Accounting Numbers’ Contribution To The Sharia Firm Value: Evidence From Firm Level Cross-Sectional Data

Author: Iloka Benneth Chiemelie
Published on: 1/12/2013

Introduction

This review of literature is designed to understand the theoretical implications of the concepts being studied in this paper. As such, the literature review will resolve around an understanding of the concept of Shari’a firm and then link accounting contributions to the value of the firm. Overall, Shari’a firm can be described as any firm that functions under the Islamic rule and such firms are generally known as “Islamic firm.”

Understand Shari’a firm: a review of firm value

One of the main characteristics of an islamic society is the prohibition of interest based business. As such, this has high implication on accounting practices in firms that adopt such islamic teaching and requirements – which is an inherent feature of the Shari’a law. The reason for such statement is based on the notion that accounting is not purely a technical activity as it is shaped up by the cultural, economic, and political features that guide a society. On that note, the purpose of this paper is to understand the accounting and valuation models adopted in islamic firms where islamic firm is defined as an “interest free firm.”

There have been a number of studies conducted to understand the influence of interest free nature in firms (For example, Gambling and Karim, 1986, Hamid, Craig and Clarke, 1993, and Karim, 1995). Most of these studies go deep into understanding the reasons for such prohibitions on the use of interest. The prohibition of interest also means that discount is not allowed. Considering the believe that the future is in the hand of God, Almighty, islamic preachers urges the followers of islam not to predict the future. However, the use of discount rates significantly involves the prediction of future. There are a number of islamic scholars that have also question the used of net present value in calculating the value of an asset, which require the prediction of future. The implication of the teaching means that adoption of debentures and other loans with interest are not allowed. On that note, the balance sheet of islamic firms will not likely contain debentures, preference shared and interests.

The use of interest in islam is seen as the exploitation of borrowers by lenders, which is against the islamic teaching, that businesses should not be conducted in such a way that one group is being exploited by another. As such, the accounting objectives delivered in Islamic teaching is that practices must conform to prohibition of interest.

This is basically the concept form which a Sharia firm is developed; it is such firm that aligns itself with the values and morals of the Islamic teaching by providing a network of understanding in Islamic business principles through operating an interest free business in which the main purpose of the business is for the interest of the society. As such, this will be the background from which the concepts for this paper will be developed.

For islam followers, one of their main principle in economic system is the principle of God “as owner of wealth.” This is the preaching in islam, which implies that God is the ultimate owner of wealth and people are just trustees. As such, the ownership of property by an individual is a trust (Amanah). This produces a new concept of accountability that is not well known within the western system. This concept is much boarder than the concept of private accountability, which is a new format of accountability that can only be discharged in accordance with Shari’a law. The islamic Shari’a lays down the understanding and way of achieving accountability. The understanding presented is that people are individually accountable for their actions with what have been entrusted unto them on the final day of judgement (Quar’an 6: 165; 57:7). The implication is that such an meaning presented another view on the valuation of things an deeds as compared with what is inbuilt in the conventional accounting systems and financial statement (Siddiqi, 1981, Baydoun and Willett, 1997).

Establishing relationship with God in islam is guided by the concept of Tawheed, which means unity of being one with God. The implication of this concept is a total commitment to the will of Allah. Another emphasis presented by this preaching is the role of individuals in a wide social context and the obligation that these individuals have as not to benefit at the expense of other people. All business dealings must be legitimate, and justifiable and far and achieve reasonable amount of profit. While profit is acceptable, excess profit is considered to be the same as exploitation. This is a direct contradiction with the conventional accounting system in businesses, where high level of profit is viewed as an indication of efficiency in the use of resources.

In islam, preference is given to satisfying communal needs instead of individual needs. Whenever the needs of the general public (Ummah) is conflicting with that of individuals, the needs of the general public must prevail. However, the implication here is not that individuals should not put effort to attain their own treatment and cannot be rich. Becoming rich in islam accepted so long as the wealth is achieved in compliance with the principles of Shari’a.

