Islamic Finance Project Final

23 April 2009

Project Report on Financial Statement / Accounting of Islamic Banking Group Members:

• Mohib Gul Khan (3538) • Qaisar Khan Khattak (3572) • Shehbaz Masood (3539) TABLE OF CONTENTS

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Executive Summary

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Introduction

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Qualitative

Characteristics

of

Financial

Statements

....................................................... 06 •

Objectives of Financial Accounting for Islamic Banks and IFIs

……………………….…

………………………… 08 •

The importance of establishing objectives of financial accounting for Islamic banks and financial institutions

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The approach to establishing objectives of financial accounting for Islamic banks and financial institutions

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Objectives of financial accounting and financial reports for Islamic banks and financial institutions

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Corporate AAOIFI

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Accrual Method Of Accounting To Islamic Banks

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…............................21 •

Islamic

modes

of

financing

.......................................................................................22 •

Methods

of

calculating

Zakat

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Accounting

for

Islamic

Banks

.......................................................................................29 •

Conventional Banking ( Interest-based) VS Islamic Banking (Non-Interest-based)… …......................41

•

Interview With Adnan Yousuf – Manager FAYSAL BANK LIMITED F-10 Branch…………… ………………………63

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Executive Summary There has been large-scale growth in Islamic finance and banking in Muslim countries and around the world during the last twenty years. This growth is influenced by factors including the introduction of broad macroeconomic and structural reforms in financial systems, the liberalization of capital movements, privatization, the global integration of financial markets, and the introduction of innovative and new Islamic products. Islamic finance is now reaching new levels of sophistication. However, a complete Islamic financial system with its identifiable instruments and markets is still very much at an early stage of evolution. Many problems and challenges relating to Islamic instruments, financial markets, and regulations must be addressed and resolved. The emergence of Islamic banks and financial institutions as relatively new organizations and the great challenge they face to successfully serve the societies in which they operate, have led them, together with specialists in Islamic Shari’a and in accounting, to seek the most appropriate means through which accounting standards could be developed and implemented in order to present adequate, reliable, and relevant information to users of the financial statements of such organizations. The presentation of such information is critical to the economic decision making process by parties who deal with Islamic banks and would also have a significant effect on the distribution of economic resources for the benefit of society. The principles of Islamic Shari’a strike a balance between the interests of the individual and society. It is known that investment is the foundation of economic activities in any society. However, not every individual is capable of directly investing his own savings. Accordingly, Islamic banks play an important role by acting as a vehicle to attract the savings of individuals and investing those savings for the benefit of the individual and society. The Objectives of financial accounting of Islamic banks is to determine the rights and obligations of all interested parties, contribute to the safeguarding of the Islamic bank’s assets, its rights and the rights of others in an adequate manner, contribute to the enhancement of the managerial and productive capabilities of the Islamic bank and -3-

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encourage compliance with its established goals and policies and, above all, compliance with Islamic Shari’a in all transactions and events, provide, through financial reports, useful information to users of these reports, to enable them to make legitimate decisions in their dealings with Islamic banks.

In this paper, we provide a comprehensive comparative review of the literature on the Islamic financial system. Specifically, we discuss the basic features of the Islamic finance and banking. We also introduce Islamic financial instruments in order to compare them to existing Western financial instruments and discuss the accounting of the Islamic mode of financing and issues involved in it. The paper also gives a preliminary empirical comparison of the financial statements of the Islamic Bank with Conventional Bank.

INTRODUCTION

ISLAMIC BANKING: Efforts have been made in recent years to promote Islamic banking services. In particular, the State Bank of Pakistan (SBP) exempted Islamic commercial banks from the moratorium on the establishment of new banks, and the first full-fledged Islamic bank, Meezan Bank, was licensed in 2002. Several conventional banks have also opened branches that provide only Islamic financial services. The size of these Islamic banking institutions remains very small. Although legal ambiguities remain regarding the process of Islamization of the financial system of Pakistan, the establishment of new Islamic banking institutions is likely to continue in the coming years.

Financial Standards: The Accounting Standards Board contributes to the achievement of the Financial Reporting Council's fundamental aim of supporting investor, market and public confidence in the financial and governance stewardship of listed and other entities by pursuing its own aims of establishing and improving standards of financial accounting and reporting, for the benefit of users, preparers, and auditors of financial information.

Objectives of Financial Statements: Goals financial statements are supposed to accomplish. The intent of financial statements is to provide information useful in economic decision making. In particular, the data should be useful in making investment and credit decisions. Financial statements should provide a -4-

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reliable indication of a company's financial position, operating results, and changes in financial position. Also, statement components and categories should aid in decisions. Financial statements may provide information in addition to that specified by authoritative requirements and regulatory groups. Inasmuch as management knows the most about the business, it is encouraged to identify certain circumstances and explain their financial effects on the enterprise. Financial statements provide an overview of a business' financial condition in both short and long term. All the relevant financial information of a business enterprise presented in a structured manner and in a form easy to understand, is called the financial statements. There are four basic financial statements: Statement Of Financial Position: also referred to as statement of financial position or condition, reports on a company's assets, liabilities, and net equity as of a given point in time. Statement Of Comprehensive Income: also referred to as Profit and Loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. Profit & Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state. Statement of retained earnings: explains the changes in a company's retained earnings over the reporting period. Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities. For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and management discussion and analysis. The notes typically describe each item on the Statement Of Financial Position, Statement Of Comprehensive Income and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements. Purpose of financial statements: "The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions."[2] Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organization's financial position. Reported income and expenses are directly related to an organization's financial performance. Financial statements are intended to be understandable by readers who have "a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently."[2] •Owners and managers require financial statements to make important business

decisions that affect its continued operations. Financial analysis are then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders. -5-

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•Employees also need these reports in making collective bargaining agreements (CBA)

with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings. 2. External Users: are potential investors, banks, government agencies and other parties who are outside the business but need financial information about the business for a diverse number of reasons. •Prospective investors make use of financial statements to assess the viability of

investing in a business. Financial analyses are often used by investors and is prepared by professionals (financial analysts), thus providing them with the basis in making investment decisions. •Financial institutions (banks and other lending companies) use them to decide whether

to grant a company with fresh working capital or extend debt securities (such as a longterm bank loan or debentures) to finance expansion and other significant expenditures. •Government entities (tax authorities) need financial statements to ascertain the

propriety and accuracy of taxes and other duties declared and paid by a company.

•Media and the general public are also interested in financial statements for a variety of reasons

Qualitative Characteristics of Financial Statements:

UNDERSTANDABLE & USEFUL: •Accounting information should be readily understandable to the intended users of the information. •This is a function of both the intended users and the intended uses of the information. Accounting systems that define either the users or uses narrowly may justify more complex information requirements and standards. Accounting systems that envision a broad body of users and/or uses would tend towards less complexity in published information and standards. •Typically the belief that, for information to be understandable, information contained in

the various financial disclosures and reporting must be transparent (i.e., clearly disclosed and readily discernable).

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RELEVANT: The information should be relevant to the decision-making users of the information. It should make a difference in their decisions. Typically, this means the information must be: •Timely •Have predictive value •Provide useful feedback on past decisions

RELIABLE: The information should be reliable and dependable. This usually includes the concepts of: •Representational faithfulness - the information represents what it claims to represent. For example, if the reported value of a common stock holding purports to be the current market value, that value should be approximately what the stock could be sold for by the company holding it. •Verifiability - another person or entity should be able to recreate the reported value using the same information that the reporting entity had. •Completeness - the reported information should not be missing a material fact or consideration that would make the reported information misleading. •The concept of neutrality is sometimes incorporated into the concept of reliability.

COMPARABLE AND CONSISTENT: •For accounting information to be usable, it must allow for comparisons across time and across competing interests (such as competing companies or industries). •This leads to a need for some consistency, wherever such comparisons are to be expected. For example, comparisons of two companies would be very difficult and potentially misleading if one discounts all its liabilities while the other discounts none of its liabilities. UNBIASED: •Information that is biased can be misleading. •Biased information is not useful unless the users understand the bias, any bias is consistently applied across years/firms/industries, and the users can adjust the reported results to reflect their own desired bias. -7-

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•When faced with uncertainty, there is a need to either require reporting of unbiased values accompanied with sufficient disclosure, or require the reporting of biased (prudent or œconservative) values with the bias determined in a predictable, consistent fashion.

COST-BENEFIT EFFECTIVE: •General understanding that the development of accounting information consumes resources. •As such, the cost of producing such information should be reasonable in relation to the expected benefit. •Use the materiality accounting rule - may not have to be fully followed for immaterial items if full compliance would result in unwarranted higher costs.

"Objectives of Financial Accounting for Islamic Banks and IFIs" 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 -8-

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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, Statement Of Comprehensive Income, 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. -9-

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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. - 10 -

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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 nonIslamic countries. This is so because there are common objectives between Muslim and nonMuslim 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. - 11 -

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(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.

