The need of accounting standards for Islamic financial institutions: evidence from AAOIFI

The need of accounting standards for Islamic financial institutions: evidence from AAOIFI

Adel Mohammed Sarea 

College of Business and Finance, Ahlia University, Kingdom of Bahrain, and 

Mustafa Mohd Hanefah

 Faculty of Economics and Muamalat, Universiti Sains Islam Malaysia (USIM), Malaysia

          At present, Islamic banks represent the majority of Islamic financial institutions (IFIs), which are spread locally and internationally across both Muslim and non-Muslim countries. The emergence of Islamic banking is due to the increasing demand from Muslims communities worldwide for Shari’ah complied Islamic financial products, services and the variety of modes of Islamic finance. However, Islamic banking is evolving and growing at a rapid rate with an impressive record of more than 200 IFIs operating in 63 Islamic and non-Islamic countries (Maali and Napier, 2010). The past ten years saw high growth in the number of IFIs around the world that has attracted major Western institutions such as Citibank, HSBC, and Deutsche Bank, which operate Islamic windows within conventional banks (Maali and Napier, 2010). Furthermore, given the rate of growth of the IFIs, the continuous sustainability of the development by IFIs in both Islamic and non-Islamic countries needs Islamic accounting standards otherwise called accounting and auditing organization for Islamic financial institutions.

          (AAOIFI) accounting standards due to the unique characteristics coupled with the growing demand of IFIs’ products and services so as to facilitate and enhance the credibility and reliability of the financial statements and reports. It is argued that the current standards which are based on conventional framework seem insufficient to guide the IFIs. 

Currently, the various IFIs apply different accounting standards in their preparation of their accounts due to the absence of Islamic accounting standards (Zaini, 2007). The trend towards the AAOIFI standards has become a pressing issue that has generated heated debate among Organization of Islamic Cooperation countries.

         The needs for accounting standards and IFIs are emphasised in the Quran: [...] Never get bored with recording it, however small or large, up to its maturity date, for this is seen by Allah closer to justice, more supportive to testimony, and more resolving to doubt [...] (al-Baqara: 282) (Tag El-Din, 2004). 

              In addition, “Those who eat Ribaˆ (usury) will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitaˆn (Satan) leading him to insanity.” That is because they say: “Trading is only like Ribaˆ (usury)”, whereas Allaˆh has permitted trading and forbidden Ribaˆ (al-Baqara: 275). Based on the above quoted verses of the holy Quran, Allaˆh has permitted trading and forbidden Ribaˆ (usury). For that, Allah sent his Prophet Mohammed (S.A.W) to teach the Ummah and guide them. Over the years, Islam has gained tremendous popularity and is currently recognized as the second largest and fastest growing religion in the world. Islam does not only lead to ritualistic religion confined to individuals rather, it also involves an integrated way of life that combines politics, economics, culture, religion and every aspect of human life (Hameed, 2001). Based on the fact that, Islam is a belief system that unites about 1.2 billion people around the world which approximately constitutes one-quarter of the global population(Masood and Tahir, 2008), it is necessary that, Muslims develop and embrace a unique economic system (Islamic Economic System) to meet their needs. In this regard, IFIs have been established to fulfill this need by helping the Muslims community to avoid Ribaˆ (usury) in their financial engagement and daily financial transactions. One of the IFIs is Islamic banks. Islamic banks transactions as reflected in the financial reporting are prepared under a variety of accounting standards which pose a threat to its unique accounting and reporting system. Thus, Islamic accounting standards will ensure a compatible accounting system. This, therefore, led to the growing aspiration for a financial statement that has the potential to enhance the credibility of financial statements that are in accordance with the Shari’ah, and the need to make the Islamic accounting standards relevant. 

             However, before the implementation of the Islamic accounting standards such as AAOIFI by IFIs, it is necessary to ascertain whether AAOIFI accounting standards are appropriate and suitable for Islamic banks, and whether the compliance with the AAOIFI accounting standards may disclose more information to users in order to create confidence among investors and the public to invest their money in these sectors.

           Islamic banks operate mainly in developing countries-for example, the Middle East, Africa, and South-East Asia. These countries are facing accounting problems in their practice due to dissimilar accounting standards adopted to prepare financial reporting. For instance, financial institutions in Jordan, the UAE and Qatar are officially required to comply with the IASs. Meanwhile, in countries such as Saudi Arabia, the authorities require compliance with both IAS and local accounting standards. In Malaysia, there are national accounting standards (MASB) which are based on IAS (Ahmed, 2002). Beginning January 2012, Malaysian accounting standards are in full congruence with the IFRSs.

