Islamic Firms and Valuation model in Accounting

Author: Iloka Benneth Chiemelie

Published: 7th of March 2014

Abstract

Accounting and valuation is an important aspect of any business and investment and this is centred on the fact that it helps to determine the success or failure of any investment by presenting a figurative representation of the company or portfolio being reviewed. Such a figurative representation will help to understand how efficiently the resources have been used. Efficiency of resources is measured on the yielded interested for investors, in which the investment can be considered a success if the returns to investments are high, or considered a failure if the returns are low.  As such, interest becomes a direct measure of performance. However, this interest is the centres of islamic firms, in which investments that have potentials of yielding interest are prohibited. It is against the islamic teaching to invest in businesses while also requiring interest from such investment. The main reason behind such is the understanding in islamic preaching that God is the owner of all wealth and human are just the trustees. On that note, human investors should not seek interest from investment as it will allow them to take advantage of the company. The main purpose of investment is to aid the growth of the society through a subsequent growth of the economy in the business settings. This is the focus of this paper, as it is built around understanding accounting and valuation models as they are being adopted in islamic firms.

Introduction

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 with prohibition of interest.

On that note, this paper seeks to understand the accounting and valuation models adopted in islamic firms as it related to prohibition of interest. In line with the research objective, this paper will seek to illustrate islamic accounting practices and valuation models separately, then combine them to write-up an evaluative report on the concept being studies. As such, the paper will basically be divided into three different sections. The first of such sections will be an understanding of islamic business and accounting practices, while understanding of accounting and valuation models will be the second section. The third section will be an illustration of differences between islamic practices in terms of accounting and valuation as compared with what is obtainable in conventional firms. Following this section will be a conclusion that summarizes the findings from the paper.

Basic principles of islamic economic system

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).

What islams think about interest

Interest in islamic firms is normally translated as “riba”, and riba is strictly forbidden as it leads to the only few people being given higher wealth as opposed to equality in public. According to Allah, “those that live in riba will rise up in front of God like men that have been demented by the touch of Satan, because their claim is that riba is more like trading with God, and as such it has given them the permission to trade the forbidden riba.

Basically, the emphasis laid down by the islamic teaching is that interest is forbidden and as such it is something that is against the will of God and must not be acknowledged under any circumstances. As such, islamic firms are normally designed in such that interest is not part of its valuation and accounting practices. This is because, such practices is prohibited. On that note, this paper will proceed to understand the accounting models and valuation approaches that are applicable in islamic firms.

Valuation and accounting models in islamic firms

Numerous islamic nations (e.g. Saudi Arabia, Iran, Pakistan, Malaysia and Brunei) across the globe function in accordance with islamic code in a number of areas in both their human and business lives. Recent studies have also shown that there is a new growing concern with relation to understanding the relationship between religion and accounting, with particular reference to the issue of what the proper form of islamic accounting is all about (Karim, 1995; Hamid et al, 1993, Gambling and Karim, 1991). The emphasis laid down by these studies is the need to develop set of standard for islamic accounting and reporting.

Sprouse (1987) affirmed to such conception by stating that: “there is no much difference between the need for accounting standards as related to the need for other standards, be it standards in measurement and weight, or standards in clothing size, grades of beef, or baseball statistics. The main goal set by these standards is to facilitate a defined level of comparison and as such minimize the social and economic liabilities associated with understanding and accessing alternatives that people face in the process of making rational decisions. In terms of financial accounting, we do sometimes seem to view issues only in terms of investment decisions, but it is not the only decision for which financial information can be considered to be useful, if not significant (p.83).

The need for developing standards in accounting and valuation has become an urgent affair for firms in islamic society as the islamic world fight strongly in order to revive the islamic ideology. Additionally, if there is a general agreed standard, then the overall bookkeeping of islamic firms will greatly be minimized as such standards can easily be integrated into accounting and valuation practices in order to fit the organization’s choice instead of adopting standards that frequently require changes as the organization transforms from on phase to another. The issue, which still remains well debated in literature is the issue of how to develop an islamic accounting system. The question addressed by this issue is whether the development should be based on the basis of international standards, or be based on other standard that easily represents the inception of islamic values into the firms.

There have also been developments in recent years of a new branch of accounting literature which highlights the differences between Western and Muslim business environment. Such development is based on the assumption that interest in any shape or form is prohibited in islam, such making suggestion that a separate and distinct accounting system should be developed. The major differences when comparing islamic accounting systems with that of the western accounting system will be based on the treatment of certain items in the balance sheet. On the conceptual basis, the main difference comes in the special treatment of unrestricted Mudaraba and other investments as a separately identifiable category of assets and fund accounts, which functions by combining sme features of an equity and some features of a liability. Another high context differences comes in the addition of special statements that detail the sources Zaka and Qard funds and what they are being used to achieve. There is also the possibility of notes in the accounting containing details of financial expenditure that will discharge the firm’s social obligations.

