Sukuk and Islamic Investment
By Rose Anderson

Islamic finance govern by Shari’ah law , as per Shari’ah law interest is strictly restricted in Islam.Free debt help is allowable without taking any interest, or these can be treat as to help anyone, without taking any interest from the lender. As interest is against the Islamic law bond market not develop in the Islamic world. Most of the Petroleum exporting countries are investing there surplus amount in the US free debt help bonds and they not taken interest on investment. Sukuk is invested to protect the religious value and also to increase the Muslim investment market.Malaysia is the largest issuer of the sukuk bonds ,sukuk is not only famous in islamic market but also some European and American countries issued sukuk bonds to get the islamic investment of rich middle east countries.Sukuk is also consider as a portfolio investment to diversify the investment.

A major challenges facing Islamic financial products like sukuk bonds are the lack of liquidity.According to S&P, there are more sukuk listed in Dubai than any other else, but the secondary market is virtually non-existent. Further, the bulk of sukuk are over-the-counter instruments,with listed sukuk accounting of only 20-255 of outstanding sukuk is issued worldwide; that is, $10-15 bn so far, says the rating agency. Zeti contends that creation of persistent supply of Islamic papers and instruments that would upgrade the secondary trading of instruments and greater depth of the market is the hour. According to her, another factor that could help futher expand the market for Islamic finance products would be to bring in greater diversity in the market for Islamic financial institutions and portfolio manager to manage their funds effectively. Pricing issues also pose significants challenges to the unhindered growth of the market. There is the need for developing a relevant benchmark for efficient and credible pricing. For example , if sukuk is issued based on the Ijarah principle, and if it uses the property as its underlying assets then actual rate of rental may be explored to be used to determine the rate of return on the instrument. However, it may then fluctuate depending upon the demands and supply for that property. Shari’ah experts, who have a full understanding of the mechanics of sukuk, should play an important role in ensuring its proper pricing as well as governance, she suggests.

Taking Islamic finance products global is another challenges as it requires harmonization of standards and practices between those of regional Islamic finance and international standards. Zeti suggests that full support has to be accorded to the international standard setting organizations such as Islamic Financial Service Board (IFSB) and to the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) to formulate appropriate standards that would strengthen the Islamic Financial system.The Malaysia based IFSB has already formulated the prudential treatment for sukuk investment by the Islamic Financial Institution s as specified in the Capital adequacy standards and has also undertaken a set of initiatives to strengthen the framework and practices in the Islamic money market.

Also, lack of rating is another major issue. Given the complex legal structure, it adds to the cost and complexity of rating. Further rated instruments are almost non-existent in the Middle East.
However, global rating agencies such as S&P, however, feel that there is a way out. “the provisions of Islamic debt instruments may add level of complexity to rating analysis long stading methodologies and rating scales are sufficiently broad so far to incorporate the varied features of Islamic debt financing,”It said in recent report. Islamic finance largely centers on assets-backed approaches and sometimes involves a degree of risk-sharing more commonly born by equity investors.In practice,however,as illustrate d in the sukuk that Standard & Poor’s has rated, binding guarantees and other contractual obligations can place transactions firmly in the debt category.

R. Anderson is a financial writer .She is the Community Member of "Debt Community" and has been contributing her suggestions to the Community . She has also made notable contributions through various articles written on different subjects related to debt industry.

Any source

The new UK tax law on sukuk

Mohammed Amin MA FCA AMCT CTA (Fellow), tax partner at PricewaterhouseCoopers LLP and head of the firm's Islamic finance practice in the UK, explores the new UK tax law on sukuk. This article is based on the presentation given by the author at IIBI's monthly lecture in London, July 2007.

Diagram 1 illustrates an ijara sukuk. The owner has a building and decides to raise money using that building. It sets up a special purpose vehicle (SPV) and sells the building to that SPV, and then rents it back. The SPV pays for that building by issuing sukuk. Those sukuk are not a debt owed by the SPV; instead they are a direct legal claim on a proportionate share of the building and of the rent it generates.

