How should Islamic financial institutions account for Zakat?

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 [email protected] 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:

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

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.

zakah -zakat (Finding zakah but excluding zakat)

zakat -zakah (Finding zakat but excluding zakah)

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.

1. My personal response to AAOIFI