Accounting Practices and Islamic Banking

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Review of Islamic Economics, Vo1.3, No.2, 1994), pp 29-30

COMMENTS ON PAPERCONTEMPORARY ACCOUNTING PRACTICES

AND ISLAMIC BANKING BY M.A. KH ANPUBLISHED IN VOL.3, NO.1, 1994 pp. 51-61

ABDUL JABAR KHAN

National Management Consultancy CentreJeddah Saudi Arabia

The contents of this paper can be divided into two parts. T he first part deals w ith thehistory of accounting standards. In the latter part, the author discusses possiblesolutions for equity financing by individuals, banks o r other institutional financiers, toovercom e the limitation of generally accepted principle s of accounting .

Th e autho r has very aptly traced the origin of the double entry book-keeping ,subsequent development of auditing as a profession, various attempts to makeuniform rules for the profession and difficulties faced to achieve that goal. He hascorrectly pinpointed the difficulties faced by bank s and othe r financia l institutions indetermining with reasonable accuracy the amount of profit or loss to be shared bythem in the business financed on profit participation basis. He is true in his statementthat the disclosu re at the end does not, how ever, serve the purpose of equ ity financingbut an agreem ent at the beginning can be of significant importance . In the context ofsharing of profit for the term financing the au thor has listed different item s of revenuesand exp enses and how to treat them w hile calculating the profit to be shared with theprovider of short-term financing. However, the suggestions offered by him are notgoing to solve the problem. There would always be difference of opinion aboutcategorizing an item of expense or income at the time of making out the finalaccounts. Furthermore at times it may not be easy to determine as to whether aparticular item directly relates to the period and more so, was responsible ingenerating the revenu e for the period. Similarly whether o r not a particular item ofrevenue being taken for the period, was the result of business activities for that period.Another problem is that of false reporting or conc ealing the transactions through sh eerdishon esty. Although the au thor has mentioned this in his pape r, he has, however, not

discussed this aspect treating it as outside the scope of his paper.As the author has stated, even the International accounting standards d o not provide

solution for the apprehensions of the parties interested to enter into aMusharakah


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or Mudcirahah contract. Each standard provides mo re than one acce ptable treatmentin a particular area. In fact these standards are a compromise formula betweendifferent vested interests and pressure groups.

The refore, to protect the in terests of the banks and financia l institutions, a differentmethodo logy has to be adopted for determiningMushcirakahlMudarahah profit/loss.An entrepreneur may need outside funds in all or any of the following threecategories:

(a) Contribution to the permanent equity.(b) Long or medium-term finance in the form of redeemable equity.(c) Short-term finance for working capital.As for participation in the permanent equity, accounts as certified by the outside

Chartered Ac countants should be accepted. Th e entrepreneur is also getting dividend

if any on the basis of such certification.In the case of short-term working capital, a much simplified procedure may be

adopted. Instead of having o verallMushcirakahlMudcirahah the bank should havelimited purpose MushcirakahlMudcZrabah in the sense that theMushcZrakahlMudcira-huh arrangemen ts between the client and the bank w ould be only fo r the purpose ofacquisition of the goo ds and their sale with or w ithout further processing.

The profit or loss amount of a business concern is the resultant of three figuresnamely:

(a) cost of the goods/raw materials

(b) overhead expenses including manufacturing expenses, if any processing ofgoods is involved and(c) sale proceeds of the goods traded in or manu factured by such concern.The main problem of accou nting or otherwise is related to the charging of overhead

expenses to the profit and loss account. Hence da tam anip ulation g enerally takes placeeither through sheer dishonesty or under the umbrella of generally acceptedaccounting principles o r under both. To safeguard the bank against manipulation,over-head expenses should be fixed and stipulated in theMushcirakahlMud6rahahagreemen t either in lump-sum or amoun t per unit of the goods. As for the other twoitems, namely cost of goo ds and their sa le proceeds, chances of false reporting and/ormanipulating are there but they are controllable.

Medium or long term financing under these categories of redeemable equlty isgenerally needed for acquiring assets. Such acquisition of assets can be financedeither through leasing or on Murcihahah basis. But when the funds are to becommitted to an industry or organization in a temporary phase of difficulty formeeting its working cap ital requirements, it has to be on the basis of limited purposeMushcirakah as explained earlier. It is hoped that in financing a client on the linessuggested above, the banks and financial institutions would be saved from m uch ofthe difficulties and pitfalls enumerated in the paper under review.


