ANNUAL FINANCIAL REPORT OF BANKS Islamic & Western Approaches Comparison

Prof. Dr. Khawaja Amjad Saeed*
Email: professor@kamjadsaeed.edu.pk

Section I: / General

Prelude
By the grace of Allah, Islamic Banking is on the rise. In a global perspective there has been tremendous growth in Islamic Banking in the last three decades. The annual growth is 15%. At present, Islamic Banking is practiced in 75 countries in the world. Alone in Bahrain, there were 26 Islamic Banks till 2003. However, Islamic banking is being practiced in parallel with conventional banking system in Malaysia, Bahrain and in some Gulf Islamic Banks and Financial Institutions. In Pakistan, the Central Bank of the county is also granting permission to establish Stand-Alone branches for Islamic Banking.
Therefore, there is a need to develop a comprehensive framework for disclosure of financial information to be included in annual report of Islamic Banks/Financial Institutions and also carry out a comparison with Western bank approaches.
Sample Selection
The study has been restricted to selected samples. This includes the following:
1. USA-Bank of America, Charlotte, NC, USA.
2. UK-Standard Chartered Bank, London.
3. Europe-Deutsche Bank, Frankfurt, Germany.
4. Asia:
a) MCB Bank Limited, Islamabad, Pakistan.
b) Islamic Bank Bangladesh Limited Dhaka, Bangladesh.


* Principal, Hailey College of Banking & Finance, University of the Punjab, Lahore Pakistan.
Member Governing Council, International Federation of Accountants (IFAC) (1997-2000) President, South ASIAN Federation of Accountants (SAFA) (1997) President, Institute of Cost and Management Accountants of Pakistan (1997-2000) PRESIDENT, Association of Management Development institutions of South Asia (AMDISA) (1993-96) Pro Vice-Chancellor University of the Punjab, Lahore (1994-1996) Founder Director, Institute of Business Administration (IBA), University of the Punjab, Lahore (1973-1996).

The study has been exclusively devoted to disclosure requirements of Annual Report of Banks/Financial Institutions of Western selected banks and Islamic Banks.
Review of Literature
Sources of reading included the following:
1. Annual Financial Reports of selected banks as mentioned above.
2. International Accounting Standards (IAS No. 1) issued by the International Accounting Standards Board, London.
3. Accounting, Auditing and Governance Standards for Islamic Financial Institutions issued by Accounting and Auditing Organization for Islamic Institutions, Bahrain.
4. Literature published including presentation given on the topic entitled “General Presentation on Disclosure in Financial Statement of Islamic Banks and Financial Institutions” in the Conference held in 2004 in Islamabad.

Methodology
Desk Research was undertaken in respect of studying selected sample of foregoing banks in USA, UK, Europe and Asia. Information available in the book entitled “Accounting, Auditing & Governance Standards” released by Accounting & Auditing Organization of Islamic Financial Institutions, Bahrain was carefully read, comparison has been drawn and a suggested comprehensive framework has been developed for suggested use and application by Islamic Banks.
Annual reports of selected sample banks were collected.
Section II: Islamic and Western Approaches

Islamic Approach
So far no research study has been commissioned at Organization of Islamic Countries (OIC) level as yet. Muslim countries have developed their approach on the basis of Western approaches on broader basis. Muslim countries are following parallel/hybrid system of banking operations.
Moreover, a steady start has been made for Stand-Alone Islamic banks/financial institutions. Therefore developing Islamic approach for preparation of annual report of Islamic banks/financial institutions in an agenda of tomorrow.
For current practice, Islamic banks/financial institutions are generally following guidelines and formats included in the book entitled “Accounting, Auditing and Governance Standards for Islamic Financial institutions” released in 2001 by Accounting and Auditing Organizations for Islamic Financial Institutions, Manama, Bahrain. Specific reference be made to the following:
“Accounting

a) Statement of Financial Accounting:
1) Objectives of Financial Accounting for Islamic Banks and Financial Institutions.
2) Concepts of Financial Accounting for Islamic Bank and Financial Institutions.
b) Financial Accounting Standards:
1) General presentation and disclosure in financial statements of Islamic Bank and Financial Institutions”.
Summarized version of the contents of above is at Annex “A”.
Western Approach
Western countries follow mandatory provisions of their respective countries. Scrutiny of the financial statement of selected sample countries revealed that they follow transparency, implement legal requirements of disclosure in their annual reports and even disclose much more than the legally prescribed requirements. Use of Information Technology (IT) is extensive. Graphics are found in plenty. Statistical analysis relating to stakeholders-borrowers, consumers, beneficiaries of corporate social responsibility etc.
IAS-1 entitled “Presentation of Financial Statements” was released by International Accounting Standards Board (IASB), London. This is a generic IAS. A specific one relating to banks/financial institutions is an agenda of tomorrow.