Diagram 2 illustrates a mudarabah sukuk, based upon an actual example. XYZ trading company has a collection of business assets and wants to raise $500 million to use in its business. It sets up an SPV, here XYZ Sukuk Ltd, which raises $500 million to buy the assets. That $500 million comes from the investors as payment for sukuk certificates. Next the assets, which are now owned by XYZ Sukuk Ltd on trust for the investors, are contributed to a mudarabah whereby 99 per cent of the profits of the mudarabah will go to the trust for payments to investors subject to a maximum limit, in this case of six per cent, i.e. six per cent of $500 million = $30 million p.a. Again, the investors are not receiving interest but a share
of the business profits.

Before this year's tax law, what happened if a sukuk was issued? The basic problem was that tax costs arose in the issuing SPV company. The SPV is receiving something that is clearly taxable income. However the payments that the SPV makes to the investors do not give rise to any tax relief. Those payments to the investors are not interest; they are simply paying on to the investor the fractional entitlement to the rent or the fractional entitlement to the income of the mudarabah. There is no reason why the SPV should get tax relief for those payments under basic UK tax law. So tax arises in the SPV.

Even if the sukuk-issuing SPV tried to argue that this payment to the investors should really be treated like interest, it still wouldn't get tax relief. There is a very specific provision in our tax code, in the Income and Corporation Taxes Act (ICTA) 1988 section 209(2) (e) (iii). If you issue securities, in other words debt instruments, under which the interest payable on those securities is dependent upon the results of the company's business, then that interest doesn't get tax relief. Instead it is treated as a distribution, like a dividend. It is not a tax-deductible expense.

We now have some new legislation in the Finance Act (FA) 2007. However, if you search FA 2007 for the word 'sukuk', you will not find it. The rules for sukuk introduced in 2007 follow the same overall approach as the 2005 rules for murabaha transactions or mudarabah transactions. HM Treasury simply created a definition, a new concept in UK tax law; something called an 'alternative finance investment bond' (AFIB). If the definition is met, certain tax consequences follow.

The definition of an AFIB

The legislation requires one or more persons to pay money to a bond issuer. The bond issuer is going to acquire some assets which will generate income or gains.

There has to be a fixed period of time when the arrangements will end. A sukuk that is perpetual won't qualify. As part of the legal agreements, the issuer has to undertake that at the end of the sukuk it will dispose of any bond assets that are left.

The issuer will also make other payments to the investors, which are called additional payments. In diagram 1, the additional payments come from the rent and in diagram 2 from the business profits.

The additional payment must not exceed a reasonable commercial return on a loan equal to the amount of the capital. One of the things that the UK Government was most concerned about was ensuring that it did not give a tax deduction for payments on sukuk instruments which had equity characteristics, i.e. which were equivalent to ordinary shares. The law does not stipulate what is a reasonable commercial return; that would depend upon the facts and circumstances.

The bond issuer is going to manage the bond assets. In other words, the bond assets are not managed by the investors. Of course, the bond issuer can delegate management. In diagram 2, once the bond assets have been contributed to the mudarabah, XYZ Trading Company as the mudarib is going to manage that mudarabah.

The sukuk, the bond, has to be transferable. This doesn't mean it has to be physically transferred. The sukuk could be issued and the same people may hold it for its entire five- or ten-year life, which is actually very common with sukuk. There is relatively little secondary trading in practice, but the critical thing is that they have to be transferable.

The AFIB has to be listed on a recognised stock exchange. There is a provision in the Income Tax Act 2007 section 1005 which details what a recognised stock exchange is and there is a provision in the legislation to recognise a stock exchange purely for the purpose of the AFIB rules. As well as a long list of fully recognised stock exchanges, HM Revenue & Customs (HMRC) lists seven exchanges which are recognised only for the purposes of the AFIB rules. (See www.hmrc.gov.uk/fid/rse.htm)

Diagram 1 Ijara sukuk

If issuing a sukuk from the UK, it is important to make sure that it is listed on a fully recognised stock exchange within the Income Tax Act 2007 definition to avoid paying withholding tax. If a sukuk is listed on a fully recognised stock exchange, then the consequence of the 2007 rules is that it is treated for tax purposes as if it were a debt instrument and the exemption for listed eurobonds should apply. Interest on listed eurobonds can be paid without withholding tax.

