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Separate Business Entity Concept – Conventional and Islamic

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    The manner of this short essay is that it will discuss my findings regarding the generally accepted accounting concepts and principles a. k. a. the GAAPs that most accountants and professional accountancy bodies worldwide have, in unison, established to be the essence of the most ordinary way of businesses treating their everyday activities within the scope of accounting. All businesses do have in their rights the ability of creating their own method of dealings with their own personal accounting treatment, but they should, in some degree, declare the reasons as to why they opted out for using the normally accepted accounting treatments.

    In light of that, I will then try to comprehend what have most Islamic scholars and jurists have their say in this topic, whether or not this particular GAAP is within the Syariah of Islam. The topic in discussion is the conventional ‘Separate Business Entity Concept’. Before going any further, some clarifications ought to be pronounced. There are two ambiguities here as to how most common students and of those that are illiterate in accounting in general have mistakenly understood by this concept. It is only fair that I state these two because I myself was initially intertwined with both of the ambiguities.

    I will start by articulating the most basic understanding of the concept. Accordingly, owners and their business are two very distinct character or entities; meaning that you cannot count Mr J and J Enterprise to be of one entity or body. What this concept further implies is that Mr J and J Enterprise is of the relationship of a debtor and a creditor; meaning that initially, Mr J had injected his own personal money into J Enterprise to start the business namely the capital, and J Enterprise should therefore treat Mr J as if it owes Mr J money.

    Throughout the course of an accounting period, Mr J can rightfully take from J Enterprises whatever he wishes, be it cash or any other physical things, and that is called drawings. J Enterprise is thus fully able to acquire personal assets and lands, and hold liabilities; it is very much in distinction with Mr J. Furthermore, J Enterprise can also sue others and be sued by others, hold contracts with other businesses, responsible for taxes to the government, hold properties under its name, and ultimately can be declared bankrupt as any other human being can.

    This understanding of this concept is applied to all types of businesses, namely sole traders, partnerships and companies. Just for the sake of this discussion, pretend that J Enterprise would eventually be large enough to become a limited company with the name J Ltd. What normally happens is that in a limited company there is a group of people who purchases portions of J Ltd, which are called shares, and those people can now to a degree be called one of the owners J Ltd. A collective of them is termed shareholders.

    Now, as J Ltd and its shareholders are two very distinct entities, in the case of J Ltd gaining profit, all the shareholders will enjoy a certain amount of the profit under the term of dividends. The division of profits amongst the shareholders are directly proportional to the amount of shares each shareholder initially invested inside J Ltd. But, in the case of J Ltd experiencing loss or liquidation, the shareholders will bear no more liability to the settlement of all J Ltd. ’s debts to its creditors to the extend only that which the amount they initially invested in, just like with dividends.

    J Ltd. ’s creditors cannot demand from the shareholders of J Ltd for remedies no more than the amount of which the shareholders have invested initially in J Ltd. These two paragraphs highlighted the two ambiguities that were aforementioned. The first one is that in all types of business, from sole traders to the most complex public limited companies, the owners and the business are two very distinct entities. All transactions between the business and the owners should be officially documented just like any other business transactions.

    The second point is that, if a business should incur a loss for that period, as mentioned before, the shareholders of a company will not be held responsible for settling the company’s debt. The shareholders have ‘limited liability’ over the company. As Mufti Taqi Uthmani wrote in this issue, “’The limited liability’ in the modern economic and legal terminology is a condition under which a partner or a shareholder of a business secures himself from bearing a loss greater than the amount he has invested in a company or partner-ship with limited liability”.

    As also written under the English Law which is applied in Malaysian Law, under the Companies Act 1965 (Act 125) Section 16(5), ‘A company shall be regarded as a body corporate, capable of exercising all the functions of an incorporated company’. But under no circumstances these terms of legality applies to a sole trader. A sole trader is very much held liable for each and every debt is business incur, and all the creditors are rightfully able to claim the sole trader’s personal assets in order to settle their debts. These two ambiguities, in much shorter words are as follows : * Separate Entities : applicable to sole traders and all other business types * Separate Legal Entities : not applicable to sole traders What most scholars and jurists have discussed upon is the second point, which is the separate legal entity between the shareholders and the company.