Statement Of Financial Position analysis: Islamic vs. conventional The goal of financial risk management is to maximize the value of a financial institution as determined by its level of profitability and risk. Since risk is inherent in banking and unavoidable, the task of the risk manager is to manage the different types of risk at acceptable levels to achieve optimal profitability. Doing so requires the continual identification, quantification, and monitoring of risk exposures, which in turn demands sound policies, adequate organization, efficient processes, and skilled analysts and elaborates computerized information systems. In addition, risk management requires the capacity to anticipate changes and to act in such a way that a bank’s business can be structured and restructured to profit from the changes or at least to minimize losses. Regulatory authorities should not prescribe how business is conducted; instead, they should maintain prudent oversight of a bank by evaluating the risk composition of its assets and by insisting that an adequate amount of capital and reserves is available to safeguard solvency. Although the approaches to risk management are diverse, a good starting point is to undertake a top-down approach starting with the Statement Of Financial Position. One cannot underestimate the importance of understanding the structure and composition of the Statement Of Financial Position of a financial institution. It is critical to assess the ways in which a bank’s risk managers and analysts can analyze the structure of Statement Of Financial Positions and Statement Of Comprehensive Incomes, as well as individual Statement Of Financial Position items with specific risk aspects so that the interaction between various types of risk is understood to ensure that they are not evaluated in isolation. The relative share of various Statement Of Financial Position components – assets and liabilities – is a good indication of the levels and types of risk to which a bank is exposed. Table 1 below shows stylised Statement Of Financial Position of a conventional commercial bank. On the liability side, it accepts demand and saving deposits, issues term certificates - 12 -

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such as certificate of deposits (CD), and has capital. Table 1 Stylised Statement Of Financial Position of a conventional bank – based on functionality Assets

Liabilities

Loans and advances to customers

Customers’ deposits

Cash and cash balances with other Due to banks and other financial banks institutions Investments in associates, Other liabilities subsidiaries and joint ventures Financial assets held for trading

Sundry creditors

Cash and cash balances with the Equity and reserves central bank On the asset side, there is much more diversity and options in the form of marketable securities, trading accounts, lending to corporations and to consumers. From the risk point of view, two observations can be made. First, the deposits create instantaneous pre-determined liabilities irrespective of the outcome of the usage of the funds on the asset side, thus creating an asset-liability mismatch. Second, medium- to longterm assets are financed by the stream of short-term liabilities, exposing the bank to a maturity mismatch risk and discouraging the bank from investing in long-term non-liquid projects. An increase in the level of non-retail deposits or funding could expose a conventional bank to greater volatility in satisfying its funding requirements, requiring increasingly sophisticated liquidity risk management. Certain funding instruments also expose a bank to market risk. For Islamic financial institutions, the nature of financial intermediation, including the function of banking, is different from that of conventional financial institutions. This is the key to understanding the difference in the nature of risks in conventional and Islamic banking. For Islamic banks, the mudarabah contract is the cornerstone of financial intermediation and thus of banking. The basic concept is that both the mobilisation and (in theory) the use of funds are based on some form of profit sharing among the depositors, the bank, and the entrepreneurs (users of funds). The financial intermediation is merely a ‘pass-through’ arrangement similar to funds management, with the difference that there are multiple portfolios on the asset side. Table 2 below presents a stylised Statement Of Financial Position of an Islamic bank, displaying different activities and financial instruments. It serves as a good starting point for understanding the dynamics of the risks inherent in Islamic banks. This Statement Of Financial Position classifies the functionality and purpose of different instruments – a common practice among Islamic banks.

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Table 2 Stylised Statement Of Financial Position of an Islamic bank – based on functionality Application of funding

Sources of funding

Cash balances

Demand deposits (amanah)

Financing assets salam, ijara, istisna) Investment assets musharakah)

(murabaha,

Investment accounts (mudarabah)

(mudarabah, Special investment accounts (mudarabah, musharakah)

Fee-based services (ju’ala, kafala, Reserves and so forth) Non-banking assets (property)

Equity capital

The structure of a typical Statement Of Financial Position has demand deposits and investment accounts from customers on the liability side and Islamic financing and investing accounts (the equivalent of conventional banks’ loans to customers) on the asset side. This pattern reflects the nature of banks as intermediaries, with ratios of capital to liabilities at such a low level that their leverage would be unacceptable to any business outside the financial services industry. The analyst should be able to assess the risk profile of the bank simply by analysing the relative share of various asset items and changes in their proportionate share over time. While the types of liabilities present in an Islamic bank’s Statement Of Financial Position are nearly universal, their exact composition varies greatly depending on a particular bank’s business and market orientation, as well as the prices and supply characteristics of different types of liabilities at any given point in time. The funding structure of a bank directly affects its cost of operation and therefore determines a bank’s potential profit and level of risk. The structure of a bank’s liabilities also reflects its specific asset-liability and risk management policies. When compared with conventional banks, Statement Of Financial Position risk profile of Islamic banks is different. First, the foremost feature of anIslamic bank is the ‘pass-through’ nature of the Statement Of Financial Position. This feature removes the typical asset-liability mismatch exposure of a conventional bank, as the Islamic bank’s depositors’ return is linked to the return on the assets of the bank. However, this feature also introduces some operational issues, such as estimation and accrual of ex-post returns and the treatment of intra-period withdrawal of deposits. Second, the nature of assets of two institutions is different. Whereas a conventional bank tends to stay with fixed income very low credit risk debt securities, an Islamic bank’s assets are concentrated on the asset-based investments which has credit risk but are also backed by a real asset. As a result, the lending capacity of the Islamic banking sector (at least for commercial banks) is bound by the availability of real assets in the economy. Thus, there is no leveraged credit creation. Third, the assets of Islamic banks contain financing assets where tangible goods and commodities are purchased and sold to the customers. This practice creates distinct - 14 -

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exposures. For example, in case of conventional banking, the asset is financed by a loan from the bank to the customer whereas in case of an Islamic bank, the asset and the financing are coupled together. The bank is not limited to the exposure as a financier but can develop additional exposures resulting from dealing with physical assets. Another feature which distinguishes the risks of an Islamic bank from a conventional bank is the general lack of liquid securities on the asset side. This feature is not a design issue but is a temporal phenomenon until a well-functioning securities market for Shari’ah-compliant instruments is developed. Finally, due to prohibition of interest, Islamic banks cannot issue debt to finance the assets which consequently discourages creation of leverage. Due to the lack of leverage, Islamic banks can be considered less risky during a time of financial crisis. The current financial crisis was precipitated by excessive leverage and complexity in the financial system, which had developed multiple layers of intermediaries. Hence, the financing – or the claims on assets – became remote from the underlying assets. For Islamic banks, the financial intermediary is closely associated with the asset and is able to perform better monitoring of the asset as well as the obligor. These features can enhance the stability of the banking system. In short, a holistic approach to understanding the risk of Islamic financial institutions should start with a rigorous analysis of the risk profile of different financial contracts on each side of the Statement Of Financial Position. Standard analysis techniques such as trend analysis, impact analysis, bucketing, duration and maturity mismatch, and value-at-risk analysis can be applied to each financial contract or instrument type but then the results should be aggregated at the Statement Of Financial Position level to understand a global picture at the institution level.

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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 - 16 -

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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.

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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 - 18 -

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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. - 19 -

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(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.

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Corporate AAOIFI: The emergence of Islamic banks and financial institutions as relatively new organizations and the great challenge they face to successfully serve the societies in which they operate, have led them, together with specialists in Islamic Shari’a and in accounting, to seek the most appropriate means through which accounting standards could be developed and implemented in order to present adequate, reliable, and relevant information to users of the financial statements of such organizations. The presentation of such information is critical to the economic decision making process by parties who deal with Islamic banks and would also have a significant effect on the distribution of economic resources for the benefit of society. The principles of Islamic Shari’a strike a balance between the interests of the individual and society. It is known that investment is the foundation of economic activities in any society. However, not every individual is capable of directly investing his own savings. Accordingly, Islamic banks play an important role by acting as a vehicle to attract the savings of individuals and investing those savings for the benefit of the individual and society. Islam clearly encourages investment and spending. Indeed, when Islam imposed Zakah, it required that wealth should be invested, otherwise it would be exhausted by Zakah over a period of time. It has been reported that the Prophet (may the blessing and peace of Allah be upon him) said “Trade in orphans wealth (property) lest it would be exhausted by Zakah”. However, to induce individuals to invest through savings with their Islamic banks, it is essential that such individuals develop a trust in the ability of Islamic banks to realize their investment objectives. In the absence of trust in the ability of Islamic banks to invest efficiently and in full compliance with Islamic Shari’a, many individuals may refrain from investing through Islamic banks. One of the pre-requisites for the development of such trust is the availability of information that assures the investing public of the ability of Islamic banks to achieve their objectives. Among the important sources of such information are the financial reports of Islamic banks which are prepared in accordance with standards that are applicable to Islamic banks. However, in order to develop such standards it is essential to define the objectives and concepts of financial accounting for Islamic banks. In this respect, it is not harmful to begin where others have ended, if what has been developed by others is beneficial and does not contradict the Islamic Shari’a. The interest in developing financial accounting standards for Islamic banks started in 1987. In this respect, several studies have been prepared. These studies have been compiled in five volumes and deposited in the Library of the Islamic Research and Training Institute of the Islamic Development Bank. - 21 -

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The outcome of these studies has been the formation of the Financial Accounting Organization for Islamic Banks and Financial Institutions (the Organization) which was registered as a not-for-profit organization in the State of Bahrain in 12/9/1411H corresponding to 27/3/1991. Since its inception the Organization has continued the efforts to develop accounting standards. Periodic meetings of the Executive Committee for Planning and Follow Up (the Committee) have been held with the aim of implementing the plan approved by both the Supervisory Committee (the supreme authority of the Organization) and by the Financial Accounting Standards Board for Islamic Banks and Financial Institutions. In this respect, the Committee has retained the service of several consultants on Shari’a, experts and practitioners of accounting, and bankers.

