INCEIF

The Global University of Islamic finance

MSc in Islamic Finance

Fundamental Accounting Principles from Shari'ah

Perspectives
_______________________________________________________________________

ACCOUNTING FOR ISLAMIC FINANCIAL TRANSACTIONS

Semester Sep 2015

Submitted to
PROFESSOR DR ZULKARNAIN MUHAMAD SORI

Submitted by
Md Akther Uddin - 1400225
Yousuf Sultan - 1400226
Mosharrof Hosen - 1500176
Nazim Ullah - 1500015

Table of Contents
1. Introduction..................................................................................................................................... 1
1.1. Emergence of Islamic finance and need for Islamic accounting..............................................1
1.2. Objective of the Study.............................................................................................................. 1
2. Substance over Form...................................................................................................................... 2
2.1. Example: Ijra......................................................................................................................... 3
2.2. The concept of substance over form from the sharah point of view......................................3
2.3. The Resolution of the Sharah Advisory Council (SAC) of Bank Negara Malaysia (BNM)
on the Principle of Substance over Form........................................................................................ 4
2.4. Literature Review..................................................................................................................... 5
2.5. Commentary............................................................................................................................. 5
3. Time value of money...................................................................................................................... 6
3.1. Interest, Time Value of Money, Discounting Factor and Its Implications................................6
3.2. The concept of time value from the classical to contemporary jurists.....................................7
3.3. Commentary............................................................................................................................. 8
3.4. Literature Review..................................................................................................................... 8
3.4.1. Commentary...................................................................................................................... 9
3.5. Resolutions on the Time Value of Money................................................................................9
3.5.1. Commentary.................................................................................................................... 10
4. Fare value measurement................................................................................................................ 11
4.1. Classical view on fair value measurement.............................................................................11
4.2. Arguments supporting the fair value measurement................................................................12
4.3. Argument against fair value of money...................................................................................12
4.4. Interpretation.......................................................................................................................... 12
4.5. Commentary........................................................................................................................... 13
5. Application of Probability Principle.............................................................................................. 13
5.1. Estimation of Probability under AAOIFI and IFRS...............................................................13
5.2. Literature review.................................................................................................................... 14
5.3. Resolutions of the SAC of BNM on probability...................................................................14
5.4. Other Resolutions related to the concept of Probability.........................................................15
5.4.1. Commentary.................................................................................................................... 15
6. Do We Really Need Accounting for Islamic Financial Transactions?...........................................15
7. Conclusion.................................................................................................................................... 16
References:................................................................................................................................... 19

1. Introduction
Accounting principles are the rules and guidelines that companies must follow when reporting
financial data. Accounting principles differ across the world, and countries usually have their
own, slightly different, versions of International Financial Reporting Standards (IFRS).
Generally Accepted Accounting Principles (GAAP) was widely used and accepted until IFRS
has emerged to harmonize accounting standards and currently IFRS standards adapted or
adopted in more than 120 countries across the world set by the International Accounting
Standards Board (IASB). IFRS are principles based rather than rules based (GAAP) which
guide countries to formulate their own accounting standards according to their local needs,
rules and regulations. The acceptance of IFRS has grown significantly not only in European
countries but also in the USA, where GAAP was widely used before worldwide convergence
towards IFRS. This convergence of course helps not only international acceptance and rating of
sovereign but also give better comparability picture for multinational investors for whom it
would be easier to compare various potential investing companies from different jurisdictions.
For example, Malaysian Accounting Standard Board formulates their own accounting standards
based on the IFRS principles.

1.1. Emergence of Islamic finance and need for Islamic accounting

The growth of Islamic finance, more specifically, Islamic banking in the last four decades has
been phenomenal and many Muslim and non-Muslim countries have started to promote
Sharah based financing on the backdrop of global financial crisis, where corruption,
manipulation, frictional reserve and subprime credit were rampant and many scholars have
started to ask the credibility of financial institutions (Zingales, 2015). The rapid growth of
Islamic banking industry in the late eighties and early nineties stimulates to establish a separate
accounting standard setting organization for Islamic Financial Institutions (IFIs), consequently
on the 27th March 1991, Accounting and Auditing Organization for Islamic Financial
Institutions(AAOIFI) was established in Bahrain. AAOIFI has so far issued 26 accounting
standards for IFIs and currently, as an independent international organization, AAOIFI is
supported by institutional members (200 members from 40 countries, so far) including central
banks, Islamic financial institutions, and other participants from the international Islamic
banking and finance industry, worldwide. AAOIFI standards are followed as part of
regulatory requirement or IFIs internal guidelines in jurisdictions that offer Islamic finance
across Middle East, Asia Pacific, South Asia, Central Asia, Africa, Europe, and North America;
and Islamic Development Bank Group (AAOIFI, 2010; AAOIFI Official Website, 2015).

1.2. Objective of the Study

Prohibition of Rib, Gharar and Maysir in financial transactions is the fundamental of Islamic
finance which distinguishes it from conventional finance. In addition to that, financial behavior,
practice and contracts used by IFIs must be in accordance with the Sharah principles.
Although most of the accounting principles issued by IFRS are more or less in line with the
Sharah, however, there are some principles which may contradict with the core principles of
Sharah. As a result, many scholars propagate for separate accounting standards for IFIs. In the
ISRA research paper An Appraisal of the Principles Underlying International Financial
Reporting Standards: A Sharah Perspective, researchers discuss whether the key underlying
principles of IFRS are acceptable from the Sharah perspective. Based on the classical fiqh
literature and Sharah resolutions from local and international organizations, the four key
principles are: 1) substance over form, 2) time value of money, 3) fair value measurement, and
4) recognition based on probability are elaborated.
We are going to discuss and argue the above mentioned four accounting principles from
conventional accounting point of view and explore the classical fiqh literature and resolutions
mentioned in the ISRA paper and beyond to support or argue against their views and finally
give our own judgment based on the existing literature.

