Economic substance or legal form: an evaluation of Islamic finance practice

Abstract

Purpose Islamic financing is based on the ideology of Islam, proposing a different economic system than capitalism. The essence of Islamic financing lies in trading of goods, provision of services and/or investment under profit and loss sharing. This study aims to examine legal forms and economic substance of the contracts used by the Islamic financial industry. Design/methodology/approach To conclude on the objectives of the study, five most widely used contracts (modes/products), including Murabaha, Ijarah, Diminishing Musharaka, Sukuk and Mudaraba (deposits), were selected to test against the theory of the Islamic financial system. Findings It is found in the process that legally (legal form) contracts/products are in line with theory; however, economic substance is not very different from conventional counter parts. Practical implications Through application of alternative calculation measures/methods and proper training of human resources, Islamic financial institutions can shift economic substance of contracts in line with the theory of Islamic finance. Originality/value Islamic finance is an emerging area, and reasonably good amount of literature is available; however, perhaps, this is the only piece of work focusing on calculation methods, contributing in economic substance of contracts, being used in modern Islamic finance in addition to legal form as per essence of Islamic financial system.