An accounting perspective on the use of combined contracts and donations in Islamic financial transactions

Purpose - The purpose of this paper is to investigate the techniques used by Islamic financial institutions (IFIs) to shift conventional instruments toShariah-compliant instruments. The paper additionally aims to explore the effect of these techniques on financial reporting. Design/methodology/approach - The study recognized two techniques used by the IFI: the combination of contracts which compartmentalizes the economic transaction into a series of linked sub-transactions, and the inclusion of donation (Tabarru) in commercial contracts. The paper also reviews the accounting treatment according to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and compares it to the concepts adopted by the traditional financial reporting framework concepts (especially substance over form concept). Findings - With regard to the combination of contracts technique, the major accounting challenge is whether the substance over form concept is considered. Mixed results are found: in some products, the economic substance is presented in the financial reports, while in other cases, the legal form of the contract is reported. This ambiguity may hinder the faithful representation of financial statements. TheTabarrucontract is used to justify the risk-shifting practices by Islamic banks. The accounting effects of such contracts may result in failure to recognize assets or liabilities in the financial reports, earnings management and incomplete financial information for the users of the financial reports. Originality/value - This study is a response to the call raised by the consultative group established by the International Accounting Standards Board. It provides an additional insight into the accounting treatments for a combination of contracts andTabarrucontracts. It also contrasts the accounting treatments, as stipulated by the AAOIFI, with the conventional accounting frameworks.