ACCOUNTING REGULATORY ISSUES ON INVESTMENTS IN ISLAMIC BONDS

International Journal of Islamic Financial Services, Vol.4, No.4

ACCOUNTING REGULATORY ISSUES ON
INVESTMENTS IN ISLAMIC BONDS


Abdul Rahim Abdul Rahman


The main objective of this paper is to examine contemporary accounting regulatory issues on
investments in Islamic bonds or sukuk. Investments on Islamic bonds (sukuk) give rise to a
number of accounting and reporting issues related to recognition, measurement and
disclosure. The underlying rationale of this paper is that proper development of Islamic
financial market requires a well regulated Islamic financial instruments and one of the key
elements of regulation is accounting regulation. Therefore, a well regulated Islamic financial
market requires a sound accounting and reporting standard of Islamic financial instruments
that, first, meet the requirements of syari’ah, and, second, relevant to be practiced in our time.

The need for Islamic accounting that deals with Islamic financial instruments has prompted AAOIFI recently to introduce Financial Accounting Standard No.17 on investments in securities (AAOIFI FAS 17, 2003). The need for a codified Islamic accounting standard are primarily stemmed from the need that Islamic accounting objectives, concepts and principles to be developed based on syari’ah requirements. However, the Islamic accounting regulation also needs to adapt to the modern accounting regulatory environment to make it relevant to be practiced in our time. The examination of AAOIFI FAS 17 shows that AAOIFI has been pragmatic in its approach by considering both requirements when developing its standard. This is a pro-active step to provide a sound accounting regulation as part of a comprehensive regulation of Islamic financial institutions.

1. Introduction

The growth of Islamic financial market and institutions, culminating in the growing interest in Islamic
banking, finance and insurance reiterates the need for different accounting requirements. Islamic accounting
is needed to serve different principles of financial instruments that are founded on the Islamic worldview
and syari’ah requirements. The efforts of Accounting and Auditing Organizations of Islamic Financial
Institutions (AAOIFI) in the 1990s to develop accounting standards for Islamic financial institutions are
commendable as a positive contribution towards harmonizing accounting practices of Islamic financial
institutions. The standards developed by AAOIFI are also expected to facilitate the needs of the users of
accounting information of Islamic financial institutions who, in theory, demand different sets of information.

The main objective of this paper is to examine contemporary accounting regulatory issues on Islamic
bonds or Islamic Private Debt Securities (IPDS) or sukuk. Investments on Islamic bonds (sukuk) give rise
to a number of accounting and reporting issues. These issues relate to recognition, measurement and
disclosure. This study also highlights and discusses the requirements made by AAOIFI’s Financial
Accounting Standard No.17 (FAS 17) on accounting for investments in Islamic bonds or sukuk.


International Journal of Islamic Financial Services, Vol.4, No.4


The underlying rationale of this paper is that proper development of Islamic financial market requires a well regulated Islamic financial instruments and one of the key elements of regulation is accounting regulation. Therefore, a well regulated Islamic financial market requires a sound accounting and reporting standard of Islamic capital market instruments that, first, meet the requirements of syari’ah, and, second, relevant to be practiced in our time.

The paper will be structured accordingly to address the above objectives, by first, introducing how the
Islamic worldview influences the objectives and concepts of modern accounting and reporting. Secondly,
the paper examines accounting objectives and concepts from an Islamic perspective. Thirdly, accounting
issues on investments in Islamic securities particularly Islamic bonds or sukuk are discussed to highlight
contemporary accounting issues on providing a sound accounting regulation for Islamic financial market
instruments.

2. Islam and Accounting

Islam literally means ‘peace’ and ‘obedience’, and adherence to Islam have to be ‘obedient’ to God and to appreciate the purpose of their existence in this world (Al-Faruqi, 1982). God is said to have proclaimed that, “I have only created… men that they may serve me” (al-Qur’an, 51:56). The nature of this service is taken to have been spelled out clearly when God, upon creating men, declared, “I will create a vicegerent on earth” (al-Qur’an, 2:30). Muslims consider humans to be vicegerents of God. Thus, whatever worldly possession a Muslim has is to be held in a stewardship capacity - that is simply in trust from God (AbuSulayman, 1994). According to Islam, Muslims are trustees (or stewards) for God: Man therefore agrees to assume this great responsibility in a covenant with God.
In a Muslim society, accounting is expected to be influenced by the way the economic system is organized
and the philosophy underpinning its system. If we examine the role of economic activities in Islam we will
find that the philosophy of human activity should be directed towards the achievement of Falah a
comprehensive human welfare in this life and also in the hereafter. According to Siddiqi (1972) Falah is
a tangible quality towards the achievement of God’s pleasure. Human welfare as believed by Muslims can
be achieved without any conflict in the genuine interest of this worldly life and the Hereafter.

To achieve this Falah, economic activities must be morally directed. In any economic decisions, including
financial reporting upon economic activities, the ethical values should act as a norm and economic
relationship must be regarded as moral relationship. The achievement of Falah is neither dependent on
nor related to maximization of wealth or profit nor to the size of the individual business enterprise and
quantity of output. Therefore, to a profit making organization their activities should serve as a means for
them to function in the economy. The worldview should be that they provide service to the public by
manufacturing and/or trading goods or providing services and in return profit is only aim to ensure they
can operate and grow.

Accounting functions to discharge the accountability of enterprise as a result of separation of ownership
and the management. The users might be shareholders, creditors, potential investors and the public. In the
Muslim society, the concept of accountability is ingrained in the basic creation of Man as a vicegerent of
God on the earth. Man mission on earth is to fulfill the purpose of its existence in the universe. Man is thus
created as trustees and accountable for all their actions (Abu-Sulayman, 1994). In Islam, accounting


International Journal of Islamic Financial Services, Vol.4, No.4

should function not only as a service activity providing financial information to the users and to the public at large but more important accountants should discharge their accountability by providing information to enable society to follow God’s commandments.

