A customer wants to buy a ₦8m machine. A conventional bank would lend ₦8m and charge interest. An Islamic bank cannot charge interest. Instead, the bank buys the machine and sells it to the customer for ₦8.8m, payable in instalments. The cash flows may look much alike, yet the contract is a trade in an asset, not a loan of money.
The difference matters in law, in accounting and in how risk is shared.
This topic covers the principles of Islamic finance (based on Shariah), what is prohibited and permitted, the main products (murabaha, ijara, mudaraba, musharaka and sukuk) and how sukuk are structured, and the role of the Shariah board. The previous topic covered finance for small businesses and venture capital. The next covers capital structure and financing theories. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic.
In 30 seconds
Islamic finance applies Shariah. Its principles: wealth comes from legitimate trade and asset-based investment; investment should bring social and ethical benefit; risk is shared; and harmful activities (haram) are avoided. Interest (riba) is forbidden, as are alcohol and gambling, speculation and contracts with uncertain terms (which rules out short selling). Banks earn profit shares or fees.
Murabaha: the bank buys the asset and resells it at a fixed mark-up on deferred terms. Ijara: the bank buys the asset and leases it. Mudaraba: the bank supplies capital and the customer expertise, with profit shared in an agreed ratio and the bank bearing losses. Musharaka: a joint venture, with profit shared by agreement and losses by capital contributed.
Sukuk are certificates of asset ownership, not interest-bearing bonds. Each institution has a Shariah board.
Key terms in plain English
| Term | What it means |
|---|---|
| Shariah | Islamic law, from the Quran and the teaching of the Prophet |
| Riba | Interest: charging or receiving a return on money lent |
| Haram | Forbidden or harmful activity |
| Murabaha | A deferred sale at cost plus an agreed mark-up |
| Ijara | A lease of an asset bought by the bank |
| Mudaraba | A partnership of capital from one side and expertise from the other |
| Musharaka | A joint venture where both sides provide capital |
| Sukuk | Shariah-compliant certificates of ownership of assets |
Syllabus check
This topic is in syllabus area C (financing decisions). It covers:
- how Islamic finance differs from traditional Western finance;
- the types of Islamic financial product.
CAMA 2020 and Islamic finance
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Financing choices should respect the company’s duties and its stakeholders |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should understand the terms and risk of any finance used |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
Non-interest finance in Nigeria is regulated by the Central Bank of Nigeria for banks and by the Securities and Exchange Commission for sukuk and other capital market products.
The principles
Islamic finance rests on Shariah, derived from the Quran and the teaching of the Prophet Muhammad. Shariah classifies actions as obligatory, meritorious, commendable, reprehensible or forbidden. The main principles are:
- wealth must come from legitimate trade and asset-based investment; using money simply to make money is forbidden;
- investment should have a social and ethical benefit beyond return;
- risk should be shared;
- harmful activities (haram) are avoided.
The aim is to avoid injustice, asymmetric risk, moral hazard (where the one who causes a problem does not bear its consequences) and unfair enrichment.
Prohibited and permitted
Prohibited
- Charging or receiving interest (riba). It contradicts shared risk, partnership and justice.
- Investing in companies with too much borrowing. What is “too much” is a matter of interpretation, typically debt above 33% of stock market value over the last 12 months.
- Businesses in alcohol, gambling or anything else the Shariah treats as unlawful.
- Speculation or extreme risk, treated as gambling.
- Contracts with uncertain subject matter or terms, including short selling (selling what is not yet owned).
Permitted
Islamic banks earn through profit-sharing investments or fees. If a loan is for business, the lender should share the risk. Typically the lender buys the asset and lets the customer use it for a fee.
The products
The cash flows may resemble conventional ones, but the return is based on the asset transaction, not interest on money lent.
- Murabaha. A form of trade credit. The bank buys the asset and sells it to the customer on deferred terms at a price that includes an agreed mark-up. Instalments are allowed, but the mark-up is fixed in advance and cannot rise, even if payment is late.
- Ijara. A lease. The bank buys the asset and leases it over a period at a rental that lets the bank recover its capital and a return.
- Mudaraba. The bank provides capital and the customer provides expertise. Profits are shared in a pre-agreed ratio but cannot be guaranteed. The bank does not manage the business. This is like equity finance. If there is a loss, the bank loses and the customer cannot be made to compensate it, since that would defeat shared risk.
- Musharaka. A joint venture or partnership where both parties provide capital. Profits are shared in an agreed ratio, which lets management skill be rewarded, and losses are shared in proportion to capital.