    The question of syari’ah compliance is being thrown into doubts when a company incur a loss, and its creditors are not able to receive their rightfully amount of money owing to them. As Mufti Taqi Uthmani wrote so eloquently on this issue, “No doubt, the concept of ‘limited liability’ is beneficial to the shareholders of a company. But, at the same time, it may be injurious to its creditors.

    If the liabilities of a limited company exceed its assets, the company becomes insolvent and is consequently liquidated; the creditors may lose a considerable amount of their claims, because they can only receive the liquidated value of the assets of the company, and have no recourse to its shareholders for the rest of their claims. Even the directors of the company who may be responsible for such an unfortunate situation cannot be held responsible for satisfying the claims of the creditors”.

    It is especially because of that aspect in the concept that requires a considerable amount of discussion and research amongst the Muslim ulama’ and from the Syari’ah viewpoint. From this point forward, I will be quoting the points that of which Mufti Taqi Uthmani reasons out that the concept is to be accepted inside the Syari’ah because of factors that will follow on later. After that, I will proceed with an opinion of a paper written by two lecturers of University Kelantan Malaysia regarding the issue, which in their defence, is not syari’ah compliant.

    The most prominent point of understanding in order to resolve this issue as argued by Mutfi Taqi Uthmani is whether the concept of ‘juridical person’ is in itself syari’ah compliant, because as written by Mufti Taqi, ‘Once the concept of ‘juridical person’ is accepted and it is admitted that, despite its fictive nature, a juridical person can be treated as a natural person in respect of the legal consequences of the transactions made in its name, we will have to accept the concept of ‘limited liability’ which will follow as a logical result of the former concept’.

    It is now reasonable to comprehend first what is the official definition of juridical person. A juridical person is defined as an individual, company, or other entity which has legal rights and is subject to obligations by Oxford University Press. Thus, if we are to accept that a company in its fullest ability are able to act as a juridical person in the eyes of the law, which is very much similar to that of a human being, than the same principle will inevitably, be applied to a company that is nearing bankrupt.

    Hence, Mufti Taqi Uthmani then proceeded with his arguments as to why in his personal opinion thinks that the concept of ‘juridical person’ is acceptable in syari’ah by presenting evidence that our forefathers have in precedent showed example of transactions and dealings which is near to the concept of a juridical person. The first argument is that of a term in Arabic called the ‘Waqf’. Waqf is in essence a legal and religious institution that is defined in the action wherein a person dedicates some of his properties for a religious or a charitable purpose.

    Once whatever the thing that the person declares to be a waqf, then it is no longer in ownership of the person. But the person accepting the waqf, or beneficiaries, is neither the owner of the waqf. The beneficiaries may obtain some benefits from the waqf, but never full ownership. Its true ownership vests in God Almighty alone. So in an angle it seems that older Muslim Jurists have treated waqf as a separate legal entity and have ascribed to it some characteristics similar to those of a natural person.

    This will be more in clarity with the following two rulings given by the Fuqaha’ (Muslims jurists) in respect of a waqf. * If a property is purchased with the income of a Waqf, the purchased property cannot become a part of the Waqf automatically. Rather, the jurists say, the property so purchased shall be treated as a property owned by the Waqf. It clearly means that a Waqf, like a natural person, can own a property. * Another renowned Maliki jurist, namely, Ahmad Al-Dardir, authenticates an inheritance request made by a mosque, and gives the reason that a mosque can own properties.

    Not only this, he extends the principle to an inn and a bridge also, provided that they are Waqf. “It is clear from these examples that the Muslim jurists have accepted that a Waqf can own properties. Obviously, a Waqf is not a human being, yet they have treated it as a human being in the matter of ownership. Once its ownership it established, it would logically follow that it can sell and purchase, may become a debtor and a creditor, and can sue and be sued, and thus all the characteristics of ‘juridical person’ can be attributed to it”. Mufti Taqi’s next argument is that which is very commonly found in our classic literature, the exchequer of an Islamic State, the Bait al-Mal. Being a public property, every citizen of an Islamic State have to a certain degree some beneficial rights over their Bait al-Mal, but none can claim full ownership. And still, the Bait al-Mal do have some rights and obligations that of which is unique only to it.

