CHAPTER 2 LITERATURE REVIEW

Transcription

1 CHAPTER 2 LITERATURE REVIEW 2.1 Characteristic of Islamic Banking System As suggested by Khan (1983), the existence of Islamic banks is to promote, foster, and develop the banking services and product based on Islamic principle. The Qur an in many of it verses indicate the principle which serve as guidance for the Islamic banks in their practical affairs. To involve themselves in business is highly encouraged by Islam but the business must be conducted on he basis of equity and justice. Islamic banks are prevented from engaging themselves in the business prohibited by Islam. According to M. Shahid Ebrahim and Tan Kai Joo, Islamic Bank can be defined as a bank that, by its own choice, opts to comply with two sets of law: the law of the Land (Jurisdiction); and the Islamic Law (Shariah). This is why Islamic bankers have two types of legal counsel: traditional ``lawyers'' and ``Shariah Councils'' (Al-Bahar, 1996). As Islamic finance is intertwined within its religion, the basis of the religion affects the finance in two important ways: (1) Islam aims at building a socio-economic order based on justice and considers economic activity as a means to an end and not an end in itself. It enjoins Muslims to harness natural resources, which is a trust from Allah SWT, for carrying out rightful activities; but abhors exploitation and manmade inequalities of income and wealth. 6

2 7 (2) Islam is deeply concerned with the problem of economic development, but treats this as an important part of a wider problem, that of total human development. The primary function of Islam is to guide human development on correct lines and in the right direction. It deals with all aspects of economic development but always in the framework of total human development and never in a form divorced from this perspective (Al-Harran, 1993) The Objectives of Islamic Banks Like any other business entity, Islamic banks are expected to make a profit from their operations. It is considered unjust for Islamic banks if they are unable to provide sufficient returns to the depositors who entrusted their money to Islamic banks (Mirakhor, 1987). Making profits is allowed in Islam. However at the same time, Islamic banks are required to recognize the message stated in Verse 87 of Chapter 5 of the Quran that prohibits Muslims from committing any excess. Applying this message to banking operations means that Islamic banks are prohibited from making excessive profit at the expense of their customers. Therefore, while ordinary business institutions are likely to place profits as their primary objectives, Islamic banks have to incorporate both profit and morality into their objectives Prohibition of Maysir, Gharar and Riba Subject to Shariah principle, Islamic financial transaction is considered valid if it fulfills the basic requirements of a valid legal contract and in addition, does not contain

3 8 certain elements such as Maysir (gambling), Gharar (lack of information disclosure), and Riba (usury) Maysir (gambling), basically is a kind of game that results in one party burdening the other party s responsibility. Maysir involves speculative elements in a contract where expected gains are not clearly defined at the initiation of the contract. Quran revealed the prohibition of gambling in Verse 90 of Chapter al-maidah. O you who believe! Intoxicants and gambling, dedication of stones, and divination by arrows, are an abomination of Satan s handiwork. Avoid such abomination that you may prosper. Gharar (uncertainty) is implied as ``deception based on the absence of knowledge or the unlikelihood of delivery with the prospect of causing harm'' (Thomas,1995). In conventional banking, the actual returns on the bank's portfolio of loans are unknown, although the bank commits itself to paying depositors a predefined rate of income. Gharar also can be defined as a situation when either party to a contract has information regarding some element of the subject of the contract, which is withheld from other party, and/or the subject of contract is something over which neither part has control. Another area of financial service that raises concern the prohibition of Gharar is the area of insurance. Riba is implied as addition in the principle however the one that is called riba is every addition that is taken without any righteous substitute. From the Shariah point of view, however, riba technically refers to the premium that must be paid by the borrower to the lender along with the principle amount as a condition for the loan of for an

