One of the most important fundamental principles of modern accounting and financial reporting is the impact of the economic substance should be reflected rather than the legal form. The economic substance reflect the purpose of the financial transaction or the economic consequences truly and fairly. The legal form is secondary important because it only accounted the legal or the technical aspect of the transaction.
The best example is when a motor vehicle company purchase motor vehicle for business purposes i.e. for sale. The substance that should be reflected is purchase of stock of goods for sale. However, if the company purchase a motor vehicle to be used by the company or by the management then the economic substance is fixed asset purchase. Even though the legal form is the same, the economic substance should be different due to different purposes of the purchases.
In the case of Islamic financial transaction, when an investor put their money in the Islamic bank let say based on a Mudarabah contract, the economic substance is the same like conventional deposit. However, the legal form is different. Conventional deposit is a lending transaction and the bank pays the depositor interest. In the case of Islamic and Mudarabah investment, it is a relationship between the investor (Rabbul Mal) and the bank (Mudarib). The profit earned by the Islamic bank is then shared with the investor and it is not an interest payment.
From the above example, if Islamic financial transactions used Substance Over Form principle then we missed out the legal form that make up the transaction. Legal form must be reflected to distinguish the accounting treatment of Islamic investment from interest-based lending. The profit must also be distinguished from interest income that reflect the different underlying principle of Islamic financial transactions.
To be continued...
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