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Review of Islamic Econo mics, Vo1.3, No.2, ( 19 94 ),pp 31-38

TIME VALUE OF MONEY AND DISCOUNTING INISLAMIC PERSPECTIVE: RE VISITED

MONZER K A H F

Islamic Research and Training InstituteIslamic Development Bank

Jeddah. Saudi Arabia

In an article titled Time V alue of Money and Discounting in Islamic Persspective:published in theReview of Islamic Econom ics,volume 1, No. 2, 1991, pp. 35-45 M.Fahim Khan argued that the prohibition of interest in Islam denies any recognition oftime value for money despite the fact that rent, wages,Bay Mu ajjal (deferredpayment) and Salam (imm ediate paym ent against deferred delive ry) all include a

fixed and pre-determined element as compensation fo r time . He argued that thedifference in the present and future values of the same commodity cannot beconsidered to have been allowed just because of the pure time element involved , butrather for recognition of changing forces of supp ly and demand. H e refused the ideathat in Bay Mu ajjal the time factor is always reflected in a higher price againstdeferment of paym ent. He further argued that the decisive element in the prohibitionof financing le is e, as well as of interest, is that Islam doe s not permit a fixed andpre-determined time value of money , adm iting that time preference and time value ofmoney ar e revealed by confronting a consumer with a choice between present andfuture consumption and finding out his point of indifference . He consideredrisk-bearing as the permisible basis for profit earn ing in Islam, and lastly suggestedthat the rate of return on deposits of Islamic banks can be considered to be the mostsound rate of discount for project appraisal necessary for investment decision in anIsla n~i c conomy.

There are several points in this article that call for discussion, especially that manycontemporary writings in Islamic eco nom ics and finance take it for granted that timevalue of money is dei-ived purely from consumption preferences and find them selvesconfused between the prohibition of interest on one hand and the recognition of valuedifferences related to the time element in real market transactions on the other.


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I Is the time value of money a purely consum ption phenomenon?

There is no d oubt that time is important for human beings in all their relationshipsas time is in fact life itself. Hum an beings carry ou t all their activities through time .Hay Bin Yaqqan the original Arabic version of Robinson Cruzoe found himself inan island alone and noticed from his own experience that eating an apple or cooking afish, or accidentally discovering fire, takes time. Consum ption requires time for us toenjoy and derive utility. Hay Bin Yaqzan also recognized from experience that hecould build a cottage to protect himself from sun -light and cold w ind, using w oods heessentially collected for fire. He also discovered that instead of eating the s eeds of hisfruits he could throw them on the ground and have other trees growing that will givehim more fruits later. Robinson Cruzoe recognized that by abstaining from

consum ption, applying further purposive effort and thinking he c ould transform hissavings into productive goods such as a cottage, new trees or pieces of wood andstones to be used a s tools in hunting -and in increasing his physical capabilities.

This investment process, i.e. the process of transforming consump tion goods intoproducer goods by exercising new, planned and purposive effort), is done throughtime and it usually gives positive results, i.e. more income in the future. Hay BinYaqzan also realized that investment is alwa ys surrounded by risk and uncertainties.He could not acquire perfect foresight about the future since there are manyuncontrollable elements and factors that influence the process of his investment.In a

social context additional factors, relating to dem and and supply forces, are add ed tothis wholesome uncontrollable factors that affect the result of investment.Consequently, there are three points that need clarification with regard to time

preference:1 The act of eating an apple today yields exactly the sam e utility to the co nsum er

as the act of eating an apple tomorrowother things being equ al i.e. apple of thesame size and quality, no change in taste, no saturation, no diminishing orincreasing utilities etc. Hence, a consume r need not necessarily prefer anapple today to an apple tomorrow.

2) An investor is implied in each consumer/income earner. A consumer knowsthat giving up today part of hisher income for investment use, this usuallygives higher income tomorrow. Consequently, while abstention fromconsum ption does not entail any increase in future income, the use of savingsin a productive manner usually brings a bout higher income that m akes a higherlevel of con sumption accessible. At this stage it is necessary to ma ke explicitan assumption which M. Fahim Khan did not make in his paper, that humanbeings prefer more consumption over less consumption.

