1. The Islamic Financial System
FN 6103
Accounting for Islamic Financial Transactions

2. The basic principle
O ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye are indeed believers. If ye do it not, Take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums: Deal not unjustly, and ye shall not be dealt with unjustly. (Al-Baqara,2: )

3. Islamic Economic and Financial System and Riba.
The Islamic economic system aims to achieve social justice from a religious ethical perspective.
Although the Western economic systems whether capitalist, socialist or welfare state, aim to achieve human welfare, they all seem to have accepted interest as a fair reward for capital, although interest has been condemned by Western thinkers such as Marx.
The Islamic economic system is based on its complete elimination from the economy by introducing the alternative of participative investment as opposed to a rentier economy.
The capitalist system strives to attain human welfare through the operation of the invisible hand driven by self-interest and a free market. The Marxist system attempted to create social welfare by ownership and centralisation of the production function by the state (representing the workers).
However, all these systems have been ‘unsuccessful’ in achieving social welfare for all (Chapra, 1992).
There is no complete Islamic economic system in operation, the unique characteristics and features of the Islamic economic system are worth discussing in order to better understand the philosophy under which Islamic financial institutions operate.

4. The objectives and characteristics of the Islamic Economic System
Ahmad (1994a) observes that the Islamic economic program includes
a different concept of the individual and his rights,
a different concept of property and
a different approach to civil and economic contracts.
Its principles of economic organisation are also different including;
how and on what basis co-operation and collaboration between individual and
society is to take place,
the need for regulating the market to attain efficiency and equity,
and the role of the state in the fiscal system.

5. The objectives and characteristics of the Islamic Economic System
Al-Faisal & Ali (1996) sum up the principal characteristics of the Islamic Economic System as follows:
Although every individual has a right to seek his economic well being, Islamic makes a clear distinction between what is lawful and what is unlawful in the pursuit of economic activity. Broadly, Islam forbids all forms of economic activities, which are morally or socially injurious. The particulars as to what is considered morally or socially injurious vary from the secular capitalistic system.
Although Islam recognises, the ownership of legitimately acquired wealth, the individual is obligated to spend his wealth judiciously and not to hoard it, keep it idle or squander it.
Although an individual may retain surplus wealth, Islam seeks to reduce the margin of this surplus for the well being of the community as a whole.
It seeks to prevent the accumulation of this wealth in a few hands to the detriment of the society as a whole through its law of inheritance
It aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually selfdestructive.

6. The objectives and characteristics of the Islamic Economic System
Chapra (1992) observes that in line with the Islamic concept of brotherhood and justice, all resources at the disposal of human beings must be utilised to actualise the objectives of the Shari’a. He suggests four objectives of the Islamic economic system:
Need fulfilment: the basic needs of all individuals must be satisfied and everyone must be assured of a humane and respectable standard of living.
Respectable Source of Earnings: The dignity attached to man’s status, as God’s khalifah or representative means that need fulfillment should be through the individual’s effort. In the case of handicap or inability to earn a living, it is the collective obligation of the Muslim community to fulfil their needs through Islamic socioeconomic institutions such as Zakat, and charitable endowments- awqaf.
Except for Zakat, which is administered by the state, the other institutions are voluntary but form part and parcel of the Islamic economic ethic.
Equitable distribution of income and wealth: Although inequalities in income and wealth can be tolerated in proportion to skill, initiative, effort and risk, skewed inequalities are incompatible with Islamic teachings. The elimination of interest, the introduction of Zakat and change in consumer behaviour patterns to one conforming to Islamic guidelines are essential to achieve this.
Growth and Stability: Growth and stability are essential to maintain employment and to ensure the goal of equitable wealth distribution as the poor can reap the fruits of economic growth thus lessening the burden of the rich to redistribute wealth.

7. OBJECTIVES OF THE ISLAMIC ECONOMIC SYSTEM (Chapra 1992)
a) Introducing a socially agreed filter mechanism: In addition to the price mechanism, a double layer of moral filters tempers claims on resources. Individually, Islamic consumers should avoid wasteful expenditures because of legal/moral precepts of the Shari’a. In addition the Islamic financial system also acts as moral filters in their investing and credit expansion activities.
b) A strong motivating system to induce the individual to render his best in his own interest as well as in the interest of society. This comes from the Islamic concept of accountability to Allah, from whom no actions can be hidden, and to whom every action has to be accounted for in the life after death.
c) Restructuring the entire economy to realise the Shari’a objectives in spite of scarce resources. This is to be done by reforming all social, economic and political institutions including public finances and financial intermediation to minimise wasteful and unnecessary consumption and to promote investment for need fulfillment.
The Islamic structures will also support the filter and motivating system by not allowing material possessions and conspicuous consumption to become a source of prestige, thus killing off the economic man.
d) A positive and goal-oriented role for the government. The government would support the raising of the moral consciousness of people, motivate and help the private sector play its role effectively and accelerate political, social and economic reform and provide incentives and facilities.

8. OBJECTIVES OF THE ISLAMIC ECONOMIC SYSTEM
reforming the banking and monetary system to eliminate interest transactions and putting them on an Islamic plane is one of the cornerstones of the Islamic financial system.
The development of an interestfree, ethical Islamic economic system is an important agenda of most Islamic movements and some governments such as Pakistan, Iran and Sudan (Ahmad, 1994a).
Other countries, such as Malaysia and Bahrain, allow Islamic economic institutions such as Islamic banks to operate in parallel with the conventional financial system.
Social Justice is said to be the hallmark of the Islamic economic system (Ahmed et al., 1996). In order to achieve this Islamic economy, two institutional devices i.e. “the abolition of interest and presence of a well-functioning Zakat system (p3)” are considered essential.
As the Islamic financial system relies mostly on the former, this aspect will be discussed in some detail.

9. Riba - Definition and classification
The Qur’an and the Hadith of the Prophet (pbuh) specifically prohibits riba in economic transactions in the sternest terms (e.g. Al-Qur’an, 2:275,278,279).
Riba has been translated into English as usury or interest.
However, it has in fact a much broader meaning under the Shari’a as suggested by its dictionary meaning of “increase” or “gain”. Saleh (1992) has defined riba in the Shari’a context as “an unlawful gain derived from the quantitative inequality of the counter-values in any transaction purporting to effect the exchange of two or more species, which belong to the same genus and are governed by the same efficient cause” (p16).
Thankfully, the author has adopted a shortened version of this rather long technical definition as “an unlawful advantage by way of excess or deferment” (p17).
Riba has been classified into two categories: riba al-fadl and riba al-nasi’a (Muslehuddin, 1987).
Riba al-fadl is riba by way of excess of one of the exchanged counter-values e.g. the exchange of 2 Kg. of low quality rice for 1 Kg. of high quality rice.
Riba al-nasi’a is excess by way of deferment of completion of exchange, for example a loan of £100 for a deferred repayment of £110 a year later.
As Islamic banking involves the elimination of Riba al-nasi’a, further discussion on riba will be limited to this form only.