4 9 extension on its maturity (Chapra, 1992). Based on this definition, we can conclude that riba and interest are the same thing and can be used interchangeably. The prohibition of riba in the Quran first appeared in Verse 39 of Chapter al-rum That which ye lay out For increase through the property of (other) people, will have No increase with Allah: But which ye lay out For charity, seeking The Countenance of Allah, (Will increase): it is These who will get A recompense multiplied. 2.2 Comparison between Conventional and Islamic Bank Many countries, all over the world, currently experience what became known as dual banking, where interest-free banks operate side by side with conventional banks. This interest-free bank conducts normal business like any conventional bank but does not pay or receive interest. It operates on profit/loss sharing principles following the Islamic laws which prohibit interest on any type of transaction. Therefore the characteristic between Islamic bank and conventional bank is considerably different. More comprehensive discussion about comparison between Islamic bank and conventional bank will be presented in table 2.1 Table 2.1 Islamic and Conventional Bank Comparison Dimension of Comparison Islamic Conventional Funding Characteristics 1. Ownership of Banks Predominantly shareholder-owned except in Iran and Egypt where all banks are nationalized. Predominantly shareholder-owned. Although in some countries such as Italy and France large banks are owned by the

5 10 government. 2. Leverage : Bonds and No : because it is interestbased Loans 3. Receipt of Deposit Yes on profit / loss sharing basis. All deposits (except specific investment deposits) are fungible. 4. Main Sources of Share of profit / loss from Income musharakah, murabahah, and commission from services. Application of Funds 5. Granting of Loans : Interest-based No Interest-free benevolent Yes loans 6. Investment in nonequity securities interest securities) Yes (excluding fixed 7. Investment in equities Yes- for example, Kuwaiti Investment House owns approximately 20% of British Petroleum 8. Trading in commodities Yes (mudarabah) Yes Yes- Interest bearing and non-interest bearing types. All deposits are fungible. Interest and commission. Yes : main activity No Yes (all types) Yes, but banks are not allowed to invest in equities in some countries No Leasing (ijarah) 9. Participation in clients businesses : Yes No (but non-bank subsidiaries can and often do)

6 11 Profit / loss sharing (musharakah) Profit sharing with Yes (main field) No (except some banks in Germany) clients and loss borne by the bank (murabahah) 10. Investment in foreign Yes Yes currencies Services Rendered 11. Social Collection and management of zakah fund on a regular basis. This is guided by Shariah Ad-hoc services as collection points for contribution in response to mass appeal for donations by charitable organizations 12. Current account Yes Yes 13. Credit cards Yes (no overdrafts) Yes 14. Collection of cheques Yes Yes for customers 15. Collection and payment Yes Yes of bills for clients 16. Investment in securities Yes (excluding fixed Yes for clients interest securities) 17. Sale and underwriting of securities Yes Yes, but in some countries (e.g., Japan, South Korea, and the United Kingdom) commercial banks are prohibited by law from engaging in this type of business. Only investment bank or securities

7 12 brokerage houses can undertake this type of business in these countries. 18. Letters of credit Yes (100% down payment) Yes 19. Letters of guarantee Yes Yes 20. Purchasing for clients Yes (main field) No on a pre-agreed profit basis (murabahah) 21. Futures and arbitrage No Yes 22. Discounting of bills No Yes 23. Leasing of safe deposit Yes Yes boxes 24. Carrying out feasibility studies Yes (for bank projects and clients) Yes (for bank projects only) 25. Providing advice to clients Yes on normal business and Islamic matters relating to Yes on normal clients businesses only clients businesses 26. Foreign exchange Yes (provided no interest is Yes transactions charged) Accounting Matters 27. Main Sources of Income No such problem as these are interest-based Valuation methods vary widely investments 28. Main Sources of Income Market value is preferred to lower of cost or market Majority of banks value method or market value basis 29. Main Sources of Income Amount reserved vary from Nil to about 10% of assets at risk. In many cases, directors use their Fixed by law in some countries (e.g., Canada, Hong Kong, Japan, South Korea, Germany, and

