Sukuk Classification and the Substance-over-Form Test
An entity issues a 200 million sukuk al-mudaraba with a 7-year term. The sukuk holders receive a distribution calculated as 6% of the issue amount, payable semi-annually, and the issuer has a contractual obligation to make the payment even if the mudaraba makes a loss; the shortfall is funded by the issuer's own resources. At maturity the issuer must redeem at par. The issuance costs are 4 million. The CFO argues the sukuk is an equity instrument because it is labelled mudaraba and Shari'ah-compliant, so the 6% distributions should be treated as equity distributions and the 4 million as a deduction from equity. The auditor notes the sukuk assets are ring-fenced and the issuer has no obligation to repay if the mudaraba assets are insufficient - but the contractual guarantee contradicts that. Management wants the most favourable classification for the debt covenant, which measures debt-to-equity.
1. How should the sukuk be classified under the AAOIFI financial accounting framework, and why does the label not control?
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Classification follows substance over form, not the Shari'ah label. The key question is whether the issuer has an unconditional obligation to deliver cash or another financial asset, or to settle in a way that is a financial liability.
Here the issuer:
- Must pay 6% semi-annually even if the mudaraba makes a loss, funded from its own resources;
- Must redeem at par at maturity.
Those features create an unconditional obligation to pay cash, so the instrument is a financial liability, not equity. The mudaraba label and the ring-fencing are contradicted by the contractual guarantee; the guarantee is the dominant term. The 6% distributions are therefore finance costs (profit expense), not equity distributions, and accrue over the term. The 4m issuance costs are amortised over the 7-year term as part of the effective cost, not deducted from equity.
Management's covenant motive is irrelevant to classification. The auditor should require liability classification and disclosure of the terms, the guarantee, and the accounting policy.
2. If the guarantee were removed so that holders genuinely bear the mudaraba loss and there is no par redemption obligation, how would the analysis change?
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Without the guarantee and without a par redemption obligation, the holders genuinely share in the mudaraba's profit and loss and the issuer has no unconditional obligation to pay cash. The instrument would then have equity characteristics:
- Distributions would be recognised as equity distributions when declared, not as a liability or expense.
- The 4m issuance costs would be deducted from equity (or from the sukuk proceeds) rather than amortised as finance cost.
- No finance cost accrual; the return depends on actual performance.
However, the analysis must still check for any embedded obligation (e.g., a redemption feature, a conversion, or a mandatory distribution) that reintroduces a liability component. If the instrument is compound (part liability, part equity), it must be split and each component accounted for separately. The change in classification must be disclosed with the reasoning, and the entity cannot switch classification to suit a covenant.