                Therefore, researchers in the area of financial reporting for IFIs have conducted a considerable number of studies to investigate the Islamic banks’ compliance with accounting standards. Until recently, one of the main problems facing Islamic banking includes a lack of standardized accounting and auditing standards (Pomeranz, 1997). However, conventional accounting is inappropriate for Muslim users and Islamic organizations according to Hameed (2001), and it is inappropriate to impose unmodified Western accounting practices on developing countries (Karim and Tomkins, 1987). In addition, IASs based on such techniques would create difficulties for Muslims around the world. Therefore, it is imperative for the Muslim accountants to develop accounting standards which are specially adapted to Islamic needs, and for Muslim countries (Shadia, 2007).

Basically, there is a lack of evidence regarding the adoption of the Islamic accounting standards and analysis of Islamic banking principles under national Shari’ah advisory council, central bank roles, political system and economic structure. Moreover, the major problem is in the adoption of accounting standards and disclosure in IFIs that is still based on the conventional accounting philosophy (Harahap, 2003). It is argued that the adoption of accounting standards by Islamic banks will help to enhance their credibility and fuel their growth worldwide (Ariss and Sarieddine, 2007). However, the rapid development of IFIs requires standards for disclosing information, satisfying not only the general standards of disclosure but also standards relating to Islamic values (Harahap, 2003).  

The actual practice and the level of implementation of the Islamic accounting standards such as AAOIFI requirements among Islamic banks are currently unknownand needs to be investigated. Based on the fact that, these requirements are voluntary in some countries, as well as due to the absence of authorities to implement Islamic accounting standards, IFIs are currently applying different accounting standards in their financial reporting. Thus, diversities exist in terms of their class structure, political systems, legal systems, financial systems, educational systems, and the very nature of conducting business and business ownership (Choi and Meek, 2005). Furthermore, the problem may be due to lack of representative of the diverse environment factors as a result of adopting or complying with different accounting standards by Islamic banks. These differences among countries would dictate different accounting practices that reflect the environmental factors of each country. A single harmonized standard of accounting practices would be inappropriate and not representative of all the varied environmental factors exhibited in global markets (Lovett, 2002). However, accounting standards are used to generate comparable and reliable accounting information to help investors, creditors and other users to make investment decisions. These standards reflect the culture, history, and other characteristics of accounting problems facing those countries (Abongwa, 2006).

                      Due to the current different regulatory requirements and legislations, the relevance and comparability of financial statements are the foundations upon which accounting standards are predicated. Lovett (2002) documented that, with financial statements prepared under different accounting standards a problem may exist in: . comparability of financial statements prepared globally; and . reliability and creditability. The Accounting Standards Steering Committee (ASSC) was a self-regulatory private sector body, and ASSC became the Accounting Standards Committee in 1975 in the UK (Whittington, 1989). Similarly, the AAOIFI Committee is a self-regulatory private body. Both ASSC and AAOIFI brought in leading accountancy bodies to prepare and develop accounting standards relating to recognition, measurements and disclosure. Furthermore, ASSC and AAOIFI are professional bodies sponsored by charted institutions and are non-profit corporate and independent organizations. The AAOIFI is supported by institutional members (200 members from 45 countries) including central banks, IFIs, and other participants from the international Islamic banking and finance industry, worldwide (AAOIFI, 2010a, b). Similarly, ASSC is also an independent body sponsored by some chartered institutions (the Irish and Scottish institutes) (Whittington, 1989).

        By using the same approach of Solomons Reports 1989 to address this issue, the AAOIFI’s current problem is lack of authority. Similarly, the main problem to impose accounting standards in the UK is lack of authority as well as ASSC failure to avoid controversy by accommodating the needs of pressure groups (Whittington, 1989). Similar problem is being experienced by AAOIFI which does not have authority to impose Islamic accounting standards globally. This is due to differences among member countries to adopt AAOIFI standards in their respective countries.

          However, regarding comparability, reliability, and creditability of financial reporting globally or locally, Callao and La´inez (2007) pointed out that, local comparability is negatively affected if both the IFRS and local accounting standards are applied in the same country at the same time. In a related study, Mutter (1993) stated that, it can be argued that the adoption of IASs would benefit many users of accounting information, who demand comparable and reliable information.

in aditional Haverty (2006) found that, lack of comparability is mainly caused largely by the revaluations of property, plant and equipment (IAS 16) permitted under IFRS, but not permitted under US GAAP.