Commerce has a high level of recognition and value in islam (Lieber, 1968, p. 230). God says that ‘Oh you who believe! . . . let there be amongst you traffic and trade by mutual goodwill’ (an-Nisa 4: 33). The Prophet Muhammad (Peace Be Upon Him) referred to the honour bestowed upon traders by saying, ‘The truthful, honest merchant is with the prophets and the truthful ones and martyrs in the hereafter’ (Tirmidhi 12: 4) and ‘You ought to be engaged in commerce because ninety-nine per cent of the bounties of God are contained therein’ (Mansor, 1984, p. 11).

The contribution of accounting numbers to the value of Sharia firms

Sharia Equity Value

Valuation of equity is a common practice in business investment and as such is very important in Islamic firms. However, the valuation of equity under the Islamic setting is different from what is obtainable under conventional settings. This is because “riba” (interest) is prohibited under the Islamic setting and any firm valuation will be such that is based on the exclusion of interest related features.

Under the Sharia setting, the legal form of any Islamic business enterprise or contracts of such nature should be light on how the capital for investment are sources, employment of labour, remuneration factors, decision makers, dissolving of enterprise or contracts and risk bearing. Such form of business contract and organizations are in line with those that have been used during the times of Prophet Muhammad (sallahu alaihi wa sallam), which he didn’t prohibit, are the one that are accepted as the legal forms in Islamic enterprise or contracts (Abdul, 2011). A number of accounting numbers also influence the adoption of Islamic concepts in contracts and financing and some of these accounting figures are as discussed below.

Mudaraba

This is a profit sharing principle in the Islamic business concept which is bases on the Mudaraba principles in which the people providing the necessary funds required to establish the business sets the conditions that the profits generated will be shared amongst them (Abdul, 2011). On that same note, if there is any incurred losses in the business process, the loss is borne by the capital owners. Entrepreneurs on the other hand don’t invest anything in the business except for their human capitals and as such doesn’t make claims for any wages in the process of conducting the business activity (Abdul, 2011). The willingness to share losses becomes a clear justification for benefiting from profits, and the profit sharing ratio is such that is mutually agreed between the finance providers and the finance users, and it is determined by the forces that shape the market (Siddiqui, 1987). Funds are returned by the finance users only on two conditions as: if the finance user uses the funds negligently or breaches the conditions of mudaraba (Iqbal and Mirakhor, 1987). In relation to loss under the mudaraba settings in the business rocess, Ibn Qudama stated that “if however the loss is as a result of mismanagement or misuse or a violation of the conditions set in the contract from the fund user, then the fund user is liable to recovering the lost funds (see, Ibn Qudama, Al Moghni—5/49). The mudaraba concept is classified into two settings as:

Restricted Mudaraba – in this form of mudaraba, the owners of the capital requests the users to trade by their own capital, subject to certain terms and restricting them to only the related commodity that is to be traded, the time for which it is traded, the place at which the trading is going on or the person with whom the working partners will have to be trading within (Abdul, 2011). Basically, the conditions for using the capital are inter-alia with the desires of the owner and the conditions set by the owners of the capital used in the business process.

Unrestricted Mudaraba – this is the direct opposite of the mudaraba, in the sense that the owners of the capital makes the capital available for business investment but doesn’t give conditions on how the capital will be used or restricts its use in any business area.

Besides the two opposing mudaraba discussed above, there are other forms such as the: Mudaraba Mutlap – a non-contractual mudaraba; Mudaraba Muqaiadah – a contractual mudaraba; Single Mudaraba – which involves one Mudarib and one provider of funds taking part in the contract; and Compound Mudaraba – which involves either more than one mudari or providers of funds taking part in the contract process (Abdul, 2011).