    As Imam al-Sarakhsi, a well-known Hanafi Jurist says in his work ‘Al – Mabsut’, “The Baitul-mal has some rights and obligations which may possibly be undetermined”. He also mentioned further in the same work that, “If the head of an Islamic state needs money to give salaries to his army, but he finds no money in the Kharaj department of the Baitul-mal (wherefrom the salaries are generally given) he can give salaries from the sadaqah (Zakah) department, but the amount so taken from the sadaqah department shall be deemed to be a debt on the Kharaj department”.

    What can be taken from this is that not only does the Bait al-Mal as a whole, but the different departments within are more than able to borrow and advance loans to each other. The concern of repayments of the loans is not of the concern of the Head of State, instead it lies under the effected departments themselves. It means that each department of Baitul-mal is a separate entity and in that capacity it can advance and borrow money, may be treated a debtor or a creditor, and thus can sue and be sued in the same manner as a juridical person does. It means that the Fuqaha of Islam have accepted the concept of juridical person in respect of Baitul-mal”. The third argument made by Mufti Taqi is based on the example so very much close to the concept of a juridical person he found in the Fiqh of Imam As-Syafi’i, the concept of a Joint Stock.

    According to an accepted principle in the school of As-Syafi’i, if in any business concerning partnerships where each partners contribute some portion of their assets into it, and hence mixed together inside the partnerships, the obligatory Zakah is then imposed upon each of the partners individually, but the collecting of the zakah afterwards is payable specifically on their collective joint stock as a whole, so much so that even if one of the partners’ portion of asset within the joint stock doesn’t even come into nisab, but the combined value of their total assets collectively do reach and excess the prescribed amount of nisab, zakah is nonetheless is payable on the whole joint stock including some of the shares of the one partner that isn’t come of nisab. If the zakah were to be levied based on individual proportion of each partners’ assets, that one partner would not be subjected to zakah.

    The same principle, which is called the principle of ‘Khultah-al-Shuyu‘’ is more forcefully applied to the levy of Zakah on the livestock. Consequently, a person sometimes has to pay more Zakah than he was liable to in his individual capacity, and sometimes he has to pay less than that. That is why the Prophet has said that : ‘The separate assets should not be joined together nor the joint assets should be separated in order to reduce the amount of Zakah levied on them. The principle of Kultah al-Shuyu’ which is accepted to some extent by the Maliki and Hanbali schools with some variances in details, and have in its essence some basic concepts of a juridical person.

    The concept is that it is not the partners or owners themselves are subject to zakah, instead is the joint stock as a whole has been made subject to levy. Thus, what this further implies is that the joint stock in it of itself has been treated as a separate entity from the owners or partners, and the obligation of zakah has been focused towards the joint stock, which can be seen as an entity, and that itself indicates much similarity with the concept of a juridical person. The fourth argument made by Mufti Taqi regarding this issue can be expressly defined as the property left by a deceased person whose liabilities exceed the value of all the property left by him, but for brevity we would just call it the ‘Inheritance Under Debts’ concept.

    According to Muslim jurists and scholars, this special type of property is neither owned by the deceased, because he is no more alive, nor is it owned by his heirs, for the debts on the deceased have a preferential right over the property as compared to the rights of the heirs. It is not even owned by the creditors, because the settlement has not yet taken place. The creditors may have their claims over the debts, but those claims would not make it theirs unless the property is divided between them. Thus, the inheritance under debt, being of nobody’s, has its own existence and it can be termed a legal entity. The heir of the deceased may become the managers of the property, but never the owners.