                Global accounting standards are perceived by a segment of the financial community as the solution to this problem, while other members of the community adhere to the philosophy of maintaining individual, national accounting standards (Lovett, 2002). In the adoption process of the accounting standards, influences that affect the rate of adoption are identified. These influences cause changes in the attitudes of participants in a social system towards the adoption of accounting standards. The influences and their effect on the rate of adoption are what need to be studied in order to interpret the association of the variables influencing the adoption of accounting standards (Lovett, 2002).

Moreover, diversity in IFIs practices means that, there are practices that have not been covered by Islamic accounting standards (AAOIFI) or any accounting standards that are in line with Shari’ah principles. Therefore, developing unique accounting and auditing standards for the dissemination of such information about IFIs becomes a necessity (Tag El-Din, 2004). Islamic banks worldwide prepare their financial statements using variety of accounting standards either IASs or local accounting standards, the problem may exist in the practices and the level of understanding among accountants and the level of compliance of Islamic banks global (KPMG and ACCA, 2010, Report). Thus, the need for Islamic accounting standards may possibly be the right way to resolve these issues. In this regard, there have been arguments in previous studies that, because of the unique transactions of Islamic banks, conventional accounting rules such as the IFRSs are not compatible to Islamic banks (Maali and Napier, 2010). This is because, in the IFIs, depositors’ funds are not guaranteed, and customer deposits cannot be reported as liabilities in the balance sheets of Islamic banks. Recently, however many Islamic banks have been adopting the accounting standards set by AAOIFI (Maali and Napier, 2010). Therefore, understanding factors affecting the levels of compliance with the Islamic accounting standards (AAOIFI) need to be investigated in the future studies.

Furthermore, the acceptability and understanding of the role of the Islamic accounting standards (AAOIFI) can be of high significance for policy implications, regulators, and standard setters. Currently, the evolving literatures surrounding the interpretation of the levels of compliance with the accounting standards for IFIs generated a heated debate among the researchers. Thus, this paper aims to provide answers to the current debate. A clear understanding and acceptability have the potential to lead to more compliance with Islamic accounting standards such as AAOIFI. Therefore, it is uncertain to determine whether the Islamic banks would switch to the AAOIFI standards or adopt a combination of both of the AAOIFI and local standards.

 It is therefore necessary to ask the following question: do we need Islamic accounting standards?

Furthermore, the acceptability and understanding of the role of the Islamic accounting standards (AAOIFI) can be of high significance for policy implications, regulators, and standard setters. Currently, the evolving literatures surrounding the interpretation of the levels of compliance with the accounting standards for IFIs generated a heated debate among the researchers. Thus, this paper aims to provide answers to the current debate. A clear understanding and acceptability have the potential to lead to more compliance with Islamic accounting standards such as AAOIFI. Therefore, it is uncertain to determine whether the Islamic banks would switch to the AAOIFI standards or adopt a combination of both of the AAOIFI and local standards. It is therefore necessary to ask the following question: do we need Islamic accounting standards?

AAOIFI had tended to start with objectives established in contemporary accounting thought, test these objectives against Islamic Shari’ah, and accept those that are consistent with Shari’ah and reject those objectives that are not consistent with Shari’ah (Maurer, 2010). The objectives of the AAOIFI organization is to prepare and develop accounting, auditing, governance and ethical standards relating to the activities of IFIs. According to AAOIFI (2008) the objective of financial accounting for Islamic banks and IFIs are as follows: . 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’ah and its concepts of fairness, charity, and compliance with Islamic business values. . To contribute to the safeguarding of the Islamic bank’s assets, its rights and the rights of others in an adequate manner. . 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’ah in all transactions and events. . To provide, through financial reports, useful information to the users of these reports, to enable them to make legitimate decisions in their dealings with Islamic banks. In reference to the above objectives, this research attempts to contribute to the current framework and serve as a guide for IFIs regarding interest free transactions through determining the levels of compliance with the AAOIFI accounting standards by Islamic banks.

               The adoption or compliance with the AAOIFI accounting standards and IFRS has become the focus among IFIs. The objectives of the AAOIFI accounting standards are to prepare and develop accounting, auditing, governance, ethical, and Shari’ah standards relating to the activities of IFIs. Based on the stakeholder theory, this paper discussed the importance of the AAOIFI accounting standards for IFIs globally. The AAOIFI accounting standards for IFIs that are in accordance with the Shari’ah requirements are the best choice for increasing foreign investments and investor’s confidence among Muslim societies and economies. AAOIFI through its global network has also persuaded regulatory authorities to adopt its standards, but until now AAOIFI has not been fully successful. It does not have the power to enforce its standards on IFIs globally. It is strongly recommended that Muslim countries should give full support to AAOIFI standards by adopting and making them mandatory for all IFIs.