A REVIEW OF INCOME AND VALUE MEASUREMENT CONCEPTS IN CONVENTIONAL ACCOUNTING THEORY AND THEIR RELEVANCE TO ISLAMIC ACCOUNTING

Shahul Hameed Bin Hj .Mohamed Ibrahim

Abstract

The purpose of this essay is to review the various proposals suggested in the accounting literature on the measurement of income and value and discuss their relevance to Islamic accounting. In Part I of the essay, the definitions of the concepts of income, capital, value and capital maintenance and their inter-relationships are discussed. Alternative income measurement models including traditional accounting, economic and current value models are then elaborated . Belkaoui's (1992) evluation of the different income measures is then discussed.

In Part II, The world view and nature and objectives of Islamic Accounting, as opposed to conventional accounting is discussed as a background to possible differences in income and valuation concepts in Islamic Accounting. Two main institutions of Islam, Zakat and the prohibition of interest and its consequences for income and valuation models are discussed. Finally, the relevance of conventional accounting's income measurement and valuation models are examined in the light of zakat determination and equitable profit distribution and avoidance of doubt and conflict among stakeholders. It is concluded that a form of current value based income models are more compatible with the Islamic accounting objectives of fairness and full disclosure.

Part I: A Review of Conventional Income and Valuation Models

1. Introduction

Measurement and valuation of assets, liabilities and the consequent determination of income have been the most intractable problems in accounting theory. In fact the true income school is one of the most important schools of accounting theory which concern is to find a measure of 'true income' (AAA 1977). Various income measurement models have been put forward in the literature. This issue is undeniably intertwined with the problem of asset valuation if one adopts a Hicksian economic concept of income as the difference in "well- offness". Even under a traditional accounting concept of income as the residue of revenue over expenditure. the recognition of revenue and costs and the amount of depreciation which depends on how assets are valued presents the same problems.

2. The Importance of Income Measurement

In conventional accounting, the determination of income or 'profit' is one of the main function of accounting as it determines wealth transfers between persons. For example, Employee bonuses are often made based on income numbers. Dividends of investors are dependent on income (although dividend policy may not lead to a direct relationship). Income is also a measure of the efforts and accomplishments of management of a business upon which they are rewarded (bonuses / share options) or otherwise. Their future employment prospects may depend on income numbers as their effectiveness is often evaluated by investors on the basis of company earnings. Income is also a guide to investment e.g. earnings per share , based on an income number is a major indicator on which share value depends on which investors make decisions on whether to buy , sell or hold their investments. In addition, accounting income is the basis of taxation although it is adjusted to comply with requirements of fiscal policy. In Islamic accounting, wealth and profits are both bases on which Zakat (Islamic tax) is assessed on individuals and organizations. It becomes especially important because interest is forbidden in Islam and thus a predetermined fixed return on capital is prohibited. Thus profit or income is especially important in Islam, more so than in conventional accounting for the income is the only basis on which financiers get a return on the renting/employment of their capital. Further income measurement has taken up a major portion of the subject of accounting theory and there have been entire books devoted to the subject e.g. Davidson et al (1964). Hence it can be seen that income is a very important concept , we shall therefore review the concept of income in the literature next.

3. Accounting and Economic Concepts of Income

We have seen above how the concept of income is important in accounting. However, as Lee (1985, p6) observes, despite this importance in both accounting theory and practice , there is little relevant literature in accounting devoted to the exposition of the fundamental nature of income. The more important works have been in the economics and or inter-disciplinary literature by authors with an economics background (e.g. Fisher (1906), Canning (1929), Lindahl (1933), Sweeney (1936), McNeal (1939), Hicks (1946) and Alexander (1950)). Income to the economist is different than what it means to the accountant. According to Parker and Harcourt (1969)

Hence, economists define income as an ex ante measure i.e. before the event in terms of future expectations whereas accountants measure income as the result of economic activities of an entity for a defined past period of time i.e. ex-post. We shall now discuss the differences in some detail.

Accounting concept of income

The traditional definition of income or profit by the accountant is the surplus resulting from business activity , resulting from the cash to cash cycle of business operation. It is arrived by matching the revenues against the associated expenses of an entity for a period of time (usually a year) known as the financial year. Thus income is determined ex-post i.e. after the event . The matching process causes an aggregation of unallocated costs to be carried forward (in the balance sheet) at the end of the defined accounting period. These unallocated costs (non-monetary assets) together with the monetary resources of the entity after deducting the liabilities gives rise to a residue called accounting capital or residual equity. Accounting income therefore results in a corresponding measure of capital and in fact analyzed as a temporal change in capital. The exact definition of accounting income has been elusive as it can mean many things. Pertinent questions include:

Does income include incidental gains which are not the main activity of the organization e.g. sale of fixed assets (extraordinary and exceptional items )?

Does income include gains which occur infrequently (non-maintainable earnings/quality of earnings). This has implications for share-price in the market.

Does income include unrealized holding gains arising from increases in the value of assets?

The FASB (1980) for example , has come out with the term "comprehensive income" which is taken to include all changes in equity except those that result from investment by and distribution to owners. According to Belkaoui (1992, p 204), this is more inclusive than the traditional concept of accounting income. Presumably, this would include loan receipts in income as well, as long-term creditors are not owners of business although this would not be correct.

Economic concept of income

On the other hand, the economist consider income as a series of personal psychic experiences i.e. enjoyments or perceived events of a more personal nature rather than arising to an entity (Fisher 1930). In fact, according to him, an artificial entity such as a business cannot have an income because it has no consciousness. The absolute necessity of consumption to Fisher's concept of income was so important that he did not recognize savings as income because he considered savings was only potential consumption from which no psychic enjoyment is derived. However, later economists have adapted his personal income concept to the business entity by including savings in addition to consumption as part of income.

Since personal enjoyments are subjective and is not measurable directly, Fisher approximated it by going two steps behind enjoyment income to the cost of living or the money measure of real income i.e. the monetary value of the final consumption of physical goods and services in the outer world.

Hicks (1946) extended the concept of economic income to include what is known today as the maintenance of capital intact, before any income is recognized. Following from the idea that "income calculations in practical affairs is to give people an indication of the amount they can consume without impoverishing themselves", he introduced the concept of well-offness as a basis in the approximation of personal income of Fisher. According to him, income is :

This elegant definition which insists that the capital must be returned before income can be calculated, however, begs the question, how 'well-offness' is defined. This is answered in part by Hicks himself . He further elaborates & operationalises his well-offness concept in a series of approximations i.e.

1) under conditions of unchanging interest rate and absence of inflation

2) under changing interest rate but no inflation

3) under fixed interest rate with inflation

and defines income under each of these conditions.

Under condition 1, income is defined to be the maximum amount which can be spent during a period , if there is an expectation of maintaining intact the capital value of prospective receipts ( in money terms ).

Under condition 2) income is defined as the maximum amount a person can spend in a period and still expect to be able to spend the same amount in each ensuing period. This definition reduces to the one under condition 1) when interest rates are fixed.

Under condition 3) income is defined as the amount a person can spend in a period and still be able to spend the same amount in real terms in the ensuing weeks.

Economic income thus can be written in the following equation:

Ye= C+Kt-Kt-1 where

Ye = economic income

C = consumption

Kt and Kt-1 are the capital at the end and beginning period respectively as measured by the present value of expected future cash flows at times t and t-1 respectively.

This can be compared with the accounting income Ya,

Ya= Rt-Rt-1 +D where Rt and Rt-1 is the residual equity at the end and beginning of the period and D is dividend distributed to owners. Although the equation is similar, economic income is the result of capital valuation at the beginning and of the period as the capitalized value of the expected future receipts in contrast to accounting income which results from the matching process resulting in a residual capital. Hence in economics, income is the residue i.e. the economists computes capital to measure income whereas in traditional accounting, capital is the residual figure after income is calculated.