The Muslims also believed that Men are vicegerents on earth and directly accountable for all their actions as they are only trustees of God. Therefore, in this sense, accountants should lay formal claim to the status of moral arbiters to ensure the responsibility and transparency of an organization’s internal procedures, so that issues of policy and governance are properly debated and recorded, at the point where the moral problems arise in the first place (Gambling and Karim, 1991).

In the light of the above worldview of Islam, some ethical notions assume a broader and more holistic
significance to the accountant. In terms of responsibility, the accountant in Islam is not merely responsible
to human superiors, the management/client or shareholders. He/She is a servant and trustee of God in all
situations, is simultaneously responsible to God the Owner of his very self and the resources he is utilizing
and managing. To forget or to neglect this fundamental aspect of this responsibility is tantamount to a
betrayal of divine trust with all the attending consequences in this world and in the next (Hassan, 1995).

The accountant in Islam is not only required to maintain good relationship with superiors, client or the management but also maintain, improve and strengthen his relationship with his Master by fulfilling the religious obligations. In fact the relationship with the Master (Hablun Min’Allah) will determine the mode of relationship with fellow servants (Hablun Min’An-Nas) (Hassan, 1995). Guided by the proper relationship with God, the human Accountant and public relations would then be inspired by value of truthfulness, fairness, tolerance and uprightness etc.

The accountant in Islam is motivated to provide work and excellent service because as a holder of Amanah (Trustee of God) on earth he must search for the bounties of God. His/Her work is a form of Amal Salih (virtuous deed) which is then the key for the attainment of Falah (true success in this world and in the hereafter). His/Her work is also a form of Ibadah (servitude to God) in so far as it is in conformity with the divine norms and values. The Accountant who is imbued with the world-view of Tawhid (oneness of God) is not anti profit or anti-worldly gain within the limits provided by religion. His vision of success and failure however extends beyond worldly existence to the life in the hereafter.

3. An Islamic Perspective of Accounting Objectives and Concepts

According to conventional accounting, accounting objectives and concepts are needed to guide existing
accounting practice; prescribe future accounting practice; and define key terms and fundamental
accounting issues (Miller, 1985). According to AAOIFI’s Statement of Financial Accounting No.1 (AAOIFI
SFA 1), the need for accounting objectives for Islamic financial institutions stemmed from the role of
accounting. Since the role of financial accounting is to provide the information which users of the financial
statements of Islamic banks depend on in assessing the bank’s compliance with the precepts of syari’ah,
therefore, in order for the Islamic financial institutions to perform the role effectively, accounting standards
need to be developed and complied with by Islamic banks. The development of such standards must be
based on clear objectives of financial accounting and agreed upon definitions of its concepts.


International Journal of Islamic Financial Services, Vol.4, No.4


Allah SWT said:

“We shall set up justice scales for the day of judgement, not a soul will be dealt unjustly in the least. And if there be (no more than) the weight of mustard seed, we will bring it (to account); And enough are We to take account” (Al-Qur’an Chapter 21, verse 47).

“O you who believe! When you deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing” and “Let a scribe write down faithfully as between the parties” (Al-Qur’an Chapter 2, verse 282)

Based on the above verses we can deduce that the objectives of accounting should be to ensure fair and just financial transactions between human beings. Accounting information is expected to fulfill the needs of those who are in need or expected to require such information. However, the primary objective of accounting information must be to fulfill the ultimate accountability to Allah SWT.

In addition to fulfilling the ultimate accountability to Allah SWT, the preparers of financial information
must know the common information needs of users of financial reports. Common information needs of the
users are normally consist of the needs for information which can assist in evaluating the entity’s ability in
using its economic resources and fulfill its obligations. In this respect AAOIFI’s SFA 1 has broaden the
scope beyond just economic responsibilities to encompass information that can assist in evaluating the
entity’s compliance with the principles of syari’ah and its ability to carry out social responsibilities
specified by Islam
Some scholars have also argued that accounting objectives can be derived from the way one account for his
or her zakat obligations (Adnan & Gaffikin, 1997). Adnan and Gaffikin (1997) argue that by making
zakat the primary objective, one tend to avoid the unwanted practices of cheating or ‘window dressing’
because he or she believes that accountability to Allah SWT is of utmost important and Allah SWT always
watches him or her.

On the other hand, accounting concepts are variously referred to as principles, axioms, postulates,
assumptions and rules. One of the basic accounting principles is the use of historical cost for asset
valuation that basically derived from the concept of conservatism. Many Islamic accounting writers (e.g.
Gambling and Karim, 1991; Adnan and Gaffikin, 1997) cast doubt on the relevance of the concept of
conservatism. Many refer to the principles of zakat where trade assets subjected to zakat must be based on
current market value (Qardawi, 1999) or cash equivalent value (AAOIFI FAS 9). Adherence to the cost
principles leads to the conventional accounting practice that is lower of cost or market value. This will lead
to understatement of trade assets to be subjected for zakat. Thus, the cost concept cannot be acceptable in
Islam.

The preparation of financial information in Islam should be aimed among others for zakat purposes. Thus,
the aim for zakat purposes may lead to the need of periodicity assumption as zakat is only paid once a year.
The periodicity assumption has led to the development of accruals accounting, and the principles of
income recognition and matching. Therefore, accounting statements would, therefore, be prepared for that
particular period, showing the amount of which zakat would be levied (Gambling and Karim, 1991).


International Journal of Islamic Financial Services, Vol.4, No.4

4. Islamic Accounting Concepts on Recognition, Measurement & Disclosure

Accounting recognition refers to recording the basic elements of the financial statements. The concepts of
accounting recognition define the basic principles that determine the timing of revenue, expense, gain and
loss recognition in the entity’s income statement and, in turn, the basic principles that determine the timing
of assets and liabilities recognition. AAOIFI’s SFA 2 recommends that “revenues should be recognized
when realized”. Realization of revenue shall take place when one of the three conditions are met: (1) The
entity has the right to receive the revenue; (2) There is an obligation on the part of another party to remit;
and (3) The amount of revenue should be known and collectible with reasonable degree of certainty.