8. ACCRUAL METHOD OF ACCOUNTING TO ISLAMIC BANKS: The difference between the two accounting treatments is meant to reflect the risk to which the Islamic bank is exposed in executing this type of transaction. In the case of non-obliging the purchase orderer to fulfil his promise, the bank is exposed to the risk of not being able to recover the historical cost of the asset if the client decides not to proceed; with the sale. On the other hand, the bank is exposed to a relatively lower risk if the client is obliged to fulfil his promise and he refrained from purchasing tha asset after the bank has acquired it. This is because the Islamic bank usually asks the client to pay an amount up-front - hamish algedyyah - from which the bank can remedy the damage incurred to it if the client retreats from purchasing the asset. Moreover, if the amount of hamish algedyyar is not adequate to cover the loss of the bank, the latter can have recourse to the orderer for the remaining amount of the loss. The standard requires the Islamic bank to disclose in the notes accompanying the financial statements, whether it considers the promise made in the sale oy Murabaha to purchase orderer, obligatoiy or not. The standard also prescribes two accounting treatments for profit recognition. In addition to the accrual method of allocating profit over the period of the contract, the Board decided after the public hearing to add a cash basis method whereby the Islamic bank can recognise profit when the instalment is received. However, the standard gives preference to the accrual method and requires for the implementation of the cash basis method the approval of either the bank's Shariah supervisory board or the concerned super visory agency in the country. The reason for allowing two accounting treatments for asset valuation and profit recognition is mainly due to the different acceptable Shariah interpretations related to these two issues. This is in line with the Board's recently adopted policy of pursuing a harmonisation approach to entertain different Shariah rulings which have accounting implications, but within narrow bounds. This policy, which the Board implements in close co-ordination with AAOIFI's Shariah Committee, is meant to enhance the adherence to the full text of the standards by maiy Islamic banks, particularly as AAOIFI lacks the power of enforcement. On the other hand, the Board's policy calls for standardising accounting treatments that are not affected by the Shariah rulings (e.g., issues of disclosure). - 22 -

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The standard also requires the netting of deferred profits off against Murabaha receivables. The latter should be measured at their cash equivalent value i.e., the amount due from debtors less provision for doubtful debts. This is meant to give relevant information and a faithful representation of the financial position of the Islamic bank.

9. ISLAMIC MODES OF FINANCING Debt creating modes: •Murabaha •Salam •Istesna •Ijara Partnership based modes •Musharaka •Mudarabah Murabahah (sale with or without deferred payment):

In this particular kind of sale, the seller clearly mentions the cost of the sold commodity, and then sells it to the buyer by keeping a profit margin. Thus, Murabaha should not be seen as a loan given on interest, it is rather a sale of a commodity for cash/deferred price.As regards Bai Murabaha, the bank purchases a commodity, on a client’s behalf, and then resells it to the latter, on the basis of plus-profit. Under this kind of agreement, the bank discloses its cost and profit margins to the client. Thus, unlike Conventional banks (which advance money to a borrower), the bank will buy the goods from a third party and sell it onwards to a customer for a pre-agreed price, thus abstaining from interest. The growing use and vitality of Murabaha agreement is proven by the fact that in Islamic banks world over, 66% of all investment transactions are through Murabaha. It is argued by critics of Islamic banking that Murabaha agreements are in reality interest-based contracts, under the garb of a notional sale and buy back transaction, profit being synonymous to interest in this case. Islamic scholars have reverted to this argument by stressing that a ‘true’ Murabaha financing structure is quite different from an overdraft provided by Conventional banks and the former offers various benefits to the bank and its customers, namely that depositors have a share in - 23 -

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the bank’s profits. Furthermore, the basic difference is the Aqd (contract), which specifies the Islamic conditions, as against the interest element in Conventional banking transactions. Basic Rules for a Murabaha transaction: 1. The subject of sale must be in existence at the time of the sale. 2. The seller must have the ownership of the commodity in question. 3. The subject of sale must be in physical or ‘constructive possession’ of the seller while he is selling it. 4. The sale must be instant and absolute; no provisions for contingencies should be made part of the contract. 5. The goods/commodity to be sold must reflect a value and must be specified to the buyer, leaving no room for ambiguities or confusion as between the parties. 6. The sale must be unconditional and the price of the commodity should be certain. SALAM: Another contract that is used for financing is the "‘BAI AL SALAM "(in short SALAM). One of the basic rules for Islamic Contracting is that nothing can be sold that does not already exist. This contract form was basically intended to finance agricultural exploitations and is used in this manner to allow farmers to receive financing to assist in the development of crops. Therefore, contracting over future goods is allowed, but quantity, quality and time of delivery have to be specified. The commodity must be composed of units with homogenous characteristics and which are traded by counting, measuring or weighing according to usage and customs of trade (excluding precious stones of which quality can differ). Payment must be immediate and instant buy-back in general is not allowed. This mode of financing can be used by modern banks and financial institutions, especially in order to finance the agricultural sector. In Salam, the seller undertakes to supply specific goods to the buyer at a future date, in exchange of an advanced price fully paid at the spot. The payment is made in cash, and the supply of purchased goods is deferred. Purpose of Salam Contracts: The purpose is to meet the need of farmers, who operate on a small scale, and thus need the finance for farming purposes, so that they can carry out their day-to-day activities. Moreover, it is designed to assist the traders, in their export/import transactions. Salam Proves beneficial to the seller, as he receives the price in advance, and at the same time, advantageous to the buyer, as the price under the Salam arrangement is normally lower than the price in spot sales. - 24 -

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ISTISNA: ISTISNA’ in many regards appears the same as a SALAM, with the difference that ISTISNA’ always relates to commodities that are to be manufactured. The Manufacturer sells the yet-to-be-made commodity to the Buyer/Financial Institution. The difference between SALAM and ISTISNA’ is that: •the payment of the price is not necessarily immediate (deferred payment possible) •and individualized goods can be envisaged. If the Manufacturer is acquiring the goods that he will use to make the commodity from the Buyer / Financial Institution - and therefore his only contribution really is his labor, then an ISTISNA’-contract in general is not permissible (the IJARAH or rent of labor contract is then used). Istisna’ is a sale transaction whereby a commodity is transacted before it comes into existence. It is an order for a manufacturer to manufacture a certain kind of commodity, to be used by the purchaser. The manufacturer uses his own material to manufacture the required goods. The price must be fixed with consent of all the parties involved. All other vital specifications of the commodity must also be fully settled. Subject to the acknowledgment or receipt of prior notice, either party can cancel the contract before the manufacturing party has begun the work. The time of delivery need not be fixed, however a time limit may be imposed as between the parties. MUDARABAH: This is also a kind of partnership, whereby one partner provides finance to the other for investing in a commercial enterprise. The investment is provided by the first partner called the ‘Rab-ul-Maal’, while the entire responsibility for the management and work falls upon the other partner, who is called the ‘Mudarib’. The profits generated, are shared in a predetermined ratio.There are two kinds of Mudarabah • Restricted • Unrestricted Restricted Mudarabah: Rab-ul-Maal may specify a particular business for the Mudarib, in which case he shall invest the money in that specified business only. This is known as ‘ Al-Mudarabah-al-Muqayyadah’ Unrestricted Mudarabah:

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But if he leaves it open for the Mudarib to undertake whatever business he wishes, the Mudarib should be authorized to invest the money in any business he wishes. This type of Mudarabah is called ‘Al-Mudarabah-al-Mutlaqh’ Roles of Mudarib: • He is an Ameen (trustee), who is responsible to look after the investment, with an exception of natural calamities. • He is a Wakeel (agent), as he makes the purchases from the funds provided. • He is also a Shareek (partner), thus sharing the profits with Rab-ul-Maal. • He can also possibly be a Zamin (liable), and thus will have to compensate for any loss suffered during the course of Mudarabah, due to any erroneous act on his part. IJARAH: The IJARA can best be described as the Islamic version of the western style lease: Transfer of the usufruct only: The risk and liabilities associated with the use of the asset will be borne by the Client. All the risks and liabilities connected with the ownership (loss, destruction ...) of the assets rest with the Owner / Financial Institution. The IJARAH can become a "Ijarah wa Iqtina" (financial lease) when the User/Client has the right to acquire the commodity at the end of the lease period.In an Islamic leasing (Ijaraha), the owner of the asset, while retaining the corpus of the asset, transfers its usufruct to another person for an agreed period, at an agreed consideration. All the liabilities arising from the ownership must be endured by the lessor. The period of lease must be determined in clear terms and the asset must be clearly identified as between the partiesSubject leased should be: • Valuable • Identified • Quantified

Musharakah (ordinary partnership) This partnership refers to a joint business enterprise in which the partners (two or more persons) undertake to share all the profit/losses of the venture. The way profit will be shared must be agreed at the outset and any periodical advance for one or more partners will be off-set at the settlement of the accounts. The profit sharing has to be in relationship to the input of capital, but it can be agreed that one partner gets a bigger share (ex. Provides more labor) provided that a non-working partner to the MUSHARAKAH (the "silent partner" or capital provider) is always granted a maximum of the ratio linked to his input in capital. It is impermissible to establish a fixed and guaranteed return to be allocated to a partner; since it would suggest the loan of money and/or would mean that a partner does not take his share in possible losses.

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Buy-out clauses (unit per unit) can be built into a contract, preferably at market price or at historic value. Consequently, one partner will slowly buy out the other partner. This technique sometimes is used for investment purposes, where the Financial Institution partners up with a Client, leases the good to the Client (through IJARA) and slowly exits the project.

Methods Of Calculating Zakat IN ISLAM, zakat is not a simple charity out of our own sweet will. It has its own mathematics, just like faraid (Islamic estate distribution law). Therefore, Muslims need to adhere to the zakat law, and not pay the zakat amount arbitrarily. The cardinal rate to remember when in computing your zakat is that it is based on a flat rate of 2.5 % as opposed to the conventional income tax rate that varies according to the amount taxable. This is the rate for all zakatable wealth that is valued on gold and silver such as zakat on income, statutory savings, shares, business etc. However, this rate is not applicable - 27 -

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to some types of zakat such as livestock, agricultural output (done in traditional method and not by business entities) and found treasures. Zakat assessment also differs from income tax, with the former based on assets while the latter on income. In zakat jurisprudence, `assets' do not only cover fixed and liquid assets, but also the inflow of income. Zakat is obligated only for individuals and entities who have complete or unencumbered possession on assets. However, for mixed- ownership companies, it is only compulsory upon the equity held by Muslims. Furthermore, assets that are zakatable must be halal assets or income. Businesses whose core operations are non-halal activities, such as liquor-and pork-based products or delivery services, gambling and interest gaining activities, are not subjected to zakat. Zakat is an ibadat and does not accept from non-halal sources. If a company runs a halal product/services as their core business, but is slightly involved in impermissible revenue/projects, then the revenue from such projects will be excluded in the zakat calculation. Nisab valuation: Another criterion is nisab valuation (threshold of zakat obligation). It is determined based on the current value of 85gm of gold. When the zakatable assets in a business are equivalent to or exceed nisab valuation, zakat should be paid at the rate of 2.5%.