If a UK-based sukuk is created and listed on a stock exchange which is only recognised for the purpose of the AFIB rules and not recognised for any other purposes, then the eurobond exemption would not apply. The eurobond exemption looks specifically at stock exchange designations under Income Tax 2007, not at the extension for sukuk. Finally, there is an accounting test. If the issuer were to prepare accounts under International Financial Reporting Standards (IFRS), the sukuk would be treated as a financial liability.

After all the strict definitions there are a few relaxations:

• The issuing entity can acquire the bond assets either before or after the sukuk itself is issued.


• Bond assets can be any kind of property and can be secondary rights in property. For example, it could be that instead of owning a building the asset could be a lease over a building.


• A declaration of trust is permitted but not mandatory.


• Bond holders may be given the right to terminate early.


• The additional payment, the economic return to the bond holder, can be either fixed or variable. However, if the payments are not fixed then the test of whether they represent only an amount equivalent to a normal commercial return on the capital is made by looking at the maximum amount of the additional payments. To ensure that the additional payments cannot exceed a reasonable commercial return, it may be worth including a numerical cap in the documentation, as in diagram 2.


• Finally, the redemption payment can be satisfied by the issue or transfer of shares. This caters for convertible or exchangeable sukuk, corresponding to convertible or exchangeable bonds.

Tax consequences of qualifying as an AFIB

From the issuing company's perspective, the AFIB is treated as a loan relationship. In other words, it is treated as if it were debt and all the tax rules for corporate debt apply to the AFIB. The Government is not saying that this is a debt instrument or that the issuer is paying interest, it is merely saying that it is going to apply the same tax law that would have applied if there had been a debt instrument.

Diagram 1 Mudarabah sukuk

The additional payments are treated as if they were interest for tax purposes. This potentially makes them tax-deductible, and there is an express override of section 209 (2) (e) (iii). The issuer is taxed as if it beneficially owned the assets, which means that it is entitled to any capital allowances (tax depreciation) the assets qualify for.

To a limited extent the issuer is treated as a financial institution. The existing tax law for Islamic finance in FA 2005 and FA 2006 applies only if one party to the transaction is a financial institution, broadly speaking a bank, a building society, a wholly owned subsidiary of a bank or building society, or an overseas recognised deposit taker. The issuer of an alternative finance investment bond is treated as a financial institution but only for two specific categories of asset. These are purchase and resale assets, in other words assets which are used in a murabaha transaction, and diminishing shared ownership assets.

The reason for these two choices is that when drafting this legislation HM Treasury primarily saw sukuk as an equivalent to conventional securitisation. Conventional banks lend conventional mortgages and often securitise them. Islamic banks typically provide mortgages by purchase and resale of property or proportional ownership of property. Accordingly, the AFIB rules enable Islamic banks to securitise their Islamic mortgages.

Taxation of buyers and sellers of AFIBs

Buyers and sellers of sukuk are legally buying and selling a fractional ownership interest in assets. Before FA 2007, this gave rise to many technical questions. Was the purchase and sale of the assets subject to stamp duty; was it subject to capital gains tax or income tax; and was it subject to VAT or stamp duty land tax? If a sukuk paid rental income, was that rental income taxed in the UK if you were non-resident? Most of these questions are actually unresolved because sukuk were quite unfamiliar in a UK tax context.

The situation now is that for both corporate and individual investors, sukuk are treated exactly as equivalent conventional debt would be treated for tax purposes, both for the taxation of income payments and for the taxation of gains or losses from buying and selling sukuk.

Areas where further change is needed

In diagram 1, the first thing the owner does is to sell the buildings to the SPV. That sale is a taxable sale. If the building has gone up in value, the company will pay tax on the gain. If the company had issued a conventional eurobond it would not have sold the building or transferred the building anywhere and therefore it would not have paid tax.