The above recommendation indicates the use of accrual basis accounting which has been claimed to be
better than the alternative cash basis accounting. Accrual basis of income recognition does meet the
requirement of Islamic objectives to determine the ‘real’ wealth of an entity. Contrary to cash accounting,
it likely provides an underestimate value of wealth as the recognition is based on actual cash received and
paid.

In addition, according to the matching principle, expense recognition is realized either because the expense
relates directly to the earning of revenues or because it relates to the period when the expense is incurred.
From the Islamic perspective, the matching principle which allocates expenses to their related revenues,
provides fairness and justice simultaneously to the shareholders and other stakeholders (El-Tegani,undated)

The conventional accounting measurement is based on the cost principle that considers the acquisition cost
or historical cost as the appropriate measurement basis. However, this principle is questionable from the
Islamic point of view due to it conflicts with the concept of fairness and justice. In the case of zakat
determination, majority scholars recommended the use of current prices on the due date of zakat (Al-
Qardawi, 1999). The argument for the use of current market value has been based on the needs for the most
accurate valuation of wealth to be subjected for zakat in order to serve justice to both the zakat recipients
and zakat payers.
AAOIFI, however, asserts that the measurement attributes should be guided by the relevance, reliability, understandability and comparability of the information to be provided to the users. AAOIFI has recommended the use of cash equivalent value that indicates the value that would be realized if an asset was sold for cash in the normal course of business as at the date of the financial statement. In order to ensure the reliability and comparability of the cash equivalent value, it must be supported with objective indicators; logical and relevant valuation methods; consistency of the use of valuation methods; expert valuation; and conservatism in the valuation process (AAOIFI SFA 1). AAOIFI also recommends an alternative method i.e. historical cost that refers to its fair value at the date of its acquisition including amounts incurred to make it usable or ready for disposition.
In terms of disclosure requirements, it is of interest to examine Baydoun and Willet’s (1997) proposed objectives of accounting disclosure. They argued that there are at least four objectives of accounting disclosure for an Islamic firm, whereby the first two are specific requirements laid down by syari’ah for the firm to avoid riba’ and pay zakah. The second two objectives are based on inferred general requirements which can be referred to as ‘social accountability’ and full disclosure’.


International Journal of Islamic Financial Services, Vol.4, No.4


While the first two objectives i.e. prohibition of riba’ and payment of zakat have extensively been covered by many past literature, the second two objectives require special attention. Baydoun and Willet (1997) viewed the Islamic concept of social accountability to encompass the accountability ultimately to God. The fundamental concept of Islamic accountability is where Muslims believed that all resources are made available to individuals in a form of trust. The success of individuals in the life hereafter depends upon their performance in this world.
The implications of Islamic accountability on accounting is that the management and providers of capital
need to be accountable for their actions (or in-action) both within and outside the firm by providing proper
accounting and reporting. Thus, the Islamic concept of social accountability departs clearly from the
western attitudes toward accountability which are most applicable to the concept of private accountability.
The concept of social accountability in Islam is also related to the principle of full disclosure. According to Baydoun and Willett (1997) full disclosure does not mean to disclose everything down to every minute detail of transactions. There is, however, the need for the preparer of account to disclose everything that is believed as importance to users for purposes of serving God. In a more precise word, AAOIFI’s Statement of Financial Accounting No. 2 on Concepts of Financial Accounting for Islamic Banks and Financial Institutions (SFA 2) made it very clear that the Islamic concept of disclosure revolved around the concept of ‘adequate’ disclosure. Here, adequate disclosure means that the financial statements should contain all material information necessary to make them useful to users.

AAOIFI’s SFA 2 elaborated the concept of adequate disclosure into two aspects namely optimal aggregation and appropriate descriptions and clarifications. Optimal aggregation means the financial statements should provide sufficient details to meet the users’ need for information. However, too much detail can contribute to confusion. Therefore, it needs appropriate descriptions and clarifications to make the information provided to be useful to users and sufficient additional notes become necessary.
5. Aaoifi Fas 17 & Accounting Issues On Investments In Islamic Securities Background of the Standard
The AAOIFI Financial Accounting Standard No. 17 (AAOIFI FAS 17) shall apply to the institution’s investments, whether in the form of direct investment funds or investment portfolios, in sukuk (Islamic bonds), shares, and real estate. The standard is relatively new that is it shall only be effective for financial periods beginning 1 Muharram 1424H or 1 January 2003. Thus, it makes the discussion of this standard necessary especially for institutions that have investments in Islamic capital market instruments. There is lack of academic writings in this area that require special attention to ensure proper accounting for complex instruments such as Islamic bonds (sukuk).



International Journal of Islamic Financial Services, Vol.4, No.4

AAOIFI FAS 17 classifies Islamic bonds (sukuk) into at least four types:

(a) Mudaraba (Muqaradah) sukuk
These are investments in sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the mudaraba equity and its returns according to percentage of ownership of share. The owners of such sukuk are the rabbul-mal (capital provider).

(b) Musharaka sukuk

These are investments in sukuk that represent ownership of Musharaka equity. It does not differ from the Mudaraba sukuk except in the organization of the relationship between the party issuing sukuk forms a committee from the holders of the sukuk who can be referred to in investment decisions.

(c) Ijarah sukuk

These are sukuk that represent ownership of equal shares in a rented real estate or the usufruct (benefit) of the real estate. These sukuk give their owners the right to own the real estate, receive the rent and dispose of their sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such sukuk bear all cost of maintenance of and damage of the real estate.

