Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual CORPORATE REPORTING OF ISLAMIC FINANCIAL INSTITUTIONS: EXAMINING THE GAP BETWEEN

THE DESIRABLE AND THE ACTUAL Maliah bt. Sulaiman * Interntional Islamic University Malaysia, and Radziah Abdul Latiff, Universiti Kebangsaan Malaysia ABSTRACT Abstract The paper develops a corporate reporting model for Islamic financial institutions using the Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI) framework, Baydoun and Willett’s (2000) theory of Islamic corporate reporting and Sulaiman and Willett’s (2003) extension of Baydoun and Willett’s work. While the corporate reporting model developed was based on what Muslims ought to want in their corporate reports, what is currently being disclosed by Islamic financial institutions may not align with the “desirable”. Accordingly, we examined annual reports of Islamic financial institutions in Malaysia and various other Muslim countries to investigate whether or not a ‘gap’ exists between the “desirable” and the “actual”. The paper concludes with a suggestion that corporate reporting of Islamic financial institutions should be about 61

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual how the individual (and more specifically the accountant) discharges the task of social accountability before God. Key words: corporate reports, Islamic financial institutions, social responsibility, environmental accounting Acknowledgement The authors thank the participants at the International Islamic Conference, Monash Prato Centre – Italy (September 2003), and two anonymous ACFIP reviewers for their insightful comments on an earlier draft of the paper. *

Corresponding Author, Kulliyyah of Economics and Management International Islamic University Malaysia, Malaysia

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Sciences,

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual 1 Introduction Today, countries throughout the Muslim world are gradually realigning their economic activities to accord with the Islamic principles. As a consequence of this, one observes a growing interest in Islamic banking practices. Accordingly, there has been an increase in the number of Islamic financial institutions, worldwide. In Egypt, the Nasser Social Bank was founded in 1971 (Tomkins and Karim, 1987) and in 1975, the reluctance of residents to deal with conventional financial institutions led to the Gulf Arab States to incorporate its first Islamic bank (Al-Suwaidi, 1991). Thereafter, various other Muslim countries provided interest free banking services to their nationals. In Malaysia, the growing influence of Islam culminated in the formation of its first Islamic bank in 1983. Presently, conventional financial institutions in Malaysia have Islamic banking counters to serve the needs of Muslims (as well as non-Muslims) who do not want to be involved with any form of usury. Not only are Islamic financial institutions on the increase in Muslim countries, such financial institutions are also appearing in Great Britain and continental Europe (Tomkins and Karim, 1987). With the rising trend in Islamic banking operations, one pertinent issue that needs to be addressed is the reporting aspect of such entities. Sulaiman and Willett (2003), using the Hofstede-Gray framework on the cultural relevance of accounting practices, argue that Islamic societies should favour a more transparent disclosure policy and less conservative measurement practices. Given this, it 63

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual would be interesting to determine if, indeed, corporate reports of Islamic financial institutions exhibit such characteristics. With this objective in mind, our study examines corporate reporting of such institutions from two perspectives: at the level of the “desirable” and the “actual”. Accordingly, there are two main contributions of the paper. Firstly, the study develops an ideal reporting model specifically for Islamic financial institutions. The model is derived by consolidating the various frameworks developed in previous studies by authors such as Sulaiman (1997), Baydoun and Willett (2000), Sulaiman and Willett (2003) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). Secondly, we examined the reporting practices of Islamic financial institutions in Malaysia and four other countries to determine whether or not a gap exists between what Islamic financial institutions ought to report and what they are actually reporting. Thus, while prior studies primarily focused on the normative (i.e. what ought to be reported), the empirical work undertaken here provides evidence on the extent Islamic financial institutions are reporting in accordance with the Shari’ah Islami’ah. The paper is organized as follows. The following section develops a reporting model for Islamic financial institutions while section 3 focuses on the empirical work, examining the annual reports of various Islamic financial institutions. Section 4 is a discussion on the findings while section 5 concludes. 64

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual 2 Corporate reporting from an Islamic perspective Objectives of Islamic corporate reporting To develop any reporting system, it is essential that one understands the purpose it serves (Sterling, 1970). From Islam's perspective, the primary objective of accounting and reporting is to ensure that the system discharges the Islamic concept of accountability satisfactorily. To understand accountability from an Islamic perspective, one needs to understand the Islamic worldview. The Quranic view of life divides man's functions into haqooqullah, his obligations to God and haqooqulabad, his obligations to society (Brohi, 1978). Faruqi (1978) concurs with this viewpoint. According to him, Islam defines the norms of human conduct and ends of human desire in terms of values which focus on society. Accordingly, man's accountability to God also encompasses his accountability to his fellow men. Similarly, Kahf (1991) argues that the Islamic concept of accountability can be interpreted as one that promotes both social justice and social accountability. As alluded earlier, the underlying objectives of corporate reporting determine the scope and nature of information to be included. From a Western, secular, perspective, the primary objective of reporting is to provide information for economic decisions. By contrast (as indicated earlier), Islam emphasizes on the discharge of accountability. In line with this, the Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI), specifies four primary objectives of financial statement. Besides 65