    If the process of the settlement of the debt requires expenses, then it will be charged to the property itself. Thus, in an angle, this inheritance under debt has its own entity, which may sell and purchase, becomes debtor and creditors, and the same characteristics that which makes up similarly of that a juridical person. Not only this, the liability of this ‘juridical person’ is certainly limited to its existing assets. If the assets do not suffice to settle all the debts, there is no remedy left with its creditors to sue anybody, including the heirs of the deceased, for the rest of their claims. Concluding Mufti Taqi’s argument and his fifth argument, is the most common custom of the classical Arab’s lifestyle, Slavery.

    The concept of slavery that is in question of this issue is as such; when a slave is initially being traded, his soon to be master would have to go into a business transaction and purchase the slave, in other words, investing in the slave. The initial capital of the master on the slave is fully of the master’s. If the slave were to generate in any ways means of income, then whatever the slave earns is exclusively the property of its master’s. Furthermore, if the slave is asked to help his in his master’s business transactions, and during the course of the trading some debts are incurred, the debts are then will be set off by the cash and stock present in the hands of the slave.

    However, if those are deemed insufficient, the creditors then have rights to sell the slave to some other buyer to acquire their debts. If even then their claims is not fulfilled, the slave will then die in a state of indebtedness, and more crucially, the creditors are by no means have any rights to approach his initial master for their claims of the debt. Here, the master was actually the owner of the whole business, the slave being merely an intermediary tool to carry out the business transactions. The slave owned nothing from the business. Still, the liability of the master was limited to the capital he invested including the value of the slave. After the death of the slave, the creditors could not have a claim over the personal assets of the master.

    I would like to conclude Mufti Taqi Uthmani’s arguments with quoting his own word of conclusion. He said that “These are the nearest examples found in the Islamic Fiqh which are very much similar to the limited liability of the shareholders of a company, which can be justified on the same analogy. On the basis of these five precedents, it seems that the concepts of a juridical person and that of limited liability do not contravene any injunction of Islam. But at the same time, it should be emphasized, that the concept of ‘limited liability’ should not be allowed to work for cheating people and escaping the natural liabilities consequent to a profitable trade”.

    He further emphasized that some restrictions ought to be placed, such as for partnerships and private company, these arguments shouldn’t be made because practically, each one of their shareholders and partners can easily acquire a knowledge of the day-to-day affairs of the business and should be held responsible for all its liabilities. As for public companies which have thousands of shareholders, these arguments are valid. I will now proceed with one argument made by two lectures from University Kelantan Malaysia, a paper on ‘Islamic Accounting and Business Practices: A Conceptual Framework’. In this paper, they have similarly initiated a study that compares the conventional accounting and business practices and decided using arguments from the Holy Quran and Authenticated Hadiths as to their approval in the syari’ah.

    It is their argument that the concept in discussion is not within Syari’ah approval because ‘the owners are not liable for the company’s debt at the time of bankruptcy but have the rights to residual profits which is unlawful and similar to gambling’. They have also mentioned that in Islamic Accounting, ‘if the owners become bankrupt, then the liabilities may be distributed to their successors or legal inheritors, and, it will be better for the owners because he will be asked for it in hereafter [Al-Qur’an, 23:115]’. They have also pointed out that in accordance to other opinions, others have accepted the concept to be of syari’ah compliant with reference ‘to the early age of Islamic State there were Mosques or Baitul-Mal with separate financial status and [Abdul-Rahman, 1996 and AAOIFI, 1999]’.

    Thus, with much modesty it is of my opinion that this discussion should not in any way be concluded because looking further into the preferred professions of students and students such as myself that is in sha Allah will be on the line of business and accountancy, we are not aware of these crevasse of opinions with what we are being fed now in college. These things will eventually be part and parcel of our lives and yet, declaring Islam is our way of life, we are still ignorant. Presently, I am nowhere in a position able to decide for myself which is compliant with the syari’ah, nor am I in a position of choosing what materials I should be learning due to decisions made. So, in reality, it is self-awareness separates between the wise from the ignorant, the truth from the deceits, the successful from the losers, and of course, the blessings of The Most High from His Wrath. With that tone, I conclude this essay. Wallahu a’lam.

    This essay was written by a fellow student. You may use it as a guide or sample for writing your own paper, but remember to cite it correctly. Don’t submit it as your own as it will be considered plagiarism.

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