8 13 discretion some other European countries). Not fixed in some (e.g., Australia, Malaysia, Singapore, South Africa, and the United Kingdom). In the United Kingdom, this requires the approval of the Bank of England (Source: Naser & Pendlebury, The Influence of Islam in Bank Financial Reporting) 2.3 Products of Islamic Bank The most widely used Shariah principle adopted by Islamic banks in delivering their product are mudaraba, musharaka, murabaha, bai-mua zzal, ijara, ijara wa-iktina, qard hasan, wadiah, and rahn. Brief explanations of the most widely used principles are as follows: Mudaraba Mudaraba means profit sharing or trust finance or investment through self-employed entrepreneur. This is basically an agreement between at least two parties, one being a lender or known as investor and an entrepreneur also known as an agent manager. In the agreement the investor agrees to finance or entrust money to the entrepreneur who is to trade in an agreed manner and return to the investor the principle and pre-agreed proportion of profits and keep for himself the remainder. The distribution of profit between two parties must necessarily be on proportional basis and cannot be a lump sum or a guaranteed amount.

9 14 Musharaka Musharaka can be translated in English as partnership. In the context of Islamic banking, however, musharaka means participating financing. Literally, it means a joint venture agreement between two parties to engage in a specific business activity with an aim of making profit. In this principle, both parties will provide the capital and the investor or the lender may also participate in the management. Murabaha Murabaha or cost-plus financing or financing resale of goods refers basically to sale of goods at a price covering the purchase price plus a profit margin agreed upon by both parties concerned. This agreement transforms a traditional lending activity into a sale and purchase agreement, under which the lender buys goods wanted by the borrower for resale to the borrower at a higher price, agreed upon by both parties. Bai Mua zzal Bai Mua zzal or deferred payment sale is a variant concept of murabaha and in this case the borrower is allowed to defer settlement of payment for goods purchased within period, and in a manner determined and agreed by both parties Ijara This is the Shariah s concept of leasing finance, whereby the bank purchase the asset required by the customer, and then leases the asset to the customer for a given period. The lease, rental and other terms and conditions have been agreed upon by both parties.

10 15 Ijara wa -iktina In English, it is called lease purchase financing, refers to a contract where the bank purchases an asset for the purpose of renting the same to the customer against an agreed rental, together with the client s agreement to make payment which will eventually lead to the transfer of ownership from bank to customer. Qard hassan This is a benevolent loan that obliges a borrower to repay the lender the principle sum borrowed on maturity of the loan. The borrower however has the discretion to reward the lender for his loan by paying any sum over and above the amount of the principle. Wadiah Wadiah or trusteeship refers to an agreement between the owner of assets and other party, whereby the owner will deposit and give consent to the custodian to make use of their assets as long these assets remain in the custodian s hand. Rahn It means pledge or pawn. It is a contract of pledging a security and becomes binding when possession of the pledge has taken place. In this principle the ownership of the security is not transferred to the pledge. The transfer occurs only under certain condition. 2.4 Accounting Recognition in Indonesian Islamic Bank System In Islamic Bank, income is received from four main sources: equity participation, term financing, trade financing, and investment. According to Harahap, Wiroso, & M. Yusuf in Akuntansi Perbankan Syariah, 2006, before PSAK 59, there is no basis for Islamic Bank in Indonesia whether to use cash or accrual basis. Usually they use cash

11 16 basis to recognize income and use accrual basis for the expense. After Accounting for Islamic Bank was released, all Indonesian Islamic bank s recognition of income standardize into cash basis, since all the recognized income should have been really received. For expenses, it is using accrual basis since it is already clear which expenses that will occur in the future and also bank can control it based on necessity. Accounting concept basis assumption for Islamic Bank is as same as accounting concept basis assumption for general that is business continuity concept and accrual basis. Whereas for income that has purpose for income sharing calculation, then it will be using cash basis. Financial statement is prepared using accrual basis. With this basis, influential transaction and any other event will be recognized at the moment when it happens, not when cash or cash equivalent is being accepted or paid. It will be explained in accounting note and reported in financial statement for the related period. Financial report that is prepared using accrual basis gives information to user not only past transaction that involves cash income and payment, but also cash payment obligation in the future and resources that represent cash that will be received in the future. Therefore, financial statement arranges information about past transactions and other events which is very useful to user in making economic decision. Income calculation for production sharing is using cash basis. From explanations above, it can be concluded that accrual basis is used for financial statement necessity, whereas cash basis is used for income sharing calculation. In implementation, this is not an easy matter because Islamic Bank is asked to have a legal and accurate administration so accrual income and cash income can be differed.