The implication of the above is thatI will not give up part of my incometoday as an investor) without having an expectation of getting higher incom e

tomorrow. This expected increment is the compensation to the investor formaking saving today and it is his main source of time preference and time valueof money.


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whatsoever such as an increase in demand. How ever, human experience indicates thatgrowth takes place because of pu rposive and planned effort effected on the propertyeither by its owner o r by another party. The claim of a growth-producing human efforton part of the actual increment is justified by the fact that human effor t contributed toproducing the increment.2

On the other hand, ow ners of physical assets are exposed to risk of loss, destruction,lack of demand, competition, etc. Ownership itself is characterized by risk anduncertainty. Earning a profit cannot be justified by risk bearing which is acharacteristic of ownership as risk bearing is not the reason for earning profit, i.e.deserving a share in the increment.Risk baring is not a factor of production whilecapital goods are

This distinction is very im portant when we talk about the Islamic financal system .

In Islam, risk bearing alone is not considered as a reason for earning profit. Theexample Shari'ah provides is Kafiilah (guarantee).Kafiilah embodies risk bearing byadding one's own guarantee to somebody else's responsibility without contributing toa production process or being an ow ner of producer goods. InKafcilah ownership isseparated from risk bearing. Shari'ah prevents earning any return or profit3 forproviding Kafiilah, although it recognizes the risk-bearing nature ofKafiilah.

111 Rent wage and profit

In any society there may be different legal formulae for the combination ofproductive factors and these different formulae influence the distribution of risk.Fairness in transaction also requires that exchange contracts be compensatories.There should be a balance between responsibility and gain. This is required in theIslamic system as well as in human rationale.

One legal formula of factors of production combination is one in which theentrepreneur acquires investible funds on the basis of sharing the outcome ofinvestment. Under this formula, the financier actually and legally owns theenterprise's assets. Profit will be distributed between entrepreneur and financier inaccordance with agreed sharing ratio while losses will be born by the owner of theassets as explained earlier.

Another formula of combining the factors of production may be in dividing theenterprise into two separate and legally independent units, each of them makes anindependent enterprise. In the first enterprise, owner of investible funds takesentrepreneurial decisions of buying, owning and m aintaining fixed assets and sellingtheir usufruct. In the second enterp rise, theentrepreneurllessee rents fixed assets, i.e.,buys their usufruct, the same way as one may buy the man-hours of labourers andproceed in one's investment enterprise to produce, say, cloth. In the first firm theoutput is the benefits that may be extracted from the fixed assets. Th e sam e is an input

in the second firm. The rent acquired by the first firm is its gross income w hich is, likeany producer good subject to deduction of operation costs in order to reach its netincome. T he relative stability of the gross incom e of this firm throughou t the period of


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the lease contract is caused by the nature of its output (usufruct) which can only beme asured by units of asset per unit of time. Th is fact does no t mean that there is a timevalue of mon ey involved in rent if rent exceeds the asset's depreciation. T o illustratethis point, let us take the example of transportation whose output is measured bypassengers per mile. W e cannot derive a distance value of money simply because theoutput of transportation industry occurs only through distance and when transporta-tion fare exceeds its cost and depreciation4. By the sam e token, there cannot be app levalue of money simply because apple sale price is more than apple costConsequen tly, there is no time value of m oney in the lease business even when therent exceeds fixed assets' depreciation, as mentioned byM. Fahim Khan (page 35 .This is because the increm ent obtained is a profit of the lease business, as the rent inleasing, being a price, is subject to the sam e factors that determine any othe r market

price. The time element involved in the lease business is part of the nature of theprodu ct of this business itself. Selling any outpu t for a price that exceeds its paid costis after all the purpose of business itself and that applies to the production of apple,usufruct of fixed-assets or any other product.