Hawl: Another condition called hawl is based on the asset value calculated from the initial inception or start of business until the completion of one whole year. The completion of hawl is not measured on the particular stocks or goods for sale but on the business operation itself. Originally, the periodic term is based on the lunar calendar but zakat assessment can also be made using the financial year of the company. Growth assets: The quality of assets that are subjected to zakat is that it must have growth (al-nama) potential. The component of growth assets include cash (in-hand/bank), financial instrument or securities such as shares, bonds, unit trusts and are classified as a current asset, inventory of finished goods. However, raw materials and work in process are exempted because they are not in a form ready to be sold. Fixed industrial assets like buildings, machines, furniture and office supplies are also exempted from zakat because they are not business products and only assist in the business. Nevertheless, revenue from fixed assets is zakatable. Calculating business zakat: - 28 -

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This refined approach has been published by Jabatan Kemajuan Islam Malaysia (Jakim) and adopted by almost all the state zakat authorities. In the past, zakat authorities were found to be using several approaches to calculating zakat on business. Nonetheless productive and successful efforts have been made by the authorities to streamline and `finetune' these approaches. The original text on business zakat assessment only instructs for zakat payment based on inventories or goods for sale. However, generations of Muslim jurists have broadened the scope of business zakat based on their observation of general Islamic jurisprudence. Conceptually, they have broadened the scope of urud tijarah (literally meaning goods for trade) to working capital used in business operations. Please take note that in zakat calculation, all kinds of fixed assets (property, plants and equipment) and long-term investments will be excluded. Some of the religious scholars have expressed their opinions concerning the basic calculations of business zakat. One of the famous opinions is as said by Abu `Ubayd; `Maimun ibn Mihran clarified: when it comes to you the time to pay zakat (exact time), count your cash money that you have with you, and also the merchandise you have, value it in the form of money, and include it in the debts from your customers (with the opinion that it will be collected) and minus your own debt. Then the balance is the amount for you to calculate zakat.' Basically, any organization that is profit-oriented is obliged to pay zakat. There are two methods that can be used to calculate zakat: Urfiyyah and Syari'yyah. Urfiyyah is known as the Growth Capital method. It considers equity of ownership of that particular company and other financial sources. In short, it looks at all resources available, less the normal (uruf) exemption. Syari'yyah, meanwhile, is called the Working Capital method. It considers current assets after deducting current liabilities (in short, net current assets).

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Accounting for Islamic Banks Nexus of Contractual Rights & Obligations in Islamic Financial Activities

ISLAMIC COMMERCIAL TRANSACTIONS Gratuitous Contracts Gift

Trading Contracts Leasing

Sale

Waqf Loan

Operational Lease

Ijarah Operating Lease + Transfer of Ownership

Ijarah Muntahia Bittamleek

Investment Contracts

Murabaha

Musharaka Mudharaba

Murabahah Salam Istisna’ etc.

 The major financing instruments used by Islamic banks are Murabaha, Salam, Istisna's, Ijarah and Ijarah Muntahia Bittamleek, Musharaka, and Mudaraba. - 30 -

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 Murabaha, Salam, and Istisna's are all forms of asset financing based on a sale-

purchase transaction. Salam and Istisna'a are forms of working capital finance, while Murabaha is normally a credit sale. The return to the financier (profit margin) is predetermined in advance. Ijarah and Ijarah Muntahia Bittamleek are forms of leasing.  Musharaka and Mudaraba are forms of profit sharing finance.

Risks Involved to Banks in Islamic Modes of Financing Financing Type

Contract Type

Risk Exposure Credit Risk

Sales type

Murabaha Bai Muajjal Salam Isitna’a

Non-delivery & Credit Risk

Equity

Mudaraba Musharaka

Credit/Market risk Equity investment Risk

Leasing

Ijarah Market risk Ijarah MuntahiaCredit risk Biltamleek

Accounting Issues  How should Islamic banks account for and present in their Statement Of Financial

Positions the funds in their investment accounts - which are mobilized on profit- 31 -

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sharing terms via the mudaraba contract where the risk of loss is borne by the investors.  How should Islamic banks recognise income generated by the different asset classes

under each of the Islamic instruments, for example, murabaha, istisna 'a, salam, ijarah, musharaka and mudaraba  How should Islamic banks measure different asset classes under each of the Islamic

instruments? Asset valuation is needed for many purposes, Statement Of Financial Position reporting, assessment of Zakah on wealth, and fair appropriation of profits to investors, on the one hand, and to Islamic banks (as asset managers) on the other.  How should Islamic banks account for prohibited income, such as interest on accounts held with correspondent banks which, incidentally, is earned?  What are the particular disclosures, in financial statements or notes thereto, which

Islamic banks may need to make, given their ethical stance and in particular their commitment to compliance with Shari'a?  How should Islamic banks account for the provisions for doubtful debts or decline in value of impaired assets in case those assets are funded, wholly or party, by investment accounts?  To what extent do members of the Shari'a Supervisor}' Boards participate in the

setting of accounting policies and methods which are adopted by Islamic banks? What is the impact of such participation on financial reporting by Islamic banks?  Variations within Islamic banks over accounting policies and/or methods can be clearly seen in the published financial reports:      

Financial Statements Asset Valuation Income Recognition Allocation of Profits Provisions Zakah

 Reporting

contracts

 Statement Of Financial Position  Off-Statement Of Financial Position  Value

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Treatment in Accounts:  (FAS No 1) General Presentation and Disclosure in the Financial Statements of Islamic

Banks and Financial Institutions, AAOIFI named and defined the financial statements that Islamic banks need to prepare and publish. In addition to the ordinary financial statements - the statement of financial position (Statement Of Financial Position), Statement Of Comprehensive Income, statement of cash flow and statement of changes in owners' equity - Islamic banks are required to prepare some specific financial statements necessitated by their different nature and objectives. The standard named and defined three financial statements: statement of changes in restricted investments, statement of sources and uses of Zakah and charity funds, and statement of sources and uses of qard fund.  FAS No 1 requires that unrestricted investment accounts be presented on the claims

side of the statement of financial position (liabilities and equity) in a separate section, not as liabilities but under "equity of unrestricted investment account holders". Thus, the statement of financial position for an Islamic bank will have two different equity sections. A possible explanation is that the Islamic bank has the right to commingle its own funds with the funds of the holders of these accounts. On the other hand, FAS No 1 requires that restricted investment accounts be reported off-Statement Of Financial Position in the statement of changes in restricted investments. Assets

Valuation:

 AAOIFFs FAS No 2: Murabaha and Murabaha to the Purchase Ordered requires the

bank to measure the asset at historical cost if the customer is obliged to conclude the contract. On the other hand, if the customer is not obliged to fulfil his promise to execute the transaction.  FAS No 2 requires the bank to value the asset on the basis of cash equivalent value. Furthermore, unlike the treatment of many Islamic banks that presents deferred profits as liability.  FAS No 2 requires that these profits be deducted from murabaha receivables.  In an ijarah. muntahia bittamleek contract, the ownership of the leased asset is

transferred to the lessee at the end of the contract. Some Islamic banks treat ijarah muntahia bittamleek as a finance lease. However, such a treatment does not give a faithful representation of the underlying transaction. This is because according to AAOIFI pronouncements the Shari'a rules relating to the ijarah contract do not allow the lessor to transfer significant risk and reward to the lessee.  AAOIFFs FAS No 8 requires leased assets to be booked in an ijarah muntahia

bittamleek assets account and measured at book value. It further requires the outstanding ijarah rental amounts to be booked in an ijarah instalments receivable account and measured at their cash equivalent value.

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Income Recognition:  AAOIFI's SFA No 2: Concepts of Financial Accounting for Islamic Banks and Financial Institutions states that: "revenue should be recognized when realized". This requires that  the earning process is complete or virtually complete.  there is an obligation on the part of another party to remit a fixed or determinable amount to the bank, and  the amount of revenue should be known and should be collectible with a reasonable degree of certainty.  FAS No 2 states that income generated by murabaha transactions with a contract

period not exceeding the current accounting period should be recognised at the time of contracting. If the contract period exceeds the current accounting period.  FAS No 2 proposes two alternative methods: "Proportionate allocation of profit pro

rota tempor is over the period of the credit" or "as and when the instalments are received" if required by the bank's Shari'a Supervisory Board and/or supervisory authorities.  FAS No 3 (and No 4) state: income generated by mudaraba (or musharaka)

transactions shall be recognised at the time of liquidation if the contract commences and ends during a single financial period. In the case of a transaction that continues for more than one period, income shall be recognised to the extent that profits are being distributed.  The wording in FAS No 3 (and No 4) regarding income recognition tends to be

confusing as it entertains the possibility to mean accrual or cash accounting. The phrase "time of liquidation" and the clause "to the extent that the profits are being distributed" may indicate that the standards are advocating the use of cash accounting. This is so although what is meant is that the bank's share of income from mudaraba and musharaka transactions is to be recognised on accrual basis. For other assets generated by salam, ijarah and istisna 'a contracts it is explicitly stated that income shall be recognised on accrual basis Allocation of Profits (AAOIFI, FAS No 5)  bases applied by the bank in the allocation of profits;  bases applied by the bank for charging expenses to investment accounts;  bases applied by the bank for charging provisions and to whom they should revert if no longer required;  percentages for profit-allocation between investment account holders and the bank; - 34 -