10. Reasons for the prohibition of Riba
We can thus surmise that any interest or excess above the principal sum in a deferred repayment transaction is riba. The reason given in the Qur’an for the prohibition of riba is that, a pre-determined fixed rate of return on capital lent leads to injustice because there is an uneven distribution of risk and reward in the transaction (Obiyathulla, 1995).
One party bears the risk, while the other party receives a reward irrespective of the outcome of the use of the borrowed amount.
Riba is also said to lead to the concentration of wealth by transferring wealth from the poor to the rich, a position not unreasonable given the current distribution of wealth and third world debt crisis (Caufield, 1998).
It is also said to increase the instability of the trade cycle, causing more violent fluctuations because a high rate of interest, by increasing the cost of capital, discourages investments (Keen, 1997).

11. Comment from conventional practitioners
An IMF economist observes that Islamic banking, based on the elimination of riba will to lead to a more stable banking system, thus:
“The Islamic model of banking based on the principle of equity participation may well prove to be better suited to adjusting to shocks that result in banking crisis and disruption on the payment mechanism of the country. In an equity-based system that ...does not guarantee the nominal value of deposits, shocks to asset positions are immediately absorbed by changes in the values of the share deposits held by the public in the banks. Therefore, the real value of assets and liabilities of banks in such a system will be equal at all points in time. In the more traditional banking system since the nominal value of deposits is fixed, such shocks can cause a diversion between real assets and liabilities”. (Mohsin, 1986, p19)

12. Controversies on the prohibition of Riba
In the light of modern financial practices, the elimination of interest would seem to be an unworkable plan. In fact, the elimination of interest has been thought to be irrational and a sign of a backward economy. Although usury i.e. excessive rates of interest, especially on consumption loans are regarded by some in the West as immoral, commercial interest is seen as a legitimate reward for the use of capital in modern economies.
It is justified as reward for the “time value of money”. Indeed, some modern Muslim economists (in the early part of this century) and even some Islamic scholars have tried to restrict the definition of riba to usury and thus legitimise the institution of interest among Muslims. Among the arguments offered in favour of legitimising interest are:
(a) Riba is only usury and not interest
(b) Riba is compound interest and not simple interest
(c) Only interest on consumption loans is prohibited, not on investment loans.
(d) Islam recognises the time value of money and therefore interest should be allowed.
(e) Bank interest is not prohibited because it is not exploitative.

13. The first controversy as to whether riba is limited to usury begs the question as to what is the upper limit of the interest rate which is justified and what rate does illegitimate usury begins.
Prior to 1571 in England, at least, all rates of interest above zero were considered usurious following the edict of St. Thomas Aquinas (Keen, 1997).
Of course, a legal solution could be offered but the historical evidence shows, at different times, different rates were considered usurious.
For example, the Sumerians considered 25% interest rate normal while the 1571 Act against Usury of England indicated that anything more than 10% was usurious.
Although in a secular framework, the rate of usury may be a matter of individual conscience or to parliamentary consensus, this does not provide the specific technical, moral or any other reason why the rate below the benchmark is justified and that above is not. (Shaikh, 1987).
The second controversy asserting that riba is only compound interest is based on one interpretation of the Quranic verse: “ O you who believe, do not devour riba, doubling and redoubling” (Al- Qur’an, 3:130).
However, Islamic rules of interpretation state that the whole Qur’an (together with the Hadith) must be considered in interpreting any verse.
Verses 275 to 279 of the second chapter of the Qur’an leave no doubt regarding what is meant as they clearly state that only the principal lent is the amount the borrower is obligated to return.
Further, as Hoque (1987) observes, the distinction between compound and simple interest is apparent and not real as an overdue interest on simple interest becomes compounded.
As the compulsory notification of the APR (Average percentage rate) in the UK shows that a compound interest rate can also be expressed in terms of a simple interest rate.
In fact, it is just a matter of time before the interest doubles and triples the principal amount. Thus, this sophistry is not enough to deny the prohibition of riba.

14. Is interest a Riba’?
The secular reasoning that, interest is only injurious, if at all, in consumption loans and not in the case of commercial or investment loans as is the case in commercial bank lending, is not acceptable from an Islamic point of view. This is due to the fact, that at the time of prohibition, Arabia was a major commercial centre of the Indian – Mediterranean trade route (Chaudhuri, 1985).
In fact many of the Companions of the Prophet (pbuh) received loans on an interest basis (before the Qur’anic prohibition) to invest in their trades. The Prophet (pbuh) specifically banned such interest-based loans after the Qur’anic prohibition was revealed, retrospectively. The Qur’an states that “Allah has permitted trade and prohibited riba”, in spite of the protests of the Arabs that “Trade is like riba” (Al-Qur’an, 2:275), Islam is quite clear on this. Further Islam has not prohibited other avenues of lawful employment of capital to generate income in the form of rent, labour-capital participation, joint venture and mark-up trading.

15. Consumption loans vs Development loans
Chapra (1985) quoting Shaykh Abu Zahrah, an eminent Muslim scholar, observes that:
“There is absolutely no evidence to support the contention that
the riba (prohibition)...was on consumption loans and not on
development loans. In fact the loans for which a research
scholar finds support in history are production loans. The
circumstances of the Arabs, the position of Makkah and the
trade of the Quraysh (the tribe of the Prophet (pbuh)), all lend
support to the assertion that the loans were for production and
not consumption purposes”. (Chapra , 1985, p 62).
One might protest that despite the historical basis on which the prohibition was based, the ruling is irrational in view of the fact the loans provide for development or investment accrue profits and it would be unreasonable for the lender not to share in it.
The answer to this is that Islam does not bar the association of capital and entrepreneurship.
However, it prohibits interest-based loans because the predetermined fixed return to the lender is irrespective of the fortunes of the entrepreneur. If the investor agrees to share any eventual loss, he can contract for a share of the actual profit earned by the entrepreneur.

16. Islam and the Time Value of Money
Whether Islam recognises the time value of money is more controversial.
In the case of the Islamically allowable murabaha or mark-up contracts, in which a supplier contracts with a buyer to acquire a product and sell it to the buyer at a mark up on cost, the price can be deferred or paid on an instalment basis.
By allowing, the extra charge for delayed payment - Islam appears to recognise the time value of money by recognising the opportunity cost foregone by the entrepreneur who might have otherwise have his capital tied up – a subtle distinction from the charging of interest (Vogel & Hayes, 1998).
On the other hand, Khan (1994a) is of the opinion that discounting violates the Shari’a prohibition of interest. Khan (1994a) observes that only in the case of the poor people is it true that the current utility of money is greater than the future utility.
He opines that every cent saved testifies to the fact that savers have a preference for the future utility of the money rather than current. Hence there is no need to discount future inflows.
Tomkins & Karim (1987), however, observe that the objection to the use of interest rate for discounting can easily be avoided by using an expected return rate as a hurdle rate.
Hence using discounting techniques is not a problem in capital budgeting and valuing assets.

17. Islam and the Time Value of Money
Finally, many scholars argue that the modern banking institution was not present at the time of the Prophet (pbuh).
As it performs vital functions of financial intermediation in the modern economy and is not exploitative, bank interest should not come under the gambit of the riba prohibition. Some court ulemas especially those from the Egyptian government have in fact given legal opinions (fatawas) to this effect.
However, the majority of the Islamic scholars view that bank interest is no exception because the bank in fact represents a group of individuals (the shareholders) who are in the money-lending business.
Since the riba prohibition equally applies to individuals as well as groups, banks are not exempted (Hoque, 1987).
Despite this, however, the same author observes that it is a fallacy to view the whole conventional banking process itself to be UnIslamic.
A close look at the function of banks in channeling savings to productive enterprises is actually facilitating the realisation of the objectives of the Shari’a, which abhors and penalises idle savings.
Only the interest mechanism used to achieve this objective is objectionable. Hence if interest is replaced by any permissible mechanics and the bank limits its activities to financing businesses approved by the Shari’a banking becomes an important Islamic institution (Hoque, 1987).

