Unique Financial Statements Used by Islamic Financial Institutions - dummies

Unique Financial Statements Used by Islamic Financial Institutions

By Faleel Jamaldeen

In addition to the four financial statements most commonly issued by all corporations, Islamic financial institutions issue four more. That’s because an Islamic institution must keep certain pools of money separate — because of their special nature compared to other activities — to achieve purity and transparency regarding how money is being used. Here are the four statements you find only in Islamic financial reporting:

  • Statement of changes in restricted investments and their equivalents: When investors place their money with an Islamic financial institution, they have the choice of selecting their specific investments or making restricted investments. The institution must issue a separate statement that shows these restricted transactions so the investors are confident that their money has been used according to their specifications.

  • Statement of changes in the interest-free loan fund: Islamic financial institutions also have a separate fund for providing qard hasan — interest-free loans — to fulfill their social responsibilities. Most often, these loans are offered to bank employees who are getting married, need medical treatment, or are pursuing education opportunities. Again, a separate statement is prepared by the Islamic financial institution to show activity in this fund.

  • Statement of changes in the policyholders’ surplus (issued by takaful, or Islamic insurance, companies only): Participants in a takaful fund benefit from any surplus money remaining in the pool at the end of the year. This statement spells out how much surplus exists so policyholders are clear about the amount and how it’s distributed.

  • Statement of changes in the charitable fund: Each Islamic financial institution has a separate fund for zakat — alms that are donated directly by customers — and for other charitable funds that arise from transactions, including certain types of fees that the firm cannot accept as income. The financial institution must prepare a statement to show changes to this fund.

This last statement warrants a bit more explanation because this fund is so crucial in fulfilling the bank’s social responsibilities.

An Islamic bank is obliged to pay zakat if local and/or national laws require it; if its stockholders pass a resolution requesting that it do so; or if its charter requires it. Zakat is paid into the bank’s charitable fund. (Note: The words zakat and charity don’t mean the same thing. Zakat is an obligation; charitable giving is voluntary.)

The fund may receive money directly from customer contributions, or it may receive money in these ways:

  • Directly from customer profits: Customer profits are charged a certain percentage for zakat, which is allocated to the charitable fund.

  • From various business operations. Here are just two examples of ways the charitable fund receives money from business operations:

    • Penalties for default: If a customer who has a murabaha (cost plus profit) or ijara (lease) contract with the Islamic bank defaults on his payment, the bank can’t charge the customer interest based on the default date or amount owed. But the bank must be permitted to take some punitive action or else it runs enormous credit risk and sets itself up for liquidity problems.

      (Why would borrowers pay if they didn’t incur a penalty for defaulting?) For these reasons, Islamic scholars agree that customers can be fined a penalty. That gives customers incentive to make each payment installment. However, the bank can’t take these penalties as other income; it must give the money to the charity fund.

    • Equity compliance: Equities go through a screening process to determine whether they’re sharia-compliant and therefore acceptable for Islamic investment. But scholars understand that in the real world, few if any companies can achieve 100-percent compliance.

      Therefore, if a bank wants to invest in a company that has 5-percent noncompliant activities, the bank can accept dividends and capital gains from that company as long as the bank gives 5 percent of such income to the charity fund.

How is the charitable fund used? In a Muslim country, the bank turns over the zakat portion to an external authority that collects such moneys. The bank may use charitable contributions to fund education initiatives, support the poor and needy, supplement its qard hasan (interest-free loan) fund, and more.