Economic under uncertainty is termed ideal income (Lee, 1985, p31). In a "dynamic economy" to borrow the term of Alexander (1977), where values are changing both because prices and expectations are changing, this income cannot be computed objectively and therefore is impractical for business. Predicting the amount and timing of cash flows and choice of an appropriate discount rate (which depends on the individual's preferences and the availability of alternative investments) approximating the entity's opportunity cost presents considerable problems. Further in economic income, it is assumed that returns of capital included in the realized cash flow is reinvested at the discount rate. This presumes that reinvestment can be made and the interest rate remains constant. However this is not the reality in a world of uncertainty and will lead to unexpected gains (referred to as windfalls by Lee 1985). The reiteration of the reinvestment in subsequent periods compounds this problem. Finally there is a problem of the assumption of constant well-offness which is not realistic because in reality, a person or a business would have as one of its objectives capital growth. Despite the fact that growth can be incorporated in the economic in the model (e.g. Gordon's Dividend growth model), the prediction of the growth rate confounds the problem.

However, economic income is considered to be the most perfect of all income models theoretically, because the value of capital is undeniably related to the cash flow deriving from it. It takes into account both the human and physical resources of an entity which underlies capital. It (ex ante economic income) also reflects 'guidance to prudent conduct' i.e. the maximum amount the owner of capital anticipates he can consume (or dividends a company can distribute) without impairing his capital and future consumption. Its valuation based on prediction of future cash flows is particularly relevant for decision making (this is the basis of discounted cash flow investment appraisal techniques in management accounting). Economic income is also takes into account the important factor of timing (potential economic benefits becoming more valuable as the relevant realization dates nears). Finally, return of capital are specified as guides to reinvestment and capital maintenance (Lee 1985 p43).

4. Capital and Capital Maintenance

In accounting, capital can be said to be the collection of tangible and intangible assets , both monetary and non-monetary , less any liabilities of the entity. It is "an expression of the property rights of the entity in net assets" and representing future service potential (Lee 1985). It is transactions based and depend on the process of deriving income from recorded transactions. To the economists , however, capital is the stock of service potential from which income flows i.e. economists look forward in time in terms of anticipated services and these expectations form the basis of determining capital (Lee 1985 p9).

Fisher (1930), for example, defined capital as the present value of future anticipated benefits which can be represented by the equation;

Ko=S Ct(1+i)-^t

where Ko= capital at time t=0 and Ct represents anticipated future consumption in terms of predicted cash flows and i, the subjective rate of interest ( a personal opportunity cost rate). Fisher saw interest as the bridge between income and capital, while Hicks defined capital as well-offness and defined it as the capitalized money value of future receipts. His view was that capital and income was actually one and the same but isolated for measurement purposes.

It can be seen that the difference between accounting and economic capital is one of measurement. As Boulding (1962) points out; whereas accountants measure capital in terms of actualities as the by-product of the income measurement process , economists measure it in terms of potentialities in order to measure economic income.

The idea of capital and its maintenance depends on the definition and valuation system adopted. For example capital can be defined as money capital, physical capital (tangible assets/operating capacity), potential consumption (economist's discounted cash flow measurements) or purchasing power. Values could include historical cost, current replacement cost, net realizable value or present value. All these possibilities give various permutations of income and capital.

Capital Maintenance

Capital Maintenance is a very important concept in income measurement. Capital needs to be maintained before any income is recognized (thus the need for depreciation) , otherwise distributions (e.g. dividends) can be made out of capital. This is illegal under the Companies Act for corporations as it is feared that distributing dividends out of capital would reduce the amount of money available to creditors, whose only recourse to a limited liability company , in normal circumstances, is the capital and reserves.

The concept of maintenance of capital intact implies the necessity for depreciation. According to Pigou (1941), capital, at any moment consist of an unambiguous collection of physical things and if any object in this collection were to wear out or scrapped, then it must be replaced by equivalent objects.

However, changes in values of components of capital makes the notion of capital maintenance difficult (Hayek 1941). Since capital , in real life, consist of many heterogeneous things, a physical magnitude can only be arrived at by equating all these items in terms of an equivalent item in terms of what each component is worth in terms of the equivalent item. The difficulty lies, however in that the relative values of different things are not independent of the equilibrating process, hence capital would not be maintained if there was a change in the relative value of its components, even if the physical inventory remained the same. Another problem is whether obsolescence due to changes in technology should be regarded as depreciation, although the physical capital remain intact. Hayek suggested that forseeable obsolescence should be made good before considering income as 'net'. Hicks also regards forseeable obsolescence as "true depreciation" and thus should be provided for in order for capital to be maintained. Unforseeable obsolescence according to him is capital loss. In actual practice, however, it is difficult to distinguish between foreseen and unforeseen obsolescence and thus all cases of obsolescence would result in a capital loss (Goyle 1990)

The various concepts of capital also leads to difficulties. What capital is to be maintained? Is it the money (original cost) capital, real capital (purchasing power) or operating capacity (in order to maintain the income stream ). In order to maintain money capital intact, it is adequate for depreciation to based on acquisition (historic) cost of the asset. In periods of general inflation, however, although the money income would be the same in successive periods, the owner would not be able to consume the same amount of goods as he did in the previous period and this would thus rebel against the Hicksian concept of income. If real capital is to be maintained in periods of rising prices, then the cost of the asset would be multiplied by a relevant index number and the depreciation would be based on this new value. If however, the specific prices of assets move differently in relation to general price level, then even the adjustment for price level would not be sufficient to maintain capital as when the time comes to replace the asset, the amount of fund retained (not cash) would not be able to acquire the replacement of a similar or equivalent asset in order to produce at the same capacity. If we are to provide an amount adequate to maintain the physical capital then, we must provide depreciation based on the current value of assets at any accounting period and adjust for any back-log depreciation which was the line taken by SSAP 16. The problems becomes more complex if due to new technological improvements, the new replacement equipment has more capacity at a lower cost e.g. in the case of computers where the power/cost ratio doubles almost every six months. In that case, if we follow a current cost depreciation concept, we might be 'over maintaining' capital.

Grinyer and Symon (1980) argue that capital maintenance is an unnecessary abstraction for which they could not identify any logical reasons why the 'constraint' of capital maintenance should be imposed in the long term interests of the participants in business. Their arguments are based on the fact that economists have been unable to agree on a definition of income and of its relationship to capital. Since wealth cannot be defined unambiguously, therefore , they argue that it is not possible to maintain what one cannot define.

Valuation is always a problem in any type of income measurement. Just because we cannot all agree on a valuation basis does not mean that capital need not be maintained. The very word profit or the less precise American term "income" means the excess over the original capital. As long as one states the assumption one makes e.g. in historical cost based accounts, it is the money capital that is maintained, with possible additional disclosures on alternative values or information from other sources, the user will be able to make the necessary adjustments to arrive at the correct decision. As Boulding (1962) puts it succinctly:

The authors (Grinyer & Symon) again seem to confuse the maintenance of physical capital with the collection of the same assets or technology the business started out . For example, when considering the interest of employees, they state:

Physical capital maintenance , I believe, is the maintenance of the operating capacity of a firm in order for it to be able to produce at least the same if not better income as the previous period. It does not mean as Grinyer and Symon would have us believe, that the firm would have to stick to obsolete technology and the same machines. What is important is the ability to produce products (new or old) which will generate at least the same income to the firm as in the last period. Obviously, if this is not true, then any distribution would be partly return of capital and this will deteriorate over time to a point where all the capital would be eaten up and the income stream would evaporate.

Grinyer and Symon (1980) further argue that capital maintenance is an unnecessary abstraction . by pointing out alternative bases for the measurement of income. They point to the transactions based matching concept used in conventional accounting and the proposed cash flow accounting. Their argument is that since these 'alternatives' do not require valuation but are transaction based, therefore capital maintenance is unnecessary as a concept. The author seem to forget that historical cost IS a valuation system though it is not current, it is based on a value at a point in time. Further the very idea of matching revenues with costs implies capital maintenance although what is maintained is the historical cost i.e. money capital and not real capital or operating capacity. If capital maintenance was unnecessary, then there would no need to match the revenues with the costs, just take the revenues as profits or income! Similarly cash flow alternative is not an 'alternative' to capital maintenance but alternative to the concept of income itself to overcome the effect of arbitrary allocations. Prof. Grinyer does not seem to emphasis that it is 'net cash flow' generated from operations that is important. Net in the sense of deducting the cash outflows necessary to maintain capital!