(d) Salam or Istisna’ sukuk
These are sukuk that represent a sale of a commodity on the basis of deferred delivery against immediate
payment. The deferred commodity is a debt in-kind against the supplier because it refers to a commodity
which is accepted based on the description of the seller. The Istisna’ sukuk is similar to Salam sukuk, except it is permissible to defer payment in an Istisna’ transaction, but not in a Salam. In both Salam and
Istisna’, the subject matter of the sale is an obligation on the manufacturer or builder in the case of Istisna’
and the seller in the case of Salam. Hence both instruments can neither be sold nor traded before their
maturity date if either the buyer or the seller of the commodity issues them. Accordingly, these sukuk are
treated as investments held to maturity.

Classification of Investment

One notable contribution of AAOIFI FAS 17 is the classification of investment in sukuk into three types namely: for trading purposes; available for sale; and held to maturity. The basis of AAOIFI classification is based on the well-known syari’ah classification of trade commodities for the purpose of zakat. For example, the jurists of Maliki School have classified trading assets into the following: (a) assets that are meant for buying and selling; (b) assets that are held for sale in the expectation of making profits through price appreciation in the future; and (c) assets acquired not for trade, but for personal use.


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However, if we examine the conventional classification of investment in securities, normally it is only
classified into 2 types i.e. either dealing (short-term); or investment (long-term). The use of AAOIFI’s
classification of investment into three types would be more desirable and useful to users of accounting
information as it provides an additional classification that distinguishes the intention or purpose of
investment. However, the main problem of classifying the investments is to objectively determine the
intention of the investors and intention may also subject to change overtime due to the changes in economic
climate.
Recognition
AAOIFI’s FAS 17 has recommended that recognition for investment in sukuk and shares shall be
recognized on the acquisition date and shall be measured at cost. However, at the end of accounting
period, investment in sukuk and shares held for trading purposes and available for sale shall be measured
at their fair value. The unrealized gains or losses as a result of re-measurement need to be recognized in the
income statement.
The additional requirement is the share of portion of income related to owners’ equity and portion related to unrestricted equity investment account holders must be taken into consideration. This is considered crucial as no proper treatment and disclosure of this transaction of profit sharing and distribution may lead to confusion as to the method, ratio and process to disburse profit that have been taken place. This is to ensure transparency in profit and loss sharing on re-measurement of investment at the end of the year to be properly disclosed to the users. At the same time it fulfils the syari’ah requirement of ensuring fair and just profit sharing and distribution between shareholders and depositors (investors).
Any unrealized gain or loss resulting from re-measurement at fair value, according to AAOIFI FAS 17 shall be recognized in the statement of financial position under the “investment fair value reserve”. This reserve account will reflect the net gain or loss at the end of the year. The standard also makes a provision that in case the institution has reserves created by appropriation of profits of previous financial periods to meet future investment risks, it is recommended that unrealized loss resulted from re-measurement of investment at fair value shall be deducted from this reserve.

Measurement
In the case of sukuk held to maturity, it needs to be measured based on historical cost except that if there is
impairment in value it should be measured at fair value. The difference in value will then need to be
recognized in the income statement and the information related to the fair value is then need to be disclosed
in the notes to the financial statements. For securities held for trading and available for sale, AAOIFI FAS
17 recommends the measurement to be based on fair value.
Fair value is normally defined as the amount which the instrument could be exchanged or settled between
knowledgeable and willing parties in an arm’s length transaction, other than forced or liquidation sale.
Quoted market price, when available, normally are used as the measure of fair values. However, for many
financial instruments and it may include Islamic bonds (sukuk), quoted market prices may not available.
In the case of unquoted securities, conventionally the estimate is based on the net present value or other
valuation techniques. However, these techniques involve uncertainties and are significantly affected by the
assumptions used and judgments made regarding risk characteristics of various financial or capital market
instruments. The uncertainties include the arbitrary used of discount rates, future cash flows, expected loss
and other factors.


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The determination of fair value for unquoted securities requires the availability of objective indicator and expertise, as well as conservatism in the valuation process. The objective of Islamic valuation should be to provide both relevant and reliable value that can be relied on by the users of financial statements to make useful judgment and decision (El-Tegani, undated).

In the case of securities held to maturity, the rationale of AAOIFI’s FAS 17 to recommend historical cost
rather than fair value could be because of the inherent uncertainties in relation to the use fair value for
capital market instruments. Another reason could be because there is no intention to trade in the securities
before maturity, thus, there is no apparent need to measure the securities at the end of the year at fair value.

The AAOIFI’s FAS 17 also prescribes that the realized profits or losses resulting from sale of any
investment shall be measured at the difference between the book value and the net cash proceeds from the
sale of investment. The standard also makes recommendation that different types of investment must be
shown separately according to the three classifications as defined earlier. This is important to give a better
picture of profit resulted from different types of investment. This recommended treatment is also necessary
to assist users in determining and comparing profitability between different types of investment.

In the case of dividends received from investment in shares and sukuk, the standard requires it to be recognized in the income statement at the declaration date rather than at the date when the cash proceed is received. This indicates the use of accrual basis of accounting to ensure that the institution recognized income when it is realized based on the contract or the right to receive that income. The use of accrual here is required in order to reflect the actual or fair income at that point when it is realized.
The additional requirement of realized profit from sale of investment and dividends received is the need to distinguish between the portion to be shared by owners’ equity and depositors (investors). The rationale is similar to the case of treatment of profit on re-measurement of investment at fair value as discussed above, as it will ensure sufficient information to be provided to users of accounting information particularly on the distribution of profit between equity holders and depositors.

