1. Financial Accounting for Islamic Banking Products
Introduction to Islamic Banking and Finance: Principles and Practice M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni
Chapter 4
Financial Accounting for Islamic Banking Products

2. Learning Objectives
Upon completion of this chapter, the reader should be able to:
Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making
Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation
Understand the basic principles of accounting
Understand the basic principles of Islamic accounting
Differentiate between the accrual and cash flow accounting methods
Draft the main financial statements for Islamic finance products

3. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making
The Definition and the Significance of Accounting in Financial Decision-making
What is Financial Accounting?
Financial accounting is a process where business operations and their activities are measured and measurements are processed into information for these decision-makers:
    - Internal decision makers include the management of the company
- External decision makers are mainly investors and customers

4. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making
The Definition and the Significance of Accounting in Financial Decision-making
The definition of accounting involves the following main issues:
1. Recognizing, recording, classifying and summarizing business transactions
2. Measuring, analyzing, processing, interpreting operating results
3. Reporting and presenting the financial position

5. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making
The Definition and the Significance of Accounting in Financial Decision-making
What is Islamic Accounting? … is ‘the accounting process that provides appropriate information to stakeholders of an entity that will enable them to ensure that the entity is continuously operating within the bounds of the Islamic Sharī‘ah and delivering on its socioeconomic objectives’

6. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making
The Definition and the Significance of Accounting in Financial Decision-making
The general definition of financial accounting is acceptable within the Islamic finance framework if it complies with Islamic Sharī‘ah
Financial accounting in both Islamic and conventional frameworks enable stakeholders to make informed decisions
Financial accounting fulfills the needs of external decision-makers

7. Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making
The Definition and the Significance of Accounting in Financial Decision-making
Accountability in Islam
The Holy Qur’an emphasizes the need and requirement of accountability ‘hisab’ in every human activity
Transparency and fair dealings involve a great commitment towards accountability in financial transactions
Muslim accountants have more responsibilities than non-Muslim counterparts

8. The Significance of Accountability in Islam
Learning Objective 4.1 Understand the definition of accounting from both conventional and Islamic perspectives, respectively, and its significance in financial decision-making
The Significance of Accountability in Islam
The significance of accountability with particular reference to financial transactions is evidenced by the following Islamic concepts:
Khilafah (vicegenrency)
Taklif (responsibility)
Documentation of financial dealings
Islamic law of inheritance (mawarith)
Calculation of obligatory alms (zakat)
The underlying concept of tawhid (unity of God)

9. International Financial Reporting Standards (IFRS)
Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation
International Financial Reporting Standards (IFRS)
IFRS standards developed by independent, non-for-profit organisation (International Accounting Standards Board [IASB])
The IASB is the standard-setting body of the IFRS Foundation
The IFRS provides globally acceptable standards for public companies preparing and disclosing financial statements
The IFRS contains general guidelines for financial reporting
The IFRS is more relevant to multinational companies
IFRS replaced the International Accounting Standards (IAS)

10. International Financial Reporting Standards (IFRS)
Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation
International Financial Reporting Standards (IFRS)
The Different Aspects of the Structure of IFRS
International Financial Reporting Standards (IFRS)—standards issued after 2001
International Accounting Standards (IAS)—standards issued before 2001
Interpretations originated from the International Financial Reporting Interpretations Committee (IFRIC)—issued after 2001
Standing Interpretations Committee (SIC)—issued before 2001
Conceptual Framework for the Preparation and Presentation of Financial Statements (2010)

11. International Financial Reporting Standards (IFRS)
Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation
International Financial Reporting Standards (IFRS)
IFRS and Islamic Banks and Financial Institutions
IFRS designed for conventional forms of business
Islamic banks have specific requirements e.g. transactions, reporting and disclosures
Therefore, the Islamic finance industry requires alternative sets of accounting and financial reporting standards
The establishment of the Bahrain-based Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1991

12. International Financial Reporting Standards (IFRS)
Learning Objective 4.2 Explain the relevance of International Financial Reporting Standards (IFRS) in international accounting regulation
International Financial Reporting Standards (IFRS)
Differences between Islamic Accounting and Conventional Accounting
- Financial instruments
- Accounting standards
- Accounting treatment
- Types of information contained in financial statements
- Financial reporting
- Functions of commercial/financial contracts

13. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting
Accounting comprises two main business activities:
Bookkeeping The detailed recording of all financial transactions in the business
The preparation of financial statements or financial accounting (periodically) Depending on the policy and the accounting standards adopted by the business

14. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting.
Basic Principles of Accounting
Recording Financial Information
Records for every financial transaction must be kept
Information recorded must reflect revenue and expenditures
Journal: Accounting record where financial transactions of a business are originally entered
Account or Ledger or (T Account): Ledger account format resembling the letter T originating from process of using debits and credits

15. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting.
Basic Principles of Accounting
Double Entry Bookkeeping
Every financial transaction has two main aspects:
1- Debit aspect: the receiving, incoming or expenses/loss aspect of financial transactions
2- Credit aspect: the giving, outgoing or income/gain aspect of financial transactions
For every debit, there must be a corresponding credit of an equal amount
For every credit, there must be a corresponding debit of an equal amount
In a balanced account, total debits must equal total debits

16. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting
Basic Principles of Accounting
Figure 4.1: The Basics of the Double Entry System

17. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting
Basic Principles of Accounting
The Branches of Accounting
Cost and management accounting
Financial accounting
Auditing
Figure 4.2: The Three Branches of Accounting

18. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting
Basic Principles of Accounting
Cost and Management Accounting
The information generated in cost and management accounting
- Provides relevant information helping managers make informed decisions in managing the business
  - Is useful in planning, controlling and the measurement of performance

19. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting
Basic Principles of Accounting
Financial Accounting
Provides relevant information to interested parties (stakeholders) outside the domain of the business such as investors, banks, future partners, regulatory bodies, government agencies, stockholders, prospective buyers
Allows stakeholders in the industry to make sound economic decisions that could have an impact on the populace

20. Basic Principles of Accounting
Learning Objective 4.3 Understand the basic principles of accounting
Basic Principles of Accounting
Auditing
Determines the authenticity, validity and reliability of the financial information recorded or disclosed during a financial period
Forms of auditing:
- Internal auditing where the business carries out auditing
- External auditing when the business engages an outside company, usually an auditing firm, to conduct auditing
Modern practices combine internal and external auditing for a particular financial year

21. Basic Principles of Islamic Accounting
Learning Objective 4.4 Understand the basic principles of Islamic accounting
Basic Principles of Islamic Accounting
The objectives of Islamic accounting are diverse
depending on the approach used
The purposes of Islamic accounting include:
- reporting of accurate income information
- promotion of efficiency and leadership
- compliance with the Sharī'ah
- commitment to justice
- reporting best practices and adapting to social change through corporate social responsibility  

22. Basic Principles of Islamic Accounting
Learning Objective 4.4 Understand the basic principles of Islamic accounting
Basic Principles of Islamic Accounting
Consumers of Accounting Information for Islamic Banks
The most popular method of communicating financial
information to consumers or users is through the use of
financial statements

23. Basic Principles of Islamic Accounting
Learning Objective 4.4 Understand the basic principles of Islamic accounting
Basic Principles of Islamic Accounting
Consumers of Accounting Information for Islamic Banks
Equity holders
Holders of investment accounts
Other deposits
Current and saving account holders
Others who transact business with the Islamic bank, who are not equity or account holders
Zakah agencies (if there is no legal obligation for payment)
Regulatory agencies
(AAOIFI Statement of Financial Accounting (SFA) No. 1, para 26)

24. Basic Principles of Islamic Accounting
Learning Objective 4.4 Understand the basic principles of Islamic accounting
Basic Principles of Islamic Accounting
(SFA No. 1) requires information intended for external users:
Information about the bank’s compliance with Sharī'ah and its objectives to establish such compliance
Information about the Islamic bank’s economic resources and related obligations
To assist in the determination of Zakah on the Islamic bank’s funds
To assist in estimating cash flows from dealing with the bank
To assist in evaluating the bank’s discharge of fiduciary responsibility
Information about the Islamic bank’s social responsibilities

25. Basic Principles of Islamic Accounting
Learning Objective 4.4 Understand the basic principles of Islamic accounting
Basic Principles of Islamic Accounting
 An Islamic Perspective of Accounting Concepts
The Qur’an and prophetic precedents emphasise accountability in commercial transactions
Full disclosure, social and financial accountability
Ethics for accountant entails trustworthiness and objectivity
The Islamic financial institution needs to provide relevant information on all transactions for the user. The Islamic bank needs to account for social responsibilities
The religious-spiritual element in financial transactions is as important as the element of profitability

26. Basic Principles of Islamic Accounting
Learning Objective 4.4 Understand the basic principles of Islamic accounting
Basic Principles of Islamic Accounting
Accounting and Auditing Organization for Islamic Financial Institutions Standards
(AAOIFI): Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) established in Algiers in 1990 as an independent non-governmental organization based on Agreement of Association among financial institutions from different Muslim countries
AAOIFI issued the first accounting auditing, governance and Sharī'ah standards in 1991 followed by a series of relevant standards for specific Islamic finance products
Many countries have adopted AAOIFI accounting standards