Con sequently, in a lease we are actually sp litting the investment decision into twoindependent firms: the lessor's and the lessee's. Each on e of the them is subjec t to themarket fo rces which in the final analysis determ ine the net return on investmen t in eachfirm. Lease, as defined by theFuqaha , is simply sa le of utility of a fixed asset (or of alabou rer). Th e rules that apply on sale in general a lso apply on lease. The most essential

principle relevant in this regard is that human beings are authorized within the legalframework of Shari ah over their property to dispose of it the way they like.In a third formula of combining factors of production, the investor may obtain

investible fund s on the basis of interpersonal relationship , i.e. a loan obtained aga insta personal pledge (w hich may be supported by a collateral) to be repayed later on.Funds, in this case, becom e a property of the investor who transforms them into fixedand w orking capital for the production and collects the w hole outco me as his profits o rbears the losses therein. The owner of funds becom es an ow ner of a pledge which is anabstract right on the debtor. Abstrac t right as a form of interperson al relationship is, byits very nature, not susceptible to increase or decrease. Consequently, he/she is nomore an owner of assets involved in production, and therefore he/she is not entitled toany part of the output of investment.

V Time Preference Time Value of Money and Bay Mu ajal

Earlier in this paper, we argued that the time value of money is an investmentphenomenon 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. W e also argued that the valuation of time p reference canonly be affectedex-postbecause its nature does not allow an opportunity of know ing itex-ante.


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How then would people take an investment decision without anticipating certainvalue for time preference? The fact is that human beings do undertake investment.They have been doing it since Hay Bin Yaqzan. Th is indicates that they make certaincalculation within their minds - of the compensation they like for sacrificing theirtime preference. Hence, any investment decision has an implicit time value of money.In an interest-free economy, the anticipated time value of money is obviouslyestimated on the basis of accumulated exper ience as may be projected into the future.Since interest does not exist, there will be no reference, in such an economy, to interestrate in the process of formulating exp ected time value of money in the minds of theowners of investible funds.

All the requirements of Shari ah in this regard focus on the point that thedetermination of any return o n investible funds has to be related to, and dependent on

the actual net profit.Shari ah does not prevent any estimation, mental calculation orexpectation of the return by either party. But it conside rs all these like an illusion thatmust not be exchanged for a real increment accruing to either party until theinvestment process actually produces an increment, then the shares belonging to theowner and user of funds become real facts.

T o apply this idea onBay Mu ajjal and Salam, one should not incorporate otherfactors such as changing supply and dem and. Because when w e talk about the timevalue of money, we should keep in mind that we are implicitly isolating otherfactors.

Muslim scholars throughout history as well as contemporaryFuqaha do notdispu te the effect of time value of money o n exchange transactions. This effect shouldnot be made ambiguous by incorporating changes in supply and demand. Involvementin trade as a business requires a process of purchase (production) and sale. Trade hasthe sam e characteristic, that other production processes have, of ownership of goodswith the intention of selling at a higher price than the ir cost. InBay Mu ajjal and inSalam, the owner of investible funds incorporates hisher expected time value ofmoney in the investment process he/she pursues. The fact that once a contract isconcluded in Bay Mu ajjal, we reach the ex-post evaluation of time preference doesnot change the nature of the process. InBay Mu ajjal one begins by the mentaloperatio n of formulating an anticipated time value of money , then transforming fundsinto goods, owning them and taking responsibility of one s ownership, thenconcluding a deferred payment sale which transforms hisher expectation into anactual and final reality although this actual time value of money needs not be the sam eas the anticipated one. This process is essentially the same as inMushdrakah,Muddrabah and leasing. In Salam, the same process also takes place with someinterchange between the internal steps to become as follows: 1) formulating ananticipated time value of money,(2) concluding a contract of purchase of goods and3) receipt of goods, owning the m an d taking responsibility of one s ownership, and

(4) selling these goods and realizing an ac tual evaluation of the time value of moneywhich may, or may not, coincide with the anticipated one.

Two Shari ah rulings give further insight to the above mentioned analysis:


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1) Th e prohibition of sale at either of two different prices, spot and deferred. Thisis because the evaluation of time value of m oney is detached from the actualinvestment process.

2 In case of annu lmen t of aSalam contract, the provider of fun ds takes back onlythe amount paid. This is because a planned investment process did not takeplace and therefore no actual time value of money is revealed.