Disclosure

AAOIFI’s FAS 17 has made special requirements of disclosure in the case of investments in sukuk. Among
the requirements are that disclosure shall be made by the issuer of sukuk, if material, the face value of
sukuk, the percentage of sukuk acquired from each party issuing the sukuk and each type of sukuk. There
is also a requirement to disclose the party guaranteeing the sukuk and the nature of the guarantee. Another
useful disclosure requirement is the need to disclose the contractual relationship between the issuer and/or
manager of sukuk and the holders of such sukuk. The additional disclosure with respect to investment in
sukuk is the requirement to disclose the classification of sukuk according to their maturities.

All the above disclosure requirements indicates the need for the Islamic institutions to be more transparent
in disclosing financial information pertaining investment in securities especially sukuk. The underlying
rationale is to provide useful information for users to make informed judgement especially about institution’s
investment in securities. The users are expected to require all the above information and disclosure not
only with respect to the risks of investment undertaken and the potential return (full disclosure) but the
contractual relationships of the parties involved that is expected to fulfill the syari’ah requirements (social
accountability).


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6. Concluding Remarks

The need for Islamic accounting that deals with Islamic financial instruments has prompted AAOIFI
recently to introduce Financial Accounting Standard No.17 on investments in securities. The need for a
codified Islamic accounting standard are primarily stemmed from the need that Islamic accounting
objectives, concepts and principles to be developed based on syari’ah requirements. However, the Islamic
accounting regulation also needs to adapt to the modern accounting regulatory environment to make it
relevant to be practiced in our time. The examination of AAOIFI FAS 17 shows that AAOIFI has been
pragmatic in its approach by considering both requirements when developing its standard. This is a
pro-active step to provide a sound accounting regulation as part of a comprehensive regulation of Islamic
financial institutions.

The development of modern accounting has shown that accounting itself is an emerging and pragmatic discipline. Another paramount challenge and conventional accounting is of no exception, is compliance of the standard. For the standard to be adopted by commercial participants, the regulatory agencies of respective Muslim states at least must be convinced not only for the need of such standard but the necessity to adopt it as a mandatory requirement.

Another pre-requisite for a sound accounting regulation is the credibility of standard setter. In the case of AAOIFI, the credibility of its standard will be subjected to ‘acid’ test of acceptance by commercial participants especially Islamic financial institutions. In addition, another challenging task would be the acceptance of juristic rules made by AAOIFI’s board of syari’ah scholars by Islamic financial institutions worldwide. As syari’ah opinion can be subjected to vast differences among scholars, this leads to another need that is a standard or a codified syari’ah rules based on consensus of credible Muslim scholars of our time that transcends beyond geographical boundaries of nation states.

Finally, the development of a new discipline called Islamic accounting establishes an urgent need for the
accounting academics and practitioners to undertake studies that attempt to understand how accounting is
influenced by and adapted to the way the economic system is organized and the philosophy underpinning
its system. The interests on Islamic accounting has been growing for the past two decades, however, the
development of Islamic accounting is still at the infancy stage. This paper is just a small contribution to the
literature on contemporary accounting regulatory issues on investments in Islamic bonds or sukuk.


International Journal of Islamic Financial Services, Vol.4, No.4


References
AAOIFI Statement of Financial Accounting No.1 (SFA 1), Objectives of Financial Accounting for Islamic Banks and Financial Institutions.

AAOIFI Statement of Financial Accounting No.2 (SFA 2), Concepts of Financial Accounting for Islamic Banks and Financial Institutions.
AAOIFI Financial Accounting Standard No. 9 (FAS 9), Accounting for Zakah.. AAOIFI Financial Accounting Standard No. 17 (FAS 17), Investments.
Abu-Sulayman, A.H. (1994) Crisis in the Muslim Mind. Herndon, US: International Institute of Islamic
Thought

Al-Faruqi, I.R. (1992) Tawhid: Its Implications for Thought and Life. Herndon, US: International Institute of Islamic Thought.

Adnan, M.A and Gaffikin, M. (1997) “The Shari’ah, Islamic Banks and Accounting Concepts and Prac-
tices”, Proceeding International Conference on Accounting, Commerce & Finance: The Islamic Per-
spective.
Baydoun, N and Willet, R. (1997) “Islam and Accounting: Ethical Issues in the Presentation of Financial Information” Accounting, Commerce & Finance: The Islamic Perspective, Vol.1 No.1.

El-Tegani, A.G.A. “Accounting Postulates and Principles from an Islamic Perspective”, undated.

Gambling, T and Karim, R.A.A. (1991) “Business and Accounting Ethics in Islam”, London: Mansell.
Hassan, M.K. (1995) “Worldview Orientation and Ethics: A Muslim Perspective”, Proceedings International Conference on Development, Ethics and Environment, Kuala Lumpur.

Siddiqi, M.N. (1972) “The Economic Enterprise in Islam”, Lahore: Islamic Publications.
Miller, P.B.W. (1985) “The Conceptual Framework: Myths and Realities”, Journal of Accountancy. Qardawi, Y. (1999) Fiqh Az-Zakat: A Comparative Study, Dar al-Taqwa, London.

sukuk bond

THE ISLAMIC BONDS   POSSIBILITIES AND CHALLENGES

Bonds are long-term debt obligations that are secured by a specified asset or a promise to pay. In effect, a bond investor has lent money to the bond issuer. In return, the issuer of that bond promises to pay interest and to repay the principal on maturity¹ .

The certificate itself is evidence of a lender-creditor relationship. It is a “security” because unlike a car loan or home improvement loan, the debt can be bought and sold on the open market. In fact, a bond is a loan which is intended to be bought and sold.²

It is clear from this definition that in the conventional system of bond issuance and trading the issue of interest is at the centre of any transaction. In contrast, in the Islamic financial system usury and interest are the first elements to be avoided. However, this does not mean that the door of debt financing or, more generally, the possibility of bonds issuance and trading is closed to Islamic finance. However, it shall be noted that beside the rejection of the obvious system of interest in bond trading, the Islamic alternative must also avoid any transaction of debt and credit on future basis which may result in usury and interest.