2. Substance over Form

Substance over form refers to the principle of recording a transaction based on its economic
substance or financial reality rather than its legal form. For instance, in a sale and buy back
contract, the financial reporting will record the overall effect of all contracts involved in the
transaction, whereby the profit generated from the contracts will be recorded as the financing
cost payable by the finance (BNM, 2010).
IFRS gives greater weight to economic substance rather than legal form for recognition and
measurement purposes. For instance, in paragraph 4.6 of the IASBs Conceptual Framework
for Financial Reporting, the preference for economic substance over legal form is specifically
mentioned as follows: In assessing whether an item meets the definition of an asset, liability
or equity, attention needs to be given to its underlying substance and economic reality and not
merely its legal form.
AAOIFI on the other hand, even though it did not include the substance over form concept as
an element of reliability in Statement of Financial Accounting No. 2, but it indirectly
recognised this concept in its statements of concepts, although not necessarily in its standards
(Napier, 2007).
The principle of substance over form in the reporting of a Sharah -compliant financing
transaction means that the end result or substance of the transaction is recorded. The area of
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concern regarding this concept of substance over form is that, in applying it, the reporting of a
Sharah compliant transaction may render it virtually indistinguishable from an interestbearing transaction. Thus the difference between a transaction in conventional bank and an
Islamic Bank will be insignificant.

2.1. Example: Ijra

Ijra is a form of leasing arrangement. The pure Ijra is essentially an operating lease and
there would appear to be little conflict in accounting for this. Another form of leasing
increasingly used by IFIs is the Ijra Muntahia Bittamleek (a lease that concludes with the legal
title in the leased asset passing to the lessee) or Ijra wa Iqtina, which are similar to the hire
purchase agreement popular in conventional finance.
This is treated as a finance lease under IFRS because, as with a hire purchase agreement, the
risks and rewards associated with owning the asset are in substance transferred to the lessee.
Thus under IAS17 the asset would be booked as such by the lessee, while the lessor (the
financer) would book a receivable for the rent and related interest receivable (ACCA, 2010).
By contrast, under AAOIFIs FAS8, the legal form of the contract is paramount, meaning that
the ownership of the asset remains with the lessor, until legal title is transferred at the end of the
lease period. In this case the IFI would remain the owner, and record the asset on its balance
sheet in the same way as an operating lease or operating Ijra (ACCA, 2010).
The paper argues that in case the principle of form over substance is used for the recording of
this transaction (according to IFRS), the financial statements will recognise two separate
transactions:
(1) Rental is recognised throughout the ijrah period.
(2) A sale is recognised when the aqd (contract) to transfer the leased item is entered
into.
However, if the substance-over-form concept is applied, the financial statements will
recognise only one transaction, which is to account for the final sale similar to the case of a
conventional hire-purchase agreement whereby the two contracts of lease (hire) and sale
(purchase) are combined into one.

2.2. The concept of substance over form from the sharah point of view
The paper argues that Sharah gives importance to both the form and the substance of the
transaction. However, as most Islamic financial products are designed by using a series of
contracts, debates arise as to whether the effect of each contract in isolation is to be recorded,
hence recognizing the form of each contract; or whether the overall economic effect of the
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series of transactions is to be recorded, thus recognizing the economic substance of the overall
transaction.
It further argues that the principle of substance over form is in line with the legal maxims of
Sharah. The following two legal maxims give precedence to the substance.

Matters are determined according to intentions.1

In contracts, effect is given to intention and meaning and neither words nor forms.2
The words maqsid and maani refer to the intention indicated by the verbal clues found in the
contract that change it to another contract. For example awlah can be contracted in the
name of Kaflah and vice versa. Similarly, Hibah can become Bay if an exchange is
conditioned. In case of Mudarabah, if all the profit is conditioned for the Mudarib, the contract
will become a qardh contract. On the other hand, if all profits are conditioned for Rabb-alMaal, the money will be considered Amanah in the hands of Mudarib (Al-Zarqa', 1989).
The paper mentions that the principle of substance over form is supported by Sharah and
majority of the scholars have supported it, including the Hanafs, Maliks and Hanbals.
However, Shafii scholars have disagreed and favoured the form over substance.

2.3. The Resolution of the Sharah Advisory Council (SAC) of Bank Negara
Malaysia (BNM) on the Principle of Substance over Form
The SAC of BNM, in its 57th meeting 3, has resolved that in principle, substance and form
are equally important and highly taken into consideration by the Sharah. In this regard, the
Sharah emphasises that substance and form must be consistent and shall not contradict
one another. In the event of inconsistency between substance and form due to certain
factors, the Sharah places greater importance on substance rather than form (BNM,
2010).

