The UAE Accounting Equation: Balancing Islamic Finance

Discover the intricate world of Islamic finance and its practical applications within the UAE’s unique economic landscape. Explore the principles and applications of accounting equation in this comprehensive guide.

Islamic financing has made a lot of progress in the financial world over the past many years and has now proven to be a serious contender to conventional financial instruments in the UAE.

Still in its infancy compared to the older conventional banking system, there are stumbling blocks to coming up with Islamic financing products that are able to compete with their conventional versions. The challenges are slowly being overcome. One of the major ones is the interplay between the laws of the UAE and Islamic concepts.

The Islamic concept is an abstract form of law derived from Islamic laws and is capable of adaptation, evolution, and further interpretation. It is not a written law in the UAE. The Shari’a does not give general principles of law but instead purports to deal with and cover particular cases or transactions and sets out rules that govern them.

Applicability of Shari’a Principles in the UAE

The main challenge in structuring and offering Islamic-compliant products in the UAE is to bridge the current mismatch between the laws of the UAE and the principles of Shari’a.

In many instances, the UAE law’s provisions reflect Shari’a principles, such as the prerequisites relating to capacity to contract, the demand for clarity of contractual terms, the absence of coercion, and the specific conditions governing sale and purchase transactions. In these instances, such transactions fully comply with Shari’a elements and the UAE system from the outset.

Islamic Finance: A UAE Legal Perspective

1. Introduction

Almost three decades ago, the concept of Islamic finance was considered wishful thinking. Today, more than 500 Islamic financial institutions are operating worldwide, estimated to be managing funds in the region of US$200bn. Their clientele is not confined to citizens of Muslim countries but is spread over Europe, North America, and the Far East. Muslims now have the option to invest their financial resources following the ethics and philosophy of Islam.

The first thorough studies on establishing Islamic financial institutions (referred to hereafter also as Islamic Banks) appeared in the 1940s. Although Muslim-owned banks were established in the 1920s and 1930s, they had similar practices to conventional banks. In the 1940s and 1950s, many experiments with small Islamic Banks were done in Malaysia and Pakistan. The first great breakthrough was the establishment of an Islamic Bank in the Egyptian township of Mit Ghamr in 1963. Other successes include establishing the Inter-Governmental Islamic Development Bank in Jeddah in 1975 and several commercial Islamic Banks, the likes of the Bahrain Islamic Bank the Dubai Islamic Bank, and the Kuwait Finance House, in the 1960s and 1990s. Commercial banks have also realized this new field’s potential and several major worldwide institutions have grasped Islamic banking as a significant mechanism for more diversified growth.

This feature aims to provide a general overview of Islamic finance. It describes the fundamental principles of Islamic finance, the main financing techniques, the services usually offered by Islamic Banks, and relevant laws and regulations for establishing such Islamic Banks.

2. Principles of Islamic Finance

Background

Islam, the religion of Muslims, is a complete way of life with goals and values that cover all aspects of human life, These things include social, economic, and political matters. It is not a religion in the limited sense of the word, interested only in man’s salvation in the life to come, and rather, it is a religion that organizes life completely. The body of Islamic Law is known as “Shari’a,” and the exact literal translation of “Shari’a” is “a clear path to be followed and observed.”

The Shari’a is not a codified law. It is a mixed form of law capable of adaptation, development, and further interpretation. The Shari’adoes did not prescribe general principles of law. Instead, it purports to deal with and cover specific cases or transactions and set rules governing them.

The Shari’a developed through four major Islamic juristic schools of thought, the main ones being the (Hanafi, Maliki, Shafi, and Hanbali) and is taken from two primary sources, the Holy Book (the transcription of the Almighty’s message to the Prophet Mohammed) and Sunna (the living tradition from the Prophet Mohammed), on top of this to two dependent sources, includes ijma (consensus) and ijtihad/qiyas (personal reasoning by analogy).

The recent surge of religious consciousness amongst Muslims has provided the drive for implementing and adopting Islamic principles in financial transactions. In an attempt to purify assets in Islam’s eyes, Muslims seek a greater balance between their lives in the modern technological world and their religious faith and beliefs.

