P4 Islamic finance – theory and practical use of sukuk bonds(1)

The growth and popularity of the use of Islamic finance has been exceptional

since the Central Bank of Bahrain issued the first sovereign sukuk bonds in

2001. It is estimated that by the end of 2012 Islamic financial assets will have

exceeded $1,600bn, which is around 1–2% of global financial assets

worldwide.

ACCA recognised the importance of Islamic finance and introduced it in the

Paper F9 syllabus two years ago. The ACCA syllabus states students should be able to: ‘Identify and briefly discuss a range of short- and long-term Islamic

financial instruments available to businesses.’

From this year, Islamic finance becomes part of the Paper P4 syllabus, but at a

different level to that which is tested at Paper F9. A successful Paper P4

student must: ‘Demonstrate an understanding of the role of, and developments

in, Islamic financing as a growing source of finance for organisations;

explaining the rationale for its use, and identifying its benefits and

deficiencies.’

This article is focused on Islamic finance as a growing and important source of

finance. In particular, it looks at the success and failure of the use of sukuk

bonds to finance the purchase of assets. However, for the purpose of reference,the attached appendix explains the basic principles of Islamic finance.

Sukuk finance

What is sukuk finance? The official definition provided by the Accounting and

Auditing Organization for Islamic Financial Institutions (AAOIFI), the Bahrainbased Islamic financial standard setter, is ‘certificates of equal value

representing undivided shares in the ownership of tangible assets, usufructs

and services or (in the ownership of) the assets of particular projects or special

investment activity.’

Sukuk is about the finance provider having ownership of real assets and

earning a return sourced from those assets. This contrasts with conventional

bonds where the investor has a debt instrument earning the return

predominately via the payment of interest (riba). Riba or excess is not allowed

under Sharia law.

There has been considerable debate as to whether sukuk instruments are akin

to conventional debt or equity finance. This is because there are two types of

sukuk:

l  Asset based – raising finance where the principal is covered by the

capital value of the asset but the returns and repayments to sukuk

holders are not directly financed by these assets.

l  Asset backed – raising finance where the principal is covered by the

capital value of the asset but the returns and repayments to sukuk

holders are directly financed by these assets.

There are fundamental differences between these. The diagrams set out below explain the mechanics of how each sukuk operates.

Asset-based sukuk

Sukuk Al-ijarah: financing acquisition of asserts or raising capital through sale

and lease back.