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 any increase by the bank of its percentage profit share;  if the bank included unrestricted investment accounts in the sharing of earnings generated by current accounts;  if the bank included unrestricted investment accounts in the sharing of earnings generated by banking operations;  source of funds given priority in case of unutilised idle funds. Provision  FAS No 11  Provisions are defined as amounts charged in the Statement Of Comprehensive Income and used to revalue assets down to their cash-equivalent values.  The standard also sets the accounting rules relating to the recognition, measurement, presentation and disclosure of provisions. Reserve  Is a component of equity  Profit equalization Reserve  Amount appropriated by the Islamic bank out of the mudaraba income, before allocating the mudarib share, in order to maintain a certain level of return on investment for investment account holders and increase owners’ equity  Investment Risk reserve  Amount appropriated by the Islamic bank out of the income of investment account holders, after allocating the mudarib share, in order to cater against future losses for investment account holders Recognition of Reserves When management of the Islamic bank decides, with approval of investment account holders, to set up a profit equalization reserve and/or an investment risk reserve Zakah  Zakah is a religious alms-giving duty that a Muslim has to pay on his wealth every lunar year if the wealth exceeds a fixed minimum amount.  According to AAOIFI's FAS No 9: Zakah, an Islamic bank is obliged to pay Zakah on

behalf of its shareholders when:  the law requires the Islamic bank to satisfy the Zakah obligation;  the Islamic bank is required by its charter or by-laws to satisfy the Zakah

obligation;  the general assembly of shareholders has passed a resolution requiring the

Islamic bank to satisfy the Zakah obligation.  Zakah should be treated as a (non-operating) expense of the Islamic bank and should

be included in the determination of net Statement Of Comprehensive Income. - 35 -

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 Unpaid Zakah should be treated as a liability and presented in the liabilities section in

the statement of financial position of the Islamic bank

Murabaha: Murabaha is a cost plus profit sale, i.e. a sale in which the seller informs the customer about his cost and the amount of profit. Contemporary Murabaha transaction (referred to as Murabaha to the Purchase Orderer by AAOIFI Standard) is normally a deferred payment sale. Ba’y Murabaha, by its very nature, is a purchase-sale / trading transaction. In other words it is not a “financing” transaction and instead, it is a substitute to financing transactions. Accordingly, the IFAS - 1 issued by ICAP, as well as, the AAOIFI standard consider it a trading transaction and suggest the accounting treatment like a trading transactions with certain exceptions. On the other hand, the conventional banks, as well as, Islamic banks operating in Pakistan were accounting for Murabaha as a financing transaction (just like an interestbearing loan) and ignoring the purchase and sales of goods. Payment made to supplier or agent for purchase of asset is accounted for as advance. Asset is initially measured and recorded at historical cost, including all costs necessary to bring the asset in its present location and condition. Perpetual or periodic method of accounting for inventories / purchases may be used. Valuation of Inventory: Payment made to supplier or agent for purchase of asset is accounted for as advance. Asset is initially measured and recorded at historical cost, including all costs necessary to bring the asset in its present location and condition. Perpetual or periodic method of accounting for inventories / purchases may be used. AAOIFI requires that if there is an indication of non-recovery of costs of goods, the asset shall be measured at cash equivalent value (Net realizable value) through a provision. - 36 -

Accounting of Islamic Banks

Financial Statement /

According to AAOIFI standard, if a discount is received from the supplier, it shall not be considered as revenue and instead it should reduce the cost of goods. The discount may be treated as revenue if this is decided by the Islamic Bank’s Shari’a Supervisory Board. Murabaha – Sale to the Purchase Orderer shall be recorded at the time of occurrence at invoiced amount i.e. gross selling price. Profit shall be recognized at the time of consummation of sales, if the sale is for cash or on credit but the term does not exceed the current financial period. The profit on portion of Murabaha receivable not due for payment should be recorded as “Unearned Murabaha Income” with a corresponding liability on the Statement Of Financial Position called “Deferred Murabaha Income”. As per AAOIFI Standard, profits of credit sale whose payment due after the current financial period shall be recognized using any of the following methods: Preferred method – Proportionate allocation of profits whether or not cash is received; Allowed Alternative method – Profit may be recognized as and when the amount is received. Accrued amount of profit which is not yet received is disclosed. Deferred profits shall be offset against (shown as a deduction from) Murabaha receivables in the statement of financial position / Statement Of Financial Position. According to most of the jurists in Pakistan, no discount can be allowed in case of early settlement. Accordingly, in case of early settlement, deferred Murabaha income should be immediately recognized. However, IFAS – 1 is silent in this respect. Mudaraba: Capital Invested Include in this column total amount of capital invested with corresponding counterparty, whether related or not. This should include amount before any provisions are made against the invested capital. Net Asset Value The amounts in this column should represent the net value of assets relating to the corresponding counterparty for Restricted investment accounts after the necessary provisions are made. Report this amount as net asset value at the reporting date. Mudarib Fee Mudarib fee is the amount that the bank (as a Mudarib) is entitled to receive for undertaking the investment of the funds provided by the restricted investment account holders. The amount or percentage of the Mudarib fee is agreed between the bank and the investment - 37 -

Accounting of Islamic Banks

Financial Statement /

account holders before implementing the contract. In case of a loss, the bank is not entitled to any Mudarib fee and the loss is entirely shouldered by the restricted investment account holders.

Beginning Balance of Profit Equalization Reserve Include in this item the beginning balance of the profit equalization reserve that the bank has set aside in order to maintain a certain level of return on investment for investment account holders and to increase owners’ equity. Appropriation during the period The amount in this item should represent the appropriation made during the period. For write backs, report here assets written back during the period.

Closing Balance of Profit Equalization Reserve Include in this item the closing balance of the profit equalization reserve which is obtained by adding or deducting the inward or outward transfers respectively, to/from the beginning balance of profit equalization reserve . Musharaka:  AAOIFFs FAS No 2: Murabaha and Musharaka to the Purchase Ordered require the

bank to measure the asset at historical cost if the customer is obliged to conclude the contract. On the other hand, if the customer is not obliged to fulfil his promise to execute the transaction  FAS No 2 requires the bank to value the asset on the basis of cash equivalent value. Furthermore, unlike the treatment of many Islamic banks that present deferred profits as liability  FAS No 2 requires that these profits be deducted from murabaha receivables.

Salam & Parallel Salam: A salam is a purchase agreement for ordered goods (muslam fiih) where the delivery of the goods is delayed by the seller (muslam ilaihi) and where the buyer immediately pays for the goods in full before they can be delivered in accordance with specific conditions.

- 38 -

Accounting of Islamic Banks

Financial Statement /

A bank may act as either buyer or seller in a salam transaction. Where it acts as the seller and then orders a third party to supply goods in the framework of a salam agreement, this is referred to as a parallel salam. A parallel salam may be entered into on the condition that: (a) The second contract between the bank and the supplier be separate from the first contract between the bank and the final buyer; and (b) The second contract is entered into only after the first is valid. The buyer and seller agree on the specifications and price of the ordered goods at the beginning of the contract. The price of the goods may change over the term of the contract. Where the bank acts as buyer, a Islamic bank may seek a guarantee from a customer to avoid the risk of loss to the bank. The general characteristics of all ordered goods must be made known, including: type, technical specifications, quality, and quantity. The ordered goods must be the same as those characterized in the agreement between the buyer and seller. Where goods are incorrect or damaged, the seller shall be liable for negligence. The bank as buyer Salam loans are recognized when the salam operating capital is paid or transferred to the seller. Salam operating capital may be in the form of cash and non-cash assets. In the form of cash it is assessed as the amount paid, while non-cash assets are assessed at fair value (the value agreed by the bank and the customer). Ordered goods are recognized and assessed as follows: (a) Where the goods ordered are in accordance with those stated in the contract they are valued at the agreed value; (b) Where the quality of the goods varies: (i) The goods are assessed based on the terms of the contract if the market value (fair value if a market value is not available) of the goods is equivalent or higher than the value of the goods stated in the contract. (ii) ordered goods already received are assessed at market value (fair value if the market value is not available) when taken receipt of and any difference is recognized as a loss, if their market value is lower than the value of the goods as stated in the contract. (c) if the bank fails entirely or in part to receive the ordered goods on the due date:

- 39 -

Accounting of Islamic Banks

Financial Statement /

(i)

if the date for receipt is extended, the recorded value of the salam loan equivalent to the portion not yet repaid remains at the same value stated in the contract;

(ii)

if the salam contract is canceled, whether partially or entirely, the amount of the salam loan is that portion not yet repaid by the customer.;

(iii)

if the salam contract is canceled, whether partially or entirely, and the bank has a guarantee over the ordered goods and the proceeds from the sale of the guarantee do not cover the value of the salam loan, the difference between the recorded value of the salam loan and the sale proceeds is recognized as a receivable due from the customer. Conversely, if the sale proceeds exceed the recorded value of the salam loan the customer is entitled to the difference.

(iv)

The bank may impose a penalty against a customer but may only do so against those customers capable of meeting their obligations but who intentionally fail to do so. This provision shall not apply to customers incapable of meeting their obligations as a result of force majeure.

(v)

Ordered goods already taken receipt of are recognized as stock. At the end of the financial reporting period, any stock acquired in the framework of a salam transaction is assessed at the lowest acquisition cost or the net realizable value. Where the net realizable value is lower than the acquisition cost, the difference is recognized as a loss.