The fact that capital maintenance is central to any measure of income is vividly demonstrated by Revisine (1981). According to him,

He goes on to elaborate that each of the popular income measurement options is built upon a different associated capital maintenance foundation i.e. Historical cost income (traditional accounting income) maintains nominal dollar capital, current cost income from continuing operations maintains physical capacity and these concepts can be combined to adjust for inflation (constant dollar income under historical and current cost).

In Islam, capital maintenance is essential as profit is recognized only after capital is returned. This concept has the highest support in the hadees (traditions) of the Prophet Muhammad (pbuh) which is considered the second source of Islamic Law after the Qur'an.

The Prophet (pbuh) is reported to have said:

Udovitch (1970) quotes an extreme example in Sarkashi's Mabsut where a hypothetical situation is discussed by the Islamic law scholar. If an investor gives an amount of 1000 dirhams as fixed capital to his sleeping partner on the basis of commenda , profits to be shared 50:50, and the partner makes another 1000 dirhams profit out it. This investor's share of profit of 500 dirhams is distributed to the investor while the partner spends his half but keeps the original capital of 1000 dirhams. The partner continues to trade and looses all the 'capital' of 1000 dirhams, the earlier distribution becomes void and the partner needs to reimburse the investor of his share of 500 dirhams because according to the scholar, the full capital of 1000 has not been restored to the investor. As such the 500 dirhams previously distributed was a return of capital and he still owes another 500 dirhams original capital to the investor. The principle is that the partner could not have taken his share of profit before capital was maintained and returned to the investor. Since he had taken his share of profit, he has to return the investor's capital. The amount retained in the business was not 1000 dirhams original capital but 500 dirhams of capital and 500 dirhams of profit.

The concept of value is important in the determination of capital and income. Value is the appraising or prizing some object either in ethical (reflecting the moral attributes of the object or concept) or economic terms (reflecting choice, preference or willingness to sacrifice) (Lee 1985 p12). Valuation is thus the process of ranking these attributes or preferences. Valuation is the process of measurement of the sacrifices or choices made and is temporal in nature i.e. past , present or future value. It can also be situational i.e. entry or exit values. Valuation requires a valuing agent (Anderson 1976) which is the asset used to express the value of other heterogeneous assets in order to give additivity to arrive at an aggregate valuation of net assets. The valuation agent is usually money. However to be an effective valuation agent , money (or the measuring scale) needs to standardized and non-variable. Unfortunately, in inflationary times, the purchasing power of money varies and money becomes an unstable valuing agent. Despite this problem and attempts to solve it, accountants continue to use money as the valuing agent as valuation of capital i.e. wealth measurement needs to be additive of all the assets and not of constituent heterogeneous assets.

5. Income Measurement Models

There are many income measurement models mentioned in the literature including the traditional historical cost accounting model defended by Ijiri (1971), the current valuation model using replacement cost in the business income of Edwards and Bell (1961), realizable income using exit prices (net realizable values) by Chambers (1966)and Sterling (1970 ) , the closer to economic income concept of variable income by Solomons (1961) , the concepts of residual income by Solomons (1965) and Interested Adjusted Income by Shwayder (1970) for internal reporting and Earned Economic Income (Grinyer 1985). To keep the discussion shorter and due to the prohibition of interest in Islam and the consequent religious sensitivity of interest based models, Earned Economic Income (which I personally believe can be adapted to Islamic requirements due to the variability of interest rate in the model), Residual Income and Interest Adjusted Income will not be discussed here.

Historical Cost- Ijiri

This is the basis of traditional accounting income. Income is the difference between the realized revenues and the historical cost of earning the revenues i.e. the sacrifice in terms of money valued at the point of acquisition of the asset or service consumed in the realization of the revenue. Depreciation is a measure of the use of long-lived asset is based on the historical cost of acquisition of the asset and this along with other expenses are matched against revenue to compute the income.

The most ardent defender of historic cost income is Yuji Ijiri. He points out that historic cost accounts have withstood the test of time as it has been practiced for centuries, only familiarity has bred contempt and thus the reason for attacks on it. Ijiri (1971) starts of his defence with the following quotation

In his view, accounting has a two fold purpose which are fundamentally different i.e.

Equity Accounting: to protect the equity of interested parties of a firm ( nowadays known as stakeholders) and

Operational Accounting: to provide information for decision making.

Whereas operational accounting information needs to be relevant and timely but this comes at the expense of verification and objectivity which is essential for equity accounting and which historical cost provides. He claims that historical cost valuation is the only valuation method which includes, as an integral part of its valuation procedure structured on the double-entry system, the essential requirement of equity accounting that every actual changes in the resources of an entity be recorded by relating relates inputs and outputs which can be traced and identified whenever necessary. Presumably this traceability lends itself to the verifiability and objectivity required.

He further asserts (p9) that for the proper functioning of the economy, the accounting system must not only ensure investors that their total resources invested are properly controlled (custodianship or stewardship function) but also each investor's share is properly protected from other investors and stakeholders. This is the objective of equity accounting and the area in which accounting has traditionally developed.

We can link the equity accounting to his earlier argument (p5) of the use of the income figure as a means of solving conflicts of interests in income distribution. Ijiri argues that current cost income provides a far more disputable figure and therefore less suitable as a basis for income distribution than historical cost income.

MacNeal (1962) , on the other hand trenchantly criticizes historical cost accounting and its inconsistent principles. He cites cases of major fraud such as that of McKesson and Robbins in 1938, in which conventional accounting figures was used to misguide investors and creditors to part with their money. It arose from the fact that the transactions oriented accountants were more interested checking documents for historic cost than the current physical reality and valuation of the entity. The "going concern theory" together with the insistence of accountants to insist on realization before any profit is recognized , leads to misleading interfirm comparisons and misrepresentation of earnings and the subsequent defrauding of the investor. This can hardly justify historical cost accounting's pretence to protect investors and resolve conflicts of interest as claimed by Ijiri.

Ijiri , however , argues that current cost accounting is based on contemplated transactions and there are numerous transactions that may be contemplated with respect to the replacement or disposal of a given resource (e.g. domestic vs. foreign markets, quantity discounts etc.). It is not enough that a contemplated transaction be reasonable due to the multiplicity of reasonable contemplated transactions. "In order to avoid disputes over the income figure, there must be a means of determining a unique transaction that may be contemplated with respect to a given resource" (p 6). Since , historical cost avoids this problem due it being based on the actual transaction chosen by the entity, it is better in avoiding disputes. He further argues that the non-additivity of current costs i.e. the fact that current cost of two resources together could be worth more (or less) than the sum of their individual current costs. He further points out that it is difficult in specifying (how likely) and verifying contemplated transactions if current cost valuation is used due to the fact that it would be easy for firms to exchange phony offers. Historical cost by relying on actual transaction which can be verified is better in avoiding disputes of conflicts of interest because "contemplation alone is not subject to reward or punishment by law regardless of its content because it is too weak a legal relationship among interested parties (p8)."

Further , current cost accounting which cost of establishing and running could be enormous considering, the yearly cost of assessment, calculations and auditing and the cost of solving disputes (if the auditor is challenged for negligence or fraud). Historical cost accounts , on the other hand are prepared as a by-product of equity accounting and the additional cost of publishing historical cost financial statements are negligible compared with those prepared under current costs.

Although , Ijiri recognizes the need for additional types of information, he believes that information provided by historical cost accounts is still useful both for management and investors . The dynamic process of management "requires a careful study of the past in order to predict the future . To substitute current cost data for historical data is like wiping out their past experience"( p10). Historical Cost information is useful when analyzing trends, cycles and interfirm comparisons and when compared with current cost data. Investors using historical cost information can also be assured that they are not given a false rosy picture of the firm by management in order to attract funds or increase share price, as historical cost is less prone to manipulation compared with current cost and they are subject to more severe rules and regulations of financial reporting than current cost data used in operational accounting.

Ijiri suggests that instead of searching only for alternate valuation bases, accountants should explore other ways of providing useful information to redress the shortcomings of historical cost system by:

a) establishing a recording and reporting system on commitment basis to better control contracts and other financial commitments management makes and provide information on outstanding contracts etc.

b) attempt to move towards a more timely reporting system by more frequent reporting and immediate disclosure of major facts to the public e.g. of mergers and acquisitions, construction of major plants, introduction of new project lines etc., although this need to be weighed against the need to protect trade secrets from competitors.

c)Historical cost valuation provides data which (presumably) are less disputable than provided under other valuation methods and this is an essential requirement of equity accounting.

