Islamic Financing Shift from Debt to Equity An analysis of Business Framework Muhammad Hanif (FCMA) Assistant Professor NU-FAST Islamabad. i Electronic copy available at: http://ssrn.com/abstract=1690867
ii Electronic copy available at: http://ssrn.com/abstract=1690867
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Dedication This work is dedicated to those who helped me at any stage of my life especially my teachers, parents, family and friends & those making sincere efforts for promotion and To implementation of Interest free Banking in true spirit. v
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Preface The sole motivation of writing this book is the promotion of Islamic finance in its true spirit as an alternative to interest based financing. The chief difference between conventional and Islamic banking is of risk and reward sharing by Islamic financial institutions (IFIs). Debt financing was proposed to be replaced by equity financing. Products (financing tools) of IFIs can be categorized objectively as Sharia 1 compliant and Sharia based. For this study Sharia compliant products mean the financing options designed to match the conventional banking operations within Sharia constraints. Under Sharia compliant tools return of financier is predetermined and certain. It includes Murabaha (cost plus profit), Ijara (rental agreement), Bai Salam (advance payment deferred delivery), Bai Istasna (order to manufacture) and diminishing Musharaka (mortgages). While Sharia based transactions mean sharing of risk and reward by financier with entrepreneur. Under Sharia based tools of financing return of financier is neither certain nor predetermined. Return depends upon the outcome of the project. It includes Musharaka (partnership of capital) and Mudaraba (partnership of capital and skill). One of the objectives of establishment of separate (Islamic) financial institutions was distributive justice which can be achieved through application of Sharia based financial system. Empirical evidence suggests that efforts/ operations of IFIs for application of Sharia based financial system are discouraging. Murabaha and Ijara dominating in portfolios of IFIS while Musharaka and Mudaraba least. This study is conducted to understand the existing business frame work and document the causes of lesser application of Sharia based financial system. The real difference of Islamic financial system with conventional banking is risk reward sharing 1 Sharia is Arabic word which means Islamic law. vii
characteristic. It is (as claimed by pioneers in the field) replacement of debt financing with equity. Although Sharia compliant instruments used by IFIs are much different from conventional banking in legal form but not very much in economic substance. The great job which IFIs have done so for is the linkage of currency/money with real sector which is not the case in conventional financial system. However IFIs could not advance much on the front of risk and reward sharing which is the chief reason of establishment of separate (Islamic) financial system. Chapter one of the book deals with analysis of interest in context of revelations (Bible, Qur an). It is found that interest is declared haram (unlawful, forbidden) by Allah (God) for believers in Allah (Jews, Christians and Muslims). Study objectives, methodology and need of this study is also discussed in chapter one. Chapter two is dedicated for understanding accounting frame work, profit calculation process, loopholes in accounting frame work, issues in financial reporting, profit manipulation techniques and likely impact on risk reward sharing (Sharia based) financing. It is found in the process that accounting frame work has some serious implications for Sharia based financing as whole system of profit and loss sharing depends upon true profit depiction which is based on accounting frame work. In chapter three literature reviews on earnings management (accounts manipulation by managers) is presented. The areas covered are definition, motives, measuring methods, tools, environmental weaknesses and control measures. Chapter four depicts the results of opinion survey of professionals and academicians on the issue. Very interesting finding was that chief hurdle in the popularity of Sharia based financing is the conventional banking. Other hurdles found are weaker audit, higher taxes, and riskiness of Musharaka, loopholes of conventional accounting, lack of trust and confidence among IFIs and entrepreneurs and profit manipulation behavior of managers. One of the findings viii
of survey was that management of IFIs has not made serious efforts for promotion of Sharia based financing. I must acknowledge to all those who helped me at any stage of my life including teachers, parents, family and friends. I am obliged to Dr Abdullah Iqbal and Prof. Amanullah Khan for guidance, support and motivation. I am also indebted to Prof. Alvi Abdul Rahim and Mr. Hashir Ibne Irshad CFA for putting hard work in review process. Special thanks to associate and fellow members of ICMAP and officers of IFIs (Islamabad) for participation in survey. Finally my wife and kids deserve special thanks and appreciation for their patience during the whole project completion process. Muhammad Hanif Islamabad April 21, 2010. ix
