Last February, the accounting and Auditing Standards Board, the body responsible for the setting of accounting and auditing standards in the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), adopted accounting standards for three financial instruments, namely Murabaha and Murabaha to the purchase orderer, Musharaka financing and Mudaraba financing. The preparation of these standards followed the Board's due process which includes, among other things, the vetting of standards by the Shariah Committee of AAOIFI and the holding of a public hearing.

The public hearing is meant to provide interested parties with a platform to express their views on the proposed standards and tear the comments of the Board's Accounting Standards Committee on those views. The public hearing for the three financial instruments was held in December 1995 and was attended ty more than 40 individuals representing cental banks, Islamic banks, Shariah scholars, accountants, academics and other users of the financial statements of Islamic banks. Most of those who attended the public hearing had sent their institution's comments on the exposure drafts before the hearing. In addition, AAOIFI received the written comments of individuals who did not attend the public hearing. The three accounting standards will become effective beginning 1 Muharram 1418H or 1 January 1998.

Murabaha and Murabaha to the purchase orderer

This standard prescribes two accounting treatments to measure the asset value after its acquisition by the Islamic bank. In the sale by Murabaha to the purchase orderer, if the bank follows the Shariah ruling that obliges the client to fulfil his promise after the bank acquires the asset then the bank is required to use the historical cost to measure the asset ordered by the client at the end of the financial period. Alternatively, if according to the bank's Shariah ruling the client is at liberty to fulfil his promise or not, and the cash equivalent value of the asset at the end of the financial period was less than its historical cost, then the bank is required to use the cash equivalent value to record the value of the asset. The Islamic bank is also required to recognise the difference between the historical cost of the asset and its cash equivalent value by making a provision for the decline in the value of the asset.

The difference between the two accounting treatments is meant to reflect the risk to which the Islamic bank is exposed in executing this type of transaction. In the case of non-obliging the purchase orderer to fulfil his promise, the bank is exposed to the risk of not being able to recover the historical cost of the asset if the client decides not to proceed; with the sale. On the other hand, the bank is exposed to a relatively lower risk if the client is obliged to fulfil his promise and he refrained from purchasing tha asset after the bank has acquired it. This is because the Islamic bank usually asks the client to pay an amount up-front - hamish algedyyah - from which the bank can remedy the damage incurred to it if the client retreats from purchasing the asset. Moreover, if the amount of hamish algedyyar is not adequate to cover the loss of the bank, the latter can have recourse to the orderer for the remaining amount of the loss.

The standard requires the Islamic bank to disclose in the notes accompanying the financial statements, whether it considers the promise made in the sale oy Murabaha to purchase orderer, obligatoiy or not.

The standard also prescribes two accounting treatments for profit recognition. In addition to the accrual method of allocating profit over the period of the contract, the Board decided after the public hearing to add a cash basis method whereby the Islamic bank can recognise profit when the instalment is received. However, the standard gives preference to the accrual method and requires for the implementation of the cash basis method the approval of either the bank's Shariah supervisory board or the concerned super visory agency in the country.

The reason for allowing two accounting treatments for asset valuation and profit recognition is mainly due to the different acceptable Shariah interpretations related to these two issues. This is in line with the Board's recently adopted policy of pursuing a harmonisation approach to entertain different Shariah rulings which have accounting implications, but within narrow bounds. This policy, which the Board implements in close co-ordination with AAOIFI's Shariah Committee, is meant to enhance the adherence to the full text of the standards by maiy Islamic banks, particularly as AAOIFI lacks the power of enforcement. On the other hand, the Board's policy calls for standardising accounting treatments that are not affected by the Shariah rulings (e.g., issues of disclosure).

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

Mudaraba Financing

In addition to the capital provided in the form of cash at the time of contracting, the standard also caters for the capital provided in the form of trading assets (goods) or non-monetary assets for utilisation (land, ships, equipment). In the case of trading assets or non-monetary assets for utilisation, the standard requires that these assets be measured at their fair value (the value agreed between the Islamic bank and the client), and any difference between the fair value of the assets and their book value should be recognised as profit or loss to the Islamic bank.

The standard requires the recognition of profits or losses either at the time of liquidation if the transaction is concluded within the financial period or when both the Islamic bank and the client make partial or full settlement.

The accounting treatments for Mudaraba financing, as regard the measurement of capital in kind and profit recognition, apply to Musharaka financing.

In the case of diminishing Musharaka financing, at the end of a financial period the share of the Islamic bank is measured at historical cost less the portion transferred to the partner at fair value. The difference is recognised as profit (loss) in the income statement. In addition, if the diminishing Musharaka financing is liquidated before the share of the banks is transferred to the partner, the recovered amount (by liquidation) from the Islamic bank's share therein should be deducted from the Musharaka financing capital and the resulting profit (loss) from the difference between the book value and the recovered amount should be recognised in the income statement.