1 Ahmad al-Zarqa, Syarh al-Qawa`id al-Fiqhiyyah, Dar al-Qalam, 1989, p. 47.

2 Ahmad al-Zarqa, Syarh al-Qawa`id al-Fiqhiyyah, Dar al-Qalam, 1989, p. 55.
3 Dated 30 March 2006 and 71st meeting dated 26 - 27 October 2007
4

SAC further states that the principle of substance over form is in line with the legal maxims of
Sharah. In case the substance conflicts with the form, the substance will have the precedence.

2.4. Literature Review

Napier (2007) argues that religion has effect on the construction of reality of the transactions in
Islamic Banks, so there can be difference in perception of a similar transaction in a Western
context and in an Islamic context. This would render the transactions different in their Islamic
substance although they might be similar to conventional bank transactions from a Western
perspective (Napier, 2007).
It is argued that there are those who believe that the recognition and measurement of an Islamic
financial transaction should give prominence to its legal form to differentiate it from a
perceived conventional equivalent. One writer even claims that substance over form is a
blatant violation of Sharah. Conversely, others believe that it is acceptable, and would benefit
users more, to show the economic substance of an Islamic financial transaction, and
information about the legal form may be relegated to the notes to the financial statements
(AOSSG, 2010).
ACCA (the Association of Chartered Certified Accountants) states that the conflict between
accounting based on economic substance as opposed to Sharah - compliant form appears to
be a recurring theme. IFRS is reliant on a strong framework of principles that emphasise the
economic nature of transactions, whereas in Islamic finance the contractual aspect of the
transaction is crucial for Sharah compliance. Underpinning those contracts are Sharah
principles that give rise to products (eg mudaraba, musharaka, salam and istisna) that are
unique to the industry and that have different rights and obligations associated with them
(ACCA, 2010).
Maurer (2010) argues that there is not much conflict between El-Gamal and Moodys. ElGamal has argued persuasively for an Islamic banking that focuses on substance rather than
form. For him, substance means meaningful understanding of and adherence to the prohibition
of rib. Moodys too, put the emphasis on substance rather than form. Where El-Gamal seeks
an Islamic finance that is true to the substance of Islamic fundamental principles rather than
engaging in analytical or semantic tricks to achieve a form that appears in compliance with
Islamic norms but introduces a host of inefficiencies and transaction costs, Moodys seeks an
Islamic finance that is true to the market fundamentals (Maurer, 2010).

2.5. Commentary
As mentioned above, the ISRA paper supports the principle of substance over form in financial
reporting based on its literature review and sharah resolutions. We agree with it; however we
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think that the issue doesnt need to go much further. Substance over form in financial reporting
has no conflict with the Sharah in the first stance.
The verse in Al-Quran (2:282) which orders us to write a contract says:

O you who believe! When you deal with each other, in transactions involving future
obligations in a fixed period of time, reduce them to writing. Let a scribe write down
faithfully as between the parties. (2:282)
The word writing denotes the writing of the contracts, rather than recording in the financial
reports. The financial reports are just some records, where we can use any of the principles
from substance over form or form over substance. This can be easily understood by the
majority Tafseers like Ibn Katheer, Qurtubi etc. However, since the reports are means of
communication between the stakeholders, therefore they should have some clarity. And thus we
propose that IFRS should have some additional notes or sections that clarifies the types of
contracts used in the financial reports, so that they are distinguishable from the interest based
contracts.

3. Time value of money

Time value of money is the core principle of finance which explains that money available today
is worth more than the same amount in the future; this is because of potential earning capacity
of money in the form of interest or be invested up until the time the future dollar is received 4. In
other words, money is worth more to an economic actor if it is available immediately for
consumption or investment purpose. This concept applies to many contracts; for example,
credit sale, and stock, project or company valuation. This concept may be thought of as a
financial application of the saying, "A bird in the hand is worth two in the bush." Based on this,
it is argued that since current consumption brings more satisfaction than future consumption,
people (i.e. creditors) who are asked to postpone current consumption must be compensated for
the pleasure foregone today. Hence, in a capitalist economy, this positive time preferencean
alternative term for time value of moneylays the rationale for the payment of interest.

4 Time value of money. (n.d.) Financial Glossary. (2011). Retrieved October 2 2015 from http://financial
dictionary.thefreedictionary.com/Time+value+of+money

3.1. Interest, Time Value of Money, Discounting Factor and Its Implications
Interest is defined in IAS 39 as the consideration for the time value of money and for the credit
risk associated with the principal amount outstanding during a particular period of time. As
the computation of the time value of money and the discounting technique used in calculating
Net Present Value (NPV) generally involve reference to the interest rate, many Muslim jurists
consider this non-permissible as it is in conflict with the outlawing of interest charges (Rib)
under the Sharah (AOSSG, 2010). In other words, as conventional finance revolves around
the interest rate, time value of money is acceptable principle, however, some controversies arise
in Islamic finance when we consider in credit sale the deferred price is higher than the spot
price, also interest rate as a discounting factor to get the NPV of future cash flows of a stock,
project, or company. Consequently, Islamic banking in its current form also appears to accept
the validity of charging higher prices for future payments in comparison with prices for
immediate payment, such as in the case of the murabaha (cost plus profit) contract. For
example, an Islamic bank may charge a customer MYR 2 million for a house if he chooses to
repay over twenty years, but only MYR 1.5 million if he pays immediately in full.
In the following section, based on the ISRA article we are going to discuss the concept of time
value of money and various issues from the fiqh sources starting from the Quran, the Sunnah,
classical and contemporary jurists and the fiqh scholars.

