Financial Statements of Islamic Banks

The following are the accounting definitions in a general conceptual framework of an Islamic bank’s financial statements.

Assets

An asset is defined as having possession of anything that can generate positive cash flow or deliver other economic benefits by itself or in conjunction with other assets. For Islamic banks this definition, however, needs further elaboration. The asset must be acceptable in Shari’ah terms. For example, interest receivable cannot be considered an asset in the balance sheet of an Islamic bank. The asset must be also reliably measurable in financial terms. Additionally, the bank should be able to obtain benefit from this asset while controlling the access of others to the asset. Also, the asset should not be associated with the right of another entity.

Liabilities

Liability is the obligation on part of the bank for a probable transfer of cash, goods, or services in the future due to a transaction or other financial event. The liability may also be due to forgoing receipt of some future cash. The date and settlement of this obligation must be reasonably measurable. For an Islamic bank, the liability must be enforceable under Shari’ah principles. However, if the bank carries a Shari’ah non-compliant obligation, it is still considered a liability and must be reported as such.

Revenues

Revenue is the gross addition to assets or reduction of liabilities covering the period of the income statement. The revenue must be generated from lawful trading or other profit-oriented activities or delivery of services of the Islamic bank. The revenues cannot include additions to the bank’s capital by the owners, deposits of investment account holders, deposits of current account holders or the disposal of assets.

Expenses

Expenses are the reverse of revenues and represent gross reduction in assets or addition of liabilities covering the period of the income statement. The expenses must be generated from lawful trading or other activities or delivery of services of the Islamic bank. The expenses cannot include distribution of dividend to bank owners, withdrawals by current account holders, withdrawals by owners or investment account holders or acquisition of new assets.

Risk Disclosure

One of functions of financial statements of a bank is to reveal the risk profile of the institution. When it comes to Islamic banks, the nature of risks is different than conventional banks due to the avoidance of interest and utilization of more trade based structures like Mudarabah and Musharakah. Compared to interest based ventures, trade structures tend to be riskier. Following are some of the risks that Islamic banks should disclose in their financial statements.

Credit Risk

Credit Risk disclosure for an Islamic bank includes information on assets by sectors/industries, regions, currency profile, and maturity level or expected period of cash conversion of different asset classes. The bank should also disclose information on non-performing financial assets and policies for writing off such assets. Since majority of financial contracts of Islamic banks are still based on Murabaha sales, the banks must disclose which contracts are solely funded by the bank’s assets and which are jointly funded by the bank and the account holder funds. This helps in assessing the fiduciary and liquidity risks by separation of two funding sources.

Investment / Market Risk

Islamic banks also invest in equities and fixed assets such as property since these investments are more in line with Shari’ah principles. Disclosure about these investments provides information on market risk. The banks classify equity investments into marketable securities, related/associated companies investments, fund portfolios, and short and long-term Mudarabah investments. The market value of marketable securities should be presented along with movement in provision for securities to help in market risk assessment.

Liquidity Risk

Islamic banks usually have good liquidity since most of their investments are in self-maturing short term Murabaha or commodity backed placements. However, their ability to raise funds through other banks or central banks in case of a financial distress is of concern. This is simply because they cannot borrow money on interest like conventional banks. Though Islamic banks have arrangements with other banks to provide liquidity in case of urgent needs, these arrangements are usually not disclosed in financial statements.

Operational Risk

Operational risk arises from the risk of losses due to inadequacy of internal bank processes or external factors. This risk may be also attributed to technology, systems, personnel, or analytical models. Islamic banks may carry operational risk due to the nature of their contracts or due to legal issues. Specifically these risks could come from cancellation of non-binding Mudarabah or Istisna’a, failure of internal controls, legal issues with enforcing Islamic contracts, illiquid commodity inventories, Shari’ah non-compliance, or high costs or monitoring equity-type contracts.