Musharaka 

This is a form of business organization in which at least two people contribute to the financing process and also the management of the business, in either an equal or unequal proportions. The generated profits will be shared in the ratio that has been agreed between the partners in the business process because two of the parties might be sharing the work of managing the business as well as the process of providing finance in either equal or unequal proportion. Both of the parties involved in the process have the right to charge any fee or wages for the management activities in which they undertake in the business process (Khan, 1987). The people who provided the capital are entitled to participate in the management process but it is not a most that they will have to do so. As the profits are shared in the exact proportion as provided by the parties involved, so will the losses be shared as well.

The implication of the above Sharia principles is that financing and risk or business profit is something that comes together and any investors who is willing to commit his financial dispositions will also be willing to take necessary risks that might arise from the business process, but if the business becomes a success, the it is important to understand that the investor should be applauded for his commitment through a definitive profit sharing approach. On that note, dividend is something that comes with defined value in the Islamic setting and the dividend payable is as agreed between the providers of the fund (investors) and the users of the fund (companies).

Diminishing Musharakah

In a diminishing Musharakah, the process involves the customers seeing for fund from the bank or through joint purchase of an asset/property. It involves the consultation of designated valuation agencies for the purpose of providing the right valuation of the asset/property. The owner of the property who is also selling it is being paid by the bank, then the bank and the customers enter into a Musharakah agreement (Salman, 2010).

The process is referred to as diminishing Musharakah because an evaluation of the agreement process shows that the ownership stake of the tenant increase in the passage of time, while that of the bank decreases as well. This is because as time goes on, the customer will be gradually paying the bank off, and as such the bank’s authority and ownership stake in the agreement will slowly begin to decrease.

Salman (2010) also noted that in the Musharakah agreement, the floor rate (which is the minimum rate) and the ceiling rate (which is the maximum rate) are based on which of the rates that can be varied. In the Musharakah agreement, it has been noted that if the customer is able to make on-time payment, the transfer of ownership will effectively take place as designed. The risk of any damage to the property is borne by the bank and the customers, which is valued at the stake of the property at the time of such damage. Just like other forms of mortgage, the customer standard the change of being penalized by a specified fee is the customers withdraws from the contract when it is being paid to charity. The logic for such kinds of penalty is that the contract is all about a promise to pay rent and purchase units of asset/property and if the customers at any point is no longer willing to abide by the promise/undertaking, then the client will be asked to pay a certain penalty in order to maintain the financial discipline.

Murabaha

Murabaha is a form of sales transaction. On the technical aspect, it is basically a scale used in measuring deferred payment for sales (Salman, 2010). For instance, if the trader has the right to sell a good at a profitable point, then the bank should also have the right to sell the client’s assets if such client obtains possession of the asset physically/constructively and bears the risks that are related to the property up till the moment of sale.

Murabaha is one of the most popular financing approaches adopted in working capital financing, financing of SME and financing of trade. The customers are required to make purchase of the assets while acting as agents to the bank as a result of their advanced knowledge about the product and better relationship established with the suppliers in order to obtain the goods at a very competitive price and in a timely and appropriate manner (Salman, 2010). 

The process of Murabaha in the Sharia se4tting involves the bank and client coming to an agreement and signing the Master Murabaha Finance Agreement and the agency agreement. In accordance with the agency agreement, the customer is the one who makes purchases for goods from the supplier as a representative for the bank. The customers also undertakes to make repurchase of the assets from the bank. Basically, it is a one sided form of promise and undertaking in which the customer serves as the link between the bank and the seller. The bank makes payment to the supplier and obtains the title and physical possession of the asset, while the customers on the same hand signs an agreement to make purchases of the goods on the behalf of the bank and also willing to purchase the same good from the bank at an agreed price with the band. It must be noted that the price for which the customers makes purchases for the goods from the bank is usually higher than the price in which the bank bought it as the bank needs to make profits for such business operations. However, it must also be noted that under the Sharia setting, “riba” (interest) is forbidden and the price that the customer might be paying will probably end up being the same price as the value of the assets, but the bank might adopt other strategies which are not interest specified in order to obtain profit from such business process. Sales is executed after the offer and acceptance, and the customer pays the agree price to the bank. An important note is that rollover (which involves the rescheduling of Murabaha) is not allowed and goods cannot be sold if they have already been consumed by the customers (Salman, 2010).  The client will incur penalty if the payment is delayed and the penalty is made payable to charity.