The bank as the seller: A salam debt is recognized when the bank receives the salam working capital at an amount equivalent to the amount of salam working capital received. The salam working capital received may take the form of cash or non-cash assets. In the form of cash, it is assessed as the amount received. As non-cash assets are assessed at fair value (being the value agreed by the bank and the customers). Where the bank enters into a parallel salam transaction, the difference between the amount paid by the customer and the acquisition cost of the ordered goods is recognized as a gain or loss upon delivery by the bank to the customer Ijara: The IFAS – 2 issued by ICAP, as well as, the AAOIFI standard suggest the accounting treatment similar to an operating lease transactions with certain exceptions. On the other hand, the conventional banks, as well as, Islamic banks currently operating in Pakistan are accounting for Ijarah as a financing transaction, just - 40 -

Accounting of Islamic Banks

Financial Statement /

like finance lease – in accordance with IAS-17. Modarabas, are however, not following IAS-17. Accounting by Islamic Bank as Lessor •

Asset is recognized at historical cost and depreciated as per normal depreciation policy with an expected realizable value at the end.

•

According to AAOIFI standard, these are presented as Investments in Ijarah Assets, while as per IFAS – 2, these are included in property, plant and equipment with separate disclosure.

•

Depreciation has to be calculated in line with the methods allowed by IAS – 16. Most suitable method is generally the straight line method because, the rentals are generally also accounted for on a straight line basis.

•

Depreciation term shall generally be equal to the lease term, except where it is expected that the asset will be given on Ijarah again, to same or some other customer, in which case, the depreciable life shall be equal to the asset’s useful economic life.

•

Lease rentals including other associated charges and Ijarah related expenses are allocated proportionately in financial periods over the lease term.

•

Initial direct cost is amortized over the lease term. However, IFAS-2 allows that the same may be charged to income as and when incurred.

•

Repairs undertaken are recognized as expense.

•

According to AAOIFI Standard, a provision for repairs is established if repairs are material and differ in amount from year to year.

Ijarah Muntahia Bittamleek IFAS – 2 does not deal with Ijarah Muntahia Bittamleek separately. Same accounting treatment should be applied as in case of Ijarah, as according to the substance of transaction, all the risks and rewards remain with the lessor. In case of expected selling price is Nil or fixed or equivalent to some pre agreed amount, the residual value for the purpose of depreciation should be equivalent to such amount. - 41 -

Accounting of Islamic Banks

Financial Statement /

Sale and lease back resulting into an Ijarah: If the sale price is same as that of its fair value any gain or loss shall be recognized in period in which such transaction occurs; and If the sale price is different from its fair value any gain or loss shall be amortized / allocated as an adjustment to Ijarah expenses over the lease term. Sale and Lease Back Transaction – Ijarah Muntahia Bittamleek – Lessee’s Perspective According to AAOIFI Standard, in case of sale and lease back resulting into Ijarah Muntahia Bittamleek, gains or losses resulting from sale shall be allocated as an adjustment to Ijarah expenses over the lease term.

Conventional Banking (Interest Based) - 42 -

Accounting of Islamic Banks

Financial Statement /

Versus

Islamic Banking (Non Interest based)

- 43 -

Accounting of Islamic Banks

Financial Statement /

Financial Statements This study is based upon the financial statements of two banks that are operating in Pakistan and that are renowned in their respective sectors. These financial statements were selected from the annual reports of the said two banks. Conventional Interest Based Bank Askari Commercial Bank Was selected as a conventional interest based bank. Askari Bank Limited (the Bank) was incorporated in Pakistan on October 09, 1991 as a Public Limited Company and is listed on the Karachi, Lahore and Islamabad Stock Exchanges. Islamic Non Interest Based Bank The bank selected for study in this regard is AL Baraka Islamic Bank. The bank operates as a branch of a foreign bank domiciled and is incorporated in Bahrain on February 21, 1984 and is a member of AL Baraka Group. Al Baraka Islamic Bank mainly is engaged in Islamic Banking whereas Askari Bank is engaged in the business of Corporate Banking. Comparisons were made between the financial statements of these banks and points were made. Some points were common between both of the banks and some entirely different those which includes the way of transacting the banking business. Main Differences between Askari Commercial Banks Financial Statements and Al Baraka Islamic Banks Financial Statements are summarized below. Difference Between Islamic & Conventional Banking. Askari Commercial Bank Askari Commercial Bank prices money. Depositors get the fixed rate of interest which does not depends upon the profitability or loss that is made by the bank. The depositor does not have any share in the business of the Bank so the customer income is not dependent upon any slump in bank’s business.

Al Baraka Islamic Bank Al Baraka Islamic Bank prices goods and services such as assets. Profit is shared between the bank and the customer. If bank gets the higher profit then the customer also gets the higher profit and if the bank suffers a loss then the customer also suffers the loss. This implies that the customer (depositor) is also having share in the business that bank undertakes. Commercial bank deals in money or Islamic bank deals in assets. paper. It borrows the funds from the Maharabah partnership arrangement depositors and pays them interest exists between the customer and the and the interest is charged in the bank. If the bank gets the profit then Statement Of Comprehensive Income it shares the profit with the customers and the amount due to the customer and if they get loss then they share is showed on the liability side of the the loss between them. The sharing - 44 -

Accounting of Islamic Banks

Financial Statement /

Statement Of Financial Position. Bank borrows the fund at a lower rate and advances the same fund to the customers at the higher rate of interest and the difference between the interest earned from the customers and interest paid to customers is the income of the bank and the amount that is receivable from the customers is shown in the Statement Of Financial Position under the assets side as receivable from the customers. The depositor is not informed about the source in which the bank is going to invest the money. He is just informed about the rate of interest and other contractual provisions. The interest or rate of return on investment is predetermined on the funds that are borrowed by the bank. The depositor earns the interest in any case at the rate that is specified. There is no risk to the investment of the investor form the conditions that prevail in the market.

- 45 -

of profits earned depends upon the agreement or the amount of investment.

Depositor (Investor) is informed by the bank as to the nature of investment that the bank is going to make and the conditions on which the profit or loss depends. This is a purely profit and loss sharing agreement. The depositor gets the loss if there is loss to the bank. Profit earned depends entirely upon the conditions that are prevalent in the market.

Accounting of Islamic Banks

Financial Statement /

Difference in the financial statements Statement Of Financial Position Askari Commercial Bank Al Baraka Islamic Bank The format of presentation for The format of presentation for different categories of assets in different categories of assets in Financial Statements Statement Islamic Financial Statements Of Financial Position is Statement Of Financial Position is ASSETS Cash and balances with treasury ASSETS banks Cash and balances with banks These represents overnight to Cash in hand three months placements with Balances with State Bank of correspondent banks, carrying Pakistan interest rates determined Current account with respect to underlying Capital deposit account currency benchmarks at the Cash reserve account rates ranging from 2.37% to Balances with Central Bank of 4.69% (2006: 2.34% to 5.23%) Bahrain (CBB) per annum receivable on Balances with other banks and maturity. financial institutions Balances with other banks Lendings to financial institutions Call money lendings Sales receivables Repurchase agreement International commodities lendings ( Others Purchase under resale Gross sales receivable arrangement Deferred profits Trade related deals Provision for impairment Others Particulars of lending In local currency In foreign currencies Mudaraba Securities held as collateral Banks and financial institutions against lendings to financial There are no non performing as institutions of 31 December 2007 (2006: Market Treasury Bills nil). Pakistan Investment Bonds Purchase under resale Ijara Muntahia Bittamleek arrangement Cost: of listed shares Opening balances Additions Disposals Closing balance Accumulated depreciation: Opening balance Charges during the year - 46 -

Accounting of Islamic Banks

Financial Statement /

Disposals Closing balance value: At 31 December

Net

book

Musharaka financing Musharaka Provision for impairment (note 24)

Investments Investments by segments: Federal Government Securities Market Treasury Bills Pakistan Investment Bonds Government of Pakistan Sukuk Bonds Government of Pakistan Euro Bonds Fully paid up ordinary shares Listed companies Unlisted companies Fully paid preference shares Listed companies Term Finance Certificates (TFCs) Listed Term Finance Certificates Unlisted Term Finance Certificates Foreign Securities Callable notes Mena Transformation Fund Credit Linked Notes Other Investments Sukuk Certificates NIT Units Advances Loans, cash credits, running finances, etc. - 47 -

Investments i)Investment in quoted shares ii) Held to maturity Unquoted investments Sukook Leasing (bonds) Sukook Salam (bonds) iii) Available for sale Quoted investments Managed funds Unquoted investments at cost Private equity Real estate Others Less: Provision for impairment

Investment properties These include the investmenst in the properties that are made by the bank.

Ijara income receivables Ijara income receivables Provision for impairment Ijara income receivables, which are non-performing as of 31 December 2007, amounted to US$ 6.1 million (2006: US$ 6.5

Accounting of Islamic Banks

Financial Statement /

In Pakistan Outside Pakistan Ijara Financing – In Pakistan

million) out of which US$ 2.5 million (US$ 3.4 million) is not yet past due.