The con clusion is that one does not need to bring any changing d eman d and sup plyforces for explaining the legitimacy of Bay Mu ajjal and Salam as they arerationalized a long the sa me lines ofMushdrakah, Muddrabah and leasing, i.e., thebasis of ownership and distinction between anticipated and realized time value ofmoney.

V A Critical Appaisal

Before con cluding this rejoinder, there are a few errors inM. Fahim Khan 's paperthat needs to be corrected:

1) The equation of the net r e a m of Capital r (R C, on page 37 hasM

two mistakes: first, division of return by invested funds implies that we are

talking about a rate of return not a return; second, in the preceding paragraphthe writer mentioned that the lessor is responsible for maintenance anddepreciation. Yet the equation d oes not incorporate maintenance unless the Ris redefined a s rent of the asset per year after the deduc tion of main tenance cost,which the writer did not do.

2) W hile criticizing the financial lease from an Islamic point of view, the writersaid that Islam does not permit a fixed pre-determined time value of money(page 38). In fact, this is a necessary but not a sufficien t cond ition. Even if thiscond ition is satisfied through a device of variable interest on a loan, the retu mremains prohibited. A statement of sufficient cond ition is that while giv ing ashare of the net profit to the entrepreneur because of hi s h e r efforts, the funds'provider's net outcome is based on ownership, not on interpersonalrelationship (lending).

3) In exp laining what he called theFiqhi principle of no compensation for timealone (page 38): first, the writer failed to give aFiqhi source of this principleand second, he gave a w rong example. The exam ple he gave is that ofWadi ahwhich is permissible inShari ah (OIC Fiqh Academy Ru ling No. 661217 in its7th Annual Plenary Se ssion held in Jeddah, Saudi Arabia, 9-14 Ma y, 1992). Abetter wording of theFiqhi principle would be no compensation for time when

completely detached from an investment process and a better exam ple wouldbe the prohibition of any compensation fo r the re-scheduling of debt . Thisprinciple is repeatedly mentioned byFuqaha whenever they talk about the


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prohibition of Riha as eating people s fu nds in vanity and there are man ysources of it.

4 On page 40, the writer assumed that the longer the time frame of an investment,the higher would be the anticipated time value of money. For this assumption,he did not provide an empirical or theoretical rationale. In our opinion, this isnot a theoretical matter and it requires only empirical testing. The example oflong-term investments of IDB (using Islamic modes of financing) and theWorld Bank (using interest-based modes of financing), both indicate theopposite. ow ever this whole assumption is not needed for the argument ofthe paper.

5 In proposing the rate of return on deposits of Islamic banks as a goodapproximation of the rate of discount in the me ntal calculation of returns oninvestment, the writer did not make a distinction between owner of fundsdecision and investor s project appraisal decision. For the investor w hodiscounts future returns in orde; to comp are them with the cost of funds, therate of return realized in Muriihahah of Islamic banks would be a betterapproximation, for Muriihahah is one of the most risk-averting modes ofIslamic financing.

Whereas for owner of investible funds the rate of return on deposits of Islamicbanks represents a good approximation of the opportunity cost, he/she sacrifices for

committing hislher funds to an investment. This rate makes, therefore, a goodapproximation for the anticipated time value of money.

VI Conclusion:

This rejoinder aimed at clarifying the concept of time value of money in Islam andI fully agree withM. Fahim K han that Islam recognizes the presence of time value ofmoney and emph asize that as the time value of money is an investment phenom enon,

its valuation can only be realistic if it takes place at the end of investment when itsoutcome becomes known. Any evaluation before that point is only illusionary.However, illusion can be used for mental operation but must not be exchanged foractual goods and services.

1. See , for instance, Al-Mabsour, volume 11, page 159, A1 Badcii e, volume 6 , page 62 , and A1 Mughni,volume 5, pp. 114-129.

2. AI-Binriyah Ala Hidriyah, vo lume6, p. 1 17,Al-Mah.~our, olume3, p. 17-59 and Al-Mughni, volume 5,p. 558.

3 OIC Fiqh Academy resolution No. 12, second annual plenary session, Jeddah, 10-16 Rab i Thani,1406122-28 Decem ber, 1985.

4. This example is suggested to me by a colleague at the Islamic Research and Training Institute, Mr.Ahmad Islamouli.

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Accounting Practices and Islamic Banking