Accounting income has the benefit of time-testedness , 'objectivity' and verifiability. However, it lacks relevance for business decisions as past values are irrelevant to decisions except in so far as they can predict future cash flows. Accounting income has also been criticized for excluding changes in going value (i.e. goodwill )changes by Alexander (1977 p60) . He concludes that "no valid principle has been advanced to warrant the exclusion of going value from the determination of income" except for the possible reason that such inclusion would prevent inter-period comparison. Accounting income has also been criticized for its insistence on the realization principle which ignores valuation changes unless realized.

Business Income (Edwards & Bell)

Business Income is an attempt to correct the defects of traditional accounting income arising due to the realization principle and the conservatism concept and also problems arising from the use of historical costs as its 'valuation base'. It is not an attempt to take into account the changing value of the valuing agent i.e. money , although business income can be adjusted to incorporate these changes.

The realization principle states that revenue cannot be recognized until the exchange is substantially complete e.g. goods delivered or an obligation by the customer has taken effect. Accounting income does not recognize these holding gains until they are realized. However, before realization takes effect, the value of non-monetary assets may change at different rates to that of the retail or wholesale price index. Hence there are unrealized gains (or losses) termed cost savings by Edwards and Bell due to the fact that if the price of an asset rises or falls during a period , management by purchasing this asset in advance has avoided the cost of the additional purchase price that need to be paid, if the asset is to bought in the current period. Business income uses current replacement cost as its valuation base.

Bell (1971) argues that by using current costs:

This (following the realization principle for holding gains) according to him has two implications:

(1) Different accounting periods having absolutely identical events will give a different figure for profits because the data for each period are influenced by past data, and

(2) There is no way to determine when holding activities were successful or otherwise, if holding gains are only reported when realized.

Lee (1985) has depicted business income with the following equation:

Yb= COP + RHG + UHG,

where COP = current operating profit measured as revenue - replacement cost of sales and expenses;

RHG= realized holding gains accruing in the current period

UHG= unrealized holding gains representing the change in resource's replacement cost prior to realization.

Business income can be reconciled with accounting income with the following equation (derived from Lee 1985 P 77).

Yb= Ya + UHG -RHG' where

Yb and UHG as defined above , Ya= accounting income

RHG' = realized holding gains accruing in the past period as under business income, this should have been recognized in an earlier period.

Thus business income bases its measurements on replacement costs, and recognizes current period income in both its realized and unrealized forms. It dichotomizes income into current operating profit and holding gains of the same period; both realized and unrealized.

This dichotomy of income is said to "facilitate the evaluation of past decisions by management and formulation of future decisions i.e. (a) operational decisions involving processing and subsequent sale of goods and services and (b) holding decisions involving the holding of resources over time as their pre-realization value changes" (Lee 1985 p74)..

Business income is also said to have relevance for the investor and external parties in that they "may wish to evaluate managerial performance in relation to the aggregate and separable effects of these two categories of transactions" (ibid p74). The operational decisions which result in the operating income component of business income are thought to be more within the control of management from those that are not entirely within the control of management (holding gains). This may be useful for investors to evaluate the management's effectiveness in conducting entity affairs as well as for the self-assessment of management.

However, as Prakash and Sunder (1979) has argued that holding and operating decisions are not independent but intertwined. If the two activities are to be independent, it is necessary and sufficient that the 'holding risks' of the assets be separable ; i.e. it should be possible for the firm to hold the assets without also having to carry the economic risk of specific price changes. The argue that this not possible for a manufacturing firm or trading firm because production is not "timeless" i.e. production or form change can only take place through time intervals and not "timeless moments", therefore it is not possible to conclude that all gains due to the passage of time are attributable to holding activities. Further , both change in form and holding of assets are two joint consequences of single production decision . To decompose this two attributes of one single decision would be a fallacy.

They therefore conclude, the proper breakdown of income would not be between all holding gains and operating profit but into a holding component and an operating component. The holding component of income would include holding gains on speculative assets (which holding risk are separable) and on operating assets with separable risk netted off against carrying cost of speculative assets and savings of imputed risk premium on the separable risk which management chose to carry instead of shifting it to someone else.

The authors further argue that cost of income dichotomy must not only include the incremental cost of compiling and reporting dichotomy (as suggested by Bell (1971), but also the loss associated with suboptimal decision behaviour that may result from the use of the dichotomized information as well as the inductance effects on management (p 20).

After demonstrating the arbitrariness of COP-HG dichotomy by dichotomizing income in an alternative way (p17-19), the authors conclude by stating that descriptive validity and feasibility of implementation , while necessary , are not sufficient in themselves to recommend adoption of any particular income model, but any such model should be judged on the basis of their usefulness compared to their cost.

Other advantages of business income can be summarized as follows:

1) By separating , holding gains from operating income, it concentrates on the maintenance of physical capital rather than monetary capital.

2) It provides more relevant and useful accounting information by its recognition of current values and its abandonment of the realization conservatism conventions. It rectifies traditional accounting's view of values in the balance sheet and its incomprehensible heterogeneous mixture of gains in the aggregate income figure.

3) It is said to be feasible in terms of time and cost as compared to the historical cost income (Dickerson 1965)

4) Replacement cost Income is said to approximate economic income, since replacement costs would be based on estimates of future income streams, "business profit is not too bad an approximation of the current increment in the present value of future net receipts (economic income)... (Zeff 1962). However, this is disputed by Revsine (1970), who argues that replacement cost income would not be approximate to economic income in an imperfect but a more realistic competitive market because price changes of assets and future potential cash flow could be in opposite directions e.g. where new entrants to a market initially raise asset prices but depress the market in the long run with excessive supply of products.

Realizable Income

Realizable income is a measure of the periodic change in the capital of an entity when this is measured in exit value terms. It can be represented as

Y_r = D+ R_t-R_t-1,

where Yr = realizable income, Rt = ending capital valued on the exit price basis, Rt-1, =opening capital valued on the exit price basis, D = periodic distribution of income.

Realizable Income uses exit prices or net realizable values to value assets in the calculation of income. There are a few variation to this. Market prices was first suggested by MacNeal in 1939 and later developed by Stirling (Enterprise Income) and Chambers (Current Cash Equivalent/Continuously Contemporary Income). Lee (1985) terms this as realizable income.

Current exit price represents the amount of cash for which an asset might be sold or liability refinanced. These are prices the business would realize if the assets are sold under conditions which are orderly rather than forced liquidation and it is the selling price at time of measurement rather than adjusted future selling prices (Belkaoui 1992, p286).

Along with replacement cost valuation, exit price valuation based realizable income also completes abandons the realization principle for the recognition of revenues. Thus operating gains are recognized at the time of production whereas holding gains are recognized at the time of purchase and afterwards, whenever price changes rather than at the time of sale.

The argument for exit prices is that it provides a measure of the economic concept of opportunity cost i.e. the cash value arising from the sale of the asset as against the continued use of the present assets. It is an expression of the economic sacrifice of the entity expressed in terms of the entity's ability to command alternative goods and services. These values are said to be relevant to making decisions concerning whether a firm should continue to use or sell the assets and invest it in something else i.e. whether or not the firm should remain a going concern.

Current Exit prices are also said to provide relevant and necessary information on which to evaluate the financial adaptability and liquidity of a firm. A more liquid firm would be more adaptable to changing economic conditions. Chambers (1966) criticizes historic cost as "simply a matter of history" and only present prices have any bearing on the choice of an action. He argues that "no useful inference may be drawn from past prices which has a necessary bearing on present capacity to operate in a market" and dismisses replacement cost because it does not represent capacity to go into a market with cash for the purpose of adapting oneself to contemporary conditions. He therefore proposes realizable price or market price as "the one single financial property which is uniformly relevant at a point of time for all possible future actions in markets" (ibid p 91-2). Further, Stirling (1968) has pointed out that exit value ignores the invalid and unnecessary of the entity as a going concern with an indefinite life which is the basis of the replacement cost model. In fact, the realizable income model assumes that the entity will have a definite life in its existing form.

