Management accounting systems in

Islamic and conventional

Financial institutions in Malaysia

1. Introduction

Management accounting systems (MAS) refers to the systematic use of managementaccounting techniques to achieve organizational goals. The International Federation ofAccountants (IFAC, 1998) defines management accounting as the process ofidentification, measurement, accumulation, analysis, preparation, interpretation, andcommunication of information (financial and operational) used for the planning, controland effective use of resources by an institutions management. Thus, managementaccounting becomes an integral part of the management process in an organizationproviding information essential for:

Controlling the current activities of an organization; Planning its future strategies, tactics and operations; Optimizing the use of its resources; Measuring and evaluating performance; Reducing subjectivity in the decision-making process; and Improving internal and external communication (IFAC, 1998).

The Malaysian financial system is based on the dual banking system in which theconventional financial system operates alongside the Islamic financial system. Thedevelopment of the Islamic Financial Institutions (IFIs) has contributed to thestrengthening of Malaysia as an International Islamic Financial Centre (MIFC). MAS forIFIs has received limited attention as most prior literature on accounting for IFIs focusesmainly on financial accounting related to measurement and reporting issues, the purposeof this paper is to explore whether there is any difference in the MAS of conventional andIFIs in Malaysia. The current study is intended to fill the void in the literature onmanagement accounting in IFIs.

The remainder of the paper is structured as follows. The next section reviews the?relevant literature and develops the hypotheses, followed by the research method in?Section 3. Results and discussion are presented in Section 4 and finally, Section 5presents the conclusions

2. Literature review

A well-designed MAS will assist managers to be more effective in decision-making.Traditionally, management accounting information has been delineated in financial terms,but recently it has been expanded to include non-financial (operational or physical)information, including quality and process times. Besides fulfilling the traditionalfunction of providing quantitative and financial information, MAS have expanded toinclude information relevant for innovation, marketing and organizational design.

The challenge faced by financial institutions is in sustaining their competitive edge bybeing cost efficient without compromising the quality of their services. The key tosurvival is to have an internal management reporting system that can signal problem areasand allow management to react swiftly and assuredly. Following the deregulation of thefinancial sector and the rapid advances in technology, information on pricing, productmix and market share strategies have become more important to the financial servicessector. MAS in a financial institution can play an important role by providing informationon the effectiveness of a sales promotion programmer, revenue by business units, productlines and customer category. The management of financial institutions depends onconcise and relevant information to help them carry out their daily duties. Well-managedfirms should have good information structures and MAS can be seen as a tool formanaging resources, measuring performance, warning of risks, aiding decisions, andproviding data for planning, specifically argues that a good MAS does the following:

Tells the cost and profitability of doing business by organization, product, andmajor customers;

Avoids surprises; Allows all managers to explain their performance as it is reported; Allows everyone to participate in planning via plan-to-actual reporting used as a

management tool; Provides timely, accurate, relevant, and understandable reporting; Ensures that only one set of numbers is circulating within the organization; and Reduces or eliminates complaints about information non-availability.

Some financial institutions have turned to activity-based costing (ABC) as a way tomeasure accurately the consumption of shared resources by a particular customer or

product. In fact, the application of ABC in the financial services sector today identifiesnew and unique ways to leverage cost and profitability information, including:

Activity-based pricing, particularly for business-to-business services; Linking ABC information to performance management scorecards and processes; Providing information on a process view of costs, both to support cost

improvement needs and to enable ongoing accountability for management by thebusiness process; and

Information on the profitability of discrete customer relationships.

2.1 Relevance of MAS to IFIs

The management of IFIs needs management accounting information as an organizationalcontrol mechanism. Since all IFIs activities should comply with the norms of Shariah andIslamic ethics, they need more management information for decision-making, planningand control activities to meet both business and religious objectives. The need of MAScan also be argued from the sources of funds perspective. Unlike conventional bankingsystems where customers are entitled a guaranteed return, the return on investment forIslamic bank investment holders is uncertain since they share the profit or loss incurredby the bank.

The implications of the Shariah compliance framework on the use of MAS information

need to be explored. The research on this issue is still scant; with the only study availableto date being one by Islam studied the information adequacy of MAS in the banks inBangladesh. They argue that the adoption of a profit-sharing system of mudarabah andmusharakah by Islamic banks in their financing activities requires a different set of MASinformation in terms of scope and integration.