There needs to be some mechanism designed to stop tax arising on the gain when the building is sold, perhaps by deferring it as long as the building eventually reverts to the entity which sold it to the SPV.

Similarly, that sale of the building will give rise to stamp duty land tax. Again, that is an extra cost which does not arise if a conventional debt instrument is issued. The sale may also give rise to value added tax consequences. These are areas where the law needs to go further to put sukuk issuers into an equivalent position to conventional bond issuers.

Any source

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 oninvestments in Islamic bonds or sukuk. Investments on Islamic bonds (sukuk) give rise to anumber of accounting and reporting issues related to recognition, measurement anddisclosure. The underlying rationale of this paper is that proper development of Islamicfinancial market requires a well regulated Islamic financial instruments and one of the keyelements of regulation is accounting regulation. Therefore, a well regulated Islamic financialmarket requires a sound accounting and reporting standard of Islamic financial instrumentsthat, 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 promptedAAOIFI recently to introduce Financial Accounting Standard No.17 on investments insecurities (AAOIFI FAS 17, 2003). The need for a codified Islamic accounting standard areprimarily stemmed from the need that Islamic accounting objectives, concepts and principlesto be developed based on syari’ah requirements. However, the Islamic accounting regulationalso needs to adapt to the modern accounting regulatory environment to make it relevant to bepracticed in our time. The examination of AAOIFI FAS 17 shows that AAOIFI has beenpragmatic 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 comprehensiveregulation of Islamic financial institutions.

1. Introduction

The growth of Islamic financial market and institutions, culminating in the growing interest in Islamicbanking, finance and insurance reiterates the need for different accounting requirements. Islamic accountingis needed to serve different principles of financial instruments that are founded on the Islamic worldviewand syari’ah requirements. The efforts of Accounting and Auditing Organizations of Islamic FinancialInstitutions (AAOIFI) in the 1990s to develop accounting standards for Islamic financial institutions arecommendable as a positive contribution towards harmonizing accounting practices of Islamic financialinstitutions. The standards developed by AAOIFI are also expected to facilitate the needs of the users ofaccounting 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 Islamicbonds or Islamic Private Debt Securities (IPDS) or sukuk. Investments on Islamic bonds (sukuk) give riseto a number of accounting and reporting issues. These issues relate to recognition, measurement anddisclosure. This study also highlights and discusses the requirements made by AAOIFI’s FinancialAccounting Standard No.17 (FAS 17) on accounting for investments in Islamic bonds or sukuk. The underlying rationale of this paper is that proper development of Islamic financial market requires awell regulated Islamic financial instruments and one of the key elements of regulation is accountingregulation.Therefore, a well regulated Islamic financial market requires a sound accounting and reportingstandard 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 theIslamic worldview influences the objectives and concepts of modern accounting and reporting. Secondly,the paper examines accounting objectives and concepts from an Islamic perspective. Thirdly, accountingissues on investments in Islamic securities particularly Islamic bonds or sukuk are discussed to highlightcontemporary accounting issues on providing a sound accounting regulation for Islamic financial marketinstruments.