3.2. The concept of time value from the classical to contemporary jurists
The paper argues that a literature review shows that the Sharah does not totally rule out the
concept of the time value of money. Authors provided authentic Quranic verses (The Holy
Quran, 75: 20-21; The Holy Quran, 87:16-17) to support the permissibility of the time value of
money, however, some scholars tend to disagree and they argue that these verses have nothing
to do with the time value of money, it is mere admonishing of people who prefer life here than
life hereafter. However, we can argue that an innate human nature (fitrah) is to prefer present
gratification (al-Masri; Khan FM; al-Zarqa) even though higher reward granted by Allah
(SWT) for deferred gratification and some people still prefer not to spend money immediately
and save it for the future consumption (Al-Muwdudi, Khan MA). Furthermore, classical and
contemporary jurists of four major schools of thought like, Al-Dasuqi, Al-Kasani, Al-Sharbini,
and Ibn Taymiyyah support the concept of time value of money, but no sound opposition from
scholars are noted in the paper. Therefore, we can state that the time value of money concept in
exchange contracts is well accepted among majority scholars but not in loan contracts as the
subject matter is money rather than an underlying asset. In this manner, positive time
preference has been found acceptable to Sharah scholars in an exchange contract (Khan,
1991; Khaf, 1994; Ahmad and Hassan, 2004).

It is well argued in the article that Sharah permissibility of Bay al-Salam and Bay al-Istisna
further strengthens the support in favor of time value of money. However, we can argue that the
difference in the present and future values of the same commodity cannot be considered to have
been allowed just because of the pure time element involved (Khan, 1991). As Khan argues that
the jurists could have allowed this difference because they recognized that supply and demand
forces are different at different points of time. Refuting the idea that demand and supply in the
future must have been considered to permit bay muajjal, Kahf argues that the legitimacy of
bay muajjal and bay salam can be rationalized along the lines of musharakah, mudarabah,
and ijrah on the basis of ownership and the distinction between moneys anticipated and
realized time value (Kahf, 1994). According to Siddiqui, unlike Kahfs assertion, bay muajjal
is neither similar to mudarabah or musharakah, nor could its permissibility be linked to bay
salam.
While the paper argues that the time value of money concept is also applicable in evaluating
projects under construction and higher deferred price in future is settled. But the issue of using
interest rate in the discounting process, similar to the conventional practice, given that the
Sharah prohibits a fixed promised return on debt transactions, is a significant issue. The issue
was also raised by PricewaterhouseCoopers (2010) more specifically, the question is whether
the use of a discount rate benchmarked to the interest rate for calculation of fair value purposes
actually poses a problem in the context of Islamic financial transactions. Khir (2012) states that
there is no consensus regarding this among scholars, some argue there is no issue in using
interest rate as a benchmark as they consider this a human innovations which do not contradict
Sharah. On the contrary, Zarqa (1983) totally rejects it although he concluded that discounting
is accepted and even desirable for promoting investing efficiency, consequently he proposes to
use return on equity as the appropriate discounting rate.

3.3. Commentary
Based on the research paper, we can argue that economic agents in an Islamic economy will
have positive time preference and there will be indicators available in the economy to
approximate the rates of their time preferences. There is no justification to assume zero rate of
time preference in an lslamic economy as is done in many studies on investment behavior from
lslamic perspective (Khan, 1991; Khaf, 1994; Ahmad and Hassan, 2004). In the following
section, we are going to present a review of selected works on the time value of money from
Sharah perspective.

3.4. Literature Review

Khan (1991) states that Anas Zarqa, Rafiq al-Masri and Rauf Azhar accepts the concept of
positive time preference and time value of money. By analyzing classical and contemporary
fiqh scholars and jurists he also confirms that positive time preference or time value of money
8

is acceptable as long as it is not claimed as a predetermined value. Furthermore, he proposes

return paid by Islamic banks on deposits of different maturities to be considered as a close
proxy for discount rates for the evaluation of projects of different maturities (Khan, 1991).
While critically analyzing Khan(1991), Kahf (1994) considered time value of money is an
investment phenomenon not a phenomenon related to abstention from current consumption.
Time preference is, therefore, a real factor in the mind of the income earner and provider of
investible funds. He further argues that the valuation of time preference can only be affected
ex-post because its nature does not allow an opportunity of knowing it ex-ante (Kahf, 1994).
Ahmad and Hassan (2004) argue that any conditional increase in the loans principal in return
for a deferred repayment due to an expected depreciation in the value of the money, asset, or
other factors (e.g., inflation and commercial losses) is prohibited. They further state that even
though there is near consensus among Islamic jurists that in a credit sale contract where
repayment is deferred, a commoditys price may be increased. However, the issue remains
unresolved from an Islamic legal financial perspective (Ahmad and Hassan, 2004).
Pervez, on the other hand, argues that there are no specific Islamic theories on moneys time
value, since postponing an assets enjoyment to a future date is, in effect, a sacrifice made by
the investor; an expected depreciation of the moneys or assets value due to factors related to
inflation, depreciation, and commercial loss (Pervez, 1997).
Khir (2012) states the opponents of TVM have argued that recognizing it will lead to
acceptance of Rib, against which Islam is at war however, he concludes that Islamic
acceptance of TVM should not be disregarded, particularly in financial transactions, such as
deferred sales and loan contracts, in order to uphold justice. He further argues that if the
Sharah parameters are completely complied with, the application of TVM may result in
removal of Rib and achievement of fair economic effects in financial transactions (Khir,
2012).

