Islamic Financing Instruments (Sukuk)


Prepared by:  Dr. Rafiq Tawfiq Al Dweik
ASCA (Jordan) BOD Member
The first part of the article: General Provisions and Accounting Principles
First: Difference between sukuk (Islamic bonds) and conventional bonds:

Emerging Islamic (sukuk) have emerged to fill the gap in the global capital market. An Islamic investor wants to balance his portfolio with products such as bonds. Sukuk is an asset-based investment - not a debt instrument - and it suits Islamic Shari’a. In other words, sukuk represents ownership in tangible assets, usufruct of an asset, service, project, business or joint venture.

Each suk has par-value (based on the value of the asset that the investor subscribe in part of its value), and investor may pay the purchase price (as in conventional bonds) at a premium or discount.

Investors' reward for Sukuk

For Sukuk, future cash flows from the assets in question are translated into current cash flows. Sukuk may be issued against existing assets or assets to be created in the future. Investors who purchase sukuk are rewarded with a share of the profits derived from the assets, and do not receive interest from the sukuk because it is against Islamic Shari’a.

Re-purchase the sukuk at maturity

As with conventional bonds, sukuks are issued with specific maturity dates. On the maturity date, the sukuk issuer repurchases them, and the sukuk is usually issued through a facility called the "Special Purpose Company" or “Special Purpose Vehicle-SPV” as will be explained later.

However, for sukuk, the initial investment value is not guaranteed. The sukukholder may or may not be able to collect the entire investment (par-value). This is because, unlike conventional bondholders, sukukholders share the risk of Sukuk-issued assets. If the outcome of the project or the business for which the sukuk is issued is not as expected, the sukukholder shall bear a share of the loss.

The issuance of Islamic sukuk is based generally on the principle of repurchase of Sukuk on the basis of the net asset value of the Sukuk issued against it or at a price agreed at the time of purchase of the Sukuk.

In practice, some sukuk are issued with repurchase guarantees just as with conventional bonds. Although there is no consensus among Shari’a advisors that this arrangement is in line with Islamic Shari’a, bearing in mind that Ijara Sukuk (lease sukuk) may be issued with a guarantee of repurchase.

Ensure compliance of sukuk with Shari’a

The main feature of Sukuk – represented by granting of partial ownership of assets issued against them - is in line with Islamic  Shari’a. This provision means that sukuk investors have the right to receive a share of the profits from operating assets issued.

Second: Legislative and regulatory matters related to Islamic instruments:

a- Jordan has recently been concerned about issuing Islamic sukuk. In the last third of 2012, the Islamic Finance Sukuk Law No. (30) for the Year 2012 was issued to regulate the issuance, trading and listing of these sukuks, and issued several by-laws and regulations pursuant to the provisions of the said Law, deals with regulating the issuance of sukuk, registering and listing them at Security Depository Center and trading them on the Stock Exchange Market, organizing sukuk contracts and establishing the registration and operation of the “Special Purpose Company” that is entitled with issuing the sukuk.
b- The above Law stipulates that Islamic sukuk are documents with equal value that represent common shares in the ownership of a project which is an income generating economic activity. Sukuk are issued in the names of its owners in exchange for the funds they provide for the project and its exploitation for a period specified in the prospectus according to Islamic Shari’a principles. Sukuk are tradable in the Stock Exchange Market and the ownership of Sukuk continues as far as the project is existing or until amortizing sukuk whichever is earlier.
c- Pursuant to the above-mentioned Law, the party wishing to issue Sukuk may establish a “Special Purpose Company-SPC” to own the assets, benefits or rights against which the sukuk is issued. SPC shall own the Project for the purpose of securitization, issuing sukuk, manage the Project and distributing Project’s revenues to sukukholders.  The Special Purpose Company By-Law No. (44) for the Year 2014 stipulates that SPC shall take the type of private limited liability company listed in the Jordanian Companies Law.
d- The SPC shall undertake to transfer the ownership of the Project’s assets in its name by asking the relevant authorities to establish a record that the assets transferred in its name are for the purpose of issuing sukuk, and may not be disposed of by sale, mortgage, provisional seizure or execution. SPC is required to prepare annual financial statements, and financial statements for the  Project, both shall be audited by an external auditor.
e- Pursuant to  FASB Interpretation 46(R) Special purpose Company (SPC), also referred to as off–balance-sheet arrangements, were used as far back as the 1970s, when many companies engaged in securitization. Originally, these transactions served a legitimate business purpose: to isolate financial risk and provide less-expensive financing. In theory, because SPCs do not engage in business transactions other than the ones for which they are created, and their activities are backed by their sponsors, they are able to raise funds at lower interest rates than those available to their sponsors.