2. Islam and Accounting

Islam literally means ‘peace’ and ‘obedience’, and adherence to Islam have to be ‘obedient’ to God and toappreciate the purpose of their existence in this world (Al-Faruqi, 1982). God is said to have proclaimedthat, “I have only created… men that they may serve me” (al-Qur’an, 51:56). The nature of this serviceis taken to have been spelled out clearly when God, upon creating men, declared,“I will create a vicegerenton earth”(al-Qur’an, 2:30). Muslims consider humans to be vicegerents of God. Thus, whatever worldlypossession a Muslim has is to be held in a stewardship capacity – that is simply in trust from God (Abu-Sulayman, 1994). According to Islam, Muslims are trustees (or stewards) for God: Man therefore agreesto 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 organizedand the philosophy underpinning its system. If we examine the role of economic activities in Islam we willfind that the philosophy of human activity should be directed towards the achievement of Falah acomprehensive humanwelfare in this life and also in the hereafter. According to Siddiqi (1972) Falahisa tangible quality towards the achievement of God’s pleasure. Human welfare as believed by Muslims canbe achieved without any conflict in the genuine interest of this worldly life and the Hereafter.Toachieve this Falah, economic activities must be morally directed. In any economic decisions, includingfinancial reporting upon economic activities, the ethical values should act as a norm and economicrelationship must be regarded as moral relationship. The achievement of Falah is neither dependent onnor related to maximization of wealth or profit nor to the size of the individual business enterprise andquantity of output. Therefore, to a profit making organization their activities should serve as a means forthem to function in the economy. The worldview should be that they provide service to the public bymanufacturing and/or trading goods or providing services and in return profit is only aim to ensure theycan operate and grow.Accounting functions to discharge the accountability of enterprise as a result of separation of ownershipand the management. The users might be shareholders, creditors, potential investors and the public. In theMuslim society, the concept of accountability is ingrained in the basic creation of Man as a vicegerent ofGod on the earth. Man mission on earth is to fulfill the purpose of its existence in the universe. Man is thuscreated as trustees and accountable for all their actions (Abu-Sulayman, 1994). In Islam, accounting sould function not only as a service activity providing financial information to the users and to the publicat large but more important accountants should discharge their accountability by providing information toenable society to follow God’s commandments.The Muslims also believed that Men are vicegerents on earth and directly accountable for all their actionsas they are only trustees of God. Therefore, in this sense, accountants should lay formal claim to the statusof moral arbiters to ensure the responsibility and transparency of an organization’s internal procedures, sothat issues of policy and governance are properly debated and recorded, at the point where the moralproblems 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 holisticsignificance to the accountant. In terms of responsibility, the accountant in Islam is not merely responsibleto human superiors, the management/client or shareholders. He/She is a servant and trustee of God in allsituations, is simultaneously responsible to God the Owner of his very self and the resources he is utilizingand managing. To forget or to neglect this fundamental aspect of this responsibility is tantamount to abetrayal 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 themanagement but also maintain, improve and strengthen his relationship with his Master by fulfilling thereligious obligations. In fact the relationship with the Master (Hablun Min’Allah) will determine themode of relationship with fellow servants (Hablun Min’An-Nas) (Hassan, 1995). Guided by the properrelationship with God, the human Accountant and public relations would then be inspired by value oftruthfulness, 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 thehereafter). His/Her work is also a form of Ibadah(servitude to God) in so far as it is in conformity with thedivine 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 andfailure 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 existingaccounting practice; prescribe future accounting practice; and define key terms and fundamentalaccounting issues (Miller, 1985). According to AAOIFI’s Statement of Financial Accounting No.1 (AAOIFISFA 1), the need for accounting objectives for Islamic financial institutions stemmed from the role ofaccounting. Since the role of financial accounting is to provide the information which users of the financialstatements 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 standardsneed to be developed and complied with by Islamic banks. The development of such standards must bebased on clear objectives of financial accounting and agreed upon definitions of its concepts.Allah SWT said:“We shall set up justice scales for the day of judgement, not a soul will be dealt unjustly in the least. Andif there be (no more than) the weight of mustard seed, we will bring it (to account); And enough are Weto 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 afixed period of time, reduce them to writing” and “Let a scribe write down faithfully as between theparties” (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 justfinancial transactions between human beings. Accounting information is expected to fulfill the needs ofthose who are in need or expected to require such information. However, the primary objective ofaccounting 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 informationmust know the common information needs of users of financial reports. Common information needs of theusers are normally consist of the needs for information which can assist in evaluating the entity’s ability inusing its economic resources and fulfill its obligations. In this respect AAOIFI’s SFA 1 has broaden thescope beyond just economic responsibilities to encompass information that can assist in evaluating theentity’s compliance with the principles of syari’ah and its ability to carry out social responsibilitiesspecified by IslamSome scholars have also argued that accounting objectives can be derived from the way one account for hisor her zakat obligations (Adnan & Gaffikin, 1997). Adnan and Gaffikin (1997) argue that by makingzakat 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 alwayswatches 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 assetvaluation 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 ofconservatism. Many refer to the principles of zakat where trade assets subjected to zakat must be based oncurrent market value (Qardawi, 1999) or cash equivalent value (AAOIFI FAS 9). Adherence to the costprinciples leads to the conventional accounting practice that is lower of cost or market value. This will leadto understatement of trade assets to be subjected for zakat. Thus, the cost concept cannot be acceptable inIslam.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 ofincome recognition and matching. Therefore, accounting statements would, therefore, be prepared for thatparticular period, showing the amount of which zakat would be levied (Gambling and Karim, 1991).

