Issues in the reporting of Islamic financial instruments have been discussed since early 2000. Among these issues is the debate about whether the accounting standards promulgated by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) or the International Financial Reporting Standards (IFRS) should be adopted for reporting Islamic financial transactions. Abdel Karim (2001) explained the need to implement the AAOIFI accounting standards as these standards specifically cater for the unique characteristics of the contracts that govern the operations of Islamic banks. The IFRS, on the other hand, do not have any specific reporting standards for the unique contracts adopted by Islamic banks but report the transactions based on the accounting principle of substance over form.

The purpose of this paper is to examine the accounting treatment and reporting of a murabaha contract and its implication to the financial statements of Islamic banks. In addition, the paper also explains the implication of time value of money on the measurement of a murabaha contract and the concept of substance over form in recognising financial transactions. This study reviews the accounting treatment and reporting for a murabaha contract as stated in the Financial Accounting Standards (FAS) of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the application of a murabaha contract as a financial instrument based on International Financial Reporting Standards (IFRS). The paper finds that, while IFRS-based financial reporting primarily focuses on economic consequences of financial instruments, AAOIFI further takes into consideration the legal structure of the instruments, which are based on Shari'ah precepts. The paper also finds that IFRS-based financial reporting cannot always capture the distinctive structure of the murabaha and, hence, may lack representational financial reporting. However, the IFRS recognizes the substance of a murabaha contract as financing, and the majority of Islamic banks in Malaysia report it as one of financing and not as a trading contract. For measurement, IFRS adopted the concept of time value of money where the profit allocation is based on amortized cost, which is similar to the measurement of conventional loan transactions that apply the concept of effective interest rate. Meanwhile, AAOIFI uses a straight-line basis to allocate the profit of a murabaha contract. The forthright discussion and the observations of the paper are expected to assist regulators and standard setters in developing accounting standards that are in convergence but also cater to the unique characteristics of Islamic financial transactions.