Considering the fact that bond issuance and trading are important means of investment in the modern economic system, Muslim jurists and economists are striving to find the Islamic alternative. However, to meet the various demands of investors Islamic bonds and certificates should be diversified. We have so far the mudarabah or muqaradah bonds, the musharakah bonds, the Ijarah bonds, the istisna‘ bonds, the salam bonds and the murabahah bonds. However, it should be noted that although some of these instruments have been generally accepted as being in compliance with Islamic principles so that they can be traded in the secondary market, the negotiability of certain others is still a point of debate and controversy due to their legal acceptability or compliance with shari‘ah. Therefore, some of these bonds can be traded in the secondary market while the trade of others is limited to the primary market because they can be exchanged only at face value.

In Malaysia for instance, almost all of the domestic Islamic debt papers issued so far have been based on the
principles of murabahah and bay‘ bi al-thaman al-ajil despite the controversy surrounding the issuance of
tradable bonds in the secondary market based on the above two contracts. At the same time, there is a perceptible
increase in the willingness amongst Malaysian issuers of bonds to explore other Islamic principles of financing,
namely the profit-oriented based musharakah as well as the asset-backed mode of ijarah. The progress of
developing Islamic securities based on these financing codes, nonetheless, has been painfully slow and, to some
extent, stalled by the 97 economic recession.³   However, the economy is picking up again and it is hoped that the
future issuance of Islamic bonds will focus on the widely accepted bonds such as musharakah bonds, mudarabah
bonds and ijarah bonds.

In this paper we will try to investigate the possibilities and challenges of developing an Islamic bonds market free from usury and interest and capable of making use of the existing financial resources.

Salam Bonds

Salam is the sale of a specific commodity, well defined in its quality and quantity which will be delivered to the purchaser on a fixed date in the future at the price paid at the spot as it is the condition according to the majority of Muslim jurists or three days according to the Maliki school. To illustrate the possibility of issuing a salam certificate let us consider the following assumption of a corporation which is in need of funds.

1.  If a corporation requires for instance, 500 million ringgit, it can use salam certificates equalling that amount in
      small denominations, say 10,000 ringgit each.

2.  Each certificate represents a salam contract. The seller is the corporation while the buyer is the holder of that
      certificate who paid its nominal value.

3.  Each certificate promises that on maturity (one year for example) the corporation will deliver to the holder a
      specified quantity of the underlying commodity, which is described fully on the back of the certificate or in the
      prospectus.

4.  Once the corporation receives the cash, it can use it for any purpose.

5.  On maturity the seller will be delivering the sold goods in kind. For this purpose the corporation will certainly
      buy on the open market and deliver to the certificate holder. However, it should be noted that salam is possible
      only for fungible goods or mithli. These are standardised into identical units. For instance, wheat, rice, barley
      and other grains are of this type. Oil, iron and copper are also mithli. Similarly, electricity measured in kilowatt
      could be considered a mithly. Seats on a aeroplane flight can also be mithli⁴ .

Later, the corporation floats these salam certificates and it will receive immediately the face value of each certifi-
cate in cash according to the majority of Muslim jurists or three or more days later according to the Malikis and
certain contemporary Muslim jurists⁵ . The parties can use this flexibility of paying immediately or some time later.
However, a viable salam-based bonds market will not be possible if the issued bonds cannot be liquidated easily.

Liquidity is one of the most important aspects of short-term investment, second only to profitability. A money market instrument that is not negotiable will not be very useful. Thus, an investor will buy a salam certificate if he expects prices of the underlying commodity to be higher on the maturity date. But if his expectations change before that date, he can offload his investment and dispose of his certificate. Furthermore, when an investor knows that it is possible to resell the salam certificate before maturity in an organised market, more and more people will invest in this instrument and subscribe to this venture.

However, there is a difference of opinion among Muslim jurists regarding the legality of selling the purchased goods in a salam contract prior to taking delivery. Thus, the majority⁶  maintains that it is illegal to resell the subject matter in salam before taking possession, relying on the hadith of the Prophet (PBUH)  “whoever makes salam shall not exchange it before taking possession”.⁷  They argue that in this hadith it is clear that the buyer should not exchange the subject matter of salam with the seller or with another person. However, this is a weak hadith as pointed out by Ibn Hajar.⁸  Therefore, it could be not the basis for any ruling.

Ibn Taymiyyah and his disciple Ibn al-Qayyim maintained that there is no legal problem in exchanging the subject matter of salam before taking possession. However, if it is sold to the seller himself it should be at the same price or a lower price but not a higher price as the case may be. However, if it is sold to a third party it could be at the same price, a higher price or a lower price. Moreover, Ibn Abbas and Imam Ahmad in one of his opinions have the same opinion on the issue. This is also the Maliki stand. However, they maintained that it is illegal to resell salam before taking possession, if it is foodstuff.⁹

The contemporary position of Muslim scholars is also divergent. Thus, Nazih Hammad for instance, maintains that
it is legal to resell salam before taking possession as it is maintained by Ibn Taymiyyah and Ibn al-Qayyim because
there is no text from the Qur’an or sunnah, ijma‘ or qiyas to prohibit this. On the contrary the texts as well as the
qiyas convey its legality.¹⁰  This stand has also been backed by other scholars such al-Qaradaghi,¹¹  al-Zuhaili¹² ,
Jasim Ali Salim,¹³  Hashim Kamali¹⁴ , Sami Hammod¹⁵  and Majd al-Din Azzam.¹⁶  On the other hand, Siddiq al-
Darir, Ajil Jasim al-Nashmi¹⁷  and others have maintained that it is illegal to resell anything before taking possession
of it.

However, it seems that it is logical to take into consideration the opinion of those who uphold the legality of reselling salam before taking possession since there is no genuine text to prohibit that and as a result the idea of salambased bonds will materialize.

