
Fixed assets are the same for conventional and Islamic financial institutions. These resources, which are needed to run the day-to-day operations of the bank or other business, include things like computers, furniture, and supplies.
In addition to the stockholders’ equity, the funding side of a financial institution includes its liabilities. Banks are largely funded by customers who deposit their money, but a bank’s liabilities also include funds that belong to other financial institutions, funds for charity, and other payables.
The largest portion of the liabilities category for a bank is represented by deposits made by individuals, businesses, and even governments. Some customers make deposits in Islamic banks strictly for safeguarding purposes. When that’s the case, they may make wadia deposits, which can be used by the bank for any purposes and must be returned when the customer requests the money, or amana deposits, which the bank can’t use. (In the real world, amana deposits are rare.) I explain both types of deposits in Chapter 9.
A second purpose for deposits in Islamic banks is to get returns for the investment. In this case, the Islamic bank acts as an intermediary, much like a conventional bank does. The Islamic bank accepts customers’ deposits and makes investments based on mudaraba or musharaka contracts. Profits from these investments are distributed among deposit holders. (In the unlikely case of the bank losing money on such investments, the deposit holders share the loss as well.) The customer can decide between restricted investments (in which the money supports only the specific venture or project selected by the depositor) and unrestricted investments (in which the bank — not the customer — chooses the investment).
No matter which purpose is at play, which Islamic contract is used, or which specific deposit products a bank offers, all deposits must reflect on the balance sheet as liabilities.
Amounts due to other financial institutions
For both conventional and Islamic institutions, this category reflects any amounts owed to other commercial banks, investment banks, and central banks — in other words, any interbank outstanding balances. The key difference in Islamic banking is that this situation is based on an Islamic (interest-free) contract and sharia-compliant interbank principles. For conventional banks, interbank balances almost always incur interest.
A bank may owe money to another institution even though the bank didn’t borrow the funds. If an Islamic bank has excess funds, for example, it may choose to deposit that money in another bank. The second bank owes the money to the first simply because the first bank is a depositor.
Interbank balances may reflect on the balance sheet as profit-sharing or non-profit-sharing deposits. They may be payable on demand, or they may be time deposits. These designations all depend on the agreement between the two banks at the time of deposit.
Zakat (charity fund)
As I explain in Chapter 2, zakat is an obligation of wealthy Muslims to give a certain percentage of their income to charity or the needy. Bank customers may make contributions to the bank’s zakat fund to fulfill their obligations. Or, when an Islamic bank distributes profits both to equity stockholders and profit-based deposit holders, the bank may deduct the required zakat amount from that profit and reserve it in the designated fund. (Not all Islamic banks take this step.) Any money in the bank’s zakat fund is later given to the relevant authority that collects zakat in Muslim countries.
The zakat fund is a specific liability entry on the balance sheet so the bank can be transparent about its efforts to fulfill this social responsibility. Stockholders and depositors want to know that the bank is paying their zakat as charity and not using it for the bank’s own financial needs.
For a conventional bank, all liabilities except deposits and money owed to other banks are usually grouped under a balance sheet heading called, appropriately enough, other liabilities. But some Islamic banks may opt to have separate headings for each sub-liability classification. For example, you may see the following items on the balance sheet for an Islamic bank:
Declared undistributed dividends: The dividends belonging to equity holders (just as in a conventional bank).
Returns payable to customers: The profits from investment activities due to be given to mudaraba (profit and loss sharing) customers. This category is equivalent to interest payable on a conventional bank’s balance sheet.
Accruals payable: Business operation payables, such as utility bills.
Amounts due to holding companies or related companies: Money due to the parent company if a bank is a subsidiary of another company.
Taxes payable: The amount of tax due to the government.
Investigating the Income Statement
An income statement reports the business performance of a financial institution. It reports on income sources and the structure of income and expenses, and it serves as a crucial decision-making tool for the company’s managers and board. In brief, the statement presents performance information in this format:
Net profit before tax/zakat
Net profit available for stockholders
Obviously, the bottom line of this statement (the net profit number) is very important to everyone involved in the company — from managers and staff members to investors and potential lenders.
Why is the income statement of an Islamic bank different from that of a conventional bank? Conventional banks basically receive money from lenders and give it to borrowers; they earn income by charging interest for those loans (and by offering other ancillary services). Islamic banks earn income based on equity participation and asset-based transactions.