Chambers (1962) also argues that current exit price provides a better guide for the evaluation of managers in their stewardship function because it forms a satisfactory basis for determining the use and dispositions of assets, which are regarded as the basis on which the performance may be judged.

Chambers (1971), also presents evidence that even in accounting practice, the use of realizable values is advocated and practiced e.g. in valuation of inventories, UK legal disclosure requirements of revaluation of land and market price of investments. Thus he argues that the realizable income model is a logical extension of these practices.

Lastly McKeown (1971) has shown in his case study of an electronic manufacturer that exit prices are feasible to implement in terms of cost and objectivity (risk of manipulation) and an accurate estimation of exit values is possible.

Exit prices are also said to be more understandable than replacement cost as realizable values are easily interpreted as market values.

On the other hand , Ijiri (1971) criticizes current costs for its non-additivity. The worth of the business as a whole is not the sum of the constituent assets. If realization is being considered, then the realizable value of the whole entity (together with goodwill and other intangible assets which do not have a separable value) is the more important to be considered instead of its component assets.

Bell (1971) argues that exit values should not be considered because they do not give relevant information to evaluate performance against expectations i.e. against operational plans and decisions which were actually made by management. The plan and the people who developed the plan should be evaluated first before alternatives about the future (i.e. opportunity cost) should be considered. Since cost of inventory sold are continuously adjusted to realizable values, the gross profit under Professor Chamber's model would be zero. Thus it does not do a good job of showing how the company moved from its economic status from the beginning to the end of they year.

Professor's Chamber's "current cash equivalent assume that a business plan would always have to be one of maximizing the acquirable cash equivalent of assets over successive short run periods. Such a view of the enterprise, its objectives and its mode of thought would just not seem to be applicable", according to Bell (1971). A healthy business is usually a going concern which intends to remain in business for some time to come and does not continually reassess its option to get out that business. We can call Professor Chamber's assumption, the fallacy of timeless business exits!. Obviously, once a business is committed to a certain business, it takes time before the plan and operations bears fruit. It cannot be continuously thinking of getting out when it just got in!

Variable Income

Changes of expectations under conditions of uncertainty leads to unexpected gains or losses due to changes in expectations. This leads to a problem of redefining the beginning of period well-offness which needs to be maintained according to the Hicksian concept of income. To avoid this problem, Alexander (1977) suggests the concept of variable income closer to accounting income, which excludes these unexpected gains or losses.

He defines variable income as the

Variable income = R_a + V_1e-V_oa,

Where R_{a =} Actual Receipts for the period_, V_1e= expected value of equity at end of period based on expectations at beginning of period and V_oa= actual beginning of year equity value.

However, the application of this model to the income of business gives rise to complications. For example, separation of the net receipts between income and changes in asset composition is time consuming. Then the question of what to do with changes in expectations as between the beginning and end of the period. If these changes occurs due to management activity, these should be included in the income but then arises the question of how to separate the result of luck (expectation changes generated externally) from the result of skill. However Alexander suggests that under constant prices, profits from sales is an acceptable approximation to variable income except where:

(i)where there is a significant change in the goodwill as a consequence of an action of the income period or an expected change in the firm's selling position and

(ii) where there is a material divergence from production and sales.

6. Evaluation of the Alternatives:

The evaluation of any income measurement is dependent on the objectives for which the measure is used. All the models have their pros and cons. Based on the objectives, specific criteria to evaluate the alternatives could be derived.

The difference among the alternative asset-valuation and income-determination model arise from the different attributes measured (historic cost, replacement cost, Net Realizable value and Present and capitalized value) and the units of measure (constant dollars or nominal dollars) used. Each valuation base gives a particular concept of capital maintenance and a particular income concept.

Belkaoui (1992) compares the models based on whether they avoid timing or measuring unit errors and evaluates the model based on interpretability and relevance. Timing errors result when changes in value which occur in one period are recognized and accounted for in another. It would be preferable recognition of changes should take place in the period the change occurs as " profit is attributable to the whole process of business activity". He concludes that:

(1) Historic cost income provides a basis of computation of taxes and dividends and for the evaluation of performance. This time tested and long standing version of income accepted by accountants is due to its 'objectivity' , verifiability , practicality and understandability. However, the historic cost income includes both timing and measuring-unit errors. However they are interpretable as money income i.e. the money capital is maintained but they are not relevant because command of goods (COG) i.e. the ability to buy goods and services necessary for capital maintenance is not measured .

(2) Replacement cost accounting (business income); the current operating profit represents the "distributable income" or the maximum amount of dividends that the firm can pay and maintain its productive capacity. The realized holding gains component of business income is an indicator of the efficiency of holding resources up to the point of sale and may act as a predictor of holding and operating performances. Further replacement cost income contains timing error only on operating profit but contains no measuring unit error. Business income is interpretable as one which maintains the productive capacity of the firm and the asset figures are interpretable as measures of the command of goods are therefore relevant.

(3) Realizable income (using NRV's); it does not contain timing errors although it contains measuring-unit errors. The income is interpretable as an indicator of the ability of the firm to liquidate and to adapt to new economic situations whereas assets are interpretable as measures of the command of goods in the output market.

In the case of Islam and Muslim society, they have their own rules, requirements and priorities which are similar but in many ways different from that of a capitalistic western society. Evaluation of the income models in those instances would have to start of with a discussion of the world-view of Islam, its objectives and priorities and what Islamic tradition says about valuation and measurement. Hence the criteria to evaluate the models would be different , thus the evaluation of the income models would have to be deferred until the foregoing issues are discussed and evaluation criteria are derived. This I do in part II which follows:

PART II : RELEVANCE OF THE INCOME MEASUREMENT MODELS TO ISLAMIC ACCOUNTING.

I now come to the second part of the essay to discuss the relevance of the income measurement models in Islamic accounting. Before I do this however, I will discuss the Islamic ontology and where accounting fits into the Islamic world view. The objectives and nature of Islamic accounting is then discussed alongside the objectives of the Islamic sharia'. I shall then discuss the need for and why income determination is very important in Islamic accounting (more so than in conventional accounting. Finally, I evaluate relevance of the conventional income measurement models and valuation concepts to in meeting the objectives of Islamic accounting.

7. Islamic Ontology, World View and Islamic Accounting.

Islamic societies are governed by the Sharia' (Islamic Law) which is derived from the Qur'an (the word of Allah (God)) and the Hadees (sayings, approval and action of the Prophet Muhammad pbuh). Its objective to establish justice and promote social welfare through the obedience of God's (Allah's) commandments. Thus according to Al-Ghazzali, a famous Muslim philosopher of the 11th Century , the objective of the sharia' is :

According to another philosopher, Ibn Al Qayim al-Jawziyyah (Chapra 1992), the  

We can thus see that promoting justice, welfare (both social and economic) and protecting property will have to be objectives of Islamic economics and thus accounting. This is not unlike Arrington's (1990) proposal to used solidarity rather than objectivity as the basis of accounting knowledge.

Man is the vicegerent (Khalifa) of Allah and are accountable for all their actions to Allah and they will be judged and rewarded or punished in the hereafter for their actions. These actions in whatever spheres of life be they politics, economics, law or social and natural sciences has to conform to the Sharia' and its ultimate objective is the pleasure of God. The Qur'an lays down eternal principles and the hadees lays down detailed application of the principles in everyday life. The Sharia' is extended to meet the needs of different times and societies by a normative-deductive process of deriving rules from the Qur'an and Hadees. Accounting is no exception to this.

The re-assertion of Islam in the political, economic and social spheres in Muslim societies have resulted in the establishment of Islamic banking , insurance and other financial institutions which practice 'interest-free' Islamic financing. This is grounded in the prohibition of interest by the Sharia and has resulted in the use of equity-funding/leasing and installment sale techniques of financing by these institutions. The basis of financing ventures in Islam is equity participation and commenda. These techniques rely heavily on the income number to distribute the agreed share of profit or losses. In addition the formal re-institution of Zakat (a welfare wealth and income tax) as a major source of social welfare and public funding and the general wish of Muslims to abide by the Sharia' in their business dealings necessitates the search of an 'Islamic' accounting alternative which will meet the needs of these organizations and the Muslim societies in which they operate (Ali 1997, Khan 1994).