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual providing information for economic decision making, Islamic financial institutions should provide information on its activities so as to enable users to determine if such activities comply with the provisions of the Shari’ah Islami’ah. Additionally, Islamic financial institutions should also disclose the extent they have discharged their social obligations. Finally, and most importantly, Islamic financial institutions should regard reporting as a religious obligation (Ismail and Abdul Latiff, 2001). Gambling and Karim (1991) are more specific when they indicate that one of the primary objectives of financial statements to Muslims is the determination of zakat. The same argument has been put forth by various authors such as Baydoun and Willett (2000), Sulaiman (1997) and Sulaiman and Willett (2003). Public or private good? Before determining what an Islamic corporate report should include, perhaps, one issue that needs to be addressed is whether or not financial statements (in an Islamic environment) should be considered a public or private good. According to Peasnell (1982), for those who are interested either in assessing the extent of monopoly power in a company or investing in rival companies, published financial statements can be considered as social goods. However, for managers of companies whose main interests lie in the reduction of agency costs, published financial information can be regarded as a private good. Given Islam's emphasis on the community, one could argue that, from Islam's perspective, financial statements should be regarded as public goods. The significance of this lies in the fact that if financial statements are 66

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual public goods, corporate reporting should have a wider focus than it currently has (Sulaiman, 1997). Components of Islamic corporate reporting In line with the preceding discussion, the AAOFI suggests that Islamic financial institutions should include the income statement, the balance sheet, the cash flow statement, a statement of retained earnings, a statement of changes in restricted investments, a statement of sources and uses of zakat funds1, and finally, a statement of sources and uses of qard2 funds in their reporting practices. The foregoing statements are perceived by AAOIFI to be adequate in discharging an Islamic bank's accountability. More specifically, the last two may be regarded as fulfilling the social responsibility/accountability focus of such organizations, to some extent. Baydoun and Willett (2000) suggest that two essential principles underlying the concept of accountability in Islam are the precept of full disclosure and the concept of social accountability. Accordingly, they argue that Islamic corporate reporting should include a current value balance sheet and a value added statement for it to be useful to Islamic users of accounting information. The significance of the two statements is discussed next. 1 This was only for banks which assume the responsibility for the collection and distribution of zakat. 2

These are loans extended without the element of profit imputed. fund is meant to be a means of achieving social justice.

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Such a

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual Current value reporting Since zakat is based on wealth, current values would satisfy Islam's concept of justice more adequately than would historical costs (Baydoun and Willett, 2000). Adhering to the concept of conservatism would lead to an understatement of the wealth that could be subjected to zakat. Further, according to Gambling and Karim (1991), using one valuation method for zakat and another for reporting purposes would somehow imply a division between religious and business matters. Given the fact that zakat is an obligatory payment calculated on the basis of some share of the assets of the wealthier members of an Islamic society, current values are advocated presumably to ensure that a just distribution of resources prevails, especially in times of rising prices (Sulaiman, 1997). In the context of Islamic banking, the AAOIFI also supports the use of current values. In fact AAOIFI is very specific on the method of current valuation to be used, advocating the current cash equivalent basis (SFAC No. 2). The rationale for this position is that present and potential investment account holders need information to evaluate the bank's ability to achieve its investment objectives in order for investors to make their 'hold', 'buy' or 'sell' decisions. In this regard, the value the investment account holder expects to realise from his investments would be substantially dependent on the cash equivalent value expected to be obtained if the investments were sold at that date. Thus, if investments were measured at their acquisition (historical) costs, inequities would 68