4. Islamic Accounting Concepts on Recognition, Measurement & Disclosure

Accounting recognition refers to recording the basic elements of the financial statements. The concepts ofaccounting recognition define the basic principles that determine the timing of revenue, expense, gain andloss recognition in the entity’s income statement and, in turn, the basic principles that determine the timingof assets and liabilities recognition. AAOIFI’s SFA 2 recommends that “revenues should be recognizedwhen realized”. Realization of revenue shall take place when one of the three conditions are met: (1) Theentity 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 bebetter than the alternative cash basis accounting. Accrual basis of income recognition does meet therequirement 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 andpaid.In addition, according to the matching principle, expense recognition is realized either because the expenserelates 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 costor historical cost as the appropriate measurement basis. However, this principle is questionable from theIslamic point of view due to it conflicts with the concept of fairness and justice. In the case of zakatdetermination, 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 mostaccurate valuation of wealth to be subjected for zakat in order to serve justice to both the zakat recipientsand 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 hasrecommended the use of cash equivalent value that indicates the value that would be realized if an assetwas sold for cash in the normal course of business as at the date of the financial statement. In order toensure the reliability and comparability of the cash equivalent value, it must be supported with objectiveindicators; logical and relevant valuation methods; consistency of the use of valuation methods; expertvaluation; and conservatism in the valuation process (AAOIFI SFA 1). AAOIFI also recommends analternative method i.e. historical cost that refers to its fair value at the date of its acquisition includingamounts 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) proposedobjectives of accounting disclosure. They argued that there are at least four objectives of accountingdisclosure for an Islamic firm, whereby the first two are specific requirements laid down by syari’ah for thefirm to avoid riba’ and pay zakah. The second two objectives are based on inferred general requirementswhich can be referred to as ‘social accountability’ and full disclosure’.While the first two objectives i.e. prohibition of riba’ and payment of zakat have extensively been coveredby 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 madeavailable to individuals in a form of trust. The success of individuals in the life hereafter depends upontheir performance in this world.The implications of Islamic accountability on accounting is that the management and providers of capitalneed to be accountable for their actions (or in-action) both within and outside the firm by providing properaccounting and reporting. Thus, the Islamic concept of social accountability departs clearly from thewestern 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 toBaydoun and Willett (1997) full disclosure does not mean to disclose everything down to every minutedetail of transactions. There is, however, the need for the preparer of account to disclose everything that isbelieved as importance to users for purposes of serving God. In a more precise word, AAOIFI’s Statementof Financial Accounting No. 2 on Concepts of Financial Accounting for Islamic Banks and FinancialInstitutions (SFA 2) made it very clear that the Islamic concept of disclosure revolved around the conceptof ‘adequate’ disclosure. Here, adequate disclosure means that the financial statements should contain allmaterial information necessary to make them useful to users.AAOIFI’s SFA 2 elaborated the concept of adequate disclosure into two aspects namely optimal aggregationand appropriate descriptions and clarifications. Optimal aggregation means the financial statements shouldprovide sufficient details to meet the users’ need for information. However, too much detail can contributeto confusion. Therefore, it needs appropriate descriptions and clarifications to make the informationprovidedtobeuseful 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’sinvestments, whether in the form of direct investment funds or investment portfolios, in sukuk (Islamicbonds), shares, and real estate. The standard is relatively new that is it shall only be effective for financialperiods beginning 1 Muharram 1424H or 1 January 2003. Thus, it makes the discussion of this standardnecessary especially for institutions that have investments in Islamic capital market instruments. There islack of academic writings in this area that require special attention to ensure proper accounting for com-plex instruments such as Islamic bonds (sukuk).
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 equityand are registered in the names of holders on the basis of undivided ownership of shares in the mudarabaequity and its returns according to percentage of ownership of share. The owners of such sukuk are therabbul-mal (capital provider).

