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How should Islamic financial institutions account for Zakat?

My response to the proposed AAOIFI Financial Accounting Standard for Zakat. I disagree with part of it.

Summary

Posted 22 August 2020

The Accounting and Auditing Organization for Islamic Financial Institutions ("AAOIFI") is proposing to issue a Financial Accounting Standard on accounting for Zakat.

The text was issued as an exposure draft, and comments can be sent to AAOIFI until 30 October 2020.

Below are:

  1. My personal response to AAOIFI
  2. My article in the August issue of Islamic Finance News on the subject with more details.
  3. A short explanation of Zakat for those unfamiliar with it.
  4. A brief note on the spelling: Zakat or Zakah?

1. My personal response to AAOIFI

I sent AAOIFI the letter reproduced below by email.

9 August 2020

By email to accounting@aaoifi.com

AAOIFI Accounting Board
AL Nakheel Tower
10Th Floor, Office 1001, Building 1074,
Road 3622 Seef Area 436,
Kingdom of Bahrain

Dear Sir

Comment on Exposure Draft (F5/2019) v5.1 Financial reporting for Zakah

I have the following comments.

Firstly, the final standard should be more precise about how Zakah expense is reported in the income statement, as this ensure greater consistency between reporting entities.

My experience is that Islamic bank accounts usually report Zakah expense below the annual profit before taxation and Zakah. This presentation should be made mandatory, with Zakah either being included in a combined “Taxation and Zakah” number which is then decomposed in the notes to the accounts, or there being two lines immediately following the “Annual profit before taxation and Zakah” to report “Taxation” and “Zakah.”

Secondly, I disagree with paragraph 5 of the proposed standard “An institution obliged to pay Zakah by law or by virtue of its constitution documents shall recognize current Zakah expense in its financial statements in line with the requirements of paragraph 6.”

In my opinion, where Zakah is not required to be paid by law, but is required by virtue of the constitution document of the Islamic financial institution, the treatment of paragraph 8 should apply.

My reasoning was set out in an article published on 5 August 2020 by the magazine “Islamic Finance News” on page 16. I have included a copy in this letter, immediately after the appendix which gives you more background on my involvement with Islamic finance.

Yours faithfully

Mohammed Amin

I have not reproduced the appendix with my Islamic finance background. It was a lightly edited version of the section on my "About me" page "Islamic finance credentials".

2. IFN article: "AAOIFI Exposure Draft on Financial Reporting for Zakah"

On 8 July 2020 the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) issued Exposure Draft (F5/2019) v5.1 “Financial reporting for Zakah.” Responses are requested by email to accounting@aaoifi.com by 30 October 2020.

When adopted as an AAOIFI Financial Accounting Standard (“FAS”) it will replace AAOIFI FAS 9 “Zakah.” That was developed in 1998, before AAOIFI Shariah Standard 35 “Zakah” issued in 2009. Later AAOIFI recognised that there were “several contradictions” (all quotations are from ED F5/2019) between FAS 9 and SS 35.

ED F5/2019 focuses on “recognition, presentation and disclosure.” Paragraph 4(b) of the proposed FAS contains the key definition:

“4(b) Institutions obliged to pay Zakah – are such institutions that are required to pay Zakah on net assets pertaining to certain or all relevant stakeholders whereby one or more of the following conditions is / are met:

  1. when the law requires the institution to pay the Zakah obligation;
  2. when the institution by virtue of its constitution documents is required to pay the Zakah obligation;
  3. when the general assembly of shareholders has passed a resolution requiring the institution to pay the Zakah obligation; or
  4. where the contract with certain stakeholders require the institution to pay the Zakah obligation.”

Specific treatments are then prescribed, separately for cases (i) and (ii), and for cases (iii) and (iv).

“5 An institution obliged to pay Zakah by law or by virtue of its constitution documents shall recognize current Zakah expense in its financial statements…” This covers cases (i) and (ii).