Section III: The Debate

1. Contents Vs Substance
There is a consensus today that rather than “disclosure” or “full disclosure”, there should be an informative disclosure of financial information in the annual report of bank/financial information. However the debate is contents Vs substance. While emphasis continues relating to contents, not much have been developed relating to the substance. The substance also depends on the “value system” followed in the bank.
2. Prescribed Format Vs Disclosure Requirements
Moreover the debate is: whether to prescribe formats for preparation of annual report of a bank/financial institution or prescribe disclosure requirement. In some countries, for the sake of inter-bank comparison, formats have been prescribed for preparation of annual reports of a bank/financial institution. In other cases, disclosure details requirements have been prescribed as minimum mandatory requirement.
3. Marshalling
There are three approaches to marshal assets and liabilities in respect of their presentation in the balance sheet. These include:
a) Liquidity:
The most liquid assets and liabilities are shown earlier and the other ones are shown later.
b) Permanence:
Permanent assets (fixed assets) and owners equity are shown earlier and the current assets and current liabilities are shown later.
c) Combination
Some banks follow a combination of (a) and (b). Liquidity principle is followed in respect of assets and permanence principle. It is generally observed that Liquidity Principle is followed in respect of assets and permanence principle is followed in respect of capital and liabilities.
4. Grouping
Recently there has been considerable improvement in presentation of likewise items in proper groups to comprehend the financial information and to undertake further financial analysis.
5. Time Cycle
Today there is a crisis of plenty as quarterly highlights, half yearly financial reports and annual financial reports of banks/financial institutions are released. Some countries follow English Calendar year (January ---- December). Others follow July to June and other periods.
6. Basel-I & Basel-II
Basel-I emphasized on maintaining a minimum of 8% as capital adequacy ratio. Basel-II follows broader and holistic approach of giving greater emphasis on risk management.
7. Off Balance Sheet Items
Earlier termed as “Contingent Liabilities”, this is now called as “Contingencies and Commitments”. The list is growing and as these are shown as footnotes. These are popularly known as “Off Balance Sheet” items. These need to be comprehended properly and disclosed appropriately. Their probability to become actual liability needs to be disclosed to enable the readers of annual report of a bank/financial institution to form a judgment.
8. Users Need
It is difficult to meet all types of users needs. Each user has his/her own focus and therefore it is difficult to develop a standard annual report format to meet everybody’s need. The regulators may define the nature and depth of details relating to their needs. The tax authorities have their own perspective to determine taxable profit. Depositors wish to see risk exposure protection. Non-performing loans need to be properly disclosed and adequately cushioned against provision to be made and/or written off.
9. “Net” Revenue
Many countries, including Pakistan, followed a policy of presenting a “net” revenue after deducting provision for doubtful debts and bad debt amounts written off. The argument was to avoid any panic in public or in the minds of depositors or major creditors. Consequently transparency principle was not followed. However now, due to application of transparency policy, proper disclosure of financial information relating to foregoing aspects is being made in developing countries, including Pakistan.
10. Scope
The scope in respect of constituents of annual report of a bank/financial institution consists of two parts namely, mandatory and optional-over and above the legally prescribed quantum of information.
Section IV: Comparative Study

A comparative study of Western approach and Islamic approach was carried out on the basis of literature reviewed earlier.
Based on this, the following conclusions emerged:-
1. There were some commonalities in both approaches.
2. In some cases, differences were noted.
3. Using twelve (12) points, comparative study of both the above approaches is tabulated below.