The results that managers of Islamic banks, in contrast to those in non-Islamic banks,believe that they have better designed MAS in terms of scope and integration. Theirfindings support the argument that profit-sharing systems in the financing activities ofmudarabah and musharakah in Islamic banks require broad scoped and integrated MASinformation.

2.2 Development of hypotheses

The scope of an information system consists of three sub-dimensions, which are focus,quantification and time horizon. The main difference between IFIs and conventionalfinancial institutions is that their objectives and operations, as well as principles andpractices, must conform to the principles of Islamic Shariah (Jurisprudence) and Islamicethics as enunciated by Shariah. The principles are:

(1) Prohibition of riba(interest);(2) Application of al-bay(trade and commerce);(3) Avoidance of gharar (ambiguities) in contractual agreements; prohibition of

maisir (gambling); and(4) Prohibition of conducting business involving prohibited commodities.

Transactions in IFIs involve different Islamic contractual relationships in which various?underlying Shariah principles have been used. In the Islamic banking sector for?example,the relationship between investment account holders and the banks and the?relationshipbetween the banks and their customers (borrowers) are different from?conventionalbanking systems. In conventional banking system, all deposits are treated?as liabilities.In Islamic banks, savings are categorized into A l-Wadiah (safe custody)?and A l-Mudarabah (profit sharing) saving accounts. Although equity-based financing(mudarabah and musharakah) is not widely used at the moment, some arguments relatedto MAS information may still be considered. Equity-based financing is risky since thereis no fixed assured return to the banks.

H1. There is a significant difference regarding the scope of MAS between IFIs andconventional financial institutions.

Timeliness of information refers to the provision of information on request and thefrequency of reporting collected information. Timeliness influences the managersabilityin responding quickly to events. MAS, together with timely information, is able to reportupon the most recent events and provide rapid feedback on decisions. In Islamic banks,the profit rates for their financing are fixed. However, the return on the deposits fluctuatesdepending on market conditions. Therefore, to prevent mismatch between assets andliabilities, timely information is required by IFIs in calculating their profit distribution.

H2. There is a significant difference in the use of timely MAS between IFIs andconventional financial institutions.

Coordination of the various segments within a sub-unit is an important aspect oforganizational control. Integrated MAS characteristics that may assist coordinationinclude information about the activities of other departments within the firm andinformation on the impact that decisions in one department have on the performance ofanother. In the Islamic banking system, different products require different contracts,which lead to different kinds of relationship. For example, unlike financing inconventional banking where the bank is the lender and the customer is the borrower, inmurabahah (deferred sale) financing, the customer is the buyer and the bank is the agentwho buys and sells the product to the buyer.

H3. There is a significant difference in the use of integrated MAS between IFIs andconventional financial institutions.

Information aggregation deals with a variety of ways to collect and summarize the datawithin periods of time or area of interest, such as responsibility centers or functional areas.Aggregate information represents summarized information that covers periods of time ordiverse management area while disaggregated information represents excessively detailedinformation that may include only one period or one functional area.

H4. There is a significant difference in the use of aggregated MAS between IFIs andconventional financial institutions.

3. Results and discussionSince IFIs have to meet both business and religious objectives, they are expected to havea broader scope, more timely, highly integrated and highly aggregated MAS informationthan conventional FIs.

3.1 Scope

The empirical evidence from this study suggests that in order to be Shariah compliant,IFIs use a broader scope of MAS information than conventional FIs. Besides looking atbusiness operations, other aspects of the organization also have to be Shariah compliant.

The findings from the survey is that managers of Islamic banks need a relatively broaderscope of information about their business operations and the prospects of their clients.IFIs require more non-financial information especially those related to the issue of Shariah compliance. As managers of customer funds, IFIs have to make sure that the funds aremanaged in accordance with the principles of Shariah . Hence, more non-financialinformation related to Shariah compliance is required by them.

In addition, in conventional commercial banking systems, there is a lender and borrowerrelationship where each transaction is subjected to interest payments. However, in theIslamic banking system, a different relationship exists depending on the nature of theproduct. Various underlying Shariah principles are used. This again requires a huge

amount of non-financial information related to Shariah issues. IFIs have to go throughmore processes than conventional in order to get approval for product introduction. Inequity-based financing, Islamic banks need to be selective in choosing their clients, as thereturns are not guaranteed.

