Islamic Finance, Research Paper Example

History

Middle Eastern traders had been engaging in financial transactions on the basis of Sharia as early as 1000 A.D. The Ottoman Empire had strong trading relationship with the Spanish and had established interest-free financial systems. Even though the real growth of Islamic finance in modern times started in the 1980s, the first financial company based on Sharia law, Mit Ghamr was established in the 1970s in Egypt. By the late 1970s, Islamic finance had started gaining transaction due to the presence of Islamic banks such as Islamic Development Bank and Dubai Islamic Bank. The Islamic financial sector has been growing at a rate of 10-15 percent since the 1990s and the trend is expected to continue into the near future (Schoon).

Principles

In Islam, the religion and financial system are not separate, thus, religious principles shape financial dealings. Thus, Islamic financing is not available to industries whose business nature clashes with one or more of Islamic principles. This means that financing is not available for activities such as manufacturing and distribution of alcohol and pork products for human consumption, gambling activities or manufacturing of gambling equipments, movie production, pornography, financial sector players such as banks, insurance companies, and brokerage firms which derive at least some income through interest, and any businesses for whom prohibited products such as alcohol serve as valuable revenue streams (Tannenbaum). Another Islamic finance principle is the sharing of profit and loss between parties to the transaction. In other worlds, the lender does not demand interest but instead becomes a partner to the borrower in the business venture or activity for which funds are lent. Thus, a lender has a vested interest in the success of the borrower because he makes money only if the lender’s venture succeeds (LAWorld).

Islamic Financial Accounting Standards

Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) had started creating Islamic Financial Accounting Standards as early as 1993. Some of the Islamic countries that follow AAOIFI’s standards include Bahrain, Malaysia, UAE, Saudi Arabia, Lebanon, Syria, Sudan and Jordan. AAOIFI standards could be divided into 5 categories which are accounting standards, auditing standards, governance standards, ethics standards, and Sharia standards. The standards under accounting category include objective of financial accounting for Islamic banks and financial institutions, equity of investment account holders and their equivalent, mudaraba financing, musharaka financing, and provisions and reserves. The standards under the auditing category include the auditor’s report, terms of audit engagement, and testing for compliance with Sharia rules and principles by an external auditor (IslamicBanker).

The standards under the governance category include Sharia review, internal Sharia review, independence of Sharia Supervisory Board, and corporate social responsibility. The standards under ethics standards are code of ethics for accountants and auditors of Islamic financial institutions and code of ethics for employees of Islamic financial institutions. The standards under the Sharia category include trading in currencies, default in payment by a debtor, guarantees, hawala, murabaha to the purchase orderer, mudaraba, Islamic insurance, and arbitration (IslamicBanker).

To date, AAOIFI has issued over fifty standards in the five categories mentioned above. In addition to AAOIFI, some other regional standard-setting groups have also developed their own standards. One example is ICAP of Pakistan which has produced two Islamic Financial Accounting Standards (IFAS) which are IFAS 1 Murabaha and IFAS 2 Ijarah. The second example is Indonesian Accounting Institute (IAI) which has developed a Framework for Preparation and Presentation of Shariah Financial Statements as well as eight Sharia accounting standards. The standards issued by IAI are PSAK 101 Presentation of Sharia Financial Statements, PSAK 102 Accounting for Murabaha, PSAK 103 Accounting for Salam, PSAK 104 Accounting for Istishna, PSAK 105 Accounting for Mudarabah, PSAK 106 Accounting for Musharakah, PSAK 107 Accounting for Ijarah, and PSAK 108 Shariah Insurance Transactions (IFRS).

Usury in Islam

As with other aspects of life, commerce is not separate from religion in Islam. Islamic finance has been shaped by the teachings in the Quran and Quran forbids either charging or earning of interest. Interest is also called riba or usury. According to Islam, money on its own should not generate profits but instead should be spent on activities that earn income. According to Islamic philosophy, a focus on interest results in money not being put into productive uses. According to Muslims, even Judaism and Christianity forbid the pursue of interest income (alBaraka).

Islamic Financial Transaction Terminology

Islamic financial transaction has established its own terminology over the years. Some terminologies may vary across Muslim countries due to language differences but certain terminologies have gained widespread acceptance in the Muslim World. Amanah refers to lender of money or a seller of a good or service keeping a property of the borrower in trust. This action is intended to develop trust and honest among the dealing parties. Arbun refers to down payment and Gharar refers to activities that may be out of one’s control. Ijara refers to leasing and Maysir refers to actual act of gambling such as derivative contracts and insurance (The Islamic Banker).