In this section, I walk you through the types of income and expenses you may see on an Islamic bank’s income statement.
An Islamic bank’s income structure can be divided into three subcategories: income from financing activities, income from investment activities, and income from operating activities. In practice, banks may list different classifications on their financial statements (to adhere to their internal policies or meet the requirements set by regulatory authorities), but these three divisions are helpful for understanding where a bank’s money comes from. I briefly explain each income category here.
Income from financing activities
An Islamic bank classifies all income it receives through various financial instruments in this subcategory, which relates directly to the bank’s financing assets reflected on its balance sheet. (See the earlier section “Financing assets.”) The possible sources of income for this category can come from mudaraba (profit and loss), musharaka (joint venture), murabaha (cost plus profit), istisna (construction project), and ijara (leasing) contracts.
Income from investing activities
Various investment assets held by an Islamic bank can (and should, if the bank is doing its job well) earn income. This category includes income from mutual funds, equity funds, sukuk, asset resale, mudaraba and musharaka investments in investment banks or other commercial banks, and more.
Income from other operating activities
All income that doesn’t fall under financing and investing activity is classified under this other category. Following are some possible income sources from other operating activities:
Commissions: The bank receives commissions for various commercial activities, such as issuing travelers’ checks and allowing other banks to use its ATMs.
Banking fees: Islamic banks that engage in retail banking activities charge fees.
Management fees: The bank charges fees for nontraditional banking activities, such as financial advising or merchant banking.
Foreign exchange income (gain): When a bank offers foreign exchanges to other banks and customers on the local currency, the bank may experience a loss or gain at the end of the accounting or reporting period. For example, say a bank has a stock of Swiss francs at the beginning of a given year. Later, those Swiss francs are traded for a price higher than the purchase price. The resulting profit from this transaction is listed as income from other operating activities.
The relevant expenses for Islamic banks fall into the same broad classifications as for conventional banks: general and administrative expenses, and provisions for loss or impairment. These categories are very general and may differ from bank to bank. For example, some banks may have classifications that separate out personnel and/or marketing expenses.
General and administrative expenses
These expenses (for both a conventional and Islamic bank) represent what a bank needs to spend in order to conduct its day-to-day operations; general and administrative expenses may include costs related to personnel, marketing, and legal services.
Provisions for loss or impairment
As I explain in Chapter 17, banks are generally exposed to credit risk. For a conventional bank, credit risk relates to customers who may not pay back their loans; such customers may be lessees, mortgage holders, or issuers of debt instruments such as corporate bonds. (Hence, this situation may be referred to as loan loss risk.)
For an Islamic bank, credit risk arises when the bank finances equity partnerships or assets by using Islamic contracts and the customers don’t fulfill their end of the bargain. In the case of an equity investment, the bank has funneled money into a project that hasn’t been completed and may be worthless. In the case of an asset-based instrument, the bank is stuck with an asset it must try to sell to another buyer. This expense category reflects the bank’s provisions to cover its anticipated credit risk.
Some banks separate impairment loss into two categories: impairment loss on nonfinancial assets and impairment loss on financial assets. The first category includes provisions for losses resulting from general business activities, such as joint ventures and investments held for resale. The second category focuses on impairment loss related to financial and investment assets.
In addition to reflecting taxes paid to the government by the Islamic bank, the income statement also reflects the amount of zakat the bank paid during the year from the designated zakat or charity fund. Keep reading to find out how and why an Islamic institution maintains a separate account for zakat and issues a separate report on its sources and uses of funds.
Noting Unique Financial Statements Used by Islamic Financial Institutions
In addition to the four financial statements most commonly issued by all corporations, Islamic financial institutions issue four more. That’s because an Islamic institution must keep certain pools of money separate — because of their special nature compared to other activities — to achieve purity and transparency regarding how money is being used. Here are the four statements you find only in Islamic financial reporting:
Statement of changes in restricted investments and their equivalents: When investors place their money with an Islamic financial institution, they have the choice of selecting their specific investments or making restricted investments. The institution must issue a separate statement that shows these restricted transactions so the investors are confident that their money has been used according to their specifications.