“8 Where Zakah is not required to be paid by law or by virtue of its constitution documents, and where the institution is considered as an agent to pay Zakah on behalf of stakeholders, any amount paid in respect of Zakah shall be adjusted with the equity of the relevant stakeholders.” This covers cases (iii) and (iv).

ED F5/2019 does not specify the position of Zakah expense in the income statement. Islamic bank accounts usually report Zakah expense below the annual profit before taxation and zakah. To ensure consistency between institutions, the standard should have mandated this presentation.

More importantly, in my opinion category (ii) above should have been treated like category (iii) and not like category (i).

In some countries, Islamic banks are required by law to pay Zakah. It is clearly right that in category (i), Zakah payable by law is an expense, as is corporate income tax.

In the UK, the law does not require Zakah payments so case (i) is irrelevant.

John, a Muslim, creates and is sole shareholder of an Islamic bank. Its initial articles of association (the incorporation document of a UK company) oblige it to pay Zakah.  ED F5/2019 requires John’s bank to treat Zakah payments as an expense since category (ii) applies.

Jane also creates and is sole shareholder of a UK Islamic bank. Its articles of association do not mention Zakah. However, rather than paying Zakah herself (Jane is also a Muslim), Jane passes a shareholder resolution each year requiring the bank to pay Zakah to avoid her having to. ED F5/2019  classifies the Zakah as a reduction in equity since this is category (iii).

If both banks have identical financial results, they will nevertheless report different earnings per share because John’s bank treats Zakah as an expense. That is illogical.

At any time, as sole shareholder John could amend the Articles of Association, removing its Zakah obligation, to move from category (ii) to category (iii) to boost its earnings per share. In substance, the two banks are identical.

3. A short explanation of Zakat for those unfamiliar with it.

Zakat is explained quite well in the Wikipedia article "Zakat". It is a charitable donation / tax payment made by Muslims and computed by reference to capital wealth owned.

Charitable donation

In Muslim minority countries, and in Muslim majority countries with a secular constitution, it is between the individual Muslim and God what the individual gives, and how he or she gives it. In such societies, Zakat is properly described as charity.

Tax payment

When the Prophet Muhammad was ruling the Muslim community in Medina, and during the subsequent Caliphs, the payment of Zakat was compulsory. Indeed the "Apostasy wars" were fought under the first Caliph Abu Bakr when some Arab tribes rebelled by refusing to pay zakat into the central treasury.

In some Muslim majority countries, Muslims are required by law to pay Zakat to state Zakat collectors. For example in Saudi Arabia, there is a government ministry "General Authority of Zakat & Tax".

In such countries, Zakat is properly described as a tax, since its payment is compelled by the state, just like any other tax.

4. A brief note on the spelling: Zakat or Zakah?

The language of the Quran is classical Arabic, and that is also the language of the major Hadith collections and of the early Islamic scholars. However my language, and the language of most readers of this website, and of the magazine "Islamic Finance News" is English.

The religious concept under discussion has a name in Arabic. There are various standard ways of transliterating Arabic into English, and they normally transliterate the Arabic name into English as "Zakah."

However, as explained on my page "The language of international Islamic finance is English" the English language has always absorbed foreign words. The English language name for the religious concept under discussion is "Zakat" or "zakat". It is capitalised by those who wish to emphasise its religious significance.

My Google searches today came up with the following results:

zakah -zakat (Finding zakah but excluding zakat)

About 2,150,000 results.

zakat -zakah (Finding zakat but excluding zakah)

About 31,800,000 results.

This demonstrates unambiguously that the correct spelling for the name in English of the religious concept is "Zakat." That is why I always use that spelling in my own writings.

In the Islamic Finance News Column above, I used "zakah" deliberately because that was used by AAOIFI in their Exposure Draft. I expect that most staff at AAOIFI are native Arabic speakers, and that they see the English version of their Exposure Draft as a a transliteration of Arabic, rather than as a native English document.

 

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