Murabaha Muajjal refers to a profitable sale by the seller in which the buyer pays for the commodity in a lump sum or installments at future date/s. Bai Salam refers to advance payment for goods to be delivered later. Dayn is debt which is incurred as a result of a rent, sale, or purchase of a good and must be returned without profit. Hawalah is the transfer of debt claim from one individual to another. Mubah refers to lawful objects which can either be used or traded. Murabaha refers to a sale on a mutually-agreed profit terms. Mudaraba refers to partnership between two parties in which one provides funds while the other party provides expertise. Similarly, Musharakah refers to contract between parties in which they agree to share profits/losses in a joint venture. Riba refers to an amount in excess of principal or in other words, interest. Salaf refers to loans which earn no profit and they also cannot be called back before due date. Shirkah is a contract between parties for launching a joint venture to earn profits. Wakalah refers to appointing someone for the purpose of doing certain tasks in one’s place (Ayub).

Controversy

Islamic finance has had its fair share of controversies. One of the defining features of Islamic finance is prohibition on interest income but some Muslims challenge the idea and argue that ban in older times was meant to prevent enslavement of people who could not afford high interest rates. Times have changed now and a ban on interest rate is not in line with the circumstances existing today. Similarly, many Islamic countries such as Saudi Arabia are also accused of hypocrisy because they borrow money in the international markets in which interest is paid. The Sharia Boards at Islamic Banks also sometimes face credibility issues because there are very few Islamic scholars who are well-versed in both the affairs of finance and the religion. Another controversy surrounding Islamic finance is the difficulty of arriving at uniform standards. Even though AAOIFI has been trying to produce uniform standards, the lack of consensus among religious scholars make it quite a difficult task. Islamic financial system also struggles to gain acceptance because of low liquidity. For example, the Sharia compliant repo market is almost nonexistent. Similarly, Islamic financial system is often not ready to take advantage of short-term opportunities which result in liquid assets lying around idly. Similarly, the field of Sharia auditing is also in infancy (Malik, Malik and Mustafa).

Conclusion

Islamic finance is not a new idea but it has only gained traction since 1980s. Islamic finance draws its principles from the religion Islam itself and its most defining feature is prohibition on interest. Islamic finance often involves the lender becoming a partner in the venture being pursued by the borrower or the borrower may simply buy an asset from the lender at a premium to the cost. Islamic finance is still in infancy and its financial accounting standards continue to be developed. Arguably, the most influential standard-making body in Islamic finance is AAOIFI which has developed over fifty standards to date. Islamic finance is not without controversy because it is still developing and in addition, there are issues of low demand and liquidity.

References

alBaraka. Principles of Islamic Banking. 8 July 2013 <http://www.albaraka.com/default.asp?action=article&id=46#1>.

Ayub, Muhammad. Glossary of Islamic Banking Terminology. 8 July 2013 <http://www.iefpedia.com/english/wp-content/uploads/2009/09/GLOSSARY-OF-ISLAMIC-BANKING-TERMINOLOGY.pdf>.

IFRS. Financial Reporting Issues relating to Islamic Finance. 29-30 September 2010. 8 July 2013 <http://www.ifrs.org/Meetings/MeetingDocs/IASB/Archive/Leases/Leases-0511b02A-app.pdf>.

IslamicBanker. AAOIFI Standards. 8 July 2013 <http://www.islamicbanker.com/aaoifi-standards>.

LAWorld. The principles of Islamic finance. 8 July 2013 <http://www.laworld.com/welcome/home/the-principles-of-islamic-finance>.

Malik, Muhammad Shaukat, Ali Malik and Waqas Mustafa. “Controversies that make Islamic banking controversial: An analysis of issues and challenges.” American Journal of Social and Management Scciences 2011, 2(1) ed.: 41-46.

Schoon, Natalie. “Islamic finance – a history.” Financial Services Review August 2008: 10-12.

Tannenbaum, Michael G. Principles of Islamic Finance. Client Report. New York City: Tannenbaum Helpern Syracuse & Hirschtritt LLP, Winter 1998-1999.

The Islamic Banker. Islamic Financial Terminology. 8 July 2013 <http://www.theislamicbanker.com/islamic-financial-terminology/>.