Islamic Bank Balance Sheet and Profit and Loss Account
The format of an Islamic bank’s balance sheet has a very significant difference, namely, the investors’ (deposit) funds, except current accounts, are not reported as the bank’s liabilities, since they are accepted on a fiduciary basis. These funds are reported in the balance sheet below the line as funds under management. Ideally the bank’s balance sheet will have two parts – one showing the bank’s own funds and current accounts (whose repayment is guaranteed by the bank), and the utilisation of these funds. The other part will show the client’s funds accepted on a fiduciary basis and their employment.
In actual practice there are some occasions (as in Musharakah) when funds of both kinds are invested together. In such cases, care has to be taken to ensure that the distribution of profit/loss on the investments is proportionally correct.
Some Central Banks, however, insist that the clients’ funds given on a Mudarabah (fiduciary) basis be also reported on the balance sheet. In such cases another set of balance sheet is prepared to meet the requirements of the Central Bank.
Other than this major difference in reporting client funds, the pattern of reporting the liabilities and assets of an Islamic bank substantially resembles to a conventional bank’s balance sheet.
So far as the profit-and-loss account is concerned, the method of reporting is similar in the two systems, except that a conventional bank reports interest paid to or received from the clients on deposits and loans, whereas the Islamic bank reports the figures of profit paid to or received from the clients on Investment accounts/financings.
Given below is a small format of the balance sheet.
Liabilities + Equity
Issued, Subscribed and Paid up Capital
Islamic Debentures and Bonds
Current Deposits, Contingency Accounts
Investment Accounts (Deposits): 3 months 6 months 12 months Over 12 months
Amount due to other Banking companies
Profit and Loss Account (in case of profit)
Cash in hand
Balances with Central Bank
Balances with other banks and financial Institutions
Islamic securities (approved for statutory purposes)
Money at call and short notice
Investments in other Islamic securities
Bank Premises, Furniture and Equipment
Other Assets (Advance payments made, suspense account, etc.)
Profit and Loss (in case of Loss)
The usual headings appearing in the Profit and Loss account are:
Profit on financings
Profit earned on inter-bank placements
Profit on investments
Commission, fees, exchange and brokerage
Other income (rent, etc.)
Loss’(if expenditure exceeds income)
Profit paid on inter-bank funds
Salaries, allowances and other staff benefits
Rent, taxes, insurance, lighting, etc.
Stationery and printing
Publicity and advertisement
Depreciation and repairs of property
Profit before tax (if income exceeds expenditure)
The Balance Sheet and Profit-and-Loss account are followed by explanatory notes on Accounts explaining material items and accounting policies followed.
Capital and Reserves
The role of Minimum capital requirement is also important in the Islamic financial Industry, although the calculation of the charge may differ, depending on the risk exposures. Basle II deals with the minimum capital requirement .This capital is the regulatory capital. The calculation of the minimum capital is derived with the help of Capital adequacy ratio (CAR), which is defined as ratio with numerator representing the amount of available capital and the denominator a measure of the risk faced by bank.
An Islamic bank issues Ordinary shares but no Preference shares, as the latter carry a fixed rate of return and enjoy priority over Ordinary shares. Other than that, presentation of capital is similar to that of a conventional bank. Islamic Debentures and Bonds are described later on.
Statutory Reserve and Other Reserves have the same meanings as in a conventional bank. Most Central Banks require the banks to transfer a minimum percentage of their profit after tax to the Statutory Reserve till it becomes equal to the Capital amount. Other Reserves are created according to the judgement of the Board of Directors or recommendation of external Auditors, to provide against assets whose realisation become doubtful.
Islamic financial institutions have a more difficult task balancing between the economic capital and statuary capital. Non-availability of liquidity support from the market, non existence of inter-bank money market for Islamic banks, and absence of secondary market may create more pressure on capital requirement of the Islamic banks. This, together with the commitment for current account and investment account holders, exposes the Islamic bank to larger capital requirement.
The instruments used by Islamic bank to attract funds are:
a) Current and Contingency Accounts
These are similar to current accounts with conventional banks as regards the obligation of the bank to return the credit balance upon demand. The procedures for deposits and withdrawals are also similar. The relationship between the depositor and the bank is that of lender and borrower, and the capital of the bank is fully subject to the claims of current account holders, who enjoy cheque facilities. No profit is paid on current accounts. Contingency accounts cover Items such as Sundry Deposits which are pending proper allocation.
Ordinary savings accounts are payable on demand. The procedure and formalities of deposits and withdrawals are almost identical in both systems. A savings account holder may be provided with a passbook or a cheque book to make withdrawals.
The ordinary savings account holder can be given some incentive in the form of a non-fixed prize or bonus, or reduction in, exemption from, bank charges, at the bank’s discretion, to attract savings deposits. The incentive is, however, not predetermined and is not contractually fixed.
In an Islamic savings account, the depositor may, if he so wishes, assign to the bank the right to invest the deposited sum and it then becomes a profit-and-loss sharing (PLS) account. Since interest is forbidden, profits (or) losses are realised by investing these deposits usually in low-risk asset such as balances with banks and secured short-term financings.
c) Investment Accounts
The funds are provided to the bank by the investor on a mudarabah basis.