The main reason why firms exist is because using the prices system for coordination of economic activities has been identified to be costly (Coase, 1937). In comparison with firms, individual consumers, are unpredictable purchases of factors and as such incur relatively high contracting costs (Ball, 1988). On that ground, it becomes easier for firms to offer cost advantage over its competitors by adopting economies of large scale production in repetitive contracting. Generally, firms in the islamic setting are not different form this western view.

A firm can be seen as being in nexus contracts – which implies that the organization can broadly be described in the form of contract it enters into. The main essence of firms is contractual relations, and this is not only with respect to the employees, but also with direct reference to the suppliers, customers, creditors and other stakeholders that surrounds the firm (Jensen and Meckling, 1976, p. 310). There is always the possibility of firms reducing the associated costs of contracts such as the cost of negotiation, monitoring, possible renegotiation, and expected costs of bankruptcy or other failure that might befall the company in the process of conducting its business operations. The accounting and valuation policies of firms are likely to be based on the idea of minimizing contracting costs in order to achieve an efficient level of corporate governance. This view creates an important difference in the management of contracts and reduction of political costs. It was argued by Healy and Palepu (1993) that if superior information about the performance of firms are kept under the custody of managers, there have higher incentive of increasing disclosure when they view the stock of their firms as being mis-valued. Additionally, managers disclose information that are not favourable as a result of the fear of legal consequences and damage to the reputation of their company (Frankel, McNichols, and Wilson, 1995, p. 149). A number of reasons have also been identified as the reason why managers expand disclosure and they are: a) they view their firms as being undervalued by their investors, and b) they view undervaluation as being costly as a result of the fact that it increases the cost of raising new funds (Healy, Palepu and Sweeney, 1995). This increase in disclosure is however important as it helps to address the issue of redressing the undervaluation and reducing associated costs with financial intermediation of firms’ shares. As such, there is always the potential of manager to disclose information that they are confident about, while withholding those that they are not confident about. The implication is that there an “optimum” level of disclosure is created for individual firms and managers as they seek to achieve this level in order to make their contracts more accommodating.

There is no difference with islamic firms as they are also expected to operate under the guidance of set legal and political environments in which they function in. considering the fact that contracts are usually written in accounting numbers there are issues in the form of firms addressing whether the underlying rationale used in assigning value to assets is consistent with the islamic ethical position. As such, historical data are likely to be the bases of all accounting calculations in islamic firms. The essential feature of the historical cost accounting has been stated to be reflected in the firm specific aspect of the accounting system. It is a highly reliable source of information about any firm’s assets, private debts, operating performance and the management of its cash. It is well inscribed in the islamic concept of stewardship. The focus of attention of accountants in their reporting to external parties will be on the functioning of managers as stewards. Paton and Littleton (1940) laid high emphasis on the importance of this function, with the objective of stewardship being highlighted in the historical cost accounting as a contractual relationship between a firm and those that provide resources in the firm (shareholders). The concept of Amaanah is very significant in the islamic setting, and it is a concept that view managers as trustees, Ameen, of the funds that are under their disposal. The concept is quite related to the concept of fiduciary responsibility and stewardship functions. The Prophet Mohammed (Peace be Upon Him) himself was known to be called The Ameen. This form of system provided managers with the opportunity to discharge this fiduciary responsibility which might include some aspects of historical accounting.

Furthermore, if the islamic accounting and valuation principles are compared with the present method used in valuation that requires the need for managers t make predictions about the future, it can be seen that historical accounting method is less costly and quite simple to understand and use. However, weaknesses also prevail in historical account, and such weaknesses come in the form of allocation of problem and conservatism. In any case, these weaknesses are less likely to render the system totally irrelevant.

From an islamic viewpoint, the measurement of asset in determination of the amount of Zakat to be issues out is an important issue in the islamic society. In order to calculate the amount of zakat, assets need to be measured in present terms and not in its historical state. For the sake of zakat, firms need to be encouraged to undertake revaluation of their major assets occasionally. Thus, an islamic accounting system will likely adopt both historical cost and market selling prices. The double system in asset valuation will likely enhance the firm’s ability to accommodate contracts and to discharge their social obligations.

Argument in support of the need for enhanced awareness of the social impact of the activities of firms in islams looks to be in the favour of value-added statement, in addition to the balance sheet and profit and loss statement (see Baydoun and Willett, 1997). Value-added statement is those that involve the re-forming of data that are contained in the profit and loss statement. In accordance with The Corporate Report (1975), a British discussion paper, “values added is the wealth the firms presenting such report has been able to add under its own efforts and with the efforts of its employees. The statement needs to show how the value added into the statement has been used to pay for those contributing to the creation of such extra value. it is very useful in elaborating on the profit and loss statement, and may become the most preferable way for describing performance as times goes on  (p. 49).