27. Basic Principles of Islamic Accounting
Learning Objective 4.4 Understand the basic principles of Islamic accounting
Basic Principles of Islamic Accounting
Some countries like Bahrain, Jordan and Sudan have required Islamic financial institutions in their respective jurisdictions to abide by the AAOIFI reporting standards
Others allow such Islamic financial institutions to adopt the standards voluntarily

28. Accrual and Cash flow Accounting Methods
Learning Objective 4.5 Differentiate between the accrual and cash flow accounting methods
Accrual and Cash flow Accounting Methods
Accrual and Cash flow Accounting Method
1. The cash flow accounting method - based on frequency of cash flow (requires an actual exchange of cash)
2. The accrual accounting method - based on the occurrence of a transaction regardless of whether there is exchange of cash

29. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Financial statement is the formal record of the financial activities (transactions) of a business entity
Transactions are duly sorted, classified and presented in accordance with principles of bookkeeping
The transactions being recorded comprise any business transacted between the business entity and other corporate bodies, organisations or individuals
The end product of all financial transactions is the financial statement

30. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Figure 4.3:
Flow of Financial Transactions

31. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Comparative financial statements of a corporate entity
Gives direction of business change in at least two financial periods
Provides top management with information for decisions
Comparative financial statements analysis (Horizontal analysis)
Determines the performance of the business
Provides necessary information about sustained performance or poor performance
Islamic banks and financial institutions are required to publish comparative financial statements

32. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Four Basic Financial Statements
Balance sheets
Income statements
Cash flow statements
Statement of retained earnings or shareholders’ equity

33. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Balance Sheets also known as the Statement of Financial Position): a summary of financial balances of a company
Income Statements The income statement is a financial statement that measures the financial performance of a company over a specific period of time indicating how the revenue is transformed into net income
The income statement may also be referred to as
i) The Profit and Loss Statement
ii) Statement of Operations
iii) Statement of Income

34. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Cash Flow Statements 
Also called statement of cash flow or funds flow statement
Indicates how changes in the balance sheet accounts and income statements affect cash and its equivalent
Purpose is for identification of the sources and uses of cash during the financial year in question
FAS 1, para 54 states the statement of cash flows should differentiate between cash flows from operations, from investing activities and from financing activates

35. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Statement of Retained Earnings or Shareholders’ Equity
A financial statement explaining changes in retained earnings of a company over a period of time
The statement of retained earnings may also be called:
- Statement of owner’s equity (in a single proprietorship)
- Statement of partners’ equity (in a partnership)
- Statement of retained earnings and stockholders' equity (for corporations)

36. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
Statement of Retained Earnings or Shareholders’ Equity
The owners’ equity and retained earnings may be calculated using the following formulae:
Owners’ equity = Assets – Liability

37. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
AAOIFI Proposed Set of Financial Statements for Islamic Banks
 There are three major categories
The first category comprises the financial statements that are meant to reflect the position of the Islamic bank as an investor, such as:
Statement of Financial Position
Statement of Income
Statement of Cash Flows
Statement of Retained Earnings or Statement of Changes in Owners’ Equity

38. Financial Statements in Islamic Banks and Financial Institutions
Learning Objective 4.6 Draft the main financial statements for Islamic finance products
Financial Statements in Islamic Banks and Financial Institutions
AAOIFI Proposed Set of Financial Statements for Islamic Banks
The second category focuses on the financial reporting of restricted investments managed by the Islamic bank for the benefit of others. Such a statement will be referred to as “Statement of Changes in Restricted Investments”
The third category includes financial statements reflecting the Islamic bank’s role as a fiduciary of funds made available for social services
Statement of Sources and Uses of Funds in the Zakah and Charity Fund
Statement of Sources and Uses of Funds in the Qard Fund

39. Key Terms and Concepts AAOIFI Account receivable
Accrual method of accounting
American Accounting Association
Bookkeeping
Cash flow method of accounting
Cash flow statement
Compound accounting
Double entry bookkeeping
Credit
Debt
Deferred payment
Equity of unrestricted account holders
Expenditure
External auditing
Financial accounting
Horizontal analysis

40. Key Terms and Concepts Income statement Internal auditing
Islamic worldview
Journal
Journal entry
Last Day
Net income
Periodicity concept
Qard Fund
Revenue
Statement of retained earnings
T account or ledger
Waqf
Zakah