18. Islam and the Time Value of Money
Finally the Federal Shari’a Court of Pakistan’s judgement on Riba1 (Khan, 1994b) should put to rest any lingering suspicions on the nature of riba. Contrary to a normal process of interpretation of a constitution2, the Court sent out a questionnaire and collected evidence and cited various works of both Muslim and Non-Muslim scholars to discern the nature of riba.
It concluded “ a transaction which contains excess or addition over and above the principal amount of loan, payable to the creditor constitutes riba “(p13).
Therefore, any such sale, transaction or credit facility, in money or in kind, has been considered to be of riba, which is unlawful (haram) in Muslim society. Khan (1994b) observes that the court held that there was a consensus of the opinion (ijma’) of Muslim jurists upon it. Further, it did not make a difference whether the loan is for consumption or for commercial purpose, if the rate of interest is high or low, simple or compound or between Muslim and Non-Muslim or between an individual and the state.
This ruling was appealed by the Government of Pakistan whose Appeals Court turned down the appeal in December 1999, and gave the Pakistan government one year to rid the economic system of riba consistent with the constitution of the Islamic Republic of Pakistan

19. Islamic Organisations and Institutions
Conventional interest is not acceptable from an Islamic perspective.
Thus, they have no option, if they want to abide by Qur’anic principles, except to overhaul the conventional financial and banking system to an interest-free footing.
Muslims have set up Islamic business and nonbusiness organisations which attempt to operationalise the Shari’a in their economic and governmental affairs (El-Ashker, 1987). In the heydays of Islamic civilisation, there were unique socio-economic Islamic Institutions, which were replaced, by foreign economic institutions, after the olonisation of Muslim lands. The two most important institutions, which will be discussed in this research, were the “Baitul-Mal” (public treasury)- which collected and disbursed Zakat – the Islamic religious levy and the Awqaf (Muslim endowment). In the private sector, businesses were conducted for the most part, according to Islamic precepts despite the claims of Rodinson (1974) that this was more
in letter rather than in spirit.
Muslims are attempting to revive these institutions and adapt them to contemporary circumstances as part of the Islamic resurgence in the Muslim countries (Sivan, 1985).

20. Islamic Organisations and Institutions
In the business sector, although the concept of the modern corporation was unknown, Islamic law and Muslim business practice knew the concept of separate legal person and joint stock partnership (Usmani, 1998).
Muslims undertook joint ventures, especially commenda (mudharabah) and partnerships, which were based on risk-taking profit and loss sharing ventures (Udovitch, 1970).
As interest was prohibited, interest bearing bonds were unknown but interest bearing commercial loans and government loans did take place, sometime in the guise of “mark-up” or buy and resell sales contracts allowed in Islam (Rodinson, 1974).
Some Muslim governments, especially the late Ottoman Sultans took interest-bearing loans from Western countries, which eventually led to the downfall of the Caliphate.
There were even instances of Mosque funds lent out at interest, which was prohibited under Muslim Law.
However, these were always frowned at by Islamic scholars and Muslims and never accepted as legal by the majority of Muslims.

21. The development of Islamic Banks
Although the use of trade bills and cheques were known in Islamic History, modern banking was a Western Introduction in Muslim lands which took root after colonisation.
Despite being encouraged by the governments of Muslim countries, the Muslim masses harboured much suspicion of the allowability of interest charged or given on deposits by these banks.
Many strict Muslims refused to deposit their money and preferred to keep it in their homes.
Others used the banks as a safe-deposit service and would not take the interest credited to their accounts or gave them away to charity.
To solve this problem and give Muslims a Shari’a friendly alternative to conventional banking, Islamic banking was born and has since become established as a viable alternative, although there are many strategic, operational, regulatory and accounting problems faced by these banks (Al-Faisal & Ali, 1996).
In addition to the banks, Islamic finance co-operatives and savings institutions which invest the believers’ money in Shari’a approved and ethically correct ways have been set up. The Lembaga Tabung Haji of Malaysia, established in 1962 is an example of one such successful institution, which had assets totalling 5.2billion Malaysian Ringgit (around US $2billion) in 1997.

22. Islamic Banking development in Malaysia
Another financial institution, which presented problems for Muslims, is the conventional insurance company.
The Shar’iah prohibits conventional insurance because of its connections with interest, gambling and gharar (uncertainty).
In general, a contingent insurance contract is prohibited in Islam. To overcome this problem, Islamic Insurance companies (known as Takaful) have been developed, where the contributors share in a savings scheme including a compulsory contribution to a claims pool.
The Takaful Company then tries to compensate any claimant from the amount of his contribution plus earnings.
Any shortfall of the indemnified amount comes from the claims pool if available. Of course, the policy premiums are invested in interest-free, Shari’a approved investments.
The world-view of Islam and therefore Islamic organisations, whether in the public, private or voluntary sector, are different from those of conventional business and non-business organisations.

23. Islamic Banking development in Malaysia
The difference arises in the objectives, nature of profits, the activity or industry Muslims can undertake or invest and in the way the wealth is distributed.
The charging and earning of interest, gambling, alcohol and other industries and aleatory contracts are prohibited.
Further the maximising of profits or wealth as an objective is frowned upon because it conflicts with the ultimate objective of achieving falah (Islamic success/salvation in the hereafter. Although unlike Christianity (see Laughlin, 1988; Tawney, 1927), Muslims are not averse to exploiting the resources for material gain, they would have to undertake this in ways which is in accord with the Shari’a.
There is a need to differentiate between Islamic and Muslim organisations. In case of businesses. Islamic business organisations as those which have been set up specifically to operate within the Shari’a as part of the strategy to develop a comprehensive Islamic Economic and Financial system.
Their philosophy must be Islamic and not merely meant as a cover to introduce interest through the backdoor. On the other hand, Muslim business organisations are businesses set up by Muslims who may or may not follow the Shari’a. However, Muslim businesses, especially small and medium-scale ones may intend to gradually shift towards an Islamic business profile in their activities.
Islamic accounting is needed by both types of organisations – mandatory for the former and helpful for the latter to achieve their Islamic ambitions.

24. Forms of Islamic Business Organisations
Islam not only allows, but encourages trade and business. Business can be organised either as sole proprietorship, partnership and companies as in common law.
Although the concept of limited liability has been frowned upon (Usmani, 1998), the company form of organisation is lawful in Islam with certain restrictions.
These include the type of capital, which can be raised, the type of investments, which can be carried out, and the way profit and loss is shared.
Although sole proprietorships, partnerships and joint ventures have been the most common forms of businesses in the Muslim world (El-Ashker, 1987), the company form of business organisation is increasingly used in the Muslim world both by private and public companies.
The common law varieties of business organisations (sole proprietorship, the partnership and the company) are permitted in Islam. The liabilities, obligations and the rewards of ownership are pretty much the same for sole proprietorship except that the owner is not allowed to conduct business in forbidden products or services such as selling pork, liquor, gambling or interest-based money lending.
The distinction between partnership and companies in not clear in Islamic law because the modern corporation was never found in Muslim countries before the adoption of European law in Muslim lands. However, the Muslim partnership law is quite comprehensive to allow for the formation of joint stock companies, the formation of which is said to be encouraged by the Prophet (pbuh) himself (Atiyah, 1992).

