Islamic Accounting Standards

ISLAMIC ACCOUNTING STANDARDS

Principles of Islamic Finance

The main principles of Islamic finance are that:

• Wealth must be generated from legitimate trade and asset-based investment (the use of money for the purpose of making money is expressly forbidden)
• Investment should have a social and an ethical benefit to wider society beyond pure return.
• Risk should be shared
• Harmful activities should be avoided

Islamic Banking Mechanism

Islamic banks are allowed to obtain their earnings through profit-sharing investments or fee-based returns. If a loan is given for business purposes the lender should take part in the risk. This usually involves the lender buying the asset and then allowing a customer to use the asset for a fee.

Prohibited Activities

The following activities are prohibited

• Charging and receiving interest (Riba)

• Charging interest contradicts the principle that risk must be shared and also contrary to the ideas of partnership and justice.
• Using money for the purpose of making money is expressly forbidden.
• Investment in companies that have too much borrowing is also prohibited.

• Investments in business involved in alcohol, gambling, or anything else that shariah considers unlawful and undesirable (haram).
• Investments in transactions that involve speculation or extreme risk.
• Entering into a contract where there is uncertainty about the subject matter and terms of contracts.

IFAS 1: MURABAHA

Mudaraba

Mudaraba is a partnership in profit whereby one party provides capital (rab al maal) and the other party provides labour (mudarib).

In the context of lending, the bank provides capital and the customer provides expertise to invest in a project. Profits generated are distributed according in a predetermined ratio but cannot be guaranteed. The bank does not participate in the management of the business. This is like the bank providing equity finance.

The project might make a loss. In this case the bank losses out. The customer cannot made to compensate the bank for this loss as that would be is contrary to the mutual sharing risk.

Musharaka

Relationship establish under a contract by the mutual consent of the parties for sharing of profits and losses arising from a joint venture.

This is a joint venture between two parties who both provides capital towards the financing of new or established projects. Both parties share the profit on a pre-agreed ratio, allowing managerial skills to be remunerated, with losses being shared on the basis of equity participation.

Murabaha

Murabaha is a particular kind of sale where the bank buys the asset and then sells it on to the customer on a deferred basis at a price that includes an agreed mark-up for profit. Payment can be made by installments but the mark-up is fixed in advance and cannot be increased even if there is a delay in payment.