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual occur in the distribution of investment results between the holders of investment accounts who provided or withdrew at different points of time during the lives of those investments3. This is so, primarily, because the profits earned over the life of the investments can only be realised at the point of liquidation. Hence a common theme emerges: the need for socio-economic justice ensures that the needs of various stakeholders and profit sharing partners (not just the owners of the bank) must be taken into account. On the basis of the foregoing, current values appear to be more consistent with the principles of socio economic justice advocated in Islam. However, due to practical difficulties envisaged with its implementation, the AAOIFI has put its recommendation on this issue on hold. Recognising implementation difficulties associated with current values, the AAOIFI states that, Notwithstanding the relevance of revaluing assets, liabilities and restricted investments whenever investments are financed by holders of investment accounts, this concept will not be adopted at the present time. It is not evident that adequate means are currently available to apply this concept in a manner that is likely to produce reliable information (SFAC 2, p57). 3

In this sense, one party may be able to take advantage of the other, depending upon price movements. However, this argument may not hold if subjected to a closer scrutiny. In the event that the investment holder wishes to withdraw funds at a particular point of time and that action would result in a forced liquidation of the business, does this not constitute an injustice? From the perspective of the investment holder this may not be so but from the point of view of the entrepreneur and other investment account holders, a gross injustice may have occurred.

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual It was suggested, however, that supplemental information pertaining to current values be provided although it was at the same time made clear that an Islamic bank is not obliged to distribute such unrealised investment results. This ruling may appear to support the concept of capital maintenance. However, the Shari’ah Islami’ah principle involved here is primarily centred on the issue of debt settlement; unrealised holding gains cannot meet the claims of creditors (Gambling and Karim, 1991). The value added statement A value added statement discloses the share of the value added between different sections of society, namely, employees, government, owners and creditors. The distribution of wealth created by the firm implies the presence of a conscious policy of redistribution and resource transfers amongst various groups of society. Accordingly, the value added statement, is more in line with the concepts of justice and mutual cooperation that Islam propagates (than the profit and loss statement) because the statement depicts a “sharing” concept. This, it is claimed, would further enhance the process by which an Islamic society can achieve social and economic justice (Baydoun and Willett, 2000). Social and environmental reporting Sulaiman and Willett (2003) argue that the inclusion of the current value balance sheet and the value added statement in corporate reporting as suggested by Baydoun and Willett (2000) may fulfil, to some extent, an organisation’s social obligations. However, they suggested that the inclusion of these two statements in Islamic 70

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual corporate reporting is, but a bare minimum. Similarly, while the inclusion of the statement on zakat and qard funds, as suggested by AAOIFI, may further enhance the Islamic bank’s social accountability focus, this may also not be adequate. The greater awareness of the social impact of the firm's activities in a Muslim community should also emphasise on the reporting of other social responsibility issues that have been specifically laid out in the Shari’ah Islami’ah (Sulaiman, 1997; Sulaiman and Willett, 2003). For example, monopoly practices and unfair trading practices are specifically mentioned in the Shari’ah Islami’ah. In contrast, these issues have not been the focus of social responsibility accounting in the West (Sulaiman, 1997). One “unfair” trading practice that is disallowed in Islam is the hoarding of goods (alQaradawi, 1994). In the context of financial reporting, such a practice may refer to the need for Islamic financial institutions or other organisations in an Islamic community to be more transparent in its disclosure practices. Thus, hoarding, be it of goods or information, is strongly discouraged (Sulaiman, 1997). Further support for the emphasis on reporting socially related information stems from the concept of private ownership. In Islam, a person holds property in trust for God and there should be no conflict between private and social interests. Private ownership in Islam is not absolute; one’s freedom to do anything with one’s property should not, in any way, disturb social equilibrium. The ultimate aim is to ensure the well being of the community. More specifically, in a financial reporting context, such a concept suggests that the accountant's accountability focus 71

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual is enhanced to include a wider audience, namely the public (Sulaiman, 1997). Thus, issues such as monopoly and unfair trading practices (as discussed earlier) that are specifically mentioned in the Shari’ah Islami’ah as having the potential to affect the well-being of the community should be a subject for disclosure. Similarly, issues pertaining to the environment should also be reported4. This is pertinent since social responsibility reporting also includes environmental reporting (Gray et al, 1987)5. Thus, an ideal Islamic corporate report for Islamic financial institutions should include the conventional financial statements (such as the income statement, the balance sheet, the cash flow statement and a statement of retained earnings), a statement of changes in restricted investments, a statement of sources and uses of zakat funds, a statement of sources and uses of qard funds (AAOIFI), a current value balance sheet, a value added statement (Baydoun and Willett, 2000) and the reporting of social and environmental issues (Sulaiman, 1997; Sulaiman and Willett, 2003) (see Table I).

