Islamic Accounting and Financial Reporting - Essay Example

Islamic Accounting and Financial Reporting Islamic Accounting and Financial Reporting The Islamic accounting standards differ in some ways from the IFRS accounting standards in various ways. In various aspects, there are issues with the approach taken by these two accounting standards to two central concepts; that is substance over form and the time value of money concept. Though there are the differences, there is need to achieve a balance between the two accounting standards to arrive at a point of agreement. Through careful evaluation of these aspects relating to the AAOIFI accounting standards and the IFRS accounting standards, a balance can be stricken (Napier 2008). Following is an examination of the issues relating to the two standards in relation to the concepts aforementioned, an evaluation on how it affects accounting representation, how convergence can be achieved and a conclusion on the same. Substance over Form Concept To start with, substance over form is an accounting concept which is widely used by all accounting entities. This concept emphasizes more on the reality of the financial status of an entity instead of the legal standards that the entity has taken in its events and transactions as seen in their financial statements (College Accounting Coach 2006).For the operationalization of this concept of accounting, it is very important that there be an understanding of the company in question. Thus, there is a need for deep investigation to be conducted in order to establish proofs supporting the financial statements being evaluated (Supreme Justice 1935).It has to be done carefully because most of the transactions requiring investigation are usually complex to be evaluated superficially. The complexity arises since the transactions happen probably once in a year when the balance sheet is drawn. Thus, carrying out an investigation into a company’s financial statements and books of original entry which have been kept for a whole year is tricky and tiresome also for auditors (Knapp 2012). In events where substance over form concept is not properly adhered to, it is pretty easy for some mistakes to be encountered and also fraudulent transactions to be made by some people (Nathaniel 2004). There are cases such as Enron and Computer Associate which arose due to non-observance of the concept (Benston 2006). Time Value of Money Concept The time value of money is a concept in the accounting world where money is seen to have more value in the present than in the future. Through the time value of money concept, investment alternatives such as loans, mortgages and leases as well as savings can be solved effectively. In this concept, there is the usual assumption that a unit of money, let’s say a pound is worth more than a pound given after one year (Crosson 2008). The assumption is that money held in hand can be invested and earn interest in the future. The key to this concept is that a sum of money or the equivalentof a series of payments which are evenly spaced or receipts which are promised in the future can possibly be converted to a value which is equivalent today (Cengage Learning 2011). Thus, it is possible to calculate the values of different time periods if provided with information such as interest rates, number of periods, present values, payment and the future value. Basically, the time value of money largely includes interest which is a charge imposed on borrowing some money. It is usually stated as a percentage of the amount that has been borrowed over a specified amount of time. The periods, in the concept are intervals of time, which are evenly spaced which are not stated in annuity intentionally because the intervals must be corresponding to a specific period of compounding. Another thing included in the concept is the payments; here the term refers to a series of cash flows which are equal and evenly spaced. They must show all the outflows and the inflows. Due to the time value of money, it is clear that a graph will be as follows: Where $ is money in any currency.(Schaefer 2007) Differences in interpretation of the concepts in the IFRS and AAOFFI The AAOFFI stands for Accounting and Auditing Organization for Islamic Financial Institution. This is an international autonomous nonprofit organization which is responsible for developing auditing, accounting, governance, ethics and sharia standards for the international Islamic banking and finance industry. In the view of the two concepts discussed above AAOFFI and IFRS standards do differ in some sense. For example, in the Islamic finance and accounting standards, where we take that assets increase in value and the concept of interest rates being imposed on money such that it can grow over time, without the money being used in the trade is not permitted in the Islamic finance, this is taken care of in The Islamic standards of accounting and financial reporting but it becomes a nuance when we want to include it in the IFRS. Thus, as it can be purported to be, the AAOIFI does not heed conclusively to the concept of time value of money. It has been noted that the AAOIFI standards of accounting and Islamic finance have been less welcoming to the two principal concepts of accounting standards, that is, the time value of money concept and the substance over form concept (Malysian Accounting Standards Board 2012). According to the accounting board, they observed that the IFRS basically focuses on the economic nature of transactions. This means that they observe critically the essence of the concept of substance over form. They also observed that it in contrary, the AAOIFI standards tends to disregard the importance of the adherence to the concept. In terms of contracts and the adherence to the two concepts, the AAOIFI have in some cases responded to the requirements and have taken to understand the form of contracts that are involved are important to the companies. The standards allow for disclosure of information (Belkarolui 1989). There are three basic traditional functions of money, which includes money as a medium of exchange, store of value and unit of measurement. All these three functions are identified and taken care of in the IFRS accounting standards. However, this is not the case when it comes to Islamic finance. According to the Islamic finance, money being used as a store of value does not and cannot apply. The focus of money being used as a store of value is what the concept of time value of money focuses on (Pamela 2009). This being the case, it can be deduced from the analysis that the AAOIFI does not adhere to this concept. The Islamic finance focuses on the form while the IFRS focuses on the substance of the contracts and transactions. In essence, The AAOIFI and IFRS are conflicting standards of accounting relative to the concepts of time value of money and the substance over form concepts. This is primarily because these two accounting standards are mutually exclusive and their design was without the considerations of each other. Effect of the interpretations on accounting treatment of different contracts in practice These different interpretations affect the accounting treatment of different contracts in practice (Yousaf 2013).For instance, there is the Murabahah concept in the Islamic finance sector. In this case, we examine how deviation from substance over form concept affect the contracts in practice. Assuming that a bank bought a commodity, such as a machine for 1000 Pounds, later the company resold the same machine to its customer at 1250 Pounds repayable in a timeframe of five years. In this case, there is a 250 increment since the customer is given time before payment. This is the manifestation of the time value of money concept. According to the Murabaha concept in the AAOIFI accounting standards, the bank is supposed to defer the two hundred and fifty Poundsprofit. (Islamic Banking 2006). Then, ‘’there should be a proportionate allocation of profits over the period of the credit where each financial period will carry its portion of the profits, irrespective of whether or not cash is received.’’ (AAOIFI 2015). The bank will in other terms incur fifty pounds profit at the end of each year. If this was to be calculated using the IFRS standards, it will still achieve the two hundred and fifty pounds profit but the calculations will be different. Another example is where, in the Islamic banking and finance, all the transactions must be included in the balance sheet while in the IFRS, assets which are not owned by a financial institution are not included in the balance sheet. An example is; assuming that in 2012 January, a bank buys a mansion from a customer at a cost of 100 pounds, later, the bank, leases the mansion to the same customer at a cost 5 pounds in rent per year which can be paid annually in arrears. However, the bank and her customer, enter into a sales contract and the customer buys the mansion at a cost of 110 pounds where the contract was made on 31st Dec 2014. On the same day, rent is paid as agreed and sale back transaction is made. In this case, while accounting for that sale and leaseback under the IFRS will be on the basis of the substance over form concept. Therefore, the bank does not have a record of that building in the balance sheet. This is because it does not have economic exposure to the value of that particular building. From the perspective, the bank has essentially provided 100 pounds to its customer in which exchange, the customer would pay 5 pounds on or by 31st Dec 2012 and also pay 115 pounds by 31st Dec 2014. This being the case, the economics of the transaction would be as follows (Yousaf)   Loan B/F Interest Repayment Loan C/F 2012 100.00 8.08 -5.00 103.08 2013 103.08 8.33 -5.00 106.41 2014 106.41 8.59 -5.00 110.00 Accordingly, here, the bank will account as under:(Yousaf) Income statement 2012 2013 2014 Financial income from leasing 8.08 8.33 8.59 Balance sheet 2012 2013 2014 Investment in finance lease (Zero at the end of 2014 as lease finishes) 103.80 106.41 0 This differs from the accounting standards as provided by the AAOIFI. According to these standards, it is important to account for the actual transaction being effected (Mohammed, 2013). In this case, the transaction is a sale of a mansion and the repurchase of the same. Contrary to the IFRS standards where they do not indicate the building on the balance sheet, in the AAOIFI, there must be the inclusion of the building in the end year balance sheet accounts as well as the gain from the sale of the building and the rental income. Thus, the accounts would be as under: (Yousaf) Income statement 2012 2013 2014 Rental income from building 5.00 5.00 5.00 Gain on sale of building     10.00 Balance sheet 2012 2013 2014 Building (cost) (Zero at the end of 2014 as building sold back) 100.00 100.00 0.00 Thus, it is evident that the deviations in the standards affect the presentation of contracts in practice. The differences can also be seen in the diagram below (Ernst and Young 2012) Ways in which Convergence can be achievedbetween these Issues Since there are these differences between the IFRS and AAOIFI, it is important that there be a convergence between the two standards. Convergence means the goal towards achieving an established set of standards of accounting, which are to be used internationally. The achievement of this convergence would be of great gain to many parties, from multinational companies and to governments. It is definitely not a simple task to achieve convergence between these two standards since one is based on faith and religious philosophy. However, if it were achieved, it would lead to lesser and lesser crash of standards which many a time causes confusion. This much needed convergence can be achieved through strengthening of relationship and communications between these two bodies and other accounting standard setters. This is important in that the broader flow of important information as a result of these relationships informs both organizations and contributes immensely towards the shared views of different perspectives and circumstances that can lead to a reduction in unnecessary differences between the two standards. This is despite the view that these accounting standards conceive that their different interests outweigh the goals of converged accounting standards (Vellam 2004). The second way in which convergence can be achieved is through the allowance of flexibility in individual standards. Most of these standards are so rigid such that they disable convergence. By this, the two standards can be able to be converged since flexibility is the key (Talsian 2010). For example, the AAOIFI are legalistic and they have a legal based orientation, which is not compatible with the spirit of IFRS which is a principle based. Thus, for convergence to be achieved, the AAOIFI standard setters must move from the used systems of uniformity in reporting towards the broader accounting which is based on principles. The IFRS should also consider that the Islamic banking sector has their own philosophies which they should faithfully follow. Thus, in developing standards, they should include such factors as this to avoid confusion. In essence, the mutual exclusivity that exists between these two standards of accounting must be done away with if convergence is to be achieved. Thirdly, the two bodies can achieve convergence through the adoption of an entirely new accounting standard which is favorable to all their followers. This means that there will be no disagreements and the cases of standards crashes will not be experienced any longer. The fourth means possible for achieving convergence is through remaining committed to the long term goals of achieving the convergence and showing effort to ensure that convergence takes place. This is because, the two standard bodies have met and expressed interest in the convergence of the standards, what is remaining is the showing of strong resolve by the parties to achieve the objective which can be seen through continuous improvement of the existing standards to a level that both standards will eventually come to agree upon. Without the determination to achieve the convergence, it will not be possible to achieve the long dream. Conclusion In conclusion, the two concepts of accounting, that is, substance over form and time value of money differ greatly from the IFRS accounting Standards to the AAOIFI accounting standards. As seen, they affect the presentation of information since one standard omits while another includes some information in their books of accounts. The differences between the two standards can be addressed through the convergence of accounting standards as pointed out. 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