8. The Economic Objectives of the Sharia and Its Relationship to the Objective of Islamic Accounting.

The objectives of Islamic accounting arises from the economic objectives of the sharia' viz.:

Circulation of Wealth:

Wealth should be circulated widely and not held or concentrated with a few. Zakat , sadaqah (charity) and prohibition of interest is the main tool to accomplish this objective.

Prohibition of Interest:

Interest the surest way to unearned wealth accumulation while avoiding risk which besets the borrower is totally prohibited in Islam. Equity based partnership, shareholding or commenda is allowed for capitalist to join in a business venture with labour.

A Moderate lifestyle is encouraged, luxury is frowned on as is poverty e.g. man (not women) cannot wear silk and gold. Muslims cannot use gold and silver plates or crockery. Conspicuous consumption is frowned on.

Law of succession: can will away only 1/3 of property. Qur'an states share of beneficiaries and is quite detailed. This ensures the distribution of wealth.

Halal Trade :

Investment can only be undertaken in activities which are not prohibited in Islam (prohibitions include gambling, alcohol, pornography and anything which is harmful to society). Agriculture and Employment is encouraged as is dignity of labour, and the quick payment of wages Begging is discouraged. The giving of just measure for measure (cheating or misleading by giving false information is disallowed). This implies full disclosure and fair measure or valuation.

Forbidden transactions and contracts:

All contracts must be clear and any uncertain contracts (gharar) e.g. buying the fish in the pond is illegal. This is to avoid damage, conflict and disputes.

Loan transactions and other transactions which has future obligations e.g. partnership, joint ventures has to be recorded and witnessed. Speculative transactions are forbidden. Equity: Fair selling price determined in a competitive market, no fraudulent labeling or false description, free market, and no monopolies. Conventional insurance contract based on uncertainty, speculation and has an element of gambling is prohibited and replaced by takaful, a scheme based on co-operative saving , a portion of which is put into a common claims pool , if a contingency arises. Public and private ownership have their roles.

Objectives of Islamic Accounting

From the perusal of the Qur'an, Hadees and the Sharia', the objectives of Islamic accounting would seem to be the avoid doubts and (consequently disputes) between parties by ensuring fairness accounting (Qur'an 11:84-85, 6:152) and the consequent equitable transfer and distribution of property rights and wealth (Qur'an 4:29) , besides ensuring an equitable base for Zakat.

Although, the above verse apparently refers to writing of debt contracts, it would not be too far fetched to extend it to accounting especially since Littleton (1966, p12) has mentioned that amongst the other antecedents of modern accounting , credit and writing are two important preconditions for the emergence of systematic book-keeping. under stewardship accounting, investors are almost akin to creditors , their capital is akin to a loan (liability of the business to its owners), which has to be paid back barring losses or with the addition of the agreed share of profit.

Further Islam makes the fulfillment of trust and contracts a sacred duty (Quran 4:58, 17:34), which is essential in modern business where management is separated from owners.

From a macro viewpoint we can therefore summarize that the objective of Islamic accounting as follows:

(1) To provide a fair basis for the calculation of zakat.

(2) avoid disputes among members of the through provide a fair basis for sharing of profits, wealth transfers and full disclosure of activities and values.

(3) Promote and ensure only Islamically permitted economic activities are carried out by the business and ensure the quest for profits by the business does not infringe society's rights (e.g. for a clean environment, fair employment practices, contribution to the well-being of the community etc.)

9. The Importance of 'Income' and Valuation in the Islamic Accounting System.

The two basic institutions which are relevant to our discussion here i.e. Zakat and the prohibition of Interest. Zakat is basically a religious wealth and income tax and its payment is a religious obligation. Its collection should be done by the state and redistributed mainly for social welfare and defence purposes. It acts as a disincentive to holding wealth in a zero interest environment because there is a 2.5% tax on wealth . Zakat is levied on wealth in case of gold and silver (or their money equivalent) and livestock. It is also levied on income from agriculture (5% gross income or 10% net ) and on business profit and current net worth. All these requires valuation and income concepts in order to establish a 'zakatable' capacity and zakat base.

In the early days of Islam , where businesses were not capital intensive and wealth (and sources of income) consisted of either agricultural produce, livestock or stock in trade (e.g. spices, clothes, jewelry etc.), the zakat was levied on stock, debts, cash (gold and silver) at market value. Zakat on livestock and agriculture was based on numerical units rather than monetary units i.e. zakat was based on number of animals of a certain age rather than a percent of value. Hence, for business which trade in livestock using numerical units to calculate zakat would solve the problem of valuation. Obviously this is a 'realized' payment and if monetary accounting statement are still prepared, then the zakat paid would have to be converted to market value and shown as an appropriation. There is presently a controversy on whether fixed assets are liable to zakat. Conventional Islamic scholars , basing their judgments on the practices prevalent at the time of the prophet (pbuh) have ruled that fixed assets are not zakatable. This follows the prophet's exemption of zakat on tools used by farmers and artisans in the Prophet's time. If this is true, then the problem of valuation will not be that acute as valuation of fixed assets are ones which present the most problems in conventional accounting. However , business nowadays are capital intensive. Further current world-class manufacturing technologies and modern cost management techniques which minimize inventory (just in time, keiretsu, economies of scope, ABC) will almost eliminate the zakat base! from business ventures which add the most value to the economy and are very important sources in developing and industrializing Muslim countries. Therefore, in order to be in line with the maqasid or objectives of the sharia' in ensuring socio-economic justice i.e. equitable distribution of wealth, several writers(e.g. Kahf 1991, Al Zarqa (1984) have called for a re-thinking of this issue. Kahf (1991 p 187) refers to his earlier study in which he showed that if zakat is levied on these new sources of wealth and income, the amount of zakat collected can be doubled or tripled and the zakat thus collected would be able to eradicate poverty in Muslim countries within a reasonable period of time.

Many writers have called for the provision of a fair zakat base to be the most important objective of Islamic accounting (Adnan and Gaffikin, 1997, Gambling and Karim 1991, Baydoun and Willet 1994). This may seem very strange to conventional accountants many of whom make their living by giving advice on how to avoid tax! However, under an Islamic world-view, the pleasure of God and accountability to Him is uppermost. "This accountability has to be manifested in the form of how one can account for his or her Zakat obligations properly" since Muslims cannot differentiate a worship activity from a non worship activity (Adnan and Gaffikin, 1997). The Allah fearing Muslim would not dare cheat on Zakat (although he might cheat on tax!) because unlike tax, Zakat is a religious obligation for which He has to account to Allah on the Day of Judgment. Further the assurance that Zakat will not be spent on the lavishness of rulers or luxury projects, since the recipients are well defined in the Qur'an itself, motivates one to pay more rather than less because the zakat payer knows it will be mostly be used for the poor and the destitute.

Another advantage is the other problem of conflict of interests, disputes , window dressing, fraudulent disclosure ever present in conventional accounting will be minimized as far as humanly possible because the Muslim accountant and managers will not undertake such ventures because he would be depriving the poor and destitute of their rights.

The other major institution of concern here is the prohibition of interest. This rule has made conventional banking which is an important modern economic institution illegal in Islamic society. However, the absence of interest, it does not mean the cost of capital is zero in Islamic societies. What is illegal is the predetermined fixed rate on capital , i.e. the return on money without sharing the corresponding risk of the borrower. Islam allows and one can say even encourages profit and loss sharing partnership (both active and sleeping partnerships). Islam recognizes the opportunity cost and risk involved in deferred and installment sales and allows the deferred price to be higher than the cash price. It also allows operational leasing and renting. However the strict prohibition on interest means, the main way a capitalist can participate in business is by partnership, equity shareholding and commenda. All these three legitimate methods require the computation of income and asset valuations for profit distribution . Further in conventional accounting, the investor is considered more a lender of capital than a participant in the business. Hence the concentration on return either interest cover and earnings capacity. In Islam, a business has social and moral obligations which derives from the khilafa (vicegerancy) concept in Islam. Man is a trustee of property for God. Ownership of property in Islam is not absolute but conditional. Hence Islam requires the investor to be responsible for the management, activities and the liabilities of the business. This is the reason why limited liability and the entity theory of the firm is frowned upon (eg. Khan 1994 p 9).more important than in conventional accounting which has the opportunity of charging interest on capital as reward for its use.