- Sukuk. Islamic bonds. They cannot pay interest. Holders must have an ownership interest in the assets being financed and receive a share of the income the assets produce. Modern sukuk resemble securitisations.
How sukuk work
- Sukuk al-ijarah (sale and leaseback). A special purpose vehicle (SPV) buys an asset from Business A at an agreed price, funded by issuing sukuk to investors. It leases the asset back to A for agreed rentals, which are passed on to the holders. A is the “obligor”.
- Sukuk al-mudaraba. The SPV invests in a project, such as a construction, and hires Business B to run it for a fee or profit share. Income pays B’s fee and distributions to holders.
- Sukuk al-murabaha. The SPV buys goods (for example iron ore) with the investors’ cash and sells them to Business C at a profit on a payment schedule, which is passed to holders.
- Sukuk al-musharaka. The SPV forms a joint venture with Business D, which brings expertise; holders provide finance and share profits and losses.
The Shariah board
There is no single authority on Shariah compliance. Each Islamic bank has its own Shariah board, which makes sure all its products and services comply.
The rules in more depth
Why interest is forbidden
A lender who earns interest regardless of the outcome shifts all the risk to the borrower. Islamic finance requires both sides to share risk and reward.
Why cash flows can look the same
A mark-up on a deferred sale can equal what interest would be. The difference is that the bank takes ownership and its risk of the asset, and the contract is a trade, not a loan.
Why the bank bears the loss in a mudaraba
It provided the money and shares the profit, so it must also bear the loss of capital. The customer loses its time and effort.
Why sukuk need real assets
The return must come from an asset or business, not from lending money.
Effect on analysis
Identify the product, say who owns the asset and who bears the risk, and compare the cost with a conventional equivalent.
Worked examples
Example 1: murabaha. A bank buys a machine for ₦8m and sells it to a customer at cost plus a 10% mark-up, payable in four equal yearly instalments.
- Selling price.
8m × 1.10 = ₦8.8m. - Instalment = 8.8m ÷ 4 = ₦2.2m.
- The mark-up is fixed even if an instalment is late.
Example 2: mudaraba. A bank provides ₦50m. Profits are shared 70% to the bank and 30% to the entrepreneur.
- A profit of ₦20m gives the bank ₦14m and the entrepreneur ₦6m.
- A loss of ₦10m is borne entirely by the bank, which loses ₦10m of its capital.
- The entrepreneur loses only the effort invested.
Example 3: musharaka. A provides ₦60m and B provides ₦40m. Profits are shared 50 : 50 to reward management. Losses follow capital.
- Profit of ₦20m: A gets ₦10m and B gets ₦10m.
- Loss of ₦10m: A bears 60% = ₦6m; B bears 40% = ₦4m.
- Profit shares can differ from capital shares; loss shares cannot.
Example 4: a debt screen. A company has debt of ₦40bn and an average market value over the last year of ₦100bn. The rule of thumb is a limit of 33%.
- Debt ÷ market value = 40%.
- 40% exceeds 33%, so an Islamic fund would typically not invest.
- The test is a matter of interpretation, so funds may apply different limits.
How to score full marks
- State the principle that the product respects.
- Describe who buys, owns and bears risk.
- Compare with the conventional equivalent.
- Calculate profit and loss shares correctly.
- Name the Shariah board and its role.
- Avoid calling any Islamic return “interest”.
Common mistakes in the exam
- Calling the mark-up in a murabaha interest.
- Making the entrepreneur share the loss in a mudaraba.
- Sharing musharaka losses by profit ratio, not capital.
- Saying sukuk are simply bonds paying interest.
- Forgetting that haram activities are excluded.
- Saying there is one central Shariah authority.
Quick revision
- Principles: trade and assets, ethical benefit, shared risk, avoid haram.
- Prohibited: riba, alcohol and gambling, speculation, uncertain contracts.
- Murabaha: fixed mark-up. Ijara: lease. Mudaraba: capital against skill. Musharaka: joint venture.
- Sukuk: ownership certificates, often through an SPV.
- Each bank has its own Shariah board.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. Interest in Islamic finance is called:
- Riba
- Sukuk
- Ijara
- Mudaraba
Show the answer
A. It is forbidden.
Question 2. In a murabaha the bank:
- Lends money at interest
- Buys the asset and resells it at a fixed mark-up
- Shares losses equally
- Issues shares
Show the answer
B. The mark-up is fixed in advance.
Question 3. Ijara is a form of:
- Lease finance
- Equity
- Insurance
- Trade credit only
Show the answer
A. The bank buys the asset and leases it.
Question 4. In a mudaraba the loss is borne by:
- The bank
- The entrepreneur
- Both equally
- The government
Show the answer
A. The entrepreneur loses effort.
Question 5. In a musharaka, losses are shared:
- By capital contributed
- By profit ratio
- Equally always
- By the bank
Show the answer
A. Profits follow the agreement.
Question 6. Sukuk holders must have:
- An ownership interest in the assets financed
- A fixed interest right
- No claim
- Voting rights in the bank
Show the answer
A. Not a debt claim.
Question 7. Which is prohibited?