25. Objectives and operations of Islamic Organisations
The objective of Islamic business organisations is to enable Muslims to undertake economic activities within the framework of the Shari’a as a means to attain falah (success in the hereafter). This means that the businesses must follow a code of Islamic ethics in relation to their activities and behaviour towards their stakeholders (Beekun, 1997).
Conventional business organisations follow a profit or wealth maximisation model.
This is the based on the concept of the utility maximising behaviour of conventional rational economic man. Although profit is deemed legitimate and is one of the major objectives of Islamic businesses, profit maximisation, as a prime objective is not identified in the Islamic model (El-Ashker, 1987).
Even though capitalist businesses seem to be moving to wealth maximising and satisficing, the concept of maximisation is entrenched in the accounting calculus e.g. when investment appraisals are carried out.
In Islam, wealth is only considered as a means to an end. As in other religions, the Muslim scholars, for example Al-Ghazali (Al-Karim, 1995), have warned their followers of the dangers of greed for wealth.
Thus maximising wealth is not a priority of the Muslim.
On the other hand, the economic strength of a nation or group has direct implications for political and social stability. Hence, Islam encourages the pursuance of wealth in an ethical manner.
In line with this, the objective of Islamic business organisations is therefore to seek reasonable profits in line with the risk taken and any particular social consequences of high pricing policy. Survival and growth are also emphasised as important objectives in hostile environments where Islamic businesses have to compete with conventional ones.

26. Objectives and operations of Islamic Organisations
Islamic businesses have to take into account the benefits accruing to employees, society and the environment, in addition to fund providers as a matter of religious/moral obligation emanating from their Islamic beliefs. El-Ashker’s (1987) study of Islamic business enterprises in Egypt provides some evidence that Islamic businesses aim to achieve three sets of objectives related to the benefits accruing to finance providers, employees and society. He proposes a utility model for Islamic economics, consisting of secular and ritual utilities.
The secular utility is the normal conventional utility consisting of profits and financial benefits whereas the ritual utility relates to employee and nonprofit oriented social objectives intending to please God and to achieve falah. Achieving profits within this constraint is said to please God and leads to a higher divine reward and hence is a source of utility for Islamic businesses.
The Islamic business aims to achieve a balanced relationship between the three sets of objectives of the three interested parties in the course of maximising its utility.
Thus:
Maximise U = Ua(R), Ub [UaR, E, S], F(P)
Subject to Y= R+E+S, where:
U= Utility function
Ua = secular utility function
Ub = ritual utility function
R=Profit
E = cost of employment welfare (wages and the like)
S = social cost (costs of social welfare)
P = degree of piety
Y = net value of production.

27. Objectives and operations of Islamic Organisations
Since Islamic and Muslim businesses vary in the degree of commitment to Islam, the degree of piety (P) is introduced into the equation to account for this.
Thus for different organisations with different degrees of piety, the equilibrium point, E, S, and R will be achieved will be different.
The researcher proposes that an additional environmental cost (N) be added to the equation.
Hence Y= E+S+N+R and Ub [UaR, E,S,N], hence Islamic businesses will maximise its utility and will be in equilibrium when a proper mix depending on the degree of piety is achieved.
While all this might seem theoretical and not practical, the study by El-Ashker (1987) using actual case studies of Islamic companies in Egypt indicates that this is what is done in practice by Islamic companies with a high degree of piety (P).

28. Accounting implications
Both the structure and objectives of Islamic business organisations make the development of an alternative Islamic accounting an imperative.
For example, debentures, bonds and even preference shares are not allowable in an Islamic company. This is because of fixed interest bearing characteristics of the former and profit sharing arrangements of the latter which are considered inequitable according to the Shari’a.
New type of financial instruments such as mudharabah and muqarada bonds (Rosly & Sanusi, 1999), are needed to finance Islamic companies and used as investment instruments by Islamic banks.
These instruments are hybrid instruments containing both the characteristics of debt and equity (Obiyathullah, 1995) which call for special accounting treatment.
This is not only a matter of different technique but also a matter of change in the fundamental accounting assumption of substance over form, which underlies conventional accounting standards, e.g. IAS 1 (IASC, 1975) which may not be acceptable from an Islamic point of view.
Further, the objective of Islamic businesses which have to balance the shareholder, employee, society and environmental interests poses serious questions on the adoption of the profit calculus (the bottom line) as the main area of concentration of conventional accounting. It cannot be denied that the importance of the bottom line is exacerbated by the prominence given to the profit and loss account as the primal financial statement in a set of conventional accounts.
This has implications for the behaviour of stakeholders as accounting can itself lead to the construction of a social reality (Hines, 1988) not in line with the Islamic aspirations.
To balance these non-shareholder considerations, an Islamic accounting statement might have to consider an alternative scoring system other than the financial unit.

29. Organizations for Zakat collection and distribution
Zakat is one of the five ‘pillars’ of Islam. Literally, it means to purify one’s wealth.
Zakat is a “religious levy by which Muslims make over part of their wealth for the benefit of others” (Clarke et al., 1996). It is neither a tax nor a charitable donation.
A tax may be expended for any purpose while Zakat can only be paid to eight categories of beneficiaries specified in the Qur’an. Further, as opposed to a charitable donation, it is compulsory.
Zakat is a wealth based levy although contemporary Islamic scholars insist that Zakat should also be payable on salaries and wages. Zakat has been levied on animals, trading profit, and agricultural produce and gold and silver and money equivalents.
Scholars have extended the category of zakatable items. The rate of wealth Zakat is 2.5% but agricultural produce is subject to 5% or 10% depending on the use or non- use of irrigation respectively.
The collection and disbursement of Zakat has been traditionally carried out by the Islamic State, since the time of the Prophet (pbuh) (Zaman, 1991).
The Prophet (pbuh) used to appoint Zakat collectors to assess and collect Zakat from his followers. This was deposited into the Baitul Mal or the public treasury. Zakat was collected and disbursed both in cash and in kind.
The Islamic State continued to perform this function until colonisation resulted in the introduction of alternative tax systems.
However, Zakat continued to be paid individually, through charitable associations (as in the UK) or through the religious departments of government as in Malaysia.