4

See verses 7:85, 11:85 and 30:41. Social reporting is the process of communicating the social and environmental effects of an organisation’s actions to particular interests groups as well as the society itself (Gray et al, 1987). 5

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual Table I: Proposed Corporate Reporting Framework for Islamic Financial Institutions Objectives of reporting :

Accountability/Greater Transparency Financial Statements

AAOIFI

• • • • •

Income statement Balance sheet Cash flow statement Statement of retained earnings Statement of changes in restricted investments

Social, environmental and religious issues • Statement of sources and uses of zakat funds • Statement of uses of qard funds

•

BAYDOUN & WILLET (2000)

• •

SULAIMAN AND WILLETT (2003)

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Current value balance sheet Value added statement Social and Environmental Reports

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual The corporate reporting framework for Islamic financial institutions, just described, is based on the normative values of Islam, a model based on what Muslim users of accounting information ought to desire (the desirable)6. However, what Islamic financial institutions actually disclose in their annual reports may well be different. In order to determine the reporting practices of Islamic financial institutions, we examined the annual reports of 11 Islamic financial institutions from 5 countries: Malaysia, Turkey, Bahrain, Pakistan and Egypt. 3 Examination of financial reports of Islamic financial institutions We wrote to 98 Islamic financial institutions (in 40 countries) listed in the Concise Directory of Islamic Financial Institutions, (1997) (see Appendix A) requesting them for their annual reports. Only 11 financial institutions from 5 countries responded. Due 6

Given the existing business practices of Islamic banks, the above model should fulfill the Islamic concept of accountability. However, the principles of the Shari’ah Islami’ah are dynamic and may change with the passage of time or in accordance with a particular situation (Kamali, 1994). Accordingly, given the dynamic nature of business enterprises and the increased complexity of business transactions, the proposed model may have to include further information to address such complexity in the future. 74

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual to time and cost constraints no follow up was done. The annual reports of the following financial institutions from Malaysia, Bahrain, Turkey, Pakistan and Egypt were examined: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

BIMB Holdings Bhd (BIMB), Malaysia Bank Muamalat (BM), Malaysia Faysal Islamic Bank (FIB, Bahrain) Al Barakah Islamic Investment Bank(Albarakah, Bahrain) ABC Islamic Bank (ABC, Bahrain) Al Barakah Turkish Finance House (Albarakah,Turkey) Altowfeek Investment Bank (Alto, Pakistan) First UDL Modaraba (FUDL, Pakistan) Faysal Bank (FB, Pakistan) Faisal Islamic Bank of Egypt (FIB Egypt) Albaraka Islamic Investment Bank Pakistan (AIB, Pakistan)

The limited number of reports examined hinders a more rigorous statistical analysis. However the following analysis and discussion provide an overview of the reporting practices of Islamic financial institutions and the shortcoming of their practices in terms of what information they generally ought to report. In addition the discussion draws attention to the possible reasons for the gap between the ‘desirable’ and the ‘actual’. Tables II and III provide a summary of the results of the examination of the financial reports. Table II shows the availability of the disclosure of specific social responsibility issues discussed 75

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual in section 2 as pertinent for Islamic financial institutions while Table III presents other social and environmental accounting information. Table II: Disclosure of zakat, qard, current value balance sheet and the value added statement Zakat

Qard

CVBS*

VAS**

BIMB,Malaysia None BM, Malaysia None FIB, Bahrain √ Albarakah,Bahrain √ ABC, Bahrain √ Albarakah,Turkey None Alto, Pakistan None FUDL, Pakistan None FB, Pakistan None FIB Egypt √ AIB, Pakistan None * Current value balance sheet ** Value added statement √ Yes

None None √ √ √ None None None None None None

None None None None None None None None None None None

None None None None None None None None None None None

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual Table III: Disclosure of other social and environmental accounting information BIMB, Malaysia BM, Malaysia FIB, Bahrain

Environment None None None

Albarakah, Bahrain ABC, Bahrain Albarakah,Turkey Alto, Pakistan FUDL, Pakistan FB, Pakistan

None None None None None None

FIB Egypt AIB, Pakistan

None None

Social None None Lists amount expended on education and other charitable donations None (except for the statement on qard funds) None None None None Discloses amount of charitable donations Details of zakat in the “Notes” None

As indicated in Table II, Islamic financial institutions, in our study, demonstrate very little concern for statements that focus on social accountability. Any reporting on that aspect concentrates on the statements pertaining to the utilization of zakat and qard funds. As shown in Table III reporting on the environment is non-existent. The results could be explained by the fact that financial reporting 77