There are two main types of investments accounts: namely, Specific Purpose (restricted), and General Purpose (unrestricted).
In the first category, the provider of funds (client) authorises the bank to invest the fund in particular projects or sectors for a specific period, determining the level of risk to be taken. In the second category, the client gives the Islamic bank an unconditional authorisation to invest the fund without any restriction as to sector, project or period etc., provided all transactions are in compliance with the Islamic principles and fall within the bank’s investment criteria. The bank uses its full discretion in managing the affairs of the mudarabah; for example, appointing an agent for selling, buying, leasing the assets of the mudarabah, etc. and takes other necessary actions for the benefit of the mudarabah, such as creating reserves to meet contingencies. Investment accounts are usually held for short terms such as three, six or twelve months. A smaller portion is also held for longer terms up to five years.
These mudarabahs (pools of funds) are created with different characteristics (level of risk, amount, period, ratio of profit distribution, etc) to suit different types of investors. If funds in some pool(s) are not enough to invest profitably, banks normally combine the balances in different pools for investment purposes, and then distribute the total profit on a weighted basis. Since banks prefer to have long-term resources to cater for their long-term investments (which bring a higher return and facilitate fund management), more weight is usually given to long-term customer funds.
The bank’s management fee is an agreed percentage of the mudarabah profit; in the case of loss, the bank gets no management fee. Mudarabah assets are valued at defined intervals to arrive at the profit/loss figure. For Islamic banks to increase and diversify their activities, the development of new financial instruments has become a priority. Most of their activities have, so far, been directed to short-term operations, but some financial instruments of medium and long-term nature also exist, and are being created, in order to provide more stability to the bank’s resources, and to cope with the financial needs of development activities.
The following are some of the medium and long-term Islamic financial Instruments:
a) Islamic Certificates of Deposit: the Islamic certificates of deposit are not tied to a certain project or activity. They are issued with specific maturities. The issuing bank serves as mudarib, and the funds are segregated from other investment operations of the bank.
b) Islamic certificates of investment: these certificates provide finance for a specific project.
c) Mudarabah Bonds: these bonds represent a more stable source of funds. They are for long-term, say 10 to 20 years, and may be listed on the Stock Exchange. Thus, they may be traded in the secondary market. These bonds differ from the Interest-bearing bonds, as they do not have a fixed yield, but they provide a return proportionate to the profit realised. In other words, bond-holders are similar to shareholders, except that the bonds mature at a particular date. So bonds of the same denomination tend to have a market value close to the market value of the shares of the bank.
e) Participation Term certificates.(PTCs): these are substitutes for debentures in conventional banking, issued for raising medium and long-term loans for industrial financing. PTCs are transferable corporate instruments based on the profit-and-loss-sharing principle. They are usually secured by a legal mortgage on the fixed assets of the company. In the matter of distribution of profit, PTC holders rank before the shareholders. In the event of loss, the PTC holders bear it in proportion to their contribution, (after exhausting the company’s reserves). PTCs are usually issued by industrial undertakings, but can be issued by an Islamic bank also as a substitute for debentures to augment its resources.
Some governments have also issued Islamic securities, e.g. in Malaysia; the government has issued Government Investment Certificates to finance its deficit as a substitute for interest-bearing government securities. Islamic financial institutions are able to put their surplus funds in these certificates. Iran has issued Participation Bonds on Islamic principles for investment in economic projects with a positive rate of return. The bonds are negotiable and are quoted in the market. Reserves created by the bank, and retained earnings, i.e. unappropriated profit, also form part of the bank’s resources.
In almost every country the Central Bank requires the banks to keep a certain percentage of its liabilities in the form of cash-in-hand, and a certain percentage in the form of statutory deposits with the Central bank, which is usually interest-free. The Central banks also require a minimum percentage of the bank’s liabilities to be invested in approved financial instruments such as government securities, Treasury Bills, specified bonds, debentures and Unit Trusts. This poses a problem for the Islamic bank, as these instruments are mostly interest-based. The amount to be invested in these instruments is quite high, usually 20-35% of the bank’s liabilities. No bank can afford to keep so much of its funds not earning anything. It reduces the profit potential of the Islamic bank and in turn the return to the investors, hence, the necessity of devising Islamic substitutes for these instruments. Some have been created such as PTCs and Malaysia Government Investment Certificates, but many more have yet to be designed.
Then comes the balances with other banks and financial institutions, and money at call and short notice. Money at call and short notice represents funds invested overnight or for a short period. Arrangements need to be made with other institutions so that the Islamic bank’s funds are kept in profit-and-loss-sharing accounts.
Funds are also placed in trade pools, commodity pools, etc. which are free of interest.
Accounting valuation concept
Briefly, the valuation of the assets, liabilities and restricted investments of Islamic banks depends on their current cash equivalents. To make this valuation comparable and reliable, the banks should adhere to the following principles:
a) To the extent possible, realisable values in the current market should be ascertained. The market should be one in which a particular asset is normally sold or purchased by the bank.
b) All relevant information, whether positive or negative, should be utilised.
c) To the extent possible, experts in valuation should be utilised.