30. As part of the Islamisation of the economy, some Muslim countries have started organising their Zakat collection and distribution activities more efficiently. I
In Pakistan, Zakat is now deducted at source e.g. on investment deposits in banks.
In Malaysia, Zakat collection is carried out by religious departments, which come under the
jurisdiction of the various states.
Mustapha (1991) observed that Zakat collection and administration is inefficient as for example, the administrative cost is twice the pay-out to the destitute group of beneficiaries.
There have also been accusations of mismanagement and maladministration by the head of states that are ultimately responsible for it (AbdulRahim & Goddard, 1998). There have been calls in Malaysia for the proper organisation and administration of the Zakat.
The Malaysian government has proposed the establishment of an agency on a national level for the administration of Zakat3. As a preliminary step, corporatized Zakat collection agencies was first established in the Federal Territory and Selangor, the two states with the largest earning population. Zakat collection has increased considerably due to the promotional activities of these agencies. Payment of individual Zakat is also given income tax rebate.
However the authority and accountability structure of these organisations are far from satisfactory.
In the first phase, the Zakat collected was and in some states, still is, handed over to the religious department and is only subject to the Auditor General’s inspection.
Initially, in the distribution of Zakat was not transparent. At the present time, the Selangor and the Federal Territory Zakat Centres (Renamed from Zakat collection centres) are in charge of both collecting and distributing zakat. They publish a monthly magazine which incorporates an account of collections and distributions which are much detailed.
However research indicates, zakat distribution is still inefficient and in some cases ineffective

31. An interpretive study of accounting in two religious departments in Malaysia shows lack of transparency and power conflicts to varying degrees (Abdul Rahim & Goddard, 1998).
There is more professionalism and transparency to a certain level in the department situated in the more urban Federal Territory where conventionally qualified accounting personnel carry out conventional computerised accounting.
In the other department located in a more rural area, there was a general lack of transparency and the researchers reported misuse of power. However, while the departments using qualified accountants showed more transparency, the introduction of a conventional accounting system has resulted in a profit-oriented thinking which has resulted in the adoption of new marketing techniques to collect Zakat.
For example, the Pusat Pembayaran Zakat (Zakat collection centre) is a privatised profit-oriented entity who are remunerated on a percentage of the collections. Although, they do not have the power to collect Zakat by legal force, such a measure may have grave societal implications when Zakat becomes legally compulsory as the profit-motive in increasing Zakat collection may lead to arbitrary practices.
Hence, there is a need to develop an appropriate Islamic accounting system, which will induce the proper Islamically accountable behaviour including the introduction of Islamic performance indicators.

32. Awqaf
The waqf (pl. Awqaf) is one of the Islamic institutional devices to foster voluntary spending for the poor as well as to meet several other social causes (Ziauddin, 1991).
It is the setting aside of certain assets usually land, buildings etc. for the exclusive use for specific charitable/religious purposes under a legal deed.
The asset so established becomes a waqf in perpetuity, and cannot be sold, inherited or expropriated by the government. Only the income form the asset is disbursed according to the wishes of the waqif - the person setting up the waqf.
The waqf thus becomes a trust property, which is administered by one or more trustee who can claim reasonable administrative expenses and salary. According to Ziauddin (1991), “Waqf is thus a device for transferring private property to collective ownership (not public ownership) for socially beneficial purposes” Awqaf are said to date from the time of the Prophet (pbuh) but acquired clearer legal status under Islamic law in the first century A.H.
Although the legal concept is similar to trusts and endowments under common law, it is said to predate the English Institution of Trust. Thus as (Hasanuddin, 1998) observes, “there is no evidence that such a complex system of appropriating usufruct as a life-interest to varying and successive classes of beneficiaries existed prior to Islam”
However, as opposed to English Law which only recognises trusts in favour of other than the trustor and family as charitable, Islamic law recognises awqaf even if its is for the trustor’s own or his family’s benefit but with eventual succession to charitable purposes.
The former type of waqf is known as waqf ahli (family endowment) whereas awqaf specifically meant for charitable purposes from the outset is known as waqf khairi (endowment for general good).
On the surface, it seems the former type of waqf would not be practicable as it entails a lapse from the time such assets are endowed and the time it s available for public use. It would be an uphill task for the authorities or community to keep track of the asset.
However, Hoexter (1998) observes that “contrary to what one might have thought, many of the assets did eventually find their way to their ultimate beneficiary”

33. In any case, both types of awqaf have been and are very important socio-economic institutions in the Islamic world. Awqaf has been set up for various purposes e.g. the upkeep of mosques, religious schools, orphanages, hospitals, animal care centres, parks, rest-rooms, drinking water facilities and food distribution centres (Siddiqi,1996).
In many cases, awqaf are set up to feed the poor in other countries especially those of the Haramain (the Holy Lands of Islam: Makkah and Medina).
Hoexter (1998) has undertaken an extensive study of the development of this institution, the waqf al-Haramain in Algiers (Tunisia) during Ottomon rule, from its own records.
The Algerian, Waqf Al-Haramain was in fact a foundation, which managed all the individual awqaf assets dedicated to feeding the poor in the Holy Cities of Mecca and Medina (Hoexter, 1998).
Later it took other awqaf into its ambit including those of other local mosques, feeding the local poor and contributing to local public projects such as the town’s water system.
The local Qadis or Muslim judges were active in the development of the Islamic jurisprudence of Awqaf to adapt its principles for the needs of the times and locality. On the whole, the Haramain foundation was equitably and efficiently administered – a quality, which is not found these days e.g. in the Awqafs of India (Siddiqi, 1996; Hasanuddin, 1998).
Hoexter (1998) observes that the Haramain became a “most significant vehicle for advancing the interests of the local Islamic community” as well as becoming the focal rallying point in the fostering Algerian-Islamic solidarity.
Awqaf became such an important part of Islamic society, that a Ministry of Awqaf was established in 1840 by Ottoman Turkey- a tradition which has continued in many Muslim countries.

34. Unfortunately, the loss of political and economic power by Muslims resulted in the decay of this institution as shown by the contemporary state of awqaf, which leaves much to be desired. Siddiqi (1996), for instance, observes that “we find increasing state intervention in waqf management owing to a number of causes, the chief one being widespread abuse of powers by waqf supervisors”(p146). Despite this however, the state of affairs is dismal e.g. in India. Hasanuddin (1998) observes:
“But unfortunately, the Waqf institution in India, is most misunderstood and Waqf properties mismanaged. Legislative lacunae, administrative lapses, lack of political will...has given rise to the painful phenomenon that Waqf properties are the chief-attention of the land-grabbers. As against this background, colossal and gigantic Waqf buildings with tremendous commercial potential, are not even receiving the most needed repairs and maintenance, thus converting such attractive buildings into dilapidated structures and there is a general feeling that Waqf property is a cheap commodity available in the commercial market”.
(Hasanuddin, 1998, p 23-24)

35. Despite this however, as the author observes, Awqaf is an important Islamic institution which the Muslims have inherited in the past and “which possesses immense potential for the reconstruction of social and economic life in Muslim countries and communities” (p21).
This is shown by the fact that there is estimated to be about 300,000 awqafs in India alone (Haque, 1999).
Waqf is also an important wealth re-distributive mechanism of the Islamic economic system. For example, Siddiqi (1996) notes that Waqf takes property out of private ownership and vesting ownership permanently and irrevocably in Allah.
With the passage of time, more private property pass into waqf sector but the reverse cannot and does not take place (if the assets are properly accounted for!). Since awqaf are normally made by wealthy people (especially Muslim rulers in the past), it serves to redistribute wealth and mitigate the ill effects of inequality in society and counter-act the tendency to concentrate wealth. ensure this institution is properly administered and accountable to the public to ensure that it serves its function efficiently. As awqaf are not a commercial institution seeking profits, conventional accounting may not be suitable for them. An Islamic accounting system for awqaf would seek to address the following problems:
· The tracking of family awqafs until it reaches public status.
· Activity accounting , both financial and non-financial accounting
· Accountability of the trustee, and the transparency of operations.
· Islamic Social audit to ensure the beneficiaries get what is entitled to them.
· Management audit of income and property.
· Promoting the establishment of more awqaf.