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual of Islamic financial institutions is largely influenced by conventional reporting, particularly the International Accounting Standards (IASs) (Ismail and Abdul Latiff, 2001). In fact, in all the countries under study, it was found that either the IASs form the basis of their financial reporting or such IASs supplement existing law or professional regulations. For example, the GP8 guideline (which provides a mandatory disclosure format for financial institutions), issued by the Central Bank of Malaysia is largely drawn from the provisions of the IASs. Additionally, in the case of Turkey, although it has a uniform accounting system (which also accords with the relevant IASs), the system/format is not compulsory for financial institutions. In Pakistan, the requirement to comply with IASs is provided for in the Companies Act. Reporting by financial institutions in Bahrain are also in accordance with the IASs. In addition, such financial institutions are required to prepare reports to comply with AAOIFI’s standards. Because of this, as indicated in Table II above, out of the 4 financial institutions that disclose the statements on zakat and qard funds, three are from Bahrain. 4 Discussion The influence of conventional reporting, namely the requirements of IASs, is evident from the way the reporting regime of each country articulates the objectives of reporting. As discussed in the preceding section, from a Western, secular perspective the primary objective of corporate reporting is to provide users with 78

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual information in order for them to make economic decisions. This is specifically provided for in the International Accounting Standards Committee’s ‘Framework for Preparation and Presentation of Financial Statements’. As may be recalled, the underlying objective of reporting determines the scope and nature of information to be included in the annual report. Given the emphasis on economic decision making in conventional corporate reporting, the focus on the profit and cash flow statements and the balance sheet may well be appropriate. After all, such statements provide information regarding the profitability, liquidity and the financial position of the enterprise being reported. Similarly, having adopted directly or otherwise the IASs, it appears that the primary objective of reporting in Islamic financial institutions (in the study) is to provide information for economic decision making (Ismail and Abdul Latiff 2001). In addition to economic decision making, conventional reporting of financial institutions also provides for other rigorous requirements to enable users to assess the risk profile of these organizations. Examples of these include the concentration of financing (by customer, industry or geographical areas), the maturity structure of financing and liabilities, and the exposure to exchange rate fluctuations. Such disclosure practices are also required of Islamic financial institutions. More recently, there have been attempts by policy makers to include other statements or information such as the value added statement, human resource capital and environmental report (see for example the guidelines of the Global Reporting Initiative). However such attempts have either failed or have not taken equal 79

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual prominence as the three conventional statements mentioned earlier. One possible reason is the fact that such disclosures are not being made mandatory. As discussed elsewhere in the paper, specific to Islamic financial institutions, AAOIFI has moved beyond the conventional reporting objective. It has set out as an objective of reporting, the provision of information in order to assist users to assess financial institutions compliance with the Shari’ah Islami’ah and how financial institutions have discharged their social responsibilities. Thus, although the reporting practices of Islamic financial institutions are predominantly geared towards disclosure of information to enable users to assess the financial position, liquidity and risk profile of the organizations, some attempts have been made to be more socially responsible. Granted that the inclusion of the statement of zakat and qard funds is rather limited an interpretation of “socially responsible” organizations, it is, nevertheless, a first step towards a more transparent disclosure policy. As mentioned elsewhere in the paper, financial institutions in Bahrain adopt AAOIFI’s standards for the supplementary reports. Thus, as can be observed from Table II, out of the four financial institutions that disclose the statements on zakat and qard funds, three are from Bahrain. However, it is not possible for Islamic financial institutions in Malaysia to prepare the statements on the collection and distribution of zakat funds as zakat collection and distribution are carried out by a centralized body, the Baitul Mal. Thus, Islamic financial institutions in Malaysia merely deduct 80

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual business zakat on behalf of their customers and pay them to Baitul Mal. Similarly, the non-availability of such a statement in the annual reports of financial institutions in other countries may also be due to the administration of zakat in the respective countries as opposed to not having a strong emphasis on social responsibility. In Turkey, the uniform accounting system specifically sets out ‘social responsibility’ as one of the main objectives of accounting in the sense that there is a need to consider the interest of society as a whole. However the requirement does not define the scope and types of information to be disclosed in order to meet the ‘social responsibility’ objective. Consequently (as observed from the published annual reports), this objective does not appear to have been operationalized in the reporting practices of financial institutions in Turkey. Thus, it would seem that financial reporting does not go beyond reporting of economic events. As such, financial reports prepared by Turkish financial institutions are not fundamentally different from those prepared by financial institutions in Malaysia, Bahrain or Pakistan or from any other conventional financial institution, for that matter. It is interesting to note that there is a greater willingness for financial institutions to include in their annual reports the statement from the Shari’ah Islami’ah supervisory board reports. Six (6) of the financial reports examined provide a Shari’ah Islami’ah supervisory board’s report or its equivalent. Two (2) financial reports explicitly describe the role of the Shari’ah Islami’ah board or adviser. Given the fact that these financial institutions are providing the report voluntarily shows a propensity 81