3.4.1. Commentary
From the above discussion, we can conclude that the principle of time value of money (TVM)
is controversial, as Sharah scholars hold differing views regarding its conceptual and practical
foundation in the Islamic financial system. The opponents of TVM have argued that
recognizing it will lead to acceptance of Rib, against which Islam is at war. (al Mawdudi,
Khan M A). There are arguments for time value of money as time can be given a counter-value
in association with real commercial activities; as a result, this concept should not be
disregarded in financial transactions, such as deferred sales, in order to uphold justice, given
that it must be applied in accord with the specific Sharah parameters. It can be concluded that
the Islamic legitimacy of TVM is established on four bases: 1) the concept of Positive Time
9

Preference (PTP); 2) the permissibility of a different price in a cash sale as opposed to a credit
sale; 3) the permissibility of bay al-salam and bayal-Istisna; and 4) Islamic legal maxims.

3.5. Resolutions on the Time Value of Money

As discussed in the paper, the Sharah Advisory Council (SAC) of Bank Negara Malaysia
(BNM) resolved that the application of time value of money principle in Islamic financial
reporting is permissible only for exchange contracts that involve deferred payment.
Nevertheless, the SAC prohibits the charging of an extra sum for deferred repayment of Qard
(loan). The SAC explained that the jurists had long accepted that there is an economic value to
time and quoted various classical statements permitting an increase in value due to the lapse of
time.
OIC Fiqh Academy also resolved that deferred installment sales are permissible even if the
deferred price is more than the immediate price. It is also stated in the ISRA paper that the
application of deferred installment sales such as the murabaha contract is unanimously
permitted by other authorities such as Kuwait Finance House, Dubai Islamic Bank and al-Rajhi
Bank. The contemporary Middle East Sharah scholars recognize the principle of the time
value of money in the sale contractnot in a lending contractand thus allow for the

3.5.1. Commentary
By examining resolutions and guidelines regarding the application of time value of money in
Islamic financial transactions, we can argue that majority scholars accept the current use of
time value of money concept in murabaha financing as there is an underlying asset and higher
deferred price is justified due to risk associated. However, there is no resolution so far
regarding using interest rate as a discounting factor in capital budgeting technique but some
scholars seem there is no issue in using interest rate as a benchmark (Karim, 2001). Therefore,
we tend to agree based on the principle of permissibility in muamalat otherwise not prohibited
by Sharah is permissible, the time value of money is the fundamental principle of finance,
and majority scholars agree that time does have economic value, therefore they approve time
value of money concept in exchange contract and prohibit mere charging of interest on loan
contract.

4. Fare value measurement

Fair value measurements have placed greater function in financial statements, because this
information is perceived as more relevant to investors and creditors than historical cost
information in making financial decision. It is the exit market price which is equal to the
benchmark depending on the demand and supply in the market, customer perceived value or
utility, cost of the assets and risk characteristics that would result under close-to-ideal market
10

conditions, in a transaction between knowledgeable, independent and economically rational

parties, which interact on the basis of an identical information set.
The new Standard FAS 157, Fair Value Measurements, which states in para. 5: Fair value is
the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. The IASB framework at
present has no definition of fair value, yet a uniform definition can be found on the standards
level: Fair value is the amount for which an asset could be exchanged, or a liability settled in
difference time period, between knowledgeable, willing parties in an arms length transaction.
In a current convergence project, the IASB develops an International Financial Reporting
Standard (IFRS) on fair value measurements, which is based on SFAS 157 (Hitz, 2007).
Sing et al. (2005) argues that many accounting papers or standard setters have investigated the
survey on whether the investors want financial instruments to be measured based on fair value
or historical cost. And the results were to use mixture of both. The investors want fair value
information so as to better determine the true value of their investment. At the same time, they
also wish to see the historical results that provide a measure of cash flows and indicate whether
management has achieved operating results that were budgeted or predicted. This kind of
thinking in other common circumstances always create a dilemma and desirous to keep all
preference (Sing et al, 2005).
An investigation of fair value measurement is important because many commentators have
suggested that fair value measurement would be more pervasive under IFRS than under
national GAAP. Some suggested that IFRS were a fair value based accounting framework with
some exceptions for historical cost and that financial reporting under IFRS largely involved the
measurement of assets and liabilities at each balance sheet date at fair value and they use it in
the financial statement in four ways (Cairns et al, 2011).

4.1. Classical view on fair value measurement

Islam emphasizes fair dealing and just commercial transactions. The prohibition of several
forms of sales known to the medieval Arabs, such as talaqqe al-rukban, and najash, is the clear
indication of the fair value measurement. Whereas, in determining the fair value, jurists would
normally refer to Urf (customary practice). Based on Urf, determination of fair value can be
divided into two categories. The first comprises commodities whose prices are commonly
known to the public. The second comprises rare commodities. But it is also realized that the fair
value would be affected by certain circumstances such as shortage of supply of goods due to
market manipulation, war and emergency, customer perceived value or utility, cost of the assets
and risk characteristics. Therefore, Islamic law recognizes the role of experts in determining the
fair value measurement. Some Sharah scholars require or prefer that certain transactions such
as leasing with gradual sale and zakah (poor due) be based on cash equivalent values (fair
11

values) rather than on other measurement bases such as the lower of historical cost or net
realizable value (Ibrahim, 2007).
It also appears that the principle of fair value is already being applied within the practice of
Islamic finance. For instance, fair value is recognized by all authorities in murabaha financing,
especially in the event of customer default. When a customer cannot afford to pay the
installments, the Islamic bank will usually sell the asset based on the market value rather than
the historical value.