The search for an alternative banking institution resulted in the creation of Islamic banks and Insurance (takaful) companies in Muslim and Western countries which finance their customers through these allowed methods. The creation of these Islamic financial institutions has resulted in the mobilization of funds from Muslims and non-Muslims (Ali, 1994 p iii) which has been estimated to 80 billions dollars (see Islamic Banking and Insurance Institute webpage, London). These funds are mobilized either on the basis of 'al wadia' - safe custody with return of deposit guaranteed but no interest is paid. However the bank can utilize the funds while in its custody as long as the activities financed by the bank are not against the sharia' eg. gambling, alcoholic drinks industry etc. Banks are allowed to pay a part of the profit they make to deposit holders as a 'gift' to the depositors provided it is not computed as a percentage of deposits or guaranteed in advance.

Another type of deposit is the investment account. Here the depositor deposits the money as an investor and the bank as the partner. The bank then shares any profit it makes from the investment with the depositor on a pre-agreed proportions. Any loss is borne by the depositor while the bank loses its effort. Thus there is no guarantee the investment depositor will get back his capital.

Since Islamic banks are not allowed to lend on interest, they undertake Islamic financing techniques , although they use mostly murabaha (or cost plus pricing technique) financing, they do practice musharaka and mudharaba (partnership and commenda) which was the original equity-based instruments suggested in the Islamic economics literature e.g. Chapra (1992).

Musharaka is basically partnership financing where the bank participates in the capital and management of a separate business or a part of the business of the lender and share in the profit and losses of the business in a pre-agreed proportion.

Mudharaba or Commenda is where the bank invests the money with an entrepreneur who undertakes a business venture. Profit is shared between the bank and the entrepreneur. Any loss is passed on to the depositor. The entrepreneur looses his effort.

It can be seen that both musharakah and mudaraba transactions require income numbers for both the determination and distribution of profit to deposit holders. Abdelgader (1990) found the following problems in his investigation of profit determination and distribution by Islamic banks in Sudan

1) The time lag between deposits and investments, as profits to depositors is partly based on the length of deposit (as between depositors) holding whereas investments could not be related directly to the deposit holding period.

2) The right of the depositor (savings account) and investment account to withdraw his deposit at any time whereas the investment is not yet liquidated.

3) The need to ensure fairness for a depositor who has withdrawn but his share of profit is unknown until realization of the investment.

4) The pooling of various funds i.e. savings, investment, current account and the equity of the bank itself as compared to division of profits from various activities of banks.

5) The problem of bank expenses and venture expenses: should a proportion of banks own expenses be charged to the investment profit?

All these problems show that income determination and valuation concepts are important for Islamic accounting.

10. Relevance of Conventional Income Determination and Valuation Models for Islamic Accounting Theory and Practice:

If we adopt the above objectives of zakat base, avoidance of disputes and socio-economic justice (public welfare) and accountability as a framework of Islamic accounting, there are serious implications for accounting principles, conventions, concepts (see Adnan & Gaffikin, 1997 for a review of the literature on Islamic perspective of the accounting concepts and conventions) , measurement and valuation (Gambling and Karim 1986) and reporting practices (Baydoun and Willett (1994). We will discuss the implications for income measurement and valuation.

The first question is should there be a different accounting for different purposes and a single 'true' income figure? According to Khan (1994 p 17), "the sharia' supports a system of valuation which is good for all purposes, whether shareholders, government, future investors or general public." Thus different profit for different purposes is not supported . The reason is that "the business firm in an Islamic society has a social role as well, the most important manifestation of which is the payment of Zakat. Hence accounting must provide information for the businessman to determine his zakat liability and pay it promptly. Under a conventional tax system, the government may have priorities of expenditure and promotion of the economy , certain industries which result in different fiscal policies and thereby enforcing certain rules eg. capital allowances, expense exemptions, double relief etc. This does not apply to zakat calculations. The objective of zakat assessment would be to determine a fair share of the wealth and income to be distributed to the poor. Even the zakat rate is pre-determined and cannot be changed by the government.

The next question is what valuation basis is to be used for the main objective of calculating zakat? Atiyah (1984) quotes a hadees (tradition of the prophet) which is quoted as : "Value at current value (market price) and then pay zakah (on it)". This has been further refined to mean net realizable values by Al Qardawi (1979). However, the zakat laws do not offer much help for valuation of fixed assets for currently they are not subject to Zakat and fixed assets were not at the time of the Prophet and a long time therefrom until the Industrial Revolution. However, Gambling and Karim (1991) supports Prof. Chamber's Continuously Contemporary Income as the income model to be used by Muslims and that current cash equivalent which is the amount of cash or purchasing power that could be realized in an orderly liquidation, which may be measured by quoted market prices for assets of a similar kind and condition.

However , Islam frowns on unearned income and wishes the dignity of labour. Hence if we use the net change in value method , using NRV or CCE, the operational aspect of the business is not emphasized. Further the way in which the year end assets and liabilities came about is not known. This is especially important in murabaha accounting where the entrepreneur is rewarded on his effort. Should Islamic accounting ignore transactions based - historic cost accounting all together even, if as Ijiri states, it might be the best system to avoid disputes?

The current convention of historic cost and conservatism arose from the needs of bankers and shareholders. However these concepts could be contrary to the idea of fairness and justice for equitable transfer of property rights among different stakeholders and disadvantaged members of society as the zakat based on a historic cost valuation would yield lower receipts and consequently lower transfer payments to the beneficiaries in times of inflation and rising costs. The transaction basis of historic cost accounting , however, is still very important.

I suggest that a trading/ income account to the gross profit stage be based on historic costs transaction base i.e. the costs would be actual historic cost as they are incurred and the sales would be the actual revenues earned. To this a stock adjustment would be made in the profit and loss account to bring the closing stock to current market value. A current cost depreciation adjustment would have to be made taking the net realizable value or replacement cost (where NRV is not available) of the fixed assets at the end of the period less the current cost at the beginning of the period. No historical cost depreciation will be made. The final income figure would be added to capital. Zakat can be paid either on the current value of net current assets or net worth at current value.

Variable income and economic income would not be suitable as income models as they involve prediction of cash flows which are hypothetical and the use of an interest rate which is forbidden in Islam as well as difficult to obtain.

The 'financial' accounting reports may also need to be changed or replaced. Baydoun and Willett (1994), for example suggest that the main report should be a value added report as opposed to the profit and loss account, due to the latter's distributional focus which is more in line with the Islamic emphasis on the duty to account to society. They further opine that the value added statement places a greater emphasis upon the co-operative nature of economic activity and less on the competitive aspects. It further emphasises the share of the various groups rather than the owners of the firm as is the case with the profit and loss account. Although the authors propose current values in the foot notes in the interests of full disclosure, however , in view of the importance of income for zakat and distribution purposes, the profit and loss account (adjusted as discussed above) and balance sheet at current values are still important under an Islamic system.

There is also a need for extending the activities and reporting , which are accounted for by the increasingly large and monstrous organizations which gobble up more resources than states! This is highlighted in the Corporate Report (1975). Under these conditions, "externalities" become important as the activities of business affect other groups in society and the non-human environment. Thus these externalities have to be accounted for. Hence accounting should be based on "public accountability" for all resources utilized by the organization. not only to the owners but to society as a whole. Qualitative (non-financial) information which should be include potentially auditable and factual, no matter how inaccurately valued , rather than assertions and hopes for the future and integration of environmental and social accountability into the main body of accounts, even when the information is negative should be included.

REFERENCES

Abdelgader, Ahmad Eltegani (1990), Islamic Banking- Distribution of Profits: Case Study (Sudan), Unpublished Ph D thesis, University of Hull, 1990.

Adnan, M. A. and Michael Gaffikin (1997), "The Shari'ah, Islamic Banks and Accounting Concepts and Practices" , Proceedings of International Conference I on Accounting, Commerce and Finance: The Islamic Perspective, Sydney Australia, 18-20 February 1997

Al-Qardawi, Yusuf (1979), Fiqh al Zakat (Islamic Law of Zakat), Beirut.