Comparative Study
Western Approach ------ Islamic Approach
Sr. No. Particulars Western Approach Islamic approach Our Comments
1 Economic System Western (Capitalism) Islamic (Based on Quran & Sunnah) Persons are trustees rather than owners. Also see Annex “B”
2 Value System Accredited Divine Annex “B”
3 Contents Vs Substance Contents Substance & Contents Some have substance in western model also.
4 Format of Annual Report Prescribed as Mandatory Suggested by AAOIFI Annex “C”
5 Marshalling of Assets and Liabilities Open Open Discretionary power in both models/approaches exists.
6 Grouping Flexible Suggested by AAOIFI Annex “C”
7 Time Cycle Annual with Generally three years comparative data Annual with Two years comparative data
----------------------
8 Basel-I & Basel-II Being followed Being followed ----------------------
9 Off Balance Sheet Items Informative Disclosure Through suggested 45 notes by AAOIFI Annex “D”
10 Users Needs Focus: Shareholders Focus: Shareholders Western approach follows extensive information disclosure-mostly over 150 pages on an average in annual report of bank / financial institution. Islamic bank/ financial institutions also are progressing steadily on this front.
11 “Net” Revenue Full Disclosure Full Disclosure __________________
12 Scope Comprehensive Comprehensive See Annex “E” for Annual Report of A Pakistani Bank.

Section V: Conclusion

It is suggested that the State Bank of Pakistan may Commission a research study to undertake a comprehensive study of Western approach and Islamic approach and Pakistan can take a bold lead in developing:
1. Principles governing the disclosure of financial and non-financial information in Annual Report of an Islamic Bank/Financial Institution.
2. Guidelines for preparation of above Annual Report for Stand-Alone Islamic Banks/Financial Institutions.
3. Suggested formats for preparation of above Annual Report.
4. Amplified notes for explanation of major items of annual report of above Islamic Banks/Financial Institutions.
5. Other related aspects.

Indeed the output of above research will serve as logistical support for strengthening frontiers of Islamic Banking, will inspire confidence in stakeholders and will also provide food for thought for Western countries. The earlier this is done, the better.

Annex “A”
Financial Accounting Standards No.1 for Islamic Banks & Financial Institution
A: Relevance
General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions (pp 77 – 134).
B: Constituents (26)
• Scope of the Standards (1)
• General Provisions (6)
• General Disclosures in the Financial Statements (19)
C: Formats (7) & Notes (45)
1. Consolidated Statement of Financial Position.
2. Income Statement.
3. Statement of Cash Flow.
4. Statement of changes in owners’ equity.
5. Statement of changes in Restricted Investments.
6. Statement of Sources and uses of founds in the Zakat & Charity.
7. Statement of Sources and uses of Qard Funds.
General Presentation and Disclosures in the Financial Statement of Islamic Bank and Financial Institutions
Financial Accounting Standards No. 1 deals with general presentation and disclosure in the Financial Statements of Islamic Banks and Financial Institutions. This is included in a book entitled: “Accounting, Auditing and Governance Standards for Islamic Financial Institutions”* released by Accounting and Auditing Organization for Islamic Financial Institutions, Manama, Bahrain.
* This book deals with four aspects namely, Accounting, Auditing, Governance and Ethics. The Accounting portion has two constituents namely, “Statements of Financial Accounting” (objectives of Financial Accounting for Islamic banks and Financial Institutions and concepts of Financial Accounting for Islamic banks and Financial Institutions) and sixteen (16) Financial Accounting Standards. Auditing includes four aspects namely, Objective and Principles of Auditing, the Auditor’s Report, Terms of Audit Engagement and Testing for Compliance with Shari’ a Rules and Principles by an External Auditor. Governance has four parts namely;
1. Shari’a Supervisory Board: Appointment, Composition and Report.
2. Sharia’s Review
3. Internal Shari’a Review
4. Audit and Governance Committee for Islamic Financial institutions.

