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Statement of Financial Accounting No. 1

Conceptual Framework for Financial Reporting by

Islamic Financial Institutions

For Islamic Financial Institutions

Conceptual Framework for Financial

For Islamic Financial Institutions

9. Preparation and Presentation of Accounting Information

• 1. Introduction Page
  • 1/1 Rationale
  • 1/2 The importance of establishing the Conceptual Framework
  • 1/3 The approach used in developing the Conceptual Framework
  • 1/4 Users of financial information
    • information from the IFI who do not have the authority or ability to obtain additional
• 1. Authoritative Status of the Framework
• 1. Objectives of Financial Accounting and Financial Reports for IFIs
  • 3/1 Objectives of financial accounting
  • 3/2 Objectives of financial reports
• 1. Limitations
     • accounting and reports 4/1 Limitations of information provided by financial
  • 4/2 Limitations resulting from cost and benefit consideration
• 1. Financial Reports and Process
  • 5/1 Categories of financial reports
  • 5/2 General purpose financial reports
  • 5/2/1 Primary statements
  • 5/2/2 Statement of accounting policies
  • 5/2/3 Explanatory notes
  • 5/2/4 Supplementary statements
  • 6/1 Assets 6. Elements of Financial Statements
  • 6/2 Liabilities
  • 6/3 Equity of investment accountholders
  • 6/4 Owners’ equity
  • 6/5 Off-balance sheet items
  • 6/6 Income
  • 6/7 Expenses and losses
  • 6/8 Return on investment accounts
  • 6/9 Net income (net loss)
  • and Accounting Assumptions 7. Financial Accounting Process, Recognition, Measurement Concepts
  • 7/1 The financial accounting processes
  • 7/2 Recognition of profits and losses in relation to off balance items
  • 7/3 Concepts of accounting measurement
  • 7/3/1 Measurement attributes
  • 7/3/2 The matching concept
  • 7/3/3 Historical cost
  • 7/3/4 Fair value
  • 7/4 Accounting assumptions
  • 7/4/1 The accounting unit concept
  • 7/4/2 The going concern concep
  • 7/4/3 Periodicity concept
  • 7/4/3/1 Accrual basis
  • 7/4/3/2 Cash basis of accounting
  • 7/4/4 The stability of the purchasing power of the monetary unit
• 1. Financial Reports and Process Conceptual Framework for Financial
  • 8/1 High quality
  • 8/1/1 True and fair view
  • 8/1/2 Decision usefulness
  • 8/1/3 Transparency
  • 8/2 Relevance
  • 8/2/1 Understandability
  • 8/3 Reliability
  • 8/3/1 Representational faithfulness
  • 8/3/2 Neutrality
  • 8/3/3 Substance and form
  • 8/3/4 Completeness
  • 8/3/5 Verifiability
  • 8/3/6 Consistency
  • 8/4 Comparability
  • 8/5 Prudence
  • by two pervasive constraints, materiality and cost. Providing useful financial reporting information is limited
  • 9/1 Materiality
  • 9/2 Cost of information
• 1. Adoption

For Islamic Financial Institutions

Conceptual Framework for Financial

1. Introduction

The Conceptual Framework introduces the main objectives as well as the concepts underlying financial accounting and reporting by Islamic financial institutions (“IFIs”). The objective of financial accounting and reporting is the foundation of the Conceptual Framework. The concepts flow from the objectives and they represent a framework of principles underlying financial reporting.

1.1 Rationale

The Conceptual Framework provides the basis for the financial accounting standards of the Accounting and Auditing Organization for Islamic Financial Institutions (“AAOIFI”). Three important reasons underpin the development of the Conceptual Framework and separate financial accounting standards for IFIs:

a) The need to establish a common framework for accounting and financial reporting and to help demonstrate to the common users of general purpose financial reports or financial statements (these terms have been used interchangeably in the Conceptual Framework) that the entities they are associated with comply, in form and in substance, with the principles and rules of the Islamic Shariah (“Shariah”) in their financial and other dealings.

b) The relationship between IFIs and the parties that deal with them differs from the relationship of those who deal with conventional entities, insurance firms, mutual funds, and other organizations. Unlike conventional entities IFIs are prohibited the use of interest in their investment and financing transactions; from entering into highly speculative transactions and also prohibited from entering into transactions that are not permissible by the Shariah. For instance, whereas conventional entities borrow and lend money on the basis of interest, IFI mobilizes funds through investment accounts on the basis of Mudaraba^1 (i.e. sharing of profit between the investor who provides the funds and the IFI which provides the effort) and invests these funds in Shariah compliant assets or instruments.

c) The information needs of the common users of financial reports of IFI are unique and specific, and, accordingly, the financial reports of such entities must reflect the nature of the relationships established with such entities and the transactions, events or conditions involving such entities.