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual for such financial institutions to provide information that assures users of its conduct with regards to Shari’ah Islami’ah compliance (and not merely information that emphasizes only the financial status of the organization). On a related issue, in 2001, the Malaysia’s Accounting Standards Board (MASB) issued an Islamic accounting standard which requires Islamic financial institutions (or conventional financial institutions which have Islamic banking counters) to voluntarily disclose the report by the Shari’ah Islami’ah Supervisory Board. Another factor which may explain the gap that exists between what is desirable and the actual practices of Islamic financial institutions with respect to corporate reporting is the level of understanding and acceptance of Islamic banking activities in general, both at the societal and governmental level. Our reasoning is drawn from AAOIFI’s experience. AAOIFI relies on the cooperation of the government or other agencies that regulate the conduct of Islamic financial institutions to adopt its standards (Karim 2001). As observed in Malaysia and Pakistan, the general societal acceptance and awareness of Islamic banking may be inferred from the use of Islamic banking terminologies such as mudharabah, musharakah, and various other Islamic banking terms in financial reports of the financial institutions. The respective authorities in these two countries are also aware of AAOIFI’s standards pertaining to measurement and disclosure practices of Islamic financial institutions. In the case of Malaysia, where such standards do not contradict national requirements, Islamic financial institutions adopt the AAOIFI’s standards. However, where the 82

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual treatment of Shari’ah Islami’ah based transactions in accordance with AAOIFI’s standards is fundamentally different from the perceived equivalent conventional treatment, the latter prevails. In Pakistan, specific adoption of AAOIFI’s standards is left to the accounting profession. In Turkey, the relatively unaccommodating environment at the time of study, bars even the use of Islamic terms such as mudharabah, musharakah, and various other Islamic banking terms. However, as observed from the financial reports, further explanation was provided for users. The non-usage of Islamic banking terms by Turkish financial institutions does hinder a cursory understanding of what the items are (Ismail and Abdul Latiff, 2001). Yet another important point pertinent to the extent of disclosure is the cost-benefit issue. While in conventional reporting, the cost versus benefit aspect is an important consideration, in Islamic accounting (given that the model is derived from the Shari’ah Islami’ah), Islamic banks should disclose the relevant information at whatever cost. In other words, the cost-benefit debate should be a non-issue. Of course, this is the ideal position. Future studies should, perhaps, examine if, indeed, the cost benefit issue figures prominently in the bank’s decision to disclose what is generally regarded as relevant. Finally, the differences in practices amongst Islamic financial institutions and the gap that exists between practice and theory may be explained by the two perspectives of Islam: the 'universalistic' and the 'particularistic' (Siddique, 1985). The 83

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual former reflects on canonical Islam and its orthodox commentaries as embodied in the Shari’ah Islami’ah. The latter is essentially a product of the environment. Universal Islam dictates that politically, there should exist an ideal worldwide ummah (community of believers) and that there should be an economic system based on social justice and the redistribution of wealth as idealised in the payment of zakat. This universalistic perspective of Islam, sometimes referred to as normative Islam, constitutes the 'valid' Islam of the religious scholars (Holy, 1991). The model developed in the paper is, thus, based on 'universal' Islam, i.e. on what Muslims ought to perceive as appropriate. However, the way Muslims lead their lives is sometimes far from the ideal. Accordingly, a gap between the 'desirable' and the 'actual' is highly likely. The different practices adopted by financial institutions in various countries may be explained, in part, by the influence of localised elements of indigenous customs and cultural expressions and on how the Shari’ah Islami’ah is interpreted. Thus, although the fundamental elements of belief and practice of Islam are agreed upon by all Muslims as norms which they seek to fulfil, the degree of emphasis put on each one is variable throughout Muslim communities, societies and traditions. 5

Conclusion

The paper proposes a reporting framework for Islamic financial institutions. The model is adapted from Baydoun and Willett’s (2000) Islamic corporate reporting model, the extended reporting framework based on Sulaiman and Willett’s (2003) work and 84