- Short selling
- Trade in goods
- Profit sharing
- Leasing
Show the answer
A. Selling what you do not own.
Question 8. Compliance with Shariah in a bank is overseen by:
- Its own Shariah board
- A single global authority
- The stock exchange
- The tax authority
Show the answer
A. There is no ultimate authority.
Question 9. Moral hazard means:
- The one who causes a problem does not suffer its consequences
- A tax
- A lease
- A loan
Show the answer
A. Islamic finance seeks to avoid it.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) State the main principles of Islamic finance. (4 marks) (b) State four activities that are prohibited. (4 marks) (c) Explain the role of a Shariah board. (2 marks)
Question 12 (20 marks). Banu Ltd wants to acquire equipment costing ₦8m. (a) Explain how a murabaha and an ijara could finance it and how each differs from a conventional loan. (8 marks) (b) Calculate the instalment under a murabaha with a 10% mark-up payable in four equal instalments. (3 marks) (c) Explain the difference between a mudaraba and a musharaka. (5 marks) (d) Describe the structure of a sukuk al-ijarah. (4 marks)
Question 13 (10 marks). (a) A bank puts ₦50m into a mudaraba with a 70 : 30 profit ratio. Calculate the shares of a ₦20m profit and of a ₦10m loss. (4 marks) (b) A and B put ₦60m and ₦40m into a musharaka with profits shared equally. Calculate each party’s share of a ₦10m loss. (3 marks) (c) State why sukuk are not interest-bearing bonds. (3 marks)
Model answers
Show the model answer to Question 11
(a) Principles (4 marks). Wealth from legitimate trade and asset-based investment. Investment with social and ethical benefit. Risk is shared. Harmful activities are avoided. (1 each)
(b) Prohibitions (4 marks). Charging or receiving interest (riba); investing in alcohol or gambling; speculation; contracts with uncertain terms, including short selling; investing in companies with too much debt. Any four. (1 each)
(c) Shariah board (2 marks). Each Islamic institution has its own board that makes sure all its products and services comply with Shariah. (2)
Show the model answer to Question 12
(a) Murabaha and ijara (8 marks). Murabaha: the bank buys the equipment and sells it to Banu on deferred terms at cost plus an agreed fixed mark-up. (2) Ijara: the bank buys it and leases it to Banu for agreed rentals that recover its capital and return. (2) Difference from a conventional loan: the bank owns the asset and the return comes from a trade or lease, not interest on money lent.
(2) The mark-up cannot rise on late payment, and the bank bears the risks of ownership in the lease. (2)
(b) Instalment (3 marks).
- Price = 8m × 1.10 = ₦8.8m. (1.5)
- Instalment = 8.8m ÷ 4 = ₦2.2m. (1.5)
(c) Mudaraba and musharaka (5 marks). In a mudaraba the bank provides the capital and the customer the expertise, and the bank bears any loss. (2.5) In a musharaka both parties provide capital, profits are shared in an agreed ratio and losses in proportion to capital. (2.5)
(d) Sukuk al-ijarah (4 marks). An SPV buys the asset from the business and issues sukuk to investors to fund it. (1.5) It leases the asset back to the business for agreed rentals. (1.5) The rentals are passed to the sukuk holders, who own the SPV. (1)
Show the model answer to Question 13
(a) Mudaraba (4 marks). Profit ₦20m: bank 70% = ₦14m; entrepreneur 30% = ₦6m. (2) Loss ₦10m: borne wholly by the bank. (2)
(b) Musharaka (3 marks). Losses follow capital: A bears 60% × 10 = ₦6m and B bears 40% × 10 = ₦4m. (3)
(c) Sukuk (3 marks). Holders own the assets or the right to their benefits and receive a share of the income the assets generate. (2) Interest on a loan of money is forbidden. (1)
Pathfinder on Shariah principles, murabaha, ijara, mudaraba, musharaka and sukuk
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic. Questions on it are likely to ask you to explain a product and compare it with a conventional one. Worked examples 1 to 4 show the products with numbers.
Revise first: Worked examples
See the section on the products for murabaha, ijara, mudaraba, musharaka and sukuk, with who owns the asset and who bears the loss.
Revise first: The products
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
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