Last month Mustapha Hamat, General Manager, Accounts, Bank Islam Malaysia Berhad -which is currently overseeing the establishment of other Islamic banks in Malaysia - discussed the application of existing accounting laws to Islamic banking. Here, he analyses its relevance to specific Islamic transactions.

Mudharabah and Musharakah financing are quite similar to joint ventures usually carried out by investment banks - conventional commercial banks in Malaysia are not allowed to finance customers through joint ventures unless approved by Bank Negara. The profit from this form of financing is not fixed, but depends on the actual profit after the account has been closed and the project completed. Neither the Malaysian Companies Act of 1965 nor the Islamic Banking Act, 1983 gives specific directions on these forms of financing. However, the accounting conventions of accrual, matching, periodicity, and conservatism are expected to be observed.

Short and Long-Term Mudarabah

Profit portion charged by the Bank Islam Malaysia (BIMB) in its financing and investment activities is taken to be equivalent to the interest charged by other banks for income tax purposes.

The recognition of profit portion will depend on the method used. There are a number of acceptable methods, which have been used by financial institutions and banks. The most common one is the sum of digit, constant rate of return and straight-line methods. Applying anyone of these methods will enable the bank to prepare the recovery of cost and profit from monthly or quarterly and semi-annually repayment received from customers.

This practice has been accepted by the revenue law in some countries and does not violate the Shariah. As far as presentation is concerned, the standards relating to the accounting conventions will apply. Therefore the amount to be shown in the financial statement is the total receivable balance less profit portion, which is not due.

Lease Finance

Leasing is defined in Malaysian law as an agreement whereby the lessor conveys to the lessee in return for fair rent, the right to use a specified asset for an agreed period of time. This definition includes contracts for the hire of an asset containing a provision giving the hirer an option to purchase the asset upon the fulfillment of agreed conditions, and is known as hire purchase contracts.

There are two types of lease arrangements; finance lease and operating lease. Paragraph 49 of the Malaysian law IAS 17 requires that recognition of income under finance lease be based on a pattern reflecting a consistent periodic rate of return on the lessors' net investment outstanding and the method should be applied consistently.  In the case of operational lease, rental income should be recognised on a straight-line basis over the lease term unless another systematic basis is more representative.

There is no Shariah complication as far as the straight forward leasing arrangement is concerned. However, if the profit margin is tied to the interest rate, this is not permitted as it creates uncertainties. The lessees' total rental payable or the banks' total rental income now varies according to changes in the interest rate.

There is no Shariah restriction with regards to income recognition, or presentation. However, according to existing accounting standards, with finance leases BIMB does not record the lease asset as a fixed asset on the balance sheet, but it will be recorded as lease receivable, less the profit margin which is not received.

In the case of operating lease, the lease, assets should be recorded as fixed assets in i the balance sheet of the lessor. As such, depreciation for these assets is provided periodically.

Accounting for Foreign Currency Transactions

Reporting transactions conducted, or assets and liabilities stated in currencies is subject to a number of variations. BIMB translates its foreign currency transactions into the Malaysian Ringitt at the current rate of exchange of the dates of the realisation of the transactions.

However, the assets and liabilities on the balance sheet date are stated at the rate of exchange of the dates of transactions. Gains or losses resulting from this transaction are only recognised when realised, in accordance with the cash basis of accounting. Kuwait Finance House (KFH), Bahrain Islamic Bank (BIB) and the Albaraka Investment Bank (BIIB) have adopted the same method for translating transactions into foreign currencies.

In the case of assets and liabilities and the treatment of gains or losses arising from the transactions, the exchange rate current at the year-end date or the date of the balance sheet is used. Gains or losses are transferred to the profit or loss account. However, some Islamic banks such as the Faisal Islamic Bank do not disclose the method at all.

Essentially, the questions to be asked are whether the transactions or assets and liabilities belong to the shareholders fund or customer deposits, and if the latter is the case -assuming that the deposit is accepted on the Mudarabah principle - the method chosen for translating foreign currencies must reflect the terms and conditions of the contract. For example, using the exchange rate current on the date of realisation for Murabahah transactions utilising Mudharabah funds, reflects more the terms and conditions of the contract with the depositors.

The gains from the foreign currency translation can be distributed to the depositors as they arise from realised transactions. According to the Shaft school, profit distributed to the owner of capital while the capital is still tied up is not acceptable. Therefore only related foreign exchange gains can be distributed. As such the method adopted by BIMB is closer to this view, but this does not mean that other methods cannot be used, in fact, KFH have acceptable Shariah arguments for adopting a different method.

However, the main issue in this case is the fact that the existing standards are, not adequate in informing a reader of the Shariah aspects and of their influence on the profit and loss of the balance sheet.

For this reason, new accounting standards may need to be formulated. Any proposed standard must outline the disclosure requirement with regard to the foreign exchange translation, the underlying Shariah principle and the method adopted for the translation.

Provision for Bad Accounts

Prudent and conservative management of the bank's assets and liabilities is not contrary to the Shariah, so long as the Islamic banks try to be just in their dealing with all depositors.

In the case of bad accounts however, the bank may have to revalue the account to determine the extent of the loss to be specifically provided for. In line with the real nature of the loss as dictated by the Shariah principle of al-Mudarabah, and in order to be fair to the bank's present and future depositors, the valuation is based on the gross realisable value for the account that is the amount remaining from the profit expected to be generated from this amount.

The procedure of realising income from monthly or quarterly installments of the subsequent financing arrangements should be abandoned. Instead all payments received will be treated in full as recovery of outstanding cost of financing plus all incidental expenses until this amount is fully recovered. Afterwards, all of this income will be credited in full to the profit account.

There is no accounting standard that deals totally with this issue. As it is directly related to the terms and conditions of the dictated by the Shariah principle of Mudharabah contract, it is felt that any existing standard is inadequate to deal with the problem. Thus a new standard encompassing the Shariah as well as the accounting aspect should be formulated, in order like the other recommendations outlined above - to make the Islamic banks' financial statements more informative and meaningful.