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual AAOIFI’s model of corporate reporting for Islamic financial institutions. Specifically, we argue that in order for Islamic financial institutions to discharge accountability satisfactorily, besides disclosing financial statements that assist users to make more informed economic decisions, these financial institutions should also include (as part of its disclosure practices), the current value balance sheet, the value added statement, the statement on the sources and disbursements of zakat and qard funds and the reporting of social and environmental accounting information. Thus, one would expect an Islamic bank that follows strictly the tenets of Islam in its conduct, would disclose the statements just mentioned. However, our examination of the annual reports of 11 Islamic financial institutions in 5 countries reveal that there is a gap between what an ideal corporate report for Islamic financial institutions should take and what is actually being disclosed by the financial institutions. We found that the corporate reports of Islamic financial institutions (in the sample that we studied) primarily focus on economic decision making; an objective that is similar to conventional financial institutions. Accordingly, actual practice does not align with what is desirable from an Islamic perspective. The existence of this gap, perhaps, comes as no surprise. Given the external influences of international trade and the International Accounting Standards, it is highly unlikely that what is currently being practised or what Muslims desire would accord with what they should desire (the desirable). The question then arises as to whether or not Muslims should be content with the status quo (and thus continue to tolerate with the current reporting 85

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual practices of Islamic financial institutions) or alternatively to insist that Islamic financial institutions implement a reporting system that would be more in accordance with the Islamic value system such as the model developed in this paper. Additionally, the implementation of a specific reporting system for Islamic financial institutions can neither be based on expediency nor on the evidence gathered through positivistic research. Bearing in mind that the current value balance sheet, the value added statement, the statements on zakat and qard, and the social and environmental reporting information suggested here, would enhance accountability of Islamic financial institutions, such a reporting system, in our view, should be taken on board by all Islamic financial institutions (including conventional financial institutions with Islamic banking counters). Although, disclosing information that may better discharge the bank’s social responsibility would not happen voluntarily, this fact is not an argument against disclosure per se (Sulaiman, 1997). If Islamic financial institutions wish to report their business affairs to be more in line with the precepts of Islam, it implies that some kind of change in financial reporting practices must be made. Although a theory (especially one which concerns disclosure of information) can and may lead to its eventual practice, this change is unlikely unless the theory has political support (Gray et al, 1987, p204). As far as the political climate in many Muslim countries is concerned, the future of a corporate reporting system for Islamic financial institutions advocated in this paper seems promising. With the increasing number of Muslims demanding the services of 86

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual Islamic financial institutions, it is only natural that the reporting aspects have got to be in line with the Islamic precepts. However, adopting a distinct Islamic corporate reporting system may seem too radical a move on the financial institutions’ part7. Management resistance to voluntarily disclosing events that may result in increased social costs, as in the reporting of environmental pollution, plant explosions, oil spills and others, may turn out to be high. Accordingly, the process of change in reporting practice, if it is to be pursued, should be approached with caution. The problem of transition should be one of compromise, searching for options that do not contradict with the central purpose of Islamic ideals. One should not, however, regard compromises as unIslamic if they do not exactly conform to ideal situations. Changes in corporate reporting should be achieved through evolution8. 7

Once a reporting system has been established, it becomes very difficult to modify, primarily, because those who operate it have a vested interest in its perpetuation (Briston, 1978). Briston provides an interesting insight into the likely reasons for this. He argues that this was due, in part, to the high rewards which the system provides and partly because they were not prepared to admit that what they have studied and practised previously may now possibly be irrelevant. 8

As reported in Naqvi (1994) Islam advocates evolutionary changes as opposed to one that is revolution. He cites the case of Prophet (pbuh) Mohamed and the abolition of slavery. The Prophet (pbuh) did not abolish slavery outright but in stages. The Prophet (pbuh), first, taught the followers that freeing a slave is a form of piety. The Prophet (pbuh) himself set the example. While providing a slave for his daughter Fatima, the Prophet (pbuh) persuaded her that the housework should be done on alternate days by Fatima

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the Desirable and the Actual Further, resistance to change can be overcome through education. Students should be informed that what is currently being practised represents practices which are currently acceptable by the profession. In addition, research results should be refocused to reflect on the 'desired' and 'desirable' states of accounting practices as well as the actual. This may have the effect of gradually ensuring that the user, the accountant, the depositors, the directors and other stakeholders understand their respective responsibilities and can ultimately reach a consensus on what ought to be disclosed and how it should be disclosed in financial statements.

herself. Gray et al (1987) writing on social responsibility accounting also advocated an evolutionary approach to changes.