A value-added statement as is adopted in islamic firms is likely to aid the focusing of firm’s performance from the view of the shareholders. For instance, the statement can mean a calculation of new ratios like employees’ wages and salaries, and added taxations. There is the possibility of this accounting method placing higher emphasis on how economic activities are co-operative in nature and less competitive in its aspects. This is in line with what is obtainable under the islamic preaching as contained in the Shari’a principles.

There have also been growing debates on corporate social responsibility and accountability as it is applied in islamic firms, and such debate has increased over the years, with much argument being made that the responsibility of any given business is to increase its profit as is common with the “rules of the game.” Scholars in corporate social responsibility have laid down claims that profit shouldn’t in any case be the only criteria used in judging corporate performance. As Wartick and Cochran, (1985) puts it: because of the fact that the behaviour of companies is very important in the realisation of social goals such as equality in opportunity, enhanced workforce safety and health, and environmental protection, a social dimension needs to be added to enhance the performance of the company.

Basically, social reporting involves the identification, recording and communication of information that are related to the performance of an entity in the social setting. It includes such report on the contribution of a firm towards the well-being of its employees, enhanced product quality and safety, sustainability in the community, public health and safety, protection of the environment, conservation of energy, affirmative actions, other related social aspects (Mirza, 1991). Gray, Owen and Maunders (1987), made the suggestion that the mangers of firms are forced to disclose social information in their annual report as a result of the social obligations they have for their employees.

The implication in the setting of islamic firms is that they will need to put into consideration the issues of the society with high preference as opposed to the individual performance of their firm as is in line with the islamic teachings. Such an attitude will please God and it will mean that the trustee (firm) has been able to handle whatever assets that has been given to him or her well and used it efficiently for the actual purpose it was designed to be used.

Accounting and valuation policies for islamic firms

Under the settings of islamic Shari’a, all businesses must practices their operations in such a manner that interest is purely avoided. On a similar note, the prediction of future should always be avoided. As such, it is expected that the parties involve sin the business transaction should always draw their contract in such a way that it is in line with the Shari’a view. Accounting exist in the society as a reflection of the business practices that are in that society, and it has little use in terms of value as well. As such, it has to be noted that accounting and valuation practices of firms in the islamic setting are also likely to present a reflection of islamic business contracts and business practices.

Under the islamic setting, there is a potential for more emphasis to be on accounting practices adopted form partnership and joint ventures. As such, the use of interest-bearing bond will be prohibited as well as preference shares. Interest leasing transactions will also be prohibited as well as all note receivable and note payables that have interest bearing figure. Since the future is in the hand of God, prediction and the use of present net value is prohibited as well. This will also be the case for hedging against currency fluctuations.

In any case, the use of historical data will likely continue. A number of reasons exist as support to this statement. For instance, historical costs showcase the fiduciary responsibility of the managers and their stewardship functions. Besides this, the model serves as a reflection of asset value at the time of acquisition. Historical data is an appropriate model because contracts are written in historical cost numbers. Besides, historical cost is an efficient technology. It has also been understood that the test of time and the use has been survivors of numerous centuries. If there was ever any better model, it would have replaced historical data in the course of history.

There is a possibility of selling price being used as a supplement for historical cost system under the islamic setting. There are two supports for such possibility. The first of such support is that it doesn’t involve the prediction of time. Chambers’ current cash equivalent can be given as an example. Chambers (1966) proposed CCE on the bases that it doesn’t involve the use of subjective judgement in relation to the future. The second reason is based on the notion that net realisable values can also be expected in the business when any transaction is being taken place, be it sold or liquidated. This model will likely be adopted when major assets are being replaced or the current marketing prices for commodities becoming substantially different when compared with the historical cost.

The implication of these policies is that accounting and valuation under the islamic setting is likely to be more detailed than what is obtainable from conventional accounting practices as such record will put into considerations all elements geared towards elaborating the performance of the company and limiting the potential of investors being put through wrong or misleading information that might influence their investment decisions. All these factors round up towards obeying the will of God and abiding by the islamic preaching.

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.

On that note, the purpose of this paper was designed to be an understanding of the differences in terms of accounting practices and evaluation models as it relates to what is obtainable in the islamic setting. The paper started with understanding the concepts available in islamic firms as well as understanding what an islamic firm is all about. Such an understanding laid the foundation for further research on the topic of discussion and the revelation is that islami firms adopting accounting and evaluation models that are designed around eliminating the possibility of predicting the future as well as interest based transactions.

In conclusion, it will be stated that the accounting practices and valuation models adopted in islamic firms is centred around understanding the best approaches to be adopted in order to ensure that their business practices are in line with the Shari’a law. Such accounting and valuation process are more detailed that the conventional approaches as they put into consideration all elements in the business process and gradually elaborate all processes in order to ensure that none of important information is left out and the information provided doesn’t allow the customers to predict the future or persuade them into investment as is commonly obtainable in the conventional settings.

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