12 17 Inaccurate administration can have critical influence, because it can impact on production sharing calculation that will be received by shahibul maal (capital provider). There are few reasons why accrual basis is used: 1. Financial statements can be compared. Many experts concluded that Islamic Bank is using accrual basis for its financial statement so that it can be compared to another financial statement, because generally all principles that are used in financial statement are accrual basis concept. But this is not exactly right because Islamic Bank characteristic is very different from other financial institutions. Activities in Islamic Bank are considerably larger than in other financial institutions, therefore it is hard to compare their financial statements. 2. In Accounting, Auditing, and Governance Standards for Islamic Financial Institutions that discussed about Accounting for Islamic Bank, Islamic financial institutions can use accrual basis or cash basis, even though they use accrual basis assumption generally. And even if they want to use cash basis system, they have to get fatwa (decision/opinion) from Islamic council in related area. 3. International Accounting Standards (IAS). International Standard about accounting use accrual basis. Therefore with accrual basis, Islamic Bank financial statement can be compared with other financial statement. 4. National Islamic Council Fatwa. In National Islamic Council Fatwa no. 14 / DSN- MUI / IX / 2003 September 16 th 2000 about profit distribution principles, it was explained that: (a) Islamic Financial Institution can use accrual basis system and cash basis in financial administration, (b) Observed from al-ashlah aspect, it will be

13 18 better to use accrual basis system in recording; but cash basis can be used in profit distribution, (c) Which system to be used has to be agreed in akad (agreement). In National Islamic Council Fatwa, it is clearly said that it will be better to use accrual basis system in recording if it is observed from al-ashlah aspect, but cash basis is used in profit distribution, therefore: 1. Accrual basis is only used to arrange financial statement, whereas cash basis is used to arrange profit distribution. 2. After PSAK 59 about Accounting for Islamic Bank was released, Islamic Bank has to differentiate between accrual income (the income that has only been recognized and is not followed by cash inflow) and cash income (the income that is followed by cash inflow). 3. Until now there is no further study which is more detailed academically and practically about the advantages and disadvantages of accrual basis system and cash basis system. Accrual basis system is expected to give more advantages, especially in providing information for the user of financial statement. Information that is provided in the financial statement and interrelated relationships between one and another can be seen in the picture below:

14 19 Figure 2.1 Relationships between Balance Sheet and Income Statement (Source: Harahap, Wiroso, & M. Yusuf in Akuntansi Perbankan Syariah, 2006) As explained before, Islamic Bank has to differentiate between cash basis income and accrual basis income. Income that is followed by cash inflow (cash basis) is used to calculate profit distribution purpose, whereas some are Islamic Bank income as mudharib (capital manager) and some are distributed to shahibul maal (capital provider). On the other hand, income that is still in recognition (accrual basis) is not allowed to be distributed to shahibul maal (capital provider).

15 20 For recognition of income in accrual basis, should be based on certain requirement: 1. Productive Assets Income that can be recognized as accrual income is productive assets income that is categorized as performing collectable income. 2. If there is a change from performing to non-performing collectable income, then the income that has only been recognized and is not followed by cash inflow should be reversed, and recorded in administrative account. 3. Accrual income recognition for distribution of profit sharing basis (mudarabah and musyarakah financing), is only allowed if the mudarabah fund management report has been earned. Therefore in practices, accrual income recognition is prepared when Islamic Bank monthly report, only income of fund distribution (productive assets) that use buying and selling principle since principle amount and profit amount / margin have been known in this buying and selling principle, whereas for fund distribution that use using profit sharing principle can be acknowledged after closing book of Sharia bank The Base of Profit Sharing Bank in Indonesia The regulations that is used as a based by profit sharing system bank in Indonesia 1. UU No.7/92 (replaced by UU No.10/98) on Banking. That allowed two banking system: Conventional system that is using interest method and Shariah system that is using profit sharing method. 2. SE BI No.32/2/uppb and SK Dir BI No.32/34/KEP/dir dated 12/05/99 on Commercial Bank Based on Profit Sharing System.