The principles set forth in this Conceptual Framework are consistent with the precepts of the Islamic Shariah.

Accounting encompasses several areas, generally agreed to include financial accounting, managerial accounting, cost accounting, and general purpose accounting. The Conceptual Framework provides guidance on identifying the boundaries of financial accounting and reporting; selecting the transactions, other events, conditions and circumstances to be represented; how they should be recognized, derecognized, measured, disclosed; and presented in financial reports.

(^1) Mudaraba arrangements involve two parties, one providing the funds and other the “effort”

in exchange.

For Islamic Financial Institutions

Conceptual Framework for Financial

f) The determination of the information needs of the users of financial reports that require to be addressed.

1.4 Users of financial information

The information needs of users of financial reports increase and vary with the increase in the categories of users, for example, investors including equity and investment account holders, creditors including current accountholders, debtors, employees of the IFI, and those who deal with it in any other manner.

Government agencies have the power and authority to directly obtain the types of information that best serve their needs. On the other hand, other external users’ access to information is limited and must rely on the information presented in the IFI’s general purpose financial reports. Accordingly, it is essential that the common information needs of these categories of users be the focus of the financial reports. It should be emphasized, however, that the financial reports cannot be expected to provide for every possible information need of these categories of users, particularly those needs that are not common to all users due to costs involved.

1.5 Common information needs of users of financial reports who do not have the authority or ability to obtain additional information from the IFI

It is possible to summarize the common information needs of users as follows:

a) Information which can assist in evaluating the IFI’s compliance with the principles of Shariah in all of its financial and other dealings.

b) Information which can assist the user in assessing the risks inherent or associated with the IFI, its transactions, its financial position or its operation.

c) Information which can assist in evaluating the IFI’s ability in:

i. Using the economic resources available to it in a manner that safeguards these resources while increasing their value, at reasonable rates. ii. Carrying out its social responsibilities.

iii. Providing for the economic needs of those who deal with the IFI. iv. Maintaining liquidity at appropriate levels.

d) Information which can assist those employed by the IFI in evaluating their relationship and future with it, including the IFI’s ability to safeguard and develop their rights and develop their managerial and productive skills and capabilities.

It is assumed that the information described above represents the minimum required to satisfy the common information needs of external users of financial reports.

For Islamic Financial Institutions

Conceptual Framework for Financial

2. Authoritative Status of the Framework

2.1 Overriding Shariah compliance principle

There is a presumption that nothing in this Conceptual Framework or in the Financial Accounting Standards that follow this Conceptual Framework should lead to non-compliance with the Islamic Shariah.

Given the profound impact of the Islamic Shariah on the conduct of activities by the IFI it is imperative that it ensures compliance with the Islamic Shariah even in matters relating to financial reporting.

2.2 Lack of a Financial Accounting Standard in relation to a transaction, event or condition

An IFI preparing financial statements under financial accounting standards of AAOIFI is required to consider the Conceptual Framework where there is no Financial Accounting Standard issued by AAOIFI or interpretation that specifically applies to a transaction, other event, or condition that deals with similar and related issue.

Should the Conceptual Framework be considered insufficient in the judgment of those charged with the governance of the IFI, the transaction, event or other condition that gives rise to this question should be dealt with within the framework of generally accepted accounting principles. Generally accepted accounting principles for this purpose shall be taken to mean any other national accounting framework relevant to the jurisdiction in which the IFI is domiciled, provided the application of such framework does not lead to a conflict with the principles of Islamic Shariah in the judgment of the Shariah Supervisors of the IFI in question.

Accordingly, when AAOIFI issues a new or revised standard or interpretation, the IFI must apply the new or revised standard or interpretation.