Bills discounted and purchased (excluding treasury bills) Payable in Pakistan Payable outside Pakistan Advances – gross Provision against non performing advances Specific provision General provision General provision consumer loans

against

Particulars of advances In local currency In foreign currencies Short term ( for upto one year) Long term ( for over one year) Ijara Financing in Pakistan Ijara rentals receivable Residual value Minimum lease payments Profit for future periods Present value of minimum Ijara payments

Advances have been classified as under Category of classification Special mention Other Assets Especially mentioned Substandard Doubtful Loss Particluars of provision against non performing advances - 48 -

Accounting of Islamic Banks

Financial Statement /

Opening balance Charge / (reversal) for the year Amounts written off Other adjustments Closing balance Particluars of provision against non performing advances In local currency In foreign currencies Particulars of write-offs: Against provisions Directly charged to profit and loss account Premises and equipment These include the land and buildings Write offs of Rs. 500,000 and and other asstes that comes in the above bank’s premises. Write offs of below Rs. 500,000 The land and building represents the Particulars of loans and head office premises of the Bank that advances to directors, associated was sold and leased back over a 5 companies etc. year period effective from June 2005. Debts due by directors, executives Other assets of them either severally or Balance at beginning of Due from Al Tawfeek Company Loans granted during Advance against financing Repayments transactions Balance at end of year Income receivable Debts due by companies Accounts receivable Bank are interested as Advance tax (note 25) directors, Receivables under letters of companies as members credit Balance at beginning of Others Loans granted during Repayments Balance at end of year Debts due by subsidiary modarabas and other related Balance at beginning of Loans granted during Repayments Balance at end of year Operating fixed assets Capital work–in–progress - 49 -

Accounting of Islamic Banks

Financial Statement /

Property and equipment Capital work–in–progress Civil works Advances to suppliers and contractors Land-freehold Land-leasehold Buildings on freehold land Buildings on leasehold land Renovation of leased premises Furniture, fixtures and office equipment Carpets Machine and equipments Computer equipments Vehicles Other assets

Land – freehold Land – leasehold Buildings on freehold land Buildings on leasehold land Renovation of leased premises Furniture, fixtures and office Carpets Machine and equipments Computer equipments Vehicles Other assets Deferred tax assets

Other assets Income / mark–up Income / mark–up Advances, deposits, Advance taxation ( Un–realized gain on Suspense account Stationary and stamps Dividend receivable Others - 50 -

Accounting of Islamic Banks

Financial Statement /

The format of presentation for different categories of liabilities in Financial Statements Statement Of Financial Position is

The format of presentation for different categories of liabilities in Islamic Financial Statements Statement Of Financial Position is

LIABILITIES Bills payable In Pakistan

Liabilities Due to banks and other financial institutions State Bank of Pakistan Due to other banks and financial institutions

Borrowings In Pakistan Outside Pakistan Particulars of borrowings with respect to currencies In local currency In foreign currencies Details of borrowings – secured / unsecured In Pakistan – local currency Secured Borrowings from the State Bank of Pakistan: Export refinance scheme Long term financing of export oriented projects Repurchase agreement borrowings (repo) Unsecured Call borrowings Deposits and other accounts Customers Fixed deposits Savings deposits Current accounts - nonremunerative Special exporters' account - 51 -

Other liabilities Security deposit against Ijara Muntahia Bittamleek Bills payable Margins received Accounts payable Deferred tax liability Ijara rental received in advance Unearned profit on sale and lease back Provision for staff indemnity Charity fund Others

Unrestricted investment accounts Unrestricted investment accounts Profit equalization reserve Investment risk reserve EQUITY

Accounting of Islamic Banks

Financial Statement /

Margin accounts Others Financial institutions Remunerative deposits Non-remunerative deposits Particulars of deposits In local currency In foreign currencies Sub-ordinated loans Term Finance Certificates –I Term Finance Certificates –II

(i) Share capital Authorised 6,000,000 ordinary shares (2006: 2,000,000) of US$ 100 each (ii) Statutory reserve (iii) General reserve (iv) Cumulative changes in fair value (v) Foreign exchange reserve Retained earnings

Extra Note of CONTINGENCIES & Liabilities against assets subject COMMITMENTS to finance lease Deferred credits/ (debits) arising due to: Accelerated tax depreciation Tax loss for the year Minimum tax for the year Surplus on revaluation of securities Profit on securities recognized but not received Deferred tax liabilities Other liabilities Mark-up / return / interest payable Mark-up / return / interest payable Unearned income / commission Accrued expenses Advance payments Unclaimed dividends Branch adjustment account Payable against purchase of Withholding taxes payable Federal excise duty payable Others

- 52 -

Accounting of Islamic Banks

Financial Statement /

Statement Of Comprehensive Income Askari Commercial Bank Al Baraka Islamic Bank MARKUP INTEREST INCOME INCOME Income from Jointly Financed Mark-up / return / interest earned Investments On loans and advances to: Income from jointly i) Customers financed sales ii) Financial institutions Income from jointly On investments financed, other financings i) Available for sale securities and investments ii) Held to maturity securities Ijara Muntahia On deposits with financial institutions Bittamleek (note On securities purchased under Income from resale agreements investments Mudaraba Musharaka Structuring fees Mark-up / return / interest expensed Gain on sale of On deposits investments On securities sold under Dividends repurchase Rental income On sub-ordinated loans Joint investment income On other short term borrowings Return on unrestricted investment accounts (investors share of income Net mark-up / interest income before Bank's Mudarib Provision against nonshare) performing loans and advances Bank’s Mudarib share Provision for impairment in the Return on unrestricted value of investments investment accounts Bad debts written off directly Bank’s share of income Net mark-up / interest income from investment accounts after provisions (as a mudarib and as fund - 53 -

Accounting of Islamic Banks

Financial Statement /

NON MARK-UP/INTEREST INCOME Fee, commission and brokerage income Dividend income Income from dealing in foreign currencies Gain on sale of investments - net Federal Government Market Treasury Bills Pakistan Investment Term Finance Certificates Shares - Listed Others

owner) Bank’s income from self financed sales Bank’s income from self financed, other financings and investments Revenue from banking services Fees and commissions Letters of credit Acceptance fees Guarantees Others

Other revenues Foreign exchange gain Unrealised gain / (loss) on Others revaluation of investments Bank’s Mudarib share in classified as held for trading restricted investment profit net TOTAL INCOME Other income Rent of property EXPENSES Include Net profit on sale of property Operating expenses and equipment Staff costs Rent of lockers Administrative expenses Recovery of expenses from Premises costs customers Business expenses Total non-markup / interest General expenses income Depreciation NON MARK-UP/INTEREST EXPENSES Administrative expenses Salaries, allowances, etc. Charge for defined benefit plan Contribution to defined contribution plan Non-executive directors' fees, allowances and other expenses Rent, taxes, insurance, electricity, etc. Legal and professional charges Brokerage and commission Communications Repairs and maintenance Finance charges on leased assets Stationery and printing Advertisement and publicity Auditors' remuneration - 54 -

Accounting of Islamic Banks

Financial Statement /

Depreciation Other expenditure (travelling, security services, vehicle running expenses, etc.) Auditors' remuneration Audit fee Fee for the audit of provident and gratuity funds Special certifications, special credit review of selected customers, half year review and the audit of consolidated financial statements Out-of-pocket expenses Other provisions / write offs Other charges Penalties imposed by the State Bank of Pakistan Total non-markup / interest expenses PROFIT BEFORE TAXATION Taxation – current year For the year Current Deferred For prior years Current Deferred PROFIT AFTER TAXATION Unappropriated profit brought forward Profit available for appropriation

Cash Flow Statement Askari Commercial Bank Cash flow from operating activities Profit before taxation Less: Dividend income Adjustments: Depreciation Provision against non-performing advances (net) Provision for impairment in the value of investments

- 55 -

Al Baraka Islamic Bank Operating Activities Provision for impairment net Gain on disposal of premises and equipment Gain on disposal of investments Gain on disposal of

Accounting of Islamic Banks

Financial Statement /

Net profit on sale of property and equipment Finance charges on leased assets (Increase) / decrease in operating assets Lendings to financial institutions Held for trading securities Advances Other assets (excluding advance Increase / (decrease) in operating liabilities Bills payable Borrowings Deposits Other liabilities Cash flow before tax Income tax paid Net cash flow from operating activities

Cash flow from investing activities Net investments in available-for-sale securities Net investments in held-to-maturity securities Net investments in subsidiary/ associate Dividend income Investments in operating fixed assets - net of adjustment Sale proceeds of operating fixed assets-disposed off Net cash flow used in investing activities Cash flow from financing activities Payments of sub-ordinated loans-net Payments of lease obligations Dividends paid Net cash flow used in financing activities (Decrease)/ increase in cash and cash equivalents Cash and cash equivalents at beginning of the year Cash and cash equivalents at end of the year

- 56 -

investment properties Amortisation of income and expenses related Unrealised remeasurement loss Depreciation Directors' remuneration Share of result of an associate Sales receivables Mudaraba Ijara Muntahia Bittamleek Musharaka financing Ijara income receivables Other assets Other liabilities Due to banks and other financial institutions Investing Activities Dividend received from investments Purchase of investments Disposal of investments Purchase of investment properties Disposal of investment properties Purchase of premises and equipment Disposal of premises and equipment Financing Activities Increase in unrestricted investment accounts Current accounts Dividend paid

Accounting of Islamic Banks

Financial Statement /

Askari Commercial Bank Status And Nature Of Business Askari Bank Limited (formerly Askari Commercial Bank Limited) (the Bank) was incorporated in Pakistan on October 09,1991 as a Public Limited Company and is listed on the Karachi, Lahore and Islamabad Stock Exchanges. The registered office of the Bank is situated at AWT Plaza, The Mall, Rawalpindi. The Bank obtained its business commencement certificate on February 26, 1992 and started operations from April 01,1992. Army Welfare Trust directly and indirectly holds a significant portion of the Bank's share capital at the year end. The Bank has 150 branches (2006: 122 branches); 149 in Pakistan and Azad Jammu and Kashmir , including 14 Islamic Banking branches and an Offshore Banking Unit (OBU) in the Kingdom of Bahrain. The Bank is a scheduled commercial bank and is principally engaged in the business of banking as defined in the Banking Companies Ordinance, 1962. Format Of Presentation Fixed Assets are stated at the top and current assets at the end. This type of format is mostly used by the companied and is elaborated in the Companies Ordinance and International Financial Reporting Standards. Audit Report This bank has got clean audit report by its auditors A&F Ferguson & Company Chartered Accountants. Interest Based Banking These financial statements are prepared on interest based banking. The bank is engaged in the operations involving interest. International Accounting Standards All applicable International accounting standards are followed. Islamic Accounting Standards The financial statements do not state the adoption of any Islamic Accounting standards except for Islamic banking segment. Requirements of SBP Requirements of State Bank Of Pakistan (SBP) are followed. These include the prudential regulations that are issued by the State Bank Of Pakistan and further amendments and pronouncements that become effective from time to time. Basic Operations Its earnings are based upon interest earned on deposits. - 57 -