(b) Musharaka sukuk

These are investments in sukuk that represent ownership of Musharaka equity. It does not differ from theMudaraba sukuk except in the organization of the relationship between the party issuing sukuk forms acommittee 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) ofthe real estate. These sukuk give their owners the right to own the real estate, receive the rent and disposeof their sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders ofsuch 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 immediatepayment. The deferred commodity is a debt in-kind against the supplier because it refers to a commoditywhich 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 andIstisna’, 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 theirmaturity date if either the buyer or the seller of the commodity issues them. Accordingly, these sukuk aretreated as investments held to maturity.

Classification of Investment

One notable contribution of AAOIFI FAS 17 is the classification of investment in sukuk into three typesnamely: for trading purposes; available for sale; and held to maturity. The basis of AAOIFI classificationis based on the well-known syari’ah classification of trade commodities for the purpose of zakat. Forexample, the jurists of Maliki School have classified trading assets into the following: (a) assets that aremeant for buying and selling; (b) assets that are held for sale in the expectation of making profits throughprice appreciation in the future; and (c) assets acquired not for trade, but for personal use.However, if we examine the conventional classification of investment in securities, normally it is onlyclassified into 2 types i.e. either dealing (short-term); or investment (long-term). The use of AAOIFI’sclassification of investment into three types would be more desirable and useful to users of accountinginformation as it provides an additional classification that distinguishes the intention or purpose ofinvestment. However, the main problem of classifying the investments is to objectively determine theintention of the investors and intention may also subject to change overtime due to the changes in economicclimate.

Recognition

AAOIFI’s FAS 17 has recommended that recognition for investment in sukuk and shares shall berecognized on the acquisition date and shall be measured at cost. However, at the end of accountingperiod, investment in sukuk and shares held for trading purposes and available for sale shall be measuredat their fair value. The unrealized gains or losses as a result of re-measurement need to be recognized in theincome statement.The additional requirement is the share of portion of income related to owners’ equity and portion relatedto unrestricted equity investment account holders must be taken into consideration. This is consideredcrucial as no proper treatment and disclosure of this transaction of profit sharing and distribution may leadto confusion as to the method, ratio and process to disburse profit that have been taken place. This is toensure transparency in profit and loss sharing on re-measurement of investment at the end of the year to beproperly disclosed to the users. At the same time it fulfils the syari’ah requirement of ensuring fair and justprofit sharing and distribution between shareholders and depositors (investors).Any unrealized gain or loss resulting from re-measurement at fair value, according to AAOIFI FAS 17shall be recognized in the statement of financial position under the “investment fair value reserve”. Thisreserve account will reflect the net gain or loss at the end of the year. The standard also makes a provisionthat in case the institution has reserves created by appropriation of profits of previous financial periods tomeet future investment risks, it is recommended that unrealized loss resulted from re-measurement ofinvestment 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 isimpairment in value it should be measured at fair value. The difference in value will then need to berecognized in the income statement and the information related to the fair value is then need to be disclosedin the notes to the financial statements. For securities held for trading and available for sale, AAOIFI FAS17 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 betweenknowledgeable 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 manyfinancial 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 othervaluation techniques. However, these techniques involve uncertainties and are significantly affected by theassumptions used and judgments made regarding risk characteristics of various financial or capital marketinstruments. The uncertainties include the arbitrary used of discount rates, future cash flows, expected lossand other factors.The determination of fair value for unquoted securities requires the availability of objective indicator andexpertise, as well as conservatism in the valuation process. The objective of Islamic valuation should be toprovide both relevant and reliable value that can be relied on by the users of financial statements to makeuseful judgment and decision (El-Tegani, undated).In the case of securities held to maturity, the rationale of AAOIFI’s FAS 17 to recommend historical costrather than fair value could be because of the inherent uncertainties in relation to the use fair value forcapital market instruments. Another reason could be because there is no intention to trade in the securitiesbefore 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 anyinvestment shall be measured at the difference between the book value and the net cash proceeds from thesale of investment. The standard also makes recommendation that different types of investment must beshown separately according to the three classifications as defined earlier. This is important to give a betterpicture of profit resulted from different types of investment. This recommended treatment is also necessaryto 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 berecognized in the income statement at the declaration date rather than at the date when the cash proceed isreceived. This indicates the use of accrual basis of accounting to ensure that the institution recognizedincome when it is realized based on the contract or the right to receive that income. The use of accrual hereis 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 todistinguish between the portion to be shared by owners’ equity and depositors (investors). The rationale issimilar 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 thedistribution 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. Amongthe requirements are that disclosure shall be made by the issuer of sukuk, if material, the face value ofsukuk, the percentage of sukuk acquired from each party issuing the sukuk and each type of sukuk. Thereis also a requirement to disclose the party guaranteeing the sukuk and the nature of the guarantee. Anotheruseful disclosure requirement is the need to disclose the contractual relationship between the issuer and/ormanager of sukuk and the holders of such sukuk. The additional disclosure with respect to investment insukuk 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 transparentin disclosing financial information pertaining investment in securities especially sukuk. The underlyingrationale is to provide useful information for users to make informed judgement especially about institution’sinvestment in securities. The users are expected to require all the above information and disclosure notonly with respect to the risks of investment undertaken and the potential return (full disclosure) but thecontractual relationships of the parties involved that is expected to fulfill the syari’ah requirements (socialaccountability).

