Islamic Accounting (#352)
/The Nature of Islamic Accounting
Islamic countries all use international financial reporting standards. But, they do it with a few differences. The key underlying issue is the extent to which an Islamic business is supposed to be operated in an ethical manner. Islamic law emphasizes the welfare of the community over that of the individual, so it places an emphasis on investments that help the community. You’ll see what I’m talking about in a minute.
Accounting for Zakat
The first accounting issue where this arises is in the payment of zakat. This is a type of alms that’s required for any Muslim who has wealth that exceeds a certain minimum threshold. Zakat is applied at a rate of 2.5% of a person’s wealth above that threshold, and it’s calculated and paid annually. Now, having just said that the zakat rate is 2.5%, I’m going to walk that back a bit. There are higher rates of zakat, depending on the nature of your wealth, and in one case it can go as high as 20%. So, this is not a minor item.
Zakat is payable by all qualifying businesses and individuals. So, from the perspective of the accountant, you need to compute exactly what constitutes the basis for the calculation, and then pay it. The payment is usually made to a national agency that’s in charge of collecting and disbursing the funds. If you don’t pay it, then there’s a fine, and you might even end up in jail.
The basis for Zakat is governed by all kinds of rules. For example, the “wealth” of a business is considered to be its growing capital, which is defined as its inventories and any capital assets that are not being leased. And, any investments classified as trading securities are subject to Zakat, while available-for-sale securities are not. And, prepaid assets are not subject to Zakat, since the underlying asset is not fully controlled by the business. There are many more rules, but your main takeaway is that you actually need an accountant to figure it out. Sounds like a light version of the U.S. tax code.
The next Zakat issue is when to pay it. It’s supposed to be paid at the end of one lunar year, which has a duration of 354 days. However, a business is more likely to follow the normal calendar year, which has 11 more days. And to account for these extra 11 days, a business pays a higher Zakat rate of 2.5775 percent. Lots of complexity.
Zakat payments made by a business are classified as an expense, while any unpaid Zakat balance is classified as a liability. However, if the firm’s shareholders require the business to pay Zakat on their behalf, then these payments are treated as a deduction from their share of the firm’s distributable profits. And if there are not enough distributable profits to cover the Zakat payments, then the firm records a receivable due from the shareholders for the difference. So you can see that Zakat appears in lots of unexpected places.
The payment of Zakat also triggers a completely unique financial statement that you don’t see outside of Islamic accounting. This is the Statement of Sources and Uses of Funds in the Zakat and Charity Funds. This itemizes the sources of funds, which are the Zakat payable by the company and any other donations that were paid out. It also itemizes the uses of the Zakat and charity funds, which are aggregated into categories that are mandated under Islamic law. Example line items are Zakat for the poor and needy, Zakat for the wayfarer, and Zakat for the heavily indebted and freedom of slaves. The report also notes any fund balance remaining at the end of the reporting period.
As I mentioned earlier, this statement is based on the belief that businesses are supposed to help the community. I can’t help thinking that something like this would be awesome for Western corporations – maybe just a statement of charitable donations.
Accounting for Sukuk
The next Islamic accounting issue arises from the prohibition on charging interest. The reason for this is the idea that a person’s wealth should not be used to generate interest, which requires no work, and which would tend to concentrate wealth. When you think about it, it’s not actually a bad thought.
This means that a business cannot issue bonds that pay interest to investors. What they do instead is issue a sukuk, which is an Islamic financial certificate. The issuer uses the proceeds to purchase an asset, in which the investors have an ownership interest. In addition, the issuer has an obligation to buy back the certificate at a future date at its par value. This type of bond structure means that investors are sharing in the risks and rewards of the underlying asset, rather than being paid interest.
There are a couple of variations on this. For example, the issuer could use the proceeds from a sukuk issuance to acquire assets and transfer them into a special purpose vehicle, in which the investors have an ownership interest. This entity then leases the assets back to the issuer. As the issuer makes scheduled lease payments to the special purpose vehicle, these payments are distributed to the investors.
Here's another variation. A manufacturer of goods issues sukuk certificates, which represent ownership interests in goods that have not yet been produced. The money is used to pay for their production. Once the goods have been sold, the investors receive a portion of the proceeds.
These issues might appear to be just finance-related, but consider the amount of accounting involved. You have to track ownership interests in each of these deals, and then issue payouts based on the proceeds. And if there are a lot of separate deals, each one using a different profit-sharing arrangement, then the accounting could become really complicated.
The Value-Added Statement
And finally, we have another financial report that’s unique to Islamic accounting. This one is the value-added statement, which focuses on how the funds generated by a business are distributed to its various stakeholders, rather than on how much profit it generates. It essentially shows where payments come from – which is revenues – and where it all goes, which is wage payments to employees, taxes paid to the government, and payments made to charities – plus whatever profit is left over that the business elects to keep in-house. In other words, the report shows how much a business is paying back into the community. Something worth thinking about.