4.2. Arguments supporting the fair value measurement

Fair value proponents argue that such values are useful to investors in their decision making.
Such values stress current cash flow expectations for financial assets as opposed to historical
cost and amortized historical cost. Historical cost figures serve to manipulate income as
decisions on when to sell the assets can be timed to reflect higher gains or losses (Webinger et
al, 2013). Whereas Barth (1994) observes that the fair value of a banks investment securities
has incremental explanatory power beyond historical cost, but that historical cost measurement
has no incremental explanatory power beyond fair value.

4.3. Argument against fair value of money

To the best of our knowledge, the fatwa-issuing authorities in Islamic finance, such as the OIC
International Islamic Fiqh Academy and the SACs of BNM, Kuwait Finance House, Dubai
Islamic Bank and al-Rajhi Bank have not yet issued specific fatwas relating to the principle of
fair value, the issue of discounting, the use of an interest rate for discounting or in valuation
techniques for determining fair value. Many banks and other financial institutions criticized this
standard due to unrealized losses stemming from their financial assets, contending that FAS
157 aggravated the financial crisis.
Specifically, opponents of FAS 157 asserted that illiquid markets in bank financial assets do not
provide realistic long-term asset values that reflect true cash flows and also added that Fair
valuation is inherently subjective when contrasted to historical cost, yet few financial statement
items are strictly based on historical costs; even plant and equipment are subjected to
depreciation and impairments. Applying fair values, in view of their questionable reliability in
such constricted markets, has the potential to increase income volatility, reflecting a gulf
between accounting income and cash flows (Webinger et al, 2013).

4.4. Interpretation
Seng and Mean (2005) argued that both true value and historical value are important in the
organization. True value is needed to determine the investment and historical value is needed
12

for the real cash flow and indicate whether management has achieved operating results that
were budgeted or predicted.
According to Azmi (2010), while both AAOIFI and IFRS rely on the concept of fair value, their
views apparently differ when there is no active market, which makes assessment of fair value
more difficult. The IFRS view is that measurement of fair value may require the use of
valuation techniqueswhich often make use of discount ratesrather than relying on quoted
market prices. AAOIFIs (2010) FAS 25, Investment in Sukuk, Shares and Similar Instruments,
mentions the use of estimation techniques to derive fair value when quoted prices may not be
indicative of fair value, but it does not elaborate further regarding the permissibility of using
discount rates in determining fair value. Finally, AAOIFI and IFRS should be harmonized so
that to resolve the differences in the accounting treatment and disclosures of the financial
Islamic transaction.

4.5. Commentary
According to our opinion after analyzing ISRA paper and other related papers both fair value
and the historical cost are very significant for the institution, since fair value estimation will
help the institution for taking investment decision whereas historical cost will help it finding
actual cash flow estimation.

5. Application of Probability Principle

The principle of probability refers to the practice of recording transaction although the contract
has not yet been completely concluded. In this regard, assets will be recorded once there is a
probability of economic resources inflow whilst liability will be recorded once there is a
probability of economic resources outflow due to current obligation and its amount can be
estimated with certainty. Instances of item recorded based on the principle of probability is
wad (whether it is a binding promise or non-binding promise) and provision for impairment.
Nevertheless, such practice is not meant to equalise promise and contract (aqd). Instead, it is
aimed at notifying on the economic effect upon the execution of the arrangement.

5.1. Estimation of Probability under AAOIFI and IFRS

IFRS calculates profit under the IASBs proposed impairment model, impairment would be
recognised (that is, an expense would be deducted from profit) when impairment is expected. It
is thus argued whether the use of the impairment model that recognises expected but unrealized
expenses is acceptable from the Sharah point of view. In contrast, AAOIFI only caters for the
actual profit or loss calculation of an Islamic banks share in mudarabah profits or losses,
which is required to be recognised only at the time of liquidation, in case the financing
transaction is within a one-year period. In case of mudarabah financing that continues for more
13

than one financial period, the Islamic banks share of profits for any period, resulting from
partial or final settlement between the Islamic bank and the mudarib, shall be recognised in its
account for that period to the extent that the profits are being distributed; the Islamic banks
share of losses for any period shall be recognised in its account for that period to the extent that
such losses are being deducted from the mudarabah capital (AAOIFI, 2010, FAS No. 3,
Paragraph 2.4).
In the case of ijrah muntahiyah bi al-tamlik, there is a lease with a wad to transfer ownership
of the leased asset. Under IFRS, if it is demonstrated that it is probable that the transfer of
ownership will occur and the value of the transferred item can be measured reliably, then the
transfer transaction should be recognised, leading to a finance lease treatment. This treatment is
different from AAOIFI, which would require the separation of the lease and transfer
transactions.
Based on the above discussion we can conclude that, AAOIFI favors recognition of actual
profit or loss calculation in deriving the banks share in mudarabah profit or losses. Further, it
is silent on accepting expected losses used in the impairment model espoused by the IFRS
exposure draft.