Murabahah is basically the sale of goods at a price covering the purchase price plus a margin of profit agreed upon by both parties concerned¹⁸ .

The possibility of having legally acceptable murabahah-based bonds is only possible in the primary market. However, the negotiability of these bonds or their trading at the secondary market would be illegal due to the fact that they constitute debt and it is illegal in shari‘ah to trade debt for debt on a deferred basis if it will result in riba. However, their use in the primary market alone has its own benefits.

Suppose the required commodity in murabahah is too expensive for an individual or a banking institution to buy
alone e.g. 50 million dollars for an oil refinery. This requires the participation of many financiers. The financing of
the project could be mobilized on an understanding with the would-be ultimate owner that the final price of the
refinery would be 70 million dollars to be repaid by installments over five years. The various financiers may share
the 20 million dollars murabahah profit in proportion to their financial contribution to the operation.¹⁹

Despite the fact that the murabahah instruments are debt instruments, and given the fact that debt cannot be sold to another debt, it is permissible to sell these instruments if mixed with other assets such as commodities, services and cash provided that real assets and services overwhelm debt and cash. In other words, the murabahah bonds could be negotiable if they are the smaller part of a package or a portfolio, the larger part of which is constituted of negotiable instruments such as mudarabah bonds, musharakah bonds or Ijarah bonds.²⁰

It is perhaps on such a basis that it has been proposed by Sami Hamoud for instance, at the Second al-Barakah forum, that a company specializing in murabahah investment should be set up as a part of al-Barakah Islamic Bank in Bahrain and its instruments would be tradable on the grounds that although these instruments are debtbased they are just a small part of the total assets of the company. In fact, the idea has been developed and the company has been set up after a ministerial decree, to specialize in such trading.²¹

In Malaysia, the Islamic benchmark bonds were issued in 1990 and it is believed to be based on the murabahah concept. They are one of the most popular forms of Islamic financing methods used in Malaysia today and they are used as a substitute for the zero-coupon bond.²²  Therefore, it is necessary to look at these bonds in order to examine their conformity to shari‘ah principles.

The benchmark bond is a non-coupon-paying bond issued on a zero coupon basis to eliminate the coupon effect on yield. Zero coupon bonds are bonds sold at discount.

The Islamic benchmark bonds are issued on the assets backed by the murabahah concept. This concept requires
Khazanah to buy a pool of assets and investments at the behest of Private Debt Securities (PDS) investors for an
agreed up-front lump sum cash payment comprising a cost and profit element. Then Khazanah agrees with the
Private Debt Securities investors to purchase this pool of assets and investment from the investors at an agreed

^{purchase price at the end of the agreed duration e.g. three years. Pending the resale of the pool of assets and} investments to Khazanah, PDS investors appoint Khazanah as trustee and manager of the pool of assets and investments. Until the resale of the pool of assets and investments any income arising from this pool is accrued to Khazanah as trustee and management fees. As documentary evidence of the arrangement entered into between Khazanah and PDS investors, Khazanah will issue to PDS investors the Islamic benchmark bonds. PDS investors may hold the benchmark bonds to maturity or sell them at the secondary market. In order to avoid reinvestment risk from the perspective of PDS investors, and interference with the benchmark yield curve, Khazanah is not given the right to early redemption of the benchmark bonds. In this respect, should PDS investors want early exit from the benchmark bonds, they can do so by disposing of these bonds in the open market²³ .

However, some objections have been raised against the Islamic benchmark bonds based on murabahah because
of the structure of murabahah itself and the possibility that such a transaction will result in bay‘ al inah and bay‘
al-dayn bi al-dayn traded at discount which are generally considered as prohibited transactions by Muslim jurists.

However, Abdul Rashid Hussein for instance, while defending the viability of murabahah bonds says: “Questions have been voiced as to why murabahah has been chosen as the operative concept for the Islamic benchmark bonds issuance as compared to other Islamic operative concepts such as Ijarah (leasing) mudarabah (profit sharing) musharakah (joint venture) and qard hassan (benevolent loan)?²⁴  Abdul Rashid Hussein maintains that murabahah provides a sufficiently flexible structure to create, in essence, a choice of action owed by Khazanah to PDS investors without necessitating payment of coupon.

He further argues that if the financing is structured under the Ijarah concept as it is commonly understood,
Khazanah being the lessee to the pool of assets and investments has to pay periodic lease rental which is not
appropriate to the non-coupon structure. In the case of mudarabah concept, Khazanah and PDS investors are
deemed to have entered into a venture to invest in assets and projects and as a result PDS investors have to bear
any financial losses arising from such ventures. This is unacceptable to PDS investors from a risk return perspec-
tive.

Moreover, according to Abdul Rashid Hussein if the financing is structured under the musharakah concept, Khazanah is required to contribute part of the initial outlay to the joint venture with PDS investors to invest in the assets and projects that are inappropriate under the circumstances. Moreover, under musharakah, PDS investors, being co-partners to the joint venture, have the right to participate in the management of the assets and project which is inappropriate under the circumstances.

Finally, if the concept of qard al- hasan were to be used, Abdul Rashid Hussein argues Khazanah would be deemed to have received the bond subscription proceeds from PDS investors as a benevolent loan. Therefore, Khazanah being the borrower, is only obliged to return to PDS investors the entire principle amount of the benevolent loan borrowed and is not obliged to return a guaranteed return either as a gift (hibah) or as a kind of appreciation to the PDS investors²⁵ .

To illustrate the basic feature of the Khazanah Islamic bonds, suppose that through the bidding process, a RM1000 bond at par value is sold at RM 800 per unit. For one million unit issues, the market value of the securitized asset is therefore RM 800 million while the buy back price is 1billion. The return to investors is 200 million.²⁶  Thus, given the above fact about the involvement on this transaction of bay’ al-inah, Abdul Rashid Hussein’s argument in favour of the above kind of bonds could not be justified from the shari‘ah point of view.