For Islamic Financial Institutions

Conceptual Framework for Financial

3.2.2 Information about IFI’s economic resources and related obligations (the obligations of the entity to transfer economic resources to satisfy the rights of its owners or the rights of others), and the effect of transactions, other events and circumstances on the IFI’s economic resources and related obligations. This information should be directed principally at assisting the user evaluate the adequacy of the IFI’s capital to absorb losses and business risks; assessing the risk inherent in its investments and; evaluating the IFI’s liquidity position and the liquidity requirements for meeting its obligations and its operational requirements.

3.2.3 Information to assist in the determination of Zakah (4).

3.2.4 Information about the IFI’s discharge of its fiduciary responsibilities.

3.2.5 Information about the IFI’s discharge of its social responsibilities.

(^4 ) The giving of Zakah is one of the pillars of Islam and is a personal obligation of the Muslim who is financially capable towards the poor and others who are entitled to Zakah.

For Islamic Financial Institutions

Conceptual Framework for Financial

4. Limitations

4.1 Limitations of information provided by financial accounting and reports

Financial reports are incapable of providing all relevant information that might be required by those who use them. This is so because of many reasons, including those related to the nature of the financial accounting processes, and those related to cost and benefit considerations.

Financial reporting is but one source of information needed by users of the reports. Users of financial reports also need to consider pertinent information from other sources, for example, information about general economic conditions or expectations, political events and political climate and industry and company outlooks. Users need to be aware of the characteristics and limitations of the information provided by financial reports.

The following are some limitations and the reasons for such limitations.

4.1.1 Financial accounting is concerned mainly with measuring the financial effect of transactions and other events on the IFI’s financial position, results of operations and cash flows. Accordingly, financial accounting is not usually able to produce information to assist in the evaluation of the IFI’s ability to achieve objectives that are not capable of financial measurement in an objective manner.

4.1.2 Financial accounting does not differentiate, through its processes, between the IFI’s performance and that of its management. Although, management’s ability is one of the important factors that affect the IFI’s performance, there are other factors beyond management control which affect the IFI’s performance such as natural disasters and external political and economic changes. Accordingly, it is not possible for financial accounting to provide information which can assist in evaluating management’s performance aside from the IFI’s performance.

4.1.3 The information currently provided by financial accounting is predominantly historical in nature which may or may not be indicative of the future. Yet, decisions made by those who need this information are usually concerned with the future impact of alternative courses of action.

4.1.4 To a significant extent, financial reporting information is based on estimates, judgments and models of the financial effects in an IFI of transactions and other events and circumstances that have happened or that exists rather than on exact depictions of those effects. The framework establishes the concepts that underlie those estimates, judgments and models and other aspects of financial reporting.

4.2 Limitations resulting from cost and benefit consideration

The information which financial accounting produces has costs associated with its preparation, presentation and usage. Accordingly, cost considerations affect the information produced by financial accounting. Therefore, the emphasis is on common information needs of multiple external users of general purpose financial reports.

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Conceptual Framework for Financial

Statements of economic resources of the IFI as a separate accounting unit, and the claims to those resources can provide users information regarding the IFI’s financial structure, condition and solvency as reflected by assets, liablilties, owners’ equity, equity of investment accountholders. Such information is normally found in statements of financial position or balance sheets (these terms have been used interchangeably).

Information regarding the financial structure as reflected in its financial position helps users to assess its liquidity position, the quality of its assets, and thereby helps predict how future cash flows will be distributed.

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Conceptual Framework for Financial

5.2.1.2 Changes in resources and claims resulting from financial performance (income statement)

An IFI’s past financial performance provides information about the revenues, expenses and the net income. This is normally included in an income statement, or statement of operations in the case of funds, and statements of policy holders’ revenues and expenses in the case of Takaful^5 companies all of which represent comprehensive statements of financial performance.

5.2.1.3 Changes in resources and claims to them (cash flows, changes in owners’ equity and the like)

Information about an IFI’s cash flows during a period helps users to understand and interpret the information regarding IFI’s future cashlows.

Information about changes in an IFI’s economic resources and claims to them that do not result from financial performance (income). For example, information on financing transactions between the IFI and its owners helps users of general purpose financial reports understand and interpret information regarding changes in the financial structure, condition and solvency of the IFI.