36. Islamic Insurance companies
Together with the growth of Islamic banks, Islamic Insurance companies (called Takaful Companies) have sprouted, although not as numerous as Islamic banks. These are usually subsidiaries or associates of Islamic banks or Islamic Finance Groups (e.g. Syarikat Takaful Malaysia – a subsidiary of Bank Islam Malaysia) or conventional Insurance companies which have Islamic subsidiaries e.g. Syarikat MNI Takaful.
The establishment of these organisations are due to the fact conventional insurance is prohibited by Islamic Shari’a (although there are controversies in this area). This is due to the element of gharar or uncertainty in contingent contracts as well the elements of gambling especially in relation to life insurance.
In addition, the practice of investing premiums in interest-bearing securities by conventional insurance companies is also problematic (Shamsiah, 1995).
Takaful operates as a co-operative savings and mutual help scheme. In the case of Takaful, any contributions (premiums) paid by the participants (i.e. policyholders) are not recorded as income of the takaful company as in conventional insurance.
n the case of Family Takaful - the replacement for conventional life insurance, the premiums paid by the contributors are apportioned to a participator’s fund account and a claims pool. The amount apportioned to the claims pool is based on actuarial calculations.
The fund is invested in Shari’a approved investments. Any profits are shared between the Takaful Company and the contributors in a pre-agreed ratio. Any losses are born by the participants – not by the Takaful Company. Any profits accruing to the claims pool is credited to it. All actuarial surpluses are credited to the participants.
At the end of the policy term, a contributor gets the amount of his contributions plus any share of the profits, if any. He does not get any amount apportioned to the claims pool. If the policyholder dies before maturity of the policy, then any shortfall (the difference from the insured amount and the balance in his account representing his contributions + profit) is met from the claims pool.

37. In the case of General Takaful – the Islamic equivalent of General Insurance, all contributions are credited into a collective claims pool fund. Any profits from the invested funds are credited to this account.
After making any required provisions and making any claims payments, the profit, if any, is shared between the participants and the company in the pre-agreed ratio. Any losses are born by the claims pool fund.
It can thus be seen that the Takaful concept is quite different from conventional insurance.
A conventional insurance company is a risk taker while the takaful company is mainly a manager of funds. While premiums paid to Insurance companies are treated as income, takaful contributions are treated as a separate fund attributable to policyholders.
The Takaful Company shares profit arising from investments and any surplus in managing claims. The operational expenses (staff and administration costs) are born by the Takaful Company.
Thus three main stakeholders are accounted for in separate funds; shareholders funds, family takaful fund and general takaful fund, each having its own balance sheet, profit and loss account and cash flow statements.
It can be seen that Takaful companies cannot operate under accounting standards meant for conventional insurance companies. There are several technical and philosophical accounting problems to be solved, for example

38. Islamic Insurance companies
Valuation of investment assets; currently follows conventional valuation principles may not acceptable from an Islamic point of view · Apportionment of profit share; the cash basis is currently used.
This may lead to distortions in profit distributions for all the parties.
· The calculation of Zakat on profits; the value to be used and the avoidance of double taxation.
· The calculation of actuarial surpluses based on interest-based contingency tables may not be acceptable from a Shari’a point of view (see Tomkins & Karim, 1987).
· In line with the co-operative and participatory nature of Takaful, more qualitative information may need to be disclosed.
There is thus a need to develop an Islamic accounting system, which will deal with the above matters from an Islamic perspective.

39. Islamic banks and Financial Institutions: history, nature and operations
Islamic banks are perhaps the most important and developed Islamic organisations in contemporary Islamic society.
Assets of Islamic banks are estimated to range from 50 to 100 billion dollars (Pomeranz, 1997).
Although the principles on which it is based are not new, the institution itself is an innovation in Islam. An Islamic bank is an ethically based institution which performs conventional banking functions with an important exception, they do not receive interest from their borrowers or pay interest on the customers deposits as this is prohibited under Islamic Shari’a (Al-Faisal & Ali, 1996).
This does not mean Islamic banks are charitable institutions undertaking free lending and borrowing.
On the contrary, Islamic banks are businesses, which aim to make profit within the constraints of the Shari’a, by undertaking profit- sharing projects, trade financing, lease financing and providing fee-based services.
Due to the importance of Islamic banking in the Muslim world, it will be discussed in some detail as an example of an Islamic organisation in practice, which makes the development of an Islamic accounting system a practical imperative.
As the accounting problems of Islamic banks mainly concern the asset side of Islamic banks, the Islamic financial instruments used as alternatives to conventional interestbased lending are discussed. Next, the accounting problems of Islamic banks are discussed at some length. All Islamic organisations, in the opinion of the researcher, need an alternative Accounting System.
However, the accounting problems of the Islamic banks have been considered acute enough to have led to the establishment of an alternative regulatory body for the setting up of Accounting Standards for Islamic Financial Institutions (Pomeranz, 1997), which is the main concern of this book.
The chapter is concluded with a discussion of the perceived benefits of an Islamic accounting system for banks and other business organisations

40. Classification of Islamic banks
(Ahmed, 1994b) has classified Islamic banks and financial institutions into several different types, as follows:
1. Islamic Special Purpose banks aim to achieve a specific purpose or serve a special class of clientele. This include social banks, agricultural banks, co-operative and Industrial banks. Examples include the Nasser Social Bank in Egypt and Islamic Bank of Western Sudan charged with promoting the development of Western Sudan.
2. Islamic Development Banks aim to foster the process of socio-economic development amongst its members. Its clientele are usually governments
3. Islamic Commercial Banks mainly aim to make profits but still operate within the Islamic ethical system. This class forms the bulk of Islamic banks in operation.
4. Non-banking Islamic financial institutions such as the Pilgrims Fund (LTH) of Malaysia do not perform banking functions but channel savings to productive investments and pay the depositors a bonus depending on profits.

41. Development of Islamic banks and financial institutions
It is generally agreed that the first Islamic bank was established at Mit-Ghamr, Egypt in 1963 (Ahmed 1994a; Naggar 1987). Mit-Ghamr is a rural area in Egypt, where the people were mostly religious farmers and artisans. They did not put their savings in the conventional banks because of the Islamic prohibition of interest.
The bank operated three types of accounts; the savings and loan fund, the investment fund and the social service fund. The first fund was like a current account.
The depositor received no interest but could apply for an interest free loan for productive purposes. The investment funds were deposits received based on profit/loss participation. The funds were invested in local businesses and agricultural projects. The deposit received a proportion of the profits according to its amount and term. The social fund received Zakat and other charitable contributions from which grants were made to savers who were in financial difficulty as a result of sudden misfortune.
It can thus be seen that an Islamic/social ethos prevailed in the conception and operations of the bank. One Western observer noted the significance of the experiment thus:
“The majority of the population had never been dealing with the financial institutions. Because of this, capital formation had been impaired. Basically rural and religious, they tended to distrust the bankers operating in the western style. Since a substantial part of their income was not spent immediately, but put aside for social events, emergencies and the like, this idle capital could not be used for productive investment A precondition, however for any change of behaviour from hoarding and ‘real-asset saving’ to financial saving was the creating of financial institution which would not violate the religious principles of large segments of the population. Only then could the rest of the majority of the population be integrated in the process of capital formation”.
(Wohlers-Scharf, 19834, pp79-80 as quoted in Ahmed, 1994a, p351).