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TABLE OF CONTENTS Preface List of tables List of figures Executive Summary VII XVII XVIII XIX 1. Introduction 01 1.1. Background of Study 01 1.1.1. Interest 03 1.1.2. Establishment of Islamic Banks 07 1.1.3. Islamic Modes of Financing 09 1.1.3.1. Sharia Compliant 09 1.1.3.2 Sharia Based 14 1.1.4. Profit and Loss Sharing 16 1.1.5. Portfolios of IFIs 20 1.2. Purpose of Study 22 1.2.1. Research Questions 23 1.2.2. Hypothesis Development 24 1.3. Research Methodology 25 xi
1.4. Contribution 28 2. Financial Reporting Framework 31 2.1. Objectives of financial reporting 32 2.2. Users and Needs 36 2.3. Conceptual framework 38 2.4. Accounting Principles 40 2.5. Issues in Financial Reporting 42 2.5.1. Recognition 42 2.5.1.1. Sales of Goods 43 2.5.1.2. Rendering Services 44 2.5.1.2. Manipulation through Managerial Actions 44 2.5.1.2.1. Sales and Returns 44 2.5.1.2.2. Early/delay recognition of sales 45 2.5.1.2.3. Provision against maintenance 45 2.5.2. Allocation and Classification 45 2.5.2.1. Depreciation 46 2.5.2.2.Good will amortization 47 2.5.2.3. Employees Compensation 48 xii
2.5.2.4. Provision for bad debts 48 2.5.2.5. Deferred costs 49 2.5.2.6. Research and development 49 2.5.2.7. Brand Accounting 50 2.5.3. Valuation 52 2.5.4. Principles Vs. rules based debate 53 2.5.5. Conclusion and Implications on Musharaka 62 3. Earnings Management 67 3.1. Definition 67 3.1.1. Types of earnings management 71 3.2. Motives 71 3.2.1. Reference point 72 3.2.2. Technical default 73 3.2.3. Transactions costs theory 74 3.2.4. Tax considerations 75 3.2.5. Launching public issues 76 3.2.6. Management compensation 77 3.2.7. Financial analysts forecast 78 xiii
3.2.8. Poor management performance 78 3.3. Measuring Methods 81 3.3.1. Jones Model 82 3.3.2. Standard Normal Distribution 83 3.3.3. Opinion survey 84 3.4. Manipulation Tools 85 3.4.1. Working capital 85 3.4.2. Rounding off 86 3.4.3. Transactions structuring 87 3.5. Environmental Weaknesses 89 3.5.1. Legal deficiencies 89 3.5.2. Unsophisticated users 89 3.5.3. Weak accounting profession 90 3.5.4. Weak corporate governance 90 3.5.5. Limited extent of external audit 90 3.6. How to control 91 3.6.1. Employees stock ownership 91 3.6.2. Board composition 92 3.6.3. Corporate takeover defenses 93 xiv
3.6.4. Audit 94 3.6.5. Regulations 95 3.6.6. Private sector actors 95 3.6.7. Business ethics 96 3.7. Consequences of earnings management 97 3.7.1. Upward movement 97 3.7.2. Downward movement 98 3.8. Conclusion 98 4. Opinion Survey 103 4.1. Portfolios of IFIs 104 4.2. Identification of hurdles 108 4.2.1. Profit manipulation 108 4.2.2. Lack of Trust/Confidence 109 4.2.3 Riskiness 110 4.2.4. Conventional accounting framework 110 4.2.5. Higher taxes 111 4.2.6. Dominant conventional banking 111 4.2.7. Weaker auditing 112 xv
4.3. Determination of responsibility 118 4.4. Recommendations 122 4.4.1. Awareness 122 4.4.2. New product development 123 4.4.3. Capacity building of IFIs 123 4.4.4. Regulation 124 4.4.5. Accounting frame work 124 4.4.6. Role of government and society 125 4.4.7. Miscellaneous 126 5. Conclusion 129 6. References 139 7. Appendix 148 xvi
LIST OF TABLES 1.1. Islamic Modes of Financing 10 1.2. Portfolio of IFIs 20 2.1. Summary of particular objectives of financial reporting 33 2.2. Summary of general objectives of financial reporting 34 2.3. Summary of Qualitative objectives of financial reporting 35 2.4. Users (and needs) of financial reports 36 2.5. Summary of accounting principles 41 4.1. Descriptive Statistics of Portfolio of IFIs 105 4.2. Correlation Matrix of portfolios of IFIs 107 4.3. Descriptive Statistics of Hurdles 113 4.4. Ranking of Hurdles 114 4.5. Correlation matrix of hurdles 118 4.6. Descriptive statistics of responsibility of players 119 4.7. Correlation matrix of players 121 xvii
LIST OF FIGURES 1.1. Growth in Islamic Banking 08 4.1-Graph of industry average 106 4.2- Graph of Standard deviation of industry 106 4.3- Graph of CVs 107 4.4- Graph of Average of hurdles 16 4.5- Graph of Variance of hurdles 116 4.6- Graph of CVs of hurdles 117 4.7- Histogram of Averages of players 120 4.8- Graph of CVs of players 121 xviii