Accounting of Islamic Banks

Financial Statement /

Statement Of Financial Position Its Statement Of Financial Position totals Rs.12,265,987,000 Profit from Operations Its Profit from Operations is Rs.7,101,372 Profit Un Remitted Its profit available for appropriation totals Rs.4,480,991,000 Share Holders Equity Its share holder equity totals Rs.12,099,645,000 Cash Flow - Cash Position Its cash and cash equivalents at the end of the year are Rs.18,353,109 Business Segments The bank carries on its business and generates its income through different geographical as well as different business segments. The business segments are as under: 1-Corporate Financing 2-Retail Banking 3-Trading & Sales Standards not yet adopted by the Bank Standards, amendments and interpretations to existing standards that are not yet effective and have not been early adopted by the Bank. The following new standards and amendments to existing standards have been published and are mandatory for the Bank's accounting periods beginning on or after January 1, 2008, but the Bank has not early adopted them: IAS 1

Presentation of financial statements in respect of changes in the names of certain financial statements,presentation of transactions with owners in statement of changes in equity and with non-owners in comprehensive Statement Of Comprehensive Income. Adoption of IAS 1 is not expected to have an impact on the Bank's financial statements.

IAS 23

Borrowing Cost (Amendment) requires an entity to capitalize borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset (one that takes a substantial period of time to get ready for use or sale) as part of the cost of that asset. The option of immediately expensing those borrowing costs will be withdrawn. Adoption of IAS 23 is not expected to have an impact on the Bank's financial statements.

- 58 -

Accounting of Islamic Banks

Financial Statement /

IFRS 8

Operating segments (effective from January 1, 2009) requires a 'management approach', under which segment information is presented on the same basis as that used for internal reporting purposes. Adoption of IFRS 8 is not expected to have an impact on the Bank's financial statements.

IFRIC 13

Customer loyalty programmes, clarifies that where goods or services are sold together with a customer loyalty incentive (for example, loyalty points or free products), the arrangement is a multiple-element arrangement and the consideration receivable from the customer is allocated between the components of the arrangement in using fair values. Adoption of IFRIC 13 is not expected to have an impact on the Bank's financial statements.

IFRIC 14

The limit on a defined benefit assets, minimum funding requirements and their interactions', provides guidance on assessing the limit in IAS 19 (Employee benefits) on the amount of the surplus that can be recognised as an asset. It also explains how the pension asset or liability may be affected by a statutory or contractual minimum funding requirement. Adoption of IFRIC 14 is not expected to have an impact on the Bank's financial statements.

Commercial Interest based banking Commercial banking segment provides services related to project finance, export finance, trade finance, leasing, lending, guarantees, bills of exchange and deposits from corporate customers. Payment and settlement Payment and settlement includes income from payments and collections, funds transfer, clearing and settlement. Agency service Agency service includes income from rent of lockers provided to customers. Subordinated loans It represents subordinated Term Finance Certificates issued by the Bank. Types of loans granted by Askari commercial bank Secured loan A secured loan is a loan in which the borrower pledges some asset (e.g., a car or property) as collateral (i.e., security) for the loan.

Mortgage loan A mortgage loan is a very common type of debt instrument, used to purchase real estate. Under this arrangement, the money is used to purchase the property. Commercial banks, however, are given security - a lien on the title to the house - until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it. - 59 -

Accounting of Islamic Banks

Financial Statement /

In the past, commercial banks have not been greatly interested in real estate loans and have placed only a relatively small percentage of their assets in mortgages. As their name implies, such financial institutions secured their earning primarily from commercial and consumer loans and left the major task of home financing to others. However, due to changes in banking laws and policies, commercial banks are increasingly active in home financing. Changes in banking laws now allow commercial banks to make home mortgage loans on a more liberal basis than ever before. In acquiring mortgages on real estate, these institutions follow two main practices. First, some of the banks maintain active and well-organized departments whose primary function is to compete actively for real estate loans. In areas lacking specialized real estate financial institutions, these banks become the source for residential and farm mortgage loans. Second, the banks acquire mortgages by simply purchasing them from mortgage bankers or dealers. In addition, dealer service companies, which were originally used to obtain car loans for permanent lenders such as commercial banks, wanted to broaden their activity beyond their local area. In recent years, however, such companies have concentrated on acquiring mobile home loans in volume for both commercial banks and savings and loan associations. Service companies obtain these loans from retail dealers, usually on a nonrecourse basis. Almost all bank/service company agreements contain a credit insurance policy that protects the lender if the consumer defaults. Unsecured loan Unsecured loans are monetary loans that are not secured against the borrowers assets (i.e., no collateral is involved). These may be available from financial institutions under many different guises or marketing packages: • credit card debt, • personal loans, • bank overdrafts • credit facilities or lines of credit • corporate bonds

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Accounting of Islamic Banks

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AL-Baraka Islamic Bank Incorporation Incorporated in Bahrain with limited liability. The bank operates as a branch of a foreign bank domiciled and is incorporated in Bahrain on February 21, 1984 and is a member of AL Baraka Group. Branch Banking This bank is doing business in Pakistan with its branches. Audit Report This bank has got clean audit report by its auditors M/S Ford Rhodes Sidat Hyder & Company Chartered Accountants. Format Of Presentation Liquidity based presentation that is most liquid assets at the top and least liquid long term assets at the bottom. Shariah Compliance Based Banking Shariah Compliance Based Banking is practiced in accordance with IFAS Islamic International Accounting Standards Some IAS are followed and certain IAS are not followed the IAS that are not followed due to their not being effectiveness includes IAS – 1 IAS – 23 IAS – 27 IAS – 3 IFRIC –11 IFRIC –12 IFRIC –13 Requirements of SBP Requirements of SBP are followed. Current & Deferred Taxation The bank also accounts for current and deffered taxation. Basic Operations Its earnings are not based upon interest rather these are based upon investments Statement Of Financial Position Its Statement Of Financial Position totals Rs.2,444,753,000 Profit from Operations - 61 -

Accounting of Islamic Banks

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Its Profit from Operations is Rs.649,998 Profit Un Remitted Its Un Remitted profit totals Rs.400,348,000 Share Holders Equity Its share holder equity totals Rs. 2,446,533,000 Cash Flow - Cash Position Its cash and cash equivalents at the end of the year are Rs.7,600,081 Business Segments Corporate Financing consisting of income earned by way of SUKUK. Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixedincome, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets. Retail Banking net return on financing to real customers. Trading & Sales investment held for trading purposes. Islamic banking is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment of fees for the renting of money (Riba, usury) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks. were formed to apply these principles to private or semi-private commercial institutions within the Muslim community. Basic Principles Employed (Points of Distinction Between Islamic Versus Interest based Banking) Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba (usury). Amongst the common Islamic concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah).In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and resell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining - 62 -

Accounting of Islamic Banks

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ownership of the vehicle until the loan is paid).An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower forms a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rent out the property to the borrower and charges rent. The bank and the borrower will then share the proceed from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share on the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receives the proceeds from an auction based on the current equity

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Accounting of Islamic Banks

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Interview With Adnan Yousuf – Manager FAYSAL BANK LIMITED F-10 Branch. Q: What is Islamic banking? A: This is a banking activity based on Islamic principles, which do not allow the paying and receiving of interest (riba’) and promotes profit sharing in the conduct of banking business. Q: Is Islamic banking meant for Muslims only? A: No. Islamic banking is for all individuals regardless of their religious belief. Q: What are the differences between Islamic and conventional banking? A: The most important difference between Islamic and conventional banking is the prohibition of interest in Islamic banking. Islamic banking activity must comply with Shariah principles and avoid prohibited activities such as gharar (excessive uncertainty). For example, instead of lending with interest, Islamic banks provide financing based on Bai’ Bithaman Ajil whereby it is based on trade. Q: How do Islamic banks and IBS reward their depositors since payment of interest is not allowed? A: Shariah allows the profit sharing arrangement between the bank and the depositor. Profits from Islamic banking activities will be shared between the bank and the depositor based on an agreed profit sharing ratio and paid in the form of dividends. The amount of dividend payout depends on the profits generated from the bank’s operation. Shariah also allows the bank to give hibah to its depositors based on its discretion. Q: Where can I obtain Islamic banking products and services? A: You can obtain Islamic banking products and services at any bank that carry the Islamic banking logo and which provides Islamic Banking Services. Q: Does the operations of the Islamic Banks banks fully comply with the requirements of Shariah? A: All Islamic banks are required to set up Shariah Committees to advise them and to ensure that the operations and activities of the bank comply with Shariah principles. All products and services offered by the Islamic banks and IBS banks must be approved by their respective Shariah Committees. Q: Can an IBS bank transfer credit balances of a customer's Islamic account to a conventional account, or vice versa? - 64 -

Accounting of Islamic Banks

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A: Upon a customer's request, an IBS bank may transfer funds from an Islamic account to a conventional account. On the other hand, only the principal amount can be transferred from a conventional account to an Islamic account. No element of interest is allowed to be transferred. Q: What are the avenues available if I am dissatisfied with the services provided by Islamic banks or IBS banks? A: You should contact your bank if you have any complaints. All banks have set up a dedicated Complaint Unit to deal with customers’ complaints.

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Accounting of Islamic Banks

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