42. c) the provision of a mix of economic and social development services
In the words of one of its founding executives (Naggar, 1987), the three most important principles which were applied by the bank and responsible for its success were:
1. Participation of the bank with its borrowers in their profits as well as losses.
2. Decentralisation and localisation through the operation of a community based philosophy which help in:
a) the education and credit enlightenment through direct and sympathetic contacts,
b) constant follow up of projects to guarantee their repayment and effective use of the money, and
c) the provision of a mix of economic and social development servicesIn the ords of one of its founding executives (Naggar, 1987), the three most important principles which were applied by the bank and responsible for its success were:
1. Participation of the bank with its borrowers in their profits as well as losses.
2. Decentralisation and localisation through the operation of a community based philosophy which help in:
a) the education and credit enlightenment through direct and sympathetic contacts,
b) constant follow up of projects to guarantee their repayment and effective use of the money, and
c) the provision of a mix of economic and social development services

43. Consistency and integrity of the bank accounts.
The bank’s success5, however, attracted the attention of the anti-Islamic, socialist regime of Nasser. In 1967, the Egyptian government took over all the nine banks and converted them to social savings bank on the conventional model. Thus the experiment came to an end, not on the basis of its economic viability but political interference and commercial opposition of the conventional banks.
At the same time as the Mit-Ghamr bank was started in Egypt, the Lembaga Urusan dan Tabung Haji (LUTH)6 (Pilgrims Fund and Management Board) was established in Malaysian in 1963 as an Islamic savings institution. A Muslim economist who had noticed the wasteful nature of Malaysian Muslims selling of their property to go on the Haj (Muslim pilgrimage to Makkah) suggested that Muslims could save up the amount which would be invested in accordance to Shari’a principles.
Thus LUTH was born. Until then, intending pilgrims did not put their savings in a conventional bank because it would have been tainted with interest. Money thus tainted could not be used to perform the pilgrimage, as it would not have been religiously valid.
The Malaysian government initially set LUTH (Now known as Lembaga Tabung Haji) up as a savings corporation in 1963 and was incorporated in 1969.
Although LUTH is not an Islamic bank, it is an Islamic financial institution. It collects the savings from would be pilgrims and invests them in real estate, trading and plantations.
Recently it has gone into share trading and Islamic money markets. LUTH is an active investor both directly and through its seven subsidiary companies.

44. LUTH in addition to its investing activities administers the whole pilgrimage programme every year, which is a mammoth undertaking involving about 40,000 ilgrims. In cooperation with other government agencies, it takes care of their transport, food, lodging, health and emergency aid during the pilgrimage. The author having personally used its services can attest to its efficiency in organising the pilgrimage.
However, in recent years, its importance as a financial intermediary has increased. The author was informed by one of its accountants in an interview that 70% of LUTH’s deposits were investment deposits, whereas previously most depositors withdrew their savings to perform their pilgrimage. Unlike the Mit-Ghamr bank, LUTH had better fortunes because of the political climate in Malaysia, which though secular, was not socialist and anti-Islamic, as was the Nasser government. From 1,281 depositors in 1963 and RM46,600 in deposits, the number of depositors increased to 2,278,121 with deposits of RM1,541 million in 1993, a period of 30 years (Zainal & Yusof, 1993).
Its income has increased from RM6,573 to about RM95 million (excluding government contribution towards operating expenses) during the same period, Depending on the profits, a bonus is declared by LUTH once a year. The dividend rate had been around 8-8.5% but has since declined to around 4-5% after the recession in 1997.
The first private commercial Islamic bank was the Dubai Islamic Bank in It is a public limited company with 50 million dirhams. In the same year, an international Islamic bank, the Islamic Development Bank was established in Jeddah, Saudi Arabia jointly by the 45 Muslim countries under the auspices of the Organisation of the Islamic Conference.
The purpose of this bank was to foster economic development and social progress of member countries using Islamic finance financial instruments. It also grants loan and aid to Muslim organisations especially in Muslim minority countries.

45. A Chronology of the Pioneering Islamic Banks Period Institution
Thereafter Islamic banks began to be established at an increased pace in Egypt, Sudan, Jordan, Bahrain, Pakistan, Iran, UK, Malaysia, Bangladesh, African countries, Turkey, India, South Africa and the US.
Two milestones in the establishment of Islamic banking were firstly, the Islamisation of the whole banking sector in Iran (1979), Pakistan (1985) and Sudan. The second milestone was the establishment of the Dar-al Mal Al-Islamic (DMI) Switzerland in 1981 by a Saudi Prince and the Dalla Al-Barakah Group in 1983.
These two Islamic Finance Multinationals were responsible for setting up a spate of Islamic banks, Investment corporations, Takaful companies and other financial institutions in Egypt, Sudan , Africa and Europe.
A Chronology of the Pioneering Islamic Banks
Period Institution
Mid Interest Free Bank
1950s Local Islamic Bank
1963s Mit Ghamr Local Savings Bank
Nasser Social Bank
Islamic Development Bank
(OIC Foreign Minister Conference, 1970, 1973 ,1974)
Dubai Islamic Bank 1977 International Association of Islamic Banks (OIC)
Faisal Islamic Bank of Egypt
Faisal Islamic Bank of Sudan
Kuwait Finance House
Islamic Banking System International Holding Luxemborg)

46. 1979 Jordan Islamic Bank 1981 Bahrain Islamic Bank
Dar al Mal al Islami (Switzerland)
Bahrain Islamic Investment Company
Islamic International Bank for Investment and Development (Egypt)
Islamic Investment House (Jordan)
Al Barak Investment and Development Company (Saudi Arabia)
Saudi Philippine Islamic Development Bank (Saudi Arabia)
Faisal Islamic Bank Kibris (Turkey)
Bank Islam Malaysia Berhad
Islamic Bank Bangladesh Ltd
Islamic Bank International (Denmark)
Tadamon Islamic Bank (Sudan)
Qatar Islamic Bank
Beit Ettamouil Saudi Tounsi (Tunisia)
West Sudan Islamic Bank
Al Baraka Turkish Finance House (Turkey)
Faisal Finance Institution (Turkey)
Al Rajhi Company for Currency Exchange & Commerce (Saudi Arabia)
Al-Ameen Islamic & Financial Investment Corp. Ltd. (India)