Ijarah

The basic meaning of Ijarah is to give out something for rent Ijarah. In Ijarah, the property right is being transferred to another person for a considerable period of time and upon agreed price. The lease period begins when the asset in Ijarah is delivered to the lessee in a very stable/usable condition. The lessor in that case bears the responsibility of costs that are ownership related and the lessee on the same hand is responsible for all usage related costs.

Salman (2010) made known that when such assets are destroyed or become unusable, the lessor will stop taking rents from the lessee for the period in which the asset was not useable. In order to maintain financial discipline, there are penalties for late payment and the money is being paid to charity. The assets are still owned by the lessor until the lessor decides to the sell the asset to the customer in a separate agreement. However, there are no obligations that mandate the client to make purchase for the item at the end of the lease period.

The basic process involved in Ijarah as described by Salman (2010) is the lessee approaching the lessor in order to obtain the property on lease. The customer undertakes to make lease payments at specific period for amount which is agreement between the lessor and the lessee. Following the deal is the signing of agreement which details how the lease process will be undertaken, the amount to be paid by the customer periodically and the time specified for payment as well as the penalties that the client will borne if payments are not made as agreed.  Other contents include the withdrawal terms and the conditions that define the usage approaches as well as the risk bearing measures.

Bai-Salam

This term is used to describe payment of advance or forward buying (Salman, 2010). The contract setting of the Salam involves the sale of goods that will be delivered to the purchaser in a future date, which is also set at the time of the contract. This should not be confused with loan contract as it is a trade transaction contract. This form of financing is usually used when a manufacturers needs capital in order to produce finished product for the buyer. In return for paying in advance, the buyer becomes the receiver of a more favorable price – which involves the profit being split between the buyer and the seller.

Istisnaa

This is a contract for the acquisition of goods by specification or based on order in which the price is paid on a progressive pattern according to the progress of the job. This means that the longer the job, the longer the payment period (Salman, 2010). A good example for describing this form of business approach will be the payment of a house to be constructed, in which payments are made to the constructor base on the stages of the production completed. Contracts that are based on Istisnaa opens the door for varieties of possibilities in the business process and such contract include some of the forms of future contract trading of processed commodities, as it services in creation of the right platform for differing of both ends of the contract, as well as the delivering of payment (Salam, 2010).

Basically, the underlying implications from the above discussion is that under the Sharia concepts in business development and management, there is a need for the business process to be defined in such a way that profit is obtainable and the measure of profitability is highlight influenced by the level of investment in the business process. This is more like what is obtainable in the conventional setting in which investors that are willing to take higher risk by investing more of their capital in business will also be rewarded handsomely if the business becomes a high hit, or also stands the chance of losing out their investment with the failure of the business process. On simpler sense, the purpose of the business process is to make profit and since profit comes only through investment, then the investment should be managed in such a way that profit becomes very much possible. In order to ensure that the possibility of profit is significantly increased, the investors are allowed but not obliged to participate in the management process. If the investors have the necessary expertise and acumen to ensure success in the business process, they can decide to become involved in the management process in order to ensure a higher reduction of risk through a subsequent high level of management efficiency. Even when the investors are not involved in the management process, there are set standards for ensuring efficiency and the approach involves the fund user being held liable to repay the investment if the fund is not properly managed or misused for the purpose in which it was not designated to be used in. Additionally, the investors have the power to restrict the fund to be used for specific purposes only as described in the Mudabara approach in which they can decide how the fund will be used, where it will be used, and what it will be used.