Third: Shari’a controls for Islamic sukuk:

Among the most important Share'a rules governing the issuance and circulation of Islamic Sukuk are the following:
a- The sukuk are govern by Islamic investment contracts such as: Musharaka, Salam, Istisna'a (manufacturing), Ijarah (lease) and other similar contracts when they comply with the provisions and principles of Islamic Shari’a.
b- The sukuk shall be regulated by the provisions of Islamic participation, including the mixing of funds and participation in profit and loss, ie the implementation of the principle of “ Gain vs. Loss ”.
c- The issuer of the Sukuk shall have a legal personality independent of the persons participating in the sukuk and shall be responsible for the management of the sukuk.
d- The Sukuk shall be managed by the issuing company in return for a common rate of return in accordance with the Mudaraba Provision. Sometimes the Sukuk participants may agree with the Issuing Company that the latter shall manage the Project for a given fee regardless of the profit, and this is independent of Mudaraba contract that Shari’a advisors permitted that.
e- The method of distributing the yield between the participants in sukuk and the issuing company shall be expressly stated in the prospectus and shall not be deferred until after the end of the Project or activity financed by the sukuk.
f- A third party may intervene to guarantee the capital of the sukuk or to guarantee a minimum rate of return and to do so by means of donation and fornication.
g- If there is a loss, God forbid, without negligence or transgression from the issuing company that manage the Project, then participants in sukuk shall bear the loss, not the issuing company that has lost its effort.
h- The periodic yield (returns) shall be measured prior to Sukuk maturity in accordance with the principle of actual liquidation or judgmental (discretionary) settlement in the light of the Shari’a criteria that govern this issue.
i- Ownership of periodic dividends shall not be credited to the related accounts until securing the safety of the capital in accordance with the principle of "profit securing capital protection" or the accounting concept: "No profit shall be made until after the safety of the capital". (i.e. calculation of future risk reserve).
j- Sukuk shall be traded on the Stock Exchange Market or by any appropriate alternative means in accordance with the Shari’a Rules. Sukuk shall be evaluated in the course of trading through bargaining and concurrence between seller and buyer, all in light of the regulations and conditions governing this transaction.
k- The issuer of the sukuk may undertake to repurchase the sukuk from its holders according to its market value or at the price it offers, and this shall be done by mutual agreement between the parties.
l- Sukuk are amortized either at the end of the Project or the operation or at periodic intervals. This is called the amortization of sukuk. Amortization of sukuk shall be stated in the prospectus.

Fourth: Financial rules and regulations governing Islamic Sukuk:

The financial relationship between the issuing company and sukukholders:
a- Sukuk do not represent debt to the sukukholder toward the issuing company at issuance date. Considering that the sukukholders are the purchasers of the project assets, and the proceeds of issuing the sukuk are the price or the fare.
b- The sukukholder shall participate in the profits of the project and in the liquidation results by the percentage of his holdings, and shall bear the loss, if any, according to the percentage of his holdings, according to the rule of "Gains vs. loss".
c- The sukukholder shall bear the consequences of the leased assets and their guarantee as they are the owners.

Issues relating to the accounting treatment of the project assets:
a- The ownership of the assets, benefits or rights of the Project shall be transferred to the issuing company for the purpose of issuing the Islamic sukuk  at the fair value
b- The issuing company shall record the fair value of the assets, benefits or rights transferred to it as Project receivables until the price is paid from the proceeds of the underwriting in the sukuk.
c- Fair value adjustments of the assets, benefits or rights transferred to the issuing Company in the Company's books are recognized in shareholder’s equity account under "Asset Fair value adjustments" until the end of the securitization process and the collection of the assets’ price from the proceeds of the issue. At that time, fair value adjustments shall be recognized as capital gain or loss - as the case may be - in the comprehensive income statement for the year in which the transfer was made.
d- Upon completion of the Sukuk underwriting, the Issuer shall collect the value of the assets, benefits or movable rights of the Company from the underwriting proceeds.
e- In the event of non-completion of the underwriting of the Sukuk, the situation shall be returned to the same as with respect to the transfer of the assets and the their fair value adjustments.

Project Accounts and Financial Statements:
a- The issuing company maintains separate accounts for the project and shows the net assets and results of the project in contra accounts in the company's financial statements (off–balance-sheet).
b- The issuing company shall debt Project assets and credit the sukukholders in the Project accounts with the fair value of the assets, benefits or rights transferred to it.
c- The issuing company evaluates the project assets according to the market value, when preparing the financial statements of the project, and uses the expertise and competence in this respect, which is considered a sound basis for evaluating the value of the sukuk when trading, repurchase or considering of capital gains or loss.
d- The issuing company shall take into account future risks reserve by calculating the necessary provisions before distributing of the periodic (annual) returns as long as the Project or the operations related to issued sukuk have not yet ended, in order to keep safe the capital.
e- When consolidating the financial statements of the parent company (the owner of the Special Purpose Company) with the financial statements of the subsidiary company at the end of the financial year, the assets and the operational results of the Special Purpose Company shall be consolidated apart of the Project accounts, assets and results of the project. The Project accounts are presented in consolidated financial statements of the parent company contra accounts. In this case, the Special Purpose Company shall record its share of the proceeds of the Project and its own expenses only, in addition to any assets owned by the Company or liabilities realized as the Company is a legal entity, and the said items are consolidated with the parent company's financial statements.