Islamic FIs Financial Statements
A: Balance Sheet
Assets
a) Cash Equivalent
b) Sales Receivables
c) Investments (Significant Items)
d) Other Assets
e) Fixed Assets (Net)
Total Liabilities, unrestricted Investment Accounts Minority Interest and Owners Equity
a) Liabilities
b) Equity of Unrestricted investment account holders
c) Minority Interest
d) Owners’ Equity

Source: Excerpted from: Accounting, Auditing and Governance Standards (2001), Bahrain: Accounting and Auditing organization for Islamic Financial Institutions, pp 109-110

Headings of 45 Notes are listed below:
1. Incorporation and activities (6)
2. Major Accounting Policies (7)
3. Changes in Accounting Policies
4. Supervision of the Regulatory Agency
5. Shari’a Supervisory Board
6. Zakat and Tax treatment
7. Zakat Base
8. Cash and Cash equivalents
9. Sales Receivables
10. investment Securities
11. Investment Securities
12. Modaraba Investments
13. Participations
14. Investors
15. Investment in Real Estate
16. Assets acquired for Leasing
17. Instisna Contracts
18. Investments
19. Other Assets
20. Net Fixed Assets
21. Current Accounts & Savings Accounts
22. Payables
23. Other Liabilities
24. Share of Unrestricted Accounts in Income (Loss)
25. Authorized and paid up Capital
26. Reserves
27. Financial Commitments and Contingencies
28. Net Assets (Liabilities) in foreign currencies
29. Income (loss) from receivable investments
30. Other Revenues
31. Administrative and General Expenditures
32. Provisions
33. Related Party Transactions
34. Assets, Liabilities and Unrestricted Investment Accounts according to their respective periods to maturity or expected periods to cash conversion
35. Concentration of Assets Risks
36. Concentration of Sources of Unrestricted Investment Account
37. Disclosure of significant Subsequent Events
38. Earnings and Expenditure Prohibited by Sharia’h (if any)
39. Disclosure of Compensating Balances
40. Restricted Assets or Assets Pledged as security
41. Estimated Cash Equivalent Value of Assets and Liabilities compared to historical value
42. Rights, Obligations and Conditions related to unrestricted Investment s and their equivalents
43. Relations between bank and holders of restricted investment accounts as a Mudarib or an agent
44. Reciprocal transitions and non-reciprocal transfers which do not require payment or receipt of cash
45. Social responsibility





Source: Excerpted from: Accounting, Auditing and Governance Standards (2000), Bahrain: Accounting and Auditing Organization for Islamic Financial Institutions, (pp 77-134).


Annex “B”
Islamic Economic System

Quaid-e-Azam Muhammad Ali Jinnah, the father of Pakistan, on 1st July 1948, while inauguration of State Bank of Pakistan (Central Bank of the country) said:
“We must work our destiny in our own way and present to the world an Economic System based on true Islamic Concept of equality of manhood and social justice. The economic system of the West created almost insolvable problems for humanity and to many of us it appears that only a miracle can save it form disaster that is now facing the world. It has failed to do justice between man and man and to eradicate friction form the International field. On the contrary, it was largely responsible for the two world wars in the last half century. The Western world, in spite of its advances of mechanization and industrial efficiency, is today in a worse mess than ever before in the history. The adoption of western economic theory and practice will not help us. In achieving our goal of creating a happy and contended people, we must work our destiny in our own way and present to the world an economic system based on true Islamic concept of equality of manhood and social justice”

Annex “C”
Value System in Islam

A: Three Things To Be Done:
• Do justice.
• Do good to others.
• Extend charity to the kindred.
B: Three Things Not To be Done
• No act of obscenity.
• No coercion.
• No wickedness.

Source: Al-Quran, Surah Al-Nisa, 16:90

Annex “D”
A Note on AAOIFI

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established in accordance with the Agreement of Association and was signed by Islamic Financial Institutions on 26-02-1990 in Algeries. Earlier this was known as Financial Accounting Association for Islamic Banks and Financial Institutions. AAOIFI was registered in the State of Bahrain on March 27, 1991 as an International Autonomous Non-profit making corporate body. Its objectives include the following:

1. to develop accounting and auditing thought relevant to Islamic Financial Institutions;
2. to disseminate accounting and auditing relevant to Islamic Financial Institutions and its applications through training, Seminars, publication of periodical newsletters, carrying out and commissioning of research and other means;
3. to prepare, promulgate and interpret accounting and auditing standards for Islamic Financial institutions; and
4. to review and amend accounting and auditing standard for Islamic Financial Institutions.

It carries out the above objectives in accordance with the precepts of Islamic Sharia’. This represents the comprehensive system for all the aspects of life in conformity with the environment in which Islamic Financial Institutions have developed.

Source: Accounting, Auditing and Governance Standards for Islamic Financial Institutions (2001), Manama, Bahrain: Accounting and Auditing Association for Islamic Financial Institutions, p9.