Such information is normally found in:

a) Statements of cash flows.

b) Statements of changes in owners’ equity.

c) Statements of sources and uses of funds in the Zakah and charity fund.

d) Statements of sources and uses of funds in the qard^6 fund.

e) Statements of changes in equity of off-balance sheet investment accountholders.

f) Statements of changes in policy holders’ surplus in the case of Takaful entities.

5.2.2 Statement of accounting policies

The principal accounting policies that have been applied in the preparation of the financial statements must be stated to assist users in understanding the relevance of the policies in relation to the transaction, event, conditions or circumstances of the IFI that prepares the financial statements.

Information about the IFI’s choice among alternative treatments allowed by the standards or the Conceptual Framework as well as any changes in accounting policies relevant to the financial reports must be included.

(^5) Islamic insurance is a system through which the participants donate part of all of their

contributions which are used to pay claims for damages suffered by some of the participants. The company’s role is restricted to managing the insurance operations and investing the insurance contributions.

(^6) Qard fund refers to a pool or fund that has been establihsed by the IFI to provide moneys

on the basis of no consideration in return. These amounts are normally repayable.

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Conceptual Framework for Financial

is not considered as owners’ equity since the holders of these accounts do not enjoy the powers and ownership rights, for example, voting rights held by owners.

Equity of investment accountholders are considered on-balance sheet if the IFI has the authority over decisions with regards to the use of and deployment of the funds it has received.

6.4 Owners’ equity

Owners’ equity is the residual interest in the assets of the IFI after deducting all its liabilities and amounts shown in the balance sheet as equity of investment accountholders.

6.5 Off-balance sheet items

Off-balance sheet items include funds or assets held, managed, administered, or otherwise dealt with in an arrangement that gives the IFI a fiduciary responsibility as well as commitments and contingent liabilities.

Equity of investment accountholders, in respect of which the IFI does not enjoy authority over decisions with regards to the use of and deployment of funds, is considered as an off-balance sheet item.

6.6 Income

Income represents revenues and gains.

Revenues are gross increases in assets or decreases in liabilities or a combination of both during the period covered by the income statement which result from investment, trading, rendering of services and other profit oriented activities of the IFI like investment management of off-balance sheet items.

To be considered revenues, the gross increases in assets or the gross decreases in liabilities should have the following characteristics:

a) The gross increases in assets or the gross decreases in liabilities should not be the result of investment by or distribution to owners, deposits or withdrawals by investment accountholders, deposits or withdrawals by current or other non- investment accountholders or the acquisition of assets.

b) The gross increases in assets or the gross decreases in liabilities should have all the characteristics of assets and liabilities, respectively.

c) The gross increases in assets or the gross decreases in liabilities should relate to the period covered by the income statement.

A gain is a net increase in net assets which results from holding assets that appreciate in value during the period covered by the income statement or from incidental reciprocal and non reciprocal transfers, except for non-reciprocal transfers with equity owners or holders of investment accounts.

Not all gains result from the same causes. Some gains result from exchanges between the IFI and other entities, for example, gains from the sale of fixed assets that were not acquired for sale in the normal course of business. Other gains result from nonreciprocal transfers (one sided transactions), for example, donations received by the IFI. Additionally, other gains may also result from holding assets while their value changes during the period covered by the income statement.

For Islamic Financial Institutions

Conceptual Framework for Financial

6.7 Expenses and losses

Expenses are gross decreases in assets or increases in liabilities or a combination of both during the period covered by the income statement which result from investment, management of investments, trading and other activities of the IFI, including the rendering of services.

To be considered expenses, the gross decreases in assets or the gross increases in liabilities should have the following characteristics:

a) The gross decreases in assets or the gross increases in liabilities should not be the result of distribution to or investment by owners, withdrawals or deposits by investment account holders, or withdrawals or deposits by current or other non- investment account holders.

b) The gross decreases in assets or the gross increases in liabilities should have the same characteristics of assets and liabilities.

c) The gross decreases in assets or the gross increases in liabilities should relate to the period covered by the income statement.

A loss is a net decrease in net assets which results from holding assets that depreciate in value during the period covered by the income statement, or from incidental reciprocal and non-reciprocal transfers, except for non-reciprocal transfers with equity owners or holders of investment accounts.