Amortizing the sukuk:
a- Amortization or redemption of the sukuk means the distribution of the Project’s assets to sukukholders or their sale to the issuer, and the distribution of the proceeds of their sale to sukukholders by their respective sukuk holdings.
b- The Company undertakes to liquidate the sukuk assets at the end of the sukuk period at the market price, actual or judgmental liquidation, distribution of capital and realized profit, unless it is proved that the assets have been impaired or its value have been reduced without delinquency by the issuing company.
c- The liquidation shall be either at market value or as agreed upon at the time of execution of the purchase promise, or at net asset value, or at fair value or at knowledgeable judgment when performing the sale promise, conditional the prospectus to include the method to determine the liquidation value.

Equity items of the Sukukholders in the Project's financial statements:
Equity items in the Project accounts shall include:
a- Par-value of issued Sukuk
b- Future Risk Reserve
c- Fair value adjustment for the project
d- Retained earnings (loss)

The share of the issuing Company from the proceeds of the Project
a- The share of the issuing Company from the proceeds of the Project, as stipulated in the prospectus, to be recorded as income in the Income Statement.
b- Any unrealized future returns during the financial year are capitalized within a deferred income account.
c- A statutory reserve to be deducted from the net profit for the year in accordance with the provisions of Article (11) of The Special Purpose Company By-Law No. (44) for the Year 2014.

The accounting principles for issuing and trading Islamic sukuk:
The accounting, recording, measurement and accounting disclosures for the issuance and trading of Islamic sukuks govern by a set of accounting principles derived from the Accounting Standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions, the most important of which are the following:
a- The basis of the independence of the issuing Company's liability (the founder of the Sukuk) shall be considered independent from the liability of every sukukshareholder. The Company is treated as having an independent legal personality, and the sukuk operations are accounted for on this basis, especially when dealing with government entities and third parties. Accordingly, it shall have its own accounting structure and financial statements, and shall have an external auditor, as well as a Shari'a Supervisory Board.
b- The basis of the financial period, where the life of the Project or the investment process for which the sukuk were issued is divided into short financial periods, for example annually. At the end of each reporting period, the financial statements and the various reports shall be prepared, actual or judgmental liquidation principle is applied in this case pursuant to what was agreed upon, both of which are permissible from a financial and accounting perspective.
c- The basis for continuity of participation until the end of the Project or the process for which the sukuk were issued, whether the type of sukuk was: Murabaha, Istisna’, Salam, Ijara or so. Periodical accounting of the results of the business is based on the actual liquidation of a certain stage or judgmental judgment of liquidation in light of the Shari’a criteria that govern so.
d- The basis of the issuing company's issuance of the Sukuk to pear the expenses incurred in issuing the Sukuk, such as the underwriting expenses, promotion and marketing expenses and the banking expenses related to the issuance of the sukuk and the like. This should be mentioned in the prospectus unless otherwise agreed, and sukuk shall not be subject to any expenses that is the responsibility of the issuing company (the manager), assuming that the issuing company considered such when determining its common share of profits.
e- The basis of the assets of the Project or process that is the subject of the sukuk shall be evaluated on the basis of the market value when preparing the financial statements, namely the statement of financial position and the income statement - using experts and competence firms to do so, which is a sound basis for evaluating the value of the sukuk when trading or repurchase, or to specify  Capital gains or loss.
f- The basis for calculating future risks reserve, by building the necessary provisions when distributing the periodic (annual) returns as long as the Project or the operation of the issued sukuk has not yet ended, in order to preserve capital.
g- The basis of the reconciliation between operating expenses and revenues when preparing the income statement for the Project or operation financed by sukuk, in order to measure the operational returns to be distributed between the sukukholders and the issuing company and the manager, this will be ruled by Shari’a rules of the Mudaraba company as detailed in the Mudaraba jurisprudence.
h- The basis for the distribution of profit advance payments, until the final liquidation of the Sukuk, the issuing company shall debit profit account in which case any subsequent loss may be occur for the purpose of protecting capital. In this respect, actual or judgmental liquidation principle is applied as explained above.
i- The basis for the distribution of the return of the projects or operations subject to the Sukuk on the basis of a common rate for both of sukukholders and the issuing company. For example, a percentage of (  %) to sukukholders and a  percentage of  (  %) to the issuing company as provided in the Prospectus.
j- The sukuk shall be valued for trading purposes on the basis of market price on the Stock Exchange Market or consensual agreement between the parties (the seller and the buyer) and the buyer may be the issuer of the sukuk.
k- Sukuk shall be amortized periodically or at the end of the process or the project for which it was issued, in accordance with the Accepted Accounting Principles and Standards in force that are in accordance with the principles and rules of Islamic Shari’a.
l- The profits or loss of the Project or process subject to the sukuk shall be distributed in accordance with the Accounting Principles and Standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions or the prevailing financial institutions, in accordance with the provisions and rules of Islamic Shari’a.
m- Accounting disclosures for each appropriate periodic period shall be disclosed for sukuk transactions by means of accounting means, tools, and methods.
n- The Shari’a Audit of sukuk transactions shall be disclosed through the report of the Shari’a Supervisory Board of the issuing company.

Note: In the next issue we will complete the subject of Islamic Sukuk to talk about the accounting treatment for issuing and trading Islamic Sukuk.