Annex “E”
Annual Report of a Pakistani Bank

I: Balance Sheet as at December 31, 2005
a) Assets (8 headings)
1. Cash and balance with treasury banks
2. Balances with other banks
3. Lending to financial institutions
4. Investments-net
5. Advances-net
6. Other Assets-net
7. Operating fixed assets
8. Deferred tax assets
b) Liabilities (7 headings)
1. Bills payable
2. Borrowings from financial institutions
3. Deposits and other accounts
4. Subordinated loan
5. Liabilities against assets subject to financial lease
6. Other liabilities
7. Deferred tax liabilities-net
Net Assets (A-B)
c) Represented by:
Owners Equity
_ Share Capital
_ Reserves
_ Retained earnings
_ Surplus revaluation of assets-net of tax
d) Footnotes
Contingencies and Commitments
II: Profit & loss Account for the year ended December 31, 2005
a) Spread Analysis-net markup/interest income after provisions.
Mark up/return/interest earned less mark up/return/interest expressed
Disclosure:
-- Provision against loans and advances
-- Provision for diminution in the value of investments
-- Provision for potential base losses
-- Bad debts written off directly
b) Non-Mark up/Interest Income
(Fee, commission, brokerage income, dividend income, income form dealing in foreign currencies, income/gains on investments, loss on trading in government securities and other income).
c) Non-Mark up/Interest Expenses
-- Administrative expenses
-- Restructuring expenses
-- Other provisions
-- Other charges
-- Exceptional items
-- Taxation (Current & prior year & Deferred)
-- Appropriations
-- Retained earning earned forward
d) Footnote: Basic Earnings per share-pre tax
-- Annexed
-- Notes
(Integral part of financial statements)
III: Cash Flow Statement for the year ended December 31, 2005
a) Cash Flow from operating activities
b) Cash Flow from investment activities
c) Cash Flow from financing activities
d) Cash and cash equivalents at end of the year.
e) Transfer to:
-- Statutory reserve
-- Capital reserve
-- General reserve
-- Dividend:
• Interim-Paid
• Final-Proposed
IV: Statement of Changes in Equity for the year ended December 31, 2005
1. Opening Balance
2. Additions
3. Adjustment
4. Closing Balance



Source: Excerpted from MCB Annual Report 2005, Islamabad.

List of Abbreviations


AAOIFI Accounting & Auditing Organization for Islamic Financial Institutions
IAS International Accounting Standard
IASB International Accounting Standards Board
INCEIF International Centre for Education in Islamic Finance
MCB (Muslim Commercial Bank) MCB Bank
OIC Organization of Islamic Countries
pp Pages

Selected Bibliography
1. Accounting and Auditing Organization for Islamic Financial Institutions, Bahrain: Accounting, Auditing Governance Standards, 1421 H-2000, (Volume Contents: Accounting, Auditing Governance and Ethics). {www.aaoifi.com}
2. 2004 Annual Report, Bank of America, Charlotte, NC 28255, USA pp 152, March 01, 2005. {www.banamerica.com/shareholder}
3. Banking Scene in Pakistan, Lahore: Hailey College of Banking & Finance, 2004, pp 8.
4. Annual Review 2004: Deutsche Bank, Frankfurt: Deutsche Bank AG, March 205, pp 64. {www.deutsche-bank.com/04}
5. International Accounting Standards, (2002), London: International Accounting Standards Board, IAS-1: Presentation of Financial Statements. {www.iasb.org.uk}
6. Annual Report 2000, Islami Bank Bangladesh Limited, Dhaka: Islami Bank Bangladesh Limited, pp 52. {www.islamibankbd.com}
7. Annual Report 2005: MCB Bank Limited, Islamabad: MCB Bank Limited. {www.mcb.com.pk}
8. Saeed, Khawaja Amjad, General Presentation on Disclosure in Financial Statements of Islamic Banks and Financial Institutions. A presentation given in the conference organized by International Institution of Islamic Economics during December 18-21, 2002 in Islamabad, Pakistan.
9. Annual Report and Accounts 2004: Standard Chartered Bank, London. February 16, 2005, pp 130. {www.standardchartered.com/investors}
10. Al-Quran, relevant verses.