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An Introduction to Islamic Finance

Islamic finance is an emergent series of financial products that have been developed to meet the requirements and constraints of people that would like to follow the Shari’ah law. Islamic finance is a term that reflects financial business that is not contradictory to the principles of Shari’ah. Conventional finance relies on taking deposits from the public and providing loans to the public.

Elements such as interest and risk which are commonly found in conventional finance are prohibited under Shari’ah law. Islamic finance allows the group of people, who would like to follow Shari’ah law to invest save and raise finance by using a method which would not compromise their religious beliefs, (investments in forbidden products such as pork, prostitution and alcohol are prohibited under Shari’ah law).

Shari’ah compliance

The central focus of Islamic finance is Shari’ah compliance. To ensure compliance a distinctive feature of Islamic finance is the establishment of a Shari’ah advisory or Supervisory Board to advise the Islamic Financial Institutions (IFIs), Islamic insurance companies, Islamic funds and any other providers which offer Islamic financial products. The establishment of such a board, the opinions of which are binding on each IFI, is required to guide the institutions towards Shari’ah compliance. An institution cannot claim to be doing Islamic financial business until and unless it sets up a Shari’ah Board or Committee consisting of qualified scholars who are of high reputation and who possess the necessary skills.

The Shariah Supervisory Board issue a report that is attached with the annual audited financial statements confirming that (I) all contracts and transactions which had been entered into during the financial year as presented to the Board had complied with the Shariah rules, principles (ii) the profit distribution and loss bearing on the investment accounts are in compliance with the terms of our approval in accordance with the rules and principles of Shariah, (iii) that all incomes that have been received from non-Shariah compliance sources or by means prohibited by Shariah have been cleansed and donated to charitable purposes, (iv) that the Zakat calculation has been carried out in accordance with the relevant provisions of Zakat principles and (v) that the Shariah Audit lists all activities and operations, (if any) that had been observed not to be in compliance with the Shariah rules.

Unlawful goods or services

Another equally important feature is that Islamic finance must not be involved in any activities pertaining to unlawful goods and services. These prohibited goods and services include, among others, non-halal foods such as pork, non-slaughtered animals or animals which were not slaughtered according to Islamic principles, intoxicating drinks, entertainment and pornography, tobacco-related products and weapons. Non-involvement is not only limited to buying or selling but also includes all chains of production and distribution, such as the packaging, transportation, warehousing and marketing of these prohibited goods and services.

Avoidance of Riba

As a key to understanding Islamic finance it is important to further explain the meaning of two terms or concepts that must be avoided by Islamic finance in all circumstances: Riba and Gharar. The avoidance of these two elements is a basic requirement of all Islamic financial activities.

Riba

Riba is simply translated into English as ‘usury’ or ‘interest’. Any premium charged on money borrowed is tantamount to Riba irrespective of the amount paid. Riba in its simplest term is an advantage to one party at the expense of another for no appropriate consideration. Islamic commercial law addresses the issue of this unjustified advantage from two possible transactions, namely in a loan or currency exchange contract as well as in a barter trading contract.

Muslim jurists have unanimously agreed that two separate classes of assets are susceptible to Riba, namely currency or money and a few commodities, mainly food items. The requirements of an exchange involving these two types of assets are the same.

These requirements are only applicable when there is an exchange of one currency for another currency whether it is the same currency or different currencies.  The requirements also apply to the exchange of a food item for another food item, be it of the same food item or of different types and kinds.

The avoidance of uncertainty or gambling

All transactions made by Islamic financial institutions (IFIs) must be free from elements of uncertainty (Gharar) and gambling (Maisir). This is because Gharar might lead to disputes caused by an unjustified term in the contract arising from misrepresentation and fraud. Gambling is seen as an action that always enriches one party at the expense of the other; a zero-sum-game.

The components of Islamic finance

Takaful – Islamic insurance

Takaful is an Islamic alternative to conventional commercial insurance based on the concept of mutual support. Takaful provides mutual protection of assets and property. Takaful is similar to mutual insurance in that members are the insurers as well as the insured.

Sukuk (Islamic bond)

Sukuk in Islamic finance is the financial certificate equivalent to conventional debt issuances such as bonds. However, unlike debt issuances, sukuk holders are the legal and/or beneficial owners of the underlying assets, and as such, receive the equivalent of a coupon from the performance of the yielding asset.

Major contacts used

The two most popular forms of finance are Mudarabah and Murabahah.

Mudarabah-Partnership Contract

Under a Mudarabah financing contract, the bank agrees to finance the entrepreneur on the understanding that both parties will share the profits of the particular venture being financed.

Murabahah-Cost plus sale

Murabaha is a sale in which the seller sells his merchandise for more than the price at which he acquired it.

Murabaha is a financing scheme in which a financial institution agrees to purchase merchandise for a client provided that the client promises to purchase it from the financial institution at an agreed mark-up.

Accounting Policies

Although there is an Islamic Board for Auditing and Accounting that issues auditing and accounting policies, these are mostly in line with International Auditing Standards and International Financial Accounting Standards. The reason for this is that both the banking regulators and the stock exchanges required that the financial statements of all listed companies prepared on the basis of IFRS.

Short-term Murabaha

As an example short-term murabaha maturing within one year of the financial position date are stated at amortized cost.

Depositors’ Accounts

The depositors’ accounts of an Islamic Bank comprise the following:

  • Non-investment deposits in the form of current accounts. These deposits are not entitled to any profits nor do they bear any risk of loss as the Bank guarantees to pay the related balances on demand. Accordingly, these deposits are considered as Qard Hasan from depositors to the Bank under Islamic Shariah. Investment savings accounts are valid for an unlimited period.
  • Investment deposits comprise various types of deposits for unlimited periods and Tawfeer (savings) accounts. Unlimited investment deposits are initially valid for one year and are automatically renewable for the same period unless notified to the contrary in writing by the depositor.

In all cases, the investment deposits receive a proportion of the profit as the board of directors of the Bank determines, or bear a share of loss based on the results of the financial year. ­There is a formula that is used for the various types of deposits for unlimited.

On the basis of the results for the year, the Board of Directors determines the depositors’ share of profit of depositors of the Bank.

Dahman Awadh Dahman 
RSM Dahman
United Arab Emirates

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