What it means
Islamic finance applies Shariah principles to banking, lending, investing and insurance. The main prohibitions are on riba, which means charging or paying a guaranteed return on money lent, on gharar, which is excessive uncertainty in a contract, and on maysir, which is gambling or speculation.
Businesses in certain industries, such as alcohol and gambling, are also excluded. Instead of lending money at interest, Islamic institutions use contracts based on real assets and shared risk.
In a murabaha, the bank buys an asset and sells it to the customer at a disclosed profit margin, which the customer pays in instalments. In an ijara, the bank buys an asset and leases it to the customer, and in a sukuk, investors hold certificates that represent a share in an asset or business, instead of a debt.
Compliance is overseen by a Shariah board, a panel of scholars that approves a bank's products, contracts and policies, and reviews them over time. Many investment indices and funds apply screening rules to filter out companies that fail the tests.
Different schools of thought and different countries interpret the rules in slightly different ways, so standards are not identical everywhere. For a business, Shariah-compliant finance is relevant whenever it raises funds, banks or sells in markets where Islamic finance is common.
It can also give access to investors who only invest in compliant assets. The contracts can look different from conventional loans, so finance teams need to understand how the payments are structured and how they will be shown in the accounts.
Accounting for these contracts needs care, because the legal form and the economic effect may differ. Standards setters have published rules for Islamic financial institutions, and many follow international financial reporting standards alongside them.
A finance team should confirm how a murabaha receivable or an ijara lease is classified before preparing its statements. The nuance is that Shariah compliance is about the structure and substance of the transaction, not only about the label.
A product that copies the cash flows of an interest-bearing loan without a real asset or shared risk can draw criticism from scholars. Rules and screening thresholds vary between standard setters, so they should be checked for each product.
In practice
Real-world examples.
Example
A small business needs to buy a delivery van but wants to avoid an interest-based loan. It uses a murabaha, where the bank buys the van for $40,000 and sells it to the business for $43,200, payable in monthly instalments.
Example
A government in a Muslim-majority country wants to fund a new road without issuing a conventional bond. It issues a sukuk, so investors receive payments linked to the income from a defined asset.
Example
A fund manager builds a Shariah-compliant equity portfolio. She screens out banks that rely on interest, alcohol producers and highly indebted companies, and the fund's Shariah board reviews the list each quarter.
Formula
Calculation
Debt screening ratio = total interest-bearing debt / market capitalisation x 100
Suppose a screening standard requires this ratio to be below about one third, or 33%, though thresholds vary by standard. A company has a market capitalisation of $900,000,000 and interest-bearing debt of $240,000,000. The ratio is 240,000,000 / 900,000,000 = 0.2667, or about 26.7%. That is below 33%, so the company passes this test, although it would still need to pass the tests on business activity and on interest income.Case study
Seen in the real world.
Desert Bloom Trading is an illustrative, fictional company that imports building materials and wanted to expand its warehouse. Its owners preferred a Shariah-compliant structure and approached an Islamic bank.
The bank agreed to buy the new warehouse equipment for $500,000 and lease it to the company over five years under an ijara contract, with the company paying $110,000 each year. The total payments were $550,000, and the company took ownership at the end of the term.
The finance manager compared this with a conventional loan and found the total cost was similar, but the contract was based on a real asset and a lease. The illustrative lesson was that Islamic finance can give businesses a different route to funding, provided they understand the structure and its legal obligations.
Watch out
Common mistakes.
- Assuming Islamic finance is simply conventional finance with different names, when the contracts are built around real assets and shared risk.
- Believing that Shariah standards are identical in every country, when scholars and regulators interpret details differently.
- Thinking Shariah-compliant products are only for Muslims, when many are open to any customer or investor.
Questions
People also ask.
What does Shariah-compliant mean?
It means a product or investment follows Islamic principles, which means avoiding interest, excessive uncertainty and prohibited industries.
Who decides whether a product is compliant?
A Shariah board of qualified scholars reviews and approves it, often under the guidance of national regulators or standard-setting bodies.
Is Islamic finance more expensive?
Costs vary, and for many products the total cost is comparable to conventional alternatives, although structuring and legal work can add fees.
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