Understanding the Accounting and Auditing Organization for Islamic Financial Institutions

In Islamic finance, there are unique rules, restrictions, and requirements regarding business and investing. In order to be considered acceptable, transactions must adhere to the principals under Shariah. The Accounting and Auditing Organization for Islamic Financial Institutions sets compliance standards for institutions that wish to gain access to the Islamic banking market.

The AAOIFI is continually updating its scope to include the various new financial instruments entering markets around the world. For example, new hedging mechanisms would first need to be discussed and accepted by the AAOIFI before any member would offer these services.

Islamic Finance Basics

Two fundamental principles of Islamic (shari'ah) banking are the sharing of profit and loss, and the prohibition of the collection and payment of interest by lenders and investors. Islamic law prohibits collecting interest, known as "riba." Although Islamic finance began in the seventh century, it has been formalized gradually since the late 1960s. This process was driven by the tremendous oil wealth that fueled renewed interest in and demand for Sharia-compliant products and practice.

To earn money without the use of charging interest, Islamic banks use equity participation systems. Equity participation means if a bank loans money to a business, the business will pay back the loan without interest, but instead gives the bank a share in its profits. If the business defaults or does not earn a profit, then the bank also does not benefit.

For example, in 1963, Egyptians formed an Islamic bank in Mit Ghar. When the bank loaned money to businesses, it did so on a profit-sharing model. To reduce its risk, the bank only approved about 40% of its business loan applications, but the default ratio was zero.

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