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the “Desirable” and Actual Practice” APPENDIX A: List of countries Albania Algeria Bahamas Bahrain Bangladesh British Virgin Island Brunei Canada Cayman Island Channel Island Cote D'Ivoire Djibouti Egypt Guinea Guernsey India Indonesia Iran Iraq Jordan Kibris Kuwait Luxembourg Malaysia Maurittania Morocco 89

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the “Desirable” and Actual Practice” Niger Northen Ireland Pakistan Qatar Saudi Arabia Senegal South Africa Sudan Switzerland Tunisia Turkey UAE UK and USA.

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the “Desirable” and Actual Practice” BIBLIOGRAPHY AND REFERENCES Accounting And Auditing Organization For Islamic Financial Institutions, (88). Accounting And Auditing Standards For Islamic Financial Institutions 1418H -1997’ 1997. Al-Suwaidi, A.A.M. (1991), "The Finance of International Trade in the Gulf Arab States: A Comparative Study between the Conventional and Islamic Banking Systems with Special Emphasis on the United Arab Emirates", Unpublished Doctoral Dissertation, University of Exeter. Al-Qaradawi, Y. (1994), The Lawful and the Prohibited in Islam. Islamic Book Trust, Malaysia, 1994 (Translated by K. ElHelbawy, M. Siddiqui and S. Shukry).. Baydoun, N. and Willett R. (1994), Islamic Accounting Theory, Proceeding of AAANZ Annual Conference, Sydney, Australia. Baydoun, N. and Willett R.(2000), Islamic Corporate Reports. Abacus, 36(1), 71-90. Briston, R.J. (1978). "The Evolution of Accounting in Developing Countries", The International Journal of Accounting Education and Research, Fall, pp105-120.

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the “Desirable” and Actual Practice” Brohi, Islam A.K. (1978), and Human Rights., In A.Gauhar (Ed.), The Challenge of Islam, Information Services, London. Faruqi, I. (1978), "Islam and other Faiths." In A. Gauhar (Ed.), The Challenge of Islam, Islamic Council of Europe, London. Gambling, T. and Karim R.A.A. (1991), Business and Accounting Ethics in Islam. Mansell, London. Gray, R., Owen, D. and Maunders K. (1987), Corporate Social Reporting: Accounting and Accountability. Prentice-Hall International, UK. Holy, L. (1991). Religion and Custom in a Muslim Society: The Berti of Sudan. University Press, Cambridge. Institute of Islamic Banking and Insurance. (1997), Concise Directory Of Islamic Financial Institutions, UK. Ismail H and Latiff, R.A. (2001), Survey and Analysis of Financial Reporting of Islamic Banks Worldwide Arab-Malaysian Banking Group and Malaysian Accountancy Research and Education Foundation Kahf, M. (1991), "The Role and Importance of the Private Sector in Islamic Perspective", In M. Ariff (Ed.), The Muslim Private 92

Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the “Desirable” and Actual Practice” Sector in Southeast Asia, Institute of Southeast Asian Studies, Singapore. Kamali, M.H. (1994), Freedom of Expression in Islam. Berita Publishing Sdn. Bhd., Kuala Lumpur Karim, R.A.A (2001) ‘International accounting harmonization, banking regulation, and Islamic banks’ The International Journal of Accounting, pp 169-193 Naqvi, S.N.H. (1994), Islam, Economics and Society, Kegan Paul International, London and New York. Peasnell, K.V. (1982), "The Function of a Conceptual Framework for Corporate Financial Reporting", Accounting and Business Research, 1982, 12(48), pp243-256. Statement of Financial Accounting No. 2: Concepts of Financial Accounting for Islamic Banks and Financial Institutions. (1993), Financial Accounting Organisation for Islamic Banks and Financial Institutions, Jeddah. Sterling, R.R. (1970), Theory Construction and Verification, The Accounting Review.

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Accounting, Commerce & Finance: The Islamic Perspective Journal Volume 9. No. 1 & 2, June and December 2005 Sulaiman and Abdul Latiff: Corporate Reporting of Islamic Financial Institutions: Examining the Gap between the “Desirable” and Actual Practice” Sulaiman, M. (1997), Testing A Theory of Islamic Corporate Reporting: The Case of Malaysia, PhD Thesis, University of Otago, Dunedin, New Zealand. Sulaiman, M. and Willett, R. (2003), “Using Hofstede-Gray framework to argue normatively for an extension of Islamic corporate reports”, Malaysian Accounting Review. 2(1): 81-105. Tomkins, C. and Karim R.A.A. (1987), "The Shari’ah Islami’ ah and its Implications for Islamic Financial Analysis: An Opportunity to Study Interactions among Society, Organisations and Accounting." The American Journal of Islamic Social Sciences, 1987, 4(1), pp101-115.

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