47. The ownership of the Islamic banks varies between 100% government ownership and 100% private ownership. Most Islamic banks have been set up as joint-stock companies.
The total number of Islamic banks and financial institutions number in the thousands (if the Islamic banks in Sudan, Pakistan and Iran established by wholesale Islamic legislation are counted) but those established voluntarily number 192 (IAIB 1997).
As at 2003, there were more than 300 Islamic banks and financial institutions globally with total equity of US$15billion and total assets of billion (CIBAFI).
The aggregate net profit was US2.74 billion. This compares to 133 institutions with $5 billion of paid up capital and $53.3 billion in assets in Considering that there was no wholesale Islamisation of the banking sector in any Muslim country between these dates, the increase represents about 72% increase in assets and capital over 10 years or about 23% growth rate.
It would have been much higher if not for the devaluation of the Iranian currency against the dollar in 2002 when the Islamic banking assets decreased by 44% in that year. These statistics excludes assets under Islamic windows and investment funds. The industry employs around 300,000?? employees spread across 34 countries in all continents except South America .
It can thus be seen that the Islamic finance sector is no longer a theoretical possibility but a practical and viable fact here to stay. However, Islamic banks face many regulatory, operational and accounting problems which prevent the further realisation of its Shari’a oriented ethical and social goals. In Malaysia for instance, the industry where non-Muslims play a major part, there is some tendency to go for the “loan mode” and to account for it as such.
Recently, International Accounting Standard Board with its new International Financial Reporting Standards insists wholesale adodption of its standards may pose a problem to Islamic banks. Resisting these pressures by means of developing and supporting a set of high quality parallel Islamic accounting standards would be helpful in developing this important Islamic institution to be in accord with its own worldview rather than being derailed into the capitalistic mould.

48. Modus operandi of Islamic Banks
Siddiqi (1998b) has classified the activity of Islamic banks into three activities:
a) Services for which the bank charges a fee or commission.
b) Investment of capital on the principle of partnership or mudharaba and
c) Fee based or uncharged services
The services in category a) above include many of the functions performed by conventional banks on a fee basis, such as keeping accounts, clearing cheques, providing funds transfers and business advisory as well as providing financial guarantees and safety deposit lockers.
The activities under b) are the major theoretical basis on which Islamic banks operate although a recent survey shows only 20% of financing of Islamic banks is done through this way (IAIB, 1997).
The main activity of a conventional bank, lending and borrowing money through fixed and savings deposits is changed in an Islamic bank.
The relationship in conventional banking between the bank and its deposit holders is that of a debtor-creditor relationship. This is not so in the case of Islamic banks. The relationship in an Islamic bank, depending on the type of deposits, is either trustee for deposits or a business partner.

49. On the liability side, in the case of both current and savings accounts, conventional banks pay interest based on a pre-determined percentage of the amount deposited varying with the length of time. The Islamic bank does not pay interest but may give a gift, which is at the option of the bank.
The bank guarantees the principle amount, which can be withdrawn by the customer at any time. Current and savings account deposits are based on the Islamic contract of al-wadia’ – safe keeping. In the Middle East, the qard al-hasan (benevolent loan contract or Amanah contract (trusteeship) is used.
Under this contract, the depositor gives permission to the bank to use the funds in any Islamically permissible activity but he can request the money back on demand.
In practice, some Islamic banks pay an amount called hibah or gift depending on the profit of the company, which is permissible. However, the depositor is not legally entitled to this as that would amount to interest. The bank, however, guarantees the principal sum. Islamic banks do not accept fixed or term deposits on which interest is paid.
Instead, customers can open an investment account for a fixed period. After the period, the customer is entitled to a share of the profit (the percentage share of profits being predetermined), if the banks make a profit. If the bank makes a loss, the whole loss is borne by the customer.
This contract is called mudharaba- capital/labour partnership. Under this contract, the depositor as the capitalist gives the capital to the bank who acts as the entrepreneur in managing the funds for which it is entitled to a share of the profit. The banking expenses are not charged to depositors as management expenses as in the case of a loss, it is wholly borne by the depositor. The bank is only entitled to a share of profits the ratio being pre-determined at the beginning of the agreement.

50. What in fact happens, is all investment deposits are pooled and invested in various projects- forming portfolios with varying maturities. Sometimes the bank’s shareholders funds are also pooled to finance projects. In this case, the bank is also entitled to a share in proportion to its capital invested. Profits are allocated to the depositors in proportion to deposit amount and time for which the amount is deposited with the bank.
Most Islamic banks have two types of investment accounts, unrestricted and restricted.
Unrestricted investment account deposit can be invested in any sector according to the wishes of the bank, provided the investment does not contradict the Shari’a.
Restricted Investment accounts allows the depositor to specify in what sector, his deposit will be invested.
On the Assets side of the balance sheet, conventional banks usually grant credit facilities such as term-loans, overdrafts and housing mortgage loans.
They also invest in the short-term money market, government securities, treasury bills, company bonds and equities in the stock exchange. In the case of Islamic banks, as all interest-bearing instruments are prohibited, these financial instruments, except for equities, are not available to it.
Instead Islamic banks use Islamic financial instruments, some of which have equity features while others have features of both debt and equity (Obiyathullah, 1995) and still some others have features of debt. This will be explained in some detail in the next section.
The third type of activity is unique to Islamic banks (although some conventional banks provide free overdraft to student customers).
Providing interest-free loans is part of the social activity of Islamic banks although only a small portion of its total funds is allocated to this. Usually the funds come from Zakat and charity pool created by the bank from its own Zakat contributions and charitable contributions of others.
In theory, Islamic banks should set aside a portion of the shareholders and depositors funds for this purpose. It is not certain how many banks actually undertake this function, as they seem to operate mostly along commercial lines. However, as we have seen in the case of Mit-Ghamr bank, this is not theoretical and has been applied in practice. In Pakistan, Islamic banks have given interest-free study loans to students.

51. The Asset side of islamic banks: Islamic Financial Instruments
Since Islamic banks cannot grant loans on interest, the assets side of the balance sheet cannot have any advances (except interest free loans) as assets.
Since banks cannot earn any money on interest-free loans, they have to resort to participatory finance and other Islamic financial instruments to earn an income.
Questions
1. To argue that “good is lawful and hence what is lawful must be good” is an example of which of the following techniques of deriving the law:
a) ‘Urf.
b) Qiyas.
c) Maslaha.
d) Istihsan.
2. How does the Murabaha contract avoid Riba’ elements:
a) It is a trade-based contract and thus any increase above the cost is justified as a
profit element on the sale of the asset.
b) Murabaha only avoids Riba’ al-fadhl when they buy and sell non-ribawi items.
c) Murabaha avoids Riba’ by combining the contract with a collateral agreement.
d) Statements (b) and (c) are correct.

52. Questions 3-5 refers to the following Hadith:
“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt – like for like, equal for equal, and hand-to-hand; if the commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand”
3. What are the two categories of goods that can be classified as ribawi goods:
a) Foodstuff and clothing.
b) Foodstuff and fuel.
c) Jewelry and fruits.
d) Foodstuff and currencies.
4. In an exchange of gold against silver, the following rules must be adhered to to avoid riba’:
a) The items exchanged must be similar in quantity, weight and exchanged at the same
time.
b) The items must be exchanged at the similar value only.
c) As long as the exchange is conducted on spot basis without any undue delay, the value can be different.
d) None of the above is true.
5. In an exchange of gold of higher value with a larger quantity of gold of lower value, the following statement is true:
a) The exchange is not riba’ as it is fair to get more of lower value for less of higher
value.
b) The exchange is riba’ because it violates the conditions mentioned in the above
Hadith
c) The exchange is riba’ because no market value is stipulated as a basis of exchange.
d) The exchange is not riba’ because gold against gold is within the same category of ribawi items.
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