CHAPTER 1
The Islamic Accounting Environment

Learning Objectives

After studying this chapter, you should be able to:

1. Explain the governing principles of commerce and business in Islam.
2. Describe the history of Islamic accounting.
3. Explain the relationship between ethics and Islamic accounting.
4. Explain the Islamic principles affecting financial reporting.
5. Describe Islamic accounting and list its specialised fields.
6. Describe the types of business organisations in an Islamic economy.

Islam is one of the three ‘divinely inspired’ religions, the other two being Christianity and Judaism. It is monotheist, with a sacred book, the Qur'an, which calls for belief in God's revelation and the teachings of the Prophet Mohammed (pbuh)1. With regard to business and commerce, this implies a certain type of ethical responsibility and accountability, which this first chapter will discuss. To a Muslim, religious and economic affairs are considered to be intimately connected. Accounting is more than a technical activity. It is a socio-technical activity, and in Islam religion plays an important part in moulding accounting practices.

In Islamic political economy, growth should result in social justice and equitable distribution of power and wealth in the society. The accumulation and monopolisation of wealth for its own sake without regard to its social consequences is considered undesirable, as it may result in social imbalance (Quran 59:7). An Islamic sense of accountability provides a framework within which society can debate matters of equity as an integral part of business affairs.

Religious sources in Islam influence business in specific ways. For example, the Quran specifically requires followers to keep proper records of their indebtedness and the payment of zakat, which is analogous to a form of religious taxation (Quran 9:60). It also prohibits riba (of which interest on a loan is a specific instance), waste and avarice, and all activities under the heading of ‘unfair trading’ (e.g. Quran 2:282; 2:275; 9:34, 35).

In this chapter, we discuss the Islamic environment in which accounting takes place, how Islamic ethical principles apply to the practice of accounting, and the institutions and organisations involved in producing and using Islamic financial reports.

Accounting has been called the language of business. As a process, it consists of rules of measurement and rules of disclosure and reporting. Reporting rules are more affected by cultural and religious values than are measurement rules. In this book Islamic accounting is treated as the language of business in an Islamic society, which is one that follows the principles and laws of the Sharia. In certain respects it is different from accounting practised in non-Islamic societies. Most of the differences relate to the way accounting information is reported, but some also relate to the way transactions are measured. These differences are explained in the first four chapters of this book.

ISLAMIC ACCOUNTING

Commerce is afforded an important place in Islam. How commerce should be conducted, what is lawful (halal) and what is prohibited (haram) is laid down in the Islamic Sharia. The strong interest in commerce, and its legitimacy, stem from the fact that the Prophet Mohammed (pbuh) was himself a businessman. The Prophet (pbuh) urged His followers to take up trade, farming, and other economic activities. Considerable religious weight is attached in Islam to the principles governing the conduct of businesspeople, including accounting systems and practices.

The governing principles of commerce and business in Islam, derived from the Islamic Sharia, constitute the framework that governs Muslim life. The Sharia is based on two primary sources, the Quran and the Sunnah and a secondary source, jurisprudence, which is a collection of the judgements of Muslim jurists.

The Quran is the most important of the three sources. It is quite specific about certain basic aspects of business life and accounting. We have already mentioned the specific prohibitions on riba and interest. More generally, it requires followers to keep proper records of their indebtedness:

Believers, when you contract a debt for a fixed period, put it in writing. … Let the debtor dictate, not diminishing the sum he owes (Qur'an 2:282).

The second, primary source of guidance is the Sunnah, which contains the teachings of the Prophet (pbuh) as reported by His followers, who sought clarification on various aspects of the Quran, sometimes by observing His behaviour. The secondary source of the Sharia, jurisprudence, consists of the judgements of Muslim jurists on issues not specifically covered by the Quran. Together, these sources make up the Islamic law.

The attitude of Islam toward economic activity is that it is legitimate and beneficial to support oneself and one's family through honest economic activity as long as specific prohibitions in the Quran, such as those described previously, are obeyed. Firms operating in an Islamic business environment are expected to seek a reasonable profit. The generation of profit, however, is not earned at the expense of, or through the exploitation of, others; the welfare of the community is held to be more important than the rights of the owners of businesses.

Accounting entities, especially corporations, may exist for many years. The actual profit that such entities will eventually make over their lifetime is known only to the Almighty. Managers, investors, and other stakeholders with an interest in such accounting entities, however, require information on a regular basis, typically at least once a year. For example, zakat is paid at the end of every year. As a result, companies report the outcome of their operations, profits or losses, and show their financial position, assets and liabilities, at the end of yearly accounting periods based on estimates that will only be known with certainty at a later date, sometimes many years hence.

To this end, firms prepare financial statements for a number of different purposes at the end of every accounting period. One of these purposes, as just noted, is to enable zakat to be calculated and paid. Some have argued that the assessment of zakat is a primary function of Islamic accounting. This is just one example of how the Sharia influences specific accounting practices in Islam. More generally, the Sharia guides the standards used by accountants in their reporting, defines what is true and fair, and ultimately what the principles of good corporate governance and sustainability are.

Accounting is the process of recording the economic events taking place within organisations, classifying recorded information and communicating extracts of these to interested parties in the forms of financial reports. We have already noted that accounting is often referred to as the language of business. Understanding this language is necessary to appreciate if Islamic principles are being followed by preparers of the financial reports. Experience has shown that three different types of financial report are necessary, and usually sufficient if prepared properly, to enable this judgement to be made, based on the financial position and results of operations of accounting entities: a balance sheet, as a statement of financial position; income statements of different types (e.g. a profit and loss account; a value-added statement); and a cash flow statement as a report on periodic performance.

Islamic accounting facilitates the socioeconomic objectives, which underpin the existence of business organisations in Islam. With this in mind, we define Islamic accounting to be the process of recording, classifying, and communicating information about the extent to which Islamic organisations achieve their financial and socioeconomic objectives within the general precepts of the Sharia.

A BRIEF HISTORY OF ISLAMIC ACCOUNTING

The application of the label ‘Islamic’ to accounting has various interpretations. Islamic accounting can mean, for instance, accounting in countries where Islam is the religion for the majority of the population. Under this interpretation, Islamic accounting would cover accounting in the Middle East, North Africa, much of Sub-Saharan Africa, parts of the Indian subcontinent, a large part of South-East Asia, and parts of the former Soviet Union and the Balkans. Historically, Islamic accounting would also include parts of Spain between the eighth century CE (184H) and fifteenth century CE (905H).

Islamic accounting has a long history. The existence of accounting records to track revenues and expenses dates back to the early Islamic State. It is likely that the bookkeeping principles that underpin modern accounting systems originated in the Muslim world, and that the subsequent development of accounting mechanisms elsewhere was influenced by them. For instance, it has been suggested that Pacioli's Summa reflected earlier accounting developments:

The merchants of Italy and other European countries obtained their first education in the use of sophisticated business methods from their counterparts on the opposite side of the Mediterranean, most of whom were Muslims, although a few were Jews or Christians. (Lieber, 1968, p. 230).

Some research refers to Islamic accounting documents dating back to the end of the eleventh century CE (493H) and the beginning of the twelfth century CE (596H). Found in a...