Furthermore, in musharakah financing, once a partnership has been established with theclient, Islamic banks have to participate directly in the business. Aside from the constantmonitoring conducted to ensure that business activities are in accordance with Shariah,IFIs must ensure that the business activities provide the expected return to both parties.As for the Islamic insurance business, management has to monitor funds collected fromcustomers and certify that they are invested in Shariah compliant businesses. Thus, moreexternal and future information is required to ensure that operation and day-to-dayactivities of the IFIs are in accordance with Shariah.

3.2 Timeliness

The empirical findings from the survey reveal that IFIs use more timely information thantheir conventional counterparts. A possible explanation for this is quite possibly that IFIstake a partnership position. Furthermore, in Islamic banks, deposits are not based onguaranteed return but based on profit sharing, with a fixed amount on the asset side and avaried amount on the liability side. If profits are overly distributed, then banks may haveinsufficient funds to meet their obligations. Thus, calculation on profit distribution has tobe prepared and submitted monthly to the Central Bank.

With timely information, decisions on profit distribution can be made effectively and thepossible mismatch of assets and liabilities can be monitored closely. Another possiblereason for this is the size of the IFIs themselves. The IFIs in this study are mostly smallerthan conventional FIs and in smaller organizations; bureaucracy can be expected to belower. With advances in information technology, information can be stored and retrievedquite efficiently.

3.3 Integration?

The findings of this study suggest that IFIs use more integrated information thanconventional IFIs. IFIs use information about the activities of the various departmentswithin the firm alongside information on the impact of decisions on them. The issue ofShariah compliance in product innovation gives a possible explanation for these findings.Product innovation requires the integrated effort of various departments; including theSSB, product development, legal, marketing and finance. IFIs have to make sure that thecontracts associated with the new products conform to Shariah. The need for moreintegrated MAS in IFIs is increased because all transactions are monitored by SSB toensure Shariah compliance.

3.4 Aggregation

The findings of this study also suggest that IFIs use more aggregated information thanconventional FIs. The aggregation of information by product is required by IFIs incalculating their capital charge for risk management. Under the capital adequacy ratio(CAR) requirements, IFIs have to identify the Shariah concept of each product becausethe weight ratio for each product varies according to whether the products have collateralor not.

The empirical findings from the survey was supported in the interviews, which revealedthat in order to be Shariah compliant, IFIs rely on a broader scope of information inaddition to the traditional financial and quantitative nature of accounting information.The empirical findings from both the survey and the interviews also reveal that IFIs usemore integrated and aggregated information than conventional FIs. In addition, IFIs areexpected to be more transparent in reporting and consequently require more integratedand aggregated information that covers a wider scope of information.

5. Conclusion

The aim of this study has been to determine whether there is any difference between theMAS of conventional and IFIs. A survey on financial institutions in Malaysia wasconducted and semi-structured interviews were carried out to gain further insights into thesurvey findings. The study shows that IFIs use MAS information that is broader in scope,more timely, more integrated and more aggregated than conventional financialinstitutions. In order to meet both religious and business objectives, IFIs requiresophisticated MAS information, which is available through the use of strategicmanagement accounting (SMA) tools and techniques such as the BSC and ABC. The useof these techniques brings a competitive advantage to IFIs, as SMA places customerneeds at its top of priority. The study has illustrated that IFIs normally develop and adoptan integrated accounting and overall enterprise system. With this comprehensiveenterprise system, the management accounting function is integrated with other functionsin the organization.

This study covers only financial institutions in Malaysia, thus the findings cannot begeneralized to other enterprises or to other countries. As for the respondents, this studyinvolved top management as the sole respondents and representatives of their respectiveorganizations. Nonetheless, the information sought is not beyond their knowledge as topmanagement are normally well-versed in the diverse aspects of the organization. Futureresearch can consider collecting data from individuals at various levels of theorganization.

This study has provided an avenue for further investigation on issues of MAS for IFIs. A

future focus might be on how MAS helps in strategic and operational decision?makingby considering the need for Shariah compliance. Researchers might also focus?on therole of MAS in promoting transparency and accountability in IFIs. A case study approachwould be able to provide a deeper and richer understanding of this issue. In addition,future studies might examine the significance of supporting activities (departments) in thedelivery of Islamic financial products. It is also worth including for further study the needto explore value chain components in IFIs, and how they help contribute to the value ofthe products they offer.