5.2. Literature review

Certainty is the highest level of confidence in Islam. Whenever possible, Muslims are required
to make decisions base on full assurance and certitude. The legal rule which allows the use of
probability concept is, Certainty is not overcome by doubt (al-yaqin la yuzalu bi al-shakk). This
rule has many corollaries that indicate reliance on certainty. The rule for something is not
confirmed before its existence (Al-Din, 1991: 97). That which is expected to occur cannot be
treated like that which has occurred (Al-Zarkashi, 1985:161). The presumptive rule is that
transitory attributes do not exist (Al-Zarqa, 1989: 107). Despite the emphasis on certainty,
Islam also recognizes uncertain circumstances. This is because, in reality, Muslims are faced
with many probable occurrences. Hence, the use of the probability concept is not alien to the
fiqh literature, and jurists have accepted its use under certain circumstances. There is a legal
maxim which states, Acquisition is given the same ruling as present property (Al-Suyuti, 1990:
180).
In the case of a person performing prayer who form the intention to exit the prayer during the
next rakah. Is the prayer considered void immediately upon his intention, or is the prayer still
considered valid, only becoming void when he actually enters the next rakah? Some scholars
opine that the prayer is considered void immediately from the point of such intention, based on
these legal maxims. From these legal maxims, it can be deduced that the concept of probability
is accepted in arriving at certain fiqh rulings. However, the jurists emphasize the concept of
14

valid probability, which is defined as events yet to occur that do not contradict injunctions
from the Quran and Sunnah.

5.3. Resolutions of the SAC of BNM on probability

In this regard, the SAC of BNM was asked whether the principle of probability in Islamic
financial reporting is Permissible. The SAC, in its 71st meeting dated 26 - 27 October 2007, has
resolved that the application of probability principle in Islamic financial reporting is
permissible as it does not contradict the general fiqh principles.
Regarding the basis of ruling, SAC states that some scholars opine that strong presumption (alzann al-ghalib) may be taken into consideration in ascertaining a ruling. This has been
discussed by a number of scholars such as al-Amidi (1983), al-Ghazali (1992) and al-Zarqa
(1989). In addition, the permissibility of applying the principle of probability in Islamic
financial reporting is based on the following legal maxims: Consideration is given to the
predominant and widespread, not to the rare (Al-Zarqa, 1989). The original state of thing is
permissible. Consideration is based on the prevailing practice and not on the isolated cases.
Presumption must be followed (Al-Amidi, 1983).

5.4. Other Resolutions related to the concept of Probability

The OIC Islamic Fiqh Academy resolved that the original ruling of a promise is that it is
morally binding. It is considered legally binding as well if the promise is made conditional
upon the fulfillment of an obligation and the promisee has already incurred expenses on the
basis of the promise. Dallah Al-Barakah issued a similar resolution Research Paper No.
54/2013 (Majmaat al-Barakah al-Masrafiyah, 2007, Resolution No. 2/22: 47, Resolution No.
2/10: 40 and Resolution No. 2/34: 60).

5.4.1. Commentary
There is no specific sharah resolution on the concept of probability in reporting Islamic
financial transactions has. From resolutions on the issue of wad (whether it is a binding or
non-binding promise), we can safely presume that the Sharah scholars dont have any
objection to adopting this concept. This is because all fatwa-issuing bodies agree that a promise
is binding on the promisor. If the promisor reneges on his promise, compensation must be paid
for damages caused as a result of its non-fulfillment without a justified excuse. Moreover,
AAOIFI (2008), in its Sharah Standard No. 8/2/3 (pp. 116-117) and its basis of the Sharah
rulings (p. 129), argued that the customer may be forced to fulfill his obligation based on the
general sources of the Quran and the Sunnah that require fulfillment of obligations and
undertakings. Dallah Al-Barakah does not mention clearly the Sharah justification of its
resolutions. In this regard, the principle of probability in Islamic financial reporting is
permissible.
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6. Do We Really Need Accounting for Islamic Financial Transactions?

There are opinions for and against the need of separate Islamic accounting. Many scholars
opine that accounting is a process of recording, storing, analyzing and presenting financial
information to management and stakeholders in order to help their decision making.
Consequently they argue that there is no need for separate Islamic accounting.
On the other hand, many Islamic scholars and jurists argue that conventional accounting
principles are based on considering the interest rate, and money is considered as commodity.
Hence a creditor expects fixed increase in value of money over certain time period, and
therefore there is need for separate accounting standards for IFIs (Napier, 2007; Sarea &
Hanefah, 2013).
Interest rate is greatly interconnected with the key accounting concepts like time value of
money and fair value estimation technique, where interest rate is used as a discounting factor
for present value calculation of future stream of cash flows. After analyzing four key
accounting principles from Islamic Sharah perspectives, the original sources (the Holy Quran
and the Sunnah of the Prophet (PBUH)), classical and contemporary juristic opinions and
resolutions from various Sharah Advisory Councils, it is more than evident that there are mix
of opinions among Sharah scholars regarding these principles.
We can argue that accounting is above all accounting and it is considered as human
innovation, where there are very little or no Sharah issues involved (Khir, 2012) as our
analysis also support that. Majority scholars didnt find any contradiction in using such
accounting concepts of substance over form, time value of money, fair value estimation and
probability.
On the other hand, it can be argued that Islamic accounting is an absolute necessity for IFIs as
their ultimate goal is not only to maximize shareholders wealth but to maximize the welfare of
stakeholders and uplift maqasid al-Sharah. As accounting information plays a vital role for
management, board of directors, regulators, government agencies, existing and potential
investors, the presentation of each and every transactions in IFIs must be in accordance to
Sharah, so that all stakeholders can make rational and informative decision and minimize
asymmetry of information which exist in conventional accounting practices, like sophisticated
manipulation and double accounting i.e. accounting for internal use and external reporting in
order to get unfair advantages.
Therefore, in order to upheld the principles of Sharah let alone establish an interest free
economy, just, fair and ethical accounting practices is necessary, consequently, it can be argued
that Islamic accounting can fulfill the vacuum exist in conventional accounting practices.