Based on the significance demonstrated by the investment approaches described in this paper as it relates to the Islamic setting and Sharia principles, the next step will be an application of these principles in the real world setting as discussed below.

Influence of accounting number on Dividends per share in the Sharia firms

Basically, dividend can be described as the percentage of profits which are distributed to investors following a successful business process (Salman, 2010). Since the investors make provision for the necessary funds required to operate the business, it is expected that they get a fair share of the investment profits. Under the Sharia setting, dividend is not prohibited because it is not interest; instead it is the sharing of profits from a business process. As such, dividends are usually shared on per value agreed but the higher the investment, then the higher the value obtainable. For instance, is the value of payable dividend is 2% of the total profit to all investors, then investors that invested RM10 will get higher dividends than those who invested RM5. This doesn’t mean that investors with higher investments are preferentially treated; instead the implication is that they get higher returns as a result of their higher investments. This is inline within the Salam and Mushbarakah investment principles in which it is described that the higher the risk, then the higher the returns.

Influence of accounting numbers on Assets in the Sharia firms

In the business process, the level of investment is a measure of the amount of assets possessed by the investors, and the higher the assets, the higher the potential benefits from such investments. This is because, assets are used to generate the business profit and since profit is shared in the value of investment, then the investors with higher assets will have higher profits as compared with those with lower assets. This conditions are also obtainable in the Sharia setting as Salman (2010) described in the Ijarah approach in which it was made known that the leasing process involves the lessor letting go of his asset for a given period of time at agreed price to the lessee and the lessee making lease payment to the lessor at specified time and for specified amounts as agreed between both parties. In view of that, the higher asset a lessor has to lease out, then the higher returns. Basically, the implication is that asset is a measure of profit in the sense that the higher the asset the higher the profit obtainable and vice versa.

The influence of accounting number on Price variability in Sharia firms

This is the basic definition presented in the Mudabara settings as described by Abdul (2011), in which it was noted that since the seller can sale products at preferred prices, and then the bank also has the right to value the asset at any specific price as agreed with the customer. As such, there can be differences in price for a particular asset across markets.

The influence of accounting numbers on Debt in Sharia firms

It was noted in the discussions presented in this paper that in order to maintain financial principles, there will be penalties for debt (deferred payments) in the process of completing the agreed business process. As such, debts are incurred by both parties involved in the transaction in cases where the parties stand the chances of benefiting together such as in the case of Mushbaraka and Ijarah, but it is borne by the customer in cases the customer stands the chance of benefiting alone such as in Istamaa and Bai-Salam.

Hypotheses statement

Based on the above analysis, the following hypotheses can be made

HP1 The value of sharia firms is enhanced with the practice of interest free services.

HP2 In the sharia concept, people providing the necessary fund for running a business can detect how the business will be run.

HP3 Firm value is enhanced in sharia firms by the fact that profit is still the concept of business operations and investors can define the business concept in such a way that it is profitable.

HP4 Financial integrity is part of the everyday business in the sharia firms and this increase business process efficiency as parties are forced to stick with the business terms of risk being fined.

Conclusion

Accounting and valuation has been described earlier as an important tool in understanding the performance of a company and the potential for success of a new business setting. However, differences exist between the concepts as it related to the islamic setting and the conventional accounting methods. This is because accounting and valuation are done in line with islamic preaching which is basically against interest based transactions and the prediction of future.

As described above, accounting numbers play an important role in the definition of conditions that are obtainable in Sharia firms and the conditions are usually centered on the notion that the higher a customer invested in a business, the higher such person is expected to benefit if the business becomes a success and as well is the business fails. Such conditions are defined by Islamic functions in the form of mubaradah, mushrabada, musharabaka, istana, ijrah and so on. All these terms determine the conditions that are obtainable under the settings predefined by the agreement factors between the parties involved in the business process.  

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