Ijarah Bonds

^{Ijarah is a contract according to which a party purchases and leases out equipment required by the client for a rental fee. The duration of the rental and the fee are agreed in advance and ownership of the asset remains with the lessor. Hence, the relationship between the parties differs from that of a debtor-creditor relationship since it is based on buyer-seller of an asset.} Ijarah bonds, on the other hand are securities of equal denomination of each issue, representing physical durable assets that are tied to an ijarah contract as defined by shari‘ah ²⁷ .

The basic feature of Ijarah bonds is that they represent leased assets, i.e. without relating the bonds holders to any common organisation, company or institution. For instance, an aircraft leased to an airline can be represented in bonds and owned by a thousand different bondholders, each of them, individually and independently, presenting his bond (s) to the airline company and collecting the periodic rent without having to have any relation with other bondholders. In other words, the Ijarah bondholders are not owners of a share in a company that owns the leased airline, but simply a sharing owner, who only owns one thousandth or more of the plane itself.

In a second example let us assume that a group of investors bought an office building and divided up the ownership
rights into many certificates of equal face value. The group may rent out the whole building for the next ten years,
then sell these certificates to the public. A buyer of a such certificate is acquiring a share in the ownership of the
office building, and an equal share in the net income from it for the term of the lease. Such certificates could be
easily traded in the market. Moreover, their generation of steady rental income renders them even less risky than
common stocks. This is because in common stocks both annual net income and capital gains or losses are variable,
whereas in rent sharing certificates part of the future income stream is the contractually fixed rental payments.²⁸

There may be multiple forms of Ijarah bonds depending on the nature of the asset and the method and procedure
of issuance of the bonds. Thus, besides the simple forms of Ijarah bonds mentioned above, more sophisticated
forms of Ijarah bonds can be considered by including financial intermediaries. Let us suppose that the Ministry of
Defence needs a training field to be used for one of its training programs. A suitable piece of land in a suitable
location is needed. The Ministry of Defence resorts to an Islamic bank to prepare an issue of Ijarah bonds that
allow the Ministry to acquire the needed plot. The Islamic bank buys the plot for 10 million dinars and rents it to the
Ministry of Defence for 900,000 dinars a year. At the same time, the bank issues 1,000 Ijarah bonds, each bond
representing 1000^th of the plot and entitling its owner to 900 dinars per year as rent. The Ijarah contract has a
period of ten years after which the contract will be renewed perpetually for term of ten years. The Islamic bank
has an issuance commission of, say, 5% as premium above the purchase price of the land i.e., the bank sells the
bonds at 10500 dinars each. In this form of Ijarah bonds, the bondholders own the land that is rented and they are
entitled to the rent at the above-mentioned rate. The issuer of the bonds is the financial intermediary, not the
division of Real Estate Recording, nor the beneficiary of the lease.

In a somewhat different example, let us suppose that in the above mentioned case, the Ministry decides to under-
take the task of issuing the bonds on its own, without resorting to a financial intermediary, and it does not having the
money to buy the land it transfers its ownership to the bondholders. The Ministry of Defence begins with issuing
Ijarah bonds for the specific purpose of acquiring the land, whose purchase price is 10 million dinars. The bonds,
now, contain a new clause permitting that the Ministry the will collect the fund from the buyers of the bonds and will
purchase the lot on their behalf, on wakalah basis. In this case, the issuer of the bonds becomes the beneficiary of
the Ijarah contract, e.g. the user of the asset. Each bondholder has the same right to ownership and to a share of
the total rent, which equals one thousandth each (assuming there are 1000 bonds). There will be no premium paid
to a financial intermediary, although the Ministry of Defence may take some contractual compensation for its work
on behalf of the savers/ purchasers of bonds. ²⁹

Thus, from the above it is clear that the contract of Ijarah seems to be the most flexible of all nominated contracts in Islamic law and many forms of Ijarah bonds, whether short term or long term, could be issued from it.³⁰

Characteristics of Ijarah Bonds

^{The characteristics of Ijarah bonds stem from its nature and from the contractual relationship defined in the Ijarah contract governing it. These can summarised as follows;}  

1.  Ijarah bonds are securities representing the ownership of well defined existing and well known assets, that are
      tied up to a lease contract. This means that Ijarah bonds can be traded in the market at a price determined by
      market forces. This includes inter alia, the general market conditions in the economy and in the financial
      market, the opportunity cost  (current and expected return on new financing), prices of real investment assets
      and economic trends in the specific market related to securities and Ijarah bonds, etc. The Ijarah bonds are
      also subject to risks related to the ability and desirability of the lessee to pay the rental instalments. Moreover,
      these are also subject to real market risks arising from potential changes in asset pricing and in maintenance
      and assurance costs.

2.  Furthermore, the expected net return on some forms of Ijarah bonds may not be completely fixed and deter-
      mined in advance, since there might be some maintenance and insurance expenses that are not perfectly
      determined in advance. Consequently, in such cases, the amount of rent given in the contractual relationship
      represented by the bond, represents a maximum return subject to deduction of this kind of maintenance and
      insurance expenditure.

3.  Ijarah bonds are completely negotiable and can be traded in the secondary markets. Subject to market condi-
      tions, these bonds will offer a high degree of liquidity and therefore, have both the characteristics and neces-
      sary conditions for functioning as successful securities.

4.  Ijarah bonds will offer a high degree of flexibility from the point of view of their issuance management and
      marketability. The central government, municipalities, awqaf or any other asset users, private or public can
      issue the bonds. Additionally, they can be issued by financial intermediaries or directly by users of the leased
      assets³¹ .  It should be noted that Ijarah bondholders as owners bear full responsibility for what happens to
      their property. They are also required to maintain it in such a manner that the lessee may derive as much

      usufruct from it as possible.³² .

to be continued......