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7. Conclusion
Accounting for Islamic financial transactions has been evolving as a separate discipline from
mere intellectual discourses among academia. The development of Islamic finance, namely,
Islamic banking has stimulated the need for separate accounting frameworks for financial
institutions which run on the principles of Islamic Sharah. Hence many proponents argue that
it is high time to develop unique standards in order to be distinct from conventional financial
system. Consequently AAOIFI has been established exclusively for developing accounting
standards of IFIs but the acceptability of its standards is not overwhelming and only confined
with few gulf and African countries. On the contrary, many argue that IFIs can easily
accommodate existing accounting standards issued by IFRS to comply with Sharah with
minimum modification, therefore, propose greater convergence towards IFRS like in Malaysia.
In doing so, scholars try to find controversial accounting principles that exist in IFRS
accounting standards which may contradict with Sharah principles and subsequently identify
four accounting principles: substance over form, the time value of money, fair value
measurement and probability.
The principle of substance over form in the reporting of a Sharah compliant financing
transaction means that the end result or substance of the transaction is recorded. The area of
concern regarding this concept of substance over form is that, in applying it, the reporting of a
Sharah compliant transaction may render it virtually indistinguishable from an interestbearing transaction. Thus, the difference between a transaction in conventional bank and an
Islamic Bank will be insignificant. As a result, we tend to argue that the issue doesnt need to
go much further as substance over form in financial reporting has no conflict with the Sharah
in the first stance. The financial reports are just some records, where we can use any of the
principles from substance over form or form over substance. This can be easily understood by
the majority Tafseers like Ibn Katheer, Qurtubi, etc. However, since the reports are means of
communication between management and the stakeholders, therefore they should have some
clarity. Therefore, we propose that IFRS should have some additional notes or sections that
clarify the types of contracts used in the financial reports, so that they are distinguishable from
the interest based contracts.
Time value of money is a fundamental concept in not only conventional finance but also in
Islamic finance as Sharah does not totally rule out this principle. Majority of scholars tend to
agree that time has economic value therefore it is necessary to take into consideration with
higher deferred price in credit sales, where payment will be made in the future and there might
be risk and uncertainty associated with it, subsequently to upheld justice for both parties in the
contract. It can be concluded that the Islamic legitimacy of TVM is established on four bases:
1) the concept of Positive Time Preference (PTP); 2) the permissibility of a different price in a
cash sale as opposed to a credit sale; 3) the permissibility of bayal-Salam and bayal-Istisna;
and 4) Islamic legal maxims. Although, there is no resolution so far regarding using interest
17

rate as a discounting factor in capital budgeting technique but some scholars consider there is
no issue in using interest rate as a benchmark (Karim, 2001). Therefore, we tend to agree based
on the principle of permissibility in muamalat otherwise not prohibited by Sharah is
permissible, consequently, time value of money concept is acceptable in exchange contract and
prohibit mere charging of interest on loan contract.
Fair value measurements have placed greater function in financial statements, because this
information is perceived as more relevant to investors and creditors than historical cost
information in making financial decision. Proponents of this concept tend to argue that such
values are useful to investors in their decision making. Such values stress current cash flow
expectations for financial assets as opposed to historical cost and amortized historical cost.
According to our opinion after analyzing ISRA paper and other related literature on both fair
value and the historical cost are very significant for the financial institution and scholars
consider the role of experts and the use of estimation techniques in determining the fair value
when there is no clear market price for a commodity. However, the issue of using interest rate
as a discounting factor in an estimation technique is still to be resolved.
The principle of probability refers to the practice of recording transaction although the contract
has not yet been completely concluded. In this regard, assets will be recorded once there is a
probability of economic resources inflow whilst liability will be recorded once there is a
probability of economic resources outflow due to current obligation and its amount can be
estimated with certainty. Even though the paper states that certainty is the highest level of
confidence in Islam but at present there is no specific sharah resolution except the SAC of
BNMon the concept of probability in reporting Islamic financial transactions. From resolutions
on the issue of wad (whether it is a binding or non-binding promise), we can safely presume
that the Sharah scholars dont have any objection to adopting this concept. This is because all
fatwa-issuing bodies agree that a promise is binding on the promisor. If the promisor reneges on
his promise, compensation must be paid for damages caused as a result of its non-fulfillment
without a justified excuse. As a result, we can argue that the principle of probability in Islamic
financial reporting is permissible.
Finally, we can confirm that four fundamental accounting principles are more often than not in
line with sharah principles based on opinions of classical and contemporary fiqh scholars
which are also supported by resolutions from various SAC in different countries. Although,
there is no specific sharah objection on these principles, there exist strong arguments for the
separate accounting principles for IFIs in order to be distinctive from conventional financial
system and ultimately fulfill the goal of Maqasid al- sharah.

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