Not all losses result from the same causes. Some losses result from exchanges between the IFI and other entities, for example, losses from the sale of fixed assets that were not acquired for sale in the normal course of business. Other losses result from nonreciprocal transfers (one sided transactions), for example, penalties imposed on the IFI by regulators. In addition, the IFI may incur other losses which result from involuntary conversions of assets, loss of assets due to theft, destruction of assets due to flood. Other losses may also result from holding assets while their value changes during the period covered by the income statement.

6.8 Return on investment accounts

Return on investment accounts is the share of net result attributable to investment accountholders during the period covered by the financial statements.

The return on investment accounts is considered an allocation of the investment profits and losses accruing to the investment accountholders from their participation in investment activities.

6.9 Net income (net loss)

Net income (net loss) for the period covered by the income statement is the net increase or decrease in owners’ equity resulting from revenues, expenses, gains, losses, after allocating the return on investment accounts , for the period. It is the result of all ongoing profit oriented operations of the IFI and other events and circumstances affecting the value of assets held by the IFI during the period covered by the income statement.

The basic elements of the income statement may be combined in different ways to obtain intermediate measures of the IFI’s performance during a specific period of time. Examples of such intermediate measures are income (loss) from investments,

For Islamic Financial Institutions

Conceptual Framework for Financial

recognized or because it relates to a certain period covered by the income statement. The recognition of expenses that relate directly to the earning of revenues that have been realized and recognized is founded on the Islamic concept of assigning the responsibility for the cost to the recipient of the benefit.

Expenses that have no direct relationship to revenues but do have a direct relationship to the periods during which revenues are recognized fall in two categories:

a) Expenses representing costs that provide a benefit in the current period but are not expected to provide reasonably measurable benefits in the future. Examples include management compensation and bonuses and other administrative expenses which are difficult to allocate directly to specific services performed for others by the IFI or specific assets acquired by it. Accordingly, such expenses should be recognized when incurred.

b) Expenses that represent a cost incurred by the IFI which is expected to benefit multiple periods. Such cost should be allocated in a rational and systematic manner to the periods expected to receive the benefit. An example of such expenses is depreciation of fixed assets which represents an allocation of the cost of fixed assets over their useful lives to the periods that benefit from the use of such assets.

For Islamic Financial Institutions

Conceptual Framework for Financial

7.1.1.4 Gains and losses recognition

The recognition of gain or loss depend on:

a) The completion of a reciprocal or a nonreciprocal transfer resulting in the gain or loss. An examples of reciprocal transfer is the consummation of the sale of fixed assets as a basis for the recognition of gains or losses. An example of a nonreciprocal transfer is the occurrence of an event such as a natural disaster which results in a loss.

b) The availability of sufficient competent evidential matter indicating reasonably measurable appreciation or depreciation in the values of recorded assets or liabilities as a result of changes in supply and demand. Such gains and losses are estimated unrealized gains and losses resulting from revaluation of assets and liabilities, where applicable.

7.1.2 Measurement

Measurement of the financial effect of consummated transactions and the impact of other events during a given period.

Accounting measurement refers to the determination of the amount at which assets, liabilities and, in turn, equity of investment accountholders and owners’ equity are recognized in the IFI’s statement of financial position.

7.1.3 Presentation

Classifying the financial effect of consummated transactions and other events for the purpose of determining the IFI’s results of operations and other changes in its financial position including its cash flows.

7.1.4 Reporting

Preparing periodic reports about the IFI’s financial position as of a given date and the financial results of its operations and cash flows and changes in owners’ equity and off balance sheet investment accounts during a given period.

7.2 Recognition of profits and losses in relation to off balance items

The basic principles governing recognition of gains and losses within the Conceptual Framework and the financial accounting standards govern recognition of investment profits and losses associated with off balance sheet investment accounts.

7.3 Concepts of accounting measurement

7.3.1 Measurement attributes

Measurement attributes refer to the attributes of assets and liabilities that should be measured for financial accounting purposes. For example, asset attributes that may be selected for measurement in financial accounting may include the acquisition cost of the asset, the net realizable or cash equivalent value of the asset as of a given date, the asset’s replacement cost as of a given date or any other attribute whose measurement would result in relevant information.