6. Concluding Remarks

The need for Islamic accounting that deals with Islamic financial instruments has prompted AAOIFIrecently to introduce Financial Accounting Standard No.17 on investments in securities. The need for acodified Islamic accounting standard are primarily stemmed from the need that Islamic accountingobjectives,concepts and principles to be developed based on syari’ah requirements. However, the Islamicaccounting regulation also needs to adapt to the modern accounting regulatory environment to make itrelevant to be practiced in our time. The examination of AAOIFI FAS 17 shows that AAOIFI has beenpragmatic in its approach by considering both requirements when developing its standard. This is apro-active step to provide a sound accounting regulation as part of a comprehensive regulation of Islamicfinancial institutions.The development of modern accounting has shown that accounting itself is an emerging and pragmaticdiscipline. Another paramount challenge and conventional accounting is of no exception, is compliance ofthe standard. For the standard to be adopted by commercial participants, the regulatory agencies ofrespective Muslim states at least must be convinced not only for the need of such standard but the necessityto adopt it as a mandatory requirement.Another pre-requisite for a sound accounting regulation is the credibility of standard setter. In the case ofAAOIFI, the credibility of its standard will be subjected to ‘acid’ test of acceptance by commercialparticipants especially Islamic financial institutions. In addition, another challenging task would be theacceptance of juristic rules made by AAOIFI’s board of syari’ah scholars by Islamic financial institutionsworldwide. As syari’ah opinion can be subjected to vast differences among scholars, this leads to anotherneed that is a standard or a codified syari’ah rules based on consensus of credible Muslim scholars of ourtime that transcends beyond geographical boundaries of nation states.Finally, the development of a new discipline called Islamic accounting establishes an urgent need for theaccounting academics and practitioners to undertake studies that attempt to understand how accounting isinfluenced by and adapted to the way the economic system is organized and the philosophy underpinningits system. The interests on Islamic accounting has been growing for the past two decades, however, thedevelopment of Islamic accounting is still at the infancy stage. This paper is just a small contribution to theliterature on contemporary accounting regulatory issues on investments in Islamic bonds or sukuk

Any source