Statement of changes in the interest-free loan fund: Islamic financial institutions also have a separate fund for providing qard hasan — interest-free loans (which I explain in Chapter 9) — to fulfill their social responsibilities. Most often, these loans are offered to bank employees who are getting married, need medical treatment, or are pursuing education opportunities. Again, a separate statement is prepared by the Islamic financial institution to show activity in this fund.
Statement of changes in the policyholders’ surplus (issued by takaful, or Islamic insurance, companies only): As I explain in Chapter 18, participants in a takaful fund benefit from any surplus money remaining in the pool at the end of the year. This statement spells out how much surplus exists so policyholders are clear about the amount and how it’s distributed.
Statement of changes in the charitable fund: Each Islamic financial institution has a separate fund for zakat — alms that are donated directly by customers — and for other charitable funds that arise from transactions, including certain types of fees that the firm cannot accept as income. The financial institution must prepare a statement to show changes to this fund.
This last statement warrants a bit more explanation because this fund is so crucial in fulfilling the bank’s social responsibilities.
An Islamic bank is obliged to pay zakat if local and/or national laws require it; if its stockholders pass a resolution requesting that it do so; or if its charter requires it. Zakat is paid into the bank’s charitable fund. (Note: The words zakat and charity don’t mean the same thing. Zakat is an obligation; charitable giving is voluntary.) The fund may receive money directly from customer contributions, or it may receive money in these ways:
Directly from customer profits: Customer profits are charged a certain percentage for zakat, which is allocated to the charitable fund.
From various business operations. Here are just two examples of ways the charitable fund receives money from business operations:
• Penalties for default: If a customer who has a murabaha (cost plus profit) or ijara (lease) contract with the Islamic bank defaults on his payment, the bank can’t charge the customer interest based on the default date or amount owed. But the bank must be permitted to take some punitive action or else it runs enormous credit risk and sets itself up for liquidity problems. (Why would borrowers pay if they didn’t incur a penalty for defaulting?) For these reasons, Islamic scholars agree that customers can be fined a penalty. That gives customers incentive to make each payment installment. However, the bank can’t take these penalties as other income; it must give the money to the charity fund.
• Equity compliance: As I explain in Chapter 12, equities go through a screening process to determine whether they’re sharia-compliant and therefore acceptable for Islamic investment. But scholars understand that in the real world, few if any companies can achieve 100-percent compliance. Therefore, if a bank wants to invest in a company that has 5-percent noncompliant activities, the bank can accept dividends and capital gains from that company as long as the bank gives 5 percent of such income to the charity fund.
How is the charitable fund used? In a Muslim country, the bank turns over the zakat portion to an external authority that collects such moneys. The bank may use charitable contributions to fund education initiatives, support the poor and needy, supplement its qard hasan (interest-free loan) fund, and more.
Applying Specific Accounting Standards
As I note in Chapter 4, the Islamic finance industry is growing rapidly. For the industry to thrive, its growth must be accompanied by strong corporate governance that’s based on transparency and accountability. (The alternative leaves the industry open to fraud and corruption.) Because the industry is young, many critics suspect that criminals can manipulate it for money laundering. Uniform standards that allow practitioners, institutions, and regulatory bodies to communicate and monitor the organizational practices of Islamic finance institutions are crucial.
If you’re familiar with U.S. accounting standards (GAAP) and international financial reporting standards (IFRS, which are established by the London-based International Accounting Standards Board), you may assume that they suffice for Islamic financial institutions. The framework of these standards is suitable for conventional financial institutions and instruments but not for the offerings in the Islamic industry. The problem is that conventional accounting standards focus on transactions that are often prohibited in the Islamic finance industry, such as those involving interest and speculation. In addition, these conventional standards typically lack the ethical dimension so firmly rooted in religious duty that the Islamic industry demands.
The creation of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1990 filled the gap. It was a milestone for the Islamic finance industry, and it brought the industry increased international recognition. The AAOIFI works closely with international organizations such as the Bank for International Settlers (BIS) and International Organization for Securities Commission (IOSCO). These days, many countries’ regulatory bodies accept AAOIFI standards as well as IFRS. For example, in Bahrain and Kuwait, both AAOIFI standards and IFRS are accepted.
AAOIFI standards cover how to treat Islamic contracts such as murabaha, mudaraba, musharaka, salam, istisna, and ijara. They also cover treatment of sukuk, the Islamic alternative to bonds. Check out Chapter 3 to learn more about the AAOIFI.