16 21 3. SE BI No.32/4/uppb and SK Dir BI No.32/36/KEP/Dir dated 12/05/99 on Bank Perkreditan Rakyat Based on Shariah principle. Fatwa (regulation) by Shariah National Board in Fatwa Dewan Nasional Syariah for Shariah Financial Institution 1 st edition, 2001, have three regulations that related with profit sharing system: 1. Fatwa No.07/DSN-MNI/VI/2000 on Mudharabah Financing. 2. Fatwa No.14/DSN-MUI/2000 on Profit Sharing System in Shariah Financial Institution. 3. Fatwa No.15/DSN-MUI/IX/2000 on Profit Sharing System in Shariah Financial Institution. 2.5 Influencing Factors of Profit Sharing System According to Antonio Safi i, 2001, there are several influences upon profit sharing system: a) Direct influence The profit sharing system of Sharia banking perceives several direct influences which effect the calculation of profit sharing. Those direct factors are: 1) Investment rate It is the actual fund percentage invested from the total fund in the Sharia banking. 2) Fund invested It is the sum of available fund in the Sharia banking obtained from several fund sources to be invested. That fund could be calculated by using one of these methods:

17 22 - Average of monthly minimum cash account - Average of daily total minimum cash account Investment rate is provided with the sum of the available fund to be invested, which provides the actual used fund. 3) Nisbah Nisbah is the percentage of profit sharing between the shahibul maal (fund owner) and mudharib (fund manager) which is concluded in an akad (agreement). One of the system characteristics is nisbah which is determined and agreed on the early stage of the agreement. Nisbah between one bank and another are different. Nisbah also differs from one to other accounts depending on the fund amount and it is due. Nisbah is generally reported on the basis of percentage (%) for the fund owner; and for the bank, for instance, Nisbah means that 60% of the profit sharing is for the customer and 40% for the bank.

18 23 b) Indirect Influence There are several indirect factors which affect the profit sharing. Those indirect factors are as follows: 1) The settlement of income and mudharabah expense items. Banks and customers share the profit. The profit shared is perceived as the income received minus expenses. And if all expenses are paid by the banks, it is called revenue sharing. 2) Accounting Policy (principle and accounting method) Indirect profit sharing is influenced by the on-going activity applied, particularly related to the income and cost recognitions. 2.6 Profit Sharing System in Islamic Bank According to Zainul Arifin in Dasar-Dasar Manajemen Bank Syariah, 2006, there are two types of profit sharing system in Sharia banking system: a. Revenue Sharing Concept Revenue sharing concept can be calculated from total income without any operational deduction based on nisbah agreement between bank and customer. The advantage of this concept is it does not bear negative return since the total income does not deducted by any operational expense. In general, it will be more advantageous for the capital provider. The disadvantage of this concept is if the level of total income received by bank is low, then it cannot cover the operational expenses of the bank. Consequently, the bank will experience a loss that will be distributed to the owners/shareholders.

19 24 b. Profit Sharing Concept Profit sharing concept can be calculated by deducting total profit sharing income with related operational expenses based on nisbah agreement between bank and customer. The advantage of this concept is it reflects more sense of fairness between capital provider and fund manager, since they share both profit and loss possibility. The disadvantage of this concept is it hard to identify which expenses that directly connected to the fund management. It also bears risk of negative return for capital provider, resulting less competitive compare to revenue sharing concept.