Accordingly, Islamic scholars deduced from the Shari’a three principles that form the backbone of Islamic economics and set Islamic finance apart from its conventional counterpart. These are briefly listed as follows:

The Prohibition of Interest (Riba)

The ban on usury or interest (Riba) is the most significant principle of Islamic Finance. Riba translates literally from Arabic as “an increase, growth or accretion.” In Islam, lending money should not make unearned income. As a Shari’a term, it refers to the premium that the borrower must pay to the lender along with the principal amount as a condition for the loan or for an extension in its maturity, which today is commonly referred to as interest.

Security arrangements for Shari’a financing

Security arrangements for Shari’a-compliant products are similar to the conventional ones. However, with modifications to remove elements of interest or usury. One can, therefore, expect to get the usual security papers. This includes things such as mortgages, assignments over assets, obligations, and guarantees. While the desirability of such security arrangements depends on the underlying Shari’a structure, the UAE courts will enforce such security documents if they have been duly perfected under UAE law.

Accounting Equation

This thing called an Accounting Equation is also called the Balance Sheet Equation. We all know we record all business transactions using the Dual Aspect concept. This means that each debit has an equal credit and vice-versa.

This approach classifies the accounts as follows:

1. Assets Accounts: Assets are a business’s properties, possessions, or economic resources that help in business operations and in earning revenues. These are measurable in terms of money. However, the assets of a firm may be tangible or intangible. Also, we can classify the assets as Fixed Assets and Current Assets. For example, land, buildings, furniture and fixtures, plant and machinery, vehicles, debtors, bills receivable, bank balance, Cash, stock, etc.
2. Liabilities Accounts: Liabilities are the amounts that an entity owes to the outsiders, obligations, or debts payable by the entity. We can also classify the liabilities as Long-term and Current. For example, debentures, bank loans, creditors, bills payable, rent outstanding, short-term loans, bank overdrafts, etc.
3. Capital Accounts: Capital or Owner’s Equity is the money the owner brings into the business. The owner can bring Capital in the form of Cash or assets. It is an obligation of the business, and it has to pay back this amount to the owner as the business is a separate entity from its owner. Therefore, we show the Capital on the liabilities side of the Balance Sheet. Also, we show the Capital account after deducting the Drawings by the owner. Drawings are the amount of money, goods, or assets the owner takes from the business for personal use. Also, the profits increase the Capital, and losses decrease it.

The Accounting Equation is:

Assets = Liabilities + Capital (Owner’s Equity)

Or

Capital = Assets – Liabilities

It is to be said here that the Accounting Equation shall remain balanced every time, as we know, each transaction has a Dual aspect. Thus, each debit has an equal credit.

Solved Example on Accounting Equation

Analyze the given transactions under the Accounting Equation Approach.

1. Commenced business with Cash ₹500000
2. Purchased goods ₹25000
3. Paid salary ₹10000
4. Sold goods costing ₹20000 at a profit of 25% on the cost
5. Paid salary in advance ₹2000
6. Introduced additional Capital ₹10000
7. Purchased computer ₹15000
8. Deposited ₹50000 into the bank 

Ans.

Analysis of transactions:

1. It increases the Cash thus, adds to Cash. Also, it increases the Capital, hence adding to Capital.
2. Goods are purchased. Thus, Cash is decreasing. While goods are coming in, they are increasing. Therefore, deduct Cash and add goods.
3. Salary is paid; therefore, Cash is decreasing. While salary is an expense. Thus, deduct Cash and also deduct from Capital.
4. Goods are going out; thus, deduct them. Thus, Cash is coming in. Add it. Also, add the profit to Capital.
5. Salary is paid in advance, which is a current asset. Deduct Cash and add salary paid in advance.
6. Cash and Capital are both increasing. Hence, add Cash and Capital.
7. Cash is decreasing while the computer is increasing. Therefore, deduct Cash and add it to the computer.
8. Cash is decreasing, and bank balance is increasing. Therefore, deduct Cash and add to the bank.