EXECUTIVE SUMMARY The second half of 20 th century is known for liberation and renaissance of Islamic world whereby they started looking at the existing social systems through Islamic lenses and proposed modifications and developments. The Muslim thinkers and philosophers challenged the world s ruling economic systems and uncovered the weaknesses. Capitalism was examined in detail due to its magnitude and general acceptability in various leading societies of the world. One of the pillars of capitalism is interest, as charge on capital. Interest is forbidden by all known revealed religions including Islam in all of its forms. Conventional banking system is based on the principle of charging interest on borrowings and accepting deposits by the banks. In addition, banks can survive only by charging interest being the major source of revenue under conventional financial system. Initially Islamic financial institutions (IFIs) are established to provide an opportunity to Muslims being the latest nation of Islam to abide revelations and save them from disobedience of Allah however the system is equally ready to serve any individual avoiding interest (Riba) based transactions. The essence of Islamic financial system is justice in economic transactions among masses. Transactions of present day Islamic Financial Institutions (IFIs) can be grouped objectively into two broad categories. First, the Sharia based financial transactions i.e. those based on Musharaka and Mudaraba (the underlying principle is to participate in risks and rewards). Second, the Sharia compliant transactions with predetermined xix
returns such as Murabaha, Ijara, Diminishing Musharaka, Bai Salam, and Bai Muajjal (the principle is that financing is provided through assets and not in cash form to avoid charging of interest). By the end of June 2009, there have been six full fledged Islamic banks and twelve conventional banks with standalone Islamic banking branches operating in Pakistan. Their market share is about 5%. Islamic banking have been growing rapidly worldwide in a short span of time, it has established itself in 50 countries with more than 280 banks and managing funds of more than US$ 700 billion. Focus of IFIs is on Sharia compliant transactions; however, the share of Sharia based transactions is negligible. This study is conducted to get some insight into the business and accounting framework and its likely impact upon Sharia based financial transactions. The purpose of the study is to document the hurdles in the way of popularity and implementation of Sharia based transactions especially Musharaka financing. Conventional banks provide finance on a predetermined return i.e. interest basis. Existing accounting framework supports capitalism by design and transparency of financial reports is not above board. For example, earnings manipulation is well documented in literature. Through this study I examine the conduciveness of accounting and business environment for Sharia based financial transactions as the return is not predetermined and is linked with the outcome of the underlying project. The outcome of the project is usually disclosed through financial reports and if xx
financial reports fail in disclosing true and fair results due to its inherent limitations and/or earnings manipulation then application of Sharia based financial system is questionable. My methodology includes (1) literature review on accounting framework including International Financial Reporting Standards (IFRS), Generally Accepted Accounting Principles (GAAPS), accounting principles, accounting conventions and research papers highlighting issues in financial reporting and earnings management (2) opinion survey of Islamic bankers, entrepreneurs, accountants and academicians. The results of the study support the hypotheses proposed in the study. These relate to (H1:) lack of transparency in accounting framework, (H2:) opportunistic manipulation of accounts by managers and (H3:) non conduciveness of accounting and business framework for Sharia based financial transactions. It is also found in the process that increased awareness about Sharia based financial system, new products development through R&D, more incentives from government, general uplift in ethics, leadership role by central bank and capacity building of IFIs can enhance the application of Sharia based financial system especially Musharaka financing. Rest of the study is in the following order. In chapter one I have explained the background of this research, purpose of the study, research questions, hypothesis developed and research methodology. Chapter two discusses the objectives of financial reporting framework, users and their needs, conceptual framework development, accounting principles followed in financial reporting and issues in financial reporting. xxi
Chapter three reviews the literature on earnings manipulation including meanings of earnings management, types, motives of manipulation, measuring methods, tools used in manipulation, consequences (direct) of earnings management, certain controlling measures and implications for Sharia based financial system. In chapter four the results of an opinion survey is presented. It includes the percentage (%) shares in portfolios of IFIs of different modes of financing offered by Islamic banks to business, commerce and industry in Pakistan. This section is followed by hurdles in the way of Musharaka application. Third section presents the results of relative share of responsibility of operational level players of Islamic financial system for not getting the job done. Section four compiles the recommendations offered by respondents. Chapter five concludes the findings of the study, offers recommendations and identifies future area of research. The Book is available at Amazon.com and Blackwell publishing UK. xxii