Al-Zarqa, Shaikh Mustafa (1984), "Jawanib min al-Zakat Tahtaju ila Nazar Fiqhi Jadid", Journal for Research in Islamic Economics: King Abdul Aziz University, vol. 2, no. 1, Summer 1984.

Ali, O.A. (1994), in the Introduction to: Development of an accounting system for Islamic Banking, London:The Institute of Islamic Banking and Insurance, 1994

Ali, M. (1977), "Reflections on Islamic Banking", New Horizon: Islamic Banking and Insurance¸ No. 59, Jan. 1977.

Alexander, S.S. "Income Measurement in a Dynamic Economy", (Revised by D. Solomons) in Baxter and Davidson (eds), Studies in Accounting Theory, ICAEW:1977.

American Accounting Association (1977), Statement of Accounting Theory and Theory Acceptance

Anderson, James A. (1976), Studies in Accounting Research No. 12: A Comparative Analysis of Selected Income Theories in Financial Accounting, Sarasota, Florida: American Accounting Association.

Atiyah, M. Kamal (1984), Muhasabah al-Syarikat wal Masarif fil Nizamal Islami ( Bank and Company Accounting according to the Islamic system), Alexandria, Egypt: Dar al Jami'at al Misriyah, 1984.

Baydoun, N. and R. Willet (1994), "Islamic Accounting Theory", paper presented at the AAANZ Annual Conference, 3-6 July 1994: Wollongong, Australia.

Belkaoui, A. R (1992), Accounting Theory : Academic Press, Harcourt Brace Jovanovich, Publishers, 3rd Edition, 1992.

Bell, P.W.(1971), "On Replacement Costs and Business Income," in Stirling, R. (1971) (ed) , Asset Valuation and Income Determination: A consideration of the Alternatives, Kansas: Scholars Book Co., pp19-32.

Boulding, K. (1962), 'Economics and Accounting: the Uncongenial Twins', in Baxter and Davidson (eds), Studies in Accounting Theory, Sweet and Maxwell, 1962 pp 44-55.

Chambers (1966), Accounting, Evaluation and Economic Behaviour, Prentice Hall, 1966

Chambers (1971), "Evidence for a Market-Selling Price based Accounting System" in Stirling, R.R. (1971)(ed), Asset Valuation and Income Determination: A consideration of the Alternatives, Kansas: Scholars Book Co., 1971, pp 74-96

Chapra, U.M. (1992), Islam and the Economic Challenge, Leicester (UK): The Islamic Foundation, 1992.

Davidson, S., D.Green, Jr, C.T. Hongren and G.Sorter (eds.) (1964), An Income approach to Accounting Theory , Englewood Cliffs, N.J., Prentice Hall, 1964.

Dickerson, P.J. (1965), Business Income - A Critical Analysis, Institute of Business and Economic Research, University of California.

Edwards , E. and P. Bell (1961), The Theory and Measurement of Business Income, Berkeley, California: University of California Press, 1961.

Financial Accounting Standards Board (1980), Statement of Financial Accounting Concept No. 3: Elements of Financial Statements, Stamford: Connecticut., 1980.

Fisher, I. (1930), The Theory of Interest, Macmillan , 1930, pp3-35 (reprinted as Income and Capital, in Parker, R.H. and G.C. Harcourt (eds.) (1969), Readings in the Concept and Measurement of Income, Cambridge: Cambridge University Press, 1969, pp 33-53.)

Gambling, T. and R. A.A. Karim (1991), Business and Accounting Ethics in Islam, London: Mansell, 1991.

Goyle, R.N. (1990), "Concept of Maintaining Capital Intact" in P.K. Ghosh, G.C. Maheshwari and R.N. Goyle (eds) in Studies in Accounting Theory, 2nd Edition, 1990, New Delhi: Wiley Eastern Ltd.

Grinyer, J.R. and I.W. Symon (1980), "Maintenance of Capital Intact: An Unnecessary Abstraction?", Accounting and Business Research, Autumn, 1980, pp403-413.

Grinyer, J.R. (1985), "Earned Economic Income- A Theory for Matching", Abacus, September 1985

Hayek, F.A. Von (1941), "Maintaining Capital Intact: A Reply", Economica, Vol. VIII, Numbers 29-32,1941.

Ijiri , Y. (1971), "A Defense for Historical Cost Accounting" in Stirling, R. (ed) , Asset Valuation and Income Determination: A consideration of the Alternatives, Kansas: Scholars Book Co., 1971, pp 1-14.

Kahf, Monzer (1991), "Zakat: Unresolved issues in contemporary Fiqh" in A.M. Sadeq, A.H. Permanik, N Mustapha bin Nik Hassan (eds), Development & Finance in Islam:Proceedings of the International Seminar on Islamic Economics, 1987 Kuala Lumpur, Petaling Jaya, Malaysia: International Islamic University Press,p 173-190

Lee, T.A. (1985), Income and Value Measurement: Theory and Practice, Wokingham,England: Van Nostrand Reinhold (UK) Co. Ltd, 3rd Edition, 1985.

Khan, M.A. (1994), "Accounting Issues and Concepts for Islamic Banking" in Development of an accounting system for Islamic Banking, London:The Institute of Islamic Banking and Insurance, 1994

MacNeal, K. (1962), What's Wrong with Accounting?", in Studies in Accounting Theory, Sweet and Maxwell, 1962 pp 56-69.

McKeown (1971), "An empirical test of a mode proposed by Chambers", The Accounting Review, January 1971, pp12-29.

Parker, R.H. and G.C. Harcourt (eds.) (1969), Readings in the Concept and Measurement of Income, Cambridge: Cambridge University Press, 1969.

Pigou, A.C. (1941), "Maintaining Capital Intact", Economica, Vol. VIII, Numbers 29-32,1941.

Pomeranz, F. (1997), "The Accounting and Auditing Organization for Islamic Financial Institutions: An important Regulatory Debut", Journal of International Accounting, Auditing and Taxation, Vol 6 , No. 1, 1997.

Prakash, P and Sunder, S. (1979), "The Case Against Separation of Current Operating Profit and Holding Gain", The Accounting Review, Vol LIV., No. 1, January 1979.

Revsine, L. (1970), "On the correspondence Between Replacement Cost Income and Economic Income", The Accounting Review, July 1970.

Revsine, L. (1981), "A Capital Maintenance Approach to Income Measurement", The Accounting Review, Vol. LVI, No. 2 April 1981.

Shwayder, K. (1970), "A proposed modification to residual income - Interest Adjusted Income", The Accounting Review, April 1970.

Solomons, D. (1961) "Economics and Accounting Concept of Income", The Accounting Review, Vol 36, July 1961, pp 374-383.

Solomons, D. (1965), Division Performance: Measurement and Control, Financial Executives Research Foundation, 1965 pp 60-64.

Stirling ,R.R. (1968), The Going Concern: An examination", The Accounting Review, July 1968, p481-502.

Stirling, R. (1970), Theory of the Measurement of Enterprise Income, Manhattan, Kansas: The University of Kansas,1970

Stirling, R. (1971) (ed) , Asset Valuation and Income Determination: A consideration of the Alternatives, Kansas: Scholars Book Co., 1971.

Udovitch, Abraham L. (1970), Partnership and Profit in Medieval Islam, Princeton, New Jersey: Princeton University Press, 1970. (347.7 U 21).

Zakaria Mann (1991), "Islamic Banking: Prospects for Mudharaba and Musharakah Financing", in A.M. Sadeq, A.H. Permanik, N Mustapha bin Nik Hassan (eds), Development & Finance in Islam:Proceedings of the International Seminar on Islamic Economics, 1987 Kuala Lumpur, Petaling Jaya, Malaysia: International Islamic University Press.

Zeff, S.A., "Replacement Cost: Member of the Family, Welcome Guest, or Intruder?", The Accounting Review, Volume XXXVII, October, 1962.

Ziauddin Ahmad (1991), "Islamic Banking at the Crossroads", in A.M. Sadeq, A.H. Permanik, N Mustapha bin Nik Hassan (eds), Development & Finance in Islam:Proceedings of the International Seminar on Islamic Economics, 1987 Kuala Lumpur, Petaling Jaya, Malaysia: International Islamic University Press.